Malaysia takes the lead

At the opening dinner of the Malaysian central bank's 50th anniversary conference in Kuala Lumpur in February, Malaysian prime minister Datuk Seri Abdullah Ahmad Badawi told the audience of visiting central bankers and economists that the development of Islamic finance will be critical to the country's future success.

The prime minister stressed the importance of Islamic finance as an alternative channel for intermediation and its competitiveness in terms of products and services. He was also keen to point out that Malaysia intends to leverage its experience in the sector as it continues to build the country as a regional – or even global – hub.

Malaysia has already gone a long way towards laying the foundations for its Islamic finance ambitions by way of tax incentives and business-friendly policies. In 2000, the government set out a 10-year masterplan that put together the strategic directions for the country's banking and capital markets. In late 2006, the Malaysian International Islamic Financial Centre (MIFC) was set up to co-ordinate the various efforts by government and regulatory bodies.

Generous benefits

The range of tax benefits is generous. They include: a 10-year tax exemption (to 2016) for local players setting up Islamic business units, and for international Islamic banks and international takaful (Islamic insurance) operators; a tax exemption up to 2016 on the management fees received by fund managers for managing Islamic funds; and withholding tax exemptions on profits received from sukuks issued in Malaysia.

As a result of this supportive environment, the country now boasts a vibrant Islamic banking and finance industry with 14 Islamic banks (of which four are foreign) and eight takaful operators. More tellingly, according to figures from Malaysia's central bank, Bank Negara Malaysia, the country accounts for 61.4% of outstanding global sukuk bonds in volume of issues, and 76% of new sukuk issuance by value. It has the world's largest Islamic unit trust industry, with 134 trust funds boasting a net asset value of more than $5bn. More than 86% of securities listed on Bursa Malaysia are sharia-compliant; at the end of 2007, this represented a market capitalisation of $213bn and 64% of total market capitalisation.

Benefit from the crisis

Islamic finance still has a long way to go in absolute terms: it represents just 17.42%, or RM251.1bn ($68bn), of total Malaysian banking assets (against the government's target of 20% by 2010) and 7.6%, or RM10.6bn, of insurance assets. But many believe that vigorous future growth is all but guaranteed. Prime Minister Abdullah is one of a growing number who believe that Islamic finance's time has come. As Western finance reels from the collapse of over-leveraged structured products and imprudent lending, Islamic finance's principle of risk sharing and the linkage of financial transactions to tangible assets has a powerful resonance.

"Because Islamic finance principles are more conservative, Islamic financial institutions have fared better than conventional banks during the financial crisis," says Mohamed Rithuan Dato' Mohamed Shamsudin, executive director of the Association of Islamic Banking Institutions (AIBI) in Malaysia. "Islamic finance has reached a point where countries and institutions that have not previously considered Islamic finance are looking carefully at the benefits of sukuks and other Islamic financial instruments." He cites the Singapore government's recent sukuk bond and preparations for issuance in countries such as Indonesia, Japan and the UK.

Even before the crisis, the Islamic finance sector was witnessing steady annual growth of about 20%. Some individual products grew by much more. Central bank figures reveal that sukuks averaged 33% growth in the five years to the end of 2007 and the Malaysian bond market is increasingly dominated by Islamic structures. Of total public and private bonds outstanding, 36% are sharia-compliant; and of total corporate bonds outstanding, 56% are Islamic.

Islamic products take hold

Badlisyah Abdul Ghani, chief executive of CIMB Islamic, the world's largest underwriter of sukuk bonds last year, believes this steady growth trajectory is underpinned by the depth of Malaysia's conventional and Islamic investor bases. Both can invest in sukuk bonds. "The fact that sukuks can tap both conventional and Islamic investors broadens the base and injects price tension. This makes the sukuk bond market five to 10 basis points cheaper than the conventional bond market. So if issuing sukuks is cheaper than issuing conventional bonds, why wouldn't you issue a sukuk?" he says.

The retail sector is also experiencing astonishing growth. According to Mr Badlisyah, CIMB's Islamic deposit business grew by more than 100% in 2008, its retail Islamic mortgage business by 28% and its non-residential mortgage business by 33% in the same period. Maybank Islamic boasts similarly impressive figures in its retail and small and medium-sized enterprise banking divisions. In June 2008 it had RM26.9bn of Islamic assets; by December 2008 that had grown to RM31.2bn.

