Zeti Akhtar Aziz: Islamic finance - constant evolution and emerging
opportunities
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the Nikkei
Islamic Finance Symposium 2008: "Islamic Finance: Constant Evolution and Emerging
Opportunities", Tokyo, 23 February 2008.
* * *
It is my great honour and pleasure to be here in Tokyo to speak at this Islamic Finance
Symposium organised by the NIKKEI. This is an important forum that provides the
opportunity to foster a greater understanding and appreciation of Islamic finance and its
increasing role in the international financial system. We are also very honoured by the
presence and participation of Governor Fukui from the Bank of Japan at this Symposium.
My remarks today will focus on the evolution and new emerging opportunities in Islamic
finance as its growth and development in the global financial system gains further
momentum. My presentation will also touch on our experience in the development of an
Islamic financial system in Malaysia which operates side by side with the conventional
financial system and in which the international dimension has now become increasingly
significant.
Evolution of Islamic finance
Modern Islamic finance was initially developed as an intermediation channel for Muslims to
conduct their savings and investment activities in accordance with the Islamic principles. As
recent as five years ago, however, Islamic finance has experienced major transformations.
Its rapid evolution is particularly evident in five dimensions of its development.
Firstly, from being concentrated in Muslim populated regions, Islamic finance is now viewed
as a competitive form of financial intermediation that has drawn significant participation
by non-Muslims. For borrowers, it is seen as an alternative means of financing. For investors,
it is seen as a new asset class. Islamic finance has thus witnessed exceptional growth, not
only in the Muslim world, where its growth is premised on religious and business
considerations, but also across the Western world where the growth is driven by commercial
and business considerations. Today, the total assets of the Islamic financial system has
surpassed one trillion US dollars, about fivefold of its magnitude five years ago. Islamic
finance is now among the fastest growing financial segments in the world with an estimated
annual growth of 20 percent.
Secondly, the nature of the business of Islamic finance has also evolved, from being mainly
focused on retail and trade financing to the financing of other commercial business activities.
With the emergence of more diverse Islamic financial institutions and the development of the
Islamic financial markets, the scope of Islamic finance business has been expanded to
include private equity, project finance, the origination and issuance of sukuk, and fund, asset
and wealth management activities. The pace of product innovation has also intensified with
more sophisticated Islamic banking and takaful products as evidenced by the surge of
structured products and investment-linked products. These products have become
competitive both in terms of product structure and pricing. The enhanced depth of the Islamic
financial markets has also increased its attractiveness as an asset class for investment.
These developments have resulted in an extensive range of Islamic financial products and
services that is being offered to consumers and businesses.
The third dimension in which there has been significant evolution is in the regulatory and
legal framework for Islamic finance which has taken into account the distinct features of
Islamic financial transactions. This has ensured that the growth and developments of Islamic
finance is accompanied by the corresponding development of the supporting legal, regulatory
and supervisory framework to ensure its soundness and stability. The establishment of the
Islamic Financial Services Board in 2002 also marked an important milestone in the
development of the prudential regulatory standards and best practices for Islamic financial
institutions. Its establishment has also contributed to the harmonisation in the development of
Islamic finance across different jurisdictions.
Fourthly, the international dimension of Islamic finance has rapidly gained significance as it
evolves to become an increasingly important part of the international financial system,
and as is becomes poised to contribute towards greater global financial integration. Islamic
financial institutions have now ventured beyond their domestic borders and funds raised in
Islamic financial markets in different jurisdictions have drawn investors from financial centres
across the globe. As market players across continents participate in the expansion of
interregional investment flows, it has enhanced financial linkages among the major regions. To
date, the number of Islamic financial institutions worldwide has increased to more than 300,
spanning more than 75 countries both in the Muslim and non-Muslim countries.1 The
expansion of the inter-linkages among intermediaries and markets across regions would
contribute towards a more efficient allocation of financial resources across borders and thus
contribute to enhancing global growth prospects.
The fifth dimension that has seen significant change is in the development of human
capital in Islamic finance. It has been a vital development that has been key in ensuring an
adequate supply of talent and expertise for further expansion and development of the Islamic
financial services industry. High caliber professionals that have the combined knowledge and
understanding of the Shariah with the necessary skills in finance2 are now in great demand.
Recognising this, several major institutions of higher learning are offering more focussed and
structured programmes in Islamic finance. The establishment of the International Centre for
Education in Islamic Finance (INCEIF) in Malaysia in 2006 represents a structured
investment in human capital development to support the global development of Islamic
financial services industry. It is envisioned that INCEIF will act as a professional certification
body as well as an education centre for specialised post-graduate programmes in Islamic
finance.
Distinctive features of Islamic finance
While Islamic finance has continued to evolve, the distinct features remain fundamental.
Islamic finance is required to operate in accordance with the rules of Shariah from which it
derives its unique characteristics. The Shariah injunctions require that the Islamic financial
transaction be supported by an underlying economic activity. This requires that the financial
transaction must be accompanied by a genuine trade and business related activity.
