ISLAMIC BANKS CAN'T KEEP UP WITH DEMAND

UNCLAS SECTION 01 OF 04 KUALA LUMPUR 001629

SIPDIS

STATE PASS USTR - WEISEL, JENSEN AND MAIN
STATE PASS FEDERAL RESERVE AND EXIMBANK
STATE PASS FEDERAL RESERVE SAN FRANCISCO TCURRAN
USDOC FOR 4430/MAC/EAP/J.BAKER
TREASURY FOR OASIA AND IRS

GENEVA FOR USTR

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN EINV MY
SUBJECT: ISLAMIC BANKS CAN'T KEEP UP WITH DEMAND

REF: Kuala Lumpur


1. (U) Summary: Local Islamic banks are unable to keep
pace with the rapidly increasing demand for Financial
Services consistent with Islamic Law (Shariah).
According to one local analyst, demand now outpaces
supply two to one, and not just among Muslims. The
expectation of higher returns is driving the growing
demand among Muslims and non-Muslims alike. The GOM,
building toward its vision of becoming a global hub for
Islamic finance, recently announced a new initiative to
promote Islamic banking through tax incentives and
government-sponsored scholarships to train experts in
Islamic finance. Also, in an effort to attract more
business from the Middle East, the Securities
Commission of Malaysia signed a memorandum of
understanding with the Dubai Financial Services
Authority on August 15 to address different
interpretations of Shariah and work toward mutual
recognition of each other's Islamic financial products.
To further boost Malaysia's image as a global Islamic
financial center, Bank Negara (Malaysia's Central Bank)
will begin to adopt some Islamic policy instruments in
its operations. End Summary.

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Demand Outpaces Supply
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2. Malaysia's Islamic banking industry is booming. In
2005 alone, total assets of Islamic banks rose 17.7% to
RM 117.4 billion (USD 31.7 billion). Islamic corporate
bonds (sukuk) constituted 46% or RM 125 billion (USD
33.8 billion) of total Malaysian corporate bond
issuance. In the first half of 2006, 26 new Islamic
corporate bonds of RM 23 billion (USD 6.2 billion) were
issued, accounting for 71% of Malaysian corporate bond
issues. According to the CEO of a major local bank,
Islamic corporate bonds offer higher rates of return of
between 10-15 basis points over conventional corporate
bonds. In Malaysia, more than 50% of such bonds are
held by non-Muslims.


3. Islamic finance, when undertaken according to the
spirit in which it was intended, involves higher risks
as it requires an investor to take an equity position,
sharing in the profits and losses of the group, with no
guarantees. On average, this higher risk position
tends to offer higher returns. Other Islamic financial
products abide primarily by the letter of Islamic law,
for example, by using service fees in place of
interest; these closely mimic conventional products in
terms of both risk and return. Whatever the risk,
return, and fees, there is a broad perception that
Islamic financial products offer a better deal; in
fact, one prominent local U.S. businessman reports that
salesmen often claim that commercial institutions "rake
in huge profits" while Islamic financial service
providers charge only a "service fee."


4. Citibank's Islamic banking subsidiary in Malaysia
recently conducted research to determine whether
Malaysian Muslims preferred to do business with an
Islamic bank or with a global bank's Islamic
subsidiary. (At the time, Citibank was considering
whether to enter a joint venture with a local Islamic
bank.) The research showed that, on average, younger
Malaysian Muslims were concerned primarily with the
financial returns, with little regard for Islamic
banking principles. Older Malaysian Muslims responded
that, as long as the subsidiary was certified as being
Shariah-compliant, they preferred "the world-class
services of a world-class bank" (as described by one
Citibank official) over a local Islamic Bank.

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Going Global: GOM Launches the Malaysian International
Islamic Financial Center Initiative
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5. At the Malaysian Islamic Finance Forum on August

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14, Bank Negara Governor Zeti launched the Malaysia
International Islamic Financial Centre (MIFC)
initiative that aims to enhance inter-linkages in the
global Islamic financial markets and strengthen
Malaysia's position as an international Islamic
financial hub. The initiative entails three major
elements: special tax and regulatory treatment,
scholarships, and harmonization of Islamic banking and
insurance practices.

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Tax and Regulatory Treatment
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6. Bank Negara will provide tax incentives to
qualified foreign and Malaysian financial institutions
that establish International Currency Business Units
providing a full range of Islamic banking products and
services in international currencies. This represents
a significant shift from current Malaysian policy,
which permits international currency transactions only
in Labuan, Malaysia's offshore banking center. The
MIFC initiative also will allow qualified foreign and
Malaysian insurance companies to provide a full range
of Islamic insurance (takaful) products in
international currencies. Offshore Islamic banking
operations will be allowed greater flexibility to open
offices anywhere in Malaysia. Currently, the GOM sets
the number of branches foreign banks may establish
throughout Malaysia and must approve the location of
any new branch. (A recent decision allowed foreign
banks to open exactly six additional branches - neither
less than nor more than six. There is much speculation
that this also will be liberalized.) In addition,
Islamic banks will be exempt from GOM restrictions on
the employment of expatriates to top positions.


