Islamic Microfinance - World Bank Group

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FOCUS NOTE

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

No. 49 August 2008

Nimrah Karim, Michael Tarazi, and Xavier Reille

47001 Islamic Microfinance: An Emerging Market Niche

A

n estimated 72 percent of people living in

demand for Islamic microfinance products is strong.

Muslim-majority countries do not use formal

Surveys in Jordan, Algeria, and Syria, for example,

1

Even when

revealed that 20–40 percent of respondents cite

financial services are available, some people view

religious reasons for not accessing conventional

conventional products as incompatible with the

microloans.

financial services (Honohon 2007).

financial principles set forth in Islamic law. In recent years, some microfinance institutions (MFIs) have stepped in to service low-income Muslim clients who demand products consistent with Islamic financial principles—leading to the emergence of Islamic

Islamic microfinance has the potential to expand access to finance to unprecedented levels throughout the Muslim world.

microfinance as a new market niche. This Focus Note provides an overview of the current Islamic microfinance represents the confluence of two

state of the Islamic microfinance sector and identifies

rapidly growing industries: microfinance and Islamic

possible challenges to its growth. It is intended as an

finance.2 It has the potential to not only respond

introduction to Islamic microfinance primarily for the

to unmet demand but also to combine the Islamic

donor community and other potential entrants into

social principle of caring for the less fortunate with

the market.

microfinance’s power to provide financial access to the poor. Unlocking this potential could be the key

Principles of Islamic Finance

to providing financial access to millions of Muslim poor who currently reject microfinance products that

Islamic finance refers to a system of finance based

do not comply with Islamic law. Islamic microfinance

on Islamic law (commonly referred to as Sharia4).

is still in its infancy, and business models are just

Islamic financial principles are premised on the

emerging.

general principle of providing for the welfare of the population by prohibiting practices considered unfair

In a 2007 global survey on Islamic microfinance,

or exploitative. The most widely known characteristic

CGAP collected information on over 125 institutions

of the Islamic financial system is the strict prohibition

and contacted experts from 19 Muslim countries. The

on giving or receiving any fixed, predetermined

survey and a synthesis of other available data revealed

rate of return on financial transactions. This ban on

that Islamic microfinance has a total estimated global

interest, agreed upon by a majority of Islamic scholars,

outreach of only 380,000 customers and accounts for

is derived from two fundamental Sharia precepts:

only an estimated one-half of one percent3 of total microfinance outreach.

• Money has no intrinsic worth. Money is not an asset by itself and can increase in value only if it

The supply of Islamic microfinance is very concentrated

joins other resources to undertake productive

in a few countries, with the top three countries

activity. For this reason, money cannot be bought

(Indonesia, Bangladesh, and Afghanistan) accounting

and sold as a commodity, and money not backed

for 80 percent of global outreach. Nevertheless,

by assets cannot increase in value over time.

1 Honohon’s study finds that in the Islamic Development Bank’s 56 member countries, only 28 percent of the adult population uses formal (or semi-formal) financial intermediaries, whether through deposit accounts or borrowing. This percentage includes non-Muslims living in such countries. 2 Today, the total assets of Islamic financial products is estimated at US$500.5 billion (The Banker 2007) and the Islamic finance industry’s 100 largest banks have posted an annual asset growth rate of 26.7 percent, outpacing the 19.3 percent growth rate of their conventional counterparts (Kapur 2008). 3 Based on an estimated 77 million microcredit clients (Microfinance Information eXchange 2007a). 4 Sharia is derived from four sources. The main source of Sharia is the Quran, considered by Muslims to be divine scripture. The second most authoritative source of Sharia is hadith—the practice, conduct, and sayings of the Prophet Muhammad. If further clarity is required, jurists seek consensus on rulings among Islamic scholars. In the event that none of these sources provides the necessary legal authority, a jurist may use reasoning by analogy and apply an accepted principle or assumption to arrive at a rule of law. Adapted from http://www.expertlaw.com/ library/family_law/islamic_custody.html (accessed 22 March 2008).

2

• Fund providers must share the business risk.

be conflicting views on the implementation of these

Providers of funds are not considered creditors

principles in designing and extending Islamic financial

(who are typically guaranteed a predetermined

products.

rate of return), but rather investors (who share the rewards as well as risks associated with their investment). Islamic finance, however, extends beyond the ban of

Development of the Islamic Finance Industry Growth of Islamic Finance

interest-based transactions. Additional key financial principles include the following:

The global Islamic finance industry is rapidly growing. In the past 30 years, the industry has witnessed

• Material finality. All financial transactions must

the development of over 500 Sharia-compliant

be linked, either directly or indirectly, to a real

institutions, whose reach now spans 75 countries

economic activity. In other words, transactions

(KPMG 2006). These institutions include 292 banks

must be backed by assets, and investments may

(fully Islamic institutions and those institutions with

be made only in real, durable assets. This precludes

Islamic subsidiaries), 115 Islamic investment banks

the permissibility of financial speculation, and

and finance companies, and 118 insurance companies.

therefore, activities such as short selling are

Today, the industry’s total assets are estimated at

considered violations of Sharia.

