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Economic Analysis of Islamic Monetary
Framework and Instruments
SALMAN AHMED SHAIKH
Assistant Professor of Finance,
SZABIST University Karachi Campus
Outline
• Introduction
• Asset Allocation in the Interest Free Asset Market
• Economic Implications of Interest Free Asset Markets
• IFB for Short Term Financing and Investments
• Pricing Benchmark, Money Market Instruments and Monetary Policy
• Alternate Pricing Benchmark & Money Market Instrument
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Introduction • Financial development compliments economic growth.
North (1990) and Neal (1990) conclude that regions that developed more sophisticated and well-functioning financial systems were the subsequent leaders in the economic development of their times.
• Odedokun (1998) also concludes that the growth of financial aggregates in real terms has positive impact on economic growth of developing countries, irrespective of the level of economic development attained.
• Levine (2002) using cross-country data argues that financial development is robustly linked with economic growth.
• Furthermore, Hassan et al. (2011) find a positive relationship between financial development and economic growth in OIC (Organization of Islamic Cooperation) developing countries.
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Introduction
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Figure on the left plots data of 48 OIC member countries for broad money (as a percent of GDP) and annual real GDP in 2016. It can be seen that increase in the monetary assets is positively linked with GDP.
Figure on the right plots data of 50 OIC member countries for private sector bank credit to GDP and annual GDP in 2016. The graph reveals that increased private sector credit penetration is positively associated with higher levels of GDP.
Caveats • In the interest based financial intermediation, the
access to finance is available primarily to rich capitalists who can reveal the financial capacity in the form of endowments that are acceptable as collateral.
• The majority of people who do not have ownership of assets that are acceptable as collateral remain excluded especially from the financial credit services.
• WB estimates total unbanked population to be 1.7 billion in 2017 and 2 billion in 2014)
• Increased penetration and deepening of such a financial architecture brings about growth, but also exacerbates income inequality.
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Introduction
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Increased penetration and deepening of interest based financial architecture brings about growth, but also exacerbates income inequality.
Asset Allocation in the Interest Free Asset Market • In the Islamic monetary framework, the capital market
avoids the elements of interest and instead allocates capital investments based on the profit sharing ratio.
• In the interest free asset market, saving surplus units have:
▫ (𝑌𝑡 – 𝐶𝑡)>0.
▫ Pay Zakāt if (𝑌𝑡 + 𝐴𝑡– 𝐶𝑡)>𝑁𝑡. ▫ If no return is pursued, then surplus savings can be either paid to
charity or given as interest free loan.
▫ If return is pursued, no fixed stipulated increment on loaning money to individuals, financial institution or a debt issuer.
▫ 𝑆𝑡 can earn income from Halāl investments in the real economy.
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Asset Allocation in the Interest Free Asset Market • Based on economic theory and evidence, the amount of
investments would depend on:
▫ MRS between current and future consumption.
▫ Reward to variability ratio of the investment undertaking.
▫ Degree of loss aversion in preferences.
• Investors choose different levels of capital investments at different levels of profit sharing ratio.
• Steep indifferences curves, i.e. higher MRS for intertemporal consumption and loss aversion would make them demand a higher profit sharing ratio.
• Higher Sharpe ratio (i.e. higher reward to variability) of a investment undertaking would enable them to reap target level of return even with a lower profit sharing ratio.
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Asset Allocation in the Interest Free Asset Market • In the interest free asset market, saving deficient units have:
▫ (𝑌𝑡 – 𝐶𝑡)<0 for consumers and 𝐾𝑡<𝐶𝑡 for firms.
▫ For generating finance, firms will offer investments to SSU at an offered profit sharing ratio.
▫ No fixed stipulated increment on investment offered to SSU, be they individuals or financial institutions.
• Factors that determine offered profit sharing ratio include:
▫ Amount of capital needed.
▫ Duration of investment.
▫ Reward to variability ratio of the investment undertaking.
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Asset Allocation in the Interest Free Asset Market • The greater the capital requirement and the duration of
investment undertaking, the higher will be the offered profit sharing ratio.
• However, the higher the reward to variability ratio, the lower will be the offered profit sharing ratio.
• Thus, unlike the debt based financing where the savers and investors have opposite reaction to the rate of return since the return for savers is the cost to investors, the interest free equity financing based capital markets do not have an inherent tension between savings and investments.
• Both react uniformly to the internal strength of the investment undertaking, i.e. reward to variability ratio.
