Mutual Funds

A key component of Malaysia's Islamic capital market is the Islamic fund management industry, which has seen the net asset value of Shari'ah-compliant unit trust companies have a CAGR of 30.3 percent in the last 10 years. Malaysia accounts for 25 percent of global Islamic fund size at the end of 2012 and today remains the only jurisdiction in the world to issue a specific Islamic fund management licence, reflecting the nation's value proposition as a hub for dedicated Islamic fund management companies.⁵

There was an increase of five Islamic unit trust funds from December 2011 to December 2012, bringing the total number of funds launched to 169. The total net asset value was RM35 billion (US$11 billion), representing 12 percent of total industry net asset value (see Table 18.3).

The equity market is a significant component of the Islamic capital market. In order to enable the fund managers and the Muslim investing public to select from the available Malaysian equities, the SC's Shari'ah advisory council assesses the compliance of every company listed on the stock exchange every six months and publishes its findings. This review enables investors to dispose of their holdings in companies that are no longer compliant or invest in companies that have become newly compliant.

At the end of 2012, 89 percent of the 923 companies listed on the Malaysian Stock Exchange were Shari'ah-compliant (see Table 18.4). They represent 64 percent (RM942 billion, or US$295.3 billion) of the exchange's market capitalisation, thus offering a vast universe of stocks to investors looking for Shari'ah-compliant investments.

Malaysia introduced the world's first guidelines on Islamic REITs in 2005. This kick-started the Islamic REIT industry in Malaysia. The Al-'Aqar KPJ REIT (launched by KPJ Healthcare in August 2006 and the first Islamic REIT in the world), the Al-Hadharah Boustead REIT (a plantation REIT launched in February 2007), and the Axis REIT (a commercial building REIT and the first to launch on the Malaysian Stock Exchange in 2004; it converted to Islamic in December 2008) accounted for a combined market capitalisation of RM3.5 billion (US$1.1 billion) out of a total of RM24.6 billion (US$7.7 bilion), or around 14 percent of the market. In May 2013, Malaysia launched the KLCC Real Estate Investment Trust (KLCC REIT), which is the world's first Shariah-compliant stapled REIT. Table 18.5 shows the changes in REITs from 2011 to 2012.

Exchange Traded Funds

Islamic exchange traded funds (ETFs) have the same characteristics as equity and unit trust products and are listed on the Malaysian Stock Exchange. ETFs are still considered small in Malaysia.

As of December 31, 2012, Malaysia had a total of 5 ETFs with total market capitalisation of RM900 billion (US$282.1 billion). Malaysia launched the region's first Shari'ah-compliant ETF in 2008. The fund, known as MyETF Dow Jones Islamic Market Malaysia Titan 25, was listed the same year. The launch of this Islamic ETF boosted the country's aspiration to attract foreign funds, to broaden the Islamic capital market, and, eventually, to become an Islamic financial hub. It provided added diversity to the Malaysian Stock Exchange's offerings and bridged gaps between the exchange and other global Islamic markets.

Islamic ETFs represent 32 percent of the total industry, with a net asset value of RM300 million (US$94 billion) (see Table 18.6).

Endowment Funds

There are endowment funds managed by Bank Negara and other private institutions, such as the International Islamic University. The RM500 million (US$157 million) endowment fund allocated by Bank Negara is to finance the operations of the International Centre for Education in Islamic Finance (INCEIF), the Global University of Islamic Finance, and also the International Shari'ah Academy for Islamic Finance (ISRA). The objective of INCEIF is to produce high-calibre practitioners and professionals in Islamic finance as well as specialists and researchers in the disciplines of Islamic finance. The International Shari'ah Academy for Islamic Finance has the objective of promoting applied research in the area of Shari'ah and Islamic finance.

A vehicle recently launched in Malaysia that would be appropriate for the needs of managing private endowments is the business trust, a unit trust scheme under the Capital Markets and Services Act of 2007. However, unlike a typical unit trust scheme, the activity of a business trust is to manage and operate a business, similar to the way a company manages and operates its business.

The entity managing and operating a business trust is a corporation called the trustee-manager. The trustee-manager manages the business of the business trust and is also the trustee who holds the assets of the business trust on trust for the unit holders (or investors in the business trust). Typically, when a business trust is structured, a provision is included in its deed for payment of regular distributions, although an amount is usually not specified, from the residual cash flows of the business trust (if any). This provision cannot be changed without amending the deed, and to do so, unit holders holding not less than 75 percent of the voting rights in the business trust must be present to vote for such an amendment.

