The Sharia law provides human beings freedom to enter into contracts and do business transactions. However, this freedom is not unbridled. Like conventional law, Sharia regulates human dealings to safeguard the welfare and liberties of the transacting parties. The dealings could range from a simple contract like Nikah (marriage) to complex Bay’ (trade/commercial) transactions. The prohibitions that regulate financial dealings are mainly of three kinds, the foremost of which is the ban on interest. We will talk about the other two in our next post.
The prohibition of Riba (or interest) is central to Islamic financial law and ethics. It has been a topic of much scholarly effort and debate. The word Riba literally means increase or excess. Officially, Riba is an excess amount received on a loan stipulated over time. It is not only prohibited in loan or debt contracts but also in sale or exchange contracts.
- Riba in Loan
In a conventional loan transaction, there are three elements present; a loan amount, a stipulated excess amount and a time period. The Riba in this type of scenario is called Riba al-Nasia (or interest relating to delay). Therefore a loan amount of $100 accruing an interest rate of 5% annually has a Riba element of $5 at the end of the year. Under Sharia, a Qard (or loan) has to be at par, with zero interest and is called a Qard-e-Hasana (a beautiful loan). Therefore under Sharia, the loan and debt amounts are one and the same, essentially amounting to interest-free loans. In today’s world, a few economic sectors have employed this type of financing quite successfully; for example automobile loans on 0% financing and consumer loans advertising “No interest if paid in full in 12 months” for big-ticket items like furniture, electronics, and sometimes even dentists bills.
Under Sharia, if a debtor is unable to pay the full amount of debt, he is given additional time to pay without a financial penalty for the extra time taken. If the debtor is able to settle the debt, the matter is closed; if he is unable to pay, the creditor is encouraged to forgive the shortfall and the difference is considered a part of charity. However, this partial debt forgiveness is not considered “contractual” in nature. People are strongly encouraged to pay off their obligations under Sharia and the forgiveness of differential debt amount is more for exceptional cases, rather than a general rule.
This approach to debt is in stark contrast with contemporary 0% consumer financing contracts where if a debt is not paid within the stipulated period, or a payment is made too late, or if the debtor loses his ability to repay, a hefty interest rate plus retroactive interest is applied on the original amount from the date the contract was initiated.
Even though interest on a loan is prohibited, Sharia accepts the concept of time value of money. We will elaborate this in a future post when we discuss the transfer of debt.
- Riba in Exchange
Unlike a loan, in a sale or exchange transaction, another element is introduced which is goods or commodities. Any excess or increase resulting in such an exchange is called Riba-al-Fadl (or interest relating to surplus). This is based on a narration of the holy prophet Mohammad (peace and blessings upon him).
Sell gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot
The narration explains Riba vis-à-vis six defined commodities which can be classified into precious metals and food based commodities. Based on this narration, jurists have developed a tripartite rule.
- If an exchange is made between the same items, it needs to be on the spot and the items should be of equal weight.
- If the exchange is of two different items within the same category, it needs to be on the spot, and
- If the exchange is made between items from each category, there is freedom of choice.
For example, gold exchanged with gold needs to be on the spot and of equal weight, otherwise, it would be considered having Riba of surplus. Secondly, gold exchanged with silver needs to be on the spot but commodities can have different weights. And lastly, gold exchanged with wheat need not be on the spot and the commodities can have different weights.
While all six items given in the narration may give rise to Riba, we will expand our discussion on the first category i.e. precious metals as these have the characteristics of the “nature of money”. Therefore, the Riba rules would apply to anything that has the nature of money i.e. paper currency, IOUs, etc. Under Sharia, the two conditions for exchanging money for money are on the spot and in equal quantity. This is known as a currency exchange contract (‘aqd al-sarf). Any violation of the above ruling will result in either form of Riba. If money is exchanged on the spot but in different quantities, it will result in interest of surplus (Riba al-Fadl) or if more money is exchanged for money with deferment it will result in interest of delay (Riba al-Nasia). The underlying element in most contemporary financial products is the Riba of deferment (Riba al-Nasia). The present discussion of the two kinds of Riba will have implications when we discuss financial products like futures contracts, derivatives, project financing, leasing etc. in our future posts.
Our next posts will deal with the other two prohibitions concerning financial transactions which are uncertainty and chance.