sme development, constraints, credit risk & islamic banking solutions
TRANSCRIPT
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SMALL AND MEDIUM SIZED ENTERPRISES (SME)
Development, Constraints, Credit Risk and Islamic Banking Solutions
PhD Candidate
Mace Abdullah
MBA, CPA (Inactive)
LL.M. (Taxation), Juris Doctorate
SMALL AND MEDIUM SIZED ENTERPRISES (SME)
Development, Constraints, Credit Risk and Islamic Banking Solutions
Abstract
This analytic paper examines the status of small and medium sized enterprises (SME)
worldwide, provides theoretical information and explores issues regarding their development,
constraints and credit risk. SME have been heralded worldwide as being the economic “engine”
of economic development. Certainly, from an Islamic finance perspective, the development of
SME represents a propitious opportunity, a vital step towards an epistemological response to
criticism of Islamic finance and should play an indispensible role in forging a more robust
Islamic capital market. Yet, SME face persistent identifiable obstacles to growth and
development. This paper focuses on SME development, particularly as it relates to the so-called
“credit gap” and the concomitant credit risk. The SME “credit gap” is pervasive worldwide;
particularly so in emerging economies. Accordingly, this paper analyzes: the determinants and
drivers of SME development; constraints on SME development; the SME “credit gap” and
concomitant credit risk; and the role Islamic banking can play in meeting the challenge of SME
development.
Key words: Small and Medium Size Enterprises (SME); SME development constraints; SME
credit gap; SME credit risk; Islamic banking
Introduction
SME foster economic growth and are central to productivity, job creation, entrepreneurship and
innovation. They invariably contribute to the gross domestic product (GDP) of economies
worldwide. Yet, providing them with the capital to finance their growth, development and
sustainability has proved challenging to banks and other financial institutions internationally.
Financial intermediation is the “backbone” of capital allocation within an economy. Efficient
financial intermediation requires credit risk assessment in order to avoid adverse selection and
moral hazards. Therefore, it is important to identify the overall financial characteristics of SME
in order to improve their credit risk assessment.
Determinants of SME Development
Size, growth and age are significant determinants of SME development. In order to produce
development, growth must be sustainable. Sustainability is the ability to support a defined level
of activity, e.g. sales, job creation or capital asset base, over time. Economic and financial
determinants are factors, often inter-related, that limit or define economic or financial activity.
They are therefore, often measurable; thus, quantifiable. SME determinants and classifications
vary by country. Many economies use the term “micro, small and medium sized enterprises.”
This term is sometimes used to estimate the size and growth of “informal” vis-à-vis “formal”
SME. Some economies require ownership by a citizen as a necessary criterion for SME
classification. Others, e.g. China, Japan, Korea, Malaysia and Mexico, vary their SME measures
by real economic sector (OECD, 2015). Efforts have been made to harmonize SME definitions,
but homogeneity has proven elusive (OECD, Promoting Entrepreneurship and Innovative SMEs
in a Global Economy: Towards a More Responsible and Inclusive Globalisation, 2004). Even
with its challenges, the definition and metrics of SME are necessary for some very important
reasons, e.g.: preparation of statistics and the monitoring of their development over time;
benchmarking SME development as between different economies, regions and within sectors of
an economy; providing thresholds for tax and fiscal policy or other regulations; and determining
eligibility for particular forms of private and public support (Gibb, 2004).
Size. SME “size” is measured as a determinant by one or more of the following: number of
employees (emphasizing job creation); total assets (emphasizing their economic “balance
sheet”); sales or turnover (emphasizing production); and/or loan volume (emphasizing their
credit access). However, some of these measures are intermediate steps to determining other
more meaningful measures. Total assets, for example, are based on historical costs and do not
necessarily reflect ongoing fair values of assets, but may still measure periodic capital
investment. Jobs created, similarly may not measure productivity; which may require period-to-
period ratios of real changes in GDP, as well as job creation. Moreover, shear employment
growth does not necessarily account for the quality of the workforce or human capital
development and assessment of an economy’s knowledge base.
Virtually all economies use SME size determinants; some placing emphasis on more than one of
them. The most common determinants used by regulators are the number of employees, sales and
loan size. Of these, the number of employees is used most often. A study of 68 countries that
provided information on the SME measures used by their regulators, found that 50 use the
number of employees criterion, and 29 of these 50 also used one or more of the other criteria.
Out of the sample, 41 regulators used the sales value criteria and 15 used loan value criteria to
measure SME development (Ardic & Mylenko, 2011).
Lack of SME standardization, growth measurement criteria and inter-country PPP, can make
a robust analysis of SME size arduous. As noted above, sundry growth rates may focus on
employment, sales, value added, productivity, loan value or a combination of these.
Measurement criteria may have differing economic effect on different industries, firms and
economies (Kolar, 2014). New measures and data sets have been developed as research in
SME intensifies. See (Ayyagari, 2007), (OECD Statistics Directorate, 2009) and (Ardic &
Mylenko, 2011). Some analysts use gross value added (GVA) as a measurement
(Airaksinen, 2016). Still others, while not necessarily using loan size as a metric, monitor it
regularly. Malaysia’s regulator is such an example. Examples of basic SME development
determinants used by selected regulators are listed in Tables 1 (World Bank), 2 (European
Commission) and 3 (Malaysia).
Table 1-World Bank SME Measures in USD ($)
Category Employees Total Assets Annual Sales Medium >50
≤ 300
>$3 million to
≤ $15 million
>$3million to
≤ $15 million
Small 10 to
≤ 50
$100,000 to
≤ $3 million
$100,000 to
≤ $3 million
Micro <10 ≤ $100,000 ≤ $100,000
Source: (Group, 2008)
Size, as a determinant, is important because it’s indicative of the stage of development of
SME. Given the heterogeneity of SME, size is an important determinant for policymakers that
want to target SME for stimulus, capital allocation and tax revenue building capacity (see infra).
Table 2- European SME Measures in Euros (€)
Category Employees Total Assets Annual Sales Medium < 250 ≤ €43 million ≤ €50 million
Small 10 < 50 < €10 million < €10 million
Micro < 10 < €2 million < €2 million
Source: (OECD, 2015)
Malaysia revised its measurement of SME in 2014. Such measurement changes can distort
growth data, as may the effects of inflation, PPP adjustments and the nuances of industry
differences on data. Malaysia’s new SME measurements require higher sales turnover and
segregate the “Manufacturing” sector determinants.
Table 3-Malaysian SME Measures in Malaysian Ringgit (MYR)
Category Micro Small Medium
Manufacturing Sales turnover of <MYR
300,000;
or < 5 employees
Sales turnover MYR 300,000
to < MYR 15 million;
or 5 to < 75 employees
Sales turnover MYR 15 million
to ≤ MYR 50 million;
or >75 to 200 employees
Other Sectors Sales turnover of <MYR
300,000;
or >0 to <5 employees
Sales turnover MYR 300,000
to < MYR 3 million;
or 5 to < 30 employees
Sales turnover >MYR 3 million
to MYR ≤ 20 million;
or >30 to 75 employees
Source: (SME Corp Malaysia, 2015)
Growth. SME growth is measured by increases in employment and contributions to production
and GDP. Growth is measured on a period-to-period basis in nominal or real terms; the latter
accounting for the effects of inflation and purchasing power parity (PPP) in some instances.
Economic growth occurs as a result of: discovery, exploitation or better utilization of resources;
increased workforce critical mass and productivity; innovation and technology improvements;
and economic specialization in goods and services. The ground swell for each of these is SME
development.
Fast growing firms are of particular interest in financial intermediation, and are notably more
likely to be younger, as larger firms comprise less than 10% of fast growing SME (Kolar, 2014).
Fast growing SME have been classified as either high-growth or hyper-growth (so-called
“gazelles”). High-growth in SME can be sporadic, spurious and of limited duration. Hyper-
growth SME, by contrast, experience an extraordinary growth in sales over a relatively short
timeframe, accompanied by the accumulation of employees and assets. Hyper-growth firms
exhibit absolute growth rather than relative growth, as between short-term periods and in the
midst of inflation and PPP. Thus, they have been defined as a firm that grows from small to large
over a short timeframe (e.g. 5 years), exhibiting high real growth in each period therein. Hyper-
growth firms are also typically younger, but are distinguishable because they tend to be more
involved in merger and acquisition (M&A) and listing activities as their rapid accumulation of
workforce and assets makes them attractive to equity investors. However, along the way to M&A
and initial public offerings (IPO), they often raise higher levels of debt; relying relatively more
upon investments in fixed assets (Minola, Cassia, & Paleari, 2015).
It is estimated that 600 million new jobs will be needed over the next 15 years to absorb the
growing global work force. It is estimated that SME will create roughly 4 out of 5 of those new
jobs (World Bank, 2015). In high-income countries, SME contribute, on average, 50 percent of
GDP. In many economies, the majority of job creation occurs in the SME sector; up to 60
percent in the manufacturing sector (Ayyagari, 2007); (Burgstaller, 2015). In the European
Union (EU), approximately 99 per cent of all economic activity can be traced back to SME.
There, SME account for two-thirds of all jobs in the private sector (Gama, 2012). In OECD
countries, SME with less than 250 employees, employ two-thirds of the formal work force
(Beck, Demirgüç-Kunt, & Peria, Bank Financing for SMEs Around the World: Drivers,
Obstacles, Business Models, and Lending Practices, 2008).
SME development is closely correlated with GDP growth; notably a robust, positive correlation
between the size of the SME sector and economic growth (after controlling for other growth
determinants) has been observed (Beck, Demirgüç-Kunt, & Levine, SMEs, Growth, and Poverty:
Cross-Country Evidence, 2005). In 2011, there were a total of 645,136 SME operating in
Malaysia; representing 97.3% of total business establishments (Department of Statistics,
Malaysia, 2011). Table 4 shows the Malaysian SME sectors’ contribution to overall GDP.
Table 4-Malaysian SME Contribution to GDP by Real Subsector (Percentage of GDP)
Sector 2010 2011 2012 2013e 2014
p
Agriculture 4.3 4.3 4.1 4.0 4.5
Mining/Quarrying 0.05 0.05 .1 .1 .1
Construction 0.9 0.9 1.0 1.1 2.0
Manufacturing 7.2 7.2 7.4 7.5 7.8
Services 19.6 19.9 20.0 20.5 21.1
Import Duties 0.2 0.3 0.3 0.3 0.4
SME GDP to
Total GDP
32.2
32.8
33.0
33.5
35.9
Source: (SME Corp, Malaysia, 2015); e Estimate/p Preliminary
Table 4 also shows which Malaysian real economic sector is fastest growing. It further shows
the SME contribution to the overall GDP by real economic sector. Notably, the “Services” sector
in the Malaysian economy looms large as a percentage of GDP. However, its contribution to
GDP grew by 2.9% between 2013-14. “Construction,” on the other hand, registered the fastest
growth in contribution to GDP at 81.8%; while the “Agriculture” contribution grew at 12.5%
during the same period. The “Mining/Quarrying” sector was stagnant, while the
“Manufacturing” contribution grew at 4%. It is noteworthy that Malaysia’s “ease of doing
business” index for dealing with construction permits is one of the highest in the world (World
Bank Group, 2016). Overall, SME contribution to GDP grew at 7.2% from 2013-14. These
metrics demonstrate that growth can be “tricky” as noted by the work of (Kolar, 2014) supra.
The vagaries of growth can further be seen from the compounded annual growth rate of the same
SME real sectors to GDP over the 5 year period. Faster growing SME in one time period may
slow or become faster during another time period. Table 5 illustrates the volatile nature of
growth in fast growing SME by comparing the 2010-14 compounded growth per sector versus
the more recent 2013-14 growth. Table 5-Comparison of 1 Year and 5 Year Growth of SME in Malaysia as % Contribution
Sector 2013-14 % Change*
2010-14 % Change Difference
Agriculture 12.5 6.7 5.8
Mining/Quarrying 0.0 39.3 -39.3
Construction 81.8 28.9 52.9
Manufacturing 4.0 7.5 -3.5
Services 2.9 7.3 -4.4 SME GDP to Total
GDP**
7.2
8.3
-1.1 Source: Compiled from Table 5 and Table 2.1 of (National SME Development Council, 2015)
* Compounded Annual Growth Rate (CAGR); ** Includes import duties
Finally, understanding financial constraints on a sector like “Services” is important. If financial
constraints are more severe in a services sector; particularly where technology-intensive, both
innovation and technological diffusion (infra) will be significantly affected, to wit economic
growth will likely be adversely affected as well (Kukuk & Stadler, 2001); (Silva & Carreira,
2016).
Age. Age as a determinant of SME development is important for several reasons. One is that it
provides an operating history of financial data that ameliorates the perceived credit risk in SME
financing. Further, during a SME’s business life cycle, it develops financing relationships with
banks and other financial intermediaries. Age can be measured in several ways. Research has
focused on survival rates and business life cycles as two primary determinants of SME age.
Survival Rates. Survival rates are an important determinant of default intensity. Though national
survival rates may be too “broad a brush” with which to paint a credit risk profile, they do give a
macroeconomic level indication of SME development. Specifically, size and age, as key
variables, have been observed to significantly affect their credit risk (Cassar, 2004), as both
variables have been negatively correlated to SME failure. SME failures are difficult to measure
because SME often “fail” because of closures or non-financial reasons. Further, there are no
formal reporting requirements for “informal” SME, making reliable information difficult, if not
impossible, to obtain.
Default prediction models have been introduced into the study of SME failures using financial
statement data (Altman E. , 1968) and later further developed (Altman & Sabato, Modeling
Credit Risk for SMEs: Evidence from the US Market, 2005). Three variables have been
developed to predict SME failures using this approach: (1) loss of profitability and competitive
strength due to a fall in demand or a drop in internal efficiency; (2) deterioration of solvency and
liquidity conditions due to an increase in debt weight by external events (e.g. raising of costs of
debt) or by internal causes such as reduced cash flow or an unbalanced financial structure; and
(3) deterioration in the quality of the credit relationship, especially in relation to short term lines
of credit (Dainelli & Fabrizio, 2013). Using data from Italian firms, and applying these default
prediction determinants, credit historical data was found to be the predominant variable in the
credit rating of SME; followed by the quality of the credit relationship (measured by short-term
lines of credit usage) and loss of profitability (measured by deterioration of operating margins
(Id). These finding confirm theories noted herein below, i.e. the importance of information
asymmetry and the importance of banking relationship persistence.
Research has grouped SME failures into five categories: (1) ceasing to exist (discontinuance for
any reason); (2) closing, or a change in ownership; (3) filing for bankruptcy; (4) closing to limit
losses; and (5) failing to reach financial goals. (Altman, Sabato, & Wilson, 2010). Moreover,
(Headd, 2003) found that only a third of new firms closed because owners considered them
“unsuccessful.” Many insolvency regimes, and indeed banks, often do not distinguish between
the causes. Thus, a SME that has financial difficulties in its early or intermediate stages of
development, but fails for non-default reasons, may be “lumped in” with SME that fail due to
poor management or higher credit risk. This creates a so-called “fresh start” dilemma for SME
owners (Bergthaler, Kang, Liu, & Monaghan, 2015).
Although (Watson & Everett, 1996) used the size of the shopping center firms were located in as
a proxy for firm size, their research found evidence in a study of Australian SME failures that “if
bankruptcy is used to define failure, there is a positive association between size of shopping
center within which a business is located and propensity to fail. However, if failure is defined as
either discontinuance of ownership or discontinuance of business there is a negative relationship
between size of shopping center within which a business is located and propensity to fail.
Between these extreme definitions, if failure is defined as failed to ‘make a go of it’ or disposed
of to prevent further losses, no significant relationship is found between failure rates and size of
shopping center within which a business is located.”
Younger firms have a higher failure rate than older firms. Over half new firms fail by their 5th
year, regardless of their size. Although, this phenomenon may be influenced by the
macroeconomic environment in which the firm operates, it also buttresses other studies that show
a high rate of volatility among younger firms (Kolar, 2014). The longer a young firm survives,
the better its chances of survival. Firms with more employees have a higher survival rate than
firms with fewer employees within the first two years (Cook, Campbell, & Kelly, 2012). There is
evidence that industrial classification is factor in failure rates since SME within the same
industrial class have similar capital structures (Romano, Tanewski, & Smyrnios, 2001). A 2012
OECD compilation of survival rate data among new firms among selected OECD members is
illustrated the phenomenon in Table 6, as failure rates uniformly drop with years 1 to 5.
Table 6-Failure Rates of New Businesses in the First 5 Years
Source: (OECD, 2015); OECD calculations based on OECD Structural and Demographic Business Statistics
Although survival rates within an economy and among sectors is an important determinant of
SME credit risk with application through their stages of development, loan impairment is also a
harbinger of default. Impairment accounting has attracted more attention since the 2008 financial
crisis. A loan is considered impaired when the ongoing monitoring of bank loan portfolios
indicates that an individual borrower or group of borrowers probably will not fulfill their
contractual credit commitments. Impairment may result from asset or income deterioration at the
firm level, or sector or macroeconomic shocks. When this occurs, banks must make accounting
allowances for that probability. Figure 1 shows SME loan impairment has steadily improved in
the aftermath of the 2008 global financial crisis.
Figure 1-Malaysian Bank SME Impaired Loans to Total SME Loan (%)
2008 2009 2010 2011 2012 2013 2014 Source: (OECD, 2016)
A loan is impaired if there is objective evidence that impairment exists as a result of a loss event.
The identification of a single, discrete is not required. Rather, it may be the combined effect of
several events that cause the impairment. In either case, losses “expected” to result from future
events, no matter how probable, are not recognized for accounting standards purposes. A loss
event occurs when substantial objective evidence indicates any of the following circumstances:
(1) significant financial difficulty of the issuer or obligor exists; (2) the bank, for economic or
legal reasons relating to the borrower’s financial difficulty, grants the borrower a concession that
the bank would not otherwise consider; (3) it becomes probable that the borrower will file
bankruptcy or seek other financial reorganization; (4) an active market disappears for loan or
financial asset because of financial shocks; or (5) observable data indicates there is a measurable
decrease in the estimated future cash flows from a borrower or group of borrowers since the loan
initiation (International Accounting Standards Board, 2011).
Business Life Cycles. Both size and age significantly affect the capital structure of SME
(Gregory, Rutherford, Oswald, & Gardiner, 2005). Financing methods in SME vary according to
their age and size. Financing more or less evolves through their business life cycles from initial
internal sources, such as owner–manager’s savings and retained profits (Wu, 2008); to informal
outside sources, e.g. financial assistance from family and friends (Abouzeedan, 2003); to more
formal outside sources, e.g. payables credit, bank financing, venture capital and angel financiers
(He, 2007). Inevitably, formal external capital sourcing through financial intermediaries such as
banks, “shadow banks,” leasing and factoring institutions and securities markets represent a SME
“tipping point” of development and growth (Chittenden, 1996). Even though early stage SME
represent a significant credit risk class for banks, as SME grow and look more to external
financing, credit risk becomes more of a concern as well.
(Berger & & Udell, 1998) posit that the financial needs and options of SME change throughout
the various phases of their business life cycles. Different stages in their business cycles may
require different financing strategies, products and intermediation. In their start-up phase, SME
show a unique characteristic of informational opacity (Berger & & Udell, 1998), little or no track
record or history (Cassar, 2004) and a high risk of failure (Huyghebaert, 2007). Thus, SME have
been found in this stage to depend heavily on insider funding sources. Moreover, at this stage,
SME are frequently viewed by banks and financial institutions as having a higher credit risk:
thus, requiring a higher commensurate expected rate of return.
