A Definition and Meanings of

Terms
l-wadiah means safe keeping.

Bai'muajjal means deferred-payment sale.

Bai'salam means pre-paid purchase.

Baitul mal means treasury.

Fiqh means jurisprudence.

Hadith means prophet's commentary on Qur'an.

Halal means lawful.

Haram means unlawful.

Ijara means leasing.

Iman means faith.

Mudaraba means profit-sharing.

Mudarib means entrepreneur-borrower.

13

Murabaha means cost-plus or mark-up.

Musharaka means equity participation.

Qard hasan means benevolent loan (interest free).

Rabbul-mal means owner of capital.

Riba means interest.

In any economy banks play very important role. A bank is a

reliable financial institution, which has core business of

mobilizing the savings of people for investment purposes. It

receives the money from one group and lends to other group

of people. So bank performs the duty of financial

intermediary.

Usually there are two types of banks, conventional banks

and Islamic banks. In simple words Islamic banks operate in

interest free system. Prohibition of interest is ordained in

Islam in all forms and intent. This Prohibition is strict,

absolute and unambiguous.

The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! Fear Allah and give up what remains of

your demand for riba, if ye are indeed believers."

Verse 2: 279 says:

"If you do it not, take notice of war from Allah and His

Messenger. But if ye turn back, ye shall have your capital

sums. Deal not unjustly and you shall not be dealt with

unjustly."

It therefore, follows that interest is prohibited as it leads to

injustices and Islam is against all forms of injustices and

exploitations and pleads an economic system, which aims at

securing extensive socio-economic justice. The Islamic law of

prohibition of riba, which includes interest, was originally not

based on economic theory but on Divine Authority which

considers the charging of interest as an act of injustice (Dr.

Siddiqui).

Islamic banks appeared on the world scene as active players

two decades ago. But many of the principles on which

Islamic banking is based have been commonly acceptable all

over the world for centuries rather than decades, as it is

evident that Islamic finance was practiced predominantly in

the Muslim world throughout the middle Ages, promoting

trade and business activities. In Spain and the Mediterranean

and Baltic States, Islamic merchants became indispensable

middlemen for trading activities. It is claimed that many

concepts, techniques, and instruments of Islamic finance

were later adopted by European financiers and

businesspersons. "Although the western media frequently

suggest that Islamic banking in its present form is a recent

phenomenon, infact, the basic practices and principles date

back to the early part of the seventh century"

(Islamic Finance: A Euro money Publication, 1997).

The main issue here is to know about the differences

between operations of a conventional bank and an Islamic

bank by focusing on the principles and instruments of Islamic

banking.

It is difficult to say with accuracy which was the first such

company or bank that pioneered this concept of Islamic

banking in practice. Some analysts and experts in the field

are of the opinion that, Islamic banking and finance, in the

modern context, first emerged in 1963, when Mit Ghamr

Saving Bank began an experimental project offering

interest free banking in Egypt. The project was a success

and lead to the bank opening four new branches by 1967. In

the same year, eight new banks mushroomed offering

interest free banking. Due to the political climate prevailing

in Egypt during that period, the success of these Islamic

banks was seen as a threat, and they were forced to close

down in 1971.

Some observers are of the opinion that the concept of an

"Islamic bank" was born at the Islamic Summit of Lahore,

Pakistan in 1974 which recommended the creation of an

Islamic Development Bank. Since then Islamic banking and

financial institutions have grown rapidly. A 1993 report from

the International Association of Islamic Banks estimated the

then industry to be valued at $80 billion. A more recent

article appearing in the Wall Street Journal estimates the

potential market for Islamic investments to be up to $150

billion.
Within a time span of a few decades, Islamic banking and

financial institutionshave been swift to establish themselves

in all parts of the world in the form of Islamic Commercial

Banks, Investment and Holding Companies, Takaful

(Insurance) Companies, and Development Banks. The over

150 such institutions that invest money according to Islamic

economic principles, are poised to increase in number over

the next few years. Several Muslim countries, Indonesia,

Iran, Malaysia, Pakistan, Sudan and Turkey, in recent years

have been taking systematic steps to establish an Islamic

banking and financial sector. The speed with which Islamic

banks have sprung up and the rate at which they have

progressed make it worth while to study them

systematically.

