Zeti Akhtar Aziz: Current issues and developments in Islamic banking and
finance
Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the ASLI's
Conference on Developing Islamic Banking and Capital Market: "New Opportunities, New Market and
New Frontier in Islamic Banking and Finance", Kuala Lumpur, 25 August 2004.
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Islamic banking and finance has emerged as a financial intermediation process that is competitive and
resilient and that contributes to the overall wealth creation, growth and development of our nation.
Amidst an increasingly challenging and competitive financial environment, the evolution of a
comprehensive Islamic financial system seeks to meet the range of requirements of a rapidly changing
economic environment, with its soundness and stability secured through the robustness of its
regulatory framework supported by the strength of its financial infrastructure and the sophistication of
its products and services. Indeed, the strength of the respective components of the system and the
interconnections of its markets will open new frontiers in Islamic banking and finance and will
maximize the potential and opportunities that it accords.
Distinguished guests,
It is my pleasure to be here today at this conference organised by ASLI to speak on the current issues
and developments in Islamic banking and finance.
The Islamic financial system in Malaysia has evolved as a viable and competitive component of the
overall financial system, complementing the conventional financial system as a driver of economic
growth and development. The rapid progress of the domestic Islamic financial system, reinforced by
significant developments in the Islamic financial infrastructure, including the legal and Shariah
infrastructure and the regulatory and supervisory framework, has strengthened the position of the
Islamic financial system as an increasingly important component in meeting the changing
requirements of the new economy. The Financial Sector Masterplan launched three years ago
provides the strategic direction envisioned for the development of the Islamic financial sector looking
beyond the near term and taking a longer-term perspective into the needs and requirements of the
future. The strategies outlined in the Plan have emphasized the development of the respective
building blocks of the various parts of the financial sector that need to be put in place to form the solid
foundation on which sustainable future progress can be achieved. The expansion of the Islamic
financial system in Malaysia has therefore taken place with attention given for the development of a
comprehensive system.
Towards a more diversified Islamic financial system
At the onset of our journey in the development of a comprehensive Islamic financial system that is
progressive, efficient, dynamic and sustainable, due attention was thus given to the development of
the key structural components of the Islamic financial system, comprising the Islamic banking industry,
the takaful industry and the Islamic money and capital markets. The intra-dependency of these key
components creates the enabling environment for the Islamic financial system to effectively perform its
role as an efficient conduit for mobilizing resources and channeling the funds to finance productive
economic activity. The absence of any particular component could reduce the effectiveness and
efficiency and thus affect the viability and sustainability of the system. While the Islamic banking
system has an important role in mobilizing deposits and providing financing, the Islamic capital market
has an equally important role in providing a stable source of long-term funds for financing large
investments and development projects as well as for capital and business expansion. The
development of the Islamic capital market not only allows for a more balanced allocation of financial
and economic resources within an economy but more importantly, ensures greater diversification of
risks within the Islamic financial system. This enhances the resilience and robustness of the Islamic
financial system to withstand financial shocks and contributes to the overall stability of the Islamic
financial system.
In terms of the development of our Islamic financial system, as at June 2004, the assets mobilized by
the Islamic banking sector have increased to RM89.1 billion, accounting for a market share of about
10% of the banking system. At the same time, deposits have also increased to RM64 billion,
constituting a market share of 10.4% while financing mobilized amounted to RM54 billion to garner
11% of the market share. Product offerings have also increased in sophistication from the deposit
products to hybrid products that are able to enhance returns to depositors. A further advancement was
made with the introduction of the Islamic variable rate financing mechanism that provides an
alternative to the fixed-rate financing. This will assist the Islamic banking institutions in mitigating part
of the risks emanating from asset and liability mismatches.
The Islamic capital market, in particular, the Islamic debt market, has also experienced rapid growth
since its emergence in the 1990s. The issuance of Islamic bonds has expanded steadily at an average
growth rate of 33.7% since 1995. In 2003, the total funds raised via the issuance of Islamic bonds
amounted to RM8.1 billion, constituting 19% of the total funds raised in the bond market. New
innovative Islamic financial instruments such as Islamic asset-backed securities have also emerged
and the financial structures underlying Islamic securities have become more diversified. The number
of Shariah-based unit trust funds has also grown consistently over the years to reach 55 in 2003 with a
net asset value of RM4.75 billion, constituting a market share of 6.8%. The rapid growth of Islamic unit
trusts comprising a variety of bond funds, equity funds and balanced funds increases the efficiency
and potential of the Islamic financial system as an intermediation channel by providing investors
access to professional asset management that is based on their distinct risk tolerance levels.
