It has been quite some time since I started researching the structural shortcomings in Islamic banking in Bangladesh. In 1999, I authored one of the first comprehensive analyses of how Islamic banking operated in Bangladesh, and I recommended that the BB establish interest-free money market products. Twenty-five years later, the BB is announcing that it will begin operating an Islamic inter-bank money market by June 30. My immediate response was finally, and my second thought was: not like this.
The BB's announcement recognises a serious constraint on Islamic banking. Because the call-money market, which is used by conventional banks to lend short-term, uses interest-based arrangements prohibited by Shariah, Islamic banks cannot participate in the call-money market. Their only other option is to invest in the Bangladesh Government Islamic Investment Bond (BIIIB), which has been idle for many years. While a commercial bank's current account may go into overdraft during the day, if it goes into overdraft overnight, it has no organised method of borrowing from a commercial bank with excess reserves. This is a legitimate operational challenge, and an appropriately structured inter-bank money market would solve it.
However, the proposed solution reads as though it was drafted without regard to the disaster that has ravaged the industry for almost two years. You cannot construct a liquidity pipeline among banks when several of those banks have negative equity, pending fraud claims, and non-performing-loan ratios approaching 90 per cent. That is not liquidity management; that is the transmission of contagion risk with a Shariah-compliant label.
The BB reports that it has studied models in Malaysia, Indonesia, and Bahrain. However, it seems to have learned the wrong lessons. The success of Malaysia's Islamic Inter-Bank Money Market when it began trading in 1994 was due to the specific instruments that were traded on it: Bank Negara's investment issues, Bank Negara monetary notes, sale-purchase back agreements, and commodity murabaha contracts. Each of these was supported by real assets and subject to Shariah rulings issued by a centralised Shariah Advisory Council at Bank Negara. Bank Negara also established a separate settlement system for Islamic transactions, so that the funds are kept physically separated from conventional money.
Bangladesh has neither of these options available to it. There are no Shariah-compliant government securities actively being issued. There is no central bank Sukuk. There are no Islamic Treasury Bills. The proposed inter-bank market will primarily enable banks to place uncollateralised funds bilaterally amongst themselves on Mudarabah terms. This is bilateral lending, not an operating money market. To operate as a true money market, a marketplace needs tradable paper. Absent such paper, there is no price discovery, no benchmark rate, and no secondary market activity. In my edited volume, The Handbook of Islamic Banking (Edward Elgar Publishing Ltd., 2007), Sam Hakim outlined the structure of Islamic money market instruments in detail. Bangladesh Bank should review its analysis. The instruments must precede the marketplace, not follow it.
The real problem here is that the sector remains critically ill. Last year, five Islamic banks were forced to merge into Sammilito Islami Bank after their balance sheets collapsed under the weight of politically directed lending. One source reported that the S Alam Group withdrew approximately Taka 105 billion from Islami Bank Bangladesh Ltd. via a series of shell companies and insider loans. According to reports from the Bangladesh Financial Intelligence Unit (BFIU), more than Taka 93 billion of that amount was laundered. At year-end 2024, the Islamic banking segment had a Capital Adequacy Ratio of negative 4.95 per cent.
The research I completed with Molla, Farooque, and Mobarek (Journal of Financial Services Research) empirically demonstrated that the quality of Shariah Board governance has a demonstrably positive impact on risk outcomes in Islamic banking. Bangladesh provided evidence contrary to our empirical findings by demonstrating how Shariah Boards could be ignored and how Boards of Directors could become agents of a single conglomerate, subsequently converting each bank into a vehicle for looting. An inter-bank money market does not address that problem. On the contrary, it provides an additional means for banks lacking proper governance to access funding.
Bangladesh Bank has noted that Sammilito Islami Bank will likely find difficulty attracting inter-bank financing because counterparties will question its ability to repay. If Bangladesh Bank believes that this is correct, why has it failed to include measures within the market design that reflect this knowledge? For example, why have capital adequacy standards for participating banks not been included? Why have limits on counterparty exposure not been incorporated?
I do not oppose establishing an inter-bank money market. I simply believe that it should not occur in a vacuum. Several conditions must be met prior to or contemporaneously with the establishment of an interbank money market.
Firstly, the Bangladesh Bank must develop the necessary instruments. Bangladesh Bank must issue Murabaha-based or ijarah-based central bank securities, which Islamic banks can use as investments, as tradables in markets, and as collateral for other trades until such time as these instruments exist; there is nothing for traders to buy or sell.
Secondly, Bangladesh Bank must specify eligibility requirements for participating banks. All banks that fail to meet minimum capital adequacy ratios are ineligible for unsecured interbank borrowing. Such restrictions are common throughout jurisdictions that have developed successful inter-banking systems.
Thirdly, Bangladesh Bank must ensure the physical segregation of clearing processes for Islamic transactions from those for conventional transactions. Malaysia recognised this requirement more than thirty years ago.
Fourthly, Bangladesh Bank must provide for Shariah oversight mechanisms exclusive to the inter-bank money market. Our examination of the regulatory framework for Islamic banking in Bangladesh (Thunderbird International Business Review, Summer 2007), revealed virtually no presence of specialised Shariah regulation. Bangladesh Bank, however, constituted a Centralised Shariah Advisory Committee (SAC). Hopefully, the SAC of the Bangladesh Bank will take up this issue earnestly.
Lastly, Bangladesh Bank should not separate this effort from its overall reform programme. The enactment of the Bank Resolution Ordinance, changes to the provisions of the Bangladesh Bank Order that allow greater independence for the BB, the restructuring of the Boards of Directors of distressed banks, and the enactment of an Islamic banking law-- all represent prerequisites for creating a market that functions as intended. The sequence of events is important.
Islamic banking accounts for slightly less than one-third of total deposits in Bangladesh. Those monies belong to tens of millions of people who chose these banks because of their religious convictions. They were betrayed by politically connected operatives who hijacked these banks. Now, the central bank wishes to restore trust in them. Establishing an inter-bank money market correctly will be part of restoring their trust. Doing so incorrectly will result in another layer of complex financial infrastructure placed atop failing institutions.
Bangladesh Bank researched models in Malaysia, Indonesia, and Bahrain. The lesson from all three countries is identical: build your instruments, build your governance, build your oversight, then open your market. Build your foundation correctly; let the market develop accordingly. Depositors in Bangladesh cannot endure another failure caused by their bankers' incompetence.
M. Kabir Hassan is Professor of Finance at the University of New Orleans and the sole recipient of the Islamic Development Bank Prize in Islamic Banking and Finance (2016). mhassan@uno.edu