During the last few years of the previous century, there had been a number of new ideas in the financial services sector that evolved meeting the requirements of different sections of the people. While most of the innovations focused on developing products and services to be offered in developed financial markets, there has been one new concept ‘microfinance’ which evolved to meet the needs of those sections of people who are not in a position to access credit provided by regular banking channels. Microfinance institutions introduced by Professor Mohammed Yunus of Grameen Bank in Bangladesh have been found to be popular among developed and industrialized economies also. The innovative microfinance concept is regarded as a “new paradigm” in alleviating poverty in most developing nations. Prior to the introduction of the microfinance system, micro-entrepreneurs have been finding it difficult to find the necessary funding for their small ventures due to a lack of collateral and asymmetric information problems. These entrepreneurs had to approach non-institutional sources for their financial needs and they were often made to pay exorbitant interest rates. In recent times, poverty-focused microfinance institutions have come to the rescue of these entrepreneurs helping them to augment their income and wealth. This paper analyzes some of the issues relating to microfinance and its suitability to the Saudi Arabian context.
What is Microfinance
Otero defines microfinance as “the provision of financial services to low-income poor and very poor self-employed people” (p, 8). Ledgerwood identifies microfinance to cover financial services like investments and loans, but the services may also include the provision of indemnity and disbursement facilities to certain specific sections of the society who are not in a position to avail such services from the formal financial services institutions. According to Schreiner and Colombet microfinance is “the attempt to improve access to small deposits and small loans for poor households neglected by banks.” This definition signifies that microfinance encompasses the “provision of financial services such as savings, loans, and insurance to poor people living in both urban and rural settings who are unable to obtain such services from the formal financial sector,” (Schreiner and Colombet, p 339). Often there is confusion between the terms microcredit and microfinance. There is a difference between both the terms. Sinha states, “Microcredit refers to small loans, whereas microfinance is appropriate where NGOs and MFIs1 supplement the loans with other financial services (savings, insurance, etc)” (p, 2). From the definition it follows, that “microcredit is a component of microfinance in that it involves providing credit to the poor, but microfinance also involves additional non-credit financial services such as savings, insurance, pensions and payment services” (Okiocredit, p,1).
Characteristics of Microfinance
Microfinance has certain unique characteristics as compared to traditional financing by commercial banks and other lending institutions. The differences in the characteristics can be grouped under:
- lending methods,
- composition of loan portfolios,
- characteristic features of the institutions.
The non-traditional client base of microfinance institutions leads to these differences in the characteristics. The clients for the microfinance institutions include “low-income self-employed people with no or inadequate collateral.” (Janson) The lending methodology of microfinance institutions also differs from those of traditional lending institutions. The lending methodology adopted by them is capable of compensating for lack of collateral with labor and information-intensive procedures. The methodology usually depends on “character references, joint liability contracts, and conditional long-term access to credit rather than on physical collateral and formal documentation.” (Janson) The loan officers attached to the microfinance institutions visit the clients individually so that they can make an evaluation of the characters of the borrowers and their planned projects for which they require funding. Since the loan amounts are small, each officer is made responsible to monitor the accounts of a large number of clients extending to more than 500 in number. Another important characteristic of microfinance loans is the tenure of the loans. These loans are for a shorter duration and therefore the microfinance institutions are able to turn around the loans several times during a year. Because of these reasons, the cost of microfinance loans is comparatively higher than other types of loans. Therefore, microfinance institutions have to charge higher rates of interest than other lending institutions.
The distinctive features of microfinance are presented in the following table.
Table: Distinguishing Features of Microfinance
While many of the financial institutions take their root from other regulated institutions and have the capital contributed by individuals and institutional shareholders, microfinance institutions have so far been promoted as conversion from Non-Governmental Organizations (NGO), which are unregulated in nature. The capital for the microfinance institutions is contributed usually by other institutions like non-governmental organizations functioning in foreign countries. The effectiveness in the management of the microfinance institutions and their oversight is made difficult by the lack of experience of NGO personnel and the non-profit intentions of the foreign NGOs. Since the private investors do not have much interest in contributing to the capital of microfinance institutions, it is the international NGOs, which contribute more to the newly established microfinance institutions. There are no regulations, which restrict the investment by private investors in microfinance institutions.