During subsequent growth stages, SME mature, establish a track record and the ability to provide
collateral. This improves the creditworthiness, investor perception of their credit risk and
external financing sources are more willing to extend credit to SME. The capital constraints
endemic to SME during their start-up phases typically decreases over time as they are no longer
dependent so heavily on internal capital. As SME advance through their business cycle, they
become more transparent and access to collateralized debt financing and equity sources becomes
more available (Berger & & Udell, 1998). Again, monitoring, registration and regulation of SME
throughout their stages of growth and development ameliorate credit risk that may otherwise
persist due to a prolonged “informal” status.
It is noteworthy that SME benefit less from economies of scale and have limited access to a wide
resource base (Burgstaller, 2015); (Lavia Lopez, 2014). Their unusually low equity ratio makes
them more vulnerable to external events compared to larger companies (Altman E. S., 2010),
who have both a wider resource base and larger retained capital. Moreover, a SME’s capital
structure in the early stages might tend to be debt based external financing because of the
advantages leverage in debt financing has on returns, as well as its tax advantages (Modigliano &
Miller, 1958). Thus, this proclivity towards debt financing in the intermediate stages of SME
development makes the credit risk process vis-à-vis SME all the more important. Yet,
unavailable market valuation information (because few are listed, makes SME valuation and
riskiness even more difficult to ascertain).
The business life cycle progression of capital preferences among SME sounds all too familiar to
the “pecking order” theory. The pecking order theory describes the preferences of financial
managers in rising new capital and may just as well apply to owner-managers in the SME
context. The main difference between large firms and smaller SME, when considering the
“pecking order” hypothesis, is the distance between owners and managers in larger firms. In
smaller SME, the owner and the manager may be the same person. Because of this nexus of
roles, the incentives affecting the owner-manager may be riskier than in larger firms. In short, the
bank account of the owner-manager may be at the same bank as the firm’s. In other words,
income and wealth come from the same source. This dilemma is discussed below as a potential
moral hazard after credit is authorized.
Notwithstanding the risk associated with the SME owner-manager nexus, in the “pecking order”
theory, managers first choose to use internal financing or retained earnings, if available. It
follows that if the firm does not possess enough internal capital to fund its growth projects, the
second option will be external financing. External financing is either debt or equity, and the
theory posits that there is a preference towards debt. Debt financing is deemed less risky because
informational costs associated with releasing firm information, e.g. possible trade secrets that
have thus far given the SME competitive advantage. The words of the theory’s founding
proponents illuminate this point. “The firm cannot convey that information by saying: ‘We have
great prospects, but we can’t tell you the details.’” They go on to postulate through equilibrium
analysis that firms may pass on good equity opportunities as a result of this scenario (Myers &
Majluf, 1984). It should be noted that the applicability of the “pecking order” theory to SME has
drawn some dissent. That dissent is based on the “contentment theory” which posits that SME
owner-managers are less concerned with growth per se than they are for financial security (Vos
& Roulston, 2008). It can be surmised that “informal” SME care very little about growth and
often secret fairly large amounts of cash savings off the banking grid.
As SME age and grow, their banking relationships help improve their viability. SME often
enlarge the circle of banks from which they obtain credit through their business life cycles. SME
that deal with multiple banks and financial institutions are roughly twice as large as those that
finance through only one bank or financial institution, notwithstanding any adverse signaling
effect lender changes may pose. Studies show that contrary to the commonly held belief that
banks are not interested in financing SME, banks actually do consider the SME segment
strategically important. Moreover, research points to functional “distance” as a determinant of
access to credit. Proximity between the lender and borrower eases the costs of collection and
“soft” information (Petersen & Rajan, 1994).
A longer the SME-banking relationship in time promotes access to credit overall (Berger &
Udell, 2006). Nevertheless, the credit may gap persist. (Beck, Demirgüç-Kunt, & Levine, SMEs,
Growth, and Poverty: Cross-Country Evidence, 2005); (Beck, Demirgüç-Kunt, & Peria, Bank
Financing for SMEs Around the World: Drivers, Obstacles, Business Models, and Lending
Practices, 2008); and (Beck, Demirguc-Kunt, & Martinez Peria, Bank Financing for SMEs:
Evidence Across Countries and Bank Ownership Types, 2010) provide a series of studies
attempting to understand SME financing. Based on surveys, they provide evidence of how banks
seek out and serve SME through a number of “lending technologies and organizational setups.”
They found few differences in the extent to which SME are reached by banks, e.g. whether the
bank’s ownership structure is public, private or foreign-owned. They did find significant
differences in the SME lending practices between banks in developed and developing
economies. Thus, they concluded that the “enabling environment” is the most important
determinant of SME financing.
Finally, (De la Torre, Martinez Peria, & Schmukler, 2010) studied bank lending to SME,
focusing on business models and risk management. They surveyed 48 bank and leasing
companies in 12 countries and found that banks are indeed interested in lending to SME and do
so through separate organizational units, offering a wide range of products and applying different
credit risk technologies, e.g. credit scoring or risk-rating approaches. They further concluded that
both large and smaller banks have similar interests in SME. A survey study of 139 banks in 16
countries involved in SME financing in the Middle East and North Africa (MENA) found that
the SME sector there remains largely underserved by private banks. There, direct government
intervention through public banks, credit or loan guarantee schemes and other forms of
subsidized and government intervention based financing did help ameliorate the “credit gap”
dilemma. They attribute the phenomenon in the MENA market to weak financial infrastructures
(Rocha, Farazi, Khouri, & Pierce, 2011).
Drivers of SME Development
Any economic or financial variable that materially affects a financial or economic decision or
condition is a “driver.” Drivers often have no quantifiable measurement. Every decision or
condition will have its own unique set of drivers. The unique set of drivers may contain
resources, processes or conditions that affect a change in an economic phenomenon. SME have
been observed to have economic and financial drivers that materially affect their development.
Hence, aside from the quantitative determinants associated with SME development, the
qualitative drivers that were identified by (Beck et al, 2004), have been shown to be significant
factors in overcoming SME developmental constraints, as well as the “credit gap.” They include:
ease of entry; ease of doing business; financial and legal environments (of the economy hosting
the SME); innovation and technology; management capabilities and training; access to markets;
and government intervention programs.
Ease of Entry. Ease of entry for SME has been measured by the number of firms less than 2
years old as a ratio to all firms in an economy. The ability to form businesses within an economy
and the bureaucratic paperwork that goes with formation is commonly associated with the
“business environment” of the particular economy. However, there is a cost-benefit trade-off
because making registration too easy may attract business charlatans that form companies with
the intention of “fleecing” lenders and investors; while rigid registration may inhibit entry
(Klapper, Laeven, & and Rajan, 2004). This is the moral hazard and adverse selection associated
with weak regulation.
However, overly rigid bureaucratic regulations have been hypothesized as being in the “private
interest” as opposed to the “public interest.” This theory posits that the “protected” private
interests of a few well-entrenched firms are served by rigid entry requirements, while public
interests are impeded. Evidence supporting this theory suggests that countries with more rigid
entry regulation, also have higher incidents of fraud and corruption (often due to political
connections), as well as larger “informal” SME economies (Dijankov, La Porta, Lopen-de-
Silanes, & and Schleifer, 2002). Closely associated with this phenomenon is the finding that cost
of entry, as measured as a percentage of per capita GDP is higher in those economies deemed to
favor “private interests” (Klapper, Laeven, & and Rajan, 2004). Thus, it is surmised that more
rigid entry regulation is less effective in societies with “better developed information systems,
better product inspections and quality control, better contract and law enforcement, and
consequently, an entrepreneurial population less subject to misbehavior” (Id). Additionally,
foreign direct investment (FDI) may be adversely affected by a financial system that
unreasonably impedes the “ease of entry.”
Ease of Doing Business. “Ease of doing business” is tantamount to “ease of entry” in financial
parlance. The World Bank formulates its “ease of doing business” composite indices, by
variables including, but not limited to: time and cost of starting a business; time and cost of
registering property; strength of investor and minority investor protection; the tax system; the
time and cost to export and import; and the time and cost of enforcing contract claims. Other
variables include: the ease of getting construction permits; access to electricity; insolvency
resolution; labor market regulation and access to credit. Creditor rights vis-à-vis private and
public access to credit are indexed in the access to credit measure (World Bank Group, 2016).
In the area of access to credit, the World Bank’s Ease of Doing Business Index relies heavily on
research done by (Djankov, McLiesh, & and Shleifer, 2007), testing existing theories, which set
forth two broad “power theories” of what drivers influence how much private credit a financial
institution extends to firms. The first view posits that the power of creditors within a country
influences access to credit. The ease at which lenders can enforce repayment, attach collateral, or
seize control of a debtor firm, all strongly influence the willingness of creditors to extend credit.
The second view posits that “information” is king. The more lenders know about borrowers, their
credit history, operations or references, the less they are concerned about adverse selection; and
therefore, extend credit more readily. Further, impediments to “doing business” inhibit the
registration of SME, that may otherwise remain unregistered in the so-called “informal” SME
economies. If, for example, a streamlined registration is made a prerequisite to accessible
financing, increased registration should undoubtedly occur.
Table 7-World Bank Ease of Doing Business Indices
Country/Classification 2014 2015 The World 95 95
Australia 12 13
Canada 13 14
Denmark 3 3
Finland 10 10
Germany 15 15
Hong Kong 5 5
Indonesia 120 109
Korea 4 4
Malaysia 17 18
New Zealand 2 2
Norway 8 9
Pakistan 136 138
Saudi Arabia 84 82
Singapore 1 1
Sweden 9 8
Turkey 51 55
United Arab Emirates 32 31
United Kingdom 6 6
United States 7 7
The Arab World 122 122
MENA 110 111
High Income-OECD 25 25
Source: http://data.worldbank.org/indicator/IC.BUS.EASE.XQ
Table 7 shows the World Bank’s “ease of doing business” indices for 2014 and 2015 of selected
countries. While the perfect score is 1, Malaysia, for example, has a relatively favorable ease of
doing business index according to the World Bank. Malaysia’s 2015 rating of 18 is comparable
to other successful economies, e.g. Australia (13), Canada (14) and Germany (15). It is also
better than the OECD-High Income rating (25).
Financial Environment. Overall, broad institutional development is vital to alleviating SME
financing constraints. This premise suggests that for SME, the supply-leading hypothesis (infra)
is more important. The supply-leading financial intermediation hypothesis posits that financial
development drives economic development. The findings of (Beck, Demirguc-Kunt, Laeven, &
Maksimovic, 2004) suggest “that it is hard to distinguish the effects of financial, legal and
economic development from the underlying institutional development.” Accordingly, firms in
financially and economically developed countries face fewer financing obstacles. This may also
have nexus to the degree of market efficiency in those markets, as information asymmetry is less
an obstacle as financial development increases (see the discussion of financial intermediation and
innovation infra).
SME development is a function of the “host” country’s financial system. Financial systems
improve information dissemination, reduce transaction and monitoring costs, facilitate the
transfer and sharing of risks, increase investment and lending activity, and generally result in
more efficient capital allocation. These observed functions of financial development help
determine whether a financial system is efficient. If efficient a financial system produces
“financial deepening;” thus its services become more accessible at all levels of society, including
SME, which are underserved in developing countries (Beck, Demirguc-Kunt, & Martinez Peria,
Bank Financing for SMEs: Evidence Across Countries and Bank Ownership Types, 2010).
Financial deepening can induce both “formal” and “informal” SME to incorporate so as to
benefit from the resulting opportunities to diversify risks and obtain limited liability. Moreover,
financial deepening helps foster more sophisticated, independent and “formal” SME; thus,
moving the larger emerging economies away from family-owned SME predominance. The end
result is a more inclusive financial system with better SME composition and competition. Banks
are a major source of external finance for all firms, regardless of size; and thus, key financial
intermediaries (Beck, Demirguc-Kunt, & Honohan, Access to Financial Services: Measurement,
Impact and Policies, 2009). In Malaysia, for example, as of the end of 2011, 71% of its SME
were sole proprietorships, 18.4% were private limited companies, 8.5% were partnerships and
2.1% were classified as “other” (SME Corp, Malaysia, 2015).
Financial Intermediation. Efficient financial intermediation ameliorates financing constraints in
SME (Steven M. Fazzari, 1988). Financial intermediation occurs when financial firms, e.g.
banks, insurance companies, brokerages and other financial institutions, take on liabilities by
taking money and other assets from the “surplus units” of society and channeling the cash and
other sources of capital to “deficit units” (ostensibly firms), allowing the latter to finance the
production of goods and services. Financial intermediation processes differ in bank-based and
market-based financial systems. In bank-based financial systems, equity markets are not
significant competitors with banks. Banks take on added risk associated with debt and deal with
that added risk through “inter-temporal smoothing.” They increase their buffer of short-term
liquid assets when the economy is booming; and reduce this buffer when it is more constricted.
The capital adequacy requirements of banks are adjusted based on their liquidity positions. As a
result, households that hold most of their assets in bank assets are largely shielded from the
added risk and smooth their consumption streams.
In market-based financial systems, with developed or developing financial markets, the equity
market provides competition to banks which makes the inter-temporal smoothing increasingly
more difficult. Financial markets allow high returns in boom times, providing an incentive for
investors to move their savings from banks to financial markets. In order to remain competitive
in such circumstances, banks must cease inter-temporal smoothing (Allen & Santomero, 2001).
This phenomenon has also been referred to as countercyclical capital buffering (Bank of
International Settlements, 2016). The measure is significant since it has been shown that banks
that retain liquidity levels in excess of regulatory requirements are more reluctant to finance
SME (Sacerdoti, 2005).
In either case, financial intermediaries allocate capital to firms through “pricing mechanisms,”
which more or less put the rate of return afforded on the loans and investments in a state of
equilibrium with the credit risk appetites of lenders and investors. This “price discovery” or what
has been called risk adjusted pricing, results in intermediaries providing agency cost savings on
transactions, solving asymmetric information problems, diversifying risks, reducing adverse
selection and helping capital providers assess credit risk. Financial intermediaries are
distinguishable from nonfinancial firms in the real economic sector, inasmuch as the former’s
assets and liabilities are predominantly financial in nature (Bodie, 2011); to wit the term-
“financial” intermediation. (Schumpter, 1934) is credited with hypothesizing that financial
intermediation plays a central role in economic growth because intermediaries largely determine
which firms get “society’s savings.” Financial development is associated with economic growth
in three ways (Patrick, 1966).
The first is referred to as “demand-following,” in which firm production leads finance. This
hypothesis postulates a causal relationship from real economic growth to financial development.
Financial development, according to this hypothesis, is a mere response to real economic growth.
The faster the economic growth, the greater will be the demand by firms seeking capital. Which
sectors of the real economy garner the most capital, under this hypothesis will be those that are
fastest growing. This suggests that SME should garner a significant allocation of capital be it not
for offsetting credit risk factors. Capital allocation based on growth is regarded as efficient and is
thought to occur more or less in an automatic, relatively passive, manner. However, according to
Patrick, this passive, automatic allocation “mechanism” of price discovery can be inhibited in
less liberalized economies or where rigid religious restrictions are placed on the financial market.
In the case of SME development, the impediment is more likely associated with credit risk
factors.
The second type of financial development is termed “supply-leading.” It posits that the supply of
financial intermediation capital occurs in advance of demand for it. It has two functions: (1)
transferring resources from the traditional low growth sectors to the modern high-growth sectors
of the economy; and (2) promoting, and stimulating an entrepreneurial response in these modern
sectors. Thus, growth in the supply of capital stimulates the demand for it and its services (e.g.
price discovery, information symmetry, etc.) of efficient capital allocation to firms in the
modern, growing economy (Id). This process can stimulate both growth and innovation,
particularly in SME.
Thirdly, Patrick proposed a “stage of development hypothesis,” wherein he posits that the two
competing financial development behaviors (demand-following and supply-leading) may
intersect at some juncture. For example, the growth and improvement in financial services opens
up new opportunities for banks and other financial institutions, and in so doing, pulls the real
sector towards sustained economic growth. As financial development and economic growth
strengthen, the supply-leading characteristics of financial development gradually shift the reins
of economic growth to demand-following dominance. Thus, it would seem important that
policymakers know, with some particularity, whether financial development is at the supply-
leading or demand-following stage. Interestingly enough, collateral research in the area of SME
growth and development parallels this stage of financial development hypothesis. The stage of
development business cycle studies (infra) indicate that SME sources of capital change from
internal to external as they grow and begin to “dominate” the financial intermediation process by
being able to demand or “choose” between multiple sources of capital.
Legal Environment. SME face greater financial, legal and corruption constraints compared to
large firms. The impact of these constraints on firm growth is inversely correlated to firm size.
SME benefit the most from improvements in financial development and reduction in corruption.
Thus, improvements in these areas are important in promoting the development of the SME.
Taking into account national differences between financial/legal development and corruption,
SME that operate in underdeveloped systems with higher levels of corruption are impacted most
by all constraints. Generally, legal constraints and corruption, particularly the amount of bribes
paid, the percentage of senior management’s time spent with regulators and corruption of bank
officials also constrain firm growth significantly. Corruption of bank officials affects firm
growth. This evidences the existence of “institutional failure” which supports Basel initiatives
discussed herein that seek a greater monitoring role of financial institutions in overcoming
market failures due to informational asymmetries. For example, empirical evidence indicates that
corruption was found to be highly inversely correlated to within a 1% significance level to the
following growth determinants and drivers: 33%-Per Capita GDP; 18%-Firm Growth; 28%-
Financing Constraints; and 58% Legal Constraints (Beck, Demirguc-Kunt, & Maksimovic,
Financial and Legal Constraints on Firm Growth: Does Size Matter?, 2005).
An economy’s legal system’s determinants are inversely correlated with SME growth (Id). It is
noteworthy that the legal environment encompasses not only the regulatory system of
government per se, but also the legal protections afforded to creditors and investors and property
rights (including intellectual property) through the laws of the jurisdiction. Legal environments
largely determine the size of credit markets and banking rights around the world. Banking rights,
e.g. loan enforcement rights, drive bank credit expansion. Collateral is a banking lever that
offsets asymmetric information. Collateral increases creditor willingness to lend to
informationally opaque firms, e.g. SME. The quality of the legal system influences the bank’s
willingness to accept collateral. Bank rights vis-à-vis collateral is dispositive. Legal
environments that provide strong creditor rights are considered “creditor friendly” if they do not
hinder creditor collection efforts on collateral. This shifts bank lending portfolios towards the
private sector capital formation. European banks, for example, allocate their loans between:
SME, large firms, mortgages, consumer lending and government. In legal systems with weaker
creditor protections, banks lend more heavily to larger firms and government; and less to SME.
The quality of the legal system expands banks’ choice as to various types of collateral. The
measurement of the quality of a legal system is largely qualitative (although one can imagine
setting some measures based upon the level and results of legal proceedings, judgments,
bankruptcies, etc). Hence, some studies survey banker perceptions of the legal environments.
Qualitatively, some drivers include: expectation of recover, time of recovery and the simplicity
or complexity of the legal process to recover (Haselmann & Wachtel, 2010).
