10.2 Islamic Banking System & Money Markets

Islamic Banking System & Money Markets

The global architecture of modern Islamic finance is anchored by the principle of asset-backed, ethical financial intermediation. Unlike conventional banking systems that treat money as a commodity to be rented at an interest rate, Islamic banking mobilizes financial resources strictly through Shariah-compliant commercial contracts. These contracts tie financial obligations directly to tangible economic activity, real asset transfers, and legitimate risk-sharing partnerships.

Globally, Malaysia is acknowledged as having developed the most advanced, comprehensive, and systemic Dual Banking System. In this framework, a fully developed, full-fledged Islamic banking system operates in parallel with the conventional banking system, sharing a unified regulatory, supervisory, and legal infrastructure governed by Bank Negara Malaysia (BNM).

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Historical Evolution of Islamic Banking in Malaysia

The establishment of Islamic banking in Malaysia was not a sudden disruption, but rather a deliberate, multi-decade regulatory roadmap designed to build institutional depth, public confidence, and legal stability.

+-------------------------------------------------------------------------+
|                 Milestones of Malaysian Islamic Banking                 |
+-------------------------------------------------------------------------+
| 1983 | Inception Phase: Islamic Banking Act 1983 & Bank Islam founded   |
| 1993 | Expansion Phase: Islamic Banking Scheme (IBS / Windows) launched |
| 2004 | Subsidiarization: banks allowed to move windows into separate    |
|      | Islamic banking subsidiaries (e.g., Maybank Islamic, CIMB)       |
| 2013 | Modern Statutory Era: Islamic Financial Services Act 2013 (IFSA) |
+-------------------------------------------------------------------------+

1. Inception Phase: Islamic Banking Act 1983 and BIMB

The formal inception of the industry occurred with the enactment of the Islamic Banking Act 1983 (IBA 1983). This statutory legislation provided Bank Negara Malaysia with explicit powers to supervise and regulate Islamic commercial banks separate from conventional institutions (which were governed by the Banking Act 1973, and later BAFIA 1989).

Pursuant to the IBA 1983, Malaysia's pioneer Islamic bank, Bank Islam Malaysia Berhad (BIMB), commenced operations on July 1, 1983. For its first decade, BIMB operated as a monopoly, testing Shariah contracts in retail financing, deposits, and trade finance while proving the commercial viability of interest-free banking.

2. Expansion Phase: Islamic Banking Scheme (IBS / Windows) in 1993

Recognizing that relying on a single dedicated bank would limit national reach, BNM introduced the Islamic Banking Scheme (IBS)—initially designated as Skim Perbankan Tanpa Faedah (SPTF), and later renamed Skim Perbankan Islam (SPI)—in March 1993. Under the IBS framework, conventional commercial banks, merchant banks, and finance companies were permitted to offer Islamic financial products through their existing conventional branch networks ("Islamic windows").

The window model achieved rapid nationwide distribution and market penetration without requiring massive initial capital outlays. However, it presented significant governance challenges: potential commingling of funds between conventional and Islamic books, customer confusion regarding product authenticity, and difficulties in maintaining uncompromised Shariah oversight within conventional corporate hierarchies.

3. Maturation Phase: Subsidiarization (from 2004)

To address the governance weaknesses of Islamic windows, BNM from 2004 allowed and encouraged banking groups to move their Islamic windows into separately capitalized, licensed Islamic banking subsidiaries. Windows were not abolished: under Section 15 of the Financial Services Act 2013, a conventional bank may still carry on Islamic banking business with BNM's written approval, subject to Shariah governance requirements.

Under this policy, most major banking groups moved their Islamic assets into separate corporate entities endowed with dedicated paid-up capital, independent corporate boards, autonomous management teams, separate balance sheets, and dedicated institutional Shariah Committees. This produced major domestic champions, including:

• Maybank Islamic Berhad (which grew into the largest Islamic bank in ASEAN and one of the largest globally);
• CIMB Islamic Bank Berhad;
• Public Islamic Bank Berhad;
• RHB Islamic Bank Berhad;
• AmBank Islamic Berhad; and
• Hong Leong Islamic Bank Berhad.

4. Modern Statutory Era: IFSA 2013

In 2013, the Malaysian Parliament enacted the Islamic Financial Services Act 2013 (IFSA 2013, Act 759), which repealed the IBA 1983. IFSA 2013 fundamentally upgraded prudential standards and codified end-to-end Shariah compliance into federal statutory law. It established stringent legal demarcations between principal-guaranteed deposits and risk-absorbent investment accounts, introduced personal liability and severe criminal penalties for directors and officers for Shariah breaches, and formalized BNM's interventionist regulatory powers.

