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HomeGIFR 2018The Role Of Islamic Microfinance In Social And Economic Development

The Role Of Islamic Microfinance In Social And Economic Development

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Institutional microfinance with its origins in Bangladesh and Latin America in the mid-1970s has grown to be an important financial sub-sector in its own right. Microfinance has been identified as an important tool in supporting and strengthening the economy at the bottom of the socio-economic pyramid by facilitating access to financial services for the poorest and destitute. Nonetheless, it has not as some of its founders claimed, lead to ‘the end of poverty’. Nevertheless, it has made formal financial services, particularly small loans available to poor people who were previously not served by commercial banks. Islamic microfinance, on the other hand, is of a more recent origin. With the growth of the Islamic finance industry, Islamic microfinance is becoming a popular tool in alleviating poverty especially in developing countries around the world. Although it is a continually growing sector, Islamic microfinance only accounts for 1.0% of the total assets of the world’s microfinance and the global Islamic finance assets.

Concentrated mainly in Bangladesh, Pakistan, Indonesia and Sudan; Islamic microfinance has several million customers and these numbers are growing rapidly.1 This is, however, very small in relation to the number of Muslims who would like to access Shari’a-compliant micro-finance. This chapter reports on the findings of a study done on 15 Islamic microfinance institutions (IMFIs) aimed at obtaining a general overview of recent developments in the field.2 In particular, the study focused on finding whether there were some features of Islamic microfinance which could be incorporated into regular microfinance, in order to overcome some of its weaknesses.

Salient Features of Islamic Microfinance Institutions

Although the study surveyed a total of 15 IMFIs, these institutions are not a representative selection. They were chosen because they covered a range of places, types of institution and clients and a variety of financial products. Furthermore, their management were willing to allow what might be considered as confidential data to be made public.3 Table 1 summarizes some salient features of these institutions.

Table 1:

SALIENT FEATURES OF 15 ISLAMIC MICROFINANCE INSTITUTIONS

  INSTITUTION  YEAR STARTED  ACTIVE BORROWERS  % FEMALES  PORTFOLIO  AVERAGE O/S  PROFITS  SAVINGS  MAIN CREDIT PRODUCTS
AL AMAL, YEMEN   2008   40,000   54%   US$17 million   US$425   No   Yes   Murabaha
    MICRO DAHAB, SOMALIA     2014     2,750     64%     US$1.1 million     US$400     Yes     Yes   Murabaha, with some Musharaka, Mudaraba
  BASIX, INDIA   2012   400   19%   US$200,000   US$500   No   No   Murabaha, with some declining Musharaka
  START, KOSOVO   2002   1,200   30%   US$2 million   US$1,580   Yes   No   Qard hasan and Murabaha
  KOMPANION, TAJIKISTAN   2012   445   53%   US$450,000   US$1,010   No   No   Murabaha, with some Musharaka
MUTAHID, AFGHANISTAN   2011   14,000   24%   US$7 million   US$500   n/a   No   Murabaha
  ISLAMI BANK BANGLADESH, BANGLADESH   1995   940,000   79%   US$246 million   US$260   n/a   Yes   Murabaha, with some Musharaka
AKHUWAT, PAKISTAN   2001   567,000   41%   US$77 million   US$110   n/a   No   Qard hasan
KIMS/KAAH, SOMALIA   2012   3000   50%   n/a   n/a   n/a   Yes   Murabaha
    REEF, PALESTINE     2007     2,900     15%     US$8.7 million     US$3,000     Yes     No   Murabaha, with some manfa’a and Musharaka
  • Written consent was given to publish data and information.
  INSTITUTION  YEAR STARTED  ACTIVE BORROWERS  % FEMALES  PORTFOLIO  AVERAGE O/S  PROFITS  SAVINGS  MAIN CREDIT PRODUCTS
  PASED, SUDAN     2000     9000     68%     US$2.2 million     US$240     Yes     No   Murabaha, with some Musharaka, Bai salam
EBDAA, SUDAN   2014   6000   90%   US$2.2 million   US$370   No   Yes   Murabaha
VASHAM, INDONESIA   2014   3400   10%   US$2.8 million   US$820   No   No   Bai’ salam
  ACCSL, INDIA   1997   2300   40%   US$5.5 million   US$2,390   No   Yes   Murabaha, with some Musharaka
  BMT DAARUL QURAN, INDONESIA   2005   1327   n/a   US$1.2 million   US$950   Yes   Yes   Murabaha, Ijara, Mudaraba

