Islamic Approaches of Microfinancing

2 Lecture Plan Session 1: Microfinance Institutions (MFIs) Financing Microenterprises: Islamic Alternatives Islamic MFIs Islamic MFIs Vs Conventional MFIs Session 2: Financing Microenterprises: Islamic Alternatives Islamic Banks Other Specialized Institution—Waqf-based MFI

3 Session 1 Introduction Microfinance Institutions (MFIs) Islamic MFIs Vs Conventional MFIs Assessment of Islamic MFIs Conclusion

4 Introduction (1) In the last 50 years, different development strategies have been used to resolve the problem of poverty Most of these programs failed “Microfinance” initiated in the mid-1970s appears to be the ‘new paradigm’ to eradicate poverty

5 Introduction (2) Limited access to finance is key constraint to private sector growth Investment on MSEs is even more difficult The MSEs do not qualify to get funds from institutional sources (banks) lack of collateral too much risk too costly

6 Economics of Microfinancing Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) + Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the Head/regional/branch offices Microfinancing Revenue may be low due to credit risk Costs are high due to large operating costs

7 Financing MSEs Commercial financial intermediation not feasible If the poor have to be financed, there is a need for social financial intermediation Two ways to do so: Linking Approach—Existing financial institutions can do it through specialized windows Specialized institutions Approach—NGOs, non-profit organizations, etc. Almost all of MFIs models are of the second type

8 Financing MSEs-Sustainability Mitigating Credit Risk Ensure repayment in the absence of acceptable physical collateral Solving the Moral Hazard problem Ensure funds not diverted and used for intended activity Economic viability —keep costs to a minimum relative to income Operating costs Financing costs

9 Microfinance Institutions (MFIs) MFIs are target-oriented (poverty-focused) financial institutions Target group—micro and small enterprises (MSEs) (Average financing in Bangladesh is below US$ 200 and in the US is US$ 1500) Graduation from poverty -- the “Virtuous circle” Low income  credit  investment  more income  more credit  more investment  more income

10 MFIs—Typical Balance Sheet AssetsLiabilities Cash (C) Loans (L) Funds from external sources (F) Saving Deposits (D) Reserves (R) Equity (E)

11 MFIs-Main Features Interested individuals must form a group Several Groups form a Center Center has weekly meetings An official from the MFI attends the meetings and all transactions take place in these meetings (bank goes to the people)

12 Organizational Structure of MFI Clients

13 MFIs-Other Features Small amount of funds given for microenterprises for 3months -1year Capital and interest paid back in small weekly installments Forced savings and insurance programs Social Development Programs behavioral, ethical, and social development

14 MFIs-Social Collateral MFIs have devised a structure to resolve the collateral and risk problems of financing No physical collateral required The repayment of dues of a member in the group is the collective responsibility of the all the members in the group If any one in the group defaults--all members become disqualified for credit Peer-pressure works as social collateral

15 Banks Vs. MFIs (1) BankMFI A profit-maximizing firmNon-profit Government/non- government organization Financial intermediary between savers and investors in the economy Funds from external sources provided to the poor Deposits form bulk of the liabilitySavings (forced) of clients only deposits Do not have social/educational programs Includes social/educational programs Physical/financial collateral required to get funds Social collateral through group and center formation

16 Banks Vs. MFIs (2) BankMFI Clients relatively well-offClients are poor Clients come to the bankBank goes to the clients Amount of loan largeAmount of loan small Most clients are menMost clients are women Repayment frequency small (end of the contract period) Repayment is frequent (weekly)

17 MFIs and Sustainability Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem Cash given out can be used for other purposes –chances of default increases Economic Viability High administrative costs (some estimates show costs ranging from 24 to 400% of per dollar lent) Reasonable finance costs Conventional MFIs have resolved the CR problem (social collateral), but not MH problem and Economic Viability problem

18 Islamic Alternatives to Microfinancing Different alternatives: Islamic MFIs Islamic Banks Specialized Institutions Group-based microfinancing can be used (as it mitigates the CR)

19 Islamic MFIs-Features (1) Islamic MFI retains the basic operational format of MFIs Going to the Clients Weekly/Monthly Repayments A Social/Development Program (to fulfill the social role of Islamic finance) IMFIs have some distinguishing features: Sources of Funds Other than external sources, can also use funds from zakah, awqaf, and other forms of charities Use of funds (Mode of Financing) Sale based and hiring modes (murabahah, salam, ijarah) Profit-sharing modes (Musharakah and mudarabah)

