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.

The developments in the pipe-line include the unique set of prudential regulatory and supervisory standards for Islamic banking operations by the Islamic Financial Services Board, tailor-made set of accounting standards for Islamic financial business by the Malaysian Accounting Standards Board and introduction of the Deposit Insurance Scheme in Malaysia. Having achieved the critical mass, Bank Negara Malaysia conducted a review in 2003 of the existing 'window' institutional structure of the banks to prepare an enabling structure that can assimilate future developments in the Islamic financial regulatory infrastructure over the longer term and thus strengthen the prudential regulatory and supervisory regime. This represents the third phase in the development of Islamic banking in Malaysia. The new institutional structure known as 'Islamic subsidiary' was introduced in 2004. It is envisaged that greater strategic focus and resources as well as higher autonomy and governance will be accorded to the Islamic banks. To-date, two Islamic subsidiaries of two banking groups have been set up. Integrating with international financial system Another significant milestone in the progress of Islamic banking and finance in the Malaysian banking system in its two decades of development is the issuance of three new Islamic bank licences to Islamic financial institutions from the Middle East. The new entrants with distinctive capabilities and strengths will have the opportunity to bridge the two regions, participate in the growing Islamic banking industry as well as tap new markets in Malaysia and in the region, and promote healthy competition thereby contributing to elevate the industry to new levels of dynamism.