Islamic Approaches of Microfinancing

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Lecture Plan Session 1:

Microfinance Institutions (MFIs) Financing Microenterprises: Islamic

Alternatives Islamic MFIs Islamic MFIs Vs Conventional MFIs

Session 2: Financing Microenterprises: Islamic

Alternatives Islamic Banks Other Specialized Institution—Waqf-based MFI

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Session 1 IntroductionMicrofinance Institutions (MFIs)Islamic MFIs Vs Conventional

MFIsAssessment of Islamic MFIsConclusion

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Introduction (1)

In the last 50 years, different development strategies have been used to resolve the problem of poverty

Most of these programs failed “Microfinance” initiated in the mid-1970s

appears to be the ‘new paradigm’ to eradicate poverty

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Introduction (2)

Limited access to finance is key constraint to private sector growth

Investment on MSEs is even more difficult The MSEs do not qualify to get funds from

institutional sources (banks) lack of collateral too much risk too costly

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Economics of Microfinancing

Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) +

Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the

Head/regional/branch offices Microfinancing

Revenue may be low due to credit risk Costs are high due to large operating costs

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Financing MSEs Commercial financial intermediation not feasible If the poor have to be financed, there is a need

for social financial intermediation Two ways to do so:

Linking Approach—Existing financial institutions can do it through specialized windows

Specialized institutions Approach—NGOs, non-profit organizations, etc.

Almost all of MFIs models are of the second type

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Financing MSEs-Sustainability

Mitigating Credit Risk Ensure repayment in the absence of acceptable

physical collateral Solving the Moral Hazard problem

Ensure funds not diverted and used for intended activity

Economic viability —keep costs to a minimum relative to income Operating costs Financing costs

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Microfinance Institutions (MFIs) MFIs are target-oriented (poverty-focused)

financial institutions Target group—micro and small enterprises

(MSEs) (Average financing in Bangladesh is below

US$ 200 and in the US is US$ 1500) Graduation from poverty -- the “Virtuous circle”

Low income credit investment more income more credit more investment more income

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MFIs—Typical Balance Sheet

AssetsLiabilities

Cash (C)

Loans (L)

Funds from external sources (F)

Saving Deposits (D)

Reserves (R)

Equity (E)

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MFIs-Main Features

Interested individuals must form a group Several Groups form a Center Center has weekly meetings An official from the MFI attends the meetings

and all transactions take place in these meetings (bank goes to the people)

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Organizational Structure of MFI Clients

G rou p G rou p

M em b er M em b er M em b er M em b er M em b er

G rou p G rou p G rou p

C en te r

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MFIs-Other Features

Small amount of funds given for microenterprises for 3months -1year

Capital and interest paid back in small weekly installments

Forced savings and insurance programs Social Development Programs

behavioral, ethical, and social development

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MFIs-Social Collateral

MFIs have devised a structure to resolve the collateral and risk problems of financing No physical collateral required The repayment of dues of a member in the group is the

collective responsibility of the all the members in the group If any one in the group defaults--all members become

disqualified for credit Peer-pressure works as social collateral

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Banks Vs. MFIs (1)

BankMFI

A profit-maximizing firmNon-profit Government/non-government organization

Financial intermediary between savers and investors in the economy

Funds from external sources provided to the poor

Deposits form bulk of the liabilitySavings (forced) of clients only deposits

Do not have social/educational programs

Includes social/educational programs

Physical/financial collateral required to get funds

Social collateral through group and center formation

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Banks Vs. MFIs (2)

BankMFI

Clients relatively well-offClients are poor

Clients come to the bankBank goes to the clients

Amount of loan largeAmount of loan small

Most clients are menMost clients are women

Repayment frequency small (end of the contract period)

Repayment is frequent (weekly)

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MFIs and Sustainability Mitigating Credit Risk (CR)

CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem

Cash given out can be used for other purposes –chances of default increases

Economic Viability High administrative costs (some estimates show costs

ranging from 24 to 400% of per dollar lent) Reasonable finance costs

Conventional MFIs have resolved the CR problem (social collateral), but not MH problem and Economic Viability problem

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Islamic Alternatives to Microfinancing

Different alternatives: Islamic MFIs Islamic Banks Specialized Institutions

Group-based microfinancing can be used (as it mitigates the CR)

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Islamic MFIs-Features (1) Islamic MFI retains the basic operational format of

MFIs Going to the Clients Weekly/Monthly Repayments A Social/Development Program (to fulfill the social role of

Islamic finance) IMFIs have some distinguishing features:

Sources of Funds Other than external sources, can also use funds from

zakah, awqaf, and other forms of charities Use of funds (Mode of Financing)

