Contemporary Islamic Finance: Innovations, Applications and Best Practices

CHAPTER 15

How Does an Islamic Microfinance Model Play the Key Role in Poverty Alleviation?

The European Perspective*

SABUR MOLLAH

Associate Professor of Finance, School of Business, Stockholm University

M. HAMID UDDIN

Associate Professor of Finance, College of Business Administration, University of Sharjah

INTRODUCTION

The Secretary General of the United Nations declared 2005 as microcredit year for microfinance institutions (MFIs), for being so successful in alleviating poverty Murdoch (1999), in this regard, has pointed out that lending to poor households is doomed to failure as the costs are too high, risks are great, saving propensities are too low, and few households have much to put up for collateral. But MFIs have overcome these criticisms by adopting group lending, which can mitigate these problems (Stiglitz 1990). Under group lending methodology, group members agree to shoulder a monetary penalty in the case of default. The group members have incentives to monitor each other, and can potentially threaten to impose “social sanctions” when risky projects are chosen. Neighbors can monitor each other more effectively than a bank. Thus, the potential for effective delegation evolves for monitoring microlending to borrowers.

Haqq (2011) has found that major microfinance institutions like the Grameen Bank and others operate with an “ignorance zone,” as 98 percent of the participants are uneducated about the terms of credit and interest rates. Therefore, conventional MFIs have ...