IFC Advisory Services in the Middle East and North Africa. Executive Summary ISLAMIC BANKING OPPORTUNITIES ACROSS SMALL AND MEDIUM ENTERPRISES IN MENA

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1 IFC Advisory Services in the Middle East and North Africa Executive Summary ISLAMIC BANKING OPPORTUNITIES ACROSS SMALL AND MEDIUM ENTERPRISES IN MENA

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3 Contents Preface...8 SME Sector Overview...10 SME Definition and Classification SME Universe...11 SME Sector Overview...12 Key Enablers for SME Growth...14 Key Challenges for SMEs...15 Government Initiatives to Support SME Growth...17 World Bank Group Initiatives to Support SME Growth...19 Financial Sector Overview Banking Penetration Commercial Banking Sector Islamic Banking Sector SME Sector Non-performing Loans Islamic Financial Sector Regulations and Enabling Environment SME Access to Islamic Finance SME Penetration Obstacles Faced by Banks in SME Financing Supply Side Analysis of Banks in the Region Islamic Products Availability and Recommended Products Opportunities for Islamic SME Banking Funding Opportunity Sectors to be Targeted...44 Factors Affecting Growth of Islamic SME Banking Conclusion Strategic Operational Adjustments Can Help Islamic Banks Target SMEs More Effectively Proposed Strategy Framework...48 Ideal Business Model Road Map for Islamic SME Banking Inception and Growth... 50

4 Appendix Research Scope Methodology About IFC Bibliography Annexures... 64

5 Index of Figures and Tables Figure 1 : Islamic Funding and Deposit Potential Across Mena and Pakistan ($Bn)... 9 Figure 2 : Segmentation of SME Universe Across Countries...12 Figure 3 : SME Contribution to GDP...13 Figure 4 : Key Challenges Faced by SMEs During Their Evolution Phases...15 Figure 5 : Challenges Faced by SMEs Across Countries...16 Figure 6 : Major Constraints Faced by Businesses...17 Figure 7 : Banking Penetration Across Countries...22 Figure 8 : Loan and Deposit Growth Across Countries ( )...24 Figure 9 : Islamic Banking Market Overview...25 Figure 10 : Islamic Assets and Deposits Growth ( )...26 Figure 11 : NPL Overview...29 Figure 12 : SME Sector Existing Penetration...33 Figure 13 : Obstacles Faced in SME Financing...34 Figure 14 : Supply Side Analysis...35 Figure 15 : Analysis of SME Proposition of Surveyed Banks...36 Figure 16 : Evolving Financial Requirements of SMEs...37 Figure 17 : Preference for Shariah-Compliant Products Percentage wise...39 Figure 18 : Funding Potential Percentage Across Countries...40 Figure 19 : Enabling environment and Supply Side Analysis (SME and Islamic SME)...41 Figure 20 : Comparative Islamic Funding Opportunities...42 Figure 21 : Islamic Conversion Opportunity Across MENA and Pakistan ($mn)...43 Figure 22 : Strategic Operational Adjustments to Target SMEs...47 Figure 23 : Strategic Initiatives to be Undertaken by Countries...49 Figure 24 : Integration of Islamic Banking SME Model...50 Figure 25 : Roadmap for Islamic SME Banking...51 Figure 26 : Strategic Initiatives to be Undertaken by Countries...57

6 Table 1 : SME Definitions Table 2 : Importance of SMEs to Economic Development...12 Table 3 : SME Distribution by Sector...14 Table 4 : SME Enablers by Country...15 Table 5: Government Initiatives to Support SME Growth...18 Table 6 : IFC Initiatives to Support Access to Finance for SMEs...19 Table 7 : Commercial Banking Sector Overview...23 Table 8 : Banking Penetration in SME Sector (2012)...27 Table 9 : Trend in SME Portfolio Growth...28 Table 10 : Regulatory Overview...30 Table 11 : Islamic Banking Initiatives...30 Table 12 : Total SME Universe...42 Table 13 : Islamic Depository Potential by Country...43 Table 14 : Attractive Sectors for Islamic Finance Across Countries...44 Table 15 : Drivers and Challenges Faced by Islamic Banks...45 Annexure 1 : Common Shariah Structures Used Across Countries...64 Annexure 2 : Commonly Used Products and Recommended Products...65 Annexure 3 : Questionnaire for Banks...66 Annexure 4 : Questionnaire for SMEs and SME Associations...67 Annexure 5 : List of Respondents from Banking Sector...68 Annexure 6 : List of Respondents from SME...71

