An Application of Islamic Banking Principles to Microfinance

This paper notes that viable projects that are rejected by conventional lending institutions because of insufficient collateral might prove to be acceptable to Islamic banks on a profit-sharing basis.

Three basic instruments of Islamic finance could be built into the design of a successful microfinance program:

• Mudaraba (trustee financing);
• Musharaka (equity participation);
• Murabaha (cost plus markup).

The paper reports:

• The murabaha (buy-resell) model generates high initial transactions costs which can be potentially offset by low loan administrative and monitoring costs given the simplicity of the model;
• The mudaraba (profit sharing) model may require the frequent determination of business profits and it is not entirely clear how such profits would be determined? This methodology is feasible, and in some form or another can be used to achieve the goals of microenterprise lending;
• Other types of Islamic lending such as qard al hasanah (benevolent lending with a service fee) may emerge as more practitioners implement Islamic lending principles in microfinance institutions.

Finally the paper concludes that:

• Islamic banking, with its emphasis on risk sharing and, for certain products, collateral-free loans, is compatible with the needs of some microentrepreneurs;
• Because it promotes entrepreneurship, expanding Islamic banking to the poor could foster development under the right application;
• Islamic law allows room for financial innovation, and several Islamic contractual arrangements can be combined to design a hybrid.