Mullahs, Money And Interest: Islamic Clerics Stand On Significant Issues Concerning Islamic Finance

By Moin Qazi, New Age Islam

6 September 2023

One of the most contentious issues that have vexed the minds of Muslims is the concept of Interest in the modern-day economy. The Islamic clerics (ulema) have exhibited an ambivalent stand on significant issues concerning Islamic finance and, on most occasions, preferred to deflect questions relating to it diplomatically.  Islamic finance is one of the greyest areas of both Islamic scholarship and practice and has attracted a very small pool of talented researchers.  This is mainly because of the misplaced notions that discussions on Islamic finance are fraught with serious consequences and implications. People believe there are strong possibilities of one getting trapped in the act of heresy.

Islamic finance extends beyond its well-known characteristics: interest-free banking and the prohibition of investment in items or activities deemed un-Islamic, such as prostitution, gambling, pornography,   and alcohol. In contrast to conventional loans, Islamic bank loans are confined to financing the purchase of physical assets, to which they have recourse in case of default.

Creditors and debtors alike must share business risk, Islamic finance prohibits speculation ( and similarly prohibits trades that are considered to have excessive risk due to uncertainty, such as naked short-selling, where there is uncertainty involved in the future delivery of the underlying asset.   Islamic finance also prohibits speculation that property prices will forever continue to rise, as well as bailouts, since they are only loss and not profit sharing for governments. 

Islamic banks essentially mimic conventional commercial banks through profit- and loss-sharing contracts. The bank will buy goods on behalf of the borrower and then sell them on a deferred basis at a mark-up. The profit-sharing principle prevents Islamic banks from outsourcing debt origination to brokers who would have no incentive to perform thorough due diligence on prospective debtors.

The Muslim economic life, along with their political and social norms, is regulated by a code known as Sharī’ah (literally, "the path leading to the watering place"). It is a body of Qur'an-based guidance that governs, among other things, a Muslim's economic and social life, dictating how believers should conduct themselves.  

What Is Different About Islamic Banking?

•        Islamic banking operates under Shariah, the Islamic legal system that forbids transactions involving usury, or charging of interest as it is considered an unjust exchange.

•        Whereas conventional finance is debt-based and the client bears all the risk and liability in transactions, Islamic banking is asset-based, with profit and risks shared between the financial institution and the client as part of a partnership.

•        No bank can benefit from the client’s financial problems and insolvency that often happens in conventional finance,” Madina Kalimullina, the executive secretary of the Russian Association of Experts in Islamic Finance, told Al Jazeera.

•        Islamic finance promotes partnership-based relations, which is rarely the case in conventional finance

Islamic banking also does not finance sectors harmful to society such as alcohol, tobacco and gambling. Another key difference is that Islamic banking does not allow financing speculation, financial derivatives, or “deals with no real asset .

Islamic finance has emerged as an effective tool for financing development worldwide, including in non-Muslim countries. Major financial markets are discovering extraordinary evidence of Islamic finance having been already mainstreamed within the global financial system.

Islamic finance caught up fast, even in the Western world. Even though it is originally an eastern concept. Most Western financial institutions have their own Islamic subsidiaries or, at the very least, Islamic "windows" or products aimed at their clientele. As proof of how many companies are compatible with Islamic law, there is now even a Dow Jones Islamic market index.

In recent decades an array of clerics, bankers, and legal experts has used scholarship, enterprise and ingenuity to reconcile the core principles of Islam with conventional finance so that Muslims can enjoy access to the same services and products as the rest of the world. The immediate trigger was the resilience of the nascent Islamic finance industry, which successfully weathered the storm that imploded the Western world's financial system. But even though these banks are prospering, there are continued tirades of criticism and accusations of violation of the fundamental tenets of Islamic laws

As opposed to conventional banking, depositors to Islamic banks are entitled to be informed about what the bank does with their money and to have a say in where their money should be invested. Another difference is that Islamic banks avoid Interest at all levels of financial transactions and promote risk-sharing between the lender and borrower.

