What is Meant By Riba?
The word "Riba" means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars.
The meaning of Riba has been clarified in the following verses of Quran (Surah Al Baqarah 2:278-9)
"O those who believe; fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your principal; neither will you do wrong nor will you be wronged."
What is interest? Is there any difference between interest and Riba?
The origination of term interest dates back to 17th century with the emergence of banking system at global level. Interest means giving and/or taking of any excess amount in exchange of a loan or on debt. Hence, it carries the same meaning/value as that of Riba as defined in the previous question. Further, it is narrated that “the loan that draws interest is Riba”.
There is consensus among the Muslim scholars of all the fiqhs that interest is Riba in all its forms and manifestations.
What are the different kinds of Riba?
There are two kinds of Riba:
1. Riba-An-Nasiyah / Riba-Al-Quran
2. Riba-Al-Fadl / Riba-Al-Hadees
1. Riba An Nasiyah/Riba Al-Quran: In the Holy Quran, Allah (SWT) says in Sura Al-Baqarah (2-279): “ …..And if you repent, yours is your principal”
It is reported by Harith ibe Abi Usamah in his Musnad that Sayyidna Ali Radi-Allahu Anhu reportedly referred that the Holy Prophet said:
"Every loan that derives a benefit (to the lender) is riba"6.
Example of Riba-al-Nasiyah/Interest: If Mr. A lends Rs.100 to Mr. B (a borrower) with a condition that Mr. B shall return him Rs.110 after one month. In this case, the extra amount of Rs. 10 is Riba or Interest.
2. Riba-al-Fadl: Abu Said al Khudri Radi-Allahu anhu narrated that Holy Prophet (Peace be upon him) said:
it may be noted that economically speaking it would be irrational to exchange one kilogram of wheat with one and a half kilogram of wheat in a spot exchange. Therefore, some fuqaha have pointed out that Riba-al- Fadl has been prohibited because if it was left un-prohibited it could be used as a subterfuge for getting Riba-al-Nasiyah. Of the six commodities specified in the hadith, two (gold and silver) unmistakably represent commodity money used at that time. One of the basic characteristics of gold and silver is that they are monetary commodities. As a matter of fact, each of the six commodities mentioned in the hadith has been used as a medium of exchange at some time or the other.
During the dark ages, only the first form (Riba An Nasiyah) was considered to be Riba. However, the Holy Prophet (peace be upon him) also classified the second form (Riba-al-Fadl) also as Riba
Does interest/Riba is related only to consumption loans or it applies to commercial loans also?
The interest is prohibited whether it is consumption loan (loan for meeting day to day human needs) or commercial loan (loan for business purpose). There are quite a number of ahadith which clarify that in the days of Holy prophet, people not only borrowed for consumption purposes but also for productive purposes. A few of the ahadith are given as follows for reference:
(i) Ibn Saad has reported Hazrat Umar ( Radi-Allahu anhu), wanted to send a trade caravan to Syriya. He borrowed four thousand dirhams from Sayyidna Abdurrahman ibn Awaf, Radi-Allahu anhu for this purpose.
(ii) Ibn Jarrir has reported that Hind, daughter of Utbah and wife of Abu Sufyan borrowed four thousand dirhams from Sayyidna Umar, Radi-Allahu anhu, for the purpose of her trade. She invested this money in purchasing goods and selling them in the market of the tribe of Kalb.
This is an ample testimony that the commercial loan was in practice when Quranic verses on Riba were revealed and the term Riba covers not only consumption loan but also the commercial loan.
What is the difference between conventional banking and Islamic banking?
| Sr. No. | CONVENTIONAL BANKING | ISLAMIC BANKING |
|---|---|---|
| 1 | Money is treated as a commodity besides medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out. | Money is not treated as a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out. |
| 2 | Time value is the basis for charging interest on capital. | Profit on trade of goods or charging on providing service is the basis for earning profit. |
| 3 | Interest is charged even in case the organization suffers losses by using bank’s funds. Therefore, it is not based on profit and loss sharing. | Islamic bank operates on the basis of profit and loss sharing. In case, the businessman has suffered losses, the bank will share these losses based on the mode of finance used (Mudarabah, Musharakah). |
| 4 | While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made. | The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha, Salam & Istisna contracts. |
| 5 | Conventional banks use money as a commodity which leads to inflation. | Islamic banking tends to create link with the real sectors of the economic system by using trade related activities. Since, the money is linked with the real assets therefore it contributes directly in the economic development. |
What are the basic principles of Islamic banking?
