QUESTIONS
“Unlike riba, profit is recognized in Islam because of its characteristic as a justified form of
reward for capital and enterprise.”
(a) Discuss the above statement
(b) List in a table the differences between profit and riba
INTRODUCTION
“Allah forbids riba and permit trades.”
Surah 2:275
Although riba is forbidden in Islam, profit generated from trade is a justifiable source of
income in Islam. This article discusses the differences between riba and profit and from there
deduces the rationale of the above injunction.
For some people, the religious commitment will be good enough to guide them to reject the
practice of riba and deem profit as the only justifiable source of income. However, for the
other group, they deserve a more convincing explanation and clarification from economical
and social point of view. Since the author is not a Muslim herself, it will not be persuasive to
advocate that riba is unjustifiable on religious ground alone. Therefore, with fair amount of
religious elements, this article examines riba and profit largely from economical aspect.
DEFINITIONS
The Prohibited Riba
In a gradual process, little by little Al-Quran prepares the ground and social environment for
final prohibition. Riba in Islamic terminology is increase or excess over principal or more
precisely, it is called a stipulated/forced/obligatory surplus on a debt.1 Or it can be defined as
an increase or excess value (fadf) which in an exchange or sale of a commodity, accrues to
the owner (lender) without giving in return any equivalent counter value or iwad. 1 In 1992,
the Pakistan Federal Shariah Court ruled that: “Any excess which is pre-determined over the
principal sum in a loan transaction will constitute Riba in all circumstances.”2 By and large,
as a general principal, riba exist as long as the exchange/transaction involves ribawi items
and gives rise to inequality of counter values (al-fadl) and determent in time of exchange (al-
nasiah).3 Terminologically the equivalence of riba in economic tradition is usury, something
that was prohibited in Jewish and Christianity also. But modern banking gets around the
prohibition of usury little by little and eventually replaces the word usury with interest.4
Usury was also prohibited in ancient China. 5 Since it is not only Islam that prohibits riba, it
is reasonable to infer that the practice of riba is somewhat harmful to the society.
The Permitted Profit
Profit is the return on trade, which is the result of difference between revenue and cost,
encompassing the effort and risk undertaken by the entrepreneur. Existence of risks either
before-sale or after-sale inadvertently results in uncertainty in profit (or loss). This is based
on the legal maxim (Qawaid Fiqiah) that states al-ghunm bil al-ghurm which can be
translated as “gain is the result of risk-taking”.6 Thus Muhammad Ayub (2007) described
profit as ex-post, which is only known after the business venture. He also insists that profit
generated from trade should be associated with real asset. 7 Islam places a great importance
in trade and encourages it because it is the major vehicle of increasing real income. Muslims
believe that God wants his people to be prosperous and to avail themselves of the bounties of
his creation.
RIBA VS PROFIT
Riba vs Profit on Counter-value
According to Fiqh scholars profit is a justified increase which is usually generated by
exchange of two goods while riba occurs in unjust inequitable exchange of one commodity
against another.1 Hanafi, Shafii and Maliki schools all agree on the term “unequal counter-
value” when it comes to defining riba albeit the differences in the exact definitions.
Therefore, this remaining of this section dedicates to explain graphically the differences of
riba and profit in term of counter-value.
Figure 1(a) Equal Exchange1 Figure 2 (b) Exchange involved
Riba1
Figure 2 (a) shows the equal exchange between A and B for Y product, in which ya + yb = Y.
MN is the opportunity space or the maximum available endowment of Y. At point E
(intersection between MN and 45o straight line from the origin), A and B is in equal
proportions - A is getting OYaE while B is getting OYb
E. The 45o straight line is the equal
counter value line, in which Y=X. Figure 1(a) shows that, it is a zero sum game activity
where the gain of one party is directly the loss of the other one.1 Any point fall out of point E
will not result in equal counter value. Additional value that accrues to either party in this
kind of transaction amounts to excess without counter value or prohibited riba in Islam.
In the case of Figure 2(b), A has endowment of good OQAe and certain amount of money
OMAe and B has endowment of good OQB
e and money amount of OMBe. A requires to have
more money and sell some of his plenty of good. While B would like to purchase some of
good Q from A in exchange for money, in which the exchange normally takes place at a
prevailing market price. However, in this transaction, A sells (QAe-QA
E) of the good for (MBe
– MBI) which B will pay by instalment. The extra price paid than that of the market value
(MBe – MB
E) is a result of interest imposed on B. This additional amount money that accrues
to A is absolutely the loss to individual B, where the stock of individual B decreases from
MBE to MB
I . Since ΔMA = ΔMB is in absolute terms, so in exchange rationale, this is one side
flow which has no any corresponding value in repayment, resulting in riba which is shaded in
yellow in Figure 2(b). In Islam, an alternative to prevent riba in deferred payment mode is
Murabaha-Mu’ajjal.
