Lending and Borrowing: An Overview

By A.L.M. Abdul Gafoor

Appropriate Technology Foundation

Groningen, The Netherlands

Lending and borrowing between humans has taken place since time immemorial.  People borrowed and returned implements, animals, foodstuff, etc from their friends, neighbors and relations.  They returned the same after use or in the case of foodstuff consumed and returned the equivalent when they came into possession of similar stuff.  When money came into being people borrowed that too and returned.  It was all on the basis of mutual help — the borrower today may be the lender tomorrow and vice versa.  As time progressed professional moneylenders appeared on the scene, and they demanded a “fee” for the use of their money.  This fee is now called interest, but till a few centuries ago it was called usury.  In Islam, interest or usury, which in Arabic is called riba, is prohibited.  Demanding, receiving, paying, witnessing, and anything connected with these activities are all equally prohibited.  There is no controversy over this.  Similar prohibitions exist also in the religious laws of Judaism and Christianity.  Although other religions may not have written laws explicitly prohibiting usury, their followers do eschew the practice of usury. 

1.1  Lending and borrowing: then and now

In earlier times, lending and borrowing was mainly between individuals, and what was meant by usury in these transactions was commonly known and understood.  In money matters, any amount over and above the lent sum was defined as usury or riba.  The ill consequences of usurious lending — the ruination of individuals and families — were witnessed at the local level and therefore the community held the practitioners in contempt.  But the need for capital and loans existed and, in the absence of alternative solutions, the usurious lenders became an indispensable component of the society.  They also exercised invisible power over their clients’ resources.  If the clients happened to be in authority, the power extended to other areas as well; the greater the client’s authority the extensive the power of the lender. 

Kings and nobles needed money to wage war or to live extravagantly.  Moneylenders were happy to oblige, not only for the profit it brought them but also for the privileges and concessions they could extract from their royal clients.  Mining concessions, special trading licenses, tax exemptions, lucrative contracts for public projects, land grants, and personal privileges such as royal titles and appointments to influential positions are just a few examples.  These dealings were carried out discretely and the public was generally ignorant of them.  But the citizens paid the price, one way or another.

The most important concession so extracted was the passing of the Usury Law.  This law introduced an innocuous term called interest and usury was defined as high rate of interest.  Usury was still prohibited, in deference to the Church, but “reasonable” interest was made permissible.  What is reasonable and what is high was to be determined by the parliament!  Now that interest is legal, kings may lose their thrones, soldiers may lose their lives, families may lose their livelihoods, but the country must pay its debts with interest.  Moneylenders extracted their pound of flesh. 

In recent times, presidents and ministers have replaced kings and nobles, and corporate and international financial institutions the individual moneylenders.  The same game, only new names and wider settings.  It is now global, the suffering is universal, and the statistics are in the public domain.  Yet, hardly anyone dares to point the finger at the real culprit — usury, whatever the legal name it may assume.  Neither are the real needs objectively looked at.  Consequently, no meaningful alternatives are offered.

1.2  Lender, borrower and the Church: different goals

Governments, businesses and individuals need money for various purposes.  The methods of catering for these needs must match the purpose for which the money was needed.  A mismatch can lead to disastrous consequences, but this requires much thought and effort.  Borrowing is an attractively easy solution, and this is what the moneylender would recommend for all situations, for it is the most profitable one from his point of view.  When the borrower is impatient or desperate and the only game in town is the moneylender, borrowing from him is the only option and the consequences are inevitable.  To avoid disasters, then, we have to first study the different purposes for which money is needed and then devise methods most appropriate to each purpose.  We have to provide more alternatives.  The moneylender has only one purpose and concern: his profits and benefits.  But the society has more and larger concerns, for it is its responsibility to cater for and protect all its members, individually and as a whole, those living now and those still to come.  In this connection, it is well to remember that all the basic rules, methods, procedures and laws relating to banking and finance were either formulated by the moneylenders themselves or they had a hand in their design and/or execution.

When the usury law was proposed, it was argued that the merchants needed financing, they made profit using the borrowed funds and, therefore, they had the ability to pay the financiers a portion of that profit.  Very reasonable.  The trouble was, once the law was passed, it was applied to all situations — whether the borrowed funds brought about a profit or not.  The Church had become too weak but still dogmatic, and the merchants and moneylenders too strong.  The Church could not grasp the new need, brought about by the increased trade in Europe, and failed to provide an appropriate solution.  Nor could it argue successfully to limit the application of the new law to trade financing only.  Neither did it demand that the law should not be applied to non-profit-creating loans intended for basic consumption needs.  It seems that the Church granted the moneylenders a blank cheque on a platter, by default — by its all‑or‑nothing insistence on a complete prohibition and by failing in this dogmatic stance.

1.3  Islamic approach: different consequences

In Islam, the situation was different.  First, from the beginning of the history of Islam in the seventh century, the (large-scale) merchants’ need for (additional) funds was fully recognized and provided for.  There were two ways in which a merchant could finance his trade.  One: two or more merchants could pool their funds together and conduct the business together and share the profit or loss according to their (financial) contribution.  This was called musharaka, similar to the present-day partnership company.  Two: a merchant could obtain his funds from one or more financiers and share the profit with his financiers in an agreed proportion.  But he has full freedom in the conduct of his business, and any genuine financial loss must be borne entirely by the financiers.  This was called mudaraba, similar to the present-day shareholder companies.

