metadata: authors: 0: author: Fu,Xiaochen
1: author: Iqbal,Zamir
2: author: Mohieldin,Mahmoud
3: author: Rostom,Ahmed Mohamed Tawfick
count: World
docna: 0: docna: The role of Islamic finance in enhancing
            financial inclusion in organization of Islamic cooperation
            (OIC) countries
docty: Policy Research Working Paper
subtopic: Rural Microfinance and SMEs,Microfinance,Islamic Finance,Inequality,Financial Sector Policy,Access to Finance
teratopic: Private Sector Development,Finance and Financial Sector Development
abstracts: cdata!: The core principles of Islam lay great
            emphasis on social justice, inclusion, and sharing of
            resources between the haves and the have nots. Islamic
            finance addresses the issue of "financial
            inclusion" or "access to finance" from two
            directions -- one through promoting risk-sharing contracts
            that provide a viable alternative to conventional debt-based
            financing, and the other through specific instruments of
            redistribution of the wealth among the society. Use of
            risk-sharing financing instruments can offer
            Shariah-compliant microfinance, financing for small and
            medium enterprises, and micro-insurance to enhance access to
            finance. And redistributive instruments such as Zakah,
            Sadaqat, Waqf, and Qard-al-hassan complement risk-sharing
            instruments to target the poor sector of society to offer a
            comprehensive approach to eradicating poverty and to build a
            healthy and vibrant economy. Instruments offered by Islam
            have strong historical roots and have been applied
            throughout history in various Muslim communities. The paper
            identifies gaps currently existing in Organisation of
            Islamic Cooperation (OIC) countries on each front, that is,
            Shariah-compliant micro-finance and financing for small and
            medium enterprises and the state of traditional
            redistributive instruments. The paper concludes that Islam
            offers a rich set of instruments and unconventional
            approaches, which, if implemented in true spirit, can lead
            to reduced poverty and inequality in Muslim countries
            plagued by massive poverty. Therefore, policy makers in
            Muslim countries who are serious about enhancing access to
            finance or "financial inclusion" should exploit
            the potential of Islamic instruments to achieve this goal
            and focus on improving the regulatory and financial
            infrastructure to promote an enabling environment.
repnme: repnme: The role of Islamic finance in enhancing
            financial inclusion in organization of Islamic cooperation
            (OIC) countries
display_title: The role of Islamic finance in
            enhancing financial inclusion in organization of Islamic
            cooperation (OIC) countries
listing_relative_url: /research/2011/12/15576848/role-islamic-finance-enhancing-financial-inclusion-organization-islamic-cooperation-oic-countries
topicv3: Poverty m1326687 695,Microfinance m1327227 367,Islamic Finance m1327451 324,Financial Inclusion m1327456 363,Access to Finance m1327464 1249
publishtoextweb_dt: 2011-12-01T00:00:00Z
historic_topic: Private Sector Development,Finance and Financial Sector Development
no_of_pages: 61
author_keys: 0: author_key: 1152565
1: author_key: 92260
2: author_key: 435192
3: author_key: 1092295
model_extractions: WPS5920 Policy Research Working Paper 5920 The Role of Islamic Finance in Enhancing Financial Inclusion in Organization of Islamic Cooperation (OIC) Countries _Mahmoud Mohieldin Zamir Iqbal Ahmed Rostom Xiaochen Fu_ The World Bank Islamic Economics and Finance Working Group December 2011
Policy Research Working Paper 5920

# **Abstract**

The core principles of Islam lay great emphasis on social justice, inclusion, and sharing of resources between the haves and the have nots. Islamic finance addresses the issue of “financial inclusion” or “access to finance” from two directions—one through promoting risk-sharing contracts that provide a viable alternative to conventional debt-based financing, and the other through specific instruments of redistribution of the wealth among the society. Use of risk-sharing financing instruments can offer _Sharia_ h-compliant microfinance, financing for small and medium enterprises, and micro-insurance to enhance access to finance. And redistributive instruments such as _Zakah, Sadaqat, Waqf,_ and _Qard-al-hassan_ complement risk-sharing instruments to target the poor sector of society to offer a comprehensive approach to eradicating poverty and to build a healthy and vibrant economy. Instruments offered by Islam have strong historical roots and have been applied throughout history in various Muslim communities. The paper identifies gaps currently existing in Organisation of Islamic Cooperation (OIC) countries on each front, that is, _Shariah_ -compliant microfinance and financing for small and medium enterprises and the state of traditional redistributive instruments. The paper concludes that Islam offers a rich set of instruments and unconventional approaches, which, if implemented in true spirit, can lead to reduced poverty and inequality in Muslim countries plagued by massive poverty. Therefore, policy makers in Muslim countries who are serious about enhancing access to finance or “financial inclusion” should exploit the potential of Islamic instruments to achieve this goal and focus on improving the regulatory and financial infrastructure to promote an enabling environment.

This paper is a product of the Islamic Economics and Finance Working Group at the World Bank, with the support of MDM unit. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The Authors may be contacted at ziqbal@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **The Role of Islamic Finance in Enhancing Financial Inclusion in Organization of Islamic Cooperation (OIC) Countries**

Mahmoud Mohieldin, Zamir Iqbal, Ahmed Rostom and Xiaochen Fu<sup>1</sup>

## **JEL Classification: G21, G22, G32**

## **Keywords: Islamic finance, financial inclusion, access to finance, risk sharing.**

> 1 Mahmoud Mohieldin serves as  Managing Director of the World Bank. Zamir Iqbal is Lead Investment Officer with the Treasury of the World Bank. Ahmed Rostom is a Consultant with the World Bank and is also affiliated with The George Washington University in Washington, D.C. and. Xiaochen Fu is pursuing graduate studies at Kennedy Business School at the Harvard University. The views expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. An earlier version of the paper was presented at 8<sup>th</sup> International Conference on Islamic Economics and Finance in Doha, Qatar, held from December 19-21, 2011.

1
# **INTRODUCTION**

There is voluminous literature in economics and finance on the contributions of finance to economic growth and development. The main reason why finance matters is that financial development and intermediation has been shown empirically to be a key driver of economic growth and development. Finance (financial intermediation) motivates savers to save by offering them a range of instruments to fit their financial needs, channels savings to investors and in the process broadens investment opportunities, increases investment, ameliorates risk sharing, increases growth of the real sector, enables individuals and business entities to smooth income and consumption profiles over time, and there is some evidence that through this process it not only leads to economic development but it may play a positive role in reducing poverty and income inequality.

Although the linkage of financial development with economic development is established, a high degree of the financial development in a country is not necessarily any indication of alleviation of poverty in the country. There is growing realization that in addition to financial development, the emphasis should be to expand the accessibility to finance which can play a more positive role in eradicating poverty. Development economists are convinced that improving access and making basic financial services available to all members of the society in order to build an inclusive financial system should be the goal. Enhancing the access to and the quality of basic financial services such as availability of credit, mobilization of savings, insurance and risk management can facilitate sustainable growth and productivity, especially for small and medium scale enterprises. Although the research in this area is at its early stages it is already making promising progress. For example, Demirguc-Kunt, Beck and Honohan (2007) argue that finance is not only pro-growth, but also pro-poor.

Despite of its essential role in the progress of efficiency and equality in a society, 2.7 billion people (70% of the adult population) in emerging markets still have no access to basic financial services,<sup>2</sup> and a great part of the them come from countries with predominantly Muslim population. With growing interest in developing a financial system compliant with the _Shariah_ (Islamic Law), it would be worthwhile to explore what is Islam’s perspective on financial inclusion and economic development. Islamic finance is growing at a fast pace all over the globe as the demand for financial products and services compliant with _Shariah_ keeps growing. However, the focus of such financial products and services is on financial intermediation through banking and capital markets activities but the availability of financial vehicles catering to the poor is either non-existent or still at very early stages.

This paper argues that the core principles of Islam lay great emphasis on social justice, inclusion, and sharing of resources between the haves and the have nots. Islamic finance addresses the issue of financial inclusion from two directions—one through promoting risk-

> 2 WBG Financial Access 2009

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sharing contracts which provide a viable alternative to conventional debt-based financing, and the other through specific instruments of redistribution of the wealth among the society. Both risk-sharing financing instruments and redistributive instruments such as _Zakah_ , _Sadaqat_ , _Waqf,_ and _Qard-al-Hassan_ complement each other to offer a comprehensive approach to eradicating poverty and to build a healthy and vibrant economy. Instruments offered by Islam have strong historical roots and have been applied throughout history in various Muslim communities. The paper concludes that Islam offers a rich set of instruments and unconventional approaches if implemented in a true spirit and can lead to reduced poverty and inequality in Muslim countries plagued by massive poverty. Therefore, the policy makers in Muslim countries who are serious about enhancing access to finance or “financial inclusion” should exploit the potential of Islamic instruments to achieve this goal.

Section I briefly discusses the concepts of financial inclusion and economic development in the conventional thinking. Section II provides theoretical background on the Islamic approach to financial inclusion and economic development. Section III examines various vehicles offered by Islamic finance to enhance access while section IV discusses main the gaps and challenges of implementing such techniques. Finally, section V offers policy recommendations and concluding remarks.

# **Section I. Financial Inclusion and Economic Development**

In conventional finance, financial access is especially an issue for the poorer members of society including potential, or would be, entrepreneurs. They are commonly referred to as “nonbanked” or “non-bankable” and in the case of potential entrepreneurs they invariably lack adequate collateral to access conventional debt financing. While access to finance may be important for economic growth, the private sector may not be willing to provide financing to some areas because of the high cost associated with credit assessment, credit monitoring and because of the lack of acceptable collateral.

Financial inclusion, a concept that gained its importance since the early 2000s, has been a common objective for many governments and central banks in developing nations. The concept initially referred to the delivery of financial services to low-income segments of society at affordable cost. During the past decade, the concept of financial inclusion has evolved into four dimensions: easy access to finance for all households and enterprises, sound institutions guided by prudential regulation and supervision, financial and institutional sustainability of financial institutions, and competition between service providers to bring alternatives to customers. Traditionally, the financial inclusion of an economy is measured by the proportion of population covered by commercial bank branches and ATMs, sizes of deposits and loans made by lowincome households and SMEs. However, availability of financial services may not equal financial inclusion, because people may voluntarily exclude themselves from the financial services for religious or cultural reasons, even though they do have access and can afford the services (Beck and Demirguc-Kunt 2008).

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<!-- Start of picture text --> Population<br><!-- End of picture text --> <!-- Start of picture text --> financial services<br><!-- End of picture text --> <!-- Start of picture text --> Involuntary<br>exclusion<br><!-- End of picture text --> <!-- Start of picture text --> Contractual / informational<br><!-- End of picture text --> <!-- Start of picture text --> @ Access to financial services Price / product features<br>CINo access to financial services<br><!-- End of picture text -->
Development economists suggest that the lack of access to finance for the poor deters key decisions regarding human and physical capital accumulation. For example, in an imperfect financial market, poor people may find themselves in the “ **poverty trap** ”, as they cannot save in harvest time or borrow to survive a starvation. Similarly, without a predictable future cash-flow, the poor in developing countries are also incapable of borrowing against future income to invest in education or health care for children.

Without inclusive financial systems, poor individuals and small enterprises need to rely on their personal wealth or internal resources to invest in their education, become entrepreneurs, or take advantage of promising growth opportunities. Financial market imperfections, such as information asymmetries and transactions costs, are likely to be especially binding on the talented poor and the micro- and small enterprises that lack collateral, credit histories, and connections, thus limiting their opportunities and leading to persistent inequality and slower growth. However, this access dimension of financial development has often been overlooked, mostly because of serious gaps in the data about who has access to which financial services and about the barriers to broader access.

The inevitable trade-off between wealth accumulation and social inequality in the early stage of economic development also implies the crucial role of access to finance in social equality progress. Galor and Zeira (1993) and Banerjee and Newman (1993) imply that financial exclusion not only holds back investment, but results in persistent income inequality, as it adds to negative incentives to save and work and encourages repeated distribution in a society. Demirguc-Kunt and Levine (2007) conclude that building a more inclusive financial system also appeals to a wider range of philosophical perspectives than can redistributive policies: redistribution aims to equalize outcomes, whereas better functioning financial systems serve to equalize opportunities. Empirical studies by Demirguc-Kunt and Levine (2007) show that countries with deeper financial systems experience faster reductions in the share of the population that lives on less than one dollar a day. Almost 30% of the cross-country variation in changing poverty rates can be explained by variation in financial development.

# **Section II. Concept of Economic Development and Inclusion in Islam**

Islam is considered a rule-based system which specifies rules for social and economic activities of the society. In this respect, economic principles of Islam deal with (a) the rules of behavior ( **similar to the concept of economic institutions** ) as they relate to resource allocation, production, exchange, distribution and redistribution; (b) economic implications of the operations of these rules; and (c) incentive structure and policy recommendations for achieving rules compliance that would allow convergence of the actual economy to the ideal economic system envisioned by Islam.<sup>3</sup>

> 3 Iqbal and Mirakhor (2011)

5
Islam asserts unambiguously that poverty is neither caused by scarcity and paucity of natural resources, nor is due to the lack of proper synchronization between the mode of production and the relation of distribution, but as a result of waste, opulence, extravagance and nonpayment of what rightfully belongs to the less able segments of the society.<sup>4</sup> The concept of development in Islam has three dimensions: individual self-development, the physical development of the earth, and the development of the human collectivity, which includes both (Mirakhor and Askari, 2010). The first specifies a dynamic process of the growth of the human person toward perfection. The second addresses the utilization of natural resources to develop the earth to provide for the material needs of the individual and all of humanity. The third dimension of development refers to the progress of the human collectivity toward full integration and unity. Happiness and fulfillment in a person’s life is not achieved by a mere increase in income, but with a full development of a person along all three dimensions. At the same time, economic progress and prosperity is encouraged in Islam since this provides the means by which humans can satisfy their material needs and thus remove the economic barriers on the path to their spiritual progress. Economic transactions are based on freedom of choice and freedom of contract, which, in turn, require property rights over possessions to be exchanged.

It is widely recognized that the central economic tenant of Islam is to develop a prosperous, just and egalitarian economic and social structure in which all members of society can maximize their intellectual capacity, preserve and promote their health, and actively contribute to the economic and social development of society. Economic development and growth, along with social justice, are the foundational elements of an Islamic economic system. All members of an Islamic society must be given the same opportunities to advance themselves; in other words, a level playing field, including access to the natural resources provided by God. For those for whom there is no work and for those that cannot work (such as the handicapped), society must afford the minimum requirements for a dignified life: shelter, food, healthcare and education.

