Islamic Banking with SMEs

Ahmed RAZIQ
Zaid BOUTARBOUCH
Joel FERNANDES
Ziad ET-TAHERY
Imane KHARROUBA

Tipu Sultan

Islamic Finance - April 2019

 Introduction
Islamic finance is a hot topic that is attracting more researchers and practitioners.
Systems such as microfinance and Islamic banking represent opportunities and these
systems are gaining in importance and scope today. Islamic finance is based on
Shariah, the latter can be defined as Islamic law based mainly on the Koran. It was
revealed to the Prophet Muhammad (PBUH), over twenty-three years, between Mecca
and Medina, to govern not only the acts pertaining to the domain of worship, but also
those which govern relations between men in the field of finance and trade. It helped in
designing financial instruments that influenced the European banking system of the
Middle Ages, such as bills of exchange, the first forms of partnerships, checks and
promissory notes. With these established principles, the cornerstone was built of what
would be considered today as Islamic finance.
In recent years, Islamic banking has experienced unprecedented growth. This shows
that many people consider Islamic finance as an alternative or an interesting
complement to the products and services of traditional banking, although for some, the
use of Islamic finance is closely linked to the desire to respect the rules of Sharia law.
On the other hand, the latter may be attractive and advantageous for small and
medium-sized enterprises. Islamic banking emphasizes the partnership relationship in
which successes are rewarded and failures shared.
Islamic finance has attracted Muslims and non-Muslims. The large-scale practice of
modern Islamic finance has begun to develop in the early 1970s, and the fact that very
large conventional financial institutions such as UBS, BNP Paribas, HSBC, Citibank,
and others have opened Islamic bank windows is revealing enough. While they serve
primarily customers in the Middle East, Gulf and South Asia, they also have customers
in Europe, Canada and the United States.
Through this paper, we will aim to answer the following issue: Islamic finance as an
alternative to financing SMEs in Morocco. We will discuss the place of Islamic finance in
the financing of SMEs, thanks to an offer of products complementary to the traditional
system that meet the growing need of SMEs who still struggle to find adequate sources
of financing and, lastly, to address the case of Morocco and the advantages and
disadvantages of this type of financing for small and medium-sized enterprises.

I.Evolution and Basic Principles

A. Creation and Evolution
1. Origins :
Modern Islamic finance was born in the 60s and has since experienced a spectacular
development characterized by two major phases, that of its birth and its renewal.
The Islamic financial system is established in the form of ethical and religious
foundations derived from Muslim holy books. The different Islamic financing techniques
used today, called Musharaka, Salam, Murabaha, are not new today. Indeed, all these
techniques are inspired by the life of the Prophet Muhammad, his sayings and his acts,
and date from the 7th century AD Although the Islamic financial system has existed for
several centuries, the development of the system Islamic finance has appeared for
about fifty years only with the independence of most Muslim countries in the face of
colonialism.
Commonly known as "Islamic finance", this terminology has emerged since the 1940s.
In 1963, the first Islamic bank, the Mit Ghamr Saving Bank, was created in Egypt by
Ahmed Al Naggar, and formalized for the first time such financial techniques as as
Murabaha, Salam, Istisna, Ijara.
Indeed, the idea of Islamic banking was then launched by the Organization of the
Islamic Conference (OIC) in the early 1970s, then, five years later, we could witness the
creation of the Islamic Development Bank. (BID), then various banks such as Dubai
Islamic Bank and Al Baraka Banking Group. The creation of the Islamic Development
Bank marks a real launch of Islamic Shari'a-compliant funding and provides funding to
over 55 member countries and Muslim communities around the world. to contribute to
their economic development and social progress.
In the early 1980s, two countries officially introduced Islamic finance, namely Pakistan,
gradually in 1979 and Iran, in a state-imposed way in 1983.
Financial institutions have also appeared in non-Muslim countries but where an
expanding Muslim minority resides, such as Denmark, the United States (especially in
the Detroit / California region), Great Britain, the Philippines and Canada.

