Journal of Business Ethics

, Volume 117, Issue 3, pp 601–613

Halal Certification for Financial Products: A Transaction Cost Perspective

Authors

    • Department of EconomicsVU University Amsterdam
  • Frank Den Butter
    • Department of EconomicsVU University Amsterdam
  • Udo Kock
    • International Monetary Fund
Article

DOI: 10.1007/s10551-012-1534-9

Cite this article as:
Hayat, R., Den Butter, F. & Kock, U. J Bus Ethics (2013) 117: 601. doi:10.1007/s10551-012-1534-9

Abstract

We argue that although halal certification could potentially reduce the high transaction costs related to buying Islamic financial products, in practice these costs are just replaced by transaction costs relating to the certification itself. It takes considerable time (2–3 months) and money (USD 122.000) to obtain a halal certification. Partially, this is because the market is highly concentrated and non-contestable. About 20 individual Sharia scholars control more than half the market, with the top 3 earning an estimated USD 4.5 million in fees per year. Moreover, this market seems plagued with problems, most notably a strong incentive for excessively lenient certification, lack of consensus on what is considered halal and sub-standard governance practices. We discuss solutions to these problems and conclude that a neutral non-profit government entity should assume the role of halal certifiers.

Keywords

Islamic financeCertificationTransaction costs

JEL Classification

L14L15D23D82

Introduction

Standardization and certification are well known methods to reduce transaction costs. From that perspective we look at the economics of certifying financial products as Islamic. Islamic law (Sharia) obligates Muslims to only invest in assets that are halal (permissible according to Islam). However, specific knowledge is needed to assess whether a financial product is in fact halal. There is a market which fulfills this need, the market for halal certification of financial products. This market has some very interesting features with respect to value creation by providing a quality standard. As the demand for Islamic financial products increases, research in this area is also on the rise, most notably in banking (see Baele et al. 2012 for a recent overview), mutual fund investing (e.g. Hoepner et al. 2011) and the relationship between Islam and corporate social responsibility (e.g. Williams and Zinkin 2010; Beekun and Badawi 2005). Halal certification, however, has received limited attention, despite the large role it plays in Islamic finance.

We aim to fill this gap in two ways. First, we describe the market for (financial) halal certificates and the process of obtaining certification. Second, we identify inefficiencies in this process using transaction cost theory, which we underpin with empirical evidence. Our main findings are that buying a halal financial product entails high transaction costs and these costs are not yet reduced by certification.

The remainder of this article is structured as follows: “Islamic Finance and the Basics of Halal Certification” introduces Islamic finance. “Sharia Scholars” describes the agents that certify financial products as halal, namely Sharia scholars. “The Halal Certification Process” describes a typical certification process. “Halal Certification as a Standard” analyzes how (halal) standardization and certification can reduce transaction costs. That analysis is used in “Recommendations” to derive policy implications and recommendations to improve the halal certification process. The article end with “Conclusions”.

Islamic Finance and the Basics of Halal Certification

Islamic finance is a broad term for all financial transactions that are permissible by Islamic law (Sharia).1 Financial products that comply with Sharia law are halal, products that do not comply are haram. The main characteristics of Islamic finance are risk sharing, the prohibition of riba (interest), gharar (excessive risk), maysir (gambling) and products and services that are considered unethical by Islam such as alcohol and pornography. These restrictions imply that Muslims cannot receive or pay interest, they should exactly know the counter value that is offered in a transaction, they may not speculate and they may not invest in companies that sell unethical products and services. Consequently, buying conventional bonds as well as many derivatives and structured products is prohibited under Islamic law.

There are similarities between Islamic finance and socially responsible/ethical investing. Islamic finance promotes prudence and transparency in investing, sharing risks rather then shifting them and avoiding products and services that would harm society from an Islamic perspective. Furthermore, in Islamic finance, transactions have to be based on some underlying asset or economic activity. Gambling for example is considered haram because it involves (potentially) making profit without the actual production of any goods or services. Taking entrepreneurial risk to earn profit, however, is allowed, for example providing equity capital to a farmer to plant wheat.

According to Kuran (2004), Islamic finance in its current form began at the time of partitioning of India and Pakistan as an attempt to strengthen the Muslim identity of Pakistan. It was most notably advocated by the Pakistani scholar Abul Ala Maududi (1903–1979). Arguably the first Islamic bank was incepted in Egypt in 1963 (the Mit Ghamr Islamic Bank). Although initially focused on banking, the industry has branched out to capital markets and insurance as well. Nowadays, there are over 400 Islamic financial institutions operating in 39 countries offering products and services such as banking, equities, mutual funds, insurance and bonds, so called Sukuks (General Council for Islamic Banks and Financial Institutions 2009). The size of the market is relatively modest, but it has been growing rapidly at 15 % per year for a number of years (Khan 2010). Banking assets are estimated to be USD 1 trillion in 2010 (Shanmugam and Zahari 2009; Hoepner et al. 2011) and with a potential market of more than a billion Muslims worldwide these assets are expected to continue growing.

In order for a financial product to be considered halal, it must be certified as such by experts in Islamic law, called Sharia scholars. Specifically, these scholars should be experts in Fiqh Al Muamalat, which is Islamic commercial law. Williams and Zinkin (2010) contend that Islam is clear on what is halal or not. However, there are in fact quite different views on what is considered halal or not depending on which school of thought is followed. To understand these differences we must first introduce the sources of Islamic law. Shanmugam and Zahari (2009) give a good overview and indicate that there are major and minor sources of Islamic law. The main two sources are the Quran, which is the holy book for Muslims and Hadith, which are the reported sayings and actions of the Prophet Mohammed. Whatever is explicitly mentioned in the Quran or Hadith is considered Islamic law. On the topics not explicitly discussed herein Islamic scholars can debate and if they reach consensus, that consensus becomes law (Ijma). Furthermore, there is Qiyas, the method of deducting law from analogy. Essentially, it is using a preceding ruling from Islamic law and applying it to similar cases. Other (minor) ways to derive Islamic law are Ijtihad (personal interpretation of a Sharia scholar), Istislah (taking the public interest into account), Istihsan (juristic preference, exceptions to Islamic law to avoid unfairness) and Urf (local or regional practice).

