hailey paul - microfinance and islamic finance[1]
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Paul HaileyMBA Sept. 2009HEC Social Business Certificate
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Microfinance and Islamic Finance: can they be reconciled and how
can they benefit one another?
Introduction
Our destiny is strongly linked to the destiny of the poorest. Microcredit is a macro idea. Thisis a big idea, an idea with vast potential. Whether we are talking about a rural area in SouthAsia or an inner-city in the US, micro credit is an invaluable tool in alleviating poverty.Microcredit projects can create a ripple effect - not only in lifting individuals out of povertyand moving mothers from welfareto work, but in creating jobs, promoting businesses andbuilding capital in depressed areas.1Hillary Clinton
The advent of microfinance is perhaps one of the most heralded innovations in modern
finance and the field of development. By lifting developing nation consumers out of
poverty, microfinance is seen as one of the most promising means of creating sustainable
growth in an area hitherto only served in a limited fashion by various aid programs.
Equally Islamic Finance might also be regarded as one of the finance sectors more
unusual developments in recent times. Y et the idea of basing financial products on
Shariaa law can be seen as not just another niche product, but the answer to the
requirements of millions of consumers who feel otherwise ill-served by conventional
finance.
Yet despite the fact that many of those countries in which Islamic Finance otherwise
flourishes contain millions of people living in poverty, microfinance has yet to be applied
to a significant extent. Recently the concept of Islamic microfinance has started to take
root, albeit mostly in three countries: Indonesia, Bangladesh (where the standard form of
microfinance has been in place for nearly forty years) and Afghanistan. However, outside
of this trio, it is a relatively unexplored concept, despite seventy-two percent of people
living in Muslim-majority countries not using formal financial services.2
1 Speech made at Microcredit Summit, 3rdFebruary 1997, Washington D.C..2Honohan, Patrick. 2007. Cross-Country Variations in Household Access to Financial Services.
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The aim of this work is to explore how microfinance and Islamic Finance might benefit
from one another, creating a model that can serve those consumers disenfranchised from
both conventional banking and the standard microfinance model. How can we bring some
of those seventy-two percent to the point where they can access capital and spark the
drive to entrepreneurship crucial to developing an economy?
Microfinance origins and overview
I did something that challenged the banking world. Conventional banks look for the rich; welook for the absolutely poor. All people are entrepreneurs, but many don't have the opportunityto find that out.3Muhammad Yunus
The intention of this work is not to give an in-depth and detailed look at the origins and
background of microfinance, nor to define its every triumph, setback, quirk and wrinkle.
Nevertheless, in order to understand the underlying hypothesis of this project that
Islamic Finance and Microfinance are not only compatible in many ways, but can both
have a significant impact on one anothers development and influence upon large swathes
of the developing world it is worth reexamining the origins of microfinance and the
thinking that led to models currently applied in cities and villages from Bolivia to
Bangladesh.
While microcredit in its modern form dates largely from the pioneering work of
Muhammad Yunus in Bangladesh, it can be argued that many of the concepts used in
microfinance overall can be dated back to the rise of credit unions and cooperatives in the
nineteenth century. Timothy Guinnane points to Germany in the 1850s, under the
influence of Hermann Schulze-Delitzsch and Friedrich Raiffeisen4, while Beatriz
Armendriz de Aghion and Jonathan Morduch also cite the rise in cooperatives in Great
Britain (often promoted by trade unions or evangelical churches) and thence in the British
Empire, where the Cooperative Credit Societies Act of 1904 led to the creation of several
3 Interview with Time magazine, 16th October 2006.4 Guinnane, Timothy, 2001, Delegated Monitors, Large and Small, the Development of GermanysBanking System, 1800-1914, pg. 24.
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such institutions throughout India, including Bengal, whose eastern part later became the
modern state of Bangladesh.5
Nevertheless, it was Yunus work in Bangladesh that established microcredit and
microfinance as recognized disciplines within finance; using lending to stimulate
entrepreneurship among the poor, Yunus was also providing a financial service to people
excluded from a banking system that was not interested in providing bank accounts or
loans, in relatively tiny amounts, to a population with little in the way of collateral.
Consequently, Grameen Bank now has eight million borrowers across 81,355 villages6,
while microfinance and microcredit are employed across the world, in both developed
and developing nations; microfinance has now grown to encompass a variety of productslinked to savings, transfers of funds and insurance (or microinsurance).
Islamic Finance origins and overview
O ye who believe! Devour not usury, doubled and multiplied; but fear Allah; that ye may[really] prosper. Quran, 3/130-1
It may seem more than a little obvious to point to the birth of Islam as one potential
starting point for Islamic Finance (although some theological scholars might even point
to Islams origins in Christianity, Judaism or Mithraism!), yet it is an appropriate place to
begin. The prophet Muhammad was born in Mecca around 570 A.D., and is thought to
have had received his first revelation from God at the age of forty. After meeting hostility
from many of the Meccan tribes for his beliefs, Muhammad and his followers moved to
Medina, where he united the tribes and returned to conquer Mecca eight years later. In
632, Muhammad died; subsequent leaders went on to found the Caliphate and spread the
rule of Islam throughout the Middle East and North Africa, leading to the Golden Age
between 750 and 1258.
