Risk Analysis for Zakat Institutions – I

A zakat institution (ZI) intermediates between an individual or institution liable to pay zakat (muzakki) and an eligible beneficiary of zakat (mustahiq). It ensures that zakat funds are managed (mobilized and allocated) efficiently (at least cost) and effectively (with maximum impact). Traditionally, a ZI is expected to play a key role in providing for basic needs of the poor. It is expected to engage in provision of assistance to individuals stuck by natural calamities and crises. Increasingly however, a strategic role for ZI in humanitarian and development finance is being contemplated. Zakat is being seen as an alternative resource (in addition to public and private capital) to meet the massive financing needs related to the realization of the Sustainable Development Goals (SDGs). As the zakat sector gets mainstreamed, it is increasingly being seen as a part of the formal financial system.

The core business of a ZI comprises mobilization and allocation of zakat funds. The ZI acts as an agent of the zakat-payer (and at times, performs an advisory function of estimating zakat liability for him/her) and undertakes to allocate zakat funds among the mustahiq or eligible beneficiaries according to Shariah (and at times, in conformity with additional stipulations by the zakat-payer, e.g. orphans only, or single mothers only). It is expected to utilize a percentage of zakat funds mobilized towards intermediation costs (administration, socialization, marketing) that is below a maximum limit defined by the Shariah or regulation or convention. From a governance point of view, a ZI must strive to meet the expectation of its various stakeholders – zakat payers, beneficiaries, employees, government and the society at large. However, in a dynamic world and a constantly changing business environment, the ZI faces the possibility that it may not be able to carry on its core business in a sustainable manner or meet its stakeholders’ expectations. These factors constitute the risk factors. A comprehensive risk analysis of a ZI will require the identification of all such risk factors. Let us consider these risk factors one by one.

Reputational Risk: This is perhaps the most important risk factor from the standpoint of a ZI. Empirical evidence clearly points to the fact that ZIs that stand out in terms of sustained growth in their operations and high impact, are the ones with high reputational capital, known for their honesty, integrity, sincerity, commitment, frugality and overall efficiency. Reputational risk is the risk arising from a setback to reputation that can adversely affect a ZI’s credibility among its stakeholders and its ability to maintain existing, or establish new, relationships with other parties.

Withdrawal Risk: Related to reputation risk is withdrawal risk, which may result from negative perception in the muzakki-community, as well as from competitive pressures that the ZI faces from other ZIs and charity institutions. A ZI could be exposed to the risk of losing its existing muzakki clients for a variety of reasons, including poor service quality. Given that the cost of acquiring a new muzakki may be much higher than retaining an existing muzakki, the institution is exposed to muzakki-attrition risk or muzakki-loss risk.

Governance Risk: Governance risk refers to the risk arising from a failure to govern the institution, negligence in conducting business and meeting contractual obligations, and a weak internal and external institutional environment. Instances of poor governance may take the form of inability to separate the mobilization function from the allocation functions; and to separate zakat funds from other types of funds (e.g. sadaqa, waqf). It may take the form of concentration of all key managerial decisions with a single charismatic leader. It may also take the form of a wide-spread practice of nepotism that vitiates against competency-based human resource deployment. A subset of the above may be termed as leadership risk, which may be due to the ZI’s poor succession planning and consequently, the new leader’s failure to fully comprehend and implement the vision and mission of the institution. Related to this is amil governance risk, which may be caused by improper amil conduct including ineffective amil governance structures and requirements, and abuse of code of conduct.

Fiduciary Risk: Fiduciary risk is the risk that arises from an institution’s failure to perform in accordance with explicit and implicit standards applicable to its fiduciary responsibilities. Fiduciary risk leads to the risk of facing legal recourse, if the ZI breaches its fiduciary responsibility toward zakat payers, e.g. to allocate their contributions in accordance with Shariah stipulations or in conformity with their revealed preferences for specific projects/ beneficiaries. Fiduciary risk also arises in the context of zakat allocation to poverty-alleviation or economic empowerment projects, where the ZI is expected to perform adequate screening and monitoring of projects, and any deliberate negligence in evaluating and monitoring the project can lead to fiduciary risk. It becomes incumbent on management to perform due diligence before committing the zakat funds. Mismanagement by incurring unnecessary expenses or allocating excessive expenses to the projects and interventions is a breach of the implicit contract to act in a transparent manner.

Transparency Risk: Transparency in the context of a ZI refers to the public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of the sources and application of zakat funds. Transparency also demands that all ZIs in the system use a uniform set of standards, which is not the current practice. The disclosure regime for ZIs needs to become more comprehensive and transparent, with a focus on the disclosure of critical variables, e.g. expense- mobilization ratio, allocation-mobilization ratio, risk profile and impact/outcome of projects undertaken, and internal governance.

Shariah Risk: Shariah risk arises from divergent or nonstandard practices in respect of zakat collection and disbursement in different jurisdictions. It also arises due to the failure of a ZI to comply with Shariah rules, which is also a form of fiduciary risk. The former kind of Shariah risk exists due to differing interpretation of Shariah rules in certain matters, e.g. zakatability of certain contemporary forms of assets and income, allocation of zakat across regions/ countries, among certain categories of beneficiaries etc.

It may be noted that the all the above risks arise from negligence, noncompliance, lack of transparency and good governance and contribute to reputational risk. It may be noted that, while reputational risk in case of a mainstream intermediary like a bank could taint the reputation of the entire sector (as it operates in an environment of interdependence), a zakat institution can stand on its own[1]. The issue of contagion effect is of lesser significance for a ZI.

[1] For example, Edhi Foundation Pakistan collects over one-third of total zakat in an environment of acute trust-deficit among zakat-payers towards the national zakat apparatus of the Government of Pakistan.