SMEs and Islamic finance: a perfect match?
With governments worldwide still struggling to close the SME funding gap, Melodie Michel asks whether the ever-growing Islamic finance market could be the right answer.
The global Islamic finance industry reached about US$2.1tn in 2014, and is expected to surpass US$2.4tn in 2015, expanding further to around US$4tn by 2020. With an annual growth rate of around 10 to 12%, the sector has been identified by the World Bank as “an effective tool for financing development worldwide, including in non-Muslim countries”.
Not only are Islamic financial institutions hungry to grow their loan portfolios, but the very structure of shariah-compliant deals makes them
ideal for funding SMEs.
“The uniqueness of shariah-compliant financing is that it is based on the principals of risk sharing. This ethical principle is embedded in the structure of shariah-compliant financial products compared to conventional finance and differentiates the risk profiling for SMEs slightly, where they are no longer the only party in the transaction to carry the burden of the risk profile – which is the biggest restriction in their access to finance in most cases,” Harish Parameswaran, COO of newly-launched shariah-compliant supply chain finance firm Tawreeq Holdings, tells GTR.
In her paper The Development of Islamic Financing Scheme for SMEs in a Developing Country: The Indonesian Case, Aulia Nurul Huda, a faculty member at Jakarta’s Prasetiya Mulya Business School makes a similar observation: “The Islamic participatory schemes, such as mudarabah and musyarakah, integrate assets of lender and borrowers; therefore, they allow Islamic banks to lend on a longer-term basis to projects with higher risk-return profiles and, thus, to support economic growth.”
She also notes that although Islamic banks in Indonesia charge higher margins than conventional banks for their services, SMEs don’t seem to mind paying more as long as they get access to funding – a theory that is confirmed by the global take-up of alternative (and expensive) finance solutions by small businesses with no access to cheap bank finance.
However, Islamic banking penetration in the SME sector remains very low, despite significant regional differences. An IFC survey of over 160 banks in Mena (including Pakistan) reveals that 66% of the market offers an SME proposition, out of which only 50% have an Islamic SME offering (31% of the overall market), despite the fact that half the market offers Islamic banking services. Additionally, among banks offering Islamic products to SMEs, only 17% have the marketing, product and operational capabilities to effectively serve the requirements of the Islamic SME banking sector, affecting SME portfolio penetration, which stands at just 11% (compared to 37% in Mena’s conventional banking sector).
Despite their risk-sharing advantage, Islamic banks in Mena seem keen to avoid the uncertainties related to small businesses, preferring to offer short-term Islamic facilities to the sector, and keeping long-term Islamic financing for medium-sized enterprises with strong financial and business viability.
Parameswaran explains: “Even if the conventional banks are more compliant with strict capital ratios under Basel III, the same is applicable to Islamic banks regardless of the apparent differences, meaning that both kinds of banks adopt prudent lending practices and regulations to satisfy the outlook for a solid financial system globally, particularly following the global financial crisis. Lending practices differ partially from one bank to another, and we can say that the main challenge for SMEs, whether for conventional or for Islamic banks, is the nature of their business and their risk profiles. They will still be considered high-risk entities and treated as such, with stringent lending policies that restrict their access to finance.”
Perhaps for that reason, a multitude of alternative finance providers have sprouted up around the region in recent years, including Dubai-based Tawreeq, which has developed a trade receivables securitisation platform that provides SMEs with immediate cashflow and liquidity by buying their receivables, using a fast and paperless process. Services include forfaiting, factoring and reverse factoring, all shariah-compliant.
What these new providers recognise is the demand for shariah-compliant financial products across the region. According to the IFC, the preference for shariah-compliant products in Mena ranges from just 4% in Lebanon to 90% in Saudi Arabia, for a cumulative weighted average of 32.19%. “In order to enhance Islamic SME offerings, the banks need to align their strategies to the rising demand for shariah-compliant products, with a clear focus on advancement of Islamic product offerings through effective marketing,” the organisation recommends in its report Islamic banking opportunities across small and medium enterprises in Mena.
One of the main factors set to influence the development of the Islamic finance offering for SMEs is the regulatory environment: Malaysia and Indonesia are a case in point. In Malaysia, for example, the government is granting 20% stamp duty exemption on instruments used in Islamic financing or related to the issue of Islamic securities, and 100% stamp duty exemption for conversion of an existing conventional loan to Islamic financing – a strategy that has pushed Islamic banking assets to 20% of the overall Malaysian market.
Indonesia is an interesting case, as 80% of all Islamic banks’ financing goes to SMEs, largely due to the government’s active promotion of Islamic microfinance: in 2002, Bank Indonesia released a Blueprint of Islamic banking development in Indonesia, in which it outlined a nine-year plan for the development of the Islamic finance sector, including support for the 105 shariah rural banks.
Granted, Islamic banks’ total assets form less than 5% of Indonesia’s total financial sector, but the country’s financial services authority, Otoritas Jasa Keuangan (OJK), has big plans for the future of shariah financing. In June this year, it released a five-year roadmap, including the reduction of fees on shariah-compliant products and the development of education and training programmes. With these measures, Indonesia is hoping to lift Islamic banks’ market share to 15% by 2023, which – provided these banks continue to serve SMEs at the current level – bodes well for the future of the country’s small businesses.
In Pakistan, the government has come up with a strategic five-year development plan, including an Islamic SME finance handbook, as well as guidelines and prudential regulations. Similar efforts are being made in Saudi Arabia and Tunisia, a lot of which include tax incentives.
“The major focus that we can see globally for people working in the Islamic finance industry and in shariah-compliant finance is the need for unified regulations globally. The base on which shariah supervisory boards differ in accepting products and services as shariah-compliant is affecting the understanding of the products and restricting the room for development and innovation of new products that serve SME requirements. The need for further regulations and credit agencies that help in assessing SMEs and their financial standing is also very important, to ensure the sector better sees the businesses and supports their need and access to finance,” says Parameswaran.
Despite the need for improvements in terms of marketing, education and product offering, the exponential (and often government-incentivised) growth of Islamic financing, combined with increasing demand for shariah-compliant products in Muslim-majority countries, bodes well for the future of the SME segment.
“A strong enabling environment across most countries, coupled with high penetration rates ranging from 3 to 10% (Egypt) to 10 to 25% (Pakistan and Jordan), and a high demand from SMEs for Islamic finance promises strong growth for SME funding in the short to medium term,” concludes the IFC report.take me back