why islam has prohibited interest & islamic alternatives for financing

1 s t E t h i c a l ’ s G u i d e t o

© 2005 All rights reserved

Tax Planning Through Trusts

1st Ethical Limited Chorley House

58 Chorley New Road Bolton BL1 4AP

Phone: 01204 559914Fax: 01204 399786

Email: [email protected]

1st Ethical Websitewww.1stethical.com

The Musharaka Fund Websitewww.musharaka.net

Regulated and authorised by the Financial Services Authority

Disclaimer: This document does not constitute financialadvice under the Financial Services and Markets Act 2000which supersedes the Financial Services Act 1986.

Winners of the Shell Livewire:‘UK’s Fastest Growing Business of the Year’ award‘North-West Entrepreneur of the Year’ award

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Why Islam has prohibited Interest & Islamic Alternatives for Financing

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1st Ethical Limited Chorley House58 Chorley New RoadBolton BL1 4AP

Phone: 01204 559914 Fax: 01204 399786Email: [email protected] Website: www.1stethical.com

www.musharaka.net


1st Ethical: Tax Planning through Trusts

Copyright notice: All rights reserved. No part of this publicationmay be reproduced, stored in a retrieval system or transmitted inany form or by any means, electronic, mechanical, photocopyingor otherwise, without the prior permission of 1st Ethical Ltd.


Islam does not deny market forces or the market economy. Even the profitmotive is acceptable to a reasonable extent. Private ownership is not totallynegated. Yet, the basic difference between a Capitalist and Islamic economyis that in secular Capitalism, the profit motive or private ownership are givenunbridled power to make economic decisions. Their liberty is not controlledby any divine injunctions. The evils emanating from this attitude can neverbe curbed unless humanity submits to divine authority and obeys itscommandments in any case and at every price. This is exactly what Islamdoes. After recognising private ownership, profit motive and market forces,Islam has put certain divine restrictions on economic activities. Theserestrictions being imposed by Allah Almighty, Whose knowledge has nolimits, cannot be removed by any human authority. All these prohibitionscombined together have a cumulative effect of maintaining balance,distributive justice and equality of opportunity.

Retired Chief Justice Mufti Muhammed Taqi Usmani

Contents

1st Ethical: Tax Planning through Trusts 1

page

1. Introduction 2

2. Interest Defined 3

3. The Qur’anic Ban on Interest 4

4. A Brief History of Interest Based Banking 5

5. Failures of Interest Based Banking 6-7

6. The Catastrophic Impact of Debt onthe Developing World 8

7. The Nature of Money in Islam 9

8. Interest Based Financing Compared with Musharaka 10

9. Musharaka - Islamic Financing 11

10. The 1e Musharaka Fund supported by 1st Ethical 12

11. Summary 13

‘So lose not heart, Nor fall in despair,For you are bound to rise, If you are true in faith’

Al-Quran 3:139

‘The collapse of the global marketplace would be a traumatic event withunimaginable consequences. Yet I find this easier to imagine than the

continuation of the present regime’

George Soros, Global Financier

This Booklet is an abridged version of a research paper on the same subject.The entire paper is available online at www.1stethical.com/publications

2 1st Ethical: Tax Planning through Trusts

IntroductionMost prohibitions in Islam are easy to understand. The evil effects of

alcohol, adultery or gambling are not difficult for us to comprehend both

at an individual and at society wide level. However when it comes to

‘interest’, few Muslims can fully comprehend the evils of this vice, and

thus the prohibition on interest does not appear to resonate with us as

seriously as it could, both at an individual and at society level. We often

fail to grasp the significance of interest in shaping world events. The

latter half of the twentieth century was dominated by a ‘cold war’ between

two competing economic ideologies.

By refusing to accept an interest based economic ideology, Islam is effectively

presenting a viable alternative to the victor of the‘cold war’, Capitalism.

