SHARES AND EQUITIES:

3.1.5 Issues in Stability of Islamic Equity and Equity Index:

The present approach in some jurisdictions of defining the Islamic portion of market as a subset of the larger stock market and leaving this set to develop on its own is not very conducive for its growth. If there is no conscious effort to develop the Islamic portion into the dominant portion of the market some stability issues will arise. For example, suppose the Islamic portion of the market is small in terms of number of companies that qualify various shari[ah-financial tolerance ratios (such as debt to market capitalization). This assumption is not unrealistic in the present state of Islamic capital markets. Let us call the set formed by the companies that qualify shari[ah screening as the shari[ah-admissible set.

Now suppose that the overall market is facing a bearish trend hence stock prices in general are declining. It is likely that the market capitalization of companies would be declining in general including those in the shari[ah admissible set. The companies at the higher end of debt to market capitalization ratio (i.e., boundary) in the shari[ah-admissible set will start to become disqualified as this ratio grows. Therefore, all the Islamic mutual funds and shari[ah conscious individuals will try to avoid buying or start to offload these securities in anticipation and re-adjust their portfolios. This mass behavior (or correlated behavior) has the potential to drive the prices of these boundary shares further down and quicken their exit from the shari[ah-admissible set. Thus the shari[ah-admissible set

The effect of bear and bull market will not be symmetric in magnitude of price fluctuations and risk on the Islamic portion of the market as long as the set of shari[ah-admissible stocks is small.

During a bull run when stock prices start increasing some stocks will move from shari[ah-non-admissible set into shari[ah-admissible set by qualifying the debt to capitalization criteria. However, there is no direct role of shriah conscious investors in bringing them into the set as these investors do not invest in them until these stocks qualify for admissible set either by exogenous rise in price or by a change in the financial structure of the firm. Further, as the shari[ah-admissible set grows it provides better diversification opportunities to Islamic investors.

These issues are not of a concern when the shari[ah-admissible set of stocks is very large. Therefore, it is important to maintain a reasonable size of shari[ah-admissible stocks as long as the above financial ratio based Islamicity criteria is used.

Another point to note with the current criteria is that with the present approach the shares of Islamic banks (if any) remain out of the shari[ah admissible set due to high concentration of murabaha receivables on the asset side of Islamic banks. This means their stocks cannot be traded on the stock market. This also implies that market discipline on these banks will not work through market for corporate control.