Case study Islamic microfinance and socially responsible Investments

Islamic micro finance and socially responsible investment

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273. " (Charity is) for the poor who are restrained in the way of Allah, and are unable to move about in the land. The unaware consider them wealthy because of their restraint (from begging). You shall recognize them by their countenance - they do not beg people importunately. And whatever of good things you give, then Allah is All-Knowing of it."

Islamic micro finance and socially responsible investment Table of contents: 1. Introduction 2. The basic principles of Islam and Islamic finance 2.1 The principles of Islamic banking 2.2 The Islamic financing contracts a Murabaha b Ijara and Ijara wa-Iqtina c Istinsa d Mudaraba e Musharaka 3. The basic principles of microfinance 4. Islamic microfinance 3. Future perspectives 4. Micro finance helps in poverty alleviation 5. Increase in investment of banks 6. How we can increase in Islamic financing 7. Reasons fail in implementing Islamic financing 8. References

Islamic micro finance and socially responsible investment

1. Introduction In his famous book Wealth of Nations, Adam Smith argued that participation in

religious sects could potentially convey two economic advantages to adherents (Anderson 1988, Noland).The first could be seen as a reputational signal: while the poor might look alike to potential employers, lenders, and customers, membership in a specific group could convey a reduction in risk associated with the particular individual and ultimately improve the efficient allocation of resources. Second, religious groups could also provide for extra-legal means of establishing trust and sanctioning miscreants in intergroup transactions, again reducing uncertainty and improving efficiency, especially where civil remedies for failure to uphold contracts were weak

Islamic micro finance and socially responsible investment My research aims to focus on different issues: whether the economic behavior can be influenced by the predominant religious belief, the role of Islamic finance in Muslim societies nowadays but most of all its potential to fight poverty in those countries belonging to the so called developing world, when related with important economic development tools such as microfinance. Both Islamic finance and microfinance seem to be concepts surrounded by a Fashionable aura in Muslim developing countries: banks, financial institutions, MFIs, NGOs are very interested in the issues and most of all in the relation between the two, especially when it comes to fighting poverty. Strange enough, even if the interest is high, there are very few examples of actual MFIs operating in the field of Islamic finance and Islamic banks involved in microfinance. Nevertheless, evidence proved that there is a need for and an interest on Islamic microfinance, for different reasons: a. microfinance is a very flexible tool, whose models can be replicated but require to be tailored on the local socio-economic and cultural characteristics b. the potential demand for tailored microfinance services is still largely unmet, also countries where the majority of the population is constituted by Muslims c. some surveys proved that there is a high demand for Islamic banking especially in low and middle income predominantly Muslim societies. d. commercial banks could be interested in this issue as a tool to reach interesting market niches, create loyalty in their clients and accomplish their client satisfaction strategies . e. Islamic finance, microfinance and socially responsible finance share most of their principles, such as: y y Prohibition of all forms of economic activity which are morally or socially injurious Egalitarian approach (no restriction to any category of clientele) in

Islamic micro finance and socially responsible investment y Focus on the well being of the community as a whole, concentrating on the poor, destitute or deprived sections of the society y y y y y Aim at social justice Advocacy of entrepreneurship Advocacy for financial inclusion through partnership finance Participatory approach Risk sharing

Moreover, they both constitute forms of finance that represent unconventional but effective solutions to financial needs, focusing on activities that lack capital but are promising and show a potential. At a very basic level, the disbursement of collateral free loans in some cases constitutes an example of how Islamic banking and microfinance share common aims. Thus Islamic banking and microcredit programs may complement one another in both ideological and practical terms (Dhumale, Sapcanin, 1999). Even if they both constitute fairly new trends in the financial environment, the inclusion of Islamic finance and microfinance in the activities of the traditional banking system evolved in a quite similar way, because they both started from a marginal position and managed to reach a growing popularity. 2. The basic principles of Islam and Islamic finance Islam is the worlds fastest growing religion, a process of growth that does not affect only the traditional Islamic countries, namely those located in Northern Africa and Middle East,

Islamic micro finance and socially responsible investment but also other countries in every continent. Muslims cover approximately a quarter of the worlds population, 1.2 billion people. According to the tradition, the Prophet Muhammad was born in Makkah, a city in the present-day Saudi Arabia in 570 C.E. Muhammad received divine revelations (The Holy Quran) over a period of 23 years in the seventh century of the Christian Era. For Muslims, the Holy

Quran and the Sunnah constitute the primary sources of knowledge: the Holy Quran confirms what was revealed to earlier messengers of God and serves as the criterion of what is right and what is wrong while the Sunnah is collected in books which are separated from the Holy Quran and are known as Hadith books. While the Holy Quran is considered totally as the word of God revealed to the Prophet, not every hadith is considered authentic. Early Muslim scholars have classified hadith into various categories ranging from different levels of authenticity to false hadith. In Islamic societies, the Sunnah constitutes the second most important source of jurisprudence after the Quran. The most difficult part of Islamic Law for most westerners to grasp is that there is no separation of religion and state. The religion and the government are one. Islamic Law is controlled, ruled and regulated by the Islamic religion. The theocracy controls all public and private matters. Government, law and religion are one. There are varying degrees of this concept in many nations, but all law, government and civil authority rests upon it and it is a part of Islamic religion. There are civil laws in Muslim nations for Muslim and non-Muslim people. Shariah is only applicable to Muslims and it governs every aspect of their lives. The foundations of Muslim life are the so called Five Pillars of Islam: faith or belief in God and the finality of the prophet hood of Muhammad, worship respecting the five daily

Islamic micro finance and socially responsible investment prayers, almsgiving and concern for those who are in need, self-purification through fasting and the pilgrimage to Mecca for those who are able to do it. Not unlike the non-Muslim developing countries, those counting a significant Muslim population have tested a huge variety of economic systems. For centuries Muslims have

developed ways to integrate their religious beliefs with the external economic realities of the nations they lived in. This has shown varying degrees of compatibility with the empires and customs they encountered. Like most things in Islam, the economic and financial issues adapts to al-urf, "the custom". The economic systems that were set in Muslim countries have generally followed the blueprints of the developing world and reflect persistent tensions between equity and growth, import substitution and export-led industrialization, and agricultural and industrial investment. Due to the close ties between some Muslim countries and the global economic and financial system, however, these tensions have expressed themselves in particularly stark form in much of the Muslim world. For example, oil wealth and the resulting flow of labor remittances and bilateral aid has dramatically influenced the course of development in many Muslim countries, stretching from Tunisia to Malaysia. The extent to which religious doctrine has influenced economic policy and the normative choices that underpin such policies varies tremendously over time both within and among Muslim countries. Islam has no single, monolithic vision of economic justice; as a result, there is a void at the heart of Islamic doctrine which is filled by the complex interaction of political, social and economic forces. Thus the vexing question of why Islam is brought into debates on economic policy at some junctures and ignored at others becomes a task for historical and sociological inquiry.

