TOOLS FOR CONTROLLING MONETARY … for Controlling Monetary Variables in the Islamic Banking System...

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TOOLS FOR CONTROLLING MONETARY VARIABLES IN THE

ISLAMIC BANKING SYSTEM

Abdul Ghafar Ismail

1. INTRODUCTION

In monetary economics, monetary policy is a key aspect of public policy for managing

the economy. The Bank1 is given the task of conducting the monetary policy to promote

monetary and financial stability and, hence, to produce a conducive environment for

attaining sustainable growth of the economy. In Malaysia, the financial system consists of

the conventional financial system and the Islamic financial system. The latter is

prohibited from receiving and paying interest. The question arises as to how monetary

policy would be conducted in the absence of interest, which is currently both a tool of

monetary policy and the choice of monetary variables to be controlled.2 The question is

especially important when the interest rate is used as a benchmark for Islamic financial

transactions. For example, Choudhry and Mirakhor (1996) and Masood Khan (2004)

mentioned that the interest rate is the basis of securities used for open market operations.

The absence of interest, as mentioned by Mohsin and Mirakhor (1984), would not lead to

any dilution in the effectiveness of monetary policy to achieve its objective. However, the

Abdul Ghafar Ismail is Professor of Banking and Financial Economics, School of Economics, Universiti Kebangsaan Malaysia. He is also a Research Fellow at ISRA and AmBank Group Resident Fellow for Perdana Leadership Foundation. He can be contacted at [email protected]. 1 Please refer to the Bank of Malaysia Act, gazetted on September 2009. Although the Act refers to the “Central Bank of Malaysia” as CBA, it also refers to it as the Bank. The Bank of Malaysia is also known as Bank Negara Malaysia. 2 Sometimes we can call this variable an intermediate target.

ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail

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design of the Islamic banking system may change the transmission of monetary policy.

This issue has not been touched yet. The prohibition of interest not only has implications

for the working of monetary policy (including the financial system) in a dual financial

system but also the relations between depositors and banks and between banks and

entrepreneurs.

There remain questions about the choice of monetary policy tools. Basically, there are

two financial system designs. Both models incorporate, to varying degrees, the principle

of profit sharing with depositors and entrepreneurs. The first model relies exclusively on

the profit-sharing principle for both assets and liabilities. In the second model, there is a

mix of profit-sharing and non-profit-sharing principles. The difference lies in the sharing

of profit from both models. Consequently, both models have implications for formulating

the design and use of tools of monetary policy.

The discussion of this paper will explain first the choice of monetary policy tools. It will

be followed by a discussion of the theoretical basis for the operational target of monetary

policy. In determining the target of monetary variables, both the short-term interest model

and the reserve position will be presented in Sections 4 and 5, respectively. In Section 7,

the focus will highlight on the lessons from the Reserve Position Doctrine. Finally,

suggestions on the choice of the monetary target for the Islamic banking system will be

put forward in Section 8.

2. CHOICE OF MONETARY POLICY TOOLS

In formulating monetary policy, as it is normally described in textbooks, the Bank has

three tools from which to choose: reserve requirements, overnight policy rate, and open

market operations. The aim of these tools is to promote monetary and financial stability

in order to produce a conducive environment for attaining sustainable growth of the

economy. To achieve the objective, the Bank establishes the monetary policy committee.

The responsibility of this committee is to formulate the overall monetary policy as well as

Tools for Controlling Monetary Variables in the Islamic Banking System

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the detailed policies for the conduct of monetary policy operations. In the following

subsection, the discussion will focus on the working of each tool.

2.1 Reserve Requirements

The statutory reserve requirement (SRR) is a monetary policy tool used by the Bank for

the purposes of liquidity management and for the contraction or expansion of financing in

the Islamic banking system. It has been implemented since January 1959. Effectively,

Islamic banks and other banking institutions are required to maintain balances in their

Statutory Reserve Accounts equivalent to a certain proportion of their eligible liabilities

(EL). This proportion is known as the statutory reserve requirement rate. By changing the

rate, the Bank can withdraw or inject liquidity in the Islamic banking system to make up

for an excess or deficiency of liquidity.

In principle, Islamic banks must maintain their Statutory Reserve Accounts balances at

the Bank at a level that is at least equal to the prescribed ratio. If Islamic banks fail to

comply with the minimum SRR requirement, they are liable to pay a penalty. Therefore,

Islamic banks must observe the movement of SRR. To fulfil this requirement, Islamic

banks are required to maintain the average daily amount of their eligible liabilities over a

fortnightly period (the base period). Each month will have two base periods (for example,

Base Period A and Base Period B): Base Period A is the average daily amount of EL

from the 1st to the 15th day (inclusive); and Base Period B is the average daily amount of

EL from the 16th to the last day of the month (inclusive).

For the reserve maintenance period from the 1st to the 15th day of any month, the SRR

will be based on the average EL of Base Period A of the preceding month, while for the

reserve maintenance period from the 16th to the last day of any month, the SRR will be

based on the average EL of Base Period B of the preceding month.


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However, maintenance of balances in the Statutory Reserve Accounts is flexible, with a

daily variation from the SRR within a band, which currently stands at ±20% of the

prevailing statutory reserve requirement ratio. This band, within which the balances of

each Islamic bank are allowed to fluctuate on any day, allows Islamic banks flexibility in

managing their liquidity while, at the same time, ensuring that no Islamic bank behaves

imprudently by allowing their reserves on any given day to fall too far.

The components of EL consist of ringgit-denominated deposits and non-deposit

liabilities, net of inter-bank assets and placements with the Bank. As of 1 September

2007, additional adjustments were made to the EL component:3

Excluded from EL components:

- the entire proceeds of Tier-1 housing financing sold to Cagamas Berhad.

- 50% of the proceeds of Tier-2 housing financing sold Cagamas Berhad.

Deducted from EL components:

- Islamic banks are allowed to deduct from the EL components holdings of

RM marketable securities such as Islamic Government and Bank Negara

Malaysia securities; Islamic corporate private debt securities, including

Cagamas securities; RM securities issued by Multilateral Development

Banks (MDBs) and Multilateral Financial Institutions (MFIs); and any

other securities as specified by the Bank (e.g. Sukuk BNM Ijarah issued by

Bank Negara Malaysia Sukuk Berhad) and ABF Malaysia Bond Index

Fund.

- Principal Dealers (PDs) are allowed to deduct from their EL components

the daily holding of specified RENTAS securities in their trading and

3 The example for calculating SRR is given in Appendix A.


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banking books, and RM Marketable securities which are not specified

RENTAS securities in their trading book.

2.2 Open Market Operations

Open market operations―purchases and sales of financial instruments such as Islamic

treasury bills and government investment issues―are the Bank’s principal tool for

implementing the monetary policy. In implementing the monetary policy, the Bank

employs open market operations as the principle source of reserves for the Islamic

banking system and currency for the public and as the principal means of effecting short-

run adjustments in reserves. In this context, the Bank financing has two main roles. First,

it acts as a short-run safety valve for the overall banking system by making additional

reserves available when the aggregate supply of reserves provided through open market

operations falls short of demand, thereby preventing an excessive tightening of money

market conditions. Second, it enables Islamic depository institutions that are financially

sound, but have experienced an unexpected shortage of reserves or funding, to make

payments while avoiding over-drafts on their accounts at the Central Bank, at other

Islamic banks, or when facing shortfalls in meeting their reserve requirements.

