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Some Observations on the Question of RIBA and the Challenges Facing "Islamic Banking"
Ibrahim F I Shihata
Secretary General of ICSID/World Bank
[About the author: Dr. Ibrahim Shihata (1937 2001)
Born in Egypt, Dr. Shihata graduated from Cairo University Law School in 1957 and obtained a doctorate in juridical science from Harvard in 1964. After a brief spell (1964-66) on the law faculty at Cairo's Ain Shams University, Dr. Shihata took up the position of Legal Adviser and General Counsel to the Kuwait Fund for Arab Economic Development. He also served as Director-General of the OPEC Fund and, simultaneously, as a Director on the Executive Board of the fledgling International Fund for Agricultural Development (IFAD). Following his departure from the OPEC Fund in 1983, Dr. Shihata served as General Counsel for the World Bank and Secretary-General of the International Center for Settlement of Investment Disputes. For years he also directed research through his role as trustee of the Washington Institute on International and Foreign Trade Law and of the Oxford-based Center of Research on the New International Economic Order. Dr. Shihata, a poet in addition to a legal scholar, authored almost 30 books and more than 200 essays. Throughout his career, he devoted his intellect, passion and thoughtful charm in an unending effort to improve life for the worlds poor through global economic and legal development. More information on the life and works of Dr. Shihata is available at www.ibrahimshihata.com; This introduction has been taken from Washington Foreign Law Society.]
"If we interpret public interest to mean serving the purpose of the Legislator, there would be no reason to dispute its pursuit; indeed it must be followed."
Al-Ghazaly (d. 1111)
"Whoever advises people by what is inscribed in [earlier] books, regardless of their varied customs, times, places and conditions is misled and misleading."
Ibn Al-Qayyim (d. 1350)
For a long time now, I have been exposed to different aspects of the Islamic law, the civil law and the common law systems, especially with respect to economic and financial matters. This broad exposure allows me to compare the continuous advances in modern financial techniques and tools under contemporary systems with the virtual stagnation of Islamic jurisprudence in these and other fields. The stagnation of this previously rich jurisprudence came no doubt as a result of the closure of the door of ijtihād (original thinking or independent reasoning, based on detailed Islamic legal proofs) in the 13th century and the near agreement, with some noted exceptions, since that early time on the adoption of taqleed (mimicking the views of earlier scholars) as the way to develop solutions for new problems. I firmly believe, however, that, if Islamic law (Shari'ah) is to be applied at present, due attention must be paid to the need for the continuous adaptation of its jurisprudence to the necessities of development in an ever changing world. Countries applying Islamic law should not forego the benefits of developments in social sciences or the growing opportunities of an increasingly open world economy. I am also convinced that this need for continuous adaptation cannot be addressed only by traditionalist Shari'ah specialists. Despite the best intentions, those scholars are likely to rely on the safe walls of taqleed, due to their training under established schools of jurisprudence and perhaps their fear of criticism from more conservative peers in the various Islamic academies and institutes.
My intervention on a subject outside the field of my specialization, broad as the latter may be, could perhaps be excused by two factors: The deep interest I have had in Islamic jurisprudence since I studied it for four years in the mid-fifties at Cairo University, and the insistence of the Colloquium's organizers that I address "Islamic banking" in this lecture. I hope that you will tolerate the views I shall express that may be considered too innovative or blatantly wrong by those among you who are more learned than me. In this, as in other endeavors, I take the position of the early jurists of Islam who considered their respective opinions "awabun yahtamilu al-khata'," that is, correct but susceptible to error and therefore subject to correction by those who may know better.
The starting point of my analysis is that solutions developed by past scholars in the early centuries of Islam might have suited well their times or were useful for the period of the closure of ijtihād but they should no longer be the basis of contemporary Islamic jurisprudence. Instead of copying or mimicking the ways in which past scholars had addressed a certain question centuries ago, or exerting endless efforts to practically circumvent these ways, contemporary and future scholars should, in my view, feel free to develop new answers as may be needed, being limited in this respect only by the provisions and purposes of the Qu'rān and the Sunnah of the Prophet (i.e., his authenticated sayings (hadīth) and deeds, including tacit approval of practices), reliance being confined in the latter source to the undisputed Sunnah according to the "science of hadīth." Constraints in these two primary sources on the principle of freedom of contract by mutual consent (al-taradi) must always be taken as exceptions to the general rule and, therefore, be subject to strict application. The injunction in the primary sources to facilitate, rather than restrict transactions, and the jurisprudential principle of permissibility (ibāhah) in the absence of explicit prohibitions should also provide guidance in the interpretation of those constraints. Views of past scholars may always be studied for further guidance and the understanding of their thinking under the circumstances of their times, places and environments, but not as the binding law to be necessarily followed under present circumstances which bear little resemblance to the conditions that contributed to the formulation of these early views. Attempts to search for the strictest among past views or to outbid them for the sake of perceived piety, which seem to be common at present, may only be conducive to further stagnation of Islamic jurisprudence. If such views were to be applied as Islamic law under contemporary circumstances, they could also contribute to the further stagnation of the economies of Islamic countries.
Those who reject this starting point and believe that the prevailing or the strictest view in the jurisprudential school they follow constitutes Islamic law from which any deviation would be legally invalid and religiously sinful are perfectly justified in closing their minds to everything that follows in this lecture.
