An Application of Islamic Banking Principles to Microfinance

Technical Note

Rahul Dhumale and Amela Sapcanin

A study by the Regional Bureau for Arab States,

United Nations Development Programme,

in cooperation with the Middle East and North Africa Region,

World Bank

The authors are grateful to the United Nations Development Programme’s Regional Bureau for ArabStates for funding this study. They also thank Ahmed Abou El Yazeid, Judith Brandsma, NematShafik (World Bank), Abbas Mirakhor (International Monetary Fund), Rohil Hafeez, Bassel Hamwi(International Finance Corporation), and William Tucker for invaluable comments and insightson previous drafts. This report was edited by Paul Holtz and laid out by Wendy Guyette, and thecover was designed by Laurel Morais, all with Communications Development Incorporated.

The findings and recommendations expressed in this report are entirely those of the authors andshould not be attributed in any manner to the United Nations Development Programme or the WorldBank.

iii

Contents

A nexus between Islamic banking and microfinance? 1

Islamic banking—promoting equity with a range of tools 2Different interpretations 2Different instruments 3

Microfinance—providing credit to the entrepreneurial poor 6

Combining Islamic banking with microfinance 8A mudaraba model 8A murabaha model 10Experience with mudaraba and murabaha in microfinance 11

Conclusion 13

References 14

1

A nexus between Islamic banking and microfinance?

Islamic banking has grown significantlyover the past 20 years, with estimateddeposits surpassing $80 billion in more

than 45 countries. Annual turnover is cur-rently estimated at $70 billion and is pro-jected to pass $100 billion by 2000(O’Sullivan 1994, p. 7). More than 100Islamic banking institutions are in operation,ranging from pure Islamic banks to smallersharia banking units in conventional banksand investment houses. As one of the fastest-growing segments of the financial servicesmarket in the Islamic world—for the pastfive years annual growth has averaged 15percent—these institutions have attracted alot of attention. Moreover, the guiding prin-ciples of Islamic finance draw curiosity fromMuslims and non-Muslims alike as they tryto understand how a system that prohibitsthe receipt and payment of interest hasbecome so widespread.

Although Islamic financial practices arefounded on the core belief that money is notan earning asset in and of itself, there is moreto the system’s underlying tenets. Islamic reli-gious law—that is, sharia—emphasizes eth-ical, moral, social, and religious factors topromote equality and fairness for the good

of society as a whole. Although this analysisof Islamic banking focuses on its economicaspects, the system can be fully understoodonly in the context of Islamic attitudestoward ethics, wealth distribution, social andeconomic justice, and the role of the state.Principles encouraging risk sharing, indi-vidual rights and duties, property rights, andthe sanctity of contracts are all part of theIslamic code underlying the banking system.

In this light, many elements of microfi-nance could be considered consistent withthe broader goals of Islamic banking. Bothsystems advocate entrepreneurship and risksharing and believe that the poor should takepart in such activities. At a very basic level, thedisbursement of collateral-free loans in cer-tain instances is an example of how Islamicbanking and microfinance share commonaims. Thus Islamic banking and microcred-it programs may complement one anotherin both ideological and practical terms. Thisclose relationship would not only provideobvious benefits for poor entrepreneurs whowould otherwise be left out of credit markets,but investing in microenterprises would alsogive investors in Islamic banks an opportu-nity to diversify and earn solid returns.

Islamic banking andmicrocredit programs maycomplement oneanother in bothideological andpractical terms

2

Islamic banking—promoting equity with arange of tools

Interest-free lending is a basictenet of Islamic

bankingAs noted, Islamic banking is a fast-

growing sector in Middle Easternfinancial markets and other Islamic

parts of the world (Indonesia, Malaysia). Itsrole is also increasing in the West. Moreover,this growth has not been limited to a par-ticular sector of the banking industry.What are the foundations and features ofIslamic banking?

Different interpretations

An important Islamic commitment is thedenouncement of usury—that is, the lendingof money at exorbitant interest rates.According to the literature, in the pre-Islamicera riba—literally translated as excess, expan-sion, addition, or growth—referred to thepractice of lending. Debtors had to pay afixed amount above the principal borrowedfrom lenders for the use of the money. Thisadditional amount, which depended on thepredetermined rate, was called al-riba.

Most Muslim scholars believe that riba isprohibited, but there are subtle differencesin interpretation. Siddiqui (1995, pp. 43–44)states that “a controversy has arisen that inter-est paid by banks on deposits or charged onadvances is not tantamount to riba and ishence permissible.” Ayub (1995, pp. 34–35)says that “if someone indulges in trading(undertakes risk), the profit earned on it willbe permissible. But earning money by the actof loaning is haram [in discord with theIslamic code].” The discussion among schol-ars includes analyses of whether the Koranprohibits the use of interest altogether. Somescholars believe that interest should be pro-

hibited only when money is lent at exorbitantinterest rates that exploit the borrower. Thusinterest may be lawfully allowed under cer-tain conditions—including loans made bygovernments to induce savings, as a form ofpunishment for debtors, to finance trade,and to finance productive investments.

