Chapter II

REVIEW OF RELATED LITERATURE

Financial institutions in the Philippines
The issue of the linkages between the formal and informal financial sectors has gained
much attention in the literature on development finance (Floro & Ray, 1997). Thus, a study on
vertical links between these two financial institutions was conducted in a Philippine context. The
formal financial sector of the Philippines, under the direct supervision of the Central Bank of the
Philippines, includes commercial banks, thrift banks, rural banks, certain specialized government
banks and non-bank financial institutions such as investment houses, insurance companies,
financing companies, and securities market. On the other hand, the informal financial sector of
the Philippines include relatives, friends, credit cooperatives, rotating savings and credit
associations, landlords, millers, traders, and other agents who use financial dealings as an
important subsidiary activity.
Floro and Ray (1997) identified several considerations to reexamine the role of the
informal financial sector in promoting economic development in the Philippines. The first
identified consideration is the current structure of the formal credit sector.

The lack of

information about borrower characteristics and actions, which results to the limiting ability of
banks to guarantee repayment, is probably the most important constraint of the formal financial
sector. In the case of the small scale farmers, it would be not easy for them to provide collateral
that would be acceptable in the terms of the formal financial institutions. Second consideration is
the common response of governments to the perceived inadequate supply of credit in rural areas.
Generally, it has been in the form of subsidized credit programs, credit quotas, and targeted loan
policies at below-market rates of interest. This can be seen as politically attractive schemes and
such schemes do not directly address the related problems of information, incentives,
enforcement, and collateral. Moreover, the third consideration is the continuous operation of the
informal financial intermediaries in both rural and urban areas where they represent a principal
source of credit for many borrowers. These two intermediaries apply different sets of behavioral
rules and incentive to cater the needs of distinct group of borrowers.
The formal financial sector has played a very small role in the development of
microfinance programs (Dhumale & Sapcanin, 1999). On the other hand, the informal sector of

the Philippines is widely diverse. For instance, there is the highly personalistic system of
reciprocity among relatives and friends in which their loan transactions do not carry interest
charges (Floro & Ray, 1997). There are also cooperatives and credit unions which are owned and
operated by their members. These associations make us of their pooled funds to make loans and
sometimes provide other financial services to members. Lastly, there are trade and production
credit provided by input suppliers and output buyers to their client-producers.
The informal financial sector with informal financiers commonly called as the 5-6 is
prevalent in the Philippines especially in severely resource-constrained small vendors operating
in public markets (Kondo, n.d.). Both Filipinos and Indians are common to be these 5-6
financiers, each has a distinctive lending mechanism.
However, despite the efforts to provide access to financial services, it has often been
argued that both formal and informal sectors in the developing world have failed the people in
rural communities (Rao, 1980; Chowdhury, 2008 as cited in Ghalib, 2010).
Islamic Financial System
The elimination of riba, the money earned in lending out of the money itself or
commonly known as interest, claims as the most important feature of the Islamic financial
system (Institute of Islamic Banking and Insurance, n.d.). Unlike the conventional banking
system, Islamic financing can be defined as a faith-based system of financial management, which
derives its principles from the Islamic law or Sharia (Garas, n.d.). The first Islamic banks were
created in the 1970s, at the time when the aggiornamento of Islamic doctrine on banking matters
was taking shape (Warde, 2000). Islamic banks before were typically commercial banks
operating on an interest-free basis. It also take into account the operations that may or may not be
interest-free but are nonetheless instilled with certain Islamic principles: the avoidance of riba
(in the broad sense) and gharar (uncertainty, risk, speculation), focusing on Halal activities
(religiously permissible), and more generally the quest for justice and other ethical and religious
goals.
Islamic financial institutions now operate in over 70 countries and their assets have
increased more than forty-fold since 1982 to exceed $200 billion (Warde, 2000). Islamic
financial institutions come in all shapes and forms: banks and nonbanks, large and small,
specialized and diversified, traditional and innovative, national and multinational, successful and

