LABUAN AS AN

INTERNATIONAL OFFSHORE FINANCIAL CENTER

A portfolio submitted in partial fulfillment of the

requirements for the award of the degree

Doctor of Business Administration

from

University of South Australia

by

Ricardo Osmund Yampil Baba

MBA (New Haven), BBA (Ohio) Dip. PA (ITM)

International Graduate School of Management

2004
OVERVIEW

This study was on the attributes necessary for the success of offshore financial centers, and
Islamic banking as the alternatives to conventional banking. The portfolio comprises of the
following three papers:

Paper One: Review of Offshore Financial Centers (page 1);

Paper Two: Analysis of Labuan Offshore Banking Industry (page 34); and
Paper Three: The Viability of Islamic Banking as a Niche for the Labuan IOFC (page 78).

The objective of Paper One was to review the literature on conditions necessary for the success
of offshore financial centers, and feasibility of Islamic banking as a niche for an offshore
financial center The review revealed that there were eight "necessary" conditions: a liberal
environment, strategic geographic location, stable political environment, stable economic
performance, the presence of international banks, quality labor force, a developed financial and
physical infrastructure, and the assurance of confidentiality and secrecy. Most of the studies on
offshore center revolved around these attributes. More recently, researchers had begun to look
at the idea of niches and specializations for offshore financial centers based on their
competitive advantages. Niches and specializations have become more feasible for some
offshore financial centers owing to the advances in information technology, as traditional ways
of providing financial services, which used to be confined to a specific location, can now be
geographically dispersed.
As to Islamic banking, the literature revealed a growing need for shari 'a-compliant banking
products and services among the religiously conscious Muslims. This was evident from the
phenomenal growth of Islamic banking during the last two decades. The literature also revealed
that the profit-and-loss-sharing mode of Islamic banking has created an imbalance between the
assets and liabilities sides of Islamic banks' balance sheets, thus creating a problem of excess
funds not finding enough shari 'a-compliant investments. The literature suggests that this
problem could be solved through an international Islamic financial center where such funds
could be centrally collected and channeled out to other regions for shari 'a-compliant
investments. Currently Bahrain and London are the main beneficiaries of Islamic funds, and
Labuan IOFC is also aspiring to be one.
In Paper Two the objective was to determine whether the Labuan IOFC possessed the
attributes to develop as an offshore financial center. The empirical study adopted was mail
survey method, where the officers responsible for the overall operations of the banks in Labuan
were asked to give their opinions and perceptions on the Labuan 10FC. The survey used the
whole population of 49 banks in operations of which 36 participated. The findings revealed that
the offshore banking business has declined since 1997. Some foreign banks have closed their
branches and the overall volume of business decreased for the last six years. The 1997-1998
Asian Crisis was partly to be blamed for the decline in offshore banking business. However, the
main reason for the decline was due to Labuan's lack of necessary conditions, especially
physical infrastructure and geographical location. Being in the middle of South-east Asia
Labuan is too close to Singapore and Hong Kong, which are viewed by offshore players as its
major competitors. To overcome these problems the concept of twinning Labuan with Kuala
Lumpur should be adopted. Such an arrangement would enable Labuan to capitalize on the
strength and attributes of Kuala Lumpur to face up to the challenges of Hong Kong and
Singapore.

Paper Three focused on the readiness of the conventional offshore banks in Labuan to adopt the
Islamic banking practices. As in Paper Two the empirical study adopted was also mail survey
method involving the same respondents, where they were asked to give their opinions and
perceptions of Islamic banking products and services, and Labuan's competitive edge as an
Islamic financial center compared to Bahrain and London. The findings revealed that offshore
bankers have a confused notion about Islamic banking, and their banks have very few officers
who could handle Islamic banking transactions. However, the findings also indicated that the
offshore banks were willing to train their officers in Islamic banking skills, and participate in
future syndications. The findings also revealed that Labuan has no competitive advantages
compared to Bahrain and London. As discussed in Paper Two Labuan lacks the necessary
conditions, especially physical infrastructure and geographical locations. To overcome these
problems Labuan ought to intensify the existing strategic alliance it has with Bahrain. This
partnership allows Labuan to use the experience and strength of Bahrain to develop Islamic
financial products and services, and market them in the Middle East.
 DOCTOR OF BUSINESS ADMINISTRATION

PORTFOLIO/DISSERTATION SUBMISSION
SUPERVISOR APPROVAL DECLARATION

Candidate Name: Ricardo Osmund Yampil Baba

UniSA Candidate ID Number: 001130940

Dear Sir

To the best of my knowledge, the portfolio contains all of the candidate's own work
completed under my supervision, and is worthy of examination.

I have approved for submission the portfolio that is being submitted for examination.

August 2, 2004
Signature: Supervis Date
Professor Slow Heng Lake

August 2, 2004
Sign ure: Supervisor Date
Dr Karlos Knapp

Supported by:

rofessor David Richards Date

CTiair, IGSM Doctoral Board of Examiners

iv
 DEDICATION

To:

My late father, Philip Baba;

My mother, Amelia Mintar Sulok;

My wife, Yvonne Melati Idang;

And my children Alfredo, Sofia, Lorenzo

and Claudia Baba.

For Thou hast been my help, and in the shadow of Thy wings I will sing joyfully!
(Psalm 63:7)

V
 DEDICATION

To:

My late father, Philip Baba;

My mother, Amelia Mintar Sulok;

My wife, Yvonne Melati Idang;

And my children Alfredo, Sofia, Lorenzo

and Claudia Baba.

For Thou hast been my help, and in the shadow of Thy wings I will sing joyfully!
(Psalm 63:7)

V
 DECLARATION

I hereby declare that this paper submitted in partial fulfillment of the DBA degree is my
own work and that all contributions from persons or sources are properly and duly cited. I
further declare that it does not constitute any previous work whether published or
otherwise. In making this declaration, I understand and acknowledge that any breaches of
this declaration constitute academic misconduct which may result in my exclusion from
the award of the degree.

Ricardo Osmund Yampil Baba Date: July 30, 2004

vi
 ACKNOWLEDGEMENTS

This thesis would not have been possible without the guidance, support and encouragement of

many people. Firstly, I thank Professor H. L. Siow of University Malaya, Kuala Lumpur, and

Dr. Karlos Knapp of the Indonesian Institute for Management Development, Jakarta, who

provided the academic supervisions for this thesis. Their timely feedback, constructive

criticism, directions and patience made the process an academically stimulating and rewarding

exercise. I also would like to extend my thanks for their mentorship and friendship, and pushing

me so that I could achieve my schedules. Secondly, I thank Associate Professor Dr. Zainal

Abidin Said, Dean of the Labuan School of International Business and Finance, University

Malaysia Sabah, Labuan International Campus for his understanding and flexibility which

made it possible for me complete this thesis on schedules. Thirdly, I would like to acknowledge

the moral support and industrial information provided by those Labuan offshore bankers.

Fourthly, I would like to extend my appreciation to Mr. Geoffrey Harvey Tanakinjal, Deputy

Dean of the School of International Business and Finance, and Ms. Mary Ellen Gidah, lecturer

of English with the Department of Promotion of Knowledge and Language, University

Malaysia Sabah, Labuan International Campus for their patience in editing the presentation and

language of this thesis. Last but not least, my deepest thanks go to my wife Yvonne Melati

Idang, and my children Alfredo, Sofia, Lorenzo and Claudia Baba for their tolerance and

support through my research.

vii
 List of Tables

Table page

1.1 Countries, Territories, Jurisdictions with

Offshore Financial Centers 6
1.2 Deposits and Loans of Non-bank Customers 13
2.1 Types of Operations 50
2.2 Type of Products and Services Offered by Labuan Offshore Banks 51
2.3 Treasury Operations 52
2.4 Intention to set up a Treasury 52
2.5 Business Affected by the 1997-1998 Asian Crisis 53
2.6 Business Five Years After the Crisis 53
2.7 Competitiveness of Labuan After the Crisis 54
2.8 What Most Likely to Happen within the Next 3 Years 55
2.9 Government Main Objectives of Setting up IOFC in Labuan 56
2.10 Restricting Number of KL Marketing Office Staff 57
2.11 Not Allowing Fronting 58
2.12 Reasons for Setting up Offices in Labuan 60
2.13 Access to Domestic Business 61
2.14 Threats to Labuan IOFC 62
2.15 Suitability as an Offshore Banking Center 65
2.16 Distribution of Respondents by Types of Operations and by Restricting
Number of KL Marketing Staff 66
2.17 Distribution of Respondents by Competitiveness After 1997-98 Crisis
And by Suitability as an Offshore Banking Center 67
3.1 Knowledge of Islamic Banking 94
3.2 Reasons to Select Islamic Banking 95
3.3 Same as Conventional Banking 96
3.4 Offshore Bankers Concerns about Islamic Banking 96
3.5 Liquidity of Islamic Banking Products & Services 98
3.6 Viability of Islamic Banking as a Niche 99
3.7 Labuan Advantages over London & Bahrain 99
3.8 Attributes of Labuan as an Islamic Offshore Financial Center 100
3.9 Distribution of Respondents by Viability as an Islamic as an Islamic
Financial Center (IFC) and by the Same as Conventional
Banking Products 101
3.10 Distribution of Respondents by Competitive Advantage (C/A) Over
Bahrain and London and by Make Lending Structure Complicated 102

viii
 LIST OF FIGURES

Figure page

2.1 Conceptual Framework for a Successful Labuan IOFC 46

3.1 Conceptual Framework of Islamic Banking as a Niche

for the Labuan IOFC 90

ix
 LIST OF ABBREVIATIONS

ACU Asian Currency Unit

ADIL Amanah Dar al-maal al-Islami
ADM Asian Dollar Market
AOB Association of Offshore Banks, Labuan
BG Bank Guarantee
BIMB Bank Islam Malaysia Berhad
BNM Bank Negara Malaysia
BVI British Virgin Island
CAP Client, Arena, Product
DMI Dar al-maal al-Islami
FSMP Financial Sector Master Plan
FATF Financial Action Task Force on Money Laundering
GNP Gross National Product
IBF International Banking Facilities
IBFIM Islamic Banking and Finance Institute Malaysia
IFC International Financial Center
IFSB Islamic Financial Services Board
IFSC International Financial Service Centre (Dublin)
IIFM International Islamic Financial Market
IMF International Monetary Fund
IOFC International Offshore Financial Centre (Labuan)
JOM Japanese Offshore Market
LOF SA Labuan Offshore Financial Services Authority
MSC Multimedia Super Corridor
MYR Malaysian Ringgit
OBA Offshore Banking Act 1990
OBU Offshore Banking Unit
OFC Offshore Financial Center
OPEC Oil Producing and Exporting Countries
PLS Profit-and-loss-sharing
SAC Shari'ah Advisory Council
SAR (Hong Kong) Special Administrative Region
SBLC Standby Letter of Credit
USD United States Dollar (USD1.00 = MYR3.80)
VAT Value-added Tax
 TABLE OF CONTENTS
page
PAPER ONE: A REVIEW OF OFFSHORE FINANCIAL CENTERS

ABSTRACT 1

CHAPTER ONE: AN OVERVIEW OF OFFSHORE FINANCIAL CENTERS 2

1.0 Introduction 2
1.1 Offshore Financial Centers: Definitions 3

1.2 Origins and Evolution of Offshore Financial Centers 4

1.3 Inception of the Labuan IOFC 7
1.4 Summary 8

CHAPTER TWO: TYPOLOGIES OF OFFSHORE FINANCIAL CENTERS 9

2.0 Introduction 9
2.1 Teleological Perspective 9
2.2 Services Provided and Stages of Development 10
2.3 Geographical Perspective 10
2.4 Functional and Geographical Perspectives 11

2.5 Historical and Neo-Marxist Perspectives 12

2.6 Islamic Financial Center 12
2.7 Labuan International Offshore Financial Centre 12

CHAPTER THREE: REQUIREMENTS FOR A SUCCESSFUL OFFSHORE

FINANCIAL CENTER 15
3.0 Introduction 15
3.1 Liberal Environment 15
3.2 Strategic Geographical Location 16
3.3 Stable Political Environment 17
3.4 Stable Economic Performance 18
3.5 The Presence of International Banks 18
3.6 Quality Labor Force 19
3.7 A Developed Financial and Physical Infrastructure 20
3.8 Assurance of Confidentiality and Secrecy 21

CHAPTER FOUR: NICHES AND SPECIALIZATIONS 22

4.0 Introduction 22
4.1 The Need to Develop Niches and Specializations 22
4.2 Islamic Financial Centers 23
4.2.1 Labuan as an Islamic Financial Center 24
4.2.2 Bahrain as an Islamic Financial Center for the Middle East 26
4.2.3 London as the Center for Islamic Finance in Europe 26

CHAPTER FIVE: SUMMARY AND RECOMMENDATIONS 27

5.0 Introduction 27
5.1 Summary of Literature Survey Results 27
5.2 Recommendations for Further Research 28

xi
REFERENCES 29

PAPER TWO: ANALYSIS OF THE LABUAN OFFSHORE BANKING INDUSTRY

ABSTRACT 34

CHAPTER ONE: INTRODUCTION 36

1.1 Organization of this Paper 37
1.2 Purpose of the Study 38
1.3 Research Objectives 38
1.4 Research Questions 38
1.5 Operational Definitions 39
1.5.1 Activities of the Labuan Offshore Banks 39
1.5.2 Functional, Paper, and Ancillary Centers 39
1.5.3 Labuan Offshore Banks' Businesses and Strategies 40
1.5.4 Offshore Banks' Recovery 40
1.5.5 Policies, Rules and Regulations 40
1.5.6 Competitive Advantages of Labuan 40
1.6 The Significance of this Study 41

CHAPTER TWO: REVIEW OF RELATED LITERATURE 42

2.0 Introduction 42
2.1 Empirical Studies on Offshore Financial Centers 42
2.2 Studies on the Labuan IOFC 43
2.3 Review of Research Methodology 44
2.4 Conceptual Framework 45

CHAPTER THREE: RESEARCH METHODOLOGY 47

3.1 Research Design 47
3.2 Sampling and Sample Size 47
3.3 Instrument Design 47
3.4 Data Collection Method 48
3.5 Data and Statistical Analysis 48

CHAPTER FOUR: FINDINGS AND DISCUSSIONS 49

4.0 Introduction 49
4.1 Profile of the Offshore Banking Business in Labuan 49
4.1.1 Types of Operations 49
4.1.2 Products and Services 50
4.1.3 Treasury Operations 51
4.2 Effects of the 1997-1998 Asian Crisis 52
4.2.1 Labuan Offshore Banks' Performance 52
4.2.2 Labuan's Competitive Edge 54
4.2.3 Strategic Changes in the Next Three Years 54
4.3 Policies and Regulations 55
4.3.1 Objectives of Establishing the Labuan IOFC 55
4.3.2 Kuala Lumpur Marketing Office 56
4.3.3 Fronting by Labuan Banks 57

xii
4.4 Competitive Advantages of the Labuan IOFC 58
4.4.2 Reasons for Setting up Operations in Labuan 58
4.4.2 Threats to the Labuan IOFC 62
4.4.3 Suitability of Labuan as an Offshore Banking Center 63
4.4.4 Suitability of Kuala Lumpur as an Offshore Banking Center 64
4.5 Relationships of Selected Variables 65
4.5.1 Relationships Between Types of Operations and Restricting Number of
Kuala Lumpur Marketing Staff 65
4.5.2 Relationships Between Competitiveness of Labuan After 1997-98 Crisis
And Suitability of Labuan as an Offshore Banking Center 66

CHAPTER FIVE: SUMMARY AND CONCLUSION 68

5.0 Introduction 68
5.1 Summary of Findings 68
5.1.1 The Profile of the Offshore Banking Business 68
5.1.2 Effects of the 1997-1998 Asian Crisis 68
5.1.3 Policies and Regulations 69
5.1.4 Competitive Advantages of the Labuan IOFC 69
5.1.5 Relationships of Selected Variables in Relation to the Suitability of Labuan
as an Offshore Banking Center 70
5.2 Limitations of the Study 70
5.3 Implications of the Findings 71
5.4 Future Research Directions 73
5.5 Conclusion 73

REFERENCES 75

PAPER THREE: THE VIABILITY OF ISLAMIC BANKING AS A NICHE

FOR THE LABUAN IOFC

ABSTRACT 78

CHAPTER ONE: INTRODUCTION 80

1.1 Organization of this Paper 81
1.2 Purpose of the Study 81
1.3 Research Objectives 82
1.4 Research Questions 82
1.5 Operational Definitions 83
1.5.1 Knowledge of Islamic Banking 83
1.5.2 Perceptions Towards Islamic Banking Products 83
1.5.3 Liquidity of Islamic Banking Products 83
1.5.4 Viability of Islamic Banking as a Niche for the Labuan IOFC 83
1.5.5 Competitive Advantages of Labuan as an Islamic Banking Center 84
1.6 The Significance of this Study 84

CHAPTER TWO: REVIEW OF RELATED LITERATURE 85

2.0 Introduction 85
2.1 Historical Background of Islamic Banking 85
2.2 Empirical Studies on Customers' Perceptions of Islamic Banking 86
2.3 Studies on Islamic Banking in Relation to Labuan 88
2.4 Review of Research Methodology 88
2.5 Conceptual Framework 89

CHAPTER THREE: RESEARCH METHODOLOGY 91

3.1 Research Design 91
3.2 Sampling and Sample Size 91
3.3 Instrument Design 91
3.4 Data Collection Method 92
3.5 Data ;and Statiscal Analysis 92

CHAPTER FOUR: FINDINGS AND DISCUSSIONS 93

4.0 Introduction 93
4.1 Knowledge of Islamic Banking 93
4.2 Islamic Banking Products and Services 94
4.2.1 Reasons for Clients' Preference for Islamic Banking Products 94
4.2.2 Similarities of Islamic and Conventional Banking Products 95
4.2.3 Operational Complexity of Islamic Banking 96
4.3 Islamic Banking as a Niche for the Labuan IOFC 97
4.3.1 Liquidity of Islamic Banking Products and Services 97
4.3.2 Viability of Islamic Banking as a Niche for the Labuan IOFC 98
4.4 Competitive Advantages of Labuan as an Islamic Financial Center 99
4.5 Relationships of Selected Variables 101
4.5.1 Relationships Between Viability as an Islamic Financial Center and Offshore
Bankers' Perceptions of Islamic Banking Products 101
4.5.2 Relationships Between Labuan's Competitive Advantage Over Bahrain and
London and Offshore Bankers' Perceptions of Islamic Banking Practices 102

CHAPTER FIVE: SUMMARY AND CONCLUSION 103

5.0 Introduction 103
5.1 Summary of Findings 103
5.1.1 Knowledge of Islamic Banking 103
5.1.2 Islamic Banking Products and Services 103
5.1.3 Viability of Islamic Banking as a Niche For the Labuan IOFC 103
5.1.4 Competitive Advantages of Labuan as an Islamic Financial Center 104
5.1.5 Relationships of Selected Variables in Relation to the Viability of Labuan
as an Islamic Financial Center 104
5.2 Limitations of the Study 104
5.3 Implications of the Findings 105
5.4 Future Research Directions 107
5.5 Conclusion 107

REFERENCES 109

APPENDIX I 112

APPENDIX II 122

xiv
PAPER ONE: A REVIEW OF OFFSHORE FINANCIAL CENTERS

ABSTRACT
Offshore Financial Centers (OFCs) operate in a rapidly changing and increasingly competitive
environment. To remain competitive in such an environment an OFC must be innovative and
ready to align its strategies to the current market realities. This paper is a literature survey
examining the origins and evolutions of OFCs, the types of OFCs, the requirements for a
successful OFC, niches and specializations, the concept of an Islamic financial center, and the
feasibility of Islamic finance as a niche for an OFC. The survey revealed three major findings.
Firstly, the phenomenal growth of OFCs in the 1960s and 1970s was due to the imposition of
distortionary regulations on the financial sectors in the United States and Europe, the inception
of the Eurodollar market, the oil crisis, and failure of the fixed rate system. These factors
directly contributed to the growth of the Bahamas and the Caribbean OFCs. The period of
1960s through 1990s witnessed the growth of OFCs in Asia as a consequence of their fast
growing economies. Singapore launched the Asian Dollar Market (ADM) in 1968, Japan
established the Japanese Offshore Market in 1986, and Malaysia launched the Labuan
International Offshore Financial Centre (IOFC) in 1990. Secondly, for an OFC to be successful
it must have the "necessary" conditions such as a liberal environment, strategic geographical
location, stable political environment, stable economic performance, the presence of
international banks, quality labor force, developed financial and physical infrastructure, and the
assurance of confidentiality and secrecy. Singapore and Hong Kong are examples of OFCs that
have all these attributes. Thirdly, to remain competitive OFCs must develop niches and
specializations based on their competitive advantages. With the advances in information
technology the development of niches and specializations has become relatively easier, as
traditional ways of providing financial services, which used to be confined to a specific
location, can now be geographically dispersed. For example, Jersey specialized in trust and
private banking, Bermuda, the Cayman Island, and Guernsey in offshore captive insurance, and
Dublin's International Financial Services Centre (IFSC) in corporate treasury operations for
multinational companies. Lastly, there is a growing need for Islamic financial products and
services among the 20% of the world population who adhere to Islam. However, Islamic
finance is facing the problem of excess liquidity, which calls for an International Islamic
Financial Center (IIFC) for solutions. With more than two decades of experience in operating
domestic Islamic banking the Malaysian government believes that it can help solve this
problem by creating Islamic finance as a strategic niche for the Labuan IOFC.

1
CHAPTER ONE:
AN OVERVIEW OF OFFSHORE FINANCIAL CENTERS

1.0 Introduction
An Offshore Financial Center (OFC) is a location, which may be a small state or a
jurisdiction separated from the main state by geography, and or by legislation, where
international financial transactions take place with minimum or no restrictions. According to
Hughes and MacDonald (2002) the origin of OFCs can be traced back to the creation of nation-
state in the 1600s. However, the proliferation of OFCs is a recent phenomenon. OFCs initially
emerged in the early 1960s as a direct consequence of regulatory constraints imposed on their
financial institutions by both the United States and countries in Europe (Cobb 1998; Hudson
1998; Jones 1992; Goldberg, Helsley & Levi 1988; Lee 1986; Francis 1985; Chrystal 1984;
Park 1982; Wallich 1979). These constraints made it very difficult for commercial banks,
especially in the United States to borrow from the money market. To overcome this problem,
American banks opened branches in the Bahamas and the Caribbean to source funds from the
London Eurodollar market (Suss, Williams & Mendis 2002; Francis 1985).
The period of 1960s through 1990s witnessed the growth of OFCs in Asia as a
consequence of their fast growing economies (Felmingham & Dean, 1998). Singapore launched
the Asian Dollar Market (ADM) and introduced the Asian Currency Units (ACU) in 1968 (Tan
1982), and Japan established the Japanese Offshore Market (10M) in 1986 (Errico &Musalem
1999). In Malaysia the Labuan International Offshore Financial Center (IOFC) was established
in 1990 to complement the domestic financial market in financing the high-growth Malaysian
economy, and as a mean for regional development (BNM 2001; Abbott 1999).
This paper is a literature review, and the first part of a three-part study on Labuan 10FC.
The other two papers are empirical studies employing the methodology of mail survey
questionnaires. The review covers both traditional international financial centers such as
London, New York, and Tokyo, and the relatively newer offshore financial centers such as the
Bahamas, Bahrain, Hong Kong, and Singapore. By studying both categories a broad overview
of offshore financial centers can be obtained. The survey reported in this paper sought to
identify the reasons why some OFCs were successful whereas others failed, so that an aspiring
OFC like Labuan can learn from their collective experiences. A review of niches and
specializations is also done in order to gain insight into how some OFCs have found niches and
specializations for themselves. In view of the Malaysian government's choice of Islamic

2
finance as a niche for the Labuan IOFC (BNM 2001), this paper also covers the review of
Islamic finance and Islamic financial center.
This paper is organized as follows: Chapter One provides an overview of offshore
financial centers, the definitions and evolution. Chapter Two identifies the different typologies
of offshore financial centers and their roles. Based on these typologies and roles efforts are
made to identify a typology, which best describe Labuan. Chapter Three analyzes the factors
that contribute to the success of offshore financial centers. Chapter Four discusses the need for
specializations, the concept of an Islamic financial center, and Islamic finance as a niche for
Labuan. Chapter Five summarizes the review, and offers recommendations for further empirical
research on both offshore and Islamic banking in Labuan.

1.1 Offshore Financial Center: Definitions

There is no consistent definition in the literature as to what constitutes an offshore
financial center (OFC). The terms offshore financial centers, offshore banking centers, tax
havens, booking centers and others have been used interchangeably. Among the earlier attempts
to define an offshore financial center is found in the work of McCarthy (1979), and Wallich
(1979).
McCarthy (1979), in 'Offshore Banking Centers: Benefits and Costs' defines offshore
financial centers as:
Countries, areas, or cities which have made a deliberate attempt to attract international banking
business (nonresident, foreign-currency denominated assets, and liabilities) by reducing or
eliminating restrictions upon operations as well as lowering taxes and/or other levies (McCarthy
1979, p. 45).

McCarthy identifies 21 centers that qualify under this definition including Hong Kong
and Singapore. McCarthy's view is reflected in Palan (1998, p. 66) where offshore financial
centers are defined as "centers that offer an array of tax and regulatory incentives for non-
resident investors and the complete flexibility granted to the management".
Wallich (1979, p. 315) defines an offshore financial center as "a location where funds
are borrowed from nonresidents and lent to other nonresidents through the intermediation of
banks and other financial institutions"
A more recent and comprehensive definition of an offshore financial center is found in
the work of Hampton (1994), in 'Treasure Island or Fool's Gold: Can and Should Small Island
Economies Copy Jersey?'
A center that hosts financial activities that are separated from major regulating units (states) by geography
and or by legislation. This may be a physical separation, as in an island territory, or within a city such as
London or the New York International Banking Facilities (Hampton 1994, p. 237).

3
 Cobb (1998, P. 8) in 'Global Finance and the Growth of Offshore Financial Centers:
The Manx Experience' has cited Hampton's definition as the current definition of an offshore
financial center.
However, rather confusingly the International Monetary Fund (IMF) only considers tax
havens as offshore financial centers (Palan 1998), London, New York, and Tokyo are more
pragmatically described as "International Financial Centers" (IMF 2000, p. 3). Errico and
Musalem (1999) in the IMF Working Paper, 'Offshore Banking: An Analysis of Micro- and
Macro-Prudential Issues' describe offshore financial centers as:
jurisdictions where offshore banks are exempted from a wide range of regulations, which are normally
imposed on onshore institutions. Specifically, deposits are not subjected to reserve, banks transactions are
mostly tax-exempt or treated under a favorable fiscal regime, and they are free of interest and exchange
rate restrictions. Moreover in many cases, offshore bank are exempt from regulatory scrutiny with respect
to liquidity or capital adequacy. Information disclosure is also low (Errico & Musalem 1999, p. 6).

In another report 'Offshore Financial Centers IMF Background Paper' the International
Monetary Fund (2000), defines an offshore financial center as:
a center where the bulk of the financial sector activity is offshore on both sides of the balance sheet, (that
is the counter-parties of the majority of financial institution liabilities and assets are non-residents), where
the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled
by non-residents; jurisdictions that have relatively large numbers of financial institutions engaged
primarily in business with non-residents; financial systems with external assets and liabilities out of
proportion to domestic financial intermediation designed to finance domestic economies; centers which
provide some or all of the following services: low or zero taxation; moderate or light financial regulation;
banking secrecy and anonymity (IMF 2000, p. 3).

