## _wp12151

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---

### I. Introduction and scope
- Malaysia has progressively developed its Shariah-compliant Islamic finance industry, launching with a small Islamic savings sector fund in 1963.
- Malaysia is the third largest in the global Islamic finance industry and is the world’s largest issuer of Islamic bonds (Sukuk).
- Islamic banking assets and assets under management are worth US$ 1,200 billion with an average growth rate of about 20 percent annually.
- Core questions addressed for non-Muslim investors:
  - 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?

### II. Malaysia’s Islamic finance development (policy milestones)
- Key institutional and policy milestones:
  - 1983: The Islamic Banking Act; Bank Islam Malaysia Berhard granted a full banking license.
  - 1983: Government Investment Act initiating Shariah-compliant government bills.
  - 1984: Enactment of Takaful Act; Syarikat Takaful Malaysia Berhad commenced operation.
  - 1993: Introduction of Islamic windows for conventional banks.
  - 1994: Creation of the Islamic Interbank Money Market.
  - 1997: Establishment of the Shariah Advisory Council of Bank Negara Malaysia.
  - 2001: Formal prominence in Financial Sector Master Plan and Capital Market Master Plan; establishment of the Islamic Capital Market.
  - 2005: Malaysia Deposit Insurance Corporation created to ensure both conventional and Islamic deposits are guaranteed by a common deposit insurance system.
  - 2006: Government introduced a package of tax exemptions and incentives for Islamic finance.
  - 2009: Financial sector liberalization with nine new banking and insurance licenses to foreign institutions.
  - 2011: The 2011-2020 Financial Sector Blueprint to establish Malaysia as an international Islamic finance center.

### III. Islamic finance tax and regulatory incentives (Box 2)
- Tax neutrality provisions:
  - Income Tax Act (1967) equal footing provision: Shariah-compliant transactions are not taxed differently from conventional transactions; profits received in Shariah-compliant transactions treated same as interest rate gains for tax purposes.
  - Stamp Act (1949) equal footing provision: ensures transactions requiring additional sales/purchases of underlying assets remain tax neutral; partnership-like Shariah joint ventures not recognized as partnerships for tax purposes.
- Additional tax incentives:
  - Tax exemption for profits derived from Sukuk.
  - 10-year tax exemption for Islamic banks and Islamic insurance companies on income derived from business conducted in foreign currencies, including transactions with Malaysian residents.
  - 10-year income tax exemption for domestic and foreign fund managers who manage Islamic funds for foreign investors.
  - 3-year stamp duty exemption of 20 percent on instruments related to Islamic financing.
  - Tax deductions on expenses incurred in establishing an Islamic stock broking firm.
  - Tax exemption on profits paid by licensed Islamic banks in Malaysia to non-resident customers.

### IV. Stylized facts on capital markets and banking sector
- Bond market:
  - Malaysia’s bond market rose to US$ 269 billion as at end-June 2011.
  - Ratio of local currency bonds outstanding to GDP: 103.5 percent in mid-2011.
  - Government bond sector: about 60 percent of the market.
  - Year-on-year growth in 2011Q2: government sector 20.9 percent; corporate sector 11.1 percent.
  - Banks and government-linked corporations (GLCs) account for about 80 percent of corporate debt issuance.
- Foreign holdings and issuance:
  - Nonresident holdings of Malaysia sovereign debt: 24.6 percent of total government bonds outstanding in mid-2011.
  - Examples of international-demand issuance: Malaysia’s US$ 2 billion global Sukuk (July 2011); Khazanah RMB 500 million renminbi-denominated Sukuk (September 2011).
- Islamic bond market:
  - Islamic securities: about 40 percent of sovereign and corporate bond issuance.
  - Domestic corporate Islamic bonds outstanding: US$ 34 billion.
  - Example yield comparison (2010:Q3): Cagamas conventional 3-year bond yield 3.5 percent vs Islamic bond yield 3.48 percent.
- Equity market:
  - On Bursa Malaysia, nearly 90 percent of listed securities are Shariah-compliant; these account for two-thirds of stock market capitalization and 70 percent of the FTSE Bursa Malaysia EMAS Index (by market capitalization).
  - FTSE Bursa Malaysia EMAS Shariah Index slightly outperformed the overall EMAS Index since early 2010.
- Banking sector structure and size:
  - Total banking institutions: 24 commercial banks and 17 Islamic banks; 11 banks operate under both laws.
  - Conventional 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.
  - Market share of Islamic banking assets: 21.6 percent of total banking assets in Malaysia as of September 2011, rising from 12 percent in December 2006.