Source: Ajaz and Harper, 2017

This data may not be typical of all IMFIs but it indicates some general aspects. Some of the terms used may be contentious or confusing. For example, the words ‘loan’ and ‘borrower’ should not strictly speaking be used to describe a client whose relationship with the IMFI is in theory that of a customer who has bought something on credit from the institution under a murabaha contract. Similarly, a client who has entered into profit and loss sharing partnership with the IMFI under a musharaka contract is not actually a ‘borrower’ and the money is not a ‘loan’. These terms should be flexibly interpreted.

Islamic microfinance appears to be a relatively young phenomenon, as might be expected, given that mainstream microfinance has only been operating on a significant scale since the 1990s. All the IMFIs surveyed are generally young, with only two of them commenced operation before year 2000. The institutions are also small. Only 2 have more than 100,000 active borrowers, and 10 of the remaining 13 have less than 10,000 borrowers. The two larger institutions are not typical. One is the Rural Development Scheme (RDS) of the Islami Bank Bangladesh, which is not an independent institution and is not particularly large by the standards of Bangladesh microfinance. The other is Akhuwat of Pakistan, which follows a unique non-commercial model with over 2 million clients and over 875,000 active clients by 2017.

The microfinance industry is undergoing concentration, as pioneers grow and dominate the remainder. In India and elsewhere, crisis had resulted in the disappearance of some smaller institutions. This does not yet appear to have taken place in Islamic microfinance. Another interesting observation based on the data presented in Table 1 is the participation of women in Islamic microfinance. Given the general perception of women’s position in Islam, one might be surprised to see that IMFIs have mostly a high concentration of women beneficiaries. But women outnumbered men in only 4 of the 15 cases. This is a smaller proportion of female clients than most MFIs would report. In Muslim countries like Malaysia and Indonesia, majority of Islamic microfinance borrowers are women. In fact, in the case of Amanah Ikhtiar Malaysia, nearly 99% of borrowers are women.

Daruul Qu’ran does not record the gender of its clients. This may be because similar to Akhuwat, REEF and others; Daruul Qu’ran prefers to lend to households rather than to either the husband or the wife. Local rules may mean that the person who is named in the agreement is the husband. But if the finance is genuinely used by and for the benefit of the whole household, this can be less divisive than lending only to women. Experiences in Bangladesh and elsewhere have shown that this can lead to gross exploitation.

The average outstanding ‘loan’ figures should be approximately doubled to reflect the sums advanced since the balance sheet figures for the portfolios include credits at all stages from initial disbursement to final repayment. However, the relative youth and fast growing nature of some of the IMFIs means that this could result in an over-estimate of the initial advances. In 3 cases, the average figure is over US$1,000. This is well outside the usual ‘micro’ range except in Eastern Europe and parts of Latin America and Central Asia where average incomes are well above the figures in the ‘classic’ homes of microfinance such as South Asia and Africa. These high figures may arise from the practical difficulty of using Shari’a-compliant methods for the rapid low-cost advances of small sums, which can be used for consumption or for buying non-traded goods such as medical care or school fees, or for purchases from informal suppliers.

One aim of this study was to show that it is possible and that it can also be profitable to offer Shari’a-compliant microfinance in a wide range of different ways and in different conditions. Only 5 of the sample of 15 IMFIs studied here are profitable. Others such as MicroDahab, Companion or BASIX; can potentially become profitable if they can access sufficient funds that enable them to reach their breakeven volume. Whereas others seem likely to continue to make losses indefinitely. This is not different from microfinance in general, where a small number of generally large MFIs are profitable, while others barely cover their operating costs and continue to rely on subsidized or no-cost finance. There are also some MFIs still operating as NGOs or another form of not-for-profit institutions. BMT Daarul Qu’ran, however, is able to sustain itself from the profit it makes on its wide mix of loan types being offered. It also pays its depositors, who are both its borrowers and owners, a major share of its earnings.