Malaysia in 1983 passed an Islamic Banking Act to facilitate

the growth of indigenous Islamic banks and finance

companies thus became the first Muslim economy to issue

bonds on an Islamic basis. Since then, some 50-60

institutions have been established, and are now in the

process of forming an Islamic inter-bank market (i.e. in which

banks borrow or lend to each other). Within 10 years of

introducing the Islamic Banking Act, the Malaysian

government has taken further steps to popularize Islamic

banking and finance, by allowing conventional banks to offer

Shariah-compliant instruments. The most distinctive feature

of Islamic banking in Malaysia is that it is being embraced by

its Chinese and non-Muslim population who are opting to

deposit their savings or borrow money on an Islamic basis.

These trends in Malaysia and elsewhere are having a

profound effect on the banking and financial world as a

whole. For example, America's Citibank was the first major

conventional bank to establish an Islamic bank in Bahrain,

with an operating capital of $20 million (The Economist,

1996). It may be a puny sum, but, it does suggest

to some degree that conventional banks have begun to

embrace Islamic banking on a moderate scale. Here again

the point arises, that, there is some difference between the

operations of two banking systems and also there is

something which is attracting conventional banks towards

Islamic banking system.

A number of other Western financial institutions have

followed suit by offeringn Islamic mutual funds and other

investment products. For example, ANZ Grindlays is now

offering financial products that meet Islamic criteria.

Germany's fourth largest bank, Commerz bank, started

offering Islamic mutual funds from December 1999. In

February 1999, Dow Jones introduced the Dow Jones Islamic

Market index (DJIM) of 600companies worldwide that comply

with the Shariah laws

Many Western Academic Institutions are introducing Islamic

Economy and Banking as Subjects, like Harvard University

Center for Middle Eastern Studies (CMES), Durham

University, UK, Dow Jones University….etc.

These indicators reflect the rising trend of Islamic banking

and finance throughout the world. This encourages one to

know in detail what Islamic banking is all about, what are its

principles and how it is different from conventional banking

system.

The Amana Fund, the LARIBA bank, in USA and the Halal

investment company in London is another indicator of the

growing salience of Islamic banking institutions not just in

Muslim countries, but in the West as well. These efforts in

different countries for Islamic banking present not only an

excellent working examples for those who did not believe in

the practicality of the interest free banking but also provide

a spade work over which the infrastructure of interest free

banking for a country could be built up.

This chapter deals with two parts, first part consists of basic

explanation of Islamic banking system its principles and

instruments and the second part is concerned with summary

of previous researches being done on these respective

research areas. It includes the general information about the

banking sector and Islamic banks.

2.1 Banking and Financial System

(Fredric Mishkin)
A healthy and vibrant economy requires a financial system

that moves funds from people who save to people who have

productive investment opportunities.

There are many different types of institutions: banks,

insurance companies, and so on, all of which move funds

from savers to investors.

The system based on these institutions is called the

“financial system”. And this Financial System is complex in

structure and function throughout the world.

What is Bank? (Fredric Mishkin)

Bank is defined as an institution, which deals with money.

The bank draws the surplus money from the people i.e.

excess of income over consumption, which is a form of loan

to the bank and in return pays interest on it for the loans of

those who have saved or deposited their money. The bank

then gives out loans to those who need it particularly for

productive purposes, and charges interest on returning it.

In present days the banking system has been familiarized as

an organized organization. This organization by giving greed

of different benefits induces peoples to deposit their money

in banks. Then the bank lends this money on huge interest

to others. A portion of the interest money is awarded to the

creditors of savings and the rest of

money is spent by bank for its own expenditures.

