Chapter 1

Introduction
What is Islamic finance?
Islamic finance started as early as the Middle Ages when Islamic merchants became
middlemen for trading activities in Spain, the Mediterranean and Baltic states. However, the
term Islamic financial system is relatively new and only started in the mid-1980s. Islamic
financial system is not only about being interest-free. It encompasses a wide range of
principles of Islamic doctrine advocating risk sharing, individuals rights and duties, property
rights and the sanctity of contracts. In addition, Islamic finance is not limited to Islamic banking
but also covers capital formation, capital markets, wealth management and all types of financial
intermediation.
The conventional financial system focuses on the economic and financial aspects of
transactions. In contrast, the Islamic financial system emphasizes ethical, moral, social and
religious dimensions with the aim of enhancing equality and fairness for the good of society as a
whole. The Islamic financial system prohibits the payment or receipt of any predetermined,
guaranteed rate of return. The system encourages risk-sharing, discourages speculative behavior
and emphasizes the sanctity of contracts.
The basic framework of the Islamic financial system is governed by the Shariah laws in
governing economic, social, political and cultural aspects of Islamic societies. Shariah laws are
dictated by the Quran and its practices and explanations rendered by the Prophet Muhammad or
more commonly known as Sunnah. (Bank Negara Malaysia, 2010) The basic principles of an
Islamic financial system are as follow:(1)

Prohibition of Interest
The Islamic financial system prohibits riba or in other words; any unjustifiable increase
of capital whether in loans or sales. The principles of Islamic financial system do not
allow any fixed or predetermined rate to be tied to the maturity and the amount of
principal. This is because Islamic finance promotes social justice, equality and property
rights. The logic behind prohibiting riba is because business operations may not create
wealth if there are business losses. In addition, the goal of social justice states that
borrowers and lenders should share losses equally. Thus, the Islamic financial system
encourages the earnings of profits because profits symbolize successful entrepreneurship
and creation of wealth. By prohibiting riba, the process of wealth accumulation and
distribution in the economy will reflect true productivity and fair distribution of wealth in
the economy.

(2)

Risk Sharing
Suppliers of funds are regarded as investors in the Islamic financial system
instead of creditors. Business risks is shared between the provider of financial capital
and the entrepreneur in return for shares of the profits.

(3)

Money as Potential Capital

Although Islam recognizes the time value of money, capital is only treated as actual
capital when it is used with other resources to undertake a productive activity. Islamic
finance treats money only as potential capital until it is utilized.

(4)

Prohibition of Speculative Behavior

Transactions which involve extreme uncertainties, gambling and risks is prohibited in the
Islamic financial system. Besides that, the Islamic financial system also discourages
hoarding.
Sanctity of Contracts
It is a sacred duty in Islam to uphold contractual obligations and disclosure of
information. This is because it encourages the reduction of risk related to asymmetric
information and moral hazard.

(5)

(6)

Shariah Approved Activities

In Islamic finance, business activities that qualify for investment are those that do not
violate the rules of shariah and thus any investment related to to alcohol, gambling and
casinos is prohibited.

Islamic Financial Instruments

Different instruments are offered to satisfy different needs of customers in Islamic
markets. Some of the more common ones are:(1)

Murabaha
Murabaha means trade with markup or cost-plus sale in Islamic finance. It is based on
the traditional notion of purchase finance. It is widely used for short-term financing and
constitutes around 75 percent of Islamic financial transactions. It involves investors
undertaking a supply of specific goods and incorporating a mutually agreed contract for
resale to the client with a mutually negotiated margin.

(2)

Ijara
Ijara is the term used for leasing transactions. It is an exchange transaction in which a
known benefit arising from a specified asset is made available in return for a payment,
but where ownership of the asset itself is not transferred. In Islamic financing, there are
different types of leasing arrangements (Kreatoc, 2014). Some leasing arrangement
permit the lessee to purchase the buy the asset at an agreed upon price at the end of the
lease and the installment payments be included as part of the purchase price. Examples
of leasing include financing vehicles, aircrafts, machinery and equipment. Leasing
makes up 10 per cent of total Islamic financial transactions.

