practice of interest free finance and its...
TRANSCRIPT
139
Chapter 4
PRACTICE OF INTEREST
FREE FINANCE AND ITS
SIGNIFICANCE
140
Chapter 4
Practice of interest free finance and its significance
From the previous chapter it is clear that the current system of microfinance
has been facing a lot of problems including higher interest rate and interest free
microfinance has recently emerged as a tool for financial inclusion and poverty
alleviation. Interest free microfinance is the result of marriage between microfinance
and Islamic interest free banking. In this chapter an attempt is made to present the
background of interest free financial system, major practices of Islamic banking and
finance, advantages of interest free financial system over conventional interest based
system and finally modeling an interest free microfinance institution focusing on
poverty alleviation.
4.1 A Critical Analysis of Interest
Interest is the foundation of economic and financial system in contemporary
world. The entire financial system tied up with threads of interest. The relationship
between banks with its customers and central bank with financial institutions are on
the basis of interest. The monetary policies to regulate the economy are mainly based
on interest. Thus interest is the key tool used in modern economies to direct the
money and capital in to various fields. Therefore a change in the rate of interest
affects the entire financial system.
Most of the modern economists also considered interest as the strategic price
for capital. To them it is the nervous system of modern banking, the main tool for
management of monetary system, the effective saving factor and criterion to direct
investment allocation in to most efficient projects. According to them interest is
inevitable and unavoidable for the smooth functioning of the economy. Any attempt
to escape from this fate will, accordingly, be doomed to failure because the
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elimination of interest makes capital as free as air. The following part of this chapter
is an attempt to analyze the ethics and economics of interest.
Interest is the price paid to lenders for the use of their liquid money.
Economists have given different definitions to interest. Most prominent among them
is ‘Interest is the excess of money paid by the borrower to the lender over and above
the principal for the use of the lender’s liquid money over a certain period of time’.
Accepting this broad definition, the practice of interest can be traced back
approximately to four thousand years1.
4.1 a. Concept of Interest in ancient literature
From time immemorial scholars from different fields including theologians,
philosophers, social thinkers, philanthropists, and economists have been debating the
ethics of interest. The oldest known references to interest are found in ancient Indian
religious manuscripts. Jain (1929)2 provides an excellent summary of these. In the
earliest of such records derived from the Vedic texts of Ancient India (2000‐1400 BC)
the “usurer” (kusidin) is mentioned at several contexts and interpreted as any lender at
interest. Other detailed references to interest payment are found in the later Sutra texts
(700‐100BC), and in the Buddhist Jatakas (600‐400 BC). It is during this latter period
that the first sentiments of contempt against interest are expressed. Vasishta, a well
known Hindu law‐maker of that time, made a special law which forbade the higher
castes of Brahmans (priests) and Kshatriyas (warriors) from being usurers or lenders
at interest. Also, in the Jatakas, interest is referred to in a demeaning manner:
“hypocritical ascetics are accused of practicing it”. By the second century AD,
however, interest had become a more relative term, as is implied in the Laws of Manu
of that time: Stipulated interest beyond the legal rate was considered usurious way of
lending. From the time of Manu the concept interest got diluted and this dilution
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confined in the subsequent periods also. However interest confined to be condemned
in Indian society 3.
The Greek philosopher Aristotle rejected interest on the grounds that “money
is sterile”. Cato even compared it with homicide. Among the ancient western
philosophers who condemned interest, Plato, Cicero, Seneca and Plutarch got
prominence4. In 594 BC Solon cancelled all private and public debts when he
reformed the Athenian constitution. In 340 BC, Lex Genucia prohibited interest in the
Republican Rome. In Judaism interest was considered unfriendly and unfair act.
4.1 b. Interest and Christianity
The Bible specifies this in the following words. “If you lend money to any of
my people with you who is poor you shall be to him as a creditor, and you shall not
exact interest from him.” (Ex: 22:25) “He that hath not given this money upon usury;
nor taken reward against the innocent; He that doeth these things shall never fall”
(Psalm: 15) He that hath not given forth upon usury, neither hath taken any increase,
that hath withdrawn his hand from iniquity, hath executed true judgment between
,man and man” (Ezekiel: 18:8) The moral teachings of Jesus in this direction as
indicated by the following, are clear and unqualified: “Love your enemies and do
good; lend expect nothing in return” (Luke 6.35)5.
Building on the authority of Bible, the Roman Catholic Church forbade the
clergy from taking interest when Roman Empire became Christianized in 4th century.
In the eighth century under Charlemagne, they pressed further and declared interest to
be a criminal offence. This anti‐interest movement continued to gain momentum
during the early middle Ages and perhaps reached its zenith in 1311 when Pope
Clement V made the ban on usury absolute and declared all secular legislation in its
favor, null and void6.
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St. Thomas Aquinas was of the view that money was invented chiefly for the
purpose of exchange and that its principal use was its consumption and annihilation
whereby it is sunk in exchange. Hence it was unlawful to make payment for the use of
money lent.7 Zamir Iqbal, points out that prohibition of interest is not limited to Islam
but is also shared by Judaism and Christianity and the first interest free bank in
documented history Agibi Bank was established in pre-Islamic period circa 700 B.C.
in Babylonia. This bank functioned exclusively on an equity basis.8
4.1 c. Interest and Islam
The criticism of interest in Islam was well established during Prophet
Mohammed's life and reinforced by his teachings from the Holy Quran dating back to
around 600AD9. In Islam, the ruling against interest is very clear. Almighty God has
clearly stated in the Holy Quran, “Those who devour usury will not stand except as
stands one whom the Evil one by his touch hath driven to madness. That is because
they say "trade is like usury". But God hath permitted trade and forbidden usury.
Those who after receiving direction from their Lord, desist shall be pardoned for the
past; their case is for God (to judge); but those who repeat (the offense) are
companions of the fire they will abide therein (for ever)”10.
Prophet Muhammad strictly warned against interest. Prophet abolished all
interest, which the people owed to. He issued strong instructions that if they persisted
in demanding interests, war should be declared on them. He said, “All Interest on
loans taken during the period of ignorance (i.e. Pre‐Islamic era) stands abolished. And
I abolish all interest on loans advanced by my uncle Abbas”. “He who takes interest
and he who pays it and the scriber who writes the contracts of interest and he who
utilizes it will have the curse of God upon them”11.
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4.1 d. Origin of Interest based financial system
Towards the end of the sixteenth century in the face of strong movement in
favor of relaxing restrictions on interest, charging of a reasonable level of interest
generally became an acceptable practice. In 1545 King Henry VIII of England
changed his nation’s laws to allow some forms of interest. By the 1700’s charging
interest was accepted as a fair business practice. Since that time, most disagreements
about interest happened to be on the maximum rates that lenders should be permitted
to charge12.
4.1 e. Interest and modern economists
Many economists believe that the interest rate mechanism is not in practice an
effective tool for allocation of resources, particularly in the case of the amounts that
can be loaned for the purpose of investment. Indeed the opposite is the case. Some
studies find that Adam Smith, the father of modern economics was in favor of
controlling interest13. While he opposed a complete prohibition of interest, he
supported imposition of an interest rate ceiling.
The great twentieth century economist John Maynard Keynes in his General
theory defined interest as a price for demand for money and according to him rate of
interest is determined changes in liquidity preference and fixed supply of money. He
ignored the real factors like productivity in determining rate of interest. But he
revealed the inverse relationship between interest and speculative motive and agrees
the point that lower interest rate may make the capital more productive. In his own
words “the disquisitions of the schoolmen (on usury) were directed towards
elucidation of a formula which should allow the schedule of the marginal efficiency to
be high, whilst using rule and custom and the moral law to keep down the rate of
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interest, so that a wise Government is concerned to curb it by statute and custom and
even by invoking the sanctions of the Moral Law”14.
The famous economist Harrod (1956)15 opines that loans contracted to fight
unemployment, should carry no interest and suggests the creation of an independent
authority, “governing stabilization fund”, which will generate the necessary interest
free resources. It boils down to expansion of money supply through central bank
without any interest to it. Karl Marx16 rightly says “money exchanged for money, a
form that is incompatible with the nature of money. Therefore the usurer is most
highly hated” He quotes with approval of Martin Luther who gave good definition of
interest as can be whoever takes more or better than he gives, that is usury and is no
service.
The negative influence of interest rate on the process of capital formation and
its ineffectiveness in the treatment of inflationary and deflationary disorders are
considered as the most important causes of instability in the contemporary economies.
In the early 1980s the famous economist Milton Friedman asked, what caused the
unprecedented irrational performance of the American economy. He concluded that
the main cause was the equally irrational behavior of the interest rates17.
In an identical proposal made by Meade (1950)18, the name of the agency is
changed ‘Unemployment Assistance Board’ which will finance itself by new notes
issued by the bank of England on which no interest would be claimed. According to
Haberler,(1939)19 the theory of interest has for a long time been a weak spot in the
service of economics. According to Samuelson (1976)20 “for at least another 100
years we must pretend to ourselves and to everyone that fair is foul and foul is fair, for
foul is useful and fair is not. Avarice and usury and precaution must be our Gods for a
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little longer still”. He concedes that “at zero rate of interest we could reach a time of
golden age” (P 822)
J Enzler, W Conard and L Johnson (1981)21 have concluded field research
that, capital in contemporary economies has been seriously misallocated in various
sectors and various types of investment primarily because of interest rates. Interest is
an inferior tool. It misdirects the allocation of resources, prejudices as it is to large
scale projects on the unproven assumption that they are automatically credit worthy.