Models of Microsoft Interventions
Although there are no clear data on the magnitude and volume of activities of microfinance institutions, it is observed that microfinance institutions employ a number of implementation models. According to Grameen Bank, there are fourteen different models, which can be used in the provision of microfinance to needy people. Rotating Savings and Credit Associations (ROSCAS), the Grameen Solidarity Group Model, and Village Banking Model are some of the prominent models of microfinance activity.
Rotating Savings and Credit Associations
These associations are formed with an association of people joining to contribute regularly to a general fund on a rotational basis. From the fund, lump-sum amounts are given to one member of the group in each cycle. Harper identifies this model as the most common model used by people for savings and enjoying credit. Neighbors and friends often form the members of the groups and such groups are found to be the means for greater social interaction. This model is quite popular among women. These models are also known as “merry-go-rounds or Self-Help Groups” (Fisher and Sriram).
The Grameen Solidarity Group Model
Under this model, loans are provided to individuals, the majority of them being women in groups of four to seven and the success of this model depends on the group peer pressure. The repayment of the loan carries a collective assurance from the constituents. Granting of further loans depends on the prompt settlement by all the constituents of the sets. Normally weekly payment system is adopted. Grameen bank uses this model and the institution has found this model effective in reducing the defaults. Mutual trust arrangement is the core concept in the group guarantee system and therefore this model contributes to broader social benefits. “The group itself often becomes the building block to a broader social network,” (Berenbach and Guzman).
Village Banking Model
Holt identifies village banks as “community-managed credit and savings associations.” (Holt) These associations are established by NGOs with the intent to provide financial services as well as build community self-help groups. These associations also help members accumulate savings from their meager income. Village banks are in existence since the mid-1980s. The number of members ranges from 25 to 50 consisting of low-income people. These people join together to look for avenues to improve their lives by undertaking self-employment opportunities. In the village banks, the members undertake to carry on the operations, elect the office-bearers, grant loans to individual members and arrange for the collection of the loans sanctioned. The loans are guaranteed by moral collateral, which is the promise by the groups that they guarantee prompt repayments by the individual member.
Problems and Constraints of Microfinance
There is a large volume of literature, which exhibits the success of microfinance institutions. However, there are some recent studies, which indicate the failure of these institutions in reaching the objectives, for which they were established. Some of the problems are discussed below:
Unequal Information Issues
Most of the MFIs cater to female members for disbursing the loans; but actually, men within the families start the loan proposals and they mostly manage the amounts borrowed by the women from the microfinance institutions. The loans are often used for purposes other than those for which they were obtained (Rahman). In cases where the borrowers make use of the funds for the purchase of consumables, they may find it difficult to make repayment of the loans and this increases the number of defaulters.
Viability of Microfinance Institutions
In an ideal situation, the microfinance institutions are expected to run profitably and at the same time, they should improve the financial conditions of the poor people by providing them necessary financial assistance to carry on their ventures. However, in reality, the lack of ability to mobilize more funds and high administrative costs has made microfinance institutions economically unviable.
High dropout Rate
MFI in practice does not provide finance to the poor sections of the society and they are dropped out of loan proposals or they are not provided with financial assistance (Ditcher (p,261), Hulme and Mosley,(P 8), Montgomery, p 292). Karim and Osada observed that the dropout rates showed a consistent hike in the case of the constituents of Grameen banks. It is argued that the present performance of microfinance institutions is ineffective in advancing the financial status of extremely poor people.