7. There is some speculation among Islamic bankers
that the GOM's 2007 budget, to be released on September
1, will extend incentives and tax breaks to Islamic
Real Estate Investment Trusts (REITs) and to Islamic
banks outside of the Labuan offshore banking center.
Currently, a holding company established in Labuan is
not required to pay any taxes and its offshore trading
companies can choose a flat corporate tax of RM 20,000
(USD 5500) or a 3% tax on revenue. (Outside of the
Labuan offshore financial center, the corporate tax
rate is 28%.) In comparison, Dubai and Bahrain impose
no taxes on Islamic financial products, and Singapore,
a newcomer in the Islamic banking industry, offers a
very liberal tax regime across the board for the
Islamic banking products. One Islamic Banking
executive pointed out that Malaysia needs to match what
others are offering to attract more funds, particularly
from high net worth individuals from the Middle East.
He also pointed out the need for tax breaks designed to
help the industry recruit and retain talent.

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Scholarships
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8. There is broad recognition that one of the main
constraints on the industry is a shortage of financial
executives well-versed in Shariah, and a shortage of
Shariah scholars well-versed in finance. Language is
yet another barrier. Few Malaysian financial
executives are fluent in Arabic, and few Shariah
scholars are fluent in English. Fluency in both areas
of expertise -- and in both languages -- will be
essential to reach the global Islamic financial market.
The GOM plans to expand its scholarships to develop the
human resources to meet this need.

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Addressing Differences in Shariah Interpretations
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9. Addressing the August 14 forum, Bank Negara Deputy
Governor Mohammed Razif Abdul Kadir said Malaysia may
be strong in Islamic finance at the domestic level, but

KUALA LUMP 00001629 003 OF 004


needs to strategize to elevate to the next stage of
growth in the global arena. As there are differences
in the Shariah interpretations and practices between
Malaysian and Middle Eastern nations, Razif said the
MIFC would advocate mutual recognition and accommodate
the various juristic reasoning based on contemporary
analysis and logical inference, so long as it is
recognized by the Shariah advisers. Razif said Bank
Negara was ready to take the lead in the harmonization
of Shariah interpretations, and in fact has begun to
convene strategic dialogues among scholars within the
region and globally. However, he said that diversity
in Shariah interpretation must be allowed in order to
support product innovation and meet the needs of the
industry.

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Dubai and Malaysia Seal Deal
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10. On August 15, the Dubai Financial Services
Authority (DFSA) and the Securities Commission (SC) of
Malaysia signed a memorandum of understanding (MOU) to
facilitate Islamic financial transactions between the
Dubai International Financial Centre (DIFC) and
Malaysia. The Securities Commission of Malaysia
reports that the MOU will facilitate inter-
jurisdictional cooperation on enforcement; strengthen
channels for information exchange, cooperation and
consultation; and promote development and training
initiatives. It also will seek to promote cross-border
transactions and work to streamline regulatory
standards between the two countries. Securities
Commission Chairman Zarinah Anwar told Embassy Economic
Specialist that the DIFC was well-positioned as a
gateway to the vast growth potential of the Middle East
in Islamic finance.

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Central Bank to begin adopting
Islamic Banking Practices
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11. Zeti also announced that Bank Negara soon would
incorporate the Islamic practice of "murabahah" into
its policy instruments to manage short-term liquidity
in the Malaysian Islamic inter-bank money market.
Murabahah is the "cost plus" approach, whereby a
product is sold at a pre-agreed price that includes a
profit margin. The profit margin serves to compensate
the bank for its services, but provides no penalty for
late payment. Bank Negara's murabahah based-
transactions likely will utilize global or Malaysian
commodities for the underlying transaction. Zeti also
announced that Bank Negara planned to add other Shariah-
approved policy instruments, including Islamic bonds
based on the sale and lease concept ("Ijarah sukuk").
The Malaysian Islamic financial market already has
introduced a variety of Islamic financial hedging
instruments, including the Islamic profit rate swap,
the Islamic cross-currency swap and the Islamic forward
rate agreement. Malaysia also has established Shariah-
based unit trusts which have demonstrated a compound
annual growth rate of 59% from 1992-2005 with a net
asset value of RM 8.6 billion (USD 2.3 billion). These
are expected to grow rapidly.

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Comment
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12. With the government's avid support, the Malaysian
Islamic banking industry is set to continue its path of
rapid expansion. The booming demand for Islamic
financial services is not necessarily an indication
that Malaysian Muslims are becoming increasingly
religious. Rather, the perception -- and sometimes the
reality -- of greater returns is driving demand in
Malaysia. Demand-driven and government-accelerated,
Islamic finance -- with its broad array of new
financial products and services -- represents

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significant growth potential for the Malaysia's
financial sector. The biggest hurdle to Malaysia's
success in becoming a global hub for Islamic finance
may be the Government's own heavy handed regulation of
the finance industry, which it micromanages while at
the same time striving to promote. Conventional
financial institutions in Malaysia frequently complain
that Bank Negara's restrictions prevent them from
adopting innovative approaches that would expand their
business. If the central bank pursues a similar
approach to Islamic finance, institutions in this
sector may also find themselves falling behind their
foreign counterparts.

SHEAR