সোমবার, ২৭ এপ্রিল, ২০১৫

Central Banking in Islamic Framework


Class Lecture (Final)

Islamic Financial System (Fin-5402)

Central Banking in Islamic Framework

The central bank has the sole authority to issue money (currency) and the responsibility to regulate the banking system in order to secure the value of money and realize the other objectives of monetary policy. Money serves as the medium of exchange and the commonly accepted means of payment, and as such as a measure of value. Excessive fluctuations in the value of money lead to economic distortions and causes social inequities. Inflation gives windfall gains to the rich and the business people but causes hardship to the fixed and low-income groups by eroding their purchasing power. Worse still, deflation often deprives the latter of their employment and means of livelihood. The phenomena of inflation and deflation are characteristic of the financial system based on the institution of interest, which is prohibited in Islam

Objectives of monetary policy in Islam

Consistent with the Islamic ideals of social justice, equity, fairness and balance, there are three major objectives of monetary policy in an Islamic economy, which discards interest. These objectives are:
  1. Stability in the value of money;
  2. Economic well-being with full employment and optimum rate of economic growth; and
  3. Distributive justice
Stability in the Value of Money

In an Islamic economy it is almost mandatory on the central bank to preserve the value of money. Thus the central bank should allow expansion of money supply to the extent it is justified by a possible contribution to growth in real balances. The stability in the value of money should be accorded high priority because of the unequivocal stress of Islam on honesty and fairness in all human dealings, and because of the negative impact of inflation on socio-economic justice and general welfare. But, rather than absolute, this objective would mean relative stability in the general price level. Absolute price stability is neither feasible nor desirable as it may conflict with the optimum growth and full employment objective of the monetary policy

Economic Growth and Employment

While inflation is incompatible with the goals of an Islamic economy, prolonged recession and unemployment that cause human sufferings are also unacceptable. Monetary policy has, therefore, to aim at a high rate of economic growth with full employment and utilization of productive resources. However, maximization of economic growth per se and at all costs is not the objective of monetary policy in an Islamic economy. Material prosperity is to be attained within the framework of Islamic values. It should not be attained through the production of essential and morally - questionable goods and services. It should not lead to an excessive and overly-rapid use of Allah-given resources at the expense of future generations, and it should not be harmful to present or future generations by degenerating the moral and physical environment.  Environmental degeneration with degradation and depletion of land, water and forest resources and serious air and water pollution are already matters of great concern around the world. Hence the concept of “sustainable development", which means meeting the needs of the present generation without compromising the needs of future generations. Economic development and sound environmental management are complementary aspects of the same agenda. Without adequate environmental protection, development will be undermined; without development, environmental protection will fail

DistributiveJustice

Monetary policy should be used actively to promote the goal of distributive justice and prevent concentration of wealth and economic power in an Islamic economy. However, too much concern with distributive justice in formulating and implementing monetary policy may adversely affect its overall efficiency and effectiveness in attaining the other goals of monetary policy. e.g. growth, employment and development. Reduction in income inequalities and necessary redistribution should be an important policy objective of an Islamic state and hence the domain, mainly, of its fiscal policy

Functions of the Central Bank
Pivot of the Islamic banking System: The central bank should be the pivot of the Islamic Banking System, because only through its conscientious and creative efforts and eternal vigilance can the Islamic money and banking system function properly and achieve its objectives. It should be an autonomous government institution responsible for the realization of the socio-economic goals of the Islamic economy in the sphere of money and banking.

Issue of Currency: Like all central banks, the central bank in an Islamic economy should be responsible for the issue of currency and, in coordination with the government, for its internal and external stability. It should act as banker to the government and the member banks. It should make arrangements for clearance and settlement of checks and for transfers, and should act as the lender of last resort. It should guide, supervise and regulate the commercial banks, the non-bank and specialized financial institutions, without unduly affecting their autonomy. Unlike the conventional central bank, it should also bear the responsibility of preventing the concentration of wealth and power through the financial institutions.

