Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Pfeiffer University Colloquium on Microfinance: Banking on the Future Exploring Microfinance as Service, North Carolina, USA

30th September 2011

Presented By: Muhammad Khaleequzzaman Associate Professor/Consultant School of Islamic Banking and Finance International Islamic University Islamabad Pakistan

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Contents Poverty and gap analysis Issues of microfinance Why Islamic microfinance? Demand for Islamic microfinance Some experiences and products of Islamic microfinance Compatibility of Islamic framework with microfinance principles Issues relating to MFIs and Islamic banks Recommendations for mainstreaming sustainable Islamic microfinance

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Poverty and Gap Analysis Incidence of Poverty

Planning Commission GoP (2009) Task Force on Food Security UNDP HPI-1 Pakistan MF Industry Assessment-Pakistan 24.5% 36.1% 77th among 108 LDCs [22.3% + 22.5% vulnerable = 44.8%]

Financial Access (Access to Finance Study 2009)

Formally Served Informally Served Financially Excluded 12% (Female: 4%) 32% 56% (Female: 68%)

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Poverty and Gap Analysis Microfinance Spread

Microfinance Providers [PMN Network] Coverage Econ. Survey Coverage PMN Coverage Microwatch 29 MFIs 3% [1.6 mil. Poor] 18% [I mil. Poor] 13

Estimated Cost to Reach 3.0 mil. target [3 times of present coverage]

US$ 600- to 700 million (Rs. 49 to 57 billion) PMN

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issue of Microfinance Weakening Social Collateral A few instances



Hidden transcript Some women borrowers of Grameen Bank committed suicide

[Rahman, A., Micro Credit Initiatives . Who Pays?, World Development, Volume 27, No.1, 1999.]

Poorest are rarely looked after

[Hashemi, S, and Rosenberg, R. Graduating the poorest ..CGAP, Washington DC, USA. ]

Mis-targetting/Program officers bend rules in unobservable way

[Baker, J. L, Evaluating the Impact of Development Projects on Poverty- ., The World Bank, Washington DC., 2000. ]

Brokerage raises cost of already expensive transaction

[Barki, Husna, & Shah, Mehr, The Dynamics of Microfinance Expansion in Lahore, PMN, and ShoreBank Islamabad, Pakistan, 2007]

Violation of social collateral by lenders themselves [Bastelaer, Does Social Capital Facilitate the Poors Access to Credit?
.., The World Bank Washington, USA]

Islamic Microfinance-Sustainability & Mainstreaming [M. Khaleequzzaman]

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issue of Microfinance (Contd..) Ambiguous financial transactions

  

Flat rates of interest Un-explained fees Hidden charges, etc.

High cost debt economy than real economy

 

Separates finance from real economy Absence of cooperation from MFI when clients business loses De-capitalization of funds in high inflation economies

Islamic Microfinance-Sustainability & Mainstreaming [M. Khaleequzzaman]

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issue of Microfinance (Contd..) Exclusion of certain segments from development process



Self-exclusion by Muslim populations due to prohibition of interest Interest based financial services become irrelevant Poorest of the poor can not technically access MF Women in gender segregated societies cannot benefit from MFIs, hence lose empowerment opportunity

 

Value neutral system

  

Without much concern of ethics Risk transfer instead of risk sharing Emphasis on debt instead of trade comparatively more chances of mis-utilization of funds

Islamic Microfinance-Sustainability & Mainstreaming [M. Khaleequzzaman]

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Why Islamic Microfinance? Interest is prohibited primarily to render justice



Interest is transgression into the wealth of borrower as money is sterile and cannot re-produce Interest determined ex-ante Unjust distribution of production results In Islamic finance, primarily, profits determined ex-post Financial institutions shares business results Mounting cycles of high cost debt more likely find leakages hence unproductive mixed impact on poverty alleviation Risk sharing and asset building focus of Islamic finance provides link between finance and economic activity Result is entrepreneurship and real sector transformation

Economic inefficiencies of interest are obvious



Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Why Islamic Microfinance? Islamic finance facilitates inclusion



Religious and faith based settings mark the need for Islamic finance Muslim populations self-excluded owing to prohibition find access to microfinance programs Poverty alleviation programs of Islam are indiscriminating where non-enterprising poorest of the poor are also included through support of zero return Qarz Hassan (beneficence loan) and Zakat (religious tax on wealthy Muslims) MFI being partner of entrepreneur, greater expertise is available to entrepreneur in terms of availability of information, skills, efficiency and profitability In view of risk management and asset building focus, Islamic finance exhibits systemic as well as individual advantages over conventional finance establishing strong link between finance and economic activity

