After 24 years of Islamic banking in Malaysia, it must now be clear to all that the primary difference between Islamic and conventional banking is the Shariah advisory requirements in the former. Perhaps what is not apparent to newcomers is the fact that for at least 13 years until the Islamic Banking Act (IBA) 1983 was introduced, the industry was working within an informal framework. In other words, the industry had no Shariah Advisory Council (SAC) to rule on Shariah matters during those years.
The SAC for Bank Negara Malaysia (BNM) was established on the 1st May 1997 as the highest authority for the ascertainment of Islamic law for the purposes of Islamic banking business, Takaful business, Islamic finance business, Islamic development financial business, or any other business that was based on Shariah principles and regulated by BNM. A year earlier, on the 16th May 1996, the Securities Commission (SC) had established its own SAC to advise the SC on all matters related to the comprehensive development of the Islamic capital market and functioned as a reference center for issues related to the Islamic capital market.
The financial market
Prior to 1993, there was only one Islamic bank and one Takaful operator in existence in Malaysia. In 1993, when BNM allowed conventional banks to operate Islamic windows, the number of players increased hugely, rendering a structured Shariah framework a necessity.
In December 2004, BNM introduced the “Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions” (GPS-1). The guidelines took effect on the 1st April 2005, 12 years after the introduction of Islamic banking windows. The broad objective of these guidelines, as outlined by BNM, was: “An effective Shariah framework would serve to ensure uniformity and harmonization of Shariah interpretations that will strengthen the regulatory framework and governance practices for the Islamic financial industry.”
In addition to Islamic banks, GPS-1 also applies to conventional banks with Islamic windows (including those which fall under the Development Financial Institutions Act 2002) and Takaful operators. Collectively, these are referred to as Islamic financial institutions (IFIs). Prior to GPS-1, BNM had streamlined the Shariah advisory framework by amending the Central Bank of Malaysia Act 1958 in 2003 to accord its SAC as the sole Shariah authority in matters under its supervision.
GPS-1 outlines the establishment and membership of the Shariah committee. Highlights include:
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Shariah committee members must have qualifications and expertise in Usul al-Fiqh or Fiqh al-Muamalat.
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The Shariah committee must have a minimum of three members with a secretary.
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A Shariah committee member will be disqualified if he acts with impropriety, is absent regularly, becomes a bankrupt, is convicted of a crime or is subjected to restricted residence.
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endorse the Shariah Compliance Manuals;
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endorse and validate relevant documentation;
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assist various professionals (lawyers, auditors, consultants) of the IFI to ensure Shariah compliance;
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direct the IFI to consult the SAC on matters not yet resolved by SAC;
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provide written Shariah opinions; and
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assist the SAC with advice and ensure the SAC’s decisions are implemented by the IFI.
Before the guidelines were enacted, there were instances of members sitting on Shariah committees for several banks. This raised questions relating to the impartiality and independence of these advisors in supervising the IFIs. Under GPS-1, IFIs are not allowed to appoint members of the SAC to sit on its Shariah committee, and no member of a Shariah committee can serve two IFIs in the same industry. This is a move to enhance the objectivity, impartiality and integrity of Shariah committees, as well as to ensure co-ordination in Shariah rulings and consistency in decisions.
BNM issued the “Guidelines on New Product Approval Requirements for Islamic Banking Institutions” in January 2004. Under these guidelines, a simple new product notification and specific approval process was introduced to promote greater incentives in product innovation. Unclear regulatory requirements in the past for pre-product approval had been identified as a major impediment. In remedying the situation, BNM adopted the principle of “what is not prohibited is allowed” for new Islamic banking products. This is reflective of the Islamic legal maxim for Muamalat (commercial dealings between men) that all transactions are permissible except those that are specifically forbidden. Industry players were called upon by BNM to improve levels of product transparency and consumer education as they brought new products onto the market.
In February 2006, BNM implemented the Product Approval and Repository System (PARS) to automate the approval process and to provide for a repository of Islamic banking products. The secure online application system provides simplicity in data submission on new product application. PARS also enables Islamic banks to review the application history, update existing approved products and interact with external parties in seeking feedback on the submitted products.
The capital market
The first Islamic bond issued in Malaysia was in 1990. Shell MDS raised a total of RM125 million (US$36.12 million) through a syndicate of financiers using the Bai Bithaman Ajil concept. This feat was accomplished well before the SAC was established and the issuance was not based on any Islamic guidelines from the SC. The subsequent development of the Islamic bond market over the next 10 years remained stagnant.