Meaning of RIBA as a Form of Unjust Enrichment
Al-riba, an Arabic word mentioned with increasing condemnation in four places in the Qu'rān, is contrasted in what are generally believed to be the last revealed among these verses, (those in Surat Al Baqarah) with both charity and bay' (purchase and sale or trade). While al-riba is definitely prohibited, charity is strongly encouraged, and trade is broadly permitted. Except by making this clear differentiation and the explicit reference in one verse to a specific form of riba where the lender accepts delay in payment against doubling the principal once or more times (a form practiced in Arabia before Islam and hence called the pre-Islamic riba (riba al-jahiliyyah)), the Qu'rān does not further define al-riba or its forms, perhaps leaving this matter to be developed according to the exigencies of future times. The generally undisputed sayings of the Prophet do not include a specific definition either, although they prohibit, in addition to al-riba in lending, certain forms of exchange of certain generic goods and, like the Qu'rān, urge for charity rather than lending to those in need. Some early commentators were reported to have noted the doubt surrounding the subject from its inception and some noticed that "the chapter of al-riba is among the most complex for many of the learned."
The literal meaning of the word riba in Arabic is "increase," coming from the verb raba, yarbu (to increase, grow or rise above) and is associated with such words as rabwah which means an elevated place or a hill. Its technical meaning in the context of Islamic law and, hence, its English translation in this context, varies according to the source. Contrary to common assumptions, riba could not by itself have meant interest on bank loans. Such a phenomenon did not exist at the time of the Qu'rān and the Sunnah and the Arabic word developed for it in later times is "faļda" or "'aėd," i.e. "benefit" or "return."
Riba is commonly translated as "usury," a term that implies exorbitant interest on loans in exploitation of those who need them. This is not, however, an agreed meaning in Islamic jurisprudence. Some jurists, relying mainly on a number of ahād hadīths, give riba a much broader meaning, covering any stipulated increase in income or wealth resulting from lending money or the exchange of fungible goods. This seems to be the prevalent view under the neo-conservative trend popular among many contemporary Islamic law specialists. While the four major schools of jurisprudence in Sunni Islam also took a broad view of riba, applying it both to riba al-jahiliyyah or riba al-nassi'ah (the increase of an amount as a result of a delay in its payment), and riba al-fadl (the increase resulting from the simultaneous exchange of goods of the same type and measure), they provided qualifications which somewhat limited the application of riba al fadl in practice.
Such broad views of riba were not commonly accepted, however, in earlier times and have been questioned by some modern scholars as well. A number of respected sources in early Islam, including Companions of the Prophet and their followers, defined riba narrowly in terms of the specific transactions prohibited as riba at the time of the Prophet, with some finding the doubling and redoubling of the loan principal (tad'eef) to be the precise cause ('illah, in Arabic) for the prohibition. Later on, no lesser authority than Ibn Hanbal, the founder of the Hanbali school of jurisprudence, found riba al-jahiliyyah the only form of riba that is prohibited beyond any doubt (as it is the only one mentioned in the Qu'rān and known at that time in lending transactions). Another early view restricts this narrow definition further by requiring that the increase in the principal be stipulated at the time of lending in order for it to constitute riba. Many arguments have been advanced with respect to the narrow view of the prohibited riba which seem, however, to be ignored in most contemporary writings on the subject.
Between the very broad and very narrow definitions mentioned above, a view, based on the distinction made by Ibn Al-Quayyim (d. 1350) and followed by many scholars of different schools (including Al-Tabary, Al-Shatiby, Al-Dhahery and other renowned jurists), takes the position that the "real" or "perfect" riba is riba al-jahiliyyah referred to in the Qu'rān and in the ahād hadīth "no riba except in the delay (nassi'ah)." Yet, riba al fadl is also prohibited in this view because it is covered in many other hadīths and is accepted by the near consensus of past scholars. However, in this view the latter prohibition does not have the same degree of strength, as it is not based on a definitive proof, but on analogy with the "real" riba and on the principle of prohibiting what could lead to unlawful results (sadd al dharāa'i). At least according to some of the jurists upholding this view, including Ibn Al-Quayyim, such latter prohibition may be subject to exceptions based on the needs of commercial transactions. Other jurists who adopted the above distinction described riba al-fadl as a condemned practice (makrouh), but not necessarily as legally forbidden.
A commonly used definition by scholars of Al-Azhar University in Egypt, which was made much earlier by Al-San'āny (211 A.H.) and Ibn Al-Arabi, (543 A.H.), describes al-riba as any gain (other than by way of charity) realized without a consideration or compensation ('iwad), the latter having to be legitimate under Islamic law. This includes the forms mentioned as riba in the Qu'rān and the undisputed Sunnah and other forms that may be defined by the legislator or the judge applying Islamic law under current circumstances. Under this latter definition, riba represents one aspect of unjust enrichment, the prohibition of which finds varied applications in many legal systems and is included under Islamic law's broader Qu'rānic prohibition of the wrongful taking of other peoples' property (aklu amwali al-nassi bil-batel).
Those currently involved in "Islamic banking" equate the term riba with interest on loans or deposits and consider the prohibition of interest (as riba) the basis of "Islamic banking," if not of "Islamic economics." Modern Islamic theorists emphasize that the "Islamic economic system" is based on the sharing of profits and losses among parties to any commercial transaction and consequently prohibits any pre-determined return on any type of investment, including lending operations. To some of them, this is the pillar of Islamic finance that differentiates it from other economic systems. Unlike capitalism, which is also based on the principle of the freedom of contract, the Islamic economy in their view does not allow the exploitation of the needy, the rewarding of the lazy or the unfair distribution of wealth; such vices being attributed to the delinking of economic gains from risk-taking. The prohibition of pre-fixed interest on borrowed money is seen by them to ensure such a linkage. Profit sharing which "gravitates to the active entrepreneur who assumes risk and adds value" thus "provides the distinction between the Islamic and capitalist economic systems." It is interesting to note, however, that the invalidity of unjust enrichment is a general principle readily accepted in many legal systems, including those applicable in capitalist economies. The matter depends on the meaning of such enrichment and the extent to which the cost of time and the risks associated with it constitute an adequate consideration. As will be shown, the broad theorization, based on the erroneous assumption that prefixed interest frees the transaction from any risk, may be based on a misconception that hardly has a basis in early jurisprudential Islamic writings. In this context, these writings recognize only as a general principle of jurisprudence the principle that gains accompany liability for loss (al-ghunm bil ghurm) and its application to specific assets (al-kharaj bil daman). Such theorization notwithstanding, the practice of private "Islamic banks" on the whole is known to have concentrated so far on the least risky operations of credit sale and leasing.
