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AN EXAMINATION OF THE APPLICATION OF THE CONCEPT OF INTEREST (RIBA) IN THE OPERATION OF CONVENTIONAL

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4/29/2014
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INTRODUCTION

Interest or “riba” system was formally introduced into Islamic countries during the 19th and 20th centuries through two channels: secular legislation which have endorsed the western definition of usury and the modern banking system whose activities are interest based. These two channels were opened during the era of western colonial rule to the Islamic world. Besides, the riba system has increasingly gained strength in the Islamic world because of the serious economic dependence on the western world on one hand and secular education which neglected the teaching of Islam (Youssri, 1999).

In simple term, Interest is any addition on borrowed money for the purpose of consumption or Investment. Interest can be the price paid for the use of borrowed money   or money earned by deposit funds (Idris, 2002). According to Wikipedia, interest can as well be a fee paid by a borrower of asset to the owner as a form of compensation for the use of the asset.  Interest is also seen as the amount paid by the borrower to the lender, as compensation for the latter’s parting with his money for the duration of the loan.

From the above definitions, interest arises in loan agreements whereby a lender of money claims for some amount of money from the borrower over and above what the borrower actually borrowed. For example, if Tanko enters into an agreement to borrow the sum of N1, 000,000 from a commercial bank on condition that Tanko would pay N1, 300,000 to the commercial bank within a period of one year. In this example, the N300, 000 which Tanko would have to pay the commercial bank in addition to the N1, 000,000 is called interest.

It is important to note that the two parties to this type of agreement could be between natural persons and corporation or between corporation and corporation. Related to this is the issue of interest rate. This is the percentage of the principal amount borrowed that is paid as a fee over a period of time usually one month or year (Wikipedia, 2013).

Suppose the interest rate in the loan agreement between Tanko and commercial bank above is 3%.  And it is to be sprayed over a period of 12 months. In this case Tanko would be paying the sum of N105, 083.33 for the principal and another sum of N3, 250.00 as the interest each month. This mode of payment would be made through out the 12 months covered by the loan agreement.

The Concept of Usury

Beside interest and interest rate, usury occupies a strategic position in conventional economy. Usury is viewed as excessive charge on interest rate, a charge beyond what is permitted as the interest rate or unethical or immoral monetary loans. According to Oxford Dictionary, usury is the practice of lending money at exorbitant interest higher than the interest rate which is recognized by law. Usurious transactions and all practices involving it do not find any legal backing under the laws of many countries of the world. This is to say that where an interest rate has been fixed by the authorising body (usually the Central Bank of a given country), any additional charges by a loan institution above such interest rate is regarded as usury, hence becomes illegal.

The main objective of the paper is to examine the application of riba in conventional banking system in Nigeria. However, other specific objectives of the paper include:

i) To demonstrate the technicalities involved in charging interest rate by conventional banks in Nigeria.

ii) To analyse the effects of charging interest on Nigerian banking public.

iii) To recommend Islamic mode of financing as an alternative source of capital to businesses in Nigeria.

 The methodology involves context analysis of hypothetical and case specific loans offered to business ventures by some commercial banks in Kano state. Data sources essentially remained secondary. Literatures were sourced from conventional sources like text books, internet and CBN bullion, as well as from Jurisprudential sources of the Qur’an and the Sunnah. The research designed employed is essentially library in outlook.

Rationale for Interests Charges

Economic scientists have advanced arguments and counter arguments on the role of interest rates in the economy in order to justify its relevance. The common arguments in support of interest rate are summarized below:

  1. Interest rate is paid to the lender as a consideration for parting away with his money or assets. This is because by parting his money, the lender has given away his opportunity of using his money in profitable ventures which would have brought business fortunes to him. Similarly, since money is treated as part of asset and merchandise, the use of one’s money through loan is a justification for the lender to charge interest from the borrower.
  2. Interest is charged as a reward for deferred payment arrangement between the lender and the borrower. For instance, where a borrower required a mobile phone at the moment but has no money to pay. He borrowed, paid and took the mobile phone at the time he wanted it. He would pay the loan in the future together with an additional margin which serves as interest. In this situation the lender is justified to claim the margin as he has facilitated the borrower to enjoy the phone at the time he wanted it through the parting of the lenders’ money and the time period which the borrower was allowed to pay back the loan.
  3. Interest plays some significant roles in economic growth of any nation. For instance, in a country where the interest rate is low, investors are attracted to borrow, invest and generate employment. Beside, low interest leads to cheaper manufactured products thereby curtailing inflation.
  4. Interest serves as a stabilization tool for the control of inflation in an economy of a given country. Whenever there is too much money in circulation in an economy and the quantity of money is believed to have come from excess borrowings from commercial banks, raising interest rate would raise the costs of borrowings. In this way, higher interest rate charges would serve as a disincentive to borrow and spend. This leads to control of the inflation to the barest minimum within the economy (Abdul Mannan, 1986).

 

A MODEL OF THE COST OF BORROWING UNDER CONVENTIONAL BANKING

The cost of borrowing in a conventional bank can be broken down into the following components: Interest, cost of services, overhead costs, a risk premium, profit and a compensation for value depreciation caused by inflation. The model would then look like this:

Cost of borrowing (COB)       =        Interest

                                      +        Service Cost

                                      +        Overhead Costs

                                      +        Risk Premium

                                      +        Profit

                                      +        Compensation Inflation (Abdul – Gafoor, 1995) taken from (Idris, 2002).

i)       Interest:     This is the amount paid by the borrower to the lender, as compensation for the latter’s parting with his money for the duration of the loan. In normal commercial banking practice, the funds used for lending are mainly derived through the time deposit and savings deposit accounts. The bank pays a certain percentage as interest to the depositors and recovers it from the borrowers when it lends. Hence this component of the cost borrowing falls into the prohibited category.

ii)      Service Cost:       This is actual cost providing services for the specific transaction. This may include legal and other charges paid for services such as evaluation of the collateral and checking its title, preparation of loan documents, postage fax, etc. this is per transaction cost, and it may vary from transaction to transaction but does not depend on the duration or size of the loan (except, perhaps charges such as stamp duty) and therefore there should be no objection to it on grounds of any resemblance to interest. In fact existing interest – free banks to levy such service charges.

iii)     Overhead and Other Services:  Bank also provides other services to the customer - direct and particular as well as indirect and general – and incurs expenditure. The two are naturally passed onto the customer. The customer receives direct services in the form of his repayments being received regularly and the accounts maintained any problem solving, correspondence, etc. So long as his loan remains outstanding. On the part of the depositors, they are also provided transaction services and the safe keeping of their deposits. These services are provided free for the saving accounts holders only

iv)     Risk premium:     Since we are concerned with commercial banking and not investment banking, the loans are granted on the strength of the collateral. The bank has recourse to the collateral in case of failure of the enterprise. Yet defaulters, frauds, delays, etc., are common and bad loans are a fact of life. The bank naturally, has to be borne by the users of the banks funds.

This might criticized as smacking of interest. But the purpose is well defined and the risk premium paid by the borrower goes into a specified funds. Any loss the bank incurs due to bad loans is made good from this fund. Because the bank under this scheme takes no risk, it also does not make any profit on that account. On complete repayment of loan, the borrower will be paid all or part of his paid premium, depending on how much defaulters were there during the period of his loan.

v)      Profit:         The bank being a commercial profit making concern, should receive some profit. Naturally it should be charged to the customer and, therefore, there should be no objection to including it in the cost of borrowing. In order to differentiate profit from interest rate, it should be fixed as a percentage of the services and overheads costs.

vi)    Inflation:     Inflation affects the cost of borrowing in two ways. One, through its influence on the services and overheads cost; and two by affecting the value of the capital. Positive inflation increases the cost while eroding the value of the capital which compensated for (at the expense of the borrower). Thus, inflation adds two positive quantities when negative, increasing or decreasing the cost of borrowing accordingly. When inflation is absent (i.e. zero) both these quantities are zero, adding nothing to the cost of borrowing.

