Lending and Borrowing: An Overview
A.L.M. Abdul Gafoor
Appropriate Technology Foundation
Groningen, The Netherlands
Lending and borrowing between humans has taken place since time immemorial. People borrowed and returned implements, animals, foodstuff, etc from their friends, neighbors and relations. They returned the same after use or in the case of foodstuff consumed and returned the equivalent when they came into possession of similar stuff. When money came into being people borrowed that too and returned. It was all on the basis of mutual help — the borrower today may be the lender tomorrow and vice versa. As time progressed professional moneylenders appeared on the scene, and they demanded a “fee” for the use of their money. This fee is now called interest, but till a few centuries ago it was called usury. In Islam, interest or usury, which in Arabic is called riba, is prohibited. Demanding, receiving, paying, witnessing, and anything connected with these activities are all equally prohibited. There is no controversy over this. Similar prohibitions exist also in the religious laws of Judaism and Christianity. Although other religions may not have written laws explicitly prohibiting usury, their followers do eschew the practice of usury.
In earlier times, lending and borrowing was mainly between individuals, and what was meant by usury in these transactions was commonly known and understood. In money matters, any amount over and above the lent sum was defined as usury or riba. The ill consequences of usurious lending — the ruination of individuals and families — were witnessed at the local level and therefore the community held the practitioners in contempt. But the need for capital and loans existed and, in the absence of alternative solutions, the usurious lenders became an indispensable component of the society. They also exercised invisible power over their clients’ resources. If the clients happened to be in authority, the power extended to other areas as well; the greater the client’s authority the extensive the power of the lender.
Kings and nobles needed money to wage war or to live extravagantly. Moneylenders were happy to oblige, not only for the profit it brought them but also for the privileges and concessions they could extract from their royal clients. Mining concessions, special trading licenses, tax exemptions, lucrative contracts for public projects, land grants, and personal privileges such as royal titles and appointments to influential positions are just a few examples. These dealings were carried out discretely and the public was generally ignorant of them. But the citizens paid the price, one way or another.
The most important concession so extracted was the passing of the Usury Law. This law introduced an innocuous term called interest and usury was defined as high rate of interest. Usury was still prohibited, in deference to the Church, but “reasonable” interest was made permissible. What is reasonable and what is high was to be determined by the parliament! Now that interest is legal, kings may lose their thrones, soldiers may lose their lives, families may lose their livelihoods, but the country must pay its debts with interest. Moneylenders extracted their pound of flesh.
In recent times, presidents and ministers have replaced kings and nobles, and corporate and international financial institutions the individual moneylenders. The same game, only new names and wider settings. It is now global, the suffering is universal, and the statistics are in the public domain. Yet, hardly anyone dares to point the finger at the real culprit — usury, whatever the legal name it may assume. Neither are the real needs objectively looked at. Consequently, no meaningful alternatives are offered.
Governments, businesses and individuals need money for various purposes. The methods of catering for these needs must match the purpose for which the money was needed. A mismatch can lead to disastrous consequences, but this requires much thought and effort. Borrowing is an attractively easy solution, and this is what the moneylender would recommend for all situations, for it is the most profitable one from his point of view. When the borrower is impatient or desperate and the only game in town is the moneylender, borrowing from him is the only option and the consequences are inevitable. To avoid disasters, then, we have to first study the different purposes for which money is needed and then devise methods most appropriate to each purpose. We have to provide more alternatives. The moneylender has only one purpose and concern: his profits and benefits. But the society has more and larger concerns, for it is its responsibility to cater for and protect all its members, individually and as a whole, those living now and those still to come. In this connection, it is well to remember that all the basic rules, methods, procedures and laws relating to banking and finance were either formulated by the moneylenders themselves or they had a hand in their design and/or execution.