The problems with interest may be deceptively difficult for us to appreciate,

but the Ban on interest by Allah is absolute. In fact, so despised is

Riba, that the unparalleled curse of a ‘declaration of war’ from Allah

(SWT) & his Messenger (SAW) is directed towards those who refuse to

give up interest.

Our intention through this booklet is to firstly study the definition &

chronology of the prohibition of interest in the Qur’an. We will then move

on to analyse the effects of interest on the Global economy. Finally we

will introduce the Islamic Alternative to interest based financing, known

as ‘Musharaka’, and exhibit a working model of this alternative. First

though, let’s start at the beginning by defining interest.

Interest Defined


The standard dictionary definitionfor interest is as follows:

‘A charge made for a loan orcredit facility’.

Seems innocent enough. At first glance itseems reasonable for a charge to be leviedin exchange for receiving a loan. Thecapitalist system believes in money’sunbridled right to a return irrespective ofthe level of profit or loss generated by theproject to which the money was loaned.This is by definition interest. Islamfundamentally disagrees with the aboveview; and instead proposes that if capitalis lent on a ‘loan’ basis then it must berepaid with no excess; any excess beinginterest. If the lender seeks any return onhis capital, then he must invest his fundsby purchasing equity and partake in thelosses, risks and rewards of business. Evento the neutral observer, the Islamic positionpresents superior logic. Idle capital will

always be unproductively used when it isguaranteed a return. This is simply becausecapital will flow to those who posses thegreatest collateral, not those with the mostviable business projects. We will explainin due course how Islam says capital canbe more efficiently used. But let us nowrevise our definition of interest. Indeed,what better way to define the term thanfrom the Holy Qur’an. In Surah Baqarah,Allah dedicates a number of verses tointerest; from them we can infer thefollowing definition for interest;

‘Any excess paid or received onthe principal’

The prohibition on interest is bilateral.Neither can the borrower pay it, nor canthe lender receive it. So whilst investingmoney is halaal and can generate apositive return, a loan can never generatea return in excess of the amount advanced.


There are 4 explicit references in the Holy Qur’an to interest. Cumulatively,they clarify Islam’s position on the subject.

‘The first ever verse revealed onRiba was Surah Ar-Rum, verse 39,where Allah says;

‘And whatever Riba you give so that it mayincrease in the wealth of the people, itdoes not increase with Allah’

The next occasion when interest ismentioned is in Surah Nisa, verse161 where Allah says;

‘And because of their charging Riba, whilstthey were prohibited from it’.

Then came the first explicitprohibition of Riba in 2 AH, aroundthe time of the battle of Uhud. The commandment is found inSurah Al-Imran, verse 130 whereAllah says;

‘O those who believe do not consume upRiba, doubled & redoubled’.

Shortly after the conquest ofMakkah in 8AH, the mostcomprehensive and damningindictment of interest wasdelivered in the Qur’an in SurahBaqarah verse 275-280, whereAllah says;

‘Those who take usury will not stand onthe Day of Judgment except as he who hasbeen driven mad by the touch of theDemon. ………….Oh you who believe giveup what remains of Riba if you arebelievers. But if you do not then listen tothe declaration of War from Allah & hismessenger (SAW). If you repent, your’s isyour principal and nothingmore…………………………..’

In the year 10 AH, The Prophet(SAW), in his famous last sermonat Mount Arafat said;

‘All interest obligation shall henceforth bewaived. Your capital however is yours tokeep. You neither wrong, nor be wronged.Allah has judged that there be no Ribaand that all interest due to Abbas ibn AbdAl-Muttalib shall henceforth be waived’

Hadith

The Qur’anic Banon Interest

NB:Riba: Is Arabic for interestAH: Denotes After Hijrah


‘The modern Banking system manufactures money out of nothing. Theprocess is perhaps the most outstanding piece of sleight of hand that wasever invented…If you want to be slaves to the Bankers, and pay the costsof your own slavery, then let the Banks create money’

Lord Josiah Stamp, Former Director, Bank of England

Throughout history, people have alwaysused coins made from precious metalse.g. gold and silver as a basis for storingwealth and facilitating trade. Modernbanking replaced this traditional assetbased system with paper based banknotes.

