Islamic Approaches of
Microfinancing
Lecture Plan

Session 1:


Microfinance Institutions (MFIs)
Financing Microenterprises: Islamic
Alternatives



Islamic MFIs
Islamic MFIs Vs Conventional MFIs
Session 2:

Financing Microenterprises: Islamic
Alternatives


Islamic Banks
Other Specialized Institution—Waqf-based MFI
2
Session 1
 Introduction
 Microfinance
Institutions (MFIs)
 Islamic MFIs Vs Conventional
MFIs
 Assessment of Islamic MFIs
 Conclusion
3
Introduction (1)



In the last 50 years, different development
strategies have been used to resolve the
problem of poverty
Most of these programs failed
“Microfinance” initiated in the mid-1970s
appears to be the ‘new paradigm’ to
eradicate poverty
4
Introduction (2)



Limited access to finance is key constraint to
private sector growth
Investment on MSEs is even more difficult
The MSEs do not qualify to get funds from
institutional sources (banks)
 lack of collateral
 too much risk
 too costly
5
Economics of Microfinancing

Profit = Revenue – Costs




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Revenue =Rate of return on funds invested
Costs = Finance Costs + Operating Costs
Operating Costs = Variable Costs (wages) + Fixed
Costs (rent, utilities, etc.)
Variable Costs = Field Level Costs + Costs at the
Head/regional/branch offices
Microfinancing


Revenue may be low due to credit risk
Costs are high due to large operating costs
6
Financing MSEs



Commercial financial intermediation not feasible
If the poor have to be financed, there is a need
for social financial intermediation
Two ways to do so:



Linking Approach—Existing financial institutions can do it
through specialized windows
Specialized institutions Approach—NGOs, non-profit
organizations, etc.
Almost all of MFIs models are of the second type
7
Financing MSEs-Sustainability

Mitigating Credit Risk


Solving the Moral Hazard problem


Ensure repayment in the absence of acceptable
physical collateral
Ensure funds not diverted and used for intended
activity
Economic viability —keep costs to a
minimum relative to income


Operating costs
Financing costs
8
Microfinance Institutions
(MFIs)



MFIs are target-oriented (poverty-focused)
financial institutions
Target group—micro and small enterprises
(MSEs)
 (Average financing in Bangladesh is below
US$ 200 and in the US is US$ 1500)
Graduation from poverty -- the “Virtuous circle”
 Low income credit investment more
income more credit more investment
more income
9
MFIs—Typical Balance Sheet
Assets
Cash (C)
Liabilities
Funds from external
sources (F)
Loans (L)
Saving Deposits (D)
Reserves (R)
Equity (E)
10
MFIs-Main Features



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Interested individuals must form a group
Several Groups form a Center
Center has weekly meetings
An official from the MFI attends the meetings
and all transactions take place in these
meetings (bank goes to the people)
11
Organizational Structure of MFI Clients
Center
Group
Group
Group
Group
Group
Member
Member
Member
Member
Member
12
MFIs-Other Features
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
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Small amount of funds given for
microenterprises for 3months -1year
Capital and interest paid back in small weekly
installments
Forced savings and insurance programs
Social Development Programs

behavioral, ethical, and social development
13
MFIs-Social Collateral

MFIs have devised a structure to resolve the
collateral and risk problems of financing
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No physical collateral required
The repayment of dues of a member in the group is the
collective responsibility of the all the members in the group
If any one in the group defaults--all members become
disqualified for credit
Peer-pressure works as social collateral
14
Banks Vs. MFIs (1)
Bank
MFI
A profit-maximizing firm
Non-profit Government/nongovernment organization
Financial intermediary between
savers and investors in the
economy
Funds from external sources
provided to the poor
Deposits form bulk of the liability
Savings (forced) of clients only
deposits
Do not have social/educational
programs
Includes social/educational
programs
Physical/financial collateral
required to get funds
Social collateral through group and
center formation
15
Banks Vs. MFIs (2)
Bank
MFI
Clients relatively well-off
Clients are poor
Clients come to the bank
Bank goes to the clients
Amount of loan large
Amount of loan small
Most clients are men
Most clients are women
Repayment frequency small (end
of the contract period)
Repayment is frequent (weekly)
16
MFIs and Sustainability

