What Is Islamic Microfinance?

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Micro-finance has been propelled as an alternative means to access credit for the poor as well as a means to alleviate poverty in many developing countries. 

This is because it has increased the accessibility to finance and credit where there has been none from conventional lenders.

There are a number of theories that try to explain the concept of microfinance and its role in poverty alleviation, but the fact of the matter remains the aim of microfinance is to reach and make available lines of credit to the poor to help them overcome poverty and create empowerment. 

A microfinance institution or MFI is a business that receives money by way of deposits and the uses this to loan out to individuals or businesses for various purposes.

The microfinance industry in Kenya has grown tremendously over the last few decades because of the lack of access to formal financial services from conventional lenders for most of Kenya’s poor.

Microfinance as a discipline is quite developed but Islamic microfinance has not yet properly penetrated the market. Islamic microfinance represents the convergence of both Islamic finance and microfinance.

Islamic microfinance has presented the opportunity to not only tap into an underutilized market or gap but also combine the principle of Islamic social principles of caring for the less fortunate.

Islamic microfinance differs from conventional microfinance in that it must be aligned to the same principles as Islamic finance. It is important to note that it is not only structured to Muslim customers but all customers.

Islamic microfinance abides by the principles forbidden under Shari’ah law such as interest (riba) and uncertainty and deceit (gharar).

So the financial instruments are therefore designed to provide funds in a manner that avoids both interest payments while still taking into consideration the need to cover overhead costs and the cost of financing if the MFI is to be sustainable. 

The MFI also shares the risk of the investment with the financier and the recipient or places it on the MFI alone. Islamic microfinance’s exclusion of interest could alleviate a major criticism of conventional microfinance–namely the high-interest rates charged on loans.

Commonly available types of Islamic microfinance contracts that work in lieu of conventional loan agreements include: 

  • Cost plus markup (murabaha): With this, the MFI buys goods and resells them to the microentrepreneurs for the cost of the goods plus a markup to cover administrative costs. The borrower often pays for the goods in equal installments, and the microfinance institution owns the goods until the last installment is settled. The goods legally remain in the MFI’s possession until fully purchased, so the risk associated with the endeavor also remains with the MFI.
  • Profit and loss sharing (musharaka and mudaraba): Musharaka is equity participation in a business venture where the MFI and the client share profits and losses according to a predetermined ratio. Mudaraba is a form of trustee financing with one party acting as the financier and the other providing managerial expertise and executing the project; profits are shared according to a predetermined ratio while losses are borne entirely by the MFI.

Learn more:

  1. Understanding microfinance institutions
  2. Kenya urged to adopt Islamic microfinance to tackle poverty
  3. Islamic microfinance: culture, context, promise, challenges