Asia profitability and conformance: getting the balance right
Islamic finance: is it time for a new compliance system for Islamic finance? Professor Bala Shanmugam and Ananda Samudhram propose a method that could cover both profitability and Shariah law.
Profitability and conformance: getting the balance right
As Islamic finance shows double-digit growth and its asset bases add up to hundreds of billions of dollars, compliance systems are coming under increasing scrutiny. This is because, unlike conventional finance, the powerful stakeholders in the Islamic finance world are concerned with more than just profitability and returns on investments. They also seek information on whether the activities promoted by Islamic financing are halal, that is, in conformance with the teachings of Islam (Shahul et al., 2003).
Ideally, any ratings system for Islamic institutions must consider both profitability and conformance with Shariah principles. Current rating approaches focus on either profitability or compliance to Islamic principles, emphasising one while neglecting.
However, it is possible to combine both perspectives and create a new rating system in a single metric. Our study offers a novel approach for formulating such metrics in a way that would prove useful to global investors, creditors and policy makers.
A brief overview of previous studies
Conventional institutions generally employ ratios such as return on investments (ROI) and return on assets (ROA), based on an analysis of financial statements, to determine profitability and financial stability. Some scholars have used similar indicators to assess Islamic institutions (e.g. Bashir, 1999; Aggarwal and Yousef, 2000).
However, recent studies have employed various indicators of conformance to Islamic principles to assess the performance of Islamic institutions. Shahul et al. (2003) use Islamic investment ratios, Islamic income ratios and profit-sharing ratios derived from the financial statements of Islamic banks, to compute indices that measure conformance to Shariah principles. The Islamic investment ratio refers to the fraction of total investment that is associated with halal activities. The Islamic income ratio refers to the proportion of income derived from halal activities while the profit sharing ratio measures the extent to which wealth is shared with investors. These ratios measure the extent to which the Islamic institutions comply with the tenets of Islam in promoting activities that are not haram, forbidden activities, such as gambling, and distributing wealth fairly. However, these ratios can only be used when the Islamic institutions disclose the necessary information in their financial reports. At present, not all firms disclose all of the information needed.
Maali et al. (2003) employed a different perspective in evaluating Islamic institutions. They took advantage of some of the similarities between corporate social responsibility (CSR) and its emphasis on environmental protection, fair wealth distribution and caring for the poor and disadvantaged, and Shariah principles that view humans as caretakers of the environment for Allah, as well as sharing their wealth with the community and treating all fairly. They therefore use techniques from the CSR literature to derive a measure of conformance to Islamic principles. This measure is based on a content analysis of the various materials published by the Islamic institutions. This approach also assumes that Islamic firms that comply with pertinent Islamic tenets will publish the relevant information. As such, this technique would wrongly classify firms that may be in compliance with Islamic principles, but fail to disclose it.
Nevertheless, the approaches used by Shahul et al. (2003) and Maali et al. (2003) only look at the extent of compliance to Islamic principles. There is a need for a rating system that combines both the profitability-based approaches and the Islamic conformance indices and ratios. Based on the work already done in evaluating Islamic institutions, it is possible to formulate an approach that can lead to a rating index that serves this dual purpose.
A rating methodology for Islamic firms
The proposed rating methodology is based on the idea that Islamic institutions are best served by a dual rating system to indicate both compliance to Islamic principles and profitability. Our proposal rates the conformance to Islamic principles using the Arabic numerals 1 to 9.
The numbers 1, 2 and 3 generally indicate good conformance, with 1 denoting excellent compliance; 2 denoting very good compliance and 3 indicating good compliance. The numbers 4, 5 and 6 would show moderate compliance. A score of 4 indicates a higher level of moderate compliance, tending towards the practice of good compliance. A score of 5 indicates average compliance while a score of 6 indicates only moderate compliance that is tending towards poor practice, and needs to be corrected to prevent it from dropping into the poor category.
Scores of 7, 8 and 9 indicate poor compliance. A score of 7 would show poor compliance tending towards moderate, while a score of 8 indicates a mid-range within the poor performance category. A score of 9 indicates very poor compliance. All of these poor performance categories are to be avoided, and firms with these ratings need to actively seek to rise to the higher categories.
The letters A, B and C represent the profitability standards. The A category has three sub-categories. These are Aa, Ab and Ac, which would show excellent, very good and good profitability, respectively. Similarly, within the B category, the sub-categories Ba, Bb and Bc represent average profitability tending towards good performance, average profitability and average profitability tending towards poor performance. Firms in the Bc category would be prompted to take precautionary steps to ensure that they do not drop into the poor performance categories.
