## 1. Monetary Policy Frameworks and Exchange Rate Arrangements in Countries with Islamic Banks (as of 2014)

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---

### Key findings and context
- Islamic banking implementation poses challenges for monetary policy and the transmission mechanism due to:
  - core Islamic finance principles (ex-ante interest payment prohibition; profit-and-risk sharing),
  - the macrofinancial background,
  - domestic monetary policy frameworks.
- Two literature streams highlighted:
  - Theoretical: Khan and Mirakhor (1990) — Islamic finance anchored on profit-and-risk sharing and mainly equity-based.
  - Empirical: monetary transmission from conventional to Islamic segment (Cevik and Charap, 2011).
- Dual systems: Islamic banks typically develop side-by-side conventional banks; growing Islamic finance can influence conventional markets under competitive pressure.
- Common structural constraints to monetary policy (in both conventional and Islamic settings): structural excess liquidity, financial system shallowness, fiscal dominance, dominant public sectors, direct monetary financing of fiscal deficits, distorted credit environments.
- Operational consideration specific to Islamic systems: central bank (CB) influence on Islamic banks’ funding costs via targeting profit-sharing ratios in interbank Mudarabah markets.

### Macrofinancial background and monetary policy frameworks — observations
- Countries where Islamic banking is important include: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, U.A.E., Bangladesh, Brunei, Iran, Jordan, Malaysia, Pakistan, Sudan, Yemen.
- Except Iran and Sudan, the majority have dual financial systems.
- Exchange rate regimes and anchors:
  - Many operate fixed exchange rate or monetary targeting regimes.
  - GCC, Jordan, and Brunei have an explicit exchange rate anchor.
  - Bangladesh and Yemen allow limited exchange rate flexibility.
- Financial development: many have domestic credit-to-GDP below 50 percent.
- Empirical relationships noted:
  - Islamic assets per capita inversely related to degree of exchange rate flexibility.
  - Islamic assets per capita directly related to current account surpluses, oil-rents, and GDP per capita.
- Countries with fixed exchange rates tend to have more stable inflation and more volatile growth than those with flexible rates.
- Brunei, Bahrain, and Malaysia recorded the lowest inflation rates among Islamic-finance-important countries during 2004–2013.

### Monetary transmission mechanism — structure and constraints
- Determinants of the monetary transmission mechanism (MTM): nominal rigidities, market imperfections, government distortions, degree of financial development and openness, supply/demand constraints in credit.
- Focused MTM channels: bank lending/financing channel; interest rate channel; exchange rate channel.
- Interest rate channel observations:
  - CBs typically control the short end of the yield curve; transmission requires linkages across the term structure.
  - Weaknesses when: no active interbank market, absence of money market or sovereign yield curve, unsterilized liquidity surpluses, fiscal dominance.
  - Deep money and government securities markets support transmission along yield curves and to bank lending rates.
- Credit channel observations:
  - Bank lending channel (narrow) and balance sheet channel (broad).
  - Bank lending channel weakens with financial liberalization and easier external funding access.
  - More potent when banks have less liquid balance sheets, small banks dominate, and firms have limited nonbank funding sources.
  - Government interventions and fiscal dominance can crowd out private credit.
- Exchange rate channel observations:
  - Effectiveness depends on exchange rate regime, capital controls, and money/FX market development.
  - Under flexible exchange rates, expansionary monetary policy tends to depreciate the currency, potentially improving the current account.
  - Under fixed exchange rates, large CB liquidity injections can deteriorate external balance and deplete FX reserves; pegged regimes require large FX reserves and persistent current account surpluses.
- Two principal MTM transmission mechanisms: quantities (via CB balance sheet) and prices (via interest rate signaling).
- Transmission stages: CB actions → banks’ reserves and interbank markets → arbitrages across money, government securities, FX, and credit markets.

### Relevance of the bank lending channel for Islamic banks
- In early-stage dual systems, reserve balances can be central to monetary policy conduct.
- Effectiveness depends on:
  - (i) CB’s capacity to be a main supplier of liquidity for Islamic banks.
  - (ii) Islamic banks’ capacity to adjust credit/financing supply in response to reserve balance changes.
- IMF Islamic banking survey result (2012): 81 percent of central banks apply reserve requirements (RR) to Islamic banks.
- Conditions weakening the channel: surplus liquidity, fluid wholesale funding access, binding supply/demand credit constraints.
- Governments’ cash management practices can induce systemic liquidity fluctuations; oil shocks, oversized public sectors, poor government cash management, lack of sterilization policies, and weak liquidity management can render monetary policy ineffective.

