Jurisdictions with Islamic banking systems could be more vulnerable to deposit disintermediation with the issuance of central bank digital currencies (CBDCs), according to the IMF in its recently issued working paper titled ‘Monetary Policy Implications of Central Bank Digital Currencies: Perspectives on Jurisdictions with Conventional and Islamic Banking Systems’.
While the issuance of CBDCs may promise many benefits, the IMF warned that it can also have adverse macroeconomic consequences, including for monetary policy, if not well designed.
Specifically for jurisdictions with an Islamic banking system, the IMF posited that issuing a CBDC may raise several complex design issues. Shariah principles prohibit interest payments, thus remunerated CBDCs are either not an option or the central banks have to design a CBDC that incorporates a profit-sharing mechanism.
Furthermore, the prohibition of speculation implies that CBDCs cannot be used for foreign exchange derivatives transactions.
“Bank disintermediation constitutes one of the principal channels through which CBDCs can affect monetary policy in jurisdictions with [an] Islamic banking system. Due to the prohibition of interest payments, unremunerated deposits account for a very large share of bank liabilities with some countries ranging between 30% and 70%. As CBDCs are perfect substitutes for unremunerated demand deposits, the large share of unremunerated deposits elevates the disintermediation risk,” the IMF said.
The IMF went on to say that the risk of bank disintermediation in jurisdictions with Islamic banks is further heightened by the predominance of retail deposits in bank funding.
“Finally, the underdeveloped Islamic finance markets increase the risk that if deposits are used to fund CBDCs, the ability of the central bank to mitigate liquidity risk might be constrained,” the IMF added.
On this, the IMF argued that the market segmentation and lack of adequate Shariah compliant money market instruments for liquidity management limit Islamic banks’ liquidity management capacity while an underdeveloped Sukuk market in most countries limits available collateral and constrains the effectiveness of the central banks’ function as a lender of last resort.
As such, the IMF concluded that while the risks to monetary policy of issuing CBDCs will vary across countries, financial systems and across time, jurisdictions with Islamic banking systems could be more vulnerable to deposit disintermediation because of the predominance of unremunerated deposits and retail deposits in banks.
“The underdeveloped nature of Islamic financial markets and Shariah compliant liquidity management tools could also limit the central banks’ scope to respond to liquidity shocks,” the IMF said.
A multifaceted strategy is, therefore, needed to comprehensively identify the macro financial risks and strengthen liquidity management. The IMF proposed that as part of the preparations for issuing CBDCs, central banks should ensure that the macroeconomic risks that CBDCs pose are understood, identified, managed and mitigated.
“Countries need to assess potential demand for CBDCs in their countries, understand the deposit structure of banks and the vulnerabilities to deposit disintermediation, evaluate the effectiveness of proposed measures to minimize deposit disintermediation, assess potential changes in money velocity and how that might affect the effectiveness of the monetary policy regimes,” the IMF said.
The IMF noted that of the 34 countries with Islamic banking, 10 countries are experimenting with retail and wholesale CBDCs. Among these, one country, Iran, is a fully-fledged Islamic banking system and the remainder have dual banking systems.
Some of the CBDC programs announced since the beginning of this year include the Bank of England and the UK government publishing a consultation paper on the issuance of a digital pound, the Central Bank of the Republic of Turkiye continuing to test its digital lira architecture in Q1 2023 with selected banks and fintech businesses, the Saudi Central Bank exploring domestic wholesale use of CBDCs, the Central Bank of Oman announcing that it is developing a CBDC and the Central Bank of the UAE exploring deploying a CBDC as part of a program to digitally transform the financial services sector.