Based on this arrangement, interest-based transactions are prohibited. Islam encourages
business and trade activities that generate a fair and legitimate profit. In Islamic finance,
there is therefore always a close link between the financial and productive flows. This
intrinsic principle contributes towards insulating the Islamic financial system from potential
risks of financial stress resulting from excess leverage and speculative financial activities.
A further fundamental principle of Islamic finance is the risk and profit sharing feature of
Islamic financial transactions. This could involve an arrangement whereby the Islamic
financial institution shares profit with the investor in a Mudarabah contract or in a
Musyarakah contract, both parties share in the profit or loss. These arrangements involve an
explicit sharing of the risks by the Islamic financial institution and the investor, thus requiring
the Islamic financial institution to appropriately manage the risks associated with the
transaction. It entails the appropriate due diligence and the integrating of the risks associated
with the investment activity into the financial transaction. The real activity is thus expected to
generate sufficient wealth to compensate for the risks.
It is from this profit and risk sharing feature of Islamic financial transactions that a high level
of disclosure and transparency is required. This represents a basic tenet underlying all
Islamic financial transactions. There is an inherent obligation to meet the appropriate
standards of transparency. The accountabilities of the respective parties involved in the
transaction are also clearly defined in the contract. These disclosures also allow the market
to assign the appropriate risk premiums to the respective companies thereby enhancing the
potential for market discipline to take effect. These intrinsic features as required by the
Shariah injunctions provide an in-built checks and balances which serve to ensure financial
stability in the Islamic financial system.
Malaysian experience
Allow me to take this opportunity to share with you Malaysia's experience in developing the
Islamic financial system, and in particular, the Islamic capital market. Malaysia has
developed over more than two decades, a comprehensive Islamic financial system that
operates in parallel with the conventional financial system. The Islamic financial system in
Malaysia has evolved as a competitive component of the domestic financial system with a
significant number of diverse players in the Islamic banking, the takaful industry and the
Islamic money and capital markets. Our approach has been to focus on institutional
development, reinforced by a robust Shariah, legal and regulatory framework as well as the
investment in human capital development. In this more recent decade, attention has been
focussed on developing the financial markets, in particular the sukuk market, and on the
liberalisation of the Islamic financial system.
We are now entering a new phase in the development of Islamic financial system in Malaysia
with initiatives to position Malaysia as International Islamic financial hub. The initiative is
aimed at strengthening our international economic and financial inter-linkages and thus
promoting greater regional and international trade and investment activities. As part of the
wide ranging liberalisation measures, we have seen the entrance of new foreign Islamic
financial groups into our financial system. New licences have been issued and greater
foreign interest in the domestic Islamic financial institutions have also been permitted. In
addition, the listing rules were liberalised to facilitate foreign and cross-border listings. New
licences are also being issued for International Islamic Bank and International Takaful
Operator to conduct Islamic banking and takaful and retakaful business in international
currencies.
The most significant progress that has been achieved is in the development of the Malaysian
sukuk or Islamic bond market. The Malaysian sukuk market is now the largest Islamic bond
market in the world with more than 62% (or USD60 billion) of the global outstanding sukuk
having been originated from Malaysia. Supported by a comprehensive infrastructure
including the settlement and bond information system, Malaysia has an active primary sukuk
market with an average annual growth of 17% over the period 2001-2006. It also has one of
the most active secondary markets with a turnover of sukuk trading registering of more than
USD40 billion annually.
The Malaysian bond market has also been liberalised to enable foreign entities to raise
ringgit and foreign currency denominated funds from our market. International issuers may
thus issue multi-currency Sukuks or alternatively have the flexibility to swap domestic
currency funding into other currencies. At this juncture, I'm also pleased to inform you that a
Malaysian corporation recently issued the largest-ever sukuk issue in the world amounting to
equivalent USD4.7 billion which was two times oversubscribed. This hybrid sukuk which has
both equity and debt natures is one of the several innovative instruments that has been
issued in the sukuk market.
Malaysia's development of Islamic finance has contributed positively to our overall financial
system in several respects. This has resulted to a more diversified financial system that has
increased its overall resilience. Secondly, it has increased our international linkages. Thirdly,
it has also contributed to greater financial inclusion particularly in the area of financing for
small and medium scale enterprises and micro financing. Then, enhanced with the in-built
checks and balances, it contributes towards financial stability. Finally, Islamic finance has
become a new area of growth that has become very vibrant in generating income, wealth
and employment.
Opportunities in Sukuk
In the current liberalised and globalised environment, Islamic finance is now at the threshold
of a new dimension in strengthening financial inter-linkages between nations in the global
economy. With the expanded scope of activities in Islamic finance, the Islamic bond market
or Sukuk market has fast become an important avenue for
fund raising and investment
activities. The Sukuk market has registered a remarkable growth, increasing at an average
annual rate of 40 percent with a current size of more than USD82 billion. The vast potential
in Sukuk market in the international financial system indeed represents the crest of a new
wave of innovation in Islamic finance. This is evidenced by the active participation of a great
number of global players such as investment banks, Islamic banks and securities firms in the
issuance of Sukuk.