 What are Islamic Banks (RIIC by

Prof. Khursheed)
Unlike their counterparts elsewhere, Islamic bankers do not

expect to advance money and receive a predetermined sum

on a fixed date in the future. Under the Shariah, the bedrock

of the Islamic faith, they are instead responsible for ensuring

that money is invested in viable projects, with reliable

borrowers. If the project succeeds the banker

shares in the profit. If it fails he suffers the losses.

The Shariah, which dictates the activities of the banks as

well as forming the basis of the daily lives of all Muslims,

requires that reward comes from risk sharing. Profit must be

justified through the creation of value that the banker brings

to complement the value of the borrower’s efforts and skill

as mentioned in report on Islamic ideology

council.
Against a background of rapid growth in Middle Eastern

economies over the last 20 years and a desire to

increasingly compete internationally, Islamic banks have

begun to change and develop to provide a range of

alternative financial products - still firmly

based on Islamic principles.

Islamic financial techniques have been employed

successfully in a growing number of major projects in the

West. Al Rajhi Bank has completed deals for the financing of

ships and aircraft (using the Ijara - lease financing

technique), and many industrial projects including the

building of power stations, a refinery and schools, and the

expansion of an aluminium smelter in Bahrain (using the

Istisna - deferred financing technique).

Given the huge potential for development in the Islamic

world and the increasing amount of funds being invested

according to the Shariah, it seems perfectly reasonable to

suppose that the recent growth in Islamic banking will

continue at an accelerated pace (Colin Willis).

Knowledge about Islamic Bank

A research on “Bank Patronage Factors of Muslim and Non-

Muslim Customers”conducted in Malaysia in 1994 shows that

almost 100 percent of the Muslim population was aware of

the existence of the Islamic bank; the sources of knowledge

are mainly newspapers and magazines, television and radio,

and family members. Many of the

Muslim respondents visit the bank’s branch and seek

information about the bank services and operations on their

own initiative. For non-Muslims, about 75 per cent of the

respondents know of the existence of the Islamic bank from

information derived mainly

from newspapers and magazines. Other sources of

information are not so effective for the non-Muslims.

Even though it has been nearly a decade since the Islamic

bank was first established in the country, only about 63 per

cent of the Muslims have understood either partly, or

completely, the differences between the Islamic bank and

conventional banks. Non-Muslims showed much less

understanding. Only 12 per cent of the Muslims and 32

percent of the non-Muslims believe that the Islamic bank is

for Muslims customers only. In terms of why people

patronized the Islamic bank, about 39 per cent of the Muslim

respondents believe that religion is the only reason why

people patronize the Islamic bank, and, surprisingly, the

percentage is much lower for non-Muslims. More than half of

both respondent groups have indicated the possibility of

establishing a relationship with the Islamic bank if they have

a complete understanding about the operations of an Islamic

bank (International journal of bank marketing, 1994).

The changes in the banking system have created a new

dimension in the banking industry within which the

institutions in the banking system have to compete, not only

with financial institutions outside the banking system, but

also with themselves to remain in business. Indeed, the

fiercer level of competition is not only faced by the banking

industry in muslim countries, but also it is becoming the

most influential factor in the structure and activities of the

banking system around the globe.

In the UK, for example, increasing competition has pushed

British banks into much greater customer-oriented and

competitive behavior. In other countries, the industry has

been transformed from its traditional staid image to that of a

vibrant and dynamic environment (Turnbull and Gibbs,

1989).

