A. Overview of the Monetary Transmission Mechanism

The monetary transmission mechanism (MTM) differs from one economy to another and changes over time. The intensity of nominal rigidities, market imperfections, other distortions arising from government interferences, the degree of financial development and openness, as well as potential constraints on the supply and demand side of credit are important determinants of a country’s MTM. Understanding monetary policy transmission is a prerequisite to monetary policy implementation in general, but especially in dual financial systems.³ As a starting point, this section focuses on the bank lending or financing channel as well as the interest rate and exchange rate channels in the presence of Islamic banking (Figure 3).⁴

View Full Size

The Monetary Transmission Mechanism

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: Kuttner and Moser (2002).

• Download Figure
• Download figure as PowerPoint slide

The credit channel

The credit channel recognizes that monetary policy impacts the economic activity not only through the interest rate’s influence on aggregate demand but also through shifts in the supply of credit.⁸ The credit channel operates through two mechanisms: the bank lending channel (i.e. the narrow credit channel) and the balance sheet channel (i.e. the broad credit channel). Under imperfect substitutability of the retail and wholesale funding of banks, monetary policy transmission through the bank lending channel operates through the money multiplier: a change in reserve balances affects banks’ deposits and the supply of credit.⁹ However, the bank lending channel tends to weaken with financial liberalization, especially when banks have relatively easy access to external sources of funding.¹⁰ In advanced economies, the effectiveness of the credit channel is subject of debate with several researches arguing that banks balance sheets, and not just bank credit, is the main channel of monetary policy transmission.

The country’s financial structure is a key determinant of monetary transmission through the bank-lending channel. This channel tends to be more “potent” and effective for banks with less liquid balance sheets, when small banks dominate the financial sector and firms have limited access to nonbank funding sources. Highly liquid banks weaken the bank lending channel.¹¹

Other factors affect the supply and demand for credit and the effectiveness of the bank lending channel. On the supply side, the presence of weak banks, their inability to properly assess risks, weak property rights and poor judiciary systems generally constrain the flow of credit to the private sector. On the demand side, the economic structure (more-or-less bank-based or market-based), and the relative importance of credit-dependent SMEs and large firms that can borrow directly from financial markets, are key drivers of the demand for credit. Sizable informal finance may also limit the demand of credit channeled through the formal financial sector. In general, the relationship between credit demand and supply is complex, and distinguishing demand-side from supply-side drivers is not straightforward either conceptually or empirically (Figure 4).

View Full Size

Credit Demand and Supply Following an Adverse Macroeconomic Shock—Conventional System

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: April 2013 GFSR.

• Download Figure
• Download figure as PowerPoint slide

Government policies can interfere with the free functioning of credit markets and thus with the credit channel. Government interventions can introduce distortions in credit markets in many ways including through interest rate controls, bank lending ceilings, and selective credit policies.¹² Fiscal dominant regimes can crowd-out the supply of credit to the private sector, especially in the presence of high financing needs, but they also impair the interest rate channel.

B. Relevance of the Bank Lending Channel for Islamic Banks

In dual financial systems where both the conventional and Islamic segments are at early stage of development, reserve balances may play a central role in the conduct of monetary policy. In such context, the effectiveness of the bank lending—or financing—channel for Islamic banks will depend on (i) the CB’s capacity to be one of the main suppliers of liquidity for Islamic banks, and (ii) the Islamic banks’ capacity to shift their supply of credit/financing in response to changes in their reserve balances at the CB. According to the IMF Islamic banking survey results of 2012, 81 percent of the central banks have responded applying reserve requirements (RR) to Islamic banks. In cases where banks (Islamic and conventional) are in surplus liquidity or have fluid access to wholesale funding, or when there are binding constraints on the supply and demand of credit, the bank lending channel and the Islamic financing channel may tend to be ineffective. The extent to which CBs can affect the supply of Islamic credit/financing through changes in banks’ reserves is an important area that requires further empirical investigation.

At present, most countries with Islamic banks operate regimes with fixed exchange rates that are subject to important liquidity shocks. When CBs do not have the appropriate tools, capacities, and processes to offset these shocks, they can be transmitted to the economic activity and therefore influence the economic and financial cycles. Governments’ cash management can interfere with the conduct of monetary policy whenever public treasuries transactions and deposits with the banking system induce important fluctuations of systemic liquidity. In particular, the combination of oil shocks, oversized public sectors, poor government cash management, lack of sterilization policies, and weak liquidity management can result in ineffective monetary policy.