As a result interest stimulates monopolistic tendencies. Moreover, surveys by J E
Meade and P W Andrews (1938)22 have confirmed that business men believe that the
interest rate mechanism is not an important factor in determining the level of
investment. In other words the demand for investment is inelastic in relation to the
rate of interest. There are two reasons for this. First of all the rate of interest
represents only a small proportion of the expenses of new investment projects.
Secondly many projects depend of self financing, which limits the effects of interest
as an implicit cost carried out by invested capital.
In a study on the American experience carried out by H Leibling (1980)23
found that a rise in interest rates was a serious hindrance to investment. During the
period studied (1970-1978), the total interest paid out amounted to one third on the
total return on capital which led to an erosion of the profitability of companies. As a
result the proportion of risk bearing capital (shares and loans) declined and capital
formation declined as well. This forced the American economy in to downward cycle
of reduced productivity leading to a diminished capacity to compensate for the higher
cost of borrowed capital causing in turn a further decline in both profitability and
average level of capital formation.
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In a study Abdul Hamid El Gazzali (1987)24 observes the limitation of interest
rate mechanism as a corrective measure for inflationary and deflationary pressure. At
the time of inflation the expected rate of return on investment is higher than the
increased interest rate in the economy. So the interest rate mechanism is insufficient
as a cost element to control inflation. In the case of deflation the limitation is more
obvious. There is sufficient incentive to borrow, but severe stagflation prevents for
realizing a gain over and above the cost of credit. In developing countries the situation
is worse because of the already limited efficiency of financial system. According to
him the problem here is not a monitory nature but structural one.
Fluctuations in the interest rates creating uncertainty in the investment
markets, which makes difficult to make long-term investment decisions with
confidence and reliability. H Simons (1948)25 attributes the famous world depression
in 1930s to the change in commercial confidence, arising from an unstable credit
system. He believes that the danger of economic disorder can, to a great extent, be
avoided if loans, particularly short term loans are eliminated, and if all investments
are self financed or financed by partnership. In this same context H Minskey (1975)26
emphasizes the fact that self financing of projects and rational investments of
undistributed profits gives rise to a strong financial system, while external financing
through borrowing exposes the system to instability.
Shaikh Mahmud Ahmad27 searched through several theories of interest,
developed since the time of Adam Smith, to show that there had been no satisfactory
explanation of existence of a fixed and predetermined rate of return to financial assets.
He went further; analyzing the writings of economists such as Keynes, Bohm Bowerk,
Cassels, and Samuelson, to argue that an objective assessment of these writings would
lead one to believe that all of these writers held a reasonably strong conviction that
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the existence of a fixed and predetermined rate of interest was an impediment to the
process of economic growth and development.
Mohsin S. Khan28, in his article notes that the abolition of interest-based
transactions is not a subject alien to even western economic thought. Several western
writers including Fisher, I., 100 % Money, (1945), Simons, H., Economic Policy for a
Free Society, (1948) and Friedman, M., 'The Monetary Theory and Policy of Henry
Simons,' in Friedman, M., (ed.), The Optimum Quantity of Money and Other Essays,
(1969), among others, have argued that the current (one-sided liability) interest-based
financial system is fundamentally unstable. Monetary economists insist that a zero
nominal interest rate is a necessary condition for optimal allocation of resources. They
argue that after switching from metallic to fiat money, adding one marginal unit of
real balance costs no real resources to the community. Therefore, imposing a positive
price on the use of money would lead traders to economize on the use of money, in
their pursuit to minimize their transaction costs. They would therefore use some real
resources instead of money. However, when the rate of interest is zero traders will
have no incentive to substitute real resources for money. More real resources can
therefore be directed to consumption and investment. In Simon’s view the basic flaw
in the traditional system is that, as a crisis developed and earnings fell, banks would
seek to contract loans to increase reserves. Each bank could do so, however, only at
the expense of other banks.
Abdel Hamid El Gazzali (1994)29 observes when interest rate was raised
during 1970s the ratio of gross national capital expenditure to gross national output in
western countries declined. Average international growth also declined. Weak
investment performance was the main factor contributing to the slow growth during
this period. This was the result of the erosion of profitability of projects because of
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high interest rates. Many economists are the opinion that not the rate of interest but
the rate of profit is the real decision factor which drives the production and growth in
all economies. Studies carried out within the American banking system corroborate
this conclusion by demonstrating the strong link between level of investment and
profits. R Turvey30 has confirmed that the rate of interest does not control the
economy, that the interest rate mechanism is unfit to regulate the investments
decisions and that it should be replaced by rate of price of real assets.
Hifzulrab31 presented an interesting calculation on interest and proves that the
inflation is the result of system of interest. An amount lent at 15% yearly compound
interest doubles in less than 5 years, it multiplies 10 fold every 16½ years, 1000 fold
every 49½ years and 1174313 fold every 100 years. Net output of the world does not
multiply even 10 fold in 100 years. Thus, net real rate of growth is below 2.4 %.
Therefore, even if capital worth 20 % of the total resources of the world could be
invested at 12% interest compounded yearly, the overall growth of the world’s
economy will not be enough even for clearing the interest. Thus, interest is killer for
the economy especially for the economy of indebted nations.
In another paper Hifzur Rab32 points out that If 100 gm of something is
borrowed at 10% interest, amount payable to clear this loan grows to equal weight of
earth in 695 years. Dues growing in this exponential pattern cannot be cleared unless
the unit of account is manipulated (depreciated). Normally economic transaction use
medium of exchange as unit of account implying that the system of interest cannot be
sustained without monetary manipulation.
One major reason to condemning interest is that it is an agent of economic
instability. An interest based system is inherently unstable due to lack of
synchronization between enterprise’s payment obligations to its financier and its
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expected receipts33. Gesell’s (1904)34 main objections to interest are that it is an
endemic factor in the instability of interest‐based economies, i.e. the cycles of boom
and bust, recession and recovery. Ahmad, arguing from an Islamic perspective, claims
“the greatest problem in the capitalist economy is that of the crises (and) interest plays
a peculiar part in bringing about the crises” (1958: 36)35. Even Keynes, the
campaigner for interest‐based monetary policy, admits the fact that “the rate of
interest is not self‐adjusting at the level best suited to the social advantage but
constantly tends to rise too high” (1936: 350)36. Kennedy (1995)37 is bolder,
suggesting that the compounded growth of interest may in fact cause inflation.
From the above words of famous economists and practitioners it is clear that
interest is not a good instrument to regulate the economy. Instead of interest different
instruments to assure high returns for capital and secure the stability and efficiency of
economy have been developed in the world years back. Now the interest free financial
instruments and institutions have developed as an apt alternative for interest based
financial system. The following portion of this chapter will give a brief picture about
the working of interest free system.
4.2 Treatment of money in modern economic system and its influence on interest
Money is a medium of exchange. It cannot be treated as a commodity. It has
no intrinsic value. Therefore it cannot be utilized in direct fulfillment of human needs
or traded to acquire extra earnings. It means money is neither considered as a
consumer good nor a productive good. If money is exchanged for money in
exceptional situations the payment of both sides must be equal. It should not be used
for the purpose of which it is not meant for, ie trading. Similarly money becomes
productive good only when it is converted in to capital or capital equipment. The
reward for capital is variable, hence charging fixed rate of interest as the reward for
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capital is injustice. The returns can only be shared among various parties involved in
the production process. On the other hand charging of interest will increase the cost of
production and lead to price rise and inflation. Thus interest on productive loan affects
the economy as a whole40.
The famous Islamic scholar Ghazali41 rightly remarked this nine centuries
back. He describes “and whoever effects the transactions of interest on money is, in
fact, discarding the blessing of Allah and is committing injustice, because money is
created for some other things, not for itself. So the one who has started trading in
money itself has made it an objective contrary to the original wisdom behind its
creation, because it is injustice to use money for a purpose other than what it was
created for. If it is allowed for him to trade in money itself money will become his
ultimate goal and will remain detained with him like hoarded money. And
imprisoning a ruler or restricting a postman from conveying messages is nothing but
injustice”
Money is only a medium of exchange and a measure of value is universally
accepted by almost all the economists of the world, but unfortunately a large number
of these economists failed to recognize the logical outcome of this concept, so as
clearly elaborated by Gazzali; that money should not be treated as a commodity meant
for being traded in. After holding that money is a commodity the modern economists
have plunged into a dilemma that was never resolved satisfactorily. The interest is
excess money charged over the lending of money and not the reward for capital as an
agent of production. Therefore it is injustice since it treats money as a commodity
which is not correct.
During the great depression of 1930s a committee was formed under the
chairmanship of Mr. Dennis Mundy42 to study about the depression. In its report the
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committee has discussed the root causes of the depression in national and
international trade and suggested different measures to overcome the problem. One of
the important recommendations of the committee was that ‘in order to ensure that
money performs its true function of operating as a means of exchange and
distribution, it is desirable that it shouldn’t be traded as a commodity’.
The famous economist James Robertson43 observes in his work transforming
economic life in the following words. “Today’s money and finance system is unfair,
ecologically destructive and economically inefficient; the money-must-grow
imperative drives production and this consumption to higher than necessary levels. It
skews economic effort towards money out of money and against providing real
services and goods. It also results in a massive worldwide diversion of effort away
from providing useful goods and services into making money out of money. At least
95% of the billions of dollars transferred daily around the world are for purely
financial transactions, unlinked to transactions in the real economy”.
