SRI and Islamic finance: similar but disconnected

I had a chance to read through the recent report from Novethic (linked in the previous post), a SRI firm in France, about the compatibility and similarities between Islamic finance and socially-responsible investing/sustainability. The report did a fairly good job at laying out the ethical/religious underpinnings of both areas although there was more content about 'what' for each that the section on the comparison between the two was somewhat lacking in depth.

The main conclusion of the report is that the two areas share many of the same motivations for the screening of investments, although Islamic finance has a larger list of prohibited areas of investment due to the prohibition of riba as well as additional 'sin' screens. In contrast, SRI includes additional environmental, social and governance (ESG) screens (including those from the UN Global Compact) than Islamic finance. SRI, in contrast to most Islamic finance, has expanded the way in which it looks at possible areas of investment in that in addition to removing the negative, it encourages the positive through investment decisions that focus on 'best-in-class' companies, for example, in the various areas of interest (primarily ESG-related).

This analysis is, in my view, largely correct and does not necessarily mean that the Islamic finance industry does not care about promoting the positive, but the industry is still young and has other more pressing challenges due to the prohibition of riba that excludes many of the financing methods used elsewhere in the financial world. However, Islamic finance is not necessarily only focused on avoiding 'bad' companies/investments/financial products and to move the entire industry from catering to the needs of Muslims to avoid many areas that contradict the religious rules to one that offers an alternate vision of the relation between the financial world and the rest of the economy, there should continue to be work done on moving beyond negative screens.

One way that is currently more talked about than acted upon comes up when some commentators say that the Islamic financial industry is 'immune' to crisis or that it avoided the bulk of the crisis. Part of that was due to its relative newness; it did not have time yet to run out of investment opportunities in the traditional areas which many conventional banks had in some ways and to continue to produce profit growth ventured into subprime housing markets with disasterous consequences. Although some asset-based rather than asset-backed sukuk are raising important questions about the claims investors have over underlying assets, the linkage (not always absolute) between investments and assets should serve as a point for the Islamic finance industry to reach out to the SRI industry.

It may not be a focus of the SRI industry that there are other important areas of the financial system that have ethical dimensions involved besides those that are socially detrimental or environmentally damaging. However, the current economic crisis does show a case where the financial structure on which the housing market, for example, was based to some degree on the fallacy that housing prices CANNOT fall. All it took was a little deregulation and some financial sector 'innovation' to take this fallacy and create a situation where housing supply was excessive and the banks who securitized the mortgages and encouraged the lending spread the harm across many areas of the economy when housing prices violated the fundamental assumption.

That is not to say that a housing bubble could not occur with Islamic finance. It did, for example in Dubai where Islamic finance has a sizeable stake, and sukuk, for example, are currently suffering as a result. However, the more conservative nature of the Islamic financial industry leaves less room for excessive securitization and the search for fees through re-securitization and creating derivatives on these securities. While it may not be the case that Islamic finance makes a different mortgage (the economic outcome is usually identical), there are more incentives from the ethical framework to strive towards creating economically-distinct products that can provide a model by which SRI can expand beyond its investment focus and towards becoming socially responsible finance.