15© 11th June 2014

SPECIAL REPORT

The most pressing challenge faced by the Islamic finance industry is the increasing cynicism among existing and potential customers — overly-engineered financial products are seen to be moving towards a trend whereby products are being designed to comply with the technical requirements of Shariah but appear similar to their conventional counterparts.

Islam provides an alternative financial paradigm: and focusing on the spirit and purpose (Maqasid) of Shariah, the aim of this article is to move past Halal and Haram to emphasize the clear gradations in the actions of a Muslim that have been defined in Islamic teachings. We also look at how these can be applied to a new methodology of rating financial products. Concepts such as Tayyab, Mandoob (recommended) and Makruh (disliked), are equally relevant when creating a ratings methodology and eventually a range of products that provide a choice to the ultimate user of Islamic finance to opt for enhanced value-based products.

This new proposed rating methodology not only looks at the compliance to Shariah principles of financial products but also rates them according to their positive social impact to society based on Shariah teachings. The investment methodology would be known as ‘Shariah Impact Investment’ and would be, to our knowledge, the first of its kind.

Apart from a religious point of view, there is an extensive body of global research showing that ethics based investment methodologies in most cases tend to outperform the market.

Current Shariah screening practicesThe only difference between most Shariah screening methodologies globally is the type of financial ratios applied to determine Shariah compliance; otherwise core screening methodology remains the same and provides no Fiqhi’ gradation in the type of companies that make up the investment universe.

Maqasid’ Al ShariahMaqasid’Al Shariah means the purpose of Islamic law. Scholars have classified the Maqasid into three descending categories of importance:

1) Darurat (essentials): There are five absolute requirements to the survival and spiritual well-being of individuals and maintaining order within society, absence of which would lead to anarchy and chaos. These include the preservation and protection of: Religion (Al-Din), Life (Al-Nafs), Progeny (Al-Nasl), Intellect (Al-Aql), Wealth (Al-Mal).

2) Hajat (supporting needs): Benefits that seek to remove hardship in cases where hardship does not pose a threat to the survival of the normal order. The benefits are normally recognized as being concessions, which makes things easier but are not required.

3) Tahsinat (complimentary interests): These are actions which seek to attain perfection in the customs and conduct of people at all levels. These embellishments should pervade through the above two Maqasid.

Examples of adhering to Maqasid’Al

Shariah can be can include providing help and assistance to those who need them in the society, demonstration of social responsibility in the market, facilitating the process of cash-flow, increasing wealth in society through permissible means, etc.

Developing a Maqasid-based rating methodology The focus now shifts towards the development of the first advanced positive Shariah impact rating. This methodology would look to classify businesses and financial assets based on the criteria of Maqasid’Al Shariah, i.e., Shariah impact. Using the Shariah Impact Methodology, the equities/assets would be assigned one of three ratings based on the Islamic judgments of actions:

1) Tahsinat2) Mubah3) Esasiya

Tahsinat would be the highest rating, indicating that the said financial asset (equity, bond, Sukuk etc.) adheres to the teachings of Islam to a higher degree and creates a societal impact vis-à-vis Maqasid’Al Shariah, while Esasiya would be at the bottom end of the spectrum having the least Shariah impact.

It should be noted that this methodology builds upon existing Shariah screening methods and aims to be an evolution. This evolution is also observed in conventional non-Islamic investment methodologies, which have evolved from simple financial screening to negative screening and then onto positive social impact screening.

The aim is to give serious Muslim investors a platform to gauge the Shariah impact of

Shariah impact rating methodology — a new way to rate Shariah compliant products The Islamic finance industry experiences continuous double-digit growth worldwide but it still faces a number of challenges, ranging from governance issues to lack of qualified professionals. MUJTABA KHALID proposes a revolutionary new ratings system for Shariah products, which suggests an entirely new outlook on the Shariah.

