Development of Islamic Finance in Malaysia

Development and Growth of Islamic Finance in Malaysia

Student of Master of Education on Business Administration

Faculty of Management and Economic

Universiti Pendidikan Sultan Idris (UPSI)

Abstract

Over the past three decades, the Islamic finance industry has emerged as one component of a competitive and comprehensive market, consistent with the conventional financial system in contributing to economic development. Although in early development the Islamic financial system is concentrated just in the country, but its growth internationally has seen a positive trend with the creation of growth in the number of Islamic financial institutions, with shareholders from various countries. This study provides insights into the practice and prospect of Islamic finance in Malaysia. The application and mechanics of Islamic Finance are examined in the light of Islamic Finance Guidelines issued by Central Bank of Malaysia. As will be evident in this study, this system has its own advantages and value added which would make it the system of choice in meeting specific investment interests and needs.

1.0              Introduction

Islamic Finance is governed by the Shari’ah (Islamic Law), sourced from the Quran and the Sunnah, which are followed by the consensus of the jurists and interpreters of Islamic law. According to Shari’ah, the Islamic mode of finance should emphasize profit and loss sharing and prohibit fixed returns. The essential feature of Islamic Banking is the prohibition of interest or riba. Usually these two terms are used interchangeably and scholars has reviewed that there is no difference between these two terms. The prohibition of interest or riba was revealed in the Quran;

“And Allah has Permitted Trade and Forbidden Riba”

(Al Baqarah, 275)

Based on this verse, Islam clearly prohibits Muslims from taking or giving interest regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. The prohibition of interest or riba should be viewed from two important aspects. First, for Muslim it is the matter of faith. As a Muslim, it is a responsibility to follow what is clearly stated in the Quran and no argument should be made on those rules. The human’s level of thinking is limited and Allah knows best what is good and what is bad for them. Second, from the economics’ perspective interest is regarded as a pre determined cost of production, and it tends to prevent full employment In other words, any predetermined payment over and above the actual amount of the principal is prohibited. The Shari’ah also prohibits activities related to uncertainty, risk and speculation. Investment in businesses dealing in alcohol, drugs and gambling, which are considered unlawful or undesirable also included in this prohibition (Grail, 2007). Islamic financial system should be based on Islam fully, not just the name and label only. It must reflect the philosophy, values, ethics and objectives of Islamic Shari’ah.

The evolution of the Islamic finance in Malaysia has followed in the wake of innovations in the global financial services industry. Natural progressions of the Islamic finance industry are competitive retail offerings, sophisticated corporate banking products, innovative project finance solutions and commercial banking.

When Islamic finance started at 1970’s, the initiative offered simple banking solutions that encourage savings and financing. The products were structured in a manner that is in line with Shari’ah principles and easily understood by the public at large. In 1980’s, showed an increase of Islamic financial products, which is project finance and syndications. In the 1990’s, Ijarah and equity are included and in the 2000’s, Sukuk, structured and alternative assets, liquidity and management tools also are implemented.

Today, Islamic finance in Malaysia is a dynamic industry that is widely regarded as a competitive alternative to conventional financing solutions. There are now diverse local and foreign players in the market, showcasing their dynamism with a wide array of innovative financial products and services on offer. Islamic banking now comprises 20% of the total banking sector, complemented by a vibrant Islamic capital market, where 55% of outstanding domestic private debt papers are sukuk, representing the largest volume of sukuk issuances globally (Zeti Akhtar Aziz, 2008).

1.1       The Emergence of Islamic Finance

Islamic finance is a relatively young but fast developing area of finance in recent times. Although the concept is as old as the religion itself, modern Shari’ah banking and investment industry really took off in the 1960s with the launch of the Social Bank in Egypt and started to grow exponentially in the 1970s and 1980s with the development of Islamic banks in GCC countries, for examples the Islamic Development Bank and Dubai Islamic Bank (Lewis & Algaoud, 2001).