7 Abbreviations and Glossary ANPME BAS BMCE CIB CAC CAGR GDP HSBC ICD ICT IDB IFC IT JEDCO JLGC KSA MENA NCB NPL NSGB PPP SFD SME SMEDA USAID National Association of Small and Medium Enterprises Bank Advisory Services Banque Marocaine du Commerce Extérieur Commercial International Bank Cooperative and Agriculture Credit Compounded Annual Growth Rate Gross Domestic Product Hongkong Shanghai Banking Corporation Islamic Corporation for the Development of the Private Sector Information and Communication Technologies Islamic Development Bank International Finance Corporation Information Technology Jordan Enterprise Development Corporation Jordan Loan Guarantee Corporation Kingdom of Saudi Arabia Middle East and North Africa National Commercial Bank Non-Performing Loan National Societe Generale Bank Public Private Partnership Social Fund for Development Small and Medium Enterprise Small and Medium Enterprise Development Authority United States Agency for International Development

8 8 EXECUTIVE SUMMARY 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 35 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 & 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, with a corresponding deposit potential of $9.71 billion to $15.05 billion across these countries. This is due to the fact that several un-served and underserved SMEs do not borrow from conventional banks, 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 Shariahcompliant products.

9 IGNISI BLA CORE ESED EA CONULLA SME FEUGAIT, SECTOR OVERVIEW QUIPISIM 9 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 Dubai June, 2014

10 10 EXECUTIVE SUMMARY 02. SME Sector Overview The SME sector forms the backbone of economic development, private sector employment, capital investments, and GDP growth. Despite their importance to economic output, SMEs still have inadequate access to finance and other banking services. As a result, many SMEs tend to be concentrated in less capital-intensive sectors, such as retail and wholesale trade. This scenario not only restricts the development of smaller enterprises, but also retards economic activity in these countries. Government initiatives and assistance from multilateral institutions like IFC have been instrumental in these countries to enable the SME sector to grow by providing business and technical expertise to enhance access to finance. SME Definition and Classification There is no standard definition for classifying small and medium enterprises (SMEs) across various countries. The most commonly used criteria by government agencies (central banks and government departments) and commercial banks are based on employee size, asset size, and annual turnover. However, application of the same classification criteria across countries results in disparities due to different classification thresholds. These disparities exist because of the differences in economic structure, size of the economy, and the degree of development in each country. The following definitions used for the target countries are derived from definitions used by the commercial banks, central banks, and/or the statistic or trade departments of the respective countries. The lack of a standard definition makes it difficult to compare the SME sector across countries. A standard definition would enable a meaningful comparison, leading to the replication and implementation of effective policies and programs (such as credit guarantee programs, or skill development programs, etc) for SME development across countries.

11 SME SECTOR OVERVIEW 11 Table 1: SME Definitions Countries Definition Derived From Employee Size Small Annual Turnover Employee Size Medium Annual Turnover Ministry of Trade & Egypt* $87, , $878,659 1,757,318 Industry Pakistan Central Bank Up to 20 employees and annual turnover of up to $757,500 Saudi Arabia Dept. of Statistics 5 19 $ million More than 20 $ million Jordan# Central Bank 5 20 Less than $1.4 million $3 4.2 million Morocco Central Bank -- $344,400 $1.15 million -- $ million Tunisia Commercial Banks -- $1 10 million -- $10 19 million Yemen Commercial Banks -- $10,000 50, $50, ,000 Iraq^ Commercial Banks -- $5, , More than $250,000 Lebanon Commercial Banks Enterprises with turnover of less than $4 million classified as SMEs Note:* For Egypt, the definition is based on registered capital instead of turnover. # For Jordan, the definition is based on either assets or sales volumes. ^ For Iraq, the definition is based on loan size. -- means there is no official response or definition available Domestic agencies, such as central banks and government departments, are unlikely to possess an international perspective. Therefore, multilateral agencies need to play an active role in the development of a standard definition for SMEs on the basis of annual turnover or any other suitable parameter. SME Universe The enterprise population across each country is usually divided into two distinct segments: SMEs that operate in the formal sector. Very small (or micro) enterprises that operate in the informal/parallel economy. SMEs operate in high economic impact sectors such as manufacturing and construction. As a result, they are able to generate employment and significant economic value. Very small enterprises on the other hand generally operate in the trade and commerce sectors, which have low economic potential, as they serve local markets and do not add significant value to final products. The current enterprise population in the target countries is dominated by very small enterprises that do not offer the same economic advantages as SMEs. The composition of very small enterprises in the enterprise population is as high as 91 percent (Tunisia) to about 40 percent to 60 percent (Yemen and Saudi Arabia).Therefore, there is a need for the government and multilateral institutions to assist these very small enterprises to develop into SMEs. In order to achieve this, governments are looking at: A. Developing very small (micro) enterprises capabilities through training on various facets (financial knowledge, business planning, management, product quality) B. Creating an enabling environment for the SMEs (easy access to basic infrastructure, smooth approval process in government departments, and prudent regulation) C. Providing access to finance (special government bodies to channel finance to the sector, guarantee schemes and incentives to banks for targeting very small enterprises)

