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November 09, 2010Islamic Finance and Microfinance
My RCW colleague Kevin Sullivan sent along this interesting China Post article concerning the rise of Islamic finance:
Will Islamic finance be a serious challenge to traditional Wall Street finance? That is a question that deserves a good answer.First of all, thanks to the good work of Bank Negara Malaysia and the Gulf central banks, the infrastructure for Islamic finance has been laid, with the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AOFFI), the Islamic accounting standards authority, the Islamic Financial Services Board (IFSB), the international Islamic financial regulatory standard-setting organisation and the Institute for Education in Islamic Finance (INCEIF). The International Shari'ah Research Academy for Islamic Finance (ISRA) also provides an invaluable website that is increasingly the transparent source for shari'ah interpretations on what is considered acceptable under Islamic law.
For people unfamiliar with Islamic finance, the basic principle of Islamic banking is the sharing of profit and loss and the prohibition of usury. Simply put, interest is prohibited, but profit sharing is not. A cynic can say that with zero interest rate policies adopted by advanced country central banks today, they are also practicing Islamic banking.
I am a bit skeptical about these conclusions. As a general principle, Islamic finance is illiquid and overpriced, primarily because it's not a large market. The people who make use of this financial source tend to be those who have no alternate choice, for sociocultural reasons, and anybody who does have a choice doesn't bother with it. And while some European banks have gotten into Islamic finance on the sell side, they're only doing so because there's a profit opportunity.
This does, however, raise another finance item for consideration.
As you may know, and as recent editorials in the Financial Times and elsewhere have noted, the world of microfinance is becoming a profound disappointment, and rapidly turning into a debt trap for the rural poor, leading nations that had embraced the practice, such as Bangladesh, to announce rate caps. An internal announcement from SKS Microfinance today of interest rate cuts is hardly a permanent improvement, as the WSJ reports:
The microfinance industry has virtually ground to a halt in Andhra Pradesh following moves by the government to protect borrowers from high interest rates and heavy-handed recovery agents, which officials say have triggered more than 70 suicides in the state.Microfinance companies lend small amounts—usually less than $200—to poor people who use the money to start or expand small businesses such as vegetable stands or bicycle repair shops.
But interest rates can be exorbitant, from 25% to 100% a year.
This compares with rates of between the high single digits and the low double digits that banks charge for loans to retail customers, depending on factors such as the product, maturity and loan size.
I'm not about to suggest Muhammad Yunus' approach is wrong, and a firmer policy of “one loan, one client” may result in some positive ramifications. But the point here is that microfinance has its own set of negatives, and that more solutions are needed given the social and economic instability which can result from situations like this.
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