CHAPTER 14Capital Adequacy Concerns

Since the Islamic financial industry is young and the balance sheet size of the average Islamic bank is still relatively small, issues associated with the calculation of regulatory capital are in part similar to those faced by small, locally operating, conventional European and North American banks. However, because of the transaction structures employed, Islamic banks may face higher charges for regulatory capital, particularly in relation to the profit sharing investment accounts.1

For conventional banks, part of regulatory capital is absorbed by interest rate risk in the banking book. The absence of interest in Islamic finance means that Islamic banks are not subject to interest rate risk, but instead face rate of return risk, which is in some ways analogous to “interest rate risk in the banking book”. Islamic banks are not subject to lower levels of risk and subsequently regulatory capital than conventional banks.

Similarly to conventional financial institutions, Islamic banks incur liquidity, credit, settlement, leverage, operational and business risk. Liquidity risk for Islamic banks is more difficult to manage and more expensive than for conventional banks due to the absence of liquid and accepted primary liquidity instruments (i.e. certificates of deposit, commercial paper and Treasury bills). Government securities such as Treasury bonds and gilts as well as eurobonds and domestic bonds are not permissible, and although few instruments ...

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