Islamic Banking and Financial Markets Critical Issues Research Paper

Executive Summary

This paper focuses on ijarah as a mode of transaction under Islamic banking that permits Muslims to acquire property in a shariah compliant way. First an overview of ijarah including its features and conditions is presented. This is later followed by a discussion on the difference between an ijarah contract and the conventional financial system. The differences between ijarah and other contracts under Islamic financing are explained. Precisely, ijarah is distinguished from murabahah, mudarabah, diminishing musharakah, salam and istisna. Finally, the requirements of an ijarah contract and the considerations of a promise to purchase a house are talked about.

Introduction

Islamic banking is a form of banking whose objectives and operations are fully guided by Quranic principles that govern the Islamic religion. All transactions including deposit taking and financing are based on Shariah laws that are founded on Islamic principles. Central to Islamic banking is the prevention of interest or riba. In general, Islamic banks are not expected take interest.

Apparently, there are four teachings in the Quran that advice those who profess the Islamic faith against taking interest from borrowers¹. First of all, interest is regarded as a removal of wealth from the blessings that come from God. Secondly, taking interest is likened to the embezzlement of another person’s property. Thirdly, all Muslims are expected to desist from taking interest for the sake of their own welfare. Taking of interest is thus regarded as a curse. Finally, Muslims are only required to recover the principal amount and in the event that a borrower is not able to pay back what was borrowed, the lender should forgo the money owed to him or her. Arguably, any person who acts contrary to the requirements of Shariah law as far as interest taking is concerned is said to be at war with God as well as his Prophets.

Despite being a very small segment of the entire financial sector in the world, Islamic banking has continued to infiltrate various countries over the years². Similar to conventional banks, however, Islamic banks run risks as part of their operations. The Shariah Supervisory Board exists to ensure that all Islamic banks are compliant with the requirements of the Shariah law³.

Overview of Ijarah

Under Islamic banking, Ijarah is a lease or contract in which a lessor allows a lessee to make use of his or her property after paying an agreed amount as rental fee. According to Schoon⁴, two distinct forms of lease transactions can be identified under ijarah and are known as operating and financing lease agreements. Under the ijarah contract, the lessor usually transfers the usufruct of a given property to a lessee for a specified period of time. The lessor is known as the mujir while the lessee is known as the mustajir.

Ostensibly, ijarah is a strategy that is used by business enterprises to get what is needed in order to conduct their business operations. Typically, the acquisition is through a lease rather than direct buying of property or equipment. An obvious advantage of getting an asset by means of an ijarah contract is the ability of business enterprises to reduce the heavy burden often associated with the purchase of equipment. In addition, it is possible for a lessee under an ijarah contract to acquire the leased asset by purchasing it from the owner based on a mutual agreement between the two. Although the owner of the asset has the liberty to determine the disposal price for the asset under consideration, it has to be kept at a minimum. Usually, the associated lease fee is calculated in such a way that the cost of buying the equipment together with any profit realized are recovered at the end of the lease period stipulated in the contract.

Features and Conditions of an Ijarah Contract

Under the ijarah contract, the lessor must be the owner of the asset to be leased. It is the responsibility of the lessor or owner to maintain the leased property so that it continues to generate benefit for the borrower⁵. Normally, the lessor is expected to protect the leased asset by arranging for adequate insurance against any loss or damage. He or she is responsible for certain costs and liabilities arising from leasing the asset including damage to the asset, payment for any insurance premium costs and basic maintenance. While the cost must be borne by the owner of the equipment, he or she may authorize the borrower to administer the leased asset on his or her behalf for the sake of efficiency.

A key requirement is that all the terms of an ijarah contract must be stipulated in detail. The terms include the identification of the asset being leased, the agreed rental amount and period, the payment schedule, and the purpose for which the asset may be used. The leased asset must be treated as a trust in the hands of the lessee and the contract is always intended for the utilization of the asset and not for its consumption. Consequently, the contract specifies that the leased asset must not be perishable or consumable. In case of default by the lessee in making rental payments, the lessor is entitled to revoke the contract and claim the contract price for the remaining period of the contract. In the event that the leased asset is mutilated as a result of the lessee’s irresponsible behavior, he or she must compensate the owner of the asset accordingly.

