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Islamic Banking and Microfinance

Wan Kamarudin Bin Wan Omar 0700335

AT3002_HHI

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0700335 This is Professional Practice Paper for fulfillment of AT3002_HHI of Part 3 of Certified Islamic Financial Professional (CIFP) INCEIF

January 2010

Islamic Banking and Microfinance

Wan Kamarudin Bin Wan Omar

Abstract Microfinance has been in practice around the world to help poor people and eradication of poverty. However, microfinance activities are being dominated by conventional financier and Islamic banks appears to be less interested to

venture into this area. The aim of this paper is to argue that since Islamic banks are established under Shariah, they should strive to fulfill Islamic philosophy on social justice, equal wealth distribution and eradication of poverty in the society. The Islamic banks should play his role well in empowering people and promote egalitarian society. Eventhough there are many ways to achieve it, microfinance is one of the scheme which Islamic banks should perform well.

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0700335 1. Introduction Islam strives for social justice in the society. Social justice is being defined as giving each individual what he/she deserves, distribution of financial benefits in the society and providing equally for basic needs. It is also the egalitarianism in opportunities, i.e. each person has a chance to climb up the social ladder1. One of the ways to achieve social justice is by having fair distribution of wealth within a society and prohibits concentration of wealth to certain segment of people only. There should be no monopoly in the wealth accumulation and wealth should circulate as spread as possible. This vision has been stated in Al-Quran:
So that this wealth should not become confined only to the rich amongst you (59:7):

Despite Islam promotes social justice and just distribution of wealth in the society, the ideal vision is not reflected into reality. Muslim countries throughout the world are still grappled with the poverty within their country. It is estimated that2:
400 million of the 1 billion people estimated to be in absolute poverty lived in 31 of the 56 OIC member states i.e. 40% of the world' Five large states Indonesia, Pakistan, Nigeria, Bangladesh and Sudan with cumulative population of 690 million people have 250 million people living below poverty line. The incidence of poverty in these countries is slightly above 36%;

1 2

http://www.neareast.org/phil/en/page.asp?pn=24 www.isis.org.my/files/events/Sess3-IshratHusain.pdf

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Fifteen states with a total population of 143 million people out which more than 50% i.e. 74 million live below the poverty line face severe problems and also on slipping path as far as fight against poverty is concern; Nine states inhabiting 113 million people have 55 million poor Two states i.e. Uzbekistan and Albania with a population of 30 million people have 8 million poor i.e. incidence of poverty is 27% and is manageable.

Malaysia which is being regarded as a relatively well-off country compared to other Muslim countries also has it share of wealth inequality within the society. According to UNDP report on Malaysia3:
The proportion of all Malaysian households in poverty was 5.96 per cent in 2004. However, this figure masks substantial variation across the countrys states, communities, and between rural and urban areas. Poverty is particularly concentrated in the five low income states. In 2004 there were 5,459.4 thousand households in Malaysia, 5.96 per cent of which were poorover 325,000 households. Three quarters of these households live in the five poorest states: Kedah, Kelantan, Terengganu, Sabah, and Sarawak. Of poor households in 2004, 37 percent live in Sabah. Poverty in Malaysia is increasingly a regional problem. Poor households also tend to be the larger ones, so the individual and child poverty rates are above the proportions of poor households. In
3

UNDP: Malaysia Measuring and Monitoring Poverty and Inequality, pg 79

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2004 the proportion of Malaysian children in poor households was over 12 per cent. The proportion of poor children in Sabah was over 40 per cent. Relative poverty rates have tended to be constant over time. Roughly 1 in 5 households received an equivalized income less than half the Malaysian median income.

The above statistic shows that, there is miss-alignment between the Islamic thrust on wealth distribution which should be as spread as possible with the reality of the Muslim countries. There are segments within the society which still grappled with inadequate basic necessities and trapped in the vicious cycle of poverty.

2. Islam & Wealth Distribution As being stated earlier, the objective of Shariah is to ensure social justice and equitable distribution on income in the society. No one in the society should be left behind especially to live without basic necessities. The Prophet Muhammad (pbuh) view poverty as a threat and dangerous situation from which people in the society should do away with and pray to Allah for protection. The Prophet (pbuh) said that:
O my Allah, I refuge to you from the evils of poverty4

In another hadith, the Prohet (pbuh) said that:

Refuge to Allah from the evils of poverty, famine, degradation, oppressing and oppressed5.
4

Ibn Hanbel, VI/57,207; Ebu Davud, Edeb, 101; Al Nesai, Istiaze, 14, 16: Sehiv, 90

