Islamic Microfinance is a new market in Islamic finance : Islamic banks provide financial assistance to people excluded from the banking system. Microfinance as the same aim. Islamic microfinance complies with principles of Islam and to involves in projects halal (allowed by sharia)
Microfinance is another candidate for the application of Islamic finance. Islamic finance promotes entrepreneurship and risk sharing, and its expansion to the poor could be an effective development tool, particularly for economic development of marginalised communities as well as poverty alleviation. The social benefits are obvious, since the poor currently are often exploited by lenders charging usurious rates.
Extract from article by Dr Umer Chapra in NEWHORIZON magazine published by the Institute of Islamic Banking and Insurance 1 January, 2009
Greater Justice in Human Society
One of the most important objectives of Islam is to realise greater justice in human society. According to the Quran, a society where there is no justice will ultimately head towards decline and destruction (Quran, 57:25). Justice requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur, and the other is that an equitable share of financial resources mobilised by financial institutions should become available to the poor to help eliminate poverty, expand employment and self-employment opportunities and, thus, help reduce inequalities of income and wealth.
First Condition of Justice
To fulfill the first condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic finance is ‘no risk, no gain’. This should help introduce greater discipline into the financial system by motivating financial institutions to assess the risks more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system, and go a long way in reducing excessive lending.
Islamic finance should, in its ideal form, help raise substantially the share of equity and Profit-Loss-Sharing (PLS) in businesses. Greater reliance on equity financing has supporters even in mainstream economics. Professor Kenneth Rogoff of Harvard University states that in an ideal world equity lending and direct investment would play a much bigger role.
Greater reliance on equity does not necessarily mean that debt financing is ruled out. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and PLS. Debt is, therefore, indispensable, but should not be promoted for nonessential and wasteful consumption and unproductive speculation.
For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales – and lease-based modes of financing (murabaha, ijara, salam, istisna and sukuk). The purpose is to enable an individual or firm to buy now the urgently needed real goods and services in conformity with his/her ability to make the payment later. It has, however, laid down a number of conditions, some of which are:
- The asset which is being sold or leased must be real, and not imaginary or notional.
- The seller or lessor must own and possess the goods being sold or leased.
- The transaction must be a genuine trade transaction with full intention of giving and taking delivery.
- The debt cannot be sold and thus the risk associated with it must be borne by the lender himself.
The first condition will help eliminate a large number of derivatives transactions which involve nothing more than gambling by third parties who aspire to claim compensation for losses which have been actually suffered only by the principal party and not by them.
Second Condition of Justice
The second condition will help ensure that the seller (or lessor) also shares a part of the risk to be able to get a share in the return. Once the seller (financier) acquires ownership and possession of the goods for sale or lease, he/she bears the risk. This condition also puts a constraint on short sales, thereby removing the possibility of a steep decline in asset prices during a downtown. The Shari’ah has, however, made an exception to this rule in the case of salam and istisna where the goods are not already available in the market and need to be produced or manufactured before delivery. Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion.
Third and Fourth Conditions of Justice
The third and the fourth conditions will not only motivate the creditor to be more cautious in evaluating the credit risk but also prevent an unnecessary explosion in the volume and value of transactions. This will prevent the debt from rising far above the size of the real economy and also release a substantial volume of financial resources for the real sector, thereby helping expand employment and self-employment opportunities and the production of need-fulfilling goods and services. The discipline that Islam wishes to introduce in the financial system may not, however, materialise unless governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability.
One may raise an objection here that all these conditions will perhaps end up shrinking the size of the economy by reducing the number and volume of transactions. This is not likely to happen because a number of the speculative and derivatives transactions are generally known to be zero-sum games and have rarely contributed positively to total real output. Hence a decline in them is also not likely to hurt the real economy.
While a restriction on such transactions will cut the commissions earned by the speculators during an artificially generated boom, it will help them avert losses and bankruptcy that become unavoidable during the decline and lead to a financial crisis.
The injection of a greater discipline into the financial system may tend to deprive the subprime borrowers from access to credit. Therefore, justice demands that some suitable innovation be introduced in the system to ensure that even small borrowers are also able to get adequate credit. Such borrowers are generally considered to be subprime and their inability to get credit will deprive them from realising their dream of owning their own homes and establishing their own microenterprises.
There is no doubt that a number of countries have established special institutions to grant credit to the poor and lower middle class entrepreneurs. Even though these have been extremely useful, there are two major problems that need to be resolved. One of these is the high cost of finance, ranging from 30 to 84 per cent in the interest-oriented microfinance system. This causes serious hardship to the borrowers in servicing their debt. No wonder the minister of finance for Bangladesh described microcredit interest rates in that country as extortionate in an address he delivered at a microcredit summit in Dhaka in 2004. It is, therefore, important that microcredit is provided to the very poor on a humane, interest-free basis (qard hasan). This may be possible if the microfinance system is integrated with zakat and waqf institutions. For those who can afford to bear the cost of microfinance, it would be better to popularise the Islamic modes of PLS and sales- and lease-based modes of finance, not only to avoid interest but also to prevent the misuse of credit for personal consumption.
Another problem faced by microfinance is that the resources at the disposal of microfinance institutions are inadequate. This problem may be difficult to solve unless the microfinance sector is scaled up by integrating it with the commercial banks. Commercial banks do not generally lend to small borrowers because of the higher risk and expense involved in such financing. It is, therefore, important to reduce their risk and expense. This may be done partly by a subsidy from zakat and waqf funds for those borrowers who are eligible for zakat.