What Makes Interest Unconscionable?
Interest is unconscionable (or becomes riba) (1) when the interest rate is dictated by any of the participating parties, (2) when the borrowing party is in temporary financial difficulty, or (3) where humanitarian considerations apply.
Competitive market forces determine interest used in modern finance. But if the competition is imperfect, i.e., if the suppliers of funds can unilaterally influence or dictate the interest rate that they use in their transactions (because of a monopolistic situation they enjoy), then the interest rate becomes unconscionable to the borrowers. Exceptional cases like this can happen sometimes, but eventually free market forces work to correct the situation, or the financial regulators take appropriate steps to correct the situation. A recent case in point is the LIBOR (London interbank offer rate) and similar benchmark rates, which were plagued with a scandal: some influential banks manipulated such rates. However, this scandal came to the notice of the bank regulating authorities who imposed hefty fines on the banks involved in the scandal, and the determination of these benchmark rates was restored to market forces as before.
Whether any economic charge – price or interest – is unconscionable can also be judged in the light of the overriding fundamental principle enunciated in the Quran about social justice or good we need to observe. The Quran mandates that we strictly maintain justice or equity (adl) in all of our affairs (16:90; 4:58; etc.), including business dealings. It directs us to do business in particular to our mutual benefit (4:29). And it strongly urges us to respect the norms of social justice and compassion, wherever appropriate. It is for this reason that the Quran contrasts riba with zakat or sadaqa, condemning riba and extolling sadaqa (30:39). The Quranic message of interest-free loans is applicable only for disadvantaged borrowers, who deserve to be treated with a humanitarian approach. This is qard-hasana or a beautiful loan that the Quran talks about in several verses (2:245; 57:11, 18; 64:17; 5:12; 73:20). The Quran even encourages the lenders to postpone repayments or write off the original loans in cases where the borrowers are in difficulty to repay them (2:278-280). From this Quranic position and from Fazlur Rahman’s analysis of the system of sadaqa as a broader co-operative welfare system, we get another insight that where a system of sadaqa deserves to be applied, interest has no role to play. But as long as we are unable to attain that welfare system, the abolition of interest would be suicidal for the welfare of a society and its financial system.
The Special Area of Microfinance
We need also to take into account the fact that side-by-side with the institutional credit market served by banks, an informal credit market also exists and operates worldwide. The informal microfinance credit market operates precisely because the formal banks do not serve the needs of all willing borrowers. Banks operate by lending against collateral. However, small businesses and poorer borrowers often lack such collateral, and accordingly they have little or no access to bank credit. Usually, because of the lack of collateral and risks involved, the interest rate charged on such loans is considerably higher than that charged by banks. Taking advantage of the unusual character of this informal microfinance credit market, even a reputable institution such as the Nobel prize winner Grameen Bank of Bangladesh, which lends to the destitute people, charges very high interest rates. In such a situation, it should be the duty of the government to bring such interest rates into line with the rates charged by the regular banks, and better still, to lower such interest rates by subsidizing the Grameen Bank in an interim period, and by introducing pro-active policies that allow more credit institutions of the same type to come into existence, which can provide competitive interest rates.
III. DOES ISLAMIC FINANCE GO WITHOUT INTEREST?
Development and Relative Importance in Modern Finance
Modern-day Islamic finance and banking is only a recent innovation. The first Islamic bank was established in Egypt in 1962/63. Such banking took off in the 1970s, coinciding with an oil boom in many Arab countries, and made rapid inroads in other Muslim countries. It spread to other regions with sizeable Muslim populations, growing worldwide in double digits annually in the recent decade. Its increasing popularity has led some large Western banks to open Islamic windows. According to one estimate, in 2011, such institutions worldwide “included at least 435 full-fledged institutions, and 191 windows of conventional banks, operating over 48 countries.”(Al-Muharrami and Hardy 2013) “According to a 2012 survey by Ernst and Young, Islamic banking assets grew at an annual rate of 19 percent over the five years to end-2012 to reach US$1.55 trillion; growth is expected to remain strong.”
