Microfinance and Islamic Finance: can they be reconciled ... · HEC Social Business Certificate 2 The aim of this work is to explore how microfinance and Islamic Finance might benefit

Paul Hailey MBA Sept. 2009 HEC Social Business Certificate

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Microfinance and Islamic Finance: can they be reconciled and how can they benefit one another?

Introduction

Our destiny is strongly linked to the destiny of the poorest. Microcredit is a macro idea. This is a big idea, an idea with vast potential. Whether we are talking about a rural area in South Asia or an inner-city in the US, micro credit is an invaluable tool in alleviating poverty. Microcredit projects can create a ripple effect - not only in lifting individuals out of poverty and moving mothers from welfare to work, but in creating jobs, promoting businesses and building capital in depressed areas.1 Hillary Clinton

The advent of microfinance is perhaps one of the most heralded innovations in modern

finance and the field of development. By lifting developing nation consumers out of

poverty, microfinance is seen as one of the most promising means of creating sustainable

growth in an area hitherto only served in a limited fashion by various aid programs.

Equally Islamic Finance might also be regarded as one of the finance sector’s more

unusual developments in recent times. Yet the idea of basing financial products on

Sharia’a law can be seen as not just another niche product, but the answer to the

requirements of millions of consumers who feel otherwise ill-served by conventional

finance.

Yet despite the fact that many of those countries in which Islamic Finance otherwise

flourishes contain millions of people living in poverty, microfinance has yet to be applied

to a significant extent. Recently the concept of Islamic microfinance has started to take

root, albeit mostly in three countries: Indonesia, Bangladesh (where the standard form of

microfinance has been in place for nearly forty years) and Afghanistan. However, outside

of this trio, it is a relatively unexplored concept, despite seventy-two percent of people

living in Muslim-majority countries not using “formal financial services”.2

1 Speech made at Microcredit Summit, 3rd February 1997, Washington D.C.. 2 Honohan, Patrick. 2007. “Cross-Country Variations in Household Access to Financial Services.”


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The aim of this work is to explore how microfinance and Islamic Finance might benefit

from one another, creating a model that can serve those consumers disenfranchised from

both conventional banking and the standard microfinance model. How can we bring some

of those seventy-two percent to the point where they can access capital and spark the

drive to entrepreneurship crucial to developing an economy?

Microfinance – origins and overview

I did something that challenged the banking world. Conventional banks look for the rich; we look for the absolutely poor. All people are entrepreneurs, but many don't have the opportunity to find that out.3 Muhammad Yunus

The intention of this work is not to give an in-depth and detailed look at the origins and

background of microfinance, nor to define its every triumph, setback, quirk and wrinkle.

Nevertheless, in order to understand the underlying hypothesis of this project – that

Islamic Finance and Microfinance are not only compatible in many ways, but can both

have a significant impact on one another’s development and influence upon large swathes

of the developing world – it is worth reexamining the origins of microfinance and the

thinking that led to models currently applied in cities and villages from Bolivia to

Bangladesh.

While microcredit in its modern form dates largely from the pioneering work of

Muhammad Yunus in Bangladesh, it can be argued that many of the concepts used in

microfinance overall can be dated back to the rise of credit unions and cooperatives in the

nineteenth century. Timothy Guinnane points to Germany in the 1850s, under the

influence of Hermann Schulze-Delitzsch and Friedrich Raiffeisen4, while Beatriz

Armendáriz de Aghion and Jonathan Morduch also cite the rise in cooperatives in Great

Britain (often promoted by trade unions or evangelical churches) and thence in the British

Empire, where the Cooperative Credit Societies Act of 1904 led to the creation of several

3 Interview with Time magazine, 16th October 2006. 4 Guinnane, Timothy, 2001, “Delegated Monitors, Large and Small, the Development of Germany’s Banking System, 1800-1914, pg. 24.


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such institutions throughout India, including Bengal, whose eastern part later became the

modern state of Bangladesh.5

Nevertheless, it was Yunus’ work in Bangladesh that established microcredit and

microfinance as recognized disciplines within finance; using lending to stimulate

entrepreneurship among the poor, Yunus was also providing a financial service to people

excluded from a banking system that was not interested in providing bank accounts or

loans, in relatively tiny amounts, to a population with little in the way of collateral.

Consequently, Grameen Bank now has eight million borrowers across 81,355 villages6,

while microfinance and microcredit are employed across the world, in both developed

and developing nations; microfinance has now grown to encompass a variety of products

linked to savings, transfers of funds and insurance (or “microinsurance”).

Islamic Finance – origins and overview

O ye who believe! Devour not usury, doubled and multiplied; but fear Allah; that ye may [really] prosper. Qur’an, 3/130-1

It may seem more than a little obvious to point to the birth of Islam as one potential

starting point for Islamic Finance (although some theological scholars might even point

to Islam’s origins in Christianity, Judaism or Mithraism!), yet it is an appropriate place to

begin. The prophet Muhammad was born in Mecca around 570 A.D., and is thought to

have had received his first revelation from God at the age of forty. After meeting hostility

from many of the Meccan tribes for his beliefs, Muhammad and his followers moved to

Medina, where he united the tribes and returned to conquer Mecca eight years later. In

632, Muhammad died; subsequent leaders went on to found the Caliphate and spread the

rule of Islam throughout the Middle East and North Africa, leading to the “Golden Age”

between 750 and 1258.

