Establishing Appropriate Institutional, Legal

and Regulatory Frameworks:

The evolution of Islamic finance regulatory framework

and Shariah screening reform

Kamarudin Hashim

Securities Commission Malaysia

11 August 2014

Islamic Markets Programme (IMP)

http://atsc/C12/Communications/Image Library/SC_NEW_LOGO.jpg

Background Malaysias Islamic finance agenda

2

Positioning Malaysia as a global hub for

Islamic finance products and services

Islamic banking

Takaful

Islamic Capital Market (ICM)

For ICM, key focus segment in the

market include Islamic equities, Sukuk

and Islamic fund management

Going beyond the

provision of an

alternative to

conventional finance

activities for issuers,

investors,

intermediaries and

other market players

3

Islamic finance and capital market

PAKISTAN

Banking

Takaful

Shariah stocks

Mutual funds

BANGLADESH

Banking

Takaful

THAILAND

Banking

PHILIPPINES

Banking

BRUNEI

Banking

Takaful

Mutual funds

Stockbroking

SINGAPORE

Banking

Takaful

Mutual funds

Bonds

INDIA

Mutual funds

SRI LANKA

Takaful

Mutual funds

INDONESIA

Banking

Takaful

Shariah stocks

Mutual funds

Index

Bonds

MALAYSIA

Banking

Takaful

Shariah stocks

Indices

Mutual funds

Bonds

Stockbroking

Islamic fund mgmt

ICM in Msia has grown to RM1.6 trillion in Q2 2014 from RM294 billion in 2000 SC focuses on: Developing a

comprehensive and facilitative framework

Working closely with the industry to widen product range

Developing linkages with other countries

Driving thought leadership and capacity building

3

Capital markets institutional framework in Malaysia

Listed Companies

Stockbroking Companies

Unit Trust Mgt Co

Investment Banks

MINISTER OF FINANCE

Fund Managers

PRS Distributors

Unit Trust Distributors

Banking/ Islamic banking

and insurance/ takaful sector

Private Pension Administrator

Securities Industry Dispute

Resolution Centre

SECURITIES COMMISSION BANK NEGARA MALAYSIA

FIMM

Bursa Malaysia

Attorney Generals Chambers

Companies Commission

Retail and Institutional Investors

e.g. Tabung Haji 4

Investor Education e.g. SIDC, INCEIF

CRAs BPA

Trustees

Invt. Advisers Financial planners

National Shariah Advisory Council

Philosophy in developing Islamic finance regulatory framework

5

Standards for Islamic finance regulatory framework should not be less than

conventional finance

The regulatory framework for Islamic banking, Takaful and Islamic Capital

Market benchmarked against international standards and best practices

Islamic finance products and services can

leverage on existing regulatory infrastructure

not compromise the universal goals of financial market regulations

E.g. IOSCO Report of the ICM Taskforce 2004 and Analysis of IOSCOs

Objectives and Principles of Securities Regulation for Islamic Securities 2008

conventional regulatory framework applicable to Islamic capital market products and services

Islamic capital market products and services may be introduced and developed within any existing well-structured securities market

6

Regulatory outcome for Islamic finance remains consistent with the overall objectives and principles of financial market regulation

In Malaysia, we have the whole spectrum for the Islamic finance regulation.

To suit specific need of the market segment

To realize Malaysias vision as the international centre for Islamic

finance

that therefore seeks to achieve similar objective with

conventional regulatory framework

Although the form for Islamic finance regulation may differ

Specific legislation e.g. Islamic Financial Services Act 2013

Non specific legislation e.g. Capital Market and Services Act 2007, but with certain provisions for Islamic capital markets

Specific Guidelines e.g. Guidelines on Sukuk, Guidelines on Islamic

Fund Management

Non specific Guidelines - Guidelines on the offering of Structured

Products, but with certain provisions for Islamic structured products

Practical approach adopted for Islamic finance regulation

7

In Malaysia, a 2-tier approach to Islamic Capital Market is being practised

Tier 1 Universal / General Regulatory

Requirements

Tier 2 Specific Shariah Requirements

Guidelines on the Offering of

Asset- Backed Securities

Guidelines on the Offering of

Structured Products

Guidelines on Unit Trust &

Wholesales Funds

Guidelines on ETF

Bonds - Trust deed, mandatory rating, eligible persons, etc

Unit Trust - Investment committees, trustees, management company, etc.

