VZCZCXRO3722
RR RUEHCHI RUEHDT RUEHHM RUEHNH
DE RUEHKL #1629/01 2410843
ZNR UUUUU ZZH
R 290843Z AUG 06
FM AMEMBASSY KUALA LUMPUR
TO RUEHC/SECSTATE WASHDC 7440
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
RUEHGV/USMISSION GENEVA 1422
RUCNASE/ASEAN MEMBER COLLECTIVE
RUEHAD/AMEMBASSY ABU DHABI 0090

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. 
 
---------------------- 
Demand Outpaces Supply 
---------------------- 
 
¶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. 
 
--------------------------------------------- ---- 
Going Global:  GOM Launches the Malaysian International 
Islamic Financial Center Initiative 
--------------------------------------------- ---- 
 
¶5.  At the Malaysian Islamic Finance Forum on August 
 
KUALA LUMP 00001629  002 OF 004 
 
 
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. 
 
---------------------------- 
Tax and Regulatory Treatment 
---------------------------- 
 
¶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. 
 
------------ 
Scholarships 
------------ 
 
¶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. 
 
--------------------------------------------- ---- 
Addressing Differences in Shariah Interpretations 
--------------------------------------------- ---- 
 
¶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. 
 
---------------------------- 
Dubai and Malaysia Seal Deal 
---------------------------- 
 
¶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. 
 
------------------------------ 
Central Bank to begin adopting 
Islamic Banking Practices 
------------------------------ 
 
¶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. 
 
------- 
Comment 
------- 
 
¶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 
 
KUALA LUMP 00001629  004 OF 004 
 
 
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