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Articles & News
Islamic
Economics & Banking
Introduction
Why did Islam prohibit interest? What is the logic behind that?
What types of interest has Islam prohibited? These are certainly
the questions that face a lot of both Muslim and non-Muslim
economists. When Islam was introduced 1400 years ago, one of the
main issues discussed, was Riba or interest. How interest made
people manipulate poor people, and how interest made the rich
richer and the poor poorer. It also made people work less
because of their guaranteed return. Those were the assumptions
back then. Still many issues and arguments had come to life
after the death of prophet Mohammed, may peace be upon him, of
what is Riba and when it is prohibited. As the world economy
made the transition to a market economy after the industrial
revolution, it is not very hard to see when Riba applies and
when it does not. Perhaps the transition to a market economy is
not made to fit different religions or morals. What is the logic
behind the prohibition of interest, when does it apply, is it
better and how could we continue in a market economy through
banning interest? To address these issues, I will rely more on
the Qur'an rather than the hadeeth because of the uncertainty in
some of the hadeeth of whether it was actually the prophet's
words.
What is Riba?
The following definition and discussion of what is Riba is one
that is derived from many books that seem to have the same
definition. According to these books, Riba is seen as an
unjustified earning where a person could receive a monetary
advantage in a business transaction without giving a just
counter value. Riba was also seen as a misallocation of
resources, erratic growth, and economic instability in light of
the contemporary crisis. Riba literally means increase,
addition, expansion or growth. It is however, not every increase
or growth, which has been prohibited by Islam. Riba technically
refers to the premium that must be paid by the borrower to the
lender along with the principle amount as a condition for the
loan or for an extension in its maturity. In this case, Riba
obviously means interest. Riba is a sin under Islamic law, and
even those hired to write the contract or who witness (and thus
confirm) the contract are a party to the sin. Furthermore,
prohibition of Riba means that money can be lent lawfully only
for either charitable purposes (without any expectation of
return above the amount of the principle), or for purposes of
doing lawful business--that is, investment on the basis of
profit and risk sharing--an investment of the kind that seeks
profit while sharing the risk is encouraged in Islam, indeed it
is commended.
Islam made a clear distinction between trade and Riba where
trading is welcomed and Riba is prohibited. Islam does not
consider money as a commodity such that there should be a price
for its use. Money is a medium of exchange in asset-oriented
economy, and a store of value. The prohibition can be expressed
in more technical terms by saying that while money is recognized
in Islam as a means of exchange it may not lawfully be regarded
as a commodity for exchange. The important difference between
trade and Riba is that the business risk in trading is allocated
more evenly among all the parties involved, whereas in Riba
operations the business risk lies heavily, if not solely, on the
borrower (I disagree from a Finance major stand point). In its
widest general implication Riba signifies any increase of
capital not justified by a risk taken.
Part II: Two Kinds of Riba
What is Riba?
According to the different books I have studied and the
different Islamic schools, there are two kinds of Riba: Riba al-Nasi'ah,
and Riba al-Fadl.
Riba al-Nasi'ah
The term nasi'ah means to postpone, defer, or wait and refers to
the time that is allowed for the borrower to repay the loan in
return for the addition or the premium. Hence Riba al-Nasi'ah
refers to the interest on the loan. It is in this sense that the
term Riba has been used in the Qur'an in the verse "God has
forbidden interest" (2: 275). This is also the Riba which the
prophet, peace be on him, referred to when he said: "There is no
Riba except in nasi'ah."
The prohibition of Riba al-Nasi'ah essentially implies that the
fixing in advance of a positive return on a loan as a reward for
waiting is not permitted by Islam. It makes no difference
whether the return is a fixed or variable percent of the
principle or an absolute amount to be paid in advance or on
maturity, or a gift or service to be received as a condition for
the loan. However, if the return on principle can be either
positive or negative depending on the final outcome of the
business, which is not known in advance, it is allowed provided
that it is shared in accordance with the principles of justice
laid down in Islam.
Riba al-Fadl
Islam, however, wishes to eliminate not merely the exploitation
that is intrinsic in the institutions of interest, but also that
which is inherent in all forms of dishonest and unjust exchanges
in business transactions. Riba al-Fadl applies to hand-to-hand
purchases and sale of commodities. It covers all spot
transactions involving cash payment in one hand and immediate
delivery of the commodity on the other. To avoid Riba al-Fadl,
people have to exchange commodities equally. For example, gold
for gold and silver for silver.
