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Table of contents
1. The impact of the Basle capital adequacy ratio regulation on the financial and marketing strategies of
Islamic banks...................................................................................................................................................

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Document 1 of 1

The impact of the Basle capital adequacy ratio regulation on the financial and marketing strategies of
Islamic banks
Author: Rifaat Ahmed Abdel Karim
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Abstract: This article reports that, unlike Western commercial banks, Islamic banks are prohibited by Islamic
precepts to receive or pay interest, inter alia, in all their transactions. It argues that the Basle capital adequacy
ratio (CAR), which was implemented in 1992 by regulatory authorities in many countries, is irrelevant to Islamic
banks because it does not accommodate, among other things, one of the major instruments - investment
accounts - through which Islamic banks mobilize funds on the basis of profit sharing. It develops 4 possible
scenarios for the treatment of these accounts in the calculation of CAR and examines their impact on the
financial and marketing strategies of Islamic banks in the light of the risk-return relationship between the funds
contributors of these banks.
Full text: Rifaat Ahmed Abdel Karim: Secretary-General, Accounting and Auditing Organization for Islamic
Financial Institutions, Manama, State of Bahrain
ACKNOWLEDGMENT: This paper was written before the author's appointment as Secretary-General. The
views expressed in the paper are the author's and do not necessarily represent those of either the named
institution or any other organizations. The author would like to thank Roger Groves, David Llewellyn, the
participants at the 9th expert level meeting on Islamic banking, Jakarta, 7-8 April 1995, and an anonymous
referee of this journal for helpful comments on an earlier version of the paper. The usual caveats apply.
In his speculative projections of the strategic issues of the 1990s for the banking industry, Llewellyn (1992)
claims that:"
competitive and regulatory pressures are likely to reinforce the central strategic issue of capital and profitability,
and accentuate the role of the availability and cost of equity capital in shaping banking strategies (p. 24)."
The recent third world debt crisis seems to have triggered the demand for more capital regulation in the banking
industry, particularly those banks with huge international investments. Capital adequacy ratio (CAR) is one of
the key measures which regulators use as a buffer against credit risk to which banks are exposed.
Banks which do not satisfy CAR requirements are likely to incur a wide range of regulatory costs. Noncomplying banks can be asked to submit comprehensive plans describing how capital will be increased, can be
denied a request to merge or open new branches, or can be exposed to stringent dividend restrictions.
According to Moyer (1990), to reduce regulatory costs imposed by CAR regulators some bank managers tend
to adjust accounting measures.
In recent years, there has been a resurgence of the Islamic faith in almost all areas with a substantial Muslim
population (e.g. Iran, Pakistan, Sudan, Egypt and Algeria). Islam does not entertain the dichotomy between
spiritual and temporal affairs of life. This means business transactions must be conducted in consonance with
the Shari'a[Note 1] precepts. The Shari'a prohibits, inter alia, the receipt and payment of riba[Note 2], gambling,
hoarding, and speculation. Similarly, investments in the shares of companies that deal in alcohol or pork are
also considered by the Shari'a as unlawful[Note 3].
This call for strict observance of Islamic precepts seems to have led to a growing demand for the introduction of
business organizations that adhere to the Shari'a in their financial transactions[Note 4]. Islamic banking can be
considered as one of the major financial innovations which has been developed as a response to this demand.
Islamic banks are now well established in most countries in the Middle East and in many countries in Asia and
Europe. Some countries (e.g. Pakistan, Iran and Sudan) have "islamized" their whole banking industry while
others (e.g. Malaysia, Bahrain, Turkey and Jordan) have adopted a heterogeneous banking system in which
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one or more Islamic banks compete with Western-type commercial banks. Some of the latter type of banks
have responded by opening branches that operate in accordance with the Shari'a in an attempt to compete in
this growing niche of the banking market.
On the other hand, the rapid growth in the size and number of Islamic banks seems to have led regulatory
authorities to appreciate the need to develop appropriate measures that would enable them to control the
operations of these banks which differ substantially from those of their Western capitalist counterparts. The
application of the CAR measure to Islamic banks is likely to be an issue of contention between these banks and
their regulatory authorities. Indeed, according to The Banker (1988):"
Kuwait Finance House forcefully points out the irrelevance of what it calls the 'traditional" capital-adequacy ratio
of commercial banks."
Recently, the Basle Committee on Banking Regulations and Supervisory Practices (1988)[Note 5] has proposed
the application of a CAR framework to (Western) commercial banks which should:"
1 serve to strengthen the soundness and stability of the international banking system; and
2 be fair and have a high degree of consistency in its application to banks in different countries with a view to
diminishing an existing source of competitive inequality among international banks (para 3)."
This paper argues that the proposed CAR framework does not cater for the unique characteristics of one of the
major instruments - investment accounts through which Islamic banks mobilize funds on the basis of profit
sharing. The paper proposes four scenarios for the calculation of CAR and examines their implications on the
financial and marketing strategies of Islamic banks. It is argued that both the financial and marketing strategies
of an Islamic bank would be contingent on the scenario to be adopted by regulatory authorities for the treatment
of profit sharing investment account (PSIA) financing. This in turn would determine whether shareholders of
Islamic banks would be able to avail themselves of the benefits of high investment accounts financing while
keeping their equity capital at a minimum to increase their rate of return at no extra risk.
The remainder of the paper is organized as follows. First, the CAR framework proposed by the Basle
Committee is presented and the financial system of Islamic banks is described. Four scenarios for the treatment
of investment accounts for the calculation of CAR are then developed and the implications of the four scenarios
on the financial and marketing strategies of Islamic banks are examined, followed by the concluding remarks.