However, Islamic Finance as a defined segment of banking is relatively young, dating

from the Mit Ghamr savings project established in Egypt by Dr Ahmad Elnaggar in 1963,

5 De Aghion, Beatriz Armendáriz & Morduch, Jonathan, 2005, “The Economics of Microfinance”, pg. 69. 6 www.grameen-info.org

http://www.grameen-info.org/


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itself “based on profit-sharing and applying certain concepts of the modern credit union

movement”7. Elnaggar went on to establish the Islamic Development Bank in 1975,

providing development funds for member countries; subsequently the Islamic Finance

market grew quickly, especially in the Middle East and South-East Asia, and now

constitutes a rapidly growing segment of the financial services sector.

There is not sufficient time or space here to go into all the underlying principles of Islam

and Islamic Finance; instead, some of the key issues governing Islamic Finance are listed

below.

Riba (interest) The concept of interest is one which is forbidden in Islam. The Qur’an states that “God

has permitted trade and prohibited riba”8; while Islam is happy with the idea of

speculative investment (in fact, investment is encouraged as a means to prevent hoarding,

another prohibited notion), the idea of earning money from money itself, rather than a

tangible commodity or asset, is completely forbidden. Needless to say, this is not just an

issue for microcredit, but also banking as a whole. The entire modern banking system is

based upon the concept of depositors “loaning” their savings to the bank for a small

amount of interest, and the bank loaning the money to creditors at a much higher rate. As

a result, the prohibition of riba has led to several significant structural changes to Islamic

Finance, which will be discussed later.

Gharar (risk, lit. deception) The Qur’an and the Sunnah prohibit the idea of excessive risk, equating it with gambling.

However, some degree of risk is allowed, with the definition of gharar focusing more on

the idea of deception, whether through duplicitous business practices, or by using means

where the outcome is unclear or sufficiently uncertain. Agreeing a transaction with an

unspecified price, or deferring payment for an undefined time period are both considered

gharar. The above has significant implications for many of the instruments used in capital 7 Various authors, Islamic Finance Qualfication textbook, 2007, pg. 13. 8 Qur’an, Surat Al Baqara, verse 275.


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markets; this is especially true with derivatives, the vast majority of which are

unacceptable under Islamic law, as they are often complex, leveraged products, which do

not represent a tangible object itself, but are merely linked to an object’s price.

Haram (forbidden) The concept of what is and isn’t haram in Islamic Finance is not only applicable to which

instruments do and don’t conform with the Sharia’a; it is also applicable to the activities

which are being carried out by investors. For example, regardless of how the deal is

structured, it is haram to invest in a company that earns most of its revenue from sales of

alcoholic beverages, or gambling.

Zaqat (charity) Zaqat is one of the five pillars of Islam, and as such is considered a critical element in the

life of every devout Muslim. All adult Muslims who are sane, healthy and earn above a

certain amount are obliged to give a certain percentage of their wealth (usually calculated

without including their house or means of transport) as zaqat, or charity. While this

amount is not specified in the Qur’an, it is usually set at around 2.5%.

Regulation and governance of Islamic Finance Some Middle Eastern countries have gone as far as to adopt a dual-banking system, with

an Islamic banking system and a conventional banking system operating side by side. As

well as the IDB, several other international organizations have sprung up: the Accounting

and Auditing Organization for Islamic Financial Institutions (AAOIFI); the Islamic

Financial Services Board (IFSB), responsible for issuing global prudential standards and

guiding principles for the industry;9 and the International Islamic Rating Agency (IIRA),

which rates Islamic Finance institutions and instruments.

All of the above, as well as various other aspects of Islamic Finance, will be discussed in

greater detail in subsequent sections.

9 www.ifsb.org

http://www.ifsb.org/


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Microfinance structures

The great challenge before us is to address the constraints that exclude people from full participation in the financial sector. Kofi Annan10

Once again, the intention of this work is not to give a detailed description of

microfinance, but rather of the potential synergies between microfinance and Islamic

Finance. Nevertheless, in order to arrive at this, we must briefly discuss the models used

in microfinance and microcredit.

Microcredit As we discussed earlier, the classic model of microcredit is based on the idea of group-

lending. In the model used in Bangladesh, a loan officer for Grameen is responsible for

several villages; within each village, those wishing to borrow are divided into groups of

five. Funds are paid out to the first two members of the group; once those loans are paid

off completely, new loans are made to another two members, then to the remaining one

(usually the chairperson of the group), before returning to the pair again. Persistent

failure to meet repayments will mean that further loans are not distributed to that group.

Banks are thus able to overcome two of the major issues that had previously hindered

lending to the majority of those in developing nations: enforcement and risk profiles.

The issue of enforcement, given the lack of collateral, is critical within microfinance. The

group model creates a system of enforcement between members, as those who aren’t

paying off loans monitor, and sometimes even pay for, those who are, therefore allowing

the group access to the next round of loans. Pressure from peers within the group, and the

social stigma inflicted within the village as a whole (or “social collateral”, as it is

sometimes known) ensure a low rate of default that Grameen places at only 1.5%.

Furthermore, the bank is able to avoid the negative social impact (and bad publicity) of

trying to repossess the few assets that the borrower might have.