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0700335 The hadith above equates poverty as evil. Lack of resources for basic necessities destroys poor people since they have no means to support their live and family. This situation will create social problems within the society. A father will have no means to provide his family with meals to prevent them from hunger. He is also not able to provide his children with education which useful for better employment for better life. In addition, he may not have access to health services. At the end, it will force him to beg or in extreme cases, involve in unhealthy activities which will create more social problems. In searching for wealth, Islam encourages the believer to work hard and receive gain based on their effort. Verse in Al-Quran stated that:
"And when the prayer is finished, then disperse in the land and seek of Allah's grace, and remember Allah much, that you may prosper." (AlQuran, 62:10)

The encouragement in the Quran to work is further re-enforce by the hadith from the Prophet (pbuh). He said that:
"No one has ever eaten any food that is better than eating what his hands have earned. And indeed the Prophet of Allah, Dawud, would eat from the earnings of his hands."6

The verse and hadith above shows that, Islam does not want their follower to beg, instead it promotes effort and hard work by each Muslim to acquire wealth. Sadaqah receive by beggar is not sustainable since it will finish or discontinue by the givers. When this happened, they will be back at their old

5 6

Ibn Hanbel, II/540 Reported by Al-Bukhari

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0700335 state. Islamic strategy in dealing with poverty can be further observed in the following hadith: A man of the Ansar community came to the Prophet (pbuh) and
begged from him. He (the Prophet) asked: have you nothing in your house? He (the man) replied: Yes a piece of cloth, which we wear, or which we spread (on the ground), and a wooden bowl from which we drink water. He (the Prophet) said: Bring them to me. He (the man) then brought these articles to him and he (the Prophet) took them in his hands and asked to the assembly of people: who will buy these? A man said: I shall buy them for one dirham. He (the Prophet) asked twice or thrice: Who will offer more than one dirham? Another man said: I shall buy them for two dirham. He (the Prophet) gave these to him and took the two dirhams and, giving them to the man of the Ansar, he said: Buy food with one of them, and hand it to your family, and buy and axe and bring it to me. He then brought it to him. The Prophet (peace be upon him) fixed a handle on it with his own hands, and said: Go gather firewood and sell it, and do not let me see you for a fortnight. The man went away and gathered firewood and sold it. When he had earned ten dirhams, he came to him and bought a garment with some of them and food with the others. The Prophet (pbuh) then said: This is better for you

than that begging should come as a spot on your face on the Day of Judgment. Begging is right only for three people: one who is grinding poverty,

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one who is seriously in debt, or one who is responsible for compensation, and finds it difficult to pay7

The hadith above shows that the poor person is capable to become successful if he is given adequate opportunity to be involved in economic activities. Small capital which made available to him can be used to generate sustainable income to support their family. From the hadith, we can conclude that, to overcome the issues of poverty and inequality of wealth distribution in the society, Islam advocates economic empowerment. Economic

empowerment means that the poor people is given opportunity to improve themselves by being involves in economic activities to uplift himself and his family living standard. This is where the function of Islamic banks is important to fight poverty and improve wealth distribution in the society. Islamic banks are financial intermediaries, where one of the roles is to channel capital surplus in the society to people who are in need of capital, in this case to poor people.

3. Islamic bank and its function in wealth distribution Globally, Islamic banking industry has shown tremendous growth over the past decades with more than 20% growth for the past five years8. According to The Bankers Top 500 Islamic Financial Institutions survey9, assets held by fully Shariah-compliant banks or Islamic banking windows of conventional

7 8

Sunan Abu Dawood, Kitab al-Zakah, Book 9, Number 1637 http://www.calyon.com/mediaroom/interviews/the-growth-of-islamic-banking-is-seen-as-an-importanttrend-and-not-just-a-fashion.htm 9 http://gifc.blogspot.com/2009/11/double-digit-growth-for-islamic-banking.html

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0700335 banks rose by 28.6 percent to $822bn from $639bn in 2008. Comparatively, within the same period, the worlds conventional banks only posted annual asset growth of 6.8 percent. In Malaysia, currently there are 17 Islamic banks and the industry has grown tremendously with estimated annual growth rate of 18% to 20% annually10. The attractiveness of Islamic banks is due to it operations is based on the Shariah foundation. Thus all dealings, financing and investment conducted by Islamic banks are complied with Shariah principles. Shariah obliged for the transactions to be free from the prohibited elements of riba (usury), maisir (gambling) and gharar (uncertainty). It also discourages involvement of Islamic banks in transactions which inconsistent with Islamic values such as illegal activities, production of harmful materials and useless products. Nevertheless, the function of Islamic banks is not only to offer Shariah compliance products. As the name suggested, it carry religious connotation and obligation. As a bank establish under religion of Islam, it must strive to fulfill the objective of Shariah. Shariah means a waterway that leads to a main stream, a drinking place, and a road or the right path11. From the meaning, we concurred that Shariah is a tool (as a passage) to achieve certain goal or objective. So what is the objective of Shariah? According to Imam Al-Ghazali:
The objective of the Shariah is to promote the well-being of mankind, which lies in safeguarding their faith, their human self, their intellect, their

