MBF 707 Monetary and Fiscal Framework in Islamic

MBF 707: Monetary and Fiscal Framework in Islamic Finance COMSATS Institute of Information Technology (Virtual Campus)

Lecture 15 Islamic Approach to Money, Banking and Monetary Policy - A Review (Muhammad Nejatullah Siddiqi) 2

Review of the Last Lecture 3

Topics Covered Ø Introduction Ø Equity Funds Ø Ijarah Funds Ø Commodity Funds 4

Murabaha Funds If a fund is created to undertake this kind of sale, it should be a closed-end fund and its units cannot be negotiable in a secondary market. The reason is that in the case of murabahah, as undertaken by the present financial institutions, the commodities are sold to the clients immediately after their purchase from the original supplier, while the price being on deferred payment basis becomes a debt payable by the client. 5

Murabaha Funds Ø The portfolio of murabahah does not own any tangible assets. It comprises either cash or the receivable debts. Ø If they are exchanged for money, it must be at par value. 6

Mixed Funds Ø The portfolio of different funds can also be generated at large scale. Ø In this case the tangible assets of the Fund are more than 51% while the liquidity and debts are less than 50% Ø The units of the fund may be negotiable. 7

Conclusions Ø How to generate funds? Ø How to make plans and projects? Ø How to channelize funds? Ø Economic and Financial Developments. 8

Topics of Discussion in Two Lectures Ø Introduction Ø Money Ø Interest Free Banking Ø Monetary Policy Ø International Banking Ø Conclusions 9

Introduction Ø Money is part of the economic activities in the Muslim countries since its inception. Ø The emergence of modern banks and other financial institutions in Muslim countries, (paper currency, the increase in public debt and the commercial dealings in securities presented the jurists with new questions to answer) Ø The emergence of modern banks and other financial institutions in Muslim countries, the introduction of paper currency, the increase in public debt and the commercial dealings in securities presented the jurists with new questions to answer 10

Introduction Ø The Juristic debate is not the subject matter of this discussion. Ø Our focus is the very recent writings, mostly by economists, on the nature and role of money, banking free of interest and monetary policy in an Islamic framework. 11

Money Ø Money as a medium of exchange, greatly favours the transition from barter to a money economy. Ø Prohibition of interest was considered vital for freeing the money economy from injustice and exploitation and making it rational. Ø Justice and efficiency considerations demand that money should remain 'neutral', and the abolition of interest is must. 12

Money Ø Advantages of money include its liquidity premium but no carrying costs; its elasticity of substitution is zero so that a rise in its demand must raise the rate of interest Ø Abolition of interest removes the liquidity premium. Ø The liquidity premium is not the cause but the effect of interest. Ø Speculative demand for money is at the root of instability in the demand for money and is the cause of trade cycles. 13

Money Ø The 2. 5 per cent per annum zakah levy is regarded as a measure ensuring a carrying cost. Ø Abolition of interest and imposition of zakah would thus ensure that money serves its primary function of a medium of exchange. Ø Savings will have to be invested in common stocks (ordinary shares) or deposited in the 'profitsharing' accounts. Ø People will still hold cash in expectation of a rise in the expected rate of profit, or in anticipation of better investment opportunities. 14

Money Ø This means 'speculative motive' would still be operative in an Islamic economy. Ø But it will no longer be capable of generating the wide fluctuations experienced at present. Ø Fluctuations in profit expectations may be counter -balanced by loss expectations and the net result may be a movement not too wide a range. Ø There will still be a need for a monetary policy to ensure stability. 15

Money Ø Abolition of interest will curtail the harmful features of credit creation of banks. Ø However, private commercial banks will stull cause credit creation in an interest-free banking system. Ø Credit economy is in fact inflationary economy. Ø Over-expansion of credit causes easy banking profits leading to downturn and depression. 16

Money Ø In the interest-free system, credit would be created only to the extent that there exist genuine possibilities of creating additional social wealth through productive enterprise. Ø Credit will continue to be created even after the switch over from interest to Mudarabah (profit sharing) as the basis of bank advances to businessmen because of people’s habits of savings part of their income in their deposits. 17

Money Ø If the commercial banks were to operate with 100 per cent reserves, their only earnings would consist of service charges on checking deposits and fees charged for transfers, safekeeping and other services. Ø Establishment of Finance Houses for handling Mudarabah funds for investment on a profitsharing basis can be one of the solutions. 18

Interest-Free Banking Ø A bank is conceived, in the first instance, as a financial intermediary mobilising savings from the public on the basis of Mudarabah and advancing capital to entrepreneurs on the same basis. Ø Earning allowance for administrative costs. Ø Earnings from public deposits on the basis of Mudarabah and share capital. Ø Current accounts. 19

Interest-Free Banking Ø Model is based on a two-tier Mudarabah contract. Ø Islamic economists felt uneasy about the conclusion of loss. Ø The bank may build loss-compensating reserves out of good profits at good time. Ø Depositors want to be sure of getting their deposits back in full, if not with any profits. 20

Interest-Free Banking Ø A deposit insurance scheme may be launched with the backing of the central bank and participation of all banks and their depositors. 21

Issues Need Attention 1. 2. 3. 4. The supply of short-term interest-free loans. Discounting of bills of exchange Supply of credit to consumers Financing of the public sector 22

CONCLUSION 23

Thank You 24