## _wp14219

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---

### Key findings and context
- Islamic banking (IB) sector has expanded by over 15 percent per annum during the last five years.
- IB assets are estimated to exceed US$1.5 trillion.
- IB is systemically important in several countries: Iran, Sudan, Saudi Arabia, Kuwait, and Qatar.
- An Islamic financial sector is considered systemically important when total Islamic banking assets comprise more than 20 percent of total domestic banking sector assets, or at least 5 percent of the global portfolio of Islamic banking assets.
- Despite rapid expansion, IB remains unchartered territory for many practitioners and policy makers; the note aims to develop a better understanding of IB and provide policy recommendations to enhance supervision and regulation of Islamic banks.

### II. Characteristics of Islamic Banking
- Functional similarities with conventional banks:
  - Both are profit-maximizing financial intermediaries providing asset transformation, a payment system, custodial services, and risk management.
- Theoretical distinctions:
  - CBs: intermediation largely debt-based allowing for risk transfer.
  - IBs: intermediation asset-based centering on risk sharing consistent with Shariah prohibitions on interest and certain debt-sales.
- Liability and asset-side distinctions (risk sharing vs risk transfer):
  - IBs Risk Sharing
    - Sources of funds: Investors (profit sharing investment account (PSIA) holders) share risk and return with IBs; return on PSIA is not guaranteed and depends on bank performance.
    - Uses of funds: IBs share risk in Mudharabah and Musharakah contracts; conduct sales contracts in most other contracts.
  - CBs Risk Transfer
    - Sources of funds: Depositors transfer the risk to the CB, which guarantees a pre-specified return.
    - Uses of funds: Borrowers pay interest independent of project return; CBs transfer risk via securitization or hedging through derivatives.
- Practical convergence with conventional banking:
  - Many conventional products redrafted as Shariah-compliant.
  - IBs accept savings and demand deposits (non-risk-sharing).
  - Most IB financing takes the form of Murabahah contracts or installment sales; profit-loss sharing (PLS) is the exception.
  - Empirical findings show few significant differences in business models; PSIAs’ returns closely pegged to conventional deposits.
- Contract taxonomy:
  - Transactional contracts: sale (bai), exchange (sarf), partnership (shirkah), right-to-use (ijarah); core transactional contracts include murabahah, salam, musharakah, and ijarah.
  - Intermediation contracts: mudharabah and services (custody, brokerage, guarantees, insurance).
- Two theoretical IB models:
  - Two-tier mudharabah: integrated assets/liabilities; investment accounts not capital-guaranteed; no mandated reserve requirements on investment or demand deposits.
  - Two-window model: segregation between demand (100 percent reserve) and investment deposits (0 percent reserve).
- Developmental stages of IB (Solé, 2007):
  - Stage 1: Selected Islamic products offered via Islamic window or sukuk issuance.
  - Stage 2: Full-fledged IBs established (subsidiary or conversion).
  - Stage 3: Expansion of non-bank Islamic institutions (takaful, funds, sukuks, derivatives).

### III. Are Islamic Banks More Stable than Conventional Banks?
- Theoretical advantages
  - Liability-side risk-sharing could reduce susceptibility to instability by having investors share banking business risk.
- Practical neutralization of theoretical advantage
  - IBs often pay investment account holders competitive “market” returns irrespective of performance.
  - Shift away from PLS to short-term, trade-related transactions reduces theoretical risk-sharing benefits.
- Risks unique or amplified in IBs
  - Shariah compliance risk: weak compliance can weaken consumer protection and trigger liquidity then solvency problems.
  - Equity investment risk: partnership-based funds sharing business risks.
  - Rate of return risk: benchmarks rising create expectations for higher IAH returns though actual rate determined ex post.
  - Displaced commercial risk: pressure to pay IAHs higher returns than contractual terms to avoid withdrawals.
- Reserves used to mitigate risks
  - Profit equalization reserves (PER): used to reduce payout variability and align to market rates. About 58 percent of countries with IBs have allowed PER (Song and Oosthuizen, 2014).
  - Investment risk reserves (IRR): used to cushion future investment losses. About 37 percent of countries with IBs have allowed IRR (Song and Oosthuizen, 2014).
- Risks similar to CBs but potentially larger in IBs
  - Credit risk: receivables (e.g., Murabahah) often must be held to maturity and cannot be repackaged or sold at discount.
  - Operational risk: heightened due to real-transaction nature, inventory management, and nonstandard contract features.
  - Liquidity risk: exacerbated by reliance on short-term retail funding; underdeveloped Shariah-compliant interbank/money markets and government securities; limited hedging; limited access to lender-of-last-resort facilities.
  - Transparency risk: opacity from nonstandard reporting conventions and differing Shariah interpretations.
  - Legal risk: lack of consensus among scholars, nonstandard contracts, and poor enforceability increase counterparty default exposure.
  - Fiduciary risk: legal liability from breach of investment contract mismanagement.
- Factors that could enhance IB stability
  - Liability-side risk-sharing provides additional protection beyond book capital.
  - Incentives for conservatism and association with real economic activities.
  - Investment account holders’ incentives to monitor management (typically no deposit insurance).
  - Historically larger proportions of assets held in reserve/correspondent accounts with central banks.
- Empirical and comparative findings
  - Heterogeneous results across studies and countries; stability comparisons depend on relative size of risks and vary by country and bank size.
  - Čihák and Hesse (2008): "Large IBs are weaker than large CBs, small IBs are stronger than small CBs, and small IBs are stronger than large IBs." Large defined as assets larger than US$1 billion in their study period.
  - Beck, Demirgüç-Kunt and Merrouche (2013): IBs and CBs are more alike than thought; IBs less efficient but show higher loan-to-deposit ratios, better asset quality and higher capitalization; differences driven by country rather than bank type.
  - Crisis performance (2008-09): Shariah prohibitions limited exposure to crisis-triggering instruments helping profitability in 2008, but weaknesses in risk management and real economy impact led to larger 2009 profitability declines in some cases; evidence also suggests better asset quality, higher capitalization and liquidity helped IBs outperform CBs during 2008-09.

### IV. Legal, Corporate and Regulatory Frameworks in Islamic Banking
- Overarching aim: reinforce operating environment, internal governance, and market discipline to address moral hazard, safeguard demand depositors, and contain systemic risk.

