1.

Introduction

Islamic finance draws its value propositions from the application of a various
field of Shariah contracts in financial transactions that provides for different risk and
return profiles. The strict obedience by Islamic financial institutions to Shariah
principles under such distinct contracts conserves the purity and validity of Islamic
financial transactions. There have been numerous initiatives undertaken in Malaysia
to bring into being a comprehensive contract-based regulatory framework for Islamic
finance.

Before the contract-based regulatory framework had been introduced, Islamic

financial products were merely developed through a financial engineering of Islamic
contracts to impersonate the nature of conventional instruments. There were no strict
rulings in accordance with the requirements and the benchmark of Islamic Financial
Institutions in developing a new product to comply with the Shariah and resulting
sanctity in its products. Framework to be laid did not exist to help ensuring authenticity
the products and to support the effectual application of Islamic contracts in the offering
of Islamic financial products and services which is end-to-end basis.

Today, Islamic Financial Institutions are geared by the contract-based

regulatory framework toward ensuring genuineness in its Islamic financial products; it
should also move IFIs toward a Shariah-based operating environment. Innovations
should be contractually engineered on the basis of Islamic contract principles and
features. This could mean a new focus for innovation from the source of Shariah
instead of replicating conventional contracts that have caused harm to consumers
from the transfer risk to the latter.

Furthermore, the foundations for end-to-end Shariah governance and

compliance for the Islamic finance sector have been further strengthened by the
Islamic Financial Services Act 2013 (IFSA). The Act provides the legal premise for a
comprehensive regulatory framework for Islamic finance in Malaysia that reflects the
specificities of the various types of Shariah financial contracts, and supports the
effective application of Islamic contracts in the offering of Islamic financial products
and services - from the entering into a contract to the resolution of a failed Islamic
financial institution. This represents a significant step forward in aligning legal and
regulatory principles with Shariah precepts, and can serve as a useful benchmark for
developing more comprehensive regulatory frameworks globally that promote greater
legal and operational certainty in Islamic finance.

However, things that should be further considered are the ethical and social
implications of the contract. Islamic contracts and instruments must reflect the true
nature of their contractual form and substances to not only distinguish themselves
from their conventional counterparts but also to ensure system and financial stability.
With the power given to CBM under the new law to address non-compliance with
Shariah and operational standards one would expect greater supervisory intervention
to require prompt corrective actions. Enforcement is greatly assisted by a
comprehensive penalty framework that provides a credible deterrent.

2. Significance of Contract-Based Regulatory Framework

The regulatory framework in Malaysia has marked another milestone in the

financial industry with the introduction of Islamic Financial Services Act (IFSA) in 2013
to cater to the growing market of the countrys Islamic financial market. One of the
main initiatives undertaken by Central Bank of Malaysia is to put in place a
comprehensive contract-based regulatory framework for Islamic finance through the
establishment of IFSA 2013. The framework contains provisions that enables IFSA
2013 to serve for several objectives such as ensuring a comprehensive Shariah
governance and compliance, ensure that the laws are reflective of the true nature of
Shariah contracts, and to provide the standardised standards to strengthen public
confidence.
2.1 Providing a strong legal foundation

The IFSA 2013 has been introduced to provide a stronger legal foundation to
spur the growth of Islamic finance sector. Hence, the Act provides the legal premise
for a comprehensive regulatory framework for Islamic finance that reflects the
specificities of the various types of Shariah financial contracts. As the principles of
Shariah will be enforced within this framework from end-to-end, it will ensure a
comprehensive Shariah governance and compliance starting from the product
development to the implementation stages by Islamic financial institutions. This holistic
governance approach will ameliorate the lopsided or imbalanced monitoring and
oversight of Shariah compliance management and also supports the effective
application of Islamic contracts in the offering of Islamic financial products and
services. This framework represents a significant step to provide a global benchmark
that promote greater legal and operational certainty in Islamic Finance.
2.2 Strengthening the Regulatory Framework

The legislation in this framework also contains provisions that enable the
Central Bank to specify regulatory requirements that promote and are consistent with
Shariah contract-based operational frameworks. In this regard, section 29 (1) gives
power to the Central Bank of Malaysia to specify standards on Shariah matters with
consultation of the Shariah Advisory Council (SAC). SAC through the power of Central
Bank of Malaysia has issued a series of policy documents on Shariah contracts called
Exposure Drafts which outline the Shariah requirements and optional practices in
developing Islamic financial services and products. These Exposure Drafts then will
be reviewed by the institutions, industry players, and public and they will give written
comments, including suggestions for particular issues or areas to be further clarified
and any alternative proposal that the Bank should consider. After revising all the
suggestions and alternatives, SAC will approve the drafts as the Shariah standards
which will define the essential features of the contract to be adopted by Islamic
financial institutions. This well-defined Shariah standards not only reflect the
contractual requirements of an Islamic contract but also incorporate the ethical
standards or Maqasid benchmark. The outcome of these standardised Shariah
standards is believed can enhance certainty and public confidence in Islamic financial
transactions.