The inconsistency of definitions given by different writers reflects the dynamic nature
of offshore financial centers. McCarthy and Wallich's definitions are very appropriate when
OFCs were on island territories and small states outside the countries of their clients.
Hampton's work takes into account of the new phenomenon of the "on-shore" offshore
financial centers after the establishment of the International Banking Facilities (IBFs) in New
York in 1981, and the Japanese Offshore Market (JOM) in 1986, but excluded small state OFCs
in continental Europe such as Switzerland, Luxembourg and Liechtenstein.
A more practical definition of an Offshore Financial Center should take into account the
developments in the 1980s and 1990s. An Offshore Financial Center is a location, which may
be a small state or a jurisdiction separated from the main state by geography, and or by
legislation, where international financial transactions take place with minimum or no
restrictions.

1.2 Origins and Evolution of Offshore Financial Centers

Currently, there are 70 Offshore Financial Centers (OFCs) all over the world, and Table
1.1 (page 6) provides a list of countries, territories, and jurisdictions with offshore financial

4
centers. According to Hughes and MacDonald (2002), although the proliferation of offshore
financial centers is quite a recent phenomenon their origin could be traced back to the creation
of the nation-state:
offshore financial centers emerged with the creation of the nation-state particularly after the Treaty of
Westphalia in 1648. Although the movement of funds and other types of securities from the scrutiny of
the authorities in one country to another with looser government controls was not referred to as offshore
banking, cross-border flows of capital in the seventeenth through the twentieth centuries were often
arranged to find a home for "hot money" (Hughes & MacDonald (2002, p.1 85).

Switzerland became a "safe haven" after World War I for foreign funds. After the war
the Austrian and German financial systems were in shambles. Switzerland due to its neutrality
was less affected by the political unrest than other country in Europe was attractive as a safe
depository of funds during the 1920s and 1930s, especially for Germans (Christensen 1986).
In the Western Hemisphere the first offshore operations were established in the
Bahamas in 1936 by British and Canadian concerns to provide management services for the
investments of wealthy international clients. Within a short period of time, these financial
operations expanded to other British overseas territories, such as Anguilla, the British Virgin
Island (BVI), and the Cayman Islands (Suss, Williams & Mendis 2002).
However the phenomenal growth of offshore financial centers around the world came
with the inception of the Eurodollar market, the oil crisis, and failure of the fixed rate system
(Sengupta 1988). Errico and Musalem (1999) attributed the growth of offshore banking and the
proliferation of OFCs to the imposition of distortionary regulations on the financial sectors of
industrial countries during the 1960s and 1970s.
In Asia, offshore interbank markets began to develop after Singapore launched the
Asian Dollar Market (ADM) and introduced the Asian Currency Units (ACU) in 1968 (Tan
1982), and Japan established the Japanese Offshore Market (JOM) in 1986 (Errico & Musalem
1999). The ADM was an alternative to the London Eurodollar market for the investment of oil
surpluses from Indonesia and Malaysia; ACUs enable local banks to engage in international
transactions under a favorable tax and regulatory environment.
In Europe, Luxembourg began attracting investors from Germany, France and Belgium
in the early 1970s due to low income tax rates, no withholding taxes on interest and dividend
income, banking secrecy rules, and a politically stable and sound national environment (Hughes
& MacDonald 2002). In the Middle East, Bahrain began to serve as a collection center for the
region's oil surpluses during the mid 1970s after passing banking laws and providing tax
incentives to facilitate the incorporation of offshore banks (Errico & Musalem 1999; Kettell
1998).

5
Table 1.1: Countries, Territories, Jurisdictions with
Offshore Financial Centers

Africa Asia and Pacific Europe Middle East Western Hemisphere

Djibouti Brunei' Andorra Bahrain Anguilla

Liberia Guam Camp ione Israel Antigua
Mauritius Hong Kong Cyprus Lebanon Aruba
Seychelles Japan (JOM) Dublin Bahamas
Tangier Macao Gibraltar Barbados
Malaysia' Guernsey Belize
Marianas Isle of Man Bermuda
Marshall Island Jersey British Virgin Island
Micronesia Liechtenstein Cayman Island
Nauru London Costa Rica
Niue Luxembourg Dominica
Philippines Madeira Grenada
Singapore Malta Montserrat
Tahiti Monaco Netherland Antilles
Thailand (IBF) Netherlands Panama
Vanuatu Switzerland Puerto Rico
Western Samoa St. Kitts and Nevis
St. Lucia
St.Vincent and
Grenadines
Turks and Caicos
Island
United States (IBF)
Uruguay
West Indies

Source: IMF Background Paper (June 23, 2000).

'Added by the author.
2 Labuan 10FC

Studies done by Cobb (1998), Hudson (1998), Jones (1992), Goldberg, Helsley, and
Levi (1988), Lee (1986), Francis (1985), Chrystal (1984), Park (1982), and Wallich (1979)
attributed the growth of offshore banking in the 1960s and 1970s to the accumulation of large
balances of US dollar denominated deposits outside the United States and the failure of the
Bretton Woods fixed exchange rate system, as well as the various policy measures by the
United States' Government and The Federal Reserve Board to restrict capital exports. Francis
(1985) cited the Interest Equalization Tax of 1963, which made it unattractive for non-
Americans to buy American domestic dollar bonds by limiting the interest rates on these bonds
to a level below that of international rates. This made it very difficult for commercial banks to
borrow on the American money market. Consequently, the bigger banks were forced to borrow

6
on the Eurodollar market through their branches, which were normally located in London.
However, the small and medium-sized banks found the establishment of a branch in London to
be very costly, hence they turned to the Bahamas as an alternative site of their offshore
activities.

1.3 Inception of the Labuan IOFC

Unlike traditional financial centers such as London, New York, Chicago, Frankfurt,
Hong Kong, and Tokyo which developed as the natural outcome of international trade
(Kindleberger 1974), Labuan International Offshore Financial Center (10FC) was set up
entirely from scratch based on the idea of the then Malaysian Prime Minister, Dr. Mahathir
Mohamad (Hampton & Abbott 1999; Abbott 1999). Labuan was declared an International
Offshore Financial Center (IOFC) in 1990 to complement the onshore financial system centered
in Kuala Lumpur, strengthen the contribution of the financial sector towards the Gross National
Product (GNP) of Malaysia, enhance the attractiveness of Malaysia as an investment center,
and promote the economic development of Labuan and its vicinity (BNM 2001).
The move was logical as Labuan IOFC could complement the domestic financial market
in financing the high-growth Malaysian economy, which from 1960 to 1997 had real economic
growth rates of between 6.8 to 8.0% per annum (Ryan 2000). At the same time the Malaysian
government hoped that the IOFC status would improve Labuan's underdeveloped economy
(BNM 2001; Abbott 1999). The other important rationale behind the Labuan IOFC was 'the
desire to capitalize on the anticipated flight of capital from Hong Kong after its return to China
in 1997. Such a crisis of confidence did not occur; in fact the reverse was true: following the
1997 status change more funds flowed to Hong Kong' (Abbott 1999, p.194). Besides the
Malaysian government's commitment to the development of Labuan another political reason
for setting up the IOFC in Labuan cited by Abbot (1999, p. 204) was to 'illustrate to the rest of
the world the progress that Malaysia is making in its economic development.' Some of the
banks' decisions to set up operations in Labuan were not purely based on offshore finance, but
some less obvious agenda:
One of the motivations behind the commitment of a number of international banks to the Labuan 10FC
was to be seen to be supporting the Malaysian government in its long-term goals. Thus the actions of
some international banks in deciding on Labuan perhaps say more about their perception of the regional
importance of Malaysia per se, the lucrative investment opportunities, and keeping its government sweet,
than about a realistic view of Labuan as a serious OFC (Hampton and Abbot, 1999, pp. 9-10).

During the early stage of its operations the Labuan IOFC has made considerable
progress (Skully 1995; Abbot 1999), and would have remained so if not for the 1997-1998
Asian Crisis, which hit the region. The 1997-1998 Asian Crisis has done some serious damage

7
to Labuan IOFC, and is evident from the slump in the offshore banking business. The offshore
banking business has been stagnant since 1997, and banking assets declined from USD11.75
billion in 1996 to USD10.48 billion in 2002 (LOFSA Annual Reports 1996 & 2002).
Despite these setbacks the Malaysian government remains committed to the
development of Labuan as a premier 10FC in the region. To maintain the competitive edge of
the IOFC Bank Negara Malaysia has included Labuan in Chapter Eight of its 2001 Financial
Sector Master Plan (FSMP), which spells out three major recommendations: promote and
diversify further the players and activities in the IOFC, promote the development of Islamic
banking and Islamic insurance business, and develop and strengthen the capital market, e-
commerce and ancillary activities. The Malaysian government's presumption of Labuan's
competitive advantages is reflected in the Labuan Offshore Financial Services Authority's
(LOFSA) promotional material:
The competitiveness of Labuan 10FC are; low operating cost, easy accessibility, similar time zone with
most major cities in Asia, competitive tax regime, a single one-stop regulatory body, separate set of
offshore legislation, no exchange control regulations, support and commitment of the government, strong
commitment in the exercise of prudence and maintenance of a clean image, modern and complete
infrastructure, numerous double tax agreements with other countries, numerous investment guarantee
agreements with other countries, and high expertise and experience in Islamic finance (LOFSA, 1999 pp.
9-11).

1.4 Summary
There is no consistent definition in the literature as to what constitutes an offshore
financial center. The terms offshore financial centers, offshore banking centers, tax havens,
booking centers and others have been used interchangeably. The inconsistency of definitions
given by different writers reflects the dynamic nature of OFCs. Taking into account the
developments in the 1980s and 1990s, an offshore financial center is a location, which may be a
small state or a jurisdiction separated from the main state by geography, and or by legislation,
where international financial transactions take place with minimum or no restrictions.
Traditional financial centers such as London, New York, Chicago Frankfurt, Hong
Kong, and Tokyo developed as the natural outcome of international trade (Kindleberger 1974).
However, the phenomenal growth of offshore financial centers around the world came with the
inception of the Eurodollar market, the oil crisis, and failure of the fixed rate system (Sengupta
1988), the imposition of distortionary regulations on the financial sectors of industrial countries
during the 1960s and 1970s (Errico & Musalem 1999). The Labuan 10FC was set up from
scratch to complement the domestic financial market in financing the high-growth Malaysian
economy in the 1990s (BNM 2001; Ryan 2000), and as a regional economic development.
(Abbott 1999).

8
CHAPTER TWO:
TYPOLOGIES OF OFFSHORE FINANCIAL CENTERS

2.0 Introduction
Jao (1993) identified the typologies of financial centers that fall within five main
perspectives, namely teleological, services provided and stages of development, geographical,
functional and geographical, and historical and neo-Marxist perspectives. In addition to these
typologies Lewis and Algaoud (2001) came up with the concept of an Islamic financial center.

2.1 Teleological Perspective

From a teleological perspective, McCarthy (1979) classified offshore centers as either
"paper" or "functional". A paper center acts as a location of records, with little or no actual
banking transactions taking place. Paper centers are basically used by international banks to
minimize overall taxes and other levies. A functional center is where actual banking
transactions are carried out.
Within the "functional" category Jao in 1980, 1988 (cited in Jao 1993, p. 492),
distinguishes between an "integrated centre" and a "segregated center". An integrated center is
where there is no artificial barriers exist between the "onshore market" and "offshore market".
Hong Kong for example is an integrated center. A "segregated center" is where there is clear
distinction between "onshore market" and "offshore market", and non-domestic institutions are
restricted to offshore. Labuan for example is a segregated center.
Hampton (1998) in studying island offshore financial centers has classified OFCs into
three tiers. Tier 1, functional OFCs, tier 2, compound OFCs, and tier 3, notional OFCs. Similar
to McCarthy's (1979) classification, a functional OFC has actual financial activity taking place.
and location of full branches of banks. A notional OFC has brass plate or 'cubicle' offices of
banks making booking entries of transactions. A compound OFC has a mixture of functional
and notional activities, as an increasing number of shell offices have become fully operational
branches. Lewis (1998 & 1999) added the concept of an ancillary centers, where backroom-
processing functions can be relocated to lower-cost centers away from the major financial
centers. Lewis (1999) cited NatWest Markets, which has a derivatives processing unit for the
Asia-Pacific region in Sydney, and its treasury processing operations in Singapore.

9
2.2 Services Provided and Stages of Development
Dufey and Giddy (1978) identified three types of centers according to services provided
and stages of development. They are traditional or capital-exporting centers, entrepot centers,
and offshore banking centers. The traditional or capital-exporting centers" main role is to
transfer domestic savings to other regions by serving as a net creditor to the world through
lending, securities market, underwriting and placements. Centers that fall within this category
are London, New York and Tokyo. The entrepot centers engage in financial intermediation
between international borrowers and lenders. Dufey and Giddy cited London since the rise of
the Euro-currency market in the late 1950s, and New York since the late 1970s. The offshore
banking centers act as intermediaries between nonresidents. Included in this category are
Luxembourg, Singapore, Hong Kong, Bahamas, Cayman Island, and Panama.

2.3 Geographical Perspective

According to Jao (1993), from a geographical point of view, financial centers can be
classified according to the scope, or at least the main focus, of their activities. Starting from the
small to the large the first being "domestic", or "national center". Once a financial center
outgrows its national boundary, it then becomes a "regional center". The largest being the
"global center" whose activities cover the globe. Jao also argued that the concept of
"international financial center" included both "regional financial center" and "global financial
center"
Within the geographic point of view, and according to the scope of activities Lewis
(1998) draws further distinctions in terms of market centers and ancillary centers. According to
Lewis markets centers have a concentration of trading in particular market instruments.
Lewis cited London as the 'deepest' market providing the best liquidity and finest
margins, resulting in the growth of international securities and derivative markets. Chicago and
Philadelphia are examples of 'pure' market centers with a strong focus on futures and financial
derivatives relative to other aspects of international finance. Ancillary centers attract various
back-office and support services from the major centers. Information technology has made it
possible for banks to centralize information resources in areas such as derivatives trading and
market forecasting on a global basis. Managerial and support services can be transferred from
one center to another. Backroom operations can be shifted to lower-cost regions or domestic
locations away from the major financial centers. For example, clearing facilities for
international bonds have been attracted to Brussels and Luxembourg, and Dublin became a

10
location for global custody and treasury operations partly because of a special tax exemption
(Lewis 1998).

2.4 Functional and Geographical Perspectives

Combining the functional and geographic criteria, Park (1982) identified four types of
offshore financial centers according to the sources and uses of funds for the market being
served by the OFC. These are primary, booking, funding, and collection centers.
A primary center caters to the needs of global clients, but the main sources and uses of
funds are within its own market, such centers are London, New York, and Tokyo. A primary
center engages in international financial intermediation, and is the hub of international banking
and finance. A booking center undertakes financial intermediation mainly for and between
nonresidents. Booking centers such as the Bahamas, and the Cayman islands due to their low
tax status are used by international banks as the location for "shell branches" to book both
deposits and international loans. A booking center acts as a financial entrepot, where the
sources and uses of funds are regions outside the center. Funding centers such as Singapore and
Panama act as inward financial intermediaries by channeling funds from outside for local uses.
A collection center such as Bahrain undertakes outward financial intermediation where it
collects excess savings from the region that has low absorptive capacity, and invests the funds
somewhere else.
Similar to Park's classification, Errico and Musalem (1999) categorized offshore
financial centers into primary, secondary or booking centers, according to sources and uses of
funds, the liquidity of markets, and types of transactions.
Primary OFCs are large international full services centers with advanced settlement and
payments systems, operating in liquid regional markets where both the sources and uses of
funds are available. In terms of assets, London is the largest and most established primary OFC,
followed by the U.S. International Banking Facilities (IBFs) and the Japanese Offshore Market
(JOM) (Park 1982; Errico & Musalem 1999).
Secondary OFCs intermediate funds in and out of their region, according to whether the
region has a deficit or surplus of funds. Regional centers include Hong Kong and Singapore's
Asian Currency Units (ACUs) for South East Asia, Bahrain and Lebanon for the Middle East,
Panama for Latin America, and Luxembourg for Europe (Errico & Musalem 1999).
Booking OFCs do not engage in regional intermediation, but rather serve as registries
for transactions arranged and managed in other jurisdictions. These OFCs are sometimes

11
referred to as tax heavens and include most Caribbean OFCs (Park 1982; Errico & Musalem
1999).

2.5 Historical and Neo-Marxist Perspectives

From a historical and neo-Marxist standpoint, Gorositiaga 1984 (cited in Jao 1993, P.
42) distinguished between the "traditional international financial center" and the "new
international financial center". Traditional international offshore centers are the established
financial metropolises of advanced capitalist countries whose currencies are also international
trading or reserve currencies. Examples are London, New York, Frankfurt, Paris and Zurich.
The colonies and protectorates of these countries, as well as other small countries depend on
such centers as the principal source of external financing. New international financial centers
are those on the periphery of the capitalist system that have emerged since the 1960s. However,
Jao (1993) argues that this classification is not entirely accurate:
Although there is some truth in this classification, as far as the historical sequence of development is
concerned, the world financial scene has been changing rapidly during the past two decades, so that this
bi-polar typology can no longer do full justice to the increasing sophisticated global system. For instance,
Tokyo, as generally agreed, is a newcomer as a global financial center. Yet no one can seriously claim
that Tokyo is on the "periphery of the capitalist system". Similarly, no one can seriously argue that Hong
Kong and Singapore "lack financial autonomy", despite their common colonial background, Therefore,
the term "traditional centers", and "newly emerging centers" are used here without any neo-Marxist
connotation (Jao 1993, p.42).

2.6 Islamic Financial Center

In addition to these typologies, Lewis and Algaoud (2001) came up with the concept of
an Islamic Financial Center, which is characterized by the compliance with Shari 'a the
Islamic law of human conduct, which prohibits Riba (interest), payment over and above what is
lent. Besides, the Shari 'a requirement an Islamic Financial Center should have the ability to
attract both the Islamic investment money and international financing activities' which would
qualify as being Islamically acceptable. Currently, Bahrain and London are two major centers
for Islamic finance (Lewis & Algaoud 2001).

2.7 Labuan International Offshore Financial Centre

So what type of financial center is Labuan? Malaysian researchers (Aralas,
Subramaniam & Chong 2000; Shariff & Mahmood 2000; Ahmad & Kefeli 2002) have proudly
used the "international offshore financial center" appellation for Labuan. However, non-
Malaysian authors are less enthusiastic about the description. Skully (1995), and Palan (1998)
classified Labuan as a tax haven. Hampton (1998) categorized it as a notional offshore financial
center or a booking center. Abbott (1999) was reluctant to classify Labuan as either an

12
 international offshore financial center, or a tax haven, and questioned the accuracy of Labuan's
appellation:
Is it accurate to classify Labuan as an international offshore financial center instead of a more limited and
parasitic tax haven (Abbott 1999, p. 194)?

The typologies discussed earlier definitely can shed some light on the confusion of
describing Labuan as a financial center. To some extent it is quite accurate to classify Labuan
as a tax haven as its primary attraction is the tax advantages (Skully 1995). The tax rates are
among the lowest in the world (LOFSA 1999) at either 3% or a flat payment of 20,000
Malaysian ringgits whichever the company chooses to adopt. Banks in Labuan are exempted
from withholding tax levied on income or dividends earned in Malaysia and remitted out. 'Non-
trading activities, such as the ownership of securities and real estate are totally tax-exempt.
Moreover, there are no stamp duties, value-added taxes (VAT), death, inheritance, or estate
duties. Additionally, expatriate professionals and managers are given 50% tax abatement. For
Malaysian domestic trust companies, accounting and legal firms dealing with offshore players
in Labuan up to 65% of their statutory income is exempted from tax. Finally, Labuan is a duty-
free haven, and Malaysia citizens are allowed to buy duty-free goods after spending 24 hours
on the island (Sarver 1999).
Although Labuan operates- on a low tax regime, it is not a "paper center" or "booking
center" or "notional center". It is to some extent a "functional center" where actual banking
transactions are carried out, albeit on a smaller scale compared to Hong Kong or Singapore.

Table 1.2: Deposits and Loans of Non-bank Customers in Labuan 10FC

2000 2001 2002

US$ Million
Total Deposit 4,829.0 3,657.4 5,865.6
Residents 1,954.7 1,397.4 1,857.6
Non-residents 2,874.3 2,260.0 4,008.0

Total Loans Outstanding 11,425.8 11,237.2 10,478.6

Residents 8,700.3 8,792.4 7,727.4
Non-residents 2,725.5 2,444.8 2,751.2
Source: LOFSA Annual Report 2002, p.29.

Besides, it offers a full range of financial services, including fund management, trust, insurance
and Islamic finance. It is easier to say that Labuan is also a "segregated center" as the offshore
financial sector operates under the provisions of the Offshore Banking Act 1990, and exempted

13
from the normal provisions of Banking and Financial Institution Act 1989 and the Islamic
Banking Act 1983 which govern the onshore financial sector. From the geographical point of
view, and as shown in Table 1.2 (page 13) Labuan is a "national center" for Malaysian
companies to obtain funding for their export-oriented projects. Although Labuan transacts
financial business outside the country, its core business remains with the residents (LOFSA
Annual Report 2002). From the functional and geographic perspective Labuan is a "funding
center". As depicted in Table 1.2 (page 13) Labuan acts as an inward financial intermediary by
channeling funds from outside for local uses.
From the historical point of view Labuan is of course a newly emerging financial center
primarily meant to finance Malaysia's strong economic growth in the 1990s, and to provide for
the financing needs of Malaysian corporations in their export related activities (Abbott 1999).
Labuan is also an Islamic financial center, as evidenced from the growing numbers of Islamic
transactions arranged in the center. As an Islamic financial center Labuan also has its own
Shari 'a Advisory Council (SAC) to ensure Shari 'a-compliance for its Islamic financial
products. Given the types of transactions and activities undertaken it is more appropriate to
describe Labuan as a compound offshore financial center.

14
CHAPTER THREE:
REQUIREMENTS FOR A SUCCESSFUL OFFSHORE FINANCIAL CENTER

3.1 Introduction
In studies done by Felmingham and Dean (1998), Tan (1997), Skully (1995), Tan and
Vertinsky (1988), and Jao (1980), conditions cited to be "necessary" for the development of an
international offshore financial center include:
Liberal environment;
Strategic geographical location;
Stable political environment;
Stable economic performance;
The presence of international banks;
Quality labor force;
A developed financial and physical infrastructure; and
The assurance of confidentiality and secrecy.

3.1 Liberal Environment

Liberal environment refers to liberal financial and government regulations that were
characterized by flexible banking laws and financial regulations, no currency conversion
limitations, and low or non-existent domestic taxes (Hagen 1989). In their analysis of the
Caribbean financial centers (Dufey & Giddy 1978, p. 45) attributed the success of the Bahamas,
the Cayman Islands, and Panama as offshore financial centers to the 'extremely liberal
regulatory environment'.
Laws and regulations that are restrictive and anti-competition are not conducive to
banking business. Felmingham and Dean (1998) thought that Australia's tax system was a
disservice to the offshore banking unit (OBU):
Australia's OB business has not prospered, partly because of this duplicate tax system. Income taxation is
levied by the federal government, but the six state, and two territory governments impose a confused mix
of indirect taxes.. .presently, only 1 percent of Australia total foreign exchange business is conducted by
OBUs (Felmingham & Dean 1998, p. 47).

Dufey and Giddy (1978) in 'Financial Centers and External Financial Markets' argued that:
Regulations need to be administered with adequate flexibility to adjust to changing conditions, It is
precisely this lack of flexibility, for example, that has kept Germany, France, and Japan from realizing
their full potential of developing their capitals into leading international financial centers in general, and
into offshore banking centers in particular (Dufey & Giddy 1978, p. 40).

They cited London's predominance as a major international financial center due to sensible
government controls and restrictions. This aspect makes London a natural location for the

15
Eurodollar market in the early 1960s when the United States imposed restrictive regulations on
its banking business. Yet when the United States instituted regulatory and legislative changes in
1981 to permit the establishment of International Banking Facilities (IBF) US banks began to
repatriate funds from London, Luxembourg and Bahamas. By the end of the first month the
IBFs assets grew by USD63 billion, and by December 1987, 540 banks established IBFs, with
assets of USD282 billion (Hudson 1998).
Bahrain became a collection center in the Middle East in the 1970s, after passing
banking laws and providing tax incentives for offshore banking operations (IMF 2000). The
Bahrain government practices a laissez-faire policy, which encourages private enterprise;
foreign exchange and trade transactions are entirely free of restrictions (Gerakis &
Roncesvalles 1983). Luxembourg attracted many German banks to avoid the minimum reserve
requirement (Hagen 1989). When international banks started to look for an Asian city to host
the Asian Dollar Market (ADM) in the late 1960s they chose Singapore over Tokyo and Hong
Kong, because Japan was still inward looking and Hong Kong was unwilling to waive the 15%
withholding tax on interest income from foreign currency deposits (Ng 1998; Jao 1997). In
analyzing the evolution of Singapore as a financial center Bryant (1989) attributed the positive
regulatory, tax, and supervisory policies of Singapore, the provisions inhibiting foreign-
controlled banks from large-scale operations in other Asian countries to the rapid growth of
international banking in Singapore.

3.2 Strategic Geographical Location

Strategic geographical location is essential in attracting both depositors and borrowers
from countries with surplus or high demand of funds. For example, Singapore is located in the
middle of Southeast Asia where all the countries in the region including Australia and the South
Pacific constitute a natural "catchment area" and "lending domain" for Singapore's financial
institutions (Bryant 1989). Singapore sits in a time zone that allows it to enjoy overlapping
business hours with the major Asia-Pacific financial centers (Hong Kong, Tokyo, and Sydney)
as well as with London, Paris, and Switzerland. Because of this, Singapore has been able to
develop an active international money market, and it is only behind London, New York, and
Tokyo in foreign exchange trading, with an average daily trading volume of US $167 billion in
1997 (Hughes & MacDonald 2002).
Similarly, Bahrain is an island centrally located in the Arabian gulf, within 30
kilometers of the eastern province of the kingdom of Saudi Arabia, 50 kilometers to the west of
the state of Qatar, 430 kilometers south-east of Kuwait and 430 kilometers north of the United

16
Arab Emirates (UAE). Bahrain geographically lies in the center of oil surplus countries (Kettell
1998). Hong Kong's location near Korea, Japan, Taiwan, and mainland China, (countries with
high demands for capitals) makes it a major hub for the arrangement, syndication, and
management of Eurocredits to borrowers from the region Switzerland and Luxembourg are
successful offshore financial centers because of their location in the center of postindustrial
Europe, especially Germany, France, and Belgium (Hughes & MacDonald 2002).
The importance of geographical location can also be illustrated by Austria, the only
European country with secrecy laws as strict as, or even stricter than Switzerland. In Austria
accounts can be opened by using fictitious names, and unlike Switzerland there is no obligation
on bankers to find the ultimate beneficiary of an account. Very little records are kept of
foreigners who open accounts in Austrian banks, and still Austria does not succeed in attracting
offshore business. One of the reasons is its geographic position being too close to Russia does
not inspire confidence (Hagen 1989).

3.3 Stable Political Environment

Political stability is one of the most important factors for the development and
maintenance of a successful offshore center. Investors seek an assurance that their funds will be
safe. Felmingham and Dean (1998 in commenting on Hong Kong's political stability state that:
Hong Kong's future as an OFC remains in doubt until the intentions of the People's Republic are
revealed. This uncertainty has slowed the growth of OB activities in Hong Kong and created a market
opportunity for other potential players (Felmingham & Dean 1998, p. 47).

However, four years later Hughes and MacDonald (2002) have made the following
observations on Hong Kong:
Although concerns have been raised that China would not uphold Hong Kong's rules and regulations,
hence eroding confidence in Hong Kong as an offshore financial center, this has not occurred. Hong
Kong, in fact, weathered its transfer to China as well as Asia's 1997-98 financial crisis and maintains its
role as a major offshore financial center (Hughes & MacDonald 2002, p. 195).

