Arab Law

Quarterly
Arab Law Quarterly 24 (2010) 293-308 brill.nl/alq

Prohibition of Interest and Economic Rationality

Muhammad Mazhar Iqbal

Assistant Professor, Department of Economics,
Quaid-i-Azam University (QAU), Islamabad, Pakistan

Abstract
This research evaluates three reasons against the use of interest. One reason is that interest
is a tool of exploitation. It contradicts facts because nowadays ultimate borrowers are busi-
nessmen and ultimate lenders are salaried individuals, the former being financially better
off than the latter. The second reason is that interest-based external financing leads to
unfair distribution of profits. Although this reasoning is not wrong, it is not very appeal-
ing in positive economics. Having noted that risk aversion is applauded in both conven-
tional and Islamic economics, this author has propounded a third reason which states that
the risk of an investment is least when financed exclusively by equity. This reasoning is
easily understandable to conventional economists and is proved mathematically in this
article. Therefore it provides a sound economic footing for prohibition of interest.

Keywords
economic rationality; usury; bank interest; debt equity ratio; risk aversion, portfolio theory

1. Introduction
Although experimentation with interest-free banking has been ongoing
for about half a century, its logic is still not so clear to the Western mind.
Islam categorically prohibits the use of interest, but its sources of law do
not specify any clear-cut economic reasoning for its prohibition.1 How-
ever, in order to satisfy enquiring minds, Muslim jurists and economists
have provided, roughly speaking, two main reasons so far. One is that
legitimacy of interest paves the way towards exploitation of the poor by
the rich. The other is that legitimacy of interest generally leads to unfair

1
To understand why, see Emad H., “An Overview of the Sharia’a Prohibition of Riba”
in: (Ed.) Thomas, Abdulkader, Interest in Islamic Economics; Understanding Riba (Rutledge:
London, 2006).
© Koninklijke Brill NV, Leiden, 2010 DOI: 10.1163/157302510X508346
294 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

distribution of profits between lenders and borrowers because actual prof-

itability of the project for which lending and borrowing is contracted can-
not be known at the time of contract. Therefore, if actual profit exceeds
what was anticipated at the time of contract, then either the lenders or
the borrowers feel regret.2 The problem behind each reasoning will be dis-
cussed in turn.
The problem with the first reasoning is that it is counter-factual. It
implicitly assumes that the process of lending and borrowing is basically
for pressing consumption needs; only then will a borrower be poorer than
a lender and should agree to pay an interest rate that is exploitative in
nature, known as usury in the literature. On the other hand, when people
lend and borrow mainly for business purposes, which is in fact the case
nowadays, then the relative financial position of the two parties becomes
irrelevant. Moreover, if the purpose of borrowing is to start a new busi-
ness or to expand an ongoing business, then the borrower need not agree
to any usurious rate of interest.
As a matter of fact, in the current financial system, ultimate lenders are
generally salaried workers who deposit their savings in financial interme-
diaries and also buy corporate bonds with their money saved. On the
other hand, ultimate borrowers are generally businessmen and firm own-
ers who get loans from financial intermediaries and issue bonds in finan-
cial markets.3 Since the financial status of ultimate borrowers, on the
average, is much higher than that of ultimate lenders, the argument that
prohibition of interest is meant to end exploitation of poor borrowers by
rich lenders does not apply in the present situation.
Furthermore, proponents of this rationale implicitly assume that char-
ity, benevolence and interest-free lending and borrowing are the main
alternatives to an interest-based system. This interpretation of Islamic eco-
nomics, if accepted, contradicts the maxim of self-interest that is the
crown jewel of conventional economics. “In other words, what is ‘eco-

2
This is the majority view of contemporary Muslim economists as they equate usury
with bank interest. See Rehman, Abdul Rahim Abdul, “Islamic Banking and Finance;
Between Ideals and Realities”, IIUM J. Econ. Management, 15(2) (2007) 123-141; Iqbal,
Zamir and Mirakhor, Abbas, An Introduction to Islamic Finance; Theory and Practice, Ch. 3
(Vanguard Books: Lahore, 2008).
3
See, Mishkin, Frederic S., The Economics of Money, Banking and Financial Markets,
6th edn. (Addison-Wesley: New York, 2001) where it is stated that the principal lenders–
savers are households and the most important borrowers–spenders are businesses and the
government in the US economy which is also true in general around the world.
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 295