Stabilization of the Value of Money: Stabilization of the real value of money should be an important function of the central bank in order to realize the healthy sustainable growth of the Islamic economy and to ensure socio-economic justice. For this purpose, it would have to keep a close watch on money supply, to ensure that the growth in money is not out of step with that in real output. This does not imply that the money supply is the only variable influencing prices. All it implies is that the money supply matters, and that without its proper regulation one of the important instruments for realizing the economic goals of Islam will have been blunted.

Implementation of Monetary Policy: The central bank should be the primary institution responsible for implementing the country's monetary policy.  For this purpose, it should use the instruments and methods that are not in conflict with the teachings of the Islamic Shariah. Further, since the central bank cannot realize the goal of monetary stability without cooperation from the government, a harmonious fiscal - budgetary policy would be indispensable.

Promotion, Regulation and Supervision: The central bank will also have to play a positive role in the promotion, regulation and supervision of all financial institutions with the objective of helping them and making them healthy and strong. For this purpose it may have to review all existing laws and amend or reconstitute them in the light of Islamic teachings. The reformed banking legislation should reflect the different needs of the Islamic financial system.

Ensure health and Development of Public Interest: The central bank should not confine its regulatory role merely to the commercial banks. Its vigilance and assistance must envelop all other financial institutions to ensure their health and development and to safeguard the public interest. If some other government agencies are responsible for promoting and regulating non-bank financial and auxiliary institutions, then there should be proper coordination between the Central bank and other regulatory authorities to bring on harmony in their promotional and regulatory functions.

Lender of the Last Resort:  As in conventional banking, the Islamic central bank would also have to act as the lender of last resort to ensure sufficient liquidity and to sustain the banks in case of liquidity or solvency crisis. Its ingenuity would be reflected in the way it handled crisis situations without bailing out bank management and yet safeguarding the interest of depositors and equity-holders who are not a part of the management. Temporary accommodation from the central bank provides the borrowing bank with a brief respite and enables it to survive until remedial measures are enforced and become effective. This is necessary for maintaining confidence in the banking system.

Financial Assistance by the Central Banks: The central bank, to help any Islamic bank tide over its temporary liquidity problem, may provide general accommodation in the form of Mudaraba deposit on which the Islamic bank may pay profit at the rate declared on such deposits.

The central bank may also provide refinance to Islamic banks against finance provided by them for purposes, projects or sectors specified by the central bank. Such refinance may be provided under Mudaraba, Musharakaor any other Islamic mode of finance.

Current Account and Clearing House Facility: Islamic banks may be allowed to maintain current accounts with the central bank and to participate in the bank's clearing house operations. If the current account is occasionally overdrawn, the central bank may provide this facility without any charge. Alternatively, such facility may be extended on the basis of sharing of the profits of the bank.
Regulation and Supervision of Islamic Banks: Islamic banks may be subjected to regulations and controls by the Central bank in respect of  (a) permission to establish banks and to open new branches;   (b) minimum share capital;   (c) the terms governing the constitution of Boards of Directors and appointment of Chief Executives and auditors; (d) tariffs for banking services;   (e) measures regulating foreign exchange transactions;  (f) submission of periodical statements and operational data to the central bank  and  (g) Compliance with the working hours.

Inspection of Islamic Banks: Islamic banks may be subjected to periodic inspection by the central bank to ensure their operational soundness. The central bank personnel may be adequately trained in Shariah-based operations of Islamic Banks. Detailed guidelines for inspection of the Islamic banks should be prepared and set by the central bank, as it should carry out research and training of personnel.

Bank supervision and inspection would be more important in an Islamic system. Unlike the examination of conventional banks, it may be necessary to ensure that, in addition to proper documentation, the projects financed dare sound. To examine all projects financed by the banks would be difficult. It should, however, be possible to examine a random sample of projects financed to ensure that banks do not indulge in financing speculative or unduly risky ventures. Supervision should not be concerned solely with individual banks. It should acquire an operational importance and should aim at promoting the efficiency and stability of the whole financial system, by means of action directed towards both the system itself and individual components, without interfering in moral operational decisions. Moreover, supervision presupposes adequate disclosure and accurate information, and proper auditing. The central bank should play an important role in determining the requirements for this purpose. It should try to strengthen internal controls and issue policy guidelines, and monitor the quality of assets and operations. It should reform the concepts and procedures of auditing to ensure soundness and honesty.

