Central Bank Monetary Control and Monetary Policy in

Central Bank, Monetary Control and Monetary Policy in Islamic Framework Ausaf Ahmad

Preliminary Observations § Monetary Policy is a catch all name for monetary management, monetary control, regulation 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.

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

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

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.

INSTRUMENTS OF MONETARY CONTROL § Quantitative Measures § Qualitative Measures § Prudential Measures

Quantitative Measures § Legal Reserve Ratio § Bank Rate Policy § Open Market Operations § Credit Rationing

QUALITATIVE MEASURES § Margin Requirements § Maximum and Minimum rates of interests § Selective Credit Controls

PRUDENTIAL MEASURES § Minimum Capital Requirements § Maximum Exposure restrictions § Mandatory Appropriation of Profits § Moral suasion

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

Instruments of Monetary Policy in Islamic Economy Conventional Instruments New Instruments 1. Profit Sharing Ratio Suitable Unsuitable Bank Rate Policy Legal Reserve Ratio, Credit Rationing, Selective Credit Controls, Issue of Directive, Moral Suasion 2. Refinance Ratio 3. Public share of demand deposits 4. Value Oriented Allocation of Credit. 5. Qard Hasan Ratio

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

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

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.

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

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.

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.

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.

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.

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.

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.

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

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.

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.

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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