The Islamic Financial Services Industry, comprising Islamic Banking, Islamic Insurance (Takaful) and the Islamic Capital Market are areas that have become an important segment within the global financial markets. Malaysia's objectives are to develop a viable Islamic Financial Services Industry.

As globalisation and liberalisation of financial markets accelerates, it becomes more imperative to have a financial market with diverse and innovative products. The challenge is to therefore evolve strategies that will promote a competitive, dynamic and sustainable Islamic Financial Services Industry. Central to this common vision is the creation of a comprehensive Islamic Financial System that will be able to respond to the requirements of the domestic economy and also to become an integral component of the International Financial Systems.

The principles of Islamic financial instruments in Malaysia

The Islamic Financial System broadly refers to financial market transactions, operations and services that comply with Islamic rules, principles and codes of practices. These laws and rules require certain types of activities, risks or rewards to be either prohibited or promoted.

Islamic laws and rules are known as Shariah or Islamic jurisprudence.

Shariah governs all aspects of Islamic matters including worship, economic, social, political and cultural aspects of Islamic societies.

The Shariah is derived from three important sources, namely the Holy Quran (the holy book of the religion of Islam), Sunnah (the practices of the Prophet Muhammad) and Ijtihad (the reasoning of a group of qualified scholars).

There are two different approaches to developing modern Islamic financial products and services. The first approach identifies existing conventional products and services that are generally acceptable to Islam, and modifies as well, as removes any prohibited elements so that they comply with Shariah principles. The second approach involves the application of various Shariah principles to facilitate the origination and innovation of new products and services.

Prohibited elements of a commercial transaction must first be removed for it to be Shariah compliant. Among the major elements prohibited under Shariah, in summary, are:

• riba (interest);
• gharar (uncertainty);
• maisir (gambling) ; and
• non-halal (prohibited food and drinks and immoral activities).

With the fundamental prohibitions identified, products were then developed in Malaysia using a combination of approaches and have evolved over time to meet the needs of the local population.

The Islamic principles underlying the products available in Malaysia are:

• Mudharabah (profit-sharing) - loss borne by capital provider
  Mudharabah offers the owner of capital the opportunity to invest his capital in a certain project without becoming involved in managing that capital, and limits his liabilities to the capital committed.
  
  The salient features of Mudharabah is that the capital provider cannot claim a fixed amount of profit and an assured return on his capital if the project is profitable, as the profit will be distributed based on a pre-agreed ratio between the capital provider and the entrepreneur, in this case, who solely manages the projects.
  
  In the event the project is making losses, it shall be borne solely by the capital provider and none on the part of the entrepreneur, unless the loss is due to negligence of the entrepreneur.
  
• Musharakah (profit and loss sharing)
  
  Musharakah, which is analogous to a joint venture, where both the entrepreneur and investor contribute to the capital of the operations (assets, technical and managerial expertise, etc) in varying degrees and agree to share the returns, as well as risks, in proportions agreed in advance.
  
• Murabahah (trade with mark-up or cost-plus sale)
  
  Murabahah is widely used for instruments for short-term financing which is similar to more conventional purchase finance. Under Murabahah, the seller purchases the asset at cost and sells it back to the customer at marked-up price agreed by both parties.
  
  Essentially, it is an agreement that refers to the sale and purchase transaction for the financing of an asset or project, whereby the costs and profit margin are made known and agreed to by all parties involved.
  
• Bai Bithamam Ajil (BBA) (deferred-payment sale)
  
  BBA has similar features as Murabahah whereby the sale of goods is made on a deferred payment basis at a price, which includes a profit margin agreed by both parties. However, the difference is that BBA is generally used for long-term financing.
  
• Bai al-Salam (advance purchase)
  
  This is a sale and purchase transaction whereby the payment is made in cash at the point of the contract but the delivery of the asset purchased, as specified in the agreement, is deferred to a pre-determined date.
  
• Istisna (purchase order)
  
  A sale and purchase agreement whereby the seller undertakes to manufacture or construct according to the specifications given in the agreement. It is rather similar to Bai al-Salam, with the main distinction being the nature of the asset and method of payment.
  
  Istisna generally covers those things which are made to order; an advance payment is not always necessary. The method of payment is flexible according to the terms agreed to by the contracting parties.
  
• Ijarah (lease financing)
  
  Ijarah, which is similar to leasing in conventional financing, is a popular instrument designed for financing an asset or equipment. It is a manfaah or benefit or the right to use the asset or equipment.
  
  Under Ijarah, the lessor leases out an asset to the client at an agreed rental fee for a pre-determined period pursuant to the contract.

