Microcredit using Equity Financing_ an Alternate Approach to Micro by jlhd32


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									                 Microcredit using Equity Financing: an Alternate Approach to Micro
                               Financing in an Interest Free Economy
                                      Salman Ahmed Shaikh


Interest based Microfinance has had mixed results. Interest based lending at Micro level is usually carried
out at very high interest rates, more so when the lending takes place informally without institutional
intermediation. Institutional intermediation serves a good purpose, but it can also be designed using
equity modes of financing. This can relieve the financee and increase diversity of entrepreneurial
activities as in debt based microfinance, not much diversity can happen with compulsory servicing of
debt. Using Islamic equity modes of financing presents the challenge of the agency problem. The extent
of this agency problem and its impact on economic payoffs is analyzed in this paper. Based on review of
alternate solutions proposed, the author presents two possible covenants which could make Islamic
equity mode of financing more acceptable in financial intermediation. The paper also enumerates the
sources of financing and how could the system of Zakat help in generating the seed capital for proposed
institutions. The related questions as to how the institutional arrangement would work to carry out this
system, how documentation problems be resolved, how trust level can be created, how effective
monitoring can be undertaken and how the intermediaries generate finance themselves and mobilize
funds are answered in this paper.

Keywords: Interest free economy, Public finance, Taxation, Inequality, Income redistribution, Islamic
Economic System, fiscal policy, deficit financing.

    1.   Introduction

1.1.      Background of the Study

The major problems in economic development of any country include poverty, inequality and
unemployment. All other problems are more or less a result of the above-mentioned problems or the
manifestation of these problems. Problems like terrorism and political instability that apparently seem
unrelated to economics are also a consequence of poverty, inflation, inequality and unemployment.

The number of people living in poverty declined in last two decades; however, people living in poverty
rose in Latin America, Sub Saharan Africa, Central and South Asia. Instead of defining poverty line at $1,
if it is raised to $2, people earning $2 are still poor even if not extreme poor. In 2001, there were 1,100
million people living in poverty. But in Sub-Saharan Africa, the number of people in extreme poverty rose
to 313 million. (World development Indicators, UN, 2005)

As people living in extreme poverty increased in number in Africa, they also became poorer. The average
daily income or consumption of those living on less than $1 a day fell from 64 cents in 1981 to 60 cents in
2001. In the rest of the developing world, it increased from 72 cents to 83 cents. Because In Sub-Saharan
Africa, the median share of income going to the poorest 20% of the population is 4.9%, almost 2% points
less than in other developing regions. Only in Latin America and the Caribbean, do the poorest 20% fare
worse. The number of extremely poor people in Sub-Saharan Africa has almost doubled since 1981 to
313 million people in 2001. This is a terrible human tragedy and represents the greatest challenge to
development. (World development Indicators, UN, 2005)

 Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of “Proposal for a New Economic
Framework Based on Islamic Principles”. He has also written 14 papers on Islamic Economics. He is a faculty
member at Szabist, Pakistan. He can be contacted at salmanahmed_hyd@hotmail.com

The number living on less than $2 a day increased from 2.4 billion in 1981 to 2.7 billion in 2001. The 1.6
billion people in the middle, between the $1 and $2 a day poverty lines, are still very poor and remain
vulnerable to economic slowdowns. Countries with literacy rate below 60% are mostly African, Latin
American and South Asian countries. Attainment to education has also become a function of one‟s
income. In Egypt, school attendance of the poorest 20 percent of the population lags from 30% to 45%
behind that of the richest. (World development Indicators, UN, 2005)

Coming out of a debt and poverty trap requires consistent growth for a sustainable period. But,
international trade restrictions take much of the ability to grow from developing countries. Tariffs charged
by high-income countries on goods important to developing countries, such as textiles and agricultural
products, remain high. Subsidies of $350 billion a year to agricultural producers in OECD countries are
another barrier to developing country exports. Global trade is not yet a level playing field.

Other than tariffs, high-income countries accuse developing countries of not following environmental
standards, TBT, SBT etc and thereby reduce further the ability and capacity of developing countries to
gain from exchange and get out of debt and poverty trap. Due to this, most developing countries are
going through a perpetual debt trap which takes away resources that could have been used on
development, but instead are used to service compounded debt.

1.2.       Problem Statement

Given the fact that Islam prohibits interest and that the practiced Islamic finance mostly uses financing
methods which tie cash flows with an interest based benchmark, there is a need to inquire whether the
preferable equity modes of financing are usable in an Islamic economy and what institutional
arrangements could be needed to use them in Pakistan.

1.3.       Objectives of the Study

The study sets forth following important objectives:

       -   To explore alternate instruments in Islamic finance that are not only legal solutions to the
           prohibition of Riba, but are also in consonance with Islamic ethos and philosophy.

       -   To recommend institutional mechanisms to solve the principal agent problem and the problem of
           moral hazard and adverse selection in micro-equity financing.

       -   To suggest application of alternate instruments and changes in plain vanilla Islamic equity modes
           of financing in Pakistan and how they can help reduce poverty in Pakistan.

1.4.       Importance of the Study

The study has significance in academics as well as in policy making. Islamic finance industry mostly uses
KIBOR linked financial contracts which are akin to debt financing than the more preferable participatory
modes of Mudarabah and Musharakah. As per the current orthodox understanding and practice of Islamic
finance, the often cited preferable modes like Mudarabah and Musharakah are incapable even in a simple
model economy with them as the only mode of financing. This study suggests designing financial
intermediation using equity modes of financing.