Not long ago, Muslim jurists introduced another contract known as ijarah wa qtina or hire purchase agreement which is similar to the conventional lease purchase agreements. In addition to the requirements of a regular ijarah contract, a lessor under an ijarah wa qtina contract is expected to sell his or her property to the lessee at the end of the contract⁶. However, it is not mandatory for the lessee to purchase the asset under lease. Based on the prevailing circumstances, the lessee may choose to let the owner keep his or her asset. Ordinarily, the price for the residual value of the leased asset is determined in advance by both parties.

Arguably, the ijarah contract has great potential for developing advanced financial instruments to meet the demands of investors and entrepreneurs⁷. One of the main attributes of leasing practiced today is that the rental flows can be either a fixed amount or a floating amount which makes it suitable for meeting the different needs of investors. Leasing constitutes a large portion of the portfolios of Islamic banks and one of the reasons Islamic banks do not increase their lease portfolio is that by becoming then lessor of an asset, the bank takes on additional responsibilities for administering the lease which is not their main business.

Difference between Ijarah and Conventional Financial System

Although an ijarah contract is technically a sale contract, it does not involve the sale of a tangible asset. Rather, it is the sale of the usufruct or the right to use an asset for a specified period of time. The word ijarah as used under Islamic banking conveys the sense of both hire and lease agreements. Despite the fact that it refers to the lease of tangible assets such as property and merchandise, it is also meant to denote the hiring of personnel services for a fee. The renting of an asset is also covered under the ijarah contract. In such cases, the asset is leased for a much shorter period than its actual useful life which means that the asset can be rented to multiple users over its life.

In comparison to conventional type of financing which is generally in the form of a debt, ijarah contracts result in financing against an existing asset. Considering that the ownership of the asset serves as collateral and security against any future loss, an ijarah contract appears to integrate both financing and collateral. Typically, the title or ownership of the leased asset remains with the lessor who, in case of default by the lessee, can repossess the leased property. In addition, the financing of the asset is not dependent on the capital base of the lessee but on his or her ability to service the rental cash flow payments as stipulated in the lease agreement.

While the function of the Ijarah resembles that of a conventional lease agreement in various ways, there are remarkable differences between the two. Under an ijarah contract, the lessor must own the leased asset for the duration of the lease. An ijarah contract also lacks compound interest usually charged under conventional financing in case a customer fails to honor his or her rental payments as established in the contract. This notwithstanding, an ijarah contract has unique characteristics that make it appealing to investors who do not profess the Muslim faith⁸.

Ijarah and other Islamic Banking Transactions

As pointed out earlier, an ijarah contract requires the owner of a leased asset to allow the lessee to use it throughout the contract period. This is, however, subject to rental payments by the lessee. Undoubtedly, the application of shariah law helps to reinforce Islamic financing contracts solely to protect the interests of both the lender and the borrower. Apparently, this is a characteristic that is conspicuously absent under conventional financing. While the lessee is free to use the leased asset, he or she is expected to avoid any form of damage to the asset. This ensures that the interests of the lessor are well catered for. To avoid confusion, it is the responsibility of the owner of the asset to ensure that it is properly maintained. Expenses related to the operation of a leased asset are, however, the obligation of the lessee. Under an ijarah contract, the lessee has a right to terminate a lease agreement if he or she can provide sufficient evidence to show that the value of a leased property has declined. In modern practice, however, leased assets are usually insured against such contingencies. The other types of contracts under Islamic banking and how they differ from ijarah are discussed in the following subsections.

Ijarah and Murabahah

The murabahah contract refers to the sale of goods with a pre-agreed profit mark-up on the cost and is of two types. In the first type, an Islamic bank purchases the goods and makes them available for sale without any prior promise from a customer to purchase them. In the second type, the customer identified the goods or services and the Islamic bank purchases on his or her behalf. The goods or services are later sold to the customer by the bank. In the latter case, the Islamic bank purchases the goods only after a customer has made a promise to purchase them from the bank. Ostensibly, murabahah refers to a particular kind of sale having nothing to do with financing in its original sense. Unlike in the case of an ijarah contract, the selling of an item under a murabahah transaction requires full disclosure of the original cost of the commodity. The seller then determines a reasonable profit in the event that the commodity has to be sold to a third party.

