Islamic finance for SME`s - Hussein Elasrag - ebook
Opis

According to several research studies in the last decade there are greater opportunities for development and growth of Islamic financial system because Muslim community is eager to take financial products and they are willing to spend their lives according to their religion. Islamic Finance is a promising solution to SMEs to meet the requirements of formal financing. And can prove particularly effective to facilitate access to finance for SMEs. Although there is a wealth of literature around Islamic finance and around finance in general for SMEs, literature that draws and connects these two areas together is limited. The purpose of this book is to investigate the opportunities of development and growth as well as the main challenges to Islamic finance for SMEs. This book will help to deepen understanding of the concepts of Islamic finance  as well as SMEs. In addition to evaluate how Islamic financial institutions can support SMEs.

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Islamic Finance For SME`s

––––––––

Hussein Elasrag

Copyright © 2017 Hussein Elasrag

All rights reserved.

This Book

Small and Medium Enterprises (SMEs)  make up the bulk of the economic tissue of the economy. In developing countries, they represent the majority of employment, including female employment. Investing in SMEs is a long-term and smart strategy, with sustainable returns that multiply across regions, countries and societies. SMEs constitute the overwhelming majority of firms. Globally, SMEs make up over 95% of all firms, account for approximately 50% of GDP and 60%–70% of total employment, when both formal and informal SMEs are taken into account. This amounts to between 420 million and 510 million SMEs, 310 million of which are in emerging markets. Promoting access to finance for SMEs has been on the global reform agenda since the global financial crisis. Nevertheless, SMEs consistently cite lack of access to finance as a severe constraint. Often, the costs and risks of serving SMEs are perceived to be too high by banks. Because of information asymmetries and the high costs of gathering adequate information to assess the creditworthiness of typical SME borrowers, banks are usually reluctant to extend them unsecured credit, even at high interest rates. Subsequently, many SMEs with economically viable projects, but inadequate collateral, cannot obtain the most needed financing from traditional lenders. The International Finance Corporation (IFC) reports that top banks serving SMEs in non-OECD countries reach only 20% of formal micro enterprises and SMEs, and just 5% in sub-Saharan Africa. Underscoring the scale of problems with access to finance, the Asian Development Bank (ADB) estimates that there is a global gap of US$ 1.9 trillion between the supply and need for trade finance alone. This gap widens especially at the ‘lower end of the market’, where almost half of SMEs requests for trade finance are estimated to be rejected, compared to only 7% for multinational corporations.

According to The World Bank estimates, 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.

According to several research studies in the last decade there are greater opportunities for development and growth of Islamic financial system because Muslim community is eager to take financial products and they are willing to spend their lives according to their religion. Islamic Finance is a promising solution to SMEs to meet the requirements of formal financing. And can prove particularly effective to facilitate access to finance for SMEs. Although there is a wealth of literature around Islamic finance and around finance in general for SMEs, literature that draws and connects these two areas together is limited. The purpose of this book is to investigate the opportunities of development and growth as well as the main challenges to Islamic finance for SMEs. This book will help to deepen understanding of the concepts of Islamic finance  as well as SMEs. In addition to evaluate how Islamic financial institutions can support SMEs.

LIST OF ABBREVIATIONS

AAOIFI

Accounting and Auditing Organization for Islamic Financial Institutions

AuM

Assets under management

ADB

Asian Development Bank

ALA

Alternative Liquidity Arrangements

ASA

Alternative Standardised Approach

ASF

Available stable funding

BAFIA

Banking and Financial Institutions Act 1989

BASEIND

Basic Social and Economic Indicators

BBA

Baiʿ Bithaman al-Ājil

BCBS

Basel Committee on Banking Supervision

BCG

Basel Consultative Group

BCPs

Core Principles for Effective Banking Supervision (or Basel Core Principles)

