Loughborough University

Abstract: This paper critically assesses the Islamic financial sector reforms in the selected OIC countries to investigate into the factors that have hindered development of Islamic banking and finance in these countries. It also attempts to assess different impetuses for such reforms in these countries. Islamic banking and finance is certainly a religious influence in the financial sectors of these countries; this paper attempts to look into economic implications of this influence for Muslim societies in the OIC countries. A major focus is on the conduct of monetary policy in the presence of Islamic banking and finance.
Keywords: Islamic Banking and Finance; Monetary policy; Interest rate mechanism; Profit loss sharing

Islamic banking is a modern phenomenon, formally starting with the establishment of a rural saving bank in Egypt (1963), a non-bank saving institution in Malaysia (1963) and a cooperative bank in Pakistan (1966). Since then Islamic banking has grown considerably with an estimated growth in assets of 15 percent per annum in the last two decades. Today, there are about 250 Islamic financial institutions in about 70 countries, with estimated funds under their management worth $300-$800 billion.
A number of countries have embarked upon financial sector reforms to allow Islamic banks to operate along side conventional banks. The countries that have introduced such reforms include Pakistan (1977), Iran (1979), Malaysia (1983), Sudan (1984), Bahrain (1978), Bangladesh (1983), Indonesia (1991), the United Arab Emirates (1974), Kuwait (1978), Qatar (1989) and Turkey (1983). A number of other countries are taking steps to encourage Islamic banking operations (see Table 1 for a complete list of countries with Islamic banking). The institutions like Islamic Development Bank (IDB), Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), newly-established Islamic Financial Services Board (IFSB) and an increasing number of organisations are working towards development of Islamic financial and capital markets to allow Islamic banks to expand as a modern, sustainable and internationally integrated phenomenon. The IDB is spearheading the world-wide movement of Islamic banking, the AAOIFI aims at developing accounting and Shariah standards for Islamic financial institutions, and the IFSB has undertaken the task of devising an internationally acceptable regulatory regime for Islamic financial services. These organisations liaise with the central banks and regulatory bodies of their member countries to promote Islamic banking as a sound and a viable alternative to conventional banking. The governments of Malaysia, Bahrain and Sudan play an active role in the promotion of Islamic banking and finance. Bank Nagara Malaysia, Bahrain Monetary Agency and the Bank of Sudan monitor Islamic financial reforms introduced by their respective governments. Since 2002, there has been a re-invigorated interest and strategy in Pakistan to develop a sound and viable Islamic banking system in the country, which should compete with the conventional banking and finance in the marketplace.
Among the countries that have introduced Islamic banking and finance, only Sudan and Iran claim to have their financial systems in complete conformity with Islamic principles. Sudan attempts to follow the mainstream doctrine of Islamic banking and finance, which differs from the Iranian version that is based on the Shi’ite tradition. Based on a relatively liberal interpretation of the forbidden interest – Riba, the Iranian Islamic financial reforms are not radically different from similar reforms in other countries, particularly with reference to the conduct of monetary policy.
The objective of this paper is to evaluate Islamic financial reforms and how introduction of Islamic banking has affected operations of monetary policy and conduct of banking operations in these countries. In doing so, the paper also investigates the extent to which Islam has influenced banking and finance industry and vice versa. Changes in industrial relations, which must accompany successful Islamic financial reforms are also discussed, albeit briefly.
Next section describes the evolution of Islamic financial sector reforms in the context of developments in Islamic banking and finance. Section 3 investigates into Islamic influence on banking and finance and how it has itself been influenced by the mainstream banking and finance practices. Economic implications of Islamic financial reforms are discussed in section 4 before outlining some salient features of monetary policy in an Islamic framework in section 5 that also provides a brief account of the monetary policy in Sudan after the recent financial reforms. Section 6 concludes and summarises the discussion.
Introduction of Islamic banking in the late 1970s and the early 1980s in Pakistan, Iran and Malaysia started an ongoing process of financial reforms in a number of member countries of the Organisation of Islamic Conference (OIC), an umbrella organisation of 56 Muslim countries of the world. The process of Islamisation of the Pakistan economy, initiated in 1977 by the military regime of Zia ul Haq, played a pioneering role in the development of Islamic banking and finance around the world. The Islamic revolution in Iran in 1979 soon resulted in a legislation outlawing interest-based banking in the country (1983). Malaysia, however, adopted a more cautious approach by establishing Bank Islam Malaysia Berhad (BIMB) in 1983 to later develop a vibrant Islamic banking industry on its success. At the core of Islamic financial reforms in Malaysia is Islamic Banking Act 1983, which serves as a regulatory and supervisory framework for Islamic banking operations. In addition, Banking and Financial Institutions Act was amended in 1996 to allow conventional banks to offer Islamic banking and financial services.