Other scholars are indifferent to the pur-pose for which the interest is being chargedand consider all forms of riba to be unlawful.The main arguments here are that Islam doesnot allow gain from a financial activity unlessthe financial capital is also exposed to the riskof potential loss; and that interest reinforcesthe tendency for wealth to accumulate in thehands of a few, thereby diminishing man’sconcern for his fellow man (Lawai 1994, p. 8).

Thus it is not surprising that mostIslamic banking strategies have tried toremove all forms of fixed nominal interestrates. (Muslim scholars make no distinctionbetween nominal and real interest rates; itis assumed that all interest rates are real andtherefore are considered to hamper invest-ment and employment.) But the abolish-ment of fixed interest rates does not meanthat no remuneration is paid on capital.Profit-making is acceptable in Islamic soci-ety as long as these profits are not unre-stricted or driven by the activities of amonopoly or cartel (Lawai 1994, p. 10).Islam deems profit, rather than interest, tobe closer to its sense of morality and equi-ty because earning profits inherently involvessharing risks and rewards. Profit-makingaddresses the Islamic ideals of social justicebecause both the entrepreneur and thelender bear the risk of the investment.

One result of this attitude toward profitis that Islamic banking innately addresses theimperfect information and credit rationingproblems that often exist between lendersand borrowers in conventional banks.Imperfect information occurs when oneparty has more and better information thanthe other party.1 This inefficient distributionof information leads to credit rationing. Inextreme cases, given an aggregate level ofavailable credit and a perfectly elastic sup-ply curve, lending institutions establish acredit hierarchy. As a result not all borrow-ers willing to pay a similar rate are able toreceive credit. Such rationing can damagethe real sector of the economy, especiallywhen it prevents productive investmentsfrom being financed. Again, the profit- andloss-sharing schemes advocated under theIslamic principle of cooperation (shirakat)allow all parties—including investors, savers,and financial institutions—to play an activerole in the economic process and avoidcredit-rationing problems. In fact, given theincreased risks from investment returnsbased solely on profits, an argument cansometimes be made for banks to play a moreactive role in project management to over-see their investments.

In Islamic finance the technical term fora transaction between an entrepreneur andthe suppliers of funds is mudaraba (seebelow). Two of the conditions for a mudara-ba-type venture show the level of partnershipimplicit in Islamic contracts:• The gross or net return on capital or

entrepreneurship should not be prede-termined.

• Partners should share not only profits butalso losses in proportion to their sharesin the enterprise (Hasanuzzaman 1994,p. 7).The bargaining terms between the two

parties involved in the transaction can varysubstantially and are determined by con-tracts. In a business based on mudaraba,each partner shares an agreed portion of theprofits, which may or may not be predeter-mined, according to the contract.

Different instruments

The literature separates Islamic banking intothree main activities: concessional financing,trade financing, and participatory mecha-nisms (figure 1; Errico and Farahbaksh 1998,p. 6). Within these activities are various con-tractual forms that conform fully to the tenetsof profit and loss sharing. The more com-monly used profit- and loss-sharing transac-tions are mudaraba (partnership), musharaka(equity participation), and musaqat andmuzar’ah (specific counterparts in mudara-ba contracts). All of these loan productsappear to include a degree of uncertaintyregarding the eventual returns due to theentrepreneur and to the Islamic bank. Otherlending contracts used in Islamic bankinginclude qard al-hasanah (benevolent loan),bai’mua’jjal and bai’salam (sales contracts),ijara wa iqtina’ (leasing), murabaha (cost plusmarkup), and jo’alah (service charge).

Profit- and loss-sharing schemes

Under a mudaraba contract the bank pro-vides the capital needed for a project whilethe entrepreneur offers labor and expertise.The profits (or losses) from the project areshared between the bank and the entrepre-neur at a fixed ratio. Financial losses areassumed entirely by the bank; the liability ofentrepreneurs is limited to their time andeffort. In cases of proven negligence or mis-management by entrepreneurs, however, theymay be held responsible for the financial loss-es. These types of contracts are most commonin investment projects in trade and com-merce that are capable of achieving full oper-ational status in a short period. The contractbetween the bank and the entrepreneur isknown as restricted mudaraba because the bankagrees to finance specific investments by spe-cific entrepreneurs and to share relative prof-its according to an agreed percentage. Toengage in mudaraba transactions a bank mustmeet the following legal obligations:• The bank should not request collateral to

reduce its credit risk on these transac-

ISLAMIC BANKING—PROMOTING EQUITY WITH A RANGE OF TOOLS 3

Under a mudarabacontract the bankprovides the capitalneeded for a project while theentrepreneur offerslabor and expertise

tions, and thus bears the entire financialrisk. Collateral may, however, be request-ed to reduce moral hazard.