BCR

Basic Capital Requirements

BI

Business Indicator

BIA

Basic Indicator Approach

BIBF

Bahrain Institute of Banking and Finance

BIS

Bank for International Settlements

BNM

Bank Negara Malaysia

bps

Basis points

CAGR

Compound annual growth rate

CAR

Capital adequacy ratio

CBA

Central Banking Act 2009

CBB

Central Bank of Bahrain

CCE

Coordinated Compilation Exercise

CDC

United States Centers for Disease Control and Prevention

CDIS

Conventional Deposit Insurance Scheme

CDMs

Concentration and distribution measures

CGFS

Committee on the Global Financial System

CIS

Collective investment schemes

CMGs

Crisis management groups

COMCEC

OIC Standing Committee for Economic and Commercial Cooperation

ComFrame

Common Framework

CPs

Core principles

CPIFR

Core Principles for Islamic Finance Regulation

DFIs

Development financial institutions

DFSA

Dubai Financial Services Authority

DGI

Data Gaps Initiative

DIS

Deposit insurance scheme

DJIM

Dow Jones Islamic Market

D-SIBs

Domestic-systemically important banks

ECB

European Central Bank

ED

Exposure Draft

EMDEs

Emerging market and developing economies

FAS

Financial Accounting Standard

FDR

Financing-to-deposit ratio

FIS

Facilitating the Implementation of the IFSB Standards

FOMC

Federal Open Market Committee

FSA

Financial Services Act 2013

FSAP

Financial Sector Assessment Programme

FSB

Financial Stability Board

FSF

Financial Stability Forum

FSI

Financial Stability Institute

FSIs

Financial Soundness Indicators

FSIRG

Financial Soundness Indicators Reference Group

FSRs

Financial Stability Reports

FSSA

Financial System Stability Assessment

G-20

Group of Twenty

GB

Governing body

GCC

Gulf Cooperation Council

GDP

Gross domestic product

GFC

Global Financial Crisis

GFSR

Global Financial Stability Report

GHOS

Governors and Heads of Supervision

GI

Gross income

GN

Guidance Note

G-SIBs

Global-systemically important banks

G-SIFIs

Global-systemically important financial institutions

G-SIIs

Global-systemically important insurers

HLA

Higher loss absorbency

HLGs

High-level goals

HNWI

High-net-worth-individuals

HQLA

High-quality liquid assets

IA

Insurance Act 1996

IA

Investment account

IADI

International Association of Deposit Insurers

IAG

Inter-Agency Group on Economic and Financial Statistics

IAHs

Investment account holders

IAIGs

Internationally Active Insurance Groups

IAIS

International Association of Insurance Supervisors

IASB

International Accounting Standards Board

IBF

Islamic banking and finance

IBIS

Islamic Banks and Financial Institutions Information System

ICIS

Islamic collective investment schemes

ICM

Islamic capital market

ICMTF

Islamic Capital Market Task Force

ICPs

Insurance Core Principles

ICS

Insurance Capital Standard

IDB

Islamic Development Bank

IDIC

Indonesian Deposit Insurance Corporation

IFC

Irving Fisher Committee

IFDI

Islamic Finance Development Indicator

IFSA

Islamic Financial Services Act 2013

IFSB

Islamic Financial Services Board

IFSI

Islamic financial services industry

IIFS

Institutions offering Islamic financial services

IILM

International Islamic Liquidity Management Corporation

IIMM

Islamic interbank money market

ILAAP

Internal liquidity adequacy assessment

IMF

International Monetary Fund

INCEIF

International Centre for Education in Islamic Finance

IOSCO

International Organization of Securities Commissions

IRB

Internal-ratings based

IRTI

Islamic Research and Training Institute

ISFD

Islamic Solidarity Fund for Development

ISLM

Islamic Finance Platform

ISRA

International Sharīʿah Research Academy

LCR

Liquidity coverage ratio

LNG

Liquefied natural gas

LOB

Lines of business

LOLR

Lender of last resort

MDBs

Multilateral development banks

MDIC

Malaysia Deposit Insurance Corporation

MENA

Middle East and North Africa

MiFID

Markets in Financial Instruments Directive

MMoU

Multilateral Memorandum of Understanding

MoU

Memoranda of Understanding

MTP

Medium-term plan

NBNI

Non-bank or non-insurer

NMPIs

Non-mainstream pooled investments

NPLs

Non-performing loans

NPFs

Non-performing financing/facilities

NSFR

Net stable funding ratio

NSOs

National Statistical Offices

NSSs

National Statistical Systems

OECD

Organisation for Economic Co-operation and Development

OIC

Organisation of Islamic Cooperation

OPEC

Organization of Petroleum Exporting Countries

OPHI

Oxford Poverty and Human Development Initiative

PER

Profit equalisation reserves

PGI

Principal Global Indicators

PRIIPs

Packaged Retail and Insurance-Based Investment Products

PSEs

Public-sector entities

PSIAs

Profit-sharing investment accounts

PSIFIs

Prudential and Structural Islamic Financial Indicators

QE

Quantitative Easing Programme

QIS

Quantitative impact study

RAM

Risk Assessment Matrix

RCAP

Regulatory Consistency Assessment Programme

REPI

Real Estate Price Index

ROA

Return on assets

ROE

Return on equity

ROSCs

Reports on the Observance of Standards and Codes

RPSIA

Restricted profit-sharing investment account

RSAs

Regulatory and supervisory authorities

RSF

Required stable funding

SALR

Short-term asset–liability ratio

SAPR

Self-Assessment and Peer Review

SBP

State Bank of Pakistan

SCDIS

Sharīʿah-Compliant Deposit Insurance Schemes

SDDS

Special Data Dissemination Standards

SESRIC

Statistical, Economic and Social Research and Training Center for Islamic Countries

