The Prohibition of Riba in Islam

Abstract

A number of objections have been raised against the prohibition ofriba (interest) in Islam and it has been alleged that a riba-free economywill face so many problems that it may not be able to survive. This paperevaluates the nature and significance of some of the major objectionsand, in the process, also indicates the rationale behind the prohibition ofriba.I. ALLOCATION OF RESOURCESOne of the objections raised against an interest-free economy is that itwill not be able to bring about an optimum allocation of resources. Thereason given for this is that interest is a price and like all prices itperforms the function of allocating 'scarce' loanable funds among the'infinite' users of such funds in an objective manner on the basisof abilityto pay the price. If the demand for, or supply of, loanable funds changes,a new equilibrium is reached at a different rate of interest.This objection is based on two assumptions. The first assumption isthat in the absence of interest loanable funds will be available ‘free’ toborrowers, the demand will thus be infinitely large and there will be nomechanism for equating demand with supply. This implies that interestis the only objective criterion for allocation of resources and, in itsabsence, scarce financial resources will be used inefficiently to thedetriment of society. The second assumption is that the money rate ofinterest has been a successful mechanism in allocqting resourcesoptimally and that profit cannot perform the function efficiently.The first asumption is baseless because funds will not be available‘free’ in the Islamic system. They will be available at a cost, and the costwill be the ‘share’ in profit. The rate of profit will hence become acriterion for allocation of resources as well as the mechanism forequating demand with supply. The greater the expected or ex-ante rateof profit in any business, the greater may be the supply of funds to thatbusiness. If the actual or ex-post profit for certain businesses isconsistently lower than the ex-ante profit such businesses may facedifficulty in raising funds in the future. Therefore, while ex-ante profitwill be immediately important in determining the flow of investment,the ex-post performance will be crucial for the future success of thebusiness in raising funds. This should help enforce a greater discipline ininvestments through a more careful evaluation of projects, weeding outall inefficient and unproductive projects. This is not the same in interestbasedinvestment. The interest-oriented lender does not share in the riskof the business financed. He shifts the entire risk of busines to theentrepreneur and assures himself of a predetermined rate of returnirrepwtive of the ultimate net outcome of the borrower’s business. Hethus does not have to undertake as thorough an evaluation as the sahib al-mal(financier) would have to undertake in a riba-free economy, eitherby himself or with the help of a bank or consulting firm. Because of a twosidedevaluation of projects, the rate of profit in the Islamic systemshould be a more efficient mechanism for allocation of resources thaninterest can ever be in the capitalist system ...