• The 2008 financial crisis revealed how interest-driven lending and opaque financial instruments led to economic instability and exacerbated wealth inequality.
• The Islamic economic model, which prohibits interest and emphasises risk/profit sharing provides an alternative but only if all Muslim countries are willing to participate.
The Western economic and financial system, fundamentally based on interest, has long been considered the “conventional” way of running the economy. However, the 2008 financial crisis exposed significant flaws in this model, highlighting its instability and exploitative nature. Furthermore, recent economic issues have also led to deep criticism of the current system in place.
While many analysts and economic commentators have provided a range of solutions, the real solution may be much closer to home than we think. The prohibition of Riba (usury/interest) in Islam is well known but the most frequently asked question is, why? Firstly, we must remember that anything that is prohibited or allowed is done so by Allah ﷻ and is therefore done with reason and wisdom, so we must hear and obey. However, seeing and living in a world where interest is so widespread, we can begin to understand the failures of a system that revolves around interest, giving us reasons why Riba is prohibited in Islam.
Even if the failures are caused by banks or governments, we are still affected by it and even if we don’t participate in anything interest-based, we are again still affected by it. We are essentially seeing the hadith of the Prophet Muhammad peace be upon him being unfolded before our eyes. As reported by Abu Huraira, The Messenger of Allah, peace and blessings be upon him, said:
“A time will surely come upon people in which none will remain but that he consumes usury. If he does not consume it, he will be afflicted by its dust.”
Source: Sunan Abī Dāwūd 3331
Financial Crash
A great case study that illustrates some of these failures came about during the 2008 financial crisis. Without going into too much detail, the crisis was essentially caused by 2 major reasons at face value. The first reason was excessive lending and borrowing. Households, corporations, governments, and funds engaged in excessive borrowing, driven by the incentive to profit from interest. Banks and financial institutions issued loans to borrowers with poor credit histories, offering them at attractive interest rates.
An example could be someone on a £30,000 a year salary receiving a mortgage on a house worth £500,000. This was fueled by some lenders who were eager to extend as many loans as possible, often with little regard for the borrowers’ ability to repay. The goal was to package these loans into complex financial instruments like CDOs (collateralised debt obligations) which could then be sold off, transferring the risk to others.
An example of this is a bank bunching together thousands of contracts into one which is worth £1 Billion and because people will pay back their loans plus interest the value of this bunched-together contract or this CDO will be £2 Billion in 10 years time. This bank will now sell this package to another bank for £1.5 Billion in which both parties will make £500 million in the process. The issue with this is now the incentive to excessively loan in order to get more and more people who simply cannot keep up with repayments into these loans. Furthermore, these CDOs were rated by credit rating agencies as “safe investments” because they were paid to do so, showing how corrupt each part of the financial system can get.
As a result of people defaulting on their loans, the housing prices fell causing severe consequences for the broader economy. People were left in negative equity, meaning their homes were worth less than the mortgages they had taken outand economies went into deep recession and faced massive unemployment.
The reason why the prohibition of interest rates stops this is because the problem is cut at its root, if money can’t be created by renting out money (loans) then the incentive to excessively loan is not there.
A second reason why the financial crash happened could be attributed to the specific financial instruments used like MBS (Mortgage back security) and CDOs as mentioned previously. The lack of transparency and inability to calculate risk properly makes these products an issue. However, the Islamic principle of trading 1:1 simply makes these instruments impossible to create, eliminating the risk it presents.
From First Principles
Essentially, those who seek loans are typically individuals or entities in need of financial assistance, often the less wealthy. Conversely, those who provide loans are typically affluent, possessing surplus funds to lend.
This dynamic creates an inherently exploitative system where the rich get richer, and the poor become increasingly indebted.
The interest payments act as a transfer of wealth from borrowers to lenders, exacerbating economic inequality. Now if this is scaled on a macro level and becomes so widespread that it reaches every doorstep, people are bound to be worse off. This may explain the trend that we see in many western countries where the regular person may never be able to pay off their mortgage given the rise in asset prices. This is because people who could previously own a home with their current income 10 years ago can’t afford to buy a home now because of the rise in asset prices, resulting from the amount of interest-based loans that have been given out.
Profit and Loss Sharing
An important part of Islamic finance is the idea of profit and loss sharing, meaning that the lender should have a vested interest in who they are lending to and what the money is being used for. This therefore allows for financial instruments to be created that are in line with Islamic principles including: Mudarabah (Profit-and-loss sharing partnership), Musharakah(Profit-and-loss sharing joint venture), Ijarah, Sukuk and many more. The Islamic economic system, which prohibits interest, offers a more stable and equitable alternative. In this model, money is not treated as an asset to be rented out but as a means of exchange. Profit and loss are shared between lenders and borrowers, aligning their interests and promoting more prudent and socially beneficial investments. Additionally, investments will be more efficient given that the lender will now only finance projects (for example) with real potential of making returns.
Shift Away From Interest
For the benefits of Islamic finance to be fully realised, a united movement among Muslim-majority countries is necessary. Current economic policies in many Muslim nations are still heavily influenced by Western models. For instance, Turkey’s recent economic challenges, marked by high inflation and a weak currency, are often cited as examples of the difficulties in diverging from “conventional interest-based policies”. Given how interconnected the global economies of the world are with each other, individual countries moving away from interest won’t resolve the issue, what is required is a movement away from interest in all the Muslim countries and regions. That way, Islamic financial systems will be strengthened and enabled to support each other.
The failures of the Western economic system, exemplified by the 2008 financial crisis, highlights the need for a fundamental shift in how we approach finance and economics. An interest-based system inherently favors the wealthy and perpetuates inequality and instability. Embracing an Islamic economic model, grounded in equity and risk-sharing, offers a promising path toward a more just and sustainable economy.
To achieve this, a united effort by Muslim-majority countries to realign their economic policies with Islamic principles is essential. This shift would not only benefit individual economies but could also serve as a beacon for global financial reform. The time has come to reconsider what we accept as “conventional” with regards to economics and governance.
