Title : A Study of the Relationship between Religion and Development: Evidence from

the microfinance industry of Bangladesh.

Mohammad Ashraful Mobin

[email protected]
Graduate Student & Research Assistant,
INCEIF, The Global University of Islamic Finance, Malaysia

Merouane Lakehal-Ayat
[email protected]
Visiting Professor of finance,
INCEIF, The Global University of Islamic Finance, Malaysia

Abstract

This study is designed to look into the relationship between religion and development in the

area of microfinance industry. It specifically examines the Bangladesh experiment using a

comparative approach between the performances of conventional versus Islamic schemes.

This study employs advanced dynamic difference and system GMM. The results prove the

existence of religiosity effect on the social and financial performance of microfinance

institutions Our findings present important insights for Islamic and conventional microfinance

managers and donors as well as policy makers of the country to formulate a better policy. In

that context, this study provides a great opportunity for further research in the area of faith

based microfinance and development.

Keywords: Microfinance, Islamic finance, Development, Poverty, Religion, System

GMM
Introduction:

Nowadays, global poverty is of a major concern to decision makers. According to a 2005

survey by the World Bank, 16.1% of worldwide population lives with less than one US dollar

a day and 57.6% with less than 2.5 USD.1

Among these groupings, the Islamic world is quite preeminent with 1.2 billion people; it

stretches from Senegal to Philippines with a high degree of poverty. For example, Indonesia

has 129 million people under poverty line while Pakistan, Bangladesh and India have another

222 million. This situation quite noticeable in the Islamic world created a new awareness

among Muslim scholars.

They pointed the fact that The Prophet (pbuh), as narrated by Abu Huarairah is reported to

have said: “Indeed, the real richness is that of the heart (spiritual) itself.” 2 The

mafhummukhalafah (or inverse meaning) of the above statement is that the real poverty is the

spiritual poverty. Given these conditions, it is suggested by several schools of thoughts that

Muslim needs sustainable development within faith based structures to alleviate their

sufferings. In turn this will provide business opportunities to Islamic financial institutions

particularly in the area of micro- finance.

Also, Max Weber, an eminent sociologist of early 20th century, in his seminal work, The

Protestant Ethic and the Spirit of Capitalism, introduces the linkage between Religion and

Economics. Weber argues that Puritan ethics andideas influenced the development of

capitalism where he defines spirit of capitalism as the ideas and habits that favour the rational

pursuit of economic gain. Weber proved a clear linkage between the Protestantism and

pursuit of economic gain, and concluded that it was better for the survival of capitalism and it

1
www.worldbank.org
2
www.islamic-world.net
turns the growth and development of a country. Many empirical studies have conformed

Weber’s hypothesis that there’s a clear causal relationship between religion and economics.

However, there has been little academic inquiry on the relationship between Islamic based

institutions and development. Moreover, there is even less in the area of Islamic microfinance

and development.

In that context, our major inquiry would look into the relationship between religious based

scheme and development. From our angle, it is specifically examining Islamic based

approach to development through micro financing schemes and economic performance both

in Islamic and conventional sectors.

Literature Review:

The relationship between religion and development has been covered extensively through the

years. Poverty prevalence dates back to the existence of human beings. It has occupied

foremost place on human development agendas of virtually all countries of the world

including during the time of Islamic civilization where the implementation of Islamic-based

economic principles was expected to lead to poverty alleviation.3

.Although many Western policy elites hold a secular world-view and equate modernization

and secularization 4many aid and development organizations are based on religious principles

and are managed by people who are inspired by religious beliefs. More important, in a purely

secular model, the basic values of large groups of poor people are ignored. Increasingly,

several parties in the development arena seem to share this concern. A few years ago, the

United Kingdom government initiated a project known as Faith in Development, a

3
Abdelhaq(2011)
4
Thomas(2005)
multimillion-pound research consortium. Similarly, the Dutch Ministry of Foreign Affairs

instituted the Knowledge Forum on Religion and Development Policy, and the Norwegian

government recently launched a dialog initiative about religion and aid. The World Bank has

delivered several reports on religion and development issues (e.g., Marshall &Keough, 2004).