Apart from individual descriptions of client experiences, both good and bad, the cases do not include any formal data on client satisfaction nor do they include any data on the long-term impact of the institutions’ services on their client’s well-being. In some situations, as in Bangladesh, most clients probably have a choice between Islamic and non-Islamic institutions. Their choice of the Islamic option presumably indicates that they are more satisfied with it than they would be with a non-Islamic competitor. It is also clear that Islamic microfinance generally involves higher transaction costs for clients as well as for the institutions. For example, murabaha credit requires clients to obtain the full details of what they want to buy and to provide this information to the IMFI prior to the purchase. Nonetheless, their willingness to put up with this requirement suggests that, if there is an alternative, they are satisfied with the service.

Murabaha financial products are similar to fixed interest loans, in that they require the client to repay what has been borrowed over a fixed period, with the addition of a ‘profit’ which is similar to interest but with some important differences. Unlike fixed interest, the added profit is not automatically increased if the loan is not repaid on time. Compound interest on unpaid arrears often leads to high indebtedness, and clients of IMFIs are protected from this. This is a major advantage of IMFIs, which is not often mentioned by advocates of Shari’a-compliant finance.

There is more than enough evaluation literature on the impact of microfinance on its clients. In general, the verdict is that it is not a ‘silver bullet’ that can eliminate poverty, but that it can make a positive difference to poor people’s livelihoods. Islamic microfinance has an important role for promoting socio-economic development of the poor and small entrepreneurs without charging interest (riba).6 But there is no reason to presume that Islamic microfinance is any worse or better for its clients than ‘normal’ microfinance, apart from its conformity to their religious principles. Hence, it is reasonable to omit any reference to impact evaluation from these case studies.

Mobile phone fund transfers, which eliminate the need for cash, are also attracting a great deal of attention and they may in future revolutionize many aspects of microfinance. In particular, they eliminate the main overt function of group meetings, which is to collect savings and repayments; this is already eroding group attendance. Such systems are widely used in Somalia and Somaliland, the location of two of cases investigated in this study. Both these institutions are also engaged in mobile telecommunications, and their clients make extensive use of mobile phones for transferring funds. Nonetheless, there is no reason to suppose that IMFIs will be any more or less influenced by this change than secular MFIs.

The Rural Development Scheme (RDS) of Islami Bank Bangladesh is the largest microfinance programme in this study, in terms of numbers of clients and outstanding portfolio. However, the RDS is also unusual because it operates in what is generally acknowledged to be the ‘homeland’ of microfinance, which is also a Muslim-majority country. The RDS is the only large-scale Islamic microfinance programme in Bangladesh operating throughout the country, but has less than 5% of the total market of some 23 million borrowers. The programme’s growth is limited by the bank’s unwillingness to allocate further funds to it and perhaps also for political reasons. Nevertheless, it is surprising that there is so little Islamic microfinance in Bangladesh. This must cast some doubt on the growth prospects of Islamic microfinance everywhere.

Akhuwat, the second largest programme covered in the study, also poses a demand question. Its loans are virtually free of cost, requiring no more than the payment of a small fixed application fee. But the demand is not as overwhelming as might be expected given its low price. Despite its rapid growth, Akhuwat competes with a number of non-Islamic MFIs, which charge ‘normal’ interest rates of between 20% and 30% a year or sometimes much higher. This may be due to Akhuwat’s quite lengthy approval processing times and their strict requirement that clients should reside within a specified distance from branches. It shows what is already becoming clear in microfinance and indeed consumer finance worldwide; interest rates and the cost of credit are not the only or even the most important reason for client choice.

Why is Islamic Microfinance Not Growing Faster?

The cases show that there is a steady and growing demand for Shari’a-compliant microfinance. But why has Islamic microfinance not grown more quickly? Why has it not ‘taken off’ the way secular microfinance did in the 1990s? Is it lack of knowledge or lack of staff with the necessary skills? Or are the religious authorities’ standards of Shari’a compliance unrealistic?

