Despite high demand for sharia-compliant finance, a lack of expertise and services tailored to SMEs has resulted in significant underfunding of such businesses. Four specialists from the Islamic finance world look at how to make up for this shortfall.

  • Khaled Al-Aboodi, chief executive, Islamic Corporation for the Development of the Private Sector 
  • Adnan Ahmed Yousif, president and chief executive, Al Baraka Banking Group 
  • Mouayed Makhlouf, director for Middle East and north Africa, International Finance Corporation 
  • Mohamed Damak, director and global head of Islamic finance, Standard & Poor’s 

Q: To what extent has the demand-side for Islamic finance from small and medium sized enterprises [SMEs] changed in recent years? 

Adnan Ahmed Yousif: Nowadays, SMEs are considered the backbone of the economy. They contribute to sustainable gross domestic product growth, exports and employment in many countries. When it comes to the demand by SMEs for Islamic finance, it highly depends on the potential penetration of Islamic banks within the SME sector, the preference of SMEs for Islamic financial products, as well as the enabling environment.

SME financing by banks has been gradually increasing in most of the countries where Islamic banks operate. [Despite these improvements,] SMEs overall seem to remain underfunded in Muslim countries, with an average SME financing of 8.75% as a percentage of total private sector lending. Thus, fuelling growth over the long term requires an effective means to overcome both the demand- and supply-side obstacles.

We at Al Baraka are considering these issues in collaboration with many international agencies and financial institutions, such as our current partnership with the World Bank in Egypt, in conjunction with our efforts to establish a global SME fund. So far, our total financing in this sector slightly exceeds $3bn.

Khaled Al-Aboodi: There has been a surge in the number of SMEs being created across almost all the Organisation for Islamic Cooperation [OIC] member states. More and more people are trying their luck and attempting to establish their own business. As start-ups, their owners rely more on their own savings and that of family and friends. For now, these businesses will remain distanced from formal funding schemes until they are able to sustain themselves. Given the high risks associated with start-ups, the only viable funding solution one can think of is crowdfunding. For some of these businesses looking for sharia-compliant crowdfunding solutions, it's still difficult, because this financing solution is at the early stages of being created.

For the more established SMEs in OIC countries, which have some access to funding, we have observed that the preference is largely toward sharia-compliant funding solutions. Yet some seek this funding from informal sources as opposed to formal sources. In turn, the informal sources that exist in some OIC countries are targeting SMEs who are operating in the informal sector, or who are operating in the formal sector but prefer Islamic finance solutions that don't exist [through official channels]. In general, I would say that more and more SMEs are demanding sharia-compliant funding. We see that trend in regions that were disconnected from their traditional Islamic values and heritage, such as the central Asia region.

Mouayed Makhlouf: I don’t think the demand for Islamic finance has changed much – it’s always been there. However, because of more awareness and greater supply, that latent demand has come to the forefront, and entrepreneurs who would previously have used conventional financing have now started demanding Islamic products.

There’s also always been that segment that didn’t borrow at all because of the lack of Islamic instruments, which has become a potential client for Islamic banks. According to a study conducted by the International Finance Corporation [IFC] of nine countries in the Middle East and north Africa [MENA], there is a financing gap of anywhere between $8bn to $13bn for Islamic SME financing within un-served and underserved SME categories. This is a huge potential market that banks can tap into.

Mohamed Damak: I think there has been a change in terms of the product and service offering of Islamic finance rather than the demand. In some markets, such as Saudi Arabia, Islamic banks have reached a critical mass and they are now turning to SMEs to find new sources of growth. In other markets, such as Turkey, where Islamic banks are both small in absolute and relative terms and where they struggle to compete with established conventional lenders for corporate banking, SMEs are a natural growth avenue. In a sense, Islamic banks looking to SMEs for their growth is part of a natural evolution. When you look at markets such as Turkey, you can see this process unfolding.

Q: How can Islamic banks best pursue the opportunities presented by SMEs in their respective markets?

MM: The best way for banks to pursue these opportunities is to better understand their SME clients, from their business operations to their financing needs, and then ensure they have the right products to offer them. For this to happen, banks need to build robust SME banking operations, with the right business model and the right skill mix. Unfortunately, many banks have failed in the SME space because of a lack of these fundamental requirements. The IFC study also shows that approximately 32% of the entire MENA SME population would prefer sharia-compliant banking.