As announced by the prime minister in the budget for 2013, business trusts will be given income tax, stamp duty, and real property gains tax treatments similar to that of a company.

A typical structure of an Islamic business trust is shown in Figure 18.1, followed by a list of requirements for an Islamic business trust.

Requirements for an Islamic Business Trust

• Structure of the trust in accordance with approved Shari'ah principles and concepts.
• Appointment of Shari'ah advisor.
• Employment of Shari'ah-compliant business. If nonpermissible activities are involved, trust must be subjected to activity benchmarks and financial ratios.
• Procurement of takaful scheme.

Wealth Assets

Wealth assets, or wholesale funds, as managed by the Islamic fund management companies, increased by 13 from 2011 to 2012 (see Table 18.7). The total net asset value of Islamic wholesale funds in 2012 was at RM16.2 billion (US$5.1 billion), representing 30.9 percent of total industry net asset value.

Malaysia recorded a 24 percent increase in assets under management (AUM) from December 2011 to December 2012—RM79.6 billion (US$25 billion), and representing the second largest manager of Shari'ah-compliant funds globally. In term of number of funds, Malaysia is the largest (see Figure 18.2).

Islamic AUM are 15.8 percent of the total industry (see Table 18.8).

Financial Reporting Standards

Besides the MIFC, the Malaysian government's initiatives regarding the Islamic Financial Services Board (IFSB) provides guidance to promote global prudential standards and guiding principles for the Islamic banking and insurance industry and capital markets.

Since its inception in 1990, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has issued more than 60 accounting, auditing, governance, and Shari'ah standards for Islamic institutions. Although AAOIFI is a pioneer in Islamic standard setting, the Malaysian Accounting Standards Board (MASB) has concerns that the AAOIFI's accounting standards might not have been developed based on a conceptual framework similar to the MASB-approved accounting standards. Thus, the AAOIFI financial accounting standards are not used by entities under MASB purview.

This means that an entity may not apply AAOIFI recognition and measurements that depart from MASB requirements. However, the inclusion of the additional disclosures required under AAOIFI standards, may, if appropriate, be acceptable.

Malaysian financial institutions must account for Shari'ah-compliant transactions and events in accordance with MASB-approved accounting standards unless there is a Shari'ah prohibition. Thus far, the MASB accounting standard requirements have not violated Shari'ah principles. In the rare event that there is a Shari'ah prohibition in the MASB requirement, that requirement need not be complied with, and the MASB will provide alternative guidance.

However, in order to facilitate its constituents' application of MASB standards to Islamic financial transactions, the MASB has issued a series of technical releases, or Islamic accounting pronouncements, which are to complement and be read in conjunction with the MASB standards.

Tax Legislation

Generally, there is no specific tax legislation governing Islamic financial instruments in Malaysia. However, the Income Tax Act of 1967 has certain provisions on Islamic transactions. Various stamp duty exemption orders have also been issued to ensure that Islamic financing transactions are not adversely taxed compared to conventional financing transactions.

Malaysian tax legislators introduced different amendments to address the tax treatment of Islamic financial instruments. The amended tax laws are the Income Tax Act of 1967 (see Table 18.9), the Stamp Act of 1949, and the Real Property Gains Tax Act of 1976. These amendments are attempts by the Malaysian tax legislators to remove tax inequities between conventional instruments and Islamic instruments.

Tax Neutrality

Because of the underlying asset within each Islamic financial transaction in Malaysia, tax neutrality as well as the tax treatment of profits must be resolved, since tax issues tend to arise in most countries.

Tax neutrality is a form of tax incentive whereby a relief is given to the tax charge that was supposed to be imposed on the Islamic financial transaction. In fact, Malaysia was one of the first countries to accord tax neutrality to Islamic finance instruments and transactions, to reduce the cost of transferring assets in Islamic finance. This measure has created a level playing field between conventional and Islamic financial products.

Section 2(8) of the Income Tax Act essentially allows the underlying sale of assets or leases to be ignored for tax purposes so that any additional tax as a result of the underlying transaction will not arise. It enables Islamic financing to continue without any tax issues relating to asset transfer or lease, so it places Islamic financing on the same footing as conventional financing.

Approval for Islamic financing has to be granted by the relevant authorities: Bank Negara, the SC, and the Labuan Financial Services Authority.

Tax Incentives and Exemptions

Tax incentives are clearly an important aspect in developing and promoting the Islamic financial market. Basically, tax incentives can be broadly categorised as follows:

• Tax incentives for diversified players such as banking, takaful, and fund management
• Tax incentives to facilitate Islamic finance transactions in Malaysia
• Tax incentives for expertise

A wide range of tax incentives in Islamic finance will help in promoting Malaysia as an international Islamic financial centre. Table 18.10 summarises these incentives.

