Securing the silent: An untapped potential for Islamic microfinance

Friday, 10 January 2014 00:00 -     - {{hitsCtrl.values.hits}}

The 2014 budget reflects the Government’s desire to grow the country’s economy faster than other emerging market economies. Indeed, the Government has implemented some legal and tax reforms with the objective of permitting greater flexibility and meeting the needs of international investors. While such initiatives are commendable, it is to be noted that sustainable economic development cannot be achieved by focusing only on one segment of the economy while disregarding the other aspects, especially the social context. Scaling up local innovations and entrepreneurship, among other things, is imperative for achieving sustainable socio economic development. Thus, access to finance has been recognised as being vital to enhance the capacity of the poor to utilise human effort for income generation and empowerment. Islamic microfinance represents the convergence of two rapidly growing industries: microfinance and Islamic finance. It has the potential not only to respond to unmet demand but also to combine the microfinance’s power to provide financial access to the needy with the Islamic social principle of ‘caring for the less fortunate’. Unlocking this potential could be the key to providing financial access to many Sri Lankans who may be less favoured by the conventional banking system. A foundational step to this effect was taken by Amana Investments Ltd. as early in 2007 and recently by the Islamic Banking unit of the Bank of Ceylon. What is microfinance? Microfinance can be defined as the provision of financial services and products to people who are excluded from the traditional banking system, mainly because they lack the guarantees that can protect a financial institution against a loss or risk. These include microcredit, small scale venture capital, savings and certain forms of insurance. Microfinance is considered as an effective and flexible tool to eradicate poverty and income inequalities. The United Nations General Assembly declared 2005 as the International Year of Microcredit in order to recognise the contribution and importance of microfinance. The basic principle of microfinance as succinctly expounded by Dr. Muhamad Yunus, the founder of Grameen Bank Bangladesh and the recipient of the Nobel Peace Prize in 2006, is that credit is a fundamental right of a person. The primary mission of microfinance, therefore, is to help the poor in assisting themselves to become economically independent. Credit or loans are given for self-employment and for financing additional income generating activities. The assumption of the Grameen model is that the expertise of the poor is underutilised. In addition, it is also believed that charity will not be effective in eradicating poverty as it will lead to dependency and lack of initiative among the poor. Among the key features of microfinance is disbursement of small size loan to recipients who are micro entrepreneurs and needy. The loan is given for the purpose of a new income generating project or business expansion. The terms and conditions of the loan are generally easy to understand and flexible. It is provided for short term financing and repayments can be made on a weekly or on a lengthy basis. The procedures and process of loan disbursements are normally fast and easy. Additional capital may also be given after the full settlement of the previous loan is made. This system gives individuals and families the financial fuel they require to stand on their own feet without the repressive burden of repaying moneylenders beyond their means. A glimpse at Islamic finance Islamic finance refers to a system of finance based on Islamic law (generally referred to as Sharia). Islamic finance principles are premised on the general principle of providing for the welfare of the population by prohibiting practices considered unfair or exploitative. The most widely known characteristic of the Islamic financial system is the strict prohibition on giving or receiving any fixed, predetermined rate of return on financial transactions. This ban on interest, agreed upon by a majority of Islamic scholars, is derived from two fundamental Sharia precepts:
  • Money has no intrinsic value. Money is not an asset by itself and can increase in value only if it joins other resources to undertake productive activity. For this reason, money cannot be bought and sold as a commodity, and money not backed by assets cannot increase in value over time.
  • Sharing risks and rewards. A predetermined rate of return cannot be guaranteed to providers of funds. The lender and borrower should share the rewards as well as the risks associated with the investment.
  • Material finality. All financial transactions must be linked, either directly or indirectly, to a real economic activity. In other words, transactions must be backed by assets, and investments may be made only in real, durable assets. This precludes the permissibility of financial speculation, and therefore, activities such as short selling are considered violations of Sharia.
  • Investment activity. Activities deemed inconsistent with Sharia, such as those relating to the consumption of alcohol or pork and those relating to gambling and the development of weapons of mass destruction, cannot be financed. In broader terms, Sharia prohibits the financing of any activity that is considered harmful to society as a whole.
  • No contractual exploitation. Contracts are required to be made by mutual agreement and must stipulate exact terms and conditions. Additionally, all involved parties must have precise knowledge of the product or service that is being bought or sold.
