Usury: The Principle Behind Islamic Banking
Islamic banking refers to banking by the principles of Sharia, the holy law set out in the Qur’an. The Qur’an forbids the charging of interest in exchange for a loan or “riba”. In some cases, this was also the practice of the Catholic Church in post-Roman through medieval times. Modern banking systems are built around interest. The time value of money is a central concept of finance which states that a certain amount of money is worth more now than at some point in the future. When money is invested, the invested money is used to earn more money. Any money that is not invested can be loaned, but makes no profit unless interest is received. Islamic banking commands the strict adherence to religious restrictions on usury or interest and sharing in the risk of business.
In some circles, usury refers to making money by handling money by charging fees for loans in the form of interest or charging to change money. In Europe, Biblical restrictions on usury were understood as condemning the practice of taking advantage of people in need. The principle of charging no interest to your own countrymen was ignored later by the Jews. This was aptly illustrated by Jesus as he threw the moneychangers out of the temple. As a result, the term “usury” over time was applied to loans with abusively high interest rates. Banking systems built around interest were accepted and became important to restoring the economies of post-Renaissance Europe. John Calvin, an important early figure in Protestant Christianity, wrote a defense of charging interest. The Roman Catholic and Eastern Orthodox churches began to recognize usury only when high interest rates were charged.
The Qur’an contains references to usury just like the Bible. One reference is Al-‘Imran 3:1302, which makes specific reference to compound interest. Qur’anic statements condemning usury are explicit, but they are not offered with the same rationale found in Jewish teaching. The Qur’an doesn’t offer reasons for the ban on usury. This may explain why Islam has been resistant to loose guidelines on money lending that apply only to predatory lending. Restrictions on lending at interest have been essentially forgotten in Judaism and Christianity. Islamic restrictions are alive and well today in the Islamic world.
Economically, interest is the return on capital loaned. Capital refers to money and physical goods that can be bought with money invested in a business to achieve profits in the future. Interest can refer to the return on a normal investment. This kind of interest isn’t usually considered as usury because there is a risk associated with investment. Lending money is associated with liquidity risk, the risk that you might not have enough money should the need arise. Other risks exist, such as the simple risk that the person being lent the money might not repay. It can be argued that because of the risks associated with lending money, any bank that decided to offer loans without charging interest would quickly go out of business. The world of banking makes certain that this will never happen with the power of the fractional reserve, compound interest and manipulation of the money market.
How do modern economies in the more developed parts of the Islamic world do business? The answer is complicated. Many different mechanisms are used to replace familiar banking concepts. The money considered as interest in a typical bank transaction is instead designed into the contract agreement in another way. Some Muslims consider Islamic banks to be engaging in legal trickery to hide the fact that they charge and pay interest. Most economic analysts would probably agree. Compensation is being made for the time value of money and that is the definition of interest. Nevertheless, banks exist that operate under the principles of Sharia do not consider themselves to be collecting “riba” or interest.
An example of how Islamic banks provide services without charging interest is “murabaha”. The term refers to a practice in which a bank buys an item or piece of real estate and resells it to its ultimate purchaser with a mutually agreed-upon profit for the bank, allowing the purchaser to pay in installments without technically paying interest. Since there is no Qur’anic injunction against reselling an item at a profit, “murabaha” allows the bank to be compensated for the time value of the money spent and the risks associated with lending without technically violating the religious ban on “riba”. Minor differences between Islamic banks and conventional banks crop up because the bank owns the property in the interim and assumes the loss should something happen to it.
A similar service is “ijara wa iqtina”, in which a bank buys an item and leases it to the purchaser, who agrees to buy the item at the end of a specified term or length of time. Rental payments include an amount towards the value of the item so that the final payment is generally a token amount. Interest is not collected, but a profit is earned by the lender. Interest is not paid on savings or checking accounts in Muslim banking. Some banks give a gift in appreciation for the loan from the customer. This is usually in the form of periodic deposits based upon the bank’s profits. The gift is not guaranteed and is not considered to be an interest payment.
Islamic finance contains the concept of sharing risk. Instead of providing loans to businesses, practices similar to venture capital partnerships are frequent. A partnership is formed between a bank and an entrepreneur, with an agreement providing for the sharing of profits or potential losses. Such loans are provided to start businesses and for reinvestment in a business. In the case of Islamic banking, the profit to the bank is tied to the profits of the business. Risk is carried by all participants in this kind of partnership. Loans that are acceptable under Sharia involve a degree of sharing of profit and risk. The Qur’an forbids earning money by investing in unethical businesses. Islamic banks and investment firms invest only in ethically acceptable ventures: those that don’t involve the likes of alcohol, pornography, gambling or other things forbidden to Muslims.
Islamic banks hire Sharia scholars for the purpose of supervising the bank’s activities to ensure that they are in compliance with Islamic law. Committees of scholars or independent consultants are hired to establish rules for specific transactions and financial products. They also monitor bank practices to be certain that the banking contract continues to meet the agreed-upon rules.
The first modern Islamic bank was established in 1975 as the Dubai Islamic Bank. Previous experiments with smaller Islamic banking institutions occurred in Egypt between 1963 and 1967, but these were simple savings institutions operating covertly due to the government’s hostility towards Islam. The Dubai Islamic Bank and over two hundred other such institutions are fully modern banks.
Muslim scholars have argued that the modern attitude of Christians and Jews towards usury is a rationalization. Whether interest free banking as practiced by Islamic banks is a form of rationalizing away a religious mandate is debatable. Islamic banking could appear to be a similar answer to the revision of the Catholic Church’s doctrine on usury in post-Roman times or the adoption of interest by the Jewish lenders and moneychangers. In the real world of finance, lenders expect to make a profit. Islamic banking is still about the money with a new twist to encourage more liberal Islamic financial practices. ~ E. Manning