A.L.M. Abdul Gafoor ‡
Appropriate Technology Foundation
Groningen, the Netherlands
[This is actually Chapter 2 of the author’s book with the same title, reproduced here for the benefit of those students and others who are unable to purchase the book.]
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. In the following pages we attempt to find some answers.
Money lending is one of the oldest professions in the world. It had been, and it continues to be, practised everywhere in the world in various forms. Before the sophisticated arguments emerged, it was also universally despised. All the major religions and cultures explicitly or implicitly prohibited it. Documented and regulated bank lending is a recent (within the last two centuries) manifestation; it grew out of documented lending by private moneylenders at organised and individual levels. Much of this documented lending involved borrowing by businesses and governments for productive or public (often war) purposes. Recorded history is largely confined to this period, and the economic theory and arguments are mainly based on this history. It should also be noted that both the above — history and theory — largely concern and emanate from Europe. It is easily forgotten that money lending is a universal phenomenon and that much of it goes unrecorded and invisible in most parts of the world even today.
The invisible lending has two important characteristics: it is a private transaction between two persons, and the purpose of the borrowing is mainly unproductive (useful or not). The purposes include really urgent and necessary consumption needs (brought about by calamities, illnesses, unemployment due to unexpected causes or longstanding disability, etc.), avoidable consumption needs brought about by vanity and extravagance, and necessary and/or adventurous risky undertakings. The borrowers’ expectation to repay is based on uncertain future good fortune, but the lenders generally take a dim view of that expectation. Some lenders are motivated by pity and trust, some ensure the safety of their capital by obtaining collateral, and others are positively sure of the borrowers inability to repay and redeem the collateral and look forward to confiscating it. These are the realities of life in many societies, given the nature of man and his environment. Most of the religious and cultural exhortations and prohibitions of money-lending relate to the experience of this reality.
Lending and borrowing also takes place at different levels. There is mutual lending and borrowing where colleagues, friends and relations help each other, usually for short periods, and it is a two-way traffic. There are the more fortunate ones helping out the less fortunate in their difficulties by lending, out of compassion; the latter repaying the loans with gratitude when good times return. There are the private moneylenders who lend money at interest, but discreetly. Others are professional lenders who lend their money openly at interest, whatever the circumstances of the borrower. And there is the modern bank that provides various other services in addition to money lending.
In studying and understanding the nature of lending and borrowing in today’s context, it is necessary to keep in mind the different backgrounds against which economic theories, financial tools and religious/ethical guidelines evolved. Hopefully such an understanding will allow modern man’s legitimate needs to be catered for more effectively and efficiently, without causing personal or social hardships and disasters.
In order to understand the arguments, it is pertinent to examine the purposes of lending and borrowing. When the purpose of borrowing is to invest in a venture and make a profit, it seems reasonable for the lender to ask for a share in the bounty. For practical convenience, the reward (interest) is fixed in advance; and for the safety of the capital a collateral is demanded. Therefore, charging of a reasonable interest, agreed upon by both sides, is seen by many to be perfectly logical. On the other hand, where the purpose is for consumption when one has for some reason or other lost his income, to demand a fixed return where no return is produced is often regarded as unfair. Especially so if the collateral demanded is the house in which the borrower lives or land from the future produce of which he expects to pay back the loan. Thus, depending on the assumptions made at the beginning, opposite conclusions can be arrived at. There is nothing wrong with that, but the problem begins when the resulting conclusion is applied universally.
All through the ages, moneylenders have used the first type of argument to justify their profession. Ironically it is their application of it to the second set of circumstances that created the ground for the second type of argument. Western economic theories are mainly based on the first type of argument. Religious and social objections to interest are often based on the second.
At different times in history different circumstances and needs were predominant, and different groups wielded political, economic or religious power. Earlier, when the Church was in power and the misery of the poor and the unfortunate who borrowed for consumption was in focus, religious dogma and prohibition held sway. The needs of the traders and merchants for short-term credit, their use of it to earn a profit and hence their ability to reward the lenders, were practically ignored. But the need existed and the lenders operated underground. Since the fourteenth century, however, trade expanded and merchants became important in Europe. The big moneylenders catered for this group and prospered. Their voice grew strong, and their arguments came to be seen as reasonable. And they, in turn, ignored the existence and needs of those who needed money for non-productive purposes. Small moneylenders continued to service the less well off, using the arguments of the former to justify the profession but charging much more heavily and thus causing more misery. Over time, the voice of the Church became weak, their arguments lost force, and the poor were forgotten.
But never did the different circumstances cease to exist; perhaps they would never, for they are rooted in human nature and the environment in which man is fated to live in. It is unfortunate that this reality is not taken into consideration in devising modern institutions. Banking operations are based on economic theories, and they apply the resulting system to all situations; while the social institutions have largely failed to take into consideration any situations other than those that deserved charity. The particular aims and objectives of the two groups (profit and greed versus pity and service) have also contributed to this state of affairs.
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 practised all over the Christendom and elsewhere the Church was consistent and vehement in its condemnation of usury.
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. According to Encyclopaedia 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.
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. 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.
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. 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.
Shaikh Mahmud Ahmed, in his interesting book, Towards Interest-free Banking, presents and disputes many of the theories of interest.
“… leaving out some notable exceptions, like Bohm Bawerk’s Capital and Interest, significant parts of Keynes’ General Theory and parts of Harrod, Hawtey and Kurihara, questioning the validity of interest, bulk of the effort of economics has been to justify it, yet not a single argument advanced in favour of this institution has a leg to stand on. All theories of interest evolved till the time of Bohm Bawerk, including those resting on productivity, abstinence and demand and supply concepts, were unanswerably repudiated by him. Yet economics continues whipping these dead horses, without evolving any persuasive answers to his criticism.”
