6th International Islamic Finance Conference 2008 Peer Reviewed Paper
A Holistic Rating Methodology for Islamic Institutions: Introducing A Unified Rating
Framework
Ananda Samudhram *
Lecturer in Accounting and Finance
School of Business
Monash University Sunway Campus
Telephone: +603–55146293
E-mail: [email protected]
Roselee Shah Shaharudin
Faculty of Business and Accountancy
University Of Malaya
Bala Shanmugam
Chair of Accounting and Finance
School of Business
Monash University Sunway Campus
Telephone: +603–55146293
E-mail: [email protected]
*Corresponding author
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Abstract
Islamic finance is becoming increasingly important all over the globe. As such, appropriate
ratings of key Islamic financial institutions, such as Islamic banks, are useful for investors and
other stakeholders. Such information helps these stakeholders to make informed decisions.
Contemporary ratings approaches focus on either conventional profitability figures or Shariah
compliance. Implicitly, the latter approach implies that Islamic businesses tend to emphasise
Shariah compliance over profitability. This paper proposes a dual-rating approach, which offers a
set of metrics that simultaneously reflect profitability and Shariah compliance. An empirical
study based on this dual-rating concept, using the Wilcoxon signed-rank test, finds no significant
difference between Shariah compliance and profitability based rankings. The results indicate
that, in general, banks do not necessarily emphasise one over the other. However, vast
differences between Shariah compliance and profitability ratings are not uncommon amongst
individual banks, indicating a need for the dual-rating systems for making informed decisions.
Introduction
According to figures published in the Certified Institute of Management Accountants’ website
(CIMA, 2008), Islamic finance has grown by an astounding 15% per year in the last three years,
and global Islamic finance has an estimated worth of USD 700 billion. Key challenges in Islamic
finance today include effective corporate governance mechanisms, liquidity management and
avoiding complacency brought about by the runaway success. These challenges were outlined by
in the keynote address of His Excellency Rasheed Mohammed Al Maraj, Governor of the
Central Bank of Bahrain, at the World Islamic Banking European Summit, London, 8 July 2008
(Maraj, 2008).
This paper focuses on the corporate governance aspect in Islamic finance in general. It proposes
a dual ratings methodology for Islamic business organizations, illustrated by an empirical study
of Islamic banks. This ratings approach is able to support the corporate governance mechanisms
of Islamic banks, helping to ensure that both the profitability and the Shariah compliance
dimensions of business performance are met. In essence, the judicious use of these ratings will
promote long-term growth of profitable, Shariah compliant Islamic business enterprises.
“Corporate governance deals with the ways in which suppliers of finance to corporations assure
themselves of getting a return on their investment” (Shleifer and Vishny, 1997, page 737). In
conventional finance, this return generally refers to various measures of profitability, including
returns on assets. However, in Islamic financing, this notion of returns is expanded to encompass
adherence to the teachings of Islamic, or Shariah compliance (Shahul et al., 2003), with the
concept of “return on investment” taken to indicate the upholding of the tenets of Islam.
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
A sound rating methodology supports corporate governance. Ratings help investors to assess
whether a firm is utilizing the funds entrusted to it with due care, by providing indications of
performance. The earlier ratings methodologies in Islamic finance principally focused on
measures of profitability, such as return on assets. However, recent research has shifted this
emphasis to Shariah compliance, with little regard to profitability. Obaidullah (2005) suggests
two separate rating systems for Islamic financial institutions that focus on financial performance
and Shariah compliance, respectively. Virtually no studies have explored dual ratings systems,
that could indicate Shariah compliance and profitability in a single set of metrics. Furthermore,
no study to date has explored whether Islamic financial institutions in practice emphasise Shariah
compliance over profitability.
The present study looks at a dual ratings methodology. It proposes metrics that perform a dualrating function. It employs an alphanumeric approach that enables a seamless integration of
current profitability measures, by established ratings firms, with Shariah compliance ratings by
Islamic ratings bodies. As such, the objective of this paper is to develop a holistic ratings
methodology that takes into account both the profitability concerns and Shariah compliance
issues of global investors in Islamic finance. A second objective is to explore whether Islamic
banks emphasize Shariah compliance over profitability. The study is based on certain key
Islamic financial institutions, namely, Islamic banks.
