Sustainable Islamic finance

A fund was announced recently that will invest in forestry and agricultural projects, and which will be Shari'ah-compliant.  One of the interesting points raised by the fund manager is that "Sustainability has been a challenging conversation in the Gulf, as it was regarded as a competing asset class. But energy security cannot be built on one source alone".  

This led Bernardo Vizcaino, the reporter writing the article for Reuters to explain: "One reason for the lack of close ties between the Islamic and ethical investor communities is geographical: Islamic investors have strong roots in the Middle East and southeast Asia, while the ethical investment industry has its strongholds in North America and Europe."

Because of the limited offering of sustainability-related investment opportunities, a fund focusing on this area, that is Shari'ah-compliant as well, should have a natural home, but Islamic finance has so far gravitated more towards other alternative investments like capital-protected notes, and investments in real estate. 

Back in May, I wrote in my newsletter that Islamic finance should incorporate 'positive screens' focusing on the environment and poverty alleviation, not because they are good in and of themselves, but because they have strong basis within Islam on their own.  In that newsletter, I quoted Olav Kjorven, the Assistant Secretary General for the UN Development Program who, after the launch of the Muslim 7 Year Action Plan on Climate Change: "The role of Islam could be one of the decisive factors tipping the planet towards a sustainable future."

The point of that Action Plan was not that Muslims should embrace environmentalism or work to avert climate change for its own sake, but because it was an important part of the Islamic view that people do not own the earth, but are allowed to use for their benefit, acting as caretakers of the world.  The environmental movement has become influential over the past century and Islamic finance can benefit from this pool of knowledge, while adapting it to have the best combination of authenticity and impact within the Islamic finance industry (and not just as a cut and paste from how it operates in North America and Europe).  

This would provide a new area where Islamic finance can offer both a Shari'ah-compliant financial product (based on avoiding what is prohibited), but also a positive vision for economic development in harmony with the environment, based on the Islamic ethical conception of the relationship between mankind and the earth. 

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.

TID, Islamic CDs, the halal market and sustainability

The Investment Dar
The Investment Dar case became more complex with the Shari'ah board of TID requesting that the bank stop contesting the claim by Blom Bank based on the wakala contract's non-compliance with Shari'ah. In addition, the Shari'ah board asked that a similar defense not be used in the future without first consulting the Shari'ah board to determine the legitimacy of its contracts. An article in Arabian Business comments that "While the sharia board's statement puts a wrench in Investment Dar's ability to move forward with a case against Blom regarding the deal, legal experts say the reputational damage to the industry has already been done".

I disagree with the contention that TID's case has damaged the Islamic financial industry. In contrast, the UK courts held a skeptical view of TID's defense and now the institution's Shari'ah board has come out in support of the wakala product's Shari'ah-compliance. This accomplishes two things for the industry. First, the court's skeptical ruling on TID's defense provides another secular court precedent that a party to an Islamic contract cannot, ex post, argue that the contract is not Shari'ah-compliant to get out of their obligations. I have argued before that the court's ruling provides Shari'ah scholars and boards with more freedom to change their mind on Shari'ah-compliance without worrying about upsetting existing contracts.

Second, I believe it is positive is that TID's Shari'ah board came out against the institution and upheld their initial ruling. There is always a potential conflict of interest between a Shari'ah board and the institutions for whom they work. However, this provides one example of a Shari'ah board publicly demonstrating that their duty to ensure Shari'ah-compliance and preserve the integrity of their ruling is placed above their employment with one institution. The only clear loser in this development is TID, who are stuck between an adverse court ruling in a secular court and their own Shari'ah board's ruling that contradicts their claims in that court.

UAE central bank to offer Islamic CDs to Islamic banks
The UAE central bank is planning to offer Islamic CDs as short-term money market instruments for Islamic financial institutions. The lack of short-term money markets outside of Malaysia (and to a limited extent in Bahrain) hampers the Islamic banking industry because it leads banks to hold excess reserves in cash, which lowers Islamic banks' returns compared to conventional banks because they cannot generally generate returns from this cash. The Islamic CDs received preliminary approval last week from the Shariah Coordination Committee with what Hussain Hamed Hassan, the committee's chairman, described as "minor changes". It may receive final approved next week according to Mr. Hassan. Islamic CDs are offered in the US by one institution, the University Islamic Financial Corp and are used by some of the Islamic mutual funds in the US as a way to generate a return on their cash balances.

The halal market and social responsibility
The Managing Director of Al Islami said that Islamic branding is a "myth" at a halal market conference in Brunei. The point being made was that the halal brand--the certification--was important but without a quality product, it is not likely to succeed. The point was expanded by Shahed Amanullah, the founder of Halal Media, as a way to expand the market to non-Muslims as well either from incorporating organic and socially responsible halal certifications in food and through social responsibility in the broader marketplace so that "non-Muslims can see Muslims promoting halal values which includes social responsibility, stewardship of the earth and economic justice". I think that this is an often understated point. Although Islamic products, particularly in the financial world, were created to cater to Muslims' needs, they do not need to remain constrained to just Muslims. However, to reach out to non-Muslims, incorporating other shared ethical values and leverage the success of sustainable finance to expand the potential market for Islamic financial products.