2- Evolution of islamic banks:

The 1980s witnessed a huge increase in Islamic banks around the world. The number
of Islamic financial institutions in the world has increased from one in 1975 to more than
300 in more than 50 countries. The Middle East and Asia are two of the main markets in
which Islamic banks thrive. Countries like Saudi Arabia, Bahrain, the United Arab
Emirates, Kuwait and Qatar are very active in the Middle East, followed closely by
Egypt, Lebanon, Oman and the Arab Republic. Syrian.
In Asia, Malaysia already has a fully developed Islamic finance system (banks, Takaful,
or insurance, capital market and money market operations). Among them, other
countries are undergoing major development such as Indonesia, Pakistan, the
Philippines and Thailand. The growth of these markets is partly fueled by the growing
demand of the growing Muslim population.

With the growing awareness of Islamic finance and as Islamic banks expand and
expand their services, even non-Muslim clients are moving towards these institutions. In
Malaysia, for example, in some cases up to half of the clientele of Islamic banks is not
Muslim. In the West, banks are also competing for a share of the Islamic bank market.
The first Islamic finance institution, the Islamic Finance House was established in
Luxembourg in the late 1970s, followed by the Islamic Finance House of Denmark, the
Islamic Investment Company of Melbourne, Australia, and the American Finance House
LARIBA in the United States. United. The Islamic Bank of Britain was founded in the
United Kingdom in 2004, and in 2008, five Islamic banks were established in the
country. Citibank, HSBC, Standard Chartered, ABN Amro and Deutsche Bank are a few
conventional banks that have entered the Islamic banking sector. Initially, the sector
focused on retail and commercial banking while capital market activities, such as the
management of Islamic funds and Islamic bonds (Sukuk), surged after 90s. With the
development of capital market activities, more and more countries are getting on the
bandwagon.
In 2007, Singapore created its first Islamic bank, The Islamic Bank of Asia, and aspires
to become the leading Islamic financial center in Asia. Hong Kong (China) and Japan
have the same goals. The development of the capital market would allow these non-
Muslim countries to take advantage of the affluent investors of the Gulf Cooperation
Council (GCC) and to continue to play a leading role in the international capital markets.
Due to the financial crisis, golf investors have turned away from the European and US
markets and have moved to countries like Malaysia and Indonesia where Islamic
finance is being developed.

Evolution of the amounts generated by Islamic finance between 2009 and 2012 in
the world:

In Morocco, the arrival of banking techniques in accordance with the precepts of Islam
is now a reality. Bank Al Maghrib has announced the introduction of new Sharia-
compliant banking products since 2007. Attijariwafa Bank in Morocco represents the
first approved financial institution specialized in this type of financing in Morocco with a
credit company specialized in alternative products such as Miftah Al Kheir, a financing
method based on Murabaha or Miftah Al Fath, a financing method based on Ijara Wa
Iqtinaa.

B- Basic Principles of Islamic finance

Islamic banks are considered a relatively safe haven against the various turbulence of
financial markets around the world, they embody a certain spirit of fairness and justice
compared to the ruthless world of Western finance.
Islamic finance has several interesting features in terms of risk management,
transparency or regulation, and is very cautious because of the valuation of its products
for their backing to real physical assets.

Indeed, Islamic finance is above all an ethical finance, which favors a system of values
built on the need to avoid what is prohibited, on a balance between self-interest and the
public interest, but also on values, transparency, sincerity. The Islamic finance doctrine
is based on any transaction where the money does not directly generate the money and
any transaction or neither of the parties is deemed dominant.

These values are of paramount importance and must be reflected in acts and
transactions. Islam has indeed conquered Southeast Asia, not by military troops but
through Muslim silk traders, having dazzled local residents by these values translated
into their transactions. does not directly generate money as well as any transaction or
neither of the two parties is deemed dominant.

Based on the principles of Sharia, Islamic finance is distinguished from conventional

financial practices by a different conception of the value of capital and labor. The two
main sources of sharia are the Koran (sacred book of Muslims) and the Suna which
includes all the teachings transmitted by the Prophet Muhammad through his words,
expressions and deeds.