 

Interests under Islamic Jurisprudence

The equivalent of interest and usury under the Islamic jurisprudence is riba. Riba is an Arabic word which is literally defined as increase (Al-Jassas, 1443 AH, Ibn al-Arabi, 1957, Al-Jaziri, Qurtabi, 1967) addition, expansion or growth ( Ibn Manzur, 1968).

Jurisprudentially, Riba is technically defined as an increase in one of two homogeneous equivalents being exchanged without this increase being accompanied by a return (Aljaziri n.d.). According to Ibn Arabi (1957), riba under Islamic jurisprudence stands for every increase not justified by return.

Riba is broadly divided into two – Riba al-Fadl and Riba al-Nasiah. The former deals with hand to hand purchase on essential commodities where by cash payment on the one hand and it’s correlating immediate delivery on the other hand are done. This type of interest involves commercial transactions generally and is discussed under Islamic commercial law. Whereas, the latter-riba al-nasiah can be termed as loan interest.  Literally, it means to postpone, defer or wait. Under Islamic jurisprudence, it involves a contractual agreement by which a pre condition increment in a loan or debt is agreed upon between the borrower and the lender.

 Riba al-nasiah refers to time that is allowed for the borrower to repay the loan in return for the addition or premium (Chapra, 1986). Imam Qurtabi (1967), understands riba al –nasiah as the premium that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity. For al-Zubaidi (1966), riba al-nasiah is an excess or surplus over and above the principal in loan transaction. Riba al-nasiah covers any surplus which the lender recovers from the borrower over and above the borrowed amount as a reward for waiting a specified period for the return of his principal. Ibn Manzur (1968), extends ribah-al nasiah to cover any extra amount benefit or advantage received on any loan.

The practice of riba al-nasiah or loan interest was among the prevalent practices of the Arabs of Jahiliyah period – the period at the advent of the religion of Islam. Muslim scholars and Qur’anic commentators such as: Al-Jauziyya (1968), Al-Jaziri (n.d.), Al-Jassas (1347 AH), Al-Arabi (1957), Qurtabi (1967), Al-Subuni (1981), Rida (1966), Al-Razi (n.d.) have  traced the followings to be the commonest loan transactions involving riba at that time:

  1. The Arabs of Jahiliyah used to advance loans in the forms of Dirham (silver coins) or Dinnar (gold coins) with an agreed increase on the amount of principal advance.
  2. Arabs of Jahiliyah advanced loans to be paid within the agreed period without any interest initially if the borrower was able to pay back the loan within the specified agreed period. If however, the borrower was unable to pay back within the specified period, the creditor would give him more time against charging an additional amount as a consideration for the postponement or deferment for the payment of the loan.
  3. Arabs of Jahiliyah were advancing loans based on the agreement that the debtor or borrower would be paying particular amount as interest monthly before the maturity date of the principal. On the maturity date, the debtor or borrower would then pay the principal. If at the maturity date the debtor or borrower could not pay, then the creditor or lender would extend the maturity date but with an increase in the monthly payment of the addition.

When the religion of Islam came, it found the above practices on loan and debt agreements. Islam abhors these practices and therefore prohibits them. The holy Qur’an and Hadith provide clear prohibitions on all transactions and practices involving riba.

Practice of interest (riba) charges in conventional banking

Banks are engaged in essential activities, which entail balancing their liabilities with the asset in order to maintain equilibrium. No doubt, the core business of banking which is credit involves financial intermediation manifested in the mobilization of deposit from the surplus units and the passing of the funds sourced to the deficit (needy) units accordingly. The deposit is mobilized at a cost to the bank and this cost is often called interest. On the other hand, it is passed to the users who also pay interest though at higher rates than the deposits (CBN, 2006).

