Financing SMEs: An Islamic Perspective - Hussein Elasrag - ebook

Since the SMEs are important for the economy, the Islamic banks and Islamic financial institutions must play a significant role in financing these businesses. Supporting SMEs are one of the objectives of religious institutions, thus the most important goal of Islamic banks and Islamic financial institutions is to contribute to the economic and social development of the society. This study aims to analyze the appropriateness of the Islamic financial system for SME finance.

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Financing SMEs

An Islamic Perspective


Hussein Elasrag

Copyright © 2017 Hussein Elasrag All rights reserved.

Table of Contents


CHAPTER 1  What is SMEs?

SMEs Definitions

2.Qualitative Criteria for Defining SMEs

SMEs distribution in various parts of the world

Contribution of SMEs to employment and economic growth

1-Contribution of SMEs to employment

2-Number of SMEs in the total enterprise population, in the informal economy

Table 1. Estimated number of SMEs worldwide by region

3.SMEs and job creation

SMEs and Access to Finance

CHAPTER 2  What is Islamic finance?

Fundamentals of the Islamic finance

Key Shari'ah principles and prohibitions relevant to finance

Prohibition on usury and interest (riba)

Prohibition on realising a gain from speculation (mayseer)

No uncertainty (gharar) in commercial transactions

All activity must be for permitted purposes (halal)

Islamic banking

What is Islamic banking?

Advantages of Islamic banking

CHAPTER 3 What is Islamic Financing Options for SMEs

A.Trade with markup or cost-plus sale (murabaha).

B.Profit-sharing agreement (mudaraba).

C.Equity participation (musharaka)

D.Leasing (ijara).



Difference  Between  Istisna  and  Ijarah

Islamic bonds (Sukuk) :

CHAPTER 4 What is the challenges of Islamic finance for SMEs

1.Lack of Human Capital

2.Shariah Standardization and Harmonization

3.Lack of Public Awareness

4.Shariah Law and Legal Framework

4.Regulation and Supervision

5.Access to Finance

6.Monetary Policy and Liquidity Management

7.Tax Policy


CHAPTER 5  What are the key elements required to unlock the full potential of Islamic finance?

1-Creating an Enabling Environment

2-Developing the industry and markets

3-Ensuring financial stability

1- Increase in Size of the Islamic Bank and Financial Institutions ( IBFIs)

2 Brand Development

3-Quantification of Demand

4-Development of New Markets

5-Development of IBF as an Integral Part of a Global Halal Economy

6-Looking for New Alliances

Strategic operational adjustments to target SMEs

1- Strategy and Segmentation

2-Products and Services

3-Sales and Delivery

4-Advisory Services

5-Organization and Systems

6-Risk Management




Despite the fact that SMEs account for a significant part of the country's economy and provide employment opportunities for the majority of people. SMEs are less likely to be able to secure bank loans than large firms; instead, they rely on internal or “personal” funds to launch and initially run their enterprises.

Since the establishment of banks and other financial institutions, the primary objective is to provide support for the development of Large Scale Enterprises (LSEs) and the development of small and medium-sized enterprises (SMEs). Unfortunately, initial efforts were unable to provide favorable results for SMEs.

As governments around the world continue to grapple with uncertain economic prospects and important social challenges, they are looking to small and medium-sized enterprises (SMEs) and entrepreneurs as an important source of economic growth and social cohesion.

Appropriate access to finance is a critical prerequisite to enable these businesses to invest, grow and create jobs, and the issue has been climbing steadily up the policy agenda in recent years. But effective policy responses for SME finance require coherent and meaningful evidence.(OECD, 2016)

Small and Medium Enterprises (SMEs) play a major role in most economies, particularly in developing countries. Formal SMEs contribute up to 45 percent of total employments and up to 33 percent of national income (GDP) in emerging economies. These numbers are significantly higher when informal SMEs are included. According to estimates,  600  million jobs will be needed in the next 15 years to absorb the growing global workforce, mainly in Asia and Sub- Saharan Africa. In emerging markets, most  formal jobs are with SMEs, which also create 4 out of 5 new positions. However, access to finance is a key constraint to SME growth; without it, many SMEs languish and stagnate.

Fifty percent of formal SMEs don’t have access to formal credit. The financing gap is even larger when micro and informal enterprises are taken into account. Overall, approximately 70 percent of all MSMEs in emerging markets lack access to credit. While the gap varies considerably between regions, it’s particularly wide in Africa and Asia. The current credit gap for formal SMEs is estimated to be US$1.2 trillion; the total credit gap for both formal and informal SMEs is as high as US$2.6 trillion.

