Islamic Finance: Structure and Instruments 26 -30 September, Ankara, TURKEY BACKGROUND AND SOME FEATURES OF ISLAMIC FINANCE İsmail ÖZSOY Prof. Dr. , Department of Economics, FATIH UNIVERSITY, Istanbul, TURKEY Tel: +90 212 866 33 00 / 5023, Mobile: +90 532 404 75 20, Fax: +9 212 866 33 42 E-mail: iozsoy@fatih. edu. tr, ismailozsoy@yahoo. com 1
Key points n n n n Basic principles of Islamic economics Definition of interest and its kinds Sensitivity of Islam to Right Interest Theories The rationale behind the notion of Islamic finance Qur’anic Stance on Interest and the main reason for its prohibition Capitalism, Islam and Interest Usury and Interest Time Value of Money Comparison of Interest, Profit, and Rent Substitutions for interest: the systems of profit-loss sharing and equity participation, leasing, and many kinds of sales in Islamic economic system. Islamic Finance: Basic Features Conclusion 2
Basic Principles of Islamic Economics n n n n n Distinguished from other economic systems with its being based mainly on religious sources and its embracing both this and other worlds as a whole Favours ethical values, social justice and welfare, moderation and balance in all matters with related to individual and society. Locally and internationally free markets regulated by government with minimum intervention. Based on prohibition of interest and obligation of zakat-almsgiving. Prohibition of interest and alike fulfill regulatory function of economic life; while obligation of zakat and alike fulfill corrective function for economic imbalances and troubles. Islamic economics substituted interest for profit, wage and rent, and offered instead so many options not leaving any need for interest. Ready to acknowledge e-money, Islamic economics regards money as a unit of account, medium of exchange, store of value. Money is not regarded a merchandise to be sold or bought. Deferred exchanges are allowed only when one of the exchanged items is money due to its being a standard of deferred payments. 3
Basic Principles of Islamic Economics n n n n n Islamic economics differs in general from socialism by accepting private property and profit, and from capitalism by rejecting interest. Dynamism of capitalism and equality of socialism are combined in Islamic economics. Private interests reconciled with the public ones. The principle of “neither suffering a loss nor causing a loss” to protect all kinds of rights no matter to whom they belong. Islamic economics takes human life as a single life consisting of two legs: this world and the hereafter. Thus, all regulations about humans, whether related to economic life or not, have been made by Islam accordingly and with this perspective. Man is sent to this world to be tested by God, equipped with property rights and free enterprise Directed to obtain both worlds. Economic life is an important part of that testing and the issue of interest is the most difficult and crucial question for him/her. 4
Basic Principles of Islamic Economics n n n n Islam has aimed to form a generous man/woman. S/he is supposed to work and earn through efficient use of economic resources Then to share some of his possessions with the rest of community seeking spiritual utility added to his physical utility, thus balancing private and social concerns. In short, this model of man works, earns and shares some of what he/she earns with others. Feeling of sharing is motivated with spiritual utility for everybody and with consent of God for religious people. That model of man has enabled foundations and other non-profit organizations to emerge throughout Islamic economic history and they still have being carrying out important functions in modern societies. Limiting functions of state to internal and external security and to distribution of justice, most of social responsibilities are designed to be undertaken by that model of man in a typical Muslim society. 5
Basic Principles of Islamic Economics n n n n Islamic economics essentially aims at equal distribution of income and social balance. Zakat, as a tax, is supported by altruistic feelings of man who seeks spiritual satisfaction as well as otherwordly-promised rewards for its being a fundamental worship. Zakat is ordered with its effects that prevent capital from remaining inactive and cause increase in national income. Spending (infaq) is repeatedly encouraged through spiritual motives. Big investments are proposed to be generally realized by big companies established by individuals bringing their small or big savings together, so spreading capital to the bottom of society. Not limited only to wage, labor is rewarded with profit as well. And it is an essential element in capital accumulation and savings are supported through prohibition of extravagance. Profit is used as an incentive to encourage investments. 6
Basic Principles of Islamic Economics n n n Sources of income are labor, capital, bearing risk and undertaking. Labor is highly appreciated and labor-capital partnership is encouraged. Monetary capital is assessed as a fertile female, which cannot produce young unless it is mated with a male (that is labor); and which can bring in yield only if labor accompanies it. Otherwise, it is a frozen, non-living being that does not develop and produce anything only by the passing of time over it. Therefore, monetary capital is titled the right to earn profit on condition that it takes part in enterprise and bears all risks together with labor/entrepreneur. 7