It has been well over two decades now since the concept of Islamic banking was first put into practice, but this has not been enough time for its evolution as a fully integrated financial system. The conventional (interest based) system has evolved over two centuries and has reached an impressive level of organization and depth globally, yet it is still not foolproof and involves many hazards for its users. Much effort and work still has to be done if the Islamic system is to be able to run in parallel with and compete with the conventional financial system. Needless to say, Islamic finance is receiving increased attention not just in the Islamic world, but in the established and recognized markets of Europe and America. Since the late 1990s the industry has been growing at a two digits rate per year, and is expected to keep on growing in the future (Yong, 2007). The number of banks which offer Islamic financial services has been significantly growing as well and is no longer restricted to small niche banks, as large conventional banks are now setting up dedicated "Islamic windows” to offer Islamic finance services.

In Malaysia, the roots of Islamic banking go back to 1963 when the government established Tabung Haji or Pilgrims Management and Fund Board. The institution was established to invest the savings of the local Muslims in interest free places, who intend to perform pilgrim (Hajj). Tabung Haji utilizes Mudharabah (profit and loss sharing), Musharakah (joint venture) and Ijarah (leasing) modes of financing for investment under the guidance of National Fatwa Committee of Malaysia.

The first call for separate Islamic bank was made in 1980, in a seminar held in the National University of Malaysia. The participants passed a resolution requesting the government to pass a special law to setup an Islamic bank in the country. Responding to the request, the government set up a National Steering Committee in 1981 to study legal, religious and operational aspects of setting up an Islamic bank. The committee established the blue print of a modern Islamic banking system in 1983, which later enabled the government to establish an Islamic bank and to issue non-interest bearing investment certificates.

Modern Islamic banking is relatively a recent development of the financial industry as the first Islamic bank was opened in Egypt in 1963. The issue of how efficiency in banking can be enhanced is important at the micro and macroeconomic levels since efficiency has important policy implications. The study on the performance of banking sector is quiet important for the following reasons: First, the financial sector or banking sector is the major player in modern economies, as a producer of financial services and as an employer. Banking system fulfill essential functions in intermediating between savers and investor, financing private sector trade and investment, and helping to ensure that the economy’s financial resources are allocated effectively (Darwis and Azhar, 2008).The banking system must be sound and efficient in order to effectively play its role. Well functioning banking system increase the effectiveness of macroeconomic policy by providing a channel for monetary policy signals.

Secondly, financial markets have become increasingly globalize. A key challenge facing the banking or financial sector especially in developing countries is to the recent wave of globalization and the move towards global financial markets. Local banks have to work side by side with foreign banks. Less efficient banks with high operating costs are likely to suffer from international competition.

Lastly, the measurement of performance is also important to all parties that participate in the banking industry. Assessing bank’s performance helps bank management to improve managerial performance. It assists investor in making investment decisions whether to participate in financial activities. Regulators are also interested in banking efficiency since the performance of the banking sector has significant impact on other parts of the economy. The recent experience of Western Europe shows that achieving greater efficiency is one motivation for the recent rapid changes in the structure of the banking industry (Altunbas et al, 1996).

1.2       Principles and Products of Islamic Finance

Basic elements of Islamic finance include profit and risk sharing, transparency and full disclosure, good governance, value-based innovation and principles of justice. These collectively provide implicit checks and balances in the system. Currently, the guiding principles regarding Islamic finance include the following:

1.      Any predetermined payment over and above the actual amount of principal is prohibited.

2.      The lender must share in the profits or losses arising out of the enterprise for which money was lent.

3.   Making money from money is not acceptable by Islamic law. Money is only a medium of exchange, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else.

4.      Gharar (uncertainty, risk or speculation) is also prohibited.

5.      Investments should only support practices or products that are not forbidden (or discouraged) by Islam.

The following is a brief description of Islamic financial products: (Imady and Seibel, 2006) (Grail, 2007)

                          i.                  Profit sharing financial products

• Musharakah - It is joint venture. Under Musharakah, all the partners contribute funds and have right to participate in the management of the business. Profits are shared in an agreed ratio but losses are shared in the ratio of capital invested. Contributions can be made either in cash or in kind.

• Mudharabah - It can be categorized into asset based, liability based and profit sharing. Under Mudharabah, one party provides 100% capital and the other party manages the investment project. Profits are shared in a pre-agreed ratio whereas losses accrued are borne by the provider of capital only. Mudharabah is often used for investment funds, where investor provides money to the Islamic bank, which the bank invests charging a management fee.

• Qard Al-Hasan - charitable loans free of interest and profit sharing margins, repayment by installments. Modest service charge is permissible.