12 12 EXECUTIVE SUMMARY Figure 2 : Segmentation of SME Universe Across Countries SME Sector Overview SMEs contribute significantly to GDP growth, private sector employment, and capital investments SMEs form an important component of a country s economy. They play a significant role in generating private sector employment, driving gross domestic product (GDP) growth, and domestic capital investments. Contribution to GDP Egypt 80w of economic output* -- Pakistan Saudi Arabia 30 percent of GDP and 35 percent of manufacturing value added 33 percent of economic output Table 2 : Importance of SMEs to Economic Development Contribution to Exports 25 percent to manufacturing sector exports Contribution to Employment 75 percent of private sector employment 99 percent of non-agricultural sector employment Absorb 78 percent of non-agricultural workforce -- Accounts for ~25 percent of total employment Jordan ~50 percent of GDP 45 percent of exports 60 percent of the workforce and 70 percent of new job opportunities Morocco ~38 percent of GDP, 40 percent of production, and 30 percent of exports 50 percent of population 50 percent of investment Tunisia 51 percent of GDP percent of employment Yemen Iraq Lebanon Over 99 percent of GDP percent of employment generated Note: (--) signifies data is unavailable;(*) Includes contribution of microenterprises

13 SME SECTOR OVERVIEW 13 In Egypt and Lebanon, SMEs are important contributors to GDP (accounting for 80 percent and 99 percent of GDP, respectively). In Pakistan, Morocco, and Tunisia, the SME contribution is lower, but significant (38 percent to 51 percent of GDP). In addition to their GDP contribution, SMEs are the largest job creators in the formal and informal sectors. Except for Saudi Arabia, SMEs employ more than 50 percent of the working population across the countries. In Egypt, for example, they account for almost 99 percent of the employment in the non-agricultural sector and 75 percent of private sector employment. As SMEs are less capital intensive and high employment generators, they can play an important role in the economic development of Middle Eastern countries such as Morocco, Lebanon, and Tunisia, which have a sizable unemployed youth population. This is also true for vulnerable countries such as Yemen and Iraq. Figure 3 : SME Contribution to GDP Note: Statistics on the contribution of SMEs to the economies of Yemen and Iraq are unavailable Besides contributing to GDP and employment, SMEs are instrumental in promoting investments (in Morocco), increasing per capita income (in Iraq), and ensuring economic diversification (in Yemen). Given their important role in economic development, governments in the Middle East and North Africa (MENA) and Pakistan should work to identify and promote various factors/ enablers for the development of the SME sector. Policies targeting these factors/enablers need to be formulated for the long-term development of the SME sector. In most countries, SMEs are concentrated in the trading sector, which primarily comprises retail and wholesale establishments, and the services sector. The main reason for this concentration pattern is the low capital intensity, limited skill requirements, and the ease of establishment of these enterprises. Other sectors with a high representation of SMEs include the manufacturing and construction sectors. However, in most cases, the concentration of SMEs in these sectors is low due to the high capital intensity and complexity of operations. Financial, regulatory, and infrastructural factors prevent SMEs from entering and operating effectively in these complex, capital-intensive sectors. Thus, there is a need for cooperation among

14 14 EXECUTIVE SUMMARY government, private, and multilateral agencies to frame and execute strategies that would ensure growing SME participation in these sectors. Greater SME participation in these sectors would help combat poverty, low per capita income, and unemployment, which these countries suffer from. Table 3 : SME Distribution by Sector Please note no SME statistics on Iraq are available Key Enablers for SME Growth As already outlined in several IFC studies, there are a number of key enablers that contribute to the development of a country s SME sector. These enablers are macro-level factors related to political and economic stability, sound infrastructure, a transparent governance structure, and access to finance. The development of a country s SME sector would be limited in the absence of any of these factors, as each has a unique role to play. Governments should, therefore, recognize such linkages and take measures to develop these factors. The table below provides an overview of the current state of the enabling factors across countries. Most of the countries lack a conducive, enabling environment for SME growth owing to which the sector is unable to emerge from its low growth spiral.

15 SME SECTOR OVERVIEW 15 Table 4 : SME Enablers by Country Parameter Countries Political Stability Economic Conditions Corruption Infrastructure Regulatory Environment Access to Finance Egypt Fragile Low High Medium Poor Low Pakistan Semi stable Low High Low Strong Low Saudi Arabia Stable Medium Low High Strong Low Jordan Stable Medium Low High Strong Medium Morocco Semi stable Medium Medium Medium Strong High Tunisia Semi stable Medium Low High Strong Medium Yemen Fragile Low High Low Poor High Iraq Fragile High High Low Poor Low Lebanon Semi stable Low High Low Poor Medium Politically, Yemen and Iraq will continue to be impacted by factors that will affect SME prospects. In the case of other countries, the SME sector is expected to be well insulated from such factors. Economically, SMEs in Saudi Arabia, Jordan, Morocco, and Tunisia can expect a stable economic environment; while there will be risks to the economy in Lebanon, Pakistan, and Egypt in the short term. With the exception of Saudi Arabia, Jordan, and Tunisia, corruption and poor infrastructure will be key problems facing SME operations across the remainder of the countries. The regulatory environment across Yemen, Iraq, Lebanon, and Egypt is weak and likely to affect long-term growth prospects of the SME sector. Thus, there are significant lessons that these countries could learn and emulate from their neighbors such as Saudi Arabia, Morocco, Tunisia, and Jordan. In terms of access to finance, apart from Yemen and Tunisia, other countries have a long way to go to ensure financial inclusiveness among SMEs. Key Challenges for SMEs SMEs in general face a number of challenges despite the assistance provided by government and multilateral agencies. These challenges are faced during each phase of development and generally are internal (lack of managerial expertise among proprietors) and external (inadequate access to finance, government inefficiencies, and infrastructural concerns). Figure 4 : Key Challenges Faced by SMEs During Their Evolution Phases

