Islamic Microfinance

Implementing Islamic financial products into the structure of microfinance

Diploma Thesis 2004 91 Pages

Economics - Finance



List of abbreviations

List of figures


1 Microfinance an explanatory approach
1.1 Microfinance
1.2 The evolution of “Microfinance”
1.3 Why was the development of microfinance so successful?
1.4 Can microfinance be profitable
1.5 External approach
1.5.1 The government’s role in supporting microfinance
1.5.2 Regulation and supervision Prudential regulation and supervision Non-prudential regulation and supervision
1.6 Prospect and outlook

2 The basic principles of the Islam
2.1 A new language?
2.2 Al-islam din wa-daula [The Islam is religion and state]
2.3 The Islam and economy
2.4 The emergence of Islamic banking
2.5 Islamic banking to microfinance

3 Islamic Banking
3.1 Wealth is just material
3.2 Of Arbaibou’l mal and Mudarribouna [Of capital providers and clients]
3.2.1 Uqud al-Ishtirak [Direct Financial Accommodation] Mudarabah / Muqayyadah / Qirad / Muqaradah / Commenda Mazar’ah Musharaka Musaqat
3.2.2 Uqud al Muawadhat [Indirect Financial Accommodation] Murabaha Istishna Bai al Salam Ijarah Benevolent Loan—Qardh ul Hasan
3.2.3 Al Motddakharat [Saving Deposits]

4 Islamic Microfinance
4.1 “People would much rather remain poor than compromise in their faith”
4.2 The principal agent theory and the stewardship theory
4.3 Risk and effort in Islamic microfinance
4.3.1 projected on direct financial accommodation Specifics in Mudarabah in Mazar’ah and in Musaqat in Musharakah
4.3.2 projected on indirect financial accommodation Specifics in Murabaha in Istishna in Bai al Salam in Ijarah in Benevolent Loan—Qardh ul Hasan
4.3.3 projected on saving deposits

5 Conclusion



List of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1.1 - ODA Germany 1980 to 2000 Net payouts in million Euro and share of GNP in %

Figure 1.2 - Share of bi- and multilateral ODA Net payouts to LDC of GNP

Figure 1.3 - Financial Services in the poverty alleviation toolbox

Figure 2.1 - The relationship between the banking system and religion within Islam

Figure 3.1 - Perspective of Shari’ah principles on economies

Figure 5.1 - Driving forces in the co-operation process of Islamic MFIs


Microfinance is not a panacea against poverty.

Talking about Microfinance as being a so-called panacea - a pill against poverty - would be as arrogant as declaring the existence of a pill against sickness in general. Every single sickness, however, has different causes, is influenced by different ascendancies and consequently can only be treated by adjusted ways of healing.

Nevertheless, in the past, similar approaches were introduced to help people without or with very limited access to financial services (e.g. in effect of the European wars (1619-1648)1 ). Since the idea of microfinance was reborn 1976 as ‘developmental aid’ by Professor Yunus in Bangladesh, a revolution has begun that has had an enormous success. It has even been thought that they had found the solution to delete poverty completely. However, in recent years, this revolution has slowed down again probably due to multifaceted reasons (see below). Most of these reasons are not new since they have been identified as typical problems arising in the ‘development aid theory’. Nowadays, however, Microfinance is or should be seen as an industry. It is settled within the financial sector and the target group is either below or along the poverty line.

Microfinance industry - like every other industry - has to be competitive in order to be sustainable and successful. No company or organisation can rely (only) on funds for surviving in the long run. For example, government-owned companies are seldom effective or professional enough to survive in an open market. In the branch of microfinance, in which many organisations are usually very young, lacking both experience and especially educated human resources, to be competitive and thus professional would mean to adopt a business- like approach. Thus, without loosing their core philosophy of targeting the poor and enabling them to improve their living standards they need to predict risks, cover their costs, introduce new technologies, build up networks for co-operation, and adjust their products according to demand. Moreover, they need to be aware of problems that can arise while working in different cultural, social, religious, political and juridical circumstances, and cannot simply transfer and use tools or procedures from one environment in another. Basically, they need to develop a framework in which free competition is possible. Only if microfinance institutes change their traditional approach of relying mainly on funds towards a timely economical competitive approach, they will achieve their goal of effectively increasing their outreach to the poor.

The problems of microfinance institutes are common knowledge in the development field both for practitioners and scientists. The literature discussing microfinance topics like sustainability, outreach and improvement of methods as well as the role of the governments in terms of interference, supervision and regulation is getting more differentiated and substantiated. Despite this increasing interest, one aspect of microfinance has been largely neglected both scientifically and in its application: Islamic Microfinance.

This paper attempts to adjust the financial products microfinance institutes are using to be able to meet the demand of the not yet regarded group of poor devout Muslims. This group of devout Muslims below and at the poverty line is enormous in number and spread all over the world. They are not just excluded from convenient banks due to their lack of collateral, but also from convenient microfinance institutes because they produce only a limited number of products. The prohibition of Riba (interests) by the Islam is binding for devout Muslims and many poor Muslims would rather remain poor than taking the chance to escape poverty by compromising their faith. In almost every case study regarding Muslim dominant countries, this issue is remarked upon and the demand for Islamic Microfinance is described. The fact that this important issue has not received much attention yet and that, despite the obvious demand for financial opportunities of devout poor Muslims, no solutions have been found or even proposed is beyond understanding. Some of the problems causing this neglect might be seen in the higher efforts and risks Islamic products cause and which the MFIs will have to face when implementing them, as well as the higher complexity of the products.

