QUESTIONS Unlike riba, profit is recognized in Islam because of its characteristic as a justified form of reward for capital and

enterprise.
(a) Discuss the above statement (b) List in a table the differences between profit and riba

INTRODUCTION Allah forbids riba and permit trades. Surah 2:275 Although riba is forbidden in Islam, profit generated from trade is a justifiable source of income in Islam. This article discusses the differences between riba and profit and from there deduces the rationale of the above injunction. For some people, the religious commitment will be good enough to guide them to reject the practice of riba and deem profit as the only justifiable source of income. However, for the other group, they deserve a more convincing explanation and clarification from economical and social point of view. Since the author is not a Muslim herself, it will not be persuasive to advocate that riba is unjustifiable on religious ground alone. Therefore, with fair amount of religious elements, this article examines riba and profit largely from economical aspect.

DEFINITIONS The Prohibited Riba In a gradual process, little by little Al-Quran prepares the ground and social environment for final prohibition. Riba in Islamic terminology is increase or excess over principal or more precisely, it is called a stipulated/forced/obligatory surplus on a debt.1 Or it can be defined as an increase or excess value (fadf) which in an exchange or sale of a commodity, accrues to the owner (lender) without giving in return any equivalent counter value or iwad. 1 In 1992, the Pakistan Federal Shariah Court ruled that: Any excess which is pre-determined over the

principal sum in a loan transaction will constitute Riba in all circumstances.2 By and large, as a general principal, riba exist as long as the exchange/transaction involves ribawi items and gives rise to inequality of counter values (al-fadl) and determent in time of exchange (alnasiah).3 Terminologically the equivalence of riba in economic tradition is usury, something that was prohibited in Jewish and Christianity also. But modern banking gets around the prohibition of usury little by little and eventually replaces the word usury with interest.4 Usury was also prohibited in ancient China. 5 Since it is not only Islam that prohibits riba, it is reasonable to infer that the practice of riba is somewhat harmful to the society. The Permitted Profit Profit is the return on trade, which is the result of difference between revenue and cost, encompassing the effort and risk undertaken by the entrepreneur. Existence of risks either before-sale or after-sale inadvertently results in uncertainty in profit (or loss). This is based on the legal maxim (Qawaid Fiqiah) that states al-ghunm bil al-ghurm which can be translated as gain is the result of risk-taking.6 Thus Muhammad Ayub (2007) described profit as ex-post, which is only known after the business venture. He also insists that profit generated from trade should be associated with real asset.
7

Islam places a great importance

in trade and encourages it because it is the major vehicle of increasing real income. Muslims believe that God wants his people to be prosperous and to avail themselves of the bounties of his creation.

RIBA VS PROFIT Riba vs Profit on Counter-value According to Fiqh scholars profit is a justified increase which is usually generated by exchange of two goods while riba occurs in unjust inequitable exchange of one commodity against another.1 Hanafi, Shafii and Maliki schools all agree on the term unequal countervalue when it comes to defining riba albeit the differences in the exact definitions. Therefore, this remaining of this section dedicates to explain graphically the differences of riba and profit in term of counter-value.

