Should Islamic Bank Hold More Capital Compared to Conventional Banks? A Holistic Assessment of Risk Profile vis-a-vis Capital Adequacy Regulations

Abstract

The expansive generalization on the assets of Islamic Banks (IB), being relatively riskier as compared to their conventional counterpart, stand justified owing to the contractual nature and the overall business model of IBs. These assets based or backed by trade (Murabaha, Salam, and Istisna) or lease (Ijarah) accompany the incremental risk on the books of the bank. Not only that the risks are unique, but the risk transformation across various phases of the contract’s life-cycle is tricky. Needless to mention here the rarely employed equity risk inherent in the PLS modes (i.e. Mudaraba and Musharaka) based assets. However, identifying the right level of capital (aka Capital Adequacy) warrants an intricate probe of the overall balance sheet risk both on the asset and the liability side. The well-established norm of Capital Adequacy Ratio of 8% of the risk weighted Asset (RWA) (Basel Accord) dictates not only the asset composition, but also indirectly influences the capital structure of a bank in terms of the amount of fixed deposits, reserves, subordinated debt and equity (classified as various tiers of capital in the Capital Adequacy (CA) regulations (Archer et al, 2006). Visualized as a pass-on structure based on a two-tier Mudaraba (Uzair, 1978), deposits in IBs are supposedly quasi-equity in its nature. This essentially has a significant implication on the overall risk profile and subsequently on the Capital Adequacy of an Islamic Bank. The paper attempted to carry out a discursive analysis to highlight the general and unique risk in an IB, to elaborate their capital requirement. Employing an intuitive and exploratory approach, the paper expanded on the risky assets of an IB and subsequently presented a holistic view of the overall risk profile, capital requirement and performance and their interplay to assess the sustenance of IBs as faith driven financial intermediary.