However, Islamic Finance as a defined segment of banking is relatively young, dating
from the Mit Ghamr savings project established in Egypt by Dr Ahmad Elnaggar in 1963,
5 De Aghion, Beatriz Armendriz & Morduch, Jonathan, 2005, The Economics of Microfinance, pg. 69.6www.grameen-info.org
http://www.grameen-info.org/http://www.grameen-info.org/http://www.grameen-info.org/http://www.grameen-info.org/ -
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itself based on profit-sharing and applying certain concepts of the modern credit union
movement7. Elnaggar went on to establish the Islamic Development Bank in 1975,
providing development funds for member countries; subsequently the Islamic Finance
market grew quickly, especially in the Middle East and South-East Asia, and now
constitutes a rapidly growing segment of the financial services sector.
There is not sufficient time or space here to go into all the underlying principles of Islam
and Islamic Finance; instead, some of the key issues governing Islamic Finance are listed
below.
Riba (interest)
The concept of interest is one which is forbidden in Islam. The Quran states that God
has permitted trade and prohibited riba8; while Islam is happy with the idea of
speculative investment (in fact, investment is encouraged as a means to prevent hoarding,
another prohibited notion), the idea of earning money from money itself, rather than a
tangible commodity or asset, is completely forbidden. Needless to say, this is not just an
issue for microcredit, but also banking as a whole. The entire modern banking system is
based upon the concept of depositors loaning their savings to the bank for a small
amount of interest, and the bank loaning the money to creditors at a much higher rate. As
a result, the prohibition of riba has led to several significant structural changes to Islamic
Finance, which will be discussed later.
Gharar (risk, lit. deception)
The Quran and the Sunnah prohibit the idea of excessive risk, equating it with gambling.
However, some degree of risk is allowed, with the definition of gharar focusing more on
the idea of deception, whether through duplicitous business practices, or by using meanswhere the outcome is unclear or sufficiently uncertain. Agreeing a transaction with an
unspecified price, or deferring payment for an undefined time period are both considered
gharar. The above has significant implications for many of the instruments used in capital
7 Various authors, Islamic Finance Qualfication textbook, 2007, pg. 13.8 Quran, Surat Al Baqara, verse 275.
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markets; this is especially true with derivatives, the vast majority of which are
unacceptable under Islamic law, as they are often complex, leveraged products, which do
not represent a tangible object itself, but are merely linked to an objects price.
Haram (forbidden)
The concept of what is and isnt haram in Islamic Finance is not only applicable to which
instruments do and dont conform with the Shariaa; it is also applicable to the activities
which are being carried out by investors. For example, regardless of how the deal is
structured, it is haram to invest in a company that earns most of its revenue from sales of
alcoholic beverages, or gambling.
Zaqat (charity)
Zaqat is one of the five pillars of Islam, and as such is considered a critical element in the
life of every devout Muslim. All adult Muslims who are sane, healthy and earn above a
certain amount are obliged to give a certain percentage of their wealth (usually calculated
without including their house or means of transport) as zaqat, or charity. While this
amount is not specified in the Quran, it is usually set at around 2.5%.
Regulation and governance of Islamic Finance
Some Middle Eastern countries have gone as far as to adopt a dual-banking system, with
an Islamic banking system and a conventional banking system operating side by side. As
well as the IDB, several other international organizations have sprung up: the Accounting
and Auditing Organization for Islamic Financial Institutions (AAOIFI); the Islamic
Financial Services Board (IFSB), responsible for issuing global prudential standards and
guiding principles for the industry;9 and the International Islamic Rating Agency (IIRA),
which rates Islamic Finance institutions and instruments.
All of the above, as well as various other aspects of Islamic Finance, will be discussed in
greater detail in subsequent sections.
9www.ifsb.org
http://www.ifsb.org/http://www.ifsb.org/http://www.ifsb.org/http://www.ifsb.org/ -
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Microfinance structures
The great challenge before us is to address the constraints that exclude people from fullparticipation in the financial sector. Kofi Annan10
Once again, the intention of this work is not to give a detailed description of
microfinance, but rather of the potential synergies between microfinance and Islamic
Finance. Nevertheless, in order to arrive at this, we must briefly discuss the models used
in microfinance and microcredit.
Microcredit
As we discussed earlier, the classic model of microcredit is based on the idea of group-
lending. In the model used in Bangladesh, a loan officer for Grameen is responsible for
several villages; within each village, those wishing to borrow are divided into groups of
five. Funds are paid out to the first two members of the group; once those loans are paid
off completely, new loans are made to another two members, then to the remaining one
(usually the chairperson of the group), before returning to the pair again. Persistent
failure to meet repayments will mean that further loans are not distributed to that group.
Banks are thus able to overcome two of the major issues that had previously hindered
lending to the majority of those in developing nations: enforcement and risk profiles.
The issue of enforcement, given the lack of collateral, is critical within microfinance. The
group model creates a system of enforcement between members, as those who arent
paying off loans monitor, and sometimes even pay for, those who are, therefore allowing
the group access to the next round of loans. Pressure from peers within the group, and the
social stigma inflicted within the village as a whole (or social collateral, as it is
sometimes known) ensure a low rate of default that Grameen places at only 1.5%.
Furthermore, the bank is able to avoid the negative social impact (and bad publicity) of
trying to repossess the few assets that the borrower might have.