• Wakalah - a bank is authorized to conduct business on customers’ behalf.

• Hawalah - an agreement by the bank to undertake some of the liabilities of the customer in return for a service fee. The customer pays back the bank when the abilities mat.

ii) Advance purchase financial products

• Murabahah - It can be categorized into asset based and cost plus financing. Bank purchases the commodity and resells it at a predetermined higher price to the capital user, disclosing the margin of profit included in the sales price. The client pays for the goods in deferred payments or over a stated installment period. In case of default the client is liable only for the contracted sale price

• Istithna’- It can be categorized into asset based and commissioned manufacturing. Under Istithna’, a party (bank) undertakes to produce a specific thing that is possible to be made according to agreed specifications at a determined price and fixed date of delivery. As banks do not normally carry out manufacturing, a parallel contract for manufacture is instituted. The bank charges the buyer the price it pays to the manufacturer plus a reasonable profit (monetary installment) and takes the risk of manufacture of the asset.

• Mu’ajjal - a sales contract that allows purchase with deferred delivery.

• Ijarah - It can be categorized into asset based and leasing. The bank buys and leases out the asset for a rental fee, which includes the capital cost of the equipment plus a profit margin. The ownership of the equipment remains with the lessor bank and in case of finance lease is transferred on pre-determined terms. It was available under both operating lease and finance lease (Ijarah-wa-iktina). Widely used in house and aircraft financing.

• Tawarruq- It can be categorized into asset based and monetization of commodity. Tawarruq is the mode adopted by banks to lend cash and the customer buys a commodity from the bank under Murabahah which is then sold to a third person on cash at a price less than the purchase price. The customer hence obtains cash without taking an interest-based loan. If the customer resells that commodity to the bank, it is called Al-'Inah.

iii) Deposit products

• Wadi’ah - deposits, including current accounts (giro wadi’ah).

• Mudarabah - deposit products based on revenue-sharing between depositor and bank, including savings products that can be withdrawn any time and time deposit products.

• Qard Al-Hassan - unremunerated deposit products, usually for charitable purposes.

iv) Insurance products

• Takaful - It was an Islamic insurance. Takaful is insurance based on mutual co-operation, responsibility, protection and assistance between groups of participants. It is a kind to a cooperative insurance wherein members contribute a specific sum of money to a common pool. Every policyholder pays his subscription to help those that need assistance. Losses are divided and liabilities spread according to the community pooling system.

iv) Sukuk

• Sukuk - Islamic bond. Sukuks are similar to conventional bonds with the difference that these are asset backed and represent proportionate beneficial ownership in the underlying asset. Sukuk holders are entitled to a share in the revenues generated and in the proceeds of the realization of the Sukuk assets. All Shariah-based products, including private equity, project financing, organization and sukuk’s issue and fund management products, assets and property. This proved successful Islamic financial services emerged as one of the fastest growing services in the financial services industry.

1.4       Islamic Finance in Malaysia

The early history of Islamic finance in Malaysia has been affected by external and internal factors. External factors began with the establishment of the Mit Ghamr Local Savings Bank of Egypt in 1963 that sparked the development of modern Islamic banking system, followed by the establishment of the first Islamic Bank of Dubai UAE and the Islamic Development Bank (IDB) in Saudi Arabia in 1975. Internal factors played an important role in promoting Islamic banking system is the mission, the strengthening and consolidation of religious knowledge among the Muslims through the institutions of formal and informal education. In addition, awareness among the Muslims is also influenced by the success of the Tabung Haji as a respected financial institution.

The Islamic financial system in Malaysia comprises of banking institutions and companies offering discount schemes takaful, leasing companies, leasing, institutional development costs, savings institutions, cooperatives management of the institution of zakat, the national endowment institution, agency credit, rating agencies and fund management companies (Darwis and Azhar, 2008). The system also includes financial markets, accounting for offshore financial markets, money markets and foreign exchange, Islamic government securities, Islamic private debt securities, shares, unit trusts, insurance agencies and financial security.