US$500.5 billion (The Banker 2007).5

• Investment activity. Activities deemed inconsistent with Sharia, such as those relating to the

Since 2006, nearly 80 Islamic financial institutions

consumption of alcohol or pork and those relating

have been newly established or are being created

to gambling and the development of weapons of

(The Banker 2007). The 100 largest wholly Sharia-

mass destruction, cannot be financed. In broader

compliant banks have posted an annual asset growth

terms, Sharia prohibits the financing of any activity

rate of 27 percent, outpacing the 19 percent growth

that is considered harmful to society as a whole.

rate of their conventional counterparts (Kapur

• No contractual exploitation. Contracts are required

2008).

to be by mutual agreement and must stipulate exact terms and conditions. Additionally, all involved

Demand for Sharia-compliant investment portfolio

parties must have precise knowledge of the product

management is increasingly being met by Islamic

or service that is being bought or sold.

investment funds, which include private equity funds and approximately 250 Sharia-compliant mutual

The jurisprudence used to engineer Sharia-based

funds, with assets under management valued in

financial contracts is complex (see Box 1). Scholars

2006 at US$16 billion (Forte and Miglietta 2008). The

must complete several years of training before

Islamic bonds (sukuks)6 market is also growing since

becoming certified to issue financial rulings. The

Malaysia’s pioneering issuance of sukuks in 2001.

industry’s most prominent Islamic finance scholars

The size of the sukuk market in 2007 was estimated

are in general agreement on the basic set of financial

at US$47 billion, compared with US$10 billion in

precepts listed above. However, there is no centralized

2005 (AME Info 2008). The Islamic insurance market

Sharia finance authority, and consequently, there can

remains in its formative stage of development, with

5 Despite the rapid growth of Islamic finance, it remains a very small portion of the global market. While the largest Islamic bank, Bank Melli of Iran, has US$22 billion in assets, Mizuho Financial Group of Japan, the conventional banking industry’s largest bank, has total assets estimated at US$1.28 trillion. In fact, there are only six Islamic banks worldwide with assets exceeding US$10 billion. 6 Sukuks do not feature prominently in Islamic microfinance. For a discussion on sukuks, see Clifford Chance Limited Liability Partnership (2006).

3

Box 1. Basic Islamic Microfinance Contractsa The following are the most widely available types of Islamic microfinance contracts. Each can either operate individually or be combined with other contracts to create hybrid instruments.

maintenance, remains with the financier. An ijarah contract may be followed by a sale contract, in which event the ownership of the commodity is transferred to the lessee.

• Murabaha Sale (cost plus markup sale contract). The most widely offered Sharia-compliant contract is murabaha, an asset-based sale transaction used to finance goods needed as working capital. Typically, the client requests a specific commodity for purchase, which the financier procures directly from the market and subsequently resells to the client, after adding a fixed “mark-up” for the service provided. It is permissible for the financial institution to appoint the client as an “agent” on its behalf (by means of a contract) to directly procure the commodity from the market. However, ownership of the commodity (and the risk inherent thereto) strictly lies with the financier until the client has fully paid the financier. In most cases, clients repay in equal installments. The markup is distinct from interest because it remains fixed at the initial amount, even if the client repays past the due date. Among the primary conditions for a murabaha sale to remain Sharia-compliant are (i) the financier must own the commodity before selling it, (ii) the commodity must be tangible, and (iii) the client must agree to the purchase and resale prices.b

• Musharaka and Mudaraba (profit and loss sharing). The profit and loss sharing (PLS) schemes are the Islamic financial contracts most encouraged by Sharia scholars. Musharaka is equity participation in a business venture, in which the parties share the profits or losses according to a predetermined ratio. Musharaka can be used for assets or for working capital. Mudaraba denotes trustee financing, in which one party acts as financier by providing the funds, while the other party provides the managerial expertise in executing the project. In mudaraba, profits are shared according to a predetermined ratio; any losses are borne entirely by the financier. If the mudaraba joint venture results in a loss, the financier loses the contributed capital and the manager loses time and effort. Both PLS schemes require particularly vigilant reporting and a high level of transparency for profits and losses to be distributed justly. Consequently, though promoted strongly by Sharia, they result in substantial operating costs particularly for micro and small enterprises that are not accustomed to formal accounting.

• Ijarah (leasing contract). Ijarah is a leasing contract typically used for financing equipment, such as small machinery. Duration of the lease and related payments must be determined in advance to avoid any speculation. For the transaction to be considered Islamic (and not a sale with camouflaged interest), the ijarah contract must specify that the ownership of the asset, and responsibility for its

• Takaful (mutual insurance). The equivalent of Islamic insurance, takaful is a mutual insurance scheme. The word originates from the Arabic word “kafala,” which means guaranteeing each other or joint guarantee. Each participant contributes to a fund that is used to support the group in times of need, such as death, crop loss, or accidents. Paid premiums are invested in a Sharia-compliant manner to avoid interest.

a There is only one type of permissible “loan” according to Sharia, the Qard-Hassan (or Benevolent) Loan, which is interest-free and often considered a form of charity because it is typically forgiven in the event of default. All other mechanisms are better termed financing agreements, or contracts. However, for the purposes of this Focus Note, the term “loan” may be used to denote financing arrangements within the Sharia context. b Adapted from Khan (2008). c For a detailed discussion of takaful, see Maysami and Kwon.

