Introduction
Pakistan has a separate legal framework to govern the microfinance activities of the Microfinance Banks (MFBs).
The MFBs are licensed and regulated by State Bank of Pakistan. Considering the separate needs and dynamics of microfinance, SBP has in place a separate regulatory and supervisory framework for MFBs. Since its creation, the policy framework has seen various improvements on the basis of feedback of key stakeholders and assessment of the evolving needs and conditions of the sector. To promote the mainstreaming of microfinance into overall financial system, SBP encourages creation of new MFBs and transformation of existing operationally sustainable MFIs into MFBs. The presence of a large potential market and availability of an enabling policy environment offer the opportunities for both social and commercial investors to explore this segment of the financial market.
The growth and sustainability continue to be the two guiding objectives for the development of the sector. SBP is fully cognizant of the fact that pursuing these two objectives concurrently is a challenging task. This requires vision of sponsors / management, deep understanding of the target market, viable business model, appropriate organizational structure, and management capabilities to adopt innovation in products & delivery channels. All the prospective investors need to gain deep understanding of the local microfinance banking industry vis-à-vis its performance & potential, and challenges & incentives. Moreover, the promoters of prospective MFBs should also dedicate adequate time and energies to explore the learning and innovations that are occurring rapidly across the globe.
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1.1 Definition of Microfinance
A type of banking service that is provided to unemployed or low-income individuals or groups who would otherwise have no other means of gaining financial services.
Services for poor and low-income clients offered by different types of service providers. In practice, the term is often used more narrowly to refer to loans and other services from providers that Microfinance” is often defined as financial identify themselves as “microfinance institutions” (MFIs).
These institutions commonly tend to use new methods developed over the last 30 years to deliver very small loans to unsalaried borrowers, taking little or no collateral. These methods include group lending and liability, pre-loan savings requirements, gradually increasing loan sizes, and an implicit guarantee of ready access to future loans if present loans are repaid fully and promptly.
More broadly, microfinance refers to a movement that envisions a world in which low-income households have permanent access to a range of high quality and affordable financial services offered by a range of retail providers to finance income-producing activities, build assets, stabilize consumption, and protect against risks. These services include savings, credit, insurance, remittances, and payments, and others.
1.2 Goal of Microfinance
Goal of microfinance is to give low income people an opportunity to become self-sufficient by providing a means of saving money, borrowing money and insurance.
1.3 Basic Principles of Microfinance
Microfinance is constituted by a range of financial services for people who are traditionally considered non bankable, mainly because they lack the guarantees that can protect a financial institution against a loss risk.
The true revolution of microfinance is that this tool gives a chance to people who were denied the access to the financial market opens new perspectives and empowers people who can finally carry out their own projects and ideas with their own resources, and escape assistance, subsidies and dependence. Microfinance experiences all around the world have now definitely proved that the poor demand a wide range of financial services, are willing to bear the expenses related to them and are absolutely bankable.
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The target group of microfinance is not constituted by the poorest of the poor, who need other interventions such as food and health security, but those poor who live at the border of the so called poverty line. Those who could reach more easily a decent quality of life and who have entrepreneurial ideas but lack access to formal finance.
Beginning in the 1950s, development projects began to introduce subsidized credit programs targeted at specific communities. These subsidized schemes were rarely successful. Rural development banks suffered massive erosion of their capital base due to subsidized lending rates and poor repayment discipline and the funds did not always reach the poor, often ending up concentrated in the hands of better-off farmers. In the 1970s, experimental programs in Bangladesh, Brazil, and a few other countries extended tiny loans to groups of poor women to investment in micro-businesses. This type of microenterprise credit was based on solidarity group lending in which every member of a group guaranteed the repayment of all members. Through the 1980s and 1990s, microcredit programs throughout the world improved upon the original methodologies and bucked conventional wisdom about financing the poor. First, it showed that poor people, especially women, had excellent repayment rates among the better programs, rates that were better than the formal financial sectors of most developing countries. Second, the poor were willing and able to pay interest rates that allowed microfinance institutions (MFIs) to cover their costs.
These two features—high repayment and cost-recovery interest rates—permitted some MFIs to achieve long-term sustainability and reach large numbers of clients. In fact, the promise of microfinance as a strategy that combines massive outreach, far-reaching impact, and financial sustainability makes it unique among development interventions.
Microfinance is considered a very effective development tool: for this reason, year 2005 has been declared by the General Secretary of the United Nations “International Year of Microcredit”. Microfinance is also a very flexible tool that can be adapted in every environment, based on the local needs and economic and financial situation. For example, in Asia group micro lending proved to be very effective, while in Egypt or in Brazil beneficiaries prefer individual lending. One more example: MFIs (Microfinance Institutions) and NGOs (Non Governmental Organizations) in India mostly rely on savings collection to support their institution and become sustainable while in Egypt they are forbidden by law to collect savings. Microfinance can be effective both in the South of the world and in Western countries, equally characterized by financial and social exclusion.