10 Comments made on the “Year of Microfinance”, 29th December 2003.


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Equally, the problem of assigning risk profiles would seem to be a critical issue for

microcredit. Unlike a conventional loan or mortgage, the returns on the money lent are

too small for the bank to perform in depth individual risk assessments. In fact, given the

lack of any banking infrastructure or, in many cases, up to date registers of property or

ownership, such risk assessments would be impossible to carry out. However, by creating

groups locally, members of the village will automatically group together with safer

investors. Even those members of the village investing in riskier projects should be able

to pay as a group: assuming that those investments that do pay off obtain a sufficiently

high level of revenue to cover the losses of others within the group, the odds of five such

projects failing are sufficiently high to protect the bank. As a result, banks are able to

charge a constant rate that isn’t so high that it puts off “safe” borrowers.

Savings The field of microfinance has seen a marked rise in the use of “micro” savings, a field

that is one of the more recent developments for microfinance; indeed de Aghion and

Morduch point to the rise in popularity of savings accounts for very small amounts in

Bangladesh, Thailand and Indonesia.11 In an interview with Microfinance Africa, Dr

Marguerite Robinson, author of The Microfinance Revolution and former advisor on

micro-banking to the Indonesian government, identified what she described as six key

criteria for consumers in the developing world within “a very high demand among low

income people… to get their savings out of their house and into a secure place.”12

1. Security – Dr Robinson describes this as the most critical aspect, which is

possibly why many of the Large Financial Insitutions (LFIs) have recently been

so successful in attracting clients after lowering their deposit minimums.

11 De Aghion, Beatriz Armendáriz & Morduch, Jonathan, 2005, “The Economics of Microfinance”, pg. 147. 12 http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-–-interview-with-marguerite-robinson/

http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/

http://microfinanceafrica.net/interviews/savings-the-core-of-microfinance-%E2%80%93-interview-with-marguerite-robinson/


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2. Convenience – institutions have to be open well outside of normal office hours in

order to provide a service for consumers who often don’t finish their working day

until 8pm.

3. Liquidity – again another factor in the rise of LFIs, with many microfinance

institutions not able to offer the same level of immediate liquidity.

4. Friendly, helpful service.

5. Confidentiality.

6. Access to loans – a logical point given the clear need for microfinance in many

developing world communities.

Consequently many microfinance institutions that were more focused on microcredit

have now started to place a great deal of emphasis on microsavings, notably Grameen,

whose Grameen Bank II model includes a wide variety of easy access savings accounts.

Microinsurance An even more recent development, microinsurance has primarily been seen as part of a

package with microfinance, rather than a product used much by itself, especially for

protecting against a sudden loss of income. Even other forms, such as health insurance or

life insurance, are seen more through the prism of potential negative impacts upon a

client’s ability to cover repayments, rather than as important products in their own right.

Nevertheless, this is a field that has seen substantial growth, and which offers more

solutions to the issues facing developing world consumers.

Problems with microfinance Critics of microfinance have pointed to several issues that routinely crop up within the

field. These include:

• High interest rates. Many of the rates imposed can still be extraordinarily high.

Often this is justified by high rates of inflation within many developing nations;

some also point to the law of diminishing returns as proof that those receiving


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small amounts of money at the BOP often improve their revenue so dramatically

that they are still capable of comfortably covering the loan. Nevertheless, the high

rates involved are sometimes seen as undermining microfinance’s claim to be a

function of social business.

• Subsidies often required. Most microfinance organizations require significant

levels of subsidies in their early stages, with many continuing to rely on state

involvement or financing from major shareholders, some of whom are

conventional investment or retail banks. One study into the role of subsidies

within microfinance stated that MFIs were still receiving $1 billion per year, with

less than 5% “operationally sustainable”.13

• Default rates that can still be significantly high. Failure to implement policies

correctly, as well as semi-regular macro events that can annihilate income but

which local governments are incapable of dealing with (e.g. flooding in

Bangladesh), can still critically affect default rates. There is also the issue of

balancing social impact with the need to try and maintain sustainability, especially

with regard to enforcement.

• Over-zealous enforcement within groups. Perhaps a more minor aspect of

microcredit, but in some cases the social stigma relating to failure to pay, itself

sometimes due to unfortunate but understandable situations, can be seen as

unfairly high, while some incidents of social oppression within communities have

been recorded.

Variations and difficulties according to region or urbanization In what is considered to be one of the seminal texts of social business, The Fortune at the

Bottom of the Pyramid, the late C. K. Prahalad describes a variation on the Grameen

group lending model as practiced by ICICI.

13 M. Hudon & D. Traça, 2008, “On the Efficiency Effects of Subsidies in Microfinance: An Empirical Inquiry”, pg. 3.


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The yellow arrows indicate disbursement of money. As mentioned previously, in the

Grameen model, funds are given to the loan officer, who arrives at the village, and

disburses them to the first pair in the group of five, followed by the second and the third.

In the ICICI model, however, funds are passed onto “SHGs” of around twenty people.

The key difference, however, is the concept of liability; the levels between ICICI and the

SHG are primarily intended for purposes of sales and marketing, as opposed to oversight.