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Asset Allocation in the Interest Free Asset Market
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Horizontal line shows the saving deficient units demand for capital investments.
Upward sloping line illustrates the saving surplus units supply of investable funds at the different levels of profit sharing ratios.
Equilibrium occurs the amount of capital invested by the investors equals the capital investment required by the firm.
Higher capital requirement, longer duration of investment and lower Sharpe ratio will compel the firms to offer higher profit sharing ratio.
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SSU (Investors) SDU (Firms)
Asset Allocation in the Interest Free Asset Market
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Increase in the Sharpe ratio of investment indicating greater strength of the project will shift the SDU curve down as well as shift the SSU curve to the right. Firms sourcing funds can access greater investible funds or they can source the required funds at a lower profit sharing ratio as the SSU curve becomes flatter and shifts to right following increase in Sharpe ratio.
Asset Allocation in the Interest Free Asset Market
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Greater impatience in the consumers would make indifference curves steeper and hence shift the SSU curve on the left. Higher loss aversion would also result in SSU curve shifting to left. As a result, firms will have to respond by increasing the profit sharing ratio for inducing patient and loss averse consumers to engage in capital investments.
Implications of Interest Free Asset Markets • Since there is no fixed return to money capital in the
interest free asset markets, all savings must necessarily be invested in the real economy to earn return.
• The preceding analysis shows that movement in the profit sharing ratio can perform the asset allocation function in the interest free capital market.
• Investment acceleration can be achieved through institutionalizing Zakāt which levies a charge on idle wealth.
• No return on money balances and possibility of direct participation in the investment projects will lower risk for the economy to fall in liquidity trap.
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Implications of Interest Free Asset Markets • Circulation of wealth is also bolstered by Zakāt. If the
investments are made exempt from Zakāt until they are at least redeemed, savings surplus units will be further incentivized to invest.
• Macroeconomic Effects
▫ There is less pressure on current account balance if there is no or limited gap between savings and investments.
▫ A stable current account can have a stabilizing effect on the exchange rate and on domestic currency as a store of value in the interest-free economy.
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IFB for Short Term Financing and Investments • Islamic banking enables short term intertemporal
finance between risk averse investors and individual and corporate clients who require short term finance.
• Risk averse investors want to minimize risk and delegate the responsibility of credit portfolio monitoring to Islamic banks.
• Certain short term finance needs might be difficult to finance through long term equity finance or which can be more efficiently funded through employing trade and lease based modes of financing.
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IFB for Short Term Financing and Investments • Interest free Islamic banking primarily caters to short
term finance needs involving an asset.
• The investor client base of Islamic banks are investors who want to smooth the path of consumption through regular incomes with limited chances of risk.
• Thus, Islamic banking investments are suitable for impatient, risk averse and loss averse investors who invest in a limited way by sharing in the financing of real assets where the returns are linked to the asset’s sale or use rather than their long term productivity.
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IFB for Short Term Financing and Investments • The basic structure of Islamic banking can be explained
mathematically as follows.
• 𝐴𝑃 = 𝑝. 𝑛 + 𝑁𝑅𝐷𝑖𝑚𝑖=1 + 𝑅𝐷𝑗
𝑛𝑗=1 ..... (i)
• Where, 𝑝 is par value of the bank’s share price, 𝑛 is the number of outstanding shares, 𝑁𝑅𝐷𝑖 is the non-remunerative deposit of ith depositor and 𝑅𝐷𝑗 is the remunerative deposit of jth depositor.
This pool of assets is used to provide asset backed financing (ABF).
• In accounting terminology, the asset pool is the liability side of the Islamic bank’s balance sheet; whereas, the asset-backed financing and receivables comprise the asset side of the Islamic bank’s balance sheet. In economic terms, both should equal, i.e.
• 𝐴𝑃 = 𝐴𝐵𝐹 ..... (ii)
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IFB for Short Term Financing and Investments • ABF consists of various financing assets based on different underlying
financing contracts, i.e. Ijārah, Diminishing Musharakah, Murabaha, Salam and Istisnā.
• Islamic bank does not lend money. It provides asset backed financing in which the asset is owned by the bank. These financing modes can be categorized as:
▫ Lease based financing (LBF= 𝐿𝐵𝐹𝑜𝑜𝑘=1 )
▫ Credit sale based financing (CSBF= 𝐶𝑆𝐵𝐹𝑝𝑝𝑙=1 ).