The short-term objective for open market operations is specified by the Bank’s Monetary

Policy Committee (MPC). The Bank’s objective for open market operations has varied

over the years. As shown in Table 1, the focus centred on managing excess liquidity in

the inter-bank market arising primarily from large inflows due to international trade and

inward portfolio investments. In the Islamic inter-bank money market, placements under

the muÌÉrabah principle are generally undertaken with the same level of flexibility. The

Bank also increased its use of repurchase transactions (repos) as a means to sterilize

excess liquidity. For example, during the year 2005, the value of trading in the Islamic

inter-bank market fell with the decline in muÌÉrabah inter-bank investment transactions.

The decline in muÌÉrabah transactions was also attributed to stable liquidity conditions


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and the average rate of returns offered in the muÌÉrabah inter-bank investment

transactions.

The Bank can also state its target level for the muÌÉrabah inter-bank funds rate. It

can do so through their meetings, which usually include the MPC’s assessment of the

risks to the attainment of its long-run goals of price stability and sustainable economic

growth.

Table 1 also shows that the Bank can have various financial instruments in their open

market operations.

Table 1: Example of Inter-bank Funds Market and Open Market Operation

2002 2003 2004 2005

RM Billion

Total 280.7 341.4 562.5 356.5

Mudharabah interbank investment* 247.0 283.8 485.7 254.7

Financial instruments 33.7 57.6 76.8 101.8

Islamic accepted bills* 24.8 10.0 10.3 9.4

Negotiable Islamic debt certificate* 0.8 4.2 8.2 8.6

Bank Negara negotiable notes 2.2 8.9 21.2 36.1

Islamic treasury bills 0 0 1.2 4.5

Government investment issues 5.9 34.5 35.9 43.2

Sources: Annual Report, Bank Negara Malaysia, various issues

Note: * volume transacted through brokers


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2.3 Overnight Policy Rate

The overnight policy rate is the muÌÉrabah inter-bank fund rate paid by Islamic banks

and other Islamic depository institutions on financing they receive from the Bank’s

financing facility.

Under the facility, financing is extended for a very short term (usually overnight) to

Islamic depository institutions in generally sound financial condition. Islamic depository

institutions may also apply for financing to meet short-term liquidity needs or to resolve

severe financial difficulties. Seasonal financing is extended to Islamic depository

institutions that have recurring intra-year fluctuations in funding needs, such as Islamic

banks in agricultural or seasonal resort communities.

For example, in the first part of 2007 the MPC decided to keep its target for the

muÌÉrabah inter-bank funds rate at the level of 3.5 percent due to slower economic

growth in that period and to make up for ongoing adjustments in the housing sector.

Nevertheless, the economy seemed likely to expand at a moderate pace over the coming

quarters. Core inflation remained somewhat elevated. Although inflation pressures

seemed likely to moderate over time, the high level of resource utilization had the

potential to sustain those pressures. This might influence the margin rate for murÉbaÍah

financing.

From the above discussion, a monetary policy tool is a tool available to the Bank to use to

reach its operational target. Today, the Bank uses three such tools, namely reserve

requirements, overnight policy rate, and open market operation.


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3. THE CONCEPT OF AN OPERATIONAL TARGET OF MONETARY

POLICY

Today, there is little debate, at least among central bankers, about what a central bank

decision on monetary policy means: it means to set the level of the short-term money

market interest rate that the Bank aims at in its day-to-day operations during the period

until the next meeting of the Bank’s decision-making body. Although, the Bank appears

to have followed such an approach in practice most of the time, academic economists

during most of the 20th century favoured a rather different approach to defining the

operational target of monetary policy.4 The approach still remains the subject of great

debate in textbooks on monetary economics. The textbooks contain many references to

Reserve Position Doctrine (RPD) concepts; for example, substantial space is devoted to

the money multiplier.

It seems that both RPD and the short-term interest rate model (STIR)5 have contrasting

views. Before the debate goes further, this section will briefly define the concept of an

operational target of monetary policy and review the possible specifications of

operational targets. The concept of an operational target needs to be distinguished clearly

from two other concepts: tools of monetary policy and intermediate targets. The

following definitions of the two terms are proposed here. (Monetary policy tools have

already been discussed.)

The operational target of monetary policy is an economic variable that the Bank wants to

control, and indeed can control, to a very large extent on a day-by-day basis through the

4 In the words of Goodhart (1989, p. 293): “The Bank primarily conducts its policy by buying or selling securities....Academic economists generally regard such operations as adjusting the quantitative volume of the banks’ reserve base, and hence of the money stock, with rates (prices) in such markets simultaneously determined by the interplay of demand and supply. Central bank practitioners, almost always, view themselves as unable to deny setting the level of interest rates, at which such reserve requirements are met, with the quantity of money then simultaneously determined by the portfolio preferences of private sector banks and non-banks.” 5 STIR will be discussed in greater detail on page 13.


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use of its monetary policy tools. It is the level of this variable that the monetary policy

decision-making committee of the Bank actually decides upon in each of its meetings.

The operational target thus: (i) gives guidance to the implementation officers in the Bank

as to what must be done on a day-by-day basis in the inter-meeting period, and (ii) serves

to communicate the stance of monetary policy to the public. Today, there seems to be

consensus among central banks that the short-term inter-bank interest rate is the

appropriate operational target.

An intermediate target is an economic variable that the Bank can control with a

reasonable time lag and with a relative degree of precision, and which is in a relatively

stable or at least predictable relationship with the final target of monetary policy, of

which the intermediate target is a leading indicator. The typical intermediate target has

been a monetary aggregate like M1 or M3, an exchange rate, or some medium or longer-

term interest rate. It is assumed that via its operational target, the intermediate target can

be controlled or at least influenced in a significant way. The popularity of the

intermediate target concept has decreased over the last two decades, and most previous

intermediate targets are considered today more as indicator variables which convey

useful information to the Bank, without that being sufficient to justify a “target” status.

Although these concepts appear reasonably simple and clear, there has been a long

tradition of mixing them up through imprecise usage. Poole (1970), by raising the

question “whether to use the interest rate or the money stock as the policy instrument”

had an unfortunate influence in this respect. Poole (1970, p. 198) defines an “instrument”

to be a “policy variable which can be controlled without error” and considers three

possible approaches to its specification (p. 199):

First, there are those who argue that monetary policy should set the money stock while letting the interest rate fluctuate as it will. The second major position in the debate is held by those who favour money market conditions as the monetary policy instrument. The more precise proponents of this general position would argue that the authorities should push interest rates up in times of boom and down in times of recession, while the money supply is


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allowed to fluctuate as it will. The third major position is taken by the fence sitters who argue that the monetary authorities should use both the money stock and the interest rate as instruments….the idea seems to be to maintain some sort of relationship between the two instruments.

