CHAPTER NINE

AN OVERVIEW OF ISLAMIC MICROFINANCE

Edib Smolo

9 Abstract

Some estimates indicate that there are about three billion people living in abject poverty making
the problem of poverty a global challenge. With 600 million poor Muslims, this problem
represents a major challenge before Muslim Ummah as well. Microfinance is seen as a “new
paradigm” for bringing about development and eradicating poverty. Microfinance, which is the
provision of small amounts of credit to the poor who is usually outside the formal banking
system, is attracting growing attention from the World Bank and regional development banks.
Conventional microfinance institutions (MFIs) already existed for a couple of decades and
played a great role in helping the poor achieve higher income which, later on, may lead to the
higher standards of living. Islamic microfinance institutions (IMFIs), which constitute a part of
the Islamic financial system, are yet to be fully developed. This paper is addressing the issue of
Islamic MFIs, their theoretical framework and implementation. It is believed that Islamic MFIs
could play a greater role in poverty alleviation throughout the Muslim world. Various financing
modes, such as mudarabah, musharakah, ijarah, and murabahah - among others, could be used
by IMFIs to meet different needs faced by the poor.

9.1 Introduction

Poverty alleviation is not only the goal of 21st century world, but it has been a continuing

challenge throughout the history. Islam recognises that everybody should have secured basic

needs and enjoins the rich members of the society to help those in need. In other words, Islam is

not synonym for poverty since Islam strives for the betterment of its followers. The same can be

concluded from the available texts in al-Qur’an and Sunnah as the main sources of Islamic Law

(Shari’ah). During his lifetime, the Prophet Muhammad peace be upon him (p.b.u.h.), asked for

Allah’s protection from the idolatry and poverty by saying: “O Allah, I seek Your refuge from


Edib Smolo is a researcher at International Shari’ah Research Academy for Islamic Finance (ISRA). He
can be contacted at edib@isra.my or hfz_edib@yahoo.com

1
poverty, insufficiency and lowliness.”1 In another hadith narrated by Abu Sa’id (r.a.), the Prophet

(p.b.u.h.) was once seeking protection from kufr (disbelief) and faqr (poverty); a man asked him,

“Is faqr on a par with kufr?” The Prophet (p.b.u.h.) replied, “Yes.”2 Having said that, we can

see that Muslims should afford their best to fight against the poverty at all levels, since poverty is

a threat to a man’s belief, social security and stability.

Some argue that there are more than three billion human beings living in abject poverty.3

Unfortunately, the majority of the Organization of Islamic Conference (OIC) countries belong to

the undeveloped or the least developed countries group and poverty is overwhelmingly present in

Muslim countries. At the same time, Muslim societies pay much less attention to the problem of

poverty than the rest of the world. Only the bottom ten Muslim countries, according to some

authors, account for more than 600 million of the world’s poor.4

In order to solve, thus, (at least partially) the problem of poverty within the Muslim societies we

have to go to the grass-roots of the problem. A way forward, as suggested by few authors, would

be to introduce and implement microfinance techniques, based on Islamic principles.5

For last couple of decades, conventional microfinance institutions (MFIs) have made a

tremendous impact in poor countries and their presence is felt and recognised throughout the

world. Islamic economics is a young discipline and still in the process of development, therefore,

1
"Al-Bayhaqi. (1994). Al-Sunan Al-Kubrā (Vol. 7). Makkah Al-Mukarramah: Dar Al-Bāz, P. 12. This Hadith Is
Also Reported by Abu Dawud, Al-Nasa'i, Ibn Majah and Hakim on the Authority of Abu Hurayrah.."
2
Reported by Al-Nasa’i, hadith no. 5485.
3
Mohammed Obaidullah, Introduction to Islamic Microfinance (New Delhi: IBF Net, 2008), at 1.
4
Ibid., 1; Mohammed Obaidullah and Khan Tariqullah, Islamic Microfinance Development: Challenges and
Initiatives, Policy Dialogue Paper No. 2 (Jeddah: IRTI, 2008), at 9.
5
Rushdi Siddiqui, "Wake-up Call for Islamic Finance", Gulf News http://gulfnews.com/business/markets/wake-up-
call-for-islamic-finance-1.746960 (accessed 17 January 2011); Edib Smolo and Abdul Ghafar Ismail, "A Theory and
Contractual Framework of Islamic Micro-Financial Institutions' Operations," Journal of Financial Services
Marketing [forthcoming], no. (2011).

2
it is not surprise that Islamic microfinance institutions (IMFIs) have not fully developed yet.

Steps have been made towards the establishment and development of IMFIs, but there is a great

room for improvement. MFIs are seen as a new approach to fight poverty and bring about

development. It is for these reasons that this paper is focusing on the potentials of these MFIs

from an Islamic perspective.

MFIs already existed for a couple of decades and played a great role in helping the poor achieve

higher income which, later on, may lead to higher standards of living. IMFIs, on the other hand,

are infants of the Islamic finance industry (IFI), which are yet to reach their potentials.6 Up until

recently, the literature on the topic was very scarce with greater attention being given to the topic

in the last couple of years. Nevertheless, there are still many areas to be explored and addressed

further.

