Experiments in Islamic microfinance

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<ul><li><p>Journal of Economic Behavior &amp; Organization 95 (2013) 252 269</p><p>Contents lists available at ScienceDirect</p><p>Journal of Economic Behavior &amp; Organization</p><p>j ourna l ho me pag e: www.elsev ier .com/ locate / jebo</p><p>Experiments in Islamic micronance</p><p>Mohamed El-Komi , Rachel CrosonUniversity of Texas at Dallas, 800 W. Campbell Road, Richardson, TX 75080-3021, United States</p><p>a r t i c </p><p>Article history:Received 12 AReceived in reAccepted 14 AAvailable onlin</p><p>JEL classicatioC91D03D82O10</p><p>Keywords:Islamic nancExperimental MicronanceInformation asInterestProt sharingJoint venture</p><p>1. Introdu</p><p>This papIslamic (maendeavor isU.S. and abr</p><p>MicronBarua, 2006the reach othat over 1</p><p> We thankthe conceptuaAdam Pierce fthe participanEconomic Assoand Finance in</p><p> CorresponTel.: +44 0191</p><p>E-mail add</p><p>0167-2681/$ http://dx.doi.ol e i n f o</p><p>ugust 2010vised form 13 June 2012ugust 2012e 7 September 2012</p><p>n:</p><p>eeconomics</p><p>ymmetry</p><p>a b s t r a c t</p><p>Micronance has been identied as an important tool in increasing the productivity ofthe poor and in aiding economic development. However, a large proportion of the poorare practicing Muslims, and are thus unable to take advantage of traditional micronancecontracts which involve the payment of interest. This paper describes and experimentallytests Islamic-compliant micronance products in the context of information asymmetryand costly state verication. We nd signicantly higher compliance rates for the Islamic-compliant contracts (prot-sharing and joint venture) than for the traditional contract(interest-based). We believe that there is great promise for these types of loans in themicronance context, for both Muslims and non-Muslims.</p><p> 2012 Published by Elsevier B.V.</p><p>ction</p><p>er describes and experimentally tests Islamic-compliant micronance products. While both micronance andcro)nance are well-developed elds of study, very little previous research has examined their intersection. This</p><p> important for understanding the nancial attitudes and behaviors of low-income consumers, both within theoad.ance has been identied by many as a useful tool in aiding economic development (Comim, 2007; Dowla and; Wright, 2000; Islam, 2007), even though the actual impact on poverty is still a matter of debate. However,f micronance (and especially microcredit) may be more limited than was previously realized. It is estimated/3 of the worlds poor are Muslims (CIA World Factbook, 2010 and Economist, 2008), and thus are unable to</p><p> Ali Abdul-Rahman, Ahmed Al-Zahrani, Daniel Arce, Catherine Eckel, Mahmoud El-Gamal, Uri Gneezy, and Dean Karlan for their help inlization and design of this paper. Special thanks to the CBEES lab staff; Sheheryar Banuri, Tara Larson, Wendy Lee, Elizabeth Pickett andor outstanding support. We particularly thank three anonymous reviewers for their invaluable comments and suggestions. We also thankts at the Southern Economic Association Conference in San Antonio, the Economic Science Association Conference in Chicago, the Europeanciation Conference in Glasgow, the African Econometrics Association Conference in Cairo, the International Conference on Islamic Economics</p><p> Qatar and the Symposium on Analytical and Empirical Research in Islamic Finance at Aston Business School for helpful comments.</p><p>ding author. Present address: Department of Economics, the American University in Cairo, AUC Avenue,P.O. Box 74, New Cairo 11835, Egypt. 334 5433; fax: +44 0191 334 5201.resses: mkomi@aucegypt.edu (M. El-Komi), rcroson@nsf.org (R. Croson).</p><p> see front matter 2012 Published by Elsevier B.V.rg/10.1016/j.jebo.2012.08.009</p></li><li><p>M. El-Komi, R. Croson / Journal of Economic Behavior &amp; Organization 95 (2013) 252 269 253</p><p>take advantage of the existing, interest based, microcredit products (CGAP, 2008). The Consultative Group to Assist thePoor (CGAP) conducted a global survey in 19 Muslim countries in 2007, in which 2040 percent of the respondents citedreligious reasons for not using conventional microloans. Constructing and making available Islamic-compliant micronanceproducts would extend the reach of micronance and aid in the economic progress of the Muslim poor in all countries, andthe economic development of nations with large Muslim populations.</p><p>Karlan and Morduch (2009) stress the importance of the way micronance choices are offered, and argue that they maymatter more than the pure economics of the choices with regards to take-up rates. The products tested in this paper rely onprot and loss sharing (PLS) contracts, and show how these options can contribute to the variety of micronance choices,which should result in higher take-up rates of micronance products. Our results indicate that these products can be moreefcient (annon-Muslim</p><p>The useasymmetrythe problemand costly sthese PLS an</p><p>PLS cont(such as: leaand Liu (20most of thebehind the PLS is inher</p><p>That saidern Nigeria of random p</p><p>Our goalthat PLS cofranchise agthe intereststronger ob</p><p>In this pexperimentbehavioral the eld. Th</p><p>We devethem with not to the lthree contrthe borrowprojects ouborrower if</p><p>Our resuall three concontracts din the micro</p><p>The papeSection 3 deand Section</p><p>2. Islamic </p><p>2.1. Islamic</p><p>Islamic industry. Its</p><p>1 This is by nchoice of proje</p><p>2 We thank d more protable for lenders) than traditional interest based contracts which are primarily offered, even among populations.