There are other contemporary commentators who simply exclude from the scope of riba all transactions in paper money which no longer has a gold content (as is the case of all paper currencies at present). Their main argument is that repayment of loans (or payment of a deferred price) denominated in currencies made of metals other than gold and silver, i.e., in "fiat money" without intrinsic value of its own, had been based on the real value of such currencies (in terms of gold or silver) in the practice of Islamic societies through the ages. Even payment in gold or silver coins was, according to them, subject to their equivalence in weight, and not merely their numerical equivalence.
Other contemporaries argue that the prohibition of riba was introduced at a time when the monetary value of time was not adequately recognized, when long term investments were an unknown phenomenon and when money was deemed incapable of producing more money through productive investment. The subsequent creation of paper money with its depreciating tendencies and modern banking systems with their risk management techniques and deposit insurance mechanisms were also unheard of at the time the prohibition was introduced. In the view of those commentators, therefore, the prohibition of riba should be drastically limited to obvious cases of usury, not only in recognition of these important developments but also as a necessity for integration in the world economy.
The meaning of riba and its implications may vary, however, according to whether we are dealing with the exchange of goods or lending operations.
RIBA in the Exchange of Goods
Contrary to popular views, traditional Islamic jurisprudence does recognize the value of time in many forms of contracts. Both the sale of specific goods against credit and the advance sale, with immediate receipt of payment, of generic goods to be delivered on a specified future date are recognized as legitimate forms of contract by all major schools of Islamic jurisprudence. The former type of transaction, known as bay'al nassļah or bay' mu'ajjal (delivered specific goods against future payment) may and usually does involve the payment of a price in excess of the present value of the goods involved. The latter type, known as bay' al-salam (forward purchase of generically described future products, with advance payment) usually involves a lower price than that of the same goods delivered at the time of payment. At least according to one major school (the Hanafi), the commissioned manufacture of specific goods to be paid for when delivered (istina' contract) is also legitimate at the price agreed to by the parties, even if it exceeds (as it usually does) the price of already manufactured goods of identical specifications. Not surprisingly, the price in this contract of istina' would be higher than in a contract where the price is prepaid and the buyer is obligated to take the manufactured goods if they meet the agreed specifications, which is a form of contract recognized by another major school (the Hanbali) as "bay' al-mawuf fil-dhemma."
Credit sale contracts of the murabahah type allow an "Islamic bank" (or another investor) to buy goods, then sell them to a client, with a markup that includes the cost of the bank's service which typically covers the cost of deferred payment under the "interest free" credit provided by the bank to the buyer. The buyer in such a transaction may, according to some past scholars, prepay the price at a discount agreed with the seller (the bank), in recognition of the opportunity cost for the former's early payment. This "opportunity rate of capital" is, almost without controversy, legitimately, though tacitly, factored in the cost of leasing contracts, known as ijara, as an offset for the profit forsaken by the lessor who no longer retains the leased goods. This is particularly the case in leases with deferred payment (ijara bil idafa).
In 'arbun (down payment) contracts, legitimate under the Hanbali school and in the practice of "Islamic banks," the buyer makes an immediate partial payment for a specific asset and agrees either to pay the balance of the price at a specific future date or to forfeit the down payment. Here again, the seller keeps this amount when the contract is cancelled as an offset for the opportunity cost of having to hold the asset in its inventory during the agreed period.
Prepayment of the deferred price of goods sold (or simply of an outstanding loan) against a reduction of the debt amount (da' wa ta'jjal) may, according to many past scholars, beginning with the Companion Ibn Abbas, be a commendable arrangement to alleviate the burden on the debtor and does not constitute riba.
In other words, price differentials compensating for the delay in the fulfillment of a party's contractual obligations or for the opportunity cost of the money used by a contractual party in providing goods, by sale or lease, or in producing an asset commissioned for manufacture or in retaining it for future delivery or in the prepayment of its deferred price have been ordinarily recognized as legitimate under some or all traditional jurisprudence, the compensation for the value of time being included as an integral part of the price.
Only a barter of the same type of certain fungible goods, which involves inequality of the bartered goods or delay in the delivery of one of them constitutes a form of riba under traditional jurisprudence. This is based on a "famous" hadīth of the Prophet which is limited to six goods of this type. Inequality in bartered goods constitutes riba al-fadl (riba of excess) and delay in delivery by one party (which presumably involves an assumed form of inequality) constitutes riba al-nassļah (riba of delay). Some Islamic jurists, rightly in my view, limited the application of riba al fadl to the unequal exchange of goods of the same quality and not only the same type and measure (of volume or weight).