All liability rests with the SHG, which consists of twenty people, and is responsible for

disbursing funds to individuals as it sees fit. In other words, whereas the concept of social

collateral is implicit within the Grameen model, it is formalized within the ICICI model,

and, barring a catastrophic event occurring, reduces the level of risk for the bank even

further.14

However there are some microfinance institutions which eschew the group model

altogether. De Aghion and Morduch cite the example of “progressive lending”15 in the

practices of both ASA and Grameen II; here borrowers are rewarded for fulfilling their

14 C.K. Prahalad, “The Fortune at the Bottom of the Pyramid”, 2005, pg. 84. 15 De Aghion, Beatriz Armendáriz & Morduch, Jonathan, 2005, “The Economics of Microfinance”, pp. 125-6.

Third wave of loans

Second wave of loans

First wave of loans

Bank

Loan Officer

Village Village

Group Group Group

Loan Officer

Village Village

20 members per SHG

20 new SHGs /promoter/yr

6 RCs per PM

No. of PMs: 16

Bank

Project Manager

Regional Coord.

Promoter Promoter

Self-Help Group

Self-Help Group

Regional Coord.

Project Manager

Grameen Group Lending Model ICICI Group Lending Model


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payment obligations by being offered progressively bigger loans. Consequently, this is a

model that can often be applied on an individual basis, as well as a group basis.

Finally, one of the most significant developments to microfinance in recent years has

been the increased frequency of payments, reducing the size of and time between

installments. It still remains unclear as to why organizations who adopt this practice have

seen such a marked drop in their default rates; one study comparing differing collection

rates among villages in Nepal showed almost double the rate of default among villages

paying in monthly installments as opposed to daily installments (19.8% versus 11%).16

One theory is that a higher frequency of collections allows loan managers to spot

potential problems sooner and act upon them; another is that in paying weekly,

consumers have less opportunity to spend the money on something else rather than cover

their loans.

Islamic Finance – initial difficulties with microfinance In view of the above issues concerning Islamic Finance and the structures commonly

used in microfinance, there are thus several key issues with regard to combining the two:

• Riba on loans. The most obvious and fundamental issue surrounds the issue of

microcredit as the primary means of promoting entrepreneurship and reducing

poverty. Interest cannot be charged, thus seeming to remove the possibility of

deploying anything other than charitable donations; the sustainable social

business model does not seem to apply here.

• Riba on savings. Again, riba cannot be applied to savings. This is not as

fundamental an issue as that faced by microcredit, but aside from the issue of

storing savings in a secure place, it does remove one of the key incentives to save

in an environment where conventional saving is often not very well rooted.

• Insurance. The conventional insurance model takes a premium from the client in

the hope of making a profit. In other words, it is speculating that the revenue

accumulated will exceed the payouts required. This aspect of speculation is seen

16 Silwal, Ani Rudra, “Repayment Performance of Nepali Village Banks”, 2003.


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as maysir, or gambling, and is haram. Furthermore, the fact that the client is

paying a premium, but may receive nothing in return, amounts to gharar, as the

outcome is unclear.

Given these significant obstacles, how can practitioners of Islamic Finance arrive at a

solution?

Islamic Finance – alternative solutions via existing instruments Legal tools: The legal tools required to operate within Islamic Finance are similar to those used in

Western law, but are nevertheless critical in terms of their different applications.

Wa’d (promise) Wa’d is the promise to carry out (or not carry out) certain actions in the future. Opinions

are divided within the Islamic world as to whether it is legally binding or simply the sign

of noble intentions. However, assuming no force majeure, the general consensus, as

represented by the Islamic Fiqh Academy, is that some sort of penalty should be

enforceable for failure to fulfil its terms. One potential use within Islamic microfinance

would be for those given positions of authority within the local microcredit infrastructure.

Aqd’ (contract) An Aqd’ contract must consist of two counterparties exchanging goods at an agreed

price. The offer made must be matched by the agreement returned, which must be

explicit.

Kafala (guarantee) Given that riba cannot be levied, or penalties charged to the benefit of the creditor,

kafala, or third party liability, can sometimes be seen as unnecessary. However, in the

field of microfinance, the concept of a third party guarantor is one thoroughly embedded

in many of the models, and consequently relevant here.


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Wakala (agency contract) This is a concept applied in many instruments used in Islamic Finance, ranging from

brokerage to the purchase of property. Individuals or organizations are able to give

authority to another party to transact deals on their behalf, as with banks giving authority

to loan officers or village elders.

Relevant financial techniques: Islamic finance consists of a multitude of techniques, many of which are designed to

mimic instruments used in conventional finance, while avoiding issues such as riba and

gharar. Those models that seem most relevant to Islamic microfinance are listed below,

although, needless to say, there are one or two techniques not described in any detail

(musharaka, arbun etc.) which still enjoy widespread usage. Nevertheless, most of the

principal models applied in Islamic Finance are described below.

Murabaha (loan) The murabaha structure is used for deferred credit sales, and as such is the most

commonly used tool within Islamic microfinance. However, the deal is structured

according to several key steps, all of which must be observed in order to validate the

contract.


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1. Musawama (bargaining). The buyer and the seller agree the specifications of the

contract with the seller. Money must be exchanged for a specific, tangible item,

which must not be haram.

2. The buyer promises to buy the item from the Islamic Financial Institution (IFI) –

this may be in the form of a wa’d or aqd’ (i.e. binding or non-binding).

3. The IFI enters into a sales contract with the seller and purchases the item in

question. In practice, the IFI usually appoints the buyer as agent to buy the goods

on its behalf via a wakala contract.