10 Bank Negara Malaysia: Annual Banking Statistics 2007 11 http://theislamiclaw.wordpress.com/

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posterity and their wealth. Whatever ensures the safeguard of these five serves public interest and is desirable12

Generally speaking Shariah aims at protecting and preserving public interest, and it aims at removing hardships from people and providing them with solutions to their problems13. This is the fundamental differences between Islamic banks and conventional banks. Conventional bank is based on capitalism where focus is on profit maximization. Whereas Islamic banks have to ensure that they contribute to the achievement of objective of Shariah, which means to focus on its role in the society. However this doesnt mean that the Islamic banks are a charitable organization and should not generate profits. As a business entity, the banks have to generate profits to ensure their sustainability of their business. Islam recognize the right for wealth, accept income disparity and different level of social standing in the society due to the fact that each person has different level of intelligent, strength, skill set and passion in pursuing economic activities. Hence some of the people will be an employer with others work as their employee. In the Al-Quran, Allah has stated that:
''We have distributed their livelihood among them in worldly life, and have raised some above others in the matter of social degrees, so that some of them may utilize the services of others in their work." (43:32)

12 13

Chapra 2000a, P118 http://theislamiclaw.wordpress.com/

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0700335 However, there should be no situation where the wealth disparity is wide where certain segment in the society is struggles for end meet. Thus mechanism must be in place where there is ample opportunity in place for people to work hard and gain their own wealth. Islamic bank plays crucial role in the society due to their function as financial intermediaries. They provide link between surplus capital unit and deficit capital unit. Individual with excess capital deposits their money in the bank. The banks subsequently disburse the money to the entrepreneur who in need of capital for their business operation. Using this scenario, the Islamic banks have a privilege to decide where the money will be channeled. If Islamic banks decide to channel it to certain group of people, lesser capital is left to be channeled to the other groups of people. Thus, if the Islamic banks bank are decided to pursue profit maximization, off course they will channel it to good credit standing and profitable business. However, if the Islamic banks want to play their role as espoused by Shariah, they will ensure that there is adequate allocation of capital to the less fortunate people in the society. The above scenarios show that the act of Islamic banks gave wide implications on the access to capital within the society. Better access to capital will help poor people to participate in economic activities and uplift their economic. Dr Umer Chapra wrote that:
Lack of access of the poor to finance is undoubtedly the most crucial factor in failing to bring about a broad-based ownership of businesses and industries, and thereby realizing the egalitarian objectives of Islam. Unless

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effective measures are taken to remove this drawback, a better and widespread educational system will only help raise efficiency and incomes but ineffective in reducing substantially the inequalities of wealth. This would render meaningless the talk of creating an egalitarian Islamic society. Fortunately, Islam has a clear advantage over both capitalism and socialism which is built into its value system and which provides bitting power to its objective of socio-economic justice Chapra [1992: 260 261]

In addition to the social centric obligations as outline by the religious requirements, from the user side, there is growing demands by the stakeholders who want Islamic banks to play active roles in social duties. A survey conducted by Dr. Asyraf Wajdi Dusuki (2008)14 on the stakeholders of Islamic banking which comprised seven stakeholders group; i.e. customer, depositors, local communities, Islamic banking manager, employees, banking regulatory officers and Shariah Advisors concluded that:
The most important fact revealed by this study is that stakeholders of Islamic banks view the industry much more favourably by the social and ethical goals that it serves, rather than mechanics of its operation. One of the most important reflections of their attitude is that social-welfare factors are evidenced as more important objectives than commercial factors in their perceptions towards Islamic banking. This result implies that Islamic banks must ensure that all of their transactions are Shariah compliant not only on

Dr. Asyraf Wajdi Dusuki, Understanding the Objectives of Islamic Banking: A survey of Stakeholders perspective (2008)

14

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their forms and legal technicalities but more importantly the socio-economic substance which is premised on the objectives outline by Shariah.

The above discussion shows that Islamic banks have crucial roles to ensure better wealth allocation in the society. Members of the society also have high expectation for Islamic banks to perform their function well.

