That there is a need for microfinance in predominantly Islamic countries is taken as a given by most, yet providing sharia-compliant microfinance seems to be beyond many financial institutions. So what can be done? James King investigates.

The potential for a commercially viable, global Islamic microfinance industry is huge. Close to 650 million Muslims currently live on less than $2 per day, with most lacking access to financial services. Of those that can secure credit, it is typically provided informally or through conventional lenders. As a result, sharia-compliant financing options are almost non-existent. This funding gap in the Islamic world has emerged as the mainstream sharia-compliant finance industry continues to develop, with banking sector growth going hand in hand with greater sophistication in the debt and capital markets.

Arguably, if the same dedication and expertise that has supported the growth of mainstream Islamic finance were applied to the microfinance space, tangible progress could be achieved. This is particularly true, given that the sharia-compliant microfinance space offers a sizeable commercial prospect and one that would have profound implications for the global financial inclusion agenda.

“In many cases, sharia-compliant microfinance products could be better for the poor because the intention is for the finance provider and client to create wealth together, which leads to a higher probability of a successful partnership,” says Mayada El-Zoghbi, a senior financial sector specialist at the Consultative Group to Assist the Poor (CGAP), a leading global authority on microfinance.

A coordinated approach

What has been lacking is the requisite ecosystem to nourish the development of sharia-compliant microfinance, similar to the one that has helped to elevate conventional microfinance since the 1970s. To be effective, this ecosystem requires the concerted efforts of national regulators, finance providers, non-governmental organisation and religious authorities, among others, to develop a coordinated approach to the industry’s growth at national, regional and international levels.

At present, there is little cooperation between these actors. More problematic still is the absence of a clear vision for what an Islamic microfinance sector would ultimately look like and how it could be leveraged both as a tool for economic empowerment but also as a viable profit-making enterprise.

Beyond this systemic challenge, acute impediments to the sustainability of sharia-compliant microfinance business models also exist. These include a lack of product innovation, coupled with high operational costs related to the implementation of these products. For the moment, the up-front costs for most Islamic microfinance providers are exceptionally high due to the fragmented nature of the industry and the absence of economies of scale.

Alongside these questions of profitability and cost sit basic demand-side issues. A dearth of research into client demand means that it is still unclear in what circumstances individuals would select a financing option that was sharia-compliant over one that was less costly. Similarly, the diversity of the Islamic experience across different markets often leads to contested definitions of sharia-compliance. As a result, the progress of Islamic microfinance is slow.

Positive momentum

Nevertheless, despite these challenges the industry is growing and positive momentum is building, particularly among new finance providers. According to data from CGAP, the number of microfinance clients using sharia-compliant products was 380,000 in 2008. By 2013, that number had increased to 1.28 million. In tandem, since 2006 the total number of Islamic microfinance providers has doubled.

The industry’s growth is overwhelmingly concentrated in Bangladesh, Sudan and Indonesia. This reflects supportive government policy in Sudan, whose central bank has a dedicated microfinance unit, and the populous, economically active rural communities found in Indonesia and Bangladesh who benefit most from microfinance initiatives.

“In the past few years there has been a significant increase in the number of Islamic microfinance providers. I expect this trend to continue, as the success of existing sharia-compliant microfinance operations becomes evident,” says Yasir Tariq, chief operating officer of the Wasil Foundation, an Islamic microfinance provider based in Pakistan.

Product development

The key challenge for existing Islamic microfinance providers lies in product development and innovation. The most common product available today is the murabaha, essentially a cost-plus mark-up contract. Thanks to the ease and simplicity of the murabaha’s structure it is very easy to deploy. But it faces challenges, particularly when used across different Islamic markets. “There is some evidence to suggest that murabaha’s Islamic credentials can be questioned by local religious figures, since the mark-up is sometimes deemed to be a disguised form of interest,” says Ms El Zoghbi from CGAP.

Yet, according to a 2013 research note from CGAP, the murabaha product dominates the Islamic microfinance space in terms of its use, with about 672,000 customers and a total portfolio of assets of $413m. Beyond the murabaha, the qard-hassan loan is the second most popular microfinance product with an estimated 191,000 clients, according to CGAP. “The qard-hassan is a purely social product which is closely linked to the normal charitable donations that Muslims are obliged to give. The amount disbursed in the form of a loan is exactly the amount that will be returned at the agreed time,” says Matthias Range, a senior advisor for financial systems development with German development agency GIZ.