Consequently, while the riba-prohibition of Islam related to all lending and borrowing operations, it took special note of the financing needs of traders and businessmen as well as the investment and income generation needs of those who possessed extra funds.  It does not mean that riba is acceptable in these cases; it is prohibited here too.  But a different and equitable solution was already available in Arabia when the Qur’an was revealed; so it approved of it and went onto prohibit riba in all cases.  Therefore, the merchant-need-based and return-on-investment-based arguments of Europe were not relevant or valid in the case of Islam and Muslim lands.  It is necessary to recognise this fact.  That is, the all-embracing usury-prohibition law of the Church and the riba-prohibition law of Islam are not exactly equivalent, despite the similarity of appearances. 

Second, throughout the long history of Islam, Muslim caliphs, kings and nobles have, by and large, kept away from borrowing at interest.  Even though many of them had their share of shortcomings — in common with their counterparts elsewhere — their belief in after-life and the strong words used by the Holy Book against the dealers in riba kept them away from it.  The same applied to all would-be moneylenders as well.  This saved the Muslim masses and the society from many of the ills experienced by other societies, even though this blessing goes generally unrecognised and unappreciated.  Even under colonialism they have enjoyed this benefit.  However, it would be naïve to believe that there existed absolutely no riba-based lending and borrowing, but it certainly was personal, local, small, isolated, discrete and unorganised.

Only in the second half of the twentieth century, especially after many countries became independent, established their own governments, and had to run the affairs of the country on their own, that they began to experience the claws of interest through the banking system.  They needed the banking system because it provided the various services needed by the different sectors of modern society.  But the moneylenders had developed it for their own benefit, based on the all-embracing usury law.  It did not make the differentiation the Qur’an had made.  Muslims had slumbered through the formative years of the modern world, and failed to build on the head start they had and shape a business and banking model to suit modern needs.  Yet their desire to comply with the commandments of their Creator did not die.  Their leaders and intellectuals have awoken to the demands of their constituents, experiments with Islamic banking have begun, but there is still a long road to travel.

1.4  Lending with and without interest

Before we travel further, let us state clearly what we mean by interest and riba and then note the difference between lending/borrowing with and without interest, usury or riba.  Limiting ourselves to monetary dealings only,[1] any benefit demanded or received by a lender in addition to the sum he lent is termed riba.  This would, however, include both monetary and non-monetary benefits.  Interest, on the other hand, would legally limit itself to monetary benefits only.  It is useful not to forget this difference and its significance.

When a person lends without any benefits to himself, he is bound to assess the ability of the borrower to pay back the capital as well as to ensure that the capital is to be used for a purpose that he approves of.  It is also a condition of such borrowing that the lender and the borrower are known to each other or that a reliable mutual friend/relative/acquaintance has introduced them.  In such a situation, there is an unspoken moral/ethical responsibility (and a sense of shame and reluctance, otherwise) in asking, recommending or granting such a loan. 

All these restraints are absent when the lending is done at interest.  The lender assesses only the borrower’s ability to (or the means to) repay the capital and the interest.  A collateral is usually demanded, and by the very nature of interest — its dependence on time — the lender expects that he would eventually be able to acquire the collateral at a favourable price.  Both the interest and the possibility of acquiring property at very low cost drive the moneylender to readily accede to request for loans, as well as to encourage such requests.  Thus, when riba or interest enters the picture, the attitudes of both the lender and the borrower head in a direction directly opposed to the one prevalent in its absence.   This riba-induced change of attitude is remarkable, as are the opposing characteristics of the two attitudes.  One discourages debt, and the other encourages it.  One restrains expenditure on morally or ethically unacceptable items and purposes; the other places no such restrains.  One is open to social control, the other not.  One limits both the size of borrowing and its frequency; the other encourages increase in both.  One encourages short-term loans; the other thrives on long-term arrangements. 

The last two are very interesting.  For since more and larger loans would bring more profit to the lender he would try to acquire more funds.  This eventually led the moneylender to borrow from others at low rates of interest and use the same funds to lend at higher rates, as if it were his own.  The bank’s credit-creation technique was also developed for the same end.  Furthermore, long-term loans provide a stable and steady source of income to the moneylender.  This and the availability of increased funds led the banks to widen their reach and, in recent times, to enter previously untapped areas such as housing finance and student loans.

1.5  Need for money

Let us now examine the need for money in some detail.  To begin with, there are purposes that bring profit, and others that do not.  Within these two categories there are necessary, unnecessary and harmful purposes.  In the modern world one has to also make a difference between the needs of individuals, business organisations and governments.  Let us take them in turn.

1.5.1  Extravaganza and vanity

When the borrowing is for extravaganza or vanity, the borrowed fund produces no profit.  Therefore, if the borrower is unable to repay the loan and interest from his other income sources, the interest would keep on mounting and the moneylender would eventually confiscate the collateral.  All religions and sages throughout the ages have condemned extravaganza and vanity, and have advised against it.  The Qur’an has specifically prohibited spending in vanity.  Here the reference is to one’s spending from his own resources, and the onus is on the individual.  As such, if one engages in such spending using borrowed money, he is seeking his own doom.  Yet, by making the riba-prohibition applicable to both the lender and the borrower, Islam seeks to protect people against their own selves.  If there is no borrower there will be no lender; if there is no lender there will be no borrower.  This closes all doors to doom.  Thus there is no need to find any other solutions to the apparent need of the extravagant.

1.5.2  Housing and education loans

Housing and education are real needs, and therefore their financing deserves close attention.  Building or purchasing a house is obviously a capital acquisition.  So is education, though it does not seem that obvious.  Capital acquisition has always been done using one’s own savings or wealth.  It should continue to be so.  House-owning leads to individual and collective independence.  In turn they add to national wealth and well-being.  This fact is recognised by wise governments and they actively encourage private initiatives.  Free education has produced wonderful results in the twentieth century. 