4. Islamic Banks and Micro-finance Scheme Islamic banks need to effectively fulfill the objective of Shariah and also to satisfy the expectations of society where they operate. This means that Islamic banks have to find an appropriate scheme. Through the selected scheme, Islamic banks will offer economic empower to the poor people for them to have sustainable income and ultimately uplift their living status. The scheme also should be sustainable, means that it will not contribute to failure of Islamic banks due to high risk involved. Due to these factors, microfinance scheme is a perfect fit into the agenda. Microfinance is a micro-financing practice in which the financing is extended to those who have difficulty to access financing due to lack of collateral, low credit rating and lack of credit history. The definition of microfinance varies. Among the definitions are: i. Programme that extend small financings to very poor people for self employment projects that generate income in allowing them to take care of themselves and their families (Microcredit Summit 1997)

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0700335 ii. Microfinance is the provision of financial services to low-income clients, including consumers and the self-employed, who traditionally lack access to banking and related services (Wikipedia) iii. The provision of small financings (microcredit) to poor people to help them engage in productive activities or grow very small businesses. (www.pbs.org) iv. Financial services - such as financings and savings - directed toward the poor. (http://library.thinkquest.org/05aug/00282/other_glossary.htm)

Micro-finance is compatible with the objectives of Islamic banks since both focuses on the well-being of the society as a whole with the objectives of just and equitable wealth distribution. They strive to promote the egalitarian approach for social justice in which everybody have equal opportunity in the economic activities and no restriction to any category or group of people. Since financing to higher credit grading person are readily available, the micro-finance scheme focuses on the poor, deprived and destitute segments of the society. This will ensure that, the poor people will have the same opportunity to get involve in the economic activities by having access to capital. Furthermore, micro-finance can be used as a tool for financial inclusion. Financial inclusion by definition is the delivery of banking services at affordable costs to vast sections of disadvantaged and low income groups15.

15

http://en.wikipedia.org/wiki/Financial_inclusion

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0700335 Under normal financing, due to the perceived high risk group segment, the financing charge imposed on this group of people is normally high. Via microfinance, there is a potential that the charges will be accommodative or in better way, based on the capability of these micro-entrepreneurs. In a nutshell macro-finance can be used to promote participation of every individual within society. If previously, poor people is handicap economically and not able to actively participate in the economic activities due to incapability to obtain capital, micro-finance will give them new opportunity, not like before. Involvement of Islamic banks in the micro-finance will give added value to the whole scheme. This due to the nature of Islamic finance which prohibit financing to all form of economic activities which are morally and socially detrimental to the society. For example, the Islamic banks are prohibited from financing alcoholic drinks which will contribute to social ill within the society. It also prohibited from financing activities which is harmful to the nature such as dangerous chemical which produce toxic waste and pollute the environment. Due to prohibition of this type of activities in the society, Islamic banks will contribute to healthy and harmonious living of community. Among the features of micro-finance are: a. Financing is for short-term period. b. The financing is small. In Malaysia, the financing amount ranges from RM500 to RM50,000 (BNM).

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0700335 c. The financing is meant for micro-entrepreneur, which consists of self-employed, hawkers, traders and small businessmen. It also targets the poor to start business activities. d. Purpose of financing is for new business ventures or business expansion. e. The term and condition of financing is easy to understand and flexible. The above features means that the microfinance financings focus is the underprivileged segment. This is the reason why it being designed to be simple and does not require high level of knowledge to understand and operates it. However, it would be useful to find whether, based on experience, the micro-finance is really useful in helping the poor and alleviating the poverty within the society. Christopher Dunford (2006) in his article titled Evidence of Microfinances contribution to achieving the Millennium Development Goals concluded that:
.. there is already enough evidence to say with cautious confidence that microfinance can and does contribute to achievement of the Millennium Development Goals16, and in a major way already in Bangladesh, if not in other developing countries.

16

The Millennium Development Goals (MDGs) are eight goals to be achieved by 2015 that respond to the world's main development challenges. The goals are: (i) eradicate extreme poverty and hunger, (ii) achieve universal primary education, (iii) promote gender equality and empower women, (iv) reduce child mortality, (v) improve maternal health, (vi)combat HIV/AIDS, malaria & other diseases, (vii) ensure environmental sustainability; and (viii) develop a global partnership for development.

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0700335 He pointed to one major study of microfinance and its impact on poverty conducted by Khandker17 on experience in Bangladesh. Khandker performed massive survey of households participating in the scheme which was conducted in 1991/92 and repeated 1998/99. The survey concluded that microfinance accounted to 40 percent of the entire reduction of moderate poverty in rural Bangladesh. The result also suggested that access to microfinance contribute to reduction in overall poverty at the village level, thus not only helping poor participants but also the local economy. Study conducted by Mohabub Hossain titled Credit for the Alleviation of Rural Poverty: The Grameen Bank in Bangladesh (1998) found Grameen members average household income to be 43 percent higher than target non-participants in comparison villages, with the increase in income from Grameen highest for the landless, followed by marginal landowners. The positive impact of microfinance also supported by other studies such as Managing Resources, Activities, and Risk in Urban India: The Impact of SEWA Bank (2001), by Martha Chen and Donald Snodgrass, Microfinance Program Clients and Impact: An Assessment of Zambuko Trust, Zimbabwe (2001), by Carolyn Barnes and The Impacts of Microcredit: A Case Study from Peru (2001), by Elizabeth Dunn and J. Gordon Arbuckle Jr. Even though there are criticisms made to the above studies which largely based on disagreements in the methodologies used, positive impacts of microfinance to alleviate poverty cannot be denied. With refinement of

17

Khanderker, Micro-finance and Poverty: Evidence using Panel Data from Bangladesh (2005)

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0700335 methodologies are in progress and better data gathering, less criticism is expected, with no significant changes on the conclusion.