Basic Principles of Islamic Economics n n n In return for prohibition of interest, Islamic economics has developed a very rich production organization and offered so many other options based on kinds of participation, trade, exchange, leasing, and a bulk of other finance methods; so rich options that meet all needs of contemporary economic life without leaving any need for interest. These are mudaraba, musharaka, muzaraa, musaqat, salam, istisna’, juala, murabaha, deferred payment sale, and other options that can be devised thanks to dynamism of the system. Thus, interest income is substituted for profit, rental, wage, commission; each having a real consideration in the economic sense in contrast to interest that has not any comparable or just equivalent in loans or exchanges. Islam distinguishes between those income kinds with fine criteria. It accepts wages, which is the price of labor or service, rent, which is the equivalent of net benefit obtained from durable goods, and profit, which is the earning obtained by the partnership of labor and monetary capital in return for that labor or risk, but rejects interest, which is obtained in return for neither labor nor risk, and is either unearned or unequally distributed income. 8
Basic Principles of Islamic Economics Islamic economics aims a maximum economic welfare for everybody in society. n In this system, problem of production has been solved by giving vast economic freedoms to individuals such as private property and enterprise, by encouraging working, earning and then sharing, by taking measures to prevent economic resources from remaining idle and by removing all barriers blocking national and international trade. n As for the problem of distribution, it is solved through a system based primarily on obligation of zakat and prohibition of interest. n Thus, Islamic economics seems to aim a high level of production crowned with just income distribution. n The main difference between Islamic economics and other secular economic systems is that Islamic economics aims at ‘unlimited spiritual satisfaction added to the limited bodily pleasure’ while others aim only at ‘limited bodily pleasure’. n 9
BACKGROUND AND SOME FEATURES OF ISLAMIC FINANCE n n n Qur’anic Stance on Interest and the main reason for its prohibition Investment options Sensitivity of Islam to Right Interest Theories Capitalism, Islam and Interest Usury and Interest Time Value of Money Definition of interest and its kinds Comparison of Interest, Profit, and Rent Substitutions for interest: the systems of profit-loss sharing and equity participation, leasing, and many kinds of sales in Islamic economic system. Islamic Finance: Basic Features Conclusion 10
Qur’anic Stance on Interest and the main reason for its prohibition Investment options n n n n A private investor with a sum of money has four options. First, an active investment, putting, alone or together with other persons, their own capital into a project, managing it themselves and enjoying the fruits –profit in the case of a positive result- of their labor and capital themselves. Second, buying shares in a company and receiving a dividend, that is profit; Third, buying bonds or securities and receiving interest. Fourth, depositing in a bank and receiving interest. According to Islam, first two options that yield the income kinds of profit and/or rental-fee are permissible while the last two that yield interest income are prohibited. Why are these two options banned, and what is the rationale that lies behind the prohibition of interest in the Islamic perspective whereas profit and rental-fee are permitted? 11
Islamic Sensitivity of Right n n n Islam attaches an ultimate importance to the protection of ‘right’. In order to understand the rationale of the prohibition of interest, it is crucially important to take into consideration the importance Islam attaches to any kind of the right and its delivery to the owner. Irrespective of whom it belongs to, to a Muslim or a non-Muslim, to a human being or an animal, to a well-to-do person or a poor man, and irrespective of its size, -big or small, any right is protected by Islam with an utmost care. According to the Islamic understanding, if a poor man suffers from any injustice in a business with a well-to-do man, surely is it wrong. If it is the well-to-do man who is injured in the same business, this also should not be acceptable. The focus is the right itself and its protection, not who owns it. The prohibition of interest by Islam should be taken in this framework, and not only the right of interest payer but also that of the interest receiver should be embraced when it is analyzed. 12
Interest Theories (1) n n n n The issue of interest has been controversial throughout history. It was banned by the Abrahamic religions -Judaism, Christianity and Islam- as well as by all other religions, and criticized by philosophers of the Ancient Times and the Middle Ages. The expansion of commerce and trade to the end of the Middle Ages in Europe required frequent capital borrowing. Due to the need of large sums of capital borrowing, many theories of interest arose to confirm the necessity for interest and to justify it despite the robust resistance of the Church initially but being tolerant afterwards. Thus, the finance and banking system of the modern times has completely been based on the interest. But these theories have failed to explain why interest is paid. “The theory of interest is still in a state of great confusion” writes Conard (1966) 13
