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Development According to the Shari’ah: The Case of Islamic Microfinance

Luigi Galimberti Faussone

This paper has been originally conceived as the final dissertation for the Master in International Cooperation (Development), 2007-2008 at the ISPI (Istituto per gli Studi di Politica Internazionale), Milan. Please, for any enquiries, do not hesitate to contact me at Any unauthorized reproduction or distribution of this document or parts of it is strictly prohibited.

............................... p........ 3 Microfinance as a priority for international donors ................................................... 5 Islamic microfinance: The principles.............................................. enjoy now the possibility to gain access to financial services............... 6 Islamic microfinance: The instruments .. 8 Conclusion ............................................................ 4 Microfinance in conflict and post-conflict contexts...................................... a new family of financial products based on the principles of the Shari’ah is rapidly developing............. p.......... p.................................................................................................................................. p..................................................Index Abstract ..................................................................... 7 Islamic microfinance: Case studies .............. p...................................... p............................................ The ethical values of Islam combined with the social goals of microfinance give birth to a new tool for development.. p................................. 3 Key principles of microfinance ............................................................................... who have been so far reluctant to accept interest-based microcredit schemes................................................................... This paper will analyze the principles and the instruments of Islamic microfinance in details... p.................... p............ p......................................................................................................... 9 Bibliography . 2 ......................... The Muslim populations living in the poorest countries.......... after a brief overview on microfinance and its applicability in different contexts......................................... 2 Introduction ............ 11 Abstract Within the growing sector of microfinance..............

and its applicability in different contexts. The purpose of this paper is to show how Islamic microfinance works and why it does constitute a radical change in development issues. and especially to the Lebanese context. the introduction of microfinancial services to the poor is the strategy to adopt. on the one side. Microfinance as a priority for international donors However. the analysis will move on to the description of the principles of Islam which are at the foundations of Islamic finance and microfinance and to the financial products which can be made available through an Islamic microfinance scheme. a new ethical perspective and. Microfinance is not the panacea for poverty reduction. little research has been conducted on both the theory and the practice of Islamic microfinance. alternative financial instruments. With the resolution 52/194 of 18th December 1997 the UN General Assembly designated the year 2005 as the “International 3 .Introduction Poverty is a multifaceted phenomenon. but nonetheless it is a powerful tool for poverty alleviation. The combination between the socially oriented microfinancial sector and the ethical values of Islamic finance results in a radically new and potentially powerful tool for development. when applied in certain contexts and under certain provisions. A few case studies in the Middle East and Northern Africa (MENA) will then precede the conclusion. on the other. Then. The application of the basic principles of Islam to the financial system has generated. Several references will be made throughout the paper to countries in the MENA region. before going into a detailed analysis of the themes mentioned above. If we consider financial exclusion as an obstacle to development. it is useful to stress the relevance of microfinance not only in the academic literature. The discussion will also focus on whether microfinance can be applied in war and post-war contexts with particular reference to a case study in Palestine. this paper will start introducing the principles behind microfinance. While “classic” microfinance has been widely applied and thoroughly studied. but in the very policies of the main international actors within the development sector. Microfinance is a priority especially within the United Nations family. In order to achieve such an ambitious target. its usefulness. the causes of which have different origins and can be tackled with different instruments.

