Islamic Banking Practices: Islamic Law and Prohibition of Ribā

Author(s): MADIHA KHAN

Source: Islamic Studies , Autumn - Winter 2011, Vol. 50, No. 3/4 (Autumn - Winter
2011), pp. 413-422
Published by: Islamic Research Institute, International Islamic University, Islamabad

Stable URL: https://www.jstor.org/stable/41932604

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

Islamic Research Institute, International Islamic University, Islamabad is collaborating with

JSTOR to digitize, preserve and extend access to Islamic Studies

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
 Islamic Studies 50:3-4 (201 1) pp. 413-422

Islamic Banking
Prohibition of Ribā

MADIHA KHAN

Abstract

Islamic banking has become popular not only in Islamic world but also in non-
Islamic countries. The number of Islamic banking service providers is increasing due
to entry of new Islamic banks and some conventional banks have also opened units
designated to Islamic banking. It is therefore, crucial to analyse how much Islamic are
the products offered by Islamic banks. This paper makes critical analyses of Islamic
banking practices in the context of Islamic law and the prohibition of interest through
examining the product known as 'Murābahah.' It is found that certain features of
'Murābahah' are in direct conflict with Islamic law and need to be revised in order to
make it purely an Islamic product.

Key Words: Islamic Banking, Sharl'ah, Murabahah, Prohibition of ribā

1. Introduction

The history of Islamic finance system goes fourteen years back when Arab
merchants frequently lent money with the intention to earn more money in
the shape of interest. It was usual practice to find people desperate to borrow
money. Those merchants lent money to them, charged higher interest and
made fortune out of the misery of the borrowers. The debtor and even
debtor's children then spent their whole life in paying back their loan.
However debt never gets paid back in full because every time an extra amount
was added to the previous amount as a penalty for late payment and hence
suffering of poor never ends.
To protect the poor debtor from the rich creditor, Islam introduced a
financial system based on the moral principles which promote justice, fair
trade, equality1 and ethics in order to create a healthy and supportive society.

1 1. Ahmad, and S. Baloch, Islamic Banking Bulletin (Islamabad: State Bank of Pakistan, 2006).
Available on line, http:/ / www.sbp.org.pk/ibd/IBB.pdf.

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
414 MADIHA KHAN

It not only prohibits the

pornography and gamblin
and appreciates distributi
haves and haves not.
To achieve these objective
loans and investments. Alth
important for efficient all
work without interest wh
today's business world. At
banking practices in order
interest in their transaction
The purpose of this essa
context of Islamic law an
defining ribā and interes
Next, it examines core
Murābahah contract, a mos
a brief comment on the ps
'interest' on Muslims the e
Since last two decades
popularity in many Musl
Islamic banking sector is gr
financial and banking ac
US$250bn, as compared
principal rule of Islamic b
the spirit of Islamic econom
Ribā refers to "an exce
increase in a loan transact
owner (lender) without g
{'iwad) in return to the oth
or equal counter value."8

2 E. G. Kazarian, Islamic Versus

Westview Press, 1993).
3 F.Al-Omar, and M. Abdel-Ha
Oxford University Press, 1996).
* Harold L. Cole, and N. Kocherl
How to Get Them,' Federal Reserv
5 K. R. Aggarwal, and M. Tarik
Money, Credit and Banking, 32 (2
I. Ahmad, and S. Baloch, Islamic
7 F. Al-Omar, and M. Abdel-Haq
and S. Baloch, Islamic Banking B
1 F. Al-Omar, and M. Abdel-Haq,

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
ISLAMIC BANKING PRACTICES: ISLAMIC LAW AND PROHIBITION OF RIBĀ 4 jtj

