The below article was written by my good friend Mr. Tarek El Diwany, the author of the best-seller "The Problem With Interest" (www.theprobelmwithinterest.com) .
In about 1220 a canonist named Hispanus proposed that, although usury was prohibited, a lender could charge a fee if his borrower was late in making repayment. The period between the date on which the borrower should have repaid and the date on which he did repay, Hispanus termed "interesse", literally that which "in between is".
Soon, the money lenders of Europe were adding to the church's theological dilemmas with the Contractum Trinius. Here, the lending party would invest money with a merchant on a profit and loss sharing basis, insure himself against a loss of capital and sell back to the merchant any profit above a specified amount. In isolation each of these contracts was viewed as permissible by the church scholars, but their combination produced an interest-bearing loan in all but name.
Today, those who wish to make a living from lending money are adopting the same approach to defeat the usury prohibition in Islam. Combining Islamically permissible contracts to produce interest-bearing loans has become the specialism that is "Islamic banking". The fact that some leading Islamic scholars are being paid hundreds of thousands of dollars to give religious judgments by the very institutions whose products they are judging is, to say the least, a conflict of interest. But the problems run deeper than this. Even if 98 out of 100 scholars judge that a product is prohibited, an Islamic bank can employ the two who permit it. In effect, the banks are able to choose the rules of the game while telling everyone else that they are only following scholarly advice.
Overarching these issues of moral hazard and legal semantics, looms the more fundamental question of whether Islamic finance can be practised within an interest-based monetary framework.
Today's monetary system developed from the practices of European goldsmiths in the 17th century who accepted deposits of gold coins for safe-keeping. Receipts for such deposits would often be issued in �bearer� form and, with growing public familiarity, these came to be accepted in payment for goods and services. The receipts had become an early form of �bank money�.
The goldsmiths were now in a position to transform themselves into money lenders, but when the public came to borrow money it was paper receipts not gold coins that the goldsmiths loaned them. This policy had the great advantage that receipts could be manufactured at almost no cost, while gold itself could not be. William Paterson, a founding director of the Bank of England, was well aware of the commercial implications. "The Bank hath benefit of interest on all moneys which it creates out of nothing", said Paterson of his new bank in 1694.
Why, if the banker truly had the power to manufacture money, did he not simply print receipts and spend them on his own consumption? The answer was largely one of commercial risk. Spent receipts would in due course return to the bank for redemption in gold, gold which never existed in the first place. By lending the receipts instead, the banker could charge interest on the amount lent. Upon repayment, the receipts could be destroyed as easily as they had been manufactured, but the interest charge would remain as revenue. Thus, loans at interest and private sector money creation became the two core components of commercial banking.
The gestation of products within this very un-Islamic framework has resulted in the ultimate mutant, an Islamic personal loan at 7.9 per cent APR courtesy of the Islamic Bank of Britain. How different this is from the original vision of Muslim economists.
I propose that by segregating the payment transmission and money creation functions, and by sharing profits and losses instead of seeking interest payments come-what-may, bankers' motivations would be much more closely aligned with those of their clients. A link would be re-established between the financial sector and the real sector, with beneficial consequences beyond the economic domain.
The resources and infrastructure of whole nations are increasingly being sacrificed on the altar of interest-bearing debt. If Islamic banking adopts a genuinely Islamic paradigm it can offer a solution to a world hungry for alternatives. If it does not, it will enjoy a brief life as a get rich quick bandwagon and then disappear into the relics of financial history.