Involving Islamic Banks

in Central Bank Open

Market Operations
Mahmoud A. El-Gamal

EXECUTIVE SUMMARY

A variety of existing and proposed alternative government papers

are acceptable to some Islamic Banks and not to others, due to
differences of opinion among Islamic Jurists on the admissibility
of various contracts. This overview article discusses: (i)the
relevant aspects of Islamic law which govern the sale and resale
of government papers; and (ii) various government papers that
are accepted in practice by some Islamic banks in Islamic
countries, and their effectiveness in carrying out open market
operations (OMOs). The policy prescription arising from the
paper is the need for Central Banks to engage in reverse financial
engineering, to issue government papers which target banks
would accept. 0 1999 John Wiley & Sons, Inc.

OPEN MARKET OPERATIONS

Open market operations (OMOs) are among the most important

tools of monetary policy in market economies today, since they allow
central banks to control monetary aggregates easily, and with mini-

This article was presented at a seminar organized by the Central Bank of Kuwait in Kuwait
City, on design and regulation of Islamic financial instruments, October 25-26, 1997.
Thunderbird International Business Review, Vol. 41(4/5) 501-521 (July-October 1999)
0 1999 John Wiley & Sons, Inc. CCC 1096-4762/99/040501-21
501
502 E L - G W

ma1 unwarranted effects on interest rates. Arguably they may be of

special importance in some Islamic countries, since Islamic banks
are not directly influenced by interest rate changes. In countries
with highly developed financial markets, notably the US and the
UK, OMOs tend to focus on initiating sales and purchases of short-
and long-term government securities. The virtually risk-free nature
of those securities, together with their liquidity caused by the cen-
tral banks’ readiness to buy them at or near market prices, result
in high degrees of market activity. This activity, in turn, enhances
the liquidity of the market in government securities and allows cen-
tral banks to use OMOs as a primary tool of monetary policy. Due to
their need for a highly liquid outlet for excess funds, banks have be-
come the major participant in primary auctions and secondary mar-
kets where such government securities (especially short-term) are
traded.
The most commonly used securities in OMOs around the world are
Treasury Bills, which are non-interest-bearing discount securities of
various maturities, and Treasury notes, which are coupon securities
paying a fixed interest rate until maturity. Treasury Bills and Trea-
sury Notes, along with currency and other less popular government-
issued securities have one structure in common: they are promises
by the government to pay certain amounts of money at different
points in time (instantly in the case of currency, periodically for some
Treasury Notes, and at maturity for Treasury Bills).
In order to appreciate the complex issue of acceptability of various
government papers by different Islamic banks, we need to review the
positions of Islamic Jurists on three critical issues:

1. The admissibility of selling or reselling debt to the debtor or a

third party.
2. The admissibility of selling or reselling debt at a price other
than its face value.
3. Degrees of admissibility, and the different views of schools of
jurisprudence on contracts which circumvent Islamic legal in-
admissibility.

ISLAMIC JURISPRUDENCE REGARDING VARIOUS

GOVERNMENT SECURITIES USED IN OMOS
It must be noted at the outset that the question of Islamic accept-
ability of various securities can be quite complex. One is often tempt-
ed to jump to conclusions due t o the apparent simplicity of prohibi-
tion of Riba. Riba is often combined with a number of other trading
CENTRAL BANK OPEN MARKET OPERATIONS 503

arrangements (e.g., two sales in one, etc.), collectively known as in-

valid sales (al-boyu' al-batilah).l The list of such prohibited transac-
tions, together with the general ruling of admissibility of trade un-
less prohibited, encourages many people t o assume that it is easy to
say what Islam forbids or Islam admits in the economic realm.
The fact of the matter is that Islamic jurists have differed over the
centuries on what is forbidden and what is not, and they continue to
differ to this day. The disagreement among contemporary jurists,
even on the most fundamental issues regarding the Islamic accept-
ability of various banking operations, is perhaps best illustrated by
the following extreme: In an interview-published August 22, 1997
by the UAE daily newspaper Al-'Ittihad-in Abu Dhabi Sheikh Nasr
Farid Wasil, the Mufti of Egypt, is reported t o have said regarding
the most obvious form of Riba (namely, bank interest):

I will give you a final and decisive ruling (Futwa). . . So long as banks
invest the money in permissible venues (HuZuZ),then the transaction
is permissible (HuZuZ). . .The issue is an investment from money. 0th-
erwise, it is forbidden (Haram). . . there is no such thing as an Islamic
or non-Islamic bank. So let us stop this controversy about bank in-
terest.

The fundamental economic idea underlying this opinion is that

traditional banks are financial intermediaries
facilitating savings mobilization and invest- The fundamental
economic idea
ment financing. As such, their operations are underlying this
viewed as being no different from many of the opinion is that
interest-free Islamic bank operations which traditional banks
involve a fixed rate of return (e.g., leasing, are
intermediaries
Murabaha, etc.). The prohibition of Riba, facilitating savings
from this point of view, is not SO much a pro- mobilization and
hibition of the fixed rate of return, as it is a investment financing.
prohibition of attaching this rate of return to
a (possibly unsecured or uncollateralized) loan contract.
At the other end of the spectrum, we find proponents of Islamic
banking who condemn all Islamic governments and Islamic banks for
their financial operations, including those designed to be Islamic:

The sad reality is that though every one concedes that Islam prohibits
interest, there is not a single Muslim country which is running its fi-

lNote that many books on Islamic jurisprudence miss the distinction between invalid sales (ul-
boyu' ul-fusiduh),see al-Zuhayli (1998: p. 3397) for a discussion of the differences under the
Hanufi school.
504 EL-GAMAL

nancial institutions without resorting to interest. The fact is that no

one knows how to do it, and when political pressure mounts, they can
only resort to some kind of subterfuge, (cf. Ahmad 1992: p. 16):
It is not clear whom we are cheating. . . (ibid, p. 47)
The worst part of the story is that Islamic economists, as a body
in their International Monetary and Fiscal Conference held in Is-
lamabad in 1981, gave their unreserved approval to this arrange-
ment. So far this is the best that Islamic economics has to offer, viz.,
change the name of interest and you have abolished interest. (ibid,
p. 48)

Those two extremes illustrate the large spectrum of financial in-

struments which different Islamic banks may find acceptable. If one
follows the first view, all operations of conventional banks are Is-
lamic. If one follows the second view, all (or most) current Islamic fi-
nancial operations are not Islamically acceptable. Islamic banks cur-
rently in operation span the entire spectrum between those two
extremes.
As we shall discuss in the practice of the Islamic Banks section of
this article, many Islamic banks (notably in Iran and Pakistan; al-
though efforts to find alternatives are underway in the former) ac-
cept Treasury Bills and Notes which promise a fixed rate of interest,
and which most Islamic jurists agree to be Islamically unlawful.
Thus, it is very difficult to determine which government papers “are
acceptable to Islamic banks” since virtually all existing government
securities are acceptable to some and not to others.
The plan of this section is to review some of the main agreements
and differences in opinion of Islamic jurists on issues pertaining to
the sale and resale of government securities in a manner which
would make open market operations viable. The two main features
of government papers which make them suitable for use in OMOs in
various countries are:

1. Their virtual freedom from risk, since they are guaranteed by

the government which can print cash to finance the repurchas-
es at the promised or market price.
2. Their liquidity due to trading in secondary markets, which
makes them suitable avenues for banks’ short-term investment
of excess funds.2

W i l e this implies their usefulness in providing a place for Islamic banks to park their ex-
cess liquidity, I do not view this as a primary concern for Central Banks issuing such pa-
pers.
CENTRAL BANK OPEN MARKET OPERATIONS 505

In turn, those two features translate legally into requirements

that the government papers take the form of promissory notes (i.e.,
debt or deferred debt) by the government, and that the notes be sell-
able and resellable to third parties, as well as to the government it-
self, at market prices. The fundamental legal issue, thus, is the ad-
missibility of selling and reselling debt at different prices.

SALE OF DEBTS

Islamic jurists have distinguished between two types of selling of

debt (bay‘ al-dayn):(i) exchanging one debt for another, or selling a
debt with a deferred payment of the price (bay‘al-dayn nasi’ah), and
(ii) selling debt to the debtor or a third party in exchange for cash
(bay‘ al-dayn naqdan fi al-hal).The first form of exchanging debt for
debt is of little relevance t o our investigation of instruments used in
OMOs (since the net effect can be achieved through two separate
trades). This is fortunate since such a trade is controversial due to
the existence of a weak tradition of the Prophet (pbuh) prohibiting
it (as bay‘ al-kali’bel-kali?.
As for selling a debt to the debtor or a third party in exchange for
cash: The sale of debt to the debtor a t its face value was ruled as per-
missible by the majority of jurists following the four major schools of
Islamic Jurisprudence, and it was deemed prohibited by Ibn Hazm
of the Zahiri school, (cf. Al-Zuhayli 1996: vol. 4, p. 433, and the ref-
erences therein). Moreover, forgiving the debt as a gift (hibah)is al-
ways permitted, and is clearly equivalent to reselling the debt to the
debtor at zero price.
A financial engineering reading of this would suggest that a resale
of the debt to the debtor before its term at any price at or below its
face value must be permissible (the difference being a gift from the
creditor). However, such a “resale of the debt at a lower price” (list-
ed by Ibn Rushd as the usurious rule ofda‘ w a ta‘ajjal) was tradi-
tionally considered forbidden by all four major schools of Islamic ju-
risprudence due to its admission of a time-value for the loaned sum,
thus resembling Riba, (cf. Al-Zuhayli 1996: vol. 4, p. 693, and the ref-
erences therein). But recent rulings by the Islamic Jurisprudence
Academy, the Islamic International Bank for Investment and Devel-
opment, Al-Rajhi, and the Kuwait Finance House, (cf. Sakhr 1996,
fatawas #50,1291,265,740,536, resp.), agreed with the financial en-
gineering interpretation of a “gift” component and permitted the
da‘ wa ta‘ajjal (discount) resale of a debt contract to the debtor.
Thus it would seem that Islamically acceptable government debt
instruments can be resold to the government at or below their face
506 EL-GAMAL

