Bank Islam Malaysia (BIMB) symbolizes the beginning of the efforts of Muslims in Malaysia to develop an Islamic financial system in the country. Since its establishment on March 1 1983, BIMB has been pioneering Islamic banking operations within the country's banking system.

Following the liberalization of the industry in 1993, there are now 44 other commercial banks, merchant banks, finance companies and cooperative banks offering Islamic banking services through an Interest-Free Banking Scheme (IFBS). In 1995, these institutions mobilized RM4.9 billion (US$1.96 billion) in deposits, up 5.8% from RM4.6 billion in 1994. Islamic financing, meanwhile, more than doubled to RM3.5 billion from RM1.7 billion the year before. This figure is expected to grow significantly again this year with the financing of several large infrastructure projects, including the new international airport in Sepang. In January 1996, BIMB arranged a RM2.2-billion Islamic note-issuance facility to help finance this project, which is estimated to cost between RM8 billion and RM9 billion.

Ariffin Abdul Aziz, general manager of Islamic banking at Arab-Malaysian Merchant Bank, expects the total Islamic financing to exceed RM5 billion by the end of 1996 as Islamic debt securities (IDS) gain greater acceptance among borrowers. Indeed, some bankers are now predicting that the RM1.4 billion resource surplus recorded in 1995 (total deposits less total funding) could reverse into a deficit by year's end. "Project managers are now realizing that Islamic financing is better in terms of pricing and structure," says Ariffin. Although he cautions that for Islamic financing to continue to penetrate the market, "pricing must be the same or lower than the conventional market". IDS, bankers say, are suitable for large infrastructure projects with long development periods. An IDS issuer has a more predictable cash flow because the cost of funds are at a fixed rate as against a floating rate typically used in the conventional financing of projects with long gestation periods. Even so, Islamic financing constitutes only 1.3% of the total loans extended by the banking system, while total deposits account for just 2%. Bank Negara, the country's central bank, wants to see their respective share go up to around 5% each by the turn of the century.

In conjunction with the Securities Commission (SC), Bank Negara is working to set up a more formal framework to develop the Islamic capital markets. Since 1994, when BIMB Securities, Malaysia's first Islamic stockbroker, was formed, Muslim investors have been able to invest directly in halal (permitted) counters. More recently, conventional securities firms have also set up their own Islamic stockbroking windows, including ArabMalaysian, TA Securities and Rashid Hussain, which advise investors on halal stocks. Investors can always buy shares through stockbrokers that do not have an Islamic; window, but first they would need to know which stocks are halal - a classification that even the experts, at the moment, agree to disagree on. "For example, if one company manufactured bottles it would be considered halal. But if those bottles are sold to a brewery, would that bottle manufacturer still be considered a halal stock?" asks Rohani Datuk Haji, chief executive of ABRAR Global Asset Managers, one of the leading proponents in developing the Islamic capital markets in Malaysia.

As of July 1996, 364 stocks out of the 633 listed on the Kuala Lumpur Stock Exchange (KLSE) are considered halal. The list, which is updated regularly, is based on a set of criteria determined by BIMB's religious supervisory council and is widely regarded as the benchmark for Islamic investors. Halal stocks must conform with Syariah principles and exclude companies whose activities involve gambling, alcohol, interest-based banking and finance, and conventional insurance, as well as other haram (forbidden) sectors, such as non-halal food products. This prevents such blue-chip stocks as Maybank, Genting and Malaysia Airlines (the national carrier serves alcohol on its flights) from being included in an Islamic fund managers' portfolio.

However, many religious scholars in Arab countries argue that BIMB's halal criteria are already too liberal and should be further tightened. It is not enough, they say, to look only at the activities of the companies; Islamic investors must also consider whether these companies borrow money from or place short-term funds in the conventional banking system. Not all, however, agree. "If we were to look at it [investing] the way some of the religious scholars do in the Arab countries, it would exclude almost all the companies on the KLSE," says Abdul Halim, executive chairman of BIMB Securities. "There would be no counter that a Muslim could buy." That, he adds, would mean the end of Vision 2020 - Malaysia's visionary target of making the country fully industrialized and developed by the year 2020 - and of the government's New Economic Policy. 'There must be some pragmatism."

In line with the development of the Islamic capital markets, more sophisticated financial products are also being considered. For instance, the Islamic Instrument Study Group (IISG), the body set up by SC to look at Islamic capital markets development, is considering to introduce Islamic warrants and futures. The IISG believes that debt and asset securitizations are not against the Syariah principles so long as the underlying assets are halal. The SC, in association with the newly-formed Kuala Lumpur Options and Financial Futures Exchange (Kloffe), is studying to launch a derivative product based on an Islamic stock index sometime in 1997.

Efforts are also being taken to brush up the image of Islamic fund management, which many investers still perceive as an exotic financial service. "We need to disprove our critics," says Rohani of ABRAR Global Asset Managers. "The conventional wisdom is that if it is a halal investment then the returns must be lower. We want to disprove that. We don't want to be seen as operating in some fringe market. After all, an Islamic unit trust is only an ethical unit trust and should not be considered any different from other unit trusts."

Together with the development of new Islamic banking products, Bank Negara is also addressing some of the deficiencies in the Islamic banking system, including the establishment of a central Syariah council at the central bank itself and harmonizing the Islamic accounting standards, both of which it intends to put in place by the end of this year. Now, Malaysia's only Syariah council is that of BIMB's. However, the SC also has its own Islamic instrument study group, which acts as its advisers, and most IFBS banks have their own Islamic advisers. By grouping these people together, says Rustam Mohd Idris, senior assiststnt manager of bank regulation at Bank Negara, a central Syariah board will eliminate the possibility, which presently exists, of differences in opinions on similar Syariah issues. "With so many groups, it slows down the whole process of reform," adds Rustam.

Not content with building a sound domestic Islamic banking system, both bankers and regulators are also pushing to develop Malaysia as a regional Islamic financial centre. Says Arab-Malaysian's Ariffin, who is also the vice chairman of the Association of the Interest-Free Banking Institutions in Malaysia: "The time is right to start an international Islamic bank in Labuan".