Kunhibava 2012

Islamic Banking in Malaysia t
SHERIN KUNHIBAVA *
Abstract
Islamic banking is the conduct of banking according to Shariah or

Islamic law. Statistically Islamic banking has had phenomenal growth,
according to the Asian Banker Research Group, the world's 100 largest
Islamic banks have set an annual asset growth rate of 26.7% and the global
Islamic finance industry is experiencing an average growth of 15-20%
annually 1 • Recently the Prime Minister of Malaysia commented that Malaysia
has been maintaining its leadership in Islamic banking and finance for over
three decades", As an International leader in Islamic banking, it would be
interesting to explore the development of Islamic banking in Malaysia. This
will be the objective of this paper. This paper will focus on the historical
development of Islamic banking in Malaysia, from the creation of the Haj
Pilgrim's Fund Board in the 1960s to the current Islamic banking scene of 17
local Islamic banks and five International Islamic banks in operation. This
paper will also explore the unique regulatory and governance framework of
Islamic banking in Malaysia, by touching on the Islamic banking Act 1983,
the Central Bank of Malaysia Act 2009, the Banking and Financial
Institutions Act 1989 and the Shariah Governance Framework introduced in
2011 by the Central Bank of Malaysia. This paper will also briefly introduce
how Islamic banking works.
A. Background
The development of Islamic banking has been unparalleled as 'no

other financial industry, market or jurisdiction in the last decade has
t © 2012 Sherin Kunhibava.

* Sherin Kunhibava, PhD, is a Senior Lecturer at the Faculty of Law at University
Malaya. She can be contacted at sherin@um.edu.my.
1 Mckinsey & Co., Capturing the Trillion Dollar Opportunity, The World Islamic
Banking Competitiveness Report 2007-08 (2008),54-55.
2 "Klifd: A Significant Boost to Nation's Leadership in Islamic Finance,"
Bernama, April 1 2011.
191
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192 INTERNATIONAL JOURNAL OFLEGAL INFORMATION [Vol. 40.1-2
witnessed the staggering financial engineering and innovation as the Islamic

finance industry'? In Malaysia, according to the Central Bank of Malaysia's
website, Islamic banking assets has reached USD65.6 billion, with an average
growth rate of 18-20% annually". Recently the Prime Minister of Malaysia
commented that Malaysia has been maintaining its leadership in Islamic
banking and finance for over three decades.' These statistics lead to the next
logical question and that is, what is Islamic banking?
Islamic banking is the conduct of banking in accordance to the

principles of Shariah. Shariah is often simply defined as Islamic law, but a
better and far more accurate definition is as follows; Shariah refers to a 'code
of law or divine injunctions that regulate the conduct of human beings in their
individual and collective lives."
One of the chief requirements in Shariah is that interest (riba) paid to

depositors and interest charged upon fund users, is strictly prohibited.' This is
one of the main principles that differentiate Islamic banking from commercial
banking. In Shariah a loan can, however be given, known as a qard, but no
interest can be imposed for the loan to be repaid. In other words a qard of
$500 will require only $500 back.
The main reason for the prohibition of riba in Islam is that of

'distributive justice, because the prohibition of Riba is intended to prevent the
accumulation of wealth in a few hands, that is, it is not to be allowed to
"circulate among the rich' (Holy Qur' an, 59:7)' .8 Thus the main purpose of
prohibiting interest is to ensure distributive justice of money and equity.
If no interest can be taken by Islamic banks in their transactions with

customers, the question arises as to how does Islamic banking conducts its
business? It is not, after all a charity.
3 B.K Grewel, "Islamic Capital Market Growth and Trends," Islamic Finance
News (2007), http://www.islamicfinancenews.com!guide07pdf/icm-
islamic%20capital.pdf., 29.
4 BNM, "Islamic Banking Industry."
5 "Klifd: A Significant Boost to Nation's Leadership in Islamic Finance."
6 Muhammad Ayub, UNDERSTANDING ISLAMIC FINANCE (West Sussex: John
Wiley & Sons, Ltd., 2007), 21.
7 Prohibition of riba is found in the Holy Quran: (30:39), (4: 161), (3: 130) and
(2:275-281) and the Sunnah of the Prophet (pbuh).
8 Ayub, UNDERSTANDING ISLAMIC FINANCE, 54-55.
2012] SHERIN KUNHIBAVA 193
Some of the common ways an Islamic bank conducts its business is

