JOURNAL OF GLOBAL BUSINESS AND ECONOMICS

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1 86 CAN THE MODEL OF THE RIBA-FREE ISLAMIC COMMERCIAL BANK PROVIDE A NEW PARADIGM FOR THE FUTURE OF GLOBAL BANKING?: A THEORETICAL REVIEW Nico P. Swartz University of the Free State, Faculty of Law swartznp.rd@ufs.ac.za ABSTRACT The study shows that there is a need for riba-free banks in all countries where Muslims live. However, most countries operate under conventional banking laws, and it is futile to expect the situation to change; and it does not need to change. The interaction between the traditional Islamic and the conventional Western bank will make possible the setting up of a new type of bank, i.e. riba-free commercial banks. This riba-free commercial bank will serve as a new paradigm for global banking. Under the riba-free commercial bank, all current account services rendered by the conventional model will be provided. The difference is that where, in the conventional system, six components (interest, services cost, overhead costs, risk premium, profit, compensation for inflation) are treated as a compound to justify riba, the riba-free commercial system treats these components separately in order to avoid riba. The result will be that interest stands to be charged, while riba is to be prohibited. Ribafree, but not cost-free, loans and advances will form the basis of riba-free commercial banking. It means that riba-free commercial banks must be free of the encumbrances of charitable loans. In this riba-free commercial model, interest is to be associated with trade or profit, which is permissible in Islam. In ribafree commercial banking, aspects of both conventional and Islamic finances are combined. This will allow Islamic societies to have the best of both worlds, and this is the model of banking the world is waiting for. It is now up to the Muslim and conventional bankers and others to take steps to establish such ribafree commercial banks (not interest-free) in all countries of the world INTRODUCTION In the Middle-East, Islamic banks came into being as a consequence of the oil-price hike of 1973 and the resultant flow of huge amounts of money into the oil-producing countries. The only income-earning investment options available were those offered by the conventional banks (Western), and these were based on interest. The Western banks, on the one hand, provide all the conventional facilities, both nationally and internationally, and they dominate the field. On the other hand, this practice appealed to the Muslim religious conscience, and they started searching for riba-free alternatives. Their aim is to rid the economy of riba, and they began with the riba-free banking system. However, the Muslim community encountered a problem with the banking system as it exists today, and this article aims to address their concerns. There is, therefore, a need for a banking system that can accommodate both Islamic and conventional methods of finance. This paper tries to explore this phenomenon. It also suggests that Muslims and non-muslims could have the best of both worlds. This paper aims to establish

2 87 a mixed system which combines aspects of conventional and Islamic banking practices. This mixed system came to be associated with riba-free (Islamic) commercial banking. 2.0 USURY (RIBA) AND INTEREST Historically, usury (riba) and interest were always treated as one and the same thing. It was only in the post-christian, post-renaissance period of European history that the term interest was used as a substitute for usury to wriggle out of the religious and moral prohibition. Currently, there is an ongoing dispute among scholars about whether the Qur an advocates a total ban on interest. The dispute arises from a lack of consensus about the meaning of riba, which is the Arabic word for the predetermined return on the use of money. 1 This paper purports to explore the notion that there is a difference between usury and interest. Moneylending transactions involve usury and interest. 2 It is therefore necessary to have an interface between riba and interest. 3 This will enable Muslims to follow their religious precepts without creating serious distortions in their economies. 4 According to the injunctions of the Holy Qur an, anything recovered in excess of the principal amount is specifically prohibited in money-lending transactions. In money transactions, the Holy Qur an permits the lenders to take back only the amount advanced and no more. 5 Prima facie it seems that interest, like riba, is also prohibited. This will, however, be futile for commercial banking, because the notion of trade is included in interest. From this perspective, an increase on the amount lent must not be viewed prematurely as riba. Riba means excess. In Islamic jurisprudence, it encompasses an increase in the principal. 6 This explanation still does not distinguish riba form interest as riba, and interest entails both increase and excess. 7 The interface between riba and interest come to the fore only when riba is being viewed as [the] doubling of a sum when the debtor cannot pay it back at the moment when it becomes due. 8 On the strength of this, riba may not be regarded as synonymous with interest. This notion is fostered by the perception that not all Islamic scholars agree on the Qur anic prohibition of all forms of interest. 9 In light of the argument above, this paper tries to solve the problem by defining riba as high or excessive rates of interest only. The implication to be deduced from this point of view is that bank interest is not riba and is therefore to be allowed. This notion is endorsed by the phrase: it is not clear that the Qur an s ban on the institution of interest is applicable as it prevails today Mahmood Yousefi et al Islamic Banking and Friedman s Rule (1995) vol. liii, no.1, Review of Social Economy, Shahid Hasan Siddiqui Islamic Banking (1994) Ibid Mahmood Yousefi et al (1995) Siddiqui (1994) Siddiqui (1994) Mahmood Yousefi et al (1995) Mahmood Yousefi et al (1995) Mahmood Yousefi et al (1995) Mahmood Yousefi et al (1995) 67.

