Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.

), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

Islamic Microfinance: Fulfilling Social and Developmental Expectations

Mehmet Asutay

Executive Summary:

• Islamic banking and finance (IBF) is a value oriented ethical proposition; as the principle of
IBF can be located in the principles and norms of Islamic moral economy (IME), which
aims at a ‘human centred economic development’ as opposed to the financialisation of the
economy;
• Social responsibility, thus, is an essential part of IBF; however, IBF institutions has been
criticised for their social failure;
• Microfinance (MF), is a novel method for human oriented economic development and
capacity building tool, which easily fits into IBF paradigm through social responsibility;
• Financial instruments of IBF and IME’s institutions can provide an important base for the
development and progress of Islamic microfinance (IMF), which fulfils the aspirations of
the developing communities in an Islamic way;
• A number of IBF institutions have demonstrated success stories in IMF particularly through
overcoming the burden of interest from the poor and expanding the asset base.

I. Rationalising Islamic Microfinance through Essentialising Islamic Moral Economy

IBF has become a mainstream financing method utilised by Islamic, as well as conventional
banking and financial institutions, all over the world. Recently, however, IBF has been
criticised for its ‘social failure’ in the sense that it’s operations are not different than the existing
conventional tools minus the interest. An essential nature of this criticism is related to the
foundational axioms and principles of IME, which, as a worldview, is based on the authentic
principles of Islam. Thus, IME is an authentic response to the failure of economic
developmentalism in the Muslim world in constructing a ‘human-centred development’. In this
attempt, IBF was considered as the financing and operational tool of this new paradigm, and
consequently, IBF is expected to fulfil the expectations and aspirational paradigm of IME.
The foundational principles and axioms of IME aimed at revealing the principles behind IBF
through an ethical worldview, which are:
§ vertical ethicality in terms of individuals as the creature of God being equal (tawhid);
§ social justice and beneficence (adalah and ihsan) in terms of horizontal ethicality;
§ growth in harmony (tazkiyah);
§ allowing the social (individual and society) and natural environment to reach to and sustain
its perfection (rububiyah);
§ voluntary action but also compulsory action (fard) in serving the social interest; and
§ individuals being the vicegerent of God on earth (khalifah) are expected to fulfil and act
according to these principles in their economic and financial behaviour.
These foundational principles are justified by a particular methodological understanding;
maqasid al-Shari’ah (objectives of Shari’ah) that is interpreted as ‘human well-being’, which,
in this context, is achieved through a socially operating moral economy in an Islamic
framework that is expected to produce a socially and economic-financially optimum solution
in overcoming the socio-economic problems of a society.

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Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

