For the last few weeks, we have been deliberating on the subject of interest and debating the arguments usually put forward in favor of an interest-based set-up.
There is a lot more which can be written to demonstrate that the practice of applying interest has actually created more harm than good for humanity. However, in the ‘interest’ of time, this topic shall be concluded in this article since we need to move on to the next important subject in the series, ie a detailed exploration of how Islamic banks function differently than their conventional counterparts.
Argument
The advocates of interest claim that the presence of an interest mechanism in the world’s economies has been a blessing since it has succeeded in achieving the optimal allocation of resources based on the ‘equilibrium rate’. They also assert that replacing interest with profit cannot perform this function equally efficiently.
The equilibrium rate is defined as the interest rate at which the supply of money meets with its ultimate demand. This interest rate is applied by the apex banks of a country by way of a ‘base rate’ as a means of controlling the supply of money in an economy.
Therefore, when there is an excess supply of money in the country, the central bank shall increase the base interest rate which in turn shall encourage investors to put money into bonds. As the demand for bond rises, the base interest rate is lowered to dissuade people from investing in bonds. This mechanism is applied to achieve the so-called equilibrium rate in both situations on a perpetual basis.
Analysis
I was unable to locate any practical evidence in support of the equilibrium rate theory when I was part and parcel of the interest rate system. In fact, I observed recurring instances to the contrary whereby there was a constant demand for funding from the SME sector which was denied to a large extent on account of an undesired risk paradigm.
I remember some of the SMEs had pretty viable projects but unfortunately they could not see the light of the day due to a lack of funding, although my bank had excess liquidity and was forced to place it at meager overnight interest rates in the interbank market.
Some lucky SMEs did get the bank’s nod but the funds provided to them were inadequate and that too loaded with rigorous conditions and at an exorbitant cost which significantly reduced the chances of exploiting the full potential of the projects. At the same time, I saw the availability of lending to the large and ultra-large organizations in abundance, no strings attached and at a remarkably low cost.
When I look back now, I realize that it was not only the unfair allocation of the available funding resources by my bank but also the biased levy of interest whereby those who can easily afford to pay higher rates, ended up paying a fraction of the exorbitant rates imposed upon those who can ill afford to pay them.
In view of the foregoing, I finally came to the conclusion that the rate of interest system actually reflects not the objective criterion of the feasibility and the productivity of a business, but the biased measure of the credit rating mechanism. This is also the reason why in the capitalist economies, big businesses have grown bigger, assuming monopolistic powers, while the medium and small businesses have often been strangulated due to the denial of the affordable credit to them.
There could be an argument in favor of the cautious approach adopted by the banks toward SMEs owing to the downturn observed in this sector in the Gulf region during last few years and the losses amassed by some of the banks. Nonetheless, to me the situation seems more related to the conventional lenders’ false safety conviction that their credit is always payable on demand, and giving lesser emphasis to the viability of the borrowers’ business models. Had it been the other way around, ie the banks being careful in selecting the correct projects for lending, the situation would have been different.
The foregoing discussion leads to the logical conclusion that achieving a market price of money purely based on demand and supply in a free environment is truer theoretically. The varying rates on the different types of credit besides the influence by external factors such as regulatory bodies seldom allow this to happen in the real world.
Moreover, what should be the mechanism to ascertain a ‘global price for money’ or a ‘global equilibrium rate’ in the international money market where the economies of the developed nations seem to have integrated yet they are so far apart? Recent developments where the US and Europe do not see eye to eye anymore indicate a case in point.
To conclude, the Islamic economic principles are defined to effectively eliminate all such anomalies through the fair allocation of capital resources on the basis of the viability of the project, its part or full ownership through the injection of risk capital and the sharing of the resultant profit or loss.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the projects advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next week: The start of the detailed analysis of differences between Islamic and conventional banks.