nomically correct’ is not ‘Islamically correct’, and vice versa. Where one
approach sees man as inherently selfish, the other considers him altruistic
and virtuous.”4 Hence, this view renders prohibition of interest out of the
realm of positive economics.
That is why a vocal minority of Muslim jurists and a vast majority of
silent Muslim masses, like people in the West, believe that religion has
prohibited only usury, not bank interest.5 Bank interest that was actually
invented centuries after the onset of Islam, the last God-revealed religion,
is determined first and foremost by forces of supply and demand and then
remains almost the same for all bank borrowers, irrespective of their
financial positions and of their intended use of borrowed funds, whether
for consumption or for business purposes. Also in case of default of a
business or a firm for which its managers or owners have borrowed
money, neither the personal property of the managers or owners is confis-
cated nor is the issue of their personal liberty addressed as it used to be in
days of old.6 For these reasons, bank interest, as they argue, should be
considered a legitimate outcome of modern times and not be equated
with usury that is also prohibited in the West.
The second reasoning is problematic in that it is normative in nature,
implying discontinuation of an ongoing mode of contracting on social
grounds. That is, it justifies prohibition of interest on the pretext of unfair
distribution of profits. However, in economics, there are many other
unfair or suboptimal situations like monopoly pricing, subsistence wage
rate, scarcity rent and involuntary unemployment which are tolerated as
natural outcomes of free play of market forces and, thus, are not prohib-
ited by the state. Therefore, if prohibition of interest because of unfair
distribution of actual profits is enforced by the state, as Muslim scholars
have recommended, then Islamic economics would deny the right of ‘free
4
See Warde, Ibrahim, Islamic Finance in the Global Economy (Edinburgh University
Press: Edinburgh, 2000), p. 45.
5
A number of authors share this view. See, e.g., Mallat, Chibli (1996) “Tantawi on
Banking” in: (Eds.) M. Khalid Masud et al., Islamic Legal Interpretations: Muftis and Their
Fatwas (Harvard University Press); Jafarey, N.A., “What is Riba?”, J. Islamic Bank. Fin., 12/1
(1995) 50-52; Pal, Izzud-Din (1994) “Pakistan and the Question of Riba”, Mid. East.
Studies, 30/1 (1994) 64-78; Shah, Sayed Yaqub (1959) “Islam and Productive Credit”,
Islamic Rev., 47/3 (1959) 34-37; and Ulgener, Sabri F., “Monetary Conditions of Eco-
nomic Growth and the Islamic Concept of Interest” Islamic Rev., 55/2 (1967) 11-14.
6
See Kuran, Timur, Islam and Mammon; The Economic Predicaments of Islamism (Princ-
eton University Press: Princeton, NJ, 2004) where on p. 39 he states that, at the time
when Islam was revealed, defaulting borrowers were usually enslaved.
296 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

choice’ to economic agents that is also in contradiction with economic

rationality.
In positive economics, any act or contract like interest-based financing
that has been experimented upon for a sufficient period of time is
acknowledged as net value adding to economic activity. For such an act or
contract, then the job of an economist is to explain its modus operandi
and evaluate it critically by using conventional tools of economic analysis.
It can then be amended if critical evaluation discovers some flaws and
deficiencies in its functioning. It can even be replaced if its flaws and defi-
ciencies are irreparable and a parallel theory exists to take its place.
The objective of this paper is to describe the prohibition of interest in
such a manner that it appeals, on one hand, to students of conventional
economics, irrespective of their religion, and is not objectionable, on the
other hand, to Muslim jurists. In this regard, a noted feature common to
both conventional and Islamic economics is risk aversion. In Islamic law,
maysir that refers to all games of chance including gambling are strictly pro-
hibited, and gharar that refers to any confusion about the price, quantity or
quality of the good or service traded is not tolerated.7 All such restrictions,
besides prohibition of interest, indicate that uncertainty is looked down
upon or risk aversion is looked up to in an Islamic framework.
In conventional economics as well, particularly after the recent finan-
cial crisis, risk aversion has become the ruling paradigm in place of the
problem of scarcity.8 Therefore prohibition of interest is proposed as an
effective step towards controlling risk in any country. For this purpose, we
must first state the Fundamental Principle of Investment (hereafter
referred as FPI) as: “an investor, while investing, aims at minimization of
risk to achieve a given expected return or maximization of expected return
for an acceptable level of risk.”9
This principle is at the helm of bulging literature on portfolio theory
and risk management in the context of conventional economics. Parallel
to the FPI, another hypothesis (hereafter referred to as the PFPI) can be
proposed in this research that says that:

