Islamic Banking Opportunities Across Small and Medium Enterprises Pakistan In partnership with the Canadian Department of Foreign Affairs, Trade and Development, the Danish International Development Agency, Japan, Switzerland’s State Secretariat for Economic Affairs and UKaid. DISCLAIMER “IFC, a member of the World Bank Group, creates opportunity for people to escape poverty and improve their lives.We foster sustainable economic growth in developing countries by supporting private sector development, mobilizing private capital, and providing advisory and risk mitigation services to businesses and governments. This report was commissioned by IFC through its Access to Finance Business Line in the Middle East and North Africa to highlight the need for Islamic Banking across the region.” “The conclusions and judgments contained in this report should not be attributed to, and do not necessarily represent the views of, IFC or its Board of Directors or the World Bank or its Executive Directors, or the countries they represent. IFC and the World Bank do not guarantee the accuracy of the data in this publication and accept no responsibility for any consequences of their use.”  “This research is funded under the MENA MSME Technical Assistance Facility, a joint initiative between IFC and the World Bank. The facility is supported by the Canadian Department of Foreign Affairs, Trade and Development, the Danish International Development Agency, Japan, Switzerland’s State Secretariat for Economic Affairs and UKaid. Contents 01. Preface ..................................................................................................................................... 6 02. Executive Summary ................................................................................................................ 9 03. SMEs in Pakistan .................................................................................................................... 14 Definition ................................................................................................................................. 14 SMEs contribution to Pakistan’s economy ...................................................................................... 14 SMEs distribution by sector, ownership, and geography ..................................................................... 15 SMEs “doing business” environment ............................................................................................. 16 04. Current Status of Islamic Banking in Pakistan .................................................................. 18 An overview of Pakistan’s banking system ...................................................................................... 18 The state of Islamic banking in Pakistan ........................................................................................ 19 Regulatory environment for Islamic finance in Pakistan .................................................................... 27 Initiatives to promote Islamic finance to SMEs in Pakistan ................................................................ 28 05. Islamic Banking Opportunities across SMEs ...................................................................... 31 Access to finance for the SME sector ............................................................................................. 31 Obstacles faced by Islamic financial institutions in lending to SMEs ................................................... 33 Supply side analysis – penetration of Islamic banking in SMEs in Pakistan ................................................ 34 Potential for Islamic banking in the SME Sector .............................................................................. 35 Strategic operational adjustments can help Islamic banks target SMEs more effectively ............................. 39 06. Conclusion .......................................................................................................................... 41 43 Research Scope and Methodology ............................................................................................... Appendix ......................................................................................................................................... 48 Bibliography .................................................................................................................................. 52 Index of Figures and Tables Figure 1 : Islamic funding and deposit potential across MENA and Pakistan ($bn) ....................................................................... 7 Figure 2: Islamic financing potential – ‘new to bank’ ..................................................................................................................... 11 Figure 3: Depository potential ....................................................................................................................................................... 12 Figure 4: SMEs’ share of Pakistan’s economy ................................................................................................................................ 15 Figure 5: SME distribution by employee size ................................................................................................................................. 16 Figure 6: SME distribution by activity ........................................................................................................................................... 16 Figure 7: Geographical distribution of SMEs ................................................................................................................................. 16 Figure 8: Key challenges faced by SMEs ........................................................................................................................................ 17 Figure 9: Evolution of the Islamic banking sector in Pakistan ........................................................................................................ 20 Figure 10: Breakup of Pakistan’s Islamic banking assets (2006 and 2012) ..................................................................................... 20 Figure 11: Breakup of Pakistan’s Islamic banking deposits (2006 and 2012) ................................................................................. 21 Figure 12: Total assets and deposits of Islamic banks ($mn) .......................................................................................................... 22 Figure 13: NPL as a percentage of total loans ............................................................................................................................... 23 Figure 14: Market share of Islamic banks (by assets and deposits, 2011) ...................................................................................... 23 Figure 15: Market share of conventional banks with Islamic ......................................................................................................... 24 Figure 16: Islamic financing mix .................................................................................................................................................... 24 Figure 17: SME lending as a percent of total lending in Pakistan .................................................................................................. 26 Figure 18: SME lending by Islamic banks ..................................................................................................................................... 27 Figure 19: SME funding ............................................................................................................................................................... 32 Figure 20: New Islamic financing potential – ‘new to bank’ ........................................................................................................... 37 Figure 21: Depository potential ..................................................................................................................................................... 38 Figure 21: Strategic operational adjustments to target SMEs ......................................................................................................... 39 Table 1: Banking structure in Pakistan .......................................................................................................................................... 18 Table 2 : Break up of deposits in the Islamic banking sector .......................................................................................................... 22 Table 3 : Islamic banking concentration by sector (% of Islamic funds allocated) ......................................................................... 25 Table 4 : Cost of funds of selected Islamic banks ........................................................................................................................... 25 Table 5 : Historic data on financing split ....................................................................................................................................... 32 Table 6 : Pakistani banks’ supply side analysis .............................................................................................................................. 35 Table 7 : SME definition as per Prudential Regulations ................................................................................................................. 44 Table 8 : List of banks contacted ................................................................................................................................................... 45 Table 9 : Supply side analysis template .......................................................................................................................................... 45 Table 10 : Funding Potential Calculations ..................................................................................................................................... 46 Table 11 : Islamic deposit products offered by major banks in Pakistan ........................................................................................ 48 Table 12 : Islamic financing products offered by major banks in Pakistan ..................................................................................... 49 Table 13 : Other Islamic products and services offered by major banks in Pakistan ...................................................................... 50 Table 14 : Demand for Islamic banking products from the SME sector ......................................................................................... 51 Abbreviations and Glossary BAS Bank Advisory Services CAGR Compound Annual Growth Rate CWCD Centre for Woman Co-operative Development GDP Gross Domestic Product HBFC House Building Finance Corporation ICP Investment Corporation of Pakistan IFC International Finance Corporation IFSB Islamic Financial Services Board IMF International Monetary Fund KPK Khyber Pakhtunkhwa KYC Know Your Customer MENA Middle East and North Africa NIT National Investment Trust NPL Non-performing Loans PLS Profit and Loss Sharing SAB Shariah Appellate Bench SBP State Bank of Pakistan (Central Bank of Pakistan) SME Small and Medium Enterprises SMEDA Small and Medium Enterprises Development Authority WEF World Economic Forum 01. Preface Small and medium enterprises (SMEs) are now widely recognized as engines of economic growth and key contributors to sustainable gross domestic product (GDP) of all countries, including those in the Middle East and North Africa (MENA) region. These businesses predominantly operate in the manufacturing and service sectors and create employment opportunities for both skilled and unskilled persons. However, market conditions and regulatory environments are not always supportive of the growth of SMEs and access to formal finance is one of the main obstacles they face. IFC’s Financial Institutions Group (FIG) in MENA provides investment and advisory services to the region’s banks and other financial institutions to build their capacity in SME banking so that they can profitably and sustainably reach out to the SME sector. This is achieved through providing equity finance, lines of credit, risk sharing facilities, trade finance, disseminating best practices, improving processes and products, and streamlining delivery channels. Ultimately, IFC’s goal is to increase the number of banks and financial institutions that offer financial and banking services to SMEs in a profitable and sustainable manner. IFC is recognized globally as an SME finance market leader owing to its global expertise and knowledge. There is a huge demand for Islamic products by SMEs in the MENA region and, according to this study, approximately 32 percent of such businesses remain excluded from the formal banking sector because of a lack of Shariah-compliant products. In order to reach out to SMEs demanding Islamic products, and as part of IFC’s initiative to enhance its SME investment and advisory services offerings to Islamic financial institutions, we needed to better understand the market from both the demand and supply sides in order to identify any gaps or niches where IFC could assist and add value. With this objective, IFC commissioned a study in nine countries of the MENA region, which includes Pakistan, to better understand the demand and supply for Islamic banking products (both asset and liability products and other banking services) in the SME sector. The countries chosen for this study are: (1) Iraq, (2) Pakistan, (3) Yemen, (4) Kingdom of Saudi Arabia, (5) Egypt, (6) Lebanon, (7) Morocco, (8) Tunisia, and (9) Jordan. The scope of the study was to: (i) identify the countries in the MENA region facing gaps in financing and banking needs of SMEs in the Islamic products space; (ii) conduct a supply side benchmarking to review current capacity of financial institutions to offer Islamic products to this sector; (iii) conduct a demand side benchmarking to identify key SME customer needs for Islamic products and see how well they are currently being served; and (iv) review the current enabling environment and readiness levels of banks in terms of the regulatory framework and Shariah compliance. The study reiterates several of the now well researched and documented reasons for the lack of access to finance for SMEs. However, more importantly, the study reveals that, there is a potential gap of $8.63 billion to $13.20 billion for Islamic SME financing within un-served and underserved SMEs categories, with a corresponding deposit potential of $9.71 billion to $15.05 billion across these countries. This is due to the fact these un-served and underserved SMEs do not borrow from conventional banks, only owing to religious reasons. This potential is a “new to bank” funding opportunity, which is still untapped, as banks and other financial institutions lack adequate strategic focus on this segment to offer Shariah-compliant products. 