### The interest rate channel in the presence of Islamic banking
- In dual systems with developed conventional money markets, Islamic banks operate in an interest-rate-dominant environment.
- Arbitrage between conventional and Islamic segments causes spillovers from conventional interest rates to:
  - Islamic banks’ funding costs,
  - returns on profit-sharing investment accounts (PSIAs),
  - costs of Islamic credit.
- Pricing practices:
  - Some Islamic banks "tend to rely on conventional interest rates to price their Murabahah and Ijarah contracts."
  - Even when using conventional interest rates to price Islamic credit, Islamic banks can be more-or-less reactive to changes of conventional policy rates.
- Implication: 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.

### Monetary transmission from conventional to Islamic systems (Box 1) — mechanisms and evidence
- Classification of Islamic finance contracts:
  - (i) profit-and-loss sharing contracts: Mudarabah and Musharakah;
  - (ii) debt-like contracts: Ijarah and Murabahah;
  - (iii) services: Wadi’ah.
- Mudarabah interbank mechanics: surplus bank invests funds in shortage bank on a Mudarabah basis with returns based on a pre-agreed profit-sharing ratio; maturities usually 3 to 12 months.
- Empirical evidence (Malaysia and Turkey):
  - conventional banks deposit rates and PLS returns exhibit long-run cointegration;
  - time-varying volatility on conventional banks deposit rates and PSIAs returns is correlated and statistically significant;
  - causality appears to run from conventional deposit rates to PSIAs returns.
- Malaysia specifics:
  - Malaysian Islamic Interbank Money Market (IIMM) established on January 3, 1994.
  - Mudarabah Interbank Investments (MII): deficit Islamic banks obtain investment from surplus Islamic banks based on a profit-sharing ratio, maturities ranging from the overnight to twelve months.
- Signaling mechanism:
  - CBs can set profit-sharing ratios in their Mudarabah transactions with Islamic banks to influence Islamic banks’ client contracts; effectiveness depends on Islamic market development.
  - No empirical evidence that profit-sharing mechanism is effective when PLS contracts are not widely used.
- Policy recommendation from Box 1:
  - CB communication should include information related to Islamic banks liquidity conditions, interbank markets, and their Shari’ah-compliant operational framework to strengthen the expectations channel.
  - IFSB Guiding Principles: supervisory authorities should provide clarity on roles in normal and stressed times and be explicit about Shari’ah-compliant collateral types, limits, and possible financing durations.

### Sterilization policies and sources of surplus liquidity
- Sources of Islamic banks’ surplus liquidity: prohibition on interest, insufficient sterilization, lack of Shari’ah-compliant HQLA, underdeveloped Islamic money markets, insufficient sovereign Sukuk issuance, monetary financing of government deficits, weak government cash management.
- Sterilization should be part of a broad approach including fiscal, monetary, FX, and market development policies; structural and long-term instruments may be required.
- Sterilization instruments — pros and cons summary:
  - Reserve Requirements (RR):
    - Pros: under CB control; powerful effect on credit.
    - Cons: typically not remunerated for Islamic banks => increase cost of Islamic credit; non market-based.
  - Central bank securities:
    - Pros: under CB control.
    - Cons: require persistent surplus liquidity; compete with government securities early; can generate losses to CB.
  - Government securities:
    - Pros: sterilization costs borne by government; provide CB collateral; develop benchmark yield curve; impose discipline/transparency to debt management.
    - Cons: large fiscal surpluses required; potential crowding out of private credit early.
  - Stabilization funds:
    - Pros: permanently insulate economy from FX inflows.
    - Cons: mainly appropriate when excess liquidity source is FX.
- Reserve Requirements practice: features generally harmonized between conventional and Islamic banks except returns—Islamic banks’ RR typically not remunerated.

### Market infrastructure, interbank markets and collateralized transactions
- Preference for market-based instruments over direct instruments to avoid non-transparent discretionary interventions and liquidity misallocation.
- Two key development dimensions:
  - develop basic infrastructure for market-based Islamic monetary policy (Islamic money and Sukuk markets, reduce market segmentation);
  - address continuous evolution of the monetary policy framework (spillovers, competition among Islamic banks).
- Market segmentation risks:
  - Islamic banks often cannot access conventional CB monetary operations or interbank markets, reducing liquidity management options and profitability.
  - IIFS reliance primarily on interbank arrangements with other IIFS and limited transactions with conventional banks evidences segmentation.
- Basic infrastructure building blocks for market-based Islamic monetary policy:
  - Islamic collateralized money-market instruments for liquidity management;
  - high quality marketable collateral (in sufficient amounts);
  - active interbank Mudarabah and collateralized interbank markets;
  - efficient operational framework;
  - adequate payment and settlement systems.
- Operational recommendations:
  - standardize interbank arrangements initially and introduce other contract types gradually;
  - analyze comparative advantage and Shari’ah-compliance risk of interbank Mudarabah relative to other interbank structures;
  - dematerialization of government securities and effective delivery-versus-payment and collateral mobilization procedures.
- Collateralized transaction options for Islamic banks liquidity management:
  - sell and buybacks (Shari’ah-compliant repos in practice);
  - interest-free collateralized loans (Qard with Rahn).
- Collateral extension considerations:
  - IFSB suggests accepting Sukuk from public sector enterprises, major national corporations, multilateral institutions, other sovereigns and CBs; consider Sukuk issued by IDB and IILM.
  - Expansion of acceptable collateral should not impede development of domestic government Sukuk markets.
- Constraints to government Sukuk market development:
  - non-standardized issuances, reliance on non-tradable Sukuk, Shari’ah-compliance risk, continued CB direct financing, weak government debt management, narrow investor base, limited financial sector diversification, inappropriate payment and settlement systems, absence of collateralized instruments with government Sukuk as underlying assets.
- Market development prerequisites: variety of investors, effective intermediaries, robust market infrastructure, MoF commitment, mutual funds and asset management activities.
- Empirical note: Godlewski, Turk, and Weill (2014) found Ijarah-based Sukuk have lower Shari’ah-compliance risk and higher development potential relative to other Sukuk structures.