When the usury law was proposed, it was argued that the merchants needed financing, they made profit using the borrowed funds and, therefore, they had the ability to pay the financiers a portion of that profit. Very reasonable. The trouble was, once the law was passed, it was applied to all situations — whether the borrowed funds brought about a profit or not. The Church had become too weak but still dogmatic, and the merchants and moneylenders too strong. The Church could not grasp the new need, brought about by the increased trade in Europe, and failed to provide an appropriate solution. Nor could it argue successfully to limit the application of the new law to trade financing only. Neither did it demand that the law should not be applied to non-profit-creating loans intended for basic consumption needs. It seems that the Church granted the moneylenders a blank cheque on a platter, by default — by its all‑or‑nothing insistence on a complete prohibition and by failing in this dogmatic stance.
In Islam, the situation was different. First, from the beginning of the history of Islam in the seventh century, the (large-scale) merchants’ need for (additional) funds was fully recognized and provided for. There were two ways in which a merchant could finance his trade. One: two or more merchants could pool their funds together and conduct the business together and share the profit or loss according to their (financial) contribution. This was called musharaka, similar to the present-day partnership company. Two: a merchant could obtain his funds from one or more financiers and share the profit with his financiers in an agreed proportion. But he has full freedom in the conduct of his business, and any genuine financial loss must be borne entirely by the financiers. This was called mudaraba, similar to the present-day shareholder companies.
Consequently, while the riba-prohibition of Islam related to all lending and borrowing operations, it took special note of the financing needs of traders and businessmen as well as the investment and income generation needs of those who possessed extra funds. It does not mean that riba is acceptable in these cases; it is prohibited here too. But a different and equitable solution was already available in Arabia when the Qur’an was revealed; so it approved of it and went onto prohibit riba in all cases. Therefore, the merchant-need-based and return-on-investment-based arguments of Europe were not relevant or valid in the case of Islam and Muslim lands. It is necessary to recognise this fact. That is, the all-embracing usury-prohibition law of the Church and the riba-prohibition law of Islam are not exactly equivalent, despite the similarity of appearances.
Second, throughout the long history of Islam, Muslim caliphs, kings and nobles have, by and large, kept away from borrowing at interest. Even though many of them had their share of shortcomings — in common with their counterparts elsewhere — their belief in after-life and the strong words used by the Holy Book against the dealers in riba kept them away from it. The same applied to all would-be moneylenders as well. This saved the Muslim masses and the society from many of the ills experienced by other societies, even though this blessing goes generally unrecognised and unappreciated. Even under colonialism they have enjoyed this benefit. However, it would be naïve to believe that there existed absolutely no riba-based lending and borrowing, but it certainly was personal, local, small, isolated, discrete and unorganised.
Only in the second half of the twentieth century, especially after many countries became independent, established their own governments, and had to run the affairs of the country on their own, that they began to experience the claws of interest through the banking system. They needed the banking system because it provided the various services needed by the different sectors of modern society. But the moneylenders had developed it for their own benefit, based on the all-embracing usury law. It did not make the differentiation the Qur’an had made. Muslims had slumbered through the formative years of the modern world, and failed to build on the head start they had and shape a business and banking model to suit modern needs. Yet their desire to comply with the commandments of their Creator did not die. Their leaders and intellectuals have awoken to the demands of their constituents, experiments with Islamic banking have begun, but there is still a long road to travel.
Before we travel further, let us state clearly what we mean by interest and riba and then note the difference between lending/borrowing with and without interest, usury or riba. Limiting ourselves to monetary dealings only, any benefit demanded or received by a lender in addition to the sum he lent is termed riba. This would, however, include both monetary and non-monetary benefits. Interest, on the other hand, would legally limit itself to monetary benefits only. It is useful not to forget this difference and its significance.
When a person lends without any benefits to himself, he is bound to assess the ability of the borrower to pay back the capital as well as to ensure that the capital is to be used for a purpose that he approves of. It is also a condition of such borrowing that the lender and the borrower are known to each other or that a reliable mutual friend/relative/acquaintance has introduced them. In such a situation, there is an unspoken moral/ethical responsibility (and a sense of shame and reluctance, otherwise) in asking, recommending or granting such a loan.