In this paper I will discuss, if the principles of the Shari’ah (the Islamic law) are not somewhat compatible with the needs and obstacles of microfinance, where stewardship is to be shared and trust crucial. Further, I will discuss in detail if the prohibition of Riba is a serious, insolvable obstacle and if it is really more expensive for microfinance institutes to provide Muslims with financial services. By comparing traditional instruments of microfinance with new, transferred instruments borrowed from Islamic banking, I will try to explain - on the bases of the Islamic culture - why people are surprised about the neglect of Islamic Microfinance.

Chapter one will outline the development of microfinance and explain why microfinance can and is successful in so many countries. The aim of this chapter is to help the reader to comprehend the difficulties of development aid as well as to understand microfinance as a tool to stimulate a decentralized economical growth in many developing countries.

In the second chapter, I will try to explain the basic principles of the Islam. The subject is not religion itself, but rather the Islamic guidelines, which govern a Muslim’s day-to-day life. Focused on banking and financial activities within these guidelines this chapter determines the “model of man” we will use in the analysis following in chapter four based on the assumption taken by the stewardship theory.

In chapter three, I will describe the rise of Islamic banking as a success story and with this will proof that Islamic banking can work and be very profitable. Finally, before a projection of Islamic banking principles on microfinance is possible, differences between commercial banks and Islamic banks will be explained.

In chapter four, an analysis based on literature and on a survey conducted in Malaysia and Indonesia in co-operation with ASBISINDO, AIM and several NGOs as well as an internal survey of the Bank Indonesia is presented. By comparing the Islamic culture, Islamic banking and convenient microfinance practices with each other, I will test three hypotheses based on the ‘principal agent’ and ‘stewardship theory’ that could explain the obstacle to implement Islamic microfinance:

The hypotheses are as follows

- The implementation of Islamic financial products causes too high risks for microfinance institutes. The restriction of involving ‘risk’ in financial contracts for both parties by the Islam is binding. Therefore, market risks and moral hazards, make a save and steady return for the MFI not possible.
- The higher efforts of Islamic Microfinance are too much for the already weak organisation structures of MFIs. MFIs have to avoid or at least decrease market risks and moral hazards. Thus, higher efforts need to be invested by the MFIs due to the increased dependency on the success of the pre-financed projects.
- The complexity of Islamic financial products compared to convenient credit contracts leads to difficulties in both their explanation as well as their promotion in less educated areas.

“ The poor stay poor, not because

they're lazy but because

they have no access to capital. ”

Milton Friedman

Chapter 1 Microfinance … an explanatory approach

The fact, that ´Microfinance´ did not turn out to be the ‘panacea’ most people believed it to be, does not imply that the so-called “revolution of microfinance”2 has come to an end. Actually, the revolution has just taken its first step and now it has to proceed to the next one.

1.1 Microfinance

One of the clearest frameworks of microfinance has been put forward by Prof. Dr. H. D. Seibel who defines microfinance as follows: “A sector of formal and non-formal financial institutions providing microsaving3, microcredit4 and microinsurance5 services to the microeconomy, thereby allocating scarce resources to microinvestments with the highest rates of return. In a narrow sense, microfinance institutions are small local financial institutions. In a wider sense, they may also comprise national or regional banks with microfinance services for small savers and borrowers.”6

The recurrence of the preface “micro” is abusive, however, emphasising the focus that some interpretations and projects are loosing. Microfinance should provide financial services to people, both rural and urban, who farm, fish, herd, provide services, operate small enterprises, where goods are produced, recycled, repaired, or sold or to people who gain income from renting out small amounts of land, vehicles, draft animals, machinery or tools.7

Thus, in general Microfinance should reach all people who were once addressed with the term “non bankable”8.

The aim of microfinance has been reached in many examples, but still the success remains behind the potential demand of mircofinance. To maximise the reach towards people with a potential demand for financial services, the discussion about better methods have increased and new approaches are invented. I mentioned in my introduction that the microfinance revolution has to advance to the next step. Microfinance institutes have to start perceiving their services in the light of current economical situations and adjust accordingly. Providing credit to the poor is not a developmental theory anymore, or rather to be most effective it shouldn’t be one anymore.

1.2 The evolution of “Microfinance”

Since the 1960s, the major multilateral and bilateral donor organizations have concentrated their activities on a whole range of different approaches to alleviate poverty. Within this discussion the definition and causes of poverty seem to change almost every decade. The famous sentence of Karl Marx “The developed countries showing the less developed countries a vision of their own future” turned out to be an illusion. The ‘Trickle - Down effect (1960s) assumed that the economic growth expansion, through the transfer of capital (FDIs, financial development aid, etc.), outside values, technology and organisations would leak out to the poor, failed. In these days, when development co-operation was focused on a ‘growth centred’ approach, it was considered to be a process of predefined and universal stages of economic growth.9 A change came with the launching of the “World Food Program”10 by the United Nations in 1963, which is still operating today. This program was one of the first steps towards the participation of the poor and constitutes the critical break in the development aid. It is known as the ‘participatory approach’.