Islamic finance extends beyond the ban of interest based transactions and following are some other important principles laid down by Sharia: There is growing interest from financial institutions around the world in designing Sharia compliant products and services to attract more investors. This can build a greater level of trust and understanding between the lender and the borrower due to the deeper relationship built through partnering than that through a mere service provider-client relationship. Since only investment in socially beneficial activities is permitted, ethical investments and business practices would be promoted among entrepreneurs. Indeed, Islamic finance shares many of the features of socially responsible finance. The nexus Many elements of microfinance could be considered as being consistent with the broader objectives of Islamic finance. At a very basic level, the disbursement of collateral-free loans in certain circumstances is an example of how Islamic finance and microfinance share common aims. This close relationship would not only provide obvious benefits for needy entrepreneurs, who would otherwise be left out by credit markets, but also would give investors in banks an opportunity to diversify their investments. Both Islamic finance and microfinance theoretically start from a democratic approach as both systems of finance are open to all customers with different and sometimes coinciding needs without any apparent restriction among them. Both systems advocate entrepreneurship and risk taking through partnership finance and both are also forms of finance which represent unconventional solutions to financial needs focusing on cash-poor but promising business activities. The main distinction between both systems is in respect of the mode of financing. Conventional microfinance adopts interest-based financing while Islamic microfinance adopts a profit and loss sharing approach. Some research papers on the subject have questioned the overall desired impact of the conventional microfinance since the poor are subjected to very high interest rates, sometimes as high as 30%. Some have also argued that disbursing credit to the poor to make huge financial gains out of the same cannot be the aim of microfinance institutions. The rationale behind this argument is that interest charged is rather oppressive for the borrowers, thus which in effect is contrary to the noble objectives of microfinance. Islamic microfinance products Islamic finance with its emphasis on risk sharing is compatible with the needs of micro-entrepreneurs. Expanding Islamic finance to the poor could foster development in the right direction as it causes minimal financial hardship to micro-entrepreneurs and promotes entrepreneurship. Most of the Islamic finance products that are being used by banks can be adopted in microfinance with necessary changes to adjust informal environment. The following products have great potentials to be advanced and adapted as Islamic microfinance schemes: Musharakah: Musharakah can be developed as a micro finance scheme where the bank will enter into a partnership agreement with micro entrepreneurs. Where there is a profit, it will be shared based on a pre-agreed ratio, and where there is a loss, it will be shared according to the capital contribution ratio. The most suitable technique of musharakah for microfinance is the concept of ‘diminishing partnership’ or musharakah mutanaqisah. Under ‘diminishing partnership’ the capital ratio of the entrepreneur gradually increases through repayment of capital resulting in the entrepreneur finally becoming the sole proprietor of the business. The repayment period depends on the pre-agreed period. This scheme is more suitable for existing businesses which require new or additional capital for expansion. Another form of musharakah is musaqat which is a profit and loss sharing partnership contract for orchards. In this case, the harvest will be shared among all equity partners (including the entrepreneur) according to their respective capital contributions. All the musharakah principles will be applicable for this form of musharakah. This scheme, however, could be of high risk to the bank since it needs the capital and expertise to directly involve in the business, especially in managing the orchards. Musharakah capital may be subjected to capital impairment risk - the capital may not be recovered as it ranks lower than debt instruments upon liquidation. The normal risk mitigation techniques that can be adopted by banks, a third-party guarantee for example, are also applicable in the case of microfinance. Third-party guarantee can also be obtained and structured for the loss of capital of some or all partners through a system known as Credit Guarantee Corporation (CGC) as practiced in Malaysia. CGC is an institutional arrangement that provides guarantees to loans obtained by SMEs which lack collateral. Mudarabah: Mudarabah is where the capital provider or microfinance institution (rabbul mal) and the small entrepreneur (mudarib) become partners. The profits from the project are shared between capital provider and entrepreneur. Subject to some restrictions, the financial loss will be borne by the capital provider. The entrepreneur’s loss is restricted to the fact that his labour has gone in vain and his work has not brought any fruit to him. However, as stated, this principle is subject to a condition that the entrepreneur work with due diligence which is normally required for that type of business. Where the entrepreneur has worked with negligence or has committed dishonesty, he shall be liable for the loss so caused. Mudarabah structure could be based on a simple or bilateral arrangement whereby the bank provides the capital and the micro-entrepreneur acts as an entrepreneur. The profit-sharing ratio on mudarabah is pre-determined only as a percentage of the business profit and not as a lump sum payment. The profit allocation ratio must be on the basis of an agreed percentage and must be clearly stated. Profit can only be claimed when the mudarabah operations make a profit. Losses must be compensated by profits generated from future operations. Once the full settlement of capital provider’s share has been made, the business entity will be owned by the entrepreneur and the entrepreneur, therefore, will exercise