16 16 EXECUTIVE SUMMARY Challenges faced by SMEs vary across countries due to differences in the level of development, degree of human development, efficiency of governance, and the political situation in the respective countries. There exist several common challenges, such as the lack of a well-trained workforce, poor infrastructure, corruption, and bureaucratic hurdles. The biggest challenge, however, is access to finance. SMEs at various stages of development face severe challenges when accessing finance. Concerns include prohibitive interest rates, high collateral rates, and procedural hurdles in applying for a loan. This is despite the fact that there are government-supported finance schemes, incubators, and venture capital funds to finance SMEs across various countries. Figure 5 : Challenges Faced by SMEs Across Countries The chart below (Fig.6) outlines the major constraints facing SMEs across the various countries. SMEs in Egypt, Lebanon, Yemen, and Iraq are facing numerous challenges with respect to political factors, economic conditions, the regulatory environment, and infrastructure. Unless these constraints are remedied, it is unlikely that the SME sector will witness strong growth in these countries. In the countries of Pakistan, Morocco, and Tunisia, the operating environment is less challenging with SMEs operating more efficiently. However, infrastructural and transparency issues in these countries must be addressed if the SME sector is to reach its full potential. Jordan and the Kingdom of Saudi Arabia (KSA) are relatively well placed as they have sound infrastructure, a strong regulatory environment, and low levels of corruption. But SMEs operating in these countries have issues accessing finance, which is a very critical growth component.

17 SME SECTOR OVERVIEW 17 Figure 6 : Major Constraints Faced by Businesses Source: Cumulative rankings based on the evaluation and analysis of key factors that are likely to impact SME growth Government Initiatives to Support SME Growth A country s government has a very important role to play in the development of its SME sector by providing both financial and non-financial support to promote SMEs. Financial support generally includes credit guarantee schemes, collateral waivers or reduction policies, and provisions of seed capital. Nonfinancial support includes capacity building through training programs, improvement in competitiveness through quality improvement initiatives, business incubation centers, and business development assistance through export development programs.

18 18 EXECUTIVE SUMMARY Table 5: Government Initiatives to Support SME Growth Countries Financial Support Programs/Agencies SME Development Organizations Egypt Pakistan Saudi Arabia Social Fund for Development SME Bank Khushhali Bank SME Business Support Fund Saudi Credit and Savings Bank Saudi Industrial Development Fund (Kafalah program) Prince Sultan bin Abdul Aziz Fund to Support Women s Small Enterprises Centennial Fund Industrial Modernization Centre Egypt Technology Transfer and Innovation Centers Industrial Development Authority National Suppliers Development Program Ministry of Investment/General Authority for Investment Small and Medium Enterprise Development Authority (SMEDA) Trade Development Authority of Pakistan Ministry of Science and Technology Pakistan Software Export Board Pakistan Horticulture Export Board National Productivity Organization National Competitiveness Center Ministry of Economy and Planning Saudi Arabia Monetary Agency Human Resource Development Fund Jordan Morocco Tunisia Yemen Iraq Lebanon Jordan Loan Guarantee Corporation Governorates Development Fund Development and Employment Fun Central Guarantee Fund Fund for the Promotion and Industrial Decentralization Tunisian Guarantee Company Société d investissement en capital à risqué (Risk Capital Fund) Banque de Financement des Petites et Moyennes (Bank for financing small and medium enterprises) Small Enterprise Development Fund Small and Micro Enterprise Development Ministry of Labor and Social Affairs Ministry of Industry and Minerals Economic and Social Fund for Development Kafalat loan guarantee Jordan Enterprise Development Corporation National Fund for Enterprise Support Vocational Training Corporation National Association of Small and Medium Enterprises The Office of Vocational Training and Employment Promotion National Agency for Promotion of Jobs and Skills The Agency for the Promotion of Industry and Innovation The Centre de Soutien à la Création d Entreprises (Support center for business creation) Centres d Affaire (business centers) Bureau de Mise à Niveau Social Fund for Development / Small and Microenterprises Promotion Agency Ministry of Agriculture Ministry of Technical and Vocational Training Ministry of Fisheries Ministry of Tourism The Ministry of Economy and Trade (SME support unit) Euro-Lebanese Centre for Industrial Modernization Ministry of Education Ministry of Finance