Other Tax Issues

It is envisaged that a more practical and useful guidance will be issued that will enhance the efficiency of the Islamic finance market. Clearly, the tax incentives are important and should play an important role in nurturing and encouraging the ongoing development and growth of this sector.

However, aside from tax incentives, what is arguably more important is the need to ensure a clear regulatory framework for the Islamic financial sector.

As the structures of Islamic financing become more complex, constant engagements must be conducted by the industry and the Inland Revenue Department of Malaysia and other government agencies in order to ensure that fair tax treatments or incentives are accorded to these products or issuers.

Demand

At the end of 2012, microfinancing through small and medium enterprises (SMEs) accounted for RM189 billion (US$59.3 billion), or 40.5 percent of total business financing. Financing to microentrepreneurs through TEKUN's Pembiayaan Mikro scheme amounted to RM870.3 million (US$272.8 million) and has been channelled to more than 68,000 microfinance accounts. A recent development is the introduction of more flexible financing products for microenterprises, and progress has also been made in developing the credit assessment and risk management capabilities of banks to provide financing for green technology ventures.

Opportunities and Products

Malaysia is recognised for its efforts to enhance access to financing. Among the 183 countries selected in the assessment process, Malaysia was ranked by the World Bank at the top spot in terms of getting credit. There are 13 institutions that provide microfinancing in Malaysia.

In 2006, TEKUN approved a sustainable microfinance framework called Pembiayaan Mikro. The objectives of this framework are as follows:

• To define the parameters of an appropriate microfinancing product
• To raise awareness on microfinancing
• To attract the participation of financial institutions in providing microfinancing solutions

With Pembiayaan Mikro, microentrepreneurs have access to financing that does not require any collateral. It applies simple application procedures, minimal documentation, and quick approval and disbursement turnaround to meet the unique financing needs of microfinance enterprises.

Initiatives for Financial Inclusion

The commitment to the financial inclusion agenda was legislated under the Central Bank of Malaysia Act of 2009, which promotes the development of a sound, progressive, and inclusive financial system. Malaysia's financial inclusion agenda has been developed in concert with the development of the overall financial sector and encompasses five broad strategies.

The nation's blueprint for the development of the financial sector for the next decade will focus on financial inclusion and consumer protection. In the previous decade, the focus was on enhancing access to financing, improving financial education, and putting in place the supporting institutional arrangements to enhance financial inclusion. While these efforts will be intensified further in the next decade, greater utilisation will be made of technology and new institutional arrangements to extend outreach to the range of users from households to microenterprises and SMEs.

Also important is the development of an environment conducive to the innovation of the range of financial products and services required by society and businesses and to cost-effective pricing. This will be reinforced by supporting an infrastructure for the effective management of risks by financial institutions, strengthening the development financial institutions, and putting in place a comprehensive consumer protection, redress, and education framework. These strategies will be pursued under a collaborative approach that effectively combines with efforts by the private sector.⁶

Sukuk and Issuances

Sukuk has evolved in depth and sophistication. Investors now have the option to choose between RM-denominated and non–RM denominated sukuk, as well as the types of securities, tenures, asset classes, structures, issuers, and risk profiles that suit their needs. Along the way, Malaysia has pioneered many of the world's innovative sukuk structures. The structures that were originated from Malaysia are shown in Table 18.13.

The sukuk market has cemented another unprecedented record in 2012 with total issuance of US$131.2 billion worth of sukuk papers from the primary market, which represents a year-over-year increase of 54.2 percent. Interestingly, the amount represents three times the size of the primary sukuk market prior to the global financial crisis (see Figure 18.5). It is the first time the sukuk market has reached the US$100 billion mark, and it is expected to remain at this level for the next few years. Since 2008, total yearly issuances have grown at a compounded annual growth rate of 67.4 percent, taking the global outstanding sukuk market to an unprecedented high of US$240 billion at the end of 2012 (see Figure 18.6).

Strong performance was seen for Malaysia in the global sukuk market; it continues to dominate this segment of the capital market with various issuances mainly to fund infrastructure development in the country. The Malaysian sukuk market experienced its best recorded growth in 2012, with a combined issuance of both sovereign and corporate sukuk worth US$97.1 billion, up 59.4 percent from the previous year.

Malaysia's sukuk market has grown by leaps and bounds from just US$1.5 billion of global outstanding sukuk in 2001 to US$154 billion, or 64 percent of the total outstanding sukuk market, in 2012.