In the case of profit, both the Islamic bank and its customers share it in a pre-agreed proportion. In the case of loss, all financial loss is borne by the lender. In addition, Islamic banks can't create debt without goods and services to back it (such as physical assets, including machinery, equipment, and inventory).

A careful reading of the Qur'an leaves no doubt that Riba (any addition or Interest) is prohibited. The Torah and the Bible also took the same position. In contrast, the early Christian church prohibited charging high-interest rates to lend money-Western theologians eventually distinguished Interest from usury and reintroduced it during the Renaissance.

Often interpreted as a prohibition against Interest, Riba is more broadly defined as a prohibition against unjust enrichment or advantage gained by a lender without taking a risk. For example, in conventional financing, a borrower must pay Interest to the lender on the loan even if the borrower's business is unsuccessful. This structure does not comply with sharia because the lender did not exert to earn the additional funds and is not sharing in the business risks. Riba does not prohibit parties from making a return on their investments, but this return must be based on the business's profitability. Riba also prohibits transactions with guaranteed returns. According to the Qur'an, 'The world can survive with justice and unbelief, but not injustice and belief.' As a result, the Islamic system emphasizes ethical and equitable modes of financing. Wealth creation is encouraged, but 'super-normal' profits are not.

In Islamic economic theory, money is merely a medium of exchange, not a commodity to be traded. It has no intrinsic value and should not grow over time. Idle cash cannot be a source of guaranteed income. Money cannot grow by itself. It has to be used entrepreneurially to enhance the economy's health and individual well-being. Islamic finance uses a risk-sharing equity model based on physical assets- an honest exchange of goods or services. , instead of traditional accounts with given interest rates, Islamic banks offer profit/loss accounts. The bank in turn, purchases assets with the customer's money, which generate returns for the bank that are ultimately shared with the customer.

Islam regards Interest, in whatever form - disguised as "commission," a fixed or variable add-on or a discount-- as usury and speculation as gambling. In addition to the prohibition of Riba, several other essential provisions govern financial transactions. These include the ban of 'Gharar' (uncertainty or asymmetrical information), 'Maysir' (gambling, speculation),  activities and transactions involving alcohol and pork-related products, armaments, gambling, pornography and other activities deemed socially detrimental, like hoarding. The main principles guiding Islamic banks are justice, partnership, and opposition to excessive risk.

There is a glaring gap between the idealized version of Islamic finance that the Qur'an points towards – and its proponents like to wax lyrical about – and the grubbier reality of the modern Islamic finance industry, riddled with messy, imperfect compromises. Cynics conclude that in many respects, Islamic finance looks and acts exactly like its conventional counterpart, albeit with creative financial engineering to give the products a pious dress. Although the accepted position in Islamic countries is very clear there are still several strands of conflict on the position in secular countries, particularly those which have seen a series of failures of Islamic financial institutions. In these countries, there is still no unanimity on the meaning of the term Riba. Some prefer to translate it as Interest.  Others believe that accepting the term as the modern equivalent of Riba, particularly because modern finance has been cleansed of the element of usury and its coercive character, would amount to a very superficial interpretation of a term with multiple layers that colour it. According to this school, Riba has a sinister connotation and is meant to construe the coercive informal finance practices followed and pursued by rapacious moneylenders.

One unique feature of public banks in India is that they offer soft and subsidized loans to the poor, self-employed and farmers. Similarly, in case of defaulters, if a bank is convinced that the default is not wilful and deliberate and is on account of genuine circumstances, the loan is restructured or waived and the banks absorb the loss. Every year, thousands of crores of rupees are being written off by banks. Where recoveries have to be enforced, it is done in a dignified manner and after following proper legal procedures. Similarly, the operations of banks are monitored very stringently by the Reserve Bank of India and the Interest of depositors, particularly the small depositors, are well protected. In short, banks in India are playing a developmental role besides providing banking services. Instead of demonizing banks without any evidence, the Shariah experts should build awareness of the status of public banks in India

 One serious complaint against the prevalent Islamic banking model is that Interest is being charged in the garb of the service fee. In fact loans from Islamic banks are much costlier than those from conventional financial institutions, particularly public banks. The defenders of traditional banking, particularly the model followed by public and development banks, argue that they are far different from money lending and various unethical practices of private sharks.

