MALAYSIAN ISLAMIC FINANCE Issuers and Investors Forum 2006 Islamic Financial Market – The Malaysian Story By Badlisyah Abdul Ghani and Shamsun Anwar Hussain |
Over the past 43 years, Malaysia has seen significant development in both its onshore and offshore Islamic financial market. This has been achieved through trial and error, in addition to a natural evolution driven by the private sector and supported by the government. Malaysia is now the clear forerunner in the market globally. With the highest number of Islamic products and services anywhere in the world, one can find in Malaysia a comprehensive range of Shariah compliant products and services in the sectors of banking, finance, money market, debt and equity capital market, Takaful, private equity, asset management, derivatives and many more, including products and services from non-banking Islamic financial institutions such as will writing, trust and pawnbroking. What makes the Islamic financial market in Malaysia successful? What is it about the market in the country that makes it different from other markets in other jurisdictions? What makes it tick? These are some of the questions that this article will try to answer. Systemic approach to market development Realizing this problem, a group of interested bankers, lawyers and accountants in Malaysia got together in the 1970s until the early 1980s to lobby the government to come up with new legislation to provide a platform for Shariah compliant banking. Lobbying culminated in a White Paper being published and led to the enactment of the Islamic Banking Act 1983. This Act enabled the setting up of Islamic banks. In the same year, an Act called the Government Investment Instruments Act 1983 was enacted to facilitate the issuance of Islamic securities by the government. These Acts were followed by the Takaful Act 1984, which provided for the establishment of Takaful companies. Thus Malaysia experienced the birth of a separate Islamic financial system operating outside of the conventional financial system. Not yet a parallel system, but it was a beginning. During the initial 10 years of operating a separate Islamic financial market, the regulator took effective leadership of the market and in 1993 introduced sweeping changes to the Banking and Finance Institutions Act 1989. The changes gave birth to the Islamic windows concept, where existing riba-based banks could undertake Islamic banking and finance activities via a dedicated division with a separate balance sheet and profit and loss account. This provided impetus for the development of an active Islamic money market and the realization of a parallel financial system which operated side by side with the conventional financial system. The Islamic financial market advances and survives on an effective and sustainable parallel Islamic financial system. The more developed a system is in a particular market, the more advanced the market activities will be. The market does not and cannot depend merely on Islamic products for growth; instead the market relies heavily on a proper legislative and regulatory framework that governs the system. An Islamic financial product could be offered by anyone for a quick buck, but to have these Islamic products available in the market to meet a country’s developmental agenda, an effective parallel financial system is critical. A sustainable system is one that is supported by an active and effective regulator. This is true, but is not enough to develop an Islamic financial market. As Malaysia’s experience tells, from 1993 onwards there was exponential growth in Islamic banking assets. In the 1980s, the market share of Islamic banking was a mere 1%, but after the introduction of the Islamic window concept the market share shot up to around 6% in 1996. This was a great development, but although there was growth, it was very skewed toward home and car financing alone. There was a sinking feeling that there was something wrong with the market. It was then realized that although the regulator had put in place the platform for a parallel financial system, the financial institutions were operating on a product by product basis. They were not developing and operating Islamic banking and finance as a parallel business, providing comprehensive financial solutions equal to their conventional offerings. With this realization the Government introduced the Islamic banking subsidiary guidelines, and persuaded all banks with fully fledged Islamic window operations to convert and set up a fully fledged Islamic banks. Under this approach both regulators and financial institutions were now working together to build a complete Islamic financial market, where the regulator puts in place a parallel Islamic financial system and the financial institutions operate a parallel Islamic banking business. In Malaysia, the regulators are Bank Negara Malaysia (BNM) and the Securities Commission (SC). These are the two central bodies that govern the banking industry and the securities market respectively. Common Shariah Advisory Councils (SAC) are installed within these two financial authorities. BNM and the SC are both very pro-business and forward thinking and have introduced many guidelines as to how things are to be done in the Islamic financial market. Without their proactive approach to the market, the Malaysian domestic Islamic financial market and International