www.basicfinancial.org

by European Parliament

Introduction: Information, Risks, and Capital

Financial intermediation is a critical factor for growth and social inclusion. One of its core functions is to mobilize financial resources from surplus agents and channel them to those with deficits. It thus allows investor entrepreneurs to expand economic activity and employment opportunities. It also enables household consumers, micro- and small entrepreneurs to expand their own welfare and earnings opportunities, and seek to smooth their lifetime outlays. In all cases, financial intermediation drives economic growth and contributes to social inclusion, provided it is conducted in a sound and efficient way.[1]

A financial intermediary’s ability to process information on risks and returns of investment opportunities will have a bearing on the soundness and efficiency of its resource mobilization and reallocation function. Conventional financial services (CFSs) process information through institutions or markets, and have generally evolved from the former to the latter. In both cases, markets and agents provide alternative ways of processing information on risks and returns of investment opportunities. In the first form, the intermediary raises capital to set up business to collect generally liquid deposits from surplus agents and reallocates these resources, now in his trust, to ones with deficits in generally less liquid assets. In the second form, surplus agents buy directly financial assets that represent a debt of a deficit agent or an ownership share in its business. In either approach, both categories of agents engage in transactions on the basis of trust and of expectations about the degree of liquidity that would provide the option to re-contract at a reasonable cost.[2] In the case of banks, the trust can be seen as based on proprietary information. In the case of markets, the information is more commoditized and widely available.[3]

Efficiently processed information can support the efficient allocation of capital. It can help a financial intermediary to better define the capital it would need to achieve the returns sought, while maintaining its ability to face the financial consequences of unexpected events that may endanger its stability. Banks engage in gathering and processing information on clients and markets, which allows them to manage different risks by unbundling them and reallocating the components. By performing these services soundly and efficiently, banks can manage to calibrate their capital requirements and receive diversified income streams. Thus a bank’s investors and customers can gain comfort as to its reliability in allowing them to access liquidity and maintain stability. In parallel with banks, financial markets can also convey the same sense of access to liquidity and stability based on disclosed and broadly available information on market participants. Markets can provide deficit and surplus agents a direct role in processing information to facilitate the unbundling and reallocation of risks and the efficient use of capital. Thus, banks and markets compete and complement each other in financial intermediation. The competition puts pressure on individual agents to use capital at their disposal efficiently, and results in a system-wide improved allocation of capital resources.[4]

Institutions offering Islamic financial services (IIFSs) also process information on risks and returns of investment opportunities while complying with Shari’ah principles.[5] Thus, in principle, they can be expected to increase competition in financial information processing by inducing better risk management and capital use. Such competition can be expected over time to lead to an efficient use of capital at the level of each financial agent, whether they practice conventional or Islamic finance, and in aggregate, system-wide across all modes of financial intermediation. Efficient use of capital is thus a challenge which competition imposes on all financial intermediaries, whether offering Islamic financial services or conventional financial services. At the same time, Islamic financial intermediation needs to comply with Shari’ah principles, notably those of risk sharing and materiality of financial transactions. Shari’ah compliance, social responsibility, and the discipline of competition compound IIFSs’ challenge to process information efficiently in order to manage the risks they may face and use their capital endowments. Thus, by their very nature and the environment in which they generally operate, IIFSs need to be well equipped with the information and skills that can allow them to identify their capital resources and use them efficiently.

            This chapter argues for the need for Islamic financial services to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerance. It suggests that IIFSs could invest in the collection of loss information and adoption of loss data management systems. IIFSs would benefit from implementing risk management methodologies and adapting their staffing skills accordingly. The chapter starts in Section 2 by outlining views on the relationship between risk management and capital for financial intermediation. It then overviews risk categories as an initial step in risk management in Section 3. Section 4 discusses regulatory and economic capital, introducing risk occurrence frequency as a distribution probability. Section 5 concludes with suggestions on steps that may help with risk management and improve the competitiveness of IIFSs.

