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IRTI Policy Paper 1435-01. Title: Group Lending Policy and Repayment Rate in Islamic Microfinance Institutions. Author(s): Abdul Ghafar Ismail - Wan Nor ...
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Group Lending Policy and Repayment Rate in Islamic Microfinance Institutions

Abdul Ghafar Ismail - Wan Nor AisyahWan Yussof

Muharram 04, 1435H – November 07, 2013

ISLAMIC RESEARCH AND TRAINING INSTITUTE AMEMBER GROUP OF ISLAMIC DEVELOPMENT BANK

IRTI Policy Paper 1435-01 Title: Group Lending Policy and Repayment Rate in Islamic Microfinance Institutions Author(s): Abdul Ghafar Ismail - Wan Nor AisyahWan Yussof

Abstract The paper intends to contribute to the ongoing debate of whether group-lending policy are sustainable and able to achieve and maintain sound repayment performance, while serving poor borrowers without the support of third parties such as takaful operator. By aiding new features in better promoting group lending policy with hiwalah, it can further promote the development and sustainability of Islamic microfinance institutions. Keywords: lending policy, hiwalah, Islamic microfinance, repayment rate, JEL Classification:B11, D02, D14, G02, G21,

IRTI Policy Paper Series has been created to quickly disseminate the findings of the work in progress and share ideas on the issues related to practical development of Islamic economics and finance so as to encourage exchange of thought and give quick awareness for the decision maker in the field. The presentations of papers in this series may not be fully polished. The papers carry the names of the authors and should be accordingly cited. The views expressed in these papers are those of the authors and do not necessarily reflect the views of the Islamic Research and Training Institute or the Islamic Development Bank or those of the members of its Board of Executive Directors or its member countries.

Islamic Research and Training Institute P.O. Box 9201, Jeddah 21413, Kingdom of Saudi Arabia

Group Lending Policy and Repayment Rate in Islamic Microfinance Institutions Abdul Ghafar Ismail 1 Islamic Research and Training Institute Islamic Development Bank P.O. Box 9201, Jeddah 21413 Kingdom of Saudi Arabia e-mail:[email protected] Wan Nor AisyahWan Yussof 2 Research Center for Islamic Economics and Finance School of Economics Universiti Kebangsaan Malaysia Bangi, 43600 Selangor Darul Ehsan, Malaysia 1.

Introduction

The joint-liability lending (also known as group lending policy) practice has been introduced since the establishment of Grameen bank in the 1970s. The practice has been widely adopted in microfinance programs in many developing countries as an important tool to provide credit to the poor. This practice has produced many positive results, likes the expansion of the number of microfinance institutions (Gan, Hernandez and Liu, 2013), and improvement of repayment rates(Giné and Karlan, 2010). This practice also benefits the poor,becausemost of whom do not have any collateral, it is very risky to lend them money. This lack of collateral, in addition to a severe lack of financial and personal information about each potential client, puts a microfinance institution in the impossible situation of guessing who is going to pay them back, and who is going to default or run off with their money. Microfinance institution typically use this level of risk to determine the interest rates for each loan, but with a lack of information this is impossible to do. Group lending solves both of these problem.In this model, if one member of the group is unable to pay back their loan, the other members of the group must pay back that person’s share for them. This provides a form of insurance for the bank, as they know they will get paid back, even if one person defaults on their loan or is unable to make a payment. Group lending also addresses a bank’s lack of information by making the members of a community form their own groups.Since each member of the community has a more in-depth knowledge of whom is likely to repay on time and who is more risky, all of the less risky people will group together leaving all of the risky people together.This means that the more responsible groups will very rarely have to pay for each other, whereas the more risky groups will have to pay for someone else more often, thus effectively creating ahigher interest rate for those riskier people.The group-lending model is an ingenious way of overcoming some of the challenges that lending to the poor entails. 1

He is head of research division and Professor of Banking and Financial Economics. He is currently on leave from School of Economics, UniversitiKebangsaan Malaysia. He is also principal research fellow, Institut Islam Hadhari, UniversitiKebangsaan Malaysia and AmBank Group Resident Fellow for Perdana Leadership Foundation. We benefited from the comments given by partcipants at the Policy Roundtable Discussion on Financial Inclusiveness of the Poor: ‘Beyond Microfinance’,IRTI-UIN Malang 21-22 October 2013, Malang, Indonesia, especially Badr Badr-El-Din Ibrahim and Muhammad Khaleequzzaman 2 Phd Candidate in Islamic Economic, School of Economics, UniversitiKebangsaan Malaysia. She is also an Assistant Director, Department of Islamic Economics and Finance, InstitutLatihan Islam Malaysia,JabatanKemajuan Islam Malaysia.

