~~~~~v Ta t)~~~~~~~~~~~~~~~~~~~h t 23073 December 1999 An Aplilcation of Islaniic Banjlag Pri ciples to Microfinace KC F '4 g /'ZIN ~~~~~~~~~~~~~:~~~~~~~~~~~O An Application of Islamic Banking Principles to Microfinance Technical Note Rahul Dhumale andAmela Sapcanin A study by the Regional Bureau for Arab States, United Nations Development Programme, in cooperation with the Middle East and North Africa Region, World Bank The authors are grateful to the United Nations Development Programme's Regional Bureau forA rab States for funding this study. They also thank Ahmed Abou El Yazeid, Judith Brandsma, Neriat Shafik (World Bank), Abbas Mirakhor (International Monetary Fund), Rohil Hafeez, Bassel Hamwi (International Finance Corporation), and William Tucker for invaluable comments and insights on previous drafts. This report was edited by Paul Holtz and laid out by Wendy Guyette, and the cover was designed by Laurel Morais, all with Communications Development Incorporated. The findings and recommendations expressed in this report are entirely those of the authors and should not be attributed in any manner to the United Nations Development Programme or the World Bank. Contents A nexus between Islamic banking and microfinance? 1 Islamic banking-promoting equity with a range of tools 2 Different interpretations 2 Different instruments 3 Microfinance-providing credit to the entrepreneurial poor 6 Combining Islamic banking with microfinance 8 A mudaraba model 8 A murabaha model 10 Experience with mudaraba and murabaha in microfinance 11 Conclusion 13 References 14 iii A nexus between Islamic banking and microfinance? I slamic banking has grown significantly of society as a whole. Although this analysis Islamic banking and over the past 20 years, with estimated of Islamic banking focuses on its economic microcredit deposits surpassing $80 billion in more aspects, the system can be fully understood programs may than 45 countries. Annual turnover is cur- only in the context of Islamic attitudes complement one rently estimated at $70 billion and is pro- toward ethics, wealth distribution, social and another in both jected to pass $100 billion by 2000 economicjustice, and the role of the state. ideological and (O'Sullivan 1994, p. 7). More than 100 Principles encouraging risk sharing, indi- p tI t Islamic banking institutions are in operation, vidual rights and duties, property rights, and practica erms ranging from pure Islamic banks to smaller the sanctity of contracts are all part of the sharia banking units in conventional banks Islamic code underlying the banking system. and investment houses. As one of the fastest- In this light, many elements of microfi- growing segments of the financial services nance could be considered consistent with market in the Islamic world-for the past the broader goals of Islamic banking. Both five years annual growth has averaged 15 systems advocate entrepreneurship and risk percent-these institutions have attracted a sharing and believe that the poor should take lot of attention. Moreover, the guiding prin- part in such activities. At a very basic level, the ciples of Islamic finance draw curiosity from disbursement of collateral-free loans in cer- Muslims and non-Muslims alike as they try tain instances is an example of how Islamic to understand how a system that prohibits banking and microfmance share common the receipt and payment of interest has aims. Thus Islamic banking and microcred- become so widespread. it programs may complement one another Although Islamic financial practices are in both ideological and practical terms. This founded on the core belief that money is not close relationship would not only provide an earning asset in and of itself, there is more obvious benefits for poor entrepreneurs who to the system's underlying tenets. Islamic reli- would otherwise be left out of credit markets, gious law-that is, sharia-emphasizes eth- but investing in microenterprises would also ical, moral, social, and religious factors to give investors in Islamic banks an opportu- promote equality and fairness for the good nity to diversify and earn solid returns. 1 Islamic banking-promoting equity with a range of tools Interest-free A s noted, Islamic banking is a fast- hibited only when money is lent at exorbitant lending is a basic growing sector in Middle Eastern interest rates that exploit the borrower. Thus tenet of Islamic financial markets and other Islamic interest may be lawfully allowed under cer- banking parts of the world (Indonesia, Malaysia). Its tain conditions-including loans made by role is also increasing in the West. Moreover, governments to induce savings, as a form of this growth has not been limited to a par- punishment for debtors, to finance trade, ticular sector of the banking industr,. and to finance productive investments. What are the foundations and features of Other scholars are indifferent to the pur- Islamic banking? pose for which the interest is being charged and consider all forms of riba to be unlawful. Different interpretations The main arguments here are that Islam does not allow gain from a financial activity unless An important Islamic commitment is the the financial capital is also exposed to the risk denouncement of usury-that is, the lending of potential loss; and that interest reinforces of money at exorbitant interest rates. the tendency for wealth to accumulate in the According