All these restraints are absent when the lending is done at interest. The lender assesses only the borrower’s ability to (or the means to) repay the capital and the interest. A collateral is usually demanded, and by the very nature of interest — its dependence on time — the lender expects that he would eventually be able to acquire the collateral at a favourable price. Both the interest and the possibility of acquiring property at very low cost drive the moneylender to readily accede to request for loans, as well as to encourage such requests. Thus, when riba or interest enters the picture, the attitudes of both the lender and the borrower head in a direction directly opposed to the one prevalent in its absence. This riba-induced change of attitude is remarkable, as are the opposing characteristics of the two attitudes. One discourages debt, and the other encourages it. One restrains expenditure on morally or ethically unacceptable items and purposes; the other places no such restrains. One is open to social control, the other not. One limits both the size of borrowing and its frequency; the other encourages increase in both. One encourages short-term loans; the other thrives on long-term arrangements.
The last two are very interesting. For since more and larger loans would bring more profit to the lender he would try to acquire more funds. This eventually led the moneylender to borrow from others at low rates of interest and use the same funds to lend at higher rates, as if it were his own. The bank’s credit-creation technique was also developed for the same end. Furthermore, long-term loans provide a stable and steady source of income to the moneylender. This and the availability of increased funds led the banks to widen their reach and, in recent times, to enter previously untapped areas such as housing finance and student loans.
Let us now examine the need for money in some detail. To begin with, there are purposes that bring profit, and others that do not. Within these two categories there are necessary, unnecessary and harmful purposes. In the modern world one has to also make a difference between the needs of individuals, business organisations and governments. Let us take them in turn.
When the borrowing is for extravaganza or vanity, the borrowed fund produces no profit. Therefore, if the borrower is unable to repay the loan and interest from his other income sources, the interest would keep on mounting and the moneylender would eventually confiscate the collateral. All religions and sages throughout the ages have condemned extravaganza and vanity, and have advised against it. The Qur’an has specifically prohibited spending in vanity. Here the reference is to one’s spending from his own resources, and the onus is on the individual. As such, if one engages in such spending using borrowed money, he is seeking his own doom. Yet, by making the riba-prohibition applicable to both the lender and the borrower, Islam seeks to protect people against their own selves. If there is no borrower there will be no lender; if there is no lender there will be no borrower. This closes all doors to doom. Thus there is no need to find any other solutions to the apparent need of the extravagant.
Housing and education are real needs, and therefore their financing deserves close attention. Building or purchasing a house is obviously a capital acquisition. So is education, though it does not seem that obvious. Capital acquisition has always been done using one’s own savings or wealth. It should continue to be so. House-owning leads to individual and collective independence. In turn they add to national wealth and well-being. This fact is recognised by wise governments and they actively encourage private initiatives. Free education has produced wonderful results in the twentieth century.
However, the modern trend, especially in the developed world, is to have them financed by long-term bank loans. But unlike the loans for commercial purposes these loans produce no immediate profit to the borrower. Yet, to a moneylender a loan is a loan, and from his point of view these have some attractive advantages, including a secured regular return guaranteed for a long period. In many developed countries the fiscal laws encourage borrowing and discourage saving/investment/capital acquisition by taxing the interest/dividend received from the latter and granting tax exemption to the interest paid on loans. These laws enable the banks to price the products very attractively and encourage mortgages, but the subsequent experience of the borrower and the effect on the nation are different.
For example, a house-owner who bought it on mortgage remains a debtor for practically the rest of his working life and ends up paying several times the original price. On the other hand, if he fails to pay his instalments on time, he is kicked out as if he were only a tenant. A student forced to take a loan for his education leaves college/university with a certificate and a millstone round his neck. He may become a government administrator, business executive, politician or any other, but he is still a bonded man. And a bonded person cannot think or act independently. Anyone whose parents are too poor or unwilling to pay for his education, and himself refuses to be bonded, is denied higher education. It is a national tragedy. These characteristics of housing and education set them apart from other needs. Therefore these require special treatment.
