Today, we live in an environment where trust in financial institutions’ ability to bring capital to its most effective use has eroded. It would be an understatement to say that people have lost faith in finance. From the subprime mortgage debacle to the collapse of Lehman Brothers and the recent LIBOR fixing scandal, finance is a much derided industry. “Banker bashing” is all too common, with one particular financial institution even being referred to as a “giant vampire squid,” underlying people’s disgust towards the behavior of financial institutions and their focus on maximizing profits without any regard for the consequences.
Risk transfer and risk mitigation is the modus operandi of most financial institutions. This is particularly true in the case of debt financing, where the borrower or entrepreneur bears most of the risk while the investor expects to be compensated with a high interest rate while having security over the borrower’s assets in case of default. “Risk sharing” does not really register in most investors’ vocabulary.
Can a case be made for finance based on risk-sharing principles? One solution could be faith-based finance. Charging “usury” or “interest” is prohibited in all Abrahamic faiths, though there are varying definitions of what really constitutes usury among the different faiths and sects. In theory, both Judaism and Christianity are against exploitation through charging interest but formalized mechanisms and institutions to provide equitable alternatives to borrowers have not been established.
Alternatively, Islamic finance has established clear alternatives to the exploitative nature of charging interest. It goes a step beyond banning interest by also prohibiting speculation or investing in businesses which are deemed socially harmful (gambling, alcohol, weapons manufacturing, pornography, etc). Islamic finance emphasizes the concept of risk sharing, where the borrower and the financier work together to grow the business and share the profits. Being a relatively new phenomenon, the first Islamic financial institutions emerged in the 1970s in the Middle East and have now spread to major financial centers globally with over $1 trillion in assets. Even though it has achieved significant success, the industry has had its share of problems, with below par performance being the subject of great debate.
Despite these debates, one of the key successes of Islamic finance has been that the ethical nature of financing has attracted a considerable number of non-Muslim customers, as has been witnessed in Malaysia where over 50% of Islamic bank customers are non-Muslims.
Islamic finance shares much in common with impact investing in terms of its goals of poverty alleviation and equal wealth distribution. It should be a welcome addition to the impact investing landscape. Acumen Fund has already provided financing on a Musharakah (profit sharing) basis to one investee. Leveraging these Islamic modes of financing also has the potential to unlock large pools of capital from Muslim countries (where Islamic financial institutions and philanthropists are unable to make interest-based investments).
The success of Islamic finance and its acceptance with non-Muslims bodes well for the further development of socially responsible investing. Maintaining an ethical foundation while sharing risk between investor and entrepreneur will benefit all mankind, not just those of a particular faith.
In a time when capitalism’s unbridled excesses have been laid bare, it is time to ask:
How do we put the faith back in finance?
Fahim Shelot is a Class of 2013 Global Fellow working with Western Seed in Kitale, Kenya.