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AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper- 1
Islamic Banking and Microfinance
Wan Kamarudin Bin Wan Omar
0700335
AT3002_HHI
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This is Professional Practice Paper for fulfillment of AT3002_HHI of Part 3
of Certified Islamic Financial Professional (CIFP)
INCEIF
January 2010
Islamic Banking and Microfinance
Wan Kamarudin Bin Wan Omar
Abstract
Microfinance has been in practice around the world to help poor people and
eradication of poverty. However, microfinance activities are being dominated by
conventional financier and Islamic banks appears to be less interested to
venture into this area. The aim of this paper is to argue that since Islamic banks
are established under Shariah, they should strive to fulfill Islamic philosophy on
social justice, equal wealth distribution and eradication of poverty in the society.
The Islamic banks should play his role well in empowering people and promote
egalitarian society. Eventhough there are many ways to achieve it, microfinance
is one of the scheme which Islamic banks should perform well.
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1. Introduction
Islam strives for social justice in the society. Social justice is being defined
as giving each individual what he/she deserves, distribution of financial
benefits in the society and providing equally for basic needs. It is also the
egalitarianism in opportunities, i.e. each person has a chance to climb up the
social ladder1. One of the ways to achieve social justice is by having fair
distribution of wealth within a society and prohibits concentration of wealth to
certain segment of people only. There should be no monopoly in the wealth
accumulation and wealth should circulate as spread as possible. This vision
has been stated in Al-Quran:
So that this wealth should not become confined only to the rich amongst
you (59:7):
Despite Islam promotes social justice and just distribution of wealth in the
society, the ideal vision is not reflected into reality. Muslim countries
throughout the world are still grappled with the poverty within their country. It
is estimated that2:
400 million of the 1 billion people estimated to be in absolute poverty
lived in 31 of the 56 OIC member states i.e. 40% of the world'
Five large states Indonesia, Pakistan, Nigeria, Bangladesh and Sudan
with cumulative population of 690 million people have 250 million
people living below poverty line. The incidence of poverty in these
countries is slightly above 36%;
1http://www.neareast.org/phil/en/page.asp?pn=24
2www.isis.org.my/files/events/Sess3-IshratHusain.pdf
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Fifteen states with a total population of 143 million people out which
more than 50% i.e. 74 million live below the poverty line face severe
problems and also on slipping path as far as fight against poverty is
concern;
Nine states inhabiting 113 million people have 55 million poor
Two states i.e. Uzbekistan and Albania with a population of 30 million
people have 8 million poor i.e. incidence of poverty is 27% and is
manageable.
Malaysia which is being regarded as a relatively well-off country compared
to other Muslim countries also has it share of wealth inequality within the
society. According to UNDP report on Malaysia3:
The proportion of all Malaysian households in poverty was 5.96 per
cent in 2004. However, this figure masks substantial variation across the
countrys states, communities, and between rural and urban areas.
Poverty is particularly concentrated in the five low income states. In
2004 there were 5,459.4 thousand households in Malaysia, 5.96 per
cent of which were poorover 325,000 households. Three quarters of
these households live in the five poorest states: Kedah, Kelantan,
Terengganu, Sabah, and Sarawak. Of poor households in 2004, 37
percent live in Sabah. Poverty in Malaysia is increasingly a regional
problem.
Poor households also tend to be the larger ones, so the individual and
child poverty rates are above the proportions of poor households. In
3UNDP: Malaysia Measuring and Monitoring Poverty and Inequality, pg 79
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2004 the proportion of Malaysian children in poor households was over
12 per cent. The proportion of poor children in Sabah was over 40 per
cent.
Relative poverty rates have tended to be constant over time. Roughly
1 in 5 households received an equivalized income less than half the
Malaysian median income.
The above statistic shows that, there is miss-alignment between the
Islamic thrust on wealth distribution which should be as spread as possible
with the reality of the Muslim countries. There are segments within the
society which still grappled with inadequate basic necessities and trapped
in the vicious cycle of poverty.
2. Islam & Wealth Distribution
As being stated earlier, the objective of Shariah is to ensure social justice
and equitable distribution on income in the society. No one in the society
should be left behind especially to live without basic necessities. The Prophet
Muhammad (pbuh) view poverty as a threat and dangerous situation from
which people in the society should do away with and pray to Allah for
protection. The Prophet (pbuh) said that:
O my Allah, I refuge to you from the evils of poverty4
In another hadith, the Prohet (pbuh) said that:
Refuge to Allah from the evils of poverty, famine, degradation,
oppressing and oppressed5.
