Islamic Banking

1.0 Background of the Study:

1.1. Introduction:

Conventionally, the central bank is responsible for the issuance of currency, the management of the
banking system to insure the value of the currency, the formulation of monetary policies to govern
bank operations and the regulation of the fluctuations (inflation and deflation) in the value of currency
which is a result of the interest based system which is outlawed in Islamic laws regarding finance.

In modern Islamic finance, the relationship between the Islamic and Central Banks is vital for the
development of Islamic banks and the much-needed assistance to compete with the conventional
banks. Central banks are needed to buttress role that Islamic banks play in the socio-economic sector
of a country by establishing limitations on equity, licensing and setting up new branches, establishing
special funds.

The principle element to consider when revising the role of central banks in the Islamic banking
system is to recognize that it differs from one country to another and is subject to the socio-economic
principles and policies of that country

1.2 History of Islamic banking:

Although Islamic finance contains many prohibitions—such as on consumption of alcohol, gambling,

uncertainty, etc. -- the belief that "all forms of interest are RIBA and hence prohibited" is the idea
upon which it is based. The word "riba" literally means “excess or addition”, and has been translated
as "interest", "usury", "excess", "increase" or "addition".

According to Islamic economists Choudhury and Malik, the elimination of interest followed a
"gradual process" in early Islam, "culminating" with a "fully fledged Islamic economic system" under
Caliph Umar (634-644 CE).

Other sources (Encyclopedia of Islam and the Muslim World, Timur Kuran), do not agree, and state
ruses (ḥiyal), often more or less openly," including during the Ottoman Empire. (Still another source,
(International Business Publications), states that during the "Islamic Golden Age" the "common view
of riba among classical jurists" of Islamic law and economics was that it was unlawful to apply
interest to gold and silver currencies, "but that it is not riba and is therefore acceptable to apply

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interest to fiat money -- currencies made up of other materials such as paper or base metals -- to an
extent.")

However, in the 20th century, Islamic revivalists/Islamists/activists worked to define all interest as
riba, to enjoin Muslims to lend and borrow at "Islamic Banks" that avoided fixed rates. By the 21st
century this Islamic Banking movement had created "institutions of interest-free financial enterprises
across the world”.

The movement started with activists and scholars such as Anwar Qureshi,Naeem Siddiqui, Abul A'la
Maududi, Muhammad Hamidullah, in the late 1940 and early 1950s. They believed commercial banks
were a "necessary evil," and proposed a banking system based on the concept of Mudarabah, where
shared profit on investment would replace interest. Further works specifically devoted to the subject
of interest-free banking were authored by Muhammad Uzair (1955), Abdullah al-Araby (1967),
Mohammad Najatuallah Siddiqui, al-Najjar (1971) and Muhammad Baqir al-Sadr.

The first modern commercial Islamic bank, Dubai Islamic Bank, was established in 1979. The first
Islamic insurance (or takaful) company — the Islamic Insurance Company of Sudan — was
established in 1979. The Amana Income Fund, the world's first Islamic mutual fund (which invests
only in sharia-compliant equities), was created in 1986 in Indiana.

By 1995, 144 Islamic financial institutions had been established worldwide, including 33 government-
run banks, 40 private banks, and 71 investment companies the large US-based Citibank began to offer
Islamic banking services in 1996 when it established the Citi Islamic Investment Bank in Bahrain.
The first successful benchmark for the performance of Islamic investment funds was established in
1999, with the Dow Jones Islamic Market Index (DJIMI).

By 2008 Islamic banking was growing at a rate of 10–15% per year and continued growth was
forecast there were over 300 Islamic financial institutions spread over 51 countries, as well as an
additional 250 mutual funds complying with Islamic principles. Worldwide, approximately 0.5% of
financial assets were estimated to be under sharia-compliant management according to The Economist
magazine.

But as the industry grew it also drew criticism (from M.T. Usmani among others) for not progressing
from "debt based contracts", such as murabaha, to the more "genuine" profit and loss sharing mode,
but instead moving in the opposite direction, "competing to present themselves with all of the same
characteristics of the conventional, interest-based marketplace".

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1.3. Origin of the report:

The report prepared for the requirement of course FNB305,Islamic Banking and Investment under the
academic supervision of the course introducer, Debashis Saha, lecturer, Department of Finance &
Banking, ‘Roles of Central Banks in Islamic Banking’ is our topic for this Report.

1.4. Problems:

This study reviews, analyzes and appraises the existing literature available on central banking in
Islamic economics and the practices followed by central banks for liquidity management and
monetary management in countries where Islamic banking is prevalent. We contribute in devising the
role of a central bank in an Islamic economy in a paradigm compliant with Islamic principles to carry
out its functions and compatible with the environment of conventional monetary policy regimes.

1.5. Objective of the study:

 The primary objective of the report is the completion of our course FNB305
 To review the distinctive concepts of Islamic banking
 To gather knowledge about the implication of roles of central banks in Islamic banking
 To evaluate the current practice and performances of the Islamic banks of all Muslim
countries

1.6. Scope of the study:

The study focuses on how central banks can perform their functions of managing money supply,
foreign debt and liquidity in the banking sector and what mechanism they can utilize to perform their
functions.

1.7. Limits of the Study:

The study due to its limited and focused scope could not consider exchange rate stability and
signeorage.

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1.8. Research Methodology:

This study is exploratory in nature.

It discusses the role of a central bank in an interest free monetary system by reviewing academic
literature as well as practices followed in Islamic countries where Islamic banking is prevalent.

Data on two variables, Nominal Income Growth ‟as measured by Nominal GDP growth and, Nominal
interest rates ‟is taken from International Financial Statistics (IMF) for the last 20years from 14
countries where Islamic banking has been prevalent.

Equivalency of means test is carried out to determine whether there exists significant relationship
between the two variables.

1.9. Literature Review:

 Pricing of Capital

• Shadow Price vs. Accounting Price (Mannan, 1982).

• Problems in monetizing public debt (Darrat&Bashir, 2000).

• Treatment of public debt (Kurrihara, 1951).