Mitigating Credit Risk (CR)


Solving Moral Hazard (MH) Problem
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
CR mitigated by social collateral (group-based lending)
Cash given out can be used for other purposes –chances
of default increases
Economic Viability


High administrative costs (some estimates show costs
ranging from 24 to 400% of per dollar lent)
Reasonable finance costs
Conventional MFIs have resolved the CR problem
(social collateral), but not MH problem and
Economic Viability problem
17
Islamic Alternatives to
Microfinancing

Different alternatives:


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Islamic MFIs
Islamic Banks
Specialized Institutions
Group-based microfinancing can be used
(as it mitigates the CR)
18
Islamic MFIs-Features (1)

Islamic MFI retains the basic operational format of
MFIs

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
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Going to the Clients
Weekly/Monthly Repayments
A Social/Development Program (to fulfill the social role of
Islamic finance)
IMFIs have some distinguishing features:


Sources of Funds
 Other than external sources, can also use funds from
zakah, awqaf, and other forms of charities
Use of funds (Mode of Financing)
 Sale based and hiring modes (murabahah, salam, ijarah)
 Profit-sharing modes (Musharakah and mudarabah)
19
Islamic MFIs-Features (2)

Amount transferred to the poorest
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Group Dynamics

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As Islamic modes are sale based the price of the asset is
paid (no deductions are allowed)
Islamic values of brother/sister-hood improves cooperation
among the group members
Financing the poorest

Zakat and other charities can supplement MFI activities
(non-diversion of funds)
20
Islamic MFIs-Features (3)

Social Development Program
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Targeting the family through women
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behavioral, ethical, and social aspects in light of Islamic
teachings
Spouse co-signs the contract
dealing with women more efficient and convenient
Women disseminate knowledge to children
Dealing with Arrears/Default

Less aggressive and use Islamic teachings to recover
loans
21
Islamic MFIs and Sustainability

Mitigating Credit Risk (CR)


Solving Moral Hazard (MH) Problem


CR mitigated by social collateral (group-based lending)
As asset/good given instead of Cash, chances of diversion
and default decreases
Economic Viability


High administrative costs
Reasonable finance costs
Islamic MFIs can resolve the CR problem and the MH
problem, but not the Economic Viability problem
22
Problems facing Islamic MFIs
1. Dilution in the Application of Islamic Modes
of Financing

Main mode- murabahah or bai-muajjal.
It is difficult to go out with the clients and buy the
goods/assets from faraway markets
IMFIs delegates someone else (and inspects later)


Alternative is to use Profit-sharing modes

Problem is the moral hazard problem--No bookkeeping and difficult to monitor
23
Problems facing Islamic MFIs
2. Lack of Funds

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Most MFIs get their funds from external sources
Islamic MFIs have difficulty in getting funds from
these sources
Operations and expansion of activities affected
Islamic MFIs have not yet tapped the sources of
funds from Islamic institutions (like zakah, waqf,
and other charities)
3. Training

Training can enhance efficiency but is costly
24
Conclusion

Islamic approach to microfinance has certain
advantages

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Diversified asset and liability structures
Social collateral stronger
Potential to target the poorest through
complementary programs
Asset-based modes of financing can prevent
diversion of funds for consumption
Lack of funds hampering its growth
25
Session 2
Financing Microenterprises:
Islamic Approaches
 Islamic
Banks
 Specialized institutions: Waqfbased MFI
26
Financing MSE by Islamic
Banks (IBs)