Box 2. How Does Savings Work? Islamic savings products are deposits that are invested pursuant to the principles set forth in this paper. A typical savings product is a form of mudaraba, in which the saver “invests” her deposit in the business of a financial institution. The financial institution invests its managerial expertise and intermediates the deposits/ investments in a Sharia-compliant manner. Profits (or losses) are shared pursuant to prior agreement. Such

a savings arrangement also could be considered a form of musharaka because other depositors are also depositing funds for investment in the same financial institution. Even takaful can operate as a savings product because premiums are invested in a Shariacompliant manner and are often disbursed at the end of an agreed term, regardless of any insurance claim.

4

an estimated US$5 billion in premiums held in 2007

Northern Sudan, for example, adopted Sharia-

against a global insurance turnover of US$3.7 trillion

compliant regulatory frameworks for the entire

(Zawya 2008).

banking sector in 1984. Indonesia broke new ground in the realm of Islamic finance by creating in 1992 a

Global Expansion

formal, regulated Sharia banking sector alongside, and not instead of, its conventional banking sector.7

Despite its origins in the Persian Gulf, Sharia-compliant

New regulations in Malaysia, Brunei, and Pakistan also

banking has proved popular with Muslims in other

have supported the expansion of an Islamic finance

countries as well, leading to the development of new

industry alongside conventional financial services.

Islamic banks across North Africa and Asia. Of the total US$500.5 billion global Islamic finance market,

A second regulatory approach has been to address

36 percent is located in the Gulf Cooperation Council

the growth of Islamic finance by separately regulating

(GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi

unique aspects of Islamic banking, such as Sharia

Arabia, and UAE), 35 percent in non-GCC Southwest

Supervisory Boards (SSBs). For example, several

Asia and North Africa, and 23 percent in Asia (primarily

countries (such as Kuwait, Jordan, Lebanon, and

Malaysia, Brunei, and Pakistan) (The Banker 2007).

Thailand) have regulated the competence and composition of SSBs, as well as related rules governing

Over time, Islamic financial services also have

appointment, dismissal, and qualifications of SSB

expanded well beyond the Muslim world and are

members (Grais and Pellegrini 2006). However, no

offered not only by Islamic banks, but also by Islamic

country is known to regulate the Sharia jurisprudence

subsidiaries of international financial institutions.

to be used by SSBs in judging Sharia compliance

Islamic financial services are currently provided in

(though countries like Jordan and Kuwait do impose

countries such as India, China, Japan, Germany,

SSB member unanimity or majority vote requirements)

Switzerland, Luxembourg, the United Kingdom, the

(Grais and Pellegrini 2006).

United States, and Canada. The United Kingdom, which currently ranks tenth in The Banker’s listing

International Organizations

of “Top 15 Countries by Sharia-compliant Assets” (2007), has recently announced its aim to make

In parallel with increased attention by regulatory

London a global center for financial markets in the

authorities, international organizations also have

Muslim world.

been created to set Islamic finance accounting and other standards:

Government Regulation • The Islamic Financial Services Board (IFSB), based Islamic financial services originally operated in an

in Malaysia, issues prudential standards and

unclear regulatory landscape. However, as they

guiding principles for Islamic finance. IFSB has

expanded, they presented several regulatory

issued guidelines on risk management and capital

challenges that governments have attempted to

adequacy for Islamic banks.

address to various degrees.

• The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in

One approach has been to proactively encourage,

Bahrain, promotes financial reporting standards for

even mandate, Islamic financial services by law.

Islamic financial institutions.

7 Decree No. 72 (1992) concerning Bank Applying Share Base Principles.

5

• The Islamic Development Bank (IDB), a multilateral

• More than 60 percent of low-income survey

body headquartered in Saudi Arabia, fights poverty

respondents in the West Bank and Gaza claim a

and promotes economic development in Islamic

preference for Islamic products over conventional

country members. It promotes microfinance and

products. More than half of such respondents

poverty alleviation programs through its Islamic

prefer such products even if they come at a higher

Solidarity Fund for Development (ISFD), which

price (PlaNet Finance 2007).9

recently committed US$500 million to microfinance

• In Jordan, studies by USAID (2002) and IFC/FINCA

development through its Microfinance Support

(2006) show that 24.9 percent and 32 percent,

Program (MFSP).

respectively, of those interviewed cite religious reasons for not seeking conventional loans. The

Despite a shared core of Islamic values, these

IFC/FINCA study also showed that 18.6 percent

institutions often diverge with national regulators

of those interviewed rank religious reasons as the

(and each other) over Sharia standards. For example,

single most important factor in their decision on

AAOIFI standards are mandatory in only a handful of countries and are selectively implemented elsewhere (Islamic Banking & Finance 2008).

obtaining a loan. • In Algeria, a 2006 study revealed that 20.7 percent of microenterprise owners do not apply for loans primarily because of religious reasons (Frankfurt

Islamic Microfinance

School of Finance and Management 2006). • In Yemen, an estimated 40 percent of the poor