Sicat (1984), Tan and Vertinsky (1987), Bryant (1989), and Jones (1992) attributed the growth
of Singapore to its record of political stability without major disruptions since the late 1960s.
Beirut and Shanghai are examples where the lack of political stability has led to the
demise of financial centers. In the 1920s and 1930s Shanghai was a major financial center, and
lost this status in 1949 when the communist regime took over China. This was a direct
contribution to the development of Hong Kong as a financial center (Jones 1992). Similarly,
Beirut was a regional financial center of the Middle East in the 1950s and 1960s, but with the
breakout of the Lebanese civil war Beirut's position as a financial center came to an abrupt end,
thus contributing indirectly to the emergence of Bahrain as a new financial center in the region

17
(Essayyad 1989). In the case of Manila's Offshore Banking Units (OBUs) the sporadic fighting,
kidnapping, and insurgence in the south, and the resulting political instability have not been
conducive to the development of Manila as a financial center (Essayyad 1989; Abbott 1999).

3.4 Stable Economic Performance

Like political stability, economic stability is essential for the development and
maintenance of an offshore financial center. Singapore is an example of a financial center,
which grows due to the stability of its domestic economy. Singapore's economic performance
has been remarkably steady since 1965. During the late 1960s and early 1970s, it achieved
double-digit economic growth rates, well above other nations. Its economy has remained strong
despite the oil crisis and world recession in the mid-1970s. Except in 1985 when Singapore
experienced a major recession with a negative growth rate, the economy has thus far been
stable (Tan 1999).
Hong Kong had established itself as a major commercial, manufacturing and shipping
center after the Second World War, before it became a financial center. During the period of
1966-90 Hong Kong's economy grew at an average annual rate of nearly 8% in real terms, and
was ranked the world's 10th leading exporter in 1988 (Jao 1993). Today, the Hong Kong
Special Administrative Region (SAR) has a large and vibrant local business community, with
over 479,000 local companies, and 2,000 multinational companies including over 200 of the
Fortune 500 companies. Hong Kong is also a major transshipment and re-export center, which
fuel strong demand for trade support services such as banking and finance (Lowtax.Net 2003).
The importance of economic stability can also be illustrated in the case of Labuan:
The financial and economic crisis that has affected Asia since July 1997 has unsurprisingly affected
Labuan. Total loan growth for the first quarter of 1998 was a mere 1.7 per cent compared to 14.2 per cent
for the corresponding period in 1997 (Abbot (1999, p. 208).

The crisis has undoubtedly had an adverse effect on Labuan offshore banking business, and
banking assets have gradually declined since 1997 (LOFSA Annual Reports 1996 & 2002).

3.5 The Presence of International Banks

The main characteristics of the major offshore banking centers is that they are host to
international banks, London is the location for 524 international banks, New York hosts 340
international banks, and Tokyo has 90 (Lewis 1999). International banks play an important role
in the construction of a place as an offshore financial center, for they have the necessary
structure for providing the varied services required by a global clientele that ranges from major
multinational corporations to wealthy individuals. McGahey, Malloy and Kazanas (1990) in

18
'What Make a Financial Center?' are of the view that for inspiring financial centers it is
essential to maintain a critical mass of banks and activities which in turn provide the synergies
for offshore banking.
Hong Kong is an example of an offshore financial center that developed due to the
concentration of international banks. As of September 2001, 220 international banks from 30
different countries operate a comprehensive network of branches in Hong Kong (Lowtax.Net
2003). Tan (1999) cites Singapore as being served by many financial institutions of
international repute, thus providing an effective mechanism to direct the flow of surplus funds
into productive investment. As at end 1998 Singapore hosts 140 international banks.
The significance of international banks in an offshore financial center can also be
illustrated in the case of the Philippines. Lee (1986) in commenting on the predicaments of
offshore banking in the Philippines argues that:
The crux of the problem is that the financial infrastructure has not been developed to support the growth
of the offshore banking system. There are only four foreign banks (namely, Chartered Bank Hongkong
and Shanghai Bank, Bank of America, and Citibank, N.A.) and 26 OBUs. With the small number of
international financial institutions, its effectiveness in taking deposit and lending in foreign currencies,
and in having direct access to the major financial centers in the world is limited (Lee 1986, p. 230).

3.6 Quality Labor Force

Banks need sophisticated professionals to structure complex financial deals, evaluate
and manage credit and market risks, keep abreast of industry trends and innovations, execute
business strategies, and control costs. In the new, dynamic, and competitive context, a quality
workforce is a major competitive advantage (Lewis 1998 & 1999). Experienced bankers,
accountants, lawyers, and financial specialist are needed to ensure the proper functioning of an
offshore center.
As world's leading financial center London's expertise in business is renowned, and the
London financial district employs about 600,000 people (Sahakian 1998). Long before the
Euromarkets became a major aspect of international finance, London was already an
established center for world trade and banking. London's experienced bankers were among the
first to discover the enormous potential of external intermediation (Dufey & Giddy 1978).
In the case of Singapore the experts that work for the international financial institutions
have helped to upgrade the banking skills of the local workforce. This is further enhanced by
the establishment of the Institute of Banking and Finance (IBF), which conducts several
diploma and certificate programs as well as numerous short courses on specialized topics in
Finance and Banking (Tan 1999). Singapore possesses an adequate supply of skilled employees

19
from its expanding educational base; and it has an advanced information technology
infrastructure, which is essential for international banking (Felmingham & Dean, 1999).

3.7 A Developed Financial and Physical Infrastructure

Financial infrastructure refers to the financial system, which includes the
financial market. Physical infrastructure refers to air transportation, telecommunications, and
other support service industries. London for example has a dominant role in several
international financial markets, such as cross border bank lending, international bond issuance
and trading, foreign-exchange trading, over-the-counter derivatives, fund management and
foreign equities trading (Lewis 1998 & 1999). It also has the world's largest insurance markets,
the leading exchange for dealing in non-precious metals, the largest spot gold and gold lending
markets, the largest ship broking market, and more foreign banks and investment houses than
any other center, (EIU Viewswire 2003). In arguing why American and Japanese choose to
operate from London instead of Paris or Frankfurt, Lewis (1999) explains:
Unlike the position in some other countries, insurance, commodities trading, future markets, stock
broking, bond trading and legal services in the UK are all concentrated around the City. Communication
facilities are good, London is a pleasant city in which to live, and the ability to use the English Language
is clearly advantages to US and Japanese bankers (Lewis 1999, p. 100).

In the Pacific Rim Singapore is the most successful story in offshore banking, having
expanded its capital market from purely domestic to full offshore orientation. In their analysis,
Felmingham and Dean (1999) attributed the success of Singapore's financial market to the
government policies of desegregating the domestic and international aspects of the capital
market. The international aspect of the financial market was established through fiscal,
regulatory and tax incentives to attract reputable international banks. The policies were
successful as proven by the number of international banks establishing their regional
headquarters in Singapore.
Good telecommunications infrastructure is very crucial for financial services, as
banking is very dependent on telecommunications. London, New York, Singapore and Hong
Kong have been successful as international financial centers because of their excellent
telecommunications (Ng 1998). One of the reasons why Manila Offshore Banking Units is not
very successful is because its 'telecommunication system is underdeveloped' (Ho 1991, p.
401). Direct air accessibility from major financial centers and cities like London, New York,
Tokyo, Singapore, Taipei, and Hong Kong is also very important as it shortens travel time for
bankers and businessmen. Bankers cited lack of direct air accessibility as one of Labuan's
competitive disadvantages as compared to Hong Kong and Singapore (Abbott 1999; AOB

20
2002). The availability of other support services like international accounting firms, and legal
firms well versed in offshore financial transactions is also essential in the proper functioning of
an offshore financial center.

3.8 Assurance of Confidentiality and Secrecy

Confidentiality is an essential requirement for an offshore financial center. Identities of
customers, customers' assets and accounts should remain secret. Chambost's study in 1983
(cited in Hagen 1989, p. 71) cites four motives behind the reasons for the need of bank secrecy:
Search for security a client seeks a sophisticated banking system in which the
government has no participation. This is the main reason why Switzerland is popular
(Hagen 1989).
International tax avoidance individual or companies can reduce their world tax income
through the creation of foreign trust or fiduciary agreements.
(iii)Foreign exchange regulations imposed in the clients' country prohibit them from
having deposits in other countries, and a client of an offshore bank seeks assurance that
such information is not disclosed to his government.
(iv)Anonymity a client who does not want his individual wealth known can remain
unidentified. In a study done by Hagen (1989) this is one of the reasons Europeans used
the Netherlands Antilles:
With the widespread terrorist activities and kidnapping they are worried about their personal safety,
and seeks an offshore financial center that can keep their business and wealth confidential (Hagen
1989, p. 72).

The importance of confidentiality, privacy and anonymity can be illustrated by the

Bahamas. In 1983, threatened with a USD50,000-a-day fine, the Bank of Nova Scotia Florida
branch was forced to give a Florida grand jury bank records belonging to a client of its
Bahamas office. After this incident, business dropped, and the reputation of the Bahamas as an
offshore center was compromised (Hughes & MacDonald 2002).
In recent years bank secrecy has become a widely discussed issue because of the abuse
by some offshore financial centers. Under pressure from the Financial Action Task Force on
Money Laundering (FATF) countries hosting offshore financial centers are passing Anti-
Money Laundering legislations, and seeking cleaner images. Switzerland, for example, passed a
new Money Laundering Law in 1997 to include an obligation to report suspicious transaction.
In the same year, the Swiss High Court ordered the transfer of assets belonging to the late
President Marcos to the Philippines citing that it was 'against Swiss national interest to serve as
a safe haven for flight capital or criminal proceeds' (Hughes & MacDonald, 2002, p.189).

21
 CHAPTER FOUR: NICHES AND SPECIALIZATIONS

4.0 Introduction
This chapter discusses niches and specialization, the concept of an Islamic financial
center, the current centers for Islamic finance, and the feasibility of Labuan as an Islamic
offshore financial center. The discussions are set out as follows: the need to develop niches and
specializations in Section 4.1, and Islamic financial center in Section 4.2.

4.1 The Need to Develop Niches and Specializations

To develop a competitive edge it is important that an offshore financial center provides
a unique service or fills a specific niche. According to Lewis (1998), the British offshore
centers of Jersey, Guernsey, and the Isle of Man have developed their own specialties. Jersey
has led in trust and private banking business since the early 1970s, and it also delves in funds
management. Jersey now manages more than USD40 billion for 150,000 investors from
different countries. Guernsey is third largest center in the world for offshore captive insurance.
It currently hosts 250 captive insurance companies, behind Bermuda (1,300) and the Cayman
Islands (390). The Isle of Man is home to 150 captives, but its specialty is offshore life
insurance (Lewis 1998).
Dublin's International Financial Services Centre (IFSC) main businesses are insurance,
treasury management and collective investments. Dublin IFCS has 22 insurance managers and
90 captive insurance companies. Treasury management in Dublin specializes in corporate
treasury operations for multinational companies. For example, Wang International carries out
foreign exchange hedging, along with factoring, pension fund management and insurance. As
of 1993 total funds under management stood at USD12.5 billion (Lewis 1998). Cobb (1998)
summarized Lewis' point as follows:
Jersey is seen as the premier offshore private banking center, Guernsey as the dominant captive insurance
center, the Isle of Man as the fastest growing life insurance sector, and Dublin (IFSC) as the largest fund
management center (Cobb 1998, p.19).

According to Ng (1998) Singapore's competitive advantage is in foreign exchange and

derivative markets, while Hong Kong is strong in fund management and offshore loan
syndication. Singapore is the fourth largest foreign exchange trading center in the world. There
are more than 700 financial institutions operating in Singapore, participating in a wide range of
financial services including trade financing, foreign exchange trading, derivative trading,
financial advisory services syndication, underwriting, mergers and acquisition and specialized
insurance products (Hughes & MacDonald 2002).

22
 Hong Kong is a major hub for the arrangement, syndication, and management of
Eurocredits to borrowers from the Asia-Pacific region. Today, Hong Kong is the world's sixth
largest international banking center in terms of external transactions and has the representation
of 79 of the top 100 banks (Hughes & MacDonald 2002).
Malaysia, which already has more than twenty years experience in Islamic banking, and
is home to two Islamic commercial banks, one Islamic cooperative bank, and three Islamic
offshore banks, believes it has already established a strong foundation in Islamic banking and
finance. Based on this assumption, Bank Negara Malaysia (BNM) in its March 2001 Financial
Sector Master Plan (FSMP) has identified Islamic banking and finance as a niche for Labuan
(BNM 2001)
In response to the master plan Labuan Offshore Financial Services Authority (LOFSA)
initiated the idea for the establishment of the International Islamic Financial Market (IIFM),
which was supported by Bahrain, Brunei, Indonesia, Sudan, the Islamic Development Bank,
and Islamic financial institutions from Kuwait and the United Arab Emirates (LOFSA Annual
Report 2002; Lewis & Algaoud 2001). With a secretariat in Bahrain the IIFM began operations
in 2002. Labuan provides the link to the IIFM by serving market players in the Asian time
zone; the decision to establish the IIFM in Bahrain is very appropriate as Bahrain is at the
center of the Islamic world rich in petroleum, and major sources of Islamic funds.

4.2 Islamic Financial Center

According to Lewis and Algaoud (2001) there is a potential for an international center
for Islamic finance due to a strong actual and latent demand for Islamic banking and finance.
The actual demand would come from about 20% of the world population who adhere to Islam.
Latent demand according to Lewis and Algaoud (2001) is:
A demand from those Islamic investors who presently invest in conventional financing transactions but would
favour conversion into investments in 'Islamic-qualifying' transactions, provided that these were to have risk-
return and portfolio diversification characteristics roughly comparable to those similarly available in
conventional markets (Lewis & Algaoud 2001, p. 232).

There is approximately USD1,300 billion in liquid Islamic funds from the Islamic
countries of which USD1,100 billion is invested in conventional financial institutions, and only
US $200 billion invested in the Islamic financial institutions (Alam Shah 2004).
According to Gapoor (1995), and Lewis and Algaoud (2001) the Islamic banking
system is saddled with the problem of imbalance between the liabilities and the asset sides.
Zarinah Anwar, deputy CEO of Securities Commission Malaysia has aptly put it, 'Islamic
finance is a problem of billions dollars of funds with no where to invest.' (Alam Shah 2004, p.

23
4). According to Lewis and Algaoud (2001) this problem would call for an international
Islamic center for solutions. While it is easy to attract interest-free deposits from those
religiously inclined to shari'a principles on the liability side, it has been more difficult to
implement profit-and- loss-sharing on the asset side (Lewis & Algaoud 2001; Gapoor 1995).
KPMG Fakhro estimated the unsatisfied visible demand for Islamic investment vehicles in
Saudi Arabia alone is USD10 billion (Lewis & Algaoud, 2001), and the potential global market
for Islamic investment is USD200 billion (Alam Shah 2004).
Experience has shown that such financing imbalances can best be resolved by market
means through the establishment of regional or international financial centers, along with the
creation of new financial instruments (Lewis & Algaoud 2001). For example, the petrodollar
recycling crisis in the 1970s was solved when London stepped forward as the center for
Eurodollars and syndicated credit. According to Lewis and Davis 1987 (cited in Lewis &
Algaoud 2001, p.233) this enabled longterm financing to be made (especially to developing
countries) with short-term deposits of dollar from Oil Producing and Exporting Countries
(OPEC).
In the 1980s the financing problem of recycling Japanese current account surpluses to
finance the USA deficit was also solved through the international financial market. Lewis'
study in 1988 (cited in Lewis & Algaoud 2001, p.233) showed that this was done through a
financial innovation, which took place off the balance sheets of the banks in the securities
markets via securities derivatives (bonds warrants and convertibles), and Euro-note facilities of
various sorts, which enabled short-term financial instrument to be transformed into long-term
funding.
According to Lewis and Algaoud (2001) the same principle can be applied to solve the
Islamic finance imbalance problem if the 'surplus' deposits were on lent to an international
financial center, which could act as an intermediary for the funds.

For each individual bank participating in such a market, the funds provided might be on a short-term
basis. But a series of such short-term funds by different banks when combined would exhibit greater
stability and provide resources, which could be channeled into longer-term investments. At the same time,
the existence of this pool of resources would attract long-term investment avenues in need of funding.
Thus at the aggregate level the existence of the market would enable a succession of short-term surpluses
to be transformed into longer-term investments. This is exactly what happened with the London
Eurodollar market and the international syndicated credits, and much the same sort of process could occur
with Islamic finance (Lewis & Algaoud 2001, pp. 233-234).

4.2.1 Labuan as an Islamic Financial Center

At present, there are four Islamic banks in Labuan. Three of them are Malaysian banks,
Bank Islam (L) Ltd., Al-Hidayah Investment Bank (L) Ltd., and an offshore branch of Bank

24
Muamalat Malaysia Bhd., the other is a Saudi bank, RUSD Investment Bank Inc. The initial
skepticism towards the Shari 'a validity of the bay'al-inah and bay' al-dayn operations of
Islamic banks in Malaysia is gradually fading away. This is evident by the positive reception
among Islamic investors for Sukuk, or asset-based instruments. Some of Labuan's recent
notable transactions are:
First Global Sukuk by Guthries Group USD150 million, 2003;
First Sovereign Malaysian Global Islamic Sukuk ljarah USD600 million, 2003;
Islamic Development Bank Sukuk Ijarah - USD300 million, 2003; and
Qatar Sukuk Ijarah USD700 million, 2003.
In term of geographic distribution of Labuan Global Islamic Sukuk 51% were bought by
investors in the Middle-East, 30% were taken up by investors in Asia, 15% were bought by
investors in Europe, and the remaining 4% were taken up by Islamic investors in the US (Alain
Shah 2004).
Labuan is determined to overcome all barriers by working closely with the Islamic
Development Bank, and other financial institutions from the Middle East. Labuan has
introduced Arnanah Dar al-maal al-Islami Labuan (AD1L), or Dar al-maal al-Islami Trust
Labuan an Islamic growth funds, which is supported by the internationally recognized Dar al-
maal al-Islami (DMI) Trust Group. ADIL operates on the concept of profit sharing and is
designed to attract investors from the Middle East, and those from other Muslims countries in
Asia. The strength of ADIL is the monitoring of its activities by the International Shari 'a
Council (Ahmad & Kefeli 2002).
The establishment of International Islamic Financial Market (IIFM) has no doubt
greatly enhanced cooperation amongst Islamic countries and financial institutions. Apart from
that, IIFM will undertake research and development into new products that are compatible to
most Shari 'a interpretations. A Market and Product Development Committee, comprising
market experts, has been set up in 2002 by IIFM towards this end (LOFSA Annual Report
2002, p.41). The responsibility of ensuring the harmonization of such products with Shari 'a
interpretations lies with the IIFM's Shari 'a Supervisory Council, comprising Islamic experts
from various regions. The council's endorsement of a product ensures that it will be Shari 'a-
compliant and acceptable across the Islamic world.
In November 2002 further effort were made towards building a strong and sound
Islamic financial market with the establishment of the Islamic Financial Services Board (IFSB).
The IFSB, based in Kuala Lumpur is an association of central banks, monetary authorities and
other institutions. It is entrusted with the development and promulgation of internationally

25
accepted prudential regulatory standards and best practices (LOFSA Annual Report 2002, p.
41). Members of the Board will examine the extent to which existing international best
practices need to be adapted and complemented to be consistent with Shari 'a principles. They
will also focus on risk management issues, techniques and standards and ensure conformity
with Shari 'a injuctions.
Labuan is playing a pivotal role in the development and promotion of Islamic banking
and finance globally. Although there are only four Islamic banks in Labuan, these institutions
offer various Islamic financial products that include foreign currency financing facilities under
schemes such as Al-Murabaha (Cost Plus), Al-Wakalah (Agency), Al-Istisna (Order Sale), Al-
ljarah (Leasing), and Al-Musyarakah (Joint-venture) (LOFSA Annual Report 2002, P.41).

4.2.2 Bahrain as an Islamic Financial Center for the Middle East

According to Lewis and Algaoud (2001), Bahrain currently has the highest
concentration of Islamic financial institutions than any other country. It is home to two Islamic
commercial banks, twelve Islamic investment banks, two offshore Islamic banking units, and
four Takaful insurances companies along with several banks with Islamic 'windows'. Bahrain's
competitive advantage is that it is located in a region, which has the largest concentration of
Islamic investors comprising specialist Islamic financial institutions and high net worth Muslim
individuals.

4.2.3 London as the Center of Islamic Finance in Europe

According to Wilson 1999 (cited in Lewis & Algaoud 2001, p.236) London has earned
itself a status as the major Islamic financial center in Europe. London has been able to attract
the major Islamic banks because of the breath of specialist financial services offered, the depth
of the markets and the reputation of the major banks, which include all the leading global
institutions in finance (Lewis 1999b). Due to long historical connection with the United
Kingdom most Arab businessmen and bankers speak English. Some of London's conventional
banks provide an extensive range of Islamic financing services including investment banking,
project finance, Islamic trade finance, leasing, private banking and mortgages (Lewis &
Algaoud, 2001). Islamic banks and businesses can use the expertise these banks have, and their
experience and contacts. According to Freeland 2000 (cited in Lewis & Algaoud 2001) London
law firms provide legal advice on leasing and other Islamic financing techniques. London
actually has become a global ancillary center for Islamic financing (Lewis & Algaoud 2001).

26
CHAPTER FIVE: SUMMARY AND RECOMMENDATIONS

5.0 Introduction
This chapter summarizes and concludes the literature survey results in Section 5.1, and
recommendations for further research is discussed in Section 5.2.

5.1 Summary of Literature Survey Results

Offshore Financial Centers initially emerged in the early 1960s as a direct consequence
of regulatory constraints imposed on their financial institutions by both the United States and
countries in Europe. Increasing high taxes in these countries further added a stimulus to the
development of OFCs. The period of 1960s through 1990s witnessed the growth of OFCs in
Asia as a consequence of their fast growing economies (Felmingham & Dean 1998).
There is no consistent definition of an Offshore Financial Center (OFC). Generally it is
taken to mean 'a location, which may be a small state or a jurisdiction separated from the main
state by geography, and or by legislations, where international financial transactions take place
with minimum or no restriction'. This ranges from an island state like Nauru to a unit in a city
like New York. The common characteristics of offshore financial centers are that they deal in
cross border intermediation of funds under minimum regulations, low or no taxes, and are free
from exchange controls.
An OFC can be either a 'functional' or 'paper' center. A functional center is where
actual banking transactions are carried out. A paper center acts as a location of records with
little or no actual banking transactions taking place. A functional center covers both primary
and secondary centers. A primary center caters to the needs of global clients, though the main
sources and uses of funds are within its own market. Such centers are London, New York and
Tokyo. Secondary centers intermediate funds in and out of their regions. Examples of such
centers are Singapore, Hong Kong, Bahrain and Luxembourg. A paper center is also known as
a 'booking' center, or tax haven.
The success of an OFC depends on the attributes that it is endowed with or initiatives
and positive measures taken by the host countries. Generally, a liberal environment, strategic
geographical location, stable political environment, stable economic performance, the presence
of international banks, quality labor force, developed financial and physical infrastructures, and
confidentiality and secrecy are the necessary factors found in successful OFCs (Felmingham &
Dean 1998; Tan 1997; Skully 1995; Tan & Vertinsky 1988; Jao 1980).

27
 The new environment in which the offshore financial centers operate is becoming very
competitive. The globalization of the market, advances in information technology have changed
the ways banking businesses are conducted. To thrive in such environment OFCs have to find
niches and specializations in areas where they have competitive advantages (Hughes &
MacDonald 2000; Lewis (1998); Cobb (1998); Ng (1998). The Malaysian government believes
that Labuan can carve itself a niche in the Asia-Pacific region as a well-protected, well-
regulated OFC that has a good and clean reputation worldwide (Abbott 1999). Additionally,
having more than 20 years experience in Islamic banking the Malaysian government also sees
that Labuan has a calling to establish Islamic finance as a niche (BNM 2001). The results of the
literature survey form a good theoretical framework for the empirical research in Paper Two
and Paper Three.

5.2 Recommendation for Further Research

The fact that the Malaysian government is committed to the development of the Labuan
IOFC and promoting it as a premier IOFC in the region with a niche in Islamic finance implies
that Labuan does have the competitive advantages. This presumption must be examined
adequately in order to implement strategies that are effective and based on market realities. For
a subject that has been given national prominence very few studies have been done, and most of
them were evaluations of Labuan before the 1997-1998 Asian Crisis. More empirical studies
should be directed in this area especially to determine the relevance of Labuan 10FC after the
crisis, and the viability of Islamic finance as a niche.
Firstly, to determine the relevance and competitiveness of Labuan IOFC after the Asian
Crisis of 1997 and 1998 a study should be conducted to analyze the offshore banking industry.
As part of the current study a survey questionnaire will be distributed to the managers of the
offshore banks to solicit their knowledge and opinions of the industry. The data and
information collected from this survey will be the basis of an empirical study, which forms the
second part of this research.
Secondly, to determine the viability of Islamic banking as a niche for the Labuan IOFC
it is recommended that another empirical study be conducted among the offshore bankers. As
there are only three Islamic banks in the Labuan IOFC this study will also include conventional
banks. Similar to the earlier survey this research will also use the survey questionnaire method,
and will form the third and final part of the study.

28
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London, pp.315-318.

33
PAPER TWO: ANALYSIS OF THE LABUAN OFFSHORE BANKING INDUSTRY

ABSTRACT
Labuan was declared an International Offshore Financial Centre (IOFC) in 1990, with the
objectives of complementing the onshore financial system centered in Kuala Lumpur,
strengthening the contribution of the financial sector towards the Gross National Product (GNP)
of Malaysia, enhancing the attractiveness of Malaysia as an investment center, and promoting
the economic development of Labuan and its vicinity. The Malaysian government has spent
several hundred millions of ringgits building state-of-the-art infrastructure in Labuan to portray
the image of world class 10FC. However, the 1997-1998 Asian Crisis had caused some serious
damage to the aspiring IOFC, and the offshore banking business has been stagnant since the
crisis. Despite these setbacks the Malaysian government is determined to develop Labuan as a
premier international offshore financial center in the region. To ensure of the Malaysian
government's continued attention, Bank Negara Malaysia has included Labuan IOFC in chapter
eight of its ten-year Financial Sector Master Plan. This paper details the results of an empirical
survey on the Labuan offshore bankers, which solicited their opinions and perceptions of
Labuan as an IOFC. The survey used the whole population of banks, which enabled the
researcher to ignore the problems of bias in the sampling. The total number of offshore banks
was 49, of which 10 were Malaysian banks and 39 foreign banks. The questionnaire was sent to
all the 49 managers responsible for the overall affairs of the banks. Of these, 36 completed
questionnaires were returned representing a response rate of 73%. Data collected from the
survey were analyzed using descriptive statistics, using mean, standard deviation, and
frequency counts. The results of the survey indicated that offshore banking transactions were
predominantly functional, where banks carried out actual transactions. The products offered by
the Labuan offshore banks were limited to lending, and issuance of standby letter of credit
(SBLC) and bank guarantee (BG). Most of the offshore banks were adversely affected by the
1997-1987 Asian Crisis, and were responding with strategic adjustments by downsizing,
switching to investment banking and closing down. The offshore bankers also viewed that the
Malaysian government's objective of setting the IOFC as a mean to develop Labuan has
overshadowed the offshore banking industry. The major benefits for banks to set up offices in
Labuan were reliability of the Malaysian legal system, low taxes, confidentiality, liberal central
bank policies, minimum exchange control restrictions, and political stability. Singapore and
Hong Kong were viewed as the major threats to Labuan IOFC. It was also perceived that
Labuan was not a suitable location for an offshore banking center, and at a disadvantage

34
compared to Singapore and Hong Kong. The Labuan offshore bankers predominantly agreed
that Kuala Lumpur was a more suitable location, and would stand a better chance to compete
with Singapore and Hong Kong. The implications of these findings required Labuan IOFC to
have a more diversified products and services besides lending, issuance of SBLC and BG.
There was also a need for more flexible rules and regulations to facilitate the offshore banking
business. Lastly, there was a need to have proactive strategies to enable the Malaysian offshore
banking industry to face up to the challenges from the well-established centers in the region.

