Regulating success: Recent reforms will provide the sector with the support it needs

The Islamic financial services (IFS) sector has been growing rapidly in Malaysia in recent years. As a result of government promotion, increased interest among both Muslims and non-Muslims, heightened awareness of the benefits of Islamic finance and improved regulation, sharia-compliant financial products have been gaining on conventional finance. According to the IMF, Islamic capital markets in Malaysia tripled in size between 2000 and 2010; at the end of 2010, the fund says more than half the country’s financial assets were sharia compliant. Bank Negara Malaysia (BNM), the central bank, said Islamic banking assets now account for 25.7% of total banking assets. The government is still pushing to increase this, and efforts to popularise and refine Islamic finance in Malaysia are sure to result in higher participation over time.

Long History

Malaysia’s first experience with Islamic finance occurred in 1969 with the establishment of the Pilgrims Management and Fund Board, which helped religious pilgrims deal with the financial challenges of the hajj. The 1983 Islamic Banking Act gave BNM the authority to regulate the sector, and Bank Islam Malaysia was established in the same year. The Takaful Act then passed in 1984. The Islamic Interbank Money Market was launched in 1994, and in 1997 the Sharia Advisory Council was established to advise the central bank on matters related to Islamic products and to evaluate new offerings. After 2001 foreign Islamic banks were allowed in the country, as were Islamic subsidiaries. Established in 2002, the Islamic Financial Services Board (IFSB) is a global standards-setting body that deals with a wide range of issues, including risk management, corporate governance, sharia and capital adequacy.

According to the Malaysia International Islamic Financial Centre (MIFC), major firsts in the sector include: the sale of ringgit sukuk, or Islamic bonds, by a foreign company in 1990; selling global sovereign sukuk in 2002; the sale of supranational sukuk in 2004; new mortgaged-backed, sharia-compliant securities in 2005; the first sale by a Middle Eastern Islamic bank in the local market in 2005; and the establishment of the Islamic Real Estate Investment Trust in 2006. Innovation continues, and some of the products are becoming highly sophisticated. In 2014 AmIslamic Bank issued a Basel III-compliant sukuk for Tier II capital, and RHB Bank and Public Bank quickly followed. Islamic endowments, which have traditionally invested in real estate, are also considering having their assets run by fund managers. Six states are reported to have considered so-called cash awqaf, with the first established by the state of Selangor and managed by Bank Muamalat Malaysia.

Banks & Takaful

Malaysia operates what the IMF calls a dual system, as opposed to systems where only Islamic services are offered. As a result, the Islamic side of the sector has to compete directly for deposits and loans with the conventional side.

According to BNM, Malaysia has a total of 16 Islamic banks, and in terms of assets they are some of the largest in the world. The three biggest in the country are RHB Islamic Bank, Maybank Islamic and Kuwait Finance House (Malaysia), and out of the 16, six are foreign owned. The country also has five international Islamic banks. The latter are restricted to mainly non-ringgit business for non-residents, though they can work with domestic customers and in the local currency under limited circumstances.

According to BNM, the country has 12 registered takaful, or sharia-compliant insurance, operators, while the takaful association has 15 members, including three takaful reinsurers. The MIFC said half of all outstanding debt securities are sharia compliant, while 89% of listed securities are compliant. The annual trading volume of the IFS market is greater than RM1trn ($312.1bn). According Adnan Alisa, the CEO of the Islamic Banking and Finance Institute Malaysia, IFS accounts for around 11% of the total employment in the country’s financial sector.

The government has facilitated the development of the sector by providing a favourable environment, as well as playing an instrumental role in promoting its development. The Financial Sector Master Plan (FSMP) 2001-10 set a goal of sharia-compliant deposits accounting for 20% of the total. Up until the FSMP, the country had only two Islamic banks in operation. A decade later, the sector has developed substantially. Now the country has an elaborate ecosystem of regulation, supervision, accreditation, standards and education for Islamic finance, a unique advantage among countries offering sharia-compliant products.

The Financial Sector Blueprint (FSB) 2011-20 calls for further development of the industry. The FSB discusses more innovative sharia-compliant products and a strengthening of ancillary services, improvement of delivery channels, training of talent, and continued refinement of regulation and supervision. The FSB also contemplates creating a single institution to be responsible for decisions regarding all sharia matters, according to a report from Wong & Partners.