Clearly, there is no lack of policy interest concerning religion and development; however,

empirical research regarding the influence of religion on development is fragmented and still

in its infancy.

Donor governments have often been reluctant to channel much public support through faith-

based organizations because they fear using public funds for religious purposes. However,

since the launch of former President George W. Bush’s initiative to fund the social initiatives

of faith-based organizations, there has been a sharp increase in public funding for both

national and international efforts (Formicola, Segers, & Weber, 2003; Harper, Rao, &Sahu,

2008). The claim is that faith-based organizations can produce important social outcomes

(Johnson, 2002).

In addition to being involved in development efforts, faith-based organizations are common

in other industries, especially health care, retirement or nursing homes, and education.

However, whether and how religious affiliation affects operations and organizational

performance in these industries remain unclear (Amirkhanyan, Kim, & Lambright, 2009).

The microfinance revolution, begun with independent initiatives in Latin America and South

Asia starting in the 1970s, has so far allowed 65 million poor people around the world to

receive small loans without collateral, build up assets, and buy insurance. Idea of

microfinance programs has come from Dr. Yunus who began a microfinance program among

women in Bangladesh in 1976 through the University of Chittagong; however the concept is

relatively simple and enjoys a long tradition in many developing countries. The basic idea of
micro-finance is to provide credit to working poor who otherwise would not have access to

credit services. This service has been provided in variety in different countries by

moneylenders in poor communities for a long time.5

According to (Bucciferro, 2007) Microfinance programs have rapidly spread worldwide on

the premise that they help to eradicate poverty and create economic growth, however, the

impact of microcredit on poverty reduction and other outcomes is still unclear. There is no

single definition of the microfinance. Generally microfinance is small financial services to

poor people who don’t have access to traditional bank services. “Relying on their traditional

skills and entrepreneurial instincts, poor people use financial services from organizations

called microfinance institutions (MFIs) to start, establish, or expand self-supporting

businesses”. Unlike from other credit institutions vast majority of MFI were created for

poverty alleviation and empowerment for the poor.

The effect on income has been analyzed at the individual, household and enterpriselevels.

McKernan (2002) evaluated three significant microcredit programs in Bangladeshand

discovered that the profit for self employed activities of households can be increasedby

program participation.6Copestake et al (2001)estimated the effect of an urban creditprogram(a

group-based microcredit program) in Zambia, and found that microcredithas a significant

impact on the growth in enterprise profit and household income in caseof the borrowers who

have received a second loan. Sichanthongthip (2004) also pointedto a positive impact of

microcredit on the income level of individual borrowers. This canbe seen from the higher

monthly income earned after the member accessed credit, in theempirical study of Lao

microfinance on Saithani case. Shaw (2000) studied twomicrofinance institutions (MFIs) in

Southeastern Sri Lanka and showed that the less poorclients‟ micro business that accessed

5
Zeller & Meyer(2002)
6
Copestake et al (2001)
loans from microfinance programs could earn moreincome than those of the poor do. Mosley

(2001) evaluated the impact of loans providedby two urban and two rural MFIs on poverty in

Bolivia. He found that the net impact ofmicrofinance from all institutions, at the average

level, was positive in relation to borrowers‟ income, even though that net impact for poorer

borrowers might be less thanthe net impact on richer borrowers.

The application of Islamic finance to microfinance was discussed in depth by Rahul and

Sapcanin (1998). They demonstrate that Islamic banking, with its emphasis on risk sharing

and, for certain products and collateral-free loans, is compatible with the needs of some

micro-entrepreneurs. Viable projects that are rejected by conventional lending institutions

because of insufficient collateral might prove to be acceptable to Islamic banks on a profit-

sharing basis However, they concluded that from a microfinance standpoint the mudaraba

model (profit-sharing) has more drawbacks than the murabaha model (cost plus markup). The

murabaha model is overall more cost effective, has a lower margin of error, and provides

immediate collateral for a MFI because the MFI owns the goods until the last installment is

paid. Dusuki (2006) has presented the idea of Islamic microfinance initiative in the

perspective of Ibn Khaldun’s concept of ‘Asabiyah or social Solidarity that emphasizes group

efforts and loyalty over self-interests of individuals. He argues that Islamic microfinance can

be promoted through group lending to the poor who are normally denied access to

mainstream banking services.