The paper in an attempt to demonstrate the practice of interest rate charges by commercial banks in Nigeria’s business environment has used both hypothetical and real case studies of loanable funds transaction and their attendant interests. For instance, ABC Nigeria, one of the leading supermarkets in the country applied for a loan of N3, 000, 000.00 only, for a tenor of 12 months from Banko Nigeria PLC. The bank accepted to offer the loan at an interest rate of 25% per annum. However, the bank goes further to impose indirect charges to the client in the form of other variables such as processing fee (0.25%), management fee (3.75%) and committee fee (1%). These added variables beside the payable interest of N399, 590.16, have raised the principal by N7, 500.00, N112, 500 and N30, 000 respectively.

 

Table 1.    CALCULATION FOR MONTHLY REPAYMENT

REPAYMENT PERIOD

OUTSTANDING PRINCIPAL

PRINCIPAL REPAYMENT (A)

INTEREST REPAYMENT (B)

TOTAL REPAYMENT (A+B)

JANUARY

3, 000,000.00

250,000.00

61,475.41

311,475.41

FEBRUARY

2, 750,000.00

250,000.00

56,352.46

306,352.46

MARCH

2, 500,000.00

250,000.00

51,229.51

301,229.51

APRIL

2, 250,000.00

250,000.00

46,106.56

296,106.56

MAY

2, 000,000.00

250,000.00

40,983.61

290,983.61

JUNE

1, 750,000.00

250,000.00

35,860.66

285,860.66

JULY

1, 500,000.00

250,000.00

30,737.70

280,737.70

AUGUST

1, 250,000.00

250,000.00

25,614.75

275,614.75

SEPTEMBER

1, 000,000.00

250,000.00

20,491.80

270,491.80

OCTOBER

    750,000.00

250,000.00

15,368.85

265,368.85

NOVEMBER

    500,000.00

250,000.00

10,245.90

260,245.90

DECEMBER

    250,000.00

250,000.00

5,122.95

255,122.95

TOTAL

 

 

399,590.16

3,399,590.16

Source: Hypothetical Interest Computation 2014.

 

Table1 above demonstrates the process by which Banko Nigeria Plc computes the amount of interest as well as the outstanding principal to be paid by the client (ABC Nigeria) on a monthly basis. As it can be observed, repayment has been structured from January to December, however interest payment is dissipated across over. Column three of the table shows principal repayment, structured to enable N250, 000 to be paid uniformly across. While column four shows the interest repayment charges paid from first month of the year in which the loan was made available to the last month of the expiration of the loan. Column five is a summation of columns three and four, showing the monthly repayments of part of the principal and the corresponding interest. As it can be seen, highest payment is recorded at the early stage of granting the loan in the periods of January and February. Repayment figures however decrease from February to December almost at a uniform rate.

Conventional banks principal and interest repayment depend on the type of loan applied and granted. In table1 above, ABC Nigeria applies for trading facility to open a super market which records daily sales and hence repayment was scheduled to be monthly. On table2 below, ABC International School which is a subsidiary of ABC group of companies, applied for a facility of N3, 000 000.00 from Banko Nigeria PLC to expand its teaching facilities. It could be recall that private schools generate their incomes on quarterly basis. As such, the facility is structured to allow for quarterly repayment however retaining the 25% interest rate, the processing fee (0.25%), management fee (3.75%) and committee fee (1%). Quarterly repayment of principal together with interest for the periods of January – April, May – August and September to December were depicted respectively.

 

Table2 Calculation of Quarterly Repayment

REPAYMENT PERIOD

OUTSTANDING PRINCIPAL

PRINCIPAL REPAYMENT (A)

INTEREST REPAYMENT (B)

TOTAL REPAYMENT (A+B)

JANUARY

3, 000,000.00

250,000.00

61,475.41

311,475.41

FEBRUARY

2, 750,000.00

250,000.00

56,352.46

306,352.46

MARCH

2, 500,000.00

250,000.00

51,229.51

301,229.51

APRIL

2, 250,000.00

250,000.00

46,106.56

296,106.56

1ST QUARTER REPAYMENT

 

 

 

1,215,163.94

MAY

2, 000,000.00

250,000.00

40,983.61

290,983.61

JUNE

1, 750,000.00

250,000.00

35,860.66

285,860.66

JULY

1, 500,000.00

250,000.00

30,737.70

280,737.70

AUGUST

1, 250,000.00

250,000.00

25,614.75

275,614.75

2ND QUARTER REPAYMENT

 

