Review :: Fadel on the Function of the "Interest Ban" in Islamic Finance

Islamic finance creates financial products specifically aimed at Muslims that are sharīʿa compliant. Many scholars have condemned Islamic finance for condemning ribā (interest) on the one hand, particularly where usurious, but then many others have created workarounds that allow modern big-finance firms to avoid it in name only on the other hand. Those who argue against the workaround argue that nominal interest-avoidance goes against the spirit of the guidelines set forth in Islamic law (sharīʿa). Weighing in on the controversy, University of Toronto Law Professor Mohammad Fadel considers whether ribā might serve a function that goes beyond simple definitions of it as either interest or usury. Historically, the prohibition on interest was a means of regulating medieval financial industries, in ways that have little application to the modern financial instruments. The medieval prohibitions and the modern controversies about Islamic finance then, he argues, are misaligned and need rethinking. This post provides a "plain English" review of the article: Mohammad H. Fadel, Ribâ, Efficiency and Prudential Regulation: Preliminary Thoughts, 25 Wisconsin Journal of International Law 655 (2008).

Does Islamic Law Ban Interest?

Islamic finance is a relatively new and rapidly growing field. One of its central tenets, as understood by Muslims and non-Muslims alike, is a ban on interest. Therefore, Islamic finance seeks to create ways of making money without the formal use of interest. The refusal to overtly use interest in Islamic finance is based on the prohibition in sharīʿa of ribā. However, despite the fact that ribā is often translated as interest, this is an incomplete understanding of the term. Historical analysis reveals that there were two types of ribā-based restrictions on contracts, ex-post and ex-ante. While the ex-post ban on adding interest to the debt of someone who is unable to pay may be understood as a categorical restriction, the ex-ante bans merit closer scrutiny. The prohibition on the ribā of “excess,” which forbade the trading of goods of the same kind (i.e. gold for gold, salt for salt), and the ribā of “delay,” which disallowed the trade of certain commodities without immediate delivery, worked to satisfy ribā’s overriding concern with preventing unjust enrichment. They were put in place to achieve a specific goal, namely protecting the system of entitlements produced by the zakāt taxation scheme. It would seem, then, that these restrictions on ribā do not directly apply to modern trade. Therefore, one of the central goals of Islamic finance, finding ways to allow arbitrage without violating the ban on interest, is unnecessary because it is based on a misunderstanding of sharīʿas ex-ante restrictions on contracting.

Ribā in Historical and Legal Context

Ribā in historical context provides at least two definitions: ex-post and ex-ante. Ex-post ribā is when a lender increases the amount owed due to the borrower’s failure to pay on time. This was and is forbidden, even when the borrower ostensibly consents. Ex-ante ribā is divided into two sub-categories, the ribā of “excess” and the ribā of “delay.” The former is the trade of specific enumerated goods, such as precious metals and certain staple foods, for goods of the same kind (i.e. gold for gold or wheat for wheat). The latter is the trade of substantially those same types of goods without immediate delivery. The different Sunni schools of law interpreted restrictions slightly differently especially concerning which goods were subject to which rules.

Muslim jurists consistently made exceptions to the rules of ribā. Some of these exceptions were for activities that technically violated the prohibitions but lacked a profit motive.  Others were made to remove hardship, even when the activity would ultimately produce a profit. It is clear that Islamic law has always been concerned about individual welfare, particularly when it comes to economics.

Muslim scholars have long wrestled with how to justify the prohibitions placed on ribā. Historical justifications varied, but enduring themes included avoiding mis-pricing (ghabn), placing a check on extravagance (saraf), and preventing scarcity (‘izza). Modern justifications vary, as well. The dominant view, as discussed earlier, holds that interest is the equivalent of ribā. However, there is a dissenting view which rejects the idea that ribā is synonymous with interest. This position is divided into many sub-views. Some scholars claim that ribā was originally justified as a prophylactic remedy for the economic abuses of the pre-Islamic era but should now be relaxed to allow for commerce, which can serve many worthy goals.  Others agree that it was a prophylactic remedy but contend that it was meant to prevent the hoarding of food, the manipulation of currency, and the mis-pricing of goods in barter transactions. They conclude that modern interest-bearing loans are a necessity and outside the realm of issues that the prohibitions on ribā cover. Still others argue that the bans were and are justified due to the dynamic nature of economic systems. 

The overriding justification for these rules seems to be preventing unjust enrichment. Banning ex-post ribā can be seen as a kind of price-setting, as it conclusively sets the price of deferring a loan at zero, preventing the abuses that can and did take place when insolvent debtors needed extra time to pay off their loans. Prohibiting ex-ante ribā, on the other hand, requires a more sophisticated explanation. Though it seems to run contrary to the typical laissez-faire attitude of Islamic law toward arms-length bargains, banning ex-ante ribā is justified when viewed in light of the entirety of Islamic economic regulation.

Islamic law endeavored to provide a safety net, a guaranteed minimum amount of food for everyone. The device chosen to accomplish this goal was zakāt, a tax on agricultural surplus. If someone produced more than a year’s worth of food in a year, a portion of the extra was taken and given to those who had less than a year’s worth of food. The goods subject to zakāt substantially overlap with those subject to the prohibitions on ex-ante ribā. Because zakāt seems to have been a kind of rationing system, the rules of ex-ante ribā functioned to prevent recipients from wasting or being tricked out of their rations and thus becoming a social liability. This view of ribā and the regulations surrounding it squares with Qur’anic verses that contrast ribā and charity.

If this is so, it would seem, then, that the only truly convincing way of justifying ribā is as a way of controlling prices, protecting the existing system of wealth distribution set up by Islamic law. It is a temporary measure, enacted to regulate market prices in a time of economic uncertainty. Under this view, as with other dissenting views, there is no value in blind adherence to the prohibitions on ribā. Rather, these bans are simply a few of many prudential regulation devices in Islamic law. They should be interpreted functionally, and the directive Muslims should take from them is to choose economic policies that promote human welfare.