• Profit-sharing rates must be determinedonly as a a percentage of the profit, not alump sum payment. In some cases thebank may receive part of the principal fromthe borrower at the end of the period if asurplus exists. In cases of loss, the entre-preneur will not be liable unless foundguilty of negligence or mismanagement.

• The entrepreneur exercises full controlover the business; however, supervision bythe bank is permitted (Iqbal andMirakhor 1987). Musharaka is an equity participation con-

tract in which the bank is not always the onlyprovider of funds. The distinguishing fea-tures of this type of contract are the natureof the business activity and the duration ofthe gestation period for the business. Twoor more partners contribute to the capitaland expertise of an investment. Profits and

losses are shared according to the amountsof capital invested. This type of transactionhas traditionally been used to financemedium- and long-term investments. Bankshave the legal authority to participate in themanagement of the project, including sittingon the board of directors. Each investor’srights correspond to their amount of equi-ty capital in the enterprise.

Musaqat is a specific type of musharakacontract for orchards. In this case the har-vest is shared among all the equity partnersaccording to their contributions.

Muzar’ah is essentially a mudarabacontract in farming where the bank canprovide land or funds in return for a shareof the harvest.

Direct investments are similar to trans-actions in Western banking and thus requirethe greatest discretion. Islamic banks cannotinvest in the production of any good or ser-vice that might even appear contrary to theethical and moral values of Islam. Banks can

4 AN APPLICATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE

Figure 1. Types of Islamic banking contracts

Source: Kazarian 1993; Iqbal and Mirakhor 1987.

Concessionary

Profit and loss sharing

Participatory mechanisms Trade financing

Non–profit and loss sharing

MudarabaTrustee financing

MusharakaEquity participation

MusaqatOrchard financing

Muzar’ahShare of harvest

Direct investment

Qard al-hasanahBenevolent loan

Bai’mua’jjalSpot sales

Bai’salamForward contracts

Ijara wa iqtina’Leasing

MurabahaCost plus markup

Jo’alahService charge

vote according to their share and may jointhe board of directors.

Non–profit- and loss-sharing schemes

Qard al-hasanah are loans with zero returnthat the Koran encourages Muslims to maketo “those who need them.” Banks areallowed to charge a service fee to cover theadministrative and transactions costs of theseloans so long as such costs are not related tothe maturity or amount of the loan.

Bai’mua’jjal are deferred payment or spotsales in which the seller of a product acceptsdeferred payments in installments or in alump sum. The price is agreed on betweenthe buyer and seller at the time of the sale,and the seller is not allowed to include anycharge for deferring payments.

Bai’salam and bai’salaf are similar to for-ward contracts, with the buyer paying theseller the fully negotiated price of a productthat the seller promises to deliver at a futuredate. The quality and quantity of the prod-ucts involved in this type of transaction mustbe capable of being specified at the time ofthe contract.

Ijara wa iqtina’ involves pure leasing(ijara) or lease purchase (ijara wa iqtina’)transactions in which a party leases a specificproduct for a specific sum for a given peri-od. In lease purchase arrangements a por-tion of each payment is applied to the finalpurchase of the product, at which time own-ership is transferred to the leaseholder.

Murabaha is a common instrument usedfor short-term financing based on the con-ventional concept of purchase finance orcost plus markup sales. The seller reports tothe buyer the cost of acquiring or produc-ing a good, then a profit margin is negoti-ated between the two parties. Payment isusually made in installments.

Jo’alah are service charges that usuallyoccur during transactions of various services.They often occur when the buyer of a ser-vice agrees to pay the provider a specified feeaccording to a contract.

The main difference between transactionsthat do not involve profit and loss sharingand those that do is that returns for the for-mer may be calculated at the final stage as afixed percentage of the total investment.However, none of these contracts can belegally negotiated to provide a fixed rate ofreturn. Islamic banks may occasionally addan extra fee to compensate themselves forcosts incurred by the additional transactionsthey must undertake. Thus these instrumentsappear similar to those in conventionalbanks, where risk aversion and risk poolingare important factors. All of the above instru-ments, however, conform to the Islamic code,because their rates of return are related moreto the transaction than to time.

