ROME: The development of the legal and regulatory framework for Islamic financial services industry in Malaysia is grounded on the principle of neutrality in ensuring no worse-off treatment when compared to conventional finance in terms of the taxation, laws and regulations, said Bank Negara Malaysia governor Tan Sri Dr Zeti Akhtar Aziz.

She said given that Malaysia's Islamic financial system operated in parallel with the conventional system, attention needed to be given to avoid the potential for regulatory arbitrage that may result in distortions that undermined the environment of a level playing field between conventional finance and Islamic finance.

"While the inherent strengths of Islamic finance have contributed to its viability and resilience, going forward the foundations for its sustainability as a competitive form of financial intermediation continues to be strengthened.

"Concerted efforts are underway focusing on the further development of the Islamic financial markets, the financial infrastructure, the investment in research and development to support innovation, and enhancing further the legal, regulatory and supervisory framework," Zeti said in her keynote address "Islamic Finance: A Central Bank's Perspective" at the Banca D'Italia seminar on Islamic finance here on Nov 11.

The text of her speech was released in Kuala Lumpur on Nov 12.

Zeti said it was important to facilitate a more inclusive arrangement that allowed for greater interface and inter-linkages across jurisdictions and participation with the European financial systems would form an important linkage between the East and the West.

"In our pursuit and commitment to strengthening the resilience of Islamic financial industry and to enhance these linkages would not only have the potential to contribute towards global financial stability but also to the prospects for global growth," she said.

She said two important trends had increased the integration of Islamic finance into the international financial system -- the accelerated development of the Islamic financial markets and increased liberalisation.

Zeti said the higher level of foreign participation had resulted in the increase in cross-border flows, thereby enhancing international financial linkages between financial systems, and it was necessary to facilitate the potential for liquidity management across borders.

She said as part of an international collaborative effort, a Task Force on Liquidity Management was set up by the Islamic Financial Services Board (IFSB) and the Islamic Development Bank early this year to develop solutions to enhance the efficiency of Islamic institutions in managing liquidity at both the national and international levels.

She also said a further area of international collaboration was towards promoting value-added investment in human capital building as a long-term solution to sustainable growth of the Islamic financial industry.

Zeti said Malaysia had developed a comprehensive Islamic financial system that included the banking and takaful industry, other specialised financial institutions and the Islamic money and capital markets.

She said the supporting financial infrastructure included a robust regulatory and supervisory framework reinforced by the legal and syariah framework, the payment and settlement systems, the development of the pool of expertise and talent to support the industry.

Zeti said the sukuk market, the Islamic bond market, was fast emerging as the most significant form of financing that continued to receive strong interest as a means for raising funds and for investment.

She said the global sukuk market had been increasing at an average annual rate of 40%, with 90% of the issuances by the corporate sector, and in Malaysia, the issuance of sukuk had now surpassed the issuance of conventional bonds.

"The sukuk is therefore not only an attractive instrument for investment but it is also a competitive means for raising long term funding needs," she said.

Zeti said integral to the efforts in the development of Islamic finance was the strengthening of the regulatory and supervisory framework.

"While the basic legal, regulatory and supervisory framework that takes into account the distinctive features of Islamic finance are already in place, efforts are now underway to put in place a comprehensive infrastructure to deal with the new challenges confronting the international financial system," she said.

Zeti said looking beyond the current crisis, an integrated crisis management framework would be part of the infrastructure, which included a more facilitative and modernised legal framework, and that the boundaries of the regulatory framework would also have to be regularly adapted to keep pace with the evolution and transformation of the financial system.

"Finally, the supervisory framework for Islamic finance is also being reinforced by a financial safety net framework that comprises the lender of last resort facility and a deposit insurance system. These financial arrangements are now in place in Malaysia," she said.

Zeti said also important were the institutional arrangements for resolution of troubled Islamic financial institutions.

"In Malaysia, we have in place a mandated resolution mechanism to provide for expedient, effective and cost efficient resolution of Islamic financial institutions.  

"Yet to be put in place however, is a mechanism for cooperation between regulators within and across jurisdictions for resolution to contain potential systemic risks beyond the national boundaries," she said.

Zeit said in 2008, the Taskforce on “Islamic Finance and Global Financial Stability” was formed by IDB and the IFSB, together with the industry leaders and international expertise, to examine further the building blocks in the Islamic financial infrastructure that needed to be put in place to ensure financial stability.