The Time Value of Money Controversy in Islamic Banking

I. Introduction

Islamic banking that is basically dealing with syariah compliant financial instruments is becoming very popular due to the booming economy in the Middle East resulted by the increase in oil prices[i]. However, the issue of time value of money remains to be resolved in Islamic banks. For the purpose of studying time value of money, we take a research paper by Shamim Ahmad Siddiqui from the Department of Economics University of Brunei Darussalam entitled ‘The Controversy over Time Value of Money among Contemporary Muslim Economists’. Time value of money[ii] shows us that a dollar in hand today is worth more than a dollar received tomorrow because a dollar today can earn interest through investment[1].Time preference on the other hand refers to an intense preference to receive goods or services immediately[2]. The two terms may be connected but are not interchangeable. The research paper seeks to understand time value of money from the Islamic perspective.

II. Summary

The research paper attempts to give an overview and general perspective concerning time value of money and its relevance to Islamic banking and finance. The argument is centered upon the suggestion that people do not prefer present consumption over future consumption and instead points out different factors and reasons of why people prefer to receive money earlier rather than later.

M. Fahim Khan (1991) pointed out the contradiction in the prohibition of interest with the permissibility of Bay Muajjal and Bay Salam. He argues that like interest that are predetermined and fixed, Bay Muajjal and Bay Salam should not be used because of the existence of time value of money. Monzer Kahf (1994) refuted the above argument by stating that rent and wages which is permissible proves the permissibility of time value of money.

According to Zarqa (1983), a positive time preference is not a certain characteristic of an individual. He claims that even western scholars such as Patinkin and Samuelson admitted that positive interest rates do not result in time preference. This is because borrowing and lending rates of an individual depends on their net worth and credit worthiness. Furthermore, because of inflation, tax and compensation for risk, interest rates do not solely represent the lender’s time preference.

The justification of interest and also time value of money by western economists includes uncertainty, the reward for waiting, business profit, compensation for present utility, and also the prospect of increasing income for borrowers in the future. The research paper also justifies that uncertainty, inflation, and alternative investment opportunities serve to prove positive time preference. Therefore both Anas Zarqa and Monzer Kahf are correct that the prohibition of interest in Islam serves not to deny the existence of time value of money except to compensate inflation. Extra payment should be given if a business is profitable through the usage of the loan.

Banks do not invest or lend money for free and expect a positive return on their investment. Interest seems to justify this statement with the exception of the case of desperation for food, clothing, shelter, and etc. In this case, a solution by giving loans without interest seems appropriate. Bay Muajjal and Bay Salam is not the solution as Chapra in 1985 has pointed out that Riba Al Fadl (which is present in the two financial instruments according to author) is not allowed. Instead, equity financing should be carried out instead.

III. Issues

The research paper by Mr Shamim Ahmad Siddiqui seeks to understand time value of money through the Islamic perspective. Interest is prohibited in Islam as it constitutes riba[3]. However, substitutes for interest like those used in Bay Muajjal and Bay Salam posed problems of their own. Furthermore, the author insists that both financial instruments should not be permitted in Islamic banks as they are also exploitative in nature and therefore constitutes riba.

Bay Muajjal refers to credit sale while Bay Salam refers to a forward contract. Both of which are not the solution to interest because both of these financial instruments are predetermined like interest. Devising a financial instrument without interest would require a unique environment. First, inflation must be kept low and stable. Second, there must be no preference between giving loans to high net worth individuals (with good credit standing) compared to low net worth individuals. Third, loans without interest are only for inexpensive for the needy. Lastly, down payments must be to the maximum to encourage savings before the loan.

Besides that, the article stresses that just because a good (instead of money) is involved in a Bay Muajjal or Bay Salam transaction is not enough to justify their validity in Islam. Both are similar to that of interest. Chapra (1985) pointed out that Riba Al Fadl was disallowed by the Prophet (PBUH) to remove all injustices in the economy. Therefore it is hard to believe that deferred sale on higher than present price like Bay Muajjal and Bay Salam would be allowed by the Prophet (PBUH).

IV. Personal Views

The economic function of banks is to serve as financial institutions that help to channel funds from household, firms, and governments with surplus funds to those with a shortage of funds[4]. The question is now whether an Islamic bank is a business entity or a non-profit organization. Should an Islamic bank be a non-profit organization, then both Bay Muajjal and Bay Salam should not be allowed.

According to the Islamic Banking Act 1983, Islamic banking is based on syariah principles or more specifically under the muamalat section of the syariah principles. Islamic banking may be defined as an organized institution framework designed to spread the application of an interest-free banking concept by establishing banks and investment organizations carrying operations in accordance with Islamic economic doctrines[5].

In my opinion, time value of money exists because of the environment (inflation) or time preference. The problem that Islamic banks are trying to solve is how to ensure that financial instruments with time value of money taken into account is not exploitative and harmful to consumers. Therefore both Bay Muajjal and Bay Salam should be allowed as the profit margin is predetermine through mark ups and value added rates.

Furthermore, Islam does not treat money as a commodity and therefore there should be no price for its usage[6]. Ever since the collapse of the Bretton Woods System, money has lost its fundamental value and has become fiat money that is not convertible into gold[7]. Therefore, earning interest on money is prohibited while Bay Muajjal and Bay Salam are allowed on the basis that commodity and goods are involved instead of Fiat money.

V. Conclusion

According to the Qu’ran, trade is permitted while usury is forbidden[iii]. This shows that in Islam trading (with the exception of currency) is permissible and therefore both Bay Muajjal and Bay Salam are also permissible. However, the dilemma of time value of money must be solved in order to compensate lenders for time preference. In the western perspective, interest compensates lenders for both time value of money and time preference. However, interest is prohibited in Islam because it constitutes riba by exploiting and earning in excess from borrowers[8]. Profits by mark up or value add and equity financing may solve this problem. So the question remains on how much profit can an Islamic bank earn without exploiting consumers and whether Islamic bank can establish a non-profit banking arm to help desperate borrowers who are in need of financing (with low credit standing). Islamic banks should help prevent the imbalance of the rich getting richer and the poor getting poorer by adopting time value of money without interest rates.

[1] Eugene F. Brigham & Joel F. Houston, 2007. Essential of Financial Management, Thomson Learning, Singapore.

[3] Ataul Huq Pramanik. Sh. Mahmud Ahmad, 2006. Islamic Banking, How Far Have We Gone. International Islamic University Malaysia, Malaysia

[4] Frederic Mishkin, 2007. The Economics of Money, Banking, and Financial Markets 8th ed, Pearson Prentice Hall

[5] Jee Tzin Kit, K.Loghandran, 2003. Study Manual Operations of Financial Institution, Malaysia:IBBM

[7] Frederic Mishkin, 2007. The Economics of Money, Banking, and Financial Markets 8th ed, Pearson Prentice Hall

[8] Ataul Huq Pramanik. Sh. Mahmud Ahmad, 2006. Islamic Banking, How Far Have We Gone. International Islamic University Malaysia, Malaysia.

[iii] ‘Trade is like usury’ but God hath permitted trade and forbidden usury

2 Responses to “The Time Value of Money Controversy in Islamic Banking”
  1. Henrypoong says:

    so islamic banking and conventional banking are fundamentally similar in terms of the treatment of compensation for lenders.The contention is now the calculation of compensations

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