Poverty to Profit Islamic Microfinance – Part 1

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Using Islamic microfinance to alleviate poverty

Poverty alleviation has traditionally been the domain of the interest-based development agency and profit generation has always been the mainstay of the corporation. Rarely have the two overlapped: corporate shareholders have no interest in giving money away and development banks have little to offer profit-oriented investors. Until microfinance. For perhaps the first time in economic development history the poor are seen as potentially profitable.

Microfinance is a financing tool that sustainably provides very small loans to the working poor. A handful of borrowers, usually 5 to 20 individuals, assemble themselves into groups. The first set of loans are extended to an initial subset of individuals within the group, for instance 2 out of the group’s 5 individuals, and once these loans are repaid, a second subset of individuals receive their loans. This continues through the entire group, circulating until a final loan is extended to a designated group leader.

Variations of this general theme abound but the basic underlying principle remains the same: a borrower is much more likely to repay on time if not doing so affects one’s selected group partner, usually an acquaintance. The fear of a faceless bank is replaced with the mercy for one’s own neighbor. This non-traditional concept of “social collateral” banking allows the poor to break out of the poverty cycle: the provision of capital allows for greater business investment, which leads to increased income,resulting in higher household savings and eventual financial independence.

THE ORIGINS OF CONVENTIONAL MICROFINANCE

Microfinance grew out of the failure of cooperative movements and government-sponsored initiatives for concessional individual lending. With some of these heavily subsidized programs yielding repayment rates as low as 40%, there is little wonder they were short-lived.

In the1970s, Bangladesh’s Grameen Bank revolutionized the development world by extending small, interest-based loans to the extreme poor, an economic group commercial banks refused to lend to and development banks found difficult to sustain acceptable repayment rates with. But by assembling individuals into self-selected borrowing groups, particularly in homogeneous settings, peer pressure and peer assistance lead to a form of informal monitoring that paved the way for continued success.

What began as a $26 loan to 42 village women is now a major industry in Bangladesh, with 4 million Grameen borrowers and over $4 billion in disbursed loans, of which over $300 million is currently outstanding. All collateral-free.

… ITS PROBLEMS …

But critics of Grameen and other conventional micro financiers cite Draconian interest rate levels as a major impediment to many borrowers becoming truly self-sufficient; an astronomical 22% interest rate charge at Grameen (measured on a declining basis), and as high as 50% elsewhere. Anathema to Muslims, for whom taking even the smallest amount of interest is forbidden, evidenced by a number of Qur’anic verses (2:275-279, 3:130, 4:160-161, 30:39), numerous rigorously authentic traditions of the Prophet, may God bless him and give him peace, the consensus of the four schools of jurisprudence, and the ravaging effects of decades of low-interest development loans to poor countries.

The single biggest problem with conventional microfinance, and for that matter all interest-based finance, is that the borrower has to make his interest payments even if he is unable to meet them. If his business succeeds, he pays; if his business fails, he still pays.

At a time when a young business should be concerned with innovation and expansion, an interest payment looms unavoidably large at the end of the month. Putting it off only exacerbates the problem, as interest payments often become larger than the original loan principal with the passage of time. It makes little sense for small, under-capitalized micro-entrepreneurs with nothing to fall back on to assume debt instead of equity. In a protracted market downturn, when large groups of borrowers are unable to meet their repayment requirements, this precipitates heightened levels of market volatility. End game: debt forgiveness on the lender’s part or increased impoverishment on the borrower’s, means bonded labor in some countries.

Further, interest-based transactions tend to focus attentions on the process-oriented task of repayment rather than on the result-oriented task of increasing profit. And because no direct causality exists in an interest-based transaction between the size of the payout and the profitability of the business (since interest payments are already fixed), conventional microfinance requires additional technical intervention on the part of the lender in order to promote business efficiency. Equity-based investments, on the other hand, already assume an effort toward business efficiency because both the investor and the worker share the same goal: increasing profit.

… AND ITS ISLAMIC ALTERNATIVE

Islamic microfinance provides an innovative interest-free alternative to conventional micro- finance. Perhaps not so innovative since interest-free, equity-based investing has already proven itself as the predominant corporate financing tool for decades, from Wall Street investment banks to Silicon Valley venture capitalists. And while the players may change, the transaction dynamics remain largely the same, whether the transaction is worth billions of euros or hundreds of rupees: an investor takes a stake in a business for a share of the business’s profits, undertaking commensurate levels of risks.

Based primarily on the profit-sharing principles of equity-based finance, Islamic micro- finance offers greater resilience than conventional microfinance. If a business fails, nothing is paid; if a business succeeds, profits are shared. Risks and rewards are always pro- proportionate to equity shares. So while any return on capital in the form of interest is completely prohibited in Islam, there is no objection to getting a return on capital if the provider of capital enters into a partnership with a worker or entrepreneur and is prepared to share in the risks of the business.

The key dynamics of conventional microfinance arrangements are, however, still retained in Islamic microfinance, with small groups of self-selected individuals providing each other with emotional, technical, and financial support. By assembling themselves into their own groups, clients choose as partners only those individuals they trust most, filtering out to large extent poorer credits.

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