Datuk Nor Shamsiah, governor of Bank Negara Malaysia
Islamic finance faces a challenge. While the industry has grown dramatically in scale and sophistication, many of its practitioners fear this has come at a cost: a drift in intention, with so much emphasis on letter of the law compliance that the spirit of the whole idea has been lost.
|Oz Ahmed, HSBC|
“When we talk about Islamic finance, one of the problems we have is that we are always talking about the three ‘S’s – sukuk, Shariah standards and scholarly debate – at conferences,” says Arsalaan ‘Oz’ Ahmed, chief executive of HSBC Amanah Malaysia in Kuala Lumpur. “We’re not talking enough about the important S, which is social impact: the role Islamic finance has in supporting society.”
“Islamic finance-hood is defined by the size and number of issuances of sukuk, and the Islamic finance-ness is defined by how Shariah compliant you are,” he says. “While the industry focuses too much on that, we will not be focusing our attention on the right things to progress.”Ahmed believes the way his profession measures its own success has gone adrift.
Malaysia is by some distance the world’s most sophisticated market for Islamic finance and has the institution in the strongest position to do something about the loss of focus Ahmed is describing: Bank Negara Malaysia, the country’s central bank.
Malaysia has already dealt with most of the initial challenges around Islamic finance – scale, availability of products, consistency of interpretation and the creation of leading educational institutions – and is now able to take stock and deal with some of the nuances of where the industry has got to.
Islamic finance requires that transactions must be based on real assets and not on speculation, and a network of regulations and interpretations is required to ensure that people meet these fundamental rules. The more complex structures have become – particularly in areas like derivatives necessary for hedging – the harder it has become to be certain about compliance and so an industry of financially savvy Shariah scholars has evolved, and a highly technical (and lucrative) specialism of commercial law firms alongside it.
“Value-based intermediation extends the natural progression of Islamic finance by encouraging Islamic financial institutions to adopt more structured frameworks for assessing how they create value and impact, particularly in response to changing economic, social and environmental conditions,” says Datuk Nor Shamsiah, governor of Bank Negara Malaysia, in her first interview since assuming office on July 1.
“This in turn will strengthen Islamic finance’s contribution to quality and sustainable economic growth.”In Bank Negara’s case, it has so far issued 14 policy documents on Shariah contracts, outlining both compliance and operational compliance, so everyone knows what the letter of the law is. But having removed any doubt about the compliance side, the bank wants to go further, with an initiative called ‘value-based intermediation’ (VBI).
One can think of it along the lines of the triple bottom-line idea popularized by, among others, the UN Environment Programme. What if you took this idea of quantifiable positive impact and aligned it with Islamic banking?
Bank Negara began seeking banks that would be willing to support the idea.
“We were among the first they spoke to and we said we would like to be involved,” says Ahmed.
Eventually a group of five founding members came together and developed an initial paper with the central bank. The group consisted of Agrobank, Bank Islam, Bank Muamalat, CIMB Islamic and HSBC Amanah, working closely with two large non-Malaysian enterprises: the Global Alliance for Banking on Values (GABV) and Triodos Bank, the sustainable banking champion from the Netherlands.
GABV was a natural partner. Founded in 2009, it is a network of banking leaders around the world who want to change the impact the banking system has, making it more transparent and with better outcomes for economic, social and environmental sustainability. It has 54 financial institutions in its membership, serving 50 million customers.
GABV has developed a scorecard as a way of measuring just how successful any bank is in delivering these positive outcomes, and around two years ago it began discussing a similar idea for Islamic banking with Bank Negara Malaysia. For David Korslund, an ex-ABN Amro banker who serves as GABV’s senior adviser with a particular focus on scorecard development, Islamic finance was a good fit for the idea.
“It goes to the issue of ensuring Shariah-compliant banking is focused on the substance of Shariah, not the form,” he says from the Netherlands. “Quite a lot of Islamic banking had become box-ticking developed by sophisticated lawyers and consultants out of London. It looks Shariah, but it doesn’t deal with the underlying issue – providing value to society – at the core of Shariah finance.”
Bank Negara detected that Malaysian banks wanted to do more work with a genuine impact.
“Yes, this can be seen from recent undertakings by a number of Islamic financial institutions that have been more focused on innovative products and programmes that are targeted to specific economic and social purposes,” says Nor Shamsiah, who inherited the programme as governor but has been with the institution since 1987, including six years as deputy governor.
Unlike CSR, VBI is not undertaken as a philanthropic or charitable activity that is separate from a financial institution’s core business- Datuk Nor Shamsiah, Bank Negara Malaysia
She highlights affordable housing schemes, the funding of social projects through cash endowment products and affordable protection plans that serve marginalized communities. Also, she notes the growing number of Islamic financial institutions in Malaysia that are making global commitments to sustainable finance by voluntary membership of organizations like GABV, the Global Reporting Initiative and RFI Foundation.