A World Bank Group study suggests there are between 365-445 million micro, small and medium enterprises (MSMEs) in emerging markets: 25-30 million are formal SMEs; 55-70 million are formal micro enterprises; and 285-345 million are informal enterprises. Moving informal SMEs into the formal sector can have considerable advantages for the SME (for example, better access to credit and government services) and to the overall economy (for example, higher tax revenues, better regulation). Also, improving SMEs’ access to finance and finding solutions to unlock sources of capital is crucial to enable this potentially dynamic sector to grow and provide the needed jobs.

The lack of funding is one of the most important constraints faced by SMEs. Marketing and administrative barriers, the lack of an integrated accounting system, shortage of trained manpower, institutional constraints and government legislation are also limitations faced by the SMEs. (Mumani, 2014)

High interest rates and the lack of adequate collateral are the major barriers facing the SMEs where banks would usually finance large businesses and prefer to deal with them because of the low degree of risk and the ability of these businesses to provide the required guarantees.

Islamic finance has certain features which give it the potential to effectively support SME financing, and economic growth and development.

According to a 2014 report by the World Bank's International Finance Corporation (IFC), there is a shortfall of some USD 13.2 billion in Islamic finance across nine surveyed Islamic countries. The IFC report notes that despite rising demand for Islamic financing among SMEs, only 36% of MENA region banks offer SME products, and a mere 17% subset of those offer Islamic options.

This has a chilling effect on SME financing, particularly in those countries where local SMEs won't consider non-Islamic finance. In Saudi Arabia, for instance, IFC figures note that up to 90% of SMEs are only seeking Shariah-compliant banking services. When the net is widened to include Iraq, Pakistan, Yemen, Saudi Arabia, Jordan, Tunisia, Morocco, Lebanon and Egypt, around 35% of SMEs are dissuaded from borrowing due to a lack of Islamic banking options.

This is a gap that Islamic finance offerings can address. Islamic finance helps promote financial sector development and broadens financial inclusion. By expanding the range and reach of financial products, Islamic finance could help improve financial access and foster the inclusion of those deprived of financial services.

Islamic finance  emphasizes partnership-style financing, which could be useful in improving access to finance for the poor and small businesses. It could also help improve agricultural finance, contributing to improved food security. In  this regard,  Islamic finance can help meet the needs of those who don’t currently use conventional finance because of religious reasons. Of the 1.6 billion Muslims in the world, only 14% use banks. It can help reduce the overall gap in access to finance, since non-Muslims aren’t prohibited from using Islamic financial services.

However, the Islamic financial system, operating alongside the conventional sector, is also exposed to broadly the same systemic risk factors and volatilities as its conventional counterpart, despite its sustained growth momentum. The various sections of this chapter further analyze the growth momentum and structural shifts of the Islamic finance industry while assessing financial stability aspects in light of the evolving global macroeconomic and financial conditions. A resilient and well-regulated banking system is the foundation of financial stability, as banks are at the center of the credit intermediation process between savers and investors. Instability in banking institutions can cause tremendous systemic effects across various productive economic sectors of a domestic economy, with the potential to spill over into regional and global economies. Banks provide critical financial intermediation services across all sectors of the real economy, including individual households, small and medium-sized enterprises (SMEs), large firms and government institutions. (Islamic  Financial Services Board, May 2015)

The Islamic finance industry has expanded rapidly during the last decade, with annual growth rates of over 15%. In many majority Muslim countries, Islamic banking assets have been growing faster than conventional banking assets.

Since the SMEs are important for the economy, the Islamic banks and Islamic financial institutions must play a significant role in financing these businesses. Supporting SMEs are one of the objectives of religious institutions, thus the most important goal of Islamic banks and Islamic financial institutions is to contribute to the economic and social development of the society. This study aims to analyze the appropriateness of the Islamic financial system for SME finance. In accordance with these principles, Islamic finance has developed specific financing products.(Léon & Weill, 2016)

First, two core financing products are partnership contracts between the lender and the borrower based on the profit-and-loss-sharing principle: musharaka, and mudaraba. A mudaraba contract is based on the fact that the lender provides the capital and the borrower provides the effort and know-how. Profits are shared between both parties, whereas losses are borne solely by the lender. Under a musharaka contract, profits and losses are shared between the lender and the borrower because all parties have made capital contributions.