Introduced in 1968, the “Green Revolution”11 finally made the first approach to establish the bottom-up theory as the new paradigm. However, the “Green Revolution” required high investments of the poor and as a consequence the demand for credit in rural areas increased. The credits were usually given by multilateral donors e.g. the World Bank, who offered subsidized targeted credit lines. The drawback of this approach became obvious quite soon in that the “Green Revolution” was designed to reach the better-offs rather than the landless and the poorest of the poor. Furthermore, in the mid-1980s, the approach was heavily criticized since most programs had accumulated large loan losses and could not survive without continuous funding. It became evident that market-oriented loans would be more appropriate for rural development. In their book “ Undermining rural development with cheap credit ” by Adams, Graham, and von Pischke, the authors considered credit as a “financial intermediation” rather than an “input” 12.

This shortcoming - the repeated exclusion of the poor by the ‘Green Revolution’ - was discovered by Prof. Muhammed Yunus in the 1970s, who pioneered the world of development theory. Employing a special credit delivery mechanism he provided small collateral-free, affordable loans based on group-lending to the poor in Bangladesh and showed the world the possibility of providing the very poor with credit. This disproved the widespread assumption that the poor were “non bankable” due to their small loan requirements, small amounts of assets and lack of collateral. Effectively, the “Microcredit” was born. The success story of the so-called “Grameen Bank model”13 has made microcredit very popular and it has gained worldwide attention as an integral part of the development process.

“Microcredit” promotes the productive use of poor people’s most abundant asset - their labour - and gives them a chance to establish or expand their businesses. Moreover, it generates resources of income. An increase in income decreases general risks, enables consumption and provides a chance to escape hunger, disease and exploitation. Regarding Abraham Maslow’s assertion in his theory of “hierarchy of needs”14 this effect can lead from self-esteem to self-confidence and eventually to self-actualization. This process is thought to be the key of the microcredit idea. To be able to rise out of poverty on one’s own account, will form one’s personality more in the sense of Maslow’s theory than if poverty is reduced by subventions and presents15. Further, Prof. M. Yunus holds the opinion that “Credit is of fundamental importance if we are to build a just society where all human beings can live with dignity; I am convinced that credit is a basic human right.”16 Nevertheless, the reality has another face. The Women’s World Banking (1995) estimated that in most developing countries, only the top 25 percent of the economically active people have been reached by the formal financial system.17 The rest is without any access to financial services except those provided by moneylenders and family.

Is microcredit therefore just another path of the development aid, emerged from the mistakes made in the “Green Revolution” and doomed to failure? Or is the number of people with a demand for a financial services a sign for the enormous economical potential in developing countries?

1.3 Why was the development of microfinance so successful?

Worldwide microfinance has been recognized as a powerful tool for alleviating poverty, raising living standards and creating jobs. However, is the general opinion not that traditional agricultural societies, caught in a “Schultzian equilibrium”18 had little demand for formal or even semi-formal financial services?

The widespread application and success of microfinance is based on various reasons or changes. Within the changes of the policy environment19 in many countries, one of the main driving forces of microfinance was the rising awareness of the importance of an efficient financial system for economic development that reaches every level of society. This resulted in financial liberalization in many developing countries often forced by the IMF and the World Bank, which were again heavily criticized20. The still ongoing financial liberalization has pushed above the liberalization of the interest rate regulation, which has given MFIs a chance to cover their costs. Moreover, the strengthening and deregulation of the banking sector has given them more opportunities. Dr. Dirk Steinwand summed it up as follows “the new financial sector policies created some important prerequisites for the growth of the microfinance sector.”21

The 2nd force promoting microfinance are the main players in developing business (e.g. UN, EU) emphasizing more and more the co-operation with non-governmental organizations (NGOs). This increasing cooperation supported the emergence and widespread of the participatory approach22. The advantages of cooperation with NGOs are similar to the advantages of joint ventures. Using the close-to-the field experiences of the NGOs as well as their local networks saves a lot of time and money and sometimes it is the critical factor that enables market entry at all.

However, these two mentioned forces would not have been sufficient to establish a new approach in the development aid. Its success attracted also an exponentially increasing number and scale of funding companies / organizations. Moreover, the market was not perfect23. The inability of development banks and the inability or unwillingness of commercial banks to provide financial products in acceptable conditions to the microeconomy led to a missing rivalry among competitors. Thus, the MFIs faced only shopkeepers and pawn lenders as competitors, who took much higher interest rates24. Consequently, the achievement is stunning. OECD (Organisation for Economic Co-operation and Development) data indicate that the amount of aid given to the NGOs between 1975 and 1993/94 rose from 0.7% to 5%. According to the World Bank estimates, these figures are highly underestimated due to the exclusion of funds of approx. three billion US$ provided by the US, World Bank, EU and UN.25. The success of microfinance programs in reaching the poor unfiltered compared to other approaches forced donors and governments to push and contribute money to them. Seen as “a critical element of an effective poverty reduction strategy […] microfinance helps to promote economic growth and development.”26