Wars, in general, bring only death and destruction to people and property — never any profit. The winner and the loser are both losers in the end. If a war is fought by borrowing money at interest, win or lose the country will have to pay the debt with interest, and borrow again to rebuild. Whether the war was an offensive one or a defensive one, in the end, only the moneylenders celebrate — on both sides. Consequently, in history as well as in the present time moneylenders have played an important behind-the-scenes role in both beginning and prolonging wars. Only a total prohibition of riba on both the lenders and borrowers and its adherence at all levels, especially at the highest levels, could eliminate this factor in the war equation. Since everyone is a loser in a war, it is in everybody’s interest to avoid any war; eliminating its financing by funds borrowed at interest will go a long way in this effort. Therefore we need not seek any other solution to this contingency.
Government expenditure consists of two types: capital and current. The funds for both are expected to come from taxation. So a government’s ability to acquire capital goods — to buy equipment and material and to build roads, bridges, schools, hospitals, communication infrastructure, etc — are dependent on, and limited by, the tax revenue. However, the current expenditure, such as salaries of government officers, supplies and maintenance, has priority over capital expenditure. Often, like in the case of an individual, little is left over from the tax revenue for capital expenditure. Consequently, since all capital expenditure cannot be postponed indefinitely, there arises a budget deficit. A budget deficit is financed by printing money, borrowing, or both. Printing money leads to inflation, which is a tacit form of taxing the population. Borrowing increases national debt and interest payment. Credit creation by banks based on the new money (printed or borrowed) increases inflation even further.
Government bonds is one of the instruments used for borrowing money. Since capital expenditure on infrastructure does not produce any profit, borrowing at interest leads to additional current expenditure in the form of interest payments. This in turn requires curtailment of other current expenditure or further borrowing. Government bond is big business, it provides those who have money to spare with a great source of guaranteed return. But the public debt it creates keeps mounting. So does the interest on it. And the inflation generated by money-printing and credit creation add onto the interest rate and lead to further increase of the public debt.
Thus once a government begins to spend more than its tax income, or fails to tax sufficiently to cover its essential expenditures, it gets into a vicious cycle of borrowing to spend and spending to borrow. To tax sufficiently the country must produce enough, and taxes are always unpopular. Borrowing is the easy way out and the country finally ends up in the grip of the moneylenders — national and international — no matter which party or person runs the government. The debt is open and legally binding but the grip — do this or return the loan, do that or no more loans — is unseen, undeclared and least understood, and hence more hideous. It is a great mystery, though, that developed countries with very large national debts keep on prospering, while underdeveloped countries with much smaller debt burdens crumble under it. However, this is no place to probe into that mystery.
It is a time-honoured practice of any individual to spend on his needs from what he has earned. If there is no more money left, he either curtails his spending or postpones it till he comes into sufficient funds. If his income is fixed and regular, such as that of a salaried employee, and he finds himself short of money at the end of the month, he must curtail his expenditure. Otherwise he will find himself at a worse position next month because his income is not going to increase next month, but the gap would have doubled. If, instead, he borrows to bridge the gap he will have to borrow the next month and the following month too — an increasing amount every subsequent month. Eventually he will have to borrow to eat, and pay the loan as soon as he receives the salary and then borrow again for the expenses of the next month. Suppose he borrows at interest, then he will be bankrupt very soon on account of the interest payments, even though he continued to work and earn. One could get out of this situation only by earning more or selling some property and paying off all the debts and begin to live within the income and spend only from already earned income. Or by severely curtailing his expenditure, save and pay off the debts, and by living within one’s means from then on.
In the case of government current expenditure too, somewhere along the line, they threw away the time-honoured practice of spending from realised earning (collected tax) and began to borrow and spend, expecting to repay when the tax revenue came in. This committed them to an interest payment cycle. An instrument called the Treasury Bill was developed for this purpose. This, in effect, is a three-month loan, interest paid in advance. The funds are used to pay the current expenditure for the next three months and the loan is paid from the taxes collected at the end of the quarter. New treasury bills are issued every quarter, month or week. The cycle goes on. An elaborate set of financial tools and markets are built around this. So elaborate that no one remembers when, how or why it started in the first place, or how it keeps perpetuating itself. It is a given in Finance and Government, and theory and practice have canonised it. Moneylenders (private individuals, banks, financial institutions, insurance companies, pension funds, etc) thrive on it, and a whole army of professionals service it. But the general public pays for it, suffers the consequences, and is blissfully unaware of what is happening to it. Enlightening the public further on this point is not within the purview of this essay.