Ya
M

MBe

MB
E

MBI

O
B

QA
E

QBe
e E I

YaE
45o

QAE

QBE

YbE

Yb

OA

MA
e

MA
E

MAI

Figure 1(a) Equal Exchange1 Riba1

Figure 2 (b) Exchange involved

Figure 2 (a) shows the equal exchange between A and B for Y product, in which ya + yb = Y. MN is the opportunity space or the maximum available endowment of Y. At point E (intersection between MN and 45o straight line from the origin), A and B is in equal proportions - A is getting OYaE while B is getting OYbE. The 45o straight line is the equal counter value line, in which Y=X. Figure 1(a) shows that, it is a zero sum game activity where the gain of one party is directly the loss of the other one.1 Any point fall out of point E will not result in equal counter value. Additional value that accrues to either party in this kind of transaction amounts to excess without counter value or prohibited riba in Islam. In the case of Figure 2(b), A has endowment of good OQAe and certain amount of money OMAe and B has endowment of good OQBe and money amount of OMBe. A requires to have more money and sell some of his plenty of good. While B would like to purchase some of good Q from A in exchange for money, in which the exchange normally takes place at a prevailing market price. However, in this transaction, A sells (QAe-QAE) of the good for (MBe MBI) which B will pay by instalment. The extra price paid than that of the market value (MBe MBE) is a result of interest imposed on B. This additional amount money that accrues to A is absolutely the loss to individual B, where the stock of individual B decreases from MBE to MBI . Since MA = MB is in absolute terms, so in exchange rationale, this is one side flow which has no any corresponding value in repayment, resulting in riba which is shaded in yellow in Figure 2(b). In Islam, an alternative to prevent riba in deferred payment mode is Murabaha-Muajjal.

Conclusively, riba results from an exchange without equal counter value whereas profit results from an exchange with equal counter value. Therefore, the former is forbidden but the latter is permitted in Islam.

Riba vs Profit on Wealth Creation Islamic commercial law aims at promoting the actual wealth creation instead of artificial and bubble creation of wealth.1 Profit generated in the process of trade is a result of:
i.

Additional value of goods - due to physical transformation of an object from one form to another; usually quantifiable in monetary term (price difference final products between raw materials as well as other operational costs) and

ii.

Exchange of goods with others - exchanging goods with lower marginal utility with the higher ones results in higher utilities for both trading parties. This concept will be illustrated below.

Exchange of goods take place because differences in endowments and abilities of producing goods and services and differences in preferences or tastes.4 Most importantly, exchange is needed to maximize utility because of diminishing marginal utility and different marginal rate of substitution. Intuitively, well-balanced, diversified bundles of commodities are preferred to bundles that are heavily weighted toward one commodity, leading to the convex nature of most of the indifferent utility curves.8 It is noteworthy to refer this principle to the context of the story of Bani Israel when they tired of eating the heavenly food manna and salwa and they said that they could not keep satisfied with one type of food only.1 It implies that even the heavenly food is less of a choice to the Israelites than variety of foods. Figure below shows how trade can increase the real wealth between two trading parties and thus justify the return on trade profit.

OC
a

XBe OC
b

E A

UAo

YBE U
1 A

UBo
X OB

UB1

OA

XA
E

XAe

XB
E

Figure 2 (a) &(b) Individual Utility Functions before and after Trade

Figure 1 (a) & (b): Suppose A has X endowment and nothing of commodity Y while B has only Y. In the initial situation no one is engaged in trade, so the utility level is at the X and Y intercept, resulting in low level of utility UAo and UBo due to diminishing marginal utility. If they agree on trading according to their expected budget lines, they will both be better off, achieving higher utility level, UA1 and UB1. A now will have different relative prices of good X, with an offer curve labelled OCa. The offer curve intersects with the budget line at point E, resulting in higher utility function which is the tangent to the intersection point, E. The similar will be the case of B.

Y X

XB
E

OB

UA
1

N OC
b

UB YAE
1

UB
o

OC
a

YBE

M UA
o

OA

XA
E

YBo XA
o

Figure 2 (c) Superimposed Utility Functions of Two Parties of Exchange 1

Figure 1 (c): Imposing the two diagrams (a) & (b), we can find the efficiency of exchange process by raising the welfare of both individuals. Before the exchange A and B would ends

up at M and N respectively.

