Leveraging Islamic banking and finance for small businesses: Exploring the conceptual and practical dimensions

Mohamed Asmy Bin Mohammad Thas Thaker; Hassanudin Bin Mohd Thas Thaker; Anwar Allah Pitchay; Md Fouad Bin Amin; Ahmad Bin Khaliq Working Paper Leveraging Islamic banking and finance for small businesses: Exploring the conceptual and practical dimensions ADBI Working Paper Series, No. 1156 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Mohamed Asmy Bin Mohammad Thas Thaker; Hassanudin Bin Mohd Thas Thaker; Anwar Allah Pitchay; Md Fouad Bin Amin; Ahmad Bin Khaliq (2020) : Leveraging Islamic banking and finance for small businesses: Exploring the conceptual and practical dimensions, ADBI Working Paper Series, No. 1156, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/238513 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series LEVERAGING ISLAMIC BANKING AND FINANCE FOR SMALL BUSINESSES: EXPLORING THE CONCEPTUAL AND PRACTICAL DIMENSIONS Mohamed Asmy Bin Mohd Thas Thaker, Hassanudin Bin Mohd Thas Thaker, Anwar Bin Allah Pitchay, Md Fouad Bin Amin, and Ahmad Bin Khaliq No. 1156 June 2020 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. Suggested citation: Thaker, M. A. B. M. T., H. B. M. T. Thaker, A. B. A. Pitchay, Md F. B. Amin, and A. B. Khaliq. 2020. Leveraging Islamic Banking and Finance for Small Business: Exploring the Conceptual and Practical Dimensions. ADBI Working Paper 1156. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/leveraging-islamic-banking-financesmall-business Please contact the authors for information about this paper. Email: [email protected], [email protected], [email protected], [email protected], [email protected] Mohamed Asmy Bin Mohd Thas Thaker is associate professor at the International Islamic University Malaysia, Kuala Lumpur. Hassanudin Bin Mohd Thas Thaker is assistant professor at Sunway University, Kuala Lumpur. Anwar Bin Allah Pitchay is assistant professor at Universiti Sains Malaysia, Penang. Md Fouad Bin Amin is assistant professor at King Saud University, Riyadh. Ahmad Bin Khaliq is assistant professor at the International Islamic University Malaysia, Kuala Lumpur. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2020 Asian Development Bank Institute ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. Abstract Small businesses are considered one of the sources of innovation, productivity and dynamism in many countries. Thus, to translate innovative ideas into sustainable businesses, access to capital becomes a part and parcel of their business lifecycle. Despite their potential importance for economic development, small businesses are facing difficulties in attracting external finance at the early and middle stages of the entrepreneurial lifecycle in many countries, including developed and developing countries. As a response, the Addis Ababa Action Agenda on Financing for Development (2015) recognized the role of additional financing, in particular using innovative mechanisms, instruments and modalities. It encourages mechanisms based on models combining public and private resources (blended finance) and joint ventures that bring significant impact investing. In line with this, Islamic banking and finance is a broad framework that has great potential for supporting development finance particularly related to small business, given their fundamental criteria emphasizing generating positive societal impact. The main objectives covered by this paper are: (i) to perform a landscape analysis of financing small business for selected Asian countries, particularly Malaysia and Indonesia; (ii) to identify and unpack innovative financing opportunities within Islamic banking and finance instruments such as Mudharabah (profit-sharing), Musharakah (profit-loss sharing), Murabahah (sale with cost plus profit margin, Ijarah [Islamic leasing]), and Salam (forward sale) as potential solutions for addressing small businesses’ funding gaps; and (iii) to initiate the development of systematic principles for the utilization of Islamic banking and finance instruments in financing small businesses. Keywords: small businesses, financing, Islamic banking and finance, Malaysia, Indonesia JEL Classification: E5, G2, L26 ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. Contents 1. INTRODUCTION ............................................................................................................ 1 2. LITERATURE REVIEW ................................................................................................. 2 2.1 Issues of Financing Small Businesses .............................................................. 2 2.2 SME Policies in Malaysia ................................................................................... 5 2.3 SME Policies in Indonesia ................................................................................. 7 3. THE PHILOSOPHY OF ISLAMIC BANKING AND FINANCE ...................................... 8 4. THE PRODUCTS OF ISLAMIC BANKING AND FINANCE FOR SMALL BUSINESS ............................................................................................... 9 4.1 Murabahah Financing ........................................................................................ 9 4.2 Ijarah (Ijarah Muntahiya Bi Tamleek Financing).............................................. 10 4.3 Salam (Parallel Salam Financing) ................................................................... 11 4.4 Ar Rahn ............................................................................................................ 12 4.5 Tawarruq Financing (organized Tawarruq) ..................................................... 