7
See Warde, op cit., Ch. 3.
8
See, e.g., Colander, David et al. (2009) “The Financial Crisis and Systemic Failure of
Academic Economics”, Kiel Working Paper 1489.
9
This concept is explained in every textbook of finance. In particular, see Fabozzi,
Frank J. and Modigliani, Franco, Capital Markets; Institutions and Instruments, 3rd edn.
(Pearson Education: New Delhi, 2003) p. 138.
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 297

the objective of every investment should be maximization of expected return for an

acceptable level of risk or minimization of risk for a given expected return by choos-
ing an appropriate mode of external financing.

The PFPI resembles the FPI so closely that any student of economics who
acknowledges FPI as a true representation of reality can hardly object to
any part of the PFPI. Furthermore, looking at the utmost emphasis on
FPI in portfolio theory, one can safely predict that the PFPI can go a long
way in the development of corporate finance. Therefore, the ‘null hypoth-
esis’ of this research says that ‘the variance of a given investment is less if
it is financed exclusively on a PLS-basis.’ The alternative hypothesis is that
the variance in the same investment is less if it is financed by a mix of
debt and equity. The expected return of a given investment remains the
same irrespective of the mode of external financing and that is why both
the null and alternative hypotheses are set with respect to risk only.
This paper is divided into five sections. Section 2 explains how an
investor achieves the objective of FPI. Section 3 explains PFPI and illus-
trates its relevance in positive economics. On the basis of PFPI, it also
develops a hypothesis within the contours of positive economics, which,
if accepted, would mean that prohibition of interest is economically logi-
cal and which, if rejected, would ascertain the current view that prohibi-
tion of interest can be justified on normative grounds only. Section 4
contains mathematical proof of this hypothesis. Section 5 presents the
important conclusions of this research.

2. Fundamental Principle of Investment (FPI)

The objective of every prudent investor is to maximize the expected return
for an acceptable level of risk or to minimize risk for a given expected
return (a) from a single physical or financial investment or (b) from a
set of exclusively physical investments or (c) from a set of exclusively
financial investments or (d) from a mix of physical and financial invest-
ments. The FPI has gained so much in popularity within economics that
the profession has remarked that elimination of risk has replaced the elimi-
nation of scarcity as a major preoccupation of economists.10 Another author
has emphasized the importance of risk: “In fact, risk of an investor affects

10
See Siddiqi, M.N., “Islamic Banking and Finance”, a lecture delivered at UCLA in a
Fall 2001 seminar. http//www.international.ucla.edu/printasp?parentid=15056
298 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

every aspect of portfolio design from allocating across different asset classes
to selecting assets within each asset class to performance evaluation.”11
There are two main features of every investment: expected return and
risk. Between them, the former is desirable and the latter undesirable.
Therefore, a trade-off must be made between them. An investor, who
seeks a relatively higher expected return, must also be willing to accept a
relatively higher risk. In his seminal article, Tobin illustrated how the
objective of this principle can be achieved.12 An investor who is not will-
ing to accept any risk must be holding his money in cash or in checking
deposits. On the other hand, an investor who is willing to bear an accept-
able level of risk can choose from a menu of risky assets like savings or
time deposits in a commercial bank, bonds, stocks, real estate and physi-
cal investment.
For example, if he puts his money in savings or time deposits, then he
would earn due interest income but at the same time would be facing the
risk of his bank’s bankruptcy and illiquidity of savings or time deposits
relative to cash or checking deposits. Similarly, if he buys stocks, then he
would earn dividend as income but he would also face risk of loss in share
values and illiquidity of stocks. According to the Markowitz portfolio
theory, an investor who is willing to bear a higher risk must be compen-
sated with a higher expected return.13 Therefore, if risk of a bank’s bank-
ruptcy and illiquidity of savings or time deposits is less than the risk of
loss in share values and illiquidity of stocks, then the required rate of
return on stocks must be greater than the interest rate paid to bank depos-
itors and vice versa.
If an investor wants to buy a single stock or a portfolio of selected
stocks, according to the Capital Asset Pricing Model, then he should
select the one whose ratio of expected return in access of risk-free rate to
risk on that particular stock or portfolio of selected stocks is greater than
the ratio of expected return on market portfolio in access of risk-free
interest rate to risk on market portfolio.14 In this formulation, risk on the

