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Transcript of 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
Page
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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
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3
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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
5
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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.
10
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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
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
Source: Bank Negara Malaysia
22
BBA fnancing is themost popular fnanc-
ing contract.
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Source: Bank Negara Malaysia
Source: Bank Negara Malaysia
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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Source: Bank Negara Malaysia Annual Report, various years
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.
Source: Bank Negara Malaysia Annual Report, various years
25
Islamic banking de-
posits recorded a ro-
bust growth of 18.2%
in 2006.
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Kuala Lumpur Business School
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.
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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.
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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.
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