IFSA2013: RATIONALE, SALIENT FEATURES AND POSSIBLE ISSUES

KULSANOFER SYED THAJUDEEN

Abstract
The Financial Services Act (Act 758) and the Islamic Financial Services Act
(Act 759) were published in the Government Gazette on the 22 nd of March
2013. The new laws came into effect on the 1 st of July 2013. The objective
of this paper is to understand the rationale behind the formulation of the
Islamic Financial Services Act (IFSA), the main areas covered by the new
Act, how the new regulation would affect the industry and the feedback
from the industry players on the impact of IFSA.
The formulation of the new Acts involved the consolidation and
rationalization of the Banking and Financial Institutions Act 1989,
Insurance Act 1996, Payment Systems Act 2003, Exchange Control Act
1953, Islamic Banking Act 1983 and the Takaful Act 1984. With the new
IFSA, it repeals the Islamic Banking Act 1983 and the Takaful Act 1984.
The IFSA is also an omnibus legislation for the regulation and supervision
of key Islamic financial institutions such as banks, takaful operators,
international Islamic banks, and operators of payment systems using
Islamic payment instruments, issuers of Islamic payment instruments,
takaful brokers and Islamic financial advisor. It also provides for regulation
and supervision of payment systems and the oversight of the Islamic
money market and Islamic foreign exchange market.
The principal regulatory objective of IFSA is to promote financial stability and
compliance with Shariah. The new Act strengthens regulation of financial institutions,
Islamic money market and the Islamic foreign exchange market as well as Islamic
payment instruments. Consumers of Islamic financial services are also required to be
protected under the Law.
The industry players generally support the introduction of IFSA as it would help create
greater transparency, governance and accountability. Nevertheless they are apprehensive
about managing the risks as there is a paradigm shift from a risk-transfer to risk-sharing
model. Customer reaction towards the financial products that would be introduced is also
a cause for concern to the Islamic financial institutions.

Teething problems are expected and how the regulators will respond to work together
with the industry to mitigate the problems will determine the success of IFSA.

2
 Table of Contents

1.0 Introduction
2.0 The Story Behind IFSA
3.0 The Rudiments of IFSA
3.1 The Components of IFSA
3.2 The Key Features of IFSA
3.2.1 Part IV, Shariah Requirements
3.2.1.1 Division 1, Provision 28(1), Shariah Compliance
3.2.1.2 Provision 28 (2), Shariah Advisory Council
3.2.1.3 Provision 28 (3), Notification to regulators on Shariah non-compliance
3.2.1.4 Provision 28 (5), Accountability and Penalty
3.2.1.5 Provision 29 (1), (3) & (6) Shariah Standards
3.2.1.6 Provision 29 (2) (a) (i) & (ii), Appointment of Shariah Committee
3.2.1.7 Provision 30 (1) Shariah Governance
3.2.1.8 Provision 30 (2), Single Shariah Committee
3.2.1.9 Provision 33(1), Cessation of Shariah Committee member
3.2.1.10 Provision 35 & 36, Confidentiality of Shariah Committees
3.2.1.11 Provision 37 (1) & 38 (1), Shariah Audit
3.2.2 Part VIII, Financial Groups
3.2.3 Shadow Banking
3.2.4 Takaful
3.2.5 Interest in Shares
3.2.6 Deposits Redefined
3.2.7 Prudential Requirements and Corporate Governance
4.0 Implications of IFSA to the Industry
5.0 Conclusion
6.0 Glossary

Bibliography

3
1.0 Introduction

Islamic finance was first introduced into Malaysia with the establishment of Perbadanan
Wang Simpanan Bakal-Bakal Haji (PWSBH) in September 1963, as an institution for
Muslims to save for Hajj or pilgrimage to Mecca. 1 The institution is now known as
Lembaga Tabung Haji. Eventually the first Islamic bank, Bank Islam was established in
1983 while in 1993 conventional banks were allowed to open Islamic windows to
allow them to offer Islamic financial products.

To legalize these activities, the Islamic Banking Act (IBA) was gazetted on 10 th March
1983 and came into force on 7th April 1983. Following the recommendation of a Special
Task Force set up to study the viability of the setting up of an Islamic insurance company,
the first takaful operator, Takaful Malaysia was incorporated in November 1984. The
Takaful Act (TA) was gazetted on 31st December 1984 and came into force on 1 st January
1985.2
The Banking and Financial Institutions Act (BAFIA) 1989 was gazetted on 24 th August
1989 and came into effect in January 1990. BAFIA was enacted to provide new laws for
the licensing and regulation of institutions carrying on banking, finance company,
merchant banking, discount house and money-broking businesses. The Interest-free
Banking Scheme, known as Islamic Banking Scheme now was launched in March 1993.
Bank Negara Malaysia (BNM) issued Guidelines on Interest-free Banking Scheme in
July 1993, in pursuant of section 126 in BAFIA. In 1996, an amendment was made to
section 124 of BAFIA to formalize the carrying out of Islamic banking and financial
businesses by licensed institutions established under BAFIA and to establish a Shariah
Advisory Council. The BAFIA makes it clear that IBA shall not become an authority for
regulating the Islamic banking business carried on by conventional banks which is based
on the BAFIA.3

1 Malaysian Financial System, Institut Bank-Bank Malaysia

2 ibid
3 ibid

4
While the IBA and BAFIA are legislations to regulate the industry, the Central Banking
Act (CBA) 1958 was enacted to establish the Central Bank of Malaysia and outline its
roles and responsibilities. The Central Bank of Malaya Ordinance (CBO) 1958 was
enacted on 23rd October 1958. The CBO was revised in 1994 to become the CBA.

