The soul of Islamic Finance lies in risk sharing. Islamic capital market is the ideal market consistent with Islamic finance as it encourages risk sharing and investment. When one invests in the market, he or she applies the concept of Mudharabah.
Islamic capital market as a subset of Islamic finance allows Muslim investors to invest according to Shariah. Consistent with Islamic investment activities in the stock market, Shariah-compliant companies (SCCs) signify the growth and development of Islamic economics in the last two decades, precisely since the 1990s after Dow Jones became the first Shariah index provider. SCCs can be defined as companies that conduct activities which are not contrary to Islamic principles.
In short, SCCs are listed firms that pass Shariah screening. Currently, there are 7,173 SCCs according to Thomson Reuters. The large number of SCCs is due to the enthusiasm of big players such as Dow Jones, Standard and Poor and Morgan Stanley in providing Islamic indices. SCCs have become the new, alternative investment for Muslim and ethical investors that contribute to the dynamic of Islamic capital market.
Drivers of Shariah-compliant companies (SCCs)
There are four factors that drive companies to be SCCs: index providers, the government, the niche market, and intrinsic motivation. These factors may encourage SCCs behaviour in different ways of fulfilling stakeholder expectations.
- The first factor is index provider phenomena. After the launching of the Islamic index by Dow Jones in 1999, many companies were not aware of their Islamic brand. These companies were not only unaware of their Islamic brand but also did not intend to be SCCs. As a result, Muslim investors cannot expect these companies to have significant difference behaviour with counterparts in terms of Shariah governance and Shariah disclosure.
- The second factor is the captive market, which is the Muslim investor. Many Muslim investors consider stock market transactions as un-Islamic and as a cover for speculative activities. Some Muslim investors confuse risk with gharar and gambling. Consequently, they may shy away from investing in stock markets. At the same time, SCCs that are listed in the Shariah index provide the alternative investments for Muslim investors. To capture this captive market, companies may decide to seek compliance with Shariah principles.
- With regard to the government factor, companies have a strong motivation to be Shariah compliant companies as they want to support the government objective to be an Islamic financial centre. For instance, Sime Darby disclosed their willingness in their annual report (2014) to maintain Shariah compliance in order to support the government’s policy in Islamic finance. Pertamina also considered shifting their financing activities to Sukuk.
- The last driver is the intrinsic motivation. Companies have an internal motivation to do business activities that align with Shariah principles. Shariah principles may encourage companies to do business and it is reflected not only in a company’s mission but also in its annual report.
Why Incentives are needed
Governments, particularly in majority Muslim countries, are able to support SCCs to fulfil the expectation of Muslim investors by providing incentives. A few Muslim majority countries have started to provide financial and tax incentives for SCCs. For instance, the Pakistani government conceded tax incentives by introducing a tax reduction of 2% through the Finance Act 2016. In an indirect way, the Malaysian government provides a tax deduction on expenditure for companies that issue Sukuk and spend on Zakat. Last, providing incentives to SCCs in an attempt to change their behaviour may benefit the government itself in terms of better growth of Islamic finance and attracting international capital.