In the second phase of Islamic financial reforms (mainly the 1990s), the role of Pakistan and Iran got marginalised as more vibrant reforms in Bahrain and the organisations like AAOIFI assumed central stage in the world-wide movement of Islamic banking. Consequently, Bahrain emerged as a hub of Islamic finance and an international centre for Islamic finance industry. At present, there are 27 Islamic banks and other Islamic financial institutions in Bahrain that attempts to diversify its economy into financial services. Banking and finance, both conventional and Islamic, at present play an important role in the economy of Bahrain, which employs about 5,000 Bahraini and expatriates.
Since 2000, Sudan, Indonesia and the United Arab Emirates have taken measures that are fast developing Islamic banking and finance industries in these countries. After a historic ruling by the apex court of the country in 2000, Pakistan switched from a policy of complete Islamisation of economy to a partial Islamisation of financial sector – the so-called dual banking system. This was a significant development after a decade-long debate (and uncertainty ensuing from it) on the elimination of interest from all economic transactions in the country. Since then, an increasing number of private Islamic banks have been operating in the country along with state-owned and other private conventional banks. In this way, the 2000 judgement by the apex court, seen by many as a setback to Islamic banking and finance, has in fact proven to be a catalyst for further development of Islamic banking and finance in the country. This has in particular helped the State Bank of Pakistan, the central bank, to keep on pursuing an interest-based monetary policy that was seen as a major hindrance to the elimination of interest from economy.
In a number of other countries where Islamic banking and finance has significant presence, like Saudi Arabia, Kuwait, the UAE and Bangladesh, this new banking style is getting a boost since the start of the new century. The gradual development of Islamic finance industry and its increasing mainstream relevance is expected to initiate economy-wide Islamic financial reforms in these and possibly other countries that have so far shown indifference to Islamic banking and finance. The success and sustainability of Islamic is now certainly seen as a precursor for more comprehensive Islamic financial reforms in the years to come.
Perhaps the most important influence of Islam on banking and finance in the Muslim world is the Shariah’s contribution to the initiation of Islamic capitalism. Islamic banking and finance has helped in creating Islamic capital markets that are at their early stages of development. This is probably an unintended influence, as earlier proponents of Islamic banking and finance emphasised more on social welfare than creating Islamic capital. Working towards establishing Islamic capital markets received a boost in the 1990s after the collapse of the former Soviet Union, when Islamic banking and finance strengthened its alliance with the Western capital markets. Islamic banking and finance benefited from this alliance that gave it a mainstream relevance in a number of Muslim countries, including, but not limited to, Bahrain and Malaysia. Establishment of some global Islamic financial institutions like IFSB, AAOIFI, Liquidity Management Centre and offshore capital markets is definitely a move towards establishing and strengthening Islamic capital markets in the Muslim world. Issuance of global Sukuk by a number of sovereigns and corporations is certainly an extension of this phenomenon.
Although Islamic banking and finance is considered as an Islamic phenomenon, it is interesting to see the extent to which Islam has influenced banking and finance in the countries that have undergone Islamic financial reforms. While there is a widespread recognition of the Islamic influence on banking and finance, the opposite influence has so far not been studied.
Application of the paradigm version of Islamic banking and finance carries a distinct Islamic influence but the actual practice of Islamic banking and finance is more influenced by Western banking than Islam, which in turn has given rise to a re-thinking on Islamic stance on banking and finance. While the Islamic prohibition of interest has certainly been a raison de’etre of Islamic banking and finance, the actual developments in Islamic banking and finance have pre-dominantly been in the vein of circumventing hindrances to the development of Islamic banking and finance. This has resulted in endeavours to restructure the existing financial products to make them Shariah compliant. While this involves a degree of innovation, but it has actually carried more Western influence than Islamic contribution to the business of banking and finance. The menu of financial services on offer in Islamic finance industry confirms the view that Islamic banking and finance is more Western than Islamic. Products based on leasing and securtisation substantiate this view. Other products based on Murabaha, Salam, Istisna’ and other Islamic modes of financing perhaps owe more to the Islamic influence than Western traditions. However, pricing of almost all Islamic financial products, based on the Western methodology of benchmarking to a market standard (e.g., LIBOR), renders them behave more like Western products than the Islamic paradigm.
