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Transformation
The transformation of of conventional
conventional microfinance microfinance

into Islamic microfinance

in Bangladesh: proposed
Shariah-based model(s) Received 20 June 2022
Revised 25 January 2023
23 April 2023
Md Aslam Mia 7 August 2023
Accepted 19 September 2023
School of Management, Universiti Sains Malaysia, Penang, Malaysia

Abstract
Purpose – Despite being a Muslim-dominated country, Bangladesh has widely embraced traditional
microfinance since its inception in the mid-1970s. However, Islamic microfinance, which has a lot to offer to
the poor, is still in its infancy and has yet to gain momentum in the country. Therefore, the purpose of this
study is to analyze the importance of Islamic microfinance and propose alternative Shariah-compliant
microfinance models in Bangladesh.
Design/methodology/approach – This study is based on the desk research method, which relies on
existing literature to collect secondary data on key concerns of traditional microfinance programs. In addition,
institutional-level secondary data were also collected from the Microcredit Regulatory Authority (MRA) of
Bangladesh. Guided by the Maqasid-al-Shariah, this study then proposes several Islamic microfinance models
to overcome selected challenges faced by the microfinance industry in Bangladesh.
Findings – This study suggested three composite Shariah-compliant microfinance models, which are
likely to help the underprivileged and thus ensure the achievement of the sustainable development goals
in Bangladesh. The first model explained how the operational strategy of incumbent microfinance
institutions (MFIs) could be restructured, while the second proposed the organizational strategies for
establishing a new MFI. The third model used the notion of Sadaqah (charity) to address the multiple
borrowing issues of the industry. Meanwhile, the successful transformation of the conventional
microfinance industry to an Islamic one is dependent on the effective collaboration between the regulatory
authorities, practitioners and MFIs.
Originality/value – Albeit the paucity of literature on the topic, the findings of this study will guide
policymakers/practitioners in designing relevant microfinance models to help transform conventional
microfinance into Islamic microfinance in Bangladesh.
Keywords Microfinance, Islamic microfinance, Interest, Mission drift, Shariah,
Microfinance institutions, Bangladesh
Paper type Conceptual paper

JEL classification – G21, I30, L31

The author gratefully acknowledges constructive comments and feedback from three anonymous
reviewers and the associate editor. The initial draft of the paper was presented at the Annual
International Conference on Islamic Finance (AICIF 2021), Universitas Negeri Sunan Kalijaga,
Yogyakarta, Indonesia, November 17–19, 2021. The author also appreciates various feedback from
the participants and the discussant/chair of the aforementioned conference. Moreover, a great deal of
Qualitative Research in Financial
appreciation also goes to Dr. Shamima Nasrin and Noman Bashir for their thoughtful remarks during Markets
the inception of this study. © Emerald Publishing Limited
1755-4179
Conflict of interest: The author declares no known conflict of interest related to this study. DOI 10.1108/QRFM-06-2022-0104
QRFM 1. Introduction
Microfinance, one of the most significant and widely reproduced financial innovations of the
twentieth century, emerged as a response to the failures of the traditional “trickle-down”
approach (Ahmed, 2002) [1]. It was founded in Bangladesh in the mid-1970s to tackle the
several challenges that marred the country. Some of the challenges that Bangladesh faced
during that time included postwar reconstruction, severe unemployment, natural disasters,
gender discrimination and extortion of the poor by village money lenders. Professor Yunus
(2003, 2007) established one of the first microfinance institutions (MFIs), the Grameen Bank,
in the country with the primary goal of providing financial services to low-income families,
especially unbanked women (Mia et al., 2019) [2]. Since then, microfinance programs have not
only expanded in their birthplace but also spread to over 120 countries within a very short
period of time (Liñares-Zegarra and Wilson, 2018). Recognizing its tangible effects on poverty
alleviation, the microfinance program has been widely promoted worldwide by various
international development agencies, such as the World Bank and the United Nations.
Backed by favorable policies, conventional microfinance has flourished in Bangladesh,
providing services to around 36.58 million poor borrowers, which account for almost one-
fifth of the total population (MRA, 2022) [3]. To date, around 800 registered MFIs currently
exist in Bangladesh to serve the country’s huge credit demand (see Figure 1 for the historical
trend of MFIs in Bangladesh) [4]. These MFIs have a total loan outstanding of BDT
1387.44bn (US$13.089bn) and a deposit mobilization of BDT 728.89bn (US$6.876bn) as of
2022 (MRA, 2022).
While many conventional microfinance schemes operate based on market principles,
they are mainly driven by high-interest rates charged to their clients. However, with the
impressive growth of Islamic banking during the past two decades (Nomran and Haron,
2020; Safiullah and Shamsuddin, 2018), many countries are shifting toward Islamic banking
and finance because of its better features and performance compared with the conventional
one (Jubilee et al., 2021; Khan et al., 2017). Therefore, Islamic microfinance, which is a subset
of Islamic banking, has gained significant attention in the global microfinance literature
because of its superior effect (Biplob and Abdullah, 2019; Hassan and Saleem, 2017; Hassan
et al., 2021; Nabi et al., 2017; Rashid et al., 2018). Among others, the Islamic microfinance