Within the C category, the Ca, Cb and Cc sub-categories indicate poor performance tending upwards towards better performance, poor performers in the mid-range of the poor category and very poor performers respectively. In general, all of the firms in this category would need to address how to improve their profitability.
The indices for determining conformity with Islamic principles could be derived in several ways. For example, rating agencies could interview the Islamic firms and assess conformity based on a list of preset criteria. These criteria should be derived through a consensus of Islamic scholars worldwide. Alternatively, researchers can also assess Islamic conformity using ratios or some form of content analysis.
The profitability can be measured via conventional indicators, such as the ROA, ROE and profit margin (PM), computed from published financial statements. Sophisticated analysis can be conducted by professional analysts by including additional factors such as the market outlook, competitive forces, technology adoption, human capital development, management strength, product mix, and so on. The final result of such analysis is the assignment of a profitability rating, from Aa to Cc, to Islamic firms.
Application of the rating methodology
This rating proposal has multiple uses. It not only helps in the evaluation of Islamic business organisations, but it enables a holistic assessment in terms of conformity to Shariah principles and long-term profitability and sustainability of business activities.
If a business does well in the Islamic conformity component of the rating but poorly in the profitability component (for example, a rating of 1Ca), then management knows it needs to focus its attention on improving profitability. On the other hand, if it has excellent profitability scores but poor Islamic conformity scores (such as a rating of 9Aa), the attention would need to switch to improving conformance to Shariah principles. This dual rating methodology enables not only management, but analysts and general users to quickly identify potential issues in the Islamic organisation, and direct attention to the appropriate problem.
These ratings can be used by a firm to compare its current position with that of peers as well as to evaluate its performance over time. For instance, if a firm finds itself scoring in the 4 to 6 range in the Islamic conformance section of the ratings, while its peers are generally in the 1 to 3 range, the firm will know that it has fallen below industry standards in terms of Shariah conformance, even though it might be an industry leader in terms of profitability. Conversely, if its profitability ratings are in the B categories but its Shariah compliance is generally in the 1 to 3 category, the users of the ratings will know it is a firm that has moderate profitability but good Shariah compliance ratings. And informed users in the world of Islamic finance might consider this an excellent situation, because Islam places greater emphasis on conformance with Shariah principles rather than just the pursuit of profitability.
In essence, these ratings can serve to meet the specific information needs of the Islamic community. The system can also serve as a means for benchmarking Islamic organisations and offer a method for developing a roadmap for progress, where a firm that scores poorly on Islamic conformance measures may plan to improve these scores progressively over time.
Future work
Empirical work has to be undertaken to develop these ratings further. In the simplest form, it is possible to establish profitability ratios (using ROA, ROE and PM) and Islamic conformance indices (using ratios based on Shahul et al., 2003, or indices based on Maali et al., 2003) for a large sample of Islamic organisations. The computed profitability ratios can then be divided into nine quantiles, that represent the nine profitability categories mentioned above. Similarly, the Islamic conformance ratios or indices can be divided into nine quantiles. As such, it would be possible to assign Islamic ratings for the various firms in the sample.
A study of such ratings over several years will allow researchers to track the performance of Islamic firms over the sample time frame, and make pertinent decisions.
Conclusion
With the tremendous growth in Islamic finance, there is a need for a rating methodology that serves the unique needs of Islamic organisations. The dual perspective rating proposed in this paper would meet these unique needs, and help to promote the long-term growth of Islamic firms and conformance with Shariah principles all over the world.
Professor Bala Shanmugam FCPA obtained his PhD in banking and finance from Australia. An author of more than 100 papers and more than 25 books he has received several prestigious awards for his research and scholarship. He is currently attached to the school of business at Monash University Malaysia, where he is the chair of accounting and finance and also director of banking and finance. Professor Shanmugam has extensive industry experience and has served as consultant to a number of financial institutions. He is also on the editorial boards of a number of respected journals in the areas of banking and finance.
Ananda Samudhram currently holds an academic position at Monash University Malaysia. He holds a BSc (Hons) degree from the University of Malaya and a master of accountancy degree from Western Illinois University, USA. He has worked as a corporate accountant in a Fortune 500 company in the US and in Malaysia, and has taught in various tertiary level programs offered at private and public institutions of higher learning in Malaysia and has given talks to various professional accounting bodies in Malaysia. He is a fellow member of the Georgia Society of CPAs.