12 4.6 Mudharabah Financing .................................................................................... 12 4.7 Musharakah Financing .................................................................................... 13 5. MOBILIZATION OF ISLAMIC BANKING AND FINANCE TOWARDS SMEs IN MALAYSIA AND INDONESIA................................................................................. 14 6. POTENTIAL OF ISLAMIC BANKING AND FINANCE FOR FOSTERING TECH START-UPS ...................................................................................................... 16 7. ISLAMIC BANKING AND FINANCE’S RISK MANAGEMENT OF SMEs ................... 17 8. CHALLENGES OF IMPLEMENTATION OF ISLAMIC FINANCE FOR SMALL BUSINESSES ........................................................................................ 18 9. CONCLUSION AND RECOMMENDATIONS ............................................................. 19 REFERENCES ........................................................................................................................ 21 ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 1 1. INTRODUCTION Small businesses or micro-based businesses are considered one of best potential platforms for innovation, productivity, and dynamism that support many economic sectors through employment creation, output expansion, export orientation, and income increases (Wong and Aspinwall 2004). Furthermore, these businesses are also dominating various strategic business service subsectors, including services related to computer software and information processing, research and development, marketing, business organization, and human resource development (OECD 2000). It is estimated that small businesses represent about 95% of the companies providing more than 65% of the jobs as well as more than 50% of the gross domestic product globally (World Trade Report 2016). Hence, these businesses occupy a prominent position in the development agenda and essentially become a part of the overall national development strategy in most countries (Abdullah 1999). Both developed and developing countries acknowledge the role of small businesses as the primary contributors to the growth and development of an economy. Despite their potential importance for economic development, it is widely recognized that small businesses are facing difficulties in attracting external finance at the early and middle stages of the entrepreneurial lifecycle in many countries, including developed and developing countries. According to the World Bank Report (2015), small businesses in developing countries are lacking of financial support to reach their optimal capacity. Some empirical studies have been conducted to examine the small businesses’ challenges in managing external finance in both developed and developing countries Some of these challenges are related to collateral condition, legal status, transaction cost, information and documentation, financial track record, nature and quality of business, and financing procedure and options (Hashim, 1999; Aris, 2006; Saleh and Ndubisi 2006; Abdullah and Manan 2010; SME Masterplan 2012–2020; Thaker et al. 2013; Thaker 2015; Duasa and Thaker 2016). In addition, small businesses are characterized as high-risk businesses and take many years to generate returns to their investors. In addition, lack of attraction and the uncertainty of cash flows are also becoming limitations for them in accessing external finance (Block, Colombo, and Cumming 2018). Due to such constraints, most formal investors, such as retail investors, angel investors, and sophisticated investors, are unwilling to make proper investments at the pre-seed stage and focus their attention on later-stage business ventures with a proven business model. Given the constraints of accessing traditional financial institutions by small businesses, The Addis Ababa Action Agenda that initiated Financing for Development (2015) emphasized the significance of financing support through innovative financial mechanisms without losing the spirit of businesses in developing countries. This action agenda calls for innovate financial mechanisms comprised of both public and private resources termed as blended finance and joint venture to increase the flow of financing. Accordingly, the Islamic banking and finance industry is a broad framework that has great potential for supporting development finance particularly related to small business, given their fundamental criteria emphasizing generating positive societal impact. It has achieved remarkable success in terms of steady growth and product diversification across the world. According to a report by the Islamic Financial Services Board (2018), the industry has experienced a compound annual growth rate of approximately 17% over the past five years and managed approximately $1.87 trillion worth of total assets by the first half of 2014. To be more specific, Islamic banking alone expanded by about 16% in 2013, whereas global banking (comprised of assets of the ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 2 world’s top 1,000 banks) grew by only 4.9% in 2012 and 0.6% in 2013 (Islamic Financial Services Board 2018). The two most notable features of Islamic banking and finance that contribute to social and economic development via entrepreneurship are asset-backed financing and risk-sharing. According to the policy paper jointly released by World Bank Group, Islamic Development Bank and the G20 in 2015, the Islamic financial industry should be asset-based so that it can boost real economic activity that will be directing factors of production to the growth of financed assets and eliminating the stigma of "financialization” of a particular economy. Another key financial mechanism of the industry is that it is based on equity suitable for small businesses because the entrepreneurs can share profits and losses. This risk-sharing mode is a fundamental support for entrepreneurial development, particularly small business entrepreneurs relying on equity financing for their new ventures. In Malaysia, a number of institutions participate in fostering financing accessibility, focusing on SMEs which include commercial banks, Islamic banks, merchant or investment banks, and development finance institutions (Bank Negara Malaysia 2019). According to BNM, the total amount of RM2.17billions of total loans/financing disbursed recorded by the entire participant banks as of November 2019. Meanwhile, in the last five years, Indonesia’s Shariah banks have seen its assets grow by 38% compared to 15% for conventional banks (Bank Indonesia). The sector is currently dominated by two leading players, namely Bank Mandiri Syariah and Bank Muamalat, that count for 50% of total Shariah financing between them (Global Business Guide-Indonesia 2011). Indonesia appears to be a natural growing market for Shariah-compliant banking services, given the size of the Muslim majority population; however, the character of the market is starkly different from that of neighboring Malaysia or the Middle East. The majority of Indonesia’s potential Islamic banking customers fall under the “rational market” as opposed to that of the “spiritual market”. Islamic banking products are therefore pitted against their conventional counterparts and judged on their commercial merits as opposed to being chosen on the basis of faith. Furthermore, since Islamic banks in Indonesia are relatively new as they were established two decades ago, there is the domination of the conventional banks, which cover almost 70% of the industry. Considering the importance of small businesses and the scope for Islamic financial services, the present research aims to achieve the following objectives: (i) to perform a landscape analysis of financing small businesses in selected Asian countries particularly Malaysia and Indonesia; (ii) to identify and unpack innovative financing opportunities within Islamic banking and finance instruments, such as Mudharabah (profit-sharing), Musharakah (profit-loss sharing), Murabahah (sale with cost plus profit margin, Ijarah [Islamic leasing]), and Salam (forward sale) as potential solutions for addressing small businesses’ funding gaps; and (iii) to initiate the development of systematic principles for the utilization of Islamic banking and finance instruments in financing small businesses. 2. LITERATURE REVIEW 2.1 Issues of Financing Small Businesses The extant studies have shown that small businesses are facing the most common problem, which is financial challenges. In general, the majority of the studies have ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 3 indicated the factors that prevent small business from access to external financing are strict collateral requirements, high transaction costs, lack of response from financial institutions that consider the small business as a risky business, insufficient documents to support the loan application, and no financial track record. . In his study, Das (2007) claimed that Indian small businesses have for decades continued to be hindered by constraints, particularly access to loan financing. According to him, the commercial banks were only interested in channeling funds to selected small businesses after they were instructed by The Reserve Bank of India (RBI) and the Ministry of Finance to do so. The author pointed out that there were inadequate flows of funds, causing a specific bias against small loan portfolios that interrupted the normal flow of finance to small firms. The two most responsible factors— collateral condition and the lack of transparency—are identified as the main impediments to small businesses’ receiving external financing. Aris (2006) studied various challenges of external finance for small businesses in Malaysia, which are lack of collateral, insufficient documents to support loan applications, no financial track record, the nature of the business, and long loan processing time. These factors causing them to rely much more on internal financing rather than external financing. Pirvu, Giurca Vasilescu, and Mehedintu (2008) revealed a number of challenges of micro and small business entrepreneurs in getting finance from conventional commercial banks in Romania: stringent banking and legislative environment, bureaucratic banking structures, an apathetic nature towards disbursing micro and small credits, and the condition of creditworthiness. Ganbold (2008) found that external financing for small businesses remained a major obstacle in Mongolia. He noticed that the large firms can easily access finance compared to small businesses. It restricted the latter from making capital investments and funding daily operational activities, and the main causes were high interest rates, limited or no access to long-term credit, collateral constraints, and lack of market research and business planning. Stephanou and Rodriguez (2008) examined the financial challenges of small businesses in Colombia, which include the lack of proper financing for smaller, industrial and younger firms to develop or diversify their economic activities. The authors identified some other constraints related to the rate of interest, loan maturity, collateral conditions, and lending process. Rahman (2010) discussed the potential constraints faced by small businesses in Bangladesh. Among them was financial