islamic banking and microfinance

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AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper- 1

Islamic Banking and Microfinance

Wan Kamarudin Bin Wan Omar

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AT3002_HHI


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This is Professional Practice Paper for fulfillment of AT3002_HHI of Part 3

of Certified Islamic Financial Professional (CIFP)

INCEIF

January 2010

Islamic Banking and Microfinance

Wan Kamarudin Bin Wan Omar

Abstract

Microfinance has been in practice around the world to help poor people and

eradication of poverty. However, microfinance activities are being dominated by

conventional financier and Islamic banks appears to be less interested to

venture into this area. The aim of this paper is to argue that since Islamic banks

are established under Shariah, they should strive to fulfill Islamic philosophy on

social justice, equal wealth distribution and eradication of poverty in the society.

The Islamic banks should play his role well in empowering people and promote

egalitarian society. Eventhough there are many ways to achieve it, microfinance

is one of the scheme which Islamic banks should perform well.


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1. Introduction

Islam strives for social justice in the society. Social justice is being defined

as giving each individual what he/she deserves, distribution of financial

benefits in the society and providing equally for basic needs. It is also the

egalitarianism in opportunities, i.e. each person has a chance to climb up the

social ladder1. One of the ways to achieve social justice is by having fair

distribution of wealth within a society and prohibits concentration of wealth to

certain segment of people only. There should be no monopoly in the wealth

accumulation and wealth should circulate as spread as possible. This vision

has been stated in Al-Quran:

So that this wealth should not become confined only to the rich amongst

you (59:7):

Despite Islam promotes social justice and just distribution of wealth in the

society, the ideal vision is not reflected into reality. Muslim countries

throughout the world are still grappled with the poverty within their country. It

is estimated that2:

400 million of the 1 billion people estimated to be in absolute poverty

lived in 31 of the 56 OIC member states i.e. 40% of the world'

Five large states Indonesia, Pakistan, Nigeria, Bangladesh and Sudan

with cumulative population of 690 million people have 250 million

people living below poverty line. The incidence of poverty in these

countries is slightly above 36%;

1http://www.neareast.org/phil/en/page.asp?pn=24

2www.isis.org.my/files/events/Sess3-IshratHusain.pdf


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Fifteen states with a total population of 143 million people out which

more than 50% i.e. 74 million live below the poverty line face severe

problems and also on slipping path as far as fight against poverty is

concern;

Nine states inhabiting 113 million people have 55 million poor

Two states i.e. Uzbekistan and Albania with a population of 30 million

people have 8 million poor i.e. incidence of poverty is 27% and is

manageable.

Malaysia which is being regarded as a relatively well-off country compared

to other Muslim countries also has it share of wealth inequality within the

society. According to UNDP report on Malaysia3:

The proportion of all Malaysian households in poverty was 5.96 per

cent in 2004. However, this figure masks substantial variation across the

countrys states, communities, and between rural and urban areas.

Poverty is particularly concentrated in the five low income states. In

2004 there were 5,459.4 thousand households in Malaysia, 5.96 per

cent of which were poorover 325,000 households. Three quarters of

these households live in the five poorest states: Kedah, Kelantan,

Terengganu, Sabah, and Sarawak. Of poor households in 2004, 37

percent live in Sabah. Poverty in Malaysia is increasingly a regional

problem.

Poor households also tend to be the larger ones, so the individual and

child poverty rates are above the proportions of poor households. In

3UNDP: Malaysia Measuring and Monitoring Poverty and Inequality, pg 79


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2004 the proportion of Malaysian children in poor households was over

12 per cent. The proportion of poor children in Sabah was over 40 per

cent.

Relative poverty rates have tended to be constant over time. Roughly

1 in 5 households received an equivalized income less than half the

Malaysian median income.

The above statistic shows that, there is miss-alignment between the

Islamic thrust on wealth distribution which should be as spread as possible

with the reality of the Muslim countries. There are segments within the

society which still grappled with inadequate basic necessities and trapped

in the vicious cycle of poverty.

2. Islam & Wealth Distribution

As being stated earlier, the objective of Shariah is to ensure social justice

and equitable distribution on income in the society. No one in the society

should be left behind especially to live without basic necessities. The Prophet

Muhammad (pbuh) view poverty as a threat and dangerous situation from

which people in the society should do away with and pray to Allah for

protection. The Prophet (pbuh) said that:

O my Allah, I refuge to you from the evils of poverty4

In another hadith, the Prohet (pbuh) said that:

Refuge to Allah from the evils of poverty, famine, degradation,

oppressing and oppressed5.