The merging of the three concepts, clearly distinct in monetary policy practice, makes an

application of Poole (1970) in central banking difficult, but it has invited academics to

work on the same imprecise lines over decades. The extensive related literature has been

reviewed, e.g. by Walsh (1998). If one uses the term operational target in the precise

sense as defined above, one may categorise the approaches taken by central banks

towards them along the following dimensions. All are somewhat related to the

operational target’s role of communicating the policy stance, either internally, within the

Bank, or externally.

Explicit versus implicit operational target. As already mentioned, the Fed defines

its federal funds rate target explicitly, while others, for example, the Bank of

England and the European Central Bank (ECB) stick with an implicit target in the

sense that it is revealed with a fair degree of precision through the rate at which

they operate in the market (being an implicit commitment to achieve similar

market rates). The Bank of Japan is presently defining an explicit and quantified

quantitative target, namely the amount of total reserves of banks with the Bank of

Japan (see the press release of 19 March, 2001 announcing the policy). The Bank

of Japan’s target implies huge excess reserves, and zero short-term market interest

rates. It implies that this quantitative operational target as a second order target,

ranking below the zero-percent interest-rate target. As the cases of the ECB and

the Bank of England suggest, explicitness does not seem to be a necessary

condition for an effective communication of the monetary policy stance to the

public.

Quantified versus non-quantified operational target. A quantified operational

target is a target for which the Bank provides, at least internally, an exact figure


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after each meeting of its decision-making body. Quantification is a necessary, but

not sufficient, condition for explicitness. The Fed’s quantitative operational

targets were normally not explicit in the sense that they were not even quantified.

For instance, the Bank of England’s implicit short-term interest-rate target,

communicated via the fixed rate of tender operation, is a quantified target, since

the level of the tender rate is precisely applied during the inter-MPC meeting

period. Today’s fed funds target rate is both explicit and quantified. In contrast,

quantitative reserve targets were rarely quantified by the Federal Open Market

Committee (FOMC) in its decisions, with the exception, maybe, of the 1979-82

period (see the FOMC policy records in the Annual Reports of the Board of

Governors). Such a non-quantification of a quantitative operational target may be

considered odd, and leaves uncertain the exact meaning and content of such an

operational target. In fact, one could argue that such use of the operational target

concept does not really fulfil the definition one would like to give to such a

concept today, namely to indicate the monetary policy stance for the inter-

committee meeting period, both for the implementation officers in the Bank and

to the public. Noting this, Friedman (e.g. 1982) was constantly arguing that the

Fed should quantify and make explicit its supposed quantitative operational

targets.

Public immediate release, or not. Today, most central banks publish immediately

after the meeting of their monetary policy committee the quantification of the

level of the operational target variable. However, this was not always done: for

instance the Fed before 1994, and from 1974-79 did not immediately announce its

target specification, and thus the markets tried to extract it from the (variable rate

tender) operations of the Federal Reserve of New York.

A unique versus a variety of operational targets. Today, e.g. the Fed has specified

one unique operational target, the federal funds rate. The Fed thus seems to

consider the fed funds rate as a sufficient measure for its monetary policy stance.


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The opposite approach is described, for example, by Anderson (1969). According

to him, in the 1960s there were eight measures of money market conditions

considered by the Fed, namely “the Treasury bill rate, free reserve of all member

banks, the basic reserve deficiency at eight New York money market banks, the

basic reserve deficiency at 38 money market banks outside New York, member

banks’ borrowing from the Federal Reserve, United States government security

dealer borrowings, the Federal funds rate, and the Federal Reserve discount rate.”

As mentioned, one could argue that the Bank of Japan today has two operational

targets which have however a clearly defined hierarchical relationship: short-term

interest rates should be zero, and within that setting, the operational target is

defined in terms of an (excess) reserves target.

Choosing between (i) a short-term interest rate, (ii) a quantitative, reserve-

related concept, or (iii) a foreign exchange rate. The latter is done by central

banks that peg their own currency strictly to a foreign one. The focus is on the

choice between (i) and (ii). The former solution was systematically adopted by

central banks before 1914 and is standard again today. The latter was applied at

least to some extent in the US and deemed appropriate in academic circles during

the age of RPD, i.e. in the period between 1920 and 1990, approximately.

With regard to interest-rate targets, an important aspect is the maturity of the target rate.

Today, the maturity of the targeted market interest rate seems to be most often the

overnight rate, although it is probably not the overnight rate that is really most relevant in

influencing decisions of key economic agents (consumers, investors, etc.). According to

Borio (1997), in his sample of 14 central banks of industrialised countries, eleven used an

overnight interest-rate target; one used a 30-day interest-rate target; and two used

interest-rate targets of 30-90 days. Since then, the three dissenting ones (Belgium,

Netherlands, UK) have all embraced the overnight maturity. The striking advantage of

focussing on the overnight maturity is that fully anticipated changes of the operational

target in its case do not lead to anomalies in the yield curve, but such anomalies arise


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whenever (i) the target is defined in terms of longer maturities, (ii) changes of the target

are anticipated, and (iii) the target is indeed strictly implemented. Consider, for example,

what needs to happen with the overnight rate around day T if on day T, a 90-day interest-

rate target changes in an anticipated way from 4% to 5% (see Bindseil (2004). The fact

that, in the past, central banks had a 30 or 90-day target-interest rate, probably meant that

they did not implement changes in a strict way from one day to the next, or that they tried

to avoid changes that were well anticipated. Both features would today be deemed to be

suboptimal, as they conflict with the aims of simplicity and transparency.

By controlling the overnight rate to a fair degree, and by making changes to the overnight

rate target predictable within a well-known macroeconomic strategy of the Bank, medium

and longer term rates―i.e., those judged to be most relevant for monetary policy

transmission―will react in a predictable way to changes in short-term rates. It has

sometimes been argued that this implies that short-run volatility of the overnight rate is

not a problem per se, as it will not necessarily influence medium and longer-term rates.

This is true, and indeed some central banks (e.g. the Bank of England) have operated with

a significant degree of white noise in the overnight rate without this causing problems in

monetary policy transmission. Also, the ECB has accepted some degree of volatility in

overnight rates, although it could have reduced it through more frequent open market

operations. Still, one could argue that, with everything else unchanged, white noise in any

price does not add value, but creates (maybe very small) incentives for market players to

invest in activities that exploit the variability of prices, which is, from a social point of

view, a waste of resources. In any case, this is less of a monetary-policy than a market-

efficiency issue. Only if volatility of overnight rates is very different from white noise, in

the sense that shocks to overnight are rather persistent, does it become a nuisance for

monetary policy, as it will be transmitted to medium and longer-term rates (see e.g.

Ayuso et al., 2003). This is certainly the case if the Bank aims to strictly control some

quantity. RPD generally denied that the Bank bears responsibility for short-term rates,

and in its different variants suggested, instead, the following operational targets (the list


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tries to order the different quantitative concepts from broad to narrow, which is however

not obvious in all cases):

The monetary base, which is the sum of reserves of banks with the Bank and

currency. This tended to be the preferred concept of monetarists, who did not

want to get into the details of day-to-day monetary policy implementation and

the implied need to split up further the monetary base into sub-elements.

