Islamic Financing for SMEs Presented By: M.Shoaib Malick Unit Head-SME-Meezan Bank Limited

Islamic Financing for SMEs Introduction to Islamic Banking Significance of SME Sector Difference Between Islamic Banking & Conventional Bank How IB, can address business needs (100%) Comparison of Islamic Mode of Finance and Conventional Islamic Modes of Financing Short Term Modes of Islamic Financing Long Term Modes of Islamic Financing Trade Finance Facilities in Islamic Banking Challenges in SME Financing Conclusion

Significance of SME Sector 1 Total Population 182Mn 100% 2 Financially Included 18.2Mn 10% 3 Financially Excluded 163.8Mn 90% 4 Financially Excluded-Major Sector SME 5 90% of all private enterprises 6 SMEs access to finance from banking sector: Pakistan India Bangladesh 04% 33% 32% 7 SME lending of total credit 06% 8 Surveyed Facts Hard to borrow from banks Not even have a bank account 51% 31%

Contribution of SME Sector to Economy

Current Status of SME Financing: SME financing witnessed continues decline by banks/DFIs since 2008. Due to consistent decline in this sector, share of SMEs also reduced from 16% to 6% in overall advances of banks in last 4-5 years. Reasons for downfall: Adverse economic conditions. Law and order situation. Shortage & rising costs of electricity and other utilities.

Reasons for downfall: Growing NPLs. Natural catastrophes also hamper this sector badly in consecutive years of 2010 & 2011 and created wipeout situation for small sized units. Banks also took a risk-averse posture from this sector, due to deteriorating business conditions for SMEs.

5 Years trend of SMEs

5 Years trend of SMEs

5 Years trend of SMEs 9.4% 16.1% 22.1% 28.9% 32.4% 38.9%

SME Financing For Working Capital Key portion of financing is used for working capital in SMEs, which constitutes 76% of total SME lending. However other is followed by Trade Financing & Long term/Fixed Investment.

SMEs provide a significant portion of jobs world wide SME contribution to formal country employment Median values Source. Ayyagari, Beck and Demigirguc/kunt. 2003

GDP Contribution of the SME sector increases, and informality decreases with income

Definition of Riba Any increase over and above the price, without due consideration is Riba

Distinguishing Features We find the differences are on three levels: 1. Conceptual & Socio-religious level - not money lenders - cannot deal with interest & non permissible industries 2. Business model & Governing framework - IB actively participates in trade and production process - Governing framework in terms of Shariah Advisor &/or SSB

Distinguishing Features 3. Product Level Implementation - usually asset backed & involve trading/renting of asset & participation on profit & loss basis - Implementation is not just a mere change of paper work and terms but it involves - having the right intention, - the correct sequence of steps and timing of execution

PERCEPTION OF ISLAMIC BANKING Parties: Bank & Client Limit: Rs 10.00 Mn Rate: K+2 Tenor: 1 year Purpose : To buy Cotton Parties: Bank & Client Limit : Rs 10.00 Mn Rate: K+2 Tenor : 1 year Purpose : To buy Cotton Islamic Banking Conventional Banking

PERCEPTION OF ISLAMIC BANKING Parties: Bank & Client Limit: Rs 10.00 Mn Rate: K+2 Tenor: 1 year Purpose : To buy Cotton Parties: Bank & Client Limit : Rs 10.00 Mn Rate: K+2 Tenor : 1 year Purpose : To buy Cotton Islamic Banking Conventional Banking Goods = OWNERSHIP Services

Islamic Banking Basic Difference between Islamic and Conventional Modes of Finance Conventional Money Client Bank money + money (interest)

Islamic Banking Basic Difference between Islamic and Conventional Modes of Finance Islamic Goods & Services Client Bank money

Income Statement Sales xxx Cost of Goods Sold Raw Material xxx Direct Labor xxx Over Head xxx Gross Profit xxx Operating Expenses Admin. & Gen. Exp xxx Salaries xxx Utilities xxx Other xxx Net Profit xxx Liability/Deposit Products Murahaba Istisna/Tijarah Istisna/Tijarah Deposit Products

Balance Sheet Current Assets: Stocks xxx Receivable xxx Cash in hand xxx Advances & Deposit xxx Fixed Assets: Plant & Machinery xxx Land & Building xxx Total Assets xxx Owner’s Equity: Capital xxx Liabilities: Creditors xxx Financial Liabilities xxx Total Liabilities & Equity Murahaba/Import Murahaba/FIM/LC Istisna/Tijarah/Bai-Salam/Usance-Murahaba Deposit Products Murahaba/Istisna/Tijarah/LG DM/Ijarah/Murahaba Musharka Murahaba/LGs/Ijarah/Tijarah

Difference Between Islamic Banking & Conventional Bank Conventional Banks Islamic Banks 1. The functions and operating modes of conventional banks are based on fully manmade principles. 1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah. 2. The investor is assured of a predetermined rate of interest. 2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur). 3. It aims at maximizing profit without any restriction. 3. It also aims at maximizing profit but subject to Shariah restrictions. 4. It does not deal with Zakat. 4. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat. 5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks. 5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer's business very well. 6. It can charge additional money (penalty and compounded interest) in case of defaulters. 6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are give for early settlement at the Bank's discretion.

Difference Between Islamic Banking & Conventional Bank Conventional Banks Islamic Banks 7. Very often it results in the bank's own interest becoming prominent. It makes no effort to ensure growth with equity. 7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity. 8. For interest-based commercial banks, borrowing from the money market is relatively easier. 8. For the Islamic banks, it must be based on a Shariah approved underlying transaction. 9. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations. 9. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations. 10. The conventional banks give greater emphasis on credit-worthiness of the clients. 10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects. 11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors. 11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller. 12. A conventional bank has to guarantee all its deposits. 12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position..