Asset-Backed Sukuk

Asset-backed securities involve the financial technique of pooling various categories of assets, such as loans and receivables, which are then packaged as securities to represent the pooled asset. Asset-backed securities derive their value from the asset pool and the income streams generated by it. From the perspective of Rating Agency Malaysia, asset-backed sukuk falls under secured securitisation when the underlying assets drive the sukuk performance itself. Asset-backed securities represent the investors with an undivided proportionate beneficial interest in the underlying assets.

The most important feature of asset-backed securities is the securitisation transaction, which involves true sale and transfer of the asset from the originator to a third party, which is normally a special purpose vehicle (SPV). Here the originator must effectively transfer all rights and obligations in the underlying assets to the SPV to establish a certainty in the ownership of the underlying assets. The SPV will hold the assets in trust, and the transfer of assets will effectively exclude the originator from any recourse.

To ensure that the interests of investors are being taken care, the shares in the SPV will normally be held by a trust. A trust deed sets out the purposes of the trust and includes the obligations of the trustees to establish and maintain the SPV and to ensure that the SPV acts in accordance with the securities documentation.

In Malaysia, asset-backed securities are regulated by the Guidelines on the Offering of Asset-Backed Securities, which applies to both Islamic and conventional asset-backed securities. Since 2005, there have been nine asset-backed sukuk issued in Malaysia, with a combined issue size of RM6.85 billion. The asset-backed sukuk structured in Malaysia include asset-backed al-bai' bithaman aajil notes, asset-backed musharaka sukuk, and asset-backed ijarah sukuk.

Sovereign Sukuk

Sovereign sukuk serves as a way for the government to finance its development expenditures without expanding its public debt obligations. In this global market uncertainty, when budget constraints are tighter, foreign capital is very much needed to finance the economic growth and maintain employment. Islamic finance can offer a viable alternative source of funding for government to consider.

On the domestic side, sovereign sukuk has been the main booster of the sukuk market. For 2012, sovereign and quasi-sovereign issuers continued to dominate the sukuk landscape in Malaysia, with issuance amounting to US$70.3 billion, or 72.4 percent of the total market, while the rest were sold by corporate issuers. The largest single issuer was Bank Negara, with a total of US$57.3 billion, or 59 percent of the Malaysian market (see Figure 18.6).

Based on the figures from 2012 and an optimistic outlook for 2013, Malaysia will continue to lead the global sukuk market with various issuances that mainly focus on funding infrastructure development in the country. According to Rating Agency Malaysia, these infrastructure projects are supported by the National Economic Transformation Programme, which charts the ongoing development plans over the next decade. The issuance was mainly led by Bank Negara (the central bank) and numerous government-linked corporate entities such as Cagamas, Telekom Malaysia, and Khazanah Nasional.

There are strong demands for Malaysian sukuk, especially sovereign papers that are highly rated. According to the Bloomberg AIBIM Bursa Malaysia Sovereign Shari'ah Index, sovereign papers have recorded a healthy return of 3.78 percent to the investors. Practically, the return was backed by the strong economic growth in the country.

The tax incentives are shown in Table 18.14.

Regulatory Processes Applicable to Cross-Border Financing

Prospective foreign issuers of sukuk might be interested in issuing either a ringgit-denominated sukuk or a foreign currency–denominated sukuk. Both are allowed to be issued in Malaysia. Either way, all those who are eligible to issue sukuk in Malaysia must obtain the SC's approval under the guidelines on sukuk issued by the SC. There are some differences in requirements between ringgit-denominated issuance and foreign currency–denominated-issuance, such as the requirements for Shari'ah pronouncements and credit rating requirements.

Cross-border transactions may also require greater compliance with relevant requirements from other regulatory authorities, especially the Controller of Foreign Exchange, before its submission for approval by the SC. Other differences are found in terms of mode of issuance, disclosure of material information, revision to principal terms and conditions, and approval requirements.

Prospect for Expansion: Cooperation between Malaysia and the GCC

Malaysia and the GCC have both adopted Islamic finance on a significant scale, and thus it would seem logical to enhance cross-border connectivity. The established Islamic finance institutions and markets in Asia and the GCC provide a platform and opportunities for building scale to expand the growth of Islamic finance activities. Furthermore, increasing Asian foreign direct investments in the oil and petrochemical sectors of GCC economies and greater investment of GCC countries in other Asian economies would provide greater opportunities for Malaysian institutions to play a role in these developments in terms of financing.