This chapter is far from being exhaustive. The main objective here is to provide a general

overview of the topic by analysing, summarising and reviewing the existing materials. As such,

the paper is based on an extensive review of literature on Islamic microfinance with the aim to

elaborate the role, potentials, and modes of finance available to IMFIs.

This chapter further provides a general overview of Islamic microfinance. It consists of four

sections, including the introduction, and is organised as follows. Section two reviews the main

literature on the topic. Section three is the main body of the chapter. It discusses the definition of

microfinance; the importance of poverty alleviation; different microfinance models; financial

6
Hans Dieter Seibel, "Islamic Microfinance: The Challenge of Institutional Diversity," ICMIF Takaful, no. 12
(2007). http://www.takaful.coop/doc_store/takaful/SoA12.pdf (accessed 26 January 2010).

3
instruments available for IMFIs, differences between IMFIs and conventional MFIs; and

problems faced by these institutions. The last, but not the least, the section four is left for

concluding remarks.

9.2 Review of the Literature

Despite the growth of Islamic banking and finance, it was only recently that the due attention

was given to the issue of Islamic microfinance. In fact, while few researches have been done on

the topic prior to 2005 and 2006, the majority of research works has been carried out after that.

One of the reasons for that was the fact that the year 2005 was declared as the year of

microfinance by the World Bank. The other reason is that Prof. Muhamad Yunus, the founder of

Grameen Bank Bangladesh, received the Nobel Peace Prize for microfinance in 2006. The lack

of research on microfinance from Islamic perspective could be also due to a very short history of

MFIs on one side; Islamic finance in general and IMFIs in particular on the other. Here we

would like to briefly review the main literature on the topic.

One of the early works on Islamic microfinance is by Dhumale and Sapcanin, who showed the

nexus between Islamic banking and microfinance. They found that the available modes of

financing within Islamic banking could be easily adapted to and implemented within the MFIs.

In fact “Islamic banking and microfinance programs may complement one another in both

ideological and practical terms.”7 In their research, they evaluated murabahah, mudarabah and

qard al-hasan as potential instruments for Islamic micro financing. They found that murabahah

7
Rahul Dhumale and Amela Sapcanin, An Application of Islamic Banking Principles of Microfinance (New York:
UNDP, Regional Bureau for Arab States, 1998), at 1.

4
is the most practical and suitable instrument for Islamic microfinance. The result is not surprising

since murabahah - as a financial instrument - is also the most commonly used instrument by

Islamic banks in general. This is due to its relative low riskiness, easiness to administer and

monitor, as well as to its similarity with conventional interest-based lending.

It is believed that the format of Islamic MFIs will be similar to that of its conventional

counterpart with certain qualitative differences between the two. Having this in mind, Ahmed

(2002), analytically evaluated the nature of Islamic microfinance institutions and compared them

with conventional ones (see Table 2 below). As a result, the following differences are also

highlighted: sources of funds, modes of financing, financing the poorest, amount of funds

transferred to beneficiaries, group dynamics, social development program, objective of targeting

women, work incentive of staff members, and dealing with default. In addition, the study shows

that there are three fundamental cornerstones for the establishment of IMFIs. These three

fundamental cornerstones are the theoretical basis, operational framework, and empirical

support.8

In the same study, Ahmed conducted the survey with the beneficiaries and officials of three

Islamic MFIs, namely: Al-Fallah, Noble and Rescue, from Bangladesh. The empirical evidences

show that the above mentioned IMFIs performed relatively well when compared to the well-

established conventional MFIs in terms of profitability and efficiency. The total profit of all three

IMFIs is positive. Operating profit is also positive except for Rescue. However, IMFIs are not

free from problems and inefficiencies, which are discussed later.

8
Habib Ahmed, "Financing Microenterprises: An Analytical Study of Islamic Microfinance Institutions," Islamic
Economic Studies 9, no. 2 (2002): 36-41.

5
Having in mind overdependence of IMFIs on bay’ muajjal or BBA, Ahmed also suggested that

new financial instruments should be used since the this mode of financing has been diluted. In

fact, studies showed that there are three widely used Islamic modes of finance (i.e. mudarabah,

musharakah and murabahah). Out of these three, murabahah (cost-plus financing) mode of

finance is the most preferred by IMFIs.

This is because studies showed that only 20% of microfinance clients keep books.9

Perhaps the most comprehensive analysis of microfinance from Islamic perspective is done by

Obaidullah (2008), Obaidullah and Tariqullah (2008), and Khan (2008). They thoroughly

reviewed theory, principles and practices of Islamic microfinance. Furthermore, they elaborated

in details different models, products and infrastructural issues pertaining to implementation of