Sources of monetary expansion
To ensure that growth of money supply is adequate and not excessive, it would be necessary and important to monitor carefully all three of the major sources of monetary expansion. The two domestic sources are: i) Financing of government fiscal/budgetary deficits by borrowing from the Central bank; and ii) Expansion of deposits through commercial bank credit creation. The third source of monetary growth is external and is monetization of a balance of payments surplus.

i) Fiscal Deficits - Fiscal deficits can be, and have been, an important source of excessive monetary expansion. Attempts by the government to extract real resources at a faster rate than is sustainable at a stable price level could lead to continually rising fiscal deficits and accelerated increases in money supply, thus contributing to an inflationary spiral. This has tended to shift a disproportionate burden of the fight against inflation onto the monetary policy. According to one important study, "the greater the dependence of the public sector on the banking system, the harder it is for the central bank to pursue a consistent monetary policy". Hence for the monetary policy to be effective, there must be coordination between monetary and fiscal policies for the realization of national goals. This under scores the need for a realistic and non-inflationary fiscal policy in a Muslim country. This does not necessarily rule out fiscal deficits but imposes the constraint that deficits be allowed only to the extent necessary to achieve sustainable long-run growth and broad-based well-being within the framework of stable prices.

The need to eliminate unproductive and wasteful spending is a religious imperative for all Muslims. It is particularly important for governments because they use resources provided by the people as a trust, and using these wastefully or unproductively is a breach of this trust. The limited resources must be used efficiently and effectively with the acute consciousness of accountability to Allah. It requires a careful review of the entire expenditure program in the light of Islamic teachings.
After all the wasteful and unnecessary spending has been eliminated, the balance of government spending may be divided into three parts:
1.       normal recurring expenditures
2.       project expenditures
3.       emergency expenditures
All normal, recurring government expenditures, including outlays on projects not amenable to profit-and-loss sharing arrangements, must be financed by tax revenues. The non-availability of debt financing for such purposes should prove to be a hidden blessing and help introduce the needed discipline in government spending. The government may undertake projects, which are amenable to equity financing, where this is necessary in the public interest, but the financing should be obtained by selling shares to financial institutions and the public. A commercially oriented pricing system should be adopted without a general subsidy.  All subsidies needed for the poor and lower middle class families should be arranged from Zakat revenues, donations or Qard Hasan.  Equity financing and commercial pricing should help eliminate some of the unnecessary and unproductive or prestigious projects that governments sometimes undertake to satisfy vested interests. Emergency expenses or unavoidable deficits, which cannot be financed by either of the two ways may be financed by borrowing from the banking system within a non-inflationary framework and to a limited extent.

ii) Commercial Bank Credit Creation: Commercial bank deposits constitute a significant part of money supply.  These deposits may, for the sake of analysis, be divided into two parts
'primary deposits', which provide the banking system with the base money (cash-in-tills plus deposits with the central bank); and
'derivative deposits' which, in a proportional reserve system, represent money created by commercial banks in the process of credit expansion and constitute a major source of monetary expansion.
Since derivative deposits lead to an increase in money supply in the same manner as currency issued by the government or the central bank, and since this expansion, just like government deficits, has the potential of being inflationary in the absence of an offsetting growth in output, the expansion in derivative deposits must be regulated if the desired monetary growth is to be achieved. This could be accomplished by regulating the availability of base money to the commercial banks.

iii) Balance of Payments Surplus: Only a few Muslim countries have enjoyed a balance of payments surplus in recent years, while most of them have experienced deficits. In the few that did have a surplus, the surplus did not originate in the private sector and did not lead to an automatic expansion in money supply. It did so only to the extent government monetised the surplus by spending it domestically and the private sector balance of payments deficit did not offset this adequately. In the Muslim countries that have a balance of payment deficit, it is unhealthy monetary expansion along with public and private sector conspicuous consumption that generate the balance of payments disequilibrium through current account deficits and underground capital outflows. These cannot be removed without socio-economic reform at a deeper level and healthy monetary and fiscal policies in the light of Islamic teachings.