It appears to be both hard and ambiguous to understand why
anyone would want to exchange a given quantity of gold or silver
or any other commodity against its own counterpart. What is
essentially required is justice and fair play in the spot market
and spot transactions. The price and the counter-value should be
just in all transactions where cash payments are made by one
party and commodities or services are delivered reciprocally by
the other. Anything that is received as extra by one of the two
parties to the transaction is Riba al-Fadl, which can be defined
as all excess over what is justified by the counter-value.
Justice can be rendered only if the two scales of the balance
carry the same value of goods. This point was explained in
hadeeth by the Prophet Mohammed, peace be upon him, in a most
benefiting manner when he referred to six important commodities
and emphasized that if one scale has one of those commodities,
the other scale also must have the same commodity, "like for
like and equal for equal." To ensure justice the Prophet, peace
be upon him, even discouraged barter transactions and asked that
a commodity for sale be exchanged against cash and the cash
proceeds be used to buy the needed commodity. This is because it
is not possible in a barter transaction, except for an expert,
to visualize the fair equivalent of one commodity in terms of
all other goods. Hence, the equivalent may be established only
approximately thus leading to some injustice to one or the other
party. The use of money as a medium of exchange could therefore
help reduce the possibility of an unfair exchange.
Murabahah
Murabahah is the Islamic version of a just or equal profit where
no one is hurt nor damaged during business transactions. It is
one of the alternatives for a just monetary system. Murabahah is
a cost-plus contract in which a client, wishing to purchase
equipment or goods, requests the Islamic bank to purchase the
Items and sell them to him at a cost plus declared profit. By
this technique a party needing finance to purchase ceratain
goods gets the necessary finance on a deferred payment basis.
The finance provider does the purchasing of the required goods
and sells them on the basis of a fixed mark-up profit, agreeing
to defer the receipt of the value of the goods even though the
goods can be delivered immediately. The need for finance of the
one in need is thus met.
This financing technique is sometimes considered to be the same
as interest, however, in theory, the mark-up is not in the
nature of a compensation for the time or deferred payment, even
though the entire cost had to be incurred because the needy
person did nt have at hand to make the purchase he wanted.
Rather, the mark-up is for the service that the finance-owner
provides, namely, seeking out and locating and purchasing the
required goods at the best price.
Part III: Consumption vs. Commercial Loan
There are continuous debates between economists on the issue of
where Riba applies in the case of loans. Still Moslem economists
have managed to solve this situation. In their perspective, Riba
applies to both consumption and commercial loans. The following
section of this article is dedicated to illustrate their
perspective and theories.
The argument that interest was prohibited because during the
prophet's days there were only consumption loans and interest
charged on such loans caused hardship is invalid because it is
factually wrong. During the prophetic period, the Moslem society
had become sufficiently inspired to adopt simple living and shun
conspicuous consumption. There was hence no question of
borrowing for either self-display or for unnecessary consumption
needs. It had also become adequately organized to fulfil the
basic needs of the poor and those in hardship due to some
natural calamity.
However, even if it is assumed that, in spite of simple living
and the socio-political commitment of the Moslem society to
fulfil the basic needs of those hard-pressed, consumption loans
restored to, these must have been limited and for small amounts,
and fulfilled primarily through no interest loans. According to
an eminent Moslem scholar, the late Shaykh Abu Zahrah:
There is absolutely no evidence to support the contention the
Riba that had taken place during before the Prophet, peace be
upon him, was on consumption and not on commercial loans. The
circumstances of Arabs, the position of Makkah and the trade of
the time of the Prophet, all lend support to the assertion that
the loans were for production and not consumption purposes.