19 SME SECTOR OVERVIEW 19 World Bank Group Initiatives to Support SME Growth IFC has several programs targeting the development of the SME sector. This includes both investment and advisory services to banks and to SMEs directly. IFC has provided assistance to commercial banks for setting up SME banking operations. It has also assisted in establishing financial infrastructure, such as credit bureaus and provided specific credit lines, risk sharing, and trade finance facilities targeting SMEs. IFC has also provided training and awareness raising programs for SMEs. Table 6 : IFC Initiatives to Support Access to Finance for SMEs Countries Egypt Pakistan IFC Egyptian Junior Business Association: Helped train SMEs on corporate governance standards Alexandria Business Association: Assessed business environment and advocated regulatory reforms 2012 (Bank Alfalah): Capacity Building for SME Banking (HBL Bank): Capacity Building for SME Banking and Agri Finance 2009 (Standard Chartered Saadiq): Launched pilot program for SME training 2009 (United Bank Limited): Boosted SME trade finance Saudi Arabia 2011 (Saudi Hollandi Bank): Capacity building for SME Banking 2010 (Saudi Orix Leasing Company): Invested $20 million to expand sustainable energy financing and increase access to finance 2005 (Riyad Bank): Capacity building for SME Banking. Non Financial Advisory Services (Ahli Bank): Assisted SMEs in acquiring skills for business expansion and job creation 2009: Supported leasing legislation and promoted leasing awareness Jordan 2006: Worked with government to streamline licensing and inspection process Assisted government in establishing a private credit bureau industry Raised awareness in the banking sector regarding sustainable energy financing, opportunities targeting women, low-income households, and environment-friendly initiatives 2012 (Banque Centrale Populaire): Invested $204 million to acquire 5% stake to improve access to credit for SMEs 2011 (Moroccan Female Entrepreneurs Association): Promoted alternative dispute resolution among women entrepreneurs Morocco 2011 (Maghreb Private Equity Fund): Set up fund to invest in SMEs in Tunisia, Morocco, Algeria, Libya, and Egypt 2007 (Al Amana): Improved credit operations and followed a sustained growth path Established fund to invest $150 million annually over the next three years in SMEs, agribusinesses, IT, and high value-added businesses 2013 (Amen Bank): Agreement between IFC and two funds managed by IFC Asset Management Company to invest up to $48 million to help bank increase lending Tunisia (Maghreb Private Equity Fund III): A $22 million commitment to provide guidance and financial support to SMEs across North Africa 2012 (Amen Bank): Offered guarantees to assist Tunisian companies increase cross-border trade 2011 (The Arab Institute of Entrepreneurs): Helped promote sound corporate governance practices

20 20 EXECUTIVE SUMMARY Countries IFC 2010 (Al Amal Microfinance Bank): Strengthened technical capacity by focusing on product development and finance Yemen Trained 5,100 people in Yemen using Business Edge Played important role in framing new laws to improve business climate Channeling private investments in the infrastructure sector through launch of various initiatives, including the Middle East and North Africa SME Facility, the Arab Financing Facility for Infrastructure, the e4e Initiative for Arab Youth, and the MENA Fund To invest $ million annually over the next few years in the private sector (includes SMEs) in banking, telecommunications, construction, logistics, hospitality, and manufacturing Iraq : Launched $38 million facility to support financial infrastructure strengthening, capacity building of the banking/sme sector, bank risk management, SME management training (for women), and promotion of Public Private Partnerships (PPP) 2012 (Relief International): Scaled up outreach to SMEs in Iraq : Total commitment over $737 million, including $150 million for local banks to facilitate lending to SMEs Provided over $1 billion in trade guarantees to banks and financial institutions to facilitate global export and import trade Lebanon 2011 (BLC Bank): Designed and launched products, specifically for SMEs and women-owned business 2007: Collaborated with World Bank and pledged $ million through the Lebanon Rebuild Program 2007 (Bank of Beirut): Set up SME risk-sharing facility worth $25 million 2007 (Fransabank): $50 million project to establish an SME risk-sharing and corporate credit line 2007 (Société Financière du Liban): Feasibility study for establishment of private credit bureau Supported Central Bank of Lebanon in encouraging banks to strengthen SME setup

21 FINANCIAL SECTOR OVERVIEW Financial Sector Overview The commercial banking sector across most countries witnessed stronggrowth despite the financial crisis. The Islamic banking sector has, however, been more resilient due to prudent practices and the rising preference for Islamic banking services among the resident population. The growth in Islamic banking has also been supported by government initiatives aimed at enhancing the penetration of banking services. Overall SME lending by banks has been gradually rising across most countries in recent years, but the situation is still far from perfect. Banking Penetration The banking sector across the countries is in different stages of market maturity. Although countries such as Lebanon have a well-established, competitive banking structure, nations such as Iraq have a small, underdeveloped banking system that would mature only in the long term. In developed countries such as Lebanon, Jordan, and Morocco, the evolution of banking began early. Jordan s banking sector emerged in 1925, while the Moroccan banking system dates back to the 18th century. Lebanon was a late entrant; the country emerged as a financial hub during In these countries, the common factor aiding the banking sector s growth was the government s liberalization of the sector, which led to competition and the gradual sophistication within the sector. In countries such as Tunisia, Pakistan, and Saudi Arabia, the banking sector s inception and growth has been relatively late. Additionally, the banking sector s development in these countries has been affected periodically by unhealthy competition (Pakistan), economic turmoil (Saudi Arabia), and political interference (Tunisia).

