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Islamic Microfinance – Contracts and Models

Islamic Microfinance Contracts

In the Islamic finance industry, there are several microfinance contracts. These contracts can either operate individually or be combined with other contracts. Below are some of the common Islamic microfinance contracts.

1. Murabaha Sale (cost plus markup sale contract)

2. Ijarah (leasing contract) 

3. Musharaka and Mudaraba (profit and loss sharing) 

4. Takaful (mutual insurance) 

Models of Islamic Microfinance

Following are the most effective models of Islamic microfinancing successfully applied in different Muslim countries. 

A Mudaraba Model

The microfinance program and the microenterprise are partners in mudaraba-based transactions. In musharaka both the financier and the entrepreneur invest funds, while in mudaraba the financier invest only money and the entrepreneur invest labor. In this model the microentrepreneur is rewarded for his work and shares in the profit and the program only shares in the profit. In this process, profit is unknown, but profit-sharing rates are predetermined. The major drawback of this model is the uncertainty of the profit, but in reality, microfinance programs have information on local market behavior for the future prospects and profit margin.

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

A Murabaha Model

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

Under microfinance murabaha model the procedure for loan application is simple. Once a loan application approved, the loan officer buys the chosen products and resells the borrowers after adding up a markup amount. For keeping record and proper handling of this model, the microfinance program’s financial department open an account for each borrower and maintain the record of number, due date, and size of each installment.

Muslim clients sometime expressed doubts about the mechanism of murabah (buy-resell) because it looks similar to the forbidden practice of fixed interest rates (riba). In such situation, mechanism should be explained properly to borrowers and local religious leaders. With the increase in literacy rate in Muslim countries majority of borrowers agreed and accepted that some amount is necessary for the smooth running of Islamic microfinance and they are also appreciating the simplicity and transparency of this model.

In some regions of Islamic countries handling and getting loan in the form of money is considered haram (forbidden). In those areas, borrowers prefer to purchase goods that the microfinance program would purchase on their behalf and then “resell” to them. The major possible drawback of this model is the program’s higher administrative cost, but experience indicates that such cost cut down with the passage of time and increase in transactions. 

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Islamic Microfinance – The Only Solution of Global Financial Crises

Islamic microfinance has the potential to expand access to finance to unprecedented levels throughout the Muslim world. It has the potential to merge the Islamic social principle of kindness for the less fortunate by providing financial access to the poor. Islamic microfinance is now facilitating millions of poor Muslims who rejected microfinance products that do not comply with Islamic law.

Islamic finance is the process through which the financial institutions including banks raise their capital in agreement to the Islamic rules and regulations that are commonly known as “Shari’ah”. Islamic financial system strongly restricts giving or receiving any fixed, predetermined rate of return on financial transactions. This ban on interest is derived from two fundamental Sharia precepts i.e. money has no intrinsic worth and fund providers must share the business risks. 

Importance and Demand of Islamic Microfinance

Islamic finance is a centuries-old practice, now it has captivated the interest of millions across the globe and is gradually moving towards conventional financial system. Islamic microfinance found to be a very effective tool for reducing credit crisis globally.  During last few years, conventional microfinance products have been very successful in Muslim majority countries.

A Few years ago, a Banladeshi banker and economist Dr. Muhammad Younus set a great example of Islamic microfinance, who originated the first microfinance program in Banladesh. He introduces the micro credit system for poor people and to strengthen this system he has established Grameen Bank in 2006. Later his microfinance program being recognized globally and was awarded the Nobel Prize for his immense contribution in poverty alleviation of Bangladesh.

There are millions of Muslim clients globally demanding Islamic financial products, but due to lake of conventional microfinance products majority of Muslim people can’t get these products. Due to rapid increase in the demand of conventional microfinance products, it becomes essential for Muslim countries to promote Islamic microfinance at large scale. 

Islamic Microfinancing the Perfect Solution for Muslim Countries

Islamic micro financing can give millions of entrepreneurial poor access to microfinance as an option they might not consider if traditional, interest-based commercial loans were offered. There is a potential compatibility between the needs of micro entrepreneurs and the practice of Islamic financing. Muslim countries should recognize that with more experimentation and practice in the field of Islamic micro financing they could contribute more knowledge and a better understanding of effective loan delivery mechanisms.


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