4Ibn Hanbel, VI/57,207; Ebu Davud, Edeb, 101; Al Nesai, Istiaze, 14, 16: Sehiv, 90


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The hadith above equates poverty as evil. Lack of resources for basic

necessities destroys poor people since they have no means to support their

live and family. This situation will create social problems within the society. A

father will have no means to provide his family with meals to prevent them

from hunger. He is also not able to provide his children with education which

useful for better employment for better life. In addition, he may not have

access to health services. At the end, it will force him to beg or in extreme

cases, involve in unhealthy activities which will create more social problems.

In searching for wealth, Islam encourages the believer to work hard and

receive gain based on their effort. Verse in Al-Quran stated that:

"And when the prayer is finished, then disperse in the land and seek of

Allah's grace, and remember Allah much, that you may prosper." (Al-

Quran, 62:10)

The encouragement in the Quran to work is further re-enforce by the

hadith from the Prophet (pbuh). He said that:

"No one has ever eaten any food that is better than eating what his hands

have earned. And indeed the Prophet of Allah, Dawud, would eat from the

earnings of his hands."6

The verse and hadith above shows that, Islam does not want their follower

to beg, instead it promotes effort and hard work by each Muslim to acquire

wealth. Sadaqah receive by beggar is not sustainable since it will finish or

discontinue by the givers. When this happened, they will be back at their old

5Ibn Hanbel, II/540

6Reported by Al-Bukhari


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state. Islamic strategy in dealing with poverty can be further observed in the

following hadith:

A man of the Ansar community came to the Prophet (pbuh) and

begged from him. He (the Prophet) asked: have you nothing in your house?

He (the man) replied: Yes a piece of cloth, which we wear, or which we

spread (on the ground), and a wooden bowl from which we drink water. He

(the Prophet) said: Bring them to me. He (the man) then brought these

articles to him and he (the Prophet) took them in his hands and asked to the

assembly of people: who will buy these? A man said: I shall buy them for one

dirham. He (the Prophet) asked twice or thrice: Who will offer more than one

dirham? Another man said: I shall buy them for two dirham. He (the Prophet)

gave these to him and took the two dirhams and, giving them to the man of

the Ansar, he said: Buy food with one of them, and hand it to your family,

and buy and axe and bring it to me. He then brought it to him. The Prophet

(peace be upon him) fixed a handle on it with his own hands, and said: Go

gather firewood and sell it, and do not let me see you for a fortnight. The man

went away and gathered firewood and sold it. When he had earned ten

dirhams, he came to him and bought a garment with some of them and

food with the others. The Prophet (pbuh) then said: This is better for you

than that begging should come as a spot on your face on the Day of

Judgment. Begging is right only for three people: one who is grinding poverty,


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one who is seriously in debt, or one who is responsible for compensation, and

finds it difficult to pay7

The hadith above shows that the poor person is capable to become

successful if he is given adequate opportunity to be involved in economic

activities. Small capital which made available to him can be used to generate

sustainable income to support their family. From the hadith, we can conclude

that, to overcome the issues of poverty and inequality of wealth distribution in

the society, Islam advocates economic empowerment. Economic

empowerment means that the poor people is given opportunity to improve

themselves by being involves in economic activities to uplift himself and his

family living standard.

This is where the function of Islamic banks is important to fight poverty

and improve wealth distribution in the society. Islamic banks are financial

intermediaries, where one of the roles is to channel capital surplus in the

society to people who are in need of capital, in this case to poor people.

3. Islamic bank and its function in wealth distribution

Globally, Islamic banking industry has shown tremendous growth over the

past decades with more than 20% growth for the past five years8. According

to The Bankers Top 500 Islamic Financial Institutions survey9, assets held

by fully Shariah-compliant banks or Islamic banking windows of conventional

7Sunan Abu Dawood, Kitab al-Zakah, Book 9, Number 1637

8http://www.calyon.com/mediaroom/interviews/the-growth-of-islamic-banking-is-seen-as-an-important-

trend-and-not-just-a-fashion.htm

9 http://gifc.blogspot.com/2009/11/double-digit-growth-for-islamic-banking.html


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banks rose by 28.6 percent to $822bn from $639bn in 2008. Comparatively,

within the same period, the worlds conventional banks only posted annual

asset growth of 6.8 percent. In Malaysia, currently there are 17 Islamic banks

and the industry has grown tremendously with estimated annual growth rate

of 18% to 20% annually10.