through either buying or selling of goods, in cash and/or in credit for a profit
as in murabahah; or through equity participation by partnerships such as
musharakah or mudarabah; or through leasing of items and obtaining rentals
such as in ijara. Islamic banks can also charge fees for their services as in
juala or ujr or act as an agent (wakalah) and obtain a fee from there.
For example, in the case of deposits, a Malaysian Islamic bank

accepts deposits for both saving and current accounts under the contract of
wadiah (safe-custody) together with another contract, named dhaman
(suretyship contract). In a wadiah yad dhamanah transaction the custodian
(the bank) would be able to utilise the money deposited in the account since
the custodian would be solely held liable for any damage or loss incurred on
the deposit. On the other hand, the depositors are given the assurance that they
may withdraw their money at any time and their money will be guaranteed
from any damage and the like. The Islamic bank has no legal obligation to pay
depositors a fixed return. However a discretionary reward known as hibah is
usually given by the Islamic banks," The practice of awarding hibah to
depositors is deemed necessary as the Islamic banking system in Malaysia
operates parallel to commercial banks (known as a dual system) and therefore,
needs to be competitive in the banking environment."
Other requirements in Shariali in relation to banking is that there must

not be any excessive risk or uncertainty (gharar) , gambling trnaisir and
qimar), or information asymmetry and ignorance ijahalai in Islamic banking
transactions. Business and trade activities should take place on the basis of
fair and legitimate (halal) profit, there should be giving of zakah (alms tax),
and monopoly is prohibited. I I
Having explained Islamic banking briefly, next this paper will focus
on Islamic banking in Malaysia. It will start with an overview of the historical
development of Islamic banking and then it will explain the regulatory and
governance framework of Islamic banking, before concluding.
9 S.A. Rosly, CRITICAL ISSUES ON ISLAMIC BANKING AND FINANCIAL MARKETS
(Kuala Lumpur: Dinamas, 2005),151.

10 A Malaysian local Islamic bank's website states "a Hibah (gift) may be given
at the bank's discretion." RHB Islamic, "Wadiah Basic Savings Account - I,"
http://www.rhb.com.my/islamic_banking-/deposit/wbsa-i .html.
11 See generally Muhammad Taqi Usmani, AN INTRODUCTION TO ISLAMIC
FINANCE (Netherlands: Kluwer Law International, 2002).
194 INTERNATIONAL JOURNAL OF LEGAL INFORMATION [Vol. 40.1-2
B. Historical Development
In Malaysia the era of Islamic banking can be traced back to 1963

when a savings body was created to save money for future pilgrims of haj 12
(known as LembagaUrusan dan Tabung Haji or Haj Pilgrim's Fund Board).
The money that was saved by the pilgrims was utilized to invest in Shariah
permissible investments. The pilgrim's board exists until today and carries out
Shariali permissible activities."
However the new beginning of Islamic banking as we know it today,

began in the 1980s, when Malaysia officially introduced the Islamic Banking
Act 1983 (IBA 1983), and the Takaful Act 1984. Bank Islam, a fully fledged
Islamic bank was also incorporated as a public company in 1983. Bank Islam
Berhad was the first fully fledged bank that offered Islamic banking products
and services. This was to remain for 10 years.l'Tt was during this period that
Islamic banking was at its very initial and 'experimental stage' and non-
Muslim participation in Islamic banking was minimal":
Then in 1993 commercial banks, merchant banks and finance