A. The Legal Framework
- A sound legal framework is a key precondition for safe IB development.
- Jurisdictional approaches:
  - Shariah incorporated jurisdictions: aim to harmonize Shariah standards; approaches vary.
  - Purely secular jurisdictions: enact legislative changes to level playing field without incorporating Shariah into substantive law.
- Decision point: unified core banking laws for IBs and CBs versus separate laws; many jurisdictions adopt a unified core set to avoid duplication though some newer markets issue separate laws to increase transparency.

B. Corporate Governance
- Governance challenges stem from divergence of interests between investment account holders and shareholders and the role of Shariah-compliance governance.
- IFSB 2006 guiding principles recommend:
  - Transparency in policies and performance related to investment accounts to enable adequate monitoring.
  - Establishment of an internal board-level governance committee empowered to oversee governance policies including protection of investment account holders.
- Shariah governance expectations per IFSB:
  - Shariah supervisory board (SSB): qualified scholars appointed by shareholders, reporting to board of directors; responsible for product approval and compliance reviews.
  - Internal Shariah review process: independent department to monitor, evaluate and report on compliance.
  - Periodic Shariah reviews forming basis of SSB reports.
- Centralized SSB considerations:
  - Advantages: harmonize rulings, reduce costs.
  - Practice variations: some countries require bank-level SSBs; some complement with centralized SSBs; centralized SSBs exist as independent public institutions in some countries and at central banks in others.
- Remaining governance gaps:
  - Impracticality of providing investment account holders all relevant information for risk assessment.
  - Governance committees report to the board, possibly revealing conflicts ex-post; mitigation includes mandating directors accountable for enforcing investment account holders’ rights.
  - Transparency on SSB mandate, accountability and independence could be enhanced.

C. The Regulatory Framework
- Alignment with BCBS concepts is common; many jurisdictions complement with IFSB and AAOIFI standards to reflect Shariah compliance.
- About 65 percent of jurisdictions that allow IBs have tailored conventional banking regulations for IB activities (Song and Oosthuizen, 2014).
- Key regulatory dimensions and considerations:
  - Licensing:
    - Applicants in Shariah-law jurisdictions must provide Shariah compliance plans and evidence of suitable corporate governance.
    - Few jurisdictions apply fit and proper requirements to SSB members and Shariah compliance staff; developing such requirements is important.
    - Licensing Islamic windows requires effective segregation of funds and appropriate internal systems/reporting.
  - Liquidity:
    - Implementation of international liquidity frameworks (LCR and NSFR) poses challenges where IBs are significant due to treatment of investment accounts, deposit run-off rate determination, and limited short-term liquid instruments.
    - IFSB expected to issue a standard on LCR for IBs; jurisdictions should consider gradual movement to LCR where cross-border activity is minimal.
    - Jurisdictional progress:
      - Commodity murabahah developed and used in about 45 percent of jurisdictions with IB presence.
      - Interbank markets for IBs operate in about 45 percent of jurisdictions with IB presence; significant progress in Malaysia, Sudan, Bahrain.
      - Less progress in central bank liquidity facilities for IBs due to aversion to real-asset transactions.
  - Capital:
    - Jurisdictions should focus on implementing the BCBS-IFSB framework; complying with Basel Core Principles for Effective Bank Supervision (BCP) is a priority.
    - Progressive implementation of Basel II and III elements is recommended; Basel II reforms (RWA estimation) are particularly challenging.
    - Basel III’s enhanced quality of capital (numerator of CAR) generally less difficult for these countries to comply with than Basel II’s denominator requirements.

### Capital Requirements and the Alpha Factor
- CAR calculation in IB is similar to the BCBS formula but with significant adjustments due to investment account holders expected to absorb losses.
- IFSB provides two CAR formulas:
  - standard formula: assumes investment account holder bears all credit and market risks of assets funded by the investment account.
  - discretionary formula: an alpha factor is applied to capture the extent to which investment account holders share the losses.
- Jurisdictional approaches:
  - BCBS capital framework applied to all banks in some jurisdictions (Ethiopia, Kazakhstan, United Arab Emirates, and the United Kingdom).
  - BCBS framework complemented by IFSB pronouncements in others (Bahrain, Jordan, Malaysia and Sudan).
- Examples of supervisory choices for alpha:
  - Malaysia requires 100 percent of general assets financed by investment accounts to be converted into risk weighted assets.
  - Sudan requires 50 percent.
  - Bahrain and Jordan require 30 percent.
  - In practice supervisors in Turkey apply a 70 percent risk weight to Islamic banking risk-sharing products.
- IFSB Supervisory Discretionary Formula for CAR (textual expression preserved):
  - [Eligible Capital]/{[total risk-weighted assets +operational risk]-[RWAs funded by restricted profit sharing investment accounts (credit + market risk) –[(1- α*)total risk-weighted assets funded by unrestricted profit-sharing investment accounts] –[ α* risk-weighted assets funded by PER and IRR of unrestricted profit sharing investment accounts]}
  - where α*(alpha) is the proportion of assets funded by unrestricted profit sharing investment accounts and is determined by the supervisory authorities.
- Note: The leverage ratio for Islamic banks would take into consideration the Alpha factor according to IFSB standard 15 on revised capital adequacy; therefore, this ratio would not be useful for cross-country comparison purposes.
- March 2011: IFSB issued a guidance note with a methodology to estimate the value of alpha to be used in the supervisory discretion formula.

### Transparency, Disclosure, and Accounting
- Disclosure objectives: provide sufficient information to assess portfolio diversification and investment objectives, exposure to illiquid assets, main risk factors and internal procedures, adequacy of internal controls to determine PLS ratios, and methodology used to calculate bank performance.
- Specific disclosure recommendation: IBs should disclose smoothing policies (appropriations to PER and IRR, level of these reserves, and amount used for income smoothing over the period).
- Accounting frameworks in practice:
  - AAOIFI accounting standards mandatory only in a few countries (Bahrain, Botswana, Iraq, Jordan, Qatar, Sudan, Syria, and Yemen).
  - Most jurisdictions apply IFRS or national accounting standards.
  - Nature and extent of public disclosure varies by jurisdiction, Shariah legal status, and coexistence of IBs and CBs.

### Deposit Insurance and Bank Resolution
- Key challenge: define the scope of deposit insurance in IB, including whether it covers profit sharing investment accounts (IFSB, 2013).
- A sound approach to determining alpha would be instrumental in setting appropriate coverage levels for investment account holders.
- Deposit protection schemes vary:
  - single schemes applied to all banks; or
  - separate schemes for IBs and CBs, with separate Islamic depositor schemes typically investing ex ante contributions only in Shariah-compliant investments.
- Bank resolution issues needing further development:
  - whether a separate resolution framework should apply to IBs;
  - priority of claims by investment account holders;
  - nature of the resolution process, especially if resolution involves takeover by a CB.
- Current status: few countries have comprehensively addressed these IB-specific resolution issues.