The attractiveness of Islamic banks is due to it operations is based on the

Shariah foundation. Thus all dealings, financing and investment conducted

by Islamic banks are complied with Shariah principles. Shariah obliged for the

transactions to be free from the prohibited elements of riba (usury), maisir

(gambling) and gharar (uncertainty). It also discourages involvement of

Islamic banks in transactions which inconsistent with Islamic values such as

illegal activities, production of harmful materials and useless products.

Nevertheless, the function of Islamic banks is not only to offer Shariah

compliance products. As the name suggested, it carry religious connotation

and obligation. As a bank establish under religion of Islam, it must strive to

fulfill the objective of Shariah. Shariah means a waterway that leads to a

main stream, a drinking place, and a road or the right path11. From the

meaning, we concurred that Shariah is a tool (as a passage) to achieve

certain goal or objective. So what is the objective of Shariah?

According to Imam Al-Ghazali:

The objective of the Shariah is to promote the well-being of mankind,

which lies in safeguarding their faith, their human self, their intellect, their

10 Bank Negara Malaysia: Annual Banking Statistics 2007

11 http://theislamiclaw.wordpress.com/


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posterity and their wealth. Whatever ensures the safeguard of these five

serves public interest and is desirable12

Generally speaking Shariah aims at protecting and preserving public

interest, and it aims at removing hardships from people and providing them

with solutions to their problems13.

This is the fundamental differences between Islamic banks and

conventional banks. Conventional bank is based on capitalism where focus is

on profit maximization. Whereas Islamic banks have to ensure that they

contribute to the achievement of objective of Shariah, which means to focus

on its role in the society.

However this doesnt mean that the Islamic banks are a charitable

organization and should not generate profits. As a business entity, the banks

have to generate profits to ensure their sustainability of their business. Islam

recognize the right for wealth, accept income disparity and different level of

social standing in the society due to the fact that each person has different

level of intelligent, strength, skill set and passion in pursuing economic

activities. Hence some of the people will be an employer with others work as

their employee. In the Al-Quran, Allah has stated that:

''We have distributed their livelihood among them in worldly life, and have

raised some above others in the matter of social degrees, so that some of

them may utilize the services of others in their work." (43:32)

12Chapra 2000a, P118

13http://theislamiclaw.wordpress.com/


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However, there should be no situation where the wealth disparity is wide

where certain segment in the society is struggles for end meet. Thus

mechanism must be in place where there is ample opportunity in place for

people to work hard and gain their own wealth.

Islamic bank plays crucial role in the society due to their function as

financial intermediaries. They provide link between surplus capital unit and

deficit capital unit. Individual with excess capital deposits their money in the

bank. The banks subsequently disburse the money to the entrepreneur who

in need of capital for their business operation. Using this scenario, the Islamic

banks have a privilege to decide where the money will be channeled. If

Islamic banks decide to channel it to certain group of people, lesser capital is

left to be channeled to the other groups of people. Thus, if the Islamic banks

bank are decided to pursue profit maximization, off course they will channel it

to good credit standing and profitable business. However, if the Islamic banks

want to play their role as espoused by Shariah, they will ensure that there is

adequate allocation of capital to the less fortunate people in the society. The

above scenarios show that the act of Islamic banks gave wide implications on

the access to capital within the society.

Better access to capital will help poor people to participate in economic

activities and uplift their economic. Dr Umer Chapra wrote that:

Lack of access of the poor to finance is undoubtedly the most crucial

factor in failing to bring about a broad-based ownership of businesses and

industries, and thereby realizing the egalitarian objectives of Islam. Unless


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effective measures are taken to remove this drawback, a better and

widespread educational system will only help raise efficiency and incomes

but ineffective in reducing substantially the inequalities of wealth. This would

render meaningless the talk of creating an egalitarian Islamic society.

