Banking for the poor: the role of Islamic banking in microfinance initiatives

PurposeThe main purpose of this paper is to review the microfinance scheme and discuss how Islamic banks can participate in such an endeavour without actually compromising the issue of institutional viability and sustainability.Design/methodology/approachThe paper is based on an extensive review of microfinance with the objective of building a case for Islamic banking to participate in a microfinance initiative.FindingsAs reviewed in this paper, microfinance requires innovative approaches beyond the traditional financial intermediary role. Among others, building human capacity through social intermediation and designing group‐based lending programmes are proven to be among the effective tools to reduce transaction costs and lower exposure to numerous financial risks in relation to providing credit to the rural poor. This paper also suggests the use of a special purpose vehicle (SPV) as one of the possible alternatives for Islamic banks channelling funds to the poor.Research limitations/implicationsIslamic banks may benefit from the spectrum of Shariah‐compliant sources of funds and offer a wide array of financing instruments catering for different needs and demands of their clients. Furthermore, the use of a bankruptcy‐remote entity like SPV can protect Islamic banks from any adverse effect of microfinance activities.Originality/valueThe analysis here is valuable in drawing the attention of Islamic banking practitioners to the fact that they can actually practise microfinance without undermining their institutional viability, competitiveness and sustainability. This is evident from the proposed model to incorporate SPV into their microfinance initiatives.