value (i.e., at market prices) under the modern Thus it would

interpretation ruling on du' w u ta'ujjul. How- Seem that IslamicaW
acceptable
ever, since those instruments must be sold ini- government debt
tially at a price equal to their face value, and instruments can
may not be sold to a third party at a price be- be resold to the
low their face value, the possibility of Islamic government at 01
their face
bank participation in a liquid market for those value (i.e., at market
instruments seems severely limited. prices) under
The sale t o a third party was deemed pro- the modern
hibited by the Hanafi and Zahiri schools. It interpretation ruling
was deemed permissible by the Shufi'i school On da'wa ta'Muz-
as long as the default risk was minimal. It
was deemed prohibited by the majority of the Hanbali jurists, with
the exception of Ibn al-Qayyim who deemed it permissible. The Mu-
liki jurists found this sale of a debt to a third party to be permissi-
ble subject to eight conditions to guarantee that the contract does
not embody another violation (e.g., Riba, Gharar, etc.). The most no-
table condition is that the price paid for the debt by the third party
should be in a different commodity, or be legal to the face value. (cf.
Al-Zuhayli 1996: vol. 4,pp. 433-435, and the references therein).
Note that the circumvention of the prohibition of selling a debt in-
strument to a third party at a lower price by using a different com-
modity or currency is a very common method of avoiding the charge
of usury. The dealings of the Florentine Medici Bunk in the fifteenth
century included most current suggestions of avoiding interest pay-
ments on debt instruments. This included
making the loan and paying-it-off in different The dealings of
currencies, passing ink?reSt off as a gift O r the Florentine
share in the profits of a business of venture, ikfedici Bank in the
etc., c.f. de Roover (1966, p. 112): "In the Mid- fifteenth
included most
dle ages, interest was always included in the current suggestions
price, or rate of exchange, a fact which the of avoiding interest
scholastic doctors, both theologians and ju- payments on debt
rists, were reluctant to acknowledge, but instruments.
which is undeniable, since it is a matter of
simple arithmetic". Using such simple methods of circumvention, the
Medici were able to develop a sophisticated and liquid interest free
money market (de Roover, 1966; Chapter VI)-similar in many re-
gards to the Malaysian and other Islamic examples discussed b e l ~ ~ . ~

3A commonly held, but mistaken, view is that the prohibition of usury in the Middle Ages ex-
tended only to exorbitant interest. The prohibition, however, was identical to that common-
ly held by the proponents of Islamic banking today. "According to canon law, usury consist-
ed in any increment, whether large or small, demanded above the principal solely on the
CENTRAL BANK OPEN MARKET OPERATIONS 507

In a recent ruling in the Seventh Session of the Islamic League’s

Council of the Islamic Jurisprudence Academy, c.f. Sakhr (1996, fat-
wah #6l), immediate and deferred trading of bonds of all types were
declared forbidden forms of Riba. However, another recent ruling by
Bank Al-Tamwil Al-Kuwaiti, (cf. Sakhr 1996, fatwah #785), permit-
ted the purchase and repurchase of bonds in different currencies, or
at its face value, whereas the same institution, (cf. Sakhr 1996, fat-
wah #746), declared the purchase of a loan in the same currency at
a price lower than its face value t o be forbidden Riba.

PROBLEMS IN DESIGNING ISLAMIC BONDS

Many of the Islamic financial engineering efforts at designing Is-

lamic bonds or Islamic government securities aim to avoid promis-
ing a payment of interest while giving an incentive to Islamic banks
to purchase those government instruments. All such schemes, how-
ever, must suffer from some shortcomings:

They may operate on a true profit and loss sharing (PLS-shar-

ing) principle, and thus sacrifice the security of the principal of-
fered by the standard government securities used in OMOs. In
particular, the creditors (banks) may be particularly loss-averse
due to the threat of bankruptcy (following a run on the bank).
Moreover, the government (debtor) may be reluctant to pay a
large profit rate during the upswing of the business cycle, and
lower profit rates during the down-swing, as a PLS-sharing rule
would dictate. Such a pattern of profit-paying would encourage
pro-cyclical investment to carry-out counter-cyclical policies.
Thus, both creditors (banks) and debtors (governments) may
prefer a smoothed version of PLS-sharing, the extreme form of
which is a fixed interest rate.
They may attempt to guarantee the principal by selling an op-
tion at no price together with the debt sold at the face value.

strength o f a mutuum, the legal term for a straight loan . . . By definition, a loan was a gra-
tuitous contract . . . On the other hand, it was considered legitimate to receive compensa-
tion whenever a credit transaction was speculative or involved any risk or compulsion.
Rightly or wrongly, interest was often passed off as a gift or a share in the profits of a busi-
ness venture . , , Since the taking of interest was ruled out, the bankers had to find other
ways of lending at a profit. The favorite method was by means of exchange by bills , . . It
did not consist in discounting as practiced today, but in the negotiation of bills payable in
another place and usually in another currency . . . Although the presence of concealed in-
terest is undeniable, the merchants argued-and most theologians accepted these views-
that a n exchange transaction was not a loan. . .”, c.f. de Roover (1996, pp. 10-11).
508 EL-GAMAL