REGULATION AND CONTROL OF COMMERCIAL BANKS IN AN ISLAMIC BANKING SYSTEM


In the early 1980s, some countries decided to switch from interest based commercial banking to Islamic banking. The Law of Usury Free Banking was passed in Iran in 1983 and the necessary institutional framework was created by early 1984. The process of Islamization of the banking sector in Pakistan started earlier but remained gradual and partial as, in the beginning, only some specialized credit institutions in the public sector were asked to reorient their activities along Islamic lines. In 1981, all commercial banks in Pakistan were permitted to accept deposits on the basis of Profit and Loss Sharing (PLS). In July 1985, Pakistani banks were instructed not to accept any interest bearing deposits and to convert all deposits into PLS deposits. In Sudan, all commercial banks were prohibited to operate on the basis of interest on 10 December, 1984.

The purpose of this chapter is to examine the instruments of monetary control and monetary management which these countries adopted after changing to an Islamic banking system. These instruments will be different from what they were in the interest based system, and they will also differ from the instruments used in those countries in which Islamic banks and interest based banks exist side by side.

In a country where all commercial banks operate along Islamic lines on a noninterest basis, the question of the control and regulation of the commercial banking system, becomes basically a question of the evolution and implementation of monetary policy in an interest free environment. It is a case closest to theoretical formulations of Islamic banking in which it is assumed that all commercial banks in the system are operating on interest free basis. At a practical level, a legal framework is provided to conduct monetary policy in an Islamic framework.
Thus, there are theoretical and empirical reasons for the study of these cases. However, the intention here is not to study monetary policy as such which requires an analysis of goals, instruments and effects in an integrated framework. The purpose here is confined to a close examination of the instruments used for the control of Islamic commercial banks which can later be contrasted with the instruments used for Islamic banks functioning in a mixed environment in which the legal framework has not been especially designed for the requirements of Islamic banking.


REGULATION AND CONTROL OF COMMERCIAL BANKS IN IRAN/

HOW AN ISLAMIC CENTRAL BANK DETERMINES/FIXES THE PROFIT RANGE FOR COMMERCIAL BANKS IN AN ISLAMIC ECONOMY?

The legal framework for the functioning of the Islamic banking system in Iran is provided by the Law for Usury (interest) Free Banking 1983 which was ratified by the Islamic Consultative Assembly (Iranian Parliament) and approved by the Council of Protectors. While in Pakistan, the existing rules and regulations were legislated and modified, usually by executive orders to suit the requirements of Islamic banking, in Iran, completely new laws were enforced. Thus, banking institutions in Iran were completely overhauled after the Islamic Revolution of 1979. The law outlines the objectives and duties of the banking system, and the methods of the mobilization of its resources and provides for central bank and the conduct of its monetary policy.

The central Bank of Iran is called Bunk Markazi Jomhouri Islami Iran (BMJII), i.e. the Central Bank of the Islamic Republic of Iran. According to Article 21 of the Law of Usury Free Banking, the BMJII is not authorized to engage in banking operations which involve usury (interest). Similarly, commercial banks are also not supposed to indulge in such activities among themselves. The BMJII is empowered by Articles 19 and 20 of the Law to supervise monetary and banking activities by using the following instruments:

i.                    “Fixing a minimum and/or maximum ratio of profit for commercial banks in their joint venture and Mudarabah activities. These ratios may vary for different fields of activities.

ii.                  Designation of various fields for investment and partnership within the framework of the approved economic policies, and the fixing of a minimum prospective rate of profit for the various investment and partnership projects; the minimum prospective rate of profit may vary with respect to different branches of activity.

