8th Global Conference on Business & Economics

ISBN : 978-0-9742114-5-9

Development of Islamic Finance in Malaysia: A Conceptual Paper

Darwis Abd Razak
School of Management, Universiti Sains Malaysia
11800, Penang, Malaysia
e
Tel: 04 6533888
Fax: 04 6577448
Email: drwis2002@gmail.com
Mohd Azhar Abdul Karim, PhD
Faculty Business and Economics
Universiti Putra Malaysia
43400, Serdang, Selangor

Abstract
Islamic finance has made significant inroads in the international financial markets that have
achieved growing global awareness. Islamic finance now has a presence in over 60 countries,
especially in Muslim countries. In the context of financial infrastructure, the Malaysian Islamic
financial system is both robust and fast growing. The market has highly diversified players, with
Islamic banks, investment banks, takaful companies, development financial institutions, savings
institutions, fund management companies, stock brokers and unit trusts. The aim of this paper is
provide a conceptual understanding on the growth in Islamic Finance in Malaysia by exploring
its current and future development. It is observed that the participation in the Islamic finance
process would require the development of a comprehensive and well established Islamic
financial system such as: - a wide range of products and services; a good legal system, adequate
financial infrastructure with competitive tax structures, low cost of doing business, high
standards of business ethics, and conducive living conditions and cultural offerings. It would also
need to be supported by adequate human talents that would drive the business and spur
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innovation. In addition, a strong regulatory regime in the Islamic financial system would be
another pull factor. The implication of this paper is to provide a platform for industry players and
regulators to highlights the recent developments in Islamic finance in Malaysia.
Key words: Development, Islamic Finance, Malaysia

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Introduction

The Islamic finance industry is now in its fourth decade and, during that period, has developed
extremely rapidly. In the past few years, overall market growth has been estimated at between
15-20 percent annually although individual Islamic banks have reported even faster growth
(Howard, 2008). According to Bank Negara Malaysia (the Malaysian central bank), the number
of Islamic bank branches in Malaysia increased from 126 in 2004 to 766 in 2005. Elsewhere,
new Islamic financial institutions (IFIs) are being established rapidly in the industrys
traditional markets in the Gulf Co-operation Council (GCC) countries. Islamic finance is also
on the rise in new markets such as Syria, Lebanon, the U.K., Turkey and Canada. In the U.K.,
for instance, two new Islamic banking license applications are currently being considered by
the Financial Services Authority (FSA), following the authorization in the past three years of
the Islamic Bank of Britain and the European Islamic Investment Bank (Yong, 2007).

With the rapidly changing international Islamic financial landscape, Islamic finance in Malaysia
is now becoming increasingly integrated to the international financial system (Zeti, 2008). The
world has witnessed the emergence of Islamic finance, and this phenomenon, as observed has
continued to grow strongly. Global asset size for Islamic finance is estimated to be between
US$200 and US$400 billion, and growing at 15% per annum. Apart from financial institutions
in the Middle East, global banks are also responding to tap the opportunities of this huge pool of
capital. Today, the number of Islamic financial institutions worldwide now exceeds over three
hundred in seventy-five countries and offering a wide range of Syariah compliant products (ElQorchi, 2005). This development has taken place in all segments of the Islamic financial
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system in Malaysia including the Islamic banking and takaful industry, and in the Islamic
money and capital markets. These include Sukuk, takaful insurance, murabaha financing, as
well as deposits and property funds structured using Syariah principles. In conjunction with this,
there are now a large number of diverse players and institutions in the Islamic financial system
in Malaysia. There has also been a growing range of products and services being offered. The
pace of product innovation has intensified with more sophisticated Islamic financial products
including the structured and investment-linked products. These products have become
competitive both in terms of product structure and pricing. There has also been enhanced depth
of the Islamic financial markets. This has increased the attractiveness of the Islamic financial
instruments as an asset class for investment.

As mentioned earlier, the growth rate of Islamic Finance in Malaysia is impressive by any
standards. Malaysia, therefore, has the capacity to retain its leadership in global Islamic finance
despite the emergence of competition from centers such as Hong Kong and Dubai (Yong, 2007).
He said despite the stiff competition that Malaysia was facing, it was way ahead of other
countries in terms of product offerings and its sophistication, having been developing the market
for the last 40 years. This paper is therefore interested is provide a conceptual understanding on
the growth in Islamic finance in Malaysia by exploring its current and future development. The
following sections will discuss on the emergence of Islamic finance, operating environment for
Islamic finance, barriers to growth and the concluding remarks.