One of the most important economic institutions that operationalizes the objective of achieving social justice is that of the wealth distribution/redistribution rules of Islam. Islam aims for just distribution of resources by creating a balanced society that avoids extreme of wealth and poverty, a society in which all understand that wealth is a blessing provided by the Creator for the sole purpose of providing support for the lives of all of mankind. To avoid a state of extreme wealth and extreme poverty, Islam prohibits unconstrained wealth accumulation and imposes limits on consumption through its rules prohibiting overspending ( _israf_ ), waste ( _itlaf_ ), ostentatious and opulent spending ( _israf_ ). It then ordains that the net surplus, after moderate spending necessary to maintain a modest living standard, must be returned to the members of the society who, for a variety of reasons, are unable to work, hence the resources they could have used to produce income and wealth were utilized by the more able. Islam considers the more able

> 4 Mirakhor and Askari (2010), Askari, Iqbal, Krichene, and Mirakhor (2011)

6
as trustee-agents in using these resources on behalf of the less able. In this view, property is not a <u>means of exclusion but inclusion in which the rights of those less able in the income and wealth of the more able are redeemed.</u> The result would be a balanced economy without extremes of wealth and poverty. The operational mechanism for redeeming the right of the less able in the income and wealth of the more able is the network of mandatory and voluntary levies.

Islam emphasizes financial inclusion more explicitly but two distinct features of Islamic finance – the notions of risk-sharing and redistribution of wealth – differentiate its path of development significantly from conventional financial industry.

Redistribution refers to the post-distribution phase when the due share of the less able is collected through voluntary and involuntary levies. These expenditures are essentially repatriation and redemption of the rights of others in one’s income and wealth. It is the recognition and affirmation that the Creator has created the resources for all of mankind who must have unhindered access to them. Even the abilities that make access to resources possible are due to the Creator. This would mean that those who are less able or unable to use these resources are partners of the more able.

# **II.1. Inclusion through Risk-sharing**

One of the core economic principles of Islam is the notion of risk-sharing. This is based on the principle of liability, which states that profit is justified on the basis of taking responsibility, possibly even becoming responsible for the loss and the consequences. This legal maxim, said to be derived from a saying of the Prophet (pbuh) that “profit comes with liability,” implies that Shari’ah distinguishes lawful profit from all other forms of gain and that entitlement to profit only when there is also the liability, or risk, of loss.

Islam has long endorsed risk sharing as the preferred organizational structure for all economic activities, specifically the most comprehensive application of risk sharing and going beyond anything put forward by modern theories.<sup>5</sup> On the one hand, Islam prohibits, and without any exceptions, explicit and implicit interest-based contracts of any kind and requires mandatory risk sharing with the poor, the deprived and the handicapped based on its principles of property rights.

Since the central proposition of Islamic finance is risk-sharing, any debt-based instrument that is structured based on extracting a rent (interest) as a percentage of the principle that was loaned for a specific time period and without the full transfer of the property rights over the money loaned to the borrower, is eliminated from the financial system. One result of this type of debt-based transaction is that the risk is borne by the borrower. Rather, Islam proposes a mutual exchange ( _al-bay’_ ) in which one bundle of property rights is exchanged for another, thus

> 5 Askari, Iqbal, Krichene, and Mirakhor (2011)

7
allowing both parties to share the risks of the transaction—something which is sanctioned. The emphasis on risk-sharing is evident from one of the most important verses in the Qur’an with respect to economic relations (2:275).<sup>6</sup>

# **II.2. Inclusion through Instruments of Redistribution in Islam**

Full compliance with the rules of _Shariah_ (Islamic Law) covering resource allocation, production, and exchange, and the distribution of resulting income and wealth not only ensures economic development and growth, it also ensures economic justice. The rules ensure that justice prevails before production takes place, during the exchange, and in the distribution of resulting income and wealth. Justice before production is achieved by ensuring that all members of the society have equal opportunities with respect to access to and utilization of resources. This is achieved through the rules contained in the framework of Islam’s property rights.<sup>7</sup> Basic axioms of property rights in Islam provide a firm foundation for the collectivity’s right of legislative mandate that requires transfer from those more able to the less able and the individuals should be fully aware that there are members in the society who are unable, for a variety of reasons, to use the resources, but still have rights in them. Therefore, returns from the use of these resources by the more able must be shared with the less able. All these rights must be redeemed from the income and wealth which result from their use.

Various levies are imposed on the production or the income, to redeem the rights of those who are not able to participate in the economic activities. Islam places great emphasis on redistribution of income and wealth and legislates institutions for this purpose such as _Sadaqat, Zakah, and Qard-al-Hassan_ . It is important to realize that in no way are these levies to be considered charity, as often misunderstood by laymen and scholars alike.<sup>8</sup> In the following section, we will briefly discuss three main instruments of redistributions including _Zakah_ , _sadaqat_ , and _Qard-al-Hassan_ for the poor, or the unbanked. These instruments are envisaged to enhance access to financing while addressing equity and contributing to poverty alleviation.

6 The verse states that: “... they say that indeed an exchange transaction (bay’) is like a riba (interest-based) transaction. But Allah has permitted exchange transactions and forbidden interest-based transactions,” (Qur’an, 2:275 ). For further details on risk-sharing aspects of Islam, see Askari, Iqbal, Krichene, and Mirakhor (2011) 7 See Mirakhor (1989) and Iqbal and Mirakhor (2011). The first axiom of the Islam’s property rights framework is that Allah is the Creator and the Ultimate Owner of all property. Man has been granted the right of possession of property only during his life time in this world. The second axiom is that the right of possession is a collective right, and individuals can only earn priority in the use of these resources. Individuals are to use these resources with the full understanding that Allah’s ultimate ownership and the collectivity’s prior right of possession remain intact.

> 8 Mirakhor (2004) The fact that the general _Quranic_ terms for these levies, such as _Zakah_ or _Sadaqat_ are translated into “charity” is an indication of this general misunderstanding. In fact, _Zakah_ indicates a cleansing of the resulting production, or income from the rights of others in them, i.e., _Zakah_ purifies the product or income resulting from an economic activity from the rights of others in the surplus.

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The first redistributive instrument is _Zakah_ .<sup>9</sup> An individual who earns more than what he or she consumes must pay _Zakah_ , which is calculated according to his or her level of net worth (essentially a wealth tax). Business capital and housing are exempt from _Zakah_ taxation in order to promote investment in capital and construction and to encourage home ownership. It is important to note that _Zakah_ , is _not_ a substitute for taxation by the state, which may institute other forms of taxation to finance additional social, economic, infrastructural, and related programs to attain social and economic goals.

Obviously, in theory _Zakah_ is to be given willingly, not to be paid grudgingly, if Divine Law is to be fulfilled. Its obligations are to the community as a whole: they are to be made specifically and directly to the community’s less fortunate members, neither to an impersonalized government nor to its revenue-collecting agencies. According to the _Qur’an_ , poverty and denial of assistance to the needy is forbidden. The _Qur’an_ goes on to explain that material inequalities are not a manifestation of spiritual inequalities. Rather, such inequalities should be overcome through human effort and are thus meant to foster brotherhood, again stressing the importance of _Zakah_ .

The second instrument of redistribution is _Sadaqat_ (voluntary social spending). Researchers argue that according to Islam, poverty exists not because economic resources are scarce, but because they are misallocated, inefficiently managed, unproductively hoarded, and unevenly distributed. Independent social spending, according to Islam, is the best possible way for members of the Islamic social order to promote a more equitable distribution of wealth and resources. Muslims with the financial capacity to donate beyond their _Zakah_ requirements are therefore strongly encouraged to further invest in _infaq_ and _Sadaqat_ .

The term _Sadaqat_ (the plural of _Sadaqat_ ) is a derivative of the root word meaning truthfulness and sincerity because such contributions or payments are symbolizes the strength of the sincerity of a person’s belief ( _Quran_ , 2:26; 2:272). The rationale of _Sadaqat_ payments is explained as the expenditures intended for redeeming the property rights of those who are excluded from the production cycle for any reason. The payment of such levies is considered a contractual obligation between the surplus producer and God—the ultimate owner, the instant an individual begins using resources created for all by Him. He is obligated to return to others what would have been rightly theirs, had they been able to fully participate in the use of resources in production and in exchange. On these grounds, it is argued that these levies cannot be considered charity.<sup>10</sup>

> 9 Mirakhor and Askari (2010). The etymological derivation of this important word has been traced to verbs that in English translate most closely as **‘‘to be pure’’ or ‘‘to be pious** .’’ _Zakah_ also signifies virtue in general, as well as—in the _Qur’an_ —giving and the pious gift. Thus, _Zakah_ is seen as an act of purification leading to self improvement. Others have emphasized its link to the verbs ‘‘to grow’’ and ‘‘to increase,’’ and have interpreted the giving of _Zakah_ as leading to a significant increase of blessings, both of material property in this world and of spiritual merit for the next.

> 10 Askari, Iqbal, Krichene, and Mirakhor (2011). An incentive structure is designed by Islam by which there is a promise of multiple return for _Sadaqat_ . In fact, the Quran promises the return to _Sadaqat_ from God in an increasing rate (see verses 265 and 276 of Chapter 2 of the Quran).

9
The third instrument of redistribution is _Qard al-Hassan_ (literally meaning a ‘beautiful loan’) which is a loan granted to the needy and is mentioned in the _Quran_ as “beautiful” ( _alhassan_ ).<sup>11</sup> It is a voluntary loan without the creditor’s expectation of any return on the principal. Additionally, while the debtor is obligated to return the principal, the creditor, on his own free will, does not press the debtor for an exact timing of its return. Again, in the case of Q _ard alHassan_ , God promises multiple returns to such a “beautiful loan.” Unfortunately, the full potential of this institution to mobilize substantial resources for the empowerment of the economically weak or dispossessed has not been realized. While the first two instruments, i.e. _Zakah_ and _Sadaqat_ are essentially gifts, Q _ard-al-Hassan_ is designed to meet the financing needs of the poor and is a loan that has to be repaid. It is, however, a loan without interest and with the term of the loan determined by the borrower alone.<sup>12</sup> To summarize, Islam recognizes claims based on equality of liberty and opportunity, which are reflected in the degree of access to resources, the degree and extent of the ability of persons to actualize their potential liberty and opportunity, and the right of prior ownership. The right that the less able have in the wealth of those who have greater ability and opportunity to produce greater wealth is redeemed through the various levies ( _Zakah_ , khums, sadaqat, nafaqa, and so on), the payment of which is not beneficence but a contractual obligation that must be met. Islam also encourages beneficence over and above these obligatory dues, but these levies are in the nature of returning to others what rightfully belongs to them. Shirking from this obligation causes a misdistribution of wealth, which Islam considers as the major source of poverty. In the morality of property rights, Islam unequivocally considers all individuals entitled to a certain standard of life; and it is this entitlement that entails the satisfaction of their claim as a matter of equity and justice.

As we shall see, instruments of Islamic finance enable risk sharing and risk diversification through which individuals can mitigate their idiosyncratic risks. Levies— mandated or otherwise—such as _Zakah_ , _Sadaqat_ and _Qard-al-Hassan_ , enable the idiosyncratic risks of the poor to be shared by the rich, thus helping to reduce the poor’s income–consumption correlation. In other words, the poor are not forced to rely entirely on their low level (or no) income to maintain a decent level of subsistence living for themselves and their families. It is possible that at some point even these levies can be instrumentalized to be included in the fullspectrum menu of Islamic financial instruments for risk sharing. In that event, Islamic finance would become a risk manager for society (Askari, Iqbal, Krichene, and Mirakhor, 2011).

> 11 It is speculated that the reason why it is called beautiful is because in all the verses in which this loan is mentioned, it is stipulated that it is made directly to God and not to the recipient (see, for example, verse 17, Chapter 64). Mirakhor (2004)

> 12 . A number of verses in the Quran stress the importance of this instrument. The Prophet is reported to have said that the reward for _qard-ul-hassan_ is eighteen fold while that for _Sadaqat_ which is charity and does not have to be repaid is only tenfold.

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# **Section III. Enhancing Inclusion through Risk-Sharing Instruments**

Empirical studies provide strong evidence that the proportion of the Muslim population using financial services is less than their non-Muslim counterparts (El Hawary and Grais, 2005). Lack of access of the poor to finance is undoubtedly the most crucial factor in the failure to bring about a broad-based ownership of businesses and industries and thereby realize the egalitarian objectives of Islam. As mentioned earlier, access to finance can be enhanced in Islamic economy through two approaches. The first is taking the same route as conventional finance and through replicating traditional modes of inclusion such as micro-finance, micro-SME, and microinsurance (see Box 1). This section discusses the issues in each mode of financing and reviews how each is implemented to make it compliant with _Shariah_ . The second mode of enhancing inclusion is through Islam’s redistributive mechanisms such _Zakah_ , _Sadaqat_ , _Qard-al-Hassan_ , and _Waqf_ . This is an area which is not formally developed in most of the modern-day Islamic countries.

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# **Box 1 – Core Conventional Tools to Enhance Financial Access**

## **_Micro-finance:_**

Two important problems in access to credit services for households are lack of collateral or steady future income and high transaction costs. Microfinance institutions have tried to overcome these two constraints by innovations such as group lending schemes. Conventional literature focuses on how microfinance unleashes the productive potential of small and unbankable borrowers.

## **_Small Medium Enterprises (SME):_**

Countries with a higher level of GDP per capita have larger SME sectors in terms of their contribution to total employment and GDP. (Ayyagari, Beck and Demirguc-Kunt 2003). As the largest providers of new jobs and major source of technological innovation in most countries, SMEs have functioned as the engine of growth for both developed and developing economies. As for poverty reduction, SMEs are more likely to employ poor and low-income workers then larger firms; sometimes, SMEs are the only source of employment in poor regions and rural areas. However, market failures may cause biases against SMEs. For example, high risks for cost-searching and coordination failure across sectors always prevent start-ups from entering a new market. Thus, industry policies favoring SMEs, such as credit subsidies and tax credits, are recommended for developing countries.

## **_Micro-insurance:_**

(Outreville, 1990; Ward and Zurbruegg, 2002; Beck et al., 2007) provides evidence of a positive causal relationship between insurance penetration and economic growth. The policyholder benefits by increased access to a wider range of products with increased coverage and greater sustainability; and the partnering insurance company has access into a new market without taking extensive marketing, distribution, or administration costs. More importantly, the partner-agent model facilitates the pooling of risks between the formal and informal sectors.