The Basle CAR framework
The CAR is a measure of a bank's risk exposure. Regulatory authorities use CAR as an important measure of:"
"safety and soundness" for depository institutions because they tend to view capital as a buffer or cushion for
absorbing losses (Sinkey, 1989, p. 10)."
In recent years, the CAR has received considerable attention by regulatory authorities around the world. This
culminated in July 1988 in the formal adoption of the Basle Accord[Note 6] by representatives of several
European countries, Canada and the USA.
The Accord, which was implemented in 1992:"
sets out the details of the agreed framework for measuring capital adequacy and the minimum standards to be
achieved which the national supervisory authorities represented on the [Basle] Committee intend to implement
in their respective countries (Committee on Banking Regulations and Supervisory Practices, 1988, para 1)."
In arriving at the CAR of a bank, the proposed framework relates capital to its total assets weighted by their risk.
The Accord stipulates that by 1992 the minimum acceptable ratio of a bank's capital to risk-weighted assets
should be 8 per cent.
Capital is split between Tier 1 or core capital (equity[Note 7] and published reserves from post-tax retained
earnings) and Tier 2 or supplementary capital (unpublished reserves, asset revaluation reserves, general
provisions and loan loss reserves, hybrid debt/equity instruments and subordinated term debt). National
discretion is allowed over the inclusion of the individual Tier 2 elements. Tier 1 capital must be equal to a
minimum of 4 per cent of risk assets. Tier 2 elements must not exceed 50 per cent of the combined total of both
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Tiers. In addition, subordinated debt must not exceed 50 per cent of Tier 1; general provisions are limited to a
maximum of 1.25 per cent of risk assets; and latent asset revaluation reserves are to be discounted by 55 per
cent.
On the other hand, goodwill and other intangible assets as well as published or unpublished current year losses
must be deducted from Tier 1 capital, while investments in unconsolidated financial subsidiaries must be
deducted from total capital. The exclusion of holdings of other banks' capital is at national discretion.
Capital is then related to different categories of assets weighted according to broad categories of relative
riskiness. The credit risk weightings (0 per cent, 20 per cent, 50 per cent and 100 per cent) of on-balance sheet
assets depend on whether the bank is doing business with central governments, public sector entities, banks or
non-bank organizations. For the former three categories, certain distinctions are made between OECD
(Organization for Economic Co-operation and Development) members and non-OECD members. The latter
attracts a high risk weighting. With the off-balance sheet items, the framework proposes a two-step process.
First the credit equivalents are calculated, then the credit risk.
The majority of countries in which Islamic banks operate have already taken steps to introduce the Basle
framework. However, as will be shown in the next section, the parameters of the financial system of Islamic
banks are quite different from those of Western traditional commercial banks for which the Basle framework was
geared. As far as this author is aware, there has hardly been any attempt by the concerned regulatory
authorities in the countries in which Islamic banks operate to adjust the framework to cater for the unique
characteristics of Islamic banks. As will become evident later in the paper, this is likely to impact on the financial
and marketing strategies of Islamic banks.
The financial system of Islamic banks
The prohibition of interest means that Islamic banks cannot incur or earn interest in any of their financial
transactions. Hence, Islamic banks are not in the business of lending money to the public or borrowing from it.
Rather, these banks mobilize funds on bases that are quite different from those of traditional commercial banks
and use distinct financial instruments in their uses of funds.
Sources of funds
In their mobilization of funds, Islamic banks currently depend on four main sources of funds. These are
shareholders' funds, current accounts, investment accounts and savings accounts[Note 8]. The sources of
funds of Islamic banks do not, however, include bonds or debentures because of the interest paid on these
securities.
Shareholders' funds are the only source of equity funds raised by the bank through the sale of common shares
to the public. They also include any reserves accumulated by the bank over the years. Shareholders have sole
control over the management of the bank. No preferred shares are issued by Islamic banks because holders of
these shares are paid a fixed dividend which is prohibited by Shari'a.
Current accounts are similar to the services of cheque accounts which are offered by traditional commercial
banks. Customers of Islamic banks benefiting from the service of current accounts have the right to withdraw
their funds on demand, but they are not entitled to receive any returns on their current funds[Note 9]. The
revenues generated from investing the funds deposited in accounts are the exclusive right of the shareholders
because, in case of loss, holders of these accounts would be paid from the shareholders' funds[Note 10].
In most Islamic banks PSIAs usually constitute the largest source of funds. These accounts are not a liability,
nor can they be considered as equity funds[Note 11]. Rather, they are financial instruments which give Islamic
banks the right to invest funds deposited in these accounts on behalf of their holders on the basis of profit
sharing. PSIAs are not paid a predetermined rate of return and, like equity capital, are free of contractual
servicing obligations (i.e. they are serviced only in the event that the bank is profitable). Accordingly, they do not
constitute a financial risk to the bank.
Holders of PSIAs deposit their funds with the bank under the understanding that the latter is empowered with
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full and absolute authority to invest the funds in the way and manner it deems fit to achieve its objective of
earning profits, but without contravening Shari'a precepts. However, Islamic banks also offer restricted PSIAs to
those investors who are interested in investing their funds in certain projects which are specified in
advance[Note 12].
PSIAs are redeemable at maturity or at the initiative of their holders, but not without the prior consent of the
bank[Note 13]. Islamic banks can refuse to pay holders of PSIAs until the results of the investments financed by
their funds are determined[Note 14]. In some Islamic banks (e.g. Kuwait Finance House (KFH), Jordan Islamic
Bank (JIB), Tadamon Islamic Bank), the contractual agreements that govern deposits in PSIAs specify that
these funds must remain with the bank for a certain period before their holders can have access to them.