 Alternative Instruments suggested in Islamic central banking literature.

• Refinance Ratio (Siddique, 1982).

• Qard-e-Hasan ratio (Khan, 1982).

• Using Mudarabah & restricting high powered money by way of RRR than relying on OMO (Chapra,
1983).

• Time Multiple Counter Loan (Mehmood, 1991).

• Equity stake in commercial banks (Uzair, 1982).

• Composite stock (Zangeneh&Salam, 1993).

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2.0. Central Banking in Muslim Countries:

In UAE, the monetary instruments and liquidity management framework in the money market has
following salient features: a) Minimum Reserve Requirement, b) Swap Arrangements, c) Advances
and overdraft facility for banks and d) Certificates of Deposits. Source: Qualified Monetary Policy
Instruments (Central Bank of UAE website, no date).

In Sudan, the monetary instruments and liquidity management framework in the money market has
following salient features: a) Minimum Reserve Requirement, b) Central Bank of Sudan provides
financial support to the Islamic banks facing temporary liquidity problems through purchasing
financial papers “Sukuks” from them in accordance with what the Central bank may decide.

Saudi Monetary system also has Government Development Bonds and Treasury Bills for fiscal
deficit financing and liquidity management. Chandavarkar (1996) citing the case of Saudi Arabia and
Iran favored the use of reserve ratio and profit sharing ratio as the instruments of monetary policy
management. He argued that adjustments in profit sharing ratios can be used as a substitute for bank
rate variations. Credit can be tightened by reducing the share accruing to businessmen and eased by
increasing it. The monetary policy of Saudi Monetary Agency (SAMA) relies primarily on variations
in the reserve ratio requirements, since it is debarred from using the re-discount facility under Islamic
law and cannot use open market operations as the Kingdom does not have any public debt in the form
of government securities which can be used for such operations. A significant secondary tool is
selective credit controls which include regulation of credit ceilings, cash margins, terms and
conditions of customer transactions, limits, prohibitions on specific categories of loans, and fixing the
assets to be held within the Kingdom by each bank. SAMA also deploys its own accounts and
government deposits with commercial banks to regulate the money supply. SAMA uses ORR
(Official Repo Rate) for short term liquidity management.

In Iran, the set of instruments used particularly since the abolition of banks specific credit ceilings at
the beginning of 1991-92 comprises variations of reserve ratio requirements and the rates charged on
lending of encashment facilities provided to banks. The reserve ratios are specified for each class of
deposit, diminishing as their term increases (10 per cent on five years deposits to 30 per cent on
demand deposits). Specialized banks are subject to a uniform (and lower) reserve ratio of 10 per cent.
In Iran, RRR (Reserve Requirement Ratio), Participation Papers and ODA (Open Deposit Accounts)
are used for short term liquidit management. Expected profit rates are determined by MCC (Money
and Credit Council) in Iran.

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In Qatar, the monetary instruments and liquidity management framework in the money market has
following salient features: a) Required Reserve, b) Certificates of Deposit, c) QCB Rate, d) Repo
Operation-Repo and e) Open Market Operations and f) Discount Window. Source: Monetary Policy
Tools (Qatar Central Bank website, no date).

In Oman, the monetary instruments and liquidity management framework in the money market has
following salient features: a) Treasury Bills, b) Certificates of Deposits, c) Open Market Operations
and d) Repurchase/Reverse Repurchase. Source: treasury bill & Certificate of Deposit (Central Bank
of Oman website, no date). Kazmi (2009) explained the Islamic money market framework in Pakistan.
Two interbank trading agreements – the Interbank Musharakah and Interbank Wakalah – are being
used as standard contracts for the Islamic banking industry. The Islamic interbank market is hoped to
replace the conventional Karachi Interbank Offered Rate (KIBOR), with the Islamic Interbank Offer
Rate (IIBOR), and offer an avenue for Islamic banks to lend excess funds to each other. Interbank
Musharakah is a short term restricted partnership where the banks are invited to invest the amount in a
special pool of assets on a pre-agreed profit sharing ratio agreed upon at the outset. Interbank
Wakalah is an investment management contract where the investor (entity with surplus funds) agrees
to provide the Islamic bank (entity with shortage of funds) with funds to invest in different assets. The
Islamic bank acts as the investor’s agent and is paid a fee for its services, while the investor receives
the returns obtained on investments.

In Malaysia, the Islamic Interbank Money Market (IIMM) was introduced on January 3, 1994 as a
short-term intermediary to provide a ready source of short-term investment outlets based on Shariah
principle. Through the IIMM, the Islamic banks and banks participating in the Islamic Banking
Scheme (IBS) would be able to match the funding requirements effectively and efficiently. Bank
Negara Malaysia (BNM) issued the Guidelines on the IIMM on December 18, 1993 to facilitate
proper implementation of the IIMM.Source: Islamic Interbank Money Market Malaysia Information
(Islamic Interbank Money Market website, 2009). Types of Instruments in Islamic Interbank Money
Market
1. Mudarabah Interbank Investment (MII)
2. Wadiah Acceptance
3. Government Investment Issue (GII)
4. Bank Negara Monetary Notes-i (BNMN-i)
5. Sell and Buy Back Agreement (SBBA)
6. Cagamas Mudarabah Bonds (SMC)
7. When Issue (WI)
8. Islamic Accepted Bills (IAB)

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9. Islamic Negotiable Instruments (INI)

10. Islamic Private Debt Securities
11. Ar Rahnu Agreement-I (RA-i)
12. Sukuk BNM Ijarah (SBNMI)
13. Green Banker’s Acceptances
14. Repurchase Agreements
15. Islamic Private Debt Securities

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3.0. Concepts of Central Bank in Islamic Banking:

3.1. The legal concept-capital

In economics. we are basically dealing with two interrelated concepts one legal (or conventional). The
other real. All contractual agreements such as marriage, Ownership, Organizational hierarchy, money
and interest fall into the first category: while human-being, commodities, buildings, amenity and the
like are in the second. Each of these concepts is able to produce the other or be transformed. Money,
being a legal concept, is capable of producing another legal concept (actually its derivative) called”
interest" or a real concept such as capital equipment. “The unique and powerful tool of financial
policy in Islamic central banking is to determine the share of profit relative to that of capital for all
investment projects submitted to Islamic banks" Money as potential capital is a legal concept capable
of being transformed into actual capital. For example, in a Mudarabah contract, as soon as one
person's money is legally combined with another person‘s labor, the nature and the function of money
is changed into capital. The higher the speed at which the stock of money is transformed into the flow
of capital, the higher will be the rate of economic growth. This is the most important task of the
Islamic central bank.

