2017-01-18 PAGE22

LegalCraftandSuch-2017EditionRegulatingIslamicBanking:AMalaysianPerspective

RegulatingIslamicBanking:AMalaysianPerspective

byAssoc.Prof.NafisAlamandLokeshGupta

JamesMadison once said, “Ifmenwere angels, no governmentwould benecessary”. Madison’s view has direct implications for efficient banksupervisoryandstrongregulatorystrategies.Ontheonsetofthe2007–08subprimecrisis,thebankingsystemsacrosstheglobewereleftexposedtofinancial tsunami due to over-expansion and excessive riskconcentrations.

In recent years, thebanking systemsaround the globehavebeengoingthrough someof themost intense criticismand scrutiny. In part,manybelievethelackofregulationsandsupervisorystructureshasbroughttheworldtoabrinkoffinancialcollapse,whileontheothersideofthatcoinmany believed the years of prosperity the world had experienced justpriortothecollapsewerelargelyinpartduetothederegulationorlackofregulation,henceanearfreemarketwithregardtothefinancialsector1

(Reinhart and Rogoff, 2008; Brunnermeier & Pederson, 2009 and Alam,2012).

Banking regulations can generally be defined as the frameworkcontrolling the creation, operation and liquidation of banks in aneconomy.Theseregulationsareputinplacebycentralbanksandfinanceministriesandcontrolisusuallyexertedthroughmonitoringcarriedoutby specialised banking supervisory authorities. Spong (2000) 2 from theFederalReserveBankofKansasCityhighlightsa fewimportantreasonsfor introducingbankregulations.Themostbasicreason for introducingregulations is to protect depositors from undue risks to their deposits.Businessesandindividualsalikeholdsignificantportionsoftheirfundsinbanksandtherearevalidconcernswithregardstotheprotectionoftheirfunds.Asaresult,authoritiesrespondtosuchconcernswithregulationsasanattempttoprotectthebankdepositors.

Meanwhile, with the amount of transactions conducted daily bybusinesses and individuals, a stable framework is required to ensuresmoothandacceptablemethodsofthepaymentsystemareinplace.Bankregulations try to provide this stable frameworkwhich seeks to ensurecertaintyandsafetytousersofthebankingpaymentsystem,andthisinturn is critical for thewell-beingof theeconomy.Moreover,apart from

maintaining public confidence, bankingregulations also try to create a regulatoryenvironmentwherebanksareexpectedtobeefficient and competitive; and are alsoexpected to provide reasonable levels ofbanking services throughout the economy.The traditional view of the impact of bankregulations is that higher capitalrequirements will have a positive effect onthe banking sector. Bank regulations andsupervisioncantaketheformofdetailedandprecise prescriptive rules under which allbanks operate in the given territory. Forexample,activityrestrictionrulesmayspecifywhichbankingactivitiescanbeundertakentoreduce risk and prevent bankruptcy. If suchrules do not truly reflect the risks involvedthey could unintentionally induce banks toinvolveinunprofitableandriskyventures.

AnotheraspectofbankingistherecentriseofIslamic finance. While the rest of the worldandindustrycontinueonwiththebusinessofarguing as to what level of bankingregulationsisneeded,inmanycornersoftheworldadifferenttypeofbankingsystemisontherise. Islamic financeencompassesawidearrayofconceptsfromfullyfledgedfinancialinstitutions to normal financial institutionshaving an Islamic financing arm that offerssaving schemes, loans or bonds commonlyknownasSukuk.

However,likeeverysystemthatistheologicalbased, Islamic finance is open tointerpretation and that can vary betweendifferent regions. The Islamic financeindustry has also been riddled with manyissues, many of which boil down to lack ofproper supervision, and lack of complianceandregulatorymeasures.HoweverIslamicFinancialMarketsareamongthefastestgrowingfinancialproductsintheworld.Thiswillseefurthergrowth inyears tocomeasmoreandmorecountriesareembarkingonIslamic banking and discovering the benefits of using Islamic financeover conventional financing schemes. As highlighted by Rehman andPerry (2011) 3 , “while many of the conventional banks suffered majorloses in the aftermath of the sub-prime mortgage crisis, most banks

following the Islamic system were largely profitable”. However, thereexist some dark clouds over the horizon for Islamic banking to beaccepted universally as a mainstream. It would mostly be seen as analternative.

When itcomes to theregulationof the Islamicbankingsector,Malaysiastandsout fromrestof thecompetingnations in thedualbanking(bothIslamic and conventional banking running in parallel) system. ThesophisticatedMalaysianfinancialindustryrunningboththeconventionalandIslamicfinanceinaparallelfinancialsystemcallsforaneedformorestableregulatoryframework.On30June2013,theFinancialServicesAct2013 (“FSA”) and the Islamic Financial Services Act 2013 (“IFSA”)(collectively referred to as “Acts”) have come into effect by substitutingandrepealingtheBankingandFinancialInstitutionsAct1989,InsuranceAct1996,PaymentSystemsAct2003,ExchangeControlAct1953,IslamicBankingAct1983andTakafulAct1984.TheobjectivesoftheActsaretoprovide Bank Negara Malaysia (“BNM”), the Central Bank of Malaysiawith greater powers to counter future risks to financial stability in thefinancial sector, increase consumer protection, promote competition inthe broader financial services sector and step forward towards globaltrends in financial regulations. This marked another milestone forMalaysiaasitintroducedtheIFSAandFSAtocatertothegrowingmarketofthecountry’sfinancialindustry.