Sale based and hiring modes (murabahah, salam, ijarah) Profit-sharing modes (Musharakah and mudarabah)

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Islamic MFIs-Features (2) Amount transferred to the poorest

As Islamic modes are sale based the price of the asset is paid (no deductions are allowed)

Group Dynamics Islamic values of brother/sister-hood improves cooperation

among the group members

Financing the poorest Zakat and other charities can supplement MFI activities

(non-diversion of funds)

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Islamic MFIs-Features (3) Social Development Program

behavioral, ethical, and social aspects in light of Islamic teachings

Targeting the family through women Spouse co-signs the contract dealing with women more efficient and convenient Women disseminate knowledge to children

Dealing with Arrears/Default Less aggressive and use Islamic teachings to recover

loans

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Islamic MFIs and Sustainability

Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending)

Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion

and default decreases

Economic Viability High administrative costs Reasonable finance costs

Islamic MFIs can resolve the CR problem and the MH problem, but not the Economic Viability problem

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Problems facing Islamic MFIs

1. Dilution in the Application of Islamic Modes of Financing Main mode- murabahah or bai-muajjal.

It is difficult to go out with the clients and buy the goods/assets from faraway markets

IMFIs delegates someone else (and inspects later) Alternative is to use Profit-sharing modes

Problem is the moral hazard problem--No book-keeping and difficult to monitor

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Problems facing Islamic MFIs

2. Lack of Funds Most MFIs get their funds from external sources Islamic MFIs have difficulty in getting funds from

these sources Operations and expansion of activities affected Islamic MFIs have not yet tapped the sources of

funds from Islamic institutions (like zakah, waqf, and other charities)

3. Training Training can enhance efficiency but is costly

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Conclusion

Islamic approach to microfinance has certain advantages Diversified asset and liability structures Social collateral stronger Potential to target the poorest through

complementary programs Asset-based modes of financing can prevent

diversion of funds for consumption Lack of funds hampering its growth

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Session 2

Financing Microenterprises: Islamic ApproachesIslamic BanksSpecialized institutions: Waqf-

based MFI

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Financing MSE by Islamic Banks (IBs)

The Rationale Social Role –Islamic firms are not only about

fulfilling Islamic contracts…there is more to it (social justice and benevolence)

Financing is the specialization of IBs—expand the client base to the MSEs

Can be done at no cost to the IB and more cost effectively than MFIs

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Financing MSEs by IBs

Use the same format as MFIs (as it suits the MSEs)

IBs can open up a department for financing MSEs

Use the existing infrastructure (bank offices) for financing MSE operations

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IBs & Economics of Microfinance

Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) +

Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the

Head/regional/branch offices

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MFIs Vs. IBs: Operating Costs MFIs

For any level of operations an MFI will maintain offices—Higher Fixed Costs

Higher Variable Costs (wages) at Head/regional/branch offices

IBs No extra costs needed to maintain offices for the

Microfinancing program (can use bank’s premises)—lower fixed costs

Lower Variable Costs (wages) at Head/regional/branch offices

Conclusion: Operation Costs to finance MSEs is lower in case of IBs compared to MFIs

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MFIs Vs. IBs: Finance Costs MFIs: Sources of funds

Main source –external funds (MFI has pay a rate of return, though subsidized in many cases)

No Deposits—Forced Savings of Members—Competitive returns are paid on savings

IBs: Sources of Funds Deposits

Demand Deposits (no costs) Investment Deposits (has to pay competitive returns to

depositors) Conclusion: Given the excess liquidity in IBs, the

funds from Demand Deposits can be used for MSEs—Finance costs of IBs can be lower than that in MFIs

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MFIs Vs. IBs: Quality of Service Dependence on external funds in MFIs comes with

conditionalities—IBs more flexible Lack of funds in MFIs—poorer quality work force

(especially at field level)—can increase the default rate

IBs pay competitive wages—good quality workers with higher productivity

Employees of IBs can be trained by the Bank at low cost—not possible in case of MFIs

Most IBs have funds collected from penalties for late payments—these funds can be used for complementary asset building/poverty reducing programs—asset building in form of grants or qard-hassan

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IBs and Sustainability Mitigating Credit Risk (CR)

CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem

As asset/good given instead of Cash, chances of diversion and default decreases

Economic Viability Low administrative costs

No need for a hierarchy of senior management and offices Use existing branches for operation

Low finance costs Excess liquidity—use liquid funds available

IBs appear to resolve all the problems related to sustainability in microfinancing.