### V. Empirical findings summarized
- Drivers of returns:
  - Returns on Malaysian security prices are driven by common economic factors, with changes in domestic economic activity and inflation being most important and global factors affecting equity indices only.
- Comparisons Islamic vs conventional:
  - Differences between returns on Islamic and conventional bonds are not statistically significant.
  - Differences between Islamic and conventional banks are not statistically significant, especially in the most recent years.
  - Interpretation: the gap between Islamic and conventional financial practices is shrinking.

### VI. Data description, co-movement, and factor analysis (Box 2 & Box 3)
- Data and sample:
  - Sources: Bloomberg; FTSE Bursa Malaysia EMAS Index; FTSE Bursa Malaysia EMAS Shariah Index.
  - Sample period: January 2006 through November 2011.
  - Government securities indices: medium-term (3 to 10 years) conventional and Islamic government bonds.
  - Corporate fixed-term debt indices: constructed from Bloomberg pricing data for largest corporate issuers; dominated by GLCs, banks, and financial corporations.
- Co-movement and correlations:
  - Government conventional vs Islamic bonds: correlation between monthly returns 0.95.
  - Equity indices: correlation between monthly returns almost 0.99.
  - Corporate bonds co-movement: 0.32.
  - Median returns over the sample period are not statistically different for each pair of instruments.
- Principal component analysis:
  - About 40 percent of the variation in all returns explained by a “common economic factor”.
  - Whether the security is a stock or a bond explains a further 33 percent.
  - Differences between issuers account for 18 percent.
  - Whether the security is Islamic or not explains very little variation.
  - For bond returns only: common economic factor explains 60 percent; public vs corporate issuers explain 28 percent; Islamic vs conventional explains little.
- Factor loadings and sensitivities:
  - Factor loadings for the common economic factor are larger for Sukuk than for conventional bonds, especially for corporate debt.
  - Returns on the broad equity index are more strongly correlated with the economic factor than returns on the Islamic equity index.
- Regression analysis — drivers of returns:
  - Bond returns (conventional and Islamic) driven by domestic industrial production growth and inflation.
    - Parsimonious models explain about 50 percent of variation in government bond returns (marginally more in conventional bonds).
    - Models explain 46 percent of changes in corporate conventional bond returns.
    - Models explain 24 percent of changes in corporate Sukuk returns.
    - During calm periods, both bond types negatively correlated with rising inflation and positively correlated with higher industrial production growth.
  - Equity returns determined mostly by global factors.
    - Domestic factors alone account for about 15 percent of changes.
    - Global factors explain about 50 percent (marginally less for Islamic stocks).
    - During tranquil periods, equity prices tend to rise as risk sentiment improves and the U.S. stock markets strengthen.
    - Equity returns correlated positively with lower inflation and higher industrial production.
- Crisis dynamics:
  - Strong evidence of investors’ flight-to-quality during the 2008−2009 crisis: as conditions worsened, investors sold higher-risk equity assets.

- Regression specification and estimation notes (Box 3):
  - Method: monthly returns regressed on contemporaneous economic and financial variables; start large and narrow to significant variables.
  - Equity specification includes industrial production growth in Malaysia (∆IP) and allows for different correlations during crisis periods and autoregressive behavior.
  - Crisis indicator I = 1 between September 2008 and September 2009, and again between August 2011 and November 2011; 0 otherwise.
  - For bond equations, global variables statistically insignificant; regressions use domestic variables.
  - Data frequency: monthly for January 2006-November 2011; most explanatory variables in first log differences; T-bill interest rate in first difference.
  - Estimation: Newey-West standard errors.