Islamic finance promotes investment climate



Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Why Islamic Microfinance? (Contd..) Islamic finance offers more efficient social capital


MFI and clients are considered one unit than separate entities as in conventional finance Moral and ethical values embodied in religious teachings result in exit of negative social capital
Negative Social Capital -Deceit and
Coercion

Negative Social Capital MFI

y Sense of social responsibility y Justice yRisk sharing
-Selection Bias

-Mistrust

Idleness/ Niggardliness

Clients y Joint Liability y Information disclosure ySelf-esteem y Necessity of repayment

-Inefficiency

-Willful Default

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Is there any demand for Islamic Finance, after all?

Surveying Organization
CGAP 08 PlaNet Finance 07 USAID 02 IFC/FINCA 06 Frankfurt School of Fin & Mgmt 06 IFC sponsored Study IFC 2007 Bank Indonesia 2000 NRSP

Surveyed Country(ies)
Jordan, Algeria, and Syria West Bank and Gaza Jordan Jordan Algeria Yemen Syria Indonesia (East Java) Azad Kashmir (Pakistan)

Preference (%) for Islamic MF

20 - 40% 35% - 60 % 24.9% 32% 20.7% 40% 43-46% 49% 90%

Islamic Microfinance: An Emerging Market Niche, Focus Note No. 49, CGAP, Washington DC, 2008

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some experiences in Islamic Microfinance International

Institutions
7 Sudanese Islamic Banks Islamic Cooperatives and Rural Banks of Indonesia Islami Bank Bangladesh, Social Investment Bank and AlFalah & Rescue Jordan Islamic Bank UNCDF Yemen (HMFP) Sanabel (12 Arab countries, 64 MFIs meeting 80% of MF needs) Amana Ikhtiar Malaysia and Islamic Pawn Broking

Mode of Finance
Murabaha, mudaraba, musharaka, and saving deposit [SIB Productive Families] Cooperatives Members Musharaka (integrated with Zakat Fund) Rural Banks Various modes IBB Mostly bai muajjal SIBL - Recourse generation - Cash Waqf and Financing through various modes Red/able Musharaka Murabahah and Mudarabah Murabaha, Mudaraba, Musharaka

AIM interest free loan Al Rahnu short term interest free loan against collateral at market value

Islamic Microfinance - A Tool for Financial Inclusion [M. Khaleequzzaman]

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some experiences in Islamic Microfinance National

Institution Islamic Relief Partner HSBC Akhwat Karakorum Cooperative Bank NRSP* Muslim Aid CDWC** Mode of Finance/Range of Financing Murabaha [USD 115335] Qarz hassan [USD 115335] Murabaha [USD 1151725] Purpose of financing Working capital, equipments, tools, house renovation, etc. Microenterprise, liberation of money lender loan, house finance Agricultural inputs, Working capital, equipments, flour machines, wood cutting saw, welding plant, livestock, fruit processing, etc -doAgricultural inputs, W/C, livestock Agricultural inputs, Liquidity, Equipment

Murabaha [USD 115575] Murabaha [USD 57 - 335] Murabaha, Salam, Istisna [USD 115- 335]

*National Rural Support Program **centre for women cooperative development

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Microfinance should diversify into Islamic financial products Comfort level of both systems provides opportunity
Conventional MF Increased access to financial services Social collateral-Exclusion of physical collateral Joint Liability ensures repayment Micro-insurance to meet business and health/life related losses is based on interest and speculation Islamic MF Inclusion by offering interest free financial services Islamic social capital ensures information disclosure and productive use of borrowed capital Mutual guarantee (Kafalah) serves the same purpose Islamic insurance (takaful) serves the same purpose but compensation materializes through cooperation of the insured ones and beneficiary shares the business result, too.