Unfortunately, there are two sides of the story. A higher degree of funding (see above) consequently implies a higher dependence on the donors. Nowadays, many MFIs are established by governments (e.g. BancoSol in Bolivia and Bank Perkreditian Rakyat (BPR) in Indonesia) or under governmental supervision (e. g. Amanah Ikhtiar Malaysia (AIM)). It has been argued that active governmental support, including direct financial support, is critical for a viable microfinance sector27. Moreover, NGOs are often supported by several donors. While in 1970, NGOs relied on donor funds only in 1.5%; in developed countries the number increased to 30% in the mid-1990s. In developing countries these percentages of official funds are even higher and can reach up to 80 to 90% in Asian countries28. This development of relying heavily on funds is claiming decision power from the MFIs, limiting their abilities to act. It confines the incentives and efforts of employees, slows down the process of providing loans and thus limits the effect. Again, microfinance should be business not financial aid.

Overall, a successful development of a large number of MFIs since the 1980s has helped many poor people to cross the poverty line. The establishment of the Consultative Group to Assist the Poorest (CGAP)29 in 1995, to which all major multilateral and bilateral donors have subscribed and which was initiated to assist the development of microfinance internationally, reflects the increasing acceptance of microfinance as a suitable tool for poverty alleviation. Book publications about microfinance are getting more differentiated and substantiated and are based on more experience and surveys (Hulme & Mosley 1996; Seibel 1996; Ledgerwood 1999; Robinson 1999, 2001, 2003). Discussion forums emerge on the internet (i.e. yahoo.groups) and several conferences and campaigns have discussed the role of microfinance in poverty reduction (e.g. the Bank Poor`96 in Kuala Lumpur, the US-based movement Microcredit Summit Campaign (1997)). Furthermore, the proclamation of the year “2005 as the year of microfinance” by Kofi Anan has stressed its importance.

In spite of the great success of the microfinance model, there is still scepticism about the efficiency of microcredit for poverty reduction in the long run. Khandker argues that “The appropriateness of microcredit as a tool for reducing poverty depends on local circumstances”30. He claims that only if poverty is the result of unemployment, low productivity and low income, credit will be a powerful human and physical capital investment instrument designed to enhance the productivity of the poor. And moreover, the success of microfinance, in the way it is practised today, seems to be limited. According to the investigations of the German Agency for Technical Co-operation (GTZ) microfinance has not been as successful in providing financial services to the agriculture related enterprises as it has been in urban areas. This is caused by a demand for medium- and long-term loans in agro industries in contrast to the short-term loans mainly offered by MFIs.31 To aggravate the situation, the transaction costs in rural areas are higher than in urban areas. The CGAP even suggests that MFIs actually reach fewer than 2 percent of microentrepreneurs worldwide.32

However, although the hardliners of microfinance promote the objective to adopt a holistic solution, Hulme argues that “MFIs virtually never work with the poorest - the mentally and physically disabled, the elderly, street children […]”. He even proclaims that the “MFI and donor hype has created the impression that microfinance is a cure for poverty.”33 His arguments are probably based on the hot debate, which inflamed in the 1990s between two leading theories/approaches the financial systems approach and the poverty lending approach.34

- The financial system approach, also known as the minimalist approach, sees in institutional self-sufficiency the only way to meet the widespread client demand for convenient, suitable financial services. It is based on the assumption that there is a “single missing piece” for the enterprise growth - the access to capital. And this access to capital can be offered by a MFI. Additionally, the MFI tries to focus on a one core competitive advantage and with this to build up a comparative advantage.
- The poverty lending approach or integrated approach focuses also on the background and the circumstances of their mission. It includes a combination of financial and social services. The choice of emphasis on either one depends “on its objectives and the circumstances (demand and supply) in which it is operating”35. Moreover, it concentrates on reducing poverty by providing subsidized credit typically at below- market interest rates often along with complementary services such as impartment of training skills or the delivery of literacy and numeracy, health, nutrition, family planning, etc. The goal is to reach the poor, especially the extremely poor to empower themselves.

“ We could not separate it [humanitarian and social service] with financial service. We work with marginal people. Empowering them does not mean to give just financial services. Financial service is only the enter point to develop their capacities and their capabilities ” 36

On the other side, it might be irritating for the customers and difficult to differentiate between free services, aid and business.

Although there is a large number of supported NGOs (esp. Grameen Bank Replications with high repayment rates by using the poverty lending approach), the fact of the impossibility of an idealistic global solution, financed by donors and governments, is demonstrated by the latest numbers. Figure 1.1 shows the trend of a decreasing Official Development Assistance (ODA)37 (share of Growth Net Product (GNP)) in Germany between 1980 and 2000. And Germany is slightly above the average of all Development Assistance Committee (DAC)38 member countries (0,25 % of GNP in 2000). However, nowhere else is the decrease of bi- and multilateral financial development payouts as glaring as in the context of LDC (Low Income Development Countries), which can be seen in Figure 1.2. demonstrated on the example of Germany (1980 and 2002). The funding from donor agencies is limited and if it is the only

illustration not visible in this excerpt

source for financial flow, the outreach and thus the effect of microfinance will be limited. Self- sufficiency and commercial sources of finance are needed.

