2.1 IFIs and financial inclusion

Financial inclusion represents generally ease of access, availability and usage of financial system. It explains the diverse concept of inclusive development or shared prosperity to cater poverty around the world. The concept of financial inclusion across countries, for developed economies, is more about knowledge and availability of fair and transparent products, whereas in developing economies, it’s about access to financial products and basic knowledge to interact with financial institution. There are studies such as Beck et al. (2007) validating the strong correlation between ease of access to financial services and reduction in poverty.

Although Islamic economic teachings are based on the concept of shared prosperity, the lack of access to financial services and instruments or utilization issues due to religious reasons can have strong impact on efforts to reduce poverty and attain development goals. IFIs can play a vital role to address issues related to inclusion and resultant inequality. IFIs have the ability to design the innovative equitable wealth distribution instruments to cater the needs of masses in developing economies. These instruments can mobilize resources and fulfill the liquidity needs of different segments of society (Iqbal and Mirakhor, 2012).

According to World Bank and Islamic Development Bank Group (2016) on Islamic banking, the level of religiosity in Muslim-majority countries is 85 percent, whereas almost 9 percent of their population is not using any kind of financial services due to religious reasons. It’s a huge gap, more than 40m individuals can be included into the main stream financial system by enhancing reach and financial literacy about the availability of IFIs and Islamic instruments. Another important aspect is the number of banks offering Islamic financial services in the existing markets are very low except few countries (Zulkhibri, 2016). Limited geographical reach as measured by such banks per 10,000 square kilometers is another important phenomenon explained in Table I.

The recent literature suggests the need for enhanced financial inclusion by providing more and diverse and integrated Islamic banking Institutions, while improving the geographical presence of existing IFIs. There is a need to improve financial literacy by providing awareness about Islamic financial instruments especially focusing on market needs with risk sharing credentials.

2.2 IFIs and market concentration

The theory of Islamic banking is distinctively known to be based on risk sharing principles for the equity-related Shariah principles (i.e. Musharakah and Mudharabah), but there is a gap between theory and market practices. IFIs were supposed to provide alternative financing opportunities and fill the financial exclusion gap left by conventional financial system and not to adopt a widely mimicking approach.

If we look at the recent statistics regarding financing provided by the Islamic banking sector, 25 percent of financing facilitates the consumer durables, whereas 16 percent of financing goes to real estate and construction, 12 and 8 percent to manufacturing and trading accounts, respectively (World Bank and Islamic Development Bank Group, 2016). All these sectors are important for economic development and shared prosperity. But a deeper exploration of assets side of aggregate Islamic banking balance sheet would reveal the hidden challenge and reasons of growth stagnation. Murabahah and deferred sales contracts are the most dominant form of financing provided by Islamic banks globally and accounts for more than 78 percent of total assets. Lease and hire purchase contracts constitute almost 11 percent, whereas risk and profit sharing instruments also known as Musharakah and Mudarabah have less than 6 percent share within total financing offered by Islamic banks globally.

The gap between aspirations and reality is clearly visible in Figure 1. The asset side of Islamic banks shows that banking institutions are mainly focused on debt-based instruments such as Murabahah and deferred sales contracts, as the easiest instrument to mimic the conventional ones. The actual risk sharing products that are distinctive feature of Islamic banks such as Musharakah and Mudarabah are not clearly visible on aggregate Islamic banking balance sheet. The design of market competition with the conventional financial system by offering Islamic versions of famous market products is not new, rather recognized many years ago by Iqbal and Molyneux (2005).

Competing for high new worth individual in operational markets and capturing market share from conventional banks by mimicking Islamic banking products with conventional banking products is the approach adopted by majority of Islamic banks. This approach has worked in terms of improved results as Islamic banks are experiencing exponential growth in terms of total assets as well as increase in their market share, but this diverted their attention as well, from real economy to financial securitization to mitigate their financial risk. This simple approach has attracted conventional banks to diversify their existing product line by offering Islamic banking products besides conventional products. For example, after the introduction of Islamic banking services in Pakistan, which formally initiated after the registration of first Islamic bank known as “Meezan Bank” in 2002, many conventional banks started offering Islamic banking products to retain their existing customers.

This is beyond any doubt that Islamic banking products offered by Islamic banks or Islamic division of conventional banks in different countries are according to sharia board guidelines. The issue is with the market focus, one possible explanation of this strategy is extreme inequality around the globe. Almost half of the world’s wealth is owned by just 1 percent of the population (Fuentes-Nieva and Galasso, 2014), whereas richest 10 percent of the population hold 86 percent of the wealth (Credit Suisse, 2013). With such extremely skewed operational environment, Islamic banks are focusing on points having enough financial resources to fulfill their banking needs with sharia compliant products and have sustainable growth for foreseeable future. One can expect that after accumulating enough resources, these institutions would focus on neglected sectors of emerging economies as well. By enhancing financial inclusion and providing financial services to underprivileged and MSMEs, Islamic banks can contribute in poverty reduction while making it possible to attain development goals with ease.

2.3 IFIs and micro-, small and medium enterprises (MSMEs) market

SMEs and start-ups are pillars of both developed and developing economies in terms of economic growth, sustainability, employment opportunities and business integration. In developing economies, SMEs contribute up to 60 percent in employment opportunities and up to 40 percent in national income (Ayyagari et al., 2011). Accommodating various definitions of SMEs with respect to the number of employees, total turnover and working capital, several studies have confirmed the central role played by this sector in national economies (World Bank-IDB-IRTI, 2015). Given central role of SMEs, the support setup for the existing and new ventures in various countries is not significant compared to their actual participation. Multiple challenges including access to finance, technology, market, skilled human resource and legal frame work are the reasons for the underdevelopment of this sector in many developing countries.