22 22 EXECUTIVE SUMMARY Countries such as Yemen and Iraq have underdeveloped banking sectors characterized by low branch penetration and lack of a credit culture among the population. Historically, the banking sector in Yemen and Iraq has been underdeveloped as the poor regulatory framework and limited competition has stunted its growth. Political turmoil added to the woes, limiting the sector s development. Figure 7 : Banking Penetration Across Countries Commercial Banking Sector The commercial banking sector across the countries is generally concentrated with the largest players accounting for most assets and deposits. However, despite high concentration, the commercial banking sector is competitive, with large players making consistent efforts to increase market share. This has led to product innovation, expansion of branch networks, and greater financial inclusion.

23 FINANCIAL SECTOR OVERVIEW 23 Table 7 : Commercial Banking Sector Overview

24 24 EXECUTIVE SUMMARY After the global economic downturn, most Middle East and North Africa (MENA) countries initiated regulatory reforms to strengthen the banking sector. This resulted in a strong growth in depository base and financing activity within banks in MENA countries. Most countries in the region witnessed strong growth in the banking system in recent years. Iraq witnessed the highest growth in the region (loans grew 104 percent and deposits increased 24 percent during ), along with Lebanon, Jordan, and Saudi Arabia. Other countries in the region witnessed high single-digit growth in the banking sector. However, the Arab Spring and the resulting political and economic uncertainties have impacted the short-term growth of the region s banking sector. Figure 8 : Loan and Deposit Growth Across Countries ( ) Note: The figures in the box represent the Compounded annual growth rate (CAGR) for the period

25 FINANCIAL SECTOR OVERVIEW 25 Islamic Banking Sector Islamic banking has not developed uniformly across MENA countries, as its inception and development across the countries occurred at different points of time in history. For example, Egypt was the birthplace of Islamic banking, with the first Islamic bank beginning operations in On the other hand, in Morocco and Lebanon, Islamic banking has just begun to emerge, with the recent government authorization of Islamic banking operations. Egypt s first-mover advantage, however, did not lead to the sector s rapid growth and development. Despite an early introduction of Islamic banking, Egypt has witnessed muted growth over the years. In contrast, Pakistan and Saudi Arabia, which introduced Islamic banking later, witnessed strong growth over the years. Jordan, Yemen, Iraq, and Tunisia introduced Islamic banking in the 1970s and 1980s; however, the lack of government support in the past to promote Islamic banking has affected growth prospects. In recent years, most countries in the region saw the establishment of new Islamic banks. Morocco and Tunisia have initiated steps to establish and expand Islamic banking activities. In addition to government support, the growth of Islamic banking in these countries has been aided by strong positive perception for Shariah-compliant banking among the people of MENA and Pakistan. Figure 9 : Islamic Banking Market Overview In the last few years, most MENA countries (including Pakistan)have witnessed an expansion in Islamic banking activity. All countries in the region witnessed strong growth in Islamic deposits and financing activities, except Yemen, which was impacted by political instability and a deteriorating economic environment, especially after the Arab Spring.

26 26 EXECUTIVE SUMMARY Figure 10 : Islamic Assets and Deposits Growth ( ) Note: The figures in the box represent the CAGR for the period Please note that in the left hand charts figures for Egypt. Pakistan and Tunisia represent total Islamic assets while for the remainder of the countries it represents total financing

27 FINANCIAL SECTOR OVERVIEW 27 SME Sector The banking sector (Islamic and conventional) has been able to meet some of the needs of the SME sector. Despite the expansion in banking operations and the corresponding growth of loans and deposits, SMEs still remain underfunded. The lack of penetration of the SME sector is due to demand- and supply-side factors (explained later in the report). Table 8 : Banking Penetration in SME Sector (2012) Egypt Pakistan Saudi Arabia Jordan Banks lending to private sector ($bn) SME lending as % of total lending Total SME lending ($bn) Total SME deposits ($bn) ** Conventional % Islamic % Conventional % Islamic % Conventional % Islamic % Conventional % Islamic 5.1 7% Morocco Conventional % Tunisia Conventional % Yemen Conventional % Iraq* Conventional 9.4 5% Lebanon Conventional % Data for selected countries is unavailable * For Iraq, the data is for 2010 The ability of banks to meet the financing needs of the SME sector represents a mixed picture. While Morocco, Lebanon, Egypt, and Saudi Arabia have witnessed a strong increase in lending to the SME sector, in the case of other countries (Jordan, Tunisia, and Iraq) SME lending has been more muted due to a number of reasons (lack of focus, a weak banking system, and a fragile political environment respectively).