Islamic microfinance scheme.10

In short, the studies showed that there are great potentials for IMFIs. However, the growth and

sustainability of them depend largely on availability of funds and efficient operations. Besides

funding from Islamic Development Bank (‘IDB’), in order to get more funds, IMFIs can turn to

the alternative sources of fund likezakat, charity and waqf. It is believed that thezakat, charity

and waqf can be successfully integrated into the microfinance programs for the sake of poverty

alleviation.11 Kabir and Alamgir (2002) concluded that this inadequacy of MFI resources is the
9
Ahmed Al-ZamZami and Lorna Grace, "Islamic Banking Principles Applied to Microfinance, Case Study:
Hodeidah Microfinance Programme, Yemen", United Nations Capital Development Fund (UNCDF)
http://www.uncdf.org/english/microfinance/uploads/thematic/Islamic%20Banking%20Principles%20Applied%20to
%20Microfinance.pdf (accessed 6 January 2010); Dhumale and Sapcanin.
10
Ajaz Ahmed Khan, Islamic Microfinance: Theory, Policy and Practice (Birmingham, United Kingdom: Islamic
Relief Worldwide, 2008); See Obaidullah, Introduction; Obaidullah and Tariqullah, Islamic Microfinance
Development.
11
Habib Ahmed, Role of Zakah and Awqaf in Poverty Alleviation, Occasional Paper No. 8 (Jeddah, Saudi Arabia:
Islamic Research and Training Institute, 2004); Habib Ahmed, Role of Zakat and Awqaf in Poverty Alleviation
(Jeddah: Islamic Research and Training Institute (IRTI). Occasional Paper No. 8., 2004); Muhamad Ramzan Akhtar,
"Practice and Prospects of Musharaka Financing for Small Enterprises in Pakistan," Journal of Islamic Banking and

6
limitation for further expansion, “both horizontally and vertically.”12 It is believed that Islamic

law allows room for financial innovations and that Islamic financial system can offer alternatives

to microfinance industry.13

Consequently, Akhtar (1996) believes that, in case of Pakistan, musharakah can play significant

role within microfinance industries. The paper shows that the microfinance industries “account

for 81% of industrial labor force and 28.52% of the value-added of manufacturing sector. They

contribute 5.11% of GDP compared to 12.81% of large-scale industry.”14 A very nice framework

for commercial banks is elaborated in this paper. According to this framework a number of small

firms should come together and form the group. This will increase the interest of the banks,

because now they will deal with one case consisting of several small firms, instead of dealing

with each and every one of them. This will reduce transaction cost and default risk. At the same

time, it will be easier for the bank to monitor account of the group rather than to monitor every

firm individually. Furthermore, the joint assets and security of the group can easily meet the

collateral requirements of the bank. This approach of co-operative financing is initiated by Co-

operative Societies Act 1925, but has not been utilised, as stated in the paper, because of “socio-

political and bureaucratic reasons.”15

Finance 13, no. 3 (1996); Muhamad Ramzan Akhtar, "Islamic Microfinance: Credit Where Credit Is Really Due,"
Islamic Banker1998; Saad Al-Harran, "Proposal for an Integrated Marketing Model of Musharakah Financing to
Help Disadvantaged Fishing People in Malaysia," in International Workshop on Islamic Partnership Financing for
Small Enterprise, Enterprise Development Centre, Cranfield School of Management, Cairo (Enterprise
Development Centre, Cranfield School of Management, Cairo: 1995); Saad Al-Harran, "Islamic Finance Needs a
New Paradigm," New Horizon1996; Saad Al-Harran, "Islamic Partnership Financing," Arab Law Quaterly 14, no. 3
(1999); Al-ZamZami and Grace; Dhumale and Sapcanin; M. Kabir Hassan and Dewan A.H. Alamgir,
"Microfinancial Services and Poverty Alleviation in Bangladesh: A Comparative Analysis of Secular and Islamic
Ngos," in Islamic Economic Institutions and the Elimination of Poverty, ed. Munawar Iqbal(Leicester: The Islamic
Foundation, 2002).
12
See Hassan and Alamgir.
13
Dhumale and Sapcanin.
14
Akhtar, "Musharaka Financing for Small Enterprises in Pakistan."
15
Ibid.

7
Likewise, Dusuki (2008) argues that Islamic banks “should place greater social welfare

responsibilities and religious commitments to achieve the Islamic economic objectives, including

social justice, equitable distribution of income and wealth and promoting economic

development.”16 Dusuki suggested a greater role for Islamic banks in poverty alleviation through

the establishment of Special Purpose Vehicle (SPV) whereby the bank would be the sponsor or

originator of that SPV by “allocating certain amount of funds for microfinance purposes.”17

There are also other authors who believe that Islamic banks could play greater role in poverty

alleviation through microfinance mechanisms.18 For example, Wilson suggested using the

wakalah model – commonly used for takaful operations – for implementation of Islamic

microfinance. Under this model, participants contribute to the fund which can be further

supported by donors or zakat fund. This microfinance fund based on wakalah model will be

managed by a separate company that will be paid management fees and it will not participate in

the fund.19 Leveraging on Wilson’s wakalah model, Abdul Rahman suggested that this model