Interest Theories (2) n n n The common point of nearly all theories of interest is productivity of capital. Besides, there is “time-preference theory” of Bohm-Bawerk, which states that there is a difference of value between present goods and future goods. To him, the former are worth more than the latter. The difference between the two must be equalized through interest for present goods -namely ready money- to be lent for a certain period. These two points are seemingly the strongest sides of theories of interest. Islam also accepts the productivity of capital and the value differentiation between present and future goods as well. 14
Capitalism, Islam and Interest (1) n n The difference between Islam and capitalism upon that matter can be stated as follow: Capitalism imagines that potential income of capital -in ready moneyis transformed to an actual yield as soon as it is loaned. As for the value differentiation; capitalism requires the debtor to pay a fixed interest to the creditor at the very beginning of lending, deciding that this differentiation will always be against the debtor. As for Islam, it does not accept to charge interest at the beginning, realistically taking into consideration dynamism and variability of economic conditions. Because it is impossible to know at the beginning whether or not the potential income in capital will realize actually, and to estimate how much it will be even if it does. Should a comparison between Islam and capitalism be made, it could be explained through an example: While capitalism absolutely judges a female to gi birth to a baby as soon as mated with a male, Islam does not judge at the beg judges according to the result; because this female may not give birth, or may to not only one baby but two or three, or may even die without giving birth. 15
Capitalism, Islam and Interest (2) n n n n Accordingly, interest policy somehow bears a resemblance to gamble at which one party wins while the other party loses. Because, while high interest rates in hard economic conditions even may cause the borrower to go bankrupt, low interest rates in good economic conditions cause the lender to undergo an injustice. In the first case, borrower is subjected to injustice, for he has to pay the interest together with the principal even when he suffers losses, not to mention the time when he makes no profit. In the second case, the lender who suffers injustice, for he can get only it is as much interest income as fixed at the beginning of lending, even when the borrower makes large sums of profit out of his -the lender’sown capital and because he might earn much more, should he invest himself rather than loan. A just share between the two, that both sides are satisfied with, is only one of too many probabilities. Since uncontrolled deviation occurs between initially determined interest rate and finally realized return rate, interest policy become a reason for financial loss for either borrower or lender, hence it is rejected by Islam to safe both parties from inflicting on each other with harm. Thus, interest is sometimes an ‘unearned ’ sometimes ‘earned but unequally distributed ’ income. 16
Qur’anic Stance on Interest n n n Then, the most important reason for interest to be forbidden by Islam and the only reason the Qur’an particularly mentions thereabout can be stated as following: “Interest is prohibited due to the fact that either the borrower or the lender would absolutely and inevitably be subjected to an injustice in any case, for its rate is fixed at the very beginning, although it is impossible to predict the outcome, profit or loss, or how much either would be. ” “If you persist in interest the Qur’an, “Either you will wrong, or you will be ” says wronged. ” Thus, it is clear that Qur’an identifies interest with injustice. Once this very feature of interest –the fact that it is unavoidably a reason for the dealers to wrong the other side- is noticed and accepted, we can resolutely claim that it is impossible for any religion, philosophy, economic or political theory to accept or consent to interest if they favor and attach importance to the fair distribution of income. It does not matter whatever the interest rate -high or low-, and whatever it is called -interest or usury-. 17
Interest and Football Game n n n n We can resemble the interest mechanism to a football game that has so strange rules as that A team (capital) is decided to have scored virtual three goals at the beginning of the game. However, it can not score any more goals and it will only defense its goal against the attacks of the B team (labor/enterprise). As for B team, even if it actually scores two goals, it is still taken to be defeated. It can win the game only if it scores at least four goals. Here, A team stands for capital and B team for labor-entrepreneur. Is it possible to get any just and fair result from such a football game? Is there any difference between that strange football game and the interest mechanism? Here we can resemble the interest mechanism to a two-bladed saw, or a knife, that cuts on both sides, on one occasion it is the lender who is injured and the borrower on the other occasion, but either side is unavoidably wronged by the interest mechanism. So, we can say that the prohibition of interest by Islam has its origins in the ultimate sensitivity of the Qur’an to right and its protection, with an all-embracing vision. 18