1.2

The Emergence of Islamic Finance

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In essence, the purpose of Islamic economics is to identify and establish an economic order that
conforms to the precepts of the Islamic scripture and the narrated traditions of its prophet
(Chapra, 1992 and Naqvi, 1994). In the contemporary era, the move towards formulating an
Islamic economic framework that was in sync with prevailing economic needs took shape in the
1940s, and three decades later efforts to implement them were under way in dozens of countries
(Rahnema & Nomani, 1990; Kuran, 1993, 1995; and Malik, 1996). Despite the fact that Islamic
economics contains many distinguishing features, Islamic banking is now regarded as the
defining characteristic of an Islamic economic system (Kuran, 1995). The term Islamic financial
system is relatively new, appearing only in the mid-1980s. In fact, all earlier references to
commercial or mercantile activities conforming to Islamic principles were designated as either
interest free or Islamic banking. The first modern experiment with Islamic banking was
undertaken in Egypt. This pioneering initiative based on the profit-sharing principle was helmed
by Ahmad El Najjar. It involved the establishment of a savings bank in the Egyptian town of Mit
Ghamr in l963. By 1967, the number of banks operating on the same principles had grown to
nine (Siddiqi, l988). Thus, they functioned essentially as saving- investment institutions rather
than as commercial banks.

Though similar initiatives were being made in Malaysia and Pakistan, the overall growth of
Islamic banking was miniscule until the 1970s when the nascent reawakening was propelled
forward by the oil boom of 1974. The ensuing prosperity enjoyed by the predominantly Muslim
beneficiaries of this boom witnessed resurgence in the adoption of Islamic values in countries
with substantial Muslim populations and a concomitant rejection of the political and economic
structures of the West. This rejection was especially evident in the banking sector as many
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Muslims opted to deposit their money and conduct commercial transactions with Shariah
compliant banks (Lewis & Algaoud, 2001). With the passage of time, the role of Islamic
financial instruments in the economy, particularly in the banking sector, began to expand.

The increased popularity and visibility of the sector was especially evident in the 1990s when
Islamic finance grew rapidly as Islamic and non-Islamic financial institutions devised new
instruments and both Muslims and non-Muslim clients alike began to embrace and utilize
Shariah compliant features such al-Muddarabah, al-Muassasah etcetera in their daily banking
transactions (Zeti, 2007). Furthermore, Islamic banking expanded as western banks themselves
(such as HSBC and Citibank) created a number of financial innovations consistent with Syariah
in order to capitalize on the increased demand for Islamic capital investment products (Warde,
2000, 2001). The existence of such Islamic features in the Western banking sector served as a
catalyst to draw financing from countries such as Saudi Arabia and Kuwait. Consequently, a
number of predominantly Islamic countries such as Iran, Malaysia, Pakistan, Saudi Arabia, and
Sudan Islamized their banking systems using highly innovative banking initiatives.

The phenomenal growth of the Islamic Financial sector is underlined by the fact that there are
now about 300 Islamic financial institutions in 75 countries, holding assets estimated at more
than US$300 billion, and another US$400 billion in financial investments. The average growth
of the sector is estimated to be approximately 15 percent per annum and it is projected to grow
considerably in the foreseeable future, given the amount of oil wealth in much of the Muslim
world and a pent-up demand for investment products developed according to the tenets of the
Syariah, the legal and ethical code of Islam and the existence of an estimated 1.6 billion Muslims
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world wide (Beccalli et al., 2006). Thus it is hardly surprising that many multinational financial
institutions are increasingly becoming actively involved in the sector. According to Chapra and
Ahmed (2002), the conventional banking industry has utilized the services of commercial
Islamic banks, Islamic investment companies, Islamic investment banks, insurance companies,
asset management companies, e-commerce, and brokers and dealers to cater for current and
future needs. As for financial products, the predominant ones are financial instruments based on
a diverse set of Islamic principles, insurance products, mutual funds and unit trusts, Islamic
bonds, and Sharia compliant stocks (Hasan & Basser, 2003). The growth of the Islamic financial
system via the expansion of its banking sector from the historical perspective is captured in
Figure 1.

