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ZB nr 5(163)/2001, lipiec 2001

[ Part I ]


Dr. M. Umer Chapra

The article (Prohibition of Interest: Does it Make Sense?) published in a recent issue of Ahlan wa Sahlan, indicated the strong economic rationale behind the prohibition of interest by some major religions. Nevertheless, the question that still remains to be answered is about whether there is an alternative to interest. A number of people, including some Muslims, may give a negative reply. They may feel that even though there are a number of ills associated with interest, these have to be tolerated because they do not find it possible to organize a financial system without interest. Their key argument as that the rate of interest is a price and, like all other prices, it plays a crucial role in the supply of, and demand for, financial resources in any economy. If interest is abolished, how will financial resources get mobilized and allocated?

There can be no difference of opinion on the need for a realistic market price to mobilize the surplus savings form savers and to allocate them among users. There can, however, be a difference of opinion on which price is most suitable, if the objective is to actualize the humanitarian goals of need-fulfillment, full employment, equitable distribution of income and wealth, and economic stability.

As argued in the previous paper, financial intermediation on the basis of interest frustrates the optimum realization of these humanitarian goals. The relatively easy availability of credit promotes living beyond means and does not thereby accentuate only macroeconomic imbalances and financial instability but also squeezes the resources available for need-fulfillment and productive investment. Lower growth in saving joins hands with structural rigidities and other socio-economic factors to contribute to slower growth in investment, output and employment.

Islam, therefore, prohibits interest, like other major religions. This should help promote greater reliance on equity. However, while Islam encourages equity financing, it allows credit, but for only real goods and services, and not for speculation, through its sales-based modes of financing (to be discussed later). Thus, while financial intermediation in an Islamic economy would be largely on the basis of profit-and-loss sharing (PLS) modes, credit would also play a role.


The most desirable forms of Islamic financing are the PLS modes of mudârabah (commenda)1 and mushârakah (partnership)2. In both of these forms, the financier makes the funds available, not as a lender, but rather as an investor. He shares in the profit or loss and is not assured, in advance, of a positive rate of return irrespective of the ultimate outcome of business. Losses must be shared by him in proportion to his share in the total financing while profits may be shared in any mutually agreed ratio.3 His liability, however, remains limited to the extent of financing provided by him and no more.

Since the shares of joint stock companies embody the PLS principle, they are also acceptable. The presence of a well-organized and properly regulated stock market may enable investors to dispose of such stocks whenever they desire - an advantage which mudârabah and mushârakah financing may not be able to offer. The shares of joint stock companies may also serve as an alternative to interest-bearing government and corporate bonds.


>From the very early stages in Islamic history, Muslims established a financial system without interest for mobilizing resources to finance productive activities. This was done on the basis of the PLS modes of mudârabah and mushârakah. According to Professor Udovitch, these modes helped mobilize the "entire reservoir of monetary resources of the medieval Islamic world" for financing agriculture, crafts, manufacturing and long-distance trade. They were used not only by Muslims but also by Jews and Christians4 to the extent that interest-bearing loans and other overly usurious practices were not in common use.5

According to Goitein, breach of the Jewish, Christian and Islamic law against interest was found "only once in the record of a judgement, even though an unusually large amount of Jeniza documents deal with credit."6 Schatzmiller has also concluded that financial capital was developed during the early period by a considerable number of owners of monetary funds and precious metals, without the supposed interdiction of ribâ, usury, hampering it in any way".7

Financiers were known in the early Muslim history as sarrâfs. By the time of the 'Abbasid Caliph al-Muqtadir (295-320 AH/908-933AC), they had started performing most of the basic functions of modern banks.8 They had their own markets, something akin to the Wall Street in New York and the Lombard Street in London, and fulfilled most of the banking needs of commerce, industry and agriculture within the constraints of the then-prevailing technological environment.9 However, since these were not banks in the technical modern sense of the term, Professor Udovitch has preferred to call them "bankers without banks."10

The extensive mobilization of savings and their accessibility to businessmen provided a great boost to the growth of output and trade from Morocco and Spain in the West, to India and China in the East, Central Asia in the North, and Africa in the South. This is clearly indicated not only by the available historical documents but also by the Muslim coins of seventh to eleventh centuries which have been found in different parts of Russia, Finland, Sweden, Norway, the British Isles, and Iceland countries which were on the outskirts of the then-Muslim world.11

Due to a number of historical circumstances, the Muslim world lost its technological and economic vitality.12 Hence a number of Islamic institutions, including the Islamic system of financial intermediation, became displaced by Western institutions. However, the independence of Muslim countries, has led to the revival of Islam and there is a longing to gradually reinstate most of the lost institutions, the Islamic financial system being one of them.

