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Islamic Banking — more compatible with microfinancing

Islamic Banking -- more compatible with microfinancing

Microfinancing has its origin based on universal dictum of economic and social justice, to be brought in all societies so as to arrest the widening gap between the rich and poor and thus eradicate poverty from the globe. Similarly Islamic laws based on Quranic teachings, focusing all financial transactions also uphold ethical values and social justice and make it incumbent on the state to promote equality and equal opportunities for all.

All the modes of financing under Islamic banking wherever introduced to replace Riba/interest are based on following assumptions:

a) That all transactions under Islamic modes of financing involve the concept of risk sharing.

b) Everyone has a right to own assets, whether moveable or immovable.

c) The contractual arrangements between financing bank and the client have legal validity.

On the other hand, microfinancing promotes micro businesses even amongst the poorest of the poor and contains an element of risk sharing in all financial transactions and above all based on the very philosophy that poor should participate in economic activity so as to share national wealth. This provides compatible and ideological grounds for adoption of Islamic modes of financing to replace interest-based system or other modalities akin to Riba embedded in the systems and procedures of microfinance banks.

Further guiding principle of microfinance banks/institutions is to become sustainable, side by side with promoting entrepreneurship amongst financially disadvantaged segment of the population with the sole objective of creating enabling environment for them to fully participate in economic process and build up assets of their own. Islamic banking with total focus on basic philosophy of Islam, which allows financial innovations has evolved the strategies and products relating to deposit taking and financing, which are in consonance with the basic principles of social justice and ensure sustainability both for financing bank and client’s projects.

Universally accepted Islamic banking products relating to deposit taking and financing in vogue in the countries, including Pakistan where attempts have been made to eliminate Riba/interest from banking system are:

a) Investment related Musharika/Mudaraba, term finance certificates and equity participation where the concept of profit and loss sharing with equity input by the financing bank and client or by the bank alone prevails.

b) Trade related instruments like Murabaha/Bai Muajjal, based on the concept of sale and purchase of goods and services by the banks required by their customers on term where the price of goods/ services plus margin of profit (mutually agreed) are to be paid on or before the specified future date.

c) Other instruments where element of interest is totally non existence like hire purchase, leasing and rent sharing etc.

d) Qarz-Hasna and lending with service charge. (This has also been practised by the public sector banks before their privatisation).

It is to be seen that which of the above mentioned instruments are more compatible to microfinancing, which generally entails collateral free financing and at same time strongly advocates sustainability of the financial institution itself. The experience regarding lending with service charges and by way of Qarz-Hasna as has been practised in Pakistan no doubt affirms Islamic principles yet the solitary application of this mode of financing endangers the sustainability of organisation itself.

It is Bai Muajjal or Murabaha, which stems from the concept of trading of goods in vogue in Saudi Arabia and adjoining States since the period of our Holy Prophet (Peace Be Upon Him). This mode of financing is applicable to various trade related transactions. However in all transactions either of the following two modalities is involved.

a) The manufacturing concerns generally need bank finance to meet their manufacturing and administrative expenses. If they are accommodated under Murabaha arrangements, it implies purchase from customer something of value at a certain price, taken as sale price and sell it back to the client on deferred payment basis, at a price which includes mark up and termed marked up or buy back price.

b) The modality involved regarding financing customers in trading business is by sale of goods to them at marked up price on deferred payment basis.

The mark up included in the buy back and purchase prices in the cases discussed above represents the bank return on financing done at agreed price. Here the vital question is risk management. Even in the case of conventional commercial banks there is shift from collateral based financing to performance related financing. Instead of relying on collaterals, banks need to have safeguard against risk by taking into account track record of the client and operational efficiency of the business reflected from funds/cash flows and other financial returns.

Same criterion can be used by microfinance institutions and banks, which have deep penetration in the communities they serve, hence can closely monitor and supervise the business operations of their clients to prevent misuse of funds, which generally ends up in making the return of funds to funding bank doubtful.

In Pakistan after the historic verdict of Supreme court to Islamise banking in letter and spirit, banks despite finding Murarbaha easiest mode of financing are faced with innumerable problems in adhering to requirement of their iterations/constructive involvement in sale and purchase of goods and secondly sticking to agreed markup price in a scenario when in case of defaults banks cannot have recourse against the borrowers through courts within specified time( maximum allowed time of 210 days after expiry of agreement).

