islamic approaches of microfinancing. 2 lecture plan session 1: microfinance institutions (mfis)...
TRANSCRIPT
Islamic Approaches of Microfinancing
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Lecture Plan Session 1:
Microfinance Institutions (MFIs) Financing Microenterprises: Islamic
Alternatives Islamic MFIs Islamic MFIs Vs Conventional MFIs
Session 2: Financing Microenterprises: Islamic
Alternatives Islamic Banks Other Specialized Institution—Waqf-based MFI
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Session 1 IntroductionMicrofinance Institutions (MFIs)Islamic MFIs Vs Conventional
MFIsAssessment of Islamic MFIsConclusion
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Introduction (1)
In the last 50 years, different development strategies have been used to resolve the problem of poverty
Most of these programs failed “Microfinance” initiated in the mid-1970s
appears to be the ‘new paradigm’ to eradicate poverty
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Introduction (2)
Limited access to finance is key constraint to private sector growth
Investment on MSEs is even more difficult The MSEs do not qualify to get funds from
institutional sources (banks) lack of collateral too much risk too costly
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Economics of Microfinancing
Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) +
Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the
Head/regional/branch offices Microfinancing
Revenue may be low due to credit risk Costs are high due to large operating costs
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Financing MSEs Commercial financial intermediation not feasible If the poor have to be financed, there is a need
for social financial intermediation Two ways to do so:
Linking Approach—Existing financial institutions can do it through specialized windows
Specialized institutions Approach—NGOs, non-profit organizations, etc.
Almost all of MFIs models are of the second type
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Financing MSEs-Sustainability
Mitigating Credit Risk Ensure repayment in the absence of acceptable
physical collateral Solving the Moral Hazard problem
Ensure funds not diverted and used for intended activity
Economic viability —keep costs to a minimum relative to income Operating costs Financing costs
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Microfinance Institutions (MFIs) MFIs are target-oriented (poverty-focused)
financial institutions Target group—micro and small enterprises
(MSEs) (Average financing in Bangladesh is below
US$ 200 and in the US is US$ 1500) Graduation from poverty -- the “Virtuous circle”
Low income credit investment more income more credit more investment more income
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MFIs—Typical Balance Sheet
AssetsLiabilities
Cash (C)
Loans (L)
Funds from external sources (F)
Saving Deposits (D)
Reserves (R)
Equity (E)
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MFIs-Main Features
Interested individuals must form a group Several Groups form a Center Center has weekly meetings An official from the MFI attends the meetings
and all transactions take place in these meetings (bank goes to the people)
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Organizational Structure of MFI Clients
G rou p G rou p
M em b er M em b er M em b er M em b er M em b er
G rou p G rou p G rou p
C en te r
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MFIs-Other Features
Small amount of funds given for microenterprises for 3months -1year
Capital and interest paid back in small weekly installments
Forced savings and insurance programs Social Development Programs
behavioral, ethical, and social development
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MFIs-Social Collateral
MFIs have devised a structure to resolve the collateral and risk problems of financing No physical collateral required The repayment of dues of a member in the group is the
collective responsibility of the all the members in the group If any one in the group defaults--all members become
disqualified for credit Peer-pressure works as social collateral
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Banks Vs. MFIs (1)
BankMFI
A profit-maximizing firmNon-profit Government/non-government organization
Financial intermediary between savers and investors in the economy
Funds from external sources provided to the poor
Deposits form bulk of the liabilitySavings (forced) of clients only deposits
Do not have social/educational programs
Includes social/educational programs
Physical/financial collateral required to get funds
Social collateral through group and center formation
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Banks Vs. MFIs (2)
BankMFI
Clients relatively well-offClients are poor
Clients come to the bankBank goes to the clients
Amount of loan largeAmount of loan small
Most clients are menMost clients are women
Repayment frequency small (end of the contract period)
Repayment is frequent (weekly)
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MFIs and Sustainability Mitigating Credit Risk (CR)
CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem
Cash given out can be used for other purposes –chances of default increases
Economic Viability High administrative costs (some estimates show costs
ranging from 24 to 400% of per dollar lent) Reasonable finance costs
Conventional MFIs have resolved the CR problem (social collateral), but not MH problem and Economic Viability problem
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Islamic Alternatives to Microfinancing
Different alternatives: Islamic MFIs Islamic Banks Specialized Institutions
Group-based microfinancing can be used (as it mitigates the CR)
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Islamic MFIs-Features (1) Islamic MFI retains the basic operational format of
MFIs Going to the Clients Weekly/Monthly Repayments A Social/Development Program (to fulfill the social role of
Islamic finance) IMFIs have some distinguishing features:
Sources of Funds Other than external sources, can also use funds from
zakah, awqaf, and other forms of charities Use of funds (Mode of Financing)
Sale based and hiring modes (murabahah, salam, ijarah) Profit-sharing modes (Musharakah and mudarabah)
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Islamic MFIs-Features (2) Amount transferred to the poorest
As Islamic modes are sale based the price of the asset is paid (no deductions are allowed)
Group Dynamics Islamic values of brother/sister-hood improves cooperation
among the group members
Financing the poorest Zakat and other charities can supplement MFI activities
(non-diversion of funds)
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Islamic MFIs-Features (3) Social Development Program
behavioral, ethical, and social aspects in light of Islamic teachings
Targeting the family through women Spouse co-signs the contract dealing with women more efficient and convenient Women disseminate knowledge to children
Dealing with Arrears/Default Less aggressive and use Islamic teachings to recover
loans
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Islamic MFIs and Sustainability
Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending)
Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion
and default decreases
Economic Viability High administrative costs Reasonable finance costs
Islamic MFIs can resolve the CR problem and the MH problem, but not the Economic Viability problem
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Problems facing Islamic MFIs
