International Journal of Social Economics

The link between Islamic banking and microfinancing

Nasrin Shahinpoor
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Nasrin Shahinpoor, (2009),"The link between Islamic banking and microfinancing", International Journal of
Social Economics, Vol. 36 Iss 10 pp. 996 - 1007
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IJSE
36,10 The link between Islamic banking
and microfinancing
Nasrin Shahinpoor
996 Department of Economics, Hanover College, Hanover, Indiana, USA

Received June 2008

Revised April 2009 Abstract
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Accepted April 2009
Purpose – The purpose of this paper is to show the link between Islamic banking and microfinancing.
Design/methodology/approach – The approach used in this paper is first to describe the basic
principles of Islamic banking and microfinancing and then to show the link between the two financial
practices. In general, it is believed that the two practices are not compatible since microfinance allows
interest payments on loans and Islamic banking prohibits interest payment based on Islamic law,
sharia. Both practices, however, promote equality and fairness for all members of the society and
encourage entrepreneurship by giving collateral-free loans to the poor. The two practices, therefore,
are ideologically linked. This paper shows that they are also practically linked.
Findings – Islamic religious leaders usually dismiss microfinancing because microfinancing requires
high-interest rate which is against Islamic law. This paper finds that it is possible to combine the two
practices and to convince Islamic religious leaders that Islamic banking could be applied to
microfinancing.
Originality/value – Since microfinancing has been proven to help many poor people in different
countries, the findings of this paper could be beneficial to the poor in some Islamic countries that do
not practice microfinancing based on religious beliefs.
Keywords Islam, Banking, Finance, Poverty, Loans
Paper type Conceptual paper

International Journal of Social
Economics
Vol. 36 No. 10, 2009
pp. 996-1007
q Emerald Group Publishing Limited
0306-8293
DOI 10.1108/03068290910984777
Introduction
Islamic banking was virtually unknown 30 years ago. Recently, Islamic banks operate
in 55 countries with estimated deposits of over $100 billion. There are more than 200
Islamic banking institutions in operation around the world and they are one of the
fastest growing financial services markets in the Islamic world (Venardos, 2005).
What makes Islamic banking distinctive is its adherence to the basic Islamic principle
that money should only be used to exchange goods and services and nothing else.
Thus, both receipt and payment of interest for using money is prohibited by Islamic
law, sharia. Sharia promotes equality and fairness for all members of the society by
emphasizing ethical, social, and religious factors. Muslims have special responsibilities
toward the poor and are appointed by God to be God’s stewards to maintain balance in
the universe. As the Prophet Mohammad said, “He who sleeps on a full stomach whilst
his neighbor goes hungry is not one of us.”
Debt is usually central to the difficulties faced by the poor. The Islamic response to
eliminating this difficulty is to make loans available to the poor free of interest and
collateral. Since Islam requires borrowers and lenders to share the risk of success or
failure equitably, loans are made on a profit/loss sharing basis. Islamic banks, which
are the major source of loans, have an important responsibility in meeting the credit
needs of the poor and in promoting their welfare. Unfortunately, Islamic banks are
often not meeting these obligations.
 As an alternative, one innovative and broadly utilized way to meet the credit needs of Islamic
the poor was created by Muhammad Yunus, an Economist from Bangladesh. He started
the Grameen Bank, a microfinancing institution. Microfinancing involves making small
banking and
collateral-free loans to poor people who have a strong desire to start a business and make microfinancing
a good living for themselves and their families. These people are usually denied loans by
conventional banks because they have no valuable tangible assets that could be used as
collateral. Conventional banks usually consider these people as high-risk customers and 997
deny them credit. Yunus believes that the poor are bankable and making credit
available to the poor not only improves their livelihood, but it also could increase the
welfare of the community as a whole. However, his system of microfinancing charges
interest for loans.
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While the matter of charging interest is a clear and important difference between these
two systems, in this paper, we argue that this difference is not insurmountable and we
argue that there are important ideological and practical links between Islamic banking
and microfinancing. Both systems are committed to the creation of a just society using
distinctively Islamic practices that encourage entrepreneurship and risk sharing. These
links have not been clearly established in the literature and we believe these are important
to articulate so that more services can be offered to the poor in Islamic countries. In this
paper, we first describe Islamic banking and microfinancing, we then develop a link
between Islamic banking and microfinancing, and finally show how participation in
micro enterprises by Islamic banks would help the poor and the society as a whole.

