Interest And Islamic Banking

Article by Mr Saleh Majid (Advocate (Iraq), Rechtsbeistand (Germany) for business laws of Arab countries, B.A.Law (Baghdad), Dip.Air Law, Postgrad Dip.Law (London), M.C.I. Arb.and

Mr Faris Lenzen, LLM(London), Attorney at Law.

In this article we shall attempt to outline the definition of interest, so called (Riba) under the Sharia or Islamic law, followed by a short survey of the laws of some Arab countries which have prohibited or permitted charging interest. This article is supplementary to a previous article by the authors, entitled: Application of Islamic Law in the Middle East, and would be better understood if read together.

Regulation and prohibition of charging interests are as old as making laws in the human history. Babylon Code of law in 1750 B.C. laid down a number of restrictions and ceilings on the amount of interests.1

Christianity and Judaism have also restricted or prohibited charging interest. That the practice has been different is another question.

Under Islamic Law, charging interest or Riba is forbidden by verses of the holy Koran, and the "Hadith". But the uncertainty and the difficulty lie in the lack of a precise definition of Riba and the types of Riba. This difficulty is further deepened because of the many different opinions between the various schools of Islam.

Sources of Prohibition of Interest

The prohibition of Riba or interest in the Koran came gradual and in stages, starting with discouragement and condemnation of Riba by the Koran to the final prohibition as laid down in the following verse of the Quran:

"Allah permitted the sale and forbade Riba" (Verse 275, Surah Al Baqarah)

The Hadith of the Prophet went further that: "Every loan which attracts benefit is Riba".

The benefit which renders the transaction prohibited may be a sum of money, or any goods of a value.2

Thus, the prohibition has a far wider meaning and application than prohibition of charging interest on loans. It is a prohibition of usury and any unearned accretion on the capital or the principal, whether it is in the form of interest or any benefit.

Definition of Interest

Riba may be defined as: "monetary advantage without counter value, an advantage which is stipulated in favour of one of the parties in exchange of two monetary values".3 It may also be defined as: "any unjustified increase of capital for which no compensation is given".

The Economic Foundation

The basic concept of Islam is that wealth should not be hoarded or wasted, it should be put to productive use so that the owner, the society and the less privileged may share the benefits. It follows that it is not permissible to leave money idle and charge interest or profit from the mere use of the money by another party without regard to risks, or profits, that may generate. Usurers only seek profit, or interest without risks. This is contrary to the foundation of Islamic economy which is based on equity and equilibrium.

From the aforesaid concept stems the principle of profit and risk sharing between the owner of the capital and the other party, i.e. the borrower. Thus, in contrast to the conventional banking, the capital owner cannot claim both a fixed interest as well as the guarantee of the return of his capital.4

Also, Sharia does not consider money as such a commodity, but as a means of payment and as a neutral measure of valuation rather than a commodity by itself

Nevertheless, the owner of the capital may receive compensation on the basis of sharing profits and risks. The prohibition of trading with money plus interest aims at ensuring that money remains a stable value. 5

The aforementioned concepts also signify the basis of economic philosophy and Islamic banking. This underlines the difference between Western and Islamic Banking Systems, as we shall see later. In Islamic economy and banking, both profit taking and risks sharing goes together.

Based on the above, Sharia prohibited usury, as well as transactions having unusual uncertainty and unknown perils called "Gharar", such as gambling, because such transactions run contrary to the principle of balanced relationship or equivalence.

Though, Sharia recognises the sanctity of the contract, the prohibition of usury and contracts of "Gharar" together with some other principles of Sharia (such as unjustified enrichment) have created restrictions on the freedom of contracting, which Islamic banking must observe in any banking transaction.

Usury in Debts

There are several types of usury, some of which are no longer in use.6

Usury in debts or in loans, also called "Riba al-nasia", is the most relevant type of usury practised today. It is a loan or exchange of goods with a condition that the borrower repays the goods or the loan later in addition to an increase in value. Thus, there are two main elements at least:

Repayment at a future date

And an increase on the principal given by the creditor.

Repayment of the principal may be:

Of the same kind whether they are measured or weighed or not, such as selling one ton of wheat for two tons of wheat delivered later, or such as lending 100 for 120 to be paid later, or

of a different kind if measured or weighed, such as selling one ton of wheat for 2 tons of rice later, or selling one ton of wheat of a value of 10 for 20 paid later.

Prior to Islam, usury in debt was a common practice whereby the creditor provided the borrower money or goods and received from the debtor interest or increase periodically, and the principal or the loan was to be returned in full at a future date, a practice called "Ribal al Jahiliya."7

In short, usury in debt, i.e. an exchange of goods whether of the same kinds or not for a delayed repayment with an increase, is prohibited by Sharia according to the verses of Quran and the Hadith. This includes interest charging on loans in today banking transactions. Every loan containing a provision for an increase above the capital is forbidden under Sharia.

It is worthwhile to note that though it is forbidden to agree on an increase in price or value because of delay in repayment, Sharia allows an agreement to sell goods on deferred payment for a price which is higher than the price of the same sale in cash. In this case, and contrary to the ordinary loan agreement, both parties are exposed to certain risks: the seller agrees on a fixed price to be received at a future date, thus accepting the risk if the market price increases at the date of payment. At thesame time, the buyer accepts the immediate transfer of the property of the goods sold, thus assuming all the risks attached to such a transfer of property.

Also, in a contract of sale, deferred delivery of goods or forward purchase, the so called "Sale of Salam", is permitted for a lower price if the goods are specified, as an exception to the prohibition of the rules of Gharar. 8

As to the effect of interest provision on the contract, there exist different views. For instance, Hanafi School considers the provision concerning interest null and void, but the remaining contract as valid. Hanbali School considers a loan agreement with interest ipso facto as null and void.

Below is a short survey of the provisions of some of the civil and commercial Arab Codes dealing with interest followed by certain court decisions.

Interest under Arab Civil and Commercial Codes

The question as to whether charging interest is permissible or illegal has been dealt with by the Arab Civil Codes and Commercial Codes in different manners. It has also been subject to many court decisions in most of the Arab countries. But the outcome has been nearly always in favour of allowing the Western system of interest taking to continue. This...