This has brought into focus the question of whether these methods can once again play the same invigorating role in accelerating investments and promoting healthy growth as they did in the past. There is no rationale to believe otherwise. The technological advancements that have taken place since then - faster means of transport and communications, better accounting and auditing techniques, and the information technology - can only make the use of these methods relatively easier as compared with the past. They can help in maintaining proper records, calculating costs and profits more accurately, and ensuring greater transparency, checks and controls.

It is not, however, possible for the mudârabah and the mushârakah forms of financing to be amenable to all kinds of financial needs. Since the Shari'ah is realistic and wishes to fulfil all essential financial needs without compromising the realization of socio-economic goals, it has also allowed a number debt-creating modes of financing. These are all linked to trade in real goods and services and are intended to enable a person to have access to the goods and services he needs without getting involved in interest. They are all less risky than the profit-and-loss sharing modes. The most well-known of these are murâbahah13, ijârah (leasing), salam14, and itisna'15. These techniques, along with mudârabah and mushârakah, have together the ability to fulfil all the necessary financial needs of both the public and the private sectors.

Since the rate of return in all these debt-creating sales-based modes of financing is determined in advance, unlike that in âand mushârakah, the Shari'ah has laid down certain conditions for their permissibility. These conditions are intended to ensure that the financier bears at least some risk and that the borrower's interest is also protected. The proper observation of these conditions may not allow any of these techniques to degenerate into a purely financing device resorted to with the intention of circumventing the prohibition of interest.


A number of objections are, nevertheless, raised against the revival of these financing techniques in modern times. Some of these objections are:


Firstly, it is argued that in modern times when the level of individual morals is deplorable, what is the guarantee that the businesses financed by banks will show the correct level of profits? Market forces will themselves tend to take care of this problem to a great extent once the system starts operating. There will not be just one or two businesses borrowing from banks. There will rather be thousands and those who try to cheat will become exposed by the results they declare compared with those who are honest. They will thus hurt their own long-run interest by getting a poor credit rating. This will deprive them of financing in the future, because these ratings will not only be mutually circulated by banks but will also become publicly available.

Moreover, certain institutional arrangements will need to be made to protect the banks and to facilitate their task. These may include the establishment of a number of auxiliary or shared institutions in the private sector, with the help of the central bank and the commercial banks, to collect data about firms, to determine their credit rating, to evaluate projects, and to audit the accounts of businesses referred to them by banks.16 Since businesses may not wish to get a poor credit rating or to be exposed to the rigours of audit by such organizations, they may find it in their own self-interest to declare the correct profit.


Secondly, it may be argued that since a number of depositors may tend to be risk averters, they may be driven away from banks in a system where there is the prospect of erosion in their deposits through losses incurred by banks. This need not be the case because all deposits would not be sharing in the profit or loss. Islamic banks would, like their conventional counterparts, have different categories of deposits - demand deposits and different types and maturities of investment deposits. Demand deposits will be guaranteed and will not hence share in the profit or loss. They will not thus be exposed to any risk. It would be desirable to insure them partly or fully by a deposit insurance scheme. Hence, there is no reason to assume that demand deposits may be driven away.

Investment deposits would, however, share in the profit or loss. But it may be possible for banks to minimize the possibility of loss by diversifying their assets portfolios, managing their risks effectively, and building loss-offsetting reserves. It may also be possible for them to offer to their clients different types of investment opportunities, carrying varying degrees of risks, with the object of attracting the deposits of even risk averters.

Nevertheless, the possibility of loss would still remain. If the risk of loss has not reduced investment in businesses and joint stock companies, there is no reason to assume that the risk of loss on investment deposits would reduce such deposits. To the extent that the risk of loss does have an impact, it may exert a healthy influence on banks. It would tend to make them more careful in financing their clients. A great deal of the loose financing undertaken by conventional banks on the basis of the false assurance that they will receive the principal with interest may thus get minimized. It would also remove a major source of inconsistency and instability in the conventional banking system arising from their assets being exposed to risk when the deposits corresponding to these assets do not share in the risk. It would also exert a healthy influence on depositors by motivating them to take greater interest in the affairs of their banks. They would, therefore, demand greater transparency.