could be used by Islamic banks for implementation of microfinance activities.20

9.3 What is Islamic Microfinance all about?

16
Asyraf Wajdi Dusuki, "Banking for the Poor: The Role of Islamic Banking in Microfinance Initiatives,"
Humanomics 24, no. 1 (2008): 55.
17
Ibid, 61.
18
Abdul Rahim Abdul Rahman, "Islamic Microfinance: A Missing Component in Islamic Banking," Kyoto Bulletin
of Islamic Area Studies 1-2, no. (2007); Abdul Rahim Abdul Rahman, "Islamic Microfinance: An Ethical
Alternative to Poverty Alleviation," Humanomics 26, no. 4 (2010); Ahmed, "Financing Microenterprises."; Akhtar,
"Musharaka Financing for Small Enterprises in Pakistan."; Akhtar, "Islamic Microfinance."; Al-Harran, "Islamic
Finance Needs a New Paradigm."; Al-Harran, "Islamic Partnership Financing."; Dhumale and Sapcanin; Mahmoud
A. El-Gamal, Islamic Finance: Law, Economics, and Practice (Cambridge: Cambridge University Press, 2006);
Rodney Wilson, "Making Development Assistance Sustainable through Islamic Microfinance," IIUM Journal of
Economics and Management 15, no. 2 (2007).
19
Wilson: at 203-207.
20
Abdul Rahman, "Islamic Microfinance: A Missing Component," 50-51.

8
9.3.1 Definition of Islamic microfinance

Even though the microfinance is meant to be for the masses, yet its vocabulary can be

understood only by professionals. Researching through the available literature on Islamic

microfinance/microcrediting,21 the author did not come across any clearly stated definition of the

term from an Islamic perspective. All the writers on the topic have taken it for granted and

moved directly into the discussion without even trying to define it. It is believed it seems, that

Islamic microfinance is nothing more than the conventional microfinance less the interest. For

the sake of readers we will cite some definitions of microfinance given by some authors, which

are more or less coming from western perspective.

Parker defines microfinance as “the provision of small amounts of credit to the poor who usually

fall outside the formal banking sector…”22 Microfinance is also defined as “the provision of

loans, savings, insurance, and other basic financial services to low-income populations.”23

Similarly, Asian Development Bank defines it as "...the provision of a broad range of financial

services such as deposits, loans, payment services, money transfers, and insurance to poor and

low-income households and their micro-enterprises."24 Ledgerwood (1999) defined it as “the

provision of financial services to low-income clients, including self-employed, low income

entrepreneurs in both urban and rural areas.”25

21
Throughout the literature these two terms, ‘microfinance’ and ‘microcredit’ are used interchangeably.
Nevertheless, the author is of view that the term ‘microfinance’ is more appropriate for Islamic finance, reflecting
the nature of finance rather than loan as is the case with the term ‘microcredit’ that somehow brings a negative
connotation.
22
Mushtak Parker, "Credit Where Credit Is Really Due," Islamic Banker1998, at 8.
23
Kathryn Imboden, "Building Inclusive Financial Sectors: The Road to Growth and Poverty Reduction " Journal of
International Affairs 58, no. 2 (2005): at 67.
24
Cited in John D Conroy, "Microfinance in Malaysia: Time to Rebuild", The Foundation for Development
Cooperation http://www.fdc.org.au (accessed December 19 2006).
25
J. Ledgerwood, Microfinance Handbook: An Institutional and Financial Perspective (Sustainable Banking with
the Poor) (Washington, DC: The World Bank, 1999). as cited in Dusuki, 2008a, at 51.

9
Since our interest here is Islamic microfinance we will try to define it within Islamic framework.

Therefore, Islamic microfinance can be defined as an investment of capital (in cash or in kind),

based on Islamic modes of finance, to the low-income clients, low-income entrepreneurs in order

to help them start or maintain their businesses.

9.3.2 Poverty alleviation as an objective of Shari’ah

Islam encompassed all spheres of a human life and gives a special attention to welfare of people.

In fact, the fulfilment of basic needs is of the utmost importance for attaining the objectives of

Shari’ah (maqasid al-Shari’ah). As pointed out in the introduction, the Prophet (p.b.u.h.) was

asking the Almighty Allah (s.w.t.) for a protection from poverty and considered it almost as

disbelief in Allah (s.w.t.) due to the weakness nature of poor people.

In addressing poverty alleviation and best practices for Islamic microfinance, Obaidullah (2008)

pointed out that while Islam encourages charity on one side, it also emphasises a need to

minimise dependence on charity by poor on the other. He used a hadith, reported in Sunan Abu

Dawud, to illustrate an approach and strategy for poverty alleviation. Important steps in utilising

microfinance services for poverty alleviation, derived from this hadith (the full text of the hadith

below) are briefly summarised in Table 1 below.26

Narrated by Anas ibn Malik:

26
Following Obaidullah's approach, the hadith is broken down into numbered statements so as to highlight the key
principles and components of the strategy that follows from the hadith. For detailed discussion, see Mohammed
Obaidullah, "Islam, Poverty and Microfinance "Best Practices"," Islamic Finance Today2007; Obaidullah,
Introduction, at 14-17.

10
 1. A man of the Ansar came to the Prophet (p.b.u.h) and begged from him.

2. He (the Prophet) asked: Have you nothing in your house? He replied: Yes, a piece of

cloth, a part of which we wear and a part of which we spread (on the ground), and a

wooden bowl from which we drink water.