Figure 1:
History of the Industry Development
Development of Industry

Evolving richness in products

Development of theoretical
framework
1950s
Muslim-majority nation
Commercial
Structured
independence
products
banking
Egypt and Malaysia pioneering
60s
institutions
Debt issues
Establishment of OIC (1969)
Insurance
Islamic Development Bank (1974)
2000s
1970s
70s
and
DIB
One country-one bank setup
Private Advancement of Islamic products
1990s 1980s
equity Full
Islamiczation of Pakistan,
80s
Sudan and Iran
Project
Formation of BIMB, Malaysia.
finance Entry of global institutions e.g.
90s
Structured
HSBC
Equity
and trade
Tipping point reached in some
finance
markets
00s
Development of industry building
institutions
Sources: Stages of Evolution in Islamic Finance: Islamic Financial Services Industry
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The above explication clearly attest to the fact that Islamic finance has been acknowledged to be
a viable and competitive form of financial intermediation not only in Muslim countries but also
outside the Muslim world through its offering of a wide range of financial products and services
(Zeti, 2006). The viability, sustainability and competitiveness of Islamic finance have been
mainly due to a number of congealing factors that are both intrinsic and extrinsic in nature. The
intrinsic advantages of the Islamic financial system lay in its eschewing of conventional financial
tools such as interest which is anathema to the precepts of the Holy Quran. Instead, the system
adopted a sharia-based profit-sharing concept in its investment ventures thus spreading risk
profiles in a more equitable manner. Figure 2 encapsulates the types of banks and the Islamic
financial products offered in the relevant regions.

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Figure 2:
Islamic Financial Services: Stages of Evolution in Islamic Finance
Institutions
2000s

Products

Area

Commercial Islamic Banks

Commercial Islamic banking

products

Guff/Middle East

Takaful

Takaful

Asia Pacific

Islamic investment companies

Mutual funds/unit trust

Europe/Americas

Islamic investment banks

Islamic Bonds

Global/Offshore Market

Asset management companies

Syariah compliant stocks

e-commerce

Islamic stock broking

Broker/bankers

1990s

Commercial Islamic Banks

Commercial Islamic banking

products

Guff/Middle East

Takaful

Takaful

Asia Pacific

Islamic investment companies

Mutual funds/unit trust

Broker/bankers

Islamic Bonds
Syariah compliant stocks
Islamic stock broking

1980s

Commercial Islamic Banks

Commercial Islamic banking

products

Guff/Middle East

Takaful

Takaful

Asia Pacific

Islamic investment companies

Commercial Islamic banking
Guff/Middle East
products
Source: Aseambankers, World Islamic Funds and Capital Markets Conference, May 2006, Bahrain
Commercial Islamic Banks

1970s

1.3

The operating environment for Islamic finance

There are now a large number of diverse players and institutions in the Islamic financial system.
There has also been a growing range of products and services being offered. The pace of product
innovation has intensified with more sophisticated Islamic financial products including the
structured and investment-linked products (Guru et al, 2002). These products have become
competitive both in terms of product structure and pricing. There has also been enhanced depth
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of the Islamic financial markets. This has increased the attractiveness of the Islamic financial
instruments as an asset class for investment. The standards are developed by the Islamic
Financial Services Board (IFSB) to govern the operations of Islamic financial institutions (Zeti,
2006). The IFSB has, not only, an important role in the harmonization of standards, but also
contributes towards the consistent development of Islamic finance across different jurisdictions.
Several parts of the world, including in Malaysia, have implemented the prudential standards
issued by the IFSB. These standards which have been designed to take into account the unique
features specific to Islamic finance will contribute towards ensuring its soundness and stability.

In the Malaysian approach, the Malaysian scholars have applied the concept of bai al-dayn or the
sale of debts. The formal definition is: the sale of debt as a type of contract in which the
creditor sells his payable right upon the debtor either to the debtor either to the debtor or to a
third party. This sale [sic] contract between two parties may be either on the spot or forward
basis. It may also be either at a discount price or at the cost price claimed by Moustapha (2003).
The growing role of Islamic finance in mobilizing and channeling funds to productive
investment activities across borders contributes to more efficient allocation of funds across
borders and facilitates international trade and investment. According to Zeti (2007), greater
diversification of risks also contributes towards promoting international financial stability. The
more recent developments in Islamic finance is the growing significance of the sukuk market to
become an increasingly important component of the Islamic financial system. She added that
modern sukuk, sometimes referred to as Islamic bonds, are better described as Islamic
investment certificates. This distinction is as crucial as it is important, and it is stressed
throughout this pioneering work that sukuk should not simply be regarded as a substitute for
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conventional interest-based securities. The aim is not simply to engineer financial products that
mimic fixed-rate bills and bonds and floating-rate notes as understood in the West, but rather to
develop innovative types of assets that comply with Sharia Islamic law. Conventional bonds that
yield interest, or riba, are of course prohibited under Sharia law. Furthermore, those who buy
and sell conventional bonds are rarely interested in what is actually being financed through the
bond issue, which could include activities and industries that are deemed haram such as the
production or sale of alcohol. Companies that are highly leveraged with bank debt may seek
refinancing through issuing bonds, but such companies are not regarded as suitable for Muslim
investors.