constraints. In Bangladesh, the small businesses were facing difficulties in raising fixed and working capital because of the reluctance of banks to provide loans to small businesses. This reluctance was caused by the government policy that removed the interest rate subsidy, which led the financial institutions to provide less finance to small businesses. In addition, the author also found that the high requirements for collateral and improper project planning also resulted in the lack of access to finance for small businesses in Bangladesh. Hassan et al. (2010) described the various financial challenges of micro entrepreneurs in Malaysia and observed that most of the micro entrepreneurs experienced extreme financial difficulties in the initial stage of their business. Only 13% of the micro entrepreneurs received financial support from government-operated programs. In addition, they also found that the rigidity of the procedures for accessing financial programs also prevented the smooth success of the programs. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 4 Subramaniam (2010) investigated the challenges faced by the youth in microenterprises in Malaysia. She collected primary data through personal interviews conducted with young people who operated microenterprises. The results revealed that lack of access to external financing was a major factor that led them to rely more on internal financing. In another study on Thailand, Punyasvatsut (2011) illustrated that most of the financial sources of small businesses came from personal funds, such as borrowing from relatives and friends, and only 30% was obtained from external sources such as banks. In addition, the entrepreneurs exhibit overdrafts as a backdoor means of fulfilling the working capital requirement of the bank for obtaining loans. It is estimated that only 40% of small Thai firms received formal credit while the rest were excluded from formal financial services. The author mentioned a number of obstacles related to financing that arose from both entrepreneurs and financial institutions. Regarding the financial institutions, SME entrepreneurs claimed to have inadequate information, insufficient advice from financial institutions, as well as complex and cumbersome loan application processes, whereas the entrepreneurs were observed to have constraints related to collateral, business experience, business plans, loan history, and transaction costs that prevented them from accessing finance. Kyophilavong (2011) examined the financial constraints of small businesses in the Lao People’s Democratic Republic and identified that all entrepreneurs of SMEs more or less experienced critical problems in accessing required finance at the early stage of their businesses. The author explored a gap between small businesses with no financial constraints and those with financial constraints and showed that the latter performed relatively poorly. It is notable that the domestic firms with sound capital and established business enjoyed higher access to finance. Moreover, about 20% of the 198 small businesses could access finance while roughly 80% of the entrepreneurs were dissatisfied with the existing terms and conditions of the financial institutions, and most of them had common complaints about the institutions’ collateral conditions, lengthy and complex application processes, and insufficient information. Ung and Hay (2011) focused on the various financial challenges faced by small businesses in Cambodia. They revealed that based on the survey of 180 randomly selected firms consisting of 156 micro and 24 small enterprises, the businesses with larger sales and higher profits had easy access finance while the small entrepreneurs were kept mostly out of the financing mechanism because of nonfulfillment of collateral conditions. Furthermore, the authors identified a few other negative factors responsible for financial inaccessibility, such as loan amount, interest rate, and repayment periods. It was suggested that unbiased lending principles of financial institutions can support the expansion of micro-sized firms in Cambodia. Thanh et al. (2011) investigated the factors responsible for slow development of small businesses in Viet Nam, especially in the textiles and garment, electrical and electronics, and automotive components manufacturing industries. The authors found that capital inadequacy was one of the major obstacles to the development of small businesses. Similar to many other studies as outlined above, the authors also indicated a number of constraints related to accessing finance by the entrepreneurs of small businesses such as collateral, age of the enterprise, businesses experience, small size, and production networks. Machmud and Huda (2011) explored the important characteristics and financial challenges of small businesses in Indonesia and claimed that nearly 56% of small business owners have external financial access, whereas the rest of them rely on internal financial sources such as their own savings and retained earnings. They claimed a major challenge for their entrepreneurial development was the rising costs ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 11 Figure 2: Modus Operandi of Ijarah Muntahiya Bi Tamleek Financing Source: Author’s illustration. 4.3 Salam (Parallel Salam Financing) Salam is another form of Islamic financial forward sale contract whereby the payment of the goods or commodities is paid in advance (present) (mostly agricultural goods) and the delivery takes place on the stipulated date (future). This kind of contact is beneficial for small agro-businesses that need working capital. Salam provides several benefits for small businesses: (i) provision of Shariah-compliant working capital, (ii) usefulness for short-term financing, and (iii) beneficial for the agricultural industry. Figure 3: Modus Operandi of Salam (Parallel Salam Financing) Source: Author’s illustration. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 12 4.4 Ar Rahn Ar-Rahnu is one type of short-term credit or loan (termed as Qardh in Arabic). The client will pledge gold or other valuable metals accepted as security, which acts as the collateral for the loan. This special kind of contract is based on the principle of Islamic law (Shariah) under savings with guarantee or safe-keeping (Rahn and Wadiah Yad Dhamanah). Ar Rahn provides benefits such as (i) no interest, (ii) short-term financing for small businesses, and (iii) surpluses to be returned after auction in the case of default. Figure 4: Modus Operandi of Ar Rahn Source: Author’s illustration. 4.5 Tawarruq Financing (organized Tawarruq) Tawarruq is another Islamic financing mode in which a series of sales contracts are involved in the entire transaction process. Here, a client buys a commodity from a seller (on a deferred basis) and afterwards sells the commodity to a third party (not the original seller and on a cash basis), to obtain liquidity. This instrument provides benefits in terms of (i) liquidity management, (ii) suitability for meeting the needs of small business’ working capital, and (iii) no collateral requirement. 4.6 Mudharabah Financing Mudharabah is one of the ideal and most recommended Islamic financial modes of operations in which the business or project is managed/organized/run based on partnership. One party provides capital (called the capital provider or Rab-ul-Mal) and the second party manages the business (called the entrepreneur/fund manager or Mudarib). The profits (if any) are distributed based on the pre-agreed ratio, and the losses (if any) are borne solely by the capital provider except in the case where the fund manager has fulfilled all the responsibilities bestowed on him/her. If there is negligence in managing the funds or bossiness, the fund manager or Mudarib is also liable for the loss amounts. The Mudharabah contact is very appropriate for small businesses because there is (i) profit sharing; (ii) the entrepreneur does not have ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 13 to contribute capital to the joint venture; and (iii) there is the ability to negotiate the profit ratio. Figure 5: Modus Operandi of Tawarruq Financing Source: Author’s illustration. Figure 6: Modus Operandi of Mudharabah Financing Source: Author’s illustration. 4.7 Musharakah Financing Musharakah is another ideal Islamic financial contract whereby two or more parties are involved, all of the parties provide capital to a joint business or venture, they share the profits based on pre-agreed ratios, and losses (if any) are borne by all the parties proportionate to their capital contribution. The benefits of this particular instrument are (i) profit and loss sharing, and (ii) ability to receive the highest percentage of profits. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 14 Figure 7: Modus Operandi of Musharakah Financing Source: Author’s illustration. 5. MOBILIZATION OF ISLAMIC BANKING AND FINANCE TOWARDS SMES IN MALAYSIA AND INDONESIA The RAM Rating (2019) revealed that Islamic banks in Malaysia maintain strong growth as Islamic banks continue to expand at a much faster pace than their conventional counterparts with 11% in 2018 and comprising about 32% of the overall system’s financing. Islamic banks are seen as a robust platform for assisting SMEs in accessing financing as BNM statistics in early 2019 indicated that Islamic banks in Malaysia held total assets amounting to RM682,048.4 million. Recent research by the Association of Islamic Banking and Financial Institutions Malaysia (AIBIM) indicate that about 10,000 SMEs received more than 10 billion in funding (Kamel, 2019). A key indicator of the BNM reports is that RM4,716.2 million of total financing was disbursed as of November 2019 solely by Islamic banks for several sectors (Bank Negara Malaysia 2019). The AIBIM asserts that Islamic banks granted RM20 billion worth of financing access to SMEs (Kamel 2019). However, despite that, SMEs are seen as not fully utilizing various solutions provided by Islamic banks because a lack of awareness persists among SME entrepreneurs regarding the financing options obtainable. A number of financing activities were traced to supporting the prodigious growth of the SME industry. Bank Negara Malaysia (2019) data depicted a steady growth of SME financing by type of Islamic product. For instance, Bai Bithaman Ajil’s (BBA) products totaled RM64,488.9 million, Ijarah RM9,910.7 million, Ijarah Thumma Al-Bai RM72,423.0 million, Murabahah RM208,532.9 million, Musyarakah RM50,904.2 million, Mudharabah RM57 million, Istisna' RM2,059.8 million and others RM103,284.0 million. Table 1 shows the total financing and increments in total financing disbursed by Islamic banks in support of SMEs’ gradual advancement. