This thesis focuses on Islamic banking in Indonesia. It considers the related challenges of sharia compliance by Islamic banks and their regulation and supervision in Indonesia’s dual banking system. Crucial to the prudent regulation and supervision of banking is the control and monitoring of risks that could jeopardise a nation’s financial stability. Since compliance with sharia principles is the raison d’etre of Islamic banks, all their instruments and activities must be based on Islamic law. Unfortunately, sharia compliance gives rise to unique risks for Islamic banks not faced by conventional banks in Indonesia’s dual banking system. These include inconsistencies between fatwas, unique reputational risks which can cascade into liquid risks, and inefficiencies in the manifold regulatory framework governing Islamic banks. This thesis analyses the tension between classical Islamic principles required of bank contracts and the modern needs of businesses and the community. It also critically examines the less studied issue of developing an Islamic banking regulatory and supervisory framework that considers the risk pressures faced by Islamic banks operating in a financial sector dominated by conventional banking. This thesis argues that a middle way is possible for contemporary Islamic banks, which encourages prudent risk management whilst adhering to the evolving pluralistic form of Islamic law in Indonesia. The thesis critically assesses the extent to which global financial standards of the Basel Accords have been followed by Islamic banks in Indonesia with respect to their regulation, supervision, and risk management, in order to highlight the unresolved tensions in the multiple regulatory and supervisory institutions, viz. the state’s Financial Service Authority and the private agency of Sharia Supervisory Boards operating under the auspices of the National Sharia Board of the Majelis Ulama Indonesia. In this regard, one of the major challenges for Islamic banks is the potentially difficult institutional and Islamic legal reforms required to fully apply the international standards set down in the Basel Accords. Again, this thesis proposes a middle ground approach that accommodates modification of the existing financial regulatory and supervisory system in line with international best practice to provide more comprehensive guidelines for prudential regulation transparency
