1. ISLAMIC DEVELOPMENT BANK Seminar on Islamic Finance BANCA DITALIA (Rome,11 November 2009) Second session 12.00 a.m Monetary Policy and Liquidity Management

2. Objectives of monetary policy in an Islamic economy Economic well-being with full employment and optimum rate of economic growth; Socio-economic justice and equitable distribution of income and wealth; and Stability in the value of money to enable the medium of exchange to be a reliable unit of account, a just standard of deferred payments and a stable store of value.

3. Instruments of monetary policy in an Islamic economy All conventional tools normally available in a modern economy are at the disposal of the monetary authorities the exception are the tools that involve the use of interest rate such as : The discount rate Open Market Operations that can be done on the basis of Shariah approved instruments

4. Current structure of the Islamic money market The short-term instruments dominated by (but not restricted to) Interbank mutual financing facilities within the profit- sharing framework among Institutions offering only Islamic Financial Services (IIFS). Interbank transactions between conventional and Islamic counterparties based on Commodity Murabahah contract, or Special arrangements for holding compensating non-interest-bearing deposits between Islamic banks.Commodity Murabahah compensating non-interest-bearing deposits

5. Long-term instruments Islamic money market and public financing instruments based on Islamic asset securitisation of various underlying Shari`ah-compliant contracts, have led to operations based on Sukuk suitable for interbank money market transactions, and monetary management. Example Government Investment Certificates (GICs)Government Investment Certificates (GICs)

6. Monetary Policy Operations Market-based monetary operations are not well developed. Only some of money and capital market instruments are negotiable in secondary markets. Their volumes is relatively small and they are not yet suitable for flexible asset–liability management by IIFS and monetary operations by central banks. Central banks apply the same treatment to IIFS and conventional banks. Most features of the reserve requirement system (such as the length of the base period, the reserve maintenance arrangement, etc.) are the same. Most central banks do not give return on the required or excess reserves of IIFS. All central banks impose penalties on reserve shortfalls, but the method of charging the penalties differs in some jurisdictions. This led to different demand for central bank balances between conventional and Islamic banks.

7. Foreign exchange swaps are not approved by certain Shariah Boards. This limits the use of foreign exchange operations as tools to influence domestic monetary conditions.

8. Summary of issues and challenges Under-development or non-existence of a formal or organised Islamic money market in one form or another. Limited options for central banks to consider for effective open-market type operations using Shari`ah-compliant tools. Low liquidity in the Islamic money market due to the limited number of market participants and the small size of their transactions. Shortage of Shari`ah-compliant money market instruments requires IIFS to hold a substantial portion of their assets in the form of cash (with minimum or no return) which could affect their profitability and competitiveness.

9. continued IIFS tend to hold Islamic money market papers until maturity instead of trading. Negatively impact on general market depth/liquidity, mark-to-market pricing practices and liquidity of IIFS assets. Inadequacy of existing Shari`ah-compliant money market instruments, dominated by Mu_arabah-type or with linkages to commodity markets for active secondary market. Absence of lender of last resort privileges with central banks such as discount window and Lombard facilities for day-to-day liquidity management of IIFS. Reliance on conventional interest-based indices due to the limited availability of benchmark rates of return that reflect better the domestic monetary and financial conditions of the IFSI.

10. continued The interbank money market is segmented between Islamic and conventional banks. IIFS rely on interbank arrangements with other IIFS, and on special arrangements between IIFS and conventional banks. Islamic money markets are not well integrated into the overall money markets in most jurisdictions. Different interpretations of Shari`ah rulings, on financial matters has led to differing methods of structuring financial instruments, and to non- recognition of some contracts. The cost of issuance, for instruments that are designed through asset securitisation, exceed that for conventional issues.

11. Way Forward Design simple Islamic money market and Islamic Government financing instruments with relatively low risk, regularly issued, can be held by both Islamic and conventional banks, as well as non-banks, to avoid segmentation of money markets, and supported by a robust payment and settlement system. Incorporate Islamic Government finance instruments as an integral part of the overall public debt and financing programme, and foster the development of an Islamic Government securities market. Actively use Islamic Government finance instruments in market-based monetary operations of the central bank to manage liquidity in the Islamic money market.

12. Continued Develop efficient trading arrangements and the associated market microstructure for Islamic money and Government finance instruments, and develop in parallel the foreign exchange markets. Provide supervisory guidance and incentives for effective liquidity risk and asset liability management by IIFS, and in parallel foster privately issued Islamic money market securities.

13. THE END THANK YOU

14. Commodity Murabahah Interbank funds are used to execute a Murabahah transaction in a commodity, with the proceeds (net of commissions) passed on to the bank providing the fund. Another variation, a bank with surplus funds to buy metals (other than gold and silver) on international commodity market) and then sell them the same day to a counterparty for a deferred payment at a price equal to the purchase price plus mark-up

15. Compensating mutual balances Exchange of interest-free deposits with arrangements to ensure that net balances average to zero in a defined period.

16. An asset-based security issued against a number of contracts, including Ijarah, Salam, Mu_arabah and Istisna. The relationship between the holder of a GIC and the issuer is based on a restricted Mu_arabah contract. The instruments profile ranges from two to six years. The expected return is determined by the fixed rental income on Ijarah plus the income from the sale of Murabahah, Salam and Istisna contracts. Profit is distributed every three or six months. Sales of primary issues are made through an auction system. The GIC is listed on the stock exchange(Sudan) (GICs)Government Investment Certificates