Such solution falls under “loan which brings a benefit [to the
creditor]” (qard jarra manfa‘ah), which is admissible if the extra
benefit to the creditor was not promised, e.g., in the case of a gift
added to the principal upon the return but which was not
promised. The Shafi‘i school, however, makes it reprehensible
(rnalzruh) to lend when the debtor has consistently given gifts in
the past, (cf. Al-Zuhayli 1996: vol. 4, p. 727), and the references
therein. A recent ruling, (cf. Kitab AZ-Ahram, Fatwa #41: Sakhr
1996, fatwah #1364), declared that “Investment Certificates-
type C” ofAZ-Bank AZ-’AhZi in Egypt, which do not promise a rate
of return, but offers prizes a t periodic intervals, were lawful.
However, the ruling added, it is better to err on the side of cau-
tion since some of the jurists found such instruments undesir-
able.
The more elaborate suggestion of western-style Participating
Growth Notes can easily be criticized Islamically. These are in-
terpreted as a combination of a cash account and a call option,
c.f. Finnerty (19931, Ebrahim and Bashir (19951, but the cash ac-
count is in fact a loan and not a wadi‘ah (deposit, trust), (cf. Al-
Zuhayli 1996: vol. 4,p. 727). Thus, the joint transaction falls un-
der the Prophet’s (pbuh) prohibition of “a loan and a sale [in one
transaction]” (saZaf wa bay‘).
Other elaborate suggestions to create Islamic debtlike instru-
ments attempt to achieve low risk by combining multiple in-
struments, thus possibly falling into the prohibition of “two sales
in one” (bay‘atayni fi bay‘ah).
As put in Kahf (1997): “It must be noted that whenever one moves
. . . to the idea of debt, a severe blow to the liquidity of the instru-
ments takes place because of two Shari‘ah rules: (1) debts may only
be exchanged at face value regardless of date of maturity, and (2)
debts may not be exchanged for debts. . . . This eliminates the pos-
sibility of a secondary market.” Attempts to
create liquid and risk-free government securi- Attempts to create
ties for use in OMOs must draw close to the liquid and risk-free
boundary between the lawful and the unlaw- government
securities for use
ful. Different Islamic banks will respond dif- in OMOs must
ferently to such financial instruments. As a haw close to the
result, the more cautious current Islamic fi- boundary between
nancial engineering approaches favor equity/ the lawful and the
ownership based securities to debt-based ones unlawful.
(Ahmed, 1997). With such equity-based (e.g.,
through Muduraba) securities, the principal cannot be guaranteed
as part of the contract, hence limiting its attractiveness in terms of
CENTRAL BANK OPEN MARKET OPERATIONS 509

the low risk and high liquidity required to make OMOs effective.
Some government issued mark-up securities (through Murabaha or
fiura) are possible to develop, and should be acceptable to most Is-
lamic banks since most of their own operations take that form. The
ability to securitize such contracts for resale in secondary markets
is a promising direction for governments wishing to develop Islamic
money markets. However, the usefulness of such securities in OMOs
is limited, since they do not give the government the ability to in-
crease and reduce their volume at will in the short term.

DEFERRED GOODS OR PRICES

More generally, if we concede that financial instruments based on a

fured interest rate are forbidden, the success of Islamic financial en-
gineering to create financial instruments which mimic the payoff
structure of Treasury Bills and notes, but which satisfy the letter of
the Islamic law, depends on the intentions of the Islamic banks, and
the schools of Islamic jurisprudence they follow. Any sales of such in-
struments involve a deferred sale and immediate purchase (al-buy‘
nasi’atan, w a al-shira’ naqdan), which is called by jurists boyu‘ al-
’ajual or boyu‘ ul-‘aynah, and they are recognized by all jurists as at-
tempts to circumvent the prohibition (Hiyal). The jurists, however,
disagreed on whether or not such contracts are prohibited, (cf. Al-
Zuhayli 1996: vol. 4, pp. 466-470), and the references therein:

The Shafi‘is and Zuhiris noted that the contract is valid in its le-
gal form, and since the intention of the seller and buyer cannot
be ascertained by humans, punishment for such contracts aim-
ing to circumvent the prohibition of Ribu is for God alone.* How-
ever, some of the later Shafi‘i jurists agreed with the Hanbali
and Muliki scholars that it is invalid.
Imam Abu Hanifa also argued for the prohibition only if there is
observable evidence of the intention of circumventing the prohi-
bition of Ribu, and made the mediation of a third party a condi-
tion for the validity of the contract. However, some of the later
Hanufi jurists (e.g., Ibn ‘Abedin) prohibited the practice to the

4This is again reminiscent of the Middle Ages money market operations: “Since a cambium
(exchange contract) was not a straight loan, so the theologians argued, there was no usury
involved, provided it was genuine and not patently misused to cover up a usurious deal, as
was the case with dry of fictitious exchange,” (cf. de Roover 1966, p. 109). In other words,
the Christian theologians and bankers of the fifteenth century operated precisely under the
Zuhiri interpretation of the doctrine “But God hath permitted trade (exchange) and forbid-
den usury (Riba)“(Translation of the meaning of the Qur’anic verse 2:275,by A. Yusuf Mi).
510 EL-GAMAL

point of tahrim, (cf. Wafa 1984, pp. 39-45, and the references
therein).
The Hunbali and Maliki jurists concluded that this sale is for-
bidden and invalid to avoid the possibility of its abuse through
circumvention of the prohibition of Riba (saddan lel-dhra’i‘).Ibn
Taymiya spent many pages admonishing those who attempt
such circumvention (Hiyal) in his Fatawa, (cf. Ibn Taymiyah
1988, vol. 3, esp. pp. 360-361).

The general conclusion one reaches from this cursory summary of

the varied positions of Islamic jurists on different types of contracts
is that Islamic banks which wish to follow the most permissive opin-
ions may accept thinly veiled (or totally unveiled) “Islamic” Treasury
Bills and Notes, which are virtually identical to currently available
instruments. At the other extreme, those most eager to follow the
strictest notion of “no return without risk or effort” underlying most
Islamic financial prohibitions, will not be willing to accept any of the
available government securities as an outlet for their excess liquid-
ity. The latter type of banks, therefore, may not be influenced by
OMOs, and their operations can only be influenced directly through
reserve requirements (typically held interest-free with the central
bank) and/or direct trading of less liquid securities, which the gov-
ernment can generate by monetizing any assets in the economy.