to the literature, in the pre-Islamic hands of a few, thereby diminishing man's era riba-literally translated as excess, expan- concem for his fellow man (Lawai 1994, p. 8). sion, addition, or growth-referred to the Thus it is not surprising that most practice of lending. Debtors had to pay a Islamic banking strategies have tried to fixed amount above the principal borrowed remove all forms of fixed nominal interest from lenders for the use of the money. This rates. (Muslim scholars make no distinction additional amount, which depended on the between nominal and real interest rates; it predetermined rate, was called al-riba. is assumed that all interest rates are real and Most Muslim scholars believe that riba is therefore are considered to hamper invest- prohibited, but there are subtle differences ment and employment.) But the abolish- in interpretation. Siddiqui (1995, pp. 43-44) ment of fixed interest rates does not mean states that "a controversy has arisen that inter- that no remuneration is paid on capital. est paid by banks on deposits or charged on Profit-making is acceptable in Islamic soci- advances is not tantamount to riba and is ety as long as these profits are not unre- hence permissible." Ayub (1995, pp. 34-35) stricted or driven by thie activities of a says that "if someone indulges in trading monopoly or cartel (Lawai 1994, p. 10). (undertakes risk), the profit earned on it will Islam deems profit, rather than interest, to be permissible. But earning money by the act be closer to its sense of morality and equi- of loaning is haram [in discord with the ty because earning profits inherently involves Islamic code]." The discussion among schol- sharing risks and rewards. Profit-making ars includes analyses of whether the Koran addresses the Islamic ideals of social justice prohibits the use of interest altogether. Some because both the entrepreneur and the scholars believe that interest should be pro- lender bear the risk of the investment. 2 ISLAM]C BANKING-PROMOTING EQUIIY WITH A RANGE OF TOOLS 3 One result of this attitude toward profit Different instruments is that Islamic banking innately addresses the imperfect information and credit rationing The literature separates Islamic banking into problems that often exist between lenders three main activities: concessional financing, and borrowers in conventional banks. trade financing, and participatory mecha- Imperfect information occurs when one nisms (figure 1; Errico and Farahbaksh 1998, party has more and better information than p. 6). Within these activities are various con- the other party. I This inefficient distribution tractual forms that conform fully to the tenets of information leads to credit rationing. In of profit and loss sharing. The more com- extreme cases, given an aggregate level of monly used profit- and loss-sharing transac- available credit and a perfectly elastic sup- tions are mudaraba (partnership), musharaka ply curve, lending institutions establish a (equity participation), and musaqat and Under a mudaraba credit hierarchy. As a result not all borrow- muzar'ah (specific counterparts in mudara- contract the bank ers willing to pay a similar rate are able to ba contracts). All of these loan products provides the capital receive credit. Such rationing can damage appear to include a degree of uncertainty needed for a the real sector of the economy, especially regarding the eventual returns due to the project while the when it prevents productive investments entrepreneur and to the Islamic bank. Other entrepreneuroffers from being financed. Again, the profit- and lending contracts used in Islamic banking entrerneuoers loss-sharing schemes advocated under the include qard al-hasanah (benevolent loan), Islamic principle of cooperation (shirakat) bai'muajal and bai'salam (sales contracts), allow all parties-induding investors, savers, ijara wa iqtina' (leasing), murabaha (cost plus and financial institutions-to play an active markup), and jo'alah (service charge). role in the economic process and avoid credit-rationing problems. In fact, given the increased risks from investment returns based solely on profits, an argument can Under a mudaraba contract the bank pro- sometimes be made for banks to play a more vides the capital needed for a project while active role in project management to over- the entrepreneur offers labor and expertise. see their investments. The profits (or losses) from the project are In Islamic finance the technical term for shared between the bank and the entrepre- a transaction between an entrepreneur and neur at a fixed ratio. Financial losses are the suppliers of funds is mudaraba (see assumed entirely by the bank; the liability of below). Two of the conditions for a mudara- entrepreneurs is limited to their time and ba-type venture show the level of partnership effort. In cases of proven negligence or mis- implicit in Islamic contracts: management by entrepreneurs, however, they * The gross or net return on capital or may be held responsible for the financial loss- entrepreneurship should not be prede- es. These types of contracts are most common termined. in investment projects in trade and com- * Partners should share not only profits but merce that are capable of achieving full oper- also losses in proportion to their shares ational status in a short period. The contract in the enterprise (Hasanuzzaman 1994, between the bank