Islamic finance in 2008 and beyond remains positive despite the current challenging global financial environment. The viability and competitiveness of Islamic finance is derived from several factors. It is from its ability to meet the changing demands of the economy, from its cost competitiveness and from being supported by a well developed legal, regulatory and supervisory framework. But more importantly, are the fundamental Shariah requirements of Islamic finance that support its viability and stability. Shariah is the key pillar of Islamic finance from which Islamic finance derives its unique characteristics. The Shariah injunctions require that Islamic financial transactions be accompanied by an underlying productive activity. In Islamic finance, there is always a close link between financial and productive flows. Moreover, under the risk sharing principle  BIS Review 6/2008  1  required, Islamic financial institutions will share the profit or the loss incurred by the entrepreneur. There is an explicit sharing of risk by the financier and the borrower. This arrangement will thus entail the appropriate due diligence and the integrating of the risks associated with the real investment activity into the financial transaction. In this arrangement, the real activity is expected to generate sufficient wealth to compensate for the risks. In contrast, conventional instruments generally separate such risks from the underlying assets. As a result, risk management and wealth creation may, at times, move in different or even opposite directions. Conventional financial instruments also allow for the commoditisation of risks.
Six years hence, the Islamic financial landscape has been dramatically transformed into a vibrant, dynamic and competitive global intermediation mechanism that is supported by more than 300 Islamic financial institutions in more than 75 countries. It also has become among the fastest growing segments in the financial services industry. In the early phase of its development, Islamic finance was essentially domestic centric, focussing on retail financing, trade financing and the financing of other commercial business activities. Two recent developments have however, influenced the subsequent direction of the development of Islamic finance. Firstly, the drive to diversify the domestic financial infrastructure so as to avoid the over dependence on the banking sector and secondly, the trend towards greater liberalisation of the financial system. These two trends have spurred the development of the Islamic financial markets and its greater integration into the international financial system, thereby raising the international dimension of Islamic finance. This more dynamic environment, has fostered the generation of a wide spectrum of Islamic financial instruments that has ranged from instruments to manage liquidity to structures for the financing of that for financing mega investments. These developments have led to the emergence of a new asset class. It has also drawn a higher level of foreign participation in the Islamic financial markets which has resulted in increased cross-border flows. This has not only contributed to enhancing international financial inter-linkages between economies but it has also contributed towards the more efficient allocation of financial resources across borders.