However, the modern trend, especially in the developed world, is to have them financed by long-term bank loans.  But unlike the loans for commercial purposes these loans produce no immediate profit to the borrower.  Yet, to a moneylender a loan is a loan, and from his point of view these have some attractive advantages, including a secured regular return guaranteed for a long period.  In many developed countries the fiscal laws encourage borrowing and discourage saving/investment/capital acquisition by taxing the interest/dividend received from the latter and granting tax exemption to the interest paid on loans.  These laws enable the banks to price the products very attractively and encourage mortgages, but the subsequent experience of the borrower and the effect on the nation are different. 

For example, a house-owner who bought it on mortgage remains a debtor for practically the rest of his working life and ends up paying several times the original price.  On the other hand, if he fails to pay his instalments on time, he is kicked out as if he were only a tenant.  A student forced to take a loan for his education leaves college/university with a certificate and a millstone round his neck.  He may become a government administrator, business executive, politician or any other, but he is still a bonded man.  And a bonded person cannot think or act independently.  Anyone whose parents are too poor or unwilling to pay for his education, and himself refuses to be bonded, is denied higher education.  It is a national tragedy.  These characteristics of housing and education set them apart from other needs. Therefore these require special treatment.   

1.5.3  War

Wars, in general, bring only death and destruction to people and property — never any profit.  The winner and the loser are both losers in the end.  If a war is fought by borrowing money at interest, win or lose the country will have to pay the debt with interest, and borrow again to rebuild.  Whether the war was an offensive one or a defensive one, in the end, only the moneylenders celebrate — on both sides.  Consequently, in history as well as in the present time moneylenders have played an important behind-the-scenes role in both beginning and prolonging wars.  Only a total prohibition of riba on both the lenders and borrowers and its adherence at all levels, especially at the highest levels, could eliminate this factor in the war equation.  Since everyone is a loser in a war, it is in everybody’s interest to avoid any war; eliminating its financing by funds borrowed at interest will go a long way in this effort.  Therefore we need not seek any other solution to this contingency.

1.5.4  Government expenditure

Government expenditure consists of two types: capital and current.  The funds for both are expected to come from taxation.  So a government’s ability to acquire capital goods — to buy equipment and material and to build roads, bridges, schools, hospitals, communication infrastructure, etc — are dependent on, and limited by, the tax revenue.  However, the current expenditure, such as salaries of government officers, supplies and maintenance, has priority over capital expenditure.  Often, like in the case of an individual, little is left over from the tax revenue for capital expenditure.  Consequently, since all capital expenditure cannot be postponed indefinitely, there arises a budget deficit.  A budget deficit is financed by printing money, borrowing, or both.  Printing money leads to inflation, which is a tacit form of taxing the population.  Borrowing increases national debt and interest payment.  Credit creation by banks based on the new money (printed or borrowed) increases inflation even further. Government bonds

Government bonds is one of the instruments used for borrowing money.  Since capital expenditure on infrastructure does not produce any profit, borrowing at interest leads to additional current expenditure in the form of interest payments.  This in turn requires curtailment of other current expenditure or further borrowing.  Government bond is big business, it provides those who have money to spare with a great source of guaranteed return.  But the public debt it creates keeps mounting.  So does the interest on it.  And the inflation generated by money-printing and credit creation add onto the interest rate and lead to further increase of the public debt. 

Thus once a government begins to spend more than its tax income, or fails to tax sufficiently to cover its essential expenditures, it gets into a vicious cycle of borrowing to spend and spending to borrow.  To tax sufficiently the country must produce enough, and taxes are always unpopular.  Borrowing is the easy way out and the country finally ends up in the grip of the moneylenders — national and international — no matter which party or person runs the government.  The debt is open and legally binding but the grip — do this or return the loan, do that or no more loans — is unseen, undeclared and least understood, and hence more hideous.  It is a great mystery, though, that developed countries with very large national debts keep on prospering, while underdeveloped countries with much smaller debt burdens crumble under it.  However, this is no place to probe into that mystery.  Treasury bills

It is a time-honoured practice of any individual to spend on his needs from what he has earned.  If there is no more money left, he either curtails his spending or postpones it till he comes into sufficient funds.  If his income is fixed and regular, such as that of a salaried employee, and he finds himself short of money at the end of the month, he must curtail his expenditure.  Otherwise he will find himself at a worse position next month because his income is not going to increase next month, but the gap would have doubled.  If, instead, he borrows to bridge the gap he will have to borrow the next month and the following month too — an increasing amount every subsequent month.  Eventually he will have to borrow to eat, and pay the loan as soon as he receives the salary and then borrow again for the expenses of the next month.  Suppose he borrows at interest, then he will be bankrupt very soon on account of the interest payments, even though he continued to work and earn.  One could get out of this situation only by earning more or selling some property and paying off all the debts and begin to live within the income and spend only from already earned income.  Or by severely curtailing his expenditure, save and pay off the debts, and by living within one’s means from then on.   