and the entrepreneur is p. 7). known as w,stricted mudaraba because the bank The bargaining terms between the two agrees to finance specific investments by spe- parties involved in the transaction can vary cific entrepreneurs and to share relative prof- substantially and are determined by con- its according to an agreed percentage. To tracts. In a business based on mudaraba, engage in mudaraba transactions a bank must each partner shares an agreed portion of the meet the following legal obligations: profits, which may or may not be predeter- * The bank should not request collateral to mined, according to the contract. reduce its credit risk on these transac- 4 AN APPLICrATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE Figure 1. Types of Islamic banking contracts | Concessionary ||Participatory mechanisms || Trade financing l Profit and loss sharing Non-profit and iosssharing] Mudaraba Qard oI-hosonah 1 Trustee financing Benevolent loan Musharoka Bai'rnua)jal Equity participation Spot sales Musoqet Bai'solam Orchard financing Forward contracts Muzar'ah | Ija wa iqtina' Share of harvest Leasing Direct investment Murbhaho Cost plus markup Jo'alah Service charge Source: Kazanan 1993; lqbal and Mirakhor 1987. tions, and thus bears the entire financial losses are shared according to the amounts risk. Collateral may, however, be request- of capital invested. This type of transaction ed to reduce moral hazard. has traditionally been used to finance = Profit-sharing rates must be determined medium- and long-term investments. Banks only as a a percentage of the profit, not a have the legal authority to participate in the lump sum payment In some cases the management of the project, including sitting bank mnay receive part of the principal from on the board of directors. Each investor's the borrower at the end of the period if a rights correspond to their amount of equi- surplus exists. In cases of loss, the entre- ty capital in the enterprise. preneur will not be liable unless found Musaqat is a specific type of musharaka guilty of negligence or mismanagement. contract for orchards. In this case the har- * The entrepreneur exercises full control vest is shared among all the equity partners over the business; however, supervision by according to their contributions. the bank is permitted (Iqbal and Muzar'ah is essentially a mudaraba Mirakhor 1987). contract in farming where the bank can Musharaka is an equity participation con- provide land or funds in return for a share tract in which the bank is not always the only of the harvest. provider of funds. The distinguishing fea- Direct investments are similar to trans- tures of this type of contract are the nature actions in Western banking and thus require of the business activity and the duration of the greatest discretion. Islamic banks cannot the gestation period for the business. Two invest in the production of any good or ser- or more partners contribute to the capital vice that might even appear contrary to the and expertise of an investment. Profits and ethical and moral values of Islam. Banks can ISLAMIC BANKING-PROMOTING EQUITY WITH A RANGE OF TOOIS 5 vote according to their share and mayjoin The main difference between transactions the board of directors. that do not involve profit and loss sharing and those that do is that returns for the for- mer may be calculated at the final stage as a fixed percentage of the total investment. Qard al-hasanah are loans with zero return However, none of these contracts can be that the Koran encourages Muslims to make legally negotiated to provide a fixed rate of to "those who need them." Banks are return. Islamic banks may occasionally add allowed to charge a service fee to cover the an extra fee to compensate themselves for administrative and transactions costs of these costs incurred by the additional transactions loans so long as such costs are not related to they must undertake. Thus these instruments the maturity or amount of the loan. appear similar to those in conventional None of the Bai'mua'jal are deferred payment or spot banks, where risk aversion and risk pooling contracts can be sales in which the seller of a product accepts are important factors. All of the above instru- legally negotiated deferred payments in installments or in a ments, however, conform to the Islamic code, to provide a fixed lump sum. The price is agreed on between because their rates of return are related more rate of return the buyer and seller at the time of the sale, to the transaction than to time. and the seller is not allowed to include any The application of religious principles to charge for deferring payments. banking practices may affect the continued Bai'salam and bai'salaf are similar to for- development of Islamic banking. At present, ward contracts, with the buyer paying the most banks seek approval from their reli- seller the fully negotiated price of a product gious boards and shariah advisers before that the seller promises to deliver at a future marketing new financial instruments. A stan- date. The quality and quantity of the prod- dardized regulatory and legal framework ucts involved in this type of transaction must could help assimilate Islamic institutions into be capable of being specified at the time of international markets. As it stands, Islamic the contract. banks occasionally experience difficulties Ijara wa iqtina' involves pure leasing when