CHAPTER 2 THE ISLAMIC MICROFINANCE APPROACH TOWARD POVERTY
2.3.2. Financial Methodology and Products
In accordance with the earlier discussions, Islamic microfinance preserves its own inherent characteristics in delivering financial services (Dhumale and Sapcani 1999).
Therefore, its modus operandi, including the organisational arrangements, operational procedures and features of products, are governed by the Sharia compliance framework (Ali 2012).
Primarily, Islamic microfinance is an interest-free financial system in all of its products and transactions; however it allows profit generation through risk and revenue or profit and loss sharing mechanism (PLS). Equally, speculative businesses and transactions are prohibited (Gharar). The principle of the transaction must be linked to the actual and identified underlying business and/or tangible assets. In addition, it cannot deal with several kinds of business (Haram), mainly gambling, pornography, drugs and alcohol, pork, and other unacceptable conduct including dishonest, deceptive, corrupt and unjust practices (Abdul-Rahman 2010; Obaidullah 2008).
The core financial methodology of Islamic microfinance is PLS. There are two generic models of PLS: Mudaraba and Musaraka. The scheme works under mutual partnership (Sirka) between the depositor or investor (Rabb al Maal), Islamic microfinance institution (Baitul Tamwil) and borrower (Mudarib). The most common PLS mechanism is where the depositor or investor places some amount money into saving or deposit account, accordingly the institution manages the fund and also search for qualified borrower with a commercially viable business venture that can be financed. In return, all parties share the profit that is generated from the business or share the loss if the business is a failure. In addition, usually, the parties set a proportion (ratio) of profit and loss sharing in advance, but it is not allowed to state a pre-determined rate of return (exact value) and/or fixed profit that commonly practised in the conventional system (Lewis and Algaoud 2001).
Equally important, Islamic microfinance also uses trading (Murabaha) and leasing contracts (Ijara) to generate profit. These models are less complicated compared to the PLS modes and the transaction arrangement seems quite similar to the conventional system of contracts. To understand the thorough nature of Islamic microfinance, the following discussions explain how the methodologies are applied into funding and lending instruments (Obaidullah 2008).
2.3.2.1. Funding Mobilization
The funding source of Islamic microfinance comprises public saving and deposit, equity, borrowing from other financial institutions, government subsidies, donor grants, and almsgiving and charitable donations (Obaidullah 2008). Among those, saving and deposits are the most important features in the liabilities structure and the primary liquidity pool for lending and investment activities.
There are two types of saving and deposit arrangements. First, a trust account (Amanah or al Wadia), in which the contract stipulates that the depositor entrusts the funds into a zero-yield account, but it should be risk-free and can be withdrawn at any time. The nature of a trust fund encompasses two categories: a safekeeping account and a current account. The first type cannot be invested by the institution but allows the charging of a fee for the safekeeping service (Khan 2008). The latter account is very liquid and in many cases can be allocated into very short-term and secure investments in order to minimize idle funds, hence it can provide a bonus to motivate a client to invest the money over a longer period.
The second type is a PLS-based Mudaraba account in which the contract normally applies to a passbook saving, term deposit, investment account and special investment account. The general term of agreement is set in advance, for instance, the ratio of return and risk sharing, maturity, service fee and penalty. However, for special investment accounts, the contract also states in detail the peculiar right and obligation of each party in order to ensure the contract is fully binding under the Sharia compliance system (Obaidullah 2008). Technically speaking, the PLS account is the most dominant source of funds for Islamic microfinance as it can be invested in riskier and long-term projects that generate greater profit.
As its concept is based on religious tenets, Islamic microfinance commonly mobilizes almsgiving and charity donations as well. The funds are mainly allocated to support the mission to alleviate poverty and socio-spiritual empowerments hence it has separate accounting and reporting systems that ensure a clear division between the non-profit and commercial objectives (Rahman 2010). Recently, almsgiving management has been developed so that some portion of undisbursed funds (e.g. donations) could be invested into productive, but less risky, ventures in order to enhance its capacity to reach out to poorer segments of the population and develop religious philanthropic programs (Sultan 2012).