6 Pakistan Figure 1 : Islamic funding and deposit potential across MENA and Pakistan ($bn) This Regional Executive Summary provides a comparative analysis of the SME potential across these countries and the opportunities available to Islamic institutions to tap this potential. The nine individual country reports provide a deeper insight into the SME landscape and potential opportunities for Islamic banks in each country. The reports also highlight the measures that banks may need to take to successfully target the Islamic banking potential of SMEs. IFC acknowledges the commitment and cooperation of Israa Capital Management Consultants, Dubai, who carried out this study on our behalf. IFC thanks them for their dedicated efforts and contribution in compiling the individual country reports and the comparative analysis contained in this executive summary. Mouayed Makhlouf Regional Director IFC – Middle East and North Africa Islamic Banking Opportunities across Small and Medium Enterprises 7 Foreword In recent years, banks in Pakistan and the Middle East and North Africa (MENA) region have become increasingly interested in targeting the small and medium enterprise (SME) sector and have realized that many small businesses demand Shariah-compliant banking. While the IFC has conducted several studies to determine the gap in financing and use of banking services for SMEs, it was still not clear how many of them were excluded due to religious reasons. To provide clarity on the subject, IFC commissioned a study to better understand the demand and supply for Islamic banking products (both asset and liability products as well as other banking services) in the SME sector in Pakistan. The scope of the study covers (i) gaps in SMEs’ banking needs in the Islamic products space; (ii) supply-side benchmarking to review the current capacity of financial institutions to offer Islamic products to SMEs; (iii) demand-side benchmarking to identify key SME needs for Islamic products and see how well they are being served; and (iv) review of the current enabling environment and readiness levels in terms of the regulatory framework and Shariah compliance. This report on Pakistan reveals a ‘new to bank’ Islamic funding and depository opportunity, primarily due to un-served and underserved SMEs (approximately 20 percent to 25 percent), who do not borrow from conventional banks due to religious reasons. This potential is untapped as banks and other financial institutions lack adequate strategic focus on this segment to offer Shariah-compliant products. Despite many SMEs exhibiting strong interest for Shariah-compliant products, narrow product offerings, limited outreach, and restricted operational capabilities are hindering this sector’s growth. However, if banks and other financial institutions are able to implement the recommendations outlined in this report, they would be able to capitalize on this significant opportunity at the bottom of the pyramid. The successful implementation of these strategies by banks could lead to the following “new to bank” potential: Funding Potential Depository Potential Description Min Max Min Max ($bn) ($bn) ($bn) ($bn) Un-served SME population – (a) 0.5 0.7 0.3 0.4 Underserved SME population – (b) 2.1 3.1 0.6 0.9 Total “New to Bank” (a+b) 2.6 3.8 0.9 1.3 In addition to the potential offered by un-served and underserved enterprises, the well-served conventional portfolio also offers significant ‘conversion/migration’ potential. Although the well-served enterprises have sufficient financing available, they are nonetheless inclined towards Islamic banking. However, they do not approach Islamic banks due to the non-availability of Islamic banking products or cumbersome transactional processes. Such segments could offer a ‘conversion/migration’ potential of 5 percent to 8 percent of the current SME portfolio. 8 Pakistan 02. Executive Summary The objective of this study is to ascertain the number of SMEs who do not borrow because of religious reasons, reflecting a need that is unmet. How many SMEs borrow the bare minimum required to survive and would have borrowed more if Islamic financing options were available. Also, how many SMEs prefer Islamic banking, but choose conventional banks for their banking needs because of the lack of adequate Islamic banking facilities? The small and medium enterprise (SME) sector is a key component of Pakistan’s economy. It accounts for 30 percent of the gross domestic product (GDP), 25 percent of exports of manufactured goods, and 35 percent of the manufacturing value added1. It also employs more than 78 percent2 of the non-agricultural workforce. The SME sector can play an important role in revitalizing Pakistan’s economy and ensuring inclusive growth in the long term. However, SMEs face numerous problems such as low levels of skill and training, corruption, and inadequate public infrastructure. One of the biggest problems affecting the development of SMEs in Pakistan is inadequate access to finance. The banking system in Pakistan has been reducing exposure to SMEs over the past few years, primarily due to macroeconomic factors and the SMEs’ poor business conditions, which make lending to them a risky proposition. In addition to this, the banks themselves have yet to build requisite capacity to serve this segment. SME lending by the banking sector as a whole declined to $2.7 billion (6.8 percent of the total lending) in 2012 from $3.8 billion (11.7 percent of total lending) in 20083. Moreover, Islamic banks, which have traditionally followed an even more cautious approach when lending to SMEs, further reduced their exposure to just 4.1 percent of all loans in 2012 ($100 million) from 9.8 percent in 2008 ($145 million)4. However, banks are looking to reach out to the SME sector, and with improvement in business conditions and banks’ capacity, Islamic lending to SMEs is expected to revive. Access to finance is a major issue for SMEs in Pakistan; well-served SMEs account for just 11 percent of the total SME population, whereas 22 percent of the SMEs are underserved and 67 percent un-served5. Religious belief is a key reason hindering SMEs from opting for formal financing. Approximately 20 percent to 25 percent6 of SMEs (accounting for more than 150,000 enterprises) do not opt at all for formal financing or borrow less than 20 percent of their requirements due to their religious beliefs7. This type of sentiment has been growing stronger, especially over the past five to six years. Although these SMEs are creditworthy, they are excluded from accessing funding from banks as Shariah-compliant products are either not available or not properly understood by these SMEs or involve lengthy processes, making the execution of Islamic transactions cumbersome. 1 Small and Medium Enterprises Development Authority 2 State Bank of Pakistan Revised Prudential Regulations Circular No. 08 of 2013 3 State Bank of Pakistan 4 State Bank of Pakistan 5 Calculation derived from the SME population provided by SMEDA and primary research with banking experts and professionals 6 Primary research 7 Average number of enterprises sourced from Figure 1 Islamic Banking Opportunities across Small and Medium Enterprises 9 Islamic banking in Pakistan is well regulated with clear guidelines SMEs about the different Islamic banking options available to for Shariah-compliant practices them through marketing campaigns and training programs. However, there remains a significant knowledge deficit regarding Islamic banking is well established in Pakistan, tracing its origin to Islamic banking among the SMEs in the country. the late 1970s. Since then, the country’s Islamic banking industry has grown significantly with the establishment of five full-fledged • High cost of credit and huge collaterals: The cost of credit Islamic banks. Also, 12 conventional banks with Islamic windows 8 charged by Islamic banks is relatively high (about 1 percent to operate a wide branch network across the country. Islamic banking 2 percent10 higher than conventional banks for the same sector). assets and deposits increased at a compound annual growth rate In addition, SMEs are charged high collaterals ranging between (CAGR) of 38 percent and 42 percent, respectively, over the last 130 percent to 140 percent11 of the total loan amount (by way of six years; they currently account for 8.6 percent and 9.7 percent cash margins and mortgage on tangible assets)12. It is estimated of the country’s total banking assets and deposits, respectively9. that 98 percent13 of all Islamic SME loans are collateralized. In Asset quality of Islamic banks is better than the overall industry 2011, the average non-secured loan amount was just $2,300 as average. The ratio of non-performing loans (NPLs)-to-total loans compared to $26,450 for collateralized loans14. is significantly lower than the banking industry’s historical average. • Cumbersome processes: A vast majority of well-served SMEs The SBP works toward developing Islamic banking for the SME (over 100,000 enterprises), along with around of 110,000 to sector 150,000 underserved SMEs, which currently avail conventional banking services, do not aspire to use Islamic finance primarily The State Bank of Pakistan (SBP) has undertaken several measures because of the tedious to bolster Pakistan’s legal, regulatory, and Shariah compliance framework; ease liquidity concerns; and build-up the human capital processes involved15. The processes for application “ …. however, the key reason which deters SMEs from required to enhance Islamic finance. The bank has devised a five- and approval are lengthy, year development strategy, in addition to the recent measures, selecting Islamic mode of often taking two to incentivizing banks to extend their reach to agribusinesses and micro banking is the cumbersome four months. Also, the transaction execution and and small enterprises. The strategy would also focus on organizing ” exhaustive multi-step documentation. marketing campaigns to increase awareness about Islamic banking Islamic documentation across the country requirements further — Primary Survey with three leading SMEs in Punjab, discourage SMEs from Demand for Islamic banking from the SME sector is increasing, but Pakistan applying for Islamic bank high cost of credit and cumbersome processes deter customers from financing. approaching banks Banks are not well equipped to handle the requirements of the SME Pakistan’s SME sector has a positive attitude toward Islamic banking sector, thus creating a significant ‘supply side’ gap as people are becoming more sensitized to its benefits. The strong performance of Islamic banks over the past 10 years with the help A primary survey16 of the top 20 banks in Pakistan revealed that just of SBP’s initiatives has further consolidated this opinion. However, 13 banks have SME offerings, out of which only seven offer Islamic numerous factors deter SMEs from approaching formal institutions products. Only eight banks have separate business units/divisions for for finance. A few of them are: SMEs, whereas the others provide SME services through corporate or retail divisions. Although eight banks in Pakistan offer adequate • Lack of awareness and knowledge regarding Islamic banking products: Most SMEs have no knowledge of the appropriate 10 Primary research financial products for their requirements. The SBP and a few 11 Primary research 12 Primary research commercial banks are now undertaking initiatives to educate 13 Development Finance Review 2011, State Bank of Pakistan 14 Development Finance Review 2011, State Bank of Pakistan 8 State Bank of Pakistan 15 Calculations based on primary research 9 State Bank of Pakistan 16 Primary survey and secondary research of Commercial Banks 10 Pakistan Islamic banking products, just two banks have fairly “good” Islamic • Inadequate procedural realignment: Although a few banks offer an SME penetration and the rest are still looking to break through the SME suite, their transactional procedures are quite cumbersome SME market. and not geared towards SME banking. This increases the cost of each transaction, eroding the profitability and popularity of the Several factors deter banks from adequately tapping the potential SME propositions. of SME finance and these are now well documented as a result of several studies conducted by IFC. A major reason is ‘non-branding’ • Inadequate framework to evaluate creditworthiness of SMEs: of the SME proposition by these banks. At present, of the 20 banks, The credit information bureau’s coverage is currently limited just one bank is adequately branding and selling its SME proposition to about 2 percent of the entire adult population (World Bank (refer table 6). Other reasons include: 2012 data). Banks also lack capabilities to manage and analyze existing clients’ data for identifying default patterns that can later • Lack of human resources: There is a shortage of skilled be used to analyze other loan portfolios. professionals who are well versed in Shariah-compliant product structures. Although this problem exists across the country, it is • Cumbersome loan recovery process: Despite a sound regulatory more acute in rural areas. process, the loan recovery process is cumbersome and legal procedures take years to resolve a case. Another factor is the cost • Few or incomplete product offerings: Offerings for the SME of litigation, which eventually makes SME transactions unfeasible segment are limited. Most Islamic banks do not offer non- for banks. In addition, increased scrutiny on the activities of loan borrowing services such as cash management, mobile banking, recovery agents due to negative incidents in the past has made the and branchless banking. loan recovery process more difficult. Growth in demand for Islamic finance in the SME sector could result in a ‘new to bank’ Islamic funding opportunity of $2.6 billion to $3.8 billion Figure 2: Islamic financing potential – ‘new to bank’ Islamic funding potential for the Islamic funding potential for the unserved SME population is between underserved SME population is between $553 -$737 million $2.07 -$3.1 billion The total Islamic funding potential in the next few years is likely to be between $2.6 -$3.8 billion and an Islamic depository potential of $0.8 billion to $1.3 billion over the next few years, primarily on account of those SMEs who do not avail of finance due to their religious beliefs Islamic Banking Opportunities across Small and Medium Enterprises 11 Figure 3: Depository potential Islamic depository potential Islamic funding potential for the unserved SME for the underserved population is between SME population is $276- $368 million between $621 -$932 million The total Islamic depository potential in the next few years is likely to be between $898 million-$1.3 billion Note: This depository potential does not take into account the potential that could arise from offering non-banking activities Note: The funding and depository potential has been derived on the basis of SME population numbers provided by SMEDA and primary research conducted with various banking industry experts and professionals. Please refer to Section 4 of the report for an overview of the calculations In addition to the above, the existing well-served (mostly mid-sized) Considering the demand for Shariah-compliant products, Islamic enterprises have sufficient conversion/migration potential from banks could implement several measures to attract SME customers; conventional to Islamic products. These well-served enterprises are these include introduction of new SME banking models, specialized inclined toward Islamic banking, but they do not approach Islamic ‘branding of SME proposition’, separate business units/divisions banks due to the non-availability of suitable Islamic banking for handling SMEs, focus on advisory services, training the staff on products or complicated transactional processes. This potential Shariah-compliant product structures, and easing access to finance from well-served SME businesses could be in the range of 5 percent for SMEs to 8 percent of the existing SME portfolio. Since SMEs require finance more urgently than large-scale corporate This possibility largely enterprises, Islamic banks need to shorten the loan approval process. “ …. The manufacturing sector is likely to constitute a depends on the penetration of Islamic banks and is based • There is a shortage of skilled professionals well-versed in Shariah- large proportion of the Islamic on the assumption that SMEs compliant product structures. Better training on these structures funding opportunity. ” — Senior Official, State Bank of across the country would gain better understanding of could alleviate this concern. • A survey reveals that most SME customers are completely Pakistan Islamic banking structures unaware of the SME finance options provided by their banks, and have easier access to especially regarding Islamic products. excluding a few banks, finance as banks extend such as Bank Al Habib, Habib Metro, Summit, Silk, NIB, JS, branch networks to all rural Soneri, HBL, and Bank Alfalah, people are unaware about the and urban areas. Furthermore, it is assumed that banks would hire SME offerings of other banks. This lack of awareness creates skilled professionals capable of structuring Islamic SME products, a huge supply-side gap that Islamic banks can easily meet by start offering more Shariah-compliant products, offer several other properly branding and marketing the Islamic SME proposition value-added and non-borrowing services, and streamline and ease and by also creating separate business units/divisions. transactional procedures, thus enabling them to serve SMEs better. Initiatives by the SBP and private banks to promote Islamic banking would also help tap that segment of the SME population. 