304 AN INTRODUCTION TO ISLAMIC FINANCE
services. They would take demand deposits as part of these services. The
PLS intermediation has direct market discipline embedded in it and, hence,
should not require signifi cant capital. Some minimal capital may be needed
to protect the reputation of the institution, which is its legitimacy as a part-
ner for all its stakeholders. But one could argue that suffi cient transparency
and disclosure should allow markets to judge this legitimacy and induce
the institution of its own volition to maintain the needed level of capital.
The case for a capital requirement to protect orderly payments and demand
deposits would be stronger. It is not likely to lead to the same level of capital
requirement, but suggests the need to consider the appropriateness of bun-
dling the intermediation and payments services in the same balance sheet.
Consequently, the regulation of an IFI, compliant with risk sharing prin-
ciples, would need to put a heavy emphasis on transparency and disclosure
as well as licensing requirements, but de - emphasize capital requirements.
In existing IFIs, prevailing intermediation practices point to the need
for equivalent emphasis on capital requirements, supervision and licens-
ing, but more emphasis on transparency and disclosure than for conven-
tional banks. Competitive pressure is encouraging the established IFIs to
provide suffi cient safety and return to depositors in unrestricted investment
accounts. They consequently face the risk of “displacing” shareholders in
their returns and capital to accommodate these depositors. As a result, they
face an intermediation risk similar to that faced by conventional banks and
should therefore be subject to similar capital and supervision requirements.
To summarize, keeping in view the rationale for regulation, it is reason-
able to propose minimal regulation for IFIs operating fully in accordance
with the core principle of risk sharing. However, as prevailing practices of
IFIs are not fully compliant with profi t/loss - sharing principles, the situa-
tion presents risks akin to those in conventional banking. Therefore, a simi-
lar regulatory framework can be justifi ed. Such specifi c regulation for IFIs
should be supplemental to the existing regulatory framework and not a
whole new separate framework. This is the view notably taken by both the
AAOIFI and the IFSB.
CAPITAL ADEQUACY REQUIREMENT FOR IFIS
Capital plays an important role in any business but is critically important for
fi nancial institutions such as banks. The role of capital is vital for a banking
institution because capital is one of the key determinants and indicators of
the safety and soundness of a bank, since an adequate capital base serves
as a safety net against losses and absorbs possible losses. A well - capitalized
bank can boost the confi dence of the depositors and creditors. It is also the
ultimate determinant of a bank’s lending and investment capacity.
For these reasons, it is argued that the capital of a bank should have
three important characteristics: (i) it must be permanent; (ii) it must not
impose mandatory fi xed charges against earnings; and (iii) it must allow
for legal subordination to the rights of depositors and other creditors. The