Shari'a Compliant Microfinance

S. Nazim Ali

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9780415782661
• eBook ISBN: 9781136671296
• Topic: Business
• Subtopic: Finance
• Index: Business

In the recent past, Islamic finance has made an impressive case on the banking scene by becoming an alternative to the popular conventional financial systems, spurring a lively academic debate on how the Islamic finance industry can expand its services to cover the poor. Several propositions have been aired which suggest that the Islamic finance industry should consider developing an efficient Shari'a compliant microfinance model.

This book brings together original contributions from leading authorities on the subject of Shari'a Compliant Microfinance (Islamic Microfinance) to propose innovative solutions and models by carefully studying experiments conducted in various countries. Where critiques of the current microfinance concepts, methods, regulatory measures and practices have often revolved around its practice of charging very high interest, this book discusses the several models that draw on both theory and case studies to provide a sustainable Shari'a compliant alternative. Arguing that while Islamic finance might have made a remarkable contribution in the financial markets, there remains a big question with regards to its social relevance, the book provides new perspectives and innovative solutions to issues facing the Islamic microfinance industry.

A comprehensive reference book for anyone wanting to learn more about Shari'a Compliant Microfinance, this book will also be of use to students and scholars of microfinance, Islamic finance, and to anyone interested in learning about ethical and socially responsible businesses.

Part I

Islamic microfinance and shari‘a compatibility

1	Meeting the demand for sustainable, shari‘a-compliant microfinance^1
	Samer Badawi^2 and Wafik Grais^3

Introduction

Despite its popularity in predominantly Muslim countries such as Bangladesh, microfinance has few champions in the burgeoning Islamic banking industry. Although some microfinance programs have attempted to introduce shari‘a-compliant financial products, these have had only limited success. In many cases, the cost of maintaining an Islamic window at a microfinance institution has been much higher than expected. Moreover, the development and delivery of these products have generally been highly subsidized by donor or government funds. As such, current Islamic microfinance programs, even if they show limited success, do not appear capable of expanding to reach the tens of millions of unbanked Muslims. To do that, they would need to become profitable and represent a viable business proposition for Muslim and non-Muslim investors.

Islamic banks, with their wide range of well-developed and successful shari‘a-compliant instruments and strong capital base, may be well-positioned to adapt these instruments for poorer customers. The prospect is exciting because such an effort could lead to the development of an Islamic microfinance industry that is profitable from the outset and potentially able to reach scale quickly. Although there may be no turn-key solutions for Islamic financial services directed to poorer customers, Islamic banks can draw upon the experience of a highly professionalized microfinance industry to reach the unbanked who demand shari‘a-compliant financial services. Such an effort could ultimately strengthen the outreach of the entire microfinance industry and possibly contribute to innovations that would improve not only breadth and depth of outreach but also the overall transparency and efficiency of microfinance services.

The current microfinance landscape

Once a niche market centered on the single product of micro-enterprise credit, microfinance now signifies a wide range of financial services for the poor as well as diverse institutions and delivery channels. Sustained growth and stability have contributed to greater investment in microfinance, which in turn has helped further the professionalization of the industry’s services and standards.

Diverse services and institutions

Safe places to save, old-age pensions, reliable money transfers, insurance—all are now recognized microfinance services that help people, heretofore excluded from access to financial services, build assets, plan for the future, and cope with the present. Along with diversification of products, the number of microfinance service providers and resources channeled through them has expanded. Commercial, postal, and agricultural banks are all part of the vision of “scaling up” microfinance by providing access to financial services for more and more poor people. Indeed, a recent CGAP (World Bank’s Consultative Group to Assist the Poor) study suggests that poor people may have as many as 750 million credit and savings accounts in comparable alternative financial institutions.⁴

Diverse delivery channels

Some microfinance providers are overcoming the lack of infrastructure among poor sections of the populations by using technology to deliver financial services. South Africa’s Wizzit has no branches of its own but instead it reaches the unbanked through their cell phones and a debit card.⁵ Other banks have followed suit, and now 400,000 South Africans are making one million cell phone banking transactions every month. The Philippines’ two biggest cell phone companies, Globe Telecom and SMART, both offer a service that allows customers to send money, pay for goods with their phones, and more. Some 4.5 million Filipinos have signed up in just four years. Even Vodafone, one of the world’s largest mobile telecommunications firms, is piloting a link between cell phones and financial services for the poor in Kenya.

Growth

The microfinance industry is growing fast, adding nearly 15 percent more borrowers each year since 1999. The number of self-sustainable institutions is growing too. Today, there are at least 400 sustainable institutions reporting to the Microfinance Information eXchange, or MIX, the industry’s most trusted source for market data. All told, these institutions have helped microfinance mature into one of the most successful and fastest-growing industries in the world; worldwide, the leading microfinance institutions are nearly twice as profitable as the leading commercial banks.

Stability

In the last decade in emerging markets, microfinance has been a more stable business than commercial banking. During Indonesia’s 1997 financial crisis, for example, commercial bank portfolios imploded, but loan repayment among Bank Rakyat Indonesia’s more than three million micro-borrowers barely declined at all. During the more recent Bolivian and Colombian banking crises, microfinance portfolios suffered slightly, but remained substantially healthier than commercial bank portfolios, and the microfinance institutions remained more profitable.