It means that the real reason for expansion of money and economic depression
is consideration of money as a commodity. Modern economists and Islamic scholars
are joining together in the common point. Imam Ghazali44 pointing out that, “interest
is prohibited because it prevents people from undertaking real economic activities.
This is because when a person having money is allowed to earn more money on the
basis of interest either in spot or in deferred transactions, it becomes easy for him to
earn without bothering himself to take pains in real economic activities. This leads to
hampering the real interests of the humanity because the interests of the humanity
cannot be safeguarded without real trade skills, industry and construction”.
In Islamic finance money is no more than a servant and used no more than a
medium and measure, on the other in conventional finance money itself becomes a
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commodity and object. Thus the historical role of money an intermediary for
exchange (commodity-money-commodity, C-M-C) gets transformed into money-
commodity-money (M-C-M) and ultimately ends up into M-M-M. According to
Professor Khurshid45 derivatives trade at the rate of 1.2 trillion a day is almost 50
times more than the daily physical international trade in goods and services. The
balloon of the financial economy is expanding at an alarming pace via speculation,
while the real economy is only crawling. For Islamic economists the real economic
progress and development consist in the expansion of the physical and human
aggregates of the economy via the creation of assets, products and services, and not
merely in the form of fiduciary expansion.
4.3 What is the alternative?
In conventional economics interest is the reward and price for capital as a
factor of production. That is the reason why interest is prevailed in modern financial
system. Islamic economics approaches the capital and interest in a positive way.
Interest itself cannot be treated as a reward for capital. Capital is rewarded according
to its productivity. The entrepreneur uses the capital as a tool for regulating the other
factors of production like land and labor. The profit is the reward of entrepreneur and
capital jointly. In Islamic economics capital and enterprise cannot be treated as
separate factors of production. Both are one and the same and treated as a single
factor of production. This reward is shared by savers, investors and intermediary
institutions like banks or microfinance institution. The important feature here is the
losses are also shared among the capital owners46.
Interest free institutions are those financial institutions which are financing
without interest. The concept of interest free ethical finance is introduced to the
financial sector by the Muslim world. So this is also known as Islamic finance. In
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Islamic finance there are alternative methods to mobilize savings and of investment.
Islamic banks and financial institutions are receiving deposits from the public as
shares and returning it after maturity with a part of profit earned from investments.
These institutions are providing capital to the unemployed and needy entrepreneurs
and strictly monitoring the working of these institutions. Providing interest free
consumer loans are another important function of interest free establishments. In the
following pages of this chapter, we shall discuss the concept, ideology and working of
interest free institutions and their present position in different nations.
4.4 Theoretical background of Islamic banking and finance
Islam is not merely a religion; it provides a complete code catering for all
fields of human existence, individual and social, material and moral, economic and
political, legal and cultural, national and international.47 It is a comprehensive way of
life, religious and secular; it is a set of beliefs and a way of worship; it is a vast and
integrated system of laws; it is a culture and civilization; it is an economic system and
commercial norm; it is a polity and method of governance; it is a society and a family
conduct; it is a spiritual and human totality; thus worldly and other worldly.48
The recent surge of religious consciousness amongst the Muslims has
provided the drive towards implementing and adopting Islamic principles in financial
transactions. In other words, an outcome of this revival is the emergence of a new
discipline, i.e. Islamic Finance. This discipline is based on the knowledge and
application of the injunctions and norms of Shari`ah which prevent injustice in the
acquisition, management and disposal of material sources. Among the most important
teachings of Islam for establishing justice and eliminating exploitation in business
transactions, is the prohibition of all sources of unjustified enrichment and the
prohibition of dealing in transactions that contain excessive risk or
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speculation.(Siddiqi)50 Islamic scholars have deduced from the Shari`ah three
principles which distinguish Islamic finance from its conventional counterpart. These
are briefly as follows:
4.4 a. The Prohibition of interest/usury
The prohibition of riba or interest/usury is clearly the most significant
principle of Islamic Finance. Riba translates literally from Arabic as “an increase,
growth or accumulation”. In Islam, lending money should not generate unjustified
income. Riba represents, in the Islamic economic system, a prominent source of
unjustified advantage.
4.4 b. Profit and Loss Sharing (PLS)
PLS financing is a form of partnership, where partners share profits and losses
on the basis of their capital share and effort. Unlike interest-based financing, there is
no guaranteed rate of return. Islam supports the view that the Muslims do not act as
nominal creditors in any investment, but are actual partners in the business. It is
comprised of equity-based financing.
4.4 c. Gharar or uncertainty and Speculation
Any transaction that involves Gharar is prohibited. Parties to a contract must
have actual knowledge of the ‘subject matter’ of the contract and its implications. An
example of Gharar is an agreement to sell goods which have been already lost.
4.5 Financing Techniques of interest free institutions
Interest free financial institutions around the world have devised many
financial techniques that are basically derived from Islamic law of contract. Following
section gives a brief account of the interest free financial techniques adopted by
worldwide. These can be grouped under three broad categories. After a discussion
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about main contractual form some accessory contracts which facilitate the functioning
of interest free financial institution are also mentioned.
4.5 a. Participatory financing
1. Mudarabah (Trusteeship Financing)
Mudaraba is an agreement between two parties; one provides the capital and
the other known as fund manager (mudarib) uses his entrepreneurial capabilities and
manages the fund and the project. The profit arising from the project is distributed
according to a predetermined formula. Any losses accruing are born by the provider
of the capital. The provider of the capital has no control over the management of the
project.
Chart 4.1
Structure of mudarab financing
Source: Mohammed Obaidullah (2008) Islamic financial services, IDB, IRTI, Jedda
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Trusteeship financing (mudaraba) is a contract between at least two parties in
which the bank as the investor supplies the entire capital of the business forming a
relationship between the supplier of capital and the user of capital. Very important
feature of this type of contract is bearing of the liability to loss to the financier only;
the working party i.e. the user of the capital bears no part of the loss accruing to the
capital extended by the financier. His only loss will be his labor, which will get no
reward. The basic structure of mudaraba financing is illustrated in chart 4.1
Steps in mudaraba transactions
1) Bank and client decided to implement a business after the discussion; bank
provides funds to client towards capital investment.
2) Client sets up the business and manages its operations. Bank keeps
observation on acc.
3) Business generates positive or negative returns.
4) If profits is positive shared between client and bank as per a pre agreed ratio.
5) If profits are negative borne by bank;
2 Musharakah (Joint venture Partnership)
Musharaka is a partnership between two parties who both provide capital towards
the financing of a project. Profits are sharing on a pre agreed ratio, but losses are
shared on the basis of equity participation. Both or any of the party may carry
management of the project.
In this case the bank and the customer jointly contribute capital. They also
contribute managerial expertise and other essential services at agreed proportions. An
individual partner does not become liable for the losses caused by others. The
structure of a musharaka transaction of a bank is as follows.
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Chart 4.2
Structure of musharaka partnership
Source: Mohammed Obaidullah (2008) Islamic financial services, IDB, IRTI, Jeddah
Steps for musharaka partnership are
1. Client and Bank discuss business plan and jointly contribute to capital of the
venture;
2. Client and Bank jointly set up the business venture and manage its operations
jointly.
3. Profits if positive, are shared as per a pre-agreed ratio;
4. Profits if negative are shared in proportion to capital contributions
3 Diminishing Musharaka:
A diminishing musharaka is a recent innovation. Musharaka aims to involve
bank as a permanent partner in the venture. This may not be a desirable idea for a
financial institution. In a diminishing musharaka, the bank's share in the equity is
diminished each year through partial return of capital. The bank receives periodic
profits based on its reduced equity share that remains invested during the period. The
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share of the client in the capital steadily increases over time, ultimately resulting in
complete ownership of the venture. Steps in diminishing musharaka are as follows.
Chart 4.3
Structure of diminishing musharaka
Source: Mohammed Obaidullah (2008), Islamic financial services, IRTI, IDB, Jeddah
The steps for musharaka are
1) Client and bank jointly contribute to capital of the venture.
2) Client and bank jointly set up the business venture and manage its operations,
3) Profits if positive are shared between client and bank as per a pre agreed ratio.
4) The profit share of client flows into bank too, towards partial redemption of
the latter’s capital contribution.
5) Profits if negative are shared between client and bank in proportion to their
respective capital contributions.
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4.5 b. Contracts of Exchange
1. Murabahah (Cost plus sale)
Murabahah is a contract of sale between the financial institution and its client
for the sale of goods at a price which includes a profit margin agreed by both the
parties. As a financing technique it involves the purchase of goods by the bank as
requested by its client. The goods are then resold to the client with a markup which is
determined by mutual consent. Usually price is received in specified installments. In a
murabaha, both parties to the transaction must know the cost and the profit or mark-
up charged by the bank.
Chart 4.4
Structure of murabahah financing
Source: Mohammed Obaidullah (2008), Islamic financial services, IDB, IRTI, Jeddah
Steps of murabahah contract are
1) Client identifies and approaches Vendor or supplier of the commodity that he/
she needs, collects all relevant information;
2) Client approaches Bank for murabaha finance and promises to buy the
commodity from the Bank
3) Bank makes payment of base price to Vendor;
4) Vendor transfers ownership of commodity to Bank;
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5) Bank sells the commodity, transfers ownership to Client at marked-up price;
6) Client pays marked-up price in full or in parts over future time period
2. Ijarah (Leasing)
Ijara is a contract under which a bank buys and leases out for rental fee
equipment required by its client. The lease period and the rental fees are agreed in
advance. In ijara, the bank continues to be the owner throughout the ijara period
while the client receives the benefits of ownership or the benefits of using the asset.
