Home Publications Islamic Banking & Finance Page 11-10-2019

Islamic Banking & Finance Page 11-10-2019

Muhammad Arif
Muhammad Arif: Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan.

How Monetary Policy can be formulated for Islamic Finance and Banking


Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.

Further goals of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies. Monetary system can keep inflation low and stable provided that the monetary authorities conduct monetary policy by deploying a well-designed monetary rule, such as monetary targeting under a floating exchange rate system, requiring the use of monetary instruments to control the money supply. Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations

Muslim scholars now generally accept the fiat monetary system, provided that the monetary authorities commit to price stability through keeping inflation at a zero level on average. Price stability is the cornerstone of an Islamic financial system and that inflation is a monetary phenomenon that can be kept low and stable through a rule-based monetary policy, such as monetary targeting.

An Islamic monetary system is most compatible with classical monetary theory and policy.  At base, it links money to prices and distinguishes between money and credit. The price level is therefore an endogenous variable, showing a linkage between money and prices. Money is an asset while credit represents a transfer of purchasing power in exchange for (expected) reward. The interest rate is not price of money; rather it is price of credit (loan able funds) and is determined in the credit market through the interaction of credit demand and credit supply

However mostly now the profit and loss oriented business model of Islamic banks and financial institutions is neither designed to function in an unstable economic environment nor equipped to do so efficiently. As a result of this, Mostly now Islamic banks and financial institutions compromise their fundamental principles, mimicking conventional banking products and services. The reason of existence of IBF is thus lost before it reveals its usefulness in the modern economy and society. IFIs can operate ethically and morally only in an environment where price stability exists.

Islamic financial institutions are gaining acceptability in western countries for the sake of low inflation and stability; many Muslim majority countries remain uncommitted to achieving the sustained low and stable inflation. The principles of Islam are inconsistent with policy generated inflation, on the contrary Islam is consistent with the findings of mainstream monetary economics that high and volatile inflation adversely affects economic growth.

Some Examples-                                                  


The Central Bank of Bahrain (CBB) is responsible for setting and implementing monetary policy in the Kingdom of Bahrain. Bahrain maintains a fixed exchange rate regime between the Bahraini dinar and the US dollar. The exchange rate peg provides an anchor for monetary policy. Low inflation and a stable currency are important long-term features of the Bahraini economy which support a stable business environment and high levels of investment, both of domestic and foreign origin.

Bahrain has a free market economy, with no restrictions on capital movements, foreign exchange, foreign trade or foreign investment. The Kingdom has a leading position in the region as an open, free, transparent and welcoming environment for investors. The monetary policy framework is geared to support the general economic goals of the Kingdom.


The Bangladesh Bank abandoned the fixed peg exchange rate system on 31 May 2003, which had been in operation since the late 1970s, in favor of a ‘managed float’ exchange rate system. The control of money supply is an important policy tool in conducting monetary policy. The success of monetary policy depends on the degree of predictability, measurability and controllability that the monetary authority has over money supply. Monetary policy in Bangladesh is framed using projected real GDP growth rate. The targeted rate of inflation adopts Reserve Money (RM) and Broad money (M2) as operating and intermediate targets respectively. The RM is influenced by the indirect market based instrument such as CRR, SLR, repo, reverse repo, open market operation and moral suasion.


The CBE intends to put in place a formal inflation targeting framework to anchor monetary policy once the fundamental prerequisites are met. This will further enhance the predictability and transparency of the monetary policy in Egypt. In the transition period, the CBE will meet its inflation objectives by steering short term interest rates, keeping in view the developments in credit and money supply, as well as a host of other factors which may influence the underlying rate of inflation. The CBE strongly believes that real negative interest rates are inconsistent with the ongoing effort to reduce inflation rates. The continued reduction of the inflation rates that Egypt has witnessed in recent months is important in order to guide long-term inflation expectations.


To implement monetary policy, Bank Indonesia has opted for a working framework known as the Inflation Targeting Framework (ITF). Under this framework, Bank Indonesia explicitly announces the government-set inflation target to the public and monetary policy is geared towards achievement of this target. For the inflation target to be reached, monetary policy is implemented with a forward-looking approach, meaning that any change in the monetary policy stance is undertaken after evaluating whether future developments in inflation are on track with the established inflation target. Under this framework, monetary policy also operates with transparency and accountability to the public. At the operational level, the monetary policy stance is reflected in the setting of the policy rate (BI Rate) with the expectation of influencing money market rates and in turn the deposit rates and lending rates in the banking system. Changes in these rates ultimately influence output and inflation.


