Zero Interest Microfinance


Addressing Challenges in Malaysia and Indonesia’s Islamic Micro-Bank Lending and Islamic Microfinance Products

By Norma Saad

IMFI2Students at Bogor Agricultural University’s Department of Islamic Economics in Indonesia had organized the 11th Shariah Economics Symposium on September 10-12. I was invited by the students to take part in a special session on Islamic Microfinance, of which my focus was on “Shariah Micro-Banking Development: Challenges and Initiatives.” My talk examines the issues and challenges faced by Islamic micro-banking and microfinance institutions. They include:

  • bankers’ perception of creditworthiness of microfinance clients;
  • over-reliance on debt based financing (instead of equity based with risk sharing);
  • risk in adopting mudarabah model (i.e., both partners shared profits in a prearranged proportion but total loss is borne by the bank);
  • and Shariah compliance of Islamic microfinance products and services (i.e., interest-free and free of unmitigated risk).

In this blog, I will not only address the above issues, but will also provide some background in order to facilitate the understanding of Islamic finance.

First, Islamic Banks in Malaysia in general tend to regard micro-entrepreneurs and petty traders as “E-rated” (i.e., lowest quality collateral) clients and considered them as not creditworthy. Even though micro-entrepreneurs and petty traders are recognized to have the potential to substantially contribute to the Malaysia’s employment and GDP. In addition, for Islamic finance in Malaysia to achieve the next wave of growth and compete with conventional banks, it would seemingly need to reach the critical mass, especially the microfinance sector.


In fact, evidence from past studies shows microfinance clients across the industry have excellent track record for repayment and are able to develop micro-businesses. For example, in the case of Amanah Ikhtiar Malaysia, the largest Islamic microfinance institution in Malaysia, clients’ repayment rate is 95 percent and clients’ business activities have generated high monthly incomes.

On the issue of relying heavily on debt-based financing, a colleague and I conducted a survey analysis in 2009 and found that out of 8 mainstream financial banks in Malaysia that offer microfinance services, only three banks offers Islamic micro-banking products, whereas the rest of the banks offer traditional banking products. The survey also shows that there is lack of product innovation and greater reliance on debt financing using the concept of bai al-inah (i.e., sale and buy-back agreement) for micro-financing schemes in Malaysia.

Recent figure shows a slight increase, with five banks offering Islamic microfinance services. Of the five banks that offer Islamic microfinance products — Alliance Bank, CIMB, Maybank, Bank Muamalat and Bank Rakyat – the concept of bai al-inah still continues to be applied. Only Maybank is using the concept of musharaka mutanaqisah (diminishing equity partnership) financing in addition to products based on bai al-inah and murabaha (cost-plus sale financing).

For those who are not familiar with Islamic finance, the provision of equity based financing is highly advocated because it fulfills Shariah (Islamic) perspectives of ethical and social responsibility practices. However, in practice, Islamic banks and Islamic microfinance institutions (IMFIs) often draw questions of morality. This is because the use of sale and buy back, mark-up and cost-plus sale methods of which might meet the legal requirement but are believed to be in contrast to the spirit of Shariah principles. That is, many of the mentioned methods basically ensure a predetermined profit to Islamic finance institutions without actually sharing any real risk. As such, they are not in accordance with the objectives of Shariah.

Importantly, mudarabah – one of participatory financing or profit-loss sharing concepts that could facilitate Islamic socio-economic development such as social justice, economic growth, and solidarity – has been underdeveloped and crowded out. To be sure, mudarabah concept is not popular with IMFIs and not necessary with clients. The reasons include:

  • adverse selection where IMFI may choose customers that should not be chosen for the project and leaving out those who are capable to carry out the project;
  • moral hazard where there is a tendency for customers to use the funds for unproductive purposes other than its intended purpose;
  • agency problems in partnership where customers can hide important information in a business such as revenue and profit; and
  • ethical issues such as trust, honesty, and transparency on the part of the microfinance clients to disclose business information to IMFI.

Notwithstanding, the nature of Islamic finance institutions is to exert persistent and continuous efforts to improve and to achieve satisfactory results for society, shareholders, and clients. Here, Islamic scholars and researchers could further the management skills of university graduates who later could renovate Islamic finance institutions into a vibrant business partner that contribute positively to joint-venture with clients.

Moreover, there is also space for collaboration between Islamic scholars and non-Muslim scholars, particularly shared goals of social justice and humanistic development. In fact, this is where my collaboration with ZiMBank has its starts. Colleagues of mine and members of ZiMBank are working to promote ethical and zero interest microfinance (ZIF). This includes the effort to develop a more pristine environment of zero interest for IMFIs.


With regard to the issue of Shariah compliance of Islamic microfinance products and services, there indeed have been considerable innovative developments, particularly in Indonesia. At the same time, however, there should be more institutional mechanisms to assess these new products and services.

For example, a PhD thesis written by Mursalin Manggangka (2015) at the International Islamic University Malaysia on selected BMTs (Baitul Maal wat Tamwil or cooperatives engaged in Islamic finance) in Indonesia found several Shariah issues. These include using two concepts of mudarabah in one contract, which is not allowed in Islam since it raises issue of uncertainty (gharar) in a contract. In addition, Manggangka also found problematic application of the real mudarabah contract and the concept of iwad (compensation). For example, the selected BMTs would request customers to return the entire capital given in the case of losses, even though the losses or risks are not because of the negligence of the entrepreneurs (ashab al-amal).