• Hence, equation (ii) can also be written as:
• 𝐴𝑃 = 𝐴𝐵𝐹 = 𝐿𝐵𝐹𝑜𝑜𝑘=1 + 𝐶𝑆𝐵𝐹𝑝
𝑝𝑙=1 ..... (iii)
• Where, 𝐿𝐵𝐹𝑜 is the lease based financing provided to the oth client and 𝐶𝑆𝐵𝐹𝑝 is the credit sale based financing provided to the pth client.
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IFB for Short Term Financing and Investments • Income stream is generated either through profit on credit
sale or rent for the use of asset. Thus, income (I) comes in the
form of rent (R= 𝑅𝑜𝑜𝑘=1 ) or profit on sale (P= 𝑃𝑝
𝑝𝑙=1 ).
• 𝐼 = 𝑅𝑜𝑜𝑘=1 + 𝑃𝑝
𝑝𝑙=1 ..... (iv)
• If rental income is some stable proportion of LBF and profit income from the deferred sale is some stable proportion of CSBF, then equation (iv) can also be written as:
• I = α LBF + β CSBF..... (v)
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IFB for Short Term Financing and Investments • We can assume the average rental rate or profit rate to be the same except
for term premia and counterparty risk premia in customized financing assets. If ‘r’ is average rental and profit rate, then equation (v) can also be written as:
I = r x (LBF + CSBF) ..... (vi)
• Using equation (iii) in equation (vi), we can see that income is distributed among the contributors in the pool, including bank’s shareholders and depositors.
• To achieve spreads for financial intermediation function, profit sharing is done between the bank and the depositors as per the pre-agreed profit sharing ratio and pre-assigned weights to different types of depositors.
• Islamic bank is able to achieve competitive matching returns and where a significant deviation occurs, the Islamic banks can use Profit Equalization Reserves (PER) to smooth returns.
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IFB for Short Term Financing and Investments
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GINI on Capital to Assets Ratio
There is inverse relationship between capital to assets ratio and income inequality. The OIC member countries where the banks have higher capital adequacy ratios usually have lower inequality of income. Thus, in the full reserve banking system or the system where there is only asset backed financing or a greater capital buffer, the distribution effects are expected to be more egalitarian. Since remunerative accounts in Islamic banking are operated through Mudarabah, the capital buffer would be greater in Islamic banking leading to greater solvency, resilience and lesser volatility in net banking spreads due to pass-through of returns in the risk sharing model.
Country /
Indicators CAR Gross NPF ROA ROE
Net Profit
Margin
Cost to
Income
Liquid Assets
to Total Assets
Bahrain 19.00% 12.07% 1.33% 9.84% 26.46% 82.28% 17.57%
Brunei 21.22% 5.74% 1.73% 12.31% 52.39% 40.54% 49.93%
Egypt 13.54% 7.60% 2.70% 47.86% 59.21% 31.45% 68.36%
Indonesia 15.74% 4.69% 0.91% 9.39% 8.96% 91.09% 12.93%
Jordan 22.26% 2.96% 1.70% 17.90% 48.32% 51.67% 36.65%
Kuwait 17.97% 2.95% 1.21% 10.34% 21.41% 36.73% 32.01%
Malaysia 15.69% 1.30% 1.05% 15.23% 39.43% 41.62% 11.23%
Nigeria 38.31% 1.67% 0.06% 0.74% 4.93% 89.90% 21.06%
Oman 40.74% 0.06% -2.02% -3.42% -71.01% 158.24% 20.38%
Pakistan 14.11% 5.98% 1.04% 15.88% 24.57% 74.76% 30.72%
Saudi Arabia 20.30% 1.18% 2.14% 14.37% 47.73% 51.98% 26.29%
Sudan 18.69% 5.96% 2.62% 25.70% 52.93% 43.81% 37.11%
Turkey 15.48% 4.31% 1.08% 12.35% 18.66% 49.28% 48.65%
UAE 16.46% 7.91% 1.52% 12.63% 33.85% 66.15% 15.01%
Quarterly panel data from 2013 to 2018Q1 reveals that Islamic banks profitability has been impressive except in Oman.
Furthermore, in Brunei, Egypt, Kuwait, Malaysia, Sudan and Turkey, the cost to income ratio is below 50%.
Except in Bahrain, the gross non-performing finance ratio is lower than 10% in all countries.
Finally, the capital adequacy ratio on average is greater than 13% in all countries.
Islamic Banking in Practice
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Pricing Benchmark, Money Market Instruments and
Monetary Policy • Pricing of Capital
• Shadow Price vs. Accounting Price (Mannan, 1982).
