Independent central banks appeared to have tamed inflation once and for all. New sophisticated financial instruments seemingly succeeded in reducing risks to low levels for ever. A new generation of investors emerged and took on risks that they could not afford. Cross-border transactions increased rapidly at unprecedented levels. After a period of several good years, euphoria emerged at the beginning of the 21st century. The focus on return on equity (short-term) rather than on return on assets (long-term) provided wrong incentives for the owners and the managers of banks. Whereas in 1998 the detaining period for shares in a bank was three years on average in the US and in the UK, it decreased to 3 months in 2008, signalling the so-called “casino capitalism”. At the same time, while in 1989 the executive directors of the top seven US banks gained 100 times the average income of a median household, by 2007, they earned 500 times that income. This disregard for risk sparked worries among the national and international authorities concerning potential threats to macroeconomic and financial stability. The interest in macroprudential policies, which nowadays are seen as vital, became manifest early in the `80s. However, policy implementation remained feeble and the unthinkable happened. Now the most important mission is to correctly identify what went wrong and what principles we should use when making enhancements to our financial system. Before moving on to the next section which addresses these issues, let me draw two lessons. First, overregulation is not good.

In building a sound prudential framework for Islamic banking, aligning the regulatory capital requirements to the underlying risks, requires dichotomization of the risk intricacies in the Islamic  2  BIS Review 8/2006  banking asset portfolio, given the asset structure of Islamic banking institutions, such as the diverse spectrum of Islamic financing structures, which range from low-risk sales and lease-based modes to the higher risk equity-based modes of finance. The intricacy in profiling the risk in Islamic banking is further increased as the risks may transform from one type of risk to another at the various stages of the contract. For example, in the diminishing Mu-sya-ra-kah contract, the Islamic financial institution initially acts as a joint-owner of the asset, but the asset ownership will be transferred fully to the customer at the conclusion of the contract. In this regard, the Islamic financial institution is exposed to higher market and impairment risks at the initial part of the transactions initially compared with the exposure during the later stage of the contract. At the same time, the amount of repayment by customers represents the credit risk to the Islamic financial institution. As each of these respective parts of the transaction has a distinct intrinsic characteristic, it would entail different degrees of credit, market and operational risks. In this regard, in formulating prudential standards for Islamic banking institutions, there is a need to have an accurate assessment of the various risk variants underlying the alternative parts of the transaction to determine the capital adequacy requirement.