Written by Nimrah Karim, Michael Tarazi and Xavier Reille and based primarily on secondary research by the Consultative Group to Assist the Poor (CGAP), released in August 2008 as Number 49 of Focus Note, a publication of CGAP, 16 pages, available on October 27, 2008 at: http://www2.cgap.org/gm/document-1.9.5029/FocusNote_49.pdf.
Karim et al paint a picture of Islamic microfinance being the product of two rapidly growing industries: microfinance and Islamic finance. The paper’s main function is to update readers on developments and trends in Islamic microfinance by providing a host of facts and statistics gleaned from CGAP research, in particular a 2007 global survey of over 125 Islamic microfinance institutions and experts from 19 Muslim countries. The following summarizes highlights from the paper:
Principles of Islamic Finance
Karim et al provide a brief explanation of the religious motivation behind Islamic finance practices. Islamic finance refers to a system of finance based on Sharia, or Islamic law, whose guiding principle as expressed through Islamic finance appears to be the prohibition of practices considered unfair or exploitative, especially the giving or receiving of interest earned on financial transactions (p. 1). Islam places a number of additional constraints on investment activity. The principle of material finality stipulates that all financial transactions must be backed by real, durable assets and therefore forbids activities like price speculation or short-selling. Investments related to practices that Sharia deems improper or harmful to society (e.g. consuming pork or alcohol, gambling, or creating or distributing weapons of mass destruction) should not be financed (p. 2). Also, Sharia mandates that all financial contracts must state openly all terms and conditions and must be agreed to by all involved parties. Muslim scholars must complete several years of training to become certified to judge financial transactions according to Sharia; however, without a centralized Islamic finance authority there exists the potential for differing interpretations of the aforementioned principles and consequently disagreements on the validity of various financial products (p. 2).
The authors also explain a few of the most common Islamic microfinance contracts (p. 3):
- Murabaha Sale (cost plus markup sale contract): The most widely offered Sharia-compliant contract, the murabaha is an asset-based sale transaction for acquiring working capital. A client requests a tangible commodity from a financier, who purchases it from the market and resells it to the client at a pre-arranged fixed premium to cover the service provided. This premium cannot be thought of as interest because it does not vary with the repayment schedule; the amount remains fixed even if the client repays past the due date. Islamic principles dictate that the financier must retain all ownership and bear all risk until the client has paid for the asset in full.
- Ijarah (leasing contract): This contract is typically used for financing small machinery and other durable equipment. Lease term and related fees must be determined beforehand in order to comply with Sharia, and as with murabaha, asset ownership and risk must remain with the financier for the term of the contract.
- Musharaka and Mudaraba (profit and loss sharing): Musharaka is an equity-based joint-partnership in a business venture wherein involved parties share profits or losses according to a predetermined ratio. In a mudaraba contract, one party provides managerial oversight of a project while another funds it. As with other contracts, profit-sharing ratios are predetermined and financial losses are borne by the financier (who retains ownership of the project).
- Takaful (mutual insurance): Each group member contributes funds to a pool that is used to provide insurance to members facing problems such as death, crop loss or accidents. The paid premiums must be invested in Sharia-compliant activities.
Development of the Islamic Finance Industry
The authors give a brief overview of the rapid growth of Islamic finance institutions. Over the past 30 years, over 500 Sharia-compliant institutions have developed and currently operate in over 75 countries (p. 2). Of these 500 institutions, approximately 292 are banks that fully operate according to Islamic law or work with Islamic subsidiaries. Another 115 are investment banks or other finance companies, while another 118 are insurance companies. The 100 largest wholly Sharia-compliant banks on average claim an annual asset growth rate of 27 percent, eight percent higher than traditional banks (p. 2).
Total assets in the Islamic finance industry are valued at USD 500.5 billion (p. 2). Of this amount, approximately 36 percent is spread among the Gulf Cooperation Council (GCC) countries, which are comprised of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE (p. 4). Another 35 percent of assets are spread among non-GCC countries in Southwest Asia and North Africa. Twenty-three percent of total assets are located in Asia, primarily Malaysia, Brunei and Pakistan. Despite the preponderance of these assets in certain geographic regions, access to Islamic financial services is still available through subsidiaries of many international financial institutions in countries such as India, China, Japan, Germany, Switzerland, Luxembourg, the United Kingdom, the United States and Canada.
Karim et al cite a number of IFC-commissioned market studies to conclude that the demand for Islamic microfinance products is strong across the globe (p. 5):
- Sixty percent of low-income survey respondents in the West Bank and Gaza claim a preference for Islamic financial products over conventional ones. Over half of this group is willing to pay higher prices for them, although the authors of the study did not say how much higher these prices can be.
- Karim et al also examine a number of studies carried out in Jordan by USAID and IFC/FINCA, who found that 24.9 and 32 percent, respectively, of survey respondents cited religious reasons for not turning to traditional financial products. IFC/FINCA also found that 18.6 percent of those interviewed cited religious reasons as the most important factor in determining whether or not to obtain a loan.
- In Yemen, the authors found that about 40 percent of the poor demand Islamic financial services, regardless of price.
- In Syria, another survey showed that 43 percent of respondents never obtained microloans for religious reasons. Forty-six percent of people who had never applied for a loan admitted that religious reasons had prevented them from ever even applying. Five percent of current borrowers said they would not apply for another loan for religious reasons.
These surveys, however, do not paint a foolproof picture of strong demand for Islamic microfinance. People may express one preference in a survey but choose differently when asked to purchase goods in a market setting. Many of the survey respondents may have expressed a preference for Islamic products simply to show their religious piety.
