Shariah law’s ban on speculation, interest and investment in such activities as gambling, arms and alcohol provides a strong set of ethical criteria to guide business practice.
Islamic finance is at its core a structuring process that opens up investment opportunities (be it equity or profit-sharing sukuk) to investors that comply with the prescriptions of the Islamic faith. Recent years have seen this develop into a fast-growing capital market with its own banks, investment funds and bond structures.
Islamic finance provides powerful tools that could unlock a rich source of capital for SRI. Ernst & Young predicts Islamic banking assets will hit $1.8tr in 2013 and last year brought a record $146bn of global sukuk issuance, according to EuroWeek’s Islamic Finance Information Service.
Part of the market’s growth stems from Islamic finance’s socially responsible appeal. “The Islamic finance industry and many of the funds that have been created for investment have the type of screens that do exclude certain industries not considered appropriate from an SRI perspective,” says Samad Sirohey, CEO of Citi Islamic Investment Bank.
The natural implication of acting in accordance with religious values is a strong ethical framework, argues Mohieddine Kronfol, chief investment officer at Franklin Templeton in Dubai, but he adds that the basic premise of Islamic finance remains Shariah compliance.
Michael Grifferty, president of the Gulf Sukuk and Bond Association, says that SRI, since the 1970s, has involved religiously affiliated investors making ethical choices based on direction from their faith. “However,” he says, “the history of SRI is not nearly as long as the history of Islam and so I don’t think we can simply consider it a form of SRI.”
Meanwhile, the factors that determine the Shariah-compliance of an investment are rigid, while SRI criteria are more numerous and flexible, adjusting to new findings, technologies and moods.
To some participants in Islamic finance, religious connotations have become a stumbling block to further growth. New entrants such as Turkey have found the word “Islamic” to be divisive and have substituted terms such as “participation” or “non-interest” banking. There has also been a drive to adopt “ethical” as a banner.
Speaking in February at Euromoney’s Islamic finance summit in London, Tirad Mahmoud, CEO of Abu Dhabi Islamic Bank, said that Islamic finance should put the word “ethical” at its core, adding that the market has no monopoly on good values.
“[The sentiment behind Mahmoud’s speech] is a good start that others should follow,” says Harris Irfan, managing partner at Cordoba Capital. He believes banks should stay close to their roots and act as a merchant facilitating trade between buyers and sellers, while an alternative term such as “ethical” may be more helpful in attracting a wider demographic to what are essentially just sound and ethical financial principles. “Using terms of religious origin may risk ghettoising the industry,” he says.
Green pastures
At first glance, Islamic finance’s fit with SRI appears awkward where environmental criteria are paramount, given that Middle East economies are heavily dominated by hydrocarbon fuels. However, this fact in itself has identified a potential growth area for both investor sets.
“There are broader concepts of SRI investments such as ‘green’ investments which are at a nascent stage of development within the global capital markets and certainly in the context of a green sukuk,” says Sirohey.
The Green Sukuk and Working Party (GSWP) has been established by the Clean Energy Business Council, the Climate Bonds Initiative and the GBSA, to promote and develop Shariah-compliant financial products to invest in climate change solutions. This includes designing green buildings and technology as well as engaging with government and the market to back green projects.
While there is growing interest in the GCC for alternative energy, Abu Dhabi’s sustainably designed Masdar City remains the region’s standout flagship project.
“With a focus on renewables across the region, issuing a green sukuk may indeed be viable,” says Sirohey, “although what would be more important is finding appropriate retail level investment money to channel into these initiatives via specific funds. Such an initiative would be critical in achieving the objective of green specific capital allocation.”
To date, the economic rationale of Islamic finance has been more compelling than the ethical pull of Middle East green projects. Islamic banks have benefitted from a growing Muslim investor base that wishes to avoid riba (charged interest) products, as reflected in their growth numbers in Turkey, Saudi Arabia, Malaysia and the UAE.
“In every market, Islamic banks are growing at double or triple the growth rate of conventional banks,” says Kronfol. “This demand, originating from retail investors, drives the development of the institutional market including new tools, new funds, new products, and new businesses.”
