Usury Laws and Financial Evolution

by Desmond Fitzgerald

Desmond Fitzgerald
Ceo Equitable House Investments Limited

This article attempts to address what at first sight is a considerable conundrum. In mediaeval times, both the Christian (or specifically Catholic) and Islamic religions were characterised by very strict rules against the charging of interest on loans or usury as it tended to be called. Various authors have indeed traced the origin of such rules back to Aristotle, who first stated that money is sterile and barren, and that hence the exchange of money to pay back a principal with interest was most unnatural. The scholastic authors in the mediaeval period including St Thomas Aquinas held that “quidquid sorti accedit, usura est” or whatever exceeds the principal is usury. But they also said “usura solum in mutuo cadit” or that usury only occurred in a loan. Similarly it is evident that Islam worked to eliminate any exploitation or undue advantage in all business transactions. The most potent attack on interest and usury can be found in the Fourth Revelation concerning Riba in the Quran, Surah al-Baqarah, Verses 275 – 281, where it says, “Those who benefit from interest should be raised like those who have been driven to madness by the tools of the Devil. This is because they say “trade is like interest” while Allah has permitted trade and forbidden interest.” So both religions appear equally condemnatory of the classic business of finance and banking, namely the lending of money at fixed rates of interest. But there is a big difference. Islam was as much against speculation, the deliberate taking on of risk and uncertainty, as it was about Riba or interest. Risk and uncertainty correspond to the Islamic concept of Gharar. As we shall see, prohibitions against both interest (Riba) and any form of speculation or gambling (Gharar) led Christian and Islamic banking systems in different directions from the very beginning.

The primary method for mediaeval Christian bankers to get around the usury laws was to introduce a degree of uncertainty into the rate of interest payable on a loan. They did this by introducing an instrument that was to revolutionise finance, namely the Bill of Exchange. As an example, suppose a Florentine banker gave a client 100 ducats in exchange for a bill payable not in Florentine ducats but in UK Pounds in 90 days time, not in Florence but in London. Hence the initial foreign exchange rate is 1 ducat to 2 pounds. The payment is to be made to the Florentine banker’s branch or agent in London. However, the secret here is that the foreign exchange rate in London in equilibrium would not be 1 ducat to 2 pounds, but, say, 1 ducat to 1.93 pounds. Now suppose the client simply does not pay the bill in London. The bank issues a new bill for 200 pounds repayable in Florence in 90 days with a ducat amount determined by the prevailing London foreign exchange rate of 1 ducat to 1.93 pounds. Hence the ducat amount repayable in Florence would be (200/1.93) or 103.6 ducats. Expressed at an annual rate, the Florentine client has borrowed 100 ducats for 180 days at 7.2% So why did the Church not regard this transaction as usurious. Because even though the normal foreign exchange equilibrium would call for a rate of 1 ducat/2 pounds in Florence and 1 ducat/1.93 pounds in London, there was no certainty that when the bill was presented and defaulted in London, the relevant exchange rate would actually be 1 to 1.93. Maybe there could have been a French raid on the English coast threatening military complications. In such a case, the Florentine ducat might have risen to a 1/2.05 exchange rate against the English pound. Then the replacement bill would only call for (200/2.04) or 98.04 ducats to be paid in Florence, and the bank would have earned only an annual interest rate of -3.9% on the loan. It was the exchange rate driven uncertainty concerning the final realised rate of interest that meant the transaction was not deemed to be usury. Such was the rapid expansion of the Bill of Exchange market, that it is fair to say that the history of early European banking is the history of exchange. Indeed, I regard the dominant role of exchange as a very important factor in developing the range of financial instruments now prevalent in Western banking.
However, the Islamic world was precluded from following the Christian example, because of the severe strictures concerning speculation, gambling and risk-taking. Indeed in Mediaeval Islam, all forms of forward contract were forbidden unless aimed at eliminating uncertainty or Gharar. Historical and modern Islamic finance, however, may owe a greater debt to the other primary method mediaeval bankers and financiers in Europe used to get around the usury laws. This is in fact possibly the first ever form of structured finance, and was termed the “Contractum Trinius”, which consisted of three different contracts, all in themselves non-usurous, which together created a simple fixed rate loan.