Central Bank of Malaysia is also empowered to issues guidance or Operational

Standards to support the effective implementation of Shariah standards and ensure
compliance by Islamic financial institutions. Such standards address sound practice
principles and the expectation for effective risk management, governance,
disclosures, and appropriate legal and accounting treatments for key Islamic
contracts. For instance, the Guideline on Financial Reporting for Islamic Banking
Institutions were revised in 2012 to improve the quality of information provided to users
of financial statements on different characteristics associated with various Islamic
contracts applied.
 Central Bank of Malaysia also has wide powers under the law to address non-
compliance with Shariah and operational standards. For instance, they have the
ability to require prompt corrective actions through supervisory intervention as well as
a comprehensive penalty framework as stated in section 28 (5) and 29 (6) of IFSA
2013 that provides a credible deterrent.

2.3 Promoting a Cohesive National Infrastructure

Malaysia has also developed a comprehensive legal infrastructure and

framework that promotes effective enforceability of Shariah contracts beyond financial
services laws and regulations. Through this framework, oversight function has been
introduced to enhance legal certainty of financial transactions based on Shariah
principles. For instance, in 2010 the Law Harmonisation Committee was established
with a mandate to review the current conventional financial laws and provisions and
infuse Shariah principles in the law so that it can be Shariah compliance. Greater
legal certainty is also promoted through Central Bank of Malaysia as oversight body
and recognition of SAC as the final arbiters on any Shariah matter in relation to Islamic
finance business.

While for tax treatment, the tax neutrality principle has been applied and
administered by the Tax Neutrality Committee to ensure that transactional costs from
the application of Shariah contracts in Islamic finance are not structurally higher than
conventional financial transactions that produce the same economic impact.

3. Recommendation for Contract based regulatory framework

Although Malaysia has undertaken many initiatives to improve and empower

the Islamic Finance industry, there is a gap which should be closed. One of the gap is
the Islamic Hire Purchase, also known as Al-Ijarah Thumma Al-bay (AITAB), still
governed by Hire-Purchase Act 1967. It is pertinent for Malaysia regulators and Islamic
Finance practitioners to establish an independent act exclusively for AITAB.
 AITAB has been a popular contract used by Malaysia community as it has huge
demand. Unfortunately, AITAB is still governed by Hire-Purchase Act 1967 which favor
to conventional hire purchase. Even though there are many similarities between
conventional hire purchase and AITAB, in fact there are some practices which made
the former is different from the latter.

One of the examples is the issue of maintenance of the leased property. Under
the Hire-Purchase Act 1967, the lessee is fully responsible for the maintenance of the
leased property. This is contradicted with the Islamic practices whereby the lessor
should be the one who responsible for the maintenance of the leased property. As
what has been explained by Islamic scholars, AITAB is a contract which encompasses
two contracts which are lease contract and sale contract. Lease contract occurred
during the rental period, for example ten years, and the sale contract occurred at the
end of the rental period. At the end of the rental period, the lessee is given a choice
whether to buy the property, to continue with the lease contract, or to reject the
property.

However, these contracts, lease and sale contract, must be concluded

separately. In other words, it is prohibited if the lessor and the lessee concluded the
lease and sale contract on the same time. The lessor also should not oblige the lessee
to buy the property at the end of the lease period. Unfortunately, under Hire-Purchase
Act 1967, the lessor and lessee just need to use one agreement which conclude lease
and sale contract on the same time. Thus, we recommend Central Bank of Malaysia
to establish an independent Islamic Hire Purchase Act in order to ensure that AITAB
is complying with Shariah rulings.
 4. Conclusion

To sum up, Malaysia has provided strong based for Islamic Finance industry
parallel with its objective whereby to make Malaysia as the reference at the
international level in Islamic Finance industry. Malaysia also is pioneering in Islamic
Finance industry compare to other countries. Contract based regulatory framework
being introduced to ensure that Islamic Financial Institutions (IFIs) follow the authentic
Shariah principle is Islamic Finance.

Moreover, the Contract based regulatory framework should ease the IFIs in
developing their Islamic products or their operations. Consequently, IFIs will be more
innovative in developing their Islamic products. However, this Contract based
regulatory framework should be reviewed continuously as the practices and innovation
of IFIs operation and products keep changing. The Contract based regulatory
framework must follow the industry and ensure that the Islamic Finance industry
stable, grow, and following the Islamic rulings.
 5. Reference

1. Yussof, S. A. (2013). The Islamic Financial Services Act, 2013: Malaysias model
framework for Shariah-compliance and stability. Islam and Civilisational Renewal
(ICR), 4(3).
2. Malaysia, B. N. (2013). Financial Stability and Payment Systems Report 2012. Bank
Negara Malaysia. 80-82