Islamic Approaches of Microfinancing

1
Islamic Approaches of Microfinancing
2
Lecture Plan

• Session 1
• Microfinance Institutions (MFIs)
• Financing Microenterprises Islamic Alternatives
• Islamic MFIs
• Islamic MFIs Vs Conventional MFIs
• Session 2
• Financing Microenterprises Islamic Alternatives
• Islamic Banks
• Other Specialized InstitutionWaqf-based MFI

3
Session 1

• Introduction
• Microfinance Institutions (MFIs)
• Islamic MFIs Vs Conventional MFIs
• Assessment of Islamic MFIs
• Conclusion

4
Introduction (1)

• In the last 50 years, different development
  strategies have been used to resolve the problem
  of poverty
• Most of these programs failed
• Microfinance initiated in the mid-1970s appears
  to be the new paradigm to eradicate poverty

5
Introduction (2)

• Limited access to finance is key constraint to
  private sector growth
• Investment on MSEs is even more difficult
• The MSEs do not qualify to get funds from
  institutional sources (banks)
• lack of collateral
• too much risk
• too costly

6
Economics of Microfinancing

• Profit Revenue Costs
• Revenue Rate of return on funds invested
• Costs Finance Costs Operating Costs
• Operating Costs Variable Costs (wages) Fixed
  Costs (rent, utilities, etc.)
• Variable Costs Field Level Costs Costs at the
  Head/regional/branch offices
• Microfinancing
• Revenue may be low due to credit risk
• Costs are high due to large operating costs

7
Financing MSEs

• Commercial financial intermediation not feasible
• If the poor have to be financed, there is a need
  for social financial intermediation
• Two ways to do so
• Linking ApproachExisting financial institutions
  can do it through specialized windows
• Specialized institutions ApproachNGOs,
  non-profit organizations, etc.
• Almost all of MFIs models are of the second type

8
Financing MSEs-Sustainability

• Mitigating Credit Risk
• Ensure repayment in the absence of acceptable
  physical collateral
• Solving the Moral Hazard problem
• Ensure funds not diverted and used for intended
  activity
• Economic viability keep costs to a minimum
  relative to income
• Operating costs
• Financing costs

9
Microfinance Institutions (MFIs)

• MFIs are target-oriented (poverty-focused)
  financial institutions
• Target groupmicro and small enterprises (MSEs)
• (Average financing in Bangladesh is below US 200
  and in the US is US 1500)
• Graduation from poverty -- the Virtuous circle
• Low income ?credit ?investment ?more income ?more
  credit ?more investment ?more income

10
MFIsTypical Balance Sheet
Assets Liabilities
Cash (C) Loans (L) Funds from external sources (F) Saving Deposits (D) Reserves (R) Equity (E)
11
MFIs-Main Features

• Interested individuals must form a group
• Several Groups form a Center
• Center has weekly meetings
• An official from the MFI attends the meetings and
  all transactions take place in these meetings
  (bank goes to the people)

12
Organizational Structure of MFI Clients
13
MFIs-Other Features

• Small amount of funds given for microenterprises
  for 3months -1year
• Capital and interest paid back in small weekly
  installments
• Forced savings and insurance programs
• Social Development Programs
• behavioral, ethical, and social development

14
MFIs-Social Collateral

• MFIs have devised a structure to resolve the
  collateral and risk problems of financing
• No physical collateral required
• The repayment of dues of a member in the group is
  the collective responsibility of the all the
  members in the group
• If any one in the group defaults--all members
  become disqualified for credit
• Peer-pressure works as social collateral

15
Banks Vs. MFIs (1)
Bank MFI
A profit-maximizing firm Non-profit Government/non-government organization
Financial intermediary between savers and investors in the economy Funds from external sources provided to the poor
Deposits form bulk of the liability Savings (forced) of clients only deposits
Do not have social/educational programs Includes social/educational programs
Physical/financial collateral required to get funds Social collateral through group and center formation
16
Banks Vs. MFIs (2)
Bank MFI
Clients relatively well-off Clients are poor
Clients come to the bank Bank goes to the clients
Amount of loan large Amount of loan small
Most clients are men Most clients are women
Repayment frequency small (end of the contract period) Repayment is frequent (weekly)
17
MFIs and Sustainability