Global Player

The ultimate aim is to further internationalise Malaysian Islamic finance. The country already boasts a strong and well-respected IFS sector, and its continuous efforts to make its various products and offerings attractive to the financial market as a whole have been largely successful. For example, at present half of Islamic bank customers are non-Muslims. However, the country is hoping to go from having a good domestic IFS sector to being a world leader. Competition between different cities and countries has been intense, with Dubai being the main contender and London fast gaining ground. Malaysia is at the front of the pack in many respects, with more sukuk, Islamic banking assets and well-developed scholarship programmes on the subject, but it would like to cement its position and make sure that it gets a sizeable share of the international market (see analysis).

Liberalisation of the market has already been significant. Foreign investors can own up to 70% of Islamic banks and takaful companies, raised from 49% in 2009. In recent years, foreign banks have also been showing considerable interest in the sector. Mitsui Sumitomo Banking was awarded a licence to offer IFS, and in early February 2014 the bank, Japan’s second largest, started offering sharia-compliant foreign exchange via its local subsidiary. Two other Japanese banks are already active in the Malaysian Islamic market, Bank of Tokyo-Mitsubishi UFJ, with Islamic loans since 2008, and Mizuho Financial Group, with Islamic trade since 2012. Japanese regulators have allowed the country’s banks to engage in Islamic finance through overseas subsidiaries, though Japan has no IFS regulations at the local level. Many conventional banks are starting to build up their Islamic capabilities in order to keep up with demand as sharia-compliant financial services grow.

IFSA

One of the biggest advances for the sector in recent years has been the Islamic Financial Services Act (IFSA). The act, passed in 2013, replaced the 1983 Islamic Banking Act and 1983 Takaful Act. As with the Financial Services Act (FSA), the IFSA will significantly increase the level of regulation in and supervision of the sector. It gives the central bank extraordinary powers to intervene in the operations of all financial institutions in the country in order to reduce systemic risk and protect consumers. Financial holding companies are to be vetted by BNM, and the central bank reserves the right to prevent changes in the corporate structure if it feels they will weaken the institution or endanger the financial system. And as with the FSA, the IFSA allows BNM to impose significant penalties, including fines and imprisonment, for non-compliance.

A number of sections in the act will lead to immediate and significant changes within the sector. Deposit products, which are insured, are going to have to be separated from investment products, which are not insured, and financial institutions are now required to inform their customers of the difference between the two. Under the 1983 Islamic Banking Act, for example, all customer funds were considered to be deposits, and thus all monies were protected under Perbadanan Insurans Deposit Malaysia (PIDM). Mudarabah investment, or profit sharing arrangement, products had a guarantee on capital. Now, under the IFSA, they are to be classified as risk products, and customers will have to accept any potential losses on their principal. All IFS institutions have been given until June 30, 2015 to make the change. Until that time, all customer funds will be protected by the PIDM.

The IFSA, like the FSA, will also greatly affect insurance products. Takaful companies will be required to separate their life and general insurance business licences. Each line will need to have its own board of directors and be independently capitalised. Previously both life and general takaful could be covered together by the required RM100m ($31.2m) minimum capital. However, what is most significant about the IFSA is the way it deals with sharia. The act not only targets financial issues and concerns related to safety and soundness, but concerns itself directly with the religious interpretation of sharia compliance. As with the rest of the act, the provisions are strict and the penalties severe. IFS companies will be under scrutiny to ensure that all their operations and every step of the process are sharia-compliant, and sharia scholars will now be legally responsible for the products they approve. Any infractions must be reported to the regulator immediately. “The IFSA ensures end-to-end sharia compliance,” said Zainal Hasfi Hashim, deputy director of BNM’s Islamic Banking and Takaful Department.

Takaful

Some weaknesses in Malaysia’s IFS sector have also been observed. Takaful business has, for example, been particularly slow. The product currently accounts for about 13% of the total life insurance and takaful market, and the hope is that its share will reach 20-25% in five years. But after a long period of exceptional growth, the market has stagnated a bit. It is not clear why this has happened, though awareness is low, with an estimated 30% of Muslims aware of takaful and only 16.5% of those have policies. “For the past five or six years, our growth has been tremendous, but we saw a major drop in business in 2013 of 2% after seven years of double-digit growth,” said Tuan Azza, senior researcher at the Malaysian Takaful Association. “After seven years, the product needs to be enhanced.”

