This paper discusses key issues related to the conduct of monetary policy in countries that have Islamic banks. It describes the macro-financial background and monetary policy frameworks where Islamic banks typically operate, and discusses the monetary transmission mechanism in economies where Islamic and conventional banking coexist. Most economies with Islamic banks also have conventional banks and this calls for a comprehensive approach to monetary policy. At the same time, a dual approach to monetary policy should be considered whenever the Islamic segment of the financial system is not as developed as the conventional one. The paper tries to shed light on potential spillovers between conventional and Islamic financial systems and proposes specific recommendations on the design of Islamic monetary policy operations and for facilitating monetary transmission through the Islamic financial system.

Despite a fast-growing Islamic banking industry, the implementation of monetary policy and the transmission mechanism of monetary policy in the presence of Islamic banks remain a challenge for the central banks (CBS). The challenges arise not only from the Islamic finance core principles but also from the macro-financial background and monetary policy frameworks of countries where Islamic banks operate. Since the early 1990s, the related literature has broadly followed two streams: the first one, theoretical, was derived from the work of Khan and Mira Khor (1990) and was based on the premise that Islamic finance is strongly anchored on the profit-and-risk sharing principle and mainly equity-based.

The second one, empirical, has focused on monetary transmission from the conventional segment to the Islamic segment of the financial system (Cevik and Charap, 2011). This paper builds on both streams and highlights the evolving nature of Islamic financial systems and the related complexity of the transmission and operation of monetary policy in dual financial systems (i.e. coexisting Islamic and conventional systems). Financial systems where Islamic banking is systemic are typically dual and not fully developed. Islamic banks tend to develop side-by-side with conventional banks and are influenced by “standard” monetary policy instruments and conditions. As Islamic finance grows in importance, development in that segment may start to influence, under competitive pressure, the conventional financial system and overall market conditions. Islamic banks are not isolated from the macro financial background in which they operate: exogenous shocks, macroeconomic management, and systemic liquidity conditions have implications for monetary policy implementation and its transmission through the Islamic banking system.