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Islamic banking system & potential monetary policy tools

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Islamic Banking System (IBS) refers to the financial services in accordance with Islamic Shariah. The Shariah compliance function is the only and unique feature of Islamic Banking, and is essential to maintain its uniqueness of operations. Islamic banks all over the world was established with a view to promote, foster and develop the application of Islamic principles in the economy and to offer contemporary financial services in conformity with Islamic Shariah.

Shariah bans Riba (interest), Gharar (products with excessive uncertainty), Maysir (gambling), short-sales, as well as the financing of illicit activities harmful to society, which are strictly prohibited in the IBS. Abolition of Riba and a fixed rate of interest is replaced by a variable rate of return based on real economic activities makes it different from the conventional interest-based commercial banking.

Major techniques of deposit mobilisation and financing in Islamic banking system are as follows:

Deposit Mobilisation Modes

(a) Al-Wadeah Accounts: (i) Al-Wadeah Current Deposit Account; (b) Mudaraba Accounts: (i) Mudaraba Savings Deposit Account; (ii) Mudaraba Term Deposit Account;(iii) Mudaraba Special Deposit Account; (iv) Mudaraba Savings Bond

Financing Modes

(a) Bai-Modes: (i) Bai-Murabaha, (ii) Bai-Istijrar, (iii) Bai-Muajjal, (iv) Bai-Salam, (v) Bai-Istisna, and (vi) Bai-As-Sarf.

(b) Share-Modes: (i) Murabaha; and (ii) Musaraka.

(c) Ijara - Modes: (i) Hire Purchase under Shirkatul Melk

Distinguishing characteristics of Islamic Banking

n Interest-based lending and the financing of unethical goods and services are strictly prohibited.

n Returns on investments must be based on real economic activities and/or underlying assets and performance.

n Islamic finance discourages hoarding and prohibits transactions with extreme uncertainties, and gambling related activities.

n All financial transactions will have to be in accordance of: (a) sales of goods, services or benefits, or (b) profit and-loss sharing (PLS) arrangements, all of which must be underpinned by the "assets-backed" characteristics.

n Deposits are mobilised mainly based on the principles of Al-Wadia (safe custodianship) and Al-Mudaraba (trust financing).

n Investments or utilisation of funds are made mainly on profit and-loss sharing (PLS) arrangements to foster the investors' participation in equity, which promotes the assiduity in the investment management and proper monitoring.

n Other Islamic financial mechanisms (such as Murabaha, Ijara and Istisna) also require the involvement of investors in the real economy; as a result, financial transactions are also fully backed by real assets in all the economic transactions.

n Islamic banking emphasises risk sharing while conventional finance put emphasis on risk transfer, which significantly restricts IBS investors from conventional hedging mechanisms.

n Islamic banking system is based on justice and risk sharing relationship in economic transactions while conventional banking is based on the debtor-creditor relationship.

n Equity-based Islamic contracts can reduce adverse selection and moral hazard problems, which thereafter, restrain the credit risk of the Islamic banks and financial institutions.

n Islamic finance upholds contractual obligations and the disclosure of information, which in turn reduces the risk of asymmetric information and moral hazard.

POTENTIAL ISLAMIC MONETARY POLICY TOOLS FOR LIQUIDITY MANAGEMENT: Some potential monetary policy tools for the liquidity management of the country's Islamic banks are briefly discussed here.

Non-tradable 'Bangladesh Government Islamic Treasury Bill (BGITB). Bangladesh Bank on behalf of the Government of Bangladesh, may issue a non-tradable 'Bangladesh Government Islamic Treasury Bill (BGITB) based on Murabaha to the purchase ordered on a competitive bidding auction basis to finance government internal procurement or imports from overseas countries. The tenure of BGITB may be one month to one year. Detailed guidelines of issuing this type of BGITB may be determined through a consultative process involving all respective stakeholders.

Islamic Repo and Reverse Repo: Outright Purchases/Sales of BGIS: Bangladesh Bank can inject/sterilise liquidity temporarily into/from the banking system in case of liquidity shortfall/surplus via repo (outright purchase)/reverse repo (through Bai-Muajjal and outright sale) of Taka denominated Bangladesh Government Ijarah Sukuk (BGIS) issued by the government treasury and its SPV. Repo maturities can be extended from overnight to one year, but there is no time period in the case of reverse repo due to ownership transfer via outright sale. So, the maturity of a repo can be from overnight to one year, depending on the liquidity situation, but the maturity of a reverse repo is usually overnight.

Unrestricted Wakalah as an Alternative to Repo and Reverse Repo. The unrestricted Wakalah agreement may be used as an alternative to Islamic Repo and Reverse Repo. Unlike the Repo and Reverse Repo systems, BB may arrange an auction where participating Islamic banks (muwakkil) may place their excess liquidity with BB (wakil), authorizing them to use the money in a profitable venture/way, usually against a fixed fee. BB may use this Wakalah money for suitable/profitable projects/businesses run as Mudaraba, Musharaka, Murabaha, Salam, Istisna, and Ijarah. However, the Wakalah facility may be offered to absorb short-term excess liquidity of the Islamic banks as a standing facility. Similarly, BB may grant deposit facilities to Islamic banks in case of a shortfall of liquidity based on Mudaraba, where profits can depend on the deposit profit rate offered by that bank to its six-month deposit clients.

Bangladesh Bank Musharaka Certificates. The Bangladesh Bank Musharaka Certificate (BBMC) is an equity-based instrument that may be issued against the government or central bank's ownership in profitable commercial banks enable to regulate domestic liquidity through open market operations. For this purpose an Open Market Operations Fund (OMOF) may be established, and BBMCs can be issued against the OMOF. The OMOF would hold the shares in commercial banks that the government and/or the central bank own, which form the basis for issuing the BBMC. The management of the OMOF may be delegated to the central bank for usage as the desired tools of monetary policy.

Interbank Mudaraba Placements. It refers to a mechanism whereby a deficit Islamic banking institution (i.e. an investee bank) can obtain investment from a surplus Islamic banking institution (investor bank) based on Mudaraba (profit sharing) principle. The period of investment ranges from a period of overnight to 12 months, while the rate of return is based on the rate of gross profit before distribution for investment of 1-year of the investee bank.

Commodity Murabaha. It is used to facilitate short-term interbank lending using transactions in commodities to structure an investment between two Islamic banks. A variety of this transaction is the Salam Sukuk, which uses forward commodity contract to generate longer term investment (usually three months).

Central Bank Wadiah (Trust) Certificate/Deposit. This certificate is issued against funds placed by IBs at the central bank for various maturities. Remuneration is at the central bank's discretion given the debt nature of the facility. Central banks may pay a bonus at maturity that is usually tied to a domestic financial benchmark (including the average return on Interbank Mudaraba investments).

Central Bank Paper. There are two forms of these papers: (a) Musharaka Certificates issued against the central bank ownership of a pool of income earning assets; or (b) Sukuk issued against the central bank ownership of real fixed assets. These papers are freely tradable with maturities of less than one year.

Government Paper. Similar to central bank papers, these instruments can be issued as Musharaka Certificate against government ownership of a pool of income earning assets, or as Sukuk issued against the government ownership of real assets. These instruments are freely tradable with maturities that can be structured (particularly for Sukuk) similar to those of domestic government securities.

Islamic Repurchase Agreements or Sale and Buyback. Usually it involves two separate contracts, an outright sale of security at an agreed price and a forward purchase of security at a specified price and future date.

This is an amalgamation of two pieces on Islamic banking appeared in the Bangladesh Bank's Annual Report: 2021-22.

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