3 88 It is important that the perception that interest is not increase simpliciter be imprinted in the minds of humankind. If this notion is not to be accepted, interest may be tantamount to riba. However, there is an element of increase that is known as profit, which is permissible. Hence the Qur anic verse: Allah hath permitted trade and forbidden riba. 11 Mahmood Yousefi writes: Most Islamic scholars do not object to profit [interest] since it is viewed as a return on capital which is subject to risk and is not predetermined. 12 It should be noted that, while the Qur an prohibits a fixed or predetermined rate of return on financial assets, it does not forbid uncertain rates of return (such as profi ts [interest]) on financial transactions). 13 Since risk bearing is regarded as a justification for profit, Islam does permit mudarabah (a type of profit sharing) and musharakah (partnership). 14 It is acceptable to be compensated for losses incurred, because one s money was not available for use (the doctrine of damnum emergens ). Interest is the consideration or compensation payable to the financier. 15 Bank interest is therefore regarded as different from riba and should not be seen as prohibited by the Holy Qur an. Interest on commercial loans does not amount to riba and is therefore permissible. It has been argued that interest charged by banks on production loans for trade, industry, and agriculture does not fall within the ambit of riba. 16 Prohibiting interest will distort the credit market. That, in turn, will adversely affect the capital development of the economy. If a zero interest rate was simply imposed on the market, borrowers would act as if capital is not scarce, and lenders would not receive any pecuniary reward for providing such capital. 17 It is only the compound interest (doubled and redoubled) which is prohibited and not a normal or simple (bank) rate of interest. 18 Charging interest is to be justified by the temporary loss of money by the lender, and a possible gain and advantage of it to the borrower. 19 Khurshid Ahmad cited Henry W. Spiejel in The New Palgrave: A Dictionary of Economics (1987:769): in modern parlance only exorbitant interest is considered usurious. 20 Raymond De Roover writes in his article Economic Thought: Ancient and Medieval Thought in the International Encyclopaedia of the Social Sciences (1968:434): usury is an exorbitant, oppressive interest rate 21 Interest is the reciprocal of usury and is rather moderate. In other words, money transactions with a moderate rate of interest are permissible. 22 Argument in favour of interest is that it is compensation to the money lender for his risk and sacrifice. If the borrower has taken a loan to invest in a profitable business, the lender has the preemptory right to claim interest. When the borrower is earning profit on the lender s money, why should the lender be denied a share in the profit? 23 Interest on the basis of actual productivity and profitability of a venture is perfectly legitimate. Capital has a price, and this is to be determined in the light of its real productivity and profitability. 11 A. Yusuf Ali Commemorating the 1400 th Anniversary of the Holy Quran (1987A.H CE) (2:275). 12 Mahmood Yousefi et al (1995) Mahmood Yousefi et al (1995) Mahmood Yousefi et al (1995) Siddiqui (1994) Siddiqui (1994) Mahmood Yousefi et al (1995) Siddiqui (1994) Siddiqui (1994) Khurshid Ahmad Elimination of riba: Concept and Problems (1994) Institute of Policy Studies Khurshid Ahmad (1994) Muhammad Iqbal Siddiqi Model of an Islamic Bank (1986) Siddiqi (1986) 34-5.

