Malaysia and Indonesia are two key markets in the Islamic financial space. Their value to the global industry cannot be understated, and as their own domestic industries grow inexorably, the global industry will strengthen. Dr Zulkifli Hasan explores recent developments in these countries discussing the new legislative and corporate governance changes that make the sector more stable and dynamic.
Introduction
Islamic finance has emerged as an alternative and a suitable competitor to the conventional banking system. Since its establishment, the system has slowly integrated itself into the existing banking system and has proven its effectiveness and sustainability. In fact, it is reported that the Islamic finance sector grew 50% faster than the overall banking sector. Islamic finance in Malaysia and Indonesia has been pivotal in the growth of the global industry. With experience of more than 30 years for Malaysia and 21 years for Indonesia, both countries are now witnessing tremendous development in Islamic finance. This article intends to provide an overview of the state of Islamic finance in Malaysia and Indonesia. It will provide a brief overview of the current economic position, the growth of demand, regulatory reforms, corporate governance frameworks and Shari’a advisory.
Malaysia and Indonesia
Demographically, Malaysia is a multiracial state with a population of nearly 30 million people. Islam is by far the largest practiced religion with 61.3% followers, followed by Buddhism at 16.8%, Christianity at 9.2%, and Hinduism at 6.3%. Economically, Malaysia is still considered a developing country. The Gross Domestic Product (GDP) in Malaysia is valued at USD303.53 billion representing 0.49% of the world economy. In the third quarter of 2013, it was reported that Malaysia’s annual GDP growth rate was at 5%.¹
Indonesia is the largest economy in South East Asia and the fourth largest country by population in the world with more than 250 million people. Indonesia has the largest Muslim population in the world – almost 88% of the total population. The GDP value of Indonesia represents 1.42% of the world economy with annual growth rate of 5.62% in 2013.² Considering the rapid growth of the Indonesian economy, Indonesian authorities have implemented stabilization policies to ensure that the economy does not overheat. With the largest Muslim population in the world, it is estimated that Indonesia has a 5% penetration rate for Islamic finance, which is set to triple or quadruple in the next five to ten years.
The growth of demand for Islamic finance
It cannot be denied that Islamic Finance in Malaysia is growing. As of end 2013, Malaysia has 16 full-fledged Islamic banks, 12 takaful operators, five international Islamic banks and six development financial institutions that offer Islamic financial services and products. Market share is currently 24.4% of the total banking system. Total Islamic financing is at 16.6% and represents 26.9% of total loans in the banking system with the household sector continuing to account for the bulk of Islamic financing at 65.9%. 653 Shari’a-compliant securities are listed on Bursa Malaysia, representing 71.8% of the total listed securities.
Indonesia also enjoys positive figures. Rapid economic growth in Indonesia has spurred many non-Muslim foreign institutions to foray into Islamic finance such as Bank of Tokyo- Mitsubishi UFJ. In parallel with high GDP growth, the growth of the Islamic finance industry in Indonesia is very promising. In 2011, it was reported that the market share of Islamic Finance only stands at 3.8% with an average total asset increase of 48.1%. However, in 2012-2013, Islamic Finance in Indonesia grew around 50% reaching approximately 4.2% of the total market share. This is a remarkable achievement. Within seven years, from 2007- 2013, the number of fully-fledged Islamic banks has grown from just three to 11 fully-fledged banks, with around 23 Islamic windows.
Regulatory reform
The legal framework of Malaysia’s Islamic finance system has undergone tremendous change with the passing of the Islamic Financial Services Act 2013 (IFSA) and the Financial Services Act 2013. These laws, which came into force in June 2013, have replaced the existing Banking and Financial Institutions Act 1989 (BAFIA), Islamic Banking Act 1983 and Takaful Act 1984. The new laws provide BNM with the necessary regulatory and supervisory powers to fulfil its broad mandate within a more complex and interconnected environment. The law is expected to place Malaysia’s financial sector on a platform to advance forward as a sound, responsible and progressive financial system.
The IFSA was passed by Parliament in 2013, received Royal Assent on March 18, 2013 and was gazetted on March 22, 2013. Unlike previous legislation, the IFSA governs all IFIs including Islamic banks, takaful operators, international Islamic banks, international takaful operators as well as operators of payment systems which enable the transfer of funds between Islamic bank accounts or which enable payments to be made by means of Islamic payment instruments, issuers of Islamic payment instruments, takaful brokers and Islamic financial advisors. The IFSA nevertheless excludes development financial institutions and cooperative societies.