The origins of modern banking go backto the Goldsmiths of the 16th Centurywho stored gold on their premises forindividuals who needed somewhere tosafely deposit their wealth. Receiptswere then issued to those who availed ofthis service. When the receipt wassubsequently presented to the Goldsmith,the gold would be returned. As time wenton the general public started to buy andsell using the paper receipts in place ofactual gold pieces or coins. This paperbased system relied heavily on the abilityof the Goldsmiths to return the gold ondemand and is the origin of the obligatorypromise on each and every banknotestating ‘I promise to pay the bearer ondemand the sum of X pounds’.

At this critical juncture, the Goldsmith’sdiscovered one of the greatest albeitunethical money making ideas of all time.The Goldsmith’s realised that peoplewere not returning to them regularly fortheir gold and relying instead entirely onthe receipts which were now beingexchanged as legal tender. As long asthe public had confidence in these receipts

then they could be printed and issuedwithout any corresponding increase inthe amount of gold being deposited.

The market could then be flooded withthese artificial receipts, which would beused as legal tender. This would allowhuge loans to be forwarded to thegeneral public, thereby earning theGoldsmiths interest. As time went onand their credibility was enhanced, theGoldsmiths realised that they needed tohold less and less gold in relation toreceipts issued leading to the birth ofthe ‘fractional reserve system’.

Fractional reserve is therefore a deceptivesystem which allows an expansion in thesupply of paper money without acorresponding rise in the assets held bythe bank.

This new money is only available tosociety through taking an interestbearing loan from the bank, and hasbeen the cornerstone of the Westerneconomic system from the days of theGoldsmiths back in the 16th Century tothe present day.

Consequently, the money that we own is notbacked at all by real assets. It is simply andpurely worth only the paper it is written onand is only deemed to have additionalvalue because society has confidence inthe economic system.

A Brief History ofInterest Based Banking


‘The richest 225 people own more wealth than the poorest 2.5 Billion’United Nations Development Report, 1998

FACT

Failures of InterestBased Finance

“If the American people ever allow the banks to control the issuance of their currency, firstby inflation then by deflation, the banks and corporations that will grow up around themwill deprive the people of all property until their children will wake up homeless on thecontinent their fathers occupied. The issuing power of money should be taken from thebanks and restored to Congress and the people to whom it belongs. I sincerely believethat banking institutions are more dangerous than standing armies.“

Thomas Jefferson, Former President of the United States

The governments and elites of the Westernworld clearly have a vested interest in ensuringsociety retains confidence in interest basedbanking. The biggest threat comes frominflation which over time devalues theworth of a currency and thereforeundermines confidence in the system.

This effort to control inflation has beentaken very seriously, with the developmentof an entire economic school of thought‘Monetarism’. This ensures the supply ofmoney is tightly regulated and does not

lead to excessive price rises in times ofeconomic growth. Conversely, control isloosened and banks encouraged to supplymore money in times of depression as amechanism designed to artificially boostgrowth. Central Banks all over the worldhave also been tasked with a delicatebalancing act of raising central interestrates on the one hand to ensure inflation iskept under control and lowering interestrates on the other hand to prevent recession.This ‘boom & bust’ cycle has the followingglaring faults:


Banks are given too much power

The ability to create money gives banks and other financial institutions incredible levelsof power by permitting the creation of artificial wealth for which they have carried outno corresponding real economic activity. This elite have an unacceptable level ofcontrol over society’s well being. Abuse of this power takes many diverse forms but canperhaps best be understood by examining the impact of debt on the third world.

Economic growth is hindered

As money is permitted to attract a rate of return, banks are able to generate profitsthrough interest. Banks will invariably prefer to lend to those who have the greatestcollateral because they represent the lowest risk of default. Those who have the mostviable business plans are not always those who have the greatest collateral.Consequently, interest based banking inhibits economic growth by failing to promotethe best business ideas which, if supported would result in higher economic growth.

