Islamic Microfinance: The Shari’a way to bank the poor
May 20, 2011
Islamic microfinance is a buzz word in the development sphere nowadays. Both Islamic finance and microfinance have the noble goal of economic justice. As the Islamic religious law (Sharia) prohibits the use of interest (riba) when loaning or lending money. The Quran explicitly prohibits interest (or usury) on several occasions. Examples of this can be seen in the following verses: “O you, who have believed, do not consume usury, doubled and multiplied, but fear Allah that you may be successful. Allah has permitted trade and has forbidden interest.”Also the Prophet Muhammad treats the subject in his last sermon: “God has forbidden you to take riba, therefore all riba obligations shall henceforth be waived. Your capital, however, is yours to keep. You will neither inflict nor suffer inequity. God has judged that there shall be no riba and that all the riba due to `Abbas ibn `Abd al Muttalib shall henceforth be waived.”
In short Sharia sees interest as a tool of oppression and a means of usurping others’ assets in an equitable manner. By requiring interest on loans, society’s resources accumulate with the already wealthy. This leads to economic inequalities with poverty as a result, which is incompatible with Islamic equity.
However, this prohibition doesn’t mean it’s impossible to adjust interest-based microfinance to make it compatible with Sharia. On the contrary, the Quran contains segments that mandate for approaches similar to microfinance to curb poverty. Islam promotes charity from the donor’s point of view, but simultaneously wants to minimize the recipient’s dependence on charity.
The following story of the Prophet Muhammad’s living exemplifies this well:
A man of the Ansar came to the Prophet (peace be upon him) and begged from him. He (the Prophet) asked: Have you nothing in your house? He replied: Yes, a piece of cloth, a part of which we wear and a part of which we spread (on the ground), and a wooden bowl from which we drink water. He said: Bring them to me. He then brought these articles to him and he (the Prophet) took them in his hands and asked: Who will buy these? A man said: I shall buy them for one dirham. He said twice or thrice: Who will offer more than one dirham? A man said: I shall buy them for two dirhams. He gave these to him and took the two dirhams and, giving them to the Ansari, he said: Buy food with one of them and hand it to your family, and buy an axe and bring it to me. He then brought it to him. The Apostle of Allah (peace be upon him) fixed a handle on it with his own hands and said: Go, gather firewood and sell it, and do not let me see you for a fortnight. The man went away and gathered firewood and sold it. When he had earned ten dirhams, he came to him and bought a garment with some of them and food with the others. The Apostle of Allah (peace be upon him) then said: This is better for you than that begging should come as a spot on your face on the Day of Judgment. Begging is right only for three people: one who is in grinding poverty, one who is seriously in debt, or one who is responsible for compensation and finds it difficult to pay.” Muhammad asks the beggar to use his existing assets to build wealth instead of relying on handouts. This mindset is similar to the case of Islamic microfinance.
Fortunately Islamic banking system enables lending institutions to charge their clients without violating the Sharia law. These alternative solutions are not restricted to loans, but also include services such as savings, insurance and payment transactions. But since the scope of my essay is limited to loans this is the only of the Islamic banking services.
Somewhat simplified, Islamic theory regards a loan as a partnership between lender and borrower, because both parties are supposed to benefit from the deal. The loan provider benefits from the deal because he or she may charge the borrower for the service, while the borrower benefits from the deal because of the opportunity to invest the borrowed money in a business to increase its future yield. Both parties are hereby interdependent for making a profit, and according to Islam both parties should thereby share the financial risks.
According to Islamic financial theory, the risks taken by conventional banks when granting an interest-based loan aren’t sufficient for legitimizing its profits. If some individuals or corporations charge interest for lending money without sharing enough risk, this accumulates a majority of the financial means in the pockets of a handful, while a majority of the citizens are forced into a financial deficit. The fact that some live in luxury while many others live in poverty is not compatible with the Islamic vision of justice and thus it is not permissible to take interest on a loan. This egalitarian approach to the lending of money has been important in the shaping of Islamic banking.One theoretically elegant solution is that the bank decides whether a client’s investment plan is good enough. If so, the bank provides money for the investment in exchange for a share of future returns, if any. In this way, the borrower isn’t forced to repay the loan if the investment goes to nothing. But on the other hand, the repayment grows if the investment turns out to be very successful. This procedure (called Musharaka or Mudarabah depending on whether the client also invests own capital or not) is in practice suitable for larger loans because it requires the bank to investigate the client’s investment plan to a greater extent in comparison with a traditional interest-based loan since the repayment of the loan is directly dependent of if the investment plan is solid or not.
One of the most popular and most useful approaches for Islamic microcredit is the so called Murabaha loan. This loan works in such a way that the client informs the bank that he needs to buy a certain product or service. The bank then buys the product or service from a third party for a price known by the client. Then the bank sells the product or service to the client for a higher price than the bank paid for it, where the difference becomes the bank’s earnings. The client’s benefit is that the payment for the product or service is made at a later time or can be made as installments over an agreed period of time. There are several other approaches to solve the lending of funds in accordance with Sharia, but Murabaha is the method that’s had the greatest breakthrough in other geographical areas because of its simple design for both lenders and borrowers. Since alternative solutions to interest-based banking already exists; the step towards Islamic microfinance shouldn’t be far.
To conclude I recommend the microfinance institutions the need of Islamic microfinance, and the possibility to implement it, before the consequences becomes more than a moral issue.