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.

The Social Impact of Islamic Finance

Farooq Sheikh, a student at the Lahore University of Management Sciences, wrote a 2 part series for SocialFinance, a Canadian blog on impact investing ([Part 1] [Part 2]).  In a comment, he clarifies what he meant by 'social impact':

"I am referring to an influence which is beneficial to the society and delivers sustainable social and/or environmental benefits without negatively affecting the social fabric in the area one is operating. It means solving the problems of the society (e.g.  Providing equity financing to a project which would spur employment) and at the same time earning financial return on the capital for those who have provided the capital."

I am hopeful that Islamic finance will become more focused on the social impact of their activities, instead of just creating the easiest products for them to get Shari'ah approval and make a profit (while donating any non-permissible income to charity as their 'social impact').  There is definitely a wide range of Islamic financial institutions, so to some degree, statements about their concern about social impact are generalizations, but I think it is clear that most Islamic financial institutions are pre-occupied with acting as much like banks as they can. 

As much as it may have been the intent of Islamic economists for "money has no intrinsic value and hence cannot be treated as the subject-matter of trade. It is just a medium of exchange. Islamic financing is always based on tangible assets and inventories, unlike its conventional counterparts."  There is a significant question about whether this is the case in most transactions, for example, those based on commodity murabaha or tawarruq.  These transactions involve tangible assets, but the assets are involved to create a debt (through sale with deferred payment). 

For a while I have argued that this use of commodity murabaha is necessary, both to fit within regulatory requirements, but also in areas like liquidity management where other products do not exist.  I think this is the case, but without necessarily disagreeing with the idea for Islamic finance that Sheikh described.  This, I think, is a clear area where one can differentiate between different uses of commodity murabaha.  While I generally support commodity murabaha used for inter-bank money market transactions (though I have critiqued the use of commodity murabaha-based repo transactions collateralized by commodity murabaha-based certificates of deposit), I have been critical of the use of the same structure for deposits.

The difference, I think, is whether there are alternatives that would work as well that are not commodity murabaha.  In the case of Islamic repos collateralized by Islamic CDs, the commodity murabaha structure could be maintained for the repo with the collateral being tradable contracts like ijara.  In the case of deposits, there are a number of other deposit products like wadiah, qard and mudaraba which are widely used by Islamic banks. It doesn't necessarily address the social impact of Islamic finance, but it can help to combat cynicism that Islamic banks always take the path of least resistance in terms of diverging from the way conventional banks do business.