1.3.1

Developments in the sukuk markets

The year 2007 has seen an exceptional growth of the global sukuk market which expanded by
more than 70 percent during the year. New issues during the year reached a record high to about
US$47 billion and the outstanding global sukuk market has now surpassed the US$100 billion
mark. Despite the more challenging international financial environment arising from the
financial crisis that has occurred in a number of the advanced economies in the recent twelve
months, the sukuk market while also affected, it has been to a lesser extent. Up until June 2008,
it has held its ground with a total global issuance now exceeding US$10 billion (refer Figure 3
and 4).

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Figure 3:
Sukuk Market in Malaysia

Figure 4:
Sukuk Types in Malaysia

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With greater recognition of the sukuk market as a competitive and attractive form of financing,
the global sukuk market is expected to continue its growth going forward. The International
Islamic financial hub evolving in Malaysia is supported by five pillars as discussed below.

Pillar 1: Sukuk Origination

Following the first ever sukuk in the world that was issued in Malaysia in 1990, Malaysia has
now developed a deep, liquid and vibrant sukuk market. Recently, the largest sukuk ever was
raised in the Malaysian sukuk market in 2007 (Bank Negara, 2008). The magnitude was
approximately RM15 billion or about USD5 billion equivalent. Despite being issued during the
height of the sub-prime crisis, it attracted huge demand and was oversubscribed by more than
two times. Sukuk origination has thus been identified as one of the important pillars of the
Malaysian Islamic financial system. As of the end of 2007, more than 60 percent of the
outstanding global sukuks originated from Malaysia. It has been increasing by an annual rate of
about 20 percent and it accounts for about 56 percent of the outstanding bond market in
Malaysia.

Pillar 2: Islamic Fund and Wealth Management

The sukuk market has been an important source of financing for productive investment activities,
while for investors it provides potential for diversification into new asset classes. The second
pillar in the Malaysia Islamic financial hub is the Islamic fund and wealth management industry.
Malaysia is centrally located in the ASEAN region that has a population of 570 million. It is also
positioned centrally between the major Asian economies of India, China, Japan and Korea.
Malaysia has always been a highly open economy in trade and investment activities and has been
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a major recipient of foreign direct investment for more than a hundred years. As a destination for
financial investment, the Malaysian capital market offers a wide range of world class financial
products. More than 85 percent of the listed companies in the equity market are Shariah
compliant, representing about 60 percent of total market capitalization. Other investment
opportunities include in Shariah-compliant real estate investment trusts (REIT), in unit trusts and
in the Islamic exchange traded fund (ETF).

Pillar 3: International Islamic Banking

The Islamic financial system has also been extensively liberalized to allow for the entry of
foreign Islamic financial institutions that offer both domestic and international banking business.
In addition, the foreign equity ceiling in Islamic financial institutions has been raised to a
maximum of 49 percent as part of the effort to promote strategic alliances. The Islamic banking
business in foreign currencies can be conducted by the international currency business units
(ICBUs) that may be set up within existing financial institutions and the international Islamic
banks. Such international Islamic banks may be established as either a branch or a subsidiary.
Currently, about 16 percent of total assets in the Malaysian banking system are Shariah
compliant.

Pillar 4: International Takaful Business

The fourth pillar is takaful and retakaful business. There are now eight takaful operators, several
of which are joint ventures with foreign shareholding that conduct both domestic and
international takaful business. In addition, licenses have been granted to three reinsurance
players to undertake retakaful business in Malaysia. Several existing takaful operators have set
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up international currency business units (ICBUs) and one new international takaful company has
been licensed as an international takaful operator to conduct foreign currency takaful business.

Pillar 5: Human Capital and Thought Leadership

The fifth pillar is human capital and thought leadership. Several important human capital
development projects have been implemented to foster Islamic finance thought leadership and to
create a supply of talent for the Islamic finance industry. Having a sufficient pool of the talent
and expertise has been key to the development of the Islamic financial hub in Malaysia. The
International Centre for Education in Islamic Finance (INCEIF) which has an international
faculty and students from more than 40 countries is focused on programmes for Islamic finance
professionals and specialists to meet the human capital requirements of the global Islamic
financial services industry.