SHF

Shareholders’ Fund

SIBs

Systemically important banks

SIFIs

Systemically important financial institutions

SIG

Supervision and Implementation Group

SKRA

Strategic Key Result Area

SLOLR

Sharīʿah-compliant lender of last resort

SLRP

Supervisory liquidity review processes

SMC

SESRIC Motion Charts

SMEs

Small and medium enterprises

SNA

System of National Accounts of the United Nations

SPFO

Strategic Plan and Financial Outlook

SPP

Strategic Performance Plan

SRI

Socially responsible investing

STA

Statistics Department

TA

Technical assistance

TC

Technical Committee

TORF

Takāful Operators’ Risk Fund

TSA

The Standardised Approach

TSM

Total Stock Market

UAE

United Arab Emirates

UCIS

Unregulated collective investment schemes

UCITS

Undertakings for Collective Investment in Transferable Securities Directive

UNDP

United Nations Development Programme

UNSD

United Nations Statistics Division

UPSIA

Unrestricted profit-sharing investment accounts

US

United States

USD

United States dollar

VE

Vulnerability exercise

WB

World Bank

WG

Working group

WHO

World Health Organization

UNWTO

World Tourism Organization

WP

Working Paper

XOF

CFA Franc

Table of Contents

LIST OF ABBREVIATIONS

Introduction

CHAPTER 1: Understanding SMEs

SMEs Definitions

1. Quantitative Criteria for Defining SMEs

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

3. SMEs and job creation

SMEs and Access to Finance

CHAPTER 2 :Understanding Islamic finance

Fundamentals of the Islamic finance

Shari'ah law defined

Key Shari'ah principles and prohibitions relevant to finance

Regulation of Islamic Finance

Global Islamic financial infrastructure

Islamic banking

What is Islamic banking?

Advantages of Islamic banking

CHAPTER 3:Islamic Financing products for SMEs

Obstacles Faced by Banks in SME Financing

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)

E.Salam

F.Istisna

Islamic bonds (Sukuk)

CHAPTER 4: key elements required to unlock the full potential of Islamic finance for SMEs

Challenges of Islamic banking n SME Financing

Unlock the full potential of Islamic finance

1- Creating an Enabling Environment

2- Developing the industry and markets

3- Ensuring financial stability

Strategic operational adjustments to target SMEs

GLOSSARY

References:

Introduction

A growing economy requires a well-functioning financial system. The financial sector is essential not just for tasks like running the payment systems, ensuring a flow of funds from savers to investors, including small and medium-sized enterprises, and creating information and opportunities for investment. The financial sector is also necessary for diversifying investments, managing risk, and providing liquidity and other resources necessary for growth.(Stiglitz, 2015)

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 favourable 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.

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.

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.[1]

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.[2]

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.

Bank lending to SMEs seems to be tailor made for Islamic banking practises based around relationship lending as opposed to other more conventional forms of debt  financing. A key competitive benefit of this approach is a pure cost advantage brought about by reduced monitoring costs.

However, the nature of the contract may also provide opportunities for enhanced growth and an additional quality advantage based around the holding of collateral, greater managerial experience and reduced information asymmetries. Islamic banking and the use of Islamic financial products has increased significantly in recent years. A pure cost advantage should provide Islamic banks a foothold in the market for lending to SMEs. An additional quality advantage means that this advantage can be more intense in the sense that the market share of Islamic banks could increase dramatically in principle capturing the whole of the market.(Shaban, Duygun, & Fry, 2016)

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.[3]

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)

There has also been a surge of interest in Islamic finance from non-Muslim financial centers such as the UK, Luxembourg, South Africa, and Hong Kong. For example, the World Bank, acting as treasurer for the International Finance Facility for Immunization, has helped raise $700 million through two Sukuk issuances.

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.[4]

Islamic finance’s underpinning principles of promoting participation, equity, property rights and ethics are all “universal values”.

And yet, despite these important benefits and the clear potential, there is still a long way to go to fulfil the maximum potential of Islamic finance.

Today, it represents less than 1 percent of global financial assets and is still very much concentrated in a few markets. So there is clearly room to grow, especially given that the features of Islamic products can appeal to a much wider group. [5]Islam puts the highest emphasis on ethical values in human life; these ethical values are definite and absolute.

Prophet Muhammad (peace be upon Him – PBUH), regarded by Muslims as the last Messenger of Allah, said: “I have been sent for the purpose of perfecting good morals” Bukhara. Qur‟an (The Holy Book of Islam), source of supervision including the message of Allah to mankind, states: „O believers! Do not consume each other‟s wealth unjustly, but only [in lawful] business by mutual consent‟ (Qur‟an, 4: 29). Islam is familiar with the attractiveness of engagement in business transactions, and it also supports fair trade, commerce and an entrepreneurial culture.