Certain types of PSIA require deposits to remain for longer periods (one year or more) while others cater for
shorter periods.
It should be noted that, unlike other types of PSIAs, savings accounts are usually redeemable at the initiative of
their holders and without the prior consent of the bank and, in some Islamic banks (e.g. in the Sudan), these
accounts do not participate in the bank's profits and losses.
Uses of funds
In their uses of funds, Islamic banks have so far mainly focused on seven financial instruments. Musharaka
(joint venture) is based on profit and loss sharing with the recipient while mudaraba (full funding of project) is
based on profit sharing. The other five instruments are: murabaha (sale of goods at a price which includes a
profit margin agreed by both parties to the transaction), salam (sale of goods where the price is paid in advance
and the goods are delivered in the future), istisna' (acquisition of goods by specification or order, where the
price is paid in advance, but the goods are manufactured and delivered at a later date), ijara (operating lease)
and ijara-wa-igtina (lease with optional ownership)[Note 15].
Profit sharing methods
The relationship between Islamic banks and holders of PSIAs is based on the mudaraba contract. According to
this fiduciary contract, one (or more) party (called rabb-al-amal - in the case of Islamic banks this would be
holders of PSIAs) entrusts funds for a specified or unspecified period to the other party (called mudarib - in this
case the Islamic bank) in the capacity of an investor and not as a lender, for carrying on trade, investment or
service with the objective of generating profits. The Islamic bank contributes its managerial and entrepreneurial
services. Holders of PSIAs are sleeping partners and, although they have the right to specify the conditions
governing the investment of their funds, they have no control over the management of the bank.
The profits that result from investing the funds of these accounts are shared by the parties to the mudaraba
contract according to a predetermined ratio agreed on before the implementation of the contract. As owners of
the bank, shareholders receive a share in this profit as a reward for the efforts which their agent - the
management of the bank - exerts in investing PSIAs' funds[Note 16]. Islamic banks call this the mudarib share
of profit. This cannot be an absolute amount or a fixed remuneration[Note 17].
As the provider of funds, however, holders of PSIAs bear the full risk of loss resulting from normal business
causes or natural causes pertaining to their investments, but only to the extent of the amount deposited in their
accounts and no more. Hence, like holders of unit trusts in mutual funds, at the end of the financial year the
value of PSIAs would be reduced by their appropriate share of loss as reflected in the value of their related
assets. However, to cater for this risk, some Islamic banks (e.g. JIB, Faysal Islamic Bank of Bahrain (FIBB))
have established an investment risk allowance fund to act as an initial buffer for expected losses[Note 18]. On
the other hand, the Islamic bank, as a mudarib, receives no reward for its service of managing the funds of
investment account holders; its loss amounts to the opportunity cost of its services.
Most Islamic banks invest PSIAs in the same investment portfolio of shareholders. In this case, profits and
losses are allocated according to the contributed funds of each source. This means that shareholders' total
share of profit would consist of:
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1 the profits generated from investing equity funds; and

2 their share in the profits of PSIAs (i.e. the mudarib share of profit).
Islamic banks can also use one of two profit sharing methods to govern the relationship between shareholders
and PSIAs. These may be called the "pooling method" and the "separation method". The decision on which
method to use is to a large extent influenced by the bank's in-house religious advisers[Note 19]. The two
methods mainly differ over two issues:
1 should PSIAs share in all types of revenues and expenses of the bank; or
2 should PSIAs only participate in the revenues and expenses pertaining to their investments?
The latter expenses do not include the administrative expenses of the bank.
According to the pooling method, all sources of funds made available to the bank should share in all forms of
both revenue and expense. But this would not include revenues generated by subsidiary and affiliated
companies or the remuneration of the bank's directors and auditors. KFH and Bahrain Islamic Bank are two of
the Islamic banks which use this method of profit sharing.
On the other hand, the separation method calls for segregating the revenues and expenses of investments
operations from those of other banking services, PSIAs only being allowed to share in the revenues and
expenses related to the former type. Other revenues and expenses, including all administrative expenses and
directors' and auditors' remuneration, are solely borne by the shareholders. JIB, FIBB, and Faisal Islamic Bank
in Sudan (FIBS) are examples of banks that use this method.
Like the pooling method, some Islamic banks which use the separation method treat PSIAs as on-balance sheet
items and (incorrectly) list them under liabilities. In addition, both PSIAs and equity funds are invested in the
same investment portfolio and thereby run the same business risk. Other Islamic banks (e.g. FIBB and Arab
Islamic Bank), which use the separation method, treat PSIAs as an off-balance sheet item and they may or may
not be invested in the same investment portfolio of equity funds.
In the next section, the Basle framework will be examined in the light of the above description of the financial
system of Islamic banks.
The application of the Basle framework to Islamic banks
The preceding description of the financial system of Islamic banks suggests that PSIAs, which are one of the
important sources through which these institutions mobilize funds, perform some of the basic functions of
capital. And although they are not permanently available, PSIAs bear risk in aspects similar to equity capital.
Hence, it is arguable that since"
capital adequacy is about risk of the total portfolio position of a bank (Llewellyn, 1989, p. 444)"
and since"
anything that reduces risk, or shifts risks away from the bank, or in any way protects against it, is a factor [or a
source] lessening the need for capital (Llewellyn, 1988, p. 11)"
then PSIAs should play a major role in the calculation of the CAR for Islamic banks. However, if the Basle
framework is to be applied to Islamic banks in its present form, then regulatory authorities would face the
problem of how to treat PSIAs.