Second, murabaha is a mark-up sale based on the fact that the lender buys a good and sells it to the customer in exchange for a price that includes the original cost and a specified margin. It must be stressed that the price can be paid in  several installments, which makes murabaha quite similar to a loan with interest from the borrower’s perspective. There are however differences between both forms of financing. On the one hand, there is no interest in the sense that the return applies to the sale of a good and not the sale of money. On the other hand, charging a penalty for default is prohibited.

Third, ijara mirrors the conventional leasing contract in Islamic finance. The lender buys a good and leases it to the customer for a given period and a given rent. Hence the bank does not make money from money in compliance with Islamic law as it converts money into tangible assets to make the transaction.

while Islamic Finance is not new and has been practiced for centuries around the world, it has gained in popularity of late. Total Islamic finance assets are estimated at around $2 trillion, practically a ten-fold increase from a decade ago, and outperforming the growth of conventional finance in many places. It is easy to see the appeal of Islamic Finance. Here are just two:

First, Inclusivity: Islamic finance has the potential to contribute to higher and more inclusive economic growth by increasing access of banking services to underserved populations. To this day, a large segment of the Muslim population—who are a primary, but not the only, market for Islamic finance around the world—remain financially underserviced, with only one-quarter of adults having access to bank accounts.

In addition, Islamic finance’s risk-sharing features and the strong link of credit to collateral means that it is well-suited for Small and Medium-Sized Enterprise (SME) and startup financing—which we know can promote inclusive growth. For the same reason, Islamic finance has shown its value in infrastructure investment, which can spark productivity gains and catalyze high value-added growth.

Second, Stability: Islamic finance has, in principle, the potential to promote financial stability because its risk-sharing feature reduces leverage and its financing is asset-backed and thus fully collateralized. In addition, besides deposits, Islamic banks offer profit- sharing and loss-bearing accounts that can help mitigate losses and contagion in the event of banking sector distress. This leads, de facto, to higher total loss-absorbing capital, one of the key objectives of the new global regulatory reform.

According to the ISFB report, most of the sample Islamic banking jurisdictions are characterized as markets where businesses normally rely on the banking sector to meet their financing needs, particularly in the South Asia and Middle East regions, where corporate bond markets are relatively underdeveloped and have only begun to expand in recent years. As a result, the sample Islamic banking industry’s business financing exposure generally is concentrated in private-sector businesses and may include funding their working capital needs, project financing and capital financing. The reasons why banks and financial intermediaries have failed and may continue to fail in the pricing of risks and hence in optimal lending to firms, and the possible regulatory remedies for this, is an issue that certainly requires further investigation. Mobilization of financing from nonbanking channels, such as private equity, venture capital and capital markets, offers innovative asset-based and  equity-based financial products that overcome the shortcomings of banks’ SME financing. This book will try to give hints and insights into this, and to present some of the Islamic financial instruments that are being supplied by the market for the financing of SMEs in particular.

CHAPTER 1 What is SMEs?


Small and medium-sized enterprises have positive contributions in providing and maintaining balanced economic and social development. They also play an important role in decreasing the level of unemployment and creating new employment opportunities and with their flexible production structure they can follow the changes in the market conditions more effectively. SMEs make crucial contributions to job creation and income generation; they account for two-thirds of all jobs worldwide.(International Labour Office, 2015).

There is a rich body of research on the development contribution of SMEs. While not entirely without some controversial areas, there would appear to be widespread consensus on the following points (Luetkenhorst, 2004).

• SMEs (partly because of the industrial sub-sectors and product groups covered by them) tend to employ more labour-intensive production processes than large enterprises. Accordingly, they contribute significantly to the provision of productive employment opportunities, the generation of income and ultimately, the reduction of poverty.

•  There is ample empirical evidence that countries with a high share of small industrial enterprises have succeeded in making the income distribution (both regionally and functionally) more equitable. This in turn is a key contribution to ensuring long-term social stability by alleviating ex-post redistributional pressure and by reducing economic disparities between urban and rural areas.

• SMEs are key to the transition from agriculture-led to industrial economies as they provide simple opportunities for value-adding processing activities which can generate sustainable livelihoods. In this context, the predominant role of women is of particular importance.

•  SMEs are a seedbed for entrepreneurship development, innovation and risk-taking behaviour and provide the foundation for long-term growth dynamics and the transition towards larger enterprises.

•  SMEs support the building up of systemic productive capacities. They help to absorb productive resources at all levels of the economy and contribute to the creation of resilient economic systems in which small and large firms are interlinked.

• Such linkages are of increasing importance also for the attraction of foreign investment. Investing TNCs seek reliable domestic suppliers for their supply chains. There is thus a premium on the existence of domestic supporting industries in the competition for foreign investors.