Islamic Banking Vs. Interest Rate
Economic System
Islamic & Conventional
Islamic View
Objective
Justice and Equity (Economic & Social)
Law
Divine and unalterable
Rights & Responsibilities
• Rights of possession but limitation
• on ownership and disposition
•
Compulsory (Zakat) and Voluntary
• (Sadaqa) charity
•
Collective welfare more important
• than individual welfare
•
Freedom restricted to divine will
•
Ethics dominate efficiency
Conventional
Objective
Profit maximization and efficiency
Law
Man made and evolutionary
Rights & Responsibilities
• Unconditional rights to ownership
•and disposition
• Voluntary charity
• Individual welfare more important
•than collective welfare
• Freedom restricted to changing
•norms of society
• Efficiency dominates ethics
Concept of Riba (Interest)
What is Riba (Interest) ?
Practice of charging financial interest or a premium in excess
of the principal amount of a loan
Two explanations provided :

Verses related to Riba were revealed towards the end of the
Prophet’s life and therefore little history of cases where people
asked him about the term

Riba was already well known and therefore the Prophet did
not elaborate any further
The second explanation is a more plausible reason.
Lending Practices before
Prohibition of Riba (Interest)
• Person sells goods on credit for a certain period. If the price
is not paid within a certain period, an amount was added to
the price and the repayment period was extended.
• Person lends money with the understanding that an
additional amount would be paid besides the principal
within a fixed period.
• A rate would be agreed between the borrower and the
lender and would be paid along with the principal at the
end of the period. If the period was extended, then the rate
was increased for the extended period
Riba (Interest) in Shariah
• Definition in Shariah:
Riba refers to the “premium” that must be paid by
the borrower to the lender along with the principal
amount as a condition of a loan or for an extension in
the duration of loan
• Four characteristics define the prohibited Riba
Positive and fixed ex-ante (includes variable rate)
Tied to a time period and amount of loan
Payment guaranteed regardless of the outcome of the
borrowed loan
Practice is sanctioned and enforced by Law
Rationale for the Prohibition of
Riba (Interest)
• Riba and economic & social injustice
 Riba is a form of economic and social exploitation and violates the core
Islamic belief of social justice
 Lender guaranteed a positive return without sharing any risk with the
borrower who assumes all risks including his skills and labor
 Riba is differentiated from trade, which promotes risk sharing that leads
to equitable returns distribution and a more just economic system
• Nature of Money
 Money is not treated as commodity and has no intrinsic utility
 Money is not held as a subject matter of trade
 Commodities can be of different qualities whereas money has no
quality
 Money cannot be identified in a transaction of exchange
 Use is restricted to act as a medium of exchange and measure of value
Rationale for the Prohibition of
Riba (Interest) ‘Cont’d’
• Promotion of Profit and Risk Sharing
Sharing of risks and uncertainties of enterprise is
critical in Islamic financial contracts
Risk and profit sharing is essential for a return on
entrepreneurial effort and financial capital
Shareholder is liable for the debts to the extent of his
capital and earns dividend when profit is earned
Creditor lends money without owning the enterprise
and claims interest regardless of profit and loss of the
enterprise.
Creditor runs the risk of only the solvency of the
borrower but not the success of the enterprise
Murabaha – Mode of Financing
• Originally used as a type of a sale contract and not as a mode of financing.
The Shariah scholars have allowed Murabaha as a mode of financing due
to practical difficulties in the current economic set up. It used as a device
to escape interest (Riba) to carry out real objectives of the Islamic
economic system, and it used only as a transitory step under strict
conditions and where equity partnerships are not practical
• Conditions of Murabaha
 Must comply with the rules of sale
 Sale basis and not for financing purposes
 cannot be used for payment of wages or account payables
 Default by the end-user
 the financier has recourse to only the items financed no penalty or further
mark up allowed
 Basis of Profit
 the type of product, creditworthiness of the buyer and length of time the
product is financed
Modern Murabaha Contract
• It’s a Combination of Deferred Sale Contract
and Cost plus Profit Sale. This contract
includes the following parties:
Vendor or the original seller of the Product
Financier, Intermediary or the Islamic Bank
The buyer or the end-user of the Product
Murabaha Financing Structure I
Murabaha Financing Structure II
Issues with Murabaha
• Use of Promise
 Bilateral promises in contracts where both counter values are deferred
is widely prohibited
• Use of Profit Rates and Benchmarks
 Profit rates is determined based on market interest rate such as LIBOR
(London Interbank Offer Rate)
• Different pricing for cash and credit transactions
 Credit price is higher than cash price and the longer the credit period
the higher is the credit price
• Murabaha appears similar to conventional trade finance
 Substitution of interest rate by profit rate
Same Item Repurchase
(Bai-al-Einah)
• Practiced in south east Asia (Malaysia)
• Variant of a Murabaha contract
• The vendor or seller in a Murabaha contract is
different from the buyer or client of the Bank
• The vendor in Bai-al-Einah is the same as the
client
• The bank buys the commodity from the client
and resells the same to client at a higher price on
a deferred payment basis
Repurchase (Bai-al-Einah)
Structure
Distinction between Murabaha and
Bai-el-Einah
• Murabaha
• Bai-el-Einah
 The seller and buyer are
different
 The seller and the buyer are
 The financing is related to
the price of the
commodity
 The financing is cash for cash
and it may not bear any
relationship to the commodity.
 The contract cannot be
renewed or renegotiated
at maturity
 The contract may be renewed
a number of times and would be
no different than conventional
loans with compound interest.
the same
References
Iqbal, Zamir. An Introduction to Islamic
Finance "Theory and Practice" John Wiley &
Sons. Print.