Though the recent story of Islamic finance is largely a successful one, the sector's relative lack of maturity means that some shortfalls do exist. One of these – the supply-demand mismatch regarding small and medium-sized enterprises – has left a potentially lucrative hole to fill. 

The performance of the Islamic banking sector has been one of the standout features of the sharia-compliant financial industry in recent years. In the run up to the global financial crisis, these institutions surpassed their conventional peers in terms of profitability and asset growth by considerable margins.

While the recent global economic slowdown has dented this trajectory, sharia-compliant lenders are still enjoying enviable expansion. This success is attributable to the rapid growth markets in which the majority of these lenders operate. Yet, it also represents the prudent approach to growth that is inherent in the Islamic banking model.

SME shortfall

Nevertheless, the industry’s development has not been without its hurdles. The relative youth of Islamic banking, as an industry, means that key products and services are still going through a process of maturation. Compared to conventional peers, the majority of Islamic lenders lack the sophisticated spread of products that can be deployed across various market segments. For small and medium-sized enterprises (SMEs) this is especially true, particularly in the Middle East and north Africa region, where a significant supply-demand mismatch for sharia-compliant finance has emerged.

"Islamic banks have a limited product suite and that’s why their growth has not has been as strong as their potential might suggest. Meeting the standards of sharia-compliance has prevented them from easily developing a range of products to match the conventional finance space," says Walid Alameddine, chief executive of the Middle East and Turkey for the Promontory Financial Group.

The challenges facing Islamic banks’ aspirations to tap into the SME segment are numerous. The banks’ awareness of the market’s potential is one. Beyond this, the lack of sharia-compliant products is a longer term concern, as is the need to develop relevant strategies for risk management. However, though these are sizeable difficulties, the industry is making impressive inroads to address them. A number of Islamic banks now have dedicated SME divisions, while others have set ambitious targets to improve funding levels to these businesses.

An un-ignorable gap

Given the importance of SMEs to the economy of the Middle East and north Africa region, these initiatives are vital. The International Finance Corporation (IFC), in a recent study detailing the opportunities for Islamic banks to tap into SMEs across the region, paints a startling picture of their contributions to regional economies. In Egypt and Lebanon, SMEs account for 80% and 99% of gross domestic product (GDP), respectively. In Saudi Arabia this number sits at 33%, accounting for 25% of the country's total employment. Meanwhile, figures from the United Arab Emirate’s Ministry of Economy indicate that SMEs contribute an estimated 60% to the country’s non-oil GDP.

"Between 80% to 90% of companies in the Middle East and north Africa are SMEs and they typically create most of the jobs in the region. Yet, only 8% of the lending in this region goes to SMEs. That tells you that there’s a major issue for small and medium sized businesses in the region," says Mouayed Makhlouf, regional director for the Middle East and north Africa region at the IFC.

As the study went on to find, demand for sharia-compliant lending options among SMEs in the region is high. "We found that 35% of SMEs are excluded from the banking sector because of their Islamic lending preference. So they are excluded from both conventional and sharia-compliant lending options,” says Mr Makhlouf.

A hole to fill

Yet, both the Islamic and conventional banking sectors’ collective failure to address this market has left a sizeable hole in the region’s economic growth, with estimates from the IFC indicating there is a $13.2bn funding gap across the nine surveyed countries in the study. As such, sharia-compliant banks have a significant opportunity to capitalise on this untapped market and steal a march on conventional peers.

A number of Islamic lenders have been pushing ahead with their efforts to penetrate the SME market. In the United Arab Emirates, Noor Bank has developed a standalone entity called ‘Noor Trade’ that deals exclusively with small or mid-sized enterprises. “SMEs are typically tagged onto banks' retail or corporate platforms. At Noor, we realised that this is not the most efficient way of dealing with this sector, which has its unique requirements. With Noor Trade, we have created an independent identity and organisation that is focused purely on the SME space,” says Sunando Mukhopadhyay, head of emerging corporates with Noor Trade.

In 2012, Dubai Islamic Bank launched its SME Business Solutions Initiative, which is designed to support the development of the sector through various products and services including business accounts, cash management instruments, business credit cards and trade and treasury services.

Top five commercial banks in GCC

Regulation advancements

Momentum is also building from a regulatory and governmental perspective. Notably, a number of public authorities across the region have been taking a proactive approach to promoting closer links between SMEs and the region’s Islamic banks. "Interest in this topic is growing. Whenever we sit with governments from the region there is a lot of discussion around SMEs. So on the government side there is a push to get banks to engage with the SME sector," says Mr Makhlouf from IFC.

In April 2014, the UAE ratified a new law to support the development of SMEs in the country. The legislation exempts Emirati-owned SMEs from certain tax obligations, while ensuring the national development bank allocates 10% of its lending capacity to SMEs, among other encouraging reforms. Meanwhile, a report issued by the Dubai Economic Council (DEC) in August this year laid out the additional steps required to improve the financing environment in the country. Among other proposals, the DEC called for the creation of a registry that would list the assets of SMEs to ease the bank loan approval process and augment levels of transparency in the sector.

The scale of the opportunity has been compounded by the fact that a number of Western lenders have scaled down their SME-based activity in certain jurisdictions. In August this year, Standard Chartered announced it would be closing a significant portion of its SME accounts as part of an anti-money laundering agreement reached with US authorities. The UAE’s central bank estimated that between 1400 to 8000 clients may be affected. Similarly, in June 2013, HSBC announced it was scaling back its SME activities in the UAE to focus on more profitable divisions of its business.

Challenges remain

Yet, in order to develop true momentum in this space, sharia-compliant banks must address a number of challenges. A lack of suitable sharia-compliant products is the most salient of these impediments. A large proportion of sharia-compliant banking has been developed around musharakah (partnership agreement), murabaha (cost plus) and ijarah (a lease) structures. Developing new approaches tailored to the specific need of SMEs will be an ongoing process. This will include products that are designed to engage with the specific demands of SME activity.

An additional challenge, according to Mr Makhlouf, is that some Islamic lenders do not view SMEs as a viable business segment. In part, this comes down to the typical concerns related to SME lending, including a lack of collateral, a higher risk of business failure, management competence and weak financial reporting. On top of this, a significant minority of lenders lack awareness of the demand for sharia-compliant services for SMEs. In its report, the IFC says: “Nineteen percent of [surveyed] banks are yet to consider offering Islamic SME products, primarily due to not being aware of, or understanding, the demand driven by religious beliefs.”

Historically, SMEs have also tended to lack full-life-cycle support from the Middle East and north Africa's banks. While a handful of pioneering lenders, such as Noor Bank, have implemented supportive full-life-cycle systems, on a regional basis the current capacity of Islamic banks to lend to SMEs is a relatively patchy affair. “The success of a bank, Islamic or conventional, depends on creating the capability to holistically meet the dynamic needs of SMEs and in turn the owners’ needs through the life cycles of the entities and individuals. Offering fragmented or partial solutions will cause these entities or individuals to seek alternatives elsewhere,” says Mr Mukhopadhyay of Noor Trade.

These impediments will take time to fully address. Yet, the encouraging gains emerging from leading sharia-compliant lenders in the Middle East and north Africa region point to a bright future. Islamic lenders who are taking the lead in terms of SME lending can expect their already considerable profit and asset growth to improve in the coming years.

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