Malaysia hosts the most sophisticated and entrenched Islamic finance industry in the world. It permeates all areas of financial services. 88% of Bursa Malaysia’s listed securities are certified as Shariah-compliant; the country hosts 150 Shariah-compliant mutual funds with RM22.08 billion in net asset value, equivalent to 11.52% of the whole mutual fund industry; and the total combined value of outstanding sukuk issues by December 2009 was RM172 billion, or 57% of the entire bond capital market.

Seventeen of Malaysia’s 39 licensed banking institutions are Islamic, with RM233.14 billion in assets between them as of February 10. Rather than being an adjunct to conventional commercial banking – an offshoot, niche offering – Islamic finance has become very much part of the Malaysian mainstream and is expected to continue to grow.

It’s a point of pride to the country’s regulators. “Today, Malaysia has a comprehensive and well-developed Islamic financial system, including a vibrant banking and takaful sector, and well-developed Islamic capital and money markets that operate in parallel with the conventional system,” says Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “Our sukuk market is the largest in the world.”

And if Malaysia’s financial services industry weathered the financial crisis well, the Islamic component did particularly well. “From an Islamic perspective we were fairly insulated from the financial crisis, predominantly because Malaysian Islamic finance players, who are mainly domestic, were not involved in the US sub debt industry,” says Badlisyah Abdul Ghani, CEO of CIMB Islamic. “Also, a slowdown in global Islamic capital markets doesn’t have a negative effect on the Malaysian sukuk market. The level of confidence here is very high: the market has been here since 1990, unlike the international Islamic capital market which dates from 2002.” Developments in the sukuk market are discussed in more detail in the debt capital markets chapter of this guide, while the international fund managers who have come in partly to service Islamic clients are discussed in the asset management section.

Having built a strong domestic industry, the emphasis of recent years has been on turning Malaysia into an international Islamic centre. One sees this in two directions: liberalisation of financial services, allowing more and more foreign entrants to participate; and attempting to attract international capital flows.

Malaysia has long held a more liberal stance on the Islamic side of its banking sector than the conventional, particularly when it comes to foreign participation. In 2009 the foreign ownership limit at local Islamic banks, investment banks and insurance companies was raised from 49% to 70%. Already Malaysia has licensed three wholly-foreign-owned Islamic banks: Kuwait Finance House, Al-Rajhi Bank, and Asian Finance Bank (majority owned by Qatar Islamic Bank). Each of them has built significant operations on the ground, with models varying from corporate finance to a full retail offering. Other financial institutions at least partly owned by foreign houses include the Islamic units of HSBC (HSBC Amanah Malaysia), OCBC (OCBC Al-Amin Bank) and Standard Chartered (Standard Chartered Saadiq).

There is more to come. Last year Bank Negara announced two so-called “mega-bank” Islamic banking licences would be awarded to overseas lenders with capital of more than US$1 billion, alongside new permits for Islamic insurance, conventional global banking and conventional specialized banking. These mega-banks can be 100% foreign owned, provided they become locally incorporated in Malaysia. Bank Negara said at the time the new licences were “to enhance global interlinkages, leverage on global developments in Islamic finance and reinforce Malaysia’s position as an international Islamic financial hub.”

In March Bank Negara Malaysia governor Zeti Akhtar Aziz said candidates had been shortlisted and it is a subject of great conjecture who they might be. They must presumably either be the Islamic arms of multinationals like HSBC or Citi, or some of the more powerful Middle Eastern institutions, although the obvious Middle Eastern candidates – Kuwait Finance House and Al Rajhi – are already here.

The most visible example of Malaysia’s international aspirations is the Malaysia International Islamic Financial Centre (MIFC), launched in August 2006 to promote the country as a hub for international Islamic finance with the backing of government, regulators and financial institutions. Under MIFC, several foreign institutions have been given incentives, varying from tax breaks to relaxed ownership restrictions, to come and set up Islamic businesses in Malaysia. Some fund managers have been given seed capital sourced from the Employee Provident Fund. MIFC embraces sukuk origination, Islamic fund and wealth management, Islamic banking, takaful, and human capital development.

MIFC has certainly attracted plenty of new expertise: on the asset management side, for example, some of the biggest names in the business, such as Templeton, Nomura and Aberdeen, have set up. As a marketing exercise it has indisputably succeeded, but some feel that it has yet to do what it really set out to do and attract international capital to be managed from Malaysia (see the asset management chapter for fund managers’ views on capital flows).

But perhaps it’s just a matter of time. “The drive to develop Malaysia as an international financial centre is a relatively new exercise, slightly above two years,” says Badlisyah. “I can attest that in that short period of time we do have evidence of strong interest from investors from overseas to invest in Malaysia or through the MIFC.” 

Innovation in product development, too, has tended to shift towards cross-border initiatives. The most obvious example is hedging for movements in currencies or interest rates between markets. “Over the last two years the Malaysian market has introduced a number of hedging instruments in the market to give more appropriate risk management for Islamic finance,” says Badlisyah. “Malaysia is the only country that has the Islamic master agreement, a standardized derivatives agreement based on ISDA documentation, established in the market.”

So far, these structures have chiefly been domestic. “When you do cross-border investments, those hedging requirements become more sophisticated than what is typically available in the Malaysian market,” Badlisyah says. “But we are focusing on developing greater capacity for hedging – considering that MIFC is there to facilitate cross-border activities – and those products should be coming out fairly soon.”

Developments like this take time. “Hedging has been on the drawing board for quite some time,” says Mohd Effendi Abdullah, Director and Head, Islamic Markets, at AmInvestment Bank. “People are cautious about hedging instruments, especially after what happened in the US, but it is being looked at.” Mohd Effendi also welcomes the arrival of Bursa Malaysia’s commodity trading platform (see box).

Malaysia has the right infrastructure, the right regulatory backing, the right experience and the right assets to build Islamic finance further and further. So where’s the weak point? Possibly in human resources, and more specifically, in Shariah scholars – the people who sign off on the Shariah compliance of structures and funds.

Certainly, Malaysia has made more effort than most countries to develop professional expertise in Islamic finance – worldwide, perhaps only Bahrain comes close. “We have invested in human capital development to ensure a deep pool of talent and expertise to support the development of Islamic finance,” says Governor Zeti. In particular, Malaysia has established the International Centre of Education in Islamic Finance (INCEIF) and the International Shariah Research Academy (ISRA) as part of its attempts to support advanced education and research in Islamic finance.

Malaysia is unusual in insisting that no scholar can serve on the board of more than one bank – in stark contrast to practices in the Middle East. The idea of this is to force the development of a greater field of scholars in Malaysia, rather than just a small group – potentially a cartel – of people who do everything. It will, though, take time for this policy to mature and in the meantime there is a bottleneck.

Practitioners are already thinking further ahead. “A critical aspect to ensure our long term success as a financial centre is the management of Shariah committees and the Shariah profession,” says Badlisyah. “Malaysia is the only country in the world that has an official Shariah guideline in terms of how Shariah committees are managed, how members are appointed, the qualification required and how banks need to operate their frameworks internally.

“What is missing I believe is the next step in enhancing the industry, to ensure Shariah professionals are deemed professionals in the same manner as lawyers, medical practitioners and accountants, where they have their own self-regulating professional bodies, perhaps even their own legislation. This will enhance confidence in the market and boost Malaysia’s position as the best place to do Islamic finance.”

Building a corpus of Shariah expertise and attracting cross-border flows are perhaps the two biggest challenges facing Malaysia now, but on all counts there are reasons to be positive about development.

“I think this will be quite an exciting year for the Islamic finance industry,” says Mohd Effendi. “Having opened up the industry, local participants will be encouraged and given a catalyst to run faster. I expect a rapid pace of development this year.”

BOX: Bursa’s Shariah challenge

Last August Bursa Malaysia launched a major new Islamic initiative called Bursa Suq Al Sila’. This is an end-to-end commodity trading platform designed to be Shariah compliant, in order to meet the needs of commodity financing and liquidity management both domestically and, increasingly, cross-border.

It uses the Islamic structures of murabahah, tawarruq and musawwamah, and is billed as the first exchange of its kind to encompass a hybrid market, allowing participants a choice between an automated electronic exchange system and traditional voice broking.