783 805
742 753 758

641 649
576 590
516
469 453
420
344

Figure 1. 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Number of
No of MFIs
MFIs in Bangladesh
(2005–2018)
Source: Author’s based on Microcredit Regulatory Authority (MRA) annual reports
model has gained widespread recognition for its zero interest rate and risk-sharing Transformation
principles, aimed at enhancing the welfare of the poor. of conventional
Bangladesh is one of the Muslim-dominated countries that have recorded remarkable
progress in the adoption of Islamic banking during the past three decades, with one-third of
microfinance
the country’s banking system assets belonging to Islamic banks (Miah et al., 2021).
Unfortunately, the growth in the Islamic microfinance sector compared with that of Islamic
banking is slow (UNDP, 2012). Currently, only a few large and dedicated MFIs offer Islamic
microcredit services in the country, albeit with minimal coverage [5]. The Islamic microfinance
market, which currently represents only 1% of the total microfinance clientele, is relatively
small not only in Bangladesh but also internationally. However, it is rapidly gaining
momentum worldwide (Saad, 2012). According to Honohan (2008), approximately 72% of
individuals in Muslim-dominated nations have chosen not to use financial services offered by
commercial banks owing to their non-compliance with Shariah norms [6].
Moreover, there are several reasons why traditional microfinance tends to be harmful to
Islamic society and development in general. First, owing to the interest-bearing contracts,
borrowers are expected to repay the entire loan amount, including interest, even if they
suffer losses. Furthermore, traditional microfinance typically lacks a risk-sharing agreement
between lenders and borrowers, which can reduce lenders’ incentives to oversee and monitor
the performance of the business. Second, the Islamic divine revelations, namely, the Quran
and Sunnah, strongly condemn and prohibit the charging of interest (Begum et al., 2019) [7].
Furthermore, conventional microfinance practices have faced several issues and
challenges in recent years. These include mission drift, high-interest rates and multiple
borrowings, which not only tarnish the reputation of such financial initiatives but also
compromise the welfare of the poor. Amid the growing negative perception of microfinance
globally (Bateman and Chang, 2012; Ghosh, 2013), the academic community has argued that
MFIs have deviated from their original mission of social outreach in recent years (Louis
et al., 2013). This phenomenon, known as “mission drift” in the literature, involves MFIs
catering to the wealthy rather than the poor (Annim, 2012; Armendariz and Szafarz, 2011;
Augsburg and Fouillet, 2013; Conning, 1999; Copestake, 2007; Hermes et al., 2011; Mersland
and Øystein Strøm, 2009; Woller, 2007).
Also, the higher interest rates of microfinance loans remain one of the greatest concerns
among policymakers (Fernando, 2006). Sectorial nominal interest rates range from 30% to
70% and are believed to be responsible for the “debt trap” experienced by many poor clients
(Amy, 2010; Helms and Reille, 2004). These exorbitant interest rates not only rescind
consumer welfare but also impede financial inclusion on a larger scale (Mia et al., 2022).
Another prevalent issue in the microfinance market is multiple borrowing, where borrowers
obtain loans from more than one MFI simultaneously. This practice is considered one of the
key factors leading to over-indebtedness and loan defaults among borrowers (Armendariz
and Morduch, 2010; Mia, 2017a). Studies by Afroze et al. (2014) and Ali et al. (2023) in the
context of Bangladesh indicated multiple borrowing rates of 71% and 54.25%, respectively,
among surveyed respondents. The high multiple borrowing rates not only compromise the
welfare of the poor but also deplete the scarce resources of MFIs (Mia, 2017a). We provide
further detail on these three issues in Section 2.2.
Because of concerns about religious violations and other challenges associated with
conventional microfinance, as discussed above, there has been a growing acceptance of Islamic
microfinance in recent years (Hassan et al., 2021). As a result, experts and policymakers,
notably in Bangladesh, have recognized the need to transform the large, traditional
microfinance industry into Islamic microfinance. However, the main puzzle lies in how such a
transformation could be achieved in a country that has embraced the traditional microfinance
QRFM model for several decades. Although achieving the Islamization of conventional microfinance
may require sizable resources and sustainable efforts, it will bring significant benefits to the
large Muslim population (90.40%) in Bangladesh [8].
The main objective of this study is to address the negative impacts of conventional
microfinance through the advancement of Islamic microfinance models. Specifically, this
study contextualizes the current microfinance scenarios in Bangladesh and then proposes
three composite Shariah-based models that can be integrated into the mainstream
microfinance market. The first model focuses on restructuring the operational strategy of
existing MFIs. The second proposes the operational mechanism for establishing new MFIs.
Lastly, the third model introduces Islamic microfinance as a solution to the issue of multiple
borrowings.
The uniqueness and originality of this study lie in its proposed composite models. While
several Islamic microfinance models have already been proposed and practiced (Haneef et al.,
2015; Kaleem and Ahmed, 2010; Wilson, 2007), they typically cater to the general market
rather than specific ones. Moreover, these Islamic microfinance models were often developed
as an alternative to conventional ones. However, in this research, proposed Shariah-based
models specifically address the problems faced by conventional MFIs. Furthermore,
Bangladesh, being the birthplace of modern microfinance, has started experiencing some
unique issues that may not have surfaced in some new or immature microfinance markets
(e.g. multiple borrowing). These issues are also addressed in the proposed models. Therefore,
countries where microfinance is yet to flourish and achieve maturity can learn from the
Bangladesh experience when facing similar issues in the future.
The paper is organized as follows. Section 2 discusses the major issues associated with
the conventional microfinance model and the differences between conventional and Islamic
microfinance; Section 3 briefly discusses the methodology used in the study; Section 4
discusses the major findings and proposed models; and Section 5 advances the concluding
remark.

