Islamic Finance and socially responsible investing (SRI): The Expectations Gap

This article was originally published in Arab Times

 

Usman Hayat, CFA, Director of Islamic finance & ESG at CFA Institute and Raghu Mandagolathur, President of CFA Kuwait discuss Islamic finance and socially responsible investing (SRI).

With the increased profile of Islamic banking globally, the GCC Islamic banking community is well positioned to build on a leadership role versus other potential competing centers such as Malaysia, Iran or even the UK. GCC countries collectively now account for more Shariah-compliant financial assets globally than any other region or country.  GCC Islamic banks have also demonstrated their ability to be more innovative in terms of product development and provision of services as they compete for business with conventional banks. However competition in the GCC has also resulted in a fragmented Islamic finance industry with most local institutions remaining relatively minor players on a global scale. With their relatively lower asset bases they have also seen stiff competition in their own backyard from some of the largest international banks looking to tap the market.

When labels like “Islamic,” “responsible,” and “sustainable” are associated with finance, they trigger expectations of ethical differences from the mainstream. Meeting expectations of customers is a tough task for any business, but when it comes to Islamic finance and socially responsible investing (SRI), the gap between expectations and practice presents a significant challenge.

Anecdotal evidence suggests that, rightly or wrongly, some of the expectations triggered by “Islamic” finance are no lending money on interest, no financing of “sin” industries (e.g., gambling), profit and loss sharing, asset and enterprise, microfinance, small and medium sized enterprise (SME) finance, poverty alleviation, and environmental sustainability. Perhaps the underlying theme is profit sharing, doing good, and avoiding harm to society and the environment.
In practice, other than refusing to finance “sin” industries, these expectations are hard to meet. Despite the expectation of profit sharing, most of the financing in the Islamic financial sector is debt based, where the form of financing is changed to that of a sale or a lease without necessarily changing its economic substance. For example, payment schedule and terms and conditions in home financing in the Islamic financial sector may look very similar to, if not the same as, those in a conventional mortgage.
Customers are usually told that the difference between Islamic finance and conventional finance lies in fulfilling certain technical conditions of classic Islamic commercial jurisprudence, which give financing the contractual form of a trade or a lease. Some customers scale down their expectations and take what is available; others turn away in disappointment.
This gap between expectations and practice produces sarcastic media coverage—for example, “Don’t Call It Interest” (Richard C. Morais, Forbes, 2007) and “How Sharia-Compliant Is Islamic Banking?” (John Foster, BBC News, 2009). Such academic research papers as “Incoherence of Contract-Based Islamic Financial Jurisprudence in the Age of Financial Engineering” (Mahmoud A. El-Gamal, 2007) also raise similar issues. Unfortunately, form versus substance is a persistent debate in Islamic finance, with no closure in sight.

Regarding doing good and avoiding harm to society and environment, some argue that the job of financial institutions is to maximise profit for their shareholders and that profitable business leads to prosperous society. If shareholders want to do something charitable, they can do so in their private lives.

A counterargument is that to use the “Islamic” label, financial institutions need to go beyond changing the form of financing and earn their profits while actively doing something positive. For example, Islamic banking should focus on SMEs rather than high–net-worth individuals; Islamic financing for cars should finance fuel-efficient vehicles, such as hybrids, instead of fancy gas guzzlers; and Islamic project financing should push for fair treatment of construction workers and efficiencies in energy, waste, water, and carbon emissions.
The catch here is that for such positive pursuits to work, customers also have to do their part. That is, for the financier to lease a hybrid vehicle, the customer also has to want one. To avoid interest-bearing debt in financing, customers have to be ready to share profits with the financier, and to make investments rather than extend interest-bearing loans, customers should probably seek equity funds and not bank accounts.
Similarly, if customers want institutions that offer Islamic financial services to pursue socioeconomic goals, they should be willing to share any additional risks and costs. If customers are unwilling to put their money where their heart is, finance, pragmatic as it is, may also be unwilling to go very far in nonfinancial pursuits. This gap between expectations and practice is not unique to Islamic finance. Other shades of ethical finance, such as SRI, face it too. One would think that because lending money on interest is not an issue in SRI, meeting expectations would be easy - not exactly.

In 2004, in a research paper titled “Socially Responsible Investing,” Paul Hawken found that “the cumulative investment portfolio of the combined SRI mutual funds is virtually no different than the combined portfolio of conventional mutual funds.” In other words, the expected ethical difference was blurred.

In its 2007 “Guide to Climate Change Investment,” Holden & Partners provided a similar finding: “SRI and ethical funds perform just as well (if not slightly better) than their mainstream counterparts because in most cases they are in fact mainstream.”

Perhaps the titles of these two biting articles published in 2010 summarize their content: “100 Best Corporate Citizens? What a CROck!” (Marc Gunther) and “When Pigs Fly: Halliburton Makes the Dow Jones Sustainability Index” (R.P. Siegel). Paul Hawken also noted in 2004 that “Muslim investors may be puzzled to find Halliburton on the Dow Jones Islamic Index fund.”

How to deal with this gap between expectations and practice? Do financial institutions mislead customers with labels like “Islamic,” “responsible,” and “sustainable”? Or do customers have unrealistic expectations? Is it possible to bring the practice and expectations closer?

There is no easy answer to these questions. Having said that, one thing that could help in narrowing the gap between expectations and practice is honest communication of what exactly is the ethical proposition so that when someone takes “a small step” toward ethical ideals, it is not criticised for not being “a giant leap” but appreciated for what it is.