THERE has been a rise in demand for ethical forms of finance and investment in recent years.
People have begun to realise the need for adopting an ethical approach to their finances and now understand the benefits of investing responsibly.
KiwiSaver providers and investment firms have also placed greater importance on environmental, social, and governance (ESG) factors when choosing which investments to include in their portfolios, and many have some form of responsible investing (RI) policy, which shows the increased interest in sustainable investments.
Although ethical finance has only recently gained mass popularity, it has been around for centuries. Islamic finance, which comes under the umbrella of ethical finance, can be traced back over 1400 years. While Islamic finance is as old as Islam itself, it has only been adopted by banks and financial institutions since the 20th century. The industry is forecasted to have US$3.7 trillion in assets by 2024, according to the Islamic Finance Development Report 2020.
So, what exactly is Islamic finance?
The Shariah Principles
Islamic finance follows Islamic principles and jurisprudence (Shariah law), designed to promote social and economic justice. There is a great focus on partnerships in Islamic finance, which means that for both parties in any transaction, profit and risk should be shared equally. This eliminates the ability of one side taking advantage of the other.
Amanah Ethical is one such investment manager that embodies these Islamic principles. Offering KiwiSaver funds and investments that follow a strict ethical mandate, Amanah aims to make your investments work towards the betterment of mankind rather than solely pursuing profit to society’s detriment. Avoiding speculatory investments, along with their core ESG principles make Amanah a good example of Islamic finance operating in New Zealand.
Islamic finance does not deal with interest as it involves a power imbalance between a lender and a borrower. Interest benefits the lender, who charges interest at the borrower’s expense.
Islamic finance views money as a means of exchange and does not believe that money has any real value in and of itself.
Hence, money cannot be made on something that does not hold any real value (money). Instead, it encourages making money out of an asset, which holds its own value.
Risk and Speculation averted
When it comes to Islamic finance and investing, two things it steers away from are excessive risk and speculation, which are common in conventional finance.
Derivative contracts such as futures, forwards and options, and short-selling are examples of excessive risk and speculation. These contracts involve uncertainty as they aim to predict the future price of an underlying asset (gambling), leading to one party benefiting at the cost of the other. Islamic finance prevents falling into excessively risky or speculative investments and requires that all terms are clear and well laid out before either party enters a contract.
Islamic investments follow a strict set of criteria, which involve excluding investments in companies involved in controversial industries such as tobacco, weapons and alcohol. There is also a strong focus on companies that produce sustainable returns and have minimal debt.
Islamic Banking vs Conventional Banking
One of the fundamental differences between Islamic and conventional banking is the use of interest. Banks make money through multiple avenues, including charging interest via credit cards, investing their customer’s money from savings accounts, and interest on mortgage loans.
Customers who cannot pay off their credit card loans are required to pay interest to the bank. From an Islamic point of view, you are not allowed to benefit from lending money or receiving money from someone.
Conventional savings accounts are based on a creditor and debtor relationship, in which the bank borrows the customer’s money and invests or lends it to others. The bank then returns the customer’s money with an agreed-upon interest and keeps the remaining profit for itself. There is no risk taken on by the lender (customer) as they are guaranteed the interest.
In a mortgage, the bank lends the customer money to purchase a house. The customer then periodically pays back the money with interest over a set timeframe. Again, there is minimal risk from the lender’s (bank) point of view, and if the customer is unable to repay the loan, the bank will repossess the property and sell it to cover the cost of the loan.
Islamic banking is designed to make profit and loss equally shared between both parties in a transaction. This eliminates the ability of the bank taking advantage of the customer.
The Mudarabah Principle
Shariah-compliant savings accounts are typically based upon a Partnership Contract referred to as the Mudarabah Principle. The customer acts as the financier, and the bank acts as the fund manager. All investments made are screened and are Shariah-compliant. The bank and the customer agree to a profit/loss sharing ratio. As the bank will have researched the investment, there is an expected profit, but that could potentially fluctuate. Hence, both parties are taking on risk. The bank then receives a portion of the profit (just like a fund manager would), and the customer receives the remaining profit.
For Islamic mortgages, there are several types.
The most commonly used type is the Lease (Ijarah) loan. The bank purchases the property outright from the seller and then agrees to lease the property to the customer over a set period. Once the customer has made their final rental payment, the bank then transfers ownership of the property to the customer as a promissory gift. The customer did not borrow any money from the bank and is not paying back any interest.—Indian News link
