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Thursday, 23 August 2007

Towards Islamic Microfinance: A Primer

What are the basic principles of Islamic finance? Islamic finance, more precisely termed “Shariah-compliant” finance, refers to financial services conducted in accordance with Islamic legal principles. These include: Conventional interest is not allowed, on loans or savings, as a fixed return without sharing any risk, is considered unjust. Muslims cannot profit from activities considered immoral. For example, investing in casinos, pornography, or weapons of mass destruction is not allowed. Muslims are not allowed to sell what they do not own – therefore “short selling” is impermissible. In sales contracts, the product or service that is bought or sold, must be clear to both parties. Islamic finance, like the Shariah generally, emphasizes the process and structure of human interaction as well as the moral impact on society. It shares a great deal with the fields of “ethical investment” and “corporate social responsibility,” both of which are growing in popularity worldwide. People increasingly realize how important it is to be mindful of how their wealth is used and the sources of their returns. More fundamentally, Islam seeks to alleviate poverty and circulate wealth in the economy. One of the faith’s “five pillars” is Zakah, or almsgiving. Unlike a simple income tax, Zakah is calculated based on assets and therefore re-distributes wealth within the community. As Islamic scholars point out, even the rules of Zakah promote more active forms of investment and business activity – wealth from passive activities is subject to greater Zakah. Muslims are taught to have sympathy with the poor and recognize that the poor have rights over them. How do these principles apply to the development of the Islamic microfinance sector?Microfinance is an important next step for the Islamic finance industry to embrace the broad Muslim population, much of which is poor. Islamic finance stresses the importance of financing real, tangible economic activity (as opposed to financial speculation and other products which are further removed from reality). The basic moral vision, as I understand it, is to mobilize savings towards genuine economic activity which brings benefit to everyone. The Shariah promotes savings and investment, rather than excessive consumer debt. The focus on real assets fits very well with the goals of microfinance, as Islamic bankers like to fund productive assets like equipment or other capital goods. If the underlying asset has durable value and the business is viable, the current income of the business owner is less of a concern. Islamic finance integrates well with certain common microfinance practices: Islamic bankers seek to finance business activity which will lead to the economic empowerment of the poor, rather than merely lend to the poor for consumption.Can you describe several typical Islamic banking structures? Murabaha: One of the simplest and most commonly used instruments, Murabaha is a cost-plus sale structure in which a party buys something and sells it to someone else for a profit. Unlike conventional finance it links lending to the asset and involves ownership risk on the asset. Ijara: Another common structure, Ijara refers to leasing. The bank buys an asset and leases it out to clients under an installment plan. Mudaraba: The principle of Mudaraba (investment partnership) is very important as well. In this structure, investors provide capital to a manager who contributes his or her time and efforts in exchange for a portion of the return. Musharaka: The concept of Musharaka (profit and loss sharing partnership) is viewed by many as the purest form of finance – in this structure all parties share the underlying risk. On the investment side, products include equity investment, Murabaha-based instruments, and a structure called Sukuk which acts similarly to conventional bonds but involves the financing of an identifiable set of assets. What products are most relevant to microfinance? In the microfinance sector, there is huge potential for the use of Ijara (leasing) and Murabaha instruments to finance productive assets. The importance of savings should also be emphasized. Because many Muslims only have access to interest-based savings accounts which violate their principles, there has been less incentive for them to have bank accounts at all. Having Shariah-compliant savings accounts will help mobilize deposits and instill a culture of savings as well as contribute to economic development. There are two main types of Shariah-compliant savings accounts: Mudaraba-based accounts, wherein the customer deposits money in the bank and shares in the profits and risks of the bank’s use of that money. This type of account is the most liquid, but it is not insured. Murabaha-based term deposit accounts, wherein the customer deposits money in the bank and the bank conducts Murabaha transactions with the money, often on 30-day or 90-day terms. This type of account is much safer, but it is not as liquid as Mudaraba-based accounts. However, being less liquid could also be conceived as an advantage, encouraging clients to hold on to their assets. This may be the most appropriate tool to use in mobilizing savings with microfinance clients. How does Islamic finance view issues of gender?There is a misconception that Islamic finance is somehow disadvantageous or inaccessible to women. Nothing could be further from the truth. Islam recognized women’s independent property rights centuries before other legal systems. Women are encouraged to save, invest, and improve their condition just like men and are also able to access the products described above.How is the Islamic finance industry developing?Islamic finance has become popular in many countries, especially in the Arab world, with over 300 institutions offering Islamic banking. Since 2005, more than half of total banking assets in Saudi Arabia have been Shariah-compliant. Other Gulf countries such as the United Arab Emirates, Qatar and Kuwait also have Islamic assets projected to grow to about one-third of all banking assets soon. Malaysia is another important market for Islamic finance, and regulators are introducing laws to facilitate growth of the industry. In addition, HSBC Amanah introduced Islamic instruments in the UK and the US and other firms offer Islamic finance in a large number of Muslim-minority countries.Many Muslims worldwide prefer Shariah-compliant instruments when available because they feel a conflict between their belief systems and the conventional banking system. These people may today use conventional banking products reluctantly or not at all. How can Islamic finance and microfinance institutions collaborate?Microfinance is a fantastic opportunity for Islamic finance to reflect its core values and mission. At the same time, Shariah compliance can help microfinance institutions reach a large number of Muslims who prefer Shariah-compliant forms of financial activity. One possibility is to coordinate as donors, since Islamic financial institutions see poverty alleviation as central to corporate social responsibility. Collaborative partnerships in which Islamic bankers provide product structuring expertise and advice is another means of collaboration. In the future, perhaps Islamic bankers could work on securitization of Shariah-compliant microfinance portfolios as we are starting to see in conventional microfinance. What are some challenges Islamic microfinance faces as it continues to develop? First, there is a strong need to build bridges between the religious establishment and the microfinance sector. A common misconception is that the aims of the two are incompatible. The challenge is to recognize the common ground in human development to bring these two sectors together. Another challenge is to address the skepticism among Muslim consumers, especially in South Asia, about the Shariah authenticity of products. Finally, the Islamic finance industry needs to adapt its product set and operating models – not fundamentally, since the basic structures are already there – to meet the needs of the poor, the target clients of microfinance. -(by Rehman A, TMG)

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