The SME Gap In Islamic Financing

For most parts, the boom in Islamic finance within the GCC and indeed in North Africa and South Asia has been about the retail consumer – the individual who prefers to bank in accordance with his Islamic ideals – and previously, the large corporate sector.

In that rush though, the historically underfunded small and medium enterprise (SME) sector has been overlooked by financial institutions across the region.

A new study by International Finance Corporation (IFC) showed that around 35 per cent 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.

The study, which was carried out across nine countries, found a potential market gap of up to $13.2 billion for SME Islamic financing in the region with a corresponding depository potential of $9.71 billion to $15.05 billion across these countries.

“To tap the underlying potential,Islamic banks need to build capacity and develop Sharia-compliant products to cater to this emerging sector,” the report said.

Despite the rising demand for Islamic financing among SMEs, the study reported that of the 36 per cent of banks in the MENA region that offer SME products, only 17 per cent offer Islamic options.

This is not all their doing though. The study pointed out that apart from a high level of risk aversion that banks in the region have, poor regulatory environments, differing perceptions of Islamic finance, and a lack of relevant products were hindering the growth of Islamic SME banking.

“The Islamic banking industry is not adopting measures that would grow the market. They don’t have a strategic outlook and there is a lack of product innovation,” said Attiq ur Rehman, partner, Israa Capital, a bespoke consultancy firm in the Islamic finance industry.

NEW-TO-BANK’ OPPORTUNITY

The IFC study also noted a significant variation across countries; demand for Islamic banking is as high as 90 per cent in Saudi Arabia while falling as low as four per cent in Lebanon. The study was carried out in Iraq, Pakistan, Yemen, Saudi Arabia, Egypt, Lebanon, Morocco, Tunisia and Jordan, and according to the IFC, the key findings from the study apply these the GCC region.

“What we see in Saudi will be applicable to the rest of the GCC region as these markets are very similar,” said Mouayed Makhlouf, regional director for IFC, MENA.

“But more importantly, the study reveals a significant, untapped ‘new- to-bank’ funding opportunity, as banks and other financial institutions lack adequate strategic focus on this segment to offer Sharia-compliant products. It also highlights the measures they need to take to overcome this.”

Tariq Muhammad, partner and head of Islamic Finance at auditing and consulting firm KPMG Lower Gulf, agreed and added that Islamic finance products tailored to the needs of the SME sector and delivered in a cost-effective manner represent a huge opportunity.

“Traditionally, Islamic banks have focused on large corporates looking for product structuring and legal documentation, while issues around enforceability made the SME proposition slightly unattractive,” said Muhammad.

“However, over time, tailored products have emerged that suit the SME sector complexities and ticket size. Most banks in the UAE have already spotted this opportunity and are aggressively working towards bridging this gap.”

Several conventional banks in the UAE have launched Islamic windows that offer various financing options for SMEs. Picking up the trend, some financial institutions in the GCC have also been mulling Sharia-compliant products for SMEs.

Oman Development Bank (ODB) announced last year that it is considering launching an Islamic window which would also provide Sharia-compliant funds for SMEs. Meanwhile, Standard Chartered Saadiq recently launched its first Islamic banking centre in the UAE with an aim to step up its product offerings in the space.

RIDING THE BOOM

According to the IFC report, the Middle East’s manufacturing sector was the most attractive sector for Islamic funding due to its capital intensity, export potential and the ability to value- add to the economy.

The report also noted that there is a huge potential for the conversion of an existing SME portfolio that avails of finance from the formal conventional banking channels to Islamic finance. This is an opportunity worth an estimated $4.1 billion and constitutes eight per cent of the existing SME lending portfolio, the study said.

Despite such potential, Islamic financing for SMEs faces a number of challenges that could obstruct it from going mainstream.

“There is a lack of awareness of how Islamic finance products are structured and operate among SME players. This would require significant effort from the banking sector to educate the participants,” said KPMG’s Muhammad.

“Excessive documentation required under Sharia-compliant financing is also a barrier and would require simplification and adaptation of documentation to suit SME needs.”

“The nature of financial information, collaterals, ownership structures and customer relations of SMEs require in-depth knowledge of each sub sector within SMEs. This would require the banks to create an SME research center before accepting this risk,” he added.

However, there is hope that as the Islamic banking industry develops significantly over the next few years, SMEs will find apt partners to fund their growth in the region. “Islamic banking has a compound annual growth rate of 15 per cent whereas conventional banking in these countries is not more than seven per cent,” said Israa’s Rehman.

Fuelled by economic growth in core Islamic financial markets, global Islamic banking assets are set to exceed $3.4 trillion by 2018, according to a report released earlier this year by auditing and consulting firm, whose Global Islamic Banking Centre also reported that the combined profits of Islamic banks broke the $10 billion mark for the first time at the end of 2013.