Fortunately, Islam has a clear advantage over both capitalism and socialism

which is built into its value system and which provides bitting power to its

objective of socio-economic justice Chapra [1992: 260 261]

In addition to the social centric obligations as outline by the religious

requirements, from the user side, there is growing demands by the

stakeholders who want Islamic banks to play active roles in social duties. A

survey conducted by Dr. Asyraf Wajdi Dusuki (2008)14 on the stakeholders of

Islamic banking which comprised seven stakeholders group; i.e. customer,

depositors, local communities, Islamic banking manager, employees, banking

regulatory officers and Shariah Advisors concluded that:

The most important fact revealed by this study is that stakeholders of

Islamic banks view the industry much more favourably by the social and

ethical goals that it serves, rather than mechanics of its operation. One of the

most important reflections of their attitude is that social-welfare factors are

evidenced as more important objectives than commercial factors in their

perceptions towards Islamic banking. This result implies that Islamic banks

must ensure that all of their transactions are Shariah compliant not only on

14Dr. Asyraf Wajdi Dusuki, Understanding the Objectives of Islamic Banking: A survey of Stakeholders

perspective (2008)


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their forms and legal technicalities but more importantly the socio-economic

substance which is premised on the objectives outline by Shariah.

The above discussion shows that Islamic banks have crucial roles to

ensure better wealth allocation in the society. Members of the society also

have high expectation for Islamic banks to perform their function well.

4. Islamic Banks and Micro-finance Scheme

Islamic banks need to effectively fulfill the objective of Shariah and also to

satisfy the expectations of society where they operate. This means that

Islamic banks have to find an appropriate scheme. Through the selected

scheme, Islamic banks will offer economic empower to the poor people for

them to have sustainable income and ultimately uplift their living status. The

scheme also should be sustainable, means that it will not contribute to failure

of Islamic banks due to high risk involved. Due to these factors, microfinance

scheme is a perfect fit into the agenda.

Microfinance is a micro-financing practice in which the financing is

extended to those who have difficulty to access financing due to lack of

collateral, low credit rating and lack of credit history. The definition of micro-

finance varies. Among the definitions are:

i. Programme that extend small financings to very poor people for self

employment projects that generate income in allowing them to take care

of themselves and their families (Microcredit Summit 1997)


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ii. Microfinance is the provision of financial services to low-income clients,

including consumers and the self-employed, who traditionally lack

access to banking and related services (Wikipedia)

iii. The provision of small financings (microcredit) to poor people to help

them engage in productive activities or grow very small businesses.

(www.pbs.org)

iv. Financial services - such as financings and savings - directed toward the

poor. (http://library.thinkquest.org/05aug/00282/other_glossary.htm)

Micro-finance is compatible with the objectives of Islamic banks since both

focuses on the well-being of the society as a whole with the objectives of just

and equitable wealth distribution. They strive to promote the egalitarian

approach for social justice in which everybody have equal opportunity in the

economic activities and no restriction to any category or group of people.

Since financing to higher credit grading person are readily available, the

micro-finance scheme focuses on the poor, deprived and destitute segments

of the society. This will ensure that, the poor people will have the same

opportunity to get involve in the economic activities by having access to

capital.

Furthermore, micro-finance can be used as a tool for financial inclusion.

Financial inclusion by definition is the delivery of banking services at

affordable costs to vast sections of disadvantaged and low income groups15.

15http://en.wikipedia.org/wiki/Financial_inclusion


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Under normal financing, due to the perceived high risk group segment, the

financing charge imposed on this group of people is normally high. Via

microfinance, there is a potential that the charges will be accommodative or in

better way, based on the capability of these micro-entrepreneurs.

In a nutshell macro-finance can be used to promote participation of every

individual within society. If previously, poor people is handicap economically

and not able to actively participate in the economic activities due to

incapability to obtain capital, micro-finance will give them new opportunity, not

like before.

Involvement of Islamic banks in the micro-finance will give added value to

the whole scheme. This due to the nature of Islamic finance which prohibit

financing to all form of economic activities which are morally and socially

detrimental to the society. For example, the Islamic banks are prohibited from

financing alcoholic drinks which will contribute to social ill within the society. It

also prohibited from financing activities which is harmful to the nature such as

dangerous chemical which produce toxic waste and pollute the environment.

Due to prohibition of this type of activities in the society, Islamic banks will

contribute to healthy and harmonious living of community.

Among the features of micro-finance are:

a. Financing is for short-term period.

b. The financing is small. In Malaysia, the financing amount ranges

from RM500 to RM50,000 (BNM).


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c. The financing is meant for micro-entrepreneur, which consists of

self-employed, hawkers, traders and small businessmen. It also

targets the poor to start business activities.

d. Purpose of financing is for new business ventures or business

expansion.

e. The term and condition of financing is easy to understand and

flexible.

