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Laman Utama Bilik Berita Ucapan Developing an Islamic Banking System
Developing an Islamic Banking System Cetak Emel


From Moneylenders to Bankers :
Evolution of Islamic Banking in Relation to Judeo
- Christian and Oriental Banking Traditions

International Islamic Banking Conference
PRATO, Italy
9 - 10 September 2003

Keynote Address

Developing an Islamic Banking System

The Malaysian Model


Nor Mohamed Yakcop
Special Economic Adviser
To the
Prime Minister of Malaysia

In the context of Malaysia's short history of 46 years since independence, our nation's development has occurred within an environment which is peaceful, prosperous and dynamic. This development took place essentially on the basis of a conversional financial system, not an Islamic financial system. Perhaps, this is a good starting point to remind ourselves that even a less than ideal financial system is able to facilitate development, as long as the overall institutional environment is conducive. Ibn Khaldun reminds us in his Muqaddimah that social justice, the rule of law, property rights, a culture of tolerance and co-operation among the various constituents, a willingness to innovate, and economic strategies that target growth and development with equity are all crucial and inter-dependent elements that form the enabling environment to strive for success, both in this world and in the next.

Along with our efforts of pursuing well-rounded development in a multi-religious environment, Malaysia also adopted, beginning the early 1980s, the approach of gradually implementing a dual financial system, i.e. an Islamic financial system in parallel with the conventional system. Today, we are beginning to see the maturing of the Islamic financial system into a more usable and pragmatic system that goes beyond the textbooks and theories that were popular in the 1970s and 1980s.

I wish to quickly revisit the evolution of the Islamic financial system in Malaysia. First came the initial period of familiarisation (1983 - 1992). This was an exploratory, almost experimental stage, where the first Islamic Bank, Bank Islam Malaysia, was set up in 1983 under a new Islamic Banking Act. We proceeded cautiously and conservatively, and rightly so, as those were early days and one slip-up could have spelled the end of public confidence in the Islamic financial system. Over the next decade, Bank Islam Malaysia grew from strength to strength. Islamic banking was no longer regarded as a novelty or as a quaint notion; even non-Muslims started banking with Bank Islam Malaysia.

With this confidence, came the next stage, that of mainstream acceptance and pervasiveness (1993 - 2002). No longer was Islamic finance the sole domain of Bank Islam Malaysia; the entire financial system began to use and apply Islamic financial principles. We have a dual banking system in Malaysia, one conventional and the other Islamic, both equally comprehensive and viable.

Before going into what I believe is the next phase, perhaps I should explain Malaysia's overall strategy in the development of Islamic banking, which can be summarized as follows:-

(i) The objective was a full fledged Islamic banking system operating on a parallel basis with a full fledged convential system (dual banking system);
(ii) A step-by-step approach, in the context of an overall long term strategy;
(iii) A comprehensive set of Islamic banking legislation and a common Syariah Supervising Council for all Islamic banking institutions; and
(iv) A practical and open-minded approach in developing Islamic financial interests.

Dual Banking System
The OIC member countries can be divided into 4 categories on the basis of their approach in the implementation of Islamic banking. The 4 categories are us follows:-

Category Countries

1. Only Islamic banking system Iran, Pakistan, Sudan

2. Dual system Malaysia
(Islamic banking system operating
parallel with the conventional system)

3. "Conventional plus" system (The
(The system is basically a
conventional system with a few
Islamic banking institutions
Operating on the fringe of the
banking system).
Some of the countries in this
category are Saudi Arabia,
Bahrain, Bangladesh,Brunei
Egypt, Guinea and Indonesia

4. Only conventional system Some of the countries in this
category are Afghanistan,
Albania, Algeria, Azerbaijan,
Benin, Burkina Faso, Chad,
Cameroon, Comoros, Djibouti,
Gabon and Gambia.

Malaysia is the only country to implement a dual system, namely a full fledged Islamic banking system operating on a parallel basis with a full fledged conventional system. Not only do the two systems work on a parallel basis, they also utilize essentially the same set of banking infrastructure. As I will explain later, this has significant implications in terms of the cost and speed of implementing the Islamic banking system.

