Recent calls for risk-sharing - as expounded in the 2012 Kuala Lumpur Declaration, the 2014 Jeddah Declaration and the 2014 International Monetary Fund statement - elucidate the present situation of Islamic banking and finance: an acknowledgement that risk sharing is a "salient characteristic" of Islamic financial transactions on the one hand and that it is "not deeply embedded" on the other. The objective of this practical evidence-based research paper is to address this schism between prescription and practice. It recapitulates the principles underpinning risk sharing and the reasons why it is integral to the Shar??ah and why (as stated in the Declaration) risk transfer and risk shifting violate a Shari'ah principle. he paper presents preliminary research utilizing empirical data from Malaysian Islamic banks and the Malaysian stock market as a proxy for the real economy. It considers newly enacted Malaysian legislation, the Islamic Financial Services Act 2013 (IFSA), from the perspective of its aim to more clearly define the products and activities of Islamic banks.

The role of regulation extends beyond ensuring stability and confidence in the financial system, as it is also behavioral shaper of market players. The laws, standards, and guidelines issued are instrumental in creating an incentive structure for market players to behave in certain ways. Using incentive audit approach, this paper attempts to examine the efficacy of the evolving Malaysian regulatory and supervisory framework for Islamic banking, in preserving financial stability as well as supporting the growth of the financial system and real economy. The findings suggest that the present framework unintentionally misaligns incentives and discourages Islamic banks from fully embracing risk sharing as the underlying principle for their financial instruments.

The role of regulation extends beyond ensuring stability and confidence in the financial system, as it is also a behavioral shaper of market players. The laws, standards and guidelines issued are instrumental in creating an incentive structure for market players to behave in certain ways. If well designed, these tools will induce appropriate behavior that is consistent with the social objective of systemic stability and equitable economic prosperity ...

This dissertation studied the efficacy of contemporary Islamic banking regulatory framework in promoting risk-sharing finance. Malaysia is selected as a case study given its strengths as an advanced and comprehensive Islamic financial market. The study found that, risk-transfer philosophy is dominant in the design of the regulatory framework for both the Islamic and conventional financial systems. Harmonizing the regulations of the two markets is necessary to minimize regulatory arbitrage and ensure that both are governed at the same level of regulatory robustness. An unintended consequence however is the deep entrenched risk-transfer paradigm that permeates into the way Islamic banks operate. Risk transfer runs counter to the spirit of Islam that espouses for the proper exchange of property rights in Mu'amalat transactions. For example the use of credit enhancements (such as Wa'ad and ar-Rahnu) is rampant as devices to transfer the risk that the bank must undertake, back to the customers.