Islamic microfinance represents the confluence of two rapidly growing industries: microfinance and Islamic finance. It has the potential to not only respond to unmet demand but also to combine the Islamic social principle of caring for the less fortunate with microfinance’s power to provide financial access to the poor. Unlocking this potential could be the key to providing financial access to millions of Muslim poor who currently reject microfinance products that do not comply with Islamic law or Sharia.
Islamic finance, sometimes called Sharia-compliant finance, differs from conventional finance in its adherence to certain fundamental economic principles agreed upon by Muslim jurists. A key principle is that money has no intrinsic worth and cannot by itself create value. Consequently, interest—the giving or taking of any fixed, pre-determined rate of return on financial transactions—is prohibited. In addition, Islamic finance requires that transaction risks be shared by all parties. Consequently, Sharia encourages wealth creation through trade and equity participation in business activities.
The global Islamic finance industry is booming, with growth in Sharia-compliant assets in the double digits since 2007. While these assets (estimated at US$1,086 billion in 2011) still only represent 1% of global financial markets, they have nonetheless been steadily increasing, even throughout the recent financial crisis.
Though not all Muslims demand Sharia-compliant financial services, an estimated 30% would prefer them if they were offered and an additional 30% refuse to access anything else (and therefore remain excluded from the formal financial sector).
In CGAP’s first survey on Islamic microfinance (2008), Islamic microfinance supply was found to be very limited in scale and highly concentrated in only a few countries (80% of the 380,000 clients of Islamic microfinance worldwide were located in Bangladesh, Indonesia, and Afghanistan). Moreover, at that time, Islamic microfinance did not exceed more than 0.5% of total microfinance outreach.
CGAP conducted a second survey on Islamic microfinance (2011) with Agence Française de Dévelopment (AFD) and found that 82% of Islamic microfinance clients reside in just three countries: Bangladesh (445,000 clients), Sudan (426,000 clients) and Indonesia (181,000 clients), which is home to the largest outstanding portfolio ($347 million). Customers using Sharia-compliant products still represent less than 1 percent of total microfinance outreach. A more concerted effort among stakeholders is needed to harness Islamic microfinance’s momentum to develop a more diverse market where more providers offer a broader array of products based on evidence related to customer needs and behaviors.
Nonetheless, more institutions are experimenting with Sharia-compliant microfinance than ever before. But product diversity remains a challenge. The most prevalent product is the Murabaha (cost-plus-markup sale contract), in which clients typically identify a specific working capital commodity they want to purchase, the MFI then buys this item, and resells it to the client while adding a “mark-up.” However, many argue that murabaha products do not reflect the risk-sharing principle central to Islamic finance. Microfinance institutions are thus challenged to create affordable risk-sharing products that are sustainable for the micro market.
In addition to sustainable product diversity, key challenges include convincing target customers that various products are authentically Sharia-compliant, and increasing the capacity of Shariah-compliant financial service providers.
- Islamic Banking and Finance in North Africa (African Development Bank)
- Islamic Microfinance in Indonesia: The Challenge of Institutional Diversity, Regulation and Supervision (Harvard Law School)
- Islamic Microfinance Theory, Policy, and Practice (Islamic Relief Worldwide)
- Islamic Republic of Pakistan: Improving Access to Financial Services- Islamic Finance Component (Asian Development Bank)
- Trends in Sharia-Compliant Financial Inclusion (CGAP)