Home Weekly Islamic Pages Islamic Banking Page 3rd July 2020

Islamic Banking Page 3rd July 2020

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How to remove Complexities in Islamic Finance

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

Islamic finance requires the provision of financial services in accordance with the Shari’ah ban on interest (Riba). It also requires that the financing provided is asset-based, often resulting in the purchasing, ownership, transfer, and transactions of real goods between counterparties. However, there is a tendency to structure transactions and financing so that Islamic finance contracts mimic conventional (debt) financial contracts: the result is a complex layering of transactions and the involvement of third parties in order to be Shari’ah compliant. This can create complexity and risks (credit, market, operational, and legal) at different stages in execution of the Islamic finance contract.

An example is the case of some home mortgages based on Murabahah (sale at cost plus profit) which can involve multiple transactions (including with more than one commodity) and multiple transfers of ownership and layering to ensure Shari’ah compliance. In the case illustrated above, a pure Murabahah contract can be compared with a more complex Tawarruq (purchase of commodities on a deferred payment basis) and Murabahah structure combining to provide funds to the purchaser (Mutawariq) for the purchase of the property. The transaction involves an agreement between the bank and the purchaser and the property seller and purchaser. In the case of pure Murabahah, the bank purchases the property sell it to the purchaser, pursuant to the Murabahah agreement. The deferred payment obligation of the purchaser is secured by a mortgage on the property, while the actual deferred payments are made. In the Tawarruq case, the bank does not itself purchase the property, but instead purchases a commodity, for example metal, and then sell it to the home purchaser at a price that includes a profit margin and involves a mortgage agreement. The purchaser then sells the commodity for cash, which is used (with any equity by the purchaser) to purchase property from the seller. The amount financed from the commodity (metal) Murabahah agreement is repaid to the bank over time as deferred payments, mimicking the payment structure of a conventional interest-based home loan. Murabahah transactions allow the contract to mimic a conventional mortgage, but with layering of the initial set of transactions and an increase in the number of counterparties involved through the life of the mortgage.

Monetary Policy and Liquidity Management Money and interbank markets for Shari’ah-compliant instruments have not yet developed in most countries, in part because of a lack of available instruments. Shari’ah-compliant central bank facilities are also limited, reflecting the difficulty in designing market-based instruments for monetary control and governments financing that satisfy the Islamic prohibition on ex ante interest payments. This has limited the scope for money market trading and the development of central bank liquidity facilities, both of which are necessary for market-based monetary policy. Implementing monetary policy in Islamic systems also requires an understanding of the implications of Islamic finance for the monetary transmission mechanism. This will be different than in conventional systems owing to the prohibition of interest, the shallowness of financial markets in many jurisdictions where Islamic banks operate, and typically higher levels of surplus liquidity.

Moreover, in many economies where Islamic banks are reaching systemic importance, monetary policy is geared toward maintaining a fixed exchange rate. Nonetheless, some evidence suggests that central banks can maintain effective control over monetary conditions by adjusting bank liquidity and allowing this to affect the economy through the bank lending channel. However, the effectiveness of this approach is likely to wane as financial markets deepen, which suggests the need to explore the extent to which monetary authorities can also influence Islamic banks’ cost of credit by targeting the profit-sharing ratio of Interbank Mudarabah transactions.

Monetary policy implementation in dual systems will be particularly complicated. Islamic banks often operate in dual financial systems and, as a result, are influenced, especially at an early stage of development, by conventional monetary conditions and instruments through arbitrage between the conventional and Islamic sectors However, this transmission channel may have shortcomings given that Islamic interbank markets are often underdeveloped, limiting the scope for using market-oriented instruments to effect policy. This gap may become more important as the Islamic segment of the system grows in size.

 Moreover, as discussed, the shortage of Shari’ah-compliant HQLAs reduces the collateral available for liquidity management, and may also affect the smooth functioning of the payment systems . These issues highlight the importance of developing more effective instruments for monetary policy under Islamic finance. Thus far, central banks have tended to focus on changes in reserve requirements and on open market operations that take the form of government and central bank Sukuk issuances or outright purchases and sales of tradable Sukuk (for example, in Iran, Malaysia).

 Some central banks have also established standing facilities that utilize collateralized Murabahah, or reverse Murabahah (Tawarruq), which is allowed in some jurisdictions like Pakistan) for liquidity management. Some countries have also tried to develop Islamic interbank collateralized and uncollateralized instruments, mainly in the form of Murabahah contracts (in the former case collateralized with commodities).

However, the key priorities remain to bolster the supply of Shari’ah-compliant liquidity instruments and sovereign Sukuk, and to work to develop the infrastructure necessary to facilitate a deepening of interbank money markets for Islamic financial markets.

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