Islamic banking is rooted in the facts that riba is prohibited and trade is permitted, and the profit resulting from trade is permissible income. By extension, it was argued that interest, which is equated to riba, must be replaced by profit. To achieve this, lending transactions must be replaced by trading transactions. This simple concept is religiously applied to all situations. Where the difference was not clear, legal devices were adopted to dress it up as trade and profit. One may cheat himself, but can you fool God? He may be amused by our poor attempts, but does He approve of it? Whatever God does or does not, others are laughing at us. Sincerity is supposed to be the bedrock of our relationship with God. If we are sincere in our efforts to obey His commands, He will certainly show us the right way.
When the commands were issued 1400 years ago, they were directly understood in the context of the social and economic environment then prevailing, and their application was easily achieved. Today, the environment has changed and that makes the application seem difficult. But the solution is not through legal devices, but through our studying and understanding the new environment and sincerely seeking to apply the commands without any adulteration. Trade and profit have their place, but it is not appropriate for all occasions. We have to explore other options. If our intention is sincere, He will certainly guide us to the right solution.
By looking at the needs of society, we can identify three different kinds of needs — investment and finance, banking and loans, and charity — and they each need be handled using a different technique. Moneylenders offered one solution for all three needs because it was to their advantage, but the society has to cater for larger concerns and therefore must offer more appropriate solutions. The Qur’an points out these different needs and presents us with different techniques to suit each need. It is for us to translate them into present-day “language” and set up appropriate institutions. Outlines of such institutions are presented in another essay (see Meeting the Financial Needs of Muslims: A comprehensive scheme). Other essays elsewhere expand on these outlines.
Properly dealing with lending and borrowing transactions requires an understanding of the meaning of modern bank interests in relation to usury and riba. In an essay entitled, Interest, Usury, Riba, and the Operational Costs of a Bank, the history of interest, its relation to usury and riba, the origins of dogmas and theories that prohibit or justify its practice, and the meaning of interest in the modern setting of banking are explored. It also presents a general model of interest in which several scenarios — from person-to-person lending to modern commercial bank lending — become sub-models. This enables one to separate riba from the operational costs of a bank and thus to devise a riba-free system of commercial banking that is both viable and compatible with the conventional one.
Inflation has become a fact of life, it erodes the value of capital — depositors’ savings, banks’ loans, cash-in-hand. It has also been offered as an excuse for charging and accepting interest. But the main cause of modern-day inflation is not in the short-term supply-demand pull-push tensions, but in the long-term effects of increased money supply. The basic cause of this increase is the de-linking of the currency-gold relationship. It occurred gradually over time, but the final blow was dealt in 1971 when the US dollar was de-linked from gold and the promise to redeem every dollar for 1/35th of an ounce of fine gold was withdrawn, reneging on the Bretton Woods Agreement of 1945. US dollar was allowed to float (meaning more dollars were printed without the constraint of the 35 dollars per ounce of gold ratio), and the other currencies, which were all linked to gold through the dollar, also started their free-floats, each in its own pace. Today, at 350 dollars an ounce, gold is ten times more costly. It is said that the price of gold has gone up; but the reality is that the currency has depreciated that much. Re-linking all currencies directly to gold, and strictly adhering to the agreed currency-gold ratio, is the proper solution to this problem. But a global agreement on this is not going to occur anytime soon. In the meantime savings, loans and cash-in-hand are going to lose their purchasing power. To neutralise the effect of inflation (due to currency depreciation) on capital, without recourse to increasing the interest rate, a new mechanism is necessary. Such a mechanism is presented in a book entitled, Commercial Banking in the presence of Inflation. This mechanism is applicable in person-to-person lending-borrowing transactions as well. It is straightforward and not difficult to implement.
1. 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.
2. Gafoor, A.L.M. Abdul, Commercial Banking in the presence of Inflation. Groningen, the Netherlands: Apptec Publications, 1999. Published in Malaysia by A.S. Noordeen, Kuala Lumpur.
© A.L.M. Abdul Gafoor, June 2004