12 Pakistan • An array of advisory services for SMEs can also facilitate the • Other measures include adoption of appropriate credit anticipated growth. However, this initiative would only yield evaluation techniques, such as behavioral scoring, intensive results in the long term. statistical analysis, credit scoring, and cash flow- and program- based lending. • Introduction of new SME banking models is needed to target customers. Islamic banks could consider the use of mobile banking • Islamic banks can broaden their product and service offerings (on the lines of United Bank’s Omni facility) to enhance financial by providing non-borrowing services, such as cash management, inclusion and reduce the cost of administering an account. payroll management, payments, collections, and trade finance solutions. Islamic Banking Opportunities across Small and Medium Enterprises 13 03. SMEs in Pakistan SMEs in Pakistan are an important part of the economy. They can play an important role in developing the country. However, their potential is currently affected by poor access to finance and an unfavorable business climate. The government needs to take urgent steps to address these problems and ensure sustainable sector growth. Definition There is no singular, comprehensive definition of small and medium enterprises (SMEs) in Pakistan, and various authorities use different criteria to define them.17 The country’s SME landscape has already been well documented by IFC in several of its earlier publications. Therefore, an exhaustive overview of the definition is not presented here. The most widely acknowledged and used definition of small and medium enterprises is that given by the State Bank of Pakistan (SME Prudential Regulations and Microfinance Prudential Regulations). SMEs’ contribution to Pakistan’s economy The SME sector has emerged as the backbone of the country over the last few years, generating employment and driving economic growth SMEs form an important component of Pakistan’s economy, playing a pivotal role in inclusive growth. They account for 30 percent of national gross domestic product (GDP), 25 percent of exports of manufactured goods, 35 percent of manufacturing value added18, and employ more than 78 percent19 “ …. I believe that the SME sector has the potential of the non-agricultural workforce. to turn around Pakistan’s economy. ” — Chairman of a Regional Trade Association 17 Small and Medium Enterprises Development Authority 18 State Bank of Pakistan Revised Prudential Regulations Circular No. 08 of 2013 19 State Bank of Pakistan Governor Speech 7th Pakistan SME Conference 14 Pakistan Figure 4: SMEs’ share of Pakistan’s economy Contributing -25% to exports from the manufacturing sector a cc P oun ting for -30% of GD ad d d 35% de ad o f manufacturing v alue e ab rc so fo rbin g l wor k 78% of non agri cultura Source: State Bank of Pakistan Revised Prudential Regulations 2013 SMEs in Pakistan have evolved over the years, with their contribution Manufacturing units dominate the SME population (49 percent), to the GDP increasing from -6 percent in 1994–1995 to 30 percent 20 followed by community, social, and personal services (40 percent). currently. Government support and liberalization of the economy Others include wholesale and retail trade and restaurants and hotels (providing opportunities for SME expansion) have been the key (7 percent) as well as other services23. reasons for the increase in SMEs’ GDP share. Manufacturing enterprises have a higher impact on the economy The current SME structure is, however, less than optimal. Enterprises in terms of value addition, export contribution, and employment with fewer than 10 employees dominate Pakistan’s SME sector, while generation. According to a 2009 survey by the Small and Medium enterprises with more than 10 employees account for just 1 percent 21 Enterprises Development Authority (SMEDA), manufacturing of the SME population. SMEs held an estimated 25 “ percent of manufacturing The current structure, needs to evolve in the long term. These exports, while their value …. Most SMEs are sole smaller micro enterprises tend to be less employment-intensive and addition to the sector was proprietorships or family economically efficient compared with large SMEs. Therefore, efforts businesses that are managed about 35 percent. Important should be concentrated toward enabling a favorable environment for microenterprises to evolve into small and medium enterprises. manufacturing include cotton weaving, metal sub-sectors rather informally. ” — CEO of a leading Pakistani products, wood furniture, and bank jewelry making. SME distribution by sector, ownership, and geography SMEs ownership patterns are highly skewed towards sole proprietorship, which accounts for 74 percent of the total, followed by registered partnerships (13 percent) and societies (about 2 percent)22, among others. Sole proprietorship is the preferred ownership pattern in the country as minimum regulatory requirements are involved in establishing such organizations. 20 Economic Survey of Pakistan 23 SMEDA 2009 Survey 21 SMEDA 2009 Survey 22 SMEDA 2009 Survey Islamic Banking Opportunities across Small and Medium Enterprises 15 Figure 5: SME distribution by employee size The distribution of SMEs in Pakistan mirrors the country’s economic geography. About 72 percent of SMEs are in the most important provinces of Punjab and Sindh, while Khyber Pakhtunkhwa (KPK) and Baluchistan account for the rest24. Punjab and Sindh have a dense concentration of SMEs, greater penetration of government schemes and services, a large presence of industrial clusters, and better access to finance. The combination of these factors has led to the skewed distribution of SMEs across Pakistan. The current concentration pattern is not ideal and needs to be corrected in the long run. This is because SMEs play an important Source: SMEDA 2009 survey role in fostering regional development and inclusive growth across various stakeholders in the local economy by using local resources Figure 6: SME distribution by activity (raw material and labor). The greater the gap in the provision of support services (government 11% schemes and access to finance) for promoting SMEs, the larger the development gap between various regions in the country, which would affect long-term economic prospects. 49% SMEs “doing business” environment 40% Inadequate access to finance and an unfavorable business environment prevent SMEs from operating efficiently and achieving economies of scale Manufacturing Community, Social and Personal Services Others The concerns and challenges affecting the SME sector outweigh the factors that promote growth, thus preventing the sector from Source: SMEDA 2009 survey realizing its potential. According to a 2006 study, 19 percent of SMEs were less than five years old, with just 4 percent surviving Figure 7: Geographical distribution of SMEs beyond 25 years.25 This is due to the large number of challenges that they face (internal and external), which affect them at various stages of development, thereby preventing them from evolving into self-sustaining enterprises. Access to finance still remains one of the biggest obstacles to the sector’s growth due to mismatch in supply and demand. On the supply side, financial institutions in Pakistan have been reluctant to fund SMEs. In recent years, banks have realized the potential opportunity offered by the SME sector and are now setting up SME- focused operations. Many banks are doing this with the assistance of IFC advisory services. 24 SMEDA 2009 Survey Source: SMEDA 2009 survey 25 Critical Success and Failure Factors of Entrepreneurial Organization: Study of SMEs in Bahawalpur, Pakistan 2011 16 Pakistan With regard to the demand side, SMEs have historically faced personnel, low managerial acumen of owners, and the application problems in accessing credit due to procedural hassles, high of outdated technology in business processes further hamper growth collaterals, and long approval processes. SME owners prefer to prospects. utilize their own savings or borrow funds from family/friends due to the lower opportunity costs involved. The range of deposit and The Pakistani government realizes the problems affecting SMEs. The financing products available to SMEs is also limited vis-à-vis those Small and Medium Enterprises Development Authority (SMEDA) for emerging or large corporates. Additionally, while some banks is the main agency that promotes SME growth by implementing have initiated measures to provide non-borrowing services such as policies for improving the business environment, access to finance, branchless banking, internet banking, and mobile banking, these human resource development, and support for technology upgrade services are not widely available to the SME sector. Realizing this, and marketing. In addition to SMEDA, numerous other national banks are now trying to improve their processes and procedures to and regional agencies – SME Bank, Khushhali Bank, Punjab Small ensure that SMEs can access their services more easily. Industries Corporation, Sindh Small Industries Corporation, and KPK Small Industries Development Board – are complementing SMEDA’s efforts and improving the business environment to Figure 8: Key challenges faced by SMEs promote SME growth. IFC’s Business Edge program has played a External Factors significant role in enhancing the capabilities of SMEs. Internal Factors Pr “ n …. Within tio the SME sector, manufacturing oc r up ed enterprises have greater Islamic finance potential (more ura Access to Low level Cor finance than 50 percent) due to the capital intensive nature lh of skill and training of operations and their underlying export potential urdles (contribute 25 percent to manufacturing exports). The services sector, comprising hotels, restaurants, and retail Technological Organizational establishments, also have Islamic banking potential, but constraints Effectiveness ” within to a lesser extent. MSMEs In — An SBP Islamic SME Expert a re de qu a ct u te public infra stru A large proportion of SMEs (reportedly 20 percent to 25 percent or more than 150,000 enterprises26) do want to approach banks due to religious reasons despite banks’ efforts to reach out to the SME sector. These SMEs prefer Shariah-compliant banking products and would rather remain excluded from formal financing. In addition to the poor access to finance, there are problems related to the business environment, such as high levels of corruption (among the 50th most corrupt countries globally27), weak business environment (ranked 110 of 189 countries in the 2014 Doing Business Report28), and poor supporting infrastructure (ranked 119th of 148 countries in WEF Infrastructure rankings29), which create negative externalities. Internal factors such as a shortage of skilled 26 Primary research 27 Transparency International 2013 Corruption Perceptions Index 28 Doing Business Report 2014 29 World Economic Forum Global Competitiveness Report Islamic Banking Opportunities across Small and Medium Enterprises 17 04. Current Status of Islamic Banking in Pakistan Pakistan’s banking sector has gone through a three-stage evolution process from conventional banking during 1948–1980 to profit and loss sharing (PLS) banking in the 1980s and 1990s to the current mix of PLS and Shariah-compliant banking. An overview of Pakistan’s banking system Currently, approximately 3430 commercial banks, including private, public sector, and foreign banks, and four specialized banks operate in Pakistan. Of these, five are Islamic banks and 12 are conventional ones with Islamic windows31. The industry has faced a few challenges due to the global financial crisis and the subsequent deterioration in the domestic fiscal situation, which resulted in the public sector borrowing significantly from banks. Although a rise in non-performing loans (NPLs) tested the sector’s resilience, it continues to play a key, pivotal role in the country’s economy. The increasing role of private banks (which hold 81 percent32 of commercial banking assets) in the banking sector has led to a higher level of professionalism and service orientation. Value-added services such as web banking and mobile banking have also helped revolutionize the sector. Table 1: Banking structure in Pakistan Type of bank Number of institutions Public sector commercial banks 5 Local private banks 22 Foreign banks 7 Commercial banks total 34 Specialized banks 4 Islamic banks 5 Source: Statistics of the Banking System, March 2012, State Bank of Pakistan During 2006–2012, Pakistan’s banking assets expanded due to a rise in the number of new banks launched and an increase in branch penetration across the country. Development and growth of Islamic banking has also contributed to asset and deposit growth during the period. The number of branches in Pakistan has significantly increased. It is estimated that the country currently has approximately 9,52833 branches. 30 State Bank of Pakistan 31 State Bank of Pakistan 32 State Bank of Pakistan 33 State Bank of Pakistan 18 Pakistan As of December 2011, the top six banks in Pakistan accounted for In June 1980, the legal framework of the country’s financial and 57 percent 34 of total assets. National Bank of Pakistan is the only corporate system was amended to permit issuance of new interest- government-owned bank in the top six. The other five are privatized free instruments. An ordinance was passed to allow the establishment banks: Habib Bank, United Bank Limited, MCB Bank Limited, of Mudarbah companies and floatation of Mudarbah certificates and Allied Bank Limited. Bank Alfalah is the leading local private for raising risk-based capital. Separate interest-free counters began bank in Pakistan in terms of assets. In addition, these same banks to operate in all commercial banks and banks were also asked to accounted for 45 percent35 of all deposits as of December 2011. provide finance under the Musharaka (profit and loss sharing) structure. Control over non-performing loans (NPLs) is a major challenge for Pakistan’s banking sector. The ratio of NPLs to total loans increased In 1985, all commercial banking in Pakistani rupees was made from 6.9 percent in 2006 to 15.8 percent in March 2012 . NPLs 36 interest-free; no bank was allowed to accept any interest-bearing have increased significantly over the past couple of years due to tight deposits and all existing deposits in banks were treated on the basis monetary policies (which led to high interest rates), deceleration of of profit and loss sharing. However, foreign currency deposits and economic activity, power outages, and taxation policies. However, lending continued as before. Following a Shariah Appellate Bench NPLs are expected to decrease in the near future as the State Bank (SAB) judgment in 1999, it was announced that all laws involving of Pakistan (SBP) reduced its key policy rate by 1.5 percent in mid- interest would cease to have effect by June 2001. In December 2012 . 