As such, risks associated with ownership of the asset remain with the bank.
Chart 4.5
Structure of Ijarah contract
Source: Mohammed Obaidullah (2008), Islamic financial services, IRTI, IDB, Jeddah
Steps of ijarah contract are as follows
1) Client identifies and approaches Vendor of the asset that he/ she needs, collects
all relevant information;
2) Client approaches Bank for ijara of the asset and promises to take the asset on
lease from the Bank upon purchase;
3) Bank makes payment of price to Vendor;
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4) Vendor transfers ownership of asset to Bank;
5) Bank leases the asset, transfers possession and right of specified use to Client;
6) Client pays ijara rentals over future time period.
7) Asset reverts back to Bank.
3 Ijara-wa-iqtina
This is a contract similar to Ijarah with a commitment from the client to buy
the equipment at a pre agreed price at the end of the lease. In this case payment of the
client includes rent plus part of the costs of the equipment. The contract is starting
with a combination of ijara with partnership (based on musharaka or mudaraba). In
this structure, the bank and its client enter into a partnership specifically formed to
finance the acquisition of the property that the client is interested in. The bank and the
client contribute to the equity of the partnership in a certain ratio. The bank acts as the
agent-manager of the partnership. The partnership then purchases the property and
leases the same to the client against known periodic rentals. The proportion of rental
accruing to client is used to redeem part of the bank’s stake in the property. This
results in a decrease in the bank’s stake over time. Eventually, the bank’s stake in the
property reduces to zero and the client becomes the full owner of the property.
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Chart 4.6
Structure of Ijara waiqthina
Source: Mohammed Obaidullah (2008) Islamic financial services, IRTI, IDB, Jeddah
Steps of ijarah contract are as follows
1) Bank forms a partnership with the Client based on musharaka; Client promises
to take on lease the property to be purchased by the Musharaka against
predetermined rentals for a definite time period; Bank may appoint itself as
agent-manager of the partnership; subsequent activities are undertaken in this
capacity;
2) Bank on behalf of the Musharaka purchases the property;
3) Property is taken on lease by Client; generates rental income over future time
periods;
4) Bank apportions the rentals among both parties; one portion flows back to bank
as its share in rental income;
5) Another portion – the share of the Client in rental income is used to redeem part
of Bank’s stake in partnership; Bank transfers ownership of asset to Client when
its stake is reduced to zero.
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4. Salam (forward sale)
The contract for sale of goods where the price of the said item is paid in
advance is known as salam (forward sale). In this system a buyer pays in advance for
a specified quantity and quality of a commodity, deliverable on a specific date, at an
agreed price. This financing technique is similar to a future or forward-purchase
contract and is particularly applicable to seasonal agricultural purchases.
Chart 4.7
Structure of salam contract
Source: Mohamed Ayub,(2007) Understanding Islamic finance, John Wiley & SonsLtd, England.
The steps of salam contract as follows.
1. The bank will purchase the item from client with full prepayment of the price and
delivery on an agreed specified date.
2. The customer (seller) will deliver the commodity at the agreed time and place.
3. The bank will sell the commodity to any third party by way of any alternatives
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5 Istisna: (Manufacturing contract)
The contract of acquisition of goods by specification or order, where the price is
paid progressively in accordance with the progress of a job completion is isthisna
contract. This is practiced for purchase of an item that is yet to be completed or
produced. For example, a house to be constructed where payments are made to the
developer or the builder according to the stage of work completed. Important
restrictions are (a) the subject matter of the contract is always a made-to-order item,
(b) the delivery date need not be fixed in advance, (c) full advance payment is not
required and (d) the Istisna contract can be canceled but only before the seller
commences manufacture of the agreed item(s).
Chart 4.8
Structure of isthisnah
Source: Mohammed Obaidullah (2008) Islamic financial services IRTI, IDB, Jeddah.
The steps for isthisna contract are the following
1. Client asks Bank to develop or construct or manufacture an asset with clear
specifications;
2. Bank asks Manufacturer to develop or construct or manufacture asset with same
specifications
3. Manufacturer develops or constructs or manufactures asset, receives progress
payments from Bank as per agreed terms during different stages of manufacturing;
4. Manufacturer gives delivery of asset to Bank;
5. Bank gives delivery of asset to Client;
6. Client pays in full or in parts over agreed period of time.
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4.5 c. Zero return financing
1. Qard Hasan (Interest free loan):
Qard Hasan means an interest-free loan, given by the Islamic bank to the needy
people in a society. The practice of dealing with this sort of investment differs from
bank to bank. Qard Hasan is normally given to needy students, small producers,
farmers, entrepreneurs and economically weaker sections of the society, who are not
in a position to obtain loan or any financial assistance from any other institutional
sources. The main aim of this loan is to help needy people in a society in order to,
make them self-sufficient and to raise their income and standards of living.
4.6 Advantages of interest free finance over conventional finance
Modern banking and financial system have the history of more than five
centuries. But interest free Islamic financial system developed only after second half
of the 20th century. Within a short period of time a number of studies were conducted
on interest free financial system. Some of these studies focused on short comings of
interest based system and Islamic financial system as a viable solution for these
shortcomings. The following part of the study is an attempt to examine the merits of
interest free financial system in relation to its interest ridden counterpart.
Justifying the rationale of interest free banking, Professor Khurshid51 notes,
“The central issue is that the contemporary financial system is exploitative, unjust,
discriminatory, unstable and crises generating. There is no denying the fact some
positive contributions that have been made by the banking and financial system
towards the promotion of economic development and global capitalism. But when a
balance sheet of achievements and failures is made, its failures outweigh and
outnumber”. He further says that in Islamic system of banking money does not beget
money rather used as a facilitator for the greater production of goods and services,
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resulting not merely in increasing the number of billionaires but producing real well-
being for the people.
4.6 a. Efficiency in financial system
Financial efficiency measures proper availability and conveyance of saving
and investment products in the economy. The important function of banks and other
financial institutions are intermediating between savers and investors. Through proper
channeling of financial resources from first party, to entrepreneurs who need financial
resources facilitates efficient allocation of resources in an economy.
When discussing this Al-Jarhi52, observes that by reducing the cost of funds
with absence of interest the Islamic banking products maximize the allocation
efficiency. Many modern economists point out the bad consequence of interest on
allocative efficiency. The champion of monetary policy JM Keynes53 illustrates the
inverse relation between rate of interest and marginal efficiency of capital. At zero
rate of interest the cost of funds invested becomes minimum and therefore maximum
allocation of resources is possible. It may lead to optimum allocation of resources in
the economy. In all the economies where interest exists resource utilization is
suboptimal. Therefore full employment remains only as a dream in these societies.
That is why Prof. Samuelson54 comments “at zero rate of interest the economy attains
a golden age”.
Conventional banks lend money to earn interest while Islamic banks provide
finance to share profit. This fundamental difference leads to many other important
differences between the functioning of the both. Conventional banks ensure that the
loan is paid back together with interest. For the same they gave importance to secured
collateral, and not much interested in the kind of economic activity, or the
profitability of the projects financed or any other moral concern, for which the loan is
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sought. Thus, the conventional bank grants higher preference to the credit worthiness
of the borrowers than the viability of the project to be financed or the ability or the
idea of the entrepreneur. Islamic economists56 argue that this method of financing is
the primary cause of miss allocation of the economy’s resources. In Islamic finance
focus would be given to profitability of financial projects when resources are
allocated. This type of finance has the potential to divert resources to the most
productive investments. This will increase the efficiency in the productive sectors.
John Tamlinson58 an American merchant banker argues that the conversion of
the economic system from debt based to equity based will lead to increasing
achievement of stability and efficiency. “Converting debt to equity is not a panacea
for all economic ills. It can however, produce many positive benefits. These benefits
will not necessarily follow automatically from conversion. Concentrated effort will be
required to ensure they do. Without conversion they will not happen at all”.
4.6 b The Stability
Stability of the financial system is important to assure the growth and
development of the economy. Researchers have studied the reason for instability in
the modern economic system. Many western scholars are arguing that interest is one
of the most destabilizing factors in the economy. Milton Friedman has considered
erratic behavior in interest as one of the most disturbing phenomena while Mr.
Iacocoa59, the chairmen of the Chrysler Corporation, observes that interest rates have
been so volatile that no one can plan for the future. In fact the erratic behavior in
interest rates has largely been responsible for unequal movement of financial
resources between the savers and the users which has brought a high level of
instability in the financial market. According to Chapra,(1995)60 “The high degree of
interest rate volatility has injected great uncertainty into the investment market which
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has had the effect of driving borrowers and lenders alike from the longer end of the
debt market into the shorter end, thus fundamentally altering the investment decisions
of businessmen”.
Al Jarhi61 pointed out the reason for instability in the banking sector. In the
case of conventional banks there are liabilities of different nature including demand
time and saving deposits which are guaranteed full payment by the bank. On the other
hand the assets are debt instruments of different nature; its quality depends on the
ability of the debtor to repay. Defaults on massive scale on the asset side would imply
inability of the financial institution to meet the obligation on the liability side. Such
defaults may arise at the time of crisis and lead to bank run in most of the cases. The
recent crisis in US and other western nations had lead the collapse of hundreds of
banks because of this trend.
