Microfinance institutions are today reaching hundreds of millions of clients throughout the global South, but the special needs of Muslim borrowers and savers, who wish to avoid any form of fixed interest, are badly served. The purpose of Islamic Microfinance is to introduce readers to the tenets of Islam and how they are applied to microfinance. It questions why, when mainstream Islamic finance is growing rapidly, are efforts to reach poor Muslim customers so far behind? Can Islamic microfinance as it grows maintain its original spirit of fairness, transparency and sharing, principles that seem to have been almost forgotten in the world of conventional microfinance? The book contains fifteen detailed case studies of individual Islamic microfinance institutions, which include examples of successful and unsuccessful clients, and financial data about the performance of the institutions themselves. The case studies include institutions from Yemen, Afghanistan, Pakistan, India and Bangladesh, Indonesia, Sudan, Somalia, Kyrgyzstan, Palestine, and Kosovo. The case study institutions are between them using a wide range of Shari’ah-compliant financing methods, which include pure interest-free loans, profit-sharing products and a variety of other tools, including micro-savings as well as micro-debt. In the accompanying commentary the editors critically examine the performance of the fifteen institutions and demonstrate how Islamic methods can efficiently satisfy the needs of some types of client but not all. It asks which types of products are affordable and beneficial, for which purposes and for whom. This book is essential reading by all those interested in microfinance and development in the Muslim world, including researchers and students, practitioners of microfinance, NGOs and multi-lateral and bi-lateral development agencies, and staff of development banks.
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About the Author
Malcolm Harper is an emeritus professor of Cranfield University; he is an independent researcher, writer and teacher who works mainly in India. He has published on enterprise development and microfinance. He was Chairman of Basix Finance from 1996 until 2006, and is Chairman of M-CRIL, the microfinance credit rating agency and business development, and author of numerous books and articles. He is the co-editor of What's Wrong with Microfinance? (Practical Action, 2007).
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Islamic financing principles and their application to microfinance
Ajaz Ahmed Khan, Bridget Kustin, and Khalid Khan
The need to conform to certain religious principles affects the structure and operations of Islamic microfinance institutions. We outline the basic principles of Islamic finance and provide an introduction to the different financing instruments commonly used by Islamic microfinance providers. While Islam advocates profit-sharing techniques such as mudaraba and musharaka, most Islamic microfinance institutions consider these too risky and complex to implement and instead favour the simpler cost plus mark-up or murabaha technique. Islamic teachings propose that the poorest should be assisted through qard hasan or interest-free loans.
Keywords:riba, gharar, qard hasan, mudaraba, musharaka, murabaha, ijarah, bai salam, takaful
This analysis outlines the basic principles of Islamic finance and provides an introduction to the main Shari'ah-compliant financing methodologies used in Islamic microfinance. The principles and practices upon which Islamic finance is based are drawn from teachings contained in the Qur'an, Sunnah (the word and living tradition of the Prophet Muhammad, peace be upon Him), ijma (the consensus of Islamic scholars), and qiyas (the process of analogical reasoning which is used to solve or provide a response to a new problem). While Islamic teachings often provide quite specific guidance – for example, the longest ayah or verse in the Qur'an (2:282) deals with financial transactions and contracts – in general they emphasize honesty, transparency, and above all fairness in economic activities and behaviour between all parties regardless of status.
The different Islamic financing methodologies are applicable according to the skills, capacity, and economic resources of the different parties as well as the nature of the business and the period for which the project is to be financed. Importantly, though, all methodologies are founded on the core belief that money is not an earning asset in and of itself. Ensuring that money is used as a medium of exchange rather than as an earning asset helps prevent exploitation and unfairness that would guarantee self-benefit at the direct expense of broader society.
