By Camille Paldi
Abstract
This paper explores the risks involved in Islamic banking products. It argues that Islamic finance instruments pose a unique set of risks and costs, which must be taken into account when determining the amount of regulatory capital a bank must hold. Riskier products require higher capital charges; therefore, Islamic banking is more expensive than its conventional counterpart and requires more regulatory capital. In addition, the existing assets of Islamic banks are not as liquid as compared to conventional banks and due to slow development of financial instruments; Islamic banks are unable to quickly raise funds from the markets. One means of obtaining liquidity is through the securitization of Islamic financial contracts, which requires the establishment of an Islamic secondary market. This would increase liquidity and allow banks to start moving away from murabahah. Furthermore, since the existing lender of last resort (LLR) facility is based on interest, Islamic banks cannot utilize LLR facilities. Hence, illiquidity and liquidity risk are major problems for Islamic banking, which also makes it necessary for banks to hold more regulatory capital.
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