Islamic Microfinance: 47001 An Emerging Market Niche A n estimated 72 percent of people living in demand for Islamic microfinance products is strong. Muslim-majority countries do not use formal Surveys in Jordan, Algeria, and Syria, for example, financial services (Honohon 2007).1 Even when revealed that 20­40 percent of respondents cite financial services are available, some people view religious reasons for not accessing conventional conventional products as incompatible with the microloans. financial principles set forth in Islamic law. In recent years, some microfinance institutions (MFIs) have Islamic microfinance has the potential NOTE stepped in to service low-income Muslim clients who to expand access to finance to demand products consistent with Islamic financial unprecedented levels throughout the principles--leading to the emergence of Islamic Muslim world. microfinance as a new market niche. This Focus Note provides an overview of the current Islamic microfinance represents the confluence of two state of the Islamic microfinance sector and identifies rapidly growing industries: microfinance and Islamic possible challenges to its growth. It is intended as an finance.2 It has the potential to not only respond introduction to Islamic microfinance primarily for the to unmet demand but also to combine the Islamic donor community and other potential entrants into social principle of caring for the less fortunate with the market. microfinance's power to provide financial access to the poor. Unlocking this potential could be the key Principles of Islamic Finance to providing financial access to millions of Muslim poor who currently reject microfinance products that Islamic finance refers to a system of finance based do not comply with Islamic law. Islamic microfinance on Islamic law (commonly referred to as Sharia4). is still in its infancy, and business models are just Islamic financial principles are premised on the emerging. general principle of providing for the welfare of the population by prohibiting practices considered unfair In a 2007 global survey on Islamic microfinance, or exploitative. The most widely known characteristic CGAP collected information on over 125 institutions of the Islamic financial system is the strict prohibition and contacted experts from 19 Muslim countries. The on giving or receiving any fixed, predetermined FOCUS survey and a synthesis of other available data revealed rate of return on financial transactions. This ban on that Islamic microfinance has a total estimated global interest, agreed upon by a majority of Islamic scholars, outreach of only 380,000 customers and accounts for is derived from two fundamental Sharia precepts: only an estimated one-half of one percent3 of total microfinance outreach. · Money has no intrinsic worth. Money is not an No. 49 asset by itself and can increase in value only if it August 2008 The supply of Islamic microfinance is very concentrated joins other resources to undertake productive in a few countries, with the top three countries activity. For this reason, money cannot be bought Nimrah Karim, (Indonesia, Bangladesh, and Afghanistan) accounting and sold as a commodity, and money not backed Michael Tarazi, and Xavier Reille for 80 percent of global outreach. Nevertheless, by assets cannot increase in value over time. 1 Honohon's study finds that in the Islamic Development Bank's 56 member countries, only 28 percent of the adult population uses formal (or semi-formal) financial intermediaries, whether through deposit accounts or borrowing. This percentage includes non-Muslims living in such countries. 2 Today, the total assets of Islamic financial products is estimated at US$500.5 billion (The Banker 2007) and the Islamic finance industry's 100 largest banks have posted an annual asset growth rate of 26.7 percent, outpacing the 19.3 percent growth rate of their conventional counterparts (Kapur 2008). 3 Based on an estimated 77 million microcredit clients (Microfinance Information eXchange 2007a). 4 Sharia is derived from four sources. The main source of Sharia is the Quran, considered by Muslims to be divine scripture. The second most authoritative source of Sharia is hadith--the practice, conduct, and sayings of the Prophet Muhammad. If further clarity is required, jurists seek consensus on rulings among Islamic scholars. In the event that none of these sources provides the necessary legal authority, a jurist may use reasoning by analogy and apply an accepted principle or assumption to arrive at a rule of law. Adapted from http://www.expertlaw.com/ library/family_law/islamic_custody.html (accessed 22 March 2008). 2 · Fund providers must share the business risk. be conflicting views on the implementation of these Providers of funds are not considered creditors principles in designing and extending Islamic financial (who are typically guaranteed a predetermined products. rate of return), but rather investors (who share the rewards as well as risks associated with their Development of the investment). Islamic Finance Industry Islamic finance, however, extends beyond the ban of Growth of Islamic Finance interest-based transactions. Additional key financial principles include the following: The global Islamic finance industry is rapidly growing. In the past 30 years, the industry has witnessed · Material finality. All financial transactions must the development of over 500 Sharia-compliant be linked, either directly or indirectly, to a real institutions, whose reach now spans 75 countries economic activity. In other words, transactions (KPMG 2006). These institutions include 292 banks must be backed by assets, and investments may (fully Islamic institutions and those institutions with be made only in real, durable assets. This precludes Islamic subsidiaries), 115 Islamic investment banks the permissibility of financial speculation, and and finance companies, and 118 insurance companies. therefore, activities such as short selling are Today, the industry's total assets are estimated at considered violations of