The rest of this paper is organized as follows. The next section reviews prior studies. This is
followed by a proposed dual rating methodology. This rating methodology is illustrated via an
empirical study of a sample of Islamic banks. The results are discussed following this empirical
exercise. Directions for future work are then provided, and the final part concludes
A Brief Overview of Previous Studies
The evaluation of Islamic banks has been conducted from two different perspectives. The earlier
perspective regarded Islamic banks as just another form of conventional banks. This view
employed conventional measures of profitability and long-term stability, such as returns on
investments (ROI) and returns on assets (ROA) to assess the performance of Islamic institutions
(e.g. Bashir, 1999; Aggarwal and Yousef, 2000). Obaidullah (2005) mentions that ratings of
Islamic financial institutions by major agencies, such as Moody’s, is not very different from that
employed to assess conventional financial institutions. However, such ratings fail to consider the
peculiarities of Islamic businesses. In particular, investors in the world of Islamic finance attach
great importance to adherence to Islamic (or Shariah) principles in the course of running an
Islamic business. The earlier measures of business performance missed out this important area of
concern, and as such were of limited use for investors and other stakeholders within the Islamic
community. For these key stakeholders, Shariah compliance is a major area of concern.
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Later research in the evaluation of Islamic banks addressed this shortcoming by focusing on
evaluation systems that consider Shariah compliance. One approach has been to employ
indicators of conformance to Islamic principles, computed from financial statements published
by Islamic institutions (e.g. Shahul et al., 2003). Another has been to employ a content analysis
of materials published by these institutions, based on approaches that have been developed
corporate social reporting (e.g. Maali et al, 2003). Both of these approaches are discussed in
greater detail below.
Shahul et al. (2003) compute a series of ratios that essentially replicate the ratio analysis
approach of conventional financial statements from an Islamic perspective. Using data from
financial statements of Islamic banks, the authors compute several measures of Shariah
compliance. These measures assess the extent of profit sharing activities, zakat performance,
equitable wealth distribution, the excess of directors’ remuneration to that of the average
employee, Islamic versus non-Islamic investment and Islamic versus non-Islamic income. Just
like the ratios of conventional businesses, these ratios can be employed in cross-sectional and
time-series analyses. However, these ratios can be computed only when all of the necessary
information is provided in the annual reports of Islamic institutions. At present, not all Islamic
institutions provide all the necessary information for computing these ratios. Thus, it is difficult
to compute all of the pertinent ratios for all institutions.
Malli et al. (2003) conduct a content analysis of the materials published by Islamic institutions.
This approach is based on the rich literature developed in corporate social reporting (CSR). It
takes advantage of the similarities between corporate social reporting, CSR, (which emphasizes
environmental protection, fair wealth distribution, caring for the poor and disadvantaged
segments of the society) and Shairah principles (that view humans as caretakers of the
environment for Allah, and hence they must conserve and protect this environment, as well as
share their wealth with the members of the community and treat all fairly). In essence,
techniques in CSR research assess the extent to which firms act in a socially responsible manner,
based on published material released by the firm. Maali et al. (2003) employ similar techniques,
from an Islamic perspective, to assess the extent of compliance to Shariah principles. However,
when a firm fails to disclose its activities that conform to Shariah principles, this approach would
understate Shariah compliance.
Nevertheless, Shahul et al. (2003) and Maali et al. (2003) offer a means to overcome the lack of
attention to the Islamic point of view in the conventional assessment of Islamic financial
institutions. But a rating methodology that emphasizes Islamic perspectives without
incorporating conventional measures of profitability and financial stability would run the risk of
neglecting some key measures of sound performance. Indeed, Obaidullah (2005, p. 40)
“…highlights the need for two separate types of rating for measuring financial and ethical
performance of Islamic financial institutions. The need for rating financial performance is
traditionally more easily understood by market participants.
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
This is evidenced by the fact that international rating agencies are already on the job of providing
such ratings to financial institutions. While the need for rating ethical performance is also
strongly felt by market participants, such rating is rather unconventional and therefore, is
conspicuous by its absence.”
The present paper proposes integrating these perspectives in a unified rating framework. It
proposes an alphanumeric ratings system that simultaneously reflects Shariah compliance and
profitability. Current systems use alphabets, numbers or a combination of these. The proposed
system is able to assimilate existing ratings and reflect the dual perspective effectively.
The next section discusses this proposed system in detail.
The Unified Rating Framework: A Dual-Rating Approach for Islamic Firms
The dual-rating approach indicates Shariah compliance via Arabic numerals 1-9, with the smaller
numbers reflecting a greater degree of compliance. Numbers 1-3 reveal good compliance,
numbers 4 – 6 indicate moderate compliance while numbers 7 – 9 reflect poor Shariah
compliance. In contrast, profitability is indicated by alphabets. The alphabets A, B and C indicate
good, moderate and poor profitability respectively. Each of these alphabet based ratings are
subdivided with small case alphabets, a, b and c that indicate high, moderate and low level
performance within each category. For instance, Aa indicates excellent performance, Ab
indicates very good performance and Ac indicates good performance.
