Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 9

Islamic Microfinance
Learning Objectives

Upon the completion of this chapter, the reader should be able

to:

1. Be familiar with the history and basic components of Islamic

microfinance and the benefits to society
2. Identify key Islamic finance products that have been used for
microfinance
3. Understand the differences between Islamic microfinance i
Institutions and conventional microfinance institutions
1- Islamic Microfinance: Providing Credit
to the Entrepreneurial Poor

• Microfinance is the provision of small-scale financial

services to the poor (usually excluded from the formal
financial services)
• Islamic microfinance is the process of providing
small-scale financial services, based on Sharī‘ah
concepts, to the poor who may be excluded from formal
financial services
• Islamic microfinance aims to provide necessary
credit facilities to the poor and/or low-income
individuals who may not have enough finance to engage
in normal financial transactions in formal financial
institutions
Islamic Microfinance: Providing Credit to the
Entrepreneurial Poor

The History of Islamic Microfinance Institutions

• The early initiatives to alleviate poverty and promote
security in the Muslim communities include:
- The institution of zakat (compulsory alms)
- Waqf (charitable endowment)
- The praiseworthy qard hasan (benevolent loans)

• The informal savings clubs introduced by conventional

microfinance initiatives in the 16th century in Europe through
cooperative projects were tinted with interest, hence did not
serve the real objective of microfinance as a means of
assisting the entrepreneurial poor
Islamic Microfinance: Providing
Credit to the Entrepreneurial Poor

Components of Islamic Microfinance

Islamic microfinance is an umbrella concept that consists of:

• Micro-lending

• Micro-saving

• Micro-insurance (preferably known as micro-takaful)

2- Islamic Microfinance Products

Modes of Islamic Microfinance

• An Islamic microfinance institution adopts debt or equity
modes of finance for its financing requirements
• The debt-creating modes include:
- qard hasan (benevolent loan)
- murabahah (mark-up sale)
- ijarah (lease contract)
- salam (forward sale)
- bai-bithaman ajil (deferred payment sales)
• The equity financing modes include:
- mudarabah (trust partnership)
- musharakah (joint venture partnership)
- musaqah (share-cropping), etc.
Islamic Microfinance Products

The Most Commonly Used Modes of Islamic Microfinance:

• Salam as a mode of financing agriculture

• Mudarabah mode of combating unemployment

• Bai Muajjal-Murabahah mode of providing working capital
• Diminishing Partnership for Housing Microfinance
• Non-for-Profit Modes of Islamic Microfinance
Islamic Microfinance Products

Salam as a Mode of Financing Agriculture

• Salam regarded as the most viable tool for financing
agriculture
• Salam a contract where the bank is the buyer of the
commodity and the farmer is the seller who undertakes to
embark on future delivery
• Bai salam a contract where the seller undertakes to supply
specific goods to the buyer at a future date in exchange of
advance price which is fully paid on the spot
• Parallel salam a separate contract distinct from the initial
bai salam where the Islamic bank is the seller of the
commodity based on deferred payment
• The two contracts must be distinguishable from each other
Islamic Microfinance Products

Mudarabah Financing for Combating Unemployment

• Mudarabah is an Islamic finance contract where:
- an Islamic bank as an investor exclusively provides
capital for a business project
- an entrepreneur provides the management expertise

• Mudarabah a trust partnership finance mechanism

structured as a tool to combat unemployment and create
jobs
• Mudarabah can be a good product for entrepreneurial
activities, especially when there is a large amount of skilled
unemployed labour
Islamic Microfinance Products

Types of Mudarabah Contractual Arrangements

The two types of Mudarabah contractual arrangements are:
• Mudarabah al-Mutlaqah (Unrestricted Trust Financing):
where the particular business in which the micro-
entrepreneur will invest the capital finance is not specified
or restricted

• Mudarabah al-Muqayyadah (Restricted Trust Financing):

where the bank or Islamic microfinance institution (the
capital provider) specifies or restricts the business in which
the capital finance may be invested
Islamic Microfinance Products

Bai al-Mu’ajjal-Murabahah Model of Providing Working

Capital

• Bai Muajjal or Bai-bithaman ajil (BBA) a sale where parties

agree to deferment of payment to a future date – meaning
that there is already an element of Murabahah
• When Murabahah is combined with Bai Muajjal, it becomes a
microfinance product which is one of the most commonly
used instruments by the Islamic MFIs
• The mark-up price in the Murabahah contract is settled as a
deferred payment based on Bai Muajjal
Islamic Microfinance Products

Diminishing Partnership for Housing Microfinance

• Housing microfinance is a means of providing shelter for
low-income individuals
• A diminishing partnership is known as musharakah
mutanaqisah, an Islamic financial product structured to
strategically provide access to housing for the poorest
• The Islamic MFI and the client form a partnership contract
where they purchase a property and lease it out for a
specified term
• The client buys a specified number of units every month out
of the shares of the Islamic MFI which automatically
decreases the capital ownership of the MFI
Islamic Microfinance Products

Non-for-Profit Modes of Islamic Microfinance

• The non-for-profit modes of Islamic microfinance are
(i) zakat, (ii) waqf and (iii) qard hasan
• Islam institutionalised a number of mechanisms including
zakat, waqf, qard hasan and sadaqah to ensure that wealth
circulates among all the members of the society between
the rich and the poor
• A hybrid framework for these mechanisms will drastically
alleviate poverty in the society
• Despite the non-for-profit nature of the hybrid model, it can
be easily modified to accommodate the profit-oriented
modes
3- Islamic Microfinance Institutions versus
Conventional Microfinance Institutions

• The revival of Islamic finance services in the 20th century in a

formalised form brought with it the Islamic microfinance
schemes
• The Islamic finance products have been structured to suit the
requirements of the modern microenterprises and microcredit
schemes
• There are a number of operational and functional differences
between the Islamic microfinance institutions and the
conventional MFIs
• Islamic banking and finance, with its microfinance framework,
is inclusive in its approach to reach out to the disadvantaged
and poor and embed true social justice in society
Islamic Microfinance Institutions versus Conventional
Microfinance Institutions

Major Differences between Islamic MFIs and

Conventional MFIs
Sources of Fund:
• The conventional MFIs get their funds from:
Interest-bearing loans
Foreign donors
Central Banks
Government
• The Islamic MFIs get their funds (with the exception of
interest-bearing loans) from:
- Equity finance products applied in the finance of
microenterprises
- Islamic charitable sources such as waqf, zakat and sadaqah
Islamic Microfinance Institutions versus Conventional
Microfinance Institutions

Modes of Financing
• Conventional MFIs utilise interest-based modes of financing
• Islamic MFIs utilise Islamic financial instruments which are
either equity-based or debt-based
• Various financial instruments can be used to finance different
kinds of enterprises:
- A profit-sharing mode could be used for a microenterprise
where the microenterprenur and the MFI share the profit
- Salam and Parallel Salam may be more appropriate for
micro-farming
- Mudarabah trust financing may be utilised in order to
combat the curse of unemployment
Key Terms and Concepts

• Bai al-salam • Micro-lending

• bai al-mu’ajjal • Micro-savings
• Corporate social • Micro-takaful
responsibility (CSR)
• Microfinance
• Entrepreneurial poor
• Microfinance institutions
• Financial exclusion (MFIs)
• Informal savings club • Mudarabah
• Kafalah • Mudarabah al-muqayyadah
• Micro-farming • Mudarabah al-mutlaqah
• Micro-credit • Musharakah Mmutanaqisah