The fundamental nature of the available Shari’a-compliant products is probably the main constraint to the growth of Islamic microfinance. Several of the cases studied here refer to the difficulty of using murabaha for very small credits to buy non-traded goods or to finance multiple small purchases from informal suppliers. Poorer people are particularly likely to do this and for them microfinance is often a tool for cash flow smoothing rather than for the purchase of significant assets. People who are short of cash may not be able to state precisely what they need it for, from whom they will purchase their needs, or for what price or when. Quite clearly, the only form of Shari’a-compliant finance that is suitable for such people is qard hasan, through which cash can be made available without strings and also without any cost apart from the very small fixed charges such as those levied by Akhuwat.

START in Kosovo offers qard hasan loans to its most needy clients and Akhuwat uniquely lends only on the basis of qard hasan. The long-term economics of the START approach obviously depends on the majority of its business being sufficiently profitable to cover the losses on a small part of the portfolio. A fixed transaction fee of about US$67 is charged for all qard hasan loans, which amounts to an annual charge of about 9% on the lower value loans. This is more than the nominal cost but it does not cover all the costs. This may be feasible in the relatively ‘developed’ environment of the Balkans, but it would not be possible in a market where the majority of potential clients are in extreme poverty, such as a typical low-income urban slum or rural area in South Asia.

Akhuwat is unique. It is of course financially unsustainable if ‘sustainability’ means covering its operating expenses and covering the cost of funds from charges paid by customers. This type of sustainability is not the only way in which an institution can survive and grow. Akhuwat’s case is evidence that it is possible for a business with a strong social mission to be very successful both financially as well as socially; through a combination of cash, grants and in-kind donations, including gifts from own clients. If sustainability means survival and growth, Akhuwat is certainly more sustainable than many for-profit corporations including many well-known international financial institutions.

Murabaha

Murabaha is the most common financial product used by IMFIs in this study. However, murabaha is not suitable for many clients, particularly the poorest. It also has practical weaknesses for better-off clients who do need to finance relatively large purchases of traded goods from formal suppliers. The clients must identify what he or she wants to buy, and from which supplier and at what cost, and must then inform the IMFI’s field staff. The staff member must then buy the product from the nominated supplier and resell it to the client at the agreed mark-up. In order to minimize the time taken and the associated costs, the transaction must be as rapid as possible. Furthermore, IMFI cannot usually take physical possession of the product.

The clients of BASIX in India do apparently benefit from murabaha because BASIX has been able to use the combined purchasing power of its clients to negotiate lower prices. Similarly, REEF does the same for its clients in Palestine. This may compensate for the mark-up, but it is generally unlikely that an IMFI will be familiar with the whole range of products and suppliers with which its clients want to do business. Since small-scale businesses are usually specialists in one type of product, an institution that serves their financial needs cannot possibly be fully informed about all their different requirements.

However, this is inevitably something of a cosmetic operation. Some IMFIs such as Kompanion in Tajikistan appoint an agent to buy the product on behalf of the IMFI and then resell it to the client. The client may suggest an agent, or as with Al Amal in Yemen and Mutahid in Afghanistan, the IMFI may actually appoint the client as a temporary agent. The client buys the item, acting as an agent on behalf of the IMFI, and then resells the item to herself or himself. This may simplify the physical nature of the transaction in that the client and the agent are the same person. It apparently satisfies the religious authorities, but it complicates the legal position and is obviously wholly cosmetic. In such case, it may comply with the letter of Shari’a, but not with its spirit.

One feature of murabaha is that IMFI can clearly control what the client buys with the loan. Traditional MFIs can attempt to do this through on-site visits to the client but this is a costly exercise. Moreover, it is not difficult for clients to deceive the field staff by showing them a neighbor’s asset and pretending it is theirs. IMFI clients can of course re-sell the assets they have bought with their loans and use the money to purchase assets that might not have been approved, which is likely to be costly. None of the 15 institutions studied here reported diversion of this kind. The usual argument in favor of the IMFI’s control over clients’ purchases is that it prevents them, or perhaps other family members, from using the money to pay for items which are haram such as liquor or gambling debts. This is clearly a positive form of moral control, but it does run contrary to one positive feature of microcredit, which is that it empowers its clients to purchase what they know they need. The current debate about the advantages of cash transfers as being preferable to the provision of food or shelter or whatever other item the donor thinks is ‘right’ is informed by the same point.

