Professor Malcolm Harper
The present paper aims to share some of the details about ‘micro-musharaka’ and ‘micro-mudarabah’ transactions which are described in the book Islamic Microfinance: Shari’ah compliant and sustainable? by Malcolm Harper & Ajaz Ahmed Khan (2017).
One of our aims in making the collection was to identify a wide range of Islamic micro-finance institutions (IMFIs) and to find out how and with what methods they addressed the financial needs of their clients, and in particular the very poorest people who needed and could make good use of financial assistance other than simple grants.
Wide Use of Microfinance
Many poor people use micro-finance for day-to-day cash management, and to finance non-traded items such as health care, school fees, house repairs or even day to day food supplies. Such purchases are often referred to as ‘consumption’ expenses, as if they were in some way reprehensible, and some authorities argue that tools such as murabaha and musharaka enable IMFIs to ensure that their money is only used ‘productively’, because clients cannot divert it to purchases of this sort. Such attitudes betray a regrettable ignorance of the day-to-day reality of poor people’s lives, but the only form of Islamic micro-finance that is appropriate for them is Qard hasan, where the IMFI make no profit of any kind, and depends on grants for its finance and it’s expenses. Akhuwat of Lahore in Pakistan has shown that this ‘non-sustainable’ form of finance can actually be very successful for its clients and for the survival and growth of the institution itself, but we could not identify other significant users of this approach.
We also hoped to identify examples of profit and loss sharing finance, such as musharaka and mudarabah partnership approaches; my own brief observation of musharaka in Omdurman and Port Sudan in the 1980s suggested that ‘micro-venture capital’ of this kind, if the fundamental problem of reliable accounting was overcome, could alleviate or even eliminate the problem which arose when poor people’s livelihood businesses collapsed and they still had to pay off a loan, which continued to increase as time went by.
The general conclusion of the book, however, was that most Islamic micro-finance institutions (IMFIs) were using variants of ‘murabaha’, or trading finance, whereby the IMFI buys the assets which its clients require and then re-sells them to the clients at a profit, on credit, so that the transaction appears as a trade sale on credit rather than as a loan of money. Some MFIs also use ‘ijarah’, a form of leasing, particularly for purchases of capital equipment, but both these methods are in effect ‘cosmetically’ Islamic, in that they apparently satisfy the letter of Shari’ah, but are very little different from fixed interest loans.
They also suffer from some major disadvantages, when compared with simple interest-based lending, and these disadvantages are particularly significant for poorer clients. Murabaha involves substantial extra transaction costs, because items have to be bought by the IMFI and then re-sold to the clients. This is cumbersome and expensive, even if the client in theory acts as the IMFI’s ‘agent’ and buys the item and then re-sells it to her or himself at a profit which is remitted to the IMFI.
This somewhat bizarre agency expedient is used by a number of IFMIs, but the necessity for a formal and documented purchase and re-sale arrangement more or less excludes purchases from informal suppliers. It is clear, for instance, that typical ‘low-end’ microfinance clients such as women who sell cups of tea, or small packets of peanuts, often with all their stock in a hand basket or a tray held on their heads, could not possibly use murabaha for their frequent tiny purchases of tea leaves, sugar and milk.
Real Case Studies
In spite of the prevalence of murabaha and mudarabahh, ten of the fifteen IMFIs whose case studies are included in the collection were engaged in some profit and loss sharing financing, usually only with a small number of clients and sometimes on an experimental basis. The case studies included ‘micro-cases’ of some of these clients, most of which contain some details of the financial results of the clients’ ventures and how the profits, or losses, were shared between them and the IMFI.
Many writers on Islamic micro-finance expatiate at length on the virtues of partnerships but without giving any practical details about individual clients and their financial experiences. These very short and often simplified descriptions convey a sense of the reality of micro-scale profit and loss sharing finance, and the examples may serve to encourage IMFIs and others to consider offering similar products, so that Shari’ah compliant micro-finance can move beyond cosmetic approaches to include financial products which genuinely offer something different from and better than traditional fixed interest micro-finance.