Islamic micro finance and socially responsible investment In Muslim countries, especially those located in the North Africa and Middle East region, the economic liberalization and increasing interdependence of the 1980s and 1990s highly influenced the political and economical choices of governments. The banking system, in particular, strongly reacted to these changes: in the 1980s and 1990s Muslim bankers and religious leaders developed ways to integrate Islamic law on usage of money with modern concepts of ethical investing. Consequently, a sophisticated economic discipline has emerged with its own concepts, analytical tools and institutions. Some of these revived traditional micro venture capital and ethical investing frameworks that thrived in medieval times. However, they incorporated many modern techniques and technologies. A number of researchers suggest that the underlying causes of the genesis of modern Islamic economics was based more on the desire to reflect beliefs about Islamic identity than to establish a more ethical or religiously sound banking system. 2.1 The principles of Islamic banking: Islamic banking, based on the Quranic prohibition of charging interest, has moved from being a theoretical concept to embrace more than 100 banks operating in 40 countries with multibillion dollar deposits world-wide. Islamic banking is widely regarded as the fastest growing sector in the Middle Eastern financial services market. It is important then to understand the principles of Islam that underpin Islamic finance. The Shariah consists of the Quranic

commands as laid down in the Holy Quran and the words and deeds of the Prophet Muhammad. The Shariah disallows Riba and there is now a general consensus among Muslim economists that Riba is not restricted to usury but encompasses interest as well. The Quran is clear about the prohibition of Riba, which is sometimes defined as excessive interest. "O You who believe! Fear Allah and give up that remains of your demand for usury, if you are indeed believers." Muslim

Islamic micro finance and socially responsible investment scholars have accepted the word Riba to mean any fixed or guaranteed interest payment on cash advances or on deposits. Several Qur'anic passages expressly admonish the faithful to shun interest. In general, the principles of Islamic banking are: a. Al Zakat (the 4 the pillar of Islam). One of the most important principles of Islam is

that all things belong to God, and that wealth is therefore held by human beings in trust. The word zakat means both 'purification' and 'growth'. Our possessions are purified by setting aside a proportion for those in need. b. The prohibition of taking interest rates (Al Riba), Within the Islamic scholars. there are two interpretations on what Riba means: - A modernist view, according which reasonable interest rates are allowed - A conservative view, which states that any kind of fixed interest is wrong c. the prohibition of unproductive speculation or unearned income (Al Maysir ) as well as

gambling (Al Quimar)

d. e.

freedom from excessive uncertainty the prohibition of debt arrangements - most Islamic economic institutions advise

participatory arrangements between capital and labor. The latter rule reflects the Islamic norm that the borrower must not bear all the cost of a failure, as "it is Allah who determines that failure, and intends that it fall on all those involved." While the banning of interest is rooted in Muslim theology, proponents of Islamic finance provide strong motivations to support the ban of interest rate. First of all, in an Islamic profit sharing contract the return on capital will depend

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Islamic micro finance and socially responsible investment on productivity and the allocation of funds will be primarily based on the soundness of the project, improving the capital allocation efficiency. Second, the Islamic profit sharing system will ensure more equitable distribution of wealth and the creation of additional wealth to its owners. Third, the profit sharing regime may increase the volume of investments and hence create more jobs. The interest regime accepts only those projects whose expected returns are higher than the cost of debt, and therefore filter out projects which could be acceptable under the Islamic profit sharing system (Zahier, Hassan). According to the Indian researcher Dr. F.R. Faridi, Islamic Economics comprises Justice, Equality and Fair Play. In fact, it is the best form of bringing about equality among the masses. Islamic Economics defines certain rules that regulate company structure, effectively preventing abuse and corruption. For instance, Islam forbids monopolies by outlawing the hoarding of wealth and eliminates copyright or potency laws that would open the avenue for potential monopolies to develop. Also, Islam protects the ownership of businesses and companies by restricting ownership of companies only to those who contribute both capital and effort to the company or business, thus effectively putting the seal on such concepts as

corporate takeover from ever becoming a reality. Islamic banking presents a holistic approach, based on Islamic principles on behalf of the individual and at the same time of the society he/she belongs to giving serious consideration to the global development constraints of the society. 2.2 The Islamic financing contracts: Since Islamic Banking can be rather complex, Sharia principles are governed by Islamic experts or Ulama. It is always essential to obtain the approval of the Sharia advisor of the bank on the forms of the financing contracts, in order to ensure their compliance

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Islamic micro finance and socially responsible investment with the principles of Islamic Sharia. These contracts in fact are exposed to high risks and arise a problem of moral hazard. In fact, they require substantial trust between the banks and their customers in terms of honesty, integrity, management and business skills. Equally problematic is the aspect of monitoring and supervision. Given the fact that both mudharabah and musharakah are equity financing in character, collateral is not a prerequisite. .Tarek S. Zaher and M. Kabir Hassan (2001) define five basic Islamic financing Contracts: y y y y y Murabaha (Financing Resale of Goods) Ijara and Ijara wa-Iqtina (Lease financing) Istinsa Mudaraba (or Modaraba participation financing) Musharaka

a. Murabaha : This constitutes one of the most well known Islamic products, consisting in a cost-plus profit financing transaction in which a tangible asset is purchased by an Islamic institution at the request of its customer from a supplier. The Islamic institution then sells the asset to its customer on a deferred sale basis with a markup reflecting the institutions profit b. Ijara and Ijara wa-Iqtina These concepts are very close to the Western idea of leasing. In the first case the financial institution leases an asset to its customer agreeing on lease payments for a certain period of time but excluding the option of ownership for the client. In the second case, the client has the option ownership by buying the asset from the financial institution. The conditions governing both types of leasing are that assets must have a long/secure productive life, and must