Impact of Microfinance on Economic Development
According to the advocates of microfinance, the schemes developed by MFIs have a significant role to play in the economic development of different nations. There are three important roles, which microfinance plays in development. Microfinance (i) enables downtrodden sections of the people to finance their fundamental requirements and defends them from hazards, (ii) is closely connected with the financial advancement of different sections of the society, and (iii) promotes the empowerment of female members by enabling the financial sharing of women and thereby promotes equality among men and women. “Microfinance creates access to productive capital for the poor, which together with human capital, addressed through education and training, and social capital, achieved through local organization building, enables people to move out of poverty.” (Otero, p 10 quoted in Wrenn) The role of microfinance cannot be considered as just providing financial assistance to the poorer section of the society to combat poverty. It has a much larger institutional role to deliver other financial services to the poor, who are often not in a position to avail these services from the regular banking sector. By bridging this gap in the provision of financial services, microfinance becomes a part of the financial system of the economy. The MFIs can therefore access the capital markets to raise funds for supporting their lending activities, which enables them to increase the number of poor people brought into their reach.
Demerits of Microfinance
Despite the positive effects, there are some major faults in the approach of MFIs. They are:
- MFIs resort to a single-sector approach for allocating the resources to eradicate poverty
- The concept seems to be irrelevant for the poorest section of the people
- The concept uses a most simplistic notion of poverty, which cannot be considered to have practical values
- The scale of operations is over-emphasized
- There is a dearth of knowledge and training among the operators and changes take place without a proper foundation.
The major criticism of microfinance is that the schemes do not reach the poorest sections of the people producing only a limited impact on income levels of people.
Current Position of Microfinance
After Grameen Bank the pioneer of microfinancing has been found to be operating successfully, the concept has spread to different geographical locations across the world. “The Grameen Bank has been duplicated in Bolivia, Chile, China, Ethiopia, Honduras, India, Malaysia, Mali, the Philippines, Sri Lanka, Tanzania, Thailand, the United States, and Vietnam; the microfinance information exchange market (MIX) lists financial information for 973 MFIs in 105 different countries.” (Sengupta and Aubuchon)
The microfinance institutions have been able to obtain an increased amount of funding towards their working capital through public and international financing. This enabled them to expand the scope of their services to various sections of the communities. With the increase in their efficiency and funding levels, microfinance institutions have started offering different products and services to their clients. These include micro-savings, flexible loan repayment, and insurance products. The following figure illustrates the number of people who benefited from microfinance institutions in different regions of the world by enhancing their saving habits.
Performance of Microfinance Institutions in the Arab Region
Despite the slow growth rate of the global economy during the past three years, microfinance has shown an increasing trend in its growth. However, the growth rate has been slower as compared to the previous years. The microfinance borrowers across the world grew to the extent of 21 percent during the period between 2006 and 2008. In tandem with this growth rate, microfinance in the Arab region has also shown an increase of 19 percent in the outreach between the years 2006 and 2008. There has been a growth of 30 percent in the loan portfolio of microfinance institutions in the Arab region with the gross loan amount increasing from USD 605 million in 2006 to USD 1.022 Billion in 2008 (Microfinance Information Exchange). The following table provides the number of borrowers and volume of loans by country.
The following figure indicates the debt financing by different regions through microfinance.
Just after the Asian region, the Arab region has registered the second-highest growth rate in terms of outreach.
“On average an Arab MFI reached 11,785 borrowers, surpassing the more mature market of Latin America and the Caribbean, where an MFI reaches an average of 9,768 borrowers. In terms of GLP growth, the Arab region also came second globally – this time to Latin America and the Caribbean – with respect to median GLP, which reached approximately 5.1 million USD per MFI.” (Microfinance Information Exchange)
From the table, it can be observed that Morocco and Egypt dominated the microfinance sector during the year 2008. Morocco and Egypt represented 85% of the total borrowers in the region and 73% of the total gross loan portfolio of the region (Microfinance Information Exchange).