5. Current Involvement of Islamic banks in Micro-finance According to CGAP report, the outreach of Islamic micro-finance is very limited18:
In all Muslim countries, Islamic microfinance still accounts for a very small portion of the countrys total micro-finance outreach. For example, in Syria and Indonesia, Islamic financing instruments comprised only 3 percent and 2 percent, respectively, of outstanding micro-finance financings in 2006. In addition, the average outreach of the 126 institutions covered by the CGAP survey is only 2,400 clients (and none has more than 50,000 clients). The supply of Islamic microfinance is very concentrated in a few countries. Indonesia, Bangladesh and Afghanistan account for 80 percent of the global outreach of Islamic microfinance. In all other countries, microfinance is still in its infancy, with no scalable institutions reaching clients on a regional and national level

In addition, Microfinance expert Dr Saad Al-Harran laments the lack of participation by the Islamic banks and assert that as an entity based on faith, the institution should have a bigger moral obligation to contribute to the society19. This is despite the fact that more than 35% of the world population or 1.3 billion people are living in poverty.

18 19

CGAP: Islamic Micro-finance: An emerging Market Niche (2008) http://www.islamicfinanceasia.com/3_micro.php

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0700335 Currently there is no data available in the public domain to gauge the amount of micro-finance disbursed by Islamic banks in Malaysia. According to BNM, the Micro-financing has increased from RM151 million in 2000 to RM2.2 billion in September 2009, representing an annual average growth rate of 34%20. However, this figure consists of all players in the financial institutions, including conventional banks and developmental financial institutions. From observation, there is no visible micro-finance scheme actively promoted by the Islamic banks in Malaysia. In addition, the annual accounts of the Islamic banks did not specifically disclose their involvement in micro-finance scheme. Based on the financing segmentation in the financial accounts of Islamic banks, the following is noted:
Banks Community, Social Services & Personal* % to total financing
*Figure based on Annual Report

Bank Rakyat Malaysia RM84.2m 0.3%

Bank Muamalat RM192.7m 3.0%

Bank Islam RM59.3m 0.6%

The figure above shows that the involvements of Islamic banks in the financing for the purpose of community, social & personal are small. Apart from the above banks, other Islamic banks operates in Malaysia does not disclose their financing to this segment. With the growing questions on contributions of Islamic banks to the betterment of society, disclosure is the area which should be handled well by the Islamic banks. The Islamic

20

http://www.bnm.gov.my/index.php?ch=9&pg=15&ac=336

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0700335 banks should have appropriate disclosure in place especially on their efforts to satisfy the objective of Shariah. The disclosure will be useful for their stakeholders to effectively evaluate the role play by the Islamic banks in the society. It is interesting to note that earlier experiment of Islamic banks in Pakistan and Egypt focused on economic development and poverty alleviation. Establishment of Islamic banks in Pakistan during 1950s is to finance small landowners for agricultural development. Same experience is observed in Egypt with the establishment of Mit Ghamr Savings Bank in a rural area of the Nile Delta. This institution later replaced by Nasser Social Bank with the purpose mainly for social activities such as interest free financing for small projects based on profit and loss sharing, assistance to the poor and needy students for university and higher institutions (INCEIF, 2006). However, through passage of time, the focus of Islamic banks have move to profit maximization and financing billion dollar investments as seen in Dubai and other countries. Rapid development also contributed by players who want to tap petrodollar possess by Islamic countries, instead of focus on the achievement of Shariah objectives.

6. Financing Scheme for Microfinance Currently, practice of micro-finance is largely based on conventional contract i.e. charging of interest on the financing amount. Interest rate charged is very high to compensate for perceived high credit exposure and AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 20

0700335 higher transaction costs since the portfolio is larger and require higher administrative operations. However, this practice possess all characteristics prohibited by Shariah i.e. usury (riba), gambling (maisir) and excessive ambiguity (gharar). Islamic banks entry into microfinance and its operations should be in compliance with Shariah principles. There are various Shariah compliance contracts which can be utilised by the Islamic banks.