Technical aspects in turn draw conventional investors to the sukuk market, claims Sirohey. “Islamic banks continue to grow in deposits, and there is limited product available for their investment,” he says. “This creates a strong demand for this type of paper which is attractive to conventional investors as these sukuk tend to have better secondary market trading performance.”
“The appeal to conventional investors comes from the investment characteristics of Shariah compliant markets,” adds Kronfol. “Many of which offer competitive returns to traditional equity and fixed income sectors with some downside protection and lower volatility and correlations, all of which helps them build more diversified and efficient portfolios.”
A systemically
responsible investment?
Many proponents of Islamic finance aspire to a market that is “systemically responsible”, by avoiding excessive leverage. Since the global financial crisis in particular, Islamic finance has been championed for providing investments that are backed by real, tangible assets and services.
“One of the basic necessities for the sukuk market is the existence of underlying economic activity,” says Sirohey. “This is intended to channel capital towards productive use, and avoid returns generated from other avenues.”
Shariah precepts against interest and speculation means the Islamic market has largely avoided the pitfalls of financial engineering seen in Western economies, say advocates, eschewing structured and synthetic products such as credit default swaps and collateralised debt obligations.
However, while a systemic hit on the scale of that dealt to the West may have been averted, it is clear that Islamic finance did not save GCC companies from over-leveraging. Numerous big names became deeply indebted in the pre-crisis boom, resulting in a string of sukuk defaults and government bail-outs when the market turned.
This has left some investors — including those who manage sukuk portfolios — in two minds about the SRI credentials of modern Islamic finance.
“On one hand you have Islamic principles which ban the financing of certain activities that are known to destroy families, such as alcohol and pornography, but on the other hand claims that Islamic finance limits leverage are almost laughable,” says one sukuk portfolio manager. “One only has to look at balance sheets of the ultimate obligors of the plethora of sukuk that have defaulted in recent years to quickly realise that Islamic finance did nothing of the sort.”
Partly this can be seen as a failure of practice rather than principle — for example, between 2006 and 2008 many asset-poor entities used the musharaka (partnership) sukuk structure as a debt raising instrument and subsequently defaulted.
However, Islamic finance structures have also come in for criticism — in particular those that are cash rather than asset-based. According to the portfolio manager, “the synthetic commodity murabaha enables corporate entities to leverage themselves to the moon as long as there is another party that is prepared to enter into the other side of the trade.”
While the uptake of Islamic finance has been helped by the comparability of products like sukuk with conventional counterparts, there is unease among some investors that the market has diverged from its founding principles by simply replicating conventional debt instruments — with true profit and loss sharing rarely seen. There is a growing call for the Islamic market to move beyond this and do more to differentiate itself as a socially responsible business.
“Rather than focusing on big deals and trophy assets, it’s time to devote attention to small to medium size enterprises and retail investors,” says Irfan. “The industry is, after all, meant to have a socially beneficial impact. Islamic finance should be more about merchant capitalism than modern capitalism with its popular connotations of greed and excess.”
Differentiating Islamic capital markets from the conventional framework requires more than just the avoidance of interest and haram activities, believes Syed Abdul Hamid Aljunid, a professor at Islamic finance university INCEIF. “It should not be purely contractual in approach as Shariah covers areas beyond compliance to legal contracts,” he says. It should move into areas of social and intergenerational wellbeing and corporations must become purposeful organisations rather than just vehicles to meet the objectives of investors and consumers.
“Islamic economy should focus on the role of corporations as members of the society in which they operate and their members ought to be sensitive to this role,” he adds.
In other words, Islamic finance may find it easier to push forward by greater aligning itself with other forms of SRI investment.
“The best way forward is to engage Islamic finance leaders in dialogue with the well developed global SRI community,” says Grifferty. “The Green Sukuk initiative is a great example. We realise that global SRI considerations are separate from the Shariah compliance of a given transaction. But if investors are already willing to consider factors beyond the risk/return trade-off, and choose Shariah compliant, then the same may well opt for investments that contain other ethical distinctions.”