History of Islamic Banking

Haqiqi & Pomeranz in their article “Accounting Needs of

Islamic Banking” gave the history of Islamic banking. They

explained that, In Muslim communities, limited banking

activity, such as acceptance of deposits, goes back to the

time when the Prophet Muhammad (pbuh) was still alive. At

that time, people deposited money with the Prophet or with

Abu Bakr Sedique, the First Khalif of Islam. The first modern

Islamic bank, established in Egypt in 1970’s, was called

Nasser's Social Bank. Islamic accounting, an essential tool

for the success of Islamic banks, is said to have been

developed contemporaneously at the University of Cairo

(Crane).

The desirability of abolishing fixed interest rates and the

Islamization of financial systems were discussed at the first

meeting of the Islamic Organization Conference (IOC) in

Jeddah in 1973. Subsequently, many Islamic banks were

founded under the profit-and loss sharing system (PLS),

which will be discussed below.

Modern Islamic banking has undergone three phases of

development:

• Emergence-1972 through 1975: This period was marked by

a surge
 in oil revenues and great liquidity .Parallel events included

resurgence of fundamentalist Muslim movements,

reemphasis on

the Wahabi School of Brotherhood and Pan-Islamism, and

establishment of IOC.

• Expansion-1976 to the early 1980s: Islamic banking spread

from

the: Arabian Gulf eastward to Malaysia, and westward to

England.

More than Accounting Needs of Islamic Banking 155 20

Islamic

banks were established, including international and

intercontinental

institutions.

• Maturity--1983 to the present: The Arab world was

confronted by

economic setbacks, including slowdowns in oil revenues,

the
 collapse of Kuwait's Souk al- Manakh, the relative strength

of the

U.S. dollar, higher interest rates in the United States, and

capital

outflows from OPEC nations. At the same time, Arab banks

openedbranches in the United States and Islamic banking

practices

were implemented in both Pakistan and Iran.

Islamic banking operations are not limited to Arab soil, or

Islamic countries, but are spreading throughout the world.

One reason is the "growing trend toward transcending

national boundaries, and unifying Muslims into a political and

economic entity that could have a significant impact on the

pattern of world trade. ...Since Muslims are inclined to follow

Islamic traditions, there is a tendency to establish an Islamic

economic system in every Islamic nation, And to restore

Shariah Law as the basic source for legislation" (Abdel-

Magid).
Further expansion is planned for example; DMI has

announced a five-year program to create a network of

branches and subsidiaries in more than twenty countries

(The Economist, 1982). An American businessman of Iraqi

origin plans to establish a U.S. based financial institution to

be administered in accordance with Islamic banking practice.

When approved by U. S. authorities, the institution will serve

several million American Muslims (Barron's 1985).

Islamic Banking System (Fredric

Mishkin)
“Islamic banking system deal with money and not deal in

money”

It is argued by Muslim scholars that whereas traditional

banking is concerned with financial intermediation on the

basis of lender-borrower relationship between depositors and

banks, on one hand, and banks and the fund-seekers, on the

other hand, Islamic banking is about addressing genuine

concerns of the owners of funds and needs of the resource-

strapped through Shari’ah permitted forms of transactions.

The argument is built on the following premise.

“What is permitted for an individual is also permissible for

the banks (that are groups of individuals – shareholders)

unless there are reasons to conclude otherwise”.

Instruments of Islamic Banking.

(Fredric Mishkin)
The Islamic instruments which govern the operations of

Islamic banks are also known as Shariah instruments. The

applicable instruments are called Mudharabah, Musharakah,

Murabahah, Al-Bai Bithaman Ajil, Al-Ijrah, Al-Takjiri, Qard

Hasan, Al- Wakalah, Al-Kafalah and Wadiah.

Foundations for modern banking operation in Shariah are

defined in terms of trade, leasing and partnership based

arrangements and collateral and guarantees. The following

options are pro-posed to be initially made available for

banking system.

