DIFFERENCE BETWEEN RIBA (INTEREST) CHARGED IN CONVENTIONAL BANKS AND PROFIT CHARGED BY ISLAMIC BANKS
The word “riba”, often translated as “usury” or “interest”, comes from the Arabic root meaning “to increase” or “to gain”, and is specifically prohibited in the Qur’an on several occasions.
It’s an extra earning in a lender borrower relationship whereby money is treated as a commodity of trade, either being paid by a client to the financial institution or the institution paying the client. It’s that effortless gain.
Although the term riba and interest is used interchangeably, riba is much wider than interest. All forms of interest is Riba but not all forms of riba is interest. For example, the prophet ﷺ in a narration said that every loan from which we draw benefit is riba. Not all benefits are financial in nature. Thus, riba can be both financial and non-financial while interest is only financial.
Simply put, Riba is return that a Bank gets when it lends money (loan) to a client in a borrower lender agreement. This action is prohibited in the scriptures (Bible, Torah and Quran) to avoid this transaction Islamic banking engages in the buying and selling of assets/commodities so as to generate profits .
For example if the bank lends kes. 1m and charges an additional kes. 200,000 then that is riba.
Profit on the other hand, is a return on risk; based on the Shari’ah basis of No risk no Return principle. When capital is invested, some effort must be applied in order to generate a return called profit. This comes about when you engage in financing activities e.g. buying and selling of products/commodities.
Finally to make it easy to understand we may use an example of an investor who wants to purchase a piece of land; In conventional riba based banking, the customer will come to the bank and apply for loan. The loan once approved is disbursed to the customer who repays the principal with some interest on top. In most instances, the land is taken as collateral.
In Islamic Banking however, land purchase can for instance among other contracts be done through Murabaha (cost plus sale) whereby the Bank will purchase from the vendor and sell to the client at a profit.
The bank can directly purchase the land own it and then sell it to the client at profit. The client then pays for the land (principal and profit) over the agreed period of time.
Interest therefore is when you sell money and charge an additional amount without an underlying economic activity while profit is return earned from engaging in business activity.
The profit rate can be set by the bank without reference to any individual or instrument.
The common practise however is that Pricing is normally benchmarked with the Interest rates given by the regulatory authority. e.g. in London; it is based on the Libor- London Interbank Offer Rate.
In Kenya, it is based on the Central Bank Rate (CBR which is determined by the Monetary Policy Committee of the Central Bank of Kenya. This kind of system uses an interest rate as a bench mark for the profit rates charged to customers.
A customer can for example approach an Islamic bank for the purchase of a plot, and the bank will purchase a plot and sell to the customer at the prevailing CBR plus a margin of 4%.
This often confuses customers because a similar rate of interest is charged by conventional banks. They tend to argue that there is no difference between profit and interest.
The similarity in rates does not make it interest as it is only being used as a measure or benchmark, the difference is usually in the concept. How the 14% is charged.
If a conventional bank is lending kes. 1million at interest rate of 14% it becomes haram. But if Islamic Bank purchases land at kes. 1m and sells to a third party at profit of 14% or even a higher rate is perfectly in order despite the fact that the profit rate is the same as the interest rate or even higher.