Dear Colleagues,
it is interesting to observe the different Shari'ah screening methodologies applied by many Islamic index providers. Some use Total Assets in the denominator others Market Capitalization (e.g. Dow Jones, S&P, AAOIFI) in their financial ratios (e.g. leverage ratio). Some use 30% others use 33% as a threshold criterion for max. debt level (Meezan Index uses 37%). Examples:
· Total Debt/Total Assets < 33%
· Total Debt/Market Capitalization < 30%
This is a long-lasting debate among scholars, however, NON of the academic research papers and NON of the Islamic index provider provide the rationale behind these screening ratios.
I would like to highlight the importance here in regards to the judgement that have been made. In specific, companies are classified either being Shari’ah compliant or non-compliant, with the former being halal (permissible) to invest in and latter haram (impermissible) to invest in for the Muslim investors. Any classification between haram/halal must be justified and backed-up with the Islamic sources, the Qur’an, Sunnah and by the respective Ijtihad (Islamic reasoning).
From an Islamic perspective, Muslim investors have the right and are even urged to question about the rationale behind these screening criterion. Consequently, I want to trigger some brainstorming-functions with the following questions:
Note: The application of Market Capitalization in the denominator (Question 2) is heavily criticized and it is argued that Market Capitalization is more volatile than Total Assets, hence it can cause a company being screened and classified as Shari’ah compliant according to one Index provider and non-compliant according to another Index provider.
This argument favors the use of Total Assets; however, it is justified from the “Finance” Knowledge of Body and not from the “Islamic” Knowledge of Body.
Thank you.
Salam
You can look to this thesis:
Relationship between banks characteristics and shubuhat : - the case of Islamic banks in Malaysia.
Following article maybe a useful read:
https://islamiceconomicsproject.wordpress.com/2011/12/22/role-of-equity-markets-in-islamic-economy/
Well your questions are tough call to answer
The rationale for not favoring debt is the Shariah preference for Equity financing rather than debt financing. Now coming to your question why interest bearing debt instead of total debt? right?
The rationale for use of interest bearing total debt is ... In the current financial markets there are number of Islamic financial institutions. So it is possible that the firm might have some loans from these institutions. so if we use the total debt it could be a biased measure (in the presence of some non interest bearing loans which i know is very rare but we have to be careful). Thus in order to grasp the effect of interest we only focus on interest bearing debt.
Hope it helps
The rationale for total assets or total cap is also a tough call
Well the use is arbitrary and based on the opinion of Shariah scholars regarding the true replacement value of a firm. In my personal opinion both of these measures have their pros and cons. Total assets can be a biased measure because of the accounting principles used by the specific firm. Beside this i have another observation that is related to the use of Goodwill as balance sheet item. The goodwill is still a questionable claim in Shariah.
Market cap is consider to be the true replacement value of the firm. it is because it is the value assigned by the market in the presence of macro and micro factors such as the expectations of investors. And they say its better to follow the market actual position rather than the historical cost of total assets (Book value). Well i disagree
The market cap itself is a very problematic measure. it could be effected by noise in the market. The presence of mispriced securities, the speculators and bla bla bla.. you can read our paper where we criticize the use of market cap (of course the context the different but you can generalize it)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2812587
you can also find the paper here in my home page
the threshold criteria are mostly based on Hadith and fiqhi rules. and at the most extremes these are the result of Ijma and Qiyas. but all such threshold levels are subject to criticism and are arbitrary
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