Far from the fears and the different polemics that could raise this word of "sharia", we
refer here to a set of principles which privilege healthy, transparent and equitable
relations between the various actors in question.
The financial system is therefore based on a more equitable sharing of risk between the
lender and the business owner. This practice stems from five main pillars on which the
Islamic financial model is based:

1. Prohibition of Riba
Islamic finance is characterized by its constraining aspect compared to conventional
finance. Wear has been expressly forbidden in the Qur'an. The Prophet cursed the one
who takes it, the one who gives it, the writer of the act and the witness. It is forbidden to
take advantage of a loan if this advantage is not justified. This prohibition is valid both
for contractual interest on the loan and for any other form of interest for late payment or
interests disguised as penalties and fees.
However, it is important to point out that in the Muslim religion, interest and usury are
jointly associated under the name Riba, while conventionally, the first term means the
sum that one pays for the use of the money and the second is a crime committed by
someone who lends money at an excessive rate.
Of all monotheistic religions, Islam is the only one to have kept the prohibition of
interest. This one was not born with Islam but goes back to the Jewish cult.
Several historians have questioned the reasons that led the prophet to ban Riba. In the
Torah of the Jews, the practice of usury is condemned, inducing the prohibition of the
Tarbit, Hebrew words which means Riba (to the faith usury and interest), the prohibition
of the Tarbit among the Jews was more selective, the latter was forbidden between
Jews, but allowed between Jews and non-Jews.

«If you lend money to my people, to the poor who are with you, you will not
behave like a usurer with him; Moses »
The Christians also condemned the usury and lending interest based on the
Aristotelian tradition and the Bible, but implicitly:
 "If you lend to those whom you hope to receive, what credit is this for you? Even
sinners lend to sinners to receive an equal amount in return. But love your
enemies, and do good, and lend, without despairing anyone ... "

2. Prohibition of gharar and Maisir

The prohibition of any pure speculation, especially that relating to derivatives and short
selling is prohibited. It is not permitted to conclude a transaction that contains Gharar or
Maysir.
The Gharar can be defined as being any noticeable blur at the level of one of the goods
exchanged. Maysir is defined as any form of uncertainty in transactions or any form of
contract in which the right of the contracting parties depends on a random event. It is
this principle that we find in games of chance and bets with bet.
Transactions and transactions must be as transparent and clear as possible so that the
parties are fully aware of the values of their trading.

In traditional finance, some transactions are full of uncertainties and their expectations
of returns are often speculative, such as swaps, options and all forms of insurance. In
the case of options (which give the right but not the obligation to an investor to buy or
sell) for example, we find ourselves in a situation where neither the investor nor his
counterparty can determine his gain or loss. , which demonstrates this big uncertainty
existing in this type of transactions. This Prohibition aims to finance the real economy
instead of encouraging speculation.

3. Prohibition of investing in sharia non compliant products

Islamic finance is an ethical and responsible finance. Shari'a also requires that all
Muslims can not treat property deemed illegal or Haram, resulting in the prohibition of
financing certain sectors and activities related to alcohol, tobacco, drugs, pig farming,
weapons, as well as all products banned for consumption through the texts of Islam
(pork and pork products). These sectors are contradictory to morality.

To overcome this problem, the largest conventional banks have created Islamic
windows that allow them to offer Shari'a compliant products while preserving their
conventional activities. This is the case, for example, with HSBC, UBS, Citibank,
Goldman Sachs, BNP and Deutsche Bank.

4. Principle of sharing profit and losses

The concept of profit-sharing is one of the key elements in the concept of Islamic
finance because it reflects the values that Islam transmits to its followers, namely
justice, social equality and fraternity.
The principle of social justice embodied in Shari'a requires that the borrower and lender
equally share both gains and losses, and that the process of creating and distributing
wealth in the economy is representative of productivity. real. This is called participatory
finance. In other words, one party alone can not assume all the risk associated with a
transaction, there has to be mutual participation.
his principle of profit and loss sharing exists through different Islamic finance techniques
that promote and assist the development of small and medium enterprises such as
Mudharaba or the bank will take care of the entire project financing and the contractor
will provide his work in order to increase the amount invested. The profits are shared
while the losses are entirely assumed by the bank. Or the Musharaka, a transaction that
allows the bank and the entrepreneur to join in a project and to be able to share profits
and losses
On the other hand, this system represents rather significant risks because, unlike
conventional banks, the remuneration of a type of financing depends directly on the
performance of the operation and therefore on the management of the project by the
contractor.