Mohsin Khan (1986)63 and Abbas Mirakhor (1987)64 of IMF have proved that
banking contracts as found in Islamic form of banking are more stable than the
contracts found in conventional banking. A bank functioning of Islamic nature is
guaranteeing only demand deposits. Investment deposits are placed on profit and loss
sharing basis. When such bank facing crisis investment depositors automatically
sharing losses. The bank is less likely to fall and bank run is less probable. Therefore
the Islamic banking system is more stable than conventional system.
Several of the Western economists65 too have endorsed the view that equity
based system is more stable as compared to the interest based and blamed interest for
their economic woes. Sundarrajan and Luca (2002)66 have pointed out in their study
that owing to the structure of their balance sheet and the use of profit and loss
arrangements, Islamic banks are better poised than conventional banks to absorb
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external shocks. Solvency risks are typically lower in Islamic banks than in
conventional banks.
Another source of instability in the financial market is selling of debt. Bonds
are easily traded debt instruments in the financial market. In conventional finance
present money is traded in an integrated debt market against future money, which
takes the shape of commitments to pay specified amount at specified future dates or
bonds. Bond markets provide an easy and automatic mechanism through which short
term funds flow at will from one country to another. Much of those flows follow
factors that are only nebulously related to economic fundamentals. They bring an
important element of instability in to national economies. They threaten the world
economy with the spread of instability that might start in one single market and come
to all through contagion. The integrated debt market has grown immense in size as
well as in scale of integration that now encompasses the whole world economy. Many
experiences proved the role of this debt market are source of both domestic instability
and contagion67.
In contrast, in Islamic finance debt is created through selling of goods and
services on credit. Debt instruments are not readily tradable. We can visualize the
existence of a debt market for each commodity and service in which the demand and
supply to buy it on credit determines a markup rate. Such credit instruments would be
fully segmented. There is no room for sudden or mass movements of funds from one
country to another. So possibility of instability and contagion is less probable in
Islamic finance.
Siddiqi68 wrote, “You exchange money either for goods and services, or for
money or for debt. In the Islamic framework we have no problems with the first, the
second, exchange of money for money is severely constrained, and the third is almost
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eliminated. Islamic law allows cash for debt only at par, which leaves no room for a
market in which debt could be sold for cash.”
Patrikis (1996)69 argues on the charges of separating financial economy from
the real one and banking from the commerce that, this policy is grounded upon a
mixture of safety and soundness concerns and a broader public policy concern about
fair and equal access to credit and control over society's resources by banks”. On the
other Islamic economists charge that separation of commerce and banking is the result
of interest mechanism which in turn has been responsible for disproportionate and
independent growth of financial economy to such a state where these debt instruments
are themselves treated and traded like a commodity.
Rogoff (2011)70 suggested that conventional banking can learn from Islamic
alternative system to improve stability. Islamic banks generally escaped the worst
effects of the 2008 financial crisis, because they were not exposed to subprime and
toxic assets, and had maintained their close connection to the real sector. Hence, it is
suggested that conventional banking can learn from the alternative systems offered by
Islamic finance, which is less skewed toward debt instruments, uses equity for greater
risk sharing, and limits the mismatch of short-term demand deposits with long-term
loan contracts
Mohieldin (1995)71 explains the reason for not affecting crisis to Islamic banks
in the following words. “As business partners, financial institutions are more likely to
assist borrowers in working through bad times, thus lowering the pressure to sell
assets at “fire-sale” prices. This protects the system against a general fall in asset
prices and reduces the probability of cascading defaults. The sharing of losses reduces
the probability of contagion to the rest of the financial system. Moreover, Islamic
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finance protects the exchange/transaction role of a banking system by limiting the risk
on deposit balances.”
4.6 c. The Justice
The contemporary financial system is inequitable and it is against justice. The
inequitable allocation of financing in the conventional banking system is now widely
recognized by western scholars also. According to Arne Bigsten72, “the distribution of
capital is even more unequal than that of land” and “the banking system tends to
reinforce the unequal distribution of capital”. Chapra’s73 argument is that the present
interest based banking system is inherently biased in favor of rich as they are the
people who could offer sufficient collateral required for finances. Has this not been
the case finances would have gone on the merit of the project, which would have been
more equitable and just for the society as a whole. To stress his point Chapra quotes
some other western economists and Morgan Guarantee Trust of the US, which
admitted that the present banking system, has failed to “finance either maturing
smaller companies or venture capitalist”
In interest based finance efficient entrepreneurs who are unable to provide
collaterals are fail to get credit at the cost of relatively rich entrepreneurs who are
granted credit. Since those who are granted credit has to pay a fixed interest
irrespective of the actual outcome of the project. Since there is no monitoring of the
funds available to the entrepreneurs there are very likely chances that, to ensure their
own profit plus the cost to be paid to the bank, many a times entrepreneurs would try
to adopt various methods that are actually not in conformity with the societal
objectives and lead to various speculative and other harmful activities. Professor
Siddiqi74 in his speech at the Harvard has rightly pointed out, “At the top of the list is
the opportunity the current (Conventional) system provides for money to be
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exchanged for more money, making the moneyed richer. Next in importance is the
immense scope for gambling-like speculation provided by the huge volumes of debt-
based securities in a system that permits sales on margin, short selling and other
exotic money games. Last but not the least is the philosophy that regards profit
maximization as the only legitimate concern of the investment managers to the
neglect of all the other ingredients of human weal.”
4.6 d. Growth
Islamic banks and financial institutions are considering only the viability of
the project instead of wealth of the borrowers. It is more concerned about the
entrepreneurial capabilities, honesty, and truth fullness of the borrowers. In other
words Islamic bank is financing to worthy projects rather than those who are famous
for the assets. Inbuilt monitoring coupled with other Islamic prohibitions like
speculation; gamble and other kinds of frauds (Gharar) and cheating ensure that the
funds of Islamic banks are utilized for the overall benefit of the community.
All these will enhance the entrepreneurial capabilities of the society as a whole
and led to overall growth of the economy unlike the commercial way of financing,
which helps in producing a class of elites out of the funds of the masses. Islamic
economists affirm that the projects that are chosen for their viability will naturally be
more growth oriented than those that are chosen because they are proposed by rich
borrowers.
4.6 e. Systematic integrity
Al Jarhi75 likened conventional finance to a spectator’s game where few
skilled players stay in the playground and a big crowd is watching from outside.
Every person has saving with bank secured their repayment and fixed rate of return in
the form of interest. Banks and other financial institutions also place their money with
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few entrepreneurs and guaranteeing repayment with interest. These people are not
ready to share risk as take part in business activities. All risks are borne by few
entrepreneurs only. If the productive or business sector collapsed due to any natural
reasons only the entrepreneurs suffer the losses. Banks and financial institutions
provide investors with loans guaranteed by collateral. It will reduce integrity among
the business people and may affect the productivity of the nation.
On the other hand Islamic finance, meanwhile, is similar to participatory
sports, where everyone is playing and no one is concerned with mere watching. Risk
is known to be one of the most important ingredients of making investment. Those
who finance investment share a good part of the risk involved with those who carry
out actual investment activities. We can therefore notice that risk as well as decision-
making is spread over a much larger number and wider variety of concerned people.
Risk sharing is balanced by sharing in decision-making. This allows for wider
involvement in economic activities, so that people will eventually feel they are
partners rather than spectators.
The famous scholar on Islamic economics Al Ghazzali76 rightly remarks
“interest is prohibited because it prevents people from undertaking real economic
activities. This is because when a person having money is allowed to earn more
money on the basis of interest, either in spot or in deferred transactions, it becomes
easy for him to earn without bothering himself to take pains in real economic
activities. This leads to hampering the real interests of the humanity because the
interests of the humanity cannot be safeguarded without real trade skills, industry and
construction”
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4.6 f. Equity
Interest based borrowings have resulted in glaring inequalities in the system of
distribution. The injustice brought by productive loans is highly horrible to the society
as compared to the injustice on the consumption loans which is confined to the
personal sufferings of the borrowers. In an interest based system majority of loans
from financial institutions are availed by the richer sections. This money is invested in
productive sectors or advanced for further loan. Profit from the enterprises is
appropriated by themselves and only a meager share in the form of interest come to
the bank. Thus there is a grave injustice due to the fact that 10% of contributors get
90% of return while 90% of contributors get 10% return. Even this 10% return is
faded away due to upward rise in prices due to interest. The interest paid by the
entrepreneurs included in the cost of production and bounce back to the consumers in
the way of increased prices. The net result is that the depositors actually gain nothing
from the interest oriented productive ventures. While deposit comes from a broader
cross section of the population, their benefit goes mainly to the rich77.
Interest causes a continuous flow of economic resources from the
entrepreneurs to the financiers. This happens when the rate of profit is less than the
actual interest rate. In the case of loss making ventures also the financier gets back the
principal plus part of the value added as interest. Any way the net position of the
financiers must improve. In the long run there are bound to be such periods in which a
net transfer takes place from already existing wealth of the entrepreneur borrowers to
the lenders. Wealth is made always to bring more wealth. It means a redistribution of
existing wealth of the society in favor of the owners of money capital. It may lead to
the distribution of wealth that becomes more and more inequitable as time passes.
