A must read for students of MBA Finance?
People have needs -- food, clothes, houses, machinery, services; the list is endless. Entrepreneurs perceive these needs and develop ways and means of catering them. They advertise their products and services, peoples expectations are raised and people become customers of the entrepreneur. If the customers’ needs are fulfilled according to their expectations they continue to patronise the entrepreneur and his enterprise flourishes. Otherwise his enterprise fails and people take to other entrepreneurs.
Banks too are enterprises; they cater to peoples’ needs connected with money -- safe-keeping, acquiring capital, transferring funds etc. The fact that they existed for centuries and continue to exist and prosper is proof that their methods are good and they fulfill the customers’ needs and expectations. Conventional commercial banking system as it operates today is accepted in all countries except the Islamic world where it is received with some reservation. The reservation is on account of the fact that the banking operations involve dealing in interest which is prohibited in Islam. Conventional banks have ignored this concern on the part of their Muslim clientele. Muslims patronised the conventional banks out of necessity and, when another entrepreneur -- the Islamic banker -- offered to address their concern many Muslims turned to him. The question is: has the new entrepreneur successfully met their concerns, needs and expectations? If not he may have to put up his shutters!
Broadly speaking, banks have three types of different customers: depositors, borrowers and seekers of bank’s other services such as money transfer. Since services do not generally involve dealing in interest Muslims have no problem transacting such businesses with conventional banks; neither do Islamic banks experience any problems in providing these services. Among the depositors there are current account holders who too, similarly, have no problems. It is the savings account holders and the borrowers who have reservations in dealing with the conventional banks. In the following paragraphs we will see how well the Islamic banks have succeeded in addressing their customers’ special concern.
Islamic banking, characterised by interest-free loans and deposits, has become an increasingly popular area of innovation in international financial markets. This dissertation provides a brief background to the reasons for prohibition of a predetermined rate of interest and introduces the reader to the Islamic alternative to the interest mechanism--the profit and loss sharing system. In conventional banking, the bank charges the borrowers interest on their loans and pays the depositors interest on their deposits. Both are called interest, though the former is always larger than the latter. Interest is also called usury. The Arabic word riba is often translated as both usury and interest. This begs an interesting question: are they all the same? If they are different, what does each mean? Muslims claim that charging interest on loans is prohibited. If so, how does a bank meet its operational costs? These questions bother many Muslims and non Muslims.
History of Usury and Interest
Until a few hundred years ago any extra amount demanded by the lender in addition to his capital was called usury. Early European philosophers such as Plato (427-347 BC) and Aristotle (384-322 BC) condemned the practice of taking usury. Aristotle compared money to a barren hen which laid no eggs — a piece of money cannot beget another piece of money, he held. The Roman Empire, in its early stages, prohibited charging of usury. The Christian Church prohibited all usurious transactions. The famous incident in Jerusalem where Jesus Christ chased away the moneylenders from the Temple was kept alive in Church preaching. Though usury was practiced all over the Christendom and elsewhere the Church was consistent and vehement in its condemnation of usury. (Llewellyn, David T. 1992)
However, by the end of the thirteenth century several factors appeared which considerably undermined the influence of the Orthodox Church. Eventually, the reformist group, led by Luther (1483-1546) and Zwingli (1484-1531), agreed to the charging of interest on the plea of human weakness. (Schlesinger G, 1994) According to Encyclopedia Britannica, “In Old English law, the taking of any compensation whatsoever was termed usury. With the expansion of trade in the 13th century, however, the demand for credit increased, necessitating a modification in the definition of the term. Usury then was applied to exorbitant or unconscionable interest rates. In 1545 England fixed a legal maximum interest; any amount in excess of the maximum was usury. The practice of setting a legal maximum on interest rates was later followed by most states of the United States and most other Western nations.”
Thus, beginning in the mid-sixteenth century, the prohibition on usury (in the old sense) was legally removed in all Western countries. The environment, in which it took place, as evidenced by the above quote, is noteworthy — expansion of trade and demand for credit. Borrowers were mainly the rich merchants, and they used the short-term credit for buying and selling goods. And the moneylenders were lending their own money and/or that of their wealthy clients. The borrowers knew how much they could make using a given amount of credit, and they paid the lenders a portion of this profit. This supplied the justification for demanding the extra amount. (Llewellyn, David T. 1992)
But this justification for “limited interest” under a particular circumstance was, in the course of time, stretched out and applied in general. Support was forthcoming on other grounds too.(Varian H 1992) For example, Sir Francis Bacon (1561-1626) advocated, “Since of necessity men must give and take money on loan and since they are so hard of heart that they will not lend it, otherwise there is nothing for it, but that interest should be permitted.”
