Islamic Finance

170 Regulatory Issues

investment account holders by varying the percentage of profit taken as

themudaribshare, which can be compared to an arrangement or agency

fee; and

• Rate of return risk: the risk of a mismatch between yields on assets
  and the expected rates of both restricted and unrestricted profit sharing
  investment accounts, which may in turn lead to displaced commercial
  risk.

Capital adequacy and minimum capital

requirements

Capital adequacy is a measure of the financial strength of a bank or

securities firm, usually expressed as a ratio of its capital to its assets.

Basically, banks are required to hold a minimum level of capital to prevent

over-lending and to ensure that the bank has sufficient funds in case any of

its counterparties default without endangering depositors, the banking

system or the economy.

The original capital adequacy rules, which came into effect in 1988, are

generally known as Basel I and are still in use in a large number of countries

outside the “Group of 10” (G10) countries (Belgium, Canada, Sweden,

France, Switzerland, Germany, Italy, Japan, the UK, the US and the

Netherlands). Within this framework, only credit risk and market risk have

an impact on the level of regulatory capital. Each asset on the bank’s balance

sheet is assigned a risk weight as illustrated in the table below.

Example Asset Classes Risk Weight (%)

Central governments, central banks, and Organization for Economic

Cooperation and Development (OECD) governments

0

Multilateral development banks and banks incorporated in the OECD 20

Mortgages 50

Private sector, commercial companies owned by the public sector, and

all other assets

100

Risk-weighted assets (RWAs) are determined by multiplyingtheoutstand-

ing exposures per counterparty by the risk weight that applies to the type of

counterparty. Risk mitigation such as netting and pledged deposits can be

applied to reduce RWAs, as long as a set of predefined conditions are met.

Regulatory capital is then determined as the aggregate of all RWAs

multiplied by 8 per cent. The 8 per cent ratio is set by the Basel Committee

of Banking Supervision (BCBS) on the basis that it would result in sufficient

levels of capital held inthe banking sector to cover potential defaults.