From the above, it can be concluded that receiving more than principal or
actual value either in case of loan or exchange of commodities is ribā which
causes injustice to or exploitation of needy people. Consistently, Ahmad and
Baloch comment that ribā refers to "any unjustifiable increase of capital
whether through loans or sales."9 Although Ribā is a very broad term and has
seventy different types but interest is a very basic and important element of
ribā. According to Iqbal "prohibiting the receipts and payment of interest is
the nucleus of system (sharī'ah)."10 In fact interest and ribā according to the
'school of equivalence' are interchangeable terms11 but ribā is actually more
than interest.12 However for the purpose of this paper, the definition of ribā is
confined to interest only.
In simple words, interest is the price of lending money. It can be defined
as any gain without sharing risk and by considering time value of money.
According to Ahmad and Baloch it is "any positive, fixed, predetermined rate
tied to the maturity and the amount of principal (i.e., guaranteed regardless of
the performance of the investment)."13 Interest is strictly prohibited in Islam
due to the following reasons. Firstly, Islam forbids the trading of money
because according to sharī'ah money is not itself a commodity; therefore there
should be no price to use it.14 Secondly it (sharī'ah) dislikes receiving monetary
advantage without putting efforts or labouring15 and strictly forbids such
earnings (interest). According to sharī'ah these earnings do not contribute to
economic development and hence lead to inflation. However Islam encourages
profit from trade and other productive businesses such as agricultural,
manufacturing etc.16 Thirdly, Islam forbids interest because it is certain, fixed
and predetermined. Lender receives this profit irrespective of the fact whether
borrower actually gained profit or not? Rizvi, a Muslim scholar and
philosopher "[P]osed the question of what was wrong with charging interest
when the borrower was going to employ the borrowed funds to earn a profit.
His well-considered reply to the question was: While the earning of profit is
uncertain, the payment of interest is predetermined and certain. The profit
may or may not be realised. Hence there can be no doubt that the payment of

9 1. Ahmad, and S. Baloch, Islamic Banking Bulletin, 29.

10 Z. Iqbal, "Islamic Financial System," Finance and Development, 34 (1997), 2:42-5.
" S.A. Ahmed, "Global Need for a New Economic Concept," International Journal of Islamic
Financial Services, 1 (2000), 4: 28-42.
12 J. Schacht, An Introduction to Islamic Law (Oxford: Oxford University Press, 1964).
1} Ahmad and Baloch, Islamic Banking, 6.
14 Z. Iqbal, and A. Mirakhor, "Islamic Banking," IMF Occasional Paper 49 (Washington D.C.:
International Monetary Fund, 1987).
15 Schacht, Introduction.
16 F. Al-Omar, and M. Abdel-Haq, Islamic Banking: Theory, Practice & Challenges, xvi.

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
 4ļ£ MADIHA KHAN

something definite in re
(j bārām ).nV
Islamic banking is known to be based on the principles of Islamic finance
and economics and thus also based on prohibition of interest. These banks do
not lend money; instead they have devised interest free debt and equity based
products such as Mushārakah, Mudārabah , Murābabab etc18 Mushārakah (joint
venture) and Mudārabah (trust financing) are equity like products based on
profit and loss sharing mechanism.19 For example, in case of Mushārakah., bank
and client are supposed to be partners and bank invests in the client's business,
hence shares risk with the client. If business earns profit, it will be distributed
according to the predetermined ratio between partners and if business incurs
loss both have to bear this loss.20
The debt like products is Murābahah (cost-plus financing) Iājrah (operating
lease) and Istisnā' (Progressive payment). However Murābahah is most popular
form of financing in Islamic banks and in fact it constitutes greater percentage
comparing to other Islamic financial instruments.21 For example, almost 75%
transactions of Faisal Islamic Bank are Murābahah transactions.22 Due to its
popularity, the essay will discusses Murābahah contract with the help of a
Murābahah model used by a Sudanese bank in order to analyse its procedures
and reasons for being popular.

Murābahah Contract

In conventional banking, when a person needs capital to finance business he

makes a request to the bank for loan. Bank issues loan at a certain interest rate
after making risk assessment and calculating time value of money. In this way
the person receives the money to finance capital and pays back actual loan
amount plus interest amount over a certain period in monthly instalments.
Islamic banks have different procedures and processes to execute a
transaction similar to the one mentioned above. As sharī'ah does not allow
trading of money and receiving money without efforts therefore Islamic banks

17 Ibid., 9.
18 B. Hamwi and A. Aylward, "Islamic Finance: A growing international market," Thunderbird
International Business Review, 41 (1999), 4-5: 407-420.
" F. Al-Omar, and M. Abdel-Haq, Islamic Banking: Theory, Practice & Challenges.
20 S. Tarek Zaher and M. Kabir Hassan, "A Comparative Literature Survey of Islamic Finance
and Banking," Financial Markets, Institutions and Instruments, 10 (2001), 4: 155-199.
21 Tarik M. Yousaf, "The Murābaha Syndrome in Islamic Finance: Laws, Institutions and Politics."
Clement M. Henry, and R. Wilson, (eds.). The Politics of Islamic Finance. (Edinburgh: Edinburgh
University Press, 2004); A. Saeed, Islamic Banking and Interes: A Study of Prohibiton of Ribā and its
Contemporary Interpretation (Leiden: E.J. Brill, 1996).
22 Tarik M. Yousaf, "The Murabaha Syndrome in Islamic Finance."

