WHAT IS USURY?
The Arabic word 'riba' literally means 'increase in' or 'addition to' anything. Islam prohibits the lending of money for profit in order to protect the weak from exploitation. As an alternative, Muslims are encouraged to do business through partnership such as mudharabah where the investor and entrepreneur could do business on a more equitable basis.
The law prohibiting riba was introduced gradually. One of the commandments forbidding Muslims to earn interest from loan ,for example, was made through the following Qur'anic verse:
"O you who believe, devour not usury, doubling and quadrupling, the sum lent. Fear Allah and observe your duty to Him, that you may really prosper." Qur'an (3:130)
Although Islam prohibits riba, it does not prohibit trade. The proof of this is that the Holy Prophet himself engaged in business. However, some people were mixing trade with interest and insisting that there was no difference between the two. The Qur'an, however ,states:
"They say 'trade is just like interest' whereas Allah has permitted trade and forbidden interest." Qur'an (2:275)
It would appear that the prohibition regarding riba has two dimensions. The first one prohibits increases arising from debts (loans), known as Riba Duyun. This can be classified as follows:
- Riba Qardh: where the increase (interest) on the principal sum of the loan is agreed upon at the point of contract;
- Riba Jahilliyah: this refers to the increase levied on the borrower for late repayment or failure to repay the loan.
The second relates to prohibition of exchanges involving the following goods known as ribawi items if there is any increase because of difference in quantity, quality and/or time:
- gold for gold;
- silver for silver;
- wheat for wheat;
- barley for barley;
- dates for dates; and
- salt for salt.
This is known as Riba Buyu' where the prohibition is based on the authority of a sunnah narrated by Ubadah bin Al-Samat,among others.This variety of riba can be further classified as follows:
- Riba Fadhl: difference in weight, volume, quantiy;
- Riba Nasiah: difference in time.
Scholars have, by the process of analogy, extended the above ribawi items to include money and all types of foods. This is because gold and silver were used as a medium of exchange just like money is being used today. This is a very important issue because, in the insurance business, money (premium) is being exchanged with money (claim). Note that there is a difference in amount exchanged and it takes place over a period of time. Could these be regarded as Riba Fadhl and Riba Nasiah respectively?
The order against riba and the fact that it is a major sin in Islam is accepted although a detailed discussion is outside the scope of this write-up. What needs to be discussed is whether the element of usury (riba) is inherent in the insurance business or if it is only incidental.
WHAT IS RIBA?
A variety of injunctions can be seen to influence the course that commercial activity may follow in an Islamic economy, of which those relating to usury (riba), gambling (maisir) and uncertainty/deception (gharar) are extremely important. These injunctions are embodied in both the Qur'an and the ahadith.
The literal translation of the Arabic word riba is increase, addition or growth, though it is usually translated as 'usury'. Usury is not to be regarded solely as the practice of taking interest on a loan.
Two major forms of riba are defined in Islam. They are riba al-qarud which relates to usury involving loans, and riba al-buyu which relates to usury involving trade. The practice of both kinds of riba was well established by the pagan Arabs before the time of the Prophet Muhammad s.a.w., though he reminded his companions that riba could be practiced in many different ways.
Riba al-qarud, the usury of loans, involves a charge on a loan arising due to the passage of time, in other words a loan at interest. It arises where a borrower of another's wealth, in any form, enters into a contract to repay to that other person a pre-agreed amount in addition to the principal that was borrowed. In whatever manner this increase arises, if it is agreed at the outset of the transaction, the loan becomes a usurious one.
Some scholars have in the past asserted that the prohibition on riba al-qarud relates only to high interest charges and not to all forms of interest. Others such as Tantawi, the Sheikh of al-Azhar in Cairo at the time of writing, argue that bank interest is a sharing of the bank's profit and is therefore permissible. Such views have now been almost unanimously rejected.