10 Comments made on the Year of Microfinance, 29th December 2003.
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Equally, the problem of assigning risk profiles would seem to be a critical issue for
microcredit. Unlike a conventional loan or mortgage, the returns on the money lent are
too small for the bank to perform in depth individual risk assessments. In fact, given the
lack of any banking infrastructure or, in many cases, up to date registers of property or
ownership, such risk assessments would be impossible to carry out. However, by creating
groups locally, members of the village will automatically group together with safer
investors. Even those members of the village investing in riskier projects should be able
to pay as a group: assuming that those investments that do pay off obtain a sufficiently
high level of revenue to cover the losses of others within the group, the odds of five such
projects failing are sufficiently high to protect the bank. As a result, banks are able to
charge a constant rate that isnt so high that it puts off safe borrowers.
Savings
The field of microfinance has seen a marked rise in the use of micro savings, a field
that is one of the more recent developments for microfinance; indeed de Aghion and
Morduch point to the rise in popularity of savings accounts for very small amounts in
Bangladesh, Thailand and Indonesia.11 In an interview with Microfinance Africa, Dr
Marguerite Robinson, author ofThe Microfinance Revolution and former advisor on
micro-banking to the Indonesian government, identified what she described as six key
criteria for consumers in the developing world within a very high demand among low
income people to get their savings out of their house and into a secure place.12
1. Security Dr Robinson describes this as the most critical aspect, which ispossibly why many of the Large Financial Insitutions (LFIs) have recently been
so successful in attracting clients after lowering their deposit minimums.
11 De Aghion, Beatriz Armendriz & Morduch, Jonathan, 2005, The Economics of Microfinance, pg.147.12http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance--interview-with-marguerite-robinson/
http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/ -
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2. Convenience institutions have to be open well outside of normal office hours inorder to provide a service for consumers who often dont finish their working day
until 8pm.
3. Liquidity again another factor in the rise of LFIs, with many microfinanceinstitutions not able to offer the same level of immediate liquidity.
4. Friendly, helpful service.5. Confidentiality.6. Access to loans a logical point given the clear need for microfinance in many
developing world communities.
Consequently many microfinance institutions that were more focused on microcredithave now started to place a great deal of emphasis on microsavings, notably Grameen,
whose Grameen Bank II model includes a wide variety of easy access savings accounts.
Microinsurance
An even more recent development, microinsurance has primarily been seen as part of a
package with microfinance, rather than a product used much by itself, especially for
protecting against a sudden loss of income. Even other forms, such as health insurance or
life insurance, are seen more through the prism of potential negative impacts upon a
clients ability to cover repayments, rather than as important products in their own right.
Nevertheless, this is a field that has seen substantial growth, and which offers more
solutions to the issues facing developing world consumers.
Problems with microfinance
Critics of microfinance have pointed to several issues that routinely crop up within the
field. These include:
High interest rates. Many of the rates imposed can still be extraordinarily high.Often this is justified by high rates of inflation within many developing nations;
some also point to the law of diminishing returns as proof that those receiving
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small amounts of money at the BOP often improve their revenue so dramatically
that they are still capable of comfortably covering the loan. Nevertheless, the high
rates involved are sometimes seen as undermining microfinances claim to be a
function of social business.
Subsidies often required. Most microfinance organizations require significantlevels of subsidies in their early stages, with many continuing to rely on state
involvement or financing from major shareholders, some of whom are
conventional investment or retail banks. One study into the role of subsidies
within microfinance stated that MFIs were still receiving $1 billion per year, with
less than 5% operationally sustainable.13
Default rates that can still be significantly high. Failure to implement policiescorrectly, as well as semi-regular macro events that can annihilate income but
which local governments are incapable of dealing with (e.g. flooding in
Bangladesh), can still critically affect default rates. There is also the issue of
balancing social impact with the need to try and maintain sustainability, especially
with regard to enforcement.
Over-zealous enforcement within groups. Perhaps a more minor aspect ofmicrocredit, but in some cases the social stigma relating to failure to pay, itselfsometimes due to unfortunate but understandable situations, can be seen as
unfairly high, while some incidents of social oppression within communities have
been recorded.
Variations and difficulties according to region or urbanization
In what is considered to be one of the seminal texts of social business,The Fortune at the
Bottom of the Pyramid, the late C. K. Prahalad describes a variation on the Grameen
group lending model as practiced by ICICI.
13 M. Hudon & D. Traa, 2008, On the Efficiency Effects of Subsidies in Microfinance: An EmpiricalInquiry, pg. 3.
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The yellow arrows indicate disbursement of money. As mentioned previously, in the
Grameen model, funds are given to the loan officer, who arrives at the village, and
disburses them to the first pair in the group of five, followed by the second and the third.
In the ICICI model, however, funds are passed onto SHGs of around twenty people.
The key difference, however, is the concept of liability; the levels between ICICI and the
SHG are primarily intended for purposes of sales and marketing, as opposed to oversight.All liability rests with the SHG, which consists of twenty people, and is responsible for
disbursing funds to individuals as it sees fit. In other words, whereas the concept of social
collateral is implicit within the Grameen model, it is formalized within the ICICI model,
and, barring a catastrophic event occurring, reduces the level of risk for the bank even
further.14
However there are some microfinance institutions which eschew the group model
altogether. De Aghion and Morduch cite the example of progressive lending15 in the
practices of both ASA and Grameen II; here borrowers are rewarded for fulfilling their
14 C.K. Prahalad, The Fortune at the Bottom of the Pyramid, 2005, pg. 84.15 De Aghion, Beatriz Armendriz & Morduch, Jonathan, 2005, The Economics of Microfinance, pp.125-6.