- Table: Impact of 1 Percentage Point Increase in a Macroeconomic Factor on Monthly Bond and Equity Returns (selected highlights as reported)
  - Non-crisis period:
    - Inflation impacts: -0.72 *; -1.02 *; -0.13 *; -0.44 *; -1.61 *; -1.18 *
    - IP growth impacts: 0.03; 0.04; 0.04; 0.00; 0.46 *; 0.43 *
    - S&P500 impacts: 0.37 **; 0.48 **
    - VIX impacts: -0.06; -0.04
  - Crisis period:
    - Inflation impacts: -2.19 **; -2.17; -0.08; -0.41; -3.31 *; -3.24 *
    - IP growth impacts: -0.10 *; -0.04 *; 0.02 *; -0.03 *; 0.99; 0.92
    - S&P500 impacts: 0.29 **; 0.24 *
    - VIX impacts: -0.17*; -0.18*
  - Table summary statistics:
    - Number of observations: 71 (for each column)
    - R-squared for domestic factors only: 0.48; 0.44; 0.46; 0.24; 0.16; 0.14
    - Overall R-squared: 0.48; 0.44; 0.46; 0.24; 0.67; 0.61
  - Column labels: Government conventional bond; Government Islamic bond; Corporate conventional bond; Corporate Islamic bond; Broad equity index; Islamic equity index.
  - Note: Sample period: January 2006-November 2011. Single asterisk denotes significance at 5 percent; double asterisk denotes significance at 10 percent.

### VII. Malaysia: Strength and Profitability of Islamic and Conventional Banks (Box 4)
- Methodology:
  - Sample period: 2006−2010 (annual data).
  - Cross-section: 11 largest conventional banks and 11 largest Islamic banks (by total assets).
  - Seven Islamic and conventional banks in the sample belong to the same financial group and report as separate entities.
  - Dependent variables from BankScope: CAR, ROE, NIM, NPL, liquid assets/total assets, interbank assets/interbank loans, total assets/equity.
  - Explanatory variables: dummies for Islamic banks and for large banks (large banks = banks holding at least 10 percent of overall banking assets throughout the sample: Maybank, CIMB Bank Berhad, and Public Bank Berhad).
  - Estimation: panel regressions with White cross-section standard errors.
  - Subsample analysis: (1) pre-crisis 2006-2007; (2) crisis 2008-2009; (3) 2010 only.
- Average financial ratios (selected reported values, Conv. / Islamic):
  - Capital adequacy ratio (2006-2010): 14.0 / 15.1 *
  - ROE (2006-2010): 16.4 / 22.1
  - NIM (2006-2010): 2.9 / 3.4 *
  - NPL (2006-2010): 4.4 / 6.0 *
  - Liquid assets to total assets (2006-2010): 23.9 / 34.7 *
  - Interbank assets to interbank loans (2006-2010): 36.1 / 106.8 *
  - Total assets (US$ billions, 2006-2010): 17.3 / 3.9 *
  - Note: Asterisks denote ratios statistically different between conventional and Islamic banks at 10 percent level.
- Key empirical findings:
  - Capital: Islamic banks’ CAR significantly higher than conventional banks’ CAR in 2006−07 and during the global financial crisis, but not in 2010.
    - As of June 2011, capital and reserves to total assets: Islamic banks 7.5 percent, conventional banks 9.3 percent.
  - Profitability: Islamic banks exhibited higher ROE in the run-up to the crisis; during the crisis Islamic ROE was much larger; since the crisis conventional banks are significantly more profitable.
  - NIM: Islamic banks consistently show higher NIM over the whole sample period.
  - Asset quality: Islamic banks show higher NPL ratios than conventional banks across most periods.
  - Liquidity and interbank position: Islamic banks were net lenders in 2006−07 (interbank assets to interbank loans ratio 192.6 percent) but became net borrowers by 2010 (27.9 percent). Conventional banks remained around 32−40 percent.
  - Balance-sheet size and funding: Islamic banks had smaller total assets and depend more on wholesale funding.
- Loan portfolio structure:
  - 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.
  - Residential and commercial mortgages: about 22 percent of Islamic banks’ total loans but 41 percent for conventional banks.
  - About 40 percent of other loans for other purposes, with similar distribution across bank types.
  - Interpretation: Higher concentration of car and personal loans in Islamic banks explains higher NIMs and contributes to higher NPL ratios; business-model differences drive performance differentials.