What is Islamic banking?

Islamic banking is a system that provides financial services to its customers free of riba
or interest. According to sharia or Islamic law, paying and receiving interest is
prohibited in all transactions. This ban on interest makes the Islamic banking system
fundamentally different from western style or conventional banking. The main source
for the ban on interest is the Qur’an, the fundamental source of Islam. So serious is this
ban that the Qur’an (2: 278) states that those who disregard the ban on interest are at war
with God and the Prophet Mohammad. Islam considers the charging of interest as
exploitative because the lender gains money from the needs or misfortunes of the
borrower (El-Gamal, 2006). Furthermore, interest creates unjustified and unjust
property rights. According to the sharia, property can only be acquired in two ways:
first, as a result of sharing labor and resources; second, through the transfer of assets –
for example, an inheritance or a gift (Lewis and Algaoud, 2001). Interest creates property
rights that are inconsistent with either of the ways mentioned above.
Some Islamic scholars have developed economic reasons to explain the ban on
interest as well. For example, Mannan (1986) argues that interest may prevent full
employment by adding a predetermined cost to production because the higher cost of
production prevents producers from hiring more workers which contributes to higher
unemployment. It has also been argued that international monetary crises are largely
caused by the institution of interest (Venardos, 2005). That is, countries in need of credit
borrow money from other countries or international organizations. The high interests
on these loans sometimes make it impossible for these countries to pay-off the loans and
thus they default on their loans. The results could be financial crisis for these countries
as well as the lenders. The effects of this could spread throughout the world and create
an international financial crisis (Venardos, 2005).
 IJSE There is, however, more to Islamic banking than only a ban on interest. For example,
36,10 according to Islamic economic analysis, social stability and economic growth require
honesty and a sense of community (Bjorvatn, 1998). In addition, banks and financial
institutions, like any other aspects of an Islamic society, are intended to contribute to a
just social order through economic development and the equitable distribution of income
and wealth (Chapra, 1982). Everyone and every institution in the society are responsible
998 for helping the poor to become productive members of the economy. Banks are no
exception. By providing interest- and collateral- free financial resources consistent with
Islamic principles and laws, banks become instrumental in encouraging the
establishment of small businesses by people with no financial or real assets, the poor.
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These principles of Islamic banking link it to the principles of microfinancing.