4. The seller delivers the item to the IFI.

5. The IFI and the buyer enter into a murabaha agreement, by which the item is sold

to the buyer at the price it was purchased from the seller plus a mark-up. This last

stage is usually deferred, or paid in installments.

Although this instrument is often used to mimic a loan, not just in microfinance, but also

in asset management and the import/export of goods, there are several crucial differences:

Islamic Financial

Institution

Seller Buyer1. Negotiation

1.

2. 3.

4. 5.


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• The IFI must actually own the object at some point during the transaction.

• Additional charges cannot be inflicted due to extending the final due date.

• While the IFI can insist on collateral, late penalties cannot be charged to the IFI’s

benefit – if a penalty is charged, it must be paid to charity.

Mudaraba (partnership project) While the murabaha model is the most commonly used in microfinance, one possible

alternative, given that many microfinance institutions may wish to distance themselves

from the image of a conventional loan, would be the mudaraba. This model operates

according to the idea of a partnership between a Rab al Mal, who provides capital, and a

Mudarib, who provides the expertise required to invest the capital in a project (and who

may consist of one or more investors).

Profits are shared according to a pre-defined ratio, with mudarib fees sometimes charged

as well; however, only the Rab al Mal is liable for losses incurred. The Rab al Mal has an

absolute right to all information regarding their investment. Upon setting up the

agreement, the Rab al Mal may choose between a Mudaraba al Muqayyada (restricted

partnership agreement) or a Mudaraba al Mutlaqa (unrestricted partnership agreement).

The former specifies a particular project or type of investment to which the Mudarib is

Mudaraba

Rab al Mal Mudarib

Expertise Capital


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restricted; the latter gives the Mudarib free rein to invest the funds as he sees fit. Note

that for both types, investments must still always be halal.

With regard to microfinance, this model is clearly further away from conventional

microcredit as it envisages a variable share of profits rather than a specified amount for

repayment. Not only would this suggest even greater monitoring, but it also opens the

bank to the same level of risk, as consumers, or the mudarib, are not liable for losses. It

would also make regular installments a lot harder to impose, unless an amount is set

based on expected profits, with the difference between the expected amount and the

amount actually due paid every six months or so. Nevertheless, for larger projects on a

village-wide basis, or for the agreement between a bank and SHGs in the ICICI model, it

might be perceived as having more social benefit to be an investor in the project rather

than a creditor awaiting repayment.

Amanah/Wadia (bank account) While unable to offer conventional, interest-paying bank accounts, Islamic banks can

offer an Amanah or Wadia, both of whom essentially amount to a trust account where the

money is held and is guaranteed to be returned in its entirety upon request.

Furthermore, many Islamic Banks offer a return on clients’ money by requesting

permission to invest it on the clients’ behalf. This is usually done via a mudaraba

contract, or perhaps a murabaha if the investment is in a construction project, say. Some

institutions even go so far as to offer a gift, or hiba, in return for placing deposits with

them, although many Islamic scholars feel that this is dangerously close to the idea of an

interest-bearing account.

Ijara (lease) An ijara is an agreement by an IFI to acquire an asset, then lease it to a client, possibly

with a view to transferring ownership (known as an Ijara wa Iqtina), or just to retain it at

the end of the lease and perhaps sell it on. Consequently an Ijara is seen as one way of


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mimicking a conventional mortgage, as is a diminishing musharaka, another means of

financing, then gradually transferring property ownership.

1. Negotiation between buyer and seller.

2. After agreeing a contract with the buyer, the IFI purchases the asset from the

seller (again this may be carried out by the buyer as part of a wakaful with the

IFI).

3. The IFI leases the asset to the buyer.

4. Installments are paid to the IFI by the buyer over a fixed period of time.

5. If part of an Ijara wa Iqtina, ownership of the asset passes to the buyer.

Some consumable goods cannot be leased; however sub-leases are permitted if the lessor

agrees. Another form, the ijara mawsoofa bil thimma, allows for agreeing a lease in

advance on a project still undergoing completion, thus making it popular for financing

Islamic Financial

Institution

Seller Buyer3.

4.

1.Negotiation

2. 5.


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construction projects. All of these would be suited to some of the larger projects in

microfinance, especially in terms of the construction and purchase of property.

Takaful (insurance) The various permutations governing different Takaful possibilities and regulations are too

numerous to be covered in detail here. Nevertheless, it is worth briefly discussing the

structure of a generic takaful and how it operates in practice.

As mentioned previously, conventional insurance is generally considered haram, as it is

considered to contain elements of maysir and gharar, with regard to the possibility of

making a profit and uncertainty of outcome respectively. In takaful, maysir can be

avoided by adopting a structure similar to that of a mutual insurance fund. Here a

structure is adopted whereby policyholders group together and contribute to a fund

protecting against a certain type of risk. The fund is owned by policyholders, who are

entitled not only to payouts in the event of that risk occurring, but also to surpluses upon

the funds. Incidentally, it is worth noting that many conventional mutual funds are now

demutualising due to the need for greater reserves in light of capital adequacy

regulations.

Nevertheless, this still leaves the element of gharar. This is avoided by characterizing

payouts as tabarru, or charitable donations, thus justifying the element of uncertainty.

Funds not in use are invested, albeit not in bonds, as is usually the case with many mutual

funds.

