Developing an Islamic Microfinance Model

The recent awarding of the Nobel Peace Prize to Dr. Muhammad Yunus and the Grameen Bank of Bangladesh highlights a new awareness of the potential and power of microfinance programs. What's more, the Nobel committee has validated the link between poverty alleviation and peace saying, "Lasting peace can not be achieved unless large population groups find ways in which to break out of poverty."

This admission gives credence to the growing movement to promote socially responsible/ethical ventures - both large and small. But given this emphasis where is Islamic finance in the world of microfinance?

Missing the point of economic development

Most economic development projects focus on grandiose infrastructure or industrial projects. While jobs are a necessary outcome the process of empowering individual producers to become economically self sufficient is usually not a part of the equation. In the process we end up with large ventures that may provide jobs to thousands in the local population but only tangentially. In other words, an oil refinery which requires skilled labour will only hire workers that have experience or that have the capacity to be trained for work in the refinery. Or we give people their fish but don't teach them to fish themselves.

What is Microfinance?

Microfinance is usually defined as the provision of financial services and products to those whose low economic standing excludes them from conventional financial institutions or programs. These can include microcredit, small scale venture capital, savings, and some forms insurance. Access to each of these services is provided on a micro-scale allowing those with severely limited financial means to participate.

Theoretically, the main point of departure for microfinance from conventional credit/finance systems comes from the concept of joint liability. In this concept a group of individuals form an association to apply for financing. Members of these small groups are trained regarding the basic elements of the financing and the requirements they will have to fulfil in order to continue to have access to funding.

Financings are disbursed to individuals within the group after they are approved by other members in the group. Repayment of the financing (a loan in this example) is a joint responsibility on all of the group's members. In other words they share the risk. If one defaults, the entire group's members suffer. It's a rudimentary but effective credit scoring mechanism that may mean a temporary suspension from the program and therefore no access to financing for the group or other penalties. In most cases, microfinance programs are structured to give credit up to a maximum amount and require repayment within a short time period – usually a few weeks or at most a few months.

How Microfinance changed development

When the first modern microfinance experiments were being conducted in the 1960s and 1970s, the dominant development programs focused on a particular aspect toward which donor resources could be directed. For example, a farmer needing seeds to plant for produce was given seeds for cash crops or he was given loans at interest rates below market to lessen the financial burden of repayment. But what was not happening was the grass roots support of people who aspired to be self sufficient but did not have a ready business idea or skill/craft.

What Dr. Muhammad Yunus of Bangladesh started in the mid to late 1970s was to focus on people who generally did not have the means to fund a new business or craft. Inspired by the terrible Bangladesh famine of 1974, he made a loan of $27 to a group of 42 families enabling them to create small items for sale without the heavy burdens of repaying moneylenders who charged exorbitant rates of interest.

This effort gave individuals and families the financial fuel they needed to stand on their own feet without the repressive burden of repaying moneylenders beyond their means. Borrowers used loan proceeds to buy raw materials to manufacture products for sale in the market; purchase livestock to sell milk/eggs; or open small shops.

The World Bank now estimates that there are over 7000 microfinance institutions, serving some 16 million poor people in developing countries. The total cash turnover of MFIs world-wide is estimated at US$2.5 billion and the potential for new growth is outstanding. The Microcredit Summit estimates that US$21.6 billion is needed to provide microfinance to 100 million of the world's poorest families.

Other estimates tell us that worldwide, there are 13 million microcredit borrowers, with USD 7 billion in outstanding loans, and generating repayment rates of 97 percent; growing at a rate of 30 percent annual growth. Despite all this less than 18% of the world's poorest households have access to financial services (Grameen Foundation USA).

Similarities between IF and Microfinance

So we now return to where we started – where is Islamic finance in the world of microfinance? If Islamic finance is growing so rapidly all over the world why don't we hear about it more in microfinance circles? After all, both systems advocate entrepreneurship and risk taking through partnership finance. They are also forms of finance which represent unconventional solutions to financial needs, focusing on cash-poor but promising business activities. And most importantly, both Islamic finance and microfinance theoretically start from egalitarian approaches as they are open to all customers with different and sometimes coinciding needs without setting any apparent restriction to different categories of clientele.

But it's interesting to note that Islamic Finance principles are still not widely adopted by conventional microfinance and microcredit institutions. According to Dr. Abbas Mirakhor, Executive Director of the IMF:

"[An] important function of Islamic finance that is seldom noted … is the ability of Islamic finance to provide the vehicle for financial and economic empowerment … to convert dead capital into income generating assets to financially and economically empower the poor..."

Of note in this regard is a theoretical framework for a mudarabah based microfinance program which was advanced by Atif Raza in the Summer 2005 issue of Islamica Magazine. (see related links)

Why this state of affairs?

Why has Islamic finance not been seen more widely in the micro-finance field?

According to Mayadeh al-Zoghbi, a microfinance professional ??, Islamic finance principles are difficult to implement on a profit and loss sharing basis in rural settings. They require long-term involvement by the microfinance institutions (MFI) in the form of technical/business assistance which raises the cost of implementation.

In addition, there is too much uncertainty in profit/loss sharing models for MFIs to be able to understand and predict their present and future cash flows. Therefore, in microfinance too, as in the world of high finance, Islamic debt and leasing instruments dominate.

For example, the Hodeida Microfinance Programme in Yemen based its endeavours on a Murabaha model citing its ease of use. A case study of the program cited that the use of Murabaha “eliminates the need for written records, often unavailable at the micro enterprise level or if available (20 percent of HMFP clients keep books), the client may be unwilling to share them.” Other reasons to prefer Murabaha over equity based financing methods are:

• a well-defined contract exists, with pre-defined amounts

• there is no opportunity for abuse on the part of the client through inaccurate or false record-keeping… i.e. falsely claiming losses where there were profits

• a fixed contract creates a less complicated process and a lower implementation cost to the institution

According to the United Nations Human Settlements Programme (UN Habitat), “Microfinance services, including some compliant with Islamic law (Shari'ah) in the Arab region, tend to be limited to credit for enterprise... The most commonly used Islamic transaction is one in which the MFI [microfinance institution] purchases goods at the request of the 'borrower' and then sells the goods to the 'borrower' for a fee to cover administrative costs, with repayments in instalments (Murabaha).”

My conversations with Ms. Al-Zoghbi and other microfinance professionals yielded few results for MFIs using Islamic finance. In fact, in addition to the Hodeida Programme in Yemen the only other bona fide attempts at applying Islamic finance to microfinance were limited to Akhuwat in Pakistan and the Mali-North Program.

Bridging the Gaps

In many ways, the world of microfinance has followed the conventional world in its use of Islamic debt based instruments to limit risk while being able to more easily anticipate returns.

While on the surface this is understandable, the curious part of the puzzle is that microfinance is already more structurally aligned to applying Islamic equity financing structures. As mentioned previously, microfinance programs are based on group sharing of risk and personal guarantee while maintenance of trust and honesty is tied to the availability of future funds.

This model should allow for the inclusion of a Musharaka based model, or in the least, a model of collective guarantee. MFIs which look to implement Islamic finance in their programs can also develop Mudarabah based programs on the contours proposed by Atif Raza Khan in a Summer 2005 issue of Islamica Magazine. In short, MFIs can find Islamic finance a natural fit in their programs – both debt and equity based.