Methods of Islamic banking and finance

The Islamic solution to interest free financing is profit-loss sharing arrangements.
In other words, people participate in financial markets by sharing profits and risks.
Islam considers profit-loss sharing, rather than interest, to be closer to its sense of
ethics, social justice, and equity. Both parties, the lender and the entrepreneur, share
the risk of the investment. Sharing the risk of the investment addresses the asymmetric
information problems that exist in the conventional banking system.
There are two risk-sharing techniques practiced in Islam. Both techniques are based
on single objective: the sharing of profits through joint participation. These two
practices are called Mudaraba and Musharaka. Of these two, Mudaraba is the most
commonly employed risk-sharing method used by Islamic banking and finance (Lewis
and Algaoud, 2001).
A Mudaraba is a contract between two parties whereby one party provides the
funds and another party provides the labor or entrepreneurial abilities. In Mudaraba,
the financier or the lender does not participate in the management of the enterprise nor
is she/he allowed to request collateral to reduce her/his credit risk. However, the lender
is entitled to a percentage of the profit or loss outcomes of the enterprise. Profit has to
be shared in a proportional basis and not a lump-sum amount and there is no
guaranteed rate of return. In addition, the lender is not liable for losses beyond the
capital that she/he has contributed to the enterprise. Likewise, the entrepreneur is not
liable for losses beyond her/his loss of time and effort used in running and managing
the enterprise unless it is proven that the loss is as a result of her/his negligence or
mismanagement.
Mudaraba has a unique counterpart called Muzarah. Muzarah is usually used in
farming where the farmer provides the labor and the financier provides the land. The
land will be used by the farmer for a certain period of time and the output of the land
will be shared between the farmer and the financier in an agreed proportion.
Another risk-sharing method used in Islamic banking and finance is called
Musharaka or partnership. Under Musharaka, the entrepreneur adds some of her/his
own capital to what is provided by the financier. The two sides of the transition are
partners and both risk losing their capital. In the case of Musharaka, the profit shared
is based on an agreement between the two parties and any gain or loss is divided based
on the proportion of each party’s capital contribution.
Musharaka also has a unique counterpart. The counterpart of Musharaka is called
Musagah which is used in orchard keeping, for example. In this case, the financier
 provides the land and the farmer takes care of planting and harvesting the fruit trees. Islamic
The output of the fruit trees is divided between the two parties based on their banking and
contributions.
Mudaraba and Musharaka are considered to be the two pillars of Islamic banking microfinancing
and finance according to Ariff (1982). In both methods, the risk is shared by both sides
of the transaction and the participants have to follow all Islamic rules and restrictions.
The parties involved, therefore, could not invest in any good or a service that is 999
contrary to Islamic ethical standards and values.
There are, however, alternative methods to Mudaraba and Musharaka. These
alternative methods are less risky and are used by Islamic banks when the profit-loss
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sharing methods could not be used. While there are several alternative methods used
by Islamic banks and financiers, we only discuss three of them that we believe are
related to this paper. One of these methods is called Murabaha, or cost plus mark up;
another one is called Qard al-hasaneh, or benevolence loans; and the third one is Ijara,
or leasing.
Murabaha is not based on a profit-loss sharing scheme. Instead, it is based on cost
plus mark up pricing. In this case, the bank or the financier buys the product on behalf
of a client and then adds a percentage to the cost and resells it to the client. The client
then promises to pay it back in a pre-specified time period and/or in installments.
In Murabaha, the bank or the financier acts like an intermediary between buyer and
seller and does not share in profits or losses. The risk to the bank, therefore, is much
lower under Murabaha method than the Mudaraba or Musharaka methods. The
clients, on the other hand, take a higher risk under the Murabaha than Mudaraba or
Musharaka methods.
At first, the mark up pricing may look like another form of interest charged by the
bank but by another name. If interest is not permitted in Islamic banking, then how
could Murabaha be justified? Murabaha is Islamically justified because in a Murabaha
transaction, a commodity is bought and sold by the bank for profit and the transaction
is not a mere exchange of money. In this process the bank is taking a risk by buying the
product. The transaction is not complete until the client purchases the product from the
bank and the client may change his/her mind and refuse to buy the product. This makes
Murabaha perfectly legitimate according to the Islamic law (Wilson, 1990).
Another form of Islamic loan is called Qard al-hasaneh. Qard al-hasanehs are
interest free loans that the Qur’an encourages Muslims to make to people who need
them (Ahmad et al., 1983). In this case, the bank is allowed to charge a service charge
for administration of the loan. The borrower usually has to repay the loan within a
certain time period. The bank or the financier of the Qard al-hasaneh not only gives
financial support to the borrower but also provides moral support. These loans are
often given to charitable organizations or people with sudden or unexpected need for
funds (death, natural disaster, new child, etc.)
Ijara or leasing is when the bank buys the product and leases it to the customer for a
certain number of months or years. The lease arrangements, their terms and
conditions, are agreed to by both parties. In some Ijara cases, the customer has an
option to buy the product from the bank. In this case, the lease payments could apply
to the purchase of the product (Lewis and Algaoud, 2001).
Although the rate of return is calculated differently for each of the above methods,
none could be based on a fixed rate. All of the above-mentioned methods conform
 IJSE to Islamic law and calculate the rate of return based on the actual transaction of goods
36,10 and services, but not time.
In practice, however, Islamic banking and finance might be difficult to implement
and run. Islamic countries like Iran, Pakistan, and Sudan have attempted to shape their
entire financial systems based on Islam, and have faced difficulties in implementing
Islamic principles and laws in their banking practices. During the summer of 2006,
1000 I conducted several interviews with employees of Iranian banks and financial
institutions. These interviews revealed that the Islamic idea of profit sharing has rarely
been implemented in the Iranian banking system and most banks’ financial
transactions are based on Murabaha (mark-up) and Ijara (leasing). The situation is
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more or less the same in Pakistan and Sudan (Bjorvatn, 1998).