Investment

Microfinance funds’ investment in microfinance institutions (MFIs) tripled in two years to $2 billion in 2006, and CGAP estimates that foreign capital investment in microfinance has reached $5 billion. Moreover, some of the world’s largest commercial investors are putting millions into microfinance. Institutional investors such as pension fund TIAA CREF (Teachers Insurance and Annuity Association—College Retirement Equities Fund) have 17 percent of the market share in microfinance funds, up from 5 percent in 2004. In addition, equity fund Sequoia Capital—which provided venture capital funding to Google, Yahoo!, and YouTube—recently invested $11.5 million in India’s SKS Microfinance, making SKS the largest for-profit MFI in the world.⁶

Professionalization

Microfinance is today widely understood and practiced as retail banking for low-income people, with standards and services that draw upon the professionalism of the larger banking sector. The services are the same: loans, deposit facilities, money transfers. Moreover, the standards are increasingly the same: more than 100 recipients of the CGAP Financial Transparency Award comply with International Financial Reporting Standards, for example, and core performance indicators for microfinance have been widely adopted.⁷ Microfinance is serious business and, with its huge untapped market, may shape the future of retail banking.

Developing practical models for an Islamic microfinance

Islamic financial institutions have the potential to play an even greater role in the future of retail banking than they currently do by catering to a mostly overlooked segment of the poor—Muslims who demand shari‘a-compliant products. With few donor-funded non-governmental organizations (NGOs) offering shari‘a-compliant microfinance, there is an opportunity for well-capitalized Islamic banks to develop practical models that rely not on donor funds, but on well-known principles that emphasize profitability while offering the potential to be highly transparent as well as impact-driven. These principles, notably, are: the materiality of products, as represented in the murabaha and ijara instruments; and risk-sharing, as represented in the musharaka instrument. These instruments, and the principles that underlie them, can not only support the development of Islamic financial services for the poor, they can also potentially contribute to the development of the broader microfinance industry. The following discussion explores both opportunities, offering possible ways forward drawn from the broader microfinance industry.

The materiality model: murabaha and ijara

In a murabaha or ijara transaction, the provider of funds purchases a commodity and resells or leases it to the user with a mark-up against installments or delayed payment. In other words, the materiality of a murabaha or ijara transaction essentially objectifies transparency in the form of a commodity—a sewing machine sold or leased to a micro-entrepreneur, for example. In this case, the retail “price” of a microfinance transaction is actually set by a competitive market for sewing machines.

The client in such a transaction benefits from competition on the wholesale market, but the costs to a microfinance provider associated with purchasing, maintaining, selling, or leasing, and then tracking a commodity raise questions aboutthe efficiency of a murabaha or ijara transaction. Will these added costs, though perhaps improving the transparency, actually result in higher prices for microfinance clients?

More practical experience is needed to address the question of efficiency. Still, the experience of conventional microfinance to date may be instructive. The average operating expense ratio (OER) of microfinance providers reporting to The Micro-Banking Bulletin, published by the MIX, is approximately 30 percent. Although this figure probably represents considerable inefficiency (commercial banks typically report OERs of well below 5 percent), the higher cost is mostly a function of servicing many more—and much smaller—loans than larger lenders.

Islamic financial institutions must come to terms with the true cost of microfinance and the implications of serving poorer customers profitably and sustainably. One clear implication is around pricing. To cover their costs, conventional micro-finance providers charge higher interest rates than those of larger commercial banks. These rates are usually significantly lower than those charged by informal moneylenders, however, boosting the demand for microfinance services where they are available.

This argument carries the assumption that demand for micro-credit and continuous external financing is highly inelastic around initial accessibility amounts. Still, the persistence of high interest rates, even in highly active and competitive markets such as Bangladesh, has led policymakers especially to question whether the price of financial services for the poor is too high. Although many in the microfinance field see this as political grandstanding—in some cases, a legitimate claim—there is little doubt that greater attention is being paid to the price of microfinance. In addition, questions are being raised about the accessibility of microfinance services for especially poor populations and, as a corollary, to whether MFIs are by necessity serving higher-income customers.

Islamic financial institutions would not be immune to these questions. To deal effectively with them, Islamic microfinance providers, regardless of the instruments they utilize, must: (1) be realistic about the cost of serving poorer customers, especially in remote rural areas; (2) engage policymakers and others to educate them about the true cost of microfinance; and (3) explore innovative ways to reduce the cost of microfinance transactions.

Much thinking has already been done and substantial investment has been channeled towards adapting existing technologies that can be used to provide banking services for the poor more cost-effectively. By accessing banking services through an automated teller machine, the Internet, or, increasingly, a mobile phone, clients of large commercial banks can assume much of the cost burden (i.e., maintaining bank branches) of delivering financial services. Recent efforts at extending these “branchless banking” services to poorer populations show great promise.⁸

However, the vast majority of microfinance programs still rely on loan officers to collect or disburse payments. The potential to avoid such costly activities is seen most clearly in the meteoric increase of mobile phone usage in the developing world. The number of mobile phone subscribers worldwide has doubled—to two billion—in just over two years, with more than 80 percent of that growth coming from developing countries, according to the GSM Association. This bodes well for the replication of successful models like those of Wizzit,⁹ Globe Telecom, and SM...

Table of contents

• Cover Page
• Half Title page
• Series page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Contributors
• Preface
• Introduction
• Part I Islamic Microfinance and Shari‘a Compatibility
• Part II Developments in Islamic Microfinance
• Part III Islamic Microfinance Case Studies
• Part IV Resources on Islamic Microfinance
• Annotated Bibliography
• Appendix 1 Financing the Poor: Towards an Islamic Microfinance—A Short Report
• Appendix 2 Microfinance: Towards a Sustainable Islamic Finance Model—A Short Report
• Glossary
• Bibliography
• Index