Islamic finance: Attractive for non-Muslims?

Islamic finance: Attractive for non-Muslims?

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Would a non-Muslim do better to back ethical rather than Islamic funds? Prof Dr. Volker Nienhaus, Adjunct Professor at INCEIF, explores the fascinating issue.

It is often claimed that Islamic finance is not only for Muslims. This has two meanings: (1) Islamic financial institutions will not turn away non‐Muslim customers, and (2) non‐Muslims can provide Islamic financial services. In practice, one can find examples in both directions.

The large number of non‐Muslim participants in Takaful schemes in Malaysia is an often-quoted example for the first and the asset management for Shari’ah-compliant funds an example for the second direction. But the message that Islamic finance is also for non‐Muslims is often much more ambitious, namely that the market potential of Islamic finance is far greater than just the population of Muslim countries and Muslim minorities in non‐Muslim countries.

If Islamic finance is for all, the whole world is the potential market for Islamic finance, and growth could be virtually unlimited. This, however, implies that Islamic finance has to offer the world something that is superior (or at least not inferior) to what it already has. It is by no means self‐evident what that could be: Shari’ah compliance as the constitutive element of Islamic finance is in itself rather irrelevant for non‐Muslims. It could be macro‐systemic or micro‐commercial or ethical implications of the observance of Islamic law which make it appealing to non‐Muslims.

For suppliers of Shari’ah-compliant financial services and infrastructure services (such as indexes, tax consultancy, asset management, stock screening, IT support, executive training, legal advice, rating services) Islamic finance obviously was an attractive option. Since most of the Shari’ah-compliant instruments are functional equivalents of conventional products, the necessary adjustments to serve Muslim clients was technically not too complicated for conventional financial institutions.
Once they had learned the Shari’ah restrictions, conventional institutions tapped into an initially highly liquid and not too competitive market with good margins. They did this via Islamic subsidiaries, windows or special products for selected clients. Later the structuring and issuing of Sukuk were added to the service portfolio. The major challenges of banking, capital market and insurance (Takaful) products lay in taxation and in the structuring of contracts in such a way that they satisfy Shari’ah criteria and are enforceable under the law of the land. This became a very lucrative business for western tax consultants and (in particular British) law firms.


While it is mainly the profit motive on the supply side, it is far less obvious what might bring customers to Islamic financial institutions. There may be similar financial incentives that motivate western corporate clients to acquaint themselves with Islamic modes of financing: The oversubscription of most Sukuk indicates a high demand which, in turn, could translate into lower financing costs compared to conventional bonds (or even equity‐type instruments).

But what has Islamic finance to offer to the retail client? One argument is that the general observance of Islamic finance principles would create a more stable, efficient and just financial system. For a while it seemed that nearly everybody – politicians, businessmen and ‘ordinary people’ – was searching for a better alternative to the crashed “capital market capitalism”. It is debatable whether Islamic finance would really be a superior alternative – at least as long as it is predominantly a replication of conventional techniques and Shari’ah engineers structure prototypes even of those complex derivatives that were held responsible for the collapse of the conventional system.

But even if one would accept the arguments of the proponents of a superior “true” Islamic financial system, one has to realise that the enthusiasm for a fundamental reform of the financial system has evaporated. Fundamental alternatives such as narrow banking or limited purpose banking were on the radar screen of politicians and central bankers only for a (very) short while (and were received with much scepticism in general and strong criticism by lobbyists of the old system in particular).

Basel III (or ‘Basel II+’ as some commentators have called it) is definitely not a fundamental reform, and Wall Street is today occupied not by protesters but again by bankers and brokers. The persistently high unemployment and fiscal austerity measures are now on the top of protest agendas in many countries.

So if it is not ‘systemic superiority’ that will attract non‐Muslims, then there must be something in Islamic finance that the customers see as individual benefit for themselves. This “something” could be the pricing of Islamic products or their quality.


The pricing of Islamic savings products (unrestricted investment accounts usually based on Mudarabah contracts) seems to be very much in line with competing conventional products, i.e. the rate of interest for savings or term deposits. But this implies that investment account holders do not get a compensation for the risk they have to take due to the profit and loss sharing character of the underlying contract.

But even if one ignores this risk, savings products do not look particularly attractive for non‐Muslim investors who can get the same return without the risk of the underlying contract. The practice of participatory contracts is such that not only downside risks are factually eliminated or ignored, but also upside chances for fund providers are curtailed in favour of the managers of funds. This is achieved, for example, by regular adjustments of profit sharing ratios (at the discretion of the bank) or by “incentive fees” by which all profits above a benchmark rate are skimmed off by the manager of the funds (which could be the bank in the case of investment accounts or the issuer of Musharaka Sukuk who runs the business).

Such practices have factually turned nearly all Islamic savings and investment products into fixed income instruments (usually benchmarked against LIBOR or a national alternative from the conventional sector), and the participatory character of the original Islamic contracts are lost.