• Mitigating Credit Risk (CR)
• CR mitigated by social collateral (group-based
  lending)
• Solving Moral Hazard (MH) Problem
• Cash given out can be used for other purposes
  chances of default increases
• Economic Viability
• High administrative costs (some estimates show
  costs ranging from 24 to 400 of per dollar lent)
• Reasonable finance costs
• Conventional MFIs have resolved the CR problem
  (social collateral), but not MH problem and
  Economic Viability problem

18
Islamic Alternatives to Microfinancing

• Different alternatives
• Islamic MFIs
• Islamic Banks
• Specialized Institutions
• Group-based microfinancing can be used (as it
  mitigates the CR)

19
Islamic MFIs-Features (1)

• Islamic MFI retains the basic operational format
  of MFIs
• Going to the Clients
• Weekly/Monthly Repayments
• A Social/Development Program (to fulfill the
  social role of Islamic finance)
• IMFIs have some distinguishing features
• Sources of Funds
• Other than external sources, can also use funds
  from zakah, awqaf, and other forms of charities
• Use of funds (Mode of Financing)
• Sale based and hiring modes (murabahah, salam,
  ijarah)
• Profit-sharing modes (Musharakah and mudarabah)

20
Islamic MFIs-Features (2)

• Amount transferred to the poorest
• As Islamic modes are sale based the price of the
  asset is paid (no deductions are allowed)
• Group Dynamics
• Islamic values of brother/sister-hood improves
  cooperation among the group members
• Financing the poorest
• Zakat and other charities can supplement MFI
  activities (non-diversion of funds)

21
Islamic MFIs-Features (3)

• Social Development Program
• behavioral, ethical, and social aspects in light
  of Islamic teachings
• Targeting the family through women
• Spouse co-signs the contract
• dealing with women more efficient and convenient
• Women disseminate knowledge to children
• Dealing with Arrears/Default
• Less aggressive and use Islamic teachings to
  recover loans

22
Islamic MFIs and Sustainability

• Mitigating Credit Risk (CR)
• CR mitigated by social collateral (group-based
  lending)
• Solving Moral Hazard (MH) Problem
• As asset/good given instead of Cash, chances of
  diversion and default decreases
• Economic Viability
• High administrative costs
• Reasonable finance costs
• Islamic MFIs can resolve the CR problem and the
  MH problem, but not the Economic Viability
  problem

23
Problems facing Islamic MFIs

• 1. Dilution in the Application of Islamic Modes
  of Financing
• Main mode- murabahah or bai-muajjal.
• It is difficult to go out with the clients and
  buy the goods/assets from faraway markets
• IMFIs delegates someone else (and inspects later)
• Alternative is to use Profit-sharing modes
• Problem is the moral hazard problem--No
  book-keeping and difficult to monitor

24
Problems facing Islamic MFIs

• 2. Lack of Funds
• Most MFIs get their funds from external sources
• Islamic MFIs have difficulty in getting funds
  from these sources
• Operations and expansion of activities affected
• Islamic MFIs have not yet tapped the sources of
  funds from Islamic institutions (like zakah,
  waqf, and other charities)
• 3. Training
• Training can enhance efficiency but is costly

25
Conclusion

• Islamic approach to microfinance has certain
  advantages
• Diversified asset and liability structures
• Social collateral stronger
• Potential to target the poorest through
  complementary programs
• Asset-based modes of financing can prevent
  diversion of funds for consumption
• Lack of funds hampering its growth

26

• Session 2
• Financing Microenterprises Islamic Approaches
• Islamic Banks
• Specialized institutions Waqf-based MFI

27
Financing MSE by Islamic Banks (IBs)

• The Rationale
• Social Role Islamic firms are not only about
  fulfilling Islamic contractsthere is more to it
  (social justice and benevolence)
• Financing is the specialization of IBsexpand the
  client base to the MSEs
• Can be done at no cost to the IB and more cost
  effectively than MFIs