Principles of Islamic finance
There are some general principles that are of particular importance for Islamic finance. Firstly, riba, most commonly translated as interest or usury, is forbidden in that it is a predetermined, fixed sum owed to the lender irrespective of the outcome of the venture in which the funds are used. This does not imply in any way that capital is free of charge, that it should be made available without any cost, or that there should be absolutely no return on capital. Rather, a return on capital is allowed, provided that the supplier of capital participates in the productive process and is exposed to risk. Secondly, any transaction that involves excessive uncertainty and risk, deceit, or fraud (gharar) is prohibited. Gharar refers to any transaction of items whose existence or description is not certain due to lack of information or knowledge of the ultimate outcome. For example, it is not permitted to sell what one does not own; therefore, 'short-selling' – that is, selling something that one does not own in the hope that it can be bought cheaper at a later date – is impermissible. Thirdly, there should be no funding of haram or prohibited activities such as the production and sale of alcohol, pork, illegal drugs, pornography, or gambling since Islam considers these as morally and socially harmful. Instead, funds should only be used to support halal or permitted activities – preferably activities that are 'socially productive', although what exactly this term means remains open to interpretation by an Islamic microfinance institution (IMFI). Lastly, a financial transaction needs to have a 'material finality': that is, it should be directly or indirectly linked to a real, tangible economic activity or asset as opposed to financial speculation or debt, and the product or service that is bought or sold must be clear to all parties.
In addition to these general principles, Islamic teachings also emphasize the importance of honouring contracts and agreements. In general terms, contracts should be clear, by mutual agreement, the responsibilities and benefits of all parties should be clearly detailed, and the agreement should be for a known period and price. In this regard, there are certain principles that need to be considered, particularly since some of the clients served by IMFIs may lack formal education and have poor literacy skills. Firstly, an offer (ijab) and acceptance (qabul) should be made before entering into a contract to reduce the possibility of disputes in the future. Secondly, the dates of repayment must be specified in the contract to avoid any ambiguity, and preferably there should be a written contract. Lastly, there should be at least two witnesses present when the contract is signed.
To ensure that the activities of IMFIs adhere to Islamic finance principles and procedures, it is essential to seek approval from qualified Islamic scholars on the manner in which operations are structured and implemented. Some IMFIs have Shari'ah advisers for this purpose and also conduct regular Shari'ah audits to ensure that their operations remain 'authentic'.
As will become apparent from the following analysis, Islamic finance permits only one type of actual loan, namely qard hasan. Strictly speaking, the other techniques are not loans at all; they are investments or financing arrangements. Before describing the various financing techniques, we further discuss the issue of riba.
Riba is the Arabic word for the predetermined return on the use of money and it can be translated as 'increase', 'excess', or 'usury'. The consensus amongst Islamic scholars is that riba includes all forms of interest and it is a sin under Islamic law – even those hired to write the contract or who witness and thus confirm the contract are party to the sin. This also means that, if the money of an IMFI is pooled with riba-bearing funds, the pool of profits is considered 'tainted' and should be disbursed to charity or otherwise removed. The motivation for the strong prohibition of interest is to prevent the ability of one party to receive unfair gain at the expense of another. Extrapolated beyond a single contract or transaction to broader society, it is believed that riba contributes to systemic oppression and exploitation, exacerbating conditions of poverty. This perspective is, of course, not something that is unique to Islam – Christianity and Judaism also maintained strong traditions against usury.
Interest is considered an unjust instrument of financing. Thus, if a micro-entrepreneur's venture is unsuccessful through no fault of his or her own, it is unfair for the lender to receive a fixed rate of return or to demand repayment. Equally, if the micro-entrepreneur earns a very high rate of profit on the venture, it is unfair that the provider of finance should receive only a small proportion of that profit even though it supplied the majority of the funds for the enterprise. Prohibition of riba means that money can only be lent lawfully for either charitable purposes (without any expectation of return above the amount of the principal – that is, qard hasan) or for the purposes of doing lawful business (that is, investment on the basis of profit and risk sharing). Indeed, economic activity and prosperity are viewed as a religious virtue or even an obligation in Islam, provided the activity conforms to Shari'ah. The prohibition of interest is therefore a way to promote fairness between parties.
If a small business applies for finance to an IMFI, the organization should decide whether or not to support the project on the basis of a cost–benefit analysis of the project, not on the basis of collateral. Practically, however, this cost–benefit analysis commonly takes into account personal elements of the small business owner that an IMFI deems to have a bearing on the potential outcome of the project, or that suggest trustworthiness and the likelihood of repayment, or that place the client in a part of the population that the IMFI seeks to target. These elements can include age, marital status, a monthly income threshold, landownership, and so on.
Although the Qur'an prohibits the use of interest and encourages legitimate commerce, trade, and wealth creation, it does not specify any commitment to particular types of contract. In the remainder of this analysis we describe some of the principal Islamic financing techniques that have been developed in accordance with Shari'ah and are most commonly utilized by IMFIs, including those institutions examined in later chapters. Broadly speaking, we can distinguish between techniques that promote partnerships, such as mudaraba and musharaka, and arrangements that are essentially sales contracts, such as murabaha, ijarah, bai salam, and bai muajjal.
