Copyright 1994 by Zeeshan Hasan. First published in Bangladesh in the Aug. 27th, 1994 edition of the Daily Star.

All over the Muslim world, the idea that Islam prohibits interest has led to banks and other financial institutions being reordered along the supposedly Islamic lines of "profit sharing". These attempts have led to a great deal of effort being spent on the field of "Islamic economics". However, few proponents of "Islamic economics" acknowledge that a thorough examination of economic principles and the relevant Qur'anic verses may allow one to consider interest rates to be "Islamic".

To begin, we should dispel the first misconception of Islamic economics; that profit-sharing is really different from interest. This distinction has been used to justify banks which use the former and supposedly more Islamic approach. In fact the difference is purely cosmetic, and thus neither can be claimed to be any more religiously acceptable.

In economic terms, there is absolutely no difference between profit sharing and interest rate banking. Under perfect competition, lending must take place at the equilibrium interest rate. This is the price of credit. It is determined by the yield from investments on the demand side of the savings market, and the public's individual income and consumption decisions on the supply side. The market interest rate will be the price at which savers agree to supply the same amount of credit that investors agree to borrow. The banks act only as intermediaries between savers and borrowers; they have no control over the market interest rate. In particular, this means that banks cannot change anything by switching from an "interest-based" lending rate to a "profit-sharing based" lending rate.

A conventional "non-Islamic" bank fulfills its role of intermediating between savers and investors by attracting savings deposits at a particular interest rate. It then lends out these deposits at a slightly higher rate to investors; the difference between lending and borrowing rates pays for the banks' costs. Income above banking cost, which is not paid to depositors, becomes profit for the bank. However, competition between banks will tend to bring the lending and borrowing rates closer together, squeezing bank profits to zero in the ideal case of a perfectly competitive market.

If we now look at an "Islamic Bank", we will see that relying on "profit sharing" rather than interest rates makes no difference. In equilibrium, all investments will be yielding the same expected return. This return will be equal to the lending interest rate in conventional banking, since the surrounding economic conditions which determine the productivity of capital are independent of the banking system. The costs of the banks should also be unchanged, since presumably Islamic and non-Islamic banks require the same amount of manpower and office space. Since both lending and costs remain the same, it is obvious that profit will also be unchanged. Under perfect competition, the Islamic banks will have to distribute all profits to depositors or lose them to another bank which does. But this is exactly the result for non-Islamic banks as well: under both systems, banks will cover costs and then be forced to hand over profits to depositors. The result is that profits shared with depositors by an Islamic bank must be the same as interest payments in the non-Islamic case. Since the public's savings and investment decisions are the same regardless of the terminology used by the banks for payments to depositors, the overall credit situation is unaffected. The lenders and borrowers will still only agree on one price for savings, which will enable credit supply to meet demand. The only difference is that this price will be expressed on paper as a fraction of profits rather than as a predetermined interest rate. But just as before, competition will reduce the banks to powerless intermediaries.

In fact the Islamic and non-Islamic cases would be exactly the same, but for a difference in how they handle business risks. In the Islamic bank, the cost of credit will be higher due to an additional element of risk to the banks. This is because returns from profits are variable and not predetermined; they will be high in good years and low in bad years. On the other hand, return on a fixed interest rate loan is fixed. The loan repayment must be made, whether or not the business is making a profit. The Islamic bank, in order to make up for the possibility of temporary insolvency due to fluctuating returns on loans, will have to add an additional charge to each loan. In effect, an Islamic bank must provide a degree of insurance as well as credit, and the additional service provided will increase costs. Loans from Islamic banks will thus be more expensive, but they will be somewhat safer due to the incorporated insurance, and the margin thus allowed for income fluctuation. Though this represents a "real" difference between Islamic and non-Islamic banks at last, even this does not change the underlying credit market and interest rate. All that has happened is that Islamic banks are dealing with business risks by selling kind of loan insurance. The expected return from loans made by an Islamic bank will be the same as that from a non-Islamic bank; but in practice the nominal lending rate of the Islamic rate will be higher because of a non-zero probability of making a business loss in that particular investment.

So we can get away from interest-rate banking in name only. Ultimately, credit will have a cost, and competition will make this cost equivalent to the equilibrium interest rate. This may seem problematic, as it might be taken to imply that the Qur'an, in condemning interest, is asking the impossible. But a simple principle of Qur'anic interpretation must be made explicit here. If we assume, as Muslims, that the Qur'an is not absurd, then problems which arise from it must be solved through correcting our interpretations. It could not be accepted, for example, if a particular Qur'anic verse seemed to say that one could flap one's arms and fly. Since that is plainly ridiculous, our interpretation of it must be wrong; the verse must actually be saying something else, which must be determined by further investigation.

