Nizar Al Shubaily, an experienced Islamic banker, co-authors with me on Islamic finance. Although I believed that I was well versed in matters related to Islamic finance, the prevalence of misunderstood terms and concepts in the media and elsewhere have often confused matters.

Mr Al Shubaily has helped me understand a few things.

To start off, let’s take a step back and think about the meaning of interest in the financial sense. Interest is simply a fee paid on a debt, expressed as a percentage of some other number, usually the current or original amount of outstanding debt. There is nothing magical about using a percentage, or relative, amount to describe what is paid on debt as opposed to a fixed or absolute amount.

Does it matter if you say the fee is 10 per cent of an outstanding debt of US$100, versus a fee of $10? Not really. We also have to think about usury, defined as an unreasonably high interest charge or fee on a debt. Of course, it is not always clear what “unreasonably high” means in this context in terms of the general definition of usury.

Here we come to the first widespread misunderstanding in Islamic finance: it is commonly reported that “riba”, the Arabic word for payments with respect to debts (prohibited in Islam), is the equivalent of usury. But if this were true. then it would mean that if there is a level of interest on debt which is unjustified, then there must be a lower level that is justified. That is patently untrue. So what does riba, the prohibited action under Islam, actually mean? Continue reading →