Islamic Finance: Central Bank Tools

What does a central bank in an Islamic monetary system look like? And what can it do?

Operating in a non-interest environment, the Islamic central bank cannot make use of some of central bank’s conventional policies to manage the country’s monetary base and money supply. Such policies include the setting of discount rate (e.g. Federal Funds rate, Repo rate, etc) used as reference for commercial banks, and open market operations with interest-bearing securities. However, the central bank in Islamic banking system can still utilize these tools in their operation:

• Reserve requirements
• Overall/Selective controls on credit flows
• Management of currency issues
• Open market operations with equity-based assets
• Moral suasion, a.k.a influence over the banks

Although the central bank cannot set the discount rate, it has an option to employ another type of rate which is still compliant to sharia principle, i.e. profit-sharing ratios between the commercial banks and the customers (lenders and depositors). 

So, do the constraints imposed in the Islamic financial system impairs the authority or the power of its central bank to manage the monetary issues in that particular country? On one hand, we have to admit that it can’t be helped that the Islamic central bank currently has less alternatives to conduct its missions (we said “currently” because we believe that some other sharia-compliant alternatives will come up in the future). However, on the other hand, there is a simple model of Islamic monetary system established by Khan and Mirakhor (1989) which suggests that the central bank will get just as much influence in a country’s monetary system when it utilizes Mudaraba financing in its policy as it uses conventional method of monetary management (e.g. interest-based loan to commercial banks).

As a prime regulator of monetary policy, the central bank also has the responsibility to reduce uncertainty in contract and property rights structure. This is especially important in the early stages of Islamic financial system adoption. The reason is because without interest, it will create a moral hazard problem within the institutions, which in turns will lead to principal-agent problem, and will increase the cost of monitoring.

 

Crisis Measures

When an Islamic bank is under severe financial difficulties, or the whole system is under crisis, the central bank can inject money to commercial banks by the means of equity participation. Interestingly, this method was also employed by the Federal Reserve in dealing with 2008 financial crisis, in which the Fed ended up providing the banks (and AIG as the special case) with capital injection under the so-called Trouble Asset Relief Program (TARP).

 

References:

Khan, M S., Mirakhor, A. The Financial System and Monetary Policy in an Islamic Economy. 1989. JKAU: Islamic Econ, Vol. 1 pp. 39-57.

____________. Monetary Management in an Islamic Economy. 1994. JKAU: Islamic Econ., Vol. 6 pp. 3-21.