Financing Product Comparison Islamic Vs. Conventional Bank Islamic Product Conventional Products Working Capital Finance 1 a) Murabaha b) Murabaha - Spot c) Istisna - Export & Local d) Meezan Tijarah - Export & Local e) Murabaha FE-25 Export & Import Current Finance / Running Finance 2 Murabaha - Pledge Cash Finance 3 a) Ijarah - Plant & Machinery b) Ijarah - Sale & Lease Back for Plant & Machinery c) Diminishing Musharika - Plant & Machinery d) Diminishing Musharika - Premises / Land for Commercial use e) Diminishing Musharika - Sale & Lease Back (Plant & Machinery; Premises Land & Building) f) Musharaka Demand Finance / Term Finance Meezan Bank Limited

Financing Product Comparison Islamic Vs. Conventional Bank Islamic Product Conventional Products Export Related Facilities: 1 a) Bai Salam against Discrepant Export Sight Bills b) Bai Salam against Export sight contract c) Murabaha against Accepted export Usance Bill (Bank Risk Line) d) Murabaha against Un-accepted export Clean Usance LC e) Murabaha against un-Accepted export Discrepant Bills under Usance LC f) Murabaha against export Usance Contract Finance Against Foreign Bills 2 a) Murabaha against Un-accepted Local Usance LC b) Murabaha against Accepted Local Usance LC (Bank Risk Line) Local Bill Purchases 3 a) Istisna – Export b) Islamic Export Refinance Facility (IERF) Part I & II - under Murabaha c) Islamic Export Refinance Facility (IERF) - under Istisna (Local and Export) and Tijara (Local and Export) Finance Against Packing Credit Part - I & II

Conventional Products Import Related Facilities: Financing Product Comparison Islamic Vs. Conventional Bank S.# Islamic Product Conventional Products Import Related Facilities: 1 a) Sight LC under MMFA b) Sight LC under Master Agency Agreement (For Ijarah & Diminishing Musharaka) c) Sight LC wihthout MMFA (Exceptional Cases) d) Usance LC without MMFA f) Usance LC under MMFA (Exceptional cases) g) Usance LC under Master Agency Agreement (for Ijarah and Diminishing Musharaka) Import Letter of Credit 2 a) Local LC(Sight) without MMFA b) Local LC (Sight) under MMFA (Exceptional cases) c) Local Usance LC wihtout MMFA d) Local Usance LC under MMFA (Exceptional cases) Inland Letter of Credit 3 a) Murabaha - Financing of Imported Merchandise (FIM) Pledge b) Murabaha - Financing of Imported Merchandise (FIM) Spot Finance Against Imported Merchandise - FIM 4   Finance Against Trust Receipt Letter of Guarantee Letter of Guarantee / Shipping Guarantee/Standby Letter of Credit Letter of Guarantee / Shipping Guarantee Meezan Bank Limited

Short Term Financing Needs Raw Material Overheads / Utilities Finished Goods Trade receivable financing Rental financing Long Term Financing Needs Acquisition/replacement/ expansion of fixed assets, plant & machinery

Issues & Challenges of SMEs Demand Supply Lack of Collaterals to Meet Bank’s Requirements Shortage of Marketing Skills-(Bank Side) Informal Organizational Structures SMEs perceived as high risk borrowers Informal Accounts & Management System Corporate Finance Mindset Lack of Credit & Collateral History Lack of Infrastructure for SME Business Low Level of Financial Literacy High Lending Costs Reluctance on part of SMEs Absence of SME R&D Centers in Banks External Shocks

Plain Murabaha Advance Payment Murabaha Suppliers Credit Murabaha SLC under MMFA Tijarah Istisna Diminishing Musharaka Ijarah Bai Salam

Plain Murabaha Murabaha Agreement Agency Agreement Order Form Purchase of Goods by Agent Payment of Purchase Price* Intimation of possession of goods by the agent (Declaration) Offer & Acceptance (Murabaha Contract) Payment of Murabaha Price *Payment of purchase price is either direct payment to supplier or through customer account For Detail

Advance Payment Murabaha Murabaha Agreement Agency Agreement Order Form Payment of Purchase Price* Purchase of Goods by Agent Intimation of possession of goods by the agent (Declaration) Offer & Acceptance (Murabaha Contract) Payment of Murabaha Price *Payment of purchase price is either direct payment to supplier or through customer account

Credit Murabaha Murabaha Agreement Agency Agreement Order Form Purchase of Goods by Agent Intimation of possession of goods by the agent (Declaration) Offer & Acceptance (Murabaha Contract) Payment of Purchase Price* Payment of Murabaha Price *Payment of purchase price is either direct payment to supplier or through customer account

SLC under MMFA Murabaha Agreement Agency Agreement Order Form & LC Application Establishment of LC Receipt of Import Documents Intimation of possession of goods by the agent (Declaration) Offer & Acceptance (Murabaha Contract) Retirement of LC Through Murabaha Payment of Murabaha Price

Tijarah For Detail Master Tijarah Agreement Agency Agreement Written Offer Payment of Tijarah Price upon Acceptance Delivery of Goods & Acceptance of Delivery by bank Intimation of possession of goods by the agent (Declaration) Offer & Acceptance (Murabaha Contract) Retirement of LC Through Murabaha Payment of Murabaha Price For Detail

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