Country Rpt MAL

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CONTENTS

Introduction 3

History and Development 4

Laws and Regulations 11

Accounting Policies

Products and Services 19

Performance of the Islamic Banking System 24

Public Acceptance Towards Islamic Banking System 26

Future Directions 28

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The Islamic banking system in Malaysia is regarded as more progressive

and robust as opposed to similar banking system in other Muslim countries.

Malaysia is now recognised as the pioneer and at the forefront in Islamic

banking and nance. At present, Malaysia surpasses other Muslim countries

in terms of market infrastructure owing to the unwavering support by the

government in providing the impetus for growth of the local Islamic nancial

services industry.

The system has transformed from a humble beginning in 1983 to a vibrantand dynamic system that is able to full the banking needs of Muslims and

non-Muslims. The well-planned and coordinated effort between the Malay-

sian government and the industry players is the most important ingredient

to the success story of the Islamic banking system in Malaysia. Today, the

Islamic banking in Malaysia runs parallel to the conventional banking and

provides depositors with an alternative banking philosophy that is rapidly

gaining acceptance from both Muslims and non-Muslims.

The Islamic banking sector in Malaysia has been growing at a healthy pace

even before the inux of foreign investment. Under the Financial Sector

Masterplan of 2001, he industrys assets have been increasing at a rate of19% over tha past ve years. The islamic banking sector has now assets of

about RM122 billion. This accounts for about 12% of the total assets in the

overall banking system.

1. INTRODUCTION

KLBS

Kuala Lumpur Business School

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Malaysia is one of the unique countries which operate a dual banking sys-tem where the Islamic banking system operates in parallel with the con-

ventional system. Table 1 presents the key development of the Islamic

banking system in Malaysia. Development of the Islamic banking system

in Malaysia can be categorised into four distinctive periods, namely, the

initial period, liberalisation period, strengthening of the system and nally,

further progress.

First Phase: Initial Period

As with other Muslim countries, the move towards establishing an Islamic

bank in Malaysia was initiated by private parties. The rst formal request

was made during the Bumiputera Economic Congress in 1980. This Con-

gress proposed that the Government allowed the setting up of an Islamic

bank by the Pilgrimage Board. In another seminar held at the National

University of Malaysia in 1981, participants requested the government to

promulgate a special law that would allow the establishment of a bank that

operates in accordance to the Islamic principles.

In concordance to these requests, the government, on July 30 1981, es-

tablished the National Steering Committee on Islamic Banking. The Com-

mittee was given the mandate by the government to study various legal,religious and operational aspects of Islamic banking; and make recom-

mendations on the setting up of an Islamic bank in Malaysia.

The Committee submitted its nal report to the then Prime Minister of

Malaysia on July 5, 1982. In its report, the Committee concluded that the

establishment of an Islamic bank in Malaysia is a viable option but made

several recommendations to the government. Some of the recommenda-

tions made by the Committee include (BIMB, 1984):

1. The government should establish an Islamic bank whose operations

are in accordance to the principles of Shariah.

2. The proposed bank is to be incorporated as a company under the

auspices of the Companies Act, 1965.

3. Since the Banking Act of 1973 is not applicable for the operations of

an Islamic bank, a new Islamic banking act must be introduced to

l icense and supervise the Islamic bank. The supervision and

administration of the proposed act are to be the responsibility of the

Central Bank of Malaysia, i.e. Bank Negara Malaysia (BNM).

4. The Islamic bank is to establish its own Shariah Board whose function

is to ensure that the operations of the Islamic bank are in accordancewith Shariah principles.

Based on the study conducted by the National Steering Committee, the

2. HISTORY AND DEVELOPMENT

4

Development of the

Islamic banking sys-

tem in Malaysia can

be categorised into 4

distinctive periods.

First formal request

was made during the

Bumiputera Economic

Congress in 1980.


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Table 1: Key Development of the Islamic Banking System in Malaysia

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Islamic Banking Act of 1983 was gazetted in March 1983 and came into

effect in April, 1983. This paved the way for the establishment of an Is -lamic banking system in Malaysia. Subsequently, the rst Islamic bank,

Bank Islamic Malaysia Berhad (BIMB) was incorporated on March 1, 1983

and commenced operations on July 1, of the same year. This marked the

beginning of the governments commitment towards the development of a

comprehensive Islamic nancial system in Malaysia.

Second Phase: Liberalisation Period

The government, however, does not have any intention of Islamising thecountrys nancial system. On the contrary, it is the long-term objective

of BNM to create an Islamic banking system that is parallel to the conven-

tional system. The BNM believes that this objective can be accomplished

through: (i) large number of players; (ii) broad variety of instruments;

and (iii) an Islamic inter-bank market (Bank Negara Malaysia, 1994). In

the process of increasing the number of players in the system the govern-

ment introduced a scheme known as the Islamic Banking Scheme (IBS)

in 1993.

This scheme often known as Islamic windows allows existing conven-

tional banks to introduce Islamic banking products to customers alongside

their conventional banking services. The pilot phase of this scheme waslaunched on March 4, 1993; which involved the three largest commercial

banks in Malaysia. The second phase commenced on August 21, 1993 with

another 10 nancial institutions joining the scheme. At the end of 1993,

a total number of 21 nancial institutions had obtained BNMs approval to

participate in the scheme.

In 1996 several new measures were introduced by BNM to further spur the

development of the industry. First, nancial disclosure must be carries out

via the New Financial Disclosure or GP8 which requires banking institutions

participating in the system to disclose their Islamic banking operations as

part of their principal nancial statements. The disclosure, as part of theNotes to the Accounts, entails the Balance Sheet and the Prot and Loss

account of the Islamic banking operations during the nancial year. Sec-

ond, instead of providing products through the Islamic counter concept,

conventional banks are now allowed to set up full-edged branches that

deal exclusively with Islamic banking products and services.