In the case of government current expenditure too, somewhere along the line, they threw away the time-honoured practice of spending from realised earning (collected tax) and began to borrow and spend, expecting to repay when the tax revenue came in.  This committed them to an interest payment cycle.  An instrument called the Treasury Bill was developed for this purpose.  This, in effect, is a three-month loan, interest paid in advance.  The funds are used to pay the current expenditure for the next three months and the loan is paid from the taxes collected at the end of the quarter.  New treasury bills are issued every quarter, month or week.  The cycle goes on.  An elaborate set of financial tools and markets are built around this.  So elaborate that no one remembers when, how or why it started in the first place, or how it keeps perpetuating itself.  It is a given in Finance and Government, and theory and practice have canonised it.  Moneylenders (private individuals, banks, financial institutions, insurance companies, pension funds, etc) thrive on it, and a whole army of professionals service it.  But the general public pays for it, suffers the consequences, and is blissfully unaware of what is happening to it.  Enlightening the public further on this point is not within the purview of this essay.[2]

1.6  Islamic banking confusion

Islamic banking is rooted in the facts that riba is prohibited and trade is permitted, and the profit resulting from trade is permissible income.  By extension, it was argued that interest, which is equated to riba, must be replaced by profit.  To achieve this, lending transactions must be replaced by trading transactions.  This simple concept is religiously applied to all situations.  Where the difference was not clear, legal devices were adopted to dress it up as trade and profit.  One may cheat himself, but can you fool God?  He may be amused by our poor attempts, but does He approve of it?  Whatever God does or does not, others are laughing at us.  Sincerity is supposed to be the bedrock of our relationship with God.  If we are sincere in our efforts to obey His commands, He will certainly show us the right way. 

When the commands were issued 1400 years ago, they were directly understood in the context of the social and economic environment then prevailing, and their application was easily achieved.  Today, the environment has changed and that makes the application seem difficult.  But the solution is not through legal devices, but through our studying and understanding the new environment and sincerely seeking to apply the commands without any adulteration.  Trade and profit have their place, but it is not appropriate for all occasions.  We have to explore other options.  If our intention is sincere, He will certainly guide us to the right solution.

1.7  Solutions

By looking at the needs of society, we can identify three different kinds of needs — investment and finance, banking and loans, and charity — and they each need be handled using a different technique.  Moneylenders offered one solution for all three needs because it was to their advantage, but the society has to cater for larger concerns and therefore must offer more appropriate solutions.  The Qur’an points out these different needs and presents us with different techniques to suit each need.  It is for us to translate them into present-day “language” and set up appropriate institutions.  Outlines of such institutions are presented in another essay (see Meeting the Financial Needs of Muslims: A comprehensive scheme).  Other essays elsewhere expand on these outlines.

Properly dealing with lending and borrowing transactions requires an understanding of the meaning of modern bank interests in relation to usury and riba.  In an essay entitled, Interest, Usury, Riba, and the Operational Costs of a Bank, the history of interest, its relation to usury and riba, the origins of dogmas and theories that prohibit or justify its practice, and the meaning of interest in the modern setting of banking are explored.  It also presents a general model of interest in which several scenarios — from person-to-person lending to modern commercial bank lending — become sub-models.  This enables one to separate riba from the operational costs of a bank and thus to devise a riba-free system of commercial banking that is both viable and compatible with the conventional one.

Inflation has become a fact of life, it erodes the value of capital — depositors’ savings, banks’ loans, cash-in-hand.  It has also been offered as an excuse for charging and accepting interest.  But the main cause of modern-day inflation is not in the short-term supply-demand  pull-push tensions, but in the long-term effects of increased money supply.  The basic cause of this increase is the de-linking of the currency-gold relationship.  It occurred gradually over time, but the final blow was dealt in 1971 when the US dollar was de-linked from gold and the promise to redeem every dollar for 1/35th of an ounce of fine gold was withdrawn, reneging on the Bretton Woods Agreement of 1945.  US dollar was allowed to float (meaning more dollars were printed without the constraint of the 35 dollars per ounce of gold ratio), and the other currencies, which were all linked to gold through the dollar, also started their free-floats, each in its own pace.  Today, at 350 dollars an ounce, gold is ten times more costly.  It is said that the price of gold has gone up; but the reality is that the currency has depreciated that much.  Re-linking all currencies directly to gold, and strictly adhering to the agreed currency-gold ratio, is the proper solution to this problem.  But a global agreement on this is not going to occur anytime soon.  In the meantime savings, loans and cash-in-hand are going to lose their purchasing power.  To neutralise the effect of inflation (due to currency depreciation) on capital, without recourse to increasing the interest rate, a new mechanism is necessary.  Such a mechanism is presented in a book entitled, Commercial Banking in the presence of Inflation.  This mechanism is applicable in person-to-person lending-borrowing transactions as well.  It is straightforward and not difficult to implement.





1.       Emry, Pastor Sheldon, Billions for the Bankers – Debts for the People.  Free distribution booklet, undated.  Also available at: http://www.justiceplus.org/bankers.htm, and downloadable from: Billions.exe.

2.       Gafoor, A.L.M. Abdul, Commercial Banking in the presence of Inflation.  Groningen, the Netherlands: Apptec Publications, 1999.  Published in Malaysia by A.S. Noordeen, Kuala Lumpur.

3.       ……….., Interest, Usury, Riba, and the Operational Costs of a Bank.  Article available at the author’s websites: www.IslamicBanking.nl and http://users.bart.nl/~abdul/

4.       ……….., Meeting the Financial Needs of Muslims: A comprehensive scheme.  Article available at the author’s websites: www.IslamicBanking.nl and http://users.bart.nl/~abdul/

Islamic Banking – A $300 Billion Deception

Author : Dr Muhammad Saleem

ISBN: 1599268698
ISBN-13: 9781599268699

Publisher : Xlibris Corporation

About the book
This book assesses the underlying rationale of Islamic banking, that the Quran prohibits all forms of interest. The author maintains that, first, a correct interpretation of the Quran, keeping in mind the context, would indicate that what the Quran prohibits is usury

Evolution of Islamic Banking and Insurance

Evolution of Islamic Banking and Insurance as Systems Rooted in Ethics Mohammad Nejatullah Siddiqi, Professor, Centre for Research in Islamic Economics, King Abdulaziz University, Jeddah, Saudi Arabia, read this paper at the College of Insurence, NewYork in Takaful Forum, April 26, 2000. 

