A Critical Review of the Thresholds of Sharia Screening for Stocks

Abstract

Capital markets represent the second main application area of Islamic finance after the banking sector. The most important instrument traded in these markets is stocks. The character of companies is important on the legitimacy (shariah compliance) of investing in stocks. The fact that the companies with a completely Shariah compliant structure are few in number brings about investing in mixed companies that carry out Shariah non-compliant activities even though their main activity is legitimate. Depending on this necessity, companies are allowed to carry out financial activities that do not comply with Shariah principles to a certain extent. In this context, thresholds are used within the scope of Shariah screening to determine the level of non-compliant elements to Shariah in the company. There are two different approaches to determining thresholds; the minority-majority-centered approach and the necessity-centered approach. The first approach uses Shar'i evidence showing the less or more borderline when setting thresholds for all analysis of Shariah screening. The necessity-centered approach, on the other hand, focuses on determining the amount of necessity based on market data. Both methods contain methodological problems in the threshold determination processes. This study aims to reveal the problems of both methods and to propose the sectoral necessity-centered method as an alternative.