Figure 1 depicts the different possible ratings based on this scheme
GOO
D
MOD
ERA
POO
R
PROFITABILITY
Figure 1: A Unified Ratings System for Islamic Institutions
Aa
Ab
Ac
Ba
Bb
Bc
Ca
Cb
Cc
SHARIAH COMPLIANCE
GOOD
MODERATE
POOR
Excellent Very Good Moderate Moderate Moderate Poor
Poor Very
tending
tending
tending
Good
poor
to good
to poor
to
moderate
1
2
3
4
5
6
7
8
9
1Aa
2Aa 3Aa
4Aa
5Aa
6Aa
7Aa
8Aa 9Aa
1Ab
2Ab 3Ab
4Ab
5Ab
6Ab
7Ab
8Ab 9Ab
1Ac
2Ac 3Ac
4Ac
5Ac
6Ac
7Ac
8Ac 9Ac
1Ba
2Ba
3Ba
4Ba
5Ba
6Ba
7Ba
8Ba 9Ba
1Bb
2Bb 3Bb
4Bb
5Bb
6Bb
7Bb
8Bb 9Bb
1Bc
2Bc
3Bc
4Bc
5Bc
6Bc
7Bc
8Bc 9Bc
1Ca
2Ca
3Ca
4Ca
5Ca
6Ca
7Ca
8Ca 9Ca
1Cb
2Cb 3Cb
4Cb
5Cb
6Cb
7Cb
8Cb 9Cb
1Cc
2Cc
3Cc
4Cc
5Cc
6Cc
7Cc
8Cc 9Cc
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
The next section discusses an empirical study based on this unified ratings approach.
Empirical Study
The required data was obtained from Bankscope. A search by Islamic banking specialization
returned 99 banks. After accounting for redundancies and eliminating banks that did not provide
complete information on Islamic income and ROAA ratios for year 2006 (the most recent year
for which most of the banks provided the necessary data), a total of 40 Islamic banks remained.
These formed the sample on which this study is based. This relatively small number is not
surprising. The Bankscope data is extracted from annual reports and extant literature indicates
that the reports from Islamic banks do not always provide the necessary information for
compiling Shariah compliance indices (e.g. Shahul et al., 2003).
The line item “Income from transactions - Islamic operations” is taken as a proxy for income
from halal sources. This item is divided by the line item : “Subtotal: Income from transactions”,
to obtain the Islamic income ratios. These ratios are taken to reflect compliance with Shariah
principles, with larger values indicating higher compliance. The smallest possible value for
Islamic income is 0, while the largest possible value is 1. The range between 0 to 1 is divided
into nine equal parts. Islamic income ratios at the top 1/9th of this scale is taken to assume values
of 1. Ratios in the next 1/9th is taken to assume values of 2, and so on. Values on the last 1/9th are
represented with a rating of 1.
The ROAA values (read directly off the Bankscope output) were used to compute the
profitability ratings. Standardized 1 values (or Z-scores) were computed for this data. The ROAA
ratios in the top 1/9 of the sample (indicated by the appropriate Z-scores) were given a rating of 1
(or Aa in the unified scheme). The next 1/9 were given a rating of 2 (or Ab in the unified
scheme), and so on till the last 1/9, which was given a rating of 9 (or Cc). The results of these
ratings are given in Table 1.
The earlier research in the evaluation of Islamic banks’ performance used conventional
profitability measures, such as ROAA (e.g. Bashir, 1999; Aggarwal and Yousef, 2000).
However, later researchers indicated that Islamic stakeholders are more concerned with
adherence to Shariah principles, and thus strove to derive measures of Shariah compliance (eg.
Shahul et al, 2003; Maali et al., 2003). The idea that Shariah compliance is more important than
profitability measures is implicit in this later work. If this perception holds true, then firms would
pay more attention to Shariah compliance than profitability. As such, there will be a significant
difference between Shariah compliance ratings and profitability ratings, with the former
generally being higher, on average. This perception can be tested with the following hypothesis:
Standardised values were computed using (x - μ)/σ, where x is the Islamic compliance ratio, μ
is the sample mean and σ is the standard deviation.
1
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
H1: Shariah compliance ratings are significantly higher than profitability ratings.
The alternative hypothesis would indicate no significant differences between profitability ratings
and Shariah compliance ratings, implying that Islamic firms give equal attention to both
measures of performance.
The ratings derived in Table 1 were used to test H1. The results are depicted in Table 2.