1.5.       Scope of the Study
The study briefly discusses the problems in current widely used Islamic modes with respect to their
contribution in furthering the objectives of an Islamic economy; then, the study goes on to discuss the
alternate arrangements which could serve as need-fulfillment mechanisms.

1.6.       Limits of the Study

Since the preferable modes of Islamic Finance i.e. Musharakah and Mudarabah are not used by Islamic
Financial institutions (IFIs), empirical analysis of performance is not possible since they are rarely used.
However, since they are regarded as preferable modes by Islamic scholars and are well suited to Islamic
ethos and philosophy, a study on how they can be applied is mandatory.
1.7.    Research Methodology

In this study, extensive literature review on Islamic economics has been done from books, monographs,
research articles and reports/bulletins. In discussing the efficacy of proposed changes in plain vanilla
equity modes of financing and institutional arrangements, an extensive use of economic theory and
analysis through scenario based models has been used to substantiate analysis.

2.        Literature Review

Riba is a technical term in Islamic Shariah. It refers to „Anything paid/charged over and above the
principal amount on a loan‟. Allah in Quran said “Do not do wrong nor be wronged” (Al Baqarah: 279). It
means that interest either results in injustice to the borrower or sometimes it results in injustice to the
lender. That is why, lending or borrowing and taking or giving interest both are not allowed in Islam.

More importantly, prohibition of interest is also due to its discouraging effects on enterprise. If one wants
to invest money to earn profit, Islam has allowed trade over lending for interest. If one does not want to
invest money for profit, but has some surplus funds, Islam has encouraged spending in charity over
lending for interest (Al Baqarah: 276).

On the economic reasons of looking for interest free alternatives, it is worthwhile to mention few studies
on this issue. Siddiqui (2002) criticized interest stating that even in commercial loans, the borrower may
suffer a loss, yet interest based lending obliges him/her to repay the principal plus compound interest.
Conversely, the borrower may reap huge profits, yet the lender gets only the stipulated rate of interest
which may likely turn out to be small part of the actual profits. It results in inefficient allocation of society‟s
resources and increases the inequality in the distribution of income and wealth as it guarantees a
continuous increase in the monies lent out, mostly by the wealthy, and puts the burden of bearing the
losses on entrepreneurs and through loss of jobs on the workers.

Highlighting the moral void in current approach to achieve development, Chapra (2003) viewed secular
societies continuing to belittle the need for moral development; though all of them now profess
commitment to development with justice. He emphasized that even material development with justice is
not possible without moral development. The rationale for this contention is that development with justice
requires an „efficient‟ and equitable use of all resources and both „efficiency‟ and „equity‟ can neither be
defined nor actualized without the injection of a moral dimension into economic pursuits.

Khan (2004) argued against elimination of interest by a legal decree and favored free market forces to
bring the interest rates down to zero. He proposed following policy measures:

       1. Strengthening the system of social security and income maintenance to safeguard the interest of
          lenders whose major source of income is interest i.e. pensioners, widows, retirees, disabled, old

     2. Gradual decline in interest to make investments in debt based instruments less lucrative and shift
        loanable funds towards equity based instruments.

Islamic Finance is a growing industry which is constantly evolving and has been competitive to reach and
sustain its growth momentum amid even the Great Recession and beyond. Assets of the global Islamic
finance industry are estimated to grow to around $1.6 trillion by 2012 (Source: Reuters). Lately, the
Vatican said that banks should look at the rules of Islamic finance to restore confidence amongst their
clients at a time of global economic crisis. (Source: Osservatore, March 04, 2009). Some reports suggest
that assets held by Islamic financial institutions may rise five-fold to more than $5 trillion (Source: Moody‟s
Investor Service).

But, Islamic finance industry mostly uses LIBOR linked financial contracts which are akin to debt financing
than the more preferable participatory modes of Mudarabah and Musharakah. Usmani (2003) describing
the less ideal nature of Murabaha with respect to contributing to the goals of socio-economic
redistribution in economy wrote:

“The instruments of leasing and Murabaha are sometimes criticized on the ground that their net result is
often the same as the net result of an interest-based borrowing. This criticism is justified to some extent,
and that is why, the Shariah supervisory Boards are unanimous on the point that they are not ideal modes
of financing and they should be used only in cases of need with full observation of the conditions
prescribed by Shariah.” (p. 13)

El-Gamal (2008) criticized current Islamic banking by stating that the primary emphasis in Islamic finance
is not on efficiency and fair pricing. Rather, the emphasis is on contract mechanics and certification of
Islamicity by “Shariah Supervisory Boards”.

On the structural shortcomings in Islamic banking to avoid commercial risks, Warde (2000) criticized
Islamic finance on its inability to avoid 'Islamic moral hazard‟; he defined it as unscrupulous behavior on
part of those engaged in Islamic finance. This behavior is encouraged by certain features of Islamic
finance including the assumption of righteous behavior on the part of employees and customers of
Islamic banks resulting in the use of religion as a shield against scrutiny.

Aldrin (2010) cautioned that due to the absence of appropriate Sukuk pricing model, industry currently
uses same pricing benchmark for both conventional and Sukuk Islamic bond i.e. LIBOR. Hence, high
correlation between the two instruments is no surprise; rather it must be a signal for industry to make a
distinctive benchmark for itself.