In 2003, the CBA 1958 was amended to include section 16B, which allocates for the
establishment of the Shariah Advisory Council (SAC) at BNM for the purpose of
advising the BNM concerning matters related to Shariah which affects the Islamic
banking and financial industries. The CBA 1958 was repealed by the Central Bank of
Malaysia Act 2009 which was gazetted on 3 rd September 2009 and came into effect on
25th November 2009. Among the salient-features in the Act is the affirmation that
Malaysia has a dual financial system, conventional as well as Islamic.4
Other regulatory legal frameworks in place are Capital Markets and Services Act 2007
which allows prescription of Islamic securities and power to issue guidelines and the
Labuan Islamic Financial Services and Securities Act 2010 which provides rules and
regulations in doing business under Islamic principles.5
The Financial Sector Blueprint 2011-2020 was issued in 2011, to chart the strategic plan
and future of the financial system in Malaysia towards a high-income economy. The
Blueprint notes that A key pillar of financial sector development for this decade is the
strengthening of Malaysias position as an international Islamic financial centre Given
the more challenging international environment, emphasis will increasingly be placed on
enhancing the resilience of Islamic finance, including in liquidity and crisis management,
to complement the ongoing efforts in strengthening the relevant regulatory and legal
framework for Islamic finance and in promoting greater harmonisation in Shariah
interpretations.

Although Islamic finance in Malaysia has enjoyed stable growth and now constitutes
more than 20% of the banking assets of the banking system, but in order to move forward
to further enhance its value proposition for the global economy, the evolution of the legal
4 ibid
5 ibid

5
framework is necessary to facilitate the continuing market evolution and the
internationalization of Islamic finance.6

The Islamic Financial Services Act 2013 is intended to provide the strengthened
regulatory and legal regime to meet the challenges and developments of an increasingly
sophisticated and internationalized Islamic finance industry.

2.0 The Story Behind IFSA

The idea to strengthen the regulatory platform for Islamic banking was mooted way back
in 2001 in the Financial Sector Masterplan (FSMP). The main objective of the FMSP was
to improve the capabilities of domestic banking institutions over 10 years. It was to be
implemented over three phases, the first phase to develop a core set of strong domestic
banking institutions. The second phase is the removal of some of the restrictions on
incumbent foreign players to add further competition to the industry, as well as providing
wider choices for the consumers. The third phase is to introduce new foreign competition.

The FSMP stated that efforts will be made to create a separate and viable platform for
Islamic banking and takaful to function effectively in parallel with conventional banking
and insurance. The legal, regulatory, and Syariah framework of Islamic banking and
takaful will be strengthened further through the review of the existing laws and
guidelines, governing the industry. Some of the recommendation to achieve this is
outlined in Recommendation 5.8, that several amendments will be made to the existing
Islamic Banking Act and BAFIA to strengthen regulation and to develop a regulatory
framework for Islamic banking by introducing a separate capital adequacy, statutory
reserve and liquidity requirements. Harmonising the Shariah opinions on Islamic banking
and finance is also part of the recommendation. 7

6 Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 1

7 Financial Sector Masterplan (FSMP)

6
As a follow-up to the FSMP, the Financial Sector Blueprint 2011-2020 (Blueprint) also
outlines the regulatory and supervisory regime to address potential risks to financial
stability that may arise from the evolving financial landscape. The recommendations in
the Blueprint were incorporated into the FSA and IFSA. Recommendation 4.1.1 stated
Enact a comprehensive legislative framework for the conventional and Islamic financial
systems respectively. The proposed legislation will reinforce a sound, transparent, and
accountable system for effective regulation and supervision that is consolidated across the
banking, insurance, takaful, financial intermediary and payment system sectors.8

Other source of input for the IFSA is the recommendation from the Financial Sector
Assessment Program (FSAP) Malaysia, Basel Core Principles for Effective Banking
Supervision: Detailed Assessment of Observance assessment completed in February
2013, by a joint International Monetary Fund-World Bank mission. The objectives of the
assessment were to review developments in the financial sector, assess and formulate
recommendations related to financial stability, financial development, and the financial
sector oversight framework.

One of the issues highlighted in the FSAP is that the current regime does not extend
appropriately to the supervision and regulation of Financial Holding Companies (FHC).
During the last financial crisis, Bank Negara Malaysia was not able to hold the directors
and management of holding companies accountable for wrongdoing because the
companies were not financial institutions. Under the IFSA, as long as the FHC deal in
banking or financing activities, they fall under Bank Negaras jurisdiction. While
previously Islamic windows were not regulated like the standalone Islamic financial
institution, now they will be subjected to the same prudential treatment.

Other issues include the lack of explicit power for Bank Negara Malaysia (BNM) to
revoke licenses for Islamic Banks. There was no specific share ownership threshold
stipulated in IBA. The IBA does not require the external auditors to report matters of
material significance to the supervisor. There was lack of explicit power for BNM to

8 Financial Sector Blueprint 2011-2020

7
obtain information from holding companies of Islamic banks and auditors working
papers. While the BAFIA explicitly provides that decisions by Ministry of Finance
(MOF) should be made upon the recommendations of BNM, considering the interests of
the public, the IBA did not state it explicitly. 9

The IFSA was drafted incorporating all the recommendation in the Blueprint and FSAP
with the objective of promoting financial stability, Shariah compliance and strengthening
the regulation of financial institutions.

