Principles of Islamic banking and finance/PIBF202/Key differences/Banking without-''interest''

As you may have already observed the foundational stone of mainstream banking is interest. Without interest commercial banks cannot function. In the western economic tradition, charging of interest on loans did not remain an ethical and moral issue after the 15th century. A distinction was made between usury and interest, the former regarded as excessive interest. Many European countries and different states in the US made usury laws that prohibit charging of excessive interest but there is no issue with charging or receiving interest. The same is not, however, the case with Muslim societies. The reason is very simple; in the words of Qur'an charging of riba is great sin and equal to fighting ALLAH and his messenger. The issue which is raised by some scholars is whether today's bank interest can be termed as riba condemned by the Qur'an. The other question that also comes under discussions is how to establish a practical and viable alternatives of financial intermediation (preferably based on profit and loss sharing) that does not involve interest. Finally, the problem of inflation that was not a matter of concern at the time of the Prophet but a thorny feature of an economy with fiat money.

Riba and bank interest
While there are important voices, including religious scholars, who insist on distinguishing bank interest from riba, the vast majority of Islamic scholars is against such distinction. For example, Sheikh Dr. Tantawi and Sheikh Wasil (previous [Muftis] of Egypt) claim that conventional bank interest is a share in the profits of growth inducing investment, and not the prohibited riba (El-Gamal, 2000). Indeed, their assertion will be justified if it could be proven that interest is paid to the depositors of banks as a share in the profits of banks, who in turn earn their profits through investing their own funds and those of their depositors in business and productive activities on profit and loss sharing basis. Alternatively, one has to assume that all of their loans and investments always yield positive income, and that loans are not given for consumption purposes. Both of these are not possible. The outcomes of a business venture is uncertain while interest on consumption loan is difficult to justify unless the concept of time preference and hence positive time value of money is accepted.

Muslim scholars who treat riba as usury (meaning excessive interest) and are against treating bank interest as riba, often use the following verse of the Qur'an to support their argument:

O ye who believe! Devour not usury, doubling and quadrupling (the sum lent). Observe your duty to Allah, that ye may be successful.(3: 130) Translation by Marmaduke Pickthall.

However, the counter arguments are provided by quoting other verses in the Qur'an. For example, Siddiqui (2010) quotes the following verse :

Because of the wrongdoing of the Jews We forbade them good things which were (before) made lawful unto them, and because of their much hindering from Allah’s way: And of their taking usury when they were for bidden it, and of their devouring people’s wealth with false pretences. We have prepared for those of them who disbelieve a painful doom. (4: 160-61) Translation by Marmaduke Pickthall.

Siddiqui argues that it would be difficult to claim that throughout their history and up to the time when the Qur’an was being revealed, Jews were only involved doubling and quadrupling usurious dealings. In this regard he mentions University of Chicago Professor of Islamic religion, the late Fazlur Rahman who was an early opponent of treating bank interest as riba. He wrote during 1950s after demand for establishing banking system without interest were first made in several important Muslim countries as the colonial period that brought modern banking to these countries came to an end. But the logical mind of Fazlur Rahman conceded that in order to avoid riba from a system, the distinction between high and low rates of riba had to be removed:

“A natural question arises here, viz., if riba is only that part of usurious transaction that has been described above (doubling, quadrupling) and if only this form is banned then, then why is that, as an effect of the riba–ordinance of the Qur’an, all interest seems to have been abolished as is, indeed, testified by historical evidence? The answer to this is that we do not hold that in each and every given case of loan, the capital was thus doubled and redoubled --- indeed, there must have been a great deal of variation in individual cases depending on circumstances, e.g. the nature of investment, the amount of risk, etc. But what matters is that all these individual cases were part of a one riba-system in whose nature it was to be so exorbitantly usurious. Therefore, what had to be banned was the system as a whole, and hence no exception could be made in individual cases. When the entire system was banned, the milder cases within that system were also naturally abolished since the system itself was tyrannical.” (Rahman; 1969)– words in parenthesis added).

