CENTRAL BANK and MONETARY POLICY

Type of facility Purpose of facility

Appropriate contract

Overdraft window Support the payment system

General purpose mudarabah

Lender-of-last resort

Support the soundness of the banking system

General purpose mudarabah

General financing Provide general purpose financing to the economy

General purpose mudarabah

Open market operations

Quick intervention to influence money and foreign exchange markets

Outright sale/purchase of securities; underlying assets

CENTRAL BANKING AND MONETARY POLICY

Basic central operations / Appropriate Islamic financial contracts

Continue Islamic economy is a money economy In order to avoid gharar and exploitation,

Prophet (SAW) is reported to have discouraged barter exchange of goods and encouraged the use of money to buy and sell necessities of life.

Injunctions against Riba al Fadl were directed at eliminating the possibilities of injustice in barter.

Prohibition of riba al nasiah was directed at freeing money economy from injustice and exploitation in loan transactions and making them rational.

Primary function of central bank in Islamic stateStability of value of money as differed paymentAs a store of value

Monetary authorities have the power to regulate banking and financial operations to both allocate resources and to direct them to specific goals.

Loss of interest would make the economy more market oriented.

This will justly distribute the fruit to the right parties.

An important instrument is legal reserve ratio.

Enables central bank to regulate the volume of credit by raising and deposit-reserve ratio.

May be used as indirect method of credit control.

Another instrument is statuary reserves enables the central-bank to regulate money supply.

Central bank can vary the weightage to the funds provided to a banking institution in sharing profits. This change can be choose to favor certain sectors in the economy.

State bank can lay down the minimum rate of return that should be charged by banks providing funds for trade related modes like murabaha, salam or leasing.

Central bank can also acquire shares of commercial banks and financial institutions to further enhance its control over banking system.

The ‘moral suasion’ may also supplement the above package of monetary policy tool.

The device of ‘profit sharing ratios’ can be used to replace the bank rate. The Council of Islamic Ideology in its Report of 1980 describes the functioning of the mechanism in the following words.

“there is a general consensus---------------------------------national policy objectives”.

To view the full text please refer the book.

The changing of profit sharing ratio would depend on actual circumstances and ultimate ends.

Also the changes would be applicable to the new projects not to the already financed projects.

Central bank may use some other ratios,Refinance ratio would influence the quantum of

credit extended by the commercial bank.Qard-e-hasan Ratio or Lending ratio may be used

when commercial banks are obliged to lend out certain percentage of their demand deposits on interest free or service charged based loans.

The central bank may also resort to open market operations by sale and purchase of securities created on the basis of islamic modes.

For effective monetary management central bank should discretionary control over the growth of reserve money.

General financing to banks, overdraft (OD) and lender of the last resort (LLR) facilities can be provided to the banks on the basis of Mudarabah.

The state bank may like to provide refinancing to banks on Musharakah and restricted Mudarabah basis while the banks may use any of shariah compliant modes. For a general financing facility, a Mudarabah auction format can be developed.

1. profit oriented productive projects can be financed on the basis of Musharakah, Istisna’a and Leasing. Gov commodity needs/operations can also be based on Murabaha-Muajjal, Salam and Istisna’a.

2. Socio-economic expenditure can be financed through:

○ Trade operation○ Leasing operations○ Income participatory operations○ Creation of money by central bank

All instruments used for private sector finacing are available for gov finance.

How to use these Modes

1. for smooth use appropriate institutions will have to be developed.

2. establish trust that would run trading / leasing operations on behalf of government.

3. it will be possible for the trust to issue fixed income and quasi-fixed income securities.

4. Gov can issue salam certificates also on raw material s and immediate goods

Other sources for the Governement 1. Printing money 2. Taking over part of credit creation by

banking system 3. central bank can issue deposit certificates.

Eliminating interest from Government financing and in particular form the NSSs operation is also a big challenge in the process of transformation of the financial system, fraught with ceratain risks.45% have been raised through NSSs prize Bonds

scheme out of total domestic debt.

The Government may create a mutual fund out of its share in public sector corporations.

Leasing based securities may also be helpful in replacing the interest based savings instruments with shariah compliant securities.

It would be very difficult to convert all the existing stock of debt into new instruments on any given date as this may disrupt and endanger the financial system.

The system will have to be adopted for new issues or by changing the basis of investment, upon maturity of instruments issued before the cut-off date.

