In Malaysia, this has been addressed through the establishment of an effective rate of return framework, which provides a standard methodology for deriving the rate of return on deposits. The Profit Equalisation Reserve has been provided in the rate of return framework for Islamic financial institutions, which serves as a mechanism to mitigate the impact of the fluctuations in the rates of return. The reserve is appropriated from the gross income and is shared by both the depositors and the banking institution. Given the dual banking environment, as the one in Malaysia, the ability to maximize risk-adjusted returns on investment and sustain stable and competitive returns is an important element in ensuring the competitiveness of the Islamic banking system. From the regulatory perspective, the rate of return framework provides a means of assessing the efficiency of Islamic banking institutions, its profitability, management competency and fairness. To further protect Islamic depositors, the Malaysia Deposit Insurance Corporation has established a separate deposit insurance scheme based on Islamic principles. Disclosure of the true and fair value of the Islamic banking operations in the financial statements is also essential for depositors to undertake a true and fair assessment of the bank's performance. The enhanced financial disclosures need to be complemented with customer education and awareness programs to elevate the level of financial literacy among the consumers and businesses.

The implicit state guarantee for these institutions is a major source of incentive distortions. It is in complete contradiction with the functioning of a free market system and the hypotheses of our welfare theorems. Limited liability and the prevalence of bonus systems provide other significant distortions affecting individual decision-making. At various levels of financial institutions, decision-makers face asymmetric incentives. To give you an example, remuneration levels were high when risk taking paid-off, but there were no negative consequences – except possible job losses – when risks materialised. It is not surprising that excessive risk-taking was the consequence. 3  Domestic credit to private sector refers to financial resources provided to the private sector, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. Worldbank, World Development Indicators, http://data.worldbank.org/indicator/ FS.AST.PRVT.GD.ZS/countries/1W?display=graph. 2  BIS central bankers’ speeches  This problem of socially excessive risk-taking is even more damaging in the case of large interconnected institutions whose failure would endanger other institutions, with adverse consequences for the broader economy. Here, a clear externality is at work. My focus on incentive problems does not eliminate the possibility that cognitive or behavioural biases could also play a prominent role in driving excessive leverage in the banking sector. Herding behaviour and “group think” were certainly prevalent in “subprime investment”. A possible explanation for herding behaviour here is the propensity to suspect that “they know something that I don’t know”.