How to Upscale your Social Economy into a Trillion Dollar Global Market. The Convergence Paradox of Islamic Finance

This is part of a series of think pieces by scholars and practitioners working on a broad range of issues within the field of Social and Solidarity Economy. The series is being published in conjunction with the UNRISD conference “Potential and Limits of Social and Solidarity Economy”. The conference took place on 6-8 May 2013 in collaboration with the International Labour Organization and the UN Non-Governmental Liaison Service.

The contemporary Islamic banking and finance industry provides a radical critique of finance as currently practiced. In spite of this moral stance, Islamic finance has expanded in a few short decades into a trillion dollar global market. Perhaps surprisingly, many Islamic finance products have converged in both quality and price with their conventional counterparts so that they have become outwardly identical. This convergence paradox has led critics to accuse banks of cynically marketing conventional financial products as Islamic. This research paints a subtler story. I have identified four social mechanisms that have contributed not only to Islamic finance’s economic upscaling, but have also contributed to its rapid convergence with the conventional sector. For proponents of social and solidarity economies, Islamic finance is an instructive cautionary tale of how to use the engine of capitalist innovation to upscale rapidly.

Aaron Z. Pitluck is an economic sociologist, Associate Professor of Sociology at Illinois State University, and a faculty member affiliated with the Stevenson Center for Community and Economic Development. His two fields of expertise are finance and moralizing markets. He has conducted research in an influential housing cooperative, in Islamic investment banks, and throughout the Malaysian finance industry.

The radical intent of Islamic finance

Islamic finance is unusual in the depth and sophistication of its radical critique of the conventional market with which it competes. Islamic finance prohibits riba—roughly understood as making money from money without entrepreneurial risk. Ideally, Islamic banks must tether all financial investment to real economic activity and forgo speculation in financial markets—an ideal not dissimilar from social banking. In contrast, conventional financial theory celebrates financial capitalists seeking speculative arbitrage, and argues that such profit seeking improves the accuracy of prices.

Islamic finance also prohibits gharar—transactions that are gambling-like in character or that involve the exploitation of superior information. In contrast, conventional bankers argue that risk is a product that can be traded like any other, and that speculation directs capital to its most productive uses.

Islamic finance also necessitates fairness between transacting parties. In contrast, finance practitioners celebrate the principle of caveat emptor (literally, “buyer beware”) to be exercised by sophisticated financiers, arguing for the social benefit of allowing self-interested parties to pursue hard negotiations with one another.

Finally, Islamic finance insists on integrating religious and ethical imperatives in daily economic life. For example, it requires that the firms and projects it finances conform to an Islamic-inflected form of corporate social responsibility. Often, Islamic banking is also a form of religious and cultural expression.

As a consequence of this radical critique, numerous banking practices that pervade the conventional industry are usually prohibited in Islamic finance, including profiting from interest, the trading of speculative derivatives, the exploitation of information asymmetries, and financing projects perceived as harmful to the Islamic community.

Interpreting riba, gharar, and fairness in contemporary banking products and services is not straightforward. Therefore, what distinguishes Islamic from conventional finance remains passionately contested, both within countries and internationally. These controversies are fuelled in part by the geographic diversity in how Islam is practiced and how communities interpret the Sharia (divine law). More problematically, public scepticism is easily inflamed by the opaque decision-making within Islamic financial firms coupled with poor external auditing, particularly in West Asia (the Middle East).

Viewed through the lens of the social and solidarity economy paradigm (see Utting 2013 and Arnsperger 2013), I suspect that many readers would perceive Islamic finance as decidedly less radical. Islamic banks are not paragons of workplace democracy—they are typically hierarchical, profit-oriented public corporations accountable to shareholders rather than other stakeholders. Moreover, Islamic finance rarely incorporates social safety nets in its products, or concerns itself with the environmental sustainability of the projects it finances. Islamic banks also have a mixed record with regard to women’s empowerment. Yet there are certainly many voices advocating that Islamic finance should pursue a social and solidarity economy paradigm, such as Mahmoud El-Gamal and Mehmet Asutay.

While it is controversial whether Islamic finance could be understood as a kind of social and solidarity economy, I argue below that the case nevertheless has much to teach us about the potential benefits and dangers for upscaling such economies.