It is clear to me that the prohibition of riba in such exchanges does not reflect a lack of concern for the value of time, this value being broadly recognized in many other forms of contract. Rather, the concern is obviously for a fair exchange in transactions and the elimination of practices where unjust enrichment may occur. This common sense rationale was reached by Ibn Rushd (Averročs), the renowned Islamic scholar of the 12th century, who found the precise cause ('illah) for the prohibition of this riba in the need to ensure equality of measure in the exchange of goods of the same type, in order to attain fairness of exchanges which could otherwise be reached through "the mathematical quality of measure" produced by money. He accordingly limited the prohibition to goods of similar uses that were measured by volume or weight, where money was not used as a medium of exchange (money being a neutral measure of respective values reflecting market prices). In this way, the prohibition would not only combat exploitation of the weaker party in the barter but would otherwise allow markets to normally determine prices through the medium of money.
Within this framework, the economy would be based on the sanctity of contracts (a principle firmly established in the Qu'rān), subject only to the overall limits of the few Islamic prohibitions which constitute the equivalent of public policy or ordre public in modern legal systems. Basic elements of this ordre public are the inter-related prohibitions of riba and gharar, the latter being found in other contracts that create excessively uncertain risks concerning their object (which is prohibited by the Sunnah and is likened by some scholars to gambling (maysir) prohibited in the Qu'rān).
As another early scholar, Ibn Al-Qayyim, noted in the 14th century, the prohibition of riba is necessitated by the concern to protect the weak party in lending and trade transactions. An underlying factor in the prohibition in the latter transactions was the protection of the poorest who lacked currency and transacted by barter. The invalidity of delayed barter in foodstuffs and other fungible commodities essential to human life (where markets are necessarily active and speculation in their prices could lead to hoarding and exploitation) was therefore in his view a necessary precautionary measure.
Both Ibn Rushd and Ibn Al-Qayyim were in fact probing the rationale behind the prohibition and the wisdom that required it. Extending a ruling in the primary sources (the Qu'rān and Sunnah) to new situations through analogy (qiyas) has, however, been justified in traditional jurisprudence when the "'illah" behind the original ruling equally applied to the new situation. "'Illah" is defined as the precise, apparent cause of the ruling or the definite, clear attribute of the event related to it, rather than the rationale, the underlying wisdom (hikmah), or the purpose of the ruling. The reason given for reliance on the precise 'illah was that different humans can have varied views about the hikmah or purpose of a certain ruling. It may be time, however, to question this jurisprudential principle and to rebuild qiyas (a major source of Islamic law) on the rationale or purpose underlying Qu'rānic and Sunnah rulings (al-maqaid al-shari'yyah). In this manner, the 'illah would still be taken into account but would not overshadow the purpose of the text. In spite of its apparent preciseness, the 'illah did not prevent scholars from disagreeing on its meaning in many instances, including the case of the hadīth under discussion. In any event, differences of views on the rationale of a certain ruling where Islamic law is applied can always be settled by the legislator or the highest court after hearing different expert views in either case, or by a high council where Shari'ah specialists and other experts would be represented. In this way, the application of divine prescriptions to new situations would be based on rational criteria which fully take into account the evolving nature of human development and the constant changes in time and environment.
It is only reasonable in my view not to extend the rule related to the prohibition of unequal or delayed barters of certain essential generic goods (which barters are rather rare in modern societies) to other forms of trade transactions where neither apparent exploitation of the weaker party nor excessive risks are inherent. Neither the Qu'rān, nor the Sunnah requires such an extension. On the contrary, both sources call for facilitation of transactions by mutual agreement and avoid any rigid definition of riba applicable at all times.
RIBA in Lending Transactions
In the context of loans, it is common among contemporary Islamic scholars (with some important exceptions) to equate riba with interest on loans and bank deposits, so much so that the word riba has been generally translated in other languages simply to mean "interest on loans." This also is the general principle on which "Islamic banking" is based at present. I would like now to discuss whether this absolute equation is justified under the Qu'rān and the undisputed Sunnah and whether it needs to be the basis of "Islamic banking," that is, whether "Islamic banks" can, without the adoption of such an absolute equation, otherwise expand and prosper, while maintaining, or even enhancing, their Islamic character.
a. The Questionable Equation Between Riba and Interest In All Lending Operations
As already mentioned, the Qu'rān prohibits al-riba in the strongest terms but provides only a specific reference to one of its forms, increasing the principal of a loan against extending the date of its maturity or, literally, doubling the debt against doubling its term. The verses of the Qu'rān in Surat Al Baqarah, which many believe were the last revealed, ask believers to "give up what remains of al-riba," without indicating that there were other forms included in such remnants. (On the contrary, the Prophet's farewell pilgrimage sermon, also his last, referred only to terminating "riba al-jahiliyyah" and "riba Al-Abbas," the latter being deemed by historians to be the same.) The Qu'rān requests lenders, rather than resorting to this explicitly prohibited form of riba in lending operations, to "delay until the time of ease" repayment by debtors in difficulty and urges that replacing the debt in such circumstances by charity "would be good for you [the lenders], if you but knew." At the same time, the Qu'rān requires debtors, and contracting parties in general, to fulfill their contractual obligations. Default of a solvent debtor is not only a breach of a contractual obligation, but is also deemed a violation of a compact with God and, therefore, a punishable sin.
Many hadīths of different degrees of authenticity speak also of riba in loans. Some sayings attributed to the Prophet encourage providing qards (a specific type of loan explained below) to those in need, suggesting that "God is with the debtor;" others discourage borrowing and condemn debtors who die before repaying their debt. The most widely quoted hadīth on riba in loans, which is also the most comprehensive in coverage, declares that "every qard that results in a benefit is riba." The authenticity of this hadīth is in serious doubt, however. It does not appear in any of the six main compilations of the Prophet's sayings and seems to have been first reported in the fifth century Anno Hijrah (A.H.). Those who quote this particular hadīth do so on the authority of an individual Companion, not the Prophet himself. Some simply consider it "weak," "suspended," "abandoned," or even "false." It is taken for granted, however, by the prevailing view among contemporary Islamic scholars as the basis, not only of banning returns on qards, but also any interest on any type of loan. Even if we assume the authenticity of the hadīth in question, this broad prohibition may be readily questioned under the rules of traditional Islamic jurisprudence.