II. Ethical Objective Functions of Islamic Finance

As part of this ethical economic paradigm, IBF is expected to operate within such an objective
function and framework to establish the optimality between financial operations and social
objectives (as a morally identified objective function). To operationalise the ethical objective
in IBF, further principles are developed through the ontological sources of Islam. These
principles which aim to promote an ethical and socially oriented way of ‘doing finance’ are:
§ Prohibition of interest (or rib’a) with the objective of providing a stable and socially
efficient economic environment;
§ Prohibition of fixed return on nominal transactions with the objective of creating productive
economic activity or asset-based financing over the debt-based system;
§ In this moral economy, money does not have any inherent value in itself; and therefore it
cannot be created through the credit system;
§ The principle of ‘profit and loss sharing’ (PLS) and hence ‘risk sharing’ is the essential axis
around which economic and business activity takes places. This prevents the capital owner
from shifting the entire risk onto the borrower, and hence it aims at establishing justice
between work effort and return, and between work effort and capital. This axiom identifies
the essential nature of Islamic microfinance;
§ An important consequence of the PLS principle is the participatory nature of economic and
business activity, as IBF instruments, capital and labour merges to establish partnerships
through their individual contributions, which, as a principle, constitutes the fundamental
nature of microfinance;
§ By essentialising productive economic and business activity, uncertainty, speculation and
gambling is also prohibited with the same rationale of emphasising asset-based productive
economic activity.
As can be seen, each of these principles together with the above mentioned axioms provide
rationale as to why microfinancing is essential part of IME and, hence, IBF. The following
description of IBF in terms of institutional and operational features provides further rationale
as to why microfinance is inherently Islamic in its nature (Khan, 2007):
§ A form of community banking aiming at serving communities not markets;
§ Responsible finance - as it builds systematic checks on financial providers, and restrains
consumer indebtedness; ethical investment, and CSR initiatives;
§ An ‘alternative paradigm’ in terms of stability from linking financial services to the
productive, real economy; and also that it provides a moral compass for capitalism;
§ Fulfils aspirations in the sense that it widens ownership base of society, and offers ‘success
with authenticity’.
As these principles indicate, it is expected that IBF must serve social interests, such ass through
microfinance, in establishing its financial optimality whereby producing an ethical and social
solution to developing the Muslim and developing countries.
While IBF has been criticised for not fulfilling these principles in its current practice due to it
adopting a commercial banking structure, it can be seen that it has the potential to respond to
the social objective which is an inherent function of Islamic finance.
In helping IBF to demonstrate its ‘original’ ethical and social nature, new methods of financing
can be developed to appeal to their commercial nature as well. Since IBF institutions are still
expected to contribute to social development by definition, they have to move to the third
institutionalisation stage (first stage is social banking in 1960s; and then commercial banking

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Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

as the second institutional phase since mid-1970s until now), in which society and capacity
building oriented institutions, such as microfinancing and social banking, should run alongside
the commercial banks. This fulfils the social and ethical expectations as identified by IME,
but also responds to the development needs of the societies in which they are operating.
III. Islamic Microfinance
MF has become a critical tool in tackling poverty and aiding development through building the
capacity for poor to enjoy greater self-sufficiency and sustainability by granting them access
to financial services through conceptualising ‘the poor individual’ as someone with agency and
innate entrepreneurial abilities who can generate job, income and wealth if given access to
credit. Through MF, the poor are given the opportunity to become stakeholders in the economy;
and hence ‘enabled’ and ‘functioning individuals’ will be the outcome. Due to this objective
function of MF, as a development tool, it has enjoyed some success. Consequently, a number
of conventional financial institutions and banks now offer MF in supporting business ideas
from small projects to housing projects.
Despite its success, MF has been criticised from an Islamic perspective for getting people into
debt due to its fixed interest charges. If a project does not yield the expected returns in
conventional financing, then difficulties can ensue for the borrower. IBF, thus, offers a more
viable solution as a value oriented financial proposition as part of the IME. Thus, typical IBF
instruments, such as musharakah and mudarabah (based on PLS), or institutions, such as IBF
but also waqfs (pious foundations) are rather appropriate to provide microfinance. IMF fits
into the asset-based economic paradigm and equity objective of IME as well as fulfilling all
other expectations. Thus, there is a combability and complementarity between the objectives
and operational mechanism of microfinance and of IBF.
Despite having the similar objectives, IBFs have not fully appreciated MF, which is also
commercially viable programme. However, in recent years, there have been certain
movements in this direction as the successful implementation of IMF has been observed in
countries such as Bangladesh, Indonesia, Yemen, Syria etc. In Bangladesh, however, the direct
involvement and success of the Bangladeshi Islamic Bank, as a banking institution, is an
important experiment.
IBF instruments can provide an additional opportunity space for the flourishing of MF by
giving financial access to the entrepreneurial poor in an alternative and dynamic manner. The
contractual nature of such products is consistent with the financing nature of MF. The
following table, thus, provides further details of the IBF instruments and the degree of their
combability with microfinancing:

Instruments of Financing in Islamic Microfinance

Instrument Suitable for Cost of Risk to Risk to Remarks
capital Borrower Institution
Mudarabah/ Fixed assets, Very high Low Very high Costs of loan administration and
Musharakah Working capital monitoring are high given the
(Declining form complexity of the repayment schedule
suitable for housing and lack of proper accounting;
and equipment Perceived to be ideal but not popular
finance) in practice
Ijarah Fixed assets Moderate High Moderate Costs of loan administration and
monitoring are low given simple
repayment schedule allowing for

