The literal translation of the Arabic word riba is increase, addition or growth, though it is usually translated as 'usury'. As the following discussion shows, usury is not to be regarded solely as the practice of taking interest on a loan.
Several methodologies exist for describing riba. Here, two defining elements of riba are identified (riba al-fadl and riba al-nasia), and two kinds of transaction into which these elements may be incorporated are described (riba al-qarud and riba al-buyu).
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-nasia, the usury of waiting, 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. Some writers employ the term riba al-nasa to define such an exchange.
Hence, an exchange in which I part with 100 grammes of gold now in return for 100 grammes of gold to be received from you tomorrow can be described as riba al-nasia. An exchange in which I part with 100 grammes of gold now in return for 110 grammes of gold to be received from you now can be described as riba al-fadl.
It is occasionally argued that usurious loans, riba al-qarud, combine both riba al-nasia and riba al-fadl since there is both a delay and a surplus involved in such transactions. This is the modern interest bearing loan, wherein a charge is levied by one party on a debtor in respect of an amount owed. It is one of the major forms in which riba may be practised. The original debt may arise from a loan of money or from the purchase of an item on credit. In either case, the debtor enters into a contract to repay the lender a pre-agreed amount of wealth in addition to the original debt in return for a delay in the timing of repayment. Somewhat confusingly, the term riba al-nasia is occasionally used synonymously with riba al-qarud, but in this text the terms are used as defined above.
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 Dr. Tantawi, while Sheikh of al-Azhar in Cairo, have argued that bank interest is a sharing of the bank's profit and may therefore be permissible. In recent times it seems that the Sheikh has either changed his opinion on this matter, or corrected an earlier misunderstanding of his opinion by others. In any case, the view in question has now been widely 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. This of course is a complete misunderstanding of the mechanics of interest. It is simply the manner of calculating interest that varies here, not the fact of its payment. Under variable rates of interest, interest is indeed charged but the rate at which it is charged is determined at the beginning of each sub-period into which the loan is divided.
Riba al-buyu, the usury of trade, is a second major form in which the elements of riba al-fadl and riba al-nasia may appear. In order to avoid riba al-buyu, both the quality and quantity of the exchanged items must match and the exchange must be simultaneous. Hence, if dates are to be exchanged for dates, the quality and quantity of the dates must be the same and the exchange must be made on the spot. (Quite why anyone would enter into such an exchange is another matter, but Mahmoud El-Gamal at Rice University in Houston has pointed out that the requirement may simply exist in order to encourage the sale of goods for cash in order to achieve fair market values for buyers and sellers, "marking-to-market" as he describes it).
A question now arises as to which kinds of item the prohibition on riba relates to, in other words which are the ribawi items?
'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'.
According to Ibn Rushd in Bidayat al-Mujtahid, most jurists maintain that the scope of riba extends to more than just the six commodities mentioned in the above hadith. Hence, an exchange of one ounce of copper for two ounces of copper undertaken on the spot would constitute riba even though copper is not mentioned in the hadith. Note also that exchanges of the same commodity within the six (dates for dates, say) as well as different commodities within the six (for example dates for wheat) must not involve delay.
An exchange of £100 of paper money now for £110 of paper money later is also seen as a forbidden transaction. This is so because the paper fulfils the function of money, and in the hadith the reference to gold and silver is interpreted as a reference to all things that possess the characteristic of being used as money (i.e. things that have thamaniyya).
However, the illa employed by the jurists in this matter differs. For example, in respect of the prohibition of excess (the riba al-fadl element) Malik asserts that the illa is the characteristic of being food that can be stored, or the characteristic of being the same commodity and one representative of currency. In respect of the prohibition of waiting (the riba al-nasia element) for the four items of edible produce, Malik identifies the illa as being the characteristic of tastefulness and suitability of storage. However Imam Hanifa argues that the illa for all six items is the characteristic is of being something that is customarily measured by weight or volume. Meanwhile, the Zahirite opinion is that only the six commodities are to be viewed as ribawi. Under this view, one ounce of copper can be exchanged for two if the parties wish. In any event, riba al-buyu can always be avoided if a commodity is sold for money on the spot.
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'.
It therefore seems that riba al-buyu cannot occur under a money-for-goods transaction. Neither can riba al-qarud occur in a money-for-goods transaction since loans are repayable in kind. If correct, this is an important conclusion since it means that where Person A buys a good from Peron B with money, there can be no riba. This in turn means that even if Person A is asked to pay a higher price for deferred payment than for immediate payment, following the purchase of a good, riba does not occur.
Some writers have stated that riba al-jahiliyya, the usury of the days of ignorance, was the only kind of riba known at the time of the Prophet s.a.w. (This kind of riba appeared where a buyer of a good on credit reached the end of the credit period, whereupon the seller offered to extend the credit period for an extra charge). However, the majority view seems to be that both riba al-qarud and riba al-buyu were well established by the pagan Arabs before the time of the Prophet Muhammad s.a.w. and that he warned his companions that riba could be practised in many different ways.
If forced to generalise about the two major forms of riba, one might say that they occur where both counterparties in a contract do not enter, or cannot be assured of entering at a later date, into a fair exchange of countervalues. 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 countervalue. And in riba al-buyu, by exchanging two measures of corn for one measure, one party clearly receives more value than the other.
