68 AN INTRODUCTION TO ISLAMIC FINANCE
increase in the debt–equity ratio in the fi nancing of a given investment increases
its risk at an increasing rate without increasing its overall expected return.
This is probably the consequence of the fact that fi nancing an investment
exclusively by means of debt is not observed even in the conventional system
where leverage is encouraged.^3
An important implication of this study is that if prohibition of inter-
est is taken as a restriction on personal liberty without keeping in view the
negative macroeconomic externality that it generates in the form of increas-
ing risk to the underlying investment, then it seems dogmatic and coercive.
However, if the negative externality of debt fi nancing and its exploding
nature is fully understood, prohibiting interest makes more economic sense
than permitting it.
The Act of Lending is an Act of Charity
Many Muslim scholars point out that Islam’s prohibition of riba has two
dimensions: to promote more equitable risk-sharing contracts for business
and commercial purposes; and to consider lending as a benevolent act with
a view to helping someone in need. If someone needs capital for commer-
cial purposes, then capital should be given on a risk-sharing basis and if
someone needs funds to overcome some short - term need, then such need
should not be exploited and the borrower should not be put under an undue
burden. The benevolence and philanthropic elements of the prohibition of
riba are supported by the Qur’an and the traditions of the Prophet (pbuh).
The Shari’ah considers a loan to be a gratuitous contract, encourages
Muslims to offer charitable loans (qard - ul - hassan), and condemns the
accumulation of wealth for its own sake. Granting a loan without riba is
considered a charitable act worthy of bringing blessings (barakah); con-
versely, lending on the basis of riba has far - reaching and less - favorable
consequences.^4 Economists argue that acts of charity can play a critical role
in economic development.
Other Prohibited Elements
Gharar After riba, gharar is the most important element in fi nancial con-
tracts. In simple terms, gharar stems from informational problems and
refers to any uncertainty created by the lack of information or control in a
contract. It can be thought of as ignorance in regard to an essential element
in a transaction, such as the exact sale price, or the ability of the seller to
actually deliver what is sold. The existence of gharar in a contract makes it
null and void.
Gharar can be defi ned as a situation when either party to a contract has
information regarding some element of the subject of the contract, which is
withheld from the other party, and/or the subject of contract is something
over which neither party has control. Classic examples include transactions
involving birds in fl ight or fi sh not yet caught, an unborn calf in its mother’s