Amongst other actors in the UN family. UNDP. the European Commission has also expressed its interest in promoting inclusive financial systems 8 . website. Generally. drought. emergency needs. website. consumption. Furthermore. While microfinance more closely concerns the mandate of the World Bank. 3 “UNCDF FIPA: Strategic Objectives for 2008-2011”. 6 “Our Approach”. the UN Capital Development Fund (UNCDF) aims at establishing “a shared common vision and approach towards developing an inclusive financial sector” 3 . website. 4 . In addition to the various types of loans (e. while pension schemes may also be made available. it also intersects the objectives of the International Monetary Fund 7 . etc. Yet the differences between the two reflect roughly 30 years of development of the concept. the terms microcredit and microfinance are used interchangeably. 2. IFAD considers microfinance as a new frontier 5 . death) or of the poor’s assets (e. International Year of Microcredit 2005. Furthermore. but they are now only a part. of microfinance. 5 “Microfinanza. IFAD. established themselves in the 1970s.). the World Bank is a front player in the microfinance field by “helping to build financial systems that serve poor people” 6 through the CGAP (Consultative Group to Assist the Poor). a growing poor population will benefit from having access to bank accounts. UNDP adopts microfinance as a key strategy in several countries.g. p. 8 See “Better access to finance for poor people”. though still the most important. including Lebanon 4 . Insurance products aim at reducing the vulnerability of the poor (e. which refer to making small loans available to poor people excluded from financial services. many other instruments have been developed during the years to tackle the most diverse needs of the poor. A deposit taking service acts as a safe place where to put the small earnings that may be needed in the future for planned (e.g. working capital. 7 Ingves (2005).g. Microcredit schemes. website.g. housing. burglary). Finally. illness) expenses. UNCDF. website. Furthermore.g. 4 See “Lebanon: What we do/Poverty and Social Development”. una nuova frontiera”. which may be used to receive 1 2 See “Why a Year?”. European Commission – EuropeAid. UN General Assembly (18th December 1997). website.Year of Microcredit” 1 noting that “microcredit programmes have proved to be an effective tool in freeing people from the bondage of poverty. and have led to their increasing participation in the mainstream economic and political process of society” 2 . education) or unplanned (e. CGAP. Key principles of microfinance At this stage it is useful to add a fundamental clarification.

funds sent by relatives abroad. Nevertheless. small entrepreneurs are perceived from financial institutions as yielding small profit potential and higher lending costs. 11 “Key Principles of Microfinance”. Northern Lebanon) countries is difficult to assess. farmers. reliable. Yet there are roughly 25 armed conflicts in the world under way. 6. reduces their vulnerability. who are in the greatest need of instruments to alleviate poverty in order to make the effects of war on their lives more bearable. the potential clients are separated from the bank personnel by differences in language. but also those who are unemployed. post-war (e. these conflicts are affecting countries with large numbers of poor people. “the destitute and hungry who have no income of repayment need other forms of support before they can make use of loans” 11 . website.g. Canadian Gateway to Microfinance. most significantly. for instance. Palestine). small entrepreneurs. both 9 For an extensive bibliography. Microfinance is seen by the poor as a way out of poverty. 5 . in culture. Southern Lebanon) and peaceful sectors within war and post-war (e. literacy. and promotes their empowerment. 27-8. 12 Goodhand (2006). face significant obstacles to obtaining the financial resources they need to start or develop their businesses. website. Financing is usually not available to the entrepreneurial poor for many and diverse reasons: the lack of tangible assets to offer as collateral. In addition to that.g.g. Yet best practice experiences around the world have shown that “the poor are bankable and willing to pay a premium for quick. p. pp. and conventional financial services”10 . because. since it raises their living standards. and. which tend to be long-term and complex 12 . see “Selective bibliography on microcredit and microfinance”. creates jobs. Microfinance in conflict and post-conflict contexts So far the implementation of microfinance schemes in developing countries has been discussed assuming that this would take place in a peaceful environment. The impact of microfinance schemes in war-affected (e. 10 Dhumale and Sapcanin (1999). it must be noted that microfinance is not always the answer. therefore dramatically reducing the costs associated with remittances and money transfers from the developed countries. the reasons behind the growing demand for microfinancial products deserve some attention. While it is not the task of this paper to analyse microfinance into details 9 . In a conventional banking system. CGAP.