C. The Interest Rate Channel in the Presence of Islamic Banking

In dual financial systems with fairly developed conventional money markets, Islamic banks evolve in an interest rate dominant environment. Due to arbitrage between conventional and Islamic financial systems, there tends to be spillovers from conventional interest rates to Islamic banks funding costs, to returns of profit-sharing investment accounts (PSIAs) as well as to costs of Islamic credit (see Box 1).¹⁵

In dual systems where Islamic finance is still embryonic, there is often no Islamic finance equivalent to money market or government securities yield curves that can serve as references to price Islamic banks credit. As a result, some Islamic banks tend to rely on conventional interest rates to price their Murabahah and Ijarah contracts.¹⁶ Nonetheless, even when resorting to conventional interest rates to price Islamic credit, Islamic banks can be more-or-less reactive to changes of conventional policy rates. If Islamic banks’ reactions to changes of conventional interest rates are sluggish, monetary policy transmission through the interest rate channel will be less effective in the presence of sizable Islamic banking.

D. The Signaling Mechanism and the Profit-sharing Principle

The development of Islamic interbank Mudarabah markets introduces other channels through which monetary policy can be transmitted. In addition to the interest rate, the exchange rate or the RR instruments used in conventional systems, in dual systems CBs can also try to influence Islamic banks’ funding costs by targeting the profit-sharing ratio of Interbank Mudarabah transactions. The effectiveness of this monetary policy instrument depends on the level of development of Islamic financial markets.

The extent to which monetary policy affects the profit-sharing ratios through the signaling mechanism is another area that deserves further empirical investigation. In theory, CBs can affect interbank Mudarabah markets profit-sharing ratios by setting the profit-sharing ratios of their Mudarabah transactions with Islamic banks; Islamic banks can, in turn, set the profit-sharing ratios of Islamic contracts with their clients. However, there is no empirical evidence supporting the notion that the profit-sharing mechanism is an effective monetary policy channel and that economic agents make their investment and consumption decisions according to the profit-sharing ratio set by the CB. The results so far suggest that when the profit-and-loss sharing contracts such as Mudarabah are not widely used by banks, consumers and firms, this monetary transmission channel breaks down or is too weak. Figure 5 shows a simplified sketch of the monetary policy transmission in dual financial systems with sufficiently developed Islamic banking system and interbank markets.

View Full Size

Monetary Transmission Mechanism in Dual Financial Systems

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: based on Husin (2013).

• Download Figure
• Download figure as PowerPoint slide

Signaling the monetary policy stance helps the formation of market expectations and eases monetary transmission through the expectation channel.²² CBs communication typically goes beyond the policy rate and encompasses features related to macroeconomic forecasts, monetary policy strategies as well as monetary operations. To develop this channel, CBs in economies with Islamic banks should try to communicate information related to Islamic banks liquidity conditions, interbank markets, and their Shari’ah-compliant operational framework. In facts, in its Guiding Principles of Liquidity Risk Management for IIFS, the Islamic Financial Services Board (IFSB) suggested that “supervisory authorities should provide greater clarity of their roles in both normal and stressed times” and “should be more explicit regarding their handling of a liquidity crisis situation, such as defining the type of Shari’ah-compliant collateral that can be pledged, the limits applicable to various types of eligible Shari’ah-compliant collateral, and possible durations of the financing”.²³

A. The Dual Monetary Policy Regime

In countries with relatively underdeveloped financial markets (e.g. countries with low ratios of credit to GDP), the conduct of monetary policy is fundamentally different from that in countries with developed financial systems (Figure 6). In the former, monetary policy tends to be more focused on the supply of credit. At an early stage of financial systems development, CBs actions generally aim to affect the supply of conventional credit through refinancing policies—when there is a liquidity deficit—or the use of credit as collateral, and gradually introduce government securities as eligible collateral as markets for these securities develop. In presence of structural excess liquidity, it is important to distinguish situations where the excess liquidity fuels a credit boom from those where other factors affecting the supply and demand for credit constrain lending.

View Full Size

Domestic Credit to the Private Sector (1960–2013)

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: WDI.