The application of religious principles tobanking practices may affect the continueddevelopment of Islamic banking. At present,most banks seek approval from their reli-gious boards and shariah advisers beforemarketing new financial instruments. A stan-dardized regulatory and legal frameworkcould help assimilate Islamic institutions intointernational markets. As it stands, Islamicbanks occasionally experience difficultieswhen attempting to explain their practicesin countries or systems that are not based onIslamic principles.

Note

1. Asymmetric information—a common imper-fect information problem—in its simplest formcreates a situation described by Akerlof’s LemonsProblem. The Lemons Problem describes howbuyers and sellers in a used car market cannotclear the market because sellers of low-quality carshave an incentive to falsely advertise their cars asbeing of good quality (and thus demand a high-er price) while, because of asymmetric informa-tion, buyers cannot know whether cars are of goodor bad quality. Both buyers and sellers lose, for buy-ers would pay more for a better car and owners ofgood cars cannot sell their cars at a price thatwould be mutually acceptable in the presence ofcomplete information.

ISLAMIC BANKING—PROMOTING EQUITY WITH A RANGE OF TOOLS 5

None of the contracts can belegally negotiatedto provide a fixedrate of return

6

Microfinance—providing credit to the entrepreneurial poor

Microenterprisesprovide jobs and

help the entrepreneurialpoor generate

income and alleviate poverty

Microfinance institutions providefinancial services—such as creditand savings services—to the entre-

preneurial poor that are tailored to theirneeds and conditions. Good microfinanceprograms are characterized by:• Small, usually short-term loans, and

secure savings products.• Streamlined, simplified borrower and

investment appraisal.• Alternative approaches to collateral.• Quick disbursement of repeat loans

after timely repayment.• Above-market interest rates to cover the

high transactions costs inherent in micro-finance.

• High repayment rates.• Convenient location and timing of ser-

vices (Fruman and Goldberg 1997). The potential of small-scale enterprises

as an alternative to larger, more capital-intensive firms is receiving increasingattention in developing countries, and thefocus in the development community isgradually shifting to small firms when itcomes to policy and resource allocation. Inthis light, microfinance is seen as a power-ful tool for reaching the poor, raising theirliving standards, creating jobs, boostingdemand for other goods and services, con-tributing to economic growth, and allevi-ating poverty. Best practice experiencearound the world has shown that the poorare bankable and willing to pay a premiumfor quick, reliable, and convenient financialservices (box 1). Successful microfinanceinstitutions have also demonstrated that,when managed in a business-like manner,

banking with the poor can be profitable andsustainable.

Microenterprises provide jobs and helpthe entrepreneurial poor generate incomeand alleviate poverty. Although the industryhas only recently emerged in the Middle Eastand North Africa, a recent World Bank sur-vey found that more than 60 microfinanceprograms are active in the region, with anoutstanding loan portfolio of nearly $100 mil-lion and more than 112,000 active borrow-ers (Brandsma and Chaouali 1998). Butmore effort is needed to address the needsof the at least 4.5 million entrepreneurialpoor who lack access to microfinance andwho could absorb an estimated $1.5 billionin loans. Traditional banks in most countriesin the region are not adapted to meeting theneeds of this group, and many poor entre-preneurs fail to meet the conventional lend-ing standards set by these banks.

The formal financial sector has playeda very small role in the development ofmicrofinance programs. The World Banksurvey found that only one commercialbank—Egypt’s National Bank forDevelopment—is active in the microfi-nance industry and has established a sep-arate microfinance unit. But several recentdevelopments should be noted: threecommercial banks in the West Bank andGaza recently initiated microfinance oper-ations, and several other banks appearpoised to do so as well, including one inLebanon, two in Yemen, and three inJordan.

In a conventional banking system, smallmanufacturers and farmers face significant

MICROFINANCE—PROVIDING CREDIT TO THE ENTREPRENEURIAL POOR 7

obstacles to obtaining the financialresources they need to develop their busi-nesses. Lending instruments are not adapt-ed to the conditions of small borrowers, andshort-, medium-, and long-term institutionalfinancing is usually not available to theentrepreneurial poor. A major constraint tofinancing the poor is their lack of tangibleassets to offer as collateral—creating avicious circle in which microentrepre-neurs cannot access finance unless theyoffer sufficient collateral, cannot possesstangible collateral unless they build astrong productive base, and cannot

strengthen their productive base unless theyget access to finance (Abdouli 1991).

Moreover, financial institutions often per-ceive small entrepreneurs as yielding small-er profit potential and higher lending costsand risks for the bank. In addition, dealingwith a large number of widely dispersedenterprises is demanding, in terms of bothtime and effort. Borrowers may not be eas-ily accessible, and bank personnel may beseparated from clients by differences in lan-guage, literacy, and culture. Clients tend tobe unfamiliar with the necessary docu-mentation and accounting conventions.

