1.1 Introduction and Background
This paper examines the performance of Islamic mode of financing and conventional mode of financing in Pakistan for SMEs (Small and Medium enterprises). This study is carried out on the clients of one Islamic Banks and conventional Banks located in Peshawar. In order to this, it first of all discusses the history and emergence of Islamic banking System and conventional Banking System in the world as well in Pakistan. Then shortly differentiates Islamic mode of financing and conventional mode of financing that are mainly based on Islamic Shariah law and beneficiary for the clients. Islamic financing system is based on Shariah principles. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional.’[1]
It demonstrates the features of products and contracts between the parties involved in investment. It then examines its impact on SMEs. Islamic banks providing Interest free finance for the small and medium enterprises while Conventional Bank Providing finance based on Interest. Easy access to external finance is an effective tool for the growth of business.
It also highlights impact of Islamic and Conventional mode of financing on SMEs, on the basis of 40 respondents view. The paper ends with suggestion and recommendations for further improvement.
1.2 Statement of the problem
Access to finance is counted the first barrier for the growth of SMEs. Entrepreneurs need less risky and trouble-free external finance to execute their financial needs. Failure of repayment some times cases liquidation of business. This is a main problem of this study.
1.3 Significance/importance of study
SMEs have potential providing employment, generation of income, poverty alleviation and economic development of the country. This study discusses the role of SMEs for the country, there access to finance, and highlights some feed back from entrepreneurs in the analysis of data. This will be helpful for to know about the SMEs what type of finance should use.
This study will diminish the gape between the conventional financing system and Islamic financing system, by highlighting the features of products and discussing its impact on SMEs growth.
It discusses about different products of financing of Islamic and conventional system entrepreneur will find suitable financing product for his business. It is important to distinguish between Islamic mode of financing and Conventional mode of financing for the financier as well as for the fiancée.
This study is helpful for the student and others to know the main differences between the conventional and Islamic mode of financing, and products.
1.4 Population and sampling
Sampling Method
On the basis of systematic sampling initially Islamic and conventional banks were selected. Then 4 Banks were selected two Islamic banks and two conventional Banks. Then two type of questionnaire designed one for the Islamic financial instrument users, and the second is for the Conventional financial instrument users. Collectively these were 40 questioners, 20 for Islamic financial instrument users and 20 for conventional financial instrument users. The sample was selected keeping in view the following criterion.
Sample Size
The important aspect in the qualitative and quantitative research is to determine “Who will be questioned /interviewed”. As the study was mainly related to the SMEs or entrepreneurs that is an area of interests of both Islamic financial Instrument users and Conventional Financial Instrument user are included equally in this study. So the total sample size of this study is 40 (20 Islamic instrument users, 20 conventional instrument users each) questionnaires.
Population Size
The population for this study is defined as the entire SMEs (entrepreneur) sector that has access to conventional or Islamic system of financing to finance their business. The study was conducted in the capital area of NWFP, and the Cantonment area. Majorly it covers the SME sector and banking sector of Peshawar.
1.5 Purpose of Study
The purpose of this study is to comprehend the working of Islamic Banking system and conventional Banking system how it operates and what is its impact on SMEs. Instrument provide by both type of bank equally effects SMEs or not.
1.6 Objective of the study
1. The main purpose of the study is to analyze the Impact of mode of financing on SMEs Financed by Islamic Bank and Conventional Bank.
2. As the Islamic banks are new in Pakistan to understand the Islamic system of financing is also one of the objective of my study.
3. The second thing this study will discover that Conventional system of financing and Islamic system of financing has same effect on SMEs or not.
4. The analysis will come up with better recommendations and suggestions that can be implemented for the improvement function of SME financing of both types of banks. As well as will be helpful for SMEs.
1.7 Hypothesis
To achieve the objective mentioned above the two Hypothesis ware generated, one is alternate Hypothesis and other is Null Hypothesis. If the one will be accepted the other will automatically rejects.
H1: “The Islamic mode of financing, and conventional mode of financing have no equal impact on SMEs.”
The above-mentioned statement or hypothesis has an equal chance or likelihood of being proven correctly or positively and therefore this very hypothesis is the main core or backbone of this research report. The arguments in the sections to follow of the report will show whether or not the likelihood of H1 being proven as positive, are indeed accurate or not.
H0: “The Islamic mode of financing, and conventional mode of financing has equal impact on SMEs.”
This is the contradicting assumption, which opposes the notion or the main assumption of the study. Only the primary and secondary data collected from clients of Meezan Bank NIB Bank Emirates Global Islamic Bank and SME Bank in Peshawar and its cross section in the Analysis Section can prove or support the existence of this so called contradicting assumption.
1.8 Scope of Research
In order to Islamic banking system this study undertakes a detailed literature review to find the best practices in Islamic banking and the evolution through which Islamic banking has passed to get to where it is today. It focuses on the performance of the SMEs utilizing financing facility of Islamic banks and conventional Banks in Peshawar. The study ends by making recommendation on how to improve the program.