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This is what has been happening since interest became the kingpin of the
capitalist system of banking and finance roughly over the last four centuries. While
absolute poverty declined and the lot of the poor improved, relative poverty increased
and the gap between rich and the poor widened both within nation and between
nations78. A sharing arrangement between entrepreneurs and their financiers rules out
any net transfer of existing wealth from the former to the latter. Any addition to
financier’s wealth would in a sharing arrangement come out of the new wealth created
as a result of the productive employment of their capital by the entrepreneurs.
Conventional lending gives utmost attention to the ability to repay loans. To
ascertain such ability, it depends overwhelmingly on the provisions of collaterals and
guarantees. Thus those already rich would have most access to finance. In contrast,
Islamic finance providing funds on equity or profit-sharing basis would be more
concerned about profitability and rate of return and less concerned about collateral as
the primary consideration. Those who are not wealthy, but have worthy investment
projects, would have more access to finance.
4.6 g. Sustainability
Conventional debt has certain characteristics that could place debtors in
difficulties if circumstances do not allow them to repay in time. Interest is usually
calculated on the outstanding balance of debt, usually compounded annually and
sometimes at shorter intervals. Delinquent debtors are often subjected to penalty rates
of interest, which are higher than regular rates. It is not uncommon to find borrowers
who end up paying debt service that is many folds the original principal they
borrowed. This is particularly symptomatic of developing countries debt, as they
continue to face debt problems that sometimes reach crisis levels. Creditor countries
and institutions have often sought to find ways and mechanisms to provide debt relief
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to debtor countries. Despite continuous efforts, the debt problems faced by
developing countries seem to be ever-present. The system has demonstrated
unsustainability several times.
Debt created through Interest free finance has characteristics with which debt
crises are less likely to rise. Particularly, the total value of debt, which includes the
spot value of commodities purchased on credit as well as an implicit mark-up, is set
from the very beginning. The total value of debt can be repaid in installments,
without increase in its total value, as there is no compounded interest to pay on
outstanding balance.
When debtors face unavoidable circumstances that would make them
temporarily insolvent, they are often granted grace periods to help them bring their
finances back to order. No penalty fees can be levied in this case. In other words,
debt rescheduling, when justifiable, would be granted at no extra cost to borrowers.
Therefore, we can conclude that Islamic finance is sustainable and less liable in itself
to cause undue hardship to debtors.
One important reason for defaults in the debt from conventional institutions is
it cannot use for its prescribed purpose. Under the rules of conventional finance,
creditors assume that the use of the loans they extend would strengthen the ability of
debtors to meet their future obligations. However, conventional loans are usually
offered without ways or mechanisms to assure their use for certain purposes. In
contrast, Islamic debt is created through the finance of acquiring goods and services
on credit. In other words, the loan is used from the very beginning for its prescribed
purpose. Default resulting from improper use of borrowed funds would therefore be
most unlikely.
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As Interest free finance provided to finance investment is asset-based, i.e., it is
used to acquire real assets; it is much less likely to lead to debt crises. Such type of
asset-based finance, directly contributes to the ability of the economy to meet its
internal and external financial obligations. This is certainly a welcome effect.
4.7 Current position of Interest free finance
From previous discussions we got an idea about consequences of interest based
financial system on the economy and society as a whole. Interest free finance is the
growing alternative in almost all parts of the world to correct this. Global Islamic
banking report by Deutsche Bank in November 201179 explains the size and growth of
this sector in the following words. “Global Islamic financial assets have increased
significantly over the past three decades, reaching about US$1 trillion in 2010 (chart
4.9), up from about US$5 billion in the late 1980s. Banking assets account for the
bulk of this increase, complemented by Sukuk and assets under management (AUM).
Banking assets have been growing rapidly for several decades and rose from about
US$386 billion in 2006 to US$939 billion in 2010 (chart 4.9). Preliminary estimates
suggest that they climbed further to about US$1.1 trillion in 2011. In recent years,
growth in Islamic financial assets has generally outperformed conventional financial
instruments, particularly following the onset of the financial crisis that has been
gripping the world since 2008”.
Chart 4.9Global Islamic finance industry assets
Source: Deusche Bank 2011; International Islamic financial markets database March2012 and Earnest &Young 2011
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Islamic finance institutions are not only concentrated in Muslim countries but
major secular countries are also promoting the development of this new industry. It
is reported that Islamic finance sector has grown up to 715 banks worldwide with $1.4
trillion assets in 2011. Secular countries include UK, Japan, Canada and Singapore is
promoting Islamic finance. UK has 25 and US has 20 Islamic financial institutions
and UK is now going to become hub of Islamic finance industry in western world.
Islamic Banking has gained much attention after the Financial Crisis. That is it has not
affected the Islamic Banking sectors due to its mode of operation. And hence all the
countries are studying about Islamic Banking and are on the verge of introducing
Islamic Banking in the country80.
The global market in Sukuk (profit sharing bonds) has expanded rapidly
during this period. Sukuk, or Islamic bonds, are certificates of ownership that are
based on the concept of joint ownership of an asset by several financiers, giving it
features more like securitized equity- type financing. After dipping with the start of
the global financial crisis in 2008, the total volume of issuances more than doubled to
reach roughly the equivalent of US$48 billion in 2010 (chart 4.10). Although the
Sukuk market is small compared to conventional fixed-income or securitized products,
the weaker performance of conventional instruments during the crisis is combining
with a greater recognition by issuers that Sukuk are a feasible alternative to boost
market appetite81.
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Chart 4.10
Global Sukuk Issuance
Source: Islamic finance information service October 2011
We can find from the statements below that Islamic Banking is not just for the
Muslim society alone. The New Financial Dawn82 reported that in Malaysia, more
than 40% of the investors & 60% borrowers are non-Muslims, mostly Chinese, in
Islamic banks. One in five applicants for some of the Islamic products are non-
Muslims in Islamic Bank of Britain. In Kenya, a predominately non-Muslims
country, banks such as Gulf African Bank have indicated that as much as 20% of their
customer base is Non-Muslims. Similarly the unbanked population is also declining,
as access to finance is made more convenient. Many of the Underlying principles
investment strategies and objectives in the Ave Maria Catholic Values Fund are
strikingly similar to those of Islamic alternatives83. We can conclude from the above
details that Islamic Banking is developing day by day and its scope is very huge
especially in the modern scenario.
Islamic financial instruments are currently available in at least 70 countries,
with widely varying shares of banking services compared to conventional equivalents.
The recent financial crisis affected the asset quality of conventional banks adversely.
In contrast, as shown in recent research, Islamic banks had higher asset quality, were
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better capitalized, and more likely to continue their financial intermediation role
during the crisis than their conventional counterparts84.
The growth of Islamic banks has been significant during the past five years.
For example in Qatar, the assets of Islamic banks expanded by 43 percent during
2006– 10, substantially faster than the growth in assets of conventional banks, and
constituted around 23 percent of the country’s total banking assets in 2010.
Chart 4.11
Growth of Islamic banking and conventional banking;
Assets in selected countries 2006-10
Source: Deutche Bank 2011, 10
Islamic mutual funds come in different flavours, dominated by equity, leasing,
and commodity funds. The growth of such AUM has slowed since 2008, after
expanding by more than 20 percent a year in the first half of the decade. The sector
remains dynamic, however, with the number of Islamic funds reaching 699 in mid-
2011, compared with 608 in 200985.
In addition to banking, AUM, and capital markets, there is a very vibrant
industry of Shariah-compliant financing in other asset classes such as venture capital,
private equity, and project finance. Several major infrastructure projects are being
financed through Shariah-compliant modes of financing. It is worth noting that the
World Bank Group has sought to support Islamic finance through a variety of
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initiatives, ranging from academic research to execution of transactions. Engagement
on technical assistance, advice, and outreach has cantered on collaboration with
standard-setting institutions like the Accounting and Auditing Organization for
Islamic Financial Institutions (AAIOFI) and the Islamic Financial Services Board
(IFSB), as well as work at the country level. The World Bank Group has also tapped
Islamic financial markets86.
Islamic microfinance is also in a same position of growth. In a 2007 global
survey on Islamic microfinance, CGAP87 collected information on over 125
institutions and contacted experts from 19 Muslim countries. The survey and a
synthesis of other available data revealed that Islamic microfinance has a total
estimated global outreach of 380,000 customers and accounts for only an estimated
one-half of one percent of total microfinance outreach.
Obaidullah (2008)88 give a detailed picture of global outreach of interest free
microfinance. He observes that Islamic microfinance institutions display wide
variations in the models, instruments and operational mechanisms. While, in terms of
reach, penetration and financial prowess, Islamic microfinance institutions lag far
behind their conventional counterparts they certainly score better in terms of richness
and variety. Islamic microfinance institutions similar to conventional microfinance
institutions, use group financing as a substitute to collateral, have a high concentration
of women beneficiaries and aim at alleviation of poverty in all its forms. He listing
successfully functioning interest free microfinance institutions from different parts of
the world.
4.8 Similarities between Islamic Finance and Conventional Micro-Financing
The forgoing discussion has given a clear picture about the functioning of the
Islamic financial institutions and the merits of Islamic finance over interest ridden
finance. In the third chapter we have noted the functioning of micro finance
institutions and their advantages. It may be mentioned that Islamic finance and
conventional micro finance are the approaches which developed almost at the same
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time with same objectives. We have already demonstrated that interest based
microfinance has failed to function as an effective tool for poverty alleviation and
economic empowerment. However these two approaches have several things in
common.
The important among them are listed as under.