Hence, the Qur'anic verse about remitting the principle in the
event of the borrower's hardship does not refer to only
consumption loans. It refers essentially to interest-based
business loans where the borrower had encountered losses and was
unable to repay even the principal, let alone the interest. It
is only in this context that one may be able to understand the
argument of the people during the Prophet's era that trade is
like interest. The Qur'an clearly stated that trade and Riba are
not alike. This is mentioned in the Qur'an (Surah al-Baqarah,
verses 275). "Those who benefit from interest shall be raised
like those who have been driven to madness by the touch of the
Devil; this is because they say: Trade is like interest. While
God has permitted trade and forbidden interest. Hence those who
have received admonition from their Lord and desist, may have
what has already passed, their case being entrusted to God; but
those who revert shall be the inhabitance of the fire and abide
therein for ever." From those words of God, one can see the link
between forbidding interest and allowing trade as a clear and
obvious reference to commercial loans. From the previous it is
healthy to say that commercial loans were mentioned in the holy
book.
Furthermore, trade provides risk where entrepreneurs incur the
risk of either making profit or losing. In contrast to this,
interest offers no risk to the lender. Financiers who do not
wish to take the risk are entitled to only the principal and
nothing more. Apparently, Riba is essentially in conflict with
the clear and unequivocal Islamic, Marxian, and Keynesian
socio-economic justice.
The principle reason for why the Qur'an has delivered such a
harsh verdict against interest is that Islam wishes to establish
an economic system where all forms of exploitation re
eliminated, and in particular, the injustice perpetuated in the
form of the financier being assured of a positive return without
doing any work sharing the in the risk, while the entrepreneur,
in spite of his management and hard work, is not assured of such
a positive return. Islam wishes to establish justice between the
financier and the entrepreneur.
Rationale
The essential feature of Islamic banking is that it is
interest-free. Although it is often claimed that there is more
to Islamic banking, such as contributions towards a more
equitable distribution of income and wealth, and increased
equity participation in the economy, it nevertheless derives its
specific rationale from the fact that there is no place for the
institution of interest in the Islamic order.
Islam prohibits Muslims from taking or giving interest
regardless of the purpose for which such loans are made and
regardless of the rates at which interest is charged. To be
sure, there have been attempts to distinguish between usury and
interest and between loans for consumption and for production.
It has also been argued that Riba refers to usury practiced by
petty money-lenders and not to interest charged by modern banks
and that no Riba is involved when interest is imposed on
commercial loans, but these arguments have not won acceptance.
Apart from a few dissenting opinions, the general consensus
among Muslim scholars clearly is that there is no difference
between Riba interest.
The prohibition of Riba is mentioned in four different
revelations in the Qur'an. The first revelation emphasizes that
interest deprives wealth of God's blessings. The second
revelation condems it, placing interest in juxtaposition with
wrongful appropriation of property belonging to others. The
third revelation enjoins Muslims to stay clear of interest for
the sake of their own welfare. The fourth revelation establishes
a clear distinction between interest and trade, urging Muslims
to take only the principal sum and to forgo even this sum if the
borrower is unable to repay. It is further declared in the
Qur'an that those who disregard the prohibition of interest are
at war with God and His Prophet.
The prohibition of interest is also cited in no uncertain terms
in the Hadeeth. The Prophet condemned not only those who take
interest but also those who give interest and those who record
or witness the transaction, saying that they are all alike in
guilt.
Some scholars have put forward economic reasons to explain why
interest is banned in Islam. It has been argued, for instance,
that interest, being a pre-determined cost of production, tends
to prevent full employment. In the same vein, it has been
contended that international monetary crises are largely due to
the institution of interest, and that trade cycles are in no
small measure attributable to the phenomenon of interest. None
of these studies, however, has really succeeded in establishing
a casual link between interest, on the one hand, and employment
and trade cycles, on the other. Others, anxious to vindicate the
Islamic position on interest, have argued that interest is not
very effective as a monetary policy instrument even in
capitalist economies and have questioned the efficacy of the
rate of interest as a determinant of saving and investment. A
common thread running through all these discussions is the
exploitative character of the institution of interest, although
some have pointed out that profit (which is lawful in islam) can
also be exploitative. One response to this is that one must
distinguish between profit and profiteering, and islam has
prohibited the latter as well.