A study of creditor protections in 88 countries worldwide, found other debt enforcement drivers
to include: time and cost of legal proceedings, and the likely disposition of the assets (i.e.
preservation of the borrower as a going concern versus piecemeal sale). These drivers are used to
describe debt enforcement efficiency. They have been used to forecast debt market development
in a cross-section of 88 countries, where they were correlated to per capita income, private credit
to GDP ratios and origin of legal environment (English, French, German and Nordic). Debt
enforcement procedures, e.g. the structure of appeals and the availability of floating finance
charges, also influence efficiency. Interestingly, per capita income influences a legal
environment. As it increases, the time to collect or enforce a creditor claim decreases, i.e. there’s
a negative correlation. In more advanced economies, debt enforcement was approximately a
year. In lower-income countries it could take up to 5 years. These timeframes were also
correlated with legal processes of foreclosure, reorganization and liquidation vis-à-vis borrower
continuation and piecemeal liquidation. Per capita income levels also influenced the cost of debt
enforcement and the ultimate recovery. In terms of legal origin, common law jurisdictions were
found to be most efficient, followed by German and French civil law jurisdictions. Finally, it was
determined that from a macroeconomic perspective, the higher the private credit to GDP ratio,
the more developed the debt market appeared (Djankov, Hart, McLiesh, & Schliefer, 2008).
Innovation and Technology. Innovative products and services have been linked to both age
demographics and e-commerce. Malaysian SME and their owners were found to be younger than
the average Association of Southeast Asian Nations (ASEAN) counterpart at 74.2% being under
40 vis-à-vis 53.2%. The ASEAN group shows a strong correlation between younger business
owners and those that expect to “grow, sell online, use social media for business purposes, and
innovate through the introduction of new products, processes or services” (CPA Australia Ltd.,
2016). Among Malaysian SME, 29% believe they will definitely introduce a new product,
service or process that is new to their market or the world within the next 12 months (Id).
Innovation. The OECD in the Oslo Manual (Organization for Economic Co-operaton and
Development, 2005), defines innovation as “the implementation of a new or significantly
improved product (good or service) or process, a new marketing method, or a new organizational
method in business practices, workplace organization or external relations.” Innovation can
maintain existing advantages, create new ones and make today’s products and services better
(Moreno & Flores, 2016). The OECD further estimates that innovation can contribute up to 50%
of the economic growth in an economy, depending on the host country, the level of economic
development and the phase of the economic cycle (OECD, 2015).
In today’s technology driven global village, technology diffusion is a key to innovative success;
particularly in the “services” sector. Traditionally, OECD countries have emphasized invention
as the key indicator of innovation. However, research in economics suggests that it is diffusion
that yields the greatest benefits through the speed at which firms commercialize innovative ideas,
products and services in a globally competitive marketplace. Technology diffusion can be
defined as the process by which innovations, e.g. new products, processes, methods and
techniques spread. The process of technological diffusion is considered essential to economic
growth and development. Technologic diffusion is time sensitive and is measured in two ways
from an economic viewpoint: the number of firms that use and own the technology (inter-firm
diffusion); and the intensity of use within particular firms (intra-firm diffusion). Technology
diffusion runs its course or path through: invention (generation of new ideas, e.g. patents,
trademarks, copyrights, trade secrets, etc. resulting from research); innovation (the development
of those new ideas through the testing, marketing, use and ownership of the resulting techniques,
products or services); and finally diffusion (the creation of an infrastructure that allows the new
technology to spread across the potential market of users and owners).
The benefits of technology diffusion, from an economic view, are balanced against the
associated costs. This process is called the welfare optimal diffusion path. On this path, the rate
of adoption (diffusion) matches the present value of the associated costs and benefits. Stated
differently, it is the point in time where the marginal benefits of use/ownership (an economic
surrogate might be marginal revenue, though other measures might be seen over a range of time)
equal the marginal costs of producing the technology (Stoneman & Diederen, 1994). Technology
diffusion has given “birth” to a distinguishable subset in the area of financial technologies.
Financial Innovation. Financial innovation has been considered important to economic growth
for several centuries. Stated differently, research has concluded that institutions, laws,
regulations, and policies that impede financial innovation slow technological change as well as
economic growth (Laeven, Levine, & Michalopoulos, 2015). Financial innovation occurs when
banks and other financial institutions “invent” more effective processes, e.g. for “on-boarding”
(screening) and servicing new customers. Screening modalities have been found to be less
effective as entrepreneurial technologies advance. Therefore, financial institutions must continue
to enhance their screening and servicing modalities as technology innovation move their way up
the “Schumpterian quality ladder” in order to identify the best entrepreneurs. Hence, dynamic
financial innovation reduces the risk of adverse selection. This is, in part, the thrust of FinTech
infra.
Financial innovation is not without costs. The costs of financial innovation increase
proportionally with the “world technology frontier.” The world technology frontier (WTF) has
been defined as the level of technological innovation shared by the world’s most advanced
economies. Countries where it is more expensive to financially innovate, tend to experience
slower rates of technological growth. Counties with legal systems that rely less on case law, tend
to be more conducive to financial innovation (Id). Theory posits that economies can be “stuck”
in investment-based strategies vis-à-vis innovation-based strategies. Investment-based strategies
can be costly from a social perspective over time. They may further entrench the “rent shield
effect;” i.e. where “cash (rents) in the hands of insiders creates a shield that protects them from
more efficient newcomers.” This, in turn, may lead to an economy staying in the investment-
based strategy too long. Thus, delaying the switch to the innovation-based strategy and reducing
growth because the “economy is not making best use of innovation opportunities.” The delay, if
lengthy, can lead to a longer developmental distance to the WTF and can cause a “non-
convergence trap,” where convergence towards the WTF stops. Conversely, efficiently switching
to innovation-based strategies as quickly as possible can lead to what economist call
“leapfrogging” past economies that were once ahead of the “switching” economy (Acemoglu,
Zilibotti, & Aghion, 2006).
The ability of banks and financial institution to innovate their credit risk assessment of SME may
be exacerbated by the fact that SME have been found to react to shocks quicker than larger firms.
Thus, monitoring them as borrowers has increased importance. Since the 2008-9 financial crises,
SME have attracted attention from economists as a sort of economic harbinger (Ardic &
Mylenko, 2011). SME show a heightened sensitivity to economic shocks. This sensitivity has
been attributed to SME ability to compete with larger enterprises by being more flexible and
faster in responding to customer needs and by adapting to change quickly because of their
relatively simple internal organizations (Lavia Lopez, 2014). There is empirical evidence that
supports the hypothesis that SME performance, in the form of entrepreneurial activity, especially
of an innovative nature, can be a leading indicator of the broader economic cycles; i.e. increasing
ahead of economic recovery and falling ahead of economic downturns (Thurik, 2014). Research
published by the OECD shows that entrepreneurial activity had already fallen by 2007, well
ahead of the economic downturn of 2008–9 (OECD Statistics Directorate, 2009).
Information technology (or IT) can reduce paperwork submission inefficiency and bureaucratic
“red tape” can be streamlined. Information technology may be used to improve SME access to
customer and potential customer databases, as well as market information, both domestically and
internationally. Thus, technology innovation plays a key role in SME development and growth
through information gathering and dissemination used to evaluate and monitor SME, particularly
“fast” growing SME and innovation focused firms. Financial and information technologies
reduce transaction costs and improve portfolio risk management. SME loans in Hong Kong, for
example, are not accepted on the basis of traditional information in financial statements, cash
flow projections and business plans alone. Credit risk assessment techniques that gather
information on customers, sales and payments in real time, enabling a more dynamic risk
management and loan servicing model for SME financing have proved successful in Hong Kong.
Loans are extended against the current actual cash flow and business performance and secured
by accounts receivables (OECD, 2004).
Other technological approaches to information gathering may be used to screen prospective SME
firms for their financing needs using the internet. An example of such an approach is Malaysia’s
SME Bank Group’s online screening (Small Medium Enterprise Development Bank Malaysia
Berhad, 2016). SME Bank is a specialized financial institution geared to be a “one-stop
financing and business development centre” for SME development. It exemplifies many of the
advancing approaches to SME development discussed herein, e.g. financial innovation. Further,
from a credit risk management approach, it is established best practices for financial institutions
to aggregate and monitor SME by industry, stage of growth, risk profile and a number of other
financial and business considerations (e.g. branches, departments, groups, etc.) for financial
intermediation, credit risk assessment and capital allocation purposes.
Financial Technology (FinTech). FinTech is a more recent financial innovation. It should help
banks and others meet their Basel III initiatives (infra) and reduce the information asymmetry
typical of SME. Real time risk analytics enable banks to track and monitor borrower risk and
market exposure. This is accomplished by the development of data platforms that collect trade
data needed to conduct real-time analytics and provide automated reporting. It emphasizes
“knowing your customer” (“KYC”) reporting. Such platforms facilitate bank internal risk
management, stress tests, and mitigating of other risks, e.g. concentration risk. Malaysia’s Bank
Negara Malaysia (BNM) has introduced a “regulatory sandbox approach” that places banks,
FinTech firms and companies in a “live environment” to test the effectiveness of FinTech and
explore innovative business models (Bank Negara Malaysia, 2016). It effectively creates a
FinTech cluster, although the program is not necessarily focused on SME.
Application Interface Programs. As noted above, financial innovation demands that banking
services encompass customer “on-boarding,” KYC, payment, transaction history, and account
information. Current finTech initiatives seek to create a digital financial services exchange,
through application program interface platforms, generically referred to as API, that drive the
standardization and implementation of a common set of banking platforms. These platforms will
reduce both time-to-market and investment needed by banks over time. If established
successfully, this “open” exchange would also lead to the development of a range of innovative
customer centric solutions, e.g. universal digital wallets, self-service financial advice, and
efficient trade solutions. API fintech can also employ “machine learning technologies” to
identify aberrant transaction patterns or possible trouble signs that are “flagged” for further
review, including flexible, automated API regulatory rule-based engines.
Moreover, API exchanges will help establish digital marketplaces that include banks, insurance
companies, credit agencies, marketplace lenders (e.g. leasing companies and peer-to-peer
lenders) servicing the SME sector on a global, regional or national basis. Trade financiers can be
“interfaced” to list products and services available to the SME sector with online applications,
basic terms, and contracts. SME would be able to post trade finance needs and opportunities with
contact information and credit scoring. Ideally this platform would leverage on blockchain1
distributive technology to improve reliability and international visibility, while incorporating a
mobile solution to track, settle and monitor transaction flows.
Management Capabilities and Training. Certain competencies are requisite for effective
business management. Competencies such as finance, accounting, quantitative methods,
information technologies, marketing and human resource management are no less important to
SME than to larger, well staffed firms. In fact, those competencies are even more important for
SME, whose managers are often owners as well. Because of today’s fast changing technological
innovation and globalization, SME competencies must include both, i.e. innovative technologies
and international marketing procedures.
1 A “blockchain” is a distributed database that maintains a continuously, growing list of records called blocks. Each block is
secured from unauthorized access, revision and hacking. Each block is time-stamped and a link its predecessor block. Blockchain
serves as a digital ledger of transactions; thus, ameliorating information asymmetry. Compatible banks, lenders and firms are
able to connect to the network, send new transactions to it, verify transactions, and take part in the competition to create new
blocks. The competition to create new blocks is known as mining (Wikimedia Foundation, Inc., 2016).
SME tend to be flat organizationally and owner-managers are “key” persons; often wearing
numerous “hats” within the SME. The lack of owner-manager skill sets (competencies)
commensurate with their “key” responsibilities has been found to be one of the main causes of
SME failures (Pansiri & Temtime, 2006). Managerial skills, experience and education have all
been found to influence the management capability of SME owner-managers. SME without the
requisite competencies, account for a significant portion of SME failures. SME managed by
owners who have these competencies, find it easier to access financing; particularly when
coupled with interpersonal skills used to acquire political and business connections (Fatoki &
Asah, 2011).
Although there are some polemics about what competency in business actually is, given the stark
reality of the “credit gap” that most SME face, it seems appropriate that some focus be given to
finance as a core competency. Working capital management is particularly challenging for SME
owner-managers, since in their early stages, current assets comprise a large part of their asset
base and current liabilities (often trade payables) represent a significant source of external
financing. Both account receivables and payables (working capital) are current balance sheet
items and components of the cash conversion cycle resulting from turnover or sales and payment
of operating expenses, respectively. Thus, from an operational and financial standpoint, they are
fundamentally important to early stage SME development (Tauringana & Afrifa, 2013). There is
a negative correlation between days in the cash conversion cycle and SME profitability.
Financially, cash from operations is a vital part of cash flow for SME since they lack substantial
capital assets, which might provide other sources of cash flow, e.g. capital gains and
depreciation.
Although there are distinctions between managerial and entrepreneurial competencies, terms e.g.
competency, competencies, skills, knowledge and expertise are often used interchangeably
without sufficient attention to their meanings. One working definition offered is that
“competencies mean the capability of (an) entrepreneur and of her/his collaborators in acquiring,
using and developing successfully resources for their business purpose, in the specific context in
which firm operates.” Whatever definition selected, the consensus is that competency must lead
to value creation and a firm strategy that leads to growth. Moreover, research suggests that the
entrepreneurial competencies required to start a business and the competencies to operate one
over a term of years may be different, or otherwise change through the stages of development in
order to sustain growth (Mitchelmore & Rowley, 2010). That said, there still does not exist a
common framework for both competencies. Given the correlation between SME failures and
management competencies, formal training has emerged as vital; and in the United Kingdom
believed to cut SME failures in half. Moreover, the ability to provide formal training is
negatively correlated to SME size (OECD, 2002); i.e. the smaller the SME, the less likely it will
engage in formal training of its key employees.
Since the number of employees is a determinant of SME development, human capital
development in SME is important, possibly indispensible. The OECD has found that among its
member countries, education and formal training is significantly inferior in SME than among
larger firms. Several larger economies have sought to improve the “quality” of owner/managers
in SME. Governments have sought to enhance their “quality” by subsidizing training and/or
advisory, consultancy and specialized training services (Id). Because technology and innovation
are both fluid, continuous upgrading of management capabilities and focused training are among
the best practices; and are not limited to owner-managers, but rather the quality of the SME
workforce as a whole is important.
As important as formal training to SME development is, the lack of business discipline and
integrity are equally important. It has been noted that the incentive for moral hazards in SME
exists; notably after financing is in place. Once funds are placed, SME owners may mismanage
financing, reducing efforts and returns (Jensen & Mecklin, 1976); (Scholtens, 1999). Risk-taking
entrepreneurs might undertake excessively risky projects since they will gain from any “upside”
of the project, while a banker would prefer less risk, even if less profitable. Larger firms have a
range of financing options and can undertake risky projects by sharing risk, such as equity
financing.
Banks try to minimize the moral hazards caused by agency problems when they evaluate the “C”
for character in the static acronymic model. Nevertheless, it is anecdotal that early stage small
businesses are analogous to young children. There exists an inherent conflict between the self-
interest of an owner of a small business and what is in the best interests of the SME. The sound
principles of business discipline that result from education and training often conflict with the
self control of owner/managers (or the lack thereof).
Access to Markets. The OECD has recommended two “marketing” opportunities that should be
enhanced for SME: international marketing and government intervention programs. That SME
contribute significantly to employment and a nation’s GDP is well-established. However, their
contribution to international trade is far less pronounced. In Malaysia, for example, the SME
share of exports is approximately 19%. Though some variation in SME definitions disrupts data
comparability, that ratio would nevertheless appear to leave room for significant improvement.
Figure 2 shows comparable data among countries worldwide.
Although the opportunity for SME to increase exports can be facilitated by easing their access to
foreign markets and the promotion of local SME products and services internationally, it has
associated costs that necessitate financing in many instances. These costs may include: difficulty
in entering new markets, e.g. price discovery, gathering trade contact information and
establishing marketing and distribution channels; difficulty in defending products, services and
interests in foreign markets; and the lack of necessary trade export skills in-house to deal with
foreign trade standards, regulations and customs procedures (International Trade Centre; World
Trade Organization, 2014).
Figure 2-SME % Share of Selective County Exports
Source: (Yoshino & Wignaraja, 2015) from various statistical
agencies (ASEAN SME data, Business in Asia, DTI Philippines,
PRC Ministry of Industry and Information Technology, European
Commission fact sheet, Small Business and Entrepreneurship Council)
Handling the associated export trade costs may be challenging for many SME. There exists a
global trade finance gap of $1.4 trillion; $693 billion of which is in developing Asia, including
India and China (DiCaprio, Beck, & Daquis, 2015). Among firm types surveyed by the Asian
Development Bank (ADB), SME were consistently underserved.
Figure 3-SME Share of World Supply Chains
Source: (Yoshino & Wignaraja, 2015)
Moreover, the SME path to international marketing can be both direct and indirect. Indirect
participation in “supply chain trade” has been defined as trade in parts and components using the
final trade approach (Athukorala & Nasir, 2012). This approach can be illustrated by the
following hypothetical example. A mobile phone sold by Samsung in the United States is made
in China. A Chinese SME participates in Samsung’s larger firm supply chain by manufacturing
or assembling parts used in the mobile phone. Figure 3 shows the impact this trade phenomenon
has for SME in selected countries.
SME face higher rejection rates than other firm types, globally, as well as in Asia. Banks
reported that 47% of all trade applications are submitted by SME; but rejected 52% of the time.
By contrast, approximately 79% and 87% of large and multinational applications are accepted,
respectively. Hence, there is a correlation between firm size, the need for export financing and
the credit rationing based on firm size. Figure 4 illustrates this disparity graphically.
Figure 4-Trade Applications Rejected by Business Type
Source: ADB. 2015 Trade Finance Gaps, Growth, and Jobs Survey
Government Intervention Programs. Government promotion of SME is a natural response to
their economic significance to the overall economy and a socially responsible policy of “income
inclusion.” Government “set aside” or procurement programs or “schemes” can facilitate an
increasing share of government contracts and/or resources being allocated to SME. A
comprehensive approach to government programs links both public and private institutions,
firms, channels, products and services. These programs may “map” technology “incubators,”
college and university training, consulting and technical expertise, government development
policies and related funding. The OECD has promoted “competitiveness clusters” as an approach
to SME development. Clusters are defined as “the combination, within a given geographic area,
of businesses, training centers and public and private research facilities working together in
partnership to generate synergies in connection with innovative joint projects having the requisite
critical mass for international visibility” (Potter & Miranda, 2009).
An example of government sponsored SME focused credit facilities is in the United States,
where a Small Business Lending Fund (SBLF) was enacted into law in 2010 as part of the US
Jobs Act with the aim of encouraging SME lending. The US Treasury provides capital to
community banks through preferred shares incentivize them to lend to SMEs. These incentives
are provided by reducing the rate of the dividends on Treasury’s shares, with the reduction being
based on the amount of SME lending generated. For example, if a bank increases its small
business lending by 10 % or more above baseline (based on its 2007 SME lending) then
dividends will be reduced from the maximum rate of 5 % to 1 % (U.S. Department of the
Treasury, 2016). Thus, as SME lending is increased by the community bank, its dividend rate on
the preferred shares in it owned by the Treasury is reduced.
Figure 5 shows how Malaysia has structured its “financial landscape for SME.” Not shown on
the “landscape” is the National Innovation Agency Malaysia, which also promotes innovation
focusing on stimulating and developing an innovation ecosystem in Malaysia. Moreover,
Malaysia has a variety of BNM sponsored loan schemes for SME; 147 schemes are enumerated.
Some are specifically microfinance focused, others are geared towards rural and agricultural
development and assistance, while others are provide varied financing arrangements, e.g.
working capital loans, revolving credit and international trade based assistance (SME Corp
Malaysia, 2016). SME Corp uses a “one-stop” referral system that is linked to government
ministries across the board, as well as the SME Bank and other SME focused entities.