2.         Bank Capital and Risk Management

Bank capital may be considered as consisting of (a) equity capital and (b) certain non-deposit liabilities or debt capital (see Section 4). It is both a means of funding earnings-generating assets and a stability cushion. From the perspective of efficiency and returns, capital is part of a bank’s funding that can be applied directly to the purchase of earning assets, as well as being used as a basis for leverage to raise other funds for expanding assets with the net benefit accruing to shareholders. From a perspective of stability, bank capital is a cushion for absorbing shocks of business losses and maintaining solvency, with benefits accruing to depositors and other stakeholders. Both financial intermediaries and regulators are sensitive to the dual role of capital, as a means of funding earnings-generating assets and as a cushion for dealing with unanticipated events. Financial intermediaries may tend to be more focused on the former role and regulators on the latter.

A bank’s capital structure decision relates to the ratio of capital to deposits and to the ratio of debt capital to equity capital. Its performance, in terms of return on equity capital, will be influenced by its ability to calibrate the level of capital it requires. Through efficient risk management, it can reach a sense of which capital structure can best help it to: (a) achieve profitability while maintaining stability; (b) reassure markets as to the quality of its business conduct; and (c) have a constructive dialogue with regulators.

Efficient use of capital will help IIFSs to achieve profitability and stability. Allocating capital resources to low-performing or excessively risky assets is bound to drag down performance, endanger stability, or both. Equally, leaving capital idle entails at best forgoing earnings opportunities. For instance, overly cautious approaches that lead financial intermediaries to maintain larger amounts of capital than warranted by their risk profile may not allow them either to obtain the full potential of their capital or to contribute effectively to the development of the communities they serve. At the other end of the spectrum, a financial intermediary overly eager to achieve returns may allocate resources to highly risky assets that offer high returns but endanger stability. Explicit risk management practices can help in the selection of assets to which capital and other resources are applied and calibrate the level of capital that best suits business objectives and stability tolerance.

The size and composition of the resources that capital enables financial intermediaries to raise are likely to affect their profitability and stability. In a frictionless world where full information is available and markets are complete, the value of a firm would be independent of its capital structure, and so the focus should be on capital level and not structure.[6] Under such circumstances, the method by which a financial intermediary raises its required funds would be irrelevant. However, financial intermediaries do not operate in a frictionless world; they face imperfections such as costs of bankruptcy and financial distress, transaction costs, asymmetric information, or taxes. They also operate within the framework of a governing regulation possibly with a deposit insurance scheme that is expected to provide a safety net. In fact, one may contend that these market imperfections are the very reason for the successful existence of banks as financial intermediaries. Accordingly, not only a financial intermediary’s level of capital but also its structure is likely to bear on its market valuation, its business conduct, and its stability. Effective risk management strategies should contribute to a financial intermediary’s ability to assess not only the level of capital it would need in relation to assets and deposits, but also the extent to which its structure affects its value.

Market discipline contributes to responsible corporate behavior. Markets’ reactions to perceptions of a financial intermediary’s business conduct and capital strength may be unforgiving. It is thus in the interest of financial intermediaries to develop approaches to defining capital resource requirements that take into account the institutional environment in which they operate. The market’s perception of market imperfections is likely to influence views on the appropriate level of capital and the capital adequacy of financial intermediaries. For example, the availability of a safety net may lead market participants to be less demanding as to the need for capital in relation to bank assets. Conversely, anticipation of high costs of financial distress to depositors and other stakeholders may induce market participants to require the holding of more capital proportionally to assets. Similarly, wherever the institutional environment is weak and contract enforcement is uncertain and costly, markets may expect financial intermediaries to adapt the capital they hold.

