Islamic Finance and Entrepreneurship

Islamic Finance and Entrepreneurship:

Challenges and Opportunities Ahead

nIrvAnA AbOu-GAbAl

Harvard Kennedy School

ASIm IjAz KHwAjA

Professor of Public Policy, Harvard Kennedy School

bAIlEy KlInGEr

Director, Enrepreneurial Finance lab research Initiative, Harvard university

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in cooperation with

The Kuwait Foundation for the Advancement of Sciences

ISLAMIC FINANCE AND ENTREPRENUERISHIP: Challenges and Opportunities Ahead

EFLRI Islamic Finance Whitepaper January 2011

Nirvana Abou-Gabal Asim Ijaz Khwaja Bailey Klinger

Entrepreneurial Finance Lab Research Initiative Center for International Development Harvard University

http://www.cid.harvard.edu/eflri

This work has been made possible through the generous support of the Harvard Kennedy School Middle East Initiative and the HKS Belfer Center for Science and International Affairs Dubai Initiative.

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I. INTRODUCTION

In recent years Islamic finance has enjoyed rapid growth, but several challenges remain. Data show that there is significant unmet demand for shari’ah-compliant financial services, particularly among micro, small, and medium-sized enterprises (MSMEs). Moreover, the risks of concentrating in real estate, corporate, and government finance have been highlighted by the recent financial crisis, given their higher level of systematic risk compared to other segments like MSMEs. Finally, current shari’ah- compliant product offerings to MSMEs are highly concentrated in leasing and asset resale contracts, with limited use of the more legitimate profit and loss sharing contracts.

Successfully scaling up Islamic finance in the MSME market, particularly using profit and loss sharing contracts, requires resolving the problems of identifying good borrowers (information asymmetry) and ensuring repayment (moral hazard) with new technologies that are appropriate to the characteristics of this market. Namely, they must have low transaction costs, few information requirements, and be highly scalable to make a large portfolio of smaller financing sizes profitable.

The Entrepreneurial Finance Lab Research Initiative at Harvard’s Center for International Development has been piloting new screening tools that offer to resolve these problems, and are ideal complements to profit and loss sharing contracts. Adapting and implementing these tools offers a significant profit opportunity to Islamic finance institutions as well as an opportunity to accelerate entrepreneurship and economic growth in their countries of operation.

II. ISLAMIC FINANCE - GROWTH

Islamic finance is a booming industry. Despite the financial crisis which has plagued the economies of both industrialized and developing nations, the Islamic finance industry has been flourishing and has enjoyed a 29 percent growth in assets in 2009 and an 8.85% growth rate in 2010. These assets are currently estimated to be worth $895 billion (The Banker 2010). Moreover, the Global Head Islamic Finance of Thomson Reuters, predicts that Islamic finance industry will be valued at $2 trillion in the next 5 years (MENA News Headlines 2010).

Over the course of 2010, 20 new banks offering shari’ah compliant financial products have entered the market. Moreover, an additional seven conventional banks began offering services via shari’ah- compliant windows. Figure 1 depicts the level and relative growth of the number of institutions offering Islamic financial products (The Banker 2010) and shows that this growth has continued in spite of the financial crisis.

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Islamic Finance is increasing no longer just a GCC phenomenon but is gaining popularity across a wider range of countries. Although the majority of Islamic finance assets have indeed traditionally been concentrated in the Gulf Cooperation Council (more than 40 percent of shari’ah compliant assets), Islamic finance is enjoying significant geographic expansion, particularly in Asia. Islamic asset growth in the GCC slipped to just 5.5% in the 2010 ranking (down from 34.5 percent in 2009). Asia’s ranking on the other hand had a high growth rate of 22 percent. Table 1 depicts the regional breakdown of assets in Islamic finance (ibid).

Table 1: Regional and Global Assets ($m)

GCC Non GCC MENA MENA Total Sub-SaharanAfrica Asia Australia/Europe/America Global Total

262,665.4 47.5 248,264 43.9 510,929.4 41.5 6,662.1 -27.6 86,360.3 63.5 36,105.2 27.7 639,076.9

353,237.5 34.5 315,090.5 26.9 668,328.5 30.8 8,369.7 25.6 106,797.3 23.7 38,654.8 10.1 822,135.1 28.6

2007

178,129.6 176,822.2 354,951.7 4,708 119,346.5 21,475.7 500,481.9

2008 % Change Change

2010 % Change

372,484.2 5.5 337,949.8 7.3 710,434.0 6.3 10,765.1 28.6 130,904.1 22.6 42,779.5 10.7 894,882.7 8.9

2009 %

At the country-level, Iran, Saudi Arabia and Malaysia were the world’s leaders in Islamic finance assets in 2009. The top 25 countries with shari’ah compliant assets in that year are illustrated in Table 2 (ibid).

Table 2: Shari’ah Compliant Assets ($m) by Country

Rank

Country

Shari’ah Compliant Assets ($m)

Rank

Country

Shari’ah Compliant Assets ($m)

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1

Iran

314,897.40

14

Pakistan

6,203.10

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