Malaysia is in many ways one of the world's leading Islamic financial markets, but regulatory issues and comfortable balance sheets are causing it to lag behind the Gulf in one innovation: capital-boosting sukuk.

Since last year, Gulf banks have been developing sukuk designed to increase their capital, in order to meet new Basel III banking standards due to be phased in around the world over the next several years.

In November 2012 Abu Dhabi Islamic Bank issued a hybrid sukuk, one with equity-like characteristics, to boost its Tier 1 capital. Dubai Islamic Bank sold a similar $1 billion instrument in March 2013.

There have also been subordinated sukuk issues to raise Tier 2 capital, including a 1.4 billion riyal ($373 million) sale by Saudi Hollandi Bank last November. Saudi British Bank , which issued a Tier 2 sukuk in March 2012, aims to sell another one by the end of this year.

Within Malaysia, conventional banks have been among the first institutions in Asia to move to issue Basel III bonds; CIMB Group Holdings sold one this month, raising 750 million ringgit ($238 million) of Tier 2 capital. Public Bank and RHB Investment Bank have prepared similar bond programmes.

But so far no Islamic bank in Malaysia has established a programme to issue capital-boosting sukuk - partly because they see no strong need, bankers say.

"You find that in Malaysia most of the banks are fairly comfortable, with some banks more capitalised than others," said Badlisyah Abdul Ghani, chief executive of CIMB Islamic Bank, the sharia-compliant unit of southeast Asia's fifth-largest lender by assets.

"At the earliest you will probably see - perhaps next year - some banks going to market, but most will not really be in the market because they are well-capitalised."

LOSS ABSORPTION

Although subordinated debt is more expensive for issuers than secured debt, strong demand among local investors in the Gulf has allowed banks there to sell Tier 1 and Tier 2 sukuk at prices they find favourable.

Regulation is one factor encouraging such issuance. Although national financial regulators in the Gulf have not yet fully clarified how they will apply Basel III standards, bankers in the region expect local versions of Basel III will not include a loss absorption feature allowing regulators to convert debt into equity if an issuer faces insolvency.

This is particularly true in the United Arab Emirates. Because of their large state budget surpluses and lack of broad-based income taxes, Gulf governments do not see that much of a need to protect taxpayers from bank crises with loss-absorption clauses.

Malaysia's version of Basel III does require loss absorption, however, which could raise costs for the issuer of a subordinated sukuk.

Islamic banks in Malaysia are still studying how to include the clauses, so the timing of the first Basel III sukuk remains uncertain, said Leon Koay, head of global markets and co-head of wholesale banking at Standard Chartered Malaysia.

"There are a lot of challenges of dealing with the point of non-viability. There's an evolution there of how they want to get the structure right."

Even with loss absorption, Malaysia's sukuk market is deep and liquid market enough for banks to manage any additional premium required by investors, said CIMB's Abdul Ghani.

"Margins in Malaysia are very tight, so I don't think it will really influence much in regards to cost."

But for now at least, Malaysia's Islamic banks see little urgency to raise capital. The central bank requires all banks to have a core equity Tier 1 capital ratio of 4.5 percent of assets, a Tier 1 capital ratio of 6 percent and a total capital ratio of 8 percent of risk-weighted assets by January 2015.

Malaysian banks in general are so well capitalised that they could sustain a 300 percent rise in non-performing loans without Tier 1 common equity falling below 7 percent, Moody's Investors Service estimated in a report earlier this year. Islamic banks are especially comnfortable.

In the meantime, several Islamic banks in Malaysia are exploring the possibility of using alternative means to sukuk issues to handle their Basel III capital needs, said a banker who declined to be named as the matter is not yet public.

The alternatives could include the issuance of sukuk or other financial instruments by government entities; these instruments would be purchased by Islamic banks and, if they were government-guaranteed or structured to have very low or even zero risk-weightings, could improve the banks' capital ratios, the banker said.