2. Literature review
2.1 Review of conventional versus Islamic microfinance
In general, conventional microfinance refers to the provision of small-scale financial services
such as loans, savings, insurance and remittances to individuals or business owners who are
unbanked (Abdelkader et al., 2014). Similar to the conventional banking system, this micro-
banking system also relies on interest charged on loans to run its operation (El-Komi and
Croson, 2013). Because of the interest-bearing loans, microfinance loans may be unattractive
for Muslims in Muslim-dominated countries. Moreover, conventional MFIs are faced with
several issues [9]. First, the overwhelming drive for financial sustainability at the expense of
social outreach goals has led to the so-called “mission drift” in conventional microfinance
practices (Armendariz and Szafarz, 2011; Augsburg and Fouillet, 2013). Furthermore,
typical MFIs tend to target individuals with deep pockets rather than the poor to avoid high
default rates. Second, because of the extortive interest rates charged by MFIs, borrowers are
mostly disadvantaged (Dufwenberg and Gneezy, 2000), as they are not spared the payment
of interest even in the event of business losses. Most MFIs do not provide adequate
supervision for businesses financed by them but focus only on the installments paid by the
borrowers (Bedaiwy and Peter, 2022). Third, in a bid to maximize their financial gains, MFIs
often undertake an excessive loaning strategy (Sainz-Fernandez et al., 2015), thereby
increasing the tendency for multiple borrowings. Multiple borrowing is also encouraged
when borrowers have high loan demands that cannot be met by a single MFI (Mia, 2017a).
As a result, available resources (e.g. loans) that could have been directed toward the needy Transformation
and poor people in society are depleted, thereby undermining the outreach goals of MFIs. of conventional
Islamic microfinance, on the other hand, provides Shariah-compliant financial services,
such as loan and deposit insurance, that emphasize the concept of profit and loss sharing
microfinance
(PLS). Studies have argued that Islamic microfinance has more to offer than its conventional
counterpart because of its unique operational strategies and agenda (Tamanni and Haji
Besar, 2019). Furthermore, according to the study by Kaleem and Ahmed (2010), Islamic
microfinance tends to be more socially oriented and has superior financial performance than
conventional one because its ideology is built on brotherhood, local philanthropy and
volunteer activities. Islamic microfinance emerges as a confluence of two of the financial
sector’s most powerful segments: microfinance and Islamic banking. Some of the most
popular Shariah-based microfinance products are Murabaha (sale), Musharakah and
Mudarabah (PLS), Ijarah (lease), Takaful (insurance), Qard-al-Hasan (benevolent loan),
Waqf (endowment) and Zakat (charitable contribution) (Abdul Rahman and Dean, 2013;
Abdul Rahman, 2010). More information on Islamic microfinance practices can be found in
references such as Amanah Ikhtiar in Malaysia (Haque et al., 2019), Akhuwat in Pakistan
(Silva Afonso and Khan, 2019), the Rural Development Scheme (window banking of Islami
Bank Bangladesh Limited) in Bangladesh (Hassan and Saleem, 2017; Hossain et al., 2019;
Islam, 2021; Mia, 2022), Baitul Maal wat Tamwil and Islamic rural banks (BPRS) in
Indonesia (Adnan and Ajija, 2015; Seibel and Dwi Agung, 2006). The recent book/systematic
review in Islamic microfinance by Ali (2011), Hassan et al. (2021) and Kuanova et al. (2021)
also provides useful and interesting insight into Islamic microfinance.
Overall, the basic differences between the two credit systems (conventional and Islamic
microfinance) are the interest rates and primary objectives. To illustrate, unlike Islamic
microfinance, which provides financial services to the poor with zero interest rates,
conventional microfinance offers similar services but at usurious rates. Moreover, in a bid to
maximize their financial gains, many conventional MFIs may have diverted from their
original promise of catering to the poor to serving relatively wealthier clients. The high-
interest rate in microfinance is a self-defeating approach, as it impedes the achievement of
the inherent objective of microfinance – poverty eradication and the improvement of the
living standards of poor people. Thus, there is a great need to incorporate Islamic financial
contracts to restore the primary microfinance objective of poverty alleviation.

2.2 Selected issues in conventional microfinance

In this section, we have provided a detailed analysis of the three key issues currently
confronting the conventional microfinance industry. This discussion will enable us to better
understand the relevance of the proposed Islamic microfinance models.
2.2.1 Mission drift. MFIs were created to provide financial services to the underprivileged,
following their exclusion by the conventional financial sector (Morduch, 2000). However, for
MFIs to sustain this noble goal, they must be financially viable (Serrano-Cinca and Gutierrez-
Nieto, 2014; Zerai and Rani, 2012). Thus, MFIs, according to academics, have two ultimate
purposes or objectives: social outreach and financial sustainability (Ben Soltane, 2014;
Piot-Lepetit and Nzongang, 2014; Yaron, 1994; Yaron and Mundial, 1992) [10]. The
prioritization of these aims is a contentious issue, with welfarists maintaining that
microfinance should prioritize serving the “poorest of the poor.” However, institutionalists
advocate for prioritizing financial sustainability to ensure the sector’s future expansion and
improved effect on impoverished populations (Hermes et al., 2011). Considering the argument
that greater profits lead to lower outreach (Zainuddin et al., 2020), there are concerns about the
profit-making obsession of MFIs overriding their outreach goals. Consequently, studies have
QRFM found the existence of mission drift among some MFIs (Abate et al., 2014; Cozarenco et al.,
2022; Mia and Lee, 2017; Ranjani and Kumar, 2018; Serrano-Cinca and Gutierrez-Nieto, 2014).
However, the simultaneous attainment of the dual goals of MFIs is still an uncertain and hotly-
debated topic (Gutierrez-Nieto et al., 2007; Woller and Schreiner, 2002). Therefore, Islamic
microfinance has received special attention in recent years as a viable solution to merging the
two objectives of microfinancing.
2.2.2 Interest rates. Recently, some MFIs were observed to charge high-interest rates,
which is against the basic principle of microfinance. The founder of modern microfinance
and Nobel Laureate, Muhammad Yunus, has strongly condemned these MFIs, describing
them as “new loan sharks” (Amy, 2010; Mitra, 2009). Owing to the exploitative interest rates
charged by MFIs, consumer advantages are rescinded, which, to some extent, may result in
societal inequality. The overall interest rates charged to clients of MFIs in Bangladesh were
examined in Table 1 using the proxy of portfolio yield. It was observed that, on average, the
top-10 MFIs’ portfolio yield was roughly 26% in 2011, which exceeds the overall banking
interest rates in Bangladesh. Moreover, sectoral interest rates are also averagely high
(20.33% in 2011). Nonetheless, despite the increased competition, the interest rate spread
and portfolio yield have marginally decreased from 2010 to 2011.
2.2.3 Multiple borrowing. The practice of multiple borrowing, which occurs when
borrowers take loans from multiple MFIs because of the need for urgent cash9, has been
proven to have negative consequences for borrowers. Poor and late repayment (Afroze et al.,
2014; Mpogole et al., 2012), fewer savings (Islam, 2019), over-indebtedness or debt trap
(Chichaibelu and Waibel, 2017; Schicks, 2013) and loan default (Mia, 2017a) are some of the
outcomes of multiple borrowing. In addition, multiple borrowing also has a negative impact
on suppliers (MFIs) in terms of loan loss and misuse of scarce resources (Mia, 2017a;
Northcott, 2004). As such, amid the constraints of financial resources, MFIs prefer to disburse
loans to fresh borrowers as opposed to multiple borrowers to achieve greater outreach.
The multiple borrowing rate in Bangladesh’s microfinance is depicted in Figure 2.
Between 2000 and 2009, Faruqee and Khalily (2011) reported that the average individual
and household multiple loan growth rates were 15.35% and 13.81%, respectively [11]. This
trend signifies that the overlapping rates of individuals and households have gradually

