Throughout the media, the legal establishment of
interest-free banking (IFB) systems is being
announced, in reference to Proclamation Number
592/2008 and the progress made by the National Bank
of Ethiopia (NBE) through its IFB directives.
Indeed, it is an important, full step ahead for sustainable
socioeconomic development and growth for Ethiopia.
In most parts of the world, this system is modelled under
an umbrella of Islamic economics.
Islamic economics operate in accordance with Sharia’h Law.
It can refer to the application of Sharia’h on
economic activity, either where Islamic rule is in
force or not.
This paradigm, particularly as developed by modern scholars
of Islam, seeks not only to enforce Islamic
regulations, but also to implement broader economic
goals and policies.
The paradigm is, out of necessity, more limited, revolving
around a few main tenants of Islam. These include
charitable giving (zakat), borrowing and lending
without payment of fixed interest (riba), insurance,
inheritance, and socially responsible investing.
The key difference from other financial perspectives is the
noninterest rule, since most other religions
likewise favour charitable giving and socially
This banking system is widespread and accepted in 50 to 75
As far back as 1981, Citibank, a giant institution of
conventional banking, set up a dedicated Islamic
finance unit in London, offering investment services
and products aimed at Islamic investors.
The German owned Dresdner Klienwort Benson has also been
substantially involved in trade and commodity based
investment with or on behalf of Muslim clients since
1990. Other Western institutions with substantial
Islamic portfolios include Australia and New Zealand
owned ANZ Group Ltd and Dutch owned ABN Amro.
In short, the essential feature of such banking is that it
is interest-free. There is more to IFB, such as
contributions towards more equitable distributions
of income and wealth and increased equity
participation in the economy, it is often claimed.
It nevertheless derives its specific rationale from
the fact that there is no place for the institution
of interest in Islamic society.
Islam prohibits Muslims from taking or giving interest,
regardless of the purpose for which such loans are
made and regardless of the rates at which interest
To be sure, there have been attempts to distinguish between
usury and interest and between loans for consumption
and for production.
Riba refers to usury practiced by petty moneylenders and
not to interest charged by modern banks, it has been
argued, and no riba is involved when interest is
imposed on productive loans.
Yet, these arguments have not won acceptance.
Apart from a few dissenting opinions, there is no
difference between riba and interest, the consensus
among Muslim scholars holds. These two terms are
The Islamic ban on interest, however, does not claim that
capital is costless in an Islamic system. Islam
recognises capital as a factor of production, but it
does not allow a prior or predetermined claim on the
productive surplus in the form of interest.
This obviously poses the question as to what then replaces
the interest rate mechanism in Islamic framework.
Profit sharing can be a viable alternative, some
have suggested. In Islam, the owner of capital can
legitimately share the profits made by the
What makes profit sharing but not interest permissible in
Islam is that, in the case of the former, it is only
the profit-sharing ratio, not the rate of return
itself that is predetermined. Profit sharing can
help allocate resources efficiently, as market
forces can influence the profit-sharing ratio, so
that capital will flow into those sectors, which
offer the highest profit-sharing ratios to the
investor, other things being equal.
Capital, as a factor of production, deserves to be
rewarded, Islam does not deny, as mentioned earlier.
Islam allows the owners of the capital a share in
any surplus, which is uncertain.
To put it differently, investors in the Islamic order have
no right to demand a fixed rate of return. No one is
entitled to any addition to the principal sum if he
does not share in the risks involved.
The owner of the capital may invest by allowing an
entrepreneur with ideas and expertise to use the
capital for productive purposes, and he may share
the profits, if any, with the entrepreneur-borrower.
Losses, if any, however, will be borne wholly by the
owner of the capital.
One of the main selling points of IFB is that it is
concerned about the viability of the project and the
profitability of the operations but not the size of
the collateral. Good projects that might be turned
down due to a lack of collateral are sometimes
financed by IFBs on a profit-sharing basis.
It is especially in this sense that IFBs can play a
catalytic role in stimulating economic development.