In Islamic financing, murabahah is not different from a normal sale. It differs from other sales since the seller has an obligation to disclose the cost of a commodity as well as the projected profit to a prospective buyer. Every transaction must be based on the fact that the purchaser must be made aware of the cost as well as mark-up. A sale that omits this important notion is thus invalid under murabahah.

There are outstanding differences between ijarah and murabahah. First, the ownership of an asset remains with the owner for the entire lease period under ijarah while it is immediately transferred to the customer under murabahah. Rental payments under ijarah are also flexible whereas those under murabahah are fixed and no change is allowed.

Ijarah and Mudarabah

The mudarabah is one of the most popular contracts of sale used for purchasing commodities and other products on credit. The concept is that a financier purchases a product on behalf of an entrepreneur who does not have the capital to do so. The financier and the entrepreneur agree on a profit margin, often referred to as mark-up which is added to the cost of the product. Mudarabah must be based on a sale and can not be used for a purpose other than purchasing a product.

For a sale transaction to be valid under Shariah law, the sale item has to be purchased by the financier, who takes ownership and possession of it. In the event of default by the end user, the financier only has recourse to the items financed and no further mark-up or penalty may be applied to the outstanding liability. As opposed to conventional loans, there can be no accrual of interest. It is common practice among Islamic banks to consider the non-payment of two consecutive installments as default, at which stage the bank is entitled to declare that all the other installments are due immediately. In some cases, Shariah scholars allow the financier to recover additional amounts to offset any loss or damage arising from the default. The financier is allowed to ask for security in case of any non-payment in the future. Often, an asset other than the item being financed through mudarabah is taken as security, but when no such asset is available, the financier takes the item itself as security. Ostensibly, this may require additional claims by the financier on the item financed, such as naming the financier as a beneficiary in the insurance policy.

Usually, the mark-up rate charged by the financier is influenced by the type of product, the type of security and collateral, the ability of the client to pay, and the length of time for which the financing has to take place. Another distinct feature is that the resulting financial claim resembles conventional debt security characterized by a predetermined payoff. The difference is that Islamic instruments are clearly and closely linked to, and collateralized against, a real asset and are consummated by a transactional contract. As a result, a financial claim is created against a real asset with a short term maturity and relatively low risk.

Although mudarabah financing is allowed by the Shariah and is very popular with Islamic banks, there are some misconceptions about the instrument among those who do not fully understand the contract. The misunderstanding stems from the question of the difference between the mark-up and interest, since mudarabah results in a financial claim like a zero-coupon bond with a fixed rate of interest. This misunderstanding is further compounded when an outsider observes a close relationship between the mark-up and the prevailing interest rate in the market.

In distinguishing mudarabah from ijarah, it can be pointed out that in the former a specific asset is purchased for the client to ensure that the financing is linked to an asset. In addition, whereas under ijarah the financier is exposed to credit risk only, in mudarabah, the financier is first exposed to the price risk when the product is acquired for the client because the client retains an option to decline to take delivery of the product. As such, it is argued that by engaging in buying and selling the product, the bank is exposing itself to risks other than simple credit risk, as well as promoting exchange of a real asset. A mudarabah transaction is thus quite different from an ijarah contract. The legal difference between a mudarabah contract and an ijarah contract is, however, absolutely clear. The former is a sales contract in which the price is increased for the deferment of payment while the latter is an increase in the amount of a debt for deferment.

Ijarah and Diminishing Musharakah

Musharakah refers to an Islamic joint venture partnership in which the bank and its customer come together to combine financial resources to undertake and manage a business venture according to the terms of an agreement. While profits are shared according to a pre-agreed profit sharing ratio, losses are shared in proportion to the amount of capital contributed by each partner. In a diminishing musharakah contract, a party, after participating in ownership of any business or project, can liquidate his or her investment from the asset or the ongoing business.

As a financing technique, diminishing musharakah is a new type of contract suggested by contemporary jurists keeping in mind the problems perceived while discussing the traditional musharakah and mudarabah principles in the broader economic perspective. When applying diminishing musharakah through contractual partnership, the ratio of the profit distribution for each partner should be clearly determined. This ratio may, however, be changed with mutual agreement due to a change in the ratio of equity share of the parties. Where a loss has occurred, each party to the contract must bear a responsibility equal to their level of contribution. As far as partnership by ownership is concerned, the major objective of its forming is not profit earning through business and the ratio of profit distribution does not need to be stipulated in the agreement. The sharing of risks as well as rewards under diminishing musharakah is generally based on a person’s contribution.