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Islamic micro finance and socially responsible investment not be handled in an un-Islamic way, meaning that the lease payments must be agreed on in advance to avoid any speculation c. Istinsa: Istinsa is a pre-delivery financing and leasing structured mode that is used mostly to finance long term large scale facilities involving, for example, the construction of a power plant. d. Mudaraba : Mudaraba is a trust based financing agreement whereby an investor (Islamic bank) entrusts capital to an agent (Mudarib) for a project. Profits are based on a pre-arranged and agreed on a ratio. This agreement is akin to the Western style limited partnership, with one party contributing capital while the other runs the business and profit is distributed based on a negotiated percentage of ownership. In case of a loss, the bank earns no return or negative return on its investment and the agent receives no compensation for his (her) effort In this kind of contract, all the financial responsibilities rely on the business itself: the financial institution invests on an idea, a project and shares its fate. From the perspective of financial services, Modaraba falls under three categories: 1. Demand Deposits: These deposits are not restricted, payable on demand and do not share in any profits. 2. Mutual Investment Deposits: An Islamic Bank will combine these deposits with the Banks money in order to participate in mutual investment transactions conducted by the bank. Under these deposits, the percentage of profit is fixed at the end of the banks financial year. 3. Special Investment Deposits: An Islamic Bank will invest these deposits in a specific project or investment upon the request or the approval of the depositor. The depositor in this case will

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Islamic micro finance and socially responsible investment be entitled to receive profit and is liable for the losses, provided that the bank is not negligent or in default. At the end of the deposit period, the bank receives its share of profit against its contribution of experience and management, while the depositor receives his share of profit as a capital share contributor. e Musharaka : This contract is very similar to a joint venture with participation financing. Two parties provide capital for a project which both may manage. Profits are shared in pre-agreed ratios but losses are borne in proportion to equity participation The peculiar aspect. Of this contract is not the sharing the profit and losses, but sharing the management and the decision making process. 3. The basic principles of microfinance: Microfinance is constituted by a range of financial services for people who are traditionally considered non bankable, mainly because they lack the guarantees that can protect a financial institution against a loss risk. The true revolution of microfinance is that this tool gives a chance to people who were denied the access to the financial market opens new perspectives and empowers people who can finally carry out their own projects and ideas with their own resources, and escape assistance, subsidies and dependence. Microfinance experiences all around the world have now definitely proved that the poor demand a wide range of financial services, are willing to bear the expenses related to them and are absolutely bankable. The target group of microfinance is not constituted by the poorest of the poor, who need other interventions such as food and health security, but those poor who live at the border of the so called poverty line. Those who could reach more easily a decent quality of life and who have entrepreneurial ideas but lack access to formal finance.

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Islamic micro finance and socially responsible investment Beginning in the 1950s, development projects began to introduce subsidized credit programs targeted at specific communities. These subsidized schemes were rarely successful. Rural development banks suffered massive erosion of their capital base due to subsidized lending rates and poor repayment discipline and the funds did not always reach the poor, often ending up concentrated in the hands of better-off farmers. In the 1970s, experimental programs in

Bangladesh, Brazil, and a few other countries extended tiny loans to groups of poor women to investment in micro-businesses. This type of microenterprise credit was based on solidarity group lending in which every member of a group guaranteed the repayment of all members. Through the 1980s and 1990s, microcredit programs throughout the world improved upon the original methodologies and bucked conventional wisdom about financing the poor. First, it showed that poor people, especially women, had excellent repayment rates among the better programs, rates that were better than the formal financial sectors of most developing countries. Second, the poor were willing and able to pay interest rates that institutions (MFIs) to cover their costs. These two featureshigh repayment and cost-recovery interest ratespermitted some MFIs to achieve long-term sustainability and reach large numbers of clients. In fact, the promise of microfinance as a strategy that combines massive outreach, far-reaching impact, and financial sustainability makes it unique among development interventions Microfinance is considered a very effective development tool: for this reason, year 2005 has been declared by the General Secretary of the United Nations International Year of Microcredit. Microfinance is also a very flexible tool that can be adapted in every environment, based on the local needs and economic and financial situation. For example, in Asia group micro lending proved to be very effective, while in Egypt or in Brazil beneficiaries prefer individual allowed microfinance

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Islamic micro finance and socially responsible investment lending. One more example: MFIs (Microfinance Institutions) and NGOs (Non Governmental Organizations) in India mostly rely on savings collection to support their institution and become sustainable while in Egypt they are forbidden by law to collect savings. Microfinance can be effective both in the South of the world and in Western countries, equally characterized by financial and social exclusion. Following this logic, microfinance can easily be adapted to certain cultural environments, such as countries characterized by a majority of Muslims that follow the Islamic law. Moreover, the similarities in the principles of the two make microfinance easier to expand in those countries, giving life to the new hybrid reality of Islamic microfinance. A few studies have been carried out on the subject and experience on the field is still relatively small, but it proves to have huge potentialities both to fight against poverty financial and social exclusion and to enlarge and enrich the basin of clients of financial institutions in developing countries with an Islamic cultural substratum. 4. Islamic microfinance Islamic convictions on the responsibility go well beyond mere profitability goals and coincide with the renewed perception on business recently at stake within the most advanced sectors of western business and civil societies. Far from the limits imposed by neo-classical thought, this new wave implies new sorts of responsibilities on behalf of the company falling under the rubric of corporate social responsibility (Ferro, 2005). As its ultimate goal is the maximization of social benefits as opposed to profit maximization, through the creation of healthier financial institutions that can provide effective financial services also as grass roots levels, some authors (Al Harran, 1996) argue that Islamic finance, if inserted in a new paradigm, could be a viable alternative to the socio economic crisis lived by the Western paradigm. As stated before, a relatively few studies and a few experiences on the field are concentrated on

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Islamic micro finance and socially responsible investment Islamic microfinance. Between the most complete researches on the topic, Dhumale and

