The evolution of Malaysia’s Value-Based Intermediation shows a path for Islamic finance to embed responsible finance
- Malaysia’s new Financial Sector Blueprint outlines synergies of VBI with sustainable finance
- VBI has evolved to focus on environmental and social impact layered on top of a universal approach to sustainable finance
- Islamic financial institutions can build their own approach to responsible finance in order to stay competitive on ESG and climate risk and layer on a Shariah-inspired approach to achieve impact
Bank Negara Malaysia has released its Financial Sector Blueprint covering the 2022–2026 period, and it includes a focus on sustainable finance that is intertwined explicitly with the focus on Islamic finance. More than most Islamic markets, Malaysia has seen its responsible finance efforts emerge from initiatives within Islamic finance.
The mainstreaming of responsible finance in the current blueprint resolves one of the persistent questions that had come out of the Value-Based Intermediation initiative. If the environmental and social priorities that VBI brought to the fore were so relevant to Islamic financial institutions, and could impact their future successes, why wasn’t it adopted by the financial sector as a whole?
When the updated VBI Assessment Framework was released following a consultation in 2019, Bank Negara addressed this question in a feedback statement, noting that “consideration for impact-based risk management is critical to ensure a sustainable and resilient economy and hence financial stability [and] failure to address issues surrounding the environment, social and governance (ESG) risks would cause financial institutions to underestimate their risk position that could lead to increased financial vulnerability.”
In the Financial Sector Blueprint, this incongruity is addressed in the strategic priorities relating to Islamic finance where it outlines where there should be “a greater focus on opportunities [and] synergies with our efforts on climate and environmental risks — a key piece of the sustainable finance agenda”.
- This broadening of focus on ESG issues to the financial sector as a whole, especially on climate change, provides a clear strategy for how other Islamic markets can approach responsible finance:Provide a foundation of ESG integration and climate-related financial risk assessment and management linked into prudential regulatory frameworks
- Provide guidance for Islamic banks to prioritize specific sectoral issues (e.g., financing the halal sector) or towards developing impact-focused finance for environmental and social issues that are prioritized based on Shariah guidance.
Responsible finance has become mainstream across many more Islamic markets in the past 12–18 months. However, Islamic finance has lagged somewhat in that mainstreaming process. Part of that may be due to the challenge of the investment needed by financial institutions to integrate ESG and climate-related risks, which may favor larger institutions. But it may also arise if there’s not a clear separation of what Islamic financial institutions need to do uniquely on responsible finance and what can be achieved largely with the same approach that conventional peers (or parent) institutions take.
The development of the VBI framework in Malaysia has provided lessons that can be useful for Islamic finance in other countries. The challenges of developing an ESG integration strategy, or of creating a Net Zero target and pathway to achieve it, are big enough for any financial institution. Most Islamic financial institutions should focus first and foremost on keeping pace with the competition on ESG and climate-related financial risk assessment and management. Approaching the Shariah review of these efforts from a compliance perspective may be sufficient given the constraints they face in terms of resources and time, and how dynamically market practice is evolving.
An effort to define sustainable finance and ESG in terms of their connection to fulfilling Maqasid-linked goals in practice is a worthy exercise for leading institutions, though it may not be achievable for most other institutions. They instead might see general market practices in responsible finance as a disruptive threat (even if they are philosophically aligned with their ethical priorities). Responsible finance is complex, and that may favor large, institutional (and largely conventional) financial institutions that can devote more resources to implementing ESG data collection and analysis, especially with respect to climate change.
No financial institution can do everything itself, and will have to balance competing short- and long-term priorities. As a result, it will have to make hard choices about where to prioritize. For most Islamic financial institutions, that will involve taking a more conventionally oriented approach to ESG and climate change, where there are likely to be few challenges relating to Shariah compliance.
And then as efforts begin to align with market practice on ESG and climate risk management, Islamic financial institutions can develop an impact-focused approach around environmental or social impacts driven by their Shariah-aligned priorities. Much of responsible finance may have an alignment with Islamic finance principles.
However, it is not always easy to build an Islamic finance-inspired approach to responsible finance wholesale from first principles. It is also challenging for Islamic financial institutions to build an impact-oriented approach to responsible finance without already having some experience developing an approach that involves ESG and climate-related risk management. The journey that Malaysia has been on with VBI since 2017 — which has led to disbursement of RM 94.2 billion ($22.5 billion) of VBI-aligned financing — shows how a layered approach to ESG, climate risk management and Shariah-inspired impact can be effective.
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