Figure 5-Malaysian Financial Landscape for SME
Souce: (SME Corp Malaysia, 2015); BNM is Bank Negara Malaysia (Malaysia National Bank)
State or governmental ownership of firms has shown increase in recent years; even among
developed economies. This trend has been referred to as “state intervention” and even “state
capitalism.” Accordingly, research literature has been developing that seeks to explain the impact
state ownership has on investment structures. See discussion by (Jaslowitzer, Megginson, &
Rapp, 2016). They define state ownership as “stockholdings by any type of government-owned
or controlled entity, including shareholdings of national government ministries and central
banks; equity stakes held by state-owned financial and non-financial enterprises; stockholdings
of local and regional governments; and portfolio investment holdings by public pension funds
and sovereign wealth funds, which are frequently controlled by foreign governments.” They
further posit that evidence suggests that overinvestment by the state is systemically related to
“empire-building.”
Empire-building precipitates two agency problems. The first is that state ownership is associated
with weak monitoring of managers and is negatively correlated to corporate governance quality
because of less exposure to external disciplining forces, product market competition and
takeover pressures. Secondly, from a political perspective, state ownership may have multiple
socio-economic objectives that promote overinvestment, a willingness to “subsidize inefficiently
high output to maximize employment or achieve other socially desirable goals, e.g. locating
production capacities in economically underdeveloped but politically important regions,
providing cheap goods and services, and producing unnecessary products.” With that in mind,
their empirical testing suggests only marginal additional investment value results from state
ownership, which often is based on political connections, even ethnic favoritism (Id).
Constraints on SME Development
Notwithstanding the importance of SME to economies worldwide, there exist obstacles to their
growth and development. European research shows that insufficient market demand is
followed by access to financing as the primary obstacles to SME growth (European
Commission, 2009). The availability of finance has been determined to be a major factor in the
development, growth and success of SME (Ou, 2006); (Cook, 2001). A World Bank study
covering 98 countries identified 15 macro level obstacles to SME growth that included: access to
finance; access to land; business licensing and permits; corruption; courts; crime, theft and
disorder; customs and trade regulations; electricity; inadequately educated workforce; labor
regulations; political instability; practices of competitors in the informal sector; tax
administration; tax rates; and transportation.
The World Bank study (Figure 6) shows the top 6 obstacles to firm growth in developing
countries with access to finance being cited as the second most important obstacle overall; and
more among SME than larger firms. Moreover, it is also instructive to note, that tax
administration, tax rates and practices, customs and trade regulations, practices of competitors in
the informal economy and several ease of going business factors are all cited as affecting firm
growth in developing economies.
Although all constraints to SME development are important and worthy of analyses and
amelioration, three are especially so: access to finance, tax rates (and the related tax
administration) and practices of the informal sector.
Figure 6-Most Commonly Cited Obstacles to Firm Growth in Developing Countries
Source: Enterprise Surveys Dataset (Kushnir, Mirmulstein, & Ramalho, 2010)
Access to Financing. Access to finance is markedly a very significant “bottleneck” to SME
development, as it is essentially the “credit gap.” SME are less likely to obtain bank financing
than larger companies. The World Bank estimates that 50 percent of all “formal” SME don’t
have access to “formal” credit. It further estimates that there exists a “credit gap” among both
“formal” and “informal” SME worldwide of $2.1 to $2.6 trillion. For the “formal” SME sector,
the “credit gap” is estimated to be between $.9 to $1.1 trillion worldwide. Thus, more than half
of the “credit gap” in SME exists with respect to “informal” SME; who represent both an
“untapped” line of business for banks and other financial institutions, as well as an obstacle to
development of the formal SME sector. The effects of financing constraints on growth, as noted
between large and small firms, have been identified by empirical research as indicated below in
Figure 7.
Figure 7-Growth Reduction Due to Various Financing Constraints
Source: (Beck, Demirguc-Kunt, & Maksimovic, Financial and Legal Constraints on Firm Growth: Does Size Matter?, 2005)
Figure 7 identifies important constraints on small business financing; not the least of which is
financing barriers discussed elsewhere in this paper. The “catch all” financing obstacle factor
includes such determinants descriptive of the various financial systems, e.g. access to: foreign
bank financing, export financing, lease financing, operations financing and non-bank equity.
Specific finance constraining variables as lack of money, special connections, interest rates,
bureaucracy and collateral are all indicative of the presence of credit rationing. Credit rationing
in some economies results in external financing being more costly than internal financing due to
the premium (“high interest rates”) on external financing caused by asymmetric information and
macroeconomic factors. Figure 8 shows the interest rate “spread” between large firms and SME
in Malaysia.
Disentangling the determinants of credit rationing has proven difficult for economists. One study
in Japan did identify land collateral as an ameliorating determinant to credit rationing there
(Ogawa & Suzuki, 2000). Clearly, a SME’s asset base will mitigate credit constraints caused by
credit rationing (Atanasova & Wilson, 2004). Macroeconomic factors relating to bank market
power (increases credit availability) and bank competition (decreases in competition increase
credit rationing) have also been noted as credit rationing drivers (Carbo-Valverde, Rodriguez-
Fernandez, & Udell, 2009). In total, the reduction in small firm growth associated with credit
“gap” and credit risk related factors in Figure 7 is approximately 57%.
Figure 8-Malaysian SME Borrowing Rate Spread
2008 2009 2010 2011 2012 2013 2014
Source: (OECD, 2016)
Credit rationing is a by-product of financial intermediation of credit instruments that exchange
money credit for promises to repay based on information relating to borrower future cash flows.
Where demand for credit is greater than the supply of money, and information is imperfect, as it
invariably is, the bank’s perception of which borrower promise is more trustworthy may cause
banks to ration credit money based on “special connections,” interest rates and/or collateral.
These factors, along with bank paperwork, combine to form a credit constraint for many SME.
The credit allocation under instances of inchoate or asymmetric information can lead to adverse
selection, forgoing of innovative profitable projects and moral hazards. Measuring credit
rationing can be exacerbated by the “inter-termporal smoothing” and “countercyclical capital
buffering” practices of individual banks, as well as the difficulty in forecasting macro-level
variable lags and multiplier effects (Jaffee & Stiglitz, 1990).
Notwithstanding the progress Malaysia has made, access to finance is still perceived as difficult
by many of its SME. Malaysian SME that sought finance in 2015, still perceived access to
finance as more difficult. Approximately 32% of Malaysian SME found access to finance easy or
very easy, as compared with an ASEAN average of approximately 48%. As theory and other
research suggests, relatively difficult financing conditions impact the demand for external
financing. In During 2015 in Malaysia, the percentage of SME demanding external finance fell
from approximately 74% to 58% (CPA Australia Ltd., 2016). Those results suggest that a “credit
gap” may be present in the Malaysian SME sector. Figure 9 seems to confirm the survey results.
However, Malaysia’s acceptance rate for SME loans is relatively high at 91.4%.
Figure 9-Malaysian SME Loans Requested & Approved (MYR million)
Source: (OECD, 2016)
The “Informal” SME Conundrum. Studies often focus on the “formal” SME sector. Yet, the
“informal” SME sector, though obscure, is equally important. An informal SME can be defined
as a SME that is not registered with any regulatory body within an economy. Registration may
take many forms, from obtaining licenses and permits, employment benefit registrations and
filing of requisite tax forms stating the existence of a company. The “formal” vis-à-vis
“informal” classification employed by the World Bank is premised on registration and regulation
data (World Bank Group, 2016). Many SME that might be regarded as “micro” enterprises, often
operate “off the grid” and are not registered with any governmental agency, may not file tax
information returns; and as a result linger in obscurity. Moreover, as noted in Figure 6, the
practices of the “informal” SME sector are viewed as an obstacle to firm growth in developing
countries by approximately a quarter of all formal SME surveyed. This may be due to the tax and
other registrations costs that “formal” SME include in their cost structure, while “informal” SME
escape those costs.
Empirical research buttresses the survey results. The quality of institutional environments in
exacerbating or in alleviating the impact the “informal” SME sector has on the “formal” sector
has been empirically observed. Weak institutional environments increase costs and decrease
benefits to “formal” SME. A large “informal” SME sector “influences perceptions about the
substitutability between formal and informal goods,” as well as corruption (law evasion).
Moreover, “registered SME facing competition from informal firms are more likely to be credit-
constrained than other formal SME that are not confronted with such competition.” This result is
termed the ‘‘parasite” view, which posits that “informal” SME are capable of competing against
formal SME and hurting the latter’s profits. This economic phenomenon is generally found in
countries with weak rule of law and a higher degree of corruption and bureaucracy. For a
discussion of the concept of rule of law as it applies to development, see (Krever, 2011).
Registered micro and small firms are more likely to be hurt by these parasitic “informal” SME
than medium-sized firms because one of the benefits of medium-sized SME status is increased
access to credit; reflected in their progression through the SME business cycle. In short, it has
been recommended that “governments must enhance their role in increasing access to credit to
smaller firms and in providing incentives for informal firms to be integrated in the formal
economy” (Distinguin, Rugemintwari, & Tacneng, 2016).
The World Bank estimates that there are between 285-345 million “informal” SME in emerging
markets (when “micro” enterprises are included in the data). The failure to monitor, register and
regulate these SME can have a significant impact on pricing of credit risk, tax revenue building
capacity, amelioration of asymmetric information and the resulting adverse selection in the
financial intermediation and capital allocation processes by banks and other financial institutions.
Table 8 illustrates that the relative size of the “informal” SME sector. Information obtained
through registration and regulation might include such econometric data as demographic product
mapping, International Standard Industrial Codes (ISIC), OECD Structural Analysis (STAN)
Codes and important fiscal information. It is noteworthy that developed, high-income economies,
as a rule, have smaller “informal” SME sectors as percentages of GDP. The United States (8%),
Australia and the United Kingdom (11%), Canada (13%), Singapore and China (14%), all have
relatively small “informal” SME sectors. Moreover, the average worldwide percentage is
relatively small at 13%. This appears, at least at first glance, to draw correlation between
economic development and SME registration and regulation.
Table 8-Global and Selected Country SME Contributions (2010)
Country
Formal SME
% of Employees
Formal SME
% of GVA
Informal SME
% of GDP Total Worldwide 77 50 13
Malaysia 56 32 33
United Kingdom 59 51 11
Singapore 62 42 14
China 88 60 14
Pakistan 78 30 40
Hong Kong 50 21 19
Canada 70 45 13
Australia 64 50 11
Nigeria 75 10 63
UAE 63 45 29
United States 58 51 8
Russia 49 21 52
Source: (The Association of Chartered Certified Accountants, 2010)
It is also noteworthy that, in general, as the size of the “informal” SME sector increases, the size
of the “formal” SME section decreases. The ability to register, monitor and collect data on SME
activity is pivotal to ameliorating the SME “credit gap,” higher credit risk and avoiding adverse
selection by banks and other financial institutions. Yet, even without the input of the “informal”
SME sector, an estimated 77% of all employees worldwide work in the “formal” SME sector.
Tax Building Capacity. A significant “informal” SME sector suggests the loss of tax building
capacity. Tax uilding capacity is measured by “taxable capacity,” “tax effort” and “tax
diversity.” Taxable capacity is the estimated tax-to-GDP ratio, regressed using estimated
coefficients taking into account the country specific characteristics. Tax effort is the ratio of
actual tax collected-to- GDP and taxable capacity (Le, Moreno-Dodson, & Bayraktar, 2012). Tax
effort is the tax authority’s enforcement efforts. Tax diversity of revenue sources and not just
reliance on value added taxes has been central to keeping tax revenues from collapsing in the
face of trade liberalization.
Tax incentives can improve the attractiveness of registration to “informal” SME and may
include: jobs, investment, enterprise zone, research & development and productivity credits
against potential tax liabilities; amnesty for past delinquent tax returns; and private retirement,
insurance and/or annuity benefit tax incentives. Tax policy may also be used to incentivize SME
technology development through research and development (R&D) tax credits, as well as
promoting “green” SME technologies through similar credits (or conversely de-incentivizing
undesirable SME activities). Figure 10 illustrates a systematic tax approach that addresses many
of the SME tax concerns, as well as the emerging global concern for inclusive growth vis-à-vis
growth for the sake of growth.
Malaysia recently revised its tax system from a graduated income tax to a consumption based
general sales tax (GST) system (National SME Development Council, 2015). Malaysia also
made paying taxes easier and less costly by implementing a mandatory electronic payment
system for companies depositing employee benefit systems contributions and by reducing the
property tax rate. Yet, it also increased the capital gains tax, which can be a disincentive to
investors on the capital market. Nonetheless, it also ranked first among 30 nations, including the
United Kingdom, United States and France, in advancing shareholder protections (World Bank
Group, 2016).
Interestingly, research in the area of taxation and government monetary policy reveals a
correlation between taxes paid in an economy’s fiat money and money demand; thus, promoting
the development of financial systems built around an economy’s fiat money is linked to taxation.
“Except for relatively highly taxed countries, where taxes may encourage tax avoidance and
holding bank deposits, the level of taxation is a positive factor boosting financial development.”
A study using Granger causality testing on 65 countries over the past half-century concluded that
the relationship between taxation and money demand is generally supported in the 60 countries
making up the three higher income groups (Ott & Tatom, 2016).
Figure 10-Tax Policy Design to Achieve Inclusive Growth
Source: (Brys, Perret, Thomas, & O'Reilly, 2016)
SME Credit Risk
Access to credit and the resulting “credit gap” makes credit risk assessment of SME more
arduous than with larger firms. Their opacity exacerbates the difficulty. As with all risk, the
process of managing credit risk is one of identification, analysis, measurement, mitigation,
monitoring and controlling. Management often mitigates risk by transference, containment and
hedging against it. However, because of the special challenges presented by SMEs, the process
of credit risk management requires that creditors apply credit risk management policies and
procedures specific to SMEs in segregated portfolios and make a more targeted assessment of
individual credit applicants. The determinants of SME credit riskiness are: financial opacity
(which may be linked to a period of “informality;” informational asymmetry (particularly in their
early stages of their business cycles); lack of collateral (i.e. most of their assets are movable);
substandard records (e.g. unaudited or certified financial statements and possibly lack of
managerial training/coaching), shorter operating histories and little or no credit history (which
may require owner/SME combined scoring),; poorer management quality; and an array of other
constraints on credit accessibility particular to SMEs, e.g. those noted in Figure 7.
SME are privately held firms; few are publically held or have access to capital markets. Thus,
banks are the primary source of financial intermediation for SME. Major credit rating agencies
seldom maintain credit database information on SME. Thus, for banks, SME are generally
considered riskier than larger firms. This perception of riskiness significantly affects the SME
“credit gap.” Unlike larger firms, when credit tightens, SME cannot substitute longer bond debt
or equity financing for bank lending. Moreover, the perceived risk generally results in banks
requiring higher expected returns on credit to SME. Thus, the SME “credit gap” is exacerbated
by both credit rationing during credit tightening cycles and higher expected returns on loans due
to perceived riskiness. In determining the level of risk and return, banks look to credit risk as the
primary risk for evaluating their exposure to loss and price (return) discovery. Credit risk is the
risk of extending credit to a borrower or borrowers in a portfolio of loans. It is the risk of loss or
diminution of financial reward to a lender resulting from the likelihood of a borrower’s failure to
repay a present contractual obligation from future cash flows. Thus, the process of identification,
analysis, measurement, mitigation, monitoring and controlling credit risk is more difficult for
SME.
Methods used by banks to identify, analyze and measure the inherent risks of SME have led to an
evolution of credit risk models. This has been ushered on by the importance and growth of the
SME sector and the failure of larger banks that lend primarily to larger firms (but, whose failure
resulted in banking regulations that affect SME nonetheless). Acronymic and balance sheet
accounting attempts to measure credit risks have proven to be of limited application due to their
static and periodic natures. Credit rating agencies, e.g. Fitch’s, Moody’s and Standard & Poors
also are less useful in evaluating SME credit risks as few SME have credit profiles by the major
credit rating agencies. Thus, banks have turned to systematic and internal models to manage
SME credit risk.
Because of the proclivity of SME to internally finance their early stage development, SME credit
scoring should be based on the analysis of historical data about the SME’s owner as well as the
firm; thus removing some of the opacity of the SME. The data are entered into an internally
developed or purchased loan risk prediction model for credit scoring. Moreover, there exist
credit reference agencies or national credit bureaus that provide credit scoring historical
databases, where a particular bank lacks such a database. These databases encompass both the
business and the individuals in the business, based on their personal credit experience and the
business rating where available (DeYoung, Frame, Glennon, & Nigro, 2010).
Bank Credit Risk and FinTech. Existing credit risk models do not leverage new sources of
qualitative and quantitative information that encompasses both for individual owners and SME.
API technologies can leverage nontraditional data points and sources to selectively refine
existing models. These Fintech solutions offer an interactive, smarter seamless customer
monitoring interface through the use of instant messaging and smart devices. It may integrate
machine learning and artificial intelligence (“AI”) to produce faster and more accurate responses
to customer activities, including their changing needs and circumstances. This, in turn, enables
banks to lend to new customers that they would have otherwise rejected. Scalable APIs with
micro-service “app” capabilities that interface large multi-purpose relational bank databases can
create “micro-service” models that are agile and adaptable.
Credit risk assessment has traditionally used audited financial statements of companies.
However, many SME, both “formal” and “informal” may not need audited financial statements,
making credit evaluation challenging. Moreover, financial statements are not dynamic as to time
or value. Financial statements may only be issued annually or quarterly, and weeks, if not
months after the accounting period has ended. In the digital economy, banks can leverage new
data points through social media and connectivity in the market as an alternative to their existing
credit scoring model and as encouraged by Basel III.
The so-called “finternet” can develop integrated solutions that provide banking and SME
connectivity based on size, age, growth stage, and service requirements through “cloud” API.
These services are broader than simple financial services and may include business management,
cash management, working capital and other financial and consulting services. These services
may be linked to API exchanges that interface with SME focused programs, training, cluster and
integrated SME development systems and other mobile financial literacy tools. For example,
human centered disclosure statements (“HCDS”) that are legally binding but easier to read and
understand, combined with interactive digital ecosystems, e.g. working capital management
tools, can be leveraged using robo-advisor AI technology, that would allow bankers to offer
advice when appropriate.
Digital documentation and authentication may sooner than later become obsolete. Yet many
banks still communicate with customers via paper statements and advice through traditional mail
(“snail mail”), which is slow in today’s digital world, has security flaws, and involves inefficient
manual paper shuffling labor. Mobile user-friendly apps targeted at SME can provide access to
aggregated financial transaction details (if possible across different financial institutions),
customized reports from various accounts and/or financial institutions, information storage
capabilities, personal data, and real time notifications. At the SME firm level, the continued use
and reliance on paper-based methods to reconcile payments, accounts, returned checks, lost
invoices and T+2 processing time for telegraphic transfers can result in time management and
informational inefficiencies. Banks can and should develop a full product suite for SME to
manage their sales, receivables, costs, purchase orders, invoices, working capital and cash flows.
This information can be platformed into information needed by banks to monitor SME loans as
part of a risk management lending technology framework (infra). These finance technological
innovations and more are part of the emerging “internet of things” IoT, sometimes called the
“finternet of things” (Monetary Authority of Singapore; The Association of Banks in Singapore,
2016).