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
ISLAMIC BANKING PRACTICES: ISLAMIC LAW AND PROHIBITION OF RIBĀ ¿^yj

do not lend money. They usually deal in commodities through buying and
selling contracts which is known as Murabahah contract and is similar to trade
finance commonly used to finance working or fixed capital.23 Murabahah
"literally means sale on profit. It is technically a contract of sale in which the
seller declares his cost and profit."24 In other words it is a contract between
buyer and seller in which seller sells the commodity to a buyer at an agreed
price.
For Murabahah contract, there are certain conditions that must be met by
both parties in order to make a trade valid or to comply with Sharl'ah. The
basic conditions are: firstly commodity must exist (tangible) at the time of the
deal, secondly, it must be owned by the seller and thirdly, price should be
agreed by both parties.25
Therefore, in Islamic banking system, when a person makes a request for
finance, he/she has to specify its purpose. For example, if a person wants to
buy raw material, he/she will provide its specifications in the application. The
Islamic bank purchases the specified raw material and sells it to the client on
agreed price. The bank usually sells the item at a price which includes cost and
profit margin. A model of Murabahah contract is shown in the table which is
applied in the Sudanese Islamic bank.

Table 3
Example of Murabahah on soap venture (Sudanese Islamic Bank, al-Girsh
Productive Family Branch). (LS).

Description Amount (Sudanese Pound) in thousand*

Total finance 500

Murabahah period Three months

Murabahah profit margin (profit) (12% per month) 60

Banks selling Price 560

Grace Period Two months

First Instalment 84 (155 of 560)

23 1. Ahmad, and S. Baloch, Islamic Banking Bulletin.

24 F. Al-Omar, and M. Abdel-Haq, Islamic Banking: Theory, Practice & Challenges, xv.
25 A. Saeed, Islamic Banking and Interest, A. Mahmoud El-Gamal, A Basic Guide to Cont
Islamic Banking and Finance (Housten: Rice University, 2000) and Badr-El-Din A. Ibrahim
Alleviation via Islamic Banking Finance to Micro-Enterprises (MEs) in Sudan: Some lessons
contries, Discussion Paper No. 35 (Bremen: Sudan Economy Research Group, 2003).

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
 MADIHA KHAN

Other instalments 476 (= 158.66 per month)**

Bank's profit (for three months) 60

Guarantees Post dated checks

Method of Payment Equally monthly instalments

^Exchange rate US $ 1 = LS 530 (April 1995)

**The partner also pays 2% of the total finance as finance tax, in addition to stamp
duties and other finance commissions.
Source: Sudan Economy Research Group Discussion Papers by Badr-El-Din A.
Ibrahim,

The above table displays the Murābahah transaction between the bank
(seller) and its client (buyer). The bank buys the item at 500,000 Sudanese
pounds from the market and sells it to the client at 560, 000 Sudanese pounds
by adding its profit margin in the cost which is known as Murābahah profit.
The item is delivered at the spot while the payment is deferred over three
months.
However the deferred payment, monthly instalments, guarantee and
especially 12% profit make this transaction identical to the conventional loan
transaction. But the proponents of Islamic banking system frequently claim
that Murābahah transaction is purely according to the sharī'ah (Islamic law)
ancHs also different from the conventional loan transaction. They differentiate
it from conventional practices and to justify the Murābahah profit because
Murābahah is a selling transaction and not the lending transaction;26 the bank
did not lend money instead it earned profit through buying and selling
activities. According to them, lending money and charging extra price would
be interest but in Murābahah case, bank makes sale of an item and gains extra
amount as profit despite the fact that this 12% profit looks like simple interest
of 4% per month, in fact more than the conventional interest. This transaction
consists of certain and predetermined rate and hence apparently violates the
sharï'ah and sole purpose of Islamic banking.
Secondly, according to Al-Omar and Abdel-Haq, the jurists and Muslim
scholars agree that the extra amount {Murābahah profit) is not charged as a
compensation for time value of money and deferred payment.27 This
explanation is, however, unacceptable because it does not consider time value

26 G. Bilal, "Islamic Finance: Alternatives to the Western Moder The Fletcher Forum of World
Affairs , 23 (1999), 1: 145-160. A. Badr-El-Din Ibrahim, Poverty Alleviation via Islamic Banking
Finance to Micro-Enterprises.
27 F. Al-Omar, and M. Abdel-Haq, Islamic Banking: Theory , Practice and Challenges , 15.