Moreover, take-up of Islamic products and services is divided almost equally between Muslim and non-Muslim customers. Ibrahim Hassan, executive vice-president and acting CEO of Maybank Islamic, says 55% of its corporate customers and 45% of its retail customers are non-Muslim. This broad level of acceptance has been helped by increasingly competitive pricing, which can only drive further growth, says Mr Hassan. "When we first began to offer Islamic products they were more expensive, but as the market matures they are on a par – if not cheaper – than conventional products. When the market sees this kind of take-up, banks have to have an Islamic finance offering."

Islamic players are also tapping a burgeoning wealth management space. Malaysia's RHB Islamic Bank recently signed an agreement with three fund management companies (AmInvestment Services, HwangDBS Investment Management and RHB Investment Management) and two takaful companies (Takaful Ikhlas and MAA Takaful) in an effort to drive its Islamic wealth management business. As with the corporate and retail segments, there has also been take-up from non-Muslims, many of whom use sharia-compliant investments as a proxy for ethical investment.

The increasing penetration of Islamic products and Malaysia's growing importance as an Islamic financial centre cannot only be ascribed to government stimulus; much of the growth is based on the development of competitive products and structures for both corporates and retail customers, says Mohamed Faiz Azmi, partner and global Islamic finance leader at PricewaterhouseCoopers Malaysia. "The growth of Islamic finance is all about choice. Malaysian financial institutions believe that offering Islamic products gives them a competitive edge. This has driven the sector to be very innovative and it has been a pioneer in several sectors," he says.

This includes the first corporate bond based on ijarah (leasing), issued in 2004, and the first mudharabah Islamic bond, issued in 2005. In 2006, an exchangeable sukuk musharakah (the world's first sukuk bond to incorporate full convertibility features previously only found in conventional equity-linked instruments) was issued out of Malaysia.

"Malaysian institutions have demonstrated their ability to use sharia law as a springboard for innovation. If they can demonstrate the superiority of these products then corporates and consumers will take advantage of them," says Mr Azmi.

Detachable warrants

Last year, Maybank Investment Bank (formerly known as Aseambankers) chalked up another record when it launched the world's first redeemable Islamic sukuk with detachable warrants, based on the Islamic principle of musyarakah. By holding the warrants from the RM300m transaction, existing shareholders of Malaysian engineering company WCT will be able to purchase WCT shares at a cheaper price than the market offers, if and when they are in the money. WCT shareholders will be entitled to a renounceable rights basis of one warrant for every five existing subdivided WCT shares.

Maybank got around the concept of detachable warrants – controversial under Islamic principles – by turning them into 'grants', a solution that could become a blueprint for other issuers. "Maybank built on concepts applied to earlier convertible sukuks in coming up with this structure," says Feisal Zahir, head of investment banking at Maybank Investment Bank. The marketing of the grants by WCT was approved by Maybank's sharia board and that of the Malaysian Securities Commission. Ownership of the warrants represents legal ownership of an asset – the claim on shares in the company. "This kind of innovation is what makes the Malaysian market so dynamic," Mr Zahir adds.

Such determined innovation spreads well beyond the capital markets. Maybank Islamic's Mr Hassan says the bank is developing a range of treasury products based on the Islamic concept of wa'ad, or 'promise'. "It is essential we focus on product development because if we are to compete with conventional banking, we must be able to offer our clients the kind of treasury and other products that enable them to manage their business," says Mr Hassan.

FX forwards

One such product group under development at Maybank is sharia-compliant foreign exchange products, such as forwards, which the bank hopes to launch by July. Forward dealing transactions have always been a tricky proposition for Islamic banking because many of their key attributes contradict Islamic banking principles of certainty and transparency. The conventional forward contract, for example, where both payment and delivery are made at a future date, is deemed un-Islamic because the transaction is agreed and binding, but payment and delivery remain uncertain.

The deferred contract means that only one party carries the potential losses. Eligible contracts that cater for future transactions, such as the bai salam and bai istisna (where payment is made upfront for goods that are delivered or manufactured on a staggered basis), never became popular because they have so many restrictions.

With wa'ad, the rules are less strict. Because it is a 'promise' it is non-binding. And because it is unilateral, both parties can choose not to make good their promise. Under sharia, this means that the details of the promise are not fixed as they are in other contracts, and that the restrictions to which other contracts must strictly adhere – such as time of delivery, price, terms of payment and the goods' detailed description – do not apply.

