[alyasa]

A good read, I think, for those so inclined; to read that is...
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Philosophically, interest is prohibited due to the perceived exploitation of one class of people by another.

In the case of consumption loans which are generally made to people who neither have the luxury of savings to meet urgent personal needs nor have access to any other means of acquiring financing, the prohibition of interest is mainly for humane purposes. In the case of loans for productive purposes, it is not deemed fitting for lenders of capital funds to be assured of receiving a rate of return while users of such funds--the entrepreneurs--have no assurance of direction and magnitude of returns. It is socially unjust to guarantee a predetermined return for any one party when the existence of entrepreneurial profit is uncertain.

Interest is also viewed as a transfer wealth from the poor to the rich, thus increasing the inequality in distribution of wealth, which is contrary to the Islamic social interest which stands for co-operation and brotherhood. Moreover, it is thought that interest creates an idle class of people who receive their income from accumulated wealth, thus depriving the society of their labour, skills, and enterprises.

Interest-Free Alternative

The Islamic solutions, commonly referred to as Profit & Loss Sharing (PLS), suggests an equitable sharing of risks and profits between the parties involved in a financial transaction. In the banking business, there are three parties - the entrepreneur or the actual user of capital, the bank which serves as a partial user of capital funds and as a financial intermediary, and the depositors in the bank who are the suppliers of savings or capital funds. There are two different partnerships of the type mentioned in Islam: the partnership between the depositors and the bank, and the partnership between the entrepreneur (or the borrower) and the bank.

Under this proposal, financial institutions will not receive a fixed rate of interest on their outstanding loans, rather, they share in profits or in losses of the business owner to whom they have provided the funds. Similarly, those individuals who deposit their funds in a bank will share in the profit/loss of the financial institution.

As opposed to the present system of banking, where bank profits arise from the difference between the interest it receives from borrowers and the interest it pays to its depositors, the source of bank profits in interest free banking is the differences in the profit sharing ratios. The entrepreneur and the bank agree upon sharing of the profit with a higher proportion going to the entrepreneur, while the depositors share a comparatively smaller proportion of the bank's profits.

The Islamic principle of Sharakah stipulates that the partners are free to determine the extent of their profit-sharing ratio regardless of their capital contributions. Losses, on the other hand, are to be shared strictly in proportion to their capital contributions. In the case of the division of the pro- fits between a financial institution and various borrowers, however, it is suggested that the central bank should be able to control the profit/loss share ratio. This practice will not only reduce unhealthy competition among financial institutions, but also enables the central bank to influence the allocation of resources among various sectors of the economy according to national priorities and monetary policy directives.

To ensure timely payment of the loan plus the institution's share of the profits (if any), a fine could be imposed on those borrowers who do not pay on time. To conform with the principals of the Shari'ah, these fines must be deposited with the government treasury rather than given to individual financial instit utions. Other punishments such as confiscation of property and blacklisting delinquent borrowers are also suggested.

Two problems have been cited as inherent in the traditional banking system, both arising from the asymmetric availability of information between the two parties involved in a financial transaction. Adverse selection refers to the possibility that potential borrowers who are the most likely to produce an undesirable outcome are the ones who more actively seek out a loan, and are thus the most likely to be selected. Moral hazard occurs when the borrower engages in activities undesirable by the lender after the loan has been granted. The PLS system addresses both issues.

Since the profit and loss sharing emphasises distribution of both risk and profits between the lender and the borrower when a loan is made, the lending institution need only worry about the profitability of the proposed project for which the loan is requested rather the credit-worthiness of the firm to which they are lending. This leads to more conservative decisions made by the lender and to a more careful monitoring of the borrower.

Similarly, in the western banking model, heavy-handed bank regulation and the availability of deposit insurance have replaced the need for monitoring bank activities by depositors. Consequently, as far as small depositors are concerned, deposits in one bank are very similar to deposits in another bank, and hence there is no need to monitor bank activities. The Islamic, interest-free system, on the other hand, imposes the burden on depositors of gathering information about the safety, soundness, riskiness, and profitability of the bank. This will eventually lead to a sounder banking system, although the unwillingness of depositors in the short run to go through the lengthy process may lead to short-term reduction of savings in the banking system.
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