Currency mismatches have been at the origin of many banking crises in emerging economies. Nonetheless, their financial systems’ resilience to exchange rate fluctuations toward late 2008 and early 2009 showed that lessons were learned, and effects on banks’ balance-sheets, that would have translated an external recession into a far-reaching financial crisis, were avoided. Of course there were exceptions, particularly in emerging Europe, where fragilities arose precisely because of the rigidity of their exchange rate systems and currency mismatches of their banks. Another reason of the importance of having a well-functioning financial market is the distortions caused by exchange rate volatility on resource allocation. In order to minimize such effects it is prudent to develop an exchange rate hedging market allowing producers in the tradable sector to hedge against exchange rate fluctuations at least at one year’s term. In fact, evidence shows that hedging markets are more developed in economies with more flexible exchange rates, because it is that flexibility that creates incentives for these hedging mechanisms to develop (De Gregorio and Tokman, 2005; Kamil and Sutton, 2008). If, on the contrary, the monetary authority attempts to provide stability, the market will have no incentives to develop hedging instruments. However, a floating exchange rate and an inflation targeting regime may be insufficient for stabilizing large amounts of capital inflows. The appreciation that results from massive capital inflows and a credit boom cycle may require other instruments to stabilize the economy and ensure the smooth functioning of the financial system.

The Islamic financial system that has developed in Malaysia over the last two decades has emerged as a comprehensive Islamic financial system that operates in parallel with, and is able to compete on an even keel with the more entrenched conventional financial system. The development of Islamic finance as an important niche activity in Malaysia’s International Offshore Financial Centre in Labuan also complements the development of the domestic Islamic financial market. To ensure the sound and stable development of the Islamic financial industry, it needs to be supported by a strong regulatory and supervisory framework. This is to ensure that the operations of the Islamic financial institutions are sound and not a source of vulnerability to the banking system. To a large extent, it has been governed by a regulatory framework that has been reinforced by the Shariah framework and the Islamic accounting standards. The challenges facing the Islamic financial industry can be expected to be much more complex and demanding. This is because the regulatory framework in the Islamic financial industry needs to address the unique characteristics and attributes associated with Islamic banking operations and Islamic financial instruments. The complexities of the respective risks in the Islamic financial instruments need to be fully explored and quantified to provide for their effective assessment and management. With the advent of Basel II that advocates a higher degree of risk-focused regulatory approach would require the Islamic financial institutions to identify and “unbundle” the risks inherent in Islamic financial instruments.