Apparently, a partner under diminishing musharakah is allowed to lease his or her part which implies that he or she can receive rent for the part that has been leased to the other partner. The lessee who is the owner of a part of the asset gets the reward of his or her part by using the asset without paying rent. However, the amount of rental paid by the lessee may reduce in the event that the lessee buys part of what belongs to the financier. Both parties are expected to share the ownership related expenses and losses if any in the case of a sale on pro rata basis. Through partnership by contract, the lessee can decide to slowly buy what belongs to the financier at the prevailing market prices. It is not permitted to stipulate that the ownership units will be bought at a pre-agreed price or at their original or fair value, as this would constitute a guarantee of share capital of one partner by the other partner which is prohibited under the shariah law.

In diminishing musharakah through partnership by ownership, a partner is not permitted to buy what belongs to the other partner. Diminishing musharakah in trade is conducted for the purpose of profit earning. As such, the price of units of the financial institution can not be fixed in the promise to purchase by the other partner or client because it would practically mean that the client has guaranteed the principal invested by the financier with or without profit. The financial institution either has to agree to sell the units of his or her ownership on the basis of valuation at the time of the sale of each unit, or allow the client to sell these units to anybody else at whatever price he or she can. At the same time, however, it would offer a specific price to the client meaning that if he or she finds a purchaser of that unit at a higher price, he or she may sell it to him or her. If he or she wants to sell it to the financier, the latter will be agreeable to purchase it at a price fixed by him or her beforehand. However, this does not seem to be feasible as it does not serve the purpose of decreasing the equity in any business as required under a diminishing musharakah agreement.

In distinguishing an ijarah contract from diminishing musharakah it can be argued that ijarah can be part of a diminishing musharakah arrangement while diminishing musharakah can not be part of an ijarah contract. This is because the lessee under an ijarah contract has the option of either buying or disposing the leased asset through a sale at the end of a contract. In addition, the lessor may promise to gift the leased asset to the lessee after the lease period expires but the promise should not be part of the leasing contract. Under ijarah contract, the ownership and title of the asset remains with the lessor during the period of lease even if he or she made a promise to give it as a gift to the lessee after the lease period.

Ijarah and Salam

Under a salam transaction, it is permissible for a person to sell his or her goods before the actual delivery which takes place much later. The purchaser is, however, required to pay the full price in cash at the time of entering into the agreement. Although the price is in cash, the supply of goods if deferred to a later time. Seemingly, the salam agreement is designed to help borrowers such as farmers to meet their immediate needs while until it is time for the harvest. Traders are equally benefit from a salam agreement by receiving advance payments for their goods pending delivery that must take place at a future date. To a large extent, a salam contract benefits both the buyer and the seller. While the seller receives his or her payments in advance, the purchaser spends a significantly lower amount to purchase the goods. Clearly, the provisions of a salam contract are contrary to the common practice that requires delivery before any payment can be effected. In addition, the buyer has an obligation to pay the seller the full cost of the goods under consideration at the time of entering into a salam contract with the seller.

Any sale that ignores full payment is thus not recognized. Besides, a salam contract is meant to instantly help the seller meet his or her needs. If it is not paid in full therefore, the basic purpose of salam will not be achieved. For any goods to be sold through a salam contract, it must be possible to specify the exact quantity as well quality of the goods. For example, precious stones may not be sold on the basis of salam because each stone differs in terms of quality, size and weight. Besides, their exact specification is not possible. Another condition is that salam is not applicable in some specific situations where the sale of a particular commodity is not catered for under a salam contract. The concern here is that delivery of the said commodity may not be guaranteed. It is imperative for the parties to a salam contract to see to it that the terms and conditions of the agreement are clear and that no ambiguity exists. Apparently, this is meant to ensure that no dispute arises later. The terms used in the contract must be absolutely clear to both the seller and the buyer. It should be measured or weighed in its usual measure only since what is normally weighed may not be quantified and vice versa.