Mr. President, Brothers and Sisters It is heartening indeed to see that the subject of insurance has at last started getting the attention it deserves. Your Forum and the presence of distinguished scholars as well as practitioners in the field of Islamic insurance and banking is reassuring. I have come to learn and refresh myself on the subject. But in compliance with the wishes of the organisers, especially my friend Omar Fisher, I venture to make some observations which could provide a perspective to the other presentations and deliberations. 1. Economic Progress Man has needs which he seeks to fulfil in ways available. One such need is exchange as no one can survive, much less live efficiently, on what he himself can produce. In the beginning there was barter but it was problematic and inefficient. Soon some objects came to be used as means of payment. These could be carried over time, so we had ‘money’ serving as medium of exchange as well as store of value. Providing for future needs led man to invest in order to enlarge the scope of what could be done – that was money as ‘finance’. As trade developed within and between regions and communities the role of finance increased and financial intermediation became a possibility with new promises. Modern banking spread with the social acceptance of bank credit, fractional reserve and paper currency, enabling an increasing population to cope with larger and larger volumes of trade and investment in a fast expanding world. With each new development new risks appeared. The farther into future man looked the more uncertainty he encountered. Handling risk and uncertainty became an increasingly prominent aspect of economic life even for ordinary men and women. Early ways and means of handling risks and uncertainty took simple forms of cooperation between the near and the dear. Pooling, sharing, diversification all occurred within the framework of trust, reciprocity and mutuality. That was insurance / takaful. As uncertainties increased and risk became more complex shifting risks to those willing to take them (in expectation of gain, of course) and unbundling them into manageable parts took new forms. The earlier simple stratagem of insurance and coinsurance among people brought together by kinship or vocation or trade … yielded to more sophisticated arrangements open to wider groups of people. Sometime along this bumpy road man hit upon the Law of Large Numbers and the Law of Averages. This discovery reinforced a lesson learnt in antiquity: By coming together men could face risks and uncertainties they could hardly cope with individually. That I believe is the core idea behind insurance and takaful just as financial intermediation is the core idea behind banking. Both have had revolutionary impacts on economic progress, each in its own way. 2. Ethics Running parallel to the saga of economic progress is another thread, the ethical imperative of doing things in a manner that does not harm others or violate social interests. Even though morality is a human need in the sense that man’s felicity and ultimately his survival depends on ethical conduct, in reality ethical conduct does not always obtain. Men misbehave. They act in immoral ways, one harming other. Some violate public interest. Ultimately these end up harming themselves too. This necessitated reminders and warnings and a reaffirmation of ethical conduct. It also necessitated arrangements for information, its acquisition and dissemination as well as preventing its withholding where due. Prophets and saints, philosophers and statesmen, and many ordinary men and women of strong commonsense kept reminding and warning that economic activity must be informed by public purpose and a care for the interest of others along with serving the interests of the actor himself. They also emphasised truthfulness, the key to information. Islam has legislated the minimum of morality necessary for human felicity, leaving for persuasion and voluntary compliance higher standards of morality which could make life better, more decent. Prohibition of riba (interest) and maysir (gambling) along with the strictures against telling lies, fraud and deception and breach of contract are the most relevant provisions of Shariah, insofar as economic activity is concerned. Given these, helping behaviour and regard for public interest could ensure good society so far as the economic aspect is concerned. It is in this perspective that one should see how modern banking and insurance were handled by the Muslim peoples. When they came out from under colonial rule they scrutinised these arrangements in the light of Islamic laws and ethics. This was necessary as these artefacts had evolved into an alien ethos and planted in Muslim societies by rulers with little regard to the interests of these societies or their norms and values. Let us first see what the Muslim mind did to banking. 3. Islamic Banking Beginning the middle of the twentieth century projects were launched to establish banking companies which would neither pay interest nor earn interest. Bank-depositor relation would be based on the depositor sharing the profit accruing as a result of the bank’s profitable use of the deposits pooled together. On the asset side a number of ways were tried to earn profits including partnerships and profit-sharing (mudaraba) with businessmen. Many Islamic banks entered into business directly, buying and selling commodities, land or real estate. Experimentation soon led to what is currently the predominant form of Islamic finance, i.e. murabaha. In this mode of finance the bank buys something on the specific request of a client and sells it to that client at a price higher than the purchase price, to be paid after a period of time. Leasing and prepaid orders (salam / istisna) were also used as profitable employment of the pool of deposits. In a nutshell, the core idea behind commercial and investment banking, that of financial interemediation, was retained but the ethically repugnant practice of interest on loans was discarded. Within a short period of fifty years, the first half of which was devoted mainly to theory and model building, Islamic banking established itself as an alternative, claiming ethical superiority over conventional banking. What is unethical about riba / interest to evoke such a response to interest-based banking from the Islamic civilization? The Quran (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice). Man’s environment does not guarantee positive return to productive use of money capital as value productivities lie in the future surrounded by uncertainty and risk. Some risk is involved in the productive use of money capital which, in fairness, the supplier of money capital must share if he wants a share in the profit of productive enterprise. A loan seeking positive return must share the risk involved in its use, otherwise it is to be returned without increase. As argued by Islamic economists this unfairness at the root of conventional banking is bound to affect its efficiency also as money capital would tend to be allocated on the basis of credit-worthiness of the borrowers rather than expected productivity of the projects being financed. They have also demonstrated how interest contributes to the instability of the capitalist system. All this refers to loans to business enterprises. When it comes to consumption loans the unfairness of interest and its negative impact on society become more obvious. Whether for business or for consumption, interest on loans violates the cooperative nature of man’s life requiring fairness and care for others. 