4 89 This paper has revealed an interface between interest and riba. It is alleged that riba means usury, an exorbitant and oppressive rate of interest, the opposite of normal or simple (bank) interest. Whereas riba relates to loans contracted by the poor and the needy persons for consumption purposes, interest constitutes a reward on commercial, productive, and profitable loans. Interest stands for a reasonable rate of return on capital, while riba represents an excessive, exorbitant, and exploitative rate of interest. 24 Most Islamic scholars do not object to profit, since it is viewed as a return on capital which is subject to risk and is not predetermined. 25 Profit is thus equated with moderate or bank interest. 3.0 INTERACTION BETWEEN CONVENTIONAL AND ISLAMIC BANKS 3.1 A vindication of interest In the case of conventional banking, a bank charges the borrowers interest on their loans and pays the depositors interest on their deposits. Both are called interest, though the former is always larger than the latter and, in Islamic contexts, stands to be associated with riba. As indicated above, only riba is to be prohibited and not interest. The prohibition of all forms of interest is therefore ridiculous. If there are claims that the charging of all forms of interest be prohibited, how is a bank to meet its operational costs? 26 The purpose of borrowing is to invest in a venture and make a profit. It therefore seems reasonable for the lender to ask for a share of what was gained. The reward (interest) is fixed in advance, and for the safety of the capital, collateral is demanded. Charging reasonable interest is seen by many to be logical: banks charge a modest rate of interest. Such loans are an indispensable business need today. 27 Luther ( ), Zwingly ( ), and Sir Francis Bacon ( ) advocated that interest should be permitted. It (interest) was rendered legal and moral and has become an integral part of the conventional economic theory. By means of practice, this theory was reinforced so that it has now become difficult to think of any economic theory without interest as an integral part of it. Today practically everywhere, charging and paying interest is legal, and it is acceptable in both theory and practice The conventional model: The operational costs of a bank All forms of traditional Western financial relationships involve the payment or receipt of interest. 29 The conventional model dictates that, when money is lent, the lender is allowed to demand that more than his principal be returned. 30 Under the conventional model, loans are given on fixed-return basis. It means that a bank may charge a fee for its service. This is not riba, but these fees should not be made into a source of income for the banks. The criterion for fixing the fees must be the actual expenditure which the banks have incurred in scrutinizing the applications, making decisions, and maintaining accounts until loans are repaid. 24 Khurshid Ahmad (1994) Mahmood Yousefi (1995) Siddiqi (1986) Siddiqi (1986) (5 of 24). 29 Steve Cocheo Disinterest Banking (2007) ABA Banking Journal (4 of 23), (4 of 23).

5 90 Gafoor proposes that the interest charged by conventional banks be taken and split into six components in order to eliminate the element of riba. The six components are: (i) interest paid to the depositor, (ii) cost of overheads, (iii) cost of services, (iv) a risk premium, (v) profit or remuneration to the bank, and (vi) compensation for the value loss of capital due to inflation. 31 There are costs related to services, including legal and other charges paid by the bank for services such as the evaluation of the collateral, the preparation of loan documents, postage, etc. 32 This cost is specific to the concerned loan and needs to be borne entirely by the concerned applicant. This is the actual cost incurred by the bank and is independent of the size of the loan or the period of repayment. 33 There is thus no resemblance of it with riba. 34 The overhead costs go towards the maintenance of the bank, including staff salaries and office expenses. This cost is necessary to maintain the bank, whose services the community, the depositors, and the borrowers need. 35 It is not riba. 36 Profit is viewed as legitimate remuneration for providing a service, for example carrying money from the lender to the borrower and back, keeping the money safe, receiving and paying money to both the depositors and the borrowers, and buying and selling services from third parties, e.g. hiring a lawyer for title checking. 37 The remuneration of the bank for arranging these services can obviously not be regarded as riba. However, if it is computed as a percentage of the loan amount, there may be some room for doubt. If it is computed to recover the cost of the services that the bank provide, it is legitimate remuneration or profit and therefore not riba. 38 With risk premium, instead of the banks joining a deposit-insurance scheme, the borrowers join in a loan-default insurance scheme. This is designed to compensate the bank in case of defaults. Delays are discouraged and early settlements are encouraged. The premium is proportional to the size of the loan. 39 No riba is involved. With regard to the last element, the value of capital is being affected by the depreciation of the currency. This lost must be compensated in fairness to the capital holders. This component is the amount that needs to be paid to the capital holders (depositors) in order to restore their capital to its original value. 40 This is also not riba. With regard to this model, two types of low-interest lending schemes (educational loans and housing loans) will be examined to see if they involve riba. For example, a philanthropist who wants to help needy students could proceed in several ways: He could hand out a certain amount to every needy student who applies until his money is depleted. After that, he would not be able to help any more students unless he brings in new funds. He could, in the second place, require the students to pay him 31 ALM Gafoor Participatory Financing through Investment Banks and Commercial Banks (1996) 25. ALM Gafoor Commercial Banking in the Presence of Inflation (1999) 88. ALM Gafoor Interest-Free Commercial Banking (1995, 2002) 3, 29, Gafoor (1999) Gafoor (1995, 2002) (15 of 24). 35 Gafoor (1995, 2002) (15 of 24) 37 Gafoor (1995, 2002) 4. Gafoor (1999) (16 of 24) 39 (16 of 24) (16 of 24).