### Monetary policy operational framework usage and adaptation statistics
- Direct instruments still used in some countries:
  - interest rate controls in Bangladesh, Iran, and Yemen;
  - credit ceilings in Jordan, Oman, and U.A.E.;
  - directed credits and specific lending requirements in Iran; Jordan applies specific lending requirements.
  - Bangladesh Bank extends Islamic refinancing facilities for priority sector lending.
- Progress and gaps in adapting instruments for Islamic finance:
  - IFSB Stability Report of 2013 (survey of 32 regulatory and supervisory authorities) reported:
    - 72 percent rely on CB or government securities for monetary policy purposes;
    - 29 percent have adapted CB or government securities to meet Islamic finance requirements;
    - 23 percent have adapted repo and outright operations to accommodate transactions with IIFS;
    - 10 percent have adapted their credit facility to Islamic banks;
    - 25 percent have adapted their deposit facilities to Islamic banks.
  - Progress in Shari’ah-compliant instruments to mop up structural excess liquidity exists, but short-term monetary policy instruments lag.

### Lender of Last Resort (LOLR) and Shari’ah-compliant LOLR (SLOLR)
- LOLR best practices: provided at a penalty rate to solvent and viable entities whose shutdown would create financial stability risks; used after exhaustion of other funding options; temporary; subject to supervisory intrusion and conditionality.
- SLOLR design requirements:
  - separate LOLR from regular operational framework;
  - bilateral collateralized lending at CB discretion under financial stability mandate and exceptional circumstances;
  - broader collateral than conventional monetary policy but Shari’ah-compliant.
- Challenges to SLOLR: interest-bearing loan and penalty rate references complicate Shari’ah compliance.
- IFSB survey: only 25 percent of regulatory and supervisory authorities developed a SLOLR framework for IIFS using Muḍarabah, Musharakah, Murabahah structures.

### Interbank Mudarabah — structure (Appendix I)
- Interbank Mudarabah mechanics:
  - Bank A provides funds to be invested by Bank B with an agreed profit-sharing ratio.
  - Parties: Bank A (Capital Provider); Bank B (Entrepreneur).
  - Upon maturity, profit is shared according to the agreed ratio and the principal is returned to the capital provider (subject to investment outcome as implied by profit sharing).
  - Contract type: Mudarabah — a profit-sharing investment partnership where one party provides capital and the other provides management.

### Policy implications and priorities (conclusions)
- Exchange rate anchor and liquidity control:
  - Many countries with significant Islamic banking operate fixed exchange rate regimes; exchange rate is often main nominal anchor and systemic liquidity control is key to monetary policy effectiveness.
- Excess liquidity management:
  - Islamic banks are frequently in surplus liquidity; excess liquidity must be properly managed to enhance monetary transmission.
- Interest rate channel and spillovers:
  - When the interest rate channel is effective, transmission from conventional to Islamic segment can operate, but acceptance varies across Shari’ah scholars and depends on consumer and bank behavior and Islamic money market development.
- Recommended priorities:
  - orderly development of Islamic domestic interbank markets to facilitate liquidity management of Islamic banks;
  - standardization of liquidity management instruments, reduction of Shari’ah-compliance risk, and development of CB operational frameworks;
  - coordination and strong commitment of CB and fiscal authorities and regulatory changes to build Islamic interbank and government Sukuk markets;
  - more proactive CB role in developing domestic government Sukuk markets to support both implementation of Islamic monetary policy and Islamic banks’ profitability and viability.