The pricing of Islamic financing products is also more or less in line with conventional alternatives (as are required collateral). This is an achievement in view of the higher complexity of contractual and transactional arrangements (in particular in corporate finance) and of the additional costs of Islamic banks for securing the Shari’ah compliance of products and processes. However, during the last crisis customers of Islamic banks had to realise painfully that the complexity and implied rigidity of sales contracts used for financing purposes could drive the prices of long‐term Islamic financing (in particular home financing) to excessive levels.

An Islamic bank re‐sells assets (e.g. a house) to the client at a price that is determined by the amount to be financed today (the ‘loan’ amount) and the cumulated financing mark‐ups (the cumulated “interest” payments) for the full contracted financing period (e.g. 10 years). This sales price has to be paid in instalments over the whole financing period.

If a client wants to terminate the financing prematurely, say after two years, the bank can claim the repayment of the initial amount and mark‐ups for two years plus a penalty for early termination, as it would in a conventional interest‐bearing loan contract. The sale contract entitles the bank to claim the full sales price which includes mark‐ups for periods in which the financing is no longer provided. Such claims were actually made by Islamic banks, and it was only by the interventions of courts and central banks that clients were protected against such claims which were deemed unfair and
factually usurious.

With such experiences, non‐Muslims who can opt for a conventional loan may not be too enthusiastic over Islamic modes of long‐term financing, even if the initial pricing looks competitive.


If it is not the pricing, then the product quality is left. In what respects could Islamic finance products be superior to conventional products? As long as Islamic finance products are intentionally structured as replications of conventional ones, and as long as even those genuine products such as Musharaka Sukuk which could have a unique risk/return profile are transformed into fixed income instruments, the difference in quality cannot be found in the product structures (ignoring the Shari’ah compliance, higher complexity and legal risks).

If Shari’ah compliance does not alter the economic characteristics such as the (commercial) risk/return profile, non‐Muslim will not look for qualitative differences in the instruments as such but in the types of transactions and businesses for which the instruments are applied. Here proponents of Islamic finance often underline the ethical qualities of Islamic banking and capital market products.

One argument is that Islamic finance is more just and fair than conventional finance because providers and users of funds share returns and risks or profits and losses. It is considered unjust in conventional finance that the entrepreneurial partner bears all the financial risks while the provider of funds receives a risk free income. This violates the basic principle that rewards (from financing) are justified only if they are combined with risk. There are two problems with this position.

The minor problem is that there is no ultimately risk‐free income for financiers in conventional finance – companies and governments can go bankrupt, thus there is always a credit risk. The major problem is that participatory finance (i.e. the sharing of returns and risks or profits and losses) does factually not take place in Islamic finance (except contractually but not factually in the ‘deposit business’ of Islamic banks).


The other argument is that Islamic financial institutions observe ethical principles in their financing and investment decisions. No funds for Haram activities – this is taken seriously in Islamic finance, at least in principle. But is that enough to attract non‐Muslims?

A minor problem is that Shari’ah boards in some jurisdiction have allowed “tolerance criteria” for investments in Haram activities, provided the Haram business is relatively small and a kind of byproduct of a basically permissible business (such as running an airline and serving or selling alcohol
on board).

However, such tolerance criteria can become tricky if they are too lax: suppose the tolerance level were set at 10 per cent of the turnover of a company. A company that generates 50 per cent of its turnover [e.g. $50 million of a total of $100 million] from the production of tobacco or alcohol or weapons could not be financed in a Shari’ah-compliant manner.

But if this company is absorbed by another company of (at least) four times its size (i.e. a total turnover of $400 million) and so far zero prohibited business, the new larger company (with a total turnover 100 + 400 = $500 million) would generate only 10 per cent of its turnover from prohibited business. As a result, exactly the same business that was clearly Haram in the first instance can now be financed in a Shari’ah-compliant manner.

A major problem is that the avoidance of a rather limited list of Haram businesses is not “much ethics” for those who should be attracted to Islamic finance because of its ethical dimension. First, the “old style prudent banker” (who is still alive in many places) would also shy away from the financing of many of the haram businesses. But more important: individual savers who look for ethical savings products or institutional investors who want to add responsible investments to their portfolios can find already a much wider and more sophisticated choice of products in the non‐Islamic investment universe.


The avoidance of investments in “sin stocks” (shares of companies with businesses similar to those prohibited in Islam) and the observance of ethical criteria in faith‐based banking finance have a long tradition dating back to the 19th century. But after business scandals in the 1990s and a strong growth of ecological movements in many western countries, ethics, social responsibility and sustainability ranked high on the agenda of international organisations such as the OECD and the UN system and gained considerable attention from financial institutions and asset managers.