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Institutional Structure of the Islamic Banking Sector

Under the licensing regime of IFSA 2013, Malaysia's Islamic banking landscape comprises four distinct institutional categories:

1. Full-Fledged Domestic Islamic Banks: Locally incorporated institutions operating exclusively under Islamic principles. This category includes pioneer Islamic banks (Bank Islam Malaysia Berhad, Bank Muamalat Malaysia Berhad) as well as the corporatized Islamic subsidiaries of major domestic banking conglomerates (Maybank Islamic, CIMB Islamic, RHB Islamic, Public Islamic, AmBank Islamic, Hong Leong Islamic).
2. Foreign Islamic Bank Subsidiaries: Locally incorporated, wholly owned subsidiaries of foreign financial institutions licensed under IFSA 2013 to offer full-fledged retail and wholesale Islamic banking. Notable examples include Kuwait Finance House (Malaysia) Berhad, the first foreign Islamic bank to set up in Malaysia (mid-2000s), and Al Rajhi Banking & Investment Corporation (Malaysia) Berhad.
3. International Islamic Banks (IIBs): Specialized entities licensed under IFSA 2013 to conduct non-Ringgit, foreign-currency Islamic financial business with residents and non-residents. IIBs leverage Malaysia's competitive tax incentives to structure cross-border Sukuk issuances, syndicated project financings, and foreign-currency liquidity management.
4. Development Financial Institutions (DFIs) Offering Islamic Services: Specialized statutory financial institutions established under the Development Financial Institutions Act 2002 (DFIA) to support strategic economic sectors (agriculture, SMEs, infrastructure, maritime trade). Major DFIs—such as Bank Rakyat (a full-fledged Islamic cooperative bank), Bank Simpanan Nasional (BSN), SME Bank, Agrobank, and Bank Pembangunan Malaysia Berhad—operate dedicated Islamic windows or conduct comprehensive Islamic financing.

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Balance Sheet Structure of an Islamic Bank

An Islamic bank's balance sheet reflects its role as an asset-backed and equity-linked intermediary. Unlike conventional banks whose assets and liabilities consist almost entirely of interest-bearing loans (Qard bi Fa'idah), an Islamic bank's balance sheet is populated by distinct nominate commercial contracts (Uqud al-Muamalat).

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|              Balance Sheet Structure of an Islamic Bank                  |
+------------------------------------+-------------------------------------+
| Uses of Funds (Assets)             | Sources of Funds (Liabilities & Eq) |
+------------------------------------+-------------------------------------+
| 1. Retail Financing:               | 1. Islamic Deposits (PIDM Protected)|
|    - Home: MMP / BBA               |    - Demand Accounts: Qard / Tawarruq|
|    - Auto: AITAB                   |    - Savings Accounts: Qard / Tawarruq|
|    - Personal/Cards: Tawarruq      |    - Term Deposits: Commodity Murabahah|
+------------------------------------+-------------------------------------+
| 2. Corporate & Commercial:         | 2. Investment Accounts (Non-Deposit)|
|    - Working Capital: Murabahah    |    - General (URIA): Mudarabah/Wakalah|
|    - Equipment: Ijarah / AITAB     |    - Restricted (RIA): Specific Mandate|
|    - Construction: Istisna'        |      (Not capital-guaranteed by PIDM)|
+------------------------------------+-------------------------------------+
| 3. Treasury & Liquid Assets:       | 3. Other Liabilities & Equity:      |
|    - Sukuk (GII, Corporate)        |    - Interbank Borrowings (IIMM)    |
|    - BNM Notes: BNMN-i             |    - Subordinated Sukuk (Tier 2)    |
|    - Interbank Commodity Murabahah |    - Shareholders' Paid-Up Capital  |
+------------------------------------+-------------------------------------+

Sources of Funds: Liabilities and Equity

A critical regulatory development introduced by IFSA 2013 and BNM's Investment Account Policy Document (IAPD 2014) was the mandatory structural segregation between Islamic Deposits and Investment Accounts:

1. Islamic Deposits (Principal-Guaranteed Liabilities)

Under Section 2 of IFSA 2013, an Islamic deposit is strictly defined as a sum of money accepted by the bank on terms under which the principal will be repaid in full, either on demand or at an agreed time, with or without any return. Because the bank guarantees capital return, deposits are classified as direct debt liabilities on the balance sheet and are covered by statutory deposit insurance via Perbadanan Insurans Deposit Malaysia (PIDM) up to RM 250,000 per depositor per member bank.

