Introduction to Islamic Banking and Finance: Principles and Practice M

Introduction to Islamic Banking and Finance: Principles and Practice M
Introduction to Islamic Banking and Finance: Principles and Practice M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni Chapter 9 Islamic Microfinance

Learning Objectives Upon the completion of this chapter, the reader should be able to: 1. Be familiar with the history and basic components of Islamic microfinance and the benefits to society 2. Identify key Islamic finance products that have been used for microfinance 3. Understand the differences between Islamic microfinance institutions and conventional microfinance institutions 4. Be familiar with the major Islamic microfinance institutions in the modern world 5. Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises

Islamic Microfinance: Providing Credit to the Entrepreneurial Poor
Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Microfinance is the provision of small-scale financial services to the poor (usually excluded from the formal financial services) Islamic microfinance is the process of providing small-scale financial services, based on Sharī‘ah concepts, to the poor who may be excluded from formal financial services Islamic microfinance aims to provide necessary credit facilities to the poor and/or low-income individuals who may not have enough finance to engage in normal financial transactions in formal financial institutions

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor The History of Islamic Microfinance Institutions The early initiatives to alleviate poverty and promote security in the Muslim communities include: - The institution of zakat (compulsory alms) Waqf (charitable endowment) The praiseworthy qard hasan (benevolent loans) The informal savings clubs introduced by conventional microfinance initiatives in the 16th century in Europe through cooperative projects were tinted with interest, hence did not serve the real objective of microfinance as a means of assisting the entrepreneurial poor

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor The History of Islamic Microfinance Institutions As an alternative, the revival of Islamic financial services brought about the proper structuring of the Islamic models on microfinance to assist the entrepreneurial poor The history of modern Islamic finance started in rural Islamic microfinance in the remote village of Mit Ghamr in Egypt back in 1960s Number of financial institutions offering Islamic products were established across the Muslim world in the 70s and 80s

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor History of Islamic Microfinance Institutions The 1990s and the new millennium ushered in a period of consolidation of Islamic finance products The joint partnership initiative of Grameen-Jameel opened the Gulf Cooperation Council (GCC) countries to microfinance initiatives The Islamic microfinance model - excludes exploitative tendencies e.g. charging interest empowers able entrepreneurs whom only contribution to the business venture is their expertise

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Components of Islamic Microfinance Islamic microfinance is an umbrella concept that consists of: Micro-lending Micro-saving Micro-insurance (preferably known as micro-takaful)

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Micro-lending Micro-lending (also called micro-credit) Involves the provision of credit facilities in the form of interest-free loans based on the principle of qard hasan Flexibility in terms of repayment of the loan Micro-lending is provided for: - the entrepreneurial poor, to assist them to grow their income the low-income individuals in order to assist them to grow their physical asset base

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Micro-savings Micro-savings based on the concept of wadi’ah (safekeeping) in Islamic finance, which is the underlying concept of savings account (deposits) in the formal banking system Micro-savings allow low-income individuals to secure capital or profits realised in a savings account, thus enabling saving and management of finances Clients accumulate capital and profits in the micro-savings account which allows them to plan for the repayment of any micro-lending from which they might benefit

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Micro-takaful Where members of a specified group of low-income individuals mutually protect one another from risk through collaborative takaful The mutual risk transfer arrangement within the group will ultimately benefit all members of the group plus dependants Micro-takaful is relevant for certain risks that are beyond the financial capacity of the members of the group individually

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Table 9.1: Three Aspects Of Microfinance

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor ‘Microfinance’ and ‘Micro-credit’ The two terms are different in terms of meaning, scope and application ‘Microfinance’ The whole range of small-scale financial services provided for the benefit of the poor or low-income individuals (micro-lending, micro-saving, and micro-takaful) ‘Micro-credit’ Small loans or financial assistance extended to poor families practically excluded from formal financial services (micro-credit is part of the parcel of microfinance)

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Prohibition of Riba in Islamic Microfinance One major difference between conventional microfinance and Islamic microfinance framework is prohibition of interest-bearing credit facilities and interest-yielding deposits Modern conventional microfinance schemes dominated by interest-based products that can further impoverish low-income individuals Likely impact of high interest rates on microfinance schemes is counter-productive High interest rates exclude low-income households unable to afford micro-credit facilities

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Prohibition of Riba in Islamic Microfinance Islamic microfinance offers multiple sources of income through partnership and entrepreneurial commercial activities between the financial institution and the clients Islamic approach to poverty alleviation is a holistic framework that excludes counter-productive element e.g. riba and gharar Interest rates violate fundamental basis of Islamic commercial law regardless whether high or low, so are prohibited The prohibition of riba safeguards against financial exploitation and oppression by the few rich