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However, it also creates a negative result on the commitment to repayment meetings and can create social pressure for borrowers.A potential downside to group lending policy is that it often involves time-consuming weekly repayment meetings and exerts strong social pressure, making it potentially onerous for borrowers. This is one of the main reasons why microfinancial institutions started to move from joint to individual lending (Attanasio et al., 2011) It is also often argued that the high transaction costs faced by micro finance institutions in identifying and screening their clients, processing applications and collecting repayments keep interest rates high and prevent microfinance institution from reaching new clients and expanding their operations (Armendariz and Morduch 2004; Shankar 2006; Field and Pande 2008). Understanding the factors affecting repayment performance, which may vary by (unobserved) group types, are thus of great policy relevance. In particular, more accurate risk scoring tools can help to overcome information asymmetries by aiding microfinance institutions to better classify their potential clients and understand the factors driving their behavior, further promoting the development and sustainability of microcredit markets. Author likes Attanasio et al (2011) found that the impacts of group lending on poverty indicators such as income and consumption remains ambigious. They also found that there is little merits of individual and group lending in terms of borrower impacts such as repayment rate and social pressure. In this paper, we will consider group lending policy still relevant. However, the current group lending comes with a varied contract. Here, we will suggest a loan contract with the transfer of debt via hiwalah (a binding contract) which includes the principles and the rules on how borrower and lender overcome the debt. The paper intends to contribute to the ongoing debate of whether group-lending policy are sustainable and able to achieve and maintain sound repayment performance, while serving poor borrowers without the support of third parties such as takaful operator.By aiding new features in better promoting group lending policy with hiwalahcan further promoting the development and sustainability of Islamic microfinance institutions. The paper is organized in several sections.Section 2 will reviewthe current group lending policy, section 3 discuss about pros and cons of each policy and the parameters for each policy, section 4, recommendation of hiwalah contract and conclusion is presented in section 5.

2.

Review the Current Group Lending Policy

The main important policy related to microfinance institution is group lending policy. How could we learn this policy with respect toindividual lending, repayment rate, ethics, and peers? The answer for this question will be discussed below.

Group Lending versus individual lending Initially microfinance institutions began their operations with the principle of lending to individuals. 3Because, they believe that every person has the potential to become an entrepreneur. However, lending to individuals was replaced by lending to groups. Therefore, lending activities to groups have long been associated to microfinance. Under these activities or better known as jointliability lending, a loan is given to a group of borrowers. The motivation behinds group lending is due to the economics of scale, as the costs associated with monitoring loans and enforcing repayments are significantly lower when credit is distributed to groups rather than individuals. However, there are also merits and limitations of group lending as reported in Table 1.

3

See Armendariz, B. and J. Mudoch (2005)

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Table 1: Group Lending vs Individual Lending Merits of group lending

Limitations of group lending

1

Accessibility of financing services to poor households have become possible through groups

Individual specific needs have chances of being isolated/overlooked

2

Loan administration cost to the lender is low

Expression and need identification of individuals is difficult

3

Loan transaction – borrowing cost is low

Individuals do not prefer to be attached with group loans for a long period

4

Loan monitoring and supervision cost low

Coordination of divergent needs is difficult

5

Loan utilization is high

Backward members may be kept at low profile and exploited by some forward members

6

Tiny physical and financial resources can be After certain duration (5 to 7 years) group utilized as collective collateral and capital members attain individual specific efficiency to for poor individual members run individual level credit facilities.