It is of some relevance here to note that Jesus (peace be upon him) evicted the money changers from the Temple in Jerusalem for practising a kind of usury that seems in all respects equivalent to riba al-fadl. Jewish pilgrims arriving in Jerusalem to pay the Temple tax would wish to do so using the half shekel, this being the only silver coin that did not portray the head of a pagan Roman emperor. The usurers of the Temple made a business of receiving the despised silver coins and giving in return the half shekel. The exchange of coin for coin was simultaneous, but the usurers took more weight of silver from the pilgrims than they gave. Thus, they practised an exchange of unequal weight of silver hand to hand, riba al-fadl. The similarity between this mechanism and the practices of those Kings who debased their currency is obvious.
It is often suggested that the use of money sooner rather than later is a valid countervalue to the payment of interest, although the benefit of this earliness of use has itself been questioned by various writers. However, a little consideration does yield some examples of unfairness in the riba al-nasia transaction. For example, if A gives B corn today under an agreement for B to give A the same amount of corn next year, then B is effectively storing and maintaining corn on behalf of A free of charge throughout the period. The exchange may also result in one party having to provide the other with a commodity that is of more value at one time of year than another. If it is easy for A to provide B with corn at harvest time, it may not be so easy for B to provide A with corn at the outset 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 contrasted with acts of charity. It is seen in juristic writings as one of the means of 'devouring' others wealth. This accords with what is known of fixed interest financing mechanisms, relying heavily upon wealth transfer in many cases, for instance where collateral is seized by a lender in a loan default. One might equally argue that the process of money creation also results in the devouring of others' wealth, devaluing their savings through the mechanism of inflation.
Often 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. The majority seem to stick with the narrower definitions of riba and classify activities such as money manufacture and auction rigging as fraud or deception.
In the ahadith, the Prophet Muhammad s.a.w. condemns the one who takes riba, the one who pays it, the one who writes the agreement for it and the witnesses to the agreement. It is also clear that Allah in due course required the new Muslims of Arabia to give up riba 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 instalments 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 practise 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 (now commonly referred to as murabahah to the purchase orderer or in Malaysia Bay Bithamin Ajil (BBA)) is a 'promise to buy'. This promise is 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 instalments, 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 instalments if the individual defaults.
So far, there is little practical difference between the cash-flows paid under murabahah to the purchase orderer 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 also seems to be 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. (In many cases, the argument is factually incorrect because 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. Murabahah to the purchase orderer 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 instalments 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 instalment 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 murabahah to the purchase orderer are the 'they' that the Qur'an is referring to. Could it be that the practice described above is in fact permissible in Islam? Unfortunately, both classical and modern Muslim scholars are not in consensus on this issue. Regarding the instalment sale of an asset by a financier in the manner described above, Imam Shafi'i is regarded as being favourably inclined whilst 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.
(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 least one can say is that the Islamic banker enters into the realm of what is doubtful. Some commentators argue that if murabahah to the purchase orderer 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 murabahah to the purchase orderer 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 instalment. 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 practise 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 three times the cash price, 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 practising 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, of modern banks, leasing and finance companies.
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 realised that the problem arises in the monetary system itself. How can Islamic finance be practised with money that bears interest as a condition for its existence? (See Fractional Reserve Banking on this website).
The appearance of debt trading in the Islamic financial market is a further example of the kind of innovation that erodes the difference between the Islamic and the interest-based paradigms. 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 instalments on a bond.
A bond is said to be a 'zero coupon bond' if no coupons (i.e. interest instalments) 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 realised 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 instalments over the life of the bond.
Now, imagine that each instalment due under a BBA is 'securitised', that is, turned into a tradable financial instrument. For example, each instalment to be received by the builder from the house buyer could be securitised 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 instalment due from the house buyer at the end of year one could be securitised 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, some Islamic finance deals have been concluded on more or less the basis described above. Among the projects so financed was 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 programme. 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 instalments over twenty years. In the final step of this financing process, the instalments were securitised into zero-coupon bonds and sold at below face value to investors. Here is securitised BBA in action, indistinguishable in its financial outcome from the issuance of secular zero-coupon bonds.
In concluding this short introduction on the subject of riba it is worth reminding ourselves of some common misconceptions. Firstly, the view that 'interest is a guaranteed gain' is not correct. Nothing is guaranteed in life and even modern bank loans do not guarantee that the bank receives its interest. Borrowers do default from time to time. Neither is it true to say that loans at interest are permissible so long as the loan itself is used to purchase a productive asset. Interest-free loans are permissible under Islam for a wider range of purposes than production alone, whilst interest bearing loans are prohibited under practically all circumstances (situations of coercion or necessity being two exceptions that come to mind). Instead, it is the fixing in advance of a gain on money loaned that is the defining feature of modern interest. The fixing may occur by means of a transfer of money made by A to B, which B later repays to A; or it may occur by means of a transfer of money made by A to B, for which C makes the repayment to A at a later date. It is the latter of these two transaction types that underpins the murabahah to the purchase orderer contract as practised by most Islamic banks today (A is the bank, B is the seller of the house, and C is the client who needs home finance). The label may say "Islamic", but the content smells rather different.