Sapcanin (1999) drafted a technical note in which they tried to analyze how to combine Islamic banking with microfinance. They took into consideration the three main instruments of Islamic finance (mudaraba, musharaka and murabaha) trying to use them as tools to design a successful microfinance program. 1. A mudaraba model: The microfinance program and the microenterprise are partners, with the program investing money and the microenterpreneur investing in labor. The microenterpreneur is rewarded for his/her work and shares the profit while the program only shares the profit. Of course the model presents a series of difficulties, given most of all by the fact that micro entrepreneurs usually do not keep accurate accountability which makes it more difficult to establish the exact share of profit. As stated before the, these models are complicated to understand, manage and handle which implies that those who are involved need specific training on the issues. For this reason, and for an easier management of the profit sharing scheme, the mudaraba model might be more straightforward for businesses with a longer profit cycle. A murabaha model: Under such contract, the microfinance program buys goods and resells them to the microenterprises for the cost of the goods plus a markup for administrative costs. The borrower often pays for the goods in equal installments, and the microfinance program owns the goods until the last installment is paid. A murabaha model example: Hodeidah Microfinance

Programme, Yemen although traditional banking products have been available in Yemen for many years (and are still the predominant type of finance), many people, especially the poor,

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Islamic micro finance and socially responsible investment have been reluctant to take credit, in part due to religious beliefs. This is one of the main reasons why the Hodeidah Microfinance Programme (HMFP) was implemented in 1997, in Hodeidah, a port city with a population of nearly half a million. It is characterized by an active economy based on trading, fishing, food production, small industries, handicrafts and transportation. In the early 1990s, during and after the Gulf War, many families returned to this city from Saudi Arabia and other Gulf States. Now, roughly 30 percent of the total population in Hodeidah are returnees, a key market segment for HMFP. Much of the population has conservative Islamic beliefs. The population studied showed a clear preference for the methodologies of Islamic banking in terms of receiving credit. HMFP is the first microfinance project of its kind in

Yemen and consequently has had to develop its human resources itself. It had 1770 active clients as of June 2000, 23 percent of whom were women and $350,000 in outstanding loans. The

average loan size is 38,000 Yemeni Rial (YR) ($240 US dollars). There is a cycle of loans the clients go through but each level has a wide scope. The first loan can be up to 50000 YR ($300 US). The maximum loan for the final level is 250,000 YR ($1500 US).HMFP uses a group-based methodology. Group members are not confined to the same loan amounts or the same activities, although loan amounts need to be within the range of the cycle set by HMFP. There is also a small percentage of individual loans (10 percent). The procedure is as follows: upon receipt of the loan application, the credit officer investigates the group and does feasibility study for their activities. From this study, the officer can estimate the precise loan amount. If the feasibility study is positive, the client should identify items (commodities/equipment) needed from the wholesaler and negotiate a price. The credit officer then purchases items from that source and resells them immediately at that price to the client. HMFP has two elements of accounting/finance, which differ from most microfinance

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Islamic micro finance and socially responsible investment organizations. Both have implications for content of financial statements. The first is capitalization of the service charge expected upon disbursement, which affects the balance sheet. The second is the absence of the "principle of interest" on outstanding loan balances affecting yield on the portfolio and thus income earned. Source (for detailed information also): UNCDF web site 16 Range, in his paper (2004), underlines how the prohibition of Riba in Islamic finance does not constitute an obstacle in building sound microfinance products; on the contrary, the side effects of an Islamic foundation could probably enhance it. These effects are: the high rate of return (compared to a fixed interest rate), the holistic approach in supporting businesses and productive activities, a more effective mobilization of excess resources, a fairer society. An interesting case: the Mali-North Program of the German cooperation GTZ (German Technical Cooperation) and KfW (German Financial Cooperation) worked on a development project in the former civil war areas of Timbuctu, Mali, constituted by three main components: rural development, promotion of municipal structures and microfinance. The microfinance project was supposed to start through the creation of a financial institution managed and refinanced by the Banque Nationale de Dveloppement Agricole (BNDA), set in Bamako. But the potential customers of the bank preferred discuss the proposal in order to find a more suitable solution. The aim of the project was quite ambitious: the financial services were supposed to reach all the tribes of the area, the Moors, the Tuareg and various black African groups. The only common denominator on which the previous civil war opponents could agree was Islam: a bank that respected the religious rules for financial services would have been accepted by anyone. The selected bank was Azaouad Finances plc: the bank disburses loans and also promotes the collection of savings, not charging interest but participating in the profits and losses of the borrowers. With the loan from Azaouad Finances,

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Islamic micro finance and socially responsible investment the market in the area blossomed: the business relationships of local merchants now reach Abidjan and the Arabian Peninsula. The bank also has a small program intended to support women entrepreneurs. The bank also entered into cooperation with the BNDA in order to thereby link up with the SWIFT international payments system. Now the herdsmen can deposit the earnings from their business dealings in Abidjian or Dubai into their account in the town of Lere using a SWIFT transfer. Source: Small Loans according to the Koran, Kohler W. Microfinance Akzente special GTZ Poverty Alleviation through Zakat and Waqf: The institution of microfinance was developed to create access to funds for the poor and unbanked population. However, Conventional microfinance is not for the poorest of the poor. There is a sizeable substratum within the rural poor whose lives are unlikely to be touched, let alone improved by financial services. They are not "bankable" in their own or their neighbour's eyes, even when the bank is exclusively for poor people. Yet they desperately need some sort of assistance. In addition, traditional microfinance institutions based on compounding interest causes serious hardship on the borrowers in servicing their debt. It is, therefore, important that access to credit is provided to the poor on more humane, interest-free basis. This may be possible if the microfinance system is integrated with zakat and waqf institutions. An Islamic microfinance system, on the other hand, identifies being the poorest of the poor as the primary criterion of eligibility for receiving zakah. It is geared towards eliminating abject poverty through its institutions based on zakah and sadaqah. Zakah and sadaqah as instruments of charity occupy a central position in the Islamic scheme of poverty alleviation. Zakah is the third among five pillars of Islam and payment of zakah is an obligation on the wealth of every Muslim based on clear-cut criteria. Zakah has been variously described by