Third wave of loans
Second wave of loans
First wave of loans
Bank
LoanOfficer
Village Village
Group Group Group
LoanOfficer
Village Village
20 membersper SHG
20 new SHGs/promoter/yr
6 RCs per PM
No. of PMs:16
Bank
ProjectManager
RegionalCoord.
Promoter Promoter
Self-HelpGroup
Self-HelpGroup
RegionalCoord.
ProjectManager
Grameen Group Lending Model ICICI Group Lending Model
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payment obligations by being offered progressively bigger loans. Consequently, this is a
model that can often be applied on an individual basis, as well as a group basis.
Finally, one of the most significant developments to microfinance in recent years has
been the increased frequency of payments, reducing the size of and time between
installments. It still remains unclear as to why organizations who adopt this practice have
seen such a marked drop in their default rates; one study comparing differing collection
rates among villages in Nepal showed almost double the rate of default among villages
paying in monthly installments as opposed to daily installments (19.8% versus 11%).16
One theory is that a higher frequency of collections allows loan managers to spot
potential problems sooner and act upon them; another is that in paying weekly,
consumers have less opportunity to spend the money on something else rather than cover
their loans.
Islamic Finance initial difficulties with microfinance
In view of the above issues concerning Islamic Finance and the structures commonly
used in microfinance, there are thus several key issues with regard to combining the two:
Riba on loans. The most obvious and fundamental issue surrounds the issue ofmicrocredit as the primary means of promoting entrepreneurship and reducing
poverty. Interest cannot be charged, thus seeming to remove the possibility of
deploying anything other than charitable donations; the sustainable social
business model does not seem to apply here.
Riba on savings. Again, riba cannot be applied to savings. This is not asfundamental an issue as that faced by microcredit, but aside from the issue of
storing savings in a secure place, it does remove one of the key incentives to save
in an environment where conventional saving is often not very well rooted.
Insurance. The conventional insurance model takes a premium from the client inthe hope of making a profit. In other words, it is speculating that the revenue
accumulated will exceed the payouts required. This aspect of speculation is seen
16 Silwal, Ani Rudra, Repayment Performance of Nepali Village Banks, 2003.
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as maysir, or gambling, and is haram. Furthermore, the fact that the client is
paying a premium, but may receive nothing in return, amounts to gharar, as the
outcome is unclear.
Given these significant obstacles, how can practitioners of Islamic Finance arrive at a
solution?
Islamic Finance alternative solutions via existing instruments
Legal tools:
The legal tools required to operate within Islamic Finance are similar to those used in
Western law, but are nevertheless critical in terms of their different applications.
Wad (promise)
Wad is the promise to carry out (or not carry out) certain actions in the future. Opinions
are divided within the Islamic world as to whether it is legally binding or simply the sign
of noble intentions. However, assuming no force majeure, the general consensus, as
represented by the Islamic Fiqh Academy, is that some sort of penalty should be
enforceable for failure to fulfil its terms. One potential use within Islamic microfinance
would be for those given positions of authority within the local microcredit infrastructure.
Aqd (contract)
An Aqd contract must consist of two counterparties exchanging goods at an agreed
price. The offer made must be matched by the agreement returned, which must be
explicit.
Kafala (guarantee)
Given that riba cannot be levied, or penalties charged to the benefit of the creditor,
kafala, or third party liability, can sometimes be seen as unnecessary. However, in the
field of microfinance, the concept of a third party guarantor is one thoroughly embedded
in many of the models, and consequently relevant here.
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Wakala (agency contract)
This is a concept applied in many instruments used in Islamic Finance, ranging from
brokerage to the purchase of property. Individuals or organizations are able to giveauthority to another party to transact deals on their behalf, as with banks giving authority
to loan officers or village elders.
Relevant financial techniques:
Islamic finance consists of a multitude of techniques, many of which are designed to
mimic instruments used in conventional finance, while avoiding issues such as riba and
gharar. Those models that seem most relevant to Islamic microfinance are listed below,
although, needless to say, there are one or two techniques not described in any detail
(musharaka, arbun etc.) which still enjoy widespread usage. Nevertheless, most of the
principal models applied in Islamic Finance are described below.
Murabaha (loan)
The murabaha structure is used for deferred credit sales, and as such is the most
commonly used tool within Islamic microfinance. However, the deal is structured
according to several key steps, all of which must be observed in order to validate thecontract.
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1. Musawama (bargaining).The buyer and the seller agree the specifications of thecontract with the seller. Money must be exchanged for a specific, tangible item,
which must not be haram.2. The buyer promises to buy the item from the Islamic Financial Institution (IFI)
this may be in the form of a wad or aqd (i.e. binding or non-binding).
3. The IFI enters into a sales contract with the seller and purchases the item inquestion. In practice, the IFI usually appoints the buyer as agent to buy the goods
on its behalf via a wakala contract.
4. The seller delivers the item to the IFI.5. The IFI and the buyer enter into a murabaha agreement, by which the item is sold
to the buyer at the price it was purchased from the seller plus a mark-up. This last
stage is usually deferred, or paid in installments.