There are also enormous opportunities to finance the expanding trade between Malaysia and the GCC. The value of this has been growing steadily, and it has been facilitated through Islamic trade instruments. The availability of Shari'ah-compliant structures in the two regions can be, and has been, used to enhance capital investments among both regions. This would help deepen and broaden the capital markets in this cluster, which in turn can serve as a model for similar clusters to develop within other regions and across regions.

Challenges in Cross-Border Expansion

Expanding Islamic finance into new territories and across financial centres requires addressing the legal, institutional, and regulatory challenges. To enable Islamic finance to create stronger economic and business ties between Asia and the rest of the world, the right supporting infrastructure must be in pace. There is a need to deepen the legal and regulatory framework to ensure the effective resolution of disputes and to facilitate the restructuring of problem financing instruments. An important consideration in this regard is the development and availability of clear and consistent documentation that will provide a sound basis for resolving disputes and facilitating the flow of funds and ownership transfers of underlying assets.

At present, the various countries practising Islamic finance may interpret Shari'ah with some variance; as a result, what may be allowed in one market may be unaccepted in another. Clarity and consistency with regard to the interpretation of Shari'ah will contribute immeasurably toward ensuring the confidence of issuers and investors and preserving Shari'ah considerations based on the virtues of ethics, shared values, and governance.

On the regulatory front, a key agenda for Islamic finance is the development of regulatory, supervisory, and risk management frameworks that will enhance the resilience and soundness of Islamic finance and strengthen investor protection. This framework must focus on transparency, accountability, equitability, ethics, and better governance.

In order to facilitate cross-border relationships, there is a need for more intensive international coordination of regulatory approaches and supervisory oversights. At the core should be coordinating risk management and facilitating the exchange of information to ensure satisfactory oversight of the market and the settlement of disputes. Meeting cross-border needs also calls for a system of regulatory mutual recognition that will enable accessibility and the offering of investment products across jurisdictions. Many markets recognise the importance of partnerships and have taken measures to collaborate through the establishment of mutual recognition arrangements with one another.

Internal Shari'ah Governance

Bank Negara's Shari'ah governance framework on Islamic financial institutions is designed to ensure that Shari'ah compliance procedures are robust. The framework seeks to ensure that the institutions meet the expectations of Bank Negara on Shari'ah governance structures, processes, and arrangements so that all their operations and business activities are in accordance with Shari'ah. The framework also provides comprehensive guidance to an institution's board, Shari'ah committee, and management in discharging its duties in matters relating to Shari'ah. It also outlines the functions relating to Shari'ah review, audit, risk management, and research.

Shari'ah Compliance in Capital Markets

Shari'ah governance can also be seen at work in the capital market. In the issuance of sukuk and other Islamic capital market products, the issuer must appoint a Shari'ah advisor to carry out several responsibilities. This advisor must be a registered Shari'ah advisor who meets the criteria stipulated under the SC's registration of Shari'ah advisor guidelines.

The responsibilities of the advisors are to advise on all aspects of a product, including documentation and structuring. The Shari'ah advisor must also issue a Shari'ah certification—outlining the basis and rationale of the certification, the structure mechanism of the sukuk issuance, the applicable Shari'ah principles used by the product issuance, and relevant Shari'ah matters relating to the documentation of the issuance. The advisor is also responsible that the applicable Shari'ah principles and any relevant resolutions and rulings endorsed by the SC's Shari'ah advisory council are complied with. If there is an absence of any rulings by the SC's council, the Shari'ah advisors are expected to apply ijtihad to make sure that all aspects of the sukuk issuance are in compliance with Shari'ah principles.

The Role of Shari'ah Advisors

Shari'ah advisors have a great role to play, and their responsibilities are not limited only to the stakeholders. It is also a religious duty to ensure that all the Shari'ah requirements are upheld. In the development of Islamic securities, the role of Shari'ah advisors should be concurrent with that of the product itself, in the sense that the advisory body should be formed from the moment the product is devised and should provide continued supervision and the permanent checking of contracts, transactions, and procedures.

Shari'ah advisory roles in Islamic products are very different from regulatory roles in conventional products. An entity issuing conventional products may have its legal advisor or business advisor; however, these advisors are different from Shari'ah advisors. The conventional entity is not bound to take the advice of its legal and business advisors; in contrast, an entity that develops Islamic products is obliged to adhere to the decisions made by its Shari'ah advisors when the product proposed or any operational issues defined contradicts Shari'ah principles.

The role of Shari'ah advisors in general is to ensure that the products are developed according to Sharia'h requirements and specifications from the beginning to the end. In addition, it is also important to ensure that the funds raised in the issuance are utilised for a purpose that complies with Shari'ah.