### VIII. Market dynamics and demand
- Demand characteristics:
  - The majority of Islamic finance customers are non-Muslims, with an increasing presence of foreign investors.
  - Demand for sovereign Sukuk appears to exceed supply, driven by high demand from Islamic banks in Malaysia and foreign investors.
- Issuers’ preferences:
  - Issuers often have no preference between Sukuk and conventional debt; issuance type determined by market conditions.
  - Sukuk issued in Malaysia reported to be very comparable to conventional bonds in both economic and legal terms.

### IX. Policy implications and recommendations
- Regulatory convergence:
  - Empirical results suggest differences between conventional and Islamic banks have diminished and appear due to business models rather than Shariah principles.
  - Conventional and Islamic banks should be subject to the same sound regulatory and supervisory standards consistent with Basel principles.
- Supervision and prudential standards:
  - Bank Negara Malaysia (BNM) should focus on strengthening prudential standards and the supervisory framework for Islamic financial services.
  - Avoid ad hoc, individual guidelines that diverge from Basel principles solely on the basis of Shariah advisory boards’ interpretations.
- Market development:
  - Government support (including government and quasi-government issuance of Sukuk and government deposits to Islamic banks) has helped market development; as the industry matures, government support should be gradually withdrawn.
  - Prioritize establishing an internationally consistent, robust regulatory and supervisory framework and harmonizing Shariah rulings and interpretations within Malaysia and across countries.
- Inclusion:
  - Offering Islamic alternatives has increased access to finance for the under-banked Muslim population; microfinance under Islamic finance remains a small but important area to expand.

*Source: _wp12151 - References*

### References .............................................................................................................

### _wp12151 - References

### I. Introduction and scope
- Malaysia has progressively developed its Shariah-compliant Islamic finance industry, launching with a small Islamic savings sector fund in 1963.
- Malaysia is the third largest in the global Islamic finance industry (Figure 1) and is the world’s largest issuer of Islamic bonds (Sukuk) (Khan, 2011).
- Islamic banking assets and assets under management are worth US$ 1,200 billion with an average growth rate of about 20 percent annually (BMB Islamic, 2011).
- The paper addresses three questions for non-Muslim investors:
  - 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?

### II. Malaysia’s Islamic finance development (policy milestones)
- Key institutional and policy developments supporting the industry:
  - 1983: The Islamic Banking Act; Bank Islam Malaysia Berhard granted a full banking license.
  - 1983: Government Investment Act initiating Shariah-compliant government bills.
  - 1984: Enactment of Takaful Act; Syarikat Takaful Malaysia Berhad commenced operation.
  - 1993: Introduction of Islamic windows for conventional banks.
  - 1994: Creation of the Islamic Interbank Money Market.
  - 1997: Establishment of the Shariah Advisory Council of Bank Negara Malaysia.
  - 2001: Formal prominence in the Financial Sector Master Plan and the Capital Market Master Plan; establishment of the Islamic Capital Market.
  - 2005: Malaysia Deposit Insurance Corporation created to ensure both conventional and Islamic deposits are guaranteed by a common deposit insurance system.
  - 2006: Government introduced a package of tax exemptions and incentives for Islamic finance.
  - 2009: Financial sector liberalization with nine new banking and insurance licenses to foreign institutions.
  - 2011: The 2011-2020 Financial Sector Blueprint to establish Malaysia as an international Islamic finance center.

### III. Islamic finance tax and regulatory incentives (Box 2)
- Tax neutrality provisions:
  - Income Tax Act (1967) equal footing provision: Shariah-compliant transactions are not taxed differently from conventional transactions; profits received in Shariah-compliant transactions treated same as interest rate gains for tax purposes.
  - Stamp Act (1949) equal footing provision: ensures transactions requiring additional sales/purchases of underlying assets remain tax neutral; partnership-like Shariah joint ventures not recognized as partnerships for tax purposes.
- Additional Islamic finance tax incentives:
  - Tax exemption for profits derived from Sukuk.
  - 10-year tax exemption for Islamic banks and Islamic insurance companies on income derived from business conducted in foreign currencies, including transactions with Malaysian residents.
  - 10-year income tax exemption for domestic and foreign fund managers who manage Islamic funds for foreign investors.
  - 3-year stamp duty exemption of 20 percent on instruments related to Islamic financing.
  - Tax deductions on expenses incurred in establishing an Islamic stock broking firm.
  - Tax exemption on profits paid by licensed Islamic banks in Malaysia to non-resident customers.