Although this instrument is often used to mimic a loan, not just in microfinance, but also
in asset management and the import/export of goods, there are several crucial differences:
IslamicFinancial
Institution
Seller Buyer
1.Negotiation
1.
2.3.
4. 5.
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The IFI must actually own the object at some point during the transaction. Additional charges cannot be inflicted due to extending the final due date. While the IFI can insist on collateral, late penalties cannot be charged to the IFIs
benefit if a penalty is charged, it must be paid to charity.
Mudaraba (partnership project)
While the murabaha model is the most commonly used in microfinance, one possible
alternative, given that many microfinance institutions may wish to distance themselves
from the image of a conventional loan, would be the mudaraba. This model operates
according to the idea of a partnership between a Rab al Mal, who provides capital, and aMudarib, who provides the expertise required to invest the capital in a project (and who
may consist of one or more investors).
Profits are shared according to a pre-defined ratio, with mudarib fees sometimes chargedas well; however, only the Rab al Mal is liable for losses incurred. The Rab al Mal has an
absolute right to all information regarding their investment. Upon setting up the
agreement, the Rab al Mal may choose between a Mudaraba al Muqayyada (restricted
partnership agreement) or a Mudaraba al Mutlaqa (unrestricted partnership agreement).
The former specifies a particular project or type of investment to which the Mudarib is
Mudaraba
Rab alMal
Mudarib
ExpertiseCapital
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restricted; the latter gives the Mudarib free rein to invest the funds as he sees fit. Note
that for both types, investments must still always be halal.
With regard to microfinance, this model is clearly further away from conventional
microcredit as it envisages a variable share of profits rather than a specified amount for
repayment. Not only would this suggest even greater monitoring, but it also opens the
bank to the same level of risk, as consumers, or the mudarib, are not liable for losses. It
would also make regular installments a lot harder to impose, unless an amount is set
based on expected profits, with the difference between the expected amount and the
amount actually due paid every six months or so. Nevertheless, for larger projects on a
village-wide basis, or for the agreement between a bank and SHGs in the ICICI model, it
might be perceived as having more social benefit to be an investor in the project rather
than a creditor awaiting repayment.
Amanah/Wadia (bank account)
While unable to offer conventional, interest-paying bank accounts, Islamic banks can
offer an Amanah or Wadia, both of whom essentially amount to a trust account where the
money is held and is guaranteed to be returned in its entirety upon request.
Furthermore, many Islamic Banks offer a return on clients money by requesting
permission to invest it on the clients behalf. This is usually done via a mudaraba
contract, or perhaps a murabaha if the investment is in a construction project, say. Some
institutions even go so far as to offer a gift, or hiba, in return for placing deposits with
them, although many Islamic scholars feel that this is dangerously close to the idea of an
interest-bearing account.
I jara (lease)
An ijara is an agreement by an IFI to acquire an asset, then lease it to a client, possibly
with a view to transferring ownership (known as an Ijara wa Iqtina), or just to retain it at
the end of the lease and perhaps sell it on. Consequently an Ijara is seen as one way of
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mimicking a conventional mortgage, as is a diminishing musharaka, another means of
financing, then gradually transferring property ownership.
1. Negotiation between buyer and seller.2. After agreeing a contract with the buyer, the IFI purchases the asset from the
seller (again this may be carried out by the buyer as part of a wakaful with the
IFI).
3. The IFI leases the asset to the buyer.4. Installments are paid to the IFI by the buyer over a fixed period of time.5. If part of an Ijara wa Iqtina, ownership of the asset passes to the buyer.
Some consumable goods cannot be leased; however sub-leases are permitted if the lessor
agrees. Another form, the ijara mawsoofa bil thimma, allows for agreeing a lease in
advance on a project still undergoing completion, thus making it popular for financing
IslamicFinancial
Institution
Seller Buyer3.4.
1.Negotiation
2.
5.
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construction projects. All of these would be suited to some of the larger projects in
microfinance, especially in terms of the construction and purchase of property.
Takaful (insurance)
The various permutations governing different Takaful possibilities and regulations are too
numerous to be covered in detail here. Nevertheless, it is worth briefly discussing the
structure of a generic takaful and how it operates in practice.
As mentioned previously, conventional insurance is generally considered haram, as it is
considered to contain elements of maysir and gharar, with regard to the possibility of
making a profit and uncertainty of outcome respectively. In takaful, maysir can be
avoided by adopting a structure similar to that of a mutual insurance fund. Here a
structure is adopted whereby policyholders group together and contribute to a fund
protecting against a certain type of risk. The fund is owned by policyholders, who are
entitled not only to payouts in the event of that risk occurring, but also to surpluses upon
the funds. Incidentally, it is worth noting that many conventional mutual funds are now
demutualising due to the need for greater reserves in light of capital adequacy
regulations.
Nevertheless, this still leaves the element of gharar. This is avoided by characterizing
payouts as tabarru, or charitable donations, thus justifying the element of uncertainty.
Funds not in use are invested, albeit not in bonds, as is usually the case with many mutual
funds.
In practice, takaful funds are usually run according to one of two models:
1. Non-profit. The equivalent of a mutual fund is set up, with a board responsible formanaging the business and investing excess funds.