• Demand Deposits (Current Accounts): Historically structured under Wadiah Yad Dhamanah (guaranteed safekeeping), these were converted to Qard by 31 July 2018 under BNM's Wadiah and Qard policy documents. Under qard, the depositor lends to the bank, which must repay the principal on demand and may pay no contractual profit.
• Savings Accounts: Structured via Qard or Tawarruq, providing safe custody and liquidity access.
• Islamic Term Deposits: Structured almost exclusively via Commodity Murabahah / Tawarruq, where the customer purchases an underlying commodity (such as crude palm oil on Bursa Suq Al-Sila') and sells it to the bank on deferred payment terms at a cost-plus profit, locking in a pre-agreed fixed yield.

2. Investment Accounts (Performance-Linked, Non-Deposit Instruments)

Under IFSA 2013, an Investment Account is an arrangement under which money is paid to the bank to be invested in accordance with Shariah on terms where the principal and returns are performance-linked to the underlying assets. Investment account holders act as investors who share commercial risks; consequently, investment accounts are NOT covered by PIDM deposit insurance.

• Unrestricted Investment Accounts (URIA): Governed by Mudarabah (profit-sharing partnership) or Wakalah bi al-Istithmar (investment agency). The investor (Rab-al-Mal or Principal) grants the bank (Mudarib or Wakeel) full discretion to co-mingle the funds with the bank's own capital and invest in its general financing portfolio. Returns are distributed based on a pre-agreed Profit Sharing Ratio (PSR) applied to actual realised profits. Losses are borne entirely by the investor unless caused by the bank's misconduct, negligence, or breach of contract.
• Restricted Investment Accounts (RIA): The investor imposes specific parameters regarding the assets, economic sectors, maturity horizons, or risk profiles into which funds may be allocated. RIAs are frequently off-balance-sheet or managed in segregated ring-fenced portfolios for institutional clients.

3. Capital and Interbank Funds

Includes paid-up common share capital, statutory reserves, retained earnings, subordinated Sukuk issuances qualifying as regulatory capital under Basel III, and short-term interbank borrowings via the IIMM.

Uses of Funds: Assets and Financing Portfolios

Islamic banks deploy mobilized funds across three primary asset categories:

1. Retail Financing

• Home Financing: Primarily structured via Musharakah Mutanaqisah (MMP / Diminishing Partnership), where the bank and customer jointly purchase a residential property. The customer leases the bank's share under Ijarah (paying rental) and gradually buys out the bank's equity units over time until acquiring 100% sole ownership. Alternatively, legacy financing utilized Bai Bithaman Ajil (BBA), a deferred payment sale where the bank purchases the property and sells it to the customer at a cost-plus-profit price payable over an agreed tenure.
• Auto Financing: Governed under Al-Ijarah Thumma Al-Bai (AITAB), an Islamic hire-purchase structure comprising two distinct, sequential contracts: first, an Ijarah (leasing) agreement where the customer pays periodic rental to use the vehicle, followed by a separate Bai' (sale) or Hibah (gift) contract transferring vehicle ownership to the customer upon full settlement of lease payments.
• Personal Financing & Credit Cards: Executed via Commodity Murabahah / Tawarruq, where the customer buys commodities from an international broker through the bank as agent, and sells them to the bank on deferred terms, subsequently liquidating the commodities on a spot market to secure liquid cash.

2. Corporate, Commercial, and Project Financing

• Working Capital & Trade Finance: Structured via Murabahah (cost-plus deferred sale), Kafalah (guarantees/letters of credit), and Wakalah.
• Commercial Equipment & Fleet Leasing: Executed through Ijarah Muntahiah Bi Al-Tamlik (IMBT), a lease contract culminating in legal ownership transfer.
• Infrastructure & Real Estate Development: Structured using Istisna' (commissioned manufacturing / construction contract) coupled with a Parallel Istisna', where the bank contracts with the corporate customer to deliver an asset, and separately subcontracts with an engineering firm to construct the facility.

3. Treasury Assets and Liquid Reserves

To satisfy BNM's Statutory Reserve Requirement (SRR) and Basel III Liquidity Coverage Ratio (LCR), Islamic banks hold substantial portfolios of high-quality liquid assets (HQLA):

• Government Investment Issues (GII): Sovereign Islamic securities first issued in July 1983 under qard al-hasan, later on bai' al-inah (2001), and since 22 July 2013 on Murabahah (commodity-based);
• Malaysian Islamic Treasury Bills (MITB): Short-term sovereign discount paper;
• Bank Negara Monetary Notes-i (BNMN-i): Islamic notes issued by BNM to manage liquidity, replacing the earlier Bank Negara Negotiable Notes; and
• Corporate Sukuk: High-grade Islamic debt securities structured under Wakalah, Ijarah, or Musharakah.

