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September 25th, 2007


For my first couple years in grad school I seriously considered writing a dissertation on Islamic finance but before it got to the prospectus phase I changed my topic to media ownership, largely because I realized that if learning German gave me trouble, then there was no way I could learn Arabic and Urdu and that doesn’t even begin to address the problems of getting access to the field site. Nonetheless I think it’s a fascinating subject from which people with the right skill set can get some fascinating insights (for instance Timur Khuran’s Islam and Mammon) . I think there are two interesting aspects to it: the social construction of religious dogma and the practical consequences of the rules.

(Note: I haven’t read Khuran’s book or anything else on the subject in a few years. If you notice a mistake, please say so in the comments).

Social construction
There’s more to it than this, but the keystone principle of Islamic finance is that the Koran forbids using “riba.” The word means usury, but just as in English it is ambiguous with some people defining it broadly as all interest and others narrowly as excessive or predatory interest. This distinction is of tremendous practical importance as on it hinges the question of whether Muslims can participate in Western-style banks or must create complicated alternative institutions. According to Khuran, the ban on riba has historically been interpreted loosely and banks in Islamic countries often charged interest from the classical period through the recent past. In the twentieth century, certain Muslim scholars (mostly Sunnis) began to worry about interest, in part because they saw it as a way to promote their (essentially secular) ideas about post-colonial development and in part because of the general recent trend in Islam of fundamentalism displacing traditional religious case law.(1) Thus here you have a case where, in part for secular reasons, people try to find an interpretation of their religion which imposes more restrictions on behavior than had traditionally been there.

In this case the new strict interpretation does seem like a plausible reading of the relevant scriptures, but you can easily find other cases where it is not. My favorite example is Prohibition. In the late 19th and early 20th centuries, American Protestants became increasingly opposed to alcohol, mostly because of the social problems it created and in part because they associated it with Catholic immigrants. Not only were they against alcohol as citizens, but they were against it in their capacity as Christians. The trouble is that, as critics pointed out at the time, there are numerous clear positive references to alcohol in the Bible (most obviously the second chapter of John). 19th century Protestant theologians came up with a bunch of elaborate arguments to explain why we should ignore the wedding at Cana (by pretending Jesus turned water into grape juice) and instead focus on stories that put booze in a bad light, like the drunkenness of Noah.

There are other times when people swim upstream to relax dogma. A good portion of the Talmud consists of “arguing out of existence” certain unpleasant passages from Tanakh, for instance by severely restricting capital punishment to a fraction of the profligate applications of the sword and stone demanded by scripture. (In other cases, such as Kosher food laws, rabbinic Judaism makes the religion much stricter than a facial reading of the Bible would demand). The modernist/fundamentalist (aka mainline/evangelical) schism in American Protestantism most directly dates back to Victorian-era disputes about whether to use a nonliteral reading of the first two chapters of Genesis so as to accommodate evidence from Hutton and Darwin about the age of the Earth and the origin of life. More recently the big divide is over whether to ignore the half dozen or so verses that condemn gay sex or follow shifts in public opinion towards greater tolerance. The most visible consequence of this dispute is that the Episcopal Church USA is now on probation with the global Anglican Communion. The Archbishop of Canterbury has been working overtime to patch things up, but if he fails this dispute will rather quickly lead to a very bitter divorce including lots of lawsuits over church property between the newly schismatic American church and conservative congregations who wish to affiliate their churches (and church property) with conservative African bishops in good standing with the Anglican Communion.

So one of the general issues in religion is that getting from scripture to doctrine is not a straightforward unproblematic process, but one with all sorts of vulnerability to political, social, economic, and cultural influences. This seems like a very fruitful area to apply the sociology of knowledge. The issue of riba is particularly interesting for two reasons. First, it creates a lot of room for Muslim theologians to go through gymnastics figuring out how certain financial schemes that are, at their core, fixed-rate on the principle, aren’t really interest. This is actually the dominant approach in the Muslim world with only Pakistan taking a hardline “if it looks a duck” position. Second, the issue closely parallels earlier Christian debates in the Renaissance about how to interpret Deuteronomy 23:20-21. Christians eventually came to the conclusion that a) the verse was superseded by the parable of talents and b) interest represented both opportunity cost and shared risk. While Muslims have nothing comparable to the parable of talents, they have made extensive use of the concept of risk-sharing to distinguish riba from legitimate practices.