11
See Damodaran, Aswath (2008) Strategic Risk Taking; A Framework for Risk Manage-
ment, Wharton School Publishing, New Jersey.
12
See Tobin, James (1958) “Liquidity Preference in Behavior toward Risk” Review of
Economic Studies February pp. 65-86.
13
For better understanding of this concept, see Markowitz, Harry M., “Portfolio Selec-
tion”, J. Finance, March (1952) pp. 77-91.
14
Levy, Haim and Sarnat, Marshall, Capital Investment and Financial Decisions, 4th edn.
(Prentice Hall: New York, 1990) illustrate this theory with examples in Ch. 12.
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 299

market portfolio is the sum of variances of individual stocks netted of

their covariances with one another. On the other hand, risk of a single
stock is its covariance with market portfolio, not its own variance or its
covariance with another stock or with a particular mix of stocks. Simi-
larly, variance of a portfolio of selected stocks is the average of covariances
of selected stocks with market portfolio weighted by the proportion of
each stock in the portfolio.15
It is interesting to note that there is complete consensus on measure-
ment of expected return of any investment, but no such consensus exists
for measurement of risk. It is measured in so many ways like the Domar-
Musgrave Risk Index, Roy’s safety first rule, coefficient of range of possible
outcomes, absolute mean-deviation, variance, semi-variance, covariance,
Baumol’s measure of risk and value at risk.16 Each measure has some mer-
its and demerits. However, the most widely used measure of risk is
variance of possible returns around expected return of an investment.
Therefore only this measure of risk is used in further analysis of this
research.
For illustration, to choose from any two competing projects, variances
of their possible returns and their expected returns are compared and that
project is selected (a) which has a greater expected return but equal vari-
ance, or (b) which has an equal expected return but less variance, or (c)
which has both greater expected return and less variance. This two-pa-
rameter evaluation criterion works fine in the above cases but fails if vari-
ance as well as expected return of one project is less than that of another.
To avoid such a situation of indecisiveness, economists have developed
many one-parameter methods for project evaluation like the Expected
Utility Hypothesis, Second-Degree Stochastic Dominance Rule, Portfolio
Theory and CAPM.17 Although methodology and formulae of these crite-
ria are different, yet the underlying measure of risk in all of them is either
variance or covariance.
An important feature of FPI is that, for maximization of an investor’s
utility, it presumes permissibility of interest to ensure freedom of choice
that is an important element of economic rationality. Therefore, besides

15
Fabozzi and Modigliani, op cit., give exact formulae for calculation of variance and
covariance for a single stock and a portfolio of stocks in Ch. 9.
16
See Ch. 1 of Levy, Haim, Stochastic Dominance; Investment Decision Making under
Uncertainty, 2nd edn. (Springer: New York, 2006) where he describes these measures of risk.
17
See Levy and Sarnat, op cit., for expected utility hypothesis, portfolio theory and
CAPM; and Levy, ibid., for stochastic dominance.
300 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

investing or raising funds on PLS-based partnership and equity financing,

an investor is supposed to have the option of depositing or borrowing
money from a commercial bank and buying and selling of government
securities and corporate bonds which involve interest. Then the investor
chooses an option or a mix of various options depending upon his own
preferences about risk and expected return without facing any restriction
on either mode of external financing from the state.
Furthermore, it can be argued that FPI is individualistic in nature
because its emphasis is on maximization of an individual investor’s utility
without looking into its repercussions for risk and return profile of under-
lying investment or for counterparty of the contract. For understanding,
when a financier invests his money on PLS basis, he shares the risk of
underlying investment with users of funds. On the other hand, when a
financier lends money on interest, he shifts the whole risk of underlying
investment to borrowers/entrepreneurs. If most of the funding of a given
investment is on interest basis, then risk posed to borrowing entrepre-
neurs reaches to astronomical levels. That is why even in the West, a min-
imum number of shareholders is a necessary condition for any business to
raise funds externally either directly from financial intermediaries or indi-
rectly in capital markets by issuing bonds and stocks. To put it differently,
a business cannot be run exclusively by debt financing but it can be run
exclusively by equity financing.

