Islamic Finance: A Critique of Interest and a Defense of Profit-and-Loss Sharing

 Interest-based financing does not necessarily create real assets, and that it causes inflation and imbalances in the system of distribution.  These claims are based on the fundamental difference between the Islamic and the conventional concept of money and financing. In Islam, money is not a commodity that can be traded or sold for profit. Money is only a medium of exchange that facilitates transactions of goods and services. Therefore, money has no intrinsic value or utility, and it cannot generate more money by itself. This is why Islam prohibits interest or riba, which is an excess amount charged or paid over the principal amount of a loan or debt.

But interest is not only a charge or payment for money. It is also a compensation for the time value of money, the risk of default, and the opportunity cost of lending or borrowing money. These are not realities, but assumptions and conventions that are based on human perception and desire, not on divine guidance. Islam does not recognize the time value of money, because money does not change or deteriorate with time. Money is only a measure of value, not a store of value. Therefore, there is no justification for charging or paying more money for delaying or advancing the payment of money.

The risk of default is a business risk that should be shared by both parties, not borne by one party alone. Islam does not allow one party to transfer his risk to another party without sharing in his profit or loss. This is why Islam promotes profit-and-loss sharing modes of financing, such as musharakah and mudarabah, where both parties contribute capital or labor to a joint venture, and share the profit or loss according to an agreed ratio.

The opportunity cost of lending or borrowing money is a hypothetical cost that is based on speculation and uncertainty, not on reality and certainty. Islam does not allow one party to benefit from another party’s potential loss or gain without actually participating in his venture. This is why Islam prohibits gambling or maisir, which is a game of chance where one party gains at the expense of another party without creating any real value or utility.

 Interest may seem necessary and efficient in the short term, but it is harmful and inefficient in the long term. Interest creates artificial money that does not match with the real goods and services produced in the society. This leads to inflation, which erodes the purchasing power of money and reduces the welfare of the people. Interest also creates imbalances in the system of distribution, which concentrates wealth in the hands of the few and deprives the majority of their fair share. Interest also discourages productive investment and encourages speculative and unproductive activities that do not add any value or utility to the society.

Interest discourages productive investment by making it less attractive and profitable than interest-based lending or borrowing. Why would a person invest his money in a risky and uncertain business venture, when he can lend his money at a fixed and guaranteed rate of interest? Interest also encourages speculative and unproductive activities by creating artificial demand and supply of money and commodities. For example, interest-based financing allows people to buy goods on credit and sell them at a higher price before paying for them. This creates inflation and speculation, which distort the market prices and harm the real producers and consumers.

Islamic financing can compete with conventional financing in all these aspects, if it is implemented according to its true spirit and principles. Islamic financing is not limited to a specific form or procedure, but it is based on some broad principles that can accommodate various forms and procedures. For example, musharakah is not restricted to its traditional form of partnership, but it can be applied to different modes of financing, such as equity financing, project financing, venture capital, etc. Islamic financing is also not stagnant or rigid, but it is dynamic and flexible. It can adapt to the changing needs and circumstances of the society, as long as it does not violate the basic principles of Shari’ah.