*Source: _wp1672 (extracted content provided).*

### 1. Monetary Policy Frameworks and Exchange Rate Arrangements in Countries with Islamic

### 1. Monetary Policy Frameworks and Exchange Rate Arrangements in Countries with Islamic Banks (as of 2014)

### Chapter structure and main sections
- Section 1: "Monetary Policy Frameworks and Exchange Rate Arrangements in Countries with Islamic Banks (as of 2014)" — page 8
- Section 2: "Sterilization under Islamic Banking: Key Considerations" — page 27

### Figures included
- Figure 1: "Islamic Banking, Financial Development, and Monetary Policy" — page 9
- Figure 2: "Islamic Banking, Current Account Balances, and Exchange Rate Regimes" — page 10
- Figure 3: "The Monetary Transmission Mechanism" — page 12
- Figure 4: "Credit Demand and Supply Following an Adverse Macroeconomic Shock—Conventional System" — page 15
- Figure 5: "Monetary Transmission Mechanism in Dual Financial Systems" — page 19
- Figure 6: "Domestic Credit to the Private Sector" — page 21
- Figure 7: "Islamic Monetary Operations Infrastructure: Building Blocks" — page 24
- Figure 8: "Central Banks Monetary Operations Compliance with the Shari’ah Requirements" — page 28

### Boxes and appendices
- Box 1: "Monetary Transmission from Conventional to Islamic Financial Systems" — page 17
- Appendix I: "The Interbank Mudarabah" — page 33
- Appendix II: "The Commodity Murabahah" — page 34
- Appendix III: "Qard with Rahn" — page 35

### Thematic focus areas (as indicated by section and figure titles)
- Interaction between Islamic banking and monetary policy frameworks
- Exchange rate arrangements in countries with Islamic banks
- Sterilization challenges and considerations under Islamic banking
- Monetary transmission mechanisms in conventional, Islamic, and dual financial systems
- Credit dynamics following macroeconomic shocks
- Building blocks and infrastructure for Islamic monetary operations
- Compliance of central bank monetary operations with Shari’ah requirements
- Specific Islamic instruments relevant to monetary operations: Interbank Mudarabah, Commodity Murabahah, Qard with Rahn

*Source: 1. Monetary Policy Frameworks and Exchange Rate Arrangements in Countries with Islamic Banks (as of 2014); 2. Sterilization under Islamic Banking: Key Considerations — extracted from the chapter contents and listings.*

### References .............................................................................................................

### _wp1672 - References

### Glossary
- AREAER Annual Report on Exchange Arrangements and Exchange Restrictions
- CA  Current Account
- CB  Central Bank
- FX  Foreign Exchange
- GCC  Gulf Cooperation Council
- GDP  Gross Domestic Product
- GFC  Global Financial Crisis
- GFSR   Global Financial Stability Report
- GIC  Government Investment Certificates
- HQLA  High Quality Liquid Assets
- IDB  Islamic Development Bank
- IFSB  Islamic Financial Services Board
- IIFM   International Islamic Financial Market
- IIFS  Institutions offering Islamic Financial Services
- IILM  International Islamic Liquidity Management Corporation
- IIMM  Islamic Interbank Money Market
- IMF  International Monetary Fund
- ISIMP  Information System for Instruments of Monetary Policy
- LOLR  Lender of Last Resort
- MII  Mudarabah Interbank Investment
- MoF  Ministry of Finance
- MTM  Monetary Transmission Mechanism
- OMO  Open Market Operation
- PLS  Profit and Loss Sharing
- PSIA  Profit-sharing Investment Account
- REPO  Repurchase Agreement
- RR   Reserve Requirements
- SF  Standing Facility
- SLOLR Shari’ah-compliant Lender of Last Resort
- SME  Small-and-Medium Enterprise
- SPV  Special Purpose Vehicle
- U.A.E.  United Arab Emirates
- U.K.  United Kingdom
- U.S.  United States of America
- WDI   World Development Indicators
- WEO  World Economic Outlook

### I. Introduction — key findings and context
- Islamic banking implementation poses challenges for monetary policy and the transmission mechanism due to:
  - core Islamic finance principles (ex-ante interest payment prohibition; profit-and-risk sharing),
  - the macrofinancial background, and
  - domestic monetary policy frameworks.
- Two literature streams:
  - Theoretical: Khan and Mirakhor (1990) — Islamic finance anchored on profit-and-risk sharing and mainly equity-based.
  - Empirical: monetary transmission from conventional to Islamic segment (Cevik and Charap, 2011).
- Islamic banks typically develop side-by-side conventional banks in dual systems; growing Islamic finance can influence conventional markets under competitive pressure.
- Monetary policy effectiveness assessment must consider multiple dimensions:
  - Islamic principles,
  - spillovers from conventional to Islamic segments,
  - existing monetary policy framework and instruments.
- Common structural issues constraining monetary policy (in both conventional and Islamic settings): structural excess liquidity, financial system shallowness, fiscal dominance, dominant public sectors, direct monetary financing of fiscal deficits, distorted credit environments.
- Monetary policy operates through prices or quantities; the CB’s capacity to influence market conditions varies with financial system development and exchange rate regime rigidity.
- Key operational consideration for Islamic systems: CB influence on Islamic banks’ funding costs via targeting profit-sharing ratios in interbank Mudarabah markets.