REITs - At least 75% investment in real property

Guidelines on Sukuk Guidelines on Islamic

REITs Guidelines of Islamic

Fund Management Guidelines and Best

Practices on Islamic Venture Capital

Sukuk - Shariah adviser, compliance with Shariah requirements, application of Shariah rulings

Islamic Unit Trust - Shariah adviser to certify that fund complies with Shariah requirement Islamic REITs - Tenants activities and rental income must comply with Shariah

requirement

with Shariah framework viewed as a fundamental

component within the overall regulatory framework

8

Two levels for Shariah governance

National based: Shariah Advisory Council - Bank Negara Malaysia

and SC

Market based : Shariah Supervisory Boards of Islamic Financial

Institutions

Importance of Shariah governance

Ensure strict Shariah-compliance

Instill market confidence

Increasing Shariah dialogue between national and market Shariah

experts as a platform to promote thought leadership and development

9

Sukuk Issuers Tax neutrality for sukuk transactions

Stamp duty exemptions

Tax deduction on issuance cost for sukuk Company setting up sukuk SPV also given tax

deduction

Sukuk SPV not required to comply with administrative matters under Income Tax Act

Investors

Income tax exemptions for all residents on income derived from non-RM investments

No capital gains tax No withholding tax on income from RM and non-RM

investments

Intermediaries

Tax exemptions on fees obtained from arranging, underwriting and distribution of non-RM sukuk from

Malaysia

Tax exemptions on profits received from the trading of non-RM sukuk from Malaysia

Islamic funds Investors No withholding tax

Islamic Fund Management Companies

10-year tax exemption on all fees received by fund management companies for managing approved

Islamic funds for local and foreign investors up to

2016

MIFC promotion

Additional/double tax deduction for promotion of MIFC activities

Human capital

Income tax exemption given to income received by non-resident experts in Islamic Finance

Regulatory and tax framework to promote growth of ICM

Malaysias case

10

Sukuk

Deemed approval (1-day) accorded for issues rated AAA by local credit rating agency or for issues rated BBB and above by a foreign credit rating agency

Exemption from issuing a trust deed

No restriction on use of international law in the offering documentation

Opportunity to be listed on Bursa Malaysia - the top sukuk listing destination in the world

Foreign currency sukuk listed on Bursa and LFX that meet certain criteria eligible to be included in

Bloomberg Malaysian Sukuk Ex-MYR Index

Islamic funds

Islamic Fund Management Companies

Allowed to conduct foreign currency and ringgit fund management for retail and institutional investors

Islamic fund management companies are allowed to invest all their Shariah funds abroad

Up to 100% foreign equity ownership in the Islamic fund management companies

Investors

Employees Provident Fund (EPF) has set aside a specific allocation of start-up fund for foreign Islamic fund management companies

Bank Negara Malaysia (BNM) has also disbursed funds for Shariah equity investments and set up a developmental Sukuk Investment Fund specifically for Islamic fund management companies

Human capital

Expedited immigration approval through the Green Lane established for expatriates in Islamic Finance

and their family members.

Regulatory and tax framework to promote growth of ICM

Malaysias case (contd)

11

Shariah stock-screening

List of Shariah compliant securities by SCs Shariah Advisory Council published twice a year

Regulatory and tax framework to promote growth of ICM

Malaysias case (contd)

Government Investment Issue (GII)

Long-term non-interest-bearing Government securities based on Islamic principles issued by

the Government of Malaysia for funding

developmental expenditure

Benchmark for Sukuk pricing

Sukuk

Expenses for the issuance of AgroSukuk be given a double deduction for a period of four years effective from year of assessment 2013 to 2015.

Framework on issuance of Socially Responsible Investment (SRI) sukuk being finalised, in response to global trend in issuances of green and social impact bonds to finance sustainable activities.

12

Driving the growth of Islamic finance

Both the public and private sectors have an important role to play in developing the Islamic Finance market

State of development of the financial market

Need and sensitivity of the market

In the early stages of development, Malaysia took the top down approach

13

Government plays a key role to support growth and development

Strong and consistent Government support is essential

MIFC, Capital Market Masterplan (CMP) and CMP 2, Financial Sector

Masterplan and Financial Sector Blueprint

Shariah stock screening

14

Shariah stock screening refers to a process undertaken by the SC SAC that seeks to ensure securities of public listed companies (PLC) comply with the principles of shariah

Each PLC is reviewed once a year based on the audited financial statements for

each financial year end and other relevant material

The SAC issues a list of shariah-compliant stocks which are published by the SC in May and November of each year

Companies seeking to list on the exchange may apply to undertake shariah screening to ascertain its shariah compliance. Pre-IPO screening is voluntary and is subject to a processing fee of RM10,000 + 5% of SCs IPO fee with a maximum of RM50,000.