# **III.1.** **_Shariah_ -compliant Micro-Finance**

**In most OIC countries, Islamic financing instruments comprise only a small fraction of microfinance supply.** In Syria for example, Islamic microfinance comprised only 3 percent of outstanding microfinance loans in 2006. Similar situations are also found in other MENA countries (See Figure 2). Since MENA countries are relatively more financially developed than the rest of the OIC countries, the figure implies an even lower coverage rate of _Shariah_ compliant microfinance in all the OIC countries.  Providers of Islamic microfinance also tend to be small in size. 80 percent of the global outreach of Islamic microfinance concentrates in only three countries, Indonesia, Bangladesh, and Afghanistan. Islamic microfinance products are also limited in their diversity, e.g. over 70 percent of the Islamic finance products offered are _murabaha_ (cost plus). The narrow range of products offered is continuously excluding lowincome individuals and small enterprises from access to _Shariah_ -based finance.

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**Figure 2** . **Microfinance Products offered in MENA**

<!-- Start of picture text --> Region Total<br>Egypt<br>Morocco<br>Lebanon Microenterprise<br>Jordan Islamic finance<br>Iraq Consumer<br>Palestine Housing<br>Mortgage<br>Syria<br>Tunisia<br>Yemen<br>0% 20% 40% 60% 80% 100%<br><!-- End of picture text --> Source: (Sanabel 2010) However, there are some signs that this limited selection may increase: in Egypt, Bank Misr plans to introduce Islamic microfinance activities to its 33 Islamic branches, and also develop a _mudaraba_ (profit sharing agreement) product in addition to the _murabaha_ product; in Yemen, Tadhamon Islamic Bank opened an MSE division in late 2006; and in the UAE, Noor Islamic Bank and Emirates Post Holding Group announced plans to establish a company to offer Shariah-compliant financial services to low-income clients.<sup>13</sup> Table 1 provides a survey of different implementations of _Shariah_ -compliant microfinance institutions in Syria, Bangladesh, Iran, and Indonesia. Although the Islamic microfinance projects follow similar concepts of conventional microfinance, including group saving and monitoring, targeting female borrowers, etc., two characteristics distinguished them from conventional ones. First, _Shariah_ compliant microfinance institutions actively adopted various Islamic financial tools, such as trade and project finance, _Murabahah,_ as well as non-financing instruments such as _Waqf and Qard al-Hassan_ , in the process of absorbing savings and making loans. Some of these institutions also gained funding support from _Zakah_ collection. Second, since interest income is prohibited, most institutions charged administrative/service fees plus a portion of the profit from the business venture. Looking back, the innovative combination of traditional and Islamic finance has been successful in most cases under study, as suggested by the relatively high recovery rate and fast expansion of their scale in recent years. Despite success in implementing _Shariah_ -compliant micro-finance, the practice has not spread as widely as one would have hoped. We discuss some of the challenges in the next sections of the paper.

> 13 (Pearce 2010)

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# **Table 1 – Survey of Islamic Micro-Finance Case Studies**

|**Paper/**<br>**Country**|**Institution**|**Purpose**|**Business Size**|**Client**<br>**size/volume**|**Islamic**<br>**instrument**<br>**of**<br>**financing**|
|---|---|---|---|---|---|
|**(Asaad 2007)**<br>**Syria**|UNDP supported<br>village funds|The village funds are self-managed and<br>autonomous in their decision-making,<br>which has included the adoption of<br>financial practices consistent with local<br>values.| Between Sep 2000 and Dec<br>2002, 22 village funds were<br>established.<br> UNDP contributed $370,000<br>in equity.<br> Repayment rate as of 31 Dec<br>2002 was 99.7%. ROE was<br>17%| Average loan<br>balance per<br>borrower/per<br>capita GDP is<br>61%.<br> Till the end of<br>2003, 5,674 loans<br>were disbursed.|Murabahah|
|**(Ahmed 2007)**<br>**Bangladesh**|Islamic Bank<br>Bangladesh<br>Limited (IBBL):<br>Rural<br>Development<br>Scheme (RDS)|RDS is a_Shariah_based microfinance<br>model of poverty alleviating program,<br>mainly for the poor woman of the rural<br>area of Bangladesh. Target group includes<br>destitute women, distressed people, and<br>households with less than 0.5 acres of land.| Up to Dec 2006, 1,368 Field<br>Officers engaged in supervision<br> An investment amount of<br>$135 mln<br> 118 branches in 8,057<br>villages<br> Recoveryrate was 99%.|294,908<br>borrowers, 92%<br>or which are<br>woman.|Bai-Muajjal, Bai-<br>Murabaha, Bai-Salam, and<br>Hire Purchase under<br>Sherkatul Melk (HPSM).|
|**(Mannan**<br>**2007)**<br>**Bangladesh**|Social Investment<br>Bank Ltd<br>“SME programs”<br>and “Family<br>Empowerment<br>Micro enterprise<br>Program”|Helping poor family to purchase materials<br>commodities for trading, manufacturing and<br>service concern.| As of 2005, the family<br>empowerment micro credit<br>program has a total outstanding<br>of $0.3mln, with a recovery rate<br>of 96%<br> SME program has a total<br>outstanding of $1.1mln, with a<br>recoveryrate of 94%|n.a.|_Waqf_and Mosque<br>properties, cash-_Waqf_<br>certificate, joint-venture<br>projects for management of<br>Hajj affairs|
|**(Kazem 2007)**<br>**Iran**|1,229_Qard-al-_<br>_Hassan_Funds<br>(GFs)|With the objective of helping low-income<br>group through short-run credit grant, GFs<br>provide_Shariah_compliance services to<br>individuals who are unable to fulfill banks<br>loan collateral requirements and thus were<br>deprived from obtaining credit.| Total value of loans is $169<br>mln<br> Total value of deposits is<br>$227 mln<br> 60% of the total loans had<br>been paid back.| 6,480,237<br>depositors<br> 1,777,583<br>borrowers|_Qard-al-_<br>_Hassan_Funds|

14
|**(Arabmazar**<br>**2007)**<br>**Iran**|Bank keshavarzi<br>of Iran<br>"Hazrat Zeynab<br>Project"|Finance women producers and farmers of<br>agricultural sector with loans under $600<br>with the maximum repayment period of 5<br>years.| A revolving fund is about $44<br>mln| 117,322<br>women<br>borrowers|Qard al-Hassan funds,<br>Qard al-Hassan saving<br>accounts|
|---|---|---|---|---|---|
|**(Kholis,**<br>**AG**<br>**and SH 2007)**<br>**Indonesia**|BMT<sup>14</sup>Al-Ikhlas,<br>BMT Bina<br>Ummah, and<br>BMT Dana<br>Syariah|BMT is a unique Islamic micro finance<br>institution established by Indonesian<br>moslems to abolish ceti or rentenir (Usurer)<br>in Indonesian moslem societies by<br>providing many financing schemes for<br>helping micro and medium entrepreneurs.| Up to November 2006, there<br>are more than three thousands<br>BMTs in the country.<br> About 65 BMT's of them are<br>located in Yogyakarta.<br> Only 42 BMT which reported<br>their performance to PINBUK<br>Yogyakarta regularly.|n.a.|Murabahah contract for<br>SMEs, Mudarabah saving<br>account, Pendidikan<br>saving account,<br>HajiSaving Account,<br>Qurban/Aqiqah saving<br>account, Walimah saving<br>account, Wadi ‘ah<br>Damanah Aidil Fitri,<br>Saving Account, Amanah<br>saving account|
|**(Nurahayati**<br>**and Wahyuni**<br>**2007)**<br>**Indonesia**|BMT Masjid Al<br>Azhar|Serving those under-developed areas.<br>Helping in developing productive business<br>by promoting saving activity and assist<br>financing economic activities in those areas.| In 2005, total financing given<br>was $0.71 mln<br> Balance of outstanding loan<br>was $0.21 mln<br> Total balance of savings was<br>$0.23 mln| In 2005, served<br>1,446 total<br>debtors<br> 3,821<br>depositors|n.a.|
||BMT Al Kariim|Helping the poorest of the poor, the poor,<br>working poor and micro enterprises in the<br>informal sector in the Pondok Indah<br>neighborhood.| In 2005, total financing given<br>was $0.38 mln<br> Balance of outstanding loan<br>was $0.08 mln<br> Balance of savings was $0.16<br>mln<br> Balance of fixed term savings<br>was$0.21 mln| In 2005, served<br>1,324 debtors<br> 5,075 saving<br>account<br>depositors<br> 87 fixed term<br>saving users|n.a.|

> 14 BMT, _Baaitul Maal wat Tamwil_ , or Islamic Savings and Loan Cooperatives

15
# **III.2.** **_Shariah_ -compliant SME Financing**

Islamic finance highlights the significance of profit-sharing finance, which can have positive economic effects similar to direct investment leading to strong economic development.<sup>15</sup> Promotion of entrepreneurship and risk-sharing are two key features of Islamic finance and given that SMEs require both encouragement to entrepreneurship and risk-sharing, there is a natural fit for Islamic finance and SME financing. Islamic SME finance concepts can be seen to provide a comprehensive asset-based economic and equitable model that fulfills expectations such as social justice and human centered sustainable development.

Tools required for SME’s finance are not found to be different from the mainstream forms for Islamic financing in general. The necessary and sufficient conditions for full compliance with _Shariah_ should be satisfied, in terms of risk sharing (lenders and borrowers share profits and losses), in addition to the fact that return on capital shouldn’t be fixed.<sup>16</sup> Financing modes that best suit SMEs include mudarabah (principle/agent) and musharakah (equity partnership). Both forms serve a useful purpose: they provide investors with high liquidity at low risk. Islamic banks were recently encouraged to provide more profit-sharing finance and are developing arrangements to reduce risks and the costs of funding. Many innovative examples were provided in Asutay (2011), among which is setting up specialized institutions, as well as introducing new consistent products with the aim of reducing risks through pooling the funds and establishing _Wikalah_ agencies to perform monitoring and to minimize moral hazard.

However, _Shariah_ compliant SME finance is not limited to these instruments; innovative approaches tend to involve more comprehensive financing schemes that mix the aforementioned saving as a tool for insurance hedging against future turbulence. Ijarah has been one of the most widely used forms of financing SMEs as it reduces the startup cost in addition to providing security to lenders.

The issue with promoting SME financing is not the availability of appropriate tools but the challenge is to provide an enabling environment as we observe in the following sections.

# **III.3. Micro-** **_Takaful_ , Risk Sharing and Poverty Alleviation**

_Takaful_ is a cooperative insurance mechanism that evolved in the late 1970s in Sudan and Egypt. The concept is similar to conventional mutual risk mitigation, in which risk sharing is expressed as ta’awuni (mutual protection). Based on the experience of conventional micro-

> 15 For further detail, ee work for Askari, Iqbal and Mirakhor (2008), Chapra (2008) and Asutay (2011),

> 16 The three main forms of Islamic finance include _murabhah_ (trust finance), _musharkah_ (partnership finance), and _mudarbah_ (markup contract sale). These are in addition to Salam contracts, Ijarah and Qard Hassan, and Awqaf<sup>16</sup> . Other forms of long term and sophisticated forms include _salam_ forward purchase credit and _istisna_ project financing.  See also Iqbal and Mirakhor (2011)

16
insurance services and to complement Islamic microfinance products, the first Micro- _Takaful_ scheme was established in 1997 in Lebanon. Micro _Takaful_ distinguish itself from _Takaful_ by targeting the low-income individuals who are living slightly above the poverty line and usually work in informal sectors. As of January 2010 Micro- _Takaful_ providers exist in Lebanon, Indonesia, Malaysia, Sri Lanka, Bahrain and Pakistan.<sup>17</sup> Micro _Takaful_ has long been considered as one of the most promising segments among other _Shariah_ -compliant financial products. The main argument is that Micro _Takaful_ can play an important role in poverty alleviation through risk-sharing among low-income individuals. Deeper insurance penetration leads to faster economic growth.<sup>18</sup> Policyholders benefit by increased access to a wider range of products with increased coverage and greater sustainability; and the partnering insurance institutions gain access to a new market without taking extensive marketing, distribution, or administration costs. More importantly, the partner-agent model facilitates the pooling of risks between the formal and informal sectors. Like microfinance, micro _Takaful_ helps under-privileged people sustain their financial wellbeing, provides them with a feeling of togetherness, solidarity, and security, and opens avenues for joint efforts for mutual benefits. In addition, as many micro- _Takaful_ institutions raised their funding from _Zakah_ , they can also improve the redistribution efficiency and provide a financially sustainable approach to benefit the Islamic society at large.

# **III.4. Islam’s Redistributive Institutions to Enhance Inclusion**

Use of Islam’s redistributive institutions such as _Zakah_ , _Sadaqat_ , Qard-al-Hassan and _Waqf_ has enormous potential to enhance access to finance.

# **How can** **_Zakah_ contribute to poverty alleviation?**

The concept of _Zakah_ could be expanded to provide a sustainable source of income for the poor. It is seen as a significant tool for promoting financial inclusion and economic growth. If ‘ _Zakah_ ’ funds are managed properly, pooling these funds and encouraging the poor/beneficiaries to direct the funds towards starting a micro/small business would contribute to a more conducive developmental impact and help reduce disparities within the economy. ‘ _Zakah_ ’ is also perceived as an important tool for continually circulating liquidity in the system. Imposing it on aggregate wealth, including gold and silver and idle balances, benefits the system from unutilized resources and induces more investment and employment. This in turn paves the way for innovations to introduce alternative financial products that would achieve both effective accommodations to the nature of micro and small businesses in addition to poverty alleviation. Practical examples could include mudaraba agreements with institutional investors and facilitating access to dedicated _Zakah_ funds. No doubt, introducing such financial instruments to direct ‘ _Zakah_ ’ resources

> 17 (ICMIF _Takaful_ , 2010)

> 18 (Outreville, 1990; Ward and Zurbruegg, 2002; Beck _et al_ ., 2007).

17
promotes more social equity and equality in a sustainable and productive manner and could maximize the value added of such resources.

_Zakah_ has great potential as the main resource of social spending supporting poverty alleviation in Islamic society. The argument is not only theoretically true, but can be supported by statistical evidence. Here we used the method adopted by (Shirazi 2006) to estimate the _Zakah_ collection in OIC member countries. Besides updating the data source, we also took the potential _Zakah_ collation in the form of incoming remittances into consideration. Table 2 shows estimates of the percentage of _Zakah_ proceeds to GDP according to different economic structures of selected Muslim countries based on the methodology by (Kahf 1989).

Table 3 estimates the resource shortfall to fill the poverty gap while Table 4 estimates the _Zakah_ collection based on domestic and remittance contributions<sup>19</sup> and determines whether the _Zakah_ collection is sufficient to cover the estimated shortfall. Using this estimation, we find supporting evidence that 20 out of 39 OIC countries can actually alleviate the poorest living with income under $1.25 per day out of the poverty line simply with domestic and remittances _Zakah_ collection.