Based on the previous description of their characteristics, four possible scenarios can be developed for the
treatment of PSIAs by regulatory authorities. The choice of which scenario to adopt can be left to national
discretion, as is the case with a number of items in the Basle framework. The four scenarios are discussed next.
The first scenario suggests that since PSIAs share in the profits and losses of the bank, they possess two basic
characteristics of capital. These are:
1 "to absorb operating losses while enabling the bank to stay in business"; and
2 "to enable the bank to absorb risks and sustain shocks while continuing to operate" (Llewellyn, 1989, p. 444).
However, it depends on which profit sharing method the bank is using. If it is the pooling method, then PSIAs
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share in all the losses of the bank except those which are the exclusive responsibility of shareholders[Note 20].
In this case, Islamic banks can argue that PSIAs would qualify to be added to the core capital elements. Table I
shows that, according to this scenario, Al-Siddiq bank[Note 21] would have a CAR of 78.4 per cent which is
much higher than the 8 per cent required by the Basle committee.
However, one of the caveats of this scenario is that, since current accounts cannot be paid from PSIA funds
(because only shareholders are entitled to receive the revenues generated from investing current accounts
funds), then the treatment of PSIAs as one of the items of core capital may give a misleading picture of the
bank's capital ability to absorb losses and still meet its obligations. Accordingly, regulatory authorities may
consider setting a limit to the amount of PSIA that can be included in the Tier 1 items.
If, however, an Islamic bank is using the separation method, then the share of PSIAs in the bank's losses is
confined to the losses emanating from the investments into which their funds have been invested. Accordingly,
they are neither compensated with equity funds nor do they act as a cushion for absorbing losses other than
those which are attributed to their own investments. In other words, they bear their own risk. In this case, PSIAs
may not qualify to be added to the capital elements. Hence, the second scenario proposes that, since PSIAs
only bear their share of risk in the investments into which their funds were placed, then they (PSIAs) should be
deducted from the total risk-weighted assets. This treatment overcomes the caveat produced by the first
scenario. Table I shows that, according to the second scenario, Al-Siddiq bank would have a CAR of 26.4 per
cent[Note 22] which also is much higher than what is required by the Basle committee.
The third scenario maintains the view that, although PSIAs share in the profits and losses of the bank, they are
not a perfect substitute to equity capital which is permanently available. Rather, they are more akin to hybrid
capital instruments. Although investment accounts are unsecured and are able to support losses on an ongoing
basis without triggering liquidation, they are redeemable at maturity or at the initiative of the holder but not
without the prior consent of the bank[Note 23]. Furthermore, unlike hybrid capital instruments, PSIAs do not
carry an obligation to receive profits if they are not achieved by the bank. Hence, it can be argued that PSIAs
should be classified with Tier 2 capital elements.
However, scenario 3 is not without problems. According to the Basle framework, the total of Tier 2 elements
should not exceed 50 per cent of a bank's capital base. Hence, in the case of Al-Siddiq bank, this means that
$302,000,000 should be deducted from Tier 2 capital, i.e. the total amount of PSIAs and an additional
$2,000,000. Table I shows that, according to this scenario, Al-Siddiq bank would have a CAR of 7.3 per cent
and it would, therefore, be obliged to raise enough Tier 1 capital to reach 4 per cent or to reallocate its assets in
favour of lower risk-weighted categories.
Hence, the treatment of PSIAs as a Tier 2 capital item would not be of help in meeting the CAR requirements
for regulatory purposes by Islamic banks which have a similar balance sheet structure as that of Al-Siddiq bank.
Indeed, it would tend to disadvantage those Islamic banks (e.g. KFH) which attempt to achieve growth by
pursuing a financial strategy that aims at mobilizing funds mainly through PSIA financing (see Karim and Ali,
1989).
The fourth scenario depicts the present situation in which the characteristics of PSIAs are ignored and the Basle
framework is applied without any adjustment to the capital elements or deductions from the total risk-weighted
assets. According to Table I, Al-Siddiq bank continues to have a deficiency of Tier 1 capital, and Tier 1 plus Tier
2 capital will be constrained by the amount of Tier 1 capital. The 50 per cent limit would apply to non-deposit
sources of Tier 2 capital (i.e. $2,000,000 should be deducted) and Tier 1 plus Tier 2 ratio would be 7.3 per cent.
Like the third scenario, the bank would be obliged to raise enough Tier 1 capital to reach 4 per cent or to
reallocate its assets in favour of lower risk-weighted categories.
The theme emerging from the proposed four scenarios suggests that PSIAs can be:
1 classified as a core capital element;
2 deducted from the risk-weighted assets;
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3 added to Tier 2 capital elements; or

4 ignored.
The other side of the Basle framework, which is expected to affect Islamic banks negatively, is the allocation of
risk weights to assets to cater for credit risk. Given the principles which govern their operations, Islamic banks
do not provide loans. Rather, the structure of their assets reflects the instruments through which they invest
their resources (in addition to the banks' premises, plant and equipment and other fixed assets).
As stated earlier, these would include transactions conducted through murabaha (sale of assets on
instalments), salam (advance cash purchase of products at a predetermined price), istisna' (advance payment
for manufacturing of goods that are delivered at a later date), musharaka (joint venture between the bank and
the customer), mudaraba (full funding of project by the bank and it bears all the risk in case of loss), ijara
(operating lease) and ijara-wa-igtina lease with optional ownership).