3.0 The Rudiments of IFSA

The Islamic Financial Services Act (IFSA) 2013 was gazetted on 22 nd March 2013 and
came into force on the 1st of July 2013. The Act has 18 parts, 291 provisions and 16
schedules. The IFSA is an omnibus legislation for the regulation and supervision of key
Islamic financial institutions such as Islamic banks, takaful operators, international
Islamic banks, international takaful operators as well as operators of payment systems,
issuers of Islamic payment instruments, takaful brokers and Islamic financial advisors.
As an omnibus legislation, it also provides for regulation and supervision of payment
systems and oversight of the Islamic money market and Islamic foreign exchange
market.10

The IFSA is also a landmark law, perhaps the only Islamic finance legislation in the
world. It codifies Shariah governance with regards to Islamic finance, in the legislation. It
can further enhance Malaysias profile as the Islamic finance marketplace and it position
Malaysia as a reference centre for laws on Islamic finance services.

9 Financial Sector Assessment Program (FSAP) Malaysia, Basel Core Principles for
Effective Banking Supervision: Detailed Assessment of Observance, International
Monetary Fund, 2012
10 Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 1

8
With the Financial Services Act and Islamic Financial Services Act 2013, the Acts that
have been repealed are the Islamic Banking Act 1983, Takaful Act 1984, Banking and
Financial Institutions Act 1989, Insurance Act 1996, Payment Systems Act 1996 and
Exchange Control Act 1953. Existing guidelines and circulars under existing laws will be
deemed to have been issued under corresponding provisions of new laws, unless revoked.
Approval granted under existing laws shall be deemed to have been granted under
corresponding provisions of new laws. Transactions, dealings, contracts or arrangements
lawfully entered into under repealed Acts shall remain valid under new laws. Licenses
granted under existing laws shall be deemed as licenses granted under new laws.11

3.1 The Components of IFSA

Figure 1: The Components of IFSA (source BNM)

11 Sundaram, Gopal, The Islamic Financial Services Bill 2012

9
BNM decided to enact a comprehensive legislative framework for the conventional and
Islamic financial Systems respectively. Among the reasons why a dedicated Islamic
finance Act was enacted is to contribute to development of precedents in Islamic finance
international laws and facilitate robust development of case laws on Islamic finance due
to its unique features. It sets the strategic direction that Malaysia is set to position itself as
an international Islamic financial center with enhanced regulation in line with
international best practices and Shariah governance aspects.12

3.2 The Key Features of IFSA

The provisions in place for end-to end Shariah compliance by Islamic financial
institutions from the time of licensing, during operations and until the winding up of the
Islamic financial institution is the most distinctive features of the IFSA 2013. The Islamic
financial business has a particular operational risk that is Shariah risk which can lead to
legal and financial ramifications thus Shariah compliance is of utmost importance.

3.2.1 Part IV, Shariah Requirements

3.2.1.1 Division 1, Provision 28(1), Shariah Compliance

The new Act now imposes a statutory duty under section 28(1) for Islamic financial
institutions authorized under the Act to ensure at all times that their aims, operations,
business, affairs and activities are in compliance with Shariah.

3.2.1.2 Provision 28 (2), Shariah Advisory Council

Due to the lack of consensus in permissibility of certain transactions like Tawarruq and
Al- Inah, among the Islamic scholars, there is a problem of universal acceptance of
Islamic finance products. To legally address this issue and to promote greater uniformity
and standardisation of Shariah finance products, the Central Bank of Malaysia Act 2009
established the Shariah Advisory Council which is the authority for the ascertainment of

12 Financial Sector Masterplan (FSMP)

10
Islamic law for the purposes of Islamic financial business. Rulings of the Shariah
Advisory Council are binding on financial institutions, the courts and arbitrators.13

3.2.1.3 Provision 28 (3), Notification to regulators on Shariah non-compliance

It is now legally incumbent upon an Islamic financial institution to immediately notify

the regulator and and its Shariah committee once it becomes aware that it is carrying on
any of its business, affair or activity in a manner which is not in compliance with Shariah.
The Islamic financial institution is required to immediately cease from carrying on such
business and from taking on any other similar business, affair or activity and within 30
days, to submit to the regulator a plan on the rectification of the non-compliance.
The Act empowers the regulator to carry out an assessment to determine the rectification
has been carried through. As most of Islamic financial institutions are aware, the
rectification normally resorted to is to annul the transaction where possible and in any
case to donate any profits made under the transaction to charity.14

3.2.1.4 Provision 28 (5), Accountability and Penalty

The Islamic financial institutions under the Act are required to comply with the Shariah
standards issued by the regulator in accordance with the advice of the Shariah Advisory
Council, Bank Negara Malaysia. The requirement to comply with the Shariah standards
issued by the regulator is also imposed on the directors, the chief executive officer, senior
officers and members of the Shariah committee of the financial institution. Under IFSA
the liability of the Shariah scholars is defined and they are held accountable just like any
other professional. The penalty for any person who contravenes the section commits an
offence and shall on conviction be liable to imprisonment for a term not exceeding 8
years or to a fine not exceeding RM25 million or both.15