Andreas & et al. (2008) critically analyzing industry practices in Sukuk argued that compared to the
replication efforts made, less research and efforts were made on how to innovate and develop purely
Shariah based products.

3.      Critical Analysis of Mudarabah

Mudarabah is considered to be one of the most preferable modes of Islamic Finance both by earlier and
contemporary jurists and Islamic scholars. Ibn Taymiyyah observed: "One who deliberates on the basic
principles would easily conclude that Musaqat, Muzara’ah and Mudarabah are nearer to justice than hire."
(Fatawa, Vol.20. p.356).

Maulana Taqi Usmani (2004) in his book “Introduction to Islamic Finance” stated on at least 5 number of
times that Mudarabah and Musharakah are ideal mode of financing respectively on page 12, 17, 72, 107
and 164. His comments on Murabaha which is the most prevalent mode of financing also deserve serious

“It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to
escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam.
Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of
the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah are
not practicable.” (p. 72)

Khan & Mirakhor (1987) commenting on the preferable nature of Mudarabah commented as follows:

“Even though in practice the role of profit-sharing and partnership is very small at present, they continue
to dominate the theory of' Islamic banking. They are regarded as the norms towards which practice
should and would, eventually gravitate.” (p.185-199).

One of the major impediments in the use of Mudarabah on the asset side of a bank i.e. for financing is
that only Rabb-ul-Maal is considered to bear all the financial losses. Therefore, if an Islamic bank enters
into the Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses.
Mudarib (Fund manager) bears no loss while he has the complete authority in running the affairs of the
business. The Rabb-ul-maal (investor) is not allowed to interfere in the affairs of the business (it is unlike
the case in VC funds where the Venture Capitalist could include several covenants for dealing with
agency problem and even select BoD and BoM and change them accordingly). When a loss occurs, the
Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he
was the only reason behind the profits.

Bacha (1997) highlighted serious agency problems in Mudarabah and argued that it lacks the bonding
effect of debt financing and can induce perverse incentives. Using scenario analysis, he showed that for a
„borrower‟ faced with the alternative of using Mudarabah, debt or equity financing, Mudarabah would be
best in a risk-return framework. For a financier faced with the same three alternatives however,
Mudarabah financing would be the worst. Likewise, Khalil et al. (n.d), Dar & Presley (2000), Warde (1999)
and Rosly & Zaini (2008) also highlighted the structurally chronic agency problem in Mudarabah.

State Bank of Pakistan in its report „Financial Stability Review for 2007-08‟ commented on the issue in
following words:

“In fact the agency problem is one of the major factors for the reluctance on the part of banks to
undertake equity based modes of financing, as it gives entrepreneurs the incentive to under‐state profits.”
(p. 7, Chapter 8)

To overcome agency problems, several researchers gave their solutions. Bacha (1997) proposed that the
Mudarib must „reimburse' the Rabb-ul-Maal in the event of certain outcomes. This reimbursement will be
in form of the Mudarib giving up part of his equity to the financier. Sarker (n.d) favored incentives for
honesty like providing stake in the ownership, linking transfer of ownership through granting bonus shares
on the performances, build reserve scheme to induce to hold company shares and provision for profit-
related pay linking with the declaration of profits etc. to reduce the agency problem. Central Bank of
Malaysia allowed tiered profit sharing structure in Mudarabah (Shariah Parameter Reference 3 for
Mudarabah, Bank Negara Malaysia).

Karim (2000) argued that agency problem could be resolved with Mudarib contributing some capital or
collateral in the project. Adnan & Muhammad (2008) argued that while cases of negligence of mudarib
leading to losses are taken care of in mudarabah, proper systems should evolve to establish such
negligence and ascribe the losses to the mudarib. Khan (2003) and Tegani (2003) suggested banks to
guarantee investment deposits by „Tabarru‟ to minimize agency problem.

Now, we analyze these proposals and see how effective they could be in solving the agency problem in
Mudarabah. The proposal by Bacha (1997) is only applicable while the Mudarib is a corporation having its
own paid up capital. His proposal tries to solve the problem after it has occurred rather than preventing it
beforehand. Another possible problem with this proposal is the fact that market value of shares of the
Mudarib‟s corporation could be anything at the time loss occurs in the joint venture of Mudarabah.
Sarker‟s proposal is also focused on incentivizing than preventing the problem beforehand. It also fails to
solve the problem of adverse selection which requires a preventive measure than just incentives. Tier
wise profit sharing structure is not completely agreed upon by scholars worldwide.

The problem is in the disparity in payoffs if loss occurs in Mudarabah. In Mudarabah, to be willing to take
higher risk, the financier would demand higher returns reflected in demand for higher PSR (Profit Sharing
Ratio). But, with higher, PSR, the Mudarib‟s motivation and incentive diminishes especially if the Mudarib
requires bearing no financial losses and already having means of sustenance with another business line.

Now, we present our analysis on the issue. The principle that loss sharing should be based upon and
limited to the amount of capital invested is not a condition mentioned in Quran or authentic Hadith. This
juristic viewpoint didn‟t create much problem during early Islamic era when mostly the Mudarib was a poor
and resource-less person in financial need with limited incentive and authority to enter in corruption and
no capacity to participate in loss sharing if the loss was caused by any reason other than negligence on
his part. This could be appreciated by looking at the specific rules in Mudarabah highlighting the rights
and duties of Mudarib. Mostly, the Mudarib was a skillful, but a poor and resource-starved person in those

In Musharakah, loss participation by all partners across the board is justifiable because all partners are
also allowed to work. But, due to the fact that in Mudarabah, the working partner is the sole authority to
do the business, making Rabb-ul-Maal completely responsible for sharing all losses is unjustified in the
first place.