Yb
Ya
M
ON
EYaE
YbE
45o
Q
OA M
O
B
e E IQ
AE
QA
e
MA
MA
MA
I
MB
IMB
e MB
QB
e
QB
E
Conclusively, riba results from an exchange without equal counter value whereas profit
results from an exchange with equal counter value. Therefore, the former is forbidden but
the latter is permitted in Islam.
Riba vs Profit on Wealth Creation
Islamic commercial law aims at promoting the actual wealth creation instead of artificial and
‘bubble’ creation of wealth.1 Profit generated in the process of trade is a result of:
i. Additional value of goods - due to physical transformation of an object from one
form to another; usually quantifiable in monetary term (price difference final
products between raw materials as well as other operational costs) and
ii. Exchange of goods with others - exchanging goods with lower marginal utility
with the higher ones results in higher utilities for both trading parties. This
concept will be illustrated below.
Exchange of goods take place because differences in endowments and abilities of producing
goods and services and differences in preferences or tastes.4 Most importantly, exchange is
needed to maximize utility because of diminishing marginal utility and different marginal rate
of substitution. Intuitively, well-balanced, diversified bundles of commodities are preferred
to bundles that are heavily weighted toward one commodity, leading to the convex nature of
most of the indifferent utility curves.8 It is noteworthy to refer this principle to the context of
the story of Bani Israel when they tired of eating the heavenly food manna and salwa and
they said that they could not keep satisfied with one type of food only.1 It implies that even
the heavenly food is less of a choice to the Israelites than variety of foods. Figure below
shows how trade can increase the real wealth between two trading parties and thus justify the
return on trade – profit.
Figure 2 (a) &(b) Individual Utility Functions before and after Trade
Figure 1 (a) & (b): Suppose A has X endowment and nothing of commodity Y while B has
only Y. In the initial situation no one is engaged in trade, so the utility level is at the X and Y
intercept, resulting in low level of utility UAo and UB
o due to diminishing marginal utility. If
they agree on trading according to their expected budget lines, they will both be better off,
achieving higher utility level, UA1 and UB
1. A now will have different relative prices of good
X, with an offer curve labelled OCa. The offer curve intersects with the budget line at point E,
resulting in higher utility function which is the tangent to the intersection point, E. The
similar will be the case of B.
XA
eX
AE
Y
XO
A
E
OCa
YA
EU
Ao
UA
1
XB
e
X
BE
Y
XO
B
E OCb
YB
E
UB
oU
B1
Figure 2 (c) Superimposed Utility Functions of Two Parties of Exchange 1
Figure 1 (c): Imposing the two diagrams (a) & (b), we can find the efficiency of exchange
process by raising the welfare of both individuals. Before the exchange A and B would ends
Y
E
XA
OA
OB
M
N
UA
o
UB
o
X
UB
1
UA
1
OC
OC
XA
YB
E
XB
YA
E
YB
o
up at M and N respectively. However through exchange they will arrive at anywhere
between M and N with the highest point, E.
In contrast with trade, Riba activities do not create new stock of wealth. It is a zero sum
phenomenon arises from exchange of two identical goods, which there is no way to increase
the utility of one party without reducing the other. For an example, in many countries
government raise fund from the public by issuing interest-based notes and bonds with a fixed
return.9 If the fund raised does not result in return higher than the promised interest rate,
these interests will have to be paid by the next generation in the form of tax as suggested by
Ramsey-Cass-Coopman infinite horizon model (which is indifferent between tax and bond).
In this case wealth is merely transferred from the future generation to the current one. The
government may even find itself caught in the vicious cycle of debt, which eventually leads
to debt crisis that further deepen the hole of debt. On the other hand, if the government is to
raise shariah-compliant bond (sukuk) based on real assets by sharing the real profit or loss,
then it will be free from the problem above. It should be noted that the above example is only
one of the examples of the detrimental effect of riba to the real economy.
Conclusively, trade takes place only when situation shows a surplus of satisfaction thus
resulting in real wealth creation – profit; whereas riba activities involve only wealth transfer,
any return from these activities will result in loss of the others thus not resulting in any real
wealth creation.
ARGUMENT IN DEFENDING RIBA
In this section, two of the most common arguments defending the justifications of riba will
be discussed and the validity of these arguments will be examined.