Note, however, that this impressive growth is not matched by Islamic banks’ current relative weight in total credit supplied in many of these countries. In Sudan and Iran, the banking systems are wholly Islamic. In other Muslim countries, such banks operate side by side with conventional banks. Turkey and Bangladesh are important examples, where Islamic banking has only a marginal presence. Such banking is dwarfed by conventional banks even in countries like Malaysia, where Islamic banking is well developed. In the largest Muslim country, Indonesia, even with a more rapid growth of Islamic banking than the conventional one, the Islamic banks accounted for a market share of only 4.2 percent of the total banking industry in September 2012.
Main Characteristic Features and Investment Products
In an effort to make their operations compliant to the key requirement that no interest receipt or payment is involved, Islamic banks have devised their various products differently from the products used in conventional interest-bearing banks. Their financial products are required to be backed by real assets on the ground or linked to specific real activities, i.e., the provisions of goods or services, which themselves are not financial investments. They are barred from trading in financial derivatives to make a financial profit (although they can use forward contracts). In other words, Islamic banks are not permitted to operate on a predetermined rate of return basis. However, as we will soon see, the effort on the part of these banks to avoid interest has been only partially successful, but this also at a cost.
The main idea was to make these banks operate as private equity or venture capital firms, i.e., to operate on a profit and loss sharing (PLS) basis, allowing profits and risks to be fairly shared among the parties involved – the banks, the entrepreneurs, and the depositors. The products offered by these banks to implement this idea are called mudaraba (passive partnership) and musharaka (joint venture) contracting. Other major products offered fall in three major groups: markup or cost-plus murabaha (sales-based products), ijara (lease-based products), and sukuk (bond financing). Murabaha and ijara in turn have some sub-groups. Murabaha contracts include bai al-inah (sale and buyback), bai salam (deferred delivery sales), and istisna. Bai salam and istisna are used to fund goods that are yet to be produced or properties that are under construction.
In actual practice, the PLS or equity financing principle is found to be the least used. Investment is concentrated in sukuk and sale- and lease-based products. Using data of a sample of 30 Islamic banks in nine Middle East and North African (MENA) countries for 2008, Salman Ali shows, as in the chart below, that mudaraba and musharaka (PLS) financing was significant only in Saudi Arabia. It was absent or considerably insignificant in other MENA countries – completely absent in Kuwait and Yemen and very insignificant in UAE and Jordan. Murabaha mode has dominated the financing pattern, ranging across countries from a maximum 90 percent to near 50 percent, followed by ijara. “On the average 75 percent of financing activity in the MENA region during 2008 was based on murabahah”(Salman Ali 2012). As an IMF Working Paper reports, “According to statistics available from Bank Negara Malaysia, musharakah and mudarabah products constituted 5.2 percent of Malaysian Islamic bank financing at end-2012, whereas bai al inah, istisna, and other murabahah products constituted 49.5 percent, and ijarah products constituted 25.4 percent.” According to a 1997 study, some 75 percent goes to markup or cost-plus (murabaha) lending and another about 10 percent goes to leasing (ijara) financing (Iqbal, 1997). By using data for six Islamic banks of
Bahrain for the period 1991-2001, Abdus Samad finds that only 0.9 percent of such banks’ total credit went into long-term PLS (mudaraba and musharaka) projects (Samad, 2004). That PLS financing features only marginally has been emphasized by other Muslim scholars as well.
The reasons for Islamic banks’ low PLS or equity financing are clear. There are inherent difficulties that banks face in engaging in equity financing. The banks lack needed expertise in project selection and evaluation and requisite business experience for equity investment. Also, business entrepreneurs are often reluctant to share all information with their bankers, in part, also because of their concern that this might make them exposed to tax authorities’ watchful eyeing of their activities. That means that information that the concerned parties have about the PLS projects is asymmetrical, which necessarily makes Islamic banks more averse to financing such operations as involve risk and uncertainty than short-term trade or other businesses that assure certain returns.
ISLAM COLUMN: Reform in Finance: Riba vs. Interest in the Modern Economy (2)(Opens in a new browser tab)