Consider an Islamic economy with Mudarabah on asset and liability side and there is no other instrument
used, Mudarib (usually blue chip companies) with no liability to share loss can obtain financing from
banks who would be Rabb-ul-Maal in asset side use of Mudarabah. On liability side, bank will be Mudarib
and the small savers and investors will be Rabb-ul-Maal. So, any loss incurred by blue chip companies is
ultimately paid by small savers and investors who have all the liability to share losses without having a
say in the affairs of the business!

Restricted Mudarabah and clause of willful negligence is insufficient to protect them from losses strictly
due to business cycle fluctuations. This example shows that with current structure, even Mudarabah used
alone in an economy is insufficient to bring about any egalitarian change.

Let us analyze trust deficit and documentation problems which are cited as reasons why Mudarabah is
not being used widely. Relax these assumptions and now consider there is no trust deficit and
documentation problem in the economy. If a loss occurs due to business cycle fluctuations, no part of the
loss is borne by the business that had all the authority to run the business. The loss is borne not by the
bank as well because bank is Mudarib on liability side. All loss is borne by the small savers and investors.
Now consider the government prohibits interest based lending and borrowing too. Will the people want to
be Rabb-ul-Maal in Mudarabah with bank or the shareholder in a blue chip company which can take all
the money, invest it, earn from it and if loss occurs, pass it onto the small savers! Mudarabah (with current
structure) even when assumptions of trust deficit and documentation problems are relaxed and even
when there is no competing conventional banking system is ineffective to say the least.

Suppose there is a Company which has established itself with 100% equity investment of Rs
100,000,000. It faces three scenarios in the economy, i.e. Recession, Normal and Expansion. These

scenarios have a bearing on the Sales of the company. We assume that Cost of Goods Sold (CoGS) of
the Company is 60% of the Sales and its Operating Expenses (OE) are 60% of the Cost of Goods Sold.
The Balance Sheet and Income Statement of the Company is presented below. This particular project is
named as „A‟. The company also has a plan to invest in another project which is named as „B‟ in our
example. It has three ways to finance the project „B‟. It could inject more equity, it could issue a bond at
10% rate of interest or it could contact an Islamic Bank and enter into a Mudarabah agreement as

ROE is calculated as Net Profit (NP) divided by Equity multiplied by 100. Since we have not deducted
interest expense separately from Operating Expenses (OE), we deduct from NP (Net Profit) the interest
expense (Interest Based Liabilities x 10%) and then divide the result by Equity to obtain RoE when debt
financing is used.

Project A:Investment:100 Mln)    Income Statement (Recession)       Income Statement (Normal)           Income Statement (Expansion)
Scenarios                        Particular      Rs.                Particular      Rs.                 Particular     Rs.
Phase        Sales               Sales           5,000,000          Sales           20,000,000          Sales          50,000,000
Recession    5,000,000           Less: CoGS      3,000,000          Less: CoGS      12,000,000          Less: CoGS     30,000,000
Normal       20,000,000          GP              2,000,000          GP              8,000,000           GP             20,000,000
Expansion    50,000,000          Less: OE        1,800,000          Less: OE        7,200,000           Less: OE       18,000,000
                                 NP              200,000            NP              800,000             NP             2,000,000

                                 Balance Sheet       (100%   Non-   Balance Sheet       (100%    Non-   Balance Sheet (100%        Non-
                                 Leveraged)                         Leveraged)                          Leveraged)
                                 Total Assets    100,000,000        Total Assets    100,000,000         Total Assets   100,000,000
                                 Liabilities     -                  Liabilities     -                   Liabilities    -
                                 Equity          100,000,000        Equity          100,000,000         Equity         100,000,000
                                 RoE             0.20%              RoE             0.80%               RoE            2.00%

In the example below, first we assume that the Company incurs a loss in all scenarios on Project „B‟. The
analysis will show the impact on ROE if the company incurs a loss. Project „B‟ requires an investment of
Rs 25,000,000. We assume that Cost of Goods Sold (CoGS) of the Company is 60% of the Sales and its
Operating Expenses (OE) are 75% of the Cost of Goods Sold. The Consolidated Balance Sheet
(combining both projects) and Income Statement of the Company is presented below.