Usury and Interest (1) n n n Muslims have a consensus throughout history that ‘usury includes interest’. The phenomenon of Islamic banking and finance can be said to be the outcome of this consensus. Accordingly the Pakistan Council of Islamic Ideology clearly declared that fact in its 1980 report on the elimination of interest from the Pakistan economy stating that: “The term riba (usury) encompasses interest in all its manifestations irrespective of whether it relates to loans for consumption purposes or for productive purposes, whether the loans are of a personal nature or of a commercial type, whether the borrower is a government, a private individual or a concern, and whether the rate of interest is low or high” (The Council’s Report, 1980, p. 1). Injustice and unequal distribution of income is an indispensable outcome of interest as well as so-called usury. Because, while any high rate of interest causes the borrower to lose in hard economic conditions, any low rate works to the loss of the lender in favorable economic conditions where return on capital is high. That is why we can not take interest and usury separately. Usury is blamed throughout history to be exorbitant and excessive and thus disapproved by almost everybody. 19
Usury and Interest (2) n n n A question: Is not a high interest rate (usury) closer to justice in the favorable economic conditions where return on capital is very high than a low interest rate that is favored by many? Hence, so called a reasonable –that is low- interest rate is as much exposed to criticism as usury. It means that it is not logical to exclude usury from interest, or interest from usury, since both have the same effect -the effect of injuring one of the parties-. This case reveals that there is not any acceptable rate of interest, low or high, from the standpoint of the equitable distribution of income. That character of interest arises from the fact that its rate is predetermined despite the impossibility for mankind of predicting whether or not a profit will be made, and even if, how much it will be. Thus, the discussion throughout history of distinguishing between interest and usury does not make any sense to us. However, the reason the focus has been on usury throughout history is that it is mostly the borrower who has been damaged historically at any interest bearing transaction. Yet, rational approach requires either to admit all kinds of interest including usury despite all its negative outcomes, or to reject it totally in order to be logical and consistent. 20
Time Value of Money (1) n n n As for differentiation of value, it is called today ‘time value of money’ and used to justify the interest. The time value of money is the central concept in finance theory. Time value of money is based on the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. It is derived from the timepreference theory of Bohm-Bawerk. In fact, it is pointed out by the Prophet Muhammad fifteen centuries ago. As regards the position of Islam on the differentiation of value, it does not agree to set a price for ‘time’ during which a sum of money is loaned, or a due payment is postponed to a future time, since it is not possible to know what ‘time’ will bring for either side. This is because a great importance is attached to the value equality between the two items that are exchanged. In this respect, a ready 100 euros can not be exchanged for a delayed 110 euros for it is impossible to foresee the future. Hence, these two amounts may not be equal in value at the maturity. Is not it probable that a 90 euros of today may turn to have the value of 100 euros next year due to revaluation of that currency? 21
Time Value of Money (2) Likewise, since it is impossible to predict for which side (for the creditor or the debtor) the value differentiation would appear, Islam has forbidden all delayed sales in order to protect the rights of both sides. n Thus, while a tone of iron can be exchanged today for 100 packs of cement at the market price, the same exchange is not permitted in case one of two items is delayed. n Nor two items of the same kind are allowed to be exchanged because of the possibility of value differentiation in one of two items, even if they are of the same size. n So, a tone of coal in summer can not be exchanged for the same amount of coal to a term in winter, let alone for an excess amount of it. In short, because it is not possible what ‘the time’ brings in the future, any exchange on a deferred basis is not allowed in Islam. n 22
Time Value of Money (3) n n There is an exception to that prohibition: Islam allows no delayed sales but one wherein one of two items exchanged is money. This is so for several reasons. First, people need for delayed sales because they may not have a ready purchasing power –cash money- while the need for good or service to be bought is urgent and pressing. Second, common reliance is placed upon money as a standard unit of measure of value more than other units of measure. Third, people are indifferent to the differentiation of value between money and goods because of their being of different kinds, and because market conditions may cause commodity prices any time. 23
Time Value of Money or Time Value of Goods? (1) n From the Islamic perspective, Money is definitely distinguished from the commodities for its being: n n n a unit of value measure for all other goods. It is a unit of measure like measures of weight and length. Thus, its value should not change day-today like elastic materials that stretch or shrink by the time as with other units of measure, for example, as one meter is 100 cm as well as one kg is 1000 gr. all the time. Its value is not measured by other things, but it always measures all other goods, except the inflationary cases where its value is restored by indexing it to a group of goods, or the case of foreign exchange. So, 100 lira should be exchanged for 100 lira today and tomorrow if it is a unit of value to measure other things, not a commodity to be measured by other measures. 24
