Ethical Dimensions of Islamic Finance

Discussing the role of morals and ethics in economics and finance is not new but several developments including the financial crisis of 2007–2008 and its aftermath have led to a debate about the need to consider the role of ethics and morality in the economic and financial workings of contemporary capitalism. Financial scandals, crimes, and unethical practices by financial institutions leading to financial repression are being noticed and the moral failure of capitalism is being discussed. Gradually, attention is being paid to the most fundamental change—the erosion of morality. In addition, repeated failure of governance, regulations, and accountability are considered a sign of deteriorating ethics in financial markets. Finally, new evidence is emerging on a widening gap in income and wealth, and reduced opportunities for the poor to share growth and prosperity, which raises ethical questions. All these developments call for a deeper understanding of the strong roots of ethics in finance, which has been mostly ignored by mainstream research.

This chapter follows up on two major explanations of unethical behavior in the business community. The first focuses on the massive cultural changes originating from the rapid technological growth and globalization of the last few decades that have led to moral disorientation. The second view suggests there is a need for reorientation of education and practices of the business community toward morality and ethics. Before a theory of business ethics can be developed, it is critical to form a perspective of a moral sense which can provide philosophical basis for ethical behavior. What values determine the moral sense and how it affects economic and business behavior is essential to understand. The chapter provides such perspective from the history of economics and raises the question if a universal moral principle can be derived to formulate a theory of business ethics. The validity and applicability of the golden rule is evaluated and it is argued that this rule as a universal principle should become the basis of business ethics.

A framework of business ethics in Islam can be developed by identifying key virtues that are the preferred character traits of a human being. This chapter discusses select virtues that have direct implications on any economic, social, business, or financial activity such that a decision taken in light of such virtues would be ethical. By embracing and living the virtues and avoiding vices, an ethical economic and financial system could emerge that is just as well as efficient. Key virtues such as recognition of the unity of creation, striving for justice, preservation of rights, sanctity of contracts, truthfulness, and trustworthiness form the foundation of theory of ethics in Islam. The emphasis is on the internalization of these virtues such that the resultant economic and financial system optimizes the social and economic welfare of the society.

Discussion on business ethics in Islam is not new; it has been dealt with extensively since the early history of Islam, but the discussion mainly took place while developing principles underlying legal axioms. Virtues of justice, truthfulness, and benevolence were identified as the main ethical values that must be internalized by agents in any business transactions. This chapter builds on these core virtues and character traits desirable in a human being in the Islamic perspective, which lay the foundation of defining business ethics. The internalization and actual realization of these virtues in day-to-day social and economic matters would ensure that decisions and actions taken lead to ethical practices. For example, internalization of core virtues such as the realization of the unity of creation, justice, and protection of rights would lead to ethical business practices in all cycles of business starting from production to consumption to distribution. In addition, core virtues would determine market conduct rules to promote transparent and just markets void of malpractices.

Having developed a framework of virtues and business ethics in previous chapters, this chapter discusses the application of the ethical framework to Islamic economics and finance. An in-depth analysis of risk sharing, materiality, social and economic justice, and governance aspects of Islamic economics and finance are provided, arguing that such a framework provides rich ethical standards and ensures finance that is responsible and good for the society. Ethics are embedded in the core principles of Islam and each rule prescribed has explicit or implicit ethical dimensions reflecting its adherence to core values and virtues. The chapter discusses the ethical dimensions of risk-sharing finance and highlights various features of Islamic finance such as materiality, anti-fragility, stability, economic justice, and redistributive justice. These features address several ethical issues prevailing in global financial systems.

This chapter argues that risk-sharing finance’s features of anti-fragility and a de-leveraged economy would lead to a stable financial system that would lead to just and equitable allocation and distribution of resources in an economy. Risk-sharing finance has the potential to enhance efficiency as each party to contracts has “skin-in-the-game,” thus eliminating or minimizing the principal–agent problem. In doing so, it can minimize monitoring, supervisory, and disciplinary costs, leading to efficiency gains. As a result, participants in a contract of an economic undertaking can choose higher risk–higher return projects and thus increase the efficiency and productivity of the system. Risk sharing can also create a reciprocal and trusting environment that strengthens social cohesion, promotes social mobility, and reduces income inequality without perverse incentive effects and resentments.

Growing disparity in income distribution despite healthy growth and deteriorating opportunities for lower segments of the society has raised awareness of the importance of ethical and responsible finance for sustainable development. Whereas ethical finance calls for fundamental change in the prevailing thinking of approaches in development, responsible finance asks for how financial services should be delivered to live up to the challenge of promoting sustainable development such that the work must incorporate social, developmental, and environmental dimensions. In other words, how the financial sector could be made responsible for the fair treatment of end-clients and in ways that protect clients’ social and economic welfare. Ethical and responsible finance could play an important role in economic development, poverty reduction, and sharing of prosperity. Generally, when financial systems are more responsible and equitable in allocating resources among all members of the population in a way that does not create economic imbalances, there is greater equity of opportunity for entrepreneurship, education, and quality of life.