Now that the new “moderate” form of usury — interest — was legal and “moral”, economic theories were developed with this limit and justification as the base. Theories found their way into textbooks, more theories were developed, and interest became an integral part of economic theory. In practice, the theory was applied universally whether the original conditions that justified the extra payment existed or not. Practice reinforced theory and, once incorporated into the foundations of economics, it is now difficult to think of any economic theory or activity without interest being an integral part of it. (Llewellyn, David T. 1992)
In 1545, the “legal maximum interest” rate in England was fixed at ten percent per annum, but it did not remain fixed for long. It varied from time to time and from place to place, depending on the economic and political circumstances. (Llewellyn, David T. 1992) Eventually, the concept of “maximum interest” ceased to exist, and usury as a word even went into disuse. Today, practically everywhere, charging and paying interest is legal, no matter how much, and it is acceptable both in theory and practice.
The Islamic position on Interest
Islam - the most modern revealed religion is still upholding the righteous prohibition of Riba (interest) although not in practice in any of the Islamic country at governmental level but there is immense enthusiasm for interest-Free financial system in Muslims. The western economists have discussed the issue at large in the twentieth century and many of them are also of the view that the religious prohibition should be brought back into the conscious of the people.
The Holy Book of Islam, the Qur’an, prohibits the demanding and receiving of interest in the following terms:
O ye who believe! Devour not usury, doubling and quadrupling (the sum lent). Observe your duty to Allah that you may be successful. (Qur’an, 3:130)
O ye who believe! Observe your duty to Allah, and give up what remaineth (due to you) from usury, if ye are (in truth) believers.
And, if you do not, then be warned of war (against you) from Allah and His Messenger. And, if ye repent, then ye have your principal (without interest). Wrong not, and you shall not be wronged. (Qur’an, 2:278-279)
The Holy Prophet (pbuh) has prohibited accepting of riba, paying of riba, and recording and witnessing it in the following terms:
Jabir (ra) said that Allah’s Messenger (pbuh) cursed the acceptor of interest, its payer, and the one who records it; and the two witnesses; and he said: They are all equal. (Sahih Muslim, Hadith no.3881)
The prohibition of riba is clear from the above statements in the original sources. However, the Qur’an did not define it — the same way it had not defined gambling, theft or adultery. What was meant was assumed understood. And the Prophet (pbuh) did not explain every possible aspect of riba. Later on, Ulama (religious scholars) have attempted to define the word riba based on the practices obtaining at the time of the Prophet (pbuh). But unanimity of opinion had not been reached on all aspects. Furthermore, since the reasons for the prohibition have not been given in either of the two original sources, it is impossible to give a new all encompassing definition of riba under any present or future conditions. (Usmani Taqi, 1999)
The difficulty arises mainly because of the existence of two kinds of riba. One is called riba al-Nasiah and the other riba al-Fadl. The former relates to money-loans and credit transactions using money, and was well known and widely practised by the Arabs since long before the advent of Islam hence it is also called riba al-Jahiliyya. Riba al-Jahiliyya is very similar to the present day interest on loans and credit sales. (Usmani Taqi, 1999) The core concept is a loan at a pre-agreed rate of interest. The variations include a grace period during which there is no interest (similar to today’s credit cards), regular interest payments till the loan is fully paid (simple interest), and interest on interest and/or punitive additions beyond the pre-agreed period. That this practice was prohibited by the Qur’anic injunctions there is no disagreement. (Abdul Ghafoor, 1995)
Riba al-Fadl relates to commodity transactions and has been mentioned only in the prophetic traditions. Here riba may enter when barter-exchanging two different commodities or due to differences in quality and/or quantity in the exchange of the same species. (Usmani Taqi, 1999)
In banking and finance, main concern is with money and money-loans. Therefore what is relevant to discuss riba al-Nasiah, and there have never been any doubts or differences of opinion as to what it meant. The Qur’an has prohibited the taking of this kind of riba in the strongest possible terms. Its authorised interpreter — the Prophet (pbuh) — has said that accepting, paying, recording and witnessing it are all equally prohibited. (Usmani Taqi, 1999) On the other hand, the Qur’an also says, “… then ye have your principal (without interest),” thus entitling the lender to the full return of his capital. Therefore, in order to comply with the prohibition fully and without a shade of doubt, and in order not to infringe on the right of the lender, a simple but comprehensive definition is popularly adopted: that in money matters; any addition to the principal sum is riba. This also accords with the definition of usury in other faiths. (Khalil et al, 2000)
Islamic Banking System
Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. (Ahmad A .1997)
The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion. (Ahmad A .1997)
With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. Local banks were established on the same lines as the interest-based foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. (Khalil et al, 2000) As countries became independent the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it. This state of affairs drew the attention and concern of Muslim intellectuals. The story of interest-free or Islamic banking begins here.