Time Value of Money or Time Value of Goods? (2) n n Therefore, we had better change the term ‘time value of money’ to the ‘time value of goods’, which are measured by money for the sake of monetary economy. This is because money is not any thing itself; its value is derived from the commodities it represents, except the case when it is a commodity-money like gold and silver. If somebody wants to make money out of money, s/he should not only deal with it, but correlate any monetary transaction with a real asset, i. e. a commodity of which value changes according to the daily supply and demand conditions, thereby making a profit or a loss. It should be noted here that, while the value of any currency as a unit of measure should not change by the time, its value changes of course compared to other currencies. That is why exchange rates of different currencies frequently change. 25
Financial Bubbles and 2008 Global Financial Crisis n n n A more important example that can be suggested to have given way to the financial bubble after the burst of which the 2008 Global Financial Crisis occurred is the sale of, say, a financial certificate of $100 with 10% rate of interest and 1 year time for a higher amount and/or for a higher interest for two years time. Thus, a financial bubble is built if the nominal increase in the value of the financial certificate is not balanced with a real value increase in the underlying assets upon which the financial certificates or derivatives are based. In short, because it is not possible what ‘the time’ brings in the future, any exchange on a deferred basis is not allowed in Islam in order to avoid any financial loss that may arise on behalf of either side while capitalism seems to favor only the creditor. 26
2008 Global Financial Crisis n n n In the current interest-based global financial system, trillion dollars’ bonds’ markets fluctuate upon any interest rate change and some people earn billions of dollars in a few hours while others lose. One point hike in interest rates pulls upward debt stocks of states or firms, while an opposite move causes losses to creditors. Thus, big fortunes change hands simply because of very small changes in interest rates. The Global Financial Crisis of 2008 is the result of bursting of financial bubbles that grew in recent decades, and the most effective factor that has generated the bubbles, we can suggest, is interest. Interest represents allocation of an unearned and ‘imaginary income’, which is assumed to have been earned out of transactions based on derivatives. Interest bearing negotiable instruments and securities are traded without any limit. Even financial transactions seemingly irrelevant to interest are somehow hand in hand with interest. In futures contracts, for example, what determines spread –difference between spot and future prices- is nothing other than interest rates. 27
Vatican’s Call n n n Avoiding future crises seem to be hard unless alternatives to interest are found since interest has become the indispensable element of the modern economies, even penetrating into their cells. Giving an ear to the voice of the Vatican calling to the Islamic finance and ethics, we had better have a closer look at the option of interest free finance and banking system in order to have a solid and sound financial system. With principles it offers, Islam has intended factors of labor and capital to earn or to lose always together like players of the same team, thus sharing the same destiny; not like two contending rival teams with either party gaining at the cost of other party unavoidably. It can be said that prohibition of interest is most intended to create a common fate for members of society. 28
Interest and Its Kinds: Islamic Perspective n n n First, interest of loan al-dain), one that appears in loans as a percentage or any fixed (riba payment added to the principle, Second is interest of exchange al-bai‘), one that appears in exchanges. (riba Interest of exchange- is also divided into two kinds; n interest of surplus (riba al-fadl) that appears as a quantitative surplus in one of the exchanged items of the same kind; (As in the case when two measures of wheat is exchanged for three measures of wheat, even if it is due to the difference of quality. ) n interest of delay or deferral al-nasia) that appears in exchanges as a quantitative or (riba potential surplus (value differentiation) when one of the items exchanged is delayed, except the exchange wherein one of the items is money. As in the case when a tone of iron is sold for the same amount of iron on a deferral basis; let alone for a more amount of iron delayed. Here, interest arises as a potential value differentiation between two items due to the delayed delivery of one of them. Time is a reason for this value differentiation between the present and future items exchanged; Hence, it causes a potential excess in one of the items when compared to the other item. Because nobody knows in advance for whom and how much this potential surplus proves to be actual, Islam prohibited all the delayed sales. ) 29
Gambling and Gharar n n Similar to interest, Islam prohibits gambling, a zero sum game where one party loses while the other gains, and any trade where one of the items traded is uncertain, that is called gharar, in order to protect both buyer and seller. Gharar is defined by the modern scholar of Islam, Professor Mustafa Al-Zarqa, as “the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling. " Specific examples of gharar transactions are e. g. , selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother’s womb etc. 30