1. Dilution in the Application of Islamic Modes of Financing Main mode- murabahah or bai-muajjal.
It is difficult to go out with the clients and buy the goods/assets from faraway markets
IMFIs delegates someone else (and inspects later) Alternative is to use Profit-sharing modes
Problem is the moral hazard problem--No book-keeping and difficult to monitor
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Problems facing Islamic MFIs
2. Lack of Funds Most MFIs get their funds from external sources Islamic MFIs have difficulty in getting funds from
these sources Operations and expansion of activities affected Islamic MFIs have not yet tapped the sources of
funds from Islamic institutions (like zakah, waqf, and other charities)
3. Training Training can enhance efficiency but is costly
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Conclusion
Islamic approach to microfinance has certain advantages Diversified asset and liability structures Social collateral stronger Potential to target the poorest through
complementary programs Asset-based modes of financing can prevent
diversion of funds for consumption Lack of funds hampering its growth
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Session 2
Financing Microenterprises: Islamic ApproachesIslamic BanksSpecialized institutions: Waqf-
based MFI
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Financing MSE by Islamic Banks (IBs)
The Rationale Social Role –Islamic firms are not only about
fulfilling Islamic contracts…there is more to it (social justice and benevolence)
Financing is the specialization of IBs—expand the client base to the MSEs
Can be done at no cost to the IB and more cost effectively than MFIs
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Financing MSEs by IBs
Use the same format as MFIs (as it suits the MSEs)
IBs can open up a department for financing MSEs
Use the existing infrastructure (bank offices) for financing MSE operations
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IBs & Economics of Microfinance
Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) +
Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the
Head/regional/branch offices
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MFIs Vs. IBs: Operating Costs MFIs
For any level of operations an MFI will maintain offices—Higher Fixed Costs
Higher Variable Costs (wages) at Head/regional/branch offices
IBs No extra costs needed to maintain offices for the
Microfinancing program (can use bank’s premises)—lower fixed costs
Lower Variable Costs (wages) at Head/regional/branch offices
Conclusion: Operation Costs to finance MSEs is lower in case of IBs compared to MFIs
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MFIs Vs. IBs: Finance Costs MFIs: Sources of funds
Main source –external funds (MFI has pay a rate of return, though subsidized in many cases)
No Deposits—Forced Savings of Members—Competitive returns are paid on savings
IBs: Sources of Funds Deposits
Demand Deposits (no costs) Investment Deposits (has to pay competitive returns to
depositors) Conclusion: Given the excess liquidity in IBs, the
funds from Demand Deposits can be used for MSEs—Finance costs of IBs can be lower than that in MFIs
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MFIs Vs. IBs: Quality of Service Dependence on external funds in MFIs comes with
conditionalities—IBs more flexible Lack of funds in MFIs—poorer quality work force
(especially at field level)—can increase the default rate
IBs pay competitive wages—good quality workers with higher productivity
Employees of IBs can be trained by the Bank at low cost—not possible in case of MFIs
Most IBs have funds collected from penalties for late payments—these funds can be used for complementary asset building/poverty reducing programs—asset building in form of grants or qard-hassan
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IBs and Sustainability Mitigating Credit Risk (CR)
CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem
As asset/good given instead of Cash, chances of diversion and default decreases
Economic Viability Low administrative costs
No need for a hierarchy of senior management and offices Use existing branches for operation
Low finance costs Excess liquidity—use liquid funds available
IBs appear to resolve all the problems related to sustainability in microfinancing.