One such was Bank Muamalat, one of Malaysia’s leading Islamic banks. According to chief executive Dato’ Redza Shah Abdul Wahid, Muamalat was the first Islamic bank, and the first southeast Asian commercial bank, to join GABV.
Dato’ Redza disagrees that Islamic finance has lost its way, instead believing that innovation has put the sector on a level footing with the conventional sector and thus strengthened it immensely.
“Over the years more and more Shariah-compliant products have been developed and able to meet the increasingly sophisticated needs of our clients,” he says. “We are probably at the same level as conventional banks because of the innovation that has been done on Shariah-compliant products.”
But he has another reason for supporting the principles, namely that if more people acknowledged the overlaps between Shariah and socially responsible financing, it would benefit the industry.
“As we look into the principles of responsible investment, we realize there is a lot of common ground between Islamic finance and value-based finance,” he says. The Bank Negara initiative “might help the western world to understand us better, as people understand that Islamic finance links with socially responsible banking. It will tell the world that our standards are as good as socially responsible standards.”
As meetings got underway, there was a sense of momentum. The founder group was engaged right to the level of chief executives and senior management, as new iterations of the document came and went.
“Even before we had got anything materially out of it, we were getting other banks interested to join,” says Ahmed. “There were nine banks we would term initial influencers,” including large local and international names. Then it began to expand beyond banks into a broader connected and mutually dependent ecosystem.
Are you really financing the real economy or just the financial economy? When you have to put these things down on a scorecard, it really makes you ask- Oz Ahmed, HSBC Amanah Malaysia
While GABV’s existing work was very helpful, all were clear that they were trying to achieve something distinctive. Although VBI has similarities with environmental, social and governance criteria, ethical finance and socially responsible investment, Nor Shamsiah says: “In Islamic finance, the central tenets of Shariah drive and anchor the underlying values that underpin financial and business models.
“Unlike CSR [corporate social responsibility], VBI is not undertaken as a philanthropic or charitable activity that is separate from a financial institution’s core business. It is what drives and shapes the core business activities of the financial institution – its offerings, practices and processes.”
Fitting a rubric to quantify it all was a challenge but necessary.
“This is important,” says Ahmed. “When you talk about things which are softer in nature – looking after the environment and people – that’s a wonderful and left-leaning inclusive statement, but you also need a bit of right-leaning structure on understanding what this is and how to execute it.”
Last year a light version of the scorecard was developed, then a more fully- fledged one earlier this year; in March, Bank Negara launched its strategy paper on VBI in Islamic finance, a 36-page document filled with graphics and case studies.
By now the scope of the intention had become clear – reducing social impact to a score on one hand, but embracing a whole approach to finance across a community on the other.
“VBI accords equal emphasis to economic value creation and the upholding of ethical values,” says Nor Shamsiah, reflected in four key aims: nurturing entrepreneurship, promoting community empowerment, incentivizing good governance and exemplifying best conduct.
“To illustrate,” she says, “a VBI-oriented bank would complement the provision of financing to a corporate client in the agriculture sector with post-financing advisory services on sustainable business operations such as proper resource management for land irrigation and environmental restoration.”
The scorecard idea is expected to be launched in October at the Global Islamic Finance Forum in Kuala Lumpur. The idea of it, says Ahmed, is that it helps banks outline where they are today and the areas they can focus on to improve.
“It allows you to start to put your best foot forward,” he says. “That in itself is a discovery process that leads to reflection.”
For example, a bank might ask itself: how often are you talking about a particular social theme in your management process? If you are developing a product, do you look at the social and environmental impact of that product? When you approve a financing, how do you take that into consideration?
It also applies to the composition of a bank’s book.
“Are you really financing the real economy or just the financial economy?” asks Ahmed. “When you have to put these things down on a scorecard, it really makes you ask.”
Here’s the problem: we reject somebody who can make nine out of 12 payments, but we would never reject a glass of water that’s 75% full- Oz Ahmed, HSBC Amanah Malaysia
As the launch has approached, however, there is a sense of pullback among some members of the group.
“Initially I feel there was a high level of enthusiasm, mainly because this does hark back to the values of Islamic finance. It resonates,” says Ahmed. “But as we go through the process there are reality checks happening, as we are getting measured. It’s natural that when people don’t score as well as they thought they were going to score, you will face some headwinds.”
Nor Shamsiah says: “Changing mind sets will take time, and is made more difficult without a critical mass of sufficiently diverse investors and funding providers that are committed to driving sustainable businesses.”
She adds, it is “important to ensure the scorecard reflects practical insights from the industry as well as the unique features of Islamic banking operations in Malaysia.”