Since the scope of this article is on Islamic banking regulation,wewilldwellonsomekeyfeaturesoftheIFSA.UndertheIFSA,Islamicbanksarenow required to separate Islamic deposits with a principle guaranteedfeature from investment accounts with a non-principle guaranteedfeature.ThisdistinctionwillallowIslamicbankstodevelopawiderrangeof products for both deposit and investment uses in order tomeet thediverseneeds of Islamicbanking customers (both retail and corporate).To facilitate smooth implementation of the reclassification process andensurerelevantstakeholdersinterestsareprotected,BNMhasformulateda transition plan to allow Islamic banks to complete the processwhichended on June 2015 (two-year period from the enactment of IFSA).Additionally,theIFSAprovidesgreaterlegalclarityonapplicationofthevarious types of Shariah financial contracts, and ensure end-to-endcompliance in full cycle of Islamic banking operations, eg investmentaccounts. From market conduct standpoint, the customers are able toclearly differentiate between products which are principal guaranteedwiththosewhicharenot.Onthedepositclassification,Islamicbankscanoffer both products with principal guaranteed or non-principalguaranteedfeature.However,Islamicbanksarerequiredtoclassifysuchproducts as either Islamic deposit which uses Shariah contracts withprincipal guaranteed featureor investmentaccountwhichusesShariahcontractswithnon-principalguaranteedfeature.

The main purpose behind the introduction of the IFSA is to provide a

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stronger legal foundation to spur the growth of Islamic finance sectorwithin thecountry.Themarketshareof Islamicbanks in theMalaysianbankingsectorhasincreasedto23%asof1H2015(IFSB,2016).TheIFSAfurtherboostedthedevelopmentofalegalplatformforthedevelopmentof Islamic finance inMalaysiawhich is reflecteduponacomprehensiveregulatoryframeworkofthevariousIslamicfinancialcontracts.TheActsalso support the effective application of Shariah financial contracts inoffering Islamic financialproductsandservices.The introductionof theIFSA has marked a significant milestone in aligning the Shariahrequirements of Islamic financial services in regulatory principles. Thecontract-based regulatory framework also gives BNM greater oversightand powers to further scrutinise financial holding companies and non-regulated entitieswhomight pose a risk to financial stability. It is alsobelievedthattheIFSAwillsupplementimprovedinvestors’protectionasthere areprovisions that requirebanks todistinguishbetweendepositsmadeforsavingsandthosemadeforinvestments.

Anothernotableelementof the IFSA is regarding thenotification to theregulatorsonShariahnon-compliance. It isnow legallyobligatoryuponanIslamicfinancialinstitutiontoimmediatelynotifytheregulatoranditsShariahcommitteeonceitbecomesawarethatitiscarryingonanyofitsbusiness,affairoractivity inamannerwhich isnot incompliancewithShariah.TheIslamicfinancialinstitutionisrequiredtoimmediatelyceasefrom carrying on such business and from taking on any other similarbusiness, affair or activity and within 30 days, and to submit to theregulator a plan on the rectification of the non-compliance. The IFSAempowers the regulator to carry out an assessment to determine therectification has been carried through. Another distinct feature of theIFSAisthatBNMisempoweredtospecifystandardstogiveeffecttotheadviceor rulingsof theShariahAdvisoryCouncil. The standards issuedby the regulator are binding on all Islamic financial institutionsauthorisedundertheActandontheirdirectors,ChiefExecutiveOfficersandShariahcommitteememberswhofunctionasprecursorsforShariahcomplianceintheseinstitutions.

TheIFSAwasdesignedtoaddressseveralloopholesafflictingthebankingindustry. With IFSA, Malaysia has achieved the distinction of the firstcountry in the world to legislate Shariah governance which furthercements Malaysia’s position as the leading hub of Islamic financeregionallyandglobally.

FOOTNOTESFOOTNOTES

Reinhart, C., & Rogoff, R. (2008) This Time is Different: A Panoramic View of Eight Centuries of Financial Crises. NBER:WorkingPaperno.13882.

Brunnermeier,M.andPedersen,L.(2009)MarketLiquidityandFundingLiquidity.ReviewofFinancialStudies22:2201–2238.

Alam, N. (2012) Does Banking Regulation Affect Banking Efficiency? A Survey of Dual Banking Systems. Journal of

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InternationalBankingLawandRegulation27(6):231–238.

Spong,K.(2000)BankingRegulation:ItsPurposes,Implementation,andEffects.FederalReserveBankofKansasCity,KansasCity:MO.

Rehman,S.andPerry,F.(2011)GlobalizationOfIslamicFinance:MythOrReality?InternationalJournalofHumanitiesandSocialScience1:107–119