Keynote Address at Seminar on the Rating of Islamic Financial Institutions
1 April 2000 |   By : Encik Ali Abdul Kadir, Chairman, Securities Commission
"SELECTED ISSUES ON THE DEVELOPMENT OF ISLAMIC FINANCIAL MARKETS"

Keynote Address by Encik Ali Abdul Kadir,
Chairman, Securities Commission


at the Seminar on the Rating of Islamic Financial Institutions
1 April 2000, Bahrain

Introduction

I would firstly like to thank AAIOFI for inviting me to this seminar on the rating of Islamic financial institutions. The focus on the need for a developed and transparent rating methodology for Islamic financial institutions is essential for establishing international best practices for Islamic financial services. The seminar is also a timely initiative, in the light of rapid changes sweeping Islamic financial markets due to globalisation and technological innovations.

In Malaysia, we have long appreciated the uniqueness and potential of Islamic financial products and services, as well as issues and challenges of developing Islamic financial markets in moving forward. The key challenge facing the global Islamic financial system is for it to reach its full potential and to be fully integrated into mainstream international finance.

Today I would like to share with you some of my perspectives on the issues going forward in developing Islamic financial products, services and markets and Malaysia's experience in developing our Islamic capital market.

International trends, issues and challenges

It is encouraging to note that since the first Islamic bank was established in Egypt in 1971, the Islamic financial services and products sector has gained importance and greater recognition. In this regard, I would like to commend the authorities in Bahrain for their active roles in accelerating the development of Islamic financial services and enhancing the profile of Islamic finance globally.

A wider product and service base is increasingly evident with more than 80 Islamic funds in operation globally, several global Islamic indices, innovations in Islamic product origination, retail banking, takaful and other capital market services. There is also now a greater diversity of market-players on both sides of the Atlantic, often involving the major financial players of the developed world.

A developing trend is also that of greater co-operation and strategic alliances between Islamic financial market institutions with their Islamic and conventional market counterparts. The advent of new technology would certainly facilitate international co-operation and alliances, in addition to providing many new opportunities for furthering the growth of lslamic financial markets at a scale larger than we could possibly envision. Just recently, I was informed that an Islamic finance and investment portal would soon be launched in both English and Arabic versions, to provide financial information and online share trading services.

While technology has brought on many opportunities for developing the Islamic financial markets, it also brings many challenges. For example, it has accelerated the process of liberalisation and globalisation of financial markets. To survive and grow in an increasingly borderless world, the Islamic financial community must continuously explore and identify common areas for the purposes of developing products, services and ways of working together. Differences must not be seen as an obstacle against open discussion. There should be greater appreciation for each other's relative strengths and weaknesses to facilitate international co-operation. The potential for strategic alliances must be explored further. In this regard, I would like to applaud the efforts linking the Bahrain Monetary Agency, Labuan Offshore Financial Services Authority and Islamic Development Bank to form an International Islamic Money Market to enhance the matching of the global pool of funding sources from Islamic financial markets with syariah-compliant investment opportunities. Each of us here is an important link in the global development of Islamic financial services sector. I strongly believe that the key is not to compete but to complement and add value.

Apart from strategic alliances, the Islamic financial community must recognise the need to develop instruments and institutional frameworks for Islamic financial markets. It is imperative that a wider product base with competitive rates of return be developed so that these products can be viable investment alternatives to conventional financial market products. As we know, Islamic financial markets still generally lack syariah-compliant fixed income, risk-management and liquidity-enhancing instruments both for the purposes of public debt financing and private asset allocation and diversification needs. The Islamic financial community must partake in a pro-active development of muamalat instruments. While adapting conventional instruments for Islamic financial purposes reduces the risk of non-acceptability by market players, we should not settle with merely playing "catch up" with the conventional financial sector.

Another challenge I would like to highlight is to enhance the demand for Islamic products at a global level. Strong demand for products can only be a function of a sufficiently wide investor base. As yet, it is still difficult to identify an adequate set of debt-financing products deemed acceptable by every Muslim country or school of thought. Hence, for those of us embracing different Islamic schools of thought, we must ask ourselves to what extent are we committed to working together to resolve some of these differences and to continuously work towards identifying common goals and areas of understanding. The lack of acceptability of capital market products among the Islamic world itself would severely undermine the global development of viable Islamic financial markets.