6.1. Profit and loss sharing (PLS) arrangement Profit and loss sharing is unique concept of financing in Islamic finance. In this arrangement, Islamic bank act as equity provider or as a partner with micro-entrepreneur. Return to the Islamic bank is contingent upon results of the business venture. It is fairer arrangement compared to the borrower relationship practice in the conventional micro-finance. Since the nature of this world is uncertain, business ventured by microentrepreneur may generate a profit or may suffer a loss. As a financier, they should share this uncertainty with their clients. They cannot just sit there, do nothing and expect to receive return especially when dealing with poor people. With Islamic banks carry the same risk, it will promote Islamic banks to get involved directly or indirectly in the business to ensure the venture will be profitable. It is a known fact that micro-entrepreneur consists of people with low level of knowledge and technical skills. On other hand, bank has the knowledge and expertise as they have wide experience in dealing with AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 21

0700335 business activities. As a mean to ensure that their partnership is successful, the Islamic banks have to impart this knowledge to their partner. Knowledge may be in form of good business practices, proper accounting and record keeping, effective marketing and packaging and etc. This gesture is useful to micro-entrepreneur and will greatly help them to become successful entrepreneur. Muslim economists regards PLS as truly Islamic financing transactions. Scholars include Sadr (1982); Siddiqi (1983, 1985); Chapra (2000a, 2000b) Ziauddin Ahmad (1984); Ahmad (2000); Siddiqui (2001); Haron (1995, 2000), Ahmad (2000); Rosly and Bakar (2003); Haron and Hisham (2003); Naqvi (2003) and others favour equity-based

instruments and place greater social welfare responsibilities and religious commitments upon Islamic banks in order to realize the Maqasid Al Shariah with respect to economic and financial transactions, including social justice, equitable distribution of income and wealth and promoting economic development and growth21. There are two types of contracts under PLS arrangement i.e. Mudharabah and Musharakah.

I. Mudharabah Mudharabah is a trust based financing arrangement between Islamic bank and micro-entrepreneur in which the bank entrusts

21

Dr. Abdulazeem Abozaid & Dr. Asyraf Wajdi Dusuki (2007)

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0700335 capital to micro-entrepreneur to fund their business activities. Profits made will be shared between the bank and microentrepreneur based on the pre-agreed ratio. Loss is solely borne by the capital provider as the micro-entrepreneur use the capital under basis of trust, which means he is not liable for the losses except for his negligence or misconduct. In Mudharabah arrangement, bank has no control in management of business since it will be carried out by the micro-entrepreneur only.

II. Musharakah In Musharakah arrangement, its equivalent to joint venture between Islamic bank and micro-entrepreneur. In this arrangement, both Islamic bank and micro-entrepreneur provide capital and manage the business venture. Profit sharing is based on preagreed ratio, while loss is borne in proportion to the equity participation.

Both Mudharabah and Musharakah are suitable to finance working capital and project financing. For asset purchase, it can be arrange under Diminishing Musharakah, in which the percentage of ownership in the asset by micro-entrepreneur increase with every payment of installments. The Mudharabah and Musharakah financing can be use to

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0700335 finance the needs of existing business, business expansion or as seed money for newly start-up business.

6.2. Murabaha contract Under Murabaha arrangement, the micro-entrepreneur appoints Islamic bank to acquire asset or equipment on their behalf from supplier. The bank acquired the asset and subsequently sells it to microentrepreneur at mark-up price. Payment on the mark-up amount is made by micro-entrepreneur on installment basis. This transaction is also called cost plus transaction since the Islamic bank charge higher selling price to micro-entrepreneur which represent the profit on transactions. All the purchase price and mark-up has to be made transparent to the micro-entrepreneur. Types of transactions suitable for Murabaha concept of financing are to finance working capital and purchase of assets.

6.3. Ijarah Ijarah is mainly a leasing contract. In this case, the Islamic bank acquires the asset and subsequently leases it to micro-entrepreneur. The micro-entrepreneur pay periodic rental for the use of equipments. This financing is suitable to finance assets used by microentrepreneur to generate income.

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0700335 6.4. Bay al-Salam Bay al Salam is contract of sale whereby the Islamic banks paid the price of goods in advance while receive the goods in the future. The purchase amount must be paid in full and the quantity of goods and timing to receive it is set on transactions date. This type of financing is suitable for agriculture activities since the farmers require money during plantation stage such as seeds, fertilizer and land preparation. The settlement for the financing amount is made when the crops generate income.

6.5. Qardhul Hasan Qardhul Hasan means an interest free financing. It also means benevolent financing or gratuitous financing. In this case, microentrepreneur returns the financing at the end of the period, with the same amount. This mode of financing is useful for very poor people as an act of charity for them to be involved in business activities and generates income to sustain their family.