Schools of thought on Islamic law differ mainly in their acceptance of the various sources of law. The liberal views accept more sources while the stricter views accept fewer sources. Shanmugam and Zahari (2009) and Visser (2009) give concise overviews of the four most widely accepted schools of thought.2 From most to least liberal, they are: Hanafi, Maliki, Shafi’i and Hanbali. The Hanafi view is most popular (Hoepner et al. 2011). It is based on the writings of Abu Hanifa who died in 767 and allows personal interpretation (Ijtihad), reasoning by analogy (Qiyas), consensus among Islamic scholars (Ijma), juristic preference (Istihsan) and custom (Urf). The Maliki view (founded by Malik Ibn Anas who died in 795) strongly relies on Hadith but also allows Ijma, Qiyas and arguably Urf. The Shafi’i view (founded by Muhammad Ibn Idris Al-Shafi’i who died in 819) relies mostly on Hadith. It does not allow Ijtihad and Istihsan but does allow Ijma and Qiyas. The Hanbali school is most strict. It was founded by Ahmad Hanbal who died in 855 and follows a literal interpretation of the Quran. According to this view, the Quran and Hadith are the sole sources of law. For example, it ranks weaker Hadith over valid analogies (El Gamal 2006).3

In practice, the different schools of thought lead to financial products being accepted as halal by some schools but not by others. The distinction between the strictness of the schools is not always sharp though. In some cases, a more strict school allows a financial product even though it requires flexibility in interpretation and vice versa. Specific examples are Urbun and Tawarruq. Urbun is a contract that resembles a call option.4 This type of contract is not allowed by the more liberal schools Hanafi, Shafi’i and Maliki which argue that it involves gharar. The stricter Hanbali school permits it based on certain hadith. Tawarruq is a contract that involves an intermediary (usually a bank) buying a commodity from a dealer and then selling that commodity to its client (the party that needs capital) for a higher price. However, the client is allowed to defer the payment. The client then engages the intermediary to the sell the commodity on the spot market on his or her behalf and receives the proceeds of the sale. In a way, this contract resembles a conventional loan, with the difference between the price paid by the intermediary and the price paid by the client being the interest rate of the loan. This contract is also not allowed by the Hanafi, Shafi’i and Maliki schools but is allowed by the Hanbali school.

The important countries for Islamic finance differ in the schools of thought they follow (Visser 2009). Malaysia for example follows the Shafi’i view, while Bahrain and Saudi Arabia follow the Maliki and Hanbali view respectively. This might be one of the reasons there are no widely accepted standards for Islamic finance. It may also be a reason that in this case the market for certification and standardization will not evolve to a “winner takes all” market but that in the end there will be a few competing halal certifiers, which reflect the different schools of thought. Partly because countries adhere to different schools of thought, there is, as yet, no widely accepted authority that oversees and legally enforces the quality of halal certification for financial products. Apparently because of these different schools of thought the network externalities of standardization, which may bring about a “winner takes all” market (see e.g., Schilling 2002), are not (yet) large enough generate one or a few uniform standards of halal certification.

There are, however, a number of important standard setting bodies (Table 1). The most well known and influential are the Bahrain based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Malaysian Islamic Financial Services Board (IFSB). Both organizations issue standards on interpretation of Islamic law with the AAOIFI focusing more on accounting and auditing and the IFSB focusing on risk management and corporate governance. Others are the Malaysian Accounting Standards Board’s (MASB), the International Islamic Financial Market (IIFM) and the Liquidity Management Centre (LMC). The MASB is similar to (and works closely with) the AAOIFI, but has a focus on Malaysia. The IIFM’s main focus is on standardization of Islamic financial products and documentation, for example by providing standardized Islamic swap contracts. The LMC helps Islamic banks and financial institutions invest their surplus funds in short and medium term Islamic financial products (mostly Sukuk bonds). In addition, the International Islamic Rating Agency (IIRA) provides credit and Sharia compliance ratings for financial institutions. Interestingly, while in most cases Sharia compliance is binary (either halal or haram), the IIRA provides Sharia ratings ranging from AAA to B. Here AAA indicates the highest level of Sharia compliance while B indicates that the entity/instrument is Sharia compliant but has weaknesses in some areas of Sharia quality. A rating below B would thus be considered non Sharia compliant. This is another example of difficulties for common consumers to evaluate Islamic financial products. It is not quite clear whether financial products can in fact be considered just halal or not or whether a certification should indicate the level of Sharia compliance as with the IIRA ratings. Table 1 also underscores the influence of Bahrain, as most of the important standard setting bodies in Islamic finance are based there. Malaysia is the second most influential country. It may foreshadow that on the further road to a “winner takes all” market, in the end there will be two competing world standards for halal certification, namely that of Bahrain and that of Malaysia.
Table 1

Standard setting bodies in Islamic finance

Name

Description

Website

Country

AAOIFI

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an international organization that prepares accounting, auditing, governance, ethics, and Sharia standards for Islamic financial institutions and the industry. It also provides professional designations such as the Certified Islamic Professional Accountant (CIPA) and Certified Sharia Adviser and Auditor (CSAA). The AAOIFI was established on 26 February 1990 in Algiers.