1.9 Methodology of the Research
The study was carried out by first of all reviewing Islamic bank literature by different eminent writers to understand the philosophy, background and best practice in the field of Islamic financing today. Some of the information about Islamic Financing and conventional Financing is taken form State Bank of Pakistan (specially SME Department), Meezan investment Bank, Emirates Global Islamic Bank, NIB (National Investment Bank), SME Bank and the work done by the Islamic scholars, published reports, research reports Books on Islamic Banking and Financing and conventional Banking and Financing. Wide range of discussions was held with the Management of Meezan Bank Islamic Bank (Sadder Branch), Emirates Global Islamic Bank (PDA Peshawar Branch) NIB (National Investment Bank) Hayatabad Branch, etc to gain further insights into its programme to financing SMEs. Field visits were made to the programme area of both types of Bank to see the operations of the programme and to collect primary data from clients.
Data used in this report is taken both from primary and secondary sources. For primary data collection purpose questionnaire distributed among the clients and also information collected through interviews.
1.10 Theoretical Framework
The dependent variable is SMEs growth and Development, which is the variable of primary interest, in which the variance is attempted to be explained by dependent variables of,
Islamic mode of Financing
Conventional mode of financing
Ø Short Term finance
Ø Short term Finance
Ø Long term Finance
Ø Leasing
The Islamic mode of financing is based on profit and loss shearing ratio and the conventional mode of financing is based on Interest.
So if the Profit and Loss shearing Ratio increases it means the less profit for SMEs and if the Ratio decreases it means the more profit for SMEs. This statement shows that there is Positive relationship between Profit and Loss shearing Ratio and the SMEs growth.
Same as if the Interest Rate increased by conventional bank it cases the decrease of Income of SME and if the Interest Rate decreases the net Income of SME increase it means there is positive relationship between Interest rate and the SME growth.
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
Conventional Banks
Financial institution using interest based system.
SMEs (Small and Medium Enterprises)
The SMEs in terms of employment generated as well as investment in productive assets. SMEDA's definition of SMEs is primarily based on the number of personnel employed in the enterprise. The secondary criteria for classification of the SMEs, is the value of productive assets employed in the enterprise.[ii]
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Micro enterprise development
In this paper micro enterprise development means that how Islamic Finance and conventional finance helps to increase the income from such enterprises. On the other hand we also see the business expenses consumption and saving of such respondents after they have utilized finance provided by Islamic Banks.
Mudaraba (Passive Partnership)
This is a contract between two parties; a capital owner and an investment manager. Profit is distributed between the two parties in accordance with the ratio that they agree upon at the time of the contract. Financial loss is borne by the capital owner; the loss to the manager being the opportunity cost of his own labor, which failed to generate any income for him.
Musharaka (Active Partnership)
This is similar to the Mudaraba, with the difference that in the case of Musharaka both partners participate in the management and provision of capital and also share in the profit and loss. Profits are distributed between partners in accordance with agreed ratios, but the loss must be distributed in proportion to the share of each in the total capital.
Diminishing Musharaka
This is a contract between a financer (bank) and a beneficiary in which the two agree to enter into a partnership to own an asset. As described above, but on the condition that the financier will gradually sell his share to the beneficiary at an agreed price and in accordance with an agreed schedule.
Musharaka (sale contract at a Profit Markup)
Under this contract, the client orders an Islamic bank to purchase for him a certain commodity at a specific cash price, promising to purchase such commodity from the bank once it has been bought, but at a deferred price, which includes an agreed upon profit margin called markup in favor of the bank.
Ijara (Leasing)
The subject matter in a leasing contract is the usufruct generated over time by an asset, such as machinery etc. this usufruct is sold to the lessee at a predetermined price. The lesser retains the ownership of the asset with all the rights as well as the responsibilities that go with ownership.
Conventional Banks also offering different types of financing facilities there are some Products of SMEs Bank are as follows.[iii]
Running Finance (Short Term Finance)
This product is offered by SME Bank to clear the short term financing needs of SMEs. And can be used to meet the working capital needs. Such as purchase of Raw materials semi finished goods etc. it is a short term loan for Three months minimum and Interest is been charged Kibor+ 4%
Medium Term Loan (Smart loan)
This is a term loan facility to be approved for a period up to three years and to be repaid in equal monthly installments. The existing SME Bank borrowers can also avail this facility.
The interest been charged Kibor + 8%
Long Term Finance (Asset Finance Loan)
It is long term secured loan to fill full the long term financing need of SMEs. Normally SME Bank provides facility for 1 to 4 years duration payable in flexible monthly installment. The interest rate is Kibor +4%.[iv]
References
[1] Hj Abdurrhman,Usd Hj Zahuruddin (2007) Retrieved from Zahuruddin.net [online 2,22,2007] www.zahurruddin.net/index2.php
[ii] SMEDA Pakistan(2005). “SME guide.” [Online] 2005. [Cited: 4 13, 2009.] www.smeda.org.pk/smeguide.
[iii] AIMS-uk.(2007) “An over view of Islamic mode of Financing”. AIMS-Uk. [Online] 2007. [Cited: 4 15, 2009.] www.learnIslamicFinance.com
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