The Malaysian model has a number of advantages when compared to the other 3 categories. The advantage of the Malaysian model, when compared to the countries which have only a conventional banking system, is obvious. The Muslims in the countries which have only a conventional system do not have the opportunity to benefit from the facilities of a modern banking system without being involved in riba. The choice they have is to decide only between using the facilities of the riba-based domestic banking system or to avoid using the domestic banking system altogether.

The same is also largely true in the case of the conventional plus system, where the Islamic banking institutions operate on the fringe of the domestic banking system and the services they offer are not as comprehensive nor as sophisticated as the conventional system. The small scale nature of the operations of the Islamic banking institutions in these countries also make their services less efficient and more costly compared to the conventional institutions. In the dual banking system in Malaysia, the Islamic banking system is a full-fledged system with a large number of products, a large number of institutions and an interbank money market. The Islamic banking products offered in Malaysia's dual system are therefore much more sophisticated and cover a wider range of services than the Islamic banking products offered in the conventional plus system.

The advantages of Malaysia's dual system, when compared to the system in countries that have only the conventional system or the conventional plus system are quite straightforward. But does Malaysia's dual system have any advantage compared to Pakistan, Sudan and Iran, which have an entirely Islamic banking system, with no conventional banking system? My view is that, when compared to the countries with a single system of Islamic banking, Malaysia's dual system has two basic advantages, as follows:-

(i) The range of Islamic banking products in a dual system tend to be wider when compared to the products in a single Islamic system, since a dual system the Islamic banks have to, willy nilly, provide all the services provided by the conventional banks. If they do not, then the non-Muslim clients are very likely to shift back to the conventional system. In the case of the Muslim clients, some of them may also shift back to the conventional system. And even in cases of Muslim clients who do not shift back to the conventional system, one can expect them to complain loudly on the inadequacies of the Islamic banks compared to the conventional banks. In a dual system, therefore, the Islamic banks cannot afford to be complacent, since they operate in a competitive and dynamic environment. In the single Islamic system model, on the other hand, the financial institutions would not have a similar incentive to expand the range of the Islamic banking products as the possibility of domestic customers shifting away to the conventional system does not rise.

(ii) In addition to wider range of services, the Islamic banking products in the dual system can also be expected to have a higher level of sophistication compared to the Islamic banking products in the single Islamic system. In the international conventional banking system, innovations are the order of the day. New products come one stream very regularly. In a dual system of banking, such innovations will quickly find their way to the domestic conventional banking system. The Islamic bankers operating in the dual system would have no choice but to create similar sophisticated products on an Islamic basis. This will be an on-going process, whereby the level of sophistication in the Islamic banking system will continuously be upgraded.


An important feature in the implementation of Islamic banking in Malaysia is the step-by-step approach. The setting up of Bank Islam Malaysia in 1983 was an important first step. A single bank, however, does not make a system. For a viable Islamic banking system, there need to be three basic elements, namely:-

(i) A large number of instruments

          A large number and range of different types of financial instruments must be available to meet the different needs of different investors and borrowers.

(ii) A large number of institutions

          There must be an adequate number of different types of institutions participating in the Islamic banking system. This is required to provide depth to the Islamic banking system.

(iii) An Islamic interbank market

          There must be an efficient and effective system to link the institutions and the instruments.

During the first ten years (1983 to 1992), we focused our efforts on creating a large number of different types of Islamic financial instruments. By the end 1992, we had created 20 Islamic banking instruments covering a very wide area of activities.

In 1993, we considered the next step, namely the creation of a large number of institutions offering Islamic financial services. Two alternatives were considered, namely:-

(i) to establish new Islamic banks; or

(ii) to allow the conventional banking system to also offer Islamic banking services.

