Riba in Islamic Banking And Finance Free Essay Example

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What is Riba’?

Riba’ literally means excess, increase or growth but technically, it can be defined as every excess in return of which no reward or equivalent counter-value is paid that can happen in any transactions. Riba’ is always synonymously referred to as interest or usury.

The Arabic term riba’ is wider in definition. Unjustified borrowing or lending money, paid in kind or in money above the amount of loan, as a condition imposed by the lender or voluntarily by the borrower is called riba’. Many Islamic scholars have given definitions on riba’. Some of them are:

Ibn Hajar Askalani defines the essence of riba’ as ‘excess’ whether it is in commodity or in money, as two dinars in exchange of one dinar.

Shah Wallullah said the element of riba’ exists in the debt, which is advanced in the condition that the borrower will pay more or better than what he has received from the lender.

Abu Bakr Ibn al- Arabi states that every excess in return for which no reward is paid is riba’. This view is thus general. It includes both material and non-material gains.

Classification of Riba’

There are two types of riba’ in the light of Quran and Sunnah. They are:

1. Riba’ Al-Nasiah: The word Nasiah means “to postpone”. It is also known as riba’ al-Quran or riba’ al-Qard because the prohibition comes from the Quranic injunction. Also called as riba’ al-jahiliyyah because it was the common practice during the pre-Islamic days. It involves money transaction where creditor asks for extra payment apart from the principle. This kind of riba’ is the one commonly found in conventional banking products. Usually applied to a loan or to any debt regardless of the cause of that debt (debt resulting from a loan contract or from a deferred payment sale). Riba’ al-Qard can be applied in some situations like loan with interest or other benefits, loan of usufruct of asset with stipulations and penalty imposed on delinquent debt repayment or default.

2. Riba’ Al-Fadhl: Referred to as “interest in barter”. Also known as riba’ al-Hadith or riba’ al-Bay’ because its prohibition comes from Sunnah. The basis for the prohibition of riba’ in the exchange of commodities is the Hadith of the Prophet Muhammad s. a. w on six commodities and those are gold, silver, wheat, barley, dates and salt. The Arabs used commodities like wheat, barley, dates and salt as medium of exchange to purchase other things, as like money a long time back.

Rationale Prohibitions

For Muslims, the prohibition of riba’ as said in the Qur’an and Sunnah should be sufficient. Some of the possible rationale for the prohibition of riba’ can be articulate as follows:

Element of injustice in financing productive activities: Obligated to pay interest even if business venture results in no profit or loss that is injustice to debtor. Again, in the event of substantial profits, creditor receives a return disproportionate to amount of generated profits which is injustice to creditors.

Element of exploitation in financing consumption: Riba’ assumes money as a commodity, which the rich have in abundance. In that case the rich are able to generate more wealth without giving much effort.

Riba’ inconsistent with Islamic perspective on debt: Limited money can be borrowed according to someone’s need. The Prophet s. a. w refused to offer janazah prayer of a person who died indebted. So, in Islam, incurring debt is discouraged.

Negative effects of a “credit society”: When there is easy availability of credit, it cultivates a money-oriented society. Again, since banks are motivated to lend as much as possible, people have to work harder and harder in order to repay bank debt. As a result, people become enslaved to the banks. Some other problems like unethical business practices, degradation of the natural environment, less emphasis on the institution of family leads to social ills longer working hours, multiple jobs, forced female and teenage labor also occurs. Social relations among people are also negatively affected and thus it is said that riba’ breeds hatred, jealousy and ill-will towards the rich.

Negative effects on production: Riba’-based lending is security oriented rather than growth oriented that is, lending is confined to established businesses with known creditworthiness and adequate security. Bank interest return does not vary with actual profits, no incentive to give priority to ventures with highest profit potential. The lending is based on creditworthiness, not profitability. Riba’-based lending strictly discourages innovation. Hence, interest obligation act as disincentive for experimenting with new, unproven methods of production, especially for small-scale enterprises and agriculture. Again, this results in domination of big businesses over smaller entrepreneurs will curtail competition and in turn will affect product variety and innovation. It is anti-productive. We know that inflexibility in a loss situation leads to bankruptcies, loss of productive potential and unemployment. Utility of certain projects is with reference to criteria other than profitability. Like, projects that benefit the public, poverty alleviation. 6. Negative effects on distribution: Because the primary basis of interest-based lending is creditworthiness, there will be disproportionate supply of credit to the already affluent segments of population. For example, wealth inequality is widened.