www.aaoifi.com

Bahrain

IFSB

The Islamic Financial Services Board (IFSB) is an international organization that issues standards for the supervision and regulation of Islamic financial institutions. Its areas include corporate governance, risk management, capital adequacy, supervisory review processes, transparency, market discipline, recognition of ratings on Sharia compliant financial instruments, and the development of money markets. It also arranges summits, conferences, and workshops on issues relating to Islamic banking.

www.ifsb.org

Malaysia

MASB

The Malaysian Accounting Standards Board’s (MASB) primary role is to develop accounting and financial reporting standards. Its financial reporting standards are developed in harmony with the AAOIFI. The standards are developed specifically to meet the needs of Islamic financial practices as well as the needs of the regulatory and economic structure in Malaysia.

www.masb.org.my

Malaysia

IIFM

The International Islamic Financial Market (IIFM) is an organization dedicated to enhance co-operation among Islamic countries and their financial institutions, specifically in promoting trading in the secondary market for Sharia compliant financial instruments. It does this for example by standardizing Islamic financial instruments.

www.iifm.net

Bahrain

IIRA

The Islamic International Rating Agency (IIRA) is similar to a credit rating agency, but next to creditworthiness, it also provides ratings for sharia compliance and corporate governance ratings to financial institutions.

www.iirating.com

Bahrain

LMC

The Liquidity Management Centre (LMC) was established to facilitate investment of the surplus funds of Islamic financial institutions into quality short and medium term financial instruments structured in accordance with Sharia principles. It seeks to develop an active secondary market for short-term Sharia compliant treasury products.

www.lmcbahrain.com

Bahrain

Sources Shanmugam and Zahari (2009), Visser (2009) and websites listed in the table

Sharia Scholars

Sharia scholars are crucial for the Islamic Finance industry. El Gamal (2008) even proposes that the major source behind the industry’s growth is due to Sharia scholars selling their expertise. According to El Gamal, they have convinced the Muslim public that conventional investing is haram, consequently creating demand for halal investments. Conveniently, the eligibility of these investments just happens to be determined by the same people that indicated it was haram in the first place.

According to Zawya.com, a Middle East focused online business intelligence platform, there are 391 Sharia scholars in the World5 as of November 2011 and their number seems to be growing fast. Zawya.com obtains data from Funds@Work, a consultancy firm specialized in Islamic finance. According to Funds@Work there were only 221 Sharia scholars in 2010.6 The difference between the 391 and 221 scholars may be partially accounted for by better coverage and data collection rather than an actual increase in the number of scholars. There are also Sharia advisory firms. It is difficult to obtain reliable information on how many of these firms there are.7 However, the advisory firms are less important than the scholars. The industry is driven by the scholars, who often sit together on the same Sharia boards. The difference between Sharia advisory firms and Sharia boards is that the advisory firms act as an advisor of parties looking for a certification and intermediate between these parties and Sharia scholars. The advisory firms assist their clients in the process of applying for a certification. They often have a pool of (well known) Sharia scholars which they use to form a Sharia board for each certification. In addition they provide consulting and training on how to retain a certification.

So who are these scholars? Table 2 (based on Ünal 2011) shows some descriptive statistics and the names (first column) of the top 20 Sharia scholars based on the number of board positions they hold.
Table 2

Sharia scholars

Top 20 Sharia scholars

From

# Board positions

Cumulative (%)

Rank # board positions

Rank # positions in standard setting bodies

Nizam Mohammed Yacoubi

Bahrain

85

7

1

6

Abdul Satar Abdul Karim Abu Ghuddah

Syria

85

15

2

1

Mohammed Ali Elgari

Saudi Arabia

71

21

3

3

Abdul Aziz Khalifa Al-Qassar

Kuwait

39

25

4

Not available

Abdullah Sulaiman Al Manee’a

Saudi Arabia

36

28

5

7

Hussein Hamid Hassan

Egypt

31

30

6

4

Mohammed Daud Bakar

Malaysia

27

33

7

2

Essa Zaki Essa

Kuwait

27

35

8

Not available

Ali Mohuddin Al’Qurra Daghi

Qatar

25

37

9

5

Ajeel Jasem Al-Nashmi

Kuwait

24

39

10

18

Esam Khalaf Al-Enezi

Kuwait

21

41

11

Not available

Esam Mohammed Ishaq

Bahrain

21

43

12

Not available

Khaled Mathkour Al Mathkour

Kuwait

21

45

13

Not available

Mohammed Imran Ashraf Usmani

Pakistan

20

47

14

13

Mohammed Taqi Usmani

Pakistan

16

48

15

8

Mohammed Abdul Razaq Al-Tabtabae

Not available

16

50

16

Not available

Yusuf Bin Abdullah Al-Shubaili

Not available

14

51

17

9

Abdullah Bin Mohammed Al Mutlaq

Saudi Arabia

14

52

18

Not available

Ahmad Bazie Al-Yaseen

Kuwait

14

53

19

Not available

Mohammed Abdulhakim Zoeir

United Arab Emirates

14

54

20

Not available

Rest

 

520

100

 

Not available

Total

 

1141

   

Source Ünal (2011)

Table 2 reveals that the market for financial halal certificates is highly concentrated. Since each financial product is certified by a separate Sharia board incepted for that very purpose, the number of board positions can be interpreted as the number of financial halal certificates given per year. The total number of board positions is 1141 (as of July 2010). The top 20 scholars hold more than 54 % of the entire market, while the top three scholars hold 21 % of the market. Data collected by Ünal (2011) shows that the top 20 % of the scholars (80 out of 391 scholars) control 80 % of the market, which is a typical Pareto distribution found in many other economic phenomena (Mizuno et al. 2008).8

The last two columns of Table 2 show the ranking of the top scholars based the number of board positions (column five) and on positions in standard setting bodies (column six). There is significant overlap between the two rankings. Nearly all the top 10 scholars based on the board position ranking are in the top 20 of the standard setting body ranking. Thus, the very people that control the market are the ones responsible for governing it. Form a corporate governance perspective, too much power is concentrated in the hands of a small number of people. There is a strong conflict of interest here. The monitors are, in fact, monitoring themselves.

