There are two main institutions which are concerned with the monetary policy, that is, executive government and central bank. The decisions of executive government are generally based on their political agenda whereas the decisions of central banks are based on the theoretical knowledge and practical experience of the technocrats. However, an agreement between two poles and sufficient condition for the implementation of the policies are necessary. Generally executive government is giving the policy targets to the central bank which is independently developing its own strategies for achieving the agenda of the executive government. In the following sections, an effort is made to review the relationship among the role of central banks, monetary policy, and corporate governance in the conventional as well as in an Islamic economy. This chapter is organized in the following manner. Section 1.1 visualizes the role of central bank in detail. In Section 1.2, a detailed discussion on the monetary transmission and corporate governance is provided. The relationship between monetary policy and corporate governance from the perspective of Islamic point of view is articulated in Section 1.3. Section 1.4 has shed some light on Shari’ah governance while Section 1.5 concludes the whole chapter.
1.1. Role of Central Bank
In the recent literature of economics, law, and political science, the role of central bank is getting more importance. In typical literature, two hypotheses got more importance in the theoretical literature. The first one is Minsky’s (1986) financial instability hypothesis, in his opinion during the expansionary period of monetary policy because of good investment and high expected returns, demand for loans increases, in resultant the banks are issuing more risky loans to their customers, therefore, the stability levels of financial institutions will decline. Other school of thought considering the supply side of money. In their opinion, banks are the primary source of transmission instruments of the monetary policy applied by the central bank. In this scenario, the pattern of lending and borrowing of banks is dependent upon the monetary policy of the central bank, that is, contractionary or expansionary. It means that the stability levels of the banking industry are dependent on the variables of monetary policy (Bernanke & Blinder, 1992). Bucher, Dietrich, and Hauck (2013) and Bikker and Hu (2002) are of the view that money growth is the main instrument which is responsible for the stability levels in the banking sector.
Mishkin (2007) described that the role of central bank is to stabilize the prices along with output stability while maintaining the low inflation rate. He argued as: “Price stability should be the overriding, long-run goal of monetary policy” (p. 41). Leybek (2004) discussed the role of central bank in the framework of economic policies and expressed as,
Good central bank governance means that the objectives and tasks delegated to an institution are performed effectively and efficiently, thus avoiding misuse of resources, which is crucial for establishing a good track record.
Tucker (2020) expressed his view about the role of central banks, “They provide public goods (such as price stability) and preserve common goods (such as financial stability) that can be enjoyed by all but eroded by the exploitative.” Amtenbrink (2004) stated that Central bank has three pillars of its governance, that is, independence, democratic accountability, and transparency. There are multiple objectives to achieve for any economy; therefore, this is the policy of the central bank to develop its clear preference order. It is suggested that once executive government fixes the targets of the monetary policy, then it should be left on the central bank to achieve these targets without any influence of the government otherwise central bank will not be able to achieve those targets smoothly. The other view is based on the “so-called contract approach,” that is, the central bank and government have an agreement in which monetary policy objectives are quantified. By following this approach, central bank is independent to achieve the realistic and decided targets. Due to this agreement, executive government has no choice other than to follow the strategies of central bank and it is also difficult for the executive government to criticize the central bank while it is conducting the monetary operations as agreed with the executive government. This approach is following the Central Banks of Canada and New Zealand for achieving the targets of monetary policy.
It is argued that the independence of central bank not only increases the accountability of the central bank and also its credibility. The function of transparency creates a confidence between the bank and the public. This confidence gives the strength to the decisions of the monetary policy, for example, the decision of monetary policy toward inflation and output is not the pure decision of monetary policy but also based on the expectations and behavior of the public. The understanding of the public is an important ingredient of the implementation of any strategy of the central bank. For example, the economic behavior of the public has a significant influence of bank’s decisions.
However, in this modern era of media and technology, the role of media is very much important, that is, how media is communicating the strategies of monetary policy of the central bank to the general public and how it has an impact on the understanding of the public. Goldfajn (2019) stated that general public should be satisfied and understand the rationale of the decisions of the central bank. He has given the example of Brazil, the minutes of the decision of the central bank of Brazil comes out within a week. In his opinion, it should be simple, concise, and in a clear way. In his opinion the most important element is the expectations about the inflation. If public knows that what is the objective of the monetary policy and strategies of the central bank, then the outcome will be favorable and will help in implementing the strategies.