Development in the capital market followed a slightly different pattern in that SC has no guidelines on Shariah governance, although it did provide elaborate guidelines on how products should be introduced. Two guidelines played a major role in shaping the Islamic bond market into it is today. The first was the PDS Guidelines, issued in July 2000, which are primarily for conventional bond products but do have Shariah advisory provisions. And the second are the “Guidelines on the Offering of Islamic Securities” (IS Guidelines), which were introduced on the 26th July 2004 to recognize the distinct features of Islamic securities. With the second set of guidelines, issuance of Islamic securities based on Mudarabah and Musharakah principles was enabled. Islamic securities were no longer constrained by the debenture definition of the PDS Guidelines.
The debenture definition in practice limited the issuance of Islamic securities only to those that were based on the principles of Bai Bithaman Ajil, Ijarah and Murabahah, which basically represent debt obligations. However, Mudarabah and Musharakah are risk-sharing schemes and participants in these schemes are akin to being investors in a business or asset.
The IS Guidelines also provide considerable protection for investors. Issuers must comply with the statutory requirements on trust deeds and the duties of trustees and borrowers. Furthermore, if a transaction is structured under the Mudarabah or Musharakah principles, an Information Memorandum must be issued to investors. The disclosure via the memorandum allows them to make informed investment decisions. This is only apt, given the true nature of Mudarabah and Musharakah schemes.
Another major set of guidelines for the capital market are the “Guidelines for Unit Trust Funds.” The third edition was dated the 1st April 2003 and was last updated on the 30th September 2003. These guidelines contain provisions requiring a Shariah committee or advisor to be appointed if a fund is to be managed and administered in accordance with Shariah principles. This type of fund is now commonly known as an Islamic unit trust. Every unit trust fund must appoint an investment committee consisting of a minimum of three members. For Islamic funds, the investment committee must comprise at least two Muslim members.
The quality of the Shariah committee members prescribed by the SC is the same as that of BNM and the appointment of Shariah committee members must be approved by the SC. The guidelines also stipulate that where a Shariah advisory company is appointed, the advisory company must employ a minimum of one full-time officer designated to be responsible for Shariah matters relating to the fund.
Under the unit trust guidelines, the management company must remove immediately any Shariah committee member or designated officer of the Shariah advisor if the member or officer becomes subject to any disqualification or becomes otherwise unfit to hold office. Also, a Shariah committee member or designated officer cannot be appointed to the investment committee of funds managed by the same management company. Additionally, the Shariah committee or advisor must review the Islamic fund’s compliance report and investment transaction reports provided by the compliance officer and the trustee respectively, to ensure that the investments are Shariah compliant.
On the 21st November 2005 the SC issued the “Guidelines for Islamic Real Estate Investment Trusts.” An Islamic REIT is a collective investment scheme in real estate. Current cash inflows are generated from rental income and tenants must operate permissible activities according to the Shariah. In cases where tenants are found to be operating non-permissible activities, the fund manager for the Islamic REIT must perform additional compliance assessments.
The SAC has set a 20% threshold level of non-permissible activities for Islamic REITs. The total rental from non-permissible activities is compared to the total turnover of the Islamic REIT to obtain the percentage of rental from non-permissible activities. The guidelines provide specific remedial treatments and ways to calculate non-permissible activity ratios. They also stipulate that all forms of investment, deposit and financing instruments related to the Islamic REIT must be Shariah compliant. In risk management, coverage for the real estate can only be sourced from conventional insurance companies in cases where no Takaful schemes are available. An Islamic REIT can participate in forward sales or purchases of currency, and is encouraged to deal with Islamic financial institutions.
Another significant guidance issued by the SC to industry players comes in the form of a book entitled Resolutions of the Securities Commission Shariah Advisory Council. This is a major reference point, especially to Shariah advisors and academicians, and for those wanting to understand the products and the Shariah principles applied in the Malaysian capital market.
Conclusion
Looking at Shariah advisory and product development from a macro perspective, one can presume that BNM and SC have addressed the major issues effectively and successfully laid out building blocks for the future. Nonetheless, there are still areas that require the regulators’ guidance, such as Shariah compliance audit for Islamic financial institutions and Islamic financial advice and education for consumers. However, one clear observation from the discussions above is the high level of commitment demonstrated by the regulators in shaping the Islamic financial services industry and in pursuing the Islamic finance agenda in general.
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