Why is it that Islamic banks are not successful in profit-loss sharing practices in
different countries? One major reason for the lack of success is asymmetric information
between banks and entrepreneurs that causes a moral hazard problem. If an
entrepreneur approaches the bank for a profit sharing project, it would be very difficult
for the bank to verify the true profitability of the project. Even though Islamic laws are
based on honesty and ethical behavior, there is no guarantee that individuals would
behave that way. Banks, therefore, are reluctant to participate in profit sharing projects.
Islamic banks, however, could play an important role in rural development projects.
Banking that is based on profit-loss sharing could be more successful in rural areas for
several reasons. For one, people in the rural areas are more religious than urban areas
and they follow the religious laws closely and are less likely to cheat. Second,
measuring the profit of an agricultural project is relatively easy. And third, in small
villages the problem of moral hazard is highly unlikely because there is a very limited
degree of privacy. In other words, everybody in the village knows what others are
doing and monitoring entrepreneurs who have entered into a profit sharing project
with a local bank could be relatively costless. This is why we believe that Islamic
banks could be more useful, and successful, if they offer credit to the rural poor. This
not only helps the poor, but it also helps the economic development of the rural areas.

What is microfinancing?
Microfinancing is the giving of small loans to people who need capital to start a small
business and become self-employed to help themselves and build a sustainable future.
With microfinance, poor people are given an opportunity to change their lives with
capital and sweat equity.
One of the major reasons for social and economic inequality is financial exclusion
(Sinclair, 2001; Kempson and Whyley, 2000). Poor and disadvantaged people have no
access to capital and financial services, especially affordable credit (Whyley and
Brooker, 2004). As a result, poor people could stay in the cycle of poverty for a long
time, if not forever. One of the solutions to this problem is microfinancing, first
introduced by Muhammad Yunus, an economist in Bangladesh, in the early 1970s.
Yunus started a bank called the Grameen (village) Bank of Microcredit (Hussain et al.,
2001). The bank was started based on Yunus’ belief that credit is a powerful weapon
and poor people’s access to credit is crucial for building a just and ethical society where
people live with dignity and hope for their future. Yunus (1997) argues that credit
unlocks the door to all other important human rights: food, shelter, education, and
health care.
 Microfinancing focuses on small-scale enterprises as an alternative to large and Islamic
more capital intensive firms. These small scale enterprises have changed the lives of banking and
millions of poor people around the world. Microfinance has received a lot of attention in
developing countries where small-scale enterprises by farmers and villagers are seen microfinancing
as solutions to the economic development of rural communities and keys to reducing
poverty. With access to credit, instead of waiting around for employment, the poor
become self-employed and use their knowledge, effort, and creativity to support their 1001
families and to increase their standard of living. Independent studies by the World
Bank and the International Food Research Policy have documented the positive
impacts of the microcredit on the poor and formally poor borrowers of the Grameen
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Bank (Yunus, 2007a, b).

Experience in many countries has shown that the poor are creditworthy and
are willing to pay a premium for reliable and quick credit (Bransma and Chaouali,
1998). These practices have also shown that banking with the poor could be sustainable
and profitable (Bransma and Chaouali, 1998). The “microfinance revolution”, as
Murdoch and Armendariz (2005) put it, is that institutional innovations along
with legal and regulatory policy changes could increase and sustain financial services
to the poor.