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Islamic micro finance and socially responsible investment scholars as a tool of redistribution of income, a tool of public finance, and of course, as a mechanism of development and poverty alleviation. Rules of Shari[ah are fairly clear and elaborate in defining the nature of who are liable to pay zakah and who can benefit from zakah. The first and foremost category of potential beneficiaries is the poor and the destitute. A greater degree of flexibility exists with respect to beneficiaries of sadaqah. The primary issue with zakah and sadaqah-dependent institutions is the issue of sustainability as they are essentially rooted in voluntarism. Funds mobilized through charity could fluctuate from time to time and may not lend themselves to careful planning and implementation. The issue of sustainability is addressed in the institution of awqaf through creation of permanent and income-generating physical assets. Awqaf has historically been the major vehicle for creating community assets. On the flip side, the restrictions on development and use of assets under waqf for pre-specified purposes introduce rigidity into the system. Undoubtedly, it is important to preserve and develop assets under waqf to add to productive capacity and create capabilities for wealth creation. Awqaf may also be created specifically to impart knowledge and skills in entrepreneurship development among the poor as microfinance alone cannot create wealth unless combined with entrepreneurial skills. Indeed all technical assistance programs can be organized as awqaf. While zakah funds must be distributed to the destitute and poorest of poor, this institution could be integrated with microfinance. This may be attempted by seeking to push such individuals through zakah distribution out of dire poverty to levels, where they are no longer regarded as unbankable by MFIs. A linkage if established between the MFIs and zakah funds would enhance the effectiveness of microfinance towards achieving poverty alleviation.

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Islamic micro finance and socially responsible investment Zakat is a cornerstone of the values that govern Islamic economics. It created the first universal welfare system in human history. It specifies the manner in which zakat revenue is to be raised and who pays it. On the expenditure side it set forth the uses of zakat revenue. Like a modern budget it describes the economic order that it attempts to establish and express the ideals and aspirations of society. As a fiscal mechanism zakat performs some of the major functions of public finance which deals with social security entitlement system like food subsidy, education, health care etc. Thus Islam discourages accumulation of personal assets and encouraging eradication of poverty. Zakat is Free Money. t is a grant for the poor it may be reiterated that zakat is an Islamic charitable fund and therefore, no form of interest or profit can be made from it. It is free money and it a right of the poor and hence may be used in Islamic microfinance. Although traditional interest based microcredit has evolved as an important tool for poverty alleviation, it is failing to attain desired effects for many reasons: A major portion of loan disbursed to the poor is diverted to fulfill their basic consumption needs that leaves them with smaller investable fund and hampers business profitability.

Traditional microfinance institutions (MFIs) charge higher interest rate than banks that may lead to credit rationing problem as only higher return projects being selected and overall social welfare not being maximized.

Similar projects in different locations may differ in their profitability. But MFIs usually charge standard fixed interest rates for similar projects.

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Islamic micro finance and socially responsible investment Because of these three reasons, non-graduation from poverty for conventional MFIs is falling. In addition to zakat funds in Islamic Microfinance Shairah based and profit and loss sharing or equity pariticpation modes may also be utilized to give the poor access to funds. The banks sharing of risk and the return is undoubtedly more beneficial for the poor.

3. Future perspectives: Social welfare, unemployment, public debt and globalization have been re-examined from the perspective of Islamic norms and values. Islamic banks have grown recently in the Muslim world but still constitute a very small share of the global economy compared to the Western debt banking paradigm. It remains to be seen if they will find niches, although hybrid approaches, such as microfinance, which apply classical Islamic values using at the same time conventional lending practices, as lauded by some proponents of modern human development theory.

Islamic law allows room for financial innovation, and several Islamic contractual arrangements can be combined to design a new hybrid. In the globalization era, banks and financial institutions in general cannot afford to face financial exclusion. The segment of the population that has been excluded from financial services so far, has to be seen as an opportunity, a profitable market niche. As a result of a major interest towards these people, positive social externalities will show. The financially excluded group is heterogeneous and includes not only poor people in developing countries, but also migrants who need money transfer to manage their remittances in their home countries, young people with the enthusiasm of staring some new income generation

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Islamic micro finance and socially responsible investment activity but lack capital, Exclusion can come about as a result of problems with access, prices, marketing, perceptions. Barriers to inclusion include: y y y y y Difficulty in accessing financial services, whether that be geographically or culturally (for instance, language barriers) Inappropriate and not tailored products Excessive cost of some products such as home contents insurance Scarce knowledge of financial products caused by a lack of marketing in certain areas considered less profitable by financial institutions or difficulty in understanding financial products, for example low levels of financial literacy, which may lead to debt problems or wasting money on inappropriate products. y Government regulations or the interpretation of these (for instance, in the case of identification documents required for bank account opening) y Psychological barriers such as negative perceptions of financial institutions or previous bad experience. Other issues include: y y y y Lack of free debt advice Lack of generic (non-brand specific) financial advice Lack of confidence in the banking industry Groups particularly affected by financial exclusion tend to be those on low incomes. financial literacy or self-exclusion in response to negative experiences or

However, financial exclusion is dynamic as people move in and out of work and may have more or less need of financial services 24

Islamic micro finance and socially responsible investment Ina future perspective, the key words will be: y y y y Inclusion Tailoring of financial products on needs and religious belief Diversification of the financial services offered Attention to the social outcomes of the financial activity both in developed countries ( meeting the sensibility of some clients who are very attentive towards specific issues such as respect of human rights and environment, socially responsible criteria in the choice of investments and so on) and in developing countries (including the non bankable in the financial system will improve the general conditions of the whole society while socially responsible criteria will educate in being more

respectful towards human and workers rights, gender and environmental issues and so on) . y Separation of competencies and specialization in the whole range of financial institutions, the diversification and tailoring of products could also mean specialization of different institutions. MFIs that are close to or deriving from NGOs could specialize in financial services at the grass root level, commercial banks could specialize in micro and small entrepreneurs, Islamic banks to those clients with specific religious beliefs which do not fit with the western financial model. y Effectiveness both socially responsible investments in Western societies and Islamic branches/products in Muslim societies often proved to be merely a marketing operation used to attract new clients belonging to small niches. Given their high values, they should be taken into more serious consideration, and not only used as an easy way to attract new clients.