Experience in countries as varied asBangladesh, Bolivia, Egypt, Senegal, Mali,and the West Bank and Gaza shows that thepoor are bankable and that savings and creditservices can be delivered to the poor on a sus-tainable basis. The guiding principles under-lying best practice microfinance include:• Covering costs. To become sustainable,

microfinance institutions—regardless oftheir institutional setup—must cover theircosts of lending. If microlending costs arenot covered, the institution’s capital willbe depleted and continued access ofmicroenterprises to financial services—and even the existence of the microfi-nance institution—will be in jeopardy.

• Achieving a certain scale. Successful microfi-nance institutions have reached a certainscale, as measured by the number ofactive loans. This number depends on thecountry setting, lending methodologyused, and loan sizes and terms offered.

• Avoiding subsidies. Microentrepreneurs donot require subsidies or grants—but theydo need rapid and continued access tofinancial services. Besides, microlenderscannot afford to subsidize their borrow-

ers. Subsidies send a signal to borrowersthat the government or donor funds are aform of charity, which discourages bor-rowers from repaying. Moreover, microfi-nance institutions have learned that theycannot depend on governments anddonors as reliable, long-term sources ofsubsidized funding.

• Promoting outreach and demand-driven servicedelivery. Successful microfinance institu-tions increase access to financial servicesfor growing numbers of low-incomeclients, offering them quick and simplesavings and loan services. Loans are oftenshort term, and new loans are based ontimely repayments. Loans are based onborrowers’ cash flow and character ratherthan their assets and documents, and alter-native forms of collateral (such as peerpressure) are used to motivate repayment.

• Maintaining a clear focus. It takes time andcommitment to build a sustainable micro-finance program. Thus mixing the deliv-ery of microfinance services with, forexample, the provision of social services isinadvisable because it sends conflictingsignals to clients and program staff.

Box 1. Guiding principles of best practice microfinance

Source: Brandsma and Chaouali 1998.

8

Combining Islamic banking with microfinance

In a mudaraba-based transactionthe microfinance

program takes“equity” in the

microenterprisethrough the loan

Three basic instruments of Islamicfinance could be built into thedesign of a successful microfinance

program: mudaraba (trustee financing),musharaka (equity participation), andmurabaha (cost plus markup; Abdouli1991).

A mudaraba model

In a mudaraba-based transaction the micro-finance program and the microenterpriseare partners, with the program investing themoney and the microentrepreneur invest-ing the labor.1 (Note that in both mudara-ba and musharaka the financingorganization and the business work in part-nership. But in mudaraba the financierinvests only money and the entrepreneurinvests labor, while in musharaka both thefinancier and the entrepreneur investfunds.) The microentrepreneur is reward-ed for his or her work and shares in the prof-it; the program only shares in the profit. Theprofit-sharing rates are predetermined,but the profit is unknown. In effect, themicrofinance program takes “equity” in themicroenterprise through the loan. Initially,the program may own 100 percent of theshares and would hence be entitled to itspredetermined share of all the profit. But aseach loan installment is repaid, the microen-trepreneur “buys back” shares. As a resultthe microfinance program earns less prof-it with each repayment received.

Consider, for example, a case where themicroentrepreneur is a vegetable trader andmakes a weekly profit of 1,000. (For sim-

plicity, the units of currency in these exam-ples will be generic.) The microcredit pro-gram provides a loan of 10,000 to be repaidin 20 weekly installments. With each loanrepayment the entrepreneur buys back ashare of 500. Profit per share is 50(1,000/20). The program and the entre-preneur agree that the program will receive10 percent of the weekly profit, and theentrepreneur will receive 90 percent.

In the first week the microfinance pro-gram owns 100 percent of the shares and isentitled to 10 percent of the weekly profit of1,000; thus it receives 100. The entrepreneurreceives 90 percent of the weekly profit, or900. The entrepreneur uses 500 of this 900to buy back one share.

In the second week the microfinance pro-gram is entitled to 10 percent of 19/20 of theweekly profit of 1,000, since it now owns only19 of the 20 shares. Thus the program is enti-tled to 95. The entrepreneur gets the rest(1,000 – 95 = 905). Put another way, the entre-preneur receives (0.90 x 950) + 50. The 950is the profit to be shared with the program;the 50 is the profit per share. (Rememberthat the entrepreneur owns the share he“bought back” the previous week for 500; hedoes not have to share the profit made on hisown share.) Again, the entrepreneur uses 500of his profit to buy back a second share. Thisprocess would continue for the 20 weeks ofthe mudaraba agreement, with the programearning total income of 1,050 and the entre-preneur earning 18,950 (table 1). A con-ceptual visualization of this loan structure isshown in figure 2; the entrepreneur’s repay-ment schedule is shown in table 2.

