Luma Saqqaf is a leading expert on sustainable and Islamic finance. Here she looks at the strong ethical, moral and social dimensions connecting the two markets, and their ultimate goals to share health and wealth.

The global market for Islamic finance is expected to exceed USD $5.9 trillion by 2026. As a sector, it has traditionally grown faster than its conventional counterpart. Many ask about the rapid rise of Islamic finance, but its growth warrants an examination into the very principles driving its expansion. Moreover, the principles of Islamic finance have perceived compatibility with ESG, but how will these synergies affect the growth of Islamic finance as a whole?

Islamic finance and its principles

Islamic finance is a means to engage in the financial system and achieve the same business goals, where possible, as conventional finance but through the lens of Islamic religious scriptures and principles. The largest Islamic finance markets are based in the GCC, Southeast Asia and South Asia, with the UAE and Saudi the leading jurisdictions in the Middle East, with Malaysia and Indonesia leading the way in Southeast Asia.

Islamic finance principles are derived from the holy Qur’an and prophet teachings and sayings. They promote ethical, moral, social and religious dimensions transcending the parties to the overall good of the society. These principles seek to avoid exploitation, unjustified enrichment, excessive uncertainty and speculation. They have been applied through jurisprudence into a set of contractual law, forms and concepts applicable to all Islamic financing.

Some of Islamic finance key principles are:

Prohibition of interest. Islam encourages the earning of profits but forbids the charging of interest because profits reflect entrepreneurship and creation of additional wealth whereas interest, which is pre-determined, is seen as a cost that accrues irrespective of the outcome of business operations.

Money cannot generate money without a trading or permissible activity. Money cannot be “sold” (but can be exchanged as a currency). Transactions in their essence are of two types: either based on risk sharing and partnerships where partners agree to share profits and losses ensuing from this partnership. Examples are Mudaraba and Musharaka structures. Alternatively, transactions are asset based and their subject matter relates to an asset. Examples are sale and lease structures.

“Negative screening”. Only those business activities that do not violate the rules of Shariah quality for investment. For example, any investment in businesses dealing with alcohol, gambling, and casinos would be prohibited.

Diverging interpretations

These principles are not applied universally across jurisdictions as, first, there are four key schools of jurisprudence to interpret these principles. Second, scholars working with financial institutions to approve sharia compliant transactions tend to subscribe primarily to one of these four schools but adding their own interpretation when applying these principles to modern day transactions. This divergence in interpretation, sometimes within the same jurisdiction, is a key challenge on both the product and business level, and the operational level.

On the product and business side, it has led to lack of standardisation in the market and the limited penetration of Islamic products. It has also limited innovation to an extent, and certainly limited finance tools and instruments available.

For sukuk issuers (sukuk are shariah-compliant bonds) this means they have to choose structures depending on where they want to attract investors from. For their sukuk to be tradeable, they may be limited by the need to have underlying assets for a value that varies between 33% and 51% of the face value depending on the jurisdictions involved. This can lead to additional complexities and costs.

Operationally, Islamic financial Institutions are treated as financial institutions and will be required by Central Banks to adhere to related rules on, for example, capital adequacy, provisions and liquidity. But of course, always respecting the Islamic nature of their operations.

The lack of standardisation means that Islamic banks and financial institutions need to think carefully about their products, their expansion, but also the ability to manage their liquidity optimally. For instance, many Islamic banks in key Islamic finance markets rely on two types of instruments – Murabaha and Wakala – for Islamic interbank placements.

To what extent does the rise of ESG impact Islamic Finance?

The ethical lens through which Islamic finance transactions are structured, suggests inherent compatibility with sustainable finance. Both encourage economic expansion and financial stability, creation of sustainable value, and improving the general well-being of communities.

Both Islamic and sustainable finance adhere to a fundamental principle of avoiding harm and strive to avoid financing projects with adverse effects, as defined by each. Given the principles previously mentioned, not every sustainable finance transaction is Sharia compliant. It has to be related to a non-prohibited activity and structured in the correct way.

As demand for sustainable finance grows, so does the need for a greater understanding of Islamic finance principles across jurisdictions, to ensure the greatest possible degree of compatibility.

The way forward

Despite the challenges to the development of Islamic finance mentioned above, we are seeing some positive developments. In addition to a wider acceptance of Islamic repo products, some countries such as Saudi Arabia, have adopted a standardised model for the entire country (through Double Wa’ad agreement).

More advanced concepts such as cryptocurrencies trading and carbon credit related products are also increasingly being adopted by Islamic scholars. The above, coupled with the surgency of ethical and sustainable finance globally, can only give impetus to further develop the market, emboldened by increased demand.

Luma is a recognised sustainability consultant advising financial institutions and corporates on issues such as climate and sustainability strategies. She advises regulators and financial markets including the UAE Securities Authority (SCA) on the UAE Green and Sustainability-linked Bonds and Sukuk Regulations (conventional and Shariaa compliant). She is a recognised Islamic finance practitioner and pioneer, and former finance partner and global head of Islamic Finance at “magic circle” law firm Linklaters and previously Allen & Overy. Luma played a part in the development of the capital markets, most notably Islamic finance market in the region and globally. Details at Ajyal Sustainability Consulting.