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Home > Financing Checklists > Islamic Microfinance

Financing Checklists

Islamic Microfinance


Checklist Description

This checklist describes microfinance arrangements for small, low-income individuals or companies in the Islamic world.

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Definition

Islamic microfinance refers to a system of localized finance arrangements set up as an alternative source of funds for small, low-income Islamic clients. Typically, users of Islamic microfinance have little or no collateral, as they do not possess significant assets, and would therefore be excluded from other forms of financing, including Islamic bank financing. Thus, Islamic microfinance provides a means of accessing funds for those who are unlikely to qualify for other forms of finance, yet are still seeking full compliance with Islamic law and the Islamic way of life.

In essence, key Islamic microfinance contracts are based on musharakah and mudarabah, while microfinance users can also take advantage of takaful Islamic insurance.

Musharakah can be used either for assets or working capital. In principle it involves an equity participation in a business. The parties involved will share any profits or losses resulting from the business according to a pre-established ratio.

A mudarabah contract is basically a trustee financing scheme. The financier invests the funds while the other party supplies the expertise for the project. The contract requires rigorous following and transparency to ensure a fair distribution of profits.

Takaful insurance is based on the principle of shared responsibility and has been practiced in one form or another for well over 1,000 years. As a mutual-style concept, takaful does not function on conventional profit-making lines. It derives from the Arabic word kafalah, which means a joint guarantee. According to the takaful principle of insurance, each member of a scheme contributes to a fund that is used to help in case of need such as accidents, loss of crops, or death.

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Advantages

  • Islamic microfinance can play an important role in helping to address poverty in parts of the Muslim world.

  • Islamic microfinance contracts can be operated individually or combined, giving greater flexibility to their application.

  • Islamic microfinance contracts provide an alternative to low-income Muslim clients.

  • Musharakah and mudarabah are the most approved contracts under shariah law and their application is encouraged by shariah scholars.

  • Takaful is flexible in its range of applications, covering areas such as residences, places of business, cars, and inventory, as well as accident and life cover.

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Disadvantages

  • Mudarabah arrangements require a high level of regulation and transparency to ensure a fair distribution of profits, so can be expensive to operate.

  • Some Muslims may be uncomfortable with the scope for takaful to be used for investment purposes on the basis that investors are effectively speculating that low accident payouts will generate a surplus or profit.

  • In general, Islamic microfinance is seen as more a social support system based on philanthropic principles rather than a business.

  • Like other forms of microfinance, Islamic microfinance needs support to ensure its sustainability. Typically this support entails some form of ongoing subsidy such as a waqf endowment.

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Action Checklist

  • Assess carefully the contracts and products offered and whether they are too expensive to operate. Often smaller-scale transactions cost more to operate, process, and regulate than larger ones.

  • Investigate and understand local customs and financial practices, as these can vary widely between countries and even regions.

  • Gain an understanding of local cultural attitudes to maximize the potential of microfinance; for example, some schemes have more success than others in introducing microfinance to women.

  • Certain Muslim countries actively encourage Islamic microfinance. Potential users should investigate whether state support is offered to promote local microfinance schemes.

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Dos and Don’ts

Do

  • Encourage communication and dialogue between shariah experts and the financiers in order to ensure that the products offered are compliant with shariah law.

  • Understand that there will be differences between schemes in different countries according to local attitudes and conventions.

  • Be realistic in assessing that Islamic microfinance has potential for growth but currently is still exercised on a very small scale.

Don’t

  • Don’t underestimate the help that local religious leaders can give in explaining to the local population that the financial contracts offered are shariah-compliant, which will increase confidence in the use of the products.

  • Don’t assume that limited-income clients will accept any products offered on unattractive terms; they often drive a hard bargain.

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Further reading

Books:

  • Al-Harran, Saad. An Islamic Microfinance Enterprise: The Financial Vehicle That Will Change the Face of the Islamic World. London: Xlibris, 2008.
  • Nenova, Tatiana, and Cecile Thioro Niang. Bringing Finance to Pakistan’s Poor: Access to Finance for Small Enterprises and the Underserved. New York: World Bank Publications, 2009.

Articles:

  • Abdul Rahman, Abdul Rahim. “Islamic microfinance: A missing component in Islamic banking.” Kyoto Bulletin of Islamic Area Studies 1:2 (December 2007): 38–53. Online at: hdl.handle.net/2433/70892
  • Ahmed, Habib. “Financing microenterprises: An analytical study of Islamic microfinance institutions.” Islamic Economic Studies 9:2 (March 2002): 27–64.

Websites:

  • Consultative Group to Assist the Poor (CGAP), an independent policy institute promoting financial access for the world’s poor: www.cgap.org
  • Microfinance Management Institute (MMI): www.themfmi.org

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