It should be noted that, with the exception of the instalments of murabaha transactions and forward deals of
salam and istisna', none of the other instruments deals with credit claims. Such a situation would disadvantage
Islamic banks. On the one hand, the nature of the financial instruments other than murabaha, salam and istisna'
is not catered for in the Basle framework. On the other hand, murabaha is the most widely used by Islamic
banks (Ahmad, 1987; Karim and Abdallah, 1995) and almost all sales through this instrument are directed
towards the private sector and hence, according to the risk weights suggested by the Basle frameworks, would
attract 100 per cent weight.
The irrelevance of the Basle framework to Islamic banks would put the regulatory authorities in the concerned
countries in an unenviable situation. If the whole banking sector is "Islamized", then a major departure from the
recommendations of the framework would be required to make it compatible with the characteristics of Islamic
banks. This would belittle one of the fundamental objectives of the framework which is to achieve a high degree
of consistency in its application to banks in different countries. Nevertheless, it may be argued that, since
Islamic banks are different in nature, then issues of competitive neutrality are not strictly relevant.
On the other hand, if the banking industry is heterogeneous, then this would mean that regulatory authorities
would have to use an adjusted framework in addition to that of Basle in order to measure the capital adequacy
of Islamic banks. Hence, the whole banking sector would not be subject to the same capital adequacy measure.
This also would cast doubt on the consistency objective of the Basle framework.
In the light of the above analysis, the next section examines the implications of the CAR regulation on the
financial and marketing strategies of Islamic banks.
Implications of CAR on the financial and marketing strategies of Islamic banks
Under the profit sharing method, shareholders of Islamic banks can afford to increase their share of profits
without increasing their equity capital or incurring an additional risk. Since an Islamic bank invests PSIA funds
on behalf of their owners, its shareholders are entitled to receive a percentage of the profits which are
generated from such investments without incurring any liability to these accounts in case of loss. This is
because PSIAs bear their own risk and do not have a first claim on the bank's earnings or assets. Hence, any
increase in these deposits does not create any financial risk for the bank.
It follows that one of the financial strategies that can best serve the interests of shareholders is to keep their
equity capital to the minimum level possible and at the same time maximize PSIA financing. This would mean
that every extra pound generated from investing PSIA would increase the rate of return of shareholders at no
extra risk, other things being equal and constant. Hence, contrary to the objectives of the Basle framework,
such a financial strategy would not make equity capital of central concern to Islamic banks.
On the other hand, since the returns of holders of PSIAs are directly determined by the profits (losses)
generated by the bank, their decision to invest or continue to invest with a particular Islamic bank would mainly
depend on the risk of the projects in which their funds are invested, the returns which they expect to receive
from those projects compared with returns from other similar risk class projects, and the bank's ability to
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achieve those returns. However, in countries where there is only one Islamic bank, depositors who are keen to
adhere to their religious faith in their financial dealings may not have many options from which to choose.
KFH and JIB are two of the largest Islamic banks which, during the period 1979-1994 and 1980-1994
respectively, have managed to pursue a financial strategy that mainly depended on increasing PSIA financing
and keeping equity capital at a minimum (see Figures 1 and 2). However, environmental factors (e.g. regulatory
authorities, market competition (see Duncan, 1972)) can force Islamic banks not to implement such a strategy.
Figure 3 shows that, during the period 1979-1994, the financial strategy followed by FIBS tended to depend on
current accounts as the bank's main source of funding rather than PSIAs. This was coupled by an increase in
equity capital in 1983 to cater for the increased liability of current accounts. Karim and Ali (1989) claim that FIBS
was forced into such a strategy because the regulatory authorities in the Sudan subjected the bank to different
rules from the ones granted to it during the early years of its operations. This, Karim and Ali argue, seems to
have reduced the bank's ability to service PSIAs competitively and, accordingly, in 1983 the bank opted to stop
accepting PSIAs.
The enforcement of the Basle CAR also is likely to have an impact on the financial and marketing strategies of
Islamic banks. However, whether or not Islamic banks would be negatively impacted by such requirements
depends on the scenario to be adopted by regulatory authorities.
According to the first scenario, PSIA should be added to the core capital elements. Islamic banks like KFH and
JIB, which are pursuing a financial strategy of increasing PSIA financing, would tend to benefit from this
scenario. The high strategic choice provided by this scenario would also mean that these banks are likely to
pursue a marketing strategy of expanding their market share of these accounts in order to fulfil their financial
strategy. In addition, not only would this scenario help these banks to comply with the CAR regulation, but also
it would enable them to increase the rate of return of shareholders at no extra risk and without having to
increase their equity capital.
On the other hand, this scenario would encourage Islamic banks like FIBS to change their financial strategy as
well as to adjust their marketing strategy to focus their efforts on mobilizing more funds through PSIAs if they
were to meet the CAR requirements without having to increase equity capital or reallocate their assets in favour
of lower risk-weighted categories. Indeed, Islamic banks like FIBS may be forced to follow other Islamic banks
which change their financial strategies and pursue an aggressive marketing strategy to increase their market
share of PSIAs in order to enable their shareholders to reap the benefits of high PSIA financing.
If, however, a limit is set to the amount of PSIAs that can be included in Tier 1, then, depending on their balance
sheet structure, Islamic banks may find it necessary to raise equity capital and/or restructure their assets in
order to meet the CAR requirements. This would also mean that Islamic banks are likely to adopt a marketing
strategy of maintaining their market share of PSIAs, as there would hardly be incentives to attract more funds
through these accounts.