A few IMFIs use ijara leasing contracts to finance purchases of capital equipment. As with murabaha, this makes little difference to the client’s cash flows but it complicates the process of acquiring the asset since it must at least nominally be bought by the IMFI before being leased to the client. The IMFI retains the right to reclaim the asset in case of non-payment. But this is of little practical use unless the asset has a substantial resale value. As with murabaha, leasing is less useful or affordable for smaller items, second-hand equipment or for ‘home-made’ tools, which are more likely to be required by smaller-scale less well-off clients. The inescapable conclusion is that this mode of financing is also likely to incline IMFIs to support larger businesses rather than modest self-employment activities of the poor. This is not in itself a problem in that such businesses need finance and are likely to provide jobs for poorer people. However, it does make Shari’a-compliant microfinance less suitable for poorer people. As with murabaha, this method of financing makes it harder for the client to use the money for other than the declared purposes. It may also be possible for IMFIs to negotiate better terms from supplies than individual clients could on their own.

Two IMFIs, Ebdaa in Sudan and Vasham in Indonesia, use bai’ salam. This is essentially a form of forward sale whereby a client, usually a farmer, sells and is paid for his crop by the institution before it is harvested. The institution then takes delivery and resells the crop after harvest. Profit, if any, may accrue to the IMFI or it may be shared between the farmer and the IMFI on a pre-agreed basis. This appears to function quite effectively and the transactions are fully approved by the religious authorities in Sudan and Indonesia. Vasham makes no claim to be Shari’a-compliant but it is generally considered to be more genuinely Islamic than the many other IMFIs in Indonesia, which use more ‘cosmetic’ methods. Bai’ salam is mainly applicable to farm crops and it requires the financing institution to act as a crop trader. This involves a range of specialist skills and may require storage and transport facilities. This mode of financing is, nonetheless, not suitable for non-farm businesses or for the mass of micro-trading enterprises that make up most of the microfinance clients in urban and often in rural areas as well.

Profit and Loss Sharing Products

The study found that only 8 of the 15 institutions offered musharaka or mudaraba profit and loss sharing products. Although these products are offered only on experimental basis at present, these institutions may intend to expand this proportion of their portfolio in the future. The study also found that only 4% of MicroDahab’s portfolio and only 8 of Kompanion’s 450 clients have this type of loan. In the case of Islami Bank Bangladesh, although its staff believe that it is fair for the IMFI to share the losses and profits with their clients, the bank has stopped offering this product except to a few larger clients who have graduated from their earlier micro-Murabaha loans.

BASIX and some other IMFIs offer what is called a ‘declining musharaka’ product for the purchase of substantial assets such as cattle. But this is effectively similar to hire purchase or ijara. Here, the client pays a rental fee for the asset and its ownership is transferred from BASIX to the client over the agreed period. If the value of the asset is substantially reduced during this period, through no fault of the client, BASIX takes its share of the loss, but it does not include any element of profit sharing. BASIX anticipates that this form of financing will eventually make up 10% of its portfolio and that the average amount involved will be US$8,000, which is 10 times more than its projected loan size for other products. This suggests that this product will be more suitable for better-off clients.

The share of the profit which is taken by the client and IMFI varies substantially. For instance, MicroDahab works on a 60:40 basis, with 60% going to MicroDahab. Others use a 70:30 ratio, with 70% for the client. The share going to each party may be calculated after allowing the client to take a certain percentage to remunerate her management time. Some IMFIs also use mudaraba, which is similar to musharaka except that 100% of the investment is covered by the IMFI and the client only contributes her or his management. In this case, the client takes a pre-agreed share of the profit for managing the business. BMT Daarul Qur’an serves an urban market in Jakarta and uses a mix of products, including mudaraba. Almost half of its loans are for less than US$400, which suggests that it is serving very small-scale businesses and its remaining mudaraba loans are for much larger sums.

