Security design, incentives, and Islamic microfinance: Cross country evidence

https://doi.org/10.1016/j.intfin.2019.08.002Get rights and content

Highlights

  • We compare Sharia-compliant with non-Sharia-compliant Microfinance Institutions.

  • Sharia-compliant MFIs have less credit risk but are less profitable.

  • Sharia-compliant MFIs have better poverty outreach and are less likely to “mission drift”.

  • Religiosity and security design can help to explain these differences.

Abstract

We provide cross country evidence from microfinance institutions (MFIs) that are Sharia-compliant and their comparisons with non-Sharia-compliant MFIs. We find that, compared with non-Sharia-compliant conventional MFIs, Sharia-compliant Islamic MFIs have less credit risk but are less profitable and financially sustainable, have better poverty outreach, and are less likely to ‘mission drift’. Our results highlight the differences in religiosity and security design between these two institutions. Our study also helps practitioners and policy makers improve the understanding of the difference between conventional and Islamic MFIs.

Introduction

Microfinance institutions (hereafter MFIs) have been recognised as an effective development tool and even as one of the main innovations in the past 25 years (Servin et al., 2012, Hartarska et al., 2013). However, MFIs face some difficulties in penetrating regions with substantial Muslim populations, since conventional microfinance is not compatible with the financial principles in Sharia (Islamic law) (Karim et al., 2008). A study conducted by the World Bank shows that over 30% of interviewed poor people from Jordan, Syria and Indonesia consider religious reasons the largest obstacle to microfinance. Consequently, a great demand for financing among the Muslim poor remains unmet.

Despite the high demand for and increasing popularity of Islamic microfinance institutions (Islamic MFIs) since the last decade, little is known about this type of financial institution. In this paper, we aim to investigate the financial and social performance of Islamic MFIs, in comparison with conventional MFIs. We conjecture that the Sharia compliance feature can help to mitigate the information asymmetry between lenders and borrowers for Islamic MFIs because of the role of religiosity and their special product design.

First, both lenders and borrowers of Islamic MFIs should not conduct any unethical behaviours to violate the guidance of Sharia law, whereas conventional MFIs have no such restriction. The religiosity could effectively reduce information asymmetry, as found in literature that religiosity promotes ethical attitudes (Terpstra et al., 1973, Conroy and Emerson, 2004, Brammer et al., 2007). Believers in God may be less willing to act unethically since they believe that an omniscient Goss will ‘catch’ them in the action or know their unethical thoughts or attitudes. The previous literature finds that firms in religious areas or countries are less likely to engage in financial reporting irregularities and to experience stock price crash, so they have reduced auditing prices, higher credit ratings and lower debt costs (McGuire et al., 2011, Callen and Fang, 2015, Kanagaretnam et al., 2015, Leventis et al., 2015, Jiang et al., 2016). Baele et al. (2014) find that borrowers tend to default on their conventional rather than on their Islamic loans, and Islamic loans are less likely to default during Ramadan, a period of greater religious orientation.

Second, the product designs of the two institutions are different. Muslims are prohibited from taking or providing riba, which refers to interest or any predetermined return on a loan. The prohibition of riba is generally regarded as a part of Islam’s general vision of a moral economy.1 Hence, Islamic MFIs should comply with Sharia law, which prohibits the charging of interest, requires assets back up and promotes profit-and-loss sharing (PLS) schemes. This requirement leads to the main differences between the two types of financial institutions in the product designs, where Islamic MFIs tend to have equity-like products while conventional MFIs tend to have debt-like products. The equity-like and risk-sharing nature of Sharia-compliant financial products could induce Islamic MFIs to have strong incentives to participate in and monitor the entrepreneurs’ projects and may hence reduce the information asymmetry between lenders and borrowers and adverse selection cost. On the other hand, investment depositors of Islamic MFIs may also have more incentives to exercise tight oversight and discipline over the Islamic MFI management, since they need to share the risks (and normally do not have deposit insurance) (Čihák and Hesse, 2010). By risk-sharing, Islamic MFIs also reduce the debt risk-shifting effect documented in Karim, 2001, Iqbal and Llewellyn, 2002, Obid and Naysary, 2014.

Many Islamic MFIs use leasing contracts to get around the prohibition of making return on lending, which are also Sharia-compliant. By way of these leasing contracts, Islamic MFIs keep the ownership of the investment goods and rent them for a fee. As argued in Eisfeidt and Rampini (2009), in most legal environments, it would be easier for the lessor to regain control of the leased assets than it is for a lender who takes a security interest in an asset to repossess it. The higher ability to repossess the assets gives the Islamic MFIs an extra cushion for credit risk. While it is argued that although the separation of ownership and control in a leasing contract increases the agency costs from the borrower side (Eisfeidt and Rampini, 2009), it reduces the information asymmetry between the lender (Islamic MFIs) and the borrower from the lender’s perspective.

Hence, if our conjecture that Islamic MFIs have lower information asymmetry between lenders and borrowers than conventional MFIs is true, we should predict that, compared with conventional MFIs, Islamic MFIs should be less profitable and financially self-sufficient, and have lower credit risk due to the costs associated with the Sharia-compliant products, have better poverty outreach and are less likely to have ‘mission drift’, where financial sustainability is attained by sacrificing poverty outreach.

