Introduction to Islamic Banking and Finance. M Kabir Hassan

2.1. Increase in price due to interest cost.

Panel A: Assumptions
Interest rate	10%
Debt to asset ratio	0.5
Number of units produced	1,000
Direct material cost per unit	$40
Direct labour cost per unit	$20
Factory overhead cost per unit	$20
Desired profit markup	25%
Total assets	$100,000
Panel B: Market Price with No Leverage
Ex-factory cost per unit	$80
Profit margin per unit	$20
Initial market price	$100
Panel C: Working of Interest per Unit
Sales revenue	$100,000
Total debt	$50,000
Interest expense	$5,000
Interest per unit	$5
Panel D: Market Price with Leverage
Ex-factory cost per unit	$80
Interest per unit	$5
Total cost per unit	$85
Profit margin per unit	$21.3
Initial market price	$106.25

      Interest expense per unit increases with leverage, interest rate and decreases with the number of units of goods produced. Panel C computes the interest expense incurred per unit. Thus, financial institutions also prefer to serve big corporates that are able to absorb the cost of capital over a larger output. Finally, Panel D shows how the additional interest expense per unit raises the cost price as well as market price. It shows how the interest expense incurred by profitable and larger firms is eventually recouped from the pockets of consumers when they purchase the goods and services from the goods market. Furthermore, profitable and larger firms have preferable asymmetric access to credit services in comparison to small firms and micro-entrepreneurs.

      On the other hand, in the interest-based financial intermediation, the market interest rate becomes a benchmark return or hurdle rate of return. Social and environment friendly investment projects yielding a lower rate of return than the market rate of return remain unfunded as a result.

      In addition to that, firms having an obligation to service debts with fixed payments regardless of their profitability are compelled to push growth in revenues. Often, this results in aggressive advertising and promoting consumerism to meet the cost of interest on borrowed funds. If the demand remains sluggish, then the surplus output remains unsold and causes a recession in the economy leading to unemployment.

      Furthermore, since interest is an additional cost in the production process, there is lesser chunk of cost budget available to invest in environmental friendly technologies. Thus, firms squeeze budget by paying less to unskilled labour and overuse other resources which may cause environmental problems. Rather than internalizing the cost of damaging ecological imbalance, firms free ride on whatever leeway they obtain to use and overuse public goods and common property resources.

      Finally, since the loans are usually provided to richer segments of the population who can furnish collateral and already have sufficient incomes to service the cost of debts, the gap in incomes between those who are able to access credit services and those who are not able to access credit services rises overtime.

       2.2Critical Analysis of Arguments in Favour of Interest

      Sometimes, arguments are made in favour of the justification of interest. These arguments are not potent from the perspective of economics. This section looks at some of these arguments and shows how they do not justify the institution of interest from even the economics standpoint.

       2.2.1Interest is the price of risk

      Lending money for stipulated interest does not involve risk. The lender gets interest in any situation, no matter whether the borrower earns profit or loss. Even when the borrower takes a loan for meeting health expense or buys essential food intake from the borrowed money, the borrower is required to pay interest. Even when the loans are provided to commercial businesses, the returns from enterprise in the real economy are uncertain. After taking the risk, businesses either earn profit or incur loss.

       2.2.2Share in the profit of the borrower

      Interest cannot be regarded as the profit share in the business of the borrower. Not all borrowing is for commercial purposes. Even when borrowing is sought for commercial undertakings, the lender does not agree on sharing profits. Rather, the lender stipulates a pre-determined rate of increase demanded over the principal amount of loan. For sharing in the profit and loss of the business, the appropriate way of engagement is to provide investment funds on equity financing basis. In genuine equity financing, profit-sharing ratio is agreed at the beginning. If the profit is earned, it is shared on the basis of profit-sharing ratio. If there is a loss, it is shared on the basis of investment share.

       2.2.3Interest is a rent on money

      It must be noted that the assets on which rent is charged are used and given back in the same existing condition after the use, such as homes or cars. On the other hand, money and other consumption goods are consumed. When we borrow money, we consume it and then regenerate it to repay our liabilities. In a loan transaction, when the money is used by the borrower, it is consumed. The borrower has to regenerate it and the lender without taking any risk is entitled to receive the consumed money with interest. An example here would illustrate the difference between rentable and non-rentable goods. Can we borrow apples or mangoes on rent? The answer is “no” since these are consumption goods. Thus, we can borrow a hammer, but not the nails based on the above classification between rentable and non-rentable goods.

       2.3Flow of Funds in the Islamic Capital Market

      On the choice of financial architecture, we have two major systems: bank based and market based. Market-based systems are characterized by large and active capital markets where firms are able to raise external funds by issuing debt and equity securities. On the contrary, bank-based systems are characterized by financial systems where a major source of external finance is banks.

      Several researchers deliberated on the relative merits of both systems, but the consensus view of recent research is that classifying countries as bank based or market based is not important. Bank-based view holds that bank-based systems — particularly at early stages of economic development and in weak institutional settings — do a better job than market-based financial systems at mobilizing savings, allocating capital and exerting corporate control. In contrast, the market-based view emphasizes that markets provide key financial services that stimulate innovation and long-run growth. This section discusses the flow and allocation of investible funds in the Islamic capital market.

      The Islamic capital market avoids the elements of interest and instead allocates capital investments based on the profit-sharing ratio. In any typical economy, there are some consumers who have income which is more than their consumption for the period. Such individuals are known as saving surplus units where the savings in a period are the portion of income that is not consumed in the same period. These consumers are required to pay Zakat on their surplus wealth endowment in every period if their wealth is above the value of Nisab. In contrast to the interest-based asset market, there is no fixed return that they can earn at the prevailing rate of interest by simply lending their surplus savings to a financial institution or debt issuer in the interest-based capital markets. Thus, in order to avoid a reduction in wealth and to earn any legitimate return on their surplus savings, these saving surplus units have to undertake investment in the real economy.

      In making investments, these consumers forgo present consumption for possibly higher future consumption. In the light of economic theory and empirical evidence in both mainstream and behavioural finance literature, the amount of investments they make would