2. Commercial. This is what is known as a two-tier model, where a takaful operatorwill manage excess funds via a mudaraba or wakala (i.e. profit-sharing or fixed
fee) arrangement. Often this operator is itself owned by shareholders, sometimes
through a separate mudaraba agreement.
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As shown above, the takaful operator is responsible for underwriting the fund in the event
that there are not sufficient funds to cover payouts; this is done as a series of interest-free
loans.
Consequently the takaful fund provides a good model of mutual insurance that is highly
suited to many of the philosophies underlying microfinance. If communities form a fund
together, managed perhaps by a larger institution, they will be able to further guard
against the possibility of default due to illness or incapacity. Furthermore, in the event of
a significant, macro event that severely impacts the community as a whole, the large
institution underwriting the fund should be capable of stepping in to keep the fund
solvent and ensure payouts.
Sukuk (bond)
A sukuk is perhaps the nearest tool available to microfinance in terms of imitating a
bond. It allows ownership rights to a proportion of a certain asset, usually within a
company. Subscribers are therefore liable to gains and losses linked to revenues from the
assets, such as rent. As with the takaful, the number of varieties and permutations of
sukuk is innumerable; additionally, it is used much more in the context of capital markets
Shareholders Policyholders
Takaful fundTakaful
operator
Shareholdersfunds coveroperations andunderwriting
Takafuloperator createsprofits via feesor mudaraba
Policyholderscontribute toand owntakaful fund
Takaful operatoradministers,manages andunderwrites fund
Takaful fundpays operatorvia wakala ormudaraba
Fund pays out ifrisk realized orsurplus notreinvested
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and financing large projects. Consequently it is perhaps not especially relevant to Islamic
microfinance. However, sukuk are one of the most commonly used forms in Islamic
Finance, with estimates of the value of assets financed in this manner varying from $700
billion to $1 trillion.17 Indeed, there may be a degree of interest for Islamic microfinance,
not at the consumer level, but more at the level of small to mid-size microfinance
enterprises, or even communities looking to raise capital for investment.
Islamic Finance solutions to common issues in microf inance
If the answer to many of the issues surrounding Islamic microfinance can be found in the
various models above, does Islamic Finance provide solutions to some of the issues
plaguing microfinance as a whole? Could Islamic Finance extend microfinance in certainrespects?
In discussing the issues relating to microfinance, we first mentioned the issue of high
interest rates. Of course, such interest rates are not (or should not be) inflicted simply to
make a healthy profit margin, but are instead symptomatic of the high costs involved in
setting up and operating microcredit in developing, or even developed, nations. The fact
that interest is not clearly stated as such, but is instead reflected in the mark-up in a
murabaha, or in the required rate of return from a mudaraba, will not eliminate it as a cost
to be borne by the consumer. However, although it would require further monitoring, the
mudaraba model may at least offer a greater sense of social benefit by involving the
institution in the gains and losses of the consumer.
Another area addressed was the role of subsidies within microfinance. As mentioned
previously, subsidies still play a significant role within the industry. While this work does
not intend to discuss whether it is morally or economically justifiable to subsidize social
businesses, de Aghion and Morduch point to a theory supported among many studies of
subsidize start-up costs, not ongoing operations.18 This suggests that subsidies at least
have some role to play in microfinance; consequently the substantial role played by zaqat
17 Islamic Financial Services Industry Development, Ten Year Framework and Strategies, pg. 7.18 De Aghion, Beatriz Armendriz & Morduch, Jonathan, 2005, The Economics of Microfinance, pg.246.
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in Islam offers an easy route, both practically and philosophically, for start-up costs at
ground level among communities.
Finally, we mentioned the opposing issues of defaulting clients and overzealous
enforcement. These are issues which will occur in any model along these lines, but in
terms of reducing their impact, one solution may be to involve local institutions, such as
mosques or tribal leaders, to ensure both consumers and representatives of the IFI behave
in a proper manner. This will be covered in greater detail in subsequent sections.
Ultimately all of the above issues relating to microfinance are symptomatic of the
challenges involved in working with BOP consumers, and as such are unlikely to be
entirely solved by any model. However, Islamic Finance can perhaps alleviate them in
some respects, while providing a solution for those consumers who feel excluded from
microfinance due to their beliefs.
Islamic Finance philosophical similarities and new social models
The models described in previous sections provide significant evidence that Islamic
finance and microfinance can be compatible, at least from a technical standpoint.
Standard microcredit arrangements can be mimicked by a murabaha agreement, orpossibly even a mudaraba agreement; equally the leasing or purchase of property or other
goods can be accomplished via an ijara agreement. Elsewhere in microfinance, we have
seen that bank accounts can still be provided under an amanah or wadia contract, while
the community-based solution found in a takaful contract is ideal for providing
microinsurance.
However, to what extent are the models contained within Islamic Finance compatible
with the philosophy of microfinance, and vice versa? We have already discussed the
fundamental importance of zaqat within Islam; one quote reads
They ask you what they should spend [in charity], say, whatever you spend on good [let it befirst] on your parents, and [then] your close relatives, the orphans, the poor, and the childrenof the path. And whatever good you do, God surely knows. Quran, Surat Al Baqara, verse215.