The exchange has begun to garner some cross-border success: Gatehouse Bank conducted the first international transaction last year, and is said to have been followed by a number of trades from GCC institutions. “We’ve had daily trades,” says Raja Teh, “and we have a good track record of GCC trades. They still come through Malaysian banks but they are essentially cross-border. So the next phase is to try to admit these GCC banks as members so they could trade with each other: they still use bilateral arrangements now.” Trades have been conducted in ringgit, US dollars and GCC currencies.

While the exchange purports to be Shariah-compliant, that is not an entirely straightforward claim to make. Last April, before the exchange was launched, the Shariah scholars at the influential Fiq Academy in Jeddah issued a fatwa saying that organised tawarruq were prohibited. This appears to undermine the exchange’s Shariah compliance, as the use of an organised bid is, as Raja says, “an inherent feature of the exchange”.

Bursa’s approach has been to look at the reasons they think underpin the fatwa and attempt to address them one by one within the exchange’s structure. “Generally we believe the pronouncement stems from the fact that there had been a couple of fraudulent trades” using tawarruq structures, she says, such as warrants backed with futures contracts, which are definitely not Shariah compliant. But she is adamant that Islamic finance needs a commodity financing exchange. “From an Islamic banking perspective, if we don’t have that, how are we going to manage liquidity, because there’s no instruments available at this point in time.” The market appears to agree with her, as banks have continued to use the platform despite the Fiq pronouncement.

It doesn’t appear that commodity murabaha themselves are the problem: AAOIFI, the main standard setting body for Islamic finance in Bahrain, has issued guiding principles on them. Instead, Bursa has focused on regulating trades to avoid fraud, or trades where the underlying asset isn’t really there. “Commodity suppliers must have a real spot commodity. Because we are a regulator, we can compel an audit at any point in time.” The exchange is also requiring buyside members (the financial institutions) to sign an undertaking that the financing they raise from trades on it will only be used for Islamic finance. Raja doesn’t think that prohibiting trades on the grounds of being organised holds up. “The premise is: clients have now ended up with a commodity that they don’t have any real use for, and which they need to sell for cash – this is the tawarruq element. Scholars are concerned that the trade is organised from day one and therefore not real. But it is real, because the exchange takes it and sells it back to the market.”

Philosophically, standing in the way of this organised approach makes little sense, Raja says. “Where in any of the [Islamic] sources does it say that being organised is haram? Are we saying the more haphazard we become the more Islamic we are? It’s not about organisation, it’s about whether the trade is real, and we are trying to address that through the exchange.”

Practitioners seem to side with Bursa. “The tawarruq principle is quite broad,” says Mohd Effendi at AmIslamic Bank. “It depends how you utilise that principle. In certain parts of the Middle East they are against that product because they say you are using the same asset, transacting with the same parties, and it’s an organised transaction. But with Bursa they have made it a true sales transaction by using the commodity market, with a tripartite arrangement instead of two parties. It is more acceptable.”

A paper expressing Bursa’s position will be presented to the Islamic Financial Services Board annual summit in Bahrain in May, and in time the exchange hopes it can go back to the Fiq academy with an explanation of what it has done and get a more favourable ruling. In the meantime, the technical lack of Shariah compliance with Fiq does not appear to be keeping the industry away: trades on any given day on the new exchange are typically between Rm500 million and 2 billion. The potential is far bigger: pre-crisis, Raja estimates that as much as $100 billion per day of commodity murabaha trades were being conducted, chiefly in the Middle East, all of them through laborious bilateral agreements through commodity brokers.

There were interesting developments in Malaysian Islamic finance last month, where a chief executive move provided a commentary on the rising power of foreign banks in Malaysia while also raising questions about their conduct.

In February, Jamelah Jamaluddin cleared her desk as chief executive of RHB Islamic, one of Malaysia’s leading domestic Islamic banks, and joined Kuwait Finance House (Malaysia) as chief executive.

It is the second time JJ, as she is known in Kuala Lumpur, has followed this particular path. She was chief operating officer at RHB Sakura Merchant Bank until 2005, back in the days before Malaysian banks’ Islamic arms were hived off into separate entities. She then moved to KFH when the Kuwaiti group became one of three Middle Eastern institutions to be given wide-ranging licences to conduct Islamic finance in Malaysia. She rose to be deputy chief executive there before coming back to RHB, this time as chief executive of its Islamic entity, RHB Islamic. Now she’s heading back the other way.

It is striking that one of Malaysia’s most senior Islamic bankers finds it more alluring to work at a branch of a foreign bank than to lead a much bigger domestic one. Granted, KFH is not just any foreign bank: it is the second-largest Islamic institution in the world by assets, and almost certainly the one with the most dynamic international mindset, with long-standing regional ambitions in Asia (the odd recent closure of a Singapore office notwithstanding). But RHB Islamic is hardly a tiddler: it was managing M$10.9 billion ($3.2 billion) of assets by June 30 2009 and has been among the fastest-growing Islamic financial institutions in the country, with regional ambitions of its own.

In Kuala Lumpur, though, few seem particularly surprised. A Malaysian-born head of a foreign entity in Malaysia says: “If I was put in the same situation and given the choice of either leading a much larger local outfit or staying where I am in a foreign house, I would stay, because in terms of personal development the opportunities are much bigger.”

Attitudes like this must give Malaysia’s institutions, particularly Bank Negara Malaysia, food for thought. On one hand, it’s evidence of success in Malaysia’s efforts to turn itself into a truly global hub for Islamic finance, attracting leading global institutions, if not yet any actual money, to Kuala Lumpur to do business. What might not have been part of the plan is foreign institutions coming in and stealing the top talent from domestic institutions rather than bringing in their own people: Malaysia has a skill shortage in Islamic finance as it is.

Responding to a Euromoney request for comment on the appointment, KFH (Malaysia) chairman Shaheen Al Ghanem replied in an email: “It has always been the intention of KFHKuwait to engage a local talent to head its bank in Malaysia, and we have found it in Jamelah…Puan Jamelah holds the distinction for being the first woman to head a KFH bank as CEO, representing a special milestone and significant breakthrough within the KFH Group.”

There are reasons Malaysia’s regulators may be happy to see a proven home-team player stepping into the KFH Malaysia top job.

When KFH launched in Malaysia, K SalmanYounis was seconded from head office in Kuwait City to Kuala Lumpur in 2005. He was well known and accessible, driving deals, outlining plans to build the business from niche areas of expertise such as air finance into broader investment banking, corporate banking, commercial and finally retail. He was instrumental in KFH’s attempts to buy a 33% stake in RHB’s overall parent, Rashid Hussain, which came with a commitment to invest M$12 billion in turning the group into an Islamic banking powerhouse; that deal was thwarted by Malaysia’s own pension fund, the EPF, which won the bid ahead of KFH.

But did Younis push a deal too far? Officially, he was recalled to Kuwait because projects needed his involvement there, in a decision that took formal effect on June 1 2009 when he relinquished his chief executive position. But the move was sudden, with leadership temporarily passing to a deputy, Ab Jabar Ab Rahman. And it has been noticeable that since Younis’s departure, a number of the property deals he was instrumental in have fallen apart. On Christmas Eve, for example, Mah Sing Group confirmed that a deal to sell part of The Icon@Tun Razak, an office development, to Prompt Symphony for M$237.1 million had been aborted because the purchaser had failed to pay the balance, forfeiting a M$42.7 million deposit in the process.

KFH Malaysia denies having an interest in the transaction but Euromoney understands Prompt Symphony is a special purpose vehicle 80% controlled by KFH entities. Six weeks earlier a similar Prompt Symphony deal, for The Icon@Mont Kiara, also lapsed. In another instance in December, YNH Property said it had been told by KFH that it would not go ahead with a 50% purchase of another Kuala Lumpur office tower, Menara YNH.