7. Source of Funding for Micro-finance Scheme It is well known fact that financing the poor is a risky business. There is high chance that the Islamic banks may not received back the payment on the amount disbursed to the micro-entrepreneur. This due to most of the microAT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 25

0700335 entrepreneur has little knowledge and technical skills to operate business activities. Internally, micro-finance scheme requires substantial operational cost to administer since it involves large number of customers. This will put strain on the Islamic banks operations since not all depositors or investors are interested to invest in this area. Due to these risk factors, Islamic banks need to find reliable source of funding to fund micro-finance scheme. These sources of funding also need to be sustainable to ensure its viability. Islam is unique due to the availability of mechanism in place for the redistribution of wealth within society. The Islamic banks may leverage on these mechanisms to fund their micro-financing programmes. The

mechanisms are zakat, sadaqah and waqaf. a. Zakat is compulsory religious levy and the third pillar of Islam. The philosophy of zakat is that, from Islamic point of view, wealth is belong to God and held by human on trust basis. Thus wealth which held by a person has others share in it. There is where the function of zakat is. Zakat means cleanse or purify. By paying zakat, the wealth held by individual is being purified since portion of it has been put aside for the poor and the needy. Zakat is useful as a form of wealth redistribution and it manifest the social responsibility of the wealthy people. This contributes to a balance of wealth distribution in the society. In Malaysia, the collection and distribution of zakat is conducted by the Islamic Affairs Councils of the various states. Distribution of Zakat is in form of monthly cash to the needy and poor, conduct aid programs and AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 26

0700335 build house. Zakat also can be paid directly to the eligible beneficiaries (asnaf) which being mentioned in the Quran.
"Alms are for the poor and the needy, and those employed to administer the (funds); for those whose hearts have been (recently) reconciled (to the truth); for those in bondage and in debt; in the cause of God; and for the wayfarer: (thus is it) ordained by God, and God is full of knowledge and wisdom." (9:60)

b. Sadaqah as opposed to zakat, is a voluntary charity given by those who have, to others who does not have. This is good deed promotes by Islam. Sadaqah can be in various forms and not confine to material wealth. Sadaqah is part of the social justice of Islam in which portion of wealth is given to the needy for them to alleviate their burden. c. Waqaf is a form of perpetual charity in which the assets such as land and building are donated for charitable purposes. It is some form of wealth distribution in which assets donated for charity can be used in production process for wealth generation. Waqaf is useful since the benefit derive from it can be in perpetuity, so long as the Waqaf s asset is exist. All of the above can be use as a funding source for micro-finance scheme of Islamic banks. Since the risk exposure towards micro-finance scheme is high and it possibility that it will affect the other operations of Islamic banks, the bank may create specific funding fund to cater for interested investors for microAT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 27

0700335 finance activities. It can be in form of Restricted Investment Account (RIA) or Special Purpose Vehicle (SPV): a. Restricted Investment Account (RIA) RIA is an investment accounts with certain restriction as to where, how and for what purpose these funds are to be invested (IFSB). By investing in this account, the investors authorize the Islamic banks to use their funds to finance micro-finance activities. b. Special Purpose Vehicle (SPV) SPV is a legal entity created by a firm (known as the sponsor or originator) to undertake some specific purpose or restricted activity spelt out by the sponsoring firm (Gorton & Souleles, 2005). The benefit of SPV is that it is bankruptcy remote in nature. This means that in the event SPV gone bankrupt, the creditors cannot claim the debt from the sponsoring organization. In this regards, to fully separate it from other operation, Islamic banks may establish a SPV with the focus is to undertake microfinance activities. Funding for this SPV is via sukuk issuance which will be subscribed by interested investors. Islamic banks can provide their expertise by getting involve in the management and operations of SPV. By using both arrangements, whether RIA or SPV, the Islamic banks can approach potential investors to the program. The potential investors to RIA or SPV are: AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 28

0700335 i. Islamic Affairs Councils As being mentioned above, in Malaysia, collection of zakat falls under jurisdiction of State Islamic Affairs Councils. The amounts of zakat collected are quite substantial. For example, in 2008, Selangor Zakat Board collected RM244.4million in 2008 while Majlis Agama Islam Wilayah collected RM20.26 million. Based on this, State Religious Councils can put aside some of the Zakat and become investor in RIA or SPV. This is useful, since Islamic banks, with their expertise, able to use zakat money to empower the poor people, for them to have better life rather than fire fighting effort by the Councils. ii. Individual Islamic banks also may open the fund to interested individual. Islam promotes sadaqah or charity to the needy person and this act is being widely practice by Muslim. Currently, donation went straight to the recipient and they used it in their daily lives. Eventhough, it is good for the recipient to be able to use it straight away, however it is not sustainable. Thus, it is better for some of this donation is channeled to fund micro-finance activities which may generate sustainable income to the participants. iii. Government Fund Government has many funds disbursed to the poor and the needy. Some of the fund is used to build house to the poor, live maintenance, to support single mother and etc. Since the government has all these AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 29

0700335 funds, it may appropriate for some amount to be set aside for microfinance which being administered by professional bankers. This will give more value towards effectiveness of government poverty eradication programmes. iv. Islamic Bank Own Fund Islamic banks also may channel part of their internal fund for microfinance activities. Using its own fund has its own benefits. Islamic banks will have additional motivation to ensure their micro-finance program successful since they also involve in funding it.