Characteristics and principles of microfinance

Microfinance has several characteristics. The first characteristic of microfinance is to
provide small short-term loans mainly to poor farmers and villagers. The loans will be
used by farmers and villagers to grow crops, to buy farm animals, or to start
micro-enterprises (Fruman and Goldberg, 1997). The second characteristic of
microfinance is an alternative approach to collateral. The collateral that is usually
used for micro loans is based on group peer pressure instead of tangible assets. In other
words, a group of people (usually five) work together and are responsible for helping
and encouraging each other to pay back the loans. If the loan is not paid back by one
member of the group, the other members would not get loans in the future (Yunus,
1997). The third characteristic of microfinance is the relatively easy and quick way of
evaluating the qualifications of the borrowers. This means that there would be no
lengthy waiting period and evaluation time would be short with very little paperwork
involved (Fruman and Goldberg, 1997). The fourth characteristic is the higher than
market interest rate to cover the transaction costs. Without covering these costs,
microfinance institutions may not be sustainable (Yunus, 1997). The fifth characteristic
is high-repayment rates. The loan recovery rates are usually 98 percent (Yunus, 1997).
And the final characteristic is convenient locations for easy access to financial services
for borrowers (Fruman and Goldberg, 1997).
Microfinancing has been practiced differently in many countries with different
outcomes and success rates. What all these countries have in common, despite different
practices, is that credit services are delivered to the poor on a sustainable basis and
that microfinancing creates jobs and generates income for the poor. Higher income for
the poor reduces poverty and contributes to the economic development of the country,
especially the development of the rural areas. Microfinancing, therefore, could be
considered an important practice that could help countries to move toward a better
living standard and more hopeful future for people who are caught in a cycle of
poverty.
 IJSE According to Brandsma and Chaouali (1998), the best practices of microfinance have
36,10 the following guiding principles:
.
Covering costs. In order for microfinance institutions to be sustainable, they must
be able to cover their costs of lending.
.
Achieving a certain scale. To become successful, microfinance institutions should
reach a certain scale which is measured by the number of clients and active
1002 loans.
.
Avoiding subsidies. Microfinance institutions could not afford to give subsidies to
their clients. Borrowers should realize that micro credit is borrowed money and
not charity and they have an obligation to pay it back. Besides, microfinance
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institutions could not depend on government or private organizations to

continuously subsidize them. In other words, microfinance institutions should be
financially independent.
.
Promoting outreach and demand driven service delivery. To be successful,
microfinance institutions should increase their services and provide access to
credit for the growing number of low-income families. While there is no real or
financial asset collateral, peer pressure is used as an alternative form of collateral
to motivate borrowers to repay their loans on time.
.
Maintaining a clear focus. The microfinance institutions should have a clear
focus and not mix their services with other social services such as schooling and
health care. Microfinance institutions’ main job is to provide access to credit
and financial services to the poor and that should be their main focus.

Microfinance institutions that practice these principles are sustainable and successful
in providing loans to those who need them the most, the poor farmers and poor
entrepreneurs who have no financial or tangible assets.