unsuccessful, prudent and reckless, and strictly regulated and freewheeling (Warde, 2000). By
the application of the Shariah law or Islamic rulings to the operations of banks and other
financial institutions, it aims to eliminate exploitation and to establish a just society. It may be
viewed as a form of ethical investing or ethical lending except that no loans are possible unless
they are interest-free (Institute of Islamic Banking and Insurance, n.d.).
In Islam, money is not considered as an asset. Instead, it is viewed purely as a medium of
exchange, has no value, and just a way of defining the value of a thing. As stated in the Holy
Quran (2:279), interest is unfair, as implied by the word zulm (oppression, exploitation) and
can lead to injustice and exploitation in the society. All lenders in Islam obtain ownership
interests in the assets that they finance and earn a profit-share or purely fee-based compensation.
Obtaining equity or ownership and interest in a non-monetary asset are necessary for an Islamic
bank to earn a return on the money lent to the clients (Institute of Islamic Banking and Insurance,
n.d.). The participation of the lender in the sharing of risk is also required. Furthermore, the
practitioners and clients of Islamic financial institutions need not be Muslims but abiding the
ethical restrictions under the Islamic law is mandatory.
In Islam, there is a clear difference between lending and investing. Lending can be done
only on the basis of zero interest and capital guarantee, and investing only on the basis
of mudaraba or profit-and-loss-sharing (Gafoor, 1999). Conventional banking does not and need
not make this differentiation. However, an Islamic bank has to take this into consideration in
devising a system to cater to the Muslims. There are basically three (3) reasons for the
unlawfulness of riba (Qureshi, 1999 as cited in Rahman, 2007); (1) the creditors can ensure its
income from the interest paid by the debtor that will lead to the exploitation and living in
reduced circumstances which is a massive inequity, (2) riba is predetermined and the creditor is
certain to receive the interest imposed and therefore may prevent the creditor from being
involved in any occupation since it is certainly easy to receive income from the interest on a load
(Qureshi, 1991 as cited in Rahman, 2007), and (3) riba is due to an end of mutual sympathy,
human goodliness, and obligations since it may lead to borrowing and squandering.
The Islamic financial system promotes the concept of participation in a transaction
backed by real assets, utilizing the funds at risk on a profit-and- loss-sharing basis. Thus, Ahsan
(n.d.) identified five (5) Islamic contracts for commercial transactions:

Musharaka or profit and loss sharing In this contract, all participants share in the capital
as well as the profits and losses incurred. The profits will be distributed as per agreed
ratio while the losses are distributed as per capital ratio. Since both participants share the

profit and loss, every participant of the contract is agent of the other.
Mudaraba or profit sharing There are two (2) participants under this contract; the Rab
al Mal or the person who contributes the capital and the Mudarib or the person who
contributes his/her skills or services to the venture. The profits are shared by both of the
participants in a pre-agreed ration. On the other hand, losses are distributed to the Rab al

Mal only while the Mudarib loses his/her services.

Ijarah or leasing An asset is passed to other participant against a periodic rent payment.
The asset under this contract must be tangible. Furthermore, the rights will remain with
the original owner of the asset and therefore will bear all the risks related to the

ownership.
Salam or advance payment This contract is the exception to the general principle of
instant exchange of counter values in a contract of sale. In the case of paying in advance,

full payment must be observed. Installment in advance, however, is not allowed.

Murabaha or cost plus margin sale It is a sale of a commodity at cost plus margin and
has fulfilled all the conditions of a valid sale. It may be a credit sale but deferred price
becomes a debt and shall be dealt as a loan transaction. Under this contract lies the
following conditions:
- it must fulfill all the conditions of a valid sale,
- the bank should purchase the asset from a third party and not from the
-

customer itself,
the bank must own the asset before it sells to the customer,
the seller must know and disclose the cost including freight, insurance, taxes,

etc., and
profit may be fixed in aggregate sum or through agreed ratio to be charged
over the cost.

Islamic Finance to Microfinance

Microfinance institutions provide financial services such as credit and savings services to
the entrepreneurial poor that are suitable to their needs and conditions. Many elements of
microfinance could be considered consistent with the broader goals of Islamic banking (Dhumale
& Sapcanin, 1999). Since both systems advocate entrepreneurship and risk sharing and believe

that the poor should take part in such activities, Islamic banking and microfinance may
complement one another in both ideological and practical terms. According to Dhumale and
Sapcanin (1999), this relationship between the two would not only provide obvious benefits for
poor entrepreneurs who would otherwise be left out of credit markets, but investing in
microenterprises would also give the investors in Islamic banks an opportunity to diversify and
earn solid returns. There are three (3) basic instruments of Islamic finance that could be built into
the design of a successful microfinance program (Dhumale & Sapcanin, 1999): mudaraba
(trustee financing), musharaka (equity participation), and murabaha (cost plus markup; Abdouli,
1991 as cited in Dhumale & Sapcanin, 1999).

