How Islamic Microfinance Works

HOW ISLAMIC MICROFINANCE WORKS

The Islamic microfinance arrangement falls under the Mudarabah contract, a participative agreement in which one party provides capital (the principal) and the other (the worker) utilizes it for business purposes in which profit from the business is shared according to a decided upon proportion, and loss, if any, unless caused by fault or violations of contract by the worker, is borne by the principal.

Some considerations include the following:

>> The bank as the principal should not interfere in the routine transactions of the business of the worker, though the bank is permitted to provide general technical advice. The worker should provide regular periodical reports to the bank on the state of the business;

>> Profit earned from a Mudarabah business is distributed between principal and worker on the basis of proportions settled in advance;

>> No fixed amount, whether as profit, commission, or wage, may be settled in favor of either party beforehand; Islam permits the fixing of profits in percentage terms (e.g. “share 10% of your profits with me every month”), but forbids fixing profits in absolute terms (e.g. “give me $100 of your profits every month”), the obvious difference being that the former is linked to the performance of the business, whereas the latter is linked to nothing;

>> In a running business, losses may be offset by business earnings until the business comes to a close and accounts are settled;

>> A qualified Shari’a scholar should be consulted throughout the investment process to ensure that financial transactions comply with Islamic law.

An Islamicized version of the Grameen model resembles the following:

1. A group of 5 clients approach an Islamic microfinance bank for investment capital for 5 separate projects.

2. After assessing feasibility for each of the 5 projects, the bank draws up separate contracts, explaining repayment schedules and profit-sharing percentages, and underscoring the possibility of larger investments in future depending on their individual performances.

3. The bank first invests in 2 individuals.

4. These first 2 individuals repay one-fourth of each of their original investments each week for four weeks (clawing profits back into the business each week) until at the end of the month the entire original investment is repaid, and 75% of all profits remain with the individual and 25% of profits return to the bank (primarily to fund the bank’s future operations and growth); in the event of losses, only what remains of the investment is repaid.

5. In the second month, the bank then assesses the performance of these first 2 individuals and decides whether to reinvest; increasing investment sizes for those individuals with rates of return higher than 10%; maintaining existing investment sizes for those individuals with rates of return between 0% and 10%; and reducing investment sizes for loss- making individuals, where a second round of losses would disqualify them from any future investment, forcing the remaining group to find another group partner.

6. In the second month, the bank commences investment in the next 2 individuals, using the same repayment schedule and profit-sharing agreement as for the first 2 individuals.

7. In the third month, the bank assesses the performance of the existing 4 clients and decides whether to reinvest, using the same criteria as before.

8. In the third month, the bank invests in the final and fifth individual of the group, using the same repayment schedule and profit-sharing agreement as for the previous 4 individuals.

9. The bank continues this transaction cycle, using the same repayment schedule, profit-sharing agreement, and reinvestment criteria for all future investments.

One might wonder why simply giving money away to the poor, as opposed to investing in their businesses, might not be the most effective poverty alleviation tool. Now more than ever, with large capital inflows entering the Islamic banking industry and the possibility of securitizing microfinance contracts a proven reality, we stand at the beginning of a second microfinance revolution, in which Islamic micro-financiers alleviate poverty with sustainable, replicable, and inexpensive transactions, without the costs and risks associated with conventional microfinance.

These simple steps are as effective in a rural village in a Muslim country as they are in an urban ghetto in a non-Muslim one, whether the client is female or male, young or old, Muslim or not. Group sizes, repayment schedules, profit- ability targets, reinvestment criteria, investment duration, and other integrals of the transaction may be tailored to suit client needs as necessary.

In calculating profit, the client needs to provide only three pieces of information: purchase price, sale price, and quantity purchased. It is critical that at the outset, clients are explained that profitability (and, implicitly, declaring profits honestly) translates into larger investments in future. Islamic Law does not permit parties to contractually condition future investment sizes on past investment performances, but parties are permitted to enter into unenforceable pledges whereby the investor agrees, as a matter of policy at his own discretion, to increase or decrease future investment sizes on the basis of historical performance, perhaps according to the investor’s own internal investment matrix. And because original investment sizes are sufficiently small suiting only the extreme poor of the locality, the bank filters out free-riders and other untargeted individuals.

Now more than ever, with large capital inflows entering the Islamic banking industry and the possibility of securitizing microfinance contracts a proven reality, we stand at the beginning of a second microfinance revolution, in which Islamic micro-financiers alleviate poverty with sustainable, replicable, and inexpensive transactions, without the costs and risks associated with conventional microfinance.

It is critical that at the outset, clients are explained that profitability (and, implicitly, declaring profits honestly) translates into larger investments in future. Islamic Law does not permit parties to contractually condition future investment sizes on past investment performances, but parties are permitted to enter into unenforceable pledges whereby the investor agrees, as a matter of policy at his own discretion, to increase or decrease future investment sizes on the basis of historical performance, perhaps according to the investor’s own internal investment matrix.

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