Dadang Muljawan Humayon A. Dar Maximilian J. B. Hall
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, because of 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 behaviour by the banks. This requires analysis of the effect of financial participation by shareholders on Pareto optimality, and analysis of potential behaviour by shareholders when facing financial uncertainty. This paper combines modern banking theory and principal-agent analysis to develop a framework for an optimal capital structure for Islamic banks. The proposed capital regulation includes a minimum risk-based equity capital cushion (as required under the Basel Accord), a prudent assets-liabilities (capital) structure (i.e. appropriate proportions of PLS- and non-PLS-based assets and liabilities) and a minimum 'financial participation' requirement. It is inferred from the analysis that such capital adequacy requirements will improve the soundness of current Islamic banking practice, thus paving the way for the wider use of PLS by Islamic banks in the long run.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
file. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
For technical questions regarding this item, or to correct its listing, contact: (Christopher F. Baum).
Related research
Keywords:
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)