Peer monitoring and Islamic microfinance

Abstract

• We study micro credit contracts that are based on profit sharing and hence compliant with the Islamic (i.e. Shari’ah) injunction regarding not charging interest. • Profit sharing loans provide borrowers better insurance for borrowers but also exacerbate the problem of strategic default. • We then consider a peer monitoring mechanism that harnesses locally available information to mitigate the problem of strategic default. • With peer monitoring, under certain conditions we show that the Shari’ah compliant loans can yield greater borrower welfare than interest bearing loans. Many Muslims, abiding by injunctions of Shari’ah law, avoid using credit market institutions that charge interest. Due to this constraint, current best estimates suggest that in some Muslim majority countries, around 20% of the poor opt not to participate in microcredit programs. This paper is a theoretical contribution towards increasing financial inclusion of the Muslim poor. We study methods to make micro lending Shari’ah compliant, based on profit sharing in which there is a possibility of strategic default. We show that introducing a new peer-monitoring mechanism, whereby agents are incentivized to report on each other’s profits, can be used along with profit sharing, and in so doing, improve upon the individual borrower, profit-sharing contracts. We then compare interest-based lending with profit-sharing lending in both individual and peer-monitoring settings and show conditions under which profit-sharing contracts with peer monitoring, outperform interest-based contracts in terms of borrower welfare.