Demand for Islamic market products can also be strengthened when there is adequate awareness in the availability of products and services, especially those offered by other market jurisdictions. In an era where advancement in internet technology allows for almost zero information cost, it is hard to appreciate how the lack of awareness should persist as a long term constraint. Perhaps, the more fundamental reason is a lack of investment certainty and familiarity with the markets in which the Islamic products are offered and traded. Here, market regulators have a crucial role to play. Facilitating the development and regulation of an Islamic financial market which is accepted as an adequate platform for general investment purposes and at the same time, friendly to the various schools of Islamic thought is a huge undertaking. Such a market must have an investment climate based on transparency, accountability, strong corporate governance, supported by the appropriate technological infrastructure and comprised competent finance professionals conversant with both Islamic and conventional finance.

The Malaysian experience

Let me now share with you Malaysia's experience in developing Islamic financial services. Islamic finance in Malaysia could be said to have begun in 1962 when the Pilgrimage Fund Board was formed to enable intending pilgrims to undertake interest-free savings for the Haj. Since then, with its retail banking services, takaful, burgeoning capital market services sectors and supported by the relevant syariah-consistent regulatory framework, the Islamic financial system is in the process of developing a distinct and parallel sector to the conventional system. The Islamic banking system offers products based on trade financing transactions whilst the Islamic capital market offers debt, equity, equity-linked and commodity-linked derivatives securities. In terms of services, the capital market offers Islamic product structuring, project financing, stock-broking and fund management services.

The Islamic financial market in Malaysia sector has 2 Islamic banks, with Bank Islam being the larger of the two. Its merchant banking activities are involved in wholesale corporate banking, primary and secondary money markets, corporate advisory and investment management. Apart from the two Islamic banks, Islamic banking services is offered through Islamic windows in conventional banks and other financial institutions. Total Islamic banking deposits mobilised in 1998 amounted to RM 16.43 billion (US$ 4.30 billion) representing an increase of approximately 59 % over 1997 deposit's of RM 10.33 billion (US$ 2.72 billion). Rating of Islamic banks is not required by law and not undertaken by the rating agencies in Malaysia.

The Malaysian government is committed to developing its Islamic capital market sector to provide a unique set of assets which caters to institutional and retail investors seeking syariah-compliant investments. This is being undertaken as part of a larger scheme to develop the overall capital market. It is also recognised that developing Islamic capital markets must necessarily take a multi-pronged approach to address the needs for instruments, market intermediaries, awareness and education programmes and open dialogues between Islamic jurists and market participants.

To date, the Securities Commission has addressed the development of the Islamic Capital Market at two fronts, i.e., establishing the necessary support infrastructure and widening the product base. In the area of infrastructure, the SC has established the Islamic Capital Market Unit and the Syariah Advisory Council to support its work. The Islamic Capital Market Unit comprises both researchers trained in fiqh muamalat and capital market practices to undertake research in product origination and Islamic capital market operations. The SC is committed to building up skills in fiqh so that these principles can be fully appreciated and incorporated into all aspects of market regulation and development. The Syariah Advisory Council which comprises reknown fiqh scholars, key market participants of the Islamic financial market and academics advises the Securities Commission on Syariah compliance matters on all aspects of Islamic capital market operations.

In Malaysia, Islamic equity-related products include Syariah-compliant stocks listed on the Main and Second Board of the KLSE, two Syariah indices and equity derivatives. Equity derivatives such as warrants are approved provided that the underlying shares are Syariah-compliant. Apart from warrants, the Syariah Advisory Council has approved the structural concept of index futures to facilitate the development of risk management products.

As of mid March 2000, 544 out of 745 or 73% of equity stocks traded on the KLSE are syariah compliant. Malaysia has a very liquid secondary equity market with listed companies from a wide range of sectors of the economy. The vibrant Islamic equity market has been instrumental in spearheading the growth of the Islamic fund management industry in Malaysia especially in the 1990s. As of 31 December 1999, there were 13 unit trust funds administered according to Islamic principles with an NAV of RM1.4 billion (approximately US$368 million), compared to 10 funds in 1997.

In order to have a wider asset base, Malaysia has been making concerted efforts to develop its Islamic bond market for the last ten years. In general, there are three broad categories of Islamic Private Debt Securities which can cater to various financing objectives and cash-flow needs of issuers. These are long term Islamic debt securities of more than five years, medium term notes of two to five years and short-term commercial papers of one to twelve months. The two rating agencies in Malaysia provide long term and short term ratings on the likelihood of timely repayment of financial commitments of Islamic debt instruments.