In practice, takaful funds are usually run according to one of two models:

1. Non-profit. The equivalent of a mutual fund is set up, with a board responsible for

managing the business and investing excess funds.

2. Commercial. This is what is known as a two-tier model, where a takaful operator

will manage excess funds via a mudaraba or wakala (i.e. profit-sharing or fixed

fee) arrangement. Often this operator is itself owned by shareholders, sometimes

through a separate mudaraba agreement.


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As shown above, the takaful operator is responsible for underwriting the fund in the event

that there are not sufficient funds to cover payouts; this is done as a series of interest-free

loans.

Consequently the takaful fund provides a good model of mutual insurance that is highly

suited to many of the philosophies underlying microfinance. If communities form a fund

together, managed perhaps by a larger institution, they will be able to further guard

against the possibility of default due to illness or incapacity. Furthermore, in the event of

a significant, “macro” event that severely impacts the community as a whole, the large

institution underwriting the fund should be capable of stepping in to keep the fund

solvent and ensure payouts.

Sukuk (bond) A sukuk is perhaps the nearest tool available to microfinance in terms of imitating a

bond. It allows ownership rights to a proportion of a certain asset, usually within a

company. Subscribers are therefore liable to gains and losses linked to revenues from the

assets, such as rent. As with the takaful, the number of varieties and permutations of

sukuk is innumerable; additionally, it is used much more in the context of capital markets

Shareholders Policyholders

Takaful fundTakaful

operator

Shareholders’ funds cover operations and underwriting

Takaful operator creates profits via fees or mudaraba

Policyholders contribute to and own takaful fund

Takaful operator administers, manages and underwrites fund

Takaful fund pays operator via wakala or mudaraba

Fund pays out if risk realized or surplus not reinvested


20

and financing large projects. Consequently it is perhaps not especially relevant to Islamic

microfinance. However, sukuk are one of the most commonly used forms in Islamic

Finance, with estimates of the value of assets financed in this manner varying from $700

billion to $1 trillion.17 Indeed, there may be a degree of interest for Islamic microfinance,

not at the consumer level, but more at the level of small to mid-size microfinance

enterprises, or even communities looking to raise capital for investment.

Islamic Finance – solutions to common issues in microfinance If the answer to many of the issues surrounding Islamic microfinance can be found in the

various models above, does Islamic Finance provide solutions to some of the issues

plaguing microfinance as a whole? Could Islamic Finance extend microfinance in certain

respects?

In discussing the issues relating to microfinance, we first mentioned the issue of high

interest rates. Of course, such interest rates are not (or should not be) inflicted simply to

make a healthy profit margin, but are instead symptomatic of the high costs involved in

setting up and operating microcredit in developing, or even developed, nations. The fact

that interest is not clearly stated as such, but is instead reflected in the mark-up in a

murabaha, or in the required rate of return from a mudaraba, will not eliminate it as a cost

to be borne by the consumer. However, although it would require further monitoring, the

mudaraba model may at least offer a greater sense of social benefit by involving the

institution in the gains and losses of the consumer.

Another area addressed was the role of subsidies within microfinance. As mentioned

previously, subsidies still play a significant role within the industry. While this work does

not intend to discuss whether it is morally or economically justifiable to subsidize social

businesses, de Aghion and Morduch point to a theory supported among many studies of

“subsidize start-up costs, not ongoing operations”.18 This suggests that subsidies at least

have some role to play in microfinance; consequently the substantial role played by zaqat 17 “Islamic Financial Services Industry Development, Ten Year Framework and Strategies”, pg. 7. 18 De Aghion, Beatriz Armendáriz & Morduch, Jonathan, 2005, “The Economics of Microfinance”, pg. 246.


21

in Islam offers an easy route, both practically and philosophically, for start-up costs at

ground level among communities.

Finally, we mentioned the opposing issues of defaulting clients and overzealous

enforcement. These are issues which will occur in any model along these lines, but in

terms of reducing their impact, one solution may be to involve local institutions, such as

mosques or tribal leaders, to ensure both consumers and representatives of the IFI behave

in a proper manner. This will be covered in greater detail in subsequent sections.

Ultimately all of the above issues relating to microfinance are symptomatic of the

challenges involved in working with BOP consumers, and as such are unlikely to be

entirely solved by any model. However, Islamic Finance can perhaps alleviate them in

some respects, while providing a solution for those consumers who feel excluded from

microfinance due to their beliefs.

Islamic Finance – philosophical similarities and new social models The models described in previous sections provide significant evidence that Islamic

finance and microfinance can be compatible, at least from a technical standpoint.

Standard microcredit arrangements can be mimicked by a murabaha agreement, or

possibly even a mudaraba agreement; equally the leasing or purchase of property or other

goods can be accomplished via an ijara agreement. Elsewhere in microfinance, we have

seen that bank accounts can still be provided under an amanah or wadia contract, while

the community-based solution found in a takaful contract is ideal for providing

microinsurance.

However, to what extent are the models contained within Islamic Finance compatible

with the philosophy of microfinance, and vice versa? We have already discussed the

fundamental importance of zaqat within Islam; one quote reads

They ask you what they should spend [in charity], say, “whatever you spend on good [let it be first] on your parents, and [then] your close relatives, the orphans, the poor, and the children of the path.” And whatever good you do, God surely knows. Qur’an, Surat Al Baqara, verse 215.


