Factors Determining Mergers of Banks in Malaysia's Banking Sector Reform - Essay Example

The banking system in Malaysia has the Bank Negara Malaysia (BNM) as the central bank, along with other banking s that include commercial banks, finance companies and merchant banks. In addition, there are other financial institutions which include discount houses, foreign bank representative offices, and offshore bank in the International Offshore Financial Centre in Labuan (Radam, Baharom, Dayang-Affizzah & Ismail, 2009). Malaysia has the ‘dual banking system’ that separates the regulatory system for Islamic banks from mainstream or commercial or conventional banks (Seif, El-Din & Abdullah, 2007). The philosophies and principles that form the basis of Islamic banking have been detailed in the Holy Quran and the Sunnah of Prophet Muhammad. Islamic banking is seen as the revival of Islam. This is also taken as an expression of the Muslims to live on the principles of Islam. In Malaysia, there is a separate legislation governing the Islamic banks and these co-exist with the traditional banks. The Islamic Banking Act of 1983 vested the powers in the BNM to ensure that the Islamic banks worked under regulation. Bank Islam Malaysia Berhad (BIMB) was the first Islamic bank to be established in 1983 and they adhere to the principles as stated in the sharia. (PKUKM, n.d.). By 1992 BIMB spread out all over the country. Very soon it developed a network of 80 branches with 1200 people working in them. Bank Muamalat Malaysia Berhad (BMMB), the second Islamic bank, came into existence following the merger of Bank Bumiputra Malaysia Berhad (BBMB) with Bank of Commerce (Malaysia) Berhad (BOCB). The Islamic banking system can be viable if it fulfills there vital requirements. The number of players in the banking system should be large; they should offer a wide range of financial and banking instruments. Besides, there should be an active Islamic money market (PKUKM, n.d.). In addition, the Islamic banking system should have the characteristics of Islam and work under those principles. BNM played the lead role in disseminating Islamic banking at the national level so that it could reach all Malaysians. The commercial banks too were encouraged to promote Islamic banking products and services from their existing infra structure and branches. This increased the number of institutions that offered Islamic banking products and services within the shortest time and minimum costs. Under the scheme known as "Skim Perbankan Tanpa Faedah" BNM further enhanced the promotion of Islamic banking. The Islamic banks or the commercial banks engaged in Islamic banking services used different Islamic concepts which enabled them to offer over 40 Islamic financial products and services. The different concepts include Mudharabah, Musyarakah, Murabahah, Bai’ Bithaman Ajil (Bai’ Muajjal), Ijarah, Qardhul Hasan, Istisna’ and Ijarah Thumma Al-Bai’ (PKUKM, n.d.). Banks that offered Islamic banking were required to disclose their Islamic banking operations in their annual accounts. The Islamic banks also participate in the Islamic inter-bank money market (IIMM) which serves as a source of ready investment based on sharia principles. All the Islamic banking institutions could trade among themselves in the Islamic financial instruments like Islamic accepted bills and Islamic debt securities. Apart from the two main Islamic banks – BIMB and BMMB, other institutions participating in Islamic banking include commercial banks, finance companies, merchant banks, and discount houses. In addition, there are four foreign banks that provide Islamic banking products and services (Ahmad & Haron, 2002). The range of Islamic banking products and services offered by the Islamic banks is wide. It includes deposits, retail financing, card services, trade finance, and banking services. The Chartered Mercantile Bank of India, London and China was the first commercial bank in Malaysia, established in 1859 (How, Karim & Verhoeven, 2005). The first domestic bank was established in 1913 and by 1990 there was massive growth in the banking sector. All the financial institutions could participate in the scheme based on the Islamic Interest-Free Banking Scheme, which was launched in 1993. Islamic banking picked up in Malaysia because the financial instruments offered by them were based on sharia principles and the culture in Muslim societies. The religion does not permit Muslims from taking or giving interests including on deposits or loans, no matter what the purpose of the loan is. Charging interest is considered exploitative which led the Islamic financial system to be equity-based. Under such an arrangement, both the investor and the one who receives the capital, have equal share in the profit and loss. However, the Islamic banking system in Malaysia does not have interest-rate risk management in place. Malaysia has also played the lead role in developing the international Islamic financial system. Labuan was realigned as an international Islamic financial centre from merely being an offshore financial centre (Ahmad & Haron, 2002). As the world banking system underwent liberalization, Malaysia too came up with a ten-year plan known as ‘Financial Sector Stability’. The purpose was to create an efficient and competitive financial system that was focused on its purpose. At the end of 2004, the Islamic banking sector recorded total assets as RM 94.6 billion. This figure accounted for 105% of the total assets