### Supervision of Islamic Banking in Practice
- Two supervision models where IBs and CBs coexist:
  - Single supervisory authority model (e.g., Saudi Arabia, Ethiopia, Kazakhstan, Kenya, Kuwait, Qatar, Tunisia, Turkey, United Arab Emirates, United Kingdom) where a single framework applies to IBs and CBs.
  - Separate supervisory units within a single authority (e.g., Bahrain, Indonesia, Jordan, Lebanon, Pakistan, Syria) where separate frameworks may apply to IBs.
- Supervisory design considerations:
  - Appropriateness of model depends on country needs and costs of reorganization; alternatives include enhancing communication, coordination and information sharing.
  - Effective supervision requires operational independence, adequate resources (funding, skills, personnel), sound legal framework, well-designed governance, and robust accountability practices.
- Supervisory practice specifics:
  - CAMELS rating system is generally appropriate but must be adapted to IB-specific risks (Shariah compliance, capital adequacy, asset quality, liquidity).
  - Stress testing frameworks need adaptation to IB characteristics; accounting enhancements and data collection should focus on IB main characteristics.
  - In jurisdictions with Islamic windows, strict controls and enhanced oversight are advisable to reduce Shariah compliance risks and protect consumers.
  - Resource allocation example: in Shariah law jurisdictions where only IBs are permitted, up to 80 percent of supervisory authority resources reportedly are devoted to ensuring Shariah compliance.
- Supervisory capacity building and standards:
  - Develop FSIs for IBs with adequate disclosure to explain methodology and differences with CB FSIs.
  - Build supervisory expertise through technical assistance (IFSB and others).
  - Adopt upcoming IFSB core principles for IB, aligned with Basel Core Principles for Effective Bank Supervision, to reduce regulatory arbitrage.

### Conclusions and Main Policy Recommendations
- Comparative risk profile:
  - IBs and CBs share similarities, but IBs face unique risks from Islamic contracts and risk-sharing features.
  - Theoretical higher risks in IBs: operational, liquidity, transparency, and legal risks; credit and concentration risks may also be greater.
  - Empirical evidence is limited and mixed; riskiness of IBs may vary with bank size.
- Policy recommendations:
  - Legal and regulatory framework:
    - A unified set of banking laws and regulations covering IBs and CBs is generally advisable to avoid duplication; this practice is adopted in most jurisdictions.
  - Governance:
    - Recognize divergence of interests between investment account holders and shareholders; internal governance committee established by 2006 IFSB principles is a step forward but gaps remain.
    - Consider mandating one or more directors to be accountable for enforcing investment account holder rights.
    - Strengthen Shariah compliance frameworks: SSB, internal Shariah review, periodic Shariah reviews; consider centralized SSB to harmonize rulings and reduce costs; enhance transparency about SSB mandate and accountability.
  - Regulatory alignment and implementation:
    - Ensure alignment with Basel Core Principles; progress toward Basel II and III is recommended but will be challenging (LCR implementation due to limited HQLA diversification; Basel II capital reforms complex due to RWA estimation differences).
    - Expect careful planning, dedicated resources, and consideration of bank/system characteristics when implementing Basel II and III.
  - Specific enhancements:
    - Licensing: develop fit and proper criteria for SSB members and Shariah compliance staff.
    - Liquidity: enhance legal and operational central bank frameworks to allow Islamic liquidity management instruments.
    - Capital: adopt IFSB standards (including alpha estimation) to facilitate cross-country CAR comparisons.
    - Transparency: adopt AAOIFI and IFSB standards to reduce transparency risks.
    - Disclosure: encourage disclosure of smoothing policies to reduce uncertainty about loss absorbency of investment accounts.
    - Deposit insurance: develop sound approach to estimate alpha to determine coverage for investment account holders.
    - Bank resolution: clarify need for separate IB resolution framework, priority of investment account holders, and resolution process when takeover by CB occurs.
  - Supervision strengthening actions:
    - continue adapting CAMELS to IB-specific risks;
    - employ stress testing tailored to IB risk specificities;
    - apply strict controls and enhanced oversight for Islamic windows;
    - promote enhanced transparency and disclosure, including FSIs for IBs;
    - strengthen supervisory capacity on IB issues;
    - increase focus on cross-border and consolidated supervision.
- Outlook:
  - IB is likely to continue growing and could play a role in directing finance toward the real economy and reducing incentives for financial engineering.
  - IB currently in developmental mode needing legal, accounting, governance, regulatory and supervisory enhancements; its role is expected to increase in promoting financial inclusion.

### Annex 1 — Shariah Law, Contracts, and Capital Adequacy Highlights
- Shariah basic principles:
  - prohibition of riba (interest);
  - risk sharing;
  - prohibition of speculative behavior;
  - sanctity of contracts;
  - prohibition of investment in certain activities (drugs, alcohol, pork, games of chance).
- Key contracts (sources of funds)
  - Profit Sharing Investment Account (PSIA): Mudharabah; losses borne solely by PSIA holder unless due to IB’s misconduct, negligence or breach of contract terms.
  - Wadiah: deposit/custody with IB guaranteeing value and allowing easy withdrawals.
- Key contracts (uses of funds)
  - Murabahah: cost-plus financing; creates credit risk on receivable.
  - Salam: purchase with deferred delivery; buyer makes full payment up front.
  - Ijarah: lease requiring IB to purchase/own the asset before leasing.
  - Musharakah: equity financing with profit/loss sharing proportional to capital contributions.
  - Mudharabah: bank provides capital; entrepreneur manages; losses borne by capital provider unless due to misconduct.
- Islamic Window vs Fully-fledged IB
  - Advantages of windows: leverage conventional bank experience, facilitate liquidity management, enhance competition and financial inclusion in small-demand countries.
  - Risks of windows: reputational risk from commingling, governance and risk management weaknesses, regulatory arbitrage, oversight and resolution complexities, and monetary policy/ pricing linkage difficulties.
- Capital adequacy in Islamic Banking
  - IFSB minimum capital adequacy requirement: 8 percent for credit and market risks as in conventional institutions (December 2006 standard).
  - IFSB revised capital adequacy standards incorporated many elements of Basel III (December 2013).
  - Treatment of PER and IRR varies by jurisdiction; IFSB-15 clarified PER and IRR are not part of capital of Islamic banks.
  - March 2011 IFSB guidance provides methodology to estimate alpha.