37 2001, the SBP issued detailed criteria for establishing full-fledged Islamic commercial banks and Al Meezan became the first Islamic NPLs in the small and medium enterprise (SME) sector increased commercial bank. rapidly during the last four years. Banks’ asset quality deteriorated significantly due to a weak business climate in the SME sector and Since then, the Islamic banking industry has grown significantly, lack of the banks’ ability to work in the SME sector. The ratio of with five full-fledged Islamic banks being established in the country. NPLs to total loans for the SME sector was 36 percent in 201238, In addition, numerous conventional banks have Islamic windows, however, NPLs for Islamic SME have reduced significantly (from 36 operating a wide branch network across the country. percent) and vary between 15 percent to 18 percent39. The state of Islamic banking in Pakistan Islamic banking in Pakistan can trace its origins back to the late 1970’s when steps for the Islamisation of the banking and financial system were introduced Pakistan was among the first three countries in the world to attempt to implement interest-free banking at a comprehensive/national level. Considering the magnitude of the task, it was undertaken in a phased manner. Islamisation measures included the elimination of interest from the operations of specialized financial institutions, including House Building Finance Corporation (HBFC), Investment Corporation of Pakistan (ICP), and National Investment Trust (NIT), in July 1979 and that of commercial banks from January 1981 to June 1985. 34 Pakistan Banks› Association 35 Pakistan Banks› Association 36 State Bank of Pakistan 37 State Bank of Pakistan 38 State Bank of Pakistan 39 State Bank of Pakistan Islamic Banking Opportunities across Small and Medium Enterprises 19 Figure 9: Evolution of the Islamic banking sector in Pakistan Source: State Bank of Pakistan Islamic banking assets and deposits increased at a CAGR of 38 percent and 42 percent during the last six years, currently accounting for 8.6 percent and 9.7 percent of the country’s total banking assets “ ….In recent years, Islamic banking and finance in and deposits, respectively Pakistan has experienced The new initiatives launched at the turn of the century to gradually expand Islamic banking, along phenomenal growth…. every with the development of conventional banking, have enabled the sector to develop steadily over the 10th rupee is now being past few years. deposited in an Islamic bank The current framework allows three kinds of Islamic banking institutions in Pakistan: 1) full-fledged Islamic banks; 2) Islamic banking subsidiaries of conventional banks; and 3) Islamic banking branches account. ” — Leading Islamic Banking of conventional banks40. Expert Figure 10: Breakup of Pakistan’s Islamic banking assets (2006 and 2012) 97.2% 91.4% 8.6% Conventional Banks Islamic Banks 2.8% 2006 2012 Source: State Bank of Pakistan 40 State Bank of Pakistan Islamic Bulletin, December 2012 20 Pakistan SBP has also provided a Shariah compliant framework, including a Shariah board at the central bank level, a Shariah advisor at the indi- vidual bank level, mandatory internal Shariah audits, and periodic Shariah inspections by the central bank. Although Islamic banking assets account for just about 8.6 percent41 of the country’s total banking assets, the segment has grown rapidly over the last few years. The rapid rise in Islamic banking assets was due to an increase in the number of Islamic banks, growth in the number of branches, measures taken by the government and the central bank, better asset quality metrics, and greater demand for Shariah-compliant products from customers. Figure 11: Breakup of Pakistan’s Islamic banking deposits (2006 and 2012) 97.4% 90.3% 9.7% Conventional Banks Islamic Banks 2.6% 2006 2012 Source: State Bank of Pakistan With regard to deposits, Islamic banking penetration has increased rapidly over the years. Customers have had an increasing tendency to hold deposits in Islamic accounts, raising the penetration of Islamic deposits from 2.6 percent in 2006 to 9.7 percent in 201242. There are currently five full-fledged Islamic banks in Pakistan and 12 conventional banks with Islamic windows. As of December 2012, the country had approximately 1,097 Islamic banking branches, up from just 15043 in December 2006. The Punjab province accounts for the maximum number of Islamic banking branches (476), followed by the Sindh region (369), and KPK (120)44. The widening network of branches alludes to the rising demand for Islamic banking and the efforts taken by banks to expand their reach across the country. 41 State Bank of Pakistan 42 State Bank of Pakistan 43 State Bank of Pakistan Islamic Bulletin, December 2012 44 State Bank of Pakistan Islamic Banking Opportunities across Small and Medium Enterprises 21 Figure 12: Total assets and deposits of Islamic banks ($mn) 10.000 8,454 CAGR 8.000 Assets: 38.4% 7,135 6,474 Deposits: 42.6% 4,818 5,262 6.000 3,697 3,939 4.000 2,788 2,858 2,081 2,040 1,202 1,485 2.000 848 0 2006 2007 2008 2009 2010 2011 2012 Total assets Total deposits Source: State Bank of Pakistan Islamic Bulletin, December 2012 Growth of deposits in the Islamic banking sector has significantly outpaced that of the overall banking system. The trend is expected to continue in the near future due to the increasing religious sentiment in the country and penetration of Islamic banks into smaller towns. Depositors also perceive Islamic banks as less risky vis-à-vis conventional ones. Moreover, Islamic banks have been investing quite heavily in Sukuk offered by the central bank during the last couple of years. Table 2 : Break up of deposits in the Islamic banking sector $ mn Dec-09 Dec-10 Dec-11 Dec-12 Deposits 2,855 3,939 5,262 7,135 Customers 2,661 3,668 4,880 6,676 Fixed deposits 1,048 1,441 1,870 2,354 Savings deposits 918 1,276 1,741 2,618 Current account 675 924 1,245 1,671 Others 20 27 25 32 Financial Institutions 194 272 382 460 Remunerative deposits 186 271 378 359 Non-remunerative deposits 8 1 3 101 Source: State Bank of Pakistan Islamic Bulletins, December 2009 to December 2012 Asset quality of Islamic banks is better than the overall industry average Islamic banks in Pakistan have traditionally followed a more cautious approach toward lending, enabling better control over asset quality vis-à-vis conventional banks. The sector’s ratio of NPLs to total loans is significantly lower than the banking industry’s historical average, which has helped create a positive image for Islamic banking in the country. 22 Pakistan Figure 13: NPL as a percentage of total loans 40.0 36.0 35.0 32.4 28.9 30.0 25.0 22.7 18.0 20.0 15.0 15.0 14.7 15.4 15.8 10.0 12.6 5.0 7.3 7.6 8.4 6.3 0.0 Dec-09 Dec-10 Dec-11 Dec-12 NPL as % of total loans for Islamic Banks NPL as % of total loans for overall banking system NPL as % of total loans SME NPL as % of total Islamic SME financing Source: State Bank of Pakistan, December 2012 Full-fledged Islamic banks account for 63 percent of all Islamic Figure 14: Market share of Islamic banks (by banking assets and 65 percent of Islamic banking deposits in assets and deposits, 2011) Pakistan The five full-fledged Islamic banks in the country are Al Baraka Bank (Pakistan) Limited, Bank AlIslami Pakistan Limited, Burj Bank Limited, Dubai Islamic Bank Pakistan Limited, and Meezan Bank Limited. Together, they operate 657 branches in Pakistan, while the 13 conventional banks with Islamic banking windows operate the rest45 . Bank Alfalah Limited has the largest branch network (110 branches) among conventional banks that offer Islamic banking services, Source: Pakistan Banks Association followed by Faysal Bank Limited (52 branches)46. “ Meezan, the first Islamic bank launched in Pakistan, is the largest Among banks with Islamic in terms of assets and deposits, holding almost one-third of the branches, Bank Alfalah ….The Islamic finance country’s total Islamic assets and deposits. Full-fledged Islamic and Standard Chartered industry is likely to increase banks account for 63 percent of total Islamic assets and 65 percent are the two largest players, its share in the banking of Islamic deposits in the country47. accounting for more than system to 15 percent during half of Islamic advances and deposits. the next five years. ” — Deputy Governor, State Bank of Pakistan 45 State Bank of Pakistan 46 State Bank of Pakistan 47 Pakistan Banks’ Association Islamic Banking Opportunities across Small and Medium Enterprises 23 Figure 15: Market share of conventional banks with Islamic windows (2011) Source: Individual bank annual reports. Murabaha and Diminishing Musharaka structures dominate the Islamic financing market Several Islamic financing options are available in Pakistan. The Murabaha and Diminishing Musharaka structures are the most sought after and widely used. These account for approximately three-fourth of the Islamic financing market in Pakistan, with the rest contributed by Ijarah, Istisna, and Salam, among others. Figure 16: Islamic financing mix 5.7% 1.4% 7.0% 5.3% 3.0% 2.4% 5.8% 4.4% 6.5% 12.7% 10.4% 9.3% Others Salam 29.5% 32.0% 36.2% Istisna Ijarah Diminishing Musharaka 44.9% 43.8% 39.7% Murabaha Dec-10 Dec-11 Dec-12 Source: State Bank of Pakistan Islamic Banking Bulletin Textile and energy are the major sectors that avail of Islamic banking products in Pakistan In terms of sector concentration, textiles and energy (production and transmission) receive almost 30 percent48 of Islamic banking funds. The textiles sector was the largest recipient of Islamic banking funds during the past few years, in line with the trend witnessed in the overall banking industry. Despite an increase in the share of Islamic funds to the agribusiness sector, it remains underpenetrated. 48 State Bank of Pakistan 24 Pakistan Table 3 : Islamic banking concentration by sector (% of Islamic funds allocated) Overall banking Sector Dec-10 Dec-11 Dec-12 industry share* (2012) Textile 22.0% 20.1% 19.0% 16.7% Individuals 17.0% 14.9% 14.2% 7.9% Energy 7.0% 10.2% 10.3% 11.7% Chemicals and pharmaceuticals 7.0% 7.4% 7.4% 3.6% Cement 4.0% 3.0% 1.5% 1.4% Agribusiness 3.0% 4.0% 3.7% 8.4% Sugar 2.0% 3.3% 3.8% 2.5% Electronics 2.0% 1.5% 1.5% 1.4% Other 36.0% 35.6% 38.6% 46.4% Source: State Bank of Pakistan Islamic Banking Bulletin *Note: Overall banking industry reflects the conventional banking share. In 2010, the IFC, in conjunction with the SBP, conducted a detailed assessment to identify the top ten priority SME sub-sectors in Pakistan and evaluate their financial needs. The sectors included manufacturing (comprising sub-sectors such as textiles and chemicals, among others), wholesale and retail trade, social and community services, and transport, storage and communication. While these sectors were found to be highly attractive, the statistics with regard to advances made to these sectors varies with the information published periodically by SBP. Currently, these sectors receive just 4.1 percent49of Islamic lending. Table 4 : Cost of funds of selected Islamic banks Bank Cost of funds (%) 2009 2010 2011 Meezan Bank 5% 5% 5% Al Baraka 8% 3% 8% Bank Islami Pakistan 4% 5% 6% Dubai Islamic Bank 6% 7% 6% Burj Bank 10% 6% 7% Bank Alfalah 5% 4% 5% Faysal Bank 1% 4% 5% Source: Individual banks’ balance sheets and primary research 49 State Bank of Pakistan Islamic Banking Opportunities across Small and Medium Enterprises 25 The cost of funds for Islamic loans was in the range of 5 percent to 8 percent50 in 2011. Most banks maintained a stable rate between 2009 and 2011. The cost of funds of Faysal Bank increased during the period due to the high amounts of non-remunerative deposits, which were not deployed during the period. Islamic and conventional banking exposure to the SME sector in Pakistan has declined during the past few years (in terms of the total lending / financing) owing to high levels of NPL rates associated with the sector Under the current scenario wherein asset quality is deteriorating and NPLs are increasing constantly, banks, particularly Islamic banks, are taking a more cautious approach towards lending. Figure 17: SME lending as a percent of total lending in Pakistan 15 11.7 12 10.3 9.6 8.3 9 9.8 6.8 6 7.7 5.8 3 5.2 4.1 0 2008 2009 2010 2011 2012 Conventional Banks Islamic Banks Source: State Bank of Pakistan Islamic Banking Bulletins and Development Finance Report, State Bank of Pakistan The SME sector is considered riskier and has been severely affected by this safety-first approach. Funding to the sector has decreased considerably over the years, with conventional and Islamic banks preferring to divert funds to safer asset classes. Additionally, the limited number of products on offer to SMEs and the lack of product reengineering have contributed to a decline in lending to the SME sector. Lending by conventional banks to the SME sector declined from $3.8 billion in 2008 to $2.7 billion in 2012, while Islamic banks’ lending to the sector also declined “ ….Financing to SMEs is the natural fit for Islamic banking from $145 million to $102 million during the same period51. However, as of September 13, the figure is increased to $116 million (14 percent increase in three quarters). growth. ” — CEO Leading Islamic Bank in Pakistan 50 Individual banks’ balance sheets and primary research 51 State Bank of Pakistan Islamic Banking Bulletins and Development Finance Report, 26 Pakistan Figure 18: SME lending by Islamic banks 2,470 2500 125 2,147 1,548 120 1,991 2000 1,848 115 2,356 2,285 1,722 1,657 1,756 1,530 1,960 1,479 1,430 1500 110 1,603 105 1000 100 113 111 108 111 113 105 101 111 105 110 101 102 121 103 116 500 95 90 0 Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 Outstanding Financing ($mn) No. of Borrowers Source: State Bank of Pakistan - Islamic Banking Division This decline in the Islamic SME portfolio could be largely attributed Three-pronged strategy to promote Islamic banking: to the high levels of risk associated with lending to SMEs (the average NPL rate for Islamic SMEs is between 15 percent to 18 1. To promote Islamic banking in Pakistan, the SBP has: percent). As a result, the total number of Islamic SME borowers • Granted licenses to full-fledged private sector Islamic banks, have also declined, resulting in a stagnant financing portfolio. • Permitted conventional banks to set up Islamic banking subsidiaries, and Regulatory environment for Islamic finance • Allowed existing conventional banks to open full-fledged in Pakistan Islamic banking branches. The SBP has undertaken numerous measures to strengthen the 2. Introduced guidelines for conventional banks with Islamic legal, regulatory, and Shariah compliance framework; ease liquidity branches for segregation of funds as well as systems and concerns faced by the industry; and develop human capital required controls. The SBP has also implemented internal control and to fuel growth of Islamic finance in the country measures to ensure segregation of funds and protect the interest In 2003–2004, the SBP established an Islamic banking department, of depositors in conventional banks that have Islamic banking as a focal point for all matters related to the Islamic finance branches. In addition, the regulations mandated the appointment industry in Pakistan, with the objective to strengthen the regulatory of a Shariah committee, stringent ‘Know Your Customer’ (KYC) framework to be in line with global best practice and successfully rules, adherence to prescribed risk management guidelines, and implement the strategic plan formulated for the development of the implementation of appropriate internal controls and information Islamic banking industry. technology systems. Banks that have weak systems and controls are debarred from starting Islamic banking operations to ensure The current regulations and policies formulated by the SBP are soundness of the system. geared toward creating an enabling environment for the development of Islamic banking in Pakistan. The regulations governing Islamic 3. Compliance to Islamic Financial Services Board (IFSB) standards banking comprise: and risk management guidelines. To ensure soundness and financial stability of the Islamic banking system, the SBP requires Islamic banks