Sharia. US$500.5 billion (The Banker 2007).5 · Investment activity. Activities deemed inconsistent with Sharia, such as those relating to the Since 2006, nearly 80 Islamic financial institutions consumption of alcohol or pork and those relating have been newly established or are being created to gambling and the development of weapons of (The Banker 2007). The 100 largest wholly Sharia- mass destruction, cannot be financed. In broader compliant banks have posted an annual asset growth terms, Sharia prohibits the financing of any activity rate of 27 percent, outpacing the 19 percent growth that is considered harmful to society as a whole. rate of their conventional counterparts (Kapur · No contractual exploitation. Contracts are required 2008). to be by mutual agreement and must stipulate exact terms and conditions. Additionally, all involved Demand for Sharia-compliant investment portfolio parties must have precise knowledge of the product management is increasingly being met by Islamic or service that is being bought or sold. investment funds, which include private equity funds and approximately 250 Sharia-compliant mutual The jurisprudence used to engineer Sharia-based funds, with assets under management valued in financial contracts is complex (see Box 1). Scholars 2006 at US$16 billion (Forte and Miglietta 2008). The must complete several years of training before Islamic bonds (sukuks)6 market is also growing since becoming certified to issue financial rulings. The Malaysia's pioneering issuance of sukuks in 2001. industry's most prominent Islamic finance scholars The size of the sukuk market in 2007 was estimated are in general agreement on the basic set of financial at US$47 billion, compared with US$10 billion in precepts listed above. However, there is no centralized 2005 (AME Info 2008). The Islamic insurance market Sharia finance authority, and consequently, there can remains in its formative stage of development, with 5 Despite the rapid growth of Islamic finance, it remains a very small portion of the global market. While the largest Islamic bank, Bank Melli of Iran, has US$22 billion in assets, Mizuho Financial Group of Japan, the conventional banking industry's largest bank, has total assets estimated at US$1.28 trillion. In fact, there are only six Islamic banks worldwide with assets exceeding US$10 billion. 6 Sukuks do not feature prominently in Islamic microfinance. For a discussion on sukuks, see Clifford Chance Limited Liability Partnership (2006). 3 Box 1. Basic Islamic Microfinance Contractsa The following are the most widely available types of maintenance, remains with the financier. An ijarah Islamic microfinance contracts. Each can either operate contract may be followed by a sale contract, in individually or be combined with other contracts to which event the ownership of the commodity is create hybrid instruments. transferred to the lessee. · Murabaha Sale (cost plus markup sale contract). · Musharaka and Mudaraba (profit and loss sharing). The most widely offered Sharia-compliant contract The profit and loss sharing (PLS) schemes are the is murabaha, an asset-based sale transaction used Islamic financial contracts most encouraged by to finance goods needed as working capital. Sharia scholars. Musharaka is equity participation Typically, the client requests a specific commodity in a business venture, in which the parties share the for purchase, which the financier procures directly profits or losses according to a predetermined ratio. from the market and subsequently resells to the Musharaka can be used for assets or for working client, after adding a fixed "mark-up" for the capital. Mudaraba denotes trustee financing, in service provided. It is permissible for the financial which one party acts as financier by providing the institution to appoint the client as an "agent" funds, while the other party provides the managerial on its behalf (by means of a contract) to directly expertise in executing the project. In mudaraba, procure the commodity from the market. However, profits are shared according to a predetermined ownership of the commodity (and the risk inherent ratio; any losses are borne entirely by the financier. thereto) strictly lies with the financier until the client If the mudaraba joint venture results in a loss, the has fully paid the financier. In most cases, clients financier loses the contributed capital and the repay in equal installments. The markup is distinct manager loses time and effort. Both PLS schemes from interest because it remains fixed at the initial require particularly vigilant reporting and a high amount, even if the client repays past the due date. level of transparency for profits and losses to be Among the primary conditions for a murabaha sale distributed justly. Consequently, though promoted to remain Sharia-compliant are (i) the financier strongly by Sharia, they result in substantial operating must own the commodity before selling it, (ii) the costs particularly for micro and small enterprises that commodity must be tangible, and (iii) the client are not accustomed to formal accounting. must agree to the purchase and resale prices.b · Takaful (mutual insurance). The equivalent of · Ijarah (leasing contract). Ijarah is a leasing contract Islamic insurance, takaful is a mutual insurance typically used for financing equipment, such as scheme. The word originates from the Arabic word small machinery. Duration of the lease and related "kafala," which means guaranteeing each other or payments must be determined in advance to joint guarantee. Each participant contributes to avoid any speculation. For the transaction to be a fund that is used to support the group in times considered Islamic (and not a sale with camouflaged of need, such as death, crop loss, or accidents. interest), the ijarah contract must specify that the Paid premiums are invested in a Sharia-compliant ownership of the asset, and responsibility for its manner to avoid interest. aThere is only one type of permissible "loan" according to Sharia, the Qard-Hassan (or Benevolent) Loan, which is interest-free and often considered a form of charity because it is typically forgiven in the event of default. All other mechanisms are better termed financing agreements, or contracts. However, for the purposes of this Focus Note, the term "loan" may be used to denote financing arrangements within the Sharia context. bAdapted from Khan (2008). cFor a detailed discussion of takaful, see Maysami and Kwon. Box 2. How Does Savings Work? Islamic savings products are deposits that are invested a savings arrangement also could be considered a pursuant to the principles set forth in this paper. A form of musharaka because other depositors are also typical savings product is a form of mudaraba, in which depositing funds for investment in the same financial the saver "invests" her deposit in the business of a institution. Even takaful can operate as a savings financial institution. The financial institution invests its product because premiums are invested in a Sharia- managerial expertise and intermediates the deposits/ compliant manner and are often disbursed at the investments in a Sharia-compliant manner. Profits (or end of an agreed term, regardless of any insurance losses) are shared pursuant to prior agreement. Such claim. 4 an estimated US$5 billion in premiums held in 2007 Northern Sudan, for example, adopted Sharia- against a global insurance turnover of US$3.7 trillion compliant regulatory frameworks for the entire (Zawya 2008). banking sector in 1984. Indonesia broke new ground in the realm of Islamic finance by creating in 1992 a Global Expansion formal, regulated Sharia banking sector alongside, and not instead of, its conventional banking sector.7 Despite its origins in the Persian Gulf, Sharia-compliant New regulations in Malaysia, Brunei, and Pakistan also banking has proved popular with Muslims in other have supported the expansion of an Islamic finance countries as well, leading to the development of new industry alongside conventional financial services. Islamic banks across North Africa and Asia. Of the total US$500.5 billion global Islamic finance market, A second regulatory approach has been to address 36 percent is located in the Gulf Cooperation Council the growth of Islamic finance by separately regulating (GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi unique aspects of Islamic banking, such as Sharia Arabia, and UAE), 35 percent in non-GCC Southwest Supervisory Boards (SSBs). For example, several Asia and North Africa, and 23 percent in Asia (primarily countries (such as Kuwait, Jordan, Lebanon, and Malaysia, Brunei, and Pakistan) (The Banker 2007). Thailand) have regulated the competence and composition of SSBs, as well as related rules governing Over time, Islamic financial services also have appointment, dismissal, and qualifications of SSB expanded well beyond the Muslim world and are members (Grais and Pellegrini 2006). However, no offered not only by Islamic banks, but also by Islamic country is known to regulate the Sharia jurisprudence subsidiaries of international financial institutions. to be used by SSBs in judging Sharia compliance Islamic financial services are currently provided in (though countries like Jordan and Kuwait do impose countries such as India, China, Japan, Germany, SSB member unanimity or majority vote requirements) Switzerland, Luxembourg, the United Kingdom, the (Grais and Pellegrini 2006). United States, and Canada. The United Kingdom, which currently ranks tenth in The Banker's listing International Organizations of "Top 15 Countries by Sharia-compliant Assets" (2007), has recently announced its aim to make In parallel with increased attention by regulatory London a global center for financial markets in the authorities, international organizations also have Muslim world. been created to set Islamic finance accounting and other standards: Government Regulation · The Islamic Financial Services Board (IFSB), based Islamic financial services originally operated in an in Malaysia, issues prudential standards and unclear regulatory landscape. However, as they guiding principles for Islamic finance. IFSB has expanded, they presented several regulatory issued guidelines on risk management and capital challenges that governments have attempted to adequacy for Islamic banks. address to various degrees. · The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in One approach has been to proactively encourage, Bahrain, promotes financial reporting standards for even mandate, Islamic financial services by law. Islamic financial institutions. 7 Decree No. 72 (1992) concerning Bank Applying Share Base Principles. 5 · The Islamic Development Bank (IDB), a multilateral · More than 60 percent of low-income survey body headquartered in Saudi Arabia, fights poverty respondents in the West Bank and Gaza claim a and promotes economic development in Islamic preference for Islamic products over conventional country members. It promotes microfinance and products. More than half of such respondents poverty alleviation programs through its Islamic prefer such products even if they come at a higher Solidarity Fund for Development (ISFD), which price (PlaNet Finance 2007).9 recently committed US$500 million to microfinance · In Jordan, studies by USAID (2002) and IFC/FINCA development through its Microfinance Support (2006) show that 24.9 percent and 32 percent, Program (MFSP). respectively, of those interviewed cite religious reasons for not seeking conventional loans. The Despite a shared core of Islamic values, these IFC/FINCA study also showed that 18.6 percent institutions often diverge with national regulators of those interviewed rank religious reasons as the (and each other) over Sharia standards. For example, single most important factor in their decision on AAOIFI standards are mandatory in only a handful of obtaining a loan. countries and are selectively implemented elsewhere · In Algeria, a 2006 study revealed that 20.7 percent (Islamic Banking & Finance 2008). of microenterprise owners do not apply for