The award as well as the UN declaration of 2005 as the ‘International Year of Microcredit’ have greatly increased awareness about microfinance. Microfinance involves the giving of small loans to poor borrowers to help them finance education, respond to income shocks and emergencies and, most notably, start micro-businesses.

One area where microfinance is not yet well developed is in providing financing in a Shari’ah-based way. The success of conventional microfinance in Bangladesh, a conservative Muslim country, suggests that the demand is so great that even interest-based microfinance is viable in Muslim countries. However, the growth of conventional microfinance is still limited by its reliance upon conventional loans.

Microfinance could grow significantly if it adopted Shari’ah-based products alongside the conventional products to reach out to clients who eschew interest-based financing. The Institute of Halal Investing, a nonprofit think tank based in the US, presented a paper, ‘The development of a Shari’ah based microfinance using the Grameen Group financing methodology’ at a pre-forum workshop on Islamic microfinance at Harvard University on 18 April.

The foundation of the paper is the development of a model of microfinance using the Murabaha and Musharaka products frequently used by Islamic banks to construct an alternate framework to conventional microfinance. Not only will this alternate form of microfinance have more appeal among Muslims, it can also be used in a non-denominational context to improve upon the results of conventional microfinance.

Conventional microfinance begins with self-selected groups of five borrowers, often women, who approach a microfinance institution (MFI) asking for small loans to begin or expand each of their own businesses. The MFI, if financing is approved, disburses small loans, usually under $200, to group members with weekly repayment of principal plus interest. The interest rates charged are usually around 20 per cent, but can be as large as 100 per cent. These rates, considered high particularly by people in the west, are often lower than the interest rates charged by the moneylenders MFIs replace. Despite these high interest rates, most MFIs experience repayment rates in excess of 95 per cent due to the group responsibility structure. Each borrower is responsible for the other members’ loans and if any member misses repayments, all other group members could lose access to future loans. This provides an incentive for group members to monitor each others’ businesses.

"MICROFINANCE COULD GROW SIGNIFICANTLY IF IT ADOPTED SHARI’AH-BASED PRODUCTS ALONGSIDE THE CONVENTIONAL PRODUCTS TO REACH OUT TO CLIENTS WHO ESCHEW INTEREST-BASED FINANCING."

The ability to create an incentive for group members to monitor each other’s repayments provides the possibility that profit-and-loss sharing financial products can be implemented in a microfinance context using products developed for Islamic banking. The first product that will be offered to client groups is Murabaha, a cost-plus financing product that will allow the MFI to build a relationship with the group to understand whether the group members act honestly, make on-time repayments and allow for training in basic bookkeeping needed for the profit-and-loss sharing Musharaka financing product.

In the Murabaha financing, all members meet with the MFI and elect a leader who will manage the group. In order to provide them with an incentive to lead monitoring of the other group members, the leader will receive financing last. Initially, two members will work with the MFI to develop a list of items needed. The MFI then prices the items requested and the clients sign an agreement specifying the original price, the markup and the repayment schedule. Once the agreement is signed, the MFI purchases the items on behalf of the client and delivers them to the client. Each week, the group meets with the MFI and the first two members receiving financing make repayments.

After six weeks, if the first two members are current in their repayments, two other group members receive financing. A further six weeks later, the leader receives financing as long as all members are current on their repayments. The Murabaha product, with its fixed repayment amounts, resembles conventional financing but has several advantages. First, the similarity with conventional microfinance allows the MFI to incorporate ‘best practices’ developed in the first 30 years of microfinance. Second, in contrast to conventional microfinance, the Murabaha product allows the MFI to more easily track the use of the financing since all the goods purchased are done so by the MFI on behalf of the client. Finally, it allows for the incorporation of a flexible repayment schedule.

If the groups are successful in repaying the initial financing, the MFI offers additional financing using either Murabaha or Musharaka. The latter is an innovative way to expand the product offering of MFIs using Islamic finance. The structure is similar to the Murabaha except that instead of buying goods on behalf of the client and then receiving fixed repayment amounts, the MFI takes an equity stake in the micro-business in which it is investing. At the outset, the MFI provides financing to the micro-entrepreneur and they agree to share profits and losses. In addition, both parties agree to a buy-out schedule which provides an exit for the MFI from its ownership of the micro-business.

For example, if the MFI and client agree to a 75:25 profit sharing ratio and a 10-week buyout period, then the first week, the client repays one-tenth of the investment plus or minus 75 per cent of the profits or losses realised that week. The following week, the client repays another 10 per cent of the investment plus or minus 67.5 per cent of the profits or losses, this equates to 90 per cent of 75 per cent. This continues until the client has fully bought out the MFI. Each client in the groups receive similar financing agreements: first two members, then second two members, then the group leader.

The advantages of Musharaka financing are two-fold. For the client, the risk that the business does not succeed is shared with the MFI. The weekly payments to the MFI include both the buy-out, which is a fixed percent of the total investment and the profit-sharing component, which varies depending upon the actual profitability of the micro-business. If losses are realized, the client and MFI share the losses according to the profit-sharing ratio. For the MFI, the additional risk from being liable for a share of the losses is compensated by receiving a share of all profits realised. Unlike an interest-based loan, where profitability risk and reward lies with the client and the MFI earns the fixed interest payment, the sharing of risk and reward provides the MFI with greater upside potential if the business is successful.

Although the Musharaka microfinance product has the potential to benefit both clients and the MFI compared with the conventional microfinance products, there is one significant challenge to successful implementation. The MFI is unable to accurately monitor clients to determine whether reported profits are accurate. This problem is a principal-agent problem; the MFI, the principal, cannot monitor the client, or the agent, without incurring costs and the client has an incentive to understate profits or overstate losses to reduce the amount shared with the MFI. This is where the use of group financing can provide a solution that cannot be incorporated if the MFI were lending to each client separately.

Using a group financing methodology, the MFI can enlist the help of other group members to monitor the other members and make sure profits and losses are reported accurately. In order to accomplish this, the members need to have an incentive to monitor other members’ behavior. One way in which this can be accomplished is by making all the members of the group benefit from higher profitability of the group as a whole. Therefore, any under reporting of profits or over reporting of losses by one group member will hurt the other members. This can provide the incentive needed to ensure accurate reporting of profits and losses needed for the Musharaka product to operate successfully.

Using products developed by large Islamic banks in a microfinance context, the market for Islamic finance products can be expanded, as well as creating a new tool for microfinance that may be better able to alleviate poverty and create income than conventional microfinance.

Blake Goud is executive director of the Institute of Halal Investment