Today Islamic finance has evolved into a complete and competitive form of financial intermediation that serves both Muslim and non-Muslim consumers and businesses. The Islamic finance industry is currently grown as more countries around the world seek to further develop Islamic finance within their jurisdictions. The appeal of Islamic finance has led a number of established conventional players to enter the industry, thus widening the diversity of Islamic financial institutions and its product range. The impressive growth however is not confined to the Muslim world, but spans across the West and the Asia Pacific region where the growth is driven by commercial and business considerations (Zeti Akhtar Aziz, 2008).

1.5       Barrier to Growth of Islamic Finance

The prospects for the growth of Islamic finance look bright. Nonetheless, there are several obstacles currently preventing faster uptake of Islamic financial products. These include the issue of regulatory capital and relative risk weightings under Basel II and the Islamic Financial Services Board (IFSB) guidance, a lack of human capital, piecemeal financial and legal architecture, weaknesses in financial reporting and transparency, and the overarching problem of a lack of Shari’ah convergence.

1.5.1 Risk weighting

In 2006, the Islamic Financial Services Board (IFSB) issued two standards – the Capital Adequacy Standard (CAS) and the Guiding Principles of Risk Management for Institutions offering Islamic Financial Services. CAS offers guidance on the requirements for minimum capital adequacy to cover for credit, market and operational risks of IFIs that is equivalent to the Basel II Capital framework for conventional banking institutions (IFSB report, 2009)

According to the IFSB, the key difference between CAS and Basel II provisions is the computation of an institution’s risk-weighted capital ratio (RWCR). In Islamic banking, given that the risks on assets financed by profit-sharing investment account holders do not represent risk to the capital of the institution, the CAS allows risk-weighted assets that are funded by the account holders to be deducted from the institution’s total risk-weighted assets in the calculation of RWCR. In addition, the assets of IFIs often have different risk characteristics to conventional products, and hence calculating their risk weights may not necessarily be as straightforward as the Basel II proposals. It is the intention of the IFSB to bridge this gap.

1.5.2    Human capital

Human capital development is crucial, as the current lack of qualified young Islamic bankers looks set to hamper the development of the sector should it not be addressed. In part, this low investment in the industry stems from the fact that the sector lacks a global industry body to oversee standardization of continuous education and training.

The lack of human capital in the sector affects all regions, including nascent markets. Training of Islamic bankers has not kept pace with the rapid growth of the sector and, as a result, there are shortages throughout the industry. The two centers for training have been KFH and Bank Islam Malaysia, which between them have been responsible for training many Islamic bankers. But high turnover remains a problem. The International Centre for Education in Islamic Finance (INCEIF), with the main objectives of making Malaysia the leading center for Islamic finance education and developing human capital for the global Islamic finance industry (Roszaini and Hudaib, 2010).

1.5.3    Regulation and legal frameworks

While rising demand for Islamic finance has helped lead to handsome returns for key players, some experts in the industry are concerned that the rapid proliferation of International Financial Institutions (IFIs) has not been matched by development in the Islamic finance regulatory and supervisory architecture and infrastructure. There are a huge number of new IFIs being established in the market. Many banks and traditional companies are converting to Islamic finance. Islamic banking windows at global majors are proliferating. Many of these institutions are not going after the concept itself, but are following the flow of money (Rifaat, 2006). Many Muslim countries still do not have enabling legislation in place covering the authorization of Islamic banks; issuance of Sukuk and securitization; establishment of trusts and special purpose vehicles (SPVs); the introduction of Takaful (Islamic insurance) products, and other such issues. Additionally, and of equal concern, many countries have not yet considered putting it on the agenda. The IFSB has released prudential regulations on corporate governance and an exposure draft on disclosure and transparency. These prudential regulations should now be considered and adopted by the various countries offering Islamic finance.

1.5.4    Financial reporting

The quality and transparency of financial reporting and disclosure in the Islamic finance industry differs significantly from one regulatory jurisdiction to another. There is a general concern in the market and among those interviewed that IFIs, with the notable exceptions of those operating in the U.K., Malaysia, Bahrain and perhaps Turkey, should have more rigor in their disclosure and financial reporting, especially to the general market. Standardization of financial reporting is a key challenge for the rapidly growing Islamic finance industry in order to avoid fragmentation at a time when Shari’ah compliant investment vehicles as an asset class are coming of age (Emily, 2011).