Is it prudence in the wake of the financial crisis? Perhaps, but that doesn’t explain KFH’s darkest moment in southeast Asia to date in early 2008, when it pledged to spend S$818.4 million ($518.4 million) on GucoLand’s Goodwood Residence in Singapore, then failed to go through with the deal, although it did later buy some units in the residence. This deal, under Younis’s watch, had raised eyebrows from the outset: S$818.4 million was about four times KFH Malaysia’s paid-up capital at the time and it has never been clear if head office in Kuwait had approved the deal – or, for that matter, the grand commitment involved in the RHB bid.

Insiders suggest KFH’s aggression in property investment had become a thorny issue in Malaysia, where prudence has been a watchword ever since the country’s banking sector reformed itself after the Asian financial crisis (notably, no domestic institutions got into any significant trouble in the global version a decade later). There are also suggestions that Jamelah’s departure from KFH the first time, and the departure of Raja Teh Maimunah, a rising name in Islamic finance who left her role as KFH’s chief corporate officer and head of international business without another job to go to in July 2008, reflected unease at the bank’s investment style and extension of credit in Malaysia. Raja Teh is now the head of Islamic capital market development at Bursa Malaysia, the stock exchange.

KFH (Malaysia) chairman Shaheen Al Ghanem directed Euromoney to the firm’s previous public statements on these transactions, offering no new comment beyond a statement that “it is part of KFHMB’s banking process and governance policy to have a constant and vigorous monitoring of all banking transactions to ensure that the bank obtains optimum value from all its transactions, especially in view of the changed economic environment”.

In this context Jamelah is a proven, experienced, safe pair of hands – and local. Her first job will be to give leadership and direction to a business that does, after all, have a lot going for it: chiefly one of the biggest chequebooks anywhere in the Islamic world.

In December, world markets reacted strongly to the news that an expected default on a US$3.52 billion sukuk issue from Dubai’s Nakheel Developments would not now take place, following a US$10 billion bailout by the Abu Dhabi government. For creditors in the Nakheel sukuk – the Islamic equivalent of a bond – the news was clearly good: only weeks earlier they had been told that Dubai World, the state-owned holding company that includes Nakheel, was entering a debt standstill and that they would have to wait indefinitely to get any of their money back. But one can also argue that Nakheel’s step back from the brink is a lost opportunity.

How so? Well, the Nakheel/Dubai World standstill represented something that has to happen at some stage, but hasn’t yet: a default in an international sukuk. Without it, uncertainty hangs over the whole sector and impedes its maturity. That, in turn, hinders its development as an asset class for fund managers.

The sukuk industry is youthful and most of its activity has taken place in the last decade. Zawya, a research group in the United Arab Emirates, calculates US$106.6 billion was raised through 747 sukuk issues between December 1996 and September 30 2009, the majority of it since 2002, and that more than 90% of that total is still outstanding, with only US$12.6 billion having matured so far. At a local level, defaults have happened and been worked out in Malaysia’s sophisticated ringgit sukuk industry, but in the more complicated global, cross-border deals, they remain an unknown quantity. Two have happened in the last 18 months – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which is under Chapter 11 bankruptcy protection in the US and has a sukuk outstanding that will be impacted by that filing. But neither has yet made it to court so not much can be learned from either.

A Nakheel default – on the biggest sukuk ever launched – might have answered a lot of questions about how the sukuk market works when, as must inevitably happen from time to time, things go wrong. That would have helped to create a path for the future which, in turn, would give investors a clearer idea about the level of risk they are entering into when they buy a sukuk.

A sukuk behaves broadly like a conventional bond, in that it pays out a predictable and regular amount over a pre-agreed period of time. Its key difference from conventional finance stems from the fact that in Islam, riba, or interest, is prohibited. So sukuk use the cashflows of an underlying asset, usually a property, to pay out a regular income stream. While this may sound like just semantics, the point is that money isn’t just turning into more money without doing something else – which is what happens with interest on a bond – but is instead a sharing of the profits being created by a tangible asset. In Nakheel’s case, this was a 50-year leasehold on two plots of land in the Dubai waterfront.

So the first question many people have is: if things go wrong, what are the rights of the creditor to the underlying asset? Some investors believe that, had Nakheel defaulted, they ought to have had rights to those underlying plots of land (or at least the leasehold on them). Others believe that, unless it’s specifically stated in the documentation, the creditor’s rights are instead to the obligor’s balance sheet – and that the underlying asset is only there to make the whole thing Shariah-compliant, not to serve as collateral. This latter is the norm in Malaysia, where these issues have been successfully tested by the courts. We don’t now know what the answer would have been for Nakheel.

Things are much more complicated in an international than a domestic deal. A Moody’s analyst, studying the sukuk, says that in the case of Nakheel, different parts of the structure fall under different legal codes. The declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and share pledge, amongst other things, are under UAE laws – which are Islamic. That would have a big bearing on the enforcement of rights in a default. And, even those areas that are governed by familiar and commercially-savvy English law are not clear cut, because any English judgment would need to be enforced locally.

And for that, consider the position of the creditor, going after Nakheel assets – owned, ultimately, by Sheikh Mohammed bin Rashid Al Maktoum, Dubai’s emir. Who’s going to go into a court (in which there is a symbol of the ruler behind the judge) and say: “Give me that land. It’s mine”?

In practice, for this reason and the general reluctance of creditors to head to the courts in the Gulf, Nakheel would almost certainly never have made it to court but instead been hammered out in a behind-the-scenes restructuring – but this, too, would have been instructive. A Nakheel default would have told potential buyers in any global sukuk just what they should expect – what they really own, where they would rank in bankruptcy restructurings, what their recourse is to assets in different jurisdictions and under different laws.

One good thing that does appear to have come out of the confusion is the promise of a new bankruptcy law. One of the things creditors, and market-watchers generally, had been so concerned about as Nakheel approached default was the lack of clarity about bankruptcy and the whole process of pursuing a debt. This, too, is an area of difference with Malaysia, where the bankruptcy legislation is clear and tested. When Dubai announced the Abu Dhabi bailout in December (in a statement from the chairman of Dubai’s Supreme Fiscal Committee), it announced a new bankruptcy law in the same release, saying: “The law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations.”

That, at least, does represent some of the dispute resolution maturity that the industry needs to grow further. And this matters considerably to portfolio managers in the region. So far, sukuk-only funds are reasonably rare: examples are from Dubai’s Algebra Capital, in which Franklin Templeton owns a stake, and some newer Saudi Arabian asset managers such as Jadwa Investment Co. But, although it’s difficult to track, sukuk are much more widely held than that, and not just in the Middle East. In recent years the yield pick-up offered by sukuk over some conventional bonds, coupled with the supposed security of being underpinned by real assets, have seen sukuk move into portfolios run by conventional asset managers worldwide too. Prominent holders of the Nakheel sukuk are understood to include BlackRock, Ashmore and the New York hedge fund QVT Financial.

The sukuk market faces other challenges too. One is that, again notwithstanding Malaysia’s domestic market, they just don’t trade: there is hopelessly thin secondary market liquidity because supply is still exceeded by demand and people who buy them don’t want to sell. Also, there are a number of different structures used for sukuk, and the most commonplace was recently denounced by one of the world’s leading Shariah scholars, Pakistan’s Sheikh Taqi Usmani, in a speech that appeared to suggest that 85% of non-ijarah sukuks were not Shariah compliant at all (ijarah is a type of structure that is increasingly commonly used for sukuk in the Middle East, but less so in Asia). This raises another issue: standards on Shariah compliance vary between the Middle East and southeast Asia, and even within Gulf jurisdictions, which impedes cross-border sales and trading of sukuk.

Nevertheless, the fact that this youthful market faces challenges does not suggest it lacks a vibrant future; these are necessary teething troubles from which the sector has the potential to emerge stronger. More sukuk mutual funds are bound to follow in due course, while the presence of individual sukuk in global conventional debt portfolios is here to stay. It’s just that, for true acceptance globally, there has to be clarity on what happens when things go wrong – because sooner or later, they always do.

Asiamoney, December 2009

Dubai went to the brink – and it’s still there. Abu Dhabi’s decision in December to supply Dubai with $10 billion for debt repayment allowed it to forestall, at the very last moment, a default on the world’s largest ever sukuk – the $3.52 billion Nakheel Developments issue which matured on December 14. But it doesn’t repair Dubai’s tarnished reputation as a financial centre and issuer, or give any reason to suggest investors will rush back to help Dubai refinance the $100.6 billion of outstanding debt Moody’s believes Dubai Inc owes, $12.5 billion of it due next year. And it leaves significant questions unanswered about the credibility of the sukuk industry that has become a bedrock of global Islamic finance.

