Micro, small and medium enterprises (MSMEs) referred to as the “backbone of the economy” due to their significant contribution in employment creation and national GDP, continue to face severe difficulties in accessing credit from the banking system. Mainstream financial intermediaries often view them as inadequately capitalized, lacking in collateral, led by inexperienced management or operators and thus too risky to provide credit. In cases where credit is offered, it comes with a high cost to MSMEs.
Due to shortfalls in the banking system, government and non-government entities have taken initiatives to support the development and growth of MSMEs. One area of such support is access to credit as collateral seems to be the only barrier. This is achieved through the establishment of a Credit Guarantee Scheme (CGS). It is estimated that there are over 2,000 CGS in almost 100 countries, as reported by the World Bank.
Role and Benefits of Credit Guarantee Scheme
CGS acts as a third-party intermediary risk sharer and facilitator between a bank and MSME seeking financing. According to the World Bank, ‘CGS provides third-party credit risk mitigation to lenders (financiers) through the absorption of a portion of lender’s losses on the loans (credit facilities) made to SMEs in case of a default, typically in return for a fee.’
CGS has shown enormous potential to positively contribute towards increasing access to credit for MSMEs especially in a professional (non-politicised) institutional environment. However, CGS has been criticised on several counts such as higher costs of credit due to the guaranteeing party’s administration costs, increased danger of moral hazard and turn-around time, being subsidy-dependent, and the weakening of credit discipline.
Shari’a Concerns on existing Credit Guarantee Schemes
CGS is not only important for MSMEs to access finance, but also to issuers of Islamic bonds (sukuk). According to Reuters, the demand for credit guarantee is gaining attraction for the issuers of sukuk in markets where credit and political risks pose a greater challenge. For example, the Danajamin Nasional Berhad in Malaysia, GuarantCo and the Britain export credit agency have at different times issued a guarantee to facilitate Islamic bonds, particularly corporate sukuk.
But were these Shari’a-compliant guarantees? What are the Shari’a concerns associated with the conventional credit guarantee schemes? In order to understand the Shari’a concerns, we have to examine the designs and associated elements of CGS. While most designs take into account several elements, below are only three of them.
- Risk Sharing: While there are some CGSs that provide 100% coverage, majority provides guarantee coverage in the range between 60% and 80%, so that the credit risk is shared between the financier, customer and guarantor. This partial coverage is highly recommended as it limits moral hazards from the financier and the customer. However, there are Shari’a concerns with regards to the terms of contractual agreement designed to achieve this. Existing guarantees have been drafted conventionally by observing only the country’s laws rather than the Shari’a requirements. Thus, unless the agreement is crafted by avoiding invalidating factors of a contract from a Shari’a perspective, the whole guarantee design will not be suitable for Islamic financial institutions or issuers of sukuk.
- Fees: In order to meet administrative costs and become sustainable, CGS usually charge specific fees. While the fees can differ from one CGS to another, a registration fee for processing the application is a common requirement. According to a discussion paper on CGS published by OECD, the fee is 1% of the loan amount in Europe and other developing countries. Other fees might include an annual or per-loan fee of 1% to 2% as well as membership fees. These fees are largely paid by borrowers and a portion by financial institutions receiving the guarantees.
Charging fees to customers for the guarantees is deemed impermissible in classical Shari’a schools of thought. However, there are divergent opinions among contemporary Shari’a scholars on charging fees due to the commercial nature in which these guarantees are requested by the beneficiary. However, some scholars don’t allow them, while others allow some of these fees with certain restrictions and modifications. Thus, unless the types of fees and the manner in which they are imposed are thoroughly evaluated and modified, participation in CGS with above fees becomes repugnant to Shari’a.
- Risk management: Majority of CGS use risk management tools such as reinsurance, loan sales or portfolio securitization. While Shari’a recognises the need to manage risks, the above mechanisms are problematic in Shari’a. Thus, risk management mechanisms should also consider Shari’a-compliant requirements.
Shari’a-Compliant Alternatives
Three models can be considered to structure CGS that satisfy the Shari’a requirements.
- Takaful Insurance Model. At the corporate level, this model was adopted by the Islamic Corporation for Insurance of Investment and Export Credit (ICIEC). It can also be in the form of mutual credit guarantee whereby associations, groups or individuals come together in order to assist each other in the provision of guarantee to fellow members.
- Islamic Social Finance Model. Islamic social finance contracts are employed to design the scheme. This ranges from using sadaqa or waqf or a combination of these contracts.
- Partnership Model. This involves a guarantor partnering with Islamic financial institution to share profit or loss from financing MSME clients.
In conclusion, CGS is becoming popular in both Muslim and non-Muslim countries and are thus beneficial to various business segments that lack access to finance due to a lack of collaterals or political risks, among others. Unfortunately, the conventional CGS fall short to attract partnerships with Islamic financial institutions due to the Shari’a concerns highlighted above. To resolve these concerns, we must pay attention to CGS designs and its elements, and adopt or design appropriate Shari’a-compliant models.
“It is estimated that there are over 2,000 CGS in almost 100 countries, as reported by the World Bank.”