35
CHAPTER ONE: INTRODUCTION

Unlike traditional financial centers such as London, New York, Chicago, Frankfurt,
Hong Kong, and Tokyo which developed as the natural outcome of international trade
(Kindleberger1974), Labuan International Offshore Financial Center (IOFC) was set up entirely
from scratch based on the idea of the then Malaysian prime minister, Dr. Mahathir Mohamad
(Hampton & Abbott 1999; Abbott 1999). The Malaysian government's objectives in declaring
Labuan as an International Offshore Financial Center (IOFC) in 1990 were to complement the
onshore financial system centered in Kuala Lumpur, strengthen the contribution of the financial
sector towards the Gross National Product (GNP) of Malaysia, enhance the attractiveness of
Malaysia as an investment center, and promote the economic development of Labuan and its
vicinity (BNM 2001).
The move was logical as Labuan IOFC could complement the domestic financial market
in financing the high-growth Malaysian economy, which from 1960 to 1997 had the real
economic growth rates of between 6.8 to 8.0% per annum (Ryan 2000). From a political
perspective the Malaysian government hoped that the IOFC status would be able to improve
Labuan's underdeveloped economy (BNM 2001; Abbott 1999). Besides, Labuan was in the
same time zone as major financial centers in the region, and stable political regime. The other
important rationale behind the Labuan IOFC was 'the desire to capitalize on the anticipated
flight of capital from Hong Kong after its return to China in 1997. Such a crisis of confidence
did not occur, in fact the reverse was true: following the 1997 status change more funds flowed
to Hong Kong' (Abbott 1999, p. 194).
During the early stage of its operations the Labuan IOFC has made considerable
progress (Skully 1995; Abbot 1999), and would have remain so if not for the 1997-1998 Asian
Crisis which hit the region. As at December 1996, the height of the economic boom there were
60 offshore banks operating in Labuan. However, the 1997-1998 Asian Crisis has taken its toll
on Labuan. Mergers and closures of some of the foreign banks have brought the number down
to 50 operational banks (LOFSA Annual Report 2002). The offshore banking business has been
stagnant since 1997, and banking assets declined from USD11.75 billion in 1996 to USD10.48
billion in 2002 (LOFSA Annual Reports 1996 & 2002).
Despite these setbacks the Malaysian government remains committed to the
development of Labuan as a premier IOFC in the region. Lessons learnt from the crisis
prompted the Malaysian government to direct Bank Negara Malaysia to formulate the Financial
Sector Master Plan in March 2001 as a means to create a more stable and secured financial

36
industry in the country. As discussed in Paper One, Labuan IOFC was included in chapter eight
of the master plan, which spelt out three major recommendations:
Promote and diversify further the players and activities in the IOFC;
Promote the development of Islamic banking and Islamic insurance business;
and
Develop and strengthen the capital market, e-commerce and the ancillary
activities.
Theories reviewed in Paper One suggest that for an offshore financial center to be
successful it must have the "necessary" conditions (Felmingham & Dean 1998; Tan 1997;
Skully 1995; Tan & Vertinsky 1988; Jao 1980). These are liberal environment, strategic
geographical location, stable political environment, stable economic performance, the presence
of international banks, quality labor force, a developed financial and physical infrastructure,
and the assurance of confidentiality and secrecy. The Malaysian government presumption
indicates that Labuan has all the above attributes, which form the basis for its competitive
advantages, and this presumption has not been adequately supported by any empirical study.
The first attempt to validate this presumption was done by Aralas, Subramaniam and Chong
(2002) where they identified factors that contributed to the functioning of Labuan as an
offshore financial center. The study concluded that Labuan has all the attributes of a successful
offshore financial center.
However, both the Malaysian government's presumptions and the findings of Aralas et
al. (2000) were to some extent unable to explain the predicaments currently faced by the
offshore banking industry in Labuan. As discussed in Paper One the offshore banking business
has been stagnant since the 1997. More empirical studies should be directed toward this area
especially to determine whether Labuan has the necessary infrastructure, or a strategic
geographic location. The outcomes of such studies would be helpful to the decision-makers in
formulating new strategies, and making sensitive adjustments to current policies and
regulations to suit the prevailing market realities.

1.1 Organization of this Paper

This paper is organized as follows: Chapter One is an introduction covering the
significance of the study, research objectives and research questions. Chapter Two reviews the
literature related to studies on offshore financial centers, and on Labuan. Offshore financial
center and offshore banking theories, which deal with the success of offshore financial center
will be assessed, and provide a theoretical framework for this paper. Chapter Three describes

37
the research methodology and design of the empirical survey adopted in this study. Chapter
Four presents, analyzes and interprets the findings. Chapter Five concludes the study by
discussing the implications of the findings, the limitations of the study and future research
directions.

1.2 Purpose of the Study

The purpose of this research was to examine the business of offshore banking in
Labuan, and determine the reasons why the industry has not developed as anticipated. To
answer the question an empirical survey on Labuan offshore banks was carried out,
highlighting the perceptions and opinions of those directly involved with the offshore banking
industry. These perceptions and opinions are important, as they would have an impact on the
offshore banks' actions, which in turn would determine the future of Labuan as an offshore
financial center.

1.3 Research Objectives

The objectives of this study are to:
Examine the operations and activities of Labuan offshore banks;
Examine the effect of the 1997-1998 Asian Crisis on offshore banking business,
and offshore banks subsequent reactions; and
To solicit offshore bankers' perceptions on Labuan as an offshore banking
center.

1.4 Research Questions

The offshore banking business has been stagnant since the last six years (LOFSA
Annual Reports 1996 and 2002), and the central question of this research is as follows:
How competitive is Labuan as an offshore financial center?
The data-gathering process of this study was guided by the following six questions:
What are the activities of the Labuan offshore banks?
To what extent is Labuan being used as functional center or a paper center, or
ancillary center?
To what extent has the 1997-1998 Asian crisis affected Labuan offshore banks'
businesses and strategies?
To what extent have these banks recovered from the crisis?

38
 What are the perceptions of Labuan offshore bankers towards the current
policies, rules and regulations?
To what extent is Labuan competitive compared to other offshore centers in the
region?
To what extent does the offshore bankers' preference for functional or booking
operations depends on LOFSA's policy of restricting the number of Kuala
Lumpur marketing office staff?
To what extent does the competitiveness of Labuan after the 1997-98 Crisis
depends on its suitability as an offshore banking center?

1.5 Operational Definitions

The constructs of this research are classified according to the following: activities of the
Labuan offshore banks, functional, paper, and ancillary centers, Labuan offshore banks'
businesses and strategies, offshore banks' recovery, policies, rules and regulations, competitive
advantages of Labuan.

1.5.1 Activities of The Labuan Offshore Banks

Many authors in the financial service industry refer to activities in different ways. Thus
Lewis (1998) in explaining the concept of location of finance discusses the six core activities of
the financial firm - financial packing, delivery systems, production activities, regulations,
management information systems, and market interface. McCarthy (1979) when discussing the
concept of 'paper' center talks about loan booking activity. In this study, activities refer to
products and services offered by the financial institutions in Labuan.

1.5.2 Functional, Paper, and Ancillary Centers

As discussed in Paper One, McCarthy (1979) classifies offshore centers as either
'functional' or 'paper'.
(i) Functional Centers, where banks have a physical presence, and raise, invest and
lend funds on their own initiative.
Paper Centers, where banks act as a location of records, with little or no actual
banking transactions taking place, and are hence booking offices for transactions
and decisions made outside the center.
Lewis (1998) has added another concept, ancillary centers, where banks act as backroom
processing locations for transactions done outside the center.

39
1.5.3 Labuan Offshore Banks' Businesses and Strategies
The offshore banking business has been stagnant since 1997, and according to the
Labuan Offshore Financial Services Authority's (LOFSA) annual reports banking assets
declined from USD11.75 billion in 1996 to USD10.48 billion in 2002. In this study the Labuan
offshore banks' businesses refer to total deposits and banking assets, and strategies refer to
strategic actions taken by the Labuan offshore banks in response to the decline in deposits and
banking assets.

1.5.4 Offshore Banks' Recovery

As evident from the LOFSA's 1996 and 2002 annual reports, the overall deposits and
banking assets of the Labuan offshore banks have declined since the 1997-1998 Asian Crisis.
Offshore banks' recovery would mean the increase in the banks' deposits and banking assets
after the crisis.

1.5.5 Policies, Rules and Regulations

Policies refer to the Malaysian government objectives of setting up the offshore
financial center in Labuan, and rules and regulations are directives issued by LOFSA on how
the offshore banking businesses in Labuan should be conducted. Such rules and regulations
include having small number of staff in the Kuala Lumpur marketing office, the requirement
for the principle officers to reside in Labuan, and prohibition of Labuan offshore banks to act as
fronts for banks from outside Malaysia to take part in Malaysian deals (LOFSA 2003).

1.5.6 Competitive Advantages of the Labuan IOFC

In order to be competitive, an offshore financial center must have the "necessary"
attributes such as a liberal environment, strategic geographic location, stable political
environment, stable economic performance, the presence of international banks, quality labor
force, a developed financial and physical infrastructure, and the assurance of confidentiality and
secrecy (Felmingham & Dean 1998; Skully 1995; Tan & Vertinsky, 1988; Jao 1980). Labuan's
competitive edge in the region entails comparing the Labuan 10FC to Singapore, Hong Kong,
Bangkok International Banking Facility (IBF), Brunei International Financial Centre (IFC), and
Manila Offshore Banking Unit (OBU).

40
1.6 The Significance of this Study
The success of a financial center depends more than just government support (Skully
1995). Despite the presence of necessary features of a successful financial center, Labuan's
offshore banking business has not improved since 1997, in fact, banking assets shrunk by
USD1.3 billion over the six-year period (LOFSA Annual Reports 1996 & 2002). Despite these
setbacks the Malaysian government is committed to the development of Labuan as an
international offshore center. This commitment was clearly reflected when Labuan (IOFC) was
included in Bank Negara's ten-year Financial Sector Master Plan (BNM 2001) which
recommended for diversification of financial players and activities, the development of Islamic
banking and Islamic insurance, strengthening of the capital market and e-commerce. But for a
subject that has been given a national prominence very few studies were done on Labuan 10FC,
and except for a limited exploratory study conducted by Aralas et al. (2000) none of those
studies were empirical. This gives the research area significance in term of theoretical
contribution on the one hand and applied research contribution on the other. The findings of
this study could provide those involved in policy formulation with useful insights into the
current predicaments of Labuan IOFC, as well as a basis for strategic policy adjustments.

41
CHAPTER TWO: REVIEW OF RELATED LITERATURE

2.0 Introduction
As the major part of the literature review on offshore financial centers (OFCs) have
been covered in Paper One, this background chapter only confines itself to literature related to
empirical studies on OFCs and Labuan. The theoretical constructs for the empirical surveys for
this study were derived from both the literature review in Paper One and in this chapter.

2.1 Empirical Studies On Offshore Financial Centers

Tan and Vertinsky (1987) studied international financial centers (IFC) in two cities,
Singapore and Vancouver. They explored the geographical, economic, and infrastuctural
attributes of each city and the public's policies designed to stimulate growth and fine-tune their
international financial services sectors. They argued that although formal public policy provides
a vision and facilitates some preconditions for the development of an IFC, but the actual pattern
of actions taken, and the strategic niche the IFC occupies depends to a large extent on the
preferences and actions of those who actually provide financial services. Their analysis of the
strategies adopted by Vancouver and Singapore clearly indicates:
That marginal modification of supply advantages may shift the distributions of
benefits with the national economy and may affect the natural pace of growth of
international financial activities;
That an aggressive, proactive policy requires a flexible, and highly centralized
financial system; and
That product innovations and sensitive adjustments to changing market
environments and important condition for the success of proactive strategies.
Lessard (1993) did a study on Singapore as an offshore financial center. Lessard
highlighted the factors that have contributed to its progress as well as evaluating its potential
growth using Ingo Walter's Client, Arena, Product (CAP) model. The CAP model analyzes a
market structure by combining three principal dimensions in the delivery of financial services
in terms of the client served (C), the geographic arenas where business is done (A) and the
product supplied (P) (Walter, 1988). The CAP model was useful in understanding strategic
positioning of individual financial institutions and in assessing factors that appear to explain
differential competitive performance in the international financial services industry. To
understand the market position of Singapore, as well as to evaluate its potential global
competitive position Lessard surveyed the various financial institutions in Singapore, and

42
determine the CAP mixes of these financial institutions. The outcome of the study suggested
that the different financial institutions in Singapore showed a fair degree of differentiation of
functions, clientele, and arena. The study confirms that Singapore is an established financial
center.
Jayaraman (1998) studied the determinants of OFC activities in Vanuatu using the 'zero
friction' theory. Based on this theory it can be hypothesized that global funds generally flow to
the OFC of a country whose revenue-raising efforts are relatively less than those of 'higher-
friction states'. That is, the lower the revenue-mobilizing efforts of a tax haven the greater
would be the number of OFC institutions attracted to the location and the greater their
contributions to GDP.
The result ofJayaraman's study revealed the following:
There was no significant association between the contribution of OFC activities
to GDP and government low-revenue efforts, ruling out any sensitivity of local
taxes and levies on OFC activities;
There appeared to be a confirmed positive relationship between tourism
promotion efforts directly influencing OFC activities;
Political stability significantly influenced OFC activities in a positive manner;
and
Inflation had a significant negative impact on OFC activities contribution to
GDP; which shows that economic stability is necessary to attract OFC
institutions.

2.2 Studies on the Labuan IOFC

Since its inception in 1990 Labuan International Offshore Financial Centre (IOFC) has
attracted the attention a number of researchers. Among the first to study Labuan IOFC was
Skully (1995), who examined the operations of Labuan 10FC and concluded that while Labuan
has made considerable progress in improving its competitive edge more investment was still
required.
Sarver (1998) evaluated the development of Labuan IOFC five years after it's inception,
and observed that Labuan pursued well-thought-out strategies, and benefited from being in the
high growth South-East Asian region. The advantages of Labuan were the population spoke
English, and adhered to British business practice, accounting, and legal standards.
Abbott (1999) cited that Labuan had a number of features that make it a logical choice
for an offshore financial center. It shared the same time zone as most of the major financial

43
 centers in East Asia, and enjoyed a stable political environment. However, it was the 'low tax
status that made it internationally competitive' (Abbott 1999, p. 196). Abbott concluded that
although business had grown remarkably since 1990 it was still not the level of business that
would make Labuan a premier international financial center. Labuan had a long way to go
before it would be at par with established offshore financial centers such as Jersey, Guernsey,
or the Isle of Man (Abbott 1999).
The first empirical study on Labuan was conducted by Aralas et al. (2000) which
attempted to identify the factors that contributed to its as an international offshore financial
(IOFC). The study used factor analysis as a statistical tool to identify and rank factors such as
banking secrecy, political stability, geographic location, infrastructures, and government
incentives. The findings indicated that secrecy, political stability, government commitment,
lower operating cost were among factors that were highly ranked, and other factors were air
accessibility and economic stability. The study concluded that Labuan had all the attributes of a
successful offshore financial center.

2.3 Review of Research Methodology

The research methodology used in this study was derived from the work of Lessard
(1993), Hagen (1989), and Tan and Vertinsky (1987), which employed the mail survey method.
Lessard (1993) studied offshore banking operations to identify factors that had contributed to
the development and success of Singapore as a financial center, and evaluated its potential as an
international financial center. The study used mail survey questionnaires sent to the full
licensed banks, restricted licensed banks, offshore banks and merchant banks listed in the
Schroder International Merchant Bankers Limited Directory.
Hagen (1989) studied the offshore banking center of Curacao in the Netherlands
Antilles as a doctoral thesis for the University of Miami. The study focused on the advantages
offered by Curacao, its market position, type of banking activities, and benefits and costs
associated with the provision of offshore banking services. The study also used mail survey
involving 47 offshore banks, and 10 trust companies in Curacao, as the main method in
gathering data supplemented by interviews.
Tan and Vertinsky (1987), analyzed the evolution of international financial centers in
Singapore and Vancouver by exploring the key geographic, economic, and infrastructure
attributes of each centers and the government policies in stimulating growth and enhancements
of their financial services center, and the strategic outlook of service providers in each center.

44
 The study too used mail survey method involving 150 senior bankers, senior managers of
financial institutions, and regulators in Canada and Singapore.
A mail survey is most suited to situations where the questions are not complicated, and
require straightforward and concise answers. It can be a very effective method of gathering data
as no other survey method can match its low cost advantage (Jobber & O'Reilly 1996).
Furthermore, mail surveys permit recipients to consult documents and complete the
questionnaire in their own time. Answers may be more honest than in a face-to-face interview,
errors such as the mis-recording of answers, non-uniformity in asking questions, differential
probing and questionnaire falsification can be eliminated.
However, a major problem associated with mail surveys is that of obtaining an adequate
response rate. The loss of sample size may restrict the range of analytical techniques that can be
used, and reduce the power of statistical testing. Other drawback is the likelihood that non-
respondents differ in some critical ways from respondents leading to biased estimates.

2.4 Conceptual Framework

As discussed in Paper One the dependent variable of the development of an offshore
financial center (OFC) is influenced by eight independent variables: namely, a liberal
environment, strategic geographic location, stable political environment, stable economic
performance, the presence of international banks, quality labor force, a developed financial and
physical infrastructure, and the assurance of confidentiality and secrecy (Felmingham & Dean
1998; Tan 1997; Skully 1995; Tan & Vertinsky 1988; Jao 1980). But the core of this study
focused on two major independent variables strategic geographical location, and financial and
physical infrastructure. The rationale behind this choice was based on information obtained
from informal interviews with visiting senior bankers from other regions as well as the Labuan
offshore bankers themselves. Factors such as stable political environment, stable economic
performance, assurance of confidentiality and secrecy, liberal environment, and financial and
physical infrastructure are internal variables, which could be controlled by the government or
central bank However, presence of international banks, strategic geographic location and
quality labor force are external factors which the government cannot influent.
Strategic geographical location is essential in attracting both depositors and borrowers
from countries with surplus or high demand of funds. Singapore is a good example (Hughes &
MacDonald 2002; Bryant 1989). But strategic location alone is not enough to guarantee the
success of an OFC unless supported by a developed financial and physical infrastructure.
Financial infrastructure refers to the financial system, such as the financial market, and physical

45
infrastructure refers to air transportation, telecommunication, and other support services
industries. According to the Association of Offshore Banks, Labuan (AOB) (2002), lack of
direct air accessibility was one of Labuan's major disadvantages compared to Hong Kong and
Singapore. The empirical survey was aimed at soliciting the opinions and perceptions of
Labuan offshore bankers on how these two variables became impediments in Labuan's quest to
become a premier IOFC in the region.

Figure 2.1: Conceptual Framework for a Successful Labuan 10FC

Stable
Political
Environment

Stable
Economic
Performance
Bank
Assurance of Negara
Government
Confidentiality Malaysia
and Secrecy

Liberal
Environment

Laboan A
Developed Successful
Offshore 110.
Banking Financial/ Labuan
Predicaments Physical 10FC
Infrastructure

ol Presence of
International
Banks

Strategic
Geographic
Factors Location
_olExternal
Quality
Labour
Force

46
CHAPTER THREE: RESARCH METHODOLOGY

3.1 Research Design

The research design adopted in this study was an empirical survey, and analysis of data
gathered from the survey was descriptive using simple inference statistics. The survey was
conducted by mailing each prospective respondent two questionnaires integrated in one
instrument, Part A and Part B, and Part A for this paper. This design was based on the choice of
a sampling frame and availability of sources for the research. The whole offshore bank
population consisted of 49 banks in operations as of October 2003. Many of the issues in the
survey were considered 'sensitive' by the Labuan offshore banking community, and in
recognition of such sensitivity a mail survey was selected to maintain the anonymity of
respondents.

3.2 Sampling and Sample Size

The survey used whole population of banks, which enabled the researcher to ignore the
problems of bias in sampling. The total number of operational offshore banks as of October
2003 was 49, of which 10 were Malaysian banks and 39 foreign banks.

3.3 Instrument Design

The questionnaire (Appendix I) was based on information obtained from informal
interviews with managers of offshore banks, and partly from the researcher's experience during
his eight years' career in the industry. The questionnaire was later sent to six offshore bank
managers for their comments. After receiving their replies minor adjustments were made. The
questionnaire contained four major sections. The first section was designed to gather
information about the respondent's bank nature of business, operations, and products and
services offered. The second section was designed to gather information on the effect of 1997-
1998 Asian Crisis on the respondent bank's business, Labuan's competitiveness and
organizational strategies. The third section was designed to gather information on government
policies, rules and regulations. Finally, the fourth section was designed to gather information on
the competitiveness of Labuan IOFC, it major competitors, it suitability as an offshore banking
center, and whether Kuala Lumpur would be a more suitable location.

47
3.4 Data Collection Method
Since the number of offshore banks operating in Labuan is relatively small, the
questionnaires were sent to all the relevant banks listed in the Labuan Offshore Financial
Services Authority's (LOFSA) list of offshore banks. Of the 53 banks in the list two were not
operational, and another two were investment banks managed by the same General Managers
who headed the commercial banking subsidiaries. To avoid redundancy, questionnaires were
only sent to the commercial banking arms, and a total of 49 questionnaires were distributed.
The questionnaires with explanatory letters (Appendix II) were addressed to the Chief
Executive Officer, General Manager, Branch Manager, or Manager depending on the titles of
the principal officers responsible for the overall affairs of the bank. Prospective respondents
were assured of confidentiality and to maintain their anonymity stamped and self-addressed
envelopes were provided.
Before distributing the questionnaires the researcher personally contacted the principle
officers, or where not available, the personal assistants, or secretaries via telephone, or email
and they were informed of the reasons for the research. The first set of questionnaires was
distributed in November 2003, and 17 returned. In December 2003 the second set of
questionnaires were distributed, and another 19 returned.

3.5 Data and Statistical Analysis

The descriptive statistics were the main statistical tools measures of central tendency
(mean) and dispersal (standard deviation), and frequency counts. The data analysis and
presentation were categorized in four areas in the questionnaire, nature of business operations,
business after the 1997-1998 Asian Crisis, policies, rules and regulations, competitive
advantages of Labuan 1.0FC.

48
CHAPTER FOUR: FINDINGS AND DISCUSSIONS

4.0 Introduction
The respondents were principal officers responsible for the overall affairs of the banks.
The choice of subjects was based on judgmental sampling that involved managers who were in
the best position to provide the information required. Twenty-seven of the respondents
represented foreign banks, and nine worked for Malaysian banks. The results of the survey
were summarized under the following main headings: profile of the offshore banking business
in Labuan, effect of the 1997-1998 Asian Crisis, policies and regulations, and competitive
advantages of Labuan.

4.1 Profile of the Offshore Banking Business in Labuan

To determine whether Labuan was a functional or booking center, and products and
services offered by offshore banks varied, the respondents were asked to indicate their types of
operations, products and services offered, and if they have treasuries.

4.1.1 Types of Operations

To determine whether Labuan was a 'genuine', or a booking center the respondents
were asked to indicate if the transactions carried out in Labuan were functional, paper, or
ancillary. Functional transactions were where actual banking transactions were carried out, and
banks raised, invested and lent funds on their own initiative. Paper transactions were where
banks act as a location of records, with little or no actual banking transactions taking place, and
are hence booking office for transactions and decisions made at head and/or regional office
outside the location (McCarthy 1979; Jao 1983; Hampton 1998). Ancillary transactions were
where banks acted as backroom processing locations for transactions outside the location
(Lewis 1988). The result is shown in Table 2.1 (page 50). Seventeen respondents carried out
functional transactions, and four paper transactions. A total of fifteen respondents carried out
all three types of transactions, nine were predominantly functional, four paper, and two
ancillary.
The findings indicated that most banks set up offices in Labuan to carry actual
transactions. However, there were some banks, which used Labuan merely for booking deals
done in other centers to take advantage of the low tax, and a smaller number of banks used
Labuan as a back office processing location. Overall, offshore banking transactions in Labuan
were mixed. With 17 banks carrying out fully functional transactions, and 9 banks carrying out

49
mixed transactions that were predominantly functional, the Labuan IOFC was a functional
center and not a booking center.

Table 2.1: Types of Operations

Frequency Percent

Functional transaction 17 47.2

Paper transaction 4 11.1
All three, majority functional 9 25.0
All three, majority paper 4 11.1
All three, majority ancillary 2 5.6

Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

4.1.2 Products and Services

To determine the types of products and services offered by the Labuan offshore banks a
list of 10 products/services were provided and respondents were asked to rate the significance
of products or services of their banks in terms of "extremely important" (5), "very important"
(4), "important" (3), "somewhat important" (2), and "not important at all important" (1). Table
2.2 (page 51) depicts these findings. Measured on a five-point scale, with a mean of 3.92
lending is considered the major function of offshore banks in Labuan. Thirty-one of the
respondents rated it either "extremely important", "very important", or "important". The
second major function was the issuance of standby letter of credits (SBLCs) and bank
guarantees (BGs) with a mean of 3.36.
Twenty-eight respondents rated it "important", and higher. Advisory (mean = 2.91),
accepting and placing deposits (mean = 2.83), treasury operations were not considered major
functions by the respondents. Private banking, debt securitization, trade financing, derivatives
trading/hedging, and securities trading were not considered important functions by the
respondents.
The results indicated that the products and services offered by the offshore banks in
Labuan were very limited. Most of the banks were only engaged in lending (mean = 3.92) and
issuance of SBLC/BG (mean = 3.36), and a fair degree of advisory (mean = 2.91), and deposit
taking and placing (mean = 2.83). The findings revealed that the Labuan offshore banks were
predominantly engaged in simple operations, and did not venture into value-added products
such as debt securitization, derivatives or securities trading.

50
Table 2.2: Types of Products and Services Offered by Labuan Offshore Banks

Extremely Very Somewhat Not at all Standard

Important Important Important Important Important Mean Deviation
(5) % (4) % (3) % (2) % (1) %

Lending (13) 36.1 (15) 41.7 (3) 8.3 (2) 5.6 (3) 8.3 3.92 1.20

Issuance of
SBLC/BG (8) 22.2 (10) 27.8 (10) 27.8 (3) 8.3 (5) 13.9 3.36 1.31

Advisory (4) 11.1 (9) 25.0 (7) 19.4 (10) 27.8 (5) 13.9 2.91 1.27

Accepting and
placing deposit (4) 11.1 (11) 30.6 (6) 16.7 (5) 13.9 (10) 27.8 2.83 1.42

Treasury
operations (4) 11.1 (8) 22.2 (7) 19.4 (7) 19.4 (10) 27.8 2.69 1.39

Private banking (3) 8.3 (5) 13.9 (5) 13.9 (11) 30.6 (12) 33.3 2.33 1.31

Debt
securitization (3) 8.3 (2) 5.6 (7) 19.4 (10) 27.8 (13) 36.1 2.20 1.26

Trade
Financing (2) 5.6 (3) 8.3 (7) 29.4 (11) 30.6 (13) 36.1 2.17 1.18

Derivatives
trading/hedging (2) 5.6 (I) 2.8 (7) 19.4 (8) 22.2 (18) 50.0 1.92 1.16.