Though the discussion about pros and cons is still continuing, I agree with Robinson and others about drawing a clear dividing line between Microfinance and Development Aid (Figure 1.3). Commercial microfinance is not designed for ill, malnourished and / or unskilled poor people. Starving customers would use the loans to fill their bellies or those of their children instead of establishing a business. These people need development aid and charitable contribution. “For these people, microfinance is the next step - after they are able to work.”39

illustration not visible in this excerpt

A further discussion of this subject can be found under the topic of microfinance as supporting economical growth or just as a reallocation of money40. However, I could not find any analysis regarding this issue.

Summing up, microfinance seems to be a powerful tool to give poor people a chance for development especially within the participatory approach, which is being supported by many NGOs, donors and governments. Changes of the banking sector by strengthening and deregulation, the awareness of the importance of the co-operation of main players in the developing business with NGOs and its success itself were crucial driving forces that led to this success. But success always has a counterpart and being aware of the youth of this development, it is understandable that even fundamental discussions are still proceeding. But can Microfinance be profitable? Can it be sustainable?

1.4 Can microfinance be profitable?

This question is one of the most analyzed issues in microfinance and still not solved.41 But why should it be unprofitable in the first place? As long as the supply meets a demand and risk is adequate to the possible return, there is no logical reason to doubt its success. Delivering financial services is a business that has worked in every culture and country since centuries. The differences are the methods, which are marked by trial and error, cultural influences and legal restriction. And by comparing MFIs and commercial banks it becomes obvious that the key success factors or the presupposition are the same: financial sustainability and focus on institutional viability. Sustainability refers to the extent, to which an institution, besides being viable, mobilizes its own financial resources (by equity, savings and/or reserves from profit) instead of depending on government or donor resources. Viability, on the other hand, refers in this context to covering the costs, e.g. having the loans repaid. Fact is, however, that most MFIs are operating since less than a decade42 and are lacking experience as well as training opportunities for their staff. Still, survey reports exist that name 63 of the world's top MFIs with average return rates of 2,5 %43 after adjusting for inflation and excluding subsidies programs. This is very impressive and can be compared to the commercial banking sector. Success depends largely on market circumstances and social norms, thus on tailored solutions as will be discussed in the following chapters. Avoiding the term “best practices44 ”, “sound practices” are ensembled in various books disregarding “that successful microfinance institutions can become successful financial without any effect on other neighbours. Another possibility would be an economic growth: This would occur for instance when this supermarket would empower another family of this village to open a dough cake production and sell them through the supermarket. Through this production in turn, a third family could start a flour production. institutions by diversifying their services and targeting specific groups”45. The aim of microfinance should be to 1) realize the diversification of products and target groups and 2) the change to commercialization.

Christen (2000) mentioned competition to be the “key feature of the commercialization of microfinance”46. Commercialization is further defined by Poyo and Young (1999) as “the application of market-based principles to microfinance”47 to survive in a competitive market. According to Charitonenko, Campion, and Fernando (2004), who proclaim the third critical core issue apart of viability and self sustainability in microfinance, outreach, commercialization (competition and market-based principles) would allow MFIs a “greater opportunity to fulfil their social objectives of [exposing the poor to the access] to an array of demand-driven microfinance products and services (…)”48

1.5 External approach

The need for regulation of economic activities is often justified as a policy instrument to minimize the effects of market failures. It has gained substantial attention recently, particularly in the course of reform measures in developing countries49. But are these effective means in the market of microfinance?

The financial crises in various countries in the ‘90s have indeed brought the issue of regulation to the forefront of financial sector reforms. But these processes are mostly very unpredictable and the success is not guaranteed e.g. the relapse of Thailand due to the effect of the bird flue. Thailand followed most advises of the IMF regarding the financial crisis in 1998, but missed some. Kieser and Woywode argue accordingly „ Gestalter setzen folglich häufig Ä nderungsprozesse in Gang, die sie nur z. T. kontrollieren können: ihre Pläne enthalten unrealistische Annahmen, ihre Ma ß nahme zeitigen Konsequenzen, die sie nicht vorausahnen, ihre Ma ß nahmen lösen u. U. andere Probleme als diejenige, die sie ursprünglich lösen sollten usw. “ . 50

These problems are even more evident when trying to work across different nations and especially if the same principles are supposed to be used in more than one country or culture.

1.5.1 The government’s role in supporting microfinance

The role of governments in intervening in the evolution of microfinance is still uncertain and heavily discussed. Even if the question whether the so called “invisible hand”51 needs to support or regulate, is a discussion with a long history, the trend to a consensus in the literature is more obvious in developing countries than in developed economies. While statements like “government failure as a pendant to market failure” of the so-called New Political Economy or “governments may be the problem, rather than the solution”52 are still present, the inclusion of the state authority in developing countries is necessary and successful. Basing his arguments on the experience of East Asian regulations before 1998, Stiglitz emphasises “the active role of governments in the creation and regulation of financial institutions”53 as an example (a showcase) for successful development.