to adhere to the IFSB accounting standards, which Islamic Banking Opportunities across Small and Medium Enterprises 27 are being rolled out in a phased manner. In addition, the SBP has Islamic banking regulations include provisions for the establishment formulated risk management guidelines based on the ‘Guiding and operation of Islamic institutions in the country: The guidelines Principles of Risk Management for Institutions offering Islamic include licensing and capital requirements (minimum paid-up capital Financial Services’ issued by the IFSB. of $10.1 million by 201352), internal controls and audit requirements, as well as statutory liquidity and cash reserve requirements. In Other guidelines: Islamic addition, it also prescribes the minimum qualifications, experience, “ …. Although the decline can partly be attributed to banking include regulations guidelines also on and integrity standards for board members and managers. adverse economic conditions schedules of service charges of during the period and growth Islamic banks, an institutional Initiatives to promote Islamic finance to in non-performing loans, a risk assessment framework SMEs in Pakistan more risk-averse posture of for monitoring and evaluating banks remains a major factor banks, and an enforcement The SBP has undertaken numerous measures to strengthen and responsible for their low promote Islamic finance to SMEs. Regulations on SME financing ” framework to ensure exposure to SMEs. compliance with Shariah focus on implementing effective risk management measures to — Deputy Governor, State Bank standards. The SBP also facilitate easier access to finance, ease liquidity concerns faced by of Pakistan formulated a comprehensive the sector; and develop human capital required to fuel the growth of Shariah compliance Islamic finance for SMEs in the country. framework for Islamic banking institutions, the guidelines includes; The SBP has developed strategic five-year plans in collaboration • Shariah board at SBP and Shariah advisor at Islamic banks: The with the Islamic finance sector SBP established a national-level, five-member Shariah board to advise on procedures, rules, and regulations pertaining to In 2007, the central bank developed a strategic plan for the Islamic Islamic banking and evaluate and approve Islamic products banking industry in Pakistan, aimed at increasing the market share or instruments developed by the SBP. Moreover, every Islamic of Shariah-compliant assets to 12 percent53, expanding outreach of banking institution is required to appoint a Shariah advisor to Islamic banking products across commercial sectors, strengthening ensure that all products and services comply with Shariah rules the regulatory and compliance framework, and developing the and principles. industry’s human capital. • Essentials and model agreements of Islamic modes of financing: Furthermore, several measures were adopted to improve the The SBP has prescribed eight modes of financing that are governance and Shariah compliance framework of Islamic banks considered minimum requirements for Shariah compliance, as well as educate consumers on Islamic banking practices. The SBP including Mudarbah, Musharaka, Diminishing Musharaka, is developing a strategic plan for the next five years (2013–2017) Ijarah, Murabaha, Musawamah, Salam, and Istisna. The SBP has to provide a roadmap for the growth of Pakistan’s Islamic banking also issued guidelines on the structure of these modes of finance industry, particularly SME financing. and the standardization of documents required. Besides this, the The SBP is addressing liquidity management through the issuance SBP issued directives with regard to profit and loss distribution and pool management in Islamic banks to help improve of sovereign Sukuk transparency. The central bank, in collaboration with the central government, • Instructions and guidelines for Shariah compliance in Islamic started regular issuance of sovereign Sukuk for the domestic banking institutions: The framework is meant to provide guidance market—an important liquidity management tool for the country’s to banks in areas such as Shariah compliance, internal Shariah Islamic finance industry. During the last two years, issuance of audits, investment in shares, policy for profit distribution with sovereign Sukuk worth $3.7 billion54 enabled Islamic banks to PLS depositors, and financial reporting and general disclosure. efficiently manage their liquidity problems. Furthermore, in March 52 State Bank of Pakistan 53 State Bank of Pakistan 54 Primary Research 28 Pakistan 2013, the SBP issued instructions for issuance of Ijarah Sukuk. Several banks in Pakistan have taken various initiatives to promote Islamic banking in the country. Some examples include: The SBP has undertaken initiatives to improve public awareness of Islamic banking and develop qualified and trained personnel In 2008, Meezan Bank, the largest Islamic bank in Pakistan, joined the IFC Global Trade Finance Program as an issuing bank, boosting The SBP has been undertaking several programs to create awareness access to trade finance services for entrepreneurs and businesses in regarding the industry through seminars, conferences, and Pakistan. In January 2013, Bank Islami also joined the program, workshops. The SBP has also initiated a mass media campaign to which would further assist the SME sector in accessing cost- enhance public awareness and allay apprehensions about Islamic effective trade finance. These measures are expected to help boost finance to SMEs. the country’s Islamic banking sector. Lawmakers have also recognized the need to develop human capital to Bank Alfalah is in the process of implementing a new core banking support the growth expectations of Pakistan’s Islamic finance industry. software for its Islamic branches. This would significantly improve In line with this, the central bank has been running specialized training customer interface and enable the bank to offer facilities such as programs and encouraging Islamic finance institutions to invest in the internet banking, branchless banking, and cash management services development of human capital for SME financing. and help the bank reduce its transaction costs for SME customers. Furthermore, in February 2013, the SBP announced it would Bank Islami Pakistan conducts regular training programs for its initiate a comprehensive media campaign to promote the strengths employees to ensure they understand the basics of Islamic banking of Islamic finance, particularly for SMEs. and can easily explain Islamic products structures to SMEs. In 2012, Incentivizing banks to expand in tier 2 and tier 3 cities more than 400 employees were given basic as well as specialized product training on Islamic banking. The bank further plans The SBP has started providing incentives to Islamic banks to expand to initiate a ‘Train the Trainer’ program in 2013 to increase the their network in tier 2 and 3 cities where most SMEs are located. frequency of training programs, particularly in rural areas, so that According to the SBP, any district with less than 10 Islamic branches micro and small enterprises can be easily served. is defined as a rural and underserved area with regard to Islamic banking facilities. In addition, the SBP is encouraging Islamic banks In September 2012, Silk Bank launched its ‘Emaan Islamic Banking’ to be more aggressive in their approach to these areas as more than services by converting seven conventional branches to Islamic 70 percent of Islamic branches are concentrated in just 12 cities banking ones. It plans to launch additional branches in due course. across Pakistan . 55 The bank aims to offer a comprehensive list of Islamic finance products such as Islamic auto finance, personal goods finance, and Commercial banks and the IFC are actively boosting Islamic investment in Sukuk to SMEs. banking and SME finance in Pakistan “ ….There is huge untapped potential for Islamic banks in Pakistan, particularly in the SME sector. Increasing religious The SBP has issued a number of prudential regulations for SMEs, including a ‘Handbook on Islamic SME Financing’ 56 sentiment among the population and limited avenues available to customers to park the existing Islamic liquidity Some of the regulations issued by the SBP to ensure better control of in the market are expected to increase Islamic banking the Islamic SME sector include the following: penetration significantly. The initiatives being undertaken by the SBP and other agencies are also expected to aid • Proposed products and structures for Islamic SME financing, its growth of the industry. Experts estimate that penetration basic rules, transactional flows, and accounting treatment. of Islamic banking in the sector could reach as much as 15 percent by 2015, with SMEs Islamic financing having a • Banks should identify repayment sources and assess repayment substantial par. ” — Governor of SBP interview, 2012 capacities of borrowers on the basis of the assets conversion cycle and expected future cash flows. 55 State Bank of Pakistan 56 By Islamic Banking Department – State Bank of Pakistan Islamic Banking Opportunities across Small and Medium Enterprises 29 • All facilities, except those secured against liquid assets, extended to SMEs shall be backed by owners’ personal guarantees. • In order to encourage cash flow based lending, banks will be allowed to take clean exposure, SMEs subject to prescribed thresholds. • The maximum exposure of a bank on a single SME shall not exceed $757,500. • Banks will be free to determine margin requirements after considering the risk profile of clients. • Banks should look to develop and implement systems to ensure SMEs have used financing for the specified purpose. • Specifying thresholds on the classification and provisioning of assets as well as the aggregate exposure of banks to the SME sector. 30 Pakistan 05. Islamic Banking Opportunities across SMEs There is a potential opportunity to tap the SMEs’ demand for Islamic financing in Pakistan and address the unmet needs of the un-served and underserved SME population, owing to religious beliefs. The opportunity is currently worth an estimated $2.6 to $3.8 billion. Access to finance for the SME sector Penetration of formal financing channels is relatively low in Pakistan, largely restricted to medium-sized enterprises in larger cities, while access to finance is a major constraint for the SME sector Small and medium enterprise (SME) financing in Pakistan has gained momentum in the last decade due to various initiatives undertaken by the State Bank of Pakistan (SBP) and the government, such as the introduction of prudential regulations for Islamic SMEs. However, the sector’s credit gap remains wide and ranges from $2.6 billion to $3.8 billion (sourced from figure 18) of “new to bank” financing requirements. Most of the borrowers are based in Pakistan’s three largest cities (Karachi, Lahore, and Faisalabad), which together account for more than 50 percent of the country’s total SME financing, while the 20 largest cities account for nearly 85 percent of financing. Moreover, these borrowers are largely medium-sized enterprises. Small enterprises generally obtain funds through informal mediums57. Access to finance is a major issue for SMEs in Pakistan; well-served SMEs account for just 11 percent of the total SME population, and the other two categories are: • Underserved SMEs: These enterprises, which represent 22 percent58 of the total SME population, avail of formal financing (Islamic or conventional) that meets less than 20 percent of their requirements. • Un-served SMEs: These represent 67 percent59 of the SME population who do not borrow at all for various reasons, including religious beliefs. Religious belief is certainly one of the key reasons hindering some SMEs from opting for formal financing. Approximately 20 to 25 percent60 of SMEs (accounting for more than 150,000 enterprises) do not opt at all for formal financing or borrow less than 20 percent of their requirements due to their religious beliefs61. This sentiment has been growing stronger, especially over the past five to six years. Although these SMEs are creditworthy, they are excluded from accessing funding from banks as Shariah-compliant products are either unavailable or not properly understood by these SMEs or involve lengthy processes, making the execution of Islamic transactions cumbersome. 56 Development Finance Quarterly Review, State Bank of Pakistan 58 Sourced from figure 18 59 Sourced from figure 18 60 Primary research 61 Average number of enterprises sourced from Figure 1 Islamic Banking Opportunities across Small and Medium Enterprises 31 SMEs in Pakistan largely seek finance to meet working capital requirements During the last few years, 80 percent of funds received by SMEs were used to meet working capital needs; capital expenditures and trade financing accounted for only 10 percent each.62 Table 5 : Historic data on financing split 2007 2008 2009 2010 2011 Working Capital 71% 77% 76% 78% 80% Long-Term Loans 14% 12% 12% 11% 10% Trade Finance 16% 11% 13% 11% 10% Total ($ bn) 4.4 3.8 3.5 3.4 3.0 Source: Development Finance Report, 2011, State Bank of Pakistan SMEs in Pakistan prefer short-term financing, which is in line with the characteristics exhibited by the sector in other emerging economies where small businesses adopt a short-sighted, reactive approach to business planning and management. Informal channels fulfill major credit needs of Pakistan’s SME sector Most SMEs in Pakistan operate as sole proprietorships or family businesses. These enterprises primarily engage in cash transactions and, thus, prefer to acquire funds through informal channels. Moreover, a large number of SME owners, especially outside urban areas, are not financially literate regarding their banking needs. They prefer informal funding routes because they are based on trust and offer more flexibility in terms of documentation, repayment, timing and transactions costs, which formal financial institutions do not provide. Figure 19: SME funding 2% 7% 16% 61% 10% 30% 50% 24% Friends and Family Relatively high direct and indirect costs Landlords, merchants, shopkeepers Banks do not offer Islamic products Banking and Financial Institutions Collateral Professional money lenders Others Note: Others include convenient location of financial institutions, quality of service of financial institutions’ staff and availability of other financial services from the same provider. Source: Bringing Finance to Pakistan›s Poor: Access to Finance for Small Enterprises and the Underserved 62 Development Finance Review 2011, State Bank of Pakistan 32 Pakistan Despite a preference for Islamic banking, many factors, including Economic conditions and domestic business environment have high collaterals, knowledge deficit, and cumbersome and affected willingness of banks to lend to SMEs complicated processes, restrict SMEs from approaching Islamic financial institutions Natural calamities in Sindh and Punjab in 2010 and 2011 and the prevailing economic environment have led to the deterioration of Perception and creditability of Islamic banking: People in Pakistan business conditions. Power shortages and issues related to law and have a positive outlook towards Islamic banking and are becoming order in the country have further impacted SMEs’ ability to operate increasingly aware of its benefits. Islamic banking, through its businesses, due to which banks have been cautious in lending to emphasis on social responsibility, resonates with the beliefs of the such firms. population. The positive perception was further strengthened by the strong performance of banks over the last 10 years. A 2011 Banks have limited specialization in SME lending survey63 revealed that Shariah adherence is an imperative factor for Most financial institutions in Pakistan do not have the skills or consumers when selecting a bank. Similarly, within the SME sector, tools to evaluate SMEs. Hence, they measure