The Role of Central Banks in Islamic Banking-Final

Assertions:

8. Removal of interest and all its derivatives (i.e. lending on interest, money market and speculation) from an economy will lead Islamic banks to finance investment projects through PLS. The criteria to be used by such banks are both profitability and feasibility of the projects. Hence, projects compete with each other on the bases of their Internal Rates of Return (IRR). However, the criterion used by a potential investor is IRR of a specific project. The role of the central bank in determining arrays of IRRs for different sectors and various activities is highly valuable in channelling resources into proper projects. Ranking IRRs in descending order, an investor would first choose the project with the highest IRR. However, the rule, which seems appropriate in choosing the amount to be invested, is "cut-off rate". The maximum amount one investor is willing to invest in a project is determined by the IRR of the next project whose value is almost equivalent to the chosen project, without it being "the opportunity cost" of capital.

Cut-off rate, seems to me, has long been mistakenly interpreted as opportunity cost. In investment decision making most of the times we are dealing with the cut-off rate concept (even in an interest based economic system) but very rarely with opportunity cost. In capitalistic system, rate of interest is justifiably used as the opportunity cost of capital. It is well justified that interest rate is essentially determined independently from the rate of return in the real sector of the economy. However in the absence of interest, projects compete with each other to obtain finance from Islamic bank on the basis of their IRR because there is no other alternative.

Comparison among various IRRs brings about the role of cut-off rate without anyone of them becoming opportunity cost of another project. Cut-off rate functions as a signal to show an investor up to what point he should invest and where to stop and select another project. Interdependencies among various investment projects produce cut-off rate the special character and function of which differ from those of interest rate. The reason, seems to the author, that we often fail to distinguish between these two concepts is the interdependence condition. Furthermore, choosing one, IRR of one project as the opportunity cost of another project in the same activity (on the basis of the principle of next best alternative) will lead one to a whole range of so-called opportunity cost list, none of which have possibly the same value. Hence, different cost calculations in the same activity. Whereas cut-off rates could be numerous for many producers in the same activity without making them run into any problem. In the absence of interest rate there is nothing to compare IRR of an investment project with. Therefore, we can conclude that in an Islamic economy opportunity cost of capital is zero.

The foregoing statements were justified on the basis of economic logic; accountants do not seem to have any reason to believe otherwise. One final remark can be added to above statements. Opportunity cost of capital can also be used as the cut-off rate but the reverse is not true. After their feasibility and profitability have been confirmed by Islamic bank's qualified personnel, projects become eligible to obtain finance; furthermore, the projects themselves become collateral for finance. Central bank's role in providing guidelines about both of these two aspects will certainly be appreciated by Islamic banks. As long as there are unemployed factors of production suitable to be utilized in investment, projects have to be financed by Islamic banks no matter how much money is required to finance them. This gives appropriate apparatus to materialize the assertion made by S. M. Bagher Sadr when he says; "Tools of production are treated servants in Islam and man the master". It is the right of labour, in Islam, not to be kept unemployed. In the final analysis, every piece of bank note coming out of an Islamic bank in response to financing an investment project can be called Certificate of Asset Building (C.A.B.). These C.A.B.'s are appropriate both to production and household sectors.

9. In dealing with various modes of contract, Islamic banks finance profitable and appropriate projects. Appropriateness of projects are expected to be determined by the central bank; however, to determine which projects are more profitable to finance is the task of each individual Islamic bank.Central bank's task is to instruct Islamic banks to give priority to those projects, which are more compatible with the country's economic plan (be it either explicit and written or unwritten and implicit).

Islamic modes of contract can be classified into two broad categories:
1. Those with variable return and (2) with fixed return. Musharakah and Mudarabah contracts fall into the first classification and Instalment Sales, Hire-Purchase, Joalah, and the like into the second one. Musharakah (i.e., PLS) has well and rightly been recognized as the core of Islamic banking. In Mudarabah contract labour has no responsibility as to any loss that may occur provided that it had done its best. The second class of contracts may be defined as auxiliary contracts, which could be used in conjunction with and after the first category has been utilized. Risk is involved with the first type but the second is risk less which is more appealing to Islamic banks.

To reduce or even to eliminate the burden of risk from the shoulders of investors it requires another paper, which IS beyond the scope of this presentation. However, to make sure that the guideline controlling the complementarity of the second type contracts has properly been observed, the Islamic central bank is supposed to keep close eye on the contracts signed by each individual Islamic bank. I skip going into the mechanism of how the burden of risk can be lessened or even eliminated; to determine the degree of risk in different sectors and regions throughout the country. This is another crucial task of an Islamic central bank. This will facilitate the task of Islamic banks in determining the relative share of their own profit vis-à-vis that of the investor. This task not only is beyond the capabilities of an individual Islamic bank, but also provides a uniform procedure for all Islamic banks for various sectors, locating in different regions of the country.

10. Whether an Islamic bank uses the variable or fixed- rate-of-return contract, accountants are very keen about costs that are supposed to be deducted from, total revenue.Accountants who are responsible to approve and submit both balance sheets and profit and loss statements to tax authorities do not accept anything under the heading of cost from neither of the two types of contracts provided that they have been financed by Islamic banks. It is a fact that economists use these two valuable documents for economic analysis and their own interpretations without being able to adjust them on the basis of their own interpretation of cost.

Nevertheless, neither of the two professions (accounting and economics) can deny that the Islamic banks' share of profit paid by investors (i.e. financees) is in fact sort of dividend which is essentially determined after all costs have been subtracted from revenue and hence can no longer be considered cost.

To sum up the role of a central bank in an Islamic state, we come up with six different crucial functions to be performed at different levels of rigorousness:
a) Active participation in the process of preparing economic development plan.
b) Informing individual Islamic banks about the priorities of investment projects as outlined in the country's economic development plan at different regions and various sectors.
c) Calculating and submitting to Islamic banks the profit shares of banks relative to those of capital for different projects at various regions and sectors.
d) Calculating and submitting to Islamic banks the value of risk involved in different projects, different regions, and various sectors of the country.
e) Constant inspection and supervision to make sure that projects have properly been financed relative to the priorities and the value of risks. Note: To do all above functions effectively an Islamic central bank is supposed to be well equipped with highly qualified personnel in portfolio and risk management and project appraisal. This is also a must for each individual Islamic bank.
f) After making sure that Islamic banks have concisely followed the central bank's instructions they can safely be allowed to gradually reduce RRR down to zero.

Let me admit that monitoring cost in Islamic banking compared to the conventional banking is relatively high. However, potential benefits as to its effects on reducing unemployment and keeping prices constant over-shadow the cost. Most important, distribution of income and wealth is expected to be more equitable than otherwise. Such a scheme of distribution guarantees sustained economic development. The role of an Islamic central bank in a uniform distribution of information and prevention of moral hazard cannot be overstated.Whether it is the Islamic banking or the realization of Keynes' expectation to reach full employment, it is yet to be seen.

In closing my presentation, I would like to cite what Keynes has to say about this whole issue: "If I am right in supposing it to be comparatively easy to make capital goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism." Nonetheless it seems that these two models, in the final analysis, converge. He, in this respect, admits that "...it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of the capital at which there is full employment."