Adoption of the scorecard will be voluntary, she says.
“We do, however, expect that it will gain traction, given the maturity of the Islamic finance industry in Malaysia, the level of commitment that we have seen from several large institutions that will set the pace for wider adoption across the industry and competitive pressure as awareness increases.”
Korslund, too, is aware of some reticence, but argues it is all to the good.
“Some banks are using it as a strategic discussion tool internally, some as a communication tool and some as a ticking-the-box exercise,” he says.
“But even some of the ones that take it less seriously are still doing good work. In general, the quality of Malaysia vis-à-vis values-based is quite high.”
Dato’ Redza at Muamalat expects the scorecard to be used internally at first but argues it has value.
“We will use the scorecard to look at our balance sheet, and to strategize,” he says. “It will help us to know which are the areas we need to emphasize in delivering positive social impact, and to avoid or reduce environmental damage through our banking practices.”
The scorecard “will help with our strategic planning,” he says; “It is not something that we are going to use to compare between one bank or another, because the nature of each bank is different.” Comparing a consumer bank, a corporate bank and an investment bank on the same metric, for example, may be problematic. “Instead each bank’s own scorecard will tell them how to improve themselves.
If value-based intermediation, with or without scorecards, is widely adopted, what will it mean in practice?
Euromoney asked Nor Shamsiah to address a controversial industry at the heart of Malaysia, palm oil. She says that there are widespread misunderstandings of the industry and its impact on deforestation. She believes that adopting VBI would encourage a more informed and open dialogue with Malaysia’s trading partners on sustainable palm oil practices in the country, accelerate improvements in production methods through value-adding financing activities, and encourage the expansion of down-stream activities that would lift economic potential and create higher value jobs.
More broadly, she says: “VBI would amplify the value propositions of Islamic finance and strengthen the foundations for more inclusive intermediation by Islamic financial institutions.”
She expects greater differentiation between those that do and do not adopt VBI, “which will also be better understood by shareholders, fund providers and financial markets more generally.”
Longer-term, she expects greater innovation in Islamic financial institutions, a more diverse talent pool and a more robust industry. Given time, she says it will also contribute to financial stability “by ensuring prudent leverage through a strong nexus between finance and sustainable real economy activity, and better risk management across businesses that are financed by financial institutions that adopt VBI.”
Ahmed offers more precise examples. One would be combining home financing with solar panels or water collection, and working with Tenaga, the national utility, to sell excess electricity back onto the network, with that money offsetting the person’s home financing.
“How about we go to the central bank and say: ‘If we do this, we would like a lower capital charge, as the risk has gone down slightly’? Then this looks way more interesting, working as an ecosystem.” Doing this would require a residential house green standard, so that might also bring a rating agency into the ecosystem.
He also suggests an ecosystem for home ownership and medical insurance.
“Here’s the problem: we reject somebody who can make nine out of 12 payments, but we would never reject a glass of water that’s 75% full, because that water provides you value. But we as a bank can’t take risk on that person because of the 25% that’s missing.”
One option would be to use money collected from social sources like Islamic charitable giving and endowments – a considerable pool of assets in Malaysia – to invest in a conservative way with reliable average returns, with the returns used to meet the gap in payments.
If this system was used to provide medical insurance to people who otherwise couldn’t afford it, they would potentially have a better quality of life and work longer, he argues, further enriching themselves and the economy. If this system helped home ownership, future generations would benefit from greater wealth transmission.
“Banks can’t do it alone,” Ahmed says. “Everyone should be asking: ‘How have we not done this on an industry basis anyway, given the unique nature of large pools of capital that exist that require no financial return and also, for some of it, no principal return?’ It’s because we are not working as an ecosystem.”
Redza says he will be willing to remove products if they fare badly in the value-based environment.
“If we find any of our products are not socially responsible, we will take them off from the table,” he says. “We can really go back to the drawing board and look afresh at some of our strategies.”
There should, too, be benefits if the world’s perception of Islamic banking moves closer to its perception of ESG. “This is really about banking in the future,” Redza says. “In order for Islamic banks to have access to international funding that is already being invested in a socially responsible way, it is important for us to be able to say that we are responsible banks.”
Korslund has the same hopes for Islamic banking as the rest of the industry. “The number one priority for any bank in being value-based is building into its risk review and underwriting processes a focus: does that risk provide social value or not?” he says. “It doesn’t mean you only underwrite risk with social value. But at least you ask the question.
“That’s where the banking system has gone wrong. It starts with: where can we make money and how do we exploit human needs to make money?
“By asking the question about social value, you are getting at a fundamental risk question: is it long-term sustainable? Because companies that are creating negative social value are, long term, not sustainable.”