A negative interest rate policy will influence the way lending and borrowing rates are charged in conventional Financial markets. The objective behind such a policy is to deliberately boost aggregate demand and output by encouraging business and trade activities, which is no different from principles of Islamic Finance. This article provide insight into how Islamic Finance can help in achieving the same objectives expect from negative interest rate.

1. 19©
9th
March 2016
SPECIAL
REPORT
INTEREST RATES
By Lokesh Gupta &
Nafis Alam
The turmoil in financial markets has
been observed globally due to tumbling
oil prices, uncertainty due to China’s
slowdown and US rate hikes. The
fallouts due to the global downward
spiral are surfacing and policymakers
such as the central banks in Europe,
Japan, Denmark, and Switzerland have
already adopted the path of lowering
interest rates to below zero and now it
has gone negative.
In layman’s terms, the plunge in interest
rates signifies an increase in fiscal
deficit, deflation (fall in prices) and weak
economic conditions. Central banks
opt to cut interest rates as a measure to
make saving less attractive by charging
commercial banks and depositors for
keeping their money with banks. This
means depositors will have to pay to
keep their money with banks. This is
intended to incentivize banks to lend
money more freely to individuals
and corporates to invest, inject into
Negative interest rates and Islamic inance:
Where ideology meets reality
Negative interest rates, which were once unbelievable by most economists, now do not seem abnormal. Zero interest
rates do sound familiar as most of us would have studied it as part of economics; however, interest rates are now
getting pushed into the negative territory. LOKESH GUPTA and NAFIS ALAM write.
Table 1: Aftereffects of negative interest rates
Positive effects of negative
interest rates
Reactive measures in conventional financial system
due to negative interest rates
Proactive measures stated under principles of Islamic
financial system
No incentives for depositors
depositing their money with
banks.
Depositors will have to pay banks to safekeep their
money. This is to discourage excess holding and to
encourage spending.
Under Islamic finance, depositors are not entitled to
any share of the profits for the money deposited in an
Islamic bank. The Islamic bank act as a custodian and
the money is deposited on the basis of trust and for
safekeeping. The underlying contract is Wadiah Yad
Amanah and Islamic banks can charge a safekeeping
fee for Wadiah accounts.
This is to discourage savers from hoarding their
money with banks and to encourage them to put it into
productive investments.
Encourage loans to stimulate
economic growth.
Commercial banks are disincentivized for holding
excess reserves by central banks. This is to encourage
more lending and investing at the margin to
individuals and corporates where collateral, negligible
interest rate terms and charges are more business-
friendly.
Islamic banks emphasize on financial inclusion and
offer financing under various contracts based on
partnership and profit-sharing to promote equality and
fairness, where collateral is the underlying physical
asset. This is to facilitate easy access to finance for the
poor and small businesses in areas such as agriculture,
industrial production and other finance needs.
Money will flow more into
productive investments
such as equity and venture
financing.
Interest-based lending promotes risk-shifting, risk-
shedding and risk-transfer, whereby the risk is solely
borne by the borrower. The borrower will have to pay
principal and interest irrespective of profit and loss
in the business. With the negative interest rate, the
depositor will be more interested in doing investment
in the form of a project financing, seed capital, private
equity funding as there is a high probability of better
returns in comparison to bank deposits or investment
in bonds or securities. This in turn will promote a
partnership model and will follow the risk and return
principle, whereby partners share profit and losses
based on pre-agreed percentages.
Creditors and debtors alike must share risk and
return, ie the ‘no risk, no gain’ concept. Islamic finance
emphasizes on a partnership and profit-sharing style
of financing based on the Islamic contracts such as
Mudarabah (trustee financing) and Musharakah
(equity partnership). Profits are shared according to a
predetermined ratio and the investor is not guaranteed
a return and bears any financial loss. This provides
financial support to entrepreneurs and productive
enterprises to increase output and venture into
new projects. This will generate more employment,
increase in production and will contribute to economic
development.
The time value of money
will not be applicable due to
negative interest rates.
Zero or negative rates mean that the money loaned
has no value. It is lent out below cost. In the case of
deposits, there will be negative returns, which breaks
down the core principle, ie no potential earning
capacity.
Money has no intrinsic value under Islamic economics.
It can only be used to acquire goods or services and
is not a commodity which can be directly exchanged
for some other things. Money is just a medium of
exchange. This is one of the fundamental reasons
behind the prohibition of Riba (interest/usury).