Four social mechanisms promote the convergence paradox

Drawing on the best-practice case of Malaysia, I have identified four social mechanisms that have harnessed entrepreneurship and capital to rapidly expand Islamic finance into a global, trillion dollar market. However, these same social forces simultaneously mould Islamic finance to increasingly resemble the very industry that it scorns. I call this the convergence paradox. By viewing Islamic finance as subject to these four social forces, we may be able to understand how an industry with such radical intent could nevertheless grow to strongly resemble the conventional finance industry.

This argument is drawn from ethnographic research that I have been conducting in Islamic investment banks and the scholarship of two influential organizational sociologists, Paul DiMaggio and Woody Powell.

1. Competitive Convergence
The most readily acknowledged of the four mechanisms is efficiency-based rationality. The winnowing effects of market competition, combined with firms’ emulation of existing best practices, combine to push Islamic banks to offer a similar portfolio of products as their conventional competitors. This is an evolutionary argument in which organizations survive by efficiently adapting to fit an environmental niche.

Islamic finance competes with conventional finance by creating such a market niche. It distinguishes itself as having superior morality, by identifying with Islam, and by harnessing referrals from charismatic religious and community leaders.

In each market, we can imagine a “moral premium” in which clients are willing to forego a degree of quality and pay higher prices for the opportunity to participate in Islamic finance. In markets where this premium is high and stable, Islamic banks can afford to offer distinctive products even when they are not as cost-effective as conventional financial products. In all markets, competition drives the “moral premium” to decrease over time. If the niche is profitable, we observe increasing competition among banks to enter this moralizing market niche, thereby reducing the moral premium that clients are willing to pay. If the niche is unprofitable, existing Islamic banks will desperately seek to appeal to clients to increase the moral premium—however such appeals have limitations and grow tiring over time. Ultimately, Islamic banks facing the existential requirement of survival will attempt to mimic their more successful competitors, including their conventional competitors.

In social and solidarity economies, we often observe firms seeking to appeal to clients to pay a moral premium—either by forgoing quality or paying higher prices—so as to support the market niche. Such premiums are invaluable in insulating social enterprises from market competition. However, such appeals may be insufficient for economic survival, or the premiums may be too volatile. Under such circumstances, the case of Islamic finance suggests that we should expect such social economies to grow increasingly similar to the conventional sector as they rationalize their operations and attempt to cut costs. Market competition forces social enterprises to rationalize and thereby converge with the very industry from which they seek to distinguish themselves.

The remaining three social forces that jointly explain the convergence paradox are not premised on a highly competitive market and do not require a low and stable “moral premium.” Most distinctive of all, the remaining three social forces are efficiency-neutral—they may enhance or erode the Islamic banks’ bureaucratic capacity to efficiently provide social services, maximize profits or lower costs.

2. Mimetic convergence
The second social force that produces the convergence paradox is the strategy of imitation. Because of uncertainty and risk aversion, organizations imitate—with minor variations—preexisting products and organizations. Two common sources of uncertainty are the social enterprises’ clients, and contradictions between internal and external gatekeepers (particularly regulators).

Consider the uncertainty generated by clients in Islamic finance. As a new industry, there is a great deal of uncertainty regarding what clients want an Islamic financial product to look like. After all, clients’ knowledge of financial markets is shaped by their experience with the conventional banking sector, and this in turn shapes their expectations for niche markets, including the Islamic finance sector. One could make a similar argument with organic food. Prospective customers’ expectations of what organic food should look and taste like is shaped, in large part, by the preexisting food market with which organic produce competes. So uncertainty of clients’ demand is a mimetic force pushing Islamic finance to resemble conventional financial products.

A second source of uncertainty is the tension between the demands of internal and external gatekeepers. In Islamic finance, new Islamic financial products must meet the requirements of two kinds of gatekeepers with very different criteria: the firm’s internal Sharia scholars, and the external market regulators. Each financial product must be crafted so that it satisfies the internal Sharia scholars who evaluate whether bank products and practices are compliant with Islam. Each innovation must also meet the requirements of external gatekeepers. Regardless of their sympathy or antipathy to the social enterprise or social movement, market regulators must use conventional market regulations as their yardstick for appraising the legality and safety of new products and services. These regulations have developed in a historic response to the interests and functional needs of the conventional market, and may conflict with the values and processes of the social enterprise.

Conflicting demands by these three parties also generate uncertainty for social enterprises. To satisfy external gatekeepers—as well as customers who use the conventional market as their reference point—organizations strategically mimic the conventional products and only deviate insofar as it is necessary to satisfy their internal gatekeepers. While such a strategy may allow for the rapid expansion of the social economy, it also produces a rapid convergence with the conventional market so that their products bear a strong superficial resemblance to their conventional competitors.