Operating cost (%) Portfolio yield (%) Interest rates spread

Name of MFIs 2010 2011 2010 2011 2010 2011

BRAC 20.28 21.21 29.52 28.80 21.07 22.33

ASA 17.39 14.99 26.99 26.32 25.97 22.61
BURO 30.86 29.57 31.62 31.80 18.73 20.79
TMSS 19.18 21.10 22.94 23.54 19.13 18.42
JCF 17.38 16.39 22.53 23.10 16.33 16.24
SSS 21.97 20.39 25.87 25.05 19.12 19.12
SHAKTI 24.48 23.53 26.46 28.28 16.92 19.36
UDDIPAN 20.2 20.47 23.58 24.67 18.25 18.96
RDRS 23.01 23.56 22.87 21.84 18.22 15.42
Table 1. CARITAS 16.33 21.56 17.93 23.72 15.06 19.36
The top-ten and the Avg. 10 21.11 21.28 25.02 25.72 18.88 19.26
sectorial average of Avg. of 516/576 22.02 19.58 22.71 20.33 18.10 16.26
operating cost, Note: The structured information for these variables is not available in the subsequent statistics report of
portfolio yield and the NGO-MFIs
interest rate spread Source: Micro-credit Regulatory Authority (MRA) Report, 2011
increased over the period. Nonetheless, the multiple borrowing rate of households remained Transformation
higher than that of individuals during the study period. Although we do not have extensive of conventional
country-level statistics on multiple borrowings for recent years, we argue that the individual microfinance
and household levels of multiple borrowings are increasing over the years. This has been
evidenced in the studies of Ali et al. (2023) and Afroze et al. (2014).

3. Methodology
This is a conceptual paper that is based on the desk research method, involving the collection
of existing literature from different journals, reports and books, consistent with other studies
(Vong and Song, 2015; Zain and Muhamad Sori, 2020). Some secondary and relevant data
were obtained from the Microcredit Regulatory Authority (MRA), a government regulatory
body established in 2006 to monitor and supervise microfinance activities in Bangladesh. To
derive the proposed Islamic microfinance models, Maqasid al Shariah, the underlying intent
of Islamic law, was used as the benchmark. Maqasid al Shariah identifies five essential
human needs, namely, religion, life, intellect, honor and wealth, known as Al-Daruriyyat
al-Khamsah (the five essentials or requirements) (Alam et al., 2015; Hassan and Saleem, 2017;
Hassan et al., 2021). Alkhan and Hassan (2021) and Hassan and Saleem (2017) have provided
a comprehensive discussion on the relationship between Maqasid al Shariah and Islamic
microfinance. These studies highlight how Islamic microfinance can promote wealth creation
and alleviate poverty in line with the principles of Maqasid al-Shariah. Microfinance may
have an impact on other dimensions of Maqasid al Shariah, but we specifically focus on the
wealth dimension because of its relevance in this study. To illustrate, microfinance aims to
provide funding to the poor and foster entrepreneurship, which aligns with the scriptural
(Quran and Sunnah) emphasis on the importance of seeking permissible means of livelihood
and managing their wealth properly.
Furthermore, Islamic business ethics oppose the exploitation of others and thus forbid the
imposition of interest on borrowed funds (Hassan and Saleem, 2017). Therefore, in developing
any Islamic microfinance products, elements of interest should be avoided. Also, the Maqasid
al Shariah discourages the destruction of others’ wealth and encourages the sharing of excess
wealth from the rich among the poor and needy. This is echoed by the Quranic text, which
promotes justice and the easing of hardship (Hassan and Saleem, 2017). Therefore, the practice
of coercive loan recovery from the borrowers is also discouraged, as it goes against the
Shariah objectives of promoting Maslahah (benefit) and preventing Mafsadah (harm).
Moreover, the Islamic microfinance model should ensure risk-sharing between parties,

45
40
35
30
Percentage

25
Individual overlapping
20
Households overlapping
15
10
5 Figure 2.
0 Multiple membership
2002 2003 2004 2005 2006 2007 2008 2009
in the Bangladesh
microfinance sector
Source: Redrawn based on the data provided by Khalily and Faridi (2011)
QRFM integrate the time value of money and prohibit any types of uncertainty while designing
products for their intended customers (Azmi and Thaker, 2020; Dhaoui, 2015).
The products offered by conventional MFIs in Bangladesh can be divided into five broad
categories:
(1) microcredits for small-scale income-generating activities;
(2) microenterprise loans;
(3) agricultural loans;
(4) loans for the ultra-poor; and
(5) loans for disaster management.