In terms of microfinance, however, the role of governments is more complicated. Feeling responsible for developing activities such as ’development finance’, governments failed in their approaches over the last three to four decades. Nowadays, as microfinance is gaining in popularity, governments are tempted to use savings banks, development banks, postal savings banks, and agricultural banks to mobilize micro financial service. This motivation or promotion, which leads to the opening of possibilities in the first place, is not compatible with the regulatory goal of a sound financial system54. Governments see a tool in microfinance, which seems to be successful, but the questions are if they should intervene and if yes, for what are they responsible?

A review of literature on the development of microfinance enabled Fernando55 to differ between three schools of thought on the role of the government:

- Laissez-faire school:

Supporter of this school (mostly South America) assign governments to be only responsible for macroeconomic stability and leave microfinance development to nongovernment organizations (NGOs) and the private sector.

- Moderate interventionist school:

Governments should, additionally to macroeconomic stability, provide an enabling policy environment and an essential financial infrastructure. But that does not mean this school supports direct interventions by the government in the provision of services.

- Interventionist school:

Based on the postulation of failing markets and non-regarding of the microfinance market by traditional commercial banks for various reasons, this school recommends governments to play a major role in expanding the outreach to “non bankable” people including provision of services by different type of government-owned organizations. The bulk of supporters of this school are found in South Asia.

It can jauntily be agreed upon that “there appears to be a consensus among the three schools that there is a role for the government in microfinance development. However, there is no such consensus on what exactly that role should be.”56

Providing the best practices, sound practices or standard lists, is in this literature as common as in other fields and most people who discuss the role of governments in the context of microfinance are doing so as well. The (most frequent named) schemes include improvement of policy environments and development of a legal, regulatory and supervisory framework - commonly branded as “financial infrastructure development”. Regarding the frequency that these two schemes are implemented in modern microfinance compared to other schemes, the “moderate interventionist school” seems to be the most accepted one However, most of the practice lists are not transferable from country to country, and sometimes not even within countries. Several factors make adjustments unquestionable

critical and refer to 1) the level of macroeconomic stability, 2) the different stages of infrastructure, 3) the stage of development of the banking system, 4) the size of the potential microfinance market, 5) the stage of development of the microfinance sector itself, 6) the geographical diversity of the country, and 7) the population density, as well as 8) the ethnic and cultural mix of a country.

Moreover, it is necessary to name two more possible tasks of governments, which are not as country-dependant as the above mentioned factors and should be considered:

- Curtail the emerging trend for re-introduction of directed credit programs

In recent years, these occurred again esp. in Asian countries like Indonesia and the Philippines. Although they are adjusted and improved, the consensus of the damage of those practices is still unchallenged.

- Support ICT development in rural areas

Government interventions are needed to support the use of new information and communication technology in rural areas. They are crucial for sustainable institutions and the future of any possible regulations.

Prima-facie, the biggest and most successful MFIs have been and still are heavily supported by the government.57 Examples include the Grameen Bank (since 1983) in Bangladesh with currently two million borrowers and the BRI (since the mid-80ies) in Indonesia with nowadays 22 million customers. Nevertheless, most examples are flagships of this development and can hardly been taken as a typical institution involved in providing financial services to the poor.

But, it is also true that governments “have little or no experience with implementing microfinance programs”.58 They hardly have a competitive advantage in running MFIs and when programs are set up, they are often perceived as social welfare as opposed to economic efforts. Not realizing what they are doing, some programs even grow too large. They often disburse too hastily and thoughtlessly; they collect repayments too sporadically and/or often are unwilling to be tough on defaulters59. Undoubtfully, political and ethnic turmoils, short-term goals and external requirements of bilateral and multilateral co-operation do not make it easier.

Taking Malaysia as an example, this becomes obvious even though Malaysia is a relatively stable environment. The Amanah Ikthiar Malaysia60 (AIM), a Grameen Bank replication starting as a result of the “Project Ikhtiar”, literally “Project Attempt”, was very successful in reaching out to the poorest of the poor. AIM was soon regarded as a powerful tool of poverty alleviation by the government, which has led to the integration of AIM into the national development policy, not at last because it fitted perfectly into national priorities for poverty reduction. In the Sixth Malaysian Plan (1991-1995) the government placed emphasis on poverty reduction through the “creation of the right environment for the poor to utilize their own economic potential in order to develop a self-reliant community.”61 Therefore, AIM got an allocation of RM 20 million during the plan period. In the second half of the 1990s, the Seventh Malaysian Plan provided AIM with an allocation of RM 200 million with an additional RM 100 million in response to the economic crisis. But AIM experienced some painful detrimental consequences out of this special relationship in the mid-1990s. Like one employer stated in one of our interviews:

“ If you get money from them, you have to do what they want “ 62

In return for providing assistance the government asked AIM to take their objectives into consideration as well. Yet, as soon as AIM accepted the funds, it became subject to certain expectations from the government and in the end a hostile take-over came along. The management was changed and the positions were filled with government people. This was the most threatening influence imaginable on each single part of the organization with major detrimental implication for the outcome of the work and therefore for the life of the poorest of the poor. The focus shifted from the poor, to the better-offs or “not-so-poor” with a blatant disregard of the Grameen Principles. The goals of the government stated target lines for the outreach; reputation and special target groups were heavily followed by new methods and products. Nowadays, the portfolio at risk (PAR - an indicator for repayment quota) of the new introduced products like SKIT and SPIN63


1 See Steinwand (2001) for further reading.

2 Robinson, M.S., “The Microfinance Revolution, Vol. 1, Sustainable Finance for the Poor”, Washington,DC, 2001, and Robinson, M.S., “The Microfinance Revolution, Vol. 2, Lessons from Indonesia”, Washington, DC, 2003, and Robinson, M.S., “The Microfinance Revolution, Vol. 3, The Emerging Industry”, Washington, DC, 2003.