The first full-fledged Islamic bank was the established in Dubai in March 1975. This was rapidly followed by others. By the end of 1997, more than 176 banks and financial institutions, having total assets of $147.7 billion, had become established around the world. This does not include the profit-and-loss sharing counters that conventional banks have opened in Muslim as well as non-Muslim countries for their customers who wish to avoid interest. The rapid progress shows that Islamic banking is not only conceivable but also feasible and viable. A report prepared by Dr. Traute Wohlers-Scharf for the Development Centre of the OECD confirms that Islamic banks "have attracted hitherto untouched segments of the Muslim population which, for religious reasons, had stayed outside financial circuits". They "have also generated sizable profits for their shareholders and investment depositors. This indicates that the concept of interest-free finance can work in a modern context".17

What is equally admirable is the rapid expansion in the volume of theoretical as well as empirical literature available on the subject. The various concepts related to Islamic modes of financing have consequently become more clarified than they were at the start of the Islamic financial movement. The desire to tackle a number of issues faced by Islamic banks has also led to the writing of a number of juristic papers and monographs of excellent quality and to the formulation of juristic decisions involving ijtihad. It is not just Muslims but also non-Muslims, and not only Muslim institutions like the Islamic Development Bank, the International Association of Islamic Banks and the fiqh boards of various Islamic banks, but also international organizations like the IMF and the BIS that are taking a keen interest in the subject. A number of Western Universities, including the Harvard Law School and Rice University in the U.S. and the Durham and Loughborough Universities in the U.K. have organized lectures and seminars on the subject and initiated teaching programmes leading to the Master's and Ph.D. degrees in Islamic economics and finance. Something that may perhaps have been indirectly responsible for this increasing popularity of Islamic finance is the search for a 'new architecture' for international finance even in the Western world as a result of recurring crises in the international financial system over the last three decades. There seems to be a realization that a system replying more on equity and less on debt may be able to help reduce the intensity and frequency of these crises. Thus one can safely state that on the whole there has been great progress in every direction.


The Islamic financial movement is, however, experiencing some difficulties. Some of these difficulties are of a teething nature - difficulties that were bound to be encountered during the initial phase of an entirely new experiment. These difficulties would undoubtedly be overcome gradually as the banks become richer in experience and larger in size, and have access to the economies of scale that large conventional banks are able to have. Some of their difficulties are due to the lack of a proper understanding of the true nature of Islamic banking among their depositors as well as their clients, and lack of proper training among their employees, most of whom come from conventional banks.

The absence of an Islamic financial market makes it difficult for these banks to employ their surplus funds, or to have access to liquidity, in an Islamic manner. They are, therefore, forced to resort to the conventional money market. Most of the banks do not even have access to a lender of last resort. They are thus forced to keep larger liquidity than what conventional banks would normally keep. This adversely affects their profitability. Shared institutions (like credit rating agencies) do not exist either, thus forcing the banks to perform all the different tasks themselves This raises their costs. These difficulties have tended to slow down their progress towards the classical Islamic financing techniques of mudârabah and mushârakah.


It may have been possible to remove some of these difficulties faster if all the monetary authorities in Muslim countries had played a more positive and helpful role in the evolution of an enabling environment for this system. They would have tried to provide a proper legal framework, facilitated the establishment of shared institutions and an Islamic financial market, and made some arrangement for the creation of a lender of last resort. The Islamic banks would not have thus been like an embryo struggling to survive in an inhospitable environment without support systems.

What is needed is a change of attitude on the part of monetary authorities of those Muslim countries which are allergic to Islamic finance. They need to take a keen interest in the rapid and healthy development of these institutions. They must regulate them adequately to ensure that they have sound management, adequate capital and reserves, proper risk management systems and greater transparency, and that they do not indulge in practices that would tend to sap their strength and credibility. The central banks should not, however, confine their role merely to regulation and control. They should also help them overcome the difficulties that prevent them form adopting the classical techniques. This is not an option which the central banks may or may not exercise. They owe this to Islam and to the Muslim ummah. Islamic banking is undoubtedly more difficult than conventional banking and one would expect that central banks would render to Islamic banks at least as much assistance as the conventional central banks normally provide to their commercial banks for their healthy and sound development.