1.4

Barriers to Islamic Financial

The prospects for the growth of Islamic finance look bright. Nonetheless, there are several
obstacles currently preventing faster uptake of Islamic financial products. These include the issue
of regulatory capital and relative risk weightings and the Islamic Financial Services Board
(IFSB) guidance; a lack of human capital; piecemeal financial and legal architecture; weaknesses
in financial reporting and transparency; and the overarching problem of a lack of Shariah
convergence. These barriers are discussed below:-

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1.4.1

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Risk weighting

In 2006, the IFSB issued two standards the Capital Adequacy Standard (CAS) and the Guiding
Principles of Risk Management for Institutions offering Islamic Financial Services. CAS offers
guidance on the requirements for minimum capital adequacy to cover for credit, market and
operational risks of IFIs that is equivalent to the Basel II Capital framework for conventional
banking institutions. According to the IFSB, the key difference between CAS and Basel II
provisions is the computation of an institutions risk-weighted capital ratio (RWCR). In Islamic
banking, given that the risks on assets financed by profit-sharing investment account holders do
not represent risk to the capital of the institution, the CAS allows risk-weighted assets that are
funded by the account holders to be deducted from the institutions total risk-weighted assets in
the calculation of RWCR.

1.4.2

Human capital

Human capital development is crucial, as the current lack of qualified young Islamic bankers
looks set to hamper the development of the sector should it not be addressed. In part, this low
investment in the industry stems from the fact that the sector lacks a global industry body to
oversee standardization of continuous education and training. The lack of human capital in the
sector affects all regions, including nascent markets such as the U.K. Training of Islamic bankers
has not kept pace with the rapid growth of the sector and, as a result, there are shortages
throughout the industry. The two centers for training have been KFH and Bank Islam Malaysia,
which between them have been responsible for training many Islamic bankers. In 2006, for
example, Bank Negara set up an RM500m endowment fund to support The International Centre
for Education in Islamic Finance (INCEIF), with the main objectives of making Malaysia the
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leading center for Islamic finance education and developing human capital for the global Islamic
finance industry. Similarly in 2006, The Central Bank of Bahrain set up a US$4.6m Islamic
Finance Education scheme in cooperation with eight IFIs based in Bahrain.

1.4.3

Regulation and legal frameworks

While rising demand for Islamic finance has helped lead to handsome returns for key players,
some experts in the industry are concerned that the rapid proliferation of IFIs has not been
matched by development in the Islamic finance regulatory and supervisory architecture and
infrastructure, especially in the GCC states. One thing that worries me, explains Ali AlGhannam, Head of International Real Estate at Kuwait Finance House (KFH), is that the IFIs
should be controlled better to avoid any bubble in the industry. There are a huge number of new
IFIs being established in the market. Many banks and traditional companies are converting to
Islamic finance. Islamic banking windows at global majors are proliferating. Many of these
institutions are not going after the concept itself, but are following the flow of money.

1.4.4

Financial reporting

The quality and transparency of financial reporting and disclosure in the Islamic finance industry
differs significantly from one regulatory jurisdiction to another. There is a general concern in the
market and among those interviewed that IFIs, with the notable exceptions of those operating in
the U.K., Malaysia, Bahrain and perhaps Turkey, should have more rigor in their disclosure and
financial reporting, especially to the general market.

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Concluding Remarks

Islamic finance has made significant inroads in the international financial markets that have
achieved growing global awareness. Islamic finance now has a presence in over 60 countries,
especially in Muslim countries. In the context of financial infrastructure, the Malaysian Islamic
financial system is both robust and fast growing. The market has highly diversified players, with
Islamic banks, investment banks, takaful companies, development financial institutions, savings
institutions, fund management companies, stock brokers and unit trusts. The aim of this paper is
provide a conceptual understanding on the growth in Islamic Finance in Malaysia by exploring
its current and future development. It is observed that the participation in the Islamic finance
process would require the development of a comprehensive and well established Islamic
financial system such as: - a wide range of products and services; a good legal system, adequate
financial infrastructure with competitive tax structures, low cost of doing business, high
standards of business ethics, and conducive living conditions and cultural offerings. It would also
need to be supported by adequate human talents that would drive the business and spur
innovation. In addition, a strong regulatory regime in the Islamic financial system would be
another pull factor. The implication of this paper is to provide a platform for industry players and
regulators to highlights the recent developments in Islamic finance in Malaysia.
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of the Central Bank of Malaysia, at the Malaysian Islamic Finance 2008 Issuers and
Investors Forum ISSUER'S DAY (Launch of the MIFC Global Communications
campaign), Kuala Lumpur, 11 August 2008.

October 18-19th, 2008

Florence, Italy

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