attempting to explain their practices (ijara) or lease purchase (ijara wa iqtina') in countries or systems that are not based on transactions in which a party leases a specific Islamic principles. product for a specific sum for a given peri- od. In lease purchase arrangements a por- Note tion of each payment is applied to the final purchase of the product, at which time own- 1. Asymmetric information-a common imper- ership is transferred to the leaseholder. fect information problem-in its simplest form Murabaha is a common instrument used creates a situation described by Akerlof's Lemons for short-term financing based on the con- Problem. The Lemons Problem describes how ventional concept of purchase finance or buyers and sellers in a used car market cannot cost plus markup sales. The seller reports to clear the market because sellers of low-quality cars the buyer the cost of acquiring or produc- have an incentive to falsely advertise their cars as ing a good, then a profit margin is negoti- being of good quality (and thus demand a high- ated between the two parties. Payment is er price) while, because of asymmetric informa- usually made in installments. tion, buyers cannot know whether cars are of good Jo'alah are service charges that usually or bad quality. Both buyers and sellers lose, for buy- occur during transactions of various services. ers would pay more for a better car and owners of They often occur when the buyer of a ser- good cars cannot sell their cars at a price that vice agrees to pay the provider a specified fee would be mutually acceptable in the presence of according to a contract. complete information. Microfinance-providing credit to the entrepreneurial poor Microenterprises icrofinance institutions provide bankingwith the poor can be profitable and provide jobs and financial services-such as credit sustainable. help the and savings services-to the entre- Microenterprises provide jobs and help entrepreneurial preneurial poor that are tailored to their the entrepreneurial poor generate income poor generate needs and conditions. Good microfinance and alleviate poverty. Although the industry programs are characterized by: has only recentlv emerged :.n the Middle East alleviate poverty * Small, usually short-term loans, and and North Africa, a receni World Bank sur- secure savings products. vev found that more than 60 microfinance * Streamlined, simplified borrower and programs are active in th2 region, with an investment appraisal. outstanding loan portfolio of nearly $100 mil- * Alternative approaches to collateral. lion and more than 112,000 active borrow- Q Quick disbursement of repeat loans ers (Brandsma and Cha3uali 1998). Biit after timely repayment. more effort is needed to a-ddress the needs * Above-market interest rates to cover the of the at least 4.5 millior entrepreneurial high transactions costs inherent in micro- poor who lack access to rrnicrofinance and finance. who could absorb an estimatecd $1.5 billion * High repayment rates. in loans. Traditional banks in most countries * Convenient location and timing of ser- in the region are not adapted to meeting the vices (Frmman and Goldberg 1997). needs of this group, and inanv poor entre- The potential of small-scale enterprises preneurs fail to meet the conventional lend- as an alternative to larger, more capital- ing standards set by these banks. intensive firms is receiving increasing The formal financial sector has played attention in developing countries, and the a very small role in the development of focus in the development community is microfinance programs. The World Bank gradually shifting to small firms when it survey found that only one commercial comes to policy and resource allocation. In bank-Egypt's Natioral Bank for this light, microfinance is seen as a power- Development-is active in the microfi- ful tool for reaching the poor, raising their nance industry and has cstablished a sep- living standards, creating jobs, boosting arate microfinance unit. But several recent demand for other goods and services, con- developments shouldl be noted: three tributing to economic growth, and allevi- commercial banks in thc West Bank and ating poverty. Best practice experience Gaza recently initiated m: crofinance oper- around the world has shown that the poor ations, and several other banks appear are bankable and willing to pay a premium poised to do so as well, including one in for quick, reliable, and convenient financial Lebanon, two in Yemen, and three in services (box 1). Successful microfinance Jordan. institutions have also demonstrated that, In a conventional bankiing system, small when managed in a business-like manner, manufacturers and farmers face significant 6 MlICROFINANCE-PROVIDING CREIIT TO THE ENTREPRENEURIAL POOR 7 Box 1. Guiding principles of best practice microfinance Experience in countries as varied as ers. Subsidies send a signal to borrowers Bangladesh, Bolivia, Egypt, Senegal, Mali, that the government or donor funds are a and the West Bank and Gaza shows that the form of charity, which discourages bor- poor are bankable and that savings and credit rowers from repaying. Moreover, microfi- services can be delivered to the poor on a sus- nance institutions have learned that they tainable basis. The guiding principles under- cannot depend on governments and lying best practice microfinance include: donors as reliable, long-term sources