• Download Figure
• Download figure as PowerPoint slide

In dual financial systems, it is often the case that the conventional segment is more developed than the Islamic one. Addressing the shallowness of the Islamic segment when the conventional system is developed is challenging. Clearly, monetary policy cannot operate in the same way when the dual financial markets have different levels of development. Further, as some economic activities are prohibited under Islamic rules, Islamic credit might not flow through the economic sectors as conventional credit.²⁴ Whether monetary policy will have broadly similar effects on the conventional and Islamic segments of the market will depend on several factors including: the size of the Islamic segment relative to the conventional one; the jurisdiction; the structure of Islamic contracts; the behavior of consumers and Islamic banks; and the extent to which consumers are responsive to changes in interest rates. In some cases, Islamic banks clients can be indifferent to the level or changes in returns of the PSIAs or cost of Islamic credit mainly due to their deep religious beliefs. However, in other countries consumers’ arbitrages may lead to a convergence of returns of PSIAs and costs of Islamic credit to conventional banks’ deposits and lending rates.

Designing a monetary policy framework for countries where Islamic finance reaches an important share of the financial system entails different levels of complexity. The first one is related to the Islamic finance core principles and the cautious interpretation of the Shari’ah rules; the second one, is the heterogeneity of the financial systems and monetary policy frameworks; and the third one, is the relationship between monetary policy, financial development and financial stability policies for Islamic banks.

B. Fixed Exchange Rate Regimes Considerations

As noted earlier, pegged exchange rate regimes limit the CBs’ ability to significantly influence monetary conditions through changes in quantities. Even in cases when there is some exchange rate flexibility, external vulnerabilities and high exchange rate pass-through may constrain the ability of CBs to stimulate credit through large liquidity injections.²⁵ Hence, monetary policies aimed at significantly expanding banks reserves can be challenging in many countries where Islamic banks operate. For these countries, the level of FX reserves and the control over systemic liquidity are key features of the viability of the exchange rate anchor.

CBs with fixed exchange rate regimes are limited in their capacity to freely manipulate a policy rate—especially under high capital mobility—but can still enhance their liquidity management. This requires having in place adequate sterilization policies and monetary policy instruments aimed at offsetting liquidity shocks, thereby supporting market development.

C. Making Monetary Transmission Operational

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.²⁶

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.²⁷ 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. IIFS usually 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 (Figure 7). 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 Shari’ah-compliance risk of each structure.

View Full Size

Islamic Monetary Operations Infrastructure: Building Blocks

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: the author.

• Download Figure
• Download figure as PowerPoint slide

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”²⁸ of government securities, and effective delivery-versus-payment and collateral mobilization procedures are important prerequisites for smooth monetary operations.

A. Sterilization Policies

As in conventional financial systems, excess liquidity has to be managed properly to enhance monetary policy transmission through the Islamic banking system. One of the characteristics of Islamic banks around the world is that they often are in surplus liquidity. Key reasons for this include: prohibition on interest rates; insufficient sterilization; lack of Shari’ah-compliant High Quality Liquid Assets (HQLA) and more generally insufficiently developed Islamic financial markets. Islamic banks have not been able neither to create viable Shari’ah-compliant money markets nor to effectively participate in the prevailing conventional money markets. This outcome was largely the result of difficulties in developing Shari’ah-compliant interbank markets when the size of the industry could not, in many jurisdictions, justify or support the creation of such markets. Finally, the constraints have been compounded by insufficient issuing of sovereign Sukuk, even if recently on a growing trend. In extreme cases, surplus liquidity can be aggravated by monetary financing of government deficits and weak government cash management. Addressing the surplus liquidity issue requires first identifying its main causes, and deploying the adequate combination of fiscal, monetary, foreign exchange, and market development policies to eliminate them.

Sterilization of Islamic banks structural liquidity surpluses should be considered in a broader approach that does not rely exclusively on a CB Shari’ah-compliant short-term liquidity absorption instrument, but also on the development of structural and/or long-term sterilization tools. Surplus liquidity can originate not only from CBs unsterilized FX interventions but also from other factors such as the persistence of direct monetary financing of government activities or CBs quantitative measures. When the source of surplus liquidity is monetary financing, then it should be prohibited preferably than having the CB offsetting the effect of government expenditures with its short-term monetary operations. Sterilization is also a policy or a strategy because CBs have usually to choose among different types of structural and/or long-term instruments such as the issuance of CBs securities, government securities or RR, and consider the best option or combination of these instruments.