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Prohibition of Riba in Islamic Microfinance The Islamic approach to the management of micro-credit schemes is highly sensitive to clients who are unable to redeem their loans within the contractual period: - be given additional time in some extreme cases, the loans may be written off completely - in some other extreme situations, remittal of credit facilities may be considered

Learning Objective 1.1 Be familiar with the history and basic components of Islamic microfinance and the benefits to society Islamic Microfinance: Providing Credit to the Entrepreneurial Poor Box 9.1: Features of Islamic Microfinance

Islamic Microfinance Products
Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Modes of Islamic Microfinance An Islamic microfinance institution adopts debt or equity modes of finance for its financing requirements The debt-creating modes include: qard hasan (benevolent loan) murabahah (mark-up sale) ijarah (lease contract) salam (forward sale) bai-bithaman ajil (deferred payment sales) The equity financing modes include: mudarabah (trust partnership) musharakah (joint venture partnership) musaqah (share-cropping), etc.

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products The Most Commonly Used Modes of Islamic Microfinance: Salam as a mode of financing agriculture Mudarabah mode of combating unemployment Bai Muajjal-Murabahah mode of providing working capital Diminishing Partnership for Housing Microfinance Non-for-Profit Modes of Islamic Microfinance

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Salam as a Mode of Financing Agriculture Salam regarded as the most viable tool for financing agriculture Salam a contract where the bank is the buyer of the commodity and the farmer is the seller who undertakes to embark on future delivery Bai salam a contract where the seller undertakes to supply specific goods to the buyer at a future date in exchange of advance price which is fully paid on the spot Parallel salam a separate contract distinct from the initial bai salam where the Islamic bank is the seller of the commodity based on deferred payment The two contracts must be distinguishable from each other

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products The Applicability of the Salam Contract Salam contract is used in Islamic commercial transactions - To meet liquidity needs of traders for import/export business - To meet financial needs of small farmers Salam contract is important in the financing of micro-farming, small-scale farming where farmers require funding to grow crops and feed their family up to the harvest time

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Figure 9.1: Profits from Islamic Micro-credit Schemes for Agriculture

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Mudarabah Financing for Combating Unemployment Mudarabah is an Islamic finance contract where: - an Islamic bank as an investor exclusively provides capital for a business project an entrepreneur provides the management expertise Mudarabah a trust partnership finance mechanism structured as a tool to combat unemployment and create jobs Mudarabah can be a good product for entrepreneurial activities, especially when there is a large amount of skilled unemployed labour

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Types of Mudarabah Contractual Arrangements The two types of Mudarabah contractual arrangements are: Mudarabah al-Mutlaqah (Unrestricted Trust Financing): where the particular business in which the micro-entrepreneur will invest the capital finance is not specified or restricted Mudarabah al-Muqayyadah (Restricted Trust Financing): where the bank or Islamic microfinance institution (the capital provider) specifies or restricts the business in which the capital finance may be invested

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Figure 9.2: Mudarabah Model of Microfinance

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Bai al-Mu’ajjal-Murabahah Model of Providing Working Capital Bai Muajjal or Bai-bithaman ajil (BBA) a sale where parties agree to deferment of payment to a future date – meaning that there is already an element of Murabahah When Murabahah is combined with Bai Muajjal, it becomes a microfinance product which is one of the most commonly used instruments by the Islamic MFIs The mark-up price in the Murabahah contract is settled as a deferred payment based on Bai Muajjal

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Bai al-Mu’ajjal-Murabahah Model of Providing Working Capital The parties must know the cost price and the profit or mark-up in Murabahah transactions In Bai Muajjal, cost price and the profit or mark-up is the deferment of the payment of the price regardless of whether the parties are aware of the cost and mark-up The parties must fix price of commodity and the terms of payment at the time of concluding the contract to prevent any element of gharar in the contract

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Figure 9.3: Bai al-Mu’ajjal-murabahah Model of Microfinance

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Diminishing Partnership for Housing Microfinance Housing microfinance is a means of providing shelter for low-income individuals A diminishing partnership is known as musharakah mutanaqisah, an Islamic financial product structured to strategically provide access to housing for the poorest The Islamic MFI and the client form a partnership contract where they purchase a property and lease it out for a specified term The client buys a specified number of units every month out of the shares of the Islamic MFI which automatically decreases the capital ownership of the MFI

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Diminishing Partnership for Housing Microfinance The capital ownership of the Islamic MFI diminishes gradually until the client buys the total capital share in the property (out of the profit distributed over a period of time) The title passes to the client and he/she owns the property In situations where the poor clients do not have funds to buy a small portion of the capital share, qard hasan, zakat or waqf funds may be provided for such purpose - If qard hasan is given, the client only needs to repay the capital amount If it is a zakat or waqf grant, there is no need for repayment