Demand

demand Islamic financial services, regardless of price.10

Conventional microfinance products have been

• In Syria, a survey revealed that 43 percent of

very successful in Muslim majority countries. One

respondents considered religious reasons to be

of the earliest microfinance programs originated in

the largest obstacle to obtaining microcredit. In

Bangladesh with the experience of the Grameen Bank

addition, 46 percent of respondents who had never

initiated by Nobel Prize winner Mohammed Yunus.

applied for a loan stated that religious reasons were

Islamic countries, such as Indonesia and Pakistan, have a

the primary reason they had never applied. Nearly

vibrant microfinance industry; approximately 44 percent

5 percent of current borrowers said they would not

of conventional microfinance clients worldwide reside

apply for another loan for religious reasons (IFC

8

in Muslim countries. Yet, conventional microfinance

2007b).

products do not fulfill the needs of many Muslim clients. Just as there are mainstream banking clients

In addition to the IFC–commissioned studies, a 2000

who demand Islamic financial products, there are

Bank Indonesia report indicated that 49 percent of

also many poor people who insist on these products.

the rural population of East Java considers interest

Indeed, Sharia compliance in some societies may be

prohibited and would prefer to bank with Sharia-

less a religious principle than a cultural one—and

compliant financial institutions.

even the less religiously observant may prefer Shariacompliant products.

Although there is a market of poor clients who strictly engage in Islamic transactions, there is also

A number of IFC-commissioned market studies suggest

a category of Muslim clients who use conventional

a strong demand for Islamic microfinance products:

products but prefer Islamic ones. Microfinance

8 Based on figures provided by the Microfinance Information eXchange. 9 Thirty-five percent of West Bank respondents and 60 percent of Gaza Strip respondents stated that they do not access finance because of the Islamic prohibition on interest. 10 Phone interview with executive director of the National Microfinance Foundation, Yemen.

6

practitioners11 in Muslim-majority countries indicate

arrangements for offering Islamic microfinance:

that in Afghanistan, Indonesia, Syria, and Yemen,

via (i) the creation of Islamic microfinance banks,

some conventional microborrowers tend to switch

(ii) Islamic banks, (iii) conventional banks, and (iv)

over once Islamic products become available.

conventional microfinance banks. The guidelines set forth requirements regarding licensing, appointment

Anecdotal evidence, however, suggests that survey

of Sharia advisers to rule on Sharia compliance, and

respondents may verbally express a preference for

segregation of Islamic product funds (and related

Islamic products simply to demonstrate piety or

documentation) by banks and MFIs that offer both

(when given a choice in practice) will opt for a lower

conventional and Sharia-compliant products.12

priced conventional product. Consequently, despite indications of demand for Islamic microfinance products, further research is needed to ascertain the

Banks Downscaling and Expanding Product Line

nature and extent of the demand and how to meet this demand in a cost-effective manner.

An encouraging development in the growth of Islamic microfinance is that Islamic commercial banks have

Government Promotion of Islamic Microfinance

started to offer Islamic microfinance services. Yemen’s Tadhamon Islamic Bank, for example, opened a micro and small enterprises division in late 2006 (IFC

As in the case of the larger Islamic banking industry,

2007a). In addition, some Islamic banks are planning

government regulation can play a significant role in

to offer Islamic microfinance products beyond just

the expansion of Sharia-compliant microfinance.

microcredit. On 20 January 2008, Noor Islamic Bank and Emirates Post Holding Group announced plans to

Indonesia. In Indonesia, the government has actively

establish a company that will offer Sharia-compliant

promoted Islamic microfinance. In 2002, Bank

banking services to the low-income segment of

Indonesia prepared a “Blueprint of Islamic Banking

the UAE population. The proposed company will

Development in Indonesia” in which it developed

provide a wide array of Islamic microfinance products,

a nine-year plan for development of the Islamic

including microcredit, insurance, debit and credit

finance sector, including support for the 105 Sharia

cards, remittance and currency exchange, and salary

rural banks. Indonesia now provides a supportive

payments (Emirates News Agency 2008). Also in

regulatory framework and has licensed 35 new Islamic

January 2008, Allianz Life Indonesia announced that,

rural banks in the past five years. Bank Indonesia

after an 18-month pilot project, the Sharia-compliant

also is spearheading efforts in capacity building by

microinsurance “Family Umbrella” product is now an

establishing a center in Medan to offer training and

established line.

certification on Islamic financial operations to Sharia rural bank staff, managers, and directors.

Islamic Microfinance: CGAP Survey Results

Pakistan. The State Bank of Pakistan, which already has a legal and regulatory framework in place for

CGAP conducted a global survey on Islamic

conventional MFIs, also developed guidelines in

microfinance in 2007, collecting information on over

2007 for the rapid expansion of Islamic microfinance.

125 institutions and contacting experts from 19

The guidelines stipulate four types of institutional

Muslim countries. This section presents the principal

11 These practitioners include FINCA (Afghanistan), German Technical Cooperation (Indonesia), Sanadiq in Jabal-al-Hoss (Syria), Social Fund for Sustainable Development (Yemen), and Hodeidah Microfinance Program (Yemen). 12 Guidelines for Islamic Microfinance Business for Financial Institutions (Annexure to Circular No. 05 of 2007), State Bank of Pakistan Islamic Banking Department, available at http://www.sbp.org.pk/ibd/2007/Annex-c5.pdf.