3 Microsavings deposits facilities for: Safekeeping of savings, consumption-smoothing, emergencies, accumulation of resources.

4 Microcredit, with access to loans of various sizes and maturities for external financing of investments, consumption-smoothing and / or emergencies.

5 Microinsurance, including specialized services (life, health, accident or cattle insurance) and non- specialized services (providing social protection through access to one’s savings or to credit in cases of emergency) for risk management, social security and / or loan protection.

6 Seibel, H.D., Kumar, B.K.C., 1998, Page 5.

7 Robinson, M.S., 2001, Page. 9.

8 See Page 2 above.

9 Holloh, D., “Microfinance in Indonesia, Between State, Market and Self-Organization”, Hamburg, 1998, Pages 5 -11.

10 Set-up in 1963, the WFP is the UN frontline agency in the fight against global hunger. In 2003, WFP fed 104 million people in 81 countries. “In the first case, food aid is essential for social and humanitarian protection. […] In the second case, food aid is a pre-investment in human resources. In the third, it uses poor people's most abundant resource, their own labour, to create employment and income and to build the infrastructure necessary for sustained development.” Mission statement taken from: www.wfp.org.

11 Further reading: Robinson, M.S., “The Microfinance Revolution, Vol. 2, Lessons from Indonesia”, Washington, DC, 2003, Pages 90 - 93. The Green Revolution by Boilang, N.E. (Rockefeller Foundation): The introduction of HYV (High Yielding Varieties), a new sort of seed which promised to increase the farmer output by new technology of irrigation, pesticides and fertiliser.

12 Compare: Adams, D.W., Graham, D., von Pischke, J.D., “Undermining rural development with cheap credit”, Boulder, 1982.

13 Founded in 1976, by 1994 the Grameen Bank had mobilized more than 2 million members, 94% of them are women. The Grameen Bank reached a loan recovery rate of more than 95%.

14 Maslow, A., “Motivation and Personality”, 2nd edition, New York, 1970, - Human beings are motivated by unsatisfied needs, seeing physiological needs as the most basic one it is followed by safety, love, esteem and self -actualization. In this hierarchy lower needs need to be satisfied before higher needs can be achieved or even satisfied.

15 Brüntrup, M., „Kleinkredite: Bänker statt Entwicklungshelfer“,

Published on: www.der-ueberblick.de, 2002.

16 Yunus, M., “The Grameen Bank Story: Rural Credit in Bangladesh” in: Krishna A. “Reasons for Hope, Instructive Experiences in Rural Development”, Connecticut, 1997), Page 12.

17 McGuire, P., Conroy, J., “The Role of Central Banks in Microfinance in Asia and the Pacific”, Metro Manila, 2000, Page 7.

18 Low marginal rate of return on investment provide little incentives to savers and for capital accumulation. Occasional demand for emergency loans can be met by informal sources of loans.

19 This includes: Macroeconomic stability; Emphasizing on “good governance”; Ease of setting up banks or branches; Low minimum requirements for MFIs. Still, property rights, confidential judicial procedures and an appropriate legal framework are still lacking in many developing countries.

20 See almost all publications of Joseph E. Stiglitz, and www.attac.org or www.weed.org.

21 Steinwand, D., “The Alchemy of Microfinance”, Berlin, 2001, Page 27.

22 Suratman, S., “Poverty Alleviation in Rural Malaysia. A case study of the Credit Scheme of Amanah Ikhtiar Malaysia”, Bielefeld, 1995, Page 24.

23 A “not perfect market” in business terms means less competition, uneven power of competitors, no or less power of buyers and sellers, restrictions.

24 Seibel, H.D., Kumar, B.K.C., Working Paper No. 1998-3, “Microfinance in Nepal: Institutional viability & sustainability and their compatibility with outreach to the poor”, Köln, 1998, Page 6.

25 Hulme, D., Edwards, M., “NGOs, States and Donors”, New York, 1997, Page 6.

26 Asian Development Bank, “Finance for the Poor: Microfinance Development Strategy”, Manila, 2000, Page1.

27 See the discussion in: McGuire, P.B., Conroy, J.D., Thapa, G.B., “Getting the Framework Right: Policy and Regulation for Microfinance in Asia”, Brisbane, 1998.

28 Hulme, D., Edwards, M., 1997, Page 7.

29 http://www.cgap.org/.

30 Khandker, S.R., “Fighting Poverty with Microcredit; Experience in Bangladesh”, New York, 1998, Page 1.

31 Internal Newsletter of the GTZ, “Prepared for the 21st Century - Financial Systems Development and Banking Services”, “Rural and Agricultural Finance”, Eschborn, 2003.

