INTEREST AND GHARAR IN ISLAMIC BANKING

Iako još uvek relativno nepoznato kod nas, i za sada samo „niša“ globalnog bankarskog tržišta, islamsko bankarstvo igraće u ne tako dalekoj budućnosti značajniju ulogu. Islamske banke, naročito u svetlu najnovijih ekonomsko-političkih dešavanja u Srbiji (Etihadova akvizicija JAT-a, projekat „Beograd na vodi“ itd) nisu tako daleko od bankarskog sistema Srbije, pa je nužno razumeti osnovne zabrane islamskog bankarstva, što je tema ovog rada. Kamata i garar, što je kategorija u islamskom bankarstvu mnogo šira, sveobuhvatnija i višeznačnija od rizika ili špekulacije, detaljno su razmotreni.


Concept of islamic banking
The concept of Islamic banking is based on the so-called Islamic savings where depositors are investors.At the end of the year, the depositor/investor receives profit as a percentage of the invested funds in proportion to the percentage of the bank's profits.(In case the bank incurs a loss -the depositor/investor will incur loss in the same percentage).Unlike conventional banking, which focuses primarily on the economic and financial aspects of the transaction, i.e. profit, Islamic banking devotes at least equal (if not greater) importance to ethical, moral and social dimensions within the acceptable religious dimensions in order to achieve a socially acceptable distribution of wealth (i.e.equity), in the spirit of solidarity.Righteousness and justice are embedded in the basic principle of Islamic banking, and the objective is to achieve equality in the society for the benefit of the society as a whole, in the spirit of the teachings of the Islamic religion (as well as other monotheistic religions) by which the achievement of more important goals is above any tangible benefits.
In the last twenty years, and especially since the beginning of the global financial crisis, there has been a trend of growing interest in Islamic banking.In order to fully understand Islamic banking, it must be known that it is based on Sharia (Islamic law).Since in Islam there are some strictly prohibited categories -there is no room whatsoever for the activities that take place through the system of Islamic banking and have to do with these prohibitions.
The list of prohibited categories in Islam, and thus in the Islamic banking system, is not long but is very strict: • The most widely known is the fact that interest is prohibited (in Arabic: riba), which is explained in more detail in the following subsection.• Gharar (risk or speculation) is also forbidden.All transactions in the Islamic banking system must be free of any hint of uncertainty, risk and speculation, which is the universal goal and target in Islamic religion and philosophy -to protect the poor from exploitation as manifestation of justice is the main pillar of Islamic banking and Islam in general.The best way to achieve this is through division of risk (gharar is explained in more detail in one of the subsequent subchapters).

• Trade in particular goods (bay-al-inah) is also
prohibited (e.g.pork, drugs, alcohol, as well as activities related to pornography and other sorts of immoral doings, etc.) because it is among the prohibited activities (haram / sin/).Everything that is not forbidden is permitted (halal) and even better if it is for the common good (mashallah /also means a private good/).Islamic law prohibits the above stated because it can result in the accumulation of wealth at the expense of another.In the banks that operate according to the principles of Islamic banking personal loans is an absolutely unknown category, due to the fact that the loan must have a purpose.Also, loans are not granted in cash, hence the possibility of one loan being misused is virtually excluded.The simplest possible illustration is an example from everyday business, in which the previously mentioned principles would look like this: if a bank that operates on the principle of Islamic banking borrows money -it does not pay the (passive) interest, nor are these funds lent with the (active) interest.Instead, the borrowed money is invested in a particular project, and the lenders receive a share in the project.Thus, in addition to avoiding the payment and collection of interest, this is a relatively uloga novca, koji ne postoji sam zbog sebe već da bi se olakšala i ubrzala razmena.To je ujedno i jedna od najstarijih ekonomskih istina, a i jedan od principa na kojima islamsko bankarstvo principijelno istrajava.