The new IFSA 2013 contains 291 sections which covers almost every aspect of the Islamic financial system, including the establishment of an IFI, its winding up and the enforcement framework for any offence under such law. The IFSA has provided the BNM with statutory duties to foster fair, responsible and professional business conduct amongst financial service providers. IFIs have been imposed with two statutory duties, namely compliance and reporting.
The IFSA is expected to promote a robust financial consumer protection regime, particularly in respect to unfair and deceptive business conduct and disclosure obligations, and provide clear demarcation between conventional and Islamic finance. On top of the IFSA, the BNM has issued four new guidelines to further improve the practice of Islamic finance, namely:
- Capital Adequacy Framework for Islamic Banks (Risk-Weighted Assets), effective as of 1st January 2013;
- Capital Adequacy Framework for Islamic Banks (Capital Components), effective as of 1st January 2013;
- Financial Reporting for Islamic Banking and Islamic Financial Institutions, effective as of 28 June 2013; and
- Guidelines on Ibra (Rebate) for Sale-Based Financing, effective as of 4th February 2013.
To overcome impediments in the practice of Islamic finance, the Law Harmonization Committee Report 2013 formulated four recommendations to resolve the inherent issues in the Islamic finance industry namely:
- Introduce provisions in court rules on imposition of late payment charges on judgment debts;
- Allow better access to Islamic financing for consumers through recommended amendments to reserve land legislations in all states;
- Facilitate Islamic financing involving landed property through recognition of Islamic finance in the National Land Code 1965; and
- Amend the Companies Act 1965 in order to facilitate the effort to offer globally accepted Shari’a-compliant product structures for the Islamic money market.
The Committee is now in the midst of studying the legal implications pursuant to the implementation of IFSA 2013. With the findings from several consultations and studies, the Committee proposed recommendations to improve the Islamic finance regulatory framework by providing legal certainty of Shari’a contracts enforcement, to be responsive and sensitive to implement legislative changes, developing human capital through producing highly qualified legal talent and commercially experienced judiciary, and finally to create a supportive and reputable dispute resolution environment for adjudication and dispute settlement at the national and international levels.
Unlike Malaysia, Bank Indonesia is no longer the banking supervisory authority following the Financial Services Authority assuming capital market and banking supervisory functions. IFIs are also governed and bound by any direction and instruction of the Financial Services Authority. The Financial Services Authority in Indonesia is expected to boost market confidence and to promote financial stability and good governance as well as to enhance consumer protection.
“ An interesting provision in the IFSA in Malaysia is the potential liability of Shari’a scholars who could face punishment for rule breaches as stipulated under the IFSA. Shari’a committee members may be jailed for up to eight years or fined up to RM25 million which is equivalent of approximately USD7.6 million if they fail to comply with the rules. ”
In terms of legislation, there is no significant reform on the regulatory framework of Islamic finance in Indonesia. Indonesia is still relying on the Act No 21 of 2008 Islamic Banking Law which provides legal foundation for the development of Islamic finance. In terms of guidelines and directives, no new guidelines were issued in 2013 by either Bank Indonesia or the Financial Services Authority, which relates specifically to Islamic banks. IFIs in Indonesia are governed by the following directives:
- Bank Indonesia Regulation Number 13/23/ PBI/2011 Concerning The Implementation Of Risk Management In Islamic Commercial Banks and Islamic Business Units;
- Bank Indonesia Regulation Number 13/14/ PBI/2011 Concerning Asset Quality Rating for Islamic Rural Banks.
- Bank Indonesia Regulation Number 13/23/ PBI/2011 Concerning The Implementation Of Risk Management In Islamic Commercial Banks and Islamic Business Units.
It is expected that in 2014, there will be several regulatory improvements and reforms for Islamic finance in Indonesia. Under the Indonesia Banking Architecture Guidelines, there are two major developmental plans namely the Blueprint of Islamic Banking Development and the Grand Strategy of Islamic Banking Market Development.