The development of a vibrant, efficient and effective Islamic capital market requires the creation of a
broad spectrum of innovative Islamic financial instruments and the infrastructure to promote active
trading so as to enhance the breadth and depth of the market. In the development of Islamic financial
instruments, the challenge is to develop innovative and more diverse Islamic financial structures that
are not only able to accord flexibility to issuers in managing their distinct financing requirements but
also able to meet investor's demand in accordance with their risk and return preferences.
At the international level, the successful issuance of the first sovereign global Islamic sukuk by the
Government of Malaysia which attracted significant interest from a wide international investor base,
acted as a catalyst for other countries and corporations to tap the international Islamic financial market
and provided the impetus to the development of the International Islamic Financial Market (IIFM). The
IIFM is entrusted with the task of creating an enabling environment that will encourage active
participation by both Islamic and non-Islamic financial institutions in the secondary market for Islamic
financial instruments. Strategic alliances such as those forged between IIFM, the Labuan International
Financial Exchange and the Bahrain Stock Exchange will further pave the way for cross-border listing
and trading of Islamic financial products. This will increase international investors' access to Islamic
financial instruments, enhance liquidity and spur the development of an Islamic capital market with
greater global reach.
Strengthening the foundations for the development of a sound, progressive and sustainable
Islamic financial system
The strengthening of the financial infrastructure is a key pre-requisite for the development of a
dynamic and progressive Islamic financial system. An important feature of a comprehensive and
welldeveloped financial infrastructure is the diversity of the players and institutions in the system that have
been developed based on their distinctive capabilities and competitive advantage thus raising their
performance level, valued added and contribution to overall growth and development. In addition, as
part of the strategy to enhance our integration with the international financial system and to strengthen
our inter-linkages with other economies, the liberalization of the Islamic banking industry has been
brought forward to take place in 2004. The issuance of new Islamic banking licences to qualified
foreign financial institutions will allow for the presence of foreign Islamic banking players to act as a
bridge between Malaysia and other global Islamic financial markets and increase the potential to tap
new markets and growth opportunities. It will also contribute to spur financial innovation as well as
facilitate international trade and investment flows between Malaysia and the rest of the world.
An important dimension of the financial infrastructure is a comprehensive and effective legal
infrastructure for legal redress arising from Islamic financial transactions. The legal infrastructure
needs to comprise both effective regulatory and substantive laws as well as appropriate adjudicative
fora for parties to resolve disputes relating to Islamic financial transactions. This will instill confidence
and promote the sound expansion of the Islamic financial industry. Towards meeting this objective, the
High Court of Malaysia has assigned a dedicated High Court to preside over litigated cases on matters
relating to Islamic banking and finance. To complement the court system, disputes may also be
referred to the arbitration centre for resolution. In this regard, the Kuala Lumpur Regional Centre for
Arbitration will be enhanced to serve as a platform to deal with dispute cases on Islamic banking and
finance, and to extend these services beyond our borders. In addition to the dispute resolution
mechanisms, the Central Bank has formed the Law Review Committee to review the common
law-based domestic legislations to assimilate Shariah principles with the aim of removing any
impediments to ensure the unhindered and efficient functioning of the Islamic banking and financial
system. This review covers tax and stamp duty laws, company laws, land laws and procedural laws.
An important consideration in the development of an effective legal framework for Islamic banking and
finance is the need to ensure enforceability of Islamic financial contracts in accordance with Shariah
principles. In this regard, the Central Bank of Malaysia Act 1958 was amended to position the Shariah
Advisory Council of Bank Negara Malaysia as the sole authority on Shariah matters pertaining to
Islamic banking and finance that fall under the purview of the Central Bank. With this stature, the
Shariah Advisory Council will therefore serve as the reference point for the court or arbitrator in
dispute resolution that involves Shariah issues in Islamic banking and finance cases.
To further strengthen the Shariah infrastructure, guidelines will be issued to define the new structure,
roles and functions of the Shariah Committees of the Islamic banks, the Islamic Banking Scheme
banks and the takaful operators. The guidelines would specify among others, the requirements for the
appointment of the Shariah Committee members and the duties and responsibilities of Islamic financial
institutions to facilitate the effective functioning of the Shariah Committee. In the Islamic capital
market, the establishment of a strong Shariah infrastructure is equally pertinent to ensure that the
structuring of Islamic capital market instruments, the construction of Islamic investment funds and the
execution of Islamic investment fund strategies are Shariah-compliant. This is important to preserve
the integrity of the Islamic financial system and promote confidence that Islamic banking and financial
operations do not deviate from the dictates of the Shariah.
