Conventionally, the central bank is responsible for the issuance of currency, the management of the banking system in order to insure the value of the currency, the formulation of monetary policies to govern bank operations and the regulation of the fluctuations (inflation and deflation) in the value of currency which is a result of the interest based system which is outlawed in Islamic laws regarding finance.
In modern Islamic finance, the relationship between the Islamic and Central Banks is vital for the development of Islamic banks and the much-needed assistance to compete with the conventional banks. Central banks are needed to buttress role that Islamic banks play in the socio-economic sector of a country by establishing limitations on equity, licensing and setting up new branches, establishing special funds.
The principle element to consider when revising the role of central banks in the Islamic banking system is to recognise that it differs from one country to another and is subject to the socio-economic principles and policies of that country.
However there are three features of the relationship between Islamic banks and central banks irrespective of the host country namely;
- It acts as a lender of last resort- this element enables central banks to control the supply of money to the commercial banks therefore the public. The loans are given to conventional banks to provide liquidity, however they are done on the basis of interest accumulation which is prohibited in Islamic finance.
To ‘halalify’ the loaning, the central bank instead of charging interest to the loans given to Islamic banks, instead settle on the profit and risk sharing policy of the sharia-compliant institution and instead take a share in the returns of the Islamic bank’s investment of the loaned money over the pre-determined period of profit-making.
- It acts as a clearing house- In the modern Islamic banking structure, central banks supply Islamic banks with provisions for the defrayal of cheques and other disbursements and also facilities such as documentary letters of credit and guarantee for a charge.
The Islamic bank establishes a current account with the central bank with the clearing system and restricted short-term provisional overdraft services which are also free of interest. The Islamic bank is sometimes allowed to pay for any transitory deficits for clearance reasons. For returns, the central bank may allow partial temporary services interest-free of Islamic banks on the agreement that the Islamic bank would share their profits during the deficit phase.
- Lastly, it acts as a supervisor in regard to monetary policy- the central bank regulates credit availability and inflation via money to manage a stable economic growth. The central bank is obliged to create blueprints and types of standard data needed from Islamic banks to be utilized by Islamic bank agents and the central bank itself so as to adhere to the principles of Islamic banks procedures.