loans primarily because of religious reasons (Frankfurt Islamic Microfinance School of Finance and Management 2006). · In Yemen, an estimated 40 percent of the poor Demand demand Islamic financial services, regardless of price.10 Conventional microfinance products have been · In Syria, a survey revealed that 43 percent of very successful in Muslim majority countries. One respondents considered religious reasons to be of the earliest microfinance programs originated in the largest obstacle to obtaining microcredit. In Bangladesh with the experience of the Grameen Bank addition, 46 percent of respondents who had never initiated by Nobel Prize winner Mohammed Yunus. applied for a loan stated that religious reasons were Islamic countries, such as Indonesia and Pakistan, have a the primary reason they had never applied. Nearly vibrant microfinance industry; approximately 44 percent 5 percent of current borrowers said they would not of conventional microfinance clients worldwide reside apply for another loan for religious reasons (IFC in Muslim countries.8 Yet, conventional microfinance 2007b). products do not fulfill the needs of many Muslim clients. Just as there are mainstream banking clients In addition to the IFC­commissioned studies, a 2000 who demand Islamic financial products, there are Bank Indonesia report indicated that 49 percent of also many poor people who insist on these products. the rural population of East Java considers interest Indeed, Sharia compliance in some societies may be prohibited and would prefer to bank with Sharia- less a religious principle than a cultural one--and compliant financial institutions. even the less religiously observant may prefer Sharia- compliant products. Although there is a market of poor clients who strictly engage in Islamic transactions, there is also A number of IFC-commissioned market studies suggest a category of Muslim clients who use conventional a strong demand for Islamic microfinance products: products but prefer Islamic ones. Microfinance 8 Based on figures provided by the Microfinance Information eXchange. 9 Thirty-five percent of West Bank respondents and 60 percent of Gaza Strip respondents stated that they do not access finance because of the Islamic prohibition on interest. 10 Phone interview with executive director of the National Microfinance Foundation, Yemen. 6 practitioners11 in Muslim-majority countries indicate arrangements for offering Islamic microfinance: that in Afghanistan, Indonesia, Syria, and Yemen, via (i) the creation of Islamic microfinance banks, some conventional microborrowers tend to switch (ii) Islamic banks, (iii) conventional banks, and (iv) over once Islamic products become available. conventional microfinance banks. The guidelines set forth requirements regarding licensing, appointment Anecdotal evidence, however, suggests that survey of Sharia advisers to rule on Sharia compliance, and respondents may verbally express a preference for segregation of Islamic product funds (and related Islamic products simply to demonstrate piety or documentation) by banks and MFIs that offer both (when given a choice in practice) will opt for a lower conventional and Sharia-compliant products.12 priced conventional product. Consequently, despite indications of demand for Islamic microfinance Banks Downscaling and products, further research is needed to ascertain the Expanding Product Line nature and extent of the demand and how to meet this demand in a cost-effective manner. An encouraging development in the growth of Islamic microfinance is that Islamic commercial banks have Government Promotion of started to offer Islamic microfinance services. Yemen's Islamic Microfinance Tadhamon Islamic Bank, for example, opened a micro and small enterprises division in late 2006 (IFC As in the case of the larger Islamic banking industry, 2007a). In addition, some Islamic banks are planning government regulation can play a significant role in to offer Islamic microfinance products beyond just the expansion of Sharia-compliant microfinance. microcredit. On 20 January 2008, Noor Islamic Bank and Emirates Post Holding Group announced plans to Indonesia. In Indonesia, the government has actively establish a company that will offer Sharia-compliant promoted Islamic microfinance. In 2002, Bank banking services to the low-income segment of Indonesia prepared a "Blueprint of Islamic Banking the UAE population. The proposed company will Development in Indonesia" in which it developed provide a wide array of Islamic microfinance products, a nine-year plan for development of the Islamic including microcredit, insurance, debit and credit finance sector, including support for the 105 Sharia cards, remittance and currency exchange, and salary rural banks. Indonesia now provides a supportive payments (Emirates News Agency 2008). Also in regulatory framework and has licensed 35 new Islamic January 2008, Allianz Life Indonesia announced that, rural banks in the past five years. Bank Indonesia after an 18-month pilot project, the Sharia-compliant also is spearheading efforts in capacity building by microinsurance "Family Umbrella" product is now an establishing a center in Medan to offer training and established line. certification on Islamic financial operations to Sharia rural bank staff, managers, and directors. Islamic Microfinance: CGAP Survey Results Pakistan. The State Bank of Pakistan, which already has a legal and regulatory framework in place for CGAP conducted a global survey on Islamic conventional MFIs, also developed guidelines in microfinance in 2007, collecting information on over 2007 for the rapid expansion of Islamic microfinance. 125 institutions and contacting experts from 19 The guidelines stipulate four types of institutional Muslim countries. This section presents the principal 11 These practitioners include FINCA (Afghanistan), German Technical Cooperation (Indonesia), Sanadiq in Jabal-al-Hoss (Syria), Social Fund for Sustainable Development (Yemen), and Hodeidah Microfinance Program (Yemen). 