Financing Microenterprises: An Analytical Study of Islamic Microfinance Institutions

This paper provides the theoretical basis, operational framework, and empirical support for the establishment of Islamic microfinance institutions (MFIs). It argues that:

• While conventional MFIs have expanded their operations in the last two decades, poverty-focused Islamic MFIs (IMFIs) are lagging behind;
• IMFIs do not face the challenges that conventional MFIs face, such as problems of non-graduation from poverty, debt trap, high dropout rate, etc.
• IMFIs are richer and can be integrated into microfinance programs to effectively alleviate poverty;
• IMFIs benefit from the social capital derived from Islamic values:
  • Employees have an incentive to work for the betterment of the lives of the poor in an Islamic financial institution,
  • Islamic teachings increase solidarity among beneficiaries,
  • The moral teachings of Islam make the beneficiaries better debtors.
• IMFIs deal with the family and this mitigates adverse selection and moral hazard problems.

The paper presents empirical evidence from three Islamic MFIs operating in Bangladesh, revealing that Islamic MFIs have not tapped some of the sources of funds, nor have they used the variety of financial instruments in their operations.The paper concludes that:

• The growth and sustainability of IMFIs depend on the availability of external funds during the initial stages of operation;
• The Islamic Development Bank (IDB) can play an important role in supplying external funds as well as training to IMFIs on a commercial basis.