companies were allowed to offer Islamic banking products and services under
what was known as Islamic banking scheme also known as "Islamic
windows". This was hugely successful because a greater number of the public
whether Muslim or non-Muslim were allowed to participate in Islamic
banking." Any perceptions disappeared that Islamic banking was only for
Muslims.
12 One of the five pillars of Islam. Where a Muslim who is able and has the
means, must perform pilgrimage to Mecca at a specified time in the Islamic calendar,
at least once in their lifetime
13 ISRA, Islamic Financial System Principles and Operation (Kuala Lumpur:
ISRA, 2011), 114.
14 Nik Norzul Thani, Mohamed Ridza Abdullah, and Megat Hiziani Hassan, LAW
AND PRACTICE OFISLAMIC BANKING AND FINANCE, 2nd ed. (Petaling Jaya: Sweet &
Maxwell Asia, 2010), 103.
15 Nor Mohammed Yackop, "Developing an Islamic Banking System: The
Malaysian Model," in FROM MONEYLENDERS TO BANKERS: EVOLUTION OFISLAMIC
BANKING INRELATION TO JUDEO CHRISTIAN AND ORIENTAL BANKING TRADITIONS
INTERNATIONAL ISLAMIC BANKING CONFERENCE (PRATO, Italy: 2003).
16 Thani, Abdullah, and Hassan, LAW AND PRACTICE OFISLAMIC BANKING AND
FINANCE., 245.
2012] SHERIN KUNHIBA V A 195
Then in January 1994, in order for the Islamic banking system to

function as a full-fledged banking system, an Islamic Interbank Money
Market (IIMM) was set up, to link the institutions and the instruments."
After ten years, Islamic subsidiaries were introduced with RHB

Islamic Berhad, and Hong Leong Islamic Berhad launched in the year 2005.
These Islamic subsidiaries are established by the domestic commercial banks
and are licensed as Islamic banks under the IBA 1983. 18 Thus Islamic
subsidiaries are for all purposes treated as a fully fledged Islamic bank.
During the same period foreign Islamic banks were given licenses to
practice Islamic banking in Malaysia. The foreign Islamic banks include,
Kuwait Finance House, AIRajhi bank, and Asian Finance House. 19
Currently, there are 17 local Islamic banks and five International

Islamic banks in operation in Malaysia. While there are 15 banks participating
in the Islamic Banking Schernc.i"
c. Regulatory and Shariah Governance Framework of Islamic Banking
As stated above Malaysia officially introduced Islamic banking to its

shores with the passing of the IBA 1983. Its main purpose is to govern the
operations of Islamic banks, such as stating requirements for a bank to be
licensed as an Islamic bank.
The IBA 1983 defines an Islamic bank as any company which carries
on Islamic banking business and holds a valid license. And it defines 'Islamic
banking businesses as any banking business whose aims and operations do not
involve any element which is not approved by the religion of Islam. The
religion of Islam is not defined by the IBA 1983. Instead the IBA 1983 leaves
the religion of Islam and Shariali interpretation through its s. 3.
According to s.3 of the IBA 1983, every bank that wants to practice
Islamic banking must establish a Shariali Advisory body to advise the bank
on the operations of its banking business to ensure that the bank complies
Yackop, "Developing an Islamic Banking System: The Malaysian Model."

17
Thani, Abdullah, and Hassan, LAW AND PRACTICE OF ISLAMIC BANKING AND
18
FINANCE. 101-102.
19 BNM, "Islamic Banking Industry."
20 MIFC, "List of Islamic Banks,"

http://www.mifc.comlindex.php?ch=menu_know_ibt_ib&-
pg=menu_know_ibt_ib_Iist.
with the 'religion of Islam' . Thus the Shariah Advisory body ensures that
Shariah is complied with by the Islamic bank.
The Shariah Advisory board used to be made up of a minimum of

three individual members, but now with the Shariah Governance framework"
a minimum of five members is required. Each individual Shariah Board
member is only allowed to sit on one committee in the same industry.
Committee members must at least be qualified in the field of Islamic
Jurisprudence (usul fiqh) or Islamic transaction/commercial law (jiqh
Mu' amalat) or possess the necessary knowledge, expertise or experience in a
related field. Of the five committee members necessary, the majority have to
have Shariah background. 22
To ensure uniformity and standardization in the decisions by the