The management of capital structure should in principle mitigate the risk of bank failures. When comparing a highly leveraged bank and a bank that is well capitalized, the leveraged bank will likely experience a greater loss of value during times of financial distress when the asset quality deteriorates, due to the increased risk of bankruptcy. To cope with downturns, in most countries banks hold a minimum amount of capital, based on the risk embedded in their asset holding. Accordingly, banks with relatively risky assets would hold a higher amount of capital than those banks with less risky assets. However, fearing the harshness of market discipline, many banks maintain a higher level of capital than the minimum required to allay the perception that they may be undercapitalized and avoid the losses this may induce, as witnessed in the 1980s. The key capital adequacy ratio provides an assessment of just how adequately the capital cushions such fluctuations in the bank’s earnings and supports higher assets growth.

Finally, efficient risk management should allow financial intermediaries to have a constructive dialogue with regulators. It would help them to articulate their views with respect to capital needs. The regulators’ rationale for regulating capital stems from the perception of the public-good nature of bank services, their potential macroeconomic growth and stability impact, and experience with costly bank failures. According to some estimates, such costs have varied between 3% and 55% of GDP.[7] Thus, regulators’ concerns with possible systemic risk resulting from the contagion effects of bank runs lead them to seek to mitigate risks of financial distress with regulatory requirements on banks’ capital.[8] Regulators’ concerns may be compounded by the presence of deposit insurance schemes. The moral hazard that may result from deposit insurance may lead to additional regulatory requirements such as linking the level of insurance premia to the risk embedded in assets and captured in associated risk weights. Indeed, deposit insurance may induce banks to lever up capital by expanding their own funding with liabilities, thus placing more risk on their capital and increasing their vulnerability. Efficient risk management practices would allow banks to improve their dialogue with the regulator and convey more convincingly their views on their soundness and capital requirements.

Regulators would generally also be concerned with the overall impact on the economy of the resources raised by the financial system under their purview. From an economy-wide perspective, banks may be viewed as firms’ competitors in raising capital on financial markets. The outcome of this competition has a bearing on economic performance and financial stability, and points to a cost–benefit tradeoff in holding capital. For instance, Gersbach (2007) suggests that a benefit of bank capital is the equity acting as a buffer against future losses, thereby reducing excessive risk taking of the banks. At the same time, raising bank capital may lead to a crowding out of industrial firms, limiting their access to equity and other market funding and also impacting their access to funding from banks and its cost. Furthermore, raising equity on markets may increase the cost of banks’ resources, inducing them to seek to invest in higher-yielding but more risky assets and thereby increasing their risk exposure. Thus, while potentially providing a cushion against unforeseen events, a higher level of equity may actually induce more risk taking, notably through raising the cost of funds to banks and their clients. Efficient risk management can provide inputs to both banks and regulators to better calibrate capital needs and deal with the foregoing type of tradeoff.

The level of a financial intermediary’s capital may also have a bearing on its ability to provide liquidity. The financial intermediary provides liquidity by funding assets that may be less liquid than the deposit resources it collects. There is a view that requirements for higher levels of capital may have a negative impact on liquidity creation.[9] On the liability side, a higher capital requirement may lead to a corresponding reduction in the level of deposits, thus constraining the ability to provide liquidity. Also, higher capital requirements may induce financial intermediaries to be more restrained in extending financing, thus constraining their ability to provide liquidity. However, according to another view, higher capital would allow the financial intermediary to create more liquidity since its risk-absorptive capacity would be improved.[10] In this regard, an empirical study concluded that for larger banks capital has a statistically significant positive net effect on liquidity creation, while for small banks this effect is negative.[11] Accordingly, each financial intermediary would need to evaluate carefully the level and composition of the capital it needs, since the latter plays a significant role in its ability to function as a liquidity provider. Equally, regulators would need to pay attention to the impact which capital requirement would have on the funding of the economy.

