Growth in Malaysia's Islamic finance market is outstripping that in both the country's conventional banking market and the Islamic industry in the rest of the world. James King looks at the factors fuelling its success. 

Malaysia’s reputation as the centre of global Islamic finance is well deserved. Not only does it dominate the global sukuk market, accounting for 67% of total issuance in 2014, but its sharia-compliant banks have exceeded global norms both in terms of return on assets and asset growth in recent years. Today, the country’s Islamic lenders are expanding sharia-compliant finance to new groups, including the underbanked, while exploiting their regional presence to promote the development of Islamic finance across south-east Asia.

“Malaysia has benefited from strong domestic growth, as well as the performance of other economies in the region, including Indonesia and Singapore. [In turn], Malaysia’s Islamic banks have been enjoying a sustained period of growth,” says Muzaffar Hisham, chief executive of Maybank Islamic, the largest sharia-compliant lender in south-east Asia by total assets.

Sustainable growth

The Banker's Top Islamic Financial Institutions report, published in November 2014, points to the health of sharia-compliant finance in the country. Over the five-year review period, Malaysia's Islamic banks achieved an aggregate return on average assets (ROAA) of 1.8%, up from 1.73% from the 2013 report. This exceeded the global average, of 1.68%, by some distance. More impressively, this hike in ROAA occurred as the country's lenders continued to grow their assets, with 11 banks registering year-on-year asset growth of 10% or higher.

The impressive growth of the sector was also picked up on by rating agency Moody's. "Islamic financing increased 15% year on year to December 2014. This is three times faster than conventional banks. [Moreover], 25% of all loans in Malaysia are sharia-compliant. This is up from 16% to 17% just five years ago. To a certain extent this mirrors the appetite of larger Malaysian banks to conduct more financing in Islamic form,” says Eugene Tarzimanov, vice-president and senior credit officer at Moody's.

Two factors, in conjunction with the country’s overall economic performance, are responsible for this stellar growth. On the one hand, personal financing options, particularly household, auto and credit card-related products, have experienced surging demand in recent years, while small and medium-sized enterprises and larger corporates are also turning to sharia-compliant lending financing to support their growth.

“We expect this type of growth to continue. What gives us confidence is that the Islamic banks aren’t overstretching themselves. A lot of the growth in the sector is the conversion of conventional clients within larger banking groups to the Islamic business unit. Conventional clients are essentially refinancing through Islamic means,” says Mr Tarzimanov.

Helping hand

Meanwhile, the Malaysian government has worked hard to structure an attractive environment for Islamic finance. This has enabled world-leading innovation in Malaysia’s Islamic finance space, which in turn has opened up new opportunities in terms of product and service offerings for the country’s lenders.

“Regulatory support for Islamic finance in Malaysia has levelled the playing field for sharia-compliant lenders, offering clarity and stability. Encouragingly, stronger government support is also emerging from other Association of South-East Asian Nations [Asean] jurisdictions which are a promising development for Islamic finance in the region,” says Mr Muzaffar.

In 2013, the Malaysian government introduced the Islamic Financial Services Act (IFSA) as means of harmonising previous regulations covering sharia-compliant financial services. The act also strengthened the foundations of the banking sector’s sharia governance mechanisms by ensuring that the institutions themselves bore full responsibility for the end-to-end sharia compliance of their policies, procedures and operations. This principle has provided more leeway for lenders, in particular, to pursue innovation across their product and service delivery.

“The [act] gave the industry a much-needed confidence boost for both finance providers and consumers. It helped to reduce some of the uncertainty that existed between the courts, the central bank and sharia advisory council, and to provide more clarity in terms of dispute resolution, governance and consumer protection. To strengthen the industry, we have to make sure that we continuously improve the environment in which we operate,” says Badlisyah Abdul Ghani, chief executive of local Islamic lender CIMB Islamic.

New trends

Despite this supportive environment, Malaysia’s Islamic banks are facing a number of challenges. As a whole, the sector remains highly competitive. As such, the prospects for consolidation remain high in what is quickly becoming a saturated market, particularly on the personal financing side.

In January 2015, a proposed three-way merger between CIMB Group Holdings, RHB Capital and Malaysia Building Society, to create a regional ‘mega bank’ and one of the largest Islamic banks in the world, fell through. Citing the ‘current economic environment’, the banks also noted that they were not able to arrive at a ‘value-creating transaction for all stakeholders’. For now, the acquisition of smaller independent banks by some of the larger lending groups in the country is regarded as a more likely medium-term scenario.

"As far as CIMB Islamic is concerned, it was an opportunity that would have provided us with a bigger capacity to deliver our products and services to the market. Whenever such an opportunity presents itself, we have to consider it,” says Mr Badlisyah.

In conjunction with this competitive environment, a number of near-term impediments are also emerging. As part of the IFSA, Malaysia’s Islamic banks have until June 2015 to separate Islamic deposit and investment accounts. Under deposit accounts, the funds are guaranteed while investment accounts carry no such provision.

“Previously, deposits and customer funds were insured and classified in mostly the same way. But in June, about half of sharia-compliant deposits [the investment accounts] will be ineligible for deposit insurance. The industry will probably cope with this by adjusting the funding rates,” says Mr Tarzimanov.

In addition, this adjustment is expected to have significant implications for the domestic sukuk market. “I expect to see Islamic banks become more active in terms of debt issuance. They might issue more than they did last year to cope with the funding challenges and this deposit transformation,” says Mr Tarzimanov.

Good prospects

Beyond bank issuances, the sukuk market is expected to play an increasingly important role in funding large infrastructure projects in Malaysia and south-east Asia, as well as in the Gulf countries. "I expect and foresee the sukuk market to have a prolific year in 2015, albeit with a slower start. The previous model of issuers coming up with two tranches – of conventional and Islamic debt – is slowly diminishing. Instead I think we will see a focus on issuing the whole funding requirement in sharia-compliant terms,” says Mr Badlisyah.

As competition among Malaysia’s Islamic banks intensifies, most lenders are now driving into new markets, at home and abroad, to pursue the next stage of their growth. In early 2015, CIMB Islamic announced plans to offer financial services to Malaysia’s underbanked groups. While the lender is still studying its strategy, as well as the regulatory implications of operating in this space, the longer term aim is to approach this market from a regional perspective by harnessing the opportunities offered across the Asean member countries.

“In Malaysia, there is a large pool of people without access to financial services, essentially the ‘unbanked’ market. We believe that it is our obligation to cater to that segment and to ensure that financial inclusion is appropriately facilitated. CIMB Islamic's aim is to offer a full wealth management service and product suite, from microfinancing to microsavings and advisory services,” says Mr Badlisyah.

Meanwhile, other lenders are also looking to south-east Asia for new growth opportunities, both in frontier and developed markets. “Over the past couple of years Maybank Islamic enjoyed strong growth in both Indonesia and Singapore. Last year, our Indonesian unit recorded the third fastest asset growth among sharia-compliant lenders in the country. Moreover, Islamic finance has an important role to play in Asean integration. This will help to develop a more competitive industry and one that will benefit communities across the region,” says Mr Muzaffar.

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