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Loans are available to clients at the door steps

8

The group saving and center fund also provide loans to members as factor of self reliance

Individual entrepreneurship may be under shadow

Group Lending and Repayment The loan given to a borrower in group lending depends upon the successful repayments from another borrower, thus transferring repayment responsibility off of microfinance institutions to borrower. Hence, the whole group is liable for the debt of any individual member in the group, i.e., individual member is responsible for the repaymentof each other’s loans. Thus, joint liability provides as insurance against individual risks. In this sense, joint liability serves as a substitute for collateral. Group borrowers are treated as being in default when at least one of them does not repay. Subsequently, all borrowers are denied a new loan. This practice has gone through many years with the establishment of microfinance institutions such as the Grameen Bank (1983), Bangladesh Rural Advancement Committee, BRAC (1971), Association for Social Advancement, ASA (1978), and then, microfinance reached Latin America with the establishment of PRODEM in Bolivia (1986). Microfinance quickly became a popular tool for economic development, especially as a tool for poverty alleviation, with hundreds of institutions emerging throughout the third world who provide microfinance services to the poor. It shows that the group lending policy has contributed to the expansion of microfinance services. Economists also argue that the high repayment rates are frequently associated with group lending. Their belief is roughly divided into three explanations: (i) those that view the relational

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aspects of social capital as key to the performance of group lending; (ii) those that view the informational aspects of social capital as as key to the performance of group lending; and (iii) those that view the merits of group lending (relative to individual lending) solely through its innate properties as a joint-liability contract, where social capital plays little or no role. The distinction is important. If the first two groups of explanations hold, the existing level of social capital in the form of strong personal relationships or local information may be critical to group lending’s success. If the third group of explanations holds, then group lending may succeed whether or not it is implemented among borrowers with high levels of existing social capital. Research that falls in the first explanation therefore emphasize the potential for social sanctions as a primary factor in group loan repayment. Because group members are jointly liable for repayment of the loan of each group member, they have an incentive to pressure fellow members who fail to maximize the probability that their on share of the group loan will be repaid. Floro and Yotopolous (1991) who demonstrate that where social ties are strong, group lending can both improve loan repayment and relax credit constraints. While Besley and Coate (1995) argue that without the potential for social sanctions, group lending may offer little advantage over individual lending. Social sanctions, combined with peer monitoring also play a role in papers such as Stiglitz (1990) and Armendariz de Aghion (1999) though in focusing on peer monitoring, social sanctions are assumed to be exogenous. In the Wydick model (2001), sanctions in the form of group expulsion are endogenous in that they represent a credible threat that comprises part of a perfect Bayesian equilibrium punishment strategy. Papers in the second explanation focus on the heightened informational flows that exist in high social-capital areas, and their impact on group loan repayment. Van Tassel (1999) and Ghatak (1999) who both demonstrate that the borrower self-selection process used in most group lending schemes improves repayment rates through mitigating adverse selection in credit markets. If borrowers have clear information over the riskiness of one another’s projects, they sort themselves into homogeneous group through an assortative matching process. A third explantion of group lending downplays the influence of existing social capital in the performance of group lending altogether. The advantages of group lending over individual lending rest on neither the potential for social sanctions nor informational flows between members. Instead, the relative advantage of group lending arises simply from the terms of a joint liability contract. The best example of this view is Armendariz de Aghion and Gollier (2000). They show that, in a pool of “safe” and “risky” borrowers, if the higher return realized by a risky borrower in a good state of nature is (uniquely) sufficient to cover for a defaulting group member, then the group lending contract can reduce the equilibrium interest rate and induce higher repayment rates relative to individual lending. Wenner (1995) provides some evidence that active screening and social pressure among members of twenty-five Costa Rican credit groups improved group performance. Zeller (1998) finds credit group performance positively related to social cohesion within groups. Wydick (1999) finds that while peer monitoring appears to have some positive effect on group loan repayment, strong social ties within groups appears to make it more difficult to pressure fellow members to repay loans. Thejoint liability model assumes repayment always occurs if the borrower’s project is successful, while in strategic default borrowers choose whether or not to repay based on ex post project outcomes. Here the incentive to repay depends on the outcome of other group borrowers and penalties for default. Both types of penalties are assumed increasing in project outcome.

Group Lending and Ethical Elements Borrowers in a group are neighbours. They know each other well, so they might be able to observe each other’s usage of loans. By knowing each other, Li, Liu and Deinigner (2012) argues that lender could distinguish deliberate default and default due to irresponsible behaviors (such as investing in projects that are too risky or spending on non-halal activities) from default due to unexpected negative shocks. Thus, social penalties can be imposed to borrowers in order to increase the cost of deliberate default and default due to irresponsible behaviors. Social penalties can take the forms of exclusion such as not providing help in their production and other activities in the future.