From a microfinance perspective thismodel has several drawbacks. The mostimportant is the uncertainty of the profit. Animportant assumption in developing this

example was a fixed weekly profit of 1,000.In reality, although microfinance programshave information on local market behavior,weekly profits fluctuate. Fluctuating profits

COMBINING ISLAMIC BANKING WITH MICROFINANCE 9

Table 1. Program and entrepreneur profits under the mudaraba example

Week Profit to be shared Program income Entrepreneur income

1 20/20 x 1,000 = 1,000 1,000 x 10% = 100 1,000 x 90% + 0 = 9002 19/20 x 1,000 = 950 950 x 10% = 95 950 x 90% + 50 = 9053 18/20 x 1,000 = 900 900 x 10% = 90 900 x 90% + 100 = 9104 17/20 x 1,000 = 850 850 x 10% = 85 850 x 90% + 150 = 9155 16/20 x 1,000 = 800 800 x 10% = 80 800 x 90% + 200 = 9206 15/20 x 1,000 = 750 750 x 10% = 75 750 x 90% + 250 = 9257 14/20 x 1,000 = 700 700 x 10% = 70 700 x 90% + 300 = 9308 13/20 x 1,000 = 650 650 x 10% = 65 650 x 90% + 350 = 9359 12/20 x 1,000 = 600 600 x 10% = 60 600 x 90% + 400 = 94010 11/20 x 1,000 = 550 550 x 10% = 55 550 x 90% + 450 = 94511 10/20 x 1,000 = 500 500 x 10% = 50 500 x 90% + 500 = 95012 9/20 x 1,000 = 450 450 x 10% = 45 450 x 90% + 550 = 95513 8/20 x 1,000 = 400 400 x 10% = 40 400 x 90% + 600 = 96014 7/20 x 1,000 = 350 350 x 10% = 35 350 x 90% + 650 = 96515 6/20 x 1,000 = 300 300 x 10% = 30 300 x 90% + 700 = 97016 5/20 x 1,000 = 250 250 x 10% = 25 250 x 90% + 750 = 97517 4/20 x 1,000 = 200 200 x 10% = 20 200 x 90% + 800 = 98018 3/20 x 1,000 = 150 150 x 10% = 15 150 x 90% + 850 = 98519 2/20 x 1,000 = 100 100 x 10% = 10 100 x 90% + 900 = 99020 1/20 x 1,000 = 50 50 x 10% = 5 50 x 90% + 1,000 = 995Total 1,050 18,950

Figure 2. Distribution of program and entrepeneur income and ownership under the mudaraba exampleTotal income

2019181716151413121110987654321

Income to program Buyback shares Income to entrepreneur

also create a challenge for microlendingwithin Islamic banking principles. Moreover,most microentrepreneurs do not keepaccurate accounts. How, then, are profits tobe calculated and distributed? In addition,the model is difficult to understand for loanofficers and borrowers alike.

The second drawback of the model is theburden of loan administration and moni-toring. Even in the hypothetical situationthat profits were known, the borrower hasto repay a different amount each period(and the loan officer has to collect a dif-ferent amount each period). This lack ofsimplicity—relative to equal repaymentinstallments—also would confuse borrowersand loan officers. The margin for error isconsiderable given that a single loan officeroften manages 100–200 borrowers.

The key issue in using this profit-sharingmodel is whether it is possible under Islamicbanking principles for the lending agencyand the entrepreneur to agree on the week-ly (or biweekly, monthly, or some other inter-val) profit prior to disbursement of the loan.Different settings may allow for different

arrangements. Given that very few microen-trepreneurs—no matter what country theyare in—keep track of their accounts in a waythat would permit the independent verifi-cation of, say, weekly profits, the acceptabil-ity of the above model depends rather heavilyon whether such an agreement is in accor-dance with Islamic banking principles. Aswith other forms of Islamic banking, the lend-ing agency would not be entitled to a distri-bution of its share if the entrepreneur wereto suffer losses. But the lending agency couldalso agree that if the entrepreneur were togenerate more profits, he would be entitledto retain 100 percent of the same.

Applying the mudaraba model might bemore straightforward for businesses with alonger profit cycle. Say that a microenter-prise takes a loan of 20,000 to raise fourgoats. Such an undertaking may be consid-ered common, and people will know theprofit well in advance. Normally the businesswill raise the goats and resell them after fiveto eight months for 40,000, a profit of 100percent. The “working capital” (that is, thefood eaten by the goats) is considered freebecause the goats live around the dwellingand eat whatever they can find.