Project B (Investment: 25 Mln)

            Scenarios            Income Statement (Recession) - B   Income Statement (Normal) - B       Income Statement (Expansion)
Phase        Sales               Particular      Rs.                Particular      Rs.                 Particular    Rs.
Recession    1,000,000           Sales           1,000,000          Sales           4,000,000           Sales          10,000,000
Normal       4,000,000           Less: CoGS      600,000            Less: CoGS      2,400,000           Less: CoGS     6,000,000
Expansion    10,000,000          GP              400,000            GP              1,600,000           GP             4,000,000
                                 Less: OE        450,000            Less: OE        1,800,000           Less: OE       4,500,000
                                 NP              (50,000)           NP              (200,000)           NP             (500,000)

                                       Consolidated Balance Sheet            Consolidated Balance Sheet           Consolidated Balance Sheet
                                              (100% Equity)                         (100% Equity)                        (100% Equity)
   Project B Financed with Equity   Total Assets    125,000,000           Total Assets    125,000,000           Total Assets   125,000,000
                                    Liabilities     -                     Liabilities      -                    Liabilities        -
                                    Equity          125,000,000           Equity           125,000,000          Equity             125,000,000
                                    RoE                  0.12%            RoE                   0.48%           RoE                       1.20%
                                    Consolidated Balance Sheet (80%       Consolidated Balance Sheet (80%         Consolidated Balance Sheet
                                                 Equity)                               Equity)                            (80% Equity)
  Project B Financed with Debt at   Total Assets    125,000,000           Total Assets    125,000,000           Total Assets     125,000,000
                                    Liabilities     25,000,000            Liabilities      25,000,000           Liabilities            25,000,000
                                    Equity          100,000,000           Equity           100,000,000          Equity                 100,000,000
                                    RoE                 -2.35%            RoE              -1.90%               RoE                       -1.00%

                                    Consolidated Balance Sheet (80%       Consolidated Balance Sheet (80%         Consolidated Balance Sheet
                                                Equity)                               Equity)                            (80% Equity)
     Project B Financed with        Total Assets    125,000,000           Total Assets     125,000,000          Total Assets           125,000,000
    Mudarabah with PSR = 50%
                                    Mudarabah       25,000,000            Mudarabah        25,000,000           Mudarabah              25,000,000
                                    Investment                            Investment                            Investment
                                    Equity          100,000,000           Equity           100,000,000          Equity                 100,000,000
                                    RoE                  0.20%            RoE                   0.80%           RoE                       2.00%

 It could be seen that RoE is higher in all scenarios (Recession, Normal and Expansion) if the company
 finances project B with Mudarabah financing. Now, we consider what happens if there is a profit in Project
 „B‟ in 3 scenarios i.e. Recession, Normal and Expansion. The example shows that the company will still
 be having better ROE with Mudarabah if PSR is relatively high. The ROE in Mudarabah with high PSR is
 comparatively better than ROE in the case when the company issues bonds and also when it issues
 equity to finance project.

 We assume that Cost of Goods Sold (CoGS) of the Company is 60% of the Sales and its Operating
 Expenses (OE) are 60% of the Cost of Goods Sold. The Consolidated Balance Sheet (combining both
 projects) and Income Statement of the Company is presented below.

Project B Investment: 25 mln

                                    Income Statement (Recession) -                                                            Income Statement
            Scenarios                            B                            Income Statement (Normal) - B                     (Expansion) – B
Phase          Sales                Particular                    Rs.         Particular                  Rs.       Particular                       Rs.

Recession         1,250,000         Sales                1,250,000            Sales                 2,500,000       Sales                  25,000,000

Normal            2,500,000         Less: CoGS             750,000            Less: CoGS            1,500,000       Less: CoGS             15,000,000

Expansion       25,000,000          GP                     500,000            GP                    1,000,000       GP                     10,000,000

                                    Less: OE               450,000            Less: OE               900,000        Less: OE                9,000,000

                                    NP                      50,000            NP                     100,000        NP                      1,000,000

                                   Consolidated Balance Sheet                Consolidated Balance Sheet         Consolidated Balance Sheet
                                         (100% Equity)                             (100% Equity)                      (100% Equity)

                                 Total Assets          125,000,000         Total Assets      125,000,000       Total Assets    125,000,000
Project B Financed with Equity
                                 Liabilities                     -         Liabilities                    -    Liabilities                   -

                                 Equity                125,000,000         Equity            125,000,000       Equity          125,000,000
                                 RoE                    0.20%              RoE                  0.72%          RoE                2.40%

                                   Consolidated Balance Sheet                Consolidated Balance Sheet         Consolidated Balance Sheet
                                          (80% Equity)                              (80% Equity)                       (80% Equity)

                                 Total Assets          125,000,000         Total Assets      125,000,000       Total Assets    125,000,000
Project B Financed with Debt
            at 10%               Liabilities            25,000,000         Liabilities        25,000,000       Liabilities      25,000,000

                                 Equity                100,000,000         Equity            100,000,000       Equity          100,000,000
                                 RoE                       -2.25%          RoE                    -1.60%       RoE                   0.50%

                                   Consolidated Balance Sheet                Consolidated Balance Sheet         Consolidated Balance Sheet
                                          (80% Equity)                              (80% Equity)                       (80% Equity)

                                 Total Assets          125,000,000         Total Assets      125,000,000       Total Assets    125,000,000
   Project B Financed with       Mudarabah                                 Mudarabah                           Mudarabah
         Mudarabah               Investment             25,000,000         Investment         25,000,000       Investment       25,000,000