Shariah stock screening historical background

15

Pioneered in Malaysia by Bank Islam as they sought to identify permissible counters for investment by reviewing the activities of companies listed on the then KLSE

A national level screening methodology was first developed in 1995 by the SC through the work of ICM unit and Islamic Instrument Study Group (IISG)

Publication of the list of shariah-compliant securities began in 1997 following the formation of SCs SAC in 1996

Revised screening methodology announced by the SC in 2012 and implemented in November 2013

Publication of methodology and list of shariah-compliant securities allows scale and

growth of shariah-compliant equity and investment management segments and expansion on Islamic capital markets international reach outlined in CMP2

List of shariah-compliant securities forms the basis for Bursas Shariah indices, as well as investable securities for Islamic funds, ETFs, structured products etc.

Shariah stock screening milestones

16

Pre-1993

Shariah screening pioneered by Bank Islam

1995 Development of shariah screening criteria to facilitate compliance review

process undertaken by SCs ICM unit and Islamic Instrument Study Group (IISG)

1996 Establishment of the Shariah Advisory Council of SC

1997 The SAC announced the official list of shariah compliant securities

1999 Bursa Malaysia launched the Kuala Lumpur Shariah index

2004 The SC disclosed the benchmarks applied in the screening of shariah

compliant securities

2004 Shariah compliant review at pre-initial public offering stage undertaken by the

SAC upon application by issuers

2007 Bursa Malaysia and FTSE launched 2 Shariah indices - (i) FBM EMAS Shariah

Index and (ii) FBM Hijrah Shariah index

2012 The SC announced the revised screening methodology

2013 Revised screening methodology made effective in November

The SAC provides a national level shariah compliance review

17

Facilitates efforts to promote centralisation and harmonisation of shariah decisions on

the status of listed stocks SCs regulatory mandate also allows for the issuance of relevant guidelines on shariah

compliance e.g. guidelines on disposal of non-compliant stocks

Enhances market confidence as the stocks are endorsed by the shariah body at the national level

SC has appointed scholars, academicians and practitioners from diverse backgrounds for membership of the SAC to accommodate broad perspectives on Islamic jurisprudence

Revised stock screening methodology November 2013

18

Stock screening involves both quantitative and qualitative assessments: 1. Quantitative assessment

I. Contribution from shariah non-compliant activities (computed and compared with group revenue and the group profit before tax) must be below predetermined thresholds

II. Financial ratio benchmark - shariah non-compliant cash and debt must be below a predetermined percentage of total assets (i.e. 33%)

2. Qualitative assessment

I. Public perception and image of the company is assessed

The listed security must pass screening at both stages in order to qualify as shariah-compliant

Revised vs. previous screening methodology

19

The revised screening methodology introduces financial ratio benchmarks, in addition to the business activity benchmarks of the previous methodology

Quantitative assessment Business contribution

thresholds: 5% 10% 20% 25%

Quantitative assessment Business contribution

thresholds: 5% 20%

Financial ratio benchmark: 33%

Previous methodology Revised methodology

Qualitative assessment Qualitative assessment

Impact of revised screening methodology

20

817

650

923 911

Dec-2012 Dec-2013

Number of Shariah-compliant Securities

Shariah-compliant

Total listed securities

942 1030

1466

1702

Dec-2012 Dec-2013

Market Cap of Shariah-complaint Securities (RM bil)

Shariah-compliant

Total Market Cap

Revised screening methodology reduced the number of shariah-compliant securities however market capitalisation as a whole was not severely impacted

Despite the contraction in numbers, shariah-compliant securities continue to experience robust growth.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

% Growth FBM EMAS vs. FBM EMAS Shariah

FBM EMAS Shariah FBM EMAS

Guidance on disposal of shariah non-compliant securities

21

Within six months of effective date Six months after effective date

Price = or > investment cost (Breakeven/Net

profit)

Price < investment cost (Net loss)

Price > investment cost (Net profit)

Price < investment cost (Net loss)

