Ethica Institute of Islamic Finance™

What is wrong with charging a moderate excess over the principal, as with commercial interest rates, if participants mutually agree that a dollar is worth more today than it is tomorrow?

The argument is that because any unit of capital is worth more today than it is tomorrow, providers of capital should be compensated for foregoing the opportunity to use their capital for that time. But the problem with this arrangement is that the borrower of capital is compelled to guarantee (often at a considerable price) the return of this capital, in addition to a fixed premium, while the lender incurs no risk (in so far as the loan collateral compensates his risk). There is no mutual participation of risk: the lender’s motivation is not the mobility of capital for the sake of investment; the lender's motivation is the commitment of capital for the sake of preservation. In a risk-oriented investment, the principal (lender) is rewarded for his business acumen; in an interest-based transaction, the lender is rewarded simply for the ownership of capital.

It is this imbalance of benefit that Islam addresses. The equal participation among borrowers and lenders in a commercial market is entirely illusory. The source of capital value is not determined by the subjective desire of the participants in the market, but rather by the financial competition of the lenders in the market. In a competitive market, lenders will always extract the highest possible interest rate from their borrowers. It is this asymmetry between the economic advantage of the lender and the economic disadvantage of the borrower that Islam seeks to address by ensuring that market participants are equal stakeholders in risk capital. In the absence of investment risk there is a tendency for the market to focus on repayment of loans rather than the enhancement of investments.

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