3.2.1.5 Provision 29 (1), (3) & (6) Shariah Standards

13 Sundaram, Gopal, The Islamic Financial Services Bill 2012, Part 2

14 Sundaram, Gopal, The Islamic Financial Services Bill 2012Part 2 Shariah Compliance

15 Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 3 Shariah Governance

11
BNM is empowered by IFSA to specify standards to give effect to the advice or rulings of
the Shariah Advisory Council. The standards issued by the regulator are binding on all
Islamic financial institutions authorized under the Act and on their directors, chief
executive officers and senior officers and in particular, on their Shariah committee
members who function as vanguards for Shariah compliance in these institutions. BNM is
in the process of developing Shariah standards to outline regulatory requirements for
individual Shariah contracts to ensure compliance to Shariah requirements. The standards
will ensure that products introduced by Islamic financial institutions will be based on the
specific Shariah contract and it is an effort to harmonize the Shariah standards. The
distinct risk and reward profile for each Shariah contract has been identified. In addition,
the Act provides that internal policies and procedures adopted by the institution to
implement the standards specified by the regulator are binding upon every director,
officer or Shariah committee member of the institution. A failure to comply with the
standards issued by the regulator in respect of Shariah governance is an offence under the
Act and carries with a maximum penalty of 8 years imprisonment or a fine of RM25
million ringgit or both. Shariah advisers are legally liable for the financial products they
approve.16

3.2.1.6 Provision 29 (2) (a) (i) & (ii), Appointment of Shariah Committee

The new Act vests the regulator with the power to specify the functions and duties of the
board of directors, senior officers and Shariah committee members of the institution in
relation to Shariah compliance. The standards may also detail the fit and proper
requirements or disqualifications of Shariah committee members. The existing rules
which limit the number of Shariah committees that such members may sit in will be
subsumed under these standards. 17

3.2.1.7 Provision 30 (1) Shariah Governance

Initially the Islamic banks and takaful companies were regulated like conventional banks
and insurance companies except the governance, business and operations of the

16 ibid
17 ibid

12
businesses should not contain any element that was against Islam. It was also a statutory
requirement that a Shariah Committee should be set up in each institution licensed under
these legislation which would have the role to ensure that the governance, business and
operations of the institution were consistent with the Shariah. With the continued growth
and internationalization of Islamic finance, the IFSA was necessary to provide more
provisions to ensure proper supervision and regulation of Islamic finance and Shariah
governance for institutions licensed under the Act.18

3.2.1.8 Provision 30 (2), Single Shariah Committee

There is a statutory duty placed on Islamic financial institutions to establish a Shariah

committee for the purposes of advising the institution in ensuring Shariah compliance in
its business activities. The IFSA is however, more practical as it permits a financial group
which has more than one licensed institutions in the group with the approval of Bank
Negara Malaysia to establish a single Shariah committee for the financial group. The
established Shariah Committee must be capable of ensuring compliance with Shariah by
all licensed persons within the financial group.19

3.2.1.9 Provision 33(1), Cessation of Shariah Committee member

The cessation as a member of the Shariah committee is subject to several statutory

requirements in the 2013 Act. Primarily these requirements ensure that a Shariah
committee member resigns only of his own volition and his termination or removal is
only on grounds of disqualifications under the fit and proper requirements. The law
requires resignations and proposals to terminate a Shariah committee member to be
notified to the regulator.20

3.2.1.10 Provision 35 & 36, Confidentiality of Shariah Committees

18 ibid
19 Sundaram, Gopal, The Islamic Financial Services Bill 2012Part 1 Shariah
Governance
20 Sundaram, Gopal, The Islamic Financial Services Bill 2012Part 2 Shariah
Governance

13
Shariah committee members are subject to the usual banking secrecy rules under the Act.
Shariah committee members enjoy statutory protection for actions for breach of
confidentiality provided they have acted in good faith in the course of the discharge of
their duties and performance of their functions. Shariah committee members are also
statutorily protected from actions for defamation in respect of any statement made by
them without malice in the discharge of their duties.21

3.2.1.11 Provision 37 (1) & 38 (1), Shariah Audit

The regulator is empowered to require the Islamic financial institution to appoint any
person approved to conduct a Shariah audit on institution. The person appointed by the
institution shall abide by the duties and function specified by the regulator and is required
to submit a report to the regulator on the audit performed. All costs shall be borne by the
institution. In addition the appointed person enjoys a statutory protection for liability for a
breach of duty of confidentiality between that person and the institution in respect of
matters reported to the regulator pursuant to the Shariah compliance audit. In the case
where an institution fails to appoint a person to carry out the Shariah compliance audit,
the regulator may itself appoint a person to carry out the Shariah compliance audit. The
regulator can also appoint another person in addition to the person appointed by the
institution to carry out the Shariah compliance. 22

3.2.2Part VIII, Financial Groups

One of the major changes to the regulatory regime under the IFSA is the formal
recognition of financial groups for the purposes of regulation and supervision. Holding
companies of any financial institution will come under the purview of Bank Negara
Malaysia and be subject to the same rules as any financial institution in Malaysia. BNM
is empowered to exercise oversight over financial groups for promoting the safety and
soundness of any member of the group who is an authorized person licensed to carry on
banking, insurance or investment banking business. The reason for the oversight is the
lack of empowerment that BNM had during the last financial crisis in 1998, the directors

21 ibid
22 Sundaram, Gopal, The Islamic Financial Services Bill 2012Part 2 Shariah
Compliance

14
and management of the holding companies escaped penalty for wrongdoing because the
companies were not financial institutions. 23