4. Islamic Insurance The story of Islamic insurance is no different. One issue was to avoid interest in the investment of the contributions / savings / premia deposited by those taking insurance. That was easily done as the establishment of Islamic banks preceded the establishment of Islamic insurance companies. As a matter of fact the first Islamic insurance company was established towards the end of 1978 at the behest of the Faisal Islamic Bank of Sudan. Now Islamic insurance companies have a whole range of Islamic financial instruments in which to invest. The other ethical imperative was to prevent insurance from degenerating into gambling. Gambling inheres into games of chance played for a gain. The activity is created or voluntarily entered into. It is not like the chances one has to take in the ordinary business of life, i.e. the risks and uncertainties attending upon sale, purchase, investment and production, even upon travel, choosing a career or choosing your doctor. The unambiguous examples of gambling are bets in horse race, in games of cards or on spinning a roulette wheel. The financial risk involved in gambling could have been avoided if the gambler wanted to do so, by not playing the game. Not so in the case of risks in productive enterprise, investment or travelling, for to avoid financial risks in these cases one has to give up not a game but the ‘ordinary business of life’. Like interest, gambling also violates the spirit of cooperation and fairness on which civilization is based. The appropriation of existing wealth already owned by some one by mere chance is unethical. Wealth is either appropriated directly from the (yet un- owned) pool of nature, or transferred to the new owner by the old owner as a gift, against a price or by inheritance. As the gains of the gambler do not belong to the first category we have to examine its legitimacy as a transfer from the old owner. The unethical nature of this transfer reveals itself if we look at the way the old owner must have come upon it. It is largely a product of work. As explained elsewhere ownership rights on the bases of work, inheritance or gift are ethically justifiable[1]. They have a rationale, serve a social purpose and do not violate fairness or the spirit of cooperation. Allowing wealth to be transferred by pure chance would make a mockery of that rationale and the social function of ownership. It would be unfair to transfer wealth acquired on the above mentioned grounds to one who does not qualify on any one of those grounds. One need read the whole passage[2] to appreciate Wali Allah’s conclusion that “Both ways of gain (i.e. maysir and riba) are tantamount to inebriation, as they are in flagrant contradiction with the principles God has laid down for earning a livelihood”[3]. 5. The Core Idea Behind Insurance Modern insurance (Takaful) is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. ‘Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the Law of Large Numbers.[4]’ Of course the numbers are not usually ‘large enough[5]’ so that actual values deviate from the expected values. The theory of risk seeks to analyse these deviations. Theories seldom reach perfection, yet practice fumbles on as life in the modern metropolis is hardly possible without insurance, especially in societies with shrinking nuclear families and neighbourhoods of diverse ethnic groups. Insurance, however, is only one form of handling risk by pooling or unbundling and/or shifting it to those who are willing to take it in expectation of a gain. One other form is the market for common stock. As explained by Kenneth Arrow, ‘By this means, the owner of a business could divest himself of some of the risks, permitting others to share in the benefits and the losses. Since each individual could now own a diversified portfolio of common stocks, each with a different set of risks attached, he could derive the benefits of a reduced aggregate risk through pooling: thus, the stock market permits a reduction in the social amount of risk bearing[6].” Arrow has also pointed out that ‘insurance is a very subtle kind of contract; it is an exchange of money now for money payable contingent on the occurrence of certain events'[7]. It is this subtlety that has been causing problems for contemporary Islamic jurisprudence which failed to take a macro view of the matter. In order to avoid endorsing ‘contingent’ payments which obviously involve gharar, under pressure from the necessity of insurance, some have tried to model it on altruistic giving (tabarru`) or charity. But the notion of charity can hardly survive the explicit reciprocity involved in takaful. The gharar / uncertainty involved in the contract between one individual and the insurance company, because of the contingent nature of the payment, tends to disappear when large numbers are involved. What is still contingent for the individual becomes routine for the group as a whole as well as for the company[8]. 6. Commercial Vs. Cooperative Insurance Since the core idea on which mutual insurance or takaful is based is the same as behind all insurance, the distinction between mutual and commercial forms of insurance is a matter of organisation, not a matter of substance. When the give and take involve large number of people some coordination would be necessary. Such coordination has to be paid for. The manager may receive his salary from a mutual or a commercial, the activity remains the same. The choice between the two forms of organisation should be guided by considerations such as efficiency, transparency etc, in short, on maslaha, good of the people. The form of the organisation does not affect the legitimacy of the activity itself. It is not good reasoning to characterise mutual insurance as cooperation and commercial insurance as illegitimate profiteering. As Ibn Khaldun remarked[9], trade itself is a form of cooperation: “Man cannot survive as an individual in isolation, by his very nature he needs cooperation to get what he requires. This cooperation inevitably involves, first quid pro quo (mu`awada) then sharing (musharaka) and other forms”. In fact for – profit activities often prove to be better coordinated than those done in charity – the lesson so succinctly taught by Adam Smith[10]. That these same require regulation and overseeing by Social Authority is not to be denied. Having said that, I have no intention to wish away the problems surrounding insurance. Regulators worked hard to purge insurance from elements of gambling in its early days. But the task is hardly complete as newer more subtle opportunities of speculation present themselves. Nor has the battle against fraud and deception ended. We have only to remember the breaking story of the Lloyd’s of London to convince ourselves to the contrary[11]. Then there is the perrenial issue of moral hazard; of insurance changing the behaviour of the insured in an undesirable way. There is no doubt a ‘dark side[12]’ to insurance. Neither the regulators nor the preachers can leave things as they are. Public intervention would always be called for to ensure fairness, elminate fraud and protect the consumer. Insurance is too important for modern living to be prohibited as a preventive measure (saddan liz zariah) No doubt it is vulnerable to fraud and deception, even gambling, but so are the activities in the share market, currency market, even in commodity markets. Rather, the correct approach would be for the social authority as well as consumer groups to exercise vigilance and introduce needed regulations. 7. The Future Islamic insurance is there to stay, whatever the organisational setup and whatever the juristic rationale. The question before forums like the present one is how to take it to Muslim homes and how to do this ethically i.e. carefully protecting the interests of the people concerned. As Islamic banks and Islamic funds proliferate, it should not be difficult for Islamic insurance institutions to tag on, entering into strategic alliance with these banks and funds. Also the ulama owe it to the community to endorse Islamic insurance as vehemently as they have endorsed Islamic banking so that the community can forge ahead with a clear conscience. Having efficient banking and insurance would still leave the larger issues of social justice and equity in need of attention. It is time we start doing that. But that beginning can be made only once we have left the exhausting as well as mind boggling job of wrangling with the formal legitimacy of insurance and some other financial contracts behind us. Shall we expect this Forum to make it possible. I pray for this. Join me, and thank you. © 2000 Muhammad Nejatullah Siddiqi End Notes:____________________ 1. Mohammad Nejatullah Siddiqi, Islam ka Nazariyah Milkiyat (Islam’s Theory of Property) Chapter II and III, Delhi, Markazi Makteba Islami, 1978. Shah Wali Allah of Delhi (1703 – 1762) saw the above clearly. As Baljon noted: “The requirement of mutual aid is, in the opinion of Shah Wali Allah, the main ground for the prohibition of maysir (gambling) and riba (interest)”