In this case the microfinance programtakes “equity” of 20,000, with 20 shares of1,000 each. The program and the entrepre-neur agree that 15 percent of profits will goto the program and 85 percent will go to theentrepreneur. After five months, when theentrepreneur has sold the goats and made aprofit of 20,000, he repurchases the 20 sharesat 1,000 each and pays the program its shareof the profit: 15 percent of 20,000, or 3,000.

A murabaha model

The murabaha contract is similar to tradefinance in the context of working capitalloans and to leasing in the context of fixedcapital loans. Under such a contract themicrofinance program literally buys goodsand resells them to the microenterprises forthe cost of the goods plus a markup foradministrative costs. The borrower often pays

10 AN APPLICATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE

Applying themudaraba model

might be morestraightforward for

businesses with alonger profit cycle

Table 2.The entrepreneur’s repaymentschedule under the mudaraba example

Share Profit Total Week buyback distribution payment

1 500 100 6002 500 95 5953 500 90 5904 500 85 5855 500 80 5806 500 75 5757 500 70 5708 500 65 5659 500 60 56010 500 55 55511 500 50 55012 500 45 54513 500 40 54014 500 35 53515 500 30 53016 500 25 52517 500 20 52018 500 15 51519 500 10 51020 500 5 505

for the goods in equal installments. Thismodel is easier for borrowers to understandand simplifies loan administration and mon-itoring. The microfinance program owns thegoods until the last installment is paid.

How would this Islamic model work withthe group liability mechanism common tomicrofinance? A microfinance programintroduced in Yemen in mid-1997 providesan example. Today this program has morethan 1,000 active borrowers, 30 percent ofthem women, and $150,000 in outstandingloans. Target clients are the entrepreneur-ial poor in urban slum districts. The loanturnaround is one week.

Loan application procedures are simple.Existing or startup microenterprises inter-ested in obtaining microfinance are askedto form a five-person group. Group mem-bers then submit a loan application—which includes basic business data, personalinformation, and the proposed loan size—to a loan officer. Group members are alsoasked to sign a guarantee form indicatingtheir agreement to vouch for one anotherand their willingness to pay in case of arrearsor delinquency. After a simple appraisal ofeach group member’s business by the loanofficer, the loan officer forwards the group’sapplication, business appraisal, and theguarantee form to the district supervisor anddistrict loan committee for review andapproval.

Once a loan application has beenapproved, the loan officer buys the chosenbusiness items and resells them to the bor-rowers after adding a specific margin—amarkup—to the actual purchase amount. Inthis example, the markup determined by theproject is 2 percent a month. Finally, the bor-rower signs an agreement indicating thefinal price of the resold items, the repay-ment period, and the installment amount.

To administer the model, the microfi-nance program’s financial departmentopens an account for each borrower indi-cating the number and size of each install-

ment and the due date. The loan officerissues receipts to borrowers (from a receiptbook issued by the program) when collect-ing loan installments. In addition, the loanofficer collects 30 rials a week from eachgroup member for the insurance fund anddeposits them with the financial depart-ment. The insurance fund has a separateaccount that indicates its income andexpenses. This fund compensates borrowerswho face emergencies—such as fire, flood,and death—that affect their business.Borrowers are eligible for compensationfrom the insurance fund if group membersand the responsible loan officer approve.

To ensure proper follow-up, the districtsupervisor, project manager, and assistantproject manager conduct random field vis-its to project clients to confirm the existenceand sustainability of their businesses. In addi-tion, the project management team, work-ing with the financial department, preparesmonthly progress reports indicating numberof loans distributed, types of businesses, gen-der distribution of borrowers, loans per loanofficer, repayment rate, overdue rate, delin-quency rate, aging of arrears, and the like.Borrowers who manage their business wise-ly and efficiently and pay back their loans ontime are eligible for a consecutive loan forthe same or a larger amount, based on theirbusiness needs.

Experience with mudaraba andmurabaha in microfinance

Borrower feedback from the field indicatesan initial preference for the profit-sharingmechanism—that is, mudaraba. This pref-erence may reflect borrowers’ familiarity withthis mechanism, as it is commonly used forsupplier credit and other types of informalfinance. But not all borrowers may under-stand that the profit-sharing mechanism may,under certain designs, be more expensive forthem than other alternatives within Islamicbanking. Moreover, some borrowers recog-

COMBINING ISLAMIC BANKING WITH MICROFINANCE 11

Borrower feedbackindicated an initialpreference for themudaraba mechanism

nize the potential for conflict between themicrofinance program and the borrower indetermining profit. Other borrowers did notlike the profit-sharing of mudaraba becausethey did not want to reveal their profits to theprogram (and their group).

