How do Islamic banks act ethically?

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It is common for people to describe the potential of Islamic finance beyond just Muslims based on its socially responsible or ethical foundations.  However, given the structures used and limited screening methodology (focusing only on excluding what is prohibited outright), without any consideration for activities which may not be prohibited outright, but which are socially detrimental, such as environmental and labor standards. 

Even beyond this critique, some (myself included at times) focus solely on the "asset" side of the balance sheet and criticize the use of products that are functionally equivalent to conventional lending, but which have been re-structured to be sale or lease contracts instead of ones based on interest.  Part of the criticism is that by acting the same way as conventional banks, albeit with different contracts, there is no "ethical" benefit to Islamic finance.  However, that does miss the conflicting demands an Islamic bank (like any bank) faces between interest groups which may have different objectives and to which the bank may have different levels of responsibility. 

For example, as pointed out in this article, giving additional forbearance on a loan or renegotiating the terms beyond what is required in the contract or under the laws of the country in which it is executed, it may be viewed as more ethical by borrowers (and people whose interests are aligned with that borrower, like other debtors to the bank who may expect similar treatment).  However, it will be viewed very differently by the bank's depositors and shareholders, who will see a lower return on deposits or on their shareholdings in the bank.  To them, while the action of the bank may have been charitable, it was done not with the bank's money, but at the expense of the depositors or shareholders' return. 

As a result, it becomes more of a challenge to decide whether an Islamic bank is 'ethical' simply by viewing how it treats borrowers who are in distress, either because of factors out of their control like an economic downturn, or where they overextended themselves by buying a property they could not afford (in the latter case, some of the responsibility lies with the bank for not analyzing the borrower's ability to pay).  In normal times, and where there are no disputes about the bank acting in bad faith, it is perfectly ethical for a bank to demand repayment or to foreclose on the borrower to minimize the loss of depositors and shareholders.

However, in strained times, when there is a general economic downturn, especially when a lot of the bank's assets are exposed to a particular sector that has been hit hard, the Islamic banks should react differently and consider offering payment moratoriums, reducing the amount borrowers owe.  However, it should not do these out of charity to the borrowers, it should do so out of the responsibility to maximize the return (or minimize the losses) to shareholders and to protect depositors.  It should be a strictly economic decision--if the bank has high exposure to real estate, it cannot hold onto hope that all of the assets it holds will be worth their book value. 

By getting in front of the problem and determining what assets are impaired and which are not, it can decide how to maximize the value of its assets.  If the Islamic financial contracts and the bank's balance sheet is simpler and clearer than a conventional competitor, then it should be easier to identify losses, supplement capital where needed and move forward than in a conventional bank with a complicated balance sheet where its assets are more difficult to understand and value.  This may be more ethical in the end, but only if the bank 's management is willing and able to deal with the problems quickly.

If Islamic banks keep their operations simple and don't get too heavily leveraged with balance sheets filled with assets that are difficult to impossible and the management is honest with itself and its constituencies, then it may be judged to be more ethical.  The screens used in Islamic finance (particularly those relating to gharar and maysir) may tie the hands of management in a good way, it cannot be relied upon to keep the Islamic banking system any safer than the conventional banking system, or more ethical and transparent.  Combining the limitations on some types of activities may help, but in the end qualified, competent and ethical management has to be in place for the ethical ideas to be translated into practice.  Another reason why Islamic banking should not be viewed as inherently better, more ethical or more stable than conventional banks.