Following the successful setting-up of the rst Islamic Bank and the in-

creasing number of Muslims who wanted to realign more to Islamic prac-

tices in their economic activities, these paved the way for the establish-

ment of a second Islamic bank. In October 1999, the government granted

a license for the establishment of the second Islamic bank known as Bank

Muamalat Malaysia Berhad (BMMB).

The establishment of BMMB was the result of the Share Exchange Agree-

ment between the Ministry of Finance Incoported, Khazanah Malaysia Ber-

6

Long term objective is

to create a dual bank-

ing system.


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had and Commerce Asset-Holding Berhad in February 1999. Under the

merger arrangement, the Islamic banking assets and liabilities of Bumipu-tra-Commerce Bank Berhad (BCBB), Bank Bumiputra Malaysia Berhad

(BBMB) and BBMB Kewangan Berhad were transferred to BMMB. At the

same time the conventional operations of BBMB, BCBB and BBMB Kewan-

gan Berhad were transferred to BCBB accordingly. The BMMB had an initial

shareholders fund of RM300 million, assets of RM2.5 billion and a network

of 40 branches.

Third Phase: Strengthening of the System

As the banking industry in Malaysia entered the turn of millennium, the

government reafrmed its long-term commitment in developing Islamic

banking in the country. This is reected in the formulation of the Financial

Sector Masterplan in 2001. The main objective of this plan is to create

a more resilient, efcient, competitive, innovative and dynamic nancial

system with best practices.

Importantly, the Plan outlines a detailed long-term strategy to promote

the Islamic banking industry as a niche area where Malaysia will be com-

petitively placed as an international leader in the Islamic nancial services

industry. By 2010, the Plan proposed that the following criteria be achieved

by the Islamic banking system in Malaysia:

1. Constitute 20% of the banking and insurance market share in the

Malaysian economy.

2. Islamic banking institutions and takaful operators should offer a

comprehensive and complete range of Islamic nancial products and

services.

3. Malaysia is epitomised as the regional Islamic nancial centre.

4. There should be sufficient numbers of well-trained, high-calibreindividuals and management teams.

5. The industry should be supported by a dedicated institution (Shariah

commercial court) in the judiciary system that should address legal

issues related to the Islamic banking and takaful industry.

Another signicant milestone taken by the government in positioning Ma-

laysia as an international Islamic nancial hub was to bring forward the

liberalisation of its Islamic banking sector to 2004, three years ahead of

the World Trade Organisations deadline through the granting of three new

Islamic bank licenses to foreign institutions.

These three Islamic nancial institutions are from the Middle East, namely

Kuwait Finance House, Al-Rajhi Banking & Investment Corporation and a

consortium of Islamic nancial institutions represented by Qatar Islamic

7

Commitment in devel-

oping Islamic bank-

ing is reected in the

Financial Sector Mas-

terplan.


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Bank, RUSD Investment Bank Inc., and Global Investment House. Kuwait

Finance House started its operations in August 2005. The second foreignIslamic bank was the Al-Rajhi Bank which was established in January 2007

and the third Islamic foreign bank to set up in Malaysia in March 2007 was

the Asian Finance Bank (AFB). The AFB bank is a joint venture between

Qatar Islamic Bank, RUSD Investment Bank Inc. of Saudi Arabia and Ku -

waits Global Investment House.

In concurrent with the progressive liberalisation of the Islamic banking in-

dustry, several strategic initiatives were undertaken to further strengthen

both the institutional capacity as well as the nancial resilience of the

domestic Islamic banking institutions. In this regard, the government ap-

proved that the seven domestic banking groups transform their current Is-lamic window institutional structure into an Islamic Subsidiary (IS) within

their respective banking groups. This strategic move is in line with the

recommendations of the Financial Sector Masterplan (FSMP) to further

strengthen the institutional structure of the banking institutions participat-

ing in the IBS.

Under this new structure, Islamic banking subsidiaries are now governed

under the Islamic Banking Act 1983 instead of BAFIA 1992; and thus, re-

moving most of the impediments that had prevented Islamic windows in

participating in non-traditional banking business such as wholesale and re-

tail trading, purchase of assets and landed properties as well as purchases

of equities via joint-venture and portfolio investments. Nonetheless, thistransformation of Islamic banking windows into Islamic banking subsidiar-

ies is not made mandatory by Bank Negara Malaysia.

In addition, the new IS structure provides the opportunity to potential

domestic and international investors to participate in the Islamic nancial

activities through direct equity participation. A more liberalised policy un-

der the IS structure currently allows foreign participation in Islamic sub-

sidiaries of up to 49% of total equity.

The transformation from Islamic windows to Islamic subsidiaries is seen

as a positive step in creating greater potential to tap regional as well asinternational business opportunities and further enhance the global inte-

gration of the domestic Islamic banking industry. Consequently, help boost

Malaysia to the forefront of Islamic banking and nance. Presently, there

are a total of 11 Islamic banks comprising six Islamic subsidiaries, two

domestic Islamic banks and three new foreign Islamic banks.

Further Progress

The Islamic banking industry in Malaysia has experienced rapid transfor-

mations predominantly in the past ten years. The Malaysian Islamic bank-

ing system has continued to register strong performance with higher prof-

itability and positive trends in all key indicators. Nonetheless, the global

nancial landscape has witnessed tremendous changes due to globalisa-

8

The new Islamic sub-

sidiary structure of-

fers a more liberalised

policy.


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coordinating committee to efciently and effectively act collectively in

the implementation of the MIFC recommendations. The Committee ischaired by the Governor of Bank Negara Malaysia with members com-

prising heads of relevant Ministries, Government departments, agen-

cies, nancial and market regulators and industry representatives. The

Committee is entrusted to provide direction as well as review existing

policies for the comprehensive and coordinated promotion of MIFC, and

to align the role and responsibilities of the respective parts of Govern-

ment and the industry to the development of MIFC.