1) The objective of both is economic development, social upliftment and fighting
poverty
2) Both aims at financial inclusion by extending finance to those excluded from
the mainstream financial sector
3) Both advocate innovative means of finance to the poor to combat financial
exclusion
4) Strive for ensuring fair access to capital and catering to the excluded and the
under-served
5) Both recognize that financial exclusion is a vicious cycle that could be tackled
through entrepreneurship and risk sharing
6) Promote equitable economic development by empowering the poor
7) Appreciate the potential of the excluded as being disadvantaged does not
necessarily suggest lack of ability or talent to break this vicious cycle.
Different from the above, micro-financing and Islamic finance have some
fundamental differences regarding the financing modes employed, as well as their
strategic objectives. Some of these differences are listed below.
1) Micro-financing mostly in practice is interest-based financing which is
fundamentally different from the modes of finance employed by Islamic banks.
2) Profit maximization is not a goal for microfinance institutions. Islamic banks
on the other hand are private institutions and, like any other private entity,
shareholder wealth maximization is their most basic objective.
3) Funding sources are also different as Islamic banks’ capital is contributed by
private individuals who are mainly motivated by profit maximization. The
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major source of funding of conventional micro-financing institutions is from
international donors and philanthropists.
It is examined the similarities and the differences between conventional
microfinance institutions and Islamic banks, it is clear that although the two share a
lot in common, there are some stark differences. This would make us question the
practicality of the proposal that Islamic banks should directly bridge the gap vacated
by conventional micro-finance in tackling financial exclusion. Islamic micro-
financing has been suggested by many scholars as one of the most practical ways of
responding to the financial services needs of poor. As Shari’a compliant micro-
financing is one of the most popular solutions proposed by the critics of current
practices, it will devote the following part to the subject of Islamic micro-financing as
a tool for combating financial exclusion.
4.9 Modeling of an interest free microfinance
The mission of a microfinance institution is poverty alleviation and economic
empowerment. For the fulfilment of this mission the microfinance should emphasizes
access and not cost. Obaidullah (2008)89, an expert in Islamic microfinance argue that
in the first stage the microfinance institution should be a charity based (donor aided)
institution. It focuses on financial services among poorest of the poor. Sustainability
of the institution may be considered only after a shift from a charity-based approach
to a market-based for-profits approach. In this stage importance should be given to
efficiency and transparency and restrict use of donor funds. Donor funds have played
a major role in the birth and subsequent growth of the global microfinance industry.
Initial capital of many NGOs is provided by donations from international donor
organizations. Many NGOs are depends on donor funds to meet the deficits. A
microfinance institution will become sustainable only when avoiding dependence on
donor funds. But an interest free non profit microfinance institution may always
depends on donor funds or grants in different forms.
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Obaidullah (2008)90 illustrates a brief sketch about the working of an interest
free nonprofit microfinance institution. The sources of funds for IMFI are many and
varied. Some of the popular sources are including Compulsory donation (zakat or
Almsgiving), Charitable giving (sadaqa), charitable endowments (awqaf) and
benevolence loan (qard-hassan). Zakat is one of the compulsory payment for rich
Muslims while the others are discretionary and entail all forms of philanthropic
giving such as donations, gifts, charitable spending. When these are expected to
continue over long period of time they are called awqaf (charitable endowments).
Qard hasan implies loans that are free from any benefit or return to the lender and is
more commonly referred to as zero return loan.
4.9 a. Charity (non-Profit) model of microfinance
Chart 4.12
Model of microfinance charity based
Source: Obaidullah (2008)
186
The model may be described in terms of activities as follows:
1) Microfinance Institution creates a Zakah (compulsory charity) fund.
2) Mobilising Waqf (charitable endowments) of physical assets as well as
monetary assets. The physical assets are used to facilitate education and skills
training.
3) Program carefully identifies the poorest of the poor and financing for the
improvement of living condition from zakah funds.
4) Program provides skills training to economically inactive, utilizing
community-held physical assets under waqf;
5) Beneficiaries graduate with improved skills and managerial ability;
6) Beneficiaries are formed into SHGs;
7) Financing is provided on the basis of qard hasan (benevolent loan) to the
group;
8) Group members pay back and in turn, are provided higher levels of financing;
9) Actual defaulting accounts are paid off with zakah funds; this is indeed the
distinct feature of this model
10) Group members are encouraged to save under appropriate micro savings
schemes;
Obaidullah (2008)91 discusses three major non-profit modes of Islamic
microfinance – zakah, awqaf and qard hasan means compulsory charity, charitable
endowments and benevolent loans. By incorporating these techniques develop a
model of microfinance. This is a model that uses for non-profit modes only. The
model is presented in Figure 4.12.
It was pointed out in second and third chapters that main drawback of
conventional microfinance is it cannot provide services to poorest of the poor. The
187
main reasons specified by many writers that lack of education and skill, absence of
any type of assets etc. Charity based Islamic microfinance is targeting this group of
people first. By using funds from donations and grants in different modes various
services are provided. They cannot need loans first; but fulfilment of livelihood
means. For the same different type of activities like supplying of necessary goods,
availing medical care, educational promotions are implemented. And to promote this
group to economically active poor, skill training are also given. In the next stage
SHGs are forming among them and regular microfinance services like savings, credits
and insurance are provided.
In a secular set up like India not only the members from Muslim community
but also others wants to introduce interest free micro finance. By using this model it is
possible to develop such microfinance. Instead of Islamic terminologies like zakah,
waqf and qard hasana it is possible to develop seed money by receiving donations
from likely minded peoples and public. By using this initial fund try to avail welfare
measures, education and training programmes and other measures to make them
economically active. Then by forming SHGs and collecting thrifts develop a fund and
provide interest free loans. When this system develops other products of microfinance
also is introduced.
Meeting of expenses of microfinance institution is a question to all interest
free microfinance. When commercial microfinance institutions become sustainable by
earning through collection of interest and other means, interest free microfinance on
non profit basis has no such option. Many institutions are collecting a nominal service
charge but it is only for office stationary expenses. But most prominent non profit
microfinance institutions are depends widely on volunteer ship to reduce cost. These
188
types of NGOs have very few paid staff at the management and executive level; and
its local level activities are managed by volunteers.
4.9 b. Profit based model of microfinance
Profit based model of interest free microfinance is combining charity based
and participatory modes. After developing poorest of the poor to economically active
poor participatory methods are using. The model is presented in Figure 2 below.
Chart 4.13
Profit based model of microfinance
Source: Obaidullah (2008)
189
The model may be described in terms of activities as follows:
1. Microfinance institution creates a Zakah fund.
2. Program facilitates Waqf of physical assets as well as monetary assets. The
physical assets are used to facilitate education and skills training
3. Program carefully identifies the poorest of the poor and financing for the
improvement of living condition from zakah funds.
4. Program provides skills training to economically inactive, utilizing
community-held physical assets under waqf;
5. Beneficiaries graduate with improved skills and managerial ability;
6. Beneficiaries are formed into SHGs;
7. Financing is provided using participatory and debt based modes, such as,
ijara, salam, istisna or isthijrar or equity based modes, such as, mudaraba or
musharaka or declining musharaka;
8. Group members pay back their debt; and/or perform and meet the expectations
of equity providers and, in turn, are provided higher levels of financing;
9. Actual defaulting accounts are paid off with zakah funds;
10. Group members are encouraged to save under appropriate micro savings
schemes;
Islamic Microfinance includes not only non profit modes but also for profit
modes. When poorest of the poor got the services of interest free loans and other
services of non profit modes only, the “economically active” category of poor may be
provided finance using for-profit modes as well. Such groups do not belong to the
extremely poor or the destitute category and are in a position to create wealth. These
types of financing provide financial sustainability to Islamic Microfinance Institutions
(IMFI). The instruments used for mainstream financial institutions are the same for
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microfinance with minor modifications wherever needed. By applying these modes to
economically active poor the beneficiary’s income will increase and at the same time
the IMFI received a part of income created by the client.
4.10 Instruments used in for profit model
4.10 a. Micro-Savings
Poor need a range of microfinance services, such as, micro-savings, micro-
credit, micro equity, micro-insurance and micro-remittance. Micro-savings are an
important financial service for financially excluded. Poor people want deposit
services that allow for small balances and transactions. There are different options for
saving in Islamic finance. Those are wadia (Trust account), qard hasan (benevolent
loan) and mudaraba (trusteeship partnership). All these products must be free from
elements of interest and uncertainty.
Wadia means trust deposits. Under wadia mechanism, the deposits are held as
trust deposits and microfinance institution is utilized at its own risk. Any profit or loss
resulting from the investment of these funds accrues entirely to the microfinance
institution. There is no special condition for withdrawal.
Another form of deposits is benevolent loan (qard hasan) by the depositor to
the microfinance institution. The institution utilise this deposits at its own risk. As a
depositor the lender is not entitled to any return as interest or profit. The saving
products under wadia and qard are not allowing any excess over and above the
principal to the depositors.
Different from above savings under trusteeship partnership (mudaraba) is
allowing share of profit to the depositor. Here the depositor authorizes the
microfinance institution as an entrepreneur (mudarib) for the purpose of investing the
funds. If the profit is positive, are shared between depositor and microfinance
191
institution as per a pre agreed ratio. When profit is negative, it is absorbed by
depositor. There is freedom to withdraw deposits in this mechanism only with pre
agreed basis.
When the savings are remunerated on the basis of revenue-sharing rather than
profit-sharing, the underlying mechanism is not a classical mudaraba but an agency
contract known as wakala. In this contract the depositor appoints the microfinance
institution to manage its funds.
