302 AN INTRODUCTION TO ISLAMIC FINANCE
principle, which is different to the intermediation relationship between
depositors and conventional banks. Given the partnership - based relation-
ship, the two - tier mudarabah model of Islamic banking does not require
banks to have reserves. It is argued that in the presence of symmetrical risk as
well as profi t/loss sharing, introducing a guarantee on the downside would
run counter to the essence and the core objective of the system. Investment
depositors should, however, expect to be informed on the features of the con-
tract they enter into and have recourse to law if it is breached. Therefore, the
focus of regulation will shift from protection of investment account holders
to ensuring the integrity of the fi duciary contracts.
Depositors vs. Investors
Depositors in the conventional banking system create a debt claim on the
fi nancial institution, whereas the depositors in the Islamic banking system
are investors and therefore do not create such a claim; rather, they act like
pseudo - equity holders. Because of the pass - through nature of intermedia-
tion, where all profi ts and losses are passed through to them, investors theo-
retically do not have a claim on the capital of the bank except in cases of
misconduct or negligence. This pass - through feature has a major impact on
the capital requirements of Islamic banks. Requiring a certain minimum
level of capital is the cornerstone of the regulation of conventional banks.
Systemic Risk
Islamic banks are not immune from bank runs when depositors/investors
lose confi dence in the bank and withdraw funds in panic. Large volumes of
panic withdrawals by investment account holders could result in fi nancial
distress. Archer (2004) argues that unlike conventional banks, which main-
tain liquid assets on their liabilities, the assets of Islamic banks are illiquid,
which makes such risk primarily a liquidity risk. In the event of a liquidity
crisis, a conventional investment fi rm will generally be able to wind down
its business in an orderly manner by meeting its obligations through prompt
disposal of marketable securities at the market price. In contrast, an Islamic
bank’s asset portfolio is dominated by less-liquid trade - fi nanced or rental -
generating assets, which exacerbate the problem of illiquidity and therefore
the systemic risk.
IFIS AS UNIVERSAL BANKS
As mentioned in earlier chapters, fi nancial intermediation performed by
IFIs combines commercial and investment banking activities similar to a
universal bank in the conventional system. This combination of banking
with securities (underwriting) operations demands that a different regula-
tory framework, including capital - adequacy requirements, be applied to