He takes some more theories, including time preference, liquidity preference, deposit mobilisation, scarcity of capital, and rationing capability of interest, and proves them untenable. We will take up here only two most popular ones.
If one possessed some capital and had it at hand in liquid form (i.e. readily available for use), he can make use of any opportunity that may come his way to make some profit, using that capital. If that capital was held up elsewhere, he loses the opportunity to make that profit. If someone else had borrowed that capital and could not make it available to the owner when the opportunity came his way, the borrower is expected to compensate the owner for the profit he would otherwise have made. This is the opportunity cost of money.
This argument is valid, if the owner of the capital is a person who is always on the look out for opportunities to make money — and prepared to take the risk of making or losing money on his adventures — and the only thing that would prevent him from doing so is the lack of liquid capital at his disposal. This applies to many businessmen. But moneylenders are generally not businessmen on the lookout for business opportunities that involve risk — they lend only when a good positive return is assured. Therefore this argument of opportunity cost does not apply to them.
As for the modern capital-holder, who has his capital deposited in a bank — whether in a fixed or ordinary savings account — his money is available to him anytime he wants. So, where is this lost opportunity, asks Sheikh Mahmud. Not only did he not lose any opportunity, his money was earning interest even when he had no opportunity!
Thus, once again, we have a theory developed assuming a specific set of circumstances and then applied to situations where the assumptions do not hold.
“Time is money” is the present-day business slogan. It is so in the case of loans from a moneylender too since interest on a loan is calculated in terms of time — the longer the loan remains unpaid the larger the interest to be paid. But how does the simple passage of time add value to capital? Suppose there is a shopkeeper. He has a stock of goods, and he sells them to anyone who asks for any item and pays for it. He uses the collection to purchase the replenishment as soon as possible because another customer may drop in anytime and ask for the same product. If he does not have it in stock when demanded he may lose the opportunity to make a profit. Since the demand may occur at anytime, the longer the absence of an item the greater the chance of a loss. Therefore a shopkeeper would rather hold stocks of goods than cash. Now, suppose an item is sold on credit. The money due is now not available to the shopkeeper to replenish his stock. Consequently he may be unable to serve some of his customers’ demands and thereby lose income and profit. In this case the longer the credit remains unpaid the greater the loss the shopkeeper suffers. Here is a case for “time value of money”, and if the shopkeeper has two prices for the sale of the same good — one for cash sale and another (greater one) for credit sale — there is some justification for it.
But when the argument is taken out of context and applied to money in general it loses its justification. A moneylender does not operate like a shopkeeper. He holds onto his money, earning no income and enjoying no “time value” nor “lost opportunity” until a borrower turns up promising to pay a positive interest. His money begins to enjoy “time value of money” the moment it leaves his hands — but not until then! “Time value of money” is not an intrinsic characteristic of money; it is dependent on the context.
It is interesting and instructive to note that all the above theories were developed in Europe before the invention of modern commercial banks. But it is also necessary to note the circumstances in which loan transactions of the merchants of Europe took place. Here the borrowers often had equal (or even greater) clout with their lenders. This is noteworthy. Furthermore, lenders lent their own money, and the transactions took place mainly in a person-to-person context. Borrowing and lending was mainly for the short term, and the parties were known to each other. The risk of default was minimal. So was the risk of failure of the project for which the money was being borrowed, for in general credit was requested only when a trading proposition was at hand, and the gains were roughly known. Paper currency had not yet been invented, and inflation, as currency depreciation, was still in the future.
Economic theories of interest evolved against this background. One consequence was that interest was a single entity — the extra amount paid by the borrower to the lender. All economic theories treated interest as a single entity. Though the environment has changed over time, and several new factors have come into play, even new formulations treat interest as a single entity.
With the invention of the modern commercial banks, as an intermediary between the depositor (the fund-provider) and the borrower, two types of interests emerged. One, the interest the bank paid its depositors, and two, the interest it charged the borrowers. The latter is always larger in magnitude than the former. To illustrate, keeping it simple, the depositors may be paid 5 percent while the borrowers are charged 15 percent, and the difference is the due of the bank. That due to the bank consists of components such as the real costs it incurs in providing the service, a risk premium against possible defaults, compensation for inflation and its own profits. Economic textbooks rarely refer to the existence of the two types of interests. Nor does any theory of interest treat it as consisting of several components.
When these facts are taken into consideration in devising a theory of interest, a way opens for greater understanding of the working of banking and economics, and provides transparent solutions to some knotty problems. We will return to this later in this essay.
Today, a fixed deposit in a bank is considered an investment because it earns a return, and a loan is considered an asset by the bank for the same reason. But they are both interest-earning loans. Whatever the purpose, money is available only as a loan at interest. The lenders (both the depositors and the bank) are not really concerned about whether the money was invested in any productive activity or consumed; neither is their return related to the result of any productive activity in which their capital was used. Even when the loan was intended for consumption or the investment resulted in loss, the pre-determined interest must be paid. In contrast to this, in the Islamic tradition, the distinction between investment and lending had been clearly recognised and provided for, but unfortunately, in modern times, its importance does not seem to have been fully appreciated and acted upon.
