Monetary policy and Islamic banking

Abstract

Despite rapid growth of Islamic banking and finance, the emerging industry faces several challenges which are hampering future prospects for its potential growth. These problems are related to liquidity management, monetary policy instruments, standardization of financial products, the supervisory and regulatory framework, cost inefficiencies, shariah-compliance, and development of interbank and money markets. The most important task to be done is the availability of suitable monetary management instruments to conduct monetary policy in an Islamic financial system. There is a need to develop a mechanism for standing credit facilities by the central bank which can be drawn on in a distress situation. Absence of these facilities along with inefficient Islamic interbank and money markets creates liquidity management problems for Islamic banking institutions (IBIs). Thus, to meet any unforeseen liquidity shock, these banks hold costly excess reserves which render IBIs inefficient. Some countries, such as Malaysia and Bahrain, have addressed the issue of liquidity management by developing an Islamic interbank money market. The problems related to liquidity management and monetary instruments can be resolved through increasing the volume and frequency of ijarah sukuk to match the demand for these instruments. Since these sukuk are also eligible for trading in the secondary market, the same will help in developing an efficient interbank market and open market operation mechanism. Musharakah sukuk may be issued against infrastructural projects of the government such as roads, dams, power plants, schools, and hospitals; the return on these sukuk can be linked to the nominal GDP of the country. Similarly, salam can be issued against the agriculture products employing the services of government procurement organizations. A national mutual fund can be created which can act as a special purpose vehicle. Since the world is moving towards interest rate targeting, a suitable mechanism is needed to be devised for an alternative system. In this regard, nominal income targeting can be a good choice to be followed, in which both inflation and nominal income growth are considered as the final objective of the monetary policy.