Thoughts from Iraj Toutounchian’s Islamic Money & Banking: Integrating Money in Capital Theory
In examining the scope of interest on money, we adhere to the valuable Judgment on Interest produced by the Pakistan Federal Shari’ah Court in 1995. Unless otherwise specified, all the following assertions are adopted directly from this valuable work.
The definition of Riba as:
The excess amount chargeable over and above principal in lieu of time and by way of a condition. The definition is applicable both to contemporary simple and compound interest. Excess, whether a penny worth or compounded to many fold, is Riba if the same is stipulated at the time of contract.
To resolve the misunderstanding about simple and compound interest, the assertion is:
Some scholars have misunderstood the verse “Devour not Riba, doubling and quadrupling,” interpreting thereby that the Qu’ran bans only compounded Interest but not simple interest…The verse was revealed to discard the anti-social pre-Islamic custom. That is why they are warned of their selfishness by adding the word doubled and quadrupled. This does not mean that if interest is not thus multiplied, it would become acceptable. Absolute prohibition of interest appears in the other two verses … An examination of the contemporary practices of interest would suggest that it multiplies itself firstly by becoming a part of capital for re-lending and secondly by debt servicing retaining the principal intact.
With respect to savings accounts:
Interest [that is, any nominal excess over and above the principal amount deposited and being the obligation of the bank] accruing on the Provident Fund or Saving [bank] Account comes under Riba … The Account as in vogue consists of Riba (383).
With respect to the opinion of the Fuqaha (Shari’ah Scholars in Islamic Jurisprudence):
…an excess over and above the sum lent would become interest and is treated to be strictly prohibited. This fact is born out of the Qu’ran, the Holy Prophet’s (peace of Allah be upon him) tradition and the detailed discussion by the Fuqaha of all the schools of thought without any exception.
Islamic Fiqh Academy, Jeddah, which is representative body of the Muslim world, has declared bank interest in all forms and on all accounts as Riba, prohibited in Islam.
At this point, it should be clear that a sharp distinction exists between a ‘loan’ and all other Islamic modes of contract. A loan, by definition, is a temporary abstinence from using a sum of money and is generally paid by the lender, the abstainer, to the borrower, the user of the money, for whatever purpose the borrower has borrowed and for an excess over and above the principal amount, varied on the basis of the time period of the loan. It is, further, the obligation of the borrower to pay back the principal amount of loan plus the agreed excess. The lender does not have any claim over the outcome of the use to which the borrower puts the money as long as the lender receives the principal plus the excess. The lender can obtain a warranty from the borrower to ensure both parts of this obligation are met. The excess is obviously independent of the outcome of the purpose for which the loan has been borrowed. This independence makes it realistic to consider the excess as ‘the cost’ to the borrower. Finally, in a loan contract, the legal aspect of money remains intact in that it does not have to be involved in ‘investment’ in its strict sense. It could be used in any activity – consumption, speculation, or investment. Unlike an equity fund, a loan, or debt fund, is the liability of the borrower. In the case of a Musharakah contract, for instance, the equity fund composed of each partner’s money is pooled and no one is responsible for another partner’s share. They all have inseparable responsibility to the extent of their individual share of the whole.
Riba occurs when the borrower is obliged, by whatever means, to pay back an excess, over and above the nominal principal. Such excesses are strictly forbidden in Islam. Even in Qard-ul-Hassan loans (which are generally short-term and for small amounts), the only obligation on the borrower is to repay the principal. All Islamic contracts are strictly purpose-oriented and each party to the contract must know the exact purpose and, in some cases, the period of time for which they have agreed to sign the contract. The signed contracts, with all the pre-specified conditions, make them very different and distinct from loans. The central issue in Islamic contracts lies in the fact that it is a legal device which transforms the legal nature of money to that of ‘capital.’ For reasons that will be made clear later, I prefer to use ‘asset’ rather than ‘capital’ in order to avoid any confusion and misunderstanding, and to bridge the gap that exists between the different connotations employed by economists and accountants about these two concepts. As I see it, ‘loan’ stands in the same relation to Islamic contracts as bonds do to stocks. The interest paid to bond-holders is considered as a cost to the issuer of the bond but not the dividend paid to the stock-holder by the stock-issuer. The obligation of the bond-issuer has to be clearly distinguished from that of the stock-issuer. This distinction plays a crucial role in distinguishing Islamic banking practices from those of conventional banking.
Ironically, this important point has slipped the mind of many Muslim scholars.
Conventional Banking is based on loans received from depositors and loans granted to customers. An Islamic Bank behaves, on the one hand, as the advocate of depositors and, on the other, as the partner of potential investors. When it comes to signing contracts with investors, the Islamic bank behaves as one of the partners to the contract, both on behalf of depositors and of itself. In essence, this makes Muslim depositors shareholders in the investment projects the Islamic bank signs with potential investors…
Surprisingly, for whatever reason, some Muslim scholars attempt to find ‘resemblances’ between Islamic and conventional banking (especially with US banking) despite the fundamental differences that exist between them in many aspects; philosophical foundations (world view), type of analysis, factors included or left out, and outcomes. For example, Mohsin S. Khan writes:
“It will be noted that the model here is a dynamic variant of the standard IS-LM model, and no special factors have had to be introduced up to now … In many ways … lack of understanding and confusion … exists about Islamic economics … As was shown in the paper, this model does provide a reasonable portrayal of the types of Islamic banking systems that have been put into practice in certain countries…The model that has been developed in this paper also turns out to have many similarities with standard models used to analyze the behavior of banks at an aggregate level … Indeed, it is readily apparent that the Islamic model of banking, being based on principles of equity participation, bears a striking resemblance to proposals made in the literature on the reform of the banking systems in many countries, particularly in the United States.”; (Khan and Mirakhor 1987: 15-35).