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 15 Table1: Total Financing Year Total Financing (in RM million) Increment in Percentage 2014 335,385.1 – 2015 393,956.9 17.5% 2016 436,708.4 10.9% 2017 481,247.3 10.2% 2018 511,660.5 6.3% These financing products are found to be used for a number of productive purposes such as purchase of securities (RM316.2 million), purchase of transport vehicles (RM3,112.5 million), purchase of landed property (RM27,824.2 million), purchase of fixed assets other than land and buildings (RM1,189.1 million), personal uses, credit cards, purchase of consumer durable goods, and construction (RM6,280.8 million), mergers and acquisitions (RM22.8 million), working capital (RM38,019.5 million), and other purposes (RM3,820.0 million). Therefore, it is evident that a number of sectors re enormously aided through the financing facilities provided by Islamic banking and finance institutions to SMEs in Malaysia. For instance, the Bank Negara Malaysia (2019) reported these sectors included agriculture, mining and quarrying, manufacturing (including agro-based), electricity, gas and water supply, wholesale and retail trade, restaurants and hotels, transport, storage and communication, finance, insurance, real estate and business activities, education, health and others, household sector, and other sectors. Meanwhile, Islamic banks in Indonesia were established in 1991 and pioneered by Bank Mualamat. According to Otoritas Jasa Keuangan (OJK) data on June 2018, there were 13 Shariah commercial banks, 21 Shariah business units, and 168 Shariah rural banks. The largest providers of Islamic microfinance in Indonesia are 150 Islamic rural banks (BPRS) and more than 3,000 BMTs (Baitul Maal wat Tamwils), which is a network of Islamic financial cooperatives. Bank Rakyat Indonesia Syariah (BRI Syariah) is an important player. It is a subsidiary of Indonesia’s largest microfinance institution, Bank Rakyat Indonesia (BRI). In the last five years, Indonesia’s Shariah banks have seen assets grow by 38% compared to 15% for conventional banks (Bank Indonesia). The sector is currently dominated by two leading players, namely Bank Mandiri Syariah and Bank Muamalat that account for 50% of total Shariah financing between them (Global Business GuideIndonesia 2011). The development of Islamic banks in Indonesia started two decades ago, and the conventional banks still covered almost 70% of the industry at that time. However, the trend of subsidiaries and the promotion of rational behavior in this industry will trigger more Shariah-based banking in the near future. In terms of the financing contracts, more than 80% of the financing at the full-fledged Islamic banks in the country is based on three contract types—Murabahah (54%), Musharakah (34%) and Mudharabah (6%), adhering more closely to the classical Islamic model of economics than possibly any other country. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 16 Figure 8: Usage of Islamic Finance Product Figure 8 shows that most of the financing of Islamic banks is for the household sector. The financial intermediaries are the best indicator of usage of Islamic financial products in the economic sectors. Thus, real usage of the microenterprises in Indonesia is still the lowest, and this may be influenced by various factors such as the scale of borrowing within the five economic sectors. Most of the time, the usage of SMEs is less compared to the above five sectors. In addition, these indicators also explain that expansion and demand for Islamic finance products in Indonesia is significant in the top five economic sectors. Indonesia appears to be a natural growing market for Shariah-compliant banking services, given the size of the Muslim majority population; however, the character of the market is starkly different from that of neighboring Malaysia or the Middle East. The majority of Indonesia’s potential Islamic banking customers fall under the “rational market” as opposed to that of the “spiritual market.” Islamic banking products are therefore pitted against their conventional counterparts and judged on their commercial merits as opposed to being chosen on the basis of faith. 6. POTENTIAL OF ISLAMIC BANKING AND FINANCE FOR FOSTERING TECH START-UPS Islamic banking and finance are widely known as banking systems focusing their operations and activities purely based on Shariah rules and regulations. Since 1960, the progression of Islamic banking and finance has been undeniably significant and continues to growth at peak levels and to compete against conventional counterparts who have been in existence for the last 420 years. One unique feature of Islamic banking and finance is the profit-and-loss scheme whereby all assets and liabilities are integrated, and with this arrangement, Islamic banking and finance are able to lend on a longer-term basis for projects or start-up businesses that have higher or lower return characteristics. This will also promote economic well-being and growth. The most common types of financing used by Islamic banking and finance to support long-term businesses are Mudharabah (profit sharing) and Musharakah (joint venture). Existing literature highlighted that in view of the preference for profit/loss ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 17 sharing scheme over other trading modes, Murabahah can also play a role as financing facility, given its permissibility. In addition, under the Murabahah scheme, the buy-andsell financing, given equal instalments, is flexible, easier to understand, and simple to monitor (Suzuki and Uddin 2016). Kessler, Allocca, and Rahman (2017) mentioned that SMEs or start-ups encourage entrepreneurship and obviously will enhance economic expansion under the Islamic banking and finance setting. The products such as Murabahah, Mudharabah, and Qardhul Hasan under IB seem to be most suited for start-up businesses and other equivalent businesses. Interestingly, Qardhul Hasan, Murabahah, and Ijarah financing are flexible in usage and easy to implement in determining capital needs (Qardhul Hasan), equipment and assets (Murabahah), and leasing (Ijarah) for SMEs (World BankIDB 2015; Dhumale and Sapcanin 1998). Thus, plenty of financial schemes can be suitable