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30 Jun 2019 
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Islamic microfinance on the other hand, faces more challenges compared to its conventional counterpart. Although Islamic MFIs follow the same dual objective as Conventional MFIs (financial and social objective) they also face the challenge of being strictly operating as the principles of the Islamic law (Sharia). In addition, although Islamic MFIs serve the same category of clients (poor and the poorest of the poor) and face the same high level of default risk, yet, these institutions face more challenge because they are supposed to operate according to the Islamic law in which interest based financial products are prohibited. Profits are generated from three category of financing viz. trading, leasing and direct financing based on profit and loss sharing principle. Sharia-compliant products are considered as investment instruments (i.e. the Mudaraba and Musharaka contracts) except the Murabaha contract and Qard Al-Hasan, which are the Islamic alternative of regular debt instruments. Beside differences of financial products and services that Islamic MFIs offer compared to the Conventional counterparts, their capital structure also show a several number of differences. For example, some of the funding sources of these Islamic institutions such as philanthropic funds under Wakala model, Zakat funds and Awqaf funds (Ismail & Possumah, 2012). Moreover, the deposits on the liability side are considered as investment accounts in the form of Moudharaba contract, thus, depositors are considered as shareholders (Abdul Karim et al., 2014). The characteristics of the financial resources of Islamic microfinance institutions are unique.
The capital structure choice is an important decision in the management of financial institutions. The vast majority of theoretical and empirical work does not distinguish between firms and banks and mostly concerns non-financial firms only. Modern finance theories are essentially developed to explain the choice between debt and equity financing. Each theory proposes a number of indicators that determine the
Chapter 1:
Capital Structure and Efficiency of Conventional and Islamic Microfinance Institutions: Theoretical literature
Capital structure can be defined as the relative proportions of debt, equity and other securities that constitute the capital structure (Baker et al., 2004). Capital structure theories explore the relationship between debt and equity financing and the market value of the firm. The capital structure literature is constituted of three major theories which diverge from the assumption of perfect capital markets under which the irrelevance model proposed by Modigliani and Miller (1958). These three main theories are: 1) the trade off theory, 2) the peaking order theory, and 3) the market timing theory. The capital structure\’ theories differ in their interpretation of various factors known as taxes costs, bankruptcy costs, asymmetric information and agency costs. The studies on the capital structure of financial and banking institutions are inspired by the corporate financial theory; the capital structure is thus studied without the consideration of prudential regulation. In addition, the analysis of the financial structure of the banks integrates the regulatory constraints.
The ability of microfinance institutions to absorb unexpected losses depends critically on the amount of equity and the ability to monitor capital adequacy and solvency ratios. It is in this context that the Basel Committee on Banking Supervision (BCBS) has developed the three main prudential regulatory agreements: Basel I, Basel II and Basel III. The purpose of the Basel agreements is to impose solvency and prudential supervision requirements on banks. The first Basel I agreements date back to 1988 and mainly provided for a ratio of 8% of equity to loans granted, also called the Cooke ratio. The Basle II agreements, which came into force in 2008, mainly provided for a risk-weighting of the credits granted by the banks for the calculation of their solvency ratio, the former Cooke ratio, which became the McDonough ratio on that occasion. The Basel III agreements, drawn from the lessons of the 2008 financial crisis, mainly provide for a more restrictive definition of equity, the creation of a liquidity ratio, and a maximum leverage ratio since equity must represent at least 3% of a bank\’s total assets. Their implementation is progressive and extends until 2019.
The chapter will be organized in 3 parts microfinance institutions. Section 1 will provide a comparison of the capital structure between conventional and Islamic microfinance institutions. Section 2 will discuss financial theories related to capital structure in the context of microfinance. Section 3 will discuss prudential regulation and adaptation of the Basel agreements for microfinance institutions.
Section 1: Capital structure of Conventional and Islamic microfinance institutions
Microfinance institutions (MFIs) are considered as micro-banks providing financial products such as micro-credit and micro-saving to poor clientele excluded from formal financial system. This particular category of clients are considered to be very risky since they don’t have a fixed income and they cannot provide guarantees and collaterals as an exchange for borrowing and thus, they are often exposed to repayment difficulties. The majority of MFIs have always been supported by external sources of funding (Atkinson et al., 2011, Bogan, 2012). Since their early ages these institutions has often depended on subsidies and concessional loans from governments and donor organizations. Recently, a growing number of MFIs witnessed a commercialization movement and transformed their capital structure from donations based toward a financial structure connected to financial markets and composed of investment funds in the form of loans at markets rates and investments equities (Ledgerwood, 2013). This transformation from non- government organizations and unregulated institutions to a regulated for profit institutions allows them for greater funding diversifications and opportunities (Hoque et al., 2011). MFIs across the world have different characteristics. They can register and operate as cooperative (the majority of Islamic MFIs in Indonesia), credit union (in UK) or NGOs (in Bangladesh, Pakistan and Latin America). Some of them have transformed into commercial and formal institution as a bank such as BancoSol in Bolivia or Compartamos in Mexico (Tchuigoua, 2014).
