Sharing lessons between Islamic finance and ESG-based finance

There have been several interesting articles by Funds-at-Work about Islamic finance, which use a network analysis to highlight aspects of the industry that may not be as clear from other forms of analysis (I wrote a few blog posts about their analysis on Shari'ah scholars in 2010).

Their latest is a short article (PDF) that compares the factors used in conventional finance, Islamic finance and conventional finance with ESG (environmental, social and governance) consideration.  They find that there is very little overlap between finance incorporating ESG considerations and Islamic finance, specifically that both use a set of negative screens to exclude certain sectors, for which there is overlap between the two in terms of what is excluded. 

However, there is a much more robust set of other criteria for ESG-centered conventional finance, including positive screening (adding positive weights for best-of-class companies), active engagement with the companies in which they are invested including voting their proxy votes in line with the ESG criteria they use, as well as incorporating far more non-financial factors in their financing decisions. 

Islamic finance, as described in the report, focuses on negative screening, incorporating zakat and other forms of distributions to the needy, avoiding excessive debt, and linking to real assets.  I would put an asterisk on avoiding excessive debt and linking to real assets.  On the debt issue, most Islamic financial institutions do use less debt than some conventional financial institutions, but there are other Islamic financial institutions that employ significant leverage in their financing, so long as it can be structured to be Shari'ah-compliant. 

I put less of an asterisk on the point of linking products to real assets.  There are fewer products that build on other financial products (rather than serving as financing to another business directly), although the most talked about exception is commodity murabaha, which is used to synthesize as much as possible a conventional loan.  There are situations where that is appropriate (where there are no good alternatives) but there are others where it is probably applied in situations where another structure could function equally as well, but which is more connected with the financing of a specific activity (rather than creating an unsecured loan). 

The main point, however, is that there is much that ESG and Islamic finance can gain from greater appreciation of the goals of each.  For example, in almost every place where finance of any kind operates, there are members of society who are in need of assistance, and so perhaps companies that extend financing that includes ESG consideration can set aside a portion of their profits for specific financial assistance within the communities they operate (and many probably already do, but maybe not with as much connection between the level of profit and the level of giving). 

Islamic finance can incorporate greater consideration to ESG criteria in their financing decisions, to incorporate not just the financial and sectoral screens, but consider whether companies have good relations with their workers, with the environment and the best-in-class systems of governance to protect the 'stakeholders'.  Where these analysis come up short (or where the company proposes changes that would impact the ESG criteria, or the criteria specific to Islamic finance, like proposing taking on additional debt), Islamic financial institutions can become more engaged with management to suggest alternatives, or at least use their ability to participate in proxy voting to encourage changes. 

It's beyond my pay-grade to suggest the specific ways these are implemented, and most of the changes would probably be set with a discussion between the management and Shari'ah board at the individual Islamic financial institution.  They can adapt their implementation of selecting the aspects of the ESG criteria, and how they are applied, to fit within their Shari'ah board's idea of what will encourage positive outcomes and avoid creating any issues with the existing Shari'ah rules. 

Priorities in Islamic finance

Rushdi Siddiqui asks a question he has asked before (and which I have written about before) about whether Islamic finance is missing a focus on microfinance and making institutions whose focuses include social responsibility (a focus on environmental, social and governance, or ESG, metrics, in addition to profits).  When I talk to people about Islamic finance, one of the areas that sparks the most enthusiasm is Islamic microfinance, and using Islamic finance as a way to broaden financial inclusion.

Yet, there is too little attention paid to these issues by Islamic financial institutions, where the focus is more on creating new alternatives to conventional products like allowing brokerages to offer 'Islamic margin accounts'. There is a demand for these products, I'm sure, and they help Islamic financial institutions compete with conventional brokerages for business, but is that the best use of resources for broadening Islamic finance?

Why not help new initiatives to reach the broad majority of Muslims who are not thinking "well, can an Islamic brokerage allow me to make leveraged bets on stocks?" but are instead thinking "I want to use microfinance to start a business, but I don't want to be involved with an interest-based microfinance institution".

There are new Islamic microfinance institutions starting up, including one, the Zayd Chit Fund in Bangalore, India (a form of rotating savings and credit association, or ROSCA), which launched last weekend, in a market that has huge potential for Islamic finance, but where political constraints have limited the ability of large Islamic financial institutions to enter.  What better way to enter the market than to go support (financially and with technical knowledge) the development of Islamic microfinance institutions, including Shari'ah-compliant chit funds.  It provides a way to enter a large, untapped market, and a way to show that the Islamic bank is focused on more than just the next quarterly earnings report. 

The Islamic finance industry is vast and rich with resources and talent (although, as many have noted, not as successful in finding jobs for the recent graduates).  It is also by its nature supposed to be concerned with providing ethically-based financial services that do not just preserve wealth for those who have it, but also in providing opportunities for people who, with an oppportunity, can create wealth, and jobs. In addition to providing banking products for higher-income people and those with significant wealth, it should also support financial institutions that provide for people with lower incomes or with no access to Islamic finance.  Not just because it makes nice PR material, but because it will help attract and retain talented employees, and will create a market of people familiar with Islamic finance who will then look to Islamic banks for services into the future.