28 28 EXECUTIVE SUMMARY Table 9 : Trend in SME Portfolio Growth Country Egypt Pakistan Saudi Arabia Jordan Morocco Tunisia Yemen Iraq* Lebanon Rising Declining Rising Stagnant Rising Stagnant Declining Stagnant Rising SME Portfolio Growth Lending to SMEs by Egyptian banks has increased at a CAGR of 10.4 percent over Yet, the proportion of SME loans to the total outstanding loans by banks has remained in the range of 7-8 percent during this period. Of the 26 banks operating in the country, 17 operate a separate SME business unit. However, of these only 9 banks offer adequate SME products. Lending by banks to the SME sector has declined at a compounded rate of 8.5 percent over largely due to an increase in the non-performing loan (NPL) rate for the sector. As a result, banks have become more cautious in financing SMEs, instead diverting funds to safer investment opportunities. Thus, the SME lending penetration rate also declined from 10.3 percent in 2009 to 6.8 percent in Although the SME lending penetration rate in the KSA is only ~2 percent, there is greater impetus on SME financing by banks, supported by the Shariah-compliant Kafalah program (a financing guarantee program for SMEs). Hence, SME financing by banks has increased at a CAGR of 23 percent during the period of A large part of this growth has been driven by Shariah-compliant financing (backed by the Kafalah program), which has increased at a CAGR of 28.4 percent during this period. Although lending by banks to the private sector has increased over the years, disbursements to the SME sector has remained conservative, with 12.5 percent of the total loans being directed toward this sector. This is mainly due to less risky and more profitable investment avenues available to banks in the form of corporate or government lending. Although credit disbursements by banks to the SME sector has only increased at a CAGR of 7.7 percent for the period of , the SME penetration rate in the country stands at 24 percent, much higher than the MENA average of 7.6 percent. The higher penetration rate has been on account of proactive measures implemented by the government through the National Association of Small and Medium Enterprises (ANPME) that not only encourage SMEs but also facilitates financial access to these enterprises. The SME lending rate in Tunisia, which is 15.3 percent, is comparatively higher than the MENA average of 7.6 percent. Yet, growth of lending to the sector has been slow, increasing at a CAGR of 6.5 percent during the period of However, this slow growth is largely a result of problems plaguing the banking sector as a whole, such as weak corporate governance and efficiency standards and a high NPL rate. Yemen s private sector predominantly consists of SMEs. As a result, any increase in lending to the private sector positively impacts financial access to SMEs. However, credit disbursements to private enterprises have been declining over the years, from 43 percent in 2009 to 30 percent in SME lending penetration in Iraq has been stagnant at around 5 percent in the last few years. Although there has been a lot of activity in terms of providing financial access to SMEs, the banking institutions in Iraq have been reluctant to advance financing to them because this sector is considered to be highly risky. SME lending penetration rate in Lebanon is currently at percent. This is expected to increase as banks reduce exposure to government debts and instead divert these funds to the private sector.

29 FINANCIAL SECTOR OVERVIEW 29 Non-performing Loans Financial institutions in MENA have always adopted a cautious lending approach. Therefore, asset quality of conventional and Islamic banks has remained strong. Although countries such as Egypt, Yemen, and Tunisia have a NPL ratio of 11 percent to 18 percent, it has been declining over the last few years due to the adoption of better risk management policies and improved banking infrastructure. The rise in banking sector NPLs resulted from the Arab Spring and the effects of the financial crisis. Both factors affected the repayment capacities of the private sector, leading to a high rate of NPLs. The problem was exacerbated by the existing weak economic and political conditions in Egypt, Jordan, and Yemen. In addition to political and economic factors, a poor regulatory (Tunisia) and business environment (Pakistan) contributed to the rise in NPLs. There is a disparity between the NPLs of the conventional and Islamic banking sectors. The NPLs of Islamic banks have traditionally been lower than those of conventional banks as they are more prudent with regard to lending to various sectors. Figure 11 : NPL Overview Please note that in Egypt data on the Islamic banking sector is unavailable The growth of NPLs in the financial sector presents an opportunity to establish credit bureaus in such countries for capturing and disseminating credit-related data to financial institutions and other lenders.