The first three categories could be grouped as financing for enterprises, while the latter two
can be regarded as humanitarian loans. It is important to consider these different types of
products when designing Islamic microfinance models to ensure that they meet the needs of
various customer segments. Therefore, this study took into account these issues in
designing the proposed Islamic microfinance products.

4. Results and discussion

4.1 Proposed Islamic microfinance models
Islamic banking principles of Qard-al-Hasan (benevolent loan), Mudaraba (trustee financing),
Musharaka (equity partnership) and Murabaha (cost plus markup) could be used to structure
Shariah-compliant microfinance products. The manner in which these existing products
could be integrated into microfinance operations for the successful transformation of
traditional microfinance in Bangladesh is explored in the following section.
4.1.1 Proposed model for incumbent microfinance institutions. As depicted in Figure 3,
this study proposes a three-stage transformation process to facilitate the transition
from conventional to Islamic (Shariah-based) microfinance in Bangladesh. During the
preliminary stage, existing MFIs will allocate some of their resources to the Islamic
microfinance window and gradually incorporate their existing and new borrowers into the
new loan contracts. This may take several years because most microfinance loan contracts
range from one to three years. In the second stage, half of the resources should be allocated
to the Islamic window of microfinance, with half of their clients included. In the meantime,
MFIs can learn from their ongoing operations and modify their models if needed under new
operational strategies. Finally, in the third stage, full-fledged Islamic microfinance should
take off by migrating all its resources and clients to the new institution. The expected
timeline for each stage is three years; thus, the Bangladeshi microfinance sector could be
restructured to Islamic microfinance within 7–10 years. However, because MFIs have been
operating under the conventional approach for a long period, a gradual transformation is
advocated.
To enable Islamic microfinance in Bangladesh, several Shariah-complaint contracts can
be used. For example, the Murabaha model can be implemented to facilitate trade financing,
the disbursement of working capital and the acquisition of machinery and equipment by
microenterprises. In this contract, the MFI will purchase the goods and resell them
to microenterprises with a markup on the cost to cover administrative expenses. The
microenterprise can then repay MFIs in equal installments. This model is much simpler to
administer, as payments are made in equal installments. The Murabaha contract is widely
recognized and popular among customers of Islamic banking in Indonesia (Munir et al.,
2021; Ratnasari et al., 2021), as it is easier for the poor and micro-entrepreneurs to use it to
 Transformation
of conventional
microfinance

Figure 3.
Stepwise
transformation of
conventional
microfinance to
Islamic microfinance

