This report was prepared at the request of the Government of Malaysia (GOM) as a contribution to the long term development objectives for the university sector under the Ninth Malaysia Plan. The GOM is considering new policy directions to make the country a more competitive player in the world economy. Such a strategy will require bold innovations in many sectors, including the university system whose contribution to greater value-added production should come from the generation and diffusion of relevant knowledge and the production of a critical mass of graduates with appropriate skills. Malaysia is thus attempting to transform its universities into dynamic and responsive institutions which can hold their place internationally. In this context, the Economic Planning Unit (EPU) and the Ministry of Higher Education (MOHE) have requested analytical and advisory services from the World Bank to help develop a strategic vision for the evolution of the country's universities towards becoming world class. The present study, which seeks to add value by sharing international experience with relevant strategies and policy measures, provides practical short-term, medium-term and long-term recommendations and an action plan for the government's consideration, and served as an input into the Ninth Malaysia Plan (2006-2010). This report assesses and analyzes the current state of the Malaysian university system and makes recommendations on ways to further strengthen existing higher education institutions. It looks in particular at the policy framework needed to support the growth and development of the higher education system--legal framework, quality assurance systems, incentives for investment, R&D policies, financing mechanisms that help low income students access education, and public financing programs that direct subsidies to strategically important institutions or fields of study. This report aims to identify key challenges and appropriate solutions which could constitute relevant policy advice for the GOM. The report is organized into two main parts. It starts with a diagnosis of the present situation, relying on a range of key indicators to benchmark Malaysia's national innovation and higher education systems against select Organization for Economic Co-operation and Development (OECD) and East Asian countries and on an in-depth analysis of the universities' main strengths and areas of weaknesses. The second part provides policy recommendations and detailed action plans to improve the Malaysian higher education system, with special attention paid to the research and innovation nexus, graduate employment, quality assurance systems, financing mechanisms, and the governance and management framework. Annexes include: (1) Terms of Reference of the Study; (2) List of Institutions Visited and Persons Met; (3) Classification of Countries by Models of National Technological Learning; (4) Resource Diversification Matrix for Public Higher; (5) Monitoring Indicators for the Student Loan Program; (6) Which Allocation Mechanism is more Effective?; (7) Indicators Used by International Ranking Exercises; (8) Rankings of Business Administration Schools; and (9) Recent "Excellence" Initiatives. (Contains 41 tables, 28 figures, 40 boxes, and 135 footnotes.) [This report was prepared by the East Asia and the Pacific Region of the World Bank.]