Islamic banking is in a phase of growth and change. On one hand, Islamic finance is being

celebrated as a promising financial industry. Its assets currently exceed $300 billion

(compared to $160 billion in 1997) and the market is estimated to be growing at 10-15% per

year (The Economist, 2008).

Theoretical Framework

Different Theories have been formulated to define the relationship between religion and

development.

Neo-classical

The Neo-classical growth model emphasizes the importance of savings in order for

acountry‟s economy to grow. According to Todaro et al. (2003), one of the mainconstraints

for poor households in developing countries is the lack of access to financialservices. This is

a consequence of poorly developed financial markets and commercialbanks tending to offer

its service almost exclusively to medium and large companies thatare thought to be credit

worthy. In view of neo-classical growththeories, it implies thatthe accumulation of capital is

hampered and the growth of the country’s economy isrestrained.

Welfarist theory

The Welfarist theory focuses on reducing poverty through credit, often provided togetherwith

complementary services such as skills training and teaching of literacy andnumeracy, health,

nutrition and family planning. Robinson (2001) points out that under thisapproach, credit is

provided to poor borrowers, typically at below market interest rates.The goal is to reach the

extremely poor with credit to help them overcome poverty and also gainempowerment. The

performance of the MFI‟s are measured through household studies with focus on the living

standard of the individuals; number of saving accounts, numberof loans, productivity

improvement, incomes, capital accumulation, social services suchas education and health as

well as food expenditures(Congo,2002).

Micro-Finance Unity Theory

Another theory connected to microfinance is the uniting theory of microfinance. This theory

advocates for joint liability in the repayment of microfinance loans. The argument fronted by

this theory is that joint liability could improve repayment rates and the welfare of credit-

constrained borrowers. In joint liability, when one borrower cannot repay a loan, group

members are contractually require to pay instead. Second, the perception of joint liability can

be implicit. Borrowers believe that if a group member defaults, the whole group will become

ineligible for future loans even if the lending contract does not specify this punishment.7

Empowerment Theory of Micro-finance

The empowerment theory shows how microfinance loans can empower people to improve

their standard of livings by enabling them to start businesses. The theory points out that

women account for nearly74 percent of the 19.3 million of the world’s poorest people now

being served by microfinance institutions. Most of these women have access to credit to

invest in businesses that they own and operate themselves. The vast majority of them have

excellent repayment records, in spite of the daily hardships they face. Contrary to

conventional wisdom, they have shown that it is a very good idea to lend to the poor and to

women.8

7
Ghatak and Gunnane (1999)

8
Cheston and Kuhn (2002)
Delineation of key concepts:

Religion and development:

Historically speaking, people in all parts of the world have assimilated and adapted the

notions of development that were originally conceived in Europe and then were exported

largely through colonial rule. Various societies have brought, and still bring, their own ideas

to notions of development and progress. These ideas are often articulated in a religious idiom,

not least because the notions of development and religion have so much in common. They

both contain a vision of an ideal world and of the place of humans therein. It is not difficult to

find examples of the ways in which people’s religious understanding of the world may have a

bearing on development. The traditional Hindu idea of humankind, for example, emphasizes

harmony with the living environment. This easily translates into a view that economic growth

should be integral to the well-being of the humanity as a whole. Similarly, Muslims believe

that the ultimate aim of life is to return humanity to its creator in its original state of purity. In

African traditional religions, the pursuit of balance and harmony in relations with the spirit

world is paramount. Charismatic Christians (of which there are large numbers in Africa and

in developing countries more generally) believe that personal transformation – inner change –

is the key to the transformation of society. All of these ideas help to shape people’s views on

development. They stem from intellectual traditions associated with particular religions that

have been formed by local histories and experiment.

The microfinance revolution which begun with independent initiatives in Latin America and

South Asia starting in the 1970s, has so far allowed 65 million poor people around the world

to receive small loans without collateral, build up assets, and buy insurance. The idea of

microfinance programs has come from Dr. Yunus who began a microfinance program among

women in Bangladesh in 1976 through the University of Chittagong; however the concept is
relatively simple and enjoys a long tradition in many developing countries. The basic idea of

micro-finance is to provide credit to working poor who otherwise would not have access to

credit services. This service has been provided in variety in different countries by

moneylenders in poor communities for a long time (Zeller & Meyer, 2002)

Islamic Microfinance:

Given the dominance of western culture and values as well as the plight and vulnerability of

today’s Islamic world, there has been competing visions between the two civilizations.

