An unprecedented global financial crisis has raised a variety of questions regarding the banking industry, and has also unleashed a rethinking momentum that has not spared the very model of capitalism that we live in today.

Indeed, Islamic finance has attracted significant attention as an alternative or potential solution.

The principles of Islamic finance can contribute a great deal to the rebuilding of our financial system. However, we should distinguish the principles from the industry as it exists today. Simply put, the Islamic finance industry is very young, and currently operates within a broader conventional framework. Indeed, a quick survey of the Islamic world would reveal that money creation, to date, is still based on a conventional equation. In other words, in the Islamic world, money creation and issuance still follow conventional non-Islamic methodology.

This is revealing as it indicates that the principles of Islamic finance have not yet been applied to the very process of money creation and issuance. Indeed, what would an Islamic money creation process look like? I propose the concept and mechanics of an Islamic money creation process, or Islamic monetisation.

States and state institutions create and manage the economic game of nations.

The two arms of the state that are responsible for economic management are the government and the central bank.

Both are part of the state, and they are the key entities whose relationship and mode of interaction is the underlying equation that supports the printing and creation of money.

Monetisation describes the process through which the central bank replaces government bonds with high-powered money. As such, it is directly linked with a fundamental premise of money creation, that is, the central bank uses government bonds as assets that back the issuance of currency, which is a central bank liability. While this fact has to do with central bank accounting, it also reveals a money creation process which is fundamentally an institutional arrangement between two arms of the state.

While currency issued is a liability of the central bank, government securities are an asset. This, in short, is the equation through which fiat money is injected into an economy. Table One provides the balance sheet of the Bank of England Issue Department that substantiates the arguments made here.

Looking at the Saudi Arabian Monetary Agency's (Sama) balance sheet, Table Two, we find that Sama backs currency issuance with gold and foreign currency (mainly United States dollars). We also observe that in the banking department balance sheet "investment in securities abroad" and "deposit in banks abroad" are the largest items. The dollar is a currency backed by conventional government securities, and foreign investments are in vast majority, if not completely, in conventional debt securities.

SAMA BALANCE SHEET

An Islamic money creation process would use an equity-like product to back currency issuance, instead of a debt security as it is common today across many countries and central banks.

Indeed, given that the government and the central bank are the ultimate creators of money, there is no reason they could not actually share the risks and rewards of macroeconomic management.

In other words, if an Islamic instrument, for example Public Capitalisation Notes, were to be used for money creation and issuance, central banks could capitalise the government, rather than lend to the government when necessary. As such, an equity-like monetisation tool does not promise a fixed interest. It promises a return which is paid out in the form of a dividend sharing surpluses and profits where they are earned.

Public Capitalisation Notes (PCNs) would have to be issued by the government treasury, and offered for sale to the country's Central Bank. Without transforming this paper into a financial engineering exercise and leaving the legal structures and term sheets involved to a later discussion, one of the key features of PCNs is worth mentioning here. The underlying real assets/activities that support these Islamic instruments would be the tangible and intangible resources of the state and their productive management in the pursuit of economic growth. PCNs can also be earmarked to specific projects and spending plans, such that the liquidity injected into the government and thus the economy is directed and targeted, involving a business plan and a profit potential.

Indeed, when earmarked to projects, PCNs could also be sold to other private and institutional investors.

An Islamic money creation process is not yet practiced in the Islamic world. As suggested here, Islamic monetisation uses an equity-like instrument to back currency issuance, without fixed predetermined interest payments. The structure of the instrument is grounded in a risk-sharing principle where government and central bank share the risks of macroeconomic management.

Given that the state is the ultimate source of money, Islamic monetisation could be a key architectural innovation, allowing human societies to print and manage their monies, which they already do, in a logic of existence and ownership, rather than a logic of survival and debt.

Moreover, given that we are creating money through an institutional arrangement between governments and central banks, public debt is a paradox and a self-inflicted burden that could be resolved through an Islamic money creation process.



- Armen V Papazian is head of Islamic Finance at UBS Investment Bank