Comparison of Interest, Profit, and Rent n n n As an earning, interest income is confused in many cases with profit and rent/rental, and sometimes with wage in the capitalistic economics. In the socialistic economics the word ‘profit’ is almost always used to include interest and even rent. Whereas, Islam precisely defines these earnings of different factors and carefully distinguishes them from one another. 31
The Comparison of Interest with Rental Fee (1) n n n n Say, one has a sum of money, who wants to make money out of it. Question: What is the difference between “the interest income” he gets by lending his money at interest and “the rental” he gets by leasing a house he has bought with the same money? The element of differentiation between interest income rental-fee and depends on the nature of the rented things and on their advantages and expected benefits: If the thing is a physical capital that is non-consumable and capable of being used without changing its essence and without damaging its intactness, the advantage or benefit would be a good consideration for the rental-fee. This advantage may be a service rendered by persons or a usufruct (right to use) of things. On the other hand, where the borrowed thing is monetary capital that is consumable and perishes when it is used, -as in the case of money, food and drink-, the rental fee paid for the use would be in excess of what is owing (the principal) by the lessee. This excess so paid is interest, regardless of the fact that it is called ‘rental’. 32
The Comparison of Interest with Rental Fee (2) n n This is because the advantage and benefit of the thing rented -which is non-consumable- is certain, for it is always ready to be used in any case, and it is strongly possible for it to be handed over by the lessee to the lessor. To put another way, in a leasing contract, both the fruit that will be enjoyed from the property leased and the fee to be paid in return are certain. The lessor and the lessee both certainly know what they will get from the business. This case explains the legitimacy of the fixed income Islamic securities, i. e. sukuk. Sukuk are real asset backed securities that comply with the Islamic law and its investment principles, which prohibits the charging or paying of interest. They bring profit or loss according to the outcome of the business when they are shares, and fixed rental fee when they are leasing certificates. 33
The Comparison of Interest with Rental Fee (3) n n But, as regards the interest, neither the advantage of the consumable thing rented -as in the case of ready money- is certain, nor is it possible for itself (the same coins or notes) to be returned to its owner. Because it is unknown whether the renter of money would make profit out of it and how much it would be even if he does. In short, rental-fee has a certain consideration: that would be either service of persons or usufruct of properties. In contrast, interest has no certain consideration. In interest, while the lender, in the case of loan at interest, knows exactly what he will earn, what result the borrower come across is definitely unpredictable. 34
The Comparison of Interest with Rental Fee (4) n 1. 2. 3. n n n To put it shortly, the conditions of an earning to be a legitimate rental fee are: that the good rented should be durable, that the limits and all the qualities of the benefit that is received form the rented thing and paid for could be specified, and that the rented good could be returned back to its owner as it is; its intactness should not be damaged. It is clear that lending money does not meet any of these conditions. Thus, so-called rent of a monetary loan is nothing else than ‘interest’. In the Islamic finance, thesukukthat pays a fixed income are the certificates that represent the partnership in the real properties that ar rented. Therefore, fixed income can not be compared to fixed sukuk interest income on the loan. 35
The Comparison of Interest with Profit (1) n n n Profit is a surplus to assets, shared between monetary capital and entrepreneur, resulting from the investment of capital coupled with entrepreneurial ability, in a course of production, through transformation of the capital from one state to another; for instance, from money into commodities and from commodities into money again or another state. In other words, profit is earned by investing money in an economic activity -agriculture, industry and commerce- and then it is retransformed whether into a larger sum of money (profit) or a lesser sum (loss). Profit is a result and consideration of a supplement that is an actual service rendered to community by monetary capital coupled with entrepreneur. When the owner of capital participates in a business only with his capital, he has to take risks of loss in that business to deserve a profit. Therefore, profit can be seen as the return for bearing risk. For, after all, business is subject to failure; so in profit, the principle is: “c”. 36
The Comparison of Interest with Profit (2) n n n What makes profit permissible is its being a ratioof the realized positive outcome at the end of the business, not the rate of return on the loan itself that is predetermined as in the case of interest. Thus, while profit is a result of a positive result of a productive business, interest has nothing to do with the result of the business regardless it is a positive or a negative sum game. In profit, when the investment results in a loss, the owner of capital is directly affected by it, whereby the community is affected indirectly. But, interest is an income given to money loaned, in any case, even when there is no surplus to assets and no service rendered to the community. In interest, when there is a loss, capital is not affected by it, whereas that loss directly concerns the capital itself before all and the community all is affected by it. 37