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The idea of responsibility to the community is one that is deeply ingrained in Islam, and
thus throughout many Muslim communities. Zaqat may provide an opportunity in terms
of aiding very poor communities to develop to the point where they can be helped by
microfinance; it may equally provide a means to finance the start-up process for very
small microfinance institutions or community groups. Another angle to this concept is the
disapproval expressed within Islam of hoarding.
Let those who hoard the wealth that God has given them never think that they will benefitfrom it. It will bring them nothing but evil.The riches that they have hoarded will be theirchains on Judgement Day.Quran, 3:180
As a result there is a clear need within the Islamic community for both charitable
contributions and investments that include a social aspect, thus fulfilling obligations to
the community as a whole. Therefore by looking beyond the technical aspects of Islamic
Finance, it may be possible to envisage a social model whereby Islamic microfinance
institutions are initially financed, then later underwritten by the richest members of the
community, those above the BOP categories (this would obviously only be feasible in
those developing nations with a significantly wealthy elite, as it the case with many of the
Gulf states).
We also mentioned earlier the possibility of including mosques or other community
institutions within Islamic microfinance; by using mosques as a meeting place for both
Tier 1
Tier 2-3
Tier 4-5 (BOP)
Wealthymembers
Microfinancefund
BOP BOP
Start-up financeUnder-
writing
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the disbursement of funds and the payment of installments, the impact of social collateral
could be increased significantly. Furthermore, virtually every community in the Muslim
world is guaranteed to contain a mosque, which acts as both community centre and a
store of local knowledge. Consequently the risk of default could be reduced, as well as
the cost of monitoring, possibly to the extent that a mudaraba, or profit-sharing
agreement could be extended to many consumers.
However, this model could in itself pose several moral issues. Although we are looking at
the deployment of Islamic finance in the microfinance context, this is primarily to enable
BOP consumers in the Muslim world to access capital and other financial products.
Nevertheless, IFIs are not necessarily religious organizations. Should religious authorities
be given significant economic influence over communities? Certainly in most developed
nations, the role of religion is usually strictly delineated, with countries such as France or
the UK doing their utmost to prevent the mixing of religion and politics; in fact many
countries within the Arab world (Egypt, Tunisia, Turkey) have done their utmost to
stamp out any designs on political or economic power by religious organizations.
Nevertheless, this ignores the fact that any excess on the part of the mosque can be
regulated just as easily as inappropriate behavior on the part of a conventionalmicrocredit group or SHG by threatening to remove funding. Ultimately the role of the
mosque should be that of guarantor and mediator, with responsibility for fund
management and disbursement lying with a separate board of community members.
Islamic Finance problems compared to orthodox microfinance
The most significant issue facing those wishing to combine Islamic Finance and
microfinance is that of gender. The role of women in microfinance is seen as critical to
the model laid out in the Grameen paradigm: Grameen boast of 8.1 million borrowers,
97 percent of whom are women, while various estimates place the proportion of women
among all microfinance borrowers at between seventy and eighty-five percent.19
19 ILO, Small Change, Big Changes: Women and Microfinance, pg. 4.
http://www.ilo.org/public/libdoc/ilo/2008/108B09_28_engl.pdfhttp://www.ilo.org/public/libdoc/ilo/2008/108B09_28_engl.pdf -
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This approach is supported by considerable anecdotal and statistical evidence, so that
even while taking into account the bias towards women that already exists among the
client base of microfinance organizations,
MFIs with higher proportions of female borrowers have a lower portfolio-at-riskthesecombined findings provide compelling evidence that that focus on women clientsenhances microfinance repayment, and that women in general are a better credit risk.20
However, the reasoning behind this is yet to be clearly elaborated. Various theories have
been put forward in a part of microfinance that has proved hard to define and quantify.
The most commonly proposed arguments are:
Social pressure the idea that women are more susceptible to the estimation ofothers, and are consequently more easily swayed by the concept of social
collateral.
Conservative risk profiles several studies have indicated that women less likelyto pick risky investments than men.
Empowerment by giving economic power to women in societies that often denythem significant authority, MFIs see better results from women as they are more
likely to work hard and use funds in a more conscientious manner.
Family units women are more concerned by the welfare of dependants, andmore likely to be working from home as they will often be looking after children
and elderly relatives. Consequently they will work harder and be less mobile, thus
making them easier for MFIs to monitor.
Of course there are arguments against all of the above as an individual solution, but in
combination, the above reasoning may well serve as an explanation for the focus on
women within MFIs. This focus is seen in many circles as one of the main arguments for
microfinance in terms of social benefit; by targeting women, MFIs are not only
improving their status in unequal societies, they are also responding to the higherproportion of women among the very poor (70% of the 1.3 billion earning less than $1
per day, according to one estimate).21
20 DEspallier, Gurin & Mersland, Women and Repayment in Microfinance, 2009, pg. 27.21 UNDP Human Development Report, 1995.