Central bank has always trying to achieve two targets, that is, inflation and growth. There is always short-term trade off among inflation, recession, and unemployment. Currently, it is a general practice that central banks are also dealing with the markets whenever they feel any disorder in the markets. Simultaneously, the fluctuation of exchange rate is always in their under considerations. It is their task to distinguish in between the situation where they will give special attention or to leave it to work at its own.
Tucker (2020) explained about the current status of Central Banks in this way:
Today’s central banks are, of course, extraordinarily powerful. First, the right to create money is always latently a power of taxation, capable of redistributing resources across society and between generations through a burst of surprise inflation (or deflation). Second, as lenders of last resort, central banks can potentially pick winners and losers. Third, through the terms of their financial operations (collateral, counterparties, and so on), they can affect the allocation of credit in the economy.
Fourth, acting as banking system supervisors, they are, like regulators in other fields, effectively delegated lawmakers and judges.
1.2. Monetary Transmission and Corporate Governance
It is a consensus among the experts that monetary transmission has an impact on the behavior of banks and the conditions of corporate sector, and consequently the decision of corporate sector has a significant influence on the fluctuations of the business. It is a process which starts from the decision of monetary authorities and, at the end, it has its impact on the economy through the decisions of corporate sector (Cecchetti, 1999; de Bondt & Stokman, 2000; Guiso, Kashyap, Panetta, & Terlizzese, 1999; Kashyap & Stein, 1997, 2000). In this context, two variables play a very important role, one is the credit issued by the banks and other is the governance characteristics of the firms. There is a big question in front of the policy makers, either that model of corporate governance of the banking sector which benefited the stakeholders of banks is leading to the bank stability or not. However, in the literature, there are two approaches discussed regarding the issue of corporate governance in the banking industry. From the one corner, it is assumed that if financial intuitions have good governance structure, then managers and shareholders are able to develop a stable and sound strategy for their functions and business. Therefore, in resultant, the stability levels of good corporate governance are far better than those who have poor corporate governance. Another corner has different opinion and, according to this group, the good corporate governance structure leads to more profit-oriented initiatives. Consequently, banks are involved in riskier activities. These riskier activities are the major cause of instability in the banking industry.
de Haan and Sterken (2002) analyzed the impact of different indicators of monetary policy on the financial structure of the firms in Netherland, that is, leverage, financial debt, loans, and trade credit. First three are becoming down in the period of contraction. They further argued that this effect is very strong when it was analyzed on the governance of private firms. Prasad and Ghosh (2005) studied the behavior of manufacturing firms during the period of the tight monetary policy in India. They observed that tight monetary policy lowers the total debt, in particular, to the private firms. It was interesting to note that short-term borrowing was increased in the listed firms and, in this way, they are adjusting their debts and also maintaining their relationship with the banks. It is important to note that maintaining the relationship with the banks is also an important aspect for the firms. Davis and Stone (2004) argued that corporates’ “state of balance sheet” has a significant influence on the stability of the financial system of the economies. In their opinion, if there is continuously deterioration in the balance sheets of the corporates, then it has a significant negative impact on the adverse selection and moral hazards. They further argued that if researchers are examining the stability of the financial system, then they have to consider also the balance sheets of corporates. Prasad and Ghosh (2005) examined the role of bank debt on the balance sheets of Indian corporates and its reaction to the tight monetary policy. On the other hand, Lipton (2019) discussed the money laundering and its impact on the social well-being. In his opinion, this is a hidden money which comes from illicit activities and it is 8% of the global GDP. He stated as: “Improving governance isn’t easy; it requires sustained effort over the long term. It’s not only the right thing to do, it also brings tangible benefits to millions.”
de Faria and Streit (2016) are in view that the degree of three pillars of central banks (i.e. independence, transparency, and accountability) are dependent on the level of maturity of democracy, if political system is more matured, then central banks are more independent and transparent. And also, information is given by the central banks that their governance practices are strengthening the process of accountability and transparency.
Dube (2018) discussed the case of Zimbabwe and concluded that there is a strong positive association between the corporate governance and the financial stability (stability in financial institutions and financial market). It is also observed that financial stability is strengthening the business confidence. There is consensus among the policy makers and experts that poor corporate governance has an impact on the efficiency of the banks and does not able to attract the foreign investors. The control of monetary policy on inflation and prices plays a very important role and gives the hope to the business sector especially in the developing countries. Brandao-Marques, Gelos, Harjes, Sahay, and Xue (2020) studied the case of different emerging markets and concluded as:
Importantly, having a modern monetary policy fram...