### II. Macrofinancial background and monetary policy frameworks — observations
- Countries where Islamic banking is important include: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, U.A.E., Bangladesh, Brunei, Iran, Jordan, Malaysia, Pakistan, Sudan, Yemen.
- Except Iran and Sudan, the majority have dual financial systems.
- Many of these countries operate fixed exchange rate or monetary targeting regimes; GCC, Jordan, and Brunei have an explicit exchange rate anchor; Bangladesh and Yemen allow limited exchange rate flexibility.
- Financial development: many have domestic credit-to-GDP below 50 percent.
- Empirical relationships noted:
  - Islamic assets per capita inversely related to degree of exchange rate flexibility.
  - Islamic assets per capita directly related to current account surpluses, oil-rents, and GDP per capita.
- Countries with fixed exchange rates tend to have more stable inflation and more volatile growth than those with flexible rates.
- Brunei, Bahrain, and Malaysia recorded the lowest inflation rates among Islamic-finance-important countries during 2004–2013.

### III. Monetary Transmission Mechanism — structure and constraints
- MTM determinants: nominal rigidities, market imperfections, government distortions, degree of financial development and openness, supply/demand constraints in credit.
- Focused channels: bank lending/financing channel; interest rate channel; exchange rate channel.
- Interest rate channel:
  - Standard models: monetary policy affects real interest rate, cost of capital, aggregate demand.
  - CBs typically control the short end of the yield curve; transmission requires linkages across the term structure.
  - Weaknesses occur when: no active interbank market, absence of money market or sovereign yield curve, unsterilized liquidity surpluses, fiscal dominance.
  - Deep money and government securities markets support transmission along yield curves and to bank lending rates.
- Credit channel:
  - Operates via bank lending channel (narrow) and balance sheet channel (broad).
  - Bank lending channel relies on money multiplier and reserve changes affecting deposits and credit supply.
  - Channel weakens with financial liberalization and easier external funding access.
  - More potent when banks have less liquid balance sheets, small banks dominate, and firms have limited nonbank funding sources.
  - Government interventions (interest rate controls, lending ceilings, selective credit policies) and fiscal dominance can crowd out private credit.
- Exchange rate channel:
  - Effectiveness depends on exchange rate regime, capital controls, and money/FX market development.
  - Under flexible exchange rates, expansionary monetary policy tends to depreciate the currency, which may improve the current account depending on trade responsiveness and domestic absorption.
  - Under fixed exchange rates, large CB liquidity injections can deteriorate external balance and deplete FX reserves; fixed regimes can be supported when countries have large FX reserves and persistent current account surpluses.
- Two principal MTM transmission mechanisms:
  - Quantities: via CB balance sheet.
  - Prices: via interest rate signaling, which presupposes developed markets for price formation.
- Transmission stages:
  - CB actions affect banks’ reserves and interbank markets.
  - Arbitrages across money, government securities, FX, and credit markets form the second stage linking returns and rates.

### IV. Relevance of the bank lending channel for Islamic banks
- In early-stage dual systems, reserve balances can be central to monetary policy conduct.
- Effectiveness of the Islamic bank lending/financing channel depends on:
  - (i) CB’s capacity to be a main supplier of liquidity for Islamic banks.
  - (ii) Islamic banks’ capacity to adjust credit/financing supply in response to changes in reserve balances.
- IMF Islamic banking survey result (2012): 81 percent of central banks apply reserve requirements (RR) to Islamic banks.
- Conditions weakening the channel: surplus liquidity, fluid wholesale funding access, binding supply/demand credit constraints.
- Governments’ cash management practices can induce systemic liquidity fluctuations; combination of oil shocks, oversized public sectors, poor government cash management, lack of sterilization policies, and weak liquidity management can render monetary policy ineffective.

### V. The interest rate channel in the presence of Islamic banking
- In dual systems with developed conventional money markets, Islamic banks operate in an interest-rate-dominant environment.
- Arbitrage between conventional and Islamic segments causes spillovers from conventional interest rates to:
  - Islamic banks’ funding costs,
  - returns on profit-sharing investment accounts (PSIAs),
  - costs of Islamic credit.
- In embryonic Islamic finance systems, Islamic equivalents to money market or government securities yield curves often do not exist to serve as reference points for Islamic institutions.

*Source: _wp1672 - References (extracted content provided).*

### references to price Islamic banks credit. As a result, some Islamic banks tend to rely on

### _wp1672 - references to price Islamic banks credit. As a result, some Islamic banks tend to rely on

### Pricing practices of Islamic banks
- Some Islamic banks "tend to rely on conventional interest rates to price their Murabahah and Ijarah contracts."
- 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.
- Citations in the text: 15, 16, 17.