4Ibn Hanbel, VI/57,207; Ebu Davud, Edeb, 101; Al Nesai, Istiaze, 14, 16: Sehiv, 90
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The hadith above equates poverty as evil. Lack of resources for basic
necessities destroys poor people since they have no means to support their
live and family. This situation will create social problems within the society. A
father will have no means to provide his family with meals to prevent them
from hunger. He is also not able to provide his children with education which
useful for better employment for better life. In addition, he may not have
access to health services. At the end, it will force him to beg or in extreme
cases, involve in unhealthy activities which will create more social problems.
In searching for wealth, Islam encourages the believer to work hard and
receive gain based on their effort. Verse in Al-Quran stated that:
"And when the prayer is finished, then disperse in the land and seek of
Allah's grace, and remember Allah much, that you may prosper." (Al-
Quran, 62:10)
The encouragement in the Quran to work is further re-enforce by the
hadith from the Prophet (pbuh). He said that:
"No one has ever eaten any food that is better than eating what his hands
have earned. And indeed the Prophet of Allah, Dawud, would eat from the
earnings of his hands."6
The verse and hadith above shows that, Islam does not want their follower
to beg, instead it promotes effort and hard work by each Muslim to acquire
wealth. Sadaqah receive by beggar is not sustainable since it will finish or
discontinue by the givers. When this happened, they will be back at their old
5Ibn Hanbel, II/540
6Reported by Al-Bukhari
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state. Islamic strategy in dealing with poverty can be further observed in the
following hadith:
A man of the Ansar community came to the Prophet (pbuh) and
begged from him. He (the Prophet) asked: have you nothing in your house?
He (the man) replied: Yes a piece of cloth, which we wear, or which we
spread (on the ground), and a wooden bowl from which we drink water. He
(the Prophet) said: Bring them to me. He (the man) then brought these
articles to him and he (the Prophet) took them in his hands and asked to the
assembly of people: who will buy these? A man said: I shall buy them for one
dirham. He (the Prophet) asked twice or thrice: Who will offer more than one
dirham? Another man said: I shall buy them for two dirham. He (the Prophet)
gave these to him and took the two dirhams and, giving them to the man of
the Ansar, he said: Buy food with one of them, and hand it to your family,
and buy and axe and bring it to me. He then brought it to him. The Prophet
(peace be upon him) fixed a handle on it with his own hands, and said: Go
gather firewood and sell it, and do not let me see you for a fortnight. The man
went away and gathered firewood and sold it. When he had earned ten
dirhams, he came to him and bought a garment with some of them and
food with the others. The Prophet (pbuh) then said: This is better for you
than that begging should come as a spot on your face on the Day of
Judgment. Begging is right only for three people: one who is grinding poverty,
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one who is seriously in debt, or one who is responsible for compensation, and
finds it difficult to pay7
The hadith above shows that the poor person is capable to become
successful if he is given adequate opportunity to be involved in economic
activities. Small capital which made available to him can be used to generate
sustainable income to support their family. From the hadith, we can conclude
that, to overcome the issues of poverty and inequality of wealth distribution in
the society, Islam advocates economic empowerment. Economic
empowerment means that the poor people is given opportunity to improve
themselves by being involves in economic activities to uplift himself and his
family living standard.
This is where the function of Islamic banks is important to fight poverty
and improve wealth distribution in the society. Islamic banks are financial
intermediaries, where one of the roles is to channel capital surplus in the
society to people who are in need of capital, in this case to poor people.
3. Islamic bank and its function in wealth distribution
Globally, Islamic banking industry has shown tremendous growth over the
past decades with more than 20% growth for the past five years8. According
to The Bankers Top 500 Islamic Financial Institutions survey9, assets held
by fully Shariah-compliant banks or Islamic banking windows of conventional
7Sunan Abu Dawood, Kitab al-Zakah, Book 9, Number 1637
8http://www.calyon.com/mediaroom/interviews/the-growth-of-islamic-banking-is-seen-as-an-important-
trend-and-not-just-a-fashion.htm
9 http://gifc.blogspot.com/2009/11/double-digit-growth-for-islamic-banking.html
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banks rose by 28.6 percent to $822bn from $639bn in 2008. Comparatively,
within the same period, the worlds conventional banks only posted annual
asset growth of 6.8 percent. In Malaysia, currently there are 17 Islamic banks
and the industry has grown tremendously with estimated annual growth rate
of 18% to 20% annually10.