3. Proposed Fundamental Principle of Investment (PFPI)

Whatever FPI suggests for an individual investor/financier, to have the
same for an investment that includes both financiers and entrepreneurs or
users of funds, another hypothesis, PFPI, is proposed. It is that the objec-
tive of every investment should be minimization of risk for a given
expected return or vice versa. The reason for proposing PFPI, on one
hand, is to extend the horizon of economic research and, on the other
hand, is to evaluate prohibition of interest purely on economic grounds.
The hypothesis of this research that is stated below makes sense if PFPI is
accepted as a desirable goal for corporate finance. Since both FPI and
PFPI are so similar, therefore it is assumed henceforth that PFPI is not
only unobjectionable to a Western mind but it is also an equally desirable
goal for each and every investment in a country.
The ‘null hypothesis’ of this research is therefore stated as ‘the objective
of PFPI can better be achieved if each and every investment is financed
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 301

exclusively on equity basis.’ The alternative hypothesis is that the risk and
return profile of an investment improves if it is financed on both PLS and
debt bases. Clearly if the null hypothesis is accepted, then it will establish
that prohibition of interest in Islam also makes economic sense and if the
alternative hypothesis is accepted then it will verify the current view that
prohibition of interest is mainly for normative reasons.
Due to the dearth of data on such investments that are financed totally
on equity basis, empirical research may not be conclusive. In the real
world, most of the investments, particularly those on a medium to large-
scale, are carried out by a mix of equity and debt financing. Therefore, the
null hypothesis is proved only mathematically in the following section. In
this regard, the same parameters, expected return and variance, are used
that are being used, in the literature, to achieve the objective of FPI.
As can be seen from the statements of the two hypotheses, the main dif-
ference between them is that the FPI focus of analysis is on an investor/
financier while that of the PFPI is on an investment. Since an investment
includes both financiers and users of funds, therefore it can be argued that
PFPI is holistic in nature. In other words, if the risk and return profile of
an investment financed on PLS basis turns out better than the risk and
return profile of the same investment financed on debt basis, then it will
indicate that debt financing generates a negative externality for the coun-
ter-party of underlying investment.
Another subtle difference between the two hypotheses is that FPI pre-
sumes permissibility of interest-based lending and borrowing on the pre-
text of human liberty to choose a gainful act or contract, whereas PFPI
will evaluate economic rationality of interest-based lending and borrow-
ing. If a mix of debt and equity financing as compared to exclusive equity
financing improves risk and return profile of a given investment, then
interest-based financing will qualify the test of economic rationality, oth-
erwise it will not.

4. Mathematical Proof of PFPI

Suppose that a new investment opportunity arises that requires a given
amount of money for its materialization. The amount can be raised either
internally or externally. Internal financing means an increase in retained
earnings or savings. On the other hand, external financing could be either
on PLS or debt basis. In the case of PLS-based financing, funds can be
raised either by invoking partnership or by issuing stocks that is simply a
302 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

modern form of PLS-based financing. Similarly, funds on debt basis can

be raised either from commercial banks and other financial intermediaries
or by issuing bonds of various maturities on a fixed-interest basis.
Then, for pedagogical purposes and easy comparison, two surrogate
setups with respect to external financing, Islamic and conventional, are
invoked. Under the Islamic setup, interest is assumed to be prohibited by
the state; therefore all funds for the investment are raised on equity basis.
On the other hand, under the conventional setup, interest is assumed to be
permitted, therefore the required funds are raised on both debt and equity
bases. As mentioned earlier, since a business or a firm cannot be run totally
by borrowed money, even in the West, therefore the option of exclusive
debt financing under the conventional setup is dismissed.
When financing is based exclusively on equity, it is assumed that n
shares of equal value are issued to raise the required amount of money
and that the holder of each share draws 1/n share of actual profit and loss
accrued on the underlying investment. On the other hand, when financ-
ing is based on both debt and equity, it is assumed that the amount to be
raised by issuing stocks is reduced by the amount of money borrowed. To
begin, initially a 50:50 debt equity ratio is assumed. It means that half of
the required amount is borrowed either from a single or many commer-
cial banks, or by issuing bonds of suitable denomination and maturity,
while the other half is raised by issuing n/2 shares, each with same book
value as in the case of exclusive equity financing. The assumption of a
50:50 debt equity ratio is relaxed later in this section.
It is also assumed that the outcome of a new investment opportunity
is uncertain. However, it is assumed to be probabilistic, i.e., there are
m possible outcomes each with a known probability. It should be noted
here that, for some investments, the probabilities of some individual pos-
sible outcomes may not be known objectively. However, economists
believe that, in such cases, probabilities can be easily assigned at least sub-
jectively that are as good as probabilities obtained objectively for decision-
making purposes under uncertainty. In rare cases ambiguity abounds and
probabilities of possible outcomes cannot be ascribed meaningfully, even
subjectively. Such ambiguous cases were first discovered by Ellsberg,
which are therefore highlighted in the literature under the topic of the
‘Ellsberg paradox’.18 In this analysis, however, the probability of each out-