28
Financing MSEs by IBs

• Use the same format as MFIs (as it suits the
  MSEs)
• IBs can open up a department for financing MSEs
• Use the existing infrastructure (bank offices)
  for financing MSE operations

29
IBs Economics of Microfinance

• Profit Revenue Costs
• Revenue Rate of return on funds invested
• Costs Finance Costs Operating Costs
• Operating Costs Variable Costs (wages) Fixed
  Costs (rent, utilities, etc.)
• Variable Costs Field Level Costs Costs at the
  Head/regional/branch offices

30
MFIs Vs. IBs Operating Costs

• MFIs
• For any level of operations an MFI will maintain
  officesHigher Fixed Costs
• Higher Variable Costs (wages) at
  Head/regional/branch offices
• IBs
• No extra costs needed to maintain offices for the
  Microfinancing program (can use banks
  premises)lower fixed costs
• Lower Variable Costs (wages) at
  Head/regional/branch offices
• Conclusion Operation Costs to finance MSEs is
  lower in case of IBs compared to MFIs

31
MFIs Vs. IBs Finance Costs

• MFIs Sources of funds
• Main source external funds (MFI has pay a rate
  of return, though subsidized in many cases)
• No DepositsForced Savings of MembersCompetitive
  returns are paid on savings
• IBs Sources of Funds
• Deposits
• Demand Deposits (no costs)
• Investment Deposits (has to pay competitive
  returns to depositors)
• Conclusion Given the excess liquidity in IBs,
  the funds from Demand Deposits can be used for
  MSEsFinance costs of IBs can be lower than that
  in MFIs

32
MFIs Vs. IBs Quality of Service

• Dependence on external funds in MFIs comes with
  conditionalitiesIBs more flexible
• Lack of funds in MFIspoorer quality work force
  (especially at field level)can increase the
  default rate
• IBs pay competitive wagesgood quality workers
  with higher productivity
• Employees of IBs can be trained by the Bank at
  low costnot possible in case of MFIs
• Most IBs have funds collected from penalties for
  late paymentsthese funds can be used for
  complementary asset building/poverty reducing
  programsasset building in form of grants or
  qard-hassan

33
IBs and Sustainability

• Mitigating Credit Risk (CR)
• CR mitigated by social collateral (group-based
  lending)
• Solving Moral Hazard (MH) Problem
• As asset/good given instead of Cash, chances of
  diversion and default decreases
• Economic Viability
• Low administrative costs
• No need for a hierarchy of senior management and
  offices
• Use existing branches for operation
• Low finance costs
• Excess liquidityuse liquid funds available
• IBs appear to resolve all the problems related to
  sustainability in microfinancing.

34
IB and Microfinancing An Example

• Islami Bank Bangladesh Ltd (IBBL) has a Rural
  Development Program (RDS) to finance MSEs
• Started in 1996 and funded from IBBLs general
  investment fund
• As of October 2006, RDS operated from 116
  branches (of 176 total), covering 7,788 villages
  giving a total of Tk. 8589.7 mill. to 368,360
  clients
• The recovery rate is 99 percent.
• Employees involved with RDS have better benefit
  packages than other MFIs
• Employees get in-house training at IBBL Training
  Academy

35
RDS of IBBL

• Loan amount (Tk. 3000 to Tk. 25000)
• Paid back in weekly installments
• No physical collateral required
• Group-based lending
• Rate of return charged is 10 percent with 2.5
  rebate for timely payment (other MFIs rate range
  from 16 to 20 )

36
Microfinancing by Specialized Institutions

• 1. Cash Waqfwaqf established in the form of cash
  
• Can be used for microfinancing
• 2. Qard hassan banknonprofit financial
  intermediary
• Capital would be cash waqf
• Will receive current accounts
• Provide qard hassan (interest free loans) for
  microfinancing
• 3. MFI based on Awqaf and Zakat
• Returns from waqf given for investment purposes
  and zakat funds for consumption purposes
• Use the same operational format as MFIs (as it
  suits the MSEs)