"This sort of flexibility, which is central in the structuring of many products common in conventional banking, means that wa'ad has a great deal of potential," says Mr Hassan. "We have many GLC [government-linked companies] clients and big corporations waiting for these kinds of products."

But while many people have predicted that Islamic products would benefit from the limiting of Western finance, the figures coming out of the sukuk market tell a different story; just like other credit markets, global recession stopped issuance in its tracks. From a record high of $30.8bn in 2007, sukuk issuance plummeted by 56% to $14.9bn in 2008, according to ratings agency Standard & Poor's (S&P). Malaysia, the world's largest sukuk market, was hit hardest with a drop of 59%, followed by the Gulf states with 55%.

"In export-dominated economies such as ours, less demand naturally means fewer financing needs," says Jamil Hassan, principal Islamic finance consultant at technology firm Oracle. "It does not matter how much its reputation for prudence has been enhanced – if the appetite for debt isn't there and the cost of borrowing is rising, then Islamic finance will be hit just like any other market."

The slowdown has also affected the sovereign market. While Singapore went ahead with its $200m issue in January in a bid to develop its own nascent Islamic financial industry, Indonesia, Japan and Thailand have all delayed sukuk issues because of weak market conditions. S&P estimates that more than $45bn of sukuk are waiting to be issued.

CIMB's Mr Badlisyah believes that the global market may shrink further, to $13bn this year, and in Malaysia to about $5bn or $6bn. With yields reaching more than 11 percentage points above the benchmark London interbank offered rate, such a decline is unavoidable. "Higher yields have deterred many corporate issuers in Malaysia and the Gulf states, and the fall in the oil price has reduced the appetite of Middle Eastern investors, who are the main buyers of the bonds," says Mr Badlisyah.

More worryingly for some observers are disagreements about sharia compliance. Some fear that Malaysia's drive for innovation may have pushed the Islamic envelope too far.

In January this year, ratings agency Moody's Investors Service issued a report which argued that, while much of the fall in sukuk volumes was due to the travails of the broader credit markets, a ruling by the Bahrain-based Accounting Auditing Organisation for Islamic Financial Institutions (AAOIFI) had also discouraged issuers and investors. The Moody's report referred to a comment from AAOIFI early last year, which recommended that Islamic financiers should refrain from issuing sukuk structures that have a purchase undertaking or a guarantee from a sukuk issuer to repurchase at a future date because it believed this structural mechanism does not comply with the sharia principles of profit and risk-sharing.

This criticism, levelled at many of the sukuks issued under a Malaysian interpretation of sharia law, is vigorously refuted by CIMB's Mr Badlisyah. He believes the debate is more about competition than about sharia compliance. "Before we structure any sukuk products, we are always rigorous in looking at what is permissible under sharia," he says. "There are different schools of thought, but as long as a product complies with sharia law, each school is allowed to follow its own interpretation."

Contract questioned

Other criticism is closer to home. Last July, a Malaysian High Court judge ruled that the application of Al-Bai' Bithaman Ajil (BBA) – an Islamic home loan financing contract popular in Malaysia but criticised in other Islamic jurisdictions – is contrary to the Malaysian Islamic Banking Act of 1983. The judge ruled that the sale element in the BBA was not bona fide, and questioned the profit portion of the facility.

The BBA contract is a deferred payment sale at an agreed selling price, which includes a profit element agreed by the customer and the bank. The profit is allowed since it is derived from the buying and selling of the house and not from interest accruing from the principal amount lent out. The High Court judge, however, argued that where the bank purchased directly from its customer and sold back to the customer with deferred payment at a higher price in total, the sale is not a bona fide sale but a financing transaction, and the profit portion is therefore contrary to the Islamic Banking Act.

The calculation of the profit portion is particularly relevant in cases where borrowers have defaulted. Bank Negara Malaysia has subsequently formulated a 'rebate' concept – under which borrowers pay back a sum related to the length of time they had the loan, rather than the sum agreed at the outset of the full-term loan. But the case, which is a collective judgment for 11 cases involving Bank Islam Malaysia and Arab-Malaysian Finance, is still being appealed, and the High Court judgment could have far reaching effects if is upheld.

Calls for standardisation

Such disputes about the legitimacy of products from different jurisdictions fuel calls for greater standardisation, but PwC's Mr Azmi thinks that this argument is overplayed. "There is, anyway, increasing harmonisation of products across different jurisdictions, but will always be different interpretations of sharia law," he says.