The rich get richer

Those with the most collateral are by definition the wealthiest in society, By givingthese people preferential access to money, capitalism has a persistent tendency tofavour the rich and discriminate against the poor, ensuring that the rich just keepgetting richer, and the poor just keep getting poorer.


The Catastrophic Impact of Debton the Developing World

They no longer use bullets and ropes, they use the World Bank and IMF

Jesse Jackson, US Civil Rights Leader

FACT

FACT

FACT

FACT

FACT

FACT

FACT

In 1944, the IMF & World Bank were created inorder to provide developmental assistancefor non-commercial projects and to ensurestability through assisting nations in short-term balance of payment difficulties.

In 1987, the Institute for African Alternatives(IAA) called for the dissolving of the IMF &The World Bank, largely on the groundsthat they had done more harm than goodto the developing world.

The IAA established that banks were happyto use future income streams stemming fromthe mineral wealth of developing countriesas collateral for making massive but dubiousloans to ruling cliques. Consequently,interest based financing resulted in banksbeing adequately insulated againstdefault, but the developing countries wereleft impoverished. Empirical reports andanalysis have revealed the following:

In 1989, The World Bank conducted areview of its policies and was unable topoint to one single project which hadimproved the lives of the citizens in thecountry in question.

No country has ever paid off debt takenfrom the World Bank or private Banks.

The Debt imposed by the World Bank isnot on the heads of individual leaders,but rather becomes a burden on thebacks of ordinary citizens.

Consequently the reckless actions of acorrupt dictator will impoverish unbornfuture generations.

For many developing countries, interestrepayments often constitute a greater %of GDP than Education, Healthcare andinfrastructure combined.

The level of debt INCREASED by 61%from the 1980’s to the 1990’s. Livingstandards in Africa have stayed level ordropped during this period.

During 1982-90, developing countriespaid £1.3Bn in interest & Capital tocreditor countries.

The largest faith group in 3rd World are Muslims.

In essence loans forwarded to thedeveloping world are not linked closelyenough to specific developmental projects.They therefore constitute pure interestbearing debt, secured against what preciouslittle natural resource these countries mayhave. Corrupt leaders have used loans toline their own pockets instead of improvingtheir countries services. Populations havesuffered as their mineral wealth has beenused to service interest based debt insteadof being used to provide essential services.

The above clearly demonstrates the failureof interest based financing to ensuresocieties overall well being.


Islam and Capitalism both agree that money is used as a store of wealth,and also as a means of exchange. However, Islam, unlike Capitalism doesnot view money as a commodity which can be bought and sold at a profit.

By denying money the role of a commodity,Islamic finance ensures the only way afinancier can generate a profit is by purchasingan equity share in a business venture inexchange for his capital. This onedifference strikes at the heart of the evils ofinterest based banking by ensuring moneyis better able to flow to those projectswhich are viable and away from thoseprojects which offer the greatest collateral.This in turn enables economic growth ratesto increase and the wealth generated to beshared more equally by society.

Islamic financing only permits thegovernment to issue currency which mustbe backed by an underlying asset. This inturn, removes from private banks, controland power over the issuing of artificialpaper money.

The origins of modern economic theorycan be traced back centuries. In ‘Ihya Al-Uloom Ud-Deen’, Imam Ghazzali says thefollowing about money;

‘The creation of dirhams and dinars area blessing from Allah (SWT) as theyhave no intrinsic usufruct or utility. Butthere must be a basis of measure onwhich price can be determined as theexchanged commodities are neither ofthe same type nor the same size…….Therefore all these commodities needa mediator to judge their exact value,hence Allah (SWT) has createddirhams and dinars’

Imam Ghazzali

Contemporary Shariah scholars havedeveloped three modes of Islamicfinancing for use in today’s banking system.