The Comparison of Interest with Profit (3) n n n Interest represents the selfish philosophy of Nasreddin Hodja’s neighbour who believes that the pot he loaned has given birth, but doesn’t believe that it has died. Nasreddin Hodja is a Turkish populist philosopher and wise man who is always remembered for his funny and lesson-giving stories and anecdotes. One day he borrowed a pot from his neighbour. The next day he brought it back with another little pot inside. "That's not mine, " asked the neighbour. "Yes, it is, " said Nasreddin. "While your pot was staying with me, it gave birth to a baby. " Some time later Nasreddin asked the neighbour to lend him a pot again. The neighbour agreed, hoping that he would once again receive two pots in return. However, days passed and Nasreddin had still not returned the pot. Finally the neighbour lost patience and went to ask for his property. "I am sorry, " said Nasreddin. "I can't give you back your pot, since it has died. " "Died!" screamed the neighbour, "how can a pot die? " "Well, " said Nasreddin, "you believed me when I told you that your pot had a baby. Why don’t you believe me now when I tell you that it has died? " 38
The Comparison of Interest with Profit (4) n n Interest is the cause of injustice in any case, regardless of whoever pays it, whoever it is paid to, whatever its form or its rate is -exorbitant or reasonable. As interest is identified with injustice, wherever there is interest, there is inevitably an injustice. The most important economic effect of interest is its being a serious obstacle to a justly share of outcomes of economic activities, positive or negative, between monetary capital and ‘labour-entrepreneur’ nationwide, and between the borrowing and the lending countries at the international level, so violating distribution of income any time, anywhere, any level and in any case. Thus, starvation and poverty prevailing in the most part of the present world can be said to be the result of not lack of resources but a global economic exploitation, which stems from a worldwide dominant economic system based on mostly interest to a considerable extend. 39
Islamic Finance (1) n n n Though Islam prohibited the option of interest in the business life, it has offered a wide variety of many other options in a way that there is not need left to interest any more to carry out all kinds of economic activities, and Islamic banking and finance in particular. In Islamic economics, interest is substituted for profit, rental, commission, and wage, which are regarded as legitimate earnings of trade, its derivatives, joint venture and partnerships, leasing, and other lawful economic activities. So many kinds of sales and equity participation with its many alternatives, which are precisely defined in the Islamic law books, can be said to be enough to meet the needs of the modern communities. Moreover, there is no limit to devising and formulating new methods provided they are cleared of interest. Here, Islamic finance is a financial system in consistent with Islamic economics that prohibits interest as well as investing in unlawful businesses such as alcohol, pork, pornography, gambling, etc. In Islamic banking and finance, profit maximization is limited with social and moral values. So, it is multi-purpose and not purely commercial and it is strongly equity-oriented. 40
Islamic Finance (2) Basic Features n n n Islamic banks and financial institutions differ from the traditional ones in that: they operate according to the Islamic principles; they trade in commodities not in money; and there is more to Islamic financial institutions than maximizing the profit in contrast to the traditional ones as they aim to contribute towards a more equitable distribution of income and wealth, and increased equity participation in the economy (Chapra l 982). Profit and loss sharing (mudarabaand equity participation ) (musharakaare the most favored modes of Islamic finance as well ) as Islamic banking. 41
Islamic Finance (3) n n n Mudaraba (Profit/loss sharing) Mudaraba is an arrangement between a capital provider and an entrepreneur, whereby the entrepreneur can mobilize funds for its business activity. The entrepreneur provides expertise and management and is referred to as the Mudarib. The profit is shared between the capital provider and the entrepreneur according to a pre-agreed ratio of the realized positive outcome. While both parties share in profits, only capital provider bears the losses of capital, if occurred, and entrepreneur suffers the loss of his labour. Participatory arrangements between capital and labor, as in the case of mudaraba, reflect the Islamic view that it should not be only the borrower who bears all the risks and costs of a failure in business. Thus, the result is a more balanced distribution of income, not allowing lender to monopolize the economy as with the most outstanding outcome of interest mechanism. 42
Islamic Finance (4) Musharaka (joint venture or equity participation) n n n Musharaka (joint venture or equity participation) is a partnership contract by the mutual consent of the parties for sharing of profits and losses in a joint business. Here, the bank provides funds, which are mixed with the funds of the business enterprise, and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios of the actual positive outcome, while the loss is borne by each partner strictly in proportion to respective capital contributions. As stated repeatedly, in equity participation (musharaka) or in a profit and loss sharing (mudaraba), what makes profit permissible is the profit-sharing ratioof the realized positive outcome at the end of the business, not the rate of return on the loan itself that is predetermined in the case of interest. 43
