Sustainable Finance, Social Finance and Islamic Social Finance: Primer on Concept and Differences (Part 3 of 3)

By: Syed Alwi bin Mohamed Sultan

1. Islamic Banking and Finance: Foundations and Principles

Islamic banking and finance is a financial system that has its foundations firmly rooted in the Quran and the teachings of Prophet Muhammad (pbuh).It is a branch of the Islamic legal system that governs aspects of financial transactions and commercial dealings between individuals and society as a whole. Islamic banking is much more than just a set of Shariah compliant financial products and services. It is a system which aims at contributing to the fulfilment of the socio-economic objectives and the creation of a just society.

The Islamic banking and finance system is a financial system that advocates financial practices based on values and principles of fairness and justice. It is built upon the central tenets of Islamic law regarding commercial transactions including prohibition of interest-taking (riba’), prohibition of undue speculative practices and prohibition of exploitative practices through lack of transparency (gharar) in commercial dealings. It contains a set of products and solutions based on contracts that are structured upon the central tenets of Islamic law and is designed to achieve the Maqasid as-Shariah, which effectively promotes the wellbeing of society, upholds the sanctity of the religion and preserves the environment as a trust for future generations. 

Based on the research and views of many scholars who have written extensively on this subject, such as Chapra (1985), Hawary, Grais, Iqbal (2004), Siddiqi (2002), Vogel and Hayes (1998), Archer and Karim (2002), Islamic banking and finance can be viewed as grounded on six basic principles as follows;

i) Social Justice – Islamic finance aims to achieve social justice and economic prosperity for the whole community through altruism, humanism and social responsibility.

ii) Productive Activities – Islamic finance promotes the capital allocation to be channeled towards real productive economic activities rather than synthetic financial transactions.

iii) Risk Sharing - the terms of transactions in Islamic finance contracts need to reflect a symmetrical risk return distribution that each participant to the transaction may face.

iv) Avoidance of Usury – all financial dealings must strictly adhere to the avoidance of usury or Riba’ which is one the most fundamental prohibitions in any financial dealings in Islamic jurisprudence.

v) Avoidance of Sinful Activities – Islamic finance prohibits financing or investments into sinful activities such as production of alcoholic beverages or activities that create greater harm to mankind such as warfare business.

vi) Avoidance of Exploitative Practices – Islamic finance is grounded on principles of transparency, accountability and good governance thus financial transactions should not lead to the exploitation of any counterparty to a transaction.

The success of Islamic finance represents an ample demonstration of the hypothesis that business can be conducted effectively in the modern marketplace without elements of interest. Performance of an Islamic bank should be measured not only by its profitability or bottom line, but also by the commitment and responsibility, the stewardship of the trust given by the All-Mighty, and about caring for the needs and concerns of others, which can be succinctly coined as “social performance”.

2. Modern Practices of Islamic Banking and Finance

While the principles of Islamic banking and finance are ingrained within the religion of Islam which originates from the time of the Prophet Muhammad (pbuh) more than 1400 years ago, the integration of Islamic finance within modern banking systems can be traced back to the 1960s. It is difficult to identify precisely the date of the first formal Islamic financial institution in recent history but many researchers often make references to the Mit Ghamr Egypt Savings Association in 1963.

The early experiments of Islamic finance through the setting up of the Mit Ghamr Egypt Savings Association between1963 to 1967 in Egypt that replicated the model of the German Savings and Loans banks on the basis of Islamic tenets was motivated by social and community banking needs.  Further developments took place with the establishment of the Nasser Social Bank in 1971, which is a social lending institution assisting the poor and needy citizens and financing students and small-scale entrepreneurs. So effectively, the foundational era of Islamic finance within modern finance was aligned to achieve socio-economic objectives adopting a social finance model.

Then, in the 1970s, the real expansion and integration of the Islamic banking into the modern financial system happened. According to Wilson (2002), three critical factors contributed to the emergence of modern Islamic banking in the early 1970s; firstly the role of the Islamic Development Bank (IDB) in promoting the development of Islamic finance amongst governments of its member states; secondly the oil price rise in 1973-74 in Muslim countries in the Gulf that vastly increased the financial resources available; and thirdly the significant contribution of Islamic scholars to financial innovation that enabled product development in Islamic finance.

Consequently, studies regarding the profitability and viability of Islamic banking were researched earnestly with many studies proving that Islamic banking is a viable business venture within the financial system. As at 2018, total Islamic finance assets stand at US$2.6 trillion, with more than 505 Islamic banks including Islamic window of conventional banks in operation (GIFR, 2019). The cumulative average growth rate of Islamic finance between 2009-2018 is 12.5%.

3. Recalibrating the Mandate Through Islamic Social Finance

Following the phenomenal success and rapid expansion of the Islamic banking and finance industry, there were hopeful expectations that the Islamic banking and finance system will be the creative destruction force that revolutionizes the global financial system from within and gradually create a more values-based sustainable and equitable financial system that promotes humanism through greater financial inclusion and social development alongside the pursuit of commercial success.