Practical consequences
Despite the presence of alternatives, fixed-rate on the principle with recourse to seize collateral is the core form of finance in the West (and for that matter, much of the Muslim world). In Pakistan this is illegal and elsewhere (including the United States and Britain) some Muslims and Muslim organizations voluntarily avoid interest. Such taboo-abiding actors do not save up in advance to make purchases in full, nor do they hide their savings in the mattress.

Some forms of Islamic finance are basically fixed-rate on the principle by another name. For instance, a bank may buy a piece of equipment for a firm then loan it to a business for a year at the end of which the firm pays the bank the original price for the equipment plus a “usage fee.” This form of financing is allowed in most places but forbidden by really strict theologians.

So what is open to such particularly strict folks? There are a broad family of practices, but all of them involve substantial risk-sharing. If one party is guaranteed a return, then the strict people say it’s riba. So for instance, while keeping your personal assets in a savings account is forbidden (because the bank owes you points even if its investments fail), using a credit-union is cool (because you only get points if the investments are profitable). Likewise, venture capital (vc) is a uniformly acceptable form of credit because the vc is not guaranteed a return. In general, for a scheme to pass the stricter rules, it has to involve the investor agreeing to share profits from some venture but with the investor getting nothing if the venture fails to turn a profit.

This implies a huge principle-agent problem in that there is an obvious incentive for a firm to conceal its profits from investors, either by skimming profits through fees directed to the management or by simply keeping two sets of books. This means that the monitoring transaction costs are extremely high in Islamic finance as one must scrutinize a venture for its likely profitability before investing and then monitor it to see if it is accurately reporting profits. In contrast, with interest you know from the outset what you are owed and whether you actually get it is simple arithmetic. Although I have seen no empirical evidence on this, it leads me to speculate that (controlling for country) embedded transactions and social networks are more important in strict Islamic finance than they are Western-style finance.

Compounding the issue is that many Muslim countries rank extremely high on corruption indices. For instance 7 of the top 10 countries to accrue NYC parking tickets by UN diplomats are Muslim, though diplomats from Azerbaijan, UAE, Oman, and Turkey scrupulously fed the meter. Particularly worrying is that Pakistan not only has the strictest laws against Western-style finance, but also has the tenth highest number of parking citations/diplomat in the whole UN. If we think that their financial system requires an especially high level of trust, this is a problem.


1. Occasionally you read a newspaper column suggesting that Islam needs a Protestant reformation. Such a statement demonstrates complete ignorance of both Islam and the Protestant reformation. If you want to find a historical Christian parallel for Zawahiri, Cromwell is a much closer fit than Torquemada. What these columnists mean to say is they want Islam to experience an enlightenment (no doubt one that lacks a Muslim Robespierre).

This entry was posted on Tuesday, September 25th, 2007 at 11:08 pm and is filed under economics, guest bloggers, what does this have to do w/ org theory?.

3 Responses to “riba”

The Lounsbury Says:
September 26th, 2007 at 12:44 am

Reasonably well based understanding on the practice, and Kuran is fairly accurate.

A note: Likewise, venture capital is a uniformly acceptable form of credit because the vc is not guaranteed a return.

Venture capital is not credit, it’s equity investment (well some exceptions).

Actual Islamic financing operations tend to be either (i) merely conventional lending with some expensive legal / theological dressing, or (ii) equity, and thus venture investing, and yes, either done naively and thus w/o the proper monitoring or expensive.

gabrielrossman Says: oops, i meant to describe VC with the more general term of “finance.”September 26th, 2007 at 1:52 am

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