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Tuesday, March 16, 2010

Islamic Microfinance – An overview.

IslamOnline - Islamic Finance | 15 March 2010 - Micro-finance as a means of offering basic banking and small loans to those typically unable to gain such services in the mainstream finance markets was pioneered by Bangladeshi economist Dr. Muhammad Yunus. Dr Yunus was awarded the Nobel Prize for his immense contribution in poverty alleviation of Bangladesh.

Islamic Microfinance Contracts

Micro Islamic or Sharia compatible products use the same contracts and methods as traditional mainstream Islamic Banking.

These contracts can either operate individually or be combined with other contracts. Below are some of the common Islamic microfinance contracts.

Murabaha Sale (cost plus markup sale contract):
Ijarah (leasing contract)
Musharaka and Mudaraba (profit and loss sharing)
Takaful (mutual insurance)

Mudaraba Model:

The microfinance program and the microenterprise are partners in mudaraba-based transactions. In musharaka both the financier and the entrepreneur invest funds, while in mudaraba the financier invests only money and the entrepreneur invests labor. In this model the microentrepreneur is rewarded for his work and shares in the profit and the program only shares in the profit. In this process, profit is unknown, but profit-sharing rates are predetermined.

In this model with comparison to other forms of Islamic banking, the lending agency would not be entitled to a distribution of its share in case entrepreneur’s suffer losses. However, the lending agency could also agree that in case the entrepreneur was to generate more profits, he would be entitled to retain 100% of the same. For businesses with a longer profit cycle the mudaraba model might be beneficial

A Murabaha Model:

The murabaha contract is similar to trade finance in the context of working capital loans and to leasing in the context of fixed capital loans. Under this contract, the microfinance program buys goods and resell them to the microenterprises for the original cost of the goods plus a markup against administrative costs. The borrower is responsible to pay back the amount against commodity he gets in equal installments. The murabaha model is simple to understand for borrowers, under this model the microfinance program will remain the owner of product until the last installment is paid.

Under microfinance murabaha model the procedure for loan application is simple. Once a loan application approved, the loan officer buys the chosen products and resells the borrowers after adding up a markup amount.

Some sharia focused clients have expressed doubts about the mechanism of murabah (buy-resell) because it looks similar to the forbidden practice of fixed interest rates (riba). In such situation, mechanism should be explained properly to borrowers and local religious leaders.

In some interpretations the handling and obtaining a loan in the form of money is considered haram (forbidden). In those areas, borrowers prefer to purchase goods that the microfinance program would purchase on their behalf and then “resell” to them. The major possible drawback of this model is the program’s higher administrative cost.