Core screening Financial Shariah compliant stocks

Figure 1: Current Shariah screening methodologies

Figure 2: The hierarchy of Maqasid’Al Shariah

Tahsinat

Hajat

Darurat

continued...

16© 11th June 2014

SPECIAL REPORT

their investments — both for the benefit of society and to receive a higher reward in the form of Allah’s blessings as well as financial returns.

Overview The Shariah Impact Rating Methodology will take a multi-faceted approach:

Equity universe: For equity screening, we start off by defining the available equity universe. These would be equities pre-defined in the Shariah index of the country specific bourse. For example, for US equities in the S&P Shariah index would be used, for Pakistan the Meezan Bank Shariah index, for Malaysia the SEC index and so on. For private equity investment ratings or rating other financial products, we would start off by first determining whether the underlying investment is Halal and then move on to the steps mentioned below.

Sector weightage: The first step would be the rating of equities in terms of the sector they belong to for example basic materials, health care, industrials etc. Some sectors would carry higher weights compared to others. The weights will be based on the Shariah impact on society as well as Islamic teachings and traditions. For example if we look at the following Quranic Verse:

“...And We send down iron, in which there is great strength and benefits for mankind…” [57:25]

It can be concurred that iron is a blessing for mankind, therefore using this as an analogy, companies involved in metals and mining will have a positive weight. Using this approach, a metrics would be developed that rates certain sectors higher than others.

Product impact weightage: The next step would require the assessment of the Shariah impact of the company’s product or service. Weights would be assigned according to the positive Shariah impact created by the product. Business operational weightage: The last step would require taking a detailed view of the company’s operational mechanisms –both internal and external and giving weightages accordingly. Two aspects of a company would be looked at in this step:

• Internal business practices — corporate governance, organizational behavior, treatment of employees

• External business practices — corporate social responsibility, interactions with stakeholders such as customers, shareholders etc.

Rating methodologyEach of the first two steps would be given a weightage of 10 points each and the last step would have a total weightage of 20 (10 for internal business practices and 10 for external).

Product impact and business operational weightages would have sub-categories within them but as mentioned above, the

total weightage when it comes to rating would be 10 for Product Impact and 20 for business operational weightage.

All equities (and other assets) which score above 30 would be rated as Tahsinat, below 30 and above five would be rated as Mubah and the remaining would be categorized as Esasiya (very basic Shariah compliance).

Mujtaba Khalid is a senior associate with the UK Islamic Finance Council, and can be contacted at mujtaba@ukifc.com.

Figure 3: Example of product Shariah impact weightage metricsSubject Shariah/Social impact of product

Facilitates access to clean waterFacilitates access to educationFacilitates access to financial servicesFacilitates access to informationFacilitates access to affordable housingFacilitates agriculture productivityFacilitates capacity buildingFacilitates community development Facilitates conflict resolutionFacilitates employment generationFacilitates equality empowermentIncreases food securityFacilitates health improvementAids human rights protection or expansionIncreases income/productivity growth

Beneficiary demographic targeted by organization’s product or services

Children and adolescents, disabled, minority. Previously excluded populations, women

Socioeconomic group of beneficiaries targeted by organization’s product and services

Very poor, poor, Low income

Target beneficiaries setting Rural

Figure 4: Shariah Impact Rating Methodology

Universe of Shariah compliant equities

Sector weight Product impact weight Business Op. weight Rating

Positive weight if acompany operates

in sector that areconsidered noble

in Islamic teachingor sectors which are essential to societye.g. Mining, health,

care, agriculture,utilities

Positive weight ifthe main product(or product range)

of the companyhas a positive

impact on societyor individual e.g

access to cleanenergy, increased

agricultural productivity,

construction of affordable housing

Internal business practise weighted sub-categorized

based on corporate governance etc

External businesspractises-weighted

sub-categories basedon CSR etc.

Total of 10 Total of 10 Total of 20

Tahsin

Mubah

Esasiya

Continued