CONTRACTUM TRINIUS
1. A invests 10,000 in B’s enterprise for one year.
2. A sells back to B the right to any enterprise profit over a specific level for a fee of 1,500.
3. A insures the value of his investment at 10,000 for a payment to B of an underwriting fee of 500.

It will be immediately obviously that the net result of all this was a loan of 10,000 to B at a minimum fixed annual rate of 10%. However it was to be deemed non-usurious because none of its parts were usurious. In the process, it will be noted that the banker has invented the concepts of limited risk investments, call options on a company’s profits, and financial insurance. Once again, the ramifications of the Contractum Trinius for the evolution of Western finance were enormous. Moreover, here is where Islamic and Christian finance developments began to converge. I first introduce the concept of the Murabarah contract.
Here party A promises to buy good X from the bank in the event the bank buys good X from B. The bank agrees that A can pay for the goods three months after delivery at a price of 105. The bank buys goods from B for 100 and passes them on to A for the delayed payment of 105. Although effectively the bank has financed A’s purchase of the goods to the tune of 100 and is receiving annual interest of 5%, as I understand this would not be deemed Riba by the majority of Islamic scholars. The rapidly growing Sukuk bond market follows similar sorts of structures. These are Islamic Investment Certificates, where the securities must be backed by real underlying assets, and the income from the securities must be related to the purpose for which the funding is used, and obviously not simply represent interest or Riba. However, many such products contain binding promises by the issuer to repurchase the underlying assets at a fixed price, plus a rental fee for the assets which is sometimes benchmarked to a well-known interest rate such as Libor. A breakdown of most of the Sukuk issues, in my view, will reveal pretty much the same structure as the Contractum Trinius used by bankers in mediaeval Europe, and with pretty much the same aim. However, I further note that many of the embedded elements if taken in isolation are not necessarily acceptable to Islamic banking scholars. I would include there the use of insurance-type guarantees, the linking of the rental payments to a market interest rate, and the substitution of rental income for true profit-sharing.
Another area of differing views on a major financial area is that of insurance. In mediaeval Europe, the insurance industry arose naturally out of the requirements of international trade. Indeed marine insurance essentially started with the sea-loans of the Roman Empire where investors would put up a higher proportion of the capital required for a shipping voyage in exchange for a specific proportion of the profit, but with the investment (loan) to be forgiven if the ship failed to return within a certain period. Pleasingly from the point of view of both Christian and Islamic scholars, that represents a loan plus insurance as a profit-sharing investment, welcome to all views. Modern forms of marine and casualty insurance then multiplied in Italy in the Middle Ages, as did associated markets such as life insurance, and the use of annuities (which involved risk) as another way of getting around the usury laws. However, the development of insurance under Islam was rather different. First there was the issue of avoiding Riba or interest on the insurance premiums, given that the insurance provider needed regular income to cover the potential insurance claims. Second and more importantly was the need to prevent insurance being seen as or becoming a form of gambling. Islamic scholars, or at least a proportion of them, have tended to argue that even though each individual insurance contract involves Gharar or uncertainty, this will disappear when large numbers of underlying unrelated events are concerned.
This would clearly not be the case for financial insurance, however. In the end, it does seem difficult to get away from the view that any form of insurance must involve uncertainty. The same argument must apply to the use of derivatives and all forms of contingent claims. By definition, there is always uncertainty as to whether an option will be exercised or not. In addition, the use of derivatives can clearly create synthetic short or sold positions in the underlying asset, and under Islamic restrictions any selling of what is not owned is clearly prohibited. And finally the more complex the derivative, the more uncertainty is likely to be attached to it. Since a very large number of conventional banking and investment products in the Western economies depend upon embedded derivative exposures to a greater or lesser degree, it is surprising that one learns of so many structured finance losses in major Middle Eastern banks.
In essence, I believe the conclusion must be that although attitudes to interest or Riba in mediaeval Christian and Islamic communities were essentially similar, the main reason the financial systems and institutions developed so differently was the very distinct attitudes to the role of uncertainty/risk or Gharar. Avoiding usurious loans via the use of uncertainty led mediaeval European financial institutions in the direction of foreign exchange, contingent claims, structured products and huge financial inventiveness. Restrictions on usury, and profound worries about the role of uncertainty slowed down the development of Islamic finance significantly, and are still obviously playing a major role today. Which system actually possesses the best features as a result remains open to debate.