The different types of MFIs (both conventional and Islamic) obviously bring the different features of their external funding (capital structure). For shareholder-based MFIs, the main source funding are commercial funding and deposit while for non-commercial based MFIs the borrowing and donations are their main source of funding (Tchuigoua, 2014). However, it makes decisions about capital structure more complex and it puts microfinance institutions under pressure to perform efficiently and to run higher profits. This situation has been subject to criticism from the welfaristes, since microfinance institutions are in fact double bottom line objectives institutions and their main focus should be putting on improving their social performance through financial inclusion and poverty reduction by reaching and serving a larger number of poor. Although, the institutionalists has always claimed that commercialized and financially sustainable MFIs can socially perform better (Polanco, 2005; Morduch, 2000; Woller and Brau, 2004), yet, several number of studies showed that microfinance institutions don\’t seem to have a significant impact on social development and poverty alleviation (Banerjee et al, 2015).
Islamic microfinance institutions (IMFIs) are younger in age and very limited in number compared to their conventional counterparts. However, they express the same continuous need for funding and financial support. IMFIs offer a varied package of Sharia-compliant products e.g. the Murabaha contract which is the most prevalent (El-Zoghbi et al., 2015) with total portfolio of assets almost US $ 413 million in 2011 (Al-Amal Microfinance Bank from Yemen) (Nimrah et al., 2011). Also, in the second place “Qard Al-Hasan” an interest free benevolent loan that relies on subsidies and donations, and other Islamic financial products such as Musharaka, Mudaraba and Salam contracts, etc. (Mohammed, 2011). Although the Islamic microfinance sector with innovative product line is the answer for a considerable social market, yet the lack of funding sources can negatively affect its sustainability.
MFIs differ from regular banks especially on the liabilities and assets side. Most of the sources of funds of banks are a combination of owned and borrowed capital while MFIs operate on borrowed funds. Unlike regular bank, microfinance is considered as an illiquid asset class (Matthäus-Maier and Pischke, 2007). However, this review study focuses on Conventional and Islamic MFIs. For this purpose, table 1 exposes different details on capital structure compositions between these two types of microfinance institutions. Several numbers of differences exist between these two types of MFIs especially on the capital structure side. It is of major importance to understand the specificities of these institutions in order to have a full image of the financial environment in which the manager makes decisions. The main sources of fund of any financial institutions are deposits. The impact of savings mobilization cannot be ignored in funding structure as it contributes to the microfinance institution’ financial growth and increases its social outreach (Campion and White, 2001). Islamic MFIs receive deposits from their clients in the form of “Wadiah” or “Mudharaba” contracts. Wadiah contract is a safekeeping contract based on the principal of trust. Islamic banks and MFIs practice Wadiah in their savings and current account. While a Mudharaba contract is a partnership in which one of the two or more parties provides the capital and the other provides the labor or the skill. The capital provider is known as Rab Al-Mal while the counterpart is known as the Mudarib. It is a trust contract; the mudarib is not liable for losses except in case of breach of the requirements of trust. Mudharabah deposits are based on profitloss sharing with the depositor as rabb-al-mal and the microfinance institution as the mudarib. Beside deposits and saving services, MFIs has always been depending on grants, donations, subsidies and concessional loans from public and private entities (Tchuigoua, 2014).
The importance of borrowing is that MFIs benefit from moderate interest rates and relatively long term maturities allowing them to reduce liquidity risk and term mismatch risk. However, they face exchange rate risks since they also borrow from international donor institutions. In the start-up phase, MFIs needed these funds to support payment of salaries and other expenses, yet these funds seem to become insufficient and less available to respond the increase in demand for microfinance services and the growth and the development of microfinance institutions. the deposits on the liability side are considered as investment accounts in the form of Moudharaba contract, thus, depositors are considered as shareholders (Abdul Karim et al., 2014). Since investment depositors share in the profit and loss in the Islamic system, their interest needs to be protected.