Shariah, the body of law that governs all aspects of Muslim life, forbids riba, a word in Arabic commonly interpreted as "interest," though it also means usury and all forms of unearned income. However, modern banking is established on the basis or riba, or paying interest to depositors and charging interest to borrowers. Islamic banking attempts to provide modern financial services that are permissible in Islamic jurisprudence.
Usury and Interest
Ancient civilizations and major religions since pre-Biblical times have tried to define the difference between the charging of interest on loans and usury. The former is seen as an acceptable fact of commercial life, while the latter, or excessive interest, is frowned upon because it is an extortionate charge for money and regarded as exploitation. The concept of riba as either interest, usury or both is one of the most hotly debated topics among Muslim scholars. Nico Swartz of Free State University in Bloemfontein, South Africa, argues that bank interest is not riba but a reasonable rate of return on a business transaction, while riba is the exploitation of the poor.
Other Shariah Prohibitions
In addition to prohibiting riba, Shariah also forbids “gharar,” meaning deceit, uncertainty, hazard and risk. The aim of the ban is to protect individuals against unexpected losses through exploitation by others. Islamic law also forbids “maysir,” or all forms of gambling and easy acquisition of wealth by chance. As an example, a conventional bond issued by a Western bank is “haram,” or sinful, in Islam because the issuer stipulates a predetermined interest rate (riba), to compensate for as yet unknown future circumstances (gharar), in order to make money from his money (maysir).
Time Value of Money
Despite the prohibition of riba, Shariah recognizes the time value of money. A lender may disburse money to a creditor and charge fees for the service to compensate for lost financial opportunities had she kept the money. The return on the investment for which the loan was contracted forms the basis for calculating the lender’s fee, which can include losses as well as profits. This is charging a fee for “certainty” as opposed to the forbidden “uncertainty,” and is the principle behind different Islamic financing techniques.
Mudaraba is the oldest form of Islamic banking. It’s a partnership between a bank and a borrower. The bank uses depositors’ funds to invest in a project, which may be a real estate development or an industrial plant. It distributes the profits from this investment to the depositors according to a pre-agreed, fixed ratio. The bank, or other capital provider, carries any losses the investment may make.
In Musharaka banking, the bank and its depositors share in both the profits and losses of the investment. They agree in advance how to share the profits and losses. The depositors may also participate in the management of the investment, but are not obliged to do so.
Murabaha is a form of costs plus financing, and is the most popular form of Islamic banking. The bank buys a product, often a commodity cargo such as oil or wheat, on behalf of a client. The bank resells the commodity back to the client at an agreed markup that includes an agreed sum for the bank's costs as well as a profit margin. This setup effectively charges the client for the use of money, but not through interest. The markup, or fee, does not increase if the client fails to make a payment on time, but remains as pre-agreed.
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