By Mufti Asad Gul, Ph.D. Scholar Islamic Finance and Shariah Auditor, Bank of Khyber –Socioeconomic justice is one of the cherished goals of all societies. There is, however, a difference of opinion on the strategy that should be used to realise this goal. Despite this difference, one common element in the strategy of four of the world’s major religions (Hinduism, Judaism, Christianity, and Islam) is the prohibition of interest or riba. 

Since the followers of the three major religions have generally moved away from this prohibition, some Muslims wish to do the same by arguing that Islam has prohibited riba and not interest. In their opinion, bank interest is not riba. This raises the question of whether interest is really prohibited in Islam. This article tries to answer this question in light of the Qur’an, hadith, and fiqh.

The consensus among Muslims throughout history has been and continues to be that riba, among other things, includes interest. This consensus is clearly reflected in the unanimous verdict of several international conferences of fuqaha (jurists) which have been held to discuss the question of riba, including the Mu’tamar al-Fiqh al-Islami held in Paris in 1951 and Cairo in 1965 and the OIC and Rabitah Fiqh Committee meetings held in 1985 and 1986 in Cairo and Makkah respectively. 

The Pakistan Council of Islamic Ideology reflected this consensus when it concluded in its 1980 report on the elimination of interest from the Pakistan economy that: “The term riba encompasses an interest in all its manifestations irrespective of whether it relates to loans for consumption purposes or productive purposes, whether the loans are personal or of a commercial type, whether the borrower is a government, a private individual or a concern, and whether the rate of interest is low or high.” 

Four of the world’s major religions (Judaism, Christianity, Hinduism, and Islam), having a following of more than two-thirds of the world’s population, have prohibited interest. In sharp contrast with this prohibition, the entire international financial system is now based on interest and has been so for more than two hundred years.

However, protests have been, and continue to be, made against interest. These protests have been particularly prominent in the Muslim world, where an effort is underway to replace the interest-based system of financial intermediation with the profit and loss-sharing (PLS) system.

The introduction of a new model of financial intermediation based on PLS is a challenging task. The difficulties involved in the changeover justifiably raise the question of why anyone should try to replace the conventional system, which has been in existence for a long time and has become highly sophisticated by now.

Implications of the two types of riba

Riba al-nasi’ah and riba al-fadl are essentially counterparts of the verse “God has allowed trade and prohibited riba.” While riba al-nasi’ah relates to the prohibition of loans in the second part of the verse, riba al-fadl refers to trade and is implied in the first part. Because trade is allowed in principle, it does not mean that everything is permitted in trade.

Since the injustice inflicted through riba may also be perpetuated through transactions in commodities and currencies, riba al-fadl refers to all such injustices or exploitations. It requires the absence of rigging, uncertainty and speculation. It demands a fair knowledge of the prevailing prices and the quality of goods being purchased or sold on the part of both the buyer and the seller. It necessitates the elimination of cheating in prices or quality, and in measures or weights. 

All business practices which lead to the exploitation of the buyer or the seller must be effectively eliminated. While riba al-nasi’ah can be defined in a few words, riba al-fadl, interspersing a vast array of business transactions and practices, is not so easy to specify. This is what may have prompted ‘Umar, the Second Caliph, to say: “The Prophet, peace and blessings of God be on him, was taken without elaborating it to us” The attempt to justify riba al-nasi’ah or the interest on loans on the basis of this saying of Umar is absolutely fallacious because the reaction of Umar, by way of caution, was to give up riba.

Forms of injustice and exploitation in trade and currency exchange have changed over the centuries. No one could foresee and specify them all 1400 years ago. The Qur’an and the Sunnah are there to provide the principles based on which the Ummah can do so. This is the ongoing challenge to all Muslims – continually examining their economic practices in the light of Islamic teachings and eliminating all shades of injustice. 

This is a more difficult task than eliminating riba al-nasi’ah. It requires a total commitment and an overall restructuring of the entire economy within the Islamic framework to ensure justice. This was, and is, the unique contribution of Islam. While riba al-nasi’ah was well-known in the Jahiliyyah, the concept of riba al-fadl was introduced by Islam and reflects the stamp of its own unflinching emphasis on socioeconomic justice.