The second alternative was chosen as it was considered the more efficient and effective way of expanding Islamic banking. Since the conventional banking system (commercial banks, merchant banks and finance companies) already had a wide network of branches, they could offer Islamic banking services throughout the country at very little additional cost. On the other hand, setting up new Islamic banks, even as subsidiaries of existing banks, would be expensive in terms of logistics and infrastructure. The cost of setting up one branch of a financial institution in Malaysia, in 1993, was about US$200,000.

Having decided on the second alternative, the Interest-free Banking Scheme, known as Skim Perbankan Tanpa Faedah (SPTF) in Malay, was launched on March 4, 1993 on a pilot basis involving the three biggest commercial banks in Malaysia, namely Maybank, Bank Bumiputra Malaysia and United Malayan Banking Corporation. The scheme worked smoothly during the period of the pilot run. Subsequently, Bank Negara Malaysia issued three sets of guidelines on July 5, 1993, one each for the commercial banks, finance companies and merchant banks. With the issuance of the guidelines, any licensed financial institution that meets the Guidelines on SPTF could offer Islamic banking services, and almost all the conventional financial institutions in Malaysia quickly began to also officer Islamic banking services.

By the end of 1993, therefore, we had already in place two of the three elements required for viable Islamic banking system. What was missing in order for the Islamic banking system to function as a full-fledged banking system was an Islamic interbank money market. In January 1994, an Islamic Interbank Money Market (IIMM) was set up, thereby completing the process of creating an Islamic banking system in Malaysia with all the 3 main ingredients in place.


An important feature of the Malaysian model is that there was in place a comprehensive set of Islamic banking legislation to guide the activities of Islamic financial institutions in Malaysia. The Islamic Banking Act, 1983 ensured that the operations of the Islamic banking system in Malaysia had the force of law. It is important to note that at that time (and even now in most cases) the common practice among Islamic countries, whenever an Islamic financial institution was set up, was to grant them certain exemptions from the conventional banking laws. Islamic banking was treated as a special case under the conventional banking legislation. In Malaysia, we realized from the beginning that if Islamic banking was going to be developed into a full fledged system, it has to be on the back of comprehensive set of Islamic banking legislation.

One of the important provisions of the Islamic Banking Act, 1983 was the creation of a Shariah Supervisory Council at Bank Islam Malaysia Berhad. When Islamic banking was extended to the other financial institutions in 1993, we transferred the Shariah Supervisory Council to the Central Bank, Bank Negara Malaysia, to be the sole source of interpretation for all Islamic financial institutions in the country. This ensured uniformity in interpretation and avoided the need to coordinate and reconcile between different views of various Shariah supervisory councils.

Over the last 20 years, the Islamic scholars who are members of the Shariah Supervisory Council in Malaysia, through regular interactions with Islamic bankers and economists, have developed a deep understanding of the modern financial mechanisms. They are, therefore, in a strong position now to gauge, on the basis of a broader perspective, the new Islamic products proposed by the Islamic bankers. This is an important aspect of implementing Islamic banking, since in many countries, one of the basic obstacles to Islamic banking has been the inability of Islamic scholars on the one side, and the Muslim economists and bankers on the other side, to communicate and discuss issues on the basis of a common understanding. It is important that Shariah scholars appointed to Islamic banking supervisory boards have a deep understanding of the modern day investors' requirements and find solutions within the realm of Shariah to meet the changing needs of a dynamic economy.


One of the most important factors in Malaysia's success in the implementation of the Islamic financial system is that, from the very beginning, the founding fathers of the system adopted a practical and open-minded approach. There was a conscious acknowledgement of the need for a great deal of research and development work to be done. Although Muslim scholars had, through the ages, written excellent expositions on Islamic economics, this is not adequate in the context of the needs and requirements of the modern day. Unfortunately, even today, there are some quarters which claim that everything useful about Islamic economics has already been said by Muslim philosophers, such as Farabi, Tusi and Ibn Khaldun. According to them, what is required is merely the political will on the part of the authorities to implement an Islamic economic system immediately in one go.