Some writings have alluded to the "unearned income" aspect of
interest payments as a possible explanation for the islamic
doctrine. The objection that rent on property is considered
halal (lawful) is then answered by rejecting the analogy between
rent on property and interest on loans, since the benefit to the
tenant is certain, while the productivity of the borrowed
capital is uncertain. Besides, property rented out is subject to
physical wear and tear, while money lent out is not. The
question of erosion the value of money and hence the need for
indexation is an interesting one. But the islamic jurists have
ruled out compensation for erosion in the value of money, or,
according to Hadeeth, a fungible good must be returned by its
like: "gold for gold, silver for silver, wheat for wheat, barley
for barley, dates for dates, salt for salt, like for like, equal
for equal, and hand to hand." The Islamic ban on interest does
not mean that capital is cost-less in an Islamic system. Islam
recognizes capital as a factor of production but it does not
allow the factor to make a prior or pre-determined claim on the
productive surplus in the form of interest. This obviously poses
the question as to what will then replace the interest rate
mechanism in an Islamic framework. There have been suggestions
that profit-sharing can be a viable alternative. In Islam, the
owner of capital can legitimately share the profits made by the
entrepreneur. What makes profit-sharing permissible in Islam,
while interest is not, is that in the case of the former it is
only the profit-sharing ratio, not the rate of return itself
that is predetermined.
It has been argued that profit-sharing can help allocate
resources efficiently, as the profit-sharing ratio can be
influenced by market forces so that capital will flow into those
sectors which offer the highest profit-sharing ratio to the
investor, other things being equal. One dissenting view is that
the substitution of profit-sharing for interest as a resource
allocating mechanism is crude and imperfect and that the
institution of interest should therefore be retained as a
necessary evil. However, mainstream Islamic thinking on this
subject clearly points to the need to replace interest with
something else, although there is not clear consensus on what
form the alternative to the interest rate mechanism should take.
The issue is not resolved and the search for an alternative
continues, but it has not detracted from efforts to experiment
with islamic banking without interest.
Part IV: Flaws in the theory of interest & roots of the
crisis
Muslim economists have always searched and are still searching
for flaws in an economy that is driven by interest so that they
could justify their theories of a just monetary system. After
intense reading of different publications regarding flaws in the
theory of interest that are written by Muslim scholars, I did
not find a well-constructed argument supporting the flaws in
interest rates that is worthy of extracting the idea of adding
it to this research.
The general consensus that I found on this issue of a
macroeconomics level is the harm which interest rates have
contributed to thus far. Muslim economists continually refer to
the global economic crisis as a result of interest rates from
the great depression to the crisis in Southeast Asia. Huge
budgetary imbalances, excessive monetary expansion, large
balance of payments deficits, insufficient foreign aid, and
inadequate international cooperation can all be related to flaws
in the theory of interest, which is also the root of the crisis.
Muslim economists see the demand for economic growth as parallel
to inflated interest rates and global economic crisis. It is
healthy to say that most countries, which make the transition to
a market ecomony, had developed some kind of crisis in the early
stages. Inflation often occurs as a result of a fast growing
economy, hence, contracting the monetary policy is a must to
offset inflation. This increase in interest rates would only add
to the unemployment level. The Keynesian school had emphasized
the problem of high interest as a contributor to unemployment,
therefore, stressing the need of reducing interest rates to the
lowest possible. But the question is what is the optimal rate of
interest? Or should interest exist? The answer of both these
questions would be discussed at the end of this article where I
will conclude with my own opinion and insight.
Goals of Islamic Economics
The money and banking system should, like all other aspects of
the Islamic way of life, be made to contribute richly to the
achievement of the major socio-economic goals of Islam. The
system should also continue to perform the usual functions that
relate to its own special field and which other banking systems
perform. From the previous arguments in this project, I came up
with a list of goals and functions in the framework of Islamic
banking which is illustrated in the following:-
Broad-based economic well-being with full employment and optimum
rate of economic growth.
Stability in the value of money to enable the medium of exchange
to be a reliable unit of account and a stable store of value.
A just return is ensured on investment and development projects.
Effective rendering of all services normally expected from the
banking system.
Socio-economic justice and equitable distribution of income and
wealth.
Aspects of an interest free system & its efficiency
A banking system is a must for any economy to flourish or to
stay in shape. The primary function of banks is to allocate
capital to support entrepreneurs or industrialists in seeking
economic prosperity. But, from the Islamic perspective, this
kind of support from banks in the form of lending, has to be
done without charging interest and, hence, being a risk taker
instead of risk averter (Islamic economists point of view). From
that, Islamic economists came to an interest free banking system
which will supposedly replace the current system and will be
more efficient.