Konvencionalno (kamatno) bankarstvo Islamsko (beskamato) bankarstvo
Ono što dominantno privlači klijente Many of the specifics in respect of which the concept of Islamic banking differs from conventional banking are presented in Table 1.The table does not show that whether the loan will be approved or not in conventional banking depends on the creditworthiness of the borrower.In contrast, Islamic banking aspires to the ideal of financing those economic transactions which are feasible, without the criterion being the borrowers' creditworthiness.In addition, the fact is that the conventional banking system is based on fractional reserve deposit on the account at the central bank, which is a system that allows banks to generate multiple sources of funding that exceed the financing needs of the real economy.Initially approved loans often granted by conventional banks, which is not linked to the real economy may "generate" in the following iterations an immeasurable number of loans that are also unrelated to the real economy.As a result, we have a situation (the current global situation) that the financial sector in many ways surpasses Table 1: The main differences between conventional and Islamic banking

Dominant attractor
Money Life as prescribed by God in all monotheistic religions, as ordained in the Judeo-Christian-Islamic value system and way of life

Defining purpose
Use money to make money for those who have money Employs available resources within its means to meet the basic needs of everyone without extravagance

Bank size
Very large (e.g., mega-banks) Small and medium-sized

Ownership
Impersonal, with shareholders having no role in most cases Personal, with shareholders playing an active role in bank management and procedures

Financial capital
Global, with no borders Local/national, with clear community reinvestment borders and assessment areas

Purpose of investment
Maximize private profit and wealth Increase beneficial output to the community to make it prosper

Coordinating mechanisms
Centrally planned by mega-corporations Self-organizing markets and networks of communities around temples, synagogues, churches, masajid, and other social congregations and networks

Cooperation
Among competitors, to escape the discipline of competition and in some cases to avoid regulations Among people and communities to advance the common good for all

Purpose of competition
Eliminate the unfit and capture the markets Stimulate efficiency and innovation

Government's role
Protect the interests of property Advance the human interest, as revealed in all God's messages

Trade
Free, but for the benefit of mega-corporations Free, but fair and balanced
Islamic economics does not remain only in the sphere of theoretical considerations and research.One could rightfully say that the fundamentals, principles and models of Islamic economics have a broad practical application in the field of finance.The objectives of the financial system are identical to the goals of the traditional financial systems.They are reflected in the mobilization and allocation of financial resources necessary to fund the development of national and regional economies.These objectives are realized in the context of financial institutions, by means of financial instruments and mechanisms.However, although they have identical objectives, the principles of the institutions, instruments and mechanisms of realization of the Islamic finance goals are significantly different from the conventional ones (Štulanović and Hadžić, 2007, p. 221).