The attractiveness of Islamic banks is due to it operations is based on the
Shariah foundation. Thus all dealings, financing and investment conducted
by Islamic banks are complied with Shariah principles. Shariah obliged for the
transactions to be free from the prohibited elements of riba (usury), maisir
(gambling) and gharar (uncertainty). It also discourages involvement of
Islamic banks in transactions which inconsistent with Islamic values such as
illegal activities, production of harmful materials and useless products.
Nevertheless, the function of Islamic banks is not only to offer Shariah
compliance products. As the name suggested, it carry religious connotation
and obligation. As a bank establish under religion of Islam, it must strive to
fulfill the objective of Shariah. Shariah means a waterway that leads to a
main stream, a drinking place, and a road or the right path11. From the
meaning, we concurred that Shariah is a tool (as a passage) to achieve
certain goal or objective. So what is the objective of Shariah?
According to Imam Al-Ghazali:
The objective of the Shariah is to promote the well-being of mankind,
which lies in safeguarding their faith, their human self, their intellect, their
10 Bank Negara Malaysia: Annual Banking Statistics 2007
11 http://theislamiclaw.wordpress.com/
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posterity and their wealth. Whatever ensures the safeguard of these five
serves public interest and is desirable12
Generally speaking Shariah aims at protecting and preserving public
interest, and it aims at removing hardships from people and providing them
with solutions to their problems13.
This is the fundamental differences between Islamic banks and
conventional banks. Conventional bank is based on capitalism where focus is
on profit maximization. Whereas Islamic banks have to ensure that they
contribute to the achievement of objective of Shariah, which means to focus
on its role in the society.
However this doesnt mean that the Islamic banks are a charitable
organization and should not generate profits. As a business entity, the banks
have to generate profits to ensure their sustainability of their business. Islam
recognize the right for wealth, accept income disparity and different level of
social standing in the society due to the fact that each person has different
level of intelligent, strength, skill set and passion in pursuing economic
activities. Hence some of the people will be an employer with others work as
their employee. In the Al-Quran, Allah has stated that:
''We have distributed their livelihood among them in worldly life, and have
raised some above others in the matter of social degrees, so that some of
them may utilize the services of others in their work." (43:32)
12Chapra 2000a, P118
13http://theislamiclaw.wordpress.com/
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However, there should be no situation where the wealth disparity is wide
where certain segment in the society is struggles for end meet. Thus
mechanism must be in place where there is ample opportunity in place for
people to work hard and gain their own wealth.
Islamic bank plays crucial role in the society due to their function as
financial intermediaries. They provide link between surplus capital unit and
deficit capital unit. Individual with excess capital deposits their money in the
bank. The banks subsequently disburse the money to the entrepreneur who
in need of capital for their business operation. Using this scenario, the Islamic
banks have a privilege to decide where the money will be channeled. If
Islamic banks decide to channel it to certain group of people, lesser capital is
left to be channeled to the other groups of people. Thus, if the Islamic banks
bank are decided to pursue profit maximization, off course they will channel it
to good credit standing and profitable business. However, if the Islamic banks
want to play their role as espoused by Shariah, they will ensure that there is
adequate allocation of capital to the less fortunate people in the society. The
above scenarios show that the act of Islamic banks gave wide implications on
the access to capital within the society.
Better access to capital will help poor people to participate in economic
activities and uplift their economic. Dr Umer Chapra wrote that:
Lack of access of the poor to finance is undoubtedly the most crucial
factor in failing to bring about a broad-based ownership of businesses and
industries, and thereby realizing the egalitarian objectives of Islam. Unless
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effective measures are taken to remove this drawback, a better and
widespread educational system will only help raise efficiency and incomes
but ineffective in reducing substantially the inequalities of wealth. This would
render meaningless the talk of creating an egalitarian Islamic society.
