Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 14

Measuring Risk for Capital Adequacy: The Issue of Profit-Sharing Investment Accounts

Simon Archer and Rifaat Ahmed Abdel Karim

1. INTRODUCTION

This chapter is concerned with the rationales for the regulation of capital adequacy and their applicability to Islamic banks. Section 2 examines the rationales for capital adequacy of conventional banks. Section 3 analyses the extent to which these rationales are applicable to Islamic banks, and examines the issues that arise in that context. Section 4 considers the links between capital adequacy and risk management in the context of the Basel Committee on Banking Supervision’s (BCBS) Revised Framework (Basel Committee on Banking Supervision, 2004) and the subsequent BCBS publications on the subject in the context of what is generally known as Basel III. Section 5 sets out some concluding remarks.

2. WHY CAPITAL ADEQUACY?

All organisations that incur liabilities require some form of capital backing in order to support those liabilities—that is, for the purpose of creditor protection. In the nonprofit or government sectors, this backing may be in the form of a guarantee. For commercial firms, market forces operate so that undercapitalised firms find it hard to obtain credit. In many jurisdictions (but not, for example, in the United Kingdom), commercial firms that are limited companies are also required by law to build up a “statutory reserve” out of retained profits for creditor protection purposes, and are subject to dividend ...