Trade-related modes…………Bai-mu’ajjal (sale on deferred

payment

basis),Bai’salam (sale with

cash

payment with future delivery)

Leasing modes……………. .. Ijarah (operating on lease)

Partnership modes………… .Modarabahah & Mosharakah

Lending …………………….. Qard (loan)

Collateral and Guarantees

Shari’ah requires that not only the ends be Shuri’ah

compatible but that the means to achieve those ends be

right as well. In the light of this principal the above modes

can be adopted.
Trading-based arrangements

Bai’mu’ajjal is the Arabic acronym for “sale on deferred

payment becomes debt against the buyer payable in lump

sum or in installments (as per agreement with the seller). In

addition to the concurrence of the seller, conditions for a

valid bai’mu’ajal are as follows:

1.The price to be paid must be agreed and fixed at the time

of the

deal. It may include any amount of profit without qualms

about riba.

2. Complete/total possession of the thing in question must

be given to

the buyer, while the deferred price is to be treated as debt

against

him.
Bai’ salam involves advance payment to a party for delivery

of a thing in future a converse of bai’mu’ajjal. It applies to

the case in which things come into the possession of the

seller due to his being their producer or towards discharging

his occupational functions for instance, a wholesaler

acquiring goods from a manufacturer and supplying them to

the retailers.

Bai’salam is a valid transaction with the following three basic

conditions:

1.The nature, quality and quantity of the merchandise (to be

delivered in future) must be clearly specified along with

the delivery

date.

2. The price to be paid in advance should also be fixed.

3. The transaction should be settled with the delivery of

goods, not on

the margin.

Leasing-based arrangements
Ijarah or leasing is a contract for the usufruct of an asset

while its ownership still remains with the original owner, i.e.,

the lessor. In this case, the lessor leases his asset to another

party, the lessee, against a predetermined rental for a

prescribed period. Thus, besides the concurrence of the

concerned parties, there are three fundamental conditions

for a valid ijarah contract:

1. The asset is the property of the lessor.

2. The period of contract is specified.

3. The rental and its payment schedule are precisely stated.

That the asset remains in working condition (during the

period of lease is the

lessor’s responsibility.

Partnership-based arrangements

Modarabah and musharakah are two partnership modes that

allows two or more parties to share both the contributions to

and the fruits of economic activity, albeit in varying degrees,

trough mutually agreed arrangements. The bank can adopt

both of these modes. It can act as mudarib as well as a

partner. Critical points and conditions about modarabah and

musharakah from the Shari’ah perspective are as follows:

1. All these arrangements represent a situation in which

(a)ownership of capital is shared, albeit for the duration of

the

contract,

(b) rewards are addressed through a share in the outcome of

the

activity, and

(c)material losses are shared in proportion to ownership

stakes of the various partners along with labour going totally

unrewarded.

2. The modarib should not lay any material claims against

the joint

venture except those necessary for discharging the

required

functions according to the letter other contract.

3. In the settlement of accounts, the first claim on revenues,

over and

above theoperating costs, would be in lieu of the capital

contributions. After this, the residual or operating profit

can be

distributed among all partners according to the prescribed

profit-

sharing ratios.

Collateral (Rehn) guarantees

Creditors may seek collateral to protect their interests. In

this regard, the following principles need to be observed:

Collateral should not be of the same kin as the object of the

loan/debt.

Creditors may not draw benefits from the object of collateral.

The collateral may be liquidated as per agreement. However,

if the liquidation proceeds exceed the quantum of debt, the

balance has to be paid to the debtor. Likewise, if the value of

liquidated collateral falls below the amount of debt, the

balance would stand as unpaid debt against the debtor.

Principle of Islamic Banking

For millions of Muslims, banks are institutions to be avoided.

Islam is a religion which keeps Believers from the teller's

window. Their Islamic beliefs prevent them from dealings

that involve usury or interest (Riba) Yet Muslims need

banking services as much as anyone and for many purposes:

to finance new business ventures, to buy a house, to buy a

car, to facilitate capital investment, to undertake trading

activities, and to offer a safe place for savings. For Muslims

are not averse to legitimate profit as Islam encourages

people to use money in Islamically legitimate ventures, not

just to keep their funds idle (Nida'ul Islam 1995).