                                 Equity                100,000,000         Equity            100,000,000       Equity          100,000,000
                                 RoE (PSR=5%)              0.203%          RoE (PSR=5%)           0.805%      RoE (PSR=5%)          2.050%
                                 RoE (PSR=10%)             0.205%          RoE (PSR=10%)          0.810%      RoE (PSR=10%)         2.100%
                                 RoE (PSR=20%)             0.210%          RoE (PSR=20%)          0.820%      RoE (PSR=20%)         2.200%
                                 RoE (PSR=30%)             0.215%          RoE (PSR=30%)          0.830%      RoE (PSR=30%)         2.300%
                                 RoE (PSR=40%)             0.220%          RoE (PSR=40%)          0.840%      RoE (PSR=40%)         2.400%
                                 RoE (PSR=50%)             0.225%          RoE (PSR=50%)          0.850%      RoE (PSR=50%)         2.500%
                                 RoE (PSR=60%)            0.2300%          RoE (PSR=60%)         0.8600%      RoE (PSR=60%)        2.6000%
                                 RoE (PSR=70%)            0.2350%          RoE (PSR=70%)         0.8700%      RoE (PSR=70%)        2.7000%
                                 RoE (PSR=80%)            0.2400%          RoE (PSR=80%)         0.8800%      RoE (PSR=80%)        2.8000%
                                 RoE (PSR=90%)            0.2450%          RoE (PSR=90%)         0.8900%      RoE (PSR=90%)        2.9000%

 The above example shows the condition of preference for the company about choosing a particular
 financing method if it has profit.

                                                      Condition of Preference
                                               Debt              (Kd*TD)<(PSR*GP)
                                               Mudarabah         (Kd*TD)>(PSR*GP)

 The Company will choose equity if its ROE with conventional equity financing is more than ROE in
 Mudarabah financing. Its ROE will be more in conventional equity financing if PSR is lower. Hence, to be

encouraged to finance through Mudarabah, the Company will want higher PSR in Mudarabah. Demand
for higher PSR which equates both ROEs could be beneficial for financee, but fruitless for the Islamic
Financial Institution since it will get smaller returns with unlimited and exclusive exposure to financial risk.
The problem of adverse selection necessitates a preventive mechanism than an incentive mechanism.

With important covenants in place, equity financing can be used and is used widely. It is interesting to
study the size of debt and equity market in developing countries. For instance, in Pakistan, corporate
bond market hardly exists, whereas equity financing is more prevalent and widely used. Equity financing
through shares will forever deny the claims of bankers in general and Islamic bankers in particular who
hide behind trust deficit and documentation problems. Why people invest in shares of companies without
any guarantee over par value let alone dividend?

In Mudarabah, following two covenants can be introduced.

a) Mudarib can be asked to contribute some capital. The contract will still remain different from
Musharakah as only the Mudarib is the working partner.

b) Mudarib can be asked to share in loss to some extent.

These two covenants will minimize the problem of adverse selection, moral hazard and principal-agent

There is a famous Hadith in this regard which clearly states:

     “All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is
                                    prohibited or prohibited which lawful.”

It may be argued that these two covenants may violate the principle of Al-kharaj bil Daman (Link of
exposure to risk i.e. one can claim profit only if one is ready to bear the business risk).

These covenants will not result in violation of the said principle because the proposal is not to transfer all
liability to the Mudarib and guarantee profit to the Rabb-ul-Maal. Rabb-ul-Maal will still be liable to bear
losses, but Mudarib by way of participation with some capital will also feature in loss sharing. It is unlike
the proposal by Khan (2003) and Tegani (2003) who suggested banks to guarantee investment deposits
by way of „Tabarru‟.

To structure this model in compliance with principles of Islamic Fiqh, combination of Musharakah and
Mudarabah can be used whereby Mudarib in lieu of participation with capital will become a Sharik in the
combination. This combination is prevalent in offering liability products and is proposed by Maulana Taqi
Usmani (2004, p. 36) for project financing as well.

Infact, it is interesting to study whether the principle of Al-Khraj bil Dhaman and Al-Ghanum bil Gharam
(One is entitled to a gain only if one agrees to bear the responsibility for the loss) are violated in
Murabaha and all prevalent Islamic Finance contracts where unilateral undertaking which is binding as
well links two sales contracts or one sale and the lease contracts. Masri (2002) argued that unilateral
undertaking must be inadmissible in Sale and lease contracts wherein the unilateral undertaking is taken
by the bank before it has possession of the goods.

4.       Fiscal Side of the Proposed Poverty Alleviation Framework

Zakat is a religious obligation to pay a part of wealth and production to the government. Islahi (1985) and
Qardawi (2000) explained that it is not necessary to make some living person the owner of the Zakah.

                                                     - 10 -
Zakah can be given to any person or cause or an organization working for a cause. It is not necessary to
make some living person the owner of the Zakah. This argument provides an opportunity to use Zakat
funds by using an intermediary to make allocation widespread, efficient and effective.

Ghamidi (2007) in his monumental book „Meezan‟ has argued that no tax can be levied other than Zakah.
Following narrations point to the fact that Zakat is the only compulsory payment to the government on
one‟s income and wealth in an Islamic economy.

a) There is no [legal] share [for the society] in the wealth [of people] except Zakat.” (Ibni Maajah: Kitab-uz-

b) “After you have paid the Zakat of your wealth, you have paid [all] that was [legally] required of you.”
(Ibni Maajah: Kitab-uz-Zakat).

c) “No tax-imposer shall enter paradise.” (Abu-Daud: Kitab-ul-Khiraj).

