Islamic Banks: Have They Eliminated Interest, or Just Changed its Name?

"Those who charge usury are in the same position as those controlled by the devil's influence. This is because they claim that usury is the same as commerce. However, GOD permits commerce, and prohibits usury. Thus, whoever heeds this commandment from his Lord, and refrains from usury, he may keep his past earnings, and his judgment rests with GOD. As for those who persist in usury, they incur Hell, wherein they abide forever" [The Koran]

The rise of Islamic Banking over the past 40 years into an institutional financial structure spread over the globe has been a phenomenon that has attracted lots of interest. As is often the case whenever a new idea arises it s rise is associated with many falsehoods, half truths and unfulfilled promises. The whole concept of Islamic Banking rests on 4 Qoranic verses that speak against Ribaa (2275-81; 3:130-2; 4:161 and 30:39). Although the Arabic word Ribaa does not mean interest rate yet the four schools of Islamic jurisprudence have interpreted Ribaa to imply interest rates. In the opinions of many that interpretation could easily have been usury. In that case the idea of “Islamic Banking” would no longer appear to be inviolable.

The Islamic Development Bank, the largest Islamic Bank, is a breath of fresh air in the stultified field of economic development. How appropriate it is to give interest free loans to the developing nations instead of burdening them with huge debt service and strict conditionalities a la World Bank and the IMF. But this idea of interest free banking which rests strongly on the two sources of (1) Ijma, Consensus, and (2) Qiyas, analogy, becomes more problematic in other areas.

It should be clear from the above that the basis on which interest free banking rests does not sanctify the idea but in fact is an attempt to replace the interest rate income with a substitute that achieves the same objective as the banished instrument. This is nothing short of a process that seeks conformity with the letter of the prohibition against Ribaa but not its spirit. Since income that flows from trade and risk sharing is considered to be Hallal, lawful, Islamic Banks have adopted Profit Loss Sharing (PLS) as a replacement for the Lender-Borrower Haram, forbidden, relationship.

The Mudarabah and Musharakah, the most popular methods to avoid interest rate income are structured so as to yield the same income that traditional interest rates would have produced in traditional banks. Such a cumbersome structure makes Islamic Banks less competitive than traditional ones. It might be instructive in this regard to recall the words of the Islamic Pakistani economist Ahmad: “”No single Moslem country is running its financial institutions without resorting to interest… no one knows how to do it…they resort to some kind of subterfuge..change the name of interest and you have abolished interest”.

An even more scathing criticism is delivered by Dr Hasanuz Zaman who writes:
".. many techniques that the interest-free banks are practicing are not either in full conformity with the spirit of Shari’ah or practicable in the case of large banks or the entire banking system. Moreover, they have failed to do away with undesirable aspects of interest. Thus, they have retained what an Islamic bank should eliminate. "

The current Sharia prohibition on Ribaa renders consumption loans very difficult to structure and as a result the practice of financing trips and personal purchases under Islamic Banking rules becomes harder to structure and implement. Furthermore, a real challenge of Islamic Banking is the ability to develop effective tools that Central Banks can employ in transacting their monetary policies.

Equity and justice, the hallmarks of an Islamic society, do not have to be incompatible with a banking system that charges interest rates. All what is needed to make traditional banking acceptable to the Moslem believer is an act of Ijma, consensus, by Islamic fiqh whereby a distinction is made between usury and a regular interest rate. Once the Islamic Ulamah agree to equate Ribaa with usury then the often cited reason for the prohibition of Ribaa in the first place, ruinous borrowing and the need for Adl, justice, in protecting the weak and the poor would have been met.

Moslem societies do not have to invent financial instruments to perform the function of what is already being done but albeit under a different name. Islam can enrich us all by emphasizing the importance of ethics in the economic sphere but it does not need to reinvent the wheel in order to accomplish that.