It is in some sense a shame that Nakheel didn’t enter formal default. While that sounds absurd, professionals across the Middle East and the Islamic finance industry globally had become increasingly sanguine about a potential Nakheel default, believing it would have answered vital questions about just what happens when a sukuk turns bad.

These, after all, have never been answered or tested satisfactorily. The sukuk market has grown with mercurial haste in the last 13 years: The UAE-based research group Zawya says there were $106.6 billion of sukuk raised in 747 issues between December 1996 and September 30 2009, most of it since 2002. But such is the sector’s youth, well over 90% of that total is still outstanding: to date only $12.6 billion has matured. Consequently, outside of Malaysia’s more mature domestic sukuk industry, there has been hardly any experience of default. Two did fall in the global financial crisis – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which has a sukuk outstanding but has filed for Chapter 11 bankruptcy protection – but since they have yet to make it to court (and may never do so), it is hard to learn much from them yet.

There is a feeling, therefore, that this had to happen sooner or later, to answer that nagging question: what if? What happens when something goes wrong? For this reason, after the initial shock when Dubai announced a debt standstill and a $26 billion restructuring including the Dubai World state-owned holding company and its Nakheel Development subsidiary, market practitioners had started to look forward to a little clarity.

“In a sense, defaults in a type of transaction reveal the actual rights held by investors in that type of transaction,” says Ayman Adel Khaleq, partner at Vinson & Elkins in Dubai. “Pure economics aside, the defaults facing various sukuk in the current market are therefore not entirely negative occurrences.”

The same sentiment was echoed all over the world in the weeks up to Abu Dhabi’s intervention. “The sukuk market is growing up,” said Dino Kronfol, managing director at Algebra Capital in Dubai, one of the few Gulf asset managers to run a mutual fund investing exclusively in sukuk. “Nakheel will be an opportunity to set some important precedents. First and foremost, we are going to have a better understanding of what the path is going to be like post-default.” Three thousand miles east in Malaysia, Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, said: “There’s always a silver lining. What is happening now will make the market even stronger in future because it will cause people to build the necessary framework and infrastructure to make sure these things do not happen again.” Well, maybe now they won’t.

So what’s at issue here? Part of the uncertainty is structural. The principle of a sukuk is that it replicates the mechanics of a conventional bond in a Shariah-compliant way. In Islam, riba, or interest, is prohibited: money can’t just turn into more money without doing something else. So instead, sukuk use the cashflows of an underlying asset – typically a property – which pay out an income stream. In Nakheel’s case (there are actually three separate sukuk worth $5.25 billion maturing between December 2009 and January 2011), that’s a 50-year leasehold interest in two plots of land within Dubai Waterfront. In a sukuk, the return is a share of profits among the creditors.

But if it goes wrong, it’s not clear what the rights are of creditors to the underlying assets. Unless it’s specifically stated in the documentation, a creditor’s right is not typically to that cash-generating asset – which is there chiefly to ensure Shariah compliance – but to the obligor’s balance sheet, which can be a very different proposition. Also, the ethical stance of a sukuk is an equal sharing of profit and risk. Well, if it all goes sour, doesn’t this principle of equal sharing alleviate any obligation the issuer has to continue to pay out if it feels it can no longer do so?

Nobody is entirely sure. “Until recently the growth of the sukuk market has been driven more by an abundance of financial resources than by, for example, regulatory or legal considerations,” says Khaleq. “In conventional finance and investment markets, the post-default path is well worn.” Consequently when you structure and document a new conventional bond, you take into account a worst case scenario like a default or insolvency, based on what you’ve seen happen before. “Precedents indicating what such a scenario may entail are readily accessible. The same cannot yet be said for Islamic transactions, particularly in debt capital markets.”

Abdul Ghani says in Malaysia, through experience, these things are understood and therefore practised. “The majority of sukuk are unsecured paper, and there is no expectation whatsoever on the part of the creditors for using the underlying asset to get back their money,” he says. “That asset is just there in a transaction to make it Shariah compliant, it is never intended to be collateral.” Instead, creditors can seek a liquidation of a sukuk, in a process well established over the years in Malaysia’s courts. And this, really, is the difference: experience. “One of the major things that is missing in the Gulf is the bankruptcy law,” he says. “That’s not fully tested.”

One other area Nakheel could have shed some light is the issue of multiple jurisdictions. There are major challenges with different bits of a sukuk being covered by different laws and codes. Khalid Howladar, an analyst specialising in sukuk for Moody’s, says that the declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and the share pledge, among other things, are under UAE laws – which are Islamic. “This complicates issues such as enforcement of rights,” he says. “Ultimately, even an English judgment will need to be enforced locally, and given the conflict of government ownership of the entities involved, as well as the immaturity of the legal environment, it’s not clear how transparent or fair local courts would be.”

In truth, nobody in their right mind would have taken Nakheel’s backers – ultimately, Sheikh Mohammed bin Rashid Al Maktoum, emir of Dubai – to court in the United Arab Emirates. “It’s a brave person who stands up in court and says to him: ‘that’s mine, not yours’,” says one banker. “When you go to court in Dubai, there’s a symbol of the ruler behind the judge. Are you going to go into that court and ask for the ruler’s assets?”

Kronfol also doubts the point of going to court. “It’s never helpful. And even if you got the court to give you access to the asset, why would you? It will be complicated – you won’t own the land, you’ll own a lease, and that land is just desert with a fence around it. You’re much better off with a planned restructuring.”

The sukuk market has a host of other challenges to deal with besides: a lack of secondary market liquidity anywhere outside Malaysia; the damning remarks recently by leading scholar Sheikh Taqi Usmani from Pakistan, who said 85% of non-ijarah sukuk issues were not in compliance with Shariah law, undermining the credibility of the entire industry; and divergent standards on compliance between the Middle East and southeast Asia. Issuance more than halved between 2007 and 2008, to $15.4 billion, although it did rebound to $16.2 billion in the first three quarters of 2009; issuance is driven by southeast Asia rather than the Middle East, with the Gulf nations accounting for only 16% of issuance in the first half of 2009.

But despite this continuing lack of clarity about rights and processes, the market itself will no doubt persevere. In particular, few in Malaysia – whose US$66 billion of outstanding public and private sukuk at the end of June 2009 accounted for 62% of the total outstanding sukuk globally, according to Bank Negara Malaysia – feared much contagion even when a default was on the cards. “The Malaysian ringgit sukuk market will be isolated from this incident,” says Abdul Ghani. “It’s a domestic market with its own framework, its own infrastructure, its own investor base. It’s the most mature sukuk market and its activities have been tested in court, in restructurings and reschedulings since 1990.” He did, though, expect dollar sukuk issued from Malaysia to struggle to tap Gulf investors “as most of them have been affected by Nakheel.” For its part, Bank Negara Malaysia told Asiamoney a default, if it came, would be “a credit issue on a particular issuer” with “no systemic impact on the Islamic capital market” and “no adverse impact on the overall sukuk market in the long run.”

That said, the market will evolve. Ernst & Young expects more sovereign issuance, including European and Asian issuers such as the UK and South Korea; others say investors are likely to show a preference for those from wealthy companies with assets to back them – such as oil for Abu Dhabi, and gas for Qatar. Efforts are likely to increase to build secondary market trading in sukuk – Saudi Arabia is already trying this by introducing sukuk trading on the Tadawul stock exchange, and the Islamic Development Bank proposes to launch an investment bank to create an Islamic interbank market. And, more than anything, even if Nakheel’s survival has deprived the market of a chance to learn more about creditor rights, the future must involve an evolution of structures that makes these things more clear. “There is going to be an increased push for transparency and better governance,” says Kronfol.

But today, the whole market looks tarnished. As Asiamoney went to press, the great and the good of the Islamic finance industry were meeting in Bahrain for the landmark annual World Islamic Banking Conference. “We were expecting to be able to celebrate the triumph of Islamic finance over conventional,” says one person in attendance. “In the last year most Islamic bankers have been saying: ‘look at us, if people had worked with us they wouldn’t have lost any money’. Well, nobody is saying that right now.”

