Challenges in implementing capital adequacy guidelines to Islamic banks

Abstract

Throughout the past 30 years or so, the practice of Islamic banking has proved to be a viable alternative and is growing at an estimated annual rate of 15 per cent. Many challenges still lie ahead, however, for Islamic banks to be able to comply with international standards and guidelines. A key issue relates to the implementation of Pillar 1 of the Basel II Accord, or capital adequacy requirements that were originally set to capture different types of risks faced by conventional banks, and that do not cater to the risk specificities of Islamic banks. The objective of this paper is to overview the recent guidelines for risk management and capital adequacy in Islamic banking and to study the implications of applying Pillar 1 to a major Islamic bank. We specifically raise serious issues related to the nature of risks arising from the uses of funds of Islamic financial institutions and their implication on the banking book of the Islamic financial institution. Still other challenges lie ahead of international regulatory bodies in order to cater to other types of risks that are unique to Islamic financial institutions.