306 AN INTRODUCTION TO ISLAMIC FINANCE
may not apply. Two main features of Islamic banks were highlighted: the nature
of intermediation and the risk weights of the assets they held.
CAR and the Nature of Intermediation
Unlike depositors of conventional banks, the contractual agreement between
the Islamic bank and the investment account holders (IAHs) is based on the
concept of sharing profi t and loss, which makes IAHs unique in that they
are neither depositors nor equity holders. Although IAHs are not part of
the bank’s capital, they are expected to absorb all losses on the investments
made through their funds, unless there is an element of negligence or mis-
conduct on the part of the bank. The nature of intermediation and liabili-
ties has serious implications for the determination of adequate capital for
Islamic banks, as follows:
■ (^) Deposits taken on the basis of profi t/loss - sharing agreements should not
be subject to any capital requirements other than to cover liability for
negligence and misconduct, and winding - down expenses.
■ (^) Investments funded by current accounts carry commercial banking risks
and should be subject to adequate risk weights and capital allocation
accordingly.
■ (^) The existence of restricted investment accounts on the liabilities side
constitutes a collection of heterogeneous investment funds resembling a
fund - of - funds and therefore such fi nancial institutions should be subject
to the same capital requirements as are applicable to a fund manager.
■ (^) The presence of displaced commercial risk and the practice of income
smoothing have indirect implications for the Islamic bank’s capital
adequacy, which a regulator may take into account in determining
the CAR.
■ (^) Islamic banks acting as an intermediary (mudarib) can face a moral-
hazard issue. Since, as mudarib, the bank is not liable for losses but
shares the profi ts with IAHs, it may have an incentive to maximize the
investments funded by IAHs and by attracting more IAHs than it has the
capacity to handle. This in turn can lead to risky investment decisions
where the IAHs have a lower tolerance for risk that they are prepared to
accept. Such a misalignment of incentives may lead to an increased dis-
placed commercial risk, which necessitates higher capital requirements.
Determination of Risk Weights
Determining which risk weights to assign to different asset classes depends
on the contractual relationship between the bank and the borrower. For
conventional banks, a majority of assets are debt - based, whereas for Islamic
banks the assets range from trade fi nancing to equity partnerships; this fact
changes the nature of risks. In some Islamic instruments there are additional
risks that are not present in conventional lending instruments. Therefore,