Systematic Approach to Credit Risk Management. Credit risk, like all risk, once identified, can
never be completely diversified away or hedged against. The idiosyncratic nature of some
portion of credit risk, for example, remains due to the underlying debtor, its business model, its
industry, the subject matter of the financing and the systemic risks that are part of both local and
global economies. The methods used to measure credit risk are not disjointed. Credit risk
analysis is not a standalone component of financial analysis. Managing credit risk requires
analyses of borrowers, their products, industries, operations and personnel. Lending to SMEs, for
example, not only involves tailored risk management techniques, but also managing the
concomitant risks which result from the additional costs associated with those techniques, e.g.
investigation, monitoring, advisory and collection costs. They are quite often used together and
integrated as part of systematic credit risk analysis method employed by the financial institution.
Hence, once identified and analyzed, the process of measuring, monitoring and controlling credit
risk, as with all risk, is ongoing. In this sense, the process of credit risk management begins with
the identification of the risk and continues analytically and systematically as long as the specific
credit risk exists.
Technology has facilitated the systematic process. Accordingly, many modern banks use an
overall systematic credit risk framework, which includes such tools as data management, risk
profiles, monitoring and feedback; as well as a variety of credit risk measurements (Bluhm,
Overbeck, & Wagner, 2010). One such approach to systematic credit risk management employed
for SMEs is shown in Table 9 below (International Finance Corporation, 2010).
Basel. The Basel Committee on Banking Supervision, based in Basel, Switzerland, was
mandated by the Bank of International Settlements (BIS) in the 1980s in order to promote
standards to enhance bank safety through risk measurement and monitoring methods. Basel I
(1988) or the Basel Capital Accord, as it is called, emphasizes a bank balance sheet by protecting
the regulatory capital of banks. Regulatory capital is the amount of capital a bank must maintain
as required by the bank’s regulator and is generally a ratio of bank equity that must be
maintained relative to the “weighted” riskiness of the assets the bank holds. The method is
measured in two steps: the measurement of weighted risk exposures assigned to assets classes;
and the quantification of the regulatory capital available relative to the risk measured (Iqbal &
Mirakhor, 2007).
Regulatory capital is divided into Tier 1 and Tier 2. Tier 1 is the core measure of a bank's
financial strength as determined by its regulator and it typically comprised of the bank’s common
stock, disclosed reserves, stock surpluses or retained earnings; and may also include non-
redeemable non-cumulative preferred stock. Tier 2 is supplemental to the core capital component
and is typically comprised of revaluation reserves, undisclosed reserves, hybrid instruments and
subordinated term debt. The ratio of regulatory capital (Tier 1 and 2) to risk-weighted assets is
the minimum level of recommended regulatory capital or capital adequacy ratio (CAR). In the
wake of banking volatility and rapidly changing financial markets, including financial product
innovation, Basel II was promulgated in 2004. Basel II introduced enhanced prudential
supervisory review processes and more effective market discipline. Market discipline placed
greater emphasis on bank transparency and risk disclosure (Investopedia LLC, 2016).
Basel III was adopted in general in 2010 and was scheduled to be gradually implemented from
2013 until 2015 but delayed full implementation to 2019 (Basel Committee on Banking
Supervision, 2011).
Table 9-World Bank Systematic Approach to SME Risk Management
Understand the SME
Market
Develop
Products &
Services
Acquire & Screen
SME Customers
Manage & Service
the SME
Customers
Manage Data,
Information &
Knowledge
Identify and quantify risks in the targeted market; leverage
existing research and bank data
Develop loan
pricing
models that
match client
risk profile
Lend to current
customers first,
Integrating portfolio
information
Dedicate staff to
identify signs of SME
default early
directly liaison with
SME management to
minimize losses
Establish centralized
teams to monitor loan data for risks &
early warning signs, &
to incorporate data &
improve credit policies
Sub-segment the market by risk profile and target
according to bank risk appetite
Incorporate
innovative
forms of
collateral,
such as
accounts
receivable
Use internal rating &
scoring methods to assess loans &
customers
Provide advisory
services
to assist SMEs in cash
flow management
Use portfolio data to
customize models
for statistical credit
scoring
Enhance predictive capabilities
by gathering information on local
SME success factors
Prioritize
role of non-
lending
products;
establishing
customer
relationship
& providing
predictive
data
Use transparent
external data
such as credit bureau
reports; Separate sales
from
credit approval
for more rigorous
underwriting
Dedicate processes
& staff to SME
segment to streamline
Operations
Enhance profitability
analysis capabilities
to disaggregate
revenue & costs by
revenue, cost & profit
centers, e.g. branches,
products, customers
Implement pricing &
operational approaches
by understanding level & nature
of unmet SME demand;
including service preferences
Sophisticate
standardized
products
to minimize
transaction
costs
Focus customer
acquisition
on clients
“close to” the current
portfolio; Automate
screening processes
to reduce underwriting
costs
Use direct channels
e.g. branches & call
centers to reduce
relationship
management cost
Learn from & apply
cost-saving
innovations discovered
from branches,
products, customers,
etc.
Segment the market by costs
in order to identify & limit
effects of cost drivers linked to
SME characteristics
Increase the
overall
value of each
SME
customer by
offering &
bundling a
wide variety
of products &
services
Separate business
development from
relationship
management
for efficiency
Adjust level of
personal service
to SME size or value
Revise qualitative &
quantitative internal
credit scoring models
based on the data,
information and
knowledge obtained;
Implement modified
restructuring,
collection & transfer
policies & procedures
Source: (International Finance Corporation, 2010); modified by author
Basel III has mandated that banks pay closer attention to measuring and managing credit risk. Its
requirements affect large and small banks alike. Smaller banks, whose business model focuses
on small business, are the primary SME lenders in many economies. In Germany, as in many
other EU countries, these banks issued almost 60% of all SME loans (Angelkort & Stuwe, 2011).
While these smaller banks were not the real cause of the financial crisis, they are included in the
gamut of the Basel III regulations. Moreover, the liquidity coverage ratios introduced by Basel
III exclude commercial paper of SME. Nevertheless, Basel III is particularly important to SME
because SME seldom have external credit ratings. That has proved to be an impediment to bank
measurement of credit risk for SME. However, the introduction of internal rating based approach
to credit risk and the automatic credit scoring models approved by Basel III have shown a
positive effect on SME. Banks are increasing their use of small business credit scoring (SBCS)
as an internal rating approach to credit risk. SBCS uses statistical evaluation of historical
financial information (including credit profiling) for both the SME owner and the SME.
Empirical tests of the result of using these methods by “community banks,” which are generally
smaller, but frequent SME lenders, shows that their use is positively correlated with SME credit
availability (broadly defined). The determinants of credit availability included: quantity of
lending; riskier (marginal) lending; lending in low-income and high-income areas; and lending
over greater distances. These methods are often combined with other credit risk techniques.
(Berger & Frame, Small Business Credit Scoring and Credit Availability, 2006). Moreover,
research shows that the use of credit scoring is associated with an increase in credit availability
for credit facilities to $100,000, without any significant change in the quality of the banks’ loan
portfolios. There appears to be a learning curve in using the technology (Berger, Cowan, &
Frame, The Surprising Use of Credit Scoring in Small Business Lending by Community Banks
and the Attendant Effects on Credit Availability and Risk, 2009).
Table 10 SME Credit Risk Management Competencies
Description Core Competency Criteria Assess the bank’s ability to
shift from a traditional
risk management approach,
based on risk avoidance,
systematic collateralized
lending, and relationship
lending to an industrial and
objective approach to risk
based on adequate risk
assessment, mitigation and
pricing. A good credit risk
management framework
should ensure that
(1) credit risk is appraised in
a thorough and consistent
way across the institution,
(2) segregation of duties
between origination,
underwriting, and
disbursement is adequate,
(3) mechanisms are in place
to efficiently manage and
monitor the portfolio, and to
learn from negative
experiences
Management and
Organization
Credit underwriting
Portfolio monitoring
Bad debt management
Risk modeling
Organization of the
credit risk function
Credit policy
Approval criteria
Credit
administration
Monitoring process
Early warning
signals
Early arrears
management
Portfolio reviews
Recovery process
Rescheduling
Provisioning
Analytics
Risk modeling
culture
Systems
Source: (International Finance Corporation, 2010)
Notwithstanding the advance of internal credit scoring models, credit risk management extends
beyond the origination of the actual loan. As noted in other sections of this paper, ex poste risks
for SME must be monitored in order to properly manage credit risk in a holistic manner. Table
10 annotates credit risk management competencies related to a holistic approach.
Information Asymmetry. Because SME typically suffer from opacity and substandard records,
and because credit risk assessment is in large part based on information, an asymmetric
information problem among SME should be viewed as a major determinant of perceived credit
risk. In a financial sense, banks trade in financing. In the SME sector, banks exchange finance at
a price that is intermediated according to the information the SME possesses and has given to the
bank. The exchange of information reduces the bank’s risk of adverse selection; and hence,
credit risk. A bank needs this information to write a loan contract. It needs as much symmetry as
possible not only to determine its required return and the loan size, but also to ascertain whether
there is a “better” borrower to ration credit. Table 11 summarizes a conceptual framework for
SME lending technologies at a “loan-level granularity.”
Table 11-SME Lending Technology Conceptual Framework
Technology Information Source Screening &
Underwriting Policies
Contract
Structure
Monitoring
Mechanisms
Small business credit scoring
Hard information (data points) about the
Enterprise
Based on the SME’s score in a statistical model
No collateral required, higher expected returns
Observation of timely Repayments
Financial statement Lending
Audited financial Statements
Based on the strength (and credibility) of the
SME’s financial ratios
Contracts may vary but future cash flow is
primary source of
repayment
Ongoing review of financial statements
(suggesting possible
mechanisms, e.g. debt covenants)1
Relationship
Lending
Soft information on
the SME, owner, and
community, gathered over time
Based primarily on the
decision or
recommendation of the loan officer
Variety of structures Continued observation
of the enterprise’s
performance on all dimensions of its banking
relationship (suggesting
possible mechanism, e.g. compensating balances)1
Factoring Value of collateral:
accounts receivable
Based on the quality of
the enterprise’s clients
Factor purchases the
accounts receivable outright, thus taking over
credit and collections
Lender owns the accounts
receivable
Asset-based Lending
Value of collateral: accounts receivable or
inventory
Based on value of collateral
Primary method of repayment is asset
collateral
Problematic, as value of the assets must be
regularly updated
(suggests the feasibility of fair value and asset
impairment actg)1
Leasing Value of the asset
Leased
Based on value of the
asset
Lessor purchases asset
and rents to borrower;
purchase option at end of
lease
Observation of timely
Repayments
Fixed-asset Lending
Value of collateral: real estate,
equipment
Based on the assessed market value of the
asset, and coverage ratios
measuring the SME’s ability to service debt
Collateral (asset) worth over 100 percent of loan,
throughout amortization
schedule; lien prevents borrower from selling
asset
Observation of timely Repayments (suggests the
feasibility of fair value
and asset impairment accounting)1
Source: (Berger & Udell, 2006); 1 Comments are the author’s.
Monitoring SME information and activity is important because it not only results in increased
registration and promotes data gathering, but thereby helps ameliorate asymmetric information in
the SME sector. Addressing information asymmetries is pivotal to SME development.
Information infrastructures for credit risk assessment, such as local, regional or national credit
registries or data warehouses with “loan-level granularity,” can reduce the perceived credit risk
in SME financing. Similarly, reducing the perceived credit risk may also reduce financing costs,
which are typically higher for SME than for large firms. In the “digital age,” where information
“blockchains” and application program interfaces “feed” on wider and wider information
gathering, a systemic approach to gathering SME information and the “reeling in” of the
“informal” SME sector loom far more important than in any time heretofore.
The SME “informal” sector provides “fertile ground” for both banking lending capacities and
various forms of moral hazards. The failure to monitor the “informal” SME sector and moral
hazards associated with lax registration and regulation, greatly increases the likelihood of
lawlessness (showing a disregard for the “rule of law”), secreting profits (due to a tendency
among them to deal on a cash basis) and other forms of inappropriate financial conduct; possibly
crimes. The obvious implication for tax revenue building capacity is tax evasion and/or fraud.
Finally, even in the “formal” SME sector, the ex ante monitoring of SME information can
prevent moral hazards.
Islamic Finance and SME Development
Islamic finance emphasizes risk sharing, as must Islamic banking, if it is to remain true to its
epistemology. When Islamic banking does so, it exhibits characteristics that render it “inherently
stable.” Conventional banking, because of its emphasis on debt-based products that are
uniformly interest-based, has proven “inherently unstable.” Modern historical analysis shows
that most, if not all, banking crises, can be traced back to debt leveraging crises and monetary
policies that place too great an emphasis on interest rate manipulation. Governments are no less
susceptible. Bankruptcy and insolvency have marked the 21st century geopolitical map in
Europe, e.g. Greece, Italy, Portugal and Spain. Speculative financing nearly brought the
international financial system to the brink of destruction during the 2007-2009 global financial
crises. Islamic banking prohibits speculative financial transactions and securitizations that are
un-tethered to real assets, just as it prohibits interest-based systems. These governments
borrowed at level they thought were reasonable debt vis-a-vis their GDP; and ultimately found
themselves in an “unsustainable debt spiral” and forced into painful austerity programs
(Mirakhor & Krichene, 2010).
Islamic banks are mandated to promote benefit and prevent harm. At their core are the
underlying moral foundations of Islam that serve as the epistemology upon which Islamic
banking rests. Islamic banking contracts require Islamic Law (Shari’ah) compliance in the legal
banking relationships on both the asset and liability sides of banking balance sheets. Islamic
banks are tasked with providing financial products and services that meet the Objectives
(Maqasid) of Islamic Law. To ensure that the Islamic banking contracts and Objectives are
fulfilled in practice, Islamic banks are overseen by Shari’ah supervisory boards, both at the
individual bank and regulator levels. These aspects of Islamic banks serve as safeguards. First,
they mandate that Islamic banking transactions are fair and transparent, avoid exploitation and
promote the wellbeing of society’s stakeholders in its financial system through normalized
prohibitions. Secondly, they provide stability in financial relationships by following rules
(ahkam) that govern banking contracts. These “rules” provide a systematic approach to banking
contracts that are tethered to Islam’s moral foundation.
The Islamic Epistemology of Sharing. Islamic banking has at its core the financial preference
of sharing both risks and profits or losses. Hermeneutically, this is the natural result of the
obligations and prohibitions derived from the sacred texts (nusus) or sources of the Islamic Law
(Al-Shari’atul Islamiyyah or Shari’ah for short). Those texts include preeminently the Qur’an2
and Hadith3. Other texts, sources and legal methods to derive rules (ahkam) from Shari’ah are
used, including, but not limited to: consensus (ijma), analogy (qiyas), statements of the
companions of the Prophet, PBUH (qawl al-sahabi), custom (‘urf), juristic preference
(istihsaan), public welfare (istislah or maslahah), presumption of continuity (istishaab), blocking
the means to sin (sadd al-dharaa’i), preceding Scriptures (Shar’u man qablanaa), the practices
of the people of Madinah4 (amal ahl al-Madinah) and exegesis (ijtihad).
Because of its religious and moral underpinnings, Islamic finance prefers risk sharing to risk
taking and risk shifting whenever possible. This does not mean that equity financing is the goal
of all financing in Islam. Islamic banking contracts provide a formative line-up of both debt-
based and equity-based financing. Moreover, the prohibition against “interest” does not proscribe
debt. Debt, in fact, is specifically mentioned in the Qur’an. For example, Verse (Ayat) 285 in the
2nd
Chapter (Surah) states in an unambiguous manner: “O you who have believed, when you
contract a debt for a specified term, write it down…” (Saheeh International, 1997). It is further
given legitimacy in the Sunnah and other sources of Islamic Law. Thus, the misnomer that
Islamic banking proscribes debt is inappropriate and misleading.
Islamic banking proponents proffer that it is different from conventional banking. Most look to
the prohibition of “interest” (infra) as the distinctive feature of Islamic banking. Some claim the
distinction is more form than substance. See (Al-Gamal, 2006), (Hamoudi, 2010) and (Kuran,
Islamic Economics and the Islamic Subeconomy, 1995), who see Islamic economics and finance
2 Al-Qur’an (literally meaning The Recitation) is the central sacred text in Islam; considered literally the Word or Speech of the
God, Who in Arabic translates to Al-Illah or contracted form Allah. 3 Hadith or sometimes called Sunnah are written collections of the sayings, actions and approvals (tacit or otherwise) of the
Prophet Muhammad, PBUH. The six major collections are Saheeh Bukhari, Saheeh Muslim, Jami’a Tirmidhi, Sunan an-Nasa’ai,
Sunan Abu Dawud and Sunan Ibn Majah. Other collections exist as well. 4 Madinah is the second holiest city in Islam, next to Makkah. It is the city that the Prophet, PBUH, resided while many of the
rules of law were established and implemented during and after his lifetime.
as being either a façade of legal pluralism, illusionary or dysfunctional. In their nascent modern
history, Islamic banks have not always carried their moniker that well. They have consistently
favored debt-based modes of financing. This trend “creates suspicions amongst unconvinced
Muslims and other critical outsiders who observe that Islamic banks in reality are no different
from conventional banks since the net result of Islamic banking operations is the same as that of
conventional banking” (Dusuki A. , 2007). Moreover, there are disparate views of what Islamic
banking should be.
One view emphasizes profit and loss sharing in the bank-customer relationship and places
greater social welfare as an overriding objective, including “social justice, equitable distribution
of income and wealth, and promoting economic development.” This view encompasses
consideration of all seven Islamic banking stakeholders, i.e. customers, depositors, shareholders,
managers, employees, regulators, Shari’ah advisors and local communities (Id). The other view
posits that Islamic banks should operate as conventional commercial banks inasmuch as they
should seek to maximize shareholder profits and honor their responsibilities to depositors, but do
so in a Shari’ah compliant manner. The latter “view is somewhat similar to the Western
worldview, particularly Friedman’s concept of corporate responsibility which contends that
society is served by individuals pursuing their self-interest (ala Adam Smith’s invisible hand)”
(Id).
Shari’ah vis-à-vis Smith. The Shari’ah is regarded in Islamic finance, as in all other aspects of
life, as superseding guidance as to human interaction (mu’amulat); a substantial part of which
governs financial and economic transactions. Islam’s ultimate objectives require financial
transactions to serve the interests of all human beings (jalb al-masaalih) and to save them from
harm (daf’a al-mafasid). This is tantamount to social responsibility and accountability.
Protection of human needs is established under the Objectives of Islamic Law (Maqasid al-
Shari’ah), by not only removing harm as it relates to human beings, and in particular as it relates
to the necessities of life (dururiyyat), but also in removing hardship (raf’ al-haraj). These human
rights, which require protection from harm and hardship, encompass at least five (5) essential
areas, to wit: faith (din), life (nafs), family (nasl), intellect (‘aql) and property (ma’al) (Dusuki,
2011). These objectives protect the rights of individuals (khassan) and the public (amma) in
general (Auda, 2008). Economics as a social science; and finance, as an outgrowth of economics,
have socioeconomic implications. Islamic banks have collective religious obligations (furud
kifayyah) imposed on them by the Shari’ah, which once fulfilled by some members of society,
relieves all other members of the specific obligations. Those obligations extend far beyond
prohibiting riba or so-called interest and include the necessity that Shari’ah-based products and
services mitigate harm to individuals and society (Farook, 2007).
