Challenges in implementing capital adequacy guidelines to Islamic banks

In 1998, Hong Kong Shanghai Banking Corporation (HSBC), one of the leading banks in the financial intermediation international landscape, opened HSBC Amanah, a global Islamic division dedicated to catering to the demand for Sharia-compliant products.

Only Malaysia and Indonesia have made efforts to develop a separate legal framework under which Islamic banks can operate in a dual banking system.

Iqbal, M., Ahmad, A. and Khan, T. (1998) Challenges facing Islamic banks, Islamic Research Institute, Islamic Development Bank.

Basle Committee on Banking Supervision (2001) The New Basel Capital Accord, Bank for International Settlements.

Basle Committee on Banking Supervision (1996) Amendment to the Capital Accord to Incorporate Market Risks, Bank for International Settlements.

Basle Committee on Banking Supervision (1988) International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Bank for International Settlements.

Accounting and Auditing Organization for Islamic Financial Institutions (1999) ‘Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks’, AAOIFI, Bahrain.

Islamic Financial Services Board (2005) Capital Adequacy Standard for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services. Available from www.ifsb.org .

Tier 1 capital is defined as core capital that comprises common stock, noncumulative perpetual preferred stock and reserves. Tier 2 is often referred to as supplementary capital and it includes financing funds such as long-term subordinated debt, preferred stock (not included in tier 1) and loan loss reserve, all up to 100 per cent of tier 1.

Under the old accord, market risk was only applied to off-balance sheet items such as derivatives. The new accord extends the applicability of market risk to the trading book activities of a bank as well, that is, to cover the investments held with a trading intend. For more details, see International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Basel Committee on Banking Supervision.6

Another possibility is for the bank to shift its asset allocation to a less risky distribution although this might impact its profitability.

Cunningham, A. (2000) ‘Islamic banks — In for a pound, in for a penny’, The Banker, February.

El-Hawary, D., Grais, W. and Iqbal, Z. (2004) ‘Regulating Islamic financial institutions: The nature of the regulated’, Policy Research Working Paper 3227, World Bank.

Davies, H. (2004) Regulatory issues facing Islamic financial institution. IFSB Summit, London, 9th May, 2004.

Foot, M. (2004) The future of Islamic banking in Britain. IFSB Summit, London, 9th May, 2004.

Chapra, U. and Khan, T. (2000) Regulation and Supervision of Islamic Banks. Islamic Research Institute, Islamic Development Bank.

Islamic banks are exposed to a unique type of operational risk, or Shariah compliance risk.

Islamic Financial Services Board (2005) Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services, www.ifsb.org .

The central bank of UAE was only established in 1980 after the collapse of two banks in 1977.

In 2004, total assets amounted to AED 30.613 and 12.687bn, respectively, for DIB and ADIB.

Augustine, B.D. (2005) ‘Four new entrants — RAKBank, Mashreqbank, Union National Bank and First Gulf Bank — have pending applications to start Islamic financial institutions’, Khaleej Times, 31st October, 2005.

As measured by the geometric mean over a period of five years.

For further details on the treatment of the different uses of funds and the set of conservative credit and market risk assumptions that were made for the CAR calculation, please contact the corresponding author.

For instance, allowances to the market risk capital charge are made for derivatives held for the sole purpose of hedging or when the value a two-leg instrument moves in the opposite direction and ‘broadly to the same extent’ (BIS, 2005).