The second scenario proposes that PSIAs should be deducted from the total risk-weighted assets of the bank.
One of the implications of this scenario is that Islamic banks like KFH and JIM would be encouraged to continue
implementing both their financial strategy of bolstering PSIA financing and their marketing strategy of expanding
their market share of these accounts. This is because the more funds raised through these accounts, the less
would be the total risk-weighted assets, and the higher would be the bank's CAR, other things being equal.
An additional advantage of this scenario is that the deduction of PSIA financing from the total risk-weighted
assets would help Islamic banks to compensate for the assets that are allocated a high risk weight. This would
act as an extra bonus for attracting more PSIA financing. However, Islamic banks would still have to ensure that
the percentage of their core capital is in line with what is stipulated by the Basle framework.
Like the first scenario, the second scenario would urge Islamic banks like FIBS, which depend on current
accounts financing, to change their financial strategy as well as their marketing strategy to promote PSIA
financing if they were to meet the CAR requirements without having to inject extra equity capital. Otherwise,
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competition may force these banks to change their financial strategies.

This scenario is likely to appeal both to regulatory authorities and Islamic banks perhaps more than the first
scenario. On the one hand, it satisfies the core capital requirements stipulated by the Basle framework without
any adjustments. On the other hand, it caters for the inclusion of PSIAs in the calculation of CAR and also avails
Islamic banks of the opportunity to adopt a financial strategy that satisfies the CAR regulation and increases the
rate of return of their shareholders at no extra risk.
The third scenario calls for classifying PSIAs with Tier 2 capital elements. The constraint that the total of Tier 2
capital elements should not exceed 50 per cent of the total of both tiers means that PSIA financing would be
used in Tier 2 capital only to the extent that the total of Tier 2 capital does not exceed the total of Tier 1 capital.
Indeed, in situations where the total of other items of Tier 2 capital already equals the total of Tier 1 capital,
PSIA financing would not be included in the calculation of the CAR. The adoption of this scenario would further
imply that Islamic banks are likely to pursue a marketing strategy of maintaining their market share of PSIAs, as
there would be no incentives to attract more funds through these accounts.
Hence, Islamic banks like KFH and JIB are likely to find it necessary to invest funds mobilized through PSIAs in
assets that attract low risk weightings if they were to continue enjoying the benefits of high PSIA financing and
avoid having to increase equity capital. However, such an option would not be easily implemented given that
Islamic banks rely heavily on the financial instrument of murabaha in their investments which would attract 100
per cent risk weightings because they are mainly directed towards the private sector. On the other hand, the
financial strategy of Islamic banks like FIBS that focus on current accounting financing would be of little help to
them in this scenario. These banks are also likely to adjust their marketing strategy to focus on promoting
products other than current accounts.
The fourth scenario represents the present situation in which no adjustments are introduced to the Basle
framework to cater for PSIAs. In this scenario, PSIA financing would hardly be of help to Islamic banks which
have a CAR below the stipulated 8 per cent and are pursuing a financial strategy similar to that of KFH and JIM
or FIBS. Such banks would have no option but to increase their equity capital (as suggested by Figures 1, 2,
and 3) according to the conditions of Tier 1 and Tier 2 capital and/or reallocate their assets in favour of lower
risk-weighted categories in order to comply with the requirements of the Basle framework. However, like the
third scenario, Islamic banks are unlikely to find it easy to concentrate their investments in assets that attract
low risk weightings which would allow their shareholders to reap the benefits of high PSIA financing. On the
other hand, like the third scenario, the adoption of this scenario would also mean that Islamic banks like KFH
and JIB would tend to pursue a marketing strategy of maintaining their market share of PSIAs, as there would
be no incentives to attract more funds through these accounts while Islamic banks like FIBS are likely to adjust
their marketing strategy to focus on promoting products other than current accounts.
Table II gives a summary of the four scenarios. It shows that scenarios 1 and 2 would achieve a congruence
between the Basle CAR requirements and the financial strategy of Islamic banks like KFH and JIM which aims
at increasing PSIA financing while keeping equity capital at a minimum. The marketing strategy of these banks
would focus on expanding their market share of PSIA. On the other hand, Islamic banks like FIBS would be
encouraged to change their financial strategy and adjust their marketing strategy accordingly to enjoy the
benefits of PSIA financing.
However, whereas in scenario 1 a limit may be set for the amount of PSIA financing to be included in Tier 1
capital, scenario 2 provides an additional advantage of using PSIA financing to reduce the total risk-weighted
assets of Islamic banks, thereby helping in increasing their CAR. Unlike the former scenario, in which Islamic
banks are likely to adopt a marketing strategy of maintaining their market share of PSIAs, scenario 2 would tend
to encourage these banks to adopt a marketing strategy that aims at capturing more share of PSIA market.
On the other hand, unlike the first and second scenarios, in scenarios 3 and 4 the financial strategy of
promoting PSIA financing would hardly be of help to Islamic banks in meeting the CAR requirements. In
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addition, given the nature and the financial instruments of the investments of Islamic banks, which would attract
high risk weightings, it is unlikely that their shareholders would reap the benefits of high PSIA financing. This
would also imply that Islamic banks would tend to adopt a marketing strategy of maintaining their share in the
PSIA market.
The theme emerging from the analysis of the four scenarios suggests that both the financial and marketing
strategies of an Islamic bank would be contingent on the scenario to be adopted by regulatory authorities for the
treatment of PSIA financing. This in turn would determine whether or not shareholders would be able to
increase their rate of return at no extra risk.