Reserves of banks. As mentioned, this operational target is currently applied

by the Bank of Japan and was also occasionally advocated by academics.

The total volume of open market operations (Friedman, 1982).

Non-borrowed reserves, i.e. reserves minus borrowed reserves, applied by the

Fed from 1979 to 1982.

Excess reserves, i.e. reserves in excess of required reserves (for critical

reviews, see e.g., Dow, 2001, or Bindseil et al. 2004).

Free reserves, i.e. excess reserves minus the reserves the banks have

borrowed at a borrowing facility (in the US case: at the discount window).

This concept was applied, at least in theory, by the Fed during the period

1954 to 1970 (see, for example, Meigs, 1962).

Borrowed reserves, applied by the Fed from 1982 to 1990.

A categorisation of different historical and present specifications of operational targets is

summarised in Table 1.


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Table 1: Examples of Operational Targets Specifications

Period Explicit (X)

or

not

Quantified

(X) or not

Immediately

published (X)

or not

Unique (X)

or not

Short-Term

Interest Rate

(SID) vs.

Reserve

Concept

(RPD)

1960s X x SID

1970s X x x SID

1980s X x x SID

1990s X x x SID

2000s X x x X SID

4. TODAY’S MODEL OF STEERING THE SHORT-TERM INTEREST RATE

The nature of day-to-day monetary policy implementation needs further clarification. To

show how monetary policy instruments impact on reserve quantities and short term

interest rate, this section presents a brief model which may be called the short-term

interest rate (STIR) model.

4.1 The Taylor Rule vs. the McCallum Rule

While the Bank relies on interest rate targeting in the context of monetary policy, it still

needs a way to choose the target level of the interest rate. In deliberating the target level,


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it needs to incorporate many factors about the economy. Taylor (1993) has synthesized

these factors in the Taylor rules for interest-rate targeting. The Taylor rule states that the

current interest rate target should be the sum of the inflation rate, the equilibrium real

interest rate (defined as the interest rate consistent with long-run full employment), and

two additional terms. The first of these terms is the difference between actual inflation

rates and target inflation rates (or known as “inflation gap”); the second is the “output

gap” – the percentage difference of real GDP from its estimated full-employment level.

The Taylor rule states that:

Interest rate target = inflation + Real equilibrium interest rate + (1/2) Inflation gap + (1/2)

Output gap

Or the rule can be written as follows:

푖 = 휋 + 푟∗ + 훼 (휋 − 휋∗) + 훼 (푦 − 푦 )

In this equation, 푖 is the target short-term nominal interest rate (e.g. the inter-bank rate), 휋 is the rate of inflation as measured by the GDP deflator, 휋∗is the desired rate of inflation, 푟∗is the assumed equilibrium real interest rate, 푦 is the

logarithm of real GDP, and 푦 is the logarithm of potential output, as determined by a linear trend.

In calibrating this rule, let’s say the equilibrium real interest rate is 2% and the target rate

of inflation is 2%. In practice, implementing the Taylor rule requires estimating the

inflation gap and the output gap.6 For example, if inflation is 4%, the inflation gap will

be 4% − 2% = 2%, and if real GDP is 2% greater than full-employment potential GDP,

the Taylor rule recommends an interest-rate target of 4% inflation + 2% equilibrium real

interest rate + (1/2)(2% inflation gap) + (1/2)(2% output gap) = 8%.

6 These gaps reflect the concerns of the Bank’s MPC regarding both inflation and real output fluctuations.


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However, McCallum (1993) introduced an alternative monetary policy rule that specifies

a target for the monetary base (MB) which could be used by the Bank. The rule gives a

target for the monetary base in the next quarter (about 13 weeks). The target is:

푚 = 푚 − ∆푣 + 1.5 (+ ∆푝 + ∆푞 ) − 0.5∆푥

where

푚 is the natural logarithm of MB at time t (in quarters);

∆푣 is the average quarterly increase of the velocity of MB over a four year period from t-16 to t; ∆푝 is desired rate of inflation, i.e. the desired quarterly increase in the natural logarithm of the price level;

∆푞is the long-run average quarterly increase of the natural logarithm of the real GDP; and

∆푥 is the quarterly increase of the natural logarithm of the nominal GDP from t-1 to t.

The explanation of the above formula is as follows. Let, we define the velocity of (base) money, V, by

푉 =푋푀

where: M is the money supply (in our case, the monetary base, MB); and X is the aggregate money traded for goods or services (in our case, the nominal GDP for the quarter in question). Then, let we define the price level, P, (in our case, the GDP deflator divided by 100) by

푃 =푋푄

where Q is the quantity of goods or services exchanged (in our case, the real GDP during the quarter). Together, these definitions yield the so-called equation of exchange

푀푉 = 푋 = 푃푄


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Now, define m, v, x, p, and q as the natural logarithms of M, V, X, P, and Q. Then the equation becomes

푚 + 푣 = 푥 = 푝 + 푞

These quantities are functions of time, t, which we will take to be an integer which counts the quarters of years. So mt means the (average) value of m during the t quarter. The

forward difference operator, is defined by

∆푚 = 푚 − 푚

If we apply the forward difference operator, we get

∆푚 + ∆푣 = ∆푥 = ∆푝 + ∆푞

and so

푚 = 푚 − ∆푣 + ∆푥

The velocity of money changes due to changes in technology (e.g. ATM, and payment mechanism) and regulation (e.g. financing loss provision and required reserve requirement). McCallum assumes that these changes tend to occur at the same rate over a period of a few years. He averages over four years to get a forecast of the average growth rate of velocity over the foreseeable future. Thus one approximates

∆푣 ≈ ∆ 푣 =푣 − 푣

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The velocity term is not intended to reflect current conditions in the business cycle. Then,

we assume that when the rate of inflation is held near its desired value, ∆푝 for an extended period, then the growth rate of real GDP will be near to its long-run average,

∆푞. And thus that the growth rate of nominal GDP will be close to their sum

∆푥 = ∆푝 + ∆푞 ≈ ∆푝 + ∆푞

However, it is not obvious what that desired value of inflation should be. McCallum takes the long-run average rate of growth of real GDP to be 3 percent per year which amounts to


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∆푞 = 0.0075

on a quarterly basis. He expects the Bank to choose an inflation target of 2 percent per year which amounts to

∆푝 = 0.0050

on a quarterly basis (although he would personally prefer a lower inflation target). So the target for the monetary base should be given by a rule of the form

푚 = 푚 − ∆푣 + ∆푥 = 푚 − ∆푣 + ∆푝 + ∆푞 + 휀

where 휀 is a correction term which can only depend on information available at time t. The correction term is intended to compensate for current cyclical conditions. It should be positive when recent growth of output and the price level has been slow. If one takes the correction to be

휀 = 0.5 (+∆푝 + ∆푞) − ∆푥

then the result is McCallum’s rule. A large resulting increase in MB tends to generate or

support a rapid rate of increase in broader monetary aggregates and thereby stimulate

aggregate demand for goods and services. The figures used for the monetary base (MB)

should be the adjusted base. The adjustments serve to take account of changes in legal

reserve requirements that alter the quantity of medium-of-exchange money (such as M1)

that can be supported by a given quantity of the base.