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Islamic micro finance and socially responsible investment Recommendations from the Institute of Hazrat Mohammad SAW : One of the most important objectives of Islam is to realise greater justice in human society. The Holy Quran states the following. Where there is no justice will ultimately head towards decline and destruction (Quran, 57:25). Justice requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values. One of these is that the financier share in the risk so as not to shift the entire burden of losses to the entrepreneur, and the other is that an equitable share of financial resources mobilised by financial institutions should become available to the poor to help eliminate poverty, expand employment and selfemployment opportunities and, thus, help reduce inequalities of income and wealth. The Holy Quran States Deal not unjustly, And ye shall not be dealt with unjustly (Holy Quran 2:279) Islamic Finance was established by the Beloved Prophet of Islam, Prophet Hazrat Mohammad SAW. He urged his followers to struggle against riba (interest) stating that Allah and His Rasool (The Prophet) has declared a war on riba.

The noble teachings of Islam are shining examples for all ages and time. It is the curse of the interest that is the biggest vice of todays economic system that concentrates wealth among few, making the rich richer and the poor poorer. Economic justice can only be achieved through an economic system based on fulfillment of basic human needs for all. Interest is prohibited and access to funds are made available through other modes of financing based on

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Islamic micro finance and socially responsible investment principles of sharing of risks and return. A system grounded on the principle of welfare for all has the necessary ingredients for promoting peace through economic well-being. The Institute of Hazrat Mohammad SAW is a research and advocacy think tank committed to promoting and upholding the teachings of Prophet Hazrat Mohammad SAW for peace and human development through research, discourse and advocacy programs. It is committed to mainstreaming Islamic Microfinance for establishment of socio-economic justice and peace. The Institute makes the following recommendations for promoting Islamic Microfinance for poverty allevaition and lasting peace. Promote the availability of skilled personnel to handle the diverse & innovative transactions possible within the framework of the Shariah through training.

Advocate for the development of Sound Legal and Regulatory Framework to address current and forthcoming innovations and challenges in Islamic Microfinance.

The need for advocacy programs to highlight the sound moral principles of Islamic Microfinance which is fair on the poor and geared towards equitable economic development. Reasons why Islamic banking is fail to implement: Recognizable products: The products that modern-day Islamic bankers have created are very similar to conventional products. So similar, in fact, that to an outside observer they could be considered the same.

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Islamic micro finance and socially responsible investment Islamic banks now offer Islamic mortgages, Islamic car loans, Islamic credit cards, Islamic time deposit and guaranteed return accounts, Islamic insurance and some even offer Islamic managed and hedge funds. This point is conceded by Samir Alamad, Sharia, or Islamic law, compliance and product development manager of the Islamic Bank of Britain. The industry does not want to alienate its products, he says. They have to be recognisable, produce the same outcome as conventional products, but remain within the guidelines of Sharia. No interest: The core of Islamic economics is a prohibition on interest. This immediately creates a problem for Islamic banks, as conventional banks charge borrowers an interest rate through which they can reward their depositors and make some profit for being the broker. With interest ruled out it is harder to make money. The modern Islamic banker has found a way around this prohibition, however. As in many Islamic products, the bank enters a partnership with its depositors and invests his money in a Sharia compliant business. The profit from this investment is then shared between the depositor and the bank after a set time. In many cases this profit rate is competitive with the conventional banking systems interest rate for savers.

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Islamic micro finance and socially responsible investment Lease agreements: Alternatively, an Islamic banker might enter into a lease agreement for a car or a house with an individual. The bank would buy a vehicle outright and then lease it back to the person who wanted it, over a time period that would ensure that the capital was repaid and the bank made a profit. Alternatively the bank would enter into a partnership with a person wanting to buy a house. The bank would buy 70% of the house, the individual 30%. The bank then rents its share of the house back to the individual until the house is fully paid for. The bank makes a profit on the rent, which would be higher than equivalent rents in the area, but on an annualised percentage basis, would look very much like a conventional mortgage interest rate. To the casual observer, a spade is a spade. Whether the product is dressed up in Arabic terminology, such as Mudarabah, or Ijarah, if it looks and feels like a mortgage, it is a mortgage and to say anything else is semantics. Sophisticated finance: The potential wealth locked up in oil-rich Gulf states encouraged the conventional banks to enter Islamic finance.

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Islamic micro finance and socially responsible investment HSBC established the Amanah Islamic Finance brand in 1998 and Deutsche Bank, Citi, UBS and Barclays quickly joined the fray, all offering interest-free products for wealthy Arabs. However, this new generation of Islamic bankers had cut their teeth in the City and Wall Street, and were used to creating sophisticated financial products. They often bumped heads with the Sharia scholars who authorised their products as Sharia compliant. However, these bankers had a way of dealing with this, as one investment banker based in Dubai, working for a major Western financial organisation explains: We create the same type of products that we do for the conventional markets. We then phone up a Sharia scholar for a Fatwa [seal of approval, confirming the product is Shari'ah compliant]. If he doesnt give it to us, we phone up another scholar, offer him a sum of money for his services and ask him for a Fatwa. We do this until we get Sharia compliance. Then we are free to distribute the product as Islamic. No consensus This Fatwa shopping, which was carried out by some institutions, brings us back to the Sharia scholars. Even these scholars do not agree all the time, which means that in some cases a product is deemed Sharia compliant in one market and not in another. This is especially the case with Malaysian products, which are often deemed not Sharia complaint in the more austere Gulf.

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Islamic micro finance and socially responsible investment Often no rulings exist for modern day problems, such as use of narcotics, Alamad explains. In Islam intoxication by wine is forbidden, but at the time of the Prophet Mohammed there was no crack cocaine. Modern scholars had to interpret the rules on intoxication, and the consensus was that crack should also be forbidden to Muslims, as it is a dangerous intoxicant. This is how we make rulings, whether in finance or societal, Alamad says. The consensus rules, which usually will become mandatory for all Muslims to follow, but there are some opinions and sometimes scholars are not in the consensus. Banking is banking: This makes it more important to be in the consensus, and so getting a favourable ruling from a leading Sharia scholar is important for a product manager. That is why the top scholars can earn so much money often six-figure sums for each ruling. The most creative scholars are the ones in the most demand, says Tarek El Diwany, analyst at London-based Islamic financial consultancy Zest Advisory. To date, most Islamic financiers have been looking at examples of financing in Islamic history and figuring out how to apply them to todays financial products. But banking is banking. It is the taking of a deposit and then using it to finance a purchase or business. The lender pays the depositor compensation for the opportunity cost of his money, and the person borrowing the money rents it off the bank.