It is in the Islamic bond market that much financial engineering and innovation in project financing has been undertaken in Malaysia. Most financing deals were structured along the concept of Al-Murabahah, Al-Ijarah and Al-Bai Bithaman Ajil. The Islamic debts or assets as in the case of Al Ijarah, are then securitised to enable the investors or subscribers to trade the securities in the secondary market. These tradable securities are generally long-term zero coupon bonds with periodic profit payments with a maturity period of more than five years. Many of the country's largest corporations such as Petronas, Tenaga and Telekom have sought financing and issued long-term corporate bonds. A more recent example is the raising of approximately RM2.2 billion (US$880 million) funds from Al-Bai Bithaman Ajil transactions to finance the construction of the Kuala Lumpur International Airport.

Issuing Islamic bonds was also used for purposes other than project financing. The Malaysian government has issued Government Investment Issues based on Al-Qardh Hasan transactions to provide liquidity and to facilitate asset management within the Islamic banking system. Cagamas, the national mortgage agency has issued Al-Mudharabah bonds to finance the purchase of Islamic house financing debts based on Al-Bai Bithaman Ajil transactions. Since 1997, the Malaysian government has issued Khazanah Benchmark Bonds which are series of zero-coupon bonds based on Al-Murabahah and Bai`Al-Dayn to allow for efficient pricing of credit risks for both conventional and Islamic bonds. Though economic and circumstantial reasons placed constraints on Khazanah bonds' reliability as a benchmark instrument, it was significant in that an Islamic instrument was designed to facilitate the price discovery process for instruments in the conventional market.

Increasingly, Al-Ijarah is being recognised in the domestic Islamic capital market for its structural flexibility and broad appeal amongst global Islamic investors as a viable financing structure base for corporate bonds. For Malaysia, Segari Energy Ventures was the first Islamic debt securities issuance with multiple tenure tranches which raised RM521.5 million (US$208.6million). Another Al-Ijarah transaction was the off-shore and cross-border US$60 million syndicated Ijarah Wa Iqtina deal for Telekom Malaysia in 1998 involving international banks in Labuan and Bahrain.

I would like to stress that in order to diversify its financing base, the Malaysian government has been stepping up efforts to develop its corporate bond market including the Islamic bond market. All round efforts are currently being put in place by both government and the private sector to enhance the competitiveness of Malaysia's Islamic financial system. For instance, with a RM100 million (US$26.316million) upgrade on its Management Information System, Bank Islam will soon be able to offer new facilities such as on-line, phone and Internet banking. Recent regulatory measures to promote a level-playing field between conventional and Islamic banking include ensuring that all instruments related to Islamic banking and "Al-Ijarah Term Loan" be subjected to stamp duty similar to instruments in conventional banking.

There is also now greater participation between the Malaysian Islamic banking and takaful sector and their regional counterparts. For instance, Bank Islam has agreed to provide Bank Muamalat-Indonesia with training and research support. A re-takaful joint venture between takaful operators from Malaysia, Brunei and Singapore has started to expand the takaful business beyond regional markets.

The SC recognises that a pre-condition for developing vibrant capital markets is to have the right environment for business and investment both for domestic and foreign investors. Various initiatives were undertaken to provide greater market transparency, enhancing corporate disclosure, raising corporate governance standards, improving protection of minority shareholders and pursuing regulatory reforms. Recognition of the need to raise corporate governance standards led to the formation of a high-level finance committee with members from private and pubic sectors was established to review the framework for corporate governance in Malaysia and to set best practices. Also, with the ongoing implementation of the SC's Disclosure Based Regulation or DBR Programme, we foresee investors increasingly taking on the responsibility of assessing the merits of their investments. SC's recent initiative to encourage the private sector to focus on enhancing shareholder value as a long-term business strategy is consistent with our overall emphasis on elevating corporate practices and transparency to globally competitive levels.

Conclusion

In concluding my speech for this morning, it is my hope that the esteemed members of the Islamic financial community gathered here today will continue efforts to converge ideas and thoughts towards developing the Islamic financial markets globally. God willing, may we all be successful in upholding the uniqueness and essence of Islamic finance which seeks to promote economic growth with distributive justice, profitability with social responsibility, prudent management and transparent dealings.

Thank you.
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