Muslims have always been struggling for decades at almost every walk of real life to retain

their values and culture. The philosophy behind such struggle is underpinned in powerful

expression of collective identity that is multiple and highly diversified following the contours

of each culture and historical formation of each identity. The feeling of this collective identity

has urged Muslim scholars to find solutions of current economic problems to make their lives

compatible with Shari’ah and to safeguard the Muslim world against the shortcomings of the

western culture.9

While conventional microfinance products have been successful in Muslim majority

countries, these products do not completely the needs of all Muslim clients. Combining the

Islamic social principle of caring for the less fortunate with microfinance’s power to provide

financial access to the poor has the potential to reach out to millions more people, many of

whom say they would prefer Islamic products over conventional microfinance products.

From affordable loans and insurance products to safe places to save, microfinance services

have been powerful weapons in the fight against poverty, especially in Latin America and

South Asia (CGAP News, 2008).

9
Yusuf, 2006; pp.56-63
Microfinance refers to making small loans available to poor people (especially those

traditionally excluded from financial services) through programs designed specifically to

meet their particular needs and circumstances (Khan, 2008; p.6). The needs of the poor in

Islamic countries are no different from the poor in other societies except that these are

conditioned and influenced by their faith and culture in a significant way. They need financial

services because they are often faced with events that call for spending more money than

might be available around the house or in the pocket (IRTI, 2007, p.20).

Methodology we used

To examine the effect of religion this study employs System GMM on a panel dataset of 90

conventional and Islamic MFIs.

Generalized method of moments (GMM)

Dynamic panel data regressions are characterized by two sources of persistence over time,

namely, autocorrelation due to the presence of a lagged dependent variable among the

regressors and individual effects characterizing the heterogeneity among the individuals. The

endogeneity problem associated with dynamic models is dealt with in this paper using the

generalized method of moments (GMM) procedure proposed by Arellano and Bond (1991)

which is more efficient than the instrumental variable (IV) estimation procedure suggested by

Anderson and Hsiao (1981). Arellano and Bond (1991) demonstrate additional instruments

can be obtained in a dynamic panel data model if one utilizes the orthogonality conditions

that exist between lagged values of the dependent variable and the disturbances. Using these

moment conditions, Arellano and Bond (1991) propose a two-step difference GMM

estimator.
Blundell and Bond (1998) demonstrate however that the instruments used in the difference

GMM estimator become less informative in two important cases. Firstly, as the

autoregressive parameter increases toward unity; and second as the variance of the parameter

effect increases relative to the variance of the transitory shocks. Arellano and Bover (1995)

and Blundell and Bond (1998) propose that an additional mild stationarity restriction on the

initial conditions process allows for the use of an extended system GMM estimator. The

system GMM estimation is found to be more appropriate in the presence of variables that are

close to a random walk (Bond, 2002; Roodman, 2009). The difference GMM estimation

under these conditions is found to suffer from a weak instrument problem (Sarafidis et. al,

2009). The difference GMM approach also magnifies gaps in unbalanced panels (Roodman,

2009). This motivates the use of forward orthogonal deviation transformations.

In view of the above, we run both the two-step difference and system GMM estimations for

our panel data set (see tables in the Appendix). We follow up with post estimation

specification tests, namely the Sargan (1975) test for over-identifying restrictions and the

Arellano-Bond (1991) test for no autocorrelation in the first-differenced errors. We base our

decision to proceed with the difference GMM estimation in spite of the above limitations,

given the relatively low level of persistence in the time series dimension of capital buffers

(average of around 0.34). High persistence in the series is a necessary condition for

expectations of asymptotic efficiency gains using the system GMM10(Blundell and Bond,

1998; Roodman, 2009). The application of difference GMM is also warranted given the

estimated coefficient of the lagged dependent variable for the system estimator does not

increase significantly on average relative to the two-step differenced estimator.