IIFS’s risk management arrangements will bear on their ability to calibrate capital to their business objectives and risk tolerance, to deal with market discipline, and to maintain a dialogue with regulators. The IIFS’s characteristic of mobilizing funds in the form of risk-sharing investment accounts in place of conventional deposits, together with the materiality[12] of financing transactions, may alter the overall risk of the balance sheet and, consequently, the assessment of their capital requirements. Indeed, risk-sharing “deposits” would in principle reduce the need for a safety cushion to weather adverse investment outcomes. Similarly, the materiality of investments is likely to modify the extent of their risk and have a bearing on the assessment for the overall need for capital; asset-based modes of finance may be less risky and profit-sharing modes more risky, than conventional interest-bearing modes. Nevertheless, IIFSs would operate within a regulatory framework that is likely to impose on them capital requirements with a view to promoting stability and limiting contagion risks. However, besides regulatory and market demands for IIFSs to hold capital, IIFSs need to put in place risk management assessments for their own purposes of returns and stability in accordance with the requirements of Shari’ah, their own mission statements, and the protection of their stakeholders.

[1] See Honohan (2004) and Levine (2004).

[2] Sir John Hicks identifies such liquidity as one of the main factors behind the Industrial Revolution.

[3] Actually, a deposit can be viewed as a purchase of a debt asset issued by the intermediary and redeemable at its face value.

[4] The institution–market competition is reflected in the trends of their relative market shares of total financial assets. For example, in the United States, between 1960 and the early 1990s, commercial banks’ share of total financial intermediaries’ assets fell from around 40% to less than 30%. See Edwards (1996).

[5] They do respond to a latent demand for financial services that do not breach Shari’ah principles. Accordingly, they have the potential to contribute to financial deepening, economic growth, and social inclusion. See also Burghardt and Fuss (2004).

[6] Modigliani and Miller (1958).

[7] See Klingebiel and Laeven (2007).

[8] Views differ on the need for and extent of regulation, as well as on the usefulness of deposit insurance; see Barth, Caprio, and Levine (2007).

[9] Diamond and Rajan (2006).

[10] Allen and Gale (2007).

[11] Berger and Bouwman (2005).

[12] By the “materiality” of financing transactions is meant that, in such transactions, capital must be “materialized” in the form of an asset or asset services (as in Murabaha credit sales, Salam and Istisna’a financing, or Ijarah leasing), or of a business venture (Musharakah or Mudarabah). Capital in the form of money is not entitled to any return, as this would be interest (riba). 

Introduction: Information, Risks, and Capital

Financial intermediation is a critical factor for growth and social inclusion. One of its core functions is to mobilize financial resources from surplus agents and channel them to those with deficits. It thus allows investor entrepreneurs to expand economic activity and employment opportunities. It also enables household consumers, micro- and small entrepreneurs to expand their own welfare and earnings opportunities, and seek to smooth their lifetime outlays. In all cases, financial intermediation drives economic growth and contributes to social inclusion, provided it is conducted in a sound and efficient way.[1]

A financial intermediary’s ability to process information on risks and returns of investment opportunities will have a bearing on the soundness and efficiency of its resource mobilization and reallocation function. Conventional financial services (CFSs) process information through institutions or markets, and have generally evolved from the former to the latter. In both cases, markets and agents provide alternative ways of processing information on risks and returns of investment opportunities. In the first form, the intermediary raises capital to set up business to collect generally liquid deposits from surplus agents and reallocates these resources, now in his trust, to ones with deficits in generally less liquid assets. In the second form, surplus agents buy directly financial assets that represent a debt of a deficit agent or an ownership share in its business. In either approach, both categories of agents engage in transactions on the basis of trust and of expectations about the degree of liquidity that would provide the option to re-contract at a reasonable cost.[2] In the case of banks, the trust can be seen as based on proprietary information. In the case of markets, the information is more commoditized and widely available.[3]

Efficiently processed information can support the efficient allocation of capital. It can help a financial intermediary to better define the capital it would need to achieve the returns sought, while maintaining its ability to face the financial consequences of unexpected events that may endanger its stability. Banks engage in gathering and processing information on clients and markets, which allows them to manage different risks by unbundling them and reallocating the components. By performing these services soundly and efficiently, banks can manage to calibrate their capital requirements and receive diversified income streams. Thus a bank’s investors and customers can gain comfort as to its reliability in allowing them to access liquidity and maintain stability. In parallel with banks, financial markets can also convey the same sense of access to liquidity and stability based on disclosed and broadly available information on market participants. Markets can provide deficit and surplus agents a direct role in processing information to facilitate the unbundling and reallocation of risks and the efficient use of capital. Thus, banks and markets compete and complement each other in financial intermediation. The competition puts pressure on individual agents to use capital at their disposal efficiently, and results in a system-wide improved allocation of capital resources.[4]