KA: The huge potential offered by SME financing is open to both Islamic and conventional banks. However, the prevailing belief is that financing SMEs imposes higher risks [on the lender]. Therefore, banks tend to avoid lending to this sector. What the Islamic banks need to do is to establish their own SME financing programmes to take advantage of the growth potential in the sector. In my opinion, Islamic banks are better equipped to take such a role because of the fact that Islamic finance is asset backed, and as such it's characterised as relationship banking, which is exactly what SMEs need.  

AY: Islamic banks are already emphasising SME finance, as demonstrated by the recent General Council for Islamic Banks and Financial Institutions Global Islamic Bankers Survey, which found that SME finance serves as a key driver of the sustainable growth of Islamic banks. Nonetheless, expanding this business line depends on the external development of this market segment, as well as on the ways that Islamic banks can enhance their technical infrastructures in serving SMEs. The General Council survey revealed that a lack of transparency is a common challenge [facing the banks], along with low levels of corporate governance. A lack of suitable collateral for loans, among other issues, was also identified as an impediment to further lending.

SMEs are also more sensitive to economic downturns or sudden changes in monetary conditions, due both to their small size and the fact that they are often only recently established. In addition, there is a lack of supporting infrastructures for SME finance in many jurisdictions, including SME credit scoring, secured transaction laws, a secondary equity market for SMEs, and a securitisation framework. Islamic banks also need to further enhance their technical infrastructures such as in-house expertise, through a dedicated SME unit, as well as their variety of Islamic products.

Q: To what extent, if any, can Islamic financial products offer a unique value proposition to SMEs?

MD: In many ways, Islamic finance is a natural partner for SMEs due to its profit- and loss-sharing principle. Products such as musharakah provide a good example of the partnership opportunities than can exist between Islamic banks and small businesses. Islamic banks can also make a difference in terms of offering advisory services. On the liability side, the needs of SMEs remain very basic and can be met with the current product and service offering of Islamic financial institutions.

AY: The value proposition of Islamic finance is that it does not simply consist of giving ‘loans’ for financing activities. One of its key features is that it is based on sales-based transactions that are directly linked to real sector activities with the variety of Islamic financial contracts that exactly fit different types of underlying businesses. Islamic finance is also based on a risk-sharing principle, with a strong emphasis on different types of equity-based financing. This can tackle the common problem of over-leveraging by SMEs, while assisting many start-up enterprises to gain a foothold in the economy. Finally, Islamic financing criteria also encompasses notions of social return as well as environmental considerations. Therefore, the benefits of sharia-compliant lending will ultimately be felt by the wider community.

Al Baraka Banking Group has brought this into practice, where any investments may only be made in sectors and industries that meet ethical standards of the sharia, inherently driven by the moral values of Islam which dictate that Muslims must invest in the production of, and trade in, useful and beneficial goods only. Furthermore, the business model of Islamic finance is that wealth creation is the result of a partnership between investors and entrepreneurs in which both the risks and the rewards are shared.

MM: The fundamental concept of Islamic finance is that the financier shares in the risk of the venture. Because of this, the bank is more proactive, to ensure that clients succeed. In addition, Islamic financing is backed by assets and hence isn’t trading in debt. This makes it less prone to risk in a crisis.

Q: What degree of further product and service innovation is required by Islamic financial institutions to cater to the full needs of SMEs?

KA: This area has not received the required attention and innovation it deserves simply due to a lack of historical interest by Islamic banks in the SME sector. If we agree that the SME sector has huge growth potential, then product development to address the needs of this sector should also be seen as having significant potential. There is of course a need to further develop existing products to be more sophisticated so that they can address the needs of SMEs, while also taking into consideration the risk mitigation needed to cater for the higher risk of these businesses.

MM: According to the IFC’s report, SMEs across the region cite high interest rates, cumbersome procedures and collateral requirements as the primary impediments to accessing financing from formal institutions, as well as a lack of products customised to meet their needs. Like conventional banks, Islamic banks also need to ensure that the products they offer are in line with the needs of their client SMEs. So understanding these needs by understanding their businesses is of prime importance. It is essential that banks offer a full range of products – from working capital to asset funding to distribution and more.

MD: As far as innovation goes, both conventional and Islamic lenders need to have the necessary products and risk management procedures in place, in conjunction with well-trained staff. In addition to this, in countries with existing successful SME financing initiatives, a lot of support has been provided by governments or multilateral institutions through dedicated facilities, guarantees or similar instruments. The Islamic Development Bank provides these services across a number of markets and also partners with other multilateral institutions to improve the financing environment.

