Author: Santiago Fittipaldi
New instruments, government enthusiasm and a growing market are driving Islamic finance toward the mainstream.

When Malaysia first laid the groundwork for what has become a thriving Islamic finance sector, much of its focus was on the need to provide Muslims with financial instruments that complied with Shariah rules. Yet, some three decades later, Malaysia now realizes that much of the sector’s growth is being supported by Muslims and non-Muslims alike.

Government studies show that 70% of Malaysians who choose Islamic banking are non-Muslims, with a similar percentage of Islamic banking assets now generated by conventional banks offering Islamic products in a country where nearly 60% of the population is Muslim. The data reveal that, with non-Muslims also seeking Islamic financial services, the sector has a much broader appeal than many had initially expected, providing greater upside potential.

Although there are several Malaysian banks that are fully Islamic, including Bank Islam Malaysia Berhad and Bank Muamalat Berhad, for example, conventional banks are keen to take a piece of the action. Citigroup, HSBC and UBS are just a few of the international banks that have established global Islamic banking divisions.

According to Zaha Rina Zahari, the head of exchanges at the Malaysian Stock Exchange (MSEB), the global Islamic finance sector is estimated to be a $230 billion market, with an expected annual growth rate of 15%. Speaking at a financial conference in Kuala Lumpur in April, Zahari said there is about $1.3 trillion worth of untapped Islamic funds worldwide.

The Malaysian government, which is working aggressively to capture a share of those untapped resources, last year announced that it would grant three licenses for foreign banks to establish Islamic operations locally in 2004 as part of a strategy to integrate the country’s Islamic banks into the global financial system. The move is also part of a broader plan to liberalize the sector.

“Although the structures are often quite complex since all services must comply with Shariah religious law, non-Muslims are seeing the value in these innovative services that are safe and still provide good returns,” says one banker. “If 25% of the world’s population is Muslim, then the sector’s long-term success depends on the ability to not only reach that 25%, but to tap the remaining 75% of the population as well.”

Malaysia has already captured 76 billion ringgits ($20 billion) in Islamic banking assets, with the sector tipped as a key area for growth in the government’s 10-year Financial Sector Master Plan. According to the 2003 annual report for Bank Negara Malaysia (BNM), the nation’s central bank, Islamic banking accounted for 9.7% of the banking system’s total assets in 2003 (8.9% in 2002), 10.4% of total deposits (10.2% in 2002) and 10.3% of total financing (8.1% in 2002). Islamic bonds accounted for 38% of Malaysian corporate paper last year, while 81% of shares listed on the Malaysian Stock Exchange were Shariah-compliant.

Malaysia’s impressive economic growth—5.2% in 2003 and 4.1% in 2002—is helping fuel the sector’s expansion as consumers increase spending, for which they are also increasing their borrowing needs. The Association of Islamic Banking Institutions of Malaysia reports total financing by Islamic banks rose by 32.4% in 2003 on the back of impressive growth in financing for purchases of automobiles, up 60.8%, and residential real estate, which rose by a third. Official forecasts suggest GDP will grow by 6.5% this year, providing a further boost.

“One of the problems that I see in bringing these products to non-Muslims is that right now there is an aversion to almost anything that has the word Islamic attached to it,” says the banker. “I’m sure that some of the reforms and changes being made to the sector by the Malaysian government will help ease some investor concerns. The banks also have to continue designing new products that appeal to a broader customer base, even if the core client will always be Muslim.”


Zeti Akthar Aziz: “The Shariah should be viewed as an enabler of innovation”

BNM focused much of its efforts to support expansion of the Islamic finance sector last year on strengthening the institutional financial infrastructure, enhancing the regulatory framework and increasing intellectual capital development and consumer education. This year, it will also push for the creation of an arbitration mechanism for Islamic banking, finalize tax reforms to accord a neutral tax treatment between Islamic and conventional financial products, introduce an Islamic reference rate and review the government’s Islamic Banking Act of 1983 to strengthen the sector’s legal framework.

The Malaysian Accounting Standards Board (MASB) expects to introduce new Islamic accounting standards by as early as the first quarter of next year. The first standards will be on ijarah (leasing), with an initial draft slated for release this June. The board then plans to introduce standards on zakat (tax), murabahah (deferred sales) and takaful (insurance). The MASB is working closely with the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions to create the standards that could become a model for Islamic financial sectors worldwide.

Malaysia is regarded as a model for the sector. Although the philosophy and principles behind Islamic financing were laid out in the Holy Qur’an more than 1,400 years ago, based on the precept that financial transactions must be free of usury or “riba”—for which there can be no interest charged or excessive profits derived—many point to Malaysia’s introduction of the Tabung Haji (Malaysian Pilgrims Fund Board) in 1973 as the foundation of the modern Islamic financial sector.

Bank Islam Malaysia Berhad was founded as the country’s first fully Islamic bank in 1983, while conventional banks were then allowed to open Islamic windows to offer parallel services 10 years later. In 1994 Malaysia created an Islamic money market, and by 1997 the system’s expansion warranted the creation of the National Shariah Advisory Council as the highest authority in the country to decide on Shariah compliance in Islamic financing. The government went on to create the Labuan International Offshore Financial Center that is fast becoming a virtual Islamic Wall Street.

In 2002 the government again entered uncharted territory when it issued the world’s first dollar-denominated Islamic global bond, a $600 million five-year deal structured as a Sukuk (trust certificate) and managed by HSBC. Even though the bond was launched the same week that Prime Minister Mahathir Mohamed announced his surprise decision to step down, demand still outstripped supply, and the issue had to be upsized from an initial $350 million. Bankers close to the deal said demand had topped $1 billion and that 65% of the bonds were acquired by investors new to the Malaysian credit.

Malaysia is already taking Islamic finance to the next level. In February the government launched the Merdeka Savings Bond as a savings mechanism for retirees. The savings bonds produce a 5% per year profit margin that is higher than the return on 12-month fixed deposits offered by local commercial banks, while income earned from the bonds is tax-exempt. The government is now studying the possibility of introducing exchange-traded funds (ETFs) and derivatives-based ETF futures to the sector.

Risk Mitigation Poses Problems

“While innovation in conventional banking has led to the development of a number of derivative instruments to hedge risks, there is still considerable debate among Islamic scholars about the acceptability of the various forms of derivative products from the perspective of Islamic jurisprudence,” central bank governor Zeti Akthar Aziz said recently. “The Shariah should therefore be viewed as an enabler of innovation,” she said, “rather than a constraint.”

Aziz has worked hard to push for a greater level of harmonization in the global Islamic financial sector. However, standardization may still be far off. “There is still a long way to go before countries engaged in Islamic financing adopt a unified code of practice, and considerable research is being done in this direction,” says an official of the London-based Institute of Islamic Banking and Insurance.

Aziz considers creativity to be the key: “While the initial focus has been on institutional building and financial infrastructure development,” said Aziz, “greater attention needs to be given to increasing the range of products and services to meet the greater sophistication of consumers and the more complex requirements of today’s businesses, in addition to enhancing the overall efficiency at which some products and services are provided.”

Santiago Fittipaldi