Islamic finance: An opportunity for SME funding

Small to medium-sized enterprises (SMEs) often struggle to secure financing from lenders because of limited asset base, and even more so nowadays where risk appetite of lenders is lower than that of previous years. One would expect financing to be extended to an SME on the basis of creditworthiness emanating from sound business practice that is augmented by support of dependable sponsors, the absence of which is likely to cause lenders to take a conservative approach to SME lending. Despite this, lenders with Islamic windows still maintain some appetite, albeit subdued when compared to previous years, for expansion.

 

Recent trends indicate that a large part of regional SMEs prefer Sharia-compliant debt compared to conventional debt. However, not many appreciate the fine nuances of Sharia-compliant financing and those that do are discouraged by prohibitive factors such as the costs associated with custom made lending agreements and obtaining a fatwa approval for Sharia compliance. Most regional Islamic offerings entail financial products involving structures including those based on murabaha and Ijara. Under the murabaha structure, upon the borrower’s request, the lender purchases an asset and sells to the lender at cost plus profit. On the other hand, Ijara is a lease under which the lender, being the lessor, agrees to transfer the benefit of use for the asset to the lessee, being the borrower, in return for payment of lease rentals. This is typically used for assets that are not entirely consumed within the period of lease rentals. However, various Shariah-compliant structures are available depending on factors including utilisation of funding and whether the facility is to be funded or unfunded. 

 

Regrettably, majority of lenders have continued to offer Shariah-compliant products designed to cater to the needs to large corporates, without strong focus on the needs of the SME sector. This, however, is changing – some reports indicate that Shariah-compliant financing needs of SMEs constitute a multi-billion dollar opportunity for lenders.

 

Many feel that issuance of bonds by an SME is another viable method of raising debt. However, Shariah does not permit issuance of fixed-income interest-bearing bonds, so sukuk are Shariah-compliant alternative to conventional bonds. They involve tangible assets in which the bondholder is given ownership interest and, for instance, is permitted to collect rent as profit. Sukuk can be structured in many different ways depending on the borrower’s need for raising debt, for example, sukuk al Ijara is used for funding asset acquisition and sukuk al Istisna is used for financing projects of varying scale. Proponents of sukuk often overlook the prohibitive nature of sukuk in the context of SMEs, for example, documentation for issuance of sukuk is not available off-the-shelf and preparation of custom documentation is expensive and time consuming. SMEs would often require a lender to underwrite subscription of sukuk, as public subscription would be unlikely in the absence of sound credit rating of the sukuk - credit rating agencies are reluctant to rate a Sukuk issue by an SME. Therefore, a sukuk issue is not a commercially viable option for SMEs to raise debt.

 

In sum, Islamic financing is driven by faith and not by availability of excess liquidity or by lax collateral and or security requirements of lenders. Be that as it may, lenders are gradually fortifying their Islamic offerings by adding products geared towards SMEs, which in due course shall eliminate the notion of Islamic financing being “alternative”. In the short term, SMEs are no better placed to avail Islamic financing than conventional financing.

 

Imran Shafiq is a Partner and Ali Iqbal Khan is an Associate atGaladari Advocates & Legal Consultants (DIFC) Limited. Email difc@galadarilaw.comfor further information