</p><p> of PLS contracts has traditionally been minimized in Islamic banking due to risks resulting from information (such as enterprise failure, adverse selection, moral hazard and costly state verication) (El-Gamal, 1997). Whiles of enterprise failure and adverse selection are common for both PLS and interest based nance, moral hazard</p><p>tate verication are more acute risks of PLS nance (e.g. Gale and Hellwig, 1985). Our paper focuses on comparingd interest based contracts when the lender needs to verify the projects state when the loan has not been repaid.1</p><p>racts are surprisingly sparse in the eld. El-Gamal (1997) notes that Islamic banks over-rely on non-PLS contractssing, cost-plus and deferred payment sales), while using an accounting interest rate for their bookkeeping. Chong09) show that less than 1 percent of Islamic banking operations in Malaysia use PLS-based products and thus,</p><p> operations are interest based or -pegged. Dar and Presley (2000) cite agency problem as one of the main reasonslack of PLS in Islamic banking. However, they conrm that there is no theoretical reason to make us believe thatently less efcient than interest based contracts., sometimes interest contracts incorporate PLS features. For example, Udry (1990) cites an example from North-</p><p>(where Muslims are predominant) in which risk is shared by varying the interest rates that based on the realizationroduction shocks.</p><p> in this paper is to investigate the feasibility of PLS contracts in the presence of information asymmetry. We arguentracts pool risk between the lender and the borrower, much as a sharecropper agreement or a prot sharingreement. This risk pooling generates in a different power structure between the borrower and the lender than</p><p> contract. As a result, PLS contracts are seen as more equitable than interest contracts, and borrowers will feel aligation to comply with their terms and, in particular, to repay the loan when their project succeeds.2</p><p>aper, we develop and test Islamic-compliant micronance contracts that are based on PLS. We use laboratorys as a testbed or wind-tunnel for these contracts (Plott, 1987). The laboratory can test, at very low cost, theresponse to different types of contracts. These contracts can then be adjusted or amended before being used ine laboratory thus serves as an intermediate step between theoretical development and eld-testing.lop two micronance contracts which are Islamic-compliant (prot sharing and joint venture) and comparean interest based loan. Borrowers invest these loans in risky projects, whose outcome is known to them butender. We examine compliance rates, the rate at which individuals comply with the terms of the loan, in theacts under three conditions. A no-enforcement condition involves a simple repayment or reporting decision byer. An enforcement condition allows the lender to follow up on the decision, and to force collection or audit thetcome if appropriate. An enforcement with penalty condition also allows the lender to charge a penalty to the</p><p> he has defaulted on the loan or misreported the success of his project.lts indicate that the Islamic-compliant loans induce at least as much compliance as the interest based loans inditions (no-enforcement, enforcement and enforcement with penalty), although the differences between the three</p><p>ecrease as the possibility of penalty is introduced. We believe that there is great promise for these types of loansnance context, and discuss strategies for eld implementation in the conclusion of the paper.r is organized as follows. Section 2 discusses the practice of Islamic nance, micronance, and their combination.scribes our theoretical model and Section 4 our experimental design. Section 5 presents our experimental results</p><p> 6 concludes.</p><p>nance, micronance, and their combination</p><p> nance</p><p>nance is in a phase of growth and change. On one hand, Islamic nance is being celebrated as a promising nancial assets exceed $1.3 billion (compared to $160 billion in 1997) and the market is estimated to be growing at 1015</p><p>o means the only interesting or important problem in micronance or microcredit. Adverse selection of borrowers, and moral hazard of thect funded with the borrowed money are also relevant issues, but are beyond the scope of this single paper.an anonymous reviewer for pointing out asymmetric power as a causal mechanism for the increased sense of obligation felt in PLS contracts.</p></li><li><p>254 M. El-Komi, R. Croson / Journal of Economic Behavior &amp; Organization 95 (2013) 252 269</p><p>percent per year (The Economist Online April 4, 2012). On the other hand, despite its boom, the Islamic banking industrysuffers from two crucial shortcomings.