There are at least six basic principles which are taken into consideration while executing any Islamic banking transaction. These principles differentiate a financial transaction from a Riba/interest-based transaction to an Islamic banking transaction.
⦁ Sanctity of contract: Before executing any Islamic banking transaction, the counter parties have to satisfy whether the transaction is halal (valid) in the eyes of Islamic Shariah. This means that Islamic bank’s transaction must not be invalid or voidable. An invalid contract is a contract, which by virtue of its nature is invalid according to Shariah rulings. Whereas avoidable contract is a contract, which by nature is valid, but some invalid components are inserted in the valid contract. Unless these invalid components are eliminated from the valid contract, the contract will remain voidable.
⦁ Risk sharing: Islamic jurists have drawn two principles from the saying of prophet Muhammad (SAW). These are “Alkhiraj Biddamaan21” and “Alghunun Bilghurum22”. Both the principles have similar meanings that no profit can be earned from an asset or a capital unless ownership risks have been taken by the earner of that profit. Thus, in every Islamic banking transaction, the Islamic financial institution and/or its deposit holder take(s) the risk of ownership of the tangible asset, real services or capital before earning any profit there from.
⦁ No Riba/interest: Islamic banks cannot involve in riba/interest related transactions. They cannot lend money to earn additional amount on it. However as stated in point No. 2 above, it earns profit by taking risk of tangible assets, real services or capital and passes on this profit/loss to its deposit holders who also take the risk of their capital.
⦁ Economic purpose/activity: Every Islamic banking transaction has certain economic purpose/activity. Further, Islamic banking transactions are backed by tangible asset or real service.
⦁ Fairness: Islamic banking inculcates fairness through its operations. Transactions based on dubious terms and conditions cannot become part of Islamic banking. All the terms and conditions embedded in the transactions are properly disclosed in the contract/agreement.
⦁ No invalid subject matter: While executing an Islamic banking transaction, it is ensured that no invalid subject matter or activity is financed by the Islamic financial transaction. Some subject matter or activities may be allowed by the law of the land but if the same are not allowed by Shariah, these can not be financed by an Islamic bank.
What is meant by Shariah/Islamic Law?
Shariah lexically means a way or path. In Islam Shariah refers to the divine guidance and laws given by the Holy Quran, the Hadith (sayings) of the Prophet Muhammad (Peace Be Upon Him) and supplemented by the juristic interpretations by Islamic scholars. Shariah embodies all aspects of the Islamic faith, including beliefs and practices. Islamic Shariah or the divine law of Islam is derived from the following four sources:
⦁ The Holy Quran
⦁ The Sunnah of the Holy Prophet (Peace Be Upon Him)
⦁ Ijma’ (consensus of the Ummah)
⦁ Qiyas (Anology)
The end result of Islamic Banking and Conventional Banking is the same. Why do they appear similar?
The validity of a transaction does not depend on the end result but rather the process and activities executed and the sequence thereof in reaching the end. If a transaction is done according to the rules of Islamic Shariah it is halal even if the end result of the product may look similar to conventional banking product.
For example a normal McDonalds burger in USA and Pakistan may look similar, smell similar and taste similar but the former is haram and the later is halal due to its compliance of Islamic guidelines of slaughtering animals.
Similarly, if a person is feeling hungry, he may steal a piece of bread and eat or alternatively buy a piece of bread to eat. The apparent end result would be same but one is permissible in Shariah and the other is not allowed.
The same is also true for Islamic and conventional banking. Therefore, it can be concluded that it is the underlying transaction that makes something “Halal” (allowed) or “Haram” (prohibited) and not the result itself. Apparently, Islamic banks may look similar to conventional banks, however the contracts and product structures used by Islamic banks are quite different from that of the conventional bank. In the verse 2:275 of the Holy Quran, Allah the Almighty has responded to the apparent similarity between trade and interest by resolutely informing that he has permitted trade and prohibited Riba (though they may look similar to someone).
If Islamic banks do not invest in interest-based activities then how do they generate profit to pay to their customers?
The Islamic bank uses its funds in various trade, investment and service related Shariah compliant activities and earns profit thereupon. The profit earned from such activities is passed on to the depositors according to the agreed terms.