In addition, Table 2 indicates that most of the top Sharia scholars are from the Middle East (mostly from Kuwait or Saudi Arabia) although Malaysia, Pakistan and Sudan are also represented. The only scholar from a non Muslim country is Yusuf Talal de Lorenzo from the United States.

Table 3 shows data on the education of the Sharia scholars. Almost all top scholars have a PhD in Fiqh Al Muamalat. However, only about a third of the top scholars have a degree in Economics or Finance,9 while Legal Studies and Arts dominate (Panel A). This raises the question whether the scholars are competent enough to evaluate increasingly complex financial products. An interesting recent development is that an increasing number of Western universities and private companies now offer Master level programs and “certificates” in Islamic finance. Some examples are Durham University (UK), IE Business School (Spain), RSM Erasmus Business School (The Netherlands) and the International Centre For Education In Islamic Finance (INCEIF, Malaysia). It remains to be seen, however, how much merit these programs have in the industry.
Table 3

Education of Sharia scholars

Education besides Sharia

%

Panel A: supplementary education

 Legal Studies

28

 Arts

23

 Economics

23

 Finance

11

 Business Administration

6

 Education

6

 Other

5

Total

100

University

Country

Scholars

Panel B: universities attended by Sharia scholars

 Al Azhar University

Egypt

44

 Imam Muhammed Ibn Saud Islamic University

Saudi Arabia

25

 International Islamic University Malaysia

Malaysia

19

 University of Malaya

Malaysia

16

 Islamic University of Medina

Saudi Arabia

15

 Umm Al Qura University

Saudi Arabia

13

 University of Damascus

Syria

9

 University of Cairo

Egypt

9

 University of Jordan

Jordan

8

 Karachi University

Pakistan

8

 Ain Shams University

Egypt

8

 University of Kuwait

Kuwait

7

 Edinburgh University

Scotland

7

 University of London

England

6

 National University of Malaysia

Malaysia

6

 Harvard University

USA

6

 Qatar University

Qatar

5

 International Islamic University Islamabad

Pakistan

5

 Darul Uloom Karachi

Pakistan

5

 University of Chicago

USA

4

 United Arab Emirates University

UAE

4

 University of Wales

Wales

3

 University of Khartoum

Sudan

3

 Omdurman Islamic University

Sudan

3

 McGill University

Canada

3

 Islamic Science University of Malaysia

Malaysia

3

 Darul Uloom Deoband

India

3

 Boston University

USA

3

 Birmingham University

England

3

Source Ünal (2011)

Egypt is dominant when it comes to universities attended by Sharia scholars (Panel B). 61 of 320 scholars that we identified obtained his degree from an Egyptian university, with Saudi Arabia second (53 scholars) and Malaysia third (44 scholars). The dominance of Egypt is due to Al Azhar University, which is widely regarded as one of the most prestigious Islamic universities in the world. Saudi Arabia’s dominance is also understandable as it is the birthplace of Islam. The popularity of Malaysian universities is interesting given that only 3 of the top 20 scholars are Malaysian. However it is understandable because Malaysia arguably has the most sophisticated Islamic finance industry of all Muslim countries, mainly due to strong government support (Jobst et al. 2008).

Furthermore, Ünal (2011) states that the top Sharia scholars tend to sit on the same boards together. For example, scholars that are members of the AAOIFI have an average probability of more than 70 % of sharing a board with another AAOIFI member. This indicates that the suppliers of halal certification form a rather closed network.

There are no widely accepted criteria for what actually constitutes a Sharia scholar, or which of these scholars are allowed to give a halal certification for financial products. In only a few countries has the government identified specific criteria. Table 4 (based on Grais and Pellegrini 2007) shows criteria to determine eligibility of Sharia scholars for a number of countries. In these cases, being an eligible Sharia scholar means that such a person is allowed to certify financial products as halal. As mentioned before, in most cases though, it is not just one scholar that gives the certification, but a Sharia board, often consisting of three members. To the best of our knowledge, Malaysia and Pakistan are the only countries that have specific requirements for people wanting to become halal certifiers of financial products. In Malaysia, these certifiers (also called Sharia advisors) have to be registered with the Malaysian Securities Commission. They have to apply for a registration and meet “fit and proper criteria”, which for example include a Bachelor’s degree or higher in Fiqh Al Muamalat and at least 2 years of experience in Islamic finance. This list of registered Sharia advisors is publicly available.10 Interestingly, the list shows only 45 names. Comparing these names to the first column of Table 2 reveals that only 5 of the top 20 scholars are registered Sharia advisors suggesting that such registration is not yet taken seriously by the industry. In Pakistan, a minimum level of education and experience as well as minimum grades are required. In most other countries, the criteria for assessing Sharia scholar eligibility are undeveloped. Many countries do not specify any criteria while others only vaguely require that “members must have the proper experience” and “show honesty and integrity”. The fourth column of Table 4 shows that only three countries have limited the number of Sharia board positions a scholar can have. Malaysia and Pakistan allow only one, while Indonesia allows four. Malaysia stands out, since the top two Sharia scholars (Nizam Mohammed Yacoubi and Abdul Satar Adbul Karim Abu Ghuddah) both have 85 board positions and are clearly violating this rule. Still, they are both on the registered Sharia advisor list of Malaysia’s Securities Commission.
Table 4