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
ISLAMIC BANKING PRACTICES: ISLAMIC LAW AND PROHIBITION OF RIBÃ ^

of money. In that case, why one should pay more for an item that is available
in the market at less price? If we apply economic principles here, one pays
more for an item only if the supply of that item is short. But in the above case,
that the higher price is obviously charged because of time value of money and
deferred payment.
Thirdly, later in the same writing, Al-Omar and Abdel-Haq have further
explained the that bank is charging mark-up not because of time value of
money but due to the fact that it is providing services in the form of locating
and buying item at competent price on the request of client so it deserves to
charge mark up.28 On the other hand, several other writers mention that the
bank appoints the buyer as an agent who locates the item and negotiates the
price29 but it is not mentioned any where, whether buyer (bank's client) gets
paid or offsets certain debt as a compensation for his/her services? After all
seeking and locating item and negotiating price is the job of the bank and not
the bank's client.
Fourthly, Sharī'ah allows buyer to cancel the deal at any time and to
reject buying the item from the bank. This point is often used by the jurists to
justify the profit. They point out that seller remains at risk during the period
between purchase and sale because the price of item can decrease suddenly and
buyer may refuse to buy the item.30 However this element of risk is now
abolished by introducing a promise contract within the Murãbahah deal by
Islamic banks: promise from the buyer to buy the item.31 However it is against
the sharī'ah to bind the buyer but banks do it to decrease their risk.
Now the question is that if a debtor makes late payment then what
should creditor do in order to get compensation? Initially, the debtor will be
given grace period as shown in the Murãbahah model, without an additional
price32 but what if the debtor gets fail to make payment even after the grace
period. There is still no consensus over this issue. Islamic Fiqh Academy
concluded that it is not permitted in Islam to charge extra amount to debtor if
he gets late in making payment because charging more than principal is
interest which is prohibited.33 Similarly, El-Gamal described that "charging an

2* Ibid.

29 1. Ahmad, and S. Baloch, Islamic Banking Bulletin , and Zaher and Hassan, "A Comparative
Literature Survey of Islamic Finance and Banking."
F. Al-Omar, and M. Abdel-Haq, Islamic Banking: Theory, Practice and Challenges.
31 1. Ahmad, and S. Baloch, Islamic Banking Bulletin, 6.
A. Badr-El-Din Ibrahim, Poverty Alleviation via Islamic Banking Finance to Micro-Enterprises in
Sudan.

33 Islamic Fiqh Academy, Resolutions and Recommundations of the Council of the Islamic Fiqh
Academy 1985-2000 (Jeddah: Islamic Research and Training Institute, Islami Development Bank,
2000).

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
 ¿20 MADIHA KHAN

increase for further deferm

would constitute ribā al-jā
Qur'ân."34
It does not seem appropriate to let the debtor go without penalizing
him/her as it will encourage the attitude of late payment which further results
in non-payment.35 In addition to that it is injustice to the lender that he
forgoes his/her loan. To avoid these issues State Bank of Pakistan announced
that debtor is liable to pay the penalty but penalty amount will go to charity
and not to the bank.36 The bank can go to court for compensation and it is
discretion of the court to make decision regarding this matter.
Due to the fact that sharī'ah does not pay any consideration towards late
or non-payment and also rejects to demand collateral.37 Although most banks
do not demand collateral, but they try to secure their investment in other
ways such as the requirement of post dated checks.38 Recent studies have found
that '40 to 85 percent' investments by the banks are secured in certain ways.39
Banks try to secure their profit and investment from every possible risk
of loss. My last argument is about liabilities and obligations of seller being the
owner of selling item, although it is not mentioned in the Murãbahah model
but it is a very important element from the buyer's point of view. As Zaher
and Hassan mentioned "Islamic financial institutions may be exposed to
contractual and statutory liabilities (such as warranties) resulting from its
ownership of goods. These should be disclaimed to the extent possible or be
limited by indemnities received from the customer."40 The seller tries to save
at its end from every expected obligation or in other words they try to avoid
the rights of buyer and hence try to marginalize their say in the contract.
One greater disadvantage of the Murãbahah contract, again, not
mentioned in the Murãbahah model, is that once the contract is signed, buyer
has to pay the additional amount or so called Murãbahah profit in order to
complete the transaction while conventional loans do not charge interest if