Results and Discussion
Table 1: Unified Ratings 2
Banks
Islamic Bank 1
Islamic Bank 2
Islamic Bank 3
Islamic Bank 4
Islamic Bank 5
Islamic Bank 6
Islamic Bank 7
Islamic Bank 8
Islamic Bank 9
Islamic Bank
10
Islamic Bank
11
Islamic Bank
12
Islamic Bank
13
Islamic Bank
14
Islamic Bank
15
Islamic Bank
16
Islamic Bank
17
Shariah
Compliance ROAA Unified
Ratings
Ratings Ratings
5
7
5Ca
8
6
8Bc
9
8
9Cb
5
6
5Bc
9
3
9Ac
9
3
9Ac
7
6
7Bc
8
6
8Bc
8
6
8Bc
8
6
8Bc
1
7
1Ca
9
8
9Cb
6
7
6Ca
9
7
9Ca
8
8
8Cb
1
3
1Ac
7Ca
7
8
2
ROAA ratings: The conversion of the numeric scale to the alphabetical scale is given in
Appendix 1
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Islamic Bank
18
Islamic Bank
19
Islamic Bank
20
Islamic Bank
21
Islamic Bank
22
Islamic Bank
23
Islamic Bank
24
Islamic Bank
25
Islamic Bank
26
Islamic Bank
27
Islamic Bank
28
Islamic Bank
29
Islamic Bank
30
Islamic Bank
31
Islamic Bank
32
Islamic Bank
33
Islamic Bank
34
Islamic Bank
35
8
8
8Cb
1
5
1Bb
9
7
9Ca
8
3
8Ac
1
2
1Ab
8
7
8Ca
9
1
9Aa
9
9
9Cc
7
7
7Ca
1
7
1Ca
8
7
8Ca
1
3
1Ac
9
7
9Ca
8
7
8Ca
8
3
8Ac
8
7
8Ca
5
7
5Ca
1
6
1Bc
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Islamic Bank
36
Islamic Bank
37
Islamic Bank
38
Islamic Bank
39
Islamic Bank
40
9
6
9Bc
9
6
9Bc
1
5
1Bb
9
7
9Ca
9
9
9Cc
Table 2: Results of the Wilcoxon Signed Rank Test
Banks
Islamic Bank 1
Islamic Bank 2
Islamic Bank 3
Islamic Bank 4
Islamic Bank 5
Islamic Bank 6
Islamic Bank 7
Islamic Bank 8
Islamic Bank 9
Islamic Bank
10
Islamic Bank
11
Islamic Bank
12
Islamic Bank
13
Islamic Bank
14
Islamic Bank
15
Islamic Bank
16
Islamic Bank
17
Islamic Bank
18
Islamic ROAA
Ratings
Rank
Absolute
Rating Ratings Difference Difference Difference
5
7
-2.00
-2.00
2
8
6
2.00
2.00
2
9
8
1.00
1.00
1
5
6
-1.00
-1.00
1
9
3
6.00
6.00
6
9
3
6.00
6.00
6
7
6
1.00
1.00
1
8
6
2.00
2.00
2
8
6
2.00
2.00
2
Rank
17.5
17.5
6
6
32.5
32.5
6
17.5
17.5
R+
R17.5
17.5
6
6
32.5
32.5
6
17.5
17.5
8
6
2.00
2.00
2
17.5
1
7
-6.00
-6.00
6
32.5
9
8
1.00
1.00
1
6
6
7
-1.00
-1.00
1
6
9
7
2.00
2.00
2
17.5
8
8
0.00
0.00
0
0
1
3
-2.00
-2.00
2
17.5
17.5
7
8
-1.00
-1.00
1
6
6
8
8
0.00
0.00
0
0
9
17.5
32.5
6
6
17.5
6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Islamic Bank
19
Islamic Bank
20
Islamic Bank
21
Islamic Bank
22
Islamic Bank
23
Islamic Bank
24
Islamic Bank
25
Islamic Bank
26
Islamic Bank
27
Islamic Bank
28
Islamic Bank
29
Islamic Bank
30
Islamic Bank
31
Islamic Bank
32
Islamic Bank
33
Islamic Bank
34
Islamic Bank
35
Islamic Bank
36
Islamic Bank
37
Islamic Bank
38
Islamic Bank
39
1
5
-4.00
-4.00
4
26.5
9
7
2.00
2.00
2
17.5
17.5
8
3
5.00
5.00
5
29
29
1
2
-1.00
-1.00
1
6
8
7
1.00
1.00
1
6
6
9
1
8.00
8.00
8
35
35
9
9
0.00
0.00
0
0
7
7
0.00
0.00
0
0
1
7
-6.00
-6.00
6
32.5
8
7
1.00
1.00
1
6
1
3
-2.00
-2.00
2
17.5
9
7
2.00
2.00
2
17.5
17.5
8
7
1.00
1.00
1
6
6
8
3
5.00
5.00
5
29
29
8
7
1.00
1.00
1
6
6
5
7
-2.00
-2.00
2
17.5
17.5
1
6
-5.00
-5.00
5
29
29
9
6
3.00
3.00
3
25.5
25.5
9
6
3.00
3.00
3
25.5
25.5
1
5
-4.00
-4.00
4
26.5
9
7
2.00
2.00
2
17.5
10
26.5
6
32.5
6
17.5
26.5
17.5
6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Islamic Bank
40
9
9
0.00
0.00
0
0
Sum of ranks:
391
T = 241 (not significant); Conclusion: Accept null hypothesis.