Institutions offering Islamic financial services (IIFSs) also process information on risks and returns of investment opportunities while complying with Shari’ah principles.[5] Thus, in principle, they can be expected to increase competition in financial information processing by inducing better risk management and capital use. Such competition can be expected over time to lead to an efficient use of capital at the level of each financial agent, whether they practice conventional or Islamic finance, and in aggregate, system-wide across all modes of financial intermediation. Efficient use of capital is thus a challenge which competition imposes on all financial intermediaries, whether offering Islamic financial services or conventional financial services. At the same time, Islamic financial intermediation needs to comply with Shari’ah principles, notably those of risk sharing and materiality of financial transactions. Shari’ah compliance, social responsibility, and the discipline of competition compound IIFSs’ challenge to process information efficiently in order to manage the risks they may face and use their capital endowments. Thus, by their very nature and the environment in which they generally operate, IIFSs need to be well equipped with the information and skills that can allow them to identify their capital resources and use them efficiently.

            This chapter argues for the need for Islamic financial services to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerance. It suggests that IIFSs could invest in the collection of loss information and adoption of loss data management systems. IIFSs would benefit from implementing risk management methodologies and adapting their staffing skills accordingly. The chapter starts in Section 2 by outlining views on the relationship between risk management and capital for financial intermediation. It then overviews risk categories as an initial step in risk management in Section 3. Section 4 discusses regulatory and economic capital, introducing risk occurrence frequency as a distribution probability. Section 5 concludes with suggestions on steps that may help with risk management and improve the competitiveness of IIFSs.

2.         Bank Capital and Risk Management

Bank capital may be considered as consisting of (a) equity capital and (b) certain non-deposit liabilities or debt capital (see Section 4). It is both a means of funding earnings-generating assets and a stability cushion. From the perspective of efficiency and returns, capital is part of a bank’s funding that can be applied directly to the purchase of earning assets, as well as being used as a basis for leverage to raise other funds for expanding assets with the net benefit accruing to shareholders. From a perspective of stability, bank capital is a cushion for absorbing shocks of business losses and maintaining solvency, with benefits accruing to depositors and other stakeholders. Both financial intermediaries and regulators are sensitive to the dual role of capital, as a means of funding earnings-generating assets and as a cushion for dealing with unanticipated events. Financial intermediaries may tend to be more focused on the former role and regulators on the latter.

A bank’s capital structure decision relates to the ratio of capital to deposits and to the ratio of debt capital to equity capital. Its performance, in terms of return on equity capital, will be influenced by its ability to calibrate the level of capital it requires. Through efficient risk management, it can reach a sense of which capital structure can best help it to: (a) achieve profitability while maintaining stability; (b) reassure markets as to the quality of its business conduct; and (c) have a constructive dialogue with regulators.

Efficient use of capital will help IIFSs to achieve profitability and stability. Allocating capital resources to low-performing or excessively risky assets is bound to drag down performance, endanger stability, or both. Equally, leaving capital idle entails at best forgoing earnings opportunities. For instance, overly cautious approaches that lead financial intermediaries to maintain larger amounts of capital than warranted by their risk profile may not allow them either to obtain the full potential of their capital or to contribute effectively to the development of the communities they serve. At the other end of the spectrum, a financial intermediary overly eager to achieve returns may allocate resources to highly risky assets that offer high returns but endanger stability. Explicit risk management practices can help in the selection of assets to which capital and other resources are applied and calibrate the level of capital that best suits business objectives and stability tolerance.