finance their ventures (Azmi and Thaker, 2020). This model can also be adopted for
financing the agricultural and manufacturing sectors.
Second, Qard-al-Hasan is a benevolent loan that is free from interest and collateral. It is
considered a virtuous act and is rewarded in the afterlife. The primary aim of Qard-al-Hasan
loans is to provide assistance rather than generate profits. This loan scheme could serve
ultra-poor and disaster-stricken individuals. This category of loans falls under humanitarian
loans, which are intended to help the most impoverished people overcome their financial
difficulties. The concept of Qard-al-Hasan has been implemented in Pakistan by Akhuwat,
one of the largest Islamic MFIs in the country (Bashir et al., 2019; Harper, 2012; Khan et al.,
2018; Saqib and Malik, 2018) [12]. Akhuwat has observed a better loan recovery rate (around
99%), enhanced financial performance, reduced operational costs and increased loan
disbursement for the past several years (Bashir et al., 2019; Khan et al., 2018). Therefore,
replicating Akhuwat’s practices of providing interest-free loans to the poor, in line with the
concept of Qard-al-Hasan, in Bangladesh’s microfinance industry would be a valuable and
interesting addition.
The Mudaraba-based model places significant emphasis on the partnership between the
capital provider (MFI) and the entrepreneur. Under this model, the MFI provides the capital
for investment (Rabbul-mal), while the microenterprise contributes labor and entrepreneurial
inputs (Mudarib). The profits are shared between the MFIs and microenterprises according
to a predetermined ratio. In the event of a loss, the Rabbul-mal (capital provider), which is the
MFI, bears the entire burden. Another extension of Mudarabah is “the diminishing
Mudarabah model,” which is suitable for financing micro-enterprises and small-scale self-
employment. In this model, the MFI provides all the capital and initially owns 100% of the
shares and profits. The microenterprise would then purchase part of the shares from the MFI
QRFM with each installment, thereby diminishing the shares and profits of the MFI over time. When
all shares are eventually bought by the microenterprise, complete ownership of the venture
would be transferred to the microenterprise.
Moreover, Australia has adopted the Mudarabah-based lending scheme through an
institution called the “Muslim Community Co-operative (Australia) Ltd.” This institution
provides loans to both Muslims and non-Muslims to finance various entrepreneurial
activities/businesses (Ahmad and Ahmad, 2009). The adoption of this lending scheme could
prove useful for agricultural-related ventures in an agrarian economy such as Bangladesh.
In such cases, farmers could partner with MFIs (capital providers) to offer their effort/land in
exchange for financial support from MFIs (Obaidullah, 2015). Additionally, Mudarabah-
based contracts can be used to promote entrepreneurship, particularly small-medium
enterprises, in Bangladesh. This approach has been found to be effective in Uganda
(Kakembo et al., 2021). Similarly, Adnan and Ajija (2015) discovered that the use of Islamic
products like Mudarabah contracts has significantly improved the standard of living and
businesses of the poor in Indonesia. By using survey data from Malaysia, Islam and Ahmad
(2020) also demonstrated that the Mudarabah-based microfinance model can be a viable
service option for underprivileged Muslim women entrepreneurs. However, the duo
emphasized the need to promote Shariah knowledge among clients to ensure the
effectiveness of the model. Studies also found that Mudarabah is one of the most popular
products among Muslim clients because losses are completely borne by the lender, i.e. the
MFI (Fianto et al., 2018). However, Lawhaishy and Othman (2022) and Ishak and Rahman
(2021) argued that because risk is completely shifted to the lender, this model is more
appropriate for ventures that have a relatively low-risk profile and require small capital.
In the Musharakah model, MFIs and microentrepreneurs provide capital to establish and
manage a business, with profits shared based on the capital provided or any agreed ratio.
Losses are also shared proportionately between the partners according to their capital
contributions. What sets the model apart from the conventional financing model is that both
parties share in the management, decision-making process and risk (according to their
capital) of the business. The application of the Musharakah model is beneficial for financial
inclusion, especially for the poor and underprivileged women in Muslim-dominated
developing countries (Fianto et al., 2018; Islam and Ahmad, 2020; Tamanni and Haji Besar,
2019). As highlighted by Tamanni and Haji Besar (2019), the Musharakah model is one of
the most popular Islamic financial products because it gives more incentives to banks and
MFIs, minimizes inflation pressures on borrowers and promotes a sustainable form of
financing for large-scale businesses. However, El-Komi and Croson (2013) suggested that
Islamic microfinance (based on Mudarabah and Musharakah) works more efficiently when
there is no information asymmetry.
4.1.2 Proposed model for the establishment of new microfinance institutions. As
discussed earlier, most conventional MFIs do not partner with microentrepreneurs when it
comes to the supervision, monitoring and risk-sharing of businesses. Therefore, we propose
a model based on the concept of the Mudarabah contract, which takes into account both the
supply and demand sides of finance (Figure 4). However, in the proposed model, rather than
providing direct capital, MFIs will purchase the raw materials, goods and commodities
required for the business venture. The procedures are as follows:
First, the establishment of an MFI begins with the acquisition of resources (funds,
physical assets, etc.) from internal (from the board, trustees, etc.) and external sources (such
as surplus households, donors and so on). Thereafter, micro-entrepreneurs approach MFIs
with business proposals, similar to the approach used by Akhuwat in Pakistan. Second, if
the proposal satisfies the MFI’s criteria, the MFI will purchase the required raw materials
 Transformation
of conventional
microfinance

Figure 4.
Proposed Shariah-
based model for
new MFIs

and commodities from the supply markets. Third, the micro-entrepreneurs then establish
their micro-enterprise and produce goods and services for the product market. However, the
same capital providers (MFIs) may repurchase the final products from the entrepreneurs at
market price and resell them to potential clients. Fourth, the gain or loss from the business,
after deducting the cost of the raw materials and other administrative costs, is shared by
both parties (MFIs and micro-entrepreneurs) based on the initial contract. This profit-loss
sharing can be varied depending on the nature of the business and the mutual agreement
between both parties. A portion of the profit gain, if any, is used for the expansion of MFIs,
while the remainder is distributed to the sources of funds as a Hibah (Gift). This Mudarabah-
based microfinance model has been shown to improve the welfare of the poor and
underprivileged in several countries, including Australia, Pakistan, Indonesia, Uganda and
Bangladesh (Fianto et al., 2018; Kakembo et al., 2021; Islam and Ahmad, 2020; Obaidullah,
2015; Tamanni and Haji Besar, 2019; Ahmad and Ahmad, 2009).
The uniqueness of this model is that, unlike traditional microfinance models whereby
MFIs provide loans to borrowers and do not partake in product sales, MFIs will provide
the required materials for business operations and also be involved in the sale of products
generated from the business venture. This means that MFIs share in the business risks
and rewards, thus fostering the relationship between borrowers and MFIs. By reducing
information asymmetry and transaction costs, this model allows for greater financial
sustainability, as evidenced by its success in the context of Akhuwat in Pakistan (Khan
et al., 2018).
4.1.3 Proposed model to mitigate multiple borrowing. Model 3 is an extension of Model 2
and is based on the Islamic notion of Zakat or Sadaqah (charity) (See Figure 5). Under this
QRFM

Figure 5.
Proposed model to
mitigate multiple
borrowing

model, as proposed earlier, micro-enterprise clients are encouraged to commit part of