Islamic Financial Center would not be what they are today. Some of the regulations introduced include guidelines on the management of Shariah committees, the issuance of Islamic securities, Islamic IPOs, Shariah compliant stocks and financial reporting for Islamic financial institutions. The success of the Islamic financial market in a particular jurisdiction depends substantially on its legislative and regulatory framework. The more developed the framework – the more resilient the Islamic financial system would be to support the market. However, a parallel Islamic financial system is worthless if the Islamic financial market is limited to only a few industry components. Most jurisdictions only have an Islamic banking industry, or an Islamic asset management industry, or an Islamic equity capital market, or an Islamic private equity market, or a combination of two or three of these industries. Malaysia is currently the only country with an effective and active Islamic financial market with nearly all of the required industry components (such as banking, money market, Takaful, etc). This is illustrated in the diagram below. Regulated Shariah management The first level relates back to the very foundation of the Islamic financial market, which is the prohibition of riba. This provides for how the whole system must operate. In Malaysia, a financial institution that operates under the Islamic Banking Act 1983 or as an Islamic banking window allowed under the Banking and Financial Institutions Act 1989 must ensure that all banking transactions take place in full accordance with Shariah. For an institution with an Islamic banking window, although it is in essence a conventional riba-based bank, it is required to maintain a separate balance sheet and profit and loss statement, as well as providing a separate financial report to the authorities. This approach ensures that all Islamic banking and financial activities in Malaysia are 100% Shariah compliant, from deposit taking to financing activities, and from treasury operations to investment. In some jurisdictions there are many financial institutions that undertake Islamic banking and finance activities by actually taking on the placement of Islamic funds and utilizing them for riba-based transactions. To make it even worse, some Islamic banks in some jurisdictions actually collect Islamic deposits and place them with conventional banks (that have no Islamic windows), whether in the form of Mudharabah or in synthetic Shariah products such as the commodity Murabahah. This should not happen, and Malaysia has put in the place necessary legislation to ensure it does not happen. This guarantees that the intention of a customer wanting to complete financial transactions Islamically is complied with and market credibility is assured. The second level of Shariah management relates to the management of the Shariah committee itself. Malaysia was the first and currently the only country that has regulated the appointment of Shariah scholars/experts on the Shariah committees of financial institutions. The regulation provides that no person may sit on the Shariah committee of more than one institution in the same industry. All appointments must be endorsed by the Central Bank and subject to proper due diligence. All Shariah committees of financial institutions are subject to the authority of the SAC of the regulators. What this means is that the decisions of the SAC are paramount and will be adhered to by all financial institutions, irrespective of whether their own Shariah committee agrees. This provides certainty in the market and creates greater customer confidence. The guideline effectively puts more control of Shariah in the hands of the regulators, rather than individuals who may be open to abuse and manipulation. The third Shariah management level relates to the management and monitoring of the activities of the individual financial institutions. Under the guidelines, the Shariah committee is responsible for ensuring that the operations of financial institutions are in accordance with the Shariah, including approval of new products, vetting legal documents, setting Shariah policy and procedures, audit and endorsing financial statements. Financial institutions in Malaysia are also required to have an in-house Shariah expert(s). What this means is the regulator has internalized the responsibility and accountability regarding Shariah to the institution itself, so that no financial institution is able to disclaim responsibility relating to Shariah and rely on the Shariah committee. This creates a new standard of fiduciary duty on Shariah compliance, previously unseen. Moreover, all new product developments need to be approved by the regulator and the SAC. Once approved, the product becomes a standardized product in the market, thus creating a dynamic competitive environment. This regulation means that in Malaysia a product cannot be developed by a financial institution that complies with Shariah on the surface, but does not in substance. Synthetic products such as commodity Murabahah, which is famous amongst conventional riba-based banks globally, cannot be used in Malaysia like it is in the Middle East and Europe. Shariah compliance in Malaysia must relate to the full activity of the institution releasing the product. So if a commodity Murabahah is being used by institutions to facilitate