3.2. Asset value-investment

The various modes of contract available to Islamic banks are the major means of transforming the
money deposits of individuals and firms into capital (or assets). Financing under any mode of contract
will essentially increase the value of the economy‘s assets. However, some modes of contract
(Musharakah and installment sales originated by firms), for example, increase the productive capacity
of the economy. Again, any positive change in a firm's asset values can be called "investment."
Following this practice, it is easy to calculate with a high degree of precision the amount of
investment which has taken place in an economy in any specific year. This can be done by reading the
asset values off the current balance sheets that firms submit to the tax authorities. Putting asset values,
rather than capital, into the production function makes it more precise and meaningful.

3.3. Rate of profit

A firm's rate of profit is, hence, logically defined as the ratio of profit to assets. Since the value of the
assets is normally greater than that of capital, using the ratio of profit to the value of capital would
underestimate the true rate of profit.

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3.4. Artificial risk

Speculation, which entails artificial risk, is not permissible in an Islamic setting. A corollary of this is
that stocks are expected to be exchanged in an Islamic stock market based upon their book values. In a
stable price system, the market to book value becomes unity, because in an efficient Islamic stock
market, the book value of shares reflects all relevant facts about a firm based on its assets. Tobin ‘s Q
(a ratio comparing the market value of a company’s stock with the value of a company's equity book
value) then becomes irrelevant One implication of this is that in a world with perfect markets, valuing
the firm would be easy; that is, we could read the economic value of the firm off the current balance
sheet. Risk is essentially interwoven with investment. It can be considered “natural" and can be
accounted for, and thus is permissible in Islam.

3.5. Profit sharing ratio

However, the impermissibility of artificial risk is grounded upon the fact that income received by a
speculator will cause excess demand for goods/services, and this, in turn, can cause inflation. The
unique and powerful tool of financial policy in Islamic central banking is to determine the share of
profit relative to that of capital for all investment projects submitted to Islamic banks. This is probably
the most important role a central bank can play, because if effectively used, it could channel the
bank's financial resources into asset-building without having to worry about the emergence of a
money whirlpool. The ratio determined by the Islamic central bank is especially useful in cases where
different risks are involved. Another task of the central bank would be to list the different risks
involved in various investment projects.

3.6. Applying other properties to money

Western economists have always and justifiably been worried about unnecessary expansion of money
supply, the volume of which is hard to control. Nevertheless, as Islamic banks are prohibited from
lending on interest, the different modes of contract available to them enable them to finance the
specific needs of both firms and individuals. Through effective supervision by the central bank, the
chances of a money market developing are very slim. By providing accurate, accessible and
symmetrical information, the central bank would be able, to a certain extent, to prevent moral hazard.
The fact that money is not a tradable entity and its production and volume will be closely monitored

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by the central bank makes it appropriate for classification as an impure public good in an Islamic
state. Other properties of such goods which also apply to money include: . Demand can be constructed
by vertical summation of individual demands. Externality can be derived from its capability to
become actual capital; hence, government (that is, central bank) intervention.

3.7. Another wealth money

Furthermore, it benefits each person simultaneously and is thus equally available to each person
Additional individuals looking for money may be added at zero marginal cost The indivisibility of
money refers to its purchasing power and not its physical character. . Its velocity is greater than unity,
implying that it is not supposed to be withheld, contrary to the case with private goods Money has two
distinct attributes. At the micro level, it is part of the assets of the individual possessing it, But at the
macro level, it cannot be added to the assets of the economy. To count money as the wealth (or asset)
of a nation will lead both to the fallacy of composition and to double-counting. This factor makes it
distinct from other public goods and may well be the consequence of it being the medium of
exchange. The removal of interest and all its derivatives will lead Islamic banks financing investment
projects through profit and loss sharing (PLS), based on the profitability and feasibility of the
projects.

3.8. IRR
Potential investors evaluate projects based on the internal rate of return (IRR). The role of the central
bank in determining the lRRs for various activities in different sectors is valuable for effectively
channeling resources. After the feasibility and profitability have been confirmed, projects become
eligible to obtain finance. Furthermore, the projects themselves become collateral for finance. As long
as there are appropriate factors of production available for investment, projects have to be financed by
Islamic banks, irrespective of how much money is required. In Islam, it is the right of labor not to be
kept unemployed.

3.9. CAB
In the final analysis, everything coming out of an Islamic bank in response to financing an investment
project can be called a certificate of asset building (CAB).

3.10. Social welfare

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CABS are appropriate to both the production and household sectors. The appropriateness of projects
is to be determined by the central bank with a close eye on social welfare. However, to determine
which projects are more profitable to finance is the task of the individual bank. The central bank's task
is to instruct the banks to give priority to projects which are more compatible with the country’s
overall economic plan.

4.0. Role of Central bank in Islamic Banking:

Conventionally, the central bank is responsible for the issuance of currency, the management of the
banking system to insure the value of the currency, the formulation of monetary policies to govern
bank operations and the regulation of the fluctuations (inflation and deflation) in the value of currency
which is a result of the interest based system which is outlawed in Islamic laws regarding finance.

In modern Islamic finance, the relationship between the Islamic and Central Banks is vital for the
development of Islamic banks and the much-needed assistance to compete with the conventional
banks. Central banks are needed to buttress role that Islamic banks play in the socio-economic sector
of a country by establishing limitations on equity, licensing and setting up new branches, establishing
special funds.

The principle element to consider when revising the role of central banks in the Islamic banking
system is to recognize that it differs from one country to another and is subject to the socio-economic
principles and policies of that country.