However through exchange they will arrive at anywhere

between M and N with the highest point, E. In contrast with trade, Riba activities do not create new stock of wealth. It is a zero sum phenomenon arises from exchange of two identical goods, which there is no way to increase the utility of one party without reducing the other. For an example, in many countries government raise fund from the public by issuing interest-based notes and bonds with a fixed return.9 If the fund raised does not result in return higher than the promised interest rate, these interests will have to be paid by the next generation in the form of tax as suggested by Ramsey-Cass-Coopman infinite horizon model (which is indifferent between tax and bond). In this case wealth is merely transferred from the future generation to the current one. The government may even find itself caught in the vicious cycle of debt, which eventually leads to debt crisis that further deepen the hole of debt. On the other hand, if the government is to raise shariah-compliant bond (sukuk) based on real assets by sharing the real profit or loss, then it will be free from the problem above. It should be noted that the above example is only one of the examples of the detrimental effect of riba to the real economy. Conclusively, trade takes place only when situation shows a surplus of satisfaction thus resulting in real wealth creation profit; whereas riba activities involve only wealth transfer, any return from these activities will result in loss of the others thus not resulting in any real wealth creation.

ARGUMENT IN DEFENDING RIBA In this section, two of the most common arguments defending the justifications of riba will be discussed and the validity of these arguments will be examined.

Riba as Commodity The practice of riba will be permissible by considering money as commodity. However, Islam never recognized money as commodity. Money as well as fungible items have been viewed in Islam as ribawi item, which if exchanged, have to be in equal amount as well as on the spot interpreted from the passage as below:-

Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt, like for like, equal for equal and hand to hand. If the commodities differ, then you may sell as you wish provided the exchange is hand to hand. Narrated by Sahih Muslim Islamic banking and finance cannot deal with money directly to generate income or profit because money is ribawi item.7 In Islamic law, benefit or profit accruing to one party out of bilateral contracts must be always justified on the basis on ones exposure to some degree of risk and liability. 9 In the case of lending with a stipulated rate of interest, the lender is not exposed to uncertainty since the interest rate is pre-determined. Additionally, in Islam giving a loan or extending credit (debt) comes under the contract of tabarru (benevolence). One asks a loan or debt because he is in need. Such need should not be exploited by charging riba on the loan, 3 thus prevent inflicting injustice in the society.

Riba actually bring some benefits AP Dr Mohd Daud Bakar revealed that some may justify riba by suggesting that riba actually benefitted the society, individuals and institutions, lenders and borrowers. For an example, profit earned by financial institutions is in part used to pay salaries and thereby allow employees to enjoy life. And surely shareholders of the banks, they will also benefit of the income earned.9 It should be noted that however, Islamic bank in Malaysia is not less efficient than the conventional banks according to the studies done by Mariani Abdul Majid , Nor Ghani Md. Nor, Fathin Faizah Said.10 This implies that Islamic banks can perform as well as conventional banks without engaging in riba related activities. Therefore, the arguments that riba is needed for the good of employee and shareholder have no ground. Even if it really brings some benefits to the society, the harm that it does (which will be discussed in next section) will be too big to be surpassed by the advantages.

IMPACT OF RIBA-BASED BANKING SYSTEM Some of the undesirable features of riba-based banking system suggested by AP Dr. Mohd Daud Bakar from Islamic International University Malaysia are as below: i.

Inflexibility of riba-based banking system tends to cause loss of productivity in the future.
a. The borrowers have to pay a pre-determined rate of interest of the sum even

though he may have incurred loss or earned less than the sum needed to pay for the interest rate, adding into the burden of entrepreneurs and thus its expansion.9
b. In the early stage, some businesses may achieve a smaller rate of return than

that of the interest rate imposed on them. However, these businesses may possess high growth potential in long term point of view. A pre-determined interest rate may jeopardize the solvency of the businesses and the worst case scenario is folding-up before good profits can be generated. This again results in loss of productive potential.
c. Inflexibility in the interest-based system also causes inflexibility in business

strategies. Businesses tend to draw strategies that enable them to meet the current financial obligations instead of what is really good for long term productivity. The less than perfect business strategies again results in loss in future productivity.
ii.