Access to finance is the most prominent challenge faced by this sector, according to IFC (2017), MSME market is facing US$2.4 trillion financing gap. This is huge challenge for international financial institution, governments, and national financial sector of respective countries. The situation is more severe in developing nations, where 55–68 percent SMEs are financially underserved or not served at all.

The role of Islamic banks in financing MSME market is almost insignificant due to risk associated with this sector. According to the survey of Islamic bank offerings for SMEs (IFC, 2014), only 16 percent banks offer products for this sector, whereas the portfolio penetration rate is much lower and stands at 11 percent. In another similar survey conducted by IFC (2014), SMEs operating in Muslim-majority countries prefer financial products based on Islamic principles. Although there is a large demand from the MSME sector as shown in Figure 2, Islamic banks are rather incapable or reluctant to cater this demand.

An alternative approach to fulfill the financing needs of MSME is Non-Banking Financial Institutions (NBFIs), although the NBFI sector is small in many developing countries, Islamic NBFIs are emerging with the passage of time, for example, in Pakistan the Islamic NBFI sector has experienced the growth of more than 200 percent from 2010 to 2015 (SECP, 2016). Islamic NBFIs are operating in emerging MSME markets through their extensive gross route networks, such as Akhuwat (Pakistan), Dompet Dhuafa Republika (Indonesia), Waqaf Al Noor (Malaysia) and The Fa’el Khair Program (Bangladesh) that are few prominent examples of innovative solutions to explore the MSME market. These organizations are based on philanthropic principles, so their operation model needs basic modifications to fulfill the Islamic banking risk mitigating criteria. A survey of 36 providers of Islamic microfinance products to SMEs (Sanabel, 2012) showed only 15 percent of providers were Islamic banks, whereas 49 percent financing share was covered by non-governmental organizations and 24 percent by NBFIs. This explains the huge demand for Islamic finance products by the MSME sector, and NBFIs can play a role to fulfill these financing needs. In next section, we would explore the possibility of collaboration between Islamic Banks and Islamic Non-Banking Financial Corporations (NBFIs) to explore the large MSME market in emerging economies.

3.1 Special purpose entity (SPE) model

The “SPE[1]” model is proposed to fill the financing gap for the neglected MSME sector with institutional and governmental collaboration. Being the real growth and development contributor in developed and developing economies, the MSME sector can flourish with better financing access and advancement opportunities. On the contrary, the SPE would be useful to diversify Islamic Banking assets while providing liquidity to NBFIs for SME financing projects. MSME projects fulfilling SPE financing criteria can receive financing guarantee from central, provincial or local government to mitigate the higher risk for financial institutions.

As explained in Figure 3, SPE is collaborative effort by multiple financial institutions and government. Roles and responsibilities of each SPE formation partner are intended to achieve the underlying objectives regarding financial access, inclusion and to enhance IFIs role in real economy.

4.1 SMEs loan guarantee program (KAFALH)

The Saudi Ministry of Finance and SIDF initiated the KAFALH SME financing guarantee program in 2006 to improve the financing for MSME sector. The program works in collaboration with financial institutions mainly Islamic and conventional banks by covering lenders risk up to 80 percent in the case of repayment issues, partial or complete default. Since its inception, the program achieved remarkable growth and success in terms of providing guarantees for SMEs to avail financing for their operation projects or expansion plans.

According to SIDF, main objectives of the “KAFALH Program” are as follows:

1. development of the SME Sector by providing valuable financing;

2. equality through distribution of income;

3. enhancing capital investment in communities;

4. increasing national production;

5. increasing volume and quality of goods and services available in market;

6. integration of SMEs with large corporations;

7. development of neglected areas in different provinces;

8. diversify exports and increasing volume;

9. countering unemployment issues through the SME sector; and

10. attracting SMEs to avail funding for better future prospects.

Since its inception, the program received overwhelming response and extended financing guarantees to more than 7,222 SMEs, with almost 15,000 number of guarantees as shown in Figure 8.

4.2 Current model of KAFALH

In current operational model, the SMEs having knowledge of the KAFALH program can obtain financing. SMEs has to approach the financial institution with business plan to justify the financing requirements, and bank can accept and proceed with KAFALH guarantee or reject the application according to their set standards, the process is shown in Figure 9.

With the KAFALH program, the financing becomes more and more accessible to the SME sector and the program filled the important gap to some extent. The default rate of guaranteed financing stands to about 1 percent in 2014. Almost 49 percent of the value of financing received guarantees from this program, whereas maximum coverage goes up to 80 percent. This clearly depicts the potential for more financing and strict requirements being enforced by banks.

The current KAFALH model is designed to fill the financing gap for existing SMEs already working with financial institutions but unfortunately ignore the financial inclusion of excluded segments of MSME market. We propose the application of the SPE model for the KAFALH program to include neglected areas and segments of SME market.

4.3 SPE model for KAFALH

In the SPE model, the KAFALH program can be included as a “Government’s initiative” to provide guarantees for SPEs financing operations. As the system is already in place, the banking institutions and NBFIs can combine their efforts to establish specialized entities to focus on certain geographical regions and segments of MSME market to utilize the full potential of available financing guarantees.

The SPE model can help to attain long-term goals of “Vision 2030.” The government can designate each region to focus on particular product or service, and SPEs can provide the financing with the help of KAFALH guarantees as shown in Figure 10. This would enable every region to develop their specialty and have competitive edge in it, and this approach can attract financial as well as human capital from all over the region. Regional development and integration can pursue national development goals, and regions can play their role in a much better way to realize goals of “Vision 2030.” Technical details such as, size of SPE, share of financing by financial institutions, optimal size of target market, geographical limitations, segment focus and extent of utilization of capital markets would be focus of our upcoming studies.