12 Guidelines for Islamic Microfinance Business for Financial Institutions (Annexure to Circular No. 05 of 2007), State Bank of Pakistan Islamic Banking Department, available at http://www.sbp.org.pk/ibd/2007/Annex-c5.pdf. 7 Box 3. What About Iran? The Iranian government requires all of its commercial are typically (i) made for large one-time expenditures banks to provide Sharia-compliant noninterest bearing and (ii) forgiven in the event of default. They are not loans to the low-income population. Typically, these generally considered to provide access to finance in a loans are disbursed to cover personal expenses, such sustainable manner. as wedding expenses, repayment of outstanding debts, home rental and repair costs, medical expenses, Outside the Qarzul-Hassaneh Funds, microfinance tuition fees, and the purchase of consumer goods. in Iran is informal, though a number of originally Outreach is very significant and, as of March 2008, the charitable organizations have reportedly started Central Bank of Iran estimated that 3 million families microfinance operations. These organizations have benefit from approximately 6,000 Qard-Hassan been registered by the Ministry of Interior and are institutions ("benevolent loan funds" known in Iran outside the scope of Central Bank regulation. as Qarzul-Hassaneh Funds), with a total outstanding loan amount of 50 trillion rials (or US$5.5 billion). Consequently, statistics on Iranian microfinance and However, Qarzul-Hassaneh Funds are most often Qarzul-Hassaneh Funds are not reflected in this Focus considered charities, and not MFIs, because loans Note. findings of this first global survey on the performance by the CGAP survey is only 2,400 clients (and none and outreach of Islamic microfinance. has more than 50,000 clients). Current Performance ThesupplyofIslamicmicrofinanceisveryconcentratedin a few countries. Indonesia, Bangladesh, and Afghanistan The outreach of Islamic finance is very limited. account for 80 percent of the global outreach of Islamic According to the CGAP survey, Islamic MFIs13 reach microfinance. In all other countries, microfinance is still 300,000 clients through 126 institutions operating in in its infancy, with no scalable institutions reaching 14 countries and an estimated 80,000 clients through a clients on a regional and national level. network of Indonesian cooperatives. According to the survey, Bangladesh has the largest Islamic microcredit For most countries, the average Islamic microloan outreach, with over 100,000 clients and two active amount (with respect to primarily the murabaha institutions. However, Bangladesh is also the country product) is similar to conventional microloans. where conventional microfinance products have the There are notable exceptions, however, such as in largest outreach--nearly 8 million borrowers--and Indonesia (where the average Islamic product loan size Islamic microfinance represents only 1 percent of its is 45 percent higher than the average conventional microfinance market. microloan)15 and in the West Bank and Gaza. In all Muslim countries, Islamic microfinance still Like conventional microfinance, Islamic microfinance accounts for a very small portion of the country's tends to focus on female clients--a majority of total microfinance outreach. For example, in Syria and Islamic MFI clients according to the CGAP survey Indonesia, Islamic financing instruments comprised were women (59 percent on average, but up to 90 only 3 percent14 and 2 percent, respectively, of percent in Bangladesh). Overall, the percentage of outstanding microfinance loans in 2006. In addition, female clients using Islamic microfinance products (59 the average outreach of the 126 institutions covered percent) is comparable to those using conventional 13 The term "Islamic MFI" in this Focus Note refers to any institution offering Islamic microfinance services and not just to Islamic institutions. 14 Sanabal Microfinance Network data. 15 Microfinance Information eXchange. 8 Table 1. Outreach of Islamic Microfinance, by Country # of Included % Female Total # Total Outstanding Avg. Loan Region Institutions (Avg.) of Clients Loan Portfolio (US$) Balance (US$) Afghanistan 4 22 53,011 10,347,29 162 Bahrain 1 n/a 323 96,565 299 Bangladesh 2 90 111,837 34,490,490 280 Indonesia* 105 60 74,698 122,480,000 1,640 Jordan 1 80 1,481 1,619,909 1,094 Lebanon 1 50 26,000 22,500,000 865 Mali 1 12 2,812 273,298 97 Pakistan 1 40 6,069 746,904 123 West Bank and Gaza** 1 100 132 145,485 1,102 Saudi Arabia 1 86 7,000 586,667 84 Somalia 1 n/a 50 35,200 704 Sudan 3 65 9,561 1,891,819 171 Syria 1 45 2,298 1,838,047 800 Yemen 3 58 7,031 840,240 146 TOTAL 126 59 302,303 197,891,882 541 * Micro and rural banks only. **There were seven MFIs in the West Bank and Gaza that offered, with the help of training and funding facilities offered by the Islamic Development Bank, a total of 578 Islamic loans between 2005 and 2006. Data on only one of these seven are displayed in the table because the remaining six MFIs were disbursing Islamic loans with average loan sizes higher than 250 percent of the region's gross domestic product per capita. microfinance products (65.7 percent globally, and 65.4 was provided by the Deprived Families Economic percent in the Arab world) (Microfinance Information Empowerment Program). The table excludes the eXchange 2007b). outreach of Indonesia's 4,500 Islamic cooperatives. However, according to experts in Indonesia, only 60 Finally, the CGAP survey identified that over 70 percent of these Islamic cooperatives are still active, percent of the products offered are murabaha. Islamic and their total outreach is estimated at 80,000 clients. MFIs generally offer only one or two Sharia-complaint As in the rest of this Focus Note, an MFI is defined as products. Concentrating primarily on asset financing, an institution targeting the poor and whose average the industry still lacks product diversification to serve loan size is less than 250 percent of the country's the various financial needs of the poor. gross domestic product per capita. Table 1 