By Mohamed Ebrahim
This article was first published in Islamic Finance news Volume 17 Issue 6 dated the 12th February 2020.
The link is only functional until the 11th March 2020:https://www.islamicfinancenews.com/a-brief-overview-of-islamic-agricultural-finance.html?access-key=6b73e3e68e1204087db8f566beb01d57
The Islamic banking and finance movement is a revolution in the making for rural agriculture based farmers, with it being a major departure from conventionally accepted interest based banking. This Islamic agricultural finance presents the foundation for a potential transformation of peasant economies in North Africa (Egypt, Sudan, Tunisia etc) and parts of Asia (Pakistan, Indonesia and Bangladesh to be a healthy, agriculturally-based, Islamic economies.
The Mudarabah contract is likely to become increasingly popular choice as a mode of financing among poor rural agriculturalists, who seek capital to finance their agricultural activities. This is because the Mudarabah contract is more just, to the farmer and is not exploitive as loans originating from traditional village money lenders of these regions who charge exorbitant amounts of interest.
Issues relating to Islamic agricultural finance
Criteria of financing:
There is an undue emphasis on credit needs of farmers against performance of financing -related criteria like efficient credit decision-making and loan administration , the ability of borrowers to repay debt and risk-bearing by borrowers, contributed most to the current low level of penetration of Islamic agricultural finance. Focusing on credit needs may also have led to distortion of the costs of finance, not being aware of behavioural incentives to be given to farmers profit-making motives and the under-emphasis of agricultural output
Structure:
Islamic agricultural finance consists of informal and formal sources. Informal sources included unorganized Salam (the traditional Islamic mode for agricultural finance, forward payment with deferred delivery), sharecropping, and Musharakah mainly from family members and village money lenders. Formal sources normally include commercial banks and agriculture finance institutions set up by governments and non-governmental organisations.
Informal sources of finance have their own merits which include low administrative costs, simple procedures for lending, absence of collateral, suitability to the borrowing farmers needs and flexibility in repayment of loans. Depending heavily on informal sources of finance, however, have their disadvantages consisting mainly of the susceptibility of farmers to exploitation by lenders in terms of undervaluation of the borrowers crop for sharecropping arrangements and overcharging of interest by village money lenders.
Key challenges for development of Islamic agricultural finance
Challenges and problems encountered by Islamic modes of finance, as applied to Islamic financing of agriculture, are not due to inherent performance-hindering characteristics in these modes, but to structural, institutional and organizational factors most significant among which are the following:
- Neglect of element of risk mitigating or transfer mechanisms, identified mainly as, marketing risk, default risk, crop price risk and macroeconomic risk. Sharing and transfer of such risks can be achieved by more prudent screening of borrowers, closer monitoring , rationing of finance, agricultural insurance, using of forward contracts for price risk and better utilization and management of collateral.
- Low level of market-based credit systems.
- Low level of regulation and supervision. This is mainly due to the public nature of financing institutions, whether specialized or development banks, which means less prudential regulation and supervision and lack of internal control mechanisms and efficient lending procedures.
- Emphasis on the goal of quantity of production increase versus the goal of sustainable production and long term productivity enhancement
- Low level of operational efficiency. Highly centralized operational structures, deficient risk management tools, absence of proper administrative accountability, technological obsolescence and shortage of investment in human capital.
Conclusion and recommendations
Institutional innovations
Institutional Innovations are needed to have a holistic approach to serving the Islamic agriculture finance niche, focusing on the overall “ecosystem” of the many products and services that are tailored to specific segments in different value chains, and leveraging aggregation and interactions among players in each value chain.
Agricultural Management information system
Management information systems need to be developed for the agricultural sector, to enable the development of a credit scoring system that helps evaluate portfolio risks and make better credit disbursement decisions. The credit scoring systems currently gives relatively minor weight to guarantees, focusing instead on performance indicators; helps reduce the time needed for approval and disbursement of agricultural finance; and allows decentralization of the decision-making process, without restricting appraisal capacity.
Delivery and distribution strategy
The delivery and distribution strategy related to agriculture and sustainable food security systems, may need to be changed as the knowledge of the farmers should allow the Islamic agricultural financier to avoid requiring real collateral as a condition for financing and should, rely instead on assessment of the viability of the farming enterprise.
Develop microfinance institutions
Developing microfinance institutions creates the potential for the coordinated provision of a wider menu of financial services to rural farmers, who would receive short-term financing, and micro-insurance from the same institution and long-term agricultural financing from specialized agricultural finance organisations. This would effectively solve the risk in agricultural finance, get implements financing and long term finance for purchase of assets like tractors and harvesters, to mechanise agriculture.
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