Home' Trinidad and Tobago Guardian : July 24th 2014 Contents Next week, Muslims in T&T
and around the world cel-
ebrate Eid-ul-Fitr. The cur-
rent upheavals in the Middle
East bring to the fore a
number of different issues,
but there is one aspect of the religion of Islam
that is of particular interest to students of
finance in the West.
Imagine a world without either the receipt
or payment of interest. In other words, rather
than dealing with the issue of the level of
interest rates, consider a scenario where inter-
est is neither paid nor collected.
The prohibition of receiving and paying
interest is well documented in Islam, even if
it is not as widely practiced as it is supposed
to be. However, this is not a construct that
is unique to Islamic theology and students
of the Old Testament can cite many references
where interest is either prohibited or limited
to some degree.
Interest is born out of the issuance of credit.
However, credit (borrowing) is not necessarily
a bad thing. Conventional finance argues it
is the rate of interest that is the arbiter of
credit. The rate of interest should reflect the
risk associated with the lending. In other
words, the person s ability to repay as well
as level of available credit with the higher
the demand for credit, the higher the rate of
interest and the lower the demand, the lower
the rate of interest.
Interest is therefore the compensation paid
by the borrower of capital to the lender, for
permitting him to use his funds. A typical
economic definition puts interest as the rent
paid by the borrower of capital to the lender
to compensate him for the loss of the oppor-
tunity to use the funds when it is on loan.
It can be likened to the decision not to live
in an apartment or house that you own. One
would, in such circumstances, rent it out to
The tenant pays a monthly rental because
as long as he is occupying the property, the
owner is deprived of the opportunity to use
it. The same principle is involved in a loan
of funds. The difference is that the compen-
sation in the case of property is to rent,
whereas in the case of capital, it is to inter-
The suggestion here is that the rental of
an asset (the house) and the rental of money
is effectively the same type of transaction,
even though one involves the rental of money
and the other the rental of a real tangible
asset. Further, there is the assumption there
is always an opportunity cost for surplus
Islamic finance starts by focusing on the
surplus as just described. By definition, a
surplus suggests no existing need or use and
argues that if there is currently no existing
need or use for the available funds, then there
can be no opportunity cost associated with
The question then becomes: what is the
justification for charging interest to provide
someone with access to your funds if it was
truly surplus to your needs and there is no
opportunity cost of ownership?
Conventional finance answers this on the
basis that money has a time element to it
and so even funds for which there is no use,
lent at a point in time to be repaid at a future
date, introduces an element of risk as the
future is uncertain. That charge for uncer-
tainty forms part of the interest charge.
Further, even though the funds are surplus
to the owner by lending, it confers a benefit
to the borrower and so the owner must be
duly compensated for the use of their funds
just as the property owner is compensated
for the rental of the unused home.
Islamic finance counters that argument
through the definition of money.
In Islam, money is seen as a medium of
exchange, a store of value and a measuring
tool. It is not a commodity to be traded.
Based on this view of money, in a transaction
involving two or more parties, money carries
a passive role. Money itself cannot be traded
for profit and so it is not possible in the con-
text of Islamic finance to benefit from the
trading in money as if it were an active part
of the transaction analogous to a commodity.
In Islamic finance, lending money is not
something that can be done for profit, even
if lending gives rise to uncertainty given that
the future is unknown.
A common conclusion is that Islamic
finance does not recognise the time value of
money, but this is not the case. What is pro-
hibited is any claim to the time value of
money as a predetermined quantity calculable
at a predetermined rate, in other words inter-
est.In Islamic finance, it is not sufficient to
assume that there is an opportunity cost to
holding surplus funds as a justification for
charging someone interest to use these funds.
The onus is put on the owner of these funds
to find the opportunity (or have an agent
source the opportunity), and once this oppor-
tunity is found, translate the surplus funds
into a real asset by engaging in a partnership
with the entity in need of the funding.
By translating the funds into a real asset
that has an underlying use, it is no longer
surplus. It is in fact now put to use and the
compensation for its use is the charging of
an economic rent, which can be accumulated
over time, as per the example of the rental
of the house above.
Islamic finance basically argues that interest
is an unjust mechanism for generating a
return as it is in many ways exploitative and
can also lead to an allocation of capital to
activities that are unproductive. The theory
of Islamic finance argues there should be a
more "equitable" distribution of risk and
returns between borrower and lender, and
advocates the use of a mechanism known as
profit and loss sharing.
Consider the scenario where interest is
charged in a transaction involving a borrower
and a lender. If the project is a very viable
one, then the risk/return dynamic of the
transaction is skewed in the direction of the
borrower. In such a scenario, the borrower
carries a small risk of any losses, but they
also enjoy the potential for outsized returns
if the transaction funded by the loan is very
On the other hand, the lender is likely to
generate a single return regardless of how
the funds are utilised since the interest rate
charged is irrespective of any other factors.
Exploitation may result because a borrower
is one who is experiencing a deficit of capital
while a lender is one with surplus capital.
Generally speaking, it is the wealthy that
will be the owners of surplus capital and if
that capital is lent based on a predetermined
return in the form of interest, which is payable
regardless of the outcome of the use of the
funds, then it can be argued that the skewed
risk/return trade-off is directed towards the
party who can ill afford such a dynamic (the
borrower) while the wealthy are faced with
a more stable risk/return dynamic, despite
the fact that they may have the capacity to
take on greater variability of outcomes.
One may take a step back from the trans-
action itself and consider interest in the con-
text of the broader economy.
Recognise that the issue of fairness is not
unrelated to the issues of productivity and
efficiency. The basic point here is that a more
"equitable" risk/return profile for both bor-
rower and lender allows for a more compre-
hensive evaluation of any venture requiring
third party funding and therefore leads to a
more efficient allocation of resources resulting
in a stronger, more productive and inherently
more stable economy.
The bottom line is that from the perspective
of Islamic finance, it is not the interest rate
or the availability of credit that should be
the arbiter on a project, but rather a
risk/reward trade off that involves both the
provider and the user of capital via a profit
It s a different concept that is gaining
acceptance around the world.
Ian Narine is a broker registered with the
Securities and Exchange Commission
BUSINESS GUARDIAN www.guardian.co.tt JULY 2014 • WEEK FOUR
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