deposits or investment in Islamic funds, then the proceeds from the commodity Murabahah trade must be used for Shariah compliant transactions, e.g. Islamic car financing, Sukuk investment, etc. Asset liability management matching Islamic liability with Islamic assets is a must. In Malaysia there is a strict liability rule whereby if any financial institution licensed or approved to conduct Islamic banking activities is found to do so in contradiction with the Shariah, it will lose its license. Shariah management insufficient if legal framework constraints exist In Islamic banking and finance, activities are conducted differently from conventional riba-based banking and finance. If conventional finance is about LENDING and BORROWING activities, then Islamic finance is more about SALE, PURCHASE, LEASE, CONSTRUCTION, INVESTMENT, PARTNERSHIP and other trade relationships. Like it or not, both operate under the same laws. When conducting Islamic transactions in Malaysia, Islamic financial institutions have to deal with a wide range of laws, which are categorized as “key governing laws” and “accidental laws,” as below:
Although key governing laws are clear and directly relevant, the “accidental” laws are equally important as they often carry a negative impact on Islamic fixed income transactions. This is not because these laws are not good, but because they were developed based on conventional riba-based market practices. The concepts approved under Shariah have been applied in banking and financial relationships all over the world, but they do not operate under banking or securities law. Due to the tax regime dimension, national land code, takeover codes and other relevant laws, the simple and clear requirements of Shariah appear more difficult than they should do. In addition to fine-tuning its banking laws, any jurisdiction interested in developing an Islamic financial market needs to revise its tax legislation and other laws to allow Shariah/legal relationships to be operated under banking or securities law at the same cost level as conventional banking or securities activities. In Malaysia, when the Islamic Banking Act was enacted in 1983, Islamic activities were very limited, only amounting to a 1% market share of the banking assets. This was due to an unaccommodating tax law whereby Islamic transactions were hit by the Real Property Gain Tax (RPGT), resulting in double stamp duty for Murabahah transactions, change of land ownership issues for Ijarah transactions, the need to file tax returns for Musharakah financing, etc. When the laws were changed in the late 1980s and early 1990s to accommodate Islamic transactions, the industry grew significantly to a 6% market share. Shariah principles applied in 1983 and in the early 1990s remained the same, but the legal framework changed. This demonstrates that the constraint was caused by the latter, rather than the former. Realizing that Shariah is not the constraint to development, but that the legal framework is, the Malaysian regulators proactively facilitated changes to the legal framework to spur Islamic financial market development. In Malaysia today, tax neutrality for Islamic financial transactions is automatic and company laws have been changed to accommodate Musharakah. These changes resulted in further market growth. In 2005, 70% of corporate bonds were issued under Shariah principles and the market share of Islamic banking assets grew to about 12%. Again, Shariah rules did not change, as they are eternal, but the legal framework, such as tax law, was changed. If this active legislative approach is applied in other jurisdictions such as Indonesia, Singapore, Thailand and Pakistan, then the Islamic financial market should prosper there. Market impact of systemic approach, Shariah regulation and active legislation The platform provided by the Islamic financial system, the focus created by the strict management of Shariah, and the proactive facilitation of the industry in Malaysia has led to greater demands for Islamic financial products and services. In essence, Islamic financial institutions are bound by law to utilize Islamic funds for Islamic activities, and this encourages a greater supply of such products and services. The significance of this from an issuer’s perspective in the Sukuk market is lower yield curve for Islamic securities, which translates to cheaper financing costs for the issuer. From an investor’s perspective this means a wider pool of investors, which translates to better secondary market liquidity, thus providing a higher return to investors. Islamic banking assets have also been growing steadily. Pursuant to Malaysia’s Budget 2007, an additional 20% duty exemption has been proposed to be given to Islamic financing instruments. This will catalyze and intensify the Islamic financial market in Malaysia even further. Conclusion Malaysia’s domestic Islamic financial market and International Islamic Financial Center (MIFC) ticks because it has an effective Islamic financial system that supports a parallel and comprehensive Islamic financial market, a regulated approach to Shariah management, and an accommodating legal framework. Badlisyah Abdul Ghani is executive director/CEO of CIMB Islamic Bank and can be contacted on: tel: +603 2116 1270 (sec.); fax: +603 2144 4746; email: badlisyah.abdulghani@cimb.com.
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