These measures and initiatives will serve as a catalyst in the governments

effort to promote Malaysia as the centre of origination, issuance and trad-

ing of Islamic capital market and treasury instruments, Islamic fund andwealth management, international currency Islamic nancial services, and

takaful and retakaful business.

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Islamic banks have to conform to types of laws, positive law and Shariahlaw. While positive law is promulgated by the monetary authority to safe-

guard public interest, Shariah law is based on religious foundations. In

Malaysia, a separate Islamic legislation and banking regulations exist side-

by-side with the conventional banking system.

3.1 Positive Law

In Malaysia, a separate legislation exists in governing Islamic and con-

ventional nancial institutions. Conventional banks and Islamic Banking

Scheme (IBS) banks are regulated under the Banking and Financial Insti-

tutions Act (BAFIA) 1989, which repealed and replaced the Finance Com-

panies Act 1969 and the Banking Act 1973. On the other hand, Islamic

banks are governed by the Islamic Banking Act (IBA) 1983 and not by

BAFIA since their operations are based on Shariah principles.

The IBA was enacted in March 1983 and came into force on 7 April 1983.

The enactment of the new Act created a dual banking system in Malaysia.

In order to create a holistic and competitive Islamic banking system, the

government needed to ensure that the related markets and nancial or

supporting institutions are in placed.

The IBA 1983 enables the Central Bank to supervise and regulate Islamicbanks in the same way BAFIA enables it to regulate other licensed nancial

institutions. The IBA 1983 contains sixty sections and is categorised into

eight parts as follows:

Part I: PRELIMINARY (Sections 1 & 2)

(Short title, commencement, application and interpretation)

PART II: LICENSING OF ISLAMIC BANKS (Sections 3 to 13)

(Islamic banking business to be transacted only by a licensed Islamic bank,

Minister may vary or revoke condition of licence, licence not to be granted

in certain cases, foreign-owned banks, opening of new branches, Islamic

bank may establish correspondent banking relationship with bank outside

Malaysia, licence fee, restriction of the use of certain words in an Islamic

banks name, revocation of licence, effect of revocation of licence, and

publication of list of Islamic banks).

PART III: FINANCIAL REQUIREMENTS AND DUTIES OF ISLAMIC

BANKS (Sections 14 to 20)

(Maintenance of capital funds, maintenance of reserve funds, percentage

of liquid assets, auditor and auditors report, audited balance sheet, statis-

tics to be furnished, and information of foreign branches).

PART IV: OWNERSHIP, CONTROL AND MANAGEMENT OF ISLAMICBANKS (Sections 21 to 23).

(Information on change in control of Islamic banks, sanction for recon-

struction of bank required, and disqualication of directors and employees

3. LAWS AND REGULATIONS

11

Enactment of IBA

1983 created a dual

banking system.


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of banks).

PART V: RESTRICTIONS ON BUSINESS (Sections 24 to 30)

(Restrictions on payment of dividends and grant of advances and loans;

prohibition of loans to directors, ofcers and employees; restriction on

grant loans, advances or credit facility to directors, ofcers and employees;

restriction of credit to single customer; disclosure of interests by directors,

limitation on credit facility for purpose of nancing the purchase or holding

of shares, and proof of compliance to all restrictions and prohibitions).

PART VI: POWERS OF SUPERVISION AND CONTROL OVER ISLAMIC

BANKS (Sections 31 to 43)

(Investigation of banks, special investigation of production of banks books

and documents, banking secrecy, action to be taken if advances are against

interests of depositors, bank unable to meet obligations to inform Central

Bank, action by Central Bank if bank is unable to meet obligations of con-

ducting business to the detriment of depositors, effect of removal of ofce

of director or appointment of a director of a bank by the Central Bank, con-

trol of Islamic bank by Central Bank, Islamic bank under control of Central

Bank to cooperate with Central Bank, extension of jurisdiction to subsidiar-

ies of banks, moratorium, and amendment of banks constitution).

PART VII: MISCELLANEOUS (Sections 44 to 56)

(Indemnity, priority of sight and savings account liabilities; penalties on

directors and managers; offences by directors, employees and agents; of-fences by companies and by servants and agents; prohibition on receipt

of commission by staff, general penalty, power of Governor to compound;

consent of the Public Prosecutor; regulation; bank holidays; applications

of other laws; and exemption).

PART VIII: CONSEQUENTIAL AMENDMENTS (Sections 57 to 60)

(Amendment of Banking Act 1973, amendment of Companies Act 1965,

amendment of Central Bank of Malaysia Ordinance 1958, and amendment

of Finance Companies Act 1969).

As for conventional banks operating Islamic windows, these nancial insti-

tutions are governed under BAFIA. Section 32 of BAFIA 1993 with amend-

ments states that the permissible activities must be conducted based on

prot margin and not conducted on interest basis. In addition, Section

124 of BAFIA amended in 1996 further states that any conventional banks

wanting to carry out Islamic banking business must obtain approval from

the Central Bank.

Apart from the IBA, the government also introduced the Government In-

vestment Act 1983. With the passing of this Act, the government was now

able to raise funds through the issuance of a non-interest bearing cer-

ticates known as the Government Investment Issues (GII). The GII arebasically government bonds issued in accordance to Islamic principles and

thus, conrm to the liquidity requirements of the Islamic banks.

12

Conventional banks

operating Islamic win-

dows are governed

under BAFIA.


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The primary reason for the introduction of a Shariah-compliant GII is

to enable Islamic bank to hold rst class liquid assets instruments tomeet its statutory liquidity requirements as well as for investments.

In the attempt to further strengthen the legal framework governing

Islamic nancial institutions, the Government Investment Act 1983

was amended in June 2005 and renamed as the Government Funding

Act 1983. This essentially allowed the government to issue a wider

range of Islamic securities as the new amended act accorded greater

exibility for the government to source funds from the capital market

through the issuance of leased-based and asset-based Islamic nan-

cial instruments.