Rejected too have been those arguments that proposed fixed interest rates to be haram and variable interest rates halal. It is occasionally argued that if the rate of interest is allowed to vary then this is permissible since the rate of return is not fixed in advance. For example, a loan contract may specify that A will loan B £100 and that B will repay this loan over a period of ten years with the yearly interest rate to be determined by A at the beginning of each year. (Under the fixed rate loan, the rate of interest to be charged in each year would be specified prior to the commencement of the loan, rather than at the beginning of each year during the loan period). Of course, both fixed and variable loan contracts require interest to be paid and only the method of determining the amount of interest differs.
Riba al-buyu may comprise either riba al-fadl or riba al-nasa. Riba al-fadl involves an exchange of unequal qualities or quantities of the same commodity simultaneously, and could therefore be described as the usury of surplus. Riba al-nasa involves the non simultaneous exchange of equal qualities and quantities of the same commodity and does not therefore involve a surplus but only a difference in the timing of exchange.
Thus, in order to avoid riba al-buyu, both the quality and quantity of the exchanged amounts must match and the exchange must be simultaneous. Though six commodities are mentioned specifically, some scholars maintain that the principle extends to all commodities. As the following ahadith show, riba al-buyu can be avoided so long as commodities are exchanged for money simultaneously.
'Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, and salt by salt - like for like, equal for equal, payment being made on the spot. If the species differ, sell as you wish provided that payment is made on the spot'. Hadith : Muslim
Abu Sa'id said that Bilal brought to the Prophet some barni dates and when the Prophet asked him how the dates had been obtained, Bilal replied, 'I had some inferior dates so I sold two sas for a sa'. On this the Prophet said 'Ah the very essence of riba, the very essence of riba. Do not do so, but if you wish to buy, sell your dates in a separate transaction, then buy with the proceeds'. Hadith : Muslim
Some scholars argue that riba al-qarud combines both riba al-nasa and riba al-fadl since there is both a delay and a surplus involved in interest-bearing loan transactions. Many do not formally identify riba al-nasa as defined above but do employ the term riba al-nasia (which according to many early jurists is the same as riba al-nasa). However, somewhat confusingly, many modern writers use the term riba al-nasia interchangeably with riba al-qarud.
If forced to generalize about the two major forms of riba, one might say that they occur where both counter-parties in a contract do not enter, or cannot be assured of entering at a later date, into a fair exchange of counter-values. For example, in riba al-qarud, the borrower is held to pay an amount of value (interest) to the lender for which there is no valid counter-value. And under riba al-buyu, in accepting two measures of corn in return for one measure, one party receives more value than the other as a result of the exchange
It is less easy to identify what kind of unfairness there might be in a riba al-nasa transaction. Alternatively, the exchange may result in one party having to provide the other with a commodity which is more valuable at one time of year than at the other (it may be cheap for A to provide B with corn at harvest time, but not so cheap for B to provide A with corn at the beginning of the growing season).
Riba is mentioned in a number of Qur'anic verses (2:275 279, 3:130, 4:161 and 30:39) and is sometimes referred to as the 'devouring' of others wealth. Fixed interest financing mechanisms can often be seen to rely heavily upon such wealth transfer, for instance where collateral is seized by a lender in a loan default. One might equally well argue that the process of money creation by the commercial banking system also results in the devouring of the wealth of others through the resulting devaluation of their money holdings. By employing such arguments, and by reference to less widely known ahadith, some writers regard riba as including a variety of commercial activities such as the artificial bidding up of prices at auction, the payment of commission to a middleman and rent on land. Others prefer to stick with the narrower definitions of riba and classify activities such as money manufacture and auction rigging as fraud or deception.
Whatever the precise scope of riba, in the ahadith the Prophet Muhammad s.a.w. condemns the one who takes it, the one who pays it, the one who writes the agreement for it and the witnesses to the agreement. It is also clear that the Qur'an requires riba to be given up in all its forms and in its entirety.
O you who believe, give up what remains of your demand for usury if you are indeed believers. If you do it not, take notice of a war from God and his Messenger.. Qur'an 2 : 278 to 279
A heated debate is now occurring within the world of Islamic finance because, in practice, Islamic financing has come to rely for its legal form much more heavily upon contracts of exchange than contracts of investment.