In many developing countries like Ethiopia,
development banks are supposed to perform this
IFBs are expected to be more enterprising than their
conventional counterparts are. In practice, however,
most of the IFBs have been concentrating on
short-term trade finance, which is the least risky,
particularly at the early phases of newly
Long-term financing requires expertise, which is not always
available, some explain. There are no backup
institutional structures, such as secondary capital
markets for Islamic financial instruments, others
The tendency to concentrate on short-term financing
reflects being in the early years of operation.
After all, short-term financing is easier to
administer, less risky, and the returns are quicker.
The banks may learn to pay more attention to equity
financing, as they grow older.
Historically, all banks have generally served governments,
businesses, and the well-to-do. Good collateral and
guaranteed revenues for servicing loans are
essential considerations in granting loans.
As time passed on, the banking business expanded into the
newly developing middle class that has gradually
acquired savings, property, and stable income. Their
savings made them welcome, and their property and
stable (mainly wage) income made some of them
eligible for small loans.
Legislation was passed to safeguard the interests of both
parties, although, by now, the banks have emerged as
the stronger of the two.
This is the case in developed countries.
In developing countries, like Ethiopia, with their low
levels of literacy and underdeveloped financial
sector at the grass-roots level, participation of
the majority of the population in the banking sector
is very limited.
There is a long way to go. Yet, they, too, have a need for
credit, albeit in small measures.
However, the conventional banks are not designed to cater
to them. The modern banks are not like their
forerunners, the moneylenders of old who lent their
Modern banks handle, borrow, and lend other people's money
and are managed by professional executives who are
governed and constrained by legally binding rules
and regulations. They have very little personal
That leaves a large section of the population in Ethiopia
and other developing countries as well as many small
communities in developed countries outside of the
This is where the private moneylenders come in. They are
still alive and well, and ready to pounce.
They usually know their clients, live in the same locality,
are very reasonable as to collateral, and are quite
accommodating. They have no lengthy approval
procedures either, if the “risk premium” is set
It is difficult to beat them. They have survived many
attempts, but it is worth a try. Massive efforts at
educational and economic development at the
grass-roots level are still necessary to keep the
unfortunate out of their clutches.
In the meantime, there is a need for special financial
institutions with development motives to establish
IFB and interest-free micro financial institutions
that will mobilise the savings and loans at the
local community level to serve the needs of those
overlooked by interest-bearing commercial banks.
They can also be organised and run along the lines of the
commercial banks by operating in interest-free
windows and non-profit community lending schemes.
Community leaders can play a major role in this
respect, and religious leaders should promote and
support it because, being an alternative to private
interest or riba-based money lending, it is an
effective preventive strategy.
There are still the un-bankable, who are either completely
avoided by moneylenders or mercilessly exploited by
them. These are the ones living on the fringes of
the society, and their concern is daily subsistence.
They are not beggars; neither are they unwilling or unable
to work. They often have a useful locally marketable
skill. They simply lack the very small capital,
which can enable them to own the tools and the small
stocks of raw materials necessary for their trades.
In dollar terms, the capital they need is often less than
the cost of a meal in New York City or London.
Such people are bankable, the Grameen Bank Movement in
Bangladesh has proved, and, with very little help,
they can stand on their own two feet and regain
their place in society with dignity. Grameen has a
25-year history of success, and its methodology has
been adopted in many countries around the world.
The tools are already here. What is necessary is for the
community to examine whether it needs such a bank,
and then to set about providing one. It needs
dedicated workers, but the results can be very
Given the infancy of the financial industry in Ethiopia and
the presence of communities not served by existing
financial institutions, the introduction of an
interest-free, pro-poor financial system is not just
an alternative. If there is a need for speedy
economic growth and reduction of poverty, it is a
Recently, there have been new banking businesses coming on
board with IFB based features, like ZamZam (under
Along with existing public and private banks, a difference
in the country’s socioeconomic growth and
development will soon be affected.
The success of these banks, particularly IFBs, like ZamZam,
as well as existing banks interested in opening up
branches using similar modes of financing, depends
on government support through the creation of an
enabling legal and regulatory environment.