Riba as an extreme form of gharar -- Thinking aloud

I had taken it for granted that if you accept the view of the forbidden bay`u al-gharar as trading in risk, then you would recognize riba as an extreme special case of trading credit risk. Dr. Siddiqi objected that the essence of gharar is uncertainty, but -- he said -- there is no uncertainty in riba. I guess classical writers and Islamic economists for too long have been saying that riba is forbidden because the interest received is not compensation for commensurate risk, to the point that people have taken this to be true. This means that I need to have a full section dedicated to this issue in my academic paper. For now, let's see why it should be obvious that riba is an extreme form of gharar.

Economists regularly divide the types of asymmetric information that lead to market failure (due to uncertainty) into two categories: adverse selection and moral hazard. Let's look at the manifestations of those problems in riba and gharar, using examples from canonical texts and classical jurisprudence. We begin with adverse selection:

• Adverse selection in gharar examples:
  
  
  
  • Defective merchandise: seller knows if the good is defective but buyer doesn't
    
  • Diver's catch: diver knows if this is a good spot to dive but buyer of catch doesn't
    
  • Unborn calf: seller knows if cow has had previous miscarriages, etc., but buyer doesn't
    
  
  
• Adverse selection in riba examples:
  
  
  
  • Debtor knows if he has defaulted before, creditor doesn't
    
  • Debtor knows better the chances of solvency at maturity of debt
    
  
  

Then, of course, there is moral hazard:

• Moral hazard in gharar examples:
  
  
  
  • Defective merchandise: temptation to deliver lowest quality acceptable goods
    
  • Diver's catch: temptation to shirk
    
  • Unborn calf, unripened fruit, etc.: temptation not to care for cow or orchard, since risk has already been transferred to buyer
    
  
  
• Moral hazard in riba examples:
  
  
  
  • Of course, this is the classical example: debtor has an incentive to take large risks with the creditor's money, since all return up to the interest payment goes to creditor, and -- depending on bankruptcy laws -- liability may be limited.
    
  
  

Classical writers looked at the creditor/debtor relationship as creditor receiving return without commensurate risk, which is obviously incorrect. If that were the case, other crediors would compete for that riskless return opportunity, driving the interest rate all the way to zero. The problem is that the risks are difficult to quantify, and there is too much asymmetric information, which modern financial markets and institutions reduce with various structures and regulations:

• The creditor is exposed to credit risk and interest rate risk, thus favoring that the debtor takes very little risk with his money (explaining in part why a deposit, which is a contract of trust, turns into a loan, or contract of guaranty, if the depositary uses the property). However, due to moral hazard conditions, debtor may be tempted to take excessive risk.
  
• The debtor is exposed to business risk and bankruptcy risk. Of course that risk was substantial not only in antiquity, but well into the modern age, where quasi-slavery still resulted from excessive indebtedness to loan-sharks, white-slave traders, etc.
  

So, we can see that for the creditor (buyer of credit risk), the risk is very extreme, since incentives could encourage the debtor to take excessive risk and expose him to the possibility of losing all his money.

For the debtor, the risks may be substantial if bankruptcy laws are not in place to protect him, and may still be substantial if default makes it impossible to obtain further credit or get into other business arrangements.

Hence, riba is an extreme form of trading in risk (credit risk), or an extreme form of gharar.