their profits to a common fund, which will be used to meet urgent short-term loan
demands of desperate borrowers. The main objective of this approach is to satisfy the
immediate financial needs of borrowers, prevent them from falling into debt and
discourage them from multiple borrowings. The common fund will be managed directly
by the MFIs and will not be the main source of funding for loans. Instead, it may be used
for community development initiatives through corporate social responsibility. Unlike
this model, conventional microfinance models often lack the facilities to cater to the
urgent liquidity needs of borrowers. At best, they might consider rescheduling or
restructuring the loans (Labie et al., 2017; Malik et al., 2020), which could motivate
borrowers to seek loans from other institutions and in turn exacerbate their overall
overindebtedness. Thus, it can be said that conventional microfinance models also fuel
the debt trap risk for borrowers.
Islamic microfinance has the ultimate goal of bringing larger benefits to society by
providing equal financial opportunities to people. This is exemplified in the Zakat and
Sadaqah-based microfinance model, which was observed to be more advantageous
than other models in promoting financial inclusion and alleviating the condition of the
hardcore poor (Rohman et al., 2021; Uddin et al., 2020). Specifically, it is effective and
useful for poor farmers seeking to promote their agricultural production and secure
fair and transparent pricing (Hossain et al., 2019). We also believe that this model has
the added advantage of serving poor borrowers in the event of a crisis like COVID-19.
The scheme would enable the borrowers severely affected by COVID-19 to get
access to emergency funds to lessen their financial hardship. Additionally, MFIs using
this model can benefit from reduced operational costs, as the model incurs almost
zero financing expenses (Kaleem and Ahmed, 2010). Overall, the Zakat and Sadaqah-
based microfinance model is expected to bring significant social and economic benefits
to society.
In sum, these Islamic microfinance models are unique in that they are driven by Shariah-
compliant principles of PLS as well as zero interest. These models encourage financial
services for the extremely poor and underserved populations, who are often ignored by
conventional MFIs. Thus, the proposed models have the potential to gain greater acceptance
in Muslim-dominated developing countries.
4.2 Role of regulatory authority in the transformation process Transformation
Despite the growing importance of Islamic microfinance in Bangladesh, there is currently no of conventional
separate regulatory authority responsible for overseeing the growth and development of this
niche banking industry. Therefore, given the current regulatory environment, it may be
microfinance
challenging to implement the proposed models outlined in this study. The MRA, established
in 2006, monitors and oversees the microfinance activities of only NGO-MFIs in Bangladesh.
Most of these MFIs operate based on conventional microfinance models. Other types of
microfinance services provided by government agencies and banks fall under the
jurisdiction of relevant ministries and the central bank. The MRA issues licenses and
statutory guidelines for the smooth operation of microfinancing activities (Mia, 2017b for
details of the MRA activities). As we have hinted earlier, for the successful transformation of
conventional microfinance to Islamic microfinance, the proposed models discussed in this
study need to be backed and supported by the MRA.
Upon examining the organogram of MRA, it became apparent that there is currently no
specific department responsible for overseeing the operation of Islamic microfinance in the
country. This is not surprising given that the majority of MFIs in the country operate using
conventional mechanisms. However, to facilitate the growth and development of the Islamic
microfinance sector, a separate department within the MRA should be established to oversee
its licensing and regulation. One potential model for such a department is the Central
Shariah Board for Islamic Banks of Bangladesh (CSBIB). The CSBIB provides prudential
guidance and assistance to the government, central bank, regulatory authority and its
members for promoting Islamic banking activities in the country (Alam et al., 2019) [13]. By
integrating the operations of Islamic microfinance with the CSBIB or establishing its own
board/department, the MRA can more effectively and conveniently oversee the development
and growth of Islamic microfinance in the country.
Furthermore, although the guidelines for microfinance operations issued by the MRA are
intended for conventional MFIs, there is a need to officially integrate Islamic microfinance
under its jurisdiction. To achieve this, the MRA must make amendments to its rules and
regulations to formally incorporate Islamic microfinance. Therefore, we recommend that the
governing body of the MRA prioritize the issue of Islamic microfinance and undertake
relevant policy reforms to ensure the sector can thrive in the country.

5. Conclusion, policy implications and guidance for future research

In a Muslim-majority country such as Bangladesh, the conventional microfinance approach
has several disadvantages (e.g. promotion of multiple borrowings, over-indebtedness, etc.).
In this regard, Islamic microfinance represents an alternative path for driving social
development in the country. Hence, this study proposes three models for the actualization of
Islamic microfinance. The first model suggested the transformation of conventional
microfinance to Islamic microfinance through the incorporation of several Shariah-based
products, such as Mudarabah, Musharakah, Murabaha and Qard-al-Hasan. The second
model revealed the operational strategy that can be adopted for the creation of new MFIs.
Furthermore, this model emphasized the adoption of risk- and profit-sharing systems by
both clients and MFIs. In Bangladesh, there are concerns about the restriction of loans to
fresh borrowers because of multiple borrowings or membership. Thus, Model 3, which is an
extension of the second model, has been established based on Qard-al-Hasan (benevolent
loans) to fulfill the emergency credit demand of the existing borrowers.
The implications of the proposed models depend on their successful implementation in
Bangladesh. However, we envisage several intended outcomes. First, the proposed models,
which are based on Shariah principles, can deepen financial inclusion in the country. This
QRFM means that borrowers who were previously excluded from conventional microfinance or
banking services can be integrated into Islamic microfinance schemes. Second, the issues of
“mission drift” and high interest rates can be mitigated because the proposed models are
based on profit-loss sharing principles. MFIs that were heavily focused on profitability will
now have direct involvement with poor entrepreneurs and will no longer aim to maximize
profit. Moreover, the transfer of risks to the lender can help restore the welfare of the poor
and minimize inequality. Third, MFIs established based on these proposed models will be
considered borrower-friendly because of the vested interests of both parties in the
established ventures. During emergencies, Islamic MFIs would stand by their clients and
provide adequate assistance rather than ignoring them.
The adverse effects of the conventional microfinance industry on vulnerable borrowers have
been longstanding, making it imperative to establish an Islamic microfinance system. This study
suggests a gradual adoption and implementation of Islamic microfinancing in the country, which
necessitates raising awareness and building confidence among the poor regarding this kind of
financing. Moreover, several similar models, such as those successfully practiced in countries
such as Indonesia, Pakistan, Malaysia and Uganda, were discussed in this study. Therefore,
practitioners and managers of conventional MFIs who are willing to implement Islamic
microfinance in the country can learn from these institutions’ successes, such as Akhuwat,
Amanah Ikhtiar Malaysia, Bank Rakyat Indonesia. We also suggest that the top MFIs in
Bangladesh take the lead in the transformation process to encourage others to follow suit [14].
Moreover, the role of policymakers is very important in the effective implementation of
Islamic microfinancing. However, given the dominance of interest-based microfinancing in the
country, policymakers may be hesitant to accept newly proposed models. Therefore, a
coordinated effort by various stakeholders, including the MRA and microfinance practitioners,
is needed to overcome all possible barriers to the transformation of conventional MFIs. Because
the current regulatory environment is geared toward conventional microfinance, the MRA
must undertake the required policy reforms to create a level playing field for Islamic MFIs.
With their support and policy changes, the transformation process is expected to be smooth
and borrower-friendly.
This research has expanded our knowledge of Islamic microfinance and its potential to
transform one of the world’s largest financial (microfinance) industries in Bangladesh. Although
this research presents some novel insights, it has several limitations that need to be considered
when interpreting its findings. For example, the proposed Shariah-based models address three
major issues with conventional MFIs. However, they may ameliorate other minor issues not
discussed in detail here for brevity. Moreover, the industry has several other burning issues aside
from the ones discussed in this study, which may warrant need- and context-specific Islamic
microfinance products rather than a general one. In addition, the study’s recommended models
have not been put to the test, making it necessary to conduct a pilot study to confirm their
effectiveness. Furthermore, exploring the credit needs of the hard-core poor may provide further
insights into the development of need-based products. This research also suggests further inquiries
(both qualitative and quantitative) into the regulatory and institutional capacity of the relevant
authorities in Bangladesh. Therefore, a multi-faceted approach should be undertaken before the full-
scale implementation of Islamic microfinance in the country.