*Source: Excerpt from IMF working paper _wp14219 (Sections II–IV and Annex 1) contained in the supplied PDF content.*

### References .............................................................................................................

### _wp14219 - References

### Key findings and context
- Islamic banking (IB) sector has expanded by over 15 percent per annum during the last five years.
- IB assets are estimated to exceed US$1.5 trillion.
- IB is particularly large in many Muslim countries and is systemically important in several countries, specifically: Iran, Sudan, Saudi Arabia, Kuwait, and Qatar.
- There is increasing interest in Islamic finance in non-Muslim countries.
- Despite rapid expansion, IB remains unchartered territory for many practitioners and policy makers.
- A significant literature discusses key characteristics of IB and their implications for regulation and supervision.
- The note is divided into six sections; Section II reviews the key characteristics of IB banking.

### Figures, tables, and annexes (as listed in source)
- Table 1. Risk Sharing and Risk Transfer (page indicated in contents).
- Figure 1. The Growing Importance of Islamic Banks.
- Annex 1. Shariah Law and Islamic Banking (page 25).
- Annex 2. Definition of key Shariah-compliant Contracts (page 26).
- Annex 3. Islamic Window vs. Fully-fledged Islamic Bank (page 28).
- Annex 4. Capital Adequacy in Islamic Banking (page 30).

### Glossary (acronyms and exact terms preserved)
- AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions
- BCBS Basel Committee on Banking Supervision
- BCP Basel Core Principles for Effective Bank Supervision
- CAMELS Capital-Asset-Management-Earnings-Liquidity-Sensitivity
- CAR Capital adequacy ratio
- CB Conventional Banking
- FSI Financial soundness indicators
- HQLA High quality liquid assets
- IB Islamic Banking
- IFRS International Financial Reporting Standards
- IFSB Islamic Financial Services Board
- IRR Investment risk reserves
- LCR Liquidity coverage ratio
- NFSR Net stable funding ratio
- PER Profit equalization reserves
- PLS Profit and loss sharing
- PSIA Profit sharing investment account
- RIA Restricted investment account
- SSB Shariah Supervisory Board
- URIA Unrestricted profit sharing account

### Purpose and policy orientation
- Aim: develop a better understanding of Islamic banking and provide policy recommendations to enhance supervision and regulation of Islamic banks (IBs).
- Emphasis on reviewing key characteristics of IB (to be covered in Section II of the note) and drawing implications for regulation and supervision based on existing literature.

*Source: _wp14219 - References*

### Section III discusses whether IBs are more stable than conventional banks (CBs). Section IV

### _wp14219 - Section III discusses whether IBs are more stable than conventional banks (CBs). Section IV

### II. CHARACTERISTICS OF ISLAMIC BANKING
- Islamic and conventional banks share roles as profit-maximizing financial intermediaries providing asset transformation, a payment system, custodial services, and risk management.
- Theoretical differences:
  - CBs: intermediation is largely debt-based and allows for risk transfer.
  - IBs: intermediation is asset-based and centers on risk sharing, consistent with Shariah prohibitions on interest and certain debt-sales.
- Liability and asset-side distinctions (Table 1 summary):
  - IBs Risk Sharing
    - Sources of funds: Investors (profit sharing investment account (PSIA) holders) share risk and return with IBs; return on PSIA is not guaranteed and depends on bank performance.
    - Uses of funds: IBs share risk in Mudharabah and Musharakah contracts; conduct sales contracts in most other contracts.
  - CBs Risk Transfer
    - Sources of funds: Depositors transfer the risk to the CB, which guarantees a pre-specified return.
    - Uses of funds: Borrowers pay interest independent of project return; CBs transfer risk via securitization or hedging through derivatives.
- In practice differences are smaller because:
  - Many conventional products can be redrafted as Shariah-compliant.
  - IBs accept savings and demand deposits (non-risk-sharing).
  - Most IB financing takes the form of Murabahah contracts or installment sales; profit-loss sharing is the exception.
  - Empirical findings: few significant differences in business models (Beck, Demirgüç-Kunt and Merrouche, 2013); PSIAs’ returns closely pegged to conventional deposits (Chong and Liu, 2009; Khan, 2010).
- Contract taxonomy:
  - Transactional contracts: sale (bai), exchange (sarf), partnership (shirkah), right-to-use (ijarah); core transactional contracts include murabahah, salam, musharakah, and ijarah.
  - Intermediation contracts: mudharabah (partnership between capital provider and entrepreneur) and services (custody, brokerage, guarantees, insurance).
- Two theoretical IB models:
  - Two-tier mudharabah: integrated assets/liabilities; investment accounts not capital-guaranteed; no mandated reserve requirements on investment or demand deposits.
  - Two-window model: segregation between demand (100 percent reserve) and investment deposits (0 percent reserve).
- Practical balance-sheet realities:
  - Preference for asset-backed securities and leasing over PLS instruments.
  - No barriers in asset deployment across different funding sources complicating regulation.
  - Investment account losses often absorbed by equity holders; limited governance participation by investment account holders.
- Developmental stages of IB (Solé, 2007):
  - Stage 1: Selected Islamic products offered via Islamic window or sukuk issuance.
  - Stage 2: Full-fledged IBs established (subsidiary or conversion).
  - Stage 3: Expansion of non-bank Islamic institutions (takaful, funds, sukuks, derivatives).
- Supplementary numeric/threshold note:
  - An Islamic financial sector is considered systemically important when total Islamic banking assets comprise more than 20 percent of total domestic banking sector assets, or at least 5 percent of the global portfolio of Islamic banking assets.