One issue that must engage us is if Islamic banking is a viable alternative for us. How can we justify the collapse of so many Islamic financial institutions in India in recent times? We know full well that small investors have been duped in the past in a big way by hustlers claiming to offer Islamic financial services. The protagonists of Islamic banking must provide a satisfactory explanation. Fairness, transparency, justice and certainty are the backbone of a Shari'a centric finance. But are directors of Islamic financial institutions serious about this? Are they the people who actively seek to pursue these onerous principles?

Sadly, there is a huge disconnect between the ethics and principles of Islamic finance and the actual practices of Islamic finance institutions. The loss of credibility that Islamic finance suffered in recent times in South Asia points to a distinct lack of passion from the Islamic bankers for the fundamental ethical principles of their profession, for the Maqasid al Shari'a, the objectives of Shari'a.

The situation in India is much different. We do not live in an Islamic state. The spate of failures of Islamic banks in India has caused untold suffering to small depositors. There is no alternative except to transact with conventional banks. There are few reliable and authentic Islamic financial institutions, but they have minimal outreach. Moreover, the common Muslims themselves are    increasingly wary of Islamic banking for all kinds of reasons,

Modern-day banking has emerged from the wisdom gleaned over the ages. It is a blunt weapon for eradicating usurious and unscrupulous moneylenders who have turned borrowers into enslaved people and stripped them of all their self-dignity. It will be grossly unfair to equate modern banking with money lending. Money lenders are treated as outcasts in the formal financial system. They have no presence in the universe of civilized finance .it will be foolish if we try to get them into the debate. They are an alien species.

Development banking is very professionally operated, and in developing economies, interest rates are subsidized to enable individuals and institutions to set up their own livelihood businesses. The giant leaps in all spheres of life have been powered by financial institutions that have promoted healthcare, education, entrepreneurship, self-employment and a host of services that have profoundly influenced human life.

The great philosopher-poet Sir Muhammad Iqbal argues in his magnum opus, The Reconstruction of Religious Thought in Islam: "The claim of the present generation of Muslim liberals to re-interpret the foundational legal principles in the light of their own experience and altered conditions of modern life is, in my opinion, perfectly justified…..Each generation, guided but unhampered by the work of its predecessors, should be permitted to solve its own problems."

Several Muslim scholars question how "Islamic" this approach is and whether it is an appropriate ethical alternative to mainstream investments. Or is it a creative way of transplanting conventional finance using Islamic names for normal products and services? Or by tweaking the rules and other broad principles so they don't appear to hurt the core Islamic tenets. There is increasing evidence that rigorous scrutiny of many; Islamic financial products would show stark deficiencies.

Many banks have shown that, with some creative finesse, a surprising number of Western financial products can be executed along the lines of Islamic law. But there is plenty of evidence in the criticism against western banks for using means that don't answer the questions that most clerics raise. The vast majority of clients who are not eligible for services from mainstream financial institutions but enrol with Islamic banks are depriving them of all types of banking services in the market because they feel the clerics is not endorsing these institutions.

Indeed, one of the most contentious issues that have vexed the minds of Muslims is the concept of Interest. It still poses a big dilemma for moderate and liberal Muslims who are keen to become part of the modern-day economy but are still not entirely convinced of what the divine laws say about the current choices. Many f these individuals are opening are non -Interest accounts with regular banks because the safety of funds is guaranteed here. They don't mind the loss of Interest credited to the bank's profits. Some wiser and good-intentioned Muslims engage with ordinary banks but donate the Interest earned to charities.