This does not mean that it is a totally new source of poverty reduction mechanism using _Zakah_ as it is already distributed to the poor in several Islamic countries but we can make an argument that proper collection, streamlining, accountability, prioritization, and allocation to productive activities can have significant impact on enhancing access and opportunity for the poor segment of the society which will ultimately lead to reduction in poverty.

> 19 _Zakah_ collected from remittances is estimated by the 2.5% of the remittances saved domestically (2.5%*domestic savings rate*incoming remittances).

18
**Table 2 Percentage of estimated** **_Zakah_ proceeds to GDP in selected Muslim countries**

||Z1<sup>~~20~~</sup>|Z2|Z3|
|---|---|---|---|
|Egypt,Arab Rep.|2.0|3.9|4.9|
|Indonesia|1.0|1.7|2.0|
|Pakistan|1.6|3.5|4.4|
|Qatar|0.9|3.7|3.2|
|Saudi Arabia|1.2|3.7|3.4|
|Sudan|4.3|6.3|6.2|
|Syria|1.5|3.1|3.1|
|Turkey|1.9|4.9|7.5|
|average|1.8|3.9|4.3|

Source: (Kahf 1989)

**Table 3 Resource shortfall to fill the poverty gap**<sup>21</sup>

|**(1)**<br>**Country**<br>**name**|**(2)**<br>**Survey**<br>**year**|**(3)**<br>**GDP (PPP)**<br>**current USD**<br>**(million)**<br>**Group**<br>38487887|**(4)**<br>**Total pop.**<br>**(million)**<br>**1: countries**<br>2747|**(5)**<br>**Poverty gap**<br>**at $2 a day**<br>**(PPP) (%)**<br>**with moderate re**|**(6)**<br>**Poverty gap**<br>**at $1.25 a day**<br>**(PPP) (%)**<br>**source shortfall (**|**(7)**<br>**Resource**<br>**shortfall**<br>**under $2 per**<br>**annum**<br>**(million)**<br>**<=1.0 percent of**<br>3208|**(8)**<br>**Resource**<br>**shortfall**<br>**under $1.25**<br>**per annum**<br>**(million)**<br>**GDP)**<br>000|**(9)**<br>**Resource**<br>**shortfall**<br>**under $2**<br>**per annum**<br>**as % of**<br>**GDP**|**(10)**<br>**Resource**<br>**shortfall**<br>**under**<br>**$1.25 per**<br>**annum as**<br>**% of GDP**|
|---|---|---|---|---|---|---|---|---|---|
|**Malaysia**|2009|,.|.|0.16|0.00|.|.|0.01|0.00|
|**Kazakhstan**|2007|169,633.06|15.48|0.26|0.05|29.39|3.53|0.02|0.00|
|**Jordan**|2006|26,142.82|5.54|0.62|0.10|25.08|2.53|0.10|0.01|
|**Albania**|2008|26,449.68|3.14|0.85|0.19|19.50|2.72|0.07|0.01|
|**Azerbaijan**|2008|76,730.04|8.68|1.52|0.25|96.31|9.90|0.13|0.01|
|**Maldives**|2004|1,197.43|0.29|2.53|0.14|5.33|0.18|0.44|0.02|
|**Iran**|2005|643,503.42|69.09|1.80|0.34|907.80|107.17|0.14|0.02|
|**Kyrgyz**<br>**~~Reublic~~**|2007|10,620.40|5.23|5.46|0.08|208.65|1.91|1.96|0.02|
|**~~p~~**<br>**Syrian**<br>**~~Arab~~**|2004|70,017.06|18.51|3.28|0.20|443.24|16.89|0.63|0.02|
|**Gabon**|2005|17,839.03|1.37|5.02|0.90|50.18|5.62|0.28|0.03|
|**Turkey**|2005|781,243.40|71.17|2.64|0.88|1,371.57|285.74|0.18|0.04|
|**Egypt,**<br>**~~Arab Rep~~**|2005|333,218.41|77.15|3.45|0.39|1,943.13|137.29|0.58|0.04|

> 20 (Kahf 1989): “Z1 was estimated accordance with the majority traditional view according to which _Zakah_ was levied on agriculture, livestock, stock in trade, gold, silver and money. Z2 was based in according with the views of contemporary Muslim scholars where _Zakah_ can be deducted from net returns of manufacturing concerns and building rents and from net savings out of salaries. Z3 was based on Malikite views, where _Zakah_ base includes buildings and other fixed assets except those assigned for personal and family use.

> 21 (2)-(6): Data source: World Bank Databank; (7) = 2*(5)*365*(4)/100; (8) = 1.25*(6)*365*(4)/100; (9) = (7)/(3)*100; (10) = (8)/(3)*100

19
|**Morocco**|2007|127,848.85|31.22|3.15|0.54|718.00|76.93|0.56|0.06|
|---|---|---|---|---|---|---|---|---|---|
|||9496920|2995|||121332|8198|||
|**Iraq**|2007|,.|.|5.55|0.60|,.|.|1.28|0.09|
||<br>**Gro**|**up 2: countries wit**<br>|**h Intermediate**<br>|<br>**resource shortfal**|<br>**l (>=1.0 percent**|**of GDP and >=**<br>|**6 percent of GD**<br>|<br>**P)**<br>||
|**Algeria**|1995|129,750.66|28.27|23.60|1.40|4,869.54|180.54|28.27|0.14|
|**Cameroon**|2007|39,768.07|18.66|8.21|1.20|1,118.35|102.16|18.66|0.26|
|**Indonesia**|2009|965,571.03|229.96|15.48|3.62|25,986.93|3,798.15|229.96|0.39|
|**Suriname**|1999|2,018.46|0.46|11.74|5.90|39.48|12.40|0.46|0.61|
|**Yemen,**<br>**~~R~~**|2005|46,125.24|21.02|14.76|4.18|2,265.26|400.95|21.02|0.87|
|**~~ep~~**<br>**Guyana**|1998|1,538.50|0.76|6.94|3.90|38.37|13.48|0.76|0.88|
|**Pakistan**|2005|340,262.06|155.77|18.74|4.35|21,309.92|3,091.59|155.77|0.91|
|**Djibouti**|2002|1,239.64|0.76|14.58|5.29|81.20|18.41|0.76|1.49|
|**Tajikistan**|2004|8,774.25|6.45|16.76|5.06|789.55|148.98|6.45|1.70|
|**Cote**<br>**~~d'Ii~~**|2008|34,295.23|20.59|17.79|7.50|2,674.13|704.61|20.59|2.05|
|**~~vore~~**<br>**Senegal**|2005|18,208.36|11.28|24.66|10.80|2,030.84|555.89|11.28|3.05|
|**Uganda**|2009|39,813.64|32.71|21.25|8.26|5,074.12|1,232.71|32.71|3.10|
|**Uzbekistan**|2003|42,757.17|25.57|33.18|15.04|6,192.85|1,754.46|25.57|4.10|
|**Gambia,**<br>**~~Th~~**|2003|1,457.33|1.44|24.88|12.05|260.87|78.97|1.44|5.42|
|**~~e~~**<br>**Bangladesh**|2005|163,728.14|153.12|33.81|13.08|37,792.51|9,137.94|153.12|5.58|
|**Benin**|2003|9,135.56|7.36|33.50|15.73|1,799.43|528.08|7.36|5.78|
|||**Group**<br>|**3: countries wi**<br>|<br>**th severe resourc**|<br>**e shortfall (>=6**|**.0 percent of GD**<br>|**P)**<br>|||
|**Togo**|2006|4,962.81|6.14|27.92|11.37|1,252.43|318.77|25.24|6.42|
|**Guinea**|2007|9,777.15|9.62|31.03|14.96|2,178.00|656.28|22.28|6.71|
|**Mali**|2006|12,672.38|12.12|36.50|18.79|3,228.87|1,038.88|25.48|8.20|
|**Guinea-**<br>**~~Bi~~**|2002|1,256.42|1.37|34.83|16.52|347.96|103.15|27.69|8.21|
|**~~ssau~~**<br>**Nigeria**|2004|224,618.00|137.54|46.89|29.57|47,080.76|18,556.44|20.96|8.26|
|**Niger**|2007|9,248.52|14.14|30.59|11.92|3,157.49|768.99|34.14|8.31|
|**Comoros**|2004|628.48|0.59|34.18|20.82|146.70|55.85|23.34|8.89|
|**Burkina**<br>|2003|12,090.91|12.85|39.26|20.27|3,683.78|1,188.71|30.47|9.83|
|**~~Faso~~**<br>**Mozambiqu**<br>|2008|18,885.83|22.38|42.91|25.18|7,011.17|2,571.39|37.12|13.62|
|**~~e~~**<br>**Sierra**<br>**~~Leone~~**|2003|2,722.93|4.73|37.53|20.30|1,296.57|438.32|47.62|16.10|

20
# **Table 4** **_Zakah_ Estimation to fill the poverty gap**<sup>**22**</sup>

|**(1)**<br>**Country name**|**(2)**<br>**Survey**<br>**year**|**(3)**<br>**GDP**<br>**PPP**<br>**Current**<br>**USD**<br>**(Billion)**|**(4)**<br>**Muslim**<br>**pop.**<br>**(%)**|**(5)**<br>**Adjusted**<br>**GDP PPP**<br>**USD**<br>**(Billion)**|**(6)**<br>**Domestic**<br>**_Zakah_**<br>**(Billion USD)**|**(7)**<br>**Incoming**<br>**remittances**<br>**(Billions**<br>**USD)**|**(8)**<br>**Domestic**<br>**savings rate**<br>**(% of GDP)**|**(9)**<br>**_Zakah_**<br>**considerin**<br>**g**<br>**Remi-**<br>**ttances**<br>**(% of**<br>**GDP)**|**(10)**<br>**resource**<br>**shortfall**<br>**under $1.25**<br>**per annum**<br>**as % of GDP**|**(11)**<br>**Does**<br>**_Zakah_**<br>**cover**<br>**(10)?**|
|---|---|---|---|---|---|---|---|---|---|---|
|**Albania**|2008|26.45|79.9|21.13|0.38|1.50|1.60|1.44|0.01|y|
|**Algeria**|1995|129.75|98|127.16|2.29|1.12|28.11|1.77|0.14|y|
|**Azerbaijan**|2008|76.73|99.2|76.12|1.37|1.55|64.89|1.82|0.01|y|
|**Bangladesh **|2005|163.73|89.6|146.70|2.64|4.31|18.06|1.62|5.58|n|
|**Benin**|2003|9.14|24.4|2.23|0.04|0.06|5.98|0.44|5.78|n|
|**Burkina Faso**|2003|12.09|59|7.13|0.13|0.05|4.51|1.06|9.83|n|
|**Cameroon **|2007|39.77|17.9|7.12|0.13|0.17|18.53|0.32|0.26|y|
|**Comoros**|2004|0.63|98.3|0.62|0.01|0.01|0.00|1.77|8.89|n|
|**Cote d'Ivoire**|2008|34.30|36.7|12.59|0.23|0.20|17.85|0.66|2.05|n|
|**Djibouti**|2002|1.24|96.9|1.20|0.02|0.01|4.87|1.75|1.49|y|
|**Egypt **|2005|333.22|94.6|315.22|6.30|5.02|15.71|1.90|0.04|y|
|**Gabon**|2005|17.84|9.5|1.69|0.03|0.01|58.35|0.17|0.03|y|
|**Gambia**|2003|1.46|95|1.38|0.02|0.06|11.05|1.72|5.42|n|
|**Guinea **|2007|9.78|84.4|8.25|0.15|0.15|9.68|1.52|6.71|n|
|**Guinea-Bissau**|2002|1.26|42.2|0.53|0.01|0.02|0.00|0.76|8.21|n|
|**Guyana**|1998|1.54|7.2|0.11|0.00|0.01|16.94|0.13|0.88|n|
|**Indonesia**|2009|965.57|88.2|851.63|8.52|6.79|33.76|0.89|0.39|y|
|**Iran**|2005|643.50|99.4|639.64|11.51|1.03|41.09|1.79|0.02|y|
|**Iraq**|2007|94.97|99|94.02|1.69|0.00|0.00|1.78|0.09|y|
|**Jordan**|2006|26.14|98.2|25.67|0.46|2.88|0.00|1.77|0.01|y|
|**Kazakhstan**|2007|169.63|56.4|95.67|1.72|0.22|43.84|1.02|0.00|y|
|**Kyrgyz Republic**|2007|10.62|86.3|9.17|0.16|0.71|0.00|1.55|0.02|y|
|**Malaysia**|2009|384.88|60.4|232.47|4.18|1.13|36.03|1.09|0.00|y|
|**Maldives**|2004|1.20|98.4|1.18|0.02|0.00|46.15|1.77|0.02|y|

22 (4) data source: wikipedia.org. (3) (7) (8) data source: World Bank Databank. (8) Savings rate is floored to zero if negative (5) = (3) * (4) = (5)*reference ratio of Z1 from Table **2** (9) = ((6) + (7) * (8) * 2.5%) / (3) (10) = Column (10) from Table 3 (11) = Y if (9) > (10), N otherwise.

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|**Mali**|2006|12.67|92.5|11.72|0.21|0.21|14.75|1.67|8.20|n|
|---|---|---|---|---|---|---|---|---|---|---|
|**Morocco**|2007|127.85|99|126.57|2.28|6.73|23.37|1.81|0.06|y|
|**Mozambique**|2008|18.89|22.8|4.31|0.08|0.12|1.57|0.41|13.62|n|
|**Niger **|2007|9.25|98.6|9.12|0.16|0.08|0.00|1.77|8.31|n|
|**Nigeria**|2004|224.62|50.4|113.21|2.04|2.27|0.00|0.91|8.26|n|
|**Pakistan**|2005|340.26|96.3|327.67|5.24|4.28|15.21|1.55|0.91|y|
|**Senegal**|2005|18.21|96|17.48|0.31|0.79|14.09|1.74|3.05|n|
|**Sierra Leone**|2003|2.72|71.3|1.94|0.03|0.03|0.00|1.28|16.10|n|
|**Suriname**|1999|2.02|15.9|0.32|0.01|0.00|11.25|0.29|0.61|n|
|**Syrian Arab**|2004|70.02|92.2|64.56|0.97|0.86|20.20|1.39|0.02|y|
|**Tajikistan**|2004|8.77|84.1|7.38|0.13|0.25|0.61|1.51|1.70|n|
|**Togo**|2006|4.96|12.2|0.61|0.01|0.23|0.00|0.22|6.42|n|
|**Turkey**|2005|781.24|98|765.62|14.55|0.89|16.49|1.86|0.04|y|
|**Uganda **|2009|39.81|12.1|4.82|0.09|0.75|12.52|0.22|3.10|n|
|**Yemen**|2005|46.13|99.1|45.71|0.82|1.28|0.00|1.78|0.87|y|

Source: World Bank Databank

# **_Qard-al-Hasan_ as a tool for financial inclusion**

Qard-al-Hasan (QH henceforth) is defined in _Shariah_ as an interest free loan. It is usually granted from well off lenders to poor borrowers. It can also be directed from borrowers to intermediaries that can redirect it on their behalf to poor borrowers. QH is therefore a non rewarding loan (with no expected return) and the borrower is under obligation to repay the loan depending on the borrower’s financial capacity to do so. Loan procedures are usually informal and social capital is the basic collateral for this instrument.