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However, one of the more notable aspects of many Muslim societies is the status of
women therein. In many of the Gulf States, women are deprived of the right to vote, drive
or even be in the company of men not related to them without a guardian. Amnesty
Internationals 2009 report on Saudi Arabia noted that
the concept of male guardianship over women (mehrem), as applied, severely limitedwomens rights, notably in relation to marriage, divorce, child custody, inheritance, propertyownership, and choices about residency, education and employment.22
Equally a similar report on Qatar for 2009 stated that
Women continued to face discrimination in law and in practice and were inadequatelyprotected against violence within the family. In particular, family law discriminates againstwomen, making it much easier for men to divorce than women, and placing women whosehusbands leave them or who seek a divorce at a severe economic disadvantage.23
Similar difficulties can be seen elsewhere in the Muslim world, with a 2009 Human
Rights Watch report on the status of women in Afghanistan concluding that
Eight years after the fall of the Taliban, and the establishment of the Karzai government,Afghan women continue to be among the worst off in the world. Their situation is dismal inevery area, including in health, education, employment, freedom from violence, equalitybefore the law, and political participation.24
There is, of course, little in the Quran or the Sunnah to insist on such limited legal and
political status for women. However, it remains true that in many of the states where
consumers would be most interested by Islamic microfinance, women have so little
independence that its efficiency might be called into question.
What is the solution to such a fundamental issue? On the face of it, this appears to be a
choice between microfinance as a tool for social improvement and as a tool for improved
economic performance. Should MFIs insist on only working in an environment where
women are able to sign contracts, own property and run their own businesses, or should
they simply aim to improve the economy of the region in which they are operating?
22http://www.amnesty.org/en/region/saudi-arabia/report-200923http://www.amnesty.org/en/region/qatar/report-200924 Human Rights Watch, We Have the Promises of the World Womens Rights in Afghanistan, 2009,pp. 2-3.
http://www.amnesty.org/en/region/saudi-arabia/report-2009http://www.amnesty.org/en/region/saudi-arabia/report-2009http://www.amnesty.org/en/region/saudi-arabia/report-2009http://www.amnesty.org/en/region/qatar/report-2009http://www.amnesty.org/en/region/qatar/report-2009http://www.amnesty.org/en/region/qatar/report-2009http://www.amnesty.org/en/region/qatar/report-2009http://www.amnesty.org/en/region/saudi-arabia/report-2009 -
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In fact, the choice of women as microfinance customers is critical to both aspects. As we
have seen previously, women are simply the most efficient consumers of microcredit and
microfinance. In the early days of microfinance in Bangladesh, Grameen faced a similar
issue in terms of overcoming the reluctance of communities to allow women greater
independence, as well as the freedom to meet with loan officers unsupervised. However,
as the benefits of microcredit became clear, this hurdle was lifted, and the proportion of
female borrowers went from fifty percent to todays ninety-seven percent. Ultimately, it
will be in the interest of both MFIs and the community to improve access to financial
tools for women, even if they are less willing to consider equivalent political rights.
Elsewhere, there are still significant issues relating to Islamic Finance, which, likemicrofinance, is still very much in its infancy. Most of all, despite the international
organizations put in place, there is still very much the need for a coherent set of rules,
with one governing body in place to set them. The variation in opinions between different
scholars, as well as the more relaxed approach to Shariaa laws in Malaysia compared to
the Middle East, mean that there is still a degree of uncertainty with regard to the
standardization of regulations. As one practitioner puts it
there is no one basic regulatory environment across geographies that manages Islamicbanking today I think that is one of the fundamental pieces that needs to be addressed inorder for the true potential of Islamic banking to be realized.25
Conclusion
When first looking at microfinance and Islamic Finance, it seems as if they are two
models that are mutually incompatible. But by combining the techniques laid out above,
we should be able to arrive at a model that is able to both accommodate the demands of
Shariaa law and serve the needs of those at the BOP. Furthermore, the emphasis placed
on community is one which both models share, and which can provide a solution which
will only aid one another during a time when disillusionment with conventional banking
has never been more pronounced.
25Asif Mumtaz (HSBC Amanah), Islamic Finance Summit, 5th February 2008.
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Glossary of terms
AAOIFI
Amanah
Aqd
BOP
Fiqh
Gharar
Halal
Haram
IDB
IFI
IFSB
IIRA
Ijara
Kafala
LFI
Maysir
MFI
Mudaraba
The Accounting and Auditing
Organization for Islamic FinancialInstitutions
Trust, or bank account
Binding contract
Bottom of the Pyramid, those whose
purchasing power is equal to or less than
$1500 per year
Islamic jurisprudence
Risk, or deception, prohibited in Islam
Permissible according to Islamic law
Not permissible according to Islamic law
Islamic Development Bank, responsible
for fostering development in Muslim
world
Islamic Finance Institution
Islamic Financial Services Board,responsible for issuing guidance and
standards for the industry
International Islamic Rating Agency,
responsible for rating Shariaa compliant
instruments and investments
Lease contract
Third party guarantee
Large Financial Institution e.g. a bank
Gambling, speculation
Microfinance Institution
Partnership project, profit-sharing
arrangement
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Murabaha loan equivalent within Isla
Musharaka, Diminishing
Quran
Riba
Shariaa
SHG
SukukSunnah
Takaful
Wad
Wadia
Wakala
Zaqat
Loan equivalent within Islamic Finance
Mortgage equivalent
Revealed text of Gods words to the
Prophet Muhammad
Interest, prohibited in Islam
Islamic scholarship interpreting Quran
and Sunnah
Self-Help Group, borrowing group and
unit of microfinance, as described by
C.K. Prahalad
Islamic bond equivalentThe sayings of the Prophet Muhammad
Islamic insurance
Promise, not necessarily binding
Trust, bank account
Agency contract, granting third party
authority
Charity, required for most Muslims, one
of the five pillars of Islam
top related