Corporate governance framework
IFIs are governed by several existing guidelines on governance issued by the BNM. Only one revised guideline has been issued by the BNM in 2013 specifically for IFIs – the Guideline on Corporate Governance for Licensed Islamic Banks (Revised BNM/GP1-i). This revised Guideline laid down provisions to promote best practices and good corporate governance for IFIs. Previously, corporate governance of Islamic banks was governed by several guidelines, such as Guidelines for Appointment of Directors of Islamic Banking Institutions, and others. This revised guideline supersedes all.
Corporate governance framework
IFIs are governed by several existing guidelines on governance issued by the BNM. Only one revised guideline has been issued by the BNM in 2013 specifically for IFIs – the Guideline on Corporate Governance for Licensed Islamic Banks (Revised BNM/GP1-i). This revised Guideline laid down provisions to promote best practices and good corporate governance for IFIs. Previously, corporate governance of Islamic banks was governed by several guidelines, such as Guidelines for Appointment of Directors of Islamic Banking Institutions, and others. This revised guideline supersedes all previous guidelines and is considered as the main reference for good corporate governance for Islamic banking Institutions. The primary objective of this guideline is to promote the adoption of effective high standards of corporate governance practices by Islamic banks and Islamic bank holding companies. It provides 14 principles of corporate governance and the minimum requirement of good corporate governance.
In discussing recent developments in corporate governance in Malaysia, it is important to highlight the legal consequence of the IFSA on the corporate governance framework for IFIs. Generally, the IFSA provides a clearer and more comprehensive set of provisions for corporate governance for IFIs. The IFSA vests the BNM with wide-ranging powers to issue standards, which are binding upon every director, officer or Shari’a committee member of the institution. More importantly, section 28(6) of the IFSA provides that a failure to comply with the standards issued is an offence under the Act and carries a maximum penalty of eight years imprisonment or a fine of 25 million ringgit or both. In other words, this provision potentially charges board of directors, management, officers and even Shari’a committee members with heavy penalties including imprisonment. Therefore, IFIs are required to be more vigilant and diligent in carrying on their business.
The corporate governance framework is also the main concern for the Indonesian financial authorities. The Indonesian Banking Architecture Programs clearly stipulate the need for robust and strong corporate governance covering the full extent of the banking system. It pertains to commercial and rural banks, both conventional and Islamic banks, and the development of small, medium and macro enterprises. A number of corporate governance guidelines by Bank Indonesia have been issued including:
- Peraturan Bank Indonesia No.15/14/ PBI/2013 tentang Perubahan Atas Peraturan Bank Indonesia Nomor 11/10/PBI/2009 tentang Unit Usaha Syariah.
- Peraturan Bank Indonesia No.15/13/ PBI/2013 tentang Perubahan Atas Peraturan Bank Indonesia Nomor 11/3/PBI/2009 tentang Bank Umum Syariah.
Both guidelines came into effect on 30 December, 2013. These guidelines amended several provisions of the ‘Peraturan Bank Indonesia Nomor 11/10/PBI/2009’ which relates to the corporate governance framework in financial institutions. Amongst the objectives of these regulations are to improve corporate governance practices and standards of Islamic banks (Bank Umum Syariah) and Islamic windows (Unit Usaha Syariah) and to increase the accountability of both types of bank as well as to strengthen their institutional structure.
Development of Shari’a advisory
The existing framework of Islamic finance in Malaysia and Indonesia shares some similarities and diversities. Despite having a Shari’a board at the national level in both countries, Malaysia prefers greater involvement of regulatory authorities whereas Indonesia favours otherwise. In Malaysia, the National Shari’a Advisory Council (SAC) is part of the BNM whereas Dewan Syariah Nasional, Majlis Ulama Indonesia (DSN, MUI) is independent and not part of Bank Indonesia or the Financial Services Authority. It is still debatable whether the former or the latter is more prevalent or considered as the best practice of the two-tier Shari’a governance model.
Shari’a governance is one of the most developed areas of Islamic finance in Malaysia. Top-down initiatives by the BNM or bottom-up endeavours by practitioners shape the practice of Shari’a governance. The International Shari’a Research Academy for Islamic Finance (ISRA) and various institutions of higher learning have been at the forefront in improving Shari’a governance-related matters including research and development. The establishment of the Association of Shari’a Advisors initiated by prominent Shari’a scholars further stimulates the degree of professionalism and talent development in Islamic finance. The level of grass-root awareness on Islamic finance is also increasing whereby Shari’a scholars are now actively engaging with communities and civil society entities. To complement this, the media has also been very supportive, producing and publishing news, documentaries, talk shows and information on Islamic finance even during prime time hours.