The link between the two practices

In the Middle East and North Africa, the microfinance industry has only been introduced
recently. According to a survey by the World Bank, in 1997 there were more than 60
microfinance programs active in the region and they had an outstanding loan portfolio of
more than $100 million and about 112,000 borrowers (Brandsma and Chaouali, 1998).
According to the same study, less than a third of these institutions practice the best
guiding principles mentioned above. Furthermore, according to the Grameen
Foundation (2007), poverty is a major problem in the Middle East and North Africa.
There are at least 75 million people in the region who live on less than $2 a day.
Approximately, 10-20 million of these poor people live on less than $1 a day and are
barely surviving. The entrepreneurial poor in these regions need about $2 billion in loans
and it is estimated that less than 10 percent of these loans are met by microfinance
agencies in the region. Conventional banks in most countries in the region do not lend to
poor people since they do not meet the conventional lending standards of these banks.
The poor, therefore, have no or very limited access to credit and financial services.
This data reveals a huge disparity between the number of poor people who could be
served by microfinancing institutions or conventional banks and the actual number
who actually are. Finding a way to serve these poor people, many of whom are farmers
or who live in rural areas, is thus vitally important.
 The formal financial sector in the Middle East and North Africa has played a very Islamic
limited role in the development of financial services for the poor. Most conventional banking and
banks are not equipped to give small or medium size loans to individual farmers or
small manufacturers. Small loans are not profitable for these banks and the cost of microfinancing
administering these loans is often much higher than large loans to large manufacturers.
In addition to costs, the conventional banks’ personnel also face problems finding and
accessing poor clients. Poor people usually do not go to the bank; the bank has to go to 1003
them. The bank personnel, therefore, have to travel to the poor areas and interview their
potential clients and most banks are not equipped to do so. Another problem is that
the bank personnel may not be able to relate to clients because of language and cultural
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differences.
The alternative for the poor is to seek loans from microfinancing institutions, but
these institutions charge interest and this makes adopting it problematic in more strict
Muslim communities. On the one hand, Islamic banks are frequently not accepting the
risks and on the other hand microfinancing institutions charge interest. Both create
practical problems for the poor gaining access to credit. And both hinder, the spread of
Islam’s vision of a just society.
We offer an alternative. We argue that the establishment of local microfinance
institutions in rural areas of the Middle Eastern and North African countries might be
the best solution to the problem of poverty in these regions. Operating in a fashion
consistent with the ethic of Islamic banking, based on equal access to credit as well as
equal opportunities to participate in economic activities, these establishments could
very well be Islamic microfinance institutions. These Islamic microfinance institutions
could be designed using Islamic banking practices. These institutions should be rural
banks that bring financial services to the poor. If possible, the employees of the
institutions should be from the same area so that they can speak the language and
relate to the people they are serving. The Islamic banking practices that could apply to
microfinance are profit-sharing (Mudaraba and Musharaka) and cost plus markup
(Murabaha).
In the case of Mudaraba and Musharaka or profit-sharing, the microfinance
institution provides the funding and the entrepreneur provides the labor and/or
entrepreneurial abilities. An arrangement could be made between the two about the
distribution of profit. For example, the microfinance institution could request to receive
20 percent of the profit and the entrepreneur will keep 80 percent. The loan and the
profit will be paid in weekly or monthly installments. The payments for each period
will be adjusted based on the profits of each period. The periodic payments, therefore,
may not be the same.
The major problem with this practice is the uncertainty of the profit. Monitoring
and calculating weekly or monthly profits are difficult for micro-lenders since most
borrowers do not keep accurate records of all transactions. Furthermore, since
borrowers pay different amounts each period, the system can become confusing and
complex, both for lenders and borrowers. The enforcement of the contract might also
be very difficult in this case because of the uncertainty of the profit.
In this case, the main question is whether Islamic banking rules allow the
micro-lending agency and the borrower to agree on a certain percentage of profit per
period before the loan is finalized. This allows for equal payments per period which
makes the administration of the loan easy and less costly. There is, therefore, no need
 IJSE to calculate the profit for each period. The two sides could also make an agreement that
36,10 if the project generates more profit than the agreed upon amount, the borrower will
keep all of it. If the borrower suffers loses, however, the lender is not entitled to any
profit and the loss will be shared by both parties.
If Islamic religious leaders could be convinced that this practice is legitimate under
Islamic law, then the micro-lending agency could very well be an Islamic one and
1004 provide loans to the poor and fight poverty as Islam dictates. In this case,
micro-lending agencies could be part of a larger bank with branches in rural areas
where most poor people live.
Applying Islamic banking to microfinance could be much easier under Muzarah and
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Musagah models. As we described above, in both of these cases, the bank provides the
land and the farmer provides the labor. At the end of the season, the crops could be divided
between the bank and the farmer based on an agreed proportion. The administration of
these loans is relatively easy since the distribution of the income is done at the end of the
season and no calculation of profit is needed during the life of the loan.
Another Islamic banking model that could be applied to microfinance practice is
Murabaha or cost plus mark up. In this model, the microfinance agency would buy the
good and resell it to the entrepreneurs or micro enterprises for the cost of the good plus
processing and administration costs. The good is then given to the entrepreneur and
entrepreneur will agree to pay the price in equal monthly or weekly installments.
The lender owns the good until the price is paid completely. Compared to the
profit-sharing model, this model is easier for both borrowers and the lenders to
understand. The administration of this model is also much easier than the Mudaraba
model. After the loan is accepted, the repayment schedule is very simple and easy to
follow.
The Murabaha model is very important for regions of the world where Islamic
religious leaders consider any loan in the form of money in discord with Islamic law or
haram. In this case, borrowers receive the loan in the form of goods that the lending
agency buys on their behalf and resells these goods to them. This practice is acceptable
and considered legitimate under Islamic law (Lewis and Algaoud, 2001).
One of the problems with this model is that the acceptance rate might be much
lower than the profit-sharing model. In this case, buyers have to go through an
extensive evaluation process before buying the good and many may not be eligible.
The major reason for a lengthy evaluation process is to make sure that the buyer is
serious about buying the product and willing to pay the price (Lewis and Algaoud,
2001). One solution to this problem is to reduce the evaluation process and use group
lending and peer pressure as motivation to pay for the good (Yunus, 1997). In this case,
clients will be pressured by their peers to buy the good and pay the agreed upon price.
Murabaha has been successfully practiced in Syria and Yemen. In the Syrian region
of Jabal Al Hoss, the United Nations Development Program in 2000 supported the start
of a small network of village funds that were owned and managed by shareholders.
The original funds were contributed by shareholders. These shareholders shared the
profit based on their shareholding. In these villages, over 5,600 Murabaha contracts
have been issued between 2000, the start of the program, and the end of 2003
(Brandsma and Bujorjee, 2004). By the end of 2003, however, the microfinance
programs in Syria only served 8 percent of potential borrowers (Brandsma and
Bujorjee, 2004).
 Murabaha has also been successfully practiced in Yemen. In 1997, the Yemen Islamic
Hodeideh Microfinance Program was established. This program was founded by the banking and
Yemen Social Fund for Development and is based on a group lending approach
(Brandsma and Bujorjee, 2004). The loan application is usually submitted by a five microfinancing
person group. After acceptance of the loan application, the loan officer buys the chosen
business product and resells it to the borrowers with a mark-up. Finally, the borrower
signs a purchase agreement that includes the repayment period and the installment 1005
amount (Brandsma and Bujorjee, 2004).
At the end of 2003, Yemen had over 10,000 borrowers of which 83 percent were
women. While this was a major improvement compared to the number of borrowers at
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the beginning of the program, it was only 2 percent of the potential market (Brandsma
and Bujorjee, 2004).
Examples from both Syria and Yemen indicate that Islamic microfinancing is
possible and could be successful. These examples also show that there is more need for
Islamic microfinancing in these countries as well as other countries in the region.