GOVERNMENT PAPERS ACCEPTED BY ISLAMIC BANKS

Many proponents of Islamic banking have lamented the unwilling-
ness of the governments in Islamic countries to support the growth
of Islamic banking. One of the major handi-
caps that Islamic banks are perceived to face Many proponents
in many countries is the existence of reserve of Islamic banking
requirements which mandate the holding of have lamented the
interest-bearing securities, (cf. Ahmad 1987). unwiuinaess Of the
governments in
Western banking observers viewed the s o h - Islamic to
tion as a relaxation of the Shari‘a rules pro- support the growth
hibiting interest, thus making traditional gov- of Islamic banking.
ernment securities more appealing to Islamic
banks, (cf. Euromoney 1987, pp. 137-138). The recent futwa of the
Egyptian Mufti in August 1997 (cited previously), as well as several
futwus by previous Egyptian Muftis on the admissibility of interest
payments on Investment Certificates, are an indication that this ap-
proach may continue to carry momentum. It is, however, clear that
many Islamic banks simply refuse to hold interest-bearing govern-
CENTRAL BANK OPEN MARKET OPERATIONS 511

ment securities. For example, the holding company Dar al-Mal al-
IsZami declared that it refuses to operate under government rules
which make it compulsory t o hold such securities, and would try to
arrive at agreements with governments on liquid assets which are
acceptable to both parties, (cf. Dar al-Ma1 al-Islami 1986).
Information on the asset-side operations of Islamic banks in vari-
ous Islamic countries are very difficult to find. Publicly available bal-
ance sheets of Islamic banks (e.g., as reported in the Harvard Islamic
Finance Information Program CDROM database) do not state the
form of short-term investments held by the reporting banks. More-
over, the literature on Islamic banking has been focused on their re-
lationship to their customers, with very little attention paid to their
regulation and short-term excess liquidity management. In this sec-
tion, we shall review a few of the cases on which information is avail-
able to the public. The countries on which such information is read-
ily available can be divided into three groups:
1. The Malaysian Model: Of all Islamic countries, Malaysia has
developed the most sophisticated and successful transition of
its banlung sector to accommodate Islamic banks. We shall
spend most of this section on the Malaysian experience with Is-
lamic Bonds, and an Islamic Money Market. However, it must
be noted that due to divergences of opinions among jurists, as
a Financial Times (November 28, 1995) survey article put it:
“Some see Malaysia as leading the way in Islamic banking,
while others do not deem the system in Malaysia to be a truly
Islamic system.” This is to say, once more, that many govern-
ment securities which are acceptable to some Islamic banks in
some countries, may very well be unacceptable to other Islam-
ic banks in the same and other countries. Since the Malaysian
dual-banking system is becoming the model for many Islamic
countries’ transitions to or regulation of Islamic banking, it is
very useful to study its evolution in some detail.
2. The Pakistani and Iranian Model: The second model of
Central Bank relationship with Islamic banks which we shall
consider is that of Pakistan and Iran. Both countries under-
went an explicit Islamization of the banking sector in the last
decade, but have maintained the interest-based transactions
between the Central Bank and the commercial banks. The fun-
damental point underlying this model, and to some extent the
Arab model as well, is the view that government borrowing at
a fixed interest rate does not constitute Riba. This view was ex-
plicitly articulated by previous Muftis of Egypt (in particular,
Sheikh Shaltut, and Dr. Sheikh Tantawi) who declared the fat-
512 EL-GAMAL

was that government borrowing through post office certificates

and investment certificates, where the funds are reportedly
used by the government t o foster economic development, were
permissible. This opinion was based on two main points: (i) that
there is no fear of exploitation of the debtor (government) by
the creditors, and (ii) that the government’s expenditures are,
in some form, welfare improving for all residents of the Islam-
ic country, thus providing a positive incentive to allow the bor-
rowing which mobilizes savings and makes such expenditures
possible.
3. The Arab Model: The third model we shall consider is the one
prevalent in most Arab-Islamic countries. In those countries,
Islamic banks deal mainly as investment bankers rather than
commercial bankers, with very little or no direct relationship
with the Central banks. Islamic banking in those countries is a
sensitive issue, due to the divergence of opinion on what con-
stitutes Islamic banking. States do not wish openly to criticize
interest-free Islamic banks, while at the same time, they find
it infeasible to license them fully, thus implicitly admitting that
all other banks (including state-owned and operated ones) are
non-Islamic. Although the opinion of the current Egyptian
Mufti (that there is no distinction between Islamic and non-
Islamic banks based on the use of fixed interest rates) is not
commonly articulated in most Arab Islamic countries, the
modes of operations in those countries seem to follow from a
view very similar to his. The sensitivity of the issue in those
countries arises from the possible divergences of opinion with-
in the country over what forms of banking are Islamically per-
missible, which policy makers would prefer not to discuss.

