Islamic And Conventional Finance In Malaysia

Introduction:

Malaysia has a dual financial system with Islamic and conventional finance markets operating in parallel. Both systems offer a full range of financial products and services; often use the same infrastructure and compete for overlapping groups of customers in all segments of the financial system, including banking, insurance, fund management, and capital markets.

The Islamic finance industry in Malaysia has steadily built the depth, quality, and quantity of its product portfolio, supported by the government’s long-term commitment to developing and promoting the industry. Amongst others, the following policies provided a favorable environment for growth Islamic banks have responded to economic and financial shocks in the same way as conventional banks, suggesting that the gap between Islamic and conventional finance practices is shrinking.

What attracts conventional investors to Islamic financial instruments?

This paper compares Islamic and conventional finance instruments from the perspective of non-Muslim investors, aiming to answer the following three questions:

 How do Islamic stocks and bonds differ from their conventional peers?

 Which global and domestic economic factors influence both types of securities?

 Are Islamic banks safer and more profitable than conventional banks?

Malaysia’s Capital Markets And The Banking Sector: Stylized Facts:

Malaysia has one of the largest bond markets in Emerging East Asia. The size of the bond market rose to US$ 269 billion as at end-June 2011, making Malaysia the third largest debt market in Emerging East Asia. The ratio of local currency bonds outstanding to GDP stood at 103.5 percent in mid-2011, the second highest in Emerging East Asia. The government bond sector constitutes about 60 percent of the market and is expanding particularly rapidly, with a year-on-year growth rate of 20.9 percent in 2011, compared with 11.1 percent for the corporate sector. Banks and government-linked corporations (GLCs) account for about 80 percent of the corporate debt issuance.

Malaysia’s sovereign debt attracts substantial interest from foreign investors:

In mid-2011, nonresident holdings of Malaysia sovereign debt reached 24.6 percent of total government bonds outstanding, one of the highest levels in Emerging Asia and continues to rise. In particular, Islamic bonds continue to attract strong international demand despite increased global financial turbulence, including for Malaysia’s US$ 2 billion global Sukuk in July 2011 and for the pioneering renminbi-denominated Sukuk of RMB 500 million issued by Khazanah in September 2011.

Islamic securities account for about 40 percent of the sovereign and corporate bond issuance:

The government, Bank Negara, and many companies issue both conventional bonds and Sukuk, at diminishing spreads between the two. According to market participants, Sukuk issued in Malaysia are very comparable to conventional bonds in both economic and legal terms. Indeed, issuers often have no preference for emitting either Sukuk or conventional debt, with the type of issuance determined by market conditions only.

The banking sector is dominated by conventional banks but Islamic banks are increasing their market share:

There are 24 commercial banks and 17 Islamic banks in Malaysia. Within this system, 11 banks operate under both laws, with Islamic and conventional finance parts treated separately in all statistics. Islamic and conventional finance banks hold about 80 percent of total banking assets, loans, and deposits. On average, Islamic banks’ balance sheets are 3 times smaller than commercial banks’ balance sheets.

Islamic And Conventional Finance Bonds And Stocks In Malaysia:

This section compares Islamic stocks and bonds with their conventional counterparts. First, the principal component analysis focuses on the common factors that drive bond and equity returns. Second, the regression analysis sheds light on which domestic and global macro financial variables influence bond and stock returns in Malaysia.

Returns on bonds and equities tend to move together:

For government Islamic and conventional finance bonds, the correlation between monthly returns was 0.95 during the sample period; for the equity indices it was almost 0.99. However, the co-movement between corporate bonds was relatively weaker (0.32), probably due to the relative illiquidity of the corporate Sukuk market. For each pair of instruments, the median returns over the sample period are not statistically different from each other.

A large proportion of changes in bond and equity returns can be explained by economic factors:

To assess the main drivers of the different types of securities, a principal component analysis was applied to the data. The analysis suggests that about 40 percent of the variation in all returns can be explained by a “common economic factor”. Whether the security is a stock or a bond explains a further 33 percent of the variation in the data. Differences between types of issuers account for 18 percent of changes. In contrast, whether the security is Islamic or not explains very little variation in the data.