The size and composition of the resources that capital enables financial intermediaries to raise are likely to affect their profitability and stability. In a frictionless world where full information is available and markets are complete, the value of a firm would be independent of its capital structure, and so the focus should be on capital level and not structure.[6] Under such circumstances, the method by which a financial intermediary raises its required funds would be irrelevant. However, financial intermediaries do not operate in a frictionless world; they face imperfections such as costs of bankruptcy and financial distress, transaction costs, asymmetric information, or taxes. They also operate within the framework of a governing regulation possibly with a deposit insurance scheme that is expected to provide a safety net. In fact, one may contend that these market imperfections are the very reason for the successful existence of banks as financial intermediaries. Accordingly, not only a financial intermediary’s level of capital but also its structure is likely to bear on its market valuation, its business conduct, and its stability. Effective risk management strategies should contribute to a financial intermediary’s ability to assess not only the level of capital it would need in relation to assets and deposits, but also the extent to which its structure affects its value.

Market discipline contributes to responsible corporate behavior. Markets’ reactions to perceptions of a financial intermediary’s business conduct and capital strength may be unforgiving. It is thus in the interest of financial intermediaries to develop approaches to defining capital resource requirements that take into account the institutional environment in which they operate. The market’s perception of market imperfections is likely to influence views on the appropriate level of capital and the capital adequacy of financial intermediaries. For example, the availability of a safety net may lead market participants to be less demanding as to the need for capital in relation to bank assets. Conversely, anticipation of high costs of financial distress to depositors and other stakeholders may induce market participants to require the holding of more capital proportionally to assets. Similarly, wherever the institutional environment is weak and contract enforcement is uncertain and costly, markets may expect financial intermediaries to adapt the capital they hold.

The management of capital structure should in principle mitigate the risk of bank failures. When comparing a highly leveraged bank and a bank that is well capitalized, the leveraged bank will likely experience a greater loss of value during times of financial distress when the asset quality deteriorates, due to the increased risk of bankruptcy. To cope with downturns, in most countries banks hold a minimum amount of capital, based on the risk embedded in their asset holding. Accordingly, banks with relatively risky assets would hold a higher amount of capital than those banks with less risky assets. However, fearing the harshness of market discipline, many banks maintain a higher level of capital than the minimum required to allay the perception that they may be undercapitalized and avoid the losses this may induce, as witnessed in the 1980s. The key capital adequacy ratio provides an assessment of just how adequately the capital cushions such fluctuations in the bank’s earnings and supports higher assets growth.

Finally, efficient risk management should allow financial intermediaries to have a constructive dialogue with regulators. It would help them to articulate their views with respect to capital needs. The regulators’ rationale for regulating capital stems from the perception of the public-good nature of bank services, their potential macroeconomic growth and stability impact, and experience with costly bank failures. According to some estimates, such costs have varied between 3% and 55% of GDP.[7] Thus, regulators’ concerns with possible systemic risk resulting from the contagion effects of bank runs lead them to seek to mitigate risks of financial distress with regulatory requirements on banks’ capital.[8] Regulators’ concerns may be compounded by the presence of deposit insurance schemes. The moral hazard that may result from deposit insurance may lead to additional regulatory requirements such as linking the level of insurance premia to the risk embedded in assets and captured in associated risk weights. Indeed, deposit insurance may induce banks to lever up capital by expanding their own funding with liabilities, thus placing more risk on their capital and increasing their vulnerability. Efficient risk management practices would allow banks to improve their dialogue with the regulator and convey more convincingly their views on their soundness and capital requirements.

Regulators would generally also be concerned with the overall impact on the economy of the resources raised by the financial system under their purview. From an economy-wide perspective, banks may be viewed as firms’ competitors in raising capital on financial markets. The outcome of this competition has a bearing on economic performance and financial stability, and points to a cost–benefit tradeoff in holding capital. For instance, Gersbach (2007) suggests that a benefit of bank capital is the equity acting as a buffer against future losses, thereby reducing excessive risk taking of the banks. At the same time, raising bank capital may lead to a crowding out of industrial firms, limiting their access to equity and other market funding and also impacting their access to funding from banks and its cost. Furthermore, raising equity on markets may increase the cost of banks’ resources, inducing them to seek to invest in higher-yielding but more risky assets and thereby increasing their risk exposure. Thus, while potentially providing a cushion against unforeseen events, a higher level of equity may actually induce more risk taking, notably through raising the cost of funds to banks and their clients. Efficient risk management can provide inputs to both banks and regulators to better calibrate capital needs and deal with the foregoing type of tradeoff.