Interest-free Banking (5) Bank Accounts n n Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safekeeping (alwadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors' money. Cheque books are issued to the current account deposit holders. Islamic banks provide the broad range of payment facilities clearing mechanisms, bills of exchange, travelers’ cheques, credit/bank cards etc. The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it predetermined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please. (Ariff, 1988, 51) The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. If withdrawn, no profit is paid. The profit-sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions. 44
Islamic Finance (6) Investment Portfolio n n n n At the investment portfolio end of the scale, Islamic banks and financial institutions employ a variety of instruments. The mudaraba musharaka and modes are supposedly the main channels for the outflow of funds from the banks. In practice, however, Islamic banks or financial institutions have shown a strong preference for other less risky modes. The most commonly used mode of financing seems to be the 'mark-up' device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before reselling it to the client on a 'cost-plus' or ‘mark-up’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank that simply lends money to the client to buy the good. 45
Islamic Finance (7) Leasing n n n Leasing or ijara is also frequently practised by Islamic banks and institutions. It means selling benefit or use or service for a fixed price or wage. Under this mode, Islamic banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i. e. , rental for the use of the equipment and installment towards the purchase price. 46
Islamic Finance (8) Other kinds of sales n n n Islamic banks and institutions have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai' muajjal. It is considered lawful in Islamic law to charge a higher price for a good if payments are to be made at a later date. According to Islamic law, it is not interest, since it is not a lending transaction but a trading one. A pre-paid purchase of goods, which is termed bai‘salam, is a means used to finance production by Islamic banks and financial institutions. Here the price is paid at the time of the contract but the delivery takes place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Similar bai‘salam, but more extended than it, Istisna'a is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery. It can be used to finance the manufacture or construction of houses, plants, projects, and building of bridges, roads, and highways. 47
Conclusion (1) n n n The issue of interest is a complication of all the economies and a problem for all the mankind. Since it is naturally a reason for an unavoidable inequitable distribution of income in any interest bearing transaction, Qur’an explicitly identifies interest with injustice either for borrower or lender, thus prohibits it in order to protect the rights of both in an all-embracing manner. Interest is replaced with so many other options based on the kinds of participation, trade, exchange, and leasing in a way that no need is left to interest. Islam regards any addition to a principal or a debt based on time as interest no matter what the name or the form is. All of the deferred goods-for-goods and money-for-money exchanges are prohibited due to the possibility of value change that causes one of the parties to suffer a financial loss. The exception to those banned forward exchanges is money-for-goods or goods-for-money exchanges, which is widely used in all societies. Interest income is substituted for profit, rental, wage, commission; each having a consideration in the economic sense in contrast to interest that not any comparable equivalent in loans or exchanges. Islamic banking and finance system based on these kinds of income mostly favors the modes of profit loss sharing and equity participation. 48
Conclusion (2) n n However, since these modes of business activities demand such humanistic/ethical values as trust, honesty, integrity and professionalism, they are the limits to the ultimate success of Ilamic banking and financial institutions in all societies. Even in its present form that prefers risk free or less risky kinds of transactions, Islamic banking and finance system can be taken as a considerable step and an opportunity for the whole mankind towards a more equitable world. More importantly, Islamic finance can be a bridge between the Western communities and the Muslim societies, thereby contributing to the world peace as well as the common welfare. The roots of this cooperation are available in the common origins of the Jewish, Christian and Islamic traditions that prohibit interest. Resisting the interest for 1500 years, longer than the lifetime of Islam since its birth, the Vatican accomplished its historic mission by referring to the Islamic finance to the current western financial world, which can be regarded as the beginning of a new age when the whole mankind can expect a better future in terms of peace and socio-economic welfare for all. n 49
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