MCCA November Article | The Wisdom Behind the Prohibition of Riba
In Islam, the prohibition of riba (interest) is well known. However, many people often wonder about the logic behind such rules, particularly when it comes to exchanging money.Â
In this blog, our trusted Shariah advisor, Almir Colan, helps us break down the wisdom behind the prohibition of Riba in Islam, by examining a case study from the Global Financial Crisis (GFC).
What was the GFC?
During the GFC, banks and financial institutions would offer home loans to customers, giving them time to repay the amount borrowed, plus a surplus. For example, if someone took a home loan of $400,000, they would end up returning maybe $600,000 or more over time. The banks, therefore, would be doubling their money in the future. This practice led to the creation of collateral debt obligations (CDOs), a type of derivative that returns a cash flow of, say, $2 billion over 20 years.
The banks would then package these CDOs and sell them to other banks for a profit. For instance, they might spend $1 billion creating a package and sell it for $1.3 billion, promising the buyer a return of $2 billion over 20 years, and a profit of $700 million. This created an incentive for banks to give out as many loans as possible to create bigger contracts and bigger profits.
However, this led to a situation where banks would offer loans to people who could not afford them. For example, a waitress earning $20,000 a year might be sold a half-million-dollar home with an attractive ‘honeymoon’ rate that she could initially afford but would eventually default on. The banks did this to create bigger packages of CDOs to sell to other banks.
When people started defaulting on their loans, the value of the CDOs dropped rapidly, causing the banks to start selling homes, which in turn caused house prices to plummet. More and more people defaulted on their loans, causing a downward spiral that ultimately led to the collapse of the housing industry and the economy.
To protect themselves, some banks took out insurance on the CDOs, effectively betting on the economy to fail. This created a system of incentives that was completely disconnected from the realities of the market, allowing some to benefit from the disaster while others suffered.
The Root Cause
At the heart of this issue is the ability to exchange unequal amounts of money. Exchanging $2 billion in the future for an unequal amount today created the building blocks for the entire financial crisis. This is why Islam prohibits such exchanges, insisting that money exchanged for money must be equal, on the spot, with no delay and no surplus.
This prohibition goes against all mutual cooperation in society, creating an incentive to exploit those who need to be protected. Therefore, when we see these rules in Islam, we should embrace and appreciate them as they are designed to protect us from the harmful effects of a system built on exploitation.
In conclusion, the prohibition of riba in Islam is not just a religious commandment but a safeguard against the creation of a financial system that benefits a few at the expense of many. It promotes mutual cooperation in society and protects those most vulnerable from exploitation. By understanding the wisdom behind this prohibition, we can better appreciate its importance and strive to create a fairer and more equitable financial system for all.