Riba as Commodity
The practice of riba will be permissible by considering money as commodity. However,
Islam never recognized money as commodity. Money as well as fungible items have been
viewed in Islam as ribawi item, which if exchanged, have to be in equal amount as well as on
the spot interpreted from the passage as below:-
“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt
for salt, like for like, equal for equal and hand to hand. If the commodities differ, then you
may sell as you wish provided the exchange is hand to hand.”
Narrated by Sahih Muslim
Islamic banking and finance cannot deal with money directly to generate income or profit
because money is ribawi item.7 In Islamic law, benefit or profit accruing to one party out of
bilateral contracts must be always justified on the basis on one’s exposure to some degree of
risk and liability. 9 In the case of lending with a stipulated rate of interest, the lender is not
exposed to uncertainty since the interest rate is pre-determined. Additionally, in Islam giving
a loan or extending credit (debt) comes under the contract of tabarru’ (benevolence). One
asks a loan or debt because he is in need. Such need should not be exploited by charging riba
on the loan, 3 thus prevent inflicting injustice in the society.
Riba actually bring some benefits
AP Dr Mohd Daud Bakar revealed that some may justify riba by suggesting that riba actually
benefitted the society, individuals and institutions, lenders and borrowers. For an example,
profit earned by financial institutions is in part used to pay salaries and thereby allow
employees to enjoy life. And surely shareholders of the banks, they will also benefit of the
income earned.9 It should be noted that however, Islamic bank in Malaysia is not less
efficient than the conventional banks according to the studies done by Mariani Abdul Majid ,
Nor Ghani Md. Nor, Fathin Faizah Said.10 This implies that Islamic banks can perform as
well as conventional banks without engaging in riba related activities. Therefore, the
arguments that riba is needed for the good of employee and shareholder have no ground.
Even if it really brings some benefits to the society, the harm that it does (which will be
discussed in next section) will be too big to be surpassed by the advantages.
IMPACT OF RIBA-BASED BANKING SYSTEM
Some of the undesirable features of riba-based banking system suggested by AP Dr. Mohd
Daud Bakar from Islamic International University Malaysia are as below: -
i. Inflexibility of riba-based banking system tends to cause loss of productivity in the
future.
a. The borrowers have to pay a pre-determined rate of interest of the sum even
though he may have incurred loss or earned less than the sum needed to pay
for the interest rate, adding into the burden of entrepreneurs and thus its
expansion.9
b. In the early stage, some businesses may achieve a smaller rate of return than
that of the interest rate imposed on them. However, these businesses may
possess high growth potential in long term point of view. A pre-determined
interest rate may jeopardize the solvency of the businesses and the worst case
scenario is folding-up before good profits can be generated. This again results
in loss of productive potential.
c. Inflexibility in the interest-based system also causes inflexibility in business
strategies. Businesses tend to draw strategies that enable them to meet the
current financial obligations instead of what is really good for long term
productivity. The less than perfect business strategies again results in loss in
future productivity.
ii. The interest-based system is security-oriented rather than growth-oriented9.
a. In their lending operations, banks are most concerned about the safe return of
the principal lent along with the stipulated interest because of their
commitment to pay a pre-determined rate of interest to depositors. To reduce
risk, banks tend to allocate resources to well established big businesses instead
of potential entrepreneurs who may not be able to satisfy the banks criteria of
creditworthiness. As a result, entrepreneurship which is the backbone of
economic growth could not reach its full potential growth.
b. Oversupply of credit to well established parties and its denial to a large
segment of population also results in increasing inequalities in income and
wealth.
c. Security-oriented economy inadvertently results in stock market boom and
bust.
iii. The interest-based system discourages innovations9.
a. This is particularly true on the part of small-scale enterprises. Small-scale
enterprises are less willing to involve in R&D activities or new method of
production with the money borrowed from banks because these activities do
not always guarantee a fixed return. On a contrary, the business is obliged to
pay for the interest in addition to the principal for the money borrowed. Big
businesses, given preference from the banks and large cash reserve, will do
most of the R&D and getting more productive, resulting in further inequality.
b. In addition, with lack of incentive to innovate, the society does not reach its
full potential of technological change given the same resources. Many modern
economists suggest that technological change is one of the most important
determinants in economic growth. Thus a less aggressive technological change
may result in a slower economic growth.
Equity or debt financing in Islamic banking does not result in any of the above mentioned
problems. The techniques of the newly emerged riba-free institutions consist of: musharaka
(partnership), murabaha (cost-plus-profit contract), ijara (lease contract), ijarawa-iqtina'
(hire-purchase contract), qard hasan (interest-free loan), takaful (mutual guarantee) and
mudaraba (commenda partnership)4, which will not be discussed here as they deserve
another article to discuss in detail.