Based on the above issues and challenges, the followings are recommended to policy makers:

  • NGO microfinance institutions and government agencies responsible for socio-economic development of society need to educate and advocate mainstream financial institutions that microfinance clients are creditworthy and in which micro-banking products should be developed.
  • There is a need to diversify Shariah microfinance products and when appropriate should seek exchange of knowledge and ideas across the microfinance industry in promoting ethical microfinance and risk sharing joint venture.
  • The IMFIs should carefully review the profiles of prospective customers before offering partnership-based products.
  • IMFIs need to improve and strengthen monitoring mechanisms to develop new skills in the area of partnership (​​al-Shirkat). 
  • IMFIs should deal with the issue of trust and honesty by incorporating religion and ethics in the training modules.
  • There should be stricter monitoring and supervision from the government to ensure Shariah compliancy of Islamic microfinance products.

Detecting When Microlending Shifts to “Microloan-sharking”?

By Long Le

How do we detect when microfinance institutions (MFIs) experience mission drift?

In general, MFIs have dual missions: 1) being financially sustainable; and 2) providing loans to low-income borrowers. Because of these above dual missions, MFIs have become vivid demonstration of the fundamental belief within the field of social entrepreneurship. That is, private value and social value can be complementary rather than contradictory. However, mission drift is said to occur when MFIs deviate from its social mission in order to achieve financial sustainability.

In a comprehensive research based on 379 MFIs in 74 countries spanning from 1998-2008, Roy Mersland and R. Øystein Strøm found that mission drift is correlated when the MFI seeks higher profitability as well as when the MFI’s average cost becomes higher. But, overall, the research finds that its measure of average loan size, which is thought to be a proxy to mission drift, has not increased across the industry as a whole; nor is there a tendency towards more individual loans or a higher proportion of lending to urban costumers. For Mersland and Strøm, the focus should be on the reduction costs per client (rather than on criticisms of MFIs’ commercialization), and that better management may provide MFIs with good economic reasons to stay in the poorer customer segment.

Notwithstanding, the “consensus” of whenever possible microfinance should be done in a commercially based and financially sustainable manner has come under heavy fire. That is, the global average interest rate since 2008 have stopped declining. The global average in interest rates/service fees for microfinance in 2010 has surged to about 37 percent, and in countries such as Mexico and Nigeria the average was above 70 percent due mostly to the absence of regulations.

In particular, practitioners of the more socially oriented microfinance, such as Grameen Bank’s Founder Muhammad Yunus, are very concerned. That the microfinance industry, with over $60 billion in assets, has unquestionably outgrown its socially oriented roots with focus on social impact maximization. According to Yunus, the ideal “spread” between the cost of the fund and the lending rate should be between 10 to 15 percent. For instance, Grameen Bank charges 20 percent to its borrowers – 10 percent is the cost to fund and the other 10 percent is to cover operational costs and contribute to profit.


Still, no one can claim the “soul” of microfinance and the above debate appears to be continuing on. In fact, on the one hand, recent indicators show that since 2011 profit on interest rates, returns to shareholders’ equity, and operating expenses have fallen, but too many clients of too many commercialized microfinance institutions have taken on too much debt on the other.

For ZiMBank, our concern relating to mission drift is the ability to assess individual MFIs, including our own. In exploring, we are utilizing Ana Maria Peredo and Murdith McLean’s framework to place commercial exchange along the continuum of social goals. Doing so, we hope to detect when a microfinance institution moves from one end to the other on this continuum. By implication, it also leads to an important question: at one point does a MFI’s social value and private value become contradictory or when it shifts from microlending to “microloan-sharking”? However, this framework also leaves open the potential for MFIs who have high interest rates — particularly those from Central America and Sub-Saharan Africa — to efficiently reduce their operational costs and implement thorough assessments to minimize their clients’ likelihood of default and over indebtedness.

The below table attempts to identify a continuum of possibilities. The continuum ranges from microfinance institutions that see social goals as exclusive in which commercial exchange is to directly support its social mission to those that see social goals as one of the objectives but subordinate to other goals where commercial exchange is to primarily generate profits. In this table, we also list an actual microfinance institution for each point on the continuum, not as a matter of fact but as an exploration to discuss implications for each point on the continuum.


For us, ZiMBank is open to commercial exchanges, specifically those exchanges in which profits, in part, go to social investors who for various reasons expect a lender return. For us, we would cap a lender return of about 6 percent. As a microfinance that is founded and managed by a professor and students, our zero interest loans can be sustainable because we don’t have administrative overhead costs; in addition, we collaborate with seasoned operative partners. However, we do need seed capital to develop more high-end socially responsible products for our ZiMBusiness in order to generate revenues for zero interest loans.


In general, the more effective and efficient that ZiMBank is at capitalizing on social investment, the sooner we can return to our original belief. Specifically, any profits from commercial exchange would go directly to the operation of our social enterprise, so that we are able to uphold and expand our zero interest loans to poor working individuals — both abroad and at home.