One of the main objectives of this book is to strive against biases, confusion, misunderstanding and finally misdirecting the authorities of Islamic banks. Another objective is to show, to the best of the author’s knowledge, how Islamic banking is supposed to operate given that justice will be obtained and maintained in conjunction with efficiency.
Let us return now to the judgments about Riba made by the Pakistan Federal Shari’ah Court, which points out that ‘interest’ and Islam cannot remain together in a Muslim society. Having made clear what the nature of a loan is, the Court says, ‘It may, therefore, be stated that what Riba has forbidden in the Qu’ran and Sunnah includes interest due on the loans taken or given for commercial and productive purposes by banks or other financial institutions. With reference to Dinar and Dirham it says: ‘Guided by the Hadith, the Fuqaha have pointed that in case Dirham or Dinars are lent out by counting, they will be paid back by counting not by weight. Similarly, in case these are lent out by weight, they will be returned by weight, not by counting.
On the verdict made on commodity loans, it is interesting to note the following: ‘In respect of the loan of a commodity, it is further provided by the Fuqaha that it should be returned in the same kind and quantity irrespective of any change in its price at the time of return of the loan.” It notes also, however, that ‘there is a considerable juristic opinion available to the fact that an increase to offset the inflation would have legal justification and would not be counted as Riba.
However, we need to elaborate on these last two verdicts, on several grounds:
a. The opinions expressed are not necessarily the verdict of one jurist. However, if it happened to be the one person’s verdict, they would necessarily be contradictory unless the jurist has correctly made the distinction between money and commodity.
b. It is not clear in the second of these as to whether it is applicable to a ‘loan’ or potential capital (that is, deposits) made by Muslims in an Islamic society. If it happened to be restricted to loans (that is, Qard-ul-Hassan) it would seem to be justified; but if it is not, and it refers to a truly Islamic banking system in which deposits are share-holdings in investment project undertaken through Islamic banks on behalf of depositors, it runs into a problem in that the verdict has failed to make a distinction between loan and Islamic contract. At this point, I would like to make a strong assertion that is subject to verification in theory as well as practice as follows: If Islamic banking is properly launched using Islamic contracts, then inflation, if any, is automatically taken care of. This assertion can easily be derived from the mere fact that money and Islamic banking will no longer be exogenous to the system, but endogenous. The evidence of economic history throughout the world has shown that dealing with the monetary sector independently from the real sector will necessarily make the system unstable. An important symptom of instability is inflation, or unemployment, or both simultaneously.
Let us briefly go over the part of the assertion that seems to have been ignored by jurists.
Islamic banks take part of the profits earned based on preconditions set out in the signed contract. Profits are, by definition, the difference between total revenue and total costs. Total revenue is, in return, the product of the price of the commodity sold multiplied by the quantity sold. Any probable inflation is reflected in total revenue terms. In other words, in Islamic contracts the depositors are automatically hedged against inflation as opposed to a loan, where the lender is always worried about the probable decline in the purchasing power of the principal lent out.
If the verdict refers to the decline of the purchasing power of the deposits made in an Islamic bank, it is worth the reader’s while to note the results obtained by the author’s experiments on the data of 12 highly advanced industrial countries. The results show that inflation is deeply rooted in interest-based loans and speculation (on money or any other durables), these being the principal sources of money creation. Given that the statistical results are correct and reliable, the verdict has failed to recognize the real cause of inflation; hence a different verdict is called for and soon.
To end this section, let us see what the most celebrated economist of the century, Lord Keynes, has to say about interest:
It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of interest is the reward for parting with liquidity for a specified period. (Keynes 1936: 166-7)
Though he doesn’t say so explicitly, it is clear from the fact that he includes time as one of the essential components of interest that Keynes is referring to a loan contract here. His definition substantiates ours in such a way as to prevent any misunderstanding. He further observes that ‘the rate of interest is, in itself, nothing more than the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.’ (Keynes 1936: 167)
This last statement seems to remove any possible confusion about our definition in that it contains all the elements for interest to prevail. Additionally, it substantiates our formulation for the interest rate emerging from speculation. Finally, he is quite clear on the equilibrating force behind the rate of interest: “The rate of interest is not the ‘price’ which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption.’ (Keynes 1936: 167)
Again, this statement clearly demonstrates that the rate of interest is the outcome of the money market and not that of the real sector.
Yet, strikingly, there are many writers who still believe that interest (rate) cannot be avoided as long as economic forces are in play, even in an interest-free Islamic system!