The arguments for and against using contracts of exchange as a means of providing finance are not always clearly defined. It is agreed among Islamic scholars that a businessman is allowed to share the profits of his business with an investor who finances that business. The investor and the businessman agree the proportions of future profit that they will each share prior to the commencement of business. However, some commentators argue that profit-sharing does not satisfy all of the potential demands for financing in an economy. An individual wishing to buy a house usually buys that house to live in, not in order to make a monetary profit. So how would a Muslim raise the money to buy a house if that house never produces a profit which can be shared with a financier? The answer according to some is for the Islamic banker to use a contract of exchange instead of a contract of investment.
Imagine, for example, that an individual approaches an Islamic bank having identified a house that he wishes to purchase from a builder. The banker agrees to buy the house from the builder on behalf of the individual at the market price of say £100,000, and then sells it to the individual for a price of £150,000 to be paid in installments of £7,500 per year over twenty years. The 'mark-up' of £50,000 represents the banker's profit, not an interest charge, argue the Islamic bankers who practice this technique. The bank acts as a trader, they say, buying the house for £100,000 and selling it for £150,000. In this manner, a contract of exchange is used to provide the required finance to the house buyer.
Among the agreements that are normally required by the banker under a deferred payment contract of exchange such as that described above (often referred to as Bay Bithamin Ajil (BBA) or Bay Mu'ajjal is a 'promise to buy'. This promise would be given to the bank by the individual before the banker buys the house from the builder. Under this promise, the individual confirms that he will buy the house from the bank at an agreed date in the future. With the promise in its possession, the bank purchases the house from the builder and then sells it on to the individual. The banker will usually take some form of security for repayment of the installments, such as a charge over the house. This is the familiar process of taking collateral and it allows the bank to sell the house in order to repay any outstanding installments if the individual defaults.
So far, there seems to be very little practical difference between the cash-flows paid under BBA (or ordinary murabahah) on the one hand and interest-based forms of finance on the other. An interest based bank might also advance £100,000 to a borrower for the purchase of our hypothetical house, and require repayments of £7,500 per year for twenty years.
Often there is little noticeable qualitative difference between the two forms of finance. Islamic banks tend to take a charge over the house, just as interest-based banks do, and would be empowered to sell it in the event of the borrower's default, just as interest based banks would be. In this manner, Islamic banks attempt to guarantee receipt of their mark-up to no less a degree than any interest-based bank would attempt to guarantee its interest charges under a conventional loan.
Some say that the difference between Islamic and conventional finance in this case is that, under Islamic finance, the house is transferred into the individual's ownership in the first instance instead of a cash loan of £100,000. But this argument is irrelevant because it relates to the manner in which the financing is put in place, whereas we are trying to determine whether the payments due under that financing are equivalent to the charging of interest. And in many cases, the argument is simply incorrect. Even a conventional bank might pay the loaned sum of money direct to the builder's account when the deed of ownership is transferred to the buyer.
When a pre-agreed rate of return is combined with a promise to buy, there arises a situation which is indistinguishable in its practical aspects from the definition of riba al-qarud (riba al-nasia) that was introduced earlier. BBA and murabahah contracts allow Islamic banks to compete with conventional banks in the sphere of interest based lending, which is the lifeblood of banking. This competitive success has been accomplished simply by setting the murabahah mark-up in line with prevailing interest rates. As a result, not only do the cash-flows of most Islamic financing contracts look like interest, they are also set at the same level as market rates of interest.
Let us go back to the house, the builder and the individual for one moment, and look at the problem from a slightly different perspective. Now it is of course quite permissible under Islam for the individual to buy the house from a builder for £100,000 in cash and to occupy it more or less immediately. Alternatively, that individual might negotiate with the builder to pay installments of £5,000 per year for twenty years. The same sale price would then be paid, £100,000, but over a twenty year period instead of in one lump sum up-front. No interest here. In both cases the builder would make his profit, being the difference between the cost of building the house and the £100,000 sale price. And in both cases the individual would buy the house to live in under a contract of exchange whose validity few scholars would question.
Imagine now that the builder offers the house at £100,000 for up front payment but at £150,000 for installment payment over twenty years. If the buyer decides to go for the deferred payment option, does the extra £50,000 represent an amount of interest charged by the builder, or just a further amount of profit that the builder is trying to make? And if the builder of the house can charge this extra amount for deferred payment, why can't an Islamic bank do the same thing when it buys an asset and then sells it on more expensively?.
