Malaysia’s Islamic financial system was born in 1963, when the country established the Malaysian Pilgrims Fund Board, or Tabung Haji, to facilitate savings for the pilgrimage to Mecca through investment in sharia-compliant vehicles. The first Islamic bank followed 20 years later, in 1983, with the establishment of Bank Islam Malaysia Berhad (BIMB). Initially, an Islamic Banking Act was enacted to regulate this system, but the Bank Negara Malaysia (BNM) later allowed conventional banking institutions to offer Islamic banking services using their infrastructure.

Fast forward to 2014, and Malaysia is now a regional and global Islamic finance powerhouse. According to the ICD Thomson Reuters Islamic Finance Development Report 2013, it topped a list of countries on the Islamic Finance Development Indicator, which is based on five factors, namely, quantitative development, knowledge, governance, corporate governance and awareness. Malaysia is currently the world’s largest sukuk issuer, second-largest takaful (Islamic insurance) market and a major Islamic banking and securities market, with more than $165 billion in assets.

According to Malaysia’s International Centre for Education in Islamic Finance (INCEIF), the success of Islamic finance in Malaysia has been the result of a clear and coherent policy on the growth and development of the industry and focusing on the development of a global Islamic finance marketplace.

“For many years, the characteristics of the Malaysian IF marketplace have been worked on by all stakeholders,” it says, “and these characteristics are: a robust regulatory, supervisory, sharia and legal framework; an efficient and transparent price-discovery platform; a deep primary market and active secondary trading of instruments; diverse players and talent base with global capabilities and connectivity; product breadth and depth which are attractive to global investors and issuers; and an efficient settlement system that allows settlement and clearing in ringgit, U.S. dollar and renminbi.”

Much of this has happened due to the support of the authorities, which have provided strong, visible support on legislative and regulatory aspects, including enacting the Islamic Financial Services Act 2013, launching major talent initiatives like INCEIF which was established by BNM in 2005, and actively supporting new jurisdictions that are opening for Islamic finance. “The government has been instrumental in driving this growth,” says Lukman Sheriff Alias, a partner at Zul Rafique & Partners. “It has been a strong, focused champion of Islamic finance, pushing through a lot of policies from the outset and following through with their implementation. By having been very receptive in developing Islamic finance, it managed to gain the cooperation of a number of other institutions, which has been critical to the mission.”

However, INCEIF believes that Malaysia’s Islamic finance industry is once again at crossroads, poised to move to the next level. “Part of that is to become more global with products that are accepted across the jurisdictions,” it says. “As Islamic finance becomes increasingly internationalised, there will be an increasing convergence toward financial products that are acceptable across jurisdictions, which comes through greater awareness and understanding, and from the strengthened sharia frameworks and governance process within financial institutions.”

The next level

Despite Malaysia’s roaring success in Islamic finance, it is obvious that the country is not content with resting on its laurels as it looks to further internationalise the industry and firmly establish itself as a global powerhouse. “Although we are leading, I think there’s a lot of room for us to improve,” says Alias. “There is some way to go actually. Take for example, banking. Malaysian Islamic lenders hold just over 20 percent of the domestic banking assets. There are a lot of conventional transactions that we need to persuade to adopt Islamic financing.”

According to INCEIF, as Islamic finance further evolves and advances in Malaysia, more fundamental questions on the framework for financial stability in the context of Islamic finance will need to be addressed. “Such questions will include the relevance and design of financial safety nets such as deposit insurance and lender of last resort facilities in an Islamic financial system,” it says. “To a large extent, these safety nets have in mind the traditional roles played by conventional banks - the acceptance of deposits which are payable on demand, and which enjoy principal protection for the depositors.”

It adds that in a risk-and-profit sharing model with participatory or equity-based contracts that support ventures involving entrepreneurship endeavours, savers and fund providers stand to bear the losses in such ventures, similarly gaining profits from them. “A main challenge would be in structuring financial safety nets which honour the true nature of Islamic contracts while preserving confidence in the financial system, given the entrenched expectations of consumers,” it says.

Finally, INCEIF notes that consumer protection and education initiatives are also essential to further deepen the understanding and awareness of consumers on the associated risks and rewards in Islamic financial contracts. “In addressing these questions, there is much to be gained from sharing experiences and strengthening cooperation in research initiatives.”

In order to internationalise its Islamic finance industry, Malaysia has taken a number of steps, including introducing standards in November since sharia-compliant equities are expected to attract more Islamic investment funds from the Gulf. This included a revised list of Malaysian equities that qualify for Islamic investment, using a new screening methodology which incorporates quantitative filters such as benchmarks for financial ratios, moving closer to the approach generally used in the Gulf. But the most talked-about reform in recent times has been the introduction of the Islamic Financial Services Act (IFSA) 2013.

IFSA

The IFSA, which was enacted in June last year, gives Malaysian regulators greater oversight. The new law will boost protection for depositors by making religious advisers legally accountable for financial products, and liable to steep fines and prison time for wrongdoing. Additionally, it also includes a plan to require Islamic life insurers to separate the life arm from other parts of their business. According to Reuters, the regulations also could spur takeovers in the Islamic insurance sector through capital-base provisions that encourage larger participants.