The two largest IFMIs which are represented in the collection are Akhuwat of Pakistan, which is 100% devoted to qard hasan lending, and the Rural Development Scheme (RDS) of Islami Bank in Bangladesh, which is not actually an independent institution but is a department of Islami Bank, the country’s largest Islamic bank. Some RDS staff were keen to move to products which were more than cosmetically Shari’ah compliant, and they introduced an experimental musharaka product in 2007. It was found to be too cumbersome for general adoption, and it was a loss making proposition for the bank because some clients were unable or unwilling to declare their real profits. It continues to be available, but only for a small number of long-standing and larger clients.
REEF in Jordan uses murabaha for the majority of its loans, but they have made four musharaka profit and loss sharing loans on an experimental basis. Three of these were unsuccessful, in that the borrowers and REEF lost money, but the fourth was profitable for both parties. The details of the transaction were as below:
Mustafa sought a musharaka partnership with REEF in May 2014 in order to purchase damaged greenhouses which he repairs and rehabilitates before re-selling them. Mustafa buys the greenhouses from local farmers in and around Ramallah and even from areas in Israel. He was against taking an interest based loan because of his religious beliefs. Mustafa and REEF each contributed US$10,000 to the venture. They opened a joint account in a Jordanian Bank where the funds were deposited and the money could only be used for purchasing used greenhouses. They initially agreed to divide any profits from the enterprise equally, that is in accordance with their capital contributions. However, after the partnership began Reef Finance agreed to allocate 75% of the profits to Mustafa as he was managing the project and undertaking all the work. At the end of three months they brought the partnership to a close with Reef Finance making a profit of US$580, in addition to its capital investment of US$10,000, an amount far greater than it would have earned through a murabaha loan.
REEF’s profit was the equivalent of an annual interest rate of almost 25%, which was far higher than its normal rate of profit, but both parties considered this to be reasonable in view of the fact that REEF shared the risk with Mustafa.
As with any type of loan, businesses financed with musharaka credits are not always successful; Kompanion Finance in the Kyrgyz Republic, like most IMFIs, uses mainly murabaha, but they have occasionally used mudarabah, where the lender advances the full cost of the investment rather than a share as is the case for musharaka.
Kompanion advanced $3,300 to a client on the basis of mudarabah to buy meat for the production of Halal sausages. However, he had no experience in this business and did not follow the proper methods for sausage making. As a result, the product was unsellable and the shop was forced to close, resulting in losses for the business. These losses were shared by the client and Kompanion. The loss amounted to about $170, 70% of which was covered by the client and 30% by Kompanion. Kompanion had initially tried to help the client to find a consultant to help him run his sausage business, but he was no longer interested in it. After a six months delay, the client returned repaid the debt in full, not by selling equipment, but from the family’s other income. He recognised that as a Muslim he was obliged to repay a debt, even if it had been forgiven. Eventually, he restored the sausage shop and is now successfully manufacturing traditional sausages, without any external finance.
This case illustrates the importance of religious obligations in Islamic microfinance. Kompanion of course lost money on the transaction, because of the time they had spent and the lost opportunity of the funds, but the IMFI did not incur a capital loss.
A major part of microfinance credit is used for farming, which is risky and often not profitable, and is unattractive to most regular commercial banks, but is the main source of livelihood for many of the poorer people in Muslim countries. Ebdaa Bank in Sudan, is heavily involved in finance for small farmers, and uses Bai salam, a form of profit and loss sharing, for many of its loans to them. Ebdaa Bank’s advances to smallholders for the cultivation of gum Arabic and sorghum, common smallholder crops in the Kordofan region of Sudan has proven to be successful. The Bank made an average profit of 14% on the transactions, whose term was on average six months, so that the Bank’s annual gross return averaged 28%. This was well above the rate of profit on other products.
The concept of the bank and other successful clients sharing the losses of those whose ventures have not been so fortunate is fundamental to Islamic finance; the profit is well under the amount made by informal lenders, who do not forgive losses, and bai salam is growing in popularity. It does of course require the Bank to be knowledgeable and directly involved in the famers’ businesses, so it is not suitable for every kind of client, but it is likely to form an increasing proportion of the Bank’s portfolio.
The Port Sudan Association for Small Enterprise Development (PASED) is mainly engaged in murabaha trading finance, but it has extended profit and loss sharing finance to a small number of clients who have successfully completed these transactions and who need to ‘graduate’ to larger and longer term finance. BASIX is a major player in Indian microfinance, and they also initiated a small experimental Shari’ah-compliant operation in Mewat, a drought prone and predominantly Muslim area south of New Delhi. They offered murabaha as well as bai salam and musharaka credit, and their general policy was to try to emphasize those aspects of Islamic financial products which were not only Shari’ah compliant but also offered other advantages beyond this. Basix made arrangements with a number of wholesalers who sold to village shops, for instance, which enabled shops who were its clients to benefit from lower prices as well as credit; this in some cases more than absorbs the profit which Basix added for its own costs.