By contrast, epistemology of modern finance can trace its genesis back to Adam Smith’s
treatises on the “The Theory of Moral Sentiments” (“Moral Sentiments”) and “An Inquiry into
the Nature and Causes of the Wealth of Nations” (“Wealth of Nations”). Smith’s Moral
Sentiments starts by examining the vested self-interest of mankind and the motivation of
individuals to avoid poverty so passionately as to cause them to pursue riches with “avarice and
ambition,” even as seen in “the wages of the meanest labourer” (Smith, The Theory of Moral
Sentiments, 1759). Smith’s view of economics is one that starts from an individual’s inward
motivations. It is individualist occidentalism; narrowly construed. While he makes good use of
the notion of men wanting for others what they want for themselves, the subjective nature of
what men want, its vagaries and the notion that man’s desires or “disapprobations” as he calls the
opposite of approbations, guide human beings in their financial affairs, is positivistic in origin.
Smith posits that human beings have “sentiments” that are both good and bad. He labors to find a
cohesive system of explaining mankind’s proclivities toward “self-love, reason and sentiments.”
Finally, he admits that no systematic set of rules governing natural jurisprudence, other than as
applies to “justice,” can be identified because those he has examined are “loose, vague and
indeterminable.” (Smith, The Theory of Moral Sentiments, 1759). From the Islamic perspective,
this is exactly why an overriding moral framework in the form of a systematic set of rules, with
objectives, is required to avoid the vagaries of sentiments and errant rationalization.
Smith posits that it is only individual security that motivates each person; and by directing his
industry to produce the greatest value that he intends only for his own gain, that he is led by an
“invisible hand” to “promote an end which was no part of his intention.” He infers from his
personal observations that an individual, by “pursuing his own interest…frequently promotes
that of the society more effectually than when he really intends to promote it.” He dismisses the
notion of social welfare and public good by concluding: “I have never known much good done
by those who affected to trade for the public good” (Smith, An Inquiry into the Nature and
Causes of the Wealth of Nations, 1776). One is left to ask: what then of the goals of social
welfare and nation building? One might say that in contrast to Smith’s “invisible hand,” in Islam,
the Hand, though invisible, is evident, axiomatic and part of the normative Islamic worldview.
Moreover, the Hand does not so much emanate from the individual’s desires as it does from the
community striving together for common good, as Muhammad, PBUH5 said: “Indeed, Allaah’s
Hand is on the community.”6
This is, in part, why ‘urf and ‘aadah are, within proscribed limits of the Shari’ah, are considered
sources of law in Islam. The term ʿurf, means "to know" things that are well established in a
given society, e.g. customs or traditions. ‘Aadah refers to conventions or usage of those customs
and traditions that are brought or carried forward. Technically, these terms overlap. They also
form the basis for acceptance of pre-Islamic financing traditions incorporated into Islamic
banking (Ghani, 2011). Thus, the quwaid al-Fiqiyyah or legal maxim: customary practice is
5 PBUH is tradition acronym for sending salutations on Prophet Muhammad, i.e. “May God’s Peace and Blessings be upon him.” 6 Sunan an Nasa’ai. Ruled authentic by Shaykh Nasirdin al-Albani. Also, found in Jami’a Tirmidhi with the version: “Indeed my
community will not agree on error and the Hand of Allaah is upon the community; he who sets himself apart from it will be set
apart in Hell.
among the juridical authorities or al-‘aadat al-muhakkamah. And further, in order to repel public
harm, private harm is to be tolerated or ‘yutahammal al-darar al-khas li daf’ darar ‘am.’
Turning to banking; it is a collective enterprise nearly by definition. It is the depositor
stakeholders that play a fundamental role in banking and financial intermediation. The notions of
an individual’s sentiments or desires to avoid poverty are not eminent, but are preserved and
protected. Thus, the Islamic principles of protecting the interests (maslahah) of individuals
(khassan) and the public (amma). Maslahah is the juristic set of principles that preserve and
promote the Objectives (Maqasid) of the Law (Shari’ah), and further, secure benefits and protect
harm to all (Laldin, 2013).
American Capitalism. Smith’s fixation with self-interest, self-love and sentiments in pursuit of
wealth ultimately gave birth to the notions of the “profit motive” and capitalism. Profit is
mentioned in Smith’s Wealth of Nations innumerable times; but loss relatively seldom. For
Smith, self-interest results in social benefit through commercial intercourse of merchants and
other members of society, e.g. a “butcher,” who’s production was of benefit to others; becoming
so, almost by chance, as a result of his own selfish sentiments. Smith believed this intercourse
resulted in a satisfaction to the butcher; further providing incentive for his profit motive. A bit of
history helps see the progression and divergence that emerges from an abstract, universal drive
for an asocial, if not antisocial “profit motive (Levy, 2014).
The single-minded obsession and longing for money and power gave rise to capitalists, like
Rockefeller and Carnegie. Rockefeller7 and Carnegie;
8 both appeared on the American economic
landscape in a little over a century after Smith. In America, the bastion of capitalism, Scottish
financial thought (e.g. the Carnegie and the Forbes family) became a “stable mate” of the post-
revolutionary quest for freedom from the sentiments against poverty that resulted from centuries
of feudalism and coveted wealth by the ruling families and aristocracies of Europe. During this
period, various American state legislatures began to grant corporate charters, (then considered
concessions of popular sovereignty), on a discretionary basis. These property-based corporate
concessions were private, but states brought them into existence only if they fulfilled some
“public purpose.” Such public purposes might be the construction of a road, highway or turnpike,
or the issuing of money, or other government or benevolent work of charity. The language of
these corporate charters held them to a public accountability. Further, the charter restricted
corporate activity so as not to violate these “public trusts.” A banking corporation, for example,
could not build a railroad simply because doing so would increase its profits (Hovenkamp,
1988).
7 Rockefeller founded Standard Oil Company, Inc. in 1870 the state of Ohio; as a partnership. The U.S. Supreme Court later ruled
(1911) that it must be broken up into 34 separate entities because it violated federal “anti-trust laws.” Those entities became
ExxonMobil, Chevron, and others. 8 Andrew Carnegie was an Scottish American, who founded Pittsburgh's Carnegie Steel Company, which later became U.S.
Steel.
Towards the middle of the nineteenth century, states began to pass general incorporation laws,
liberalizing access to corporate charters. By the end of the second half of the nineteenth century,
the legal personality of American corporations had transformed and public expectations were
largely abolished by joint-stock or stock corporations, which were decidedly “private actors,”
even if they maintained many of the privileges once granted in return for public purposes;
including limited liability. This, among other things, freed these private corporate actors to
pursue “profits” anywhere. Corporations, rather than receiving charters that expired in a term for
years, enjoyed perpetual legal existence; conveying profits, wealth and property into the
“limitless future” (Hurst, 1970). In the decades after 1850, the privatized language of corporate
charters replaced “public purpose” with “lawful purpose;” and lawful purpose became profit; to
wit the “profit motive.”
Partnerships as a Common Thread. Obviously, commerce and banking did not begin in America.
Commerce is as old as human history or immemorial. Aside from the butcher or ironsmith and
similar trades, commerce took on collective, feudal, joint ventures very early in human history.
The epistemology of conventional partnerships and their concomitant laws can be traced to Near
Eastern, North African (Egypt) and Medieval European societies; all long before Smith’s time
(Henning, 2007). See also (Rodriguez, 2002). Roman expansion and conquest gave shape to lex
mercatoria or merchant laws. These laws contributed several important concepts. Foremost
among them was the idea of parties “coming together” for consensual good faith dealings inter
se or among themselves. Moreover, lex mercatoria advanced another fundamental legal
principle, i.e. the doctrine of agency or each partner having the right to participate in the
management of a business (mutua praepositio), as well as the liability of all the partners (in
solidum) to third parties for “partnership obligations and the entity theory of the legal nature of
partnership” (Id).
Another form of partnership known as a commenda or “an arrangement by which an investor
(commendator) entrusted capital to a merchant (commendatarius) for employment in business on
the understanding that the commendator, while not in name a party to the enterprise and though
entitled to a share of the profits, would not be liable for losses beyond his capital” (Id). The
commendatarius would only lose the value of his labor and time; possibly reputation. It parallels
the modern limited partnership, as well as the Islamic mode of finance known as mudarabah
(infra). In fact, some scholars have specifically attributed this mode of financing to Islamic trade
origins (Udovitch, 1970) and to the Hebrew ‘isqa and Islamic qiraad ( (Udovitch, At the Origins
of the Western Commenda: Islam, Israel, Byzantium?, 1962).
In fact, among the Mediterranean merchants, there were other contracts in commenda, i.e. the
collegantia maris, which in contrast to the societas maris, did not involve a joint expedition or
travel to obtain profit. In this form of contract, the limited partner does not travel (socius stans -
one who stands), but instead borrows two thirds of capital required, and the traveling partner
(socius tractator) the other third. The loss was covered according to the invested capital, but the
profits were shared equally between the two parties. Onshore collectives arose in the form of
compagnia and societas terrae, which handled expansions from major ports to inland traders.
The compagnia was predominantly a family company, which included the father, sons, brothers
and other relatives (con-with and panis-bread), being based on unity and responsibility of capital,
labor and results. Later, they were called by their collective name, societas terrae, because its
members were jointly responsible, not only within the part that participated, but also to guarantee
of all their goods. (Pacala, 2016).
Others believe that the partnership origins can be traced to early societal “merchant houses” or
family businesses that ultimately formed ventures and companies with other “merchant houses”
(Kohn, 2003). Taking a more “organic” view of how partnerships developed, Kohn draws a
similitude between these family “houses” of merchandising and trades with family agricultural
endeavours. He traces these origins to “sea lions” or commerce in the Mediterranean Sea (as this
sea served as a Medieval “super-highway” between the West and East) and the Roman forms
noted above. He repeats another theme found in other literature in this area and that is that one of
the motivations for using the partnership form in the Roman and European environments was to
avoid Roman edicts against usury (Id). In other words, a partner might be able to secure
legitimate profits at a rate suitable to him through the partnership form that he would not be able
to charge by simply loaning money to a merchant. This is certainly an interesting phenomenon
from the Islamic perspective, as it is a fundamental norm in Islamic banking.
Still other historical research ties commercial development more closely to the “collective.” The
association of individuals into groups pursuing a common goal as a “collective” was critical to
both family and state in early Roman jurisdictions. Under Roman law, the state, not the
individual, was empowered to hold “property and transact with natural individuals as though it
was itself a person." Collectively held Roman tax farms called societas publicanorum outlived
the individual partners and had representatives who acted for the company as a unit, and allowed
the trading of their shares (Kuran, 2006). Even though Kuran sees the religious restrictions in
Islamic Law as an impediment to growth, it may be seen alternatively as a stabilizing force that
prevented Islamic societies from rushing headlong into a individualistic, capitalistic financial
model that is now, more than ever, being questioned by many economists and financial
professionals because of its lack of inclusiveness, inability to alleviate poverty; not to mention its
instability and volatility that seem to plague it in cycles, if not perennially.
Hence, what we find instead of Smith’s individualist, occidental view of commerce and finance,
we find an evolution of non-banking finance and commerce based on profit and loss sharing
arrangements among families, merchants and collectives. This approach to commerce and
finance can be found in Asian commerce long before the Northern-to-Southern Europe to
Mediterranean-to-Egyptian line of merchandising practices and laws. Early Chinese traders
spread their merchandise over several ships, instead of putting all their property on one ship. If
one ship sank, no individual trader bore the loss or was “wiped out.” If two traders spread their
goods over two ships and one sank, each trader lost only half of his goods rather than everything.
The Chinese and Babylonians, in the 3rd
and 2nd millennium BCE, respectively, also engaged in
practices of risk, and profit and loss, sharing and the latter codified such practices in the Code of
Hammurabi, circa 1750 BCE (Wikimedia Foundation, Inc., 2016).
Early Banking Origins. Banking as a business can be seen historically in Babylonia in the 2nd
millennium BCE, where there were written standards of practice in the Code of Hammurabi.
Obviously, these early banking practices were very different from modern-day banking practices.
For example, deposits were not made with money but with livestock, grain or other commodities;
eventually precious metals. These deposits were accepted, loans were made and fees were
charged. These same basic concepts underlie today’s banking system were present in these
ancient arrangements. Similar banking practices were found in ancient Egypt. These resulted
from the requirement that grain harvests be stored in centralized state warehouses. Depositors
could use written orders for the withdrawal of a certain quantity of grain as a medium of
payment. This system continued to exist even after private banks dealing in coinage and precious
metals were established there (Davies, 1994).
More modern banking practices can be traced to the Mediterranean Italian cities of Florence,
Venice, and Genoa. Italian bankers made loans to princes to finance wars and and to merchants
engaged in international trade. Again, these early banks tended to be organized by trading
families as a part of their more general merchant activities. The Bardi and Peruzzi families were
dominant in Florence in the 14th century; establishing branches in other parts of Europe to
extend their merchant activities. Both of these banks eventually failed when Edward III of
England defaulted after financing the “100 Year War” with France (Hoggson, 1926). The most
successful Italian banking family was the Medici family and Medici Bank established by
Giovanni Medici in 1374. The Medici began as money changers, eventually expanding to
London. The Medici Bank’s principle customers were merchants, royalty and the Pope; the latter
being the primary reason for the bank’s success.
International business of the Medici banks was facilitated through the use of bills of exchange.
This usually involved a creditor providing local currency to the debtor in return for a bill stating
that a certain amount of another currency was payable at a future date, e.g. the date of a big
international fair. In order to circumvent the Roman Catholic Church’s prohibition on usury or
directly charging interest, these banks were closely affiliated with merchants. Bankers took
deposits in one city, made a loan to merchants transporting goods to another city and received
payment at the destination. In short, it was international trade and the varying currency exchange
rates provided a means of concealing interest charges; thus, circumventing the Christian usury
prohibitions (Goldthwaite, 1995).
During the 17th and 18th centuries, Dutch and British banks improved Italian banking
techniques. Key to this development was the notion of fractional reserve banking. By the middle
of the 17th century, Europe was engulfed in wars. Goldsmiths transitioned from forging gold and
silver to becoming bailsmen for the safekeeping of precious metals. In return, they issued a
“receipt” for the deposits. The receipts began to circulate as a medium of exchange; a form of
fiat money. Keen to their advantage, the goldsmiths realized that all depositors would not
withdraw their gold and silver simultaneously. They began to issue more receipts than they had
precious metal in their vaults (Davies, 1994).
Ultimately, banking reached the shores of North America. Banks became an integral part of the
fledgling American economy almost from the start of the colonies. In 1781, just five years after
the Declaration of Independence, the first chartered bank was established in Philadelphia; by
1794, there were 17 more. Initially, bank charters could only be obtained through a legislative
act. However, by 1838, New York had adopted the Free Banking Act, which allowed anyone to
engage in banking business as long as they could meet the statutory requirements. Each state
then passed its own banking act and soon banks from the various states had differing bank notes.
Bank failures made matters worse. The American Civil War to end slavery ushered in federal
legislation for nationally chartered banking. A national currency was adopted and a tax placed on
state issued bank notes. The national bank notes came with a federal guarantee; protecting the
holder in the eventuality of an individual bank’s failure. This centralized legislation placed all
banks under federal supervision; ultimately leading to the present day federal reserve system
(Klebaner, 1974).
Much of the world has now forgotten the international merchant-banker, partnership and
collective origins of commerce and banking, Smith’s view is one of individual maximizing
behavior, self-motivating and self-reinforcement. It provided a rationale for the capitalist “profit
motive,” but little else. Islamic finance has largely retained the “sharing” aspects of humanity’s
early commercial origins and after a hiatus caused by colonialism, now seeks to resurrect the
collective spirit of broad-based stakeholder accountability, and the sharing of risks, profits and
losses. These values are inherent in the sanctity of its contracts, socioeconomic objectives and
norms. Therein lays the challenge of Islamic banking, which is at an embryonic evolutionary
crossroads seeking to synchronize its legal banking instrumentals to modern markets in the face
of stiff competition from a well-entrenched and formidable conventional international banking
system. What will be the trajectory of Islamic banking; one positively or negatively aligned with
its underlying epistemology? Kuran9, though a critic of Islamic finance offers an observation that
seems noteworthy:
9 Timur Kuran is a professor of economics and law at the University of Southern California and the King Faisal professor of
Islamic Thought and Culture.
“I reject…the view that laws evolve instrumentally to track hanging material
needs in a perfectly synchronized manner. However, I also reject the counter-
view that laws are fully autonomous from market outcomes. In my analytical
framework institutions not only constrain activities but they shape the
incentives to modify them. In formal terms, I recognize path dependence10
as
well as the impact that material outcomes have on the specific "path" the
economy subsequently follows…As such, my argument falls within the rubric
of "historical institutional analysis" (which) distinguishes among self-
enforcing, self-reinforcing, and self-destroying institutions. In the short run, a
self-enforcing institution perpetuates itself as the expected actions of agents
motivate and enable other individuals to follow the associated behavioral
regularity. Such an institution is also self-reinforcing if it exhibits positive
feedback, in other words, it expands the range of situations in which the
behaviors in question are observed…A self-enforcing institution is self-
destroying if, while perpetuating itself in the short-run, it exhibits negative
feedback by sowing the seeds of its own eventual demise” (Kuran, The Islamic
Commercial Crisis: Institutional Roots of Economic Underdevelopment in the
Middle East, 2003).
Normative Prohibitions and Obligations. The juristic foundation of Islamic Law is in its
simplest expression is based on prohibitions (tahrim) and obligations (ijab). Islamic banking
incorporates the prohibitions in its rules regarding usury (riba), speculation (gharar) and
exploitation (zulm). Islamic banking is also prohibited from financing proscribed transactions,
i.e. those dealing in impermissible (haram) goods (e.g. alcoholic and addictive substances),
services (e.g. night clubs or places where alcoholic beverages are served or illicit contact
between genders is commonplace, pornographic media, etc.) and practices (e.g. gambling or
maysir, which has been found to exist in certain conventional insurance contracts). Thus, these
products, services and practices, among others not enumerated here, are strictly prohibited in
Islam, i.e. they are impermissible or unlawful per se. Islamic Law prohibits usury (riba),
speculative or excessively ambiguous dealings (gharar) and exploitative business practices
(zulm). It also commands and encourages the sharing of profits by mandating an assessment on
profits, encouraging the sharing of them and discouraging the hoarding of them.
Riba. The term riba is commonly equated with interest in conventional (and some Islamic)
financial texts. However, the term has a much broader application in Islamic finance. In Islam,
riba and interest are not the same; the former being more expansive than the latter. Riba is
10 Path dependence can be described as an historical economic theory that sometimes minor, even fleeting advantages of some
technology, product, standard or legal precepts, can have important and sometimes irreversible influences on the ultimate market
allocation of resources, even in an economy dominated by voluntary decisions and individually maximizing behavior.
defined differently depending on its usage. The particular form of riba called interest has been
prohibited in other religions and societies before the formal establishment of Islam as a world
religion; most notably in the Law of Moses, Peace be upon him, i.e. the Torah. The Catholic
theologian, Thomas Aquinas, condemned all interest as usury; while Martin Luther, the
Protestant, likened usury to murder (Goetz, 1952). The conceptual condemnation does not end in
religions, but also includes ethical and philosophical condemnations. The classical Greek
philosophers, Plato and Aristotle, both prohibited interest on loans. Aristotle described this form
of commerce as the “birth of money from money” and the most unnatural form of commerce.
Aristotle wrote that money is “intended to be used in exchange, but not to increase at interest” Id.
Notwithstanding its broad condemnation, it persists and is the foundation of modern
conventional finance; thus fulfilling the prophecy: “There will certainly come a time for mankind
when everyone will take riba and if he does not do so, its dust will reach him.” This Hadith11
is
reported in Abu Dawood, Vol. 2, #3325; Ibn Majah, Vol. 3, #2278 and in both Ahmad’s Musnad
and An-Nasa’i.