Beyond these two dominant products, a few other options are also used, including the musharaka, a form of profit-and-loss sharing equity participation agreement, and the salam, which acts as an advanced payment against future delivery in agricultural contexts. But the limited deployment of these options, which account for approximately only 10,000 clients, shows the industry’s relative immaturity. That the second largest Islamic microfinance product – the qard-hassan loan – has no profit making attributes points to the fact that a large swathe of the industry is geared towards a social or charitable model.

“If you look at the history of conventional microfinance the donor community stepped up to support the development of a market, until there was enough capital, expertise and best practice in place to learn from. In Islamic microfinance we don’t see the same kind of investment being made. It is either perceived as a humanitarian-type activity or it is a purely investment opportunity. Very few actors are stepping up to build out the broader ecosystem needed to help transition it from a subsidised business into a commercially viable business,” says Ms El-Zoghbi from CGAP.

Limited information

The problems associated with product development are closely linked to a lack of structural support from regulators, scholars and other stakeholders. But this lack of product innovation is also tied to the demand-side issues which blight the sector’s development. Information on client behaviour and the various factors that motivate decision making in the context of cost-versus-religious compliance is limited. As such, Islamic microfinance providers are frequently offering products and services in a location, and to a demographic, for which they are ill-prepared.

This is particularly true in the context of rural communities, where agricultural microfinance options are the norm. “In the rural market space you have to be able to identify the economically active strata of individuals who are producing commodities for an organised value chain,” says Jonathan Agwe, senior technical specialist with the International Fund for Agricultural Development (IFAD). The lack of available information on micro level socio-economic constituencies in the Islamic world often means microfinance providers are left targeting the wrong groups.

“Islamic microfinance providers don’t have the resources to perform market segmentation studies so they are often relying on out-dated information. These studies are expensive to conduct and significantly increase the up-front investment required in a project. This can lead to providers engaging with subsistence-based market segments that cannot offer the finance provider with any kind of return,” says Mr Agwe.

Beyond the example of rural communities, broader demand-based issues related to financial literacy and religious observance also prevail. More research is required to determine the relationship between price-sensitivity and sharia-compliance and how these pressures inform prospective client decision making. Put another way, in what context would an individual select a cheaper credit option even if a more costly sharia-compliant variant was available?

“There is a clear demand for products which conform to Islamic principles. We do have a lot of potential clients who are not able to go to a conventional bank because it is against their principles and it is an important issue for them. The Islamic microfinance industry as a whole is in desperate need of more research on this issue to meet the demand with value-adding products,” says Mr Range from GIZ. 

Geographic disparities

Related to this issue is the divergence of the religious experience at the micro level. Low levels of education and financial literacy ensure that most questions of sharia-compliance fall into the hands of local religious leaders. For example, this means that a product such as murabaha, which may be acceptable in northern Cameroon, could fall foul of local clerics in south Asian communities. Overcoming various religious interpretations through greater stakeholder engagement is therefore paramount.

“Unlike mainstream Islamic finance institutions, microfinance providers don’t have a dedicated sharia board. As such, products are often cleared by a local religious leader. Though this individual may be well schooled in Islamic principles, this may not always apply to the concepts found in Islamic microfinance. There is often a misconception that microfinance has to be a socially motivated instrument, so profit-based schemes or innovative ideas can be rejected,” says Mr Range.

In one example of this dynamic, a lender in Afghanistan sought approval for a microfinance product it intended to offer in the country. To do this, it secured support from clerics at the al-Azhar University in Cairo, which is considered to be the highest seat of clerical authority in the Sunni world. Yet, the decision was contested by local religious leaders in Afghanistan and the bank ultimately failed in its attempt to offer the product locally.

“We know what it takes to overcome these types of challenges; a functioning sharia-compliant ecosystem that has sufficient funding and knowledge to support its development. So far, there has been a lack of coordination among the various stakeholders,” says Ms El-Zoghbi.