THE MALAYSIAN MODEL

Under the Islamic Banking Act of 1983, and subsequent supporting

laws, the Malaysian monetary authority has taken many steps to-
wards creating an environment conducive to the success of Islamic
banks, without surrendering her ability to monitor them and control
the money supply. Islamic banks in Malaysia are allowed more flex-
ibility than regular banks in liquid asset holding requirements. Gov-
ernment Investment Certificates, which do not promise any fured in-
terest, are issued in accordance with the Government Investment
Act of 1983, and are held largely by Malaysian Islamic banks in com-
pliance with their liquid asset requirements, (cf. Wilson 1995; p. 64,
Business nmes 30 November, 1994). These certificates are widely
CENTRAL BANK OPEN MARKET OPERATIONS 513

viewed as an Islamic version of Treasury Bills, and they are issued

with denomination RM10,OOO and with maturities ranging from 1to
5 years. They have been quite popular, and the Malaysian govern-
ment has sequentially increased the amount outstanding to meet the
increasing demand, (cf. Business Times 3 August, 1994b).
The Malaysian Central Bank (Bank Negara Malaysia) argued
against developing the Government Investment Certificates on a di-
rect PLS-sharing basis, due to the perceived difficulty of determin-
ing the rates of return incurred by any specific group of funds. More-
over, Bank Negara oficials decided not to anchor rates of return to
some macroeconomic performance indicator such as GDP, since, they
argued, GDP growth rates are not a good proxy for the rates of re-
turn on government investments. As the governor of Bank Negara
Malaysia put it, Hussein (1989, p. 296): “We, therefore, felt that the
principle of profit-and-loss sharing would not be appropriate, at this
stage, in determining the return on the Government Investment
certificate^."^
The purchase of a Government Investment Certificate is treated
as an interest-free loan (qard hasan) with only the principal being
guaranteed by the government. Each year, a
committee of Government officials announces The purchase of
the rate of return which will be given to the aGovernment
holders of those certificates. This rate of re- ~ e ~ ~ $ treated~ ~ ~ t i s
turn can (in theory be zero, but has been con- as an interest-free
sistently chosen at a “satisfactory rate,” (cf. loan (qard hasan)
Hussein 1989: D. 297). This examde, which is with only the
identical to theprocedure followed in’Egypt by principal being
al-Bank al-Ahli in issuing its Investment Cer- guaranteed
government,
by the
tificates, Type C, as well as earlier practices of
the Medici bank in the 15th century, has been
an inspiration for many types of “Islamic Bonds” suggested in the Is-
lamic financial engineering literature. If a historical record of re-
turns above a certain level builds an implicit expectation on the part
of buyers of such certificates, their legitimacy may be questioned un-
der the Shafi‘i ruling stated previously. However, since such implic-
it expectations cannot be observed, the contract becomes valid, even

5A recent ruling: Islamic Jurisprudence Academy ruling #5, (cf. Sakhr 1996, fatwah #22), de-
clared that the admissible investment certificates or loan certificates (Sokuk al-muqaradah)
must ear-mark each investor’s funds to the projects in which their money is invested, and
they should not guarantee the repayment of the principal. With the exception of more direct
investment vehicles (e.g., limited partnership through ownership of stocks in Government
enterprises), which are preferred by jurists, c.f. the ruling Rajhi Exchange Company ruling
#12, (cf. Sakhr 1996, fatwah #273), PLS-sharing government papers seem to exist only in
theoretical treatises on Islamic banking.
514 EL-GAMAL

in the Shafi‘i school. Islamic banks in other countries, however, may

decide to err on the side of caution and may find those Islamic Bonds
unacceptable. A significant part of the total liquid assets held by
Bank Islam Malaysia Berhad, Malaysia’s largest and oldest Islamic
bank, has been in the form of Government Investment Certificates,
(cf. Man 1988).
The next step taken by the Malaysian government was starting
an Islamic Money Market in January 1994, to facilitate secondary
trading of deposits with Islamic Banks, Government Investment
Certificates, Islamic Bills, and other forms of Islamic Bonds, (cf.
Business Times, 3 August, 1994a). The variety of liquid short-term
vehicles traded on such an Islamic Money Market might in theory
allow Bank Negara to influence the operations of Islamic Banks
through OMOs in that market. However, the amount of deposit in-
flows to Islamic banks has been significantly larger than the amount
of investment opportunities available to them. Consequently, the
banks held 5-year Government Investment Certificates to maturity,
thus preventing the development of a liquid secondary market in
them, (cf. Business Times, 22 March 1996).

THE PAKISTANI AND IRANIAN MODELS

A number of Islamization banking laws were passed in Pakistan,

culminating in the abolition of all interest-based deposits or loans
for all banks starting in 1985, except for foreign-currency accounts,
which still earned a fixed interest, (cf. Siddiqi 1988). Since 1991, do-
mestic residents as well as foreign residents have been allowed to
open interest-bearing accounts in foreign currency. On the asset
side, starting in August 1985 (soon after the initial banking laws
abolishing all interest-based dealings was passed), banks were al-
lowed to invest monies deposited with them (including those from
PLS-sharing accounts) in government interest-bearing securities,
(cf. Ahmad 1994). As a result, despite the laws to “abolish interest”
in the Pakistani financial system, all interbank and central bank
operations are carried-out on the basis of a fixed interest rate, (cf.
Ayub 1994). In recent years, the government financial operations in
Pakistan have become progressively more interest-based, with an
explicit policy of mobilizing savings directly through the Directorate
of National Savings by offering savings accounts, auctioning Trea-
sury Bills, and (interest-bearing) Federal Investment Bonds. The
Eighth Five Year Plan (1993-1998) explicitly stated among its ob-
jectives the development of secondary markets for government (in-
terest-based) debt securities, to enhance their liquidity through a
CENTRAL BANK OPEN MARKET OPERATIONS 515