Islamic banking and interest
Islamic banking, which is based on the assumptions and principles of the Islamic law, completely prohibits all business activities that involve any kind of interest.Given that the very idea and principles of conventional banking are based precisely on the interest as a key factor of the banks' profit, the following question imposes itself: if the interest rate as an instrument is prohibited, how does Islamic banking function?Islamic banking derives from Islamic economics and works within the limits which have been determined in all its activities.Islamic banking does not accept and strictly forbids interest as a safe, predetermined and fixed income and is based on the business activities which include participation in the distribution of profit or loss from business partners, i.e. the bank and the client.This essentially means that it is not acceptable to create "money from money" because fiduciary money does not represent any real value, i.e. it is mainly represented only by the figures in the bookkeeping accounts.According to Islam, money is only potential capital as long as it is not invested and associated with human labor through the business activities of production, trade and services, which must be based on moral, ethical and religious principles within the Sharia.The lack of interest does not mean that it is forbidden to invest or borrow money for profit, or to conduct transactions based on risk sharing in the realization of profit or loss.Islam forbids interest ("interest rate"), but allows and encourages trade and commercial transactions ("rate of return"), which is a big difference.In the interest-free Islamic banking system, those who lend money can earn a "rate of return" on their money only if they take part in the risk of generating profit (Čočić, 2012, pp. 214-215).
Given the fact that in North America and Europe there is a psychological aversion to the Islamic world, Islamic banking has also been regarded with revulsion for a long time.The main reason is the simplified perception of the price of loan capital.The Islamic teaching considers interest as immoral, which is why loans cannot be granted with interest.In Europe there is, therefore, a simplified view that loan capital brings no profit to the Islamic banking and, thus, has no price.However, this is not true.Loan capital generates returns, although not in the form of interest, but in the form of a share in the profit achieved by investing the borrowed capital.Therefore, in the Islamic world loans are related to real economic activity, which is, in fact, the healthy economic logic.Consequently, this type of banking is quite developed in the Islamic world, and is also based in the European countries including Luxembourg, as well as UK, as one of the major banking markets in the world.
Probably the most striking prohibition derived from Islam (the same is, in fact, in the original Christianity as well as in Judaism and in Hinduism), which is the dominant feature of Islamic banking, is that it is unacceptable "to make money from money", i.e. if someone lends money to someone, it is considered immoral to seek more money for the repayment of such a loan than it was borrowed.To lend money to somebody in Islam is considered an act of mercy, regardless of whether it is an ordinary private individual or an entrepreneur.If someone is borrowing money, then he or she is probably forced to do it.Therefore, it would be unethical to make money on someone else's misfortune.The borrowed money, according to the Islamic ethics, can be repaid solely as principal.Thus, Umesto toga, dozvoljeno je plaćanje, odnosno naplata izvesnih provizija.
Jednostavna definicija ribe mogla bi biti da je to "praksa zaračunavanja finansijske kamate ili premije koja premašuje glavnicu zajma".Arapski izraz riba doslovno se odnosi na prekoračenje, dodavanje ili višak, dok povezani glagol upućuje na "povećati se, umnožiti, prekoračiti, iznuditi više od duga ili lihvariti".Riba se tehnički odnosi na "premiju" koju dužnik mora platiti poveriocu zajedno sa iznosom glavnice kao uslov za zajam ili produženje trajanja zajma.Najmanje četiri obeležja definišu zabranjenu kamatnu stopu ( One of the fundamental principles of Islamic finance, representing the biggest difference between Islamic finance and traditional finance, is contained in the Islamic attitude towards usury (the old name for interest).Interest is the payment of a debtor to a creditor during a specified period in exchange for the use of capital.Riba is an Arabic word that is mentioned in the Qur'an, referring to the surplus money that the borrower pays to the lender in respect of a loan.Islamic understanding of interest is similar to that of the ancient philosophers