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Following this logic, microfinance can easily be adapted to certain cultural environments, such as countries characterized by a majority of Muslims that follow the Islamic law. Moreover, the similarities in the principles of the two make microfinance easier to expand in those countries, giving life to the new hybrid reality of Islamic microfinance.
A few studies have been carried out on the subject and experience on the field is still relatively small, but it proves to have huge potentialities both to fight against poverty financial and social exclusion and to enlarge and enrich the basin of clients of financial institutions in developing countries with an Islamic cultural substratum (Segrado, 2005).
1.4 Islamic Microfinance
Islamic, more correctly termed ‘Shariah-compliant’, microfinance is the provision of financial services for low-income populations in which the services provided conform to Islamic financing principles. In many respects, Islamic finance is simply ethical finance.
Islam sets out some broad principles that govern commercial transactions in general and the provision of finance in particular. One of the most important financing principles is that money is not an earning asset in and of itself. This means that interest is prohibited under Islamic law. Many Muslims therefore refrain from using interest based microfinance services for fear of breaching their religious beliefs. Islamic microfinance programmes cannot therefore imitate conventional microfinance programmes and are obliged to provide finance without charging interest. However, this does not mean that capital is free of charge, that it should be made available without any cost, or that there should be no return on the funds provided. Rather, a return on capital is allowed, provided that the capital participates in the productive process and is exposed to business risk.
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In addition to not charging interest, there are other principles that must be followed in Islamic microfinance programmes. Firstly, transactions should be directly or indirectly linked to tangible economic activity and not financial speculation and excessive uncertainty. Secondly, the product bought or sold must be clear to both parties and only socially productive activities that are not exploitative and socially or morally harmful should be funded. For example, funding gambling or the sale of alcohol is prohibited. Furthermore, selling what one does not own is impermissible, and financial risk must lie solely with the lenders of capital and not with those who work the capital.
1.5 Islamic Microfinance Banking
Islamic banking was created as a separate path of financing in order to comply with prohibitions stipulated by Islamic law. Also referred to as Sharia law, Islamic law can be considered God’s law as interpreted by Muslims.
Islamic scholars called Muftis in the Sunni tradition and Mullahs in the Shia tradition are charged with interpreting this law. The central texts of Sharia law are the holy book of the Qur’an, and the examples set forth by Muhammad and his early followers are documented in a collection of texts called the Hadith. To render a legal opinion, scholars weigh an action or principle against these texts and determine if it is in accordance with the spirit of the law.
Sharia law is very clear about charging interest on loans. The Qur’an forbids usury, or riba, in four different revelations based on the belief that money is only a medium of exchange and has no value in itself. Islam has not relented to pressures from the marketplace and has maintained its stance that charging interest on loans is usurious and a violation of Islamic law.
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However, by differentiating trade from usury, the Qur’an reaffirms the practice of trading as a respectable profession. The importance of trading partnerships has motivated financial intermediaries to find creative ways to help Muslims access loans without violating Islamic law.
Some of Kiva’s Field Partners that serve Muslim borrowers have created loan products based on Islamic principles to better serve their clients. These products have 0% interest and vary in design and delivery mechanisms. While some charge a service fee to cover the costs of administering loans, others share risk between lenders and borrowers or lease assets to borrowers.
To certify that these products are compatible with Islamic principles, it is important for a microfinance institution to receive a fatwa, a legal pronouncement made by an Islamic scholar or religious leader, that officially condones its work.
1.6 Islamic Loan Products Appear on Kiva
Kiva Field Partners post the following loan products to serve Muslim clients (adapted from traditional Islamic financial principles):
1.6.1 Qard Hassan: Interest free loans, usually to students or the very poor.
1.6.2 Murabaha: Purchasing goods for borrowers and charging a fee or mark-up.
1.6.3 Musawama: The seller and buyer arrive at an agreed price for a commodity.
1.6.4 Mudaraba: A limited liability partnership (not allowing for direct investor involvement).
1.6.5 Musharaka: A joint venture with profit and loss sharing.
1.6.6 Salam: An advance purchase of goods delivered on a future date set by the buyer and seller.
1.6.7 Ijarah: Leasing of goods with a second contract to purchase them at the end of a lease period.
1.6.8 Joala: Payment of upfront fees.
The fees associated with Islamic loans vary from one microfinance institution to another. As with all loans on the Kiva site, the best measure of fees paid by a borrower is the Portfolio Yield, displayed on borrower profile pages as well as Field Partner profile pages.
1.7 Paying a Fee on a Loan Different than Paying Interest
For many Muslim borrowers, paying a fee on a loan is like paying a service fee on any other service transaction. Borrowers are purchasing the service of being provided with money. They pay a fee in the same way they would pay for consulting or advisory services.
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When a borrower is about to receive a loan, he or she pays a fee to the microfinance institution before receiving the funds. In contrast, interest paid during the course of a loan is seen as money earned by the microfinance institution on the money itself, rather than a fee for the service.