Basix also offers bai salam to smallholder farmers on a similar basis to PASED to Sudan, as well as a diminishing musharaka products for capital purchases. If a farmer needs a buffalo, for instance, Basix enters into a partnership to buy and own the buffalo. The customer and Basix jointly purchase the buffalo, and the clients uses and takes care of the buffalo for the payment of monthly rent; this covers the use of Basix’s share of the buffalo as well as buying part of Basix’s share every month. The rent decreases in accordance with Basix’s diminishing share in the ownership of the asset. After buying back all Basix’s share, the customer becomes the complete owner of the buffalo, and does not have to pay anything more. If the animal or other asset is lost or is in any way diminished in value before Basix has been wholly bought out, the client and Basix share in the loss in proportion to their shares In its ownership.
MicroDahab in Somaliland is a subsidiary of Dahabshiil, Africa’s largest remittance company, which also operates an international bank and a mobile phone company. They went into microfinance in order to offer a further service to their clients, using their existent branch and agent network. They work mainly with murabaha trading finance, but they also offer partnership financing to clients who have proved their ability in smaller murabaha transactions with shorter repayment terms.
Generally musharaka or mudarabah profit and loss sharing methods are most suitable for larger and longer duration operations, where the clients are known to the institution and where they also have the capacity to keep reliable and verifiable records. This is not typical of the small fast turnover operations which are more usual in small-scale petty trade and similar activities which are undertaken by poorer clients.
Indonesia has the world’s largest Muslim population but it is also home to a wide variety of microfinance institutions, which offer both Shari’ah-compliant and conventional fixed interest credit, such as is provided by Bank Rakyat Indonesia, which is by most measures the world’s largest and most profitable microfinance institution. There are also a large number of small cooperative and other institutions; Daarul Qur’an was set up 2005, as a community owned cooperative in Tebet, a district of Jakarta, by a group of ex-students from the School of Shari’ah and Islamic Economics of the national university. The IMFI offers a range of shari’ah-compliant savings instruments to its members, some of which enable them to share in the profits (and losses) of the institution, so it can be regarded as a genuinely Islamic and self-sustaining institution, on both the liability as well as the asset sides of the balance sheet.
It is clear that Shari’ah compliant micro-finance can have important advantages over and above its conformity to the letter of Shari’ah. However, this type of finance is by its nature unsuitable for very poor people, who tend to share the following characteristics:
- They have neither the time nor the ability to keep financial records which can enable IMFI staff easily and quickly to assess the performance of their businesses.
- They need very small sums, often very quickly.
- Many of their financial needs are for small quantities of non-traded items, such as schooling, health care, house repair or day-to-day subsistence.
- Many of the suppliers of such items are themselves informal micro-businesses, which are not able to provide formal invoices or fixed prices.
Straightforward cost free credit, qard hasan, as is provided by Akhuwat in Pakistan, is of course suitable for needs of this kind, but it appears to depend on an unusual combination of charismatic leadership, government collaboration and massive generosity. It is to be hoped that Akhuwat’s efforts to expand beyond the borders of Pakistan will be successful, but it would be unwise to depend entirely on this for the wider spread of Islamic micro-finance to effectively reach the poorest people.
Most of the institutions which offer examples of profit and loss sharing are mainly engaged in murabaha financing; the clients who are partners in musharaka and mudarabah are a small minority. Some of the clients are experimental, and the institutions may in future scale up the numbers, although in other cases such as Islami in Bangladesh profit and loss sharing appears to be reducing in importance.
Nevertheless, there does now appear to be enough experience, with a sufficient variety of clients, investments and modalities of arrangements. It is to be hoped that this experience can be drawn together so that IMFIs will in future be able to learn from it and to design and offer profit and loss sharing products which overcome the disadvantages and demonstrate that Shari’ah compliant micro-finance is not merely a cosmetic device to conform to the letter of Islam, but a genuine improvement in micro-finance from which secular MFIs as well as IMFIs can learn.