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Islamic micro finance and socially responsible investment The same symbiotic relationship occurs whether it is conventional banking, ethical banking, Islamic banking or Presbyterian banking. As Majid Dawood, chief executive of Yasaar, a UK-based Islamic finance consultancy says: Everything that is not forbidden in the Holy Quran is OK. Yes, the industry has to evolve, but it is only 40 years old and its competing with a conventional finance system that is over 800 years old.

The Islamic credentials of Islamic banks and their financial products have been doubted in both newspapers and scholarly articles. It has been suggested that to the man on the street the Islamic bank may look very similar to its conventional counterpart. In particular the predominant murabaha contract, which is the financing of the purchasing of goods by banks and their subsequent sale to clients at mark-up prices, does appear to mirror conventional consumer credit. Need for regulation: The relative infancy of Islamic financial institutions, in comparison to longer established conventional interest (riba) based banking, has led to some regulatory problems and some spectacular bankruptcies for Islamic investment institutions. There may be a lack of sufficient expertise amongst staff and/or a lack of training in some banks. No uniform regulatory and legal framework for an Islamic financial system has been developed, with Islamic banks having their own boards of guidance. The Asian Development Board, with the Islamic Financial Board set up in Kuala Lumpur, recently took the initiative to provide a regulatory structure. An appropriate regulatory framework for Islamic banks and microfinance institutions is critical for the robust financing of the

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Islamic micro finance and socially responsible investment housing, land and property industry, especially as housing usually forms a major part of the national asset of any country. Strategies For Empowerment Through Islamic Microfinance Authenticate Islamic finance products: Many customers of Islamic banks may have a history of banking in the conventional commercial banking sector. However, there is also evidence that an institution rooted in Islamic values and financial principles will draw in customers new to banking. These customers may have excluded themselves due to their religious beliefs, but the behaviour of the bank itself may also be a factor. The increasing demand for Islamic banking and financial products, the entry of a variety of financial institutions into the market and the sheer range of Islamic products, raises the question of whether these justify the label Islamic. That demand, rather than inherent Islamic expertise, triggered the explosion in Islamic finance is well documented. For example, a Western bank, Lloyds TSB, opened its Islamic banking services in the UK on the basis that there is a demand from over twothirds of the 2 million Muslims in the UK who want Islamic banking (BBC 2005). Global financial institutions that have established Islamic banking with Sharia compatible services include Citibank, BNP Paribas, UBS and ABN Amro. Equally, there are an increasing number of national and local providers in the field. In many countries Islamic and conventional microfinance coexist and the difference is not always obvious. Fadel (2004) notes that this proliferation has led to Islamic Law in the area of banking and finance being in a flux with Islamic products needing to be sufficiently distinctive from conventional banking and finance to justify the label Islamic finance (Fadel 2004).

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Islamic micro finance and socially responsible investment Islamic banks are a co-operative venture between financial experts and sharia experts (or committees) who comment on the Islamic validity of the product. However, there is room for interpretive differences of opinion among jurists and different Sharia committees may and do react differently to similar contractual provisions. There are no easy answers, but sharing of best practice and harmonisation of general Islamic products, allowing for inherent diversity, would enhance the credibility of the Islamic finance industry. The demand for the development of Islamic microfinance products may not be as obvious or as strong as the demand for Islamic financial instruments in the commercial banking sector. However, it is also important in this regard that the vulnerable, particularly those on very low-incomes, are provided with the opportunities and fora to learn about Islamic products, particularly Islamic microfinance products, and ultimately to participate in their development. Microfinance schemes, particularly those funding the purchase of houses, their improvement or services, have an important role to play in extending and enhancing property and land rights, while alleviating poverty. In many Islamic countries, or in those countries with significant Muslim populations, Islamic microfinance which is both Islamic law (Sharia) compliant and shaped by local communities has the potential for enjoying consumer confidence and acceptance within those communities, which may not be so readily available to conventional schemes. How we can increase in Islamic financing: Regulate Islamic microfinance:

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Islamic micro finance and socially responsible investment The modern Islamic microfinance institutions are still a recent phenomenon and have not yet fully evolved. They have experienced also haphazard growth. While diverse models and practices are inherent in the choice and flexibility Islamic microfinance offers, these services need to be regulated in order to provide transparency, instil consumer confidence and prevent fraud on beneficiaries due to the unfamiliarity with the products. State regulation, though necessary, has been ad hoc and sometimes an obstacle to the evolution of effective microfinance mechanisms. Housing microfinance programmes in particular, although less developed than entrepreneurial credit, tend to involve larger loans and traditionally require guarantees and/or collateral. Effective regulation of housing microfinance schemes which are Islamic law (Sharia) compliant is, therefore, of particular importance. A recent International Monetary Fund working paper (2004) points to the special risks surrounding Islamic banking. The first is that the profit and loss sharing modes of financing make the Islamic banks vulnerable to the risks that are normally borne by equity investors rather than holders of debt. The second relates to the special nature of investment deposits where capital value and rate of return are not guaranteed. Some suggest a modified CAMEL (capital adequacy, asset quality, management, earnings and liquidity) system of supervision for Islamic banking. There is a special risk for those banks involved in the profit-sharing forms of lending. In the case of microfinance, states should be encouraged to support the membership of Microfinance Financial Institution (MFIs) in the Islamic Financial Services Board (IFSB) and provide fora for sharing of best practice and success. An appropriate regulatory framework is required for a vigorous

