Is Islamic Finance Ethical?

Islamic finance is ethical in the sense that it conforms with the commonly accepted understanding among Shari'ah scholars of what is ethical.  However, the industry markets itself in a different idea of what is ethical.  Islamic finance is supposed to be a superior alternative to the current financial system, one which appeals to Muslims as well as non-Muslims and one which takes as a minimum a standard that is more stringent than the 'industry average'. 

On this metric, I think Islamic finance has much more work to do.  If one thinks that Islamic finance is supposed to meet the baseline standards of financial ethics with an additional set of constraints specific to the dictates of the Shari'ah, than Islamic finance meets the definition of 'ethical'.  However, the way Islamic finance is presented, and I would argue also how it views itself, this standard is not sufficient to be 'ethical'. 

For example, take socially responsibly investing.  It is an 'ethical' framework for investing and it has broad appeal (although there is nothing 'unethical' about disagreeing with the standards under which it operates).  However, it operates in an environment with conventional finance is a competitor and where it has to offer something valuable to consumers.  Islamic finance, on the other hand, is largely concerned with serving a market where it is not in direct competition with conventional finance. 

For Islamic finance to gain consumers--at least until that market is saturated--all it has to offer is the same types of products that conventional finance, but in a way that passes muster of a Shari'ah board.  This type of Islamic finance industry does not directly compete with conventional finance because it is targeted towards a consumer who is not deciding between Islamic and conventional financing, but instead is deciding between working with an Islamic bank or keeping his or her money under the mattress.  This market is almost entirely Muslim, although not all Muslims use Islamic finance. 

There has been a trend in recent years for non-Muslims to use Islamic finance, whether this is Islamic banks in Malaysia or Islamic mutual funds in the United States.  This decision is primarily financial: if an Islamic bank or mutual fund offers a better deal than conventional financial institutions, then non-Muslims will use it regardless of the "ethical-ness" of the product.  However, being price competitive alone does not make the product "ethical", even if it happens to be designed to fit within an ethical system like the one derived from Islam. 

Islamic finance talks a lot about being superior to conventional finance and being an alternative that is attractive to conventional finance to non-Muslims as well as Muslims.  While this is admirable, there still remains a disconnect between creating an "ethical" alternative based on the precepts of Islam.  Returning to the socially responsible investing example, that industry started (like Islamic finance) by avoiding things that were viewed as "unethical", whether that was weapons or tobacco makers or producers of alcohol or companies that produced other harmful or toxic products.  But, the evolution of socially responsible investing did not become an "ethical" alternative until it started offering a product that was defined by what it did, not by what it did not do. 

Today, Islamic finance is approaching the point where it too will have to define what it is, not what it is not.  This ties back into my earlier post on the debate between the idealists and pragmatists in Islamic finance with the former saying that creating financial products that Shari'ah scholars approve using financial engineering in some cases which fit into the current regulatory environment is sufficient.  The latter say, "no", and argue that only profit-and-loss sharing (PLS) products are true to the roots of Islamic finance. 

When viewed through the ethical lens, the idealists have the edge because they are offering an idea about what they want, not how they have not done X, Y or Z.  However, they promote an idea that I think is incompatible with financial services today because of regulatory barriers, as well as consumer preference.  Not every financial consumer's needs can be met with a PLS-based financial product.  For example, how would one structure a student loan to pay for college using PLS?

But, I do think their focus on what Islamic finance does that other types of finance do not is useful for the Islamic finance industry.  To create an ethical product in Islamic finance, financial institutions should consider not only avoiding what is haram, but also on incorporating ideas of what is encouraged within Islam into financial products.  This will make it easier to explain to non-Muslims why they should consider Islamic finance, without either resorting to platitudes about fairness and justice or hoping that the economics of the transaction are more beneficial than a conventional financial product.

Until Islamic finance moves towards this idea, it will be stuck selling its products to the segment of Muslims who will not deal with conventional banks, or those who prefer to deal with Islamic banks, if the cost is similar.  There will remain examples that can be tossed out to refute my argment based on the large non-Muslim customer base, but in large part, those will be isolated examples where the economics work out better for the consumer.  There will be little progress in making inroads on the non-Muslim market (and also among many Muslims) if there is not something being offered that is not solely based on superior performance.