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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. 

Related Links

Musharakah

Al Barakah Islamic Bank

 

 

Are Islamic Banks really Islamic? Dr Zakir Naik

Islamic Finance – Musharkah

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