8. Conclusion Islamic banks should fully perform their function to achieve end game as being espoused by Islam i.e. to create fair and just society with every individual have equal opportunity to have better life for their family and themselves. Islam banks should not only focus on profit maximization, but should live to the expectations to better play their role in the society. Eventhough there are many ways to achieve it, microfinance is one of the scheme that has proven to effectively help the poor people to stand on their feet.

AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 30

0700335 Reference Abdul Rahim Abdul Rahman, Islamic Banking and Finance: Between Ideals and Realities, IIUM Journal of Economics and Management 15, no.2, 2007. Also available online at: www.iiu.edu.my/enmjournal/152art0.pdf Abdul Rahim Abdul Rahman, Islamic Microfinance: A Missing Component in Islamic Banking, Kuliyyah of Economics and Management Sciences, IIUM, Kuala Lumpur. Also available online at:
www.asafas.kyotou.ac.jp/kias/contents/pdf/kb1_2/06abd_rahim.pdf

Ajaz Ahmed Khan, Islamic Microfinance: Theory, Policy and Practice, Islamic Relief, 2008. Also available online at:
www.islamicrelief.com/.../IslamicMicrofinance%2020Theory,%20Policyand%20Practice.pdf

Chiara Segrado, Islamic Microfinance and Socially Responsible Investments, University of Torino, 2005. Also available online at: www.gdrc.org/icm/islamicmicrofinance.pdf

Christopher Dunford, Evidence of Microfinances Contribution to Achieving the Millennium Development Goals, Freedom from Hunger, USA, 2006. Also available Datuk Dr. Syed Othman Alhabshi, online Poverty Eradication From at: Islamic
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Perspectives. Also available online at: www.osun.org/alhabshi-pdf.html Dr. Abdulazeem Abozaid & Dr. Asyraf Wajdi Dusuki, The Challenges of Realizing Maqasid al_Shariah in Islamic Banking & Finance, paper presented at IIUM International Conference on Islamic Banking & Finance, Kuala Lumpur, 23rd-25th April 2007. Also available online at:
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Dr. Asyraf Wajdi Dusuki, Banking for the Poor: The Role of Islamic Banking in Microfinance Initiatives, Department of Economics, Kuliyyah of Economics and Management Sciences, IIUM, Kuala Lumpur. Also available online at:
www.asyrafwajdi.com/artikel.html

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0700335 Dr. Asyraf Wajdi Dusuki & Nurdianawati Irwani Abdullah Maqasid al-Shariah, Maslahah, and Corporate Social Responsibility, Department of Economics, Kuliyyah of Economics and Management Sciences, IIUM, Kuala Lumpur. Also available online at:
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Dr. Asyraf Wajdi Dusuki, Understanding the Objectives of Islamic Banking: A Survey of Stakeholders Perspectives, Paper published in Journal of Islamic and Middle Eastern Finance and Management; Vol.1, Issue 2. 2008. Also available online at:
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Mohammed Obaidullah, Introduction to Islamic Microfinance, IBF NET: THE ISLAMIC BUSINESS AND FINANCE NETWORK, 2008. Also available online at: www.imad.in/mf-obaidullah.pdf Mohammad Omar Farooq, Partnership, Equity-financing and Islamic Finance: Whither Profit-Loss-Sharing, Upper Iowa University, Draft, 2006. Also available online at:
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Nathanael Goldberg, Measuring the Impact of Microfinance: Taking Stock of What we Know, Grameen Foundation USA Publication Series, 2005. Also available online at:
http://www.givewell.net/files/Cause12/Independent%20research%20on%20microfinance/GFUSAMicrofinanceImpactWhitepaper-1.pdf

Nimrah Karim, Michael Tarazi and Xavier Reille, Islamic Microfinance: An Emerging Market Niche, CGAP, 2008. Also available online at:
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Osman GUNER, Poverty in Traditional Islamic Thought: Is it Virtue or Captivity, Studies in Islam and the Middle East [SIME], Vol.2, no. 1, 2005. Also available online at: www.majalla.org/papers/2005/01/osman01.pdf Rodney Wilson, Making Development Assistance Sustainable Through Islamic Microfinance, IIUM Journal of Economics and Management 15, no.2 (2007). Also available online at: www.iiu.edu.my/enmjournal/152art3.pdf AT3002_HHI Wan Kamarudin 0700335 Professional Practice Paper - 32