Development of the Malaysian Islamic Financial System

ISLAMIC FINANCIAL LEGAL FRAMEWORK

Mahyuddin Khalid

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DEVELOPMENT OF THE MALAYSIAN ISLAMIC FINANCIAL SYSTEM

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CONTENT

MALAYSIAN ISLAMIC FINANCIAL SYSTEM HISTORICAL DEVELOPMENT OF ISLAMIC

BANKING NSC REPORT ON BANK ISLAM MALAYSIA 1ST PHASE OF DEVELOPMENT 2ND PHASE OF DEVELOPMENT 3RD PHASE OF DEVELOPMENT CONCLUSION

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MALAYSIAN ISLAMIC FINANCIAL SYSTEM

Comprehensive Islamic financial system covering all financial sectors operating in parallel with conventional financial system

Diversities of players Twelve full-fledged Islamic banking institutions

2 domestic Islamic banks 3 full-fledged foreign owned Islamic banks 7 Islamic banking subsidiaries

9 takaful operators Sound and robust Islamic financial institutions

governed by international best practices Rapid growth with wide range of product and services

Retail, corporate & investment banking Internationally integrated with international Islamic

financial system

• Mit Ghamr, Egypt1963• Pilgrims’ Fund Board (Lembaga Tabung Haji), Malaysia1969• Oil boom1970• Islamic Development Bank, Saudi Arabia• Dubai Islamic Bank, UAE1975• Fatwa issued by the Fiqh Council of Muslim World League in favour of Islamic

insurance (takaful)1977• Luxembourg Islamic Bank (1st attempt in the West )1978• Sudanese Islamic Insurance Company is established as the world’s 1st Takaful

company by Faisal Islamic Bank of Sudan1979• Malaysia passes comprehensive legislation on Islamic finance (Islamic Banking

Act)1983• OIC Islamic Fiqh Academy legitimizes Sukuk which paves the way to the

development of Islamic debt securities1988• World 1st sukuk issued in Malaysia (Based on BBA) by Shell MDS worth USD 30

million1990• AAOIFI , Bahrain1991• IFSB, Malaysia2002• International Islamic Liquidity Management (IILM), Malaysia2011

HISTORICAL LANDMARKS IN ISLAMIC FINANCE DEVELOPMENT

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HISTORICAL DEVELOPMENT OF ISLAMIC BANKING

Traditional Malay Muslim society is very cautious in involving themselves in riba transactions

In order to avoid interest-based transactions in getting cash or liquidity, they practice a local customary transaction known as jual janji (conditional sale).

The Courts recognize jual janji as a Malay customary transaction arising out of religious consideration

According to Ungku A. Aziz, the main purpose of savings for Malay Muslims was to meet the expenses for the journey to perform haj, thus they preferred to use traditional ways of savings.

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In Malaysia, Islamic banking can be traced back to its root in 1963, with the establishment of the Lembaga Urusan dan Tabung Haji (LUTH), which was the first Islamic savings institution for the special purpose of performing hajj.

Islamic resurgence in the Middle Eastern countries had initiated the call for the establishment of an Islamic financial system that would allow Muslims to practice their banking and finance according to Shariah principles.

This can be seen with the establishment of Islamic Development Bank in Jeddah in 1974 and Dubai Islamic Bank in 1975, being the first Islamic commercial bank.

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Move towards establishing an Islamic bank in Malaysia was initiated by various private parties e.g during the Kongres Ekonomi Bumiputera (The Bumiputera

Economic Congress) in 1980 and at the National Seminar on Konsep Pembangunan Dalain Islam (the Concept of Development in Islam).

A resolution was passed calling off the Government to allow LUTH to establish an Islamic hank in Malaysia in order to mobilise and invest the funds of the Malays and the Muslims.

Main factors contributing to the successful growth of Islamic banking in this country: Support and encouragement from the government Commitment and dcdicat ion of the regulatory authority Favourable economic environment Creativity of the financial engineers in designing new products.

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LUTH undertook a study on the establishment of an Islamic bank in Malaysia.

