INTRODUCTION TO THE CONCEPT OF ISLAMIC BANKING IN

THE MICRO FINANCE MARKET IN KPK

SUBMITTED TO:

SUBMITTED BY:

IM|SCIENCES, HAYATABAD, PESHAWAR

Contents

Section.1: ...................................................................................................................................................... 3
1. Introduction: ....................................................................................................................................... 3

1.1. Problem statement: .......................................................................................................................... 3

1.2. Purpose of the study: ...................................................................................................................... 4
1.3. Research Questions:........................................................................................................................ 4
1.4. Significance of the study: ................................................................................................................ 4
1.5. Scope of the study: .......................................................................................................................... 4
Section 2:....................................................................................................................................................... 5
Literature Review: ......................................................................................................................................... 5
Figure 1: Conceptual frame work derived from literature ................................................................. 11
1.1.1. Factors related to MFIs: .......................................................................................................... 11
1.1.2. Factors related to regulating bodies: ...................................................................................... 11
2. Methodology:...................................................................................................................................... 12
2.1. Introduction: ............................................................................................................................... 12
2.2. Sampling technique: ................................................................................................................... 12
References: ................................................................................................................................................. 13
Section.1:

1. Introduction:

Micro finance is very integral tool for the growth and development of any economy. Its role

increases many folds in case of developing economies. In many countries it has been running

very effectively like Grameen in Bangladesh and Shakti in India. However, no one so far has

tried to induct the concepts of Islamic banking in the practices of micro financial institutions. So

this study will be used as an attempt towards the introduction of concepts of Islamic banking in

the practices of micro financial institutions.

This study is an attempt to qualitatively analyze the challenges faced by micro financial

institutions in introducing the concepts of Islamic ways in their practices. For this purpose the

data will be collected via structured interviews. The data would then spliced and coded. From

this there is a chance that many new factors and relationships would have explored. While

analyzing strategically some recommendations would also be put to introduce the concepts of

Islamic banking in this process of financing. This in turn will put its part in the overall GDP

growth of the country and the economy would grow.

1.1. Problem statement:

The first modern experiment with Islamic banking can be traced to the establishment of the

Mit-Ghamr Savings Bank in Egypt in 1963. During the past four decades, however, Islamic

banking has grown rapidly in terms of size and the number of players. Islamic banking is

currently working in more than 50 countries of the world. The Islamic banking is not limited

only to the Islamic countries. With the intense growth rate, these practices have been adopted by

banks in many non-Islamic countries. However, its importance has not been recognized in the

practices of micro financial institutions.

1.2. Purpose of the study:

The purpose of this study is to explore different measures through which the concepts of islamic

banking can be embedded in the practices of micro financial institutions.

1.3. Research Questions:

a. Why the concepts of Islamic banking have not been inducted in the practices of micro

financial institutions?

b. How the concepts of Islamic banking could be embedded in the practices of micro financial

institutions in KPK?

1.4. Significance of the study:

This study would be of greater significance both to practitioners and researchers. For

practitioners it would be of value because in the end this study will suggest measures how micro

financial institutions in KPK can take the advantage of highly growing Islamic banking practices.

For researchers this study would be of value because it will qualitatively explore different

reasons why the concept of Islamic banking has not been adopted so far and it will also suggest

measures how these practices can be adopted. So, researchers may quantitatively test the

variables explored in this study. Further, since this study will be conducted in the micro financial

institutions of KPK, so a replicated study can be conducted in other areas of the country.

1.5. Scope of the study:

This study will attempt to cover the micro financial institutions operating in KPK.
Section 2:

Literature Review:

1. Islamic banking:

In Islam, there is no separation between mosque and state. Business, similarly, cannot be

separated from the Islamic religion. The Sharia (Islamic law) governs every aspect of a

Muslim's religious practices, everyday life, and economic activities. Muslims, for

example, are not allowed to invest in businesses considered non-halal or prohibited by

Islam, such as the sale of alcohol, pork, and tobacco; gambling; and prostitution. In

Islamic contracting, gharar (uncertainty and risk) is not permitted, i.e., the terms of the

contract should be well defined and without ambiguity. For example, the sale of fish from

the ocean that has not yet been caught is prohibited. The prohibition of gharar is designed

to prevent the weak from being exploited and, thus, a zero-sum game in which one gains

at the expense of another is not sanctioned. Gambling and derivatives such as futures and

options, therefore, are considered un-Islamic because of the prohibition of gharar.

More importantly, Muslims are prohibited from taking or offering riba. What constitutes

riba, however, is controversial and has been widely debated in the Islamic community.

Some view riba as usury or excessively high rate of interest. But the majority of Islamic

scholars view riba as interest or any pre-determined return on a loan. The basis for the

prohibition of riba in Islam may be traced to the common medieval Arabic practice of

doubling the debt if the loan has not been repaid when due. This practice in its extreme

form had led to slavery in medieval Arabia because of the absence of bankruptcy
legislation that protects the borrower from failed ventures. Therefore, the prohibition of

riba can be viewed as part of Islam's general vision of a moral economy.