repurchase facility made available to all scheduled banks, (cf. bin

Fazil 1995).
In summary, despite the fact that all banks in Pakistan, and in-
deed the entire banking system is officially Islamic, all banks rou-
tinely accept and hold standard interest-bearing government debt
instruments, (cf. NBP 1995). However, OMOs have traditionally
been an insignificant component of Pakistan’s monetary policy, and
the banks’ willingness to hold interest-bearing securities has not cre-
ated an incentive for the development of Islamic alternatives, al-
though the possibility of financing government investment through
investment bonds (sokulz al-muqaradah) was contemplated, (cf.
Meenai 1984: pp. 135, 257).
In form, the Iranian Islamization of the banking sector was faster
and more far-reaching than its Pakistani counterpart. However, in
the area of government borrowing from banks,
it was decreed that such borrowing from na- In form, the Iranian
tionalized banks (and the entire banking sys- Islamization of
tem was quickly nationalized following the the banking sector
was faster and
revolution) at fixed rates of interest is not fmmmachhgthan
Riba. The rationale was that this payment of its Pakistani
interest by the government to nationalized c o ~ ~ r p ~ .
banks holding its interest-paying securities
was only for accounting purposes, and that those interest payments
would not appear in the government’s consolidated accounts. More-
over, with the nationalized banking system under the direct control
of the Central Bank, monetary policy is implemented through direct
manipulation of the profit (interest) rate, rather than indirect mea-
sures such as OMOs, (cf. Valibeigi 1991).6

THE ARAB ISLAMIC MODEL

In many Arab Islamic countries, the licensing and supervision of Is-
lamic Banks has been a politically unappealing one. A full recogni-
tion that interest-free banks are Islamic amounts to an implicit
wowadmission that other banks (including state-owned ones) are un-
Islamic. Given the divergence of opinion on the Islamic status of tra-

6New attempts to issue government papers which can be sold as Mudaruba contracts, where
the buyers of the papers are viewed as participants in public investments, are contemplat-
ed in Iran. The pricing of such instruments, however, requires estimating the rate of return
on public investments using proxies in the private sector. This is clearly problematic given
that military expenditures and infrastructure projects are the dominant public investment
items. For a theoretical analysis of those novel instruments, see Mirakhor and Ul-Haq
(1997).
ditional banking operations, as discussed In many Arab
above, Arab Islamic governments are, under- Islamic countries,
licensing and
standably, reluctant to make such an implicit thesupervision of
admission. Islamic Banks has
Despite having no legal banking status in been a politically
Saudi Arabia, Islamic banks (including the unappealing one.
Saudi-in-origin international banking giants
DMI and Albaraka, as well as branches of Al-Rajhi) have operated
for a number of years. However, the Saudi Arabian Monetary Agency
(SAMA, which has Central Bank licensing, regulatory, and supervi-
sory authorities) refuses to grant them banking licenses according
them equal status with other banks in the Saudi banking system,
which is a traditional (interest-based) one. Since the Islamic banks
in Saudi Arabia are not licensed and/or supervised by SAMA, they
are not forced to hold any government paper; and the government
has not needed to issue Islamic instruments. The instruments used
by SAMA for Money Market operations included investment certifi-
cates which were quickly withdrawn from the market, and bankers’
security deposit accounts which have not been sufficiently liquid to
create an active money market, (cf. Wilson 1991: Chapter 10).
The legal status of Islamic banks in Egypt is more complicated. A
special laws was passed (Central Bank of Egypt, Law no. 48,119771
on the establishment of the Faisal Islamic Bank of Egypt [FIBEI) to
allow FIBE to function as a commercial bank. The Islamic Interna-
tional Bank for Investment and Development (IIBID, established un-
der the Investment Law) functions technically as joint-stock compa-
ny rather than a commercial bank. The Central Bank of Egypt does
not distinguish in its regulatory requirements between Islamic and
non-Islamic banks, so that FIBE is subject to the same requirements
as other private and state-owned banks. However, since the banking
industry is still dominated by state-owned banks, and since the Cen-
tral Bank of Egypt has not traditionally used OMOs as a policy tool,
the existence of Islamic banks has not encouraged the government
to issue Islamic instruments, (cf. Kazarian
1993). Savings have been mobilized Islamical- theIn recent years
Central Bank of
ly, however, by state banks issuing Certifi- Egypt has distanced
cates of Deposit under the name Investment itself from the
Certificates (shahadat ab’istithmar). “Type C” operations of Islamic
Investment Certificates do not promise a fixed banks after a series
of scandalous
rate of interest, and are in most respects iden- failures.
tical to the Islamic Bonds (or Government In-
vestment Certificates) used in Malaysia and elsewhere. Clearly, sim-
ilar instruments with larger denominations and different maturities
can easily be issued if the government were to decide on using them
CENTRAL BANK OPEN MARKET OPERATIONS 517

for OMOs instead of relying on direct regulation. However, in recent

years the Central Bank of Egypt has distanced itself from the oper-
ations of Islamic banks after a series of scandalous failures.