The Qur’an recognised two different sets of purposes for which money was needed, and noted the two techniques used by capital-owners to cater to these needs. But the techniques must match the purposes. The need of entrepreneurs for capital was recognised, and in order to cater to this need investment of capital in productive employment was encouraged, but it must be done on a profit and loss sharing basis. Borrowing and lending (for productive or non-productive purposes) were also recognised as legitimate need and technique, but they should be done on the basis of mutual help — without loss or profit to either party.
Besides these two, the Qur’an also recognised another set of circumstances in which one may find himself/herself — circumstances which warranted leniency or pure charity. A borrower, who borrowed with the intention of repaying the loan, hoping on better future circumstances, may find that hope remaining unrealised within the expected timeframe. He needs leniency until better times return. Others may find themselves in circumstances where they could not even promise to repay. They deserve charity. The Qur’an encourages leniency on the part of lenders, and recommends voluntary charity to those who posses the means.
To illustrate the position of the Qur’an, let us take an example. Suppose a person at the time of the Prophet (peace be upon him) in Mecca had some capital. He could earn an income from it in one of two ways: by engaging in trade (buying and selling) or by lending at interest. The Qur’an said: do the former and avoid the latter, for they are not the same though some do argue so.
At this point, it is necessary to note that trade was the main occupation of the Meccans at the time. But the principles involved are applicable to all enterprises. Trade was practised either individually or in partnership. Partnership was on the basis of either musharaka or mudaraba. Musharaka is where both partners invested capital in a business (trade) and jointly ran the business, and shared the resulting profit or loss. A capital-holder who did not wish to engage himself directly in the business opted for mudaraba, where he teamed up with an entrepreneur (trader), provided him with all the necessary capital, and shared in the profit of the enterprise at a pre-agreed ratio (or absorbed the full loss if and when that occurred). In effect, a sleeping partnership. So a capital-owner who wished to earn an income using his capital but without directly engaging himself in an enterprise was given only one option: go into partnership with an entrepreneur on the basis of mudaraba (profit sharing and loss absorbing).
It is remarkable that the same choices exist even today: a) put your money in a partnership company (with you as the sleeping partner) or buy shares in a shareholder company; b) deposit in a bank or buy bonds and securities. In the former you share in the profit and loss, and in the latter you receive an interest income.
By recognising the different types of needs and circumstances which naturally occur in any human society and dealing with them using suitably different techniques, the Qur’an seeks to prevent unpleasant consequences, rather than seeking to find solutions after the damage is done.
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 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.
Yusuf Ali, in his Commentary of the Qur’an, says:
Usury is condemned and prohibited in the strongest possible terms. There can be no question about the prohibition. When we come to the definition of usury there is room for difference of opinion. Umar, according to Ibn Kathir, felt some difficulty in the matter, as the Prophet left this world before the details of the question were settled. This was one of the three questions on which he wished he had had more light from the Prophet, … Our Ulama, ancient and modern, have worked out a great body of literature on usury, based mainly on economic conditions as they existed at the rise of Islam.
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. 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.
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. Umar’s difficulty is said to be related to only some details of this riba. According to the recent (23 December 1999) historic judgment of the Supreme Court of Pakistan (section written by Justice Taqi Usmani):
65. These narrations [given earlier] of the statement of Sayyidina Umar, Radi-Allahu anhu, clearly reveal two points: firstly, that all his concerns in the issues of riba related to riba al-Fadl and not to riba al-Nasiah which was prohibited by the Holy Qur’an, and secondly, that even in the issue of riba al-Fadl he did not feel difficulty in many transactions which were clearly prohibited, however, he was doubtful only with regard to some transactions which were not expressly mentioned in the relevant Hadith or in any other saying of the Prophet, Sall-Allahu Alayhi wa sallam.
In banking and finance, our concern is with money and money-loans. Therefore what is relevant to our discussion here is only riba al-Nasiah, and there has 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. 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.
According to the above definition the additional amount paid to the lender is riba and is prohibited in Islam. Does borrowing involve any other costs besides riba? If so, who is to pay these costs, and is it riba? We propose to answer both the questions by analogy, using a scene that is played out all over the world, every day — one equally true today as in the time of the Prophet (pbuh).
Suppose a man (or woman) asked a friend of his (or hers) to lend him (her) some money. The friend agreed. But the friend (now the lender) lived in a distant place. So our man (now the borrower) has to travel (say, by train) to the lender’s place. It is necessary to pay the train fare and it is the traveller who must pay it. The traveller in this case is the borrower, and it is neither customary nor fair to ask the lender to lend money as well as to pay for the train; nor would one ask him to bring the money to the borrower. In fact the borrower has to travel again to return the loan. It is obvious that the borrower had to spend some money to obtain the loan, but that was not riba by any stretch of imagination because the lender did not ask for or receive any amount besides his principal. The borrower did spend some extra money to obtain the loan, but that was paid to the train operator, not to the lender. It is clear then that borrowers sometimes do incur expenses in obtaining loans and they are not necessarily riba.
On the other hand, if the borrower and the lender lived in the same city or village and met each other in the course of their daily activities, such as in the market, the mosque, the work-place, the bath-house, the eating house, etc., the question of travel and extra expense would not arise. Similarly, if they lived close by and the borrower could reach the lender by foot or by using his own transport such as a horse, camel, donkey, bicycle, or car, the travel cost would be nil or negligible and hence goes unmentioned. This is a person-to-person transaction in a small geographical area. This occurs everyday in numerous locations all over the world, and will continue to take place for all time to come. These were also the situations in the small towns of Mecca and Medina 1400 years ago. It was against this background that the Qur’anic prohibition of riba was promulgated. Even then, if, for example, the lender lived in Mecca and the borrower in Medina, the earlier scenario would have come into play and the lender would have had to incur extra expenses, which were not riba.