1.8 Principles of Islamic Microfinance
Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital. But that is not the sole purpose either. Adherence to Islamic law and ensuring fair play is also at the core of Islamic banking. Because Islam forbids simply lending out money at interest, Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to prevent it. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which is seen in conventional banking. Islamic banking introduces concepts such as profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar).
In an Islamic mortgage transaction, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank’s profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabahah. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).
An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank’s share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party’s current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.
There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company’s individual rate of return. Thus the bank’s profit on the loan is equal to a certain percentage of the company’s profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.
Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. The Islamic Banking and Finance Database provides more information on the subject.
In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio.[citation needed] However, in practice, this is not the case, and no examples of 100 per cent reserve banking are known to exist. Islamic banks have groce Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).
No Haram investment
Encouraging risk sharing
No Riba
Financing based on real asset
Key principles of Islamic finance
Belief in divine guidance
Figure no.1
1.9 Interest Rate
Akhuwat was doing for conventional microfinance what Professor Muhammad Yunus had done for conventional banking in the late 1970s it was showing that things could be done differently, and that the ‘accepted wisdom’ could be challenged Dr. Malcolm Harper.
It is estimated that 72 percent of the population of Muslim countries are not using formal financial services (Honohon 2007).
Where such services or conventional financial products are available, they are viewed incompatible with the Islamic prohibition against interest.
Islamic microfinance, considered a niche market, is still in its infancy and business models are still being developed.
1.10 The Akhuwat Model for Microfinance
The name, Akhuwat, is derived from the age-old Muslim spirit of “mua-khaat” or brotherhood, historically referring to the financial support offered by the citizens of Madina when they shared their wealth with the “muhajirin”, the immigrants from Makkah. Dr. Saqib and the founders wanted to build an institution which would foster a sense of common ownership and community among borrowers, donors and whoever was managing the institution. Philan-thropy and volunteerism, it appeared to the founders of Akhuwat, was the answer.
It all started with an interest-free charitable loan (qarz-e-hasana) of Rs. 10,000 provided by one of Dr. Amjad’s friends to a widowed woman with guarantees from a group she formed with his help. The idea? To start a pool of charitable loan money for the poor – then recovering it so to recycle indefinitely.
Dr. Saqib, who managed the Punjab Rural Support Programme at the time, volunteered to manage the process of identifying borrowers, lending the money and ensuring recovery. Soon, friends of the founding members offered more donations and lent more money to more groups on a guarantee basis – weekly meetings were attended by the founders to ensure accountability and support to the borrowers.
As more donations came in and loans were given out to more groups, Akhuwat began to grow, was registered as a society and could not rely on volunteers alone. They decided to charge a 5 percent administration fee regardless of when repayment was due to hire paid employees. However, this did not apply to loans under an amount of Rs. 4000.
Individual loans (that were based on guarantees from the community for the borrower) as opposed to group loans (which replicated the Punjab Rural Support Programme model) were also introduced.
1.10.1 Joint, Couple Loans
This not only catered to those who could not or did not wish to take out a group loan and attracted new clients but also cut down time invested in weekly group meetings. Staying culturally sensitive and relevant, soon after its inception, Akhuwat began giving out household or family loans to husbands and wives: income jointly shared by the whole family, co-signed by the male and female heads of the family. This was done based on the results of some studies which showed that separate loans to male and female in a family may result in tension for the family.
Akhuwat seeks to relieve poverty and to help people to better themselves, rather than to grow for the sake of growth, or to create permanent dependence. Growing sustainably and staying relevant to the community is key.
All transactions take place at the local mosque or church where loans are promoted to the community after prayers, given out and collected. This attaches a moral responsibility to the repayment of the loan and evidence suggests that it plays a huge part in Akhuwat’s loan recovery rate of 99.50 percent. Having a mosque or church-centred structure also provides an avenue for community participation and awareness. And, this cuts organizational costs.
1.10.2 No Strings Attached
Akhuwat’s current policy is not to accept donations from financial institutions or organizations (which may come with “strings attached”) so that it may be accountable to stakeholders alone: the local community, borrowers, individual donors, its volunteers and staff.
On the same principle (and due to the interest-reliant nature of the fund), Akhuwat has not requested for funding from the Pakistan Poverty Alleviation Fund, established by the Government, with foreign assistance, to finance micro-finance institutions. Of course, the organization does not discriminate on the basis of gender, religion, political affiliation or ethnic background for employees or clients.
1.10.3 Responsive & Relevant
The loan products offered by Akhuwat are a response to the economic needs of the community. The Family Enterprise Loan is for households that can or have come up with a solid, viable business plan (usually Rs.15,000, average) and forms 91 percent of what Akhuwat gives out. The whole family is a signatory and involved in the appraisal and lending process.
A Liberation Loan is given to those who have borrowed money from moneylenders at very high interest rates. Akhuwat pays the principle amount in one go and the client pays the amount (up to Rs. 40,000) back to Akhuwat in interest free installments. The Education loan is for poor students to pay for books and material (up to Rs. 25,000).
The Marriage Loan is given to poor families in order for them to afford dowry and wedding expenses (up to Rs. 25,000) for their daughters (males are not eligible).