Microfinance – Comparison of Microfinance Institutions and Islamic Banks
This section presents a comparison of the economic performance of microfinance institutions (MFI) and Islamic banks in providing microfinance to poorer sections of the community. Islamic banks will follow the same model as followed by the micro-financial institutions since such a model is found to be ideal to help poor people. Funds are provided to the needy without demanding any collateral securities. In the case of Islamic banks, several branches of the bank can control the field-level operations of disbursing the loans and collecting repayments. The microfinance activities over the country can be managed by a separate division formed with the specific responsibility of microfinancing at the apex level. The branches can cater to the needs of the poor people near the branch. The following table presents a comparison of the relative effectiveness of providing microfinance by MFIs and Islamic banks.
|Larger operating costs in the form of costs at the head office, regional offices, branches, and other variable costs like rent, utilities, and additional costs for appointing professionals to administer the financing operations||Lower operating costs with no additional variable costs as the Islamic banks will provide microfinance from the existing branches. Reduced cost of operations as there is no need for specialized professionals|
|Higher borrowing costs as MFIs do not have a large deposit base and have to borrow from external sources||The cost of borrowing is less for the Islamic banks as they can divert part of the deposits received to offer microfinance|
|MFIs have certain limitations in providing funds for socially beneficial programs as they have to calculate profits in each transaction to cover the cost of borrowed funds||Islamic banking institutions have the liberty to use their funds for socially beneficial programs even if these programs do not provide any profits to the banks|
|MFIs generally suffer from a lack of funds, which is a major constraint to growth and efficient operations. Lack of funds also prevent the institutions from hiring a sufficient number of able staff at competitive salary levels||Islamic banks do not have this problem, as they can appoint an adequate number of qualified staff at competitive salaries with other benefits. This enhances the productivity of the Islamic banks and makes them efficient in earning profits|
|To improve the efficiency of the operations MFIs have to organize necessary training programs. Lack of funds often deter the institutions from conducting such training sessions and therefore are not in a position to upgrade the skills of their employees||Islamic banks are in an advantageous position to provide the necessary training to the staff in microfinancing activities. Since the banks are relatively large institutions they can afford to have their in-house training departments to train the employees|
|It may not be possible for the MFIs to meet the needs of the poorest sections of the people, as extending credit to these people would lead to the diversion of funds to unproductive purposes and purchase of assets. Therefore, the MFIs normally neglect this section of people.||The Islamic banks are in a position to formulate some balancing programs through which these banks can assist the nucleus of the poor people. Most of the Islamic banks have funds created out of late payment overdue amounts, which can be used only for some charitable purposes. The banks can use this fund to meet the needs of the poorest section of the society|
Analysis of Performance and Efficiency of MFIs
The following table presents the performance and efficiency of the MFIs in South Asia on a comparative basis. “These Indicators can be divided into outreach indicators, Institutional Characteristics, Financing Structure, Overall Financial Performance, Efficiency Indicators, Productivity Indicators, and Risk and Liquidity Indicators,” (Qayyum & Ahmad). The average existence of MFIs in South Asia is 16 years, while the MFIs in Pakistan have a life of 10 years and the MFIs in India have 11years, which is less than the mean life. MFIs in Bangladesh have more than the average life with 21 years of existence.
Performance Indicators of MFIs in South Asia
It can be observed from the table that the average number of active borrowers is more in the case of Bangladesh. The outreach ratio of India and Pakistan is lower, compared to that of Bangladesh. Based on the value of assets and equity, the MFIs in Bangladesh can be seen as larger as compared to those in India and Pakistan. MFIs in Pakistan show a negative performance in the rate of return. The efficiency ratios of the MFIs in Pakistan are lower as compared to the other two countries.
The performance indicators of MFIs in different regions of the world as of the the years 2005 are shown in the following table.
Table: Performance Indicators of MFIs in Different Regions of the World
From the table, it may be observed that the MENA region has a reasonably higher Return on Assets of 5% second to Eastern Europe and the Central Asian region. This region has a lower total expense ratio as compared to all other regions. The region also seems to be self-sufficient in operations. All these ratios present a strong case for the introduction of microfinancing in the Kingdom of Saudi Arabia.
The following table indicates the performance of different types of MFIs in South East Asia and the South Asian region.
Table: Performance Indicators of Different Types of MFIs in South East and South Asia
The performance indicators signify that the NGOs farewell than other types of MFIs. The Return on Equity in the case of NGOs is the highest at 7.0 as compared to other types of institutions. These types of institutions are also found to be financially self-sufficient, although they have a high total expense ratio. The cost per borrower is also comparatively lower. However, the NGOs have lower borrowers per staff member as compared to the banks and non-banking financial institutions.