CONCLUDING REMARKS: NON-BANK FINANCIAL

INTERMEDIARIES,ISLAMIC BANKING,
AND MONETARY POLICY

As seen previously, in the Arab model, Islamic Banks, whether they

are domestic or international conglomerates, operate mostly as In-
vestment banks, Finance companies, etc., rather than commercial
banks. On the other hand, the Malaysian experiment has strived to
integrate Islamic banks into the overall banking sector and to make
them responsive to monetary policy instruments such as OMOs.
Under one over-simplified model, Islamic bank operations are a
combination of a wadi‘ah system of demand deposits (for which 100
percent reserve requirements need to be kept), and PLS-sharing in-
vestment banking operations. In this simplistic model, reserve re-
quirements which are held interest-free with the Central bank play
the same role for Islamic and non-Islamic banks, and prevent the Is-
lamic banks from excessive violation of the theoretical fire-walls be-
tween wadi‘ah accounts and PLS-sharing investment accounts. With
the reserve requirements for the demand deposit part held at 100
percent (as suggested by Fisher (1945)and Simons (1948),for in-
stance), there is no “Islamic banking multiplier” effect to any OMOs,
since they would not change the reserve ratios for those banks.
Hence, the need for OMOs acceptable to Islamic banks is nonexis-
tent for the simple Islamic bank.

REVERSE FINANCIAL ENGINEERING

In more complex situations, reverse financial engineering can facil-

itate OMOs. Government instruments mimicking the financial in-
struments offered by the banks must be acceptable to those banks.
So, if an Islamic bank issues Muqarada bonds, the government can
issue similar bonds which are acceptable to those banks. If an Is-
lamic bank is involved in a deferred-price Murabaha contracts, the
government can issue Murabaha based instruments which are ac-
ceptable to that Islamic bank. If an Islamic bank only uses its in-
vestment fund deposits in Mudaraba (the genuine PLS-sharing con-
tract) then the government may only be able to sell Mudaraba based
instruments to those banks, and so on. Indeed, some of the most suc-
518 EL-GAMAL

cessful dealings between governments and Islamic banks have been

in the form of leasing (Ijuru, e.g., in Kuwait) or Murabuha-like (e.g.,
the actual past practice in Malaysian GICs).
The ability to create a liquid market in such government instru-
ments which are acceptable to Islamic banks depends on the homo-
geneity of operations procedures of Islamic banks. In this sense, just
as standard government papers used in OMOs mimic the interest
structure of traditional banking operations, Islamic government pa-
pers should mimic the structure of Islamic banking operations. The
problem of developing government papers for OMOs in Islamic coun-
tries is not a problem of finding the appropriate type of such papers.
Rather, the problem is the possibility of creating a liquid market in
those securities, thus making OMOs an effective tool of monetary
policy. The ability to generate such liquidity depends on the homo-
geneity of the operations of various Islamic banks in Islamic coun-
tries. It is the homogeneity of traditional bank operations which fa-
cilitates the construction of a simple and effective monetary policy,
and the heterogeneity of views on what constitutes Islamic Banking
which stands as the greatest obstacle to adapting such simple and
effective policy tools to the Islamic model.

WILL THIS PROBLEM BECOME IRRELEVANT?

The further away Islamic banks deviate from standard commercial

banking practice (i.e., the closer they get to the ideal Islamic PLS-
sharing practice), the more they operate like the western version of
nonbanking financial intermediaries. The trend towards nonbank
intermediation through Islamic banking which It is widely believed
we have witnessed in Islamic countries par- that the us Federal
allels a similar (though explicitly nonreli- Reserve Bank is
giously motivated) decline in traditional bank- no longer able to
ing in the west, starting the 1980s, (cf. thesupply
of money as well as
Edwards 1996). The regulation of such non-
bank financial intermediaries. and the effec-
tiveness of monetary policy in an economy dominated by such
financial intermediaries, is a global problem, and not one restrict-
ed t o Central Banks in Islamic countries. It is widely believed
that the US Federal Reserve Bank is no longer able to control the
supply of money as well as it once had. Since 1980, the Fed has
stopped targeting M1 and began to target the larger measure of
money supply M2, but with a fast change in the composition of
M2, it is not clear if the Fed is able to control the money supply,
however measured, (cf. Edwards 1996: pp. 108-110). Indeed, tradi-
CENTRAL BANK OPEN MARKET OPERATIONS 519

tional views in Economics on monetary policy and the monetary

transmission mechanism, which underlie most common approaches
to monetary policy, have been seriously questioned in recent years
(e.g., see “The Monetary Transmission Mechanism,” Journal of Eco-
nomic Perspectives, 1995).
The only effective tool of monetary policy in the US today seems
to be the Fed‘s ability to influence short-term interest rates. If the
Islamic countries’ financial sectors become dominated by nonbank fi-
nancial intermediaries whose behavior is not affected by such inter-
est-rates, traditional monetary policy may become totally ineffective
in such countries. So far, the patrons of Islamic banks, and the Is-
lamic banks themselves, have been influenced by the opportunity-
cost of funds defined by short-term interest rates (or their proxies
implicit in gifts associated with so called Islamic bonds), thereby en-
abling Central Banks in Islamic countries to exercise effective mon-
etary policy. If this trend persists, minor vari-
ants on OMOs using Islamic bonds should The only effective
continue to be effective. However, if Islamic ~ ~ ~
banks and their customers begin to approach today seems to be
the ideal PLS-sharing approach, and reject the Fed’s ability to
the Islamic bonds and similar instruments in influence short-term
favor of stricter interpretations of the Islamic interest rates-
economic doctrine, Central Banks in Islamic
countries may lose their ability to influence real economic variables
in those countries. In the meantime, however, developing financial
instruments which aid them in conducting OMOs which engage the
Islamic Banks under their direct or indirect supervision is a n im-
portant short- and medium-term objective.

About the Author

Mahmoud A. El-Gamal is the Chaired Professor of Islamic Econom-
ics, Finance, and Management, and Professor of Economics and Sta-
tistics at Rice University in Houston, TX, USA.

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