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Small and medium enterprises (SMEs) are widely recognized as engines of economic growth and key contributors to the sustainable gross domestic product (GDP) of all countries, including developing and emerging economies. SMEs play an important role in creating employment opportunities for both skilled and unskilled workers across many sectors, including manufacturing and service. However, higher costs and strict regulatory environments do not support SME growth and access to finance in the countries they operate.

SMEs, by number, dominate the world business stage; although precise, up-to-date data are difficult to obtain, estimates suggest that more than 95% of enterprises across the world are SMEs, accounting for approximately 60% of private sector employment (Small vs. Young Firms Across The World—Contribution to Employment, Job Creation, and Growth, Policy Research Working Paper 5631, World Bank Development Research Group). Given the importance of the SME sector, it is unfortunate to notice the lack of financing options available for them. A study by the International Finance Corporation (IFC) showed that approximately 35% of SMEs in the Middle East and North Africa (MENA) are excluded from the formal banking sector because they seek Sharia-compliant products that are not readily available in the market.

SMEs faces similar problems in the countries and regions where Islamic finance is flourishing, negating one of the aspirations of Islamic finance: access to financing for all Shariah-compliant businesses irrespective of the size of business operations. In the aftermath of recent global financial crises, various financial institutions and regulatory bodies have claimed that Islamic finance is more stable than conventional finance. This argument is supported by the foundation of Islamic finance, which is structured on strong ethical precepts and prohibits interest and speculation as well as asset-based financing. Moreover, Islamic financial institutions are considered to be a good platform for increasing access to financial inclusion, including access to finance for SMEs, thereby supporting growth and economic development. This aspiration is further supported by a recent finding by the International Monetary Fund that states that “Islamic Finance’s emphasis on asset-backed financing and risk-sharing feature means that it could provide support for small and medium–sized enterprises.”

The IFC has noted a potential gap of $8.63bn to $13.20bn for Islamic SME financing across the nine surveyed countries in the region. The report highlighted that only 36% of more than 160 surveyed banks in Iraq, Pakistan, Yemen, the Kingdom of Saudi Arabia, Egypt, Lebanon, Morocco, Tunisia, and Jordan, had an SME offering.

Limited access to finance for SMEs is one of the main obstacles to their growth in the majority of Islamic finance territories. Most SMEs do not have access to credit, or have limited access to credit. SMEs’ limited access to finance reflects the interaction of demand, supply, institutional, regulatory, and other policy factors that are a hindrance for the growth of SMEs. SMEs also lack awareness and knowledge regarding Islamic banking products and what products may suit their requirements. Additionally, the cost of credit charged by Islamic banks is relatively higher than conventional banks for the same sector. Growth is also hindered in those countries with developed Islamic banking by the lack of suitable Islamic finance offerings for SMEs. On average, around 35% of SMEs in MENA and Pakistan are not borrowing money despite the significant demand due to the lack of Islamic finance offerings.

Most SMEs in Muslim countries operate as sole proprietorships or family businesses. These enterprises primarily engage in cash transactions (due to their small size) and, thus, prefer to acquire funds through other channels. Moreover, a large number of SMEs operate outside urban areas and owners are not financially literate (literacy rates are generally lower in Muslim countries[1]) and thus have limited information regarding their banking needs. They prefer informal funding routes based on trust that offer more flexibility in terms of documentation, repayment, timing, and transactions costs, which formal financial institutions do not provide. This is further aggravated by lack of knowledge of Islamic financial products and solutions by most SMEs. SMEs are generally unaware of Islamic financial products that suit their needs given the complexity of Islamic financing models.

It is clear that access to financing is a major issue for the SME sector, especially in Muslim countries. SMEs either do not use conventional financing or only use limited financing due to religious reasons and sentiments. SMEs that do not use available finance due to religious reasons represent a new funding potential for Islamic finance over the next few years. The funding shortage is most acute in countries where local SMEs won’t consider conventional banking alternatives. In Saudi Arabia, for example, up to 90% of SMEs are specifically looking for Shariah-compliant banking services, which means a large chunk of them are effectively shut out of the lending market because they are not open to non-Islamic finance. Most banks also avoid regional SMEs, regardless of their religious affiliation, because average SME loans yield relatively low returns and the industry has poor regulatory environments. Islamic financial institutions needs to target this cash deficient SMEs.

SMEs approach banks largely for working capital requirements or asset financing. Even though several products and structures are in place, the sector continues to be underpenetrated by Islamic banks. There is significant potential for Islamic banking products in the SME sector largely due to the religious orientation of many of these companies, especially those operating in rural areas. Banks should look at targeting smaller customers with retail-based offerings and larger customers with more corporate and sophisticated banking services.

Nafis Alam

Associate Professor of Finance, University of Nottingham Malaysia

Nafis Alam is an Associate Professor at the Nottingham University Business School (NUBS) in the University of Nottingham - Malaysia Campus (UNMC). Prior to this, he worked at Monash University at Sunway campus where he worked as lecturer in finance. He has also participated in leading Islamic finance conferences worldwide among them significant was participation in Harvard Islamic Finance forum at Harvard Law School and Gulf Research Meeting at Cambridge University, UK.