Financial sector reforms in most of the Muslim countries have by and large not aimed at promoting Islamic banking and finance; they have at best attempted to accommodate Islamic banking and finance in the mainstream banking and finance. For example, Islamic economists have for long advocated for the use of profit loss sharing (equity-based finance) but the required changes in the corporate sector were not introduced to cater for this demand. It has only been recent that most of the Muslim countries have ensued corporate reforms in the wake of the Asian financial crisis and failure of the giant corporations like Enron, Worldcall etc in the USA. The resulting changes in corporate governance are expected to benefit Islamic banking and finance but it will be too much to argue that the recent corporate reforms are in fact an Islamic influence. On the contrary, such reforms may affect the Islamic financial operations in certain areas. For example, Mudaraba companies in Pakistan do not grant any control rights to the minority shareholders – thus creating an imbalance in management and control functions. This type of arrangements will have to change following the recent corporate reforms that aim at safeguarding minority shareholders’ interests. In that case, there may be a need for re-thinking on the corporate governance of Mudaraba business in countries like Pakistan. If this happens, it will be another mainstream influence on Islamic finance.
This leads us to conclude that Islamic influence and the Western heritage have resulted in financial sector reforms in the Muslim world, which amalgamate Islamic and Western financial systems to accommodate Islamic banking and finance in a dual banking system.
Islamic banking and finance favours equity participation as opposed to debt-based finance. Consequently, debt-equity ratio in capital structure of firms is expected to be lower in the economies that have gone under Islamic financial reforms. But it appears as if Islamic countries are not much different from other countries of the world in terms of firms’ capital structure (Yousef, 2004). Incidence of Murabaha-based financing among Islamic banks confirms this trend. Thus, it will take quite a lot of more time before we witness Islamic banking and finance to be influencing ownership structure in the Islamic countries in favour of equity.
The lack of diffused ownership in the Islamic countries can be attributed to underdevelopment of stock markets. However, one must recognise that this is only a partial explanation. Other factors, like tendency of families to retain control over their businesses, perhaps provide more convincing explanation. For example, in about 50 percent of listed companies in Pakistan one family controls more than 40 percent of the total share capital. Table 2 in the following provides an interesting comparison. In Pakistan, where Islamic financial sector reforms took a significant turn only in recent years, family control is much more significant than Malaysia that started implementing Islamic financial sector reforms way back in the 1980s with the establishment of Bank Islam Malayisa Berhad (1983). Having observed that, one must be careful in concluding that Islamic financial sector reforms tend to be more successful in countries with wider equity participation, as even in Malaysia the incidence of profit loss sharing is not much different from other such countries.
For successful functioning of what has been termed as the “paradigm version of Islamic banking” (Errico and Farahbaksh, 1998), it is imperative that profit loss sharing is prevalent in manufacturing, services and agriculture. Successful implementation of Islamic financial reforms thus requires a change in the property rights regimes to allow more diffused ownership of production activity.
The central banks of Muslim countries have for long felt uncomfortable with the idea of devising a monetary policy that does not use the interest rate mechanism. An Islamic alternative to the interest-based monetary policy is based on the principle of profit loss sharing between banks and the central bank, which was perceived complex and unmanageable by the central banks and monetary authorities. The complexity of monetary policy is considered even more unmanageable in economies with huge budget deficits that leave the public sector more dependent on the banking system, making it harder for the central bank to pursue a consistent monetary policy. As Muslim countries run large budget deficits, the central banks prefer to adopt a rather simple monetary policy that allows them creation of money through interest rate mechanism. For example, Pakistan, which has resisted the adoption of Islamic recommendations for the conduct of monetary policy, has been running huge budget deficits for decades. Thus, government’s unhealthy fiscal position has hindered the introduction of Islamic financial sector reforms.
However, there has in the recent past been some practical application of the PLS model in countries like Sudan and now there is a limited, but growing, acceptance of the idea. It is expected that the idea will attract more followers with the further issuance of Sukuk certificates by the sovereign states and development of secondary markets in such certificates. The PLS-based monetary policy may comprise the following elements:
1. Direct control on credit creation
2. Regulation of short-term liquidity
3. Open market operations on the PLS-based (say Musharaka) certificates
4. Regulation of cost of borrowing
5. Exchange rate stability
The paradigm version of Islamic banking requires a 100 percent reserve system to restrict creation of money as a multiple of an original sum of money of a demand deposit (Ahemd et al, 1983). However, the predominant view holds that fractional reserve requirement is also acceptable as long as it is in line with the objectives of monetary justice, economic equality, social balance and an Islamic economic order. In reality, there is no Islamic country requiring 100 percent reserves. In fact, the reserve requirements have declined in recent times, in commensurate with the trend in the Western world.
Under a fractional reserve requirement regime, changes in the statutory reserve requirements can be used to control credit creation – a function that is common in an Islamic and conventional monetary policy. In the instances wherein an individual bank faces a short term liquidity problem, the central bank may finance its liquidity shortage by crediting the individual bank’s current account with the central bank according to a pre-determined formula. Restrictions on using this facility may discipline the credit creation. In addition to this, open market operations in Musharaka certificates may be designed to smooth short term fluctuations of liquidity in the market.