full control over the business without any interference from the bank. Meanwhile, muzara’ah is a form of mudarabah contract in farming where the bank can provide land or monetary capital for farming products in return for a share of the harvest according to a pre- agreed profit sharing ratio. In the context of microfinance, the capital provider may need huge capital and expertise to manage such initiative and may need to manage high risk since the bank needs to involve directly in the farming sector through provision of assets such as land. Although the entrepreneur exercises full control the bank can still undertake supervision as part of risk mitigation. Murabahah: Using murabahah as a mode of microfinance requires the bank to acquire and purchase an asset or business equipment and then sell it to the entrepreneur at a mark-up. The entrepreneur may settle the selling price on an instalment basis. The bank will be the owner of the asset until full settlement. This is the most appropriate scheme for purchasing business equipment for a micro-entrepreneur. Murabaha may seem similar to a hire purchase agreement but it must be noted that murabaha is essentially a contract of sale where the profit element is disclosed to the buyer and the buyer is given the option to pay the sales price in deferred terms. Murabahah is said to be a more feasible and suitable scheme of Islamic microfinance to be provided by banks. This is due to the fact that the buy-resell model which allows repayments in equal instalments is easier to administer and monitor. Under the extended concept of Murabahah i.e. Murabahah to the Purchase Orderer; a micro entrepreneur can enter into a sale and purchase agreement or memorandum of understanding to purchase a specific kind of goods or equipment needed by the micro-entrepreneur with the bank. The bank then can sell the goods to the entrepreneur at cost plus mark-up and the entrepreneur can pay back later in lump-sum or by instalments (bai muajal). A number of Shariah principles must be met for the contract to be valid such as the goods must be in existence at the time of sale; ownership of the goods must be with the bank; the goods must have commercial value; the goods are not to be used for a prohibited (haram) purpose; the goods must be specifically identified and known; the delivery of goods is certain and not conditional upon any event; and the selling price is fixed at cost plus mark up. Murabahah could be easily implemented for microfinance purposes and can be further exemplified by the use of deferred payment sale.  The credit risks that may associate with Murabaha can be mitigated by requiring a third party financial guarantee or a pledge of assets. Besides, the bank can also institute direct debit from the entrepreneur’s account or make use of the centralised blacklisting system or impose a minimum non-compounded penalty to deter delinquent entrepreneurs. (Such penalty should not be considered as an income of the bank and the same should be used for Shariah approved charity after deducting bank’s administration charges). Murabahah to the Purchase Orderer also exposes banks to delivery risk where the goods are not delivered or not delivered on time or not according to specification by the entrepreneur after payment is made by the bank. In order to mitigate delivery risks bank may request a performance guarantee from the seller to give assurance on the due delivery of goods. Ijarah: Ijarah by definition is a long term contract for rental of property, plant and equipment subject to specific conditions as prescribed by Shariah. Unlike conventional finance lease, the lessors (bank) not only own the asset but also takes the responsibility of monitoring the use of the asset and discharges its responsibility to maintain and repair the asset in case of mechanical default not caused due to wear and tear. The bank should first purchase the asset prior to the execution of an ijarah contract. The bank takes possession of the assets and subsequently offers the asset on lease to the customer. The bank is then responsible for the risks associated with the asset. Ijarah Muntahia Bitamleek is an elaborate concept of ijarah where the transfer of ownership will take place at the end of the contract period and is pre-agreed between the lessor and the lessee. The title of the asset will be transferred to the lessee either by way of gift, token price, at a pre-determined price or through gradual transfer of ownership. Ijarah Muntahia Bitamleek is more suitable for micro finance schemes especially for micro entrepreneurs who are in need of assets or equipment. The entrepreneurs can use the asset on rent the asset over a period of time and pay the rentals at regular intervals. The entrepreneur, as the lessee, will be responsible for the safeguarding of the asset whereas the lessor will monitor its usage.  The bank may be exposed to minimal risk for ijarah in which case the bank, as the owner of the asset, should have the right to repossess the asset. Qardhul Hasan: Another simple concept that can be advanced for microfinance purposes is qardhul hasan - an interest free loan. Banks can pursue this concept as one of their Corporate Social Responsibility (CSR) initiatives to provide finance to the entrepreneurs who are in need of small start-up capital. The bank, however, is allowed to charge a service fee. The terms of repayment will be on an instalment basis for an agreed period of time. The scheme is also relevant for micro entrepreneurs who are in need of immediate cash and also have the potential to make full settlement. The bank will bear the credit risk and the bank must choose the right technique to ensure repayments will be received as agreed. Potential challenges and strategic responses Even though Islamic microfinance has high potential to expand, the industry is yet to validate the fact that it can actually provide financial services that meet the needs of the poor on a larger scale. There are several challenges that could hinder the scaling up of Islamic microfinance in Sri Lanka.  National reach In order to improve the access of target groups, Islamic microfinance schemes should not be considered as a marginal program but as integrated programs with the general banking and financial services industry. Islamic microfinance will reach its full potential only if it is integrated into the country’s mainstream of finance. This is necessary to promote greater awareness of products; standardise regulations; improve transparency and strengthen outreach mechanisms.  