### IV. Stylized facts on capital markets and banking sector
- Bond market size and composition:
  - Malaysia’s bond market rose to US$ 269 billion as at end-June 2011, making Malaysia the third largest debt market in Emerging East Asia (Table 1).
  - The ratio of local currency bonds outstanding to GDP stood at 103.5 percent in mid-2011.
  - Government bond sector constitutes about 60 percent of the market.
  - Year-on-year growth rate in 2011Q2: government sector 20.9 percent, corporate sector 11.1 percent.
  - Banks and government-linked corporations (GLCs) account for about 80 percent of corporate debt issuance.
- Foreign holdings and issuance:
  - In mid-2011, nonresident holdings of Malaysia sovereign debt reached 24.6 percent of total government bonds outstanding (Figure 4).
  - Examples of sovereign and corporate issuance attracting international demand: Malaysia’s US$ 2 billion global Sukuk in July 2011; Khazanah RMB 500 million renminbi-denominated Sukuk in September 2011.
- Islamic bond market:
  - Islamic securities account for about 40 percent of sovereign and corporate bond issuance (Figure 5).
  - Domestic corporate Islamic bonds outstanding: US$ 34 billion.
  - Sukuk issuance is becoming cheaper and more cost-effective; some Sukuk issues have a few basis points advantage over conventional bonds (example: Cagamas conventional 3-year bond yield 3.5 percent vs Islamic bond yield 3.48 percent in 2010:Q3).
- Equity market:
  - On Bursa Malaysia, nearly 90 percent of listed securities are Shariah-compliant; these account for two-thirds of stock market capitalization and 70 percent of the FTSE Bursa Malaysia EMAS Index (by market capitalization).
  - FTSE Bursa Malaysia EMAS Shariah Index slightly outperformed the overall EMAS Index since early 2010 (Figure 6).
- Banking sector structure and size:
  - Total banking institutions: 24 commercial banks and 17 Islamic banks; 11 banks operate under both laws (Islamic and conventional parts treated separately in statistics) (Figure 7).
  - Conventional banks hold about 80 percent of total banking assets, loans, and deposits (Table 2).
  - On average, Islamic banks’ balance sheets are 3 times smaller than commercial banks’ balance sheets.
  - Market share of Islamic banking assets: 21.6 percent of total banking assets in Malaysia as of September 2011, rising from 12 percent in December 2006 (Figure 2).

### V. Empirical findings summarized
- Drivers of returns:
  - Returns on Malaysian security prices are driven by common economic factors, with changes in domestic economic activity and inflation being most important and global factors affecting equity indices only.
- Comparisons between Islamic and conventional instruments:
  - Differences between returns on Islamic and conventional bonds are not statistically significant.
  - Differences between Islamic and conventional banks are not statistically significant, especially in the most recent years.
  - Interpretation: the gap between Islamic and conventional financial practices is shrinking.

### VI. Market dynamics and demand
- Demand characteristics:
  - The majority of Islamic finance customers are non-Muslims, with an increasing presence of foreign investors (PricewaterhouseCoopers Malaysia, 2008).
  - Demand for sovereign Sukuk appears to exceed supply, driven by high demand from Islamic banks in Malaysia and foreign investors (BMB Islamic, 2011).
- Issuers’ preferences:
  - Issuers often have no preference between Sukuk and conventional debt; issuance type is determined by market conditions.
  - Sukuk issued in Malaysia are reported by market participants to be very comparable to conventional bonds in both economic and legal terms.

*Source: _wp12151 - References*

### Box 2 for details).

### _wp12151 - Box 2 for details)

### Data description and sample
- Data sources: Bloomberg; FTSE Bursa Malaysia EMAS Index; FTSE Bursa Malaysia EMAS Shariah Index. Sample period: January 2006 through November 2011.
- Government securities: indices based on medium-term (3 to 10 years) conventional and Islamic government bonds (Malaysian Government Securities and Government Investment Issues).
- Corporate fixed-term debt: indices constructed from Bloomberg pricing data for largest corporate issuers listed in Asian Development Bank (2011); most liquid medium-term issues weighted by size of issuance. Corporate indices dominated by government-linked companies, banks, and financial corporations.