Introduction to Takaful


Islamic finance has developed mainly in two directions namely Islamic banking and Islamic insurance (Takaful). While information about Islamic banking is being increasingly disseminated, features, models and structures of Takaful are little known particularly in Pakistan. Purpose of this brief article is to describe main features and models of Takaful system operating in various parts of the world.

All human beings are invariably exposed to the possibility of meeting catastrophes and disasters giving rise to misfortunes and sufferings such as death, loss of limbs, accident, destruction of business or wealth, etc.  Notwithstanding the belief of all Muslims in Qadha-o-Qadr, Islam provides that one must find ways and means to avoid such catastrophes and disasters wherever possible, and to minimize his or his family’s financial losses should such events occur. One possible way out is to buy an insurance cover as in the conventional system. 

Different views have been expressed about the status of conventional insurance from the point of view of Islam. An overwhelming majority of the Shariah scholars believe that it is unlawful due to involvement of Riba (interest), Maisir (gambling) and Gharar (uncertainty).@ Takaful, the Islamic alternative to insurance, is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may inflict upon any of them, out of the fund they donate collectively. The Takaful contract so agreed usually involves the concepts of Mudarabah, Tabarru´ (to donate for benefit of others) and mutual sharing of losses with the overall objective of eliminating the element of uncertainty. 

Takaful is not a new concept in Islamic commercial law.  The contemporary jurists acknowledge that the foundation of shared responsibility or Takaful was laid down in the system of ‘Aaqilah’, which was an arrangement of mutual help or indemnification customary in some tribes at the time of the Holy Prophet (pbuh).  In case of any natural calamity, every body used to contribute something until the loss was indemnified. Similarly, the idea of Aaqilah in respect of blood money or any disaster was based on the concept of Takaful wherein payments by the whole tribe distributed the financial burden among the entire tribe.  Islam accepted this principle of reciprocal compensation and joint responsibility. 

The contract of Takaful provides solidarity in respect of any tragedy in human life and loss to the business or property. The policyholders (Takaful partners) pay subscription to assist and indemnify each other and share the profits earned from business conducted by the Company with the subscribed funds.  Takaful companies normally divide the contributions into two parts, i.e., donations for meeting mortality liability or losses of the fellow policyholders and the other part for investment.  Accordingly, the clause of Tabarru´ is incorporated in the contract.  How much of the contribution is meant for mortality liability and how much for investment account is based on a sound technical basis of mortality tables and other actuarial requirements.  Both the accounts are invested and returns thereof distributed on Mudarabah principle between the participants and the Takaful operators. The profit attributable to the participants is credited into the two accounts separately.  To describe from another angle, a Takaful contract may comprise clauses for either protection or savings/investments or both the benefits of protection as well as savings and investment. The protection part of Takaful works on the donation principle according to which individual rights are given up to indemnify the losses reciprocally. In the Savings part, individual rights remain intact under Mudarabah principle and the contributions alongwith profit (net of expenses) are paid to the policyholders at the end of policy term or before, if required by him.

The distinction between the conventional insurance and Takaful business is more visible with respect to investment of funds.  While insurance companies invest their funds in interest-based avenues and without any regard for the concept of Halal-o-Haram, Takaful companies undertake only Shariah compliant business and the profits are distributed in accordance with the pre-agreed ratios in the Takaful Agreement.  Likewise they share in any surplus or loss from the pool collectively. Takaful system has a built-in mechanism to counter any over-pricing policies of the insurance companies because whatever may be the premium charged, the surplus would normally go back to the participants in proportion to their contributions.

The terms ‘Family Takaful’, ‘Takaful Ta´awani’ or just ‘Takaful’ are generally used for family solidarity in place of conventional life insurances. Other products available in various countries are General Takaful, Education/Medical Takaful, etc. Based on the nature of relationship between the company and the participants, there are various models like Wakalah (agency) Model, Mudarabah Model and the combination of agency and Mudarabah models. In the Sudanese Takaful Model that is preferable to majority of the contemporary Shariah experts, every policyholder is also the shareholder of the Takaful Company. There is a Board that runs the business on behalf of all the participants and there is no separate entity managing the business. The legal framework in other Islamic countries normally does not allow this arrangement and Takaful companies work as separate entities on the basis of Mudarabah (as in Malaysia) and on the basis of Wakalah (as in the Middle East region).  In Mudarabah model that is practised mainly in the Asia Pacific region, the policyholders get profit on their part of funds only if Takaful Company earns profit.  The sharing basis is determined in advance and is a function of the developmental stage and earnings of the Company. The Shariah committee approves the sharing ratio for each year in advance. Most of the expenses are charged to the shareholders.  