Fortunately, Islam has a clear advantage over both capitalism and socialism
which is built into its value system and which provides bitting power to its
objective of socio-economic justice Chapra [1992: 260 261]
In addition to the social centric obligations as outline by the religious
requirements, from the user side, there is growing demands by the
stakeholders who want Islamic banks to play active roles in social duties. A
survey conducted by Dr. Asyraf Wajdi Dusuki (2008)14 on the stakeholders of
Islamic banking which comprised seven stakeholders group; i.e. customer,
depositors, local communities, Islamic banking manager, employees, banking
regulatory officers and Shariah Advisors concluded that:
The most important fact revealed by this study is that stakeholders of
Islamic banks view the industry much more favourably by the social and
ethical goals that it serves, rather than mechanics of its operation. One of the
most important reflections of their attitude is that social-welfare factors are
evidenced as more important objectives than commercial factors in their
perceptions towards Islamic banking. This result implies that Islamic banks
must ensure that all of their transactions are Shariah compliant not only on
14Dr. Asyraf Wajdi Dusuki, Understanding the Objectives of Islamic Banking: A survey of Stakeholders
perspective (2008)
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their forms and legal technicalities but more importantly the socio-economic
substance which is premised on the objectives outline by Shariah.
The above discussion shows that Islamic banks have crucial roles to
ensure better wealth allocation in the society. Members of the society also
have high expectation for Islamic banks to perform their function well.
4. Islamic Banks and Micro-finance Scheme
Islamic banks need to effectively fulfill the objective of Shariah and also to
satisfy the expectations of society where they operate. This means that
Islamic banks have to find an appropriate scheme. Through the selected
scheme, Islamic banks will offer economic empower to the poor people for
them to have sustainable income and ultimately uplift their living status. The
scheme also should be sustainable, means that it will not contribute to failure
of Islamic banks due to high risk involved. Due to these factors, microfinance
scheme is a perfect fit into the agenda.
Microfinance is a micro-financing practice in which the financing is
extended to those who have difficulty to access financing due to lack of
collateral, low credit rating and lack of credit history. The definition of micro-
finance varies. Among the definitions are:
i. Programme that extend small financings to very poor people for self
employment projects that generate income in allowing them to take care
of themselves and their families (Microcredit Summit 1997)
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ii. Microfinance is the provision of financial services to low-income clients,
including consumers and the self-employed, who traditionally lack
access to banking and related services (Wikipedia)
iii. The provision of small financings (microcredit) to poor people to help
them engage in productive activities or grow very small businesses.
(www.pbs.org)
iv. Financial services - such as financings and savings - directed toward the
poor. (http://library.thinkquest.org/05aug/00282/other_glossary.htm)
Micro-finance is compatible with the objectives of Islamic banks since both
focuses on the well-being of the society as a whole with the objectives of just
and equitable wealth distribution. They strive to promote the egalitarian
approach for social justice in which everybody have equal opportunity in the
economic activities and no restriction to any category or group of people.
Since financing to higher credit grading person are readily available, the
micro-finance scheme focuses on the poor, deprived and destitute segments
of the society. This will ensure that, the poor people will have the same
opportunity to get involve in the economic activities by having access to
capital.
Furthermore, micro-finance can be used as a tool for financial inclusion.
Financial inclusion by definition is the delivery of banking services at
affordable costs to vast sections of disadvantaged and low income groups15.
15http://en.wikipedia.org/wiki/Financial_inclusion
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Under normal financing, due to the perceived high risk group segment, the
financing charge imposed on this group of people is normally high. Via
microfinance, there is a potential that the charges will be accommodative or in
better way, based on the capability of these micro-entrepreneurs.
In a nutshell macro-finance can be used to promote participation of every
individual within society. If previously, poor people is handicap economically
and not able to actively participate in the economic activities due to
incapability to obtain capital, micro-finance will give them new opportunity, not
like before.
Involvement of Islamic banks in the micro-finance will give added value to
the whole scheme. This due to the nature of Islamic finance which prohibit
financing to all form of economic activities which are morally and socially
detrimental to the society. For example, the Islamic banks are prohibited from
financing alcoholic drinks which will contribute to social ill within the society. It
also prohibited from financing activities which is harmful to the nature such as
dangerous chemical which produce toxic waste and pollute the environment.
Due to prohibition of this type of activities in the society, Islamic banks will
contribute to healthy and harmonious living of community.
Among the features of micro-finance are:
a. Financing is for short-term period.
b. The financing is small. In Malaysia, the financing amount ranges
from RM500 to RM50,000 (BNM).
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c. The financing is meant for micro-entrepreneur, which consists of
self-employed, hawkers, traders and small businessmen. It also
targets the poor to start business activities.
d. Purpose of financing is for new business ventures or business
expansion.
e. The term and condition of financing is easy to understand and
flexible.