The government accepted the proposal by LUTH and appointed a National Steering Committee on Islamic Bank (NSC) to study various proposals for the establishment of an Islamic bank.

The NSC was given the following tasks: To study and identify various critical aspects of Islamic

banking such as the basis of the establishment, areas of operation and business relationships with the customers and other financial institutions.

To examine the suitability of Islamic banking in the Malaysian context from various points of view including religious, legal, racial, social and development; and

To present to the Government recommendations regarding the establishment of ‘Bank Islam Malaysia’

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NSC REPORT ON ‘BANK ISLAM MALAYSIA’

An Islamic bank, which operates according to the rules of Shariah, should be established; provide services and operating profitably.

Only one Islamic bank should be established. The proposed Islamic bank should be incorporated as a

limited company under the Companies Act 1965. The Islamic Banking Act needs to be legislated in order to

provide for the licensing and supervision of the Islamic bank The Central Bank should administer the Islamic Banking

Act. The proposed Islamic bank should set up a Religious

Supervisory Council to supervise the compliance of its operations with Shariah principles.

The proposed Islamic bank should be named ‘Bank Islam Malaysia’.

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Gradual and pragmatic

..achieved significant milestones in building comprehensive and integrated Islamic financial system with diversity of players….

Milestones

1969 1983 1993 2003

Pilgrimage Fund Board

Bank Islam Malaysia Bhd.

Bank Muamalat Malaysia Bhd.

Foreign Islamic banks

Full-fledged Islamic banks

Conventional banks offer Islamic window

Takaful Operators

Syarikat Takaful Malaysia Bhd.

Takaful Nasional, Mayban Takaful, Takaful Iklhas, Commerce Takaful

Islamic subsidiary

Islamic money markets

STAGES OF DEVELOPMENT

Institutional & Regulatory

Development

Product and

market developm

ent

Legal and Shariah framework

Enhancement of

knowledge and

expertise

DEVELOPMENTAL FOCUS

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1st PHASE OF DEVELOPMENT

All recommendations of the NSC Report were accepted by the Government.

The Islamic Banking Bill was passed and the IBA came into force on 7th April 1983.

Consequently, the Islamic bank was incorporated and officially launched on July 1, 1983.

The establishment of BIMB marked a new milestone for the development of the Islamic financial system in Malaysia.

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LEGISLATION OF THE ISLAMIC BANKING ACT (IBA) 1983

To enable an Islamic bank to be established and operated in Malaysia, a suitable legal framework according to the Shariah principles should be provided.

The existing Banking Act 1973 (now replaced by BAFIA 1989), did not conform with the principles of Islamic banking because : It required all banks to operate on the basis of interest Prohibited all types of trading

The Islamic Banking Act (IBA) 1983 was legislated in March 1983 provided BNM with the power to supervise and regulate Islamic banks.

IBA was the first act to provide the necessary amendments to allow Islamic banks to operate without interest as well as to engage in trade and commerce.

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THE ESTABLISHMENT AND DEVELOPMENT OF BIMB

BIMB was incorporated as a public limited company to enable the Bank to conduct its activitics freely without being constrained by regulations imposed on statutory bodies.

Even though BIMB was a private company, the largest portion of its shares should be held by the Government to generate the public’s confidence in the bank.

BIMB was established with the initial paid-up capital of RM80 million consist of : Malaysian Government RM30 million LUTH RM10 million Muslim Welfare Organization of Malaysia RM5 million State Religious Councils RM20 million State Religious Agencies RM3 million Federal Agencies RM12 million

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THE ESTABLISHMENT AND DEVELOPMENT OF BIMB

The corporate objective of the Bank was to provide banking facilities and services in accordance with Islamic commercial law.

In order to supervise its operations to ensure its compliance with the principles of Shariah, the Bank had to set up a Shariah Supervisory Council.

BIMB was listed on the main board of the Kuala Lumpur Stock Exchange (KLSE) on 17 January 1992

After 23 years in existence, BIMB has proven that Islamic banking is viable and has demonstrated its ability and capacity to operate in parallel with conventional banks with the banking system.

