What can Sukuk learn from Social Impact Bonds in the context of COVID crisis?

Rami Abdelkafi

22 Nov, 2021

Beyond the lack of financial resources, delivery failures are among the main causes of poor public services in developing countries. The incapacity of states in developing countries to perform and to complete  tasks entrusted to them is what Andrews et al. (2016) termed  as “capability trap”.  Their study shows that most developing countries suffer from weak capability states, and out of a sample of 102 developing countries, only 3 would be able to build strong delivery capacity for basic services by the end of the 21st century (Gungadurdoss, 2021).

Driven by this context of state failure and by the ongoing pressures on public spending in developing countries, the last decade has witnessed an increasing interest in Results-Based Financing (RBF) or Outcome-Based Financing (OBF) to achieve the Sustainable Development Goals (SDGs). Embraced by development institutions, like the World Bank and other multilateral and bilateral institutions, the objective of the RBF approach is to achieve measurable social targets (Instiglio, Lopez, J. A. 2018). Compared with traditional financing, RBF is intended to pay for the achieved results. While traditional financing serves to pay for inputs and activities, RBF remunerates the success in achieving measurable outcomes.

Social Impact Bonds (SIB) are one of the most common instruments under the RBF approach. In the last decade, the use of SIB has been increasing and more studies have been conducted to assess the different experiences of using these instruments in developed as well as developing countries (Fichera & al. 2021, Gungadurdoss, 2021, Lopez Taylor and Bode (2021), https://golab.bsg.ox.ac.uk/the-basics/impact-bonds/). SIB involve investors, especially from the private sector, who are interested in achieving a double dividend by contributing to measurable positive social, economic or environmental objectives and at the same time earning returns on the invested funds (Broccardo & al. 2019). The government represents the outcome payer for these services. However, what differentiates SIB from conventional contracts is the fact that this payment is contingent upon the materialization of the pre-defined outcomes that the government wants to achieve.

By design, SIB bring together three key partners (Carter & al., 2018): the outcome payer, the service provider, and investors. In practice, the interaction between these partners can be complex and involves other actors that will provide the necessary technical and legal expertise. A basic SIB structure can be found in Gustafsson-Wright et al. (2015) as presented in Figure 1.

In practice, the results of using SIB are mixed and their success remain in some cases not guaranteed (Maier et al. 2018). However, there is a consensus that SIB should be treated as a tool to bring together public efforts and private investors to achieve social objectives. These SIB are considered as a strategy that would create an opportunity to investors to give back to the society while earning financial returns from their investments.

Interest in SIB has increased with the pandemic and with the impact it has had on the society. Research on the SIB approach has focused on two aspects. First, on the impact the pandemic could have had on the ongoing SIB (Gustafsson-Wright, 2020, CORDAID, 2020, Costanza, 2020). Second, on how SIB could be an efficient approach to overcome the challenges imposed by the pandemic, especially on public financial resources (Gungadurdoss, 2021, Hassan et al., 2020, Séra, 2020).

From an Islamic finance point of view, the SIB approach could be attractive for at least three reasons. First, the focus of SIB on social benefits reminds of the overlap between the objectives of Islamic finance and impact investing. In fact, the ultimate role of Islamic finance is to achieve tangible positive results aiming at enhancing the well-being of the society. This corroborates exactly with what socially responsible financing is trying to achieve. Second, by construction, SIB focus more on financing the delivery of specific social results. As mentioned above, these instruments finance the achieved outcome, rather than financing inputs and activities. From this perspective, SIB ensure the link that Islamic finance imposes between financing and real economy in any financial transactions. Third, the fact that return on investment is contingent on the achieved results matches perfectly with the Sharia principles governing financial transactions. Based on that, SIB constitute an interesting approach that Islamic finance researchers and practitioners should explore.

Recently, an increasing interest in SIB has been sensed among researchers in Islamic finance. From this perspective, bonds are replaced by Sukuk which can be issued for social impact purposes (Marwan et al. 2019, Marwan et al. 2020, Mohamad et al. 2017, Pasi et al. 2019). In many aspects, the proposed structures of Sukuk are like the ones using SIB. Nevertheless, despite the vibrant debate around SIB and their increasing role in the context of the pandemic, the potential role of Islamic finance is still to be explored. Islamic finance practice has not yet moved from its formalism to its main function. This is what Bälz (2010) calls the “formalist deadlock”, where the form has dominated the function of Islamic finance practices, leading to continuous efforts to mimic conventional instruments to give them an Islamic hue. In essence, Islamic finance should be oriented towards the achievement of developmental objectives. The use of Islamic modes of finance in place of interest is an important first step, but the real objective should remain attainment of the developmental results. In this context, the SIB experience during the actual crisis should serve as a lesson to Islamic finance practitioners to reorient Islamic finance towards its ultimate objective: economic development. 

The crisis related to the covid pandemic has enriched our understanding of results-based financing and has put forward the issues that may underpin the implementation of such mechanisms. In the same line, the interest of Islamic finance practitioners to use sukuk to achieve social objectives should be enriched and fine-tuned through the SIB experience. While conventional finance has the choice to abandon the use of SIB or to limit their use, and to replace them by an interest-based financing, in Islamic finance there is no option other than adopting an approach linking finance to the real economy. The use of sukuk should be explored further to see how they can contribute to economic development.

The pandemic crisis has shown that any strategy using results-based financing should predict the potential impacts of such a crisis on the delivery of the expected services. Gustafsson-Wright (2020) shows that the crisis had an impact on the delivery of services, as well as an impact on monitoring and evaluation in addition to the financial impact. Depending on the nature of the activities, the situations ranged from no impact at all to the extreme cases where services delivery, the monitoring and evaluation, and the outcomes were not achieved. In such circumstances, any results-based financing structure, including sukuk, should be flexible enough to consider the potential disruption in services delivery. The underlying contracts and structuring should allow for amendments and modifications to mitigate all potential risks.

Overall, the use of a strategy based on results-based financing would depend on the readiness of different stakeholders to bear a part of the underlying cost. The crisis impact on the ability of services providers to achieve the expected outcome would make investors more risk averse and more cautious about the transfer of risk from the outcome funder to them. In this context, a SIB strategy would be more efficient if the financial structure used allows for a shift from the initial targets to the new needs emerging due to the crisis. Furthermore, the governance structure, strong relationships, and problem-solving capacity that are built up though the design of the impact bonds provide an important safety net in a time of crisis Gustafsson-Wright (2020). All this makes a SIB strategy more efficient and more adaptable in a time of crisis.

Due to the immature experience with the use of RBF, SIB would continue to be considered more as grant-giving mechanism than as profit-seeking investments. A strategy based on SIB would be more attractive to maximize limited granted capital (Giacomantonio, 2017). Even in that case, Islamic finance is well equipped with the adapted tools, including Awqaf and sukuk, to tackle the emerging needs. More than ever, Islamic finance must be adapted to tackle real economic problems.   

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