Riba and Islamic Banking

Islamic banking, which principally should be completely free from Riba (interest), is practiced under the same "fractional reserve" banking system that has to maintain a minimum "capital adequacy ratio" instructed by central bank of the country they are operating in.

Capital Adequacy Ratio (CAR) is a defined percentage of customer's deposit that goes to the central bank while the customer's bank is free to lend/invest remaining part to its other customers, also it is the main constituent of formula that define the "money multiplying factor" in monetary terms. The banks to create money use "Money multiplying factor". One of the simplest formula for money multiplying factor is:

MMF = DEPOSIT/CAR

An important observation In the existing system of money creation by the banks, what an Islamic Bank would be doing? If they are also involved in the creation of money and issuing banking instruments based on the newly created money, then they must be extremely conscious in designing financial and investment instruments, a wrong assessment or interpretation of Islamic principles may create the same effect of the instrument in the society and the economic system as Riba (interest) is doing. This is extremely sensitive subject. This is not the problem of Islamic directives on financial dealings, but it's the limitation imposed by the controlling master economic system that is ruling and is non-Islamic. There are certainly many questions regarding this system of money creation like who should create money, when and why? Unless, Islamic spirit of financial system is not inducted at the governmental level, there cannot be a true Islamic economic society.

Discounting

It has been clearly mentioned in Quranic verses and Hadiths that Riba relates to the increase, and surely that is the truth because only increase can create artificial scarcity of the produce in the society, while if we see the discounting, it does not depict any artificial behavior rather more precisely it has a basic sharing behavior.

The prevailing misunderstanding in the concept of Riba (Interest) that relates it with time as stated by many economists and scholars, has created unrealistic confusion between banking Interest and discounting, most people think that both are same things but actually they are not. The reason of this confusion comes from the practice of applying time-based rate in both cases. Riba is independent of time, it can exist in a hand-to-hand exchange in zero time frame to any large time frame incase of loans, but it is surely an increase not the decrease.

It is a well thought and thoroughly researched conclusion that discounting of financial instruments/bills does not come under the prohibition of Riba. The discounting mechanism inherits a strong characteristic of keeping the circulation of money natural and is an alternative driving force for economic activity for banks and thus for capital.

Discounting is opposite of a Loan transaction (rather one may call it a negative of interest/riba mechanism), the following comparison may be helpful to emphasize on this difference :

Loan Transaction

Discounting Transaction

When : Capital is in-handWhen : Capital is not in-hand
Scenario : I give you an amount of 100, after one year, I receive 110Scenario : I give you a Bill of 100, I receive 90 on spot, after one year, you receive 100
Analogy : I sold 100 for 110Analogy : I sold 100 for 90
An increase of 10 is noticed A decrease of 10 is noticed
This increase of 10 is an extra liability created on the borrowerThis decrease of 10 is basically sharing of what is available
Nature : A loan is required when the wealth has to be created.Nature : Discounting is required after the wealth is created.
Activity is dependent on loanActivity is already done.

beside above tabulated differences, there are other differences in nature of these two types of transactions, but the below are two basic differences further explained as :

  1. The increase of 10 in loan is artificial and does not exist in the transaction cycle as part of the principal transacted amount rather is an extra created liability on the part of the borrower, while -10 in discounting is a sharing part of the transacted amount.

    Please refer to the page Why Riba was prohibited...? - the subject of artificial increase is discussed there in detail. Additionally, to emphasize on this difference, we must keep in mind the concept of equity which is the base of specific modes of Islamic financing, where labour, capital, knowledge, capability, need, availability etc. have respective values and any combination / agreement is allowed to share these assets between the players of wealth creation activity.

  2. I give 100 and receive 110 in loan, while I give 100 and receive 90 in discounting. (The analogy to this is - I sold my 100 for 110 in loan and my 100 for 90 in discounting)

    Obviously both can not be same. Some people may ask that who gave me 90 on spot would actually get 100 after one year and that is an increase in his money. This is a very common misconception that is noticed and therefore must be replied accurately. Please review :

    1. The capital is not rejected in Islam or in nature, the role of capital is guided with the prohibition of riba and some other ethical and social limitations, otherwise there would be no meaning to Islamic modes of financing. The benefits of capital can not be rejected out rightly, but definitely all those benefits must be permitted which are lawful.
    2. It must be noted here, I am giving him 100 for discounting and not that way as he is giving me 90 as loan. These are two completely different situations.
    3. Although already mentioned above but to emphasize again it is repeated here that only the similarity of time based rate as practiced these days in loan and discounting transactions can not become the reason for equating the loan and discounting transactions and classifying both as riba transaction, whereas these are two completely different types as tabulated above.

In short, discounting by any means does not have the must elements of riba as discussed and defined here earlier, it is a real and much powerful mechanism that can be explored as the lawful driving force for the capital in the Islamic banking industry.