3. Coercive Convergence
Social enterprises are dependent on other organizations and institutions for economic resources, political legitimacy, or for status. It is not uncommon for these parties to require, persuade, or invite social enterprises to increasingly resemble their conventional competitors.

Probably the strongest such structure forcing Islamic financial organizations and products to resemble those in the conventional sector is a secular legal system that has co-evolved with an interest-based financial services industry. Each country’s existing regulatory structure and legal precedent therefore poses unique challenges for Islamic finance both to exist and to maintain its distinctiveness. States, self-regulatory authorities, and civil watchdog groups make numerous legal and technical requirements of financial institutions that may be ill-suited to Islamic banks. Equally problematic, Islamic banks have distinctive needs—such as transparently and credibly demonstrating that they are complying with religious requirements—that are entirely overlooked by the established regulatory and monitoring authorities. The social mechanism of coercive convergence pushes Islamic finance to very closely resemble conventional financial products.

4. Professional Convergence
When social enterprises hire professionals—as they often must—the new employees are Trojan horses promoting convergence from within the organization. Professionals are distinguished from other employees by their collective struggle to control their work practices. To gain, maintain and legitimize such workplace autonomy, professionals typically develop an occupational knowledge base. Social enterprises benefit when they hire professionals because it allows them to tap into established industry-wide education and training systems, professional industry associations, as well as preexisting cross-organization career ladders. However, hired professionals also exert potentially conflicting normative pressure, as their body of expertise may conflict with the knowledge, beliefs and practices that make the social enterprise distinctive from the larger conventional market.

In the early decades of the Islamic finance industry, in university and professional training, all investment bankers were inculcated with expertise in conventional finance, and this was reinforced inside investment banks by on-the-job socialization and career ladders. The social force of professionalization is alleviated in some countries as Islamic finance has developed its own on-the-job training in Islamic investment banks, and as post-secondary education institutions have promoted Islamic finance certificates, coursework and some degree programmes. Nevertheless, even in Malaysia, where such training in the public and private sector is rather mature, the bulk of investment bankers’ training is in conventional finance, and this approach to solving problems, with its related ontological view of the world, is deeply embedded in the professionalization of investment bankers.

When social enterprises hire professionals (no matter how dedicated the hired individuals may be to the organizations’ distinctive values), the organization is in effect staffing itself with individuals with conflicting values—those of the organization and those of their profession. A potential consequence of these conflicting interests is a persistent pressure from within the organization to resemble the profession’s perceived best practices, typically of their conventional competitors.

What can be done?

The case of Islamic finance provides a vivid illustration of the promise and dangers that many movements face in developing a social and solidarity economy. How can we tap into the growth and dynamism of conventional capitalist markets and preserve the radical intent of deliberately low-profit endeavours? While we are unlikely to find a simple answer to such a question, the four social forces I have outlined may provide readers with a theoretical lens through which to understand the strategic challenge of upscaling social enterprises while resisting the convergence paradox.
 
REFERENCES
Anrsperger, Christian. 2013. Want to really help expand Social and Solidarity economy? Then start rethinking money! Geneva: United Nations Research Institute for Social Development.

Asutay, Mehmet. 2012. "Conceptualising and Locating the Social Failure of Islamic Finance: Aspirations of Islamic Moral Economy vs. the Realities of Islamic Finance." Asian and African Area Studies 11(2):93-113.

DiMaggio, Paul and Walter W. Powell. 1983. "The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields." American Sociological Review 48(2):147-60.

El-Gamal, Mahmoud A. 2006. Islamic Finance: Law, Economics, and Practice. Cambridge and New York: Cambridge University Press.

Fourcade, Marion and Kieran Healy. 2007. "Moral Views of Market Society." Annual Review of Sociology 33:285-311.

Pitluck, Aaron Z. 2008. “Moral Behavior in Stock Markets: Islamic Finance and Socially Responsible Investment.” In Economics and Morality: Anthropological Approaches, edited by K. E. Browne and B. L. Milgram, 233-255. Lanham: AltaMira Press, Rowman & Littlefield Publishers. Available at SSRN.

Pitluck, Aaron Z. 2012. "Islamic Banking and Finance: Alternative or Façade?" In The Oxford Handbook of the Sociology of Finance, edited by K. Knorr Cetina and A. Preda, 431-49. Oxford: Oxford University Press. Copy available from author.

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Warde, Ibrahim. 2010. Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press.