Islamic Banking and Finance: Fundamentals and Contemporary Issues

Monzer Kahf

Another important aspect in gaining the confidence of clients is the
bank’s capital strength that induces trust in the bank’s future and its
commitment. This gives the depositors a sense of security on their
investment and current deposits and a peace of mind based on investment of
bank’s own capital in various projects. The capital strength of the 7 Islamic
banks is depicted in Table 22.

Several recent studies suggest that the Islamic bank needs a higher ratio
of capital to total assets, i.e. a higher index of capital adequacy, than what is
required in conventional banks that deal on the basis of guaranteed loan
contracts because the Islamic bank is not merely a commercial bank, but
combines the qualities of commercial and investment banks together. Table
22 indicates that capital adequacy in some Islamic banks does not instil
enough confidence especially if we take into account their excessive reliance
on current and demand deposits. For example, the banks A and E both
occupy the lowest ranks in capital adequacy.

Table 22: Percentage of Equity/Total Assets

BANK 1998 1999 2000 2001 Avg. 98/99 99/00 00/01 98/01

A 7.20 6.95 6.58 5.91 6.66 -3.51 -5.31 -10.23 -17.98

B 9.42 9.72 20.42 19.87 14.86 3.14 110.42 -2.85 110.82

C 12.82 11.24 9.27 7.41 10.19 -12.28 -17.52 -20.05 -42.15

D 28.72 22.82 28.92 31.89 28.09 -20.55 26.77 10.26 11.06

E 7.45 7.44 8.25 8.40 7.88 -0.14 10.89 1.83 12.75

F --- 7.98 7.87 10.24 8.69 --- -1.40 30.15 28.33

G 10.12 10.86 10.72 10.09 10.45 7.29 -1.28 -5.86 -0.29

Average 12.62 11.00 13.15 13.40 12.40 -4.34 17.51 0.46 14.65

While the average index of capital adequacy is not less than 8.2 per cent
in the US commercial banks and 30.2 per cent in US investment banks^15 , we
find that this index for 2001 dropped to 5.91 per cent in bank A and 7.41 per
cent in bank C. Capital adequacy witnessed a continuous decline since 1998 in
the two banks, while it revolves around 1/12 in bank E despite its modest
rise during 1999-2001. Bearing in mind that the ratio of demand deposits
and/or current accounts to total deposits in these three banks is higher than
in other Islamic banks as shown in Table 23 it is not a satisfactory state of
affair.

Islamic banks should have at least 1/12 capital adequacy. This is very
important for maintaining soundness of the bank and for attracting all types
of deposits.