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For some reasons, such as group lending often involves committing to repayment meetings and can create social pressure for borrowers. Although some may move towards individual lending, but others prefer to have a group lending. The group lending policy also allows the lenders to largely rely on accountability and mutual trust among group borrowers, rather than collateral to insure against default. Normally the poor often do not have appropriate collateral to offer, group lending policy offer a feasible and even profitable channel to extend credit to the poor, who are usually kept out of traditional banking systems. Others might encourage more diligent work ethics, and inspire reciprocity and solidarity within groups. Zeller (1998) finds credit group performance positively related to social cohesion within groups

Group Lending and Peer Effects Early work by Stiglitz (1990) and Varian (1990) explore how joint liability may induce borrowers in a group to monitor each other, thereby alleviating moral hazard problems. Besley and Coate (1995) address the question on how joint liability contracts affect the willingness to repay. They show how they may induce borrowers to put peer pressure on delinquent group members, which may lead to an improvement in repayment rates. The success of group lending has been attributed to, among other factors such as the ability of such groups to mitigate adverse selection and moral hazard through peer effects. 4Peer effects could work and operate through peer selection, peer monitoring, and peer pressure. All of which could mitigate the information asymmetry problem in credit markets and are less costly than the tools available to banking institutions in achieving the same goals.The process of peer selection tends to screen the more risky borrowers out of a group lending program. Through peer monitoring, borrowers in a groupcan effectively monitor other borrowers’ usage of a loan and reduce ex ante moral hazard (e.g. risky investment). Peer pressure refers to the influence peers can exert on enforcing repayment and mitigating ex post moral hazard (e.g. deliberate default). The effectiveness of these effects hinges on the premise that group borrowers living in close-knit poor communities or as suggested by Naveen Kumar (2012) as social collateral, can effectively identify, as well as punish, irresponsible borrowers and deliberate defaulters through social penalties. However, both Manski (2001) and Gan, Hernandez and Liu (2013) argue that peer effects can be categorized into endogeneous peer effects or contextual peer effects. For endogeneous peer effect, it can capture the fact that peer’s behaviour (e.g. in repayment schedule) could be directly affected by the behaviour of other peers. For contextual peer effect, it relates to how characteristics/parameters of a group affect its borrower’ decisions.Both, as mentioned by Li, Liu and Deininger (2012) have different implications. Endogenous peer effects give rise to “multiplier effects’through the feedback in borrowerbehaviors whereas contextual effects do not.Socially heterogeneous groups consistently performing worse than socially homogeneous groups supports the notion that relational social capital matters to group lending. Cassar, Crowley and Wydick (2005) found the personal trust between specific pairs of group members significantly affects performance in the microfinance games that supports the notion that informational social capital in the form of group self-selection and screening is important to group lending.

3.

Discussion

Although, there are pros of cons of each policy. Those who are pros said that group lending is: (i) helping financially: By having a group model, the group is able to pay for the loan of someone who is undergoing severe financial strains due to illness, unemployment, or numerous other factors; (ii) helping their businesses: By meeting with a large group of small business owners each week, there are often instances when one business owner shares some business knowledge or gives a suggestion to 4

Both adverse selection and moral hazard appear in a principal-agent relationship when actions taken by an agent are not Pareto optimal, see Holmstrom (1979)

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another owner about how to improve their businesses. This is often beneficial for the whole group, as they are able to greatly learn from each other; (iii) women’s empowerment: Many of the business owners receiving loans are women, and therefore it is an opportunity for these women to meet out of the house, and make an income that allows them to not be completely reliant on their husbands; and (iv) social affair: It is also a chance for the business owners to chat about life while meeting session. There are also others who are against the group lending. They said that group lending: (i) paying for someone else: While the group lending model is designed so that the group covers the cost of someone that is unable to pay, this often causes tension within the group, even among friends.When many of the business owners are struggling to make ends meet themselves, the last thing they want to do is have to pay more to cover someone else’s loan; (ii) group attrition: While there is no shortage of people wanting to receive a loan, there is a very high attrition rate as people decide they no longer want loans anymore. This usually stems from an unwillingness to attend weekly meetings, the above-mentioned un-satisfaction with paying for others, etc.; and (iii) differences in abilities and knowledge level: For microfinance organizations that also provide capacity classes to their clients, a big challenge they face is the wide variety of learning abilities, education levels, and levels of motivation. By allowing groups to be formed based on geographical location or outside of the control of the organization, it is very difficult to effectively help teach each group essential business skills. Therefore, in the following discussion, we will discuss the policy parameters that could be compared and contrasted to the other parameters (columns 1 and 2 of Table 2) as well as the implications of those features (column 3 of Table 2). Table2: Parameters for Group Lending Policy Parameter Formation of a group