Therefore, Islamic finance permits financing based
on contracts of exchange and contracts of investment
partnership in compliance with Shariah principles.
Source: Author’s own

2. 20©
9th
March 2016
SPECIAL
REPORT
businesses, and spend money rather
than paying a fee to the central bank.
The increase in flow of money into the
economy will boost industrial production
and recovery. The effects of negative
interest rates can be summarized as
follows:
• Retail/corporate depositors will be
charged for holding their money with
banks
• The central bank will charge
commercial banks for reserves
• A reduction in borrowing costs to
stimulate lending and boost inflation
• Increase in spending and investment
elsewhere due to negative returns
from deposits, and
• Lower or negative yields on bonds.
If we compare the present market
situation with the principles of Islamic
finance, we can observe that this has been
thought through and is well taken care
of under the fundamentals of the Islamic
financial system.
The Islamic financial system, which is
also known as interest-free banking,
provides pro-active measures to ensure
that the economy does not reach the
point of a spurting economy. The
surprising fact is that the ‘pro-active’
measures followed under the Islamic
financial system are ‘reactive’ measures
followed by the conventional economy
for recovery.
Interest is strictly prohibited under
Islamic finance and it emphasizes the
ethical, moral, social, and religious
dimensions. The most fundamental pillar
of Islamic finance is the profit-sharing
feature and permissible (Halal) financial
products and services, which must be in
compliance with Shariah. The principles
of Islamic finance focus primarily toward
uplifting society through the concept of
justice, equitable distribution of wealth,
risk-sharing, no gambling and the
sanctity of contracts and offering Riba
(usury)-free products and services.
Table 1 shows the aftereffects of negative
interest rates, which lead to positive
measures for economy recovery which
has already been pre-defined under the
principles of the Islamic financial system.
From Table 1, it can be derived that
a negative interest rate policy will
influence the way lending and borrowing
rates are charged in conventional
financial markets. The objective
behind such a policy is to deliberately
boost aggregate demand and output
by encouraging business and trade
activities. The underlying principle
behind the policy is that cash is not
subject to a negative interest rate once
it is withdrawn from the bank. This
will create liquidity surplus in the
market and will open channels for
other sources of investment driven by
equity and partnership models. This
will uplift society, create social equity
and narrow the wealth and income
distribution between the rich and the
poor. This is precisely what is preached
and practiced under Islamic finance,
ie there is an emphasis on fairness,
transparency, equitable income and
wealth distribution.
The negative real interest rate ideology is
a closer example of what Islamic finance
intends to achieve. Islamic finance has
already proven its stability during the
subprime crisis, that the crisis would
have been averted if Islamic financing
principles were followed, ie financing
the purchase of physical assets and not
permissible to finance a debt. A negative
interest rate does have its limitations.
It does not wave a magic wand to do
away with inherent business risks such
as the flocking of non-performing loans
due to easy loans and the economy
sinking into recession. The success of a
negative interest rate implementation in
stimulating the economy is something
that the future is going to decide.
However, the current negative interest
rate policy could also be an opportunity
for Islamic financial institutions, where
the expected outcome has already been
taken care of under the principles of
Islamic finance. The Islamic financial
system is driven by profit-sharing,
equity-sharing and asset-based financing
and shares the same intended outcome as
negative interest rates. This brings an
opportunity for Islamic financial
institutions to illustrate to the world that
the fundamental operating principles of
risk-sharing strengthen financial stability.
This does not mean that Islamic financial
institutions are risk-immune and not
vulnerable to financial shocks; however,
there are inbuilt checks in place as
guided by the principles of Islamic
finance to mitigate adverse financial risk
and volatility.
The materials presented above are provided
voluntarily. The information is made
available in good faith and is derived from
sources believed to be reliable and accurate
at the time of release. Readers are responsible
for making their own decisions about the
accuracy, reliability and correctness of the
information given. We do not accept any
liability for any loss or damage incurred by
reliance on the information provided.
Lokesh Gupta is the head of consulting at RM
Applications and Nafis Alam is an associate
professor and director at the Center for
Islamic Business and Finance Research at the
University of Nottingham Malaysia Campus.
They can be contacted at Lokesh@rma.com.
my and nafis.alam@gmail.com respectively.
A negative
interest rate
policy will in luence
the way lending
and borrowing
rates are charged
in conventional
inancial markets.
The objective behind
such a policy is
to deliberately
boost aggregate
demand and output
by encouraging
business and trade
activities
Continued