of * Covering costs. To become sustainable, subsidized funding. microfinance institutions-regardless of * Promoting outreach and demand-driven service their institutional setup-must cover their delivery. Successful microfinance institu- costs of lending. If microlending costs are tions increase access to financial services not covered, the institution's capital will for growing numbers of low-income be depleted and continued access of clients, offering them quick and simple microenterprises to financial services- savings and loan services. Loans are often and even the existence of the microfi- short term, and new loans are based on nance institution-will be in jeopardy. timely repayments. Loans are based on * Achieving a certain scale. Successful microfi- borrowvers' cash flow and character rather nance institutions have reached a certain than their assets and documents, and alter- scale, as measured by the number of native forms of collateral (such as peer active loans. This number depends on the pressure) are used to motivate repayment. country setting, lending methodology * Maintaining a clearfocus. It takes time and used, and loan sizes and terms offered. commitment to build a sustainable micro- * Avoiding sutbsidies. Microentrepreneurs do finance program. Thus mixing the deliv- not require subsidies or grants-but they ery of microfinance services with, for do need rapid and continued access to example, the provision of social services is financial services. Besides, microlenders inadvisable because it sends conflicting cannot afford to subsidize their borrow- signals to clients and program staff. .Sw(iUr(e: Branidsma and Chaotiali 1998. obstacles to obtaining the financial strengthen their productive base unless they resources they need to develop their busi- get access to finance (Abdouli 1991). nesses. Lending instruments are not adapt- Moreover, financial institutions often per- ed to the conditions of small borrowers, and ceive small entrepreneurs as yielding small- short-, medium-, and long-term institutional er profit potential and higher lending costs financing is usually not available to the and risks for the bank. In addition, dealing entrepreneurial poor. A major constraint to with a large number of widely dispersed financing the poor is their lack of tangible enterprises is demanding, in terms of both assets to offer as collateral-creating a time and effort. Borrowers may not be eas- vicious circle in which microentrepre- ily accessible, and bank personnel may be neurs cannot access finance unless they separated from clients by differences in lan- offer sufficient collateral, cannot possess guage, literacy, and culture. Clients tend to tangible collateral unless they build a be unfamiliar with the necessary docu- strong productive base, and cannot mentation and accounting conventions. Combining Islamic banking with microfinance In a mudaraba- r hree basic instruments of Islamic plicity, the units ofcurrencyin these exam- based transaction finance could be built into the ples will be generic.) The rnicrocredit pro- the microfinance design of a successful microfinance gram provides a loan of 10,0J00 to be repaid program takes program: mudaraba (trustee financing), in 20 weekly installments. With each loan "equity" in the musharaka (equity participation), and repayment the entrepreneur buys back a microenterp rise murabaha (cost plus markup; Abdouli share of 500. Profit per share is 50 through theloans 1991). (1,000/20). The program and the entre- preneur agree that the program will receive A mudaraba model 10 percent of the weekly profit, and the entrepreneur will receive 90 percent. In a mudaraba-based transaction the micro- In the first week the microfinance pro- finance program and the microenterprise gram owns 100 percent of the shares and is are partners, with the program investing the entitled to 10 percent of the weekly profit of money and the microentrepreneur invest- 1,000; thus it receives 100. The entrepreneur ing the labor.' (Note that in both mudara- receives 90 percent of the weekly profit, or ba and musharaka the financing 900. The entrepreneur uses 500 of this 900 organization and the business work in part- to buy back one share. nership. But in mudaraba the financier In the second week the microfinance pro- invests only money and the entrepreneur gram is entitled to 10 percent of 19/20 of the invests labor, while in musharaka both the weekly profit of 1,000, since it now owns only financier and the entrepreneur invest 19 of the 20 shares. Thus the program is enti- funds.) The microentrepreneur is reward- tled to 95. The entrepreneur gets the rest ed for his or her work and shares in the prof- (1,000 - 95 = 905). Put anotlher way, the entre- it; the program only shares in the profit. The preneur receives (0.90 x 950) + 50. The 950 profit-sharing rates are predetermined, is the profit to be shared with the program; but the profit is unknown. In effect, the the 50 is the profit per share. (Remember microfinance program takes "equity" in the that the entrepreneur owns the share he microenterprise through the loan. Initially, "bought back" the previous week for 500; he the program may own 100 percent of the does not have to share the profit made on his shares and would hence be entitled to its own share.) Again, the entrepreneur uses 500 predetermined share of all the profit. But as of his profit to buy back a se cond share. This each loan installment is repaid, the microen- process would continue for the 20 weeks of trepreneur "buys back" shares. As a result the mudaraba agreement, with the program the microfinance program earns less prof- earning total income of 1,050 and the entre- it with eacl repayment received. preneur earning 18,950 (table 1). A con- Consider, for example, a case where the ceptual visualization of this loan structure is microentrepreneur is a vegetable trader and shown in figure 2; the entrepreneur's repay- makes a weekly profit of 1,000. (For sim- ment schedule is shown in table 2. 