and classic economists, even Keynes as a prominent representative of the modern economy.Islamic teachings indicate that interest discourages people from being engaged in the production and exchange of the manufactured goods.If the interest is forbidden, people will lend to each other with pleasure and their good deeds will be rewarded by Him-who-only-can-reward. Interest slows down the process of investment and thus the overall economic and social development.Many decide to save due to the expected and promised interest, withdrawing it from the investment process, which is a socially harmful activity.On the other hand, in traditional banking banks are using interest and other instruments of ensuring loan repayment to hedge themselves against the risk.Thus, banks transfer the entire risk on the borrower and become insufficiently interested in the successfulness of his business.In Islamic banking risk is divided between the bank and the user of capital.The bank is directly interested in the effect of the client's business and actively participates in the management of the future company.Such placement of funds means that the bank can achieve larger profit in comparison to interest, but it is exposed to a greater risk (Štulanović and Hadžić, 2007, p. 227).
A simple definition of riba could be that this is the "practice of charging financial interest or premium that exceeds the principal of the loan".The Arabic word riba literally refers to overrun, addition or excess, while the associated verb means "to increase, multiply, exceed, extort more than the debt, or perform usury".Technically, riba is 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 the duration of the loan".At least four characteristics define the prohibited interest rate (Iqbal and Mirakhor, 2009, p. 50 and 52): • it is positive and fixed ex ante; • it is tied to the time period and the amount of loan; • its payment is guaranteed regardless of the outcome or the purposes for which the principal was borrowed; • the state apparatus sanctions and enforces its collection.
In theory, Keynes believes that saving is actually not the function of interest, but rather a function of income, which is determined by aggregate demand, including investments, which are the reverse function of interest.This means that interest does not directly encourage savings; it could be said that it is indirectly reduced, affecting aggregate demand components that are sensitive to interest rate, including investments, demand for durable goods, etc. High interest rates will reduce aggregate demand, which will affect the income and employment.This, in turn, will reduce the savings.Based on that, savings could be considered a reverse function via variable interest income.Thus, the elimination of interest should have a positive impact on savings in Islamic economy.Eliminating interest rates will, in addition, cause more investments, which is a keystone of economic development (Sadeq and Ghaazali, 1996, p. 28).
Većina savremenih ekonomista ne dovodi u pitanje praksu kamate i prihvata instituciju kamate kao bitan sastavni deo savremenog ekonomskog sistema.U novije vreme osporavanja potiču od islamskih stručnjaka.Šeik (Shaikh) Mahmud Ahmad proučavao je nekoliko teorija kamata razvijenih posle Adama Smita (Smith) kako bi pokazao da nema zadovoljavajućeg objašnjenja za postojanje fiksne i unapred utvrđene stope povraćaja na finansijsku imovinu.Zatim je analizirao i radove Kejnza (Keynes), Bem Beverka (Bőhm Bőwerk), Kasla (Cassel) i Semjuelsona (Samuelson), tvrdeći da objektivna ocena njihovih radova upućuje na stanovište da su svi oni bili prilično uvereni da je postojanje fiksne i unapred utvrđene kamatne stope prepreka procesu ekonomskog rasta i razvoja.Do sredine osamdesetih godina XX veka ekonomska i finansijska teorija pokazala je da ugovori sa fiksno utvrđenim plaćanjem, koji su dominantni u bankarstvu temeljenom na kamati, imaju određene nedostatke.Naime, vezano za ugovore sa fiksno utvrđenim plaćanjem zaključeno je da ( It is often wrongly interpreted that, by prohibiting interest on loans, Islam challenges the concept of time value of money.Islamic experts have always recognized the time value of money, but they also consider that compensation for such value has its limitations.Knowing the supporting economic value of time does not necessarily imply the acceptance of any right to the equivalent material compensation for the value in all cases.According to Sharia, the compensation for the value of time in sale contracts is recognized, but it is forbidden to charge more as material compensation for the time.The Islamic concept of opportunity cost of capital and the time value of money can be simply understood if we consider the difference between