Central Banks
Central Banks play the major role in supervisory activities applied on banks in different parts of the world, their activities cover checking registers and books for the purpose of validating sound assets and operations. They are also involved in developing rules and principles related to bank operations in general, and establishing the range of dealing with specific activities and clients. The cooperation between Islamic and Central Banks of states where they operate is an important aspect to help foster the growth and development of Islamic banks and to assist them in competing with conventional banks. In fact, the position of Islamic banks necessitates that central banks facilitate the work of such units, and support them in performing their positive role in sustainable development in the countries in which they operate. Islamic banks need to be accorded equal treatment in regard to fulfillment of the requirement of building up of general and special reserves, limitation on equity, voting rights, licensing and establishment of new branches. Therefore, central banks in a number of Muslim majority countries have established the Islamic Financial Services Board to promote establishment and development of Shari’ah compliant financial services industry, characterised by prudence and transparency, through the adoption of international standards compatible with Islamic banking principles and methods.
The nature of the relationship between Islamic banks and central banks differs from one country to another; it depends on the legal framework which regulates the status of Islamic banks within these countries. Some states have issued special legislation for Islamic banks besides the legislation for conventional banking system. Other states have had the initiative to develop and enforce legislations which would allow establishing Islamic banks in accordance with specific laws and regulations. Yet, there are three aspects of the central bank’s relationship with Islamic banks that are lender of last resort, a clearing house and supervisor in regard to monetary policy. As a lender of last resort, the central bank can manipulate the supply of money to the commercial banks and hence to the public, it can lend directly to banks to provide liquidity support directly to a bank that cannot obtain finance from other sources. And more generally it oversees the financial sector in order to prevent crises, protect depositors, prevent wide-spread panic withdrawal, and thus to prevent the damage to economy that may be cause by the collapse of banks. While, the central bank provides finance to conventional banks in the form of an interest based debt, mostly short-term, or by rediscounting commercial bills, which are prohibited in Shari’ah, it provides liquidity for Islamic banks on the basis of form of Mudarabah or Musharakah capital. The central bank would share in the profits from the Islamic bank’s investment of the money over the period for which the fund are advanced. As a clearing house, the central bank provides Islamic banks with facilities for the settlement of cheques and other payments and services around documentary letters of credit and guarantee in return for a commission. The Islamic bank using the clearing system opens a current account with the central bank and limited short-term temporary overdraft facilities exempted of interest are occasionally allowed to cover any temporary shortfalls for settlement purposes. The central bank may allow limited short-term temporary facilities free of interest in the case of Islamic banks on the basis that these banks would place compensatory funds of the same amount for an equivalent duration, interest free with the central bank, or on the basis of sharing in their profits for the period of the shortfall. And as supervisor in regard to monetary policy, the central bank influence credit availability and inflation through money to provide a stable economic growth. It should design patterns and forms of regular data required from Islamic banks to be developed and approved by central bank and Islamic bank representatives in order to comply with the nature of Islamic bank operations. Some central banks have set a lower level for the liquidity ratios within Islamic banks in comparison with their counterparts in other banks, taking into account the specific nature of their dealings.
However, there are some areas where different controls need to be done between Islamic and conventional banks depending whether they involve interest or not; these controls include statutory cash reserve requirements, liquidity ratios, deposit insurance schemes, credit ceilings, distribution of Islamic banks ‘profits, inspection of banks, profit equalisation fund and monetary assets. In fact, control of Islamic banks should take account of their specific characteristics; the statute of an Islamic bank must be approved by the central bank before the latter gives the bank permission to operate. Thus, control of the activities of an Islamic bank and examination of its processes should be conducted in accordance with its statute. Central banks should have a distinctive set of guidelines for the inspection of Islamic banks as well as regulations to safeguard Islamic investors’ interests. The central bank may also evaluate the investment programmes of Islamic banks. For example, in cases where central banks pay interest on cash reserves, the ratio of reserves required from Islamic banks could be reduced on the grounds that they are not demanding any interest. Also a special consideration should be applied by central banks when applying credit ceilings to Islamic banks. Also, the minimum interest rates prescribed to commercial banks to pay on savings and time deposits should be replaced in the case Islamic banks by a weightage system to be given to these deposits for the purpose of profit distribution by the banks.
The nature of the relationship between Islamic banks and central banks differs from one country to another; it depends on the legal framework which regulates the status of Islamic banks within these countries. Some states have issued special legislation for Islamic banks besides the legislation for conventional banking system. Other states have had the initiative to develop and enforce legislations which would allow establishing Islamic banks in accordance with specific laws and regulations. Yet, there are three aspects of the central bank’s relationship with Islamic banks that are lender of last resort, a clearing house and supervisor in regard to monetary policy. As a lender of last resort, the central bank can manipulate the supply of money to the commercial banks and hence to the public, it can lend directly to banks to provide liquidity support directly to a bank that cannot obtain finance from other sources. And more generally it oversees the financial sector in order to prevent crises, protect depositors, prevent wide-spread panic withdrawal, and thus to prevent the damage to economy that may be cause by the collapse of banks. While, the central bank provides finance to conventional banks in the form of an interest based debt, mostly short-term, or by rediscounting commercial bills, which are prohibited in Shari’ah, it provides liquidity for Islamic banks on the basis of form of Mudarabah or Musharakah capital. The central bank would share in the profits from the Islamic bank’s investment of the money over the period for which the fund are advanced. As a clearing house, the central bank provides Islamic banks with facilities for the settlement of cheques and other payments and services around documentary letters of credit and guarantee in return for a commission. The Islamic bank using the clearing system opens a current account with the central bank and limited short-term temporary overdraft facilities exempted of interest are occasionally allowed to cover any temporary shortfalls for settlement purposes. The central bank may allow limited short-term temporary facilities free of interest in the case of Islamic banks on the basis that these banks would place compensatory funds of the same amount for an equivalent duration, interest free with the central bank, or on the basis of sharing in their profits for the period of the shortfall. And as supervisor in regard to monetary policy, the central bank influence credit availability and inflation through money to provide a stable economic growth. It should design patterns and forms of regular data required from Islamic banks to be developed and approved by central bank and Islamic bank representatives in order to comply with the nature of Islamic bank operations. Some central banks have set a lower level for the liquidity ratios within Islamic banks in comparison with their counterparts in other banks, taking into account the specific nature of their dealings.
However, there are some areas where different controls need to be done between Islamic and conventional banks depending whether they involve interest or not; these controls include statutory cash reserve requirements, liquidity ratios, deposit insurance schemes, credit ceilings, distribution of Islamic banks ‘profits, inspection of banks, profit equalisation fund and monetary assets. In fact, control of Islamic banks should take account of their specific characteristics; the statute of an Islamic bank must be approved by the central bank before the latter gives the bank permission to operate. Thus, control of the activities of an Islamic bank and examination of its processes should be conducted in accordance with its statute. Central banks should have a distinctive set of guidelines for the inspection of Islamic banks as well as regulations to safeguard Islamic investors’ interests. The central bank may also evaluate the investment programmes of Islamic banks. For example, in cases where central banks pay interest on cash reserves, the ratio of reserves required from Islamic banks could be reduced on the grounds that they are not demanding any interest. Also a special consideration should be applied by central banks when applying credit ceilings to Islamic banks. Also, the minimum interest rates prescribed to commercial banks to pay on savings and time deposits should be replaced in the case Islamic banks by a weightage system to be given to these deposits for the purpose of profit distribution by the banks.
