At the core of a strong Islamic financial system in any jurisdiction, there needs to be a strong regulatory framework which enforces the standards for capital adequacy, ensures effective risk management practices, financial disclosure and governance, reinforced by a strong Shariah and legal framework. Shariah principles serve as a self-regulating mechanism that protects Islamic financial institutions from unproductive, speculative and unethical activities, given the prohibition of interest or usury in banking business, and the requirement that all financial transactions are to be accompanied by genuine trade and business-related transactions and the prohibition from the involvement in illegal and unethical activities. The regulatory framework in which Islamic banking operates is thus able to draw on the strength of the Shariah injunctions, to reinforce financial soundness and stability of the Islamic banking system. In Malaysia, Islamic banking institutions are required to have a Shariah Committee council within their respective institutions to ensure that products and services to be introduced are Shariah-compliant. In addition, emphasis is also placed on the internal audit function to ensure that all transactions undertaken by Islamic banking institutions are in compliance with the Shariah principles. In designing and implementing financial regulation and supervision for Islamic banking institutions, the challenge is to enforce a framework that takes into account the unique characteristics of Islamic banking business, without being a regulatory burden and restricting its growth potential or providing arbitrage opportunities between the conventional and Islamic financial systems. This is important to ensure the stability of the overall financial system.

The reform effort has many moving parts, and further efforts are clearly needed to ensure that those parts fit together, and that the various parties work together. And these reforms are yet to be fully implemented, let alone tested over a full credit cycle. Of course, building a stronger system is not just about regulatory reform. Changes in institutional governance and culture are also needed. Many of the problems that surfaced during the crisis and more recently reflect a culture that emphasizes short-term gain over institutional sustainability – a culture in which regulation is viewed as an obstacle to be arbitraged or circumvented, rather than as an additional check on broadly shared objectives. That needs to change if progress is to take root. Making sure that happens will require a realignment of incentives, and strong leadership from the top. All of this will take time. The question is, how much time do we have? While risk-taking has been somewhat constrained in the aftermath of the crisis and the resulting uncertainties in the macro environment, we are beginning to see signs of things heating up in some areas of the markets: e.g., record issuance of junk bonds and emerging market debt, including enthusiastic take-up for issuers from “frontier markets” with little to no prior presence in the capital markets; increased leveraged buyouts; weakening covenants; and a rebirth of the collateralized loan obligation market. Complacency at this point would not be a good thing.