In Islam there is an absolute prohibition against the payment and receipt of interest (the Arabic term for which is riba). It is this prohibition that makes Islamic banking differ in a very basic and important way from a conventional banking system. 1/ As the use of the interest rate in financial transactions is precluded, Islamic banks can operate only on the basis of profit-sharing arrangements or other modes of financing permissible under Islamic law (the Shariah).
Technically, riba refers to the addition in the amount of principal of a loan based on the time for which it is loaned and on the amount of the loan. From a legal standpoint, it signifies the additional money charged in money-to-money transactions or the extra commodity in commodity-to-commodity operations. While earlier there was a debate as to whether riba referred to interest or to usury, it appears there is now a consensus of opinion among Islamic scholars that the term extends to all forms of interest, and without distinction being made between real and nominal rates. The fundamental sources of Islam, namely the Qur’an and the Sunnah (the teachings and traditions of the Prophet Mohammed) do not provide a detailed explanation for the prohibition against interest beyond asserting, axiomatically, that charging interest is an act of injustice and thus forbidden. Contemporary Muslim economists have, however, provided various rationales for this restriction by appealing to the supposedly adverse consequences of the existence of interest in modern societies, or by asserting that interest is exploitative, or by arguing that modern economic theory has not provided a justification for the existence or need for interest, and furthermore, that interest is inconsistent with the Islamic notion and concept of property rights (Chapra 1982; Siddiqi 1983; Ahmad 1984; Khan and Mirakhor 1989). A universal view on this issue is as yet unavailable.
Ahmad, Ziauddin, “Concepts and Models of Islamic Banking: An Assessment,” paper presented at the Seminar on Islamization of Banking, Karachi, Pakistan, November 27–29, 1984 (Islamabad: International Institute of Islamic Economics, 1984).
Chapra, M. Umer, “Money and Banking in an Islamic Economy,” in M. Ariff, (ed.), Monetary and Fiscal Economics of Islam (Jeddah: King Abdulaziz University, 1982), pp. 147–176.
Khan, Mohsin S., and Abbas Mirakhor, (eds.), Theoretical Studies in Islamic Banking and Finance (Houston: Institute for Research and Islamic Studies, 1987).
Khan, Mohsin S., and Abbas Mirakhor, “The Financial System and Monetary Policy in an Islamic Economy,” Journal of King Abdulaziz University: Islamic Economics (1989), pp. 39–57.
Khan, Mohsin S., and Abbas Mirakhor, “Islamic Banking: Experiences in the Islamic Republic of Iran and Pakistan,” Economic Development and Cultural Change (January 1990), pp. 353–375.
Mirakhor, Abbas, and Iqbal Zaidi, “Stabilization and Growth in an Open Islamic Economy,” Review of Islamic Economics (1991), forthcoming.