Table 1 indicates that five banks have identical Islamic income and ROAA ratings. Of the
remaining banks, 22 have scored higher Shariah compliance ratings while 13 have better ROAA
ratings.
Although more firms have an higher Shaiah compliance rating, an analysis of the ratings, via the
Wilcoxon signed rank test, indicates no significant difference between the two ratings. Thus,
there is no evidence to support H1, and the null hypothesis is accepted. In essence, this sample
data indicates that Islamic banks do not seem to emphasize Shariah compliance over
profitability. As such, both Syariah compliance ratings and profitability ratings are important.
This conclusion is consistent with the views expressed by Obaidullah (2005).
Limitations and Future Research
The small sample size is necessitated by the fact that not all Islamic banks disclose all of the
required information needed to compute the Islamic compliance ratios. Furthermore, the line
item “Income from transactions – Islamic operations” proxies for income from halal operations
in this study. Syariah compliance is taken to be the ratio of halal income over the total income
from transactions. However, in Bankscope data, the income from the line items other than
“Income from transactions – Islamic operations” do not necessarily mean that they come from
non-halal sources 3 . Future work can be carried out via a survey or direct interviews to obtain a
more direct measure of the proportion of income from halal sources. Nevertheless, the current
measure does indicate a very high level of conformance to Shariah principles, with almost two
thirds of the Islamic banks in the study indicating good compliance (i.e. in the 7,8 or 9 ranges).
This very high percentage is consistent with the expectation the Islamic banks are particularly
concerned with Shairah compliance.
Conclusions
This study explores the idea of a unified ratings concept, which provides metrics that indicate
Shariah compliance and profitability simultaneously. It provides an example of such ratings,
based on data taken from published annual reports. These ratings have several limitations,
resulting from small sample sizes and different natures of the Syariah compliance profitability
measures. The study indicates that a unified set of metrics are possible, but further refinements
need to be made to the ratings methodologies.
3
Information obtained via e-mail communication with Bankscope
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
References
Aggarwal, R., and T. Yousef (2000), “Islamic banks and investment financing,” Journal of
Money, Credit, and Banking, Vol. 32, No.1, pp. 93-120.
Bashir, A. (1999), “Risk and Profitability Measures in Islamic Banks: The Case of Two
Sudanese Banks”, Islamic Economic Studies, Vol. 6, No. 2: pp.1-24.
CIMA (2008), http://www2.cimaglobal.com/cps/rde/xchg/SID-0A82C2899B5F146F/live/root.xsl/1630_11502.htm?itemid=18720703&categoryname=Strategic%20positi
on Accessed on 11th August, 2008
Maali, B., Casson, P. and Napier, C. (2003), “Social Reporting by Islamic Banks”, Discussion
Paper in Accounting & Finance, University of Southampton
Maraj, (2008) Keynote address given at the World Islamic Banking European Summit, London,
8 July 2008.
Obaidullah, M. (2005), “Rating of Islamic Financial Institutions: Some Methodological
Suggestions”, Scientific Publishing Centre, King Abdulaziz University, Saudi Arabia.
Shahul, H., Wirman, A., Alrazi, B., Nazli, M.N., and Pramono, S. (2003), “Alternative
Disclosure and Performance Measures for Islamic Banks”, available from: www.iiu.edu.my/iaw.
Shleifer, A. and Vishny, R. (1997), “A survey of corporate governance”, Journal of Finance,
Volume 52, No. 2, pp. 737-783.
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6th International Islamic Finance Conference 2008 Peer Reviewed Paper
Appendix 1
ROAA: Conversion from numeric to alphabetical ratings
Numerical Alphabetical
1
Aa
2
Ab
3
Ac
4
Ba
5
Bb
6
Bc
7
Ca
8
Cb
9
Cc
13