iii.                Fixing a minimum and maximum margin of profit, as a proportion to the cost price of the goods transacted, for banks in instalment and hire purchase transactions.

iv.                Determination of the types and the minimum and maximum amounts of commissions for banking services, provided that they do not exceed the expense of service rendered and the fees charged for putting to use the deposits received by the banks.

v.                  Determination of the types, amounts, minimum and maximum bonuses to different kind of deposits.

vi.                Determination of the minimum and maximum ratio in joint venture, Mudarabah, investment, hire purchase, instalments transactions, buying and selling on credit, forward deals, Muzara'ah, Musaqat, Joa'alah, and Qard Hasan for banks or any thereof with respect to various fields of activity; also fixing the maximum facility that can be granted to each customer."

[Article 20 of the Law for Usury Free Banking.)

REGULATION AND CONTROL OF ISLAMIC BANKS IN A MIXED ENVIRONMENT/ECONOMY:

In many Muslim countries today, a large part of the money market is controlled by interest based banks. However, in the last decade, a few Islamic banks have appeared and are increasingly claiming a growing share of the money market. During the past fifteen years or so, Islamic banks have been established in Egypt, Jordan, Malaysia, Bangladesh, Qatar, Bahrain, Kuwait, U.A.E., and in some European countries.

Several of these countries (Malaysia, Qatar, Kuwait, and U.A.E.,) have only one Islamic bank while others (Bangladesh, Egypt and Jordan) have two or more Islamic banks. The presence of Islamic banks in these Countries has raised the following question : How should Islamic banks be controlled and regulated in a mixed environment which consists of traditional interest based banks and Islamic banks? The question is being debated among Islamic bankers, central bankers and economists although not much documentation exists on the subject.

Islamic banks insist that they should not be subjected to the same controls as interest based banks because their financing techniques are much different than those of traditional banks. Interest based banks, it is argued by Islamic banks, advance their funds on the basis of loans, thus creating credit and adding to the money supply. Hence, any attempt by the central bank to keep the credit creating activities of these banks in check, seems to be justified. However, Islamic banks point out that their own financing activities are not in the nature of loans but take the form of investment. Hence, any control on them is not desirable. Some arguments which have been pressed by the Islamic banks in this connection are listed below:

a.       It is argued that reserve requirement should be enforced only on demand deposits. The imposition of reserve requirements on investment deposits hampers the investment activity of Islamic banks and deprives them of the opportunity to earn profit on the reserved portion of investment deposits.

b.      It is also argued that the financing activities of Islamic banks such as, Murabahah, Musharakah and Mudarabah, are not loan making activities. They resemble investment more than they do lending. Hence, they should not be subjected to the same controls which are devised to control credit.

In contrast to these views, the central banks of most of these countries treat Islamic banks in the same way as traditional interest based banks. Their main argument is that so far Islamic banks finance their activities using the deposits of the general public, they create credit and at least in this respect there is no substantial difference between the operations of traditional banks and Islamic banks. Hence, their activities are to be regulated in the same way as the activities of traditional interest based banks.

As Siddiqi has pointed out, the truth probably lies somewhere in the middle of these two extreme positions [Siddiqi,1989.] An important point to keep in mind is that credit (or additional money supply) is not created by any bank ( traditional or Islamic) in isolation. It is the commercial banking system as a whole which creates credit. In a traditional system, the advance made by one commercial bank does not leave the banking system. It comes back to other commercial banks in the form of new deposits and other receipts. The presence of Islamic banks does not alter this fact in any way. The advances made by Islamic banks, either in the form of Murabahah, or letters of credit or any other form, are also not likely to leave the banking system. They will come back to either the same Islamic bank, or to another Islamic bank, if there are more than one, or they may even go to other non – Islamic commercial banks.

However, there is some merit in the argument that the financing operations of Islamic banks are different from the financing operations of interest based banks. The monetary authorities should consider the fact that Islamic banks cannot convert their financial assets into liquid assets with the same ease as interest based banks which keep a large portion their total assets in interest bearing financial papers.