The above features means that the microfinance financings focus is the
underprivileged segment. This is the reason why it being designed to be
simple and does not require high level of knowledge to understand and
operates it.
However, it would be useful to find whether, based on experience, the
micro-finance is really useful in helping the poor and alleviating the poverty
within the society. Christopher Dunford (2006) in his article titled Evidence of
Microfinances contribution to achieving the Millennium Development Goals
concluded that:
.. there is already enough evidence to say with cautious confidence that
microfinance can and does contribute to achievement of the Millennium
Development Goals16, and in a major way already in Bangladesh, if not in
other developing countries.
16The Millennium Development Goals (MDGs) are eight goals to be achieved by 2015 that respond to the
world's main development challenges. The goals are: (i) eradicate extreme poverty and hunger, (ii) achieve
universal primary education, (iii) promote gender equality and empower women, (iv) reduce child
mortality, (v) improve maternal health, (vi)combat HIV/AIDS, malaria & other diseases, (vii) ensure
environmental sustainability; and (viii) develop a global partnership for development.
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He pointed to one major study of microfinance and its impact on poverty
conducted by Khandker17 on experience in Bangladesh. Khandker performed
massive survey of households participating in the scheme which was
conducted in 1991/92 and repeated 1998/99. The survey concluded that
microfinance accounted to 40 percent of the entire reduction of moderate
poverty in rural Bangladesh. The result also suggested that access to
microfinance contribute to reduction in overall poverty at the village level, thus
not only helping poor participants but also the local economy.
Study conducted by Mohabub Hossain titled Credit for the Alleviation of
Rural Poverty: The Grameen Bank in Bangladesh (1998) found Grameen
members average household income to be 43 percent higher than target
non-participants in comparison villages, with the increase in income from
Grameen highest for the landless, followed by marginal landowners. The
positive impact of microfinance also supported by other studies such as
Managing Resources, Activities, and Risk in Urban India: The Impact of
SEWA Bank (2001), by Martha Chen and Donald Snodgrass, Microfinance
Program Clients and Impact: An Assessment of Zambuko Trust, Zimbabwe
(2001), by Carolyn Barnes and The Impacts of Microcredit: A Case Study
from Peru (2001), by Elizabeth Dunn and J. Gordon Arbuckle Jr.
Even though there are criticisms made to the above studies which largely
based on disagreements in the methodologies used, positive impacts of
microfinance to alleviate poverty cannot be denied. With refinement of
17Khanderker, Micro-finance and Poverty: Evidence using Panel Data from Bangladesh (2005)
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methodologies are in progress and better data gathering, less criticism is
expected, with no significant changes on the conclusion.
5. Current Involvement of Islamic banks in Micro-finance
According to CGAP report, the outreach of Islamic micro-finance is very
limited18:
In all Muslim countries, Islamic microfinance still accounts for a very small
portion of the countrys total micro-finance outreach. For example, in Syria
and Indonesia, Islamic financing instruments comprised only 3 percent and 2
percent, respectively, of outstanding micro-finance financings in 2006. In
addition, the average outreach of the 126 institutions covered by the CGAP
survey is only 2,400 clients (and none has more than 50,000 clients). The supply
of Islamic microfinance is very concentrated in a few countries. Indonesia,
Bangladesh and Afghanistan account for 80 percent of the global outreach
of Islamic microfinance. In all other countries, microfinance is still in its infancy,
with no scalable institutions reaching clients on a regional and national level
In addition, Microfinance expert Dr Saad Al-Harran laments the lack of
participation by the Islamic banks and assert that as an entity based on faith,
the institution should have a bigger moral obligation to contribute to the
society19. This is despite the fact that more than 35% of the world population
or 1.3 billion people are living in poverty.
18CGAP: Islamic Micro-finance: An emerging Market Niche (2008)
19http://www.islamicfinanceasia.com/3_micro.php
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Currently there is no data available in the public domain to gauge the
amount of micro-finance disbursed by Islamic banks in Malaysia. According to
BNM, the Micro-financing has increased from RM151 million in 2000 to
RM2.2 billion in September 2009, representing an annual average growth rate
of 34%20. However, this figure consists of all players in the financial
institutions, including conventional banks and developmental financial
institutions. From observation, there is no visible micro-finance scheme
actively promoted by the Islamic banks in Malaysia.