Concluding remarks
The Shari'a, which governs Islamic banks in all their transactions, prohibits the receipt and payment of interest,
among other things. Islamic banks mobilize funds on the basis of profit sharing and use different methods in
their application of funds. Some of these methods are also based on profit sharing.
The Basle Accord, which came into effect in 1992, stipulates the minimum CAR which banks have to achieve
and specifies how it should be measured. Capital is split into two Tiers and is related to total assets weighted by
their risk.
This paper develops four possible scenarios for the treatment of PSIAs by regulatory authorities and examines
their implications on the financial strategies of Islamic banks in the light of the risk-return relationship of
shareholders and PSIAs. It is argued that the scenario to be adopted by regulatory authorities would tend to
influence both the financial and marketing strategies of Islamic banks. This in turn would determine whether or
not shareholders would be able to keep their equity capital at a minimum and increase their rate of return at no
extra risk.
Notes
1Shari'a is the sacred law of Islam. It is derived from the Quran (the Muslim Holy Book), the Sunna (the sayings
and deeds of Prophet Mohammed), Tjma (consensus), Qiyas (reasoning by analogy) and Maslaha
(consideration of the public good or common need).
2Riba is translated strictly as usury, but interpreted universally as interest.
3Similarly, ethical mutual funds in the West do not invest in companies that fail to meet their social criteria. See
Owen (1990) and Perks et al. (1992) for more details on social investments.
4See chapter 4 in Gambling and Karim (1991) for more details on the development of business organizations
and financial institutions within Islam.
5This is a standing committee of the Governors of the Group of Ten major industrial countries based in Basle,
Switzerland. Its task is to promote supervisory co-operation and co-ordination mainly in the field of banking. The
committee has no direct authority other than the weight of its collective opinion and the support of the Central
Bank Governors. Its recommendations are implemented in its member countries and many other countries
around the world.
6See the International Convergence of Capital Measurement and Capital Standards published by the
Committee on Banking Regulations and Supervisory Practices (1988).
7This includes issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred
stock (but excluding cumulative preferred stock).
8In this paper, the term profit sharing investment accounts (PSIA is used to refer to both savings and
investment accounts. This does not include current accounts because they are not accepted on the basis of
profit sharing as the other two types of accounts.
9Unlike Western commercial banks which pay interest on some current accounts, Islamic banks are prohibited
to pay interest on current accounts or any other type of deposits.
10 In markets where competition is high, some Islamic banks (e.g. Kuwait Finance House) attempt to attract
funds in PSIAs by offering their holders the opportunity to share in the revenues from current accounts but
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without holding them accountable for these accounts if there were losses.
11 This is the position adopted by the Accounting and Auditing Organization for Islamic Financial Institutions
(1993) - the body established to regulate the financial reporting by Islamic banks - in its Financial Accounting
Statement No. 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions. PSIAs would
neither be listed under liabilities, as is currently the practice of almost all Islamic banks, nor would they be
included with owners' equity funds. Hence, the formula of the balance sheet of an Islamic bank should be:
assets = liabilities + profit sharing investment accounts + owners' equity.
12 The Accounting and Auditing Organization for Islamic Financial Institutions (1993), in its Financial
Accounting Statement No. 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions,
treats restricted investment accounts as an off-balance sheet item and requires Islamic banks to report them in
a separate statement.
13 For example, article 45 of the Articles of Association of Kuwait Finance House states that funds deposited in
investment accounts cannot be withdrawn before maturity or without the prior consent of the bank.
14For example, the General Conditions Governing Investment and Current Accounts of Faysal Islamic Bank of
Bahrain include the following:11. In the case of an Investor withdrawing his/her investment during a month, the
corresponding profit for that month shall be payable to him/her only after the valuation of assets at the end of
that month.12. Withdrawals before maturity are not permitted...
15 For more details on the nature and operations of these mechanisms see Karim and Ali (1988), Nienhouse
(1986), Shirazi (1990) and Wohlers-Scharf (1983).
16 This does not necessarily mean that shareholders have to be directors of the bank.
17 This is because such an arrangement would include a strong element of gharar (risk, speculation,
uncertainty) which is prohibited by Shari'a. According to Saleh (1992, pp. 135-6), "the future existence of the
promised lump sum was very uncertain when the promise was made, and furthermore its actual ratio to the real
profit was totally unknown. Another reason for the illegality of such an arrangement is that it is not the business
risk which is rewarded but the mere act of remitting money to the agent-manager [bank]. That amounts to a
ribawa [susceptible toriba] transaction" (emphasis in original).
18The General Conditions Governing Investment and Current Accounts of FIBB state that:26. Each Investor
shall authorize FIB[B] to deduct up to a maximum of 10 per cent from his/her net profit in favour of the Reserve
Modarabas Fund as Takafol [solidarity] among other investors to face any risk encountered by the assets of the
Modarabas, although FIB[B] may not necessarily always need to make such deductions.Similarly, Section 20
(a) in JIB's Statute states that:In order to replenish the special account for meeting investment risks the Bank
shall deduct annually an amount equal to 20 per cent of the net profits realised from the various investment
operations during that year.
19 These are commonly known as Shari'a Supervisory Board and are employed by the bank to assure
consumers of its services that it is adhering to the precepts of the Shari'a in its financial transactions. See
Briston and El-Ashker (1986) and Karim (1990) for more details on the duties of the Board.