The Islamic clerics (ulema) have exhibited an ambivalent stand and have preferred to deflect questions relating to it intelligently. Not all Muslims are silent about it. Some of them are highly outrageous in the matter of Interest. Others feel that we need not be rigid about it because an emerging economic ecosystem keenly focuses on inclusive development.

Despite growing scholarship in Islamic finance, this field remains one of the greyest areas in both Islamic scholarship and practice. It has attracted a tiny pool of researchers because the contours of Islamic finance are still quite hazy. There are so many misplaced notions, which is why discussions on Islamic finance are fraught with serious moral implications for one's faith. There are also strong apprehensions of one getting trapped in acts of heresy.

The Muslim economic life, along with its political and social norms, is regulated by a code known as Sharī’ah, literally (the path leading to the watering place). It is a body of Qur'an-based guidance that governs, among other things, a Muslim's economic and social life, dictating how believers should conduct themselves. Although it is a huge corpus, very little of the wisdom in this religious code has been channelled into evolving laws on Islamic finance.

The principles of Islamic finance are universal: you cannot make money off money. No one can charge or pay Interest or invest in items Islam forbids, such as alcohol and gambling.

As opposed to conventional banking, depositors in Islamic banks eschew Interest at all levels of financial transactions and participate in risk-sharing between the lender and borrower. 

Islamic banks are typically funded by current accounts, which do not receive Interest, and profit-sharing investment accounts, on which investors receive a return determined by the eventual profitability of the bank or the pool of assets financed by these accounts.  Central to Islamic finance is the fact that money itself has no intrinsic value; it is simply a medium of exchange

Cynics conclude that in many respects, Islamic finance looks and acts exactly like its conventional counterpart but disguises its operation with creative financial engineering to give the products a pious dress. 

Islamic finance attracts mostly those clients driven by spiritual imperative; others who prefer better usually compromise on the terms, replacing the fear of God with the fear of exposure and retribution on earth. The returns in Islamic banks are meagre and most of those investing in these banks are highly pious people with a powerful conscience and faith. But some have no idea that there are alternatives that can improve their investment yield. Most of those investors who are averse to banking with Islamic banks are primarily on account of this reason.

Countries with large Muslim populations have still not been enthused by Islamic finance because of low returns. The most significant disincentive for big businesses is that in Islamic finance, they have to eschew higher returns (foregoing Interest on deposits for example) for religious reasons.

In several developing countries, particularly Bangladesh, banking has played a pivotal role in eliminating poverty and uplifting the lives of impoverished populations. However, in several   of these economies, there is still no unanimity on the correct meaning of the term "Riba." Some prefer to translate it as Interest. Others believe that accepting the term as the modern equivalent of Riba, particularly because modern finance has been cleansed of the element of usury and its coercive character, would amount to a very superficial interpretation of a term with multiple layers and colours.

According to this school, Riba has a sinister connotation and operates with coercive informal practices followed by rapacious moneylenders. Riba is more broadly defined as a prohibition against unjust enrichment or advantage gained by a lender without taking the risk. For example, in conventional financing, a borrower must pay Interest to the lender on the loan even if the borrower's business is unsuccessful. This structure does not comply with sharia because the lender did not exert to earn the additional funds and is not sharing risks.

Riba does not prohibit parties from earning a return on their investments, but this return must be based on the business's profitability. Riba also prohibits transactions with guaranteed returns. According to the Qur'an, "The world can survive with justice and unbelief, but not injustice and belief." As a result, the Islamic system emphasizes ethical and equitable modes of financing. Wealth creation is encouraged, but 'super-normal' profits are not.

In Islamic economic theory, money is merely a medium of exchange, not a commodity to be traded. It has no intrinsic value and should not grow over time. Idle cash cannot be a source of guaranteed income. Money has to be invested entrepreneurially to enhance the economy's health and individual well-being.