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IB and Microfinancing: An Example
Islami Bank Bangladesh Ltd (IBBL) has a Rural Development Program (RDS) to finance MSEs
Started in 1996 and funded from IBBLs general investment fund
As of October 2006, RDS operated from 116 branches (of 176 total), covering 7,788 villages giving a total of Tk. 8589.7 mill. to 368,360 clients
The recovery rate is 99 percent. Employees involved with RDS have better benefit
packages than other MFIs Employees get in-house training at IBBL Training
Academy
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RDS of IBBL
Loan amount (Tk. 3000 to Tk. 25000) Paid back in weekly installments No physical collateral required Group-based lending Rate of return charged is 10 percent with
2.5% rebate for timely payment (other MFIs rate range from 16 to 20 %)
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Microfinancing by Specialized Institutions
1. Cash Waqf—waqf established in the form of cash Can be used for microfinancing
2. Qard hassan bank—nonprofit financial intermediary Capital would be cash waqf Will receive current accounts Provide qard hassan (interest free loans) for microfinancing
3. MFI based on Awqaf and Zakat Returns from waqf given for investment purposes and
zakat funds for consumption purposesUse the same operational format as MFIs (as it suits
the MSEs)
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Waqf-based MFIs
Historically, waqf based institutions did provide loans to the disadvantaged (Turkey and Iran)
W-MFI will retain the basic operational format of MFIs, but will have some distinguishing features
Group-based microfinancing can be used (as it mitigates the CR)
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W-MFI: Sources and Uses of Funds
Sources of Funds Obtain funds from Waqf and other sources (waqf
certificates, qard hasan deposits, etc.) Use of funds (Mode of Financing)
Qard (loan at service charges) Sale based and hiring modes (murabahah, salam,
ijarah) Profit-sharing modes (Musharakah and
mudarabah)
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W-MFI: Typical Balance Sheet
Assets Liabilities
Cash (C)
Assets (A)Fixed income assets (F)
Microfinancing (M)Qard, investments(murabahah, ijarah, salam, istisna, mudarabah, musharakah)
Savings Deposits (Ds)
Qard hasan Deposits (Dq)
Waqf Certificates (S)
Takaful reserves (T)
Profit equalizing reserves (P)
Reserves/Econ Cap. (V)
Capital-Waqf (W)
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Special features of W-MFI
Liability Waqf—the corpus (endowment) has to be intact Savings deposits — mudarabah contracts
Loss of lower return can lead to withdrawal risks
Assets Allocation of assets into fixed income and
microfinancing activities
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WMFI – Nature of waqf and investment options
Waqf—the requirement of keeping the corpus intact Simplest-option—Invest the waqf endowment in
some safe fixed-income asset and use the returns for MF operations
The scope of MF will be limited
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Example
Waqf of $10 million, rate of return 5%, financing $100 per beneficiary
(Grameen Bank 5.5 million beneficiaries given $5 billion)
AssumptionNo. of beneficiaries
Use waqf returns only5,000
Use 90% of the endowment
90,000
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Allocation of Assets
Risk and returns depend on allocation funds into different assets Fixed income (FI) assets—low-return low-risk
assets Microfinancing—higher returns with higher risks
Invest in FI assets so that returns can cover expected losses from microfinancing
In addition, build various reserves to cover various risks
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Risk-reducing reserves
Takaful reserves Contributed by beneficiaries Used in case of default due to unexpected reasons
Profit-equalizing reserves Contributed by depositors Used to maintain competitive returns
Economic capital reserves Contributed from the surplus of MFI (no dividend
distribution) Used in case of negative shock
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Other funding sources
Funds from Zakah and other charities Funds from waqf given for investment purposes
and zakah funds for consumption purposes
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W-MFI & Sustainability Mitigating Credit Risk (CR)
CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem
As asset/good given instead of Cash, chances of diversion and default decreases
Economic Viability High administrative costs Low finance costs
Being charities there are no finance chargesThese specialized institutions resolve CR and MH
problems and to lesser extent the viability problem
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Sustainability-Relative Status
Credit Risk
Moral Hazard
Economic Viability
Conventional MFIs
NoYesYes
Islamic MFIsNoNoYes
Islamic BanksNoNoNo
W-MFINoNoSomewhat
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Conclusion
There are strong economic reasons for establishing Islamic alternatives to poverty-focused microfinancing.
Financing should adopt operational mechanisms of MFIs (as they suit these clients)
Financing MSEs by IBs is most efficient (cost effective)—given the social responsibility and excess liquidity in IBs, financing MSEs should be undertaken
Traditional institutions of waqf, zakat, and qard hassan are important means of financing MSEs during contemporary times—should be integrated with microfinancing
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THANK YOU!