Stable Income Securities and Certificates of Deposits 1- securitize or sell a pool of assets or offer

CDs against a fund composed of pooled Ijarah and some Murabaha, Installments sale and Istisna’s contracts.

2- the instrument of CD will offer the depositors a defined stream of cash flow constituting the return on the pooled assets.

3- such securities would accommodate risk averse investors, enhance liquidity and generate new resources for additional intermediation and income flow to the bank.

Growth Oriented Securities (Shirkah Based) 1. Securitize a pool of Musharakah and

Mudarabah contracts like central bank Musharakah certificates (CMCs) or Government Musharakah Certificates (GMCs).

2. Such securities will offer an investors a stream of variable income with potential for growth, based on the strength of the underlying projects.

3. these would accommodate risk taking investors with commensurate growth oriented income.

Mixed (Growth/Stable income) Securities 1. Securitize a pool of Musharakah, Ijarah

and some Murabaha, Installment sale, Istisna’a and Joa’alah contracts.

2. The risk/return on the security will depend on the chosen mix of contracts.

3. such securities would accommodate various degrees of risk preferences of the investors with the commensurate income, and liberate capital or generate new resources for additional intermediation or liquidity

NATIONAL INVESTMENT FUNDS

Eliminating interest from gov borrowings is the most difficult area in the process of transformation of financial system.

The best way to transform is to restructure public sector financing by establishing a number of National Investment Funds and securitization of bank contracts and gov assets.

These funds will raise resources for joint pools by issuing units, certificates or shares on the basis of Mudarabah and invest the same in public sector finacing operation on the basis of equity sharing, Murabaha, Salam, Ijarah, Istisna’a etc.

Certificate / unit holders of these funds would get pro-rata return based on the financial results of concerned funds.

Mgt of these funds can be carried out by the organization acting as mudarib or agent.

The management of the fund would be given a pre agreed fee for its services. The fee can be lump sum or periodic or any percentage of net asset value of fund.

Depending on the nature of business, these funds can be called equity fund, Ijarah or leasing fund, Murabaha / trade fund or the mixed fund.

Equity funds would invest their resources in shares of joint stock companies and earn capital gains or dividends.

Shares of all companies whose functioning conform to shariah can be unanimously bought and sold.

Problem is that most of the companies even dong halal business are involved in interest transactions.

Many contemporary scholars are of the opinion that it is permissible to deal in the shares of companies whose leverage based on their market capitalization does not exceed 33 % and whose income from prohibited/doubtful sources is not in excess of 5% of its total income.

Also it is condition that all income from prohibited sources must go to the charity.

Scholars in general say that if majority of assets (more than 51%) of a company are in liquid form, i.e. in the form of money or receivables, they cannot be purchased or sold except at pr value because such shares represent money which cannot be traded except at par.

Ijarah or leasing based funds would use the pooled amount for purchasing the real assets for leasing to the ultimate users.

Each subscriber of these ijarah funds will be the pro rata owner of the leased funds and the certificates will be negotiable and traded in the secondary market.

A trading fund would use the pooled sums for purchase of goods and their sale on margin of profit.

the fund must possess the ownership of the purchased goods before selling them to the gov (client).

Transfer of constructive possession is also acceptable whereby risk of commodity must pass to the owner.

Certificates/units of such funds can only be traded provided that the portfolio owns the inventories all the times.

If the goods are sold on deferred payment basis immediately after purchase from supplies, the funds will not possess any tangible assets and will have only the cash or receivables on the balance sheets, and the certificates or units will not be negotiable/tradable except at face value.

If the pooled amounts in a fund are employed in different types of investments like equities, leasing or trade, the fund may be called a mixed investment fund. If the tangible assets of such a fund are more than 50%, its certificates can be traded at any price.

Monetary and Credit policy in IRAN 1. In Iran, whatever existed in the old law as

objectives and functions of the central bank has been retained as valid and applicable for usury free banking.

2. The words ‘Interest rate’ have been phased out of the banking system.

3. The amount or value of prizes and bonuses for Qard-e-Hasnah depositors and commission of banks in respect of investment deposits can be used by monetary authorities as a monetary tool.

4. Return of the principal amount of all the deposits has been guaranteed by the law.

5. Irrespective of the nature of the mode of refinancing, the banks have been advised to remain as the “intermediary of funds” and not to engage in commercial activities as traders.