Hence, in order to remain liquid, Islamic banks have to keep a large portion of their assets in the form of cash on hand. In other words, the cash - asset ratio of Islamic banks is usually higher than that of traditional interest based commercial banks. This means that the capability of Islamic banks to create credit is lower because of their inability to invest in short term financial assets and the absence of an Islamic financial papers market.

Furthermore, Islamic banks provide finance through Musharakah and Mudarabah. Unlike interest based banks, they also participate in real investment. Hence, there is a case for evolving and adopting new methods of credit control for Islamic banks in a mixed environment.

CONFLICTS BETWEEN CENTRAL BANKS AND ISLAMIC BANKS:

Regulation and control of Islamic banks in the mixed environment where Islamic banks and interest based banks function side by side presents a mare challenging situation. Experience has shown that in most cases central banks, subject Islamic banks to the same controls, conditions and regulations which they apply to the interest based banks. So far as these instruments of credit control are free of interest, no objection can be advanced against them at least on Islamic grounds.

However, there are certain cases in which there seems to a conflict between central banks and Islamic banks. Some of these include:

a.       Islamic banks keep their deposits with the central bank. The central bank pays interest to commercial banks but Islamic banks have to forego this income.

b.      The central bank functions as lender of the last resort. However, this loan, should the need arise for it, is granted on the basis of interest. There have not been many cases in which Islamic banks have had to face a liquidity problem. However, a case occurred in Egypt in which an Islamic bank approached the central bank for additional cash to face a run on the bank. It is reported that the central bank was not willing to lend the required amount free of interest. Consequently, the bank had to borrow from the central bank on interest obtaining a Fatawa from its religious board on the plea of need (Darurah) .

c.       In countries, where the central bank conducts open market operations, Islamic banks are not able to participate in these operations because of the interest based nature of the securities bought and sold. Thus, Islamic banks are constrained by the fact that financial assets which could be liquidated quickly are unavailable.

d.      It has been noticed in some countries that central bank authorities do not comprehend the nature of Islamic financing techniques. This is particularly true in the case of Mudarabah and Musharakah financing whose nature is entirely different from interest based debt financing. In debt financing, the granting of a loan is a one-time activity, no matter what the size of the loan. But Mudarabah and Musharakah are ongoing activities and the participation of Islamic banks has to last as long as the project remains in operation. It was pointed out by an Islamic bank that the concerned central bank insists on separate approval for different stages of the same Musharakah operation. This kind of situation results because there is little appreciation of the techniques of financing used by Islamic banks.

SUGGESTIONS FOR ISLAMIC BANKS:

In light of the above, the following suggestions could be made for a healthier relationship between Islamic banks and central banks:

a.       It may be observed that Islamic banks, at present, control a very small portion of the total money market in mixed environment countries. At best this share is around 10 percent of the market. If Islamic banks are established in these countries and they claim a substantial share of the money market, the central banks in these countries will be compelled to take notice of Islamic banking. Then it may be hoped that central banks would resort to those techniques of regulation and control which would be more conducive to Islamic banking.

b.      Islamic banks may persuade their respective central banks to offer them some facilities in lieu of interest free deposits they maintain with central banks. One particular facility may be the provision of interest free loans from central banks to Islamic banks in time of need. It can be argued that as Islamic banks do not receive interest on the deposits which they keep with the central bank, the central bank should return the favor by providing loans on an interest free basis (Qard Hasan) whenever the central bank has to function as a lender of the last resort to Islamic banks.

c.       Central banks in those countries where the entire banking system has been reorganized along Islamic lines, may experiment with open market operations bearing non-interest based financial papers. These may be in the form of Participation Certificates, Investment Certificates, Muqaradah Bonds, etc. This will go a long way towards developing secondary market for Islamic banks and providing Islamic banks with financial assets which they will be able to liquidate quickly when necessary.

Central banking in the Islamic framework and the regulation and control of Islamic banks in a mixed environment also deserve more attention from researchers.

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