However unfortunately, many critical analyses point out that the Islamic banking and finance model has gradually gyrated closer to the conventional banking system rather than offer a fresh alternative. Islamic banking players and regulators are accused of adopting the business model of conventional banking, pursuing profit maximization goals by improving processes and rolling out products to compete head-on with conventional banks and prove itself to be equally competitive with conventional banks.

The realization that the Islamic banking system had to find a reset button was amplified following the Global Financial Crisis of 2007-2009. Eventhough the Islamic financial system showed relative resilience to the GFC, it however still exhibited traits of technical mistakes and flaws that would create a fertile ground for any future crisis especially arising from lack of discipline in risk controls, asset quality and insufficient liquidity and capital buffers.

Consequently, following the launch of the Financial Sector Assessment Program (FSAP) jointly between the International Monetary Fund (IMF) and The World Bank (WB) in 2005, the Islamic Development Bank (IDB) together with the World Bank established the IDB-WB Working Group on Islamic Finance (WGIF) and held discussion with relevant stakeholders in the Islamic financial industry to establish a similar framework like the FSAP for the IFI industry. In 2012, the Islamic Research and Training Institute (IRTI), a member of the IDB, issued a report titled the Financial Sector Assessment Program for the Islamic Financial System (iFSAP). One of the findings in that report stated that the Islamic financial industry should recalibrate the role of Zakat, Infaq, Sadaqah and Waqf (ZISW) segment of the Islamic financial industry to better serve the low income society more effectively through the financial intermediation function towards achieving greater financial stability and economic growth. This gave birth to the term Islamic Social Finance.  

So Islamic Social Finance refers to all institutions, products and services involved in the collection and distribution of funds on the basis of Zakat, Infaq, Sadaqah and Waqf, which are predominantly philanthropy-based and not-for-profit for the benefit of the poor, needy and destitute segments of society. The primary objective is to remove these groups of people from the vicious cycle of poverty and improve their well-being not only by offering funds for consumption needs but also through training, education, scholarships or provisions of micro-funds to kick start an entrepreneurial venture or business. These are the “bottom-of-the-pyramid” segments of society who are either unbanked or underbanked and very likely not credit-worthy for a credit facility from a commercially run Islamic banking institution.  

The concepts of Zakat, Infaq, Sadaqah and Waqf which form the core fundamentals of Islamic Social Finance are not new financial developments. These are concepts and foundations that are firmly rooted in the Quran and the teachings of Prophet Muhammad (pbuh), for over 1400 years. The effective implementation and transmission of the funds for the needs of the target group have faced difficulty due to various factors including management inefficiencies, inadequacies in legal framework and authority, lack of data integrity, weakness in infrastructure for collection and distribution of funds and many other shortcomings. With the fortification of Islamic Social Finance through leadership at IRTI and IDB including political will at domestic levels, there is renewed hope that Muslim countries will be able to utilize economic redistribution tools that have been available to them through religious scriptures for thousands of years to eradicate poverty and improve socio-economic prosperity.

4. Conclusion

This 3-series of articles have attempted to shed light on the various concepts of Sustainable Finance, Social Finance and Islamic Social Finance. Obviously, it is just a drop in the ocean of information and knowledge regarding this vast subject matter. Here are a couple of final points as key takeaways:

1. The concept of Islamic finance and Islamic social finance is not different from the more recent concepts on sustainable finance and social finance. All of these concepts diverge towards achieving a better quality of life for the present generation and to preserve the environment and planet system as a trust for future generations.

2. Islamic finance and Islamic social finance derive from a much deeper and spiritual connotation because of its theological foundations and Divinely inspired texts of the Islamic religion that was revealed more than 1400 years ago. This shows that the principles of redistribution of wealth for the benefit of the poor and needy in society are a huge part of the Islamic economic system and the Islamic financial system.

3. However, the fact that the principles of Islamic Social Finance had to be given a fresh reboot in very recent times shows that the Islamic financial services sector has perhaps inadvertently excluded the Islamic social and philanthropy-driven segments of the Islamic economy in pursuit of profit maximization and shareholder-centric goals. Clearly, these two components of the Islamic financial industry have to converge in order to achieve greater social and economic prosperity towards achieving sustainable development and growth.

4. The concept of sustainable finance is a more recent phenomenon that can be traced to the 1970s following a report by Meadows et. Al (1972) titled “The Limits to Growth: A Report to The Club of Rome” that effectively states that the world will witness a sudden and uncontrollable decline to world population and economic activity if the present growth trends continue unchanged without limits. This report led to the Brundtland Report in 1987 and the first Earth Summit in Rio de Janeiro in 1992 where the definitions of sustainable development and sustainable finance were first coined.

5. It is an inevitable fact that the success of sustainable finance, in whatever form or model, hinges heavily on the adoption of technology-based solutions. Fintech and technology solutions enable the allocation of financial resources to the high-impact economic segments to improve social justice and achieve financial inclusion far more efficiently and effectively. In most instances, these would require heavy funding and investment involving both public and private finances.

6. The role of regulatory authorities especially central banks and monetary authorities is paramount. For sustainable finance to quantum leap towards impactful success, the regulatory authorities must be aligned to the objectives of sustainable finance and compel financial institutions under their jurisdictions to report their sustainable practices and measure the social performance of these financial institutions.