### Implications for monetary policy transmission
- 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.

*Source: _wp1672 - references to price Islamic banks credit. As a result, some Islamic banks tend to rely on*

### Box 1. Monetary Transmission from Conventional to Islamic Financial Systems

### Box 1. Monetary Transmission from Conventional to Islamic Financial Systems

### Classification of Islamic finance contracts and implications for liquidity management
- Islamic finance contracts are classified in three broad categories:
  - (i) profit-and-loss sharing contracts such as Mudarabah and Musharakah;
  - (ii) debt-like contracts such as Ijarah and Murabahah;
  - (iii) services such as Wadi’ah.
- Mudarabah:
  - financier (Rab-al-mal) provides capital; beneficiary (Mudarib) provides labor and expertise.
  - when used for interbank transactions, the surplus bank invests funds over the short-term (usually 3 to 12 months) in the shortage bank on a Mudarabah basis with returns based on a pre-agreed profit-sharing ratio.
- Musharakah:
  - joint partnership/joint-venture where banks enter equity partnerships to jointly finance projects; profits distributed per pre-agreed ratio, losses shared in proportion to capital.
- Ijarah:
  - lease contract where a party leases a good for a specific sum and period.
- Murabahah:
  - bank purchases a good from a third party and resells to customer at an agreed mark-up for immediate or deferred payments.
  - commodity Murabahah can be used for interbank or central bank transactions using an underlying commodity (mostly a metal).
- Wadi’ah:
  - safekeeping contract used for demand deposits that earn no return; central bank Wadi’ah certificates can be issued against funds deposited by Islamic banks at the central bank.

### Transmission linkages between conventional and Islamic systems
- Competitive pressures in conventional-dominant jurisdictions can limit PSIAs returns deviation from conventional deposit rates, leading Islamic banks to link mark-ups/returns to conventional interest rates.
- Empirical evidence (Cevik and Charap (2011)) in Malaysia and Turkey found:
  - conventional banks deposits rates and PLS returns exhibit long-run cointegration;
  - time-varying volatility on conventional banks deposits rates and PSIAs returns is correlated and statistically significant;
  - causality appears to run from conventional deposits rates to PSIAs returns.
- Malaysia specifics:
  - Islamic banks’ funding costs are strongly influenced by the Bank Negara Malaysia Overnight Policy Rate (OPR).
  - Malaysian Islamic Interbank Money Market (IIMM) established on January 3, 1994.
  - Mudarabah Interbank Investments (MII) within IIMM: deficit Islamic banks obtain investment from surplus Islamic banks based on a profit-sharing ratio, maturities ranging from the overnight to twelve months.

### The signaling mechanism and the profit-sharing principle
- Central banks (CBs) in dual systems can try to influence Islamic banks’ funding costs by targeting profit-sharing ratios of interbank Mudarabah transactions; effectiveness depends on the level of Islamic financial market development.
- The signaling channel:
  - CBs can set profit-sharing ratios in their Mudarabah transactions with Islamic banks, potentially influencing Islamic banks’ client contracts.
  - No empirical evidence that the profit-sharing mechanism is an effective monetary policy channel when Mudarabah and other PLS contracts are not widely used.
  - If PLS contracts are not widely used by banks, consumers, and firms, this transmission channel breaks down or is too weak.
- Policy recommendation:
  - CB communication should include information related to Islamic banks liquidity conditions, interbank markets, and their Shari’ah-compliant operational framework to strengthen the expectations channel.
  - IFSB Guiding Principles suggest supervisory authorities should provide clarity on roles in normal and stressed times and be explicit about Shari’ah-compliant collateral types, limits, and possible financing durations.

### Adapting the monetary policy framework in dual systems
- Monetary policy differs in underdeveloped financial markets (focus on supply of credit) versus developed systems.
- In dual systems, conventional segment is often more developed than Islamic segment; monetary policy cannot operate identically across segments when development levels differ.
- Whether monetary policy has similar effects across segments depends on:
  - size of Islamic segment relative to conventional segment;
  - jurisdiction and structure of Islamic contracts;
  - behavior of consumers and Islamic banks;
  - extent to which consumers respond to changes in interest rates.
- Consideration:
  - In some cases, deep religious beliefs can make clients indifferent to PSIAs returns or Islamic credit costs; in others, consumer arbitrage drives convergence of returns/costs to conventional rates.
- Three layers of complexity in designing frameworks where Islamic finance is significant:
  - Islamic finance core principles and cautious Shari’ah interpretation;
  - heterogeneity of financial systems and monetary policy frameworks;
  - relationship between monetary policy, financial development, and financial stability policies for Islamic banks.

### Fixed exchange rate regimes considerations
- Many countries with Islamic banks have pegged exchange rate regimes, limiting CBs’ ability to influence monetary conditions via quantity changes.
- Pegged regimes constrain significantly expanding bank reserves; level of FX reserves and systemic liquidity control are key to exchange rate anchor viability.
- CBs with fixed exchange rates can still enhance liquidity management through sterilization policies and monetary policy instruments to offset liquidity shocks.