Mudaraba is a form of partnership in which an IMFI provides the capital required to fund a project, while the micro-entrepreneur manages the investment using his or her expertise. For example, an IMFI might provide the necessary funds to both rent land and buy sheep, while a farmer uses his or her skills to raise the animals. In a mudaraba contract, when a profit is realized – for example when the sheep are sold – it is shared between the partners according to a predetermined ratio. The profit-sharing ratios must be determined only as a percentage of the profit and not as a lump sum payment. In the case of a loss, providing it is incurred in the normal process of business and not due to neglect or misconduct by the micro-entrepreneur, the IMFI loses its money, while the micro-entrepreneur loses his or her time and effort. In case of proven negligence or mismanagement by the micro-entrepreneur, however, he or she may be held responsible for financial losses. The micro-entrepreneur does not invest anything in the business, save his or her labour, and should not claim any fee or wage for conducting the business. In practice, most IMFIs lack the funding, staffing, or technical capacity for robust monitoring and evaluation of the micro-entrepreneur's activities, and, in any case, the small scale of such activities is likely to make the transaction uneconomic. For this reason, mudaraba contracts are considered to be risky and require a great deal of trust and confidence, and are unusual in Islamic microfinance.
There are many distinguished instances in Islamic history of partnerships and involvement in trade: for example, the first four Caliphs and the famous Islamic jurist Imam Abu Hanifa were traders. However, perhaps the most prominent example of a mudaraba partnership was between the Prophet Muhammad (peace be upon Him) and his wife Khadija (may Allah be pleased with her), who was a venture capitalist. Before their marriage, she offered him the opportunity to travel as part of a caravan heading to sell goods in present-day Syria, according to a profit-sharing arrangement. It is reported that the Prophet Muhammad (peace be upon Him) returned with goods which Khadija (may Allah be pleased with her) sold for nearly twice the price they had been bought, making a considerable profit.
Literally meaning 'partnership' in Arabic, musharaka involves two or more parties contributing towards financing a venture. At the end of the project, the costs of production are deducted from the revenue, and a certain percentage is earmarked for management fees. Any profits are shared exactly in proportion to the equity participation of each partner or according to another previously agreed ratio, but losses must be borne exactly according to the ratio of each partner's investment. All partners have a right to participate in the management of the project but they can also waive this right in favour of a specific partner. If a micro-entrepreneur wholly manages the project, the management fees go to him or her, in addition to his or her profit share. If the IMFI is involved in management, it receives part of these fees. Management fees usually range between 10 per cent and 30 per cent of the profit, depending on the micro-entrepreneur's bargaining power and the nature of the project (for example, if the activity requires special skills, the share of the micro-entrepreneur may be greater). The micro-entrepreneur does not have to contribute in cash to the proposed investment. Instead, his or her share might be in-kind inputs, labour, and the rent of machines or equipment.
The main difference between musharaka and mudaraba is that under the latter the micro-entrepreneur offers his or her labour and skills only, without any contribution in cash or in kind, and any losses are borne entirely by the IMFI. A musharaka can be continuous (to the end of a project's lifespan) or it can be a diminishing partnership, in which case one partner is allowed gradually to buy out the other partner's share.
Partnership financing for small enterprises has various advantages, the most obvious being that it avoids the necessity of demanding repayment from a micro-entrepreneur when a business does not succeed for reasons beyond his or her control. Since the IMFI is obliged to monitor the business closely, and sometimes take part in management as well, it broadens the organization's understanding of financed activities and the needs of its clients. Partnership finance also encourages innovation and entrepreneurship, since in relatively profitable ventures the return on investment can be much higher than in other modes of finance, and it also reduces the effects of inflation since debt financing is replaced by equity- and share-based financing.
However, IMFIs face several challenges in promoting successful partnership finance. Many micro-entrepreneurs lack the necessary bookkeeping skills to keep accurate accounts and as a result it may be difficult to calculate the exact level of profits. A grocery kiosk owner might take his own family's weekly staples out of his stock, provide groceries on credit to regular customers, and automatically roll cash towards purchases of next week's stock. Accounting processes for cash flow versus profit versus debts might be porous. How, then, should profits be calculated and distributed, and according to what time frame? Furthermore, small businesses may also try to conceal actual profits or report greater losses than they actually experience; the intent and personal ethics of each client will be as diverse as the individuals themselves – one cannot assume that all those using Islamic microfinancing are uniquely pious.