BOX: Dubai

Sheikh Ahmad Bin Saeed Al Maktoum, the chairman of the Dubai Supreme Fiscal Committee and uncle of Dubai’s ruler, had some soothing words to say when he announced the $10 billion bailout of Dubai World on December 14. There was talk of “our strong commitment as a global financial leader to transparency, good governance, and market principles.” He wanted to “reassure investors, financial and trade creditors, employees and our citizens that are government will act at all times in accordance with market principles”. And he promised: “Our best days are yet to come.”

It is to be hoped so, because the two weeks prior to his statement are never going to appear in any précis of Dubai’s best days. Credit and stock markets worldwide were delighted at the news, but that doesn’t mean are going to forgive Dubai’s conduct in a hurry. That’s going to matter when Dubai comes to refinance its other debt.

One of the biggest complaints that came after the announcement of the standstill was that people felt misled: that they had assumed the state would stand behind its subsidiary companies. Nakheel – “where vision inspires humanity”, as its tagline continues to trumpet – is the backer of the vast palm-shaped property developments that are sprouting into the Gulf, among the most iconic projects in this most ambitious of cities. Nakheel, in ownership and symbolism, is Dubai.

In fact, the 237 page prospectus for the sukuk itself contains no mention of state backing, which has led some to question the wisdom of investors and rating agencies in their approach to assets like the Nakheel issue. “As there were various risk factors listed in the Nakheel sukuk prospectus, a clear statement that Dubai World depends on its subsidiaries, and none actually giving any indication that the Emirate of Dubai would pay for Nakheel in case of insolvency, the original rating based on implicit sovereign support seems to be exaggerated, and not really wise,” says Michael Salah Gassner, a banker and founder of the website islamicfinance.de.

On paper, that’s clearly true, but what muddied the waters was the apparent statement of support from Dubai’s leadership – right up to Sheikh Mohammed – in the weeks and months before the standstill announcement. “A few weeks ago Sheikh Mohammed publicly said the Dubai economy was in good shape and he didn’t expect any more problems for it,” says Douglas Hansen-Luke, CEO for the Middle East at Robeco in Bahrain. “I am sure there are no records anywhere of him explicitly guaranteeing the debt of companies in which he is the largest shareholder. But at the same time there are no explicit statements until these last two weeks that he would not stand by them. And it would certainly be true to say that the vast majority of the investment community thought they were almost pari passu.” And, in the end, it appears it was.

Hansen-Luke stresses there is another side to the coin. “The ruler in Dubai has got the opportunity to show two things – one, that Dubai is a normal economy, where companies that invest soundly and are in the right markets will do well, and companies that don’t will become smaller, restructure or close – that’s the nature of capitalism. It’s good for people to see this is a capitalist economy and nothing is too big to fail: that is a positive message. The other is that Sheikh Mohammed will not tolerate corruption or wrong-doing. That’s also very positive for the long term future of Dubai. But to get that right in the near term, a third element is needed, which is transparency.” And this is really where the greatest hand-wringing is taking place: the sense of being surprised, of being in the dark.

This is only the first stage of Dubai World’s restructuring so there is much to be worked out. “This really is a key moment in Dubai’s evolution,” says Khalid Howladar at Moody’s. “If it hopes to retain and improve its position as a financial centre it needs to show fairness and transparency in its restructuring.”

One thing in particular infuriates foreign investors: that the standstill was announced immediately before a four-day public holiday, letting uncertainty and rumour drive world markets until Dubai got back to work. And the bailout, when it came, was a matter of hours before the sukuk would have entered technical default. Investors don’t like a white knuckle ride like that, particularly on what they thought was state-backed paper; many will doubtless think twice before rushing back to Dubai.

“The direct impact of the standstill and the relatively small amount of money involved,” says Hansen-Luke, “is much less important than the impact on perception and credibility.”

 Nizam Yaquby, Shariah Scholar

If you want an illustration of the growth in Islamic finance over the last 10 years, forget bankers: look to the scholars.

 Here, a whole new profession has evolved. People who buy Shariah products or put their money in Shariah bank accounts need to be sure that what they are buying or investing in is Islamic. Shariah scholars provide this endorsement – and in so doing, have become some of the most powerful, prized and scarce people in the industry.

 The bottleneck in the development of scholars who are schooled in law, understand finance, realise where businesses are coming from and are proficient in enough languages to explain it all, is one of the biggest challenges in Islamic finance. Until it is redressed there is a slender elite of barely half a dozen names who appear with remarkably regularity on the advisory boards of the world’s Islamic institutions. Just how big that industry is will forever be in dispute, but we do know, for example, that the 100 biggest Islamic banks had US$580 billion in assets at the end of 2008 – and that was a 66% increase on the previous year despite the global financial crisis. A big industry to be policed by so few.

 The most well-known of them all is Sheikh Nizam Yaquby, the Bahrain-based scholar who is believed to serve on more than 40 Shariah boards from Citi Islamic and HSBC to Abu Dhabi Islamic Bank and the Dow Jones Islamic Index. Operating for years out of a desk at the back of an electronics store in the Manama souq, he exemplifies the speed with which the Shariah advisor role has evolved from fusty scholarliness to a jet-setting profession on a par with commercial law.

 Sheikh Nizam is also probably the most widely-recognised of the scholars, forever on the road addressing conferences to improve knowledge of Islamic finance and of the Shariah scholar discipline. Strong voiced and sometimes strident, particularly if people challenge him on what scholars get paid these days, he is also considered at the cutting edge of financial innovation.

 But – and this is also a characteristic of this new profession – this embrace of innovation is something of a double-edged sword. Nizam and his peers, like Mohd Daud Bakar in Malaysia and Yusuf Talal Delorenzo in the USA, have become known as commercially-minded scholars, for their ability to understand the most complex structures and the way they work in financial markets. But some feel that some of the products that have been approved by these scholars run perilously close to breaching the spirit of Shariah, whether it be an Islamically compliant hedge fund or the tawarruq or reverse murabaha structure, which the OIC Fiqh Academy as declared non-compliant.

 “There is no perception among Scholars that there is one more conservative and one more progressive,” Nizam once told the author. “These are terminologies used by outsiders. Within our Islamic legal community different scholars reach different conclusions for different reasons… Yes, in the last five or 10 years more conventional products are being designed in a way to be acceptable from a Shariah point of view. I believe if it is properly done, with proper approval and procedure, there is no harm in that, in giving Islamic bankers and investors more tools.”

 Despite reservations about whether scholars act as the guardians of the industry or seek to find ways to let borderline structures through, the fact is Islamic finance can’t thrive without Shariah scholars, and their practice needs to be recognized and developed. Nizam will be recalled as one of the pioneers of a new profession.

To see how the article ran, click here: GFPsupplement 4

Dr Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, is a lifelong central banker whose career has embraced some momentous periods for both Malaysia and Asia. She has been at Bank Negara for more than half of Malaysia’s history as a federal state, becoming assistant governor in 1995 and governor in 2000; in her time in those senior positions she has gone through the southeast Asian economic boom, the Asian financial crisis, food and commodity boom and busts, the global financial crisis and the dawning of political change in Malaysia. “People keep telling me I should write my memoirs,” she says.

Zeti has been a part of two movements that are likely to be seen as key to Malaysia’s long-term economic development. The first is being a part of the country’s we’ll-do-it-our-way riposte to both financial crises a decade apart, a stance that is highly unlikely to change. Zeti was not the main architect of Malaysia’s strident approach to the Asian financial crisis – Mahathir was – but she was influential and looks back on that time with evident pride, apparently feeling that lessons could have been learned by bigger powers last year. “Leadership plays an important role in being decisive and we didn’t have a fragmented regulatory regime, which plays a very important role,” she recalls. “It all resided in the central bank.” The central bank drove the launch of an asset management corporation to deal with the bad assets – “and we just called them that, bad assets” – an approach that, much doubted at the time, worked. “There was a comprehensive plan from the central bank but there was a machinery in government that allowed us to implement it quickly.”

