The Prohibition on Usury (Riba)
The usury verse is not the only verse in the Quran on business. Much more prominent in the Quran is the command to engage in honest business.
Two Quranic verses which explicitly rule out usury are: O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are indeed believers (Quran 2: 278).
However, other than making a distinction between trade and usury, such that the former is allowed and encouraged, while the latter is expressly frowned upon, the Quran does not exactly define what constitutes riba. Those who devour usury will not stand except as stand one whom the Evil one by his touch Hath driven to madness. That is because they say: Trade is like usury, but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past, their case is for Allah (to judge); but those who repeat (The offence) are companions of the Fire: They will abide therein (for ever) (Quran 2:275).
Thus scholars have turned to the Sunnah for elaboration. The majority of the scholars claim that there is an absolute prohibition against transaction involving interest. During the Makkan period, it is noted as a strong recommendation against taking interest. During the Madinah period, however, it is articulated as an outright prohibition. But, there are varying degrees of difference among the legal schools as to how this prohibition is put into practice. There is a tendency to conflate all types of interest as being equally forbidden without delving into the details.
Semantically, riba means excess or an addition. It refers to an excess stipulated in a contract or an exchange. There are two juristic categories of riba: riba al fadl and riba al nasiah. Riba al fadl refers to an excess in weight/measure, while riba al nasiah refers to an excess arising from the benefits of delay. Some Hambali scholars, including Ibn Qayyim al Jawziyya, have added a third category, called riba al jahiliyya, referring to the riba practised in the pre-Islamic period. According to this period, the lender increases the interest on debt if borrower has not paid it by the maturity date of the loan. In effect, the rate of increase is so great that it pushes the borrower deeper and deeper into debt, and unable to ever pay it off. This kind of exploitative practice is what the Quran refers to in its discussion of riba. The other two types of riba have been developed later by jurists by examining the Sunnah.
However, most Islamic scholars over the years have interpreted the prohibition on usury to mean all forms of interest, which essentially means that debt financing is illegal in Islam, at least according to that interpretation. This has led to the creation of so-called Islamic banking, a banking system that allegedly does not rely on debt financing, but only equity financing. The reality is that Islamic banking essentially re-packages interest under a different name such as mark-up rate or profit rate, and re-prices goods to include the full interest cost within the loan. For example, if a person bought a new $15,000 car with a conventional 8% loan, he would pay interest and principle until the debt is cleared. An Islamic bank on the other hand would simply calculate the total dollars he would pay back over the loan term with interest, and then charge him that amount for the car to be paid over the same loan term while claiming that there was no interest being levied. It is simply a semantic game being played. There are few exceptions in which the Islamic banks do engage in equity financing, but then they are unable to finance consumption purposes.
We argue that the Quran does not mandate equity over debt financing, and allows transactions that are mutually beneficial. The usury verse is not the only verse in the Quran on business. Much more prominent in the Quran is the command to engage in honest business, in particular to give full measure. Specifically, the Quran says, Woe to those that deal in fraud; those who, when they have to receive by measure from men, exact full measure- but when they have to give by measure or weight to men, give less than due (Quran 83:1-3). This command requires that both parties to any business transaction pay the full and fair values of what they are purchasing. Failure to do so is a profound violation of Quranic commercial principles. Debt financing, when done in accord with this principle is permissible. When the lender gets more than he is entitled to, he commits the sin of usury. When he gets less, he is engaging in charity. But charity is a voluntary act, and not one required in business transactions.
What is the full measure in debt financing? It is the value that the borrower gains from the use of the funds and the lender foregoes by giving up control of those funds for the period of the loan. There are three components of the value of the funds. The first is the inflation premium. If a borrower takes money this year, and returns the same amount 10 years later, has he returned what he borrowed? Only if there has been no inflation in those ten years. Inflation shrinks the value of borrowed funds, and this shrinkage must be compensated for if the borrower is to fully return the value of the borrowed funds. Secondly, there is what is called the opportunity costs. Savers can always engage in equity financing rather than lending money. They can purchase a piece of rental property, or shares of stock of a company, or they can find a partner with an idea and fund his business for a share of ownership. Some of these schemes may yield fantastic profits, while others may go bankrupt. This rate varies over time depending on the economy and business conditions. But let us assume for argument purpose that it averages out to about 5% per year. This notion is often referred to as the time value of money. If a saver is to lend money, he is giving up the opportunity to earn 5% in equity investments by lending money instead. A borrower must then compensate him for this opportunity loss over the life of the loan, otherwise the borrower is not giving full measure. Finally, the last component to consider in debt financing is risk. When a saver lends money, she has no guarantee that the borrower will pay the money back. The borrower may lose his job, or his newly bought car might be stolen, or his business may fail. In these circumstances, the lender is unable to get her money back, and takes a loss. The risk level can be reduced by the borrower offering collateral, but even collateral can lose a value, for example if the price of houses collapse and homeowners stop paying their mortgages due to job losses.
Some Muslims criticise interest as inherently exploitative, and believe that it creates an oppressive economic system. This is not necessarily a correct reflection of the nature of modern commercial lending and the activities of the village moneylender, who often was exploitative. Modern banks gather together the modest savings of millions of the poor and middle class, and then make that pool of savings available to big business and large borrowers. The majority of saving is done by the poor and middle classes, while most of the borrowing is done by the powerful. So who is exploiting whom? The purpose of Shariah is to implement justice. If there is justice, then it is Shariah. Where is the injustice in this that would lead debt financing to be banned? It is for Muslim economists to offer a contemporary ijtihad on the issue.
Excerpts from the book: In Pursuit of Justice: The Jurisprudence of Human Rights in Islam by Dr.Maher Hathout, Uzma Jamil, Dr. Gasser Hathout & Dr. Nayyer Ali (Muslim Public Affairs Council, 2006).
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