3. He (the Prophet) said: “Bring them to me.” He (the man) then brought these articles to

him and he (the Prophet) took them in his hands and asked: Who will buy these? A man

said: “I shall buy them for one dirham.” He said twice or thrice: “Who will offer more

than one dirham?” A man said: “I shall buy them for two dirhams.”

4. He (the Prophet) gave these to him and took the two dirhams and, giving them to the

Ansari, he said: “Buy food with one of them and hand it to your family, and buy an axe

and bring it to me.”

5. He then brought it to him. The Prophet (p.b.u.h.) fixed a handle on it with his own hands

6. and said: “Go, gather firewood and sell it, and do not let me see you for a fortnight.”

7. The man went away and gathered firewood and sold it. When he had earned ten dirhams,

he came to him and bought a garment with some of them and food with the others.

8. The Prophet (p.b.u.h.) then said: “This is better for you than for begging to appear as a

spot on your face on the Day of Judgment. Begging is right only for three people: one

who is in grinding poverty, one who is seriously in debt, or one who is responsible for

compensation and finds it difficult to pay.”27

Table 1: Fundamental Conditions of a Successful Microfinance Program in Islam

1. Access of the poorest of the poor to the program: The hadith shows that the
Prophet (p.b.u.h.), being both the spiritual and political leader of the Muslims,
was accessible to the poor and needy at all times for economic and financial
27
Abu Dawud, Sunan Abī Dāwūd (Riyad: Maktabah al-Ma'arifi li al-Nashri wa al-Tawzi'i, 2003/1424H), 285. Kitab
al-Zakah, No. 1641. NOTE: Some refer to this hadith as Kitab al-Zakah, Book 9, No. 1637, as is the case with
Obaidullah.

11
 assistance.
2. Careful assessment of the financial health of the poor; enquiry blended with
empathy; insistence on contribution and beneficiary stake: It is believed that the
failure of many microfinance programs is due mainly to inadequate evaluation of
the client’s financial condition. Thus, careful assessment of the financial status of
clients is a must.
3. Transformation of unproductive assets of the beneficiary into income-generating
ones through rigorous valuation (on the basis of price discovery through auction
method); involvement of the larger community in the process: In some cases
clients own assets, but are unable to derive benefits from those assets. Thus, there
is a need for asset transformation from unproductive asset into income-generating
and productive one. However, to ensure that the seller receives the fair price and
does not lose the value, this transformation or a sale should be done through
auction, which is believed to be the most efficient process of discovery of fair
price.
4. Meeting of basic needs on a priority basis and investment of the surplus in a
productive asset: This implies the importance of the hierarchy in addressing the
needs of the poor. Hence, the basic needs should be met before investing surplus
in income-generating activities.
5. Direct involvement of the program in capacity building in the run-up to income
generation and technical assistance to the beneficiary; commitment of top
management of the program: This part of hadith shows the direct and proactive
role of the Prophet (p.b.u.h.) in the process of poverty alleviation. The same is
expected from the top management of the program.
6. Technical assistance in the form of imparting requisite training to the beneficiary
for carrying out the business plan / income-generating project; monitoring
through a time-bound schedule and impact assessment through a feed-back
mechanism: This emphasises the importance of merging between financial and
technical assistance as well as the importance of impact assessment.
7. Transparent accounting of operational results and liberty to use part of income to
meet higher needs: The transparency and proper documentation of financial
transaction are enjoined by the Holy Qur’an. In surah al-Bakarah, verse 282,
Allah s.w.t. says: “O ye who believe! When you deal with each other, in
transactions involving future obligations in a fixed period of time, reduce them to
writing… and let a scribe write down faithfully as between the parties..”
8. Strong discouragement to seeking charity: This part of hadith shows clearly that
begging is discouraged in Islam. It has been allowed only to three categories of
people: “one who is in grinding poverty, one who is seriously in debt, or one who
is responsible for compensation and finds it difficult to pay.”
Source: Obaidullah, M. (2008). Introduction to Islamic Microfinance. New Delhi, IBF Net, pp. 14-17.

9.3.3 Microfinance models

12
Due to their distinct characteristics, microfinance institutions are seen as specialised components

of financial system.28 Over the years, conventional microfinance programmes developed several

models for implementation of microfinance services. Similarly, Islamic microfinance

programmes implemented the same or similar approached, yet these approaches have been

revised to reflect the unique nature of Islamic finance based on Shari’ah teachings. Some of these

models are briefly highlighted below:29

The most popular model that has been widely replicated in many countries is the Grameen Bank

model. Muhammad Yunus, a Nobel Peace Prize winner, introduced this model in the late 1970s

with US$27 loan to 42 families. It is estimated that Grameen Bank nowadays has around 8.28

million borrowers with 2,564 branches in Bangladesh.30 This model is based on group lending,

whereby groups usually consist of five members, mainly women. Peer pressure of a group is also

used as substitute for collateral. Shari’ah-compliant version of this model is implemented by

Islami Bank Bangladesh Limited.31

The Second model is the Village Bank model widely implemented in Latin America and Africa.

