Abstract
Conceptually, an Islamic bank has an equity-based capital structure, dominated by shareholders’ equity and investment deposits based on profit and loss sharing [PLS]. There is no need for capital adequacy regulations if the Islamic banks are structured as pure PLS-based organizations. However, due to informational asymmetry and risk aversion by investors, there currently exist fixed claim liabilities on the Islamic banking balance sheets. This necessitates the imposition of capital adequacy requirements, which aim at maintaining systemic stability by achieving two fundamental objectives. First, capital regulations should protect risk-averse (assumed unsophisticated) depositors. This requires a minimum equity capital cushion and an optimal assets-liabilities composition. Second, capital regulations should give the right incentives to shareholders to promote prudent behavior by the banks. This requires analysis of the effect of financial participation by shareholders on Pareto optimality, and analysis of potential behavior by shareholders when facing financial uncertainty.
Highlights
The fact that deposits in Islamic banks are not treated as a liability on the balance sheet does not mean that they should not have a minimum capital requirement and improved corporate governance as Emphasis on improved corporate governance and having minimum capital requirement go hand in hand with the need for improvements in risk management standards
Robust internal controls to provide qualitative standards are necessary to complement the quantitative analysis of risk to provide a check and balance in the capital adequacy framework for Islamic bank
Islamic banks have unique balance sheet features that have a direct impact on their exposure to the risks, for instance, Khan points out that traditional banks face market risk mostly in the trading book. in contrast, Islamic bank face the market risk in their banking book since instruments such as Murabaha, Ijarah, Salam, Musharaka and Mudaraba all reflect a commercial risk that bundle market risk and credit risk
Summary
The fact that deposits in Islamic banks are not treated as a liability on the balance sheet does not mean that they should not have a minimum capital requirement and improved corporate governance as Emphasis on improved corporate governance and having minimum capital requirement go hand in hand with the need for improvements in risk management standards. Robust internal controls to provide qualitative standards are necessary to complement the quantitative analysis of risk to provide a check and balance in the capital adequacy framework for Islamic bank. The importance of research is to study the possibility of managing the capital adequacy framework for Islamic banks in an optimal manner. Research Importance The importance of research is highlighted by the capital adequacy framework for Islamic banks as a result of their reliance on investment in excess liquidity on short term financing models rather than long term financing formulas to control liquidity and risk mitigation. The profit return of Islamic banks is uncertain and risky expected in the cost of capital
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