The hallmark of a well-developed financial infrastructure is an effective regulatory and supervisory
framework which underpins the stability of the financial system. The regulatory and supervisory
function is an indispensable and vital component of the financial infrastructure. In a dual financial
environment, the prudential regulatory design needs to take into account the unique characteristics
peculiar to Islamic banking and finance as well as provide a level playing field in relation to
conventional banking and finance so as to ensure that Islamic financial institutions and transactions
are not at a comparative disadvantage. It also needs to assess and mitigate any potential regulatory
arbitrage practices between the conventional and Islamic financial system that could undermine the
stability of the overall financial system. While conventional banking is primarily premised on an
interest-based debtor-creditor relationship, Islamic banking transactions are relatively more complex
arising from the diverse contractual relationships between the Islamic financial institutions and their
customers, ranging from the low risk sales and lease-based modes of finance to the higher risk
equity-based modes. Each of these modes of finance has a distinct intrinsic characteristic dictated by
its underlying Shariah principles and thus, entails different risk profiles. Therefore, the risk
management infrastructure in Islamic financial institutions must be in place to identify, unbundle,
measure, monitor and manage all the specific risks in Islamic financial transactions and instruments to
provide for their effective quantification and management.
The establishment of the Islamic Financial Services Board (IFSB) in 2002 marks an important
milestone in the development of internationally accepted prudential regulatory standards and best
practices for the Islamic financial services industry. Since its establishment, the IFSB has attracted
wide participation. To date, there are 13 full members, 4 associate members and 35 observer
members in the IFSB. The technical committee of the IFSB is now in the final stages of the formulation
of the prudential standards on capital adequacy and risk management. The IFSB has also
commenced work on standards for corporate governance.
Whilst appropriate regulations and standards are vital to mitigate the risks involved, of equal
importance is the oversight and monitoring of the Islamic financial institutions through effective
supervision by the regulatory authority to ensure that the prudential requirements are observed. Lack
of oversight, inadequate check and balances, and over exposure to risks are amongst the factors that
may result in vulnerabilities to the system. The best of regulations and financial safety nets would not
be able to avoid vulnerabilities if early warning systems are not in place. To effectively perform the
supervisory function it is important to not only identify the risks involved in the various Islamic financial
transactions but also to be able to detect any contravention of Shariah principles in financial
transactions and operations.
A central feature of the regulatory framework for Islamic financial institutions is financial transparency
and disclosure. This is particularly pertinent for Islamic financial transactions. For example, investment
depositors in the Islamic banking institutions have the role of quasi shareholders that are not only
entitled to share the profits of the Islamic banking business but are also exposed to the risks of losing
their capital in the event of losses. In this connection, the issuance of a standard framework for the
derivation of the rate of return in Islamic banking business has an important role in addressing the
information asymmetry between the Islamic banking institutions and the depositors so as to ensure
depositors receive their appropriate share of returns on the investment. In addition, the issuance of the
guidelines on the model financial statement for Islamic banks will provide for greater disclosure on the
risk and return profiles of the different categories of deposits. This will enable depositors to obtain the
true and fair assessment of the Islamic banks' financial performance and hence, promote confidence
and strengthen the competitiveness of the Islamic financial industry.
Enhanced financial disclosure needs to be complemented by customer education and awareness
programmes to elevate the level of financial literacy of consumers and businesses to be able to make
informed financial decisions and instill market discipline amongst financial players. The launching of
the Consumer Education Programme and the organization of the Islamic Banking and Takaful Week
are aimed at achieving these objectives. These programmes have contributed to enhance the
understanding and appreciation of the unique characteristics of Islamic banking and finance, Islamic
financial products and services and their underlying Shariah principles and concepts. Enhanced
awareness on the manner in which Islamic financial transactions are being conducted and Islamic
financial contracts are being executed will not only strengthen the role of market discipline in driving
Islamic financial institutions towards ensuring Shariah compliance in the operations, but also
contribute towards improving operational efficiency, strengthening risk management infrastructures
and instituting sound and dynamic risk management practices.
Conclusion
To harness the full potential of the Islamic financial system, genuine endeavors to strengthen further
the Islamic financial infrastructure, to develop the Islamic financial markets and to innovate Islamic
financial instruments and activities that are able to meet the changing requirements of the new
economy and the contemporary global marketplace need to be continuously pursued. With the
acceleration of the global integration of Islamic finance, it will provide the synergies and opportunities
for the Islamic financial industry to evolve into an important component of the international financial
system that can contribute to enhance the prospects for a more balanced global growth and global
financial stability.
On that note, I wish you a successful Conference. Thank you.