Why Has Islamic Microfinance Not Reached Scale Yet?

If there are so many poor Muslims in the world, and if the overwhelming majority of those Muslims do not have access to financial services, and if two thirds of these either insist or prefer having financial products that comply with Sharia, and if there are MFIs that are providing Islamic microfinance services, then what went wrong? How come in a country like Bangladesh, the largest MFI or bank providing products complying with Sharia reach only 100,000 active borrowers compared to the 22 million active borrowers reached by Grameen Bank, BRAC, and ASA, all of which are providing conventional products? The Arab World is no different. While we have conventional MFIs reaching tens and hundreds of thousands of active borrowers, Islamic MFIs have stagnated below 10,000 thousand active borrowers and in most of the cases only have 2-3 thousand active borrowers. Why hasn’t microfinance succeeded in reaching as many clients as conventional microfinance?

Islamic Financing Instruments: In addition to Al-Qard Al-Hassan (the benevolent loan), the loan with zero return, the literature separates the other Islamic financing instruments into two main categories:

1) Debt like financing (non profit and lost sharing) such as: Murabaha (cost plus mark up), Ijara waqtina’ (leasing), bai’ salam (forward contracts) and bai’ mua’jjal (spot sale), etc.

2) Investment Financing (profit and lost sharing) such as: Mudaraba (Trustee Financing), Musharaka (Equity Participation), Musaqat (Orchard Financing), Muzar’ah (Share of Harvest) and Direct Investment.

For more on Islamic financing instruments, click here.

So far, the focus for Islamic microfinance practitioners has been on debt financing instruments that closely resemble conventional microfinance. The most widely offered Sharia-compliant contract is Murabaha (cost plus markup sale contract), an asset-based sale transaction used to finance goods needed as working capital. Typically, the client requests a specific commodity for purchase, which the financier procures directly from the market and subsequently resells to the client, after adding a fixed “mark-up” for the service provided.

According to the 2008 CGAP focus note on Islamic Microfinance:                                                                                                                                                                              
“Although there is ample evidence of demand for Islamic microfinance products, this demand can only be met if low-income clients are convinced that the products offered are authentically Islamic. Critics of Islamic finance products suggest that the pricing of some products offered as Sharia-compliant too closely parallels (or even exceeds) the pricing of conventional products. For example, some institutions offering Murabaha, seem to disguise interest as a cost markup or administration fee.”

The cost of Murabaha involves more than simply giving the money to a borrower so he/she can go and buy the items needed for their enterprise. Costs are elevated by the additional staffing costs incurred when staff members accompany clients to buy the goods/materials/equipment covered by the loan — on top of all of the transactions completed in conventional lending. To minimize this cost, in most cases, MFIs try to minimize the number of loans by giving larger loans to a smaller number of borrowers. As a result, they either serve less impoverished clients, clients who were not impoverished, or they serve a poor client with a loan larger than his/her capacity to pay.

In addition, in most cases, Murabaha does not allow a late payment fee, and MFIs seems to take that into consideration when they price their product. Murabaha also tends to be less flexible, and does not allow borrowers to get cash they need to pay other expenses, such as utilities. Some MFIs even began to use what is called Alwakala Alnaqdeyyah, according to which, instead of giving the cash to the client as in the conventional lending or buying the goods/materials/equipment, the MFI gives the cash to the guarantor of the borrower after having the second signing a wakala which authorizes the guarantor to buy things for the borrower. All of these factors could be behind the limited outreach of MFIs offering Murabaha, as compared to MFIs using conventional microfinance. It seems to me that what was done so far is copying and pasting from conventional microfinance.

Many practitioners simply added another product instead of devising a new business model. When the conventional microcredit/microfinance movement began in the late 70s, the pioneers at that time thought outside the box of the conventional banking and its business models and came up with new models which proved over the years that the poor are credit worthy and can take loans and pay them back without the need for the collaterals conventional banks ask for and can pay high enough interest rate to cover the cost of the operations and to allow the MFI/bank to make some profit. We need to think outside the box of conventional microfinance and its business models and come up with new models that comply with the Sharia on the one hand, and that can reach millions of poor Muslims with financial services on a sustainable basis.

Those MFIs that focused on Al Qard Hassan products with no fees or a small fee were unable to cover operational costs and remained dependent on subsidies which prevented a wide outreach. The other MFIs used Murabaha which is the closest to the conventional microcredit and raised suspicions about their compliance with Sharia law. To be sustainable, MFIs charged rates and fees that were equal or higher than the rates of conventional loans making clients wary because of the high cost of services.

Moreover, low-income populations, who often rely on local religious leaders to address religious issues, These leaders seem to perceive the Murabaha as if it is simply a “rebranding” of conventional finance and not truly reflective of Islamic principles. More efforts should be invested in convincing those local leaders and the poor clients, with the authenticity of the Islamic financial products if Islamic microfinance is to reach its full potential.

The Islamic Microfinance Challenge 2010 was organized to encourage thinking outside the box and the design of new business models.