However, with the growing signicance of the Islamic banking in-dustry requires, a more effective regulatory framework needs to be

developed in order to provide the enabling environment to support

the development of the industry. Recognising this, BNM had intro-

duced several measures to create an effective and efcient regulatory

framework.

In 2003, BNM reviewed the Framework of the Rate of Return with the

intention to further strengthen the methodology for deriving the rate

of return to depositors. The revised framework is to provide a stan-

dardised approach in the derivation of the rates of return to deposi-

tors and a standard methodology on the calculation of the distribut-

able prots. Previously, Islamic banking institutions adopted variousmethods in deriving the rates of return which led to large variations in

the results and implications. Thus, the introduction of the new frame-

work will effectively address the information asymmetry between Is-

lamic banking institutions and depositors.

A guideline on the issuance of credit card based on Shariah principles

was issued by BNM in 2004. The guideline known as Credit Card-i

Guideline is an extension of the Credit Card Guideline issued to the

conventional banks in March 2003. Under this new Guideline, the

credit card-i can either apply the Shariah concept ofbai inah (sell

and buy back arrangement) or bai bithaman ajil(deferred paymentsale).

Under the bai inah concept, the fund for the cardholders spending

limit is created upon the bank buying back the asset from the card-

holder for cash on the assets which the bank had previously sold

to the cardholder on deferred terms. Under the bai bithaman ajil

concept, the fund is created upon the bank buying the asset from

the cardholder for cash which will be sold back to them on deferred

basis.

Islamic banks are also required to observe the Basel Capital Accord in

maintaining a minimum risk-weighted capital ratio (RWCR) of 8% anda minimum core capital ratio of 4%. As for the IBS banks, they must

observe the compliance to the RWCR framework for the Islamic bank-

ing portfolio in addition to the compliance on a consolidated basis.

13

The Central Bank re-

viewed the Frame-work of the Rate of

Return in 2003.


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The Market Risk Capital Adequacy Framework for Islamic banks was issued

by BNM in September 2004. It sets out the approach in determining thelevel of capital to be held by the Islamic banks against their market risk,

which is dened as the risk of losses in on- and off-balance sheet positions

arising from movements in market prices.

Another important aspect in the development of the Islamic institutional

nancial infrastructure is the enhancement of risk management capabili-

ties of the Islamic banking institutions. To this end, several initiatives had

been implemented. For example, a variable rate nancing product under

the concept ofbai bithaman ajil(deferred payment sale) was introduced

in 2003. This instrument enables Islamic nancial institutions to diversify

their nancing portfolio from over-reliance on xed-rate nancing. Underthe xed-rate regime, Islamic nancial institutions faced a funding mis-

match because their long-term nancing was funded by short-term bank

deposits.

As such, since Islamic banks locked in their prot rates for the nancing

over a long-period, any upward movement in the market rates would result

in the Islamic banking institutions nding it difcult to give a satisfactory

return to their depositors. Hence, the variable rate nancing was designed

to mitigate the risk associated with funding mismatch by allowing Islamic

nancial institutions to vary the prot rate for the nancing in order to

raise the deposit rates.

So as to complement the bai bithaman ajil(BBA) oating rate nancing

mechanism, another variable rate nancing product based on the concept

of ijarah muntahia bittamleek (leasing ending with ownership) is being

explored. Additional measures were also introduced by BNM in 2005 to

further strengthen the risk management of the conventional banking insti-

tutions operating under the IBS.

These measures included a separate compliance on the single customer

limit for nancing facilities based on the capital funds of the Islamic bank-

ing portfolio, a separate compliance on the new liquidity framework and

statutory reserves requirement for the Islamic banking portfolio and theapportionment of overhead costs and other expenditure incurred in man-

aging the Islamic banking portfolio.

In the 2005 Budget, the government announced a tax neutrality policy

for Islamic banking and nance with the aim of creating an equitable tax

treatment of Islamic banking and nancial transactions vis--vis similar

conventional banking transactions. Under this tax neutrality framework,

exemption is given to additional instruments and transactions executed to

full Shariah requirement from additional stamp duty and tax payment.

Hence, subsequent amendments were made to the Income Tax Act 1967,

Real Property Gains Tax Act 1976 and Stamp Duty Act 1949.

14

In the 2005 Budget,

tax neutrality policy

for Islamic baking

and fnance was an-

nounced.


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3.2 Shariah Laws

Islamic banks are required under the IBA 1983 to establish a Shariah

advisory body. Section 3(5)(b) of IBA provides that the Central Bank (i.e.

Bank Negara Malaysia) shall not recommend the grant of a licence, and the

Minister shall not grant a licence, unless he is satised:

(b) that there is, in the articles of association of the bank concerned, pro-

vision for the establishment of a Syariah advisory body to advise the bank

on the operations of its banking business in order to ensure that they do

not involve any element which is not approved by the Religion of Islam.

For the IBS banks, under the BAFIA 1989, these nancial institutions arerequired to appoint nancial consultants. Section 124(7) of BAFIA 1989,

provides for the establishment of a Shariah Advisory Council to advise the

bank on Shariah matters relating to Islamic banking business or Islamic

nancial business.

On the other hand, nancial institutions under the Development Financial

Institutions Act 2002 appoint Shariah bodies on their own initiatives. Even

though Islamic banks and IBS banks appoint their own Shariah bodies to

advise them on their day-to-day operations, these banks are still required

to refer to BNM on policy-related Shariah issues. Hence, central to these

bodies is the Shariah Advisory Council (SAC) at BNM. The SAC was estab-

lished in 1997 with the objectives of:

1. Advising BNM on matters related to the operations of Islamic banking

institutions and takaful operators.