An Emergency Loan of Rs. 5000 from Akhuwat may be used to pay for unexpected medical expenses or other major fallbacks.
Akhuwat started the housing loan in collaboration Al-Noor Umar Welfare Trust which pays for home renovation and construction expenses for the very poor and varies between Rs. 25,000 to 70,000. Then there is the Silver Loan of up to Rs. 50,000 which clients with excellent credit history with Akhuwat can use to expand their current enterprise.
The average Akhuwat loan is for about Rs.11,000 (less than 200 dollars).
Akhuwat’s lending is restricted by the amount of funds it can raise from donors and usually first-time borrowers cannot borrow more than Rs. 10,000 and the organization seeks to relieve poverty and to help people to better themselves, rather than to grow for the sake of growth, or to create permanent dependence. Growing sustainably and staying relevant to the community is key.
1.10.4 Credit: Capacity-Focus
Currently, the organization also offers what it calls a credit plus approach: social guidance and technical training for its credit beneficiaries. The purpose of this is to help borrowers further improve and develop their small enterprises and provide sustainable economic development to the community as well as stay abreast of latest knowledge, market research, etc. Clients are also provided technical training and “internships” with borrowers who are already running a successful enterprise. Legal aid is also sometimes provided by volunteer law students.
1.10.5 Terminating Traditional Challenges
Recruiting staff from the same communities as their borrowers and not hiring unnecessarily highly qualified professionals reduces costs and ensures that staff turnover is much lower than in other micro-finance institutions.
The operating systems are minimal: no interest charges are levied, and success depends mainly on inter-personal relationships. The organization has no vehicles. However, loan staff can take loans from Akhuwat to buy them and receive compensation for fuel. New hires are interns that go through an intensive three-months training in micro-finance. All permanent staff is provided with medical cover. Student volunteers form part of the workforce and the offices are small with very little furniture and floor seating.
Most of the original founders are now on the Board consisting of seventeen members who, like all of Akhuwat’s top management, work for non-monetary compensation. The Board provides internal governance, formulating and directing policies, mobilizing loans and marketing Akhuwat, reviewing operations and management and so on. Under the Head Office is the Credit Operation Manager who leads a team of five area managers, who are accountable for their respective branches. Each branch is run by a branch manager with 4 to 6 unit managers for field operations.
Today Akhuwat has a trained workforce of more than 85 employees and the support of more than 500 local donors. Akhuwat now operates through 20 branches and is being replicated in 15 cities of Pakistan. It is registered with the Government of the Punjab and Pakistan Center for Philanthropy (PCP) and the Pakistan Micro-finance Network (PMN).
What happened to the first loan that was given out to the widow? She purchased two sewing machines and started a small boutique in her house and in six months she returned the loan. During this period she also ran her house and funded the wedding of one of her daughters. That, was the small beginning of what later became a pioneering revolution in micro-finance in Pakistan.
1.11 Acquire Low Interest and Islamic Loans from Microfinance Banks in Pakistan
1.11.1 Microfinance Banks (MFB)
Microfinance banking is ‘ banking for the poor’. The Microfinance Banks and Institutions operate under Microfinance Institutions Ordinance, 2001 in Pakistan. They provide financial services particularly to the underprivileged areas in city suburbs and villages and Goths. They provide both deposit and loan products including loans for purchasing motorbikes, generators, sewing machines, etc.; loans for emergency medical care, basic shelters, and social works such as disbursement for tube wells, schools and dispensary and medical care in villages.
The procedure for receiving loans are simple and the cost of the funding of loans are lower and also some microfinance banks offer islamic mode of finance. For further detail visit the following home page of the respective Microfinance banks.
1.11.2 Banking facilities at Microfinance Banks
* Easy account opening at retail shops using mobile phones
* Check book facility
* Money transfer facility
* Utilities and services bill payments
1.11.3 Microfinance Banks that are Licensed to Operate in Pakistan:
* Khushali Bank,
* The First Microfinance Bank,
* Tameer Microfinance Bank,
* Pak Oman Microfinance Bank
* Kashf Microfinance Bank
* Rozgar Microfinance Bank
* Network Microfinance Bank.
LITERATURE REVIEW
In his famous book Wealth of Nations, “Adam Smith argued that participation in religious sects could potentially convey two economic advantages to adherents (Anderson 1988, Noland).The first could be seen as a reputational signal: while the poor might look alike to potential employers, lenders, and customers, membership in a specific group could convey a reduction in risk associated with the particular individual and ultimately improve the efficient allocation of resources. Second, religious groups could also provide for extra-legal means of establishing trust and sanctioning miscreants in intra group transactions, again reducing uncertainty and improving efficiency, especially where civil remedies for failure to uphold contracts were weak.
Both Islamic finance and microfinance seem to be concepts surrounded by a “fashionable aura” in Muslim developing countries: banks, financial institutions, MFIs, NGOs are very interested in the issues and most of all in the relation between the two, especially when it comes to fighting poverty. Strange enough, even if the interest is high there are very few examples of actual MFIs operating in the field of Islamic finance and Islamic banks involved in microfinance.
