CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.0 Introduction

This chapter discusses the literature review related to “impact Islamic microfinance and

poverty reduction in Mogadishu Somalia.

2.1 Islamic microfinance

Microfinance is a way of helping financially disadvantaged individuals to improve their

economic well being. Group-based lending, small loans, periodic frequent repayment and being

collateral-free are among the features of microfinance (Abdul Rah man, 2010; Ahmed, 2002;

Solo and Ismail, 2011). To obtain a loan, a prospective borrower has to join a microfinance

recipient group. The borrower receives a small loan and agrees to shoulder a monetary penalty

in the case of default by a peer (Abdul Rah man, 2010). Under such group-based lending

arrangements, the group members have incentives to monitor each other for the greater good

(Abdul Rah man, 2010; Ahmed, 2002). Although microfinance has been widely recognised as a

poverty alleviation tool, some scholars criticize interest-based microfinance as being

exploitative (Hudon and Sandberg, 2013). Ahmed (2002) pointed out that the borrowers of

conventional microfinance often take additional loans from other sources to pay the

installments' and thus become trapped in a vicious debt cycle. Furthermore, Ahmed (2002)

noted that microfinance has a high dropout rate and rate of non-graduation from poverty. This
view is supported by other researchers such as Abdul Rah man and Dean (2013) as well as

Smolo and Ismail (2011).

Islamic microfinance, on the other hand, complies with the Shariah principle of prohibiting riba

(interest). Islamic microfinance is built upon the concept of interest-free loans (qard-hasan) and

the idea of mobilizing funds between finance seekers and fund providers (Usman and Tasmin,

2016). The main differences between Islamic microfinance and its conventional counterpart are

as follows: sources of financing, modes of financing, dealing with defaults, and repayment

amount (Ahmed, 2002). Unlike conventional microfinance, Islamic microfinance can benefit

from religious endowments such as waqf and zakat, which could be used as sources of financing

(Smolo and Ismail, 2011). Furthermore, Islamic microfinance providers could lease waqf land

and assets to those in need. Islamic teachings could also encourage devoted, religious

borrowers to consider the repayment of debt as a religious obligation (Ahmed, 2002).

2.1.1 Muraabaha

Murabaha is considered as a kind of trust sale. Because, the buyer trusts on seller in his

disclosure of acquisition cost and profit. That’s why, if the seller is found guilty of any deception

or fraud in disclosure, the buyer has option whether to accept the subject matter or cancel the

contract.

The purchasing order of the customer to the bank the following conditions:
1: The customer order the bank to purchase goods that needs.

2: The bank purchase the goods that request the customer.

3:The bank translate the ownership of the goods

4: the bank and customer enter the agreement, the bank clear the price of the good can

purchase the good and add the profit.

5: the customer advance the percentage of the bank, then installment.

2.1.2 Salam

Salam literally means to giving, payment in advance and leaving. Technically, bay al-salam refers to a
type of sale where the price is paid in advance at the time contract for specified goods which will be
delivered in future. In other words, salam is a type of sale where the seller undertakes the supply of
some specific goods to the buyer at a future date in exchange of an advance price which is fully paid on
the spot. The price is known as the salam capital and the deferred commodity is known as muslam fihi
which is the subject matter of the salam contract. The seller is known as muslam ilaihi whereas the
buyer is known as rab al-salam.

The contract of salam is equally beneficial for both buyer and seller. Because, the seller gets the price in
advance which he can use to produce goods and meet his cash needs. Likewise, the buyer gets the
commodity in cheap price. Because normally, the price in salam is lower and cheaper than price is given
on spot sales. The contract of salam was allowed by the Prophet Muhammad (peace be upon him) when
he migrated to Madinah. The basic purpose of this sale was to meet the needs of small farmers.
Because, they couldn’t take the interest-based loans due to prohibition of Shariah. But they had a need
of money to grow their crops and to feed their family until the time of harvest. So, they were allowed to
sell their agriculture products in exchange for payment in advance. Likewise, the Arab traders used to do
export and import business. They needed money to run this type of business. The door of usurious loans
was closed. So, the contract of salam was allowed from them to sell their goods in advance and meet
their liquidity needs for their business.