Features Voluntary

Group size

Dynamic Incentive

Small (up to 10 individuals) or big (more than 10 individuals) Follow-up loan

Joint Liability

Sharing of debt burden

Repayment method

Pay to head of a group

Selection citeria of individual

Up to individual to choose

Loansize

A mixed of different loan scheme

Implication Social sanction- members in the group difficult to make pressure or social sanction on the other as the relationship is too close If more than one person default, it is a burden Distract the other member loan and financial resources. Burden the other member if one or more member does not pay the loan and the group disable to pay Repayment arrears or nonperforming financing (NPF). Create a homogeneous or heterogeneous borrower Unfair the burden

Basically, in most group lending practices, individual voluntarily forms a group (Row 2) based on a set of common parameters. These parameters, among others, are group size, loan size, and sharing risk.

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The group size (Row 3) - in practice, it is unclear how far group size affects repayment rates. FINCA, the organisation which pioneered the village banking concept, lends to borrower groups of between 10 to 50 members, and boasts repayment rates of 96%. On the other hand, Grameen prefers smaller groups with typically only five members, in order to keep free-riding and in-group coordination problems under control. The dynamic incentive (Row 4) - follow-up loans are frequently made subject to whether previous loan have been repaid. Creating dynamic incentives may become vital if microcredit schemes are to be applied to other economies. In the urban contexts of transition economies, for instance, it may be more difficult to form self-selected borrowing groups than in closer-knit rural communities. For this reason, Armendariz deAghion and Murdoch (2000) argue that in such economies the focus on grouplending should be abandoned and suitable dynamic incentive scheme should be sought. The joint liability as collateral or insurane to individual risk (Row 5)- in practice, individual creates a group fund in order to recover the default payment by an individual. The group members will collect the group fund each week and if one member faced difficulties to pay, the group can used the fund in order to pay the lender. Similarly, the operator can also create a microtakaful group. The repayment schedule (Row 6) - the standard of procedure in micro-financing states that each loan will be given a schedule of repayment. This schedule will be set according to the amount of loan and well-agreed period. The method of financing repayment is on a weekly-basis according to what has been prescribed. In the event of default, the other member will pay it. However, it can also take place in the following week. Selection process (Row 7) - depending on the objective of Islamic microfinance institution. They might select their clients based on the clients’average monthly household income. Households with average monthly household income below the poverty line income (PLI) benchmark are eligible to get the loan facility. This benchmark was estimated based on the necessity of food and other basic needs and hence, it would be considered as absolute poor. Households with average monthly household income below half of the PLI would be categorized as hardcore poor. Normally, microfinance institutions only selects those households, whose average monthly household income falls below the PLI, which includes both poor and hardcore poor households. In practice, the members will choose voluntarily their members in the group.

4.

Recommendation

The discussion in section 3 shows that loan contract is basically become the contractual basis on the relationship between the contracting parties, i.e., between microfinance institution and borrower. Under the shariah law, a debt contract only happens between a microfinance institution and an individual borrower.While, the individual can only transfer her debt to another borrower based on hiwalah contract. How does this additional feature in group lending policy work? In principle, hiwalah means change or transfer. The Hanafi's define the term legally thus: "The transfer of the liability for a debt from the legal personality of the debtor to the legal personality of the liable person named in the contract”. Thus, transfers of debt must be distinguished from guaranty contracts, since the latter entails the conjoining of liabilities rather than the transfer thereof. As a consequence, once a transfer of debt is concluded, repayment may not be sought from the original debtor. Here, the juristic definition of al-hawalah is "the transfer of debt from being a liability on the principal debtor to being a liability on the transferee, as a means of ensuring the debt." 5 There are proofs in the Sunnah and Ijma' for the legality of transfers of debt to transfer debts, the obvious exception being the forbidden trading of debts for debts: • The proof from Sunnah is provided by the Hadith in which the Prophet (pbuh) is reported by al-Bayhaqi to have said: “Delinquency of rich debtors is a form of transgression, so if one of you has his debt transferred to a rich person, let him accept the transfer of debt". The majority of jurists infer from this Hadith that is preferred to accept the transfer of debt, but that is not an obligation. On the other hand, Dawud and Ahmad ruled that the text of the 5