4.2 A Benchmark for Financial Transactions

Inflation is usually measured as the change in prices for consumer goods, called the

Consumer Price Index (CPI). Inflation targeting assumes that this figure accurately

represents growth of money supply (due to an increase in financing),7 but this is not

always the case. The most serious exception occurs when factors external to a national

7 Through the multiplier effect, an increase in financing would increase the money supply.


20

economy are the cause of the price increases. The oil price increases since 2003 and the

2007-2008 world food price crises combined to cause sharp increases in the price of food

and consumer goods, which in turn resulted in a sharp increase in the CPI. This is

especially true in the very emerging markets that often follow the new policy of inflation

targeting, because they are often dependent on imported oil or food.

Currently, interest rates are used as a benchmark for financial transactions in the Islamic

banking system. Taylor’s rule might need to be re-evaluated because the final impact is

on the volume of financing that comprises the cost of acquiring assets and the profit

margin that has an impact on the price level. Hence, if the Bank changes the benchmark,

the amount of financing for particular years would also change. In addition, the amount

of financing (over time) could also capture the price level. Since the inflation rate tends to

be positively related, the likely moves of the Bank to raise or lower interest rates become

more transparent under the policy of inflation targeting. For example:

if inflation appears to be above the target, the Bank is likely to reduce interest

rates. (In the conventional approach, the Bank is likely to increase the interest

rate because inflation and interest rates are inversely related.) This usually

(but not always) has the effect over time of cooling the economy and bringing

down inflation.

if inflation appears to be below the target, the Bank is likely to increase

interest rates. This usually (again, not always) has the effect over time of

accelerating the economy and raising inflation.

Under the policy, investors know what the Bank considers the target inflation rate to be

and therefore may more easily factor in likely interest rate changes in their financing

choices. This is viewed by inflation users as leading to increased economic stability.

Therefore, since the benchmark is exogenously determined by the Bank, the only option

available for Islamic banks is through the changes in percentage margin in order to curb


21

the inflation rate. The lower margin might be translated into a lower inflation rate.

Therefore, the benchmark and the inflation rate are positively related.

4.3 The Lesson from Zero Interest Rate Policy

The zero interest rate policy (ZIRP) is a concept in macroeconomics where economies

exhibit slow growth with a very low interest rate. For example in February 2009, Japan’s

benchmark interest rate was 0.3 percent and recently headed to zero. The U.S. federal

funds rate was 1 percent and headed lower, too. The U.K.’s rate is 2 percent, Canada’s is

2.25 percent and the euro zone’s is 2.5 percent. As the fallout from the global crisis

worsens, these and many other benchmark rates will edge toward zero.8

Under ZIRP, the Bank maintains a 0% nominal interest rate. The ZIRP is an important

milestone in monetary policy because the Bank is no longer able to reduce nominal

interest rates. Many economists believe that monetary policy becomes ineffective under

ZIRP because the Bank has no more tools left to reinvigorate the economy. Some

economists argue that when monetary policy hits the lower bound of the ZIRP,

governments must use fiscal policy. The fiscal multiplier of government spending is

expected to be larger when nominal interest rates are zero than they would be when

nominal interest rates are above zero. Moreover, the multiplier has been estimated to be

above one, meaning government spending effectively boosts output.

5. RPD ACCORDING TO ECONOMISTS

The current debate on Reserve Position Doctrine can be discussed according to three

different views, i.e., Keynesian, Monetarist and Islamic Economists.

8 William Pesek (2009) Fed, BOJ Signal that We Are All Islamic Bankers Now, refer to http://www.musliminvestor.net/banking/bank-of-japan-gives-away-money-interest-free/


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5.1 The Keynesian View

From the early 1930s until the early 1950s, monetary policy had, in the US and many

other countries, a break in the sense that short-term interest rates were at or close to zero

and the main danger was deflation, not inflation. RPD emerged in the US with

consolidated dominance after this break. It is plausible that one reason for this was

enthusiastic support for RPD by Keynes, mainly in the second volume of his Treatise on

Money of 1930. This support seems surprising today, for Keynes’ argumentation appears

to have obvious weaknesses. Maybe two psychological factors may help to understand

what went on in Keynes’ mind when he provided such transatlantic help for RPD. First,

Keynes, of course, liked modern, affirmative approaches, and RPD, having emerged in

the 1920s from scratch, was exactly such a theory. Secondly, RPD was, as will be

described below, systematically ignored by the Bank of England, and Keynes had more

and more during the 1920s become a general arch-critic of the “orthodoxy” of the Bank

of England. Thus, praising RPD was also an additional way for Keynes to attack the

Bank of England’s supposed refusal to accept modern thinking.

Nevertheless, Keynes’ (1930, p. 226) defense of RPD is very interesting because it more

explicitly addresses a number of related key issues than any other author of his time, and

thus guides us today most easily to the weaknesses of RPD:

The first and direct effect of an increase in the Bank of England’s investments is to cause an increase in the reserves of the joint stock banks and a corresponding increase in their loans and advances on the basis of this. This may react on market rates of discount and bring the latter a little lower than they would otherwise have been. But it will often, though not always, be possible for the joint stock banks to increase their loans and advances without a material weakening in the rates of interest charged.

Today, and that should have been valid also in the 1920s, one would argue that the

money market rates obviously always react faster than the loan and investment policy of


23

banks, i.e. it is precarious to assume that “the first and direct effect” of excess reserves

are additional loans. As is well known to anybody who had been in direct contact with

money markets since at least Bagehot (1873), small excesses or deficits in the money

market are sufficient to push interest rates to zero or to very high levels, respectively (or

to the levels of central bank standing facilities). In addition, anyone has worked in the

credit department of a bank will confirm that the decision to grant a loan is never done on

the basis of the bank’s current level of excess reserves. Excess reserves can be traded in

the money market, and what matters is their opportunity cost. Seeing perhaps the flaw in

his argument, Keynes (1930, p. 227) takes recourse to more sophisticated reasoning:

I fancy that a considerable part of the value of open market operations delicately handled by the Bank may lie in its tacit influence on the member banks to move in step in the desired direction. For example, at any given moment a particular bank may find itself with a small surplus reserve on the basis of which it would in the ordinary course purchase some additional assets, which purchase would have the effect of slightly improving the reserve positions of the other central banks, and so on. If at this moment the Bank snips off the small surplus by selling some asset in the open market, the member bank will not obstinately persist in its proposed additional purchase by recalling funds from the money market for the purpose; it will just not make the purchase… In this way a progressive series of small deflationary open-market sales by the Bank can induce the banks progressively to diminish little by little the scale of their operations… In this way, much can be achieved without changing the bank rate.

But again, the assumptions taken appear too arbitrary and to lack a micro-foundation.