32 McGuire, P., Conroy, J., 2000, Page 10.

33 Hulme, D., “Is microdept good for poor people? A note on the dark side of microfinance” in: Harper, M., “Microfinance Evolution, Achievements and Challenges“, London, 2003, Page 156.

34 See as well: Rhyne, E., “The Yin and Yang of Microfinance: Reaching the poor and Sustainability”, MicroBanking Bulletin, 1998, Pages 6 - 8. http://www.microfinancegateway.org/download/yym.pdf, 16.07.2004.

35 Ledgerwood, J., “Microfinance Handbook, An institutional and financial perspective”, Washington, DC, 1999, Pages 65 - 66.

36 Compare own survey. Questionnaire: Yayasan Siti Khadijah, Jakarta, Mai 2004.

37 Official Development Assistance.

38 The list of developing countries issued by the Development Assistance Committee (DAC) of the OECD was initially drawn up in 1962 to create a comprehensive systematic overview of ODA and other inputs provided by DAC members to the developing countries. Since 1993 the DAC List has been divided into two parts: Part I includes all recipients of ODA. The DAC designates all countries in Part I of the list as developing countries. Pursuant to a United Nations agreement, funds equivalent to at least 0.7% of the gross national product of the respective DAC member state should be spent on ODA. Part II of the DAC List includes all recipients of Official Aid, which is distinguished from ODA and is not counted in reaching the target of a 0.7% share of GNP as expenditure on development assistance. These include the more advanced transition countries and former developing countries which, due to their increase in per capita GNP, have been classed as HICs (High Income countries) for three consecutive years. These countries are termed “more advanced countries”.

39 Robinson, M.S, 2001, Page 8.

40 Reallocation in this context means, exampled: The habitants of one village, who would spend their money on the market in the next village, are now spending it at the neighbours’ supermarket,

41 www.cgap.org; www.gtz.de; www.microfinancegateway.org/; www.uni-koeln.de/ew-fak/aef/; etc.

42 Compare as well: Lianto G.M., Chua, R.T., “Transaction Costs of Lending to the Poor: A Case Study of Two Philippine Non-Governmental Organisations“, India,1996. They determine an inverse relationship between an organisation’s transaction costs and the number of years in existence. This results, like the authors argue, from an organization’s capacity to learn and develop. http://www.bwtp.org/publications/main.htm, 05.06.2004.

43 http://www.microfinancegateway.org/.

44 It is difficult to state “best practices” in such a young industry.

45 Brandsma, J., Chauali, R., “Making Microfinance Work in the middle East and North Africa”, Washington, DC, executive summary. http://www.mafhoum.com/press/54E18.pdf, 02.02.2004.

46 Christen, R.P., “Commercialization and Mission Drift: The Transformation of Microfinance in Latin America. Consultative”, Group to Assist the Poorest (CGAP), Occasional Paper, Washington, DC, No. 5, 2000, Page 21. http://www.microfinancegateway.org/content/article/detail/2589, 03.02. 2004.

47 Poyo, J., Young, R., “Commercialization of Microfinance: A Framework for Latin America”, United States Agency for International Development, Microenterprise Best Practices Project. Washington, DC, 1999, Page 47. http://www.mip.org/PDFS/MBP/Commercialization_of_Microfinance.pdf, 22.01.2004

48 Charitonenko, S., Campion, A., Fernando, N.A., “Commercialization of Microfinance. Perspectives from the South and Southeast Asia”, Page 4. http://www.adb.org/Documents/Reports/Commercialization_Microfinance/South_SE_Asia/defaul t.asp, 03.02.2004.

49 See: Armstrong, Cowan and Vickers, 1994 as well as Majone, 1996.

50 In Kieser, A. , Woywode, M., „Evolutionstheoretische Ansätze“, in Kieser, A. „Organisations- theorien“, Stuttgart, 1999, Pages 253 - 285. Own translation: “Consequently, formers stimulate often changing process, of which only parts are controllable: their plans include unrealistic assumptions, their suggested arrangements have unpredictable consequences and perhaps even solute other problems, which were not aimed in first place, etc…”.

51 A metaphor brought up by Adam Smith, assuming that the forces of market act in same matters like the evolutionary approach.

52 Steinwand, D., 2001, Page 41.

53 same.

54 Meagher, P., “Microfinance Regulation in Developing Countries: A Comparative Review of Current Practice”, Maryland, 2002, Page 11.

55 Compare: Fernando, N.A., “Do governments in Asia have a role in development of sustainable microfinance services? Some views“, Manila, 2003, Page 2, http://www.adb.org/Documents/Slideshows/Microfinance/Fernando_paper.pdf, 05.04.2004.

56 Fernando, N.A., 2003, Page 3.

57 Zeller, M., Lapenu, C., „Institutionelle Diversität im Mikrofinanz-Bereich ist gefragt. Unterschiedliche Ansätze für Arme und nicht ganz so Arme“ in „E+Z - Entwicklung und Zusammenarbeit“, No.11, Frankfurt/Main, 2000, Page 311.

58 Ledgerwood, J., 1999 Page 14.

59 Internal Newsletter of the GTZ, “Prepared for the 21st Century - Financial Systems Development and Banking Services”, “Microfinance”, Eschborn, 2003.


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islamic microfinance implementing




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