We have previously explored the links between social finance and Islamic finance; here, we explore Islamic finance claims of social impact. Part 1 examines the model; Part 2 lists a few examples of Islamic finance being used to produce social benefits.

What is the scale of social benefits of Islamic finance? Can conventional social finance learn anything from its principles?

Islamic Finance derives its principles from the teachings of Islam. The religion does not consider business to be something that is impious or harmful to society. In fact, it considers business activity as necessary and virtuous for its followers. Nor does it consider profit-making as something that is detrimental to human society. The main distinction between Islamic economic theory and mainstream economics lies in the fact that in Islam, the profit motive does not reign supreme and private owners are not given unrestrained power to make economic decisions. Islam also places certain restrictions on economic activities. All these prohibitions, combined, aim to create an egalitarian society with socio-economic justice and equitable distribution of wealth.

In addition, Islam places strong emphasis on the principle that profits should not:

• be achieved through the production of inessential or impermissible goods (for example, gambling or tobacco)
• involve excessive and wasteful use of scarce resources, and
• harm the social and physical environment of the society.

Hence, one of the objectives of business in an Islamic economic framework is an optimal profit appropriately weighted against all the relevant implications.

Contrary to the popular belief that Islamic finance has failed to deliver social benefits, the industry has performed a lot better than its conventional peers. The criticism primarily stems from the apparent similarity between the transactions carried out by Islamic financial institutions and their conventional counterparts. This criticism not only ignores the underlying processes, which form the core of an Islamic financial transaction, but also ignores the scale at which the Islamic financial institutions are currently operating.

Despite tremendous growth during the last decade, Islamic Finance still commands a very small share of the world’s financial markets. Hence, due to the small magnitude of the social impact, the benefits of Islamic financial transactions largely remain unnoticed. Also, Islamic banks and financial institutions are not usually supported by the legal and tax systems and central banks of their respective countries, leading to a loss of benefits due to regulatory constraints.

One of the most important characteristics of Islamic financing is that financing is asset-backed. The conventional concept of financing is that the banks deal in money and monetary papers only. In Islam, money has no intrinsic value and hence cannot be treated as the subject-matter of trade. It is just a medium of exchange. Islamic financing is always based on tangible assets and inventories, unlike its conventional counterparts.

Hence, all financial transactions are accompanied by an underlying productive activity due to which genuine trade transaction occur, eliminating speculation and preventing debt levels from rising far above the size of the real economy. It also releases a greater volume of financial resources for the real sector expanding employment opportunities and the production of need-fulfilling goods and services. This creates a society which is theoretically more resilient and robust against adverse economic shocks.

Some information for this post was taken from An Introduction to Islamic Finance by Muhammad Taqi Usmani (2007)

Photo credit: http://www.flickr.com/photos/cottonm/2483549347/

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