The term qard as used in traditional jurisprudence describes one of two types of gratuitous, non-binding loan contracts. Qard normally covers the loan of money and other fungibles which are to be used (i.e., consumed) by the borrower who is expected to return to the lender goods of identical description, not the same goods he borrowed. If the same type of such goods could not be found, (e.g., if a certain currency, fulus, not gold or silver, is no longer in use because of its discontinuity (kasad) or suspension (inqita')), the contract becomes null in the view of Abu-Hanifa but is valid in the view of his two main disciples, Abu-Yusuf and Mohamed Al-Shaybany as well as the Hanbalis and Shafi'is. According to Abu-Yusuf and many other Hanafis, the borrower (or the buyer in a credit sale) would in such a case be obligated to return the value of the borrowed (or purchased) goods determined as of the time of lending or sale; and, according to Al-Shaybany, as of the time of unavailability. If the currency in question loses some of its value while on loan, the two major Hanafi scholars opined that the debtor would be obligated to return its original, not nominal, value, as of the time of the loan or sale (Abu-Yusuf) or of the currency's last depreciation (Al-Shaybany). Interestingly, none of these views requires repayment according to the possibly lower value at the time of repayment. As noted earlier, these views are said to have been broadly followed in actual practice.
In a qard transaction, ownership of the borrowed money or other fungibles is transferred to the borrower on delivery but the lender maintains the right to demand repayment at any time. Qards do not therefore have a binding fixed term (except under a Māliki view), unlike other types of debt-creating instruments where the Qu'rān requires their recording in writing when they are "for a fixed term." Clearly, qard, a simple type of loan transaction, traditionally made in kind as a gratuitous, non-binding arrangement subject to reversal on demand by the lender, was meant to accommodate individual needs, not to be the basis of domestic or international commerce and investment. In fact, the Qu'rān often uses the term qard in the context of charity, describing the latter as a "qard hassan" to God that will be repaid by Him many times over. A hadīth attributed to the Prophet states that "every qard is a charity (adakah)."
The other type of gratuitous loans known in Islamic jurisprudence is 'ariyah which covers the loan of specific goods, not for consumption by the borrower, but to be used and returned to the lender, again at the latter's discretion. No transfer of ownership is involved in 'ariyah, just as in the case of wadi'ah or amanah, where the owner entrusts another person to keep an asset until he asks for its return, except that in the latter case the right of usufruct is not granted by the owner to the holder of wadi'ah or amanah.
Noting the characteristics of qard and its semi-charitable nature, some scholars have thus defined it exclusively to cover loans which are meant to meet the consumption needs of the borrower. Others went further to authorize qards only for "meeting the necessities of life." This is the view of the scholar holding the highest religious position in Egypt at present, the incumbent Imam of Al-Azhar. Interest on such type of loan is prohibited as riba in these views, as it clearly exploits the needs of the poor and contradicts the semi-charitable nature of the transaction. The matter is different for interest on postal saving accounts, a national Bank's investment bonds, treasury bills,and deposits given to banks for investment purposes, where interest is not considered a prohibited riba in these views, but a legitimate return on investment earned by mutual agreement, consistent with commercial custom and public interest or general welfare (malahah mursalah) as currently conceived. "Such transactions and the profit resulting therefrom are lawful (halāl), either as modern transactions required by the circumstances and developments of contemporary life or because they are based on absolute agency [i.e., a general power of attorney given to the Bank by the depositor or bond holder], or, according to some scholars, because they represent a form of mudarabah."
In the latter and other forms of commercial loan transactions, a borrower can voluntarily pay back more than what he received. This practice was blessed in many hadīths which spoke of debt in the broad sense (tadayun; istislaf), and not of qard as such. It was followed by the Prophet himself. A pre-fixed return on what is seen as a form of investment is, according to one of the above mentioned views, not only legitimate but "closer to Islamic Shari'ah." It provides a reliable income to the small investor who needs it and "allows each party to clearly know its right, especially that such fixing [of the return] is subject to increase and decrease" [according to objective criteria]. Needless to say, such views are still in the minority among contemporary scholars in various Islamic countries (with the possible exception of Egypt) and have been much criticized by the more prevalent neo-conservative trend in Islamic academies and Shari'ah boards of "Islamic banks."
It is clear to me, in any event, that neither qard nor 'aryiah covers all forms of modern loans, certainly not the typical debt instruments irrevocable on the part of the lender which have a fixed duration and a pre-determined return, be it fixed or variable. Such financial instruments, including commercial bank term deposits, are hardly comparable to the gratuitous loans of the simple qard type made at the time of the Prophet that were not binding before delivery and, once delivered, were repayable on demand. The latter were not investment tools for savers; they were semi-charitable acts that represented an addition to the alms tax (Zakat) required from Muslims and the other charities (adaqat) recommended by their religion. To automatically extrapolate from this a rule applicable to all types of modern lending instruments certainly requires a profound explanation.
The explanation given by most contemporary scholars (and by the Shari'ah boards of Islamic banks) is that a pre-determined interest on any type of loan represents a risk-free gain, contrary to the principle that gain accompanies liability for loss (al-ghunm bil-ghurm); any lender must therefore share in the loss as he shares in the profit resulting from the use of his borrowed funds. This argument may be based, however, on a misconception; agreement on the payment of a fixed interest on loans does not by itself shield lenders from the risk of default on either principal or interest. The interest is simply meant to compensate the lender for the alternative uses or the opportunity cost of his capital, in realization of the monetary value of time. An interest-free loan or deposit denominated in current currencies leaves the lender or depositor worse off in real terms.