In addition, the annual accounts of the Islamic banks did not specifically
disclose their involvement in micro-finance scheme. Based on the financing
segmentation in the financial accounts of Islamic banks, the following is
noted:
BanksBank Rakyat
MalaysiaBank Muamalat Bank Islam
Community, Social
Services & Personal*
RM84.2m RM192.7m RM59.3m
% to total financing 0.3% 3.0% 0.6%
*Figure based on Annual Report
The figure above shows that the involvements of Islamic banks in the
financing for the purpose of community, social & personal are small.
Apart from the above banks, other Islamic banks operates in Malaysia
does not disclose their financing to this segment. With the growing questions
on contributions of Islamic banks to the betterment of society, disclosure is
the area which should be handled well by the Islamic banks. The Islamic
20http://www.bnm.gov.my/index.php?ch=9&pg=15&ac=336
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banks should have appropriate disclosure in place especially on their efforts
to satisfy the objective of Shariah. The disclosure will be useful for their
stakeholders to effectively evaluate the role play by the Islamic banks in the
society.
It is interesting to note that earlier experiment of Islamic banks in Pakistan
and Egypt focused on economic development and poverty alleviation.
Establishment of Islamic banks in Pakistan during 1950s is to finance small
landowners for agricultural development. Same experience is observed in
Egypt with the establishment of Mit Ghamr Savings Bank in a rural area of the
Nile Delta. This institution later replaced by Nasser Social Bank with the
purpose mainly for social activities such as interest free financing for small
projects based on profit and loss sharing, assistance to the poor and needy
students for university and higher institutions (INCEIF, 2006). However,
through passage of time, the focus of Islamic banks have move to profit
maximization and financing billion dollar investments as seen in Dubai and
other countries. Rapid development also contributed by players who want to
tap petrodollar possess by Islamic countries, instead of focus on the
achievement of Shariah objectives.
6. Financing Scheme for Microfinance
Currently, practice of micro-finance is largely based on conventional
contract i.e. charging of interest on the financing amount. Interest rate
charged is very high to compensate for perceived high credit exposure and
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higher transaction costs since the portfolio is larger and require higher
administrative operations. However, this practice possess all characteristics
prohibited by Shariah i.e. usury (riba), gambling (maisir) and excessive
ambiguity (gharar). Islamic banks entry into microfinance and its operations
should be in compliance with Shariah principles. There are various Shariah
compliance contracts which can be utilised by the Islamic banks.
6.1. Profit and loss sharing (PLS) arrangement
Profit and loss sharing is unique concept of financing in Islamic
finance. In this arrangement, Islamic bank act as equity provider or as a
partner with micro-entrepreneur. Return to the Islamic bank is contingent
upon results of the business venture. It is fairer arrangement compared
to the borrower relationship practice in the conventional micro-finance.
Since the nature of this world is uncertain, business ventured by micro-
entrepreneur may generate a profit or may suffer a loss. As a financier,
they should share this uncertainty with their clients. They cannot just sit
there, do nothing and expect to receive return especially when dealing
with poor people. With Islamic banks carry the same risk, it will promote
Islamic banks to get involved directly or indirectly in the business to
ensure the venture will be profitable.
It is a known fact that micro-entrepreneur consists of people with low
level of knowledge and technical skills. On other hand, bank has the
knowledge and expertise as they have wide experience in dealing with
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business activities. As a mean to ensure that their partnership is
successful, the Islamic banks have to impart this knowledge to their
partner. Knowledge may be in form of good business practices, proper
accounting and record keeping, effective marketing and packaging and
etc. This gesture is useful to micro-entrepreneur and will greatly help
them to become successful entrepreneur.
Muslim economists regards PLS as truly Islamic financing
transactions. Scholars include Sadr (1982); Siddiqi (1983, 1985); Chapra
(2000a, 2000b) Ziauddin Ahmad (1984); Ahmad (2000); Siddiqui (2001);
Haron (1995, 2000), Ahmad (2000); Rosly and Bakar (2003); Haron and
Hisham (2003); Naqvi (2003) and others favour equity-based
instruments and place greater social welfare responsibilities and
religious commitments upon Islamic banks in order to realize the
Maqasid Al Shariah with respect to economic and financial transactions,
including social justice, equitable distribution of income and wealth and
promoting economic development and growth21.
There are two types of contracts under PLS arrangement i.e.
Mudharabah and Musharakah.
I. Mudharabah
Mudharabah is a trust based financing arrangement between
Islamic bank and micro-entrepreneur in which the bank entrusts
21Dr. Abdulazeem Abozaid & Dr. Asyraf Wajdi Dusuki (2007)
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capital to micro-entrepreneur to fund their business activities.