Let us now take our scenario a step further. Suppose our borrower, instead of going himself to meet the lender, employed someone else to do the job for him. He has to pay the same train fare and, in addition, remuneration to the one he employed. The latter is an intermediary — a courier of money — and he is paid his costs and remuneration by the borrower. Again this has nothing to do with the lender. Therefore it is obvious that these cannot be regarded as riba.
Now, let us go another step further. Suppose the law of the land requires that for any money transaction beyond a certain amount to be valid an attorney should attest it. The attorney has to be paid. Who will pay the bill? Naturally it is the borrower. Similarly, if the collateral for the loan has to be evaluated or its title checked, a payment has to be made. Again it will be on the shoulders of the borrower. It is of course, obvious that these are not going to the lender, and are therefore nothing to do with riba.
From the above we have come to the point that there are at least three different kinds of costs incurred by the borrower that are not riba. Now, suppose the borrower asks the courier to go to the attorney as well to get the transaction attested and also to have the title checked by a notary or attorney, and the courier agrees. This will make the borrowing process easier and quicker, and the borrower need to deal with only the courier; and he could pay all the costs to, and through, the courier. Since none of the above costs are riba, and since the lender did not demand any riba and the borrower did not pay any riba and therefore the courier did not carry any, there is no riba involved in the entire transaction. Yet it did cost the borrower some extra money to obtain the loan. The loan was riba-free, but not cost-free.
Now, suppose this courier does a good job, the word spreads, and more borrowers retain him to do similar jobs for them. He grows, he no longer runs the errands himself but employs others, and as time passes and the business grows, he employs his own attorney and notary so that their work can be done in-house. Now he is an institution. His couriers travel to many towns and cities, his institution is well known and trusted. On account of the economies of scale his per-transaction cost is reduced, and the borrowers find his charges cheaper compared to employing a private courier; and more convenient too.
As time passes he discovers that there are borrowers and lenders in every location, and even though a borrower in a particular location may be borrowing from a lender in a distant location, since money is the same wherever it comes from, the courier could give the amount to the borrower in a particular place from the money obtained from the same location. This would reduce his costs, transaction time, and transport risks. His services become even cheaper.
In course of time, borrowers and lenders discover that they need not deal with each other directly, nor even know each other, and that they could approach this courier institution for their respective needs. Borrowers go to the courier to obtain loans, and they can get from this courier more funds than they can from any specific lender known to them, and trusting and willing. They are no longer obliged to any particular friend-lender. The lenders now deposit their funds with the courier, for safety and with the knowledge that their money will possibly be used by others, including their friends, while they are not in need of it. The courier assures the safe and full return of their funds whenever needed. The courier no longer sends his staff to the lenders and borrowers but they come to him. A bank is born!
But this bank has two distinguishing features. One, its progenitor is a courier of money rather than the moneylender of old as is the case with the conventional bank. It started as a courier of money and remains a courier of money — it is no moneylender. Two, this bank is not involved in any riba transaction, and the fee it charges the borrower is not riba.
Our arguments that the bank may charge a fee for its services, and that it is not riba have been based on common sense and general knowledge. However, it is good to know if there are any other supporting voices. Iran is one country where riba is prohibited and which has a comprehensive law on usury. Pakistan is another country where riba is prohibited. Siddiqi is the most referred-to author on interest-free banking. Therefore, let us examine the provisions in the Iranian, Pakistani and the Siddiqi models. All three models provide for loans with a service charge. Though the specific rules are not identical, the principle is the same. Therefore we are not alone in our conclusions.
Let us now look at the existing relevant rules in the three models.
The Iranian model provides for Gharz-al hasaneh whose definition, purpose and operation are given in Articles 15, 16 and 17 of Regulations relating to the granting of banking facilities:
Gharz-al-hasaneh is a contract in which one (the lender) of the two parties relinquishes a specific portion of his possessions to the other party (the borrower) which the borrower is obliged to return to the lender in kind or, where not possible, its cash value.
........ the banks ... shall set aside a part of their resources and provide Gharz-al-hasaneh for the following purposes:
(a) to provide equipment, tools and other necessary resources so as to enable the creation of employment, in the form of co-operative bodies, for those who lack the necessary means;
(b) to enable expansion in production, with particular emphasis on agricultural, livestock and industrial products;
(c) to meet essential needs.
The expenses incurred in the provision of Gharz-al-hasaneh shall be, in each case, calculated on the basis of the directives issued by Bank Markazi Jomhouri Islami Iran and collected from the borrower.
In Pakistan, permissible modes of financing include:
Financing by lending:
(i) Loans not carrying any interest on which the banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds and provisions for bad and doubtful debts. The maximum service charge permissible to each bank will be determined by the State Bank from time to time.
(ii) Qard-e-hasana loans given on compassionate grounds free of any interest or service charge and repayable if and when the borrower is able to pay.
An appropriate way of levying such a fee would be to require prospective borrowers to pay a fixed amount on each application, regardless of the amount required, the term of the loan or whether the application is granted or rejected. Then the applicants to whom a loan is granted may be required to pay an additional prescribed fee for all the entries made in the bank’s registers. The criterion for fixing the fees must be the actual expenditure, which the banks have incurred in scrutinizing the applications and making decisions, and in maintaining accounts until loans are repaid. These fees should not be made a source of income for the banks, but regarded solely as a means of maintaining and managing the interest-free loans.
