SRI Investing, Islamic Finance: 2 Sides of Same Coin

‘Ethical bridge’ built on shared concern about society and environment.

Sustainable, responsible, and impact (SRI) investing and Islamic finance may seem unrelated, but they are two sides of the same investment coin, according to a report from the CFA Institute. They share key similarities, and emerging trends may allow financial services providers to create products that meet the criteria of both approaches.

The report was authored by Usman Hayat, CEO of Audit Oversight Board, Pakistan’s independent regulator of audit firm. It said SRI and Islamic finance share a focus on ethical considerations of stewardship and social responsibility, despite having evolved in different cultural circumstances and separate historical periods.

“There is an ethical bridge between Islamic finance and SRI investing,” said the report. “It is built upon a shared concern about society and the environment as well as a historical connection.”

Islamic finance must abide by Islamic prohibitions regarding the purpose and structure of finance, and it must avoid financing prohibited businesses. For example, because the consumption of alcohol is forbidden by Islam, Islamic finance can’t be used to finance a brewery.

It also can’t provide financing to businesses related to pornography, or gambling. It also must also abide by the Islamic prohibitions of riba (lending at risk) and excessive gharar (sale of risk), which means the money can’t be used for conventional bonds or conventional derivatives. Therefore, conventional banking, insurance, breweries, casinos, and providers of adult entertainment are excluded.

Although SRI investing and ESG investing doesn’t prohibit bonds or derivatives, Hayat cited ethical links between the two distinct modes of finance. For example, some prohibitions of Islamic finance are consistent with the negative screening approach commonly used by SRI investors.

He also said there are financial services providers who have been able to create offerings that both meet Islamic prohibitions and consider ESG considerations. Saturna Capitals’ Amana Mutual Funds, for example, seeks companies that demonstrate both Islamic and sustainable characteristics.

According to the fund provider, the investment process for the Amana Income and Growth Funds “integrates ESG considerations with Islamic principles and financial analysis to holistically review a security’s suitability for each fund.”  This analysis includes rating companies on their alignment with Islamic principles, sustainability, and investment appeal.

Hayat said that an idea strongly associated with Islamic finance is that financiers and those being financed need to assume risk associated with business outcomes or ownership of an asset. He said that where risk is to be managed through insurance, it should be done through a mutual risk-sharing arrangement.

“Since the 2008 global financial crisis, blamed on the excesses of the financial sector, Islamic finance has been saying the kinds of things many want to hear from the financial sector,” wrote Hyatt, “such as making finance a servant, not the master, of the real economy where goods and services are produced.”

The ESG method most widely used in Islamic finance is exclusionary screening, according to the report. All institutions in Islamic finance across all segments, including banking, capital markets, insurance, and microfinance must apply exclusionary screening regarding the primary business of the client entity.

The exclusionary screening in Islamic finance may vary depending on how the ratios are defined and calculated. In general, the screening is largely consistent across providers and jurisdictions. Where SRI and Islamic Finance don’t converge is in  tobacco-related investments as tobacco consumption is not prohibited by Islam. Nevertheless, tobacco is included in the list of mandatory exclusions in modern Islamic finance, most likely because of its harmful effects on people’s health.

“The precedent of tobacco shows that Islamic exclusionary screening may continue to evolve with respect to ESG issues,” said the report. “After the mandatory requirements have been met, the voluntary options begin. The entity then decides how and to what extent it applies other ESG methods, such as best-in-class selection or ESG integration.”

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Many Institutional Investors Confuse ESG with Socially Responsible Investing

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