Sharia-Compliant Microfinance: 5 Takeaways from CGAP's Research

It has been just over six years since CGAP published its first look at the then-nascent Islamic microfinance sector. Back then, calling it a sector was a stretch: In fact, our surveys showed that providers of sharia-compliant products only reached about 380,000 clients - or one-half of one percent of the total microfinance market.

Although client numbers have roughly quadrupled in the last half-decade, they still represent the proverbial drop in the bucket of potential clients. Measuring that potential market is still a best-guess exercise, of course, but it is safe to say that some 650 million Muslims hover at or below the poverty line today. Although we still have a lot to learn about how many of them would opt for sharia-compliant products, we are also learning a lot about what works - and what doesn't - for those who have.

Here's a look at five takeaways from CGAP's most recent research on the subject, "Understanding the Costs and Sustainability of Sharia-Compliant Microfinance Products", which traces the evolution of two products offered by two different institutions - one a bank, the other a non-profit:

Person sifting grain.
Source: Wasil Foundation: Islamic Financing to Farmers

1. Some "Islamic" products are tough to scale

Both Algeria's Al Baraka Bank and Pakistan's nonprofit Wasil Foundation have clear Islamic mandates, which is to say they prioritize sharia-compliance over minimizing costs. They are motivated to offer sharia-compliant products because of their belief that human development trumps short-term profits. That's supposed to be a hallmark of all microfinance, of course, but truly sharia-compliant products actually split the risk between clients and financial service providers. In Wasil's case, for example, their salam product - a kind of "futures" purchase of anticipated crop yields - is designed to help smallholder farmers benefit from government-set crop prices. No matter how high those prices get, Wasil caps its profit at 30%, preferring to pass the windfall to its client farmers. After significant upfront investment in building its knowledge and staff on the wheat and rice markets, the two crops Wasil finances, the operating budget is split between 22% fixed and 78% variable. This means Wasil can benefit from economies of scale as it expands its operation beyond its current 4,000 clients, but significant expansion will require ongoing investment in storage facilities, land and other significant assets.  Al Baraka’s diminishing musharaka product, on the other hand, has nearly the opposite cost breakdown, with about 76 percent of its costs as fixed and 24% variable. This means it’s much more difficult to scale and any expansion requires significant investment in building its human capacity and relationships with the communities it serves.  

2. Comparing Islamic products to conventional microfinance doesn’t always work

As the new CGAP paper makes clear, comparing sharia-compliant products with conventional loans is misleading: "Other than murabaha or qard-hassan, which are debt instruments, most other sharia-compliant products are investment instruments." So if non-performing loans, for example, can give us a good read on a conventional microfinance institution's overall health, the same measure doesn't apply to at least a chunk of an Islamic provider's portfolio. We need to compare, apple-to-apple, products within the sharia-compliant ecosystem. Sizing up Al Baraka's musharaka product, for example, against a conventional SME loan only goes so far. Because of its emphasis on risk-sharing, musharaka is more like an equity investment product. As a nascent industry, we do not yet have benchmarks or even data on performance so it is hard to know if the existing institutions offering sharia-compliant products are as efficient as they could be or are achieving sustainability in a reasonable timeframe. The industry needs to build up the data infrastructure, as we did for conventional microfinance, by selecting standard indicators, reporting on them and housing them in a data hub like the Mix Market.

3. Sustainability is possible, but it will take significant investment

CGAP’s research shows that sustainability is indeed within reach for institutions offering sharia-compliant products. Our case studies on Wasil and Al Baraka showed that both institutions can cover their operating costs, but significant up-front investments are needed. The biggest investment needed is a re-think of the business model used for conventional lending products. Other than murabaha, all other sharia-compliant products require a different business model that requires an institution to invest in training its staff and building up its knowledge in the sectors it aims to serve. For salam, the institution also needs to have access to significant infrastructure and contacts in the commodities sector it is financing. Making these kinds of investments is a serious decision for any institution, one that should not be entered into lightly.

4. We need more time to understand how these products are working - and who is using them

It's a familiar question for observers of Islamic microfinance: Given the choice, how many Muslims would pick a sharia-compliant product over a conventional one? At what point - if at all - would affordability and access matter more? At CGAP, we're working with our partners on better answering that question. Our answers will be more accurate as more and more people use products like Al Baraka's and Wasil's. That's when we'll be able to better gauge what kind of value clients are deriving from these products and, more to the point, how to better measure that value within an Islamic context.

5. In the meantime, Islamic financial service providers are here to stay

When we first started counting, we found 250 Islamic financial service providers to learn from and observe. Today, there are more than a thousand. That strikes us as much more than a passing fad. The reality is that sharia-compliant microfinance is here to stay, and the more we can do to better understand and develop what already exists, the more effective - and sustainable - future entrants will be. That's why CGAP is committed to continuing our research into this fast-evolving sector. If you're not already, start following our work and read our new paper on the topic. 



This Focus Note explores the operational costs associated with musharaka and salam products by delving into two case studies: Bank Al Baraka in Algeria and Wasil Foundation in Pakistan.

Islamic microfinance represents the confluence of two rapidly growing industries: microfinance and Islamic finance.

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