In banking operations, the bank typically acts as a financial intermediary between the sources of funds (shareholders, depositors, bondholders and other creditors) and investors. If this intermediation function is properly managed and supervised, the risk of a loss to the bank or its depositors/creditors would hardly arise under normal circumstances. Such a proper management is required in fact in all countries by banking regulations issued and supervised by the central bank or other supervisory authorities. If such regulations are inadequate or are poorly supervised, the risk of loss to the bank and its depositors/creditors would be real, as repeatedly demonstrated in the cases of failing banks. Banks in many countries are required to guard against this risk through deposit insurance schemes which cover the money they collect as deposits, this insurance being sometimes limited to a percentage or a maximum level of individual deposits. It is also not unusual for governments to interfere when a bank fails, at least in favor of small depositors. In addition to providing this implicit guarantee, governments may require the restructuring of troubled or failed banks. Some are doing so systemically as a result of chronic weaknesses in their banking sector. As a last resort, government authorities may close a failing bank altogether. The end result of all this is that the intermediation function of modern banks may either be practically free from risk (due to the combination of strict risk management standards, including capital adequacy, provisioning, disclosure, accounting and other standards, deposit insurance requirements and whatever implicit government guarantees that may exist) or it may carry risks which are shared, if not primarily borne, by the bank's depositors/creditors. If a bank acts as a direct investor, rather than an intermediary, under the expanding phenomenon of "universal banking," the risk of loss to the bank's investment will inevitably reach its depositors/creditors to the extent their deposits and loans could not otherwise be serviced. In the event, the fact that a pre-fixed interest was agreed to be paid by the bank would not provide a shield against such loss sharing. To put it differently, when there is no real risk, risk-sharing becomes a moot issue and when the risk is real, it will certainly be shared by the bank's creditors, including, in the first instance, its depositors. Whether the return on their deposit was prefixed or not becomes immaterial in this case. Through the agreed interest they receive, depositors share in the Bank's profits and are compensated for the possible depreciation of the value of their deposits (in terms of their real purchasing power). They bear, however, a possible, though not excessive risk - that of the bank's failure.
Interest paid by banks to their depositors/creditors, charged to their debtors or received on the investment of their short term cash surplus represents the price of the credit involved. Whether its rate is fixed by the central bank or left to be determined by market forces, it is bound, like other prices, to be heavily influenced by the law of supply and demand. Other factors do play a role however when the government or central bank uses the interest rate as a tool of economic policy. Good policy suggests that efforts be made to lower interest rates in order to reduce the cost of future investment but to keep it positive, i.e. above the inflation rate, to encourage savings. High interest rates may also be needed for other purposes such as sterilizing an overly liquid economy, temporarily defending the local currency or curbing credit in an inflationary situation. The scope of speculation or excessive uncertainty in this area may be much smaller than in the pricing of commodities and stock in the market.
In view of the above, it is not clear how properly regulated and supervised banking operations can constitute riba or gharar or suffer from the underlying factors that justified the prohibition of these two condemned phenomena.
Analogy with insurance operations, currently recognized as legitimate by most Islamic scholars and supported in its takaful form by the conservative OIC Fiqh Academy, is relevant. The consistency of such operations with Islamic law is based on the fact that the law of large numbers, modern actuarial techniques and other insurance standards diminish uncertainty in them to the point of virtually guaranteeing the payment of insured losses as well as making profit for any properly managed insurer. (No wonder that banking and insurance are among the most rewarding businesses.) Any suspicion that the insured parties unduly exploit insurance companies in need sounds as implausible as the suggestion that bank depositors unduly exploit their banks, either on the basis of need, unjust enrichment or exposing banks to excessive risk. In fact, one may easily argue that it is the banks which decline to pay any return on time deposits that clearly exploit depositors (who are often in greater need than the banks and their shareholders) and unjustly enrich themselves at their expense, contrary to the principle that gain accompanies liability. As commercial banks make loans only to creditworthy borrowers often after scrupulously reviewing their networth, and ordinarily require collateral or other securities to ensure repayment, the suspicion that the banks lend to poor clients, exploiting their basic needs is not plausible either.
b. Interest-Bearing Instruments for Islamic Banks?
"Islamic banks" play an important role, and, due mainly to self-imposed constraints, face formidable challenges.
Private "Islamic banks" have no doubt succeeded in collecting deposits and attracting other funds from sources that did not previously deal with the banking sector for their own religious or other reasons. This success is laudable and should be further encouraged under appropriate regulations and supervision. Effective channels for saving and investment, especially equity investment, are needed in practically all Islamic countries (provided of course that funds are invested for productive purposes in these countries and not siphoned away to other saturated markets). "It is estimated that of all Islamic assets only between 3 percent and 4 percent are invested in equity." The inter-governmental Islamic Development Bank also plays a pivotal role as an instrument of financial solidarity among Islamic countries and a development finance institution for these countries and other Islamic communities. There is no question therefore concerning the relevance and usefulness of these institutions when properly managed. The question rather centers on how to lift undue constraints on their operations, allow them to tap greater resources, reduce the need for their excessive liquidity position and risk averse attitudes, expand their investment outlets (with acceptable risks and rewards beyond the short term trading and leasing operations where the bulk of their assets are being used at present) and better hedge their resources all without losing their Islamic character which accounts for their attractiveness to their shareholders and clients.