Neither the Prophet Muhammad (P.B.U.H) nor the pious Caliphates (rta) levied any tax other than Zakat
even when they were aware of the taxes imposed by neighboring non-Muslim countries on their citizens.
Zakat is a tax in the sense that it is involuntary payment to the government who would use the Zakat
funds on eight heads of Zakat mentioned in Verse 60 of Al-Tauba. It may be argued that had the
government finances were not financed solely through Infaaq; the government would have levied other
taxes. But, since such a need didn‟t arise, taxes were not levied by Caliphates or by Prophet Muhammad

Zakat is actually a tax. Tax is involuntary payment to the government. Zakat is also involuntary payment
to the government. Three Ahadith quoted above, verse 5 of Al Tauba and the declaration by Hazrat Abu
Bakar (rta) that “I will not take anything less or more than the Zakat people used to pay in Prophet‟s
(pbuh) time)” are the reasons why some scholars think that Zakat is the only tax that an Islamic
government can levy and this author agrees with that proposition.

A very simple question to the above mentioned argument is that does the government first announce to
the people to pay voluntarily and then impose taxes? If it can impose taxes, then, it certainly will impose
taxes in the first place.

Zakat is the right of the government who would use the Zakat funds on eight heads of Zakat mentioned in
Verse 60 of Al-Tauba. That is why, there is a mention of „Aamileen a Alaiha‟ in verse 60 of Surah Al
Tauba. Hazrat Abu Bakar (rta) said as head of the government that “I will not take anything less or more
than the Zakat people used to pay in Prophet‟s (pbuh) time”. Letters of Khulfa-e-Rashideen (rta) to the
Aamileen are all testimony to that.

Secondly, if it is the right of the government, then it should use the right before asking people for Infaaq.
Does it remain to have any right to levy taxes based on three Ahadith, Verse of Quran, Qaul-e-Sahabi,
and Amal-e-Khulfa-e-Rashideen?

Furthermore, an argument is presented that taxes mentioned in the Ahadith quoted above were special
taxes and they were oppressive and involuntary. This is a very weak argument as Zakat is that part of
Sadaqah, which is obligatory and which is involuntary. It does not matter whether the taxes are low or
high, they remain an instrument to fetch a part of wealth and production from the citizens by the state.
This is required as the government needs finances to run its operations. But, Allah solved this natural
tension between citizens and the state by defining the line as to how much of taxes could be levied.
Zakah is Ibadah for an individual, but it is also a tool for government to run its operations by spending on
particular heads. For instance, Jihad is an Ibadah for Mujahid, but it is also a tool for a country to defend

                                                    - 11 -
its territory and citizens from foreign invasion. The rate of interest, amount of theft, quantity of liquor
taken, quantity of pork eaten etc do not matter in absolute prohibition of Riba, stealing, liquor and pork
etc. Likewise, low or high rate of taxation does not matter.

Further, concept of „Ushr‟ can be applied in industrial production as well on the premise that rain fed land
was taxed at 10% and irrigated land was taxed at 5% during Prophet‟s (pbuh) time. Ghamidi (2007)
argued that rain fed land use primarily labor as a factor of production; whereas, irrigated land use both
labor and capital. Thus, production from industries employing both labor and capital can be taxed at 5%
and those employing only labor or capital can be taxed at 10%. This proposal will expand the tax base in
an interest free economy and hence the revenues which will provide access to funds to the micro equity
intermediaries in the proposed framework.

Zakatable assets should include all assets above the value of nisab except the assets in personal use
and means of production. Minimum Nisab Amount is the market value of 612 grams of silver only as
explained in the Hadith quoted below.

“There is no Zakat below five wasaqs of dates; there is no Zakat below five uqiyahs of silver and there is
no Zakat below five camels.” (Mu‟atta Imam Malik, No: 578)

Investment in stocks should be interpreted as any other investment with some means of earning income.
Stock is a means of earning dividend or capital gains. Just like means of production/income are exempt
from Zakat, investment in stocks should be exempted from Wealth Zakat as investment in stocks means
that the money is not kept idle. Therefore, any income arising from investment in stocks i.e. capital gains
or dividend must be subject to Ushr. Similarly, this argument could be extended to introduce Ushr on
income from mutual funds, investment in other financial instruments etc. Likewise, if land/building/house
is leased, the land/building/house becomes the means of earning rent. Hence, Ushr could also be
introduced on rental income on houses, assets, buildings etc. Through an empirical study, Shaikh,
Salman (2010) concluded that Zakat in this way can relieve the government of Pakistan from deficits.

In the proposed framework, it is suggested to discontinue interest based financial system complimented
by an imposition of broad based wealth tax (Zakah). An imposition of wealth tax (Zakah) would ensure
that loanable funds increase even when there is no interest. The loanable funds would be invested in
equity modes of financing including Mudarabah and Musharakah. Investments in equity will be exempted
from wealth tax. This would ensure that investors get a minimum return i.e. tax savings plus income on
their equity investments. This tax exemption would also ensure the availability and supply of loanable
funds. Such a lenient taxation structure will itself increase productive activities, employment generation on
a large scale and higher tax collection for the government. It will allow the government to allocate more
resources on development.

5.     Poverty Alleviation in Proposed Framework

In Pakistan, about 40% people live below the poverty line (SBP Annual Report, 2010). Approximately,
more than half of the population of Pakistan still lives in rural areas where Microfinance is needed.
Approximately, 40% of the labor force is employed in Agriculture and this sector can be the main target
market for Microfinance.