Malaysia’s approach, and Zeti’s, since then has been in keeping with this sense of a broader plan and an apparently healthy disdain for what the world thinks it should do. Plenty is arguably wrong in Malaysia – competitiveness of its companies on a world stage, corruption in politics, quality of the judiciary, and people will forever argue about whether the 1998 capital restrictions helped or hindered the country – but monetary policy has not been among the problems under Zeti’s governorship. Instead Malaysia has gradually loosened foreign exchange and other restrictions, liberalized its financial sector at its own pace, and continued to do its own thing in the face of international opinion. Along the way a much more viable free-standing banking industry has grown, one that survived the global financial crisis unscathed. In policy, Zeti’s refusal to raise interest rates during the food price crisis in 2008 despite heavy criticism, because she believed there were problems ahead, was typical, and she was right: her slashing of rates ahead of perceived need earlier this year was equally strident. 

This year she has driven through a new Central Bank Act which enshrines her institution’s independence, although she insists: “At no time in my entire career have we ever been instructed [by government]. During my tenure there have been six ministers of finance and they have all made public announcements that the central bank decides interest rates and determines monetary policy.”

For all her monetary savvy, though, history may remember Zeti most for her contribution to the development of Islamic finance. Malaysia has the most sophisticated legal and regulatory environment in the world for Shariah banking, takaful and asset management, and while this has been a tri-partite drive by finance ministers, Securities Commission chiefs and the central bank, it’s Zeti who has been around throughout, going around the world spreading the word about both the overall financial discipline and Malaysia’s role in it. Having built a strong domestic industry Zeti has been at the heart of the next step: to bring in international expertise and, ultimately, capital through the Malaysia International Islamic Financial Centre.

“We are evolving ourselves as an international Islamic financial hub,” she says. “It’s a meeting place of those who need to raise funds or have surplus funds for investment from any part of the world.” The jury is still out on whether she and Malaysia can achieve this next step – the foreign institutions have come, but not yet the portfolio flows – but if she does make Malaysia a global home for Islamic capital rather than just a vibrant domestic industry it may prove the most significant contribution of all.

To see article as it ran, click here: GFPsupplement 3

The regulator – Dr Zeti Akhtar Aziz, Governor, Bank Negara Malaysia

Dr Zeti Akhtar Aziz has been arguably the single most important person in the drive towards making Malaysia a hub for Islamic finance. The idea has consistently had the backing of government and the Securities Commission too, but by dint of longevity – Zeti has held the governorship of Bank Negara Malaysia since May 2000, and has now worked with six different finance ministers while in that role – she has perhaps been the most instrumental in ensuring a consistent drive in Islamic finance.

It’s fair to say that Malaysia has already built a successful, credible and well-regulated domestic Islamic banking industry, whether in banking, takaful or funds management. Zeti’s vision now, like that of Malaysia generally, is to bring foreign expertise and capital in.

Consequently Islamic finance was a mainstay of the banking liberalisation measures announced by Bank Negara and the government in April. Liberalization has consistently been more generous to foreigners in Islamic banking than conventional, and that continues to be the case: domestic Islamic banks may now have foreign equity ownership of up to 70%, a level that is not permitted for conventional banks.

Alongside a number of new commercial banking licences – the most significant of which, for “world-class banks”, won’t come into effect until 2011 – two new Islamic banking licences were announced to take effect in 2009, for foreign players “to establish new Islamic banks with paid-up capital of at least US$1 billion to enhance global interlinkages, leverage on global developments in Islamic finance and reinforce Malaysia’s position as an international Islamic financial hub,” to use Bank Negara’s own words. These institutions can be 100% foreign-owned. At the same time two new family takaful licences will be granted. On the conventional side, only two new licences will be awarded in 2009, for banks with “specialised expertise”, and at the time of writing no formal bids had been lodged for these and there was some doubt as to whether any would be.

The new Islamic bank licences have become known as the mega-bank licences – and that US$1 billion minimum paid-up capital is strikingly, almost off-puttingly large. (The new takaful operators, by contrast, will have a capital requirement one tenth of that size.) Why raise the bar so high?

“We already have quite a number of Islamic financial institutions, but they are all quite small in size,” Zeti tells IFR Asia in her expansive Kuala Lumpur office in the Bank Negara Malaysia complex. “That is sufficient for retail, financing and other domestic business. But in order to see an increase in international activity, you would need the kind of capitalisation to be able to conduct international business that would originate out of Malaysia. Therefore you need capitalisation and scale in terms of technology, human talent, the expertise that is required, and international networks. So it really is the international financial institutions, very different from what we already have.”

The deadline for these licence applications comes up on October 31 and Zeti says that firm bids have been lodged already. It is interesting to contemplate who these might be: the biggest players in the Middle East – Al Rajhi and Kuwait Finance House – are here already, while other heavyweights from that region, such as Saudi Arabia’s National Commercial Bank or the Egyptian based EFG Hermes, have been hit by the financial crisis. Of the true multinational Shariah operations, HSBC, Citi and Standard Chartered are also already here in various licensed forms, although not always with the degree of freedom the new licence seems to afford. It is possible that bids have come from some of these groups that wish to upgrade their status in the country, although Asian Finance Bank, which holds an Islamic licence already, has ruled itself out of applying.

Zeti was one of the driving forces behind the Malaysian International Islamic Financial Centre (MIFC). In some senses this appears successful: a number of entities are licensed within it, particularly in asset management. (See the article on foreign businesses for more on this.) But there is widespread conjecture about whether it has yet achieved its real investment of bringing money from outside Malaysia (particularly the Middle East) to be managed from Kuala Lumpur.

Asked if MIFC has achieved what she wanted it to, she says: “Within less than three years we have made quite significant progress. Malaysia is a centre now for the origination and the raising of sukuk, and more than one third of new sukuks are issued out of Malaysia. If we look at outstanding sukuk we have 60% of the outstanding.” This is true, but it was also true without MIFC: Malaysia’s standing in the global sukuk market has been a point of differentiation for at least five years. “We have also issued licences to foreign entities to conduct foreign currency business. We are offering the international community to participate in our system for the conduct of international business. That is how we are evolving ourselves, as an international financial hub: it is a meeting place of those who need to raise funds, or those who have surplus funds for investment from any part of the world.”

And has it brought in foreign capital? “Yes it has, in terms of investments by various entities, particularly from the Gulf,” she says. “They have been coming out here in terms of joint ventures, strategic alliances with local businesses, and direct foreign investment in projects here, as well as fund management out of Malaysia.” Zeti points to the 300 financial products and services that have been developed; “we are at the frontier of innovation. We also participate aggressively to facilitate convergence in interpretation of Shariah.” But what about portfolio investment? “Directly it has brought investment by these institutions; indirectly they have brought investors, and have opened up potential for trade. This is one area we want to enhance, and there is some growth already,” she says, highlighting the Middle East. “The financial institutions who have a presence here will facilitate this kind of investment and we are already seeing this happen.” She declines to put a number to inflows generated by MIFC. “That would be difficult because in terms of the direct investment, you can see it obviously in terms of the strategic stakes they have taken in our local banks and takaful companies. But the indirect one, you can’t attribute it.”

Bank Negara is ultimately responsible for approving sukuk issuance, which tailed off notably in line with all debt or debt-like markets around the world over the last 18 months before receiving a major boost with the Petronas issue in August, in which $1.5 billion of $4.5 billion raised was Shariah compliant. This, says Zeti, was something of a landmark. “It was significant because it was the first foreign currency sukuk issue out of our market,” says Zeti. “We have liberalised to allow for foreign currency sukuk issuance out of our market but because of the crisis in 2007 and 2008 there was no issuance. And so although there were many that had actually submitted [for approval to launch], they had deferred because of international financial conditions. And most of the issuance was ringgit denominated even though it was by foreign corporations and entities.” So the Petronas deal, in dollars but out of Malaysia and by probably the most important state-owned company in the country, was a big step and is hoped to be the first of several – hence the fact that Bank Negara has developed a new designation, Emas, to apply to foreign currency issues out of Malaysia.