Relying exclusively on RR to sterilize large liquidity surpluses can constrain the growth of Islamic credit if RR are not remunerated. Setting RR at a certain level is generally appropriate, especially when combined with an averaging mechanism, as it helps create a structural refinancing need while reducing the volatility of banks’ funding costs. Nonetheless, because Islamic banks reserves are typically not remunerated, imposing high RR ratios creates distortions and tends to increase the cost of Islamic credit. If Islamic banks’ reserves could be remunerated through Shari’ah-compliant mechanisms, RR would be more easily used as an effective sterilization mean. In practice, when applying RR, CBs operating in the context of Islamic banks tend to harmonize their features through conventional and Islamic banks except for the return: there is generally no return on Islamic banks’ RR while there can be for conventional banks. Not all CBs in these economies, however apply RR to PSIAs.

The development of HQLA that Islamic banks can use as collateral plays an important role in successful sterilization policies. However, monetary policy cannot rely solely on government Sukuk issuances as they cannot substitute for standing facilities (SFs) and standard open market operations (OMOs), but they can provide the necessary collateral to CBs to offer SFs and OMOs to Islamic banks through a Shari’ah-compliant manner. In full-fledged Islamic banking systems, public investment on infrastructure were often used to issue government securities for monetary policy purposes.

Examples of government instruments issued to absorb liquidity surpluses are the Government Investment Certificates (GICs) in Sudan. GICs were mainly designed as long term Ijarah contracts involving payment of rentals by the government for durable assets sold. The leased assets were owned by a Special Purpose Vehicle (SPV), which enters into a lease agreement with the government, and issues securities to the public in order to finance the purchase of assets. Recently, Godlewski, Turk, and Weill (2014) have found that the structure of Sukuk matters in terms of its acceptance and potential of development. In particular, the Ijarah-based Sukuk appear to have the lower Shari’ah-compliance risk compared to other types of Sukuk, and a higher potential of development due to better investor’s reaction to them compared to other structures.

Islamic CBs securities also have been issued to mop up structural excess liquidity. In Bahrain and Malaysia, Sukuk or other Shari’ah-compliant papers were issued over different maturities.²⁹ When the markets for CBs securities are undeveloped, it is possible to resort to government securities. The use of government securities can help introduce discipline and transparency to government debt and cash management, curtail direct monetary financing of government activities and fosters financial markets development. Issuing CBs securities on the other hand can create competition with government securities markets especially at early stage of their development and when coordination between the CB and the Ministry of Finance (MoF) is weak, and may result in market fragmentation. In addition, these securities can generate losses for the CB.³⁰ Continuous issuance of CBs’ securities requires persistent levels of surplus liquidity. When monetary financing is not allowed and CBs have not heavily monetized the economy, excess liquidity often originates from FX reserves accumulation that depends on global macrofinancial conditions. In the post-GFC crisis, many developing and emerging markets switched from a situation of liquidity surplus to deficit limiting the scope for issuance of CBs securities. Stopping CBs issuances can create a gap in the short end of the yield curve impairing monetary transmission.

There might be some cases where the issuance of CBs’ securities is unavoidable especially when there is no possible agreement between the CB and the MoF to issue government securities for sterilization purposes and when large and persistent liquidity surpluses impair the conduct of monetary policy. However, whenever such agreement can be reached and government securities markets are not yet developed, it is preferable to focus on developing those instruments first (Table 2).³¹

Table 2.

Sterilization under Islamic Banking: Key Considerations

Table 2.

Sterilization under Islamic Banking: Key Considerations

STERILIZATION INTRUMENT	PROs	CONs
Reserve Requirements	Under CB’s control Powerful effect on credit	Not remunerated for Islamic banks ⇒ Increase cost of Islamic credit Non market-based instrument
Central banks securities	Under CB’s control	Require persistent levels of surplus liquidity to maintain regular issuances Can compete with government securities at early stage of development Can generate losses to the CB
Government securities	Sterilization costs borne by the government CBs preferred collateral Development of a benchmark yield curve Impose discipline and transparency to debt management	Large fiscal surpluses Crowd out of private credit at early stage of development
Stabilization funds	Permanently insulate the economy from FX inflows	Mainly a solution when excess liquidity source is FX

View Table

Table 2.