includes the outreach data of only the Islamic Microfinance by Institution Type institutions that CGAP was able to contact during its survey, except with respect to those institutions in Among the institutions that offer Islamic microfinance Indonesia (about which information was obtained from products, nongovernment organizations (NGOs) are the Indonesian Central Bank's 2007 Statistics) and in the dominant players in reaching the largest number the West Bank and Gaza (about which information of clients, with just 14 institutions reaching 42 percent 9 Table 2. Outreach of Islamic Microfinance, by Institution Type Total Outstanding Loan Avg. Loan Size Total # of Clients Portfolio (Islamic) (Islamic) # of % of % of Institution Type Institutions # Total US$ Total US$ Cooperative 1 6,671 2 926,251 <1 132 Village Bank (Syria) 1 2,298 1 1,838,047 <1 800 NGO 14 125,793 42 41,421,580 21 303 Rural Bank (Indonesia) 105 74,698 25 122,475,158 62 1,640 NBFI 3 4,293 1 1,893,207 <1 595 Commercial Bank 2 87,569 29 29,030,997 15 305 TOTAL 126 305,237 100 198,090,268 100 629 Note: This table reflects the data of only those institutions (mixed and fully Islamic) that provided reliable outreach information to CGAP during its 2007 global survey of Islamic microfinance. Data regarding the 105 rural banks in Indonesia were obtained from the Indonesian Central Bank's 2007 Statistics. This table excludes data on the outreach of Indonesia's 4,500 cooperatives. As in the rest of this Focus Note, an MFI is defined as an institution targeting the poor and whose average loan size is less than 250 percent of the country's gross domestic product per capita. of clients. Commercial banks (represented by only BPRSs are more socially oriented than BPRs. Their two institutions: Yemen's Tadhamon Islamic Bank mission statement calls for supporting the community and Bangladesh's Islami Bank Bangladesh Limited) and, in particular, microentrepreneurs. They also have have the second largest outreach with over 87,000 strong links with Indonesian Muslim mass movements, clients. Interestingly, 105 Sharia-compliant rural banks such as Nahdlatul Ulama or Mohammedia. Each in Indonesia account for 25 percent of total clients, but BPRS has a Sharia board to monitor the conformity 62 percent of the outstanding loan portfolio because of products to Islamic principles. However, board of their significantly higher average loan size and focus rulings are not consistent, and consequently, Islamic on small and microenterprise financing. microfinance products can vary widely depending on the specific BPRS. BPRSs primarily offer murabaha Focus on Indonesia products and savings services based on a revenue- sharing model.16 They have been quite successful at Indonesia gives insight into the development of Islamic mobilizing savings for the community, and their loan- microfinance because of its dual conventional/Islamic to-deposit ratio is over 110 percent. microbanking system, which includes both conventional rural banks (Bank Perkreditan Rakyat or BPRs) and It is impossible to draw general conclusions on the Sharia-compliant rural banks (Bank Perkreditan Rakyat performance of Islamic MFIs based only on the limited Syariah or BPRSs). BPRSs are privately owned and are case of Indonesian BPRSs. Nevertheless, BPRSs offer regulated and supervised by Bank Indonesia. They are some insights on profitability and efficiency. licensed to offer banking services (loans and savings facilities, but no payments services) in a district area Higher costs. The average operational efficiency ratio only. As of December 2006, there were 1,880 BPRs of BPRSs is 20 percent--higher than the 15 percent and 105 BPRSs. operational efficiency ratio for conventional BPRs. 16 This savings product is a form of mudarabah (see Box 1) in which the depositor acts as "financier." 10 Table 3. Financial Performance of Indonesian MFIs Compared to Small Asian MFIs Average Number of Average Total Outstanding Loan PAR > 30 Operational Institution Type Institutions Assets (US$) Portfolio (US$) days Efficiency Ratio ROA Sharia Rural 105 1,538,571 1,166,476 8.67% 20% 1.41% Banks (BPRSs) Conventional 1,880 1,225,797 n/a 9.73% 16% 2.21% Rural Banks (BPRs) Small Asian MFIs 30 1,244,593 886,728 1.90% 9.60% 3.40% Source: Bank of Indonesia (2007a). Operational Efficiency figures are based on BPRs in North Sumatra (Microfinance Innovation Center for Resources and Alternatives). The difference may reflect the higher transaction the ROA of BPRs (2.2 percent). However, the range costs inherent in certain Sharia-compliant products. for both was wide, with several being very profitable BPRSs are mainly engaged in murabaha, which incurs and others not breaking even. BPRSs are still young the expense of first procuring the commodity to be institutions without a proven track record. It is too later resold and the expense of managing its resale early to draw conclusions about BPRS profitability; through the murabaha contract. However, although however, several factors might explain a lower ROA, overall transaction costs are higher, the extra cost to including the social mission of BPRSs. the customer may be offset by wholesale prices and the related saving of time otherwise spent selecting BPRSs are meeting a growing demand for Sharia- suppliers and negotiating contract terms. Both BPRs compliant microfinance products. Their rate of growth and BPRSs do not compare well with their closest has been impressive: from March to December 2007, "peers"--small MFIs in Asia17--as far as operational these banks' murabaha receivables increased by efficiency is concerned. This could be due to a number 26 percent, musharaka financing increased by 27 of factors, including average loan size, cost structure, percent, and mudaraba financing increased by almost and staff productivity. 