The interest-based system is security-oriented rather than growth-oriented9.

a. In their lending operations, banks are most concerned about the safe return of

the principal lent along with the stipulated interest because of their commitment to pay a pre-determined rate of interest to depositors. To reduce risk, banks tend to allocate resources to well established big businesses instead of potential entrepreneurs who may not be able to satisfy the banks criteria of creditworthiness. As a result, entrepreneurship which is the backbone of economic growth could not reach its full potential growth.

b. Oversupply of credit to well established parties and its denial to a large segment of population also results in increasing inequalities in income and wealth.
c. Security-oriented economy inadvertently results in stock market boom and

bust.
iii.

The interest-based system discourages innovations9.

a. This is particularly true on the part of small-scale enterprises. Small-scale

enterprises are less willing to involve in R&D activities or new method of production with the money borrowed from banks because these activities do not always guarantee a fixed return. On a contrary, the business is obliged to pay for the interest in addition to the principal for the money borrowed. Big businesses, given preference from the banks and large cash reserve, will do most of the R&D and getting more productive, resulting in further inequality.
b. In addition, with lack of incentive to innovate, the society does not reach its

full potential of technological change given the same resources. Many modern economists suggest that technological change is one of the most important determinants in economic growth. Thus a less aggressive technological change may result in a slower economic growth. Equity or debt financing in Islamic banking does not result in any of the above mentioned problems. The techniques of the newly emerged riba-free institutions consist of: musharaka (partnership), murabaha (cost-plus-profit contract), ijara (lease contract), ijarawa-iqtina' (hire-purchase contract), qard hasan (interest-free loan), takaful (mutual guarantee) and mudaraba (commenda partnership)4, which will not be discussed here as they deserve another article to discuss in detail.

SUMMARY OF DIFFERENCES BETWEEN RIBA AND PROFIT Table 1 Differences Between Riba and Profit Definition Riba Stipulated surplus of debt. Riba exist as long as the exchange/transaction gives rise to inequality of counter values Prohibition Counter Value Wealth Creation (al-fadl) and determent in time of exchange (al-nasiah). Prohibited in Islam Unequal counter value Deals only with money thus do not create real stock of wealth. Profit Profit is the return on trade, which is the result of difference between revenue and cost, encompassing the effort and risk undertaken by the entrepreneur. Permitted in Islam Equal counter value Deals with real assets thus creates real stock of wealth from: i. Additional values of the goods sold ii. Increase in utility through exchange Arguments of Justification Impact of the banking system ii.
iii.

i. Money as commodity invalid ii. Riba actually brings some benefits - invalid Undesirable features of riba-based banking system:i.

Always justified in Islam Equity and financing in Islamic banks does not cause these (partnership), murabaha (cost-plus-profit contract), ijara hasan (interest-free loan), takaful (mutual guarantee) and mudaraba (commenda partnership).

Inflexibility of riba-based banking system tends to problems through new techniques like musharaka cause loss of productivity in the future. than growth-oriented. The interest-based system discourages innovation. Other effects: increased inequality and vulnerability The interest-based system is security-oriented rather (lease contract), ijarawa-iqtina' (hire-purchase contract), qard

iv.

COMMENTS Current economic crisis has awakened the world the many loopholes of conventional banking system. Islamic banking and finance is the most appealing alternative for the regulators and investors as they are looking for a better way of doing things. For an example, French Finance Minister Christine Lagarde at a recent forum in Paris said that Western financiers could learn a thing or two from the Islamic world as global leaders try to establish new principles for the international financial system, based on transparency, responsibility and, I would like to add, moderation.
11

It neighbouring country, Britain owns the largest sharia-

compliant asset among the non-muslims countries. (See figure below). Undoubtedly, the potential of Islamic banking and finance is vast, however fully shariahcompliant especially in the area of interest-free is unlikely, at least for the next few decades. This is because interest rate is one of the most important regulatory tools for the government in monetary policy. Additionally, many economic theories which are used in deriving fiscal policies have been established in which interest rate is one of the variables. A complete overhaul of such well-established policies and theories is unlikely in a foreseeable future albeit the recognition of the detrimental effects of interest-based banking system. The society may deem the cost of changing the system is higher than the cost paid for the mess created from the riba-based system and thus choose to stay in the old system. This case is especially true for non-Muslims as religion is not a strong ground for change. Therefore, the author suggests that while riba-free banking system is a more viable one, it will remain a complementary to that of the conventional system in the next few decades until a set of new and sound economic theories and policies emerge and become well-established.

