Regulatory emphasis has shifted towards a more risk sensitive regulatory capital framework and the assessment of risk management systems and processes in financial institutions. Extensive investment has been made by the industry to adopt a comprehensive and robust internal risk management infrastructure. In Islamic banking, the requirement to manage risks becomes more important due to the special nature of the financial intermediation process that is guided by the Shariah. Islamic financial institutions have a multi-facet role. On the asset side, Islamic financial institutions enter into diverse modes of Islamic financial contracts, each with its own peculiar risk characteristics. Basel II, has to a certain extent, incorporated the identification of credit, market and operational risks that can be assimilated by Islamic financial institutions. However, Islamic financial institutions need to be ahead in exploring other dimensions of risks in these Islamic financial contracts. The risk management infrastructure in Islamic financial institutions must therefore be in place to identify, unbundle, measure, monitor and control all the specific risks in Islamic financial transactions and instruments to provide for their effective quantification and management. Strong risk management capabilities become more pertinent in view of the different contractual arrangements entered into by the Islamic financial institutions with the different classes of depositors. Demand deposits, under the guaranteed custody contract and investment deposits, under the Mudharabah contract, each has its own unique risk and return attributes. Islamic financial institutions must ensure that demand depositors are protected from the risks of Islamic banking business.

The regulatory framework should not be so onerous that it forms a high cost and a burden to businesses. Intrusive regulatory approaches on new products can become a disincentive. Tax structures can also be structured to support the innovation process. Within financial institutions, organisational structures can also create an environment for innovation by avoiding product-oriented structures and aligning instead to the organization’s processes as well as implementing appropriate performance incentives. Fifth, entering into strategic alliances with entities may bring new approaches, new technologies or specialisation in a new product. In addition, collaborative efforts amongst Islamic financial institutions would strengthen the ability to leverage on the industry’s expertise. The introduction of innovative Islamic financial products in a specific jurisdiction can be expanded to other jurisdictions, which in turn, will contribute to broaden and deepen Islamic financial markets and thus strengthen the overall development of the Islamic financial industry. To facilitate the achievement of this objective, the sharing of information can be made on the product features and the Shariah methodology adopted in ascertaining the permissibility of the products in the various jurisdictions. Strengthening risk management capabilities While financial liberalization and innovation have expanded the range of opportunities, it has also led to heightened uncertainties, greater volatility and increased potential of financial vulnerabilities. These  2  BIS Review 20/2004  developments require financial institutions to move to a higher standard of risk awareness and management.