37
Waqf-based MFIs

• Historically, waqf based institutions did provide
  loans to the disadvantaged (Turkey and Iran)
• W-MFI will retain the basic operational format of
  MFIs, but will have some distinguishing features
• Group-based microfinancing can be used (as it
  mitigates the CR)

38
W-MFI Sources and Uses of Funds

• Sources of Funds
• Obtain funds from Waqf and other sources (waqf
  certificates, qard hasan deposits, etc.)
• Use of funds (Mode of Financing)
• Qard (loan at service charges)
• Sale based and hiring modes (murabahah, salam,
  ijarah)
• Profit-sharing modes (Musharakah and mudarabah)

39
W-MFI Typical Balance Sheet
Assets Liabilities
Cash (C) Assets (A) Fixed income assets (F) Microfinancing (M) Qard, investments(murabahah, ijarah, salam, istisna, mudarabah, musharakah) Savings Deposits (Ds) Qard hasan Deposits (Dq) Waqf Certificates (S) Takaful reserves (T) Profit equalizing reserves (P) Reserves/Econ Cap. (V) Capital-Waqf (W)
40
Special features of W-MFI

• Liability
• Waqfthe corpus (endowment) has to be intact
• Savings deposits mudarabah contracts
• Loss of lower return can lead to withdrawal risks
• Assets
• Allocation of assets into fixed income and
  microfinancing activities

41
WMFI Nature of waqf and investment options

• Waqfthe requirement of keeping the corpus intact
• Simplest-optionInvest the waqf endowment in some
  safe fixed-income asset and use the returns for
  MF operations
• The scope of MF will be limited

42
Example

• Waqf of 10 million, rate of return 5, financing
  100 per beneficiary
• (Grameen Bank 5.5 million beneficiaries given 5
  billion)

Assumption No. of beneficiaries
Use waqf returns only 5,000
Use 90 of the endowment 90,000
43
Allocation of Assets

• Risk and returns depend on allocation funds into
  different assets
• Fixed income (FI) assetslow-return low-risk
  assets
• Microfinancinghigher returns with higher risks
• Invest in FI assets so that returns can cover
  expected losses from microfinancing
• In addition, build various reserves to cover
  various risks

44
Risk-reducing reserves

• Takaful reserves
• Contributed by beneficiaries
• Used in case of default due to unexpected reasons
• Profit-equalizing reserves
• Contributed by depositors
• Used to maintain competitive returns
• Economic capital reserves
• Contributed from the surplus of MFI (no dividend
  distribution)
• Used in case of negative shock

45
Other funding sources

• Funds from Zakah and other charities
• Funds from waqf given for investment purposes and
  zakah funds for consumption purposes

46
W-MFI Sustainability

• Mitigating Credit Risk (CR)
• CR mitigated by social collateral (group-based
  lending)
• Solving Moral Hazard (MH) Problem
• As asset/good given instead of Cash, chances of
  diversion and default decreases
• Economic Viability
• High administrative costs
• Low finance costs
• Being charities there are no finance charges
• These specialized institutions resolve CR and MH
  problems and to lesser extent the viability
  problem

47
Sustainability-Relative Status
Credit Risk Moral Hazard Economic Viability
Conventional MFIs No Yes Yes
Islamic MFIs No No Yes
Islamic Banks No No No
W-MFI No No Somewhat
48
Conclusion

• There are strong economic reasons for
  establishing Islamic alternatives to
  poverty-focused microfinancing.
• Financing should adopt operational mechanisms of
  MFIs (as they suit these clients)
• Financing MSEs by IBs is most efficient (cost
  effective)given the social responsibility and
  excess liquidity in IBs, financing MSEs should be
  undertaken
• Traditional institutions of waqf, zakat, and qard
  hassan are important means of financing MSEs
  during contemporary timesshould be integrated
  with microfinancing

49

• THANK YOU!