Central Bank, Monetary Control and Monetary Policy in Islamic Framework

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Central Bank, Monetary Control and Monetary
Policy in Islamic Framework

• Ausaf Ahmad

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Preliminary Observations

• Monetary Policy is a catch all name for monetary
  management, monetary control, regulation of
  commercial of commercial banks, and management of
  money market.
• Is multiple deposit creation possible under
  Islamic banking?
• Power of deposit creation is not with a single
  bank. It is with the banking system
• Power of deposit creation is because of
  fractional reserve. With 100 percent Reserve
  Requirement, all money is representative money
  and no further deposits are created.

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CENTRAL BANK IN ISLAMIC ECONOMICS

• Functions of central bank in Islamic economy are
  similar to any modern economy
• Regulation of money supply according to
  requirements of the economy
• Influencing the movement and direction of bank
  finance in desirable directions
• Providing a measure of safety and ensuring
  prudent banking

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ISLAMIC BANKS AND CREDIT CREATION

• Controversy Do Islamic banks create credit?
• Deposit creation through Mudarabah
• The Deposits never leave the banking system. It
  comes back to the system through deposit in
  another bank.
• Role of Fractional Reserve System

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OBJECTIVES OF MONETARY POLICY IN AN ISLAMIC
ECONOMY

• To Promote a sustained and balanced economic
  growth and mobilize resources for economic
  development.
• To maintain stability in the value of money so as
  to avoid excessive periodic fluctuations.
• To maintain stability in the external value of
  money.
• To promote an equitable distribution of income
  and wealth.

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INSTRUMENTS OF MONETARY CONTROL

• Quantitative Measures
• Qualitative Measures
• Prudential Measures

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Quantitative Measures

• Legal Reserve Ratio
• Bank Rate Policy
• Open Market Operations
• Credit Rationing

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QUALITATIVE MEASURES

• Margin Requirements
• Maximum and Minimum rates of interests
• Selective Credit Controls

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PRUDENTIAL MEASURES

• Minimum Capital Requirements
• Maximum Exposure restrictions
• Mandatory Appropriation of Profits
• Moral suasion

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Suitability of conventional Measures
Method of Credit Control Suitability to Islamic economy
1. Legal Reserve Ratio Suitable
2. Bank Rate Policy Unsuitable
3.Open Market Operations Modification Necessary
4. Credit Ceilings Suitable
5. Selective Credit Control Suitable
6. Lender of Last resort Modification Necessary
7. Issue of Directives Suitable
8. Moral Suasion Suitable
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Instruments of Monetary Policy in Islamic Economy
Conventional Instruments
New Instruments
1.Profit Sharing Ratio 2. Refinance
Ratio 3.Public share of demand deposits 4. Value
Oriented Allocation of Credit. 5.Qard Hasan
Ratio
Bank Rate Policy
Unsuitable
Suitable
Legal Reserve Ratio, Credit Rationing, Selective
Credit Controls, Issue of Directive, Moral Suasion
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LEGAL RESERVE RATIO

• Required Reserve Ratio does not involve interest
  in any manner.
• Controversy Fractional reserve system Vs.100
  required reserve
• Application of cash reserve system only to
  investment deposits

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OPEN MARKET OPERATIONS

• Open market Operations are based on interest.
• Direct manipulation of interest rates and
  indirect manipulation of money supply
• Modification necessary
• Should the central bank be allowed to buy and
  sell equity of companies?
• Mudarahah/ Musharakah/ Certificates

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BANK RATE POLICY

• The bank rate policy refers to interest rate
  which the central bank charges to commercial
  banks to lend money. Through changes in bank
  rate, the central bank indirectly changes the
  quantum of credit in the economy.
• Unsuitable for the Islamic Central Bank.

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CREDIT RATIONING

• More popular techniques in developing countries
  because financial infrastructure is not fully
  developed.
• A credit ceiling is allotted to each sector and
  to each bank
• Because of its non interest nature, suitable for
  controlling Islamic banks.
• Issue of Penalty

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SELECTIVE CREDIT CONTROL

• Quantitative measures control volume of credit,
  SCC control direction of credit.
• May be more relevant in developing countries.
• Matching finance if bank finance projects in the
  desirable sectors.
• Either as an interest free loan or at a lower
  profit sharing ratio.

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LENDER OF LAST RESORT

• Loans are provided to face liquidity crises.
• In Islamic economy, central banks would continue
  to function as Lender of Last Resort.
• Interest free loans with or without service
  charge.
• Special Fund at the Central Bank.
• The case of International Bank for Investment and
  Development in Cairo.

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ISSUE OF DIRECTIVES

• In the conventional system, this is used to
  regulate interest rates and channel credit in the
  desired direction.
• In the Islamic system, the same directives may be
  used to influence profit sharing ratios.
• The central bank may prescribe ranges for profit
  sharing ratios for Mudarabah contacts and for
  mark up in the case of Murabaha contracts.

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MORAL SUASION

• Informal contacts, consultations, meetings, to
  explain position of central bank on various
  issues.
• The technique remains available in the interest
  free system. Some economists are of the opinion
  that this technique may have to play greater role
  in the new system.

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INTEREST FREE INSTRUMENTS OF MONETARY POLICY

• Profit sharing ratio
• Refinance ratio
• Public share of demand deposits
• Value oriented allocation of credit
• Qard hasan ratio
• Maximum and minimum mark up ratio.

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PROFIT SHARING RATIO

• Potentially it may perform the same role as
  interest rate as it may work as a signaling
  device.
• Depositors and borrowers profit sharing ratio
• Management of first may influence supply of money
  and of the latter may affect demand for money.

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RE FINANCE RATIO AND LENDING RATIO

• Re-finance ratio would move in the opposite
  direction of cash reserve ratio.
• To reduce expansion of credit, refinance ratio
  would be lowered, to increase supply of credit,
  it would be raised.
• Appropriate changes in lending ratios would
  reinforce the impact

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PUBLIC SHARE OF DEMAND DEPOSITS

• It is suggested that 25 of total demand deposits
  may be diverted to public treasury. It is argued
  that
• Commercial banks do not pay any thing for these
  deposits and public does not bear any risk on
  these deposits if they are fully insured.
• The share may vary in accordance with the
  economic conditions and objectives of economic
  policy.

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CRITIQUE

• It may encourage the governments to spend more.
• It may reduce Monetary Base (high powered money)
  and hence indirectly reduce credit creation.
• Lacks swiftness of response.
• The proposal appears to be in conflict with the
  Islamic concept of property.

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CONCLUSION

• Any fear of chaos in monetary management on
  account of Islamic banking is not well founded.
  There are enough tools in the battery of central
  bank to control commercial banking activity and
  achieve the goals of economic policy.

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THANK YOU FOR YOUR PATIENCE