What can Islamic Finance Bring to the Sustainable Finance Table?

The 2007/8 financial crisis and various corporate governance scandals have dented the reputation of the financial sector as the ‘bogeyman of progress’ and served as a wake-up call for the sector to actively take up their fiduciary duties while balancing their risk-return trade-offs in finance and investments. Hence, financial institutions and markets are embracing sustainable finance which is concerned with creating long-term business value by factoring environmental, social and governance responsibilities while simultaneously meeting economic responsibilities and financial objectives.

Islamic finance (IF) has been factored into the sustainable finance equation due to its ethical inclinations as it is concerned with providing financial services based on Islamic Shari’ah law. Unlike mainstream finance, it is based on a profit-loss sharing model instead of the charging of interest (riba) and full disclosure of transaction related information to promote equity and fairness. It also emphasises the linking of financial activities to real or productive activities and asset ownership to reduce ambiguity (gharar) and gambling or speculation(maisir). In addition, Islamic financial transactions are restricted from dealing in prohibited (haram) businesses that promote crime and/or anti-social behaviour such as pork, pornography, alcohol and arms which mirror screening in ethical financing in western markets.

Whereas IF has existed since the 8th century, its current commercial form has been active since the 1970s with a handful of financial institutions and is currently concentrated in Malaysia, the Middle East and North African (MENA) region as well as the UK while slowly diffusing into the Sub-Saharan Africa (SSA). According to the International Monetary (IMF), the market for Islamic financial assets has grown at an average rate of about 16 percent since 2006 and Islamic Financial Institutions began in the grown to 350 institutions with total assets of about US$ 1.7 trillion. The industry is the industry’s assets make up 1 percent of the global financial assets.

The global acceptability of IF has been primarily driven by participation of multinationals in the Islamic economy as they continue to seek growth markets in emerging countries. Doing business after the global financial crisis has seen increased focus on business ethics and social responsibility which parallels the key principles in IF. Some have even contended that IF might probably nudge conventional finance providers to clean up their act given their gross misdeeds.

This article will contend that IF can also augment mainstream sustainable finance by contributing to financial inclusion, risk diversification and greening the global economy.

First, a World Bank study showed that the Muslim population in SSA currently is nearly 250 million and is likely to increase to nearly 386 million in 2030 indicating a largely untapped market as only 24 percent of adults have a bank account and 7 percent have access to formal finance among the Muslim population as compared to 44 percent and percent respectively for non-Muslim populations. Most Islamic financial institutions may argue that their products are not limited to the unbanked Muslim population, they still remain a key demographic in their niche. Interestingly, the same study showed that both groups cited cost, distance and documentation as barriers to account ownership.

Given the above the data, coupled with the principles of risk-sharing and the strong credit link to collateral means that Islamic banking is well-suited for small and medium enterprise (SME) financing. This indicates a potential market for SME financing by expanding acceptable collateral by extending funds on a participatory basis in which collateral is either not necessary or included intangible assets.

On a macro level, sovereign Sukuk (Shari’ah-compliant bonds) have gained prominence due to the possibility of tapping into the international markets without necessitating a domestic Islamic financial system like in the case of Japan. Unlike conventional vanilla bond, sukuk confer ownership of a share of the asset along with the commensurate cash flows and risks.

SSA countries can attract capital from Gulf and other Middle Eastern countries with high savings and are projected to grow significantly and channel them to green infrastructure projects that have definite socio-economic spill over benefits. Apart from infrastructure financing, sukuk has also been involved in International Finance Facility for Immunization (IFFIm) projects raised USD 500M in the first sukuk issuance in 2014 which was oversubscribed by 1.4 times. The second sukuk issue of USD 200M was also oversubscribed by 1.6 times. It was noted that most sukuk investors participated because 50 percent of vaccinations from IFFIm funds take place in the Islamic world.

It is clear that the development of IF can facilitate financial inclusion while meeting development needs by extending their customer pool by tailoring products to meet their needs and lifestyles. Moreover, it can enhance financial deepening by increasing the depth and breadth of intermediation through maturity extension and facilitation of hedging and risk diversification.

Second, IF can only be extended to productive activities and real assets which curbs the use of speculative financial instruments. They focus more on wealth acquisition more from effort than is favoured as opposed to some investors who are further removed from both the firm and development of their investment which many have agreed contributed to excessive leveraging, opaque financial securities and poor corporate governance.

Relatedly, conventional sukuk holders also report to be comforted by the fact that Islamic banks who invest alongside them tend to hold their investments until maturity, creating a more stable environment for everyone else. Whereas it can be argued that risks are inherent in any financial arrangement, the concept of justice helps in safeguarding against excessive uncertainty and undue risk transfer.

Lastly, IF presents potential in the green finance space especially through the issuance of green sukuk. Green sukuk are fixed income instruments with proceeds for low carbon and climate-resilient projects that consistent with Shari’ah principles. These bonds are gaining mileage especially in countries like Saudi Arabia and Malaysia where there is investor awareness, government support, demand for energy supply as well as demand for energy financing. Nonetheless, challenges posed in conventional green finance such as externalities, maturity mismatch, lack of clarity in green definitions, information asymmetry are further exacerbated in IF.

Asymmetric information may pose additional challenges due to the nature of exclusionary screening in Islamic finance. This is a major barrier to market development especially in developing and emerging countries as lack of adequate information on borrowers, use of proceeds, assets and monitoring will hinder the development, labelling, pricing and marketing of the products.

Unfortunately, the aforementioned opportunities in IF are dimmed by its nascent nature. IF requires demystification and appropriate regulatory and supervisory frameworks as each country has a different approach to the application of capital requirements as well as the nature and extent of information disclosure; this is quite common in countries where Shari’ah may not be a fundamental source of the law of the land.

IF possesses unique risks that relate to customer protection such as Shari’ah compliance risks which is hinged on the determination of sources and uses of funds and the threat of client flight in the event of non-compliance. The scarcity of Shari’ah compliant liquidity instruments and infrastructure may also pose liquidity risk while credit risk may arise from difficulty in selling debt, charging accrued interest in the case of default and recognising non-performing loans in some profit and loss sharing contracts may heighten it. On a micro-level, the complexity of some products coupled with the nature of financial institution-client relationships would require consumer education.

There are fears that IF could be a conduit of terrorist financing but so far, there is no evidence that AML/CFT* risks are materially different from those by conventional finance. The choice of financial institutions would appear to be more about convenience and opportunity rather than inherent differences. A lot more work needs to be done by international standard setters on specific AML/CFT risks associated with IF starting with closer examination on the management of Zakat which is levied on high net-worth clientele and used in income distribution, poverty reduction and stabilisation mechanisms.

Islamic finance will prove difficult to ignore in the coming decade especially with the increased appetite for alternative and sustainable sources of finance. Though its acceptability has been hampered by fears of extremist Islamisation, the focus should be on achieving sustainability in both the conventional and Islamic finance realms.

*AML/CFT : Anti-Money Laundering or Combating the Financing of Terrorism

Disclaimer: Updated on 7th April 2017 for more clarity. All views expressed here do not necessarily reflect the opinions of my employers or clients, past or present.