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Financial crises

The efficiency argument in favour of the conventional interest-based system of financial intermediation has been substantially weakened by the crises it has experienced over the last few decades.

[By some reckonings, there have been 100 crises in the past 35 years. The more important of these crises are the US stock market crash in October 1987, the bursting of the Japanese stock and property market bubble in the early-1990s, the breakdown of the European Exchange Rate Mechanism (ERM) in 1992-93, the bond market crash in 1994, the Mexican crisis in 1995, the East Asian crisis in 1997, the Russian crisis in August 1998, the breakdown of the US hedge funds in 1998, the Brazilian exchange rate crisis in 1999, and the steep decline in US stock prices in 2002.] 

No single geographical area or major country has been spared the effect of these crises. Hence there is an uneasy feeling that “something is wrong with the global financial system.” This has led to a call for comprehensive reform of the financial system to help prevent the outbreak and spread of financial crises or, at least, minimize their frequency and severity. The needed reform has come to be labeled ‘the new architecture.’

The roots of financial crises

A number of economists have made an effort to determine the causes of the crises. Some consider financial liberalisation to be the cause in an environment where many countries’ financial systems are not sound due to improper regulation and supervision.

Others feel that the ultimate cause is the bursting of the speculative bubble in asset prices driven initially by the excesses of financial intermediaries. It has also been argued that the root cause of the crises was the maturity mismatch: short-term international liabilities were far greater than short-term assets. 

Even though all these factors had some role to play in the crises, no consensus seems to have developed so far in pinpointing the ultimate cause or the cause of all causes. In the absence of a proper understanding of the ultimate cause, conflicting remedies have been proposed. This makes it difficult to lay down an effective reform program.

Hence the proposals for the new architecture have been unable to step beyond the basic principles of conventional wisdom, which emphasize sound macroeconomic policies, sustainable exchange rates, proper regulation and supervision, and greater transparency. 

Why can market discipline not prevent macroeconomic imbalances in the public sector and living beyond means in the private sector? What makes it possible to have excessive leverage, which is one of the significant factors that lead speculative bubbles to the point of bursting? Is it because there is inadequate market discipline?

Also, an equally important question is why some well-regulated financial systems, like the United States and the United Kingdom, have also faced crises and whether greater regulation, supervision, and transparency will help avoid such crises.

What is the solution?

Strict compliance with regulations and supervision would be more effective if they are complemented by a paradigm shift in favour of greater discipline in the financial system by making investment depositors and banks share in the risks of the business. Just the bailing-in of banks may need to be able to take us farther.

It is necessary not only to make the shareholders suffer when a bank fails but also to strongly motivate the depositors to be cautious in choosing their bank and the bank management to be more careful in making their loans and investments.

Bank managers are better placed to evaluate the quality of their assets than regulators and depositors, and risk-sharing would motivate them to make the decisions that they feel are in the best interest of banks and depositors.

Therefore, it is necessary to reinforce the regulation and supervision of banks by injecting self-discipline into the financial system. Banks, shareholders, and investment depositors (those who wish to get a return on their deposits) can share in banking risks by increasing the reliance on equity and reducing debt, as the major religions desire.

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It is also necessary to confine credit availability to financing tangible goods and services with some risk-sharing by the lender. Making the depositors, as well as banks, participate in the risk of business would motivate the depositors to take more excellent care in choosing their banks and the bank management to assess the risks more carefully and to monitor the use of funds by the borrowers more effectively.

The double assessment of investment proposals by both the borrower and the lender would help raise market discipline and introduce greater health into the financial system.

The IMF also supports equity financing by arguing that Foreign direct investment is often regarded as providing a safer and more stable way to finance development.This is because it refers to ownership and control of plant, equipment, and infrastructure and therefore funds the growth-creating capacity of an economy. In contrast to debt-creating inflows an, short-term foreign borrowing that is more likely to be used to finance consumption.