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IB and Microfinancing: An Example

Islami Bank Bangladesh Ltd (IBBL) has a Rural Development Program (RDS) to finance MSEs

Started in 1996 and funded from IBBLs general investment fund

As of October 2006, RDS operated from 116 branches (of 176 total), covering 7,788 villages giving a total of Tk. 8589.7 mill. to 368,360 clients

The recovery rate is 99 percent. Employees involved with RDS have better benefit

packages than other MFIs Employees get in-house training at IBBL Training

Academy

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RDS of IBBL

Loan amount (Tk. 3000 to Tk. 25000) Paid back in weekly installments No physical collateral required Group-based lending Rate of return charged is 10 percent with

2.5% rebate for timely payment (other MFIs rate range from 16 to 20 %)

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Microfinancing by Specialized Institutions

1. Cash Waqf—waqf established in the form of cash Can be used for microfinancing

2. Qard hassan bank—nonprofit financial intermediary Capital would be cash waqf Will receive current accounts Provide qard hassan (interest free loans) for microfinancing

3. MFI based on Awqaf and Zakat Returns from waqf given for investment purposes and

zakat funds for consumption purposesUse the same operational format as MFIs (as it suits

the MSEs)

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Waqf-based MFIs

Historically, waqf based institutions did provide loans to the disadvantaged (Turkey and Iran)

W-MFI will retain the basic operational format of MFIs, but will have some distinguishing features

Group-based microfinancing can be used (as it mitigates the CR)

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W-MFI: Sources and Uses of Funds

Sources of Funds Obtain funds from Waqf and other sources (waqf

certificates, qard hasan deposits, etc.) Use of funds (Mode of Financing)

Qard (loan at service charges) Sale based and hiring modes (murabahah, salam,

ijarah) Profit-sharing modes (Musharakah and

mudarabah)

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W-MFI: Typical Balance Sheet

Assets Liabilities

Cash (C)

Assets (A)Fixed income assets (F)

Microfinancing (M)Qard, investments(murabahah, ijarah, salam, istisna, mudarabah, musharakah)

Savings Deposits (Ds)

Qard hasan Deposits (Dq)

Waqf Certificates (S)

Takaful reserves (T)

Profit equalizing reserves (P)

Reserves/Econ Cap. (V)

Capital-Waqf (W)

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Special features of W-MFI

Liability Waqf—the corpus (endowment) has to be intact Savings deposits — mudarabah contracts

Loss of lower return can lead to withdrawal risks

Assets Allocation of assets into fixed income and

microfinancing activities

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WMFI – Nature of waqf and investment options

Waqf—the requirement of keeping the corpus intact Simplest-option—Invest the waqf endowment in

some safe fixed-income asset and use the returns for MF operations

The scope of MF will be limited

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Example

Waqf of $10 million, rate of return 5%, financing $100 per beneficiary

(Grameen Bank 5.5 million beneficiaries given $5 billion)

AssumptionNo. of beneficiaries

Use waqf returns only5,000

Use 90% of the endowment

90,000

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Allocation of Assets

Risk and returns depend on allocation funds into different assets Fixed income (FI) assets—low-return low-risk

assets Microfinancing—higher returns with higher risks

Invest in FI assets so that returns can cover expected losses from microfinancing

In addition, build various reserves to cover various risks

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Risk-reducing reserves

Takaful reserves Contributed by beneficiaries Used in case of default due to unexpected reasons

Profit-equalizing reserves Contributed by depositors Used to maintain competitive returns

Economic capital reserves Contributed from the surplus of MFI (no dividend

distribution) Used in case of negative shock

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Other funding sources

Funds from Zakah and other charities Funds from waqf given for investment purposes

and zakah funds for consumption purposes

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W-MFI & Sustainability Mitigating Credit Risk (CR)

CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem

As asset/good given instead of Cash, chances of diversion and default decreases

Economic Viability High administrative costs Low finance costs

Being charities there are no finance chargesThese specialized institutions resolve CR and MH

problems and to lesser extent the viability problem

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Sustainability-Relative Status

Credit Risk

Moral Hazard

Economic Viability

Conventional MFIs

NoYesYes

Islamic MFIsNoNoYes

Islamic BanksNoNoNo

W-MFINoNoSomewhat

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Conclusion

There are strong economic reasons for establishing Islamic alternatives to poverty-focused microfinancing.

Financing should adopt operational mechanisms of MFIs (as they suit these clients)

Financing MSEs by IBs is most efficient (cost effective)—given the social responsibility and excess liquidity in IBs, financing MSEs should be undertaken

Traditional institutions of waqf, zakat, and qard hassan are important means of financing MSEs during contemporary times—should be integrated with microfinancing

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THANK YOU!