“ With the understanding that strong, efficient and robust regulatory frameworks balanced with a certain degree of flexibility will lead to market stability, Malaysian and Indonesian financial authorities are consistently enhancing and improving the Islamic banking framework through comprehensive means and various initiatives. ”
An interesting provision in the IFSA in Malaysia is the potential liability of Shari’a scholars who could face punishment for rule breaches as stipulated under the IFSA. Shari’a committee members may be jailed for up to eight years or fined up to RM25 million which is equivalent to approximately USD7.6 million if they fail to comply with the rules. This latest development also raises another issue of having professional indemnity Islamic insurance as is the case for lawyers and medical practitioners.
As regard to the issuance of new parameters for Shari’a contracts at the national level in 2013, the SAC, in exercising its authority as the highest Shari’a authority, has issued Resolutions on Murabahah and Exposure Drafts on Islamic Financial Contracts (Shari’a Requirements and Optional Practices) and Contract paper on Shari’a Requirements, Optional Practices and Optional Requirements of Musharakah, and Contract paper on Shari’a Requirements, Optional Practices and Optional Requirements of Mudarabah. These parameters cover various types of Shari’a contracts including hiba, bai ina, kafala, wakalah, wadiah, wa’d, musharakah, mudarabah and tawarruq.
In Indonesia, we are witnessing several interesting developments. This is in line with the structural reform of Indonesian financial authorities whereby in 2011 the authority of regulating and supervision of banks has been transferred to the Financial Services Authority. With this reform, DSN, MUI is expected to cooperate and deal with the Financial Services Authority rather than Bank Indonesia. Similarly with Malaysia, any IFIs either fully-fledged or windows, must establish a Shari’a board as it is considered a statutory requirement under Indonesian law. This requirement indirectly demands all 11 fully-fledged Islamic banks and 23 Islamic windows to have a set of institutional arrangements through which IFIs can ensure that there is effective independent oversight of Shari’a compliance.
In terms of Shari’a governance-related initiatives, DSN, MUI has implemented several programmes and one of them is to improve the level of professionalism of its members through professional training and members’ certification. The report entitled ‘Ratusan Dewan Pengawas Syariah RI Cuma Bersertifikat Level Dasar 2013’ mentioned that DSN, MUI has established three levels of certificate for the Dewan Pengawas Shari’a (DPS) namely basic, intermediate and advance.⁷ Another report, ‘Kebutuhan Dewan Pengawas Syariah tinggi 2013’ stated that the total number of registered DPS under DSN, MUI record is only 167 members.⁸ Considering the demand and needs of qualified and skillful Shari’a scholars, one of the main concerns highlighted in the report refers to the lack of capable and qualified human resources. The report recommended further policies including regulatory initiatives which oblige the institutions to have certified DPS in each institution. This is actually a global issue and not exclusive to Indonesia. Lack of talent is one of the biggest challenges for the Islamic finance industry. It is estimated that one million professionals are required globally for Islamic finance by the year 2020 where Malaysia alone needs an additional 56,000 finance professionals.
Conclusion
Both Malaysia and Indonesia as Islamic finance leaders in South East Asia have extensively facilitated the implementation of Islamic finance by enhancing their policies to suit domestic and global market behaviour. With the understanding that strong, efficient and robust regulatory frameworks balanced with a certain degree of flexibility will lead to market stability, Malaysian and Indonesian financial authorities are consistently enhancing and improving the Islamic financial framework through comprehensive means and various initiatives. Their approach is working well in both jurisdictions as we clearly observe tremendous developments in terms of growth in market share and banking assets. The Indonesian market seems to offer more opportunities considering the size of the economy and the size of the Muslim population. As the largest economy in South East Asia, and second amongst the OIC countries, the current 4.2% market share of Islamic finance in Indonesia indicates there is room to grow. As the Malaysian market is relatively small, Islamic finance players have no other option but to venture into more dynamic and competitive global markets. In this regard, they must be ready to compete by offering competitive and universally accepted products and services.