It is clear from the above that all three models agree on the need for having cash loans as one mode of interest-free financing, and that this service should be paid for by the borrower.
A more comprehensive and direct approach has been employed in Gafoor (1995). Here, the usual interest charged by the conventional banks has been taken and split into six distinct components, the purpose of each component is determined, each is examined to see if it contained any element of the prohibited riba, and then a formula is developed with respect to each component in order to compute its value. It has been shown that, of the six components only one is riba and all the other five belong to the category of costs and remuneration. On account of this the usual interest charged by conventional banks is called the cost of borrowing. Its six components are: interest paid to the depositor, cost of overheads, cost of services, a risk premium, profit (or remuneration to the bank), and compensation for the value loss of capital due to inflation. The reader is best referred to the original for details, and for how this model of the cost of borrowing is used for many analyses. For the present we will examine the components of the model briefly with the above courier-bank in mind.
In normal commercial banking practice, the funds used for lending are mainly derived through the savings deposits. The bank pays a certain percentage as interest to the depositors and recovers it from the borrowers when it lends. This interest is the first component in our model of the cost of borrowing. Of all the six components of the cost of borrowing, only this component is received by (or paid to) the depositor, in addition to his capital (deposit). In the general case, this component is positive and is dependent on the interest rates the bank pays its depositors.
In the case of a Muslim community, this component is riba because any addition to the capital has been defined to be riba. Therefore, a Muslim depositor will not demand or accept this component. Hence, this component will be zero in our version of the model. The implication is that the bank will not collect this component from the borrowers in order to pass it onto the depositors.
This is the cost involved in processing the application. This may include legal and other charges paid by the bank for services such as the evaluation of the collateral and checking its title, preparation of loan documents, postage, etc. This cost is specific to the concerned loan, and therefore need be borne entirely by the concerned applicant. This is an actual cost incurred by the bank, and is independent of the size of the loan (except, perhaps charges such as stamp duty) or the period of repayment. Therefore there should be no objection to it on grounds of any resemblance to interest (or riba).
This goes to the maintenance of the bank, including staff salaries and office expenses. This is unavoidable, but it is also difficult to determine the exact amount used up by any given loan. Therefore a method has to be found to charge an average rate. What has been suggested is to compute the bank’s average total running expenses per annum (p.a.) and divide it by the average total assets of the bank p.a. to obtain a per dollar p.a. cost. Then this rate will be used to compute the overheads cost due from the borrower. For example, if this rate works out to be 1.5 cents per dollar per annum, a loan of 5000 dollars paid over two years will entail an overheads component of 0.015*5000*2 = 150 dollars. It may sound like the usual interest rate, but we know why and how we arrived at it, and we know that it is not riba but a cost necessary to maintain the bank whose services the community, the depositors and the borrowers need. For a more elaborate explanation see Gafoor (1995).
The proposed bank is a commercial concern providing a service — carrying money from the lender to the borrower and back, keeping it safe, receiving from and paying to both the depositors and the borrowers, keeping accounts, buying and selling services from third parties (e.g. hiring a lawyer for title checking), etc. The costs of these are taken into account in the two preceding components. But, how about remuneration to the courier-bank for arranging these services? Should it do it without any benefit to itself, investing its own money, time, expertise and effort? Is such remuneration riba? Obviously not. However, it may give rise to concerns depending on how it is computed. If it is computed as a percentage of the loan amount there may be some room for doubts. But, here it is proposed to be computed as a percentage of the costs of the services the bank provides (i.e. the services and overheads components, seen above). Thus it is a legitimate remuneration or profit.
The proposed approach has already introduced a radical change in the perception of a bank — from a moneylender to a money-courier. Now it introduces another radical innovation in guaranteeing the capital of the depositor by ensuring the full repayment of the loans — now the onus is on the borrower and not on the bank. Instead of the banks joining a deposit insurance scheme, here the borrowers join in a loan default insurance scheme. This is a collective insurance scheme designed to compensate the bank in case of defaults, and to discourage delays and encourage early settlements. The premium is proportional to the size of the loan. But good behaviour increases the credit rating of an individual borrower and decreases his premium rate, and vice versa. The scheme is to be run by a third party, and the unused part of the premium is to be returned to the borrowers pro-rata. See Gafoor (1995, 2000) for details.
Inflation comes into this model in two different forms: the general inflation affecting the costs (second and third components), and currency depreciation affecting the value of capital. The first is unavoidable, inseparable and legitimate. Therefore we need not do anything about it. But the second is value erosion of capital; in fact, an illegal and surreptitious tax on all cash holdings. In fairness to the capital holders this loss must be compensated, so that their capital is not eroded due to no fault of their own. This component is the amount (in terms of currency) that needs to be paid to the capital holders (depositors) in order to restore their capital to its original value. For the rationale and computational details please see Gafoor (1999). (This model provides for the reverse action too, in case of currency appreciation.)
The alternative approach presented above is a general model of the cost of borrowing (CoB). In fact, it is a general theory of interest. Here the interest charged by a bank is split into several components, which are all factors every bank takes into consideration in determining its interest rate. However, bringing them all into a comprehensive model is new. In addition, each component is estimated separately and independently of others. This too is new and innovative. In the process, each component of the bank interest is shown to be originating from different considerations. In economic parlance, each component is influenced by a different set of economic variables. In turn, each component influences another set of economic variables. This should lead to more meaningful economic and econometric modelling and to a deeper understanding of the working of interest in the economy. In this essay, however, we will limit ourselves to a few applications of this theory to situations that concern us. For the sake of simplicity we will assume zero inflation in what follows. The complications of inflation are dealt with in Gafoor (1999).