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Non-for-Profit Modes of Islamic Microfinance The non-for-profit modes of Islamic microfinance are (i) zakat, (ii) waqf and (iii) qard hasan Islam institutionalised a number of mechanisms including zakat, waqf, qard hasan and sadaqah to ensure that wealth circulates among all the members of the society between the rich and the poor A hybrid framework for these mechanisms will drastically alleviate poverty in the society Despite the non-for-profit nature of the hybrid model, it can be easily modified to accommodate the profit-oriented modes

Learning Objective 1.2 Identify key Islamic finance products that have been used for microfinance Islamic Microfinance Products Figure 9.4: Model of Islamic Microfinance using non-for-profit modes

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions Islamic Microfinance Institutions versus Conventional Microfinance Institutions The revival of Islamic finance services in the 20th century in a formalised form brought with it the Islamic microfinance schemes The Islamic finance products have been structured to suit the requirements of the modern microenterprises and microcredit schemes There are a number of operational and functional differences between the Islamic microfinance institutions and the conventional MFIs Islamic banking and finance, with its microfinance framework, is inclusive in its approach to reach out to the disadvantaged and poor and embed true social justice in society

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Islamic Microfinance Institutions versus Conventional Microfinance Institutions Major Differences between Islamic MFIs and Conventional MFIs Sources of Fund: The conventional MFIs get their funds from: Interest-bearing loans Foreign donors Central Banks Government The Islamic MFIs get their funds (with the exception of interest-bearing loans) from: Equity finance products applied in the finance of microenterprises Islamic charitable sources such as waqf, zakat and sadaqah

Islamic Microfinance Institutions versus Conventional Microfinance Institutions
Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Modes of Financing Conventional MFIs utilise interest-based modes of financing Islamic MFIs utilise Islamic financial instruments which are either equity-based or debt-based Various financial instruments can be used to finance different kinds of enterprises: A profit-sharing mode could be used for a microenterprise where the microenterprenur and the MFI share the profit - Salam and Parallel Salam may be more appropriate for micro-farming - Mudarabah trust financing may be utilised in order to combat the curse of unemployment

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Financing the Poorest The framework of the conventional MFIs completely excludes the poorest from the microfinance net Islamic microfinancing scheme ensures that no segment of the population is excluded - Zakat involves the provision of grants to the poor for consumption Qard hasan involves the provision of benevolent loans to the poor for their entrepreneurial needs The mechanism of zakat and sadaqah may be combined with the microfinance activities to manage default of repayment that might be occasion by extreme poverty

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Funds Transferred to Beneficiaries In the conventional MFIs, once a loan has been approved: A part of the principal is deducted by the institution for different funds The beneficiary pays interest on the total amount approved The beneficiary may divert the funds to non-productive means Alternatively, the Islamic MFIs - Prevent the diversion of the funds to non-productive means since no cash is handed out to the beneficiaries Do not make any deductions

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Guarantee and Group Dynamics In the conventional MFIs, the repayment of the loan remains the sole responsibility of the borrower In the Islamic MFIs, group guarantee in the repayment of the loans takes the form of kafalah (guarantee) - Any of the group members can stand in as a guarantor for the repayment of the loan - In the event of any default in the repayment of the loan, the group members might agree to give such a member qard hasan to pay his or her instalments

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions Objective of Targeting Women The conventional MFIs consider women seeking microcredit as a means of women empowerment Recent research suggests that: - Men more often encourage women to take credit facilities - Men spend the borrowed money while the women are held responsible for the repayment of the instalments since they got the credit facilities

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Major Differences between Islamic MFIs and Conventional MFIs In the Islamic MFIs - The objective of targeting women differs from that of the conventional MFIs - The target group is the family - Women and their spouses are made to sign the contract as the target is the family and not the women alone - Both parties are liable for the repayment of the instalments

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Work Incentives of Staff Members The work incentive of the staff of the conventional MFIs is mainly monetary gains from salary The work incentives of the staff of Islamic MFIs are both monetary and religious - In addition to earning a living, the staffs of Islamic MFIs also perform a socio-religious duty of alleviating poverty within the society - Such an incentive gives the staff more zeal to work efficiently towards the realization of the vision of the Islamic MFIs

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Social Development Programme The Social Development Programme of the conventional MFIs is secular and in some cases goes against the ideals of Islam The Islamic MFIs put in place a social development programme where the ethical, social, behavioural aspects of Islamic ideals are brought to the fore - The Islamic MFIs programme helps in promoting the idea of brotherhood and partnership among beneficiaries who are morally compelled to repay their instalments regularly as at when due