The now widely used term for the consideration of environmental, social and governance (ESG) criteria in investment decisions is “responsible investing”. This generic term comprises a wide range of different approaches and strategies which are summarised by the European Sustainable Investment Forum as follows:

Sustainability themed investments are investments in themes or assets linked to the development of sustainability with a focus on specific or multiple issues related to ESG.
Best‐in‐Class investment selection is an approach where leading or best‐performing investments within a universe, category, or class are selected or weighted based on ESG criteria.
Norms‐based screening is based on the screening of investments according to their compliance with international standards and norms, in particular those of the OECD and the UN system (including Global Compact, ILO, UNICEF, UNHRC).
Exclusion of holdings from the investment universe means that specific investments or classes of investment are excluded from the investible universe such as companies, sectors, or countries engaged in weapons, pornography, tobacco and animal testing; this approach is also referred to as ethical‐ or values‐based exclusions.
Integration of ESG factors in financial analysis is the explicit inclusion of ESG risks and opportunities by asset managers into a traditional financial analysis and investment decisions based on a systematic process and appropriate research sources.
Engagement and voting on sustainability matters is the active use of ownership rights through voting of shares and engagement with companies on ESG matters in order to improve their ESG performance; it is a long‐term process, seeking to influence behaviour or increase disclosure.
Impact investments are investments made into companies, organisations and funds with the intention to generate social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending upon the circumstances.
The responsible investment business is supported by a sophisticated infrastructure, including data and index providers, screening consultants, legal advisors, marketing companies, specialised asset managers, industry associations and lobby groups. Although the volume growth of the RI industry is mainly driven by an increasing engagement of institutional investors (especially pension funds), retail clients can find customisable and interactive web‐based screenings of responsible investment funds and tests of their performance.

The volume of responsible investments exceeds by far the global assets of the Islamic finance industry (estimated at $1.3 trillion by 2011): the volume of assets under management (AuM) in responsible investment funds in Europe alone is estimated at EUR 6.8 trillion by 2011 [Eurosif: European SRI Study 2012] which is half of the total European asset management industry (and the AuM of the European asset management industry accounts for approximately 33 per cent of the global AuM).

Obviously, there is a huge market for investments with a ‘responsible’ dimension, and Islamic finance structures fit well into this scheme as an exclusion strategy. But to capture a wider share of this market, Islamic finance has to make considerable progress.

Similarities in the structure (form) of processes in Shariah-compliant and responsible investing cannot hide the fact that there are fundamental differences in substance. Conventional and Islamic institutions apply an “exclusion” filter on the first‐level of their screening process and exclude prohibited (haram) businesses. Islamic fund managers have to limit the investment universe further by filtering out companies with an unacceptable level of interest‐based assets and liabilities.

Such financial ratios are not a major concern for conventional responsible investors. What is a major concern is how the actual investment objects are chosen from those which passed the exclusion filter(s). Here lies the major difference: while Islamic financial institutions (like ‘non-responsible’ conventional institutions and responsible funds that apply only an exclusion strategy) decide on the basis of financial performance criteria, the majority of responsible investment funds (which combine exclusion with other strategies) take additional non‐financial criteria such as the ESG performance into account. This is where the attraction lies for individual and institutional investors (such as Western pension funds) who are looking for responsible investment opportunities.


For the time being, Islamic finance has not much to offer in this area: The exclusion strategy alone is probably not the most appealing one of all responsible investing strategies. Given the widespread poverty in the majority of Muslim countries, themed investments with high relevance for poverty alleviation (e.g. sanitation, healthcare or renewable energy related themes) and impact investment strategies could make substantial contributions. Western funds have shown that such strategies can yield a satisfactory return on investment.

Unfortunately, Islamic funds or financial institutions with such profiles are extremely difficult to find. If they do exist, they are virtually invisible for non‐Muslims.

While even universal banks with a strong investment banking arm rediscover the retail client and acquire deposit collecting institutions (such as Deutsche Bank who bought the German Postal Bank), Islamic retail business is scaled down – most visible by the closure of HSBC Amanah in the UK. This could be seen as an early warning sign.

Given meagre market shares of 10 per cent or less of total bank deposits from the general public even in many Muslim countries where Islamic finance is operating since two decades or (much) more, it becomes apparent that Islamic finance as it is practiced today is not so well received by the average Muslim. Thus it may be a good idea not only to look for non‐Muslim clients, but also to target the 90 per cent or more of Muslims who still prefer conventional finance.

Maybe they have similar problems as non‐Muslims have to appreciate a difference in substance that could compensate for increased contractual complexity and legal risks without higher returns or superior product qualities. The responsible investing movement is a great opportunity for Islamic finance, but also a great challenge at the same time.

Zulkifli Hasan
Hospital Raja Perempuan Zainab II, Kota Bharu

2 thoughts on “Islamic finance: Attractive for non-Muslims?

  1. rabeah says:

    Assalamualaikum doctor,can you give some opinion on..’What are the biggest obstacles to develop Islamic Corporate Governance(theory and practice) in Malaysia and else where?tq.

  2. asma says:

    assalamu alaikum doctor can you please provide more concise facts on how islamic finance and banking attracts on non muslim investors and companies?

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