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Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

flexibility and customization based on

client preferences; Popular among
IMFs and potential for easy
adaptation by conventional MFs
Murabahah Fixed assets and Moderate High Moderate Costs of loan administration and
Working capital monitoring are low given simple
repayment schedule; multiplicity of
transactions in working capital
financing can push up costs; Highly
popular in practice notwithstanding
popular perception of it being a close
substitute of riba-based lending
Qard All-purposes Very low Very low Moderate Charity-based usually combined with
voluntarism; low overheads; Popular
because perceived to be the purest
form of financing
Salam Working capital High High High Back-to-back nature creates risk of
lack of double coincidence; Untried
Istisna Fixed assets High High High Back-to-back nature creates risk of
lack of double coincidence; Untried
Istijrar Working capital Moderate Moderate Moderate Ideal for micro repetitive transactions;
Complexity not easily understood by
parties; hence not a popular
mechanism
Source: Obaidullah and Khan (2008: 21).

In addition, other financing methods have also been proposed: such as the wakalah model and
SPV. It is suggested that SPV can be used by banks for the financing of microfinance projects,
which can be a subsidiary of the sponsoring firm or it may be an independent SPV. Dusuki
(2008: 61) highlights the features and the procedures of using SPV for Islamic microfinance as
follows: “(i) the Islamic bank mobilises various sources of funds with specific microfinance
objectives; (ii) the Islamic bank creates a bankruptcy-remote SPV; (iii) the bank allocates
certain amount of funds and pass it to the SPV; (iv) the funds are, then, channelled to various
clients depending on needs and demands. For example, zakah funds may only be allocated to
poor clients for consumption purposes and capacity building initiatives, while other type of
funds can be used to finance their productive economic activities”. The selective nature of
expenditures and investments, for instance from zakah fund under such an arrangement, can
overcome the fundamental problems of MF, as this would render financial accessibility for the
poor for their consumption but also help them to engage in capacity building projects with the
objective of productive economic activity and job creation.
In addition to mostly commercial MF instruments, Wilson (2007) proposes non-banking
institutions to conduct microfinancing by using the wakalah model through the collection of
zakah (compulsory alms giving for those whose wealth is beyond the established threshold)
and waqf (or the religious charitable foundations) funds. The wakalah agency model combines
certain features of a credit union through financial management with the capital provided by a
donor agency, in this case it can be zakah fund or a waqf. The use of zakah fund or waqf under
such arrangement would work in the same manner as described above.
It should be noted that waqf, as private non-banking institutions, were used extensively
throughout Muslim history to provide welfare services to the poor. Therefore, there can be a
clear justification for their revitalization in modern times to fund MF projects aiming at self-
sufficiency and sustainable economic life for the poor. Furthermore, ‘zakah’ has great potential
in creating funds for development purposes. However, due to the absence of clear and
transparent management structures in most Muslim societies, zakah funds are disbursed to
individual causes without the questioning of their wider sustainability and social objectives.
Thus, IMF can be an excellent solution for the collection and management of zakah funds for

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Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