So the real issue when speaking of scriptural opposition to interest is the myopia of Qur'anic interpreters. Rather than pretending to eliminate interest through "profit sharing", Muslims should investigate the possibility that the simplistic no-interest-allowed interpretation of the Qur'an is incorrect. In fact, a detailed consideration of the relevant Qur'anic verses and their economic significance does allow for a new Muslim view of interest. If we begin with the following verse:

O believers, devour not usury, doubled and redoubled, and fear you God; haply so you will prosper. (Qur'an 3:130)

The Pakistani scholar Fazlur Rahman noted that "doubled and redoubled" (ad'afan muda'afa) had the meaning of a "many many-fold" increase. This becomes significant when we realize that modern market economy has built up financial markets which are vastly different from those which existed previously. Private banks and stock exchanges today give us financial markets that are much more efficient and competitive than ever before. Competition tends to reduce profits by forcing banks to lend cheaply on one hand and pay more to depositors on the other. Given perfect competition, the stable market interest rate will be the lowest rate possible; any lower would cause the bank offering it to make losses. The resultant financial sector competitiveness is integral to the efficiency which has allowed capitalism to develop and flourish. The modern interest rate is thus remarkably "fair" in that money-lending at arbitrarily high rates is impossible. Banks must lend and pay depositors whatever the market dictates, which in turn will depend on the potential for profitable investments in the rest of the economy. Individual banks cannot manipulate interest rates for their own advantage.

Contrast this to the pre-modern situation, in which banking was not nearly as competitive. Borrowers were forced to resort to individual moneylenders who were often limited to the few richest individuals of society. Under these circumstances, interest is a completely different arrangement. If lenders are a small group of individuals, they can easily cooperate with each other. Without a competitive environment, interest rates and profits can be fixed at arbitrarily high levels. Poor people in dire need of credit for their survival, for example the farmer who must buy seeds or starve, will be willing to pay any amount of interest on a loan. One possible result is the system of virtual enslavement of "bonded laborers" who are hopelessly indebted and thus trapped in servitude to their creditors for life. Another is the gradual starvation of the borrowers who may be forced to repay their debts regardless of their costs of living. The problem here is that of limited-competition banking which leads to the sort of artificially high prices characteristic of supplier monopolies. In this special case, capital is being monopolized.

What is important is that the Qur'anic verse condemning "usury", and especially high rates of interest, can be interpreted as applying only to the generally pre-modern and specifically non-competitive situation. Competitive and non-competitive prices are different in character. The former is bound to be economically fair; the latter is not. Economic theory recognizes this through acknowledging that monopolies result in few goods being sold at high prices, resulting in a net loss for society, which would prefer more goods at lower prices. Thus, most market economies establish anti-monopoly laws. There is no reason to simply place both competitive and non-competitive interest rates in the category of forbidden usury, which is what the Islamic economists have done. It is sufficient to say that the unfairly high interest rates, as were charged by moneylenders and other such pre-modern institutions, is un-Islamic. This is probably more in keeping with the differences between the economic circumstances of Muhammad's time and the vastly different situation today.

An additional consideration will support my contention that there is nothing un-Islamic about interest rates. The Qur'an explicitly allows for business, even as it forbids "usury".

God has permitted trafficking, and forbidden usury. (Qur'an 2:275)

In fact, the above distinction between business and interest does not hold in a competitive market. Interest on a loan corresponds to (for example) the rental cost of machinery used in a business. In the first case, the borrower is loaned money; in the second he is loaned equipment. Each loan, whether of money or equipment, is purchased at market prices, and competition renders the expected returns from both equivalent. If profits in the rental car business are lower than those in banking, there is nothing to prevent one from selling one's cars and going into banking. Of course, as in the Islamic bank, selling cars is accompanied by a certain business risk, which will dictate a nominally higher rate of interest rate in order to achieve the same expected return as with conventional secured-loan banking. But once again, we cannot get away from the competitive interest rate. In this example, there will be a difference between "business income" and "interest" only when the market is not competitive. The fact that the Qur'an distinguishes these two should be sufficient evidence for us to do the same; and by realizing that the underlying difference is only that of competitiveness, we can extend approval to modern interest rates.

It seems obvious that the question of Islamic economics is not as easily resolved as one might think. If interest rates are acceptable, then there is nothing un-Islamic about conventional market economy. The only remaining question, then, is whether or not there is anything in an economic system that can truly be said to be �Islamic�. But the answer to this is obvious, and has nothing to do with interest rates.

Hast thou seen him who cries lies to the Doom? That is he who repulses the orphan And urges not the feeding of the needy. So woe to those that pray To those who make display and refuse charity. (Qur'an 107)

This is just one of many Qur�anic verses encouraging social justice and equality, which is the true essence of �Islamic economics�. From this point of view the only �Islamic� financial institutions are those which are actively helping the poor to better their circumstances. In the case of Bangladesh, this generally means micro-credit institutions like Grameen Bank, whose loans have helped millions of small borrowers with business opportunities. Ironically, it is this very non-govermental organization sector in Bangladesh which is generally perceived to be secular and un-Islamic.