Domestically, Zeti says the pipeline for sukuk issuance is coming back “tremendously.” She also highlights a new credit enhancement institution designed to allow issuers to reach the debt markets at attractive pricing.

Observers admire Zeti as a central banker, and consider her one of the most able in the region; there is also respect for what has been achieved domestically in Islamic finance. But implementing this next step of the vision, of truly going global and bringing the world of Islamic finance to Malaysia, is perceived by many as being a tougher challenge still, particularly because of the differences in interpretation of Shariah between the Middle East and Malaysia (which MIFC has tried to get around by saying that any school of Shariah thought is permissible within it). “Islamic finance has been a major success in this country but I really struggle to see how it gets beyond where it is today,” says one banker in Kuala Lumpur. Still, Zeti has seen off both an Asian financial crisis and now a global one and come out intact, so she’s not unfamiliar with challenge.

Takaful is probably the area of Islamic finance that has received the least attention in Malaysia, but its rate of growth has been impressive. The net contributions income to takaful operators was RM1.12 billion in 2004; by 2008 it had almost trebled to RM3.03 billion. Over the same period takaful fund assets doubled from RM5.03 billion to RM10.57 billion.

Today there are eight registered takaful operators in Malaysia, compared to four in 2004; the latest batch of financial liberalization in April allowed for two more family takaful licences (licences fall into two categories, family and general) to be granted in 2009 to “players that can offer significant value proposition to Malaysia to spur the development of the takaful industry and reinforce Malaysia’s position as an international Islamic financial hub,” according to Bank Negara Malaysia. Bids are due in at the end of October.

One institution that has watched this growth with interest is Syarikat Takaful Malaysia, which was incorporated in 1984 and listed in 1996 – the first of its kind. Its incorporation came about because of the recommendations of the Task Force on the Study for the Establishment of an Islamic Insurance Company in Malaysia set up by the government in 1981. This task force concluded that a takaful company based on the principle of al-Mudharabah – one of several models in Islamic finance allowing for an equal allocation of profits from an underlying fund – would be a viable venture. Today, it is majority owned by BIMB Holdings, which is also the majority shareholder in Bank Islam Malaysia, the first Islamic bank in the country.

Asked what Takaful Malaysia has seen over that period, Dato’ Mohamed Hassan Kamil, the group managing director, says: “The most significant development over that time is the growing interest of foreign parties in Islamic finance and the development of the comprehensive regulatory framework.” Indeed, the regulatory environment for takaful is as comprehensive in Malaysia as it is for mainstream banking or capital markets. But the potential for growth is perhaps greater still. “The level of penetration is still low – below 10% compared to conventional, where penetration is almost 50%,” he says. But “the industry will continue to attract a lot of interest and will grow faster than the conventional industry for the next five years.”

The growth of takaful is being closely watched by the country’s fund management industry. Takaful houses in Malaysia are obliged to conduct all of their investment in Shariah-compliant assets although, to the disappointment of foreign houses, they tend to do so domestically. “We invest only in Malaysia, mainly in Shariah bonds, property and Islamic money market instruments,” says Kamil. Still, it’s likely that as takaful operators become more international in their approach – it would not be a surprise to see them expand in Indonesia, for example – they will need to invest overseas too in order to match the diversity of their business mix with their funding.

A structural shift is taking place in the way takaful products are put together. Again, Takaful Malaysia is illustrative of the trend. In December it unveiled a series of products called MyMedicare, MySiswa, MyImpian and MySinar, a range of life, medical and health products using the Wakalah structure.

This was an interesting step since until then, it has used the Mudharabah model. All Takaful Malaysia’s general takaful products will continue to operate on that model, while all other new products will migrate to Wakalah.

What’s the difference? In Mudharabah, contributions are credited into a fund called the Participants’ Risk Fund. The surplus generated from that fund is then distributed evenly between the participants and the company.

In wakalah, all the contributions and the Wakalah fee are credited into the fund, with the fee covering commission and expenses allocated up front. Then the surplus generated from the fund is distributed at certificate termination. This is the more common approach in the Middle East, and has also been adopted by a number of other takaful operators in Malaysia.

“A mudharabah product is based on profit sharing to cover the acquisition expenses, including commissions,” says Kamil. “This model does not work for an agency type distribution model. Thus, we have switched to wakalah to enable payment of commissions to intermediaries. We believe the Wakalah model can work better for growing the retail business which is dependent on agents for distribution.” He believes agency and bancassurance are the two best methods of distribution for takaful in Malaysia.

A look at Bank Negara statistics shows why this structure is becoming more and more popular. While the number of employees in takaful operators has remained almost static between 2004 and 2008, the number of agents has quadrupled, from 14,370 in 2004 to 60,197 in 2008. Any model that allows payment of commissions to those agents is obviously going to become the norm.

Labuan is Malaysia’s offshore financial centre and, like everything else in Malaysian finance, has a clear Islamic dimension to it. Having an offshore jurisdiction with the necessary infrastructure to support Islamic finance is considered a key part of Malaysia’s MIFC offering.

“The best way to describe the MIFC is as a community,” says Martin Crawford, CEO of Labuan IBFC Incorporated, a company set up by Labuan Offshore Financial Services Authority, the local regulator, to market and promote Labuan as an international banking and finance centre. “It’s the group that links the relevant players together. Onshore, you have Bank Negara, the Securities Commission, Bursa Malaysia and the companies commissions who register fund management companies or banks or insurers for working in Islamic finance onshore. The offshore equivalent is LOFSA, which is like a one-stop-shop for all those other functions: it plays the role of central bank, insurance regulator, fund management regulator and banking regulator.” LOFSA is one of the four official members of MIFC. “We are very much a part of it.”

In practice, Labuan has had an additional function. “Generally Malaysia has tried to use Labuan as a bit of an incubator for new developments, and when they become proven they might bring them onshore,” says Crawford. “There’s been a lot of pioneering deals done through Labuan: the first corporate sukuk ever issued in the world was in Labuan, by Guthrie; the first sovereign sukuk was through Labuan; and recently the Petronas bonds [a US$4.5 billion combined issue of which US$1.5 billion was Islamic].”

The landmark sukuk issues have been what has given Labuan the greatest profile in Islamic finance, but it has other areas of strength too, most notably insurance. Overall Labuan has 140 insurance licences on issue, of which 13 are Islamic (four full-fledged retakaful operators and nine retakaful windows). When retakaful operators got together to form the Global Takaful Group in 2007, they based it in Labuan. Retakaful contributions through Labuan increased by 48.2% to US$162.3 million in 2008. “The size of the takaful operation is very considerable and is growing quite fast,” says Crawford. Additionally, there are five Islamic fund managers registered in Labuan, and the amount under management in Islamic private funds – US$2.8 billion – doubled in 2008. In banking, there are six Islamic banks and a further three windows, with US$337.3 million in deposits as at the end of 2008.

Still, the question has to be asked, as Malaysia becomes more and more accommodative to foreign participation onshore, why do people still need to bother with Labuan? “There are more reasons historically than there are now, because as you say some of the onshore environment has relaxed quite a lot,” Crawford says. “It used to be very hard to break into the onshore market. But there are still some reasons you’d go to Labuan and not onshore.” One is that the regulatory structure is more flexible in Labuan, where the rigour of Bank Negara and the Securities Commission is geared towards the protection of the domestic consumer; and the other is that Labuan still falls outside Malaysia’s foreign exchange controls. In fact, almost all of their controls have gone now but the ringgit does still not have complete convertibility, and if restrictions were ever to be imposed again, they would not affect Labuan. Additionally, Crawford feels that as more and more of the Islamic population in places like Indonesia, China, southern Thailand or even the Middle East build their savings, they are likely to want mutual funds domiciled offshore, ideally in regulated products.

Also, Labuan seeks to become a venue of choice for personal high net worth individuals: it is particularly well set up for the foundation or trust structure, and already one major Indonesian bank, Bank Muamalat, has signed a joint venture with a Labuan institution to build trust structures there for wealthy Indonesians.