SMEs with the too, there is a strong preference for Shariah-compliant products. This same yardsticks applied to corporate companies or low-volume perception is expected to rise gradually over the next few years due relationship models. Generally, banks do not have specialized loan to measures implemented by the SBP and other banks to promote officers or proper procedures for SME lending. Islamic banking and raise awareness among the population. High operating costs and an inefficient legal environment prevent Knowledge about Islamic banking products: SMEs’ preference banks from expanding their SME loan portfolio for Islamic banking is not complemented by the knowledge of Islamic financial products and solutions. Most SMEs are unaware In general, SMEs have small requirements that entail high of financial products that suit their needs. This lack of knowledge administrative costs for banks, thereby affecting their profitability. about financial products is not limited to SMEs alone. Islamic banks The operating costs-to-loans ratios of small businesses are high, which are not adequately staffed with employees well versed in financial makes it difficult for banks to create a viable and profitable business products and, consequently, they are unable to recommend and model for the SME sector. The underdeveloped legal framework structure ideal products for clients. (transaction security and credit information infrastructure) also limits bank lending. Obstacles faced by Islamic financial Inadequate risk assessment framework institutions in lending to SMEs The State Bank of Pakistan “ Relatively high risk of lending and growing NPLs have discouraged has established a credit financial institutions from lending to this sector …. They lack the information bureau to expertise to document assess risk levels, but the their transactions properly. Generally, banks (both conventional and Islamic) are reluctant bureau’s coverage is limited Besides, there is a general to extend credit to SMEs, largely due to the non-availability of tendency in our society not to just 2 percent of the adult documentation related to the financial position of businesses, to pay taxes. People avoid population (World Bank 2012 documentation also to get project feasibility studies, business plans, tax records, and credit ” data). Since a large number of away from paying taxes. history. The NPL ratios of SMEs witnessed a significant increase, SMEs operate in the informal thereby prompting financial institutions to reassess their SME loan — CEO of a leading bank in sector, it becomes difficult for portfolio and divert funds to safer alternatives. Pakistan banks to assess credit risks involved in lending to such parties. Efforts to spot signs of default early and directly engage with borrowers to mitigate losses are inadequate. 63 Hamid, A., and Masood, O. (2011). Selection criteria for Islamic home financing: a case study of Pakistan. Qualitative Research in Financial Markets Islamic Banking Opportunities across Small and Medium Enterprises 33 Supply side analysis – penetration of Islamic banking in SMEs in Pakistan A majority of banks are not well equipped to deal with the requirements and potential of the SME sector, thus creating a significant ‘supply side’ gap. In order to meet this demand, banks, including Islamic banks would have to build capacity in the areas First Mover in the Islamic SME market: Meezan Bank targets the highlighted above untapped SME sector in Pakistan, especially those enterprises who do not borrow ‘due to religious reasons’ A primary survey of the top 20 Pakistani banks revealed that just 13 of these banks have SME offerings and seven offer Islamic Pakistan’s ‘high growth potential’ SME sector, the backbone of the country’s economy’, was underfunded, especially from the Islamic propositions to SMEs. Only eight banks have separate business funding viewpoint; thus, Meezan Bank decided to be the first bank to units/divisions for SMEs, while others provide such services through commit itself in solving this problem corporate or retail divisions. Although eight banks have adequate Islamic product offerings, just two banks have ‘fairly good’ Islamic Despite the fact that SMEs are the growing force behind Pakistan’s growth, they had limited access to finance. Conventional banks were SME penetration, while the rest are still striving for excellence (refer limiting their exposure to this sector due to their conservative approach. to table 6). There are several reasons for this under-penetration, In contrast, Meezan Bank believes that SMEs are more faith driven than some of which include: larger corporations and access to Islamic finance would increase the SME sector’s financial inclusion. Therefore, the bank put into operation Branding is the major reason why SME finance propositions, its independent SME unit in 2002 with the aim of channeling Islamic especially Islamic offerings, lag finance into Pakistan’s SME sector. Most SME customers in Pakistan are unaware of the availability of To effectively enter the SME sector, Meezan Bank had to reinvent the strategy followed by conventional banks. The bank established SME offerings from banks, especially Islamic products. Other than a geographical ‘hubs’ for improved business focus and better controls. In few banks such as Bank Al Habib, Habib Metro, Summit, Silk, NIB, addition, Meezan Bank designated senior officials to ensure necessary JS, HBL, Bank Alfalah, ABL and Soneri, customers are unaware of impetus and direction to the bank’s SME strategy. The bank emphasized banks that offer SME finance. training across all levels, including basic orientation in Islamic banking, specialized functional modules, certificate programs, product-related The gap in product offerings prevents Islamic banks from offering trainings, and refresher programs. In 2012, through 109 knowledge SME financing to customers sharing sessions, Meezan Bank extended the knowledge base training of Islamic banking to over 3,300 employees. Moreover, in 2012, the bank Full-fledged Islamic banks and conventional banks with Islamic created awareness about Islamic banking by conducting 42 Islamic windows in Pakistan largely offer similar products, Islamic structures, banking seminars and workshops for the corporate and SME sectors in and service offerings to corporate clients of all sizes as well as to SMEs. 26 cities across Pakistan (attended by more than 5,000 participants). Due to this strategy, Meezan Bank witnessed strong growth in its According to industry participants, the financing mix in terms of business. Islamic structure remained fairly constant over the past two to three During 2007–2012, Meezan Bank multiplied its SME as well as years. With regard to liability, the main products offered include commercial banking assets and trade business due to its SME strategy deposit accounts based on the Mudarbah structure. 541 556 On the asset side, the Murabaha structure accounts for 40 percent of 390 Pakistan’s SME financing market, followed by the diminishing Musharaka 310 (35 percent), Ijarah (20 percent), and other structures (5 percent)64. 185 138 140 100 133 127 127 The Salam and Istisna structures have very low penetration in the 2007 2008 2009 2010 2011 2012 SME sector. The Istisna structure is estimated to account for less than 1 percent65 of the overall market. SMEs in the country lack sufficient SME Banking Assets SME Banking Trade Business knowledge about these products. Moreover, industry experts do not Source: Meezan Bank annual report anticipate any significant change in the financing mix over the next At present, Meezan Bank is planning to further enhance its position two to three years. in the SME sector by (a) deepening existing relationships, (b) geographically diversifying its client base, (c) expanding into the untapped agricultural market, and (d) offering innovative products and 64 State Bank of Pakistan services. 65 State Bank of Pakistan 34 Pakistan Table 6 : Pakistani banks’ supply side analysis SME Doing Separate Branding Overall Islamic Bank Proposition Islamic Business SME SME SME Islamic Products Availability Available SME Division Proposition Penetration Penetration Finance Liability Transaction Meezan Bank Yes Yes Yes No Good Good Yes Yes Yes Al Baraka Bank No, Under Yes Yes No Fair Fair Partial Partial No (Pak) Ltd. Corporate Dubai Islamic No, Under No No No Poor Poor Marginal Marginal No Bank Corporate No, Under Bank Al Islami Yes Yes No Fair Fair Partial Partial No Corporate Bank Al Habib Yes No Yes No Good Poor Marginal Marginal No -a Bank Alfalah Yes Yes Yes No Good Fair Yes Yes Yes No, Under Askari Bank No No No Poor Poor No No No Corporate Habib No, Under Metropolitan Yes No No Good Fair Partial Partial Partial Corporate Bank -a Not SAMBA No No marketing No Poor Poor No No No at all No, Under MCB No No No Poor Poor Marginal Marginal Marginal Corporate Summit Bank -a Yes No Yes No Good Poor No No No Silk Bank -a Yes No Yes Yes Good Poor No Partial No NIB Bank -a Yes No Yes No Good Poor No No No No, Under JS Bank -a Yes No No Good Poor No No No Corporate No, Under Allied Bank No No No Poor Poor No No No Corporate National Bank No, Under No No No Poor Poor Marginal Marginal No of Pakistan Corporate Soneri Bank -a Yes Yes Yes No Good Fair Partial Partial No Standard Yes Yes Yes No Good Good Yes Yes Yes Chartered Bank United Bank No, Under No No No Poor Poor Marginal Marginal No Limited Corporate Habib Bank Yes Yes Yes No Fair Fair Partial Partial Yes Limited Source: Primary survey with banks and analysis through websites Note (a): Entire business proposition is on SME basis Islamic Banking Opportunities across Small and Medium Enterprises 35 Islamic banks can consider offering a product structure in line with preset daily purchase limits, thereby allowing SMEs to separate the overdraft facilities offered by conventional banks personal expenses from business ones. SMEs approach banks Potential for Islamic banking in the SME “ …. Access to formal financing channels has largely for working capital requirements or asset Sector financing. While several A high demand for Islamic finance in the SME sector could result in always been a constraint to the development and growth products and structures are in a funding opportunity of $2.6 billion to $3.8 billion over the next of SMEs in Pakistan. Banks place, the sector continues to few years and financial institutions be underpenetrated by Islamic have stringent policies for banks thus rendering several Funding to the SME sector has declined considerably over the years lending to the sector. SMEs, as conventional and Islamic banks have preferred to divert funds thousands of SMEs unbanked. particularly enterprises There is significant potential to safer asset classes. Islamic finance to SMEs accounts for just 4 outside major cities where financial literacy is not well- for Islamic banking products percent of the total Islamic finance volume (7 percent in 2008). spread, feel more at ease in in the SME sector largely due Conventional SME lending accounts for just 7 percent of the total an informal environment to the religious orientation lending volume (12 percent in 2008)66. due to the lack of knowledge of many of these companies, and exposure to banking Access to finance is a major issue in the SME sector. SMEs either especially those operating in products and procedures. do not avail of formal financing or avail of limited financing due rural areas. Banks should look Moreover, religious beliefs at targeting smaller customers to religious reasons and sentiments. It is estimated that about 20 restrict many SMEs from with retail-based offerings and percent to 25 percent67 of SMEs fall under this category, and this approaching conventional sentiment has increased considerably, especially in the last five to financial institutions. ” — Islamic Banking Expert in larger customers with more corporate and sophisticated six years. Pakistan banking services. SMEs that do not avail of finance due to religious reasons represent a ‘new funding potential’ of $2.6 billion to $3.8 billion for Islamic finance over the next few years. While SMEs opine that most of their current requirements are met by Islamic banks, they would prefer an Islamic structure similar to overdraft facilities, known as “running finance” or “current finance” offering, by conventional banks. While some Islamic banks offer a “running Musharaka” structure that resembles an overdraft facility offered to a larger corporate, banks should consider providing SMEs with a similar structure due to the high demand and large future potential. From a liability perspective, Islamic banks meet all the requirements of SMEs through current accounts, savings accounts, and financing against deposits. Banks should also broaden their product and service offerings to SMEs through non-borrowing services, such as cash management, payments, collections, and trade finance solutions. Other measures include appointments of dedicated SME business managers and encouraging SMEs to use mobile and Internet banking. Banks such as Meezan, Bank Alfalah, Bank Al Habib, Habib Metro, and Standard Chartered Pakistan are adept at providing such facilities to SMEs. Banks can also explore the 66 State Bank of Pakistan possibility of providing SME-specific debit and credit cards with 67 Primary research 36 Pakistan Figure 20: New Islamic financing potential – ‘new to bank’ Unserved (67%) Underserved (22%) Minimum funding No. of entities potential $2.6 bn (A+B) No. of entities 737,727 243,675 Reqd. average funding Reqd. average funding $5,000 $85,000 Min. marketshare and Min. marketshare and potential potential A 15% = $553mn 10% = $2,07bn B Max. marketshare and Max. marketshare and potential potential C 20% = $737mn Maximum funding 15% = $3,1bn D potential $3.8 bn (C+D) Note: Well served medium scale enterprises which account for the remaining 11 percent of the SME population have been excluded from the calculations. Possibility of a bull-case scenario: The possibility of a bullish scenario is based on the assumption that SMEs across the country would have greater access to Islamic banks with Shariah principles that would appeal to them and prompt them to avail of financing from formal channels. It is also assumed that customers and bank employees would be educated on the various Islamic finance structures. Banks would also start offering various non-borrowing and value-added services. It is estimated that 20 percent of the un-served population and 15 percent of the underserved population, which stayed away from banks due to religious reasons, would start banking with Islamic banks. This would result in an Islamic financing potential of $3.8 billion to the SME sector. Possibility of a bear-case scenario: Under a bearish scenario, it is estimated that banks would be able to tap a maximum of 15 percent of the SME population that does not currently bank due to religious reasons. Furthermore, banks are assumed to increase their branch penetration in urban areas and introduce more diversity in Islamic structured products. Loan processing would also be made easier for SMEs. This would result in an Islamic financing potential of $2.6 billion to the SME sector. The manufacturing sector is likely to account for a large proportion of the funding opportunity From a funding perspective, the manufacturing sector holds significant potential. This is based on the fact that, currently more than 70 percent68 of the Islamic SME finance goes toward the manufacturing sector. Further, due to the capital-intensive nature of operations, which ensures that adequate collateral can be provided, this sector could be a first target of Islamic SME financing. Moreover, manufacturing activity has a significantly higher economic impact. SMEs in the manufacturing sector contributed 25 percent to exports and their value addition to the sector was about 35 percent69. Manufacturing enterprises have higher employment potential. Other viable sectors for funding are hotels and