An application of Islamic banking principles to microfinance: technical note

This short paper focuses on the fact that many elements of microfinance can be considered consistent with the broader goals of Islamic banking. Both systems advocate entrepreneurship and risk sharing and believe that the poor should take part in such activities. The authors provide a good introduction to the principles of Islamic banking and to the types of Islamic banking contracts – mudaraba or profit and loss sharing and various non-profit and loss sharing schemes that include benevolent loans, foward contracts, leasing or lease purchase arrangements and purchase finance (cost plus mark-up).

The paper goes on to review the guiding principles of best practice microfinance and gives examples of how Islamic banking and microfinance share common aims, such as the disbursement of collateral-free loans in certain instances and character-based lending. Three basic instruments of Islamic finance are examined for their potential for inclusion in a successful microfinance programme, i.e. mudaraba (trustee financing), musharaka (equity participation) and murabaha (cost plus markup).

The authors conclude that these techniques could, if used, give thousands of entrepreneurial poor access to microfinance but that more experimentation and practice in the field is needed.

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