For bond returns, the common economic factor plays an even larger role, explaining 60 percent of the variation in the data:

The differences between public and corporate issuers explain 28 percent of changes in bond returns but—similar to the overall results—the differences between Islamic and conventional finance bonds provide little information about the movement of bond prices.

Regression analysis suggests that returns on Malaysian Islamic and conventional finance bonds are driven by domestic economic factors, in particular domestic industrial production growth and inflation:

The correlation between domestic factors and bond returns is stronger for government bonds (our parsimonious models explain about 50 percent of the variation in the bond returns, marginally more in the conventional bonds) than for corporate bonds (the models explain 46 percent of changes in corporate Islamic and conventional finance bond returns but only 24 percent of changes in corporate Sukuk returns). During calm periods, both types of bond returns are negatively correlated with rising inflation and positively correlated higher industrial production growth.

Equity returns are determined mostly by global factors:

While domestic inflation and industrial production growth matter, changes in the U.S. equity index S&P 500 and the CBOE S&P 500 volatility index VIX are considerably more relevant: domestic factors alone account for only about 15 percent of changes in the equity returns, whereas global factors explain about 50 percent (marginally less for Islamic stocks). During tranquil periods, Malaysian Islamic and conventional finance equity prices tend to rise as the risk sentiment improves and the U.S. stock markets strengthen. As with bond returns, equity returns are correlated positively with lower inflation and higher industrial production.

Are Islamic Banks Safer And More Profitable Than Conventional Banks?

This section analyzes the behavior of Islamic and conventional finance banks in Malaysia before, during, and after the global financial crisis. Panel regressions are employed to investigate correlations between bank financial ratios and bank fundamental characteristics: whether a bank is an Islamic bank and whether it is a large bank. The analysis is conducted using annual data and supplemented with BNM’s statistics.

Distinct loan portfolios could explain the differences in NIM and ROE:

Vehicle and unsecured personal loans (including credit cards) account for about 20 percent of commercial banks’ total loans but twice as much for Islamic banks. Conversely, residential and commercial mortgages account for about 22 percent of Islamic banks’ total loans but 41 percent for conventional banks. About 40 percent of other loans are for other purposes, with similar distribution for both types of banks. The higher concentration of car and personal loans in the Islamic banks’ loan portfolio explains the higher NIMs but also lower quality of assets, as measured by the non-performing loan ratio.

In mid-2011, Islamic banks held less capital than conventional banks:

As for the CAR, Islamic banks’ capital and reserves to total assets ratio of 7.5 percent is lower than conventional banks’ ratio of 9.3 percent. Conversely, the ratio of total deposits to total assets is larger for Islamic banks than for conventional banks (77 percent and 72.3 percent, respectively).

Islamic banks also became net borrowers in the interbank market:

Their interbank assets to interbank loans ratio fell from 192.6 percent in 2006−07 (when Islamic banks were the net lenders in the interbank market) to 27.9 percent in 2010. By contrast, the ratio of interbank assets to interbank loans for conventional banks remained relatively stable at around 32−40 percent. Overall, Islamic banks depend on wholesale funding much more than conventional banks.

Conclusion:

Even though the Islamic financial services industry represents only 1 percent of global financial assets, it has been growing strongly over the past decade. In 2011, Islamic financial assets expanded US$ 1,086 billion, an impressive 21-percent growth over the previous year. Malaysia’s efforts to become an important player in this market are clearly paying off: Malaysian Islamic finance has grown to the third largest market in the global Islamic finance industry and the local Sukuk market is the biggest in the world.

This paper contrasts Islamic and conventional finance instruments and banks in Malaysia. First, the analysis compares bond and stock returns during 2006−2011 and examines which macro financial factors drive the returns. Next, the focus shifts to the performance of Islamic and conventional finance banks; and the impact of the global financial crisis on banks’ profitability and liquidity.

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