50 percent (Bank of Indonesia 2007b). BPRSs can be profitable but nevertheless, like many microfinance Elevated portfolio delinquency, but improving over providers, they face several challenges in reaching time. The average portfolio at risk (PAR) at 30 days for sustainable scale (see Box 4). both BPRs and BPRSs are comparable at approximately 9 percent--high by microfinance standards. By Possible Challenges to the comparison, small Asian MFIs have a PAR at 30 days Growth of Islamic Microfinance of 1.9 percent. But over time, late payments seem to be recovered and long-term loss (defined as payments Islamic microfinance could potentially expand access more than 180 days overdue) for BPRSs is reported to finance to unprecedented levels throughout the at 3.1 percent.18 Consequently, portfolio delinquency Muslim world. However, the industry has yet to does not generate significant long-term loss. demonstrate it can provide financial services that meet the needs of poor people on a large scale. A Lower return on assets (ROA). The average ROA for deeper base of market research and proven business BPRSs was 1.4 percent in 2006, significantly lower than models are very much needed. Nevertheless, several 17 As identified in the MicroBanking Bulletin (2007). 18 Statistik Perbanken Syariah (Islamic Banking Statistics), Bank Indonesia (Direktorat Perbanken Syariah), December 2007. 11 Box 4. A Tale of Two Islamic Microfinance Banks BPRS Wakalumi in Ciputat, was established in 1990 2003 of 4.1 percent, 3.65 percent, and 3.35 percent by a foundation (Yayasan Wakalumi) as a conventional and ROEs of 20.3 percent, 21.05 percent, and 24.1 BPR; for religious reasons, it converted into a BPRS percent, respectively, it is highly profitable. in 1994. It has 118 shareholders, among them Bank Muamalat Indonesia (19 percent, down from 49 BPRS Artha Fisabililah, in Cianjur, was established percent), the former Minister of Cooperatives (23.5 in 1994 by nine shareholders. By 1997, as a result of percent), a Citibank manager (26 percent), the lack of management experience, it was technically founding foundation Yaysan Wakalumi (5.6 percent), bankrupt and was restructured. The new management and more than 100 individuals, mostly Muslims working was not very dynamic and was replaced in 2001 by a at Citibank. retired bank credit officer. The bank seems to have a successful staff promotion The bank, located next to a local market, has 1,150 strategy: the president director, with a bachelor's savers and 163 clients. With a staff of 11, including six degree in agriculture, has been with the bank since loan officers, it offers doorstep collection services to 1994, learning on the job and being promoted up about 200 clients a day. It also offers deposit services the ranks; the director, a woman with a diploma in to school children and institutions. Total assets are accounting, has been an employee since 1997 and IDR 1.4 billion, deposits total IDR 0.62 billion, and was promoted to director in 2003. The bank has grown financings outstanding equal IDR 1.21 billion. rapidly, and now has five branches and a staff of 38, including 13 loan officers. Its overall performance is not yet satisfactory. Its main problem is lack of funds, because of a shortage of Its 2,000 clients are mostly small traders on traditional deposits and capital from the owners. The bank was markets, to whom it sells its financings as Islamic in the black for the years 2001, 2002 and 2003, with products. It has four financing products, with ROAs of 2.3 percent, 1.7 percent, and 2.4 percent murabaha being the dominant one. Through eight and ROEs of 7 percent, 4.3 percent, and 8.75 percent, savings products and four term deposit products, respectively. Its main future strategy to improve it has attracted 5,000 savers. With ROAs in 2001­ efficiency is staff upgrading through training. Source: Adapted from Seibel (2007). possible challenges to scale up Islamic microfinance poor. Managing small transactions is expensive, and can be identified. MFIs must innovate to reduce transactions costs. In murabaha or ijara transactions, the provider of Building Sustainable Business Models funds purchases a commodity (such as equipment or inventory) and resells or leases it to the user with Islamic microfinance business models are still a markup. Islamic MFIs may benefit from cheaper being developed and no performance benchmarks prices on the wholesale market, but the costs have been established. However, two areas are of associated with purchasing, maintaining, selling, or particular importance: operational efficiency and risk leasing a commodity (such as a sewing machine) are management. expensive, and the added costs are often passed on to clients. However, some institutions have cut · Operational efficiency. Operational efficiency is their costs in murabaha transactions by requiring key to providing affordable financial services to the the end user to search for and identify the desired 12 commodity. Islamic institutions should consider financial experts and Sharia experts on product developing similarly novel techniques and practices authenticity, (ii) encourage exchange of experiences to minimize costs and offer more attractive pricing among religious leaders (particularly those serving to their clients. poor populations at the local level) relating to Sharia · Risk management. Risk management is another compliance of microfinance products, and (iii) educate important factor to building sustainable institutions. low-income populations, in collaboration with local The conventional microfinance industry has religious leaders, on how financial products comply developed a set of good practices to manage credit with Islamic law. risk, and MFIs boast excellent portfolio quality.19 Conventional MFIs generally do not secure loans Building Capacity through collateral but instead rely on peer pressure and strict discipline for collection. Such techniques Capacity building is needed at all levels to realize should be adapted to comply with the risk-sharing, the full potential of Islamic microfinance. At the and no-interest principles embedded in Islamic macro level, the Islamic Development Bank and finance. For example, some suggest that pressure Islamic financial standard setters (such as IFSB or from the