According to Hanif (2011; 168) "Islamic Fiqh Academy (IFA) Jeddah of Organization of Islamic Conference (OIC)representing the collective wisdom of Sharia experts is of the view that any increase stipulated in a contract of loan irrespective whether consumption loan or productive loan is Riba and prohibited by Allah (SWT). "The equivalence of riba to interest has always been unanimously recognized in Muslim history by all schools of thought. In conformity with this consensus the Islamic Fiqh Academy of the Organization of the Islamic Conference (OIC) has recently issued a verdict in its Resolution No. 10(10/2) upholding the historical consensus on the prohibition of interest”.

Banking with profit and loss sharing(PLS)
For the early proponents of Islamic banking that included religious scholars as well as people with background in economics and finance, its meaning and manifestation was never in doubt. They believed that Islamic banking could be established through profit and loss sharing modes of Islamic finance such as musharakah and mudarabah. Foremost among religious scholars, Syed Abul Ala Maudoodi who wrote an extremely persuasive book ‘Sud’ (interest) in Urdu language in 1961. Uzair, an economist and financial expert, wrote a short (21 pages) booklet on the practically of Islamic banking in 1955 which is often regarded as the first important technical and professional work in the field.

In most cases the criticism of interest based banking system made by these early writers, was based on the fact that it allowed the providers of funds claiming a fixed positive return irrespective of the situation of the lenders. The issue of inflation was perhaps not so severe at the time. Therefore, they generally ignored the injustice due to the prevalence of low levels of returns to bank depositors that at times could even go to the negative territories in real terms.

Uzair (1980) made some persuasive arguments to merge capital and entrepreneurship into one factor of production for an Islamic economic system without the institution of interest; both having a share in the profits as well as in the losses. He then discussed the issue of profit sharing ratios at the two tiers of mudarabah financing that would prevail in a PLS Islamic banking system; one between the depositors and the bank, and the other between the bank and the ultimate or actual user of the fund or the entrepreneurs. There may be, for example, an arrangement that the entrepreneur and the bank would share the profit in a ratio of 50 per cent each, or 60 per cent for the entrepreneur and 40 per cent for the bank, or any such ratio which may be agreed upon between themselves or regulated by the government or the central bank.

Similarly, there will be an arrangement between the bank and the supplier of capital (depositors) for sharing the profit in the ratio of 50 per cent each or 60 per cent for the bank and 40 per cent for the supplier of capital funds or the depositors. Uzair claimed that it might seem at first sight to be a complex arrangement. However, once the system was introduced and begins to operate in practical life, it will become as mechanical and routine as the present-day system wherein banks charge a higher rate of interest on certain categories of deposit while paying nothing to some types of depositors, e.g. the current account depositors.12

According to Uzair, whether percentage or the ratio for sharing the profit between the entrepreneurs (borrowers) and the banks on the one hand, and that between the banks and the depositors on the other, should be determined in the normal course of business activities and bargaining or should be regulated by the government or central bank as a policy variable or a political decision by the government either arrangement would serve the purpose as far as the conceptual framework is concerned. The decision will have to be taken in the light of the actual circumstances prevailing and the inclination of the people who make the decision. The central bank of the country could be empowered to introduce slight modifications in the details of the terms and conditions from time to time, depending upon the overall economic situation and the expansionary or contractionary policy pursued by the central bank in the interest of the overall national economic well-being.

More on ratio of profit sharing
Siddiqui (1998)also explains the issue of sharing ratio between mudaraib and Rab-Ul-Mal in a mudarabah.

According to him, in general, only if the investment is very small, the share of Mudarib should be high compared to that of the Rab-Ul-Mal. For example, suppose A is a Rab-Ul-Mal who wants to invest  $10, 000 with B, a Mudarib. If the expected total monthly profit is $1000, B may not be willing to work as a Mudarib, if his share of profit, for instance, is less than fifty percent. This would be particularly the case if (a) it is a full time job and the only source of his income, and  (b) B has an option to work for someone else where he may earn a salary of somewhat less than $500 a month. For a risk averse person, the equivalent of an expected income of $500 per month is somewhat less than a certain income of $500 per month. The exact amount would depend on the degree of risk aversion and the probability distribution.

