Incentive-based regulation for Islamic banks

Purpose - Recent calls by prominent Islamic scholars to shift the focus of Islamic finance away from bond-like sukuk have been met with great unease by bankers in the industry. Islamic Financial Institutions, which hold the majority of all sukuk issued, face deposit side constraints on the types of returns they distribute, due to a need to match returns to market-based deposit interest rates. Hence, it is in their interest to hold assets that provide stable benchmark-based returns. The purpose of this paper is to provide an outline of an incentive-based regulatory mechanism to encourage Islamic banks to reconcile their intended normative structure (profit and loss sharing) with the operational and pragmatic realities within which Islamic banks exist. Design/methodology/approach - The paper traces the regulatory infrastructure and in particular Islamic Financial Services Board regulations on Capital Adequacy for Islamic Banks and provides recommendations for technical improvements to particular aspects of the regulations. Findings - The paper provides practical regulatory recommendations on the capital adequacy regime implemented by central banks that could potentially align more effectively with the intended form of Islamic bank's operational structure, either as an investment bank or as a commercial bank. Practical implications - By aligning the activities of Islamic banks with their intended operational structure through the implementation of a system of regulatory incentives as recommended in this paper, may help in quelling the increasing tide of criticisms of the current Islamic banking model which has deviated from its intended form. More importantly, if such regulation is implemented, it could also lead to enhanced systemic stability, since Islamic banks will be more resistant to economic shocks that affect the system. Originality/value - While there are studies that research the effect of the capital adequacy ratio, none really provide practically implementable recommendations that align the Islamic bank business model with its intended objectives.