With eight full-fledged Islamic banks including three Middle East players, predominantly Muslim Malaysia has set the stage to become a key Islamic financial hub in the region, analysts say.
The central bank last week completed a plan to fast-track the liberalisation of the Islamic banking sector this year, three years ahead of the World Trade Organisation deadline in 2007.
It awarded the remaining two foreign Islamic banking licences to Saudi Arabia's largest bank Al Rajhi Banking and Investment and a consortium led by the Qatar Islamic Bank after granting the first one to Kuwait Finance House in May.
Three local banking groups - Hong Leong Bank, Commerce-Asset Holding Bhd. and RHB Capital - were also granted approvals recently to open Islamic banking arms, joining existing players Bank Muamalat and BIMB Holdings Bhd.
Analysts said the entrance of foreign players would push local banks to innovate and compete more aggressively in developing Islamic products and services.
While neighbouring Singapore and Hong Kong have established themselves as the financial centres in Asia, Malaysia is carving a niche to tap billions of dollars of Muslim funds seeking new investment homes after the 2001 terror attacks in the United States and uncertainties in the Middle East, they said.
"The intention of bringing in foreign players was not for them to compete in the local market but to use Malaysia as a springboard to do regional and global businesses, which will eventually raise Malaysia's profile as a global hub for Islamic finance and banking," said TA Securities research chief Ngu Chie Kieng.
Islamic banking, first introduced in mainly-Muslim Malaysia in 1983, combines Islamic laws against interest payments with modern banking principles.
The government has said it would gradually award Islamic banking licences to all banks as part of efforts to make the segment grow and encourage the expansion of such services offshore.
As of June, assets in Malaysia's Islamic banking sector stood at 89.1 billion ringgit (23.45 billion dollars), representing nearly 10 percent of the overall banking system, and the government aims to double this to 20 percent by 2010.
Avenue Securities analyst Chan Ken Yew said the new foreign players would bring in a different scope of experience and expertise in terms of Islamic-compliant products and services.
"These foreign banks will be able to help attract the inflow of funds from West Asia, a region with higher income per capita, so the pie can eventually grow bigger for everybody," he said.
But despite the huge potentials, Chan cautioned that the challenge for the Islamic banks were to ensure they have strong risk management.
"It is hard for Islamic banks to do hedging. They will not be able to capitalise on a high interest rate environment as they cannot pass on the high rates to the customers," he said, adding most banks generally favour conventional to Islamic banking.
Economists said there has been a boom in Islamic banking in the aftermath of the September 11 terror attacks in the United States as investors pulled funds out of the West. The Islamic finance market world-wide is estimated to be worth 200 billion dollars and is growing at 15 percent a year, they said.