These are what I planned on saying at the conference, which I diverted slightly from (there will eventually be a video, I am told). The conference was great, with a good mix of speakers.
Thank you for asking me to speak at the forum.
Microfinance institutions of all types have demonstrated innovative means of differentiating themselves from conventional finance to address issues of poverty alleviation, but Islamic microfinance is just beginning to offer something unique to both conventional finance and microfinance.
The Islamic microfinance industry will face the same criticisms as its macro counterpart if it relies too heavily on murabaha and ijara—debt based methods of finance—over equity-based financial products. However, the type of financing provided to each client will need to be determined based on the client’s needs, not a belief that either equity or debt are inherently superior.
A few years ago, I presented a model of Islamic microfinance at the Harvard Islamic finance conference. While I was ambitious in believing that equity-based products could be incorporated into Islamic microfinance, I was aware that it is also difficult to administer these equity-based products. A product where the microfinance institution assumes some of the business risk creates an incentive for the client to under-report profits. This would hurt the profitability of the MFI and slow the growth in equity-based products. This is in part why macro Islamic financial institutions use debt-based products for most of their financing.
The idea I had to mitigate this problem was to use murabaha as a “screening mechanism” for a mudaraba microfinance product. A group of clients will build a reputation with the MFI of being trustworthy and could also receive the training necessary for the mudaraba product, mostly experience keeping adequate, accurate accounting records.
That paper generated a lot of conversation with some ambitious social entrepreneurs around the world and looking back, I think I was probably being overly conservative in my model, much like bankers who refused to provide loans to the entrepreneurs that Muhammad Yunus sought out.
I was too focused on the risks of mudaraba rather than the opportunities. Focused on avoiding the “worst case scenario”, I added too many caveats to the type of model I started out trying to create. The more I thought through the “two-stage murabaha-mudaraba” model, the more it tries too much to force a solution that reduces risks for the MFI rather than finding the best way to help the clients expand their business. In many ways, it voluntarily gave up the innovative aspects of Islamic microfinance that I wanted it to showcase.
Smart diligence on the ground can recognize entrepreneurs who will work best with each type of finance and also choose the product most appropriate to their business. One example, which wasn’t strictly speaking an Islamic microfinance institution but which used an equity-based approach, was the ESB Group. In one case, they provided financing to women in Malawi who wanted to start a business growing and selling mangoes, but had not been able to get financing from a conventional microfinance institution. The conventional MFI was not interested in financing this type of business. Instead, the women were told they would be better off raising chickens, despite the greater costs and risk of the chickens dying from disease.
Although I didn’t have real life experience with chickens at the time, I have since lived in a house and saw first hand, the risks that raising chickens could present to the client. The chickens could stop laying eggs or even die suddenly. It is a real business risk that growing mangoes doesn’t have to the same extent. The idea of raising chickens sounds like a solid business idea—and it may be in some situations—however, the MFI should not determine ex ante that raising chickens is ok and another type of business suggested by the client is not.
The Malawi example shows the benefit that local knowledge can play in determining the best microbusiness opportunities. Their financing was provided to women who saw an opportunity and just needed the money to get it started. The financing was equity-based because profits from the business were used to buy out the investor, but only as they were generated. A similar business idea could be financed using mudaraba.
Another person I spoke with Saif Ahmed of Infinity Consultants. He is currently setting up an Islamic microfinance institution in Bangalore, India using musharaka, partially inspired by the paper I presented at Harvard. While it is not yet operational, it will also not use the murabaha component and focus just on equity investments.
It will use a group methodology and take advantage of local knowledge from community leaders, who would recommend entrepreneurs for each 3 to 4 person group receiving financing. In addition, the entrepreneurs will be required to contribute some money to the business, even if it is only a very small portion.
The plan for monitoring the investments will rely to a large part on the daily recordkeeping of all income and expenses of the business using a handheld device provided by the MFI. The repayment will be funded by a portion of the client’s profit paid to gradually buy out the MFI’s ownership percentage.
One of the main goals of the MFI, which Saif describes as “livelihood financing” will be to foster independence by the clients. Rather than building something that leads the client to repay one loan and then return to the MFI for another loan, the goal of the financing is to create a business that ends up 100% owned by the client and which generates enough profit on its own to sustain the client and his or her family.
Both of the MFI models which I have described use equity-based financing, and I am encouraged that this is their focus. However, I think that using murabaha in some situations could be beneficial. As I was reminded recently discussing the Malawi experience of the ESB Group, profits are a function not only of the business’ margins on the products sold, but also on the velocity, the number of time that the inventory is turned over.
If a business focuses on buying a product wholesale and selling it retail—whether that is buying fruits and vegetables or mobile phone minutes—then the murabaha financing could make more sense to the client because it is easier to administer. The time freed up using murabaha could be devoted to more productive activities like maximizing turnover. If I just need someone to finance the purchase of the good and I can pay the cost plus profit out of my margins, then it benefits me as the client to simplify the financing structure.
Returning to equity-based financing, both examples are based on offering funding to a business that might not initially be profitable or generate immediate cash flows. This challenges the setup of conventional microfinance. Either a loan is provided and regular payments of principal and interest begin immediately, or there is a grace period where interest will still accrue.
Assuming the business model makes sense, the equity-based MFI can be more patient. For example, it takes time to cultivate mango trees, but as long as the trees are kept healthy, there will be a self-sustaining source of revenue and profits that can be split between the MFI and the client.
The microfinance industry is facing challenges and many of them have become acute particularly in India. Making microfinance Shari’ah-compliant will have its own specific challenges, but can also benefit from the experience of conventional microfinance. The biggest thing that I learned that has re-shaped my thinking about the model described in my paper is that flexibility is key and rigidity is a risk. If Islamic microfinance is developed as flexibly as possibly, it will evolve to create new ways of helping clients, which at the end of the day is what microfinance is all about.