Al-Zuhayli, Wahbah. Financial transactions in Islamic Jurisprudence, Vol 2, 2007,chapter 64,pg 51

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Hadith includes an order which makes it obligatory to accept the transfer of debt (where the transferee is rich) There is also proof for the legality of transfers of debt provided by the concensus of jurists on its permissibility. In this regard, jurists have permitted transfers of debt for the transfer of fungible debts. However, it is not permissible for non-fungibles since the transfer of liability may only affected for fungibles. 6

A hadith from al-Bukhari, in book of Hawalah..from Abu Hurairah r.a.,( no 2166) “When someone you transferred the debt to someone else rich, let him receive it”. Referring to this, those who lend to people, then the debtor requesting that the debt be transferred to another person who will pay for it, then he (another person) is encouraged to receive this transfer, rather than mandatory." There are six cornerstones or components to the transfer of debt for the majority of (nonHanafis) jurists: (i) principal debtor or transferor, (ii) creditor or transferred party, transferee or ultimate debtor, (iv) the transferred debt, (v) a debt owed to the principal debtor by the transferee or ultimate debtor, and (vi) contract language.(in Zuhailiy,2007, pg 54). There are also few conditions must be followed in order to implement hawalah. (i) The consent of the principal debtor and creditor (Imam Maliki and Shafi'i). For instance, an offer can be issued by the principal debtor by saying: "I have transferred your credit to so and so", and the creditor may issue an acceptance by saying: "I agree". (ii) The transferor (principal debtor) must be eligible to conduct such contracts, for example he must be of legal age and a sane mind. While, there are three conditions for the creditor and transferee. (a) he must be eligible for the contract, (b) The creditor and transferee must be consenting to the transfer of debt, otherwise contract is not valid (The Hanafis, Malikis and Shafiis). (c) The acceptance must be issued by the transferred party during the contract session, and listed this as a a conclusion condition (Abu Hanifa and Muhammad). (iii) The transferred item must be a debt. Malikis and Shafiis added that the transferred debt must have matured, equal to the debt owed to the transferor by the transferee in kind and amount,and also object of Salam sale (foodstuffs).The debt also must be binding. A transfer of debt may be terminated in one of seven ways which is voiding, death or bankruptcy, debt repayment, death of the creditor or debtor, gift, charity and absolution. In general, Hiwalah means the debt is transfer from one party to another.7 In current practice, the word Hiwalah as defined by Accounting and Auditing Organization For Islamic Financial Institutions (AAOIFI) refers as a transfer of debt from the transferor (muhil) to the payer (muhal alayh) 8. The Majallah (Art.673) defines it as “to make a transfer from one debtor account to the debtor account of another”. Thus, hiwalah is an agreement by which a debtor is freed from a debt by another becoming responsible for it.9 In the Arabic language, the term hiwalah means change or transfer. The Hanafi's define the term legally thus: "The transfer of the liability for a debt from the legal personality of the debtor to the legal personality of the liable person named in the contract. Thus, transfers of debt must be distinguished from guaranty contracts, since the latter entails the conjoining of liabilities rather than the transfer thereof. As a consequence, once a transfer of debt is concluded, repayment may not be sought from the original debtor. The juristic definition of al-hiwalah is "the transfer of debt from being a liability on the principal debtor to being a liability on the transferee, as a means of ensuring the debt." 10

5.

Implementation

They are several steps that need to be taken in implementing the recommended policy option. 6

Ibid, page 51-52 Refer in Mughni al-Muhtaj- in KitabFikahMazhabSyafie, vol.6, pg 1449 8 Shari’a Standard No.7: Hawala. Definition of hiwalafromShari’aStandards by Accounting and Auditing Organization For Islamic Financial Institutions (AAOIFI) Rabi’ I 1424H – May 2003 9 Refer also to Ismail et al (2013), chapter 12. 10 Al-Zuhayli, Wahbah. Financial transactions in Islamic Jurisprudence, Vol 2, 2007,chapter 64, pg 51 7

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Step1: A Debt Contract between micro-finance institutions and individual borrower Microfinance institution may use the concept of qard al-hasan. However, there are some projects uses tawaruq contract which is for funding the bigger size of loans to borrower who are not under the categories of the needy or poor. In addition, the borrower has liability towards others.Usually, the loan amount under the contract of qard hasan is lower than tawarruqcontract.