In Wakalah Model, the surplus of policyholders’ funds investments – net of the management fee or expenses – goes to the policyholders.  The shareholders charge Wakalah fee from contributions that covers most of the expenses of business.  The fee rate is fixed annually in advance in consultation with Shariah committee of the company. In order to give incentive for good governance, management fee is related to the level of performance.

The Takaful business has proved its viability in a period of only two decades.  It has been growing at the rate of 10-20% p.a. compared to the global average growth of insurance 5% p.a. A large number of Takaful Companies exist in the Middle East, Far East, Iran, Turkey, and Sudan and even in some non-Islamic countries. There are over 60 companies offering Takaful services (including Windows- 5%) in 23 countries around the world. Malaysia has developed Re-Takaful business as well. Takaful products are available to meet the needs of all sectors of the economy, both at individual as well as corporate levels to cater for short and long term financial needs of various groups of the society.

A Convention of D-8 countries was held in Kuala Lumpur in November, 2002 on “The Emergence of Takaful in the Wake of Globalization”.  It is worth noting that among D-8 countries it is only Pakistan where Takaful business has not been introduced so far. Islamic banks and financial institutions require Takaful services for their operations. Although, the insurance business in Pakistan falls in the jurisdiction of the Securities & Exchange Commission, Pakistan, institutions operating Islamic banking would have to deal with insurance. As such, the Central Bank should desire that Takaful business be introduced in the country at the earliest.  In the revised Insurance Act, the Government of Pakistan has added the provisions for Takaful companies in the country.  As reported in the press, Pak Kuwait Investment Corporation has recently been allowed by the SEC to establish a Takaful Company in Pakistan under the name of “First Takaful Insurance Company Limited” with authorized capital of Rs 100 million.

By: Muhammad Ayub


Why Islamic Banks formed


The Prophet said: “There will come a time for men when no one will be anxious about profits, whether lawful or unlawful” Bukhârî, Ventes (34), bâb 7.

One of the aspects of the Islamic renewal is the growing importance of Islamic banking organizations in economic life. With the oil boom, Arab states found themselves with a surplus of petro-dollars which had to be invested somewhere, and at the end of the 1970’s this situation led private groups as well as, occasionally, state enterprises to set up financial institutions in accordance with the spirit of Islam. Hence arose a whole host of banks proclaiming their adherence to the sharî’a and seeking to attract the new capital. Countries like Iran and Pakistan even Islamized the whole of their banking system, both for religious motives and also to show their disapproval of Western capitalism. There was even talk of an “Islamic economic theory”. There were international colloquia on the subject and Internet sites blossomed. There is already a substantial literature on this subject. Because of its topicality, it may be useful to try and examine the subject in greater depth. One can however deal here only with the essential problem. We shall look first at the ban on usury in the Koran and in the tradition, and then at juridical developments. Then we shall consider the different juridical attitudes in different Muslim countries.

Usury in the Koran

We must of course seek in the Koran the initial reason for the condemnation of the taking of interest. The root ribâ means “increase”. The word ribâ in the sense of usury is only found in four Koranic passages. We may study them in chronological order.


The first is in surat 30 (al-Rûm), dating from the third Meccan period, shortly the reform before Hegira. “What you lend at interest (ribâ) for the sake of increasing (li-yarbuwa) your property will bring you no increase (lâ yarbû) in the sight of God, while what you give away as alms (zakât) in seeking the face of God will bring many times its value.” (Q. 30, 39)


There is not yet an explicit condemnation but only a moral directive according to social justice. This fits the context of the time and place, in which the Muslim community is still a small minority in a society in which commerce recognizes no moral rules and in which usury is a widespread practice. The three other passages are all from the same period and probably date from a few years after the installation in Medina. Following the order established by J. Schacht , we be gin with the verse 3, 130: “Do not practice (literally “eat”) usury by multiplying capital beyond due measure.”


Here is the first formal prohibition. It may well have been addressed in the first place to the Jewish community of Medina, well-known for its financial practices. It seems to be aimed at a particular form of usury, later called ribâ al-jâhiliyya (pre-Islamic usury), according to which if a debt was not repaid at the proper time the amount due was increased.


Here next is a long passage from the surat al-Baqara : “Those who feed on usury will only rise again (on the last day), like those possessed by the devil. They say in effect, usury and selling are the same thing, whereas God permits selling but forbids usury… God will reduce interest to dust while making alms fruitful…O you believers, fear God, and renounce the excess of usurious interest, if you really believe. If you do not follow this ruling, you may expect the hostility of God and of his Messenger. If you repent, you will retain your capital, neither harming anyone else nor suffering harm yourselves. To a debtor in difficulty, grant a delay until his situation improves. And if you renounce your rights that will be better still.” (Q.2, 275-280).5


This is a fundamental passage for our present reflection. One may list the following points

  • The clear distinction between commerce and ribâ;

  • Ribâ is condemned by God, while on the other hand he encourages almsgiving;

  • Faith implies the renunciation of usury;

  • Nevertheless, capital will be safeguarded;

  • Further, one may not put pressure on people who are in difficulties. There is a final, third passage whose context suggests that it is also addressed to the Jews. It confirms the preceding prohibitions.