8 COMBINING ISLAMIC BANKING WITH MICROFINANCE 9 Table I. Program and entrepreneur profits under the mudaraba example Week Profit to be shared Program income Entrepreneur income 1 20120 x 1,000 = 1,000 1,000 x 10% = 100 1,000 x 90% + 0 = 900 2 19/20 xI ,000 = 950 950 x 10% = 95 950 x 90% + 50 = 905 3 18/20 x 1,000 = 900 900 x 10% = 90 900 x 90% + 100 = 910 4 17/20 x 1,000 = 850 850 x 10°' = 85 850 x 90% + 150 = 915 5 16120 x 1,000 = 800 800 x 10% = 80 800 x 90% + 200 = 920 6 15120 x 1,000 = 750 750 x 10% = 75 750 x 90% + 250 = 925 7 14/20 x 1,000 = 700 700 x 10% = 70 700 x 90% + 300 = 930 8 13/20 x 1,000 = 650 650 x 10% = 65 650 x 90% + 350 = 935 9 12120 x 1,000 = 600 600 x 10% = 60 600 x 90% + 400 = 940 10 11/20 x 1,000 = 550 550 x 10% = 55 550 x 90% + 450 = 945 11 10/20 x 1,000 = 500 500 x 10°% = 50 500 x 90% + 500 = 950 12 9120 x 1,000 = 450 450 x 10% = 45 450 x 90% + 550 = 955 13 8/20 x 1,000 = 400 400 x 10% = 40 400 x 90% + 600 = 960 14 7/20 x 1,000 = 350 350 X 10% = 35 350 x 90% + 650 = 965 15 6/20 xI ,000 = 300 300 x 10% = 30 300 x 90% + 700 = 970 16 5120 x 1,000 = 250 250 x 10%' = 25 250 x 90% + 750 = 975 17 4/20 x 1,000 = 200 200 x IO'/ = 20 200 x 90% + 800 = 980 18 3/20X 1,000= 150 150X 10%= 15 150x90% +850=985 19 2120 x 1,000 = 100 100 x 10%= 10 100 x 90% + 900 = 990 20 1/20 x 1,000 = 50 50 x 10% = 5 50 x 90% + 1,000 = 995 Total 1,050 18,950 From a microfinance perspective this example was a fixed weekly profit of 1,000. model has several drawbacks. The most In reality, although microfinance programs important is the uncertainty of the profit. An have information on local market behavior, important assumption in developing this weekly profits fluctuate. Fluctuating profits Figure 2. Distribution of program and entrepeneur income and ownership under the mudaraba example Total income 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 E Income to program 0 Buyback shares U Income to entrepreneur 10 A-N APPLICATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE Table 2.The entrepreneur's repayment arrangements. Given that very few microen- schedule under the mudaraba example trepreneurs-no matter what country they Share Profit Totol are in-keep track of their accounts in a way Week buyback distribution payment that would permit the independent verifi- I Soo lo5 600 cation of, say, weekly profits, the acceptabil- 2 500 95 5 ity of the above model depends rather heavily 3 500 90 590 on whether such an agreement is in accor- 4 500 85 585 dance with Islamic banking principles. As 5 500 80 580 with other forms of Islamic banking, the lend- 6 500 75 575 i 7 500 70 570 ig agency would not be entitled to a distri- 8 soo 65 565 bution of its share if the entrepreneur were Applying the 9 500 60 560 to suffer losses. But the lending agency could mudaraba model I0 Soo 55 555 also agree that if the entrepreneur were to might be more 12 500 45 55 generate more profits, he would be entitled straightforward for 13 500 40 540 to retain 100 percent of tie same. businesses with a 14 500 35 535 Applying the mudaraba model might be I 5 500 30 530 more straightforward for businesses with a 17 500 20 520 longer profit cycle. Say that a microenter- 18 500 15 515 prise takes a loan of 20,000 to raise four 19 500 10 510 goats. Such an undertaking may be consid- 20 500 5 505 ered common, and people will know the profit well in advanlce. Normally the business will raise the goats and resell them after five also create a challenge for microlending to eight months for 40,000, a profit of 100 within Islamic banking principles. Moreover, percent. The "working capital" (that is, the most microentrepreneurs do not keep food eaten by the goats) is considered free accurate accounts. How, then, are profits to because the goats live arcund the dwelling be calculated and distributed? In addition, and eat whatever they can find. the model is difficult to understand for loan In this case the microfinance program officers and borrowers alike. takes "equity" of 20,000, with 20 shares of The second drawback of the model is the 1,000 each. The program and the entrepre- burden of loan administration and moni- neur agree that 15 percent of profits will go toring. Even in the hypothetical situation to the program and 85 per-cent will go to the that profits were known, the borrower has entrepreneur. After five rnonths, when the to repay a different amount each period entrepreneur has sold the goats and made a (and the loan officer has to collect a dif- profit of 20,000, he repurchases the 20 shares ferent amount each period). This lack of at 1,000 each and pays the program its share simplicity-relative to equal repayment of the profit: 15 percent of 20,000, or 3,000. installments-also would confuse borrowers and loan officers. The margin for error is considerable given that a single loan