(3)

Mudaraba
Mudaraba is a contract between a capital provider (rabbul mal) and an entrepreneur
(mudarib) under which rabbul mal provides capital to be manged by the mudarib and any
profit is shared between the rabbul mal and mudarib according to mutually agreed profit
sharing ratio (PSR) whilst financial losses are borne by the rabbul mal provided that such

losses are not due to the mudaribs misconduct, negligence or breach of specified terms
(Bank Negara Malaysia). It is a profit-sharing agreement in which managers manage a
pool of funds by investors. It is more suitable for trade activities as the maturity structure
ranges from short to medium term.
(4)

Musharaka
Musharaka means equity participation and it is similar to a classical joint venture. In
Musharaka both the investor and entrepreneur contribute to the capital invested such as
assets, technical expertise, managerial expertise and working capital. In return, both
entrepreneur and investor share the risks and returns of the operations in varying degrees
as earlier agreed upon. Musharaka is mostly used for financing fixed assets and working
capital for medium and long-terms transactions.

(5)

Sales Contracts
In the context of Islamic finance, credit sales are conducted using deferred-payment sale
(bay muajjal) and deferred-delivery sale (baysalam). For deferred-payment sale, the
delivery of the payment is delayed for an agreed upon period while the delivery of
product is taken on the spot. On the other hand, a deferred-delivery sale is where
delivery of the product is in the future but the payment for the transaction is made on the
spot. Deferred-delivery sale is similar to a forward contract.

Islamic Financial System Components

The Islamic financial system consists of two main components namely Islamic banking
and takaful. Another important component closely related to banking is the Islamic capital
market.
Islamic Banking Industry
Islamic banking refers to a banking system that complies with Shariah law and practices
the underlying principles of mutual risk and profit sharing. Under Islamic banking, activities that
cultivate entrepreneurship, trade and commerce and bring societal development or benefit is
encouraged. Islamic banking incorporates the various Islamic finance concepts such as ijarah
(leasing), mudharabah (profit sharing) and musyarakah (partnership). These Islamic finance
concepts led to the creation of various Islamic finance products that support genuine trade and
business related activities. Currently, Malaysia has a substantial number of full-fledged Islamic
banks including several foreign owned entities (Bank Negara Malaysia, 2014).
Takaful Industry
Takaful or Islamic insurance is a concept whereby a group of participants mutually
guarantee each other against loss or damage. The takaful operator manages a fund contributed
by each participant and this contribution is called donation or tabarru. Takaful operates as a
source of protection as in the event of loss or damage suffered, the takaful operator will disburse
the funds accordingly to its participants.
The takaful industry is growing rapidly globally and in Malaysia, the first takaful
company was established in 1985 with the enactment of the Takaful Act 1984. The takaful
industry has been a significant contributor to Malaysias overall Islamic financial system with
assets amounting USD 2.8 billion as of year 2007. This is partly due to the liberalization of
Malaysias Islamic financial industry that has encouraged participation from foreign institutions
(Bank Negara Malaysia, 2014).
Islamic Capital Market
The Islamic capital market is a component of the overall capital market in Malaysia but
practices market transactions that do not conflict with the shariah law. Its transactions are free
from activities prohibited by Islam such as usury (riba), gambling (maisir) and ambiguity
(gharar). The Islamic capital market plays a complementary role to the Islamic banking system
in diversifying and deepening the Islamic financial markets in Malaysia. Various products are
available in the Islamic capital market such as sukuk, Islamic unit trust, Shariah-compliant
securities, Shariah indices, warrants, call warrants and crude palm oil futures contract (Securities
Commission Malaysia).