religious community and appeals to a AAOIFI) should consider developing global financial sense of religious duty should complement reliance reporting standards adapted to microfinance to on peer pressure. build the infrastructure for transparency in the global Islamic microfinance sector. This infrastructure The Question of Authenticity would entail comprehensive disclosure guidelines on Islamic microfinance accounting principles, pricing Although there is ample evidence of demand for methodologies, financial audits, and eventually, rating Islamic microfinance products, meeting such demand services. requires that low-income clients are comfortable that the products offered are authentically Islamic. Critics At the micro and institutional levels, international of Islamic finance products suggest that the pricing donor agencies can play a major role in expanding of some products offered as Sharia-compliant too access to finance in Muslim countries by helping closely parallels the pricing of conventional products. existing institutions reach scale and funding pilot For example, some institutions offer murabaha where projects testing various business models. In addition, interest appears to be disguised as a cost markup or more efforts should be made to train Islamic MFI administration fee. Islamic finance sometimes suffers managers and staff through, for example, the from the perception that it is simply a "rebranding" development of operational tools and manuals (such of conventional finance and not truly reflective of as those developed by Deutsche Gesellschaft für Islamic principles. Technische Zusammenarbeit for use in Indonesia). Consequently, low-income populations, who often Product Diversity rely on local religious leaders to address questions of religion, must be convinced of the authenticity Islamic MFIs rely heavily on the murabaha (cost plus of Islamic financial products if Islamic microfinance markup sale) product.20 However, poor people have is to reach its full potential. Greater efforts should diverse financial requirements, and for many, savings be explored to (i) increase collaboration between or housing products may be more urgent needs. The 19 The 1,200 MFIs reporting to the Microfinance Information eXchange report an average PAR at 30 day is less than 5 percent. 20 The murabaha sale is the sole product of 34 percent of the MFIs operating in Northern Sudan. In addition, as of December 2006, murabaha sales accounted for 62.3 percent of the outstanding portfolio of Indonesian Islamic rural banks. 13 innovative design of a range of Sharia-compliant tendency to view zakat (funds donated pursuant to the products and services would provide greater financial Muslim obligation to pay alms) as a source of funding. access to a broader segment of Islamic microfinance Indeed, given the underlying principle of Islamic customers. finance to promote the welfare of the community, zakat funds appear ideally suited to support Islamic Leveraging Zakat and Islamic Funds microfinance. However, a heavy reliance on charity is not necessarily the best model for the development Throughout the Muslim world, microfinance (Islamic of a large and sustainable sector, and more reliable, or otherwise) is still seen as a philanthropic activity commercially motivated streams of funding should rather than a business enterprise. Consequently, in be explored. the context of Islamic microfinance, there is a growing 14 References Grais, Waifk, and Matteo Pellegrini. 2006. Corporate Governance in Institutions Offering Islamic Financial Services. World Bank Policy Research Working Paper AME Info. 2008. "Sukuk Issuances Continue to Rise 4052. Washington, D.C.: The World Bank, November, Despite Slowdown." AME Info, February. http://www. Annex III. ameinfo.com/147369.html. Accessed 4 April 2008. Honohon, Patrick. 2007. "Cross-Country Variations in Bank of Indonesia. 2007a. Indonesian Banking Household Access to Financial Services." Presented Statistics, Volume 5, no. 12 (November). at the World Bank Conference on Access to Finance, Washington, D.C., 15 March. Bank of Indonesia. 2007b. Statistik Perbanken Syariah (Islamic Banking Statistics). Bank Indonesia (Direktorat IFC and FINCA. 2006. Business Plan for a Microfinance Perbanken Syariah), December. Institution in Jordan. 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(Annexure to Circular No. 05 of 2007.) State Bank of Pakistan Islamic Banking Microfinance Information eXchange. 2007b. Department. http://www.sbp.org.pk/ibd/2007/ MicroBanking Bulletin, Issue 15 (Autumn):58. Annex-c5.pdf PlaNet Finance. 2007. Microfinance Market Survey The Banker. 2007. Top 500 Financial Islamic in the West Bank and Gaza Strip. Washington, D.C.: Institutions Listing. 5 November. PlaNet Finance, May. Zawya. 2008. "Takaful Has Miles to Go." http://www. Seibel, Hans Dieter. 2007. "Islamic Microfinance in zawya.com/Story.cfm/sidZAWYA20080331033424. Indonesia: The Challenge of Institutional Diversity, Accessed 4 April 2008. Regulation and Supervision." Presented at Harvard Law School Symposium Financing the Poor: Toward an Islamic Micro-Finance, 14 April. No. 49 August 2008 Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org © CGAP, 2008 The authors of this Focus Note are Nimrah Karim; Michael Sihombing, Hans Dieter Seibel, Syed Hashemi, Steve Rasmussen, Tarazi, senior policy specialist, CGAP; and Xavier Reille, lead Deepak Khana, Momina Aijazuddin, Kate McKee, Ignacio Mas, microfinance specialist, CGAP. The authors would like to thank Jeannette Thomas, the Sanabel Microfinance Network, the Islamic the following for their help in producing this Focus Note: Matthias Development Bank, the Islamic MFIs, and all other institutions Range, Mohammed Khaled, Samer Badawi, Wafik Grais, Meynar participating in the CGAP survey. CGAP publications are frequently cited in other works. The suggested citation for this paper is as follows: Karim, Nimrah, Michael Tarazi, and Xavier Reille. 2008. "Islamic Microfinance: An Emerging Market Niche." Focus Note 49. Washington, D.C.: CGAP, August.