Islamic Bank Runs A Microfinance Project

Can an Islamic bank run a microfinance project as part of its mandate?

The definite answer to this question is Yes. One of the roles of Islamic bank as the financial intermediary is to provide access for financing to the deficit units that it has accumulated from the surplus units. The same role also played by conventional banks. However, the operations, philosophy, and objectives differ significantly between the conventional and Islamic bank. Islamic bank operates within the Islam’s mu’amalat, promotes maslahah mursalah and emphasis social justice in economy. Unlike the peers conventional banks who run the business to achieve the ultimate profit from riba-based lending activities.

As the financial intermediary, Islamic bank can run the microfinance project by providing financing to the poor entrepreneurs, socio-economic development projects or small businesses. The service is termed small because a person or small business does not have a lot of money will not need financing of several hundred thousand ringgits. They just need money to run “micro” business or small project out of necessary to support their daily lives and family.

Islamic banks offer products and services based on equity-based participation. The products it selves such as mudharabah or musyarakah types financing will allow an Islamic bank to participate in a small business or project. The bank and owner of the business will share profit and loss from the business. Thus, both parties are exposed to business risk and it is a fair deal.

One of the reasons why the poor people unable take a loan from the bank is they do not have credit history track record but the Islamic bank can address this issue. Islamic bank should be able to run a micro business by being a partner. The criterion used by Islamic bank is to evaluate the potential of micro-business itself not the credit history before approving a microfinance facility. Islamic microfinance offers the best alternative to normal loan.

Zakat payment by Islamic bank could be utilized to help poor people who have the capability to run a micro-business. For example, the tax authority of Malaysia (Inland Revenue Board) allows the reimbursement of certain portion of zakat payment. The zakat reimbursement payment could be channeled to a special fund meant for micro financing activities. This is not only considered as the bank’s corporate social responsibility but also fulfilled the zakat distribution rules that only certain parties can receive zakat such as the poor for microfinance with no interest payment.

Managing microfinance could cost a lot of money for banks and as far as Islamic bank is concerned, they are not allowed by Shariah principles to charge interest for loans. Nevertheless, Islamic bank still can mitigate the higher financing cost by setting a more viable profit sharing ratio to cover the costs. A study on global micro financing shows a very excellent track record of loan repayment with an average about 97 percent. Hence, the microfinance financing is a viable option for Islamic bank to venture into it.

Microfinance’s objectives among others are used to reduce and solve poverty problems. Islamic bank can be pulled in to provide assistance for the poor. They will be able to train, advice and facilitate micro businesses operators to run the business and project professionally, efficiently and effectively. The Islamic bank can tap onto their pool of experts for this purpose. As a result of banks indirect involvement in microfinance, the business will have better chances to generate good result and profit, which will eventually help to payback the small capital given to the poor and reaps the investment returns.

The example concept of a bank that runs a microfinance project is the Grameen Bank project founded by Professor Dr Muhammad Yunus. The bank provides loans to the poor people who have skills that can be utilized to earn more money. The concept can be applied to Islamic banks as well. In order to comply with Islamic laws that prohibit the charging of interest, the Islamic bank can act as the capital provider for microfinance project under mudharabah concept or the bank it selves become the co-owner of the project under the musyarakah arrangement where the Islamic bank will be able to recoup the money invested through profit sharing derived from the profit of the microfinance project.

Author: saupee @ All copy rights reserved 2013.

Suggestions to Establish An Islamic Financial Institution

You are asked for advice by the government of a small country that wants to establish an Islamic financial institution. What advice would you give? (10 marks)

Establishing an Islamic financial institution (IFI) requires comprehensive planning and consideration of several factors. Among the factors that need to be factored in are the existing financial system, social composition, economic and business environment, current legislations and the country’s political structure. As far as planning is concerned, a short term, medium and long term development progress should have clear objectives and concrete strategies in achieving the mission so that the IFI concerned will have a prosper growth and well rounded development. In pursuing the effort to establish an IFI, the following suggestions should be considered:-

1)        Develop and enact regulation on Islamic financial institution

The first step that the government should do is to develop and enact an Islamic Banking/Financial regulation to govern, regulate and guide the orderly development of the IFI. The regulation also acts as the control instrument for strong governance, adherence to Shariah principles as well as protects the IFI’s future growth.

2)        Employ talents with Islamic economic and financial knowledge

One of the success factors for the IFI is to have the managements and employees who have knowledge on Islamic economic and modern financial system. This is because IFI must be managed and operated in accordance with Islamic rules and regulations. The talents are responsible to create innovative products and services, promoting and explaining the concepts of Islamic products to the customers.