4.10 b. Micro-Credit
Micro credit is the important service of a microfinance institution. The
alternative to interest-based conventional loan the Islamic microfinance has products
of different nature. The operational features of these products we have already
discussed. Those classified in to contracts of exchange and contracts of charity.
These products are developed by mainstream Islamic financial institutions. Contracts
of exchange are murabaha, ijara, ijara wa iqthina, isthisna and salam. The main
contract of charity is qard hasana loans. The partnership contracts are using for equity
financing and not for credit. The important micro credit products are discussed briefly
as under.
1) Micro Murabaha (Cost-Plus Sale)
Under this model, the microfinance institution selling durable consumption
goods or producer goods like vehicles, machineries etc. to the clients on deferred
payment basis. Here the MFI is fixing the price with the cost plus a markup for
covering administrative costs. The borrower often pays for the goods in equal
installments or paying in lump sum within a specified period of time. Interest free
microfinance institutions working in India as well as abroad are operating this model.
In a murabaha, both parties in the transaction must know the cost and the profit or
192
mark-up. Where the seller does not disclose the cost and profit thereon, the
transaction is called musawama.
2) Micro-Leasing (Ijara)
Ijara implies leasing or hiring of a physical asset. It is a popular debt-based
product in which the IMFI assumes the role of a lessor and allows its client to use a
particular asset that it owns. Producers, farmers and households needed different types
of equipments and machineries. But they have no capability to purchase the same. All
kinds of income-generating equipment or physical asset, such as, tools and machines
to manufacture commodities, rickshaws and boats to transport, carts to sell
merchandize and low-cost houses may be financed through this mode. Here the
clients are paying rent to the institution.
3) Deferred delivery sale (Bai-salam)
Salam is a deferred delivery contract. It is essentially a forward agreement
where delivery occurs at a future date in exchange for spot payment of price. This
mechanism is originally designed as a financing mechanism for small farmers and
traders. Under a salam agreement, a farmer or a trader in need of short-term funds
sells its output or merchandize to the IMFI on a deferred delivery basis. It receives
full price of the merchandize on the spot that serves its financing need at present. At a
pre-agreed future date, it delivers the merchandize to the IMFI. The IMFI sells the
merchandize in the market at the prevailing price. Since the spot price that the IMFI
pays is pegged lower than the expected future price, the transaction should result in a
profit for the IMFI.
4) Manufacture contract (Bai-Istisna)
Bai-Istisna is a contract of manufacture. A seller under an istisna agreement
undertakes to develop or manufacture a commodity with clear specifications for an
193
agreed price and deliver after an agreed period of time. The unique feature of istisna
is that nothing is exchanged on spot or at the time of contracting. The buyer makes
payment of price in parts over the agreed time period or in full at the end of the time
period. In an istisna, the seller and the manufacturer may be different entities. This
allows an IMFI to engage in istisna by assigning the job of development, manufacture
or construction to a third party under a parallel istisna arrangement.
5) Qard hasana
In this system microfinance institution is providing micro credit on interest
free basis. Funds are transferring without receiving any return to meet urgent needs of
the client. For meeting the working expenses service charge is collecting from the
borrowers. There is lots of interest free microfinance institutions are working in
different countries by using this model only.
The above mentioned modes create debt and may be used as an instrument of
microcredit. There is a possibility of default here. Islamic modes do not admit the
possibility of any payment in excess of the original amount of debt in any cases. But
scholars generally permit the IMFI to impose a penalty on the defaulting client to act
as a deterrent against wilful default, but such penalty must be donated to a charity. It
cannot be treated as an earned income for the IMFI as this would tantamount to
interest.
4.10 c. Micro-Equity
Interest free Islamic MFIs may consider various partnership based modes or
equity based modes for microfinance. Three modes commonly discussed in this
context are mudaraba and musharaka and diminishing musharaka. The former
involves a combination of entrepreneurship and capital while the latter involves a
partnership in entrepreneurship and capital. Diminishing musharaka is lead to
194
complete ownership of asset or project by the micro entrepreneur. The operational
features of these instruments are already discussed in the first part of this chapter.
These equity-based products are unique to Islamic microfinance and in some sense,
account for its superiority over conventional microfinance on grounds of ethics and
efficiency.
4.10 d. Other Services
Major financial techniques in Islamic microfinance have already discussed.
All these techniques are used in for-profit models. But non profit models are
practicing only those techniques which promote welfare of the people. For-profit
microfinance simultaneously operates these two types of products. As a financial
entity there are lot of scope to microfinance institutions to perform various types of
services to the beneficiaries. Few of them are fee based products while others are
service charge based. By inculcating all the activities under an umbrella of
microfinance institution it may become more effective for poverty alleviation and
socio economic upliftment. Islamic finance has lot of such like products and practices
to apply microfinance field. In the following part a brief discussion on some accessory
contracts and few new types of techniques are discussed.
1) Ar-rahn (pledging)
When People needs money for urgent transaction purposes one of the ways to
seek it is from financial institutions by pledging gold. Conventional financial
institutions are charging interest for the same. But lots of interest free financial
institutions are working in different countries on interest free basis and they are
serving the same function. Ar rahn means simply gold loan. A service charge is
receiving from the beneficiaries for meeting the operational expenses.
195
2) Hybrid products
Many interest free microfinance institutions are developed hybrid products for
providing service to different types of beneficiaries. Important among them is
salam+murabaha financing in agricultural sector. This model is practicing in Srilanka
to develop paddy cultivation. Here agricultural inputs are selling to the paddy
cultivators on murabaha basis. To assure the reasonable price and demand the output
is purchased by MFI on salam basis. Here Paddy cultivation is promoting through this
hybrid model.
Another hybrid model is Murabaha+Ijara. Here input is selling on murabaha
basis and machineries are provided by ijara basis. For the promotion of agricultural
production and resultant employment microfinance institutions are developing this
model and practicing in different countries.
3) Micro thakaful (insurance)
In Islamic finance thakaful means insurance. Microfinance includes insurance
also. Scholars developed a particular type of insurance to fit rural poor on sharia
compliant basis. This is known as micro insurance. Small premium from the thrifts of
members of MFIs are collecting and insuring the micro enterprise or any other assets.
The cost of risks is taken from common funds of the clients. This type of insurance is
practicing different institutions.
4) Kafala (Suretyship)
Kafalah means to add an obligation to an existing obligation in respect of a
demand for something. This may relate to a person, finance or act (performance). In
simple language it is a bail. In microfinance instead of physical collateral SHGs and
other models widely depends on mutual bails. If a delay is happens in the payment by
principal debtor a delay also granted to surety.
196
5) Hiwalah (Transfer of debt)
Hiwalah means transferring a debt from one debtor (transferor) to another
(transferee). Once the transferee has accepted the transfer of debt, the transferor
would be released from any obligation. In many occasions the transfer of debt is
occurred in micro finance activities.
6) Hibah (Gift)
Gift contract is defined as a voluntary contract that results in uncompensated
ownership transfer between living individuals. There are two categories of gifts:
presents given to please the recipient, and charities given to please God. The
properties may be known or unknown, but they must be conventionally given as gift.
The use of property transfer in those definitions is stipulated to exclude loans, as well
as the transfer of non-valued properties. In the case of poverty alleviation and
economic and social upliftment microfinance institutions sometimes depends on gifts
to mobilize resources.
7) Bai’al istijrar (Supply contract)
Istijrar is not a specific mode; it is rather a repeat sale purchase arrangement of
normal sale in which a seller agrees to sell various units of a commodity from time to
time. The seller may also deliver the commodity agreed upon once in a number of
consignments and the price may be determined in advance, with every consignment or
after the delivery of all consignments. The terms and conditions of repeat sale may be
of any normal cash or credit sale. An agreement may take place between the buyer
and the supplier, whereby the supplier agrees to supply a particular product on an
ongoing basis, for example monthly, at an agreed price and on the basis of an agreed
mode of payment. While interest free microfinance institutions are mostly depends on
197
financing in the form of raw materials, consumer durables or productive equipments it
needs this type of contract.
8) Ju‘alah (reward)
Ju’alah is a contract in which one party undertakes to give a specific reward to
anyone who may be able to realize a specific or uncertain required result. Ju‘alah may
be used by Islamic microfinance and banks for recovery of overdue debts and certain
other services whereby the subject of the required work cannot be minutely specified.
9) Wakalah (Agency)
It is defined wakalah legally as the delegation of one person (the principal) for
another (the agent) to take his place in a known and permissible dealing. In this
regard, the wakil (agent) deals in the other’s property and preserves it. Islamic
microfinance may act as agent for beneficiaries or the institution may appoint other
institution or individuals as agent to fulfill certain services.
10) Ujrat (Fee)
Ujrat means fee. The poor also need many other services besides savings and
financing, such as, remittance. These services may be easily provided by an IMFI in a
fee (ujrat) based framework. In order that these services are provided in interest free
manner, scholars insist that the amount of fee permitted.
The discussion in this chapter makes it clear that conventional interest based
financial system has many drawbacks. It also gave a brief idea about theoretical
framework of interest free microfinance institution. Interest free microfinance is not
only a concept now but is practicing in different parts of the world including in our
state. As a viable alternative to interest based system, interest free Islamic financial
techniques are practicing in different countries. In the microfinance sector also have
lot of such initiatives. It is reported that many positive results of Islamic microfinance
198
on poverty alleviation in different countries. The next two chapters of this study are
examining the impact of these ventures on its beneficiaries in Kerala.
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