In implementing monetary policy, the Central Bank can directly resort to its regulating power or affect money market conditions indirectly as issuer of high-powered money (notes and coins in circulation and deposits held with Central Bank). On this basis, two different monetary policy instruments are being utilized: direct instruments (with no reliance on market conditions) and indirect instruments (market-oriented): 1. Direct Instruments 1 Banking profit rates 2. Credit ceiling. Indirect Instruments include 1. Reserve requirement ratio: 2. CBI Participation Papers: 3. Open deposit account (ODA):. One of the bold measures taken for the efficient utilization of indirect monetary instruments in the framework of the Usury-free Banking Law is to allow banks to open a special deposit account with the CBI


 In Malaysia, Bank Negara Malaysia (BNM) conducts monetary policy by influencing the level of interest rates that borrowers have to pay on their loans and depositors earn on their deposits. During the peak of economic overheating and when the threat of inflation is high, monetary policy is tightened by withdrawing fund from the banking system and raising interest rates.


SBP signals its monetary policy stance through adjustments in the policy rate; that is, the SBP Target Rate for the overnight money market repo rate. Changes in the policy rate impact demand in the economy through several channels and with a lag. In the first place, changes in policy rate influence the interest rates determined in the interbank market at which financial institutions lend or borrow from each other. The market interest rates are also influenced by central bank interventions in money and foreign exchange markets as well as by its communication. Until the mid 1980s Pakistan pegged its rupee to US dollar. Since then it has maintained a managed float exchange rate system. The financial system in Pakistan can be regarded as adequately developed to adopt a rule based, forward looking strategy of monetary policy, such as inflation targeting. For Islamic Banks Bai Muajjal (Islamic OMO) have been introduced to get funds from the SBP by placement of Sukuk or vice versa.

Saudi Arabia

In Saudi Arabia, the exchange rate anchor provides the long-term framework for monetary policy. Within that framework, there is some flexibility to alter domestic monetary conditions. This can be done by changing policy interest rates (repo rates), introducing prudential guidelines on bank lending, and adjusting reserve requirements. The Saudi Arabian Monetary Agency (SAMA) is vested with the conduct of monetary policy and has instrument and operational independence in pursuing its policy objectives. Saudi Arabia takes a long-term view that looks through the cycles in the oil market. Both fiscal and monetary policy are used to dampen the effect of oil price volatility on domestic economic development (i.e. adjusting the level of foreign exchange reserves and retiring domestic debt in good times to help insulate the economy from oil price swings). For a volatile resource-based economy, such as Saudi Arabia, countercyclical fiscal policy and the fixed currency parity are more appropriate for containing output shocks than using the exchange rate route. As financial stability is key to effect monetary policy transmission, SAMA takes a proactive role in supervising banks through risk-based as well as macro prudential approaches.


Turkey is still skeptical about appropriateness of Turkish Central Bank’s monetary policy regarding inflation targeting since the financial sector is not fully developed. The use of interest rate as the instrument of monetary policy has not been very effective in stabilizing inflation. The money growth rate has become more volatile. The key question for Turkey now is whether it should, while retaining inflation targeting, substitute monetary aggregate for the current short term interest rate as its monetary policy instrument of choice, at least until the financial sector develops further and interest rate comes to play a greater role in the transmission

Final words-

Depending on the given global economic and financial architecture, policies which can bring stability to these economies can set the necessary environment for emergence and development of Islamic finance. Once price stability and financial stability are achieved, Islamic finance can operate parallel to conventional finance and can also keep some comparative superiority. Fiat monetary system can keep inflation low and stable provided that the monetary authorities conduct monetary policy by deploying a well-designed monetary rule, such as monetary targeting under a floating exchange rate system, requiring the use of monetary instruments to control the money supply. Price stability is the cornerstone of an Islamic financial system and that inflation is a monetary phenomenon that can be kept low and stable through a rule-based Islamic monetary policy system.


Please enter your comment!
Please enter your name here