In Islamic economics, the lender should bear the risk of the venture with the borrower

because it is deemed that neither the borrower nor lender is in control of the success or

failure of a venture. Thus, a unique feature that differentiates Islamic banking from

conventional banking, in theory, is its profit-and-loss sharing (PLS) paradigm. Under the

PLS paradigm, the ex-ante fixed rate of return in financial contracting, which is

prohibited, is replaced with a rate of return that is uncertain and determined ex-post on a

profit-sharing basis.8 Only the profit-sharing ratio between the capital provider and the

entrepreneur is determined ex-ante. PLS contracts, in general, allow two or more parties

to pool their resources for investment purposes and to share the investment's profit-and-

loss.

The PLS paradigm is widely accepted in Islamic legal and economic literature as the

bedrock of Islamic financing. Islamic bank financing, which adheres to the PLS principle,

is typically structured along the lines of two major types of contracts: musyarakah (joint

venture) and mudarabah (profit-sharing).

• Musyarakah contracts are similar to joint venture agreements, in which a bank and an

entrepreneur jointly contribute capital and manage a business project. Any profit-and-loss

from the project is shared in a pre-determined manner. The joint venture is an

independent legal entity, and the bank may terminate the joint venture gradually after a

certain period or upon the fulfilment of a certain condition.

• Mudarabah contracts are profit-sharing agreements, in which a bank provides the entire

capital needed to finance a project, and the customer provides the expertise, management

and labor.

The profits from the project are shared by both parties on a pre-agreed (fixed ratio) basis,

but in the cases of losses, the total loss is borne by the bank.

Most theoretical models of Islamic banking are based on the mudarabah (profit-sharing)

and/or musyarakah (joint venture) concepts of PLS (Dar and Presley, 2000). There are,

however, other financing contracts that are permissible in Islam but not strictly PLS in

nature. Such financing contracts, for example, may be based on murabaha (cost plus),

ijarah (leasing), bai' muajjal (deferred payment sale), Bai' salaam (forward sale), and

istisna (contract manufacturing) concepts.

• Murabaha financing is based on a mark-up (or cost plus) principle, in which a bank is

authorized to buy goods for a customer and resell them to the customer at a pre-

determined price that includes the original cost plus a negotiated profit margin.9 This

contract is typically used in working capital and trade financing.

• Ijarah financing is similar to leasing. A bank buys an asset for a customer and then

leases it to the customer for a certain period at a fixed rental charge. Sharia (Islamic law)

permits rental charges on property services, on the precondition that the lessor (bank)

retain the risk of asset ownership.

• Bai' muajjal financing, which is a variant of murabaha (cost plus) financing, is

structured on the basis of a deferred payment sale, whereby the delivery of goods is

immediate, and the repayment of the price is deferred on an installment or lump-sum

basis. The price of the product is agreed upon at the time of the sale and cannot include
 any charge for deferring payments. This contract has been used for house and property

financing.

• Bai' salaam is structured based on a forward sale concept. This method allows an

entrepreneur to sell some specified goods to a bank at a price determined and paid at the

time of contract, with delivery of the goods in the future.

• Istisna contracts are based on the concept of commissioned or contract manufacturing,

whereby a party undertakes to produce a specific good for future delivery at a pre-

determined price. It can be used in the financing of manufactured goods, construction and

infrastructure projects. The acceptability of the above non-PLS modes of financing,

however, has been widely debated and disputed because of their close resemblance to

conventional methods of interest-based financing. Many Islamic scholars, including

Pakistan's Council of Islamic Ideology, have warned that, although permissible, such

non-PLS modes of financing should be restricted or avoided to prevent them from being

misused as a “back door” for interest-based financing.

2. Micro financial Institutions:

Micro financial institutions play the role of a soul in the economy of any country (Khan

& Hamid, 2006). The population is expanding with an intensely high rate. The number of

the middle class would grow to three billions from the current two billions till 2020

(Tariq, 2013). This trend of enormous increase in population becomes worse in the

developing world. This increasing trend in population has plummeted the capacity of

governments for ensuring high living standards. So, Micro financial Institutions (MFIs)

have identified as the engines for the economic growth in any country. The importance of

MFIs in contemporary world has not been emphasized as its need was. Having such
 gargantuan importance MFIs are not being supported. Till now MFIs face a lot of

problems (Beck & Kunt, 2006). Some factors that are considered as key constraints in

accessing MFIs to formal credit sources in many countries of the world are:

a. The lack of financial and business management capacity.

b. High interest rates of banks.

c. Stringent policy of accepting the non-movable property as collateral (Hansen, Kimeria,

Ndirangu, Oshry, & Wendle, 2012).