investing and borrowing.Time per se cannot generate any income, but it can contribute to the creation of value when economic activity occurs.A certain amount of money can be invested in a business or can be borrowed for a specified period of time.In case of investment, investors will be compensated for any gain or loss realized during that time.Islam fully recognizes the return on investment as a result of economic activity.On the other hand, if the money is borrowed in the form of a loan, it is an act of mercy, where the excess of money is used to promote economic development and social welfare.In response to the modern interpretation that the interest on the loan is an award for the opportunity cost of the lender, Islamic experts believe that the fixed ex ante interest rate is safe, while gains and losses are not, and taking something certain as compensation for the uncertain is the same as getting into riba and, therefore, illegal.The element of uncertainty is gradually reduced and eventually the resulting return on investment is achieved instead of the refund growing only because of the passage of time.In short, the Islamic viewpoint on the time value of money is simple and clear: money is a medium of exchange; time makes completion of economic activity easier.Capital owner should be compensated for any income rising from economic activity.Lending should be an act of mercy without any expectation of monetary benefits (Iqbal and Mirakhor, 2009, p. 57).
The majority of modern economists accept the institution of interest as an essential ingredient of the modern economic system.However, from time to time, the notion of charging interest on money is being challenged.The challenge has come mainly from Islamic scholars.Sheikh Mahmud Ahmad, for example, studied several theories of interest, developed since the time of Adam Smith, to show that there has been no satisfactory explanation of the existing of fixed and predeterminated rate of return on financial assets.His analysis of the writings of economists such as Keynes, Bőhm Bőwerk, Cassel and Samuelson led him to argue that an objective assessment of these writings would lead to the belief that all of these writers held a reasonable strong conviction that the existance of a fixed and predeterminated rate of interest was an impediment to the process of economic growth and development.By the mid-1980s, economic and financial theory demonstrated that there were disadvantages in the fixed payoff contracts that dominated interest-based banking.It was shown that (Iqbal and Mirakhor, 2009, p. 70): 1. such contracts create inefficient defaults on financial obligations or non-performing assets; 2. in the presence of asymmetric information, debt contracts also suffer from the effects of adverse selection and moral hazard; 3. fixed fee contracts create a fundamental conflict between the interests of borrowers and the lenders; 4. socially desirable sectors with low profitability will not get finance; moreover, new entrepreneurs with good projects may not be able to obtain finance in the absence of the security required.
Garar je posle ribe najvažniji element finansijskih ugovora.Jednostavno rečeno, garar proizilazi iz problema sa informacijama (informacione asimetrije), a odnosi se na nesigurnost stvorenu zbog manjka informacija ili kontrole u ugovoru.Garar se može opisati kao neupućenost u bitne elemente transakcije, kao što su tačna prodajna cena ili sposobnost prodavca da zaista isporuči ono što je prodao itd.Postojanje garara čini ugovor ništavnim (nevažećim).Garar se može definisati i kao situacija gde jedna strana raspolaže nekom informacijom vezanom za ugovor, ali je uskraćuje drugoj strani i/ili je predmet ugovora nešto nad čime ni jedna od ugovornih strana nema kontrolu.Klasični primer bi bio još neulovljena riba.Savremeniji primeri su transakcije gde predmet ne poseduje nijedna od ugovornih strana, a nesigurno je čak i njegovo posedovanje u budućnosti.Imajući interest-increased, and banks are not allowed to charge a fee from the clients.Investment deposits have a fixed nominal value, and are similar to the company's property.In the process of opening the investment deposit with a bank, the share of the bank's profit is negotiated, which cannot be changed (except by agreement) prior to maturity of the deposit.On the asset side of the bank's balance sheet are loans that bring banks a share in the profits of the company, as well as other permitted financial instruments.There are such bank loans that give the right to manage the company and loans without such right.Among other financial instruments, the most important are deferred payments, margin on the sales price of the company, leasing and loans with zero interest rate but with a fee.