Fit and proper criteria for Sharia scholars

Country

Fit and proper criteria

Criteria based on

Restrictions on board positions

Required board members

Bahrain

General integrity, reputation, competence, experience and conflict of interest clauses

Bahrain Monetary Agency (BMA) Rule Book, Volume 2, LR-1A.2

Unspecified

Minimum 3

DIFC

Competence (based on previous experience and qualifications) and conflict of interest (may not be directors or controllers of the institution they are reviewing)

DFSA Rulebook: Islamic Financial Business Module

Unspecified

Minimum 3

Indonesia

Integrity (not on Disqualified List of Bank Indonesia), competence (have knowledge of and experience in Fiqh Muamalat, and knowledge of banking/finance), financial reputation (no history of bankruptcy)

Bank Indoneisa Regulation Number: 11/3/PBI/2009

Max 4

Minimum 2, Maximum 50 % of number of Board of Directors

Jordan

Unspecified

Jordan Banking Law of 2000, Law No. 28 of 2000, as amended by temporary Law No.46 of 2003

Unspecified

Unspecified

Kuwait

Unspecified

Kuwait Law No.30 of 2003

 

Minimum 3

Lebanon

Unspecified (background must be in Islamic law and finance/banking)

Lebanon Law No. 575

Unspecified

3

Malaysia

A number of criteria, among others: Must be a Muslim, must be a registered with the Malaysia Securities Commission, minimum bachelor’s degree from a recognized institution in Fiqh Muamalat, minimum of 2 years experience in Islamic finance, proficiency in Arabic and English, must attend at least 75 % of Sharia Committee meetings and intergrity and conflict of interest clauses.

Ammendmant of Central Bank of Malaysia Act 1958, Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions, BNM/GPS1

Max 1 per industry

Unspecified

Pakistan

Minimum 4 years of experience in religious rulings, at least a Shahadat ul Aalmia degree (a standardized Sharia based educational program) from any recognized Board of Madaris with minimum 70 % marks and Bachelor’s Degree with a minimum of 2nd Class, sufficient understanding of banking and finance, integrity and conflict of interest clauses.

State Bank of Pakistan, IBD Circular No. 02 of 2004, Annexure-IV, Revised vide IBD Circular 2 of 2007

Max 1

Minimum 1

Philippines

Unspecified, members must be Islamic scholars and jurists of comparative law

Manual of Regulations for Banks, Implementing Rules and Regulations of Republic Act No. 6848

Unspecified

Minimum 2, Maximum 5

Thailand

Financial integrity, competence, honesty and conflicts of interests.

Islamic Bank of Thailand Act B.E2545

Unspecified

Maximum 4

UAE

Unspecified

Federal Law No. 6 of 1985

Unspecified

Minimum 3

Source Grais and Pellegrini (2007) and country websites

The Halal Certification Process

The halal certification process for financial products is costly and lengthy. The scheme presented in Fig. 1 is based on a Request For Proposal (RFP) that we sent to a number of Sharia advisory firms for the certification of an Islamic Equity Fund (IEF).11 IEFs are very similar to conventional mutual funds, except they exclude firms from industries that are considered unethical such as alcohol and pornography and firms with high leverage, usually a leverage ratio of no more than 33 % is allowed.12 IEFs have become very popular among Muslim investors in recent years, even though many of them have been found to underperform the Islamic market (e.g. Hayat and Kraeussl 2011; Hoepner et al. 2011).13
https://static-content.springer.com/image/art%3A10.1007%2Fs10551-012-1534-9/MediaObjects/10551_2012_1534_Fig1_HTML.gif
Fig. 1

The Halal certification process. Source Based on a sample of 6 replies to a Request For Proposal sent to several Sharia advisory companies

In the RFP we requested an overview of the certification process and the costs. We received a reply from 8 companies out of 14 RFPs submitted, of which 6 provided an overview of the certification process. From this, we constructed a typical halal certification process for a plain vanilla Islamic financial product.

As Fig. 1 shows, the first part of the process is finding and contracting a party that is able and willing to provide a certification. Based on our sample, this process takes approximately 3–4 weeks. In this stage the panel of Sharia scholars (the Sharia board) that will certify the product is assembled. The party looking for certification has to choose between developing the legal structure of the product itself with a risk of complete rejection or developing it in cooperation with the certifier and incurring higher costs. In the second stage, the main legal documents are drafted and subjected to a preliminary review. A Pre and Interim Sharia report is written, containing proposed changes in the product’s (legal) structure. The client incorporates these changes and re-submits the legal documents to the certifier. Based on the revised documents, a final Sharia report is written, which is sent for review to the Sharia board. The third stage is the actual certification. Here, the Sharia board reviews the final Sharia report and accepts or rejects the product as being halal. This process takes approximately 2–3 days. It results in a document provided to the client with a signed statement by the Sharia board that the relevant financial product is deemed halal. The final stage is an ongoing process in which the Sharia board regularly re-assesses the product and retains or withdraws the certification. Depending on the product, this takes place quarterly or annually.

The conclusion from our RFP and the answers we obtained is that the process requires involvement from the certifier throughout. The certification itself requires a relatively small amount of time (2–3 days), but the pre-certification process is quite lengthy. A large part of the pre-certification process is identifying and contracting a certifier. Finally, retaining the certification requires continuous monitoring. The fact that it takes a considerable amount of time to have a financial product certified as halal could hinder the industry’s growth. Benaissa et al. (2007) give the example of an Islamic bank in the Gulf region that developed a new financial product in two months, and then had to wait three months to obtain halal certification.