We also realized from the begging that an Islamic financial system cannot be implemented only on the basis of profit and loss sharing. We were, therefore, willing to experiment with other forms of financing, apart from profit and loss sharing, as long as such instruments meet Shariah requirements. For example, in the case where an entrepreneur wishes to purchase capital goods, such as machinery, the Islamic bank may provide the machinery itself by way of Al-Ijarah (leasing) facilities. In the case of raw materials or trade merchandise, a possible route is a fixed profit mark-up for the bank (Al-Murabahah). The entrepreneur can even be allowed to defer payment through a Bai Bithman Ajil facility. Such transactions do not involve the pure lending of money, but represent special ways of conducting the financial side of the real transfer of goods.

In Malaysia, in the implementation of the Islamic financial system, emphasis was always placed on substance rather than label. An Islamic financial system must reflect the values and ethics of Islam. A case in point is the pawnshop system in Malaysia. When the Islamic pawnshop system was implemented nationwide in August 1993, the fees paid by those using the facilities was 50% lower compared to the interest rate charges imposed by the conventional pawnshops. Given that the users of the pawnshop facilities are among the poorest in the country, this step is certainly Islamic in substance. On the other hand, if the Islamic pawnshop system in Malaysia was implemented merely with the objective of removing interest rates, but with very high profit margins for the owners of the Islamic pawnshops, the Islamic system will only be Islamic in label, but not in substance.

Moving Forward - The Next Phase

After the first two phases of development, it is time now to consider where we should be heading and what needs to be done to get there.

At the beginning of this paper, I mentioned how the conventional system, within our overall development model, had served us well, and how the Malaysian economy has grown by leaps and bounds over the years. We are, however, today facing several challenges. As an ambitious nation, we are not satisfied with the current level of achievement. Our Vision 2020 necessitates us to grow our GDP by 8 percent per annum between 1990 and 2020. With these growth targets, the productivity of capital becomes especially important. And this where I believe one of the many strengths of the Islamic financial system lies.

Let me now return to my earlier summary of the stages of development of the Islamic financial system in Malaysia. While the first phase was that of discovery, and the second phase was that of acceptance, I believe in this current phase, beginning in 2003, we will need to increasingly use Islamic financial principles as a tool of competitive advantage.

Let me explain that I mean by the term competitive advantage. The conventional financial system has been in existence for over 600 years. While, undoubtedly the conventional system has been instrumental in the development and growth of many countries, this growth has not been equitable. The conventional financial system has now produced 358 billionaires, while keeping 1.3 billion people living in absolute deprivation. There is certainly a need for a more equitable financial system. The ultimate objective of the Islamic financial system, both domestically and internationally, will be to design and put in place an economic system supportive of economic justice. We have the competitive advantage to do it because Islamic values are rooted in goodness and justice. Of course, to achieve the objectives of Phase III will required a radical altering of the dominant culture and the restructuring of many important institutions.

For Islamic finance to meet its objectives in Phase III, a number of pre-conditions are necessary. First, Islamic finance will have to be developed into a genuine parallel system in the international arena. At present, only in Malaysia does Islamic finance functions parallel to the conventional system. In the many OIC countries, Islamic finance is treated merely as a special case of the general system; it is not yet a genuinely alternative system. We, of course, can and must adopt the best practises of the conventional system, such as openness, transparency, accountability and uniform regulations, but we must, at the same time, develop a comprehensive parallel system, where capital is intermediated to the best use based on Islamic values.

Second, while in the first two phases, bankers were in the vanguard leading the development of Islamic finance, in the third phase leaders in the capital market will have to play a prominent role. The bankers have done an excellent job during the nascent period of Islamic banking, but one unfortunate effect of the prominent role of bankers during early period Islamic banking is that many of the existing Islamic products are skewed towards debt-based instruments, where collateral is still important.

As we know, in most third world countries, an important reason for the lack of entrepreneurial development is the absence of capital being intermediated to the needy as they lack collateral and banks rarely look at the viability of projects alone. With the capital market experts playing an important role from hereon in the development of Islamic finance, we can starting promoting, in a bigger way, equity-based instruments. And even in the case of debt-based instruments, the emphasis must be on project viability rather than collateral.