Securities
trading (2) 5.6 (2) 5.6 (4) 11.1 (6) 16.7 (21) 58.3 1.80 1.21
Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency
SBLC/BG - Standby letter of credit/Bank Guarantee

4.1.3 Treasury Operations

To determine the feasibility of treasury management service, respondents were asked to
indicate whether or not their banks were engaged in treasury operations. The results are shown
in Table 2.3 (page 52). Only 13 of the respondents' banks were engaged in treasury operations,
and 23 did not. In addition, those respondents whose banks did not have treasury operations
were asked if they had the intention to set up treasuries in one or two years time, and the
findings are depicted in Table 2.4 (page 52). Only four indicated that their banks would set up
treasury operations in two years time. Nineteen indicated that they had no intention to set
treasury operation at all, and one did not respond. The results contradicted Bank Negara's
presumption that treasury management was a viable business in Labuan (BNM 2001).

51
 Table 2.3: Treasury Operations

Frequency Percent
Yes 13 36.1
No 23 63.9
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

Table 2.4: Intention to set up a Treasury

Frequency Percent
N/A 13 38.9
Two years time 4 11.1
Not at all 19 50.0
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

4.2. Effects of the 1997-1998 Asian Crisis

To find out how the crisis affected Labuan offshore bank business and influenced their
subsequent strategies, respondents were asked on three major areas, performance of the Labuan
offshore banks both during and after the crisis, the competitiveness of Labuan after the crisis,
and strategic changes adopted by the offshore banks in response to changes in market realities
after the crisis.

4.2.1 Labuan Offshore Banks Performance

The 1997-1998 Asian Crisis has left some undesirable consequences on Labuan IOFC.
To gain insight into its effects on the offshore banking business the respondents were asked to
indicate their banks' performances both immediately after the crisis and five years later. To find
the extent of offshore bank's business affected by the crisis the respondent were asked to
indicate if their banks' business "decreased, increased, no change, and not applicable". The
findings are depicted in Table 2.5 (page 53). Three claimed that their business had actually
increased by 25% due to the crisis. Five saw their business decreased by 25%, ten decreased by
26-50%, five decreased by 51-75%, and four no change. Eight respondents reported not
applicable because their operations in Labuan started after the crisis. These results concurred
with the observations of Abbott (1999) that the Labuan offshore banking business was badly
affected by the crisis.

52
Table 2.5: Business Affected by the 1997-1998 Asian Crisis

Frequency Percent
Increased by 25% 3 8.3
Decreased by 25% 5 13.9
Decreased by 26-50% 10 27.8
Decreased by 51-75% 5 13.9
No Change 4 11.1
Not applicable 9 25.0
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

To have an idea whether the banks have recovered from the crisis the respondents were
asked to indicate "increased, no improvement, and not applicable". Table 2.6 (below) depicts
the findings. Three respondents reported their business increased by 51-75%, eight increased by
26-50%, and eight increased by 25%. However, nine of the respondents reported no
improvement, and seven indicated not applicable because their business started after the crisis.
The findings indicated that 17 of the offshore banks were adversely affected by the crisis, and
have not regained their pre-crisis status. Those banks that have recovered only saw their
businesses increased between 25-75%, and nine of the banks never recovered. The crisis has
left the once promising offshore banking industry in a state of uncertainty. These results
concurred with the industry's records as reported by LOFSA. The offshore banking business
has been stagnant since 1996, and banking assets declined from USD11.75 to USD10.48 billion
over the period of six years (LOFSA Annual Reports 1996 & 2002).

Table 2.6: Business Five Years After the Crisis

Frequency Percent
Increased by 51-75% 3 8.3
Increased by 26-50% 8 22.2
Increased by 25% 8 22.2
No Improvement 9 25.0
Not applicable 8 22.2
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

53
4.2.2 Labuan's Competitive Edge
To gain further insights into the effect of the crisis on the offshore banking business the
respondents were asked to rate Labuan's competitive edge after the crisis on a Likert-styled
scale of 1-5. Scale (1) represented "least competitive", (2) "somewhat competitive", (3)
"competitive", (4) "very competitive", and (5) "most competitive". Table 2.7 (below) depicts
the findings. A mean of 2.69 indicated that the respondents did not perceived Labuan as
competitive. These findings too were consistent with LOFSA's report on the industry that the
number of operational offshore banks in Labuan decreased from 60 to 51 (LOFSA Annual
Report 2002), and the observations of the Association of Offshore Banks, Labuan (AOB 2002).

Table 2.7: Competitiveness of Labuan After the Crisis

Most Very Somewhat Least Standard

Competitive Competitive Competitive Competitive Competitive Mean Deviation
(5) °A) (4) % (3) % (2) % (1) %

(0) 0.0 (3) 8.3 (20) 55. 6 (12) 33.3 (1) 2.8 2.69 .67
Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

4.2.3 Strategic Changes in the Next Three Years

To find out the influence of the crisis on the strategies of the offshore banks five items
were provided and the respondents were asked to indicate what would be the most likely to
happen to their banks' operations in Labuan in three years time. The items were "downsize,
change to investment banking, move to Singapore, move to Hong Kong, and others". "Others"
comprised of "status quo", "close down", "expand", and "depends on the market liberalization
policies after 2007".
The findings are shown in Table 2.8 (page 55) Fifteen respondents indicated that their
operations would remain "status quo", six indicated that their banks would "downsize", six
"expand", four would "depend on the expected liberalization of the banking industry in 2007",
three would "change to investment banking", one would "move to Singapore", and another
would "close down".
This finding confirmed with the Association of Offshore Banks' records. Since this
survey was conducted, one bank European bank has already closed down and another has
indicated to the same by end of the year (AOB 2004).

54
Table 2.8: What Most Likely to Happen within the Next 3 Years

Frequency Percent
Downsize 6 16.7
Change to investment banking 3 8.3
Move to Singapore 1 2.8
Status Quo 15 41.7
Expand 6 16.7
Close down 1 2.8
Depends on 2007 policies 4 11.1
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

4.2 Policies and Regulations

To investigate the perceptions of Labuan offshore bankers towards the current policies,
rules and regulations the study focused on three major areas, the government original objectives
of establishing the IOFC in Labuan, Kuala Lumpur marketing office, and fronting by Labuan
banks.

4.3.1 Objectives of Establishing the Labuan IOFC

The Malaysian government's objectives of setting up an International Offshore
Financial Center (IOFC) are:
To complement the onshore financial system centered in Kuala Lumpur;
To strengthen the contribution of the financial sector towards the Gross National
Product of Malaysia;
To enhance the attractiveness of Malaysia as an investment center; and
To promote the economic development of Labuan and its vicinity.
To gain insight into the offshore bankers perceptions towards the government policies
on the development of the offshore banking industry, the respondents were asked to rank the
objectives in term of "extremely important" (5), "very important" (4), "important" (3),
"somewhat important" (2), and "not at all important" (1). The findings are shown in Table 2.9
(page 56). Based on a five-point scale the objective to enhance investment was perceived as
very important (mean = 3.89). The mean of 3.83 for "to complement the onshore financial
system" is also above average and considered very important by the respondents. The mean of
3.28 for "contribute to GNP" is about average, and so was "to develop Labuan" (mean = 3.20).
The findings indicated that only two of the objectives, to enhance investment, and to
complement the onshore financial system were considered very important, and should become

55
the government top priority. The other two, to contribute to GNP, and to develop Labuan were
important, but not considered as priority items. In other words the government policies should

Table 2.9: Government Main Objectives of Setting up IOFC in Labuan

Extremely Very Somewhat Not at all Standard

Important Important Important Important Important Mean Deviation
(5) % (4) ')/0
(3) % (2) (1) %

Enhance investment (8) 22.2 (19) 52.8 (7) 19.4 (1) 2.8 (1) 2.8 3.89 .89

Complement onshore
financial system (4) 11.1 (24) 66.7 (6) 16.7 (2) 5.6 - - 3.83 .70

Contribute to GNP (4) 11.1 (12) 33.3 (13) 36.1 (4) 11.1 (3) 8.3 3.28 1.09

Develop Labuan (8) 22.2 (7) 19.4 (11) 3.6 (6) 16.7 (4) 11.1 3.20 1.30

Overall mean 3.56

Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

be focused on developing the offshore banking industry as a means to enhance investment and
to complement the domestic financial system, and not using offshore banking as a means to
develop Labuan.
These findings too concurred with Association of Offshore Banks' findings that the
government should give priority to the development of the offshore banking industry by
adopting the concept of twinning Labuan with the Multimedia Super Corridor (MSC) as
outlined in Bank Negara's master plan (AOB 2002). The proposed structure would further
support the original objective of setting up Labuan IOFC to complement the financial system in
Kuala Lumpur, enhance further development of the international and offshore banking business
in the country.

4.3.2 Kuala Lumpur Marketing Office

The issue of restricting the number of staff allowed in the Kuala Lumpur marketing
office has always been a sensitive one to most offshore banks. The respondents were asked to
rate the rule as "strongly disagree" (1), "disagree" (2), "neutral" (3), "agree" (4), "strongly
agree" (5)". In addition the respondents were also encouraged to give their comments. The
findings are depicted in Table 2.10 (page 57). On a five-point scale the mean of 2.54 indicated

56
that the respondents disagreed with the rule. The respondents' comments against the rule were
as follows:
Businesses are mostly in Kuala Lumpur;
Frequent traveling between Labuan and Kuala Lumpur are not cost-effective;
The number of staff should be increased;
Policy does not support market reality; and
Kuala Lumpur is the gateway for business arrivals and meetings.
For the few respondents who agreed with the rule their comments were as follows:
LOFSA is quite flexible on this issue; and
There are many ways of circumventing the rule.

Table 2.10: Restricting Number of KL Marketing Office Staff

Strongly Strongly Standard

Agree Agree Neutral Disagree Disagree Mean Deviation
(5) 13/0 (4) % (3) % (3) % (I) %

(I) 2.8 (2) 5.6 ( I 8) 50.0 (8) 22.2 (6) 17.1 2.54 .95
Source: Mail Survey Data (Feb. 2004)
N-36
Number in parenthesis indicates frequency

The findings indicated that most offshore banks were unhappy with the rule to limit the
number of staff in the marketing office, and those who 'agreed' with the rule have resorted to
some 'tricks' to go round the rule. These findings concurred with a recent random survey done
by Business Times, where interviewees commented that the offshore bankers spent most of
their time in Kuala Lumpur instead of Labuan (Yusof 2004).
Under the rule LOFSA might allowed more people in the marketing office based on the
'merit of the case', usually not more than the number of people in the Labuan. The offshore
bankers lamented that this was practical only for those banks that maintained a large number of
staff, but not those manned by three or four people.

4.3.3 Fronting by Labuan Banks

In line with Malaysian government policy of granting Labuan banks the 'right of first
refusal' for residents of Malaysia seeking foreign currency financing as discussed earlier in
Paper One, LOFSA has issued a circular disallowing offshore bank to 'front' for banks from
outside Labuan to enable them to participate in Malaysian deals (LOFSA 2003). The

57
 respondents were asked to rate the rule as "strongly disagree" (1), "disagree" (2), "neutral" (3),
"agree" (4), and "strongly agree" (5). In addition the respondents were also encouraged to give
their comments. The findings are in Table 2.11 (below). On a five-point scale the mean of 3.26
indicated that the respondents were neutral on the issue. For the respondents who agreed with
the rule their comments were as follows:
LOFSA should uphold the competitiveness of Labuan; and
Fronting may discourage new banks from setting up branches in Labuan.

Table 2.11: Not Allowing Fronting

Strongly Strongly Standard

Agree Agree Neutral Disagree Disagree Mean Deviation
(5) % (5) % (3) % (2) % (1) %

(5) 13.9 (11 30.0 (8) 22.2 (10) 27.8 (1) 2.8 3.26 1.12
Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

Those respondents who did not agree with rule have the following comments:
Policy should not limit secondary market activities;
Fronting would generate income to Labuan banks; and
Fronting could mean strategic alliance.

4.4 Competitive Advantages of the Labuan IOFC

To determine the competitiveness of Labuan IOFC compared to other centers in the
region this study focused on four pertinent issues: reasons for setting up operations in Labuan,
threats to Labuan IOFC, suitability of Labuan as an offshore banking center, and suitability of
Kuala Lumpur as an offshore banking center.

4.4.1 Reasons for Setting up Operations in Labuan

To gain insight into the competitiveness of Labuan a list of 11 attributes was provided
and respondents were asked to rate the benefits of setting up branches in Labuan in terms of
"extremely important" (5), "very important" (4), "important" (3), "somewhat important" (2),
and "not at all important" (1)." Table 2.12 (page 60) depicts the findings. Banks chose to
establish offices in Labuan based on the particular benefit they perceived. Malaysian banks, for

58
 example viewed the setting up of offices in Labuan as their entrance to the international
financial markets in contrast to foreign banks who saw it as an important gateway to the high
growth Malaysian economy.
On a five-point scale the attributes considered as major benefits by the respondents
were, reliable legal system (mean = 3.76), low taxes (mean = 3.69), bank secrecy law (mean =
3.67), central bank policies (mean = 3.64), minimum exchange control restrictions (mean =
3.50), and political stability (mean = 3.42).
Reliable legal system with a mean of 3.76 was considered the main benefit of setting up
offices in Labuan. Legal reliability is where a business is guaranteed that for a specific length
of time tax rates will not be changed, and there is an existence of fair law on bankruptcy, and
reliable court system. Malaysia adheres to the English legal system, and has long track records
of honoring the rules of law. The findings were consistent with an earlier study done by Aralas
et al. (2000), which indicated reliable legal system was among the factors contributing to the
functioning of Labuan IOFC.
Low tax, with a mean of 3.69 was considered the second major benefit by the
respondents in setting up offices in Labuan. The tax rates were among the lowest in the world
(LOFSA, 1999) at either 3% or a flat payment of 20,000 Malaysian ringgits, whichever the
company chooses to adopt. The findings were consistent with earlier observations by some
authors that Labuan was a tax haven (Hampton 1998; PaIan 1998; Skully 1995).
Bank secrecy law, mean of 3.67 was the third major benefit. The finding was consistent
with an earlier study done by Aralas et al. (2000), which indicated bank secrecy system was
among the factors identified as an advantage to the Labuan IOFC.
Confidentiality is an essential requirement for an offshore financial center. Identities of
customers, customers' assets and account should remain secret. Individual or companies can
reduce their world tax income through the creation of foreign trust or fiduciary agreements.
Foreign exchange regulations imposed in the clients' country prohibit them from having
deposit in other countries, and a client of an offshore bank seeks assurance that such
information is not disclosed to his government. Client who does not want his individual wealth
known can remain unidentified.

59
Table 2.12: Reasons for Setting up Offices in Labuan
Extremely Very Somewhat Not at all Standard
Important Important Important Important Important Mean Deviation
(5) % (4) % (3) % (2) % (1) %

Reliable Legal System (8) 22.2 (13) 36.1 (11) 30.6 (2) 5.6 (1) 2.8 3.76 .99

Low Taxes (8) 22.2 (13) 36.1 (12) 33.3 (2) 5.6 (I) 2.8 3.69 .98

Bank Secrecy Law (5) 13.9 (19) 52.8 (8) 22.2 (3) 8.3 (I) 2.8 3.67 .93

Central Bank Policies (9) 25.0 (11) 30.6 (11) 30.6 (4) 11.1 (1) 2.8 3.64 1.07

Minimum Exchange
Control Restrictions (7) 19.4 (13) 36.1 (10) 27.8 (3) 8.3 (3) 8.3 3.50 1.16

Political Stability (9) 25.0 (8) 22.2 (12) 33.3 (3) 8.3 (4) 11.1 3.42 1.27

Reputations (4) 11.1 (12) 33.3 (11) 30.6 (6) 16.7 (3) 8.3 3.22 1.12

Access to domestic
Business (14) 38.9 (3) 8.3 (4) 11.1 (3) 8.3 (11) 30.6 3.17 1.76

Ideal Time Zone (1) 2.8 (7) 19.4 (15) 41.7 (7) 19.4 (6) 16.7 2.72 1.06

Geographical Location (1) 2.8 (2) 5.6 (12) 33.3 (8) 22.2 (12) 33.3 2.20 1.08

Overall mean 3.29

Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

The central bank policies, mean of 3.64 were considered the fourth major benefit. Bank
Negara Malaysia has shown itself to be predictable, transparent and apply rules strictly. This
finding concurred with earlier observations of Delhaise (1998, p. 146), where it was stated that
'Bank Negara is one of the best regulators in Asia, and its annual report has long been the best
in the region.'
Minimum exchange control restrictions, mean of 3.50 were also among the major
benefits for setting up offices in Labuan. Political stability (mean = 3.42) was another major
benefit. Sicat (1984), Tan and Vertinsky (1987), Bryant (1989), and Jones (1992) attributed the
growth of Singapore to its record of political stability without major disruptions since the late
1960s. This finding concurred with earlier observations of Abbott (1999), Sarver (1998), and
Skully (1995) where they cited Malaysia's political stability has contributed to establishment of
Labuan IOFC.
Good reputation (mean = 3.22), and the opportunity to get into the domestic business
(mean = 3.17) were considered important by some respondents. With regards to reputation

60
criminal activity has been inhibited because of the strict policies of Bank Negara and the
presence of the Anti-money Laundering Act. The opportunity to get into the domestic market
when the Malaysian banking industry eventually liberalized in 2007 was identified as a major
benefit for the foreign banks that do not have domestic operations. As depicted in Table 2.13
(below) where 18 respondents rated it important and higher. This finding confirms and earlier
survey conducted by The Star newspaper where a senior offshore banker working for an
international bank summed up the industry's view as follows:
It would be illogical not to have an operation in the country once liberalization happens, as foreign banks
set up their offshore business to mainly tap Malaysian business, and the ringgit business is much bigger
than the non-ringgit for Malaysian client (The Star 2 Aug. 2003, p.6).

Table 2.13: Access to Domestic Business

Extremely Very Somewhat Not at all

important important Important important important
(5) (4) (3) (2) (I) Total
Malaysian Bank (1) (2) ( 6) 8

Non-Malaysian Bank (14) (2) (2) (3) (5 ) 26

Total 14 3 4 3 10 34

Source: Mail Survey Data (Feb. 2004)

N=34
Number in parenthesis indicates frequency

Ideal time zone (mean = 2.72), and geographical location (mean = 3.22) were not
considered important by the respondents. This finding indicated that strategic location had
never been the attribute of Labuan, and when the banks decided to open branches in Labuan it
was never a prime consideration. These findings confirmed earlier findings by Abbott (1999),
where it was cited that some of the international decisions to set up branches in Labuan had
little to do with offshore finance, but some less obvious agenda.
According to some interviewees most of the foreign banks were already having their
Malaysian portfolio with their Singapore offices long before Labuan IOFC came into being in
October 1990. With the enactment of the Offshore Banking Act (OBA) 1990 which stipulated
that foreign currency borrowing could only by done through Labuan, these foreign banks had
no choice but to set up offices in Labuan regardless of the relevance of its geographic location.
As for the Malaysian banks they had very little choice but to support the government's
initiative to make Labuan IOFC a premier international offshore financial center (Abbott 1999).
Besides, the Malaysian banks saw Labuan as a gateway to the international capital market.

61
4.4.2 Threats to the Labuan IOFC
The fast economic growth of the Asian countries since the late 1960s until 1990s has
resulted in the proliferation of OFCs in the region. To determine the competitive advantages of
Labuan a list of five other OFCs was provided, Singapore, Hong Kong, Bangkok (IBF), Brunei
(IFC), and Manila (OBU). The respondents were asked to rate the threats on a Likert-styled
scale, 5 being the "most serious" 4 "very serious", 3 "serious" 2 "somewhat serious" and 1 "not
at all serious" threat. The findings are depicted in Table 2.14 (below). The respondents
predominantly viewed Singapore (mean = 4.58) as the major threat, and Hong Kong (mean =
4.03) as the second major threat to Labuan. Bangkok IBF (mean = 2.43), Brunei IFC (mean =
2.14), and Manila OBU (mean = 1.54) were not considered as threats to Labuan.

Table 2.14: Threats to Labuan 10FC

Extremely Very Somewhat Not at all Standard
Serious Serious Serious Serious Serious Mean Deviation
(5) % (4) % (3) % (2) % (1) %

Singapore (23) 63.9 (12) 33.3 (1) 2.8 4.58 .65

Hong Kong (11) 30.6 (20) 55.6 (2) 5.6 (1) 2.8 (2) 5.6 4.03 1.00

Bangkok 1BF (19) 52.8 (12) 33.3 (4) 11.1 2.43 .70

Brunei IFC (3) 8.3 (1) 2.8 (6) 16.7 (13) 36.1 (12) 33.3 2.14 1.19

Manila OBU (1) 2.8 (3) 8.3 (10) 27.8 (21) 58.3 1.54 .78

Overall mean 2.88

Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

The respondents were also asked to give two or three reasons for the two OFCs they
considered as major threats to Labuan, and most common reasons given were as follows:
Well-established and advanced infrastructure;
Environment is conducive for expatriates and their families;
Easy access to expertise and skilled workforce;
Strategic geographical location;
Diversified and competitive products and services;
Presence of top international banks;
Liberal and transparent regulatory bodies; and
(vii) Center of excellence.

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 These findings concurred with that of Association of Offshore Banks, Labuan's
workshop on the 'Critical issues for the Continued Development of Offshore Banking in the
Labuan IOFC' where Singapore and Hong Kong were found to be the main competitors of
Labuan (AOB 2002). The findings also indicated that if Labuan was to continue as an offshore
banking center it should be willing to match what Singapore and Hong Kong already have.
Labuan IOFC may not compete with Singapore or Hong Kong in term of products and services,
but the international banks would see it from the perspective of efficiency. Some interviewees
from the international banks revealed that visiting senior bankers from other regions always
asked if Labuan could match the efficiency and convenience of Singapore.

4.4.3 Suitability of Labuan as an Offshore Banking Center

Labuan offshore bankers have to put up with less than interesting questions asked by
visiting senior executives from regional or head offices; 'why of all places Labuan was chosen
as a location of offshore banking center?' The respondents were asked to rate Labuan in term of
"extremely suitable" (5), "very suitable" (4), "suitable" (3), "somewhat suitable" (2), and "not
at all suitable" (1). The respondents were also asked to give some reasons for their answers.
The result of the finding is depicted in Table 2.15 (page 65). On a five-point scale the mean of
1.86 is not at all impressive. Twenty-nine rated Labuan below "suitable". The reasons given by
the respondents were as follows:
Away from the business center;
Lack of expertise and skilled workforce;
Location is not strategic;
Limited products and services;
Poor air accessibility;
Unreliable water, electricity supplies; and
Unreliable medical facility.

These findings contradicted LOFSA's presumption of the strategic location of Labuan

as being in the hub of a circle that links Bangkok, Hong Kong, Jakarta, Kuala Lumpur, Manila
and Singapore (LOFSA 1999). The claim looked perfectly well on the map of South-East Asia,
but bankers and businessmen alike lamented about taking "kangaroo" flights to reach Labuan.
In the words of one senior offshore player the predicament could be summed up as follows:
It's very difficult to get to these places from Labuan. The transport, the flight system, they just do not
cater for this part of the world (Business Times 12 Jul. 2004, p. I).

63
 The findings concurred with that of a recent random survey by Business Times, which
cited poor air accessibility, unreliable water and electricity as some of the major drawbacks of
Labuan (Business Times 12 Jul. 2004, p.1). Interestingly, reasons given by the respondents
revealed the opposite attributes, which made Singapore and Hong Kong successful offshore
financial centers.

4.4.4 Suitability of Kuala Lumpur as an Offshore Banking Center

To further determine the strategic geographic location of Labuan, the respondents were
also asked to rate Kuala Lumpur in the same order, and encouraged to give reasons for their
answers. The findings are also shown in Table 2.15 (page 65). The mean of 4.00 on a five-point
scale indicated that the respondents predominantly viewed Kuala Lumpur more suitable for an
offshore banking center. Thirty-three respondents rated Kuala Lumpur "suitable" and above.
The reasons given by the respondents were as follows:
Good and well-developed infrastructures;
Availability of expertise and skilled workforce;
Easy air accessibility;
Close to the clients; and
Conducive environment for expatriates and their families.
However, one respondent answered that the idea of Kuala Lumpur as a center of
offshore banking was not relevant. This answer reflected the views of some Malaysian offshore
bankers who believed that the government has decided to make Labuan an international
offshore financial center, and banks should make the best out of it regardless of what they
thought of the location. As a whole the attributes cited by the respondents for the suitability of
Kuala Lumpur bore a striking resemblance with those of Singapore and Hong Kong. The
findings indicated that Kuala Lumpur would stand a better chance than Labuan to compete with
these two centers.
These findings concurred with that of the Association of Offshore Banks', where the
offshore bankers proposed the creation of a structure that links Labuan with Kuala
Lumpur/Multimedia Super Corridor (MSC) 'to overcome the threat of the more established
Singapore and Hong Kong, newer center like Bangkok and Bahrain' (AOB 2002, p.7). One
senior international banker has echoed this view in a press interview:
We may see a move to a Singapore-style differential bank licensing system i.e. onshore versus offshore,
allowing all banks to locate their branches in say Kuala Lumpur, as against the current system involving a
compulsory physical present in Labuan (The Star 2 Aug. 2003, p. 6).

64
Table 2.15: Suitability as an Offshore Banking Center
Extremely Very Somewhat Not at all Standard
Suitable Suitable Suitable Suitable Suitable Mean Deviation
(5) % (1) % (3) % (2) % (I) %

Kuala Lumpur (15) 41.7 (7) 19.4 (11) 30.6 (2) 5.6 4.00 1.00

Labuan (1) 2.8 (6) 16.7 (16) 44.4 (13) 36.1 1.86 .80

Overall mean 2.93

Source: Mail Survey Data (Feb. 2004)
N-36
Number in parenthesis indicates frequency

Consistent with the facts on the development of offshore financial centers, an offshore
financial center need not necessarily be located on an island, (PaIan 1998). In 1981 when the
US decided to attract back the dollars, which resided in the island offshore financial centers in
the Bahamas, and Caribbean, it did not choose Hawaii because it was an island, instead it chose
to establish the International Banking Facilities (IBF), a bookkeeping entry with banks in New
York city, the world's second largest financial center (Hudson 1998). Similarly, when Japan
copied the idea in 1986, it did not choose the island of Okinawa as a location, but instead
established its Japanese Offshore Market (JOM) in Tokyo, the third largest financial center in
the world. Even when Singapore wanted to have the equivalent of the London Eurodollar
market 1968, it did not try to develop Sentosa Island as an "Offshore Financial Center", instead
it set up the Asian Currency Unit (ACU) as a bookkeeping entry for banks in the heart of
Singapore city.

4.5 Relationships of Selected Variables

The chi-square analyses were performed to determine whether there were any
relationships between selected variables such as preference for types of operations and
restricting number of Kuala Lumpur marketing office staff, and competitiveness of Labuan
IOFC after the 1997-98 Crisis and suitability of Labuan as an offshore banking center.

4.5.1 Relationship Between Type of Operations and Restricting Number of Kuala

Lumpur Marketing Staff

This section answers research question: To what extent does the offshore bankers'
preference for functional or booking operations depends on LOFSA's policy of restricting the
number of Kuala Lumpur marketing office staff? Although the chi-square analysis could not be

65
computed due to a significant numbers of the cells with cases less five, results of Table 2.16
(below) seem to suggest that the majority (71.4%, 25) of respondents had functional operations,
and the rest were booking offices. Specifically, the results also indicate that among the
functional operators, majority (56%, 14) of them were neutral towards LOSFA's policy of
restricting the number of Kuala Lumpur. On the other hand, about half (50.0%, 5) of the
respondents with booking offices disagreed with the policy.