### Co-movement and correlations
- For government conventional and Islamic bonds, the correlation between monthly returns was 0.95 during the sample period.
- For the equity indices, the correlation between monthly returns was almost 0.99.
- For corporate bonds, the co-movement was 0.32, likely reflecting 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.

### Banking sector size (Table 2: Malaysia: Size of the Banking Sector)
(In US$ millions)
- Number of banks: Conventional banks 24; Islamic banks 17; Islamic banks' market share (in %) 41
- Total assets: Conventional banks 446,075; Islamic banks 97,488; Islamic banks' market share (in %) 18
- Average bank size: Conventional banks 18,586; Islamic banks 5,735; Islamic banks' market share (in %) -
- Total loans: Conventional banks 258,296; Islamic banks 60,168; Islamic banks' market share (in %) 19
- Total deposits: Conventional banks 318,561; Islamic banks 76,610; Islamic banks' market share (in %) 19
- Source: Securities Commission Malaysia (2011).

### Principal component analysis — contributions to variation
- About 40 percent of the variation in all returns can be explained by a “common economic factor” (Figure 10).
- Whether the security is a stock or a bond explains a further 33 percent of the variation.
- Differences between types of issuers account for 18 percent of changes.
- Whether the security is Islamic or not explains very little variation in the data.
- For bond returns only:
  - The common economic factor explains 60 percent of the variation.
  - Differences between public and corporate issuers explain 28 percent of changes.
  - Differences between Islamic and conventional bonds provide little information about bond price movements.

### Factor loadings and sensitivities
- Factor loadings for the common economic factor are larger for Sukuk than for conventional bonds.
- This is particularly pronounced for corporate debt, implying Sukuk prices are more sensitive to changes in the macroeconomic setting than conventional corporate debt.
- Returns on the broad equity index are more strongly correlated with the economic factor than returns on the Islamic equity index.
- Overall, common factor loadings for stock returns are much lower than for bonds.

### Regression analysis — drivers of returns
- Bond returns (conventional and Islamic) are driven by domestic economic factors, in particular domestic industrial production growth and inflation (Box 3).
  - Parsimonious models explain about 50 percent of the variation in government bond returns (marginally more in conventional bonds).
  - Models explain 46 percent of changes in corporate conventional bond returns.
  - Models explain 24 percent of changes in corporate Sukuk returns.
  - During calm periods, both bond types are negatively correlated with rising inflation and positively correlated with higher industrial production growth.
- Equity returns are determined mostly by global factors.
  - Domestic factors alone account for only about 15 percent of changes in the equity returns.
  - Global factors explain about 50 percent (marginally less for Islamic stocks).
  - During tranquil periods, equity prices tend to rise as risk sentiment improves and the U.S. stock markets strengthen.
  - Equity returns are correlated positively with lower inflation and higher industrial production.

### Crisis dynamics
- Strong evidence of investors’ flight-to-quality during the 2008−2009 crisis: as financial and economic conditions worsened, investors sold higher-risk equity assets (description continues in source).

### Box 3: Empirical analysis specification notes
- Method: Regress monthly returns on contemporaneous economic and financial variables; start with a large set of variables and narrow to most significant.
- Equity return specification includes industrial production growth in Malaysia (∆IP) and allows for different correlations during crisis periods and autoregressive behavior.
- Crisis indicator I is 1 between September 2008 and September 2009, and then again between August 2011 and November 2011; and 0 otherwise.
- For bond return equations, global variables are statistically insignificant; regressions use domestic variables.
- Data frequency and transformations: Monthly data for January 2006-November 2011. Most explanatory variables in first log differences; T-bill interest rate in first difference.
- Estimation: Newey-West standard errors to account for heteroskedasticity and autocorrelation in residuals.