So the access to the major source of finance is an important driver for the growth of MFIs

especially in developing countries. However, the access to formal financial products for

MFIs in Pakistan and especially in KPK is not easy. This might be due to:

 Lack of electricity

 Heavy regulations

 High tax rates

 Practices of competitors in the informal sector

 Corruption (McCartney, 2011).

In KPK, very low participation of business class has seen in the activities of Micro financial

institutions. This very low participation of subscribers may be due to the following reasons.

1. The focus on this area has taken place very recently.

2. Low access of financial services to the poor.

3. Operational and cost efficiency.

4. Product diversification (PERFORMANCE OF MICROFINACE SECTOR, 2006).

 So from the literature it could be concluded that following may be the factors due to which MFIs

are not very much adopted by individuals. However, in the studied literature no relationship has

seen amongst these factors. These factors are broadly classified as, factors related to MFIs and

factors related to regulators or bodies that make rules and regulations for banks i.e. state bank

and the relevant authorities.

A conceptual framework could be drawn as follows.

Factors related to MFIs:

1. High Interest rates of banks.

2. Policy regarding the acceptance of non-
movable property as collateral only.
3. Lack of specialization in Islamic financing.
4. Practices of competitors in the informal
sector.
5. Very recent emphasis and focus on this area.
6. Operational and cost of the loans.

Issues in adopting Islamic

concepts of banking in
Micro financial institutions

Factors related to regulators:

1. Heavy regulations.
2. High tax rates.
3. Corruption
4. Lack of electricity.
 Figure 1: Conceptual frame work derived from literature

1.1.1. Factors related to MFIs:

These are categorized as MFIs related factors because of the pitfalls in MFIs.

1.1.2. Factors related to regulating bodies:

These are called factors related to regulating bodies because these are the hindrances posed by

regulating bodies. These cause direct or indirect barriers in taking loans from MFIs.

These factors have identified by different researchers in their study. Since taken up from

literature so might be different from the local issues in KPK. In order to explore the more

relevant issues faced by SMEs in KPK and to find the interrelationship among these factors in

depth interviews have conducted.

 2. Methodology:

2.1. Introduction:

Since this study has tried to explore the factors qualitatively, a structured interview will be used

for this purpose. Only owners or managers of businesses will be targeted in order to get a deeper

look on the issues faced by MFIs in adopting Islamic ways of financing in KPK. Via interviews

finding relationships amongst these factors will also be tried.

2.2. Sampling technique:

For this study non probability sampling will be used. More specifically this study will use

purposive or judgmental sampling. The primal justification for this kind of sampling is to target

those respondents who have relevant and accurate information so that the maximum output

regarding the issues could be achieved. The sample selected for this study will be homogenous in

nature because only the owners of businesses or owners cum managers will be interviewed. In

this study our core respondents would be those who have information and also are willing to

share that. This type of sampling will be selected because the basic theme of the study is to

explore the issues of MFIs for adoption of Islamic ways of finances in KPK and also to find

some relationships among these factors that might strengthen or weaken the intensity of the issue

(Kumar, 2005).

2.3. Data collection tool:

An interview will be used for the collection of the data. This will be composed of open ended

questions. This kind of interview will be used to uncover issues faced by the MFIs in adopting

the Islamic ways of finances and also to find the interrelationship amongst factors.
References:

(2006). PERFORMANCE OF MICROFINACE SECTOR. FINANCIAL STABILITY REVIEW.

Beck, T., & Kunt, A. D. (2006). Small and Medium Size enterprizes: Access to finance as a growth
constraint. Journal of Banking and Finance.

Dey, I. (1993). Analysis in Qualitative research.

Hamid, K., & Khan, A. U. (2006). Financing the small and medium scale enterproses in Faisalabad
(Pakistan). Journal of Agriculture and social science.

Hansen, A., Kimeria, C., Ndirangu, B., Oshry, N., & Wendle, J. (2012). Assessing Credit Guarantee
Schemes for SME Finance in Africa. Agence Francaise De Developpment.

Khan, A. U., & Hamid, A. (2006). Financing the small and medium scale enterprises in Faisalabad
(Pakistan). Journal of Agriculture and social sciences.

Kumar, R. (2005). Research Methodology. S.Chand and Company Publishers.

McCartney, A. (2011). Developing a Sustainable SME Banking Franchise in Pakistan. Karachi:

International Finance Corporation.

Nenova, T., Niang, C. T., & Ahmad, A. (2009). Bringing Finance to Pakistan's Poor.

Tariq, T. (2013). Start up financing. 1st IBA Bachelor Thesis Conference (pp. 1-16). The Netherland:
Enschede.

Tariq, T. (2013). Start-Up Financing. 1st IBA Bachelors Thesis Conference , (pp. 1-16). Enschede, The
Netherlands.