A capital adequacy framework for Islamic banks: the need to reconcile depositors' risk aversion with managers' risk taking

Theoretically speaking, Islamic banks have an equity-based capital structure. This structure largely consists of shareholders' equity and investment deposits based on profit and loss sharing (PLS). Were Islamic banks to be structured as pure PLS institutions, there would be no need for capital adequacy regulations. However, many Islamic banking balance sheets show fixed claim liabilities. This is largely due to informational asymmetry and risk aversion by investors. These liabilities necessitate the imposition of capital adequacy regulations, which aim at maintaining symmetric stability by achieving two basic objectives. First of all, capital regulations should protect risk-averse depositors. This requires a minimum equity capital cushion and an optimal assets-liabilities composition. Secondly, capital regulations should provide the right incentives to shareholders to promote prudent behavior by the banks. This requires analyzing the effect of financial participation by shareholders to