In this case, an implementing agency sets up a village bank with about thirty to fifty members
28
Obaidullah, Introduction, at 6.
29
For detailed discussion of these models see ibid., 6-8; Obaidullah and Tariqullah, Islamic Microfinance
Development, at 1-4.
30
Radhika Madana Mohan, "Microfinance: Is There a Place for It in Islamic Finance?," Islamic Finance Asia2010,
at 35-36.
31
Asyraf Wajdi Dusuki, "Empowering Islamic Microfinance: Lesson from Group-Based Lending Scheme and Ibn
Khaldun’s Concept of ‘Asabiyah," in Monash University 4th International Islamic Banking and Finance
Conference. Kuala Lumpur on 13-14 November, 2006 (Kuala Lumpur 2006); Group-based lending scheme in light
of Ibn Khaldun's concept of social solidarity has been discussed by Asyraf Wajdi Dusuki, "Lifting Barriers in
Financing the Small and Poor Entrepreneurs: Lessons from Group-Based Lending Scheme and Ibn Khaldun’s Social
Solidarity," in Islamic Finance for Micro and Medium Enterprises, ed. Muhammad Obaidullah and Hajah Salma
Haji Abdul Latiff(Jeddah IRTI, Jeddah & Centre for Islami Banking, Finance and Management, Universiti Brunei
Darussalam, 2008).

13
and external capital for financing its members. This model also uses peer pressure to ensure full

and timely repayments of the loan. Once a village bank accumulates enough funds internally, it

becomes autonomous and self-sustaining institution (usually over a three-year time period).

Shari’ah-compliant version of this model is implemented by Jabal al-Hoss, Syria.32

The Third model is known as a Credit Union which is based on the concept of mutuality. Under

this model, members own and control this non-profit financial cooperative that is used to

mobilise savings and provide loans to its members. Baitul Maal wat Tamweel (BMT) in

Indonesia is an example of Shari’ah-compliant version of this model.33

The Fourth model is based on Self-Help Group (SHG) originating in India. An SHG pools

together savings from its ten-fifteen members who have relatively homogeneous incomes. In

addition to savings from its members, SGH also seeks external funding.

Another model of microfinance that is less known to general masses is the one implemented in

European countries, in particular Bosnia and Herzegovina (B&H). In this case, MFIs operate

relatively similar to commercial banks. Instead of forming groups and using peer pressure to

32
See Mahmoud Al Asaad, "Village Funds: The Experience of Rural Community Development at Jabal Al Hoss,
Syria," in Islamic Finance for Micro and Medium Enterprises, ed. Muhammad Obaidullah and Hajah Salma Haji
Abdul Latiff(Jeddah IRTI, Jeddah & Centre for Islami Banking, Finance and Management, Universiti Brunei
Darussalam, 2008).
33
For detailed discussion on BMT model see Widiyanto Mislan Cokro Hadisumarto and Abdul Ghafar Ismail,
"Improving the Effectiveness of Islamic Micro-Financing: Learning from Bmt Experience," Humanomics 26, no. 1
(2010); Nur Kholis, "Murabahah Mode of Financing for Micro and Medium Sized Enterprises: A Case Study of
Baitul Mal Wattamwil (Bmt), Yogyakarta, Indonesia," in Islamic Finance for Micro and Medium Enterprises, ed.
Muhammad Obaidullah and Hajah Salma Haji Abdul Latiff(Jeddah IRTI, Jeddah & Centre for Islami Banking,
Finance and Management, Universiti Brunei Darussalam, 2008).

14
mitigate default risk, MFIs request a borrower to provide two persons with a substantial income

who will endorse the loan. In essence, these two endorsers act as collateral.34

All of the above models can be implemented in Muslim countries applying Shari’ah-compliant

instruments and upholding the true spirit of maqasid al-Shari’ah. While some argue that non-

banking institutions and/or non-government organisations (NGOs) are the most suitable for the

task; others believe that Islamic banking sector should play a more active role in promoting

Islamic microfinance. Similarly, some authors argue that a greater attention should be given to

equity-based, profit-sharing microfinance models such as mudarabah and musharakah,

compared to predominantly used debt-based instruments such as murabahah.35

Whatever approach or model Islamic finance takes, it is a need of the hour. As pointed out,

“Comprehensive Islamic microfinance should involve not only credit through debt finance, but

the provision of equity financing via mudarabah and musharakah, savings schemes via wadiah

and mudarabah deposits, money transfers such as through zakat and sadaqah, and insurance via

takaful concept.”36

9.4 The financial instruments of IMFIs

34
For a review of microfinance sector in B&H see Edib Smolo and Anida Smolo, "Microfinancing in Bosnia and
Herzegovina: Prospects and Challenges for Development of Islamic Microfinancing Sector," in 1st Unilorin
International Conference on Islamic Banking and Finance (IRTI, Jeddah and University of Ilorin, Ilorin, Nigeria,
2009).
35
See Abdul Rahman, "Islamic Microfinance: A Missing Component."; Abdul Rahman, "Islamic Microfinance: An
Ethical Alternative."; Dusuki, "Empowering Islamic Microfinance: Lesson from Group-Based Lending Scheme and
Ibn Khaldun’s Concept of ‘Asabiyah."; Dusuki, "Banking for the Poor."
36
Abdul Rahman, "Islamic Microfinance: An Ethical Alternative," 288.

