In the case of Malaysia, an additional capital requirement is required to cushion inventory risks of underlying assets and to cover the potential equity position risks that are embedded within the partnership contracts. This is also reinforced by the requirement on the appointment of board representatives in the invested entities under the partnership contracts so as to serve as a safeguard for the interest of the Islamic financial institution thereby allowing for continuous monitoring and surveillance. Islamic financial institutions are also allowed to transfer the risk to investment account holders under Mudharabah, i.e. profit sharing and loss bearing contract, if the institution can demonstrate the appropriate disclosure and governance practices that would ensure an effective risk transfer. Islamic banks are also permitted to set aside a portion of income derived from assets funded by Mudharabah contracts, in the form of profit equalization reserves (PER) to sustain stable and competitive returns. Several of these requirements are based on the international standards that have been issued by IFSB. The implementation of IFSB standards across jurisdictions will be key in the continued robust expansion of Islamic finance. While the above measures facilitate the managing of risks peculiar to Islamic finance, the legal, regulatory and supervisory infrastructure also needs to keep abreast with the evolution and rapid transformation taking place in the industry. As part of this infrastructure, there needs to be an integrated crisis management framework to ensure that any emerging crisis in the Islamic financial system will be promptly managed.
A further similarity relates to the lack of capacity to manage the increased risks associated with the transformation of the financial sector. For Asia , the increased liberalisation was not accompanied by the development of the necessary domestic financial infrastructure and the capacity to manage the increased risks and vulnerabilities associated with the liberalisation. In the current crisis, financial innovation occurred at a pace that outstripped the ability to manage the associated risks with such innovations. There was excessive risk taking and a lack of transparency and disclosure in the financial transactions. The complex structured instruments and securitisation process resulted in multi-layered structuring of financial products which were not supported by enhancements to governance processes and the risk management infrastructures and practices. This resulted in an underestimation of the risks involved and the capital buffers that were necessary. The ensuing turmoil in the financial markets that followed was increasing illiquidity in the financial markets and the subsequent breakdown in the functioning of the markets. As this continued, it has translated into stress and insolvencies in the financial sector. In both crises, this precipitated a sudden pull back in bank lending. The ensuing credit crunch magnified further the damaging impact on the economy. In Asia, the economic contraction was severe in the range of minus 7% to 13%. In the current financial crisis, however, the spillover impact of the effects on the economy has yet to be fully felt.