Investment depositors are generally risk averters and would not like to expose their capital to risk, unlike equity investors. Forcing them to take risks may create insecurity and difficulty for them and their families. Alternatively, it should be possible for banks to invest the funds provided by risk-averting investment depositors in less risky assets.

The banks may also be required to build adequate loss-offsetting reserves so that the depositors do not suffer losses. Such an approach should have the added advantage of making the banks more effective in managing their risks, thereby making the banking system safer and healthier.

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Socio-economic justice

The stability of a financial system is indispensable for promoting trade and development. Since an interest-free risk-reward sharing system has a clear advantage, it may be considered superior to the interest-based system on the efficiency criterion.

This is, however, only one of the advantages of the interest-free financial system. It was not discussed in earlier Islamic literature because excessive volatility in the financial markets is a more recent phenomenon. It is now essential to see whether the assumption about the superiority of the interest-free system concerning the contribution that it can make to the realization of the universally cherished goal of socioeconomic justice is realistic.

Supporters of an interest-based financial system argue that interest was prohibited to prevent the exploitation of the poor resulting from the usurious rates of interest prevailing in those days.

In addition, they argue that interest rates are now much lower. The modern welfare state has also introduced several measures that fulfill the needs of the poor and prevent them from resorting to exploitative borrowing.

Even though this is true to a certain extent, living beyond means that the interest-based system tends to indirectly exploit the poor in different ways, both in the public and private sectors. Two of these are their inadequate need fulfillment and insufficient employment opportunities for them.

The Islamic Financial System

These weaknesses of the interest-based financial system create a strong rationale for introducing a new architecture for the international monetary system. 

This brings us to Islamic banking, which tries to remove interest and introduce in its place the principle of risk-reward sharing. Since demand deposits do not participate in the risks of financing by financial institutions, they do not earn any return and must, therefore, be guaranteed. 

However, investment deposits participate in the risks and must share the profits or losses in agreed proportions. What this will do is turn investment depositors into temporary shareholders. Placing investment deposits in financial institutions will be like purchasing their shares, and withdrawing them will be like redeeming these shares. 

The same would be true when these institutions lend to and get repaid by businesses. They will be sharing the risks of companies they finance, raise the share of equity in total financing substantially, and reduce debt. Equity will take the form of either stake in joint stock companies and other businesses or PLS in projects and ventures through the mudarabah and musharakah modes of financing.

Debt financing in the Islamic financial system

Greater reliance on equity does not necessarily mean that debt financing is ruled out. This is because all financial needs of individuals, firms, or governments cannot be amenable to PLS. Debt is, therefore, indispensable. 

Debt, however, gets created in the Islamic financial system through the sale or lease of real goods and services via the sales-based modes of financing (murahabah, ijarah, salam and istisna). In this case, the rate of return gets stipulated in advance and becomes a part of the deferred-payment price. 

Since the rate of return is fixed in advance and the debt is associated with real goods or services, it is less risky than equity or PLS financing. The predetermined rate of return on sales-based modes of financing may, however, make them appear like interest-based instruments. 

They are, however, not so because of significant differences between the two for many reasons. Two are: Firstly, the sales-based modes do not involve direct lending and borrowing. They are purchase and sale or lease transactions involving real goods and services. The Shari’ah has imposed many conditions for the validity of these transactions. 

One of these conditions is that the seller (financier) must also share a part of the risk to get a share in the return. This can’t be avoided because the second condition requires that the seller (financier) own and possess the goods being sold. 

The Shari’ah does not allow a person to sell what he does not own and possess. Once the seller (financier) acquires ownership and possession of the goods for sale on credit, they bear the risk. All speculative short sales, therefore, get ruled out automatically. 

Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion, which is one of the significant causes of instability in the international financial markets. 

Secondly, it is the price of the good or service sold and not the rate of interest, which is stipulated in the case of sales-based modes of finance. Once the price has been set, it cannot be altered, even if there is a delay in payment due to unforeseen circumstances. 

This helps protect the interest of the buyer in strained circumstances. However, it may also lead to a liquidity problem for the bank if the buyer willfully delays payment. This is a major unresolved problem in Islamic finance, and discussions are in progress among the jurists to find a solution that is Shari’ah compliant.