Comparison of Return on Equity of MFIs with Banks
There is the need to fix separate benchmarks for the Return on Equity (ROE) levels of MFIs. For an effective comparison of ROE of the MFIs with the banks, the MFIs must be matured institutions existing for long period and must have been profitable for several consecutive years. Moreover, the comparison of the performance based on ROE would be effective only when the activities of the MFIs are sizeable in comparison with those of the banks. The ROE of the banks in those countries where at least one MFI is registered with the Microfinance Information Exchange market (MIX) was found to be 18% on average. However, the average ROE of MFIs in these countries has been found to be 13%, which is lower than that of the banks. The following table provides the comparative performance of the MFIs against banks in different regions/countries.
The comparison of the ROEs may appear to be low; MFIs normally earn an interest margin, which is four times higher than that of the banks. While the banks register interest earnings of 6%, MFIs record earnings of 24%. The portfolios of MFIs as compared to the banks are of superior quality. The high level of operating expenses of MFI can be cited as one of the reasons for lower ROE. Nevertheless, the main reason for lower ROE in the case of MFIs is the proportionately higher equity base held by the MFIs as compared to the banks. The debt/equity leverage effect of the MFIs is comparatively lower compared to the banks, which accounts for the lower ROE of MFIs. The higher external borrowings in the absence of an increased deposit base (which is a distinct advantage for the banks) against the equity base makes the MFIs pay to bear more interest costs and consequently, there is a lower ROE. It, therefore, becomes essential that the MFIs must strive to mobile more deposits to reduce their dependence on external borrowings for disbursement of additional loans.
Table: Comparison of Average ROE of Banks and MFIs in Different Regions
Example of Microfinancing by Islamic Bank
Rural Development Scheme (RDS) of Islami Bank Bangladesh Limited (IBBL) commenced its operations in the year 1996 to meet the investment requirements of poor micro-entrepreneurs located in the rural areas of Bangladesh. The main objectives for which the scheme was initiated by IBBL are:
- “To extend investment facilities to agricultural, other farming and off-farming activities in the rural areas
- To finance self-employment and income-generating activities of the rural people, particularly the rural unemployed youths and the rural poor.
- To alleviate rural poverty through the integrated rural development approach
- To extend investment facilities for rural housing, keeping in view the needs of housing facilities of the rural dwellers.
- To provide educational services and safe drinking water, sanitation & medicare facilities to the downtrodden people.” (Isalmi Bank Bangladesh Limited)
The funding requirements of RDS were met by the general investment funds of IBBL. The bank also has an Islamic Bank Foundation, which is formed out of contributions from aid organizations. This fund also is made of the earnings of IBBL, which cannot be added to the profits of the bank. The goal of RDS is to alleviate poverty at the village level by pursuing society-based programs. RDS attempts to help the people belonging to villages who do not own lands or those people whose land ownership is less than 0.5 acres of arable land. In addition to meeting the financial needs of the target group, RDS also addresses their health, sanitation, and educational needs of them. The bank uses the dominant model of MFI financing groups with small amounts to be repaid in weekly installments. There is no physical collateral demanded by the bank for providing finance to the micro-entrepreneurs. Financing is supported by communal security of forming self-help organizations and village-level units. Like any other microfinance institution, RDS contracts with the members through females. Since the Islamic banks approach the families using Islamic financing, they will be able to eliminate the problems of asymmetric information largely as compared to regular microfinancing.
There is no requirement of security under the scheme as the objective of the scheme is the “upliftment of the socially downtrodden and economically backward and weaker section of the population of the society” (Isalmi Bank Bangladesh Limited, Introduction). However, the bank insists on strict adherence to Group discipline so that the only right persons are selected as members of the Groups for offering financial assistance. “Besides, each member of the Group gives personal guarantee for other members of the same group and the members are jointly and severally liable and responsible for payment of investment.” (Isalmi Bank Bangladesh Limited, Introduction)
Profitability of RDS
Table: Profitability of RDS
|Cumulative amount of disbursement from RDS |
|Outstanding investment of RDS Million Taka||570.90||789.97||1,106.00||2,242.00||2,885.00||3,012.00|
|Number of RDS account holders||130,465||163,465||164,116||295,012||350,278||321,484|
|Number of villages covered by RDS||3,700||4,230||4,560||8,057||10,023||10,763|
RDS records higher profitability as there are no fixed costs associated with the operation, as the MFI is functioning from the premises of IBBL. The fund incurs operating expenses only in the form of travel and other outlay of field staff. The progress of RDS can be seen from the figures shown in the table obtained from the annual report of IBBL.