30 30 EXECUTIVE SUMMARY Islamic Financial Sector Regulations and Enabling Environment Although central banks in MENA have proactively regulated the banking sector following the global financial crisis, great disparity exists across the countries in terms of quality and implementation of reforms. Regulatory authorities in these countries have initiated reforms and amended existing banking laws to include specific regulations for Islamic banks. However, most of these countries, such as Egypt, Tunisia, Morocco, Lebanon, and Iraq, are still developing separate laws on Islamic banking. Table 10 : Regulatory overview Country State of Regulations Banking Sector Islamic Banking SME Egypt Well defined Inception Non existent Pakistan Well defined Well defined Well defined Saudi Arabia Well defined Transitional Transitional Jordan Well defined Transitional Non existent Morocco Transitional Inception Non existent Tunisia Transitional Inception Non existent Yemen Transitional Transitional Non existent Iraq Inception Inception Non existent Lebanon Well defined Inception Non existent In addition to prudent regulations, government initiatives across countries have been instrumental in promoting Islamic banking. Initiatives include the issue of guidelines, instructions, and bonds, among others, to enhance the depth and ensure faster maturity and development of the Islamic banking sector. Table 11: Islamic Banking Initiatives Country Islamic Banking Initiatives Actions Stage Government has not taken any recent initiative to promote Islamic banking Strategic five-year development plan Issuance of sovereign Sukuk, incentivization for bank expansion Issue of Islamic SME finance handbook Issue of guidelines and prudential regulations

31 FINANCIAL SECTOR OVERVIEW 31 Country Islamic Banking Initiatives Development of Islamic SME financing Sukuk issue to promote development of capital market Separate authority for SME sector promotion IFC and Islamic Corporation for the Development of the Private Sector (ICD) initiatives New Islamic banking licenses Shariah-compliant loan guarantee program initiated by Jordan Loan Guarantee Corporation (JLGC) Jordan Enterprise Development Corporation (JEDCO) involved in increasing Islamic financing for SMEs Submitted draft for Islamic banking and insurance regulations Setting up $1 billion integrated Islamic investment platform 2013 Sukuk issuance and potential finance deal with Islamic Development Bank (IDB) Favorable tax regime Proposal to allow conventional banks to operate Islamic windows Expansion of Shariah-compliant products and expected increase in competition Government has not taken any recent initiative to promote Islamic banking Preparing draft of the Islamic Banking Law Education and awareness programs Effective risk management and accounting practices

32 32 EXECUTIVE SUMMARY 04. SME Access to Islamic Finance Access to finance for SMEs is hindered because of their informal nature and poorly structured operations. Another factor for this lack of access is the limited capacity of banks to capture this opportunity through an appropriate product proposition and process framework. SME Penetration Despite the existence of a reasonably well-developed banking (conventional and Islamic) sector, small and medium enterprises (SMEs) have typically remained underfunded. The low penetration is due to demand- and supply- side factors that prevent SMEs from accessing financing through formal channels. SMEs across the region cite high interest rates, cumbersome procedures and collateral requirements, as the primary impediments to accessing financing from formal institutions. Furthermore, many financial institutions do not have products customized to meet the needs of the SME sector.

33 SME ACCESS TO ISLAMIC FINANCE 33 Figure 12 : SME Sector Existing Penetration Obstacles Faced by Banks in SME Financing SMEs lack managerial capabilities to manage businesses effectively. This leads to an inefficient operations structure, weak financial reporting, and unviable operations (high debt). In addition, SMEs mostly operate in the informal sector. Hence, banks are reluctant to lend to SMEs and perceive them as risky investments. Although already highlighted in several IFC studies, it is still worth noting significant factors that affect the supply of finance to the SME sector. Factors include SME-specific problems (lack of a proper business structure), as well as issues faced by banks in servicing the SME sector (lack of capacity to lend to SMEs). Problems restricting access to finance are unique to each country, but several common themes underline these problems. Multilateral agencies should, therefore, partner with government and private stakeholders to train SMEs on efficient management of businesses (e.g., IFC Business Edge). This would increase their viability in the long run and make them more palatable for bank lending. Most banks lack capabilities to lend to the SME sector. This could include inadequate processes, lack of SME-specific products (especially Islamic products), untrained staff, and insufficient outreach. The significant risks involved together with high costs of transactions/servicing the

34 34 EXECUTIVE SUMMARY SME customer also deter banks from targeting the SME sector. Because of these institutional gaps, banks tend to focus on emerging and medium-sized businesses and corporations, which are safer investments than SMEs, and banks already possess the capabilities to lend to these businesses effectively. Multilateral institutions and other agencies need to assist banks to enhance institutional capabilities through staff training and introducing SME-specific products. Banks would then be able to screen SMEs better for lending, thus increasing credit flow to them. Lack of information on SMEs is another problem faced by banks across countries. The lack of a credit bureau with adequate information on SMEs is a significant hurdle preventing banks from lending to them. The problem presents a significant opportunity to develop an exhaustive database on SMEs, which would plug information gaps and lead to increased supply of finance to the SME sector. Figure 13 : Obstacles Faced in SME Financing Supply Side Analysis of Banks in the Region A comprehensive survey of more than 160 banks (out of the total +270 banks) in MENA reveals that they are currently ill equipped to handle the SME business. The survey revealed that, in total, only 36 percent of the surveyed banks demonstrated readiness for an effective SME proposition that is built on sound branding and marketing strategies, along with a product portfolio suited to meet the needs of the SME sector. Among banks offering Islamic products to SMEs, only 17 percent have the marketing, product and operational capabilities to effectively serve the requirements of the Islamic SME banking sector.