318 AN INTRODUCTION TO ISLAMIC FINANCE
segregation between commercial and investment - banking activities, can-
not be sustained within current capital requirements. Keeping this in mind,
Basel III (which came into effect in September 2010) recommends that the
fi nancial institutions substantially raise the quality and quantity of capital,
with a much greater focus on common equity to absorb losses. Enhanced
capital buffers can help protect the banking sector against credit bubbles
that can be drawn down during times of stress. Key features of Basel III’s
new capital requirements include (i) an increase in the minimum levels of
Tier 1 capital; (ii) a change in the rules in regard to composition/defi nition
of Tier 1 capital composed of retained earnings and common stock); (iii) a
requirement for countercyclical shock - absorbers/buffers (that vary with the
economic cycle); (iv) a requirement for a leverage ratio, limiting asset size
(both on and off balance sheet); and (v) additional capital charges consid-
ered systematically relevant to fi rms.
Proposed changes in the capital requirements are a step in the right direc-
tion. The IFSB has already announced a review of existing capital - adequacy
requirements in light of the proposed Basel III requirements. Determining
capital requirements for Islamic fi nancial institutions is not straightforward.
There are two main issues. First, technically, Islamic fi nancial intermedia-
tion is supposed to be on pass - through mode where all profi ts and losses
on the assets side are passed to the liabilities side (to investors/depositors)
and therefore the need for capital is minimal. In this mode of intermedia-
tion, as with mutual funds, the purpose of capital is to cover negligence and
operational risk. However, the reality is that capital requirements have been
set for Islamic fi nancial institutions along similar lines to those for conven-
tional banks to maintain the confi dence of investors. Following the same
tradition, it is expected that the capital requirements will also modifi ed to
comply with Basel III, although not strictly necessary. An increased capital
requirement can also have an impact on the effi ciency and return on equity
for Islamic fi nancial institutions.
The second issue concerns the exposure of Islamic fi nancial institutions
to real assets that are subject to price volatility as well as to liquidity risk.
Several Islamic banks, particularly in the Middle East, have considerable
exposure to the real estate sector. Depending on how the assets are valued —
book value or market value — the fi nancial health of Islamic banks can dete-
riorate as result of price volatility. In addition, requirements to adjust capital
to economic cycles and the activities of Islamic banks to the real sector will
also come into play. Policymakers and authorities can develop sophisticated
capital requirements to combat pro - cyclical pressures only after they under-
stand the nature of the risk/return rewards of assets for Islamic fi nancial
institutions, which are defi nitely different from those of their conventional
counterparts. Since Basel III will change the capital charge for securitization
risks, IFIs dealing with the sukuk market can also expect changes. Finally,
as discussed below, additional requirements for liquidity in Basel III will put
an additional burden on Islamic banks to maintain adequate capital and the
levels of minimum capital are expected to increase.