Person-to-person lending and borrowing is something that takes place everywhere in the world, millions of times every day, from time immemorial to the present. Its essential components are: 1) the lender and the borrower are generally known to each other (or are introduced and guaranteed by mutually trusted acquaintances), meet in person, the transaction is hand-to-hand, and any writing and witnessing is done without cost — hence the second component of the model is zero; 2) since the lender and borrower are generally from the same locality or live in close proximity the travel cost to the borrower is insignificant, and since such transactions are also infrequent there is no cost (such as employing an assistant on account of the large volume of transactions) to the lender — hence the third component is also zero; 3) since the second and third components are zero, the fourth component (profit) which is a percentage of the other two is automatically zero; 4) the lender lends only if he is satisfied that the borrower is able to and will repay the loan in full and in time (he is free to deny a loan if he is not sure) — hence the risk premium (fifth component) is also zero; 5) in the absence of inflation, the sixth component is also zero.
Therefore, in a person-to-person lending/borrowing as described above, all components except the first are zero. Hence, in such a transaction, if the borrower has to make any extra payment to the lender it can only be due to the first component being positive, and that is riba. This was the case dealt with in the original injunctions, and this had also been the case in all transactions till the advent of the banks, and even today in millions of transactions outside the banking system. Thus, in the case of a person-to-person lending, the cost of borrowing (CoB), interest, usury and riba all turn out to be the same and equal. The model helps us to see this clearly and directly.
We will now use our model to examine two types of “low-interest” lending schemes to see if they involve riba.
Suppose, some philanthropist sets aside a certain sum to help needy students. He could proceed in several ways. Let us take three scenarios. 1) He could hand out a certain amount to every needy student who applies until his money is used up. This is an outright donation and a one-time operation. After that he would not be able to help any more students unless he brings in new funds. 2) He could do as before, but require the students to pay back when they are employed. From the money so recovered he can help more students. This is a loan scheme and a continuing operation. But this would require the employment of a person to disburse the funds, keep records, receive repayments and keep accounts, etc. He needs to be paid and his office expenses met. We are talking here about several years. Unless the philanthropist provides fresh funds every year for the upkeep of the office, the original funds would be used for this purpose as well and, eventually, the operation will shut down. 3) He could proceed as 2) above but require the students to pay for the upkeep of the office as well, in addition to repaying the full amount of the loan. This might be called a “low interest” loan scheme. Since the original fund will remain intact, this is a sustainable continuing operation.
What is common to all the above scenarios is that the philanthropist did not ask or receive any monetary benefit for himself. In Islamic parlance, no riba was involved in any of these operations. However, of the three schemes, only the third is sustainable. In terms of the above theory, in the absence of inflation, all components of the CoB except the overheads component are zero. Accordingly, though the cost of borrowing is positive, it is not riba. In customary language, however, it is called interest, albeit low.
Unfortunately, Muslims take the word interest literally and equate it to riba. In the process they lose out on the benefits of a useful and sustainable system devised by a sympathetic and well-meaning philanthropist. This is not being true to the faith or is the strict practice of its rules, but refusing a helping hand due to ignorance. This is not to say that the ordinary Muslim who wishes to be faithful to his creed is wrong, but that he had not been given the knowledge about what is meant by riba and what is meant by interest as understood today, and that there is a difference. Showing this difference, however, is not possible if interest is treated as one single item. Neither the bankers, nor the economists, nor the Islamic scholars have been of help here. Hence the need and relevance of the above model which sees present-day interest as consisting of several components, only one of which is the prohibited riba.
The theory should help explain to the believing Muslims that all that is called interest is not necessarily riba and provide them with a tool to examine any interest to see if it contained riba or not. Its practical application will enable to them to set up sustainable endowments for useful purposes. Such an understanding and use of the tool will also help them to examine and benefit from several so-called low-interest loan schemes (which many currently reject out of hand), without any qualms about getting involved in riba dealings.
One such low-interest scheme which many good Muslims reject and deny themselves an important basic necessity is the housing loans organized by some well-meaning governments. Essentially they act exactly like the philanthropist in the above example, and use the third option in order to have a sustainable and continuing system. However, on account of the large size of the loans, its long term nature (20 to 30 years to recover the capital in monthly installments) and the geographical spread of the coverage, the Government will prefer to make use of the well established infrastructure of the banking system. It is cheaper, more convenient and reliable than setting up one for this single purpose. The Government simply deposits a certain amount of money with a bank, gives the specifications as to who qualifies etc, and leaves the rest to the bank. The Government does not require any interest on its deposit but the bank must make sure that the original capital remains in tact (and is used again and again to give fresh loans) by ensuring proper loan recovery. The bank may also recover from the borrowers all its own processing costs. This arrangement brings about the low-interest on the loan and ensures the continuation of the scheme.
The fact that it is called interest and, more importantly, that it is (seemingly) coming from a bank frightens off Muslims. If we apply our model to this scheme we will see that no riba is involved in this loan, since the real lender (the government) does not demand or receive any amount in addition to its capital. What is recovered from the borrower is the operational costs of the bank. In this case too, both the CoB and “interest” are positive and equal but they are not riba.
