BOOK NOTICE

Book Review

by Islamic Finance Today, June-August 2007.

Interest, Usury, Riba and the Operational Costs of a Bank

by A.L.M. Abdul Gafoor

This work entitled ‘Interest, Usury, Riba and the Operational Costs of a Bank by A.L.M. Abdul Gafoor is a noteworthy contribution to the study of an alternative Islamic banking system. Some of the arguments it puts forward, though novel and innovative, are also contentious and not unlikely to go unchallenged by the conservative camp.

The work which provides an in-depth analysis of the problem of interest including its detrimental effects on society as a whole, argues for a better understanding of banking operations in the context of its operational costs. The author attempts to show that it is possible to separate riba from the operational costs of a bank and thus to devise a riba-free system of commercial banking. To drive home this point he employs several analogies including that of a courier of money whose growing involvement as an intermediary in a given lending transaction including attestation and evaluation ultimately leads to the evolution of an institution - in other words a bank, convincingly showing that it is the borrower who has to bear the expenses incurred in borrowing money from a lender as against riba which is the payment made to the lender for the capital he lends.

As such he concludes that the loan obtained in the former context, though riba-free is not cost-free and that this cost has to be borne by the borrower. As such he argues that a bank may validly charge a fee for its services and in support he cites the Iranian, Pakistani and Siddiqi models, all of which make provision for a service charge for providing loan facilities. For instance, in the Pakistani model, it is explicitly stated that banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds and provisions for bad and doubtful debts.

Based on this premise, the author employs a methodology where the usual interest charged by conventional banks is taken and split into six distinct components, of which he shows that only one component falls into the category of riba, the other five belonging to the category of costs and remuneration. On account of this, the usual interest charged by conventional banks is called the Cost of Borrowing (CoB) and not interest which good Muslims equate with riba. These six components are :- interest paid to the depositor, in other words, riba; cost of overheads; cost of services; a risk premium; profit or remuneration to the bank and compensation for the value loss of capital due to inflation.

Leaving out the interest component which a Muslim depositor will not demand or accept, and hence one which the bank will not collect from borrowers, the author proceeds to elaborate the rest of the components. This includes the services cost which is the cost involved in processing the application. This includes legal and other charges paid by the bank for services such as evaluation of collateral. This cost is specific to the concerned loan and therefore need be borne entirely by the concerned applicant. This is an actual cost incurred by the bank, and is independent of the size of the loan, or the period of repayment. As such, he argues that there should be no objection to it on grounds of any resemblance to interest.

As for the overheads cost, this goes into the maintenance of the bank, including staff salaries and office expenses. As it is difficult to determine the exact amount used up by any given loan, the author has suggested a method whereby an average rate is charged by computing the bank’s average total running expenses per annum and dividing it by the average total assets of the bank p.a. to obtain a per dollar p.a.cost. This rate would then be used to compute the overheads cost due from the borrower. The author argues that although it may sound like the usual interest rate, we know why and how we arrived at it and are aware that it is not riba, but a cost necessary to maintain the bank whose services the community, depositors and borrowers need.

With regard to the profit the bank could make, it is proposed that since the bank is a commercial concern providing a service, any legitimate remuneration should not be considered riba. However, it may give rise to concerns as to how it is computed. If it is computed as a percentage of the loan amount, there may be some room for doubt. But here it is proposed to be computed as a percentage of the costs of the services the bank provides.

As for the risk premium, the author suggests a radical innovation in guaranteeing the capital of the depositor by ensuring full repayment of the loan, the onus being on the borrower and not on the bank. Thus, instead of the banks being required to join a deposit insurance scheme, the borrowers would have to join in a loan default insurance scheme. This collective insurance scheme is designed to compensate the bank in case of defaults, and to discourage delays and encourage early settlements. While the premium is proportional to the size of the loan, good behaviour increases the credit rating of an individual borrower and decreases his premium rate, and vice versa. The scheme is to be run by a third party, and the unused part of the premium returned to the borrowers pro-rata.

The final component which the author has taken into consideration, which is compensation for inflation, has to do with the value erosion of capital over time which he holds to be an ‘illegal and surreptitious tax on all cash holdings’. He argues that in fairness to capital holders, this loss must be compensated so that their capital is not eroded due to no fault of theirs. This component comprises the amount in terms of currency that needs to be paid to the capital holders (i.e. depositors) in order to restore their capital to the original value. The model also provides for the reverse action as well, in case of currency appreciation.

Thus what the author has sought to show is that each component of conventional bank interest when taken and estimated separately and independently of others could be shown to originate from different considerations. In economic parlance, each component could be said to be influenced by a different set of economic variables while in turn each component influences another set of economic variables. This, the author argues, should lead to a more meaningful economic and econometric modeling and to a deeper understanding of the working of interest in an economy. This new model, he argues, should help Muslims understand that all that is called interest is not necessarily riba, and provide them with a tool to examine any interest to see if it contained riba a not, contending that it’s practical application would enable them to set up sustainable endowments for useful purposes.

He then goes on to apply the methodology to situations such as ‘low interest’ lending involving educational loans and housing loans, arguing that in reality no riba is involved in these loans, since the real lender (the philanthropist or government as the case may be) does not demand or receive any amount in addition to its capital, but only such monies as are necessary to sustain the scheme. What is recovered from the borrower therefore is the operational costs of the bank and nothing more. As such, the terminology ‘interest’ should not be taken literally by Muslims and should not dissuade them from availing of these facilities concludes the author.

On a final analysis, although the work has provided some interesting and thought-provoking insights as to how an Islamic bank could operate in a viable manner, it may also raise concerns among those ulama who are quick to argue that anything that has the least semblance to interest, including charging a fix rate for the bank’s services should not even be considered. Yet another contentious issue is the payment of a surcharge for any possible currency depreciation as such scholars are likely to argue that it is only by eliminating interest from any given economic system that inflation and resultant currency deprecation could be contained in the long run.

Nevertheless, Abdul Gafoor’s book is a valuable contribution that raises several pertinent issues which should attract the attention of scholars and stimulate further research and inquiry on the subject so that some consensus could be reached for a practical and acceptable solution to the problem.

Pioneer Publications, Sri Lanka