The above features means that the microfinance financings focus is the

underprivileged segment. This is the reason why it being designed to be

simple and does not require high level of knowledge to understand and

operates it.

However, it would be useful to find whether, based on experience, the

micro-finance is really useful in helping the poor and alleviating the poverty

within the society. Christopher Dunford (2006) in his article titled Evidence of

Microfinances contribution to achieving the Millennium Development Goals

concluded that:

.. there is already enough evidence to say with cautious confidence that

microfinance can and does contribute to achievement of the Millennium

Development Goals16, and in a major way already in Bangladesh, if not in

other developing countries.

16The Millennium Development Goals (MDGs) are eight goals to be achieved by 2015 that respond to the

world's main development challenges. The goals are: (i) eradicate extreme poverty and hunger, (ii) achieve

universal primary education, (iii) promote gender equality and empower women, (iv) reduce child

mortality, (v) improve maternal health, (vi)combat HIV/AIDS, malaria & other diseases, (vii) ensure

environmental sustainability; and (viii) develop a global partnership for development.


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He pointed to one major study of microfinance and its impact on poverty

conducted by Khandker17 on experience in Bangladesh. Khandker performed

massive survey of households participating in the scheme which was

conducted in 1991/92 and repeated 1998/99. The survey concluded that

microfinance accounted to 40 percent of the entire reduction of moderate

poverty in rural Bangladesh. The result also suggested that access to

microfinance contribute to reduction in overall poverty at the village level, thus

not only helping poor participants but also the local economy.

Study conducted by Mohabub Hossain titled Credit for the Alleviation of

Rural Poverty: The Grameen Bank in Bangladesh (1998) found Grameen

members average household income to be 43 percent higher than target

non-participants in comparison villages, with the increase in income from

Grameen highest for the landless, followed by marginal landowners. The

positive impact of microfinance also supported by other studies such as

Managing Resources, Activities, and Risk in Urban India: The Impact of

SEWA Bank (2001), by Martha Chen and Donald Snodgrass, Microfinance

Program Clients and Impact: An Assessment of Zambuko Trust, Zimbabwe

(2001), by Carolyn Barnes and The Impacts of Microcredit: A Case Study

from Peru (2001), by Elizabeth Dunn and J. Gordon Arbuckle Jr.

Even though there are criticisms made to the above studies which largely

based on disagreements in the methodologies used, positive impacts of

microfinance to alleviate poverty cannot be denied. With refinement of

17Khanderker, Micro-finance and Poverty: Evidence using Panel Data from Bangladesh (2005)


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methodologies are in progress and better data gathering, less criticism is

expected, with no significant changes on the conclusion.

5. Current Involvement of Islamic banks in Micro-finance

According to CGAP report, the outreach of Islamic micro-finance is very

limited18:

In all Muslim countries, Islamic microfinance still accounts for a very small

portion of the countrys total micro-finance outreach. For example, in Syria

and Indonesia, Islamic financing instruments comprised only 3 percent and 2

percent, respectively, of outstanding micro-finance financings in 2006. In

addition, the average outreach of the 126 institutions covered by the CGAP

survey is only 2,400 clients (and none has more than 50,000 clients). The supply

of Islamic microfinance is very concentrated in a few countries. Indonesia,

Bangladesh and Afghanistan account for 80 percent of the global outreach

of Islamic microfinance. In all other countries, microfinance is still in its infancy,

with no scalable institutions reaching clients on a regional and national level

In addition, Microfinance expert Dr Saad Al-Harran laments the lack of

participation by the Islamic banks and assert that as an entity based on faith,

the institution should have a bigger moral obligation to contribute to the

society19. This is despite the fact that more than 35% of the world population

or 1.3 billion people are living in poverty.

18CGAP: Islamic Micro-finance: An emerging Market Niche (2008)

19http://www.islamicfinanceasia.com/3_micro.php


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Currently there is no data available in the public domain to gauge the

amount of micro-finance disbursed by Islamic banks in Malaysia. According to

BNM, the Micro-financing has increased from RM151 million in 2000 to

RM2.2 billion in September 2009, representing an annual average growth rate

of 34%20. However, this figure consists of all players in the financial

institutions, including conventional banks and developmental financial

institutions. From observation, there is no visible micro-finance scheme

actively promoted by the Islamic banks in Malaysia.