BMT Daarul Qur’an and ACCSL are the only IMFIs in this study that are co-operatives, where their clients are also their members. Like many IMFIs, ACCSL is experimenting with musharaka. Surprisingly, they have found that members who have been financed on this basis tend to exaggerate their profits, and subsequently tend to increase the amount they have to repay to the society. This may be because they believe that they will not be able to borrow again if they have made losses, or perhaps out of loyalty to the society. Whatever the reason, it shows that the cost of finance, regardless of how it is calculated, is less important to many small clients than its availability. It is hoped that overtime, these IMFIs will learn from their experiments and work out how to provide profit and loss-sharing products to very small-scale enterprises, whose owners are often either unable or unwilling to calculate or state their profits. This study, however, suggests that this has yet to transpire.

Murabaha financing is, on the other hand, widely used and in some cases it may have benefits for IMFIs and their clients over and above its compliance with Shari’a. Generally, however, it appears to be less adaptable, particularly for poorer clients as well as more costly to operate. Regardless, murabaha appears to be acceptable to large numbers of Muslim clients and its disadvantages do not appear to have discouraged the growth of those IMFIs using this mode of financing. ACCSL and some of the other 14 institutions were experimenting with profit and loss-sharing products, which have the potential to be more Islamic in spirit and letter in their methodologies. But it is disappointing to note that these experiments were mainly focused on ‘down-scaling’ existing methodologies that are used in larger scale non-micro Islamic finance, rather than on designing and testing new methodologies that are specifically designed to suit low-income clients.

Shari’a does not itself promote particular types of financial arrangements other than qard hasan for the poorest people; it merely sets out broad principles. Traditional microfinance can now offer a wide range of financial products, for different types of groups and for individuals. There would appear to be more than adequate potential for new financial products that are Shari’a-compliant, suitable for poorer clients and profitable for the institutions which provide them. It is to be hoped that this gap will be filled.

The Cost of Islamic Credit

Microfinance is widely criticized because it is said to charge poor people excessively high interest rates. Money is no different from many other commodities; as the poor pay more. The cost of money is not as important as it is sometimes believed, particularly when it is invested in urban petty trading businesses which are the main users of microfinance. But what is important is whether Islamic microfinance is more or less expensive than ‘secular’ microfinance?

The credits from Akhuwat in Pakistan are virtually cost-free, apart from a small administrative charge. Murabaha is the dominant method used by the other 14 institutions in this study. Here the profit margins, which are added by these IMFIs when they buy what their clients need and then re-sell it to them on credit, can be approximately compared with fixed interest rates. The margins may vary from client to client, as does the period allowed for repayment. But it was possible in most cases to estimate the effective annual cost of the credit, on a declining balance basis. The approximate figures are as below:

  INSTITUTION  EFFECTIVE ANNUAL COST OF CREDITS
  START, KOSOVO   11%
  ISLAMI RDS, BANGLADESH   17% to 23%
  MUTAHID, AFGHANISTAN   26.6%
  REEF, PALESTINE   23% to 24%
  KAAH, SOMALIA   16% to 24%
  AL AMAL, YEMEN   21%
  KOMPANION, KYRGYSTAN   30%
  EBDAA, SUDAN   30%
  PASED, SUDAN   24%
  INSTITUTION  EFFECTIVE ANNUAL COST OF CREDITS
  BASIX, INDIA   20% to 30%
  MICRODAHAB, SOMALIA   16%
  ACCCSL, INDIA   25% to 30%
  VASHAM, INDONESIA   27%
  BMT DAARUL QU’RAN, INDONESIA   21% to 24%

Source: Ajaz and Harper, 2017

Some of these estimates are very approximate and the actual figures vary depending on the exact timing of repayment instalments. Some are increased due to the requirement for clients to make up-front payments towards welfare funds or other purposes. Most murabaha contracts also allow the client some redress in case the goods are faulty, and the margins are not automatically increased if clients fall into arrears. The client may benefit from the lower prices which the greater purchasing power of the IMFI allows. This may in part compensate for the profit margin.

Overall, the above figures show that the cost of credit from these IMFIs is not excessive. The effective rates are not dissimilar to those charged by non-Islamic MFIs in the same regions. In fact they are lower in some cases, particularly when the other factors are taken into account. The credits are less flexible and they may cost more because clients have to spend more time on the transactions. But these factors may be outweighed by the other advantages. Generally speaking, the clients of these IMFIs do not appear to be paying a significantly higher price for Shari’a compliance.