in the banking system (Kamaruddin, Safa & Mohd, 2008). Islamic deposits and financing has increased in Malaysia accounting for 11.2 and 11.3 percent of the total deposits in the banking sector. This contribution is the total of all financial institutions that operate under the Islamic Banking Act. The non-Islamic financial institutions and the commercial banks realized the potential of Islamic banking. They set up departments within the system where they offer interest-free banking. Malaysia was the pioneer in such setups and this has been duplicated by other countries such as Indonesia and Thailand. Reforms are being undertaken in the Malaysian banking sector and there were plans to open up the sector in 2008. Bank Negara Malaysia (BNM), the central bank in Malaysia had reduced the commercial banks’ statutory reserve requirement and would further reduce the cost of intermediation. BNM wants to provide more liquidity to the banks (EIU ViewsWire, 2010). Non-performing loans (NPL) in Malaysia were a problem but as the economy has expanded and there have been stricter guidelines on lending, the recovery rates are expected to be better. The Malaysian banks asses did not reduce following the global financial crisis in 2008-09. The only bank that had problems with NPL was Islam Bank, the country’s oldest Islamic bank. Malaysia is the biggest centre for Islamic finance (Asiamoney, 2002). Its approaches and principles are different from the Gulf and it focuses on building a debt market within the sharia principles. Malaysia has been able to create a debt securities market and its securities are largely structured on the basis of Al-bai Bithaman Ajil, a sale with a deferred payment. According to the Malaysian view, debt refers to the structures created on the basis of payment of interest but the contracts they use do not involve payment of interest. Islamic banks have to operate in such a way that interest and trading in debt are neither given nor paid (Grose, 2008). Islamic financing received an impetus which pushed sharia-compliant banking into mainstream in Europe. Islamic banking has become attractive even to non-Muslims. According to the sharia law investment in certain industries such as tobacco, pornography and alcohol are prohibited. Islamic banking plays a vital role post financial crisis as it is accepted as a safer option in the high risk environment. While Islamic banking has been growing the pace has been slow and the penetration low. Because of the safety factor, HSBC and Standard Chartered, the global banking giants, have entered the Islamic banking sector. The financial crisis is being seen as an oppurtunity for the Islamic banking sector. While globally the Islamic banking sector has just 1% of the financial assets and deposits, in Malaysia the Islamic banking sector accounts for 18% of the total assets and in terms of values it amounts to $65bn (Anand & Bansal, n.d.). In Malaysia the Islamic assets have grown from just 8% in 2001 and it has been growing at 36% CAGR for the last three years. Te Islamic banks are deficient in attributes such as service, products and returns but customers prefer Islamic banking because of the strong religious beliefs. The banking sector in Malaysia is going beyond the traditional banking activities. They now offer wealth management, personal financial services, capital markets products, and structured finance (Marketwatch, 2005). Hong Leong Bank (HLB) has now launched Hong Leong Islamic Bank as its new subsidiary to offer financial services. All the activities will be conducted under the sharia law with a number of banking and financial products to choose from. Malaysia has become very attractive for sharia compliant financial services. HLB has 200 branches and business centers nationwide and hence are in a strong position to refer Malaysian consumers wanting Islamic financial services. The Islamic banks operate under the dual banking system. This provides them with relative advantage against a single Islamic banking system. To survive in a competitive environment requires innovation and creativity. Using innovation as the basis, the Islamic banks designed Islamic financial products, which met the requirements of the sharia principles while satisfying the sophisticated customers. One such innovative product has been the hire-purchase mode of financing commonly known as ijarah wa-iqtina (Seif, El-Din & Abdullah, 2007). This model represents the mainstream banking model and there is no difference in calling themselves as Islamic banks. This is because in the credit and hire-purchase agreement, the Islamic banks continue to retain attributes such as end-financing, banks’ legal charge on asset purchase, and also taking contractual profits by virtue of time value (Rosly & Bakar, 2003). In 1999, there were 58 financial institutions comprising 21 commercial banks, 25 finance companies and 12 merchant banks (Radam, Baharom, Dayang-Affizzah & Ismail, 2009). The number of banks shows that Malaysia was over-banked leading to inefficient use of resources duplication of resources and infra structure. The Malaysian banking sector necessitated structural changes. The banking sector in Malaysia was effective before the Asian financial crisis of 1997 but thereafter the banks started over exposing themselves to those companies that had political backing. Guided mergers, initiated by the central bank of Malaysia have taken place. This helped to consolidate all 54 institutions that were accepting deposits, into