The global experience has shown that the lack of well developed bond markets brings with it vulnerabilities arising from over-reliance on financing from the banking sector. This has often resulted in funding mismatches with adverse implications on financial stability. The development of the bond market allows for access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows for the diversification of risks by issuers and investors. The central merit of the sukuk structure is that it is based on real underlying assets. The ijarah sukuk for example – an Islamic bond which applies a sales and leaseback arrangement – is an asset-backed instrument providing continuous security to the investor. This approach discourages over-exposure of the financing facility beyond the value of the underlying asset, given that the issuer cannot leverage in excess of the asset value. In addition, Islamic finance requires that the financing must be channelled for productive purposes, such as for project financing, rather than for speculative activities. The risk exposure is therefore to the project and not to the uncertainties or activities that have no real economic benefits. Islamic financial intermediation therefore has the potential role of contributing towards financial stability. BIS Review 74/2007  1  In the current environment, the demand for sukuks significantly exceeds the supply. Today, the global sukuk market, denominated in international currencies, is estimated to be USD18 billion. If domestic sukuk issuance is included, it has now exceeded USD50 billion.

This requires financial institutions to internalize the costs of their risk-taking activities up front and to hold capital and liquidity buffers sufficient to handle a plausible range of adverse outcomes. Finally, on occasions when these buffers prove inadequate and a financial firm does reach the brink of failure, the official sector needs the capacity to smoothly wind down such firms so that future taxpayer-funded rescues prove unnecessary. Regulatory and supervisory efforts to accomplish these goals are proceeding down several distinct but related paths:   Increase the capital and liquidity standards for all internationally active banks, measured by both quantity and quality of capital and liquidity, so that they are better able to absorb financial shocks without disrupting the flow of credit to the real economy.   Introduce a credible resolution mechanism for managing the failure of a large systemic bank or nonbank financial institution, to reduce the economywide costs of such failures and, by making them less disruptive, further reduce moral hazard by diminishing expectations of future public support.   Ensure that the largest and most interconnected financial institutions – whether or not they are chartered as banks – face even more stringent prudential standards, in order to reduce moral hazard for the largest firms and lower the probability of their failure to below that of smaller and less systemically important institutions.   Strengthen financial market infrastructures so that when failures inevitability occur, the shocks generated by these failures are dampened, not amplified as they propagate through the financial system.