1.5.5    Shari’ah Convergence

There are significant differences in the Shari’ah interpretation of Fiqh Al-Muamalat (Islamic law relating to financial transactions). This can apply not only to products, but also to operations and systems, because compliance can depend on certain processes being undertaken. These can cause problems, but it is important to remember that while harmonization of contracts, documentation and standards is a desired objective, equally diversity in Shari’ah opinions (Fatwas) is enshrined in Islamic legal history, and will thus remain a feature of the market by definition (Mansoor and Ishaq, 2008)

The lack of Shari’ah convergence is not only a phenomenon between Malaysia and the Gulf Cooperation Council (GCC) countries. It also applies within the GCC markets. Much work has been done to bridge the gap between Malaysia and the GCC countries and to promote greater Shari’ah convergence in general. But such efforts have probably reached their limits.

1.6       Challenges and Opportunities in Islamic Finance

1.6.1    Challenges in Islamic Finance

Shari’ah principles adopted are intended to ensure the validity of the entire operation. However, there are issues such as differences in interpretations of shari’ah among the countries involved. This has led to the existence of many ruling on an issue. There is a difficult situation when cooperation between the countries was held because many countries still do not have provisions on the shari’ah advisory services. Each country has different laws and some laws require amendments before the Islamic financial system to operate. In addition, there are various forms of tax to be accounted for. So, those involved need to formulate an appropriate law. The collaboration may be difficult to interpret, but if successful, it will pave the way for Islamic financial system to move forward. Besides that, the challenges in the Islamic financial system is comprised of product innovation, efforts to penetrate the global market, bridging the gap of knowledge, transparency, and maintain the identity of the unique features of Islamic financial system.

Although the INCEIF and other organizations actively disseminating information, but information dissemination through partnership forums, training and education center should be improved. Effectiveness of the efforts made should be a priority. However, the most important challenge is the global market. This is because every decision must be evaluated, whether it is driven by market forces, or in accordance with shari’ah law. Muslim community itself must be wise to consider how to outline the level of harmonization of standards without interfering with the smoothness of a product that has the potential to be marketed. For those who are familiar with the practices of the conventional financial system, they will tend to ask for the same product with the characteristics of conventional products. This make the unique features of Islamic finance become difficult in application and lost identity. Thus, the conversion of conventional products is very important and necessary in accordance with Islamic financial system.

1.6.2    Opportunnities in Islamic Finance

There are existing markets and new markets in the global Islamic financial. The existing countries are Malaysia, UAE, Bahrain, Qatar, Brunei, Indonesia, Pakistan and Sudan. Potential new markets are United Kingdom, Hong Kong, Singapore, Thailand, Japan and USA. Currently, there are over 300 Islamic financial institutions in more than 75 countries though they are mainly concentrated in the Middle East and Southeast Asia, but are also gaining popularity in Europe and the United States. It is estimated that the industry will grow at a rate of 15 to 20 percent annually, from current assets of US$300 billion (Al-Salem, 2008). Furthermore, exploring new markets can be realized with more efficient when there is cooperation with various institutions that conduct research in Islamic finance such as Islamic Research and Training Institute, IDB; Centre for Research in Islamic Economics, King Abdul Aziz University; OCIS (Oxford Centre for Islamic Studies) and IIFM (International Islamic Finance Market).

Prospects for the development of Islamic finance should contain a balanced development of the shari’ah and integrated market by the prospect of a unique Islamic finance. In addition, the products and services must also not limited to Muslim’s market only. But, also emphasizes acceptance and applications globally. The creations of many innovations and initiatives have also contributed to the advancement of Islamic financial system. However, the challenges can be overcome by increased effort in every cooperation, increase understanding of the shari’ah concern, mutual respect and collaboration practices.

Islamic finance has a role in shaping the future of the global financial system and reinforcing ethical and moral values that are inherent in Islamic finance principles and fundamental towards promoting the stability of the global financial system. Ongoing efforts to further strengthen the resilience of Islamic financial industry would enhance the prospects for global growth and the potential of Islamic finance to contribute toward global financial stability (Mushtak,2010).

1.8       Conclusion

Currently, Malaysia is considered to have a comprehensive Islamic financial landscape. However, to ensure the effectiveness and competitiveness of this system continues, the institutional infrastructure of Islamic finance should be further enhanced. Each of the dissemination of information should have access to it. This is important so that investor’s awareness of the unique features of Islamic financial system will be increased.