In addition to the individual person-to-person lending and the philanthropic long-term lending by individuals or Governments as seen above, one could also think of the members of a small community helping each other in a collective manner. Suppose the members of a small community decide to set up a savings and loans society. Members deposit their savings with the society in order that other members who need some loan for a short period could be helped from this fund. This is a mutual fund; a depositor at one time may become a borrower at another time and vice versa. Members are free to withdraw some or all of their deposits if and when they want (or at short notice). No depositor demands or receives any amount in addition to his/her capital. Assume that this society is a non-profit organization, and that the members are known to each other and trustworthy and therefore there is no room for default on loans. Assume also no inflation. In this case all the components of the cost of borrowing, except the services and overheads costs, will be zero. Even if the operations of the society are run by volunteers, using some free office space, there may still be some costs for stamps, stationery, transport, communication and so on. Who pays these costs? Cannot ask the depositors for it! They already do a favour by making their savings available to the borrowers free of interest. Naturally the borrowers have to pay the costs.
Here too we see that even where the capital is cost-free the loan is not. It is riba-free but not cost-free. Again, the model enables us to see the difference clearly. In this case too the CoB and what some might prefer to call “interest” are positive and equal, but they are not riba. This should help small communities to set up their own savings and loans societies and serve their members in their needs, with clear conscience about not getting involved in riba.
As we mentioned earlier in this essay, banks pay the depositors interest on their deposits and charge the borrowers interest on their loans. Both are called interest, but they are not equal — the latter is always greater than the former. Let us examine them in turn more closely, using our model of the cost of borrowing and the definition of riba. Again, inflation is assumed zero.
In the first case, depositors are the lenders to the bank and the bank is the borrower. The depositors receive an extra amount from the bank as interest on their capital. According to our definition of riba, this is riba. Let us call it the deposit interest. This is what the bank pays the depositors to get their funds. Therefore, from the bank’s point of view it is the cost of funds or its CoB. According to our definition of riba, this too is riba. Hence, in this case, deposit interest, bank’s CoB and riba are all the same and equal. As far as Muslims are concerned this falls within the category of the prohibited, and there is no doubt about it.
In the second case, the bank is the lender and its client is the borrower. The bank demands and receives interest from the borrower. Call it the bank’s loan interest. But this “interest” consists of the deposit interest the bank pays the depositors (whose money it lends to its clients), and other components (which are costs incurred by the bank, and the remuneration for its services). The bank collects both the deposit interest and the other components from its borrowers, passes on the former to the depositors, and keeps the rest for itself. While the deposit interest is riba the other components have been shown to be no riba. According to our model, then, the bank’s loan interest and the borrower’s CoB are both the same and equal. Both of them contain the prohibited riba, but not all of either is riba. Consequently, when deposit interest is zero both of them are free of riba, and neither the bank nor the borrower is involved in any riba dealing.
Present-day banks’ loan interest might also contain, besides the six components discussed above, an additional component arbitrarily introduced by the bank which will then qualify as riba. It may even turn out to be directly proportional to the size and period of the loan. If present this component too should be eliminated to make the transaction truly riba-free.
In the foregoing paragraphs we began with explaining the meanings of interest, usury and riba. We traced their historical development, examined the arguments for and against their practice, and worked out their relationship to each other. And, we examined the Western and Islamic views on interest, and the consequences of the separate attitudes. We also looked at a new theory of interest that helped us to understand the meaning of bank interests in some detail. This in turn helped us to realise that while bank’s deposit interest was the same as riba, its loan interest consisted of both riba and the operational costs of the bank. This enabled us to devise viable lending systems without becoming involved in riba.
A note of caution is necessary at this point. The conclusions about deposit interest and loan interest should not be interpreted to mean that if the bank does not pay any interest to the depositors its loan interest becomes riba-free and therefore automatically acceptable, whatever its size. No, for it is subject to an important condition. How each component of the cost of borrowing came into existence was fully explained when formulating the theory and therefore its implementation is based on the assumption that each component will be separately estimated as explained earlier, and that this will be done transparently. That is, the data necessary for that estimation is routinely collected, the estimated coefficients (this includes the bank’s profit/remuneration rate) are made available for public scrutiny (and monitored by the Central Bank), and that each customer is routinely given the value of each component making up his total CoB. Unless this transparency condition is appreciated and strictly adhered to the theory is vulnerable to misunderstanding and misuse.
The transparency condition ensures that the profit rate is known, and any hidden riba component is revealed. If a riba component is present it will violate the riba-free assumption and will be illegal and morally reprehensible. If the profit rate turns out very high (as will be the case if this theory is applied to estimate it using present-day banking data) market forces will step in to correct it, provided there are several independent banks competing in a genuinely free market environment, to the benefit of the borrowers. Thus eliminating another two important aspects of riba – exploitation and injustice. The benefits will trickle down to the society through reduced costs, prices and, eventually, help curb inflation. Reduced cost of borrowing will also help on-the-brink enterprises to stand on firmer feet.
1. Ahmad, Sheikh Mahmud, Towards Interest-free Banking. New Delhi: International Islamic Publishers, 1992.
2. Ali, Abdullah Yusuf, The Holy Qur’an (Text, Translation and Commentary).
3. Emry, Pastor Sheldon, Billions for the Bankers – Debts for the People. Free distribution booklet, undated. Also available at: http://www.justiceplus.org/bankers.htm, and downloadable from: Billions.exe.
4. Encyclopaedia Britannica 2001, CD-ROM edition. Oxford University Press.
5. Gafoor, A.L.M. Abdul, Interest-free Commercial Banking. Groningen, The Netherlands: Apptec Publications, 1995. Revised edition, 2002. Published in Malaysia by A.S. Noordeen, Kuala Lumpur.