Many borrowers initially expresseddoubts about the appropriateness of the“buy-resell” mechanism (murabaha)because it appeared too similar to the for-bidden practice of fixed interest rates(riba). But experience has shown that oncethe mechanism is properly explained to bor-rowers and local religious leaders, it isaccepted. Borrowers accept that a microfi-nance program incurs costs and that thesecosts have to be recovered in order for theprogram to continue offering financial ser-vices. Borrowers also appreciate the sim-plicity and transparency of the model.

The “buy-resell” model, which allowsrepayments in equal installments, is easierto administer and monitor. In addition, itseems to conform to practices in regionswhere even the handling of money is con-sidered haram—that is, in discord with theIslamic code. In such areas borrowers

would not receive the loan in the form ofmoney, but in the form of goods that themicrofinance program would purchase ontheir behalf and then “resell” to them. Animportant constraint of this model formicrofinance, however, is the program’shigher administrative cost, since loan offi-cers need to get involved in the market oper-ation. But experience indicates that theseinitial higher transactions costs are offset bythe lower costs of loan administration andmonitoring. Moreover, an increase in lend-ing volume suggests that these initial high-er transactions costs can be lowered toacceptable levels.

A microfinance program has to make sev-eral tradeoffs when selecting an appropriateloan methodology based on Islamic bankingprinciples (table 3). The program mustaccount for the administrative costs and risksof a particular methodology not only to theprogram but also to borrowers.

Note

1. This section draws heavily from Brandsmaand Abou El Yazeid (1997).

12 AN APPLICATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE

The higher initialtransactions costs

of the murabahamodel are offset bythe lower costs of

loan administrationand monitoring

Table 3. Islamic finance models and their applicability to microfinance

Issue Mudaraba (profit sharing) Murabaha (buy-resell)

Most applicable for Fixed assets (investment capital) and potentially Working capital and investment capitalworking capital

Cost to borrowers Potentially higher because of higher profit sharing with Lowerthe microfinance program as a result of higher risk

Initial acceptance by Higher Lowerborrowers

Risk to borrowers Lower if no predetermined minimum profit is allowed Higher

Risk to the program Higher if no predetermined minimum profit is allowed Lower

Administrative costs Administration is potentially complex, although Initial higher transactions costs because this could be resolved by predetermining of the large number of buy-sell a minimum profit. Still, costs of loan transactions. Costs of loan administration and monitoring are high given administration and monitoring are the complexity of the repayment schedule substantially lower, however, because

the repayment schedule is simple

Enforcement Difficult if profit must be determined for each Less difficult because the program owns installment, because most borrowers do not the goods until the last installment is keep sufficiently accurate accounts paid

13

Conclusion

Islamic bankingtechniques couldgive thousands ofentrepreneurialpoor access tomicrofinance

Islamic banking, with its emphasis on risksharing and, for certain products, collateral-free loans, is compatible with the needs ofsome microentrepreneurs. And because itpromotes entrepreneurship, expandingIslamic banking to the poor could fosterdevelopment under the right application.Islamic law allows room for financial inno-vation, and several Islamic contractualarrangements can be combined to design anew hybrid (Khan 1997). Bearing in mindthe guiding principles for successful micro-finance programs (see box 1), and withadjustments to incorporate Islamic bankingprinciples, the Islamic financial system couldoffer alternatives in microfinance. Viable pro-jects that are rejected by conventional lend-ing institutions because of insufficientcollateral might prove to be acceptable toIslamic banks on a profit-sharing basis.

Islamic banking offers loan productsbased on intangibles such as a busi-nessperson’s experience and character.Microfinance programs have extensiveexperience with character-based lending, asmost microentrepreneurs lack acceptablecollateral. Thus there is potential compati-bility between the needs of microentrepre-neurs and the practice of Islamic banking.

In certain circumstances the mudaraba(profit sharing) and murabaha (buy-resell)methodologies may be appropriate formicrofinance. Although the murabaha(buy-resell) model generates high initialtransactions costs, these can be potentiallyoffset by low loan administrative and mon-itoring costs given the simplicity of themodel. And while the mudaraba (profitsharing) model may require the frequentdetermination of business profits—and it isnot entirely clear how such profits would bedetermined—this methodology is feasible,and in some form or another can be usedto achieve the goals of microenterprise lend-ing. Other types of Islamic lending—such asqard al hasanah (benevolent lending with aservice fee)—may emerge as more practi-tioners implement Islamic lending princi-ples in microfinance institutions.

Islamic banking techniques could givethousands of entrepreneurial poor access tomicrofinance—an option they might notconsider if traditional, interest-based com-mercial loans were offered. More experi-mentation and practice in the field shouldcontribute to more knowledge and a betterunderstanding of effective loan deliverymechanisms using Islamic banking principles.

14

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