Equally important is the fact that a salam contract must clearly specify the date as well as the location of delivery. A salam contract may also fail to meet its requirements if applied to any goods whose delivery has to be immediate. It must be absolutely necessary for the seller to deliver the goods at a future date. There are also critical conditions that are attached to a salam contract regarding to date of delivery. The time of delivery should be at least fifteen days or one month from the date of agreement and the period should be long enough for prices to be affected. Ordinarily, the profit earned by the buyer is the difference between the market price for the goods and the price under the salam contract. In some instances, it may be necessary for the seller to provide the buyer with some form of security as guarantee that he or she will fulfill his or her part of the agreement as stipulated in the contract document. At the time of delivery, the seller under the salam contract is expected to ensure that buyer gets the goods as earlier agreed.

Ijarah and Istisna

The Istisna contract is suitable for facilitating the manufacture or construction of an asset at the request of a buyer. An Istisna contract is immediately created the moment a person decides to produce an asset or property for the buyer. Both the buyer and the manufacturer agree on the specifications and price of the asset to be manufactured. At the time of delivery, if the asset does not conform to the specifications, the party placing the order has the right to retract the contract. One of the important features of Istisna is the flexibility it allows regarding the mode and timing of payment. Apparently, it is not necessary that the price be paid in advance nor that it paid at the time of the delivery. The parties can agree on a payment schedule convenient to both and the payment can also be made in installments. As explained by Rosly⁹ the Istisna contract is one in which an asset is bought or sold before it comes into existence.

Unlike ijarah, the Istisna contract requires the underlying asset to be manufactured or constructed and there is no requirement to pay the full price at the time of the contract. The Istisna contract can also be cancelled before the manufacturer undertakes manufacturing and it provides flexibility in the time of delivery. Like ijarah, Istisna has great potential for application in the area of project finance in different sectors and industries. It has been applied successfully in aircraft manufacturing, locomotive and ship building industries as well as the manufacturing of heavy duty machinery. The Istisna contract is also suitable for use in the construction industry for building structures such as roads, dams, housing, hospitals, and schools.

Contract

Islamic principles of finance permit the purchase of an asset for subsequent rental which may include certain profit to the investor. A commercial organization or an individual client wishing to acquire the use of capital equipment may request the Islamic bank to purchase such an asset and oblige itself to rent the asset from the bank. The Islamic bank ijarah contract stipulates specific responsibilities with regard to operating and financial leases.

Ordinarily, the rental period is agreed on and clearly stated in the contract document and the lessee is expected to surrender rental payments to the lessor on a date stated in the contract. In the event that the lessor issues a rental period notice to change the rental period, it is only applicable for the rental period for which the rental period notice is issued. To be valid, the said notice must be sent to lessee ten days before the commencement of the original rental period and first rental payment. In the same way, the lessee is expected to respond to the request by the lessor before the start of the original rental period. In his or her response, the lessee may choose to accept or reject the change suggested by the lessor. In case the lessee fails to respond within the said period, it is assumed that he or she has accepted the proposed change. The parties to the contract may also agree to an advance payment whereby the lessee is expected to give the agreed amount before the rental payment date.

If the leased asset is available and ready for use by the lessee, and the lessee fails to collect it within a period of seven days from the date of the first rental period, he or she will be expected to honor the requirements of the contract until the rental period comes to an end. Normally, the eighth day following the elapse of the seven days is the hand over date in case the hand over has not already taken place. Ordinarily, the lessee advises the lessor to deduct the rental payment from his or her account. The lessor and lessee may, however, agree on any other payment method deemed convenient to both parties. Where the rental payment has to be deducted from a lessee’s salary, the lessor is allowed to block the rental payment amount from the lessee’s salary even if the salary payment is received in the lessee’s account with the lessor before the due date for rental payment.

In the event that the due date for rental payment falls on a day that is not a business day, the previous day is usually be taken as the due date for the rental payment. The contract permits the automatic extension of the hand over date for one month as long as the said extension period is not more than 10% of the length of the lease period. Apparently, this implies that the rental payment dates will equally be delayed so as to be inline with the hand over date.