20 Islamic MFIs-Features (2) Amount transferred to the poorest As Islamic modes are sale based the price of the asset is paid (no deductions are allowed) Group Dynamics Islamic values of brother/sister-hood improves cooperation among the group members Financing the poorest Zakat and other charities can supplement MFI activities (non-diversion of funds)

21 Islamic MFIs-Features (3) Social Development Program behavioral, ethical, and social aspects in light of Islamic teachings Targeting the family through women Spouse co-signs the contract dealing with women more efficient and convenient Women disseminate knowledge to children Dealing with Arrears/Default Less aggressive and use Islamic teachings to recover loans

22 Islamic MFIs and Sustainability Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion and default decreases Economic Viability High administrative costs Reasonable finance costs Islamic MFIs can resolve the CR problem and the MH problem, but not the Economic Viability problem

23 Problems facing Islamic MFIs 1. Dilution in the Application of Islamic Modes of Financing Main mode- murabahah or bai-muajjal. It is difficult to go out with the clients and buy the goods/assets from faraway markets IMFIs delegates someone else (and inspects later) Alternative is to use Profit-sharing modes Problem is the moral hazard problem--No book- keeping and difficult to monitor

24 Problems facing Islamic MFIs 2. Lack of Funds Most MFIs get their funds from external sources Islamic MFIs have difficulty in getting funds from these sources Operations and expansion of activities affected Islamic MFIs have not yet tapped the sources of funds from Islamic institutions (like zakah, waqf, and other charities) 3. Training Training can enhance efficiency but is costly

25 Conclusion Islamic approach to microfinance has certain advantages Diversified asset and liability structures Social collateral stronger Potential to target the poorest through complementary programs Asset-based modes of financing can prevent diversion of funds for consumption Lack of funds hampering its growth

26 Session 2 Financing Microenterprises: Islamic Approaches Islamic Banks Specialized institutions: Waqf- based MFI

27 Financing MSE by Islamic Banks (IBs) The Rationale Social Role –Islamic firms are not only about fulfilling Islamic contracts…there is more to it (social justice and benevolence) Financing is the specialization of IBs—expand the client base to the MSEs Can be done at no cost to the IB and more cost effectively than MFIs

28 Financing MSEs by IBs Use the same format as MFIs (as it suits the MSEs) IBs can open up a department for financing MSEs Use the existing infrastructure (bank offices) for financing MSE operations

29 IBs & Economics of Microfinance Profit = Revenue – Costs Revenue =Rate of return on funds invested Costs = Finance Costs + Operating Costs Operating Costs = Variable Costs (wages) + Fixed Costs (rent, utilities, etc.) Variable Costs = Field Level Costs + Costs at the Head/regional/branch offices

30 MFIs Vs. IBs: Operating Costs MFIs For any level of operations an MFI will maintain offices—Higher Fixed Costs Higher Variable Costs (wages) at Head/regional/branch offices IBs No extra costs needed to maintain offices for the Microfinancing program (can use bank’s premises)— lower fixed costs Lower Variable Costs (wages) at Head/regional/branch offices Conclusion: Operation Costs to finance MSEs is lower in case of IBs compared to MFIs

31 MFIs Vs. IBs: Finance Costs MFIs: Sources of funds Main source –external funds (MFI has pay a rate of return, though subsidized in many cases) No Deposits—Forced Savings of Members—Competitive returns are paid on savings IBs: Sources of Funds Deposits Demand Deposits (no costs) Investment Deposits (has to pay competitive returns to depositors) Conclusion: Given the excess liquidity in IBs, the funds from Demand Deposits can be used for MSEs—Finance costs of IBs can be lower than that in MFIs

32 MFIs Vs. IBs: Quality of Service Dependence on external funds in MFIs comes with conditionalities—IBs more flexible Lack of funds in MFIs—poorer quality work force (especially at field level)—can increase the default rate IBs pay competitive wages—good quality workers with higher productivity Employees of IBs can be trained by the Bank at low cost—not possible in case of MFIs Most IBs have funds collected from penalties for late payments—these funds can be used for complementary asset building/poverty reducing programs—asset building in form of grants or qard- hassan

33 IBs and Sustainability Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion and default decreases Economic Viability Low administrative costs No need for a hierarchy of senior management and offices Use existing branches for operation Low finance costs Excess liquidity—use liquid funds available IBs appear to resolve all the problems related to sustainability in microfinancing.

