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How Does Islamic Microfinance Work?

To provide small size loans and insurance to the people with small means

, who have less access to procure big or macro loans from the mainstream commercial banks, is what microfinance, is. Microfinance is initiated to finance the people with small earnings to alleviate poverty, reduce disparity in income and enhance the equitable distribution of wealth. But the interest based financing at micro level seems to be less beneficial. The problems faced by micro enterprises are:

The ratio of revenues is low because of credit risk,

The costs are high owing to high cost of business operations, which include the salaries of workers, rent, utilities bills etc.

Above all, the specter of fixed amount of interest to be paid to bank.

The leadership and management of Islamic finance, too, aims at the same goals of poverty alleviation as set by the motives behind microfinance. But Islamic finance insists on establishing interest free monetary system, based on Musharakah and Mudarbah. But the implementations of Islamic finance on micro level contain some problems. For example, it is based on the principle of sharing profit and bearing loss, which seems to be unattractive to many. In this treatise, a quick view is tried to be presented to prove that Islamic finance is the most beneficial for the real economic progress and, also, an attempt is made to suggest solutions for the underlying problems in the implementation of Islamic microfinance.

At state level, the leadership and management of a government can create an Islamic microfinance unit in collaboration with the state banks, which collect investment through Sukuk issuance from the individuals willing to invest on the bases of Mudarabah and Musharakah (Sukuk is an Islamic form of bond certificate of the conventional bonds.) This can also be done by Islamic banks.

In this system the managing authority: governments especial unit for microfinance or Islamic banks becomes Wakeel or agent of the investors or Sukukholders. The Sukukholder becomes partner in the joint venture, in which the managing authority invests. The investment can be made, for example, in kiosks, taxi driving, tailoring, small farms and small dairy etc. The ratio of profit is fixed and agreed upon between the Sukukholders and the working partners, who take money to invest in his small enterprise. The managing authority charges a fixed agreed upon amount for its managing services.

It is a matter of fact that the profits generated through microfinance are usually very high as compared to that of macro finance. If a large enterprise flops, it creates havoc to the investors; and if earns a huge profit, gives out only a fixed amount as interest to investors. On the contrary, due to diversification of investment in microfinance, the possibility of loss is negligible. Since the investment is made in different small enterprises, so if partially some small enterprises fail to yield profits, the overall micro business, the most probably, yields profit. The risk of loss is diversified into a number of small business enterprises. So the possibility of loss is but a theoretical assumption.

For example, one million dollars invested in microfinance not only yield profit but due to diversification of investment make the probability of loss actually negligible, while the same amount of investment in a macro business if generates that much profit, involves high risk!

Risk Mitigation:

The risk can further be mitigated if some of the investment for microfinance is made in the avenues that provide fixed return as Sukuk Ijarah or lease, in which a fixed amount is charged as rent or as wages for provided services, for example, Car Ijarah (car lease), laptop Ijarah, money transaction etc.

The risk can further be minimized if government comes forward to guarantee against the loss sustained by the microfinance.

Guarantee on behalf of the working partner can be obtained through a third party, other than investor and working partner.

This can also be done if Islamic insurance (Takaful) companies guarantee against the loss. So the small enterprise can be insured by Islamic insurance or Takaful companies.

Islamic finance is a reality and contains enormous economic potential for financial progress, but it needs able leadership and management skills to launch them in the real world. These skills can be attained if the leadership development programs in Islamic finance are well worked out and launched in an effective way. The leadership development programs should be of high focus to produce future leaders in Islamic finance.

by: Anna Williams
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