The proponents of Bangladesh and India's women's self-help groups that use the same social concept of Islamic financial services are similar to any other type of socially responsible or ethical investing. In this case, they tend to fulfil three criteria: no explicit interest; transactions can't be in areas such as gambling, pork, or pornography; and they can't be deemed to carry high risk. Islam also emphasizes that business ventures must be carried out in the true Islamic ethos of honesty, piety, and trust. The basic instruments of Islamic finance include profit-sharing (Mudaraba), cost-plus financing (Murabaha), partnership (Musharaka) leasing (Ijara), and forward sale (Bay'salam). These constitute the basic building blocks for developing a wide array of more complex financial instruments.

One unique feature of public banks in India is that they offer appropriate loan products that are affordable to the poor, self-employed, and farmers. Similarly, in the case of defaulters, if a default is not wilful and deliberate, is on account of genuine circumstances, and is eligible for restructuring of the loan terms restructured or waived, the banks absorb the loss or partial loss of Interest on the defaulted amount. Financial services must be tailored to the needs of such marginalized families.

A serious objection against the prevalent model of Islamic banking is that several finance providers, in the guise of a service fee, are charging Interest. In normal cases also, loans from Islamic banks are much costlier than those from conventional financial institutions, particularly public banks. 

One issue that needs serious introspection by the entire Muslim community is that if we believe the Islamic banks find several impediments in non-Muslim countries,   how can we justify the collapse of so many Islamic financial institutions in India in recent times? We know full well that petty investors have been duped in the past in a big way by hustlers claiming to offer Islamic financial services. The money these people lost was hard-earned precious life savings. The protagonists of Islamic banking must provide a satisfactory explanation. They need to be more robust in monitoring and supervision.

This is possible when we hope to inject a universal or religious morality into the marketplace. An Arabic saying states that "some people feel no shame, only fear," a somewhat more concise way of echoing Hobbes' assertion that the social contract is forged because of people's fear and is enforced by fear. In the absence of a religious motivation to act responsibly as a client or a money manager and a sound conscience that is not susceptible to worldly temptations, strong regulation presents itself as the only possible deterrent.

Sadly, there is a vast disconnect between the ethics and principles of Islamic finance and the actual practices of Islamic finance institutions. The loss of credibility that Islamic finance suffered in recent times in parts of  Asia points to a glaring ethics deficit in such bankers. In many cases, there was a total breakdown of the system with weak adherence to fundamental ethical principles by promoters who picked up lavish bonuses and financed their political buddies.

Many pragmatic Muslim bankers and financiers have argued that the Islamic injunction is explicitly aimed against usury rather than Interest. They say Prophet Muhammad opposed the loan-sharking techniques employed by money changers in the lawless markets of Mecca before the establishment of Islam. The liberalists say there is nothing wrong with charging a reasonable price for using funds for a while. They argue that the Qur'anic prohibition applies to overcharging and usury, not money-market funds or interbank lending rates.

Development banking is very professionally operated, and in developing economies, interest rates are subsidized to enable individuals and institutions to set up their livelihood businesses. The giant leaps in all spheres of life have been powered by financial institutions that have promoted healthcare, education, entrepreneurship, self-employment, and a host of services that have profoundly influenced human life.

If puritans felt conventional banks couldn't fulfil the religious requirements, a choice had to be offered to common Muslims. This will require deep introspection among all stakeholders and ways of ensuring that we learn from the failures of the past. It will also need a conscientious understanding that finance is only one aspect of Islamic banking but the other more important aspect is ethics. All the stakeholders: the flag bearers of sharia, proponents of Islamic finance, academics, jurists, and the global banking community, will have to acknowledge that mere debates, slogans and pledges won't work. Islamic finance strongly needs not money but morality among the staff and clients. It is an issue that concerns the financial well-being of a large population.

