Running Head: THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

SADAM ISAQ ISGOWE

CITY UNIVERSITY
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

Literature Review

Keywords: micro-financing institutions (MFIs), small and medium enterprises (SMEs),

Islamic Banks and entrepreneurs.

Introduction

Islamic banks can be defined as a financial institution that (a) adheres to sharia

principles in all its activities by acting as a financial intermediary between savers and

investors; (b) provides banking services under legitimate contracts, and (c) strikes a balance

between economic and social returns. And in its broader sense, the beginnings of Islamic

banking date back to Islam's early days and the rise of the Islamic Empire. (Alharbi, 2015). In

addition, Tamanni & Liu (as cited in Wilson, 2007), Islamic microfinance can be defined as

the provision of micro-finance products and services based on Islamic principles, which is

similar to a definition of microfinance in general but a reference to Islamic principles.

Moreover, according to Robinson (2001), microfinance defined as the provision of

loans, savings, and other basic financial services to the poor people and low-income groups.

(John, Hides & Powell as cited in Thompson,1999, p. 406) stated that "an entrepreneur is a

person who spots a new opportunity and is minded to act on it and start something". In this

literature review, I will be reviewing an overview of Islamic banks, SMEs' awareness of

Islamic products, what are some of the challenges facing both MFIs and SMEs? and lastly the

effect of MFIs on SMEs.

Overview of Islamic Banking

Islamic banking and finance are based on Shari'a principles that preclude Riba's

payment or receipt of interest. (Abedifar et al, as cited in Pryor, 2007). Alharbi, (2015), The

first strive to set up a contemporary Islamic bank in the world occurred in Egypt in 1963

when the late Ahmed Al-Najjar created a collection of savings and funding houses in a few

small rural towns in Northern Region. However, “The second commercial Islamic bank in the
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

world incorporated in the United Arab Emirates in 1977." (Alharbi, 2015, p.21). Moreover,

the development of Islamic finance in Somalia is only a matter of time and presupposes a

reasonable level of peace and stability in the country (Muhammad, 2016). Sa'id Foundation

launched its micro-credit program in 1993, Mogadishu and SA'ID received its first major

infusion of capital from Oxfam America in 1996. (Dahir as cited in SA'ID Report, 2005).

However, Chong & Liu (2009) found that Islamic banking is not the same as conventional

banking. They added in their theory that the PLS model is a unique feature that separates

Islamic banking from conventional banking. In reality, however, we found that Islamic

banking from the viewpoint of the PLS paradigm is not very different from conventional

banking.

SMEs’ awareness of Islamic Products

A study done by Saini, Bick & Abdulla, (2011) about consumer awareness and Usage

of Islamic banking products in South Africa by using a non-probability sampling method

revealed that the awareness of the Islamic banking products by the Muslims are high,

however, the percentage who use is very low, as Muslim customers regard efficiency, lower

bank fees, the provision of automatic teller machines (ATM) and an intensive branch network

as important factors when it comes to selecting a bank, instead of religious motivations for

compliance with Islamic conventions. Moreover, Religion as the sole motivation for selecting

Islamic banks is insufficient.

Furthermore, Arzeni, Cusmano & Robano, (2015) mentioned in their book that the

major challenge for increasing the diversification of SME financial sources is the lack of

awareness of the opportunities offered by financial markets by entrepreneurs themselves.

Start-ups and SMEs' limited understanding of alternative resources have hindered the growth

of these markets. It is not only a matter of increasing knowledge of individual tools but also

of supporting SMEs in the development of strategic vision and planning. There is a need to
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

understand how different instruments can meet their particular funding needs at various

stages of the life cycle, the different benefits and risks involved, and the complementarities

and leverage opportunities between some of these sources

What are some of the challenges facing both MFIs and SMEs?

"Access to finance represents one of the most significant challenges for entrepreneurs

and for the creation, survival, and growth of small businesses." (Arzeni et al., p.216).

Moreover, research was done by Mamud & Awale (2016), about the Assessment of the

Contribution of Microfinance to Entrepreneurship Development in Mogadishu found that the

SMEs' accessibility of microfinancing services is low. Besides, the requirements of the

accessibility of the loan, such as collateral, repayment within a short term, made the SMEs or

entrepreneurs unable to get finance from the microfinancing institutions which obstruct the

entrepreneurial development. (Mamud & Awale, 2016). On the other hand, Dahir (2015),

noted that the major challenges facing microfinance institutions are default risk inherited

from lenders, insufficient donor support, and inadequate understanding of clients'

interpretation and meaning of microfinance. Furthermore, Additional challenges for

microfinance institutions are communication gaps and inadequate knowledge, inadequate

legislation, lack of adequate loan or equity capital to increase loanable funds, insufficient

government support, and limited microfinance management capability. However, effective

communication, adequate awareness, and full support from local governments and

international donors to micro-financial institutions in Mogadishu are possible ways to reduce

the challenges of micro-financial institutions. Dahir, (2015)

A study done by Heitz, (2019) about Financing SMEs in the EU, revealed that the

financial education and information barriers on the funding market for SMEs are at stake.

