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Principles of Islamic Finance

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The most famous principle of Islamic Finance is the prohibition of usury or interest ("riba" in Arabic). There is a consensus among the scholars that even the interest paid by and to conventional banks is riba. Islam does not recognize loans as income-generating transactions. They are meant only for those lenders who do not intend to earn a worldly return through them. They, instead, lend their money either on humanitarian grounds to achieve a reward in the Hereafter, or merely to save their money through a safer hand. So far as investment is concerned, there are several other modes of investment like partnership etc. that may be used for that purpose. The transactions of loan are not meant for earning income.

The basic philosophy underlying this scheme is that the one who is offering his money to another person has to decide whether:
bullet(a) He is lending money to him as a sympathetic act or
bullet(b) He is lending money to the borrower, so that his principal may be saved or
bullet(c) He is advancing his money to share the profits of the borrower.
In the former two cases (a) and (b) he is not entitled to claim any additional amount over and above the principal, because in case (a) he has offered financial assistance to the borrower on humanitarian grounds or any other sympathetic considerations, and in case (b) his sole purpose is to save his money and not to earn any extra income.

However, if his intention is to share the profits of the borrower, as in case (c), he shall have to share his loss also, if he suffers a loss. In this case, his objective cannot be served by a transaction of loan. He will have to undertake a joint venture with the opposite party, whereby both of them will have a joint stake in the business and will share its outcome on fair basis.

Conversely, if the intent of sharing the profit of the borrower is designed on the basis of an interest-based loan, it will mean that the financier wants to ensure his own profit, while he leaves the profit of the borrower at the mercy of the actual outcome of the business. There may be a situation where the business of the borrower totally fails. In this situation he will not only bear the whole loss of the business, but he also will have to pay interest to the lender, meaning thereby that the profit or interest of the financier is guaranteed at the price of the destructive loss of the borrower, which is obviously a glaring injustice.

On the other hand, if the business of the borrower earns huge profits, the financier should have shared in the profit in reasonable proportion, but in an interest-based system, the profit of the financier is restricted to a fixed rate of return which is governed by the forces of supply and demand of money and not on the actual profits produced on the ground. This rate of interest may be much less than the reasonable proportion a financier might have deserved, had it been a joint venture.
In this case the borrower secures the major part of the profit, while the financier gets much less than deserved by his input in the business, which is another form of injustice.

Thus, financing a business on the basis of interest creates an unbalanced atmosphere, which has the potential of bringing injustice to either of the two parties in different situations. That is the wisdom for which the Shar'iah did not approve an interest-based loan as a form of financing.

Once interest is banned, the role of "loans" in commercial activities becomes very limited, and the whole financing structure turns out to be equity-based and backed by real assets. In order to limit the use of loans, the Shar'iah has permitted to borrow money only in cases of dire need, and has discouraged the practice of incurring debts for living beyond one's means or to grow one's wealth.

It should be the last thing to be resorted to in the course of economic activities. This is one of the reasons for which interest has been prohibited, because, given the prohibition of interest, no one will be agreeable to advance a loan without a return for unnecessary expenses of the borrower or for his profitable projects. It will leave no room for unnecessary expenses incurred through loans. The profitable ventures, on the other hand, will be designed on the basis of equitable participation and thus the scope of loans will remain restricted to a narrow circle.

Conversely, once interest is allowed, and advancing loans, in itself, becomes a form of profitable trade, the whole economy turns into a debt-oriented economy which not only dominates over the real economic activities and disturbs its natural functions by creating frequent shocks, but also puts the whole mankind under the slavery of debt. It is no secret that all the nations of the world, including the developed countries, are drowned in national and foreign debts to the extent that the amount of payable debts in a large number of countries exceeds their total income. Just to take one example of UK, the household debt in 1963 was less than 30% of total annual income. In 1997, however, the percentage of household debt rose up to more than 100% of the total income. It means that the household debt throughout the country, embracing rich and poor alike, represents more than the entire gross annual incomes of the country. Consumers have borrowed, and made purchases against their future earnings, equivalent to more than the entirety of their annual incomes. Peter Warburton, one of the UK's most respected financial commentators and a past winner of economic forecasting award, has commented on this situation as follows: "The credit and capital markets have grown too rapidly, with too little transparency and accountability. Prepare for an explosion that will rock the western financial system to its foundation."

*From a magazine article written by Colin Willis, Treasurer, Al Rajhi Banking & Investment Corporation.

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