Third, we have seen, especially in Phase II, many western banking institutions rushing into the business of Islamic finance, and, in some respect, they appear to have taken control of the development of the industry. This is partly due to the absence of drive from the Muslim financial institutions themselves. We should continue to welcome the western financial institutions playing an important role in the development of Islamic finance, since they can provided greater depth and reach for the Islamic products, based on their sheer size and network. However, home-grown Muslim financial institutions should also come to the fore in the development of Islamic finance in order to achieve equity, social justice and creating a moral economy in their respective countries.

Fourth, home-grown Islamic financial institutions should attract first class talent to work for them, and they should pay whatever it takes to attract them. At present, first class Muslim talent is found mainly in the Islamic financial departments of Western banking institutions. In Phase III, where Islamic financial products must come to the market place as a tool of competitive advantage, it is of the highest priority that home-grown Islamic financial intermediaries are led and driven by individuals who possess the highest standards of intellectual fire-power and creativity, who are well versed in conventional finance but yet firmly grounded in an Islamic core; fully committed to the principles of promoting social justice and a moral economy through the promotion of Islamic-based finance.

To that talent that are now working with high compensation packages for Western banks, we should provide every opportunity for them to have significant equity participation in Islamic financial ventures in our own countries, that would allow them to concurrently monetize their ideas and their ideals. We must then move to ensure that these homegrown ventures engage in the international arena with both Muslims and non-Muslims. After all, Islam has commanded us to know each other and to co-operate among all human beings and we also have a duty to introduce to mankind at large the mercy that is inherent in the Islamic system. There are many mechanisms for cooperation with varying advantages of providing increased scale and reach, while maintaining different degrees of control; from strategic alliances, joint ventures to outright mergers.

It is clear to me that it is not just an article of faith that the Islamic financial system is superior to the conventional system in many ways. The Islamic system is a just and equitable system that promotes win-win relationships between economic agents. For example, the relationship between financiers and users of capital is based on co-operation and the equitable sharing of risks and rewards. It abhors oppressiveness and adversarial, asymmetric relationships. It is meant to be efficient in wealth distribution and, perhaps more importantly, the system demands that capital be used for productive purposes and abhors the hoarding of capital resources. All these are critical issues that have to be addressed in an economy that needs to grow fast.

It is not wrong to adapt from another system as long as the root values and principles are not incompatible with Islam. As we know, classical Islamic scientists and scholars did not discover all knowledge from a zero base, but learned from the Greeks and Romans, among others, handpicking what to use and what to reject based on the core values and principles of Islam. As the Holy Prophet s.a.w. says in an oft-quoted hadith: "Wisdom is the lost asset of a Muslim; he is the most deserving of it wherever he finds it."

The challenge to innovate and adapt, while remaining true to Islam's core principles, is a crucial one for the current phase of development. The earlier phases of Islamic finance initially concentrated on a somewhat captive Muslim audience. These customers tend to, literally, bank on faith, often with little regard o the actual substance and competitiveness in terms of cost and service quality of the Islamic financial products. For example, we sometimes hear of Islamic mortgages that in effect cost considerably more than conventional mortgages, compounded further by badly designed legal documentation that makes refinancing an economic impossibility for the borrower. It is perhaps no surprise that there is today some cynicism that many so-called Islamic products are merely poor quality substitutes of conventional products, dressed with an Islamic veneer.

This may be understandable, if not excusable, in the earlier phases of a nascent system in an overwhelming sea of riba. However, from hereon, the honeymoon would be increasingly over. Customers are justifiably getting more discerning. The growth and continued relevance of the Islamic financial system necessarily rests on the ability of financial institutions and issuers to innovate structures and instruments that are closer in substance to the Islamic principles of justice and co-operative based on a more equitable risk and reward sharing. The acid test must be products that are genuinely superior to the conventional instruments, in terms of its value proposition of quality and cost competitiveness. Further, as service establishments, we must also remind ourselves that basis business principles such as efficiency, customer and service orientation and ease-of-use are also basic Islamic principles.