This is one of several areas that will be bolstered by the passage of new legislation, the Labuan Islamic Financial Services and Securities Act, which had its first reading in parliament in July and will next be considered at the October session, which gives it a good chance of being gazetted by the end of 2010. In the main, this is an act that streamlines and conveniently puts all the Islamic regulatory framework into one act rather than the four that have some relevance today, but it also creates greater clarity around foundations. “Really it’s formalising what’s been in place with the guidelines issued over the years, with policy statements into one piece of legislation,” says Crawford. “It’s an opportunity for us to go out and talk to the world about what we’re doing. We’re still growing strongly.”

Islamic banks have been around for so long in Malaysia now it’s hard to recall a time when they weren’t there. There are 17 licensed Islamic banks supervised by Bank Negara Malaysia now, not counting a clutch of development institutions, investment banks, and offshore enterprises under various other licensing environments; between them they had RMB212.5 billion under management by July 2009, according to Bank Negara Malaysia.

All of Malaysia’s powerhouse banking groups have an Islamic subsidiary now, in all cases carved out as a legally separate entity: Public, RHB, CIMB, Maybank, Hong Leong, Alliance, AmIslamic among them. They are joined now by locally licensed Middle Eastern names like Kuwait Finance House, Al Rajhi and Asian Finance Bank; and entrenched foreign houses like HSBC, Standard Chartered and OCBC. And the field is going to get bigger still: by October 31 bids must be filed for the right to develop two Islamic mega-banks, which can be fully foreign owned but must have paid-up capital of over US$1 billion, aimed at taking the development of these institutions to a new, multinational level.

Today, Islamic banking assets compare to RM1.28 trillion among conventional commercial banks – so about 16% of the conventional total. It’s not clear what the likely ceiling is for the penetration of Shariah-compliant banking, but many institutions talk in terms of about 20%.

“We are now about 13 to 14% of the bank’s assets,” says Tuan Haji Yahya Ibrahim, CEO of Alliance Islamic Bank, which started out as a window concept like most Malaysian banks before becoming a fully fledged subsidiary in 2008. “We have to grow, because ultimately the target is expected to be about 20%.” At RHB Islamic, the first to move from the window model to the fully-fledged subsidiary, CEO Jamelah Jamaluddin speaks of a similar target. “We are about 10%,” she says. “But by 2012 we hope to contribute about 20%.”At CIMB Islamic, which made its name in investment banking and corporate banking and only really moved into balance sheet business about three years ago, the total today is 9%, according to Badlisyah Abdul Ghani, CEO.

These three chief executives illustrate how businesses have grown in different ways and with different objectives. Alliance started out with deposits products like Islamic savings accounts, moving into simple products such as housing loans and car hire purchase structures. From that, it has grown to a full range of consumer, commercial and corporate products including trade finance. Yahya Ibrahim says that 60% of the Islamic bank’s assets today are in consumer and the balance in commercial and corporate, with the profitability split around the same. Alliance Islamic does not have its own budgets, and instead operates branches within conventional branches: it has seven of these, predominantly in the Klang Valley. “We rely very heavily on the infrastructure of the mother bank,” he says. Like all Islamic entities, the funds must be kept scrupulously separate from the parent bank, but otherwise there is a lot of overlap: Islamic products are sold in tandem with conventional ones.

“In our business, normally when we have our annual budgets, a certain percentage of that budget will be for Islamic. So if you sell 100 housing loans, you’d probably have to sell 20 Islamic housing loans. In Islamic banking we make the products we sell Shariah compliant.” Since that means growth will be led by the conventional bank, consumer is likely to drive growth in the Islamic division since that’s the direction of the broader group.

RHB Islamic, too, is a heavy user of the parent bank’s infrastructure. Having the backing of that group has allowed it to reduce costs, and to pass savings on to customers. Jamelah says the cost to income ratio of the Islamic bank is just 44%, one of the lowest in the business. She says that the strongest growth at the moment is in retail and corporate. “The retail side is again because of the RHB bank infrastructure, so we’re able to sell our products through the branches of RHB Bank,” she says. For the future, she says she expects fee-based income to drive growth. “One area of attraction for fee-based income is cash management and transactional banking. More and more GLCs [government-linked companies] are compelling staff to borrow by way of Islamic structures, so there more and more reason for these corporations to use our transactions banking services.”

CIMB’s story is different since it built up in the investment and corporate banking side first. Badlisyah says the biggest area of growth is likely to be consumer banking. “One reason for that is because it is still very much a new business for us so in relative terms you should see more growth there: home financing, microcredit, things like that,” he says. He believes that in total assets and deposits CIMB Islamic now ranks third in the industry, behind Maybank Islamic and Bank Islam. “Investment banking and corporate continue to be a significant part of our business because they were our first core businesses anyway.”

In those core businesses, the global financial crisis obviously created major challenges, but Badlisyah says the work simply moved from one area to another. “During the height of the financial crisis when there were doldrums in the financial markets we saw more activities in corporate banking: bilateral or syndicated facilities, because it’s easier to do fund raising through that method rather than debt or equity capital markets,” he says. “Now that the momentum for debt capital markets is coming back, with quite a number of successful sukuk issuances in Malaysia and at the global level, the pipeline is getting much healthier for investment banking.”

Banks say that appetite for Shariah product is not just an Islamic phenomenon. Jamelah says that at RHB Islamic it’s 50-50. “For the retail side, I don’t think it really matters to the Chinese,” she says, arguing that it’s the return and the diversification rather than the underlying faith that matters to investors. At Alliance, the position is even more extreme. “80% of our customers are non-Muslims,” Yahya says. “From the perspective of the non-Muslims, it’s just another product, so what they count on is: is it competitive, is it cheaper? It sells on that basis rather than: is it Shariah compliant.”

As elsewhere in the Islamic world, there is much debate about whether the financial crisis was, in some measure, a good thing for Islamic banks, since they could not have exposure to the assets and securities that brought western banks unstuck. “There is a lot of talk on this,” Yahya says. “Islamic banks were not so much caught in the crisis. We did not have products as sophisticated as those in the conventional banks, for Shariah reasons. I remember before the crisis, in 2007, 2006, a lot of people were saying the Islamic banks are not complex or sophisticated enough: we don’t have options, futures and so on. Then when the downturn came, people said because we don’t have those things, we were not as badly hit. Now what I see is that, going forward, when everyone comes out of this crisis, the same arguments will appear.

“The fact is, under Islamic finance you are still asset based and you cannot run away from that,” he adds. “But unlike what some speakers say, Islamic banks are not smarter, we don’t have more sophisticated risk forecasting techniques. We didn’t have the products and therefore we were spared, it’s as simple as that.”

Badlisyah at CIMB: says “Islamic banking and finance has held up fairly well. We have benefited somewhat from the fallout in the conventional markets. More and more people are thinking and exploring about Islamic finance because they’re unable to find solutions to their financial needs in the conventional markets.”

Another consistent challenge for Islamic banks in Malaysia is human resources. Malaysia has set up numerous enterprises to help to deal with this – notably INCEIF, which bills itself as “the global university of Islamic finance” – and these initiatives are well thought-out and impressively resourced. But as Badlisyah says, “it will be some years down the track before any of the relevant bodies is able to make an impact in the industry.” The challenge is particularly acute with Shariah scholars, the people who make a judgment on whether something is Shariah compliant or not. At the best of times these people are hard to find: they need to have a sound knowledge of finance, of Islamic jurisprudence, and of the everyday mechanics of business, as well as being fluent in several languages. But in Malaysia, there is a requirement that no scholar can serve on more than one bank board, draining the pool still further.

Many have developed detailed in-house programs: CIMB has programmes which reach all the way to certification and all the group’s staff are encouraged to take them. It’s certainly a challenge. “There are going to be more players in this market, more and more banks going into Islamic finance, but the pool of people who are experts is not growing by the same number,” says Jamelah. “You will always find there is a gap in trying to get trained people to be experienced in Islamic finance.”

All three groups are watching with interest as foreign houses move into Islamic finance, with the two new mega-banks soon to be licensed. “We always look at it from the perspective of enriching the market, so the more players we have, the better the market will be in terms of products, the ability to have counterparties and things like that,” says Badlisyah. Yahya agrees. “We welcome it,” he says. “In most cases the competition is healthy, and you may see some products which we are not familiar with in this part of the world introduced. It’s a learning process.”