22

The idea of responsibility to the community is one that is deeply ingrained in Islam, and

thus throughout many Muslim communities. Zaqat may provide an opportunity in terms

of aiding very poor communities to develop to the point where they can be helped by

microfinance; it may equally provide a means to finance the start-up process for very

small microfinance institutions or community groups. Another angle to this concept is the

disapproval expressed within Islam of hoarding.

Let those who hoard the wealth that God has given them never think that they will benefit from it. It will bring them nothing but evil. The riches that they have hoarded will be their chains on Judgement Day. Qur’an, 3:180

As a result there is a clear need within the Islamic community for both charitable

contributions and investments that include a social aspect, thus fulfilling obligations to

the community as a whole. Therefore by looking beyond the technical aspects of Islamic

Finance, it may be possible to envisage a social model whereby Islamic microfinance

institutions are initially financed, then later underwritten by the richest members of the

community, those above the BOP categories (this would obviously only be feasible in

those developing nations with a significantly wealthy elite, as it the case with many of the

Gulf states).

We also mentioned earlier the possibility of including mosques or other community

institutions within Islamic microfinance; by using mosques as a meeting place for both

Tier 1

Tier 2-3

Tier 4-5 (BOP)

Wealthy members

Microfinance fund

BOP BOP

Start-up finance Under- writing


23

the disbursement of funds and the payment of installments, the impact of social collateral

could be increased significantly. Furthermore, virtually every community in the Muslim

world is guaranteed to contain a mosque, which acts as both community centre and a

store of local knowledge. Consequently the risk of default could be reduced, as well as

the cost of monitoring, possibly to the extent that a mudaraba, or profit-sharing

agreement could be extended to many consumers.

However, this model could in itself pose several moral issues. Although we are looking at

the deployment of Islamic finance in the microfinance context, this is primarily to enable

BOP consumers in the Muslim world to access capital and other financial products.

Nevertheless, IFIs are not necessarily religious organizations. Should religious authorities

be given significant economic influence over communities? Certainly in most developed

nations, the role of religion is usually strictly delineated, with countries such as France or

the UK doing their utmost to prevent the mixing of religion and politics; in fact many

countries within the Arab world (Egypt, Tunisia, Turkey) have done their utmost to

stamp out any designs on political or economic power by religious organizations.

Nevertheless, this ignores the fact that any excess on the part of the mosque can be

regulated just as easily as inappropriate behavior on the part of a conventional

microcredit group or SHG – by threatening to remove funding. Ultimately the role of the

mosque should be that of guarantor and mediator, with responsibility for fund

management and disbursement lying with a separate board of community members.

Islamic Finance – problems compared to orthodox microfinance The most significant issue facing those wishing to combine Islamic Finance and

microfinance is that of gender. The role of women in microfinance is seen as critical to

the model laid out in the Grameen paradigm: Grameen boast of “8.1 million borrowers,

97 percent of whom are women”, while various estimates place the proportion of women

among all microfinance borrowers at between seventy and eighty-five percent.19

19 ILO, “Small Change, Big Changes: Women and Microfinance”, pg. 4.

http://www.ilo.org/public/libdoc/ilo/2008/108B09_28_engl.pdf


24

This approach is supported by considerable anecdotal and statistical evidence, so that

even while taking into account the bias towards women that already exists among the

client base of microfinance organizations,

MFIs with higher proportions of female borrowers have a lower portfolio-at-risk…these combined findings provide compelling evidence that that focus on women clients enhances microfinance repayment, and that women in general are a better credit risk.20

However, the reasoning behind this is yet to be clearly elaborated. Various theories have

been put forward in a part of microfinance that has proved hard to define and quantify.

The most commonly proposed arguments are:

• Social pressure – the idea that women are more susceptible to the estimation of

others, and are consequently more easily swayed by the concept of social

collateral.

• Conservative risk profiles – several studies have indicated that women less likely

to pick risky investments than men.

• Empowerment – by giving economic power to women in societies that often deny

them significant authority, MFIs see better results from women as they are more

likely to work hard and use funds in a more conscientious manner.

• Family units – women are more concerned by the welfare of dependants, and

more likely to be working from home as they will often be looking after children

and elderly relatives. Consequently they will work harder and be less mobile, thus

making them easier for MFIs to monitor.

Of course there are arguments against all of the above as an individual solution, but in

combination, the above reasoning may well serve as an explanation for the focus on

women within MFIs. This focus is seen in many circles as one of the main arguments for

microfinance in terms of social benefit; by targeting women, MFIs are not only

improving their status in unequal societies, they are also responding to the higher

proportion of women among the very poor (70% of the 1.3 billion earning less than $1

per day, according to one estimate).21

20 D’Espallier, Guérin & Mersland, “Women and Repayment in Microfinance”, 2009, pg. 27. 21 UNDP Human Development Report, 1995.