SUMMARY OF DIFFERENCES BETWEEN RIBA AND PROFIT
Table 1 Differences Between Riba and Profit
Riba ProfitDefinition Stipulated surplus of debt. Riba exist as long as the
exchange/transaction gives rise to inequality of counter values
(al-fadl) and determent in time of exchange (al-nasiah).
Profit is the return on trade, which is the result of difference
between revenue and cost, encompassing the effort and risk
undertaken by the entrepreneur.Prohibition Prohibited in Islam Permitted in IslamCounter
Value
Unequal counter value Equal counter value
Wealth
Creation
Deals only with money thus do not create real stock of wealth. Deals with real assets thus creates real stock of wealth from:
i. Additional values of the goods sold
ii. Increase in utility through exchange
Arguments of
Justification
i. Money as commodity – invalid
ii. Riba actually brings some benefits - invalid
Always justified in Islam
Impact of the
banking
system
Undesirable features of riba-based banking system:-
i. Inflexibility of riba-based banking system tends to
cause loss of productivity in the future.
ii. The interest-based system is security-oriented rather
than growth-oriented.
iii. The interest-based system discourages innovation.
iv. Other effects: increased inequality and vulnerability
Equity and financing in Islamic banks does not cause these
problems through new techniques like musharaka
(partnership), murabaha (cost-plus-profit contract), ijara
(lease contract), ijarawa-iqtina' (hire-purchase contract), qard
hasan (interest-free loan), takaful (mutual guarantee) and
mudaraba (commenda partnership).
COMMENTS
Current economic crisis has awakened the world the many loopholes of conventional banking
system. Islamic banking and finance is the most appealing alternative for the regulators and
investors as they are looking for a better way of doing things. For an example, French
Finance Minister Christine Lagarde at a recent forum in Paris said that Western financiers
could learn a thing or two from the Islamic world as global leaders try to establish “new
principles for the international financial system, based on transparency, responsibility and, I
would like to add, moderation.” 11 It neighbouring country, Britain owns the largest sharia-
compliant asset among the non-muslims countries. (See figure below).
Undoubtedly, the potential of Islamic banking and finance is vast, however fully shariah-
compliant especially in the area of interest-free is unlikely, at least for the next few decades.
This is because interest rate is one of the most important regulatory tools for the government
in monetary policy. Additionally, many economic theories which are used in deriving fiscal
policies have been established in which interest rate is one of the variables. A complete
overhaul of such well-established policies and theories is unlikely in a foreseeable future
albeit the recognition of the detrimental effects of interest-based banking system. The society
may deem the cost of changing the system is higher than the cost paid for the mess created
from the riba-based system and thus choose to stay in the old system. This case is especially
true for non-Muslims as religion is not a strong ground for change. Therefore, the author
suggests that while riba-free banking system is a more viable one, it will remain a
complementary to that of the conventional system in the next few decades until a set of new
and sound economic theories and policies emerge and become well-established.
Figure 3 Rank in Sharia-compliant Assets 200712
CONCLUSION
Riba which is forbidden in Islam is a stipulated surplus from debt. It exists as long as the
exchange/transaction gives rise to inequality of counter values (al-fadl) and determent in time
of exchange (al-nasiah). On the other hand, profit which is permitted in Islam is a return
from trade (revenue minus cost).
Riba activities incur unequal counter value in exchange and do not create new stock of
wealth. The opposite is true for profit. Additionally, Riba has never been able to be justified
in Islam since arguments that i. money as a form of commodity and ii. riba actually brings
some benefits could not be rightly justified.
Finally, riba-based banking results in the following adverse effects to the society: loss of
future productivity, security-oriented economics, stifled innovations and increased inequality
and vulnerability. Islamic banking system, on the other hand, avoids these problems by using
various shariah-compliant techniques.
Despite all the benefits, it is unlikely for global banking and finance to be riba-free in the
near future because the practices of interest-based activities have been deeply rooted in the
current economic system. Therefore, it is presumed that riba-free banking system will only
play a complementary role to that of the conventional one.
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<http://www.cert.com.my/cert/pdf/riba_drdaud.pdf>.
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Malaysia.” International Islamic University Malaysia. 20 Feb. 2008.
<HTTP://ISLAMICCENTER.KAAU.EDU.SA/7IECON/AHDATH/CON05/5TH%20CONF%20
PPR%20FOR%20BAHRAIN/EFFICIENCY%20OF%20ISL.%20BANKS%20IN%20MALAYS
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