Learning Objective 1.3 Understand the differences between Islamic microfinance institutions and conventional microfinance institutions. Dealing with Default In the conventional MFIs - Group and centre pressure used to deal with arrears and default - In the event that this pressure does not work, the MFIs result to threats and sale of assets The Islamic MFIs have more sustainable and reasonable ways to deal with defaults and arrears - Members in a group guarantee one another through kafalah (spirit of brotherhood) The group may provide qard hasan to defaulting member which may be used to settle the arrears Members will do their utmost to pay back their loans in order to fulfil their religious obligations

Notable Islamic Microfinance Institutions
Learning Objective 1.4 Be familiar with the major Islamic microfinance institutions in the modern world. Notable Islamic Microfinance Institutions The Islamic microfinance industry is growing at a fast pace in Muslim-dominated communities across the world While some of the Islamic MFIs are developmental institutions, others specifically target poor Muslim communities Four Islamic microfinance institutions are selected in four different countries for case studies - Akhuwat in Pakistan - Hodeidah Microfinance Programme in Yemen - Islami Bank Bangladesh Limited - Amanah Ikhtiar Malaysia

Financing Micro-enterprises by Islamic Banks: Rationale
Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale Two schools of thought regarding the financing of microenterprises: The first school believes that financing microenterprises is part of the Corporate Social Responsibility (CSR) role of the Islamic banks and financial institutions The second school believes that financing microenterprises requires designated MFIs The sources of credit facilities: The institutional sources are the corporate financial entities such as banks and cooperatives The non-institutional sources include credit facilities from money lenders, friends, and family members

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale In practice, institutional sources of credit exclude the microenterprenurs from formal financial services because: 1. Microentrepreneurs are unable to provide the demanding physical collateral for such loans 2. Microenterprises are considered ‘high risk’ business entities because of the high rate of failure among young small business 3. Extending credit facilities to microenterprises is considered uneconomical due to the high running cost involved per unit of credit On the other hand, interest rates for non-institutional loans (i.e. money lenders) are too excessive for the condition of the low-income individuals

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale Financing Microenterprises by Islamic Banks: The Emergence of MFIs The establishment of MFIs has introduced a new concept of banking, lending and financing for microenterprises Grameen Bank is one of the pioneering MFIs that provided the entrepreneurial poor an opportunity to get access to credit facilities without the formal requirement of physical collateral Grameen-Jameel was launched in 2003 through a joint-venture between Bangladeshi Grameen Foundation and the Saudi Arabian Abdul Latif Jameel Group

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale Grameen-Jameel has formed strategic partnership with MFIs in the Middle East and North African (MENA) countries by increasing their capacity through the provision of: - Financial support - Technical assistance - Training - Access to best practices in the field

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale Role of Islamic Banks in Financing Micro-enterprises Traditional role of Islamic banks and financial institutions include: - accepting deposits - managing savings and current accounts - engaging in partnership financing Islamic banks and financial institutions also assume social function which is an aspect that relates to modern CSR roles The social benefits of Islamic banking and finance are extended to provide credit facilities to low-income individuals who are excluded from the conventional banking facilities

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale Role of Islamic Banks in Financing Micro-enterprises Financing small and medium enterprises (SMEs) is considered as a means to alleviate poverty, derivable from the banks and financial institutions Islamic banks and financial institutions are expected to: - Establish a department/division of the bank dedicated to Islamic microfinance - Alternatively, a subsidiary of such an Islamic bank may be established to carry out microfinance functions

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale The Social Role of Islamic Bank Imperative that Islamic banks establish, manage and consolidate the microfinance institutions to fulfil their social role Concept of fair dealing and justice in financial matters compels Islamic banks to reach out for all classes of people in the society There are no separate banks for the rich and others for the poor The social dimension of the objectives of Islamic banks is the promotion and support of (SMEs)

Learning Objective 1.5 Understand the corporate social responsibility role of Islamic banks in financing micro-enterprises. Financing Micro-enterprises by Islamic Banks: Rationale SMEs which are viable means of combating poverty through the creation of employment opportunities Extension of credit facilities to the poor leads to more equitable distribution of wealth amongst members of society Islamic banks or financial institutions may either establish a subsidiary or create departments to administer microfinance function and extend credit to low-income individuals

Key Terms and Concepts Bai al-salam bai al-mu’ajjal
Corporate social responsibility (CSR) Entrepreneurial poor Financial exclusion Informal savings club Kafalah Micro-farming Micro-credit Micro-lending Micro-savings Micro-takaful Microfinance Microfinance institutions (MFIs) Mudarabah Mudarabah al-muqayyadah Mudarabah al-mutlaqah Musharakah Mmutanaqisah

Key Terms and Concepts Muzakki Parallel salam Qard hasan Riba Sadaqah
Takaful Wadi’ah Waqf Zakat

Introduction to Islamic Banking and Finance: Principles and Practice M

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