7

Box 3. What About Iran? The Iranian government requires all of its commercial banks to provide Sharia-compliant noninterest bearing loans to the low-income population. Typically, these loans are disbursed to cover personal expenses, such as wedding expenses, repayment of outstanding debts, home rental and repair costs, medical expenses, tuition fees, and the purchase of consumer goods. Outreach is very significant and, as of March 2008, the Central Bank of Iran estimated that 3 million families benefit from approximately 6,000 Qard-Hassan institutions (“benevolent loan funds” known in Iran as Qarzul-Hassaneh Funds), with a total outstanding loan amount of 50 trillion rials (or US$5.5 billion). However, Qarzul-Hassaneh Funds are most often considered charities, and not MFIs, because loans

are typically (i) made for large one-time expenditures and (ii) forgiven in the event of default. They are not generally considered to provide access to finance in a sustainable manner. Outside the Qarzul-Hassaneh Funds, microfinance in Iran is informal, though a number of originally charitable organizations have reportedly started microfinance operations. These organizations have been registered by the Ministry of Interior and are outside the scope of Central Bank regulation. Consequently, statistics on Iranian microfinance and Qarzul-Hassaneh Funds are not reflected in this Focus Note.

findings of this first global survey on the performance

by the CGAP survey is only 2,400 clients (and none

and outreach of Islamic microfinance.

has more than 50,000 clients).

Current Performance

The supply of Islamic microfinance is very concentrated in a few countries. Indonesia, Bangladesh, and Afghanistan

The outreach of Islamic finance is very limited.

account for 80 percent of the global outreach of Islamic

According to the CGAP survey, Islamic MFIs13 reach

microfinance. In all other countries, microfinance is still

300,000 clients through 126 institutions operating in

in its infancy, with no scalable institutions reaching

14 countries and an estimated 80,000 clients through a

clients on a regional and national level.

network of Indonesian cooperatives. According to the survey, Bangladesh has the largest Islamic microcredit

For most countries, the average Islamic microloan

outreach, with over 100,000 clients and two active

amount (with respect to primarily the murabaha

institutions. However, Bangladesh is also the country

product) is similar to conventional microloans.

where conventional microfinance products have the

There are notable exceptions, however, such as in

largest outreach—nearly 8 million borrowers—and

Indonesia (where the average Islamic product loan size

Islamic microfinance represents only 1 percent of its

is 45 percent higher than the average conventional

microfinance market.

microloan)15 and in the West Bank and Gaza.

In all Muslim countries, Islamic microfinance still

Like conventional microfinance, Islamic microfinance

accounts for a very small portion of the country’s

tends to focus on female clients—a majority of

total microfinance outreach. For example, in Syria and

Islamic MFI clients according to the CGAP survey

Indonesia, Islamic financing instruments comprised

were women (59 percent on average, but up to 90

only 3 percent14 and 2 percent, respectively, of

percent in Bangladesh). Overall, the percentage of

outstanding microfinance loans in 2006. In addition,

female clients using Islamic microfinance products (59

the average outreach of the 126 institutions covered

percent) is comparable to those using conventional

13 The term “Islamic MFI” in this Focus Note refers to any institution offering Islamic microfinance services and not just to Islamic institutions. 14 Sanabal Microfinance Network data. 15 Microfinance Information eXchange.

8

Table 1. Outreach of Islamic Microfinance, by Country Region

# of Included Institutions

% Female (Avg.)

Total # of Clients

10,347,29

Avg. Loan Balance (US$)

Afghanistan

4

22

Bahrain

1

n/a

323

96,565

299

Bangladesh

2

90

111,837

34,490,490

280

Indonesia*

53,011

Total Outstanding Loan Portfolio (US$)

162

105

60

74,698

122,480,000

1,640

Jordan

1

80

1,481

1,619,909

1,094

Lebanon

1

50

26,000

22,500,000

865

Mali

1

12

2,812

273,298

97

Pakistan

1

40

6,069

746,904

123

West Bank and Gaza**

1

100

132

145,485

1,102

Saudi Arabia

1

86

7,000

586,667

84

Somalia

1

n/a

50

35,200

704

Sudan

3

65

9,561

1,891,819

171

Syria

1

45

2,298

1,838,047

800

Yemen

3

58

7,031

840,240

146

TOTAL

126

59

302,303

197,891,882

541

* Micro and rural banks only. **There were seven MFIs in the West Bank and Gaza that offered, with the help of training and funding facilities offered by the Islamic Development Bank, a total of 578 Islamic loans between 2005 and 2006. Data on only one of these seven are displayed in the table because the remaining six MFIs were disbursing Islamic loans with average loan sizes higher than 250 percent of the region’s gross domestic product per capita.

microfinance products (65.7 percent globally, and 65.4

was provided by the Deprived Families Economic

percent in the Arab world) (Microfinance Information

Empowerment Program). The table excludes the

eXchange 2007b).

outreach of Indonesia’s 4,500 Islamic cooperatives. However, according to experts in Indonesia, only 60

Finally, the CGAP survey identified that over 70

percent of these Islamic cooperatives are still active,

percent of the products offered are murabaha. Islamic

and their total outreach is estimated at 80,000 clients.

