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Understanding Islamic Finance

Thursday, July 24, 2014

Next week, Muslims in T&T and around the world celebrate Eid-ul-Fitr. The current upheavals in the Middle East bring to the fore a number of different issues, but there is one aspect of the religion of Islam that is of particular interest to students of finance in the West. 


Imagine a world without either the receipt or payment of interest. In other words, rather than dealing with the issue of the level of interest rates, consider a scenario where interest is neither paid nor collected.


The prohibition of receiving and paying interest is well documented in Islam, even if it is not as widely practiced as it is supposed to be. However, this is not a construct that is unique to Islamic theology and students of the Old Testament can cite many references where interest is either prohibited or limited to some degree.


Interest is born out of the issuance of credit. However, credit (borrowing) is not necessarily a bad thing. Conventional finance argues it is the rate of interest that is the arbiter of credit. The rate of interest should reflect the risk associated with the lending. In other words, the person’s ability to repay as well as level of available credit with the higher the demand for credit, the higher the rate of interest and the lower the demand, the lower the rate of interest.


Interest is therefore the compensation paid by the borrower of capital to the lender, for permitting him to use his funds. A typical economic definition puts interest as the rent paid by the borrower of capital to the lender to compensate him for the loss of the opportunity to use the funds when it is on loan. It can be likened to the decision not to live in an apartment or house that you own. One would, in such circumstances, rent it out to a tenant.