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issues of Islamic MF Suppliers perspective Regarding MFIs



Sub-optimal performance
Limited number of MFIs (i.e. 5 8), hence marginal outreach Uneconomic size of finance (Rs. 12000 15000) sustainability of microenterprise not ensured

Sustainability
Limited resource base donor driven practices lead to unsustainable operations Legal restriction to collect savings of clients enabling to generate resource base

Product concentration
Reliance on Islamic banking products with corporate features without any effort to innovate Preference of fixed profit related modes and neglect of risk sharing products which ensure more productive investment

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issues of Islamic MF Regarding MFIs



Virtually no capacity building for MFIs

Limited or no Shariah advisory (Advisory in Islamic law relating to financial transactions) for MFI operations Lack of training opportunities

Missing Common platform for standard setting and reporting

Lack of standardization in operating procedures and product development Lack f financial discipline

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Issues of Islamic MF (Contd..) Regarding Islamic banks



Perception about microfinance as high risk area Disregarding:

high rate of recovery Access to savings Microfinance a business case Opportunity for highly productive short term liquidity

Informal sector environment

Islamic banks articulate credit worthiness to physical collateral Regulatory constraints

Absence in rural areas

Asymmetric information and agency problem High monitoring cost

Limited concern for corporate social responsibility towards poverty alleviation

Prime Islamic value being ignored Limited opportunity afforded to poor to become integral part of economically active population

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations Mainstreaming Sustainable Islamic Microfinance Models and Products

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations 1. Downscaling Islamic Banking Operations Possible Course of Action:  Phase I:
Linkage with MFIs [Credit Lines based on Mudaraba + saving services] Benefits to MFIs: Sustainable funds, Capacity building, Governance, Sharia advisory, and Financial discipline Benefits to Islamic Banks: Higher return on short term liquidity, Outreach, low monitoring cost, Market access in rural and remote areas, Zero cost saving deposits

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations 1. Downscaling Islamic Banking Operations (Contd..) Possible Course of Action:  Phase II
Extension to financial markets while Linkage continues [Leverage + Product development + Technology transfer] Technology transfer helps developing customized products Extension of Islamic banking branches through low cost Hub and Spoke Model Experience leads to establish Islamic MF subsidiaries in addition to linkages Market leverage through Islamic securitization

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations
EXAMPLE of LINKAGE

Islamic Bank

Sharia Advisory & Technology Transfer MF NGO

MF NGO

MF NGO

Clients Clients Clients Savings

Clients Clients Clients

Clients Clients Clients Financing

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations 2. Inclusion of poorest of the poor



First Stage Non-returnable Zakat and sadaqat (Islamic tax and donations) fulfill basic consumption needs, development of entrepreneurship and provide capital investment Second Stage Zero return working capital for some initial periods Third Stage Fixed return financing for working capital

Zakat and Sadaqaat (Islamic tax and donations) Basic need fulfillment Development of entrepreneurship Capital investment

Islamic finance (Murabaha) Working capital

Transformation of hard core poor as entrepreneure

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations Product Offering from standardized to customized products Phase I [1st to 3rd cycle]
 

Murabahah (deffered payment cost plus sale Salam (forward sale)

Combination / Risk management

Phase II
 

[4th to 5th cycle]

Ijara (lease of assets) Diminishing Musharaka (Redeemable partnership)

Phase III
   

[Graduated after 5th cycle, selected clients]

Mudaraba (partnership of capital and management) Istijrar (suppliers credit) Micro venture capital Transformation of micro to small enterprises the link completely missing at present

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations
3. Venture Capital Funds
 

 

Suitable for transition of microenterprise to small enterprise Venture capital is sustainable, scalable, and market driven instrument Small businesses cannot attract traditional venture capitalists, therefore, Micro-funds to be established (by Islamic banks) for long term investments (say 5 years) Musharakah (Islamic partnership between MFI and client) should be the mode of finance Fund is managed by a fund management company Participation of fund provider in decision making process will provide management assistance, technical advice, monitoring, and mitigate agency conflict Periodical accounts would help to evaluate fair value of business assets Divesting can be gradual instead of one time redemption to save the business from any shock

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

Some Recommendations
4. Cash Waqf Model: Building Islamic Social Capital
Waqf means donating property, separating from private ownership and dedicating its usufruct to charitable purpose Allows Waqif (provider of fund) to build social capital without any expectation to get back capital investment or return Reason is purely religious to expect reward from God Cash waqf certificates of varying denomination allow anyone from any social class to participate How the fund can work?  Establish a cash waqf fund to be managed by a trust company  Invest fund in Sharia compliant business opportunities  Use returns of these investments for microfinance operations  Part of fund can be invested in microenterprises through Musharakah whose part of profit realized by fund manager can be used for welfare of the poor  Islamic banks can also establish trust/subsidiaries for this purpose

Islamic Microfinance-An inclusive Approach with Special Reference to Pakistan

THANKS
Q&A