5. Materiality of trade or the need for an underlying asset

According to sharia law, any financial transaction, to be valid, must be linked to a
tangible and material asset. A financial transaction must concern only real property and
bank transactions must correspond to tangible, and above all, owned and identifiable
transactions. This principle of "asset backing" makes it possible to reinforce the
potential in terms of stability and risk control and reassures in particular as to the issues
of disconnection from the financial sphere of the real sphere. This fundamental principle
is also one of the strong points of this Islamic economy with regard to the
dematerialized economy, because the risk assessment is better on materialized capital
and is also a way for Islamic finance to participate in the development of the Islamic
economy. real economy by creating economic activity in other areas.
It is this system of values, universal at the end, which is the peculiarity of Islamic
finance. Indeed, besides the need to meet the requirements and regulatory constraints
required by the laws in force (banking laws, financial security, laws on security ...),
Islamic financial institutions are required to comply with specific requirements and rules.
to this system of values, which have their origins in Muslim law or "Shari'a".

C. Main Distinctions Between the Islamic Bank and the Conventional Bank:

Since the creation of the first Islamic bank in 1963 in Egypt, the latter have tried to apply
the concepts of Shari'a to finance. This results in organizations, financial operations and
specific operations.
In the table below, we offer some distinctions between the Islamic bank and the
traditional bank.
1. Islamic Banks vs Traditional Banks

Islamic bank Conventional bank

Opinions differ on the importance of Customer deposits generate a

Current these deposits in the resources of significant windfall for the
accounts the Islamic bank. For some, this traditional bank.
 windfall represents only a small part As well as a product interest.
of the resources of Islamic banks By contrast, the banking
While for others, it would be an services are for the most part
important resource paid.
Does not generate any interest in If the traditional bank provides
return for the free of some services a loan, she transfers it to her
(checks, transfers of funds etc.) client's account and gets an
When an Islamic bank lends money interest in exchange.
to one of its customers for the
acquisition of a property, it does not
pass by the customer's current
account but directly by the seller
and is remunerated by a margin
obtained on the sale of the good.
In the event that the bank client
wants an urgent loan for a cause
such as a marriage or death, the
bank uses a special account with no
interest deduction. These loans are
called in Arabic "Qard Hassan".

Investment The depositor agrees that the bank

Account or will manage a fee for money In the balance sheet of
Profit Sharing management. Mudarib fees that conventional banks, there is
Investment comes from "Mudaraba", in other no equivalent to the PSIA
Account words that means sharing the accounts.
(PSIA) losses and profit in Arabic. With all On the other hand, it should
deposits, the custodian has no be known that in any
control or management of the traditional account the capital
unrestricted account but can decide is supposed to be guaranteed.
on the allocation of its funds.with a The bank must therefore be
restricted account. able to repay part of the
capital of all its depositors at
any time. What is not the case
of PSIA.

Savings The customer, as in a non-restricted In a traditional savings

account Profit-Sharing Investment Account account the amounts
(PSIA), shares the losses and deposited can be withdrawn at
profits and has no control or any time and generate a fixed
management over his funds. interest rate known in advance
most of the time.
 Customer- In an Islamic bank, the depositor is Traditional banks have
banker a partner and not a creditor. This creditor / debtor relationships
relationship will be a risk sharing if the depositor with their clients.
on a PPP account or a partnership
from the bank for Qard Hassan
loan.

Role and The traditional bank also has

operation of The Islamic bank acts as a a financial intermediary role. It
banks commercial intermediary because realizes the collection of funds
all financial transactions involve and uses them in loan
tangible assets and connect the operations.
buyer and the seller.

