Islamic Banking and Basel II

This paper consists of two parts. The first section deals with the theory of Islamic banking to understand better the need for capital adequacy regulation. To add value to the theoretical part it ends with a mathematically and graphically representation of a replicated Conventional bond with Islamic financial contracts in a complete market. The second part focuses on the capital adequacy requirements of Islamic banks and does not deal with other aspects of Basel II. Under the Basel II Accord Islamic financial institutions receive special treatment due to its nature of contracts and unique risks. A case study is developed which shows that following the IFSB guidelines, a major bank in GCC region is well capitalized for the years 2002-2005. It should be noted that the way in which one deals with the unrestricted investment accounts impacts whether the bank can meet the CAR measure. Further the implications of Pillar 1 on Islamic banking are discussed in detail.