An interest free system is a system that relays heavily on
profit sheering. This system is derived from the Arabic term
Mudarabeh. Mudarabeh is the kind of system where both the lender
and the borrower are equally exposed to risk because of the fact
that the lender shares profits or losses with the borrower are
equally (partnership). The profits in this case are the
substitute for the interest. But one might ask, how would banks
have the capital that is necessary to lend, when banks do not
pay interest for savings accounts or capital providers. Banks
will have the funds that are necessary for lending, because
according to Islamic economics there would be a triangle or
three way system where all participants are mutually beneficial
or not beneficial from engaging themselves in projects. Those
are 1) the bank, 2) the supplier of saving or funds, 3) the
actual user of capital or the entrepreneur. Now, it is obvious
that not only banks and entrepreneurs are exposed to risk but
also the supplier of funds. After discussing the previous, one
might come to the conclusion of what is the role of banks. Why
don't we cut the middle man (banks) and maximize profits by
having only a lender, borrower and a regulatory force in the
form of a central bank. The lender would be a venture capitalist
who is interested in profit sharing. But, the major argument in
which Islamic economists see the need for banking services, is
that banks can study applications of borrowers and, hence,
extend credit, offer portfolio investment for lenders, and
undertake foregone-trade services.
Islamic economics alternatives to the current system
Business financing in an Islamic economy would of necessity have
to be equity-oriented where the financier shares the profit or
loss of the business financed. Such financing would not only
distribute equal returns between the financier and the
entrepreneur, but will efficiently allocate risk. Equity
financing in an Islamic ecomony may thus have to be of joint
stock companies or shares in partnerships, or a definite (short,
medium, or long) period as it is in the case of borrowed
capital. Since borrowed capital would also be on the basis of
profit and loss sharing and could not be interest-based, it
would be in the nature of temporary equity financing and would
mature on the expiry of the specified period. Such financing
would hence not carry the same connotation as it does in the
capitalist economies. It would, like equity, not enjoy any lien
on the assets of the firm.
The liability to secure a lien on the assets of the businesses
financed, possible in the case of interest-based lending, would
make the financier more careful in evaluating the prospects of
the business and cautious in providing the necessary financing.
Moreover, it would be difficult to find medium or long-term
financing in an Islamic economy without sharing the ownership
and control of the business. Expansion of the business would
hence be closely related to the distribution of ownership and
control. Similarly it would not be possible for anyone to earn
an income on savings without being willing to share the risks of
business. Thus, we would see a more efficient allocation of risk
in an Islamic economy.
As previously mentioned, an Islamic economy is an economy that
always puts full employment as the first priority. Also, Islam
is a religion which degrades and prohibits unwanted or
unnecessary consumption. for both of these two reasons, one
could say that consumption loans are not a big issue, but if a
family or an individual found him or herself in need, there is
always the Islamic tax on fixed assets (Zakat) to provide for
any consumption or human need. Zakat is a 2.5% tax on fixed
assets. It is paid annually to people in need. Zakat is a
practice in which every Moslem who enjoys excess wealth must pay
to fulfil the Islamic obligations.
The major objection to an interest-free economy is that, in the
absence of interest, it would not be possible for the government
to finance its budgetary deficits by borrowing from the private
sector. Government budgetary deficit, is an important means of
generating growth and improving living standards. How will the
government budgetary deficits be financed after interest has
been abolished?
Unfortunately, Moslem scholars have reached a conclusion, on
government borrowing, which has a mixed signal, or in other
words, not convincing. Moslem economists, feel that the
government should work in a very efficient matter in terms of
their spending. If there was a deficit situation, the government
should resort to a contractual fiscal policy or borrow money
from the central bank. But in terms of government borrowing, I
have a different theory which came from past experience. Islam
is a religion that always encourages Zakat and other types of
spending by the private sector for poor people, institutions,
and infrastructures. So that, in my opinion, may lessen or
reduce the burden on government spending and hence solve for
budgetary deficits. Islam seldom discusses spending as a
government task, rather, Islam stresses that spending for
increasing standard of living is a task that should be performed
by the private sector.