The share of Mudarib should be a decreasing function of the total investment made by the Rab-Ul-Mal. Theoretically, Mudarib is a person who does not have financial capital but has talent to run a business which the financier lacks or does not have time to carry on the same on his own. Mudarib has an option to work for someone on a fixed salary or to run the business for the Rab-Ul-Mal on a profit sharing basis in which case his return would be zero if there is a loss. The opportunity cost of taking up the second option is the income forgone by not taking a salaried job. The risk involved in the second option requires that the expected earning for the Mudarib must be sufficiently higher than his opportunity cost to compensate for the risk involved. This expected earning would be higher, higher the level of investment and higher the expected rate of profit.

For example, suppose a Mudarib has an offer of a fixed salaried job where he can earn a million dollars in a year. He gets an offer of 10 % share in the profit for running a business worth a 100 million dollar which has an expected rate of profit of 12%. His expected earning is equal to 2.4 million which is more than double his fixed salary and perhaps enough to compensate for the risk undertaken if he is a risk averse person. For a risk neutral person the expected rate of earning is equal to a certain earning of the same amount. In that case a 10% profit sharing arrangement would be more than enough to induce the Mudarib to take up the challenge. As the amount of investment increases, all other things being unchanged, market mechanism would tend to lower the share for Mudarib. Before making a decision, a potential Mudarib would always look at the two amount, his earning in a fixed salaried job and his expected earning in Mudarabah arrangement. He will only choose to become a Mudarib if he is expected to make relatively higher income in a Mudarabah arrangement.

Finally, it can be argued that the share of profit assigned to a Mudarib would, at least to some extent, also depend on his reputation as an honest and competent person in the relevant field of business.

The example above makes it clear that in a Mudarabah arrangement, a Mudarib is not necessarily exploited even if his share of profit appears to be lower than that of Rab-Ul-Mal. Moreover, one should not think of Rab-Ul-Mal as one rich person. A typical commercial or investment bank generates funds, among others, through many small depositors. All these depositors, along with the equity holders of the bank, are Rab-Ul-Mals. Unless a good share of the business goes to the party called Rab-Ul-Mal in a Mudarabah arrangement through a financial intermediary, these small depositors would fail to get a reasonable rate of return. One should not forget that in case of a loss these small depositors too have to share the loss. Moreover, even though they are classified as small depositors, in many cases, as a whole they provide bulk of the funds to financial intermediaries as their number far exceeds those who hold big deposits.

Prohibition of interest and inflation
One of the argument that goes in favor of interest is that it covers loss of purchasing power of a loaned amount. This issue does not get enough attention from Islamic scholars, religious and academicians alike. From the time when the Qur'an was revealed until the middle of the twentieth century inflation was generally not an issue because all the exchange of goods and services were either made in kind or currency with intrinsic values or fiat money backed by gold.

Islamic religious scholars have so far ignored the issue of inflation and insist that any increase in the nominal value of loaned amount should be prohibited. Some Islamic economists may agree that extra payment on loan that covers loss of money value is just and an interest rate that covers just the inflation should be allowed. However, following the monetarist view on inflation, it is argued that the government of an Islamic economy must control inflation by controlling the money supply.

After the intense debate over inflation and unemployment between the Keynesians and Monetarists, there is now a consensus in advanced capitalist countries that inflation must be maintained at a very low levels through monetary policy tools controlling interest rates and money supply. The point made by the Post Keynesians that if a civilized nation is compelled to choose between unemployment and inflation, it has to choose the lesser evil - inflation, is no more acceptable. Unemployment must be fought with fiscal and monetary policies but not at the cost of inflation. The period of stagflation in 1970s was perhaps decisive in making that policy conclusion.

According to Siddiqui (1994), controlling inflation is one of the basic paradigms of Islamic economics that must be achieved through control over supply of money in an economy without interest. Inflation creates confusion among economic agents and redistributes income in an undesirable way. In the later sense, it is an unannounced indirect tax on lenders (especially in the presence of zero interest) and fixed wage earners. It is immoral on the part of the government to impose an unannounced tax and thus must be avoided in an Islamic economy.