MFIs generally offer only one or two Sharia-complaint

As in the rest of this Focus Note, an MFI is defined as

products. Concentrating primarily on asset financing,

an institution targeting the poor and whose average

the industry still lacks product diversification to serve

loan size is less than 250 percent of the country’s

the various financial needs of the poor.

gross domestic product per capita.

Table 1 includes the outreach data of only the

Islamic Microfinance by Institution Type

institutions that CGAP was able to contact during its survey, except with respect to those institutions in

Among the institutions that offer Islamic microfinance

Indonesia (about which information was obtained from

products, nongovernment organizations (NGOs) are

the Indonesian Central Bank’s 2007 Statistics) and in

the dominant players in reaching the largest number

the West Bank and Gaza (about which information

of clients, with just 14 institutions reaching 42 percent

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Table 2. Outreach of Islamic Microfinance, by Institution Type Total # of Clients Institution Type

# of Institutions

#

% of Total

Total Outstanding Loan Portfolio (Islamic) US$

% of Total

Avg. Loan Size (Islamic) US$

Cooperative

1

6,671

2

926,251

<1

132

Village Bank (Syria)

1

2,298

1

1,838,047

<1

800

NGO Rural Bank (Indonesia) NBFI Commercial Bank TOTAL

14

125,793

42

41,421,580

21

303

105

74,698

25

122,475,158

62

1,640

3

4,293

1

1,893,207

<1

595

2

87,569

29

29,030,997

15

305

126

305,237

100

198,090,268

100

629

Note: This table reflects the data of only those institutions (mixed and fully Islamic) that provided reliable outreach information to CGAP during its 2007 global survey of Islamic microfinance. Data regarding the 105 rural banks in Indonesia were obtained from the Indonesian Central Bank’s 2007 Statistics. This table excludes data on the outreach of Indonesia’s 4,500 cooperatives. As in the rest of this Focus Note, an MFI is defined as an institution targeting the poor and whose average loan size is less than 250 percent of the country’s gross domestic product per capita.

of clients. Commercial banks (represented by only

BPRSs are more socially oriented than BPRs. Their

two institutions: Yemen’s Tadhamon Islamic Bank

mission statement calls for supporting the community

and Bangladesh’s Islami Bank Bangladesh Limited)

and, in particular, microentrepreneurs. They also have

have the second largest outreach with over 87,000

strong links with Indonesian Muslim mass movements,

clients. Interestingly, 105 Sharia-compliant rural banks

such as Nahdlatul Ulama or Mohammedia. Each

in Indonesia account for 25 percent of total clients, but

BPRS has a Sharia board to monitor the conformity

62 percent of the outstanding loan portfolio because

of products to Islamic principles. However, board

of their significantly higher average loan size and focus

rulings are not consistent, and consequently, Islamic

on small and microenterprise financing.

microfinance products can vary widely depending on the specific BPRS. BPRSs primarily offer murabaha

Focus on Indonesia

products and savings services based on a revenuesharing model.16 They have been quite successful at

Indonesia gives insight into the development of Islamic

mobilizing savings for the community, and their loan-

microfinance because of its dual conventional/Islamic

to-deposit ratio is over 110 percent.

microbanking system, which includes both conventional rural banks (Bank Perkreditan Rakyat or BPRs) and

It is impossible to draw general conclusions on the

Sharia-compliant rural banks (Bank Perkreditan Rakyat

performance of Islamic MFIs based only on the limited

Syariah or BPRSs). BPRSs are privately owned and are

case of Indonesian BPRSs. Nevertheless, BPRSs offer

regulated and supervised by Bank Indonesia. They are

some insights on profitability and efficiency.

licensed to offer banking services (loans and savings facilities, but no payments services) in a district area

Higher costs. The average operational efficiency ratio

only. As of December 2006, there were 1,880 BPRs

of BPRSs is 20 percent—higher than the 15 percent

and 105 BPRSs.

operational efficiency ratio for conventional BPRs.

16 This savings product is a form of mudarabah (see Box 1) in which the depositor acts as “financier.”

10

Table 3. Financial Performance of Indonesian MFIs Compared to Small Asian MFIs

Institution Type

Number of Institutions

Average Total Assets (US$)

Average Outstanding Loan Portfolio (US$)

PAR > 30 days

Operational Efficiency Ratio

ROA

105

1,538,571

1,166,476

8.67%

20%

1.41%

1,880

1,225,797

n/a

9.73%

16%

2.21%

30

1,244,593

886,728

1.90%

Sharia Rural Banks (BPRSs) Conventional Rural Banks (BPRs) Small Asian MFIs

9.60%

3.40%

Source: Bank of Indonesia (2007a). Operational Efficiency figures are based on BPRs in North Sumatra (Microfinance Innovation Center for Resources and Alternatives).

