CHAPTER 2 THE ISLAMIC MICROFINANCE APPROACH TOWARD POVERTY
2.2. Schools of Thought about Microfinance
Microfinance provides financial services with particular features and a distinctive mission to alleviate poverty. Microfinance has been in existence for over a century. It has evolved in response to changing political and socioeconomic circumstances and the advancement of technology. Microfinance has become an inclusive financial system with a broad range of services, methodologies and approaches (Meyer and Nagarayan 2006).
According to Ledgerwood (1999), there are two schools of thought concerning microfinance: minimalist and integrated. Although using different terminology, Woller et al. (1999) also identifies two schools: welfarist and institutionist. This discussion uses Woller’s terminology.
The welfarist approach emphasizes that microcredit has the objective of supporting people who live below the poverty line. Microfinance provides access to loans that enable the poor to earn better income, as well as increase their capacity to save and own valuable assets, reducing their vulnerability through saving and asset building (Khandker 1998). In addition, with the provision of complementary skills training, literacy programs, health programs, nutrition and family planning, the poor are able to achieve a better standard of living (Robinson 2001). The pioneer of the welfarist microfinance approach was the Grameen Bank in Bangladesh (Versluysen 1999).
The institutionist approach argues that microfinance is the provision of financial services including microcredit, saving and other financial services that are designed to assist un-bankable micro-entrepreneurs in order to enhance their businesses to a point of becoming viable ventures that are eligible to access commercial bank services. This
approach allows the microenterprise to progress, creates job opportunities in the community and invests more capital in new technology. Hence, in return, it would increase household income and foster local economic growth. One of the foremost examples of the institutionist approach is the BRI microbanking program in Indonesia (Robinson 2002)
By and large the two approaches to microfinance share the common objective of improving the socioeconomic welfare of poor inhabitants through productive economic activity: self-employment and entrepreneurship (Woller et al. 1999); however, the two camps have been in a debate about how microfinance programs should be delivered and managed (Murdoch 2000).
The welfarist framework argues that poverty is complex in nature and most of the poor and lower-income households are generally uneducated, unskilled, lack valuable assets, have no access to the market, are socially marginalized and their source of income is heavily dependent on low-waged seasonal subsistence agricultural labour. Thus, microfinance should be an integrated intervention, a mixture of concessional loans and social empowerment programs.
Zeller and Sharma argue that the underlying reasons why subsidies are imperative are, firstly, because it is a necessary intervention to ensure the poor can afford the microcredit. Through the interest subsidy mechanism, it provides the poor borrower with the opportunity to save their remaining income for other essential needs including as a safeguard against unforeseen expenditure. Secondly, public aid to the microfinance sector within the context of the antipoverty policy is acceptable because it is used to recapitalize the microfinance program. The subsidy is akin to a social safety fund that should be allocated to assist the poorest inhabitants (Zeller and Sharma 2002).
In addition, Woller et al. (1999) emphases that the welfarist approach focuses on depth, outreach and the impact of microfinance intervention to the poorest of the poor.
Subsidy-based microfinance reaches out to the destitute segment and uses group-based lending methodologies to organize poor borrowers of similar socioeconomic and cultural backgrounds. This approach allows the microcredit and empowerment program to be managed under a ‘one size fits all’ strategy and effectively to involve a great number of poor clients in communities. Woller et al. (1999) argue that microfinance
services should be directed to smooth the irregular pattern of income of the poor so that they could maintain regular household consumption and more specifically to empower woman as central actors in the family structure. With an effective intervention mechanism, the microcredit scheme could generate positive impact on the economic wellbeing and self-esteem of the poor.
In contrast, the institutionist approach focuses solely on providing diverse financial services and underlines the importance of sustainability of the microfinance program.
For this reason, the microfinance scheme is designed to reach out to creditworthy clients who are able to repay the loan at a commercial interest rate. In turn, the interest payment would be sufficient to cover operational expenses and generate profits to sustain the microfinance programs in the long term and reach out to poorer clients. In other words, financial sustainability and robust performance are the primary objectives of this approach (Robinson 2001).
