Regulatory Review of Islamic Finance in Malaysia

Regulatory Review of Islamic Finance in Malaysia

By PricewaterhouseCoopers
Islamic finance in Malaysia had its beginnings with the establishment of a pilgrimage fund in 1963. The fund was used as a savings mechanism for Malaysian Muslims to set aside money for the cost of performing pilgrimage. Since then, the Malaysian government has undertaken various initiatives to create a vibrant and comprehensive Islamic banking and finance system, as reflected by a recent report by Bank Negara Malaysia (BNM), which stated, inter alia, that:
i) Assets of the Islamic banking system (including Islamic banking windows operated by conventional banks) have been increasing at an average annual rate of 18.9% since 2000. By end-2006, Malaysia’s Islamic banking and finance assets accounted for 12% of the total assets in the industry. This represents 6.4% of total assets in the financial system.
ii) The Takaful assets and combined Takaful contributions accounted for 6.1% of total assets and 6.5% of total premiums of the Takaful industry. iii) Malaysia’s Sukuk represent 67% of total global Sukuk outstanding as at the 23rd January 2007.

The Islamic finance system carries its own unique risks as compared to the conventional system. These include the need to be Shariah compliant, the prohibition on interest and the different risk sharing features. The conventional regulations were not formed with those needs in mind, thus applying them to the Islamic financial system would be inappropriate.

Malaysian regulatory bodies such as BNM, Securities Commission (SC), Labuan Offshore Financial Services Authority (LOFSA) and Bursa Malaysia continue to play their roles solely or jointly in adopting the conventional framework with suitable and robust guidelines and rules to tackle the peculiarity of Islamic transactions, thus strengthening the industry and promoting further growth on the global front.

Islamic Finance Developments
There have been several regulatory developments in Malaysia, particularly on the Islamic finance front. These include the introduction of a new Islamic monetary instrument by BNM, namely the Commodity Murabahah Program (CMP).

CMP is a cash deposit product based on the globally accepted Islamic concept of underlying commodity transactions to facilitate liquidity management and investments. The commodity-based transaction utilizes crude palm oil-based contracts as the underlying asset. The instrument is part of the diverse range of policy instruments in managing the short-term liquidity in the Malaysian Islamic interbank money market.

The introduction of CMP addresses the issue of managing the liquidity risk of an Islamic bank due to the limited Shariah compliant money market instruments and the issues of lender of last resort. In addition, it will contribute to realizing the vision of turning Malaysia into an International Islamic Financial Center (MIFC).

To date, BNM has executed CMP master agreements with the eight Islamic banking institutions, including three foreign owned banking institutions, in the country in its efforts to promote the use of the instrument for liquidity management. Several CMP transactions have now been conducted between the central bank and the respective Islamic banks.

Malaysia has also introduced the first global Islamic Derivative Master Agreement (IDMA), which documents Islamic derivative transactions in steps to develop Islamic hedging products that are used to mitigate investment risks. The agreement, which spells out the rights and obligations of contracting parties, is expected to enhance risk management practices, balance sheet management, increase fund mobilization efficiency and enhance investment banking capability.

IDMA is considered an important catalyst for future linkages between financial markets that offer Islamic financial market instruments as it incorporates several of the market conduct’s best practices. BNM also intends to diversify the issuance concept of Islamic monetary notes from current Bai Inah and Ijarah into Murabahah.

In the Islamic bond market segment, BNM and SC continue to play a major part in developing MIFC. They have issued the Joint Information Note, which is targeted at qualified bonds and Sukuk issuers. The purpose of the note is to set out the facilitative requirements applicable to foreign currency-denominated bonds and Sukuk issued in a transparent manner and shall be read together with the SC’s Practice Note 1A issued on the 27th March 2007.

Risk Management

In the area of risk management of banking operations, BNM has issued two frameworks: the Revised Weighted Capital Adequacy Framework that is applicable to all banking institutions (including their Islamic banking windows), and the Capital Adequacy Framework for Islamic banks. Both, which will take effect from the 1st January 2008, are consistent with the Basel II document issued by the Basel Committee of Banking Supervision (BCBS) and the Capital Adequacy Standards (CAS) issued by the Islamic Financial Services Board (IFSB).

The issuance is to ensure that the prevailing regulatory framework effectively considers the more complex risk profiles of the financial institutions arising from the offering of more sophisticated products and services. Implementation and compliance with the frameworks will place Malaysian conventional banks, Islamic windows and Islamic banks on a level playing field with global foreign banks.

Islamic banks face challenges to expand internationally while adhering to Shariah. This has altered the governance structure of Islamic banks and set them apart from conventional banks. As a result, BNM has outlined guidelines on corporate governance requirements in the revised BNM/GP1-i for Islamic banks under its purview. Compliance will certify that Islamic banks are managed safely and soundly in the normal course of banking operations where risk taking and business decisions are balanced. Effective corporate governance practices are equally viewed as key elements in the working market discipline and transparency.

Islamic Capital Market

The Islamic capital market in Malaysia has emerged as a significant area of growth. It has a full range of products, infrastructure, institutions, intermediaries and investors that contribute to the development of the Islamic capital market.

In June 2007, SC issued guidelines giving Malaysians direct access to Dubai Islamic Financial Center (DIFC) Islamic funds. This means the said funds can be distributed directly into Malaysia, thereby enabling investors to access a variety of funds available in this recognized jurisdiction. DIFC is the first recognized jurisdiction on the list to be involved in this arrangement. SC plans to expand the said list with the signing of future mutual recognition arrangements. This positive move eases local investors’ exposure to foreign funds as previously they would have had to invest in a feeder fund in Malaysia.

Earlier in 2007, Bursa Malaysia, in collaboration with the global index provider, FTSE Group launched the FTSE Bursa Malaysia EMAS Shariah index. The index is designed to provide investors with a broad benchmark for Shariah compliant investments for the Malaysian market.

The FTSE Bursa Malaysia EMAS Shariah index will act as a singular benchmark for Malaysian Shariah compliant investments when the existing Shariah index (KLSI) deactivates on the 1st November 2007.

Tax Incentives

On the back of the government’s initiatives to spur the growth of Islamic finance in Malaysia, tax neutrality and incentives have been provided over the years.

Firstly, Islamic finance transactions were provided with tax neutrality, which meant that Islamic finance would be tax neutral when compared with conventional financing products. Such initiatives included legislation to provide tax deductibility to profits on Islamic financial products similar to interest in conventional products. In addition, various tax exemptions and withholding tax exemptions available to conventional products would also apply to Islamic financial products.

Further tax incentives were then provided to enhance the treatment of Islamic financial products. These included the ability for the issuance costs of Islamic Sukuk to be tax deductible to the issuer of the bonds. This popular tax incentive has encouraged more issuers to choose Islamic financial products such that it has been extended for another three years till 2010.

The Budget 2008 announcements on the 7th September 2007 provided enhanced tax incentives to the fund management industry. Fund managers who base their operations in Malaysia will be exempted from tax until 2016 if the funds are managed based on Shariah. This incentive is available for services provided by fund managers to Malaysian residents as well as foreigners.

Such generous tax incentives have generated substantial interest from financial players to use Malaysia as their Islamic financial hub and platform in this region.

Conclusion

Islamic finance has seen significant growth in the last decade and will continue to do so. With it, there will be challenges that will push the boundaries of product innovation and development. This in turn will create the need for the regulators and marketplace to be diligent and yet not stifle the growth of Islamic finance.