for start-up businesses, but they are also subject to the risk profiles of those particular businesses. For example, in the case of SMEs, the study by Hussein, Noordin, and Taherdoost (2015) shows that 95% of all financing of SMEs in 2003 were approved based on Ijarah, Bay Bithaman Ajil, and Murabahah financing schemes. Looking at the offering patterns of Islamic banking and finance facility, start-up businesses can utilize this facility, which will be useful for accelerating their businesses. The availability of these types of financing to various businesses, including start-ups, have been recognized by various parties, such as policy makers in many countries, as it is consistent with Shariah principles. The Organization of Islamic Cooperation (OIC) emphasizes the importance of the development of SMEs and start-up businesses via active usage of Islamic financial products linked to real economic activity. Thus, it allowed various businesses in member countries to tap into the rapidly growing pool of Shariahcompliant funds. Nevertheless, the General Council for Islamic Banks and Financial Institutions, together with the Islamic Development Bank (IDB), keep finding the best innovative ways of financing to further accelerate the growth of businesses worldwide and promote the role of Islamic finance, especially the social finance aspect. 7. ISLAMIC BANKING AND FINANCE’S RISK MANAGEMENT OF SMES The partnership-based, long-term Islamic financing products have higher risks compared to the debt-based, short-term products. Islamic financial institutions need to practice both, depending on the demand and the context. As discussed earlier, the principle of risk-sharing is the key element of equity or partnership contracts. In order to use these financial products, it is necessary to have some moral or ethical values, including justice, trust, truth, honesty, and responsibility. Islamic financial institutions cannot claim any gain or profit if there is no risk. Thus, it is up to institutions to bear various risks such as default risks, which are capital risks, market risks, and economic risks. The institution cannot shift the risk to the partner or make a risk-free contract and gain a fixed rate of income as profit. To avoid this, the institution makes sufficient effort to minimize the risk factors involved in any contract that is allowed in Islam. According to the Islamic principle of financing, the risk should be shared by the capital providers and the borrowers, and it does not allow shifting the risk solely to one party. It should be borne in mind that the goal and motivation of Islamic finance is the creation of wealth and development of business. These common goals help increase the level of cooperation and decrease the flow of asymmetrical information, adverse selections, ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 18 moral hazards, and speculations among the parties involved in Islamic financial contracts. The practice of moral values particularly by the borrowers or entrepreneurs can mitigate various risks involved in the transactions, and in many cases, the collateral requirements and credit assessment can be less important. However, this does not allow Islamic financial institutions to be involved in any financial contracts without proper evaluation, monitoring, and supervising of the businesses or projects, particularly in the case of SMEs. 8. CHALLENGES OF IMPLEMENTATION OF ISLAMIC FINANCE FOR SMALL BUSINESSES Some of the challenges involving in Islamic finance implementation for small business are as follows: (i) Product Offerings The Islamic financial products offered to small businesses are skewed more toward debt financing such as Murabahah. Although there are other products such as Musharakah, Mudharabah, and Ijarah, Murabahah is more suitable for specific financing purposes, and these products come with better profit and loss sharing. Thus, there is no diversity in offering different financial products to support small businesses’ financial needs. There is a need to move towards equity-based financing instead of just relying on debt-based financing. (ii) Regulatory Framework One of the crucial challenges for Islamic finance, regardless of whether it is for small businesses or other platforms, is the lack of a regulatory framework for financial products. Looking at conventional financing, the regulation standards are more harmonized and standardized, which makes their products more marketable and easier to follow. In Islamic finance, the products are less standardized since there are no approved standards per se for Islamic finance. Most of the Islamic finance products follow the conventional banking rules and regulations. (iii) Transaction Costs and Non-movable Collateral As far as Islamic finance for small business is concerned, the transaction costs and taxes involved are relatively higher compared to their conventional counterparts in financing. Possible reasons for this may be the Shariah verification processes and complicated taxation guidelines. Furthermore, small businesses generally facing the problem of non-movable collateral cause the Islamic banks to be reluctant to finance small businesses in general. Thus, a strong legal standard is needed in order to allow small businesses to use utilize their movable tangible assets. (iv) Knowledge and Information The knowledge and availability of Islamic finance products to entrepreneurs, especially at the start-up level, is still at a low level. This may be due to the limited number of Islamic finance products offered, and this industry is still at the beginning stage, compared to conventional banks. The Muslim majority countries such Malaysia, Indonesia, and others are moving toward full-fledged Islamic finance institutions, and this will lead to a better Islamic finance eco-system. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 19 (v) Smart Collaboration Currently, the government and private sectors that offer Islamic finance products to small businesses are executing their roles individually. Smart collaboration such as shared capital, risk, training, and other responsibilities will attract more stakeholders, such as investors, to participate in the SMEs’ investments as capital providers. 9. CONCLUSION AND RECOMMENDATIONS To sum up, small businesses are playing a vital part in economies as they create employment and contribute to the national income. However, this sector faces many challenges, particularly in accessing financial services in many countries, including Malaysia and Indonesia. This research has compiled the findings of a number of empirical studies that can be viewed from the financier’s as well as the entrepreneur’s perspectives. It has been observed that the financier is quite reluctant to provide finance to the entrepreneurs of small businesses. The main causes for most of the loan applications of entrepreneurs to be denied are their early stage of business establishment and lack of proper business experience, no collateral security, higher transaction costs, improper business planning, small size of loans, limited or lower production networks, lower sales, revenue, and cash-flows, and bad credit history. On the other hand, the entrepreneurs of small businesses criticized the financiers because of their rigid terms and conditions of loan approval. In addition, there are many other objections regarding the financiers that are related to inadequate information, insufficient advice, collateral requirements, transaction costs, loan amounts, interest rate and repayment period, loan maturity, lending processes, etc. Apart from highlighting these financing challenges, this research also discussed the government policies and programs of small businesses in Malaysia and Indonesia for the development of the industry. As can be realized from the discussion, these programs are not fully satisfying the financial needs of the small businesses. The SME sector has many challenges, and one of the most important ones is the lack of required financing either to start up or to expand the existing enterprises. In this paper, we have presented a number of Islamic financial products such as Mudharabah, Musharakah, Murabaha, Ijarah, and Salam which can be adopted to meet the financial needs of the entrepreneurs. Among these products, there are some short-term in nature, i.e., Murabaha, which is particularly appropriate for financing day-to-day business activities and for satisfying the requirement of working capital which has higher risks than some of the long-term products, i.e., Mudharabah, Musharakah, Ijarah, and Salam, which are most appropriate for the economic viability of the businesses. Ideally, Islamic financial institutions should be focusing more on non-borrowing and long-term Islamic products or contracts to finance the long-term projects. As a possible solution for those challenges, the present research presents a few innovative Islamic financing modes, i.e., Mudharabah, Musharakah, Murabahah, Ijarah, and Salam. Islamic financial products can be better alternatives or substitutes for conventional financial contracts, but they are not complementary to each other. This is because of the underlying fundamental principle involved in Islamic financial contracts that is guided by Islamic law or Shariah. The key difference between these two financial systems is the practice of interest or riba, uncertainty (Gharar), gambling, and speculation, which are not accepted under any condition by the Islamic financial system. In addition, the current practice of conventional financing in most of the cases is not based on partnerships with profit-and-loss sharing principles. ADBI Working Paper 1156 M. A. B. M. T. Thaker et al. 20 In real situations, there are many uncertainties that make businesses either profitable or failures. An entrepreneur who starts a new enterprise can face many business uncertainties. The entrepreneur can share the risks of conducting business with an Islamic financial institution as the partner. In this case, the institution can create a risksharing investment account on its liability side based on Mudharabah or Musharakah, whereas on its assets side, there could be the underlying contract with various Islamic finance products. Along with this, Islamic financial institutions, including banks, can get necessary support from government and its policymakers to fruitfully use equity-based financing contracts to better serve the SME sector. The present research recommends that a successful implementation of the innovative Islamic financing mode of operations can not only mitigate the existing financial challenges of small businesses, but it can also bring solutions to varieties of problems faced by the financiers in financing to small businesses. Further research can be conducted on the suitability of each of the financing modes in different contexts, i.e., the nature of project or business, type of sector (agriculture or industry), market condition, and infrastructural and technological capacity. It is also hoped that after the successful assessment of all the possible factors, selecting the most appropriate Islamic financial modes can elevate the small business sector not only in Malaysia and Indonesia but also in some other parts of the world and thus contribute to economic growth and social welfare.