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The Islamic Interbank Money Market (IIMM) in Malaysia

An Islamic banking sector cannot function effectively without a dedicated mechanism to manage day-to-day liquidity imbalances. If an Islamic bank faces a temporary cash deficit, borrowing on the conventional interbank market is strictly prohibited due to Riba. Conversely, an Islamic bank with surplus funds cannot place them in interest-bearing interbank call accounts.

To solve this, Bank Negara Malaysia issued Guidelines on the IIMM on 18 December 1993 and launched the Islamic Interbank Money Market (IIMM) on 3 January 1994. It was the first Islamic interbank money market in the world and remains the global benchmark for sovereign liquidity infrastructure.

Core Objectives of the IIMM

1. Short-Term Liquidity Management: Enabling Islamic banks to match funding deficits and surpluses efficiently on an overnight, weekly, or monthly basis;
2. Monetary Policy Transmission: Providing BNM with Shariah-compliant market operations to influence liquidity volume, interbank rates, and systemic monetary conditions; and
3. Secondary Market Trading: Establishing a liquid secondary market for negotiable Islamic financial instruments.

Key Instruments of the IIMM

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|                       Core Instruments of the IIMM                      |
+---------------------+-------------------+-------------------------------+
| Instrument          | Underlying Fiqh   | Primary Operational Function  |
+---------------------+-------------------+-------------------------------+
| 1. MII              | Mudarabah         | Interbank profit-sharing      |
|                     |                   | investment placement          |
+---------------------+-------------------+-------------------------------+
| 2. Qard Acceptance  | Qard              | BNM absorbs surplus liquidity |
|                     |                   | (overnight or term)           |
+---------------------+-------------------+-------------------------------+
| 3. CMP              | Commodity         | CPO-based placements with BNM |
|                     | murabahah         | or between banks              |
+---------------------+-------------------+-------------------------------+
| 4. BNMN-i, SBNMI,   | Various (e.g.     | Tradable securities for       |
|    GII              | murabahah, ijarah)| liquidity and collateral      |
+---------------------+-------------------+-------------------------------+
| 5. Collateralised   | Murabahah + rahn  | Repo-like secured financing   |
|    Murabahah (CM)   | of sukuk          | using pledged sukuk           |
+---------------------+-------------------+-------------------------------+

1. Mudharabah Interbank Investment (MII)

Introduced at the founding of the IIMM in 1994, MII lets a deficit Islamic bank receive short-term funds from a surplus bank. The surplus bank acts as Rab al-Mal (capital provider) and the deficit bank as Mudarib. The return is not guaranteed. It is calculated with a pre-agreed profit-sharing ratio (PSR) applied to the deficit bank's gross return on its investments.

2. Qard Acceptance

BNM uses Qard Acceptance to absorb surplus liquidity: Islamic financial institutions lend surplus funds to BNM on a qard basis, overnight or for a term, and BNM must repay the same amount. Any return BNM gives is at its discretion and cannot be pre-conditioned. This replaced the earlier Wadiah Acceptance.

3. Commodity Murabahah Programme (CMP)

BNM's CMP was first auctioned on 14 March 2007 through BNM's Fully Automated System for Issuing/Tendering (FAST). It was the first commodity-based IIMM transaction, using crude palm oil contracts as the underlying asset. It can be transacted with BNM or bilaterally between IIMM participants. Banks also place funds with each other through commodity murabahah, often executed on Bursa Suq Al-Sila' (BSAS) since 2009. A surplus bank buys the commodity on spot terms and sells it to the deficit bank at cost plus profit on deferred terms. The deficit bank then sells it on for cash, giving a fixed-return placement.

4. Bank Negara Monetary Notes-i (BNMN-i), Sukuk BNM Ijarah and GII

BNM issues BNMN-i, Shariah-compliant notes that replaced the Bank Negara Negotiable Notes, to manage liquidity. These may be discount-based or profit-bearing. BNM has also issued Sukuk Bank Negara Malaysia Ijarah (SBNMI) through BNM Sukuk Berhad. Together with the government's GII, these give banks high-quality liquid assets that trade in the secondary market and can serve as collateral.

5. Collateralised Murabahah (CM)

Collateralised Murabahah is a Shariah-compliant financing secured by pledged sukuk: a murabahah transaction with sukuk as the pledged asset. If the borrowing bank fails to pay, the financier may sell the pledged sukuk. CM gives the IIMM a low-credit-risk, repo-like tool. Institutions use it to obtain liquidity from BNM under the standing facility and in daily interbank operations.

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Comparative Matrix: Islamic Banking vs. Conventional Banking