However, there are three features of the relationship between Islamic banks and central banks
irrespective of the host country namely;

 It acts as a lender of last resort- this element enables central banks to control the supply
of money to the commercial banks therefore the public. The loans are given to conventional
banks to provide liquidity; however, they are done based on interest accumulation which is
prohibited in Islamic finance.

To ‘halalify’ the loaning, the central bank instead of charging interest to the loans given to Islamic
banks, instead settle on the profit and risk sharing policy of the shariah-compliant institution and
instead take a share in the returns of the Islamic bank’s investment of the loaned money over the pre-
determined period of profit-making.

 It acts as a clearing house- In the modern Islamic banking structure, central banks supply
Islamic banks with provisions for the defrayal of cheques and other disbursements and also
facilities such as documentary letters of credit and guarantee for a charge.

The Islamic bank establishes a current account with the central bank with the clearing system and
restricted short-term provisional overdraft services which are also free of interest. The Islamic bank is

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sometimes allowed to pay for any transitory deficits for clearance reasons. For returns, the central
bank may allow partial temporary services interest-free of Islamic banks on the agreement that the
Islamic bank would share their profits during the deficit phase.

 Lastly, it acts as a supervisor regarding monetary policy- the central bank regulates credit
availability and inflation via money to manage a stable economic growth. The central bank is
obliged to create blueprints and types of standard data needed from Islamic banks to be
utilized by Islamic bank agents and the central bank itself so as to adhere to the principles of
Islamic banks procedures.

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5.0. Functions of Central bank in Islamic Banking:

5.1. Pivot of the Islamic banking System:

 The central bank should be the pivot of the Islamic Banking System, because only through its
conscientious and creative efforts and eternal vigilance can the Islamic money and banking system
function properly and achieve its objectives. It should be an autonomous government institution
responsible for the realization of the socio-economic goals of the Islamic economy in the sphere of
money and banking.

5.2. Issue of Currency:

Like all central banks, the central bank in an Islamic economy should be responsible for the issue of
currency and, in coordination with the government, for its internal and external stability. It should act
as banker to the government and the member banks. It should decide for clearance and settlement of
checks and for transfers, and should act as the lender of last resort. It should guide, supervise and
regulate the commercial banks, the non-bank and specialized financial institutions, without unduly
affecting their autonomy. Unlike the conventional central bank, it should also bear the responsibility
of preventing the concentration of wealth and power through the financial institutions.

5.3. Stabilization of the Value of Money: 

Stabilization of the real value of money should be an important function of the central bank in order to
realize the healthy sustainable growth of the Islamic economy and to ensure socio-economic justice.
For this purpose, it would have to keep a close watch on money supply, to ensure that the growth in
money is not out of step with that in real output. This does not imply that the money supply is the only
variable influencing prices. All it implies is that the money supply matters, and that without its proper
regulation one of the important instruments for realizing the economic goals of Islam will have been
blunted.

5.4. Implementation of Monetary Policy:

 The central bank should be the primary institution responsible for implementing the country's
monetary policy.  For this purpose, it should use the instruments and methods that are not in conflict
with the teachings of the Islamic Shariah. Further, since the central bank cannot realize the goal of

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monetary stability without cooperation from the government, a harmonious fiscal - budgetary policy
would be indispensable.

5.5. Promotion, Regulation and Supervision: 

The central bank will also have to play a positive role in the promotion, regulation and supervision of
all financial institutions with the objective of helping them and making them healthy and strong. For
this purpose, it may have to review all existing laws and amend or reconstitute them in the light of
Islamic teachings. The reformed banking legislation should reflect the diverse needs of the Islamic
financial system.

5.6. Ensure health and Development of Public Interest:

 The central bank should not confine its regulatory role merely to the commercial banks. Its vigilance
and assistance must envelop all other financial institutions to ensure their health and development and
to safeguard the public interest. If some other government agencies are responsible for promoting and
regulating non-bank financial and auxiliary institutions, then there should be proper coordination
between the Central bank and other regulatory authorities to bring on harmony in their promotional
and regulatory functions.

5.7. Lender of the Last Resort:

As in conventional banking, the Islamic central bank would also have to act as the lender of last resort
to ensure sufficient liquidity and to sustain the banks in case of liquidity or solvency crisis. Its
ingenuity would be reflected in the way it handled crisis situations without bailing out bank
management and yet safeguarding the interest of depositors and equity-holders who are not a part of
the management. Temporary accommodation from the central bank provides the borrowing bank with
a brief respite and enables it to survive until remedial measures are enforced and become effective.
This is necessary for maintaining confidence in the banking system.

Financial Assistance by the Central Banks: The central bank, to help any Islamic bank tide over its
temporary liquidity problem, may provide general accommodation in the form of Mudaraba deposit
on which the Islamic bank may pay profit at the rate declared on such deposits.

The central bank may also provide refinance to Islamic banks against finance provided by them for
purposes, projects or sectors specified by the central bank. Such refinance may be provided
under Mudaraba, Musharaka or any other Islamic mode of finance.

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5.8. Current Account and Clearing House Facility:

Islamic banks may be allowed to maintain current accounts with the central bank and to participate in
the bank's clearing house operations. If the current account is occasionally overdrawn, the central
bank may provide this facility without any charge. Alternatively, such facility may be extended on the
basis of sharing of the profits of the bank.

5.9. Regulation and Supervision of Islamic Banks:

Islamic banks may be subjected to regulations and controls by the Central bank in respect of  (a)
permission to establish banks and to open new branches;   (b) minimum share capital;   (c) the terms
governing the constitution of Boards of Directors and appointment of Chief Executives and auditors;
(d) tariffs for banking services;   (e) measures regulating foreign exchange transactions;  (f)
submission of periodical statements and operational data to the central bank  and  (g) Compliance
with the working hours.

5.10. Inspection of Islamic Banks:

Islamic banks may be subjected to periodic inspection by the central bank to ensure their operational
soundness. The central bank personnel may be adequately trained in Shariah-based operations of
Islamic Banks. Detailed guidelines for inspection of the Islamic banks should be prepared and set by
the central bank, as it should carry out research and training of personnel.

