Compounding effect of bank interest and emergence of Islamic banking

Mezbah Uddin Ahmed, Research Officer, ISRA

Email: mezbah@isra.my
The banking practice as we know it emerged only around 300 years back in the 17 th
century, but the roots of lending and borrowing can be traced back to the roots of
civilization. A 3,000-year-old written loan contract found in Mesopotamia confirms
the existence of a lending and borrowing system that included the concept of interest.
Yet, the charging of interest has always been considered as an unnatural, unjust,
immoral and evil way of making money. Aristotle writes in Politics, Book I (350
BCE), The most hated sort, and with the greatest reason, is usury, which makes a
gain out of money itself, and not from the natural object of it. For money was
intended to be used in exchange, but not to increase at interest. And this term interest,
which means the birth of money from money, is applied to the breeding of money
because the offspring resembles the parent. Wherefore of all modes of money making
this is the most unnatural.
Not only Islam, but all other major religions, including Christianity, Judaism and
Hinduism, asserts its prohibition. This is due to the fact that interest allows an unjust
increase in a lenders wealth at the expense of the borrower. If interest is charged, the
borrower is burdened with a higher amount than the actual borrowing even if the
reason of borrowing fails.
The nature of interest today is very much same as it was during the Prophets (SAW)
time, and before. According to one publication, in Ancient Greece, interest was
charged at 12% to 24% at various times. At present, according to the World Bank
data, in 2014, the lending interest rates of 62 countries were equal to or above 10%. In
10 countries, they were above 20%. For some loans, including credit cards and microcredits, the interest rate is often significantly higher than the normal borrowing rates.
The unjust and unnatural increase in the lenders claim at the expense of the
borrowers obligation can easily be understood from the pyramids in Figure 1.

Figure 1: Interest rate compounding effect

As illustrated in Figure 1, if a borrower fails to repay at a 10% compound interest rate,
a simple $1 obligation will increase by 13,781 times over 100 years. At 15% the
obligation will increase more than 1.17 million times. At 20% rate it will increase by
an astounding 82.8 million times. The borrowers obligation will be doubled (the
specific prohibition declared in the Quran in Srah 'Ali `Imran, verse 130-132) - at
10% in just 7.3 years, at 15% in just five years and at 20% in just 3.8 years.
Allah commands justice and good conduct, and forbids oppression (Srah An-Nal,
verse 90). The charging of interest is unjust even when the loan is taken for profitoriented investment purposes. This is unjust to the borrower because even if the
investment fails the borrower will have to pay the interest, a sum greater than the
original borrowing. Failure of repayment will only increase the burden which
undeniably signifies oppression.
Furthermore, in an interest-based financial system at any given point of time there is
not enough money in the system to pay off all the liabilities that arise from
borrowings, which makes the concept of charging interest fundamentally flawed.
The primary function of a conventional bank is to receive deposits in the form of
borrowings from individuals and entities with surplus funds and then to lend to
individuals and entities who are in deficit. The conventional banks make profit by
borrowing at a lower rate and lending at a higher rate of interest. They deal with

interest at both ends of the arrangement and normally the interest rate is compound in
nature. While compounding interest is the worst form, any amount of interest on a
loan is prohibited in Islam (Srah Al-Baqarah, verse 278-279). The council of Islamic
scholars around the world, including the International Fiqh Academy and the
European Fatwa and Research Council, has unanimously agreed on the existence of
rib in the conventional banking system.
In Islam, money itself is not a commodity; rather it is simply a mean of investment in
buying or selling real commodities and services. Islam promotes real economic
activities by means of trade and business. Allah says in Srah Al-Baqarah, verse 275,
Allah has permitted trading and forbidden rib. Trading implies not only buying and
selling; it includes all forms of permissible business activities. In an interest-based
loan, one party gains at the expense of another; but, in a permissible trade both parties
gain as they exchange commodities or services for a price that is of equal countervalue.
While interest-based borrowing and lending is at the core of conventional banking,
the Islamic banks applies the concepts of partnership (mu rabah and mushrakah),
sale (murbaah, muswamah, muajjal, salam and istin), lease
(ijrah), agency (waklah), and interest-free loan and safekeeping (qar, waah and
rahn).

Figure 2: Conventional vs Islamic banking concepts

Though the commercial banking was absent during the time of the Prophet (SAW),
the fundamental principles of permissible commercial and financial dealings have

already been laid out in the Qur'an and in the hadiths. There is much evidence in the
Qur'an and especially in the hadiths that establish the foundation and principles for
present-day Islamic banking contracts. In some cases the Prophet (SAW) was himself
engaged in commercial contracts and in some other cases he (SAW) gave rulings
regarding the permissibility of contracts. Some principles are deduced by the Islamic
scholars from the Qur'an and the hadiths applying permissible scientific
methodologies.
However, some still argues that the Islamic banks simply mimic the conventional
interest-based banks.
During the period of European colonial empires most countries adopted Western-style
practices. From banking systems to legal systems, colonial rules became dominant
and replaced Islamic principle-based practices. Subsequent to World War II, in the
mid-nineteen hundreds, the Muslim majority countries started to gain independence
from the colonial powers and got the opportunity, after several hundred years, to
reshape the systems based on their particular needs. We can, therefore, only trace the
beginning of modern Islamic banking back for a few decades.
The Dubai Islamic Bank, established in 1975, is the worlds first commercial Islamic
bank. It was only in the 1980s that Islamic banking started to expand worldwide.
There were a number of experimental efforts before that to establish Islamic principlebased financial institutions, but coming up with a viable and sustainable model that
could compete with already well-established conventional banking appeared to be a
great challenge and some early initiatives failed.
As the new entrants in a highly competitive financial industry, the primary concern of
the Islamic banks is naturally survival, in addition to being Sharah -compliant.
Customers expectations from banks and their willingness to participate in risk is one
of the major challenges in implementing a truly profit-and-loss sharing banking
system, as not all customers are willing to take the risk of loss. To ensure the
sustainability of the banking model at the initial stage, therefore, Islamic banks came
up with Sharah-compliant financial products that in substance are not significantly
different from conventional products. The apparent similarity between the two

banking systems allowed the Islamic banks to gain acceptance among conventional
banking customers, therefore giving it the opportunity to grow.
A regulatory framework that caters primarily for the conventional banking system is
another primary factor that forces Islamic banks to structure their financial services in
a particular way, often resembling conventional banking services. Even though
significant regulatory improvement has already occurred in some countries to
accommodate specific needs of Islamic banking, there is a long way to go.