Data and Methodology

This paper focuses exclusively on social and financial performance of 90 Islamic and

conventional microfinance institutions. Data is update to 2014. Data is collected from

microfinance regulatory authority of Bangladesh. The representativeness of the sample is

always an important issue. Although the MRA data are considered among the most

representative data that are available for studying both Islamic and conventional microfinance

industry, no data set is perfectly representative of the microfinance field. For instance, our set

contains relatively few of the largest MFIs and does not cover the virtually infinite number of

small savings and credit cooperatives active in the industry.

Variable Obs Mean Std. Dev. Min Max

oss 394 189.5699 1107.404 0 13691

averageloan 471 7474.643 3267.208 1412.31 19173.55
loanloss 442 .0137557 .056668 0 .93
cpb 436 .071055 .1249029 0 1.81
loans 473 1.15e+09 8.81e+09 1458360 1.06e+11

portflio 436 26.52213 57.73138 0 905.77

roe 440 .3964091 1.020588 0 11.66
totalequity 320 4.85e+08 2.96e+09 173415 1.90e+10
femaleclie~s 472 127659.9 943311 78 9463607

Correlation
 oss lloans~e lloanl~s lloans lequity cpb female~s portflio

oss 1.0000
lloansize -0.0687 1.0000
lloanloss -0.2202 -0.0252 1.0000
lloans -0.1311 0.4514 -0.2383 1.0000
lequity -0.3224 0.2284 -0.1519 0.9030 1.0000
cpb -0.0659 -0.0159 -0.1273 0.0935 0.1045 1.0000
femaleclie~s -0.1300 0.1485 -0.1438 0.6529 0.7004 0.0537 1.0000
portflio 0.0121 -0.0450 -0.0960 0.0487 0.0507 0.9646 -0.0169 1.0000

Difference GMM
Difference GMM

Model 1 Model 2 Model 3 Mo~4 diff22robust

L.OSS 0.170 0.0595 0.170 0.0595

(0.76) (0.23) (0.89) (0.51)

L2.OSS -0.623 -0.623***

(-1.92) (-3.41)

CPB -299.3** -259.3 -299.3* -259.3**

(-2.69) (-1.81) (-2.55) (-2.84)

Portflio 0.406** 0.208 0.406* 0.208

(2.66) (0.21) (2.51) (0.35)

ROE 16.82 36.48 16.82 36.48*

(1.11) (1.55) (1.42) (2.33)

Femaleclients -0.00000176 -0.00000153 -0.00000176 -0.00000153

(-0.37) (-0.30) (-1.29) (-1.59)

lloansize 0.140 21.50 0.140 21.50

(0.01) (1.26) (0.02) (1.43)

lloanloss -11.88** -12.64* -11.88** -12.64**

(-2.72) (-2.45) (-2.87) (-2.73)

lloans 6.082 11.69 6.082 11.69*

(0.70) (1.10) (0.99) (1.99)

lequity -8.468 -25.83 -8.468 -25.83

(-0.99) (-1.93) (-1.05) (-1.86)

Dummy Islamic 0 0 0 0
(.) (.) (.) (.)

Constant 0 0 0 0
(.) (.) (.) (.)

Observations 49 34 49 34

t statistics in parentheses
* p<0.05, ** p<0.01, *** p<0.001
System GMM
System GMM

Model 1 Model 2 Model 3 Mo~4 system22ro~t

L.OSS -0.0621 -0.132 -0.0621 -0.132

(-0.44) (-1.06) (-0.27) (-0.60)

L2.OSS 0.133 0.133

(1.48) (0.96)

CPB -309.1** -287.8* -309.1** -287.8*

(-2.99) (-2.46) (-2.62) (-2.07)

Portflio 0.414** 3.018*** 0.414* 3.018

(2.90) (3.34) (2.55) (1.10)

ROE 11.66 1.960 11.66 1.960

(0.83) (0.12) (1.01) (0.05)

