This is particularly relevant for the Islamic financial services industry given the close link of Islamic finance with the real economic sector through the various modes of Islamic financing contracts. In particular, heightened surveillance is needed over developments in the real estate and commodity markets. Equally important is a greater understanding of the inter-relationships between the financial and the real sector, including the potential for second round effects that are transmitted across sectors of the financial system and the economy. The increased cross-border reach of Islamic finance has also underscored the importance of enhanced cross-border collaboration among the supervisory authorities. Information-sharing and effective coordination among supervisors will enable a complete understanding of the entire risk spectrum of the risk taking activities undertaken across jurisdictions by the Islamic financial institutions. This is especially important in crisis situations, given the serious ramifications of a delayed or ineffective response to cross-border contagion. Robust institutional arrangements are therefore vital to improve the efficiency of the supervisory processes and to allow for the early detection and management of cross-border transmission of risks arising from group-wide activities. Another key area is the evolution of the legal framework for Islamic finance. This is to provide greater certainty and to build public confidence in the system as a whole. This necessitates a legal framework that enforces end-to-end Shariah compliance in the Islamic financial services industry – through provisions and mechanisms that unambiguously define the conduct and governance of Islamic financial institutions.

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.