Securing finance is seldom a core strength of smaller firms and entrepreneurs, who often lack
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

the resources to employ a dedicated team to manage their finances. However, “The problem

of information barriers is compounded by the information asymmetries between investors and

SMEs. SMEs often do not produce audited financial statements that yield credible financial

information, but investors and lenders need verifiable information about a company before

supporting it financially.” (Heitz, 2019, p. viii). Moreover, it was also found that Muslim

entrepreneurs lack the knowledge of financial management. Abdullah, Awang, Rahman &

Dato Yahya (2016). Lee, Sameen & Cowling, (2015) found in their study that innovative

firms find it more difficult to access financing than other firms, but that, over the past two

years, the deterioration in credit availability and more importantly the amounts available, has

been systemic for all firms rather than especially for innovative SMEs.

In contrast, the accessibility of micro-financing in SMEs impacts the gender of the

Entrepreneurs. According to, Brahmachary, (2017), revealed in his book about Microfinance

for Women-Owned Small Business in India that due to the asymmetric information about

their creditworthiness, a large number of women struggle to access formal finance. Also,

"Women entrepreneurs are less funded than their male counterparts." (Brahmachary, 2017,

P.143). Moreover, Vershinina, Rodionova & Marlow (2015), there is evidence of lower

credibility of female-owned businesses, although somewhat mixed, as assessed by overdraft,

checking/savings account, export credit, bank loan, and exposure to alternative informal

funding sources. However, Hamdan & Tawfiqi, (2018) found that Islamic banks support

entrepreneurs through the effects of non-financial services on entrepreneurs' success. They

concluded that the gender factor has a high impact on entrepreneurs' success, where female

entrepreneurs receive additional support services from other institutions that encourage

women to enter the market. We can see that Islamic micro-financing has a positive impact on

SMEs than Conventional micro-financing.

THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

According to Tamanni & Liu, (2017), wrote a book about What is Islamic

Microfinancing? They concluded in their study that due to competition, Islamic microfinance

could also be forced to embrace the industrial path and successively overlooked its mission of

poorness alleviation. This may eventually place Islamic microfinance into an equivalent

situation presently facing conventional microfinance institutions, that is susceptible to

mission drift, commercialization and in few instances, problems associated with the high

obligation of their borrowers. On the other hand, Nguyen & Wolfe (2016) found that the

results indicate that lending for collateral and relationships has a positive impact on

successful access. In addition, Mohamed, (2019), studied in his Master’s thesis about a

comparative study of Islamic microfinancing for SMEs in Somalia and Nigeria by using

primary data from Hargeisa and Ilorin revealed that because of the shortage of a proper

financial sector and challenges as well as serious collateral requirement; 80th of SMEs in

Somalia failed to utilize the products of IMFIs while in Nigeria 53.3%, used the products of

IMFIs.

The effect of MFI on SME development

Angeles, Calara & de Guzman (2019) suggested that when microfinancing is

maximized, the effect of access to finance on the growth of microenterprises is increased.

Moreover, Mamud & Awale (2016), discovered that Microfinancing institutions have an

impact on the growth and continuable development of SMEs. Plus, enhances the productivity

and gainfulness of SMEs. On the other hand, Abdullah, Awang, Rahman & Dato Yahya,

(2016) revealed, in their journal, about the role of the Islamic banking institution in assisting

Muslim entrepreneurs in Malaysia, that Islamic banking institutions have played a major role

in supporting Muslim entrepreneurs. Furthermore, Warninda, Ekaputra & Rokhim (2019),

done an empirical research about whether Murabaha and Musharakah financing impacts on

Islamic bank credit risk differently by Employing ten-year unbalanced panel data from 63
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

Islamic banks in the Middle East, South Asia, and Southeast Asia. They revealed that

Musharakah is riskier than Mudarabah. They added that Mudarabah has no non-linear impact

while Musharakah financing exhibits reverse (non-linear) U-shaped influence on Islamic

bank credit risk. They concluded that when the optimum proportion is reached, engaging in

Musharakah financing may reduce Islamic bank credit risk.

Hamdan & Tawfiqi, (2018) found in their study, The Role of Islamic Banks in The

Entrepreneurial Success: Evidence from Bahrain, that Islamic banks play a role in the

entrepreneur's success. They also added that Entrepreneurs' understanding, mobility, business

development and support from Islamic banks all play a role in Bahrain's entrepreneurial

success. Also, Dahir, (2015), found in his study about the challenges facing microfinance

institutions in poverty eradication that microfinance institutions have a positive impact on the

alleviation of the economic condition among poor individuals.

Finally, we can see that a lot of research was conducted about the role of Islamic

banks in financing entrepreneurs. To gain benefit and overcome some of the challenges face

today by both MFIs and Entrepreneurs or SMEs most literature recommended that

microfinance institution is required to set more flexible, affordable and attractive conditions

for financing small businesses, their position in growth and development needs to be felt by

small businesses. Nevertheless, some other literature advises that Islamic banks recognize

entrepreneurs' needs and provide them with the resources they need to help them in achieving

the level of success they seek. Lastly, if we want the success of SMEs, we need to ensure that

funding can flow from investors to entrepreneurs and owners of small businesses. (Heitz,

2019).
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS
THE ROLE OF ISLAMIC BANKS IN FINANCING ENTREPRENEURS

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