Government Promotion of Islamic Microfinance
Just as with the broader Islamic banking industry, government policies can help expand Islamic microfinance. The strongest examples of pro-Islamic microfinance governments are Indonesia and Pakistan (p. 6). In 2002, the Bank of Indonesia created a “Blueprint of Islamic Banking Development in Indonesia,” which outlined a nine-year plan for development of the Islamic finance sector in the country. According to Karim et al, the regulatory framework in Indonesia is “supportive,” and the government has licensed 35 new rural banks in the past five years. The Bank of Indonesia has shored up its capacity building by constructing an office in Medan that can provide training and certification on Islamic financial operations to rural bank staff, managers and directors. In 2007, Pakistan developed guidelines for the expansion of Islamic microfinance. The guidelines set forth protocol governing the licensing and appointment of Sharia advisors to rule on compliance cases and the separation of conventional and Islamic financial products by banks and other institutions that offer both.
Islamic Microfinance: CGAP Survey Results
In this section, the authors discuss in greater detail the results of a 2007 CGAP Islamic microfinance survey that collected information from over 125 institutions and experts from 19 Muslim countries.
According to the CGAP survey, Islamic microfinance accounts for a very small proportion—only one-half of one percent or about 380,000 customers—of total microfinance outreach (p. 1). Of these clients, approximately 300,000 clients are contacted through 126 institutions operating in 14 countries, while another 80,000 are reached through a network of Indonesian organizations. At 80 percent of global outreach, Indonesia, Bangladesh and Afghanistan are the top three suppliers of Islamic microfinance (p. 1).
It is worth noting, however, that Islamic microfinance accounts for a very small portion of total microfinance outreach in every Muslim country (p. 7). The average outreach of the 126 institutions in the CGAP survey is about 2,400 clients; no institution has more than 50,000 clients. Bangladesh has the largest Islamic microcredit outreach, with over 100,000 clients and two active institutions. However, Islamic microfinance represents only one percent of the total microfinance market in Bangladesh, which enjoys the largest microfinance industry in the world (p. 7).
The paper discussed a few other notable findings. Microloans across most of the countries in the survey are similar to their conventional counterparts in their terms and size. There are exceptions, of course. In Indonesia, the average Islamic product loan size is 45 percent higher than the average conventional microloan. The survey also found that Islamic microloans target women in proportions comparable to conventional microloans and that about 70 percent of microfinance products are murabaha (p. 8). The industry lacks a profound degree of product diversification and most firms offer only one or two Sharia-compliant products.
Among the institutions that offer Islamic microfinance products, nongovernmental organizations (NGOs) supply the largest numbers of clients. Approximately 42 percent of total clients are reached by 14 NGOs (p. 9). The two commercial banks in the survey, Yemen’s Tadhamon Islamic Bank and Bangladesh’s Islami Bank Bangladesh Limited, have the second largest outreach with over 87,000 clients (p. 9). The authors note that about 105 Sharia-compliant banks in Indonesia serve 25 percent of total clients but offer 62 percent of the outstanding loan portfolio because of their higher average loan size and their focus on small and microenterprise financing.
At the end of this section, Karim et al discuss the dual conventional/Islamic microbanking system in Indonesia in order to shed light on its unique Islamic finance industry and the profitability and efficiency of its firms (pp. 9-10).
Possible Challenges to the Growth of Islamic Microfinance
The authors argue that Islamic microfinance needs a “deeper base of market research and proven business models” in order to expand access to finance on a large scale across the Muslim world (p. 10). In order to construct sustainable business models, Islamic microfinance institutions (MFIs) must improve their operational efficiency and risk management (p. 11). By increasing their operational efficiency, MFIs can cut transaction costs and create more affordable financial transactions, especially murabaha or ijara transactions. Islamic MFIs can also learn something from the conventional microfinance industry’s credit risk management practices. Karim et al argue that these techniques (e.g. peer pressure and strict discipline) can easily be adapted to comply with the risk-sharing and no-interest principles inherent to Islamic finance (p. 12). They cite others who argue that peer pressure from the religious community and a desire to achieve piety can complement the reliance on peer pressure found in traditional models (p. 12).
Another challenge to the expansion of Islamic microfinance products is their perceived lack of authenticity among some communities. Some critics find product pricing to be questionably similar to that of conventional microfinance; others argue that interest is oftentimes disguised as a cost markup or some other Sharia-compliant administrative fee. The authors argue that to overcome these issues the industry needs to encourage: (1) increased collaboration between financial experts and Sharia experts to craft well-designed yet Sharia-compliant products; (2) greater exchange among religious leaders relating to religious compliance of microfinance products; and (3) public education programs promoting properly-sanctioned microfinance products (p. 12).
The authors of the paper also believe that capacity building must be improved at all levels in order to realize Islamic microfinance’s full potential. The Islamic Development Bank and other Islamic financial standard setters should agree on a set of global financial reporting standards specific to microfinance in order to shore up industry transparency (p. 12). This would require creating detailed guidelines on Sharia-compliant accounting principles, pricing methodologies, financial audits and rating services. Capacity building can also be improved through efforts at the micro and institutional levels. Donor agencies can increase funds to help MFIs reach economies of scale and to allow them to take more risks that may lead to the discovery of better business models or practices (p. 12). The development of operational tools and manuals for field operatives and other MFI personnel is also a necessity, according to Karim et al. The authors also touch on the need for greater product diversification (p. 13).