Nevertheless, evidence proved that there is a need for and an interest on Islamic microfinance, for different reasons:
a. microfinance is a very flexible tool, whose models can be replicated but require to be tailored on the local socio-economic and cultural characteristics.
b. the potential demand for tailored microfinance services is still largely unmet, also in countries where the majority of the population is constituted by Muslims.
c. some surveys proved that there is a high demand for Islamic banking especially in
low and middle income predominantly Muslim societies3
d. commercial banks could be interested in this issue as a tool to reach interesting market niches, create loyalty in their clients and accomplish their client satisfaction strategies
e. Islamic finance, microfinance and socially responsible finance share most of their principles, such as:
* Prohibition of all forms of economic activity which are morally or socially injurious
* Egalitarian approach (no restriction to any category of clientele)
* Focus on the well being of the community as a whole, concentrating on the poor, destitute or deprived sections of the society
* Aim at social justice
* Advocacy of entrepreneurship
* Advocacy for financial inclusion through partnership finance4
* Participatory approach
* Risk sharing
Moreover, they both constitute forms of finance that represent unconventional but effective solutions to financial needs, focusing on activities that lack capital but are promising and show a potential.
At a very basic level, the disbursement of collateral free loans in some cases constitutes an example of how Islamic banking and microfinance share common aims. Thus Islamic banking and microcredit programs, may complement one another in both ideological and practical terms.
Even if they both constitute fairly new trends in the financial environment, the inclusion of Islamic finance and microfinance in the activities of the traditional banking system evolved in a quite similar way, because they both started from a marginal position and managed to reach a growing popularity.
2.1 The Basic Principles of Islam and Islamic Finance
Islam is the world’s fastest growing religion, a process of growth that does not affect only the traditional Islamic countries, namely those located in Northern Africa and Middle East, but also other countries in every continent. Muslims cover approximately a quarter of the world’s population, 1.2 billion people.
According to the tradition, the Prophet Muhammad was born in Makkah, a city in the present-day Saudi Arabia in 570 C.E. Muhammad received divine revelations (The Holy Quran) over a period of 23 years in the seventh century of the Christian Era.
For Muslims, the Holy Quran and the Sunnah constitute the primary sources of knowledge: the Holy Quran confirms what was revealed to earlier messengers of God and serves as the criterion of what is right and what is wrong while the Sunnah is collected in books which are separated from the Holy Quran and are known as Hadith books. While the Holy Quran is considered totally as the “word of God revealed to the Prophet”, not every hadith is considered authentic. Early Muslim scholars have classified hadith into various categories ranging from different levels of authenticity to false hadith.
In Islamic societies, the Sunnah constitutes the second most important source of jurisprudence after the Quran. “The most difficult part of Islamic Law for most westerners to grasp is that there is no separation of religion and state. The religion and the government are one. Islamic Law is controlled, ruled and regulated by the Islamic religion. The theocracy controls all public and private matters. Government, law and religion are one. There are varying degrees of this concept in many nations, but all law, government and civil authority rests upon it and it is a part of Islamic religion. There are civil laws in Muslim nations for Muslim and non-Muslim people. Shariah6 is only applicable to Muslims and it governs every aspect of their lives.”
The foundation of Muslim life are the so called Five Pillars of Islam: faith or belief in God and the finality of the prophet hood of Muhammad, worship respecting the five daily prayers, almsgiving and concern for those who are in need, self-purification through fasting and the pilgrimage to Mecca for those who are able to do it.
The economic systems that were set in Muslim countries have generally followed the blueprints of the developing world and “reflect persistent tensions between equity and growth, import substitution and export-led industrialization, and agricultural and industrial investment. Due to the close ties between some Muslim countries and the global economic and financial system, however, these tensions have expressed themselves in particularly stark form in much of the Muslim world. For example, oil wealth and the resulting flow of labor remittances and bilateral aid has dramatically influenced the course of development in many Muslim countries, stretching from Tunisia to Malaysia. The extent to which religious doctrine has influenced economic policy and the normative choices that underpin such policies varies tremendously over time both within and among Muslim countries. Islam has no single, monolithic vision of economic justice; as a result, there is a void at the heart of Islamic doctrine which is filled by the complex interaction of political, social and economic forces. Thus the vexing question of why Islam is brought into debates on economic policy at some junctures and ignored at others becomes a task for historical and sociological inquiry.
In Muslim countries, especially those located in the North Africa and Middle East region, the economic liberalization and increasing interdependence of the 1980s and 1990s highly influenced the political and economical choices of governments.