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LEGISLATION OF GOVERNMENT INVESTMENT ACT 1983

BIMB was required to undertake short-term investments, as well as a fund management measure to meet its liquidity requirements prescribed by BNM.

The existing avenue for short-term investments was by way of purchases of Government papers in the form of Malaysian Government Treasury Bills (MGTB) and Malaysian Government Securities (MGS) that bore interests and BIMB could not invest in them.

The NSC proposed that the Government Investment Act (GIA) be legislated to enable the Government to issue Government Investment Certificates on the basis of Islamic principles.

GIA provided the solution to the problem of acquiring interest—free short-term investments which acted as an instrument to absorb surplus funds in the short run, a common problem faced by the Islamic Bank in the absence of an Islamic money market.

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ESTABLISHMENT OF SYARIKAT TAKAFUL MALAYSIA BERHAD

The NSC was of the view that the Islamic bank was responsible in ensuring the safety and security of its own assets and securities against loss, damage and destruction and recommended that an Islamic Insurance company should be established

Takaful Act were enacted in 1984 based on the Insurance Act 1973, with such modifications and amendments to conform with the Shariah and takaful business practices.

The first Islamic insurance operator Syarikat I Takaful Malaysia Sdn. Bhd. (STMB) was incorporated in November 1984 as a subsidiary of BIMB

With the establishment of STMB, other subsidiaries like Syarikat Wakalah Sdn Bhd (providing nominee and investment fund services for the bank) and Al-Ijarah Sdn. Bhd.(providing leasing finance) were also set up.

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2nd PHASE OF DEVELOPMENT

The government decided that for the first 10 years there should be only one Islamic bank before establishing other Islamic banks.

This decision was to enable BIMB to focus on the growth of Islamic banking and to develop as many Islamic banking products and services as possible without any competition

By the mid of December 1993, BIMB had developed 21 Islamic banking products and instruments covering a wide area of banking activities.

The second phase of the development of Islamic banking started in early 1990s when BNM outlined objective to develop a comprehensive and vibrant Islamic banking system operating side by side with the conventional banking system.

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2nd PHASE OF DEVELOPMENT

During the first ten years, the development of Islamic bank emphasis on creating a large number of different types of Islamic financial instruments.

Although BIMB was established in 1983. the Bank was still not able to serve the entire needs of the population, due to several constrained of the limited number of branches and resources.

The establishment of a large number of institutions offering Islamic financial services is necessary to further develop Islamic bank. For this purpose, three alternatives were considered by the authority: Establish new Islamic banks Allow the conventional banks to set up Islamic banking subsidiaries Allow the existing conventional banking system to offer Islamic

banking services After careful consideration, the third alternative was chosen as it

was considered the most efficient and effective way of expanding Islamic banking

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SKIM PERBANKAN TANPA FAEDAH (SPTF)

BNM introduced a scheme named Interest-Free Banking Scheme (Skim Perbankan Tanpa Faedah) (SPTF) in March 1993 to allow the existing conventional banking system to offer Islamic banking services

Through SPTF, conventional banks were allowed to introduce and offer Islamic banking services and facilities at their counters using their existing infrastructure, including staff and branches.

By the end of end of June 1999, the number of participating banking institutions increased significantly to 54, comprising 24 commercial banks, 18 finance companies, 5 merchant banks and 7 discount houses

Although the participation of the banking institutions was voluntary, they had to comply with the requirements of the guidelines issued by BNM.

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SKIM PERBANKAN TANPA FAEDAH (SPTF)

BNM has introduced various measures and policies to meet up the requirements: To establish an Islamic Banking Unit (IBU) to be headed by a senior

Muslim banker To create an Islamic Banking Fund (IBF) with the minimum

allocation of RM1 million To open separate current/clearing accounts for Islamic banking

operations with BNM To register as Indirect Members under the wholesale payments

system, SPEEDS (Sistem Pcmindahan Elektronik untuk Dana dan Sekuriti) (now RENTAS)

To observe a separate cheque clearing system for Islamic banking. To maintain separate ledgers for their Islamic banking operations. To appoint at least one Shariah consultant to advise on operations

of their Islamic banking division. These requirements would ensure that the banks did not co-

mingle the funds freely without proper internal controls.

