Using Islamic Micro Finance to Reduce Poverty

profit

Rarely have the two overlapped: corporate shareholders have no interest in giving money away and development banks have little to offer profit-oriented investors. Until microfinance.

Microfinance is a financing tool that sustainably provides very small loans to the working poor. The first set of loans are extended to an initial subset of individuals within the group, for instance 2 out of the group’s 5 individuals, and once these loans are repaid, a second subset of individuals receive their loans.

Variations of this general theme abound but the basic underlying concept remains the same: a borrower is much more likely to repay on time if not doing so affects one’s selected group partner, usually an acquaintance. The fear of a faceless bank is replaced with the mercy for one’s own neighbor. This non-traditional concept of “social collateral” banking allows the poor to break out of the poverty cycle: the provision of capital allows for greater business investment, which leads to increased income, resulting in higher household savings and eventual financial independence.

THE ORIGINS OF CONVENTIONAL MICROFINANCE

Microfinance grew out of the failure of cooperative movements and government-sponsored initiatives for concessional individual lending. With some of these heavily subsidized programs yielding repayment rates as low as 40%, there is little wonder they were short-lived.

What began as a $26 loan to 42 village women is now a major industry in Bangladesh, with 4 million Grameen borrowers and over $4 billion in disbursed loans, of which over $300 million is currently outstanding. All collateral-free.

In the1970s, Bangladesh’s Grameen Bank transformed the development world by extending small, interest-based loans to the extreme poor, an economic group commercial banks refused to lend to and development banks found difficult to sustain acceptable repayment rates with. By assembling individuals into self-selected borrowing groups, particularly in homogeneous settings, peer pressure and peer assistance lead to a form of informal monitoring that paved the way for continued success.

IT ‘S PROBLEMS:

Critics of Grameen and other conventional micro financiers cite Draconian interest rate levels as a major impediment to many borrowers becoming truly self-sufficient; an astronomical 22% interest rate charge at Grameen (measured on a declining basis), and as high as 50% elsewhere. Anathema to Muslims, for whom taking even the smallest amount of interest is forbidden, evidenced by a number of Qur’ anic verses (2:275 -279, 3:130, 4:160 -161, 30:39), numerous rigorously authentic traditions of the Prophet, may God bless him and give him peace, the consensus of the four schools of jurisprudence, and the ravaging effects of decades of low-interest development loans to poor countries.

The single biggest problem with conventional microfinance, and for that matter all interest-based finance, is that the borrower has to make his interest payments even if he is unable to meet them. If his business succeeds, he pays; if his business fails, he still pays.

At a time when a young business should be concerned with innovation and expansion, an interest payment looms unavoidably large at the end of the month. In a protracted market downturn, when large groups of borrowers are unable to meet their repayment requirements, this precipitates heightened levels of market volatility.

Further, interest-based transactions tend to focus attentions on the process-oriented task of repayment instead of on the result-oriented task of increasing profit. And because no direct causality exists in an interest-based transaction between the size of the payout and the profitability of the business (since interest payments are already fixed), conventional microfinance requires additional technical intervention on the part of the lender in order to promote business efficiency. Equity-based investments, on the other hand, already assume an effort toward business efficiency because both the worker and the investor share the same goal: increasing profit.

ITS ISLAMIC ALTERNATIVE:

The key dynamics of conventional microfinance arrangements are, however, still retained in Islamic microfinance, with small groups of self-selected individuals providing each other with emotional, technical, and financial support. By assembling themselves into their own groups, clients choose as partners only those individuals they trust most, filtering out to large extent poorer credits

Islamic microfinance provides an innovative interest-free alternative to conventional micro- finance. Probably not so innovative since interest-free, equity-based investing has already proven itself as the predominant corporate financing tool for decades, from Wall Street investment banks to Silicon Valley venture capitalists. And while the players may change, the transaction dynamics remain largely the same, whether the transaction is worth billions of euros or hundreds of rupees: an investor takes a stake in a business for a share of the business’s profits, undertaking commensurate levels of risks.

Until microfinance. Microfinance is a financing tool that sustainably provides very small loans to the working poor. And because no direct causality exists in an interest-based transaction between the size of the payout and the profitability of the business (since interest payments are already fixed), conventional microfinance requires additional technical intervention on the part of the lender in order to promote business efficiency. Islamic microfinance provides an innovative interest-free alternative to conventional micro- finance. Based primarily on the profit-sharing principles of equity-based finance, Islamic micro- finance offers greater resilience than conventional microfinance.

Based primarily on the profit-sharing principles of equity-based finance, Islamic micro- finance offers greater resilience than conventional microfinance. If a business fails, nothing is paid; if a business succeeds, profits are shared.

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