Although there is only anecdotal evidence on the actual costs of obtaining a halal certification for financial products, the costs appear to be significant (e.g., Morais 2007; Devi 2008). In order to obtain a fair estimate we explicitly asked for a description of the costs in our RFPs. Of the 8 companies that replied, 7 gave an indication of these costs. There are two cost components, a fixed payment for the initial certification and a periodic payment for re-certification, which must be paid throughout the life of the product. Based on the responses to our RFPs, Table 2 and data from, Ünal (2011) we made an estimate of the market size for financial halal certificates (Table 5). The fixed costs range from USD 25.000 to USD 125.000 and the annual costs range from USD 6.000–60.00014 with averages of USD 88.000 and 34.000 for fixed and annual costs respectively. Note the wide range of costs between different parties, which indicates lack of competition and inefficiencies. Obtaining a halal certificate for a plain vanilla financial product costs, on average, around USD 122.000 the first year and USD 34.000 in the years thereafter. These costs are similar to the fees charged by credit rating agencies, which have been estimated to be USD 100.000 at initiation of a financial product (Faux 2011) and around USD 45.000 per year thereafter (The Allen Consulting Group 2004). The market for these certificates is small when set against the total size of the Islamic Finance industry. Given the number of current Sharia board positions (1141) and the average costs per board (USD 122.000), we estimate the total value of the market for halal certification to be USD 139 million. Moreover, if we assume that the high end costs are typical for at least the top three Sharia scholars, we can estimate their annual income to be around USD 4.5 million per scholar.15 Such generous compensation makes the scholars prone to opportunistic behavior and gives them a strong incentive to be lenient in granting halal certifications.
Table 5

Financial characteristics of Halal certification

USD 000s

Minimum

Maximum

Average

 

Fixed cost per board

25

125

88

 

Annual cost per board

6

60

34

 

Total cost per board

31

185

122

 

Average cost per board

122

Total number of board positions

1.141

Market size average

138.795

Maximum cost per board

185

Total number of board positions held by top 3 scholars

241

Average members per board

3.3

Estimated average annual salary per scholar

4.504

Sources Ünal (2011), received replies to Request For Proposals and authors’ estimations

Halal Certification as a Standard

In this section, we use transaction cost theory to detail why transaction costs are especially high for Islamic financial products and how halal certification can, in principle, reduce them.

The main characteristic of transaction cost economics (TCE) is that it departs from the assumption that transactions are free (Coase 1937, 2005; Williamson 1985). Broadly defined, transaction costs are all costs involved in entering into, implementing and complying with a transaction (Den Butter 2012). This entails direct transaction costs such as transportation costs and tariffs as well as indirect costs such as search, contracting and monitoring, which can sometimes outweigh the direct costs.

Den Butter and Mosch (2003) describe how such costs can arise during various stages of a transaction. In the first stage buyers and sellers of a certain product/service must meet each other. In this stage the buyer is looking for a reliable party that is selling the product he needs for his preferred price to quality ratio. The seller on the other hand is trying to find a reliable party to sell his product or service to for the preferred price. Since the information that both parties need is neither free nor easily accessible or complete, both parties must incur search costs. The second stage consists of negotiating the terms of the transaction. Transaction costs arise here because time and money have to be spent to specify and negotiate the rights and obligations of both parties and lay out the consequences of default (contracting costs). In the third stage, costs are incurred to ensure that both parties abide by the terms of the agreement. These costs include monitoring costs and, if necessary, enforcement costs.

In the case of Islamic financial products, some of these transaction costs are much higher than for regular financial products for two reasons. First, Islamic financial products are credence goods, which are goods of which the quality cannot be verified even after purchase (Dranove and Jin 2010).16 The buyer of an Islamic financial product cannot accurately verify the quality (in the sense of being halal or not). Even if the buyer of the financial product has some knowledge to evaluate whether it is halal, he cannot truly verify this since what is acceptable to one school of thought may not be so for another school. This exacerbates information asymmetries between buyers and sellers and creates a stronger demand for information on quality (Dranove and Jin 2010).

Second, Islamic financial products are highly asset specific. Williamson (1985) mentions asset specificity as one of the main reasons for the existence of transaction costs. It is defined as the extent to which an investment supporting a transaction has more value in that specific transaction than for any other purpose. Asset specificity determines the scope of the continuing interest of both contracting parties in each other (Williamson 1975). In the absence of asset specificity, markets are perfectly contestable, and individuals will be unwilling to invest in continuing a specific economic relationship. Asset specificity relates to goods or services that are bound to certain specifications. When the first transaction has been defined and approved with respect to these specifications, the following transactions can take advantage of the fact that the specifications are known and thereby fewer transaction costs have to be incurred. By contrast, the more goods or services are tailored to the individual requirements of the buyer, the higher the asset specificity. If someone wants to buy an Islamic financial asset, for example a non-listed company, the buyer will have to invest considerable time and money to assess whether it is halal. Such investments are quite specific and include for example detailed knowledge of Fiqh Al Muamalat. Moreover, such investments will not benefit that person much in other transactions, they are tied to buying Islamic assets. It is a well established concept in transaction cost economics that due to opportunistic behavior underinvestment will occur in relationships requiring specific investments (Nunn 2007). In our example, the opportunistic behavior arises because the seller of a halal financial product might game the buyer by asking a higher price after the buyer has already invested in the relationship. The buyer will anticipate such behavior and consequently underinvest in the relationship, and thus in some cases the transaction will not occur.

Standards are able to reduce transaction costs because they reduce information asymmetries and asset specificity and enhance trust between buyers and sellers. A standard can be seen as a label given to a product or service that conveys certain information about its characteristics, including quality. In our case, a halal certification is a standard that reduces the transaction costs associated with buying an Islamic financial product. The buyer no longer has to find out whether the product is in fact halal. Contracting costs are reduced since the contracts need not specify as many terms (namely the ones relating to the product being halal).17 In addition, the buyer does not have to worry about monitoring and enforcement since these costs are bourn by the seller who is responsible for maintaining the halal certificate.

