Thoughts on Islamic microfinance

PBS, the American public broadcasting network, had a segment on Islamic microfiance in Pakistan and there were a couple points that I thought were worthy of a further understanding.

"There’s a lot of compatibility between the notion of Islamic finance and microfinance. That’s how I see it, very simply. The first is you only do productive lending. In Islamic finance you cannot do consumer lending, for example. Similarly, in microfinance we are not really in the business of consumer lending. The second thing is you support the business itself, so you have to do a very detailed analysis of returns from the business."

This is not necessarily true. Islamic finance is easily adaptable to consumer finance, whether through tawarruq or through murabaha for consumer purchases. In microfinance, that is not necessarily a problem; there is no reason why low-income borrowers should not have access to consumer finance. Indeed, excluding consumer finance from Islamic microfinance won't reduce the debt burden on the clients. They will just find it elsewhere, often at higher cost.

However, the story does make a good point that the ability of borrowers to access finance from multiple microfinance institutions (MFIs) can lead to crisis for borrowers (and lenders) like it did in India recently. Without any way to gauge the client's other indebtedness other than just asking the client, there is a possibility that over-agressive lenders can give clients the opportunity to overextend themselves. Initially, this is to the benefit of the MFI, but when the debt load becomes unsustainable, the MFI will lose as well.

This is a problem that Islamic finance cannot solve on its own and I think the solution to the problem can be used by both Islamic and conventional MFIs, to the benefit of the institutions and the clients. There should be an organization that collects information on all the microfinance loans extended by all MFIs, organized by client. There will need to be significant effort and expense incurred to create and maintain this database, and make sure it maintains the client's privacy (just as consumers trust that the information reported to credit agencies in the West expect that their information will be protected).

However, unless each MFI is able to accurately assess the amount of debt each client has and is required to consider this in the lending decision, there will be problems in the future of MFIs unwittingly contributing to overindebtedness of clients, with predictable results. The problem is significant; avoiding measures that allow and require MFIs to consider the ability of clients to repay the financing they are provided will lead to more crises in MFI that will harm the reputation of microfinance.

The other issue is more relevant to Islamic microfinance. The reporter notes that:

[Clients] must share the high administrative costs. Borrowers pay an effective interest rate of about 35 percent. Zafar says it’s the only way to sustain the model, because Kashf has to pay between 14 and 16 percent on the money it borrows to make loans.

On this issue, there are ways that Islamic microfinance can create a unique model to reduce the cost of microfinance to clients and, in doing so, can increase the involvement of Islamic banks and financial institutions in microfinance (enhancing their corporate social responsibility in the process).

Islamic banks that receive impermissible (haram) income, either from aspect of their financing activities that their Shari'ah boards determine are non-compliant or from charging late fees to clients to encourage on-time repayment. On the latter issue, they are permitted to charge late fees, but generally are not allowed to recognize them as income and are required to donate this income to charity.

One possibility is that Islamic financial institutions could donate this non-permissible income to a cash waqf. To avoid conflicts of interest, the waqf would be independent of the institution and to increase efficiency in its charitable use, the waqf would pool donations from many Islamic financial institutions. These funds could then be used to provide qard hasan financing to Islamic MFIs, which would lower their cost of funds from 14-16% as the article describes to 0%.

Another alternative would be for the waqf to invest directly in Islamic MFIs to provide capital on a mudaraba basis (an equity investment), which would provide funds to expand the very limited Islamic microfinance industry. Most likely, both alternatives would be used. The continuing cash flow from Islamic finance institutions' non-permissible would serve to increase the size of the waqf, as well as to replace any funds lost from qard investments.

This source of funds from Islamic finance institutions, on which no return is expected or likely even permitted, would provide a source of finance for Islamic microfinance institutions that could lower the costs to the end-client, expand them as well as make them more competitive with conventional MFIs. It would also serve as a way to distinguish Islamic (macro-)financial institutions from conventional financial institutions which must bolt-on the corporate social responsibility and for whom CSR is competing for funds internally; this model funds the CSR with income that the bank is not permitted to recognize and must donate to charity.

The Islamic microfinance industry is underdeveloped and under-recognized in the broader Islamic finance industry. Yet, it plays an important role in poverty reduction and social justice that are important parts of the underlying reasons for the rules governing Islamic finance derived from the Shari'ah. Finding a way that Islamic banks and other financial institutions can help this segment of the industry without sacrificing their own competitiveness with conventional banks should be an important focus as the global economy returns to growth.