The main objectives of Qard al-Hassan could be:<sup>23</sup>

- To help the needy fellow people.

- To establish better relationship among poor and the rich.

- The mobilization of wealth among all people in the society.

- To perform a good deed that is encouraged and appreciated by the _Allah_ (swt) and His messenger.

- To strengthen the national economy.

- To facilitate the poor to create new jobs market and business ventures by using their merits, skills and expertise.

- To establish a caring society.

- To eradicate unemployment problem from the society.

> 23 Please see (Hossain 1955) for a comprehensive exposition of al-qard-al-hasan based on Quran and Sunnah.

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- It can remove social and economic discrimination from the society, and

While the conventional microfinance industry has been globally growing at 13 percent per annum since early 1990s, only very limited information is available on micro finance institutions (MFI’s) operating under QH. A relatively small number of interest-free loans are operating in Pakistan (www.akhuwat.org.pk) and there are some small-scale micro-/rural banks in Indonesia. However, no organized institutions are known to be operating on the basis of QH except in Iran where QH has been utilized effectively to provide finance for the needy and where these institutions are widespread throughout the country.

Also QH funds have been operating in Iran since the Islamic Revolution they have enjoyed phenomenal growth and a successful track record. QH funds in Iran, by and large, provide small consumer and producer loans and, in some cases, engage in profit-sharing activities with small producers and firms, thus supplementing the fund’s capital. These funds are usually associated with local mosques or other religious organizations and sometimes with guilds or professional associations. The capital is contributed by the more well-to-do who are at liberty to withdraw their funds at any time. These funds operate with reasonably low administrative costs since most are managed on a voluntary basis by the people within the group.

A recent survey on QH based finance that has been operating with the objective of helping low-income group through short-run credit in Iran shows that there exited 1,229 _Qard-al-Hassan_ Funds (Kazem 2007). Total loans amounted to $169 mln, and deposits totaled to $227 mln with 60% of the total loans had been paid back (please see table 1 for a comprehensive survey on literature).

Conventional micro finance (MF) and Qard-al-Hassan Microfinance (QHMF) have both similarities and differences. MF charges interest, an abomination from an Islamic perspective, and MF schemes resort to collective punishments for defaulting, yet under QHMF, usually donors/subscribers introduce the borrowers and cosign for their loan, yet no collective punishment is usually imposed in case of default. On the other hand both instruments target the same income groups and they have both effectively contribute to avoiding informational problems by relying on peer monitoring, as well as good knowledge of the borrower reputation. In addition, neither requires collateral as a prerequisite for a loan.

QH can also be considered an excellent venue for supporting SME’s and penetrating to lower income levels that are deprived of financial resources that is not properly tapped in Islamic countries. It provides a reliable source of funding to economic development and targets minimizing the lending risk as it build on pooling and social collateral. In addition, it commends payback and therefore benefits from the potential recirculation of funds in poor and extremely low tiers of the economy. While the social cost of QH funds lies mainly in the opportunity cost of using these funds in alternative projects, the social benefits of availing funding to MFI’s at zero cost acts a good catalyst for growth and provide an extremely high social benefits through creating jobs and generating incomes to the poor, deprived and unprivileged.

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# **_Waqf_ (endowment) as a tool to enhance financial inclusion**

_Waqf_ (pl. _awqaf_ ) are basically real non perishable properties that are voluntarily donated for philanthropic purposes. Awqaf are dominated by fixed property mainly land or buildings, but can be applicable also to cash, shares, stocks, and other assets. The concept of Awqaf is a wellpracticed phenomenon in recent times in both the Muslim and non-Muslim world. Awqaf are usually named endowments in Non Muslim countries and are providing a wide range of services especially in education and community services<sup>24</sup> . ‘Awkaf’ by definition needs an institutional setup to ensure perpetuity and good governance..

In a nutshell, a _Waqf_ , whether in North Africa or India, functions as follows: a founder who has accumulated private wealth decides to endow his personal property for a specific, often pious, purpose. The amount of the original capital, corpus, the purpose for which it is endowed and all the other conditions of management are clearly registered in a deed of endowment submitted to the authorities. In this way the privately accumulated wealth of a pious Muslim becomes God’s property. The founder strictly stipulates how the annual revenue of the _Waqf_ should be spent. This revenue (usufruct) may be allocated completely for a social welfare purpose ( _Waqf_ khayri), or to a group of beneficiaries.

The management of the _Waqf_ is entrusted to trustees, whose functions may be fulfilled by the founder himself during his lifetime. Thus, there are four major components of any _Waqf_ : the three groups of individuals; the founder, the beneficiaries, the trustees and the endowed capital itself, or the corpus. The cash _Waqf_ was a special type of endowment and it differed from the ordinary real estate _Waqf_ in that its original capital, ( _asl al-mal_ ) consisted purely or partially, of cash. Historically, awqaf was so popular in Islamic countries especially amongst the well off tier of the society especially in early seventh and eighth century (ÇIZAKÇA 1998). However, it didn’t serve as a sustainable tool for economic development due to some social and political turbulence. Sustainability of awqaf institution was closely correlated to the persistence of political systems.

In modern Islamic economics, awakaf are mainly directed to provision of social services health, education, municipal, etc.. Awqaf Institutions (AI’s) provided such services in at no cost whatsoever to the government given AI’s are properly governed and administrated. On the

> 24 As per earlier work of ÇIZAKÇA 1998, It is well known that charitable endowments have a history considerably older than Islam and it is also very likely that Islam may have been influenced by earlier civilizations. Ancient Mesopotamia, Greece, Rome as well as the pre-Islamic Arabs certainly knew of charitable endowments. The extent to which Islamic awqaf were influenced by these ancient institutions and the extent to which they were the product of the genius of Islam is a question that is still not resolved: while Roman origins have been rejected, primarily Byzantine, but also Mesopotamian, Sasanid, Jewish and Buddhist influences have been accepted as plausible. Thus, we have a fairly clear situation; Muslims were urged strongly to endow their assets in the service of mankind and they knew how to do it from the earlier civilizations, which had dominated the geography they had found themselves in.

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macroeconomic front, AI’s are seen serving the ultimate goal of reducing government spending, which contributes to reducing the budget deficit, inflation and government borrowing (other things equal).

This is sensed through setting up a dedicated institutional setup with the purpose of providing free services at to the society in order to contribute to maximizing welfare. This is efficiently achieved while fully binding to resource constraints as the main operational feature of this setup builds on maintaining the property itself and not consuming it through the process. In addition to helping achieve inter-generational equity, awqaf help also achieve intra generational equity through supplying services to much consecutive generations. This setup needs simple prerequisites to ensure optimal social returns; this includes honesty of caretakers, entitled legal identity and finally efficient administration. This in turn alters Timur Kuran’s imprecise judgment and assessment to awqaf. Kuran thinks the nonprofit setup of awqaf wasn’t intended as it was initially proposed for corporatization<sup>25</sup> . This is not necessarily right as, awqaf; since its inception, were meant to provide non-fee charitable services to contribute to overall welfare of society. Another significant feature is that it is intended by construction to facilitate access to assets and social services and hence is not by any mean perceived as structural stagnation.

# **Section IV. Gaps and Challenges of Enhancing Inclusion through Islamic Finance**

Although the OIC countries have experienced rapid economic growth and financial expansion during the past decade, low level of financial inclusion is still constraining the development of many Islamic economies. The argument is based on our analysis of two recent databases, the Doing Business Report 2011 by the World Bank and the Financial Access Report 2010 by the CGAP. In order to obtain a comprehensive analysis of the financial inclusion status of OIC countries, we calculated and compared the financial access related indicators of OIC countries with those of other groups of countries, i.e., GCC, OPEC, OECD, OIC excluding GCC, MENA region, low Income countries, and developing countries.<sup>26</sup> We use the data from OECD countries as benchmark, because OECD countries have achieved a highly developed financial environment after overcoming many similar issues facing OIC countries currently.

We also separately examined financial inclusion in GCC and non-GCC among the OIC countries to see the dispersion of the financial inclusion status among all OIC countries. GCC are economically more developed and thus more comparable to its counterparties, such as OPEC and MENA region countries, whereas a comparison between non-GCC and low-income countries should provide more meaningful implication regarding the financial inclusion gap of the poorer

> 25 (Kuran 2011)

> 26 The low income countries and developing countries are defined by the country classification by the World Bank published in January 2011.

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OIC countries. We also included the developing countries in our analysis as another benchmark to see whether the OIC countries are lagging behind the average developing economies on a global level in terms of financial inclusion enhancement.

Below, we discuss main gaps in current implementation of _Shariah_ -compliant microfinance, SME, and micro-insurance which are hindering their effectiveness to enhance the financial inclusion.

# **IV.1. Gaps in Financial Inclusion – Microfinance (MF)**

# **Strong demand for Islamic microfinance services in OIC countries is not met by the**

**supply.** An IFC-commissioned market studies in the MENA region suggest that between 20 and 60 percent of interviewed microenterprises and low income individuals indicated a preference for _Shariah_ -compliant products. For some, the lack of _Shariah_ -compliant products is an absolute constraint to financial access, while for others, this is a preference and they continue to use conventional financial services in the absence of competitive Islamic ones.<sup>27</sup> This gap is supported by statistics in

**Figure 3** , which suggests that despite the fact that OIC countries have more MF deposits and accounts per thousand adults, values of MFI deposits and loans as percentage of GDP are still much lower in OIC countries (0.61% and 0.79%) compared with developing countries (0.78% and 0.97%) and low income countries (0.92% and 1.19%).

# **Figure 3 Limited scale of Microfinance deposits and loans**

<!-- Start of picture text --> 68 1.19%<br>62<br>0.97%<br>0.92%<br>48<br>44 OIC countries 0.78% 0.79% OIC countries<br>35 0.61%<br>30<br>Developing Developing<br>countries countries<br>Low‐income Low‐income<br>countries countries<br>Deposits: Loans: Accounts Deposits: Value Loans: Value as<br>Accounts per per thousand as percentage percentage of<br>thousand adults adults of GDP GDP<br><!-- End of picture text -->

> 27 (Pearce 2010)

26
Box 2 provides more examples of the strong and unmet demand for Islamic microfinance in selected OIC countries.

# **Box 2 – Strong demand for Islamic microfinance in different countries**

- In the West Bank and Gaza, more than 60% of low-income survey respondents prefer Islamic products to conventional products, and more than half of them still do if the Islamic products come at a higher price. (PlaNet Finance 2007)

- In Jordan, 24.9% and 32%, respectively, of those interviewed cite religious reasons for not obtaining conventional loans. 18.6% of those interviewed rank religious reasons as the single most important factor in obtaining a loan. (IFC and FINCA 2006)

- In Algeria, a 2006 study by Bankakademie International revealed that 20.7% of micro enterprise owners do not apply for a loan primarily due to religious reasons. (Bankakademie International 2006)

- In Yemen, it is estimated that 40% of the poor demand Islamic financial services, regardless of a higher price. (source: Phone interview with Executive director of the National Microfinance Foundation, Yemen)

- In Syria, an IFC survey revealed that 43% of respondents considered religious reasons to be the largest obstacle to obtaining a microcredit. In addition, 46% of respondents who had never applied for a loan stated that religious reasons were the primary reason they had never applied. Nearly 5% of current borrowers said they would not apply for another loan for religious reasons. (IFC/ The World Bank 2007)

- In Indonesia, according to a 2000 Bank Indonesia report, 49% of the rural population of East Java considers interest prohibited and would prefer to bank with Sharia-compliant financial institutions.

- In Lebanon, the success in outreach of Islamic programs relative to conventional _-_

- MFIs strongly suggests that large numbers of poor people prefer Sharia compliant finance.<sup>1</sup> In addition, microfinance practitioners report that many of the Lebanese poor refuse financial services unless they are Sharia-compliant. (Hamze 2001)

- Microfinance practitioners working in certain regions in Afghanistan, Syria, and Indonesia report similar results from their market surveys. (The Dubai Islamic Bank)

Source: World Bank Memoriam 27
**The gap of microfinance in OIC is not only demonstrated by its limited scope, but also by the lack of regulation in OIC countries compared to other developing countries.** In MENA region for example, only Egypt, Morocco, Syria, Tunisia, and Yemen have specific legislation for Microfinance institutions (Figure 4). Also, according to the CGAP financial access database (Figure 5), 68% of the covered 37 OIC countries have appointed agencies to promote access to finance in rural areas, while 57% of the countries have dedicated team or unit in charge of the task. The ratios are above the developing countries average, but below the low-income countries average.

**Figure 4. Microfinance regulation and supervision by region**

<!-- Start of picture text --> 100<br>90 20<br>7.7<br>7.8<br>80<br>70<br>30 35.4 Supervised only by other<br>60 42.7<br>regulator<br>50<br>Supervised only by a bank<br>40 regulator<br>30<br>Not regulated<br>50 47.7<br>20 37.9<br>10<br>0<br>MENA (%) Developing All (%)<br>Countries (%)<br><!-- End of picture text --> Source: Peace (2010), M Khaled, CGAP (2010)

**Figure 5. Who is responsible for rural finance promotion?**

<!-- Start of picture text --> 90%<br>79%<br>80%<br>68%<br>70% 62%<br>57%<br>60%<br>47% OIC countries<br>50%<br>36%<br>40% Developing countries<br>30% Low‐income countries<br>20%<br>10%<br>0%<br>Agency is responsible Dedicated team or unit<br><!-- End of picture text --> Source: CGAP(2010) 28
Although the Islamic microfinance institutions emerged in different forms and structures in different regions (See Table 1), the industry faces similar key challenges across countries.

