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Experiments in Islamic Microfinance

Oct 05, 2015
Financial access in Africa is heavily constrained. The percentage of adults with a
bank account
in sub-Saharan Africa was only 34% in 2014 (compared with 51.4% in Latin America, 93.6% in the US and 69% in East Asia & Pacific). This limited access has important implications for economic development; lowering savings, impeding efficient channeling of funds and generating and sustaining poverty traps. Many projects have worked on addressing the different causes of these limitations that includes
underdeveloped financial infrastructure, financial illiteracy and poor economic performance. However, other factors have been overlooked,
including the fact that cultural/religious causes
prevent many Muslims from dealing with the traditional banking services. Muslims constitute more than half of Africans (around 53%). Many Muslims are traditionally opposed to interest-bearing accounts (because of the Islamic ban of riba), which distance them even further from formal financial services. Several financial products are permissible for Muslims, although they differ in their degree of acceptance. Some of the most acceptable financial products are based on profit-and-loss sharing (PLS), although they are the least used in Islamic banking because they are perceived to be extremely risky. In a recent paper, we examine this perception and experimentally demonstrate that PLS Islamic finance products are no more risky than other financial products like interest-based loans. We compared two PLS microfinance contracts that are Islamic-compliant (profit sharing and joint venture) with interest loans. Each borrower made decisions to invest in risky projects using the three types of contracts. The outcome of the project is known to the borrower, but not to the lender. We then compared the compliance rates of the participants in each of the three contracts. If indeed, PLS contracts are riskier, we would have expected to find higher default rates in those contracts relative to interest-bearing contracts. In contrast, we found that Islamic-compliant loans induce at least as much compliance as interest loans, and sometimes significantly more. Lenders' return on investment was higher in profit and loss sharing agreements than either profit sharing or interest-based loans (which were roughly equivalent). We also found that women comply more than men, consistent with common wisdom and practice in microfinance. Further, religiosity increases compliance rates. It is worth noting these patterns hold regardless of any particular religious belief. Based on this research, we suggest that PLS microfinance products should be seriously considered. These products would benefit and attract African Muslims, and would provide the poor with a financial instrument that they can utilize without increasing the risks to the lender. Profit sharing and joint venture contracts would be useful tools for both Muslims and non-Muslims in Africa. For Muslims, they will increase banking account access and for everyone, our results suggest that they will yield greater compliance rates in microfinance than the contracts currently in use. In summary, we hope that this research will encourage microfinance scholars and practitioners to consider new and innovative contractual designs, which will help in increasing access to credit for the limited-income consumer. This blogpost is based on the academic study "Experiments in Islamic Microfinance", Journal of Economic Behaviour and Organization,
Vol.
95, November 2013, pp. 252-269.
About the Study Authors: Mohamed El-Komi is Assistant Professor of Economics at the American University in Cairo; Rachel Croson is Professor and Dean of the College of Business at the University of Texas at Arlington. This blogpost was written by Mohamed El-Komi, Assistant Professor of Economics at the American University in Cairo, and approved by the study authors.

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