Again, one of the most important problem is the rich become richer, and the poor become poorer, that is because domination of large enterprises leads to demise of smaller economic units; lacking collateral and established economic standing, poorer segments of the economy are at an economic disadvantage when competing for credit to finance economic activities. As a result, wealth and income disparities worsens. So, the real assets are transferred to the lenders. Most debt financing requires some form of collateralization in the form of real assets like, real estate, equipment & machinery. It is said that with the current monetary system, bank debt is non-repayable in aggregate, loan defaults are inevitable. And interest-based lending will, by design, lead to transfer of real assets from the borrower to the lender, in the long run. Hence, wealth inequality becomes prevalent.

Time, Value of Money and Riba

In the west, ‘riba’ is used to compensate for the time value of money and since money is treated as a commodity, interest is considered the price for use of money. Islam views money and commodities differently which is money is not a commodity though it is used as a medium of exchange and store of value, it has no intrinsic utility as it cannot be utilized to directly fulfil human needs. Commodity has an intrinsic utility and can be utilized without exchanging it for something else and it also can have different qualities while money’s sole quality lies in the fact that it is a measure of value or a medium of exchange. One of the main reason why riba’ is forbidden is in Islam is because Islam encourages people to do business and thus encourages lending as lending is a virtuous act. When interest is predetermined by the lender, it acts as a burden on the debtor and needs to be paid regardless of the outcome of the investment. For instance, if the debtor generates huge profit, the lender will just receive the interest that has been already determined. In another scenario if the debtor makes a lose the debtor is still liable to pay the interest to the lender. In both of these situations there is no proper compensation to the lender or the debtor due to the outcome and thus becomes unfair. Time value of money is also not a part of Islamic finance because it acts a burden on the debtor which contradicts with the maqasid shari’ah of protecting and preserving public interest in all points of life. However, in certain situations Islam recognizes and allows time value of money and those situations are justified and explained. The concept of time value of money is Islamic perspective is different from conventional finance whether be it in the fundamental or the financial implications. Cases where time value of money is recognized that the one who lends an amount to any other individual has to determine if: (a) the amount is being lent a sympathetic act, (b) the amount is being lent to the borrower in order that his/her principal can be stored, or (c) the amount is being advanced to share in the borrower’s earnings.

Loan is granted to person to help relief financial pressure of the borrower. If the lender lends the amount without expecting worldly reward but wants the merits of the loan in the hereafter, this loan is known as qard hassan loan and this loan is common among friends, family and charity. In this case, the debtor is encouraged to pay in excess or in the most handsome manner because Islam recognizes that the lender has made a sacrifice by helping someone in need. The excess amount is rather a gift from the borrower to the lender and this is not predetermined and so is not considered as riba’. The increment is merely encouraged. Sale of goods on credit.

When goods are sold on credit, it is permissible for the creditor to sell the good at a higher price because time value of money is recognized in this situation and since the debtor agrees for the amount to be paid for the goods supplied in advance, hence this is not considered as riba’. However, what is forbidden is if the debtor fails to pay on time, the lender is not allowed to add additional charges because of delay of payments since this increases the burden of the debtor and is considered as riba’ al jahiliyah. The reasons behind the permissibility of increasing the charge of a commodity in credit income is that when the commodity is sold, even on credit, the consumer retains its ownership on a permanent basis, and as a result the seller has no right to re-charge the offered commodity, because it does not belongs to him/her. Similarly when there is advance payment for goods to be sold at a future date the criteria, for this to be permissible is that the goods must be delivered on the exact date and the quantity and quality or specifications that was decided by the consumer. Another form of credit sales which is bay’ al murabahah where the lender is allowed to ask for a higher price for the good to be delivered at a later date because this acts as a compensation for the risk that the lender is taking to finance the commodity or project for example in the case of purchasing a house. The borrower also is benefited since he gains the ownership of the commodity before paying full payment thus both party is benefited and thus this is allowed by shari’ah and not considered as riba’.

Lastly, in the case where there is an early repayment of debt, a lender is allowed to reduce the debt amount to show appreciation to the debtor for early settlement of loan. Since this is not pre-determined, it is permissible unless a third party gets involved, in that case it becomes not impermissible.