Shariah Advisory Bodies of the various Islamic banks, there exists a National
Shariah Advisory Council which advises the Central Bank in Malaysia. The
National Shariah Advisory Council is the ultimate authority on Islam in
Islamic banking in Malaysia. It was established in 1997 by the Central Bank
and its primary objectives are: to act as the sole authoritative body to advise
the Central Bank of Malaysia on Islamic banking and takaful (Islamic
insurance) operations; to co-ordinate Shariah issues with respect to Islamic
banking (including takafuli; and to analyze and evaluate Shariah aspects of
new products/schemes submitted by the banking institutions and takaful
companies. Generally, its role is to ensure overall coherence to principals of
Islam and also that all banks offering Islamic services conform to the same
principals. 23
Further, the recent passing of the Central Bank of Malaysia Act 2009
gives greater clarity to the role of the National Shariah Advisory Council as
the ultimate authority and center for any issues and questions on Shariah by
financial institutions and also the courts of law. Under the Central Bank of
Malaysia Act 2009 any ruling made by the National Shariah Advisory
Council shall be binding on Islamic financial institutions, the court and
arbitrator.
21 Central Bank of Malaysia recently introduced the Shariah Governance
Framework for Islamic Financial Institutions in Malaysia, it came in force on the 1st
of June 2011. Available at BNM, "Shariah Governance Framework," (2011),
http://www.bnm.gov.my/guidelines/05_shariah/02_Shariah_Governance_Framework
_20101026.pdf.
22 Ibid.
23 , "Islamic Banking Industry."
2012] SHERIN KUNHIBA VA 197
The IBA 1983 also provides that an Islamic bank may seek the advice
of the National Shariah Advisory Council on Shariah matters relating to its
banking business, and the Islamic bank shall comply with the advice of the
National Shariah Advisory Council.
In Malaysia commercial banks licensed under the Banking and

Financial Institutions Act 1989 (BAFIA 1989) are also allowed to carry out
Islamic banking business in addition to their conventional banking business,
after consulting the Central bank of Malaysia (as stated above, under the
Islamic Banking Scheme). Under the BAFIA 1989, Islamic banking business
has the same meaning as in IBA 1983, whilst Islamic financial business is
defined as any financial business the aims & operations of which do not
involve any element which is not approved by the Religion of Islam. Further
like the IBA 1983 the BAFIA 1989 further provides that any licensed
institution carrying on Islamic banking business and Islamic financial
business may refer a question to the National Shariali Advisory Council and
shall comply with directions on Islamic banking business and Islamic
financial business issued by Bank Negara in consultation with the National
Sharian Advisory Council.
Another more recent development by the Central Bank of Malaysia

caters to improving Shariah governance of Islamic financial institutions (IFIs)
in Malaysia. The Central Bank of Malaysia has developed a framework
known as the Shariah Governance Framework (Framework) which has
officially been in effect from the 1st January 2011 (though IFIs were given
until the 1st of June 2011 to comply with the new Framework).
Under the framework it is the duty and responsibility of an IFI to

establish a sound and robust Shariah governance framework. The primary
objective of the Framework is to enhance the role of the Board of Directors,
the Shariah Advisory Board, and the Management in relation to Shariah
matters, including enhancing the relevant key organs having the responsibility
to execute Shariah compliance and research functions.i"
The Framework is applicable to all IFIs regulated and supervised by

the Central Bank, which includes:
(i) An Islamic bank licensed under IBA 1983
(ii) A takaful and retakaful operator registered under the Takaful Act
1984
24 , "Shariah Governance Framework."
(iii) A financial institution licensed under the BAFIA 1989 (BAFIA)

that participates in the Islamic Banking Scheme
(iv) A development financial institution prescribed under the
Development Financial Institutions Act 2002 that participates in
the Islamic Banking Scheme."
Under the framework, the Board of Directors are responsible for the
overall Shariah oversight of the IFIs and the effective functioning of the
Shariah governance structure, policies and processes. However, the Board
must recognise the independence of the Shariah Advisory Board and uphold
its decisions on Shariah aspects of the IFI's business operations."
With regards to the Shariah Advisory Board27 , it is responsible and

