Practical analysis for investment professionals
21 August 2012

Arab Spring and Milton Friedman: Is Reducing MENA’s Unemployment a Social Responsibility of Islamic Finance?

Posted In: Economics

There is buzz about the prospects for Islamic finance in parts of the Middle East and North Africa region (MENA) impacted by the Arab Spring. News reports suggest 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, including Oman and Morocco. Observers, including researchers from Credit Suisse, are also pointing to Islamic finance as a potential spur to economic growth in the Arab Spring countries.

A question arises out of all this buzz: Will the rise of Islamic finance address the problem of high unemployment among the Arab youth? After all, it is the Arab Spring that has created this shift in public policy in favor of Islamic finance.

The economic literature on MENA tends to see unemployment as the region’s greatest challenge. It is difficult to exaggerate its scale and socioeconomic implications. According to Global Employment Trends 2011 by the International Labor Organization, youth unemployment in the MENA region is estimated at 24.8% compared to the world average of 12.6%.

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 is building expectations that it could help tackle unemployment in MENA by doing things, like financing the underfinanced 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 finance institutions?

The issue is not, “Can Islamic finance solve MENA’s unemployment problem?” It cannot. Even the governments are finding the challenge overwhelming, and Islamic finance is but a niche within the financial sector. The issue is whether the Islamic finance sector should consciously attempt to contribute to tackling unemployment, to a reasonable extent, as part of its business strategy rather than as a by-product of its activities.

Why are such expectations of actively doing good for society not automatically triggered by conventional finance? That’s because conventional finance does not associate itself with a moral purpose, at least not explicitly and not to the same extent. Where conventional finance also uses terms like “ethical” or “community banking,” it is faced with similar expectations — an implicit social contract between finance and society.

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, conventional or Islamic. According to Friedman, the social responsibility of business is to increase its profits, as he argued in an 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 — maximize profits for shareholders.

Friedman’s argument is often invoked in Islamic finance. In a recent blog post, 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. The 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 deeper into actively doing good as well as avoiding harm. For instance, its “mandatory conduct” includes impact assessments of financing on the 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 the Islamic financial sector, reports that in 2010, among other philanthropic activities, it donated US$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.

The AAOIFI’s CSR standard and philanthropy are materially different from some of the modern notions about CSR. For instance, in its “2011 Environmental, Social and Governance 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 will likely 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” is interpreted by the financial institutions, their stakeholders, and the society. The term Islamic, just like other terms regularly used in finance — such as sustainable, responsible, or ethical — does not mean the same thing to everyone! To some, it may only mean avoiding financing 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 leveled 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 that “more” is remains amorphous, the AAOIFI’s standard on CSR, despite lacking regulatory power, helps us understand some of the expectations associated with it.

The institutions eager to capitalize on the renewed prospects of Islamic finance in parts of MENA will do well to clarify their position. Will they consciously channel financing to such sectors as SMEs to align with the social cause of tacking unemployment, even if it involves compromising some financial return? Or will these institutions invoke Friedman’s argument and only maximize profits because this is what they believe to be their raison d’être?

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 maximize profits while using the term Islamic will probably find it hard to maintain support from policymakers and society, because conventional finance is  already maximizing profits.

Against the backdrop of the Arab Spring, it will be interesting to observe if and how far Islamic is willing to go beyond maximizing shareholder’s wealth to tackle MENA’s unemployment.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

4 thoughts on “Arab Spring and Milton Friedman: Is Reducing MENA’s Unemployment a Social Responsibility of Islamic Finance?”

  1. Doug Hadden says:

    The CSR business opportunity is to develop a customer base that can be sustained. Unemployment doesn’t bring economic growth so wise financial institutions must operate accordingly. The Arab Spring taught many of us that it is not possible to hide unethical behaviour. In this transparent age, CSR is no longer a luxury.

  2. Rahim says:

    An excellent and very well-written article.

    It is interesting to note your assessment on CSR. As you rightly say, AAOIFI mention in its Governance Standards for Islamic Financial Institutions No.7 (standard 5/2/1) that as part of mandatory conduct, ‘IFIs shall implement a CSR policy for screening prospective clients. This policy must include: (a) Screening criteria…’

    The question is what is the screening criteria and does it go far enough to ensure the welfare of society? AAOIFI recommend that ‘The policy stipulating the screening criteria may include provisions for…review of the impact of the prospective client’s investment on the economy, society and the environment.’ This can shed the spotlight on IFIs contribution to CSR; however, the phrase ‘may include’ makes this a recommendation rather that a mandatory requirement. Perhaps this should become mandatory as part of the shari’ah audit? Or perhaps there is scope for a rating agency to be developed that can undertake such an analysis?

  3. Radouane says:

    It is a very good article!
    In my opinion, the islamic finance could be a great solution to decrease the unemployement in the MENA region (and particularly in the NA). As you say there are many SMEs in these countries, because many entrepreneurs today don’t have a shari’a compliant financial market that allow them to grow their businesses. In this case the islamic finance may be a solution to both make profit for shareholders and hiring more people for society!

    Many Thanks

  4. Doug Hadden, Rahim, Radouane

    Thank you for reading this blog and leaving your comments! Much appreciated.

    I think a lot more needs to be done regarding Islamic finance and CSR. There have also been some research studies on this subject, although their findings tend to be conflicting. There seems to be a gap between expectations and reality.

    Regards

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