Must liquidate holdings within six months

Any dividends received and capital gain from disposal can be kept by investors

May hold until price of securities equal or exceeds investment cost

Dividends received can

be used to expedite disposal

Allowed to subscribe to/receive any new issue of securities by the company e.g. rights, special, bonus to expedite disposal

Liquidate immediately

Profit (dividends received prior to and difference between investment cost and the closing price on the announcement date of the latest list) can be kept

Excess profit (dividends received after and difference between disposal price and closing price of announcement date) channeled to baitulmal and/or charitable bodies

Allowed to hold until the price of securities equal to investment cost

Dividends received can be used to expedite the disposal

Allowed to subscribe to/receive any new issue of securities by the company e.g. rights, special, bonus to expedite disposal

22

Thank You

Members of SCs Shariah Advisory Council

23

Y.A.Bhg. Tun Abdul Hamid bin Haji Mohamad Former Chief Justice Malaysia

Y.Bhg. Tan Sri Sheikh Ghazali bin Haji Abdul Rahman

Shariah Legal Advisor, Attorney Generals Chambers

Y.Bhg. Datuk Dr Mohd Daud Bakar Group Chairman, Amanie Advisors

Y.Bhg. Dato Dr. Abdul Halim bin Ismail Chairman, Shariah Committee of Shariah-Compliant Funds of Amanah Mutual Bhd

Sahibus Samahah Dr Haji Zulkifly bin Muda Terengganu Mufti

Prof Dr Ashraf bin Md Hashim Chief Executive Officer, ISRA Consultancy Sdn Bhd

Prof Dr Engku Rabiah Adawiah Engku Ali IIUM Institute of Islamic Banking and Finance (IIiBF), International Islamic University Malaysia

Prof Mohamed Ismail bin Mohamed Shariff Adjunct Professor, International Centre for Education in Islamic Finance and Founder of Mohamed Ismail & Co.

Prof Madya Dr. Aznan bin Hasan Ahmad Ibrahim Kulliyyah of Laws, International Islamic University Malaysia

Prof Madya Dr Asmadi Mohamed Naim Dean, Islamic Business School, Universiti Utara Malaysia

Dr Shamsiah Mohamad Senior Researcher, International Shariah Research Academy for Islamic Finance (ISRA)

Quantitative Assessment Business Activity Benchmarks

24

Previous

Benchmark

Revised

Benchmark Activity

5%

5%

Conventional banking; Conventional insurance; Gambling; Liquor

and liquor-related activities; Pork and pork-related activities;

Non-halal food and beverages; Shariah non-compliant

entertainment; and other activities deemed non-compliant

according to Shariah

10%

Interest income from conventional accounts and instruments;

Tobacco and tobacco-related activities; and other activities

deemed non-compliant according to Shariah

20%

20%

Rental received from Shariah non-compliant activities; and other

activities deemed non-compliant according to Shariah

25%

Hotel and resort operations; Share trading; Stockbroking

business; and other activities deemed non-compliant according

to Shariah

Streamlined business activity benchmarks are as follows:

Revised Screening Methodology

25

Revised methodology introduced is in line with global practices in Shariah screening of securities.

SC Malaysia Dow Jones Islamic Market Indices

FTSE Shariah Global Index Series

Scope Malaysian Stocks Global Stocks Global Stocks

Screener Regulator Index Provider Index Provider

Discretion Qualitative stage of screening N/A N/A

Denominator Total Assets (TA) Market Cap (MC), Trailing 12-month Average

Total Assets (TA)

Income Contribution Ratios

Specific non-compliant activity income < 5% or 20% of total revenue and profit before tax depending on activity

Specific non-compliant activity income < 5% of total revenue

Total interest and non-compliant activities income < 5% of total revenue

Financial Ratios

Total debt/TA < 33% Cash/TA < 33%

Total debt/MC< 33% Cash+Interest bearing

securities/MC < 33% Receivables/MC < 33%

Total debt/TA< 33% Cash+Interest bearing

securities/TA < 33% Receivables/TA < 50%

Quantitative Assessment Financial Ratio Benchmarks

26

Financial ratios introduced are intended to measure riba and riba-based elements within a companys balance sheet: Cash over Total Assets

Cash will only include cash and cash equivalents placed in conventional accounts and instruments, whereas cash placed in Islamic accounts and instruments will be excluded from the calculation.

Debt over Total Assets

Debt will only include interest-bearing debt whereas Islamic debt/financing or sukuk will be excluded from the calculation

Both ratios must be lower than 33%.