MBF707: Monetary and Fiscal Framework in Islamic Finance COMSATS Institute of Information Technology (Virtual Campus)

Lecture 27 The Financial System and Monetary Policy in an Islamic Economy 2

Review of the Last Lecture  FP Model Development  Discretionary fiscal policy, the government varies the disbursement of Zakat to the recipients and the exemption levels to the Zakat payers whenever necessary during the phases of the business cycle.  Expansion phase of business cycle :the government may want to decrease Zakat disbursement and exemption levels to reduce aggregate spending of Zakat payers and thus prevent the economy from overheating.  Baitul-Mal. Plays the role of B.Cycle management  Zakat Recipients Increase during the recession  Zakat Payers Increase during the boom. 3

Review of the Last Lecture  Zakat exemption levels can be increased when economy is in downswing.  Islamic State may impose taxes when its revenues are insufficient to cover its spending implying that taxation and government spending are compatible with Islam.  Zakat, government spending, and taxation complement each other as stabilization policy. 4

Topics to Cover  Characteristics of an Islamic financial system.  Actual practice of Islamic banking.  Theoretical model of an Islamic economic system VS standard IS-LM model  Expansionary MP-reducing rates of return. 5

Introduction  Absolute prohibition of interest-Central feature of an Islamic financial system.  Economies have to chose economic systems closer to the Islamic law  Restructure their banking Systems.  Ending the interest rate, permitting uncertain rate of return.  Iran, Pakistan, other Islamic countries. 6

Introduction-MP  Islamic banking is equity-based system in which depositors are treated as shareholders of the bank.  Rate return is negative/positive.  Depositor's perspective-mutual fund or investment trust  Use special modes of investment and financing based on the profit and loss sharing.  Financial instruments do not have a fixed nominal value or a predetermined rate of interest.  Finding the suitable substitutes in MP in Islamic economies. 7

Introduction-MP  Literature on Islamic banking has focused on the development of financial instruments  Monetary policy in an Islamic economy has also been addressed recently in a number of papers.  There are a number of policy instruments available for controlling domestic liquidity even if discount rate and open market operations.  Changes in reserve requirements, overall and selective controls on credit flows, changes in the monetary base through management of currency issue, and moral suasion (Akram Khan, 1982; Siddiqi, 1982). 8

Introduction-MP  Open market operations can be conducted with securities that do not bear a fixed rate of return.  The monetary authorities can directly change the rates of return on both deposits and loans by altering the ratios in which the banks and the public are expected to share in the profits and losses  It is still a controversial issue to change a contractually-determined ratio.  Regulating profit sharing ratios to achieve the goal of monetary stability, without affecting existing depositors. 9

Introduction-MP  The studies provide financial instruments but do not analyze how these would actually operate in an Islamic environment.  Indeed, little work has been done of a formal nature on the financial system and the general role of monetary policy in an Islamic economy.  We describe main characteristics of an Islamic financial system.  These features develop a simple theoretical model of the Islamic economic system. 10

Introduction-MP  This model addresses some of the main issues of concern to the monetary authorities in Islamic countries.  These issues include, the relationship between the instruments that a central bank in an Islamic economy has at its disposal and overall financial conditions in the economy, and the effects of monetary changes on macroeconomic variables. 11

Institutional Characteristics of an Islamic Banking System 1. Sources or funds  Besides own capital and equity, the main sources of funds for Islamic banks are 1.Transaction deposits 2.Investment deposits. 12

Characteristics Transaction Deposits  Deposits are directly related to transactions and payments-demand deposits.  Banks would guarantee the nominal value of the deposit but pay no interest on this type of liability.  Banks provide services to the holders of transaction deposits-checking facilities.  Funds cannot be used for profitable investment by banks. 13

Characteristics Transaction Deposits  Banks levy a service charge on deposit holders to cover the costs of administering.  These deposits should have a 100 percent reserve requirement in the form of currency, foreign exchange, or suitable government securities.  This reserve requirement would also prevent the possibility of a banking crisis from interfering with the payments mechanism. 14

Characteristics-Investment Deposits  These are the principal source of funds for banks.  They resemble shares in a firm, rather than time and savings deposits of the customary sort.  No guarantee on their nominal value, and banks would not pay a fixed rate of return.  The depositor would be treated as a shareholder in the bank and therefore entitled to a share profits  Conventional banking systems guarantees the nominal value of deposit (bank or government) through deposit insurance. 15

Characteristics-Investment Deposits  Distributable profits would be calculated by setting off administrative expenses, provisions for taxes and reserves, and payments due to the central bank and other banks in respect of the financing provided by them, from total profits.  The net profits would be divided between the shareholders of the banks and the holders of investment deposits as per formula that takes into account the relative contributions of capital and equity, and investment deposits, to the profitability of the bank. 16

Characteristics-Investment Deposits  Deposit holders would not typically have any say in the management of the bank, and second, dividends on common stock would be discretionary on the part of bank management.  Investment deposits would always yield a constant proportion of profits.  Information costs will increase to evaluate the relative performances of various banks in order to decide where to invest. 17

Characteristics-Investment Deposits  Information costs can be significantly reduced if there is a secondary market in which investment deposit certificates are traded.  An equity-based system of this type can respond more easily and rapidly in the face of a banking crisis.  In the traditional banking system the bank is expected to guarantee the nominal value of the deposit, and a shock can cause a divergence between the real value of assets and liabilities. 18

Characteristics-Investment Deposits  If the bank cannot absorb losses through its reserves and borrowings from the central bank, this divergence may well result in instability and collapse of the payments mechanism.  With the value of deposits directly linked to the earnings such a possibility is excluded from the Islamic banking system. 19

Thank You 20