Does Islamic finance have a responsibility to reduce unemployment

There is a buzz about the prospects for Islamic finance in parts of the Middle East and North Africa region (MENA). News reports are suggesting that as a consequence of change in public policy, the market share of Islamic banking in Egypt will grow to “35 per cent in five years from 5 per cent now”. Much attention in Islamic finance circles is also falling on the relatively smaller markets, such as Oman and Morocco. Observers, such as researchers from Credit Suisse, are also pointing to Islamic finance as a potential source of spurring economic growth in the Arab Spring countries.

A question arising out of all this buzz is this: Will the rise of Islamic finance address the problem of high unemployment among the Arab youth?

The economic literature on MENA tends to see unemployment as the region’s greatest challenge. It is difficult to exaggerate its scale and socio-economic implications. According to Global Employment Trends 2011 by the International Labour Organisational youth unemployment in the MENA region is estimated to be 24.8 per cent compared to world average of 12.6 per cent.

It is frequently argued that job growth in MENA is best expected from high-growth small and medium sized enterprises (SMEs). According to research by the World Bank, these SMEs consider limited access to finance to be a significant constraint. The buzz about Islamic finance in building expectations that it could help tackle unemployment in MENA by doing things like financing the under-financed SMEs that will create jobs.

But is helping create more jobs a social responsibility of for-profit shareholder owned institutions offering Islamic financial services? Or does this responsibility only belong to others, such as the government and development financial institutions?

The issue is not ‘can Islamic finance solve MENA’s unemployment problem?’ It cannot. Even governments are finding the challenge overwhelming and Islamic finance is but a niche within the financial sector. The question is whether the Islamic finance sector should consciously attempt to contribute to tackling unemployment as part of its business strategy rather than a byproduct of its activities.

If you are a follower of the economist and Nobel laureate Milton Friedman, you will probably think that tackling unemployment is not the business of for-profit finance. According to Friedman, the social responsibility of business is to increase its profits, as he argued in his article published in the New York Times Magazine in 1970. Friedman’s core argument is simple and powerful: Management of for-profit shareholder-owned companies should do what these companies are meant to do — maximise profits for shareholders.

Friedman’s argument is often invoked in Islamic finance. In a recent blog, a London-based Islamic finance practitioner writes:

Islamic financial services providers, whether they are banks, Takaful operators, asset managers or real estate fund providers, are normally companies with shareholders. Accordingly their prime responsibility is to maximize shareholder value while conducting their operations in accordance with the requirements of their Shariah supervisory board. Consequently any expenditure by the Islamic financial services firms must be directed towards building their businesses either directly or indirectly.

A somewhat different view of corporate social responsibility (CSR) is taken by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), the Bahrain-based standard setter in Islamic finance. AAOIFI’s standard on CSR is not confined to simply acting responsibly while going about business as usual — a common notion of CSR — but goes far and deep into actively doing good. For instance, its “mandatory conduct” includes possible impact assessment of financing on economy, society, and environment while its recommended “voluntary conduct” includes assisting small and micro businesses.

Some of the messages coming out of Islamic financial institutions also suggest that they do not exist solely to maximize shareholder’s wealth. For instance, Kuwait Finance House (KFH), a prominent institution in Islamic financial sector, reports that in 2010, among other philanthropic activities, it donated USD 2 million for flood victims in Pakistan. Giving away such a sum to the poor in a country where KFH does not even operate is unlikely to increase the wealth of KFH’s shareholders, directly or indirectly.

AAOIFI CSR standard and philanthropy are materially different from some of the modern notions about CSR. For instance, in its 2011 Environmental, Social, and Governance (ESG) report, Goldman Sachs says “we define our social value by what we contribute to making markets robust and economies strong.” Such modern notions of the role of corporations in society are most likely to be seen as consistent with Friedman’s position of maximizing profits.

Should Islamic finance follow Friedman’s position or should it align itself with the social cause of tackling unemployment?

The answer to this question probably lies in how the term ‘Islamic’ in financial services is interpreted by the financial institutions, their stakeholders, and society. The term Islamic, just like other terms such as sustainable, responsible, or ethical used regularly in finance, do not mean the same thing to everyone.

To some, it may only mean avoiding financing to businesses built around ‘sins’ — like drinking alcohol and gambling — and giving lending the form of sales or leases while retaining its economic substance. This minimalist and form-oriented approach, while not uncommon, also explains much of the criticism that is frequently levelled at the industry. It is safe to assume that to others, particularly the enthusiasts of Islamic finance in MENA, the term Islamic means more. While what exactly is the “more” remains relatively fluid, AAOIFI’s standard on CSR, despite lacking regulatory power, helps us understand some of the expectations associated with it.

The institutions eager to capitalise on the renewed prospects of Islamic finance in parts of MENA will do well to clarify their position. Will they consciously channel financing to business and sectors, tacking unemployment, even if involves comprising some financial return? Or will these institutions invoke Friedman’s argument and only maximise profits because this is what they believe to be their reason for existence?

Both paths will have their challenges. Those wishing to address unemployment on a sustainable basis will probably need a clear mandate from their shareholders and account holders to do so. Those wishing to only maximise profits will probably find it hard to maintain support from policy makers and society.

It will be interesting to observe if and how far Islamic is willing to go beyond maximising shareholder’s wealth to tackle MENA’s unemployment challenges.

Usman Hayat, CFA, Director of Islamic Finance and ESG at CFA Institute.

http://gulfnews.com/business/banking/does-islamic-finance-have-a-responsibility-to-reduce-unemployment-1.1092049