The COVID-19 pandemic of 2020 has indirectly enhanced investors’ focus on environmental, social and governance (ESG) products and the ethical implications of flows of capital. With this, we have seen significant growth and demand for Shariah aligned or compliant products and services in step with this wider appeal for those seeking ethical or socially responsible investments. Islamic finance as used in this article signifies financial products and services that are aligned with the purpose or Maqasid of Shariah.
This article examines the interplay between the global rise of ESG investment and growing demand for Islamic finance, and how growing investor appetite must be met with efforts to facilitate access to other markets, products and investments, including Shariah compliant products.
Review of 2020
The concept of human stewardship in Islam is noteworthy, with mankind seen as a manager or steward of resources — not an owner — therefore giving rise to the implicit moral responsibility associated with such a role. The feature of stewardship is particularly aligned with the principles of ESG and the emerging pools of global liquidity dedicated to ESG strategies.
S&P indicated that one of the current accelerators for the Islamic finance industry is the rise of ESG, with the UN Principles for Responsible Investment stating: “Islamic Finance and ESG investing are complementary capital-raising and investment approaches with many shared principles, such as being a good steward to society and the environment.”
As we know from our own experiences, especially during the pandemic, people want to work for purpose-driven organizations that stand for more than just making money. Some theorized that COVID-19 and the focus on value preservation would dampen investors’ commitment to ESG, but we are yet to see any signs that this is the case.
From what we have seen so far, there will be increased pressure from institutions to ensure that non-financial risk mitigation plans are developed and implemented and a rigorous ESG analysis of their portfolio companies will be an obvious starting point.
As the pandemic begins to abate, Islamic finance is in a unique position to act as a change agent to build back better, with Shariah presenting further opportunities to provide investment solutions to clients, innovating in line with the real Maqasid Shariah.
Preview of 2021
The regulation of Islamic finance often draws upon securities and banking regulations for the conventional sector, duly modified to reflect the nuances of Islamic finance, according to the IFSB. However, it is essential to ensure that, notwithstanding the underlying religious compliance, the duties to consumers, stakeholders and overall systemic stability are upheld in the same manner as expected of the conventional financial services industry.
This therefore requires those regulating and also implementing compliance frameworks for Islamic finance to be able to understand the products and services and the manner in which the Shariah approval process, through Fatwas, is applied throughout the product and service life cycle.
Regulation and compliance of Islamic finance must focus on substance over form to fully identify how risks manifest and arise from various structures, including the risk of Shariah non-compliance and the associated implications. If the very feature that makes a product Shariah compliant is breached, it impacts the integrity of the service being offered.
This is relevant in situations where, due to the prolonged effects of COVID-19, there may be prolonged profit-smoothing, particularly in profit-sharing investment accounts and as such adequate disclosure will be required to assure investors that the instrument remains Shariah compliant, notwithstanding the mitigation of the loss element, according to the IFSB.
The evolving regulation around technology and blockchain, crowdfunding as well as the developing integration of ESG into regulatory policies will be equally applicable to the Islamic financial services sector.
Digitalization of the Islamic financial services industry is expected to increase, given the remote working environment being exacerbated by COVID-19; as such, regulations will need to be developed to ensure that such digital platforms not only adhere to the applicable regulations, but also remain Shariah compliant and regulations should ensure the Shariah compliance feature remains a core component of an Islamic institution’s internal systems and controls framework.
Conclusion
As all financial services institutions face increasing regulatory costs, burdens and duties, this requires service providers that can understand these challenges in light of their specific business model. Regulatory compliance service providers, which can understand Shariah compliant business models, in addition to conventional business, enable clients to have a service provider with an intricate understanding and alignment of their needs.
Service providers that are able to provide a single-source solution from regulatory licensing, ongoing compliance and full-suite services to Shariah compliant products and investments, such as fund administration to Shariah compliant funds, SPV administration support in Sukuk and integrated ESG Islamic investments have a distinct competitive advantage across markets with a strong demand for Shariah compliant products and services.
Islamic finance is about ethics, integrity, accountability and social responsibility; these universal values are for all mankind, and perhaps the integration of ESG and socially responsible investing will provide the bridge between conventional and Islamic finance at a time when investors are looking for investments with a wider benefit than just economic gain.
The fact that compliance solutions are needed for an industry that must itself demonstrate compliance with Shariah is a unique opportunity for a service provider with capabilities in both Shariah and conventional finance to provide the platform for its clients to launch quickly and seamlessly into different regulated markets.
Hari Bhambra is the global head of compliance solutions at Apex Group. She can be contacted at [email protected].