Provisions are now in place to require approval for financial holding company (FHC) if a
financial company holds an aggregate interest in shares of more than 50% in a licensed
person or 50% or less in the licensed person but has control over the licensed person . A
company may propose another company within its corporate group to be approved as a
financial holding company (FHC) if it can be shown that the proposed company is in a
position to have control over the licensed person and its proposed financial group. BNM
may require any other company within the corporate group of the applicant to be
approved as a FHC if it feels neither the applicant nor the proposed company should be
approved as a FHC. It can also require more than one company within a corporate group
of the applicant to be approved as a FHC to maintain effective regulation and supervision
of licensed person.24
BNM now has extended powers to prohibit a FHC to carry on any business other than the
business of holding investments directly or indirectly in corporations which are primarily
engaged in financial services or in other services in connection with such financial
services. It can also specify standards on prudential matters to the FHC and its subsidiary,
if it is of the opinion that the activities of such FHC and its subsidiary may pose risks to
the licensed person or its financial group. Priority is towards standards on corporate
governance, risk management, capital and liquidity. BNM can now issue a written
direction to a FHC, subsidiary or its chief executive officer to cease or refrain from
committing an act or pursuing a course of conduct or to do any act, in relation to its
business affairs or property. It can also remove directors and chief executive officers who
are no longer considered fit. Among some of the transitional arrangements is the
companies that currently holds more than 50% shares in licensed institutions are required
to submit application to become FHC within 12 months from commencement date. The
existing FHCs already designated by BNM under BAFIA are deemed approved and no
further application is required but the companies must comply with applicable Prudential

23 Kaur, G., Shadow Banking: Its a Problem, 2013

24 Sundaram, Gopal, The Financial Services Act 2012- Interest in Shares (Part 2)

15
Requirements under IFSA. These steps are necessary to prevent undue risks to safety and
soundness of financial institutions and financial stability.
A FHC, subsidiary or its directors or chief executive officer who fails to comply with the
BNM issued direction commits an offence and shall on conviction, be liable to
imprisonment of 10 years or less, a fine of RM50 million or less or both.25

3.2.3 Shadow Banking

The term shadow banking refers to institutions that lend money to the public but are not
governed by Bank Negara Malaysia. The IFSA and FSA have empowered BNM to get
the shadow banking industry to comply with its rules on lending. The non-banking
financial institutions (NBFIs) supplied 60% of personal loans, which has raised the
household debt to GDP ratio to 83%, which is very high. Now, the shadow banks,
including the cooperatives, will have to comply with new lending rules, which limit the
amount of the debt of vulnerable borrowers to a maximum of 60% of their net income.
The Minister has the power to prescribe entity that poses or is likely to pose risks to
financial stability, as a financial institution and subject it to ongoing regulation and
supervision by BNM. With the IFSA too, Islamic windows will be subjected to the same
rules as standalone Islamic financial institutions in terms of things like prudential
treatment. Previously, standalone entities were subject to greater scrutiny and regulation
than the windows. These laws do not apply to licensed or approved persons under Capital
Market and Services Act 2007 and licensed entities under Labuan Financial Services and
Securities Act 2010 and Labuan Financial Services and Securities Act 2010.26

25 Take 5, Financial Services Act and Islamic Financial Services Act 2013, Ernst and
Young, volume 1 issue 1, 5 April 2013
26 ibid

16
Figure 2: Malaysias shadow bankers (source: The Star)

3.2.4 Takaful

An important change brought about by the IFSA is the separate licenses for life and
general takaful. The reason for the decoupling is to push the takaful industry into a new
level of maturity, as the players may engage in strategic joint ventures and acquisitions to
achieve the higher capital requirements imposed by the new Act. With a single license,
the takaful business can concentrate all the resources on enhancing growth of a particular
type of business. It can also pave the way for new niche players. The different risk
characteristic of family and general takaful is another factor to separate the businesses.
The takaful operators are given five years to convert their existing composite licensed
business into a specific takaful business of their choice.

Before IFSA, the composite takaful operators were required to have a minimum paid-up
capital of RM 100 million. After IFSA it is not readily known whether each licensee
would be required to have a paid-up capital of RM 100 million each for general and life
takaful respectively or split RM 50 million each. Among the responsibilities of the takaful
operator is to keep the takaful fund separate from the shareholders fund, to maintain and
manage the takaful on behalf of the takaful participants, to not withdraw from the takaful

17
fund unless interests and fair treatment of takaful participants have been given due regard
and to provide qard or financial support to takaful fund from shareholders fund under
certain conditions.

The takaful participants ownership of takaful fund is legally recognized now. In the case
that the assets of takaful fund to meet its liabilities are deficient, surplus assets of takaful
funds can be used and if still insufficient, the surplus assets of shareholders fund after
meeting all shareholders funds liabilities can be utilized.27

3.2.5 Interest in Shares

Part VI, Ownership, Control and Transfer of Business

Since the financial institutions are largely funded by deposits, investment accounts or
premiums thus the public money needs to be managed professionally. Having a
substantial amount of shares in the financial institution would render the shareholder
powerful. In order to have more check and balance, significant or substantial stakes in
financial institutions was measured using the concept of interest in shares. One of the
important uses of the concept of interest in shares in the IFSA is in the provisions relating
to the acquisition and disposal of shares of a licensed person (refers to a commercial
bank, insurance company or investment bank licensed under IFSA).

Some of the significant changes in IFSA are the approvals for acquisitions beyond 5%
and beyond are from the regulator, Bank Negara Malaysia, not the Minister of Finance.
Approvals are not needed for acquisitions beyond 5 % but not exceeding 10%. The
approval of the regulator is needed for an acquisition resulting in a 10% holding but no
approval is needed for acquisitions thereafter which would result in a holding exceeding
10% but not exceeding 15%. In short, approvals from the regulator are only needed for
acquisition but no approval in holdings, at intervals of multiples of 5, for example
holdings of 5%, 10%, 15%, 20%, etc. The power to approve a holding of 50% interest in
shares by a licensed person lays with the Minister of Finance not the regulator. Disposal
of interest in shares by a person holding 50% or more in the shares of a licensed person or
a person having control of a licensed person also require the approval of the Minister of

27 Regulator Industry Dialogue on Islamic Finance 2013,1st Quarter Session, 14

February 2013

18
Finance. The approvals of the Minister for such acquisitions or disposals are to be given
by him on the recommendation of the regulator.28

To determine the aggregate interest in shares of a licensed person, the legal, beneficial,
direct and effective interest as well as the holding of his spouse, child, family, corporation
or persons acting with him shall be added to his holding. With the FSA and IFSA, the
concept of effective interest in shares used in computing the aggregate interest in shares
of a licensed person differs from the concept of deemed interest in shares used in the
BAFIA.