What one finds today least convincing is that the whole argument seems to rely on a lack

of willingness of the banks to arbitrage, which is not even well explained. In fact, Keynes

(1930) himself recognizes that his enthusiasm for open market operations goes beyond

that of many central bankers of the 1920s. Finally, it is worth noting that Keynes also

promoted the idea of actively using changes of reserve requirements for the control of

excess reserves of banks, and thus, via the money multiplier, of credit and monetary


24

expansion. Keynes (1930) introduces the case by an example from the UK, in which no

reserve requirements were imposed at that time:9

The Midland Bank had…maintained for some years past a reserve proportion a good deal higher than those of its competitors...beginning in the latter part of 1926, a gradual downward movement became apparent in the Midland Bank’s proportion from about 14.5% in 1926 to about 11.5% in 1929…this…in fact enabled the banks as a whole to increase their deposits (and their advances) by about GBP 100 million without any new increase in their aggregate reserves….Now, as it happened, this relaxation of credit was in the particular circumstances greatly in the public interest….Nevertheless, such an expansion of the resources of the member banks should not, in any sound modern system, depend on the action of an individual member bank….For we ought to be able to assume that the Bank will be at least as intelligent as a member bank and more to be relied on to act in the general interest. I conclude, therefore, that the American system of regulating by law the amount of the member bank reserves is preferable to the English system of depending on an ill-defined and somewhat precarious convention.

Keynes (1930) then proposes a concrete specification of a reserve requirement system,

concluding enthusiastically about its power: “These regulations would greatly strengthen

the power of control in the hands of the Bank of England―placing, indeed, in its hands

an almost complete control over the total volume of bank money―without in any way

hampering the legitimate operations of the joint stock banks.” This argumentation was

taken up by central banks; for instance, the Board of Governors of the Bank of England

listed the three main instruments of monetary policy implementation as follows:

“Discount operations, Open market operations, Changes in reserve requirements”, i.e.

reserve requirements were a relevant tool, especially in so far as they could be changed.

Indeed, both the Federal Reserve and the Deutsche Bundesbank frequently changed

reserve ratios from the 1950s to the 1970s, giving evidence that RPD also determined

their understanding of this instrument of monetary policy.

9 Currently, in Malaysia, non-banking institutions are also exempted from allocating reserves at the Bank.


25

As one example of the countless changes of reserve requirements in the US during that

period, and how directly they were apparently motivated by RPD, consider the following

Fed policy action of August 1960 (from Annual Report, Digest of Principal Federal

Reserve Policy Actions; similar changes were implemented again in November of the

same year):

Authorized member banks to count about $500 million of their vault cash as required reserves, effective for country banks August 25 and for central reserve and reserve city banks September 1. Reduced reserve requirements against net demand deposits at central reserve city banks from 18 to 17½ per cent, effective September 1, thereby releasing about $125 million of reserves.

5.2 The Monetarist View

Generally, monetarists, who liked quantities but tended to dislike the idea of central bank

control of (short term) interest rates, broadly supported RPD, although they were often

not so keen on being bothered with a need to split up their most cherished concept for

monetary policy implementation, the monetary base, into petty-minded technical

concepts like excess reserves, free reserves, borrowed reserves, etc. It seems likely that

popular monetarists like, especially, Friedman played an important role in preventing

RPD from being silently buried already in the late 1960s.

Perhaps the most detailed discussion of monetarist theory applied to monetary policy

implementation is Friedman (1960). Friedman (1960) argues that open market operations

alone are a sufficient tool for monetary policy implementation and that standing facilities

(e.g. the US discount facility) and changing of reserve requirements could thus be

abolished:

The elimination of discounting and of variable reserve requirements would leave open market operations as the instrument of monetary policy proper. This is by all odds the most efficient instrument and has few of the defects of


26

the others….The amount of purchases and sales can be at the option of the Federal Reserve System and hence the amount of high-powered money to be created thereby determined precisely. Of course, the ultimate effect of the purchases or sales on the final stock of money involves several additional links….But the difficulty of predicting these links would be much less….The suggested reforms would therefore render the connection between Federal Reserve action and the changes in the money supply more direct and more predictable and eliminate extraneous influences on Reserve policy.

What may be most striking in Friedman’s (1960) analysis is his silence on the role of

short-term interest rates and in particular about the fact that his proposals would imply

high volatility, at least of short and medium term rates. Similarly, Friedman and Schwartz

(1963) in their critique of the Federal Reserve policy in the 1930s, show little curiosity

for interest rates, but argue again and again in a strict multiplier framework. They follow

the historical development of the monetary base and monetary aggregates to argue within

the multiplier model that open market operations could have increased the monetary base

and hence the money stock, preventing or at least attenuating the crisis of the 1930s (p.

393):

If the deposit ratios had behaved as in fact they did, the change from a decline in high powered money of 2½ per cent to a rise of 6½ per cent… would have changed the monetary situation drastically, so drastically that such an operation was almost surely decidedly larger than was required to convert the decline in the stock of money into an appreciable rise.

Probably the most extreme statements of monetarist views on monetary policy

implementation can be found in Friedman (1982). Friedman (1982, p. 101) summarizes

what he regarded as the predominant opinion on monetary policy implementation at that

time, which could not be more different from today’s homogenous view of central

bankers (or the pre-1914 view, etc.):

Experience has demonstrated that it is simply not feasible for the monetary authority to use interest rates as either a target or as an effective instrument….Hence, there is now wide agreement that the appropriate short-run tactics are to express a target in terms of monetary aggregates,


27

and to use control of the base, or components of the base, as an instrument to achieve the target.

He then elaborates a rather concrete proposal regarding open market operations:

Set a target path for several years ahead for a single aggregate – for example M2 or the base.…Estimate the change over an extended period, say three or six months, in the Fed’s holdings of securities that would be necessary to approximate the target path over that period. Divide that estimate by 13 or 26. Let the Fed purchase precisely that amount every week in addition to the amount needed to replace maturing securities. Eliminate all repurchase agreements and similar short-term transactions.

This proposal is in fact neither a reserve nor a monetary-base target, but an “open market

operations quantity” target and, thus, an additional variant of an RPD inspired operational

target of monetary policy. It is again too difficult to imagine how this proposal would

work in practice and why it should make sense if we accept the realities of the money

market as first described by Bagehot.

Despite the trend of the last 20 years back towards SID, monetarists have insisted on their

views on monetary policy implementation until very recently. In a Wall Street Journal

article of 20 August 2003, Friedman again advocates his approach as described, for

instance, in 1960 and 1982. Meltzer (2003) also reviews the Federal Reserve’s early

history largely from an RPD perspective, and argues, without a reference to interest rates,

that (pp. 62-63) a “complete theory of the monetary system” requires studying all aspects

of the monetary base (and its components).

Today’s central bankers are likely to reject the monetarist approach to the choice for the

operational target of monetary policy as just one more, and even particularly reality-

distant, variant of RPD. Despite that, Friedman needs to be praised for having always

insisted on the point that a target that is not quantified (i.e. for which no concrete figure is

given) cannot be a serious target and leaves in the dark what the Bank is actually aiming

at. This includes the operational target, which the Fed did not want to specify since 1920.