Bank supervision and inspection would be more important in an Islamic system. Unlike the
examination of conventional banks, it may be necessary to ensure that, in addition to proper
documentation, the projects financed dare sound. To examine all projects financed by the banks
would be difficult. It should, however, be possible to examine a random sample of projects financed
to ensure that banks do not indulge in financing speculative or unduly risky ventures. Supervision
should not be concerned solely with individual banks. It should acquire an operational importance and
should aim at promoting the efficiency and stability of the whole financial system, by means of action
directed towards both the system itself and individual components, without interfering in moral
operational decisions. Moreover, supervision presupposes adequate disclosure and accurate
information, and proper auditing. The central bank should play a key role in determining the
requirements for this purpose. It should try to strengthen internal controls and issue policy guidelines,
and monitor the quality of assets and operations. It should reform the concepts and procedures of
auditing to ensure soundness and honesty.

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6.0. Roles of Central bank in Islamic Banking in BD:

Islamic banking has achieved significant growth in Bangladesh that belongs to 20 percent share of the
whole banking industry. However, investments under Mudaraba and Musharaka are below 2 percents.
Investment in socially desirable sectors like microenterprises, small projects and agricultural sectors
are only getting marginal shares in total investment. Islamic banks are also facing challenges; among
them major constraints include absence of separate act, paucity of money and capital market
instruments, and lack of skilled manpower. Bangladesh has also tremendous potentials for further
growth of Islamic banking as she has vast population with increasing real per capital income and
Muslim majority people. Bangladesh may also bank on Islamic finance specially for financing large
infrastructure projects badly need to achieve higher GDP growth towards bringing poor people out of
poverty cycle. The ground has already been prepared by Islamic banks and its more than ten million
customers. The unlocking of unexplored immense potentials of the Islamic finance industry depends
on the appropriate legal framework, development of customized products suitable for all segments of
customer base, adoption of state-of-the-art technology and committed skilled human resources.

6.1. Promoting Investment under Musharaka and Mudaraba mode of

Investment:
Since investments made by Islamic banks are miserably low (below 2%) in Musharaka and Mudaraba,
the ideal Islamic modes, Bangladesh Bank may provide necessary directions to Islamic banks and
Islamic branches/windows of conventional bank for investing at least 10% of investable funds.

6.2. Necessary Supports for Islamic Bank Branches/Windows of

Conventional Banks:
Bangladesh Bank should pay special attention to remove the problems of Islamic Bank
Branches/Windows of Conventional Banks.

6.3. Establishment of Separate 'Islamic Banking Department' at

Bangladesh Bank:
A separate 'Islamic Banking Department' needs to be established at Bangladesh Bank to formulate and
implement policies for all the Islamic Banks and Islamic Bank Branches/windows of Conventional
Banks. The key functions of the department would include issuance of license for opening of new
bank and new branches/windows of existing banks, fixing up capital adequacy requirements,
provisioning standard and reserve requirements, making review and drafting of banking statutes,

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prescribing criteria for corporate governance, internal control and risk management system of banks,
determination of accounting standards and disclosure requirements for banks, monitoring maintenance
of statutory liquidity requirements (CRR, SLR) of scheduled banks, and performance analysis and
monitoring of the scheduled banks on the basis of CAMELS.

6.4. Formation of Central Shariah Supervisory Board at Bangladesh

Bank:
Since compliance of Islamic Shariah is a part and parcel of Islamic banking, it is imperative to
establish a Central Shariah Supervisory Board at Bangladesh Bank to formulate and implement
uniform Shariah Governance Standards for all the Islamic Banks and Islamic Bank Branches of
Conventional Banks. This board should have a unique balance of human resources comprising Islamic
bankers, Islamic Jurists and Shariah Auditors to oversee the activities of Shariah boards of Islamic
banks. In this case, Malaysian and other countries’ experiences can be explored.

6.5. Strengthening Islamic Banking Inspection Department:

Bangladesh Bank needs to adopt immediate measures to strengthen newly established Islamic
Banking Inspection Department (DBI 4) through recruitment, training and posting of officials having
clear understandings of principles and methods of Islamic banking.

6.6. A Strong Islamic Finance Research Unit under Research Department:

Conducting Research on various key issues relating to Islamic finance, and monitoring its growth
trend and impacts pattern is prerequisites to reap fuller benefits of Islamic finance. To this end, a
‘Islamic Finance Research Unit’ headed by a Professional Islamic Finance Researcher under Research
Department may be established at Bangladesh Bank. The key functions of this Department would
include (i) to collect data/information on Islamic finance and prepare monthly/quarterly and annual
report; (ii) to conduct comprehensive research in various fields of Islamic Economics, finance and
banking; (ii) to conduct field surveys on different Islamic Banking and finance issues and prepare
papers/reports on the basis of data/information collected and surveys conducted. At present, an
Islamic Banking section is in operation under Research Department for nearly three decades. But it
has no regular sanctioned manpower; it is working in a limited scale.

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7.0. Regulation and legal control of Islamic bank:

The concept of interest rate occupies a pivotal place in neoclassical economic theory. It is a bridge
between the real and monetary sectors of the economy. Hence, it provides the basis for discretionary
monetary policy which aims at achieving desired changes in the real magnitudes of macroeconomic
activity, such as income, employment, investment etc by manipulating the variables in the monetary
sector of the economy. Since the commercial banking system along with the entire financial system is
based upon interest, the control of interest rates assumes a prominent position in the conduct of
monetary policy. The central bank of the country aspires to affect the market rate of interest using
many instruments such as the bank rate, open market operations, and changes in the required reserve
ratio etc. These instruments affect the supply of money in the system. Assuming the demand for
money depends upon factors which cannot easily be manipulated, changes in the supply of money
will in-fluence the market rate of interest which in turn will influence the real variables of the
macroeconomic system. Based on the above economic theory, most developing countries adopt the
framework for conducting their monetary policies which is used by most industrially advanced
countries despite mounting empirical evidence that the neoclassical paradigm of economics may not
be of any great relevance to developing countries. The issue of the interest responsiveness of savings
and its impact on investment and growth is an article of faith in neoclassical economic theory.
However, the empirical evidence in support of a high interest responsiveness of saving is far from
convincing. [Gonzales Arrieta, 1988]. Similarly, the relationship between interest rate and other
macroeconomic variables is also of questionable validity. Deena R. Khatkhate studied the impact of
the interest rate on certain macroeconomic variables such as the rate of growth of real gross domestic
product, real financial assets, the savings income ratio, the investment income the ratio and rate of
return on investment for less developed countries (LDCs) during the period 1971-80. Based on his
studies, Khatkhate concluded that "there is no difference with any statistical nsignificance between the
two groups of LDCs above and below the mean real interest rate. This implies that the level of the real
interest rate by itself has little or no impact on the selected macroeconomic variables added, Interest
rate as a tool of monetary policy, most central banks in developing countries use more direct methods
of credit control. Central banks also find limited scope for conducting open market operations because
of the undeveloped nature of financial markets in the developing countries. This situation has helped
those countries where the Islamic banking system has been adopted on an economy wide basis in the
sense that it is not too difficult for them to use those monetary policy instruments which are not based
on interest. This is the reason why Iran and Pakistan did not have any substantial difficulty in
conducting their monetary policy after switching over to the Islamic banking system. In fact, a
number of devices are available for the regulation and control of the commercial banking system
ranging from the legal reserve ratio requirement to the direct allocation of credit among various
sectors. It can be used by central banks in regulating the commercial banking system in an interest

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free framework. Some of these have been put into practice in Pakistan, Iran and Sudan, the control of
the maximum and minimum profit sharing ratio has emerged as an important tool of monetary policy
in Pakistan and Iran. Credit ceilings are the most crucial tool used in Sudan. Therefore, any fear that
the Islamic banking system may introduce inefficiency in the system because of the unavailability of
the interest rate as an instrument of monetary policy appears to be unfounded.

7.1. Tools for Regulation and control of Islamic banks:

In the mixed environment where Islamic banks and interest based banks function side by side presents
a mare challenging situation. Experience has shown that in most cases central banks, subject Islamic
banks to the same controls, conditions and regulations which they apply to the interest based banks.
So far as these instruments of credit control are free of interest, no objection can be advanced against
them at least on Islamic grounds. However, there are certain cases in which there seems to a conflict
between central banks and Islamic banks. Some of these include:

a. Islamic banks keep their deposits with the central bank. The central bank pays interest to
commercial banks but Islamic banks must forego this income.
b. The central bank function as lender of the last resort. However, this loan, should the need arise for
it, is granted based on interest. There have not been many cases in which Islamic banks have had to
face a liquidity problem. However, a case occurred in Egypt in which an Islamic bank approached the
central bank for additional cash to face a run on the bank. It is reported that the central bank was not
willing to lend the required amount free of interest. Consequently, the bank had to borrow from the
central bank on interest obtaining a Fatawa from its religious board on the plea of need (Darurah) .
c. In countries, where the central bank conducts open market operations, Islamic banks are not able to
participate in these operations because of the interest based nature of the securities bought and sold.
Thus, Islamic banks are constrained by the fact that financial assets which could be liquidated quickly
are unavailable.
d. It has been noticed in some countries that central bank authorities do not fully comprehend the
nature of Islamic financing techniques. This is particularly true in the case of Mudarabah and
Musharakah financing whose nature is entirely different from interest based debt financing. In debt
financing, the granting of a loan is a one-time activity, no matter what the size of the loan. But
Mudarabah and Musharakah are ongoing activities and the participation of Islamic banks has to last as
long as the project re-mains in operation. It was pointed out by an Islamic bank that the concerned
central bank insists on separate approval for different stages of the same Musharakah operation. This
kind of situation results because there is little appreciation of the techniques of financing used by
Islamic banks.

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In light of the above, the following suggestions could be made for a healthier relationship between
Islamic banks and central banks:
a. It may be observed that Islamic banks, at present, control a very small portion of the total money
market in mixed environment countries. At best this share is around 10 percent of the market. If
Islamic banks are established in these countries and they claim a substantial share of the money
market, the central banks in these countries will be compelled to take notice of Islamic banking. Then
it may be hoped that central banks would resort to those techniques of regulation and control which
would be more conducive to Islamic banking.
b. Islamic banks may persuade their respective central banks to offer them some facilities in lieu of
interest free deposits they maintain with central banks. One particular facility may be the provision of
interest free loans from central banks to Islamic banks in time of need. It can be argued that as Islamic
banks do not receive interest on the deposits which they keep with the central bank, the central bank
should return the favor by providing loans on an interest free basis whenever the central bank has to
function as a lender of the last resort to Islamic banks.
c. Central banks in those countries where the entire banking system has been reorganized along
Islamic lines, may experiment with open market operations bearing non-interest based financial
papers. These may be in the form of Participation Certificates, Investment Certificates, Muqaradah
Bonds, etc. This will go a long way towards developing secondary market for Islamic banks and
providing Islamic banks with financial assets which they will be able to liquidate quickly when
necessary. Central banking in the Islamic framework and the regulation and control of Islamic banks
in a mixed environment also deserve more attention from researchers.

This study has taken note of some of the tools which are being used in Pakistan, Iran and Sudan to
regulate interest free banks: There is further need for more empirical studies, particularly to evaluate
the effectiveness of monetary policy and the tools of monetary management against the objectives and
goal which have been set for them. Similarly, studies are also required to assess, the, impact of
Islamic banking in mixed environment countries on macroeconomic magnitudes.