However, in this fast moving world, more than 1400 years

after the Prophet (s.a.w.), can Muslims find room for the

principles of their religion? The answer comes with the fact

that a global network of Islamic banks, investment houses

and other financial institutions has started to take shape

based on the principles of Islamic finance laid down in the

Quran and the Prophet's traditions 14 centuries ago. Islamic

banking, based on the Quranic prohibition of charging

interest, has moved from a theoretical concept to embrace

more than 100 banks operating in 40 countries with multi-

billion dollar deposits world-wide. Islamic banking is widely

regarded as the fastest growing

sector in the Middle Eastern financial services market.

Exploding onto the financial scene barely thirty years ago,

an estimated $US 70 billion worth of funds are now managed

according to Shari'ah. Deposit assets held by Islamic banks

were approximately $US5 billion in 1985 but grew over $60

billion in 1994.

The best known feature of Islamic banking is the prohibition

on interest. The Quran forbids the charging of Riba on

money lent. It is important to understand certain principles

of Islam that underpin Islamic finance. The Shari'ah consists

of the Quranic commands as laid down in the Holy Quran

and the words and deeds of the Prophet

Muhammad (s.a.w.). The Shari'ah disallows Riba and there is

now a general consensus among Muslim economists that

Riba is not restricted to usury but encompasses interest as

well. The Quran is clear about the prohibition of Riba, which

is sometimes defined as

excessive interest. "O you who believe! Fear Allah and

give up that remains of your demand for usury, if you

are indeed believers." Muslim scholars have accepted the

word Riba to mean any fixed or guaranteed interest payment

on cash advances or on

deposits. Several Quranic passages expressly admonish the

faithful to shun interest.

The rules regarding Islamic finance are quite simple and can

be summed up asfollows:
a) Any predetermined payment over and

above the actual amount of principal is

prohibited.

Islam allows only one kind of loan and that is qard-el-hassan

(literally good loan) whereby the lender does not charge any

interest or additional amount over the money lent.

Traditional Muslim jurists have construed this principle so

strictly that, according to one commentator "this prohibition

applies to any advantage or benefits that the lender might

secure out of the qard (loan) such as riding the

borrower's mule, eating at his table, or even taking

advantage of the shade of his wall." The principle derived

from the quotation emphasizes that associated or indirect

benefits are prohibited.

b)The lender must share in the profits or

losses arising out of the enterprise for

which the money was lent

Islam encourages Muslims to invest their money and to

become partners in order to share profits and risks in the

business instead of becoming creditors. As defined in the

Shari'ah, or Islamic law, Islamic finance is based on the belief

that the provider of capital and the user of capital should

equally share the risk of business ventures, whether those

are industries, farms, service companies or simple trade

deals. Translated into banking terms, the depositor, the bank

and the borrower should all share the risks and the rewards

of financing business ventures. This is unlike the interest-

based commercial banking system, where all the pressure is

on the borrower: he must pay back his loan, with the agreed

interest, regardless of the success or failure of his venture.

The principle which thereby emerges is that Islam

encourages investments in order that the community may

benefit. However, it is not willing to allow a loophole to exist

for those who do not wish to invest and take risks but rather

content with hoarding money or depositing money in a bank

in return for receiving an increase on these funds for no risk

(other than the bank becoming insolvent). Accordingly,

under Islam, either people invest with risk or suffer loss

through devaluation by inflation by keeping their money idle.

Islam encourages the notion of higher risks and higher

returns and promotes it by leaving no other avenue available

to investors. The objective is that high risk investments

provide a stimulus to the economy and encourage

entrepreneurs to maximize their efforts.

c) Making money from money is not

islamically acceptable.