While the growth of takaful is seen as rebounding, challenges will continue. Capital, for example, will remain an area of focus. Risk-based capital, introduced in 2009, has put weaker firms in the spotlight and has raised the cost of doing business for the entire sector. It has also led to a considerable burden in terms of compliance costs and time spent meeting the new requirements. Creating a legal framework remains very much a work in progress, and regulators continue to focus on implementing and refining requirements. In late 2012 BNM issued the Risk-Based Capital Framework for Takaful Operators, which included restrictions on the payment of dividends. It, quite reasonably, prevents takaful operators from making dividend payments if those payments would put them beneath the required capital threshold. But an update in the rules now makes the conditions even more onerous. According to a paper by Actuarial Partners, an actuarial consultancy in Malaysia, all dividend payments, regardless of whether they threaten capital levels, require prior BNM approval.

New Rules

Other tweaks for takaful include changes in the way operational expenses are charged to takaful funds and the way appointed actuaries are engaged. A BNM concept paper calls for takaful operators to hire full-time appointed actuaries, rather than contracting them, and says a pricing actuary must not be the same person as the appointed actuary. This suggested change raises the possibility that a company that once used one actuary will now need four, given the fact that family takaful and general takaful must be split.

According to Actuarial Partners, until recently the takaful sector was basically left to its own devices, which resulted in a significant regulatory gap between traditional and Islamic insurance products and created arbitrage opportunities between the two markets because equivalent products attracted very different capital charges. Risk-based capital changed all this, the consultancy asserts, and the sector is now driven by regulation. The report also said this could fundamentally alter the takaful business in ways not all that positive for the consumer. Actuarial Partners anticipates a rush toward less capital-intensive products, such as those that are investment linked, which shifts the risk to the customer. It also worries that the consumer will now have to pay for the cost of tied capital, resulting in an increase in premium prices, thus harming inclusion. On the same note, the higher capital and compliance costs may force some takaful companies away from offering small policies, which are expensive to sell and distribute and generate very small premiums. “The question that can be asked is whether this move is premature as takaful has yet to develop to its fullest potential. There is a risk that because takaful has yet to fully develop, imposing more regulations will stifle innovation in the industry,” the report concluded.

In 2013 BNM issued a concept paper suggesting improvements to the takaful segment. The central bank introduced a framework that would allow for more flexibility and improve productivity, and discussed the deregulation of commissions, as well as the expansion of channels and improvement of disclosure for consumers. The concept paper also contemplates improving the financial strength and minimum qualifications for brokers, relaxing the limits on financing options from brokers and creating incentives to encourage more sales by direct channels. A number of key performance indicators were published, with the percentage of banking customers buying bancassurance, or banctakaful, set to increase from 5% to 10%.

However, regulation is also resulting in some unintended consequences. With the increased compliance and disclosure burden, as well as the requirement to split businesses into both life and non-life lines, the need for qualified people to staff key positions has put Islamic finance under pressure to find more highly qualified individuals. According to comments made by Ernst & Young, it is expected that the takaful sector will expand to 19 companies, each with identical needs for staffing at higher levels. Added to this is the fact that the people taking the jobs not only have to master the technical side of their relevant position, but must also know how to do it within a sharia-complaint context.

Consolidiation

Consolidation is seen as inevitable. With stronger regulations, tighter capital requirements, and the need in many cases to independently finance and run insurance units, companies are likely to start buying businesses to make their operations bigger or selling units so they are not burdened with the costs of transition. Good possibilities for mergers and acquisitions include Takaful Ikhlas and Syarikat Takaful Malaysia, according to local press reports. The sector is already fairly concentrated, with the top three companies controlling an estimated 90% of assets and the rest of the sector fighting for what remains.

So far, most of the merger action has been in the conventional sector, but with the IFSA and new capital requirements for the IFS sector, it is expected that the Islamic side will catch up quickly. While some observers argue that having a large number of takaful companies is healthy and gives consumers a wide range of choices, the reality on the ground suggests that the sector will be much smaller in terms of number of players, larger in terms of overall business, and stronger and better managed in a few years.

One major transaction is already under way. In July 2014 it was announced that CIMB, RHB Capital and Malaysia Building Society will merge and form a mega Islamic bank. While the move seems to be driven from the conventional side, it will also make a big difference in the sharia-compliant world. In addition to consolidation, it is also expected that general takaful will grow as a result of the new regulations. Currently, the vast majority of the assets – 85% – are in life takaful. With the two branches of takaful business being separated, it is possible that the relatively neglected general takaful will now get more attention. Because general and life takaful will be separately capitalised and administered, the business owners are going to have more of an incentive to promote their firms.

Outlook

The IFS sector will no doubt continue to expand, and rapidly at that. Regulation may create new challenges for some businesses in the sector, but it will also increase confidence in and understanding of IFS. Once the sector digests these new rules, it will likely come back stronger and in a better position to take on a larger share of conventional financial services.