### III. ARE ISLAMIC BANKS MORE STABLE THAN CONVENTIONAL BANKS?
- Theoretical advantages:
  - Risk-sharing could reduce susceptibility to instability (banks participate in counterparty risks; investors share banking business risk).
- Practical neutralization of theoretical advantage:
  - IBs often pay investment account holders competitive “market” returns irrespective of performance.
  - IBs have shifted away from PLS to short-term, trade-related transactions.
- Risks unique or amplified in IBs:
  - Shariah compliance risk: inadequate compliance can weaken consumer protection and trigger liquidity then solvency problems.
  - Equity investment risk: from partnership-based funds sharing business risks.
  - Rate of return risk: benchmarks rising create expectations for higher IAH returns though actual rate determined ex post.
  - Displaced commercial risk: pressure to pay IAHs higher returns than contractual “actual” terms to avoid withdrawals.
- Reserves used to mitigate risks:
  - Profit equalization reserves (PER): set aside from investment profits before allocation; used to reduce payout variability and align to market rates. Example: if accepted return is 7 percent and realized return is 6 percent, then 1 percent will be paid to investment account holders from the PER account. About 58 percent of countries with IBs have allowed PER (Song and Oosthuizen, 2014).
  - Investment risk reserves (IRR): appropriated from income of investment account holders after deducting the bank’s share; used to cushion future investment losses. About 37 percent of countries with IBs have allowed IRR (Song and Oosthuizen, 2014).
- Risks similar to CBs but potentially larger in IBs:
  - Credit risk: receivables (e.g., Murabahah) often must be held to maturity and cannot be repackaged or sold at discount, increasing credit risk exposure.
  - Operational risk: heightened due to real-transaction nature, nonstandard contract features, inventory management, and contract documentation/cancellation issues.
  - Liquidity risk: exacerbated by reliance on short-term retail funding; underdeveloped Shariah-compliant interbank/money markets and government securities; limited hedging (derivatives prohibition); limited access to lender-of-last-resort facilities.
  - Transparency risk: opacity from nonstandard reporting conventions, lack of uniform accounting/auditing standards, and differing Shariah interpretations.
  - Legal risk: lack of consensus among scholars, nonstandard contracts, and poor enforceability increase counterparty default/delinquency exposure.
  - Fiduciary risk: legal liability from breach of investment contract mismanagement exposing direct and indirect losses.
- Factors that could make IBs more stable:
  - Liability-side risk-sharing provides additional protection beyond book capital.
  - Incentives for conservatism (stable returns, shareholder liability for negligence, liquidity access constraints).
  - Association with real economic activities.
  - Investment account holders’ incentives to monitor management (typically no deposit insurance).
  - Historically larger proportions of assets held in reserve/correspondent accounts with central banks.
- Empirical and comparative findings:
  - Heterogeneous results: stability comparisons depend on relative size of risks and vary by country and bank size.
  - Čihák and Hesse (2008): "Large IBs are weaker than large CBs, small IBs are stronger than small CBs, and small IBs are stronger than large IBs." Large defined as assets larger than US$1 billion in their study period.
  - Beck, Demirgüç-Kunt and Merrouche (2013): IBs and CBs are more alike than thought; IBs less efficient but show higher loan-to-deposit ratios, better asset quality and higher capitalization; differences driven by country rather than bank type.
  - Crisis performance (2008-09): IBs were affected differently—Shariah prohibitions limited exposure to crisis-triggering instruments helping profitability in 2008, but weaknesses in risk management and real economy impact led to larger 2009 profitability declines in some cases. Evidence also suggests better asset quality, higher capitalization and liquidity helped IBs outperform CBs during 2008-09.

### IV. THE LEGAL, CORPORATE AND REGULATORY FRAMEWORKS IN ISLAMIC BANKING
- Overarching aim: frameworks should reinforce operating environment, internal governance, and market discipline to address moral hazard, safeguard demand depositors, and contain systemic risk.

A. The Legal Framework
- A sound legal framework is a key precondition for safe IB development.
- Jurisdictional approaches:
  - Shariah incorporated jurisdictions: aim to harmonize Shariah standards; approaches vary (some disallow Islamic windows or conversion of CBs into IBs).
  - Purely secular jurisdictions: enact legislative changes to level the playing field without incorporating Shariah into substantive law (examples provided of policy actions in Singapore, United Kingdom, France, Japan, Hong Kong).
- Decision point: unified core banking laws for IBs and CBs versus separate laws; many jurisdictions adopt a unified core set to avoid duplication though some newer markets issue separate laws to increase transparency.

B. Corporate Governance
- Governance challenges stem from divergence of interests between investment account holders and shareholders and the role of Shariah-compliance governance.
- IFSB 2006 guiding principles recommend:
  - Transparency in policies and performance related to investment accounts to enable adequate monitoring.
  - Establishment of an internal board-level governance committee empowered to oversee governance policies including protection of investment account holders.
- Remaining gaps:
  - Impracticality of providing investment account holders all relevant information for risk assessment.
  - Governance committees report to the board, possibly revealing conflicts ex-post; one mitigation is mandating directors accountable for enforcing investment account holders’ rights.
- Shariah governance expectations per IFSB:
  - Shariah supervisory board (SSB): qualified scholars appointed by shareholders, reporting to board of directors; responsible for product approval and compliance reviews.
  - Internal Shariah review process: independent department to monitor, evaluate and report on compliance.
  - Periodic Shariah reviews forming basis of SSB reports.
- Centralized SSB considerations:
  - Advantages: harmonize rulings, reduce costs.
  - Implementation: can be regulator-established or collectively set by IBs; relevant in secular jurisdictions where regulators cannot directly engage in Shariah issues.
- Practice variations:
  - Many Shariah incorporated jurisdictions require bank-level SSBs; some complement these with centralized SSBs.
  - Centralized SSBs in some countries (Sudan, Turkey, UAE) are independent public institutions; in others (Afghanistan, Bahrain, Malaysia, Pakistan, Palestine) centralized SSBs set up at the central bank.
  - SSB mandates and accountability vary; relationship with bank boards is usually advisory; transparency on mandate, accountability and independence could be enhanced to reduce reputation and legal risks.