Step 2: A hiwalah contract among the individuals This step involves the formation of hiwalah contract. As presented in Diagram 1, when A, a drawer, draws a bill upon B ordering him to pay C, he is in fact guarantees him i.e. C, the payment of his debt due on A. Similarly, when A, a holder of debt negotiates it to B, he secures the payment of debt due on the bill. An acceptor of an instrument after accepting it becomes primarily liable while a drawer’s liability becomes secondary and conditional. In the same way a transferee in a contract of hiwalah become primarily liable.

Diagram 1: Relationship Between Debtor-Payer-Lender

A transfer debt to B A (drawer/debtor) (Muhil)

B (payer) or Muhal

C (lender) or Muhal ‘alaih

The principles of hiwalah also can also be applied in commercial‐cum‐financial transactions such as in the modern day negotiability of loan instruments. Hiwalah has the ingredients of guarantee. A hiwalah contract can also be formed for the purpose of guaranteeing or securing the payment of the loan due on a promissory note, a cheque or a bill of exchange. As a note: the hiwalah contract has been applied in Islamic financial transactions, such as factoring and debt transfer. By looking at a variety of modern transactions currently using Hiwalah contract, it is found that there have been changes on the application of Hiwalah contract. In the classical model which is based on the original definition, debt responsibility goes to Muhil will be transferred to Muhal (payer) that is Muhal will continue paying the debt. But in today's transaction, Muhil still has responsibility for paying its debts. Only the claims of debt move from Muhil to Muhal. Another example is the practice of Credit Card, a correct term for this contract is hiwalah haqq, because there is displacement demand invoice (receivable) from the customer to the bank by the merchant. This example is similar to example the current practice in Islamic microfinance tarnsaction, where the term of Sighah is not valid because the third party (muhal) does not aware of any contract of hiwalah.

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Step 3: When a borrower default When a default happens, the following steps will take place: (i) (ii) (iii) (iv) (v)

Each member aware of the hiwalah contract as discussed in Step 1 Each members will have to cosign an agreement and accept it based on mutual belief When a borrower default, a borrower has to mention to whom their debt will be transferred Then, the payer suit to her ability, have an obligation to pay The debtor has to pay back the payer on the date prescribed.

Step 4: Group fund This step is an option to Step 3(iii). The group fund will be utilized if most of the members of the group cannot afford to pay the loan. This fund is collected on regular basis and saved as deposit Islamic microfinance institutions.

6.

Conclusion

The paper intends to contribute to the ongoing debate of whether group-lending policy are sustainable and able to achieve and maintain sound repayment performance, while serving poor borrowers without the support of third parties such as takaful operator.By aiding new features in better promoting group lending policy with hiwalah it can further promoting the development and sustainability of Islamic microfinance institutions.

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References Al-Zuhayli,Wahbah.(2007)Financial transactions in Islamic Jurisprudence, Vol 2, Dar alFikr,Syria Attanasio, O., B. Augsburg, R De Haas, E Fitzsimons, and H Harmgart (2011) Group lending or individual lending? Evidence from a randomised field experiment in Mongolia. EBRD Working Paper No. 136. Armendariz, B. and J. Mudoch (2005) The Economics of Microfinance. Cambridge, Mass: The MIT Press. Gan, L., M.A., Hernandez and Y., Liu (2013) Group lending with heterogeneous types. IFPRI Discussion Paper 01268. International Food Policy Research Institute. Holmstrom, B. (1979) Moral hazard and observability. Bell Journal of Economics 10: 74-91. Naveen Kumar, K. (2012) Dynamic incentives in microfinance group lending: an empirical analysis of progressive lending mechanism. SAGE Open, April-June: 1-9. Gan, L., M. A. Hernandez and Y., Liu (2013) Group lending with heterogenous types. IFPRI Discussion Paper 01268. Ismail, A.G., Nik Abdul Ghani, N.A.R and S., Shahimi (2013) Applied Shari'ah in Financial Transactions (Volume III). Berlin: LAP LAMBERT Academic Publishing. ISBN-13: 978-3659-41581-4. Li, S., Y., Liu and K., Deininger (2012) How important are endogeneous peer effects in group lending? Estimating a static game of incomplete information.Journal of AppledEconomtrics DOI:10.1002/jae.2276