AY: Islamic modes of financing can bring SMEs into the global value chain of the economy. The emerging trends of value chain finance, supply chain finance and agriculture finance, for example, exactly match the distinctive characteristics of Islamic financing. Therefore, any product innovations introduced by Islamic banks should be geared towards satisfying the specific needs of SMEs. In addition, the varieties of Islamic financial contracts have an advantage over a simple loan structure. Any types of Islamic financial transactions must also be aligned with service quality, including payment transactions, digitisation for customisation, e-banking and social media.

Since Islamic finance also takes into account aspects of social return, Islamic banks can offer non-financial products, including technical assistance and capacity-building programmes, business coaching, mentoring, peer- and value-chain networking, and financial planning advice. This can ensure the sustainability of SMEs over the long term. Finally, equity-based financing to SMEs should be promoted through building strong venture capital-type equity financing skills and capacities. In this case, establishing a secondary equity market for SMEs will significantly help Islamic banks to manage equity risk through profitable exit routes.

Q: How can the Islamic finance industry best address a shortfall of qualified human capital, particularly with respect to SME financing?

KA: Unfortunately there is no one solution that can address the shortfall of qualified human capital in the sector and I don't believe that currently Islamic banks are doing enough to address this area. Without giving enough attention to this issue, the sustainability of the unique feature of Islamic banks will be affected. We at the Islamic Corporation for the Development of the Private Sector are doing our best to help alleviate this problem. We see this task as for the public good, and also try to address market failure, which is incapable of coming up with action plans and initiatives to address [the shortfall].  

MD: Islamic banks face a dual problem here. Not only do they need to have staff who are well trained and versed at dealing with the specific requirements of SMEs but they also need staff who are adequately trained with respect to sharia-compliant finance. It is also important to note that the shortfall of qualified human capital is a challenge for the Islamic finance industry as a whole. Nevertheless, we are seeing some progress in terms of new training and education programmes around the world, particularly in places such as France and the UK.

MM: This is one of the major drawbacks for, and impediment to, SME financing in general, and for Islamic SME financing in particular. Nevertheless, the situation today is much better than it was a few years ago. Today, a bank can find an SME banker as opposed to a corporate banker turned SME banker. However, the market demand for Islamic banking skills with regard to SMEs is much larger than the supply. So both individual banks and banking associations need to continuously train new bankers for this very important role.

AY: Islamic banks should develop departments that are dedicated to small businesses with qualified human capital, due to the fact that providing financing and other services to SMEs requires policies, training and skills that are very different from those employed in both corporate and retail financing. The SME unit should have dedicated staff that are well equipped with strategic resources, monitoring tools and strategies, and customer-orientation processes. Human resources should also have strong risk expertise, well supported by a robust risk management framework for Islamic SME finance such as risk-based market segmentation, pricing models, innovative forms of collateral, screening techniques and alternative data sources/non-traditional data, among others.

Q: What kind of benefits can be expected from improved SME financing for the broader global Islamic finance market?

AY: Once SME-based lending has reached a critical mass, it will significantly expand the total market base, thereby fuelling the growth of the global Islamic banking industry. This is due to the fact that Islamic banks are mostly based in emerging countries where SMEs serve as the backbone of the economy. Improved SME financing will also expand the business lines that serve as the growth drivers for Islamic banks, such as transaction services, supply-chain finance and agriculture finance, among others. In addition, a well-developed Islamic SME finance sector will be able to boost the global connectivity of the Islamic finance industry through improved trade finance, as well as sukuk securitisation and cross-border syndications.

MM: I think the major benefit is achieving financial inclusion. The IFC has conducted market assessments in nine MENA countries (and one country in central Asia) to determine the demand for Islamic finance. The study shows that an estimated 32% of all SMEs do not borrow because of the absence of sharia-complaint financing products. If such financing were available, several hundred thousand more SMEs could be included within the formal financial sector, helping to generate private sector employment, and drive gross domestic product and domestic capital investments.

MD: I think for the broader Islamic finance industry, it can create new opportunities for growth especially in countries where the industry has reached a critical mass in terms of large corporate and retail customers. Moreover, easier access to financing for SMEs will help to spur job creation and sustainable and inclusive economic growth in these markets. For the banks, it will mean that they are able to diversify their exposure. 


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