Notes
1. The trickle-down approach argues that the provision of economic benefits to top-income earners
will ultimately benefit society through the extra wealth being invested into the economy, thereby
creating jobs that provide wealth for lower income earners.
 2. After several rounds of field experiments and discussions with various stakeholders, including Transformation
the government, the Grameen Bank (GB) was formally established in 1983 by “The Grameen of conventional
Bank Ordinance, 1983” in Bangladesh. We should also highlight that GB is a special type of bank microfinance
aimed at serving the poor and unbanked, and it is not a so-called NGO. For more detail about the
rules, regulations and aspects of such banking creation, see http://bdlaws.minlaw.gov.bd/act-
details-651.html
3. The number of borrowers includes only the MRA-registered MFIs and Grameen Bank. However,
the total number of borrowers is likely to be higher if microfinance services offered by other
government ministries/agencies and banks are taken into account.
4. It is estimated that there are several thousand unregistered and localized MFIs that operate in
Bangladesh to provide microfinance services for the poor.
5. Some examples of Islamic microfinance service providers include TMSS (as a window), Muslim
Aid (as a full-fledged institution) and the Islamic microfinance window of commercial banks such
as Islami Bank Bangladesh Limited.
6. Shariah and Maqasid al Shariah is interchangeably used in this study.
7. Quran is considered the word of Allah and Sunnah refers to the teachings and traditions of the
Prophet Muhammad (peace be upon him).
8. The percentage of Muslim population by country can be found here: https://worldpopulationreview.
com/country-rankings/muslim-population-by-country
9. Although the conventional microfinance encounters numerous issues, we have only highlighted
three because of their relevance to this study.
10. These two goals are sometimes regarded as the “double bottom line” or “twin objectives” of
MFIs.
11. If a household obtains loans from more than one MFIs, it is termed “households multiple
borrowing or overlapping.” If an individual borrows from more than one MFIs, it is termed
“individual multiple borrowing or overlapping.”
12. Akhuwat provides interest-free loans to the poor and marginalized borrowers. More details on
Akhuwat loan process can be found here: https://akhuwat.org.pk/loan-process/
13. The details of the activities of CSBIB can be found here: www.csbib.org
14. Some of the top MFIs in Bangladesh include Grameen Bank, Association of Social Advanacement-
ASA, Bangladesh Rural Advancement Committee-BRAC, Basic Unit for Resources and
Opportunities of Bangladesh-BURO, Thengamara Mahila Sabuj Sangha-TMSS, Gram Unnayon
Karma-GUK, etc.

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About the author Transformation
Dr Md Aslam Mia holds a PhD in development economics (research area: microfinance) from the of conventional
Universiti Malaya, Malaysia. He is currently a Senior Lecturer at the School of Management (SOM),
Universiti Sains Malaysia (USM). Dr Mia has published around 50 articles related to the productivity microfinance
and efficiency of financial institutions, market structure, microfinance and, urban economics in
internationally reputed peer-reviewed journals. Among some of the journals he has published are
Economics Letters, Applied Economics Letters, Finance Research Letters, Singapore Economic Review,
Managerial and Decision Economics, Annals of Public and Cooperative Economics, The European
Journal of Development Research, Development Policy Review, Gender in Management, Business
History, Journal of the Asia Pacific Economy, Journal of Cleaner Production, Social Indicators
Research, International Journal of Social Economics, Cities, Economic Analysis and Policy, Strategic
Change and others. Recently, his sole authored book on “Social Purpose, Commercialization, and
Innovations in Microfinance” has been published by Springer. He also presented his research findings
at 30þ national and international conferences/seminars during the past nine years. Dr Mia also
conducted over 30þ workshops/seminars on various research issues/techniques/tools both in and
outside of Malaysia. Md Aslam Mia can be contacted at: aslammia@usm.my

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