Sterilization under Islamic Banking: Key Considerations

STERILIZATION INTRUMENT	PROs	CONs
Reserve Requirements	Under CB’s control Powerful effect on credit	Not remunerated for Islamic banks ⇒ Increase cost of Islamic credit Non market-based instrument
Central banks securities	Under CB’s control	Require persistent levels of surplus liquidity to maintain regular issuances Can compete with government securities at early stage of development Can generate losses to the CB
Government securities	Sterilization costs borne by the government CBs preferred collateral Development of a benchmark yield curve Impose discipline and transparency to debt management	Large fiscal surpluses Crowd out of private credit at early stage of development
Stabilization funds	Permanently insulate the economy from FX inflows	Mainly a solution when excess liquidity source is FX

B. Monetary Policy Operational Framework

While the majority of countries where Islamic banking is reaching a critical size do not rely extensively on direct instruments of monetary control, some of them still use them. ³² Interest rate controls are used in Bangladesh, Iran, and Yemen. Credit ceilings are used in Jordan, Oman and United Arab Emirates (U.A.E.). Directed credits and specific lending requirements are applied in Iran. Jordan also applies specific lending requirements. Bangladesh Bank is extending Islamic refinancing facilities to the Islamic banks and financial institutions for priority sector lending.

In terms of the development of Shari’ah-compliant instruments to mop up structural excess liquidity there has been progress in some countries; the use of short-term monetary policy instruments however, is lagging. The evidence shows an important reliance on government and CBs securities issuances in dual banking systems mainly due to liquidity surpluses and prohibition on interest rates. Outright purchases and sales of tradable Sukuk are also used in Iran, Malaysia, and Sudan. According to the IFSB Stability Report of 2013, 72 percent of the regulatory and supervisory authorities surveyed rely on CB or government securities for monetary policy purposes, and 29 percent have adapted them to meet Islamic finance requirements. The report also notes that only 23 percent of the regulatory and supervisory authorities have adapted their repo and outright operations to accommodate transactions with Islamic financial institutions; only 10 percent have adapted their credit facility and 25 percent their deposit facilities to Islamic banks (Figure 8).

View Full Size

Central Banks³³ Monetary Operations Compliance with the Shari’ah Requirements

Citation: IMF Working Papers 2016, 072; 10.5089/9781475523942.001.A001

Source: IFSB Stability Report of 2013. Bars measure the percent of CBs (out of a total of 32) that use the instrument.

• Download Figure
• Download figure as PowerPoint slide

C. Lender of Last Resort

In times of systemic crisis, CBs may use unconventional measures in the context of impaired MTM, or deflation and recession risks. Under their financial stability mandate, monetary authorities have also the discretion to respond to idiosyncratic needs for liquidity, when no other sources are available to individual banks. The dividing line between conventional and unconventional monetary policy is becoming blur, but the distinction between a systemic and idiosyncratic liquidity support is more straightforward. In this paper, we define Lender of Last Resort (LOLR) as CBs’ intervention in response to an idiosyncratic need.³⁴

In terms of best practices, LOLR support is usually provided at a penalty rate, to solvent and viable entities, assessed on an ongoing basis, and whose shutdown would create financial stability risks. Banks resort to LOLR when they have exhausted all other funding options available to them, including money markets funding, CB conventional funding and the stock of monetary policy eligible collateral. LOLR is temporary and institutions granted LOLR should be subject to supervisory intrusion and conditionality to reduce moral hazard and insure that the loan can be repaid and the funding appropriately used. When designing a Shari’ah-compliant LOLR framework (SLOLR), it is necessary to separate the LOLR from the regular operational framework. LOLR is a bilateral collateralized lending at counterparty’s initiative but at CBs’ discretion, performed under the financial stability mandate, in exceptional circumstances, with broader collateral than conventional monetary policy.

Despite the risk-sharing principle and the high liquidity typical of Islamic banks, weak banks experiencing idiosyncratic liquidity shocks may find difficulties to absorb those shocks in the absence of liquidity management instruments and money markets. It is therefore recommended to establish a SLOLR. The use of SLOLR should be clearly regulated and should not become an additional tool for increasing Islamic banks liquidity.

LOLR can be extended to Islamic banks as long as it is Shari’ah-compliant. The main complications for this reside on the interest-bearing loan, and especially the reference to the penalty rate, as well as the need for a broader collateral. To be compliant with the Shari’ah, the LOLR structure should be interest rate free and the collateral used needs to comply with the Shari’ah rules. According to the IFSB, only 25 percent of the regulatory and supervisory authorities surveyed have developed a Shari’ah-compliant LOLR framework for IIFS using different types of structures (Mudarabah, Musharakah, Murabahah). ³⁵

D. Interbank Markets

Creating Islamic interbank markets when all the markets participants are in excess liquidity and have no liquidity needs is difficult if not impossible. Although some countries with Islamic banks have developed interbank collateralized and uncollateralized money market instruments for those banks, their compliance with Islamic finance rules has raised some questions. Uncollateralized instruments can take the form of Mudarabah contracts (Appendix I), where interbank funds are invested over different maturities with returns based on an agreed profit-sharing ratio. Islamic banks have also designed collateralized money market instruments such as the commodity Murabahah contract where interbank funds are used to execute a Murabahah transaction in a commodity (Appendix II). However, the Shari’ah-compliance of the commodity Murabahah has been put in question in certain jurisdictions. In addition, some operational constraints may also limit the use of the commodity Murabahah as a very short-term liquidity management instrument.