From the above presentation, it can be observed that RDS is making good progress in the microfinance sector. RDS is charging a rate of return is 10% flat with a rebate of 2.5% for prompt repayment. This rate is much lower than the rate charged by other MFIs, which range from 16 to 55%. RDS is able to subsidize the finances to small and tiny entrepreneurs by charging low rates of interest of 10%. Because of the lower interest rate, the earnings from the amount invested by RDS are comparatively lesser than the earnings of other MFIs. However, this does not affect the earnings of the division, as a substantial portion of the expenses is the remuneration payable to the project in charge. The project officer and most of the other staff of RDS are employed by IBBL and therefore RDS incurs only very less fixed costs.
Service Levels of RDS
RDS is able to provide services of a much higher class to the people as compared to the other MFIs. With the backing of IBBL, RDS can have the benefit of better quality services by staff appointed by IBBL. Secondly, the preparatory organization of IBBL provides the necessary training to all the employees of RDS with no additional expenses to RDS. The in-house training provided by the professional staff of IBBL makes the employees of RDS efficient and helps to enhance their productivity. Third, since the RDS employees are provided with adequate logistics support, they can provide efficient and quality service to poor people. With the financial support of IBBL, RDS can employ sufficient staff to maintain a healthy employee/beneficiary ratio. Finally, RDS does not depend on external sources for its funding requirements. This helps RDS to devise any program, which it finds suitable to the beneficiaries. RDS could arrange funds for some kinds of financing where the paying of the loan will follow a special scheme, which depends on the earning capacity of the program for which the loan was granted. Even when there are no earnings generated out of the investment, the beneficiaries will not be pressurized for repayment, as RDS can withstand the non-repayment, while other MFIs may not have the financial capacity to withstand such a situation (Ahmed).
Other Schemes of RDS
RDS has been able to combine other assistance schemes successfully together with microfinancing activities for uplifting the plight of the rural people. Because of poverty, people drawing funds from the MFIs tend to divert the funds for other consumption and purchases. However, with the funds available from Islamic Bank Foundation, RDS can implement balancing plans for helping the poor to acquire assets. RDS grants loans without interest, out of this finance for purchasing various agricultural implements and in building their houses. The provision of such interest-free loans helps the beneficiaries to increase their asset base. It also helps to improve the loan settlement rate, as the clients do not divert the funds for other uses. Since any failure to repay the loans acts as ineligibility to prevent the borrowers from getting loans without interest, the privilege acts as an inducement for the clients to settle other loans taken by them from the MF (Ahmed).
Islamic banks have a unique character of performing a communal responsibility in their functioning. Because of their ability to alleviate the poverty of the poor, microfinancing can be considered a new paradigm, this paper suggests that Islamic banks in Saudi Arabia can take up micro-financing for realizing the social aspects and provide financing for the poor micro-entrepreneur. This paper argues that Islamic banks are better suited to take up microfinancing without the shortcomings faced by the conventional MFIs. Islamic banks can serve the poorer section of the Kingdom more efficiently and effectively using their financial and human resources. Large-scale Islamic banks will be able to deliver quality service to the clients because of the advantages of their scales of operation. As the Islamic financial institutions of Saudi Arabia need not depend on outside agencies for funding their microfinancing operations, they will have the capability to meet the specific requirements of the different classes of borrowers. This paper provided examples of the growth of MFIs in other Arab regions, which go to prove that the microfinance schemes when undertaken by Islamic banks in Saudi Arabia will perform successfully to meet different social objectives.
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