6. On assets side, the contract documents in respect of all modes of financing contain a guarantee for the principal amount.

7. Presently, in respect of statutory reserves, an average of 4% is paid to the banks on their treasury bonds holdings and 1% on cash reserves.

8. The profit rate, the anticipated rate of return (ARR) and the profit ratio (the bank’s share of profit) can be employed by the monetary authorities as lever.The lower the ARR, the higher will be the demand

for credit facilities.Profit rate is not being practically used as

monetary tool. 9. Payment or receipt of any amount on

deposits, loans and credits, in any manner or under any title granted by the Central bank to the gov, gov organizations, and wholly state-owned companies are by no means Riba and are recognized as permissible.

10. The tool of discounting and rediscounting is applicable on a wide level as in the case of traditional banking. The buying of any bill originating from commercial transactions or any discount relating to a factual indebtedness by the banking system is permissible. The commercial bills and drafts discounted by banks can be rediscounted by the Central bank. Similarly, certificates of indebtedness denoting the real claim of the banks on their customers can be discounted by Central Bank.

Monetary Policy in SUDAN

Monetary policy is being conducted in Sudan through all the conventional instruments of monetary control, which are interest free and are perceived to be consistent with Islamic Shariah.

These include;Cash Reserve Requirement (reserves are not

remunerated)Change in %age in participation of a client in finance.Adjustment in the minimum %age of profit margin

under Murabaha mode.

The central bank has two instruments called as1. Central bank Musharakah Certificates (CMCs)2. Gov Musharakah Certificates (GMCs)

Banks are also required to maintain a variable liquidity ratio which is watched on weekly basis. When banks foresee shortage of liquidity, they apply central bank to provide money for specific period and in specific amount. The central bank enters into Musharakah with the commercial bank for that specific period which may be renewed for another period but not beyond that.

In case, a commercial bank’s current account is overdrawn, the bank will not allow the commercial bank to operate in the clearing house for that day so the commercial bank will have to arrange resources either by selling CMCs or encash them or borrow from another commercial bank but this requires securities and other documentation.

Commercial banks can borrow from the central bank to meet temporary shortages, expected shortages, short term borrowing for investment and for agriculture and exports.

Temporary shortage for 15 days is met without any problem (returned on Musharakah basis)

For expected shortage the banking supervision department is contacted which recommends or not.

This is on the basis of Musharakah in which central bank’s share is 70% and commercial banks share is 30%.

CMCs as developed in SUDAN In Sudan, large assets of ministry of finance

and the bank of Sudan, bank of khartoum, Nilain bank and other public entities are identified for the purpose of securitization.

Value of these assets keeps changing. 30 April 1999, value stood 39.4 billion SD. It is calculated monthly and the Bank of Sudan

advices the new values. Shares are handled by a subsidiary of Bank of

Sudan called “Sudan Financial services company”

All the shares are transferred to this company.

Musharakah certificates are auctioned; a cut-off date is decided and generally about 50 certificates are auctioned.

Example of quotations

Value in SDs Quotations

10.00 10.250

10.00 10.200

10.00 10.150

10.00 10.140

10.00 10.13010.00 10.100

10.00 10.000

10.00 9.990

Cut –off point

(Illustrative)

Holders of certificates have legal claims to assets of bank of Sudan and ministry of finance etc.

These certificates have no maturity date and are open dated.

The private sector can hold these shares like pension funds, insurance co. and indviduals.

Main features of CMCs 1. the CMCs is based on Musharakah

Principle. 2. A close ended fund is established

consisting of gov and central bank ownership in commercial banks and other financial institutions.

3. The face value of the fund is established on the date of issue.

4. the fund is divided into finite number of equal value units.

5. The fair value (equal to book value + retained profits) of fund units is published on monthly basis.

6. The CMCs are issued without maturity term.

7. Dividends transferred to fund are not distributed to CMC holders but re-capitalized in the fund.

8. The CMC are sold (or bought) by the central bank through auctions.

9. The CMC can be traded in the secondary inter-bank market.

10. The central bank stands ready to buy the CMCs on demand for a daily posted price that reflects the last auction price (or published fair value, whichever is available) minus a fixed brokerage amount.

11. CMC holders get profit (or loss) from realized capital gains (or losses).

THE END