• Problems in monetizing public debt (Darrat & Bashir, 2000).
• Treatment of public debt (Kurrihara, 1951).
• Alternative Instruments suggested in Islamic central banking literature.
• Refinance Ratio (Siddique, 1982).
• Qard-e-Hasan ratio (Khan, 1982).
• Using Mudarabah & restricting high powered money by way of RRR than
relying on OMO (Chapra, 1983).
• Time Multiple Counter Loan (Mehmood, 1991).
• Equity stake in commercial banks (Uzair, 1982).
• Composite stock (Zangeneh & Salam, 1993).
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Alternate Pricing Benchmark & Money Market Instrument • In contemporary monetary system, interest based T-bills are not
Islamic since they involve Riba, which is prohibited in Islam.
• As a substitute to T-bills, the governments can issue Treasury Sukuk Ijarah Bills to source funds.
• This instrument can also be used in open market operations. In place of reverse repo and repo, ready buy deferred sale can be used to inject and mop up funds.
• In outright open market operations where the objective is to buy and hold the treasury securities till maturity, Murabaha Sukuk can also be used where there is no need for secondary market and for multiple sales between counterparties during the life of the security.
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Alternate Pricing Benchmark & Money Market Instrument • If the commercial banks want to deposit funds with the central bank, they
will buy Treasury Sukuk Ijarah Bills at a lower price on spot and sell at a higher price in future.
• Likewise, if they want to access funds from the central bank, they will sell Treasury Sukuk Bills at a lower price on spot and buy at a higher price in future.
• Difference in price will be the financial cost to the party that is obtaining funds and return to the counterparty that is providing funds. Imputed rate of return will be higher on reverse repo than on repo.
• Unilateral undertaking will separate the two legs of the transaction. To ensure that it is not a buyback transaction, it is important to ensure:
▫ Proper identification of Ijarah asset.
▫ Transfer of ownership.
▫ Constructive possession.
▫ Prior valid offer and acceptance to execute the sale of Ijarah assets.
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Alternate Pricing Benchmark & Money Market Instrument
• The question arises as to what should be the profit rate benchmark. To solve this issue, the government can setup a trading corporation that trades in commodities like food crops and petroleum products.
• In some countries, such a trading corporation already exists and the governments procure goods through these trading corporations to achieve the objective of smooth supply, exports of surplus and imports of shortage, protect the small growers and regulate prices.
• In these trading operations, the government can set prices to reflect its target profit rate. This target profit rate can become a benchmark for issuing Treasury Sukuk Ijarah Bills and affect the other rates of returns in Islamic short term debt financing instruments.
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Alternate Pricing Benchmark & Money Market Instrument
• Open market operations would involve injecting and mopping up funds. This will be achieved through purchasing and selling Treasury Sukuk Ijarah Bills.
• Credit controls can utilize:
▫ Qard e Hasan ratio (for cash reserve ratio).
▫ Sovereign investment ratio (for statutory liquidity ratio) where investments are made in Treasury Sukuk Ijarah Bills or composite equity certificate.
• In corporate finance, the weighted average profit rate in commodity trade operations of the government could be used in valuation models to provide a quantitative mechanism to rank investment alternatives. In project valuation, this benchmark rate could be used to find ‘estimated intrinsic value’ of cash flows.
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Alternate Pricing Benchmark & Money Market Instrument
• From the perspective of rules governing Islamic finance, this proposal would be appropriate since we are using a real sector oriented profit rate benchmark rather than interest based benchmark.
• Mudarib or capital deficient partner will not be obliged to provide the returns based on these valuations. But, the investor can use this indicative valuation to rank investment alternatives.
• It will provide a quantitative mechanism to rank investment alternatives. In actual distribution of income between investors and firms using equity modes of financing, profit sharing ratio would be used and agreed upon at time (t) and applied to the actual profits earned in time period (t+1).
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Alternate Pricing Benchmark & Money Market Instrument
• In ranking projects, a project with the highest net present value would be most preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract with even a slightly lower PSR.
• A project with the lowest NPV is least preferable for investment, so the Rabb-ul-Maal (investor) could prefer to enter into that contract only with a slightly higher PSR.
• Ranking would be facilitated by using profit rate as a benchmark in financial valuation models.
• This process of bargaining will lead to equilibrium in Islamic investible funds market.
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Thank You
For Questions, Comments & Feedback
Salman Ahmed Shaikh
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