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Opalesque Islamic Finance Intelligence

Editor's Note: Conventional Wisdom By Bernardo Vizcaino, CAIA

Friday, July 30, 2010

A Twisted Sister?

They seem to be forever at odds with each other, almost by default we consider Islamic finance as being diametrically opposite to conventional finance (at least conceptually that is). Theirs is the story of two rival siblings who appear to have no willingness to reconcile their differences. This is a family feud made even harsher if one regards them as next door neighbours who are forced to share the same backyard: both having to answer the same market challenges and compete for the same financial opportunities.

Despite their differences (some irreconcilable) can we inquire whether a young (almost pre-pubescent) Islamic finance can learn from the older (almost venerable) conventional finance? Can these two sisters learn from each other, even though it is unlikely they will never get along? Or is it that everything related to conventional finance is completely negated by its indulgence in interest-bearing securities and other non-permissible activities?

While conceptually different, this does not suppress everything there is to know about conventional finance. In fact it would be rather callous to discount everything that the older sister has done (or avoided doing), and in particular to overlook some key practices and methods. Sure, the recent past has brought the spotlight on some of its most pervasive failings (in a most spectacular fashion I might add). Nevertheless, conventional finance, in all its wickedness, has amassed over the years a significant body of academic work covering almost every imaginable permutation (from macroeconomic trade flows of the Japanese Yen to how subtle moves in the stock market can be explained by which day of the week it is).

This extensive research history has managed to highlight, promote, scrutinize, defeat, chastise, berate and even ridicule many practices of conventional finance. This of course is a good thing, since it is this constant (and in some cases relentless) examination that has allowed for refinements, prompted improvements, and triggered the occasional overhaul. These studies cover almost every imaginable scenario - from evaluating the cost-effectiveness of indexation products, challenging the uncorrelated nature of alternative investments, scrutinizing the independent nature of rating agencies, to analyzing litigation outcomes relating to the marketing of structured products to retail investors.

Work on the latter was published by Nera Consulting (see reference link), which is an eye-opener for those studying the implications of unleashing structured products for mass consumption. At first glance this would not seem not have anything to do with Islamic finance. However, various regulators are having to contend with the introduction of rather complex Shariah compliant instruments into their capital markets, with clear implications when there is an unprepared retail market.

On the other hand, this conventional research has supported various concepts akin to Islamic finance; this is especially true as it relates to equity investing and more specifically equity-screening. Hence we have numerous studies relating to socially responsible investing, analyzing whether such screened investing is viable and whether investors should be willing to accept a financial penalty (i.e. higher costs or diminished returns). The firm Phillips, Hager & North has done an excellent survey of the existing SRI literature (see reference link) and the paper has a very comprehensive table summarizing the key findings from many of these studies (not included here due to space constraints, although most of the quoted studies are included in our Featured Resource section). Much of this research validates the concept of equity-screening and empirically proves that ethical investing does not necessarily entail lower returns.

Look What the Cat Dragged In...

On the other hand, it is rather curious that Islamic finance is but an after-thought in many of these papers, in some it is relegated to the footnotes and for others it seemingly does not exist. Why? Are Islamic funds not regarded as ethical? Are the equity-screening methodologies of Islamic funds not 'religious' enough? Perhaps it is due to the fact that - until recently - data providers have done an absolute miserable job at surveying Shariah compliant products, and hence they went unnoticed/unreported? Or is there a more sinister explanation: has western-focused academia inadvertently overlooked Islamic finance? Worst still, has this been on purpose ¢â‚¬â€œ has Islamophobia spilled over to academia to create an Islamic-finance-ophobia of sorts?

I¢â‚¬â„¢m well aware that this is a serious accusation, but it wouldn't be the first time that the SRI industry has been caught with its pants down. After all, it has given a blind eye to microfinance for many years (if not decades); its output as it relates to interest-free finance is close to nothing; it has had to respond more than once to the spectre of high management fees; and it has been rather inconsistent with regards to sustainability and social-engagement. In fact, prior to the financial crisis, the typical SRI fund would have devoted almost 25% of its holdings to the financial services sector. Little has been heard from the SRI industry regarding responsible lending initiatives - or for that matter shunning predatory lending practices.

Even more remarkable, an Asian-based SRI firm much prefers to talk about some random climate change product (presumably fee-rich) rather than the overwhelming output that is being generated from countries such as Malaysia, Singapore and Indonesia in terms of Islamic banking products. Strikingly, this firm reports that there is ONE ethical fund in Indonesia (even the lousiest of data providers can shed light on a handful of Syariah mutual funds, well over 30 if you care to look for them properly). No laughing matter, Islamic finance is ethical, it is socially responsible, it must be recognized by the SRI industry in an upfront manner (not hidden somewhere in an appendix).

Fortunately, I can be proven wrong with multiple examples of far more professional research, from Italian academics analyzing 'Islamic Mutual Funds as Faith-Based Funds in a Socially Responsible Context" (see reference link) to the more technically-oriented (and Scottish-based) scrutiny of 'Islamic Mutual Funds' Financial Performance and Investment Style' (see reference link). While these (and many other) works don't seem to appear as often as the should they must be commended, dusted out from the bookshelves and follow-up studies should be encouraged more than ever.

The Quiet Riot

The industry does have an existing body of academic work, although this output mostly pertains to Islamic economics and not the more specific subset of Islamic banking & finance. Accordingly, the literature of the former has been focused on the macroeconomics of it all (profit and loss sharing mechanisms, the gold dinar as a currency, as well as other structural aspects). For a more thorough review see Asad Zaman's 'Islamic Economics: A Survey of the Literature' (see reference link).

Then again, we are witnessing a rejuvenated academic output in Islamic finance from the likes of BIBF, INCEIF, ISRA, and multiple universities and educational bodies from across the globe. At first glance they appear to be a motley crew of seemingly disjointed academic output, quietly toiling from the background. Nevertheless, they are all reflective of a revivalist and in certain ways a revisionist trend in Islamic finance research. Moreover, they might have governmental or institutional support but it is a new generation of academics and practitioners that is proving to be its most energetic fuel. Hence it might be very soon that we find Islamic finance boasting as vast a literature as many other industries. They will borrow from past research, scrutinize it, challenge it and polish it. We can take notice but most importantly we should encourage it as much as we can.

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