Profits made will be shared between the bank and micro-
entrepreneur based on the pre-agreed ratio. Loss is solely borne by
the capital provider as the micro-entrepreneur use the capital under
basis of trust, which means he is not liable for the losses except for
his negligence or misconduct. In Mudharabah arrangement, bank
has no control in management of business since it will be carried
out by the micro-entrepreneur only.
II. Musharakah
In Musharakah arrangement, its equivalent to joint venture
between Islamic bank and micro-entrepreneur. In this arrangement,
both Islamic bank and micro-entrepreneur provide capital and
manage the business venture. Profit sharing is based on pre-
agreed ratio, while loss is borne in proportion to the equity
participation.
Both Mudharabah and Musharakah are suitable to finance working
capital and project financing. For asset purchase, it can be arrange
under Diminishing Musharakah, in which the percentage of ownership in
the asset by micro-entrepreneur increase with every payment of
installments. The Mudharabah and Musharakah financing can be use to
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finance the needs of existing business, business expansion or as seed
money for newly start-up business.
6.2. Murabaha contract
Under Murabaha arrangement, the micro-entrepreneur appoints
Islamic bank to acquire asset or equipment on their behalf from supplier.
The bank acquired the asset and subsequently sells it to micro-
entrepreneur at mark-up price. Payment on the mark-up amount is made
by micro-entrepreneur on installment basis. This transaction is also
called cost plus transaction since the Islamic bank charge higher
selling price to micro-entrepreneur which represent the profit on
transactions. All the purchase price and mark-up has to be made
transparent to the micro-entrepreneur.
Types of transactions suitable for Murabaha concept of financing are
to finance working capital and purchase of assets.
6.3. Ijarah
Ijarah is mainly a leasing contract. In this case, the Islamic bank
acquires the asset and subsequently leases it to micro-entrepreneur.
The micro-entrepreneur pay periodic rental for the use of equipments.
This financing is suitable to finance assets used by micro-
entrepreneur to generate income.
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6.4. Bay al-Salam
Bay al Salam is contract of sale whereby the Islamic banks paid the
price of goods in advance while receive the goods in the future. The
purchase amount must be paid in full and the quantity of goods and
timing to receive it is set on transactions date.
This type of financing is suitable for agriculture activities since the
farmers require money during plantation stage such as seeds, fertilizer
and land preparation. The settlement for the financing amount is made
when the crops generate income.
6.5. Qardhul Hasan
Qardhul Hasan means an interest free financing. It also means
benevolent financing or gratuitous financing. In this case, micro-
entrepreneur returns the financing at the end of the period, with the
same amount.
This mode of financing is useful for very poor people as an act of
charity for them to be involved in business activities and generates
income to sustain their family.
7. Source of Funding for Micro-finance Scheme
It is well known fact that financing the poor is a risky business. There is
high chance that the Islamic banks may not received back the payment on the
amount disbursed to the micro-entrepreneur. This due to most of the micro-
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entrepreneur has little knowledge and technical skills to operate business
activities. Internally, micro-finance scheme requires substantial operational
cost to administer since it involves large number of customers. This will put
strain on the Islamic banks operations since not all depositors or investors are
interested to invest in this area. Due to these risk factors, Islamic banks need
to find reliable source of funding to fund micro-finance scheme. These
sources of funding also need to be sustainable to ensure its viability.
Islam is unique due to the availability of mechanism in place for the
redistribution of wealth within society. The Islamic banks may leverage on
these mechanisms to fund their micro-financing programmes. The
mechanisms are zakat, sadaqah and waqaf.
a. Zakat is compulsory religious levy and the third pillar of Islam. The
philosophy of zakat is that, from Islamic point of view, wealth is belong
to God and held by human on trust basis. Thus wealth which held by a
person has others share in it. There is where the function of zakat is.
Zakat means cleanse or purify. By paying zakat, the wealth held by
individual is being purified since portion of it has been put aside for the
poor and the needy. Zakat is useful as a form of wealth redistribution
and it manifest the social responsibility of the wealthy people. This
contributes to a balance of wealth distribution in the society. In
Malaysia, the collection and distribution of zakat is conducted by the
Islamic Affairs Councils of the various states. Distribution of Zakat is in
form of monthly cash to the needy and poor, conduct aid programs and
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build house. Zakat also can be paid directly to the eligible beneficiaries
(asnaf) which being mentioned in the Quran.