6 91 back once they are employed. From the money thus recovered, he could help more students. This would then require the employment of a person to disburse the funds, keep records, receive payments, etc. Unless the philanthropist provides fresh funds every year for the upkeep of the office, the original funds would be used for this purpose as well, and eventually the operation will shut down. In the last instance, he could proceed as in the second case above, but also require of the students to pay for the upkeep of the office, in addition to repaying the full amount of the loan. 41 The philanthropist does not ask or receive any monetary benefit for himself. In Islamic parlance, no riba is involved. Although there is cost involved in borrowing, it is not riba. Rather, it is interest. Unfortunately, Muslims take the word interest literally and equate it to riba. This paper has established that there are several differences between interest and riba. Everything that is called interest is not necessarily riba. Such an understanding may help Muslims to benefit from several so-called low-interest loan schemes (which may currently be rejected out of hand) without any qualms about getting involved in riba dealing. One such low-interest scheme is the housing loans organized by governments. Governments will prefer to make use of the banking system. It simply deposits money with the bank, gives specifications as to who qualifies, and leaves the rest to the bank. The government does not require any interest on its deposits, but the bank must make sure that the original capital remains intact by ensuring proper loan recovery. No riba is involved in this scheme, since the government does not demand or receive any amount in addition to its capital. These two cases involve interest and not riba. 42 If a riba component is present in these two cases, it will be illegal and morally reprehensible. This will be the case where profit rates turns out to be very high. Riba is therefore indicative of exploitation and injustice, but in the case of interest, benefits will trickle down to society through reduced costs and lower prices, and it will eventually help curb inflation. After this interplay between the conventional and Islamic model, it is the aim of this paper to stress that both models, on their own, would not be sufficient to set a paradigm for global banking. With the integration of these models, a new paradigm for the future of global banking can, however, be set. This new paradigm can be named riba-free (not interest-free) commercial banking. 4.0 RIBA-FREE COMMERCIAL BANKING AS A COURIER OF MONEY (A VIA MEDIA BETWEEN CONVENTIONAL AND ISLAMIC BANKING Like the conventional and the traditional Islamic model, the riba-free commercial banking also provides services for a payment. It accepts deposits, guarantees their safety and full return, and provides all current account facilities such as cash receipts, cheque collection and payment, electronic and other types of fund transfers, etc. Depositors agree that their funds may be used to grant loans to borrowers, and the bank guarantees the full return of their deposits. They (the depositors) do not demand nor are they paid any financial returns on their deposits. The depositors, therefore, do not deal in riba. The borrowers, on the other hand, are granted loans on condition that the capital, which belongs to the depositors, is returned in full, and they pay the bank a fee for making the funds available to them. The fee includes, as mentioned above, all the costs incurred by the bank and remuneration (interest/profit) for providing the service. Since the owner-lender did not demand an extra amount (which would be 41 (18 of 24) (19 of 24).

