IFR Asia Malaysia report: Islamic

IFR Asia Malaysia report, May 2010: Islamic finance

Malaysia hosts the most sophisticated and entrenched Islamic finance industry in the world. It permeates all areas of financial services. 88% of Bursa Malaysia’s listed securities are certified as Shariah-compliant; the country hosts 150 Shariah-compliant mutual funds with RM22.08 billion in net asset value, equivalent to 11.52% of the whole mutual fund industry; and the total combined value of outstanding sukuk issues by December 2009 was RM172 billion, or 57% of the entire bond capital market.

Seventeen of Malaysia’s 39 licensed banking institutions are Islamic, with RM233.14 billion in assets between them as of February 10. Rather than being an adjunct to conventional commercial banking – an offshoot, niche offering – Islamic finance has become very much part of the Malaysian mainstream and is expected to continue to grow.

It’s a point of pride to the country’s regulators. “Today, Malaysia has a comprehensive and well-developed Islamic financial system, including a vibrant banking and takaful sector, and well-developed Islamic capital and money markets that operate in parallel with the conventional system,” says Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “Our sukuk market is the largest in the world.”

And if Malaysia’s financial services industry weathered the financial crisis well, the Islamic component did particularly well. “From an Islamic perspective we were fairly insulated from the financial crisis, predominantly because Malaysian Islamic finance players, who are mainly domestic, were not involved in the US sub debt industry,” says Badlisyah Abdul Ghani, CEO of CIMB Islamic. “Also, a slowdown in global Islamic capital markets doesn’t have a negative effect on the Malaysian sukuk market. The level of confidence here is very high: the market has been here since 1990, unlike the international Islamic capital market which dates from 2002.” Developments in the sukuk market are discussed in more detail in the debt capital markets chapter of this guide, while the international fund managers who have come in partly to service Islamic clients are discussed in the asset management section.

Having built a strong domestic industry, the emphasis of recent years has been on turning Malaysia into an international Islamic centre. One sees this in two directions: liberalisation of financial services, allowing more and more foreign entrants to participate; and attempting to attract international capital flows.

Malaysia has long held a more liberal stance on the Islamic side of its banking sector than the conventional, particularly when it comes to foreign participation. In 2009 the foreign ownership limit at local Islamic banks, investment banks and insurance companies was raised from 49% to 70%. Already Malaysia has licensed three wholly-foreign-owned Islamic banks: Kuwait Finance House, Al-Rajhi Bank, and Asian Finance Bank (majority owned by Qatar Islamic Bank). Each of them has built significant operations on the ground, with models varying from corporate finance to a full retail offering. Other financial institutions at least partly owned by foreign houses include the Islamic units of HSBC (HSBC Amanah Malaysia), OCBC (OCBC Al-Amin Bank) and Standard Chartered (Standard Chartered Saadiq).

There is more to come. Last year Bank Negara announced two so-called “mega-bank” Islamic banking licences would be awarded to overseas lenders with capital of more than US$1 billion, alongside new permits for Islamic insurance, conventional global banking and conventional specialized banking. These mega-banks can be 100% foreign owned, provided they become locally incorporated in Malaysia. Bank Negara said at the time the new licences were “to enhance global interlinkages, leverage on global developments in Islamic finance and reinforce Malaysia’s position as an international Islamic financial hub.”

In March Bank Negara Malaysia governor Zeti Akhtar Aziz said candidates had been shortlisted and it is a subject of great conjecture who they might be. They must presumably either be the Islamic arms of multinationals like HSBC or Citi, or some of the more powerful Middle Eastern institutions, although the obvious Middle Eastern candidates – Kuwait Finance House and Al Rajhi – are already here.

The most visible example of Malaysia’s international aspirations is the Malaysia International Islamic Financial Centre (MIFC), launched in August 2006 to promote the country as a hub for international Islamic finance with the backing of government, regulators and financial institutions. Under MIFC, several foreign institutions have been given incentives, varying from tax breaks to relaxed ownership restrictions, to come and set up Islamic businesses in Malaysia. Some fund managers have been given seed capital sourced from the Employee Provident Fund. MIFC embraces sukuk origination, Islamic fund and wealth management, Islamic banking, takaful, and human capital development.