2.3.2.2. Lending or Financing Techniques
Lending instruments for Islamic microfinance are adopted from Islamic banking practices, however there is significant adjustment to the methodologies in order to fit with the modus operandi and the client characteristics of microfinance (Obaidullah 2008). Lending modes encompass several types including a partnership contract
(Mudarabah and Musarakah), a trade/sale contract (Murabahah), a lease contract (Ijarah), and a benevolent loan (Qard Hasan). It is also worth noting that recent developments show Islamic microfinance has adopted several new Sharia-compliant products from the Islamic banking sector, for example pawn (Rahn) and insurance (Takaful), however, these instruments are not discussed in this study.
The Mudarabah partnership is common in Islamic microfinance. The scheme occurs when funds are invested into a business venture, where the borrower is the client and the funds are regarded as a loan. Technically, the PLS model states that the financier provides the capital and the client has the expertise. In return, both parties agree to distribute the profit, but if there is loss, the financier will bear the financial risk and the client bears the cost of the labour and effort. In the partnership, the client solely manages the business venture but normally the financier periodically monitors the venture to ensure the business is performing well. The contract should not stipulate a guarantee that the business will generate profit, however, if there is loss due to misuse or fraud, the client should be responsible for the whole invested fund (Saeed 1999).
The second type of partnership financing is Musarakah. In this contract, the Islamic microfinance institution and the client form a mutual partnership in capital and management of a particular enterprise. In contrast to the previous mode, the financier and client are responsible for decision-making, daily operations and overall business performance. In general, the company is led by the party that invests bigger capital or the majority shareholder. The contract allows the parties to own an equal share, or one party acts as the majority investor. In effect, this position will determine the ratio of profit and loss that should be distributed to the financier and the client. In addition, the nature of the partnership can be permanent, or one party (e.g. the financier) may gradually transfer their share to the client partner (Lewis and Algaoud 2001).
The Murabahah concept is a trading or sales contract in which the role of the Islamic microfinance institution is as the seller, and the client is the buyer. Initially, the client requests the financier to provide particular goods, assets or commodities. Based on the agreed terms and conditions, for example – goods specification, principal price, margin, delivery and payment method – the financier searches and buys the goods then directly delivers to the client. The financier adds an amount of profit on top of the basic price and the payment can be cash or under a deferred system for a certain period. In the case
of deferred payment, the instalment should be set proportionally toward the basic price (principal) and profit. The contract appears quite similar to traditional credit term payment but the profit should not be regarded as interest (El-Diwany 2010).
The Ijarah method is basically a leasing arrangement in which the financier rents the required assets, property or services to the client. For this service the institution charges a fee for the period of the rental contract. There are two types of leasing contract. The first is a generic lease in which the client uses the object property; when the contract is due the property should be returned to the financier lessor. The second type is a lease- purchase scheme in which at the end of the agreement the ownership rests with the client. Typically, during the lease period, the financier bears the risk of damages and maintenance cost, and in return, the client pays a fixed fee regularly or makes a lump sum payment (Lewis and Algaoud 2001).
The uniqueness of Islamic microfinance is that it integrates a social-religious mission in its financial instruments through a benevolent loan model (Qard Hasan). The primary feature of this scheme is charity loan with a very low return, or in some instances, it is free of charge. The loan finances start-up and on-going microbusinesses, to support income equalization of poor households, and other social purposes. In association with the loan, there is also provision of technical assistance and coaching, mentorship and a spiritual empowerment program in order to ensure the loan performance and to generate significant benefit to the recipient. The main source of funding is from external philanthropic and lending institutions as well as government grants. The practice of benevolent loans is separate from commercial activities; if the loan generates a return, it should be reinvested into the charity program (Khan 2008; Rahman 2010).
Figure 2.1. Islamic Microfinance Lending Modes
Source: Author compilation from Saeed (1999), Lewis and Algaoud (2001)