### Table: Impact of 1 Percentage Point Increase in a Macroeconomic Factor on Monthly Bond and Equity Returns
Non-crisis period
- Inflation                                                             -0.72 * -1.02 * -0.13  * -0.44  * -1.61  * -1.18  *
- IP growth 0.03 0.04 0.04 0.00 0.46  * 0.43  *
- S&P500 0.37  ** 0.48  **
- VIX -0.06 -0.04

Crisis period
- Inflation                                                             -2.19 ** -2.17 -0.08 -0.41 -3.31  * -3.24  *
- IP growth -0.10 * -0.04 * 0.02  * -0.03  * 0.99 0.92
- S&P500 0.29  ** 0.24  *
- VIX -0.17* -0.18*

Table summary statistics
- Number of observations               71               71                71               71                71                 71 
- R-squared for domestic factors only 0.48 0.44 0.46 0.24 0.16 0.14
- Overall R-squared 0.48 0.44 0.46 0.24 0.67 0.61

Column labels (from source table)
- Government conventional bond
- Government Islamic bond
- Corporate conventional bond
- Corporate Islamic bond
- Broad equity index
- Islamic equity index

- Source: Bloomberg, Haver, and IMF staff estimates.
- Note: Sample period: January 2006-November 2011. A single asterisk denotes a coefficient significant at 5 percent level, a double asterisk denotes a coefficient significant at 10 percent level.

*Source: IMF staff analysis in _wp12151 - Box 2 for details).*

### Box 4. Malaysia: Strength and Profitability of Islamic and Conventional Banks

### Box 4. Malaysia: Strength and Profitability of Islamic and Conventional Banks

### Methodology
- Sample period: 2006−2010 (annual data).
- Cross-section: 11 largest conventional banks and 11 largest Islamic banks (by total assets).
- Seven Islamic and conventional banks in the sample belong to the same financial group and report as separate entities.
- Dependent variables: financial ratios from BankScope:
  - Capital adequacy: capital adequacy ratio (CAR);
  - Profitability: return on equity (ROE) and net interest margin (NIM);
  - Quality of assets: non-performing loans to total loans ratio (NPL);
  - Liquidity: liquid assets to total assets ratio and interbank assets to interbank loans ratio;
  - Leverage: total assets to equity ratio.
- Explanatory variables: dummies for Islamic banks and for large banks (large banks = banks holding at least 10 percent of overall banking assets throughout the sample: Maybank, CIMB Bank Berhad, and Public Bank Berhad).
- Estimation: panel regressions with White cross-section standard errors to account for contemporaneous correlation and heteroscedasticity.
- Subsample analysis by period: (1) pre-crisis 2006-2007; (2) crisis 2008-2009; (3) 2010 only.

### Average financial ratios (table highlights)
Table: Malaysia: Average Financial Ratios for Conventional and Islamic Banks (In percent, unless otherwise noted)
Periods across columns are in order: 2006-2010 | 2008-2009 | 2006-2007 | 2010
- Capital adequacy ratio (Conv. / Islamic):
  - 2006-2010: 14.0 / 15.1 *
  - 2008-2009: 13.3 / 15.1 *
  - 2006-2007: 14.2 / 14.5 *
  - 2010: 14.8 / 16.4
- Profitability — ROE (Conv. / Islamic):
  - 2006-2010: 16.4 / 22.1
  - 2008-2009: 15.4 / 40.2
  - 2006-2007: 17.8 / 11.0 *
  - 2010: 16.5 / 10.8 *
- Profitability — NIM (Conv. / Islamic):
  - 2006-2010: 2.9 / 3.4 *
  - 2008-2009: 3.0 / 3.1 *
  - 2006-2007: 3.0 / 3.6 *
  - 2010: 2.8 / 3.5 *
- Quality of assets — NPL (Conv. / Islamic):
  - 2006-2010: 4.4 / 6.0 *
  - 2008-2009: 6.4 / 7.9 *
  - 2006-2007: 3.5 / 4.9 *
  - 2010: 2.7 / 4.6
- Liquidity — Liquid assets to total assets ratio (Conv. / Islamic):
  - 2006-2010: 23.9 / 34.7 *
  - 2008-2009: 24.8 / 45.3 *
  - 2006-2007: 23.6 / 29.8
  - 2010: 23.2 / 25.1
- Liquidity — Interbank assets to interbank loans ratio (Conv. / Islamic):
  - 2006-2010: 36.1 / 106.8 *
  - 2008-2009: 39.8 / 192.6 *
  - 2006-2007: 32.1 / 63.3 *
  - 2010: 37.5 / 27.9
- Leverage — total assets to equity ratio (Conv. / Islamic):
  - 2006-2010: 15.3 / 12.1
  - 2008-2009: 16.3 / 8.6 *
  - 2006-2007: 14.9 / 15.2 *
  - 2010: 14.1 / 12.5
- Total assets (in US$ billions) (Conv. / Islamic):
  - 2006-2010: 17.3 / 3.9 *
  - 2008-2009: 14.5 / 2.1 *
  - 2006-2007: 17.6 / 4.5 *
  - 2010: 22.0 / 6.1 *

