Ensuring Shariah Compliance in Microfinance with New Modes: Case of Istijrar

About a decade ago, I came across a financial mechanism being used by Muslim Commercial Bank of Pakistan for financing cotton purchases. The New Horizon magazine had carried a 50-words brief write-up on it as an example of a new financial instrument. However, the brief description of the instrument was enough to whet my appetite to search for its parallel in fiqh. What I found was fascinating, to say the least. The mechanism in a simple form was known in the literature as istijrar or tawreed and implied a sale contract involving repeated purchases from a single seller. Since the MCB arrangement also involved options for buyer and seller that would get activated when the price shot through upper and lower bounds, I found it quite intriguing. I wrote about it in several well-known publications in the field of Islamic Economics. It was the more complex form of istijrar, i.e. with stipulation of options that was the subject of my analysis. I always looked at istijrar from an academician’s perspective. Istijar with options was an elegant contract that had built-in risk management mechanism against commodity price volatility. It was a rare combination of a forward contract, with Barrier Option and Asian Option like features.

I found a mention of istijrar subsequently in a few papers/ speeches/ conference presentations as an example of a creative financial solution. For some unknown reason the instrument had never made it to the portfolio of mainstream Islamic FIs. However, it was not until I visited the Islami Bank Bangladesh to get a first hand account of their Rural Development Scheme, that I realized the significance of this fiqhi solution.

Istijrar or tawreed is a variant of the bai or sale contract and implies a contract involving repeated purchases from a single seller. Since the sale and purchase under istijrar involve the same buyer and seller over extended periods of time, it is expected that their relationship will be one of mutual trust. In such a scenario, the Sharah requirement of specification of price at the time of contracting with the bai or exchange contract is relaxed. The buyer and seller with mutual consent may agree to continue their exchange without specifying the contractual or settlement price every time there is a transaction and to settle several transactions together at specific time intervals. Arguably, under this type of continuous relationship the possibility of conflict between the parties is minimal as long as they pre-agree on the source and the basis of calculating the settlement price. Therefore, this is a case of tolerable gharar and therefore, permitted. Indeed, the settlement price could be the market price (with mark-up) prevailing at the time of contracting, or the at the time of settlement, or even the average of prices ruling over the time period. The arrangement however, significantly increases the convenience factor for the parties.

To understand how the use of this mechanism may provide a solution to RDS and other Islamic microfinance initiatives, let me place the following fact about the operational and lending methodology of RDS. RDS essentially replicates the Grameen model, but with a Shariah-compliant bai-muajjal financing that costs almost half the price of a Grameen loan.

Coverage: Since the RDS uses the existing branch network of its parent, the IBBL, it restricts its coverage to suitable villages within 16 kilometers radius of an existing IBBL branch. The criteria used in selecting a village are: (a) easy communication; (b) availability of agriculture and other off-farm activities; (c) abundance of low-income people; and (d) predominance of Islamic values and ideas. As of now, RDS covers sixty out of sixty-four districts in the country through one hundred and sixteen Branches of IBBL leaving aside the metropolitan and the hill tract areas.

Criteria for Eligibility: After primary selection of a project area consisting of four to six villages, the Branch conducts detailed Baseline Survey to identify the target group and the verifies of economic activity in the area. The RDS like Grameen employs strict means-test criteria to identify the potential beneficiaries. The eligible beneficiaries are restricted to (i) able-bodied & industrious rural poor having age between 18 to 50 years and the permanent resident of the selected area; (ii) farmers having cultivable land of a maximum of 0.50 acres and the sharecroppers; (iii) persons engaged in very small off-farm activities in the rural areas; and (iv) destitute women and distressed people. Persons having liabilities with other banks/institutions are not eligible for financing under the Scheme.

 Formation of Groups and Centre: The target people are organized in groups of five – preferably comprising people of similar occupation. It takes a minimum of two and a maximum of eight such groups to set up a center that is put under the direct supervision of a Field Officer (FO). At least four hundred beneficiaries are placed through the centers under one FO. Each group selects a group leader and a deputy group leader. The group leaders in a center select the centre leader and the deputy centre leader who are responsible for overall discipline and performance of the centre. At times, the centers are named after prominent Islamic personalities.

Weekly Meetings: The centre has to conduct regular weekly meeting on a fixed date and time in presence of the FO to collect compulsory savings and weekly installment payments. Centre meetings are recorded in a Resolution Book along with signature of the members (members who do not know how to sign must learn it). Attendance in the centre meeting is the first requirement to become a dependable client of RDS. Weekly meetings begin with recitation from the holy Quran followed by discussions on the Islamic way of life. This is followed by discussions on proposals for new enterprises that are expected to lead to self-employment and generate income for the micro-entrepreneurs. Proposals are submitted for approval with recommendation from the members and the centre leader. Every attempt is made to resolve disputes, if any, among members. The meeting is followed by physical inspection of at least two client-locations to see whether the goods have been actually purchased and are in possession of the client.

A close look at the working of the RDS in the field reveals certain anomalies. RDS uses bai-muajjal – where the bank is supposed to purchase the commodity required by its client from the vendor and resell the same to the client at a profit – as the Shariah-compliant mode of financing. In order to ensure that this mode is distinct from conventional ribawi loan, scholars of fiqh insist on several conditions that must be fulfilled. For example, the financing must involve two distinct transactions – between the bank and the vendor or supplier of the commodity and then between the bank and the client. However, when the bai-muajjal is executed in actual practice involving recurrent and copious transactions on a day-to-day basis, the separation between the two transactions in each bai-muajjal financing seems to get blurred to an extent that the end result is often a cash-for-cash transaction. Further, it is an important requirement of Shariah compliance that the commodity must remain in ownership of the bank for some time between the two transactions. It is the risk of ownership factor that justifies the profits as a reward for risk. Ownership is often evidenced by related documentation. Such checks and balances are easily  put in place in case of mainstream IFIs where financing involves large amounts and transactions are fewer in number. Micro finance by definition, involves small amounts in large frequencies. For instance, I was told that each FO in RDS dealt with 80 clients on average every day; worked through five days dealing with 400 clients and reported to the branch on the last day of the week. One can well imagine the quantum of administrative work involved in 80 murabahas (each involving settlement of two distinct transactions in different commodities and with different prices) every day. While dealing with similar number of clients was perhaps possible with simple cash loans (e.g. of Grameen), it was too much to expect the RDS staff to carry the additional administrative burden that came with the need for Shariah compliance. The informal setting of rural markets and businesses did not make documentation any easier.

Arguably, monitoring costs even for the simple conventional micro-loans is quite high. These would be far higher for bai muajjal financing if proper monitoring of end-use including Shariah compliance is undertaken. A possible way out is to use bai istijrar in lieu of bai muajjal. Use of istijrar will accord great flexibility in settling the transactions at regular mutually agreed time intervals (unlike bai-muajjal that must be settled at the end of each transaction). The MFI can establish long-term istijrar arrangements with suppliers of key raw materials that is required by its clients and that it intends to finance. It may enter into similar istijrar arrangement with its clients. It may permit its clients to act as its agents and take repeated delivery of the raw materials directly from the suppliers. At monthly or quarterly or even longer intervals (that is mutually agreed upon) it may settle the transactions with its clients as well as with the supplier(s). This would substantially reduce the administrative costs while ensuring Shariah compliance.

Note: For further discussion on Istijrar, see Islamic Financial Services, Page 189-192, by this author.

Mohammed Obaidullah | April 25, 2014

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