The contract also specifies that any asset that is being leased must not be subject to an existing lease at the time of executing a new lease agreement. In such a case, it is imperative to wait for the existing lease to come to an end before commencing a fresh lease on the asset. The renewal of a lease that is already in place by a lessee is considered a sub-lease and any rental payment amounts made are regarded as advance rental payments which must be added to the rental payment that is due for the remaining part of the rental period. During the lease period, the contract does not permit the lessee to interfere with the rights of the lessor as far as the ownership of the leased asset is concerned. The lessee is thus expected to do whatever it takes to ensure that the leased asset is secured. This may include seeking proper authorization and the acquisition of relevant titles or licenses.

Application of Ijarah in the Purchase of a House

This section discusses how an ijarah contract may be used to purchase a house. According to Kettell¹⁰, ijarah is a popular method used by Muslims to finance the purchase of a house. Unlike murabahah, it is more flexible and allows a client to repay early or make additional lump sum payments toward the purchase of a house.

Typically, the customer identifies the house that he or she wants to buy and agrees the purchase price with the seller in the normal way. The customer proceeds to approach an Islamic bank for assistance and completes an application form. The bank then undertakes to buy the house in its name after legal representatives confirm that everything is in order. This is followed by the bank selling the house to the customer as detailed in an agreement referred to as promise to purchase. Usually, the purchase price between the bank and the customer is the same price as the original purchase price for the house. At the same time, the customer enters into a lease with the Islamic bank which details his or her right to occupy the house.

Once the house is purchased, the customer makes monthly payments to the Islamic bank as stipulated in the agreement. Each monthly payment is calculated in such a way that part of it is applied toward the purchase of the house from the bank and part is applied as rent. As a rule, the payments are fixed every twelve months and the bank reassesses the rent and payments which are likely to vary depending on the existing circumstances. The customer may, however, purchase the house from the bank at any time by paying the balance of the agreed purchase price.

As a requirement of the ijarah contract, the house is registered in the bank’s name for the entire period of the lease. The tenant or lessee agrees at the beginning to eventually purchase the house but at the original price paid by the bank without any mark-up. The monthly payments made by the client to the bank consist of three main elements. The first element covers the repayments of the funds used by the bank to purchase the house. The second element is expected to meet the rent of the house, and is the source of the profit earned by the bank. The rent is revised on an annual basis to ensure that the bank is making a reasonable return and is adjusted downward to reflect payments already made to the bank by the customer. The third and final element is an insurance rent to recover the cost of insurance that the bank has to pay on the house. Over time, the monthly payments may increase or reduce depending on the size of the first repayment element that the client decides he or she can afford. Although early repayment is advantageous for the customer, it could be potentially unprofitable for the bank unless the bank can obtain a higher return by reinvesting the funds elsewhere.

Conclusion

As has been explained in this paper, ijarah is an Islamic banking transaction that enables business enterprises to acquire property by leasing rather than direct buying. It is a strategy used by Muslims to purchase a property and its popularity comes from the fact that it enables businesses as well as individuals to reduce the burden that often accompanies the purchase of property or equipment needed for business operations. However, it is quite flexible as it allows individuals or business enterprises to purchase the leased property at the end of the lease period. Usually, the lessor is allowed to transfer the ownership of the leased property or equipment to the lessee at a small fee.

Bibliography

Iqbal, Z & A Mirakhor, An Introduction to Islamic Finance: Theory and Practice, John Wiley & Sons, Hoboken, 2011.

Kettell, B, Introduction to Islamic Banking and Finance, John Wiley & Sons, Hoboken, 2011.

Rosly, SA, Critical Issues on Islamic Banking and Financial Markets, Author House, Bloomington, 2005.

Schoon, N, Islamic Banking and Finance, Spiramus Press Ltd, London, 2010.

Footnotes

1. B Kettell, Introduction to Islamic Banking and Finance, John Wiley & Sons, Hoboken, 2011, p. 31.
2. N Schoon, Islamic Banking and Finance, Spiramus Press Ltd, London, 2010, p. 2.
3. Kettell, p. 38.
4. Schoon, p. 33.
5. Z Iqbal & A Mirakhor, An Introduction to Islamic Finance: Theory and Practice, John Wiley & Sons, Hoboken, 2011.
6. Schoon, p. 35.
7. SA Rosly, Critical Issues on Islamic Banking and Financial Markets, Author House, Bloomington, 2005, p. 25.
8. Kettell, p. 40.
9. Rosly, p. 35.
10. Kettell, p. 43.