Combining Islamic finance and sustainable finance

I've been going through the Malaysian Financial Services Blueprint (2011-2020) and there are a number of interesting ideas in there about Islamic finance.  Hopefully, I'll get to some of the others in later posts; the first one is on the connection between the Socially Responsible Investing industry and the Islamic finance industry.  The report writes:

The demand for Islamic finance is expected to emanate not only from the Muslim population but also from those with affinity for socially responsible objectives and those seeking ethical financial solutions where the central theme is a more equitable model that would foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape. This is spurred by the growing significance of global ethical consumer movement where Socially Responsible Investment (SRI) is expected to be an important mainstream asset class by 2015. With this development, Islamic finance has an enhanced growth prospect given its close synergy with ethical finance.

The idea here is worthy and there is definitely a possibility for Islamic finance to attract non-Muslim consumers based on the ethical ideas that underpin Islamic finance.  Malaysia is noteworthy in this respect and estimates place the share of Islamic bank accounts held by non-Muslims at around 25%. 

The often attributed reason for the take-up of Islamic finance by non-Muslims in Malaysia is that the products are cost-effective or even cost-advantageous, in part due to the government's efforts to promote Islamic finance.  This is something which could work in some other regions, but in many countries--particularly those with small Muslim minorities--the idea of favoring Islamic finance over conventional finance is going to be a non-starter. 

Without a government-aided cost advantage, Islamic finance will have to offer something new that conventional finance ignores.  The most frequently offered suggestion is to move Islamic finance more towards profit-sharing contracts (e.g. mudaraba and musharaka).  While this may make Islamic finance more attractive (it is not necessarily certain that this is the case), it is unlikely that, outside of some areas of finance like stock markets, this will be possible in current regulatory environments. 

Therefore the suggestion from the report to focus more on activities that "foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape" makes sense.  This is probably most likely way to tap the "enhanced growth prospect given its close synergy with ethical finance".  So far, Islamic finance has concentrated much effort in laying the groundwork and setting up Islamic finance to meet the financial needs in a way that is Shari'ah-compliant.  

Now, it should take the next step from expanding the breadth of product offering and focus on differentiation.  This need not be an industry-wide shift.  There are likely to be plenty of people who just want a Shari'ah-compliant alternative to conventional banking, so not adding complexity will make these services more competitive with conventional financial institutions.  

However, there is likely a market opportunity--among both Muslims and non-Mulims--by offering Islamic financial products with a focus on low-income communities, avoiding investments that are not environmentally sustainable, and to add other so-called ESG (environmental, social, governance) criteria to the investment decisions.  These may or may not be required to be Shari'ah-compliant, but there is nothing stopping Islamic financial institutions from adding more ethical criteria to their decision-making process. 

Islamic investing 2.0

Writing in Gulf News, Rusdhi Siddiqui runs through the equity screening criteria for Islamic stock indices and concludes that there is nothing exclusively "Islamic" about the process of "doing good by avoiding the bad". He concludes: "Islamic investing does not have a monopoly on doing good, by avoiding the bad, its common shared values with all investors of conscience".

I would go one step further and say that for equity investing in public companies--which as he notes includes companies like ExxonMobil, Nestle, Microsoft, Johnson & Johnson and Novartis--Islamic investing is far behind the curve in terms of ethical investing.

For example, consider the Calvert Funds, a well known socially responsible investing fund. Their screening criteria is similar in terms of what is excluded: firms engaged in tobacco, weapons, alcohol, gambling, human rights issues and nuclear. These have significant overlap with the Islamic screens used across the industry (with the additional exclusion of companies with poor human rights track records and those engaged in the nuclear industry). From this "doing good by avoiding the bad" strategy, Calvert adds another set of criteria: governance and ethics, environment, workplace safety, product safety, human rights, indigenous peoples' rights and community relations.

These criteria add another level of screening. Calvert not only avoids the companies engaged in socially detrimental industries, it also screens the companies that pass its 'negative' screens to ensure their businesses are conducted in an ethical way. This is something missing today in Islamic finance. All the focus is placed on avoiding companies that generate significant revenue from 'bad' industries, but doesn't ask how the companies generate revenue from the acceptable industries to determine whether they conduct business in an ethical way.

This should be an area where Islamic investing focuses because of the often-stated idea that Islamic finance supports a more ethical economy. How is this verifiable if there is no screening of companies in acceptable industries to see whether they make products that harm people, whether they deal fairly in their employment practices, have adequate corporate governance to ensure shareholders' rights are protected and there are no 'ticking timebombs' of unethical behavior (e.g. the failures of management at News Corp to stop the hacking of individuals' voicemails and bribery of police).

That leads to the final area where firms like Calvert go beyond the Islamic investing standards. When there are problems at firms in the additional criteria, investors' voices should be used to force changes through shareholder advocacy. As far as I know, most Islamic investing companies take passive positions where they could be more active and try to advocate for changes that make the companies they invest in make positive changes like avoiding certain areas of business, avoiding taking on additional debt, improving corporate governance and disclosures.

Yet, they do not. Most Islamic investors are concerned with 'avoiding the bad' but do not widen their screens to favor companies that are leaders in their industry in corporate governance, human rights, or more generally in conducting an ethical business. If Islamic investing does not adopt the 'best practices' for sustainable investing, then it is unlikely that the companies in which they invest will adopt 'best practices' in terms of sustainability.