The level of a financial intermediary’s capital may also have a bearing on its ability to provide liquidity. The financial intermediary provides liquidity by funding assets that may be less liquid than the deposit resources it collects. There is a view that requirements for higher levels of capital may have a negative impact on liquidity creation.[9] On the liability side, a higher capital requirement may lead to a corresponding reduction in the level of deposits, thus constraining the ability to provide liquidity. Also, higher capital requirements may induce financial intermediaries to be more restrained in extending financing, thus constraining their ability to provide liquidity. However, according to another view, higher capital would allow the financial intermediary to create more liquidity since its risk-absorptive capacity would be improved.[10] In this regard, an empirical study concluded that for larger banks capital has a statistically significant positive net effect on liquidity creation, while for small banks this effect is negative.[11] Accordingly, each financial intermediary would need to evaluate carefully the level and composition of the capital it needs, since the latter plays a significant role in its ability to function as a liquidity provider. Equally, regulators would need to pay attention to the impact which capital requirement would have on the funding of the economy.

IIFS’s risk management arrangements will bear on their ability to calibrate capital to their business objectives and risk tolerance, to deal with market discipline, and to maintain a dialogue with regulators. The IIFS’s characteristic of mobilizing funds in the form of risk-sharing investment accounts in place of conventional deposits, together with the materiality[12] of financing transactions, may alter the overall risk of the balance sheet and, consequently, the assessment of their capital requirements. Indeed, risk-sharing “deposits” would in principle reduce the need for a safety cushion to weather adverse investment outcomes. Similarly, the materiality of investments is likely to modify the extent of their risk and have a bearing on the assessment for the overall need for capital; asset-based modes of finance may be less risky and profit-sharing modes more risky, than conventional interest-bearing modes. Nevertheless, IIFSs would operate within a regulatory framework that is likely to impose on them capital requirements with a view to promoting stability and limiting contagion risks. However, besides regulatory and market demands for IIFSs to hold capital, IIFSs need to put in place risk management assessments for their own purposes of returns and stability in accordance with the requirements of Shari’ah, their own mission statements, and the protection of their stakeholders.

[1] See Honohan (2004) and Levine (2004).

[2] Sir John Hicks identifies such liquidity as one of the main factors behind the Industrial Revolution.

[3] Actually, a deposit can be viewed as a purchase of a debt asset issued by the intermediary and redeemable at its face value.

[4] The institution–market competition is reflected in the trends of their relative market shares of total financial assets. For example, in the United States, between 1960 and the early 1990s, commercial banks’ share of total financial intermediaries’ assets fell from around 40% to less than 30%. See Edwards (1996).

[5] They do respond to a latent demand for financial services that do not breach Shari’ah principles. Accordingly, they have the potential to contribute to financial deepening, economic growth, and social inclusion. See also Burghardt and Fuss (2004).

[6] Modigliani and Miller (1958).

[7] See Klingebiel and Laeven (2007).

[8] Views differ on the need for and extent of regulation, as well as on the usefulness of deposit insurance; see Barth, Caprio, and Levine (2007).

[9] Diamond and Rajan (2006).

[10] Allen and Gale (2007).

[11] Berger and Bouwman (2005).

[12] By the “materiality” of financing transactions is meant that, in such transactions, capital must be “materialized” in the form of an asset or asset services (as in Murabaha credit sales, Salam and Istisna’a financing, or Ijarah leasing), or of a business venture (Musharakah or Mudarabah). Capital in the form of money is not entitled to any return, as this would be interest (riba).

…… to be Cont.