MIFC has certainly attracted plenty of new expertise: on the asset management side, for example, some of the biggest names in the business, such as Templeton, Nomura and Aberdeen, have set up. As a marketing exercise it has indisputably succeeded, but some feel that it has yet to do what it really set out to do and attract international capital to be managed from Malaysia (see the asset management chapter for fund managers’ views on capital flows).

But perhaps it’s just a matter of time. “The drive to develop Malaysia as an international financial centre is a relatively new exercise, slightly above two years,” says Badlisyah. “I can attest that in that short period of time we do have evidence of strong interest from investors from overseas to invest in Malaysia or through the MIFC.” 

Innovation in product development, too, has tended to shift towards cross-border initiatives. The most obvious example is hedging for movements in currencies or interest rates between markets. “Over the last two years the Malaysian market has introduced a number of hedging instruments in the market to give more appropriate risk management for Islamic finance,” says Badlisyah. “Malaysia is the only country that has the Islamic master agreement, a standardized derivatives agreement based on ISDA documentation, established in the market.”

So far, these structures have chiefly been domestic. “When you do cross-border investments, those hedging requirements become more sophisticated than what is typically available in the Malaysian market,” Badlisyah says. “But we are focusing on developing greater capacity for hedging – considering that MIFC is there to facilitate cross-border activities – and those products should be coming out fairly soon.”

Developments like this take time. “Hedging has been on the drawing board for quite some time,” says Mohd Effendi Abdullah, Director and Head, Islamic Markets, at AmInvestment Bank. “People are cautious about hedging instruments, especially after what happened in the US, but it is being looked at.” Mohd Effendi also welcomes the arrival of Bursa Malaysia’s commodity trading platform (see box).

Malaysia has the right infrastructure, the right regulatory backing, the right experience and the right assets to build Islamic finance further and further. So where’s the weak point? Possibly in human resources, and more specifically, in Shariah scholars – the people who sign off on the Shariah compliance of structures and funds.

Certainly, Malaysia has made more effort than most countries to develop professional expertise in Islamic finance – worldwide, perhaps only Bahrain comes close. “We have invested in human capital development to ensure a deep pool of talent and expertise to support the development of Islamic finance,” says Governor Zeti. In particular, Malaysia has established the International Centre of Education in Islamic Finance (INCEIF) and the International Shariah Research Academy (ISRA) as part of its attempts to support advanced education and research in Islamic finance.

Malaysia is unusual in insisting that no scholar can serve on the board of more than one bank – in stark contrast to practices in the Middle East. The idea of this is to force the development of a greater field of scholars in Malaysia, rather than just a small group – potentially a cartel – of people who do everything. It will, though, take time for this policy to mature and in the meantime there is a bottleneck.

Practitioners are already thinking further ahead. “A critical aspect to ensure our long term success as a financial centre is the management of Shariah committees and the Shariah profession,” says Badlisyah. “Malaysia is the only country in the world that has an official Shariah guideline in terms of how Shariah committees are managed, how members are appointed, the qualification required and how banks need to operate their frameworks internally.

“What is missing I believe is the next step in enhancing the industry, to ensure Shariah professionals are deemed professionals in the same manner as lawyers, medical practitioners and accountants, where they have their own self-regulating professional bodies, perhaps even their own legislation. This will enhance confidence in the market and boost Malaysia’s position as the best place to do Islamic finance.”

Building a corpus of Shariah expertise and attracting cross-border flows are perhaps the two biggest challenges facing Malaysia now, but on all counts there are reasons to be positive about development.

“I think this will be quite an exciting year for the Islamic finance industry,” says Mohd Effendi. “Having opened up the industry, local participants will be encouraged and given a catalyst to run faster. I expect a rapid pace of development this year.”

