Islamic Principles of Finance

Let us now examine the Islamic principles of finance and evaluate their consequences which are relevant to model building. There can be no contract for a loan transaction with the stipulation for an addition in the principal sum, because that is riba. If it is a loan contract then it has to be an interest-free loan. Since present-day money markets are based on debt instruments, it follows that in an Islamic financial system there will be a very limited role for the money market. Theoretically, it is possible to have a small role for the money market consisting of instruments based on interest-free debts. For instance, the government might introduce interest- free bonds on which some incentive may be provided by way of reduction in tax liability of their holders. Or the government might issue interest-free bonds specially for banks and financial institutions for the purpose of liquidity or secondary reserves. If these interest-free bonds are traded at par for liquidity replenishment then a restricted money market may come into existence.

Surely, Islam prohibits interest-based dealings but it permits many forms of financing and trading in lawful goods. Permissible forms of financing include many variations based on the principle of profit-and-loss sharing. According to Hadith, profit can be shared as agreed between the parties concerned but loss is necessarily to be shared in the ratio of capital contributed by each one of them. Based on the above principle of profit-and-loss sharing, many instruments and forms of business relationship can be developed. Such instruments can be traded on the basis of their market valuation. It is to be expected that a capital market will have a major role to play in an Islamic financial system but the financial instruments will have to be free from all ancillary stipulations of interest.

Return on capital raised for financing in a business in the Islamic system is calculated in reverse, starting from the total profit actually earned. The expenses are deducted. Manager’s share in profit is deducted. And the remaining profit is distributed among the various providers of funds according to contract. In the interest-based system the rate payable to the providers of funds is first decided and contracted. Estimated expenses are calculated and added. Manager’s share is added. All this put together gives the figure which is to be charged from the users of funds. Thus method of calculation in an Islamic system is just the opposite of the one followed under the interest-based system.

In addition to profit-sharing, Islam permits other modes of earning money through real business transactions but not through money-lending as this is totally prohibited. We all know that musharakah and mudarba are the well-known forms of profit-sharing. Permission is, however, available to earn money by renting out durable assets, hiring services and selling goods with an addition of profit to the cost of goods. Another form of financing is giving interest-free loan with service charge comprising actual out-of-pocket expenses. An interest-free loan is sometimes a safe way of financing as it obviates the risk of loss and the capital of the financier remains intact.

Here, I would like to emphasise that the introduction of interest-free banking on national level in Pakistan and Iran and establishment of a number of Islamic banks in many parts of the world was an acceptance of the fact that present-day bank interest falls within the ambit of forbidden riba. Looking exclusively through secular economies, it can be said that interest is externally indexed cost of the capital. As such, interest should have been part of a “command economy.” In the Islamic system of profit-sharing, the cost of capital is inter nally indexed, i.e. the capital costs what it actually earns. This arrangement is obviously a natural part of a “market economy.” Against its own logic and strangely enough the institution of interest has been owned by the market economies of capitalist world. But the natural flexibility inherent in an Islamic profit-sharing system is now being initiated into the interest-based system by making the interest rates variable through frequent prime-rate fine tuning and also by linking the interest rates to LIBOR.

Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.