2  BIS Review 49/2005  Pre-requisites of the Islamic banking system The development of a vibrant and dynamic Islamic banking system that has a meaningful role in a nation's future economic and social development requires well-defined strategies that focus on two main areas, building institutional capacity and the development of the supporting financial infrastructure. Allow me to highlight the key areas of the strategies. The first task is to identify the nature of Islamic banking system that is appropriate for the country - whether to ultimately adopt a dual banking system where Islamic banks and conventional banks offering Islamic banking products operate in parallel with the conventional banking system, or alternatively to adopt a single banking system that fully accords the Shariah injunctions where all the banks are Islamic. Second, measures need to be in place to ensure that the Islamic banks are well-capitalised and resilient. For Islamic banks that are already in existence, clear criteria need to be specified on the minimum capital size that would enable them to be significant players in the market, be able to gain from economies of scale, have a diversified earnings base and stronger market presence. Such minimum size can either be achieved through organic growth or merger with a partner bank which would bring about the desired outcome in a shorter period of time. Incentives can be provided to induce the banks to consolidate while guidelines on minimum capital size can be imposed to ensure that the banks either merge or undergo a recapitalisation exercise.

In the second phase of the development of Islamic banking, conventional banking institutions were permitted to offer Islamic banking products and services on a window basis to leverage on the existing infrastructure, including staff and branch network, and achieve wider market and cost optimisation. This landmark policy was undertaken ten years after the establishment of the full Islamic bank to allow  4  BIS Review 49/2005  for its greater outreach. The window operations opened the door for the existing conventional banks to participate in the Islamic banking market for both the Muslim and non-Muslim communities. Under a pilot programme, three conventional banks were initially allowed to offer Islamic banking products and services. Then in early 1994, together with the establishment of the Islamic interbank market, a dual banking system was created. The interbank market is integral to the smooth functioning of the Islamic banking system, and became the first of such models. Concurrently, firewalls between the conventional and Islamic funds were put in place, which included separation of capital funds, cheque clearing system, clearing account with the central bank, settlement account and reporting system. They were also required to establish Islamic banking units to be headed by a senior banker, create an Islamic banking fund with a minimum allocation, and appoint at least a Shariah consultant to advise on the day-to-day operations of the Islamic banking division. In the ensuing years, additional rules and regulations were made to strengthen such operations. Eventually, more players were granted approval to offer Islamic financial products and services.