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

Pakistan, where the Islamic banking industry commands only 7% of the market share, has a lot of examples to offer. Innovative strategies to provide best products with minimal risks have led to the development of financial structures, which are producing their own unique social benefits that were not previously thought of.

In Pakistan, Islamic banking assets have been growing at a faster pace than the overall banking system. The most important benefit these institutions have able to deliver is the inclusion of previously unbanked customers into the financial system. A number of customers in the country simply did not place their savings in banks due to religious reasons and preferred to keep their savings in different other forms of investment like property or gold. Hence, this money could not be used for any productive purpose. Islamic Finance Institutions have not only brought this money into the banking system but also have increased the access of financial services to an otherwise underserved group.

Under the principles of Islamic finance, a fixed penalty on late payment is considered Riba (interest) and thus impermissible. However, in order to discourage late payments, scholars have permitted Islamic banks to charge a specified amount to a charitable fund maintained by the bank from the customer. This amount cannot be treated as a part of earned income (as is the case in conventional banks). This has led to development of charitable accounts by Islamic banks, donating heavily in the education and health sectors.

For example, Meezan Bank Limited, the largest Islamic bank in Pakistan, spends its charitable dollars through its Ihsan Foundation. The Foundation provides merit- and need-based scholarships and interest-free loans to students in Pakistan’s top universities.

Similarly, HSBC Amanah collaborated with a charitable organization in Pakistan to initiate the Jaipur Artificial Limb Project in Karachi and Islamabad which provided artificial limbs to over 900 needy people (Social Responsibility Trends at Islamic Financial Institutions, 2010 [PDF]). The limbs which were made available in Pakistan from India’s famous JaipurFoot, are highly cost-effective (available for approximately $30) and can be fitted within hours.

Another example of social impact through Islamic finance is the world’s first charitable takaful (Islamic insurance) product developed by t’azur, which is based in Bahrain. The Sadaqah Plan helps donors save regular donations which the company invests in Islamic funds over a set number of years, after which the accumulated capital is passed to a charity of the donor’s choice. In the event of unforeseen circumstances that prevent donors from making charitable donations (e.g. disability or critical illness), the institution will continue on their their behalf, thus guaranteeing that the charity continues to receive the intended donation.

There are numerous examples similar to these, where Islamic finance is contributing towards the long term well being of the society. At present, Islamic financial institutions (IFIs) are quite far from the ideals recommended by Islamic financial theory. Currently, most IFIs are complying with Islamic finance rules only by avoiding impermissible activities such as avoiding interest-based transactions and investments in impermissible industries (alcohol, tobacco, gambling, etc) and using sales and lease-based modes of financing (murabahah, ijarah, salam, and istisna).

Even though IFIs are making good headway by developing products that consider both financial and social returns, there is a still a lot to be done. There is a need for IFIs to engage aggressively in equity-based and profit-and-loss sharing (PLS) modes of financing (Mudarabah and Musharakah) in projects and ventures so that the social benefits of Islamic finance can be fully realized. In developing countries, equity-based modes have great potential - especially in Agri-finance in rural areas and spurring entrepreneurship in the urban areas.

However, despite the fact that Islamic financial institutions have lagged in their focus towards these modes, they have still been able to generate a number of social benefits in the societies in which they are operating. As the Islamic financial system and the necessary supporting organizations develop, Islamic Finance may be able to deliver more wide-ranging social benefits.

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