Research & Analysis
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Costs and Sustainability of Sharia-Compliant Microfinance

While Islamic finance is a growing industry with more than 1,000 Islamic finance institutions and combined assets in excess of $1.3 trillion (Reuters 2013), the development of sharia-compliant microfinance has been much less prolific. Since 2006, the number of service providers offering sharia-compliant microfinance products has doubled, albeit from a very small base, and the number of clients using such products has quadrupled (El-Zoghbi and Tarazi 2013). Nonetheless, customers of sharia-compliant microfinance products represent less than 1 percent of the number of clients served by conventional microfinance.The high costs of providing sharia-compliant products, particularly profit- and loss-sharing products such as musharaka or mudaraba, are often blamed for the lack of product diversity and customer take-up. But what are the costs of offering such products, and can they be sustainably offered by financial service providers (FSPs)? Are the underlying cost structures and business models required to offer these products prohibiting the rise of a sustainable sharia-compliant microfinance sector?

This Focus Note explores these questions by delving into two case studies of products (musharaka and salam) of two different FSPs in different markets (Bank Al Baraka in Algeria and Wasil Foundation in Pakistan). The case studies look at the operational costs associated with these two products and project growth to assess the scale at which these types of products can be sustainable. While these cases represent very nascent initiatives to roll out sharia-compliant products with relatively little outreach to date, they are nonetheless among the few globally that have been able to do so at all.

The two innovations presented here—from Bank Al Baraka and Wasil Foundation—offer a glimpse into how other FSPs might diversify their sharia-compliant portfolio and thus reach more clients. After examining these case studies, this paper offers preliminary takeaways on how service providers might incorporate some of the lessons of these FSPs to better serve their own markets.

While there is a variety of sharia-compliant products on offer today, the most prevalent is murabaha, which is essentially a cost-plus-fixed-fee transaction. This product most closely mimics conventional microfinance and has thus far been the most widely adapted by FSPs aiming to serve poor observant Muslims. However, in some markets, individuals may not perceive murabaha to be “authentic,” as they question whether the pricing model is little more than disguised interest. Because this type of product is already prevalent and operational structures and costs are quite similar to conventional microfinance, we have not focused our research on it.

The second most prevalent product is qard-hassan. Because of its characteristics of a benevolent loan, qardhassan relies on a subsidy or donation of some kind, and thus by definition is not commercially viable. Some FSPs may choose to offer these types of products, but they would essentially do so from a socially responsible line of activity rather than their commercial side.

CGAP research on the supply of sharia-compliant microfinance shows that there is very limited outreach on profit-and-loss (P&L) type products such as musharaka and mudaraba, which are available to fewer than 9,500 clients (El-Zoghbi and Tarazi 2013). Yet P&L type contracts are the Islamic financial contracts most encouraged by sharia scholars as best reflecting sharia principles. This paper focuses on diminishing musharaka, a P&L product whereby the FSP and client jointly own a business and the FSP gradually transfers complete ownership to the client based on a predetermined schedule and P&L sharing arrangement, subject to actual business performance.

Outreach is also low for trade-based products, such as salam, which is available to fewer than 25,000 clients (El-Zoghbi and Tarazi 2013). Salam contracts reflect Islamic principles because they are investing in a productive activity, and the funder is taking a risk in the business. Salam products are particularly relevant for the rural poor, one of the largest segments of the unserved. Salam is essentially a sales contract with deferred delivery of goods often used in agriculture as advance payment against future delivery of a crop yield, allowing farmers to finance the advance purchase of inputs to be used in crop production. The type of crop, amount, and delivery date of the expected crop yield is agreed to in advance.