Monetary policy in the presence of Islamic banks
The paper discusses key issues related to the conduct of monetary policy in countries that have Islamic banks. It describes the macrofinancial background and monetary policy frameworks where Islamic banks typically operate, and discusses the monetary transmission mechanism in economies where Islamic and conventional banking coexist.
Most economies with Islamic banks also have conventional banks and this calls for a comprehensive approach to monetary policy. At the same time, a dual approach to monetary policy should be considered whenever the Islamic segment of the financial system is not as developed as the conventional one. The paper tries to shed light on potential spillovers between conventional and Islamic financial systems, and proposes specific recommendations on the design of Islamic monetary policy operations and for facilitating monetary transmission through the Islamic financial system.
Despite a fast growing Islamic banking industry, the implementation of monetary policy and the transmission mechanism of monetary policy in the presence of Islamic banks remain a challenge for the central banks (CBs). The challenges arise not only from the Islamic finance core principles but also from the macrofinancial background and monetary policy frameworks of countries where Islamic banks operate. Since the early 1990s, the related literature has broadly followed two streams: the first one, theoretical, was derived from the work of Khan and Mirakhor (1990) and was based on the premise that Islamic finance is strongly anchored on the profit-and-risk sharing principle and mainly equity-based. The second one, empirical, has focused on monetary transmission from the conventional segment to the Islamic segment of the financial system (Cevik and Charap, 2011). This paper builds on both streams and highlights the evolving nature of Islamic financial systems and related complexity of the transmission and operation of monetary policy in dual financial systems (i.e. coexisting Islamic and conventional systems).
