Islamic Microfinance

Brought to you by CARE International

What is Islamic MicrofinanceIslamic, more correctly termed ‘Shariah-compliant’, microfinance is the provision of financial services for low-income populations in which the services provided conform to Islamic financing principles. In many respects, Islamic finance is simply ethical finance.

Islam sets out some broad principles that govern commercial transactions in general and the provision of finance in particular. One of the most important financing principles is that money is not an earning asset in and of itself. This means that interest is prohibited under Islamic law. Many Muslims therefore refrain from using interest based microfinance services for fear of breaching their religious beliefs. Islamic microfinance programmes cannot therefore imitate conventional microfinance programmes and are obliged to provide finance without charging interest. However, this does not mean that capital is free of charge, that it should be made available without any cost, or that there should be no return on the funds provided. Rather, a return on capital is allowed, provided that the capital participates in the productive process and is exposed to business risk.

In addition to not charging interest, there are other principles that must be followed in Islamic microfinance programmes. Firstly, transactions should be directly or indirectly linked to tangible economic activity and not financial speculation and excessive uncertainty. Secondly, the product bought or sold must be clear to both parties and only socially productive activities that are not exploitative and socially or morally harmful should be funded. For example, funding gambling or the sale of alcohol is prohibited. Furthermore, selling what one does not own is impermissible, and financial risk must lie solely with the lenders of capital and not with those who work the capital.

As a consequence, Islamic microfinance providers have developed a number of financing mechanisms that can be utilised according to the nature of the commodity or business and the period for which financing is sought. These are generally known by their Arabic names. Murabaha is the most popular and widely used Islamic financing instrument. This involves the resale of a commodity after the lender adds a specific profit margin (often referred to as the ‘mark-up’), which is paid by the borrower who agrees to buy that commodity. Usually, repayment is made in instalments to the financier, who pays the price to the original supplier of the commodity. This type of finance is commonly used for financing assets or working capital inputs, such as raw materials, machinery or equipment. For murabaha to be Shariah compliant the financier must own (or procure) the commodity first and then resell it, the commodity should be a tangible one, and the buyer must know and then agree to the purchase and resale prices.

Under mudaraba, a second type of contract, two parties are involved – the financier, who provides all the money, and the entrepreneur who uses his or her skill to invest the money in an attractive business venture. The profit from the mudaraba contract is shared by the financier and the entrepreneur according to a pre-determined ratio. Importantly, profit-sharing rates are a percentage of the profit and not a lump sum payment. In the case of a loss, providing it was incurred in the normal process of business and not due to neglect or misconduct by the entrepreneur, the financier loses all his or her money, while the entrepreneur merely loses his or her time and effort.

Another financing instrument called Ijarah is similar to leasing. Under this arrangement, an entrepreneur short of funds approaches a financier to fund the purchase of a productive asset. The financier may buy the productive asset and rent it out to the entrepreneur. The financier retains ownership of the asset and is responsible for its maintenance.

The Shariah compliant MFIs that participate in Lendwithcare each have a Shariah supervisory board that is comprised of local Islamic scholars who review and check all the financial services developed by each institution before they are offered to the public to ensure that they conform to Islamic law.

Lendwithcare's MFI partner from Pakistan, Akhuwat, only provides Shariah compliant finance. Therefore all loan requests from entrepreneurs in Pakistan on Lendwithcare are exclusively for Islamic financing.

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