Wasil's innovation

Nevertheless, many successful examples of Islamic microfinance operations exist today. The Wasil Foundation in Pakistan has effectively combined product innovation and local engagement to establish a sustainable business model based primarily on the salam, a sharia-compliant advanced purchase contract, and ijarah, a lease-based contract. Under its operating model, the foundation targets small farms with about four hectares of land which typically grow wheat or rice. 

Under the terms of the salam contract, the Wasil Foundation negotiates a purchase price for a future crop based on the farmer’s land size. The farmer is then provided with an advance against this price before the contract is completed once the crop has been delivered to Wasil. Aggregating this process across numerous farms allows the foundation to scale up its crop recovery to sell either on the open market or directly to the government.

“The beauty of this product is that the profit does not stem directly from services to the farmer. Over the past five years of using this system we have averaged a net profit of about 12%,” says Mr Tariq of the Wasil Foundation. At present, Wasil has more than 4000 active clients across Pakistan. However, Mr Tariq notes that there are significant up-front costs involved in this type of model. Notably, wheat storage and distribution require massive infrastructure investments.

Moreover, when selling to the open market, it may require two or three months of storage before an acceptable profit margin can be achieved based on the price of wheat. This can lead to shorter term liquidity issues for the finance provider. There is also a risk that market prices remain deflated, leaving the finance provider with a loss.

These up-front expenses can be off-putting for commercial institutions looking to engage with Islamic microfinance options. Additional costs also emerge in the form of operating costs, as well as the cost of funds. “In Islamic microfinance operations, [when] establishing and maintaining client relationships, financial service providers need to ensure they have hired the requisite technical expertise, agricultural or otherwise, as well as the personnel needed to source new business leads,” says Ms El Zoghbi.

Small-scale initiatives 

Elsewhere, a handful of sharia-compliant banks have also engaged with microfinance products. In Sudan, the Bank of Khartoum has successfully worked with the country’s agricultural community through salam products. These initiatives have allowed small-scale farmers to secure the necessary funds to support infrastructure development, including the equipment necessary to support irrigation from underground reservoirs.

Bahrain’s Bank Al Baraka (BAB), through its Algerian division, offers diminishing musharaka microfinance products, which act as a form of profit and loss-sharing equity participation by both the finance provider and business owner, to various sectors including retail, trade and light industry. Yet, in an analysis conducted by CGAP, it was found that BAB Algeria would have to expand its current client base of 54 by a factor of 10 in order to reach a point where operational costs could be recovered.

“I don’t think a typical Islamic bank can scale down easily. For example, in Sudan, the government provides subsidised funds to support microfinance ventures. This effectively subsidises the microfinance industry, making many of the banks’ strategies hard to replicate in a sustainable and profitable way,” says Ms El Zoghbi.

Unlike Sudan, most forms of regulatory intervention and oversight are typically a source of frustration for Islamic microfinance providers. In the majority of cases, national authorities have failed to introduce any kind of supportive regulatory structures to accelerate sharia-compliant microfinance. In other examples, these authorities have unwittingly impeded the industry’s development.

“It has become increasingly common for national regulators to close sharia-compliant windows of conventional financial institutions. This forces finance providers to either become fully sharia-compliant, or lose the opportunity to offer Islamic products. This happened recently in Yemen, which was a setback for the country’s Islamic microfinance sector,” says Mr Range.

Hurdles to overcome 

Clearly, the Islamic microfinance sector is beset by numerous challenges. Yet, the largest of these is the absence of a long-term vision as to how the sector can evolve. This will require coordination between regulators, in order to create a supportive structural environment, finance providers issuing sharia-compliant products, and fund-issuing institutions that can offer the requisite capital to foster growth. It will also require significant support from the non-governmental sector, particularly agencies and organisations that can offer much-needed research into market segmentation and client demand.

By addressing these issues, start-up costs for Islamic microfinance institutions can be substantially lowered. “At present, many sharia-compliant finance providers are constrained by the costs of investing in basic research and infrastructure development for their projects. If they can work together with non-governmental groups, donors, regulators and other key stakeholders, to develop products and services, this will enable the industry to flourish,” says Mr Agwe from IFAD.

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