Islamic Finance – a road of convergence with ESG and mainstream investing ahead?

Sharia finance should adopt ESG principles and push its broader ‘real assets’ model as a solution to the financial crisis.

Islamic finance currently plays a minor role compared to mainstream investments and those made under ESG (Environmental Social Governance) related aspects. Its principles though have the potential to form the basis of a global financial system that is not reliant on debt/leverage but instead on equity and real economic activity going back to its basics. The financial world needs to ‘connect the dots’ in network analytic terms to come up with viable alternatives to a system which has too long depended on easy money, high debt levels, and major detachment from real economic activity. Going back to basics means, we believe, adopting some of the principles of Islamic finance such as avoiding debt/leverage, ensuring economic transactions are underpinned by real assets, and profit and loss is the norm rather than the accumulation of guarantees on behalf of central counterparts which become too big to fail, especially when they represent central actors within the financial sector. However, Islamic finance is currently focusing too much on “financial factors” (outside of Zakat: Islamic tax or wealth distribution). Responsible investors, for example, exclude companies that don’t meet their ESG standards, as do those in Islamic finance. But the latter should also develop a tool set to include “non-financial factors” in their investment risk/return decisions as socially responsible investors do when they consider environmental, social and governance (ESG) factors, and engage with companies as well as vote their shares. They might also consider looking for the best companies in their industry sector (best-in-class) to invest in and become more active shareholders.A focus on ESG criteria though would not have prevented the current financial crisis. A system where investors use “Islamic principles” (“basic principles”) and start incorporating ESG factors on top of Zakat (where part of the income is distributed to the people in need) can help create a more equitable system with greater transparency. To get there, conventional finance, ESG related finance and Islamic finance should learn more about each other and combine the best of all worlds when it comes to using financial and non-financial factors. Transparency is essential to this process, and here we’d like to focus on some of the governance concerns around Sharia funds/Islamic finance and companies. Unfortunately, there has been little change in the last few years since we published our paper on the issue, The Small World of Islamic Finance Shariah Scholars and Governance – A Network Analytic Perspective, which has become the most cited globally in this regard: Link to report.
Islamic finance institutions compared to their conventional peers typically incorporate a third, extra layer of governance on top of the board with its executive and non-executive directors, namely the Shariah board in fully Sharia compatible organizations. The role of the Shariah scholars is to ensure that a financial services company`s products are in compliance with Sharia law and meet its principles. This is particularly true in a country where the dominant form of finance is conventional. Thus, a Shariah scholar acts as a catalyst when it comes to diffusion of Shariah principles in the finance industry. The Shariah Board is an elementary part

of a fully Islamic finance related institution and typically such an institution cannot be established without the proof of a respective board, which in countries like Malaysia is strictly checked, even when it comes to the appointment of respective scholars. This is an interesting point in itself as even the best manager could not function in an Islamic finance related context without a Shariah board as it is the fundamental basis for the creation of such an institution. Research in Malaysia shows that Shariah scholars are perceived by selected market participants as more powerful than the company`s management. In our research: “Small World of Islamic Finance – A Network Analytic Perspective” we carried out a major analysis of financial services companies across the world and their Sharia boards. This created for the first time an unparalleled overview of Shariah scholars and their involvement in Islamic Finance related activities, specifically their board memberships. Shariah board members are supposed to meet regularly and be recruited by the shareholders of the organization. They have a monitoring and a control function to ensure that all products, solutions, and transactions are Shariah compliant as set out by the respective standard setters which may be central banks which might fully apply either the Bahrain-based Accounting and Auditing Organization for Islamic Finance (AAIOFI) or the Malaysia-based Islamic Financial Services Board (IFSB), standards as a minimum. Hereby they work with the internal Shariah auditing department and generally also count on an external Shariah auditor. Typically organizations employ a board of a minimum of three Shariah scholars. In organizations which are not fully Shariah compliant you can also find so called Shariah advisory firms providing a board or the board being represented by just one scholar (such as with some mutual funds or real estate companies). The findings of our research (see link for full details above) were astonishing and based on this work we suggested multiple changes to the corporate governance in Islamic Finance institutions of which the following are still very relevant as of today:* The introduction of country level, regional, and ideally a global register of Sharia scholars (similar to the Malaysian model) where a record is kept of who is joining and/or leaving a Shariah board would make life easier for market participants and create much greater transparency. This would also help to get, as in the case of our research, insights into Sharia scholars’ commitments to boards. This should go hand in hand with a change of the regulatory framework. Limiting scholars in their board membership, such as Malaysia is doing, has not led to the desired outcome as scholars look for other countries to engage themselves in. We have prominent examples where limitations in the home country have led to dozens of assignments abroad. Unless you have a global rule it is not really going to work as it creates arbitrage opportunities.

  • An institution that advises on Sharia related matters should not at the same time be the one that audits Sharia compliancy as this might create potential conflicts of interest.
  • Furthermore there should be a rule to have a minimum of two young scholars on each board in order to break up established structures and allow for innovation and different/new views. This apprenticeship model would also allow for better succession planning and assist senior scholars in passing their knowledge to the next generation. This could create potentially 1000+ new jobs immediately for very well educated students across the world with an interest in pursuing a career in Islamic Finance/Investments
  • Rotation of Chairman and board members would help better governance, such as minutes of meetings, publication of fatwa (legal rulings) and remuneration levels of scholars (especially at listed companies). We want to know who dissented from a decision and who was in favor so that we can learn and make the reasoning available to all; financial services institutions should not treat it as intellectual property. If the community had all the data that would come from greater transparency, more research could be done and greater standardization achieved for the sake of the industry`s future. There is a lack of empirical research in Islamic Finance due to the lack of transparency, which in turn affects innovation.
  • Our empirical research shows that almost 50% of all Islamic finance boards across the world (around 1500+) are occupied by Sharia scholars who are also involved in the rule setting at the Accounting and Auditing Organization for Islamic Finance (AAIOFI), these are “just 17 out of almost 500 currently active in boards across the world”. So over 750 boards of competing organizations are staffed by only 17 individuals who also set the standards in the industry”. An important question is whether the scholars who set the standards and govern the industry should be the same as those who sit on the boards of financial institutions? Does having the most prominent scholars involved lead to better results? Our latest research suggests it doesn’t. There seems to be an inverse relationship between these kinds* of dual roles for Sharia scholars and the performance of the Islamic finance institution they service. We suspect that a board of senior as well as junior scholars could do an even better job leaving enough time for senior scholars to focus on complex issues and the young to learn new things and bring in their different perspective.
    There is still a long way to go in Islamic finance and governance related aspects and it’s crucial to address those points in order to pave the way for necessary changes. If, as we hope, mainstream finance incorporates increasingly the principles of Islamic finance (going back to basics) and ESG investments to create a new and more resilient finance system, it is crucial to ensure that the governance framework in Islamic finance is sound and transparent to gain the trust of investors. Islamic finance is becoming an increasingly important segment of the global finance industry. It could become much more interesting though if it starts to include an active shareholder approach and ESG criteria for its investments to take it closer to its financial and non-financial goals. Furthermore ESG investors would profit greatly from incorporating financial factors such as limits to debt/leverage among organizations they invest in and ensure that all their transactions are closer to real economic activity avoiding specifically financial instruments which have no real underlying asset.

Dr. Murat Ünal is a Member of the board at Funds@Work