6. ………, Participatory Financing through Investment Banks and Commercial Banks. Groningen, The Netherlands: Apptec Publications, 1996. Published in Malaysia by A.S. Noordeen, KL.
7. ……….., Commercial Banking in the presence of Inflation. Groningen, the Netherlands: Apptec Publications, 1999. Published in Malaysia by A.S. Noordeen, Kuala Lumpur.
8. ………, Islamic Banking & Finance: Another Approach. Groningen, The Netherlands: Apptec Publications, 2000. Published in Malaysia by A.S. Noordeen, KL.
9. ………, Mudaraba-based Investment and Finance. Article available at the author’s websites: www.IslamicBanking.nl and www.Riba-free-Banking.com A shorter version published in: New Horizon, Journal of the Institute of Islamic Banking & Insurance, London, July 2001.
10. ………, Riba-free Commercial Banking. Article available at the author’s websites: www.IslamicBanking.nl and www.Riba-free-Banking.com Also published in: New Horizon, Journal of the Institute of Islamic Banking & Insurance, London, August and September 2001.
11. ………, Currency Depreciation: Determination and Applications. Available on the Web: www.IslamicBanking.nl/article7.html and http://users.bart.nl/~abdul/article7.html (2005). Also published in: Islamic Banking and Finance magazine (London), issue #9, Spring 2006.
12. Iqbal, Zubair and Abbas Mirakhour, Islamic Banking. Washington, DC: International Monetary Fund, Occasional Paper No.49, 1987.
13. Pickthall, Marmaduke, The Meaning of The Glorious Koran.
14. Qureshi, Anwar Iqbal, Islam and the Theory of Interest. Lahore: Sh. Mohammad Ashraff, 1991. First published 1946.
15. Siddiqi, M. Nejatullah, Banking without Interest, Leicester (UK): The Islamic Foundation, 1983, 1988.
16. Usmani, Justice Muhammad Taqi, The Text of the Historic Judgement on Riba, 23 December 1999. Petaling Jaya, Malaysia: The Other Press, 2001.
© A.L.M. Abdul Gafoor 2002-2004
Revised May 2004, Sept 2006.
 Aristotle, Politics, Book I, Chapter X. Plato, Laws, Book V. Quoted in Qureshi (1946), p6.
 Qureshi (1946), p.8.
 Encyclopaedia Britannica 2001, CD-ROM edition.
 Bacon, Discourse on Usury. Quoted in Qureshi (1946), p8.
 Ahmed (1992), pp.13-38.
 Ibid. p.24.
 Ibid. pp.31-32.
 “And if the debtor is in straitened circumstances, then (let there be) postponement to (the time of) ease; and that you remit the debt as almsgiving would be better for you if you did but know.” Qur’an (2:280). All Qur’anic quotations are from M. Pickthall’s translation.
 “… they say: Trade is like usury; whereas Allah pemitteth trade and forbiddeth usury.” Qur’an (2:275).
 There were also reciprocal obligations on the part of the entrepreneur, the recipient of the capital. All his transactions needed to be transparent and the accounting accurate and verifiable. To be fair, the environment of the day and the society as well as the open nature of caravan trade made complying with these obligations both necessary and inevitable. Compliance was rewarded with respect and further prospects while failure to comply extracted the heavy price of social ostracism. The entrepreneur was not required to provide collateral but the goods remained the property of the financier.
 The Qur’an uses the word riba in all places. This word is sometimes translated as usury and sometimes as interest. There is now a legal difference in the English language — usury being extravagant interest. But this difference is unknown to the Qur’an.
 The Qur’an and Hadith (the sayings, doings and approvals/prohibitions of the Prophet (pbuh)) are the only original sources of all laws in Islam.
 Learned in the religion.
 Yusuf Ali (1989), p.115, footnote to 2:275.
 “At the time when the Holy Qur’an was revealed the following were the types of interest transactions which the Arabs named as riba:
a) A person sells a certain thing to another person, agreeing to receive the sale money at a certain fixed time. If the purchaser could not pay the purchase money within the prescribed time, another ‘easing-time’ was allowed to him with the addition that he agreed to pay an increased amount.
b) A person lends another a certain amount for a fixed period on condition that after the expiry of that period the borrower would pay the principal with a fixed sum as riba.
c) The creditor and the debtor agree on a fixed rate of riba for a certain fixed time. If within that time the debtor failed to repay his loan with the agreed amount in addition to it, he would then be required to pay at an increased rate of riba for the additional ‘easing-time’.” Qureshi (1946) p.44.
 Usmani (2001), p.30.
 Qur’an (2:279).
 It should be noted here that making a written and witnessed record of any loan transaction is a Qur’anic injunction. Qur’an (2:282).
Laws and regulations relating to interest-free banking in Iran and Pakistan are reproduced in Iqbal and Mirakhor (1987), pp.31-58. For the Siddiqi model, see Siddiqi (1988).
Iqbal and Mirakhor (1987), pp.36-37.
Central Bank of the Islamic Republic of Iran.
Iqbal and Mirakhor (1987), p.45.
 The other 10 and 40 percent respectively are to be used for cash reserve and mudaraba investment.
 Siddiqi (1988), p.69.
 This is identified with riba.
 It also depends on the credit creation factor, of the concerned bank, which, in turn, is dependent on the reserve requirements. These complications are dealt with in Gafoor (1999), where the complete model is presented in its mathematical formulation.