Well-designed strategies of Islamic domestic money and government Sukuk markets are crucial for monetary policy implementation and its transmission through the Islamic banking system. One such strategy may consider first the development of tradable Sukuk issued by governments on a regular basis over different maturities, and in sufficient volumes. Different categories of market operators would increase the volumes traded on those markets. A key challenge would be to avoid the proliferation of different types and structures of Islamic government securities and money markets instruments; such proliferation would impair the formation of a stock of fungible HQLA that can be more easily priced, traded and used as collateral for liquidity management purposes. Standardized structuring of Islamic government securities and money market instruments will ease their use for liquidity management by CBs and Islamic financial institutions. Going forward, Islamic financial systems development strategies should rationalize the number of different instruments created with similar functions. Once key Islamic money and government Sukuk markets have been developed, other instruments may be introduced gradually.

To foster Islamic interbank markets development, Islamic financial institutions and CBs should aim at standardizing the type of Islamic interbank market instruments. Taking into account the challenge of designing collateralized money-market instruments for Islamic banks, a strong commitment of CBs to develop these markets is needed. Two options can also be considered as collateralized transactions for Islamic banks liquidity management: (i) Sell and buybacks; or (ii) interest-free collateralized loans (Qard with Rahn-Appendix III). Ideally, the collateral would be a government Sukuk rather than a less liquid asset (e.g., a commodity), non-suitable from a monetary policy and financial deepening perspective. At the same time, interbank Mudarabah investments may remain an effective instrument for uncollateralized interbank transactions. The sell and buybacks and interest-free collateralized loans can offer alternative ways of structuring interbank and CBs’ transactions to the conventional repos that are more controversial from a Shari’ah-compliance point of view. In Islamic finance, sell and buy-backs are often referred as the Shari’ah-compliant repos even if they differ from a conventional repo. When considering the most appropriate collateralized transaction arrangement, the Shari’ah-compliance risk of sell-buyback and sell-lease-buyback arrangements should be minimized. In some jurisdictions, sell and buyback transactions are prohibited because they are viewed as replicating an interest-bearing loan.

Sukuk issued by governments might be the most suitable collateral for Shari’ah-compliant monetary operations. From an operational point of view, the existence of a liquid, transparent government Sukuk market may reduce the impact of individual transactions, such as government issuances, on price discovery mitigating the risk of fiscal dominance and reducing their market risks. They may facilitate the use of Sukuk as collateral not only for CBs operations but also between market operators. Increased collateralized transactions with underlying government Sukuk can sustain their market liquidity.

While collateral needs for liquidity management should ideally be met with government Sukuk, the IFSB suggested that the lack of sufficient supply of such Sukuk in domestic markets often will require that CBs expand the range of eligible collateral. This collateral extension may include accepting Shari’ah-compliant instruments or Sukuk issued by public sector enterprises and major national corporate bodies, multilateral institutions as well as other sovereigns and CBs. Recently issued IFSB Guidance Note on Quantitative Measures in Liquidity Risk Management of IIFS³⁶ has proposed that CBs consider Sukuk issued by the international organizations such as the Islamic Development Bank (IDB) and the International Islamic Liquidity Management corporation (IILM) as collateral for providing liquidity support to IIFS. However, expanding the range of acceptable collateral should not come at the expense of the development of domestic government Sukuk markets.

Creating active and deep government Sukuk markets is a difficult task. Many factors can constrain their development including large fiscal surpluses, non-standardized issuances, reliance on non-tradable Sukuk, Shari’ah-compliance risk, continued reliance on CB direct financing, weak government debt management strategies, narrow investors base and limited financial sector diversification, inappropriate payment and settlement systems as well as the absence of collateralized instruments with government Sukuk as underlying assets.³⁷ The development of government Sukuk markets may require a variety of investors, effective intermediaries, as well as robust market infrastructure reducing operational risks, delays and transaction costs. Beyond technical and operational considerations, other factors may hinder the development of these markets, including the degree of commitment of the MoF to develop them and the lack of mutual funds and asset management activities.