15
While conventional MFIs rely heavily on interest-based financing, IMFIs can use a wide range

of Shari’ah-compliant instruments. These financial instruments available to IMFIs are mentioned

and listed down in all major articles on the topic. These modes, among others, are as follows: (i)

Mudarabah (silent partnership); (ii) Musharakah (partnership); (iii) Ijarah (leasing); (iv) Ijarah

wa Iqtina (lease to purchase); (v) Qard al-hasan (benevolent loan); (vi) Bay’ Bithaman Ajil

(deferred payment sale); (vii) Bay’ al-Salam (pre-paid purchase); (viii) Bay’ al-Istisna’

(progressive financing); and (ix) Musharakah Mutanaqisah (diminishing partnership). The brief

description of these instruments is discussed below:

a) Mudarabah (silent partnership) – It is a partnership contract or a business venture

between two parties whereby one party, known as rabb al-mal (owner of capital),

contributes the capital and the other party, known as mudarib, manages the business

venture using his entrepreneurial skills. Any profit arising from this venture will be

shared between the two according to the mutually agreed ratio, while the loss, if any,

unless caused by negligence or violation of terms of the contract by the mudarib, is

completely borne by the rabb al-mal.

b) Musharakah (partnership) - Musharakah is another financing technique. It is a

partnership contract between two or more parties whereby all of the parties contribute

capital to the project. All partners are entitled to a share the profits arising from the

project in a ratio which is mutually agreed upon. However, the losses, if any, are to be

shared exactly in the proportion of capital contribution. At the same time, all partners

have a right to participate in the management of the project. However, the partners may

also opt not to take part in the management.

16
c) Ijarah (leasing) - It is an arrangement under which an Islamic bank buys and leases a real

asset such as machine, car, house, equipment, building or other facility to a client for a

rental fee. The period of lease may be determined by mutual agreement between the

parties. Throughout the leasing period, the asset remains in the ownership of the lessor

(the bank) but the right to use it is transferred to the lessee (client).

d) Ijarah wa Iqtina (lease to purchase) – This contract is similar to Ijara. The only

difference between the two is that in the case of Ijara wa Iqtina the client is committed to

purchase the asset at the end of the rental period. At the end of the contract, the full

ownership is transferred to the client and the rental fees paid to date by him form a part of

the price.

e) Qard al-hasan (benevolent loan) – It is an interest-free loan given for either welfare

purposes or for fulfilling short-term funding requirements. In this case, the borrower is

only obligated to repay back the principal amount of the loan without any increase.

f) Bay’ Bithaman Ajil or BBA (bay’ muajjal or deferred payment sale) - This is also the

most popular and most commonly used mode of Islamic financing. Literally, it is a sale

on profit. Technically, it is a contract of sale in which the seller declares his cost and

profit. As a financing technique, it involves the purchase of goods by the bank as

requested by its client. Consequently, the goods are sold to the client at the cost plus

profit margin and the payment is done in instalments as specified in the contract.

g) Bay’ al-Salam (pre-paid purchase) – It is a sales contract where the buyer pays in

advance for the goods, which are delivered in the future.

h) Bay’ al-Istisna’ (progressive financing) – It is a contract of acquisition of goods by

specification or order, where the price is paid in advance, but the goods are manufactured

17
 and delivered at a later date.

i) Musharakah Mutanaqisah (diminishing partnership) – It is a hybrid product that

combines Musharakah, Ijara, and sale. Parties involved jointly buy or finance a project

and share the profit on a pro rata basis. However, throughout the period and at the

specified interval, one party (usually client) will be buying the shares of the other party

(financial institution, bank). This method provides a mechanism through which the equity

of the financial institution keeps on reducing while the equity of the client keeps on

increasing. Once the client redeems all the equities from the bank there will be transfer of

ownership through the contract of sale.

Apart from the above mentioned modes of finance that could be implemented by IMFIs, there

are also other instrument-like-contracts such as muzara'ah37and musaqah.38 All these modes have

their unique features and could play a role in helping the poor finance their way out of poverty.

9.5 Islamic MFIs vs. Conventional MFIs

In this section we will try to make a comparison between the Islamic MFIs and conventional

MFIs. Both of them are there to serve the needs of the poor who are not qualified for and/or are

not able to fulfil requirements put forward by banks (i.e. collateral). It is for this reason that MFIs

are established at the first place. As we will see from the following discussion, the operation of

Islamic MFIs and conventional MFIs are very much similar. However, the due distinction exists,

37
Muzara'ah is a contract in which one person agrees to till the land of the other person in return for a part of the
produce of the land.
38
Musaqah is a contract in which the owner of the garden shares its produce with another person in return for his
services in irrigating the garden.