</p><p>The rst is its failure to meet the developmental needs of the Muslim poor. Islamic nance is not designed for micronance,but focuses on large dollar investments and loans. The second shortcoming is the reliance of the Islamic banking industryon mark-upthe principreliance has</p><p>2.2. Micro</p><p>Micronthis paper wto the very to contribucosts, leadinbetter funct</p><p>Howeveprograms. Spercent ann10 percent these challeBanerjee et</p><p>A few prthe takeup They foundincome and</p><p>Abbink eOn the one the groups(2009) ndrates in thesensitive to</p><p>AnotherMorduch, 2nd no affeexperiment</p><p>In contror PLS baseFurthermorexhibit non</p><p>2.3. The com</p><p>The aimpoor that arpoor. Survereligious re</p><p>We belieoften exclu20 percent the variety (2009) abov</p><p>3. Models</p><p>The maiularly PLS cprot sharican observe</p><p>To compsharing as s (murabaha) products that resemble interest based loans in structure (Appendix A provides a description ofles of Islamic nance and different types of products that have been developed, for the interested reader). This</p><p> reinforced the inability of Islamic nance to reach individuals who are seeking contracts without interest.</p><p>nance</p><p>ance has attracted signicant attention during the last two decades from academics and policy makers alike. Ine will be focusing on a particular type of micronance; microcredit, in which small loans ($100 or so) are made</p><p>poor. Microcredit has the potential to include the poor in the formal nancial system, which is widely believedte to economic development and growth, because formal nancial sectors reduce transaction and informationg to a more efcient economy. Levine (2005) reviews both theoretical and empirical studies demonstrating thationing nancial sectors allow countries to grow faster.r, microcredit has its challenges. First, it suffers low take-up rates; relatively few people participate in microcreditecond, in apparent contrast with its mission, microcredit is not cheap. Interest rates between 20 percent and 50ually are quite common in the micronance industry, even in places where annual ination rates do not exceed(Dehejia et al., 2009); these high interest rates reect the additional risk of this type of borrower. Overall, givennges, the impact of microcredit on poverty alleviation has not yet been conclusively demonstrated (see, e.g.</p><p> al., 2009).evious studies have examined one or another of these issues. For example, Karlan and Zinman (2009) examinedproblem, and estimated the impact of enhancing access to consumer loans in a eld experiment in South Africa.</p><p> signicant positive effects of expanded access to credit on the overall borrower outcome, in terms of employment, food consumption. The marginal loans given through the credit expansion were also protable for the lender.t al. (2006) used laboratory experiments to investigate the impact of interest rates on default in group settings.hand, they nd that higher interest rates increase default rates. On the other hand, higher interest rates increase</p><p> punishment of defaulters. Thus, higher interest rate had a mixed effect on default rates. Similarly, Dehejia et al. that different categories of the poor respond differently to increases in interest rates. They increase interest</p><p> slums of Dhaka, Bangladesh from 2 percent to 3 percent per month. They nd that poorer borrowers were more the increase in interest rate (with elasticity of .86) than relatively wealthier borrowers (with elasticity of .26).</p><p> important choice in microcredit is between individual and group-lending arrangements (Armendariz and007). Group-lending arrangements are the most popular and well-developed. However, Gin and Karlan (2010)ct of group liability on repayment rates; individual loans are repaid at the same rate as group loans in their eld</p><p> in the Philippines.ast with this previous research, we will focus on the type of microcredit contract being used; interest basedd. We will assume that all individuals have access to these contracts, and will hold constant the cost of funds.e, we will focus on individual lending, as we believe that this is the setting where individuals are most likely tocompliance.</p><p>bination</p><p> of this paper is to combine micronance and Islamic nance in order to develop nancial products for thee consistent with Islamic principles and involve PLS contracts. Almost half of the 1.6 billion World Muslims areys by CGAP (2008, 2009) indicated the 40 percent of the Muslim poor reject interest based microcredit loans forasons.ve that identifying effective PLS contracts will enhance access to nance amongst the Muslim poor, who are</p><p>ded from banking services. 80 percent of Muslims in India are excluded from banking services, as compared withof non-Muslims. Beyond the Muslim population, identifying potentially new microcredit products will add toof the available products, which could enhance take-up rates of microcredit, as stressed by Karlan and Morduche.</p><p>n question of this research is wheth...</p></li></ul>