pp. p. Kuwait.because of the absence of reliable data and of the lack of a consistent literature. fear of violence). Since for Islamic law “money is not an asset in and of itself” 18 . during and after the second Palestinian Intifada of September 2000 against the Israeli military occupation. no haram or Dhumale. 14 13 6 . loss of access to basic services) reasons 15 .g. but which actually refers to any and all forms of interest. 14. riba is strictly forbidden. Riba is an Arabic word that may be translated as “increase” or “excess”. Islamic microfinance: The principles The Islamic financial sector is mainly characterized by some key principles deriving from the Shari’ah. 19 Ibid. Iraq.9. social and political point of view. FATEN – a Save the Children programme that spun off to become an independent entity 13 – has been providing microcredit services in Palestine before. Furthermore.g. p. p. The absolute prohibition of interest in the Qur’an aims at counteracting “the injustice of the financier being assured of a positive return without doing any work or sharing the risk” 19 . Moreover. Furthermore. there is a definite stress on transparency in business matters. Islam does not allow to profit from a financial activity unless the financial capital is also exposed to risk. 62-3. Israel. or Islamic law. 11. Microfinance schemes suffer particularly in war-affected contexts also for other psycho-social (e. The conflict almost put to a halt FATEN’s activities because most of their clients lost their houses and/or their business assets.g. p. Most of the countries in the largely Muslim MENA region are theatres of current wars (e. is also strictly forbidden. they could not obtain raw materials from Israel nor access markets in Egypt and Jordan anymore 14 . However. Lebanon. see also “Microfinance in Conflict-Affected Environments: What Works?”. economic (e. 17 Bruett (2004). 16 Wilson (2003).g. Palestine) or have experienced wars in the recent past (e. Gharar. Algeria.). 18 Khan (2008). which means uncertainty. 15 ISAMI and USAID (2002). website. Sapcanin and Brandsma (1999). The Microfinance Gateway. loss of trust. rising inflation). etc. That is why Islamic microfinance may also be taken in account as a complementary tool in helping war-affected populations.1.. but also because those are very complex situations from an economic. but also speculation. and infrastructural (e. there is a high potential for microfinance to reduce vulnerability during conflicts 16 and to fuel reconstruction in post-war contexts 17 .g. See FATEN (October 2003). p.1.

. implies a compulsory levy of 2. one of the five pillars of Islam. Khan (2008). 5. On the contrary. The Zakat. 10% on the value of irrigated lands and 5% of non-irrigated lands 20 .5% on liquid assets. “this instrument involves the resale of a commodity. 25 Khan (2008). qard alhasanah or qard hassan are benevolent loans that the Qur’an encourages Muslims to make to “those who need them” 23 . and “non-profit and loss sharing”. p. 23 Dhumale and Sapcanin (1999). 20 21 Siagh (2008). Firstly. Yet murabaha has been often criticized for being a hidden form of interest-based financial product.illicit activities. including businessmen and their activities. after adding a specific profit margin by the lender to the borrower who agrees to buy that commodity for the new offered price” 25 . 19. poverty is seen “as a religious and social problem” 21 . These are interest free loans that may be charged only with the administrative costs to disburse them. 9. and are the only type of loan permitted by the Shari’ah. p. they lay their foundations in a strong social ethic. 7 . it is important to stress that Islamic microfinancial products are not a mere religious make-up operation of classic (Western) financial products. “economic activity and prosperity are viewed as religious virtue or even obligation in Islam” 22 . which are. such as the production of alcoholic beverages or gambling. may be authorized under an Islamic microfinance scheme. In other words. Indeed. however. 22 Ibid. Secondly. The latter category entails two of the most commonly employed instruments in such schemes. p. and a duty of all good Muslims. 24 See ibid. very different from one another. murabaha is the most popular and widely used Islamic financing technique for short-term financing based on the concept of purchase finance or cost plus mark-up sales 24 . On the contrary. 10. p. p. 11. Islamic microfinance: The instruments The types of Shari’ah-compliant instruments that are suitable to be implemented in a microfinance scheme can be divided into: “profit and loss sharing”. All those limitations to the economic and financial activities mentioned above must not deceive into thinking that profitable business is not possible in an Islamic context. At this stage.