- The accounts of Zakat (alms) and the accounts of the social service where are paid
respectively the sums due to the obligation of the Zakat and donations used to finance
social services. The bank administers the use of these funds.

2. The balance sheet of Islamic vs conventional banks

Assets
Conventional Bank Islamic Bank

Current assets: Current assets:

negotiable securities cash
standard price investment:
discovered Finance musharaka
other advances Finance mudraba
Murabaha interbank short-term
Non-current assets: credit sale:
participation Salam
buildings Istisnah
Murabaha

Equity, real estate investment

Non-current assets:
participation
buildings
Diminishing Musharaka
Liabilities

Conventional Bank Islamic bank

ST Debt ST Debt
Deposits Current account (Qard Hassan)
Loans and various financial debts Investment account
Savings account
LT Debt Zakat and anticipated tax
Capital Action Murabaha interbank of CT
Benefit IRR provision
Reserve
LT Debt
Islamic funds
Capital Action
Earnings
Benefits to be purified
Reserves (PER)

Islamic finance for SMEs

The financing of market and productive activities is at the core of Islamic finance. Yet,
despite the recent successes of Islamic finance and its spectacular growth rate, the
financing of SMEs is now abandoned by Islamic banks for the benefit of consumer
finance and investment funds.
Despite their social dimension and ethical character derived from Islam, Islamic banks
not only represent charitable organizations, but are also for-profit agents called upon to
sell products and make profit while reconciling between profit and ethics.

A. Financial Needs of SMEs and Islamic Financing

i)The specificity of the financial needs of the SMEs

Financing SMEs requires long credits because it is a question of financing investments
in the short to long term. The realization and the completion of SME projects can only
be successful with a policy based on huge resources. Commercial banks have always
opted for short-term financing or require significant collateral. The financial need of
SMEs is felt on the one hand in the financing of their investments and on the other hand
in the financing of their working capital or business cycle (purchases, manufacturing,
sales).

ii) Investment Basics

Any investment is primarily financed by a capital contribution consisting of the capital

provided by the shareholders and by the retained profits (the self-financing), and if these
funds are not sufficient, then through use of bank loans repayable on future cash flows
generated via operations.
As far as Islamic banking is concerned, the focus is on putting trust in the client,
especially when it comes to financing an investment in the form of Mudarabah (the type
financing that is most suitable for startups) or Musharakah.
In this case, the best guarantee can only be quality, good management and good
control. The latter is only a moral guarantee, but for Islamic banks it is the guarantee par
excellence that serves to create strong relations between the bank and its client.
The Islamic bank requires any entrepreneur starting a project, the presentation of a
feasibility study which must, provide all the necessary information on the financial,
economic, commercial, technical and organizational aspects, and also demonstrate
what are the objectives and the results of the project that can be matched with the
country's development plan, and to what extent the project can improve the social
welfare of the population of the region or solve its unemployment problems.

iii) Working capital requirements

To finance its business cycle, the SME can use its available own funds or resources
from bank credits, supplier credits or customer advances when ordering. These credits,
unlike those of the investment, are used permanently and reimbursed also permanently
from the turnover.
In many cases, traditional commercial banks only provide short-term credit or may allow
the overdraft limit to be exceeded.
As for conventional banking, the short-term commercial cycle uses different products
such as
o The overdraft account,
o Commercial discount,
o Credit Account, and
o The credit letters.

On the other hand, Islamic banking excludes overdraft financing because it wants to
know what it is financing, and has implemented forms of intervention such as
Musharakah, Mudarabah, Murabahah, and others.
Commercial discounting or debt repurchase does not respect the Islamic Sharia
fundamentals, even though it is a technique that applies to both commercial and export
effects. The credit in account whose principle is based on the fact of providing the funds
to the client is materialized by the Mudarabah or Musharakah, where the Islamic bank is
obliged to keep the capital at the disposal of the customer. For documentary credits,
they are most often used by Islamic banks for Murabaha operations by which the bank
acquires the merchandise in order to make it available to the customer in return for a
profit margin.

iv) Difficulties of access

SMEs face several difficulties in their access to banking resources under various
conditions, such as the requirement of a minimum of self-financing, the production of
reliable accounting documents, solid guarantees or the demand for high interest rates.
vis-à-vis the risk incurred.
The bank tends to overestimate the risk associated with the profitability of the project,
which is illustrated by the low level of equity contribution compared to the initial
financing requested from the bank. Very often, the SME who succeeds in obtaining
credit from its bank sometimes only compromises the profitability of its project by an
excessive cost of credit and the control of its company, by the numerous guarantees
that it must yield to its bank given the very high risk associated with this sector.

