Dear questioner, thank you very much for your important question.

As Muslims, we believe that everything Allah has legislated is all of justice, mercy and benefit for people and everything Allah has prohibited it must be involving harms to people. With regard to Riba or interest, Allah made it clearly forbidden in the Qur'an,

Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest. (Al-Baqarah 2:275)

As regarding the reasons of the prohibition of interest in Islam, we quote this rationale of the prohibition of interest in Islam from a research by Dr. Abdel-Rahman Yousri Ahmed, Director General of Institute of Islamic University, Pakistan, and was published on the Institute of Islamic Banking and Insurance site. It reads,

• The interest system is inherently incapable of allocating available liquid funds among firms and activities in the society according to considerations of efficiency, productivity and growth. An Islamic system based on profit/loss sharing financing methods would offer, in principle, an efficient substitute.
• The riba system is full of contradictions and attempts to regulate it through interest rate controls have either failed or accentuated its imperfections. On the whole, therefore, the system which is prohibited by Shari`ah, is adversely affecting economic development in the Islamic countries. On the contrary a financial system based on profit and loss sharing offers a much better alternative to Islamic countries since it is expected to be free of all the imperfections of the riba system.
• The interest system brings about and effectively maintains a pattern of income distribution which is biased towards wealthy people and large businesses, irrespective of rational economic considerations. An Islamic interest-free financial system supports a just income distribution pattern fairly correlated to economic efficiency, productivity and actual factors contributions to the total value added.
• The interest system encourages passive behavior to develop among people having liquid funds by helping them to relinquish responsibilities and risks in investment activities. In contrast sharing in responsibilities and risks is inherent in the profit/loss sharing methods of finance.
• No doubt that the interest system relieves money capital owners from holding any responsibilities and risks related to the execution or to the final outcome of the investment activities financed by them. It is claimed by the interest system's exponents that this is one of its merits since easy and risk less income is guaranteed to the capital owners periodically. It is also claimed that entrepreneurs within this system are willingly accepting its terms and satisfied that the financiers do not intervene in their business. Interest paid by the entrepreneurs is included in costs and thus transferred to purchasers through sales, while net profit once realized is totally their own.
• The growth of the interest-based finance in any society whether through the banking system or by selling bonds in capital markets will directly be reflected in growth of passive behavior among society members. Individuals who receive guaranteed interest paid to them periodically without bearing any responsibilities or risk can not be considered but inactive society members. As well as, their passive behavior is emphasized by the full option, given by the banking system, to restore their funds at any time. Those inactive individuals are considered sleeping partners in secular literature and it is estimated that the growth of their members in any society would endanger economic growth.

It goes without saying that partnership based on profit/loss sharing mechanism would help in getting rid of passive individualistic behavior. The Islamic modes of finance help directly in promoting responsibility and risk-taking morals and motivations, which are quite essential for economic growth. The economic rational of the interest-free finance is quite clear here, i.e. providers and users of finance will be sharing together in all the responsibilities and risks involved in the investment activities from A to Z. All partners are actually active in the Islamic system. Islamic ethics motivate people to exchange opinions, advice, share positively in production. All these ethics are basic for rational behaviour and good deeds. At the same time the sharing ethics will always provide a support for brotherhood and co-operation among members of the Islamic society.

• Prohibition of interest would not affect savings, as well as it would not affect their mobilization provided that Islamic ethics are prevailing, and the application of various interest-free financing methods is conducted successfully by specialised Islamic institutions.

In fact, a revival of Islamic Shar`iah and ethics would settle the matter decisively against the interest-based system and its ability to mobilize Muslims, savings. But before realizing this precious target, it is very important that the ability of any new Islamic financial institution to effectively mobilize saving resources would mainly depend on efficient practice of interest-free financing methods, success in achieving highest possible "halal" returns and thus gaining the confidence of the savers to invest their funds through them.

Please keep in touch..

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Source: Taken with modifications from http://www.islamic-banking.com/