Vince Cook, CEO of Islamic Bank of Asia, a Singapore-based joint venture between 30 shareholders in the Gulf Co-operation Council and Singaporean bank DBS, believes that instead of focusing on intra-Islamic debate, it is more important the Islamic finance industry is incorporated into the broader debate about global standards and global finance. "Recommendations from AAOIFI and the Islamic Financial Services Board are already subsidiary to national legislation and global regulation. It is more important that we, as an industry, also play a role in the global institutions that shape global finance, such as the Bank for International Settlements, [the] Basel [Committee], the World Bank and the International Monetary Fund," he says.

For others, the call for standardisation asks Islamic finance to do what conventional finance does not. "Why should Islamic finance be expected to have a single standard for every product or offering when conventional finance does not?" asks Mr Badlisyah. "If I want to list a company in New York, I would have to fulfil a set of regulatory and legal requirements specific to that jurisdiction. If I want to list that company in the UK, I would have to adhere to a separate set of requirements," he says. "Why should it be any different for Islamic finance?"

Gloomy sukuk volumes and internecine disputes aside, the outlook for Islamic finance in Malaysia is still better than for conventional markets, says Mr Azmi. "Islamic players are the most bullish. They're not leveraged and their balance sheets are clean."

Other bankers share this upbeat perspective. Maybank's Mr Hassan agrees that Islamic banks have an edge over conventional banks. Not least, he says, because those with a strong capital base will be able to pick up business from GLCs, the privatised or partly privatised companies over which the Malaysian government still has considerable influence, such as energy utility Tenaga, the fourth largest listed company on Bursa Malaysia.

Promising future

With the government preparing to pump $16.2bn into the economy, and with Islamic finance targets to reach by next year, this considerable chunk of the Malaysian economy holds promise, says Mr Hassan. "Domestically, we are seeing considerable interest in the take-up of Islamic finance by the GLCs, other large corporates and small and medium enterprises, and this could amount to quite significant business. Banks with a large enough capital base, such as Maybank, are in a good position to pick up a lot of that business."

The continued liberalisation and internationalisation of Malaysian markets – which the central bank has said will continue despite the downturn – will also provide a lot of growth opportunities for well-placed banks, says John Chong, head of debt markets at Maybank Investment Bank. "Malaysia has gone a long way to develop its domestic capital markets. There is now a big push to develop Malaysia as a market for international currency business," says Mr Chong. "As we have a head start in Islamic finance, we are in a good position to capture business from foreign companies that want to tap the Islamic finance market."

Many supporters of Islamic finance hope the current crisis is a chance for the sector to take a bigger share of global banking and capital markets. This is especially true of south-east Asia. In January, US-based financial consulting firm Celent released a report saying the crisis had made the Asia-Pacific region far more attractive to Middle Eastern investors than the West. With assets valued at $68.4bn, Malaysia already has the world's third biggest Islamic banking market after Iran and Saudi Arabia, and the report says investors from Saudi Arabia, United Arab Emirates, Bahrain and Qatar are now channelling funds to developing countries such as China, India and Indonesia.

Plenty of competition

But these flows are by no means guaranteed. With Middle Eastern investors suffering from lower oil prices, investment has slowed, as plummeting sukuk volumes show. Moreover, competition is hotting up. If there is already a battle for financial hub supremacy between Malaysia and the Middle East, then Singapore's sukuk issue in January, and Thailand and Japan's tabled issues, signal that non-Muslim majority nations in the region have also woken up to the growing potential of Islamic finance. Financial institutions in South Korea are also reportedly lobbying the government to build the necessary legal and regulatory framework to facilitate Islamic finance there, while the Hong Kong government is interested in promoting the territory as an Islamic finance hub.

Malaysia's central bank has shown that it is well aware of competitive pressures. It continues to cement its lead through strategic partnerships – such as that signed with the UK in February to "pave the way towards bridging Islamic financial markets between the East and the West" – and initiatives such as the Shariah Research Academy, which it established last year.

Islamic finance has certainly proved itself less susceptible to the excesses that have brought conventional finance to its knees. But as it grows beyond the fringes of finance it will need to prove it can combat its own vulnerabilities, such as over-exposure to real estate and the difficulty of developing structures that comply with the different interpretations of Shariah law. "The BBA case is a sign that Islamic finance has failed a stress test," says Oracle's Mr Hassan.

Ibrahim Hassan, executive vice-president and acting CEO of Maybank Islamic