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.

Enhancing the IT infrastructure has therefore become indispensable in view of the need to capture and maintain sufficient financial data and information for risk analysis. In Islamic banking, IT applications in strengthening risk management capabilities are even more demanding in view of the risk intricacies in the different Islamic modes of finance. A financing facility for example that is extended to a client based on Murabahah, Ijarah, Istisna’ and Musyarakah will all have its own unique risk exposures. The risk exposure is not only different across the different modes of finance but also across clients. In addition, different maturities of the Islamic financial contracts will have different implications for risk across modes and across clients. Islamic financial institutions need to have a robust internal rating system that can map all assets in the balance sheet in accordance with the risk characteristics of each asset. Comprehensive IT systems will be needed to capture and store long-term historical data so that expected probability of the return can be estimated and a risk weight can be quantified and assigned. Indeed, the heterogeneous modes of Islamic finance require an even more rigorous system for expected return calculation as compared to interest-based credit transactions. The complex and volatile financial environment requires enhanced capacity of Islamic financial institutions in dealing with uncertainties and probabilities. This will enable Islamic financial institutions  BIS Review 20/2004  3  to strengthen tolerance levels to deal with financial vulnerabilities.