accountable for all its decisions, views and opinions related to Shariah
matters. The Shariah Advisory Board is also expected to perform an oversight
role on Shariah matters related to the IFIs business operations and activities.
This is achieved through Shariah review and the Shariah audit functions
(explained below)."
As for the Senior Management of an IFI, apart from providing

support to the Shariah Advisory Board, it is also responsible to promote a
strong culture of Shariah awareness and compliance within the organisation,
including implementing best practices in Shariah governance in all aspects of
the IFI's operations. 29
Under the Framework IFIs are also expected to establish three

functions that provide a system of checks and balances within the
organisation, which include the following:
• Shariah risk management control function that is able to identify
all possible risk of Shariah noncompliance and, where
appropriate, remedial measures to manage this risk;
• Shariah review function that continuously assesses Shariah
compliance of all activities and operations. Where instances of
non-compliances are identified, the IFI is expected to take prompt
25Ibid.
26Ibid.
27 In the Shariah Governance Framework the Shariah Advisory Board is referred
to as the Shariah Committee.
28 BNM, "Shariah Governance Framework."
29 Ibid.
rectification measures and put in place the necessary mechanisms

to avoid such recurrences; and,
• Shariah audit function that performs annual audits to provide an
independent assessment of the adequacy and compliance of the
IFI with established policies and procedures, and the adequacy of
the Shariali governance process.
D. Conclusion
In Malaysia conventional law i.e. the IBA 1983, the BAFIA 1989 and
the Central Bank of Malaysia Act 2009 govern the operations of the Islamic
banking and financial business, but Shariali is left to the Shariali Advisory
boards of each bank and the National Sharian Advisory Councils of the
Central Bank. In this way both conventional laws and Shariali complement
each other to ensure proper governance and proper adherence to Shariali by
Islamic banking and financial institutions in Malaysia. Adding to this is the
new Framework which seeks to ensure proper Shariah governance within
IFls.
One of the main lessons that can be learnt from Malaysia's

comprehensive regulatory framework with regard to Islamic banking is on the
issue of Shariali governance. In Malaysia uniformity is maintained in
decisions on Shariali matters. It is important to ensure uniformity in the
decisions of Sharian issues to create certainty for investors and other
stakeholders. Investors and other stakeholders are certain of the outcome of
Shariah matters. Uniformity and certainty in Sharian governance is
maintained in Malaysia through the one National Shariali Advisory Council
that deals with all the Islamic banking and takaful matters in Malaysia. Even
though each Islamic bank has its own Sharian Advisory board, each Sharian
Advisory Board must comply with the directives of the National Shariah
Advisory Council. The National Sharian Advisory Council is the ultimate
authority in matters of Banking and takaful.
Another lesson that can be learnt from the Malaysian regulatory and
Sharian framework is the transparency of the structure and the distinct roles
of every organ in the Islamic financial system. Each Islamic bank is governed
by the IBA 1983, and conventional banks are governed by the BAFIA 1989.
These Acts govern the operational aspect of the banks. Matters of substance
that govern the Shariali compliance of the banks' products and services are
left to the Shariah Advisory Board, and National Sharian Advisory Council.
Each organ in the Islamic financial system has distinct clear roles for which
they are qualified for.
References
Ayub, Muhammad. UNDERSTANDING ISLAMIC FINANCE. West Sussex: John