The banking system, in particular, strongly reacted to these changes: in the 1980s and 1990s Muslim bankers and religious leaders developed ways to integrate Islamic law on usage of money with modern concepts of ethical investing. Consequently, a sophisticated economic discipline has emerged with its own concepts, analytical tools and institutions. Some of these revived traditional micro venture capital and ethical investing frameworks that thrived in medieval times. However, they incorporated many modern techniques and technologies. A number of researchers suggest that the underlying causes of the genesis of modern Islamic economics was based more on the desire to reflect beliefs about Islamic identity than to establish a more ethical or religiously sound banking system
2.2 The Principles of Islamic Banking
Islamic banking, based on the Quranic prohibition of charging interest, has moved from being a theoretical concept to embrace more than 100 banks operating in 40 countries with multi-billion dollar deposits world-wide. Islamic banking is widely regarded as the fastest growing sector in the Middle Eastern financial services market.
It is important then to understand the principles of Islam that underpin Islamic finance. The Shariah consists of the Quranic commands as laid down in the Holy Quran and the words and deeds of the Prophet Muhammad. The Shariah disallows Riba and there is now a general consensus among Muslim economists that Riba is not restricted to usury but encompasses interest as well. The Quran is clear about the prohibition of Riba, which is sometimes defined as excessive interest. “O You who believe! Fear Allah and give up that remains of your demand for usury, if you are indeed believers.” Muslim scholars have accepted the word Riba to mean any fixed or guaranteed interest payment on cash advances or on deposits. Several Qur’anic passages expressly admonish the faithful to shun interest.
In general, the principles of Islamic banking are:
a. Al Zakat (the 4th pillar of Islam).
One of the most important principles of Islam is that all things belong to God, and that wealth is therefore held by human beings in trust. The word zakat means both ‘purification’ and ‘growth’. Our possessions are purified by setting aside a proportion for those in need.
b. The prohibition of taking interest rates (Al Riba)10. Within the Islamic scholars, there are two interpretations on what Riba means:
* A modernist view, according which reasonable interest rates are allowed
* A conservative view, which states that any kind of fixed interest is wrong
c. the prohibition of unproductive speculation or unearned income (Al Maysir11) as well as gambling (Al Quimar)
d. Freedom from excessive uncertainty
e. The prohibition of debt arrangements – most Islamic economic institutions advise participatory arrangements between capital and labor. The latter rule reflects the Islamic norm that the borrower must not bear all the cost of a failure, as “it is Allah who determines that failure, and intends that it fall on all those involved.”
While the banning of interest is rooted in Muslim theology, proponents of Islamic finance provide strong motivations to support the ban of interest rate. First of all, in an Islamic profit sharing contract the return on capital will depend on productivity and the allocation of funds will be primarily based on the soundness of the project, improving the capital allocation efficiency. Second, the Islamic profit sharing system will ensure more equitable distribution of wealth and the creation of additional wealth to its owners. Third, the profit sharing regime may increase the volume of investments and hence create more jobs. The interest regime accepts only those projects whose expected returns are higher than the cost of debt, and therefore filter out projects which could be acceptable under the Islamic profit sharing system.
According to the Indian researcher Dr. F.R. Faridi, “Islamic Economics comprises Justice, Equality and Fair Play. In fact, it is the best form of bringing about equality among the masses. Islamic Economics defines certain rules that regulate company structure, effectively preventing abuse and corruption. For instance, Islam forbids monopolies by outlawing the hoarding of wealth and eliminates copyright or potency laws that would open the avenue for potential monopolies to develop. Also, Islam protects the ownership of businesses and companies by restricting ownership of companies only to those who contribute both capital and effort to the company or business, thus effectively putting the seal on such concepts as “corporate takeover” from ever becoming a reality.”
Islamic banking presents a holistic approach, based on Islamic principles on behalf of the individual and at the same time of the society he/she belongs to giving serious consideration to the global development constraints of the society.
2.3 The Islamic Financing Contracts
Since Islamic Banking can be rather complex, Sharia principles are governed by Islamic experts or ‘Ulama’. It is always essential to obtain the approval of the Sharia advisor of the bank on the forms of the financing contracts, in order to ensure their compliance with the principles of Islamic Sharia. These contracts in fact are exposed to high risks and arise a problem of moral hazard. In fact, they require substantial trust between the banks and their customers in terms of honesty, integrity, management and business skills. Equally problematic is the aspect of monitoring and supervision. Given the fact that both mudharabah and musharakah are equity financing in character, collateral is not a prerequisite.
Tarek S. Zaher and M. Kabir Hassan (2001) define five basic Islamic financing contracts:
1. Murabaha (Financing Resale of Goods)
2. Ijara and Ijara wa-Iqtina (Lease financing)
3. Istinsa
4. Mudaraba (or Modaraba – participation financing)
5. Musharaka
2.3.1 Murabaha
This constitutes one of the most well known Islamic products, consisting in “a cost-plus profit financing transaction in which a tangible asset is purchased by an Islamic institution at the request of its customer from a supplier. The Islamic institution then sells the asset to its customer on a deferred sale basis with a mark up reflecting the institution’s profit”.
2.3.2 Ijara and Ijara wa-Iqtina
These concepts are very close to the Western idea of leasing. In the first case the financial institution leases an asset to its customer agreeing on lease payments for a certain period of time but excluding the option of ownership for the client.