restaurants and wholesale and retail. However, most enterprises operating in these sectors are likely to be less capital-intensive, smaller in size, and informal in nature. The funding potential is small as demand for capital from these establishments is likely to be low and sporadic. Islamic banks could also tap a new depository potential of $0.8 billion to $1.3 billion within the SME sector over the next few years 68 Primary Interview with Islamic Banking Department, State Bank of Pakistan 69 Small and Medium Enterprises Development Authority Islamic Banking Opportunities across Small and Medium Enterprises 37 Figure 21: Depository potential Unserved (67%) Underserved (22%) Minimum depository No. of entities potential $898mn (A+B) No. of entities 737,727 243,675 Reqd. average funding Reqd. average funding $2,500 $2,500 Min. marketshare and Min. marketshare and potential potential A 15% = $276mn 10% = $621mn B Max. marketshare and Max. marketshare and potential potential C 20% = $368mn Maximum depository 15% = $932mn D potential $1.30 bn (C+D) Note: This depository potential does not take into account the potential that could arise from offering non-banking activities Based on the assumptions that margin requirements for un-served and underserved enterprises are 50 percent and 30 percent, respectively, the deposit potential for these enterprises would be $2,500 to $25,500. The potential also assumes that Islamic banks would offer a larger variety of diversified depository products similar to conventional banks (including confirmed rate fixed deposit). Under a bullish scenario, where Islamic banking penetration improves across Pakistan and banks offer additional deposit products to target SMEs more aggressively, the combined deposit potential is expected to be $1.3 billion. Alternatively, if branch penetration is less satisfactory and the number of products offered to SMEs remains limited, the deposit potential is expected to be $0.8 billion. Islamic banks could attract SME customers of conventional banks (especially well-served mid-sized SMEs), increasing Islamic financing by $3.1 billion to $4.9 billion and depository base by $0.5 billion to $0.7 billion In addition to the ‘new to bank’ funding and depository potential, Islamic banks possess considerable potential to convert or cannibalize the existing funding/lending and deposit portfolios of conventional banks, primarily pertaining to the existing well-served SMEs (mostly middle-sized enterprises). These mid-sized SMEs deal with conventional banks due to the non-availability of appropriate Islamic banking products, complex Islamic transactional processes, and most importantly, stringent access to finance provided to SMEs by Islamic banks (currently, Islamic banks’ SME sector penetration is just 4 percent vis-à-vis the conventional banks’ 7 percent)70. However, considering the availability and feasibility of adopting Islamic banking products as an alternative to conventional banking, 5 percent to 8 percent of these mid-sized SMEs would shift to Islamic banking specifically due to religious reasons. This could provide Islamic banks a funding conversion or cannibalization opportunity of $3.1 billion to $4.9 billion and deposit conversion of $0.5 billion to $0.7 billion. 70 State Bank of Pakistan 38 Pakistan Strategic operational adjustments can help Islamic banks target SMEs more effectively In order to capitalize on the funding and depository potential, Islamic banks need to look beyond the conventional ‘one-size-fits-all’ approach and provide SMEs with customized value additions, much akin to what many conventional banks are now increasingly offering. The required competency framework is highlighted below where banks would need to acquire the required proficiencies for building and managing a successful “Islamic SME Banking” business: Figure 21: Strategic operational adjustments to target SMEs Strategy and Segmentation Risk Management Products and services Islamic SME Banking Sales and Organizations and Delivery Systems Channels Advisory Services I. Strategy and Segmentation corporate and retail banking products and, more importantly, build product programs and portfolio approaches. A dedicated Islamic SME Banking strategy and business model is critical: Banks would need to adopt specific market Offering non-borrowing services: Islamic banks should broaden segmentation approaches to be able to better understand the product and service offerings by providing non-borrowing market dynamics, quantify the business opportunity, build services such as cash management, payroll management, appropriate propositions, and deploy the optimal operating payments, collections, and trade finance solutions. Internet model. Customers’ lack of awareness of banks and institutions banking and mobile banking services should also be considered (especially Islamic ones) that offer SME finance propositions along with provisions for SME-specific debit cards with daily creates a huge supply-side gap. Islamic banks can fill this gap limits. by effectively branding and marketing Islamic propositions for SMEs as well as by creating separate business units/divisions III. Sales and Delivery with specialized SME strategies. Introduction of new Islamic SME banking models: Islamic II. Products and Services banks should use new SME banking models to target SMEs. The use of mobile banking (such as United Bank’s Omni facility) to Borrowing solutions: Traditional products may now allow enhance financial inclusion and reduce the cost of administering banks to acquire the required scale for a profitable Islamic an account could be a good initial step. Another step would be to SME portfolio. Hence, it would be necessary to tailor existing Islamic Banking Opportunities across Small and Medium Enterprises 39 collaborate with Pakistan’s 13,00071 strong post office networks for a loan. The financial requirements of SMEs are urgent to cater to SMEs in Tier 2 and Tier 3 cities. The use of banking compared with those of large-scale corporate enterprises. As a correspondents to ensure last-mile connectivity of banking result, the approval process must be shortened. Islamic banks services could also be a focus area. Islamic banks could establish need to streamline processes and focus on building relationships SME-specific branches in key SME clusters. Moreover, Islamic with SMEs (existing and prospective customers), which would banks need to streamline or realign their transaction execution ensure quick delivery of credit. processes to make the execution of Islamic transactions easier for SMEs. In order to acquire the required competencies for sustainable, profitable, and high performing Islamic SME portfolio, banks IV. Advisory Services may need to seek technical assistance. SME banking is a line of expertise hardly available in the MENA region and banks in Focus on advisory services: A majority of SMEs do not have Pakistan have not been able to champion this segment owing to sufficient knowledge about finance and management, business lack of understanding of SME banking disciplines, best business skills (such as financial modeling, future planning, and and risk management practices. forecasting) and information related to government rules and regulations that impact their functioning. This knowledge deficit prevents SMEs from evolving into larger and more sustainable enterprises. Islamic banks should provide SMEs with advisory services to aid and facilitate growth. V. Organization and Systems Better training for SME professionals: There is a shortage of staff knowledgeable about Shariah-compliant products across financial institutions due to the inadequate amount of time and effort spent on training them. To rectify this, financial institutions need to incorporate better training procedures into their organizational frameworks. Investing in employee training would allow Islamic banks to serve SMEs more effectively and help increase market penetration. VI. Risk Management Adopt better and more sophisticated methodologies: Most financial institutions rely on traditional banking approaches to identify and target viable SMEs. Financial institutions need to incorporate appropriate credit evaluation techniques (such as behavioral scoring, credit scoring, and cash flow and program- based lending) and build stronger early warning systems and collections frameworks to target and manage SMEs better, price products more effectively, and reduce risk exposure. Streamline loan application processes for SMEs: SMEs face difficulty in applying for loans due to the amount of documentation required and the long approval process (exceeding more than a month). Most SMEs lack the documentation required to apply 71 Government of Pakistan 40 Pakistan 06. Conclusion Pakistan’s Islamic financing market for SMEs is estimated to be worth $2.6 to $3.8 billion over the next few years, comprising SMEs that are creditworthy but do not borrow from conventional banking institutions due to religious beliefs. Pakistan’s banking system has evolved significantly and is a vital component of the country’s economy. Islamic banking is one of the fastest- growing sub-segments in the sector, with assets expanding at a compound annual growth rate (CAGR) of 38 percent over the last six years. Shariah-compliant assets account for 8.6 percent of overall banking assets in Pakistan72. During the same period, Islamic deposits increased at a CAGR of 42 percent73. The central bank is developing a strategic five-year plan (2013–2017) for Pakistan’s Islamic banking industry, especially focused on Islamic finance for the small and medium enterprise (SME) sector. Pakistan’s SME sector accounts for -30 percent of gross domestic product (GDP), 35 percent of manufacturing value added, and 25 percent of exports from the manufacturing sector74. SMEs continue to benefit from various government initiatives aimed at promoting the sector. The sector remains significantly underfunded despite such measures. Bank lending to SMEs as a percent of total lending declined to 6.8 percent in 2012 from 11.7 percent in 200875. Lending to the sector by Islamic banks dropped to 4.1 percent in 2012 from 9.8 percent in 2008, primarily due to the cautionary approach taken by banks to maintain their asset quality76. The lack of awareness about Islamic banking and the limited range of Islamic products available for SMEs are two factors responsible for the decline in Islamic SME lending. Additionally, it is estimated that about 20 percent to -25 percent77 of SMEs do not approach banks for finance due to religious reasons. Most SMEs seek finance to meet their working capital requirements and rely largely on informal sources for funds. Islamic banks offer deposit products as well as trade finance and cash finance products under the Murabaha and diminishing Musharaka structures. However, they should consider offering SMEs the equivalent of conventional overdraft facilities (offered by conventional banks). The most important steps that Islamic financial institutions need to take to tap the SME sector are similar to what several conventional banks are now doing, i.e. streamlining their product offerings (make them more SME-focused), investing in a well-trained workforce, improving processes, and expanding their presence in rural and urban areas alongside SME clusters. Islamic banks should also consider offering the SME sector non- borrowing services, such as cash management services and branchless banking, etc. However, banks in Pakistan would need guidance and support to successfully implement this strategy as they lack the requisite knowhow and expertise. From a funding perspective, the manufacturing sector offers Islamic banks the highest potential (say over 50 percent, based on the fact that, currently, more than 70 percent of Islamic SME financing is towards the manufacturing sector78) over the next few years due to the underlying potential and the capital intensity of operations. 72 State Bank of Pakistan 73 State Bank of Pakistan 74 Small and Medium Enterprises Development Authority 75 State Bank of Pakistan 76 State Bank of Pakistan 77 Primary research 78 Primary Interview with officials of Islamic Banking Department, State Bank of Pakistan Islamic Banking Opportunities across Small and Medium Enterprises 41 Several initiatives are being undertaken to improve the reach of Islamic banking in Pakistan. However, it is important that SMEs and bank employees are educated on the various aspects and benefits of Islamic banking and awareness increases about products and structures. If banks were to successfully tap SMEs that do not bank due to religious reasons, the potential funding opportunity in the SME sector could be $2.6 billion to $3.8 billion. There is also a depository potential of $0.8 billion to $1.3 billion from this segment. Islamic banking, as a practice, has immense potential in Pakistan. The strong perception about Islamic banking and the high growth exhibited by the sector would bode well for the sector over the next few years. Islamic banks should capitalize on the potential within this sector by diversifying its products and services, easing transactional procedures, reducing documentation, training staff on the various aspects of Islamic banking, and improving existing infrastructure and capacity to better serve the needs of the SME population. Implementing these measures would enable Islamic banks in Pakistan to tap the SME sector’s demand for Islamic finance more effectively and spur growth in the industry 42 Pakistan Research Scope and Methodology IFC, private sector arm of the World Bank Group, provides a The primary objective of this report is to enable IFC to determine combination of SME Advisory and Investment Services for optimal the market opportunity for Islamic banking products in Pakistan. results. The services fall in the following categories: The main questions the report addresses are: Advisory Services: • What is the overall SME population is Pakistan and how is it structured? • Build capacity of financial institutions in strategy, market segmentation, credit risk management, and product development • Is Islamic banking in Pakistan mature enough to adequately cater through new approaches and systems to scale up their financing to the needs of SMEs? for SMEs on a sustainable basis • What are the products and services that SMEs want from banks? • Promote sub-sector focus, especially on women-owned SMEs, sustainable energy SME projects, agriculture SMEs, and leasing • What is the size of the SME market opportunity for Islamic banks? • Raise awareness on best practices in the SME finance space • Develop credit reporting infrastructure based on country needs Objectives and scope of the report • Support development of secured transactions, collateral registries, The study on Pakistan focuses on the following facets – and legal and regulatory framework • The SME population of the country; and distribution by sector, • Build capacity of public/private stakeholders through advice and ownership and geography training • The usage of banking services (lending and deposit) by SMEs Investment Services: • Ease of SME access to credit and the potential difficulties faced • Make equity investments in financial institutions/equity funds for by SMEs in accessing credit SMEs • The potential for Islamic banking services in terms of financing • Funded lines to expand investment and working capital lines, and deposits (in dollar values) especially in illiquid markets Given the significant challenges faced during the course of research • Blended finance options to support the expansion of IFC’s (such unavailability of more recent SME data), the main objective risk appetite (e.g., grace periods, performance-based pricing, of the study was to provide a high level qualitative analysis to these subordination, higher risk/lower security or in limited cases, local questions. Given these challenges we are confident that the adopted currency positions) [for selected projects] approach portrays an