The Rationale



Social Role –Islamic firms are not only about
fulfilling Islamic contracts…there is more to it
(social justice and benevolence)
Financing is the specialization of IBs—expand the
client base to the MSEs
Can be done at no cost to the IB and more cost
effectively than MFIs
27
Financing MSEs by IBs
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Use the same format as MFIs (as it suits the
MSEs)
IBs can open up a department for financing
MSEs
Use the existing infrastructure (bank offices)
for financing MSE operations
28
IBs & Economics of
Microfinance

Profit = Revenue – Costs




Revenue =Rate of return on funds invested
Costs = Finance Costs + Operating Costs
Operating Costs = Variable Costs (wages) +
Fixed Costs (rent, utilities, etc.)
Variable Costs = Field Level Costs + Costs at the
Head/regional/branch offices
29
MFIs Vs. IBs: Operating Costs


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MFIs
 For any level of operations an MFI will maintain
offices—Higher Fixed Costs
 Higher Variable Costs (wages) at
Head/regional/branch offices
IBs
 No extra costs needed to maintain offices for the
Microfinancing program (can use bank’s premises)—
lower fixed costs
 Lower Variable Costs (wages) at
Head/regional/branch offices
Conclusion: Operation Costs to finance MSEs is lower in
case of IBs compared to MFIs
30
MFIs Vs. IBs: Finance Costs

MFIs: Sources of funds



IBs: Sources of Funds
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Main source –external funds (MFI has pay a rate of return,
though subsidized in many cases)
No Deposits—Forced Savings of Members—Competitive
returns are paid on savings
Deposits
 Demand Deposits (no costs)
 Investment Deposits (has to pay competitive returns to
depositors)
Conclusion: Given the excess liquidity in IBs, the
funds from Demand Deposits can be used for
MSEs—Finance costs of IBs can be lower than that
in MFIs
31
MFIs Vs. IBs:
Quality of Service

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Dependence on external funds in MFIs comes with
conditionalities—IBs more flexible
Lack of funds in MFIs—poorer quality work force
(especially at field level)—can increase the default
rate
IBs pay competitive wages—good quality workers
with higher productivity
Employees of IBs can be trained by the Bank at low
cost—not possible in case of MFIs
Most IBs have funds collected from penalties for late
payments—these funds can be used for
complementary asset building/poverty reducing
programs—asset building in form of grants or qardhassan
32
IBs and Sustainability

Mitigating Credit Risk (CR)


Solving Moral Hazard (MH) Problem


CR mitigated by social collateral (group-based lending)
As asset/good given instead of Cash, chances of diversion
and default decreases
Economic Viability


Low administrative costs
 No need for a hierarchy of senior management and offices
 Use existing branches for operation
Low finance costs
 Excess liquidity—use liquid funds available
IBs appear to resolve all the problems related to
sustainability in microfinancing.
33
IB and Microfinancing:
An Example
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Islami Bank Bangladesh Ltd (IBBL) has a Rural
Development Program (RDS) to finance MSEs
Started in 1996 and funded from IBBLs general
investment fund
As of October 2006, RDS operated from 116
branches (of 176 total), covering 7,788 villages
giving a total of Tk. 8589.7 mill. to 368,360 clients
The recovery rate is 99 percent.
Employees involved with RDS have better benefit
packages than other MFIs
Employees get in-house training at IBBL Training
Academy
34
RDS of IBBL
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Loan amount (Tk. 3000 to Tk. 25000)
Paid back in weekly installments
No physical collateral required
Group-based lending
Rate of return charged is 10 percent with
2.5% rebate for timely payment (other MFIs
rate range from 16 to 20 %)
35
Microfinancing by Specialized
Institutions
1. Cash Waqf—waqf established in the form of cash

Can be used for microfinancing
2. Qard hassan bank—nonprofit financial intermediary


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Capital would be cash waqf
Will receive current accounts
Provide qard hassan (interest free loans) for microfinancing
3. MFI based on Awqaf and Zakat