C. The Regulatory Framework
- Alignment with BCBS concepts is common; many jurisdictions complement with IFSB and AAOIFI standards to reflect Shariah compliance.
- About 65 percent of jurisdictions that allow IBs have tailored conventional banking regulations for IB activities (Song and Oosthuizen, 2014).
- Key regulatory dimensions and considerations:
  - Licensing:
    - Applicants in Shariah-law jurisdictions must provide Shariah compliance plans and evidence of suitable corporate governance.
    - Few jurisdictions apply fit and proper requirements to SSB members and Shariah compliance staff; developing such requirements is important.
    - Licensing Islamic windows requires effective segregation of funds and appropriate internal systems/reporting.
  - Liquidity:
    - BCBS and IFSB liquidity rules can address IB liquidity risks, but implementing international liquidity frameworks (LCR and NSFR) poses challenges where IBs are significant.
    - Challenges include treatment of investment accounts, determination of deposit run-off rates in absence of Islamic deposit insurance, and limited short-term liquid instruments.
    - IFSB is expected to issue a standard on LCR for IBs; LCR implementation requires careful planning and resources.
    - Jurisdictions should consider gradual movement to LCR where cross-border activity is minimal and assess LCR parameter stringency relative to local context.
    - Assessing PSIAs from a liquidity perspective is important.
    - Jurisdictional progress in liquidity instruments:
      - Commodity murabahah developed and used in about 45 percent of jurisdictions with IB presence; usefulness limited by transaction costs, administrative process, non-tradability, and Shariah concerns.
      - Interbank markets for IBs operate in about 45 percent of jurisdictions with IB presence; significant progress in Malaysia, Sudan, Bahrain; development hampered by chronic excess liquidity and IB concerns dealing with CBs over Shariah noncompliance.
      - Less progress in central bank liquidity facilities for IBs due to central bank aversion to real-asset transactions; legal and operational frameworks need enhancement to permit Islamic liquidity management instruments to support financial stability and monetary policy effectiveness.
  - Capital:
    - Jurisdictions should focus on implementing the BCBS-IFSB framework.
    - Complying with Basel Core Principles for Effective Bank Supervision (BCP) is a priority; progressive implementation of Basel II and III elements is recommended.
    - Implementation planning should build supervisory capacity and consider bank/system characteristics and constraints.
    - Basel II reforms (risk-weighted assets estimation) are particularly challenging for many jurisdictions.
    - Basel III feature—enhanced quality of capital (numerator of CAR)—is generally less difficult for these countries to comply with than Basel II’s denominator requirements.

*Italic source: Excerpt from IMF working paper _wp14219 (Sections II–IV) contained in the supplied PDF content.*

### introduction of capital buffers. Indeed, most emerging markets where IBs are present usually

### _wp14219 - introduction of capital buffers. Indeed, most emerging markets where IBs are present usually

### Capital requirements and the alpha factor
- CAR calculation in IB is similar to the BCBS formula but with significant adjustments in recognition of sources of funds and risk-weighted assets because investment account holders are usually expected to absorb losses.
- IFSB provides two CAR formulas:
  - standard formula: assumes investment account holder bears all credit and market risks of assets funded by the investment account;
  - discretionary formula: an alpha factor is applied to capture the extent to which investment account holders share the losses.
- Jurisdictional approaches:
  - BCBS capital framework applied to all banks in some jurisdictions (Ethiopia, Kazakhstan, United Arab Emirates, and the United Kingdom).
  - BCBS framework complemented by IFSB pronouncements in others (Bahrain, Jordan, Malaysia and Sudan).
- Examples of supervisory choices for alpha:
  - Malaysia requires 100 percent of general assets financed by investment accounts to be converted into risk weighted assets.
  - Sudan requires 50 percent.
  - Bahrain and Jordan require 30 percent.
  - In practice supervisors in Turkey apply a 70 percent risk weight to Islamic banking risk-sharing products.
- Implication: wide variation in alpha values complicates cross-country CAR comparisons; supervisors are encouraged to adopt IFSB standards, assess IB risk profiles, develop robust models, decide alpha application (per bank or system-wide), and publish disclosures on alpha determination.
- Note: The leverage ratio for Islamic banks would take into consideration the Alpha factor according to IFSB standard 15 on revised capital adequacy; therefore, this ratio would not be useful for cross-country comparison purposes.

### Transparency, disclosure, and accounting
- Disclosure objectives: provide sufficient information to assess:
  - appropriateness of portfolio diversification and investment objectives (including concentration);
  - degree of exposure to illiquid assets (notably in two-tier Mudharabah arrangements);
  - main risk factors of the investment portfolio and the quality of internal procedures, organization and infrastructure for monitoring/handling risks;
  - adequacy of internal controls, given the need to determine PLS ratios on financed projects;
  - methodology used to calculate bank performance to aid investors choosing institutions for investment deposits.
- Specific disclosure recommendation: IBs should disclose smoothing policies (appropriations to PER and IRR, level of these reserves, and amount used for income smoothing over the period) to reduce uncertainty about loss absorbency of investment accounts and mitigate systemic risks.
- Accounting frameworks in practice:
  - AAOIFI accounting standards mandatory only in a few countries (Bahrain, Botswana, Iraq, Jordan, Qatar, Sudan, Syria, and Yemen).
  - Most jurisdictions apply IFRS or national accounting standards.
  - Nature and extent of public disclosure varies by jurisdiction, Shariah legal status, and coexistence of IBs and CBs.

### Deposit insurance and bank resolution
- Key challenge: define the scope of deposit insurance in IB, including whether it covers profit sharing investment accounts (IFSB, 2013).
- A sound approach to determining alpha would be instrumental in setting appropriate coverage levels for investment account holders.
- Deposit protection schemes vary:
  - single schemes applied to all banks; or
  - separate schemes for IBs and CBs, with separate Islamic depositor schemes typically investing ex ante contributions only in Shariah-compliant investments.
- Bank resolution issues needing further development:
  - whether a separate resolution framework should apply to IBs;
  - priority of claims by investment account holders;
  - nature of the resolution process, especially if resolution involves takeover by a CB.
- Current status: few countries have comprehensively addressed these IB-specific resolution issues.

### Supervision of Islamic banking in practice
- Two supervision models where IBs and CBs coexist:
  - Single supervisory authority model (e.g., Saudi Arabia, Ethiopia, Kazakhstan, Kenya, Kuwait, Qatar, Tunisia, Turkey, United Arab Emirates, United Kingdom) where a single framework applies to IBs and CBs.
  - Separate supervisory units within a single authority (e.g., Bahrain, Indonesia, Jordan, Lebanon, Pakistan, Syria) where separate frameworks may apply to IBs.
- Supervisory design considerations:
  - Appropriateness of model depends on country needs and costs of reorganization; alternatives include enhancing communication, coordination and information sharing.
  - Effective supervision requires operational independence, adequate resources (funding, skills, personnel), sound legal framework, well-designed governance, and robust accountability practices.
- Supervisory practice specifics:
  - Some authorities apply risk-based supervision but still require full Shariah compliance.
  - CAMELS rating system is generally appropriate but must be adapted to IB-specific risks (Shariah compliance, capital adequacy, asset quality, liquidity).
  - Stress testing frameworks need adaptation to IB characteristics; accounting enhancements and data collection should focus on IB main characteristics.
  - In jurisdictions with Islamic windows, strict controls and enhanced oversight are advisable to reduce Shariah compliance risks and protect consumers.
  - Resource allocation example: in Shariah law jurisdictions where only IBs are permitted, up to 80 percent of supervisory authority resources reportedly are devoted to ensuring Shariah compliance.
- Supervisory capacity building and standards:
  - Develop FSIs for IBs with adequate disclosure to explain methodology and differences with CB FSIs.
  - Build supervisory expertise through technical assistance (IFSB and others).
  - Adopt upcoming IFSB core principles for IB, aligned with Basel Core Principles for Effective Bank Supervision, to reduce regulatory arbitrage.

