Portfolio and Default Risk of Islamic Microfinance Institutions

Abstract

Islamic microfinance is a growing sector that is expected to provide a long-term solution to poverty in the Muslim world. The role of microfinance institutions in poverty alleviation is still debatable, however established literature provides assurance that microfinance does contribute to the development of financial sector and reduction of poverty in developing countries. The rise of competition in the microfinance sector has forced many microfinance institutions to resort to commercial funding and lending activities, which according to some studies has led microfinance institutions to become riskier. The paper explores portfolio and default risk of Islamic Microfinance Institutions (IMFIs) and find that they are facing relatively lower risks than conventional MFIs. Using Ordinary Least Squares regression to analyse portfolio risk of IMFIs, the research finds unexpected result. Since IMFIs are facing challenging working environment and are operating in some of the poorest countries in the world with frequent natural disasters or armed conflicts, we predicted that they will be riskier. We also find that IMFIs are also less vulnerable despite their clients are from the poorest segment in the society, often with lower educational level, and the nature of Islamic financial products are relatively unknown to most clients. Many of the IMFIs and their clients live in countries considered to be high risk or have histories of instability, either politically or economically.