In order to work properly, a standard has to be unambiguous, universally accepted and credible. Unfortunately, as we have seen, these qualities are currently lacking in halal certificates. They are not universally accepted, their meaning is ambiguous and their credibility is questionable given the incentive of the certifiers to be excessively lenient.

Recommendations

The previous discussion shows that halal certification as a standard misses the crucial qualities that make standards effective. Consequently, the same problems of asymmetric information and opportunistic behavior exist for halal certification as for Islamic financial products themselves. How can these problems be mitigated?

Certify the Certifiers

A single outside party that governs the market for certifiers would help, but can only be successful if such a party is independent. Currently, such a role is attempted by the AAOIFI and IFSB, but they seem to lack this quality. Grais and Pellegrini (2007) indicate that there are also national Sharia boards (Central Sharia Boards) in Malaysia, Kuwait, UAE, Indonesia, Sudan and Pakistan. However, more than one governing party raises the prospect of different opinions. Furthermore, the current national Sharia boards are mainly concerned with standardization of Sharia interpretation and disputes within Sharia boards. This solution also raises the question of who would govern the many certifiers of certifiers.

Increase Competition

Competition in certifier markets could also work, but is problematic when the underlying assets are complex (Skreta and Veldkamp 2009) or the certification process is not transparent (Farhi et al. 2008).18 Both problems are present in halal financial products. As a result competition will lead sellers to shop around for favorable certification. In addition, Becker and Milbourn (2011) find that in the case of credit ratings competition can also lead to lower quality of ratings due to lower expected future profits as a result of the increased competition.

Disclose Conflict of Interest

Consumers often do not properly discount advice from certifiers even if they disclose a possible bias (Cain et al. 2005). Cain et al., argue that certifiers might strategically take advantage of this fact and give even more biased ratings. The certifiers may even feel “morally licensed” to do so since any conflict of interest has already been disclosed. Some authors downplay certifier bias in Islamic finance, arguing that it is mitigated by reputation effects (e.g., Grais and Pellegrini 2006). Sharia scholars that have a reputation of being too lenient will suffer reputation loss and thus refrain from such activities. However, Mathis et al. (2009) show that for credit rating agencies reputation will only discipline certifiers if a large fraction of their income stems from certifying simple assets. When assets are complex, certification become less stringent, especially when the certifier’s reputation is good. In addition, Bolton et al. (2009) show that for rating agencies certifiers inflate ratings when consumers are naïve or when the expected reputation loss from inflating ratings is low.

Establish Non-Profit Certification

Lessons from new institutional economics (e.g., Ménard and Shirley 2005) indicate that a single, external, neutral and not-for-profit party for Sharia ratings can mitigate many of the current problems. It may not be feasible to fully avoid partiality, since the members of this new non-profit certification entity would likely include at least some of the current top Sharia scholars. However, let us assume that it is not deemed necessary that financial Sharia scholars must be scholars in Islamic commercial law with knowledge of finance and that they could also be experts in finance with knowledge of Islamic commercial law. In that case, a country with good institutional quality and financial talent could specialize in such certification and provide it on a non-profit basis to the international Islamic financial community. The individual scholars would earn a fixed salary and the number of products they can certify would be limited. The Islamic financial community would pay for this service collectively. This arrangement would require (international) governmental intervention though. If left to the market, free rider problems will prevent its inception since it would be a public good. Countries willing to host such an organization should have an excellent institutional quality, a highly developed financial industry and an open culture. Some candidates might be Switzerland, the Netherlands, Canada, Qatar or Singapore. We acknowledge that realizing such a non-profit solution is far away, nevertheless it provides a model to strive for.

Conclusions

Halal certification by a Sharia scholar can reduce the transaction costs of buying an Islamic financial product. Individual Muslims no longer have to assess whether the financial product is halal, thereby avoiding transaction costs, including the effort required to learn Islamic law and monitoring costs. However, in practice halal certification itself still entails high explicit and implicit transaction costs. The explicit costs of certifying an investment fund are estimated to be around USD 122.000 per annum for the first year and USD 34.000 per annum in the following years. In addition there are implicit costs which arise due to the relatively long time it takes to certify an Islamic financial product (between 11 and 14 weeks on average). It also remains difficult to assess whether the Sharia scholar’s assessment is correct. These findings for financial products resemble those of Van Waarden and Van Dalen (2011) who report similar problems in the Dutch market for halal certification of food.

In addition to high transaction costs and quality assessment, there are a number of other problems with halal certification of financial products. First, contrary to the view of Williams and Zinkin (2010), there is no consensus on what constitutes halal due to different schools of thought in Islamic law.

Second, the market for halal certification of financial products is highly concentrated and consists of a closed circle of just a handful of individuals. Although there are around 400 Sharia scholars, the top 20 supply more than half of the certifications. Earnings of top scholars are high. We estimate the top 3 scholars to earn an average of USD 4.5 million per year. Obtaining a position as halal certifier is difficult. The top scholars enjoy substantial brand value, and consequently the cost of obtaining certification differs significantly between well known and lesser known scholars. There is thus a clear risk of what Dranove and Jin (2010) call a certifier bias. The certifiers have a strong incentive to be excessively lenient in giving halal certificates to attract business. There is ample evidence of such certifier bias in related industries such as credit ratings (e.g., Mathis et al. 2009; Bolton et al., 2009) and stock recommendation (e.g., Hong and Kubik 2003). For Islamic finance specifically it has also been noted by El Gamal (2006).

Third, Sharia scholars often sit together on standard setting bodies (e.g., the AAOIFI) that aim to supervise the industry. As a result some of these certifiers are supervising themselves, which is bad governance.