Figure 3: Deemed interest vs Effective interest (source: BNM)

Beyond a holding of 5%, the criteria of fit and proper persons assumed greater
importance to determine whether the Ministers approval for the acquisition should be
given. Some of the criteria include the character and integrity of the shareholder, business
conduct of the licensed person, financial resources of the applicant, activities of corporate
group, effect of investment on Malaysias economy and financial stability.

28 Sundaram, Gopal, Financial Services Act Bill 2012 Part 2 Interest in Shares

19
Under the FSA, an individual may not hold more than 10% interest in the shares of a
licensed person. Under the IFSA, an individual may hold more than 10% interest in
shares of a licensed person if prior approval of the Bank has been obtained and an
undertaking not to exercise control over the licensed person is given to the Bank. A
person is presumed to have control if such person has more than 50% interest in shares of
institution, has power to elect, appoint ,remove or direct board directors.29

3.2.6 Deposits Redefined

One area the Islamic financial institutions are concerned about regarding IFSA is the
clear definition of what constitutes a deposit and what goes into an investment account.
The main difference is money that goes into a deposit account is guaranteed, while
money that is put into an investment account such as wakalah or mudharabah is not
guaranteed.

The implication to the banking industry is to replace the existing deposit product
principles with a different structure to comply with the new ruling that deposit products
need to be guaranteed while non-guaranteed products such as mudharabah and wakalah
will go into the investment accounts. With IFSA the Profit Equalization Ratio (PER) and
PIDM insurance backing is no longer available for Mudharabah investment accounts. The
Islamic financial institutions are given two years to comply with the new ruling.

Examples of categories of deposit products Examples of categories of investment

products
Savings account Structured deposits which are not
principal guaranteed
Current account (cheque facility) General and specific investment
account (mudharabah and wakalah
contract)
Fixed deposit
Islamic deposits ( wadiah, qard or
murabahah contract)

Figure 4: Examples of deposit and investment products

29 Regulator Industry Dialogue on Islamic Finance 2013,1st Quarter Session, 14

February 2013

20
3.2.7 Prudential Requirements and Corporate Governance

IFSA and FSA are modelled after the Basel Core Principles for Effective Banking
Supervision. The Basel Committee on Banking Supervision revised its Core Principles
which was endorsed by banking supervisors at the 17 th International Conference of
Banking Supervisors in 2012. The revised Core Principles define 29 principles that are
needed for a supervisory system to be effective. Those principles are broadly categorised
into two groups: the first group (Principles 1 to 13) focus on powers, responsibilities and
functions of supervisors, while the second group (Principles 14 to 29) focus on prudential
regulations and requirements for banks. The original Principle 1 has been divided into
three separate Principles, while new Principles related to corporate governance, and
disclosure and transparency, have been added. This accounts for the increase from 25 to
29 Principles.

Principle 1 Responsibilities, objectives Principle 11 Corrective and sanctioning Principle 21 Country and transfer risks
and powers powers of supervisors

Principle 2 Independence, Principle 12 Consolidated supervision Principle 22 Market risks

accountability, resourcing and legal
protection for supervisors

Principle 3 Cooperation and Principle 13 Home-host relationships Principle 23 Interest rate risk in the
collaboration banking book

Principle 4 Permissible activities Principle 14 Corporate governance Principle 24 Liquidity risk

Principle 5 Licensing criteria Principle 15 Risk management process Principle 25 Operational risk

Principle 6 Transfer of significant Principle 16 Capital adequacy Principle 26 Internal control and audit
ownership

Principle 7 Major acquisitions Principle 17 Credit risk Principle 27: Financial reporting and
external audit

Principle 8 Supervisory approach Principle 18 Problem assets, provisions Principle 28 Disclosure and
and reserves transparency

Principle 9 Supervisory techniques and Principle 19 Concentration risk and Principle 29 Abuse of financial services
tools large exposure limits

Principle 10 Supervisory reporting Principle 20 Transactions with related

parties

21
Figure 4: The Basel Core Principles for Effective Banking Supervision

The FSA and IFSA are focused at a greater level of transparency, accountability and
governance in the management and operation of both conventional and Islamic banking
in Malaysia. The new rulings will also see a greater role by the Central Bank of Malaysia
in terms of regulating and supervising financial institutions, payment systems, and other
relevant entities including the oversight of the money market and foreign exchange
market to promote financial stability and compliance with the Shariah. It would also enable
Malaysia to achieve full compliance with international standards for effective supervisory
systems.

Under the BAFIA Act 1989, prudential requirements referred only to the maintenance of
net assets depending on the nature and scale of the institutions operations, the interests of
the depositors or potential depositors, and the risks inherent in those operations and in the
operations of any other related corporation of the institution.