Garar (Gharar)
Gharar is most generally defined as risk or speculation.However, in order to better understand the concept of gharar, and why it is much more comprehensive than the concept of speculation (as well as risk), it would be helpful first to consider the wider aspects of speculation.There are several definitions of speculation (Al-Masri, 2009, p. 45-46): • speculation is the prediction of a profit opportunity to benefit from, and of a loss probability to avoid; • speculation is the benefit from price differentials resulting from the expected change in the stock values; • speculation is to buy or sell with the aim of increasing capital gains from the "natural" price differences rather than obtaining regular revenue profits.• speculation is a buying or selling process followed by a reverse transaction (purchase or sale), aimed at benefiting from the "natural" difference in prices.• speculation is buying or selling in the present, with the hope of a reverse transaction (purchase or sale) in the future when a change in prices occurs.• speculation is to buy, with a view to selling at a higher price or selling to compensate for what was sold at a lower price.• speculation is a fake buying or selling, not with the aim of investment, but rather with the aim of benefiting from the changes in the very short-term of the stock market value.This occurs when a big difference takes place between the stock market price on one side and the nominal or book-value (the real value) on the other.• speculation is a buying or selling process carried out by market experts to benefit from price changes.The nature of speculation can be best understood when compared with investments, which are in many ways diametrically opposed to speculations.Thus the investor purchases stocks because of the expected profit in the form of dividends.He could, however, sell stocks and "earn" a capital gain (if the selling price of stocks is bigger than their purchasing price), but it is not the most common case.On the other hand, the speculator buys stocks in order to sell them in the short term to make quick profits over a large capital gain.Therefore, investments are long-term, with a relatively low risk which is safer than in case of speculation, as lower risk also means lower expected profit.Thus, speculation differs from investment in three main characteristics: its duration, the level of risk and expected profit.Speculations are focused on the short term, are riskier than investments, but the expected profit is higher.Investors primarily expect earnings from investments in shares (dividends), and only secondarily -from capital gains due to positive price differences on the market.A speculator is just seeking a price-difference, as the primary motive for his "investment".(The word "investment" is under quotes because it does not refer to real investing, but rather to short-term speculative funds.See for more details: Al-Masri, 2009, p. 47).
After riba, gharar is the most important element in financial contracts.In simple terms, gharar stems from information-related problems (information asymmetry) and refers to uncertainty created by the lack of information or control in a contract.It can be thought of as ignorance regarding an essential element in a transaction, such as the exact sale price, or the ability of the seller to actually deliver what is sold.The existence of gharar in a contract makes it null and void.Gharar can be defined as a situation when either contractual party has information regarding some element of na umu pojam pravednosti u svim islamskim poslovnim transakcijama, šerijat smatra bilo kakvu nesigurnost oko količine, kvaliteta, naplativosti ili postojanja predmeta ugovorapostojanjem elementa garara (Iqbal i Mirakhor, 2009, str.62).Tipičan primer garara bili bi npr.fjučersi na žito.Teško je zamislivo u islamskim finansijama kupovati ili prodavati nešto što ne postoji u trenutku prodaje.
the contract, which is withheld from the other party.A classic example includes transactions involving fish not yet caught.More modern examples include transactions where none of the parties is in the possession of the subject and it is uncertain even whether they will possess it in the future.Keeping in mind the notion of fairness in all Islamic commercial transactions, the Sharia considers any uncertainty as to the quantity, quality, recoverability, or existence of the subject matter of a contract as pointing to the element of gharar (Iqbal and Mirakhor, 2009, p. 62).A typical example of gharar would be futures on wheat.It is hard to imagine in Islamic finance buying or selling something that does not exist at the point of transaction.
Based on gharar, as a prohibition of unclear contractual provisions in order to avoid risks of failure and establish mutual bearing of risk, there are bans on gambling and all speculations with securities.As a result, hedging is impossible.Because of this provision in Islam, the loans are not guaranteed by mortgage, because it would shift the entire business risk to the debtor, while the bank would be risk-free.Securing a loan with bank guarantees is also undesirable (Veselinov, 2009, p. 24).
It has been left to the jurists to determine the extent of gharar in a transation and, depending on the circumstances, the contract may be (but does not have to be) annulled.By prohibiting gharar, the Sharia prohibited many pre-Islamic contracts of exchange on the grounds that were either subject to excessive uncertainty or were not known to one or both parties to the contract, causing unnecessary disputes and injustice.In many cases, gharar can be eliminated from contracts by carefully stating the objectives of the sale and the price in order to remove unneccesary ambiguities.A welldocumented contract will eliminate gharar as well.Some argue that prohibiting gharar is one way of managing risk in Islam, as prohibition would force parties to avoid contracts with a high degree of information asymmetry and extreme payoffs, and would make them more responsible and accountable.By prohibiting gharar, the Sharia is also prohibiting trading of it, thus also prohibiting the use of derivative instruments designed to transfer risk from one party to another.The prohibition of gharar by implication includes the prohibition of pure speculation and gambling activities, which involve asymmetric information, excessive uncertainty, risk and lack of control.Although some of the earlier researchers raised concerns about the permissibility of trading in stock markets on the ground that it amounted to speculation, the stock market is based on some fundamental analysis of economic variables and is subject to reasonable level of uncertainty rather than pure speculation.The prohibition of gharara has also raised concerns in the area of insurance.Some argue that writing an insurance contract on the life of a person falls within the domain of gharar and thus invalidates the contract.This issue is still under review and has yet to be fully resolved (Iqbal nad Mirakhor, 2009, p. 62-63).

Conclusion
After the introductory chapter, explaining the specifics of Islamic banking compared to the conventional banking, the rest of the paper focuses on interest and gharar as the prohibited categories in Islamic banking.The paper elaborates into detail both on their theoretical considerations, and the absence of these categories from the banks operating under Islamic principles, Sharia law and rules.
and realistic way to help the process of reproduction.That is the traditional role of money, which does not exist for itself but to facilitate and accelerate the exchange.It is also one of the oldest economic truths, and one of the principles upon which the Islamic banking principle stands and persists.