Fourth, the competence of Sharia scholars in evaluating complex financial products is questionable. Our findings indicate that Malaysia and Pakistan are the only Muslim countries that have specific criteria for financial halal certifiers. In principle anyone with proper knowledge of Islamic commercial law (Fiqh Al Muamalt) could qualify. In practice, many of these certifiers have PhDs in Fiqh Al Muamalat, mostly from Egyptian and Saudi Arabian universities such as Al Azhar University and Imam Muhammed Ibn Saud Islamic University, while less than 40 % have degrees in Economics, Finance or Management. As financial products become increasingly complex, the credibility of these Sharia scholars becomes ever more questionable.

In order to deal with these problems we propose several solutions: a certifier for certifiers, more competition, disclosure of conflict, reputation loss and establishing non-profit certification. The last solution has some important policy implications: a neutral country with high governance quality should specialize in the oversight of halal certifiers. This oversight should preferably be non-profit.

The analysis of this article also has its limitations. Our dataset is very limited (6 observations), and our calculations of the market size of halal certificates are rough estimates and should be interpreted with caution. Nevertheless, we believe that the results are informative since the current number of sharia advisory firms is likely to be small (our sample thus represents a respectable portion thereof) and our assumptions for the market size calculations are reasonable.

Further research could focus on the link between halal certification and the risk and return characteristics of financial products, including Islamic Equity Funds (IEFs). Since IEFs are only allowed to invest in stocks with low leverage, they might favor growth stocks (e.g., Hoepner et al. 2011) and low beta stocks (e.g., Hayat and Kraeussl 2011). In this respect, the halal certification might also reduce transaction costs by providing risk return information to potential investors. Another relevant question is whether Muslim investors are willing to accept less return on assets because they derive utility from investing in a Sharia compliant way. Elfenbein and McManus (2010) find that people are willing to pay more for products linked to charity and halal investing might have similar characteristics. Finally, research is needed on the difference between Islamic principles and practices and how this relates corporate social responsibility. Although in principle, Islamic finance might be quite similar to corporate social responsibility (Williams and Zinkin 2010), in practice neither Islamic countries (Rehman and Askari 2010) nor Islamic financial institutions (Khan 2010) seem to follow these principles widely.

Footnotes
1

For a more detailed introduction to Islamic finance we refer to e.g. Askari et al. (2012), Visser (2009) and Shanmugam and Zahari (2009). Furthermore, the Arabic terms we use in this article are based on classical Arabic, which is conventional in research on Islamic finance.

 
2

Islam can (arguably) be divided in two main groups, Sunni and Shia. Here, we describe the law schools of Sunni Islam, to which the largest part (about 85 %) of Muslims belong to and which are most widely followed. Shia Muslims mainly follow the Jafari school of thought (Visser 2009).

 
3

Hadith are categorized as strong or weak based on their authenticity, which is determined by their chain of narrators. The most authorative collection of hadith are those by the Islamic scholars Muhammad ibn Ismail al-Bukhari (816–870) and Abul Husain Muslim bin al-Hajjaj al-Nisaburi (824–883), commonly known as Bukhari and Muslim.

 
4

This is a contract in which the buyer makes a down payment for an asset to be bought in the future for a pre specified price. However, the buyer has the right to cancel the contract, in which case the seller keeps the down payment. Otherwise, the buyer pays the remainder of the price for the asset and gains ownership.

 
7

Our search suggests that their number is limited though.

 
8

Phenomena characterized by Pareto distributions are those in which approximately 80 % of the phenomenon is caused by 20 % of the cause. Mizuno et al. (2008) for example find that 80 % of revenues of a Japanese convenience store chain are attributable to only 20 % of its customers.

 
9

Panel A is based on the top 20 scholars. Data is also available for the top 100 scholars but we omit it since it is very similar to the top 20.

 
11

We sent the same email (available on request) to all the companies. In this email we described some very basic characteristics of the fund, namely that it has an approximate size of EUR 200 million, invests in listed equities, is targeted mostly for institutional investors and has a geographical focus. For confidentiality reasons, we do not report the company names.

 
12

There is no consensus on what the threshold value for the screens should be. One of the screens is a liquidity ratio with current assets in the nominator and either total assets or market capitalization in the denominator. The eligibility threshold for this ratio ranges from 33 to 80 % (Derigs and Marzban 2008).

 
13

El Gamal (2006) mentions another problem with Islamic mutual funds, namely that the Islamic jurists that declared mutual fund investing halal characterized ownership in the fund as being the same as ownership of the underlying stocks. This is usually not the case for these funds.

 
14

The ranges are based on overall minima and maxima. They cannot be interpreted to say that the cheapest certification is USD 32.000 (6.000 + 25.000). The cheapest overall costs for certification we found were USD 85.000.

 
15

Calculated as the product of the total costs per certification (USD 185.000) and the total number of board positions of the top three scholars (241), divided by the average size per board (3.3.) and the sample size (3). This should be seen as a gross income figure, i.e. without taking into account other (fixed) costs of the Sharia advisory firm. However, we assume these to be relatively small compared to the total costs.

 
16

Some typical examples of credence goods are education and medical treatment.

 
17

More specifically, Islamic financial products often make use of Special Purpose Vehicles (SPVs) as an intermediate trading party to make Islamic financial products halal. See El Gamal (2006) for some detailed examples.

 
18

Sellers have an extra incentive to shop around for certification when the application process is not transparent because they do not fear that prior rejections of certification become widely known.

 

Acknowledgments

We thank the Netherlands Organisation for Scientific Research (NWO) for funding and two anonymous reviewers for helpful comments and suggestions.

Copyright information

© Springer Science+Business Media Dordrecht 2012