20 For example, losses from subsidiaries, because they are borne solely by shareholders.
21 This is a fictitious bank.
22 Usually Islamic banks do not invest the full amount of funds deposited in PSIAs in order to meet the liquidity
requirements of the different maturity dates of these accounts. Hence, the amount not invested should not be
deducted from the total risk-weighted assets. This is because, according to the contractual relationship between
an Islamic bank and holders of PSIAs, if the former declares that it will not invest part of the funds deposited in
PSIAs then the funds not invested are treated as an obligation on the part of the Islamic bank and, in the case
of loss, they should be paid from shareholders' equity. Hence, the need to hold equity capital to cater for this
risk.
23 This does not apply to savings accounts which, although they share in the profits and losses, are
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redeemable at the initiative of the holder and without the prior consent of the bank. Hence, they could be
excluded from PSIAs.
References
1. Accounting and Auditing Organization for Islamic Financial Institutions (1993, Financial Accounting Statement
No. 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions, Bahrain, October.
2. Ahmad, A. (1987, Development and Problems of Islamic Banks, Islamic Research and Training Institute,
Islamic Development Bank, Jeddah.
3. Banker, The (1988, "Islamic banking: sensitive issues", The Banker, December, p. 73.
4. Briston, R. and El-Ashker, A. (1986, "Religious audit: could it happen here?", Accountancy, October, pp. 1201.
5. Committee on Banking Regulations and Supervisory Practices (1988, International Convergence of Capital
Measurement and Capital Standards, Basle, Switzerland.
6. Duncan, R.G. (1972, "Characteristics of organizational environments and perceived environmental
uncertainty", Administrative Science Quarterly, Vol. 17, pp. 313-27.
7. Gambling, T. and Karim, R.A.A. (1991, Business and Accounting Ethics in Islam, Mansell, London.
8. Karim, R.A.A. (1990, "The independence of religious and external auditors: the case of Islamic banks",
Accounting, Auditing and Accountability Journal, Vol. 3 No. 3, pp. 33-44.
9. Karim, R.A.A. and Abdallah, A.A. (1995, A Study on the Juristic and Accounting Aspects of the Sale of
Murabaha and Murabaha to the Purchase Orderer, Research Document, Accounting and Auditing Organization
for Islamic Financial Institutions, Bahrain.
10. Karim, R.A.A. and Ali, A.E. (1988, "Towards an understanding of the use of the financing mechanisms of
Islamic banks", Arab Journal of the Social Sciences, Vol. 3 No. 1, April, pp. 55-67.
11. Karim, R.A.A. and Ali, A.E. (1989, "Determinants of the financial strategy of Islamic banks", Journal of
Business Finance and Accounting, Vol. 16 No. 2, Spring, pp. 193-212.
12. Llewellyn, D.T. (1988, "Capital adequacy", in Wilson, J.S.G. (Ed.), Managing Bank Assets and Liabilities,
Euromoney Publications, London.
13. Llewellyn, D.T. (1989, "Capital regulatory convergence: the Basle proposals", Butterworths Journal of
International Banking and Financial Law, October, pp. 441-5.
14. Llewellyn, D.T. (1992, "Bank capital: the strategic issue of the 1990s", Banking World, January, pp. 20-5.
15. Moyer, S.E. (1990, "Capital adequacy ratio regulations and accounting choices in commercial banks",
Journal of Accounting and Economics, Vol. 13, pp. 123-54.
16. Nienhouse, V. (1986, "Islamic economics, financing and banking: theory and practice", Islamic Banking and
Financing, Butterworths, London.
17. Owen, D.L. (1990, "Towards a theory of social investment: a review essay", Accounting, Organizations and
Society, Vol. 15 No. 3, pp. 249-65.
18. Perks, R.W., Rawlinson, D.H. and Ingram, L. (1992, "An exploration of ethical investment in the UK", The
British Accounting Review, Vol. 24 No. 1, pp. 43-65.
19. Saleh, N.A. (1992, Unlawful Gain and Legitimate Profit in Islamic Law, Graham &Trotman, London.
20. Shirazi, H. (1990, Islamic Banking, Butterworths, Sevenoaks.
21. Sinkey Jr, J.F. (1989, Commercial Bank Financial Management in the Financial Services Industry, 3rd ed.,
Macmillan, NY.
22. Wohlers-Scharf, T. (1983, Arab and Islamic Banks, Organization for Economic Co-operation and
Development, Paris.
Illustration
Caption: Table I; Balance sheet of Al-Siddiq Bank as at 31 December 1991; Figure 1; Kuwait Finance House:
main sources of funds 1979-1994; Figure 2; Jordan Islamic Bank: main sources of funds 1980-1994; Figure 3;
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Faisal Islamic Bank - Sudan: main sources of funds 1979-1994; Table II; Summary of the impact of the four
scenarios on the financial and marketing strategies of Islamic banks
Subject: Islam; Banks; Regulation of financial institutions; Profit sharing plans; Investment; Methods;
Location: Middle East
Classification: 8120: Retail banking services; 9178: Middle East; 3400: Investment analysis & personal finance
Publication title: The International Journal of Bank Marketing
Volume: 14
Issue: 7
Pages: 32-44
Number of pages: 0
Publication year: 1996
Publication date: 1996
Year: 1996
Publisher: Emerald Group Publishing, Limited
Place of publication: Bradford
Country of publication: United Kingdom
Publication subject: Business And Economics--Banking And Finance, Business And Economics--Marketing And
Purchasing
ISSN: 02652323
Source type: Scholarly Journals
Language of publication: English
Document type: Feature
ProQuest document ID: 231339776
Document URL: http://search.proquest.com/docview/231339776?accountid=25704
Copyright: Copyright MCB UP Limited (MCB) 1996
Last updated: 2014-05-26
Database: Banking Information Source

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