Islamic Finance: Bringing Ethics to the Center of Finance

By
Tarek El Diwany at the CFA Institute Middle East Investment Conference

At the CFA Institute Middle East Investment Conference in Doha, Qatar on 26 March 2012, Tarek El Diwany, a senior partner at Zest Advisory LLP, argued that religion—be it Islam, Christianity, or Judaism—is not alone in making value judgments about the purpose of life and what is right and wrong. He asserted that finance does the same and that  underlying value judgments are responsible for setting the direction of finance.

El Diwany believes that it is a value judgment that the sole job of those managing a company is to maximize shareholders’ wealth, and that money is the sole measure of value. He stated that because of this underlying value judgment, important intangible considerations—such as happiness—are conspicuous by their absence in the financial statements and decisions of corporations.

Because finance makes value judgments, it is similar to a religion, even if it is not perceived this way. “Once we recognize that finance is making value judgments,” says El Diwany, “the question is no longer whether religion should interfere in finance but rather which religion are you going to choose.”

El Diwany said that the belief that one is accountable to God can be a far more powerful regulator of human conduct in finance than any financial services regulator. He suggested that because of this belief, decision choices with higher Net Present Value (NPV) but an adverse impact on society and the environment, cannot be chosen over those with lower NPV but with benefits to society and the environment.

El Diwany explained that Islam prohibits certain means of transfer of wealth, such as gambling and lending money on interest. He emphasized that because lending money on interest is driven by collateral, lenders channel financing to those who can furnish the collateral. This, he contends, increases economic inequality and if the borrower fails to pay back the loan the lender is likely to pursue the payments even at the cost of ending the business of the borrower.

According to El Diwany, profit sharing arrangements, where the business and not collateral drives financing, those sharing profits are more likely to work together to keep the business afloat.

El Diwany highlighted that in the current financial system, which favors debt and provides it at a lower required rate of return than equity, thus substantially reduces the appeal of profit sharing arrangements for the business professionals.

Tarek El Diwany speaking at the CFA Institute Middle East Investment ConferenceEl Diwany stressed that fractional reserve banking is proliferating collateralized lending. He said that it would be considered fraud if a builder sold the same house to five different buyers but by using money multiplier, commercial banks lend far beyond the funds they possess to many different borrowers. This sets up a monetary system that is inherently unstable, as demonstrated by the banking crisis and government bailouts.

El Diwany believes that leveraging through collateralized lending also helps the resourceful to buy the competition and defeat the market mechanism. He gave the example of a UK shopping mall where stores perceived as competing by shoppers are in fact owned by the same entity.

He was critical of the modern practice of Islamic Finance for not pursuing profit sharing arrangements and using debt based financing, particularly through controversial modes such as tawarruq. He strongly favored financing arrangements that are based on sharing of risks and rewards among the contracting parties for a variety of purposes, be it home financing, capital equipment leasing, or production financing.

A key aspect of El Diwany’s thinking is the fundamental reform of the current monetary system by switching to commodity money—which he described as a tradition in Islam—and putting an end to the creation of money by private enterprise. The cost of ending creation of money by the banking system, argued Tarek, bears no comparison to the colossal cost of bank bailouts.

To show that people have long been raising their voice against the current monetary system, regardless of their religious affiliation, he shared this quote by American inventor and businessman, Thomas Edison: “If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good makes the bill good … It is absurd to say that our country can issue $30,000,000 in bonds and not $30,000,000 in currency. Both are promises to pay; but one promise fattens the usurer, and the other helps the people.” (Thomas Edison quoted in The New York Times, December 1921)

He asserted that following strict interpretation of prohibitions in Islamic Finance should not have negative implications on performance, and gave the example of strong performance of Market Eye, an unleveraged theoretical portfolio of commodities and currencies, which he started in 2002.

El Diwany’s key message was that the core value proposition of Islamic Finance is to bring ethics to the center of finance and when this is achieved, everyone, regardless of their faith, stands to gain from better resource allocation, more financial stability, and greater peace of mind.

You can also read our pre-conference blog on Tarek El Diwany’s views on Islamic Finance and watch our collection of multimedia on Islamic Finance and ESG Investing.

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2 Responses to Islamic Finance: Bringing Ethics to the Center of Finance

  1. Very thought provoking article.

  2. Prasad says:

    So now, religion can be a regulatory framework. Instead of relying on external frameworks which take time to adapt and finetune (Dodd-Frank, Basel, etc) … now are we going back to the old ways of relying on religion and messiahs to show us the way forward?

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