Difference between Interest-Based Traditional Financing and Islamic Finance’s Profit and Loss Sharing Principle

Almost in every religion there are some restrictions which are based on basic principles of those religions. Islam is one of the largest and heavenly religion and followers are called Muslims. Teachings of Quran and Hadith of holy Prophet are only and major source of Islamic Principles. Traditional principles of banking and finance are strictly prohibited in Islam. Due to this reason Islamic banking, Islamic finance and Islamic economics were determined in the light of Hadith and Quran. Islamic principle of Profit and loss sharing is very different and innovative from traditional method (Chapra, 2008). Traditional financing techniques pay a fixed percentage to the creditor that does not change regardless of change in profit and loss (Haron et.al, 2000). Fixed nature of sharing profit and loss is termed as interest which is prohibited in Islam. Islamic finance believes that money alone (without efforts) cannot generate money. Islamic finance believes in partnership where profit and loss is distributed according to contribution of partners (Farooq, 2007).

Islamic method of distributing profit and loss is based on the principle of equality among different classes. Creditors earn interest because they have excess of capital and debtors pays interest because of tough financial condition. Islamic method of sharing profit and loss is very beneficial for lender and debtor because it allows mutual growth. An Islamic economics and finance principle encourages becoming partner either sleeping or active to earn more money (Gamal, 2006). Like conventional finance and economics, Islam encourages taking higher risks to earn higher return. Equal distribution of profit and loss gives birth to innovative ideas and new entrepreneurs. Islamic principle of sharing profit and loss encourages new entrepreneurs by sharing their loss equally (Agarwal, 2000). Conventional method requires payment of interest and profit regardless of failure or success of business venture or business project. Islamic profit and loss sharing principle is getting famous even among non-Muslim investors. According to Chapra, traditional lending and borrowing system is major reasons of global financial crisis and Islamic profit and loss sharing principle can help to avoid these financial crises (Chapra, 2009). In last few decades, Islamic banking, Islamic economics and Islamic finance are expected to gain highest market share (El Qorchi, 2005). The major reason of success of Islamic profit and loss sharing principle is psychological and social impacts. Compared to conventional sharing, Islamic principle of sharing profit provides more earning opportunities.

  Islam strictly prohibits the receiving and paying of any form of interest or usury (Chong and Ming, 2009). Due to the fact that Quran and Sunnah strictly prohibit the use of interest then how Islamic financial institutions and Islamic financial system rewards investment. In conventional financial system interest or compounding interest is used to earn more money which is considered as reward for additional risk inherited in investment. Although Islamic system prohibit interest payment but does not prohibits earnings or investment. Islamic system encourages development and investment that does not hurt equality. Although there is not any perfect alternative of interest in Islamic system but profit and loss sharing is substitute to interest payment (Yudistira, 2003). Every form of interest either small or negligible is strictly prohibited in Islam because it leads to diminishing returns. There is huge difference in interest and profit and loss sharing but both can be termed as reward for taking risk. Following are major difference between interest and Islamic profit and loss sharing principle.

Psychological and Social Impacts of Traditional Financing and Profit and Loss Sharing Principle

Interest is predetermined rate payable on principle amount regardless of success or failure of project of business. Profit and loss sharing is replacement of interest in Islamic financial system which depends on the return from project. Total return is shared according to ratio of investment among investors.

Interest payment in conventional financial system is mandatory to pay regardless of success or failure of venture (Beck et.al, 2013). If business or individual is unable to pay interest then business will be declared as bankrupt. Islamic financial system, total return is shared among individual partners and in case of failure, loss is equally distributed.

Interest payment on loan always leads to exclusive growth of rich investors while negatively impact on poor class. Islam prohibits interest because Islam is in favor of inclusive growth of all classes which include rich and poor. Conventional banks are also eliminating interest and replacing interest with GDP growth (Uddin, Md Akther, and Asyraf Halim, 2015).