It must be understood that the first twomodes of Murabaha (cost plus pricingwith deferred payment) and Ijara (leasingwith buy back) do not have the capacityto cure the ills of interest based financing.This is because Murabaha and Ijara havebeen designed to operate within theinterest based system. Murabaha & Ijarahave reluctantly been approved byscholars on the basis that they:

‘may help one refrain from a glaringsin and save him from the evil fate ofdisobedience, which, in itself, is acherished goal of a Muslim, though atan individual level. Moreover this mayhelp society to advance gradually tothe ideal target of establishing a totalIslamic order.’

Justice Taqi Usmani

Our ideal target can only be achievedthrough the third mode of Musharaka; orequity financing. We now proceed tocontrast Musharaka or equity financingwith interest based financing.

The Nature ofMoney in Islam


Interest based financingcompared with Musharaka

Another way of illustrating this point would be to observe the working mechanicsof a bank and its relationship with depositors and borrowers.

The borrowerpays the bank

the agreedrate of interestnormally 6-7%and keeps the

rest as profit

Depositors

Depositorsprovide bankswith money

Borrowersinvest thismoney togenerateprofit

Bank offersmoney in theform of loansto borrowerswho havecollateral

The bankpays the

depositors theagreed rateof interest -

normally 1-2%and keeps

the rest

100% ofprofits are

received byborrower

InterestBased Bank

Borrower

BusinessVenture

Interest Based Finance Musharaka Finance

Bankpurchasesshare inbusinessventure

Bank recievesshare of

profit insteadof interest

from venture

Borrowerrecieves

profits notinterest from

businessventure

Investorsshare riskand returnof businessventure

Depositors -Investors

MusharakaBank

BusinessVenture

The above demonstrates the need to merge the disciplines of investment and banking

Musharaka requires a change of mindset so that depositors are viewed as investors.


Musharaka - Islamic EquityFinancing

The illustration of Musharaka allows us to draw the following conclusions:

Equity based finance is well established in the West, principally through investmentvehicles like Venture Capital Funds. These vehicles operate as niche players as they tendto work with those who are unable to obtain loans from the bank. By refusing to treatmoney as a commodity, Islam compels banks to operate on an equity basis.

The single biggest challenge facing Islamic banking is to adoptMusharaka and move away from Ijara and Murabaha.

In response to this state of affairs, 1st Ethical have launched a viable modelof Musharaka equity finance.

Risk and return must be shared between investor and borrower

Musharaka only allows the investor to attract a return through purchasing a share in thebusiness venture. As such, risk and return are shared between the borrower and theinvestor. Money is not deemed to be a commodity so cannot attract a rate of return inits own right.

The bank is encouraged to identify the most profitable ventures

The bank understands its profit is linked directly to the level of profit the business venturewill generate, because it is denied an opportunity to earn a fixed rate of interest. Thebank will therefore have greater incentive to seek out profitable ventures, instead of relyingon those which offer greatest collateral.

Economic power is retained by government

By ensuring all paper currency is fully asset backed, private banks and financial elites are nolonger able to manipulate the economic cycle. They are also unable to fraudulently amasshuge amounts of wealth through the fractional reserve system.

Greater wealth is generated

More profitable business ventures will generate more profit for the bank and thus forindividual investors. The borrower also benefits, as he has improved access to financecompared to interest based finance.

Wealth is distributed more equally across society

By increasing returns to investors on the one hand and improving access to capital forborrowers on the other, the distribution of wealth across society is more equal.


The 1e Musharaka Fundsupported by 1st Ethical

The following is an extract from the marketing brochure for the1e ‘Musharaka Fund’. This fund represents a genuine attempt to introduceMusharaka equity based finance.