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8.0. Functions of Islamic central bank in an economy:

Almost all economists writing on the subject, agree that the central bank in an Islamic economy would
continue to perform all of those functions performed by central banks elsewhere. Siddiqi accepts at
the very outset that a central bank in an Islamic economy "will function under the State's control and
its aim will not be to earn profit but to safeguard the public interest" He assigns almost all of the
functions of a modern central bank to the Islamic central bank: it would be the government's bank and
the government would open all its accounts with it, it would conduct transactions domestically as well
as internationally on behalf of the government, it would issue currency, it would be a bankers' bank,
etc. However, it’s most important function would be conducting the economic and monetary policies
of the State as "the central bank will keep a close watch on the general trend of business, employment,
income and price spiral in the country and will take necessary steps to promote their general standard
and maintain them at the desired levels." Siddiqi also attaches immense importance to the "sincere
advice and guidance of the central bank" in the conduct of monetary policy. The central bank will not
only determine the priority sectors where loan finance or Mudarabah finance is required but it will
also "inform all the banks regarding any additional capital investment being conducive or detrimental
to the common interest so that they may refrain from the wastage of common resources"

Uzair points out that among the seven functions usually undertaken by modern central banks three
main functions will have to undergo significant change when the banking system is reorganized on an
interest free basis. These functions are:
i. Controlling and regulating of credit,
ii. Acting as a lender of the last resort, and
iii. Promoting banking development in the country

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9.0. Conclusion:
Modern commercial banking activity, for a variety of reasons, cannot be left uncontrolled.
Commercial banks create credit and increase the money supply which in turn affects the level and
magnitude of aggregate economic activity as measured by income, employment, price level etc.
Because of its ability to create additional amounts of money, the commercial banking sector, occupies
a strategic but precarious position in the economy. If left uncontrolled, it is possible that the banking
sector may introduce destabilizing factors in the economy by adopting unsound credit policies. Hence,
in almost all market economies, commercial banking activity is controlled and regulated by the central
bank of the country, although the degree of control may vary from economy to economy. One of the
most essential functions of a central bank, inter alia, is the regulation and control of the commercial
banking system of the country. In a modern economy, a few tools and instruments are used by the
central bank to exercise control over commercial banks. Some of the most widely used methods are:
the legal reserve ratio, open market operations and the bank rate or the discount rate policy.

The purpose of imposing a legal reserve ratio (which is also sometimes referred to as the required
reserve ratio) is not to make deposits safer or to keep banks liquid. Rather, its main purpose is to
control the credit creating capacity of commercial banks. The commercial banking system has the
capacity to create credit at several times the reserve ratio. If the reserve ratio is 10 percent, the
banking system will can generate 10 times more credit than its deposits. Thus, by raising or lowering
the reserve ratio, the central bank can reduce or increase the credit creating capacity of commercial
banks.

Open market operations refer to the purchase and sale of government securities by central banks to
commercial banks, other financial institutions and individuals in the open market. By buying and
selling securities in the open market, the central bank can expand or contract the reserves of
commercial banks, and thus, influence their credit creating capacity.

The discount rate or the bank rate is the interest charged by central banks on any advances made to
commercial banks. By introducing variations in the bank rate, the central bank, in a way, controls the
price of the credit created by commercial banks. It is assumed that if commercial banks have to pay a
higher (lower) interest rate themselves, they will charge an even higher (lower) interest rate to their
clients. Thus, the demand for credit can be lowered (increased) by increasing (decreasing) the bank
rate. In some countries, the methods of credit control include qualitative or selective methods of credit
control, moral suasion and direct orders from central banks such as credit rationing.

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10.0. Appended Part:

10.1. Abbreviations:

BIMB: Bank Islam Malaysia Berhad

BNM: Bank Negara Malaysia
BNMN-i: Bank Negara Monetary Notes-i
CDs: Certificate of Deposits.
EA: Emergency Assistance
ESF: Exogenous Shocks Facility
FCL: Flexible Credit Line
GDP: Gross Domestic Product
GII: Government Investment Issue
IAB: Islamic Accepted Bills
IBBs: Islamic banking branches
IBS: Islamic Banking Scheme
IDA: International Development Association
IIBOR: Islamic Interbank Offered Rate
IMF: International Monetary Fund
IIMM: Interbank Money Market
INI: Islamic Negotiable Instruments
IPDS: Islamic Private Debt Securities
LV: Loan Value
Mo: Monetary Base
MII: Mudarabah Interbank Investment
ODA: Open Deposit Accounts
OMO: Open Market Operations
ORR: Official Repo Rate
PRGF: Poverty Reduction and Growth Facility
QCBr: Qatar Central Bank Rate
RA-i: Ar Rahnu Agreement-I
RRR: Reserve Requirement Ratio
Repo: Repurchase Agreements
SBP: State Bank of Pakistan
SBA: Stand-By Arrangements
SBBA: Sell and Buy Back Agreement
SAMA: Saudi Monetary Agency
SBNMI: Sukuk BNM Ijarah
SDR: Special Drawing Rights
SLR: Statutory Liquidity Ratio
T-Bills: Treasury Bills
TMCL: Time Multiple Counter Loan
TSR: Transferable Subscription Right
UAE: United Arab Emirates
USA: United States of America
WA: Wadiah Acceptance
WB: World Bank
WI: When Issue

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10.2. Reference:

1. Business Recorder, Karachi (September 09, 2009) Islamic Banking Industry Registers 12%
Growth, Staff Reporter.

2. Central Bank of UAE (no date). Qualified Monetary Policy Instruments. Available at:
http://www.centralbank.ae/tools.php (Accessed: October 10, 2009)

3. Central Bank of Sudan (2009). Central Bank of Sudan Policies for 2009. Available at:
http://www.bankofsudan.org/ (Accessed: October 10, 2009)

4. Central Bank of Oman (no date). Treasury Bills & Certificate of Deposits. Available at:
http://www.cbo-oman.org/ (Accessed: October 10, 2009)

5. Chandavarkar, Anand (1996). “Central Banking in developing countries”. New York: Macmillan
Press Ltd.

6. Chapra, Umer M. (1983). “Monetary Policy in an Islamic Economy”. Islamabad: Institute of Policy
Studies.

7. Darrat, Ali, F. & Bashir, M. Abdul-Hameed (2000). “Modeling Monetary Control in an Interest
Free Economy”. J.KAU: Islamic Economics, Vol. 12, pp. 3-19.