Religions are based on some doctrines and laws in every field of human life. The primary purpose of these doctrines is to create equality and justice for individual. Interest or usury is prohibited in every religion because it spread inequality and separates rich and poor (El Gamal, 2003). Following paragraph will discuss the major rational about why and how interest is prohibited in different religion.

1. Islam

Islam is based on holy Quran and Sunnah which teaches human to work hard and does not depend on chance or gambling. Riba (Interest) Maysir (Gambling, Speculation) and Gharar (Unreasonable uncertainty or Excessive uncertainty) are strictly prohibited in Islam. Interest is based on philosophy that money alone earns money. In contrast, Islamic financial and economic system believes that money or capital alone cannot earn money. There are four factors of production which are land, labor, capital and entrepreneur. Capital without entrepreneurship can never generate more money. Islamic financial institutions treat capital and commodity very different. Although followers of Islam blindly believe on teachings of Quran and Sunnah but there is strong logical reasons for the prohibition of gambling and gharar. Maysir or gambling is earning without any physical efforts or work hard therefore, it is prohibited in Islam. Gambling is also prohibited because it is zero sum game and one individual earns at the cost of other. Maysir is very dangerous for economic growth because it reduces the hardworking among individuals. Gambling and speculation transactions are prohibited because it is relying on luck and chance.

Prohibition of Usury in Other Religions

Although taking business risk is legal in Islam but transactions that involve excessive risk are termed as Gharar which is prohibited in Islam. In conventional financial system taking risk is rewarded with excess return but Islamic financial system prohibits executing economic transaction that involves excessive risk. Islam enforces to disclose defects and risks involved in any sale that’s why gharar sale is prohibited. Gharar sale involves uncertainty or defects which is a type of fraudulent transaction. Conventional financial and economic system also enforces the need of symmetric information to strengthen quality of decision making. Gharar is based on asymmetric information that forces buyer to take excessive risk or excessive uncertainty. Gharar can also be defined as economic transaction that involve cheating and misrepresentation of the facts of products.     

1. Hinduism

Hinduism also prohibits the usury which can be traced to the sacred text of Hinduism. Veda is the sacred text of ancient India which strictly prohibits the use of usury. Vasishtha was a famous law maker of Hindu religion who strictly prohibited Hindus to lend capital on interest. Vasishtha provided references to their sacred text Veda to avoid interest or Riba. Usurer is repeatedly mentioned in Veda which means any individual who lend money and charges higher than principle amount. Vasishtha warned rich casts of Hinduism to avoid lending money on interest. These costs were priests and warriors who were very rich compared to other costs. The primary purpose of prohibition of interest in Hinduism is same that it increases the income difference between poor and rich class. Although in ancient India, interest was banned but modern Indian state does not strictly regulate this belief. Buddhism in India also strongly condemns use of interest and their sacred text mentioned usurer (Kusidin) as illegal. 

1. Judaism

Like Islam and Hinduism, Judaism also forbids lending loan on interest. Torah and Talmud are two broad categories of Jews with different doctrines and principles. Both categories of Jews encourage the provision of interest free loan that does not include interest payment. Unlike Islam and Hinduism, Jews allows interest bearing loan to non-Jews. Torah is sacred script of Jews which says that secured loans or asset backed loans are also prohibited. Many Jews claim that interest was prohibited in ancient time when there was no any developed financial system.

1. Christianity

 Interest is also prohibited in Christianity which can be traced from three major sources of Christianity. Teachings of bible, supplemented words of church institutions and Christian philosophers collectively prohibit the use of interest. New Testament of bible clearly states that lend capital to other in hope of nothing which means never expect to receive excess payment in form of interest. Teachings of bible clearly states that Jesus himself disliked interest and asked his followers to lend money to poor and do not charge excess money. Usury is called nesheks in Hebrew language which means bite which is used for creditor and tarbit means excess which is used for debtor. In holy bible every form of interest whether excess rate or lower rate is prohibited for both creditor and debtor.

References

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