Riba comes from the Arabic verbal root rabaa and literally means something increased or
augmented. It has the secondary connotations (ishaarat) of excess, growth, addition, swelling,
high, being big and usury (Lane, 1863). The inference clearly has financial connotations, i.e.
money lent in expectation of receiving more in return. Riba has several technical meanings as
well, which centre on the notion that it is “any excess without any corresponding counter-value
recognized by the Shari’ah” (ISRA, 2010). This is sometimes modified by adding the phrase
“recognized by the Shari’ah at the time of the transaction, or with a delay in exchange of either
or both counter-values” (Id). Some scholars extend the meaning of riba to any prohibited “sale”
or wealth acquired illicitly, regardless of how acquired (Id). In short, it is an unjustified increase
in wealth at the expense of another (Lewis, Ariff, & Mohamad, 2014).
There are some unique forms of riba, e.g. riba al-fadl, which “occurs when commodities of the
same genus are exchanged in unequal quantities in a spot sale” (Id). The rules governing these
exchanges generally falls upon 6 commodities: gold, silver, wheat, barley, dates, salt “and the
like.” The rules have been juristically extended to modern currency trading. The rules governing
these exchanges are termed bai’ al-sarf (or bai’ meaning sale and sarf meaning exchange).
While they may seem cumbersome to the uninitiated, their significance can be seen when viewed
through the prism of consumer protection. For example, it is related that Bilal (a companion of
Muhammad) brought to the Prophet, PBUH, some barni (good quality) dates, whereupon the
Prophet asked him where they were from. Bilal replied: “I had some inferior dates which I
exchanged for these - two sa’ for a sa’ (a measurement used during the time).” The Prophet said:
“Oh no, this is exactly riba. Do not do so, but when you wish to buy, sell the inferior dates
11 Hadith or plural Ahadith are the sayings and actions of Prophet Muhammad, PBUH; as well as his approvals (tacit or
otherwise) of words or actions of others. This particular Hadith as a weakness in its transmission, but is reported in 4 different
collections of Ahadith.
against something (medium of exchange) and then buy the better dates with the price you
receive.” Reported in Sahih Muslim, Vol. 3, # 3871; also Musnad Ahmad). This Hadith provides
insight into rules (bai’ al-sarf) that seek to provide consumer protection, as well as the
importance that Islamic finance places upon the marketplace as a price discovery mechanism.
Gharar. Literally, gharar comes from the Arabic root meaning to deceive, beguile, to show
inexperience or ignorance in affairs, to act childish, to expose to danger, perdition or destruction
without knowing, danger, hazard, delusion and deficiency or imperfection. The related word
taghreer means to expose to danger. Technically, gharar implies uncertainty and/or ignorance of
one or both parties in a contract over the substance or attributes of the object of sale, or doubt
over its existence and availability at the time of contract or any of the other salient terms of an
agreement. Gharar yasir is minor or acceptable uncertainty; as few financial events are without
any uncertainty. A contract that has this level of uncertainty will not be invalidated. However,
gharar fahish is major or unacceptable uncertainty and is fatal to an Islamic banking contract,
resulting in the contract being void or voidable. Its presence eviscerates mutual consent (ridaya)
or the “meeting of the minds” that is essential to contract formation. Since Islamic contracts, as
conventionally, come in a variety of forms, the effect of gharar on each has been interpreted
somewhat differently among jurists. Ijma or consensus or unanimity of opinion exists as to the
impermissibility of the lower threshold of gharar or ambiguity in mu’awadaat contracts or
exchange contracts which contain promises (al-Dareer, 2004).
Gharar is also prohibited in Islamic financial intermediation caused by excess ambiguity, excess
uncertainty and speculation (which increases credit risk). Banking has inherent risks. The legal
maxim, no reward without risk (al ghorm bil ghonm) capsulizes this financial phenomenon
(Rosly, 2005). Though the perceived difference between ghonm and gharar may be subtle in the
mind of consumers, Islamic banking professionals must nevertheless guard individuals and
society against the spread of gharar. Thus, Islamic banks are prohibited from speculative
investing of deposits, which are treated as liabilities by all banks.
Finally, gharar in Islamic banking contracts may be caused by asymmetric information (jahl),
ambiguity (taghreer), lack of “mutual consent” (ridha), misrepresentation (ghabn), and doubt
(shubuhat). Islamic banking contracts that are unduly complex, verbose or combine within them,
two or more contracts (ijtima al-uqud), can easily lead to gharar. Onerous and unfair terms and
conditions in Islamic contracts may lead to exploitation (zulm). Misleading advertising and
marketing (khalabah) can lead to gharar and zulm for the unwary (Abdullah, Amanbayev, Omer,
& Elobeid, 2012).
Zulm. Zulm is derived from the Arabic zalama or to do wrong or evil, to treat unjustly, oppress,
harm, deprive another of his or her rights (huqouq), injure, to be unjust, act wickedly or to
misuse another. The sacred texts of Islam are replete with commands, prohibitions and
statements against zulm and warnings against it in all facets of human interactions (mu’amulat).
As noted above, the Objectives of the Islamic way mandate that Islamic society and its
institutions (and specifically its financial system) strive to be beneficial to humanity and protect
it from harm. Since the Almighty has forbidden injustice by Himself, He has also forbidden it
among humanity. In financial transactions, taking the money or property of others unjustly is a
form of zulm. The taking may be by “trick” or connivance, deceit, dishonesty, improper
measurement and accounting, theft or by any number of other means, e.g. unfair bargaining
power. It may also exist due to the lack of compassion or mercy on others, including debtors.
Zulm is often overlooked as an Islamic norm although it is proscribed in Islamic banking. The
Islamic norm against zulm includes, but is not limited to: (1) untrustworthiness; (2)
untruthfulness; (3) lack of generosity in bargaining; (4) inflated claims; (5) harshness towards the
debtor; and (6) “cut-throat” business practices (Hassan, 2006) .
Zakat. Linguistically, Zakah comes from the root zakwa, meaning to increase, augment, grow
well, flourish, prosper, produce fruit, to make pure or good and to enjoy a plentiful life. Its
technical meaning is that of a specific portion of wealth (after the passage of a year on it) that
must be given annually to a specific group of recipients. Items of accumulated wealth that exceed
the minimum levels (nisab) are subject to mandatory zakat. The rate of zakat varies somewhat by
the nature of the nisab. The nisab may include the impact on wealth resulting from debt to a
creditor, receivables, merchandise, agricultural goods, animals, jewelry, precious metals and
other items according to prescribed calculations in the texts. For purposes of Islamic banking,
zakat is mandatory on the profits from the operations, as reflected in the retained earnings and
capital of an Islamic bank that is owned by Muslims.
Zakat is one of the five pillars of the Islamic way. It encompasses both mandatory (the formal
zakat) and voluntary (sadaqat) charitable giving. It also encompasses non-monetary giving, e.g.
acts of kindness. Among the traditions of Islam is that even a smile can be a form of charity; as
can removing something harmful from a road or walkway. Sadaqat is derived from the Arabic
root, sadq or sidq, meaning to be truthful and sincere. Technically, sadaqat means charitable
giving that has 4 elements: it comes from a pure source (sometimes called one’s legitimate
holdings); it has sincerity of intention; altruistic motives; it is done or given first and foremost for
Almighty God’s pleasure (Khokhar, Dabas, & Zarabozo, 1991).
The recipients of zakat are: the poor (fuqooraa); the needy (masaakeen); those who collect zakat
(‘amiloona ‘alaihaa); those whose hearts are in need of reconciliation (mu’allafatu qulubuhum);
freeing captive or slaves (ar-riqab); debtors (ghareemoon); those stranded away from their
homes without the means to return (abna’ as-Sabil); and soldiers (mujaahideen). There is deep
meaning for each class. Overall, zakat (including sadaqat) is designed to promote solidarity and
allegiance (unity), kindness and compassion (selflessness and mercy) and social realignment or
the alleviation of poverty and income inequality (Id).
Kanz. Linguistically, the Arabic for hoarding is kanz, meaning to collect and store up, to bury a
treasure. Thus, linguistically, kanz means to hide wealth, be it food, gold, silver, fiat money,
intellectual property, etc. Property and wealth are a means to greater prosperity; not just for the
few, but for the many. That is why, in the Islamic Law, zakat is not voluntary, but mandatory;
while that which is even better, sadaqah, is best. There is some difference of opinion as to what
the technical meaning of kanz is. Some believe it applies to food and specifically to those who
hoard food in order to create shortages to increase their profits. Others believe it is that upon
which zakat is not paid. In other words, hoarding is not that upon which zakat has been paid. The
broadest view is that the prohibition of hoarding applies to everything that people need and will
be harmed if it is withheld. This view infers that hoarding applies to all forms of wealth.
This latter view also encapsulates Islam’s financial epistemology that dictates the use wealth in
production. Thus, the goal in Islam is to spread wealth. That is a basis for zakat and sadaqah and
the fact that the poor and needy have a share in the wealth of others. Moreover, an underpinning
of Islamic economics is the utilization of wealth (capital) to make the resources of labor and
natural resources productive, i.e. the sharing of profit and loss by the constituents. Hoarding can
be ameliorated in modern societies by financial intermediation. Those with surplus allow their
excess wealth to be circulated in society through credit, thus reducing the “credit gap.” The
command to circulate wealth can be gleamed from the following, powerful Verse from Qur’an:
“Is it they who would apportion the Mercy of your Lord? It is We Who apportion
between them their livelihood in this world and We raised some of them above others
in ranks, so that some may employ others in their works. And the Mercy of your
Lord is better than what they amass” (Az-Zukhruf 43:32).
Again, the Islamic epistemological notions of sharing of profit and loss are emphasized in the
sacred texts of the Islamic Law and fortify thereby a way of life tethered to principles of
socioeconomic wellbeing. Though there may exist wealth and income inequality, the “push” and
“pull” principles engrained in the Islamic Law, its Objectives and Rules thereon, act
systematically to keep wealth, wellbeing, income and fairness tethered.
Sanctity of Contracts. Economically, the goal of ensuring individual protections necessitates
transparency and fairness in contracts (uqud, plural for aqad) and what follows them (tabi’) in
normative economic behavior. There were no banking institutions during the genesis of Islam.
Fiat currency was nascent at best and the great majority of transactions were handled by
pawning, gold and silver measurements, investment through sharing contracts, exchanges and
mark-up sales. These early practices are retained in the Islamic Law of contracts. Moreover, the
sacred texts of Islamic Law compel that contracts be honored and fulfilled. The Islamic Law of
contracts is a subject in and of itself. There are a variety of forms, including what are known in
western cultures as unilateral, bilateral and trusts. In Islam, transparency and mutual consent as
to lawful goods and services are central to generic contracts. Capacity of parties to enter into
contracts is also central to formation. As in any society, where there are disputes as to the “basis
of the bargain” between parties, methods of resolving the breaches are applied. As noted,
however, a hallmark of the Islamic Law of contracts is the favoring of leniency towards a debtor
during periods of difficulty and hardship.
Islamic System of Banking Contracts. As can be seen from Figure 11, there are 6 basic
classifications of contracts in Islamic finance. The list is not exhaustive and there are hybrid
contracts structures, e.g. sukuk or securities contracts as well. Additionally, there are gratuitous
contracts, which are used in takaful (or Shari’ah-based risk sharing contracts), charitable
contribution pledges (e.g. waqf or endowments) and bank depository accounts. There are also
contracts that effectuate certain purposes, e.g. trade letters of credit. These contracts use one or
more of the basic contracts in modified form to suit the underlying transaction. It is noteworthy
that there is only one loan contract called Qard. The essence of that classification is that money
is not lent as in conventional finance at interest. Qard is a loan, but it is repaid in principal only.
As will be briefly noted under FinTech and Islamic finance infra, qard may also be the basis for
so-called “soft loans.” The prohibition against riba as discussed earlier applies to these loans.
Fiat or paper money is viewed as a medium of exchange, not a real asset. It is a financial asset in
that sense, but represents some underlying real asset, be it gold, accumulated wealth, etc.; much
as it did in the early years of “banking.” The Islamic financing contracts on the right are fee
based contracts, i.e. pawning (rahnu), guarantees (kafalah) and service (ujrah) contracts. As
noted, the list is not exhaustive. Much of the financing by Islamic banks, including that afforded
SME takes the form of sales, lease and manufacturing financing, as well as equity (or profit and
loss sharing) contracts. A distinguishing feature of Islamic banking is that much of its financing
is asset-based and tied to the real sector of the host economy.
Figure 11-General Classification of Islamic Banking Contracts
Source: Bank Negara Malaysia (BNM)
Sale Based Contracts. Murabahah contracts are cost plus contracts. They are sales contracts
because the bank buys the good wanted by the SME and then sells it to the SME at cost, plus a
mark-up (or profit) that includes the bank’s costs, risks and associated expected return. Although
the mark-up may be negotiable, they typically include: stamp duties and other regulatory fees,
general and administrative costs and risks. The risks may include credit risk, business risk and
price risk. Murabahah financing theoretically requires the disclosure of the cost basis of the
good. Typically, the sale will be on a deferred payment plan, i.e. in installments or payment in
full at a future date. Normally this sale is with deferred term, sometimes abbreviated as BBA
(bai’ bithaman ajil) or (bai’ mu’ajjil). Obviously, it may be used by SME to finance equipment,
inventory, etc. Similarly, payment can be made upfront with delivery of the commodity at a date
certain in the future, e.g. agricultural goods, at a later date. This is called purchase with deferred
delivery or literally a peaceful or firm sale (bai’ salam). The advantage to the SME in this sale is
that it receives cash in order to acquire seeds, materials, labor and other inputs to deliver the
commodities. Since farming is seasonal, it was originally a carved-out exception to the general
rule of selling that which is not known, in order to facilitate farming.
A reverse murabahah is called tawarruq. Thus, a SME would buy a commodity (ostensibly one
which it has knowledge of its market or uses a broker to do so as a murabahah purchase, i.e.
deferred payment (either in installments or in full at some future date) at cost plus. The SME
then sales the commodity to a 3rd
party at the “spot” or market price to obtain the money needed
to conduct the SME’s business, e.g. for working capital purposes. The SME will then pay the
initial seller the murabahah price over time. There are different versions of the transaction. One
such version is called a deposit placement sale. In it the SME’s bank buys the commodity from a
broker at “spot” and sells it to the SME as a bai’ bithaman ajil (BBA) or deferred cost plus. The
SME then sells it to another broker at “spot.” Placement or brokerage houses are established to
handle the brokerage part of the transaction. Malaysia’s commodities brokerage house is called
Suq al-Sila’. The end result is that the SME has monetized the commodity and ends up with cash
flow amounting to the deferred price less spot price and costs, as working capital.
Bai’ Inah and bai’ dayn are both highly controversial, but are used by some. Bai’ inah is a sale
by a SME to a bank or other financier on a deferred basis, bai mu’ajjil, and subsequent
repurchase of the same commodity the spot price. It is essentially a sale and buy-back. The net of
the prices is working capital and considered riba by many. This contract is sometimes used as a
transitory supporting contract for a larger transaction. It still remains controversial. Bai’ dayn is
the sale of debt. With only very narrow exceptions, an existing debt, can be sold. Typically, it is
by offset (muqaassah), transference (hawakah) or securities with a mixture of debt and equity
ingredients (khultah). Transference and offset might be used by SME to factor receivables,
assign debts and create a novation. Similarly, an offset might be used to relieve an SME of a debt
by offsetting it with an amount due the SME. Mixed debt and equity hybrids are generally found
in sukuk or securities. Again, there are differences of opinion on each, but each is being used in
the Islamic finance market.
Lease Based Contracts. Leases in Islamic banking are called ijarah, which comes from the
Arabic root ajr, meaning to use property or reward for services. Its technical meaning is that of
usufruct or the legal right to use and enjoy another person's property or the rents or profits there
from. Leases are useful financing vehicles for SME as they generally don’t require much capital
upfront and allow the SME to utilize the property, e.g. land, building, equipment or even services
on an ongoing basis while in operation. Islamic banks use 3 types of leases: a straight operating
lease (ijarah); lease with an option to purchase (ijarah muntahia bit tamlik) and sometimes
abbreviated as AIMAT; and lease with intention to buy (ijarah thumma al-bai), sometimes
abbreviated as AITAB. There are subtle differences between AIMAT and AITAB. The former
gives the lessee several options as to when to buy or not or to renew the lease. The latter is a
lease with the intent to enter into a purchase agreement to buy the usufruct at the end of the lease
term. There are issues that have arisen with respect to these two contracts relating to the joining
of two contracts and the issue of resembling bai’ inah. However, they are widely used by Islamic
banks and therefore available to SME.
Manufacturing Contracts. Though classified as a “construction-based” contract, istisna’ is similar
to bai’ salam. However, it is specifically designated for manufacturing something and payment
may be made in advance, deferred or made in installments. Like bai’ salam, an istisna’ contract
get be concluded without the subject matter of the contract being in existence. The seller may
also have a 3rd
party manufacture or produce the subject matter. This is sometimes referred to as
the parallel istisna’. Specifications must be precise. Banks may use parallel istina’ to contract
with the SME to manufacture the subject matter and in turn contract with a manufacturer to
actual manufacture the subject matter.
Equity Based Contracts. The 3 equity based contracts are partnership contracts. Mudarabah has
been referred to a “silent” partnership. Mudarabah have been called the “work horse” of Islamic
finance. It is a partnership of where one party provides the capital and the other party provides
the labor and/or expertise. There is no khalt or mixture of capital. The distinction is that in
mudarabah there is sharing of profits based on the efforts of the mudharib and capital of the
rabb al-mal. However, losses are borne by the financier and the SME would lose its effort and
labor. Mudarabah contracts are used by Islamic banks as both liabilities and assets. However,
they offer great potential as a stage of development financing “tool” that could be used by banks
for SME as the relationship grows and as the SME positions itself for venture capital, the
issuance of a sukuk or an initial public offering. Sukuk are often syndicated by larger banks in
many bank-based economies. Hence, an existing banking relationship with growth and hyper-
growth SME may easily development into further financial relationship beneficial to both SME
and bank. These contracts can have restrictions placed on them by the financier. Moreover,
though limited, silent partnerships are widespread in conventional finance, few if any
conventional banks form partnerships with banking customer. With the emergence of FinTech
and other financial innovations and given the need for the scaffolding of an Islamic capital
market based on Shari’ah-based versus Shari’ah-compliant equities, mudarabah initiatives in
Islamic banking could prove beneficial to all concerned.
Musharakah contracts are similar to general partnerships in conventional finance. The classical
company in Islam is the sharikat. This Arabic word signifies the mixing of two capital inputs in a
manner that makes it difficult to separate them. These partnerships are flexible as to partner
contributions. Again, in the context of the SME “capital gap,” they provide a flexible and useful
vehicle for SME development. As with mudarabah, these accounts might be used in “clusters,”
are as part of specialized funds or banking branches designated to develop the best SME that
have the greatest potential for growth. Unlike mudarabah accounts, all partners’ capital will
share in the profits and losses of operation. Thus, they might have application more fitting for an
SME that has passed the 5 year survival age and transitioning to venture capital and/or IPO. Both
mudarabah and musharakah contracts can specify the term of the partnership. These partnership
banking contracts are the most versatile banking contracts available to SME. There are at least 4
types of musharakah: ‘inan (joint limited); mufawada (joint unlimited); ‘amal (based on joint
labor or expertise); and al-wujooh (reputation based credit partnership).