In the absence of the interest rate mechanism, the profit rate on Murabaha contract and profit sharing ratio for PLS-based contracts can be used to regulate the cost of borrowing in the economy. If the objective is to target growth in certain sectors of the economy, then differential profit rates can be used in favour of the targeted sectors.
Foreign exchange operations – as in case of conventional system – can be used by the central banks running an Islamic monetary policy to smooth foreign exchange fluctuations.
5.1. Objectives of Monetary Policy in an Islamic Economy
Objectives of monetary policy in an Islamic economy may be summarised in terms of achieving monetary justice, economic equality, social balance and an Islamic economic order. According to Chapra (1985), “the Islamic central bank should gear its monetary policy to the generation of growth in money supply which is adequate to finance the potential growth in output over the medium- and long-term within the framework of stable prices and other socio-economic objectives of Islam” (Chapra 1985, pp. 189).
5.2. Monetary Policy Instruments
A number of instruments can be used to achieve the objectives of monetary policy in an Islamic framework, some of which are essentially the same as in an interest-based economy. Targeting M0 is of course a fundamental ingredient of monetary policy, which is closely linked with the government’s fiscal position. Statutory reserve requirements can be used to regulate the supply of M1 and other broad measures of money supply. These two instruments can be used without difficulty in an interest-free system. However, it is the money market operations that require some structural changes in order to conduct an Islamic monetary policy. The use of profit ratio, as opposed to interest rate mechanism, posed uncertainty in the past, but now a number of central banks are gradually moving towards constructing a monetary policy based on this principle. For example, the Bank of Sudan uses reserve requirements, open market operations (OMO) in Central Bank Musharaka Certificates (CMCs) and Government Musharaka Certificates (GMCs), liquidity financing facilities and mark up rate on Murabaha contracts as the primary tools of monetary management.
5.3. Monetary Policy in Sudan Before and After the Islamic Financial Sector Reforms
Studying financial reforms in Sudan, particularly monetary policy, is instructive as “it is a complex fusion of historical legacy, difficult political compromises, dominating Islamic rules, traditionalist mentality, macro stabilisation efforts, pure bank restructuring, external liberalisation and thorny social dilemmas” (Kireyev, 2001, pp. 4). Furthermore, Sudan is perhaps the only country with a distinctly Islamic monetary policy since it embarked upon the IMF-monitored financial reforms in 1997. Examining this experience should have implications for other countries contemplating introducing Islamic elements in the conduct of monetary policy.
The Bank of Sudan, the central bank, uses five mechanisms to conduct its monetary policy, namely, reserve requirements, financing windows, open market operations, setting of minimum rates, and foreign exchange operations. The actual functioning of monetary policy in the recent past is depicted in Figure 1 below.
The Figure demonstrates that the Islamic influence on the conduct of monetary policy in an Islamic economy is through the introduction of PLS into the regulation of short-term liquidity, open market operations and regulation of cost of borrowing. Apparently, the CMCs and GMCs are close to the Sukuk structures being used by the governments of Bahrain, Qatar, Malaysia and Pakistan. The CMCs and GMCs are, however, based on profit loss sharing, as opposed to the Sukuk issued by other governments, which are leasing based. Another difference is in terms of maturity – the Sudanese certificates being shorter term vis-à-vis other Sukuk that normally have maturity period of five years.
6. Summary and Conclusions
Islamic financial sector reforms aim at accommodating Islamic banking and finance in the mainstream business of banking and finance. Undoubtedly, they represent an Islamic influence on banking and finance, which is widely acknowledged and talked about. However, this is also true that the accommodative nature of such reforms has brought a strong influence on Islamic banking and finance that is fast embracing Western traditions and methodologies in an attempt to innovate and integrate with the mainstream Western banking style. This is on one hand side seen as a positive development paving way for mutual co-existence of the West and Islam; and on the other hand side is seen as an irreversible Western influence on the Islamic thinking on banking and finance. Advocates of such reforms believe that with the establishment of strong Islamic financial and capital markets, the Islamic influence will return as the dominant force shedding off the Western elements. Probably true, but it appears as if this marriage between the West and Islam is not going to end. The compromise continues!
Table 1: Attitude towards Islamic banking in the OIC and other countries
Islamic banks Attitude of the government
The OIC countries
Bahrain, Bangladesh, Brunei Darussalam, Indonesia, Iran, Jordan, Kuwait, Malaysia, Pakistan, Qatar, Sudan, United Arab Emirates Yes Supportive
Algeria, Libya, Morocco, Oman, Syria, Tunisia No Hostile
Egypt, Turkey Yes Mixed
Saudi Arabia Yes Indifferent
Non-OIC countries
United Kingdom Yes Supportive
India No Hostile
United States No Mixed
Other European countries No Sceptic
South Africa Yes Indifferent