Table 2.16
Distribution of Respondents by Types of Operations
and by Restricting Number of KL Marketing Staff

Types of Restricting Number of KL

Operations Marketing Staff Total
Disagree Neutral Agree
36.0 56.0 8.0 71.4
Functional
(9) (14) (2) (25)
50.0 40.0 10.0 28.6
Booking
(5) (4) (1) (10)
40.0 51.4 8.6 100.0
Total
(14) (18) (3) (35)
Note: Numbers without brackets indicate percentages, whereas numbers in
brackets indicate frequencies of respondents.
Chi-square could not be computed due to many cells having less than five cases.

4.5.2 Relationships Between Competitiveness of Labuan after the

1997-98 Crisis and Suitability of Labuan as an Offshore Banking Center

This section answers the research question: To what extent does the competitiveness of
Labuan after the 1997-98 Crisis depends on its suitability as an offshore banking center? The
chi-square value of 1.50 indicates that there was no significant relationship at p < 0.05 between
competitiveness of Labuan after the 1997-98 Crisis and suitability as an offshore banking
center. The results show that the majority (63.9%, 23) of respondents believed that Labuan
could remain competitive. It is also discernible that more than half (56.5%, 13) of those who
believed Labuan had maintained its competitive edge after the 1997-98 Crisis also perceived
that it was suitable as an offshore banking center. Surprisingly, the results also indicate that
more than three quarters (76.9%, 10) of those who perceived Labuan had lost it competitive
advantage apparently believed that it was also suitable as an offshore banking center.

66
Table 2.17
Distribution of Respondents by Competitiveness after
1997-98 Crisis and by Suitability as an Offshore Banking Center

Competitiveness Suitability as an Offshore

after 1997-98 Banking Center Total
Crisis Not Suitable Suitable
Least 23.1 76.9 36.1
Competitive (3) (10) (13)
43.5 56.5 63.9
Competitive
(10) (13) (23)
36.1 63.9 100.0
Total
(13) (23) (36)
Note: Numbers without brackets indicate percentages, whereas numbers
in brackets indicate frequencies of respondents.
Chi-square=1.50, not significant at p< 0.05_

67
CHAPTER FIVE: SUMMARY AND CONCLUSION

5.0 Introduction
This chapter summarizes and concludes the research by summarizing the findings in
Section 5.1, discussing implications of the findings in Section 5.2, the limitations of the
research in Section 5.3, future research directions in Section 5.4, and finally drawing
conclusion in Section 5.5.

5.1 Summary of Findings

The findings are classified according to the following: profile of the offshore banking
business, effects of the 1997-1998 Asian Crisis, policies and regulation, and competitive
advantages of the Labuan 10FC.

5.1.1 Profile of the Offshore Banking Business in Labuan

Offshore banking transactions in Labuan were predominantly functional with most
banks carrying actual transactions. However, some banks were using Labuan merely for
booking deals done in other centers taking advantage of the low tax, and back office-processing
location. Overall, Labuan was a functional offshore financial center, and not a booking center.
The products services offered by offshore banks in Labuan were mainly lending, and issuance
of standby letter of credits (SBLCs) and bank guarantees (BGs). There were also a bit advisory
services, and accepting and placing of deposits. Treasury management services was not
considered important by Labuan offshore banks, only 13 of the respondents answered that their
banks have treasury operations, and most respondents did not intend to set up treasuries in the
near future.

5.1.2 Effects of the 1997-1998 Asian Crisis

The 1997-1998 Asian Crisis has left some undesirable consequences on Labuan IOFC.
Most of the respondents reported that their banks were adversely affected by the crisis, and
offshore banking business has not regained it pre-crisis level. Those banks that have recovered
only saw their business increased between 25-75%, and nine of the banks never recovered. The
crisis has left the once promising offshore banking industry in a state of uncertainty. The
respondents believed that Labuan has lost its attractiveness after the crisis.
In response to market reality after the crisis offshore banks were making strategic
changes in their organizational structures. The expected changes within the next three years are

68
downsizing, change operations to investment banking, closing down, and moving operations to
Singapore. Interviewees among the international bankers conceded that "depends on 2007
policies" would mean closing down operations in Labuan if their banks were not given the
licenses to operate in the domestic market after the expected liberalization of the Malaysian
banking industry in 2007.

5.1.3 Policies and Regulations

The respondents believed only two of the government's original objectives of
establishing offshore financial center in Labuan, 'to enhance investment, and to complement
the onshore financial system' were considered very important, and should be treated as priority
items. The other two, 'to contribute to GNP, and to develop Labuan' were important, but not a
priority. In other words the respondents believed that the authorities should focus on developing
the offshore banking industry as a mean to enhance investment and to complement the domestic
financial system, and not using offshore banking as mean to develop Labuan.
Most of the respondents were unhappy with the rule to limit the number of staff in the
marketing office, and some have resorted to 'tricks' in order to go round the rule. Though
LOFSA allowed more people in the marketing office based on the 'merit of the case' and
number of people in the Labuan, it only worked for those banks that had a large number of staff
in Labuan and not those with three or four people. The respondents were neutral on the
LOFSA's policy of not allowing Labuan banks to 'front' for banks from outside Labuan to
participate in Labuan deals.

5.1.4 Competitive Advantages of the Labuan 10FC

Banks chose to establish offices in Labuan based on the particular benefits they might
see. Malaysian banks, for example viewed the setting up of offices in Labuan as their entrance
to the international financial markets in contrast to foreign banks who saw it as an important
gateway to the high growth Malaysian economy.
Furthermore the respondents considered reliable legal system, low taxes, confidentiality,
liberal central bank policies, minimum exchange control restrictions, and political stability as
the major benefits of setting up offices in Labuan. Good reputation, and the opportunity to get
into the domestic business were important to some respondents. The opportunity to get into the
domestic market upon the expected liberalization of the Malaysian banking industry in 2007
was identified as a major benefit for the non-Malaysian banks that did not have domestic

69
 operations. The respondents did not consider ideal time zone, and geographical location as the
attributes of Labuan.
The respondents predominantly perceived Singapore and Hong Kong as major threats to
Labuan because of their well-established and advanced infrastructure, conducive environment
for expatriates and their families, availability of expertise and skilled workforce, strategic
geographical location, diversified and competitive products and services, and presence of top
international banks. Bangkok IBF and Brunei IFC were not considered major threats. and
Manila OBU was not seen as a threat at all.
The respondents overwhelmingly agreed that Labuan was not a suitable location for an
offshore banking center because of its poor infrastructure, poor air accessibility, and its location
away from the main business center. On the other hand, Kuala Lumpur was predominantly
viewed as a more suitable location for an offshore banking center because it shared similar
attributes with Singapore and Hong Kong.

5.1.5 Relationships of Selected Variables in Relation to the Suitability of Labuan as an

Offshore Banking Center

The majority of those with functional operations were neutral towards LOFSA's policy of
restricting the number of Kuala Lumpur office marketing staff, and about half of the
respondents with booking offices disagreed with the policy. On the issue of competitiveness of
Labuan after the 1997-98 Crisis more than half of the respondents seemed to believe that
Labuan was still competitive, and suitable as an offshore banking center. However, about three
quarters of those who believed that Labuan has lost its competitive edge also perceived it
suitable as an offshore banking center.

5.2 Limitations of the Study

There are three major limitations of this study. Firstly, it focuses only on the offshore
banking business. The Labuan IOFC offers more than just offshore banking, it sees itself as a
financial 'supermarket' offering a wide range of products and services, which includes offshore
insurance and insurance related activities, offshore trusts, trust companies and services,
management company, offshore money brokers, offshore leasing, Islamic banking and
insurance, and investment holdings. As such the success or failure of the 10FC cannot be
judged from the performance of the offshore banking business alone.
Secondly, the persons who completed the questionnaire were the principal officers with
overall responsibility for the banks operations in Labuan. Nevertheless, their level of

70
knowledge and experience were different and hence the opinions varied from bank to bank.
There was also a danger that their opinions did not necessarily reflect the views of the bank.
Thirdly, the inherent limitations of the research method that used empirical survey as discussed
in chapter three.

5.3 Implications of the Findings

From the theoretical perspective this research supports the concepts that government
support alone would not guarantee the success of an offshore financial center, and that to be
successful an offshore financial center must have the necessary conditions. This research
therefore lends support to Abbott's (1999), and Skully's (1995) government support theory,
Felmingham and Dean's (1998), Tan's (1997), Tan and Vertinsky's (1988), and Jao's (1980)
model of necessary conditions.
There are three major managerial implications of this study, the need to have diversified
products and services, flexible rules and regulations, and proactive strategies. Firstly, the
products and services offered by the offshore banks in Labuan are very limited mainly lending,
and issuance of SBLCs and BGs. The Labuan banks do not venture into more sophisticated and
value added products and services such as treasury operations, private banking, debt
securitization, trade finance, trading and hedging with derivatives, and trading in securities.
Labuan IOFC should learn from the experience of other developed offshore centers such as
Singapore and Hong Kong. Singapore's competitive advantage is in foreign exchange and
derivative market (Ng 1998), and Hong Kong is a major hub for the arrangement, syndication
and management of Eurocredits to borrowers from the region (Hughes & MacDonald 2002).
Unless the products and services are value added and sophisticated Labuan 10FC would not be
able to attract clients from outside Malaysia.
Secondly, policies and regulations need to be more conducive to the development of the
offshore banking industry. Perhaps the original objectives of establishing the 10FC in Labuan
could be revised. The offshore bankers view the government's original objective of setting up
the IOFC 'to develop Labuan and its vicinity' has prevented the responsible authority to see the
urgent need to develop the offshore banking industry. It is timely to look into the concept of
twinning Labuan with the Multimedia Super Corridor (MSC) as recommended in the Bank
Negara's Financial Sector Master Plan (BNM 2001). The twinning concept would not affect the
status of Labuan as an IOFC, in fact it upholds one of the major original objectives of
establishing Labuan 10FC, 'to complement the financial system in Kuala Lumpur. The
implementation of this concept would resolve the issue of Kuala Lumpur marketing offices.

71
 Thirdly, there is an urgent need for more proactive strategies in order for Labuan to be
competitive. The respondents overwhelming perceptions that Singapore and Hong Kong as
their major competitors calls for a review on how the authorities position Labuan against these
two offshore financial centers. Interviewees from international banks that closed their Labuan
offices often admit that 'we can serve the Asian market more effectively from Singapore, and
Hong Kong.' This statement contradicts LOFSA's view `Labuan does not compete with
Singapore and Hong Kong but compliment them.' The results have shown that Labuan is not
suitable as an offshore banking center due to lack of attributes that have made Singapore and
Hong Kong successful. On the other hand, the results also depict Kuala Lumpur as a more
suitable location for an offshore banking center as it has similar attributes with Singapore and
Hong Kong. This paper does not call for the transfer of the offshore banking center from
Labuan to Kuala Lumpur, but a structural adjustment to link Labuan to Kuala Lumpur would be
an advantage for the offshore banking industry. Some physical attributes such as medical
facilities and air accessibility can be created but these are subject to market reality. However,
attributes like 'conducive environment for expatriates, and availability of skilled labor force are
features of metropolitans and well established financial centers, and can only evolve gradually.
Bank Negara in its Financial Sector Master Plan recommended Labuan to have an 'open
sky' policy to encourage direct flights from Singapore, Hong Kong, Tokyo, Taipei, Seoul,
Manila and Jakarta to Labuan. In theory this would raise the air accessibility of Labuan to the
level of Kuala Lumpur, Singapore, or Hong Kong. However, three years since the master plan
was adopted no airline has any direct flight from these regional capitals to Labuan. Airlines
would only fly to specific destinations based on market reality, that is, if they can profit from
such operations.
Obviously, raising the standard of Labuan at par with Kuala Lumpur, in order to be able
to compete with Singapore and Hong Kong would not be practical, but well-though-out and
proactive strategies would ensure that the Malaysian offshore banking industry maintains its
competitive edge. Again the twinning of Labuan with the Multimedia Super Corridor is a good
starting point. This concept would automatically takes the attributes of Kuala Lumpur to
compete against Singapore and Hong Kong. The issues of lack of air accessibilities, non-
conducive environment for expatriates, and unavailability of skilled labor force would be
resolved.

72
5.4 Future Research Directions
The fact that offshore banking business has been stagnant since 1997, and the offshore
bankers find Labuan's geographic location a disadvantage contradict the Malaysian
government's presumption of Labuan's competitive advantages. This inversed relationship
needs to be examined adequately to avoid costly errors as well to enable the formulation of
effective strategies. Except for a preliminary study by Aralas et al. (2000) there is no other
empirical study done on Labuan. More research should be directed toward this area. Such
future research may include the areas of business identified in the Bank Negara's Financial
Sector Master Plan. These include Islamic banking, insurance, Islamic insurance, trust services,
treasury management, and ancillary services. The recommended future research that requires
immediate attention is the Islamic banking, which will be the subject of Paper Three in this
study.

5.5 Conclusion
During the early stage of its operations the Labuan IOFC has made considerable
progress both in attracting international banks and business volume. However, the 1997-1998
Asian Crisis has done some serious damage to the rising offshore center. While the crisis was
partly to be blamed but a more disturbing aspect of Labuan's predicaments is its lack of
competitive advantages compared to Hong Kong and Singapore, its two major competitors in
the region. Labuan's major drawbacks are its geographical location, and underdeveloped
infrastructure. Its geography while strategically located in the middle of South-East Asia is too
far from the country's business main center in Kuala Lumpur, and relatively too close to
Singapore and Hong Kong. Because of this Labuan is unable to capitalize on the strength of
Kuala Lumpur, and offshore players tend to compare it with Singapore and Hong Kong. Having
started from scratch only slightly more than a decade ago there is no way Labuan can match the
infrastructure, efficiency, and sophistication of these two centers.
These problems could be overcome through the formulation of proactive strategies. One
of such strategies is the concept of 'twinning' Labuan with the Multimedia Super Corridor as
recommended in Bank Negara's master plan. This strategy would enable Labuan to capitalize
on the attributes and strength of Kuala Lumpur as a 'national' financial center. With its
infrastructure, location, and being the main business center in the country Kuala Lumpur to
some extent should be able to face up to the challenges of Singapore and Hong Kong. This
should be the mode of operations for the offshore banking industry until such time when
Labuan is able to achieve a status of its own, and offshore bankers find it cost effective to fully

73
operate out of the IOFC. This approach has already been used in Islamic banking by 'twinning'
Labuan with Bahrain, which will be discussed in Paper Three. Through the strength of
Bahrain, Labuan Islamic financial products have been well received in the Middle East. With
such a strategy in place the Malaysian government's aspiration of making Labuan a premier
IOFC in the region would be close to reality.

74
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335-349.

Sicat, G. 1984, 'Offshore Banking and the Philippine Economy', Journal of Philippine
Development, vol. XI no.2, pp. 203-229.

Tan, C. H. 1982, 'Singapore as an International Financial Centre' in East Asia

Dimensions of International Business, ed. P. Grub, C.H. Tan, K.C. Kwan & G. Rott,
Prentice Hall, Sydney, pp. 29-44, in

Tan, S. J. & Vertinsky I. 1987, 'Strategic Management of International Financial Centers:

Tale of Two Cities' in Recent Development in International Banking and Finance, ed.
S. Khoury & A. Ghosh, Lexington Books, Lexington, pp.87-104.

'Upbeat outlook for offshore business in Labuan' 2003, The Star, 2 Aug., p.6

Wallich, H. 1979 'Offshore Financial Centers', Statement before the Subcommittee on

Oversight of the Committee on Ways and Means, Us House of Representatives, April
25, 1979, Federal Reserve Bulletin, vol. 65, no. (May), pp. 396-399, in the
Globalization of Financial Services, ed. M. Lewis (1999), Edward Elgar Publishing Ltd.
London, pp.315-318.

Walter, I. 1988, Global Competition in Financial Services, Ballinger Publication.

Yusof, N. L. 2004, `Labuan must do more to enhance pull', Business Times, 12 Jul., p. 1.

77
PAPER THREE: THE VIABILITY OF ISLAMIC BANKING AS A NICHE
FOR THE LABUAN IOFC

ABSTRACT
Labuan was declared an International Offshore Financial Center (IOFC) by the Malaysian
government in 1990, with the goal of developing it as a financial 'supermarket- offering a wide
range of offshore financial products specializing in Islamic finance. Bank Negara Malaysia has
committed itself to promoting the expansion of Islamic banking parallel with conventional
banking, and recommended Islamic banking as a niche for the Labuan IOFC. Labuan has done
well in the early stages of its operations by attracting both reputable international banks and
business volume. However, the 1997-1998 Asian Crisis has done some serious damage to the
aspiring IOFC. This paper details the findings of a study to determine the viability of Islamic
banking as a niche for the Labuan IOFC. The study employed the mail survey method to ensure
the anonymity of the respondents, and used the whole population of banks, which enabled the
researcher to ignore the problems of bias in the sampling. The total number of operational
offshore banks was 49, and survey questionnaires were sent to all the 49 managers responsible
for the overall affairs of the banks. Of these, 36 completed questionnaires were returned
representing a response rate of 73%. Data collected from the survey were analyzed using
descriptive statistics, using mean, standard deviation, and frequency counts. The results of the
survey indicated that Labuan offshore bankers did not have a clear notion of Islamic banking
principles and practices. The results also showed that most of the offshore banks did not have
officers and staff who were conversant with Islamic banking. Nevertheless, conventional
offshore banks were willing to train their officers in Islamic banking skills, and participate in
future Islamic deals. The findings also indicated that Islamic banking is a viable niche for the
Labuan IOFC. However, the results also showed that Labuan does not have competitive
advantages over Bahrain and London, currently the leading Islamic finance centers in the
world. The results revealed that Labuan's main strengths are only in its political stability, low
taxes, and reliable legal system. Its main weaknesses are low market liquidity, geographical
location, and poor physical infrastructure. There are three major implications of these findings.
Firstly, the authorities ought to enhance the knowledge and expertise of the conventional
offshore bankers by facilitating training in Islamic banking skills. Acquisition of such
knowledge and skills would encourage them to participate in future Islamic banking deals.
Secondly, the industry and the authorities responsible for the IOFC have to be both innovative
and creative. In order to convince conventional offshore bankers that Islamic banking is a
viable alternative to conventional banking the products and services offered must be seen as

78
value-added. A creative tax regime should have a substantial impact in term of increased profit
margin or reduced cost on the part of the offshore banks. Thirdly, improving the physical
infrastructure and overcoming the geographical location disadvantage of Labuan should
become the priority of the authorities overseeing the development of Labuan as an 10FC. The
concept of twinning Labuan with the Multimedia Super Corridor (MSC) would solve the
problem of lack of air accessibility and poor physical infrastructure. Working closely with
Bahrain would benefit Labuan by tapping Bahrain's strength to develop new products and
services, and marketing them in the Middle East.

79
 CHAPTER ONE: INTRODUCTION

As discussed in Paper One and Paper Two, Labuan was declared an International
Offshore Financial Center by the Malaysian government in 1990. The original objectives were
to complement the onshore financial system centered in Kuala Lumpur, strengthen the
contribution of the financial sector towards the Gross National Product (GNP) of Malaysia.
enhance the attractiveness of Malaysia as an investment center, and promote the economic
development of Labuan and its vicinity (BNM 2001). The goal was to develop a financial
'supermarket' offering a wide range of offshore financial products with specialization in
Islamic finance.
The Malaysian government has spent several hundred millions ringgits building state-
of-the-art infrastructure in Labuan to portray the image of a world-class offshore financial
center (Ahmad & Kefeli 2002). During the early stage of its operations Labuan has done well in
its core business of offshore banking by attracting both reputable international banks and
business volume (Ahmad & Kefeli 2002; Abbott 1999; Skully 1995). However, the 1997-1998
Asian Crisis has done some serious damage to the aspiring 10FC. Mergers and closures of
some of the foreign banks have brought the numbers down to 50 operational banks, and the
offshore banking business has been stagnant since 1997 (LOFSA Annual Report 2002).
Despite these setbacks the Malaysian government remained committed to the
development of Labuan as a premier 10FC in the region. Lessons learnt from the crisis
prompted the Malaysian government to direct Bank Negara Malaysia to formulate the Financial
Sector Master Plan in March 2001 as a means to create a more stable and secure financial
industry in the country. The master plan spelt out a clear strategic focus to develop and promote
the expansion of Islamic banking parallel with conventional banking. As discussed in Paper
One and Paper Two, Islamic banking was also identified in the master plan as a niche for the
Labuan IOFC. To maintain the competitive edge of the Labuan 10FC the master plan proposed
three major recommendations, one of them being the development of Islamic banking and
takaful business.
However, theories reviewed in Paper One and chapter two of this paper suggested that
the government's commitment (Abbott 1999; Skully 1995), and years of experience in
domestic Islamic banking (Ahmad & Kefeli 2002; BNM 2002; Haron & Ahmad 2002; Shariff
& Mahmood 2000), and Shari 'a-compliance alone would not be enough to guarantee the
success of an international Islamic financial center. For an offshore financial center to be
successful it must have the "necessary" attributes (Felmingham & Dean 1998; Tan 1997;

80
 Skully 1995; Tan & Vertinsky 1988; Jao 1980). These attributes are a liberal environment,
strategic geographical location, stable political environment, stable economic performance, the
presence of international banks, quality labor force, a developed financial and physical
infrastructure, and the assurance of confidentiality and secrecy.
For an international Islamic financial center to be successful it should have, aside from
the Shari 'a requirement the ability to attract Islamic investment interest as well as international
financing activities (Lewis & Algaoud 2001). In addition, financial institutions residing in the
OFC Should be willing to provide the Islamic financial products and services, and to participate
in Islamic syndications (Haron & Ahmad 2002; Tan & Vertinsky 1988).
The Malaysian government's presumptions that Labuan had all the above attributes,
which gave it the competitive advantages in its quest to carve a niche in Islamic banking has
not been adequately supported by any empirical study. More empirical studies should be
directed toward this area especially to determine whether the predominantly conventional banks
in Labuan were ready to take up the challenges of Islamic banking, or whether Labuan had the
necessary infrastructure, or strategic geographic location. The outcomes of such studies would
be helpful to those involved with decision-making in formulating new strategies, and making
sensitive adjustments to current policies to suit the prevailing market realities.

1.1 Organization of this Paper

This paper is organized as follows: Chapter One is an introduction giving an overview
of the study, research objectives, research questions, and significance of the study. Chapter
Two reviews the literature related to studies on customers' and bankers' perceptions of Islamic
banking, and studies on Islamic banking that relate to Labuan. Theories that support the
concepts of Islamic finance and Islamic financial centers are assessed, thus providing the
conceptual framework for this paper. Chapter Three describes the research methodology and
design of the empirical survey adopted in this study. Chapter Four presents, analyzes and
interprets the findings. Chapter Five summarizes and concludes the study by discussing the
implications of the findings, limitations of the study, future research directions, and drawing a
conclusion.

1.2 Purpose of the Study

The purpose of this research was to evaluate the viability of Islamic banking as a niche
for Labuan IOFC. To answer the question an empirical survey on Labuan offshore banks was
carried out. The survey highlighted the perceptions and opinions of the offshore bankers

81
themselves. These perceptions and opinions are important, as they would have an impact on
whether the offshore banks are ready and willing to adopt the Islamic banking products and
services. Such decisions would in turn determine the viability of Islamic banking as well as
shape the future of Labuan as an Islamic offshore financial center.

1.3 Research Objectives

The objectives of this study are to:
Determine the offshore bankers' knowledge and perceptions of Islamic banking;
Determine the readiness of the conventional offshore banks to participate in
Islamic banking transactions; and
Determine the competitive advantages of Labuan compared to Bahrain and
London.

1.4 Research Questions

The offshore banking business has been stagnant for the last six years (LOFSA Annual
Reports 1996 & 2002), and the central question of this research is as follows:
To what extent are the conventional offshore bankers in Labuan ready to adopt Islamic
banking products and services?

The data-gathering process of this study was guided by the following eight questions:
What is the level of knowledge of conventional offshore bankers on Islamic
banking principles?
What are the perceptions of Labuan offshore bankers towards Islamic banking
products?
What is the level of liquidity of Islamic banking products?
To what extent is Islamic banking a viable niche for Labuan as perceived by the
Labuan offshore bankers?
To what extent is Labuan more competitive than Bahrain and London as
perceived by the Labuan offshore bankers?
To what extent does the viability of Labuan as an Islamic Financial Center
depends on the offshore bankers' perceptions of Islamic banking products?
To what extent does Labuan's competitive advantage over Bahrain and London
depends on the offshore bankers' perceptions of Islamic banking practices?

82
1.5 Operational Definitions
The constructs of this research are classified according to the following: Knowledge of
Islamic banking, products complexity, willingness to train officers in Islamic banking,
willingness to participate in Islamic transactions, viability of Islamic banking as a niche for the
Labuan IOFC, and competitive advantages of Labuan as an Islamic banking center.
1.5.1 Knowledge of Islamic Banking
Knowledge of Islamic Banking refers to the respondents' familiarity with the principles
and practices of Islamic banking. These principles ensure that the provision of services to
customers is free from interest, as the giving and taking of interest is prohibited in all
transactions (Lewis & Algaoud 2001). Examples of these principles include mudarabah, bai-
muazzal, ijarah, bai-salam and others (Ahmad & Haron 2002).

1.5.2 Perceptions Towards Islamic Banking Products

To some people Islamic banking products are similar to those of conventional banks
except that Islamic banks use different names and structures, which make simple lending a
complicated structure of equity ownership. Thus, when conducting a survey among 200 bankers
and 200 bank customers in Dhaka, Bangladesh to examine these apparent similarities and
differences, Hassan and Ahmed (2002) talked about clarifying the misleading concepts about
Islamic banking practices.

1.5.3 Liquidity of Islamic Banking Products

The success of any Islamic banking transaction will depend on the active participation
of the offshore banks. As the offshore banks in Labuan are predominantly conventional their
willingness to train their officers in Islamic banking skills especially in the areas of loan
structuring and credit risk mitigations would enable them to handle Islamic deals. Besides, the
Islamic banking skills these banks must also be ready to participate in Islamic transactions,
such as loan syndications, bonds and other debts instruments that are structured according to
Islamic Shari 'a.

1.5.4 Viability of Islamic Banking as Niche for the Labuan IOFC

Different authors would view viability of Islamic banking differently, thus Bank Negara
Malaysia (BNM 2001) believed that Malaysia's more than 20 years experience in Islamic
banking would make it a viable niche for Labuan. Shariff and Mahmood (2000) were
convinced of the viability of Islamic banking in Labuan based on the success of Bank Islam

83
Malaysia in the domestic market. The other dimension would be the participations of the
conventional banks in Islamic transactions.

1.5.5 Competitive Advantages of Labuan as an Islamic Banking Center

As an offshore Islamic financial center Labuan's competitive edge would depend on it
having the "necessary" attributes such as a liberal environment, strategic geographic location,
stable political environment, stable economic performance, the presence of international banks,
quality labor force, a developed financial and physical infrastructure, and the assurance of
confidentiality and secrecy (Felmingham & Dean 1998; Skully 1995; Tan & Vertinsky 1988;
Jao 1980). Labuan's competitive edge as an Islamic offshore financial center would involve
comparing the Labuan IOFC with Bahrain and London, which are currently the leading centers
for Islamic Finance.