Wiley & Sons, Ltd., 2007.
BNM. "Islamic Banking Industry."
http://www.bnm.gov.my/microsites/financial/-0204_ib_takaful.htm#ib.
- - -. "Shariah Governance Framework." (2011),
http://www.bnm.gov.my/guidelines-
/05_shariah/02_Shariah_Governance_Framework_20 101026 .pdf.
Co., Mckinsey &. Capturing the Trillion Dollar Opportunity, The World
Islamic Banking Competitiveness Report 2007-08, 2008.
Grewel , B.K. "Islamic Capital Market Growth and Trends." ISLAMIC
FINANCE NEWS (2007),
http://www.islamicfinancenews.com/guide07pdf/icm-
islamic%20capital.pdf.
Islamic, RHB. "Wadiah Basic Savings Account - I."
http://www.rhb.com.my/islamic-_banking/deposit/wbsa-i.html.
ISRA. ISLAMIC FINANCIAL SYSTEM PRINCIPLES AND OPERATION. Kuala
Lumpur: ISRA, 2011.
"Klifd: A Significant Boost to Nation's Leadership in Islamic Finance."
Bernama, April 1 2011.
MIFC. "List of Islamic Banks."
http://www.mifc.com/index.php?ch=menu_know_ibt-
_ib&pg=menu_know_ibt_ib_list.
Rosly, S.A. CRITICAL ISSUES ON ISLAMIC BANKING AND FINANCIAL
MARKETS. Kuala Lumpur: Dinamas, 2005.
Thani, Nik Norzul, Mohamed Ridza Abdullah, and Megat Hiziani Hassan.
LAW AND PRACTICE OF ISLAMIC BANKING AND FINANCE. 2nd ed.
Petaling Jaya: Sweet & Maxwell Asia, 2010.
Usmani, Muhammad Taqi. AN INTRODUCTION TO ISLAMIC FINANCE.
Netherlands: Kluwer Law International, 2002.
Yackop, Nor Mohammed. "Developing an Islamic Banking System: The
Malaysian Model." In FROM MONEYLENDERS TO BANKERS: EVOLUTION
OF ISLAMIC BANKING IN RELATION TO JUDEO CHRISTIAN AND ORIENTAL
BANKING TRADITIONS INTERNATIONAL ISLAMIC BANKING CONFERENCE.
PRATO, Italy, 2003.
Statutory Legislation
Banking and Financial Institutions Act 1989

Central Bank of Malaysia Act 2009
Islamic Banking Act 1983
Takaful Act 1984

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Islamic Banking in Malaysia t

Islamic banking is the conduct of banking according to Shariah or

The development of Islamic banking has been unparalleled as 'no

t © 2012 Sherin Kunhibava.

witnessed the staggering financial engineering and innovation as the Islamic

Islamic banking is the conduct of banking in accordance to the

One of the chief requirements in Shariah is that interest (riba) paid to

The main reason for the prohibition of riba in Islam is that of

If no interest can be taken by Islamic banks in their transactions with

Some of the common ways an Islamic bank conducts its business is

For example, in the case of deposits, a Malaysian Islamic bank

Other requirements in Shariali in relation to banking is that there must

9 S.A. Rosly, CRITICAL ISSUES ON ISLAMIC BANKING AND FINANCIAL MARKETS

(Kuala Lumpur: Dinamas, 2005),151.

In Malaysia the era of Islamic banking can be traced back to 1963

However the new beginning of Islamic banking as we know it today,

Then in 1993 commercial banks, merchant banks and finance

Then in January 1994, in order for the Islamic banking system to

After ten years, Islamic subsidiaries were introduced with RHB

Currently, there are 17 local Islamic banks and five International

c. Regulatory and Shariah Governance Framework of Islamic Banking

As stated above Malaysia officially introduced Islamic banking to its

Yackop, "Developing an Islamic Banking System: The Malaysian Model."

20 MIFC, "List of Islamic Banks,"

The Shariah Advisory board used to be made up of a minimum of

To ensure uniformity and standardization in the decisions by the

21 Central Bank of Malaysia recently introduced the Shariah Governance

In Malaysia commercial banks licensed under the Banking and

Another more recent development by the Central Bank of Malaysia

Under the framework it is the duty and responsibility of an IFI to

The Framework is applicable to all IFIs regulated and supervised by

24 , "Shariah Governance Framework."

(iii) A financial institution licensed under the BAFIA 1989 (BAFIA)

With regards to the Shariah Advisory Board27 , it is responsible and

As for the Senior Management of an IFI, apart from providing

Under the Framework IFIs are also expected to establish three

rectification measures and put in place the necessary mechanisms

One of the main lessons that can be learnt from Malaysia's

Ayub, Muhammad. UNDERSTANDING ISLAMIC FINANCE. West Sussex: John

Banking and Financial Institutions Act 1989

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