Are not Islamic banks just paying interest and dressing it as profit on trade and investments?
No, Islamic banks accept the deposits either on profit and loss sharing basis or on qard basis. These deposits are deployed in financing, trading or investment activities by using the Shariah compliant modes of finance. The profit so earned by the bank is passed on to the depositors according to the pre- agreed ratio which, therefore, cannot be termed as interest.
Islamic banks use KIBOR i.e. an interest-based benchmark to determine profit sharing ratios. In this context, how these banks can be said to be Islamic when they base conventional benchmark?
Islamic banks should ideally have their own benchmark system for determination of profit. Since, the industry is in its initial stage of development, it is using the available benchmark for the banking industry. It is expected that once it is grown to a sizable level, it would have its own benchmark. However, using interest-based benchmark for determining the profit of any permissible transaction does not render the transaction as invalid or haram. It is the nature/mechanism of the transaction that determines its validity or otherwise.
For example, Mr. A and Mr. B are two neighbors. Mr. A sells liquor which is totally prohibited in Islam whereas Mr. B, being a practicing Muslim dislikes the business of Mr. A and starts the business of soft drinks. Mr. B wants his business to earn as much profit as Mr. A earns through trading in liquor. Therefore, he decides that he will charge the same rate of profit from his customers as Mr. A charge over the sale of liquor. Thus, he has tied up his rate of profit with the rate used by Mr. A in his prohibited business. One may say that Mr. B uses an undesirable benchmark in determining the rate of profit, but obviously no one can say that the profit charged by him is haram because he has used the rate of profit of the business of liquor only as a benchmark.
The same is true for Islamic banks, it is most desirable and preferable that Islamic banks develop their own benchmark however; in the absence of any such alternative, interest rate related benchmark can be used.
Is Islamic banking meant only for Muslims?
The teachings of Islam are not confined to Muslims, rather these equally address the non-Muslims due to their universal nature. The basis of Islamic banks is laid down on ethical values and socially responsible system. The values like justice, mutual help, free consent and honesty on the part of the parties to a contract, avoiding fraud, misrepresentation and misstatement of facts and negation of injustice or exploitation form the basic principles of Islamic banking. Therefore, the principles of Islamic banking lead the economic system to achieve the common good and economic prosperity. On this premise, Islamic banking becomes a viable option for everyone irrespective of their religion.
Is it permissible for an Islamic bank to impose penalty in case receivables are delayed?
In Islamic law it is permissible to penalize a debtor who is financially sound but willfully delays payment of debt without any genuine reason. Such act of the debtor is unjust as the Prophet (PBUH) has said,
"A rich debtor who delays payment of debt commits Zulm".
A heavy non-performing portfolio and default on the part of clients is a serious problem confronting the financial institutions all over the world including Pakistan. This problem may be a threat to the success of Islamic banking system if not properly addressed. If clients do not honor their commitments in respect of timely payment of a debt created in installment sale, Murabaha, leasing or do not pay banks’ share of profit in participatory modes or do not deliver goods at stipulated time in Salam and Istisna, it could cause irreparable loss to the system. The banks, financial institutions, depositors and ultimately the economy will have to suffer its consequences. The jurists allow punishment (T´azir) to such willful defaulters in the form of fine. In view of the severity of the problem, Islamic Fiqh Academy of the OIC and Shariat Appellate Bench of the Supreme Court of Pakistan have approved the provision of penalty clause in the contractual agreements. This would also help in maintaining a credit discipline in the banking and act as a deterrent against debts becoming bad or unrealizable. However, the penalty proceeds would be used for charity as penalty cannot become source of income for the bank in any manner.
Can Islamic banks claim compensation or liquidated damages on account of late payment/default by the clients?
The contemporary Shariah scholars have evolved a consensus that banks are authorized to impose late fees on the delinquent. However, the proceeds of such penalty are to be used for charity purposes. It is the court or any recognized alternative independent dispute resolution body which can allocate any part of the penalty as liquidated damages for the banks.
Liquidated damages can be given to banks in case of default on the part of banks’ clients provided it is based on actual financial loss. The court or a recognized adjudicating forum may reasonably adjust the amount of compensation. The actual financial loss cannot be the loss in terms of conventional opportunity cost. It has to be proved by the bankers themselves to the satisfaction of the court or any arbitrator.