ten large-capitalized banks (Ahmad, Ariff & Skully, 2007). Guided bank mergers help to resolve the banking problems as Malaysia had more banks than required for such a small economy. It would also help the banks having NPL to recapitalize. Moreover, under pressure from the WTO, the government wanted to remove the restrictions foreign institutions from entering into Malaysia. The larger banks, even if they were low-performers became the acquiring bank. BNM had aimed in late 1990s that by 2010 Islamic banking would account for a fifth of all banking assets. Towards achieving this goal, in 2004 Kuwait Finance House was awarded a licence to become the first foreign bank to operate under the Islamic principles in Malaysia (Rob, 2004). With all the efforts exerted by BNM, by end 2004, the value of deposits in Malaysia reached M$85.2bn which was almost 10% of all banking assets. The growth of Islamic capital markets started exceeding expectations. BNM also regulates the takaful (insurance sector) in Malaysia. It has recently introduced regulations to expand the list of authorized assets for the operators. The Malaysia financial system is influenced by the market players. Muslims account for about fifty percent of the population in Malaysia and the public acceptance of the system reflects in the volume of deposits and assets. Compared to the total assets of the commercial banks, the total funds deposited in the Islamic financial system remain insignificant. This indicates the public unwillingness to use the system as of 2002. Ahmad and Haron (2002) found that most Muslims and about 75% of the non-Muslims knew of the operations of the Islamic banks. Even though they knew of the existence of the Islamic banks, they were not keen to bank with them. This was because the customers were not fully aware of the benefits or how the system operated. Moreover, the Islamic banks preferred the corporate customers over the retail customers. The corporate customers too did not have thorough knowledge of the mode of operation of the Islamic banks. They were under the impression that the Islamic banks, like other commercial banks would have the profit motive as the basis of operations. However, this contradicts the basic objective of the Islamic banks – combination of moral and profit motives. Since the customers lacked the right understanding and the system on which the Islamic banking system was based, they did not attempt using the Islamic banking system. This indicates that marketing by the Islamic banks has not been done suitable to attract customers and deposits. The corporate customers are more concerned with cost, benefits to the company, service delivery, size and reputation of the bank, convenience of location and parking and most importantly relationship banking. The costs of banking with Islamic banks have been found to be higher than conventional banks which also possibly dissuade customers from banking with Islamic banks. Moreover, while the Malaysian government guarantees all deposits in Malaysia, they issue no written guarantees. Thus, the customers know that deposits with conventional banks are safer because the risk of loss rests on the banks and its owners and not the depositors (Satkunasingam & Shanmugam, 2004). However, profits in the case of the Islamic banks are shared by the bank and the investor, but the bank does not participate in case of loss. Since the Malaysian government does not guarantee investments and deposits in Islamic banks, they are exposed to high risks. This could be the reason that foreign banks in Malaysia are preferred and also the reason that HSBC and Stanchart have been able to capture sizeable market share. The new government in 2004 opened up the nation to foreign banks with the aim that this could bring about the desired reforms in the local banking industry. This would make the sector competitive in Malaysia (Business Week, 2004). The WTO rules demanded liberalization on the world banking operations and this step was taken by the Malaysian government in anticipation of the opening of the sector to outsiders by. Earlier, Kuala Lumpur looked upon foreign banks with suspicion. When the government had imposed regulation in 1970s, the foreign banks’ share had fallen sharply. The foreign banks then had to innovate. Citibank Malaysia started offering phone and internet banking to attract customers. Citibank has just three branches in Malaysia but it ranks sixth largest in terms of assets and is the fifth largest in terms of profits. It also enjoys 25% market share in credit card sector. Retail banking has picked up in Malaysia with foreign banks offering loans to the cash-hungry individuals. The Malaysian banks have been unable to respond to the demand in the market promptly. The local banks focus on wealth management products and they keep their offices posh where they invite their clients. As the services are being duplicated, the gap between the foreign and local banks in Malaysia has narrowed down. Business Monitor (2010) forecasts that Islamic banking in Malaysia will grow by average annual asset growth of 8.3% between 2010 and 2013, which is a downward trend compared to the performance in the past few years. However, as borrowers are turning to sharia-compliant banking, Islamic banking in Malaysia should outperform these rates. The government is confident that Malaysia would become the focal point for Islamic markets and Malaysia has taken the lead in research and development in the capital market (Rob, 2004). Besides, they offer a range of Islamic products and services to the domestic and foreign investors, including the offshore products offered in Labuan. The existing security regulation provides investor protection, the markets are fair, efficient and transparent, and risk management is improved. The Securities Commission conducts regular consultations with the industry and other authorities with the view to enhance the services and improve the development of new products. Thus, while the BNM controls and regulates the banking sector, dual banking system prevails in Malaysia even after liberalization and reforms. However, even though foreign banks were shunned in the 1970s, today they have a larger market share while the Islamic banks have very little market share as well as assets and deposits. While the Islamic banking system has a good potential, especially in the current meltdown, the Islamic banks have not done much to draw attention to their method of functioning and their products and services. Lack of marketing efforts is to a large extent responsible for the low market share in terms of customer base as well as in terms of deposits and assets. Even though Islamic banking and financial products are available at all banks and financial services institutions, they have not been able to augment their assets base as it does not have full acceptance by the customers. This is the reason that the traditional banks have been fairing better than the Islamic banks. They have also been able to compete with the foreign banks. The Islamic banks have only 10% assets in the banking sector while the traditional banks have the rest of the assets. However, the Malaysian government is making efforts to ensure that Islamic banking is able to penetrate in the market. Towards this effect, BNM has allowed all the commercial banks, the financial institutions and the merchant banks to offer Islamic financial products and services. With this, the network of branches of banks offering Islamic banking products and services is very high. Despite this, the penetration and the asset base of the Islamic banks continue to be low in Malaysia. The government had to intervene to bring about consolidation in the sector when the larger banks acquired the banks that were suffering due to non-performing loans. The number of banks was too high compared to the nation’s population. With the reforms and restructuring that has been taking place in Malaysia in the banking sector, and with the amount of liberalization measures that the government has adopted, the nation could become the hub for capital markets. However, they need to market their services aggressively. Despite the Islamic banks being granted licences, the customers would not be willing to switch over or transfer their accounts to Islamic bank. References Ahmad, N., & Haron, S. (2002). PERCEPTIONS OF MALAYSIAN CORPORATE CUSTOMERS TOWARDS ISLAMIC BANKING PRODUCTS & SERVICES. International Journal of Islamic Financial Services. 3 (4). Ahmad, R., Ariff, M., & Skully, M. (2007). Factors Determining Mergers of Banks in Malaysias Banking Sector Reform. Multinational Finance Journal. 11 (1/2), 1-31 Anand, S., & Bansal, H. (n.d). Growth of Islamic Banking. Retrieved online 22 March 2010 from http://www.cedar-consulting.com/pdf/Cedar%20View%20-%20Islamic%20Banking%20v3.pdf Asiamoney. (2002). HOW MALAYSIA APPROACHES ISLAMIC FINANCE. Asiamoney. Business Source Complete. 13 (1). Business Monitor. (2010). Islamic Banking Overview. Business Monitor International Ltd. Egypt Commercial Banking Report. 2010 1st Quarter. 26-31 Business Week. (2004). Malaysia Rolls Out The Red Carpet. Retrieved online 22 March 2010 from http://www.businessweek.com/magazine/content/04_43/b3905156_mz035.htm EIU ViewsWire. (2010). Malaysia regulations: The financial sector is healthy. EIU ViewsWire. New York: Feb 1, 2010. Grose, T.K. (2008). The Rise of Islamic Banking. U.S. News & World Report. Business Source Complete. 145 (13). How, J.C.Y., Karim, M., & Verhoeven, P. (2005). Islamic Financing and Bank Risks: The Case of Malaysia. Thunderbird International Business Review. 47 (1), 75-94 Kamaruddin, B.H., Safa, M.S., & Mohd, R. (2008). Assessing Production Efficiency of Islamic Banks and Conventional Bank Islamic Windows in Malaysia. International Journal of Business and Management Science, 1(1): 31-48 Marketwatch. (2005). Hong Leong: Islamic bank to enhance Malaysia offerings. Datamonitor. September 2005 PKUKM. (n.d.). Overview of Islamic Banking in Malaysia. Retrieved online 22 March 2010 from http://pkukmweb.ukm.my/~hairun/EX3613/Overview%20of%20Islamic%20Banking%20in%20Malaysia.pdf Radam, A., Baharom, A.H., Dayang-Affizzah, A.M., & Ismail, F. (2009). Effect of Mergers on Efficiency and Productivity: Some Evidence for Banks in Malaysia. The Icfai University Journal of Bank Management. 8 (1). Rob, M. (2004). How Malaysia plans to dominate Islamic markets. International Financial Law Review. 23 (9). Rosly, S.A., & Bakar, M.A.A. (2003). Performance of Islamic and mainstream banks in Malaysia. International Journal of Social Economics. 30 (12), 1249-1265 Seif, I., El-Din, T., & Abdullah, N.I. (2007). Issues of Implementing Islamic Hire Purchase in Dual Banking Systems: Malaysia’s Experience. Thunderbird International Business Review. 49 (2), 225-249 Satkunasingam, E., & Shanmugam, B. (2004). Disclosure and governance of Islamic banks: A case study of Malaysia. Journal of International Banking Regulation. 6 (1), 69-81 Read More