accurate picture of the SME sector. • Increase focus on underserved segments, e.g., gender, fragile/ conflict, agriculture, climate Defining small and medium enterprises • Risk Sharing Facilities/Partial Credit Guarantees to enhance risk There is no uniform definition to classify SMEs in Pakistan with taking capacity and provide capital relief via low-risk weightings; various government authorities adopting different criteria to define avoid FX mismatches and encourage domestic resources for SME the sector. However, the widely acknowledged and used definition to financing. classify SMEs is that prescribed by the State Bank of Pakistan (SME Prudential Regulations). Islamic Banking Opportunities across Small and Medium Enterprises 43 Table 7 : SME definition as per Prudential Regulations Type of Enterprise Number of Employees Sales turnover Small Enterprises Up to 20 (including contract employees) Up to $0.8mn 21 - 250 (for manufacturing and services), and Medium Enterprises Above $0.8mn and up to $4.0mn 21 - 50 (for trading companies) Defining the number of SMEs In addition to secondary research, primary interviews were also conducted with commercial banks and SMEs to validate and To define the number of SMEs, the study first determined the total expand upon secondary research insights. A combination of primary number of MSMEs operating in Pakistan. Data published for interviews, previously published studies, IFC-McKinsey MSME micro-enterprises by MicroWatch (Quarterly Publication issued Database-June-2012 and financial reports of banks was used to by Pakistan Microfinance Network) in 2007 and an establishment calculate the average funding per enterprise or the average loan size. survey conducted by SMEDA in 2005 (published in 2009) were The average loan size thus derived ($5,000 for un-served SMEs and relied upon to determine the MSME universe. Since no other $85,000 for under-served SMEs) was a critical input for the funding surveys/census/updates were conducted by the government or potential calculations. private bodies, extrapolation was relied upon to forecast MSME population numbers to the current period. Real GDP growth figures (sourced from the IMF) were used as a proxy to forecast the increase Primary interviews in the MSME population as this is a broad indicator of economic Targeted interviews during the course of research covered both activity across the economy of a whole. The dominance of MSMEs demand and supply side aspects. In-depth interviews were conducted in the economy would make the sector sensitive to changes in GDP with banks, financial institutions and SMEs to elicit different growth. The extrapolated number was validated through interviews viewpoints and get a holistic picture. Key points that were covered with government officials and commercial bankers to ensure within the discussion guide included: consistency. Based on this method, the study determined the number of Micro and SME enterprises operating in Pakistan • Access to finance: The ease of availing finance from formal institutions, banks’ lending criteria, difficulties faced during the • Micro enterprises: These enterprises were estimated to account financing process, and ways of overcoming these difficulties for 82% of the total MSME universe or 4,988,661 enterprises • SME specific Islamic banking products: Mapping the Islamic • Small and Medium enterprises: The SME universe was estimated banking products offered by banks to the SMEs with the products to account for 18% of the total MSME population or 1,103,241 and services that are demanded/required by the SMEs enterprises. • Regulatory framework and enabling environment: Specifying government initiatives to promote Islamic banking (and Islamic Credit usage by SMEs banking for SMEs), identifying sentiments towards such services amongst banks as well as SMEs that would assist the growth of Information from multiple sources was collated to provide details the sector on the credit usage by SMEs in Pakistan. This included accessing studies published by the IFC, IMF and the World Bank on SME • Awareness about Islamic banking services: Determining the level access to finance. More importantly, annual reports and other of awareness about Islamic banking services amongst SMEs. relevant publications (such as yearly development finance reports) This was a key research area, as would prove to be an important from the State Bank of Pakistan were accessed to gather the indicator of the future potential of the Islamic banking market. In necessary information. Pakistan, approximately 25 percent enterprises exhibited strong interest in Shariah-compliant products. 44 Pakistan Supply side analysis In order to understand the supply side landscape, 20 out the 34 commercial banks operating in Pakistan were interviewed to identify and classify the various SME banking services and Islamic Banking and Financing services offered. Table 8 : List of banks contacted Pakistan Meezan Bank Al Baraka Dubai Islamic Bank Bank Al Islami Bank Al Habib Bank Alfalah Askari Bank Habib Metropolitan Bank SAMBA MCB Bank Summit Bank Silk Bank NIB Bank JS Bank Allied Bank National Bank of Pakistan Soneri Bank Standard Chartered United Bank Limited Habib Bank Limited In addition, respondents were also questioned on the customers’ (SME’s) opinions and preferences (if any) towards Islamic banking products in the respective countries. Additionally, the survey aimed to identify • The existing gap (if any) between the services demanded by SMEs vis-à-vis the services currently offered by banks and FIs • Customer preference (or lack thereof) towards Islamic banking services • Average value of lending per enterprise Table 9 : Supply side analysis template Islamic Pakistani Doing SME Doing Separate Overall SME Islamic SME Sr. No. Domestic Islamic Proposition Islamic Business Branding Portfolio Product Penetration Products Banks Banking Available SME Division Penetration Availability Availability 1 -- -- -- -- -- -- -- -- -- -- Demand side analysis SMEs were classified into un-served, underserved and well served categories based on available financial statistics, primary interviews with SMEs, commercial bank representatives and regulators. The survey was aimed to identify • The prevalence of banking (regular, SME or Islamic banking) within the SME sector • Percentage of enterprises eligible for banking services (based on credit criteria, proximity to bank / financial institutions etc.) • Challenges faced while accessing banking / financing services • Awareness about Islamic banking services, and willingness to avail such services Islamic Banking Opportunities across Small and Medium Enterprises 45 The results / hypothesis was tested with existing SME and/or Islamic Consequently they were unable to meet any of their financial SME portfolios and deviations were re-forecasted after consulting needs. These enterprises represent 67 percent of the SME the banks and regulatory authorities of the respective countries. population (737,727 enterprises) who do not borrow at all for various reasons, including religious beliefs. Funding potential calculations • the average funding potential based on SME credit usage trends, and The calculations to determine the funding potential (“new to bank” and cannibalization / conversion potential) for Pakistan were based on • the future penetration of Islamic banking services within the underserved and un-served sectors based on religious perceptions • SME population numbers (sourced from previous studies) • the classification of SMEs into well served, underserved and un- The funding potential was calculated for each category (well served, served categories based on demand side analysis underserved and un-served) based on the average funding size and the number of SMEs in each category. Through a combination of -- Well served SMEs: Large and mid-sized SMEs with access to primary interviews, financial reports of banks as well as previously the banking system, which were able to meet their financial published studies and IFC-McKinsey MSME Database-June-2012 needs fully. In Pakistan they comprise 11 percent of the total data, the average loan amount for well served enterprises was SME population (121,838 enterprises). estimated at $250,000. Similarly, the average loan amount was estimated to be $85,000 for underserved SMEs and $15,000 for -- Underserved SMEs: Mid-sized SMEs with access to the un-served enterprises. country’s banking system that were able to meet their financial needs only partially. These enterprises, which To further ensure the relevance of the funding potential estimates, represent 22 percent of the total SME population (243,675 optimistic and pessimistic scenarios were visualized based on several enterprises), avail formal financing (Islamic or conventional). ground realities (banks executing SME acquisition strategies, and SMEs displaying greater preference for Islamic products). -- Un-served SMEs: Small sized businesses that are excluded from the banking system with no access to finance. Table 10 : Funding Potential Calculations Max. Credit No. of Adaptability towards Islamic Islamic Funding Potential in Categories % Limit Size in Enterprises SME in percentage US$ ‘mn’ US$ Bull Case Bear Case Bull Case Bear Case Scenario Scenario Scenario Scenario a b c d (axbxc) (axbxd) Un-Served 737,727 67 5,000 15% 20% 553 738 Under-Served 243,675 22 85,000 10% 15% 2,071 3,107 Total ‘New to 981,403 2,625 3,845 Bank’ Potential Well-Served 121,838 11 250,000 5% 8% 1,523 2,437 Total ‘ Conversion 121,838 1,523 2,437 Potential Total Potential 1,103,241 4,148 6,281 46 Pakistan Disclaimer The information and analysis provided in this report have been based primarily on publicly available data, and other sources deemed to be reliable. These sources have been mentioned throughout the report, wherever applicable. Efforts have been made to ensure accuracy of data through cross validation from multiple sources and inputs from industry participants. Opinions and statements contained in this report are based on current economic and market conditions and are subject to change without notice. Islamic Banking Opportunities across Small and Medium Enterprises 47 48 Table 11 : Islamic deposit products offered by major banks in Pakistan Deposit Products Specialize Term Deposit Pakistan Bank Name Specialize Facilities Facilities Term Deposit - - Non Term Deposit - Current Account Saving Account Account - Account - Confirmed rate Confirmed Specialize Appendix Individual Business rate Al Barakah Bank (Pakistan) Limited Faysal Bank Dubai Islamic Bank Bank Al Islami Bank Al Habib Bank Al Falah Askari Bank Habib Metropolitan Bank MCB Bank Habib Bank Limited United Bank Limited Standard Chartered Bank Soneri Bank National Bank of Pakistan Meezan Bank Burj Bank Limited Allied Bank JS Bank NIB Bank Silk Bank Summit Bank SAMBA Source: Individual Bank websites Fully Servicing Partial Servicing Just Started Table 12 : Islamic financing products offered by major banks in Pakistan Financing Products Bank Project or Letter of Trust Performance St- EVM Auto House Shipping BNC/ Receivable Pre-Sale Development Credit – Receipt – Avalization and Payment Business Finance Finance Finance Guarantee Acceptance Finance Finance Finance All Types All Types Guarantees Finance – LT Al Barakah Bank (Pakistan) Ltd. Faysal Bank Dubai Islamic Bank Bank Al Islami Bank Al Habib Bank Al Falah Askari Bank Habib Metropolitan Bank MCB Bank Habib Bank Limited United Bank Limited Standard Chartered Bank Soneri Bank National Bank of Pakistan Meezan Bank Burj Bank Limited Allied Bank JS Bank NIB Bank Silk Bank Summit Bank SAMBA Islamic Banking Opportunities across Small and Medium Enterprises Source: Individual Bank websites Fully servicing Partial Servicing Just Started 49 50 Table 13 : Other Islamic products and services offered by major banks in Pakistan Other Islamic Products and Services Bank Trade Services Advisory Cash Management Online Banking Pakistan Al Barakah Bank (Pakistan) Limited Faysal Bank Dubai Islamic Bank Bank Al Islami Bank Al Habib Bank Al Falah Askari Bank Habib Metropolitan Bank MCB Bank Habib Bank Limited United Bank Limited Standard Chartered Bank Soneri Bank National Bank of Pakistan Meezan Bank Burj Bank Limited Allied Bank JS Bank NIB Bank Silk Bank Summit Bank SAMBA Source: Individual Bank websites Fully servicing Partial Servicing Just Started Table 14 : Demand for Islamic banking products from the SME sector Product Product Category Islamic Structure SME Requirement Manufacturing Trading Services LIABILITY PRODUCTS Current Account Quard Al Hassan High High High Current Account SME Business Current Account Quard Al Hassan High High High Savings Account Savings Account Mudarbah Low Low Medium Term Deposit – Confirmed Rate Wakala Medium Medium Low Term Deposit Term Deposit – Unconfirmed Rate Mudarbah Medium Medium Medium ASSET PRODUCTS Letter of Credit – Sight/Usance – All Murabaha/ Standardized Trade High High Low Types Musharaka/Wakala Finance – Buying Acceptance Under Usance Bill Murabaha High High Low Trust Receipt – All Types Murabaha High High Low Bills Negotiated Credit (BNC) – Murabaha High High Low Confirmed Rate Standardized Trade Shipping Guarantee Finance – Buying Murabaha High High Low Avalization Murabaha High High Low Standardized – Post- Short-Term Finance Murabaha/Salam High High High Sale ST Finance Receivable Finance (Factoring PDCs/ Standardized – Post Murabaha/Salam High High High Invoice/Export LCs) Sale ST Finance LT – Asset Base/Non- Term Finance – Equipment Leasing Asset Base Finance. Ijarah High High Low EVM Term Finance – Project or Musharaka/Ijarah High High High Development Finance Source: Israa Capital Analysis Islamic Banking Opportunities across Small and Medium Enterprises 51 Bibliography Islamic Banking Bulletins December 2009 to December 2012, State Bank of Pakistan Issue and Challenges for Islamic Banking in SME, Meezan Bank Limited IMF Financial Access Survey IMF World Economic Outlook State Bank of Pakistan Annual Report, 2011-2012 Statistics of the Banking System, March 2012, Banking Surveillance Department, State Bank of Pakistan Development Finance Review, December 2011, State Bank of Pakistan Handbook on Islamic SME Financing, December 2008, State Bank of Pakistan Pakistan’s banking system outlook remains negative: Moody’s Investor services, September 2012 A Narrative Description of Banking Sector in Pakistan May 2012 Growth and Prospects of Islamic Banking in Pakistan, Far East Journal of Psychology and Business, May 2012 Islamic Banking comes of age in Pakistan: Financial Express, July 2012 Banking cover must be extended to SMEs: The Express Tribune, September 2012 Non- performing loans reach an all time high: The Nation, September 2012 SME financing continues to decline: The International News, December 2012 Performance of SMEs in Export Growth and Its Impact on Economy of Pakistan 2011 Pakistan Economic Survey 2011–12 Entrepreneurship in Pakistan: Government Policy on SMEs, Environment for Entrepreneurship Internationalization of Entrepreneurs and SMEs 2008 Critical Success and Failure Factors of Entrepreneurial Organizations: Study of SMEs in Bahawalpur, Pakistan 2011 Barriers to SME Growth in Pakistan: An analysis of constraints; The Managerial Dimension of Small Business Failure in Journal of Strategic Change Obstacles to Small and Medium Enterprises in Pakistan 2013 IFC – MSME, Country Indicators IFC-McKinsey MSME Database-June-2012 The Global Competitiveness Report 2011-2012 World Economic Forum Transparency International Corruption Perceptions Index 2012 SME Development in Pakistan; Analyzing the Constraints to Growth 52 Pakistan Notes Xavier Reille Financial Institutions Group Advisory Services Manager Europe, Middle East and North Africa E-mail: xreille@ifc.org Kaiser Naseem Program Manager Banking Advisory Services Middle East and North Africa E-mail: knaseem@ifc.org Cornich El Nil, Ramlet Boulac, Cairo, Egypt Print Right Adv. 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