Monday, May 3, 2010

Interest-free microfinance: Best tool for poverty eradication

The interest-free microfinance can be defined as provision of financial services to those people who are denied access to the financial market; opens new perspectives, and empowers people who can pursue projects with their own resources, and who lack assistance, subsidies and dependence. Besides, it provides financial services to those, who are traditionally non bankable, mainly because they lack guarantees against a loss risk.

In the spirit of Islam that goes beyond mere profitability, this new financial system aims to maximize social benefits as opposed to profit maximization. This can be done through creation of healthier financial institutions that can provide effective financial services also at grassroots levels. Some authors (Al Harran, 1996) argue that Islamic finance, if inserted in a new paradigm, could be a viable alternative to the socio-economic crisis derived out of interest-based economic system.

Both Islamic finance and microfinance seem to be concepts surrounded by a “fashionable aura” in Muslim as well as other developing countries. Banks, financial institutions, MFIs, NGOs are taking keen interest 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.

Microfinance is a very flexible tool, whose models can be replicated but require to be tailored on the local socio-economic and cultural characteristics; and secondly, the potential demand for tailored microfinance services is still largely unmet. Some surveys proved that there is a high demand for Islamic Micro-financing especially in low and middle income predominantly Muslim societies.

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, the Islamic banking and microcredit programs may complement each other 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.

Three main instruments of Islamic finance; mudaraba, musharaka and murabaha, are tools generally used to design successful microfinance program.

Islamic Microfinance is growing rapidly

The Banker (2007) estimated the total assets of Islamic financial products at US$500.5 billion and the Islamic finance industry’s 100 largest banks have posted an annual asset growth rate of 26.7 percent, outpacing the 19.3 percent growth rate of their conventional counterparts.

The global Islamic finance industry is rapidly growing. In the past 30 years, the industry has witnessed the development of over 500 Sharia-compliant institutions, whose reach now spans 75 countries (KPMG 2006). These institutions include 292 banks (fully Islamic institutions and those institutions with Islamic subsidiaries), 115 Islamic investment banks and finance companies, and 118 insurance companies.

Despite its origins in the Middle-East, the Sharia-compliant banking has proved popular with Muslims in other countries as well, leading to the development of new Islamic banks across North Africa and Asia. Of the total global Islamic finance market, 36 percent is located in the Gulf Cooperation Council (GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and UAE), 35 percent in non-GCC Southwest Asia and North Africa, and 23 percent in Asia (primarily Malaysia, Brunei, and Pakistan) (The Banker 2007).

Over time, Islamic financial services also have expanded well beyond the Muslim world and are offered not only by Islamic banks, but also by Islamic subsidiaries of international financial institutions. Islamic financial services are currently provided in countries such as India, China, Japan, Germany, Switzerland, Luxembourg, the United Kingdom, the United States, and Canada. The United Kingdom, which currently ranks tenth in The Banker’s listing of “Top 15 Countries by Sharia-compliant Assets” (2007), has recently announced its aim to make London a global center for financial markets in the Muslim world.

Government Promotion of Islamic Microfinance

In the case of larger Islamic banking industry, government regulations can play a significant role in the expansion of the Sharia-compliant microfinance.

Indonesia today provides a supportive regulatory framework and has licensed 35 new Islamic rural banks in the past five years. The State Bank of Pakistan, which already has a legal and regulatory framework in place for conventional MFIs, also developed guidelines in 2007 for the rapid expansion of Islamic microfinance.

Although there is ample evidence of demand for Islamic microfinance products, it however requires that low-income clients are comfortable that the products offered are authentically Islamic. Critics of Islamic finance products suggest that the pricing of some products offered as Sharia-compliant too closely parallels the pricing of conventional products. For example, some institutions offer murabaha where interest appears to be disguised as a cost markup or administration fee. Islamic finance sometimes suffers from the perception that it is simply a “rebranding” of conventional finance and not truly reflective of Islamic principles.

Consequently, low-income populations, who often rely on local religious leaders to address questions of religion, must be convinced of the authenticity of Islamic financial products if Islamic microfinance is to reach its full potential. Greater efforts should be explored to (i) increase collaboration between financial experts and Sharia experts on product authenticity, (ii) encourage exchange of experiences among religious leaders (particularly those serving poor populations at the local level) relating to Sharia compliance of microfinance products, and (iii) educate low-income populations, in collaboration with local religious leaders, on how financial products comply with Islamic law.

Throughout the Muslim world, microfinance (Islamic or otherwise) is still seen as a philanthropic activity rather than a business enterprise. Consequently, in the context of Islamic microfinance, there is a growing tendency to view zakat (funds donated pursuant to the Muslim obligation to pay alms) as a source of funding. Indeed, given the underlying principle of Islamic finance to promote the welfare of the community, zakat funds appear ideally suited to support Islamic microfinance. However, a heavy reliance on charity is not necessarily the best model for the development of a large and sustainable sector, and more reliable, commercially motivated streams of funding should be explored.

Interest-free microfinance: Best tool for poverty eradication