# **First, absence of accounting standards has substantially constrained the expansion**

**of** **_Shariah_ -compliant microfinance institutions in OIC countries.** Although Islamic microfinance is developing fast, most central banks have not yet incorporate the special category into the existing regulatory and accounting framework. For example, up to Nov 2006, there are more than three thousands BMTs in Indonesia, 65 of them are located in Yogyakarta. Only 42 BMTs reported performance to PINBUK Yogyakarta regularly (Kholis, AG and SH 2007). In addition to the accounting standards, information technology assistance, risk management supervision, and infrastructure provision are also major concerns of Islamic microfinance providers.<sup>28</sup>

**Second, knowledge gap regarding** **_Shariah_ rules among working staff challenges the development of many institutions.** Since the whole industry is still in its infant stage, most employees have little background in Islamic finance before. The knowledge gap increased the risk of the institution’s deviation from _Shariah_ rules and deterred _Shariah_ -compliant financial product innovation. –Many evidences support this concern. For example, (Ahmed, 2007) found that RDS of the IBBL in Bangladesh extensively uses financial tools such as Bai-Muajjal and Bai-Murabaha without knowing the _Shariah_ implication of the terms. The knowledge gap may also trigger reputational risks of the institutions: found that in Indonesia, society prejudice toward operations of BMT that are not in line with _Shariah_ rules may cause trust degradation among potential and current clients.

**Third, the** **_Shariah_ rules increase the complexity of Islamic microfinance products and innovation process. The essence of Islamic finance is its close connection with real economy.** In some cases, this central rule has brought problems for development of _Shariah_ - compliant microfinance business in certain countries.  In the BMT case in Indonesia, no leading competitive commodity can be financed even though the funding channel has been wellestablished. In other cases, the strong linkage between Islamic finance and real economy also led to promising produce innovation. For example, (Kaleem 2007) argues that Bai Salam contract, a deferred delivery contract where delivery of  commodity occurs at some future date in exchange of some advanced price fully paid at spot, may help enable 5.44 mln small farmers to gain money to grown their crops and feed their families up to the time of harvest. Similarly, (Isnaji 2007) claims that formulating an “Islamic micro finance version program” under regular investment fund will also help coconut farmers in under-banked Muslim areas.

**Fourth, how to attract more Islamic clients to enter the market is a big issue for both government and microfinance institutions.** While further expansion of the _Shariah_ -

> 28 Notes on risk management issues: Rise and fall of SGGFs in 2003 resulted from their stepwise lending scheme, non-separation of depositors from borrowers, and the housing recession. There is no single institution which can provide guarantee in the case of liquidity problem for BMTs in Indonesia. (Kholis, AG, & SH, 2007).

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<!-- Start of picture text --> = #l<br>SS eonamny<br>OECD high income ese {=<br>—<br>Eastern Europe & Central Asia a=<br>East Asia<br>& Pacific et =<br>Latin America & Caribbean pra<br>Middle East & North Africa =<br>South Asia mS REE —OIC (118)<br>Sub-Saharan Africa aEES<br>—|<br>——<br>——= 185<br>Average ranking on<br>the ease of doing business<br>(1-183)<br><!-- End of picture text -->
<!-- Start of picture text --> 100%<br>a Very Important Important<br>80%<br>60%<br>40% Hy om 5%<br>20% 51% gag 6% Th 46%<br>"35% 39% | 949% peo, 20% = S748 35% nay 30%<br>18% 31% 24% 31% 3804, 590,<br>20% 21% 44%, 16%<br>0%<br>PP8 gE2 woBOPgo gt oF OPeeMg& ot Sg¢8id«@<br>eeaSre)Ry ”oe Ro aSn x) PSSS«s\ onTM. aetas? raCS Pa nnENCMry a % ox?<br>x?cer eo oe ew roe onde of eo kK we eo w? & oo ws<br>eo ofa Weoo coo® oxeo ? oea? oe¢ Piaseoao vex &<br>ow of oe o®<br>ee GCC Non-GCC<br><!-- End of picture text -->
# **Box 3 Key Indicators from the Doing Business Report**

|<br>Starting a business: all procedures that are officially required for an entrepreneur to start up and<br>formally operate an industrial or commercial business.|
|---|
|`o`<br>Procedure is defined as any interaction of the company founders with external parties (for<br>example, government agencies, lawyers, auditors or notaries).|
|`o`<br>Time is recorded in calendar days. The measure captures the median duration that<br>incorporation lawyers indicate is necessary to complete a procedure with minimum follow-<br>up with government agencies and no extra payments.|
|`o`<br>Cost is recorded as a percentage of the economy’s income per capita. It includes all official<br>fees and fees for legal or professional services if such services are required by law.|
|`o`<br>The paid-in minimum capital requirement reflects the amount that the entrepreneur needs to<br>deposit in a bank or with a notary before registration and up to 3 months following<br>incorporation and is recorded as a percentage of the economy’s income per capita.|
|<br>Getting Credit: the legal rights of borrowers and lenders with respect to secured transactions<br>through one set of indicators and the sharing of credit information through another.|
|`o`<br>The strength of legal rights index measures the degree to which collateral and bankruptcy<br>laws protect the rights of borrowers and lenders and thus facilitate lending.|
|`o`<br>The depth of credit information index measures rules and practices affecting the coverage,<br>scope and accessibility of credit information available through either a public credit registry<br>or a private credit bureau. The public credit registry coverage indicator reports the number<br>of individuals and firms listed in a public credit registry with information on their<br>borrowing history from the past 5 years.|
|`o`<br>The private credit bureau coverage indicator reports the number of individuals and firms<br>listed by a private credit bureau with information on their borrowing history from the past 5<br>years.|
|<br>Enforcing contracts: the efficiency of the judicial system in resolving a commercial dispute.<br>`o`<br>The list of procedural steps compiled for each economy traces the chronology of a<br>commercial dispute before the relevant court.|
|`o`<br>Time is recorded in calendar days, counted from the moment the plaintiff decides to file the<br>lawsuit in court until payment.|
|`o`<br>Cost is recorded as a percentage of the claim, assumed to be equivalent to 200% of income<br>per capita.|
|Source: The World Bank, DoingBusiness|

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# **Figure 8. Getting credit**

<!-- Start of picture text --> Rank Depth of credit information<br>index (0-6)<br>140 117 120 120 116<br>120 110 6 5<br>94<br>100 89 5 4<br>80 4 3 3 3<br>60 38 3 2 2<br>40 2 1<br>20 1<br>0 0<br>Private bureau<br>Strength of legal rights<br>coverage<br>index<br>Public registry coverage (% of adults) (0-10) 70 61<br>8 60<br>12 7<br>10 7 50<br>10<br>8 6<br>5 5 40<br>8<br>6 5<br>4 4 4 4 30<br>6 5 5 5 5<br>4<br>3 17 18<br>4 3 20<br>10<br>2 1 2 10 6 5 7<br>1<br>0 1 0<br>OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries 0 OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries<br><!-- End of picture text --> Source: Doing Business Report 2011

**In addition to the challenge of access to credit, SME in OIC countries also suffer from difficulties to start a business and enforce contracts, which further slow down the life cycle of SMEs and becomes obstacles for them to obtain financial investment.** Starting a new business requires 40 days and 8 procedures on average in OIC countries. The official fees for legal procedures and professional services required by law amount to 58% of income per capita, and the opportunity is only open to those business with a minimum capital equals to 122% of income per capita. On comparison, in OECD countries, it only takes 14 days and 6 procedures to

33
start a new business, and both cost (5% of income per capita) and paid-in minimum capital (15 % of income per capita) are insignificant (See Figure 9 and figure 10).

**Figure 9. Starting a new business**

<!-- Start of picture text --> Rank<br>Procedures (number)<br>140<br>120 107 114 110 119 12 10<br>97 98 10<br>8 8 8 8 8 8<br>100<br>78<br>8<br>80 6<br>56<br>6<br>60<br>40 4<br>20 2<br>0 0<br>Paid-in Min. Capital (%<br>Cost (% of income per<br>of income per capita)<br>Time (days) capita)<br>160 149<br>5045 40 43 44 41 39 120 108 140 122121 123<br>100<br>40 120 104<br>35<br>80 100<br>30 65<br>58<br>80<br>25 20 60<br>20 15 14 40 41 38 32 60 42<br>15<br>40 25<br>10 20 15<br>5 5 5 20<br>0 0 0<br>Source: Doing Business Report 2011<br>OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries<br><!-- End of picture text --> 34
# **Figure 10. Enforcing contracts**

<!-- Start of picture text --> Rank<br>Procedures (number)<br>140 47<br>120 116 117 114 116 117 115 99 5045 42 43 41 39 44 39<br>40<br>100<br>35 31<br>80 30<br>25<br>60<br>37 20<br>40 15<br>10<br>20<br>5<br>0 0<br>Time (days) Cost<br>800 70<br>700 667 590 594 677 613 664 638 60 58<br>600 518<br>500 50 39 41<br>40 33<br>400 28<br>300 30 20 19 24<br>200 20<br>100 10<br>0 0<br>OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries OIC GCC OPEC OECD OIC‐GCC Low income MENA developing countries<br><!-- End of picture text --> Source: Doing Business Report 2011 35
**Weak regulatory framework for financial agencies and business disputes resolution underscored the strong demand for financial inclusion reform in OIC countries.** The statistics show that OIC countries fell behind other developing countries in terms of regulatory supervision coverage. For example, only 59% of microfinance institutions are under regulation compared with the average level of 72% in low income countries (Table ). Current laws are also insufficient to provide enough protection for disputes resolution. Take the instance of client confidentiality protection, only 68% of OIC countries provide laws to restrict such unfair treatment, while 78% of developing countries do (See Figure 11).

**Figure 11. Disputes resolution: provisions in existing laws and regulations to restrict unfair treatment**

<!-- Start of picture text --> 78% 76%<br>70% 68% 71%<br>51% 50%52%<br>42%<br>38%<br>35%<br>32% 31%<br>27% 26% 24% 24%<br>21% 21%<br>16%<br>Deceptive Unfair or high‐ Abusive Breach of client No fair treat‐<br>advertising pressure selling collection confidentiality ment provi‐sions<br>practices practices<br>OIC countries Developing countries OIC‐GCC low‐income countries<br><!-- End of picture text --> Source: CGAP (2010)

**However, the statistics also shows that OIC countries have been aware of the issue and taking actions more actively than other developing countries.** According to the CGAP survey, OIC governments have been more actively promoting reforms in all aspects of financial inclusion, especially in fields of financial consumer protection and microfinance expansion. The proportions of countries taking reforms on financial capability (38%) and SME financial access (49%) are also higher than those of developing countries (37% and 43%), much higher than lowincome countries (28% and 45%). What is surprising is that non-GCC governments are even more active in financial inclusion reforms than GCC governments, especially in microfinance development (62% for OIC-GCC vs. 57% for OIC) (See Figure 12).

36
**Figure 12. Financial inclusion reform undergoing**

<!-- Start of picture text --> 72%<br>62%<br>57%<br>51% 50% 49% 50% 49% 52%<br>45%<br>42% 37% 43% 41%42%41%<br>38% 38%<br>34%<br>28%<br>Consumer Financial capability Facilitating SME Enabling micro Facilitating rural<br>protection access to finance financial access<br>OIC countries Developing countries OIC‐GCC low‐income countries<br><!-- End of picture text --> Source: CGAP (2010)

**Financial inclusion gap in OIC countries can also be reflected by governments’ heavy investment in SME policy reforms.** According to the CGAP financial access database (Table ), OIC countries are more likely to monitor the level of lending to SMEs through specific dedicated agencies than developing countries (73% vs. 48%). Also, 62% of OIC countries designated an agency to promote SME access to finance specifically, compared to the figure of 49% in developing countries. However, the SME lending as proportion of GDP in OIC countries is still far behind the OECD level (7.43% vs. 24.47%), which indicates that there is a huge gap in terms of SME funding between the two groups (See **Figure 13** ) .

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**Figure 13. SME regulation**

# **Agency monitors the level of lending to SMEs?**

<!-- Start of picture text --> 93.33%<br>86.67%<br>79.41%<br>72.97%<br>58.62%<br>53.33%<br>47.52%<br>30.00% 26.73%<br>8.11% 9.90% 8.82% 3.45% 10.81% 8.82%20.69% 13.51%17.82%14.71%6.90%<br>Yes, regularly Yes, irregularly No No, but another<br>agency does<br>OIC countries Developing countries average<br>OIC‐GCC average Low‐income countries average<br>OECD<br><!-- End of picture text -->

# **Promoting SME access to finance?**

<!-- Start of picture text --> 72.41%<br>62.16% 61.76%<br>48.51% 48.65% 52.94% 51.72% 50.00%<br>37.62%<br>33.33%<br>Agency is responsible Dedicated team or unit<br>OIC countries Developing countries average<br>OIC‐GCC average Low‐income countries average<br>OECD<br><!-- End of picture text -->

**Despite all the reform efforts exerted so far, the SME loans are still small in their sizes in OIC countries. Error! Reference source not found.** suggests that OIC the total value f SME lending in OIC countries is only 7.43% on average, much lower the benchmark of Malaysia (17.43%) and OECD (24.47%), and the severity of the issue is similar in both GCC and non-GCC countries. The argument is also supported by the Figure 14, which provides the SME loans as percentage of total loans in MENA region on country level.

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<!-- Start of picture text --> 40%<br>34%<br>30% —<br>20%<br>20% ——_ia-<br>15% 15% 1%<br>13%<br>10% |__ _ _<br>am 4%<br>0% 59% 1% 2%, 2% 2%i il2% t [ —<br>reda &Pe a3 G Seee a)& w ofa es~ e& && &Oss »eo aAS oda<br>~ g ¥ Vv *<br><!-- End of picture text -->
# **Section V.  Policy Recommendations and Concluding Remarks**

Financial inclusion is becoming an increasing priority for policy makers around the world and there is growing realization that measures should be undertaken to i) stimulate private sector investment in favor of low income individuals and SMEs, ii) remove institution and infrastructure barriers to help financial service providers to sustainably expand services, and iii) encourage product diversification and improved risk management.<sup>31</sup> Box 4 lists key guiding principles drafted by G20 for innovative financial inclusion. These principles are good starting point for the policy formulation for designing a comprehensive framework to address the issue of financial inclusion.

In this section, we propose five dimensions of policy recommendations that could be considered for the enhancement of financial inclusion for countries interested in developing Islamic financial system led development in OIC countries.

> 31 (Pearce 2010)

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# **Box 4 - G20 Principles for Innovative Financial Inclusion**

Innovative financial inclusion means improving access to financial services for poor people through the safe and sound spread of new approaches. The following principles aim to help create an enabling policy and regulatory environment for innovative financial inclusion. The enabling environment will critically determine the speed at which the financial services access gap will close for the more than two billion people currently excluded. These principles for innovative financial inclusion derive from the experiences and lessons learned from policymakers throughout the world, especially leaders from developing countries.

1. **Leadership** : Cultivate a broad-based government commitment to financial inclusion to help alleviate poverty.

2. **Diversity** : Implement policy approaches that promote competition and provide market-based incentives for delivery of sustainable financial access and usage of a broad range of affordable services (savings, credit, payments and transfers, insurance) as well as a diversity of service providers.