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SKIM PERBANKAN ISLAM (SPI)

In 1998, BNM replaced the SPTF with Islamic Banking Scheme (IBS) or known as Skim Perbankan Islam (SPI) effective from 1st December 1998.

All banking institutions participating in the SPI were required to upgrade their Islamic Banking Unit (IBU) to Islamic Banking Division (IBD) and headed by a Muslim senior management officer of the bank and reports to the Chief Executive Officer (CEO)

The minimum funds of Islamic banking were raised from RM 1 million to: RM5 million for commercial banks, gradually increased to RM20

million by 31 December 2000 RM5 million for finance companies, gradually increased to RMI0

million by 31 December 2000 RM3 million for merchant banks, gradually increased to RM6 million

by 31 December 2000. Beginning from 4 January 1999, discount houses were permitted

to participate in the SPI.

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ISLAMIC INTER-BANK MONEY MARKET

The establishment of the Islamic money market on 3 January 1994 was the last element for the Islamic banking system to function as a full-fledged banking system.

BNM decided to implement the Islamic Money Market based on the concept of mudharabah or profit- sharing

The development of an Islamic money market was crucial as an essential avenue to provide a ready source of short-term investment based on Shariah principles in case of temporary shortage or surplus of funds faced by Islamic banks.

The Islamic money market comprised 3 components: Trading of Islamic Financial Instruments Mudarabah Interbank Investments (MII) Islamic Cheque Clearing System (ICCS)

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ISLAMIC CAPITAL MARKET

Islamic capital market is one of the components in the overall capital market in the country.

It functions as a parallel market to the conventional capital market for capital seekers and providers, and plays a complementary role to the Islamic banking system in broadening and deepening the Islamic financial markets in Malaysia.

The government established the Securities Commission (SC) as the sole regulatory body for the regulation and development of capital market on 1 March 1993.

SC has identified the development of ICM as one of its main agenda in the Capital Market Masterplan (CMMP) of Malaysia, launched on 22 February 2001.

One of the main objectives set by the CMMP was to establish Malaysia as an International Islamic Capital Market Centre.

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The SC’s efforts to develop the ICM by setting up of the necessary infrastructure: Establishing an Islamic Capital Market Unit (ICMU)

to carry out research and development of ICM instruments analyzing the existing securities from Shariah perspectives

Establishing Islamic Instruments Study Group (IISG) to advise the SC on development ICM to study issues related to the operation of the ICM

Establishing Shariah Advisory Council (SAC) of SC succeeded the role and function of IISG to ensure that the operation of the ICM conform to Shariah

principles to advise the SC on all matters related to the development of

the Islamic capital market as a reference center for issues related to Islamic capital

market.

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The SC’s efforts to develop the ICM by broadening and strengthen the market such as: Analyzing existing conventional capital market instruments

to determine its validity from the Shariah perspective, Formulating and developing new financial instruments

based on Shariah principles Reviewing and identifying the activities companies listed

on the KLSE for the issuing of the Shariah approved counter list.

The ICM comprises : Primary market

New issues of Islamic Government securities and the Islamic Corporate securities are offered to the public

Secondary market, Existing Islamic Government securities and Islamic Corporate

securities are traded; the equity market and the unit trust.

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SHARIAH ADVISORY COUNCIL (SAC) OF THE BNM

BNM established its Shariah Advisory Council (SAC) on Islamic Banking and Takaful on 1 May 1997 to streamline and harmonise the Shariah interpretations among banks and takaful companies.

The SAC took over the role of SAC of Bank Islam as the consultant to the IBS banks pertaining to Shariah issues.

Prior to the establishment of SAC, there were some differences in opinion among Shariah consultants on similar issues which might obstruct the development of IBS.

The SAC is the highest authority in deciding Shariah issues pertaining to Islamic banking and takaful operations in Malaysia.