Money is only a medium of exchange, a way of defining the

value of a thing; it has no value in itself, and therefore

should not be allowed to give rise to more money, via fixed

interest payments, simply by being put in a bank or lent to

someone else. The human effort, initiative, and risk involved

in a productive venture are more important than the money

used to finance it. Muslim jurists consider money as potential

capital rather than capital, meaning that money becomes

capital only when it is invested in business. Accordingly,

money advanced to a business as a loan is regarded as a

debt of the business and not

capital and, as such, it is not entitled to any return (i.e.

interest). Muslims are encouraged to purchase and are

discouraged from keeping money idle so that, for instance,

hoarding money is regarded as being unacceptable. In Islam,

money represents purchasing power which is considered to

be the only proper use of money. This purchasing power

(money) cannot be used to make more purchasing

power (money) without undergoing the intermediate step of

it being used for thepurchase of goods and services.

d) Gharar (Uncertainty, Risk or Speculation) is also

prohibited.

Under this prohibition any transaction entered into should be

free from uncertainty, risk and speculation. Contracting

parties should have perfect knowledge of the counter values

intended to be exchanged as a result of their transactions.

Also, parties cannot predetermine a guaranteed profit. This

is based on the principle of 'uncertain gains' which, on a

strict interpretation, does not even allow an undertaking

from the customer to repay the borrowed principal plus an

amount to take into account inflation. The rationale behind

the prohibition is the wish to protect the weak from

exploitation. Therefore, options and futures are considered

as un-Islamic and so are forward foreign exchange

transactions because rates are determined by interest

differentials.

A number of Islamic scholars disapprove the indexation of

indebtedness to inflation and explain this prohibition within

the framework of qard-el-hassan. According to those

scholars, the creditor advances the loan to win the blessings

of Allah and expects to obtain the reward from Allah alone. A

number of transactions are treated as exceptions to the

principle of gharar: sales with advanced payment (bai'

bithaman ajil); contract to manufacture (Istisna); and hire

contract (Ijara). However, there are legal requirements for

the conclusion of these contracts to be organized in a way

which minimizes risk.

e) Investments should only support

practices or products that are not

forbidden in Islam.

Trade in alcohol, for example would not be financed by an

Islamic bank; a realestate loan could not be made for the

construction of a casino; and the bank could not lend money

to other banks at interest.

Prohibition of Interest (Dr. Mazhir

Iqbal)
Basically “Riba” is prohibited in Christianity and Judaism

also, but over time followers of these religions have changed

their teachings.

According to Muslim law Riba is

“An excess according to legal standard of measurement or

weight, in one or two homogeneous articles opposed to each

other in a contract of exchange and in which such excess is

stipulated as an obligatory condition on one of the parties

without any return.

Encyclopedia Americana-International Edition (1970) says:

“Interest is a charge for the use of money. Interest has not

always been considered a legitimate or even moral payment.

Until the end of middle ages, any charge for a loan was

generally considered to be usury. The teachings of

Christians, Judaic and Islamic religion, all condemned in

varying degrees, the taking of interest. In more recent times,

however, usury has come to be regarded as only the

charging of illegal rates of interest. In more recent times,

however, usury has come to be regarded as only the

charging of illegal rates of interest.”

Though there is currently consensus among Muslim

economists that riba (the word used in Quran for usury and

interest) is prohibited, yet there is difference of opinion what

riba exactly means. Different views on prohibition of interest

can be classified roughly under three headings: modernists,

mainstream, and pro-socialists.

a) Modernists

Modernists like Jafri (1988), Pal (1994), Rahman (1963), Shah

(1959), and Ulgener (1967) equate riba with usury,

exorbitant and compounded rate of fixed return that is

charged mainly on consumption loans. These writers, with

different reasoning, believe that the bank interest, which is

quite reasonable, determined by

market forces and is mainly charged on productive loans,

does not come under the Quranic prohibition of riba.

Consequently they do not feel any real need to introduce

mudharaba as the basis of banking business and corporate

financing.