The answer to this fundamental question has so far been provided for the most part through questionable, circular techniques (hiyal), such as the so-called synthetic murabahah, or complex parallel and reverse salam transactions and other cumbersome undertakings, the end result of which is to practically enable "Islamic banks" to do the equivalent of what conventional banks are doing, but in less transparent ways. If, however, the analysis provided in this lecture is not rejected outright, the suggestion that the raison d'źtre of Islamic banking lies in the ban on pre-determined interest on their deposits and loans would not be sustainable. The door would be open for those banks to deal in interest-bearing instruments that do not constitute qards or wadi'ahs (as defined above) and do not violate other tenets of Islamic law. This would free Islamic banks from so many hurdles that complicate their business and hinder their ability to compete. But would the functions of "Islamic banks" and similar financial institutions be still justified in such a case? And, if so, what would distinguish them from those of typical commercial banks?
c. Challenges Facing Islamic Banks
The financial justification for "Islamic banks" is obvious; there is a large market for them. For a variety of reasons, religiously aware muslims, whose numbers are rising, increasingly look for means to conform their transactions with the requirements and moral values of their religion. Commercial banks, including some Western ones, are increasingly opening windows for "Islamic transactions" and have established "Islamic equity funds," to accommodate this rising demand. But "Islamic banks" face the daunting challenge of having to compete with conventional banks which are free from so many burdens that the former banks have imposed on themselves through fiqh academies and Shari'ah boards. Such burdens are related directly or indirectly to the restrictions on interest-bearing transactions.
The latter restrictions have resulted in an asset structure for Islamic banks that is typically dominated by debts and cash and thus has a much shorter term than that of conventional banks. They have much less flexibility than the latter banks in evaluating the cost of capital and a grossly restricted capacity to diversify their operations and meet the different needs of diverse clients. They often find themselves unable to finance accounts receivables, housing mortgages and risk capital. They are told by their Shari'ah boards not to issue letters of credits and other guarantees for a fee exceeding the administrative cost of these guarantees. They are also unable to trade in derivatives and to enter into the sale, hypothecation or discounting of financial obligations. Even those who find leeways to venture in these areas under different names do not always share the benefits available to conventional banks, including supporting institutions such as inter-bank facilities, and insurance and reinsurance facilities, mutual funds, consumer finance companies, etc. These limitations restrict their risk management ability as well as their capacity to compete, not only with conventional banks but with trade financing companies as well. In addition, some of their operations, such as the mudarabahs, face a high degree of moral hazard.
The short term asset structure of "Islamic banks" and the lack of securitization of their financial products and of a secondary market for them have practically impeded their involvement in long term investments, leaving them with excessive liquidity or forcing them to invest in major capital markets outside the Islamic countries.
Unlike conventional banks, "Islamic banks" lack uniform accounting standards (in spite of continuous progress in this area) and are subject to auditing by Shari'ah experts who may have limited, though increasing, exposure to financial markets and products. Worse still, they are unable to benefit from central bank discounting facilities and, more often than not, from central bank supervision, as well as whatever deposit insurance facilities that may be available to conventional banks.
While interest paid by conventional banks to their depositors and creditors is treated as cost for tax purposes, profit shared by "Islamic banks" with their depositors and creditors is taxed, to their disadvantage. The ownership base of "Islamic banks" is also much more limited than that of other banks due to the concentration of their share-holding (which presents another source of instability). These banks face difficulties in operating in non-Islamic countries. The reputation of some of them has suffered in their own countries due to their concentration on murabahah activities which disguise interest taking and the lack of transparency in some of their other operations and in the treatment of their different categories of depositors and other capital providers. Their attempt to prevail through the circular techniques referred to earlier subjects them to much criticism, both from their religiously oriented clients and the public at large.
There are, I believe, other, even more credible ways to enable Islamic financial institutions to operate without much of the present constraints while maintaining, if not enhancing, their distinct identity. These suggested measures may even improve the attractiveness of Islamic institutions to those inclined to deal with them, and may, consequently, expand their market share:
1. Each Islamic financial institution may adopt a code of conduct reflecting Islamic values, along with a practical mechanism of enforcement, strictly ensuring that such values are demonstrated in the behavior of its management and staff and in their relationship with their clients and shareholders. They should, in particular, strike a fair balance between the interests of depositors and shareholders and not subsidize returns on deposit (for the sake of competition) at the expense of present or new shareholders, as was reportedly done by some such institutions in the past. A strict enforcement of such moral codes would greatly improve the reputation of these institutions where high expectations inspired by their religious names had not always been met.
2. Islamic financial institutions should avoid employing their funds in operations prohibited by the Qu'rān and the undisputed Sunnah and focus on operations which help the development of Islamic countries and communities, with particular emphasis on empowering the poor and on investments which are ethically and environmentally sound. This does not mean avoiding all barter transactions in fungibles and all interest-bearing loans and deposits (of which many could be legitimized under the liberal interpretations advocated here). It means ensuring in substance that the funds they employ are put to productive, useful purposes in Islamic societies. This task suggests strengthening the capacity of these institutions to assess and supervise the more rewarding but riskier long term investments for which the record of private "Islamic banks" so far is rather poor; it would turn them into more profitable development finance institutions.
3. Islamic financial institutions which wish to specialize exclusively in equity financing and/or in lending based on profit and loss sharing may do so under a separate set of regulations from those applicable to conventional banks, especially with regard to capital adequacy standards. They may not in this case be allowed to resort to virtual interest-taking operations under disguised names. To avoid confusion to the public, such different institutions may not carry the name of a bank; their names should reflect their characteristics as investment companies.