officer often manages 100-200 borrowers. The murabaha contract as similar to trade The key issue in using this profit-sharing finance in the context cf working capital model is whether it is possible under Islamic loans and to leasing in the context of fixed banking principles for the lending agency capital loans. Under such a contract the and the entrepreneur to agree on the week- microfinance program literally buys goods ly (or biweekly, monthly, or some other inter- and resells them to the microenterprises for val) profit prior to disbursement of the loan. the cost of the goods plus a markup for Different settings may allow for different administrative costs. The borrower often pays COMBINING ISLAMIC BANKING WITH MICROFINANCE 1 for the goods in equal installments. This ment and the due date. The loan officer model is easier for borrowers to understand issues receipts to borrowers (from a receipt and simplifies loan administration and mon- book issued by the program) when collect- itoring. The microfinance program owns the ing loan installments. In addition, the loan goods until the last installment is paid. officer collects 30 rials a week from each How would this Islamic model work with group member for the insurance fund and the group liability mechanism common to deposits them with the financial depart- microfinance? A microfinance program ment. The insurance fund has a separate introduced in Yemen in mid-1997 provides account that indicates its income and an example. Today this program has more expenses. This fund compensates borrowers than 1,000 active borrowers, 30 percent of who face emergencies-such as fire, flood, them women, and $150,000 in outstanding and death-that affect their business. Borrower feedback loans. Target clients are the entrepreneur- Borrowers are eligible for compensation indicated an initial ial poor in urban slum districts. The loan from the insurance fund if group members preference for the turnaround is one week. and the responsible loan officer approve. mudaraba Loan application procedures are simple. To ensure proper follow-up, the district mechanism Existing or startup microenterprises inter- supervisor, project manager, and assistant ested in obtaining microfinance are asked project manager conduct random field vis- to form a five-person group. Group mem- its to project clients to confirm the existence bers then submit a loan application- and sustainability of their businesses. In addi- which includes basic business data, personal tion, the project management team, work- information, and the proposed loan size- ing with the financial department, prepares to a loan officer. Group members are also monthly progress reports indicating number asked to sign a guarantee form indicating of loans distributed, types of businesses, gen- their agreement to vouch for one another der distribution of borrowers, loans per loan and their willingness to pay in case of arrears officer, repayment rate, overdue rate, delin- or delinquency. After a simple appraisal of quency rate, aging of arrears, and the like. each group member's business by the loan Borrowers who manage their business wise- officer, the loan officer forwards the group's ly and efficiently and pay back their loans on application, business appraisal, and the time are eligible for a consecutive loan for guarantee form to the district supervisor and the same or a larger amount, based on their district loan committee for review and business needs. approval. Once a loan application has been approved, the loan officer buys the chosen Experinceiwihimudaaban an business items and resells them to the bor- rowers after adding a specific margin-a Borrower feedback from the field indicates markup-to the actual purchase amount. In an initial preference for the profit-sharing this example, the markup determined by the mechanism-that is, mudaraba. This pref- project is 2 percent a month. Finally, the bor- erence may reflect borrowers' familiarity with rower signs an agreement indicating the this mechanism, as it is commonly used for final price of the resold items, the repay- supplier credit and other types of informal ment period, and the installment amount. finance. But not all borrowers may under- To administer the model, the microfi- stand that the profit-sharing mechanism may, nance program's financial department under certain designs, be more expensive for opens an account for each borrower indi- them than other alternatives within Islamic cating the number and size of each install- banking. Moreover, some borrowers recog- 12 AN APPLICATION OF ISLAMIC BANKING PRINCIPLES TO MICROFINANCE nize the potential for conflict between the would not receive the loan in the form of microfinance program and the borrower in money, but in the form of goods that the determining profit. Other borrowers did not microfinance program would purchase on like the profit-sharing of mudaraba because their behalf and then "resell" to them. An they did not want to reveal their profits to the important constraint of this model for program (and their group). microfinance, however, is the program's Many borrowers initially expressed higher administrative cost, since loan offi- doubts about the appropriateness of the cers need to get involved in the market oper- "buy-resell" mechanism (murabaha) ation. But experience indicates that these because it appeared too similar to the for- initial higher