Dr. Salman Ahmed Shaikh

The permissibility of earning interest on the amount of money lent creates distributive inequity in the financial flows as well as delinks the financial flows with the real economy.

Tremendous financial investments in exotic financial derivatives and money market ensure return to the financial capitalist on fiat money without having any commitment to give back to society any tangible real benefit. The current financial system largely funds rich segments of the population who can provide collateral as security for the grant of money based loans.

In a market following Islamic norms and values, the market forces will determine which Halal goods and services should be produced and offered at what price. Through private sector investment and production, resource markets and product markets will function to enable households to obtain purchasing power by providing rentable factors of production like labour services (Ijarat-ul-Ashkhas) or usufruct of a naturally existing or produced tangible asset (Ijarat-ul-A’yan) in the production process and earn compensation in terms of wage and rent, respectively.

As per Islamic rules of trade, the subject matter should be Halal and the price once determined cannot be changed in a credit sale after the sale is executed.

Since contemporary businesses require expensive and long duration capital goods for achieving efficiency and economies of scale, sourcing capital from individual households having surplus investible capital might be cumbersome. Islamic banks exist to reduce transaction cost, mitigate moral hazard and provide asset backed financing. Islamic banks monitor the investments made by households and share the profits on investments with them.

Since there is no provision of earning money by simply loaning fiat money, all the financing provided is backed by real assets in the Islamic economic framework. This mitigates the moral hazard problem and the misuse of funds. It also ensures that the real assets are traded or leased when a financing contract is executed. Thus, it strengthens the link with the real economy and links the payoffs with the outcome of real economic transactions rather than fixating profit for one party in investments.

By ensuring that financial intermediaries cannot simply earn interest on money capital alone, they necessarily have to ensure that they provide asset backed financing and these assets are purchased from the resource markets (such as raw materials, equipment and machinery) or goods market (such as cars and consumer appliances).

Finally, the institution of Zakat ensures that the poor and hungry people who earn below subsistence level incomes are provided with income support so that they can fulfil their basic needs. Producers and rich households who are required to pay Zakat, Ushr and Khums share their incomes with the poor households.

Thus, the Islamic economic framework ensures that investible capital is invested in the real economy and through which, a greater magnitude of employment opportunities are created as against an interest based financial system in which the funds can be invested in financial derivatives and money market to earn a risk-free return.

Finally, those households which remain unable to earn sufficient incomes to meet their needs are supported through the second phase of circulation of endowments which is not based on the profit motive, but which is driven by pure altruism.