4. Islamic financial institutions should not, as a matter of course, resort to seizure and liquidation of assets of their borrowers if the latter face genuine difficulties in servicing their debt. They should first exhaust possibilities for restructuring the debt of such borrowers and helping them restructure their businesses so that they may be able to continue their operations for their own benefit and the benefit of their creditor banks. This more Islamic attitude should not be extended, however, to solvent debtors who resort to deceptive ways to avoid payment.
5. Islamic financial institutions may systematically allocate part of their income for charitable purposes, including grants and interest-free qards, and distribute such funds according to equitable, transparent criteria. This would be best done through the establishment by each "Islamic bank" of a separate charitable foundation, both to institutionalize the process and give the donor bank the benefit of good publicity. (Interestingly, this practice is not uncommon among large corporations in some non-Islamic countries such as the United States where, in addition to its obvious benefits, it helps their strategies in expanding their market share.)
By following these and similar measures, Islamic financial institutions should not be operating in a regulatory vacuum, as is often the case at present. They must be subject to the same strict regulation and supervision applicable to their country's financial sector as a whole. Should their characteristics require special regulations, these must be issued and strictly applied. The sad experience of some allegedly Islamic financial companies which lacked transparency regarding their legal status and operations and operated pyramid schemes resulting in huge losses to large numbers of depositors should not be allowed to be repeated. Besides, regulation and central bank supervision would add to the credibility of these institutions. It would allow them to benefit from the central banks' discounting facilities (once they accept to pay the interest involved) and from whatever deposit insurance mechanisms that may be available to other banks.
Riba is prohibited beyond doubt by the two primary sources of Islamic law, the Qu'rān and Sunnah. The scope of this prohibition is not defined, however, in either source. A rational reading of these sources suggests that, as an exception to the general rule of freedom of contract, the prohibition should be strictly construed, in light of its underlying rationale and the general Qu'rānic proposition to facilitate, not complicate transactions. Prohibited riba may thus cover obvious cases of enrichment without a legitimate cause, both in trade and lending operations, in order to ensure fairness in the conduct of these transactions and to defend weaker parties from undue exploitation and excessive uncertainty. It also covers operations which are meant to be charitable or semi-charitable in nature, such as the typical qards known at the time the prohibition was introduced. This cannot automatically suggest, however, that every possible barter trading in fungible commodities and every financial instrument that has a fixed return is tainted by riba. Yet, it is this broad prohibition that is commonly required at present by most Islamic specialists and is taken for granted as the basis of "Islamic banking." Modern Islamic theorists have taken it as a symbol and a main building block, if not the principal pillar, of what they present as the "Islamic economic system."
These latter attitudes probably find their basis in the deeply rooted methodology followed in the learning of Islamic jurisprudence in the last seven centuries a methodology based on conforming with the views of past scholars in one's own jurisprudential school, or, for the more liberal, on the selection from views of past scholars, regardless of the school to which they belonged. Admirable attempts to avoid the confines of taqleed reflected in some of the views quoted in this paper are being increasingly overlooked. Many neo-conservative scholars tend in fact to ignore such liberal views and choose to adopt the strictest among past views in what seems to be a heated competition for the "purist" possible position. The fact that earlier views represented human endeavors fashioned by the circumstances of their time and place is not sufficiently recognized. Instead, the strictest among such views are often presented now with the sanctity of Islamic Shari'ah. It consistently prevails over original thinking in the absence of explicit provisions in the primary sources. Taqleed, not ijtihād has become the order of the day in many Islamic institutes (fomented in recent decades by the enthusiasm of political movements raising Islamic banners and calling for the awakening and revival of the Islamic nation). In this context, minds have been open to accept legal concepts initiated in Western systems where no views were expressed by Islamic scholars in the past, such as the juridical personality of corporations, and, more recently, insurance operations and trading in shares in the stock market. No similar tolerance seems to be shown, however, in the traditionalist and neo-conservative circles for the departure from past conservative views and the initiation of new rulings on the basis of the rationale (hikmah) underlying the provisions of primary sources, as this rationale may be presently conceived in a unified manner (reached through the legislator or a high court or council). Nor is attention being paid to the fact that riba was not precisely defined in the primary sources which allows for flexibility in its construction depending on the needs of changing times.
It is my conviction that Islamic law will be able to meet the challenges of modern and future times only through a change in the taqleed-based methodology and a broad movement of ijtihād led by broad-minded, interdisciplinary scholarly institutes. It is also my conviction that Islamic countries cannot and should not insulate their respective economies from the world economy. On the contrary, they should take full advantage of the unprecedented expansion in world trade and investment, fully recognizing the monetary value of time and reflecting it in their transactions. Their banking sector in particular should be strictly regulated and supervised. It must be subject to adequate risk management techniques, regardless of the name their banks may carry. Risks to depositors, bond holders and other creditors cannot be left uncompensated under misconceptions assuming the absence of such risks. Nor should savings be left to pile up in unproductive accounts in the name of religion.
The views expressed in this lecture may be too remote from the thinking prevalent at present in "Islamic banks" to be relevant or useful to their practice. But we do live in a world of constant change a change so dramatically manifested in the unprecedented expansion of world trade and finance, where political borders are increasingly losing their significance and money is mostly transferred by electronic means. It should not be excessively optimistic under the circumstances to expect a change in contemporary Islamic jurisprudence towards a more liberal attitude in this particular field. "Innahu la yayassu min rahmati-llahi illa al-qawmu al-zalimun."
[*Sep 1998 - a lecture prepared for delivery, upon request of the organizers, before the Colloquium on "Islamic Law and its Reception by the Courts in the West" organized by the Institute for Private International Law and Comparative Law of the University of Osnabruck in conjunction with the Hague Conference on Private International Law, 22-24 Oct 1998, Osnabruck, Germany]
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