### Conclusions and main policy recommendations
- Comparative risk profile:
  - IBs and CBs share similarities, but IBs face unique risks from Islamic contracts and risk-sharing features.
  - Theoretical higher risks in IBs: operational, liquidity, transparency, and legal risks; credit and concentration risks may also be greater.
  - Empirical evidence is limited and mixed; examples:
    - Pakistan: empirical results suggest IB credit risk exposure is less than CBs and IBs are less prone to withdrawals during liquidity stress.
    - Some evidence that IBs' business models limited profitability impacts in 2008; other evidence attributes better IB performance to better asset quality, higher capitalization and liquidity.
    - Riskiness of IBs may vary with bank size.
- Policy recommendations (summarized):
  - Legal and regulatory framework:
    - A unified set of banking laws and regulations covering IBs and CBs is generally advisable to avoid duplication; this practice is adopted in most jurisdictions.
  - Governance:
    - Recognize divergence of interests between investment account holders and shareholders; internal governance committee established by 2006 IFSB principles is a step forward but gaps remain.
    - Consider mandating one or more directors to be accountable for enforcing investment account holder rights.
    - Strengthen Shariah compliance frameworks: SSB, internal Shariah review, periodic Shariah reviews; consider centralized SSB to harmonize rulings and reduce costs; enhance transparency about SSB mandate and accountability.
  - Regulatory alignment and implementation:
    - Ensure alignment with Basel Core Principles; progress toward Basel II and III is recommended but will be challenging (LCR implementation due to limited HQLA diversification; Basel II capital reforms complex due to RWA estimation differences).
    - Expect careful planning, dedicated resources, and consideration of bank/system characteristics when implementing Basel II and III.
  - Specific enhancements:
    - Licensing: develop fit and proper criteria for SSB members and Shariah compliance staff.
    - Liquidity: enhance legal and operational central bank frameworks to allow Islamic liquidity management instruments.
    - Capital: adopt IFSB standards (including alpha estimation) to facilitate cross-country CAR comparisons.
    - Transparency: adopt AAOIFI and IFSB standards to reduce transparency risks.
    - Disclosure: encourage disclosure of smoothing policies to reduce uncertainty about loss absorbency of investment accounts.
    - Deposit insurance: develop sound approach to estimate alpha to determine coverage for investment account holders.
    - Bank resolution: clarify need for separate IB resolution framework, priority of investment account holders, and resolution process when takeover by CB occurs.
  - Supervision strengthening actions for supervisors:
    - continue adapting CAMELS to IB-specific risks (capital adequacy, asset quality, management, liquidity);
    - employ stress testing tailored to IB risk specificities;
    - apply strict controls and enhanced oversight for Islamic windows to protect consumers and ensure Shariah compliance;
    - promote enhanced transparency and disclosure, including FSIs for IBs;
    - strengthen supervisory capacity on IB issues;
    - increase focus on cross-border and consolidated supervision.
- Outlook:
  - IB is likely to continue growing and could play a role in directing finance toward the real economy and reducing incentives for financial engineering.
  - IB currently in developmental mode needing legal, accounting, governance, regulatory and supervisory enhancements; its role is expected to increase in promoting financial inclusion.

*Source: _wp14219 - introduction of capital buffers. Indeed, most emerging markets where IBs are present usually*

### Annex 1. Shariah Law and Islamic Banking

### Annex 1. Shariah Law and Islamic Banking

### Shariah framework and basic principles of Islamic Banking (IB)
- Shariah: set of rules and laws governing economic, social, political and cultural aspects of Islamic societies; originates from rules in the Qur’an and elaborated by scholars in Islamic jurisprudence.
- Jurisdictional variation: In several jurisdictions Shariah law is the fundamental law of the land (or a key source of the law of the land); in others it does not constitute part of the legal framework.
- Basic principles of IB:
  - prohibition of riba (e.g., interest) — central tenet; based on arguments of social justice, equality and property rights;
  - risk sharing — suppliers of funds become investors instead of creditors; entrepreneurs share business risks in return for a share of profits;
  - prohibition of speculative behavior — discourages hoarding and prohibits transactions featuring extreme uncertainty and gambling;
  - sanctity of contracts — intends to reduce asymmetric information and moral hazard;
  - Shariah-approved activities — prohibits investment in businesses dealing with drugs, alcohol, pork, and games of chance; banks’ involvement in trading in financial risk is seen as a form of gambling;
  - social justice — any transaction leading to injustice and exploitation is prohibited.

### Motivations for the presence and role of IB across jurisdictions
- IB as financial innovation: considered acceptable innovation that can enhance a jurisdiction’s standing as an international financial center.
- Demand-driven accommodation: jurisdictions may accommodate IB for substantial Muslim minority demand.
- Majority-Muslim jurisdictions: where Shariah law is fundamental and Islam is the state religion, IB accommodates needs of a Muslim majority.

*This annex is based on Song and Oosthuizen (2014) and Van Greuning and Iqbal (2008).*

### Definition of key Shariah-compliant contracts — Sources of funds (deposits)
- Profit Sharing Investment Account (PSIA):
  - contractual form: Mudharabah;
  - roles: IB acts as entrepreneur; PSIA holder acts as capital provider;
  - profit sharing: ratio disclosed and agreed at account opening; profits shared per Mudharabah terms;
  - loss allocation: losses borne solely by PSIA holder unless due to IB’s misconduct, negligence or breach of contract terms;
  - operational note: IB’s own money usually invested in same income-producing assets; low income (losses) affect IB through low (negative) return on shareholders’ invested capital and low (zero) income from managing PSIA accounts;
  - significance: main source of revenue for the IB; used to cover operational expenses.
- Wadiah (deposit):
  - contract between depositor and IB (custodian) for safekeeping;
  - depositor permits IB to utilize funds for Shariah-permitted purposes;
  - IB guarantees value of deposit and allows easy withdrawals.

