Malaysia's vision for Islamic finance

What are the secrets to Malaysia's success in Islamic finance? Nazatul Izma Abdullah reports

Audacious and iconoclastic, Malaysia has earned a reputation for seldom doing things by the book. Ignoring brickbats, it spearheaded industrialisation by building its own national car, PROTON. It thumbed its nose at the International Monetary Fund's high interest rate remedies during the currency crisis of 1997, skirting the economic chaos that engulfed Thailand and Indonesia.

Small surprise, then, that the little country that could boasts a vibrant and complete Islamic financial system encompassing banking, takaful (insurance), money market and capital market. Growth is fast-paced: Bank Negara Malaysia (the Central Bank) says that the annual growth rate of Islamic banking assets is 15%-20%, with current market share in terms of assets amounting to RM76bn or 10% of the total banking system. Volume traded in the Islamic inter-bank money market reached RM340bn. Total takaful assets amounted to RM4bn. In the Islamic capital market, outstanding Islamic private debt securities (PDS) amounted to RM75bn or 44% of total outstanding private securities, while in the stock market, more than 80% of counters are Shariah-compliant.

International accolades and requests to share expertise are rolling in too. The Banker, a publication of the Financial Times of London, named BNM governor, Tan Sri Dato' Sri Dr. Zeti Akhtar Aziz, as the global central bank governor of 2004, saying her work in promoting Malaysia to the forefront of Islamic finance outshone the rest. Pundits argue that Malaysia leads Bahrain and the United Arab Emirates as the centre of Islamic finance. BNM notes that Malaysia lent technical assistance to Thailand on setting up Islamic windows for their development banks and the Philippines for the establishment of an Islamic bank. Sudan sought Malaysian assistance in developing 20-year strategic plans for their Islamic financial system, whereas Pakistan and Malawi requested training on Islamic banking and takaful.

Meticulous frameworks and infrastructure are key ingredients to Malaysia's success. 'Our system is unique. We have a comprehensive infrastructure, and the proper regulatory and legal frameworks in place,' explains Mustapha Hamat, chief executive officer of the Islamic Banking and Finance Institute Malaysia. Firewalls have been erected between conventional and Islamic funds to preserve integrity in the system, corporate governance among banking institutions is being enhanced, and the relevant acts are continuously reviewed in order to adapt to a fluid environment, comments BNM.

Legal steps have also been taken to accommodate Islamic finance. Today, Malaysia has a dedicated high court in Kuala Lumpur to handle muamalat cases related to Islamic banking and finance. BNM has also strengthened the role of its Shariah Advisory Council (SAC) whereby the SAC is the sole Shariah authority on Islamic banking and Islamic finance. 'The court or arbitrator will have to refer to the SAC to determine Shariah issues in any dispute,' explains BNM.

Malaysia's brand of Islamic finance is a pragmatic system that works, which explains its increasing popularity among Muslims and non-Muslims alike. Although Malaysia is a Muslim-majority country, 'spirituality is one of the drivers, but not a major driver, of consumers' preferences for Islamic banking,' says BNM. The element of certainty, though, is a key element attracting consumers. Compared to conventional banking, where the interest rate charged fluctuates according to economic conditions, Islamic banking has the advantage of charging a fixed profit rate for the financing provided. The profit rate is determined at the beginning of the financing contract.

Loans popularity

Islamic housing loans became especially popular during the currency crisis, when interest rates climbed into the high teens. Bank Islam Malaysia Berhad (BIMB), the nation's pioneering Islamic bank, offered fixed rates of 14%, which had customers flocking. Plus, Islamic banks aim to lighten the burden of customers. 'There is flexibility, a lot of room to manoeuvre,' says Hamat. In the event of falling interest rates when the cost of funds is reduced, Islamic banks can resort to ibra', giving rebates to customers. Fixed repayments and the concept of mudharabah or profit-sharing also mean that the bank is on a more solid footing, even during times of economic difficulty when non-performing loans (NPLs) tend to soar. 'During the currency crisis, all banks were looking for capital injections from their shareholders, except BIMB,' points out Hamat. Since repayments were fixed, the cashflow of BIMB's customers was unaffected, unlike other conventional borrowers who faced payments that had suddenly doubled or tripled; therefore, BIMB had less of a problem with NPLs. Plus, under the mudharabah concept, NPLs are not charged against shareholders' funds but against deposits. 'That is the beauty of mudharabah; with three to four million depositors all helping to shoulder the load, even NPLs of RM100m are not insurmountable,' says Hamat.

But Islamic finance isn't all hunky-dory; challenges abound. Foreign participation is a double-edged sword. 'Islamic banking will move faster when foreign banks really take up Islamic banking,' says Hamat. The problem: foreign banks usually outpace locals in terms of service quality. If foreign banks and local players offer the same Islamic products, first-class service will be a differentiator.

Keeping the product pipeline humming is vital to feed the global demand for Islamic investments, which is growing at an estimated 15%-20% per annum. 'One of the most critical areas is research and development to bring new and innovative products to the market... product innovation is the key to survival,' say Bank Muamalat Malaysia Berhad and Standard Chartered Bank Malaysia Berhad in a joint paper on Malaysia's Islamic capital markets. The bulk of previous Islamic PDS (private debt securities) issues in the past were based on the Al-Bai Bithaman Ajil (deferred payment) and Al-Ijarah (leasing) concepts. Only lately were capital market products like Al-Istisna' serial bonds and Musyarakah Redeemable preference shares introduced, note the two banks. In June 2002, Malaysia launched the world's first sovereign global Islamic bond or sukuk based on the Al-Ijarah concept. This US$600m sukuk was oversubscribed by twice its issue size, says BNM. In Islamic banking, plain-vanilla products and services already include deposits, retail financing, card services, trade finance, investment, money market and banking services. Moving forward, BNM notes that potential products include floating rate financing, Musyarakah (profit-and-loss sharing) financing, Islamic asset-backed securities and risk hedging products.

But Malaysia's vision for Islamic finance is not confined to narrow local shores. 'We have successfully created a resilient system; now we need to integrate into the global system, connect to global markets,' notes Hamat. Cohesion is vital to creating a sustainable global system. Frequently, this unity of purpose has been undercut by disagreements over the universal acceptance of certain Shariah concepts. But concord is within reach. Malaysia has been in the forefront of the movement toward integration, by spearheading the formation of the International Islamic Financial Market, which will encompass the International Shariah Council, International Islamic Rating Agency, Liquidity Management Center, and Standard Accounting and Auditing procedures and practices among international financial institutions, explain Bank Muamalat and Standard Chartered. Finally, Malaysia's initiative in creating an Islamic offshore capital market, through the Labuan Offshore Financial Services Authority (LOFSA), has provided a common platform for collaborating Islamic countries - Bahrain, Brunei, Indonesia, Iran, Malaysia, Saudi Arabia and Sudan - to bring Islamic instruments to global capital markets.

Nazatul Izma Abdullah is a freelance writer on business and finance issues, based in Malaysia.