28

By insisting that the Fed should concretely quantify its supposed quantitative targets, he

eventually contributed to push it into the 1979-82 episode, which then revealed so easily

the non-practicability of RPD. It is the more astonishing that Friedman has remained an

un-compromised supporter of RPD until today.

Once the Fed had given up non-borrowed reserves targeting procedures in 1982, pressure

on the Bank of England to adopt RPD faded away (Goodhart, 1989 and 2004), and the

Bank of England thus eventually had a very narrow escape from applying RPD at any

moment during the 20th century.

5.3 Islamic Economists

As mentioned above, fractional-reserve banking is the banking practice in which banks

keep only a fraction of their deposits in reserves (as cash and other highly liquid assets)

and lend out the remainder, while maintaining the simultaneous obligation to redeem all

these deposits upon demand. This practice is universal in modern banking, and is to be

contrasted with full-reserves banking which died out over two centuries ago.

By its nature, the practice of fractional reserve banking expands money supply (cash and

demand deposits) beyond what it would otherwise be. Because of the prevalence of

fractional reserve banking, the broad money supply of most countries is a multiple larger

than the amount of base money created by the Bank. That multiple (called the money

multiplier) is determined by the reserve requirement or other financial ratio requirements

imposed by financial regulators, and by the excess reserves kept by banks.

Thus, fractional reserve banking is a consequence of bank lending, as a bank necessarily

has cash reserves that are only a fraction of deposits when it lends some of those deposits

out. The fractional reserve system allows banks to act as financial intermediaries,


29

facilitating the movement of funds from savers to investors in a society. Both Keynesian

and monetarists view the fractional reserve banking as a form of financial intermediation.

This intermediation is essential in the money (or credit) creation process. The injections

of these variables might changes the prices and quantities in the economy.

Imam Ghazali (1058-1111 CE), Choudhury (2005) and Ahamed Kameel (2002), to

whom Islamic economists owe a great debt for their contributions to monetary theory,

have consistently stressed the importance of money as a medium of exchange and the

importance of banks in facilitating its exchange. Their contribution could also be seen in

treating money as capital. Due to this, the latter two authors disagree on the imposition of

fractional reserves on Islamic banks.

6. LESSONS FROM RPD

Although RPD has been established since Day One of the modern banking system, the

doctrine is not without critics. In this section, several lessons will be highlighted.

6.1 The Liquidity Problem

The advantage of fractional-reserve banking is that it allows banks to generate income on

the funds deposited. Once a bank borrows from customers to make a loan to another bank

customer, it gets to charge interest on the loan, receiving the interest. If customers have

money in an account which generates interest, customers get a cut of the interest charged

on loans, but the bank still receives a significant portion of it. Fractional-reserve banking

is big money in a very literal way, which is why so many banks like this system.

The disadvantage of fractional-reserve banking is that it puts banks in an awkward

position when it comes to liquidity. While banks are not required to retain their deposits

on hand, they have to be able to redeem deposits upon request, as for example when a


30

customer goes in to close a checking account. If a group of depositors all demand their

money of the bank at once, a situation known as a bank run, the bank may not have

enough funds on hand, which could be a serious problem.

Liquidity problems can be compounded when a bank makes poor lending decisions and

borrowers default on loans. When a customer defaults, the bank loses the borrowed

money, along with the income from interest, and it must scramble to make up the

shortfall. Too many bad loans can cripple a bank, causing it to become insolvent.

To address depositor concerns, some countries have government agencies which insure

deposits up to a certain amount, and these agencies may also perform regular audits on

the banks which they back to ensure that they are not taken by surprise when a bank

becomes insolvent. In addition, to mitigate these problems, the Bank (or other

government agencies like PDIM) generally regulate and monitor banks, acting as lender

of last resort to banks.

6.2 Financial System Design

The initial discussion, as reported above, has shown that there are two channels through

which monetary policy changes affect economic activity and inflation. These two are the

interest-rate channel and the money channel. However, as stated in Gordon (2002), one

reason for the change in the monetary transmission mechanism could be due to the

significant structural changes in the financial system. Since the monetary transmission

mechanism depends on banks and financial markets to channel monetary policy actions,

changes in the structural components of the financial system could alter the monetary

transmission mechanism. In other words, components of the financial system might

impact the financial system design.

As a result, the financial system design processes prompt us to reassess the transmission

mechanism through which monetary policy affects the aggregate demand and ultimately


31

the final variables of prices and output. If the financial markets become dominant, then

the capital market plays a predominant role in channelling funds to the economy. The

new financial landscape and financial reforms undertaken to the capital market might

open up new avenues and increased opportunities for financial market development.

However, in this new environment with closer financial integration and strong capital

flows, the effectiveness of monetary policy has often been questioned. Financial reform

and development have had important implications for both the transmission mechanism

and the operating procedure of monetary policy. It has actually altered the channels of

monetary policy, mainly affecting the relationship between monetary aggregates,

financing aggregates and return on investment and profits. These changes posed a major

challenge in the formulation and implementation of monetary policy.

In view of the changing financial environment, the monetary policy should adhere to a

suitable policy framework so that it can remain effective in promoting economic growth

and maintaining price stability. Furthermore, there exist different views of the exact

channels of the monetary transmission mechanism. An understanding of the transmission

channels is essential to the design and implementation of monetary policy. A direct

empirical investigation of the effect of Islamic banking system on real activities is exactly

what we investigate in this research. We strongly feel that the financial intermediaries

(we emphasize the banking sector) play an important role in monetary transmission to

uphold the conduct of monetary policy in the dual banking system in Malaysia.

7. SUGGESTIONS

In this section, we suggest the following tools for the working of monetary policy.

7.1 Profit-Loss Sharing Ratio


32

The higher inflation rate might be reduced by reducing the interest rate. However, the

reduction in interest rate is not effective if it reaches the zero level. The effective way is

to emphasise fiscal policy, but this might increase the level of budget deficits. Therefore,

both policies might produce an unhealthy and unsustainable economy. The real

prescription is to move to profit-sharing ratio policy.

In the profit-loss-sharing mechanism, any profit generated comes from the revenue. This

revenue is derived from the quantity sold and the price level. Since the price level is

determined by supply and demand, if the price level is high enough, it will generate profit

for the entrepreneur (after cost deduction), which will later be shared between the capital

provider and the entrepreneur. Therefore, the percentage shares of the profit-sharing

mode of financing might offset the increase in the price level, which is due to changes in

the percentage margin.

In analysing the effect of profit-loss sharing on the price level, this paper will adopt the

following equation:

푚 = 푚 − ∆푣 + ∆푥 Since mt+1 might include new savings (st+1) and profit received (dt+1), then the above equation can be re-written as: st+1 +dt+1 = ∆ xt – ∆vt

From the above equation, if v is assumed to be stable, then the increase in the natural

logarithm of nominal GDP might increase both variables on the left side. In other words,

if the Bank chooses the inflation and real GDP targets, then the amount of profits should

be set by the rule. The intention of the rule is to preserve the wealth (i.e., both savings

and profits).