While there have been no major problems arising from lax standards, the new law - which went into effect last year - is seen as a broad way of enforcing closer adherence to sharia laws, where Malaysia is already a global leader. By making sharia advisers, Islamic scholars hired by banks to assure that financial products abide by Islamic sharia standards, legally liable for the financial products they approve, advisers would be encouraged to conduct a closer inspection of the financial products they approve. Previous rules governing sharia compliance were just guidelines; the IFSA elevates them to statutory duties, a breach of which could expose licensed financial entities to punishment. And penalties will be more severe, a Malaysia-based lawyer told Reuters, with many offences carrying a possibility of up to eight years imprisonment and 25 million ringgit ($7.86 million) in fines.

Investors' protection should also be boosted by another provision that requires banks to distinguish deposits made for savings from those made for investments. Banks will also need to guarantee the principal amount on savings deposits. The IFSA also gives Malaysia's finance ministry more powers to further scrutinise financial holding companies and non-regulated entities if they pose a risk to financial stability.

The IFSA may also reshape the takaful (Islamic insurance) sector by requiring the separation of life and general business lines, the latter covering property and automobiles. Under the new rules, firms with composite licences that cover both sectors will have five years to separate the two. Malaysia had 12 direct takaful operators with a combined 19 billion ringgit in assets as of December 2012, central bank data showed. The majority of those assets - 85 percent - were in family insurance, up 13.3 percent from a year earlier. Under the new law, companies need to establish a new board and capital base for each business under the IFSA, making operations more capital-intensive. This could favour companies with large balance sheets, spurring consolidation as smaller players struggle for scale, analysts say.

The IFSA is set to affect two-thirds of companies within the takaful sector with composite licences, with bigger players such as Etiqa Takaful Bhd, Syarikat Takaful Malaysia Bhd and Takaful Ikhlas possibly being spared, according to a report by investment bank RHB. The top three operators hold roughly 90 percent of assets, while several of the smaller firms have suffered losses or shrinking profits. Bigger operators will be eyeing smaller ones. "If their portfolio is attractive, we could be buying up business," says Hassan Kamil, group managing director of Syarikat Takaful Malaysia, the sector's second-largest after Etiqa Takaful. Takaful Malaysia will be able to raise funds on the capital market for new acquisitions, being the only listed company among its peers, says Kamil.

According to INCEIF, the act provides new dimension to the regulatory framework for Islamic finance as it now accords greater prominence to the sharia standards in Islamic financial transactions. “This new legal framework also streamlines the legal requirements across the financial sectors, and will ensure that the degree of regulation is commensurate with the level of risks that Islamic financial institutions, markets and products pose to the financial system.” Additionally, it says the act also enables the effective implementation of contract-based regulatory framework by enabling the issuance of sharia and operational standards for each sharia contract. “Such clarity and transparency will enable financial intermediation functions that use sharia contracts to better reflect the distinct risk and reward profiles of the transactions, and thus realise value propositions,” it adds.

Alias says that with the introduction of the IFSA, Bank Negara has widened its scope compared to the previous regulatory regime. “From an Islamic practitioner’s perspective, now we have more standardisation and more clarity in vision.” However, he says that it is still too early to assess the impact of the IFSA. “It’s still fairly new, and I think you need to give a bit of time to see how it’s going to settle,” he says. “We were recently involved in the disposal of the remainder of Bank Islam’s shares to BIMB Holdings, but there were certain issues that were not very clear. But I think this is just a teething problem that you deal with when you get a new law; it is sometimes hard to know the exact procedure and the exact standing on a particular point of view. I think this will be sorted out along the way.

The road ahead

According to Ernst & Young’s World Islamic Banking Competitiveness Report 2013–14, Malaysia’s Islamic banking assets are set to grow to more than $390 billion by 2018 at a CAGR of 21 percent. With 91 percent of Malaysians multibanked, the report also expects banks to embark upon customer segmentation and investment in customer loyalty schemes to improve profitability through cross-selling. Additionally, the ongoing liberalisation of the financial sector will create opportunities for partnerships between domestic and Middle Eastern banks, which may become a key driver for East-to-East linkages promoting trade and increasing the size of the global Islamic finance industry. “Going forward, sustaining [its] strong performance requires structural transformation of the domestic institutions,” the report adds. “Islamic outfits of conventional banks need to re-evaluate their brand standing, capital plan, and ability to influence the strategic direction of conventional parent. Our view is, strategic and financial independence of Islamic subsidiaries will help.”

Speaking of the next year or two, Alias of Zul Rafique is certain Malaysia’s Islamic finance industry will grow. “I think if you have a game-changer, if for example, there’s a big institution which converts from convention to Islamic, we will have a lot of supply and demand,” he says. “But I’m quite certain we will grow. The determination is there, the focus is there, support of the government is there and the incentive is there.”

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Source: ICD Thomson Reuters Islamic Finance Development Report 2013

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