... they say 'Trade is like usury', but God hath permitted trade and forbidden usury. Qur'an 2 : 274 to 275.
Perhaps those who oppose BBA and murabahah are the 'they' that the Qur'an is referring to. Could it be that the practice described above is in fact permissible in Islam? One might think that Islamic scholars could guide the layman in understanding what really the difference between trade and usury is. Yet even the scholars are divided on some of the crucial issues. For example, regarding the installment sale of an asset by a financier in the manner described above, Imam Shafi'i is regarded as being favorably inclined by most commentators. However, Imam Malik would seem to be against:
(1353) It reached Malik that the apostle of Allah (may peace be upon him) prohibited two sales within a sale. [Professor Rahimuddin comments: It means that the seller tells the buyer 'I shall sell this cloth to you for Rs. 10 for cash or for Rs. 15 on credit'].
(1354) It reached Malik that a person told another to buy a camel for him for cash and that he would buy it from him at an appointed time on credit. Abd Allah b. Umar considered it a bad kind of transaction and prohibited it.
(1355) Qasim b. Muhammad was asked about the case of a man who purchased a thing for ten dinars on cash or for fifteen dinars at an appointed date on credit, and he considered it bad business and prohibited it. Imam Malik : Muwatta', (Rahimuddin translation)
When Islamic banks attempt to guarantee receipt of a pre-agreed mark-up by forcing promises to buy and other such contractual obligations upon the purchaser, the very least one can say is that the Islamic banker enters into the realm of what is doubtful.
Some argue that if BBA is indeed a form of interest then a huge number of Muslim shopkeepers should be condemned for charging interest of 50% when selling their stock to customers at a mark-up of 50%. But, in a modern murabahah or BBA contract, the banker agrees to sell goods to his customer before purchasing them from a supplier (this of course being the purpose of the promise to buy). In contrast, a corner shop trader agrees to sell goods to a customer after buying those goods from a supplier. The corner shop trader takes the risk that no one will buy his stock. Islamic bankers don't take this risk if they can possibly help it.
The builder of our house charges a price which he is free to determine according to market conditions. He may offer this price for payment in any way that he sees fit, either cash up front or payment by installment. If his price is too high he may reduce it so that a willing buyer comes forward. The difference between the builder's cost and his selling price is then his profit. But if the builder seeks to increase his price in recompense for a delay in receiving payment, he is now attempting to earn extra revenue due to the passage of time.
The transaction to sell the house on deferred payment at a mark-up produces cash-flows that are, in essence, the same as those resulting where the house buyer borrows money at interest in order to buy the house without a mark-up. When the builder allows the buyer of the house to pay under deferred payments, the buyer will be in debt to the builder just as he would have been in debt to the bank. And just as the bank requires more in return than it gives, so does the builder. "My price is £100,000", says the builder, "but if you can't pay me now, take the house and pay me £150,000 later".
Deferred payment is clearly permissible in Islam; the crucial practical question of our time is whether it is permissible when conducted at a mark-up to the spot price. In the absence of reliable evidence to the contrary, and in current circumstances, I propose that deferred payment at a mark-up simply opens the door for interest-based banks to practice usury on the 'Muslim market'. With this technique permitted, the borrower will pay two, three or maybe four times over for the house that he buys under an 'Islamic mortgage'. The builder may find it just as profitable to build and sell one house on deferred payment, say over twenty years at a 300% mark-up, as to build four houses and sell them each for the cash price over the same period.
A brief analysis of forward market prices explains the above position clearly. It is an established principle in the conventional financial world that the price of a commodity in a trade where delivery and payment are to be made at a future date (the 'forward price') is determined largely by the rate of interest over the period. For example, if interest rates are 5% per year and the gold price is $400 per ounce today then, in the absence of any other financial considerations, the one year forward price for gold will be $420 per ounce. This is because if A agrees to deliver the gold to B in one years time, A will have to borrow $400 today, buy gold at $400, and repay the loan in the amount of $420 in one years time. In order not to loose any money on this deal, A must agree today to charge B at least $420 per ounce for that gold in one years time. If the forward price is any greater than $420, then B will make a profit. And because the market will not let profitable opportunities pass it by, a forward price of more than $420 will attract sellers and a price below that will attract buyers.