7 92 riba), the borrower does not pay any extra amount (to the owner -lender) apart from the principal amount. Therefore this bank s (riba-free commercial bank) lending operation is free of riba. 43 The payment made by the borrower to the courier for the service is not riba (because the payment is based on human labour, and it is unlikely that the charges will be excessive). Herewith, the traditional perception of banks as moneylenders must be changed to that of couriers of money (the service - delivery element = human labour). Passive participation in economic activities is therefore rejected. Active human involvement is rather encouraged. Islam advocates the commitment to hard work through which the accumulation of wealth is acceptable. It (Islam) recognizes that the meshing of capital with labour will prove to be a productive source. Capital is rather idle unless labour transforms it. 44 This notion argues against the idleness of human beings in their participation in economic activities. Under this model, financial vehicles of the traditional Islamic model, like mudarba, stand to be employed. Through mudarba, idle capital is to be transfer to an entrepreneur and not a financier. In other words, mudarba is a combination of capital and entrepreneurship. 45 It means that, in the new riba-free commercial model, the traditional Islamic model is to be adopted where a return, equivalent to the amount of the zakat, must be sought. 46 With regard to the traditional Islamic model, a zakat payment can be perceived as analogous to a return-on-investment, which amounts to an interest rate of 2.5%. Hammad argues that the zakat payment should be set off by an equivalent or by more income; otherwise the capital sum will decline. 47 This implies that interest is allowable, albeit less. It is mainly the depositors money that the banks lend to borrowers. In this sense, they are the couriers of money. As such, the riba-free commercial banking is designed as a courier of money it is a service provider in the field of banking and finance. In this sense, this bank s operations are all riba-free, and the fees it charges for its services have nothing to do with riba. The Islamic riba-free commercial banking does, however, not adopt all of the traditional Islamic vehicles or modes of finance, for example, qard-e-hasan loans. Unlike the traditional Islamic model, the riba-free commercial model will not be able to write off the loans of persons who are unable to repay them and to consider this as an act of charity. This is, in their view, a consequence of equating a bank to a moneylender who lends his own money. The question that could be voice against qard-e-hasan is the following: Does an entity that holds other people s money in trust have any right to provide charity out of it? Riba-free commercial bankers may opine that this will undermine the promise to return the full amount to the depositors. On the question of how the shortfall may be provided for, the metaphor can be used of a branch manager of a chain of banks who was given the authority to determine which of his borrowers is under financially under pressure, as well as the power to write off these loans. Such practices pose an open invitation to corruption and fraud. 48 Charitable loans should therefore be left to private individuals and charity organizations. A bank, like the riba-free commercial bank, being a courier of other people s money, must not become involved in charitable loans (7 and 8 of 23). 44 AE Hammad Islamic Banking (1989) SMH Zaman Practical Options for Central and Commercial Banking (1994) Hammad (1989) 26. Zakat is an imperative tax levied on Muslim s wealth, and must be discharged by every Muslim regardless of age or state of mind. The intention with zakat, is the abolition of the hoarding of wealth. It is to be levy on productive assets, rather than one s dwelling and clothing. It could be considered charity, but in another sense it is an imperative source of funds. 47 Hammad (1989) (7 of 23).

8 93 Compatibility with conventional banking is one of the desired goals in devising a riba-free commercial bank. 49 The bank ( riba-free commercial bank) is able to guarantee the depositor s capital, have assessable assets, and income that is sufficient to maintain the bank. This maintenance of surety of capital will satisfy banking authorities. Herewith, the riba-free commercial bank also qualifies, like the two other models, to be registered as a deposit-taking bank. There seems to be certain advantages of the riba-free commercial banks under conventional laws. They are: that riba-free commercial banks will ensure proper auditing and monitoring which inspire confidence in the bank. It ( riba-free commercial banks) will be set up in all countries of the world to be of service to the Muslim and non-muslim. It can also be set up in non-muslim countries and will be able to offer conventional commercial banking services. Unlike interest-free banks, it thus has a good chance of survival. The considerable number of Muslims living in non-muslim countries will enjoy the possibility to bank with a riba-free bank which is competitive and offers all the facilities of a conventional bank. Some people will appreciate the chance to bank without riba, provided the value erosion of their capital due to inflation is compensated and all other banking facilities are offered. People who eschew riba for reasons other than religious belief will also appreciate the opportunity given by this type of bank. The riba-free commercial bank will be able easily to communicate and deal with other banks, within and outside their own country CONCLUSION Traditional Islamic banks, as they operate today, do not offer the advantages propounded by riba-free commercial banks, even within the few Muslim countries where they are permitted to operate on their own terms. It is worth giving some serious thought to the proposed riba-free commercial bank advocated in this paper. In the riba-free commercial bank, interest charged by a bank is split into several components in order to avoid riba. This innovative stratagem is rather new and can serve as a paradigm for future global banking. According to the riba-free commercial bank, bank interest, not riba (excessive compound interest), stands to be charged. Riba-free commercial banks must be free of the encumbrances of charitable loans (traditional Islamic economy) on t he one hand and of excessive or compound interest (Western conventional economy) on the other hand. Some bankers fear that when all loans are eliminated, the banking system will collapse. The paper stresses that the bank earns its agency charges. This is its major source of income. The riba-free commercial banks perform all the conventional banking functions on the basis of commission, service charges, or remunerations. The question of a bank s right to claim a share in profit or remuneration for its service (interest) is settled in this paper. BIBLIOGRAPHY Ahmad K Elimination of Riba: Concept and Problems. In Elimination of Riba from the Economy. Institute of Policy Studies. Shirkat Press: Lahore. Ali YA 1387AH-1967CE. Commemorating the 1400 th Anniversary of the Holy Qu ran. Sartaj Company: Durban (8 of 23) (10 and 11 of 23).

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