 

 

1,133,196.72

SEPTEMBER

1, 000,000.00

250,000.00

20,491.80

270,491.80

OCTOBER

    750,000.00

250,000.00

15,368.85

265,368.85

NOVEMBER

    500,000.00

250,000.00

10,245.90

260,245.90

DECEMBER

    250,000.00

250,000.00

5,122.95

255,122.95

3RD QUARTER REPAYMENT

 

 

 

1,051,229.50

Source: Hypothetical Computations 2014.

  This paper has equally examined real cases of banks and individuals to enable us understand and analyse the exploitation of interest based loans where necessary. This could be seen in line with the actual amount borrowed, the interest rate as at the time of transaction and the outstanding amount to be paid incase of non fulfillment of the obligation. In the case of non fulfillment of obligation, normally the client is taken to court where he is compelled by law to complete payment. It is a known fact that banks are mandated to charge the rate of interests on advances, loans and credit facilities (Banking Act, 1969).

Below are three decided cases in transaction involving loan between bank and individuals.

In a transaction between Kolo verses First Bank of Nigeria PLC, Mr. Kolo borrowed the sum of N16, 000 only. He paid the sum of N13, 796.24. The bank sued him to recover the balance of N85, 637.63 as the outstanding interests at the rate of 10% from 1996 to 2002. The court upheld the claim of the bank (NWLR, 2003). Mr. Kolo however, claimed the sum N85, 637.63 as the sum outstanding. But the bank insisted that Kolo did not pay interest from 1979 to 1988. The bank further claimed interest on the said sum of N85, 637.63 at the rate of 21% per annum from June 1996 till date of judgment in the court.

In this loan transaction involving interest, Mr. Kolo the borrower, borrowed the sum of N16, 000 only from the bank, but ended up paying the total sum of N236, 454. 03. He thus, paid an addition of N220, 454.03 as interest, to the bank.

In another case between Idirisu and the Bank of the North Ltd, Idrisu borrowed the sum of N250, 000 at the interest rate of 11% from the bank in 1978. He paid the loan and the accrued interest at 11%.  The bank however sued him for an excess of N700, 000 being the outstanding balance of interest which was raised from the initial 11% of the interest rate earlier agreed upon. The bank claimed the balance on the ground that the cost of borrowing charged by the Central Bank of Nigeria was officially raised above 11% within the period of loan. The court ordered Idirisu to pay the excess amount of interest (NWLR, 2003).

This case shows that even where a borrower is to pay certain rate of interest, the bank can raise the interest rate and the borrower must comply by paying at the adjusted interest rate.

In yet another case involving Kwajaffa and the Bank of North Ltd, Kwajaffa took an overdraft of N80, 000 from the bank in 1982. By 1983, he had paid N422, 297 only. When he was sued in 1993, the court ordered him to pay the sum of N1, 858, 622.15. In the year 2004, another court ordered him to pay to the bank the sum of N5, 761, 728.17 (NWLR, 2004).

From the case above, the borrower took the loan of N80, 000 only, but was ordered by the court to pay to the creditor the sum of N6, 104, 025.17 as the accrued interest from the loan.

On the ills of interest on public loans, Nigeria’s case is a good illustration. According to Atiku Abubakar former Vice President of Nigeria, (when he was addressing Lord Desai of the London school of economics in 2001), Nigeria started with a debt with no more than $5billion in 1985. By the year 2001, Nigeria had paid out $18billion as principal interest for default and the same debt had skyrocketed to $28billion.

From the above scenario, Nigeria as a nation borrowed only the sum of $5billion from the International creditors in 1985. The interest accrued from the loan in 16 years time amounted to $41billion. As the loan could not be paid, the interest shot up to $36billion before the debt settlement arrangement was made in 2006.