Members of SAC comprise academicians and Shariah experts who posses vast knowledge and experience in the areas of Islamic banking and finance.

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SHARIAH ADVISORY COUNCIL (SAC) OF THE BNM

The primary objectives of NSAC are as follows: To act as the sole authoritative body to

advise BNM on Islamic banking and takaful operations

To co-ordinate Shariah issues with respect to Islamic banking, finance and takaful

To analyze and evaluate Shariah aspects of new products/ schemes submitted by the banking institutions and takaful companies.

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ESTABLISHMENT OF THE SECOND ISLAMIC BANK

The second Islamic bank in Malaysia, Bank Muamalat Malaysia Berhad (BMMB) was established on 1 October 1999.

The establishment of BMMB arose from the merger of Bank Bumiputra Malaysia Berhad (BBMB)and Bank of Commerce (M) Berhad (BOC).

Under the merger arrangement, the Islamic banking assets and liabilities of BBMB, BOC and BBMB Kewangan Berhad (BBMBK) were transferred in BMMB, while the conventional operations of BBMB, BOCB and BMBK were transferred to BOCB.

The establishment of the second Islamic bank has contributed to the rapid growth of the Islamic banking system.

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DEVELOPMENT FINANCIAL INSTITUTIONS (DFIS)

The aspiration of BNM to develop a comprehensive Islamic banking system had stimulated the non-banking financial intermediaries to offer Islamic banking products and services includes: Bank Simpanan Nasional (BSN) Bank Kerjasama Rakyat Malaysia (BR) Development Finance Institutions (DFIs)

i.e. Bank Pembangunan dan Infrastruktur Malaysia (BPIM) and Bank Pertanian Malaysia (BPM).

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3rd PHASE OF DEVELOPMENT

With the rapid development of the Islamic financial industry on the global front, the Government has promoted Malaysia as a regional Islamic financial centre.

The government has declared Labuan as an International Offshore Financial Centre (IOFC) to promote Malaysia as an international Islamic financial centre.

BNM has participated actively to enhance the development of Islamic banking and finance such as the formation of an International Islamic Financial Market (IIFM) and the setting up of the Islamic Financial Services Board (IFSB).

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LABUAN AS AN ISLAMIC IOFC

Government has made a decision to promote Labuan as an International Offshore Financial Centre (IOFC) to position itself as an international center for offshore Islamic banking and finance with the objectives: To complement domestic financial activities in Kuala

Lumpur To strengthen the contribution of the financial services

sector in the gross national product of Malaysia To promote the economic development of Labuan

Labuan with the status of IOFC has the advantage to attract international banking business by: reducing or eliminating the need for full compliance with

local capital requirements having lower licence fees, corporate taxes and other

business levies

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INTERNATIONAHSLAMIC FINANCIAL MARKET (IIFM)

Labuan Offshore Financial Services Authority (LOFSA) was established and responsible for setting national objectives, policies and priorities for the development and administration of offshore financial services in Labuan.

In its efforts to develop Labuan as an Islamic IOFC, LOFSA worked with Islamic scholars to identify potential offshore activities as well as to develop viable Islamic financial instruments which would attract Islamic investors to the Labuan

Following this, Malaysia, Bahrain, Indonesia, Sudan, Iran and the Islamic Development Bank (IDB) established an IIFM Board April 2002

The IIFM Board was entrusted to develop and supervise the development of the IIFM and supported by two committees, the Market and Product Development Committee MPDC and the Shariah Supervisory Committee (SSC).

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INTERNATIONAHSLAMIC FINANCIAL MARKET (IIFM)

LOFSA initiated the establishment of a global network of Islamic financial markets known as International Islamic Financial Market (IIFM) with the objectives: To establish a structured global financial market that is

based on Shariah principles To enhance the cooperative framework among Islamic

countries and financial institutions To generate the liquidity, creation and trading of

financial instruments, thus enhancing investment opportunities and spins-off of other related services and activities such as custodial, brokerage and treasury.

To promote greater awareness of Islamic banking and finance, and facilitate cross border transactions.