33

7.2 Full Reserve

The alternative to fractional-reserve banking is full-reserve banking, in which a bank

must be able to hold all of its deposits on hand.10 Full-reserve banking is a theoretically

conceivable banking practice in which all deposits and banknotes in a financial system

would be backed up by assets with a store of value. This implies the existence of a

government body (such as a central bank) that would convert currency to a more stable

type of asset if requested to do so. It also implies that the resources available to the Bank

(and banks) would be sufficient to convert all currency if so required.

With this alternative, all banks operating in such a system would be 100%, making the

deposit multiplier equal to zero. In such a system, banks would have no obvious incentive

to offer savings or checking accounts, unless users paid a fee for those services.

A system in which all currency is backed by another asset and banks are required to

maintain a 100% cash reserve ratio has never been implemented in any actual economy.

The closest system is that of a currency board, in which banks are not required to

maintain a 100% cash reserve, but all of the money in circulation is backed by another

asset held by the Bank. This system is in use in Hong Kong, where the Hong Kong

dollars are backed by United States dollars.

In theory, as suggested by many scholars such as Kameel (2002) and Masudul (2005),

Islamic banking should be synonymous with full-reserve banking, with targeting of a

100% reserve ratio. The main reason is the counter-inflationary effect of Islamic

financing. However, it may be sensible at times to remove the restraint of 100% reserve

requirement and credit issued by the Bank for productive investment.

The conventional banks and banking system today create money endlessly. They are the

real source of inflation, and it happens because of the practice of fractional reserve

10 The model of fractional reserves has not been imposed on non-banking institutions.


34

banking which allows a bank to lend many times its reserves. But because a bank only

creates money for the principal of a loan and not for the interest, the banking system as a

whole must continually increase the overall amount of debt; otherwise the economy will

collapse. The fractional reserve system is why house prices, for example, have been

rapidly rising all around the world, and some form of bust is inevitable.

With an Islamic money supply for productive capacity, it will also be policy, over time,

to increasingly restrain the banking system from creating new money. This would be

done by gradually increasing (eventually to 100%) the reserves that a bank must deposit

with the Bank. Thus, as interest-bearing money from the banks decreases, interest-free

loans (from the Bank, but administered by the banking system) will increase, thereby

fulfilling the economy’s need for credit to be made available for productive investment.

Thus, banks would become essentially depository and investing institutions that could

only lend depositors’ money with the agreement of depositors (although they would have

other functions, e.g., administering interest-free loans for productive capacity). The

banking system will then be doing what the public believes banks do and what the

banking system allows the public to believe, namely, lending its own and its depositors’

money.

Increasingly, there will be less need for control of the economy via interest rates. The

overall volume of money in the economy will be the key factor, and the Bank could

change the percentage of reserves a bank must deposit. Islamic endogenous loans start

with the Bank and eventually get repaid to the Bank. The use of the loans would be

confined to public and environmental capital projects, small and start-up businesses and

large corporations, as long as wide capital ownership is furthered. Because of no interest,

the general result would be a halving, at least, of the cost of new productive capacity and

a huge reduction in debt.

The typical structure of uses and sources of funds in Islamic banks shows that they can

influence the economy via three important monetary variables: financing (i.e., for capital


35

and consumption as well as the government budget); deposits (i.e., as part of the money

supply) and investment.11

8. CONCLUSIONS

The aim of this paper is to identify the tools for controlling the monetary variables in an

Islamic banking system. The results from this paper show that: first, in formulating the

monetary policy, the Bank has the choice to use three tools: reserve requirements,

overnight policy rate, and open market operation. Second, theoretically, both the Short-

Term Interest Rate Model and the Reserve Position Doctrine are used as target variables.

Third, this paper suggests the profit-sharing ratio and full reserve as tools for the working

of monetary policy in an Islamic banking system.

11 The typical balance sheet of an Islamic bank is shown in Appendix B.


36

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Press.


39

APPENDIX A: THE CALCULATION OF SRR

The eligible liabilities for the month of October 2007 are given as follows:

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

10.0

16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

10.0

The eligible liabilities of Base Period A and Base Period B are given, respectively, as

follows:

EL Base Period A = (202+197+….+200+200) ÷ 15 = RM 200 million

EL Base Period B = (205+214+…..+241+244+249) ÷ 16 = RM 225 million

Calculation of the statutory reserve requirement is given below:

SRR compliance period: 1 to 15 November 2007

Corresponding EL base: 1 to 15 October 2007

EL Base Period A: RM 200m

Variation band: 3.2% to 4.8%.


40

Therefore, the minimum daily balance to be maintained in the Statutory Reserve Account

from 1 to 15 November 2007 = RM6.4m (3.2% of EL Base Period A)

APPENDIX B: BALANCE SHEET COMPOSITIONS OF ISLAMIC BANK

The table below shows the differences between the balance sheet of Islamic banks and

conventional banks. One of the major differences between an Islamic bank and a

conventional bank is that the former mobilizes funds on a profit-and-loss-sharing basis

while there is no similar concept on the sources (liabilities) side in conventional banks.

On the uses (assets) side, the portfolio of Islamic banks is composed of various finance

contracts (or modes of financing) many of which are based on profit-and-loss-sharing

principles such as mushÉrakah and muÌÉrabah. Thus, unlike the situation in

conventional banking, the customer-banker relationship in Islamic banking is not a mere

debtor/creditor relationship. On the liability (sources) side for conventional banks,

deposit funds mobilized on sight and time deposit basis constitute an ultimate liability, as

the principal of these funds as well as their fixed (pre-determined) interest rates are

contractually guaranteed.

Balance sheet information is reported quarterly to stockholders, the public and to

regulatory agencies in a Report of Condition and Income. This report is sometimes

referred to as the Call Report, harkening back to days when the Bank’s chartering

authority would make a surprise "Call" for its position statement.

The review of the daily analysis of an Islamic bank’s condition may be too burdensome

for the board of many Islamic banks. Yet, the quarterly review analysis based on the Call

Report may be too infrequent and delay the board’s ability to respond to urgent matters.

Unless an Islamic bank is experiencing severe operating problems, a monthly analysis

may be a good compromise. Most boards that meet monthly conduct a monthly review.


41

Stylized balance sheet of Islamic banks Balance sheet of conventional banks

Assets Assets

Cash and cash equivalents

Investment in securities

Sales receivables

Investment in leased assets

Investment in real estate

Equity financing

Equity investment in capital ventures

Inventories

Investment in subsidiaries

Fixed assets

Other assets

Cash and cash equivalents

Investment in securities

Loans and advances

Statutory deposits

Investment in subsidiaries

Fixed assets

Other assets

Liabilities Liabilities

Current account

Other liabilities

Deposits

Other liabilities

Equity of Profit Sharing Investment

Accounts (PSIA)

Profit-sharing investment accounts

Profit equalization reserve

Investment risk reserve

Determination of return to depositors based

on actual portfolio yield

Owners’ Equity Owners’ Equity

Source: Abdul Ghafar Ismail. (2010). Money, Islamic Banks and the Real Economy.

Singapore: Cengage Learning.

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