spot sales (bai’mua’jjal). One of the most prominent examples is Jabal Al Hoss. In musharaka (and. only the financier is liable for it. but it is growing rapidly. it is shared between the two parts according to a pre-determined ratio based on a percentage of the profit and not as a lump sum payment. p. such as insurances (takaful). while Islamic microfinance is starting to develop too. Microfinance is not always the ideal answer to the needs of the poor.3. musaqat) contracts both the entrepreneur and the financier contribute to the capital and expertise of an investment. See Khan (2008). but they dramatically differ from the latter because they are not debt-like instruments. 29 Islamic Research and Training Institute of the Islamic Development Bank (2007). Furthermore. as in the case of Islamic Relief’s microfinance programme in Bosnia-Herzegovina 27 . p. Islamic microfinance can provide additional instruments for the poor. the financier provides the capital and the entrepreneur (the mudarib) invests the money. if caused neither by negligence nor by misconduct of the entrepreneur. 28 See Henyon (2006). particularly because the other word for credit is debit. 8 . In fact. This Sanadiq (village banks) model enjoyed considerable success and it has been replicated in other areas of Syria 29 .This is in fact the case for profit and loss sharing products. In a mudaraba contract. 26 27 Dhumale and Sapcanin (1999). for farmers. which would otherwise be a form of interest. a UNDP run program established in one of the poorest areas of Syria. of which more than 50 million live on less than US$2 per day 28 . Islamic microfinance: Case studies The MENA region comprises about 22 countries with a total population estimate of 300 million people. pp. In case of a loss. The potential market is estimated to be around 7 to 14 million people. lease contracts (ijara and ijara wa iqtina’). the microfinancial product that more than others conform to Islamic principles is mudaraba (and muzar’ah that is especially tailored for farmers). the liability of the entrepreneurs is limited to their time and effort” 26 . 30-1. These equity-like instruments can replace the loans usually disbursed under classic interest-based microcredit schemes. 34. and many others. Microfinance is a very young industry in the region. which implies that “financial losses are assumed entirely by the bank. This instrument may be costly and not always easy to implement. If a profit is realised. but when managed with expertise it proves very profitable for the lending institution.

34. Islamic microfinance schemes are not designed to replace classic interest-based products. social. This programme provides qard hassan loans. International cooperation to development cannot be reduced to an instrument of Western economic and cultural colonization. Errouaki and Toulouse. Finally. it is respectful of local religious and cultural traditions. but rather to complement them. Islamic microfinance constitutes a noteworthy progress in the history of development. Conclusion The application of Islamic principles to microfinance contributes to the enhancement of an instrument for development that is proving to be successful in alleviating poverty. Secondly. it is the expression of the needs of the Muslim population living in the socalled “less developed” part of the world. the Mu’assasat Bayt Al-Mal is currently run by Hizballah in Southern Lebanon 32 . 9 .Furthermore. the Hodeidah Microfinance Programme 30 has been set up in 1997 with the support of UNCDF and Grameen Foundation and it is now the third largest microfinance programme in Yemen 31 . p. Islamic finance and microfinance are viable alternatives to the dominant paradigm imposed by the Western financial market. 15. but also profit and loss sharing instruments 33 . “Hodeidah”. “Prefazione” in Siagh (2008). p. it cannot be the only source on which co-operation to development must rely on. website. Grameen Foundation. economic. 35 UN General Assembly (4th December 1986). The drift towards excessive speculation has recently 30 31 Sagrado (2005). 32 See Obaidullah (2007). and religious traditions. Muslims living in poor countries. 33 Islamic Research and Training Institute of the Islamic Development Bank (2007). but. 34 Aktouf. cultural. Firstly. which are not to be considered “local folklore” 34 . 36 UN General Assembly (10th December 1948). who have been until now either excluded from these instruments or reluctant to make use of them. As we may speak of a “right to development” 35 . While international aid coming from Western countries is in fact helping the population of some of the poorest areas of the world to live with dignity. p. xxxii. as long as they are in accordance with basic human rights 36 . on the contrary. Islamic microfinance as a tool for development has not been conceived in the “North” and then imposed on the “South”. this has to be implemented by respecting local political. will finally gain access to financial services.

which is not merely a façade. are a clear sign of a financial world that is totally disrespectful of the social consequences that its actions carry. are the key values of Islamic finance and microfinance. The prohibition of speculation. Parmalat in Italy. 10 . As the poor are the most vulnerable. they are also those who suffer mostly from global economic crises. the subprime mortgage crisis. the stress on entrepreneurial rather than financial speculative ethic. the duty of transparency and honesty. Argentina’s default in 2002. These values together with a strong culture of corporate social responsibility. The scandals of Enron in the United States. form the basis for a model of sustainable economic development.manifested itself with so far unheard violence.

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