The Prohibition of Riba in Islam An Evaluation of Some Objections

Abstract

A number of objections have been raised against the prohibition of
riba (interest) in Islam and it has been alleged that a riba-free economy
will face so many problems that it may not be able to survive. This paper
evaluates the nature and significance of some of the major objections
and, in the process, also indicates the rationale behind the prohibition of
riba.
I. ALLOCATION OF RESOURCES
One of the objections raised against an interest-free economy is that it
will not be able to bring about an optimum allocation of resources. The
reason given for this is that interest is a price and like all prices it
performs the function of allocating 'scarce' loanable funds among the
'infinite' users of such funds in an objective manner on the basisof ability
to 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 is
that in the absence of interest loanable funds will be available ‘free’ to
borrowers, the demand will thus be infinitely large and there will be no
mechanism for equating demand with supply. This implies that interest
is the only objective criterion for allocation of resources and, in its
absence, scarce financial resources will be used inefficiently to the
detriment of society. The second assumption is that the money rate of
interest has been a successful mechanism in allocqting resources
optimally 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 cost
will be the ‘share’ in profit. The rate of profit will hence become a
criterion for allocation of resources as well as the mechanism for
equating demand with supply. The greater the expected or ex-ante rate
of profit in any business, the greater may be the supply of funds to that
business. If the actual or ex-post profit for certain businesses is
consistently lower than the ex-ante profit such businesses may face
difficulty in raising funds in the future. Therefore, while ex-ante profit
will be immediately important in determining the flow of investment,
the ex-post performance will be crucial for the future success of the
business in raising funds. This should help enforce a greater discipline in
investments through a more careful evaluation of projects, weeding out
all inefficient and unproductive projects. This is not the same in interestbased
investment. The interest-oriented lender does not share in the risk
of the business financed. He shifts the entire risk of busines to the
entrepreneur and assures himself of a predetermined rate of return
irrepwtive of the ultimate net outcome of the borrower’s business. He
thus does not have to undertake as thorough an evaluation as the sahib al-mal
(financier) would have to undertake in a riba-free economy, either
by himself or with the help of a bank or consulting firm. Because of a twosided
evaluation of projects, the rate of profit in the Islamic system
should be a more efficient mechanism for allocation of resources than
interest can ever be in the capitalist system ...