Islamic Finance and Entrepreneurship: Challenges and Opportunities Ahead

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.

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