2. Coordinating Shariah issues with respect to Islamic banking, finance

and takaful.

3. Analysing and evaluating Shariah compliance of new products or

schemes submitted by banking institutions and takaful operators.

The Council is empowered with the sole authority and reference on allShariah matters relating to Islamic banking and takaful. Since its incep-

tion, this Council has agreed on several matters resolutions such as banks

are allowed to impose penalty charges on unpaid debts; no restrictions on

female and non-Muslim solicitors to act as signatories in all nancial docu-

ments; and second and third party charge is accepted as security.

The SAC at BNM also serves as the ultimate reference for Shariah ruling

in court proceedings on Islamic banking and nance cases as the sole

authority to decide on Shariah matters on Islamic banking and nancial

business that fall under the purview of BNM. Following the establishment

of the SAC under the Central Bank of Malaysia Act 1985, the Malaysian

Judiciary and the Regional Centre for Arbitration Kuala Lumpur will use the

SAC as the reference point in the event of a dispute that involves Shariah

issues on Islamic banking and nance. As the reference body and advisor

to Bank Negara Malaysia on Shariah matters, the SAC is also responsible

15

The SAC was estab-

lished as the sole au-

thority and reference

on all Shariah matters

relating to Islamic

banking and Finance.


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for validating all Islamic banking and takaful products to ensure their com-

patibility with the Shariah principles.

The Shariah bodies of Islamic banks and IBS bank operate independently

of one other and thus, resulted in divergence of Shariah interpretations on

similar matters. In order to have an effective Shariah framework that en-

sures uniformity and harmonisation of Shariah interpretations, BNM issued

the Guidelines on the Governance of Shariah Committee for the Islamic

Financial Institutions in December 2004 to rationalise and streamline the

functions and duties ofShariah bodies of the nancial institutions. So as

to enhance the role and functions of SAC, the Central Bank of Malaysia Act

1985 was amended by BNM in 2003.

With the enactment of the Act, SAC is now the sole authority on all Sha-

riah matter related to Islamic banking and nance. Thus, SAC now serves

as the reference point for the court or arbitrator in any dispute resolution

which involves Shariah issues on Islamic banking and nance cases. The

Guidelines also set out the rules, regulations and procedures in the estab-

lishment of a Shariah Committees of Islamic banks and IBS banks. It also

spells out the role, scope of duties and responsibilities of the Committee

together with the working arrangement between the Committee and the

SAC.

A signicant development with regard to legal infrastructure was the es-

tablishment of a dedicated High Court to adjudicate all muamalat cases inthe Commercial Division of High Court Kuala Lumpur. In this regard, the

Chief Judge Malaya issued a directive (Practice Direction No. 1 of 2003) to

all legal practitioners in the country to register Islamic banking and nance

cases at both the High Courts and the Lower Courts by means of a special

code number. The set up of the dedicated High Court for Islamic banking

and nance will aid in expediting the hearing of cases related to Islamic

banking and nance and create grater public condence in Islamic banking

system.

16

Guidelines on the

Governance of Sha-

riah Committee was

introduced to promote

uniformity and har-monisation of Shariah

interpretations.


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Financial statements for Islamic nancial institutions are prepared in ac-cordance with the provision of the Companies Act, 1965; Bank Negara Ma-

laysia (BNM) Guidelines, applicable Malaysian Accounting Standards Board

(MASB) Approved Accounting Standards and Shariah requirements. In Au-

gust 2003, BNM issued Guidelines on the Specimen Reports and Financial

Statements for Licensed Islamic Banks (GP8-i). Its objective is to promote

consistency and standardization amongst the Islamic banks in complying

with the provisions of the IBA and approved accounting standards of the

MASB as well as the Shariah requirements.

The Guidelines prescribed the minimum requirements of the nancial

statements that the Islamic banks need to disclose with the provisions of

the Islamic Banking Act 1983, Companies Act 1965, Shariah requirements

and other BNM guidelines. Prior to the issuance of the GP8-i, Islamic banks

observed the various provisions of the Companies Act 1965, the applicable

accounting standards and the Guidelines on the Specimen Financial State-

ment for the Banking Industry (GP8). The GP8 was formulated to facilitate

the conventional banking operations. Amongst the salient features of the

GP8-i are:

1. Performance Overview and Statement of Corporate Governance

In order to promote good corporate governance, Islamic banks are re-

quired to report their performance overview and corporate governance

practices. The performance overview requires Islamic banks to disclosetheir review on performance, measures, business plans and strategies.

Meanwhile, the statement of corporate governance compels Islamic

banks, among others, to disclose the composition and responsibilities

of the Board, internal audit and control activities and risk management

strategies and policies. Both the performance overview report and the

statement of corporate government provide important additional infor-

mation to users in evaluating the performance and conduct of Islamic

banks.

2. Disclosure of Shariah Advisory Board/Committee and Zakatobligations

Islamic banks are required to disclose the functions and duties of theirShariah advisory board or committee in monitoring the activities per-

taining to Shariah matters under the Directors Report. With regard to

thezakatobligations disclosure, Islamic banks are required to disclose

the responsibility towards payment ofzakateither on the business or

shareholders or on behalf of depositors.

3. Report of the Shariah Advisory Board/Committee

Islamic banks are required to report the conformity of their operations

with the Shariah principles under the Report of the Shariah Advisory

Board/Committee. Similar to the Auditors Report, the Report is expect-

ed to enhance the credibility of Islamic banks operation in complying

with Shariah principles.

4. Prot Equalisation Reserves (PER)

PER is a mechanism introduced in the Framework of the Rate of Re-

4. ACCOUNTING POLICIES

17

GP8-i was issued to

promote consisten-

cy and standardiza-

tion amongst Islamic

banks in complyingwith the provisions of

the IBA and approved

accounting standards

of the MASB as well

as the Shariah re-

quirements.