In addition, the annual accounts of the Islamic banks did not specifically

disclose their involvement in micro-finance scheme. Based on the financing

segmentation in the financial accounts of Islamic banks, the following is

noted:

BanksBank Rakyat

MalaysiaBank Muamalat Bank Islam

Community, Social

Services & Personal*

RM84.2m RM192.7m RM59.3m

% to total financing 0.3% 3.0% 0.6%

*Figure based on Annual Report

The figure above shows that the involvements of Islamic banks in the

financing for the purpose of community, social & personal are small.

Apart from the above banks, other Islamic banks operates in Malaysia

does not disclose their financing to this segment. With the growing questions

on contributions of Islamic banks to the betterment of society, disclosure is

the area which should be handled well by the Islamic banks. The Islamic

20http://www.bnm.gov.my/index.php?ch=9&pg=15&ac=336


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banks should have appropriate disclosure in place especially on their efforts

to satisfy the objective of Shariah. The disclosure will be useful for their

stakeholders to effectively evaluate the role play by the Islamic banks in the

society.

It is interesting to note that earlier experiment of Islamic banks in Pakistan

and Egypt focused on economic development and poverty alleviation.

Establishment of Islamic banks in Pakistan during 1950s is to finance small

landowners for agricultural development. Same experience is observed in

Egypt with the establishment of Mit Ghamr Savings Bank in a rural area of the

Nile Delta. This institution later replaced by Nasser Social Bank with the

purpose mainly for social activities such as interest free financing for small

projects based on profit and loss sharing, assistance to the poor and needy

students for university and higher institutions (INCEIF, 2006). However,

through passage of time, the focus of Islamic banks have move to profit

maximization and financing billion dollar investments as seen in Dubai and

other countries. Rapid development also contributed by players who want to

tap petrodollar possess by Islamic countries, instead of focus on the

achievement of Shariah objectives.

6. Financing Scheme for Microfinance

Currently, practice of micro-finance is largely based on conventional

contract i.e. charging of interest on the financing amount. Interest rate

charged is very high to compensate for perceived high credit exposure and


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higher transaction costs since the portfolio is larger and require higher

administrative operations. However, this practice possess all characteristics

prohibited by Shariah i.e. usury (riba), gambling (maisir) and excessive

ambiguity (gharar). Islamic banks entry into microfinance and its operations

should be in compliance with Shariah principles. There are various Shariah

compliance contracts which can be utilised by the Islamic banks.

6.1. Profit and loss sharing (PLS) arrangement

Profit and loss sharing is unique concept of financing in Islamic

finance. In this arrangement, Islamic bank act as equity provider or as a

partner with micro-entrepreneur. Return to the Islamic bank is contingent

upon results of the business venture. It is fairer arrangement compared

to the borrower relationship practice in the conventional micro-finance.

Since the nature of this world is uncertain, business ventured by micro-

entrepreneur may generate a profit or may suffer a loss. As a financier,

they should share this uncertainty with their clients. They cannot just sit

there, do nothing and expect to receive return especially when dealing

with poor people. With Islamic banks carry the same risk, it will promote

Islamic banks to get involved directly or indirectly in the business to

ensure the venture will be profitable.

It is a known fact that micro-entrepreneur consists of people with low

level of knowledge and technical skills. On other hand, bank has the

knowledge and expertise as they have wide experience in dealing with


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business activities. As a mean to ensure that their partnership is

successful, the Islamic banks have to impart this knowledge to their

partner. Knowledge may be in form of good business practices, proper

accounting and record keeping, effective marketing and packaging and

etc. This gesture is useful to micro-entrepreneur and will greatly help

them to become successful entrepreneur.

Muslim economists regards PLS as truly Islamic financing

transactions. Scholars include Sadr (1982); Siddiqi (1983, 1985); Chapra

(2000a, 2000b) Ziauddin Ahmad (1984); Ahmad (2000); Siddiqui (2001);

Haron (1995, 2000), Ahmad (2000); Rosly and Bakar (2003); Haron and

Hisham (2003); Naqvi (2003) and others favour equity-based

instruments and place greater social welfare responsibilities and

religious commitments upon Islamic banks in order to realize the

Maqasid Al Shariah with respect to economic and financial transactions,

including social justice, equitable distribution of income and wealth and

promoting economic development and growth21.

There are two types of contracts under PLS arrangement i.e.

Mudharabah and Musharakah.

I. Mudharabah

Mudharabah is a trust based financing arrangement between

Islamic bank and micro-entrepreneur in which the bank entrusts

21Dr. Abdulazeem Abozaid & Dr. Asyraf Wajdi Dusuki (2007)


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capital to micro-entrepreneur to fund their business activities.