alleviating poverty. Other forms of private charitable givings such as sadaqah (voluntary alms),
hiba (donations) and tabarru (financial contributions) can form additional funding
opportunities for IMF through non-banking microfinance institutions.
In addition to the mentioned instruments in raising funds for IMF, deposit type banking
instruments such as wadiah, qard al-hasan and mudarabah in the form of savings, current and
time deposits respectively can be used to raise funds for Islamic microfinance institutions. In
deciding on the appropriate instrument to deploy, IMF programs have to consider the relevant
costs, benefits, trade-offs and nature of the instruments as described in the table above.
In addition to the implicit costs of the administration of IMF projects, potential risk areas have
to be taken into account by both the programme and the borrower(s). The instrument selection
process is dependent on the nature of the client and the project proposed. For instance, if the
client is already in business and has a progressive attitude and good business record, then the
musharakah, mudarabah and murabahah models of financial instruments that involve various
degrees of PLS would be appropriate. In addition, new clients who do not have any credit or
track record could be financed by qard al-hasan type of ‘soft loans’, which do not have any
financing or risk implications.
In the banking oriented IMF, management of risk by the institution also becomes an important
aspect of the process – all of which is based on the guarantee (or kafalah) and collateral
(daman). The former is used as an alternative risk management tool for default and
delinquency in the case of financing individual microfinance, while mutual kafalah is
commonly used by IMF institutions in the case of group financing. It should be noted that
daman in terms of physical assets as collateral is not extensively used in managing risk by IMF
institutions.
Another aspect of risk management is the protection of borrowers against potential risks, for
which micro-takaful (in the form of mutual guarantee) is proposed as a solution; though his has
yet to be developed as a fully-fledged instrument. In reality, however, mostly informal methods
are used for the protection of borrowers or members, which often takes the form of short-terms
emergency funds in the case of hardship and difficulties. There are cases where IMF
institutions managed to raise insurance funds from contributions to compensate any form of
adversaries the clients may face.
As regards to Islamic microfinance providers, in addition to formal IMF institutions, large
numbers of informal MF institutions, member based organisations, and NGOs are active in
delivering IMF related services in different parts of the developing world.
IV. Conclusion
A financial system should be able to provide financing to different segments of a given society
such that in addition to financial and economic objectives, the social objectives should be
served. Since social objectives are an essential part of the IEM, it is imperative for IBF to fulfil
such objectives alongside their business interests. As a social and moral method of financing,
IBF, therefore, should directly contribute to economic and social development. This can be
possible through social banking and microfinance, while it should be recalled that the initial
experience of IBF in early 1960s in Egypt was a social bank and microfinancing oriented.
Due to the complementarity between IBF and MF, there is a need to see further and pro-active
involvement of IBF and non-banking Islamic institutions to provide IMF.

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Asutay, Mehmet (2010) “Islamic Microfinance: Fulfilling Social and Developmental Expectations”, QFinance (ed.), in
Islamic Finance: Instruments and Markets. London: Bloomsbury.

By using the essential methods and instruments outlined here, authentic models of IMF can be
developed that will ensure the proactive development and efficient running of microfinancing
so that self-sustaining and human centred development, aimed at helping the poor individuals
and entrepreneurs who are excluded from economic and financial life, can be achieved as
expected by IME by also creating social capital.
Further Reading:
Books:
Ayub, Muhammad (2007). Understanding Islamic Finance. Chichester, West Sussex: John
Wiley & Sons Ltd.
Obaidullah, M. (2008). Role of Microfinance in Poverty Alleviation. Jeddah: IRTI-Islamic
Development Bank.
Obaidullah, M. and Khan, T. (2008). Islamic Microfinance Development: Challenges and
Initiatives. Jeddah: IRTI-Islamic Development Bank.
Articles:
Ahmed, H. (2002). “Financing Micro Enterprises: An Analytical Study of Islamic
Microfinance Institutions”, Islamic Economic Studies, 9 (2), pp. 27-64.
Dhumale, Rahul and Sapcanin, Amela (1999). An Application of Islamic Banking Principles
to Microfinance: Technical Note. World Bank and UN Development Project Working Paper
No. 23073. Washington, D.C.: World Bank.
Dusuki, Asyraf Wadji (2008). “Banking for the Poor: The Role of Islamic Banking in
Microfinance Initiatives”, Humanomics, 24 (1), pp. 49-66.
Khan, Iqbal (2007). Islamic Finance: Relevance and Growth in the Modern Financial Age.
Presentation made at the Islamic Finance Seminar organised by Harvard Islamic Finance
Project at the London School of Economics, London, UK, 1 February 2007.
Wilson, R. (2007). “Making Development Assistance Sustainable through Islamic
Microfinance”, IIUM Journal of Economics and Management, 15 (2), pp. 197-217.