Islamic microfinance – prospects and challenges

June 2013 | EXPERT BRIEFING | BANKING & FINANCE

financierworldwide.com

An estimated 72 percent of people living in Muslim-majority countries do not use formal financial services. Even when these financial services are available, some people view conventional products as incompatible with the financial principles set forth in Islamic law. In recent years, some microfinance institutions have stepped in to service low-income Muslim clients who demand products consistent with Islamic financial principles – leading to the emergence of Islamic microfinance as a new market niche, which has seen a four-fold increase since 2006.

Islamic microfinance represents the confluence of two rapidly growing industries: microfinance and Islamic finance. It has the potential to not only respond to unmet demand, but also to combine the Islamic social principle of caring for the less fortunate with microfinance’s power to provide financial access to the poor. Unlocking this potential could be the key to providing financial access to millions of Muslim poor who currently reject microfinance products that do not comply with Islamic law. Islamic microfinance is still in its infancy, and business models are just emerging.

Despite this growth, this sector remains limited in terms of service providers, product offerings and overall outreach. While Islamic microfinance is gaining momentum, it remains dominated by a handful of service providers in a small group of countries (principally Indonesia, Bangladesh and Afghanistan) offering primarily two products, the two traditional Islamic tools of poverty alleviation, namely the Zakat and Awqaf.

Funding Islamic finance programs is a major challenge. A huge amount of cash is required and, with the lack thereof, in addition to the failure by many Islamic NGOs to reach the poorest of the poor, donors and developing agencies often show little interest in funding Islamic microfinance institutions. So, national and international Islamic donors and development agencies, as well as Islamic commercial banks and NGOs, need to be even more generous in providing funds for Islamic microfinance programs. Microfinance institutions need to cover all of their costs with a margin of profit from their operations, and not from donations or Zakat. Only sustainable institutions can reach a greater number of poor people.

Diversion of micro-credit for consumption by borrowers is one of the principal reasons that credit default is frequent in conventional microfinance. In addition, charging a high general interest rate has hindered poverty alleviation. These basic challenges of conventional microfinance can be resolved if an Islamic microfinance institution is designed in an integrated manner by incorporating the two traditional institutions of Islam, namely the Awqaf and the Zakat, with microfinance into a single framework. Such an integrated model may reduce the chances of loan default, because the basic inherent tendency of poor borrowers to use the loan fund for consumption purposes will otherwise be met. As their basic consumption needs are covered, the micro-entrepreneurs may be in a better position to focus on their business. Since Islamic financing modes are based generally on the principle of social justice and the sharing of profit and loss, and riba is prohibited, Islamic microfinance institutions are likely to yield better benefit if they are properly designed. There will always be a place for charity, notwithstanding the creation and maintenance of more efficient microfinance Islamic institutions.

There are two structures which should be considered by a financial institution or entrepreneur designing an Islamic microfinance program:

A mudaraba model.The microfinance program and the micro enterprise become ‘partners’, with the program investing money and a micro-entrepreneur investing services and labour. The entrepreneur is rewarded for his work and shares in the profit, while the program also shares in the profit. There will always be issues of accurate and transparent accountability which is required to calculate proper shares of profit. This model may be more straightforward for businesses with a longer profit cycle.

Microfinance involves providing credit without collateral to poor people. Weaknesses of conventional microfinance such as charging high interest rates, credit diversion, credit rationing and nonconformity with the Islamic faith provide substantial room for Islamic microfinance to grow by catering to the needs of underprivileged persons. When integrated with the two traditional Islamic tools of poverty alleviation – Zakat and Awqaf – in an institutional set up, Islamic microfinance will be better able to reach the ultra-poor. This model will be financially viable and sustainable in the long run, and will ensure proper use of Zakat funds which do not require any return. This will, in turn, create a win/win situation for all stakeholders, and will hopefully lead to lower default rates and faster higher graduation from poverty.

John H. Vogel is a partner at Patton Boggs LLP. He can be contacted on +1 (202) 457 6460 or by email: jvogel@pattonboggs.com.

John H. Vogel

Patton Boggs LLP