Regulation of Islamic Financial Institutions 305
nature of a fi nancial intermediary such as a bank is such that its capital - to -
liabilities ratio is lower than other types of businesses. This low ratio is a
refl ection of the nature of the intermediation business and acceptance of
large liabilities in the form of deposits. To encourage prudent management
of the risks associated with this unique balance sheet structure, the regula-
tory authorities require that the banks maintain a certain level of capital,
which is considered adequate to meet the risks of the assets. The idea behind
such a requirement is that a bank’s balance sheet should not be expanded
beyond the level determined by the ratio of the level of the capital and the
risks of the assets, so that the level of capital determines the maximum level
of assets.
In the 1980s, the Basel Committee on Banking Supervision (BCBS),
under the auspices of the Bank for International Settlements (BIS), devel-
oped a framework to determine capital - adequacy standards for banks with
the objectives of promoting soundness and stability in the international
banking system. This initiative resulted in the Basel Capital Accord of 1988
(commonly referred to as “Basel I”), which laid the framework for a “regu-
latory capital” and defi ned the guidelines to measure the risk exposures of
different asset classes. The Basel Accord introduced the concept of assign-
ing risk weights to different asset classes based on the riskiness of the asset
and defi ned the minimum levels of capital and reserves that a bank should
maintain in order to meet the risk - weighted exposures.
The determination of capital adequacy is a two - step process. The fi rst
step involves the measurement of risk exposures of the assets based on
the risk weights. For example, an investment in a government security is
assigned a lower risk weight than the lendings to a corporation or private
business, which carries a signifi cant credit risk. In the second step, the regu-
latory capital available to support the risk is measured. This is divided into
Tier 1 and Tier 2 capital. The ratio of regulatory capital to the amount of
risk - weighted assets is the capital adequacy ratio (CAR). The aim of Basel I
was to indicate a minimum recommended level of regulatory capital, with a
CAR of eight percent.
The Capital Accord standard has been accepted and adopted by more
than 100 countries. Although the initial standard was mainly focused on
credit risk, a refi ned standard in 2004 (“Basel II”)^1 included provisions for
market and operational risks, but the desired CAR level was unchanged. The
notion of a minimum capital requirement should not be confused with
the optimal economic capital. The minimum capital is a guideline and
requirement by regulatory authorities, but well - capitalized banks tend to
carry more than the minimum level and the regulator of a particular country
may decide to increase this level based on the level of risk in the system.
With the growth of Islamic banks, the issues of regulation and capital
requirements are being raised and addressed. The BCBS framework for cap-
ital adequacy provided the impetus for dealing with similar issues for the
Islamic banks. Although the need for a minimum capital ratio was recog-
nized, it was argued that the nature of intermediation by Islamic banks is differ-
ent from that of conventional banks and therefore the same capital requirements