B)Mainstream Economists
Mainstream economists like Ahmad (1978), Chapra (1984),

Khan and Mirakhor (1987), the Report of the Council of

Islamic Ideology (1983), Siddiqui (1993), and Uzair (1980)

equate riba with usury as well as with all kinds of interest

known in the literature, whether charged on productive loans

or on consumption ones. Thus, all of them feel the need to

change from current interest based banking system towards

an interest free one and they nearly unanimously propose

mudharaba as the main tool for this switch over. However,

among themselves they differ on particular forms of interest

free banking: whether it be a 100 percent reserve system

where all power to create inside money is vested to a central

bank, or fractional reserve banking or nationalized banking,

or a centralized banking in which the central bank of a

country owns equity of member banks, but not the other way

around.

The argument of the first group is that under a fractional

reserve system, banks amass a lot of financial power which

they use for their own profit maximization and not purely for
the needs of the economy. Under this system, banks find

many loopholes to get around regulatory measures taken by

monetary authorities. Thus they propose that all power to

create money, whether outside or inside, should be vested to

a central bank or monetary authorities.

Supporters of fractional reserve system, who are the

dominant group within this perspective, hold that the

mechanism of fractional reserve banking originated from the

habit of people of not withdrawing all their deposited money

at a time rather than from any coercion by financial

capitalists. Therefore, they argue that 100 percent reserve

banking would involve unnecessary rigidities.

Furthermore, they argue that after the switch over from debt

to mudharaba based banking, bank’s advances to their

corporate clients would not exceed cautious limits even

under euphoric expectations, as they would have to bear

normal business losses, in addition to extreme losses of

bankruptcies, if their expectations went wrong.

The argument of third group is more or less same as of the

first group. However, this group proposes complete

nationalization of financial sector.

c) Pro-Socialists

Pro-socialists like Abu-Sulayman (1968), Ali (1946, his

commentary on the verse 2:275 on p. 111), Haque (1985,

1989, 1993), and Naqvi (1982), equate riba with usury and

all other kinds of exploitation, like profiteering, monopoly

profits, speculation, or a return without any counter value.

These economists believe that the main motive behind

prohibition of interest is to establish social justice and an

equitable distribution of income. Mere replacement of riba

with profit in the prevailing exploitative system may not be a

sufficient measure to achieve the objective of social justice.

They claim that the bank interest rate is not so exploitative

as are profiteering, appropriation of profits by capitalists in

absentia, share cropping, and speculation. Therefore, on

their priority list, curbing of these exploitative forms comes

before the abolition of bank interest rate. Haque even doubts

the legality and validity of mudharaba.

To sum up, pro-socialist and mainstream Muslim economists

believe that the word riba is an antonym to sharing or

charity, and to trade, respectively. Accordingly, the former

group extends the meaning of this technical term, riba, to a

much wider concept of social justice and thus gives priority

to achievement of this objective over a technical definition of

riba. They propose a more active role for the state in private

economic activity to bring about social justice, without caring

much about prohibition or allowance of bank interest rate.

On the other hand, mainstream economists believe that any

increase, whether small or large, on loaned capital is riba,

and thus call both usury and bank interest rate ‘riba’.

According to this group, the alternative to interest based

lending is to trade with non-fixation of return for money

capital. Therefore, they propose to replace only a

pre-fixed rate of return with an uncertain one for money

capital, while
maintaining the same or even higher level of liquidity for

financial assets as is currently observed in the developed

world. They do not differentiate between speculation and

enterprise, as Keynes does. In their view, speculation is

undesirably only when it is destabilizing, and that happens

mainly because of trading large quantities of interest bearing

bonds on secondary capital markets. So, according to their

logic, when there are not many interest bearing securities,

trading of interest free financial assets will not generate any

negative effects: either the destabilizing speculation will

cease to exist or it will be easily controllable by appropriate

regulatory measures.