"Alms are for the poor and the needy, and those employed to
administer the (funds); for those whose hearts have been (recently)
reconciled (to the truth); for those in bondage and in debt; in the
cause of God; and for the wayfarer: (thus is it) ordained by God, and
God is full of knowledge and wisdom." (9:60)
b. Sadaqah as opposed to zakat, is a voluntary charity given by those
who have, to others who does not have. This is good deed promotes
by Islam. Sadaqah can be in various forms and not confine to material
wealth. Sadaqah is part of the social justice of Islam in which portion of
wealth is given to the needy for them to alleviate their burden.
c. Waqaf is a form of perpetual charity in which the assets such as land
and building are donated for charitable purposes. It is some form of
wealth distribution in which assets donated for charity can be used in
production process for wealth generation. Waqaf is useful since the
benefit derive from it can be in perpetuity, so long as the Waqaf s
asset is exist.
All of the above can be use as a funding source for micro-finance scheme
of Islamic banks.
Since the risk exposure towards micro-finance scheme is high and it
possibility that it will affect the other operations of Islamic banks, the bank
may create specific funding fund to cater for interested investors for micro-
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finance activities. It can be in form of Restricted Investment Account (RIA) or
Special Purpose Vehicle (SPV):
a. Restricted Investment Account (RIA)
RIA is an investment accounts with certain restriction as to where,
how and for what purpose these funds are to be invested (IFSB).
By investing in this account, the investors authorize the Islamic
banks to use their funds to finance micro-finance activities.
b. Special Purpose Vehicle (SPV)
SPV is a legal entity created by a firm (known as the sponsor or
originator) to undertake some specific purpose or restricted activity
spelt out by the sponsoring firm (Gorton & Souleles, 2005). The
benefit of SPV is that it is bankruptcy remote in nature. This means
that in the event SPV gone bankrupt, the creditors cannot claim the
debt from the sponsoring organization.
In this regards, to fully separate it from other operation, Islamic
banks may establish a SPV with the focus is to undertake micro-
finance activities. Funding for this SPV is via sukuk issuance which
will be subscribed by interested investors. Islamic banks can
provide their expertise by getting involve in the management and
operations of SPV.
By using both arrangements, whether RIA or SPV, the Islamic banks can
approach potential investors to the program. The potential investors to RIA or
SPV are:
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i. Islamic Affairs Councils
As being mentioned above, in Malaysia, collection of zakat falls under
jurisdiction of State Islamic Affairs Councils. The amounts of zakat
collected are quite substantial. For example, in 2008, Selangor Zakat
Board collected RM244.4million in 2008 while Majlis Agama Islam
Wilayah collected RM20.26 million. Based on this, State Religious
Councils can put aside some of the Zakat and become investor in RIA
or SPV. This is useful, since Islamic banks, with their expertise, able to
use zakat money to empower the poor people, for them to have better
life rather than fire fighting effort by the Councils.
ii. Individual
Islamic banks also may open the fund to interested individual. Islam
promotes sadaqah or charity to the needy person and this act is being
widely practice by Muslim. Currently, donation went straight to the
recipient and they used it in their daily lives. Eventhough, it is good for
the recipient to be able to use it straight away, however it is not
sustainable. Thus, it is better for some of this donation is channeled to
fund micro-finance activities which may generate sustainable income
to the participants.
iii. Government Fund
Government has many funds disbursed to the poor and the needy.
Some of the fund is used to build house to the poor, live maintenance,
to support single mother and etc. Since the government has all these
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funds, it may appropriate for some amount to be set aside for micro-
finance which being administered by professional bankers. This will
give more value towards effectiveness of government poverty
eradication programmes.
iv. Islamic Bank Own Fund
Islamic banks also may channel part of their internal fund for micro-
finance activities. Using its own fund has its own benefits. Islamic
banks will have additional motivation to ensure their micro-finance
program successful since they also involve in funding it.
8. Conclusion
Islamic banks should fully perform their function to achieve end game as
being espoused by Islam i.e. to create fair and just society with every
individual have equal opportunity to have better life for their family and
themselves. Islam banks should not only focus on profit maximization, but
should live to the expectations to better play their role in the society.
Eventhough there are many ways to achieve it, microfinance is one of the
scheme that has proven to effectively help the poor people to stand on their
feet.
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