In the second case, the client has the option ownership by buying the asset from the financial institution.
“The conditions governing both types of leasing are that assets must have a long/secure productive life, and must not be handled in an un-Islamic way, meaning that the lease payments must be agreed on in advance to avoid any speculation”.
2.3.3 Istinsa
“Istinsa is a pre-delivery financing and leasing structured mode that is used mostly to finance long term large scale facilities involving, for example, the construction of a power plant”.
2.3.4 Mudaraba
“Mudaraba is a trust based financing agreement whereby an investor (Islamic bank) entrusts capital to an agent (Mudarib) for a project. Profits are based on a pre-arranged and agreed on a ratio. This agreement is akin to the Western style limited partnership, with one party contributing capital while the other runs the business and profit is distributed based on a negotiated percentage of ownership. In case of a loss, the bank earns no return or negative return on its investment and the agent receives no compensation for his (her) effort”.
In this kind of contract, all the financial responsibilities rely on the business itself: the financial institution invests on an idea, a project and shares its fate.
From the perspective of financial services, Modaraba falls under three categories:
1. Demand Deposits: These deposits are not restricted, payable on demand and do not share in any profits.
2. Mutual Investment Deposits: An Islamic Bank will combine these deposits with the Bank’s money in order to participate in mutual investment transactions conducted by the bank. Under these deposits, the percentage of profit is fixed at the end of the bank’s financial year.
3. Special Investment Deposits: An Islamic Bank will invest these deposits in a specific project or investment upon the request or the approval of the depositor. The depositor in this case will be entitled to receive profit and is liable for the losses, provided that the bank is not negligent or in default. At the end of the deposit period, the bank receives its share of profit against its contribution of experience and management, while the depositor receives his share of profit as a capital share contributor.
All these deposit transactions are based an Islamic Sharia concept called ‘Modaraba’ (Participation Financing), where one party (the depositor) provides the cash and the other party (the Bank) provides the experience and management.
2.3.5 Musharaka
This contract is very similar to a joint venture with participation financing. “Two parties provide capital for a project which both may manage. Profits are shared in pre-agreed ratios but losses are borne in proportion to equity participation”18. The peculiar aspect of this contract is not the sharing the profit and losses, but sharing the management and the decision taking process.
2.4 Islamic Microfinance and Poverty Alleviation
There are a number of key Shari’a principles which distinguish Islamic finance from the conventional forms. These principles have led to the creation of a separate finance industry are the prohibition on usury and interest(riba), prohibition on realising a gain from speculation(mayseer), absence of uncertainty in commercial transactions(gharar), in addition to the requirement that all activity must be for permitted purposes (halal).
Islamic microfinance represents the confluence of two rapidly growing industries, microfinance and Islamic finance. It has addresses the unmet microcredit demands and also satisfies the Islamic social principle of caring for the less fortunate with microfinance’s power to provide financial access to the poor. Islamic microfinance in its framework could help improve the standard of living of low-income earners and the poor because it discourages exploitation and achieves an objective of social justice. The positive impact of Islamic microfinance, on poverty reduction is manifested in the inclusion of those that have hitherto been excluded from financial services. There are a variety of Islamic products that can be adapted to microfinance in order to reduce the scourge of poverty in the country. In various countries in the Middle East where the microfinance concepts have been implemented, microfinance has successfully opened economic opportunities improving the social economic condition of the poor, which attests to the fact that microfinance reduces poverty through accelerated employment rate and increase in real wages. The advantage of Islamic finance is that there is a close link between real economic activities and Islamic finance, which creates value for financial activities. In this light, there will be creation of more jobs, which will have a positive impact on unemployment and a greater long-term effect on sustainable development of the economy. However, Islamic finance has no religious inbuilt discrimination and its products are available to anybody regardless of belief. Three main instruments Islamic Microfinance (IMF) models were identified by Dhumale andSapcanin (1999).
Mudaraba is the profit and loss model where the bank provides money and entrepreneur acts as the manager with the bank bearing the loss. In the Musharka model, a joint venture arrangement exists where in both the bank and entrepreneur participate in capital and share profit and loss. The Murabaha is a cost plus markup sale with the banks buying some products, selling them to micro entrepreneur and adding a markup. Zakah fund (one of the fivepillars of Islam and is meant to finance the poorest of the poor) with which to cover the losses arising from the default by very small microenterprises. The fund also covers part of the project evaluation costs of the commercial banks. Qardhasan loans are also provided for funding micro insurance to reduce vulnerability of the non-poor from becoming poor due to external shocks. This is in addition to the creation of mutual guarantee funds to pay for accidents, losses of property. In addition, loans are also provided to build the productive capacity of the households as part of inclusive growth programmes. scheme and Ibn Khaldun’s concept of ‘Asabiyah which as a unifying force is analogous to the modern concept of social capital. In the Qardhasan savings/lending model, the loan depositor receives saving points instead of interest for the size and duration of the funds provided.