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Islamic micro finance and socially responsible investment housing finance system, especially given the importance of housing as a key national asset in most countries. SDiversify Islamic microfinance products : Though Islamic microfinance schemes are relatively limited at present, their potential is significant. Islamic Microfinance products are suitable to enable housing microfinance that is within Islamic law and to enhance security of tenure, particularly for the poor. However, several studies of microfinance in the Muslim world show that there is an emphasis on loans to the entrepreneurial poor, rather than the variety of financial services that the poor need. In addition to credit, microfinance needs to offer savings, insurance, and money transfer services. A study by a Harvard research group points to groups within the general finance industrys target population that are not currently being served by housing microfinance programs. In particular, the poorest of the urban poor, including squatters on remote or unutilized land and those living in rental arrangements in overcrowded inner-city slum tenements fall outside the net. The study argues that the development of appropriate financial instruments to meet the shelter needs of this latter population group is without doubt the greatest challenge facing the housing microfinance industry today. Appropriate financial instruments have been developed by the Islamic banking sector, which avoid usury (riba) and can enable individuals to purchase houses, just as they can provide funds to start up or expand businesses and loan money to those in particular need. Similarly, there are types of Islamic insurance, based on cooperation, which can enable the poor to avoid the asset sales, including the sale of various rights of access to land, which are a common response to natural and personal disasters. There are dangers

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Islamic micro finance and socially responsible investment of high expectations and the limits of microfinance in the overall macroeconomic poverty alleviation strategies must be recognized. However, while priorities may differ according to contexts, microfinance programmes must expand the range of products for their target groups which are sustainable and viable in the long term. Islamic jurisprudence (fiqh), with its emphasis upon partnership and a concern for community welfare, together with the expansion in Islamic banking and microfinance, has the ability to respond creatively to the needs of the urban poor. Ensure Stability of Microfinance Financial Institutions (MFIs) Though banks and financial institutions offer capital, general management and expertise, it is the MFIs that deliver financial services to the poor, particularly the rural poor in remote areas. The success of any microfinance project is dependent on the building of permanent local financial institutions that can attract domestic deposits, recycle them into loans, and provide other financial services. The failures of microfinance in general have occurred when MFIs have not been regulated or supported by either their funding bodies or government. The MFIs cannot exist in a hostile economic environment, just as they need to cultivate their credibility in a given socio-cultural and religious community. The role of the government is not to be a lender itself but to work through MFIs. Their most important responsibility is to support macroeconomic stability and the promotion of an enabling policy environment for the development of a vibrant financial sector. Similarly, donor funds should complement private capital, not compete with it and the success of MFIs lies in their ability to sustain themselves in the long run through their own capital.

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Islamic micro finance and socially responsible investment The capacity building of MFIs depends on building strong and transparent management structures. Merely espousing Islamic principles does not absolve them from creating a culture of accountability. As several reports have indicated, microfinance works best when it measures and discloses its performance. Reporting not only helps stakeholders to judge costs and benefits, but it also improves performance. Microfinance institutions (MFIs) need to produce accurate and comparable data on financial performance (for example on cost recovery) as well as social performance. An example of good practice comes from some smaller financial institutions. These are participative, not necessarily in terms of being owned and managed by the poor but in employing the poor, and have understood the experience, expectations and practices of the poor. Islamic MFIs which seek to enhance the position of the poor, including the realisation of their rights to secure shelter, must develop, like conventional microfinance institutions, a culture of financial and social accountability, which embraces innovative approaches to participation by their members. Mainstream Islamic Microfinance: To improve the access of target groups to microfinance, it should shift from being considered as a marginal program and be integrated within the general banking and financial services industry. Microfinance will reach its full potential, both generally and with respect to extending housing and property rights, only if it is integrated into a countrys mainstream financial system. This is necessary to promote greater awareness of products, standardize regulation and transparency and strengthen outreach mechanisms. Rather than being ignored or bypassed on the basis of its perceived complexity or the sensitivity owing to its religious orientation, Islamic finance should be recognized for

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Islamic micro finance and socially responsible investment what it ultimately is a financial product that needs to meet several standards. This is particularly important where microfinance is part of the informal economy or debt transfer (hawala) and based on trust and community practices. Improving access to Islamic microfinance is not only an implicit social goal but also an imperative for the survival of most microfinance projects. In order to pay for itself it must reach out to very large numbers of poor people in order to be self-sustaining. Strategies to enhance the opportunities for the poor to participate in, and become educated about Islamic microfinance and products are an essential component of outreach. In the case of Islamic microfinance where interest is replaced by profit and loss methods and there may be uncertainty as to returns, reasonable service charges from a wider constituency are necessary to cover costs particularly where government subsidies and donor funds cannot be guaranteed in the long run.

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Islamic micro finance and socially responsible investment

References: - Al Harran Islamic Finance needs a new paradigm paper February 1996 (available on line: www.islamic-microfinance.com) - Al-ZamZami, Grace L. Islamic Banking Principles Applied to Microfinance Case Study: Hodeidah Microfinance Programme, Yemen, UNCDF - Anderson, Gary M. 1988. Mr. Smith and the Preachers: The Economics of Religion in the Wealth of Nations, Journal of Political Economy 96, no. 5: 106688. - Chapra, Umer. Islam and the Economic Challenge. Leicester, UK: Islamic Foundation and Virginia, USA: the International Institute of Islamic Thought, 1992. - Dhumale R., Sapcanin A. An Application of Islamic Banking Principles to Microfinace Technical Note, A study bt yhe Regional Bureau for Arab States, UNDP, in cooperation with the Middle East and North Africa Region, World Bank

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Islamic micro finance and socially responsible investment - Ferro N., Value Trough Diversity: Microfinance and Islamic Finance and Global Banking Fondazione Enrico Mattei, Milan, Italy, June 2005 - Hagen, Everett E. 1962. On the Theory of Social Change. Homewood, IL: Dorsey Press. - Hayes, Samuel L. and Vogel, Frank E. "Islamic Law and Finance: Religion, Risk and Return." Arabic and Islamic Law Studies, V. 16, Kluwer Law International (1998) - Harper M. Musharaka partnership financing an approach to venture capital for micro enterprise Cranfield School of Management, August 1994 - Hoselitz, Bert F. 1960. Sociological Aspects of Economic Growth. Glencoe, IL: Free Press. - Ibrahim M. Risk Management: Islamic Financial Policies, Case study of Bank Indonesia Jakarta 2004 - Lal, Deepak. 1998. Unintended Consequences: The Impact of Factor Endowments, Culture, and Politics on Long-Run Economic Performance. Cambridge, MA: MIT Press. - McClelland, David C. 1961. The Achieving Society. New York: The Free Press. - Nicolas B., Angell. 1994 Islamic and Western bnaking: Part I: Major features, structural forms comparison with Western banks, Riba Middle East Executive Reports 17; 12; 9:14

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