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. 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 healthy, agriculture-based, Islamic economies. MOHAMED EBRAHIM writes.

The Mudarabah contract is likely to become an increasingly popular choice as a mode of financing among poor rural farmers, who seek capital to finance their agricultural activities. This is because the Mudarabah contract is more just to the farmer and is not exploitative as the loans originating from traditional village money lenders in these regions who charge exorbitant amounts of interest.

Issues relating to Islamic agricultural finance
Criteria of financing
There is an undue emphasis on the credit needs of farmers against the performance of financing-related criteria like efficient credit decision-making and loan administration and the ability of borrowers to repay debt and risk-bearing by borrowers which contributed the most to the current low level of penetration of Islamic agricultural finance. Focusing on credit needs may have also led to the distortion of the costs of finance, not being aware of behavioural incentives given to farmers, profit-making motives and the underemphasis of agricultural output.

Structure
Islamic agricultural finance consists of informal and formal sources. Informal sources include 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 agricultural finance institutions set up by governments and non-governmental organizations.

Informal sources of finance have their own merits including 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, has disadvantages consisting mainly of the susceptibility of farmers to exploitation by lenders in terms of undervaluation of the borrowers’ crop for sharecropping arrangements and the 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 agricultural finance, are not due to the inherent performance-hindering characteristics in these modes, but to structural, institutional and organizational factors the most significant of which are the following:
• Neglect of the element of risk-mitigating or transfer mechanisms, identified mainly as marketing risk, default risk, crop price risk and macroeconomic risk. The sharing and transfer of such risks can be achieved by more prudent screening of borrowers, closer monitoring, rationing of finance, agricultural insurance, use 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, and
• 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 agricultural 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 systems
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 give relatively minor weight to guarantees, focusing instead on performance indicators; help reduce the time needed for approval and disbursement of agricultural finance; and allow 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 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 microinsurance from the same institution and long-term agricultural financing from specialized agricultural finance organizations. This would effectively solve the risk in agricultural finance and facilitate implements financing and long-term finance for the purchase of assets like tractors and harvesters to mechanize agriculture.

Mohamed Ebrahim is CEO of Ace Financial Advisory. He can be contacted at [email protected].