Islamic capital market

The growing need of the Muslim population in Malaysia for Shariah compliant products as an alternative to conventional banking and capital markets financial instruments acted as a catalyst for the development of an Islamic capital market in Malaysia.

The Malaysian Government issued the first Islamic Bond, the Government Investment Certificate (GIC), in 1983. The issuance of the GIC was based on the Islamic concept of Qardul Hasan (benevolent loan) non-interest bearing loans. However, GIC was not a tradable instrument as Qardul Hasan did not permit secondary trading. Therefore in order to evolve, the underlying concept of Qardul Hasan was changed to Bai-al-Inah to allow it to be traded in the secondary market.

Another aspect of the development of the Islamic capital market was the need to establish clear guidance on the types of equities that comply with Shariah principles. The review and identification of Shariah-equities stocks are guided by specific criteria as set out by Shariah scholars.

In Malaysia, initial efforts were undertaken by Bank Islam Malaysia Berhad (BIMB) in 1983. This was followed by the establishment of Malaysia's first fully-fledged Islamic stockbroking service which was launched by BIMB Securities Sdn Bhd (a subsidiary of Bank Islam Malaysia Berhad) in 1994. There are also a number of conventional stockbroking companies that offer Islamic stockbroking services alongside conventional business. The Securities Commission of Malaysia in June 1997 then introduced a list of Shariah compliant equities to guide the investing public. Currently some 80% of Bursa Malaysia's counters (Malaysia's stock market) are Shariah compliant.

With Shariah investment guidance and infrastructure in place, the establishment of Islamic funds and asset management activities gained momentum.

Islamic Banking Assets 1983 - 2002

Today there are a variety of Islamic capital market products and services to meet the needs of those who seek to invest in compliance with Shariah principles. These include Shariah-compliant equities, Islamic bonds and Islamic funds. The Islamic capital market has grown in sophistication and Islamic forms of product structuring, project financing, stockbroking, asset management and venture capital services are becoming increasingly available in Malaysia.

Islamic funds in Malaysia

Islamic mutual funds or Islamic unit trust funds are managed in compliance with the Shariah principles. Islamic mutual funds typically engage a Shariah board to advise and ensure that its investment operations and portfolios are managed in compliance with Shariah principles. There are different categories of Islamic funds in Malaysia and the typical products these funds invest in are Shariah-compliant equities, Islamic bonds and Mudharabah deposits.

Shariah-compliant equities

In general, Shariah-based equities are essentially shares of companies meeting Shariah criteria. However from an Islamic perspective, corporate stocks can only be classified as Shariah compliant if the business activities are not related to any prohibited activities as outlined earlier as well as meet certain qualitative criteria.

Other than the business criteria, there is also a cleansing mechanism to purify income received from investments of the funds that are tainted by prohibited activities. For instance, if some part of the income arises from interest-bearing accounts (prohibited by Shariah) and has been distributed to the funds, the proportion of such income will be given to charity and thus will not be retained by the fund.

Islamic bonds

The origination of Islamic bonds typically involves the packaging or structuring of pools of Shariah-compliant assets with or without credit enhancement into securities.

The structure is based on a specific contract of exchange that can be made through the sale and purchase of an asset based on deferred payment, leasing of specific assets or participation in a joint-venture business.

The issuance of Islamic bonds requires an exchange of a Shariah-compliant underlying asset for a financial consideration through the application of various Shariah principles such as Bai Bitamam Ajil, Murabahah, Istisna, Bai al-Salam and others. The structure of Islamic bonds has to be reviewed and approved by Shariah advisers to ensure that the structures are compliant.

In addition, the structuring process may also involve the provision of additional protection for investors against late payment, pre-payments, potential write-offs and others. Such protection is often provided in the form of credit and/or liquidity enhancement schemes.

Malaysia, in its effort to explore the potential of the Islamic Capital Markets on a global scale successfully launched the world's first sovereign Islamic bond in June 2003. The US$600 million Shariah-compliant papers, known as Sukuk, were listed on both Labuan International Financial Exchange as well as the Luxembourg Stock Exchange. There are currently nine Sukuks worldwide issued in different jurisdictions.

Malaysian Bond Market (1997 - 2004)

Conclusion

With today's pace of development in the Islamic Financial Systems and together with an estimated 1.2 billion Muslims globally, the management of liquidity is a challenge due to the relative scarcity of Islamic Capital Markets instruments. The challenge then for Malaysia and the Islamic Capital Markets globally is to step up its efforts in term of product development, harmonisation of Shariah's views and establishment of a global Islamic Financial System framework.

Statistics on the Growth in Islamic Equity Fund Assets (1996 - 2003)