### Making monetary transmission operational: market-based instruments and infrastructure
- Preference for market-based instruments over direct instruments for both conventional and Islamic banks to avoid non-transparent discretionary interventions and liquidity misallocation.
- Two key dimensions to incorporate Islamic banks:
  - develop basic infrastructure for market-based Islamic monetary policy (Islamic money and Sukuk markets, reduce market segmentation);
  - address continuous evolution of the monetary policy framework (spillovers, competition among Islamic banks).
- Market segmentation risks:
  - Islamic banks often cannot access conventional CB monetary operations or interbank markets, reducing liquidity management options and profitability.
  - IIFS reliance primarily on interbank arrangements with other IIFS and limited transactions with conventional banks evidences segmentation, which hampers liquid money markets when Islamic banks are few.
- Active Islamic interbank markets are crucial for transmission via profit-sharing ratios and exchange rate channels.
- Basic infrastructure building blocks for market-based Islamic monetary policy include:
  - Islamic collateralized money-market instruments for liquidity management;
  - high quality marketable collateral (in sufficient amounts);
  - active interbank Mudarabah and collateralized interbank markets;
  - efficient operational framework;
  - adequate payment and settlement systems.
- Operational recommendations:
  - standardize interbank arrangements initially and introduce other contract types gradually;
  - analyze comparative advantage and Shari’ah-compliance risk of interbank Mudarabah relative to other interbank structures;
  - dematerialization of government securities and effective delivery-versus-payment and collateral mobilization procedures.

### Sterilization policies and sources of surplus liquidity
- Islamic banks often exhibit surplus liquidity for reasons including prohibition on interest, insufficient sterilization, lack of Shari’ah-compliant HQLA, underdeveloped Islamic money markets, insufficient sovereign Sukuk issuance, and monetary financing of government deficits or weak government cash management.
- Sterilization should be part of a broad approach including fiscal, monetary, FX, and market development policies; structural and long-term instruments may be required.
- Reserve Requirements (RR):
  - RRs are under CB control and powerful on credit but typically not remunerated for Islamic banks, increasing cost of Islamic credit and being non market-based.
  - Harmonization in practice: features of RRs are generally harmonized between conventional and Islamic banks except returns—Islamic banks’ RR typically not remunerated.
- Importance of High Quality Liquid Assets (HQLA) and government Sukuk:
  - government Sukuk cannot substitute standing facilities and OMOs but can provide collateral for Shari’ah-compliant SFs and OMOs.
  - Public investment-backed government securities have been used in full-fledged Islamic systems to issue securities for monetary policy.
- Examples and empirical findings:
  - Government Investment Certificates (GICs) in Sudan: long-term Ijarah contracts using SPV-owned assets leased to government; securities issued to the public to finance asset purchase.
  - Godlewski, Turk, and Weill (2014) found Ijarah-based Sukuk have lower Shari’ah-compliance risk and higher development potential relative to other Sukuk structures.
- CB securities and government securities:
  - Islamic CB securities have been used (Bahrain and Malaysia) across maturities.
  - Issuing CB securities can compete with government securities and may generate losses for CBs; require persistent surplus liquidity.
  - Preferable to develop government securities first where possible.

### Sterilization instruments — key considerations (summary of pros and cons)
- Reserve Requirements:
  - Pros: under CB control; powerful effect on credit.
  - Cons: not remunerated for Islamic banks => increase cost of Islamic credit; non market-based.
- Central bank securities:
  - Pros: under CB control.
  - Cons: require persistent surplus liquidity; compete with government securities early; can generate losses to CB.
- Government securities:
  - Pros: sterilization costs borne by government; CBs’ preferred collateral; development of benchmark yield curve; impose discipline/transparency to debt management.
  - Cons: large fiscal surpluses required; potential crowding out of private credit early.
- Stabilization funds:
  - Pros: permanently insulate economy from FX inflows.
  - Cons: mainly appropriate when excess liquidity source is FX.

### Monetary policy operational framework, usage and adaptation statistics
- Direct instruments still used in some countries:
  - interest rate controls in Bangladesh, Iran, and Yemen;
  - credit ceilings in Jordan, Oman, and U.A.E.;
  - directed credits and specific lending requirements in Iran; Jordan applies specific lending requirements.
  - Bangladesh Bank extends Islamic refinancing facilities for priority sector lending.
- Progress and gaps:
  - progress in Shari’ah-compliant instruments to mop up structural excess liquidity, but short-term monetary policy instruments lag.
  - reliance on government and CB securities issuance in dual systems due to liquidity surpluses and prohibition on interest.
  - outright purchases and sales of tradable Sukuk used in Iran, Malaysia, and Sudan.
- IFSB Stability Report of 2013 findings (survey of 32 regulatory and supervisory authorities):
  - 72 percent rely on CB or government securities for monetary policy purposes;
  - 29 percent have adapted CB or government securities to meet Islamic finance requirements;
  - only 23 percent have adapted repo and outright operations to accommodate transactions with IIFS;
  - only 10 percent have adapted their credit facility to Islamic banks;
  - 25 percent have adapted their deposit facilities to Islamic banks.

