Regulation of Islamic Financial Institutions 307
the calculation of risk weights for the assets of Islamic banks differs from
that for conventional banks because:
■ (^) Assets based on trade are not truly fi nancial assets and carry risks other
than credit and market risks.
■ (^) There are non - fi nancial assets such as real estate, commodities, and
ijarah- and istisna’ - based contracts that have special risk characteristics.
■ (^) Islamic banks carry partnership and profi t/loss - sharing assets, which
have a higher risk profi le.
■ (^) Islamic banks do not have well - defi ned risk mitigation and hedging
instruments such as derivatives to hedge some of the risks on the assets
side, which raises the overall risk level of assets.
In partnership - based contracts such as mudarabah and musharakah, the
bank is exposed to both credit and market risks which need to be analyzed
within the credit and market risk methodology of the Basel Accords. When
such partnership - based assets are acquired in the form of tangible assets —
commodities — and are held for trading, the only exposure is to the market risk
because the credit risk is minimized by direct ownership of the assets. However,
there is signifi cant risk in the form of the risk of capital impairment when direct
investment takes place in partnership - based contracts and the investments are
intended to be held to maturity. Treatment of this risk within the Basel frame-
work is not straightforward and therefore requires special attention.
CAR for IFIs: IFSB Methodology
In the early 1990s, the AAOIFI drafted a basic standard on capital adequacy
of Islamic fi nancial institutions. In December 2005, the IFSB working group
on capital adequacy issued the fi rst draft if its capital - adequacy standards
for institutions (other than insurance institutions) that offered only Islamic
fi nancial services. This document includes a comprehensive discussion of
the nature of risks and the appropriate risk weights to be used for different
assets. The standard deals with the minimum capital adequacy requirements
for both credit and market risks for seven of the Shari’ah - compliant fi nanc-
ing and investment instruments: murabahah and mudarabah; salam; istisna’;
ijarah; musharakah and diminishing musharakah; mudarabah; and sukuk.
IFSB PRINCIPLES FOR MINIMUM CAPITAL ADEQUACY
REQUIREMENTS
■ (^) The minimum capital adequacy requirements for IFIs shall be a
CAR of not lower than 8 percent for total capital. Tier 2 capital is
limited to 100 percent of Tier 1 capital.
(Continued)