By Kaushiq Kodithodika, Advent
Purification of income from conventional stock
While Shariah scholars generally accept investing in conventional companies that incur some income from interest but have acceptable debt-to-equity ratios, many do not find it acceptable to profit directly from those haram activities.
Instead they require that income from these companies be “purified.” This purification requires managers to determine what percentage of a company’s profit is derived from interest-bearing accounts and other haram activities. That ratio is used to purify-i.e. segregate-any profits the shareholder has gained from holding stock in that company (such as dividends and possibly capital gains) and an equivalent amount is then given to charitable organisations through a zakat or charity account.
The institution’s Shariah Board should advise on the treatment of purification. From a technical standpoint, there are systems that can then automate the calculations.
Segregation of funds/Islamic windows
Not all Islamic institutions are solely Shariah-compliant. Some offer mixed conventional and Shariah-compliant investments, where it is important that workflows and the IT systems segregate funds and cash flows so as not to co-mingle Shariah-compliant and non-compliant monies. This requirement can create significant workflow and technology challenges.
Workflow is of particular importance because, as mentioned, the internal Shariah advisory board will consider each transaction type and how it is required to be processed. It is essential that any system can replicate this transaction flow each time the transaction is processed.
In a Shariah-compliant banking system the term “interest” should never appear. In the case of an institution investing in both Islamic and conventional products, however, there may be a need for a system capable of dealing with the relevant vocabulary of both investment types.
Financial institutions considering the creation of a Shariah compliant offering must strive to understand and fully integrate the core principles of Islamic finance to their organisation, with the advice and assistance of their Shariah advisory board, and to abide by the locally accepted interpretations of these principles in the markets where they want to sell. This will include choosing which types of products to offer, both Islamic and acceptable conventional products, and ensuring the right screening processes, workflows, purification methods and segregations of monies are in place to ensure compliance of the Islamic investments at all times.
Much of the Islamic banking requirements relate to prohibition of interest, the methods of arranging customer lending or financing, the degree of risk or lack of certainty of a transaction, the validity of the sale transaction, or how detailed transaction processing occurs (such as how late or early payments are processed), but ultimately, Shariah compliance is concerned about what an asset is, what it is used for, and its financial constitution.
While achieving Shariah compliance involves significant effort and expense, the dramatic growth in these vehicles may well justify such an investment in future. With the continued development of many emerging markets with a dominant Muslim population, in addition to Islamic products’ potential appeal for non-Muslim investors in search of ethical products, this investment type’s 10% annual growth is indeed expected to continue over the next several years.
Moreover, international bodies are continuously working towards greater harmonization of international standards, with the increased participation of leading financial services jurisdictions such as Luxembourg or Singapore. The more standardization the industry can develop, the more exportable and replicable the products will be, enabling Islamic financial institutions to harness the benefits of their initial investments to achieve compliance.