Note: Asterisks denote ratios statistically different between conventional and Islamic banks at 10 percent level (Wald test with White cross-section standard errors).

### Key empirical findings
- Capital:
  - Panel analysis: Islamic banks’ CAR was significantly higher than conventional banks’ CAR in 2006−07 and during the global financial crisis, but not in 2010.
  - As of June 2011, capital and reserves to total assets: Islamic banks 7.5 percent, conventional banks 9.3 percent.
- Profitability:
  - Islamic banks exhibited higher ROE in the run-up to the crisis; during the crisis Islamic ROE was much larger; since the crisis conventional banks are significantly more profitable.
  - Islamic banks consistently show higher NIM over the whole sample period.
- Asset quality:
  - Islamic banks show higher NPL ratios than conventional banks across most periods in the sample.
- Liquidity and interbank position:
  - Islamic banks were net lenders in the interbank market in 2006−07 (interbank assets to interbank loans ratio 192.6 percent) but became net borrowers by 2010 (27.9 percent).
  - Conventional banks’ interbank assets to interbank loans ratio remained relatively stable at around 32−40 percent.
  - Islamic banks have higher liquid assets to total assets ratios in earlier periods, but the gap narrows by 2010.
- Balance-sheet size and funding:
  - Islamic banks had smaller total assets (e.g., US$ 3.9 billion vs. US$ 17.3 billion over 2006-2010 average).
  - Total deposits to total assets: Islamic banks 77 percent, conventional banks 72.3 percent (as of June 2011).
  - Islamic banks depend more on wholesale funding than conventional banks.

### Loan portfolio structure and implications
- Loan composition differences:
  - 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 (textual description preserved).
  - 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 across bank types.
- Interpretation:
  - Higher concentration of car and personal loans in Islamic banks explains higher NIMs and contributes to higher NPL ratios, implying business-model differences drive performance differentials.

### Additional quantitative context
- Global Islamic finance growth: Islamic financial assets expanded US$ 1,086 billion in 2011, a 21-percent growth over the previous year (Oakley, 2011).
- Sample and data sources: BankScope, Bloomberg, Haver, Bank Negara Malaysia statistics, and IMF staff estimates.

### Policy implications and recommendations
- Regulatory convergence:
  - Empirical results suggest systematic differences between conventional and Islamic banks have diminished and appear due to business models rather than Shariah principles.
  - Conventional and Islamic banks should be subject to the same sound regulatory and supervisory standards consistent with Basel principles.
- Supervision and prudential standards:
  - Bank Negara Malaysia (BNM) should focus on strengthening prudential standards and the supervisory framework for Islamic financial services.
  - Avoid ad hoc, individual guidelines that diverge from Basel principles solely on the basis of Shariah advisory boards’ interpretations.
- Market development:
  - Government support (including government and quasi-government issuance of Sukuk and government deposits to Islamic banks) has helped market development; as the industry matures, government support should be gradually withdrawn.
  - Malaysia’s efforts should prioritize establishing an internationally consistent, robust regulatory and supervisory framework and harmonizing Shariah rulings and interpretations within Malaysia and across countries.
- Inclusion:
  - Offering Islamic alternatives has increased access to finance for the under-banked Muslim population; microfinance under Islamic finance remains a small but important area to expand.

*Source: IMF staff analysis and BankScope, Bloomberg, Haver (as presented in the source document).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp12151.pdf_