Profits made will be shared between the bank and micro-

entrepreneur based on the pre-agreed ratio. Loss is solely borne by

the capital provider as the micro-entrepreneur use the capital under

basis of trust, which means he is not liable for the losses except for

his negligence or misconduct. In Mudharabah arrangement, bank

has no control in management of business since it will be carried

out by the micro-entrepreneur only.

II. Musharakah

In Musharakah arrangement, its equivalent to joint venture

between Islamic bank and micro-entrepreneur. In this arrangement,

both Islamic bank and micro-entrepreneur provide capital and

manage the business venture. Profit sharing is based on pre-

agreed ratio, while loss is borne in proportion to the equity

participation.

Both Mudharabah and Musharakah are suitable to finance working

capital and project financing. For asset purchase, it can be arrange

under Diminishing Musharakah, in which the percentage of ownership in

the asset by micro-entrepreneur increase with every payment of

installments. The Mudharabah and Musharakah financing can be use to


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finance the needs of existing business, business expansion or as seed

money for newly start-up business.

6.2. Murabaha contract

Under Murabaha arrangement, the micro-entrepreneur appoints

Islamic bank to acquire asset or equipment on their behalf from supplier.

The bank acquired the asset and subsequently sells it to micro-

entrepreneur at mark-up price. Payment on the mark-up amount is made

by micro-entrepreneur on installment basis. This transaction is also

called cost plus transaction since the Islamic bank charge higher

selling price to micro-entrepreneur which represent the profit on

transactions. All the purchase price and mark-up has to be made

transparent to the micro-entrepreneur.

Types of transactions suitable for Murabaha concept of financing are

to finance working capital and purchase of assets.

6.3. Ijarah

Ijarah is mainly a leasing contract. In this case, the Islamic bank

acquires the asset and subsequently leases it to micro-entrepreneur.

The micro-entrepreneur pay periodic rental for the use of equipments.

This financing is suitable to finance assets used by micro-

entrepreneur to generate income.


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6.4. Bay al-Salam

Bay al Salam is contract of sale whereby the Islamic banks paid the

price of goods in advance while receive the goods in the future. The

purchase amount must be paid in full and the quantity of goods and

timing to receive it is set on transactions date.

This type of financing is suitable for agriculture activities since the

farmers require money during plantation stage such as seeds, fertilizer

and land preparation. The settlement for the financing amount is made

when the crops generate income.

6.5. Qardhul Hasan

Qardhul Hasan means an interest free financing. It also means

benevolent financing or gratuitous financing. In this case, micro-

entrepreneur returns the financing at the end of the period, with the

same amount.

This mode of financing is useful for very poor people as an act of

charity for them to be involved in business activities and generates

income to sustain their family.

7. Source of Funding for Micro-finance Scheme

It is well known fact that financing the poor is a risky business. There is

high chance that the Islamic banks may not received back the payment on the

amount disbursed to the micro-entrepreneur. This due to most of the micro-


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entrepreneur has little knowledge and technical skills to operate business

activities. Internally, micro-finance scheme requires substantial operational

cost to administer since it involves large number of customers. This will put

strain on the Islamic banks operations since not all depositors or investors are

interested to invest in this area. Due to these risk factors, Islamic banks need

to find reliable source of funding to fund micro-finance scheme. These

sources of funding also need to be sustainable to ensure its viability.

Islam is unique due to the availability of mechanism in place for the

redistribution of wealth within society. The Islamic banks may leverage on

these mechanisms to fund their micro-financing programmes. The

mechanisms are zakat, sadaqah and waqaf.

a. Zakat is compulsory religious levy and the third pillar of Islam. The

philosophy of zakat is that, from Islamic point of view, wealth is belong

to God and held by human on trust basis. Thus wealth which held by a

person has others share in it. There is where the function of zakat is.

Zakat means cleanse or purify. By paying zakat, the wealth held by

individual is being purified since portion of it has been put aside for the

poor and the needy. Zakat is useful as a form of wealth redistribution

and it manifest the social responsibility of the wealthy people. This

contributes to a balance of wealth distribution in the society. In

Malaysia, the collection and distribution of zakat is conducted by the

Islamic Affairs Councils of the various states. Distribution of Zakat is in

form of monthly cash to the needy and poor, conduct aid programs and


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build house. Zakat also can be paid directly to the eligible beneficiaries

(asnaf) which being mentioned in the Quran.