We employ data from the Microfinance Information Exchange Network, an international microfinance platform that provides data on individual MFIs. We construct a panel dataset that comprises 316 MFIs located in 12 countries within three regions, namely South Asia (SA), Middle East and North Africa (MENA), and Eastern Europe and Central Asia (EECA) during the period of 1998–2014. A large percentage of the poor in these three regions are practicing Muslims. We manually classify MFIs in the MIX Market as Islamic MFIs if these MFIs partly or fully provide Islamic microcredit products and services and classify the remaining MFIs as conventional MFIs. We find Islamic MFIs have lower credit risk, but lower profitability and lower self-sufficiency, higher poverty outreach, and are less likely to ‘mission drift’ than conventional MFIs. Our result holds when we employ propensity score matching (PSM) method.

Our paper extends the literature comparing Islamic and conventional bank/finance (Aggarwal and Yousef, 2000, Abedifar et al., 2013, Gheeraert, 2014, Mallin et al., 2014), and those on financial institutions and mutual funds (Abdelsalam et al., 2014, Obid and Naysary, 2014, El-Ouadghiri and Peillex, 2018, Yanikkaya et al., 2018, Alzahrani, 2019). Our paper highlights the important features of Islamic MFIs on both religiosity and product design, i.e., equity-like and leasing-like Sharia-compliant products. We not only compare financial performance (profitability, financial self-sustainability and credit risk) between Islamic and conventional MFIs, but also study their differences in poverty outreach and the tendency of “mission drift”, which are special features of MFIs.

Our research also extends and complements the current literature on microfinance. Extant literature has analysed microfinance’s characteristics, such as capital structure, ownership and female leadership (Tchuigoua, 2015, Strøm et al., 2014), cost efficiency (Caudill et al., 2009), financial performance (Mersland and Strøm, 2009, Hartarska et al., 2013, Islam et al., 2015), sustainability (Bogan, 2012) and technical efficiency (Derigs and Marzban, 2009, Servin et al., 2012). As the only study examining the impact of religion on microfinance, the evidence of Mersland et al. (2013) shows that compared with conventional MFIs, Christian MFIs have lower funding costs, lower profitability and similar credit risk. Our study sheds light on the impact of Islam, enshrined by a quarter of the world’s population, on microfinance.

Our study is important and valuable to practitioners and investors related to MFIs. Our study helps them develop a comprehensive understanding of the difference between conventional and Islamic MFIs. This understanding could guide practitioners to take effective actions, such as generating strategies or other Sharia-compliant financial products to reduce operational costs. Therefore, in the real world, Islamic MFIs could increase their profitability and ability to sustain operations with no subsidies. Our study also has implications for policy makers in the Muslim world. Our evidence that Islamic MFIs have a better reach to the poor suggests that the regulatory support2 for the development of Islamic MFIs is a feasible way to improve income of all poor Muslims. For instance, in 1997, the Yemen government, along with the United Nations, initiates the Hodeidah Microfinance Program, which aims to apply the Islamic financial principles to the microfinance sector (Ahmed and Grace, 2001).

This paper is organised as follows. Section 2 overviews the Sharia-compliant products provided by MFIs. Section 3 reviews the relevant literature and develops our hypotheses. Section 4 discusses the data selection, measures and summary statistics. Section 5 displays the main results and their interpretations. Section 6 concludes.

Section snippets

Sharia-compliant products in MFIs

Most Islamic MFIs only offer two financial products: Murabaha and Qard-Hassan loans (El-Zoghbi and Tarazi, 2013). Under Murabaha financing, the financial institution buys an asset on behalf of the entrepreneur. The financial institution then resells this asset to the entrepreneur at a predetermined price that includes the original cost and an added profit margin. The entrepreneur makes payment to the financial institution in lump sum or in instalments in the future. The financial institution

Hypotheses development

Compared with conventional MFIs, Islamic MFIs comply with Sharia law, which prohibits the charging of interest and promotes profit-and-loss sharing (PLS) schemes and leasing-like product. Consequently, conventional MFIs and Islamic MFIs reveal different business models and mission orientations, which might influence their corresponding financial and social performance. However, the extant literature remains unclear about the differences in financial performance, credit risk and social

Data collection and selection

We collect MFI information from the MIX Market database, a worldwide microfinance information platform for MFIs. This database contains information voluntarily reported by individual MFIs about their financial statements and balance sheets. Since most of these financial statements and balance sheets are audited, this database is considered accurate and reliable. However, we should also note that this database does not contain information from all MFIs because many MFIs choose not to report to

Financial performance

Table 2 reports estimates from the baseline regressions. In Columns (1) and (2), Islamic MFI is significantly and positively associated with Operational Costs and Administrative Costs at the 1% level and 5% level respectively. This evidence reflects the economically significant difference between these two costs for the two types of MFIs. For instance, the coefficient of Islamic MFI on Operational Costs (0.093) indicates that the operational costs of Islamic MFIs are 0.093 higher than those of

Conclusion

It is hard for conventional MFIs to penetrate into regions with a substantial Muslim population because they are incompatible with the financial principles in Sharia (Islamic law), (Karim et al., 2008). The high demand for loans highlights the need to provide religiously compatible products to the underserved Muslim poor, resulting in the advent of Islamic microfinance as a new market niche (Karim et al., 2008). However, little is known about the actual performance or outcome of Islamic MFIs,

Acknowledgement

We thank for the support from Institute of Belt and Road Studies, Sun Yat-sen University. All errors are ours.

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