Islamic banking in rural areas

An article describes the push by Islamic banks in Indonesia into rural areas. This is likely to be positive because in most areas of the world, rural areas do not have as much access to financial institutions because it is more difficult (i.e. costly) to serve areas with lower population densities. The article, citing the director of Islamic banking at the country's central bank Mulya Siregar who describes mudaraba as the "ideal" method for rural and agricultural finance.

While there are benefits to the mudaraba contract for farmers, it has not been used widely by many Islamic banks and I would be surprised if it were used widely in rural areas of Indonesia. Instead, I would expect murabaha and salam to be the most common financial instruments used. Murabaha is widely understood and is similar to a concentional loan in how it works. Salam, where the financier extends finance to a farmer in exchange for a certain volume of a homogenous commodity (e.g. bushels of corn), was historically used to finance agriculture.

However suited salam is to agriculture, it does not avoid the risk to the farmer that the product is still owed even if there is a crop failure (because the contract is for a generic bushel of corn, not the specific corn grown by that farmer). Murabaha also presents risks to farmers, but no more so than a conventional loan and could lead to improving the income of farmers if it can widely replace moneylenders that charge exorbitant interest and resort to violence if they are not repaid on time.

The advantage to a mudaraba for financing activities like farming which are dependent upon weather and other unpredictable events is that a portion of the loss can be shifted from the farmer to the bank. However, it also carries the disadvantage of depending on record-keeping that may not be possible in areas where education and literacy are limited. The requirements for mudaraba financing may lead the benefits to be reduced and it may be more beneficial to offer more simple products like murabaha and salam.

To mitigate the risks posed by unpredictable weather, particularly when climate change is making weather conditions more uncertain and extreme weather more common, is to introduce some sort of takaful alongside the financing. For example, banks could offer takaful covering drought, flood or pests. This would make it easier to determine events requiring payout and also limit the effect on incentives (i.e. lower incentives for the farmer to take measures to avoid a fall in yields of the crops if they receive payments based on crop yields). A covered event would happen widely across a particular region. This would also introduce risk to the bank, but based on its scale advantage, it can mitigate the risk by either operating across a broad geographic area or by reinsuring its risk using retakaful.