Returns from waqf given for investment purposes and
zakat funds for consumption purposes
Use the same operational format as MFIs (as it suits
the MSEs)
36
Waqf-based MFIs



Historically, waqf based institutions did
provide loans to the disadvantaged (Turkey
and Iran)
W-MFI will retain the basic operational format
of MFIs, but will have some distinguishing
features
Group-based microfinancing can be used
(as it mitigates the CR)
37
W-MFI: Sources and Uses of
Funds

Sources of Funds


Obtain funds from Waqf and other sources (waqf
certificates, qard hasan deposits, etc.)
Use of funds (Mode of Financing)



Qard (loan at service charges)
Sale based and hiring modes (murabahah, salam,
ijarah)
Profit-sharing modes (Musharakah and
mudarabah)
38
W-MFI: Typical Balance Sheet
Assets
Liabilities
Cash (C)
Assets (A)
Savings Deposits (Ds)
Qard hasan Deposits (Dq)
Fixed income assets (F)
Waqf Certificates (S)
Microfinancing (M)
Takaful reserves (T)
Qard,
investments(murabahah, Profit equalizing reserves
(P)
ijarah, salam, istisna,
mudarabah,
Reserves/Econ Cap. (V)
musharakah)
Capital-Waqf (W)
39
Special features of W-MFI

Liability


Waqf—the corpus (endowment) has to be intact
Savings deposits — mudarabah contracts


Loss of lower return can lead to withdrawal risks
Assets

Allocation of assets into fixed income and
microfinancing activities
40
WMFI – Nature of waqf and
investment options

Waqf—the requirement of keeping the corpus
intact


Simplest-option—Invest the waqf endowment in
some safe fixed-income asset and use the returns
for MF operations
The scope of MF will be limited
41
Example
Waqf of $10 million, rate of return 5%, financing
$100 per beneficiary
(Grameen Bank 5.5 million beneficiaries given $5 billion)
Assumption
No. of beneficiaries
Use waqf returns only
5,000
Use 90% of the
endowment
90,000
42
Allocation of Assets

Risk and returns depend on allocation funds
into different assets




Fixed income (FI) assets—low-return low-risk
assets
Microfinancing—higher returns with higher risks
Invest in FI assets so that returns can cover
expected losses from microfinancing
In addition, build various reserves to cover
various risks
43
Risk-reducing reserves

Takaful reserves



Profit-equalizing reserves



Contributed by beneficiaries
Used in case of default due to unexpected reasons
Contributed by depositors
Used to maintain competitive returns
Economic capital reserves


Contributed from the surplus of MFI (no dividend
distribution)
Used in case of negative shock
44
Other funding sources

Funds from Zakah and other charities

Funds from waqf given for investment purposes
and zakah funds for consumption purposes
45
W-MFI & Sustainability

Mitigating Credit Risk (CR)


Solving Moral Hazard (MH) Problem


CR mitigated by social collateral (group-based lending)
As asset/good given instead of Cash, chances of diversion
and default decreases
Economic Viability


High administrative costs
Low finance costs
 Being charities there are no finance charges
These specialized institutions resolve CR and MH
problems and to lesser extent the viability problem
46
Sustainability-Relative Status
Credit
Risk
No
Moral
Hazard
Yes
Economic
Viability
Yes
Islamic MFIs
No
No
Yes
Islamic Banks
No
No
No
W-MFI
No
No
Somewhat
Conventional
MFIs
47
Conclusion




There are strong economic reasons for establishing
Islamic alternatives to poverty-focused
microfinancing.
Financing should adopt operational mechanisms of
MFIs (as they suit these clients)
Financing MSEs by IBs is most efficient (cost
effective)—given the social responsibility and
excess liquidity in IBs, financing MSEs should be
undertaken
Traditional institutions of waqf, zakat, and qard
hassan are important means of financing MSEs
during contemporary times—should be integrated
with microfinancing
48
THANK YOU!
49