Edited by M. Fahim Khan and Mario Porzio
Chapter 7: Islamic Banking: A Challenge for the Basel Capital Accord
Elisabetta Montanaro INTRODUCTION Every type of financial innovation forces regulators to question their limits and the effectiveness of the existing rules for financial institutions, instruments and cultures different from those for which the rules were initially devised (Merton 1995). In this perspective, the increasing spread of Islamic banks in the Western banking system represents an interesting test on the ability of the Basel capital discipline to reconcile a discretionary and flexible approach, necessary for coping with this type of intermediation, with the objective of safeguarding a level playing field through standardised and uniform regulations. For prudential capital rules, Islamic banking is in many ways a paradox. On the one hand, it is understandable that its operations, so different from the conventional models with which the regulatory authorities are used to dealing, are deemed potentially riskier,1 and therefore subject to stricter capital rules. On the other hand, the essence of profit-sharing contracts seems to make this type of intermediation better able to bear unexpected losses than conventional banks, questioning the same logic of capital requirements. In the Core Principles for Effective Banking Supervision, the minimum capital requirements are clearly stated as central among the global standard principles of banking regulations. According to Principle 6, ‘Banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses’ (Basel Committee 1997, emphasis added). While the regulatory...
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