Missing Middle in SME Financing: How Islamic Finance Can Bridge the Gap

In the bustling markets of Jakarta, the sprawling workshops of Istanbul, and the entrepreneurial hubs of Lagos, small and medium-sized enterprises (SMEs) toil as the unsung heroes of economic development. They account for over 95% of all registered businesses globally. They provide more than 50% of jobs globally and contribute up to 35% of GDP in emerging economies, according to the World Bank. Yet, a silent crisis brews: many of these enterprises, which drive innovation and employment, remain starved for capital. This paradox, often referred to as the “missing middle,” is where SMEs are too large for microfinance and too small for corporate financing. In regions where Islamic finance holds sway, this gap is more than a financial inconvenience—it is a moral dilemma.

Islamic finance, with its principles of fairness, risk-sharing, and ethical investment, promises a remedy. Yet, despite its rapid growth—expected to exceed $4 trillion globally by 2025—Islamic finance has struggled to fully include SMEs. Addressing this gap isn’t just a market opportunity; it’s a necessity for realizing the socio-economic potential of Sharia-compliant finance. The question is, how can Islamic finance evolve to embrace SMEs and, in doing so, transform entire economies?

Dig deeper: How Is Islamic Finance Failing the Real Test?

The Anatomy of the Problem

Consider the plight of a mid-sized textile exporter in Bangladesh. They generate consistent revenue, employ dozens of workers, and have opportunities to scale their business. Yet, they lack the collateral required by Islamic banks for Musharakah (equity partnerships) or Murabaha (cost-plus financing). Banks, eager to minimize risk, often favor large corporations with extensive assets or micro-enterprises with straightforward needs. SMEs like the textile exporters, however, present too much uncertainty to justify significant investment, leaving them in a financial no-man’s land.

This isn’t merely an anecdote. Studies from the International Finance Corporation (IFC) show that the global SME financing gap is a staggering $5 trillion annually, and the problem is magnified in Muslim-majority nations. For Islamic financial institutions, risk aversion, combined with the operational costs of serving SMEs, has limited their engagement in this space. The result? A systemic exclusion of businesses that could otherwise catalyze economic growth.

Islamic Finance’s Unique Potential

Islamic finance, with its ethical principles, has a unique edge in addressing the missing middle. By emphasizing shared risk and profit rather than debt-based transactions, it offers models that naturally align with the needs of SMEs. However, these models need to be applied creatively and with a focus on accessibility.

Take Musharakah, for example. In this partnership-based contract, a bank and an SME jointly invest in a project, sharing profits and losses proportionally. This structure aligns well with the fluctuating nature of SME revenues. For instance, a furniture manufacturer in Kuala Lumpur might partner with an Islamic bank under Musharakah to expand their production line. Instead of being burdened with fixed repayments, they contribute a share of their profits, creating a symbiotic relationship. Yet, the widespread application of Musharakah is limited by the extensive due diligence it requires—a cost that many banks are unwilling to bear.

Another promising instrument is Murabaha, often used for asset financing. Imagine an SME in Egypt needing new equipment to automate their factory. Under a Murabaha agreement, the bank purchases the equipment and resells it to the SME at a marked-up price, payable in installments. This approach eliminates the uncertainty of traditional loans while providing SMEs with much-needed liquidity. Yet, Murabaha alone cannot fill the entire gap; it is often best suited for specific, short-term needs rather than broader growth strategies.

Lessons from Islamic Fintech

The rise of Islamic fintech offers a compelling way forward. Digital platforms can democratize access to finance by connecting SMEs with investors across borders. For example, platforms like Ethics in Southeast Asia and Blossom Finance in Indonesia use crowdfunding to pool investments from individuals eager to support Sharia-compliant ventures. These platforms have funded projects ranging from affordable housing developments to small-scale agricultural initiatives, proving that fintech can scale Islamic finance to meet the needs of SMEs.

Consider the case of a tech startup in Karachi that secured funding through an Islamic crowdfunding platform. Traditional banks deemed the venture too risky due to its lack of tangible assets, but individual investors recognized the growth potential. The startup’s success not only generated returns for its backers but also created jobs and contributed to the local economy. This is the kind of grassroots impact that Islamic finance should aim to replicate on a larger scale.

Overcoming Barriers

Despite these promising examples, barriers remain. Risk management is a significant concern for Islamic banks, particularly when dealing with SMEs that often lack formal financial records. This is where governments and regulators can play a transformative role. Malaysia, a global leader in Islamic finance, has introduced frameworks that incentivize banks to serve SMEs, including risk-sharing mechanisms and guarantees for Islamic financing. These policies have led to the growth of SME-focused products and could serve as a model for other countries.

Another critical barrier is awareness. Many SME owners in Muslim-majority nations are either unaware of Islamic financing options or misunderstand their terms. Financial literacy campaigns, coupled with targeted outreach, are essential for bridging this knowledge gap. Banks, too, must simplify their products to make them more accessible. Complex contracts and opaque terms only serve to alienate the very businesses they aim to support.

A Moral and Economic Imperative

The case for bridging the missing middle goes beyond economics—it strikes at the heart of what Islamic finance represents. Shariah principles emphasize social justice, equitable distribution of wealth, and the upliftment of marginalized communities. By excluding SMEs, the industry risks undermining its ethical foundation.

The rewards of inclusion, however, are immense. Imagine an ecosystem where Islamic banks actively support SMEs in industries ranging from renewable energy in Morocco to e-commerce in Pakistan. The economic ripple effects would be profound: reduced unemployment, greater innovation, and increased economic resilience. Moreover, such an ecosystem would reinforce the credibility of Islamic finance as a driver of sustainable and inclusive growth.

Bridging the missing middle will require collaboration across stakeholders—banks, fintech companies, governments, and the SMEs themselves. It will also demand a shift in mindset. Islamic banks must see SMEs not as high-risk liabilities but as long-term partners in shared prosperity. Fintech startups must scale their platforms to reach more businesses, while regulators must create environments that encourage innovation and risk-taking.

For Islamic finance, the missing middle isn’t just a gap to be filled; it’s an opportunity to redefine the industry’s role in global development. By embracing SMEs, Islamic finance can not only expand its market share but also fulfill its ethical promise to create a more just and equitable financial system. The time to act is now, and the potential rewards—for businesses, communities, and the industry itself—are too significant to ignore.