In the case of Microfinance banks, staff inducted generally come from targeted communities/areas/ villages for financing. It becomes easy for Microfinance institutions to cater to business needs in the literal sense. In other words constructive sale and purchase of raw material, equipment and machinery etc can take place through direct involvement of the bank as against current practice of delegating it to the client to purchase from the market. Similarly strict monitoring by microfinance banks’ staff, specially through mobile teams and affordable repayment arrangements particularly after common use of latest technology that is digitalisation of the entire process particularly for repayment of loan installments ensuring timely adjustment of finance. Thus problem of alteration in agreed marked up price will not be encountered (as it was vehemently criticised in subsequent verdict of Supreme Court that agreed marked up price should not be altered in case of default as was the practice with all categories of financial institutions).

Microfinance banks dealing with clients from low and lower middle income groups to finance their micro businesses may opt for using more than one mode of financing for a client. Side by side meeting clients fixed assets purchase needs through trade related modes of financing( through Murabaha/Bai Muajjal), they can provide the loan facility on service charge basis ( rate of which to be calculated according to prescribed formula given by State Bank of Pakistan) too meet overheads of business. Low returns through service charge can be compensated by charging higher rate of mark up on financing for purchase of fixed assets of the business concerned.

Investment related modes of financing like Musharika/Mudaraba, term finance certificates and equity sharing, selectively in use by banks operating in Pakistan show little possibility of their application by microfinance institutions except Mudaraba. All other investment related financing modules require client’ s equity input in the business, whereas in case of Mudaraba the financier participated in the business by bringing in only funds and through his/her skill and expertise runs the entire business. As such for microfinance banks where majority of the clientele is from financially deprived class, it would be feasible to make use of Mudaraba module to finance business needs of their clients.

Unlike the interest based system (Alitalia provider does not share risk in business) the return on funds invested in business under Mudaraba arrangement are not fixed or predetermined. The profit occurred in business is shared between capital provider and entrepreneur in ratio agreed mutually. In case business happens to incur loss the entire loss is borne by financier. However if it is proved that situation is outcome of sheer negligence on the part of entrepreneur then he/she will be called upon to take on the entire liability as per rules governing Mudaraba.

So far the Mudaraba flotation in Pakistan is restricted only to legal entities set up under the rules and regulations enforced through Mudaraba Companies Ordinance and monitored by Securities and Exchange Commission of Pakistan and the State Bank of Pakistan. But in order to bring microfinancing also within the ambit of Islamic banking despite peculiar constraints and limitations with regard to clientele of these institutions who are the poorest of the poor having no assets of their own, Mudaraba module of financing turns out to be a feasible approach for microfinance institutions as their clients – owners of micro and small businesses cannot afford to bring in equity in the business and secondly it is an ideal module of financing where risk sharing can be practiced in letter and spirit.

Under Mudaraba module the role of microfinance banks would be of capital/ funds providers to their clients for setting up micro businesses, especially to those having good track record, adequate experience of the business and also those who own the business of longer cash conversion cycle. For example for financing livestock business involving comparatively longer term repayment arrangement can easily be covered under Mudaraba arrangements. Mudaraba in fact entails issuing Mudaraba certificates to capital provider by the entrepreneur who uses the funds for establishing/ running the business. In microfinancing constraints regarding this modality can be handled by making the clients execute a legal document in the form of a certificate value of which will be bought back in installments by the client/ entrepreneur during the period facility is availed of. For example, financing of Rs.60000/- is required for a period of 18 months, for purchase of three cows of different age groups. The financing under Mudaraba can be initiated by way of purchase of three certificates by the bank (by way of legal documents duly executed by the client).It will be on condition that the client will buy back these certificates in three six months installments, on each cow attaining the age when it is profitably marketable. Profit on sale of each cow would be shared by the bank at an agreed ratio on six monthly basis, on the capital amount I use in business during the preceding six months, from each point in time.

Mudaraba financing, however has some limitations in the scenario of microfinancing in the sense that clientele of these banks is least expected to maintain proper books of accounts. As such it is difficult to ascertain exact business transacted and funds generated so as to determine profit to be shared by the bank. It is therefore advisable that this mode of financing be applied to ongoing concerns only, which are in need of expanding their business. The deliberate attempt by the clients to hoodwink Bank can easily be traced out as microfinance banks are the banks of communities. They have presence even in far flung areas and are preferably run by staff taken from the community they serve. Hence they have extensive exposure to relevant markets as such there is little chance of encountering loss.

No doubt at the initial stage of implementation of the above discussed modes of financing, some anomalies been countered by microfinance banks, but in the course of time these can be addressed by making minor modifications in the system and procedures without disturbing the very essence shindig each mode of financing.

Since the Islamic Banking upholds norms of social justice, fair and equal opportunities for all, it is more compatible to objectives of microfinance institutions who cater to banking needs of financially disadvantaged segments of population needing economic empowerment through participation in economic process.

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