In spite of the limitations of the available financial products and the sometimes cosmetic nature of most murababa, Shari’a-compliant finance as it is now offered does appear to be affordable and widely acceptable. In most cases, Shari’a-compliant financing can also be profitable for the institutions providing it. One major existing constraint to the growth of Islamic microfinance appears to be the shortage of finance for existing and new IMFIs. This is in addition to the fact that many Muslims appear to be quite willing to borrow from secular institutions.

Akhuwat, which is the largest independent institution in our sample, is an exception in two ways. First, Akhuwat has grown, very dramatically, in spite of the totally uncommercial nature of its financing. Second, its only financial product is in no way cosmetic. Akhuwat’s qard hasan is quite different from anything offered by ‘normal’ microfinance institutions. Akhuwat has been able to access the finance necessary for its growth and to cover its operating costs because it has received donations from a wide range of supporters including its own clients. Initially these funds were from local sources within Pakistan. More recently, Akhuwat has also received funding from an increasing number of foreign sources. Unlike any of the other IMFIs studied here, Akhuwat has been the recipient of large interest free loans from government institutions, particularly from Punjab Province. These loans are nominally repayable, but are effectively grants which Akhuwat can continue to use so long as they are properly employed to alleviate poverty and promote enterprise. This source of finance, however, is very much dependent on the organization’s links to senior authorities. Government grants may damage or even destroy microfinance institutions, sometimes because the loan recipients treat them as handouts and because governments use them for political rather than development purposes.

Savings

The major traditional source of finance for retail banking institutions is their clients’ own savings deposits. Most of these institutions hold a higher amount of clients’ savings than outstanding loans. Microfinance is usually different. This is in part because the pioneers of micro-finance not unreasonably (but mistakenly) believed that poor people could not save and did not need savings facilities, and partly because deposit-taking institutions must quite properly be supervised and licensed to ensure that they do not lose or steal their clients’ savings. It is also generally less expensive to borrow large sums from international development or other institutions than it is to manage and pay even a modest return for the small demand deposits and withdrawals that are needed by poor people.

However, this is changing as more MFIs such as Grameen Bank are starting to offer demand deposit services to their clients. Other MFIs the likes of Bandhan in India have become licensed banks. Bank Rakyat Indonesia, which is not Islamic but by some measures is the world’s largest and most profitable MFI and incidentally operates in the world’s most populous Muslim country, mobilizes some four times as much finance from its clients as it lends to them.

Savings are not, however, an important component of finance used by the 15 IMFIs studied here. Six of them offer savings services as well as credit; but only Islami Bank Bangladesh, Al Amal and Daarul Qur’an raise more than 10% of their financing funds from clients’ savings. The Islami Bank Bangladesh’s RDS is part of a large full service of the bank, and its clients have deposits amounting to about a third of the outstanding loans, while Al Amal raises about two-thirds of its loan portfolio from clients. Some IMFIs, such as Ebdaa in Sudan, have many more savings accounts than loan accounts, but the aggregate balances of the savings are far below their loan portfolios. Ebdaa remunerates its longer-term depositors with a share of the institution’s annual profits on the basis of mudaraba. This is generally impractical for low-value short-term demand deposits, which are frequently paid in and withdrawn in small amounts.

These 15 IMFIs are not very different from most MFIs in respect of the nature and volume of the savings services they offer. But the requirement that the sources of their finance and loans offers must be Shari’a-compliant further constrain their ability to offer a full range of financial services to their clients. Similar to conventional MFIs, IMFIs may in the future develop and promote secure, accessible and remunerative savings products. In any case, their ability to offer such products will in part be a function of the financial strength conferred by the equity in their balance sheets. These institutions have been capitalized from a variety of different sources and their balance sheets do not appear to be seriously over-leveraged.