Chapter 2
Islamic Financial System in Malaysia
Establishment and History
In 1963, the establishment of Pilgrimage Fund (Tabung Haji) kick starts the development
of the Islamic financial system in Malaysia. Tabung Haji is the first Islamic saving institution
with the objective to develop a mechanism to encourage Muslims to save for their pilgrimage.
The Tabung Haji was established under Act 8 of Pilgrimage Management and Fund Board 1969
with the objective of enabling Muslims to save to support expenditure during pilgrimage as well
as to ensure their savings are parked under investment activities permissible in Islam. Tabung
Haji also serves to protect and safeguard interests of pilgrims during pilgrimage by providing
various facilities and services.
The establishment of Tabung Haji was successful in meeting its objectives. As of
financial year 2003, Tabung Haji has a net asset value of RM 11,635 million with a net profit of
RM 404 million. Tabung Haji was able to achieve this through its diversified investment
activities in accordance to Shariah requirement. These include Bonds, Corporate Notes,
Government Investment Certificates, Mudharabah Bank Account and Bill of Acceptance. Most
of Tabung Hajis investments are in the plantation, construction, real estate development and
services sectors. Tabung Haji fully owns four subsidiaries namely TH Plantations Sdn Bhd, TH
Technologies Sdn Bhd, TH Properties Sdn Bhd and TH Travel & Services Sdn Bhd (Laldin).
The success of Tabung Haji led to the suggestion of establishing a full fledge Islamic
Bank by the Islamic Financial Services sector. This resulted in the establishment of Bank Islam
Malaysia in 1983. Bank Islam is regulated by the Islamic Banking Act 1983 and it is also
registered under the Companies Act 1965. Registration under the Companies Act 1965 enables
Bank Islam to carry out trading activities including owning assets. Bank Islam is doing well in
the banking sector and currently has a network of 80 branches across Malaysia (Haron, 2004).
Realizing the importance of Islamic banking in contributing to the economic growth of
Malaysia, the Malaysian government decided to allow existing banking institutions to offer
Islamic banking services using their existing infrastructure and branches. By doing so, the
government was able to increase the number of Islamic banking institutions in an efficient and
effective manner. Conventional banking institutions offering Islamic banking are required to
appoint Shariah consultants to ensure their activities are in compliance with Shariah
requirements. This implementation contributed to the economies of scale and synergies in
optimizing the existing banking infrastructure and resources.
In an effort to streamline the Shariah interpretations among Islamic banks and takaful
companies, Bank Negara Malaysia established the Shariah Advisory Council for Islamic Banking
and Takaful (SAC) in May 1997. It is the highest Shariah authority on Islamic banking and

takaful and provides advice on all Shariah matters pertaining to Islamic banking and takaful in
Malaysia. Basically Islamic banks and takaful operator are guided on the musharakah and
mudharabah contracts in coming up with their product offerings.
In October 1999, Bank Muamalat Malaysia Berhad (BMMB) was established. BMMB
was the effect of the merger between Bank Bumiputra Malaysia Berhad (BBMB) and Bank of
Commerce (Malaysia) Berhad (BOCB). BMMB was the second full fledge Islamic bank in
Malaysia. Besides that, the Malaysia government started opening its markets to international
players by allowing international banks which operates Islamic product to open branches in
Malaysia.

Regulation
The Islamic financial institution in Malaysia is governed by the Islamic Financial Services
Act 2013. The Act aims to provide for the regulation and supervision of Islamic financial
institutions, payment systems and other relevant entities and the oversight of the Islamic money
market and Islamic foreign exchange market to promote financial stability and compliance with
Shariah and for related, consequential or incidental matters. Components in the Act include:a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
l)
m)
n)
o)
p)
q)
r)

Regulatory Objectives and Powers and Functions of Banks

Authorization
Shariah Requirements
Payment Systems
Prudential Requirements
Ownership, Conrol and Transfer of Business
Financial Groups
Business Conduct and Consumer Protection
Islamic Money Market and Islamic Foreign Exchange Market
Submission of Document or Information
Examination
Directions of Compliance
Intervention and Remedial Action
Other Powers of Banks
Enforcement and Penanties
General Matters
General Provisions
Repeal, Savings and Transitional