18
See Ellsberg, Daniel, “Risk, Ambiguity and Savage Axioms” Quart. J. Econ., 75 (1961)
643-669.
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 303

come is assumed to be known, whether obtained objectively or assigned

subjectively.
Possible outcomes of a new investment opportunity, when financed
internally along with corresponding probabilities, are given in first two
columns of Table 1. Expected return (ER) denoted by μx and risk mea-
sured by variance (Var) denoted by σ 2 are given below these columns. In
the next three columns of Table 1, possible outcomes for an individual
shareholder (SH) out of n/2 shareholders, and for the lender along with
respective probabilities under the conventional setup are given. Similarly
in the last two columns, possible outcomes for an individual shareholder
out of n shareholders along with respective probabilities under the Islamic
setup are given. Expected return and risk for each shareholder, for the
lender, and for all of them altogether under the conventional setup, and
for each shareholder and for all shareholders together under the Islamic
setup are worked out below the corresponding columns using the same
notations as for the first two columns.
As can be seen from the first line below Table 1, the expected return for
an individual shareholder out of a total of n/2 shareholders under the
conventional setup is 2(μx – C )/n. It is greater than that for an individual
shareholder out of a total of n shareholders under the Islamic setup, if and

Table 1. Outcomes of Investment Financed Internally and Externally

under Conventional and Islamic Setups
Outcomes in Outcomes under Conventional Setup Outcomes under
Case of Internal Islamic Setup
Financing

Outcomes Probability Outcomes Outcomes Probability Outcomes Probability

for borrower for lender for each
SH
x1 p1 2(x1 – C)/n C p1 x1/n p1
x2 p2 2(x2 – C)/n C p2 x2/n p2
• • • • • • •
• • • • • • •
• • • • • • •
xm pm 2(xm – C)/n C pm xm/n pm

ER = μx ER for each SH = 2(μx -C )/n, ER for lender = C ER for each SH = μx/n

ER for n/2 SHs & lender = μx ER for n SHs = μx
Var = σ 2 Var for each SH = 4σ 2/n 2, Var for lender = zero Var for each = σ 2/n2
Var for n/2 SHs & lender = 2σ 2/n Var for all n SHs = σ 2/n
304 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

only if, C < μx/2, otherwise it is equal or less. But expected return for n/2
shareholders and the lender altogether under the conventional setup is the
same as for all n shareholders under the Islamic setup, which is also equal
to the expected return of the investment when financed internally. On the
other hand, variance for an individual shareholder under the conventional
setup, 4σ 2/n2, is quadruple of that for an individual shareholder under the
Islamic setup, σ 2/n2. However, variance for n/2 shareholders and the
lender altogether under the conventional setup, 2σ 2/n, is just double of
that for all n shareholders under the Islamic setup, σ 2/n.
By relaxing the initial assumption of a 50:50 debt equity ratio, two
arbitrary debt equity ratios, 40:60 that is less and 60:40 that is greater
than 50:50, are considered. For a 40:60 debt equity ratio, the correspond-
ing number of shares to be issued becomes (3/5)n under the conventional
setup. Consequently, expected return for an individual shareholder out of
total (3/5)n shareholders under the conventional setup turns out to be
3( μx – C )/5n as shown in the second column of Table 2. It is greater than
that for an individual shareholder under the Islamic setup, if and only if,
C < 3μx/5, otherwise it is equal or less. However, variance for each of
the (3/5)n shareholders, shown in column three of Table 2 becomes
25σ 2/9n2 as compared with variance of a shareholder under the Islamic
setup, σ 2/n2. Expected return for all shareholders and the lender, not
reported in Table 2, remains the same as in the case of a 50:50 debt equity
ratio, but variance for them under the conventional setup reported in col-
umn four becomes 5σ 2/3n.
On the same lines, for a 60:40 debt equity ratio, the corresponding
number of shares to be issued becomes (2/5)n. Consequently expected
return for an individual shareholder under the conventional setup comes
out 2( μx – C)/5n that is greater than that for a shareholder under the
Islamic setup, if and only if, C < 2μx/5, otherwise it is less or equal. How-
ever, variance for each shareholder becomes 25σ 2/4n2 as compared with
the variance of a shareholder under the Islamic setup, σ 2/n2. Expected
return for all shareholders and the lender does not change but variance
for them becomes 5σ 2/2n that is 2½ times greater than that under the
Islamic setup.
Assuming the three debt equity ratios given in Table 2, it is shown that
risk of investment under the conventional setup increases along with
every increase in the debt equity ratio. It is interesting to note that corre-
sponding to similar increases in the debt equity ratio, expected return for
an individual shareholder under the conventional setup may increase,
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 305

