Prohibition of riba: Modernist vs. Orthodox and the ‘need’ for Islamic Financial Institutions

Prohibition of riba: Modernist vs. Orthodox and the ‘need’ for Islamic Financial Institutions – by Muhammad Akram Khan

August 29, 2013

Asian Studies, Author Articles, Economics and Finance, Islamic Studies

photo credit: Masrur Ashraf via Flickr cc

The rationale for developing Islamic Financial Institutions (IFIs) parallel to Conventional Financial Institutions (CFIs) emanates from the Muslim orthodox interpretation that equates the Qur’anic prohibition of riba with all types of interest. Since the major business of CFIs involves dealing in interest, the orthodox interpretation concluded that the business of CFIs was prohibited in Islam. That led to the need for an alternative basis for banking business within the Islamic framework.

The rationale for establishing IFIs stems from two fundamental assertions:

• All types of interest are riba and the business of CFIs is unlawful in Islam.
• The IFIs should be able to do everything that the conventional banks do.

Both of these assertions require a closer review. We need to answer the following questions:

• Once we treat interest on finance as prohibited, are we able to find an alternative that can handle all types of transactions efficiently and effectively?
• If IFIs do everything that the conventional banks do—except by using different nomenclatures, terms and phrases—how effectively would it contribute to the welfare of humanity to establish IFIs as distinct institutions?

This article aims to address these questions.
The Prohibition of Riba
There are two schools of thought among Muslims about prohibition of riba:  orthodox and modernist.
The orthodox school claims that all types of interest are riba and all types of banking transactions involving interest are illegal. This school of thought is the most influential. It has persuaded the majority of Muslim scholars around the world. The movement of Islamic finance is based on arguments presented by this school. The school claims that there is a consensus about treating all types of interest as riba among Muslims. However, that claim is not well-founded. Several serious and well-meaning Islamic scholars differ on this issue. Even among orthodox scholars, the prohibition is not categorical. They have provided space for dealing in interest in certain ways.
The modernist school says that only exorbitant and high rates of interest, along with that taken from needy persons, are riba. Interest on commercial bank loans is not riba. The weakness in this position is that there are no benchmarks to decide which rate is exorbitant and which borrower is poor and needy.
Problems with the orthodox interpretation of riba
The orthodox school is unable to answer several questions:

• If all types of interest are riba, why are differences between the cash and credit prices of the same product allowed by orthodox scholars? The difference in these two prices is clearly interest although it is included in the credit price of the product.
• Getting cash for bills receivable is a real-life business need and no business can be run without this facility. If we prohibit all types of interest, how do we arrange the discounting of bills receivable?
• How do we deal with inflation which is eroding the value of money on a daily basis? If we disallow interest on deposits, how do we protect depositors from inflation?
• The orthodox school does not have a solution for helping the vulnerable segments of society like widows and orphans who may not be in a position to carry out any business with their money, if they have it. How can we ensure that they do not expend all their principal sums and become destitute?
• The orthodox school cannot find a solution to housing finance. How can we ensure that a person who requires funds to build a house gets the funds without interest? Schemes such as rent-sharing are only bad ruses to conceal interest; are they more exploitative and more risky for buyers of houses than the conventional finance?
• How can we ensure that the microfinance required by poor people comes without a cost? The present day cost of microfinance ranges from 20-100 percent (the cost of Grameen Bank funds, the star of microfinance, is 86 percent). How should we handle that?
• How can we develop a capital market for interbank financing deals for short periods like a day or so, if there is no interest to calculate the return on funds?
• How should we appraise projects in the absence of discounted cash flow analysis that applies the cost-benefit technique for appraisal?
• The orthodox school has not been able to find a viable and equally efficient and economical alternative to the conventional credit card facility.

These and several other questions remain unanswered. In their enthusiasm to implement the orthodox interpretation, a global movement of Islamic finance has developed. It is now 30 years old and has a volume of over a trillion dollars in terms of assets. The IFIs are growing at a rate of about 15 percent per annum. The orthodox school takes a lot of pride in this development. But what are the facts?
Have IFIs achieved their avowed objectives?
The IFIs started with an avowed objective of providing a different type of banking which should be more benevolent, egalitarian and just. But actually, the IFIs are now competing with each other to prove that they are the closest to CFIs in business terms. They have devised scores of ruses to hide interest behind Arabic terms. I have devoted over 40 pages in my book “What is wrong with Islamic economics?” (Edward Elgar, 2013) to listing these ruses. However, I must say, this chapter can never be complete as new ruses are being devised on a daily basis.
In terms of efficiency, several studies have shown that IFIs are equally or less efficient when compared with CFIs. Besides, they are more expensive and more risky. The question is: if IFIs had to do what CFIs are already doing – and furthermore to do it in a more expensive, more risky and less efficient manner – where was the need to establish these institutions in the first place? The other question is that if the orthodox interpretation of riba is correct then the alternative to conventional banking should be more benevolent, more just and more poor-friendly. There are no statistics to prove that. Finally, the IFIs should be able to demonstrate that they have achieved the objectives of the Islamic faith (maqasid al-shari’ah) more efficiently and effectively and that the CFIs were failing to achieve those objectives conclusively. In the absence of any such evidence, the mere establishment of IFIs may be a good business for bankers, but it is of less benefit to the common man.

Muhammad Akram Khan (b.1945) is a professional auditor and served in senior positions in the Department of Auditor General of Pakistan and Office of Internal Oversight Services, UN. He has a life-time hobby of writing and research in Islamic economics and finance. He has written several books on the subject including What is wrong with Islamic economics?, A glossary of Islamic economics and finance, a 4-volume Annotated bibliography of Islamic economics and finance, Economic teachings of Prophet Muhammad, An introduction to Islamic economics, and Islamic banking in Pakistan. He has published over 40 research papers and about 100 book reviews on the subject.