 Islamic finance is not necessarily an end in itself, but it does serve to remind me of the need for humane banking, the elimination of moral hazard, and the reassessment of assumptions that speculators and derivatives add more value than they destroy.  

But are the ideals of Islamic finance reflected in the industry? The ground reality of Islamic finance remains disturbing. Most big defaulters are well-connected tycoons and have the money to employ legal eagles who can play the judicial system—the law flounders are here. India has some of the most draconian laws in books; they are ineffective against powerful dodgers. Why should ordinary people bear the burden of fat cats? These freeloaders are remorselessly winnowing scarce bank capital. The government has to dress up the banks' balance sheets to make them appear healthy so they can lend again. Ironically, instead of being chastised, the wayward borrowers are lauded as captains of the industry. It makes no sense for us to discuss financial discipline when we are far away from times when these sharks ruled the world.

Yet not everything is bleak for Muslims. Several noble and good-intentioned Muslim leaders are opening small ff cooperatives, which are run broadly on an Islamic line and are trying to infuse moral ethics rather than financial knowledge, emphasizing that the money they take from the bank is somebody else's deposit. Once it comes back, it has to be recycled for another need Muslim for small business. It combines financial and moral literacy.

But since these o-operatives are governed mainly by a government that normally has little idea of financial governance. We will have to devise ways of insulating these small institutions from political influences. The stark reality is that politicians promote most such c-operates. Islamic economics and, concomitantly, all concepts and business ideas growing out of its seeds and roots have not been able to come close to even guesswork of a system that has the potential for success. The ideas being cycled into Islamic financial activities do not warrant serious scrutiny. The Islamic economic activity approach must be firmly grounded in ethics and morality. Indeed the time has come to emphasize broader ethical principles over adherence to arcane contractual mechanisms.

 Aside from the absence of interest rates, the critical concept of Islamic finance is risk sharing between parties in all operations. Here are some of the vital sharia-compliant products offered by banks — they have Arabic names, but in most cases, we can find an equivalent in conventional Western banking. 

Murabaha or cost plus selling: This is the most common product in asset portfolios and applies only to commodity purchases. Instead of taking out an interest loan to buy something, the customer asks the bank to purchase an item and sell it to them at a higher price in instalments. The bank's profit is determined beforehand and the selling price cannot be increased once the contract is signed. In case of late or default payment, different options include a third-party guarantee, collateral guarantees on the client's belongings or a penalty fee to be paid to an Islamic charity since it can't enter the bank's revenues.

Ijara or leasing: Instead of issuing a loan for a customer to buy a product like a car, the bank buys the product and then leases it to the customer. The customer acquires the item at the end of the lease contract.

Mudarabah or profit share: An investment in which the bank provides 100% of the capital intended to create a business. The bank owns the commercial entity and the customer includes management and labour. They then share the profits according to a pre-established ratio that is usually close to 50/50. If the business fails, the bank bears all the financial losses unless it is proven that it was the customer's fault.

Musharakah or joint venture: An investment involving two or more partners in which each partner brings in capital and management in exchange for a proportional share of the profits.

Takaful or insurance: Sharia-compliant insurance companies offer products comparable to conventional insurance companies and functions like a mutual fund. Instead of paying premiums, participants pool money together and agree to redistribute it to members in need according to pre-established contracts. A fund manager runs the common pool of money. The fund can be run in different ways regarding the surplus distribution and the fund manager's compensation.

There are three big models:

•        The Wakala - where the fund manager receives a fee and the surplus remains the property of the participants.

•        The Mudarabah - is adapted from the banking system, where profits and losses are shared between the fund manager and the participants.

•        The hybrid model - A mix of Mudarabah and Walkala.

•        Sometimes, the fund manager creates a Waqf, or a charity fund.

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Moin Qazi is the author of the bestselling book, Village Diary of a Heretic Banker. He has worked in the development finance sector for almost four decades.

 

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