Table 2: Family control in Asian corporations
% of family control Pakistan (textile)
(%) Pakistan (non-textile)
(%) Indonesia
(%) Korea
(%) Malaysia
(%) Taiwan
(%) Thailand

10% cut off

30% cut off

More than 40%















Source: Cheema (2003)

Cheema, A., 2003, Corporate governance in Pakistan: issues and concerns. The Journal, volume 8, number 2, June 2003, pp. 7-19 (published by National Institute of Public Administration).
Chapra, M. U., 1985, Towards a Just Monetary System. The Islamic Foundation.
Errico, L. and Farahbaksh, M., 1998, Islamic banking: issues in prudential regulation and supervision. IMF Working Paper No. 98/30, March 1998.
Kireyev, A., 2001, Financial reforms in Sudan: streamlining bank intermediation. IMF Working Paper No. 01/53, May 2001.
Nomani, F., 2003, The Problem of interest and Islamic banking in a comparative perspective: the case of Egypt, Iran and Pakistan. Review of Middle Eastern Economics and Finance, volume 1, number 1, pp. 37-70.
Yousef, T. M., 2004, The Murabaha syndrome in Islamic finance: laws, institutions and politics, in Clement M. Henry and Rodney Wilson, The Politics of Islamic Finance, Edinburgh University Press, pp. 63-80.

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