Under the institutionist approach microfinance is a function of the financial intermediary system that allows surplus funds from the commercial market to be channelled to the microenterprise sector in suburban and rural areas. The flow of microfinance money would foster local economic growth and break down financial exclusion. In addition, the model uses an individual lending methodology to fit in with specific client characteristic and offers saving and deposit services in order to mobilize local sources of funds for its operation as well to extend the financial services into different poor communities that are not tapped by the formal banking system.
2.2.1. Microfinance Discourse and a Way Out
To some extent, the differences between these two approaches reflect the dilemma of microfinance. On one hand, the institutionist proponents, i.e. Robinson (2001) argue that microfinance, in the long term, would not be sustainable if they neglected market mechanisms and became dependent on subsidies to cover their operational costs. In the current situation, many microfinance programs have collapsed or been transformed into for-profit institutions because the subsidy dried up. Instead the governments in developing countries and donor agencies shift their policies to assist the poorest through the social security system and invest in education, hospitals and other basic infrastructures to broaden economic opportunity in high poverty incidence areas.
On the other hand, the supporters of the welfarist model, for instance Yunus and Jolis (1998), assert that commercial microfinance would drift away from the noble objective of poverty alleviation and focus on bankable clients and benefit investors rather than to reach the poorest segments of society. Recent evidence, i.e. Charitonenko et al. (2004) suggests that huge commercial funds flowing into the microfinance sector have driven many microfinance institutions to be more profit oriented. The microfinance services seem to be growing significantly in urban areas rather than expanding into rural areas, and providing more consumer credit instead of lending to productive microenterprises.
Research in Latin America demonstrates that many poor borrowers are over-indebted as they have taken out several loans from different microfinance providers (Gonzales and Gonzales-vega 2003).
It is likely the debate is counter-productive to the poverty alleviation movement if there is no way to resolve the differences. Outside the debate, many microfinance scholars propose a win-win solution and a compromise policy, which includes a new microfinance methodology.
Firstly, Takahatake and Maharjan (2002) propose that welfarist microfinance should be an integral part of government socio-welfare programs, in particular to ensure that the destitute population could access financial services in addition to social security benefits. In this regards, Robinson (2001) underlines the importance of adopting a
‘poverty alleviation tool box’ as a strategy guiding the development of comprehensive anti-poverty policy.
Second, Becchetti (2010) asserts the need to break down subsidy policies into three schemes:
1. A direct interest rate subsidy to the poorest borrowers;
2. An operational subsidy to cover the operational costs of microfinance institutions that serve the poorest borrowers;
3. A guarantee fund to broaden financial access to un-bankable borrowers who lack collateral to start up a microenterprise.
Aghion and Morduch (2005) suggest smart subsidies for anti-poverty microfinance programs. The subsidy should not interfere with the market mechanism, but rather
provide technical assistance in order to strengthen institutional and human resource capacity.
Third, Bangoura (2012) proposes a compromise solution between the mission to reduce poverty and sustain financial performance. In this context Woller et al. (1999) support the need of both microfinance camps to embrace social enterprise concept as a new model to achieve double bottom line objectives: profit and social impact. In addition, the Centre for Financial Inclusion (CFI) argues that microfinance system should embrace good governance and responsible lending practices, and be more transparent in setting loan interest rates, fees, terms and conditions in order to protect poor clients against excessive commercialization and over-indebtedness (CFI 2011).
Finally, Aziz (2004) argues that the faith-based microfinance should be considered as an alternative way to solve the dispute and dilemma between sustainability and poverty alleviation. The unique arrangement of the Islamic microfinance is likely provide dual mechanism to alleviate poverty, and empower the poor to be independent and productive (Rahman 2010; Sultan 2012). This approach is critically examined in this study: How does the Islamic microfinance system function in local communities? How it could play a role as the alternative microfinance model?