Download THE CASE AGAINST INTEREST: IS IT COMPELLING?

THE CASE AGAINST INTEREST:
IS IT COMPELLING?
by
M. Umer Chapra
Research Adviser
IRTI/IDB
Jeddah (Saudi Arabia)


Why a new system of financial
intermediation? Is there anything wrong with
the prevailing interest-based system ?
Evaluation of a system on the basis of its
contribution to :
 Efficiency

Ease and promptness in the transfer of funds from the
surplus to the deficit sectors

Economy in transactions costs

Stability
 Equity
(Socio-economic justice)


Interest-based system was never considered
to be superior on the criterion of equity. Its
superiority claimed on the criterion of
efficiency, why?
Confidence in the Efficiency of the system
has been shaken by its persistent instability
over the last four decades.

Call for a “New Architecture”
 Sound Macro-economic policies
 Sustainable exchange rates
 Proper regulation and supervision

Adequate capital, proper risk
management, effective corporate
governance, greater transparency
 Why is market discipline unable to
ensure the faithful observance of these
principles?

Reasons for the ineffectiveness of market discipline in
the interest-based banking system:
 As a result of the absence of risk-sharing:
 Deposits are guaranteed - therefore depositors
become complacent and do not monitor the banks
carefully - do not demand transparency
 Banks rely on the crutches of collateral, which
ensures the repayment of their loans - they do not
evaluate the risks carefully - tend to extend credit
excessively. This promotes:
 Public sector deficits
 Private sector living beyond means
 Highly leveraged short-term debt
 Rapid movement of funds
 Volatility

The greater the reliance on debt and the higher the
leverage, the more severe the crises

Some Examples:
 East Asia Crisis
 Long-term Capital Management (LTCM)
 Foreign Exchange Markets
 Remedy lies in injecting greater discipline in
the financial system – How?
 Introduce risk sharing to make market
discipline more effective
 More effective discipline will complement
the role of regulators and supervisors and
help make the financial system healthier
and more stable
 Interest-free finance is intended to inject the
needed discipline into the financial system
through risk-sharing:
 Risk-sharing by banks ?
 The bank shares in the risk with
the entrepreneur
 Risk-sharing by depositors ?
 Demand deposits
(These do not share in the risks and do not
therefore get any return –must be guaranteed)
 Investment deposits
(These must share in the risks – just like
shareholders)
 What about credit ?
 There is credit and the rate of return is fixed in
advance – Is this interest ?
 There is no borrowing and lending – Rather there is
purchase and sale of goods and services.
 The financier bears some risk in the sales-based
modes of financing : murabahah, ijarah, salam and
istisna‘
 Wouldn’t this bring instability: NO
 Credit expands in step with the growth of the real
sector
 Speculation minimized as a result of risk-sharing
 This shows that even though
Islamic finance is more difficult it
can be more efficient.
What about equity?
 Living beyond means
 Need fulfillment
 Full employment
 Equitable distribution?