Having already achieved remarkable growth and development over the recent decade, the continued success and viability of Islamic finance will also depend critically on ensuring focus on preserving financial stability. While contractual relationships and obligations may be different under Islamic finance, thus requiring different risk governance arrangements and skill sets, both conventional and Islamic financial institutions are exposed to similar risks including credit, market, liquidity and operational risks. For these reasons, the relevance of reforms to strengthen capital and liquidity buffers such as that under Basel III also extends to Islamic financial institutions and their universal implementation is important to avoid competitive distortions and regulatory arbitrage. Beyond prudential standards however, ensuring strong adherence to Shariah principles is central to delivering the financial stability benefits that were found wanting in conventional financial systems prior to the global financial crisis. In addition, the agenda to promote fair, responsible and professional conduct by Islamic financial institutions and more empowered consumers must be equally advanced. In Malaysia, the new legal framework for Islamic banking and takaful that recently came into force is set to pave the way for the development of an end-to-end Shariah compliant regulatory framework, reinforcing the effective application of Shariah principles in the conduct of Islamic financial institutions. It is encouraging to see that substantive progress has been made in respect of the development of prudential standards for Islamic financial institutions and the cooperation arrangements that are taking place to facilitate the implementation of these standards at national levels.

That is why banking operations need to be safeguarded. One safety measure is the possibility, in exceptional circumstances, of the central bank intervening as the lender of last resort. This is a matter of providing liquidity—as long as the banks are fundamentally solvent—when the stability of the entire financial system is threatened. In that way it is BIS Review 81/1998  -4possible to avoid more serious economic consequences and, provided the problems underlying the crisis are managed, stabilise the situation in the banking system and the economy in general. However, a central bank’s unique possibility of providing liquidity is restricted to the national currency. If a country has an external deficit and revenue from exports does not cover imports, to make up the difference it has to borrow in foreign currency. The vulnerability this involves increases if the loans are short-term, sizeable and have been channelled via the banking system to long-term investment projects. If a country in this situation encounters problems with the renewal of foreign loans, the central bank will have limited opportunities of coming to the rescue with liquidity unless it happens to have sufficient foreign exchange reserves or borrowing facilities. That is more or less what has happened in the countries that have recently been hit by problems. Sudden shifts in confidence as to a country’s real economy, the value of its assets or its political system are examples of factors that have triggered crises in economies that have been highly vulnerable.