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turn. Disclosure of PER would reect the capability of Islamic banks in

managing the level of prot distribution to the mudarabah depositors.Islamic banks are also required to disclose their policy on PER as well as

its movement (provision and write-back) during the nancial year.

5. Classication of Deposits from Customers and Placements from Banks

and Other Financial Institutions

Islamic banks are required to disclose their deposits into two categories,

i.e. mudarabah and non-mudarabah deposits. Such disclosure provides

additional information on the risk prole of Islamic banks deposits port-

folio.

6. Presentation of the Income StatementPresentation of the Income Statement of Islamic banks is structured to

reect the nature of the Islamic banking operation, primarily on the ap-

plication ofmudarabah concept concerning deposit-taking activities. The

statement discloses the incomes and expenses that are either shared by

the bank and depositors or fully belonged to the bank.

Another development in the accounting standards for Islamic nancial

business, the Malaysian Accounting Standards Board (MASB) has also em-

barked on the preparation of standards on leasing (ijarah), deferred pay-

ment sale (bai bithaman ajil) and cost-plus (murabahah) in relation to

the recognition, measurement and disclosure of these Islamic nancialtransactions.

18


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The Islamic banking system forms the backbone of the Islamic nancialsystem and thus, plays an imperative role in mobilising deposits and pro-

viding nancing to facilitate growth. Islamic banking institutions in Malay-

sia offer a comprehensive and wide range of Islamic nance products and

services ranging from deposit, savings and investment deposits products

to nancing products such as hire purchase, property nancing, education

nancing, project nancing, working capital nancing and other nancing

products.

In terms of product development, product innovation in the Islamic bank-

ing industry has been thriving within the Shariah framework. To date,

there are more than 40 Islamic products and services that are offered by

the banks using various Shariah concepts such as mudarabah, musyara-

kah, murabahah, bai bithaman ajil, ijarah, qard hassan and istisna.

5.1 Deposit Facilities

Similar to conventional banks, Islamic banks are dependent on depositors

money as a major source of funds, besides their own capital. According to

the Keynesian theory of demand for money, there are three main motives

why people hold money: transactions, precautionary and investment. In

order to cater for these motives, commercial banks offer three categoriesof deposit facilities that are demand, savings and time deposits.

Unlike conventional banks, there is no single approach adopted by Islamic

banks in providing deposit facilities to their customers. Nonetheless, Is-

lamic banks do offer the same types of deposits similar to those offered

by their conventional counterparts, namely, demand deposits, savings ac-

count and investment deposits. Table 2 below provides a snapshot illustra-

tion of the current types of deposits mobilised by the Islamic banks and

the different Shariah principles applied to each account. It is evident that

the General Investment account far exceeds the volumes collected by the

other accounts.

5. PRODUCTS AND SERVICES

Table 2: Types of Deposits Mobilised by Islamic Banks in Malaysia

19

There are more than

40 Islamic products

and services offered

by fnancial institu-

tions.


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Demand deposit facility is widely known as current account and is designed

for those who need money for transaction purposes, i.e. for convenience orto make payment for daily commitments. Demand deposit facilities may be

opened for various types of customers such as individuals, joint individu-

als, business organisations which include sole proprietorship, partnership

and companied and other legal entities such as societies Generally, there

are two types ofShariah principles, that is wadiah and qard hassan which

are used by Islamic banks in providing this facility. In Malaysia, demand

deposits are operated on the Shariah principle ofwadiah yad dhamanah or

guaranteed custody.

The second category of deposits is the savings account. Three Shariah prin-

ciples are used Islamic banks for savings accounts, namely, qard hassan,wadiah and mudarabah. The principle ofwadiah yad dhamanah is used by

banks in Malaysia. Under this principle, customers are not entitled for any

kind of rewards, but banks do provide rewards to their savings account cus-

tomers. In Malaysia, the reward for saving account holders is usually in the

form of rates of prot announced by the bank on a monthly basis.

The third category of deposit facility is for those who keep money for invest-

ment motives. Customers who have idle funds usually want better returns.

These customers normally prefer to place this money in the xed deposit

facilities. In the Islamic banking system, this facility is known as investment

deposit. Investment deposits available at Islamic banks are governed by

the principle ofmudarabah. Within this context, Islamic banks act as en-trepreneurs or managers and depositors become investors. The bank would

provide no guarantee or no xed return on the amount deposited and under

the principle ofmudarabah, the customers will share the prots or losses

made by the bank. The agreement on how the prot or loss will be distrib -

uted between the bank and the depositor is made at the beginning of the

deposit and cannot be amended during the tenure of the deposits, except

by consent of both parties.

Table 3 and Figure 1 provide illustrations of the growth rates of each of the

Islamic deposit account. Over the years, investment deposits (general and

specic) continually capture the largest portion of the Islamic banking de-posits. On the investment side, investment deposits accounted for 49.6%

of Islamic deposits. Investment deposits only grew by 10.3% in 2006, while

savings and demand deposits grew by 16.7% and 38.8% respectively. The

bulk of investment deposits are concentrated in the short-term maturity

prole of less than one year which constitutes 95.2% of the total invest-

ment deposits. As reported by BNM, this is mainly due to the increase in

the retail customer base in Islamic banking. There was also ample liquidity

in the Islamic banking system throughout 2006. Total deposits recorded a

signicant growth of 18.2% in 2006 to account for 12.2% of the banking

system deposits.

20

Total deposits in the

Islamic banking sys-

ten grew 18.2% in

2006.