Femaleclients -0.00000275 0.00000278 -0.00000275 0.00000278

(-0.62) (0.42) (-1.45) (0.49)

lloansize -4.778 86.91*** -4.778 86.91

(-0.44) (5.36) (-0.54) (0.95)

lloanloss -12.90** -9.996* -12.90*** -9.996*

(-3.24) (-2.05) (-3.40) (-2.00)

lloans 9.058 -14.75 9.058* -14.75

(1.21) (-1.52) (2.33) (-0.63)

lequity -16.33* -16.33**

(-2.00) (-2.65)

Dummy Islamic 25.52 138.3** 25.52 138.3

(0.92) (2.66) (0.95) (1.08)

Constant 114.3 -583.2** 114.3 -583.2

(0.96) (-2.62) (0.94) (-1.03)

Observations 82 86 82 86

t statistics in parentheses
* p<0.05, ** p<0.01, *** p<0.001

Sargan Test

Sargan test of overidentifying restrictions

H0: overidentifying restrictions are valid

chi2(17) = 21.22822
Prob > chi2 = 0.2162
According to Difference and System GMM both of methods indicate similar results for most of

the variable. For social peroformance it is OSS of microfinance institutions in case of system

GMM while difference GMM shows it insignificant. Interestingly Bank size is also significant

for System and difference GMM model but in robust model. Savings rate is significant in

conventional MFIs in system GMM model but insignificant in difference GMM model.

Operational income is insignificant in both System and difference GMM model. The major

finding is the significant relationship of political stability and education to the savings deposit of

commercial banks. At the same time dummy Islamic also found significant in case of System

GMM.

Having found focus variables have significant effect on banks deposits, and control variables

have similar effect in most of the cases, it is needed to determine the appropriate method from

the two methods. In selecting appropriate model, we just concern difference and System GMM

Method. From both tables, different models and diagnostic tests, we can summarize that system

GMM is most suitable for this study. According to system GMM, political stability and

education has significant effect on customer deposits of commercial banks. Result also shows

that religion has also significant impact on banks customer deposits.

System GMM may cause consistency problem. To solve that we run sargan test but it can’t be

run for difference GMM. So for our study in this case we prefer system GMM model and that it

proves the exiting effect of religion, political stability and education.

With an Islamic microfinance dummy we wanted to see the effect of religion on development

factors. As indicated in the above table our main findings for microfinance institutions are

broadly confirmed after controlling for time fixed effects. The coefficient is significantly higher
than the comparable coefficient for conventional microfinance institutions, and does not support

arguments that Islamic microfinance are less likely to perform.

This result shows the performance of Islamic and conventional MFIs applying system GMM. We

can see here loans loss and advances are negatively significant with financial performance of

microfinance institutions. It implies that the less loan loss will lead to the better performance of

micro finance institutions. Cost per borrower and female clients also found significant

relationship with the performance of microfinance institutions. Average loan size and total

equity do not have any significant relationship with the performance of MFIs.

Interesting part of this result is that Dummy Islamic found highly significant to the performance

of microfinance institutions. That implies that Islamic principles have significant effect on the

performance of Microfinance Institutions. This result supports the possible success of the

proposed model that based on Islamic rules and principles.

Conclusion:

Our inquiry is centered on the relationship between religion and development. We specifically,

focused on the relationship between Islamic based schemes of micro financing in Bangladesh

and overall performance in the conventional schemes. From the empirical study we find that

religion has significant effect on microfinance institutions performance while threshold does not

have effect on microfinance at least in case of Bangladesh. Our findings present important

insights for Islamic microfinance manager and donors as well as policy makers. We thus

recommend managers and donors to ensure that Islamic inspiration translates into benefits for
clients. Government agencies and social impact investors may also help MFIs in the wider

inclusion of the poorest population.

However, there are shortcomings too. For instance, the often-refuted-and-repeated “high

financing costs” criticism against conventional MFIs may be investigated in a more scientific

manner by analyzing financial data of a sample of MFIs by undertaking a cross-sectional

comparison of costs of undertaking various operations. It would also be pertinent to get more

systematic information for a number of countries on the size of Islamic microfinance relative to

the overall microfinance industry. Additionally information on how the Islamic microfinance

component is performing in relation to conventional microfinance based on a set of benchmark

indicators should be examined. On the overall, our study may help create incentives for

researchers to pursue further inquiries into an area extremely promising.

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