One group of financiers believes it has a ready-made solution to the rapidly rising global concerns over sustainability.
Islamic finance, say its proponents, can help divert capital flows towards human activities with a positive environmental and social impact, and away from those with a negative effect.
According to Rafe Haneef, Group Chief Sustainability officer at CIMB bank, there’s a growing recognition that the moral precepts of Islam have a lot in common with global standards like the sustainable development goals (SDGs) set out by the United Nations (UN).
The SDGs were set up in 2015 by the UN General Assembly and are intended to be achieved by 2030.
“Islamic banking was always focused on social impact: ensuring that sectors which are socially harmful, such as alcohol, tobacco, arms, ammunition, pornography and gambling, have been excluded,” Haneef said during a 2021 Refinitiv webinar.
“Now we are expanding the boundaries of social responsibility by aligning with the UN SDGs,” said Haneef.
“In essence, the SDGs are aspirations towards meeting the higher objectives of Shariah (Islamic law): whether that’s eradicating poverty or ensuring the sustainability of life on earth or under the sea. These are all core responsibilities of humans, as dictated in the Quran itself,” said Haneef.
There are signs that investors around the world are noting the convergence between Islamic finance and sustainability: according to Refinitiv, sustainability-linked Sukuks (Islamic bonds) grew more than thirteen times in assets during the four years to 2021.
Refinitiv forecasts that total Islamic finance assets (including Islamic banking, Sukuk, Islamic funds and Islamic insurance) will grow to nearly $5trn by 2025, up from $2.2trn a decade earlier.
Source: Refinitiv Islamic Finance Development Report 2021
But while there may be a convergence between sustainable investment approaches in conventional (Western) finance and Islamic finance, it’s important to recognise that there are also differences.
Islamic finance has a fundamentally different approach to money than Western banking systems: it is based on the belief that money doesn’t have any intrinsic value.
Instead, according to Islamic scholars, money should be seen just as a medium for exchanging products and services. Linked to this idea is Islamic finance’s ban on making money from money (in the form of interest).
As a result, equity investment strategies that comply with Islamic (Shariah) law tend to limit the amount of leverage that portfolio constituents can incur, as well as screening out whole sectors of Western finance.
FTSE Russell’s new FTSE IdealRatings Islamic Index Series, for example, prohibits investment in companies deriving more than 5 percent of their total revenue from conventional finance.
The Index Series then performs a screen for excessive leverage: it removes companies whose ratio of total debt over the larger of average daily market capitalisation or total assets (calculated over the previous 24 months) exceeds 33 percent, plus companies whose holdings in interest-bearing items (like deposits) exceed the same threshold.
This stringent approach to leverage seems miles away from the beliefs of Western finance.
But is the underlying idea—that excessive debt creates an economic approach based on gambling and risks financial instability—so different from the tenets of some global policymakers?
The Bank for International Settlement (BIS), for example, wrote in May this year that “high household and non-financial corporate debt can affect financial stability as well as macroeconomic performance.”
“Debt directly affects financial stability by making borrowers more vulnerable to shocks,” the BIS said.
And global shocks—whether it’s Covid-19, war or the accelerating climate emergency—appear to be arriving more frequently than ever.
Islamic equity investment strategies’ screening policies also overlap with conventional environmental, social and governance-focused (ESG) approaches more in some areas than others.
Both Islamic and ESG approaches routinely bar investment in alcohol and tobacco producers and distributors, in arms manufacturers and in companies promoting gambling.
But only Islamic scholars tend to view investment in entertainment and music as equally non-permissible or “haram” (non-compliant with Islamic law).
These differences clearly exist. But it’s hard to ignore the broader and deeper similarities between Islamic finance and ESG.
“S—Social—has been the driving factor for Islamic finance while E—Environment—has been the driving factor on the conventional finance side. Now, E and S are merging. It’s a beautiful confluence,” said Ali Adnan Ibrahim, global head of social and sustainable finance, Al Baraka banking group, during the Refinitiv webinar.
“The journey towards sustainability is just starting and Islamic finance is at the starting point,” said Ibrahim.
And a convergence in ideas is now increasingly becoming a convergence in business approaches and operational standards, according to one central banker.
“Sustainability has a growing practical relevance to Islamic finance. It has shifted from a more conceptual aspiration to an anchoring strategy in many organisations, including Islamic financial institutions,” said Madelena Mohamed, Director of the Islamic banking and Takaful department at Bank Negara Malaysia.
For more information about the FTSE IdealRatings Islamic Index Series visit our Product Hub.
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