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Table 3: Types of Accounts Offered by Islamic Banks

5.2 Financing Facilities

The nancing activity is one of the primary functions of Islamic banks. This

activity accounts for 50% to 80% of the total assets of the Islamic banks.Since Islamic banks are prohibited from making loans with interest all -

nancing operations are based on principles of allowed by Shariah. Amongst

the widely applied nancing principles are mudarabah, musyarakah, mu-

rabahah, bai bithaman ajil, ijarah, ijarah wa-iktina and istisna. Shariah

has suggested four categories of principles of nancing such as the prot-

sharing principle, fees or charges based principle, free service principle and

ancillary principle. These principles, however, falls within two concepts of -

nancing, i.e. debt creating modes of nancing and non-debt creating modes

of nancing. In the case of debt creating modes of nancing, the users of

the funds are obliged to repay the funds borrowed from the bank.

The Shariah principles that fall within this category include mudarabah,

ijarah, ijarah wa-iktina, bai bithaman ajiland qard hassan. On the other

hand, the principles ofmudarabah and musyarakah are non-debt creating

Source: Bank Negara Malaysia


21

Financing activities

account for 50-80%

of total assets of Is-

lamic banks.


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modes of nancing. These principles which are also known as investment

modes of nancing do not require the users to repay the total amount ofnancing. While debt creating modes involve a debt burden on the users ir-

respective of how much they benets from the loans, those who enjoy the

investment modes are without a debt burden.

In Malaysia, the methods of nancing are issued by Bank Negara Malaysia

who will issue guidelines that indicates the methods to be used for vari-

ous nancing activities. In the case of nancing acquisition of assets such

as houses, buildings, vehicles and other properties; the bai bithaman ajil

method is recommended. The principle of ijarah is applicable also to the

nancing of vehicles. Meanwhile, principle ofmudarabah recommended for

working capital and project nancing. The principle ofmusyarakah is rec-ommended for project nancing only. Table 4 below indicates the Shariah

principles employed by Islamic banks in Malaysia and the percentage of us-

age each of the principle in nancing from 2003 to end of June 2006.

Bai bithaman ajil(BBA) nancing is the most popular nancing contract in

Malaysia and has continued to dominate the market. At end of June 2006,

BBA nancing accounted 42% of total Islamic nancing in the industry. Thisis followed by ijarah (30.6%) and murabahah (7.1%). It is evident that Is-

lamic partnership contracts are the least popular, with both mudarabah and

musyarakah only capturing 0.2% of total Islamic nancing. Similar trends

can also seen since 2003.

Figure 2 and 3 illustrate the nancing growth trend of the Islamic banking

system in Malaysia where Islamic nancing expanded by 12.3% or RM78.5

billion as at end-2006. The total nancing extended by the Islamic banking

sector was a mere RM9.5 billion and 9.2 billion in 2005 and 2004 respec-

tively. Supported by the strong consumer spending, consumer nancing

continued to account for the largest component of nancing extended by

the Islamic banking institutions, mainly for the purchase of passenger cars.The second largest component of nancing was the broad property sector.

Table 4: Types and Percentage of Shariah Principles Applied in Malaysia


22

BBA fnancing is themost popular fnanc-

ing contract.


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23


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6. PERFORMANCE OF THE

ISLAMIC BANKING SYSTEM

The performance of the Islamic banking system continued to show strong

growth in 2006 since its inception in 1983, with higher protability as well

positive trends in all key nancial indicators. Protability surpassed the

RM1 billion mark for the rst time in 2005, and this year the industry again

registered higher prot. The preliminary unaudited prot before tax in

2006 for the Islamic banking system amounted to RM1.7 billion, posting a

growth of 9.6%. This higher prot gure was contributed largely by growth

in nancing income, income form funds placement and recoveries from

non-performing assets. The better protability has increased the return on

assets and return on equity to 1.3% and 16.4% respectively.

Islamic banking activity experienced rapid growth to account for 12.2%

of the total banking assets at end of 2006 from 6.9% in 2000. Malaysias

ofcial target is for the Islamic banking system to achieve a 20% banking

market share by 2010, which most observers say is achievable. Figure 4

to 6 shows the size and growth of assets, deposits and nancing of Islamic

banking in Malaysia. In terms of size, the total assets, deposits mobilised

and nancing of the Islamic banking system has registered a steady in-

crease since 2001. At the end 2006, the Islamic banking system accounted

for RM133 billion or 6.4% of the total assets of RM2,091.2 billion of the

nancial system. Similarly, the Islamic banking assets had also grown ata robust rate since 2001 to register 12.2% of total banking assets at end

2006.

Source: Bank Negara Malaysia Annual Report, various years

24

As at end 2006, Is-

lamic banking assets

accounted for 12.2%

of total banking as-

sets.


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Both deposits and nancing activities in the Islamic banking system have

shown a positive growth from 2003 to 2006 as shown in Table 6. In terms

of nancing activities, Islamic nancing in Malaysia accounted for 13.2 %

of total bank lending (12.2% in 2005) and registering a growth of 12.3%in 2006. Islamic banking deposits accounted for 12.2% of total bank de-

posits (11.7% in 2005) and thus, recording a robust growth of 18.2% in

2006.


25

Islamic banking de-

posits recorded a ro-

bust growth of 18.2%

in 2006.


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During the initial stage of development, Islamic banking industry was con-

sidered as a niche industry created to meet the banking needs of Muslims

in accordance with Shariah principles. At present, Islamic banking prod-

ucts and services has gained widespread acceptance among Muslims as

well as non-Muslims as a viable alternative to the conventional products

and services in the global nancial system.

Since its introduction, Islamic banking products have been well accepted

by Malaysians. This is reected by the increasing amounts of total deposits

and total nancing that are based on Islamic principles placed by Muslim

and non-Muslim customers. Total nancing extended by the Islamic bank-

ing system was RM78.5 billion as at end-2006 compared to 9.5 billion in

2005. Total deposits in the Islamic banking system increased from RM65

billion in 2005 to record RM82 billion as at end-2006.