In spite of these problems the movement for Islamization of banking is on sound footing. The progress made over the last quarter century is itself reassuring. A number of the people involved in the movement are extremely dedicated and competent and are trying to do their utmost to overcome the difficulties that the Islamic banks are facing. There is no reason to doubt that the movement will be able to not only overcome these difficulties but also ensure for itself a bright future.


Chapra, M.Umer (1985), "Towards a Just Monetary System (Leicester: The Islamic Foundation).

Chapra, M.Umer. (2000), "The Future of Economics: an Islamic Perspective" (Leicester: The Islamic Foundation), pp.193-252.

Duri, A.A.(1986), "Baghdad", The Encyclopaedia of Islam (Leiden, E.S. Brill), Vol.1, pp.894-909.

Fischel, W.J. (1992), "Djahbadh," in the Encyclopaedia of Islam, Vol.2, pp.382-3.

Goitein, S.D. (1966), Studies in Islamic History and Institutions (Leiden: Brill).

Goitein, S.D.(1967), A Mediterranean Society (Berkley and Los Angeles: University of California Press).

Kramers, J.H. (1952), "Geography and Commerce", in T. Arnold and A. Guillaume (eds.), The Legacy of Islam (London: Oxford University Press).

Schatzmiller, Maya (1994), Labor in the Medieval Islamic World (Leiden: Brill).

Udovitch, Abraham (1970), Partnership and Profit in Early Islam (Princeton, NJ: Princeton University Press).

Udovitch Abraham (1981), "Bankers without Banks: Commerce, Banking and Society in the Islamic World of Middle Ages", Princeton Near East Paper No. 30 (Princeton, NJ: Princeton University Press).

Wohlers-Scharf, Traute (1983), Arab and Islamic Banks (Paris: OECD).

* This is a substantially revised and updated version of the paper bearing the same title published in the August 1993 issue of Ahlan wa Sahlan, pp.11-14.
1. Mudârabah (commenda) refers to an agreement between two or more persons whereby one or more of them provide finance, while the others provide management. The purpose is to undertake trade, industry or service with the objective of earning profit. The profit may be shared by the financiers and the managers in any agreed proportion. The loss must, however, be borne only by the financiers in proportion to their share in total capital. The loss of the manager lies in having no return for his /her effort.
2. Mushârakah (partnership): is also an agreement between two or more persons. However, unlike mudârabah, all of the partners contribute finance as well as entrepreneurship and management, though not necessarily equally. Their share in profits can be in accordance with the agreement but the share in losses must be in proportion to their share in capital.
3. According to the Shafi'i school, even the profits should be divided in proportion to capital contributions. This is because it is assumed that the contribution of skill and management is difficult to measure and that labour will be contributed equally. However, if two partners contribute to the capital and only one of them contributes to work then, even according to the Shafi'i school, the working partner's share in the profit may be higher.
4. Udovitch, 1970, pp.180 and 261.
5. Udovitch.1981, p. 257, see also p.268.
6. Goitein, 1967, pp.235 and 250 respectively. See also Goitein, 1966, pp.271-274.
7. Schatzmiller,1994, p.102
8. Fischel, 1992.
9. Duri,1986, p. 898.
10. Udovitch, 1981.
11. Kramers, 1952, p.100, see also Chapra, 2000, pp.193-252.
12. For a discussion of these, see Chapra, 2000, pp.193-252.
13. Murâbahah (also called bay' mu'ajjal) refers to a sales agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within a specified time frame, either in installments or lump sum. The seller bears the risk for the goods until they have been delivered to the buyer.
14. Salam: refers to a sales agreement whereby full payment is made in advance against an obligation to deliver the specified fungible goods at an agreed future date. This is not the same as speculative forward sale because full, and not margin, payment is required. Under this arrangement the seller, say a farmer, may be able to secure the needed financing by making an advance sale of only a part of his expected output. This may not get him into delivery problems in case of a fall in output due to unforeseen circumstances.
15. Istishnâ' refers to a sales agreement whereby a manufacturer (contractor) agrees to produce (build) and deliver a certain good (or premise) at a given price on a given date in the future. This, like salam, is an exception to the general Shari'ah ruling which does not allow a person to sell what he does not own and possess. However, unlike salam,(q.v.), the price need not be paid in advance. It may be paid in installments in step with the preferences of the parties, or partly at the front end and the balance later on as agreed.
16. For an elaboration of the nature and role of these institutions, see Chapra, 1985, pp.174-81.
17. Wohlers-Scharf, 1983, pp.11-12.

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ZB nr 5(163)/2001, lipiec 2001
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