Figure 3 Rank in Sharia-compliant Assets 200712

CONCLUSION Riba which is forbidden in Islam is a stipulated surplus from debt. It exists as long as the exchange/transaction gives rise to inequality of counter values (al-fadl) and determent in time of exchange (al-nasiah). On the other hand, profit which is permitted in Islam is a return from trade (revenue minus cost). Riba activities incur unequal counter value in exchange and do not create new stock of wealth. The opposite is true for profit. Additionally, Riba has never been able to be justified in Islam since arguments that i. money as a form of commodity and ii. riba actually brings some benefits could not be rightly justified. Finally, riba-based banking results in the following adverse effects to the society: loss of future productivity, security-oriented economics, stifled innovations and increased inequality and vulnerability. Islamic banking system, on the other hand, avoids these problems by using various shariah-compliant techniques. Despite all the benefits, it is unlikely for global banking and finance to be riba-free in the near future because the practices of interest-based activities have been deeply rooted in the current economic system. Therefore, it is presumed that riba-free banking system will only play a complementary role to that of the conventional one.

BIBLIOGRAPHY

Chapter 5 Riba vs Profit in Exchage Context. 20 Feb.2009. < http://72.14.235.132/ search?

q=cache:5OphFX9QykJ:prr.hec.gov.pk/Chapters/1055.pdf+riba+vs+profit&hl=en&ct=clnk&cd=1&gl =my >.

2

Malaysia Toward an Islamic State: Islamic Banking in Malaysia. Publication of Islamic System of

Zakat. 20 Feb. 2009. <http://www.islamic-world.net/islamicstate/malay_ islambank.htm>.

3

AP Dr Radiah Abdul Kader. Main Prohibitions in Muamalat Transactions. BSP-02, FEP,

University of Malaya. 22 Jan. 2009.

4

M.H.Zahedi Vafa. Comment of M.H Zahedi Vafa on Riba Versus Profit in Exchange Economy:

Conceptual Foundations for Stable Financial System in Islamic Perspectives by Elmi Nur. 20 Feb. 2009. <http://islamiccenter.kaau.edu.sa/7iecon/Ahdath/Con06/pdf/Vol2/ 55%20 Comment%20by %20Zahedi%20Vafa.pdf>.
5

Usury. Wikepedia. 22 Feb. 2009. <http://en.wikipedia.org/wiki/ Usury>. AP Dr Radiah Abdul Kader. Profit: The Islamic Alternative to Riba. BSP-02, FEP, University of

Malaya. 13 Feb. 2009.

7

Ayub, Muhammad. Understanding Islamic Finance. John Wiley and Sons, 2007. Michael E. Wetzstein. Mircoeconomic Theory. USA: Thomsan South-Western, 2005. 34. AP Dr Mohd Abdul Bakar. Riba and Islamic Banking and Finance. 22 Feb. 2009.

<http://www.cert.com.my/cert/pdf/riba_drdaud.pdf>.
10

Mariani Abdul Majid, Nor Ghani Md. Nor, Fathin Faizah Said. Efficiency of Islamic Banks in

Malaysia. International Islamic University Malaysia. 20 Feb. 2008. <HTTP://ISLAMICCENTER.KAAU.EDU.SA/7IECON/AHDATH/CON05/5TH%20CONF %20PPR%20FOR%20BAHRAIN/EFFICIENCY%20OF%20ISL.%20BANKS%20IN %20MALAYSIA%20BY%20MARIANI%20ABDUL%20MAJID%20.DOC>.
11

Appeal of Islamic Finance. Malay Mail Your Voice. 25 Dec. 2008. Faith Based Finance. The Economist. 4 Sept. 2008.

12