A Practical Look at Malaysia’s Islamic Finance Framework

Recently, our Partner, Farhah A. Rustam, attended a short course on the regulatory framework governing Islamic finance and Commodity Murabahah (Tawarruq) in Malaysia.

In this short article, we share key takeaways from the session, focusing on regulatory structures, Shariah governance, contract enforcement, and the legal mechanics that underpin Tawarruq. While not exhaustive, these reflections offer a practical glimpse into how Islamic finance is applied, interpreted, and continuously refined within Malaysia’s legal and financial landscape, from SAC rulings and dual compliance to the contractual elements that determine enforceability in real-world transactions.

𝐁𝐲 Farhah A. Rustam, 𝐏𝐚𝐫𝐭𝐧𝐞𝐫, 𝐚𝐧𝐝 𝐇𝐞𝐚𝐝 𝐨𝐟 𝐨𝐮𝐫 𝐈𝐬𝐥𝐚𝐦𝐢𝐜 𝐅𝐢𝐧𝐚𝐧𝐜𝐞 𝐏𝐫𝐚𝐜𝐭𝐢𝐜𝐞

The Legal Framework

Islamic finance in Malaysia is supported by a multi-tiered regulatory framework, with different regulators overseeing distinct facets of the industry. The following provides a brief snapshot:

• Bank Negara Malaysia: Governs Islamic banks, Development Financial Institutions (DFIs), takaful operators.
• Securities Commission: Oversees Islamic capital markets, stockbroking, crowdfunding.
• Labuan Financial Services Authority: Covers offshore Islamic entities.

Yet, a notable takeaway is that not all Islamic financial activity is currently regulated. Unless a company falls within the defined perimeter of a licensed Islamic Financial Institution (“IFI”), it may operate outside direct oversight of the regulatory bodies, creating a “grey zone” the upcoming Consumer Credit Act (“CCA”) is expected to address.

The Shariah Advisory Council (“SAC”), established under the Central Bank of Malaysia Act 2009 (“CBMA 2009”), is the authority for the ascertainment of Islamic law for the purposes of Islamic financial business. The functions of the SAC under Section 52(1) of the CBMA 2009 includes:

• To ascertain the Islamic law on any financial matter and issue a ruling upon reference made to it.
• To advise BNM on any Shariah issue relating to Islamic financial business, the activities or transactions of BNM.
• To provide advice to any Islamic financial institution or any other person as may be provided under any written law.
• Such other functions as may be determined by BNM.

It is noteworthy how the SAC’s role is structured within the legal framework. Under Sections 56 to 58 of the CBMA 2009, when a Shariah-related question arises in court or arbitration proceedings involving Islamic financial business, the judge or arbitrator must either consider any published SAC rulings or refer the question to the SAC for a ruling.

Where such a reference is made, the SAC’s ruling is binding, not just on the Islamic financial institutions, but also on the courts and arbitrators involved. In the event of any conflicting interpretation from a Shariah body within an institution, the SAC’s position will prevail.

As such, while the SAC does not adjudicate disputes, its legal authority in ascertaining Shariah positions in financial matters carries real legal weight.

Dual Compliance for Islamic Financial Institutions

Operating as an IFI in Malaysia requires adherence to dual compliance frameworks: conventional regulatory requirements (such as AML/CFT and governance) alongside Islamic regulatory requirements.

Under the Islamic Financial Services Act 2013 (“IFSA 2013”), institutions must:

• Maintain internal Shariah governance structures (e.g. Shariah committees, internal Shariah departments).
• Vet all products for Shariah approval before launch.
• Conduct and prepare additional due diligence and documentation for transactions.
• Provide periodic Shariah audits.
• Notify BNM of any Shariah non-compliance.
• Avoid prohibited business conduct (for example, prohibited business conduct under Schedule 7 of IFSA 2013 includes engaging in conduct that is misleading or deceptive, or is likely to mislead or deceive).

Failing to do so risks not only reputational fallout but legal consequences. IFIs can face penalties, suspension of products, or operational restrictions for failure to comply.

Tawarruq & The Importance of the Contract

Commodity Murabahah, also known as Tawarruq, is one of the most used liquidity mechanisms in Malaysia. Under BNM’s 2018 Tawarruq Policy Document (“Policy”), Tawarruq consists of two sale and purchase contracts. The first involves the sale of an asset by a seller to a purchaser on a deferred basis. Subsequently, the purchaser of the first sale will sell the same asset to a third party on a cash and spot basis.

This structure ensures Shariah compliance by requiring actual transfer of ownership, valid asset selection (excluding gold, currency, debts, and under-construction assets), and possession before resale. The contracts must be binding, prices clearly agreed, and documentation comprehensive to reflect the purpose, whether for financing or deposit-taking.

In the Policy, IFIs must implement sound governance, transparent disclosure, and effective risk management to manage exposures throughout the Tawarruq’s lifecycle. Optional arrangements such as agency (wakalah), promises (wa`d), rebates (ibra’) and late payment charges are permissible within defined Shariah parameters to enhance flexibility while ensuring end-to-end Shariah compliance.

During the session, it was mentioned that the contractual structure underpinning any Shariah principle is central to ensuring Shariah compliance. This makes it critical for practitioners advising on Islamic finance to structure facility agreements with clear sequencing of transactions, proper asset descriptions, and pricing mechanics aligned with Shariah requirements.

Practitioners are also encouraged to incorporate a Shariah compliance clause in facility agreements, which may state the following:

• All SAC rulings published or referred are binding over the contracting parties;
• That the facilities and documents are Shariah compliant;
• That customers will not raise any issue or challenge the facility agreements on ground of Shariah non-compliance; and
• That customers agree to the variation of documents to the extent necessary to align the documents back to be Shariah compliant.

Conclusion

As Dr. Syed stated during the course – “To understand how Shariah laws are applied within Islamic finance in Malaysia, it is important to first understand conventional banking laws”. For practitioners, aligning Shariah compliance with Malaysia’s regulatory framework is not just a compliance exercise but a key aspect of managing legal and reputational risk in structuring Islamic finance transactions.

Looking ahead, it will be interesting to see how the CCA will shape the regulatory treatment of entities carrying on Islamic credit business and credit service business, bringing them within a clearer oversight framework while ensuring that Shariah compliance remains meaningful and enforceable within Malaysia’s legal and financial system.