Regulation of Islamic Financial Institutions 303
banking and securities operations. Differences in commercial and invest-
ment banking activities have led to the adoption of a “banking book/trading
book” approach in the EU Capital Adequacy Directive of 1993. The securi-
ties activities grouped as “trading book” are subject to a capital - adequacy
regime that is separate from the banking business as defi ned by the “bank-
ing book” (Archer 2004). One marked difference in the case of IFIs is that
the trading operations are not confi ned to securities business only, but also
include positions in commodities and other non - fi nancial assets (for exam-
ple, by means of salam and istisna’ contracts). Given the universal - banking
nature of Islamic fi nancial intermediation, it is important that well - defi ned
rules and standards are designed to clearly demarcate the boundaries of
banking and trading books, with respective allocations of capital, depend-
ing upon the nature of business.
Regulators have traditionally governed their jurisdictions through direct
rules, mostly on capital, assets, and income allocations. At the same time,
regulatory changes often lag behind fi nancial developments and may conse-
quently either constrain the ability of fi nancial institutions to fl exibly man-
age their portfolios, or provide them with opportunities to take unchecked
risks, implicitly comforted by the existence of the safety net. In adapting to
these developments, the industry is now moving toward letting the regu-
lated institutions assess and manage their risks within a framework agreed
on with the regulator. In this context, there is a call for the introduction of
mechanisms to let the market impose the necessary discipline on the fi nan-
cial intermediaries. The essence of market discipline is to induce market
investors to penalize excessive risk taking by raising the cost of funding and
limiting its availability. This can happen directly, with depositors demanding
higher returns or withdrawing their deposits. It can also happen indirectly
if there is an asset traded in the market whose price refl ects the investors’
assessments of the risks being taken by the issuing institution.
In light of the discussion on risks and the rationale for regulation, it
is clear that capital, transparency, and licensing requirements are primary
candidates for regulation. The method of regulation will depend, to varying
degrees, on a combination of direct “command and control” rules, market
discipline (direct and/or indirect), or organization - specifi c home - developed
risk assessments. The type and method of regulation chosen depends on the
adopted rationale for regulation, on the extent to which IFIs follow core
principles, and on the assessment of their practices.
For IFIs that follow strict risk sharing principles, there would be mini-
mal regulation required. There would be less emphasis on capital require-
ments, and more on transparency and disclosure, management screening,
and licensing of business lines; that is, regulation equivalent to conventional
banking. There would be greater reliance on direct market discipline and
less on “command and control” regulation.
The two - tier mudarabah or two - windows frameworks use, for the
most part, profi t/loss - sharing (PLS) accounts on both sides of the balance
sheet. They would provide trade fi nance or facilitation, as well as payments