Public support and acceptance towards the Islamic banking system is also

high as reected by the usage of Islamic banking products offered by

the conventional nancial institutions in 1994, the rst year where se-lected commercial banks were allowed to introduce Islamic deposit facili-

ties, a total of RM1,463 million deposits were collected. This gure com-

prises of deposits in the current account (RM166 million), savings deposits

(RM1,146 million) and investment deposit facilities (RM151 million). Since

then, these three types of deposits continued to receive full support from

the public. At the end of 2006, total Islamic deposits placed by customers

at commercial banks increased to RM82,036 million. The growths of vari-

ous types of Islamic deposits, in most cases, have outstripped the growth

of the conventional deposits. The comparative growth gures of funds de-

posited in various deposits facilities of conventional and Islamic facilities

are shown in Table 5.

The Islamic banking sector has registered a strong growth of 15% per

annum from 2000-2006. With the exception of 2003, the yearly growth

gures for Islamic deposits have exceeded those deposits of conventional

banks. Looking at the individual gures, it is apparent that in many in-

stances the growth of various types of Islamic deposits was greater than

the growth of deposits in the conventional system. As at the end of 2006,

market shares of the Islamic banking deposits was 12.2% of the banking

system. This reects that Islamic banking deposit facilities have gained its

popularity amongst Malaysians.

7. PUBLIC ACCEPTANCE

TOWARDS ISLAMIC

BANKING SYSTEM

26

Public acceptance ishigh as reected by

the usage of Islamic

banking products.


27/30

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Table 5: Annual Growth of Various Deposits Facilities at Commercial Banks (%)

Source: Bank Negara Malaysia, Annual Report (various issues)

27

The Islamic banking sector has registered a strong

growth of 15% per annum from 2000-2006.


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8. FUTURE DIRECTIONS

Although the Islamic nancial services industry is currently experiencinga double digit growth, the industry is still in its infancy compared to the

conventional nancial system. Nonetheless, the rapid growth and positive

performance of achieved by the Islamic banking system signies one of

the major accomplishments over the last three decades in Islamic banking

and nance in Malaysia. As Islamic banking in Malaysia journeys towards

global integration and international acceptance, there are key areas in

the banking industry that needs to be enhanced to progressively support

future development. Islamic banking system in Malaysia already has some

embedded key values and essence that are needed to move forward. The

most signicant is the strong alliance among the players within the indus-

try as well as with the relevant institutions including educational, training

and research institutions, and other professional bodies in promoting the

development of the industry.

The introduction of new Islamic banking products and services will continue

to be an uphill task if reviews are not made to the existing framework and

structures governing the issuance of global Shariah-complaint products.

Fervent structural changes as well as judicial consciousness are imperative

for the Islamic banking industry to survive the currents of globalisation

and change. Even though Malaysia have already in placed a robust regula-

tory structure, the challenge ahead remains on how to bring convergence

on regulatory structures across national borders. The changing nancial

landscape has also transformed the nancial industry, particularly in thepast ve years.

Amongst the most notable trends in the nancial services industry in-

clude disintermediation and the blurring of traditional boundaries between

banking, insurance and the securities sectors. The process of convergence

has been along several dimensions, i.e. between nancial institutions and

between jurisdictions. Hence, one cannot over stress the fact that an ef-

fective and efcient regulatory is imperative to promote and encourage

the participation of bigger customers and players into the Islamic bank-

ing industry. The Islamic banking industry would be highly inefcient if it

were to develop as a closed system in which only local or domestic clientsparticipated. A strategy of openness is essential in order to create an in-

ternational Islamic banking industry that is characterized by both liquid-

ity and effectiveness in serving the needs of both local and international

customers.

Another issue facing the development of the Islamic banking industry is

the lack of convergence ofShariah interpretations. Different Muslim coun-

tries have adopted different practices in relation to various Islamic bank-

ing product and services which is a result of the varying interpretation on

various Shariah issues across jurisdictions due to the different school of

thoughts among Shariah scholars. This may have implications for cross

border ows in relation to investment and trading of international Islamicinstruments. The harmonisation ofShariah interpretations will lead to the

creation of more homogeneous Islamic banking products and services that

in turn will increase demand and enhance the overall growth of the Islamic

28

The challenge is to

bring convergence on

regulatory structures

across national bor-

ders and convergence

of Shariah interpreta-

tions.


29/30

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banking industry.

In the environment of rapid changes, innovative solutions are required

to meet the changing and more complex customers needs. Product in-

novation is crucial in the process of deepening and broadening the Islamic

nancial industry and thus, a critical factor in the development of the

Islamic banking industry. For Islamic banking industry to remain competi-

tive, attractive and innovative; indigenous Islamic nancial products must

be introduced to meet the risk-reward proles of investors and issuers, ful-

lling all the tenets of the Shariah while remaining sufciently cost-effec-

tive and competitive vis--vis conventional products. By conning product

development to mere evaluation and adaptation of products in the conven-

tional markets, the Islamic banking industry will have to play a perpetual

catch-up game with the conventional nancial system. There will also be

a continuous reliance on the expertise within the conventional market to

take the Islamic banking system forward.

29

Product innovation

is crucial for the fur-

ther deepening of the

Islamic fnancial ser-

vices industry.


30/30

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Diamond Square Commercial Centre

Off Jalan Gombak

53000 Kuala Lumpur

Malaysia

Website: www.klbs.com.my

Copyright Kuala Lumpur Business School

Disclaimer

While all possible measures have been taken to ensure accuracy of informationcontained in this publication, KLBS cannot guarantee its accuracy and complete-ness. KLBS accepts no obligation to correct or update the information, opinionsor statements in this publication. KLBS accepts no liability and responsibilitywhatsoever for any errors it may contain, or for any loss, financial or otherwise,sustained by any person using this publication.

Copyright protection exists in this publication. No part of this publication may becopied, reproduced, repackaged, transmitted or disseminated, redistributed or re-sold or stored for subsequent use in whole or in part in any form or by any meanswhatsoever by any person, without prior consent from KLBS.

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