Basel framework and profit-sharing contracts: Islamic banking through the lens of capital requirements

This paper theoretically examines the impact of capital requirements on Islamic banks. Given the large use of profit-sharing investment accounts (PSIA) in Islamic banking and the recent implementation of Basel III capital framework, we develop a simple model where banks are able to offer PSIA contracts under a regulation applying risk-weighted capital ratios and leverage ratio restrictions. We find that banks with high or low returns on assets prefer " conventional " banking, while banks with intermediate returns on assets operate as Islamic banks, by selecting PSIA instead of deposits. We further highlight that capital requirements tend to increase this incentive to opt for Islamic banking, especially when Islamic banks benefit from a less competitive environment and from a locally tailored capital regulation.