How Islamic Finance Can Spur the Growth of Small and Medium Enterprises

By Jaafar S. Abdulkadir.

Just how can Islamic finance spurthe growth of Small and Medium Enterprises (SMEs)?

SMEs have been billed as the engine of social economic growth and poverty reduction through the creation of employment opportunities and generation of income particularly in developing countries. Statistics indicate that formal SMEs contribute up to 45 percent of total employment and up to 33 percent of national income (GDP) in emerging economies and 51 per cent in high income countries.

In the face of growing demands for social services, the dwindling tax revenue sources and the bulging levels of public debt that undermines governments’ capacity to meet its social obligations, SMEs if well facilitated could help ease these burdens. Although the sector has remained significantly underfunded, banks are increasingly looking at developing products and services to cater to these businesses. Additionally, the SME’s preference for Shariah-compliant banking services has also opened up significant opportunities for banks to invest in this segment.

The Potential of Islamic Banking

That Islamic finance has tremendous potential to serve as a tool for financial inclusion through leveraging the entrepreneurial potential of micro, small and medium enterprises (MSMEs) across sectors and bringing the financially underserved into the economic mainstream is not in doubt. Furthermore, the risk-sharing characteristics of Islamic financial products can facilitate access to finance by small and medium-sized enterprises (SMEs) whilst the asset-backed nature of Sukuk makes them suitable for infrastructure financing that can help spur economic development, including creating an enabling environment for private sector investment.

However, market conditions and regulatory environments are not always supportive of the growth of SMEs and access to formal finance is one of the main obstacles they face. The International Financial Corporation in its 2012 report indicated that medium and small enterprises have a huge financing deficit of USD 2.4 trillion in the developing countries. Given that financial institutions rely heavily on the use of collaterals and
sound credit history for their financing decisions, many SMEs in the developing countries fail to access the much needed and deserved credit facilities.

In order to reach out to SMEs demanding Islamic products, there is need to better understand the market from both the demand and supply sides in order to identify any gaps or niches where Islamic Finance could assist and add value. Research has shown that the un-served and under served SMEs do not borrow from conventional banks, only owing to religious reasons. This potential is a “new to bank” funding opportunity, which is still untapped, as banks and other financial institutions lack adequate strategic focus on this segment to offer Shariah-compliant products.

The risk sharing nature of Islamic-financial products and indeed the asset-backed nature of the financial transactions fosters entrepreneurship that can contribute immensely towards social-economic development. The Islamic principles of asset-backed financial transactions helps to promote real economic activities and minimizes the incidence of speculative transactions and excessive risk taking behaviours of economic agents. The model of profit and loss sharing works towards aligning the interests of financiers and entrepreneurs and promotes healthy partnership for their mutual benefits.

The strong emphasis on the application of participatory approaches of financing like the Mudarabah and Musharakah models helps promote active involvement in economic activities and limit the conventional practice of risk transfer to the borrowing party. Mudarabah is a partnership
between an entrepreneur who acts as a fund manager (Mudarib) and a capital provider (Rab-ul-Mal) to invest the capital in a project on condition that losses are borne by the capital provider unless there are incidences of negligence and fraud by the Mudarib.

Arrangements involving the provisions of advance payment for commodities to be delivered at a future defined date well known as Salam can be applied to provide working capital for the SMEs especially in the agricultural sectors. This financing approach may innovatively be utilized to cater for the financing needs for farm inputs like fertilizers, seeds, irrigation kits, machinery among others.

Way Forward of SME Financing

There is need to continuously improve the branding of Islamic finance as a sound alternative system owing to its inclusive approach that seeks to promote social and ethical practices in our economic and financial engagements. The showcasing of success stories involving the Islamic finance
equity-based financing model with the SMEs shall help inspire the financial sectors players and governments to support the equity financing model.

Governments have to proactively develop progressive policies and create enabling environment that supports the growth of SMEs by expand their innovative sources of funding like Islamic finance. Appropriate policies and resources have to be deliberately focused on developing human capital, enforcement of contracts, tax laws, research and quality data generation and management.