The difference may reflect the higher transaction

the ROA of BPRs (2.2 percent). However, the range

costs inherent in certain Sharia-compliant products.

for both was wide, with several being very profitable

BPRSs are mainly engaged in murabaha, which incurs

and others not breaking even. BPRSs are still young

the expense of first procuring the commodity to be

institutions without a proven track record. It is too

later resold and the expense of managing its resale

early to draw conclusions about BPRS profitability;

through the murabaha contract. However, although

however, several factors might explain a lower ROA,

overall transaction costs are higher, the extra cost to

including the social mission of BPRSs.

the customer may be offset by wholesale prices and the related saving of time otherwise spent selecting

BPRSs are meeting a growing demand for Sharia-

suppliers and negotiating contract terms. Both BPRs

compliant microfinance products. Their rate of growth

and BPRSs do not compare well with their closest

has been impressive: from March to December 2007,

17

“peers”—small MFIs in Asia —as far as operational

these banks’ murabaha receivables increased by

efficiency is concerned. This could be due to a number

26 percent, musharaka financing increased by 27

of factors, including average loan size, cost structure,

percent, and mudaraba financing increased by almost

and staff productivity.

50 percent (Bank of Indonesia 2007b). BPRSs can be profitable but nevertheless, like many microfinance

Elevated portfolio delinquency, but improving over

providers, they face several challenges in reaching

time. The average portfolio at risk (PAR) at 30 days for

sustainable scale (see Box 4).

both BPRs and BPRSs are comparable at approximately 9 percent—high by microfinance standards. By comparison, small Asian MFIs have a PAR at 30 days

Possible Challenges to the Growth of Islamic Microfinance

of 1.9 percent. But over time, late payments seem to be recovered and long-term loss (defined as payments

Islamic microfinance could potentially expand access

more than 180 days overdue) for BPRSs is reported

to finance to unprecedented levels throughout the

at 3.1 percent.18 Consequently, portfolio delinquency

Muslim world. However, the industry has yet to

does not generate significant long-term loss.

demonstrate it can provide financial services that meet the needs of poor people on a large scale. A

Lower return on assets (ROA). The average ROA for

deeper base of market research and proven business

BPRSs was 1.4 percent in 2006, significantly lower than

models are very much needed. Nevertheless, several

17 As identified in the MicroBanking Bulletin (2007). 18 Statistik Perbanken Syariah (Islamic Banking Statistics), Bank Indonesia (Direktorat Perbanken Syariah), December 2007.

11

Box 4. A Tale of Two Islamic Microfinance Banks BPRS Wakalumi in Ciputat, was established in 1990 by a foundation (Yayasan Wakalumi) as a conventional BPR; for religious reasons, it converted into a BPRS in 1994. It has 118 shareholders, among them Bank Muamalat Indonesia (19 percent, down from 49 percent), the former Minister of Cooperatives (23.5 percent), a Citibank manager (26 percent), the founding foundation Yaysan Wakalumi (5.6 percent), and more than 100 individuals, mostly Muslims working at Citibank.

2003 of 4.1 percent, 3.65 percent, and 3.35 percent and ROEs of 20.3 percent, 21.05 percent, and 24.1 percent, respectively, it is highly profitable.

The bank seems to have a successful staff promotion strategy: the president director, with a bachelor’s degree in agriculture, has been with the bank since 1994, learning on the job and being promoted up the ranks; the director, a woman with a diploma in accounting, has been an employee since 1997 and was promoted to director in 2003. The bank has grown rapidly, and now has five branches and a staff of 38, including 13 loan officers.

The bank, located next to a local market, has 1,150 savers and 163 clients. With a staff of 11, including six loan officers, it offers doorstep collection services to about 200 clients a day. It also offers deposit services to school children and institutions. Total assets are IDR 1.4 billion, deposits total IDR 0.62 billion, and financings outstanding equal IDR 1.21 billion.

Its 2,000 clients are mostly small traders on traditional markets, to whom it sells its financings as Islamic products. It has four financing products, with murabaha being the dominant one. Through eight savings products and four term deposit products, it has attracted 5,000 savers. With ROAs in 2001–

BPRS Artha Fisabililah, in Cianjur, was established in 1994 by nine shareholders. By 1997, as a result of lack of management experience, it was technically bankrupt and was restructured. The new management was not very dynamic and was replaced in 2001 by a retired bank credit officer.

Its overall performance is not yet satisfactory. Its main problem is lack of funds, because of a shortage of deposits and capital from the owners. The bank was in the black for the years 2001, 2002 and 2003, with ROAs of 2.3 percent, 1.7 percent, and 2.4 percent and ROEs of 7 percent, 4.3 percent, and 8.75 percent, respectively. Its main future strategy to improve efficiency is staff upgrading through training.

Source: Adapted from Seibel (2007).

possible challenges to scale up Islamic microfinance

poor. Managing small transactions is expensive, and

can be identified.