Musharakah mutanaqisah are diminishing partnerships. They are used extensively in residential
financing, but could have important application in SME development. It is a partnership in which
the Islamic bank gradually transfers to the SME partner bank’s share in the partnership, so that
the bank’s share declines while the SME’s share increases until the SME becomes 100% owner
of the subject of the contract or project. Figure 12-Typical Islamic Bank Balance Sheet Contracts
Source: (Dusuki A. , Islamic Financial Instruments, 2011)
Liability Based Contracts. As can be seen in Figure 12, these contracts are used on the liability
side of Islamic bank balance sheets. They are either depository accounts held in safekeeping
(wadi’ah) or in loan in trust (qard). Wadi’ah accounts may be contractually added with a
suretyship or guarantee and become known as wadi’ah yad dhaman. It is noteworthy, that
depository accounts cannot contractually require that interest be paid on them. However, many
Islamic banks will give depositors a gift from its profits, which are sometimes called hibbu,
which literally means “love.”
There are, as noted earlier, investment accounts, which are primarily mudarabah contracts.
However, they may be tawarruq and hybrid accounts. Wakalah bi istithmar is a fiduciary
account whereby an investor enters into a contract with the Islamic bank to management an
investment fund on behalf of the SME. Stipulations to the contract may be negotiated, e.g. what
types of investments may be acquired from the investment fund. This may be used by SME as a
cash and investment management account, whereby excess cash on hand may be “swept” away
into investments on an ongoing basis; or likewise accessed to provide cash flow to the SME.
Shari’ah Supervision of Contracts and Activities. Islamic banks are subjected to the same
regulatory standards of good governance and risk management as conventional banks, including
those promulgated by Basel and national central banks and regulators. In addition, they are
required to have their products and services supervised through a review, certification and
approval process by religious committees and/or boards comprised of Shari’ah scholars who
establish operating procedures verifying and certifying that no product or service is authorized
by management that does not conform to Islamic Law (Shari’ah), its Objectives (Maqasid) and
rulings (ahkam) pertaining to Islamic finance.
These Shari’ah committees or boards must be competent in the specialized knowledge of Fiqh
al-Mu’amulat (the jurisprudence or body of law, rules and objectives of Islamic Law) and best
modern financial practices and products. They must also be independent of the bank’s board of
directors, yet provide the board of directors with competent consultative and advisory services.
Shair’ah committee and board members must be objective and consistently responsible for the
approval of banking and other financial products and services offered on an ex ante and ex poste
(sometimes called the tabi’ of that which follows the approval of the products and services)
basis. Ex ante procedures include the issuance and dissemination of Shari’ah resolutions12
, while
ex poste procedures include the periodic and annual reviews.
The Shari’ah supervision function must answer questions relating to whether proposals for new
transactions or products conform to the Shari’ah, as well as perform an investigatory review of
the operations of Islamic bank to insure that its conduct in compliance with the norms
established by Islamic Law, its Objectives and rules, as well as resolutions passed by it or a
12
A resolution is a collective opinion by a Shari’ah board on a matter of Shari’ah compliance that is intended as guidance for
banks under its supervision in order to establish standardization and harmonization within a jurisdiction and is not a fatwa
(authoritative ruling having the force of jurisprudence) that may have much broader implication, e.g. regionally or globally.
Resolutions are based upon collective ijtihad (a thorough and exhaustive study, discussion and evaluation) of the sacred texts of
Shari’ah as relative to the conduct (contract, product or service) being examined.
national centralized supervising board. It ensures that the Islamic banks contracts and activities
comply with that conduct and that they are transparent and not exploitative of the bank’s
stakeholders, including the communities and society in which it operates. It encompasses
research and collective decision-making, thus providing a system of internal control over the
banks products and services.
Figure 13-Malaysia’s Shariah Governance Framework Model for Islamic Financial Institutions
Source: Bank Negara Malaysia
This Shari’ah review function may be conducted by an outside Shari’ah advisory firm or group
of individual scholars, or it may be comprised of an appointed standing embedded Shari’ah
board within the bank’s internal governance. Different Islamic jurisdictions have different
Shari’ah governance approaches, i.e. some are centralized, while others are decentralized and
still others a hybrid of both. Malaysia uses a centralized approach to Shari’ah governance with
fatawa or legal rulings being made at the national level. Individual banks must then have their
own Shari’ah compliance reviews. The Shari’ah Governance Framework that encompasses these
practices to ensure compliance with Malaysia’s formidable body of legislation and guidance
from it government, regulator and central Shari’ah Supervisory Board. Figure 13 shows
Malaysia’s Shari’ah Model Framework. The Shari’ah audit function should follow an audit
program designed to ensure Shari’ah compliance at the bank, identify any issues needing further
attention, write a report of its findings and disseminate it to the Shari’ah committee and the
bank’s management and make recommendations to them of ways to correct any deficiencies.
Shari’ah audits should be done periodically and annually and may be done by firms or an
internal audit function.
Islamic Banking and SME Development. The OECD recently identified what it considered to
be approaches to improve SME and entrepreneurship financing (OECD, New Approaches to
SME and Entreprenuerial Financing: Broadening the Range of Instruments, 2015). Among the
recommendations are: the importance of bank financing to SME; the need to de-leverage through
transitional or business cycle stages; the concern that credit constraints will become the “new
normal” for SME; the need to broaden the range of financing instruments available to SME,
including “asset-based finance,” “alternative debt,” “hybrid instruments,” and “equity
instruments;” the need for alternative debt forms that differ from traditional lending inasmuch as
investors, rather than banks, provide the financing for SME; the need to develop SME focused
venture capital funds, SME public equity markets and private equity investors; and a regulatory
environment that enables the above structures to develop while ameliorating the credit risk
perceived by investors. Many of these recommendations are easily addressed by well established
contracts and financing instrument that are part of Islamic banking. It is so much so that it like
the OECD was writing directly to Islamic bankers. Table 12 below enumerates Islamic
banking’s prodigious repertoire of financing instruments and Malaysia’s formidable enabling
environment.
FinTech and Islamic Finance. Though nascent, FinTech offers promise for Islamic finance
because of the former’s innovative base and the latter’s full array of profit and loss and risk
sharing products. Islamic banking’s role is key to the future of the collaboration and, again,
offers a propitious opportunity for Islamic banking to become innovative while retaining its
sanctity of contract. The examples are many, but several are noteworthy.
SME Corp Malaysia, which has been mentioned supra has its Shari’ah-Compliant SME
Financing Scheme 2.0 as well as Soft Loans for SMEs. The former scheme’s stated goal is “(t)o
provide financing assistance to eligible Malaysian SMEs whereby the Government of Malaysia
has agreed to pay 2% (percentage point) of the profit rate charged on the financing provided by
Participating Financial Institutions” (SME Corp Malaysia, 2016). Qualifying SME may apply
through the SME Corp website or directly at participating banks. Interestingly, in addition to the
Shari’ah screening criteria, preference is given to ethical/environmental/technology focused
SME, e.g. biotechnology, “green” technology and multi-media firms. Moreover, micro-SME are
also eligible (Id). Most firms will be required to have SCORE or MCORE ratings.13
See (SME
Corp Malaysia-SCORE, 2016) for further FinTech tools for SME evaluation and assessment.
13 SCORE is a diagnostic tool which assigns star ratings to indicate the performance level of SMEs based on a seven assessment
criteria such as financial strength, business performance, human resource, technology acquisition and adoption, certification and
market presence. Micro Enterprise Competitiveness Rating for Enhancement (M-CORE) is a simplified version of SCORE, that
identifies the performance of micro enterprises in four areas: business performance, financial capability, operation and
management.
Table 12-Islamic Banking Solutions to the OECD Recommendations
OECD Recommendation Islamic Banking Solution(s)
Importance of bank financing to SME -Islamic banking is growing on average circa
16%/yr.(see EY World Islamic Banking
Competitiveness Report-2016)
-Malaysia approves approx. 91% of its SME loan
requests (see Fig. 9)
Need to de-leverage through transitional or business
cycle stages
-Islamic banking has full range of banking contracts to
help SME transition, including debt, equity and build to
order financing
Concern that credit constraints will become the “new
normal” for SME
-Islamic banking industry is well aware that Islamic
banks must increase their profit & loss sharing “book”
Need to broaden the range of financing instruments
available to SME, including “asset-based finance,”
“alternative debt,” “hybrid instruments,” and “equity
instruments;”
-Islamic banks have a full range of “in house” contracts
and instruments, including its epistemological
preference for asset based financing and profit and loss
sharing banking contracts
-Islamic banking’s murabahah, tawarruq, parallel salaam
and istisna’ are all “alternative debt”
-mudarabah and musharakah are both equity instruments
-structured financing, sukuk and parallel hybrids are part
of the Islamic banking arsenal of instruments
Need for alternative debt forms that differ from
traditional lending inasmuch as investors, rather than
banks, provide the financing for SME
-Parallel mudarabah; tawarruq and parallel salam &
istisna’ are all alternative forms of debt
Need to develop SME focused venture capital funds,
SME public equity markets and private equity investors
-Islamic banks and particularly those in Malaysia are
perfectly positioned to do just that as noted under
Sanctity of Contracts and as can be seen in Figures 5
and 11
Regulatory environment that enables the above
structures to develop while ameliorating the credit risk
perceived by investors
-Malaysia’s Islamic finance regulatory framework is the
best in the world; all that is needed is to incentivize
Islamic banks to use FinTech and gradually increase
their profit and loss sharing book Source: (OECD, New Approaches to SME and Entreprenuerial Financing: Broadening the Range of Instruments, 2015)
Other FinTech initiatives include a number of FinTech and crowdfunding SME. They include the
following:
IFT Alliance is an alliance of Islamic crowdfunding platforms. Among its evolving goals
is “to facilitate the adoption of finance technology among Muslims...(and) bring together
Muslim-focused technologies and innovations in finance so as to better synergize and
harmonize these initiatives (IFT Alliance, 2016).
Launch Good is an Islamic crowdfunding platform that supports a variety of projects
worldwide, e.g. education, environmental, SME, ethical, informational and other projects
through its launch approach (Launch Good, 2016).
Narwi is a Islamic crowdfunding site that plans to be based on the Islamic endowment
(waqf) approach. It states that is “a non-profit Islamic crowdfunding platform which
allows donors to support microentrepreneurs of their choice by establishing an
endowment, or “Narwi-Waqf,” with as little as USD 25” (Narwi, 2016).
KapitalBoost is another Islamic crowdfunder. It stated goal is “all about growing
communities. Whether it's helping small businesses grow big or protecting the social
welfare of less-priviledged communities, our Singapore-based hybrid crowdfunding
platform allows our members to invest or donate in a way that is ethical and Shariah-
focused.” KapitalBoost has a emphasis on SME development and states “SMEs are often
disadvantaged in their access to funds for business expansion. Kapital Boost addresses
this problem by offering small businesses short-term financing alternatives with fast and
friendly approval process and at competitive rates. Via a Murabaha (cost plus profit)
structure, SMEs can raise financing for working capital needs. They may also finance
projects through a Mudharabah (profit sharing) structure” (KapitalBoost, 2016).
Ethis is a Islamic real estate crowdfunder. EthisCrowd.com states it is the world's first
Real Estate Islamic Crowdfunding Platform. It further says: “Our international
community of 10,000 private investors crowdfunds investments in entrepreneurial,
business, trade and Real Estate activities in Emerging Asia. We are headquartered in
Singapore, with branches and representative offices in Jakarta, Kuala Lumpur and
Sydney” (Ethis, 2016).
Conclusions and Recommendations for Further Research
It is unmistakable that Islamic banking, notwithstanding the bedrock of its Shari’ah based
contracts and religious epistemology, is still nascent institutionally given its relatively short
modern history. Therein lays the heart of the challenge facing Islamic banks in the 21st century.
Islamic banking, as a modern institution is by and large being developed on the infrastructure of
conventional banking institutions. But, it has retained its form due to it overriding epistemology
that is bound to the Shari’ah, the Maqasid and the Ahkam thereof; the sanctity of its contracts
and the vigilance in safeguarding its normative prohibitions and obligations. Islamic banking
grew from $490 billion in assets in 2010 to $882 billion in 2014; an average growth rate of 16%
despite the political turmoil affecting many of its host countries (EY, 2016). And while the
global sukuk market plummeted in 2015, Malaysian issuances still comprised 78.7% of the
global issuances (International Islamic Finance Market, 2016).
Conclusions. If banks can be “too big to fail,” then SME are “too important to ignore.” The list
of multinational corporations (MNC) that started as SME is impressive. Without much thought, a
partial list of such household names McDonalds, Apple, Alphabet and Microsoft come to mind.
This paper has identified how to “spot” SME from “infancy” to maturity, what hinders their
development, what promotes it and what their capital needs and corresponding credit risks are.
Moreover, it is shown how the Islamic finance epistemology, sanctity of contracts and norms, as
found in the Shari’ah, the Maqasid thereof and the Ahkam that follow, all make Islamic finance,
and in particular, Islamic banking, a “perfect match” for SME development in the 21st century.
As noted in Table 12, Islamic banking currently safeguards ethical, real economic sector, asset-
based financing, inclusive of debt, equity, hybrid and structured financing models through its
sanctity of contracts and normative prohibitions and obligations. Because Islamic financing is
tethered to underlying assets and not solely to promises of repayment, the credit rationing
dilemma discussed hereinabove is minimized; as are some of the potential for moral hazards.
Studies have shown that financing based on assets reduces credit rationing. Moreover, Shari’ah
supervision of Islamic banking not only monitors and seeks to ensures that Islamic banking
relationships conform to the contracts and norms of the Shari’ah, but also promotes the Maqasid
al-Shari’ah and the epistemology of risk, and profit and loss sharing, which is conducive to SME
long-term development.
Islamic finance has taken harsh criticism for mimicking conventional finance. Certainly, the
Islamic bank “book” still reflects heavy debt financing. Exacerbating the obvious is the fact that
most Islamic countries are bank-based, thus “hobbling” the ability of SME to seek equity
financing during their intermediate growth business cycles. Yet, Islamic banks are very active in
the sukuk market, which offers new hope for financing innovation. Islamic banking can “cut”
new cloth and distinguish itself further from conventional banking by solving the “rubik’s cube”
of bank-based equity financing in the modern era. If successful, truly Shari’ah-based (vis-à-vis
the façade of Shari’ah-compliant) SME and MNC should emerge and derision of Islamic finance
end. With respect to MNC, studies have shown that capital market development is slow at best
without MNC presence. Regressing then, alas, MNC have the celebrated habit of starting as
SME.
Recommendations. There are a few general recommendations that can be made:
1. First and foremost is that of the registration and regulation of the “informal” SME sector; if
not their taxation. Many of these SME operate on the cash basis and stow away significant sums
of cash and otherwise impede the growth for the “formal” SME sector in a parasitic manner, as
noted in Figure 6 and the discussion there under. Preliminary data appears to show an inverse or
negative correlation between the development of the “formal” SME sector and the size of the
“informal” SME sector. While the goal does not need to be one of punishing the “informal”
SME, it should be one of registration and regulation. Such an approach will likely have several
benefits. One is that of information and data gathering, which will ameliorate the information
asymmetry problem faced by all SME. Further, it will likely further the development of the
“formal” SME sector and formalize the “informal” sector; moving both away from “mom and
pop” status to more modern organizational status, e.g. private company status (Sdn in Malaysia).
As it stands, many of these “informal” SME operate “off the grid” and essentially “hoard” cash
that better serves society if circulated in the monetary system, thereby deepening financial
development.
2. Islamic banking has a well-known “branding” problem. In order for it to assume a position of
a preferred global banking system, this problem has to be solved. Assuming the “garb” of ethical
banking will help. But, full utilization of all of its Islamic banking contracts will, as noted herein
above, put to rest much of the derision that presently plagues Islamic banking; even among
skeptical Muslims, who believe Islamic banking to be no different than conventional banking.
This may require Islamic banking “literacy” initiatives that may be greatly helped by requiring
financing contracts to be easily understood or simplified. Maybe standardization or harmonizing
are keys to unlocking the rubric. Most consumers, for example, sign banking contracts and don’t
understand exactly what they’re signing because they are confronted with the “legalese” of
existing contracts. The result is effectively gharar. It may also be as simple as living up to its
epistemology of making the wellbeing (falah) by “planting the seeds” of social trust (amanah)
among all stakeholder a central objective of Islamic banking whenever and wherever feasible.
Islam has always spread its magnificent “wings” through trade and trust. In the modern world,
that same manhaj or approach is as vital as ever. Partnering nationally, regionally and globally
may be the viable means to a noble end of corporate social responsibility.
3. Hopefully, as Islamic banking begins to use more of its equity contracts in the SME sector,
monitoring and related costs can be contained. This seems to be an impediment to that
expansion. The use of “clusters” and “incubators” and the allocation of shared costs will help.
Additionally, the use of university-based training programs linked to coursework may provide
practical experience to finance and banking students, while helping to contain costs of
monitoring. FinTech may also be coupled with such approaches to further reduce and contain
costs.
4. Islamic banks may need to be given further incentives for utilization of their full array of
Islamic contracts. This may be done by setting realistic “targets” for Islamic banks from the
central banking authority or self-regulating banking associations. While it is not proposed that
the “free enterprise” mechanisms of the marketplace be overridden, it is recommended that all
available lawful and viable means of increasing Islamic bank utilization of musharakah and
mudarabah contracts be examined and implemented where possible. The narrative of the past
that these contracts are too costly to monitor by banks, and similar objections, should not be
assumed as the narratives of the future. Change is pervasive and few things change faster than
technology. Moreover, as noted herein, new and innovative SME level financing instruments are
recommended by the OECD. It may be that the use of the equity-based contracts are more
suitable for SME that are deemed high growth or “gazelles” in addition to scoring high on initial
screening credit risk scoring. Entering into equity-based banking relationships with “gazelles” on
segregated projects would seem propitious, for example, in R&D.
Further research, both empirical and qualitative, can be done to help meet the challenges of SME
Islamic financing and the constraints on SME development, including the “credit gap” and the
concomitant credit risk inherent therein. The following further research from an Islamic
perspective, are illustrative of what kind of research may help solve some of the challenges
facing both SME and Islamic banking:
1. Regressions and correlations can be run on Islamic banking-SME lending to identify factors
that contribute to or detract from SME determinants, e.g. growth, size and age. Of particular
interest might be high and hyper growth (gazelles).
2. Regressions might be run on SME survival rates, loan performance and profitability by
financing contracts at Islamic banks.
3. Case studies of Islamic SME gazelles may identify factors that are the “ingredients” successful
SME from an Islamic perspective.
4. Some finance scholars believe religion to be an inhibiting factor for SME growth and market
development. That narrative should be challenged from the Islamic banking perspective by
testing hypotheses that regress Islamic banking against entrepreneurship, innovation, technology
and other variables.
5. Further study of the correlation between the “informal” and “formal” sectors of SME in
countries where Islamic Law is the prevalent legal system (as opposed to common and civil law
jurisdictions).
6. Testing as to whether Islamic banking meets the challenges of SME credit risk better than
conventional banking, while accounting for economic size and financial development among
countries.
7. Survey the use of internal scoring of SME credit risk among Islamic banks.
8. Test and compare Islamic and conventional banking against a matrix of moral hazards in
SME.
9. Study and compare adverse selection in SME as and between Islamic and conventional banks.
10. Study the impact of corruption, private interests and “empire building” on SME development
as and between predominantly Islamic and conventional economies.
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