As the Islamic banking and finance market matures, there seems to be a growing conscience amongst market players and academics alike to contribute to the betterment of society, and to take into consideration the socioeconomic conditions across Muslim majority countries. Historically, Muslim majority countries outside of the Middle East and some pockets within Asia have not been the most economically developed, and market players have been struggling to find a panacea for these countries’ economic woes.
The topic of financial inclusion across all levels of society is quickly rising to the top of many regulators’ and industry players’ lists. This is mainly to reach out to these less developed economies which have the volume, but lack the propensity for, creating a well-regulated financial system in a short span of time.
Enter Islamic Microfinance, dubbed as the saviour to developing economies due to the nature of its lending mechanism; affording micro loans over a relatively short period of time, and creating opportunities within communities that might otherwise not have the means to gain economic autonomy. However, despite its sound value proposition to the development of the economy as a whole, Islamic Microfinance is hardly a popular choice amongst higher level decision makers and financial institutions due to the various uncertainties surrounding the sector.
Risky or Untrustworthy?
Microfinance in general deals with the subsection of society which many banks and financial institutions would not consider approaching due to their perceived uncreditworthiness or high risk of default. According to Dr Abdul Rahim Abdul Rahman, Professor of Islamic Banking and Accounting at Universiti Sains Islam Malaysia (USIM), the current banking infrastructure does not allow banks to clearly distinguish between risky and ‘safe’ borrowers. “If it could, the bank would charge the same (high) rates to all potential borrowers. The outcome of traditional lending activities is inefficient since, in an ideal world, projects undertaken by both risky and safe borrowers should be financed,” he stated. He also added that one of the core principles of microfinance is that “credit is a human right”; as expounded by the founding father of modern day micro financing, Dr Muhammad Yunus, the founder of Grameen Bank in Bangladesh.
Perhaps the most disconcerting thought with regards to microfinance for most traditional bankers is the fact that it is built almost completely on the idea of trust. This is because there is no collateral or guarantor involved in the process, and in order for a candidate to obtain the loan, they would need to join a recipient group. According to Dr Abdul Rahim, the group members are then given small loans, which will be renewed once the previous loans are paid. The repayment scheme is on a short-term basis of one to two weeks and may include a savings package.
The group lending theory helps to alleviate any possible oversight issues by the bank with regards to gaining repayment from the borrowers who may be situated in less accessible communities. This is because group lending mandates all members who have procured the loan as part of a group, to guarantee repayment to the bank and if there are individuals who are unable to make the payment or is at risk of defaulting, each group member is inadvertently responsible for ensuring that the outstanding portion is covered. “While the others are not forced explicitly to repay for the potential defaulter, they have clear incentives to do so if they wish to continue obtaining future loans. This helps micro-lenders overcome ‘adverse selection’ problem,” said Dr Abdul Rahim.
Catalyst for Critical Mass
According to reports, majority of the population in the Organisation of Islamic Council (OIC) member countries still live below the poverty line, making this demographic group almost impossible for the traditional banking system to reach out to. Whether they are deemed un-creditworthy or uninterested in the banking system, it is undeniable that there is a large population of individuals whose banking needs are currently unmet and could become a potential market for banks looking to grow their customer base across developing countries.
All too often, players within the Islamic finance industry highlight the need for the sector to pick up on growth momentum and to reach the point of critical mass where the industry begins sustaining itself - not dissimilar to the conventional banking and finance sector. Islamic microfinance could easily present itself as a means for the Islamic banking industry to gain the desired momentum and sufficient volume it needs in terms of depositors and product sales.
Microfinance, stresses the Islamic Finance Services Board (IFSB), has emerged as a viable proposition in offering financial services to low-income groups: “It serves as an important tool to access unbankable individuals, especially in Muslim countries, and is seen to be an effective tool in poverty alleviation efforts.” Argus Martowardojo, Governor of the Central Bank of Indonesia is also confident that Islamic microfinance could provide a much-needed boost to the world’s developing countries by enhancing the small to medium enterprise (SME) sector, to create a significant impact on local economies through job creation and export of local talent and expertise.
However, in order to achieve the desired levels of Islamic microfinance penetration and success across these jurisdictions, Argus says that proper risk management systems and good governance have to be put in place first: “The combination of good governance, greater transparency and well-designed risk management would shape a trust-based relationship that is essential to make the intermediation process efficient. The availability of standards on the microfinance activities is important to ensure operational prudence is practised by Islamic financial institutions when extending their facilities to the low income society. Some regulatory incentives such as relatively lower risk weighted assets could also be created to provide lower cost of capital to micro-entrepreneurs.”
Some market players have also suggested a more structured curriculum in universities and for professional courses to encourage industry participation in the Islamic microfinance industry and to pique the interest of new graduates, to help grow a potentially lucrative sector within the Islamic banking and finance sphere. With proper regulations in place, as well as a structured learning experience available to those interested in exploring the prospects of the Islamic microfinance sector, it is not impossible that this once overlooked sector could finally gain the recognition it truly deserves.