Part V, Conclusion: Challenges facing Islamic Banks
Islamic banks certainly face many challengers today which are
due to the fact that we live in an economy that is driven and
manipulated by interest. The following is an illustration of the
different challenges facing Islamic banking.
In a market economy, the banking sector is supported and
regulated by the central bank. One could see this kind of
support in terms of discount rates on loans given by the central
bank to commercial banks in times of need. Also, the central
bank to commercial banks in times of need. Also, the central
bank regulates commercial banks, which will add to the health of
those commercial banks. Unfortunately, Islamic banks in the
region, do not enjoy such privileges. Because of the fact that
most countries have a central bank which operates in a market
economy, there is no support to Islamic banks. Islamic banks
debunk the theory of interest and hence will not operate or do
transactions with the central banks. This lack of support
situates Islamic banks in an unenviable position. No one would
want to save or invest in a bank that has no means of support or
acts solely. This would hence create the problem of the lack in
liquidity which is vital to a bank's existence.
Another hurdle, is the absence of liquidity instruments, such as
bonds and other marketable securities, which could be utilized
to either cover liquidity shortages or to manage excess
liquidity. This problem is aggravated since many Islamic banks
work under operational procedures different from those of the
central banks; the resulting non-compatibility prevents the
central banks from controlling or giving support to Islamic
banks if a liquidity gap should occur.
The previous were the most important or serious challenges for
an Islamic banking system. I think that these challenges and
many others are a result of trying to build an Islamic banking
system in economies and banks that operate and literally exist
around interest. In my opinion, building Islamic banks in a
market economy is an obvious failure. Islamic banks can survive
only in a Christian, Jewish, or Islamic economy that abolishes
interest.
Final comments & Perspectives
The idea of Islamic banking is certainly very interesting and a
must in the case of the three holly-book religions. An interest
free system could work and provide unlimited prosperity but
certainly, absolutely, and undoubtedly it will not work under
the current system. The whole economic system should be altered
and changed in order for the Islamic framework to succeed.
There are several points in which Islamic scholars could be
criticized. First, is their theory of risk. Islamic scholars and
economists claim that the lender bares absolutely no risk. This
fact could be proven wrong. In finance we constantly deal with
risk calculation for the lender. For example, we use the Capital
Asset Pricing Model (CAPM) to calculate the risk based on the
two factors. 1)The risk free securities i.e. Government
securities and 2)The market risk i.e. Beta. The formula is: K =
K risk free + (K market - K risk free) Beta where K is the
required rate of return. Also, there are risk calculations for
small lenders by calculating the standard deviation of their
investment which pays interest. There are also many kinds of
calculations done by the lender for risk analyses. Although the
previous risk calculations may be convincing in terms of the
lender also claiming risk, the question is, how many times do
lenders do not receive their principal + interest? I think
nominal in this day and age.
Another thing that I am critical of is the new Islamic version
of profit in Islamic banks (Murabahah) where if a person wants
capital from a bank, the bank would buy it and a finance it for
the entrepreneur at a predetermined profit margin. This kind of
transaction is thought of lawful by Moslem economist because God
has banned interest and allowed trade. In my opinion, this type
of transaction only adds to the theory of unequal risk and
inefficient allocation of risk because the lender of capital has
claimed or decided the profit margin in which the entrepreneur
would pay to obtain the necessary capital. I do not think that
God meant this type of trade or transaction to be allowed in
reference to the holly-book. Unfortunately, Islamic banks today
take full advantage of their deliberate misunderstanding of fair
trade and build on such a propaganda by advertising to the
public that their way is the right and religious way, hence,
attracting capital to their banks on the expense of the
uneducated individual. Islamic banks in Kuwait charge profit
margins that are extremely higher than interest rates in
conventional banks and justifying it by their deliberate
misunderstanding of religious guidelines.
There are also unsolved or not understood issues for example,
why does a pre-determined cost of capital prevent full
employment, how would the government borrow money, and how could
we solve for global financial crisis. It is a possibility that
no crisis or hardships would take place in an Islamic system,
but the main point, is that it is impossible to see the Islamic
system work as a sub-system to the current market economy, and
we can not provide Islamic economic solutions under capitalism.
Written By Tariq Talib Al-Anjari
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