2.6 Advantages of Islamic Microfinance
Successful Islamic microfinance programmes can offer several potential advantages. They may engender higher rates of economic growth as evidence suggests that micro entrepreneurs are willing to undertake more profitable ventures if risk is shared. They can build greater levels of trust and understanding between lender and borrower because of the deeper relationships built through partnership rather than a service provider-client relationship. Because only investment in socially beneficial activities is permitted, they may promote ethical investment and business practices among micro entrepreneurs. Indeed, Islamic finance shares many of the features of socially responsible finance.
Islamic Microfinance does not have fixed obligation like other banking institutes have. There are no interest payments or deposits required by Islamic banking. Another of the advantages of Islamic banking is the profit sharing principle. The Islamic bank shares the risk of the profit sharing along with the customer. This creates a sense of fairness or justice with the customer. The ethnics of Islamic banking is also considered an advantage due to the morals the business shows.
It is banking, Enlightened with the guidance of Islamic Sharia principles emerged as an alternative financial system that neither gave nor take interest, thereby introducing a fair system of social justice and equality while fulfilling the financial needs of people and maintaining high standards of ethics, transparency and a sense of responsibility.
It is a banking system in which millions around the world, irrespective of religious beliefs are putting their faith in. A banking system to which even the world’s leading conventional banks are turning to. A banking system which is governed by a resilient code of ethics in all its practices and functions.
Islamic banking is unique in the way that it helps individuals as well as business bild tangible and assets for themselves. This is not only leads to prosperity founded on a solid economic base but also encourages the spirit of entrepreneurship amongst its customers. Islamic banks are based on the unique concept of profit and loss sharing with the customers by way of various Sharia complaint financing and investment tools.
Islamic banking provide an opportunity to the individuals and the businesses to build various assets which contribute to the development of the economy. Apart from this the Islamic banking encourage the investment process through adopting innovative Sharia structures in all spheres of the economy expect in few activities which are considered unethical.
Due to their very nature of complying with the Sharia principles the Islamic banks are forbidden from indulging in any such practice which may prove harmful to a customer.
Islamic banking is also the first where a customer, whether individual or corporate isn’t just a customer but is a partner with the bank or owner of good assets. This means they share the risks as well as the profits of such a partnership or ownership. And this unique arrangement is done in accordance with the laws of Sharia which ensures complete transparency at all times.
ANALYSIS
The findings of this study are that religious affiliation is not a critical hindrance to access Islamic microfinance products and services. With the existing microfinance institutions not catering enough for those who really needs their services, Islamic microfinance when established promises to widen the breath of provision of financial services to the poor and low-income earners. Furthermore, it was noted in this study, that the adoption Islamic microfinance as a poverty alleviation tool needs to be accompanied with other enabling fiscal and monetary policies for it to be effective. There should be adequate public awareness of Islamic finance concepts and it should focus more on the theme ethical finance than Islamic finance in order to circumvent religious sentiments. Islamic microfinance concepts should adopted by the government in concert with the structural transformation of the economy in order to achieve as ustainable, balanced and broad-based economic growth and development which will be inclusive of the poor and the disadvantaged.
Conclusion
It is concluded that , Islamic microfinance providers have developed a number of financing mechanisms that can be utilised according to the nature of the commodity or business and the period for which financing is sought. These are generally known by their Arabic names. Murabaha is the most popular and widely used Islamic financing instrument. This involves the resale of a commodity after the lender adds a specific profit margin which is paid by the borrower who agrees to buy that commodity. Usually, repayment is made in installments to the financier, who pays the price to the original supplier of the commodity. This type of finance is commonly used for financing assets or working capital inputs, such as raw materials, machinery or equipment. For murabaha to be Shariah compliant the financier must own the commodity first and then resell it the commodity should be a tangible one and the buyer must know and then agree to the purchase and resale prices.
RECOMMENDATION
After analyzing the whole study it is recommended that, government should provide a stable macroeconomic environment with low inflation and promote the microfinance industry in general through, for example, providing payments or credit information systems, and providing prudent regulation and supervision of MFIs in order to protect customers and prevent risks to the financial system in particular.
REFRENCES
*
* http://community.businessfightspoverty.org/profiles/blogs/dr-ajaz-ahmed-khan-what-role-for-islamic-microfinanc
* http://www.investopedia.com/terms/m/microfinance.asp
* http://investkarachi.blogspot.com/2011/09/microfinance-banks-in-pakistan.html
* http://www.kiva.org/updates/kiva/2012/05/01/kivas-approach-to-lending-and-islamic.html
* http://www.lendwithcare.org/info/what_is_islamic_microfinance
* Onakoya.A. (2013).
Islamic Microfinance as a Poverty Alleviation Tool: Expectations from Ogun State, Nigeriamore, Scholarly Journal of Business Administration, Vol. 3(2) pp. (36-43).
* http://www.sbp.org.pk/about/micro/criteria.htm
* Segrado.C. (2005).
“Islamic microfinance and socially responsible investments”.Tornito
* http://www.tbl.com.pk/the-interest-free-microfinance-option/