BOX: Bursa’s Shariah challenge

Last August Bursa Malaysia launched a major new Islamic initiative called Bursa Suq Al Sila’. This is an end-to-end commodity trading platform designed to be Shariah compliant, in order to meet the needs of commodity financing and liquidity management both domestically and, increasingly, cross-border.

It uses the Islamic structures of murabahah, tawarruq and musawwamah, and is billed as the first exchange of its kind to encompass a hybrid market, allowing participants a choice between an automated electronic exchange system and traditional voice broking.

The exchange has begun to garner some cross-border success: Gatehouse Bank conducted the first international transaction last year, and is said to have been followed by a number of trades from GCC institutions. “We’ve had daily trades,” says Raja Teh, “and we have a good track record of GCC trades. They still come through Malaysian banks but they are essentially cross-border. So the next phase is to try to admit these GCC banks as members so they could trade with each other: they still use bilateral arrangements now.” Trades have been conducted in ringgit, US dollars and GCC currencies.

While the exchange purports to be Shariah-compliant, that is not an entirely straightforward claim to make. Last April, before the exchange was launched, the Shariah scholars at the influential Fiq Academy in Jeddah issued a fatwa saying that organised tawarruq were prohibited. This appears to undermine the exchange’s Shariah compliance, as the use of an organised bid is, as Raja says, “an inherent feature of the exchange”.

Bursa’s approach has been to look at the reasons they think underpin the fatwa and attempt to address them one by one within the exchange’s structure. “Generally we believe the pronouncement stems from the fact that there had been a couple of fraudulent trades” using tawarruq structures, she says, such as warrants backed with futures contracts, which are definitely not Shariah compliant. But she is adamant that Islamic finance needs a commodity financing exchange. “From an Islamic banking perspective, if we don’t have that, how are we going to manage liquidity, because there’s no instruments available at this point in time.” The market appears to agree with her, as banks have continued to use the platform despite the Fiq pronouncement.

It doesn’t appear that commodity murabaha themselves are the problem: AAOIFI, the main standard setting body for Islamic finance in Bahrain, has issued guiding principles on them. Instead, Bursa has focused on regulating trades to avoid fraud, or trades where the underlying asset isn’t really there. “Commodity suppliers must have a real spot commodity. Because we are a regulator, we can compel an audit at any point in time.” The exchange is also requiring buyside members (the financial institutions) to sign an undertaking that the financing they raise from trades on it will only be used for Islamic finance. Raja doesn’t think that prohibiting trades on the grounds of being organised holds up. “The premise is: clients have now ended up with a commodity that they don’t have any real use for, and which they need to sell for cash – this is the tawarruq element. Scholars are concerned that the trade is organised from day one and therefore not real. But it is real, because the exchange takes it and sells it back to the market.”

Philosophically, standing in the way of this organised approach makes little sense, Raja says. “Where in any of the [Islamic] sources does it say that being organised is haram? Are we saying the more haphazard we become the more Islamic we are? It’s not about organisation, it’s about whether the trade is real, and we are trying to address that through the exchange.”

Practitioners seem to side with Bursa. “The tawarruq principle is quite broad,” says Mohd Effendi at AmIslamic Bank. “It depends how you utilise that principle. In certain parts of the Middle East they are against that product because they say you are using the same asset, transacting with the same parties, and it’s an organised transaction. But with Bursa they have made it a true sales transaction by using the commodity market, with a tripartite arrangement instead of two parties. It is more acceptable.”

A paper expressing Bursa’s position will be presented to the Islamic Financial Services Board annual summit in Bahrain in May, and in time the exchange hopes it can go back to the Fiq academy with an explanation of what it has done and get a more favourable ruling. In the meantime, the technical lack of Shariah compliance with Fiq does not appear to be keeping the industry away: trades on any given day on the new exchange are typically between Rm500 million and 2 billion. The potential is far bigger: pre-crisis, Raja estimates that as much as $100 billion per day of commodity murabaha trades were being conducted, chiefly in the Middle East, all of them through laborious bilateral agreements through commodity brokers.