Mudaraba and Musharaka models The microfinance program and the

microenterprise are partners, with the program investing the money and the
microentrepreneur investing the labor. In both mudaraba and musharaka, the
financing organization and the business work in partnership. However, in
mudaraba, the financier invests only money and the entrepreneur invests labor
while in musharaka, both the financier and the entrepreneur invest funds. The
microentrepreneur is rewarded for his or her work and shares in the profit while
the program only shares in the profit. Although profit-sharing rates are
predetermined, the profit is still unknown. This will result with the microfinance
program taking the equity in the microenterprise through the loan. At the
beginning of the contract, the microfinance program may own 100% of the shares
and would hence be entitled to its predetermined share of all the profit. However,
as each loan installment is repaid, the microentrepreneur buys back shares. As a
result, the microfinance program earns less profit with each repayment received.
From a microfinance perspective, this model has several drawbacks. First is the
uncertainty of the profit. Although microfinance programs have information on
local market behavior, the profits still fluctuate and therefore giving a challenge
for microlending within Islamic banking principles. Another drawback is the
burden of loan administration and monitoring. The lack of simplicity would

confuse borrowers and loan officers.

Murabaha model The microfinance program literally buys goods and resells
them to microenterprises for the cost of the goods plus a markup for

administrative costs. The borrower often pays for the goods in equal installments.
This model is easier for borrowers to understand and simplifies loan
administration and monitoring. The microfinance program owns the goods until
the last installment is paid.
Reliability and Validity Test
Alpha was developed by Lee Cronbach in the year 1951 to provide a measure of the
internal consistency of a test or scale which can be expressed by a number between 0 and 1
(Tavakol & Dennick, 2011). It is one of the most commonly reported reliability estimates in the
language testing literature (Brown, 2002). The validity of the content refers to the degree to
which the test is related to the traits for which it was designed (Natukunda, 2010). It also shows
how adequately the instrument samples the knowledge, skills, perceptions, and attitudes that the
respondents are expected to exhibit. However, a high coefficient alpha does not always mean a
high degree of internal consistency. Alpha is affected by the length of the test which means that if
the test is too short, the alpha is reduced (Tavakol & Dennick, 2011).
In the microfinance context, Cronbachs alpha was employed in different areas.
Natukunda (2010), for one, made use of the Cronbachs alpha in the study Microfinance Credit
Lending Terms, Networks, and Performance of Women Enterprises: The Case of Wakiso District.
Being a reliability and validity test as the nature of the Cronbachs alpha, it was employed to
determine the content validity index to ensure the appropriateness of the research instrument.
The perception of the respondents was included in the study with three (3) different components;
credit lending, networking, and performance of women enterprises. All of which were scaled
from 1 (as the minimum) to 5 (as the maximum).

Principal Component Analysis.

Principal component analysis is a variable reduction procedure. It is useful when you
have obtained data on a number of variables (possibly a large number of variables), and believe
that there is some redundancy in those variables (sas.com, n.d.). Redundancy, meaning some of

the variables are correlated, happens possibly because they are measuring the same construct. In
the course of performing a principal component analysis, it is possible to calculate a score for
each subject on a given principal component.
In the microfinance context, Fraser and Kazi (2004) applied the principal component
analysis method to determine how information from various indicators can be most effectively
combined to measure a households relative poverty status, in relation with the assessment of the
relative poverty of clients and non-clients of non-bank microfinance (MFI) institutions in
Tanzania. In the said study, the end result of the PCA generated a score representing the
households poverty status in relation to all other households in the sample. The scores of the
MFI client and non-client households were compared to measure the extent to which the MFI
reaches the poor.
On the other hand, Lpple (2012) also employed the principal component analysis
method in comparing the attitudes and characteristics of organic, former organic, and
conventional farmers in Ireland. The attitude statements under the four (4) components;
environmental attitude, profit orientation, risk attitude, and information seeking attitude were
used in the PCA as it revealed the underlying structure of the data and reduced its dimensionality.
The statements were retained if they had loadings near or above 0.6 on one component and 0.2 or
less on all other components. With the use of PCA, the numbers of statements were reduced to
twenty three (23).