Trade and Interest are the same

The title is taken from Quran 2:275.

Here’s why trade and interest are the same. A conventional bank advances a loan and charges interest on the loan, the borrower pays in instalments. So the loan amount can be “x” (or 100, if you want a number), the interest rate can be y% (or 5%) and the total comes up to x (1 + [y/100]) (or 100 + 5% of 100 = 105)

Number of instalments, let’s set it at n (number can be 5). Payment per instalment is then {x(1 + [y/100])}/n (in our numerical example, comes to 21).

Now to the case of an Islamic bank. The Islamic bank buys the good in question (“x” or 100) then resells it to the customer with some added on (total x (1 + [y/100]) or 105). Instalments of n are due (or 5). Again the instalment payments amount to {x(1 + [y/100])}/n (or 21).

So both are the same right? One way or another, they amount to the same thing.

Unfortunately, they do.

The example is one of the simplest arrangements in Islamic banking, known as murabaha. The bank is not dealing in interest, is it? Seemingly, no.

The differences and similarities:

  • Difference: One is profiting from the loan amount via interest, one is trading the good.
  • Similarity: The profit margin is the same in both.

There is a far subtle difference here that is being covered up by the way we have mandated banks to function. Conventional banks are barred from taking part in trading goods by legislation (the rule was slightly modified, leading to the JP Morgan aluminium price fixing scandal, http://www.huffingtonpost.com/2013/08/07/jpmorgan-aluminium-prices-chase-glencore-goldman_n_3718773.html). It makes sense to bar banking institutions from dealing directly with consumer goods.

So if banks are barred from being directly involved in the trade of goods and can only “finance” a purchase by a party, the only way for them to earn a return on their lending activity has to be by charging interest. Conventional banks charge interest on the loan amount, Islamic banks take possession of the good in question and resell it to the customer at a higher price. The difference being that in the first it is just the loan amount that the bank lays claim to, in the second the bank owns the commodity/good in question till the payments have been completed.

Most proponents of this style of finance will point to the “ownership status” as that differentiating the two transactions. I digress.

Let’s go over the steps for a mubarahah transaction. From Abdul Rahman’s “The Art of Islamic Banking and Finance”:

  1. Customer issues an order to the bank or finance company to buy the good.
  2. Finance institution buys the item.
  3. The institution then resells it to the customer at an amount that is cost + profit margin for the institution.

This process seemingly avoids earning interest on a loan. The institution is carrying out a trade and not profiting from interest. Question: In the case of a normal store, do customers come place their order then have the product delivered or pick it up? Is that extra step needed when making a “trade”?

It is often said that the risk is shared between the two parties in Islamic finance while the entire risk is transferred to the borrower in conventional finance, however, there is some risk that cannot be shared. In particular, when you make an investment and procure a certain number of goods, you run two risks – one good and one bad. Good – demand outstrips supply. Bad – supply outstrips demand. That is the actual risk of a business. That the firm or company ends up with unsold inventory that has to be written down or let go of at a loss. Does this happen when carrying out the murabaha transaction? There is no trading risk involved (there still is little risk to the product itself). Trading risk as in, the product the trader carries will not find a buyer. The trade is “ensured”, like the return on a loan is “ensured”. This security of trade is what is against the principle of shared risk, that each side take up their share of the risks of trading. This is the financier ensuring a definite return on their “investment”, which is why riba was banned.

The crux of my argument is best summed up in the following:

It is narrated on the authority of Amir al-Mu’minin (Leader of the Believers), Abu Hafs ‘Umar bin al-Khattab (may Allah be pleased with him), who said: I heard the Messenger of Allah (peace be upon him), say:

“Actions are according to intentions, and everyone will get what was intended. Whoever migrates with an intention for Allah and His messenger, the migration will be for the sake of Allah and his Messenger. And whoever migrates for worldly gain or to marry a woman, then his migration will be for the sake of whatever he migrated for.”

Related by Bukhari & Muslim

What is the intention behind the sale? Is it to carry out a trade? If so, where are the rest of the trades? Why do people have to apply for special permission to trade with the institution?

Afterthought: As I wrote this piece, something more began to stir in my mind. I will need to study the topic deeper and further elaborate my thoughts regarding this.

It seems I am not alone in my questions, that greatly relieves me.

3 Comments

  1. Ahmed Waris al Majid

    This happened with me a few years ago when I needed a loan and wanted to strictly avoid Riba. So I contacted an Islamic Bank in California, and by the time I ended my conversation with them, I had a strange uneasy feeling I was being charged the same amount as a non-islamic bank, which was a sad revelation.

    Reply
    1. Ahmed Waris al Majid

      It is not the “being charged” portion that is the focus of my argument, the argument is: is the transaction a valid trade in the first place?

      Reply
  2. Ahmed Waris al Majid

    I’m always puzzled when it comes to Islamic banking concepts. This piece raises more questions now, which I appreciate.

    Reply

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