### Lender of Last Resort (LOLR) and Shari’ah-compliant LOLR (SLOLR)
- Definition used: LOLR as CBs’ intervention in response to an idiosyncratic need.
- Best practices for LOLR:
  - provided at a penalty rate to solvent and viable entities whose shutdown would create financial stability risks;
  - used after exhaustion of other funding options; temporary; subject to supervisory intrusion and conditionality.
- SLOLR design requirements:
  - separate LOLR from regular operational framework;
  - bilateral collateralized lending at CB discretion under financial stability mandate and exceptional circumstances;
  - broader collateral than conventional monetary policy but Shari’ah-compliant.
- Challenges:
  - interest-bearing loan and penalty rate references complicate Shari’ah compliance;
  - IFSB survey: only 25 percent of regulatory and supervisory authorities developed a SLOLR framework for IIFS using Muḍarabah, Musharakah, Murabahah structures.

### Interbank markets and collateralized transactions
- Creating interbank markets is difficult when participants are in surplus liquidity with no liquidity needs.
- Uncollateralized instruments:
  - Mudarabah contracts for interbank funds with agreed profit-sharing ratios.
- Collateralized instruments:
  - commodity Murabahah is used but its Shari’ah-compliance is questioned in some jurisdictions; operational constraints limit its use as very short-term instrument.
- Strategy for market development:
  - develop tradable government Sukuk issued regularly over different maturities and sufficient volumes;
  - avoid proliferation of different Sukuk types to create fungible HQLA;
  - standardize structuring of Islamic government securities and money market instruments.
- Collateralized transaction options for Islamic banks liquidity management:
  - sell and buybacks (Shari’ah-compliant repos in practice, though different from conventional repo);
  - interest-free collateralized loans (Qard with Rahn).
  - ideally collateral should be government Sukuk rather than less liquid assets (commodity).
- Collateral extension considerations:
  - IFSB suggests accepting Sukuk from public sector enterprises, major national corporations, multilateral institutions, other sovereigns and CBs; consider Sukuk issued by IDB and IILM.
  - expansion of acceptable collateral should not impede development of domestic government Sukuk markets.
- Constraints to government Sukuk market development:
  - large fiscal surpluses, non-standardized issuances, reliance on non-tradable Sukuk, Shari’ah-compliance risk, continued CB direct financing, weak government debt management, narrow investor base, limited financial sector diversification, inappropriate payment and settlement systems, absence of collateralized instruments with government Sukuk as underlying assets.
- Market development prerequisites:
  - variety of investors, effective intermediaries, robust market infrastructure, MoF commitment, mutual funds and asset management activities.

### Conclusion — policy implications and priorities
- Many countries with significant Islamic banking operate fixed exchange rate regimes; exchange rate is often main nominal anchor and systemic liquidity control is key to monetary policy effectiveness.
- Islamic banks are frequently in surplus liquidity; excess liquidity must be properly managed to enhance monetary transmission.
- When the interest rate channel is effective, transmission from conventional to Islamic segment can operate, but acceptance varies across Shari’ah scholars and depends on consumer and bank behavior and Islamic money market development.
- Dual monetary policy approaches may be needed where Islamic segment is less developed.
- Key priorities:
  - orderly development of Islamic domestic interbank markets to facilitate liquidity management of Islamic banks;
  - standardization of liquidity management instruments, reduction of Shari’ah-compliance risk, and development of CB operational frameworks;
  - coordination and strong commitment of CB and fiscal authorities and regulatory changes to build Islamic interbank and government Sukuk markets;
  - more proactive CB role in developing domestic government Sukuk markets to support both implementation of Islamic monetary policy and Islamic banks’ profitability and viability.

*Source: Box 1, "Monetary Transmission from Conventional to Islamic Financial Systems" (content as provided).*

### Appendix I. The Interbank Mudarabah

### Appendix I. The Interbank Mudarabah

### Structure of the interbank mudarabah

- 1. Bank A provides funds to be invested by bank B with agreed profit-sharing ratio
  - BANK A (Capital Provider)
  - BANK B (Entrepreneur)

- 2. Upon maturity, profit gained will be shared accordingly and the principal will be returned to the capital provider

### Key features and mechanics

- Parties: Bank A acts as the capital provider; Bank B acts as the entrepreneur/manager of the investment.
- Profit-sharing: Returns are distributed according to an agreed profit-sharing ratio between Bank A and Bank B.
- Principal protection: The principal is returned to the capital provider upon maturity (subject to the investment outcome as implied by profit sharing).
- Contract type: Mudarabah—a profit-sharing investment partnership where one party provides capital and the other provides management.

*Source: Technical note on issues in the development of Islamic money and FX markets, IFSB, March 2008.*

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