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.
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.
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 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.
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:
1. Broad-based economic well-being with full employment and optimum rate of economic growth.
2. 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.
3. A just return is ensured on investment and development projects.
4. Effective rendering of all services normally expected from the banking system.
5. 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.
By : Tariq Talib Al-AnJari