3. **Innovation** : Promote technological and institutional innovation as a means to expand financial system access and usage, including by addressing infrastructure weaknesses.

4. **Protection** : Encourage a comprehensive approach to consumer protection that recognizes the roles of government, providers and consumers.

5. **Empowerment** : Develop financial literacy and financial capability.

6. **Cooperation** : Create an institutional environment with clear lines of accountability and coordination within government; and also encourage partnerships and direct consultation across government, business and other stakeholders.

7. **Knowledge** : Utilize improved data to make evidence based policy, measure progress, and consider an incremental “test and learn” approach acceptable to both regulator and service provider.

8. **Proportionality** : Build a policy and regulatory framework that is proportionate with the risks and benefits involved in such innovative products and services and is based on an understanding of the gaps and barriers in existing regulation.

9. **Framework** : Consider the following in the regulatory framework, reflecting international standards, national circumstances and support for a competitive landscape: an appropriate, flexible, risk-based Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) regime; conditions for the use of agents as a customer interface; a clear regulatory regime for electronically stored value; and market-based incentives to achieve the long-term goal of broad interoperability and interconnection.

Source: Pearce (2010) 41
# **V.1. Policy Recommendation I -** **_Need for Developing Supportive Regulatory and Supervisory Framework_**

Improved access to finance in many developing countries is constrained by inappropriate regulations, a lack of specialist supervisory capacity, and inadequate institutional models in general for financial inclusion and particularly for Islamic finance in OIC countries. Despite the significance of financial inclusion, it is observed that financial inclusion is still not a priority for financial regulators in most of OIC countries. For example, financial regulators in MENA have the second lowest degree of involvement in promoting financial inclusion, ahead only of high income countries where financial exclusion is at much lower levels (Figure 15). Almost half of all the countries covered by the CGAP and World Bank Financial Access 2010 report (48 percent) have a strategy document for the promotion of financial inclusion, with 90 percent of those introduced within the last 6 years. (Figure 16)

**Figure 15. Index of Regulator’s involvement in Financial Inclusion**

<!-- Start of picture text --> 0.92<br>0.71<br>0.65<br>0.39 0.39 0.43<br>0.34<br><!-- End of picture text --> Source: CGAP and World Bank Financial Access 2010

**Figure 16. Countries with a Financial Inclusion Strategy Document**

<!-- Start of picture text --> 19<br>12<br>6<br>4 4<br>3<br>1 1 1 1 1<br>1997 1999 2000 2001 2003 2004 2005 2006 2007 2008 2009<br><!-- End of picture text --> Source: CGAP and World Bank Financial Access 2010 42
OIC countries need to develop a regulatory and supervisory framework that supports wide financial inclusion based on sound risk management and with sufficient consumer protections. During this process, governments and regulators need to take the lead in supporting improvements in access to finance, especially through _Shariah_ -compliant financial tools, displaying the _Leadership_ called for in the G20 Principles (See Box 4). Financial inclusion, especially Islamic financial inclusion, should be considered as a goal alongside prudential regulation and financial system stability. The CGAP and World Bank Financial Access survey (2010) of financial regulators worldwide found that regions that include financial access in their strategies and mandate their financial regulators to carry such agendas are also the countries that reform the most. Regulators with a financial inclusion strategy are more likely to have more financial inclusion topics under their purview and more resources and staff dedicated to working on these matters.<sup>32</sup>

**Practical measures that can be taken by regulators** (as has been the case in Indonesia and Pakistan) include: licensing Islamic banks, supporting centers for training and certification on Islamic financial operations to staff and managers of financial service providers, and developing guidelines setting out requirements for licensing and appointment of _Shariah_ advisers to rule on _Shariah_ compliance. The political climate for Islamic finance also affects investor and lender decisions about whether to offer _Shariah_ -compliant products, and acts as an incentive or disincentive to its growth.

In addition, consumer protection is also increasingly important as access increases, so that new customers, and existing customers with access to new services, can take well informed decisions about how best to manage and use Islamic financial services. In some countries, customers stay away from Shariah-compliant services because of lack of education about authenticity and credibility of products. Consumer protection can help remove such perceptions and can lead to enhanced inclusion. Therefore, it is essential that consumer laws and regulations are developed and put in place: i) to protect against unfair or deceptive practices ii) to improve transparency through disclosure and plain language requirements for products and pricing, in a way that allows consumers to easily access to _Shariah_ -compliant products and services, and iii) to establish a low cost, efficient, and fair mechanism for resolving customer complaints and disputes.

> 32 (Pearce 2010)

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**V.2. Policy Recommendation II -** **_Strengthen Financial Infrastructure for Financial Inclusion_**<sup>33</sup>

**Improving financial infrastructure, especially the improvement of current credit informational system, should be the priority item in the policy agenda of OIC countries.** Deficiencies in financial infrastructure are one of the major obstacles for further SME lending in MENA region, as confirms by the survey result in

Figure **7. Percentage (%) of Banks responding that Obstacle is Very Important or Important for SME Financing: GCC vs. Non-GCC** . Improving financial infrastructure will entail expanding the range of collateral, improving registries for movables, and improving enforcement and sales procedures for both fixed and movable assets. It also entails upgrading public credit registries, and more importantly, introducing private credit bureaus capable of significantly expanding coverage and the depth of credit information.<sup>34</sup> Financial infrastructure improvements will reduce the information asymmetry that constrains access to credit and raises the costs and risk of financial intermediation.

**Core components of the financial infrastructure such as credit information, investors’ rights, insolvency regimes, etc. are essential irrespective of type of financing, i.e. conventional or Islamic.** For this purpose, it is suggested that, first, regulated financial entities should be required to share credit information, ideally through national credit registries. Sharing borrower information is essential to lowering costs and overcoming information constraints. As mentioned earlier, lack of access to credit information and low coverage ratio of credit history of individuals are two main features that contribute to the financial exclusion in OIC countries especially for SME financing. By integrating _Shariah_ -compliant products and customers information into credit bureaus, the coverage and utility of data in the credit bureaus can be improved. Financial institutions of all types can extend access to new customers, while managing risks and costs more effectively.  This will also help _Shariah_ -compliant financial institutions to expand their funding source and enhance their risk-sharing mechanism, as institution with its clients’ credit information available to the public can establish its reputation much easier than those with an informal credit history system.

Second, data on financial inclusion and unbanked markets/customers (especially those due to religious reason) is also needed to improve to underpin a sustainable expansion in access

> 33 For more details, please refer to (Pearce 2010)

> 34 (Rocha, et al. 2011)

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to finance, as emphasized by the G20 Principle for Financial Inclusion _._ Household and enterprise-level survey questions can provide governments and regulators with the data they need for designing reforms and then monitoring the effectiveness of those reform measures. For example, OIC governments can encourage Islamic banks to launch financially inclusive accounts, shifting G2P payments (increased transaction volume) through such accounts to enhance their viability.

# **V.3. Policy Recommendation III - Ensure a Level Playing Field for Islamic Microfinance, SME, and Micro** **_Takaful_**

**The lack of** **_Shariah_ -compliant micro-finance services is constraining financial inclusion to a proportion of the population.** The growth of Islamic microfinance will depend to a large degree on whether financial institutions can develop sufficiently attractive financial products and services, which are competitive with conventional products in terms of pricing, transparency, processing time, and burden on the client. This will be determined in part by their capacity and systems, but regulators can also provide a more level playing field for Islamic microfinance. This extends beyond financial sector regulation to the tax code, as Islamic financing that involves additional transactions such as passing on a property title, may have tax implications such as capital gains tax, which are not applicable in conventional deals. OIC governments should also extend access to a broader range of financial services through existing branch networks of Islamic banks, which can offer a unique network of existing outlets as a delivery mechanism for _Shariah_ -compliant financial services.

**When designing the financial inclusion reform plan, OIC governments should take three points into their consideration specifically** i) allowing banks to expand access through agents and use of technology (e.g. mobile phones), ii) providing a _Shariah_ -compliant finance company model for microfinance and microinsurance, and iii) removing interest rate caps for microcredit and strengthen customer protection laws.

**Competition policy can also contribute to further SME lending.** (Rocha 2010) suggests that private banks are more efficient in lending technologies and are able to generate and manage a significant SME portfolio, even within weak enabling environments.  The entry of these banks into OIC countries could contribute to more SME lending, both directly and through spillover effects.  Therefore, the policy implication is to ensure that entry requirements for Islamic financial institutions are not overly restrictive and that Islamic banking markets remain contestable.<sup>35</sup> In addition, the impact of the entry of foreign banks on _Shariah_ -compliant SME lending can be magnified if these new foreign banks have access to substantive credit information on potential SME borrowers.

> 35 Azoategui, Martinez Peria, and Rocha (2010) show that there is a higher rejection of banking licenses in MENA than in other regions.

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**Governments should play a critical role in promoting an enabling environment in which private banks can fulfill their SME finance targets prudently and responsibly.** In the case of non-GCC countries, there is huge potential for expanding SME finance, with large numbers of smaller enterprises underserved and low levels of bank competition to serve them.  In the case of GCC countries, the size of the SME sector may remain more constrained by the nature of oil economies, but there is also scope for further SME finance, especially if access to finance is also expanded for resident non-nationals.<sup>36</sup>

**V.4.** **_Policy Recommendation IV -_ Institutionalization of Islamic Redistributive Instruments**

Islamic finance advocates risk sharing and equity finance, while prohibiting debt financing and leveraging. Given the emphasis on social and economic justice and the eradication of poverty, we would expect Islamic instruments that targeted to address inequity, such as _Zakah_ , khairat, _Waqf_ , and _Qard-al-Hassan_ , to play an important role if the required institutional structures are developed. Therefore, there is need to formalize or institutionalize Islamic redistributive mechanisms designed to empower the economically weak segments of the society.<sup>37</sup> By institutionalization, we mean to build nation-wide institutions and surrounding legal infrastructure to maximize the effectiveness of these redistributive mechanisms. This institutionbuilding exercise can take place in three steps. First, is the development of institutions. An institution is nothing more that the legalization of the rules of behavior and therefore, would require crafting rules pertaining to these instruments as envisioned by _Shariah_ . The next step would be to establish these institutions and to integrate them with the rest of the economic and financial system. In this process, either existing channels of distribution, i.e. banks or post offices can be utilized to interact with the customers, or new means can be introduced leveraging of new technologies. Finally, there should be mechanism to ensure enforceability of rules through transparent means.

The objective of institutionalization of redistributive instruments is to formalize and standardize the operations to facilitate each instrument. For example, for _Zakah_ , Khairat, and Qard-al-Hassan, a formal network of institutions needs to be developed to collect, distributed, and recycle the funds in most efficient and the most transparent fashion. In some countries, point of sale such as Automatic Teller Machines (ATM) or cash dispensing machines are used to give

> 36 Maddedu provides a review of credit reporting systems in MENA (2010). (Rocha 2010)

> 37 (Mirakhor 2004) argues that given the number of poor in Islamic countries, critics argue that, a priori, Islamic institutions, which were meant to redistribute income and wealth from the more well-to-do to the weaker segment of the society, have not shown the necessary potency in performing their function, and they could be right. It is a serious problem that very little effort has been expended by our researchers and scholars in empirically investigating the behavior of Muslims vis-à-vis these institutions, i.e., why the latter have failed to achieve the objectives for which they were designed, and how the situation could be remedied. Admitting that these institutions have, by and large, failed to alleviate poverty in Muslim countries does not obviate the need to consider their potential..

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choice to the customers to make donations or contribution at the spot to make it easy for the customer to make such contributions. The financial institution can collect and aggregate funds and then disburse to needy through selected channels.

Several scholars have put forth ideas of formalizing and institutionalizing Islamic modes of redistributions through an integrated approach by combining different modes. For example, Elgari (2004) proposes establishing a nonprofit financial intermediary, the _Qard-al-Hassan_ bank that gives interest free loan (Qard al-Hassan) to finance consumer lending for the poor. The capital of the bank would come from monetary (cash) _Waqf_ donated by wealthy Muslims. Kahf (2004) and Ahmed (2003) propose establishing a microfinance institutions based on _Zakah_ , awqaf, and _Sadaqat_ .

Developing a hybrid model or an integrated one is practical and has several advantages. Taking micro-finance example, one can envision developing Universal Islamic Micro-Finance Structure to construct a portfolio of three basic and traditional _Shariah_ compliant financial products, Awqaf, _Zakah_ and micro- _Takaful_ in order to support and foster Islamic Micro-finance under a unified framework. Islamic microfinance can be more effective in diverting borrowers’ propensity to consume through providing a micro- _Takaful_ mandatory component to the micro lending service as the main mitigate for moral hazard. Besides this, charging no interest would help mitigate credit rationing, redlining and adverse selection (Stiglitz and Weiss 1992).

Although creating such a unified institution may be premature given the present context, in this paper we attempt to outline the basic concept of such a singular Islamic MFI by using funds from the _Zakah_ and Awqaf, in addition to complementing this with providing micro- _Takaful_ to micro enterprises. The IMFIs may use the _Zakah_ fund in disbursing funds to fulfill basic consumption needs for the hard-core poor target group in the first place, as on principle no return can be realized from _Zakah_ fund and _Zakah_ fund should be disbursed within one financial year. _Zakah_ funds may alternatively be directed towards funding small businesses, and support theor initiation at no funding cost.

However, the Awqaf funds may be used as investable fund in providing capital investment and working capital financing for the micro-businesses. Such an integrated model may reduce the chances of loan default because the basic inherent tendency of the poor to use the loan fund for consumption purpose will be met. As their basic consumption needs are covered, the poor micro-entrepreneurs may be in better position to focus on their business alone. Moreover, the IMFI may initiate financing through different Islamic _Shariah_ compliant modes.

a) Mitigating Credit Risk: As mentioned above, the innovative operational format of MFIs suits the poor, whose lack of physical collateral disqualify them to borrow from traditional commercial banks. _Waqf_ -based Islamic MFIs will retain the innovative format of operation of conventional MFIs and oriented the program towards Islamic principles and values. Thus, like 47
their conventional counterparts, Islamic MFIs have largely resolved the credit risks through social collateral of groups and weekly repayments.

b) Resolving Moral Hazard Problem: Islamic MFIs have some inherent characteristics that can resolve the moral hazard problem faced by conventional MFIs pointed above. The main mode of financing used by the Islamic MFIs is murabahah/bai-muajjal or ijarah (leasing). These instruments involve real transaction and instead of cash being given out, asset/good is exchanged. As a result, the opportunity of diverting funds for non-productive uses other than that requested for is reduced, if not eliminated. This increases the profitability of the MFI by decreasing the default rate.

c) Economic Viability: In cases where Islamic MFIs get funds from traditional interestbased outlets, the financing costs appear to be high. For example, the financing costs of two small Islamic MFIs, Noble and Rescue in Bangladesh, were 35.8 percent and 12.5 percent of the total expenditures respectively (Ahmed 2002). As the bulk of the _Waqf_ -based Islamic MFIs funds will come from _Waqf_ endowment, the financing costs of these institutions will be significantly lower than their conventional counterparts. Given the philanthropic nature of these funds, no returns are expected by contributors. While Islamic MFIs will pay returns on funds coming from external sources like deposits and beneficiary savings, the _Waqf_ component of funds will significantly reduce the financial costs and improve financial viability of the institution.