Table 2. Expected Return and Variance under Conventional Setup for

Different Debt Equity Ratios
D:E No. of ER for Var for Var for Change in Change in
Ratio SHs issued indiv. SH indiv. SH all SHs Var for Var for
indiv. SH all SHs

40:60 (3/5)n 5( μx – C )/3n 25σ 2/9n2 5σ 2/3n

50:50 (1/2)n 2( μx – C )/n 4σ 2/n2 2σ 2/n 11σ 2/9n2 σ 2/3n
60:40 (2/5)n 5( μx – C )/2n 25σ 2/4n2 5σ 2/2n 9σ 2/4n2 σ 2/2n

remain unchanged or even decrease, but variance definitely increases at

increasing rates. That is, when the debt equity ratio is increased from
40:60 to 50:50, and then from 50:50 to 60:40, then corresponding
increases in variance for an individual shareholder are 11σ 2/9n2 and
9σ 2/4n2 respectively.
Expected return for all shareholders and the lender altogether under
the conventional setup for any debt equity ratio does not change that is
equal to that for all shareholders under the Islamic setup, but variance for
all shareholders and the lender altogether under the conventional setup
definitely increases at increasing rates corresponding to successive increases
in debt equity ratio. It is interesting to note that the rate of increase in
variance for an individual shareholder is a multiple of that for all share-
holders and lenders altogether under the conventional setup as can be
seen by comparing figures in columns five and six of Table 2.
To sum up the results of this mathematical exercise, the following
remarks expressed in general terms may be noteworthy:

i) For an individual shareholder, expected return under the conven-

tional setup is less, equal or greater than that under the Islamic
setup depending upon whether the total interest payment is
greater, equal or less than [debt/(debt+equity)] times the total
profit of the underlying investment.
ii) For an individual shareholder, risk under the conventional setup is
definitely greater than that under the Islamic setup corresponding
to every positive debt equity ratio.
iii) For an individual shareholder, when his expected return increases
in response to similar increases in debt equity ratio, even then
increases in his risk are proportionately greater than those in his
expected return.
306 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

iv) For all shareholders and lenders altogether under the conventional
setup, expected return remains same as for all shareholders under
the Islamic setup irrespective of the debt equity ratio.
v) For all shareholders and lenders altogether under the conventional
setup, risk is definitely greater than that for all shareholders under
the Islamic setup corresponding to every positive debt equity
ratio.
vi) Under the conventional setup, risk for an individual shareholder as
well as for all shareholders and lenders altogether increases at an
increasing rate corresponding to successive and similar increases in
debt equity ratio.
vii) Under the conventional setup, the rate of increase in risk for an
individual shareholder corresponding to successive and similar
increases in debt equity ratio is greater than that for all sharehold-
ers and lenders altogether.