Under the FSA and IFSA, Bank Negara Malaysia has more empowerment to dictate what
is appropriate for an institution in respect of capital adequacy, liquidity, corporate
governance, risk management, related party transaction, and maintenance of reserve
funds, insurance funds and prevention of criminal activities. The Bank also has the power
to dictate standards which relate specifically to capital market products or capital market
services (jointly with the Securities Commission of Malaysia). Islamic financial
institutions are required to ensure that its internal policies and procedures reflect the
Banks standards on prudential requirements.

The IFSA and FSA give much importance to corporate governance, with specific
approval requirements for directors and chief executive officer. There are also fit and
proper requirements for Chairman, directors, chief executive officers and senior officers
at appointment and if they do not comply, they shall immediately cease to hold office and
licensed person shall remove such person from office. The individual and collective
duties of directors are legislated, and are to have regard for the interests of depositors and
policy holders over and above the interests of shareholders.

22
Directors and the management may be deemed liable for an offence committed by the
licensed person if there was no due diligence exercised. Directors are also required to
disclose material transaction or material arrangement. Directors duties complement and
do not derogate from the duties of directors under the Malaysian Companies Act 1965. 30

4.0 Implications of IFSA to the Industry

The industry players generally view the new regulatory regime positively. Nevertheless
implementing the changes to comply with the IFSA can be a little daunting.

CIMB Islamic Banks CEO, Badlisyah Abdul Ghani said, The distinction is no different
from what is available in the conventional banking market space. The industry has a five-
year period to manage the impact and the way it will be is to simply replace the existing
deposit product principles that we have today with a different structure so that it clearly
complies with what is defined as a deposit, which is something that is guaranteed. The
non-guaranteed products such as mudharabah and wakalah will go into the investment
accounts. 31
The industry has until end of March 2014 to comply with the regulation for deposit
products while for Murabahah contracts it is already effective from January 2014.
Thus the short transition period is an issue with financial institutions because they need to
amend legal documents, policy and also system infrastructure to comply with the new
regulation. However Kuwait Finance House (Malaysia) has complied by converting
existing KFH General Investment Account-I (GIA) and KFH Foreign Currency General
Investment Account-I (FC-GIA) under Mudharabah contract to KFH International
Commodity Murabahah Deposit-i (ICM) and KFH Foreign Currency International

30 Subramaniam, Paul, Malaysias New Financial Services Architecture, April 2013

31 Special Focus : Islamic Finance Overview : Game Change, The Edge Malaysia, Oct
2013

23
Commodity Murabahah Deposit-I (FC-ICM) at no cost to the customers effective from
January 2014. It may be possible for KFH due to their smaller volume of customers.32

Raja Teh Maimunah, CEO of Hong Leong Islamic Bank, lauds the effort of the regulator
to drive the industry towards risk sharing from risk transfer but is also concerned about
losing market share to conventional products. The new regulation no longer allows for
Profit Equalization Ratio (PER) and PIDM insurance backing for Mudharabah
investment accounts, which may, in her opinion, result in loss of customers. She also
mentioned that Hong Leong Islamic Bank would not offer any Restricted Mudharabah
products tagged to financing assets as it almost always gives a downside return.

Other operational issues are the proposed new Wadiah contracts restricts Hibah ( gift/
returns) to avoid it becoming Urf or the common norm. This restriction will impact the
bank and industry as a whole since most of Islamic banks are using Wadiah contract for
their Current Account and Savings Account (CASA) where indicative rates will be
displayed; but now it is not allowed.

Alternative Shariah products for CASA accounts are scarce and changing to Commodity
Murabahah (CM) may not be practical since CASA involves large volume of customers
and there is no maturity dates. It may be suitable for Term Deposit-i. The new Bai Inah
products cannot be used for houses still under construction and this would impact
existing products where the assets are still under construction at the time when the
customer applies for financing.
IFSA encourages Mudharabah and Musharakah venture and financing structures by
removing cost to financing but financial institutions are required to establish
comprehensive internal policies, risk management and governance structure. A dedicated
Board Committee for Mudharabah/Musharakah has to be established to ensure proper
management of ventures. All these require extensive planning and time.

Another area that will be impacted by IFSA is the takaful industry. The splitting of
licenses between life and general takaful will bring about major changes to the takaful

32 www.kfh.com.my

24
industry. Takaful operators have a five year time frame to undertake a feasibility
assessment and convert their existing composite licensed business into a specific takaful
business of their choice. It is envisaged that the separation of the licence will pave the
way for the presence of new niche players while widening the scope of business for the
existing general takaful players. Takaful providers may now require more capital if they
decide to maintain both businesses. Experts presume that operators will enter tie-ups or
sell their licences if they are unable to come up with the required capital.

The CEO of Takaful Ikhlas Sdn Bhd, Abdul Latiff Abu Bakar, said The changing
licenses means we have to change names. We can no longer refer to ourselves as Takaful
Ikhlas Sdn Bhd; we have to call ourselves Takaful Ikhlas General or Takaful Ikhlas
Family. It will be a massive exercise but we will take this opportunity to reposition
ourselves and our brand. Takaful Ikhlas has also formed a taskforce to stimulate its
business plans. The team has a year to identify its strategy and four years to implement
it.
Takaful Malaysia, group MD Mohamed Hassan Kamil said Takaful Malaysia does not
have any concerns about the capital requirements, as the company is financially strong
and has the capital to meet the IFSA requirements. We believe we will be able to manage
and sustain both classes of our businesses, even under separate entities. Asked on
whether the company will maintain two separate departments, he answered This would
involve considerable administrative efforts, so the best approach to overcome it would be
through the financial holdings company structure. The shared services divisions would be
maintained at the holding company level to serve both classes of business under entities.