In short, above-mentioned structure is one of several innovative ways to revive Islamic institutions of redistribution which has great potential to overcome the problem of financial exclusion and to contribute to alleviation of poverty in OIC countries.

# **V.5.** **_Policy Recommendation V -_ Financial Engineering**

Financial innovation and application of financial engineering have changed the face of global landscape in the last three decades. Although, some of the innovations have been criticized and have been the source of volatility in the markets, yet their positive contribution cannot be denied. There is no reason why the financial engineering cannot be used in the area of financial inclusion and to enhance the financial access. One way could be to introduce the application of securitization to securitize assets generated by micro-finance and SMEs. Sukuk (Islamic bonds) are a successful application of securitization and working on the same lines, a marketable instrument can be introduced to provide funding for much needed Mirco-finance and SME financing. With the introduction of securitization of Micro and SMEs, financial institutions would be able to pool their assets and issue marketable securities. In this way, they will share the risks with the market as well as free-up the capital for further mobilization of micro and SME financing.

While sustainability of funding represents a major challenge for Awkaf, researchers proposed a hybrid structure that targets integrating _Zakah_ and awqaf to promote microfinance.

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Sadeq (1995) presents an integrated approach on how traditional institutions of Awqafs may be revitalized through proposing innovative _Shariah_ compliant structures. Awqaf certificates of different denominations could be issued to raise sustainable funding for Awqaf. Special funds are then to be raised for financing economic development. As Awqafs are generally applied on fixed assets, such assets are often under-utilized. On the other hand, if cash Awqafs are raised by issuing Awqaf certificates, they could be used more efficiently in a wide range of development projects. This structure relies on the fact of encouraging the flow if cost-less funding of _Zakah_ , that can be directed to underwritings and subscriptions in the pooled funds as a potential tool for Islamic microfinance (Hassan 2010). Yet still, inadequacy of governance and _Shariah_ compliant accounting principles to support such structures are the main challenges for widespread implementation.

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# **Annex – Supporting  Data for Charts**

**Table 5 Microfinance Regulation and Supervision by Region**<sup>**38**</sup>

||MENA<br>(%)|Developing<br>Countries (%)|All (%)|
|---|---|---|---|
|**Not regulated**|50.0|37.9|47.7|
|**Supervised only by a bank regulator**|30.0|42.7|35.4|
|**Supervised only by other regulator**|20.0|7.8|7.7|
|**Supervised by both**|0.0|11.7|9.2|
|**Number of countries**|10|103|130|

Source: M Khaled, CGAP, 2010 38 (Pearce 2010) 50
# **Table 6 - Microfinance indicators from CGAP financial access database**

||**Financial in**<br>**Promoting**<br>**rural areas**|**clusion:**<br>**access in**|**Deposits**<br>**Account**<br>**adults**|**:**<br>**s per tho**|**usand**|**Deposit**<br>**Value**<br>**of GDP**|**s:**<br>**as perc**<br>|**entage**|**Loans:**<br>**Accoun**<br>**adults**|**ts per th**|**ousand**|**Loans:**<br>**Value a**<br>**GDP**|**s percen**|**tage of**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
||Agency is<br>responsible<br>(Yes/No)|Dedicated<br>team<br>or<br>unit<br>(Yes/No)|Coope-<br>ratives|SSFIs|MFIs|Coope-<br>ratives|SSFIs|MFIs|Coope-<br>ratives|SSFIs|MFIs|Coope-<br>ratives|SSFIs|MFIs|
|**Malaysia**|√|√|2.78|1,146.06|n.a.|0.04|13.71|n.a.|87.26|113.07|19.03|0.63|12.09|0.22|
|**OIC countries**<br>**average**|68%|57%|30.86|224.11|68.14|3.98|5.33|0.61|24.94|31.00|34.68|2.59|3.62|0.79|
|**Developing**<br>**countries average**|47%|36%|100.53|216.71|48.93|1.99|4.27|0.78|27.54|25.01|30.14|1.71|3.35|0.97|
|**Low-income**<br>**countries average**|79%|62%|32.65|18.17|62.44|0.68|1.74|0.92|16.42|8.46|43.87|0.69|1.70|1.19|

Source: CGAP financial access report data 2010 Note: The CGAP Financial Access Database covers questionnaires sent to 151 economies: 13 in East Asia and the Pacific, 27 in Europe and Central Asia, 20 in Latin America and the Caribbean, 14 in the Middle East and North Africa, 6 in South Asia, 40 in Sub- Saharan Africa, and 23 in the high-income OECD countries. Among them, 37 OIC countries are covered. For practical purposes, most small islands and economies at war were not included. The sample covers more than 94 percent of the world’s population and nearly 98 percent of global GDP.

Selected questions are presented in the first and second rows of the table. The row for OIC countries means the percentage of OIC countries that replied yes to the questions (for Yes/No questions), or means the average value for OIC countries. The same calculation applied to the groups of developing countries, OIC-GCC, and low incoming countries. OIC-GCC means OIC countries excluding the GCC countries covered by the CGAP database.

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# **Table 7** -a **Doing Business Indicators Comparison**

||**Ease of**<br>**Doing**<br>**Business**<br>|**Starti**<br>|**ng a Business**<br>||||
|---|---|---|---|---|---|---|
||**Rank**|Rank|Procedures<br>(number)|Time<br>(days)|Cost (% of<br>income per capita)|Paid-in Min. Capital (%<br>of income per capita)|
|**OIC**|118|107|8|40|58|122|
|**GCC**|43|78|8|15|5|121|
|**OPEC**|110|114|10|43|41|25|
|**OECD**|30|56|6|14|5|15|
|**OIC-GCC**|128|110|8|44|65|123|
|**Low income**|140|119|8|41|108|149|
|**MENA**|96|97|8|20|38|104|
|**developing**<br>**countries**|100|98|8|39|32|42|

Source: Doing Business Report 2011, The World Bank Ease of doing business rank: World Bank index that measures business regulations and their enforcement across countries Index.

Starting a business: all procedures that are officially required for an entrepreneur to start up and formally operate an industrial or commercial business. Procedure is defined as any interaction of the company founders with external parties (for example, government agencies, lawyers, auditors or notaries). Time is recorded in calendar days. The measure captures the median duration that incorporation lawyers indicate is necessary to complete a procedure with minimum follow-up with government agencies and no extra payments. Cost is recorded as a percentage of the economy’s income per capita. It includes all official fees and fees for legal or professional services if such services are required by law. The paid-in minimum capital requirement reflects the amount that the entrepreneur needs to deposit in a bank or with a notary before registration and up to 3 months following incorporation and is recorded as a percentage of the economy’s income per capita.

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# **Table** 7-b **Doing Business Indicators Comparison (continued)**

||**Gettin**<br>|**g Credit**<br>||||**Enforc**<br>|**ing Contrac**<br>|**ts**<br>||
|---|---|---|---|---|---|---|---|---|---|
||Rank|Strength of<br>legal rights<br>index (0-10)|Depth of<br>credit<br>informatio<br>n index<br>(0-6)|Public<br>registry<br>coverage (%<br>of adults)|Private<br>bureau<br>coverage<br>(% of<br>adults)|Rank|Procedure<br>s<br>(number)|Time<br>(days)|Cost<br>(% of<br>claim)|
|**OIC**|117|4|2|5|6|116|42|667|39|
|**GCC**|94|4|4|5|17|117|47|590|20|
|**OPEC**|110|4|3|6|10|114|43|594|28|
|**OECD**|38|7|5|8|61|37|31|518|19|
|**OIC-GCC**|120|4|2|5|5|116|41|677|41|
|**Low income**|120|5|1|1|1|117|39|613|58|
|**MENA**|116|3|3|5|7|115|44|664|24|
|**developing**<br>**countries**|89|5|3|10|18|99|39|638|33|

Source: Doing Business Report 2011, The World Bank Getting Credit: the legal rights of borrowers and lenders with respect to secured transactions through one set of indicators and the sharing of credit information through another. The strength of legal rights index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The depth of credit information index measures rules and practices affecting the coverage, scope and accessibility of credit information available through either a public credit registry or a private credit bureau. The public credit registry coverage indicator reports the number of individuals and firms listed in a public credit registry with information on their borrowing history from the past 5 years. The private credit bureau coverage indicator reports the number of individuals and firms listed by a private credit bureau with information on their borrowing history from the past 5 years.

Enforcing contracts: the efficiency of the judicial system in resolving a commercial dispute. The list of procedural steps compiled for each economy traces the chronology of a commercial dispute before the relevant court. Time is recorded in calendar days, counted from the moment the plaintiff decides to file the lawsuit in court until payment. Cost is recorded as a percentage of the claim, assumed to be equivalent to 200% of income per capita.

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# **Table 8 CGAP indicators for financial inclusion – regulation, disputes, and financial inclusion reforms**

||**Unde**<br>**agency**<br>**(**|**r regula**<br>**'s superv**<br>**Yes/No)**|**tion**<br>**ision?**<br>|**Disputes**<br>**and reg**|**resolution**<br>**ulations to**<br>|**: provision**<br>**restrict u**<br>**(Yes/No)**|**s in existi**<br>**nfair treat**|**ng laws**<br>**ment?**|**Fi**|**nancial in**|**clusion refor**<br>**(Yes/No)**|**m underg**|**oing**|**Fina**<br>**inclu**<br>**Cons**<br>**prote**<br>**(Yes**|**ncial**<br>**sion:**<br>**umer**<br>**ction**<br>**/No)**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
||Cooper-<br>Atives|MFIs|SSFIs<sup>39</sup>|Deceptive<br>advertising|Unfair or<br>high-<br>pressure<br>selling<br>practices|Abusive<br>collection<br>practices|Breach<br>of client<br>confiden<br>tiality|No fair<br>treat-<br>ment<br>provi-<br>sions|Consum<br>er<br>protecti<br>on|Financial<br>capability|Facilitating<br>SME<br>access to<br>finance|Enabling<br>micro<br>finance|Facilitatin<br>g rural<br>financial<br>access|Agency is<br>response-<br>ble|Dedicate<br>d team<br>or unit|
|**Malaysia**||**√**||**√**|**√**|**√**|**√**||**√**|**√**|**√**|**√**|**√**|**√**|**√**|
|**OIC**<br>**countries**|35%|59%|65%|51%|35%|27%|68%|24%|51%|38%|49%|57%|41%|76%|65%|
|**Developing**<br>**countries**|44%|59%|57%|70%|38%|42%|78%|16%|42%|37%|43%|49%|42%|64%|51%|
|**OIC-GCC**|35%|59%|71%|50%|32%|26%|71%|24%|50%|38%|50%|62%|41%|79%|71%|
|**low-**<br>**income**<br>**countries**|41%|72%|86%|52%|21%|31%|76%|21%|34%|28%|45%|72%|52%|79%|55%|

Source: CGAP Financial Access Report Data 2010 Note: The CGAP Financial Access Database covers questionnaires sent to 151 economies: 13 in East Asia and the Pacific, 27 in Europe and Central Asia, 20 in Latin America and the Caribbean, 14 in the Middle East and North Africa, 6 in South Asia, 40 in Sub- Saharan Africa, and 23 in the high-income OECD countries. Among them, 37 OIC countries are covered. For practical purposes, most small islands and economies at war were not included. The sample covers more than 94 percent of the world’s population and nearly 98 percent of global GDP.

Selected questions are presented in the first and second rows of the table. The row for OIC countries means the percentage of OIC countries that replied yes to the questions. The same calculation applied to the groups of developing countries, OIC-GCC, and low incoming countries. OIC-GCC means OIC countries excluding the GCC countries covered by the CGAP database.

> 39 Specialized state owned financial institutions

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# **Table 9 SME data from CGAP financial access database**

||**Agency**|**monitors t**<br>**to S**|**he level of**<br>**MEs**|**lending**|**Promoti**<br>**access to**|**ng SME**<br>**finance**||**SME definitio**|**n**|**SME**<br>**lending**|
|---|---|---|---|---|---|---|---|---|---|---|
||Yes,<br>regularly<br>(Yes/No)<br>|Yes,<br>irregularly<br>(Yes/No)|No<br>(Yes/No)|No, but<br>another<br>agency<br>does<br>(Yes/No)|Agency is<br>responsible<br>(Yes/No)<br>|Dedicated<br>team or<br>unit<br>(Yes/No)<br>|Number of<br>employees<br>(max.)|Sales|Loan size|Loan<br>value (%<br>of GDP)|
|**Malaysia**|√||||√|√|150.00|7,093,199.00|..|17.43|
|**OIC**<br>**countries**<br>**average**|72.97%|8.11%|10.81%|13.51%|62.16%|48.65%|151.00|4,008,095.95|284,592.68|7.43|
|**Developing**<br>**countries**<br>**average**|47.52%|9.90%|26.73%|17.82%|48.51%|37.62%|141.19|9,150,287.27|168,779.94|7.44|
|**OIC-GCC**<br>**average**|79.41%|8.82%|8.82%|14.71%|61.76%|52.94%|155.33|3,837,600.94|138,565.15|7.43|
|**Low-income**<br>**countries**<br>**average **|58.62%|3.45%|20.69%|6.90%|72.41%|51.72%|66.43|1,018,377.27|72,356.47|5.58|
|**OECD**|30.00%|86.67%|53.33%|93.33%|33.33%|50.00%|274.00|56,203,661.64|2,080,697.75|24.47|

Source: CGAP financial access report data 2010 Note: The CGAP Financial Access Database covers questionnaires sent to 151 economies: 13 in East Asia and the Pacific, 27 in Europe and Central Asia, 20 in Latin America and the Caribbean, 14 in the Middle East and North Africa, 6 in South Asia, 40 in Sub- Saharan Africa, and 23 in the high-income OECD countries. Among them, 37 OIC countries are covered.

Selected questions are presented in the first and second rows of the table. The row for OIC countries means the percentage of OIC countries that replied yes to the questions (for Y/N questions), or means the average value for OIC countries. The same calculation applied to the groups of developing countries, OIC-GCC, and low incoming countries. OIC-GCC means OIC countries excluding the GCC countries covered by the CGAP database.

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