1.6 The Significance of this Study

The 1997-1998 Asian Crisis has caused some serious damage to the Labuan 10FC. To
maintain its competitive edge Bank Negara Malaysia included the Labuan IOFC in its ten-year
Financial Sector Master Plan, and recommended Islamic banking as a niche (BNM 2001). But
for a subject that has been given a national prominence very few studies have been done on
Islamic banking in relation to Labuan 10FC. This gives this particular research area
significance in terms of theoretical contribution on the one hand and applied research
contribution on the other. The findings of this study would provide those involved in policy
formulations with useful insights into the relevance of Islamic banking to the Labuan IOFC, as
well a basis for strategic policy making.

84
 CHAPTER TWO: REVIEW OF RELATED LITERATURE

2.0 Introduction
A major part of the literature review on offshore financial centers (OFCs), Islamic
financial center, Islamic finance as a niche for an OFC, empirical studies on OFCs and Labuan
have been covered in Paper One and Paper Two. This background chapter only confines itself
to literature related to the historical background of Islamic banking. and studies of customers'
and bankers' perceptions towards Islamic banking. The theoretical constructs for the empirical
survey for this study were derived from the literature review in Paper One, Paper Two and in
this chapter.

2.1 Historical Background of Islamic Banking

An Islamic bank is a financial and social institution whose objectives and operations as
well as principles and practices must conform to the principles of Islamic Shari'a (Hassan &
Ahmed 2002). Islamic banking provides services to its customers free of interest, as the giving
and taking of interest is prohibited in all transactions (Lewis & Algaoud 2001).
Some pioneering Islamic banks, on a very modest scale, were established in Egypt in
the 1960s and operated as rural social banks along the Nile Delta (Hassan & Ahmed 2002;
Khan 2000). Among the first institutions was the Nasser Social Bank, which started operations
in Cairo, Egypt in 1972. Then, in 1975 the Dubai Islamic Bank was established (Khan 2000).
Since the last two decades the growth of Islamic banking has been phenomenal, speeding along
at 15% per year, and currently there are 160 financial institutions in the world today offering
Islamic banking products and services (Hassan & Ahmed 2002). This pattern of growth has
attracted traditional banks such the HSBC Bank, ANZ Grindlays, Standard Chartered Bank,
Barclays, Citibank, ABN AMBRO, Klienwort Benson, Merrill Lynch, Chemical Bank,
Midland Montagu, and Goldman Sachs (Khan 2000; Hassan & Ahmed 2002). The amount
controlled by these institutions is estimated to range from USD50 billion to more than USD100
billion (Hassan & Ahmed 2002; Lewis & Algaoud 2001; Buckmaster 2000). The latest estimate
of assets managed under Islamic Shari'a principles is USD200 billion (Alam Shah 2004).
In Malaysia the first Islamic bank, Bank Islam Malaysia Berhad (B1MB) started its
operations in 1983. The Malaysian government's aim was to develop an Islamic banking
system parallel to the conventional banking system. To this end the government introduced the
concept of an 'Islamic window' instead of establishing new Islamic banks (Ahmad & Haron
2002). The concept of the Islamic window was initiated in March 1993 when Bank Negara

85
Malaysia (BNM) introduced the "interest-Free Banking Scheme". Initially only three
Malaysian banks took up the challenge. As at end of 2003. the Islamic banking system
comprised two Islamic banks, thirteen commercial banks, seven finance companies, four
merchant banks, and seven discount houses. The distribution network comprises 152 full-
fledged Islamic banking branches and 2,065 'Islamic windows' (BNM 2000).

2.2 Empirical Studies on Customers' Perceptions on Islamic Banking

Some of the earliest studies on Islamic banking are found in the works of Erol and El-
Bdour (1989) and Erol, Kaynak and El-Bdour (1990). They conducted studies on Islamic
banking patronage in Jordan using both conventional and Islamic bank customers as
respondents. Their findings revealed that customers who patronized Islamic banks considered
fast and efficient services, reputation and image, and confidentiality as important factors in
selecting a bank.
Haron, Ahmad and Planisek (1994) studied the bank patronage factors of both Muslim
and non-Muslim Malaysians, and sought to establish the criteria used by Muslim customers in
selecting their banks. The study revealed that Muslims in Malaysia perceived fast and efficient
service, speed of transaction, and friendliness as important criteria in selecting their banks.
Another finding of the study indicated that conventional bank customers were willing to
patronize Islamic banks if they had sufficient knowledge of Islamic banking practice. Eighty
percent of Muslim and 53% of non-Muslim respondents indicated that they would consider
patronizing an Islamic bank if they understood its operations.
Gerrard and Cunningham (1997) replicated Haron et al's study in Singapore, and found
that Muslims, in contrast to non-Muslims had a different attitude towards Islamic banking. The
study revealed a small proportion of Muslims was aware of the concept of Islamic banking,
while non-Muslims had an almost total lack of awareness. Similar to Malaysians, the
Singaporeans, both Muslims and non-Muslims did not differ in their bank selection criteria.
Matawan and Alamosa (1998) studied the customers of two leading Islamic banks in
Bahrain: the Bahrain Islamic Bank and Faisal Islamic Bank. They found that customers of these
two Islamic banks considered Islamic principles as the most important factor in selecting
Islamic banks. The second important factor was rate of return (from profit and loss sharing),
which adhered to Islamic principles. The next important selection criteria were the advice and
recommendations from family and friends, followed by convenience of bank location. The
study also indicated that socio-demographic factors such as age, income and education had
strong influence in customer selection of an Islamic bank. The findings of this study, which

86
indicated Islamic bank selection as a predominantly religious-based decision, contradicted
those findings by Haron et al. (1994), and Gerard and Cunningham (1997).
Naser, Jamal and Al-Khatib (1999) studied the customers of the Jordan Islamic Bank for
Finance and Investment in Jordan, and found that the customers considered adherence to
Shari 'a principles as the overwhelming reason for banking with Islamic banks. The most
important factor influencing customer choice of an Islamic bank was reputation. This was
viewed as religious in nature, as Islamic banks operate in line with Islamic teachings, thereby
maintaining a good reputation and establishing clients' confidence in the way it operates and
discloses information. The second important factor was religious, followed by the observation
of Shari 'a principles, confidentiality, profitability, and advice from relatives and friends. The
findings of this study indicating religion as the overwhelming reason for patronizing Islamic
banks was in conformity with those findings of Matawan and Alamosa (1998).
Ahmad and Haron (2002) studied the perceptions of non-Muslim corporate customers in
Malaysia towards Islamic banking, and found that their knowledge of Islamic banking was
limited. The study indicated that Islamic banking products and services were not popular
among the non-Muslim corporate customers. The study also revealed that the most important
factor perceived by corporate customers in selecting their banks was the cost of the services and
products.
Hassan and Ahmed (2002) studied bankers and bank customers in Dhaka, Bangladesh
to examine the similarities and differences of the conventional and Islamic banking systems.
The findings indicated that both the bankers and bank customers had confused notions about
Islamic banking practices. The misleading similarities between Islamic and conventional
banking products were due to the following: first, fixed charges in percentage, which increased
with time as compensation for violation of agreement for repayment schedule on investment
taken by the entrepreneur from the bank. Second, dated payment obligations may not
synchronize with the firm's cash flow. Third, payment obligations were mandatory whether or
not the business was making a profit. Fourth, security or mortgage was essential for investment.
Finally, returns were practically based on the benchmark of interest-based bank.

2.3 Studies on Islamic Banking in Relation to Labuan

While there were numerous studies done on Islamic banking during the last two decades
almost none have been done in relation to Labuan or offshore financial centers. The first
attempt to study Islamic banking in Labuan was made by Shariff and Mahmood (2000) in a
seminal study 'Islamic Banking Products: Prospects and Challenges as a Market Niche for

87
Labuan'. The researchers chose Bank Islam Malaysia Berhad (BIMB) as a case study by
comparing changes of transaction over a period of two years, 1998 and 1999, and found an
increase of 14.47% in the usage of customer financing instruments, 57.10% increase in
customers' deposits, and increased use of investment securities by the government and
governmental bodies. Based on these observations they concluded that the Islamic banking
products did have potential to be a market niche for the Labuan IOFC.
Another attempt to study Islamic banking in relation to Labuan is found in the work of
Ahmad and Kefeli (2002). They cited the increasing corporation with the Islamic Development
Bank, and other Islamic financial institution in the Middle East would increase acceptance of
Islamic financial products introduced by Labuan. This was evident as indicated by the healthy
appetite among Middle-Eastern investors for Sukuk or asset-based instruments. The
establishment of the International Islamic Financial Market (IIFM), Special Task Force on
Islamic Banking and Takaful, and Shari'a Advisory Council (SAC) had increased the prospects
of Islamic banking as a niche for the Labuan 10FC.

2.4 Review of Research Methodology

The research methodology used in this study was derived from the work of Ahmad and
Haron (2002), which used the mail survey method. Ahmad and Haron (2002) studied the
perceptions of Malaysian corporate customers towards Islamic banking products and services.
The study used the mail survey method whereby questionnaires were sent to the financial
directors, financial managers, general managers of finance, and accountants of Malaysian
companies listed in the Kuala Lumpur Stock Exchange. In this study the mail survey method
was preferred because of the 'sensitive' and confidential nature of the offshore business as a
mail survey would assure the respondents of their anonymity.
A mail survey is most suited to situations where the scheme of questions is not overly
elaborate and when the questions required straightforward and concise answers. Here it can be a
very effective method of gathering data as no other survey method can match its low cost
advantage (Jobber & O'Reilly 1996). Furthermore, mail surveys permit recipients to consult
documents and complete the questionnaire in their own time. Answers procured may be more
honest than those obtained in a face-to-face interview, and errors such as the mis-recording of
answers, non-uniformity in asking questions, differential probing and questionnaire falsification
are eliminated.
However, a major problem associated with mail surveys is that of obtaining an adequate
response rate. The loss of sample size may restrict the range of analytical techniques that can be

88
used, and reduce the power of statistical testing. Another major drawback is the likelihood that
non-respondents differ in some critical ways from respondents leading to biased estimates.

2.5 Conceptual Framework

This literature review together with those of Paper One and Paper Two provide the
conceptual framework for this study. As discussed in Paper Two there are eight conditions
necessary for the success of an OFC. Factors such as stable political environment, stable
economic performance, assurance of confidentiality and secrecy, liberal environment, and
financial and physical infrastructure are internal variables, which could be controlled by the
government or central bank However, presence of international banks_ strategic geographic
location and quality labor force are external factors which the government cannot influent. The
moderating variable in this study is Islamic banking, which is controlled by the Malaysian
government through Bank Negara.
The previous studies were classified into three categories concept of Islamic financial
center, concept of Islamic banking as a niche for an offshore financial center (OFC), and
customers' and bankers' perceptions of Islamic banking. The review concludes as follows:
There is a growing need for Islamic banking products and services during the last two decades
(Hassan & Ahmad 2002). In response to these growing need many countries with a
predominantly Muslim population have set up Islamic banks to cater to this need. This is an
incomplete rationale for the Labuan IOFC where the banks are predominantly conventional,
and their clients mostly non-Muslims.
In the competitive environment in which the Labuan 10FC operates it has to find a
niche where it has a competitive advantage over the other offshore centers (Lewis 1998; Cobb
1998; Hughes & MacDonald 2002). The Malaysian government has identified Islamic banking
as a niche for the Labuan 10FC (BNM 2001; Shariff & Mahmood 2000). The increasing
cooperation between Malaysia with the Islamic Development Bank, and other Islamic financial
institutions in the Middle East would increase the acceptance of Islamic financial products
introduced by Labuan (Ahmad & Kefeli 2002). Lewis and Algaoud (2001), argue that there is a
potential for an international center for Islamic finance due to a strong actual and latent demand
for Islamic banking and finance. The latest information estimates that there is USD1,300 billion
in liquid Islamic funds from Islamic countries, of which USD1,100 billion is invested in
conventional financial institutions, and only USD200 billion in the Islamic financial institutions
(Alam Shah 2004).

89
 Bank customers whether they are Muslims or non-Muslims have different reasons for
using the products and services of a particular bank. These are fast and efficient services,
friendliness, and reputation (Erol & El-Bdour 1989; Erol et al. 1990; Haron et al. 1994; Gerrard
& Cunningham 1997). However, some Muslims patronize Islamic banks solely based on a
religious reason (Matawan & Alamosa 1998; Nasser et al. 1999). From the economic
perspective there are non-Muslim customers who are willing to use the products and services of
Islamic banks provided the cost of these products and services are competitive (Ahmad &
Haron 2002). Yet to some customers and bankers there are no differences between Islamic
banking products and services and that of conventional banking except they are called by
different names (Hassan & Ahmed 2002).

Figure 3.1: Conceptual Framework of Islamic Banking as a Niche for the Labuan IOFC

Stable
PoliticalPolitical

Environment

Stable
Economic
Performance
Bank
Negara
001 Government Assurance of Malaysia
Confidentiality
and Secrecy
V
Islamic

H Environment
vironment
Banking

Labuan 10FC Developed

Predicaments Financial/ A
Physical Successful
Infrastructure Labuan
10FC
Presence of
International
Banks

Strategic
Geographic
Factors Location
HExternal
Quality
Labour
Force

90
CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Research Design

As in Paper Two the research design adopted in this study was also an empirical survey.
The analysis of data gathered from the survey was descriptive using simple inference statistics.
The survey was conducted by mailing each prospective respondent two questionnaires
integrated in one instrument, Part A for Paper Two, and Part B for this paper. This design was
based on the choice of a sampling frame and availability of sources for the research. The whole
offshore bank population consisted of 49 banks in operations as of October 2003. Many of the
issues in the survey were considered 'sensitive' by the Labuan offshore banking community, in
recognition of such sensitivity a mail survey was selected to maintain the anonymity of
respondents.

3.2 Sampling and Sample Size

As in Paper Two, the survey used the whole population of banks, which enabled the
researcher to ignore the problems of bias in the sampling. The total number of operational
offshore banks as of October 2003 was 49, of which 10 were Malaysian banks and 39 foreign
banks. Two of the Malaysian banks and one of the foreign banks were Islamic banks.

3.3 Instrument Design

The questionnaire was designed based on information obtained from informal
interviews with managers of offshore banks, and partly from the researcher's experience during
his eight years' career in the industry. This questionnaire formed Part B (Appendix I) of an
integrated questionnaire of which Part A was a survey on offshore banking to gather data for
Paper Two. The questionnaire was later sent to six offshore bank managers for their comments.
After receiving their replies minor adjustments were made. The questionnaire contains four
major sections. The first section was designed to gather information about the respondent's
knowledge of Islamic banking, a modified version of that used by and published at the end of
the study of Ahmad and Haron (2002). The second section was designed to gather information
on the respondents' perceptions and concerns about Islamic banking. The third section was
designed to gather information on respondents' level of commitment to Islamic banking.
Finally, the fourth section was designed to gather information on the viability and competitive
edge of Labuan as an Islamic financial center.

91
3.4 Data Collection Method
Since the number of offshore banks operating in Labuan is relatively small, the
questionnaires (both Part A and Part B) were sent to all the relevant banks listed in the Labuan
Offshore Financial Services Authority's (LOFSA) list of offshore banks. Of the 53 banks in the
list two were not operational, and another two were investment banks managed by the same
General Managers who headed the commercial banking subsidiaries. To avoid redundancy,
questionnaires were only sent to the commercial banking arms, and a total of 49 questionnaires
were distributed. The questionnaires with explanatory letters (Appendix II) were addressed to
the Chief Executive Officer, General Manager, Branch Manager, or Manager depending on the
titles of the principle officers responsible for the overall affairs of the bank. Prospective
respondents were assured of confidentiality, and to maintain their anonymity stamped and self-
addressed envelopes were provided.
Before distributing the questionnaires the researcher personally contacted the principle
officers, or where not available, the personal assistants, or secretaries via telephone, or email
and they were informed of the reasons for the research. The first set of questionnaires was
distributed in November 2003, and 17 returned. In December 2003 a second set of
questionnaires was distributed, and another 19 returned.

3.5 Data and Statistical Analysis

The descriptive statistics were the main statistical tools measures of central tendency
(mean) and dispersal (standard deviation), and frequency counts. The data analysis and
presentation were categorized into four areas in the questionnaire: features of Islamic banking,
Islamic financial products, liquidity of Islamic financial products, and competitive advantages
of the Labuan IOFC in Islamic banking.

92
CHAPTER FOUR: FINDINGS AND DISCUSSIONS

4.0 Introduction
As in Paper Two, the respondents were the principal officers of the bank responsible for
the overall affairs of the banks. The choice of subjects was based on judgmental sampling that
involved managers who were in the best position to provide the information required. Twenty-
seven of the respondents represented foreign banks, and eight worked for Malaysian banks. At
the same time thirty-four of the banks were conventional, and two Islamic. Out of the
population of 49 offshore banks 11 banks were headed by Muslim managers, and 38 by non-
Muslim managers.
To ensure the confidentiality of the survey and to safeguard the anonymity of the
respondents the researcher deliberately omitted any kind of mechanism to identify the
respondents. As such there was no way to find out whether the respondents were Muslims or
non-Muslim. The results of the survey were summarized under the following main headings:
knowledge of Islamic banking, Islamic banking products and services, operational complexity
of Islamic banking, viability of Islamic banking as a niche for Labuan, and competitive
advantages of Labuan as an Islamic financial center.

4.1 Knowledge of Islamic Banking

Table 3.1 (page 94) depicts the respondents' knowledge of Islamic banking. Although
most of them were non-Muslims, 27 knew that Muslims were discouraged from patronizing
conventional banking because of the interest element. On the profit and loss sharing principle in
Islamic banking, 22 respondents believed that it was the only principle used by Islamic banks to
replace the element of interest, and six were not sure.
They were unaware about other principles such as al-wadia, mudharaba, musharaka, ijara,
istisna and others used in Islamic banking. When the respondents were asked about the profit
maximization principle, five respondents were not sure, and 23 believed that Islamic banks, like
the conventional banks, must maximize their profit in order to survive in the competitive
business environment.
Twenty-eight of the respondents either chose the wrong answer, or were not sure of the
answer, thus indicating that most offshore bankers were not knowledgeable about Islamic
banking. The findings indicated that Labuan offshore bankers had confused notions regarding
the practice of Islamic banking. This perception was contradictory to the philosophy of Islamic
finance, which is the combination of both moral and profit motives.

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 Table 3.1: Knowledge of Islamic Banking

Frequency Percent
1. Islamic banking is an alternative to conventional banking for
Muslims who are prohibited from associating themselves with
the element of interest.
True 27 75.0
Untrue 8 22.2
Not sure I 2.8
. Total 36 100.0
2. The profit and loss sharing (PLS) principle is the only principle
that can replace the element of interest in the operations of
Islamic banking
True 22 61.1
Untrue 8 22.2
Not sure 6 16.7
Total 36 100.0
3. Both Islamic and conventional banks must adopt profit
maximization principle in order to survive in a competitive
market.
True 23 63.9
Untrue 8 22.2
Not sure 5 13.9
Total 36 100.0
ource. Mail Survey Data (Feb.

These findings were consistent with those of Ahmad and Haron (2002), and Hassan and Ahmed
(2002) discussed in Chapter Two. The findings of Ahmad and Haron (2002) were anticipated
expected since 80% of the respondents were non-Muslims. However, the results of the study
conducted by Hassan and Ahmed (2002) were surprising since the respondents were
predominantly Muslims.

4.2 Islamic Banking Products and Services

This section details the reasons why clients prefer Islamic banking products, offshore
bankers' perceived similarity between Islamic and conventional banking products, and
perceived operational complexity of Islamic banking.

4.2.1 Reasons for Clients' Preference for Islamic Banking Products

The respondents were asked to determine which of the three factors was most influential
in guiding clients' choice when choosing between conventional banking and Islamic banking
products and services: "strictly religion, economics, both religion and economic". "No idea"

94
was also added for those respondents who have no opinion on the issue. The findings are
depicted in Table 3.2 (below). Nineteen respondents were of the opinion that such clients
select Islamic banking products based on religion and economic factors. Thirteen believed that
their clients would select Islamic banking products solely because of economic reasons. Two
respondents believed that their clients would select Islamic banking products strictly based on
religion, and another two respondents had no idea at all. These findings concurred with the
findings of Ahmad and Haron (2002) where 55% of Malaysian corporate clients in their sample
perceived that both religion and economics were the patronage factors of Islamic banking.

Table 3. 2: Reasons for selecting Islamic banking

Frequency Percent
Strictly religion 2 5.6
Economics 13 36.1
Religion & economics 19 52.8
No Idea 2 5.6
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

4.2.2 Similarities of Islamic Banking and Conventional Banking Products

Despite the phenomenal growth of Islamic banking worldwide, there is a current debate
among bankers, customers and scholars on whether Islamic banking practices are any different
from the conventional banking system (Hassan & Ahmed 2002). The offshore bankers in
Labuan are no exceptions as many interviewees stated 'I don't see any difference between the
Islamic and conventional banks.'
Respondents were asked to give their opinions in term of "true, untrue, and not sure"
regarding the statement 'Islamic banking products are similar to those of conventional bank,
except that Islamic banks use different names.' The findings are depicted in Table 3.3 (page
96). Nineteen of the respondents believed that Islamic banking products were similar to that of
conventional banks, 12 disagreed with the statement, and five were not sure. These findings
were consistent with that of Hassan and Ahmed (2002), where 200 bankers and 200 bank
customers in their samples could not differentiate Islamic banking products from those offered
by conventional banks.

95
 Table 3.3: Same as Conventional Banking

Frequency Percent
True 19 52.8
Untrue 12 33.3
Not sure 5 13.9
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

4.2.3 Operational Complexity of Islamic Banking

During informal interviews offshore bankers have raised their concerns regarding the
operational complexity of Islamic banking, and four of the main concerns are listed below:
Islamic banking makes lending structure complicated;
Islamic banking turns banks to non-voting equity holders;
Islamic banking makes risks mitigation complicated; and
What are the roles of the Shari 'a court in civil disputes between customers and banks?
The respondents were asked to indicate against the four concerns in terms "strongly
agree" (5), "agree" (4), "neutral" (3), "disagree" (2), and "strongly disagree" (1). The findings
are shown in Table 3.4 (below). The main concern of the respondents was that Islamic banking
makes lending structure complicated (mean = 3.50).

Table 3.4: Offshore Bankers Concerns about Islamic Banking

Strongly Strongly Standard
agree Agree Neutral Disagree disagree Mean Deviation
(5) % (4) % (3) % (2) % (1) %

Makes lending
structure complicated (4) 11.1 (19) 52.8 (5) 13.9 (7) 19.4 (I) 2.8 3.50 1.028

Turns bank to non-

voting equity holder (I) 2.8 (16) 44.4 (14) 38.9 (4) 11.1 (1) 2.8 3.33 .828

Makes risks
Mitigation complicated (I) 2.8 (19) 52.8 (7) 19.4 (8) 22.2 (1) 2.8 3.31 .951

Shari'a court interferes

with civil disputes - (10) 27.8 (18) 50.0 (7) 19.4 (1) 2.8 3.03 .774

Overall mean 3.29

Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

96
 The respondents second main concern was that Islamic banking turns banks to non-voting
equity holders (mean = 3.33). The third main concern was Islamic banking makes risks
mitigation complicated (mean = 3.31). That the Shari'a court interferes with civil disputes
between client and banker (mean = 3.03) was not a major concern to the respondents. These
findings reflected the concerns of the International Monetary Fund (IMF) with the profit-and-
loss-sharing (PLS) modes:
In practice, PLS modes make Islamic banks vulnerable to risks normally borne by equity investors rather
than holders of debt (Sundarajan & Errico 2002, p. 4).

These findings indicated that Labuan offshore bankers perceived Islamic banking
lending as a cumbersome process that involve extra risks, and require extra skills and resources.
Unless there are extraordinary benefits derived from these transactions they would not be likely
to participate in future Islamic financing.

4.3 Islamic Banking as a Niche for the Labuan IOFC

This section examines the liquidity of Islamic banking products and services, the
offshore bankers' perceptions of the viability of Labuan as an Islamic financial center, and its
competitive advantages.

4.3.1 Liquidity of Islamic Banking Products

To determine the liquidity of Islamic banking products a list of four questions were
asked, and the respondents were required to answer "yes" or "no" to the questions. The result
is shown in Table 3.5 (page 98). Twenty-nine respondents acknowledged that their banks did
not provide Islamic banking products or services, and did not have officers with Islamic
banking skills. Of the 29 respondents only 17 indicated that they would train their officers in
Islamic banking skills, whereas the other 12 were not going to do anything about it. However,
20 of the 29 respondents whose banks did not provide Islamic banking products or services
indicated that their banks would participate in future syndicated Islamic credit facilities and
debt instruments.
These findings concurred with the industry's records. Some interviewees conceded that
the issuance of the Malaysian government USD600 million dollar Islamic bond (Malaysia's
Sovereign Sukuk), the world's first Islamic sovereign bond dubbed by Euromoney as 'Best
Asian Sovereign bond' (LOFSA 2002), was not well received by the offshore banks. Despite its
sovereign risk, and all the publicity and accolades received from several international
publications only eight of the 53 offshore banks participated in the deal, and the remaining 45

97
banks did not subscribe at all. However the willingness of 17 offshore banks to train more of
their officers in Islamic banking skills, and the readiness of 20 more to participate in future
syndicated Islamic credit facilities and debt securities offered an encouraging sign for the
liquidity of Islamic banking products and services in Labuan.

Table 3.5: Liquidity of Islamic Banking Products and Services

Frequency Percent
I. Does your bank provide Islamic banking products
and services?
Yes 7 19.4
No /9 80.6
Total 36 100.0
2. Does your bank have enough officers who are
skilled in Islamic banking?
Yes 7 19.4
No 29 80.6
Total 36 100.0
3. Would you train your Labuan officers in Islamic
banking skills?
Yes 17 47.2
No 12 33.4
N/A 7 19.4
Total 36 100.0
4. Would your bank participate in future syndicated
Islamic structured credit facilities and bonds?
Yes 20 55.6
No 9 25.0
N/A 7 19.4
Total 36 100.0
ource: Mail Survey Data (Feb. 2004)

4.3.2 Viability of Islamic banking as a Niche for the Labuan IOFC

The respondents were asked to rank the viability of Islam banking as a niche for the
Labuan IOFC in term of "most viable" (5), "very viable" (4), "viable" (3), "somewhat viable"
(2), and "least viable" (1). The findings are depicted in Table 3.6 (page 99). Based on a five-
point scale the mean was 3.42, and a total of 31 respondents answered "most viable, very viable
and viable." These findings supported the study of Shariff and Mahmood (2000) where they
found that Islamic banking instruments had a great potential to be marketed in the Labuan
IOFC.

98
 Table 3.6: Viability of Islamic Banking as a Niche

Most Very Somewhat Least Standard

viable viable viable viable viable Mean Deviation
(5) % (4) % (3) % (2) % (I) %

(4) 11.1 (14) 38.9 (13) 36.1 (3) 8.3 (2) 5.6 3.42 .996
Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

4.4 Competitive Advantages of Labuan as an Islamic Financial Center

Currently, Bahrain and London are leading centers for Islamic finance (Lewis &
Algaoud 2001). The respondents were asked to compare the competitive advantages of Labuan
with London and Bahrain, and the findings are depicted in Table 3.7 (below). Twenty-five
respondents, as opposed to 11 others, believed that Labuan did not have the competitive
advantages over Bahrain and London.

