Cooperation between Conventional and Islamic Banks

Central banks are important building block of the financial economy of a country or a group of countries. They are responsible for managing the money supply, interest rates, inflations, reserve requirements, and being the lender of last resort to local banks to avoid insolvency or financial crises. They are also regulators of commercial banks and other financial institutions to prevent deceptive or sham practices. All the regulations and guidelines of commercial banking are also applicable to Islamic banks. However, since Islamic banks do not lend or borrow money on interest and rather, endeavor to become partners in businesses, they require a different level of relationship with central banks.

Monitoring and control of monetary policy is crucial for well being of any currency and the economy that depends on it. Islamic banks should be of no exception but the unique nature of interest free banking should be taken into consideration. For example, cash reserve, liquidity ratios, and credit ceilings for Islamic banks should be different than commercial banks. Since Islamic investors take the risk of profit and loss, and the banks do not demand interest on their deposits with central banks, the reserve requirements could be reduced. Further, the Islamic banks should be able to participate in deposit insurance schemes to protect the depositors as long as that does not involve interest. Due to interest free banking, minimum interest on savings could be replaced with minimum weightage for profit. Other similar measures should be taken in regards to inspection of banks, profit equalization, and inclusion of monetary assets in the money supply.

Central banks also facilitate clearing of checks and other payments for Islamic banks. The conventional banks could avail overdraft protection and pay interest for this service. Islamic banks should be able to use this service interest free by depositing equivalent funds or sharing their profits with the central bank. Also business documents such as letters of credit and guarantees should be available to Islamic banks without interest but for a commission or fee.

The central banks also serve as the lenders of last resort to prevent financial crises and insolvency of banks. Islamic banks should also be able to obtain liquidity support in such cases from the central banks. When central banks increase money supply by lending to the banks, it should be on Mudarabah or Musharakah basis when dealing with Islamic banks since they cannot deal in interest

Islamic banks coexist with the conventional banks and require constant interaction. They mobilize deposits and investments from customers and are active in the economy. They have the same issues of surplus and deficit liquidity faced by conventional banks. With the rising impetus of Islamic banking and the established infrastructure and experience of conventional banking, the two sectors complement each other. The means of cooperation between the two types of banks include investment accounts, funds transfer, Murabaha financing, Mudarabah and Musharakah based profit-and-loss-sharing, trust financing, lease and lease to purchase, letters of guarantee, etc. There is also a need for further development of correspondent services, documentation for foreign commerce, co-financing of large projects and leases, and interest free exchange of funds.

Correspondent banks are used by other banks in international markets where a bank does not have a presence. These banks could be involved in payments, transfers, guarantees, and trade execution. An Islamic bank might seek the services of a conventional bank for these purposes and might need to maintain interest free accounts or agreements that no interest would be charged. The corresponding bank might be compensated through commissions for their services. Conversely, an Islamic bank might play the role of a corresponding bank. There would not be any collection or payment of interest in any of accounts held at either institution. The services would be provided for a fee. Corresponding banks relationship could also exist for guaranteeing letters of credit in international trade. Arrangements must be made to avoid interest by agreeing on a fee structure, through security deposits, or by utilizing one of the modes of Islamic financing.

Large infrastructure projects require huge amounts of funding for financing or lease. Many projects require pooling of resources of a number of financial institutions. One of the participants in such case might be an Islamic bank. In that case Shari’ah compliance must be observed both for funding and for the nature of the project. The financing should be either through Musharakah, Ijarah, or a combination or variation of such schemes. As long as the conventional banks are willing to share the risks of ownership, cooperation with Islamic banks is possible.

All banks operating in the economy have to exchange funds with other banks. Islamic banks have to make sure their requirement of Shari’ah compliance is adhered to. For example, if a conventional bank has deposits with an Islamic bank, it can be in the form of Mudarabah investment where the investor bank’s return will be similar to any other customer. In case of surplus funds in a given currency, the Islamic bank can exchange the funds with another bank on a barter exchange with no interest. At the end of an agreed period, the banks would re-exchange the funds to restore to the original value. A conventional bank could also help establish an Islamic bank but that practice is not universally accepted by scholars.