Other Sources of Funds

At least 3 of the IMFIs studied, namely MicroDahab, Kompanion and BASIX; appeared to be constrained mainly by a shortage of funds and to be ‘investment ready’. As such additional funds would enable them to achieve breakeven within a short period. This may be an over-positive assessment, as it is based on a rather limited amount of information gathered in the study, but it is to be hoped that these and other IMFIs will be able to access funds and grow. In order to be fully Shari’a-compliant, an IMFI must not only offer products that are non-interest based, but it must also itself be funded from sources which are themselves Shari’a-compliant. It is again important to stress that the 15 IFMIs studied are not a representative sample of IMFIs, but it is noteworthy that many although not all were funded mainly by secular ‘Western’ institutions such as CARE or Mercy Corps.

The largest independent institution in this study was Akhuwat, which has reached over 2 million clients in Pakistan and is continuing to grow. Its total capitalization exceeds US$100 million, which has been almost entirely financed by donations and grants from individuals and institutions, including its own clients as well as from the Government of Pakistan. It is interesting to note that the biggest and by many standards the most strongly established and in some sense the most ‘sustainable’ institution is one which depends almost entirely on donations and grants, including substantial amounts from government and from its own clients. Although Akhuwat has not reached every potential client in Pakistan who needs and could benefit from its services, it had been successful in achieving national coverage. It is hope that its example can be emulated in other countries. As demonstrated by Grameen Bank, an effective model which works in one place can be successfully adapted and followed elsewhere.

This study on IMFIs (excluding Akhuwat) shows that the forms of Islamic microfinance that are most widely practiced are less suitable than ‘normal’ microfinance for very small-scale clients and for non-business uses such as consumption or health care due to their higher trans- action costs than interest-based loans. The average size of their credits is also consistent with this, in that it is rather higher than loans from other MFIs operating in the same communities.

IMFI credits appear also to have few, if any, compensating advantages apart from their conformity to Shari’a rules. However, those rules may be interpreted in their respective communities. This is not necessarily a wholly negative conclusion. Religious observance by no means always dictates the most financially profitable or convenient choices. A system which enables people to follow the letter of their religion and thus to feel comfortable with what they are doing, and at the same time to benefit from its services, is much better than a system which prevents them from obtaining the services at all, even if it at the same time involves some inconvenience.

Regular fixed-interest microfinance is widely used to finance so-called ‘consumption’ purchases as well as for enterprise expenses. It is difficult to cover the costs of items of this kind with existing Islamic microfinance methods, particularly when the purchases are unexpected, of relatively small value and are bought from informal suppliers. For such needs, qard hasan is most appropriate as it avoids burdening poor people with interest costs. It is, of course, ‘unsustainable’ in a pure financial sense, but the example of Akhuwat demonstrates that it is not only possible but can grow and reach very large numbers of people.

The present turmoil in the Middle East is already pushing many middle-income people back into poverty. They may seem to have outgrown their need for microfinance, but the current circumstances may dictate otherwise. The case of Al Amal in Yemen shows how this is already happening. Qard hasan is the best form of Shari’a-compliant finance for people in such difficult circumstances, and it can be argued that it is more suitable than fixed-interest loans and is in some sense a hybrid between pure charity and regular loans. It is to be hoped that the example of Akhuwat will be widely followed outside Pakistan, particularly in communities affected by conflict.

Findings of this study also found that there is as yet no accepted ‘best practice’ in Islamic microfinance as there is still a great deal of experimentation and the ‘ideal’ methodology has yet to evolve. Shari’a-compliant product design will inevitably vary from one location to another. This is because it has to be sustainable for clients and for the institutions and must also be approved by local religious authorities, whose views differ from one place to another. It may be that future innovations will enable for-profit Islamic microfinance, like regular microfinance, to grow very rapidly so that it reaches a more significant proportion of the millions of people who want it and can benefit from it. Or it may always be something of a niche undertaking, which is acceptable to religious people in some places but never really reaches its apparent potential. The present rather small market share of Islamic microfinance in Bangladesh, Pakistan and Indonesia suggests that this may be the more likely future.

Much (but not all) regular microfinance has become heavily commercialized. It has become closer to regular profit-maximizing consumer finance, and has in many cases lost its original welfare objectives. Islamic microfinance is still young. If it can maintain its original spirit of fairness, transparency and sharing, the future can be bright, whatever methodologies are used. If it loses these ideals, however, it may devolve into nothing more than clever cosmetic exercises which mimic conventional interest-based finance but use different terms. Only time will tell.

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