Regulatory environment For Islamic microfinance programs to be successful, governments should provide for a policy environment that allows diverse and competitive Islamic microfinance service providers to emerge and flourish. A good policy environment supported by the Government would allow a range of financial service providers to coexist, compete and offer lower cost but higher quality services to large number of poor clientele. Conducive policies should also support and provide incentives for the private sector to introduce innovative funding channels to support the poor. Furthermore, the Government’s role should ensure macroeconomic stability, liberalisation of interest rates and establishment of banking regulation and supervision to make microfinance viable and compatible for both conventional and Islamic microfinance programs. While diverse models and practices are inherent in the choice and flexibility of Islamic microfinance offers, these services need to be regulated in order to improve transparency, consumer confidence and prevent fraud on beneficiaries due to the unfamiliarity with such products. Stability The failures in microfinance, in general, have occurred when microfinance financial institutions have not been properly administered. Contd. on Page 11 (The writer is a Passed Finalist of the Chartered Institute of Management Accountants, United Kingdom and holds Bachelor of Laws Degree from the Faculty of Law, University of Colombo and Islamic Finance Qualification (IFQ) from the Chartered Institute for Securities and Investment, United Kingdom. He can be reached via shamilsm@gmail.com) The capacity building of microfinance financial institutions depends on building strong and transparent management structures. Merely espousing Islamic principles does not absolve them from creating a culture of accountability. As several reports have indicated, microfinance works best when its performance is measured and disclosed. Reporting not only helps stakeholders to evaluate costs and benefits but it also promotes a performance oriented culture. Microfinance financial institutions need to produce accurate and comparable data on financial and social performance. Islamic microfinance institutions  which seek to enhance the position of the poor, including the realisation of their rights to secure shelter, must contribute to the development of a culture of financial and social accountability which embraces innovative approaches to participation by their members. Product development Sharing of best practice and harmonization of general Islamic microfinance products, allowing for inherent diversity, would enhance the credibility of the Islamic microfinance industry.  The demand for the development of Islamic microfinance products may not be as obvious or as strong as the demand for Islamic financial instruments in the commercial banking sector is. Nevertheless, there is considerable scope for Islamic microfinance providers to develop new products as solutions to a variety of financial problems. However, the right approach to product development is a strategic one that takes a holistic view of microfinance as a composite product which comprises of the need for financing, savings and investment, insurance, remittance and other related services. Capital market participation Lack of liquidity and capital are among the potential problems that confront Islamic microfinance players. Conceptually, the problem may be overcome by  profitable  and  high performing  microfinance  providers  as they are  able  to  raise additional  resources  from  the  capital market  or  through a  processes  of  asset securitisation. Securitisation may be pursued, if necessary, after creating a single pool of Islamic microfinance borrowers together with cash-flow-earning assets of several microfinance providers. Rating agencies play an important role in debt capital raising as they provide indicators of default risk. In addition, dedicated funds could also be established to invest in Islamic microfinance financial institutions. The creation of such funds would involve a mechanism similar to that of the Islamic mutual funds within the framework of mudarabah or wakalah. Education and training As pointed out earlier, lack of education and training among clients and organisation personnel will constitute a major challenge for the Islamic microfinance sector. Especially, lack of trained manpower is a major constraint for its expansion, growth and consolidation. Thus, education and training are imperative for an effective strategy for the growth and rejuvenation of the Islamic microfinance sector. Since traditional banking is not suited for collateral-free entrepreneurship-oriented microfinance, there is a need to create a cadre of microfinance experts by imparting training to persons with diverse experience in fields such as banking, finance, investments, entrepreneurship development and community development. There is also a need to educate the clients in subjects like basic accounting and management. Accounting knowledge is of high importance because  of  the  obvious  need  to  calculate  profits  in the case  of participatory financing methods, such as, mudarabah and musharakah. Conclusion It is apparent that Islamic microfinance is an effective socioeconomic development tool that has untapped potential to achieve the development goals of the Government while strengthening growth prospects of the economy. In fact, the gap between the wealthier and the poorer would be bridged to some extent by the scaling up Islamic microfinance contributing to the underlying philosophy of distributive justice which seems to be less catered by the country’s prevailing tax system. The policy makers, regulatory authorities, banks, financial institutions, Islamic finance experts and other stakeholders should work together in order to realise the potential of Islamic microfinance. Let us wish that the financial sector in Sri Lanka will seize the opportunity of Islamic microfinance and enhance its contribution to the society and the national economy at large.

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