Private-sector led and the enabling environment
While in the earlier phases much of development of Islamic finance was Government-led, the onus of the next phase now rests squarely with private economic agents and intermediaries. Innovation and adaptation must necessarily come from private economic agents. In the case of Malaysia, the Government has already provided a comprehensive enabling environment for the private sector to now take the lead.

Islamic financial system in an increasingly globalised world
The Islamic financial system does not exist in a vacuum. We live in an interconnected and globalised world governed by non-Muslim superpowers, where Muslims are not entirely free to practise their ideals. Although we may sometimes think we can, it is impossible to entirely insulate one financial system from another. We must be pragmatic enough to realise that, under these circumstances, it will be a challenge to immediately implement an entirely Islamic financial system in all aspects. Instead, we should be prepared to consider an incremental implementation strategy and not fall into the trap of fanaticism and extremism. Small, steady steps for the purpose of a greater win is indeed preferable to hasty, headlong but ultimately unsustainable charges. This gradualist and more sustained approach, I believe, is of greater benefit to the ummah and society at large.

Within this incrementalist approach, I believe the international Islamic financial community is now ready, after some four decades of development, to venture into the next phase of greater cross-border co-operation. With the continuing global trend of cross-border mergers, local Islamic financial institutions increasingly suffer from diseconomies of scale. Strategic alliances by local Islamic financial institutions across several jurisdictions from the Gulf, to the sub-continent, to South East Asia and indeed to the West and other regions is one way to share product knowledge, distribution channels and other resources. Many jurisdictions, including Malaysia and Labuan in particular, now offer attractive incentives and a fertile enabling environment for innovation and alliances to take place.

We hope that the process of forming these cross-border alliances will draw the ummah closer, increasing co-operation and engagement in all fields, particularly in trade and capital flows. This must surely be one of Allah swt's challenge to us that He has willed that some of our Islamic nations are so overwhelmingly capital surplus, while others are so acutely capital-deficit. And within many countries too, this imbalance is replicated between the haves and have-nots.

Summary and conclusion
In conclusion, I would like to summarize the points I have raised in this paper.

Firstly, the Islamic financial system in Malaysia is on the threshold of a new beginning. The same may be true in some other Islamic countries. The development of Islamic finance that began with a period of discovery (1983 - 1992), and was followed by acceptance and pervasiveness (1993 - 2002), is now to be used as a strategic developmental tool.

Secondly, we must ensure that we understand that we are implementing the Islamic financial system not for ritualistic purposes, but as a source of competitive advantage and as a catalyst for greater growth and success of humanity as a whole, Islam was sent down to liberate us, not to shackle us.

Thirdly, in order to fully benefit from the infinite potential of the Islamic financial system, innovation and creativity are essential. Yet this innovation and creativity must be soundly based on the principles and values of Islam. Form may differ, but substance must be maintained. We must not be afraid of innovation and creativity. Instead we must be afraid of complacency and the fear to innovate. When borrowing from other systems, we must always drill down to ascertain that the core values that are used to derive the particular instrument or transaction method conform to Islamic values.

Fourthly, while the first two phases of development were necessarily Government-led, this current phase must be private sector led. The Government's role will be more of a facilitator and to set the tone, as well as to provide a conducive environment. For private economic agents, the onus is now squarely upon them to innovate. There is every opportunity for them to do so, since the enabling and incentive mechanisms are in place and issuers and investors are all eagerly awaiting.

Finally, in implementing our strategies, we must always be pragmatic - not fanatic. We must realise that we do not live in a vacuum. Not only do most of us live in a multi-racial environment, we also live in a globalised and interconnected world dominated by non-Muslim superpowers. Gradual, and well thought out, yet consistent, incremental steps are better and far more lasting than abrupt and short-lived bursts of impulse.

Let me conclude by wishing you every success and I hope this conference will generate new enthusiasm as we face, perhaps, the most promising period in the development of the Islamic financial system.

Thank you.

(October 1st. 2003)


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