By Norma Saad
Students 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.