Islamic Finance Could Aid Development

May 2011
London, United Kingdom, May, 19 2011 - Combining social principles with the power to provide financial assistance, Islamic microfinance has huge, untapped potential.

Islamic finance is becoming one of the most rapidly growing segments of the global finance industry. There is growing interest from financial institutions in designing Islamic or "sharia-compliant" products and services to attract Muslim investors. These products are designed to conform with Islamic financing principles that include linking transactions to tangible economic activities, excluding financial speculation and excessive uncertainty, and funding only socially productive activities, in addition to the well-known stipulation against charging or paying interest.

Islamic finance can play in supporting development. IFIs are in fact encouraged to allocate a proportion of their profits to support charitable projects by the Islamic scholars who sit on their advisory boards. Potentially, this represents a huge (and largely untapped) source of funding for a huge range of development activities, from providing clean water in rural communities to promoting the welfare of orphans.

Specific attention has focused on promoting sharia-compliant microfinance for low-income populations. This is partly because of Islamic teachings that encourage economic self-sufficiency among the poor, particularly through microfinance, but also, no doubt, because of the desire of the IFIs to develop future customers.

It is interesting to note that while the provision of interest-based microfinance has proliferated in recent years, relatively few microfinance initiatives adhere to Islamic financing principles even when implemented in largely Muslim countries. Despite the fact that almost half of microfinance clients worldwide reside in Muslim countries, Islamic microfinance accounts for less than 1% of total global microfinance outreach. While many Muslim countries have vibrant microfinance sectors, Islamic microfinance only has a limited outreach. It accounts, for example, for just 3% of the total number of microfinance loans in Syria and only 2% in Indonesia. Islamic microfinance institutions remain relatively small, with an average client base of just 2,400.

This is surprising, as the spectacular growth of Islamic finance has shown there is a demand among Muslims for financial services that are compatible with their religious beliefs. While many Muslims will prefer to continue using interest-based services, others are likely to prefer Islamic alternatives and access these once they become available. In fact, many non-Muslims may also be attracted by the "more equitable" nature of Islamic finance. I remember clearly from my time working in the Balkans the number of Serb micro-entrepreneurs who were attracted to loans that shared business risk between the lender and borrower.

Successful Islamic microfinance programmes can offer several advantages. They may engender higher rates of economic growth as evidence suggests that micro entrepreneurs are willing to undertake more profitable ventures if risk is shared. They can build greater levels of trust and understanding between lender and borrower because of the deeper relationships built through partnership rather than a service provider-client relationship. Because only investment in socially beneficial activities is permitted, they may promote ethical investment and business practices among micro entrepreneurs. Indeed, Islamic finance shares many of the features of socially responsible finance.

However, there are a number of challenges to overcome before Islamic microfinance can flourish. Firstly, Islamic financing – which includes profit and loss sharing techniques and the purchase and delivery of items to micro-entrepreneurs – is typically more time consuming, costly and complicated to manage than interest-based microfinance. Increasing operational efficiency and developing sustainable operating models that increase scale and outreach are therefore crucial. While increasing interest from IFIs may alleviate the traditional constraint of lack of investment for existing and fledgling Islamic microfinance institutions, this must be accompanied by a concerted effort to increase technical expertise and training opportunities as Islamic microfinance generally requires a greater level of staff involvement and understanding of micro-entrepreneurial activities.

Islamic microfinance providers also require a better legal and regulatory framework, not only to monitor their activities but to encourage them to experiment, innovate and develop. With a few notable exceptions, governments have generally failed to provide appropriate regulation and supervision for the expansion of sharia-compliant microfinance or developed comprehensive guidelines on microfinance accounting principles, pricing methodologies and sharia audits. Apart from ensuring that products and processes remain authentically Islamic, there needs to be greater clarity and understanding on what qualifies a service as sharia-compliant by seeking the necessary support from qualified Islamic scholars.

It will be interesting to see whether IFIs, development practitioners and governments can come together over the next few years to overcome these challenges and ensure that Islamic microfinance becomes more widespread.

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