8. Islamic Interbank Money Market (2009). Islamic Interbank Money Market Information. Available
at: http://iimm.bnm.gov.my/ (Accessed: October 12, 2009)

9. Kazmi, Shabbir H. (2009). “Wakalah and Musharakah for Pakistan’s Interbank”. Red Money
Group.

10. Khan, Muhammad A. (2004). “Elimination of Interest: A Proposed Strategy”. Renaissance. Vol
14, Issue 1.

11. Khan, Muhammad A. (1982). “Inflation and the Islamic Economy – A Closed Economy Model.”
International Centre for Research in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

12. Kurrihara, K.K., (1951) Monetary Theory and Public Policy, in ed. Shaikh, Mehmood A. (1990),
Towards Interest Free Banking, Lahore: Institute of Islamic Culture.

13. Mannan, Abdul M. (1982).” Interest Free Islamic Economy – A Comparative Policy Approach.”
International Centre for Research in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

14. Osservatore. Vatican. (March 04, 2009). “Islamic Banking May Help Overcome Crisis”. Press
Release.

15. Qatar Central Bank (no date). Monetary Policy Tools. Available at:
http://www.qcb.gov.qa/English/PolicyFrameWork/MonetaryPolicy/MonetaryPolicyTools/Pages/Mon
etapolicyTools.aspx (Accessed: October 10, 2009)

16. Reddy, B.Muralidhar (2001). “Of Religion and Economics”. Frontline. Vol. 18, Issue 11.

17. Siddiqui, Muhammad N. (1982).” Monetary Policy – A Review.” International Centre for
Research
in Islamic Economics. Jeddah: Kind Abdul Aziz University Press.

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18. Shaikh, Mehmood A. (1990). “Towards Interest Free Banking.” Lahore: Institute of Islamic
Culture.

19. State Bank of Pakistan (2009) Strategic Plan for Islamic Banking 2009, Karachi.

20. The Economist. [June 14, 2007]. “Tighter Monetary Policy”. Monetary Policy Section. The
Economist Newspaper Limited.

21. Usmani, Muhammad T. (2003). “Islam Aur Jadid Maeeshat-o-TIjaraht”. Karachi: Maktaba
Ma’ariful Quran.

22. Zangeneh, Hamid & Salam, Ahmed (1993).Central banking in an Interest Free Banking System.
JKAU: Islamic Economics, Vol. 5, pp. 25-36.

23. Zaheer, Dr. Khalid (1996). “A Critical Look at the Alternatives to the Popular Models of Interest
Free (IF) Banking”. Renaissance. Vol 6 Issue 6.

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11.0. Question-Answer:
Q1. What are the functions played by Central Bank in Islamic Banking?

There are three features of the relationship between Islamic banks and central banks irrespective of
the host country namely;

 It acts as a lender of last resort- this element enables central banks to control the supply
of money to the commercial banks therefore the public. The loans are given to conventional
banks to provide liquidity; however, they are done based on interest accumulation which is
prohibited in Islamic finance.

To ‘halalify’ the loaning, the central bank instead of charging interest to the loans given to Islamic
banks, instead settle on the profit and risk sharing policy of the sharia-compliant institution and
instead take a share in the returns of the Islamic bank’s investment of the loaned money over the pre-
determined period of profit-making.

 It acts as a clearing house- In the modern Islamic banking structure, central banks supply
Islamic banks with provisions for the defrayal of cheques and other disbursements and also
facilities such as documentary letters of credit and guarantee for a charge.

The Islamic bank establishes a current account with the central bank with the clearing system and
restricted short-term provisional overdraft services which are also free of interest. The Islamic bank is
sometimes allowed to pay for any transitory deficits for clearance reasons. For returns, the central
bank may allow partial temporary services interest-free of Islamic banks on the agreement that the
Islamic bank would share their profits during the deficit phase.

 Lastly, it acts as a supervisor regarding monetary policy- the central bank regulates credit
availability and inflation via money to manage a stable economic growth. The central bank is
obliged to create blueprints and types of standard data needed from Islamic banks to be
utilized by Islamic bank agents and the central bank itself so as to adhere to the principles of
Islamic banks procedures.

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Q2. How should central banking operations be conducted in an interest free environment in Islamic
banking?

Central banking in an interest free environment. Fortunately, the problem of central banking in the
Islamic framework was addressed in the initial phases of the theoretical research on Islamic banking.
The emergence of Islamic banks in the mid-1970s and the adoption of an Islamic banking system by
Pakistan and Iran in the early 1980s led to renewed interest in this area and several papers appeared
on monetary policy and the central banking system in the Islamic framework. Islamic banking is
based on interest free banking that conforms to the Islamic law or shariah that prohibits interest on all
types of loans. The conduction of interest free Banking in central banking operation is profit and loss
sharing. Both the supplier of the capital and the borrower share the risk and both suffer together when
returns are poor. Islamic banks will fit only if one replaces “interest rates paid” with “profit-shares
and fees”. Islamic banking and prohibition of interest was not founded on the principles of economics.
It was developed as a result of a decree sent by the almighty creator Allah (Ghannadian and Goswami,
2004). With the elimination of riba, appropriate mechanisms need to be developed to make feasible
the workings of the Islamic financial system (Luqman, 1999).

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Q3. What are lack of central banking accurate legal frame for Islamic bank’s mortgages?

The Islamic mortgage legal form in the world relies on two forms of lease financing in order to Offer
its services. On the one hand, the lease that leads to ownership is quite different from the hire-
purchase agreement, with which English law is familiar, and it is quite different from normal lease.
Further, it is not covered by the central bank’s current mortgage regulations (regulated mortgages
contracts). Therefore, customers do not enjoy the level of protection offered to the holder of a
conventional mortgage. On the other hand, although the lease and diminishing partnership was
recognized by the regulator in the secondary regulation of home purchase plans, the regulation is still
unable to provide the required quality of protection. Further, under the current laws, the application or
this mortgage model proves to be relatively costly, which affects its ability to compete with
conventional mortgages. This can be assigned to the extra-legal fees paid in this transaction because
two sets of lawyers would be required since there are two conveyances.

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