Other News

• Hussain Hamad Hassan said it was "not a far-fetched reality" for a Gulf-wide Shari'ah board to be in place by 2013.
  
• Gulf Finance House continues to restructure its debts. In May, Mohammed Khnifer, Aatef Baig and Frank Winkler released an article called "The Rise and Fall of Gulf Finance House", which analyzes the pre-crisis years and how they might have led to GFH's current problems.
  
• Cagamas Bhd, the Malaysian national housing company, may issue up to RM1 billion ($303 million) in sukuk that are designed to be acceptable in Malaysia and the GCC.
  
• The Shari'ah-compliant non-bank financial company being established in the Indian state of Kerala has received significant interest from GCC- and Indian-based institutions (Doha Bank and Reliance Capital, respectively), although the government has said it will not sell more than 20% of the NBFC to any single investor.
  
• The Islamic Bank of Thailand became a major shareholder of a Thai leasing company, Nava Leasing Plc, in which it will own 49%.
  
• A Malaysia law firm has released a booklet in Australia to explain commonly misunderstood aspects of Islamic finance among Muslims as well as non-Muslims. The headline writers, of course, took the most sensationalistic topic titling the article: "Islamic finance not jihad".
  

Islamic financial institutions should become UNEPFI signatories

Michael Gassner, an expert on Islamic finance based in Europe, recently called on Islamic financial institutions to become members of the United Nations Environment Programme’s (UNEP) Financial Initiative. His call was seconded by Dr. Mahmoud El-Gamal, who added that “This is consistent with my earlier call in my book on Islamic Finance that those engaged in Islamic finance should support the earlier UN initiative for financial markets knows as ‘who cares wins’.”

I would like to add my support for this because of the similarities—in theory more so than practice—Islamic finance provides an ethically-based financial model. The gap between rhetoric and reality was described by Dr. El-Gamal: “I have long been a critic of the Islamic finance industry focusing mainly on avoiding prohibitions, but not recognizing that prohibitions are secondary to positive injunctions”. My hope is that Islamic financial institutions become signatories to the UNEPFI as the first step in broadening their focus from avoiding Shari'ah non-compliant activities and adding a focus on promoting sustainable business practices.

The UNEP Financial Initiative is a voluntary initiative that requires signatory financial institutions to incorporate sustainability (the environmental, social and governance impacts of their business) into their business practices. Institutions joining must sign one of two statements (one for financial institutions, one for insurance companies).

Islamic ETF in the U.S., sukuk data from 2009Q2

One of the areas of Islamic finance in the United States that has remained relatively stagnant in terms of developing new products and the entrance of new companies is Islamic investing. However, with the launch of the first Islamic ETF in the US, this is changing. The new ETF is the Dow Jones Islamic Market International Index Fund and it is based on the Dow Jones Islamic Market Titans 100 Index composed of 100 large international Shari'ah-compliant equities. The new ETF was launched by Javelin Investment Management. The index will be rebalanced annually except for corporate actions like delistings and mergers which will be adjusted as needed.

Despite a recent surge of sukuk issues in the GCC, the pricing of these sukuk remain elevated compared with the pricing from a year or two ago. The latest reminder is the Saudi Electricity Corporation sukuk which was priced at SAIBOR+160bps compared with SAIBOR+45bps for their first sukuk in 2007. The increase could be due to a combination of factors including recent defaults as well as the impact of the credit crisis which reduced risk appetite and a fall in the oil price since its highs of $147 per barrel last year which has reduced capital inflows into the GCC.

The sukuk market for new issuance in the second quarter is 35% below the same period last year, but a pickup in activity of 164% in the second quarter compared to the first quarter as well as a healthy pipeline indicates that recovery may be in sight, according to Zawya.

Other News

• First Community Bank, an Islamic bank in Kenya, launched an investment banking subsidiary, FCB Capital, the first of its kind in the country.
  
• Mawarid Finance, an Islamic financial company in the UAE, signed an agreement to cooperate with the Dubai government in promoting small and mid-sized enterprises (SMEs) and hopes to sign similar agreements in the other Emirates.
  
• A law passed in the Malaysian parliament would make rulings by the Shari'ah Advisory Council binding on courts when the courts refer disputes to the Council. A member of parliament complained during debates that the Islamic financial industry is too focused on profits and rates in line with conventional financial industry interest rates are too high.
  
• Growth of the HSBC Amanah brand in the UAE suggests a lot of demand for Shari'ah-compliant financial services, according to Frank Kane writing in The National.
  
• The six major Pakistani Islamic Banks are close to launching an Islamic interbank market to avoid relying on conventional short-term financing.
  
• Islamic finance is finding a nexus between Shari'ah-compliant investments and a focus on sustainability with recent investments in the water industry and agriculture.
  
• Sukuk holders of the Golden Belt 1 sukuk were unable to reach a decision on whether to dissolve the sukuk and receive a payout. The sukuk was issued by the troubled Saad Group.
  
• At a time when some sukuk issuers are under pressure to meet their obligations, Kingdom Installment Company is redeeming the full value of their ijara sukuk that financed 5,000 home purcahses and was launched in 2006.