Table 3.7: Labuan Advantages over London and Bahrain

Frequency Percent
Yes 11 30.6
No 25 69.4
Total 36 100.0
Source: Mail Survey Data (Feb. 2004)

The respondents were further asked to rank the competitive advantages of Labuan as an
Islamic financial center against Bahrain and London on a Likert-styled scale, 1 (least
competitive), 2 (somewhat competitive), 3 (competitive), 4 (very competitive), and 5 (most
competitive). A list of 12 attributes was provided as shown in Table'3.8 (page 100). The major
attributes that the respondents considered to be advantages for the 10FC in competing against
Bahrain and London were political stability (mean = 3.89), low taxes (mean = 3.79), bank
secrecy law (mean = 3.59), and reliable legal system (mean = 3.57). Central banking policies.
reputations, minimum exchange control restrictions, ideal time zone, market liquidity,
geographical location, skilled workforce, and physical infrastructure were not considered as the
competitive advantages of Labuan.
The overall mean of 2.68 for all the attributes indicated that Labuan does not have the
competitive advantages over Bahrain or London. However, a positive sign is that Labuan has
four major attributes that will be helpful in its development as an offshore Islamic financial

99
center. These attributes are political stability, low taxes, bank secrecy law, and a reliable legal
system. On the other hand, Labuan has four 'low' attributes that could impede its chances when
competing with Bahrain and London in Islamic financing. These are physical infrastructure
(mean = 1.79), skilled workforce (mean = 1.94), geographical location (mean = 2.09), and
market liquidity (mean = 2.09).

Table 3.8: Attributes of Labuan as an Islamic Offshore Financial Center

Most Very Somewhat Least Standard
competitive competitive competitive competitive competitive Mean Deviation
(5) % (4) `)/0 (3) % (2) % (1) %

Political Stability (10) 28.6 (14) 40.0 (8) 22.9 (3) 8.3 3.89 .932

Low Taxes (10) 29.4 (10) 29.4 (11) 30.6 (3) 8.8 3.79 .978

Bank Secrecy Law (4) 11.8 (14) 41.2 (14) 41.2 (2) 5.9 - 3.59 .783

Reliable Legal System (6) 17.1 (12) 34.3 (13) 37.1 (4) 11.4 - 3.57 .917

Central Bank Policies (4) 11.8 (15) 44.1 (7) 20.6 (5) 14.7 (3) 8.8 3.35 1.152

Reputations (4) 11.8 (4) 11.8 (18) 52.9 (5) 14.7 (3) 8.8 3.03 1.058

Minimum Exchange
Control Restrictions (5) 14.3 (6) 17.1 (10) 28.6 (11) 31.4 (3) 8.6 2.97 1.200

Ideal Time Zone (8) 22.9 (13) 37.1 (11) 31.4 (3) 8.6 2.74 .919

Market Liquidity (1) 2.9 (1) 2.9 (10) 29.4 (10) 29.4 (12) 35.3 2.09 1.026

Geographical Location - (3) 8.6 (11) 31.4 (7) 20.0 (14) 40.0 2.09 1.040

Skilled workforce (1) 2.9 (3) 8.8 (4) 11.8 (11) 32.4 (15) 4.1 1.94 1.099

Physical infrastructure (1) 2.9 (6) 17.6 (11) 32.4 (16) 47.1 1.79 .946

Overall mean 2.68 1.004

Source: Mail Survey Data (Feb. 2004)
N=36
Number in parenthesis indicates frequency

The findings on the 'low' attributes of Labuan, especially the physical infrastructure and
geographic location were consistent with the outcome of a recent random survey conducted by
the Business Times. Among the problems cited were the unavailability of direct flights from the
major cities in the region, and the unreliability of water and electricity supplies (Business Times
17 Jul. 2004, p. 1).

100
 4.5 Relationships of Selected Variables

The chi-square analyses were performed to determine whether there were any relationships
between selected variables such as viability of Labuan as an International Islamic Financial
Center and the conventional offshore bankers' perceptions of Islamic banking products.
competitive advantage over Bahrain and London and the conventional offshore banker's
perceptions of Islamic banking practices.

4.5.1 Relationship Between Viability as an Islamic Financial Center

and Offshore Bankers' Perceptions of Islamic Banking Products

This section attempts to answer research question: To what extent does the viability of
Labuan as an Islamic Financial Center depends on the offshore bankers' perceptions of Islamic
banking products? However, the chi-square analysis could not be computed due to a significant
numbers of cells having less than five respondents. As depicted in Table 3.9 (below) the results
seem to suggest that the majority (86.1%, 31) of respondents perceived that Labuan was

Table 3.9
Distribution of Respondents by Viability as an Islamic Financial
Center (IFC) and by the Same as Conventional Banking Products

Viability as Same as Conventional Banking

an IFC) Products Total
True Untrue Not Sure
60.1 20.0 20.0 13.9
Least Viable (3) (1) (1) (5)

51.6 35.5 12.9 86.1

Viable
(16) (11) (4) (31)
52.7 33.4 13.9 100.0
Total
(19) (12) (5) (36)
Note: Numbers without brackets indicate percentages, whereas numbers in
brackets indicate frequencies of respondents.
Chi-square could not be computed due to many cells having less than five cases.

viable as an Islamic Financial Center, and more than half (51.6%, 16) of them also believed that
Islamic banking products are the same as that of conventional banking. On the other hand. only
(13.9%, 5) of respondents believed that Labuan was least viable as an Islamic Financial Center,
and surprisingly, (60.0%, 3) of them believed that Islamic banking products were no different
from conventional banking products.

101
4.5.2 Relationship Between Labuan's Competitive Advantage over Bahrain and London
and Offshore Bankers' Perceptions of Islamic Banking Practices

Table 3.10 (below) shows that the majority (69.4%, 25) of respondents believed that
Labuan had no competitive advantage over Bahrain and London. These results attempt to
answer research question: To what extent does Labuan's competitive advantage over Bahrain
and London depends on the offshore bankers' perceptions of Islamic banking practices? Even
though the chi-square analysis could not be computed due to a significant numbers of cells with
cases less than five, the results seem to indicate that the majority (68.0%, 17) of those who
believed that Labuan had no competitive advantage also believe that Islamic banking practices
make lending structure complicated. On the other hand, more than half (54.5%, 6) of
respondents who thought that Labuan had competitive advantage also believed that Islamic
banking practices make lending structure complicated.

Table 3.10
Distribution of Respondents by Competitive Advantage (C/A)
Over Bahrain and London and by Make Lending Structure Complicated

C/A Over Make Lending Structure Complicated

Bahrain & Disagree Neutral Agree Total
London
36.4 9.1 54.5 30.6
Yes
(4) (1) (6) (11)
16.0 16.0 68.0 69.4
No
(4) (4) (17) (25)
22.2 13.9 63.9 100.0
Total
(8) (5) (23) (36)
Note: Numbers without brackets indicate percentages, whereas numbers in
brackets indicate frequencies of respondents.
Chi-square could not be computed due to many cells having less than five cases.

102
CHAPTER FIVE: SUMMMARY AND CONCLUSION

5.0 Introduction
This chapter summarizes and concludes the research by summarizing the findings in
Section 5.1, discussing implications of the findings in Section - 5.2, the limitations of the
research in Section 5.3, future research directions in Section 5.4, and finally drawing
conclusion in Section 5.5.

5.1 Summary of Findings

The findings are classified according to the following: knowledge of Islamic banking,
Islamic banking products and services, viability of Islamic banking as a niche for the Labuan
IOFC, and competitive advantages of Labuan as an Islamic financial center.

5.1.1 Knowledge of Islamic Banking

There was a widespread misconception among the respondents regarding the principles
and practices of Islamic banking. They were unaware of the principles of al-wadia,
muddharaba, musharaka, ijara, istina and others used in Islamic banking. The respondents
believed that Islamic banks, like the conventional banks, must maximize their profit in order to
survive.

5.1.2 Islamic Banking Products and Services

Most of the respondents believed that Islamic banking products were similar to
conventional banking products except for the different names, and that their clients would
select Islamic banking products based on both economic and religious reasons. The respondents
also believed that Islamic banking made lending structure complicated, turned bank to non-
voting equity holder, and made risks mitigation complicated, thus making simple lending
unnecessarily complicated and riskier.

5.1.3 Viability of Islamic Banking as a Niche for the Labuan 10FC

Most of respondents' banks did not provide Islamic banking products and services, and
did not have officers conversant in Islamic banking. However, they were willing to train their
officers in Islamic banking, and participate in future Islamic banking deals. The respondents
also believed that Islamic banking was viable niche for the Labuan 10FC.

103
5.1.4 Competitive Advantages of Labuan as an Islamic Financial Center
The respondents perceived that the Labuan IOFC was rated 'low' in terms of physical
infrastructure; skilled workforce, geographical location, and market liquidity. Thus it does not
have many competitive advantages over Bahrain and London. However, it has four major
attributes that could be helpful in its development as an offshore Islamic financial center. These
attributes are political stability, low taxes, bank secrecy law, and a reliable legal system.

5.1.5 Relationships of Selected Variables in Relation to the Viability of Labuan as an

Islamic Financial Center

The majority of respondents perceived that Labuan was viable as an Islamic Financial
Center, and more than half of them also believed that Islamic banking products were the same
as that of conventional banking. On the other hand, the majority of respondents believed that
Labuan had no competitive advantage over Bahrain and London, and surprisingly, more than
half of them seemed to believe that Islamic banking practices make lending structure
complicated.

5.2 Limitations of the study

There are three major limitations of this study. Firstly, it focuses only on Islamic banking,
which is just one aspect of the Labuan IOFC's businesses. The IOFC is a financial
'supermarket' offering a wide range of products and services, which includes takaful (mutual
insurance), offshore insurance and insurance related activities, offshore trusts, trust companies
and services, management companies, offshore money brokers, offshore leasing, and
investment holdings. As such the success or failure of the 10FC cannot be judged based on the
performance of the Islamic banking business alone without taking into consideration the rest of
the businesses. Offshore banking was the subject of study in Paper Two.
Secondly, as in Paper Two, the persons who completed the questionnaire were the
principal officers with overall responsibility for the banks' operations in Labuan. Nevertheless,
their level of knowledge and experience were different and hence the opinions varied from
bank to bank. There was also a danger that their opinions did not necessarily reflect the views
of the bank. Thirdly, the inherent limitations of a research method that is based on an empirical
survey as discussed in Chapter Three.

104
5.3 Implications of the Findings
From a theoretical perspective this research supports the concepts of an Islamic financial
center, niches and specializations, and the theory of customers' and bankers' perceptions of
Islamic banking. This research therefore lends support to Lewis and Algaoud's (2001) Islamic
financial center theory, Hughes and MacDonald's (2002), Cobb's (1998), and Lewis- (1998)
models of niches and specializations, Ahmad and Haron's (2002), and Hassan and Ahmed's
(2002) theories of customers' perceptions of Islamic banking.
There are three major managerial implications of this study: the need to enhance
knowledge and expertise, the need to be innovative and creative, and the need to improve the
physical infrastructure to overcome the location disadvantage of the LabuanIOFC.
Firstly. with regards to the enhancement of knowledge and expertise regular seminars
and workshops should be held to expose conventional bankers to Islamic banking principles
and practices, as well as build competence among officers. Seminars will provide avenues for
Islamic banking concepts and principles to be discussed. For senior managers these are good
opportunities for them to understand the concepts and principles of Islamic banking. On the
other hand workshops would helpful to officers who are directly involved with the structuring
and transactions of banking products in developing their competence and expertise. The
establishment of an industry-owned Islamic Banking and Finance Institute Malaysia (IBFIM) in
2001 to provide training and education, advisory and consultancy, and research and
development (IBFIM 2004) was a positive step in the enhancement of expertise of individuals
in the Islamic banking industry.
Secondly, as for innovation and creativity the offshore bankers in Labuan were
accustomed to creditor-debtor relationships between banks and customers in conventional
banking, and viewed the lending structure of Islamic banking and its implication on risks
mitigation as cumbersome. In order to convince them to commit their time and resources
Islamic banking products and services must be seen as value-added. Again, the research and
development function of the IBFIM should be helpful in this area. Innovation should also
include the area of taxation. Bank Negara's master plan has already provided a basis for the
'formulation and amendments to tax policies to take into consideration the impact on Islamic
banking to avoid creating barriers in adopting Islamic banking concepts' (BNM 2001, p. 162).
The creation of such a favorable tax regime should have a substantial impact in term of
increased profit margin or reduced cost on the part of the offshore banks.
The central bank's master plan has also called for an increase of number of Islamic
players, by inviting financial institutions from the Middle East to set up operations in Labuan.

105
However, three years after the implementation of this master plan the outcome has not been
encouraging. So far only one Islamic investment bank from Saudi Arabia has set up operations
in Labuan. To build the critical mass of players and market participants other creative non-tax
related incentives should be offered to the conventional offshore banks currently operating in
Labuan.
Finally, there is an urgent need to improving the physical infrastructure and
overcoming the location disadvantage of Labuan. At present Bahrain and London are leading
centers in Islamic finance, and the results have shown that Labuan does not have competitive
advantages over these centers. Two major setbacks cited were poor physical infrastructure and
Labuan's inherent location disadvantage.
Some physical attributes such as more reliable of water and electricity supplies and air
accessibility can be created but these will be subject to market reality. Bank Negara's master
plan recommended that Labuan have an 'open sky' policy to encourage direct flights from
Singapore, Hong Kong, Tokyo, Taipei, Seoul, Manila and Jakarta to Labuan. As cited in Paper
Two, in theory this would raise the air accessibility of Labuan to the level of Kuala Lumpur,
Bahrain, and to some extent London. However, three years since the master plan was adopted
no airline has established any direct flight from these regional capitals to Labuan, airlines will
only fly to specific destinations based on market reality, that is, if they can profit from such
operations.
Obviously, raising the standard of Labuan to that of Kuala Lumpur, in order to be able
to compete with Bahrain or London would not be practical. However, the concept of twinning
Labuan with the Multimedia Super Corridor as recommended in Bank Negara's master plan
would be worth further examination. This concept would automatically allow Labuan to utilize
the attributes of Kuala Lumpur to compete against Bahrain, and to a smaller extent London.
The problem of the lack of air accessibility and poor physical infrastructure would thus be
resolved.
Recognizing the inherent disadvantage of Labuan compared to Bahrain it would be
prudent to work closely with Bahrain. Such an alliance has already been initiated by the central
bank's master plan in the form of the establishment of the International Islamic Financial
Market (IIFM) with its secretariat in Bahrain. The IIFM's main function is 'to stimulate the
creation of liquidity and financial instruments as well as enhance investment opportunities
aimed at greater mobilization of Islamic funds' (BNM 2001, p.146). As Bahrain is more
experienced in offshore Islamic financing, being located in the oil-rich region in the Middle
East, Labuan could benefit from Bahrain's strength in developing new products and services,

106
and then selling them in the Middle East market. This cooperation is already visible as seen in
the USD$600 million sovereign Malaysian global Islamic Sukuk transactions where 51% of the
bonds were bought by investors from the Middle East (Alam Shah 2004). These are good
starting points, and continued cooperation would be useful in overcoming Labuan's lack of
competitive advantages.

5.4 Future Research Directions

The fact that Islamic banking principles and practice have not been well understood by
th Labuan offshore bankers, their less than enthusiastic reception towards Islamic banking
products, and their perceptions of Labuan's geographic disadvantage contradicted the
Malaysian government's presumptions of Labuan's competitive advantages. This inversed
relationship needs to be examined adequately to avoid costly errors as well to enable the
formulation of effective strategies. To say that limited empirical studies have been conducted in
Labuan in relations to Islamic finance is an understatement; the fact is that there is none save
for the current work. More research should be directed towards this area. With more then
twenty years of experience in Islamic banking and takafid Malaysia has a strong foundation,
and Islamic finance appears to be a logical niche for the Labuan IOFC. Such future research
may include the areas of innovation in Islamic banking products and services, effective
marketing of Islamic banking products and services to non-Muslims, development of Islamic
banking risk management, development of Islamic banking asset-liability management,
development of takafill products, and understanding the threats of the Brunei IFC, Bahrain and
London to the Labuan IOFC.

5.4 Conclusions
The research has provided some support towards the implementation of Islamic banking as
a niche for the Labuan IOFC. Offshore bankers are willing to train their officers in Islamic
banking and participate in future Islamic transactions. Their participations would provide the
critical mass to the Labuan 10FC, thus increasing the market liquidity of the Islamic banking
products. Besides Labuan is strong on four major attributes, political stability, low taxes, bank
secrecy law, and a reliable legal system. These attributes and Malaysia's substantial experience
in Islamic banking would give Labuan a starting point in developing as an international Islamic
financial center.
In order to encourage offshore bankers to participate in Islamic banking transactions more
trainings should be conducted, and both tax and non-tax incentives offered to offshore banks.

107
The existing strategic alliance with Bahrain should be intensified, as Labuan could benefit from
Bahrain's experience and strength in products innovations and selling these products in the
Middle East market. Bahrain's involvement would lend credibility to the other Islamic
countries, especially in the Middle East where the big investors of Islamic financial products
reside. Their confidence in Labuan would eventually convince the reluctant offshore bankers
that Islamic banking products and services could generate the same level of benefits and profit
just as the conventional banking. Labuan offshore bankers' active participations in the Islamic
financial transactions would make in easier for the Labuan IOFC to attract new international
players.

108
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Centre: Treasure Island, Pet Project or Ghost Town?' in Offshore Finance Centers and
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Ahmad, N. & Haron, S. 2002, The Potentiality of Islamic Products and Services in
Fulfilling Corporate Customers' Banking Requirements, paper presented to The 15
International Conference on Islamic Banking, Finance & Insurance, Labuan 30-31 Jan.

Ahmad, N. & Kefeli, Z. 2002, 'Labuan International Offshore Financial Center:

Performance, Challenges and Prospects', Ulum Islamiyyah, vol. 1 no. 1,
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 Appendix I

Prepared by: Ricardo Baba

CONFIDENTIAL

QUESTIONNAIRE

Instructions

This questionnaire has two parts, section A on offshore banking, and section B on Islamic
banking. For some questions you may answer by ticking in the appropriate box. Some questions
require you to write the answers. However, you are encouraged to write additional comments
whenever appropriate.

SECTION A: OFFSHORE BANKING IN LABUAN IOFC

Nature of Business Operations

Please indicate if your bank is

( ) branch/subsidiary of a Malaysian bank

( ) branch/subsidiary of a non-Malaysian bank

Offshore Banking Centers can be considered as:

Functional Centers: Where actual banking transactions are carried out, and
banks raise, invest and lend funds on their own initiative, or with approval from
Head Office if the amount of facility exceeds local limit.

Paper Centers: Where banks act as a location of records, with little or no actual
banking transactions taking place, and are hence booking offices for transactions
and decisions made at head and/or regional offices outside the center, and

Ancillary Centers: Where banks act as backroom processing locations for

transactions outside the center.

Based on the functions and organization of your bank would you categorize your operation as
mainly:

) Functional transactions
(
) Paper transactions
(
( ) Ancillary transactions
( ) a mixture of all three with majority being functional transaction
( ) a mixture of all three with majority being paper transactions
0 ( ) a mixture of all three with majority being ancillary transactions

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 If your answer is b, c, e or f to question 2 please explain you reason(s) for not carrying
out more functional activities in Labuan IOFC. (You can have more than one answer).

( ) Labuan does not have the manpower with skills to handle sophisticated
banking transactions.
( ) My bank never felt a need to establish a full-fledged operations,
because

( ) We do not have sufficient volume to justify a full-staffed office.

( ) Others, please explain

To what extend are the different types of services offered or functions performed by
your bank considered important. Please tick ( ) the appropriate answers in term of
their importance:

extremely very somewhat not at all

important important important important important

Accepting and
placing of deposits

Trade financing

Derivatives trading

Securities trading

Debt securitization

Advisory

Lending

Treasury operations

Issuance of SBLCs
and BGs

Private banking

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 Does your bank have a treasury operation?

) Yes
) No

If your answer to question 5 is "no" would you consider setting up a treasury?

Yes one year time

Yes two years time
Not at all

Business after the 1997-1998 Crisis

How much was your business affected by the 1997-1998 Asian Crisis?

( ) Decreased by (a) 25% (b) 26-50% (c) 51-75% (d) 76-100%

( ) Increased by (a) 25% (b) 26-50% (c) 51-75% (d) 76-100%
( ) No change
( ) Not applicable, because our operation started after the Crisis.

How much has your business improved since the 1997-1998 Asian Crisis?

Increased by (a) 25% (b) 26-50% (c) 51-75% (d) 76-100%

No improvement
Not applicable, because we were not in operation before the Crisis.

On a scale of 1-5 (5 being most competitive) how would you rank the

competitiveness of Labuan IOFC after the 1997-1998 crisis?

1 2 3 4 5
least most
competitive competitive

What would be the most likely to happen to your operation in Labuan 10FC in 3 years
time?

a ( ) Downsize
b ( ) Change to investment banking
c ( ) Move to Singapore
d ( ) Move to Hong Kong
e ( ) Others, please specify

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Policies, Rules and Regulations

11) In your opinion, which of the following government's primary objectives of setting up
an international offshore financial center in Labuan are considered important. Please
tick ( ) the appropriate answer in term of their importance:

extremely very somewhat not at all

important important important important important

To complement the
onshore financial
system centered in
Kuala Lumpur

To strengthen the
contribution of the
financial sector towards
the Gross National
Product of Malaysia

To enhance the
attractiveness of
Malaysia as an
investment center

To promote the
economic development
of Labuan and its vicinity

12) Do you agree with LOFSA's policy of restricting the number of staff for the Kuala
Lumpur marketing office to only 4 persons? Please circle the most appropriate answer.

Strongly Agree Neutral Disagree Strongly

agree disagree

Comments

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 Do you agree with LOFSA's policy of not allowing Labuan banks to act as "fronts" for
banks from outside the center? Please circle the most appropriate answer.

Strongly Agree Neutral Disagree Strongly

agree disagree

Comments

Competitiveness of Labuan IOFC

Why did you choose to establish in Labuan? Please tick ( ) the appropriate answers in
term of their importance.
extremely very somewhat not at all
important important important important important

Geographical location

Political stability

Reliable legal system

Low taxes

Ideal time zone

Minimum exchange

control restrictions

Central Bank policies

Bank secrecy law

Reputations

Opportunity to get into

the domestic business
once the banking
market is liberalized

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 On a scale of 1-5 (5 being the greatest threat), please rank the following offshore
banking centers according to threats posed to Labuan 10FC.

Bangkok IBF
Brunei IFC
Hong Kong
Manila OBU
Singapore

Those you ranked 4 and 5 in question 13, please list 2-3 threats posed to Labuan IOFC.

In your opinion how suitable is Labuan as an Offshore Banking Center?

Extremely suitable ( ) Somewhat suitable

Very suitable ( ) Not at all suitable
Suitable

Please list 2-3 reasons for your answer

18) In your opinion is Kuala Lumpur a more suitable location for an Offshore
Banking Center?

Extremely suitable ( ) Somewhat suitable

Very suitable ( ) Not at all suitable
Suitable

Please list 2-3 reasons for your answer.

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SECTION B: ISLAMIC BANKING

Features of Islamic Banking

1
) Islamic banking is an alternative to conventional banking for Muslims who are
prohibited from associating themselves with the element of interest.

True
Untrue
Not sure

The profit and loss sharing (PLS) principle is the only principle that can replace the
element of interest in the operations of Islamic banking.

True
Untrue
Not sure

Both Islamic and conventional banks must adopt profit maximization principle in order
to survive in a competitive market.

True
Untrue
Not sure

Islamic Financial Products

In your opinion the main reason offshore banks clients select Islamic banking products.

Strictly religion
Economics
Both religion and economics
No idea

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5) In your opinion Islamic banking products are similar to those of conventional banks
except that Islamic banks use different names.

True
Untrue
Not sure

In your opinion, to what extend do you agree with the statement below. Please tick (/)
the appropriate answers.
strongly agree neutral disagree strongly
agree disagree

It makes a simple lending

structure more complicated

It turns a bank to a non-voting

equity holder instead of a lender

It makes risks mitigation

more complicated

The Syari'ah court interferes

with civil dispute between bank
and client

Liquidity of Islamic Financial Products

7) Does your bank provide Islamic banking products and services?

( ) No
( ) Yes, please list down the major products and services.

8) Does your bank have enough officers who are skilled in Islamic banking?

( ) Yes
( ) No

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 If your answer to question 8 is "no" would you like to train your Labuan officers in
Islamic banking skills? If your answer is "yes" to question 8 proceed to question 10.

( ) Yes
( ) No

Would your bank participate in future syndicated Islamic structured credit facilities and
bonds?

( ) Yes
( ) No Comments

Competitiveness of Labuan IOFC in Islamic Banking

Labuan Offshore Services Authority (LOFSA) is promoting Labuan 10FC as an

International Islamic Financial Center. On a scale of 1-5 (5 being most viable) please
rate the viability of that objective.

1 2 3 4 5
least most
viable viable

London and Bahrain are currently centers for Islamic banking services. In your
opinion does Labuan IOFC have a competitive advantage over these centers?

( ) Yes
( ) No

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13) On a scale of 1-5 (5 being most competitive) please rate the competitiveness of Labuan
10FC against Bahrain and London as an Islamic banking center according to the
following factors:
Labuan

Geographical location

Political stability

Reliable legal system

Low taxes

Ideal time zone

Minimum exchange
control restrictions

Central Bank policies

Bank secrecy law

Reputations

Physical infrastructure

Skilled Labor Force

Market liquidity

Thank you very much for taking the time and effort to answer these questions.

121
 Appendix II

UNIVERSITY OF SOUTH AUSTRALIA

International Graduate School of Management
City west Campus
Adelaide SA 5001
Australia
November 15. 2003
Dear Sir,

Research Studies On Offshore and Islamic Banking in Labuan 10FC.

Currently I am enrolled with the International Graduate School of Management, University of

South Australia, Adelaide where I expect to obtain a Doctor of Business Administration (DBA)
in International Banking. My supervisors are Professor H.L. Siow of University Malaya and Dr.
K. Knapp of The Indonesian Institute for Management Development.

The topic of my paper is "Labuan as an International Offshore Financial Center." The

objective of this study is three folds. The first part discusses the phenomenon of offshore
financial centers, the necessary conditions for their success, and the necessity to create niches.

The second part of my study deals with Labuan as an offshore banking center, while the third
part of the study deals with Islamic banking in Labuan IOFC. To complete the second and third
parts of the study I have designed the enclosed questionnaire.

This questionnaire is divided into two parts Section A, on Offshore Banking and Section B on
Islamic Banking. Section A of the questionnaire is divided into four major issues:
The competitive advantage of Labuan compared to established centers like
Hong Kong and Singapore.
The effect of the 1997-1998 Crisis on offshore banks in Labuan
The implications of government policies and regulations on the offshore banking
industry.
The nature of banking business and operations, whether functional, ancillary or booking
offices.

Section B of the questionnaire is divided into three major issues:

Perceptions of the conventional offshore bankers on Islamic banking.
Liquidity of Islamic financial products
Competitive advantage of Labuan compared to London and Bahrain.

All information collected as part of these studies will be retained for seven years and
stored in a fire-resistant cabinet in Universiti Malaysia Sabah, Labuan. All records
containing personal information will remain confidential, and no information which could
lead to identification of any individual will be released.

122
Your participation in this research is voluntary, and the main purpose of these studies is to
solicit your knowledge and opinion. Should you wish to discuss any specific ethical concerns of
the projects please contact the following official at University of South Australia:

Vicki Allen
Executive Officer
Human Research Ethics Committee
University of South Australia
GPO Box 2471
Adelaide SA 5000
Vicki.al len(0.misa.edu.au
+61 8 8302 3118

If you have any question or remark regarding the questionnaire please call or email me at the
Universiti Malaysia Sabah, Labuan International Campus at telephone numbers 087-460 466,
019-8254808, or rbabakliums.eclu.inv

Please complete and mail your questionnaire in the enclosed ready-stamped and self-addressed
envelop before 30th November 2003.

Your cooperation and early response is very much appreciated.

Sincerely,

Ricardo Baba
DBA candidate

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