The task of formulating a framework that addresses the peculiar risks associated with Islamic banking is being undertaken by the Islamic Financial Services Board (IFSB), which serves as an international standardsetting body for regulatory and supervisory agencies. Its mandate is to develop prudential, regulatory and disclosure standards for Islamic finance, and promote uniformity in the best practices on the governance of Islamic financial institutions worldwide. In this respect, the IFSB has recently issued two prudential standards on risk management and capital adequacy for institutions offering Islamic financial services, which are recommended for implementation in 2007. The IFSB has also made progress in developing three other standards on corporate governance, transparency and market discipline, and the supervisory review process to be released in due course. A key challenge in managing operational risk in Islamic banking is ensuring Shariah compliance. Bank supervisors in their assessment would need to give due attention to the adequacy of the financial institutions' board and management oversight, policies, procedures and limits, risk measurement, monitoring and management information systems, and internal controls. The risk management standards issued by the IFSB would serve as a guide to bank supervisors in this regard. Notwithstanding the significant progress made so far, there are still outstanding issues confronting the Islamic financial system today, particularly the different interpretations of the Shariah injunctions. Internationally, there continue to be debates among Shariah scholars on the compliance to the Shariah principles.

Similarly, the liability structure of the Islamic banks is characterized by two distinct categories of deposits: the demand deposits which are not subject to the risk associated with the banking business and for which the principal is guaranteed, and the investment deposits which involve risks and hence, eligible to share the profits earned from the banking business. Given that the returns are not predetermined, profit-sharing depositors of Islamic banking institutions, as the capital provider will have to bear any of the losses. This places a higher degree of fiduciary risk on the Islamic financial institutions in ensuring that the investment deposits funds are managed in the most effective and efficient manner. This is further compounded by competition in managing the liquidity in the system. The profit share distributed needs to be competitive relative to that earned and paid by the conventional banks. This is important to avoid a shift of deposits and to retain the funds in the system. A central feature of the regulatory framework for Islamic financial institutions is financial transparency and disclosure. Market conduct disclosure and customer relationship management form the core of these principles. Addressing the information asymmetry between Islamic banking institutions and the depositors is of vital importance. Under the Mu-da-ra-bah principles, there is a need for disclosure by Islamic financial institutions to investors on how the funds are being managed so as to provide the assurance that the underlying business operations, the risk profile and the risk control mechanisms are in place.