The lack of simplicity – relative to equal repayment instalments – makes partnership finance more difficult for both the IMFI's loan officers (especially when they may each have several hundred loans to monitor) and micro-entrepreneurs to understand. A further challenge facing IMFIs is the burden in terms of time and cost of monitoring and following up partnership transactions. Building a relationship and conducting business using profit and loss sharing techniques involves more time, effort, and resources because they are built on trust and confidence. Although mudaraba and musharaka can theoretically be used to extend microfinancing, they are not necessarily cost effective. In practice, this means that only a limited number of loans are given to established entrepreneurs with a proven track record and 'credit' history. Largely due to these challenges, as reflected in the case studies that follow, partnership finance is relatively uncommon in Islamic microfinance. Although, some of the IMFIs analysed in later chapters are using profit and loss sharing partnerships of various kinds, it is still relatively limited and sometimes occurs on an experimental basis.
Murabaha is the most popular and widely used Islamic financing methodology, accounting for over two-thirds of Shari'ah-compliant microfinance. This is in large part because it is relatively simple to structure, understand, and implement, particularly when compared with other financing techniques that require more elaborate arrangements. Under murabaha, a micro-entrepreneur approaches an IMFI with a request to purchase a commodity, for example a sewing machine. The IMFI purchases the sewing machine at a freely disclosed price and then resells it, after adding a specific profit margin (often referred to as a 'mark-up'), to the micro-entrepreneur, who agrees to buy the sewing machine for the new offered price. The micro-entrepreneur then pays for the equipment in instalments over an agreed period of time. Bai muajjal is another financing technique that is very similar to murabaha; the only significant difference is that the IMFI is not bound to disclose the cost of the goods and profit mark-up separately to the client.(Continues…)
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Table of Contents
PrefaceMalcolm Harper1 Islamic financing principles and their application to microfinance Ajaz Ahmed Khan, Bridget Kustin and Khalid Khan Part one: Qard hasan – pure Islamic microfinance2 Is it possible to provide qard hasan and achieve financial self-sustainability? The experience of Akhuwat in PakistanAjaz Ahmed Khan, Muhammad Shakeel Ishaq, Joana Silva Afonso and Shahzad Akram Part two: The predominance of murabaha3 Pioneering Islamic microfinance in Kosovo: The experience of STARTAjaz Ahmed Khan and Vehbi Zeqiri4 The Islami Bank Bangladesh’s Rural Development Scheme: “Need-based banking rather than greed-based micro-banking”? Mohammed Kroessin5 Providing an Islamic alternative: the experience of Mutahid in AfghanistanHashmatullah Mohmand6 The murabaha syndrome: Reef and Islamic microfinance in PalestineAjaz Ahmed Khan and Mohammed Ibrahim Elayyan7 The experience of Kaah Islamic Microfinance Services in SomaliaAbdi Abdillahi Hassan Part three: Institutions providing a range of Islamic financing arrangements8 Al Amal Microfinance Bank in Yemen: Financial services in times of warAbdullah Al-Kassim9 The experience of Kompanion-Invest in the Kyrgyz RepublicZamir Pusurov10 Ebdaa Microfinance Bank: Musharaka for small-scale farmers in SudanNawal Magzoub Abdallah11 The Port Sudan Association for Small Enterprise Development in Sudan – an NGO ‘project’ and now a profitable businessLayla Omer BashirPart four: Institutions that also promote (some) profit and loss sharing12 BASIX in Mewat, India – An Islamic experiment by a major Indian microfinance institutionSyed Zahid Ahmad, Anoop Kaul and S.N. Rahaman13 MicroDahab in Somalia – A subsidiary of Africa’s largest remittance companyMohamed Ahmed Liban14 The Al Khair Co-operative Credit Society: A co-operative Islamic microfinance institutionNajmul Hoda15 Profit and loss sharing with smallholder farmers in Indonesia: The experience of PT Vasham Kosa SejahteraIrvan Kolonas and Timothy E. Rann16 Co-operative Islamic microfinance: Daarul Qur’an BMT from Jakarta, IndonesiaRio Sandi and Ajaz Ahmed Khan17 What do the cases tell us? Malcolm Harper