34 El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance, 5.

35 M. U. Chapra and T. Khan, Regulation and Supervision of Islamic Banks (Jeddah: Islamic
Research and Training Institute, Islamic Development Bank, 2000).
36 State Bank of Pakistan, State Bank's Sbarì'ab Board Approves Essentials and Model Agreements
for Islamic Mode of Financing. Press Reíase (2004). http://www.sbp.p.k/press/2004/islamic_
modes.pdf.
37 F. Al-Omar and M. Abdel-Haq, Islamic Banking: Theory, Practice & Challenges.
A. Badr-El-Din Ibrahim, Poverty Alleviation via Islamic Banking Finance to Micro-Enterprises.
3' K. R. Aggarwal, and T. Yousef, 'Islamic Banks and Investment Financing,' Journal of Money,
Credit and Banking, 2000) 32 (1): 93-120.
40 Zaher, Hassan and Kabir, "A Comparative Literature Survey of Islamic Finance and
Banking," 160.

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
ISLAMIC BANKING PRACTICES: ISLAMIC LAW AND PROHIBITION OF RIBĀ

they are paid within specified period. But in Murãbahah deal, there is no way
to get rid of this extra amount after entering in the contract.41

In Murãbahah contract, the banks can make certain and predetermined

profit and also secure their investment in some way due to which Murãbahah is
more popular than other Islamic products.42 However Murãbahah transaction
is neither according to the spirit of Islam nor of Sharī'ah because it does not
comply with the conditions of a trade. For example a deal is made between a
buyer and the bank at the time when bank does not possess that item. Banks
take promise from the buyer which again is not permissible according to
Sharī'ah Islam and Sharī'ah forbid interest in order to prevent people from
exploitation which is still prevailing in case of Murãbahah. However all this
trade takes place in papers only; in practice the items are directly transferred
to the buyer. What are the practical implications of this activity? Apparently,
there is no advantage of trading in commodity despite increase in management
cost incurred by the bank which is definitely charged from the customer and
in the end customer has to pay more.

According to Saeed "In both cases, it is a debt and the cost of financing,
whether it is called interest or profit, which is fixed and the time allowed for
repayment is also fixed."43

Despite the fact that Murãbahah transaction has parallel characteristics

with the conventional loan transaction, it is becoming popular among
Muslims because it avoids certain terms like interest, time value of money,
opportunity cost. 'Words' have a strong psychological effect on attitudes and
behaviour of people. In the above case, the word 'interest' rather than the
actual interest irritates and causes dissatisfaction among Muslims about the
fulfillment of religious requirements just like the example given below:

Consider this discussion among patients suffering from chronic fatigue

syndrome. Many patients feel that one of the greatest burdens of having chronic
fatigue syndrome is the name of the illness. The word fatigue indicates everyday
tiredness. It reinforces negative perceptions that remain with the public ... 44

In addition to above, the word 'Islamic' also has a stronger psychological

and social effect on Muslims because they can identify and relate themselves
with this word.

41 Ibid.
42 A. Saeed, Islamic Banking and Interest.
41 A. Saeed, Ibid., 89-90.
44 C. G. Bowker and L. S. Star, Sorting Thing Out: Classification and its Consequences (London: Mit
Press, 2000), 67.

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms
422 MADIHA KHAN

Recommendations and co

Islamic banking system has

their religious and social ne
the word 'Islamic.' They h
free but actually based on
profit and fine instead of
money in order to make th
However, Islamic bankin
still untapped. In order to
and services especially th
Instead of complying with
different transactions, they
spirit of Islam.

$ $ $

This content downloaded from

111.68.96.41 on Mon, 11 Oct 2021 06:33:03 UTC
All use subject to https://about.jstor.org/terms