In addition to the huge amount of money as interest in the above loan, Nigeria faced (and is still facing) the negative consequences of the conditions attached to the loan.  The side effects of the conditions attached to Nigeria’s public loan include: very low exchange rate, closure of factories thus escalating unemployment figures within the economy, under productivity as many factories were compelled to produce at below capacity utilisation due to high costs of raw materials, and the continued embargo on public sector employment at all tiers of governments. Others included high rate of inflation, curtailing expenditure on public sector services, gradual withdrawal of production subsidies, trade liberalisation, and perpetual domination of International credit institutions in the internal affairs of the nation.

CONCLUDING REMARKS

The summary of the fore goings establishes that Islam condemnation of riba (interest) is clear and categorical. Similarly, riba has been condemned by the rulings of both classical and contemporary jurists. In prohibiting riba or interest, Shariah aims at eradicating exploitation and injustice in business dealings. The paper has identified four basic reasons on why western capitalism has recommended charging of interest. These are: First, interest rate is paid as a consideration for parting away with ones money. Second, interest is charged as a reward for deferred payment arrangement between the lender and the borrower. Third, interest plays some significant roles in economic growth of a nation. Finally, interest serves as a stabilization tool for the control of inflation and encouragement of savings in the economy.

It has been observed however, that interest charges may not bring stabilization of the economy and would only widens the gap between the rich and the poor (marginalization) incase it succeed in raising savings. Beside interest charges, conventional banks as noted have increased the costs of borrowing through unnecessary charges which include service cost, overhead cost, risk premium, profit and compensation for inflation charges. It is not surprising therefore, that riba (interests) has destroyed both small and larger businesses. The cases reviewed in the paper are still fresh in our memories.

Muslims are reminded to avoid taking or giving interest regardless for the purpose for which loans are advanced and the rates at which interest is charged. All arguments in favour of interest charged by modern banks and interest on consumption loans have not won acceptance (Khan, 2008).

Islamic banks provide finance using two basic methods. The first depend on profit and loss sharing and includes mudarabah and musharakah. In this case the return is not fixed in advance and depends on the ultimate outcome of the business. The second involves the sale of goods and services on credit and leads to the indebtedness of the party purchasing those goods and services. This incorporates a number of modes including murabahah, bai ‘bithaman ajil, Ijarah, salam and istisna.

Written by: Dr. Mansur Idris

International Institute of Islamic Banking and Finance

Bayero University Kano

 

REFERENCES

 Abdul Mannan M. (1986).      Islamic Economics: Theory and Practice. Hodder and Stoughton.      The Islamic Academy, Cambridge.

Abu Bakr al Jassas (1347 A.H.) Ahkam al Qur’an, Cairo, Al Matba’a al Bahiyya al Misiriyya. Vol.1

Al Jaziri,  A. (n.d) Al-Fiqh al- Mudhahiba al Arba’ah, Cairo, Al-Makhtabah al Tijariyya al Kubra. Vol.2

Ali al Sabuni (1981). Safwat al Tafsir li al Qur’an al Karim, Beirut, Dar al Qalami, Vol.(ii)

Al Qurtabi (1967). Tafsir al Jami’e Ahkam al Qur’an, Cairo, Dar Kitab al Arabi.

Al Zabidi, M. (1966).  Taj al Arus, Bengazi, Dar lil al-Tiba’ah.

Banking Act of Nigeria, (1969).

Central Bank of Nigeria (CBN) Bullion, (2006).

Chapra, U. (1986). Towards Just Monetary System, London Islamic Foundation.

Ibn al Arabi, M. A. (1957).  Ahkam al Qur’an, Cairo, Isa al Babi al Halabi.

Ibn Manzur (1968). Lisan al Arab, Beirut, Dar Sadir Li al-Taba’ah waal Nash

Idris, M. (2002).   Problems and Prospects of Interest Free Banking In Northern Nigeria (A case study of Kano and Jigawa States).

Khan, M. S. (2008). Islamic Banking and Finance. Shariah Guidance on Principles and Practices. Islamic Fiqh Academy, Delhi, India.

NWLR (2003) pt 806 P 216.

NWLR (2004) pt 649 P 357.

Wikipedia Encyclopedia (2013).

 






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