"Alms are for the poor and the needy, and those employed to

administer the (funds); for those whose hearts have been (recently)

reconciled (to the truth); for those in bondage and in debt; in the

cause of God; and for the wayfarer: (thus is it) ordained by God, and

God is full of knowledge and wisdom." (9:60)

b. Sadaqah as opposed to zakat, is a voluntary charity given by those

who have, to others who does not have. This is good deed promotes

by Islam. Sadaqah can be in various forms and not confine to material

wealth. Sadaqah is part of the social justice of Islam in which portion of

wealth is given to the needy for them to alleviate their burden.

c. Waqaf is a form of perpetual charity in which the assets such as land

and building are donated for charitable purposes. It is some form of

wealth distribution in which assets donated for charity can be used in

production process for wealth generation. Waqaf is useful since the

benefit derive from it can be in perpetuity, so long as the Waqaf s

asset is exist.

All of the above can be use as a funding source for micro-finance scheme

of Islamic banks.

Since the risk exposure towards micro-finance scheme is high and it

possibility that it will affect the other operations of Islamic banks, the bank

may create specific funding fund to cater for interested investors for micro-


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finance activities. It can be in form of Restricted Investment Account (RIA) or

Special Purpose Vehicle (SPV):

a. Restricted Investment Account (RIA)

RIA is an investment accounts with certain restriction as to where,

how and for what purpose these funds are to be invested (IFSB).

By investing in this account, the investors authorize the Islamic

banks to use their funds to finance micro-finance activities.

b. Special Purpose Vehicle (SPV)

SPV is a legal entity created by a firm (known as the sponsor or

originator) to undertake some specific purpose or restricted activity

spelt out by the sponsoring firm (Gorton & Souleles, 2005). The

benefit of SPV is that it is bankruptcy remote in nature. This means

that in the event SPV gone bankrupt, the creditors cannot claim the

debt from the sponsoring organization.

In this regards, to fully separate it from other operation, Islamic

banks may establish a SPV with the focus is to undertake micro-

finance activities. Funding for this SPV is via sukuk issuance which

will be subscribed by interested investors. Islamic banks can

provide their expertise by getting involve in the management and

operations of SPV.

By using both arrangements, whether RIA or SPV, the Islamic banks can

approach potential investors to the program. The potential investors to RIA or

SPV are:


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i. Islamic Affairs Councils

As being mentioned above, in Malaysia, collection of zakat falls under

jurisdiction of State Islamic Affairs Councils. The amounts of zakat

collected are quite substantial. For example, in 2008, Selangor Zakat

Board collected RM244.4million in 2008 while Majlis Agama Islam

Wilayah collected RM20.26 million. Based on this, State Religious

Councils can put aside some of the Zakat and become investor in RIA

or SPV. This is useful, since Islamic banks, with their expertise, able to

use zakat money to empower the poor people, for them to have better

life rather than fire fighting effort by the Councils.

ii. Individual

Islamic banks also may open the fund to interested individual. Islam

promotes sadaqah or charity to the needy person and this act is being

widely practice by Muslim. Currently, donation went straight to the

recipient and they used it in their daily lives. Eventhough, it is good for

the recipient to be able to use it straight away, however it is not

sustainable. Thus, it is better for some of this donation is channeled to

fund micro-finance activities which may generate sustainable income

to the participants.

iii. Government Fund

Government has many funds disbursed to the poor and the needy.

Some of the fund is used to build house to the poor, live maintenance,

to support single mother and etc. Since the government has all these


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funds, it may appropriate for some amount to be set aside for micro-

finance which being administered by professional bankers. This will

give more value towards effectiveness of government poverty

eradication programmes.

iv. Islamic Bank Own Fund

Islamic banks also may channel part of their internal fund for micro-

finance activities. Using its own fund has its own benefits. Islamic

banks will have additional motivation to ensure their micro-finance

program successful since they also involve in funding it.

8. Conclusion

Islamic banks should fully perform their function to achieve end game as

being espoused by Islam i.e. to create fair and just society with every

individual have equal opportunity to have better life for their family and

themselves. Islam banks should not only focus on profit maximization, but

should live to the expectations to better play their role in the society.

Eventhough there are many ways to achieve it, microfinance is one of the

scheme that has proven to effectively help the poor people to stand on their

feet.


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islamic banking and microfinance

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