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FIRST SOVEREIGN GLOBAL ISLAMIC SUKUK

Malaysia successfully launched the first Sovereign Global Islamic Sukuk, structured on the principle of ijarah on 25 June 2002.

The launching of the global Islamic bond signified Malaysia’s strong commitment in supporting the development of Islamic banking and finance on the global front.

The move to access the international Islamic capital market would give impetus to the development of the Islamic financial market.

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ISLAMIC FINANCIAL SERVICES BOARD (IFSB)

Islamic Financial Services Board (IFSB) was established in 2002.

The establishment of the IFSB will set the stage for the adaptation, harmonization and development of the international regulatory and supervisory standards as well as best practices for the governance of all financial institutions offering Islamic financial services and products.

The nine founding members are Bahrain, Indonesia, Iran, Kuwait, Malaysia, Pakistan, Saudi Arabia, Sudan and the Islamic Development Bank, The IFSB secretariat is located in Kuala Lumpur. Malaysia.

The Board will also contribute towards ensuring the soundness and stability of the Islamic financial system, thus paving the way for Islamic banking to expand globally.

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LICENSING OF FOREIGN ISLAMIC BANKS AND ISLAMIC BANKS SUBSIDIARIES

The financial liberation of the Islamic banking sector was introduced on 2007 with the issuance of three new Islamic bank licenses under the Islamic Banking Act 1983 (IBA)

The new entries of the foreign Islamic banks were in line with the recommendations of the Financial Sector Master plan (FCMP) to position Malaysia as an international Islamic financial hub.

The presence of foreign players will promote healthy competition which is necessary to elevate the industry to new levels of dynamism as well as to accelerate the global integration the domestic Islamic banking system.

It will also promote greater economic and financial linkages between Malaysia and the Middle East, and foster greater harmonization in terms of Shariah interpretation and understanding.

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LICENSING OF FOREIGN ISLAMIC BANKS AND ISLAMIC BANKS SUBSIDIARIES

In 2004, BNM also continued to further strengthen the overall infrastructure development of the Islamic banking system as the Islamic banking industry entered a more advanced stage of development.

The window-based’ institutional structure was reviewed to further strengthen and elevate the development of domestic Islamic banking industry through a new enabling institutional structure.

The domestic banking groups and foreign Islamic Banking Scheme (IBS) banks were encouraged to set up Islamic subsidiaries (IS) as full-fledged Islamic banks which would be licensed under the IBA.

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FINANCIAL SECTOR MASTER PELAN FOR ISLAMIC BANKING

Financial Sector Master Pelan was launched on March 2001 incorporates 10 years master plan for Islamic banking a

FSMP’s aim is to create an efficient, progressive and comprehensive Islamic financial system that contributes significantly to the effectiveness and efficiency of then Malaysian financial sector.

FSMP provides recommendations which focus on three main areas: institutional capacity enhancement financial infrastructure development regulatory framework development

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VISION OF ISLAMIC BANKING AND TAKAFUL

Constitute 20% of the banking and insurance market share with an effective contribution to the financial sector of the Malaysian economy

Represented by a number of strong and highly capitalized IBIs and takaful operators offering a comprehensive and complete range of Islamic financial products and services

Underpinned by a comprehensive and conducive Shariah and regulatory framework;

Supported by a dedicated institution (Shariah commercial court) in the judiciary system that addresses legal issues related to Islamic banking and takaful

Supported by a sufficient number of well-trained, high caliber individuals and management teams with the required expertise;

Malaysia as a regional Islamic financial center.

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CONCLUSION

Islamic banking system has experienced a rapid growth and tremendous development since its first debut in 1983

Various measures have been adopted by the authorities in implementing the Islamic banking system with a step by step and open-minded approach with each step taken after careful consideration of all implications.

In order to he a viable Islamic banking system, all the basic elements towards this purpose were being established by the authority.

These include a large number of products, instruments and institutions and the establishment of an Islamic money and capital market which would link the institutions and the instruments.

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Documents

Development of the Malaysian Islamic Financial System