The Sukuk market brings with it great benefits to both issuer and investors. For issuers that
include government agencies, multinational corporations and multinational development
institutions, Sukuk plays a multi-faceted role in meeting different funding requirements
ranging from large infrastructure and developmental projects to capital and business
expansion. This is particularly important for emerging market economies. The Middle East
and Asia currently represent the two fastest growing regions in the global economy. These
regions are aggressive in their privatisation efforts and in the implementation of infrastructure
and developmental projects. Asia alone will be spending an estimated USD1 trillion on
infrastructure over the next five years, while infrastructure requirements in the Middle East
are estimated to be USD700 billion over the same period.3 While in Malaysia, the National
Economic Regional Corridor plan requires an estimated USD192 billion (RM620 billion) of
investment.4
On the demand side, the issuer also benefits from the competitively attractive pricing of
Sukuk ranging from 10 to 20 basis points lower than mainstream bonds. This has resulted
from the continuous over subscription of the sukuk which has ranged from two to thirteen
times. The phenomenal demand for sukuk is further reinforced by excess liquidity in the
global financial system. This demand comes from a relatively wider investor base that
comprises both the conventional and Islamic investors. The strong demand for sukuk has
also been spurred by the higher level of surplus savings and reserves in Asia. In the case of
Japan , apart from the high savings rate, Japan has the largest percentage of high net worth
individuals wealth distribution in the Asia Pacific.
From the investors' perspective, besides the intrinsic value of sukuk which is largely
assetbacked, convertible to shares and exchangeable with shares, there are benefits of
diversification. Sukuk is fast becoming a new asset class. Sukuk has also generated good
investment returns for investors arising from its higher pricing in the secondary market due
to the "buy and hold" preference and its scarcity.
Opportunities in takaful
The other opportunities in Islamic finance are in the takaful or Islamic insurance and
retakaful. The global takaful market, in particular, has also undergone positive developments at
the international level. From only a single takaful company being in existence more than
twenty years ago in Sudan, the takaful industry has now expanded with the establishment of
more than 50 takaful companies worldwide with a total contribution estimated at about USD3
billion for the year 2005. The takaful industry is expected to grow at about 20% per annum to
reach USD7.4 billion in global annual contributions over the next ten years.5 It is also
encouraging to note that the number of retakaful companies have also grown in tandem with
the increased number of takaful companies.6 The need for strong and credible retakaful
operators globally is important to complement the growth and expansion of the takaful
industry.
Let me turn to Japan's potential participation in Islamic finance. We welcome the participation
of Japanese financial institutions, authorities and corporations in Islamic finance, particularly,
in the Islamic capital markets. Japan thus far has for several decades had a significant
economic role in the Asian region in terms of trade and investment. Japan's investment in the
region is estimated to be USD45 billion over the period of 2004-2006.7 Japan has also been
consistently ranked among the top five investing nations in Malaysia, with investment flows
amounting to 25.7% of the total flows for the period of 2000 to 2006. In 2006 alone, Japan
foreign direct investment inflow into Malaysia was at USD6.1 billion.8 Japan has also
remained a significant partner in trade with Malaysia.
While Japan's economic relationship in investment and trade in the region is well established,
there is a significant potential for strengthening further the financial linkages in future. There
is potential to evolve the direct investment and trade in goods to grow the financial ties.
Islamic finance represents a vehicle that could further deepen our financial relationship and
the regional financial integration process. By enhancing new linkages in this relationship and
the prospect for greater integration, it would contribute towards unlocking potential
opportunities for mutual prosperity of the region.
To advance relations in the area of Islamic finance, a memorandum of understanding
between the Central Bank of Malaysia and Japan Bank for International Corporation (JBIC)
was signed in 2007. There is also a strategic alliance between one of the world largest
Japanese insurance groups with a domestic insurance company in Malaysia which resulted
in the establishment of a takaful company. Efforts can also be focussed on facilitating cross
listing of sukuk in multiple jurisdictions. Japan may also use Malaysia as a platform for
innovation and research in Islamic finance. There are various institutions, including the
industry-owned research and training institute in Islamic finance, the Islamic Banking and
Finance Institute Malaysia (IBFIM), INCEIF and universities which have undertaken research
on Islamic finance. Thus, it is hoped that the Japanese participation in the Islamic financial
markets would contribute towards further international financial integration and thus achieve
a more efficient allocation of resources across borders.
Conclusion
Let me conclude my remarks. The increasing awareness and appreciation of the inherent
strengths of Islamic finance and its tremendous potential for advancement have ignited
interests amongst the global financial community to venture into this new sphere of finance.
Taking advantage of the increasing role of Islamic finance in bringing together different parts
of the world with surplus funds in search of investment opportunities, with those that have
financing needs, will increase these mutually reinforcing prospects. We look forward to
Japan's participation in this new financial evolution.
Thank you.