transactions costs are offset by bidden practice of fixed interest rates the lower costs of loan administration and The higher initial (riba). But experience has shown that once monitoring. Moreover, an increase in lend- transactions costs the mechanism is properly explained to bor- ing volume suggests that these initial high- of the murabaha rowers and local religious leaders, it is er transactions costs can be lowered to model are offset by accepted. Borrowers accept that a microfi- acceptable levels. the lower costs of nance program incurs costs and that these A microfinance program has to make sev- loan administration costs have to be recovered in order for the eral tradeoffs when selecting an appropriate and monitoring program to continue offering financial ser- loan methodology based on Islamic banking vices. Borrowers also appreciate the sim- principles (table 3). The program must plicity and transparency of the model. account for the administrative costs and risks The "buy-resell" model, which allows of a particular methodology not only to the repayments in equal installments, is easier program but also to borrowers. to administer and monitor. In addition, it seems to conform to practices in regions Note where even the handling of money is con- sidered haram-that is, in discord with the 1. This section draws heavily from Brandsma Islamic code. In such areas borrowers and Abou El Yazeid (1997). Table 3. Islamic finance models and their applicability to microfinance Issue Mudoraba (profit sharing) Murabaha (buy-resell) Most applicable for Fixed assets (investment capital) and potentially Working capital and investment capital working capital Cost to borrowers Potentially higher because of higher profit sharing with Lower the microfinance program as a result of higher risk Initial acceptance by Higher Lower borrowers Risk to borrowers Lower if no predetermined minimum profit is allowed Higher Risk to the program Higher if no predetermined minimum profit is allowed Lower Administrative costs Administration is potentially complex, although Initial higher transactions costs because this could be resolved by predetermining of the large number of buy-sell a minimum profit. Still, costs of loan transactions. Costs of loan administration and monitoring are high given administration and monitoring are the complexity of the repayment schedule substantially lower, however, because the repayment schedule is simple Enforcement Difficult if profit must be determined for each Less difficult because the program owns installment, because most borrowers do not the goods until the last installment is keep sufficiently accurate accounts paid Conclusion Islamic banking, with its emphasis on risk In certain circumstances the mudaraba Islamic banking sharing and, for certain products, collateral- (profit sharing) and murabaha (buy-resell) techniques could free loans, is compatible with the needs of methodologies may be appropriate for give thousands of ,some microentrepreneurs. And because it microfinance. Although the murabaha entrepreneurial promotes entrepreneurship, expanding (buy-resell) model generates high initial poor access to Islamic banking to the poor could foster transactions costs, these can be potentially microfinance development under the right application. offset by low loan administrative and mon- Islamic law allows room for financial inno- itoring costs given the simplicity of the vation, and several Islamic contractual model. And while the mudaraba (profit arrangements can be combined to design a sharing) model may require the frequent new hybrid (Khan 1997). Bearing in mind determination of business profits-and it is the guiding principles for successful micro- not entirely dear how such profits would be finance programs (see box 1), and with determined-this methodology is feasible, adjustments to incorporate Islamic banking and in some form or another can be used principles, the Islamic financial system could to achieve the goals of microenterprise lend- offer alternatives in microfinance. Viable pro- ing. Other types of Islamic lending-such as jects that are rejected by conventional lend- qard al hasanah (benevolent lending with a ing institutions because of insufficient service fee)-may emerge as more practi- collateral might prove to be acceptable to tioners implement Islamic lending princi- Islamic banks on a profit-sharing basis. ples in microfinance institutions. Islamic banking offers loan products Islamic banking techniques could give based on intangibles such as a busi- thousands of entrepreneurial poor access to nessperson's experience and character. microfinance-an option they might not Microfinance programs have extensive consider if traditional, interest-based com- experience with character-based lending, as mercial loans were offered. More experi- most microentrepreneurs lack acceptable mentation and practice in the field should collateral. Thus there is potential compati- contribute to more knowledge and a better bility between the needs of microentrepre- understanding of effective loan delivery neurs and the practice of Islamic banking. mechanismns using IsLamic banking principles. 13 References Abdouli, Abdelhamid. 1991. "Access to Finance lqbal, Zubair, and Abbas Mirakhor. 1987. Islamic and Collateral: Islamic versus Western Banking." Banking. IMF Occasional Pa per 49. 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