Islamic Banking for SMEs: 'A win-win situation'

Islamic Banking Institutions are better suited to address the financing needs of SMEs.

State Bank of Pakistan in its Prudential Regulations has defined Small & Medium Enterprises as follow:

“Small and Medium Enterprise (SME) means an entity, ideally not a public limited company, which does not employ more than 250 persons (if it is manufacturing/service concern) and 50 persons (if it is trading concern) and also fulfills the following criteria of either ‘a’ and ‘c’ or ‘b’ and ‘c’ as relevant:

a) A trading/service concern with total assets at cost excluding land and building upto Rs50 million.

b) A manufacturing concern with total assets at cost excluding land and building upto Rs100 million.

c) Any concern (trading, service or manufacturing) with net sales not exceeding Rs300 million as per latest financial statements.

An individual, if he or she meets the above criteria, can also be categorised as an SME.”

Small and Medium Enterprises play an important role in the development of a country. SMEs support poverty alleviation endeavors through employment generation process and have become the fastest growing export sub-sectors like sports goods and surgical instruments. Above all, being less capital intensive and more labour demanding, SMEs, from a social point of view, are more efficient in resource allocation as compared to large scale industries.

SMEs in Pakistan have a significant potential to add value to the economy. However, efforts towards the sector’s growth have remained restricted as efforts have been focused on large enterprises, neglecting Small and Medium Enterprises which are the backbone of the economy.

Long-term growth of the SME sector in Pakistan remains constrained by a number of factors that include skills shortage, scarcity of capital goods, poor management, lack of data on the sector, resistance to change and marketing difficulties especially for export-oriented SMEs; however, the biggest problem facing the sector is the unavailability of adequate financing facilities.

Unavailability of financing is mainly due to the reluctance of banks towards extending credit to small and medium enterprises. It is relatively easy to lend to large corporates where the economies of scale, published financial information, collaterals and credit worthiness parameters are available. Due to lack of availability of data on the SME sector, banks are unable to determine whether the borrower possesses technical, managerial and marketing skills that will allow him to generate adequate cash flows and repay the loan on time.

Being a major tool in the development and progress of any economy, growth of SME sector is of vital importance. Islamic Banking Institutions due to the structure of their transactions are better suited to address the financing needs of the SMEs. To understand this proposition better, one needs to have clarity regarding the basics of Islamic Banking.

Islamic Banking is banking based on Islamic law (Shariah). It follows the Shariah, called fiqh muamalat (Islamic rules on transactions). The rules and practices of fiqh muamalat come from the Quran and the Sunnah, and other secondary sources of Islamic law such as opinions collectively agreed among Shariah scholars (ijma’), analogy (qiyas) and personal reasoning (ijtihad).

In simple terms, Islamic Banking can be defined as a banking operation that abides by Sharia (Islamic law), under which a key rule is the prohibition of interest or riba, because of this Islamic Banking is referred to as interest-free banking. However, besides being prohibited from earning riba, Islamic Banks cannot engage in haram activities prohibited under Sharia, additionally, these banks must also minimize gharar (ambiguity) in their contracts.

Loans are a central element of conventional banking, with banks borrowing from depositors and lending to people in need of finance. Conventional banks make money from the difference between the lower interest rate they pay on deposits and the higher interest rate they charge their customers.

Islamic banks, on the other hand, being prohibited from paying or receiving interest, do not give out loans; instead, they use other modes like “sale”, “lease” and “partnership based instruments” to make profit.

A few of the basic differences between Conventional Banking and Islamic Banking are (i) Conventional Banking is finance based while Islamic Banking is faith and finance based (ii) Conventional Banking is cash backed where as Islamic Banking is asset backed (iii) Conventional Banks have lender-borrower contract while Islamic Banks have trade based, lease based or partnership contracts (iv) Conventional Banks invests in any type of financing be it prohibited activities, Islamic Banks invest in Halal avenues only.

Islamic Banking for SMEs  “A Win Win Situation”

Entrepreneurs in SME sector are more inclined towards using Shariah-compliant products and services, they are attracted to Islamic finance because it integrates ethical and moral values. Parallels are often drawn between Islamic finance and socially responsible investing. Islamic Banking seeks to maximize both financial returns and socially responsible ethical behaviour, provided that required products are available with competitive features and pricing.

The most prominent benefit of preferring Islamic banking over conventional banking is the elimination of risk of misuse of banks funds. The mandatory purchase & sale of assets ensures vigor in economic activity. It also shuts the doors for the possibility of using fresh financing to pay off old stuck-up non-performing loans.

The underlying involvement of “asset” itself in every transaction ensures that the funds are utilized for the purpose for which they were sought, thereby eliminating the risk of their misuse for any other purpose.

SME financing is a natural fit for Islamic finance, by virtue of the fact that it deals directly with the real economy; creates employment; involves the productive use of resources, especially capital and finance and contributes directly toward the alleviation of poverty.

Published in The Express Tribune, May 8^th, 2012.