3)        Establishing a regulatory and supervisory body on IFI and Shariah principles

The government concerned should be supervising and monitoring the IFI activities, managements, governance and their business practices. For example the country’s Central Bank could assume these roles. Another critical body such as the Shariah Advisory Council can be put under the Central Bank in looking after the Shariah rules, guidelines and applications matters.

4)        Supportive towards Innovative Islamic financial products and services

The IFI innovate, develops, promotes and markets the products and services. As for the roles of the government are to support, foster and facilitate the innovations. For example, the government may consider giving more encouragement for equity-based product development to stimulate entrepreneurships in the economy by providing incentives to the IFI. At the same time giving ways for the expansion of debt-based Islamic products.

5)        Friendly and supportive taxation system for new IFI

The new IFI may require assistance from the government to stay afloat at the beginning. Therefore, the government could lend the support by giving tax incentive, maybe for the first five years of operation. In addition to that, the government can allow full rebate allowance for zakat paid or capital allowance for setting up of the new IFI company. Tax exemption could also be given for employees training on Islamic financial systems.

6.         Supportive legal framework and friendly government policy

Effective, supportive and friendly government policies are equally important to ensure the success of the IFI. For example, a speedy judiciary is essential for fair treatment of IFI because its investment risk is greater than that of a conventional financial institution and the IFI’s dealings are on profit and loss sharing.

7.         Establish an Islamic financial standard or joining the international standard body

The Islamic financial institution should apply the global Islamic financial standards such as the accounting, auditing and financial reporting as well as the code of conducts standard so that it can grasp the latest development in the Islamic financial system and stay competitive at all times.

In conclusion, to conclude my opinion, a gradual implementation or a step-by-step approach is the best way to set up an IFI that will eventually become part of Islamic financial system.

The government should take a preliminary step to provide for a strong foundation of IFI development by developing and enacting a regulation framework such as the Islamic Banking Act or Islamic Financial Act followed by the establishment of the IFI. Thereon, the IFI to develop products, services and other Islamic financial instruments as their offerings and alternative for the market. Once, the IFI has shown a positive growth they have to expand. The government may consider setting up a new platform to support the IFI’s expansion such as the Islamic Capital Market. The development of IFI and the Islamic financial system should be on a continuous effort for improvement, as new challenges will emerge as the time move forward.

Author: saupee @ All copy rights reserved 2013.

Islamic Banking and Finance Contributions to Economic Development of a Country

Islam prohibits riba because riba deprives justice and discourage people from undertaking real economic activities. Riba makes people putting hopes for reward rather than putting efforts to earn it. People with excess funds keep the money in the bank and earn interests. Banks lend the money they receive from depositors (surplus people) to borrowers (deficit people) and earn interests. Banks and surplus people, by having money excess money and lend it to the deficit people, are able to grow their money because of interest. The situation of the money grows from money through interest is the main core of conventional banking and finance systems. There is no additional increase of production in the economy. Although the system itself is growing (because of the payment of interest plus the principle amount), but the real economic activity actually did not take place.

The core proposition of Islamic finance draws from its inherent features and the values that it brings to the economy, and the tremendous potential that it offers in supporting sustainable economic growth and in safeguarding financial stability. These core propositions are derived from the Shariah, which dictates that Islamic financial transactions must be supported by underlying productive activities. This Shariah ruling ensures a close link between financial transactions and the real economy of a country.

Islamic banking and finance is strongly against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy of the country.

This decade has witnessed a dramatic transformation of the Islamic financial landscape. It has been marked by sustained rapid growth and the widening of its geographical reach, resulting in more diverse Islamic financial institutions and the generation of a wide spectrum of innovative products, particularly in the high-growth segment of the sukuk market. In this decade, Islamic finance has also evolved from being domestic-centric to become increasingly internationalised. In this dynamic environment, the scope of the Islamic finance business has expanded from simple retail and trade financing to include private equity, project finance, sukuk origination and issuance, as well as fund and wealth management products. This demonstrates that Islamic banking and finance has moved up its roles from a financial intermediary and financial market to be part of financial system of the country.

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth.

In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

The developments in Islamic finance have gained greater prominence in terms of their potential to improve financial stability outcomes, and most notably by the vital contribution that they make towards restoring the foundations for finance that supports sustainable economic growth, and bringing with it immense benefits to the real economic development and to the well-being of society of the country.

References:

1. Saiful Azhar Rosly (2005), Critical Issues on Islamic Banking and Financial Markets, Kuala Lumpur, Dinamas Publishing.
2. Abdul Ghafar Ismail (2010), Money, Islamic Banks and the Real Economy, Singapore, Cengage Learning.
3. Governor Zetty Akhtar Aziz's Speech at the Islamic Development Bank (IDB) Regional Lecture Series on Islamic Economics, Finance and Banking: “Finance and the Real Economy: Fostering Sustainability”, (2002), Jakarta.