The above is a simple 'argument of arbitrage' that explains how the very existence of interest can affect prices where payment is deferred. It is easy to see that if interest rates were 10% in that example then, given the same assumptions, the arbitrage free one year forward price of gold would be $440 per ounce. Most of the Islamic banking industry still depends on the existence of this difference between cash prices and forward prices. It is a difference that arises because of interest and in this sense some Islamic banking techniques rely just as much upon interest as their conventional counterparts.
Hence, if Islamic bankers aren't actually practicing usury their talk can sound suspiciously like it: "the cost of finance that we can offer on a ten year Islamic mortgage is 10.5% per year" (Malaysia 1997). These are the words of the money lender, the language of usury. It is a language that modern banks, leasing companies and finance companies know well.
The debate over deferred payment at a mark-up arises because the bulk of the money that society is forced to use is manufactured by banks at interest. It will be difficult to resolve this debate unless it is first realized that the problem arises in the monetary system itself. How can Islamic finance be practiced with money that bears interest as a condition for its existence?
The appearance of debt trading in the Islamic financial market is another worrying innovation. From the earliest days of large-scale financing, some borrowers would issue bonds to their lenders. The bond would stand in evidence of an amount of money loaned. The amount to be repaid by the borrower at the end of the loan period would be stated on the face of the bond (which is why it became known as the 'face value'). Part of the bond document would be divided by perforations into separate sections, each section known as a 'coupon'. When an interest payment became due, the holder of the bond was required to tear off the appropriate coupon and return it to the issuer in order to claim his payment. Eventually, the term 'coupon' became widely used to describe the level of interest installments on a bond.
A bond is said to be a 'zero coupon bond' if no coupons (i.e. interest installments) are due to the bondholder during the life of that bond. Investors therefore only buy zero-coupon bonds at a price that is below face value so that, when the bond matures, the difference between the purchase price and the face value is realized as a gain of waiting. The issuer of the bond guarantees to pay the face value to the bondholder at maturity, and in the event of default the bondholder often has the right to seize collateral.
In the early years of Islamic banking some simple minded commentators argued that zero-coupon bonds are 'Islamic' because no interest is paid during their lifetime. But of course interest is paid, it is just that it is paid all in one go at the maturity date instead of in installments over the life of the bond.
Now, imagine that each installment due under a BBA is 'securitized', that is, turned into a tradable financial instrument. For example, each installment to be received by the builder from the house buyer could be securitized into a zero coupon bond with a face value of £7,500. These bonds can now be bought and sold and, if the builder decided to sell one of them, he would be selling a debt owed to him by the house buyer. And, if an investor purchased that bond at below face value, that investor would be contracting to make a gain of waiting. Thus, the installment due from the house buyer at the end of year one could be securitized into a one year 'zero-coupon bond' with a face value of £7,500. If this bond was bought by an investor at the beginning of year one for £6,818, a gain of waiting of £682 would be achieved by holding the bond for one year. The two year zero coupon bond might be bought by an investor at the beginning of year one for £6,200, giving a £1,300 gain of waiting over two years.
In Malaysia today, some Islamic finance deals are being concluded on more or less the basis described above. Among the projects so financed is the construction of the new Kuala Lumpur International Airport (KLIA).
Here, the financiers purchased assets that the KLIA already owned, such as land and the rights to the future revenues to be generated once the airport is operational. Payment was made in cash for these assets, and the KLIA thereby raised the funds that it needed to continue its construction program. Having bought the KLIA's assets, the financiers in this deal then immediately sold them back to the KLIA at a higher price but for payment in installments over twenty years. The final step in this financing process was that the installments were securitized into zero-coupon bonds and sold at below face value to investors. Here is securitized BBA in action, zero-coupon bonds in all but name.
Abridged from The Problem With Interest
(Ta-Ha Publishers, London, 1997)