Pakistan is the 7th largest country in population and has huge supply of young labor aged between 15
and 40. Density of population is high in Pakistan and therefore, transaction costs would be lower than in
regions where density of population is low. Agri-based economies of Africa and Asia have fared well with
increase in agriculture prices worldwide. Agriculture sector has not witnessed recession in the economic
crisis of 2007-08. Inelastic demand of agriculture goods can better mitigate inflation and profitability risk.

                                                    - 12 -
5.1.    Financing Arrangements

It is a hard enough job to keep record and supervise/regulate lending business in a grossly
undocumented area. It would be a very daunting task to supervise/regulate while providing equity based
financing. Profit Participation Certificates or Qard-e-Hasan can be provided, but that will create problems
of supervision and documentation besides increasing the risk and limiting business profit potential.

This need can be met through two separate institutions:

1. Several Micro Venture Capital (VC) funds could be established either privately owned or government
   owned that could invest in Micro enterprises. The idea is that it is difficult to document each and every
   person's business. Therefore, group based lending will be provided. The group could form itself as a
   Micro enterprise. A Micro enterprise could be able to obtain economies of scale, better bargains and
   tap market effectively.

2. There will be individuals left who will not be able to form a group and hence a micro enterprise and
   will require standalone financing. They could be financed through Qard-e-Hasan for consumption or
   small hard to be repayable business loans or by issuing Profit Participation Certificate (PPC).
   Showing honest records would be incentivized and bad performance will cease doors for further
   financing and hence encourage honest showing of business performance.

Figure 1: Micro VC Fund Established by Government

Figure 2: Micro VC Fund Established by Private Sector

                                                   - 13 -
5.2.        Sources of Funds

The source of funds will be as follows:

       1.   Government (Zakat Receipts).
       2.   Donors both local and foreign.
       3.   General and limited partners in a VC.
       4.   Small savings of dwellers.
       5.   Reserves built-up in past.
       6.   Commercial enterprises investing to get tax rebates.
       7.   Commercial enterprises investing to improve corporate image.

Now, the question arises where will the work come from?

5.3.        Employment Creation

The work will come in following forms:

a) Corporations outsourcing some of their tasks and operations. Corporations will need an incentive to
     outsource work to the micro enterprises funded by the Micro VC fund. The incentive will come from:
   i. Lower wages in rural areas than urban areas.
  ii. Obtaining production even without incurring huge capital expenditures, acquisition of fixed assets,
       factory etc and

                                                    - 14 -
  iii. Operational efficiency as there will be no need to hire permanent labor for the whole year.

b) Domestic work projects in rural areas producing a particular need of a rural, urban or export market.

c) Herding livestock in one's ownership or rendering this service for others.

d) Sharecropping using tenant-landlord or Musharakah / Mudarabah model. A precursor to this initiative
   would be an extensive land reform. Group based lending would ensure that land size is not reduced
   to an economically inefficient size.

e) Development/Construction projects in rural areas, e.g. building roads, schools, colleges, healthcare
   centers, mosques, bridges, cold storages, warehouses, railway tracks, post offices etc.

The regions where population density is lower, mobile banking would be introduced in those areas. With
the increase in number of Micro enterprises and Self-Employed Persons (SEP), wages in rural areas
would increase. But, since there would be a disincentive to migration, corporations outsourcing their work
projects will still save money in labor cost.

The human resource involved in Micro VC fund will be given compensation based on profit sharing, so
that moral hazard and principal-agent problem can be avoided.

The group will constitute members who can bring social collateral i.e. hold good image in their locality.
Repayment incentives could be provided e.g. enhancing future credit line and a child's tuition fee for 1
year reimbursed if loan is paid on time.

5.4.     Issue of Documentation, Security & Collateral

Poor villagers are members of a family system which usually has a larger family size than urban areas
and has closer relations with other families in the villages. Unlike in urban areas, an adult man in a village
is better known in his locality. Training shall be made compulsory to all members of the micro-enterprise.
Training would be provided before they are given membership.

Poor villagers have limited capacity to enter in corruption. They can hardly migrate abroad but they may
decide to migrate to urban areas. To confront this case, a special mention can be made on their I.D cards
that they have benefited from such Micro Enterprise/VC Fund. Furthermore, they will be asked to bring No
Objection Certificate (NOC) from such and such Micro Enterprise/VC Fund. They would be hardly trained
in diverse works than the ones in which they would be provided with training. They would hardly have any
work experience other than the work they would be trained to do under the patronage of the Micro
Enterprise/VC Fund. Therefore, they will have to mention their training and/or work experience to get a
job in urban areas and at that point, they will have to show their IDs. Urban employers might hire them
paying below minimum wages, but they will be penalized if such a happening comes under the
knowledge of labor inspection team which would make regular visit to urban work settings to identify such
a happening and prevent it from becoming a norm at least.


This study argued that financial intermediation in microfinance can be designed using Islamic equity
modes of financing with some added covenants in plain vanilla Mudarabah and Musharakah. This can
increase diversity of entrepreneurial activities as in debt based microfinance, not much diversity can
happen with compulsory servicing of debt. The institutional arrangement would involve introducing Micro
equity funds taking stakes in micro enterprises which will comprise people in need of finance. The related
questions as to how documentation problems be resolved (centralized computerized database), how trust

                                                    - 15 -
level can be created (strong communal bonds in rural areas will serve the purpose), how effective
monitoring can be undertaken (cross guarantees) and how the intermediaries generate finance
themselves (Zakat, CSR contributions by corporations, opening saving accounts and mobilize funds are
answered in this paper.


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