Thursday, June 19, 2008

How the Banks are Subverting Islam's Ban on Usury

By Tarek El Diwany
Financial Times July 14 2006

In about 1220 a canonist named Hispanus proposed that, although usury
was prohibited, a lender could charge a fee if his borrower was late in
making repayment. The period between the date on which the borrower
should have repaid and the date on which he did repay, Hispanus termed
"interesse", literally that which "in between is".

Soon, the money lenders of Europe were adding to the church's
theological dilemmas with the Contractum Trinius. Here, the lending
party would invest money with a merchant on a profit and loss sharing
basis, insure himself against a loss of capital and sell back to the
merchant any profit above a specified amount. In isolation each of these
contracts was viewed as permissible by the church scholars, but their
combination produced an interest-bearing loan in all but name.

Today, those who wish to make a living from lending money are adopting
the same approach to defeat the usury prohibition in Islam. Combining
Islamically permissible contracts to produce interest-bearing loans has
become the specialism that is "Islamic banking". The fact that some
leading Islamic scholars are being paid hundreds of thousands of dollars
to give religious judgments by the very institutions whose products they
are judging is, to say the least, a conflict of interest. But the
problems run deeper than this. Even if 98 out of 100 scholars judge that
a product is prohibited, an Islamic bank can employ the two who permit
it. In effect, the banks are able to choose the rules of the game while
telling everyone else that they are only following scholarly advice.

Overarching these issues of moral hazard and legal semantics, looms the
more fundamental question of whether Islamic finance can be practised
within an interest-based monetary framework.

Today's monetary system developed from the practices of European
goldsmiths in the 17th century who accepted deposits of gold coins for
safe-keeping. Receipts for such deposits would often be issued in
"bearer" form and, with growing public familiarity, these came to be
accepted in payment for goods and services. The receipts had become an
early form of "bank money".

The goldsmiths were now in a position to transform themselves into money
lenders, but when the public came to borrow money it was paper receipts
not gold coins that the goldsmiths loaned them. This policy had the
great advantage that receipts could be manufactured at almost no cost,
while gold itself could not be. William Paterson, a founding director of
the Bank of England, was well aware of the commercial implications. "The
Bank hath benefit of interest on all moneys which it creates out of
nothing", said Paterson of his new bank in 1694.

Why, if the banker truly had the power to manufacture money, did he not
simply print receipts and spend them on his own consumption? The answer
was largely one of commercial risk. Spent receipts would in due course
return to the bank for redemption in gold, gold which never existed in
the first place. By lending the receipts instead, the banker could
charge interest on the amount lent. Upon repayment, the receipts could
be destroyed as easily as they had been manufactured, but the interest
charge would remain as revenue. Thus, loans at interest and private
sector money creation became the two core components of commercial

The gestation of products within this very un-Islamic framework has
resulted in the ultimate mutant, an Islamic personal loan at 7.9 per
cent annual percentage rate courtesy of the Islamic Bank of Britain. How
different this is from the original vision of Muslim economists.

I propose that by segregating the payment transmission and money
creation functions, and by sharing profits and losses instead of seeking
interest payments come-what-may, bankers' motivations would be much more
closely aligned with those of their clients. A link would be
re-established between the financial sector and the real sector, with
beneficial consequences beyond the economic domain.

The resources and infrastructure of whole nations are increasingly being
sacrificed on the altar of interest-bearing debt. If Islamic banking
adopts a genuinely Islamic paradigm it can offer a solution to a world
hungry for alternatives. If it does not, it will enjoy a brief life as a
get rich quick bandwagon and then disappear into the relics of financial

The writer is author of The Problem With Interest

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