B. Instruments for financing SMEs

This category of instruments opts for the pooling of assets. These are partnership-
based contracts where the Islamic bank invests capital in order to become a partner of
the client. For the latter, the return depends solely on the client's results. There are
basically two types of participatory instruments:

i) Mudarabah: It is a financing technique used by Islamic banks for development. The

bank plays the role of the investor and agrees to finance the project in full by providing
the necessary capital (financial or otherwise). The entrepreneur who is provides his
expertise and manages the project and the bank is not obliged to intervene in the day-
to-day management of the project. The remuneration is based on a percentage of the
entrepreneur's profits fixed in advance. In this financing technique the bank alone
assumes the losses. The client does not receive a salary, and if he does not make a
profit, the time and effort devoted to the operation are lost. This method is particularly
suited to the financing of small innovative companies (particularly in the intangible field)
and is most similar to the concept of risk capital. The latter represents the financing
method best suited to the needs of business creation and development cycles, whether
for the constitution or increase of capital or the acquisition and renovation of equipment.

ii) Musharakah

Musharakah is the Arabic translation of the word “association". In this operation, two
partners invest together in a project and share the profits and losses according to the
capital invested. The invested capital not only represents cash but also in-kind
contributions, for example the Islamic bank can provide cash capital while the client can
contribute tangible assets to the partnership. As a partner, the bank can make strategic
decisions and can also intervene throughout the management of the project as it can
also choose to be a partner or passive partner. The nature of this operation is closer to
a joint venture.

iii) Istinah with SMEs

For example, if an SME wants to start shipping and wants to buy a ship. She can
contact an Islamic bank to ask her to finance the acquisition, asking her to build the
ship. In practice, the SME buys the vessel to be built at the Islamic bank (Istina
contract). The SME thus pays the purchase price to the bank (cost of the ship plus the
profit margin practiced by the bank). Of course, the bank is not able to build the ship
and therefore orders from a shipyard. This is a new Istina contract under which the
Islamic bank buys the ship from the builder.
The second part of the transaction concerns the price of the ship paid by the bank to the
shipyard. For simplicity, under this parallel Istina, the bank buys the ship under
construction from a builder and then resells it to the SME at a price plus a profit. The
SME then settles the amount due deferred.

Conclusion

Today, Islamic finance is experiencing a high rate of growth worldwide. This growth is
due to investors and funds preferring the effectiveness of this method of financing in
comparison to the conventional banking products. Various Islamic finance principles
have been highlighted, the constraints that govern it, its management, as well as the
various financial products offered to small and medium enterprises.

First, we have defined the evolution of Islamic finance which, characterized by a set of
prohibitions like Riba, Gharar, or Maisir, respects the different fundamental principles
described by Shari'a, which translates by a principle of equity, justice and redistribution
of wealth.

Secondly, the work then focused on the role of Islamic finance in the financing of SMEs
with the different financial needs of the latter as well as the various products that are
offered to them to develop their projects. To finish with a description of the case of
Moroccan SMEs, Islamic banks are a very important partner in the development,
survival and success of small and medium-sized enterprises.
Faced with all these facilities offered by the participative finance, the traditional banks
must as soon as possible revise their policy dedicated to the financing of the SMEs,
such as the difficulties in the procedures of credit granting, the very high interest rates,
the weak sharing of risks and losses, the very high number of guarantees requested, or
the lack of transparency.
SMEs need long-term financing, long-term loans that will allow them to finance
investments that are amortized in the medium or long term. The development and
success of the SME can only be established with this type of long-term resources. And
that is why SMEs are moving more and more towards Islamic finance.