74 AN INTRODUCTION TO ISLAMIC FINANCE
criticized the institution of interest and has advocated interest - and infl ation -
free money. Overall, however, critics of interest are rare exceptions among
modern economists.
The challenge has come mainly from Islamic scholars. Sheikh Mahmud
Ahmad, for example, searched through several theories of interest, devel-
oped since the time of Adam Smith, to show that there has been no satis-
factory explanation of the existence of a fi xed and predetermined rate of
return on fi nancial assets. His analysis of the writings of economists such
as Keynes, Bohm Bowerk, Cassels, and Samuelson led him to argue that
an objective assessment of these writings would lead to the belief that all
of these writers held a reasonably strong conviction that the existence of a
fi xed and predetermined rate of interest was an impediment to the process
of economic growth and development.
By the mid - 1980s, economic and fi nancial theory had demonstrated
that there were disadvantages in the fi xed payoff contracts that dominated
interest - based banking. It was shown that such contracts create ineffi cient
defaults on fi nancial obligations or non - performing assets. In the presence
of asymmetric information, debt contracts also suffer from the effects of
adverse selection and moral hazard. Fixed-fee contracts create a fundamen-
tal confl ict between the interests of the borrowers and the lenders.
As a consequence, socially desirable sectors with low profi tability will
not get fi nance; moreover, new entrepreneurs with good projects may not be
able to obtain fi nance in the absence of the security required.
ENDNOTES
- Lane’s Lexicon defi nes it this way: “To increase, to augment, swellings, forbidden
‘addition’, to make more than what is given, the practicing or taking of usury or
the like, an excess or an addition, or an addition over and above the principal
sum that is lent or expended.” - According to one of the sayings of the Prophet Mohammad (pbuh), “a person’s
wealth is as sacred as a person’s blood.” - Excessive leverage is observed in fi nancial institutions and hedge funds but it has
been criticized in the wake of the fi nancial crisis of 2007–08. Therefore, ignoring
all debt fi nancing is a reasonable assumption. - See, for example, the Qur’an 30:39, 57:11 and 64:17. The Prophet (pbuh) is
also reported as saying that “debauchery and riba lead a nation to ruin.” - Birnie (1952).
- A minor incident in 605 AD, just a few years before the revelation of Islam, is
worth mentioning. The sacred House of God, Kabbah, was damaged by fi re
and public contributions were called for to repair the damage. However, it was
emphasized that only pure, clean, and honestly earned money could be used
for this purpose and consequently prostitutes and usurious moneylenders were
specifi cally debarred from contributing. This incident is an indication that even
the pagans of Arabia did not consider money earned through lending to be from
a clean and ethical source.