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Around 35 per cent of SMEs in the MENA region are excluded from the formal banking sector because they are seeking shariah compliant products that are not readily available in the market, according to a new study by International Finance Corporation (IFC).
The study, which was carried out across nine countries, found a potential market gap of up to $13.2 billion for SME Islamic financing in the region.
Despite the rising demand for Islamic financing among SMEs, the study reported a gap in Shariah complaint offerings among regional lenders. Of the 36 per cent of banks in the MENA region that offer SME products, only 17 per cent offer Islamic options.
The study also noted a significant variation across countries; demand for Islamic banking is as high as 90 per cent in Saudi Arabia while falling low as four per cent in Lebanon.
A high level of risk aversion by banks, poor regulatory environments, differing perceptions of Islamic finance, and a lack of relevant products were found to be hindering the growth of Islamic SME banking.
"The Islamic banking industry is not adopting measures that would grow the market. They don't have a strategic outlook and there is a lack of product innovation," added Attiq ur Rehman, partner, Israa Capital.
The study was carried out in Iraq, Pakistan, Yemen, the Kingdom of Saudi Arabia, Egypt, Lebanon, Morocco, Tunisia and Jordan.
But figures are not widely different in other GCC countries, experts noted.
"What we see in Saudi will be applicable to the rest of the GCC region as markets are very similar in that sense," said Mouayed Makhlouf, regional director for IFC, MENA.
"But more importantly, the study reveals a significant, untapped new to bank' funding opportunity, as banks and other financial institutions lack adequate strategic focus on this segment to offer Shariah-compliant products. It also highlights the measures they need to take to overcome this."
The Islamic banking industry is expected to develop significantly over the next few years.
"Islamic banking has a compound annual growth rate of 15 per cent whereas conventional banking in these countries is not more than seven per cent," said Rehman.
"Islamic banking grew even during the crisis period of 2008 to 2010 when conventional banking slowed. It maintained that growth pattern after that as it saw a phenomenal growth in 2013."
Rehman attributed the growth in Islamic finance in the region to lower non-performing ratio (NPR) of loans compared to conventional banking.
"The reason is that there are real transaction and people's tendency to default is low because willful defaulters are less in Islamic banking as compared to conventional banking," he said.
Fuelled by economic growth in core Islamic financial markets, global Islamic banking assets are set to exceed $3.4 trillion by 2018 according to a report released earlier this year by Ernst & Young (EY).
EY's Global Islamic Banking Centre said the combined profits of Islamic banks broke the $10 billion mark for the first time at the end of 2013.