*This annex is based on Hasan, M. and J. Dridi (2010).*

### Definition of key Shariah-compliant contracts — Uses of funds (financing and investment)
- Murabahah (Cost-plus financing):
  - IB sells to a customer an asset already in its possession at acquisition cost plus an agreed profit margin;
  - after delivery a credit risk arises with respect to the receivable amount;
  - modern finance perspective: similar to an asset-backed risky loan.
- Salam (Purchase with deferred delivery):
  - agreement to purchase a specified commodity at a predetermined price to be delivered on a specified future date in specified quantity and quality;
  - IB (buyer) makes full payment upon execution of the Salam contract;
  - mitigation: back-to-back (Parallel Salam) to sell same specification commodity to another party to mitigate price risk.
- Ijarah (Lease):
  - IB leases an asset to a customer for an agreed period against specified lease rental installments;
  - contract requires IB to purchase or lease the asset prior to entering the contract;
  - lessee options: purchase asset at lease end by gift or token consideration, or by installments during the lease period.
- Musharakah (Equity financing):
  - IB and customer contribute capital to an enterprise or to ownership of real estate or a moveable asset, on permanent or diminishing basis (diminishing Musharakah);
  - profits shared per Musharakah terms; losses shared in proportion to capital contributions.
- Mudharabah (Participation or trust financing):
  - IB contributes capital to an enterprise managed by the customer/investor;
  - profits shared per Mudharabah terms; losses borne solely by the IB unless due to customer/investor misconduct, negligence, or breach of contract terms.

### Islamic Window vs. Fully-fledged Islamic Bank — advantages (from supervisors allowing windows)
- IB services/products benefit from conventional banks’ experience, potentially improving quality and lowering cost and enhancing intermediation.
- Windows facilitate liquidity management where Islamic liquidity instruments are limited; usually easy access to liquidity support from conventional part of the bank.
- Windows enhance market competition, potentially lowering cost of finance for Shariah-compliant products.
- For small-demand countries, windows may be the only feasible way to provide IB services, enhancing financial inclusion.

### Islamic Window vs. Fully-fledged Islamic Bank — risks (from supervisors disallowing windows)
- Reputational risk from commingling: depositors in windows may withdraw funds if rumors of commingling arise; raises consumer protection and segregation of funds issues.
- Governance and risk management: windows may hinder establishment of effective corporate governance and risk management; management and board of conventional bank may not be attuned to unique IB risks; fit and proper criteria may not be met for Islamic banking part; Shariah Boards may be unable to verify complete segregation of assets and liabilities.
- Regulatory arbitrage and unfair practices: profit-and-loss sharing nature could encourage risky financing through windows because, in case of default, account holders bear losses.
- Oversight and monitoring: windows could hinder effective financial oversight; some prudential ratios that differ for Islamic banking may be difficult to monitor; windows could hinder preparation of proper financial statements.
- Resolution complexities: resolving distressed Islamic banks per Shariah principles is under deliberation; complication increases for an Islamic window within a conventional bank; orderly resolution of distressed conventional bank with Islamic window may not satisfy financial stability objectives and Shariah principles.
- Monetary policy and pricing linkage: monitoring impact of using Islamic monetary instruments (e.g., Sukuk) could be difficult because conventional banks can use conventional deposits to finance Islamic banking assets, potentially hindering the design of appropriate monetary policies.

*This annex is based on Song and Oosthuizen (2014).*

### Capital adequacy in Islamic Banking
- General:
  - computation of required capital adequacy ratio (CAR) in IB is similar to relevant BCBS formula, but variations exist in recognition of sources of funds and risk-weighted assets (RWAs).
  - key difference: PSIA holders are neither depositors nor equity holders; they are quasi-liability holders expected to absorb all losses on investments made with their funds, unless evidence of bank negligence or misconduct.
  - PSIA buffer effect: capacity to pass-through low returns or losses to PSIA holders provides IBs with additional buffer against adverse shocks; the higher the share of PSIA as a source of funds and the lower their sensitivity to changes in returns, the better the solvency of IBs compared to CBs.
- Asset risk-weighting differences:
  - IB assets range from trade financing to equity partnership, causing different risk weight calculations compared with conventional banks.
  - income smoothing practices (reserves maintained for income smoothing) have indirect implications for IBs’ capital adequacy and regulators may consider this when determining CAR.
- IFSB standards and developments:
  - December 2006: IFSB working group issued first capital adequacy standard for institutions offering Islamic financial services (other than insurance institutions);
  - minimum capital adequacy requirement for IBs in the IFSB standard is 8 percent for credit and market risks, as in conventional institutions.
  - May 2008: IFSB issued guidance on recognition of ratings by external credit assessment institutions to facilitate Basel II application.
  - December 2013: IFSB revised capital adequacy standards to incorporate many elements of Basel III.
- CAR calculation forms under IFSB standard:
  - two forms: standard and discretionary.
  - standard formula: capital divided by risk-weighted assets excluding assets financed by investment account holders.
  - discretionary formula: modified to accommodate reserves maintained by Islamic banks to minimize displaced commercial, withdrawal, and systemic risks. In markets where Islamic banks maintain profit equalization reserves (PER) and investment risk reserves (IRR), supervisory authorities have discretion to adjust the denominator of the CAR formula.
- IFSB Supervisory Discretionary Formula for CAR (textual expression preserved):
  - [Eligible Capital]/{[total risk-weighted assets +operational risk]-[RWAs funded by restricted profit sharing investment accounts (credit + market risk) –[(1- α*)total risk-weighted assets funded by unrestricted profit-sharing investment accounts] –[ α* risk-weighted assets funded by PER and IRR of unrestricted profit sharing investment accounts]}
  - where α*(alpha) is the proportion of assets funded by unrestricted profit sharing investment accounts and is determined by the supervisory authorities.
- Definitions and practices:
  - URIA (unrestricted profit sharing account): allows fund manager (the bank) to invest in activities in any sector, industry or project they find suitable; bank can commingle these funds with their own and invest in a pooled portfolio; URIAs are more common in practice.
  - RIA (Restricted Investment Account): restricts the bank to invest in activities, sectors or projects selected by the investor.
  - variation in practices: wide variety regarding adjustment of denominator of CAR formula — some jurisdictions require capital against assets financed by URIA, others against assets financed by RIA.
  - differing treatment of reserves: in some cases PER considered eligible capital for regulatory CAR; in others IRR considered eligible capital.
  - regulatory clarification: IFSB-15 (Revised capital adequacy standards for institutions offering Islamic financial services) made clear that PER and IRR are not part of the capital of Islamic banks.
- Additional guidance:
  - March 2011: IFSB issued a guidance note with a methodology to estimate the value of alpha to be used in the supervisory discretion formula.

*This annex is based on Song and Oosthuizen (2014).*

*Source: Annex 1. Shariah Law and Islamic Banking (IMF working paper annex).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14219.pdf_