The Chairman of Malaysian Takaful Association (MTA), Zainudin Ishak feels the
separation of licences is good move to promoting growth especially in the general takaful
business. He points out that in all Organisation for Economic Cooperation and
Development (OECD) member countries, life and non-life insurance businesses are
separated, so one business cannot be used to support the other.33

33 Special Focus : Islamic Finance Overview : Game Change, The Edge Malaysia, Oct
2013

25
Some of the issues that may arise from the new regulation is a drop in the number of
general takaful providers, but this could also be an opportunity for new players. The
existing talent shortage would increase and result in more staff pinching and wage hikes,
as separate board of directors and skilled workers are needed for every composite license
split. Companies need to improve on distribution channels to penetrate the market. The
providers must now operate under a financial holding company which will now be under
heightened regulatory oversight.

5.0 Conclusion

The new regulatory FSA and IFSA Acts were developed to address several issues that
were plaguing the banking industry. With IFSA, Malaysia is the first country in the world
to legislate Shariah governance which shows the commitment towards achieving status of
Islamic financial hub. The IFSA forces the industry to adopt a risk sharing ideology as
opposed to risk transfer. The IFSA also accords more regulatory empowerment to BNM
to achieve greater corporate governance in the banking industry. The clearly defined
Shariah standards will allow better acceptance from other countries that were
apprehensive about the Shariah compliance of financial contracts in Malaysia. This
would force product innovation and wipe out complacency in the industry. The product
innovation would result in differentiation of Islamic financial institutions (IFI) from the
conventional banks. The IFIs can practice the true value proponents of Islam and at the
same time experience growth in their business. Malaysia can become the thought leader
in Islamic finance and spearhead the way towards becoming an Islamic financial hub.
Change in anyway will definitely result in apprehension and it is no different with the
Islamic financial institutions (IFI). The bottom line is IFIs are businesses required to
make profit for their shareholders thus there is apprehension about how the changes will
affect their performance. Customer reaction is something we have to wait and see but
aggressive awareness programs on the prohibition of taking or giving riba could help in
tipping the scale in the predominantly Muslim population in Malaysia. Another factor
would be a new line of alternative Shariah compliant products could entice customers to
switch over form conventional banking.

26
Its going to be some interesting times for the Islamic finance industry in Malaysia and
worldwide. We hope that with all these initiatives Islamic finance can change the banking
landscape and change how we view banking forever.

Glossary

27
This part includes interpretations of terms or words used in the Act. Some of the
important definitions are as follows:

1) Approved business means any business that Islamic requires approval like
operation of a payment system that enables the transfer of funds from one Islamic
banking account to another, includes debit transfer, credit transfer or standing
instructions but does not include the operation of a remittance system. Payment
system also provides Islamic payment instrument network operation which
enables payments to be made through the use of an Islamic payment instrument.
Other businesses which require approval are issuance of a designated Islamic
payment instrument, takaful broking business and Islamic financial advisory
business.

2) Approved person means a person approved under section 11 to carry on an

approved business.

3) authorization means the grant of a licence under section 10 or the grant of an

approval under section 11

4) authorized business means a licenced business or an approved business

5) Authorized person means a person licensed under section 10 or approved under

section 11 to carry on an authorized business.

6) Licensed business means Islamic banking business, takaful business,

international Islamic banking business or international takaful business

7) Islamic deposit means a sum of money accepted or paid in accordance with

Shariah. The sum of money will be repaid in full, with or without any gains either
on demand or at a time agreed by or on behalf of the person making the payment
and person accepting it. Under an arrangement, the proceeds under the
arrangement to be paid to the person paying the sum of money shall not be less
than such than such sum of money.

but excludes money paid bona fide

(i) by way of an advance or a part payment under a contract for the sale,
hire or other provision of property or services

28
 (ii) by way of security for the performance of a contract or by way of
security in respect of any loss which may result from the non-
performance of a contract.

(iii) Without limiting paragraph (ii), by way of security for the delivery up
or return of any property, whether in a particular state of repair or
otherwise

Bibliography

29
1. Ibrahim , Haslindar & Devagi d/o Erugan , An Analysis of the Islamic Banking Profit Rate and
Conventional Banking Interest Rate in Malaysia

2. The Malaysian Financial System, Institut Bank-Bank Malaysia

3. Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 1 of 4, Abdullah Chan Advocates and
Solicitors

4. Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 2 of 4 Shariah Cmpliance, Abdullah
Chan Advocates and Solicitors

5. Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 3 of 4, Shariah Governance (Part 1),
Abdullah Chan Advocates and Solicitors

6. Sundaram, Gopal, The Islamic Financial Services Bill 2012 Part 4 of 4, Shariah Governance (Part 2)
Abdullah Chan Advocates and Solicitors

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Advocates and Solicitors

8. Financial Sector Masterplan (FSMP)

9. Financial Sector Blueprint 2011-2020

10. Financial Sector Assessment Program (FSAP) Malaysia, Basel Core Principles for Effective Banking
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11. Kaur, G., Shadow Banking: Its a Problem, StarBiz Weekly, 6 July, 2013

12. Take 5, Financial Services Act and Islamic Financial Services Act 2013, Ernst and Young, volume 1
issue 1, 5 April 2013

13. Regulator Industry Dialogue on Islamic Finance 2013,1st Quarter Session, 14 February 2013

14. Subramaniam, Paul, Malaysias New Financial Services Architecture, April 2013

15. Special Focus: Islamic Finance Overview: Game Change, The Edge Malaysia, Oct 2013

16. www.kfh.com.my

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