Making monetary transmission mechanism operational for Islamic finance

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Relying on market-based instruments to conduct monetary policy in an economy with Islamic banks is preferable than relying on direct instruments of monetary control for both conventional and Islamic banks. Direct instruments are often associated to non-transparent discretionary interventions that may result in a liquidity misallocation. They can create distortions in favor of some sectors of the economy or segments of the banking system, impairing banks competition and interbank markets development. When implemented in a surplus liquidity situation without an appropriate liquidity forecasting framework, direct instruments of monetary control can aggravate the liquidity overhang.
To incorporate Islamic banks in the monetary policy framework, two important dimensions need to be considered. The first one is the challenge of developing the basic infrastructure necessary for a market-based Islamic monetary policy. The second is addressing more broadly the continuous evolution of the monetary policy framework. Developing Islamic money and Sukuk markets, as well as addressing the factors that give rise to market segmentation belong to the first dimension. Addressing potential spillovers from one segment of the financial system to another has implication for the monetary policy and financial stability. Competition among Islamic banks is a precondition for the development of Islamic interbank markets.
A small number of Islamic banks or a dominant role of government owned banks limits the scope of interbank market development and monetary transmission more generally. Market segmentation between conventional and Islamic banking systems can be a challenge for the conduct of monetary policy. In some countries with dual banking systems, Islamic banks are not participating in CB’s conventional monetary operations and interbank markets, creating segmentation between Islamic and conventional money markets.
While conventional banks use several money markets instruments to manage efficiently their liquidity, Islamic banks face greater difficulties as they cannot access markets that do not comply with the Islamic finance rules. Inefficient liquidity management reduces Islamic banks profitability, as they need to maintain more liquidity than strictly necessary. The IFSB Technical Note on Islamic Money Markets argues that there is an evidence of market segmentation between Islamic and conventional banking systems, as IIFS rely primarily on interbank arrangements with other IIFS, with limited usage of transactions between IIFS and conventional banks. This segmentation can hamper the well-functioning and development of liquid money markets particularly when the number of Islamic banks in the system is small represent a small share of the overall financial system in dual financial systems and interbank market instruments that are limited to Islamic financial institutions alone seldom have the scale and volume needed to generate a liquid interbank market.
Active Islamic interbank markets are crucial for monetary policy transmission through the Islamic financial system. Interbank markets allow liquidity to circulate through the banking system and reach its most needing segments. Developed interbank Mudarabah markets allow the transmission of monetary policy changes through profit-sharing ratios. Active FX interbank markets are also important for monetary policy transmission through the exchange rate channel.
The basic infrastructure for a market-based Islamic monetary policy should comprise: (i) Islamic collateralized money-market instruments for liquidity management; (ii) high quality marketable collateral (in sufficient amounts); (iii) active interbank Mudarabah and collateralized interbank markets; (iv) efficient operational framework; and (v) adequate payment and settlement systems . The operational framework should ideally encompass structural operations, such as the issuance of sovereign securities and outright purchases/sales of securities, and short-term monetary policy instruments needed to manage short-term liquidity shocks. Other options might be considered as alternatives to the interbank Mudarabah. However, favoring the development of the interbank market at an early stage may require the standardization of interbank arrangements as the first stage and introducing other types of contracts gradually. To this purpose, analyzing the comparative advantage of the interbank Mudarabah relative to other structures of interbank transactions might be useful when considering strategies of Islamic interbank markets development. This includes carefully assessing the Sharia-compliance risk of each structure. An adequate financial market infrastructure-including the adaptation and upgrading of payment and settlement systems-is necessary to facilitate the transmission of monetary policy actions through the Islamic financial system. In particular, the “dematerialization” of government securities, and effective delivery-versus-payment and collateral mobilization procedures are important prerequisites for smooth monetary operations. Dematerialization refers to the issuance and recording of securities in electronic format.