5. Conclusions

Current views about the logic of prohibition of interest are diverse. On

one side are staunch Muslims who support prohibition of interest because
they believe that their religion decrees it. However, Islam does not specify
any specific reason for prohibition of interest in the terminology of eco-
nomics. Actually economics did not exist as a separate discipline of
knowledge at the time of the revelation of Islam. However, in their endea-
vour to justify prohibition of interest on economic grounds, Muslim
scholars have come up, so far, with two main reasons. One reason is that
legitimacy of interest leads to exploitation of poor masses by a minority of
the rich, and the other reason is that legitimacy of interest leads to unfair
distribution of actual profits between lenders and borrowers.
Both of these reasons are not very appealing to conventional econo-
mists. The first reason is counterfactual; businessmen and firm owners
who are nowadays ultimate borrowers are better off financially, socially
and politically than depositors and households who are ultimate lenders.
The second reason is not wrong as such but fairness has no currency in
positive economics.
On the other side are Western economists who consider that an inter-
est-free system is veiled in Islamic fundamentalism through which an out-
dated social and economic setup is believed to be superior to the current
 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308 307

one. They think that the insistence of Muslim jurists on an interest-

free system is mainly to preserve the socio-political heritage of Islam
that is being eroded gradually due to the onslaught of Western propa-
ganda and economic backwardness of Muslims nations. To them, market
interest rate rations loanable funds like market prices ration consumable
commodities and services. Therefore, there is no justification for the
state to prohibit the use of interest rates and uphold permissibility of mar-
ket prices.
Since conventional economists welcome any new idea that qualifies the
test of economic rationality, therefore the objective of this research is to
reinterpret the prohibition of interest in such an economic jargon that
makes it equally acceptable to Muslims as well as conventional economists
and that can also take the test of economic rationality. Risk aversion is
identified as a common characteristic of both Islamic and conventional
economics looking at unequivocal prohibition of all games of chance and
disapproval of any ambiguity about the price and quantity or quality of a
traded good or service in Islamic law and FPI in conventional economics.
Therefore, an underlying reason for prohibition of interest is claimed to
be risk aversion.
FPI refers to minimization of risk for a given expected return or maxi-
mization of expected return for a given acceptable level of risk. It is the
core principle in financial economics and the objective of all innovative
financial derivative products and financial engineering. Therefore, parallel
to FPI, another principle of finance labelled PFPI is proposed in this
research by the author. PFPI expresses that the aim of every investment
should be minimization of risk for a given expected return and vice versa
by choosing an appropriate mode of external financing that can either be
based exclusively on equity or on a mix of debt and equity. Exclusive
equity financing represents an economy where interest is prohibited by
the state while a mix of debt and equity financing represents a society
where interest-based lending and borrowing is permitted. The option of
exclusive debt financing is rarely practiced in conventional economics;
therefore it is ignored in the analysis.
On the basis of PFPI’s close resemblance to FPI, it is expected that the
PFPI can be accepted by conventional economists as a true manifestation
of financial wisdom. Then the reason for prohibition of interest is stated
in the form of an hypothesis that risk and return profile of an investment
is better if it is financed exclusively by equity than if it is financed by a
mix of debt and equity.
308 M.M. Iqbal / Arab Law Quarterly 24 (2010) 293-308

Without bothering about data on investments that are exclusively

financed by equity and without getting into the intricacies of empirical
testing, the hypothesis is tested mathematically with the supposition that
a new investment opportunity arises. Its future profit or loss outcomes are
probabilistic. Its expected return remains the same whether it is financed
exclusively by equity or by a mix of debt and equity. However, its variance
comes out greater if it is financed by any mix of debt and equity rather
than by equity exclusively. Furthermore, its variance increases by a greater
margin corresponding to every similar increase in debt equity ratio.
On the basis of mathematical proof, the null hypothesis of this research
is accepted. It means that risk for a given investment turns out smaller if
it is financed exclusively by equity rather than by a mix of debt and
equity. It means that, in case of permissibility of interest, a 1% increase in
debt equity ratio in the financing of a given investment increases its risk
at an increasing rate without increasing its overall expected return. It is
probably the consequence of this fact that financing of an investment
exclusively by debt is not permissible, even in the West, where interest is
not only permissible but is also not looked down upon by any faction of
its society.
An important implication of this research is that, if prohibition of
interest is taken as a restriction on personal liberty without keeping in
view negative macroeconomic externality that it generates in the form of
increasing risk of the underlying investment, then it seems dogmatic and
coercive. However, if the negative externality of debt financing and its
exploding nature is fully understood, then prohibition rather than per-
missibility of interest makes more economic sense. Therefore, in this arena
of corporate culture in which external financing is almost inevitable, pro-
hibition of interest should be given a second thought by all economists
irrespective of their religious beliefs.