Conclusion
In this paper, we have described the principles and practices of Islamic banking and
microfinancing, and we demonstrated an important and overlooked link between the
two. Both Islamic banking and microfinance institutions are based on the belief that
everyone in the economy is entitled to economic justice. They both believe in
collateral-free loans and believe that everybody, including the poor, is creditworthy
and should be given the opportunity to participate in local economic activities.
Yet, these noble beliefs are not enough since in actual practice not enough of the
Islamic poor are being aided by either institution in their efforts to escape their dire
economic circumstances.
In my summer 2006, travels in Iran, I met and interviewed poor farmers and
villagers in rural areas who were in need of small loans to improve their lives but they
did not know to whom to turn. Local banks did not reach out to these farmers and
villagers. Microfinancing was not an alternative since it violates the Islamic ban on the
charging of interest for loans. As a tragic consequence, these people were caught in
the vicious circle of poverty.
We demonstrated that the differences between the current practices of Islamic
banking and microfinancing could be eliminated and that, with modifications, the
practices from each could very well be combined. Essentially, that is, Islamic banking
practices should be combined with interest free microfinancing. This could result, for
example, in establishing local Islamic microfinance institutions in rural areas that
provide micro credit and financial services to the poor by practicing the Islamic
banking methods of Mudaraba and Musharaka (profit sharing) or Murabaha (cost plus
mark up pricing). Both systems, of course, might have drawbacks but these drawbacks
could be remedied by minor modifications. In fact, some of these modifications are
being practiced in Syria and Yemen which proves that the system could be arranged
in a way consistent with Islamic law.
Islamic microfinance institutions should practice the guiding principles of the
successful microfinance practices (Brandsma and Chaouali, 1998). These Islamic
microfinance institutions could be set up by local banks or by private organizations.
Either way, these institutions bring micro-credit to the poor by going where they live
 IJSE and enabling them to participate more fully and profitably in local economic activities.
36,10 This would benefit both the borrower and the lender and thus ultimately benefit the
community and the country as a whole.
The participation of the poor people in the economy not only improves their lives,
but it also contributes to the economic development of the communities and the
country as a whole (Honohan, 2004). One study found that a 10 percent increase in
1006 financial development may increase the growth rate in poor people’s income by about
4 percent (Jalilian and Kirkpatrick, 2001). In Bangladesh, microfinancing not only
significantly reduced the poverty among the poor borrowers, but it also contributed
to the reduction of poverty in the entire village (Khandker, 2005). Emphasis on the
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financial sector, therefore, is crucial for fighting poverty in developing countries,

including countries in Islamic regions. Combining Islamic financial rules and laws with
microfinancing might be the best way to fight poverty in these regions.

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About the author

Nasrin Shahinpoor is an Associate Professor of Economics and International Studies at
Hanover College in Hanover, Indiana, USA. Nasrin Shahinpoor can be contacted at:
shahinpoor@hanover.edu

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