The following are Islamic Banks in Malaysia at present:-

No.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

Name
Affin Islamic Bank Berhad
Al Rajhi Banking & Investment Corporation (Malaysia) Berhad
Alliance Islamic Bank Berhad
AmIslamic Bank Berhad
Asian Finance Bank Berhad
Bank Islam Malaysia Berhad
Bank Muamalat Malaysia Berhad
CIMB Islamic Bank Berhad
HSBC Amanah Malaysia Berhad
Hong Leong Islamic Bank Berhad
Kuwait Finance House (Malaysia) Berhad
Maybank Islamic Berhad
OCBC Al-Amin Bank Berhad
Public Islamic Bank Berhad
RHB Islamic Bank Berhad
Standard Chartered Saadiq Berhad

Ownership
Local
Foreign
Local
Local
Foreign
Local
Local
Local
Foreign
Local
Foreign
Local
Foreign
Local
Local
Foreign

The following are Takaful Operators in Malaysia:No.

1
2
3
4
5
6
7
8
9
10
11

Name
AIA Public Takaful Berhad
AmMetlife Takaful Berhad
Etiqa Takaful Berhad
Great Eastern Takaful Berhad
HSBC Amanah Takaful (Malaysia) Berhad
Hong Leogn MSIG Takaful Berhad
MAA Takaful Berhad
Prudential BSN Takaful Berhad
Sun Life Malaysia Takaful Berhad
Syarikat Takaful Malaysia Berhad
Takaful Ikhlas Berhad

Ownership
Foreign
Local
Local
Foreign
Local
Local
Local
Local
Local
Local
Local

Recommendations
Malaysia is seen as a global leader in Islamic finance especially in the Southeast Asian
region. Malaysia focuses on developing its capital markets in Islamic finance which is targeted
to grow by an average of 10.3 per cent a year to top $ 1 trillion by 2020. Thus, one
recommendation is to establish a flexible regulatory framework to cope with changing dynamic
market realities. Businesses are constantly changing the way they do business and although
sound regulation is crucial in Islamic finance, the value of the regulation needs to be constantly
monitored (Varriale, 2013). It is important to create a culture of corporate governance to ensure
the Islamic financial system is viable and attractive to investors.
Another recommendation is to build the human capital in Islamic finance given the robust
growth of Malaysias Islamic market especially in the sukuk market. Malaysia will require more
Islamic financial experts with the growing demand. By attracting talented human capital,
Malaysia is able to maintain its competitive edge over competitors (Emerging Markets Monitor,
2010). The emphasis for more talented human capital in Islamic finance is evident with Bank
Negara introducing new Special Employment Passes (SEPs) that allow greater labour mobility
between countries especially for those with Islamic finance expertise. Besides that, the
Malaysian government also offers scholarship funding to encourage individuals to study masters
and doctorate in Islamic finance at the International Centre for Education in Islamic Finance
(INCEIF) located at Kuala Lumpur.

References
Bank Negara Malaysia. (2014). Islamic banking & takaful. Retrieved October 24,
2014, from http://www.bnm.gov.my/index.php?
ch=fs_mfs&pg=fs_mfs_bank&lang=en#Banking
Bank Negara Malaysia. (2010). Shariah governance framework for Islamic financial
institutions.
Bank Negara Malaysia. Shariah Standard on Mudarabah. Islamic Banking and
Takaful Department.
Emerging Markets Monitor. (2010). Malaysia: Islamic finance rising star. Emerging
Markets Monitor , 16 (20), pp. 8-8.
Haron, S. (2004). Towards developing a successful Islamic financial system: a lesson
from Malaysia.
Kreatoc. (2014). Islamic Finance. Retrieved from islamic-finance.com:
http://www.islamic-finance.com/item_ijara_f.htm
Laldin, M. A. (n.d.). Islamic financial system: the Malaysian experience and the way
forward.
Securities Commission Malaysia. (n.d.). Islamic Capital Market. Retrieved October
24, 2014, from http://www.sc.com.my/general_section/islamic-capital-market/
Varriale, G. (2013). How to build finance hub: the secret to Malaysia's success.
International Financial Law Review , 32 (8).