25

However, one of the more notable aspects of many Muslim societies is the status of

women therein. In many of the Gulf States, women are deprived of the right to vote, drive

or even be in the company of men not related to them without a guardian. Amnesty

International’s 2009 report on Saudi Arabia noted that

the concept of male guardianship over women (mehrem), as applied, severely limited women’s rights, notably in relation to marriage, divorce, child custody, inheritance, property ownership, and choices about residency, education and employment.22

Equally a similar report on Qatar for 2009 stated that Women continued to face discrimination in law and in practice and were inadequately protected against violence within the family. In particular, family law discriminates against women, making it much easier for men to divorce than women, and placing women whose husbands leave them or who seek a divorce at a severe economic disadvantage.23

Similar difficulties can be seen elsewhere in the Muslim world, with a 2009 Human

Rights Watch report on the status of women in Afghanistan concluding that

Eight years after the fall of the Taliban, and the establishment of the Karzai government, Afghan women continue to be among the worst off in the world. Their situation is dismal in every area, including in health, education, employment, freedom from violence, equality before the law, and political participation.24

There is, of course, little in the Qur’an or the Sunnah to insist on such limited legal and

political status for women. However, it remains true that in many of the states where

consumers would be most interested by Islamic microfinance, women have so little

independence that its efficiency might be called into question.

What is the solution to such a fundamental issue? On the face of it, this appears to be a

choice between microfinance as a tool for social improvement and as a tool for improved

economic performance. Should MFIs insist on only working in an environment where

women are able to sign contracts, own property and run their own businesses, or should

they simply aim to improve the economy of the region in which they are operating?

22 http://www.amnesty.org/en/region/saudi-arabia/report-2009 23 http://www.amnesty.org/en/region/qatar/report-2009 24 Human Rights Watch, “We Have the Promises of the World – Women’s Rights in Afghanistan”, 2009, pp. 2-3.

http://www.amnesty.org/en/region/saudi-arabia/report-2009

http://www.amnesty.org/en/region/qatar/report-2009


26

In fact, the choice of women as microfinance customers is critical to both aspects. As we

have seen previously, women are simply the most efficient consumers of microcredit and

microfinance. In the early days of microfinance in Bangladesh, Grameen faced a similar

issue in terms of overcoming the reluctance of communities to allow women greater

independence, as well as the freedom to meet with loan officers unsupervised. However,

as the benefits of microcredit became clear, this hurdle was lifted, and the proportion of

female borrowers went from fifty percent to today’s ninety-seven percent. Ultimately, it

will be in the interest of both MFIs and the community to improve access to financial

tools for women, even if they are less willing to consider equivalent political rights.

Elsewhere, there are still significant issues relating to Islamic Finance, which, like

microfinance, is still very much in its infancy. Most of all, despite the international

organizations put in place, there is still very much the need for a coherent set of rules,

with one governing body in place to set them. The variation in opinions between different

scholars, as well as the more relaxed approach to Sharia’a laws in Malaysia compared to

the Middle East, mean that there is still a degree of uncertainty with regard to the

standardization of regulations. As one practitioner puts it

there is no one basic regulatory environment across geographies that manages Islamic banking today… I think that is one of the fundamental pieces that needs to be addressed in order for the true potential of Islamic banking to be realized.25

Conclusion When first looking at microfinance and Islamic Finance, it seems as if they are two

models that are mutually incompatible. But by combining the techniques laid out above,

we should be able to arrive at a model that is able to both accommodate the demands of

Sharia’a law and serve the needs of those at the BOP. Furthermore, the emphasis placed

on community is one which both models share, and which can provide a solution which

will only aid one another during a time when disillusionment with conventional banking

has never been more pronounced.

25 Asif Mumtaz (HSBC Amanah), Islamic Finance Summit, 5th February 2008.


27

Glossary of terms AAOIFI

Amanah

Aqd’

BOP

Fiqh

Gharar

Halal

Haram

IDB

IFI

IFSB

IIRA

Ijara

Kafala

LFI

Maysir

MFI

Mudaraba

The Accounting and Auditing

Organization for Islamic Financial

Institutions

Trust, or bank account

Binding contract

Bottom of the Pyramid, those whose

purchasing power is equal to or less than

$1500 per year

Islamic jurisprudence

Risk, or deception, prohibited in Islam

Permissible according to Islamic law

Not permissible according to Islamic law

Islamic Development Bank, responsible

for fostering development in Muslim

world

Islamic Finance Institution

Islamic Financial Services Board,

responsible for issuing guidance and

standards for the industry

International Islamic Rating Agency,

responsible for rating Sharia’a compliant

instruments and investments

Lease contract

Third party guarantee

Large Financial Institution e.g. a bank

Gambling, speculation

Microfinance Institution

Partnership project, profit-sharing

arrangement


28

Murabaha loan equivalent within Isla

Musharaka, Diminishing

Qur’an

Riba

Sharia’a

SHG

Sukuk

Sunnah

Takaful

Wa’d

Wadia

Wakala

Zaqat

Loan equivalent within Islamic Finance

Mortgage equivalent

Revealed text of God’s words to the

Prophet Muhammad

Interest, prohibited in Islam

Islamic scholarship interpreting Qur’an

and Sunnah

Self-Help Group, borrowing group and

unit of microfinance, as described by

C.K. Prahalad

Islamic bond equivalent

The sayings of the Prophet Muhammad

Islamic insurance

Promise, not necessarily binding

Trust, bank account

Agency contract, granting third party

authority

Charity, required for most Muslims, one

of the five pillars of Islam

Documents

Microfinance and Islamic Finance: can they be reconciled ... · HEC Social Business Certificate 2 The aim of this work is to explore how microfinance and Islamic Finance might benefit