34 IB and Microfinancing: An Example Islami Bank Bangladesh Ltd (IBBL) has a Rural Development Program (RDS) to finance MSEs Started in 1996 and funded from IBBLs general investment fund As of October 2006, RDS operated from 116 branches (of 176 total), covering 7,788 villages giving a total of Tk mill. to 368,360 clients The recovery rate is 99 percent. Employees involved with RDS have better benefit packages than other MFIs Employees get in-house training at IBBL Training Academy

35 RDS of IBBL Loan amount (Tk to Tk ) Paid back in weekly installments No physical collateral required Group-based lending Rate of return charged is 10 percent with 2.5% rebate for timely payment (other MFIs rate range from 16 to 20 %)

36 Microfinancing by Specialized Institutions 1. Cash Waqf—waqf established in the form of cash Can be used for microfinancing 2. Qard hassan bank—nonprofit financial intermediary Capital would be cash waqf Will receive current accounts Provide qard hassan (interest free loans) for microfinancing 3. MFI based on Awqaf and Zakat Returns from waqf given for investment purposes and zakat funds for consumption purposes Use the same operational format as MFIs (as it suits the MSEs)

37 Waqf-based MFIs Historically, waqf based institutions did provide loans to the disadvantaged (Turkey and Iran) W-MFI will retain the basic operational format of MFIs, but will have some distinguishing features Group-based microfinancing can be used (as it mitigates the CR)

38 W-MFI: Sources and Uses of Funds Sources of Funds Obtain funds from Waqf and other sources (waqf certificates, qard hasan deposits, etc.) Use of funds (Mode of Financing) Qard (loan at service charges) Sale based and hiring modes (murabahah, salam, ijarah) Profit-sharing modes (Musharakah and mudarabah)

39 W-MFI: Typical Balance Sheet AssetsLiabilities Cash (C) Assets (A) Fixed income assets (F) Microfinancing (M) Qard, investments(murabahah, ijarah, salam, istisna, mudarabah, musharakah) Savings Deposits (Ds) Qard hasan Deposits (Dq) Waqf Certificates (S) Takaful reserves (T) Profit equalizing reserves (P) Reserves/Econ Cap. (V) Capital-Waqf (W)

40 Special features of W-MFI Liability Waqf—the corpus (endowment) has to be intact Savings deposits — mudarabah contracts Loss of lower return can lead to withdrawal risks Assets Allocation of assets into fixed income and microfinancing activities

41 WMFI – Nature of waqf and investment options Waqf—the requirement of keeping the corpus intact Simplest-option—Invest the waqf endowment in some safe fixed-income asset and use the returns for MF operations The scope of MF will be limited

42 Example Waqf of $10 million, rate of return 5%, financing $100 per beneficiary (Grameen Bank 5.5 million beneficiaries given $5 billion) AssumptionNo. of beneficiaries Use waqf returns only5,000 Use 90% of the endowment 90,000

43 Allocation of Assets Risk and returns depend on allocation funds into different assets Fixed income (FI) assets—low-return low-risk assets Microfinancing—higher returns with higher risks Invest in FI assets so that returns can cover expected losses from microfinancing In addition, build various reserves to cover various risks

44 Risk-reducing reserves Takaful reserves Contributed by beneficiaries Used in case of default due to unexpected reasons Profit-equalizing reserves Contributed by depositors Used to maintain competitive returns Economic capital reserves Contributed from the surplus of MFI (no dividend distribution) Used in case of negative shock

45 Other funding sources Funds from Zakah and other charities Funds from waqf given for investment purposes and zakah funds for consumption purposes

46 W-MFI & Sustainability Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending) Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion and default decreases Economic Viability High administrative costs Low finance costs Being charities there are no finance charges These specialized institutions resolve CR and MH problems and to lesser extent the viability problem

47 Sustainability-Relative Status Credit Risk Moral Hazard Economic Viability Conventional MFIs NoYes Islamic MFIs No Yes Islamic Banks No W-MFI No Somewhat

48 Conclusion There are strong economic reasons for establishing Islamic alternatives to poverty-focused microfinancing. Financing should adopt operational mechanisms of MFIs (as they suit these clients) Financing MSEs by IBs is most efficient (cost effective)—given the social responsibility and excess liquidity in IBs, financing MSEs should be undertaken Traditional institutions of waqf, zakat, and qard hassan are important means of financing MSEs during contemporary times—should be integrated with microfinancing

49 THANK YOU!