Adequacy of Islamic Banks and Financial Stability

Abstract

Since their inception, Islamic banks adhered to capital adequacy requirements promulgated by the Basel accord. Despite the profit and loss sharing and shariah compliance feature of Islamic banks, their technical operations in managing capital adequacy are not very much different from conventional banks in terms of provisioning for Tier 1 and Tier 2 capital. This study aims at highlighting the capital requirements for Islamic banks as delineated by the Basel accord and Islamic financial services Board (IFSB), adopting a comparative approach. It also aims at highlighting the impact of capital adequacy ratios on the financial stability, allowing Islamic banks to undertake their intermediary function at normal or stress situations. The study analyzed IFSB’s outlook on 20 Muslim countries and their capital adequacy ratios as per 2018 Financial stability Report. The research observed that IFSB’s statistics on Capital adequacy are clear indications on the positive impact on a number of variables. This would include liquidity, rise of Islamic banking assets, increased profitability, decline of non-performing financing portfolios, and an effective risk management especially those related to mudarabah and musharakah and displaced commercial risk (DCR). The analysis of IFSB’s statistics have led this research to conclude that capital adequacy ratios of Islamic banks contribute towards the overall financial stability. Besides, IFSB standard on capital adequacy may improve the performance of Islamic banks if the risk-weighted ratios for Islamic financial products are implemented as proposed in the standard. It was finally concluded that the Gulf states focused more on equity based sukuk compared to Malaysia that focused on debt based sukuk to meet Tier 2 capital.