18
even though currently this distinction is very small due to the heavy reliance of IMFIs on BBA

mode of financing. The main differences between the conventional and Islamic MFIs are listed

in the Table 2 below:

Table 2: Difference between Conventional and Islamic MFIs

Conventional MFIs Islamic MFIs
Liabilities External Funds, Savings of External Funds, Savings of
(Sources of Funds) clients clients, Islamic Charitable
Sources
Assets Interest-based Islamic Financial
(Mode of Financing) Instruments
Financing the Poorest Poorest are left out Poorest can be included by
integrating zakat with
microfinancing
Funds transfer Cash given Good transferred
Deduction at inception of Part of the funds deduced at No deductions at inception
contract inception
Target group Women Family
Objective of targeting Empowerment of women Ease of availability
Women
Liability of the loan Recipient Recipient and spouse
(when given to women)
Work incentive of Monetary Monetary and religious
employees
Dealing with Default Group/centre pressure and Group/centre/spouse
threats guarantee, and Islamic
ethics
Social development Secular (or un-Islamic) Religious (includes
Program behavioural, ethical, and behaviour, ethics, and
social development. social
Source: Ahmed, H. (2002). "Financing Microenterprises,” p. 41.

9.6 The problems faced by MFIs

As mentioned before, microfinance initiative is seen as a new approach to poverty alleviation. It

is further seen as an engine for development. Many articles praised the success of the MFIs, but

19
there are also some studies that pointed out the failure and problems of these institutions. Some

of these failures and problems are common for both conventional as well as Islamic MFIs. They

are as follows:39

i) Asymmetric information problems: MFIs usually target women, but in reality, quite

often it is a male member of the household who initiate taking of loans and he is the

one who control use of funds received by female member(s). In addition to that, very

often loans are not used for productive purposes for which it was meant to be at the

first place. Once these funds are not used for productive purposes a possibility of

defaulting increases.

ii) Economic viability of MFIs and Lack of funds: Raising funds is a crucial problem of

every MFI. They cannot attract deposits as commercial banks do. Due to this lack of

fund mobilization and high cost of administration MFIs may not be economically

viable. For IMFIs there is even greater problem which may be contrary to Islamic

principles. For example, funds collected by IMFIs are sometimes based on interest

and in order for IMFIs to repay their debt(s), they have to get certain fixed amount on

the investment. This puts pressure on IMFI and as result they usually opt for bay’

bithaman ajil (BBA) mode of financing – discouraging the use of other Islamic

modes of financing, namely mudarabah and musharakah.

iii) Low rate of return on investment: Studies have shown that funds given by MFI may

be used in low productivity activities. Furthermore, initial targeting on women by

MFIs is another factor for low rate of return as women usually engage in

productivities that are yielding relatively low returns.

39
Adapted from Ahmed, "Financing Microenterprises," at 33-35.

20
 iv) Debt trap: Studies show that a great number of initial beneficiaries of MFIs are

caught in debt trap. As they are not able to repay their debts they would take loans

from other sources to pay instalments. This keeps them trapped in “a spiralling debt

cycle.”40 In case of IMFIs, the repayment is of great concern to them. The reason for

this is that there is no penalty (in forms of increasing interest rate on defaults as is the

case in conventional banks and MFIs). Due to a lack of penalty, there is an incentive

for beneficiaries to delay repayments.

v) Socioeconomic factors of clients: Due to illiteracy, ethnicity, gender, etc., skills

possessed by beneficiaries are very low. This increases a cost of assessment of

projects and monitoring of the use of loans.

vi) Mode of financing of IMFIs: From the case studies it is shown that predominant mode

of financing of IMFIs is bay’ bithaman ajil (mark-up sale). However, this is not really

done in real Islamic sense where the IMFI buys goods first and then transfers them to

the clients. What has been observed is that IMFI gives the funds to a client to buy

goods. These increases the chances of diversion of the funds and therefore a default

risk increases as well.

9.7 Conclusion

Microfinance has gained a lot of attention from conventional economics, as it is seen as a new

approach to alleviate poverty and help development. Conventional MFIs have expended their

operations during last couple of decades, while IMFIs are yet to achieve their full potentials.

Accordingly, there are great potentials in microfinance that should be more thoroughly explored
40
Ibid., at 34.

21
by Muslim scholars. Although microfinance may not be the complete solution for such complex

problem like poverty, it is inevitably part and partial of that solution.

In this chapter, we have discussed the theoretical basis, operational models, and the problems

faced by MFIs, both conventional and Islamic with special attention given to Islamic ones. The

theoretical part of the paper, as indicated by previous studies, clearly shows that there is a great

potential in IMFIs that can serve the needs of the Muslim poor. IMFIs are richer than their

conventional counterparts on both the liability and the asset side. From the liability side we can

see that IMFIs could use alternative sources of funds like zakat, sadaqah and waqf. Likewise, on

the asset side IMFIs could use various financial instruments. Different modes of financing

available for IMFIs could be used to meet different needs of poor beneficiaries. Unfortunately,

IMFIs have not yet used many of these additional funds available to them, nor have they used

variety of financial instruments. They ended up using bay' bithaman ajil as the main instrument

in their operations.

22
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