Can Islamic Banking Offer Some Lessons to Islamic Microfinance?
Financial inclusion is a fundamental tenet of Islamic banking and finance. By striving to provide economic opportunities to the financially under-served, Islamic banking shares the same objective and spirit as Islamic microfinance.
The similarities do not end there. Just as Islamic banking and finance faced unique challenges while integrating with the international financial markets, Islamic microfinance appears to be experiencing similar challenges within the global microfinance market. For this reason, the journey of Islamic banking and finance may offer some lessons to Islamic microfinance.
Lack of Products
Islamic microfinance lacks cash-financing products. This drives potential Islamic microfinance clients to conventional providers. Islamic microfinance providers must, therefore, look for ways to offer cash-based products. Although musharaka and mudaraba—equity-based products favored under Islamic law—do offer the financial equivalent of cash-based products, pricing and managing the risks associated with them in a sustainable, profitable manner remains a challenge. These challenges have restricted the growth of musharaka and mudaraba.
Another alternative for Islamic microfinance providers competing with conventional microfinance institutions is to offer qard hasan, a benevolent loan where no increase on the amount lent can be charged (except for the actual administrative costs). The absence of enforceable rules for recovering the principal and the administrative costs have hindered development of a ready market for qard hasan.
Barring some government schemes (such as in Sudan and Pakistan), the supply of qard hasan mainly relies on zakah, or almsgiving, and other charitable contributions. As a result, there is lack of certainty on the availability of qard hasan.
The Islamic banks also faced the lack of debt-based products initially but quickly innovated asset-based financing products, where the banks would purchase the asset desired by their customers from the market and then sell these assets against a pre-agreed revenue stream. As the price represents cost-plus-profit, the Islamic banks are able to earn some margin. The product is known as “murabaha with deferred sale price” and, with its other variations, is the most popular product offered by the Islamic banks. Various forms of ijara (leasing) contracts also achieve similar economic outcome.
Islamic microfinance institutions seem to have followed suit. As CGAP identifies in its March 2013 Focus Note, Trends in Sharia-Compliant Financial Inclusion, murabaha is already the most used product by Islamic microfinance institutions.
Interestingly, Islamic banks do not generally use qard hasan for commercial financing. So how have Islamic banks managed to receive and provide cash financing in a sustainable way?
Islamic banks developed another product based on murabaha involving two transactions: first, a regular murabaha transaction to generate a fixed income stream from the sale of permitted commodities; and second, while acting as an agent of their customers, to on-sell the commodities to a third party for a spot price—thus generating cash for their customers’ immediate use. This product is known as commodity murabaha, reverse-murabaha, or tawarruq and is by far the most popular liquidity management tool among the Islamic banks.
The transaction costs for doing a commodity murabaha are so high that only sizable transactions can justify incurring them. Therefore, the question is how Islamic microfinance institutions can integrate commodity murabaha into their product line.
Envisioning the Waqf
Let’s take a look at zakah, a fixed percentage of income that every able Muslim is required to contribute toward a specified range of charitable and economic development activities. With estimates for the annual pool of Islamic charity worldwide (including zakah) ranging between $37.5 billion and $94 billion - according to Sohaib Umar in a June 2012 article in The Review, published by the Central Bank of Bahrain, this money - if organized institutionally, could become a significant funding source.
That’s why Umar and others have proposed a charitable endowment for the preservation and more efficient utilization of Islamic charitable funds. Although some Sharia scholars insist that the obligatory zakat can only be given directly to those in need and not through a third party, others, such as Muhammad Anas Zarka and Dr. Mohammed El-Gary have proposed that the funds be invested in a waqf, or an Islamic trust, and be used for microfinance, including by way of qard hasan. Once functional, a zakah-based waqf can provide a ready market for qard hasan.
For the zakah-based waqf to be scalable, it needs to be established across various countries, a move that would require political will and coordination. As there are some zakah organizations that operate across some Muslim countries, the success of the zakah-based waqf in various countries would appear plausible. Here again, the experience of Islamic banking and finance can offer some guidance, as various Islamic finance standard-setting entities are recognized in various Muslim countries and coordinate on common issues.
--------Dr. Ibrahim is a Vice President at Al Baraka Banking Group, Bahrain. He is also an Adjunct Professor of Law at Georgetown University and a World Economic Forum Young Global Leader.