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What is Islamic Finance and Islamic Banking?

(Video Series with Prof. Abbas Mirakhor)

The best way to try to explain what Islamic banking and Islamic finance is, is to look at the contrary view – or a counterfactual situation to Islamic finance – which is the conventional finance.

Conventional finance is a financial arrangement in which interest rate-based debt rules the system.

In other words the system is basically a debt system operating on interest rate basis.

Islamic banking on the other hand operates on a different premise, and this is different.

The difference between the premises are the following:

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In the conventional bank, you go to bank, put some money in your account, and that money the bank takes and loans it out.

So what you do is you transfer the risk of your money to the bank. The bank transfers that to the borrower.

So regardless of what the borrower does, he will owe that money plus the interest that has to be paid.

The first one is called risk transfer. You transfer the risk to the bank, the bank transfers risk to the borrower.

The Islamic banking system operates on a different premise that the premise is that ‘no you cannot transfer risk’.

You are part of a society, you’re part of an economy, you’re using the resources of the society, everybody else is in it with you, and consequently you can’t continue to transfer your risk to other people.

You have to put what they call ‘skin in the game’ in recent language about finance, and that means that ‘no you have to put some of your own skin in the game and you have to invest with other people to earn anything.

This is the foundation of Islamic banking. You cannot just simply earn because you’re loaning money to somebody, but that you have to invest your money which is crystallization of your past labor with somebody else’s labor in order to get something out of it and then you can share it.

From there you go to the whole financial system that says in this system there is no interest rate based debt. There is debt but it is not based on interest.

And therefore, there is a fundamental difference between the two systems.

One operates on risk transfer, this one says you operate on the basis of sharing the risk with other people who use their labor and your money put together to innovate and produce.

This video is used with the speaker’s kind permission. It is transcribed by Reading Islam team.

About Prof. Dr. Abbas Mirakhor
Prof. Dr. Abbas Mirakhor: First Holder, INCEIF Chair of Islamic Finance in Malaysia