‘Musharaka’ is derived from the Arabic root verb ‘shirkah’which means to ‘jointly participate’. It denotes the conceptof a joint venture between two parties when entering intobusiness. Musharaka lies at the heart of Islamic Financingphilosophy, where the notion of sharing in risk and returnbetween investors and entrepreneurs finds its natural home.Musharaka is a business venture which will attract capital fromall individuals in society and employ it in nurturing the mostlucrative business ideas. This pure equilibrium will be achievedby the intelligent attraction of capital and comprehensivedue diligence. The net result will be interest-free financingfor the best business ideas, whilst simultaneously enablingcapital to generate extraordinary investment returns.

……..Interest based financing has never been able to equitably or efficiently allocate profitbetween the lender and borrower resulting in the persistent concentration of wealth in thehands of the few. When the principle incentive underpinning commercial financing changesfrom a guaranteed interest based return to become profit sharing then both the borrowerand lender will prosper. Not just in absolute terms but also for each citizen relative to oneanother. Wealth distribution will be better balanced than under the current status quo. Inaddition, such a system would make far more efficient use of available capital thereby liftingproductivity and profit for all. It is this ideal which via Musharaka we hope to emulate. AsLincoln famously said ‘money rightfully fulfils its role as a ‘medium of exchange’ and becomesthe servant of all humanity, not the master’.

You can find out more about the 1e Musharaka Fund by loggingon to www.musharaka.net or ringing 01204 559914


Summary

‘So lose not heart, Nor fall in despair,For you are bound to rise, If you are true in faith’

Al-Quran 3:139

‘Actions are rewarded according to intention’. This powerful hadith, bylinking reward to the intention instead of the success of a given action, allowsthe sincere amongst us to be winners tomorrow even if we fail in achievingour objectives today. The goal of replacing interest based finance requiresus to travel along a challenging, difficult and unique path towards Musharaka.But we take every step knowing our Creator knows better than we do whatis beneficial for us.

This booklet has been our attempt to:

Explain the concept of interest, concludingthat interest is any amount repaid orreceived above the principal.

List the Qur’anic revelations relating tointerest. We clarified that the ban on interestwas revealed around 2AH, allowing sufficienttime for the Prophet (SAW) to explain theconcept to the Muslims.

Explain the origins of money creation bythe 16th century Goldsmiths and how thesepractices laid down the foundations for themodern-day fractional reserve system.

Explain the shortcomings of interest basedfinance, especially with regards to 3rd world debt.

Explained the Islamic view that money is a‘medium of exchange’ and not a commoditywhich can be traded in its own right.

Explain Murabaha and Ijara are not capableof achieving Islamic economic objectives.They can only by viewed as a steppingstone towards true Islamic finance.

Present an Islamic solution to interest basedfinancing through Musharaka equity finance.

Demonstrate graphically that the disciplinesof investment and banking need to mergein order for Musharaka to succeed.

Introduce 1st Ethical’s Musharaka fund, whichrepresents a first in achieving true Musharaka.

There are many well intentioned individualswho recognise the failures of Capitalism,especially its failure to distribute wealth fairly.We pray this booklet is a means of explaininghow these failures can best be remedied andthat it guides those who are beguiled byCapitalism onto the Straight Path. May theAlmighty make us all a means of the revivaland establishment of interest freefinancing. Ameen

Sources

There are a variety of sources we consultedin preparing this booklet. A full list iscontained in the in-depth research paperwritten on this subject which can be foundat www.1stethical.com/publications.

1 s t E t h i c a l ’ s G u i d e t o

© 2005 All rights reserved


1st Ethical Limited Chorley House

58 Chorley New Road Bolton BL1 4AP

Phone: 01204 559914Fax: 01204 399786

Email: [email protected]

1st Ethical Websitewww.1stethical.com

The Musharaka Fund Websitewww.musharaka.net


Disclaimer: This document does not constitute financialadvice under the Financial Services and Markets Act 2000which supersedes the Financial Services Act 1986.

Winners of the Shell Livewire:‘UK’s Fastest Growing Business of the Year’ award‘North-West Entrepreneur of the Year’ award

TM


TM

Why Islam has prohibited Interest & Islamic Alternatives for Financing

TM

why islam has prohibited interest & islamic alternatives for financing

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