MFIs must innovate to reduce transactions costs. In murabaha or ijara transactions, the provider of

Building Sustainable Business Models

funds purchases a commodity (such as equipment or inventory) and resells or leases it to the user with

Islamic microfinance business models are still

a markup. Islamic MFIs may benefit from cheaper

being developed and no performance benchmarks

prices on the wholesale market, but the costs

have been established. However, two areas are of

associated with purchasing, maintaining, selling, or

particular importance: operational efficiency and risk

leasing a commodity (such as a sewing machine) are

management.

expensive, and the added costs are often passed on to clients. However, some institutions have cut

• Operational efficiency. Operational efficiency is

their costs in murabaha transactions by requiring

key to providing affordable financial services to the

the end user to search for and identify the desired

12

commodity. Islamic institutions should consider

financial experts and Sharia experts on product

developing similarly novel techniques and practices

authenticity, (ii) encourage exchange of experiences

to minimize costs and offer more attractive pricing

among religious leaders (particularly those serving

to their clients.

poor populations at the local level) relating to Sharia

• Risk management. Risk management is another

compliance of microfinance products, and (iii) educate

important factor to building sustainable institutions.

low-income populations, in collaboration with local

The conventional microfinance industry has

religious leaders, on how financial products comply

developed a set of good practices to manage credit

with Islamic law.

risk, and MFIs boast excellent portfolio quality.19 Conventional MFIs generally do not secure loans

Building Capacity

through collateral but instead rely on peer pressure and strict discipline for collection. Such techniques

Capacity building is needed at all levels to realize

should be adapted to comply with the risk-sharing,

the full potential of Islamic microfinance. At the

and no-interest principles embedded in Islamic

macro level, the Islamic Development Bank and

finance. For example, some suggest that pressure

Islamic financial standard setters (such as IFSB or

from the religious community and appeals to a

AAOIFI) should consider developing global financial

sense of religious duty should complement reliance

reporting standards adapted to microfinance to

on peer pressure.

build the infrastructure for transparency in the global Islamic microfinance sector. This infrastructure

The Question of Authenticity

would entail comprehensive disclosure guidelines on Islamic microfinance accounting principles, pricing

Although there is ample evidence of demand for

methodologies, financial audits, and eventually, rating

Islamic microfinance products, meeting such demand

services.

requires that low-income clients are comfortable that the products offered are authentically Islamic. Critics

At the micro and institutional levels, international

of Islamic finance products suggest that the pricing

donor agencies can play a major role in expanding

of some products offered as Sharia-compliant too

access to finance in Muslim countries by helping

closely parallels the pricing of conventional products.

existing institutions reach scale and funding pilot

For example, some institutions offer murabaha where

projects testing various business models. In addition,

interest appears to be disguised as a cost markup or

more efforts should be made to train Islamic MFI

administration fee. Islamic finance sometimes suffers

managers and staff through, for example, the

from the perception that it is simply a “rebranding”

development of operational tools and manuals (such

of conventional finance and not truly reflective of

as those developed by Deutsche Gesellschaft für

Islamic principles.

Technische Zusammenarbeit for use in Indonesia).

Consequently, low-income populations, who often

Product Diversity

rely on local religious leaders to address questions of religion, must be convinced of the authenticity

Islamic MFIs rely heavily on the murabaha (cost plus

of Islamic financial products if Islamic microfinance

markup sale) product.20 However, poor people have

is to reach its full potential. Greater efforts should

diverse financial requirements, and for many, savings

be explored to (i) increase collaboration between

or housing products may be more urgent needs. The

19 The 1,200 MFIs reporting to the Microfinance Information eXchange report an average PAR at 30 day is less than 5 percent. 20 The murabaha sale is the sole product of 34 percent of the MFIs operating in Northern Sudan. In addition, as of December 2006, murabaha sales accounted for 62.3 percent of the outstanding portfolio of Indonesian Islamic rural banks.

13

innovative design of a range of Sharia-compliant

tendency to view zakat (funds donated pursuant to the

products and services would provide greater financial

Muslim obligation to pay alms) as a source of funding.

access to a broader segment of Islamic microfinance

Indeed, given the underlying principle of Islamic

customers.

finance to promote the welfare of the community, zakat funds appear ideally suited to support Islamic

Leveraging Zakat and Islamic Funds

microfinance. However, a heavy reliance on charity is not necessarily the best model for the development

Throughout the Muslim world, microfinance (Islamic

of a large and sustainable sector, and more reliable,

or otherwise) is still seen as a philanthropic activity

commercially motivated streams of funding should

rather than a business enterprise. Consequently, in

be explored.

the context of Islamic microfinance, there is a growing

14

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Kapur, Suchita. 2008. “Islamic Banks Post 26.7% Growth Rate.” Emirates Business 24/7, 24 March.

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Microfinance Information eXchange. 2007a. “How

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No. 49 August 2008

Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: [email protected] © CGAP, 2008

The authors of this Focus Note are Nimrah Karim; Michael Tarazi, senior policy specialist, CGAP; and Xavier Reille, lead microfinance specialist, CGAP. The authors would like to thank the following for their help in producing this Focus Note: Matthias Range, Mohammed Khaled, Samer Badawi, Wafik Grais, Meynar

Sihombing, Hans Dieter Seibel, Syed Hashemi, Steve Rasmussen, Deepak Khana, Momina Aijazuddin, Kate McKee, Ignacio Mas, Jeannette Thomas, the Sanabel Microfinance Network, the Islamic Development Bank, the Islamic MFIs, and all other institutions participating in the CGAP survey.

CGAP publications are frequently cited in other works. The suggested citation for this paper is as follows: Karim, Nimrah, Michael Tarazi, and Xavier Reille. 2008. “Islamic Microfinance: An Emerging Market Niche.” Focus Note 49. Washington, D.C.: CGAP, August.

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