Ijarah / Leasing

Ijarah Ijarah is a term of Islamic Fiqh Literally, it means “To give something on rent” The term “Ijarah” is used in two situations: 1. It means ‘To employ the services of a person on wages’ e.g. “A” employs “B” to work at his office, and pays him a salary for his work “A” hires a porter at the airport to carry his luggage 2. Another type of Ijarah relates to paying rent for use of an asset or property The 2nd type of Ijarah is relevant to our discussion This Ijarah is analogous to the English term “Leasing”

Rules governing Ijarah

Ijarah Rules governing Ijarah are similar to the rules governing sale. Because in both cases something is transferred from one person to another The only difference is: In case of sale, title of property is transferred to Buyer In case of Ijarah, title remain with the Lessor Only the use of the property is transferred to Lessee Leasing is an acceptable transaction under Shariah The difference between conventional Lease and Ijarah lies in the nature of the contract The question of whether or not the transaction of leasing is Shariah compliant depends on the terms and conditions of the contract Several characteristics of conventional agreements may not conform to Shariah thus making the transaction un-Islamic and thereby invoking a prohibition

Ijarah In order to use Leasing as a mode of finance Changes need to be made to the Lease Agreement Change of name from “Interest” to “Profit” will not suffice Some basic parameters of the agreement have to be changed to reflect the change in the nature of the transaction

Ijarah Rules of Shariah governing Ijarah 1. Leasing is a contract where the owner of an asset transfers its use to another person against an agreed price However, ownership of the leased asset remains with the Lessor Since ownership of the leased asset remains with the Lessor, all rights and liabilities relating to ownership are borne by the Lessor All rights and liabilities relating to use are borne by the Lessee e.g “A” gives his house to “B” on rent Property taxes are to be borne by the owner Water tax, electricity bill etc are to be borne by the Lessee

Ijarah Rules of Shariah governing Ijarah 4. The period of Lease must be determined in clear terms 5. The Lessee is responsible for damage to the asset caused by fraud or negligence 6. Any damage to the asset not caused by the Lessee’s neglect, is to be borne by the Lessor Normal maintenance is Lessee’s responsibility The asset to be leased should be clearly identified 9. Lease rentals for the entire lease period must be fixed; Different amounts of rents can be fixed for different periods, but they must be known. The rent may be tied to a known benchmark, acceptable to both the parties The Lessor cannot increase the rent unilaterally 11. The Lessor may receive the rent in advance, but such payment should be recorded as an “on Account” payment since rent can be received only for use of an asset

Ijarah Rules of Shariah governing Ijarah 12. The Lease period will start when the asset has been delivered to the Lessee - in a usable condition - whether or not the Lessee has started using it 13. If the leased asset is destroyed, the lease will terminate. If the Lessee is at fault, he is liable to compensate the Lessor for the loss

Ijarah Conventional leases are of two types 1. Sale & Leaseback – Where the Lessee has already purchased the asset The Lessor purchases the asset from the Lessee and leases it back to him 2. Direct lease – Where the Lessee has not already purchased the asset Lessor purchases the asset from the supplier & becomes its owner, then leases the asset to the Lessee

Ijarah Sometimes, the Lessor does not pay the supplier directly But authorizes the Lessee to purchase the asset on his behalf acting as his agent Lessee purchases the asset on Lessor’s behalf, paying from his own resources Lessor pays Lessee for the asset, and acquires its ownership Then leases the asset to the Lessee In all the above cases, under conventional Lease - The Lease rental starts from the date of payment by Lessor Regardless of when the asset is delivered This means that Lessee has to pay rent before delivery of asset. This is not allowed in Shariah because it is the same as charging rent for money, which is Interest Under Shariah, the correct way to charge rent is after delivery of the asset to the Lessee. Because rent is charged for use of the asset

Ijarah Expenses consequent to ownership Lessor is the owner of the asset He is liable to pay all expenses incurred in the process of purchase of the leased asset such as - Purchase cost - Import duties - Transportation to factory - Installation cost - Insurance He may build all these expenses into the asset’s cost And take them into consideration when calculating the lease rental

Ijarah Liability of parties in case of loss to the asset Lessee is liable for loss to the asset due to his negligence Can also be made liable for normal wear and tear But he cannot be made liable for loss caused by factors beyond his control Conventional Finance Lease agreements do not differentiate between these situations and are therefore not in conformity with Shariah

Ijarah Variable rentals in Leases Lessor would like to get a return on his asset in line with the market Hence, agreeing on a fixed rent for a long-term lease may not be desirable Because if returns in the market change, the rent will not change with them and the Lessor will not get a return on his investment in line with the market This problem can be overcome in two ways 1. The Lease contract may stipulate a regular increase in rent Say, 5% per year 2. The lease contract may be for a shorter period after which the parties can renew the lease at revised terms with both parties having the right to refuse the renewal

Ijarah The Lease rental may be tied-up with a benchmark A third option is also available The Lease rental may be tied-up with a benchmark Which is so well-known that there is no room for dispute e.g. Inflation index issued by the government of the country Such that when inflation increases by 5% the rent increases by 5% Based on the above principle Some Islamic banks use the market rate of interest as the benchmark e.g. The SBP Discount Window rate, the T-bill rate etc. e.g. SBP discount + 3% p.a., T-bill + 5% p.a. Because they want to earn the same profit rate as the market

Ijarah Objection: By using the Interest Rate as a benchmark the transaction becomes similar to an interest based transaction Response: As long as the basic requirements under Shariah are being complied with any benchmark can be used to price the transaction Benchmarking the transaction’s pricing to an interest-based rate does not render it Haram The basic difference between an interest-based financing and a valid Lease transaction does not lie in their pricing The basic difference is: In case of a lease, the Lessor assumes the full risk of the ownership of the asset. And also cannot charge rental if the asset loses its utility

Ijarah In case of an interest based transaction the financier is not concerned with the asset’s ownership-related risks And will keep charging its dues even if the asset loses its utility or gets destroyed As long as this basic difference is maintained The transaction cannot be classified as an interest bearing transaction No matter how it is priced Penalty cannot be charged on delay in payment of lease rentals Reason: Once the lease rent has become due It is a loan payable by the Lessee to the Lessor and is subject to all rules prescribed for debt. And therefor cannot be increased to compensate for delay in payment. However, the lessee may be asked to pay a penalty (as charity) to the Lessor which the Lessor should deposit into a charity account.

Ijarah Termination of Lease If the Lessee contravenes any term of the Lease agreement the Lessor may unilaterally terminate the agreement If there is no contravention, the agreement can only be terminated by mutual consent Conventional Financial Lease agreements give termination right to Lessor in all cases. This is contrary to Shariah laws Insurance of the leased assets Insurance is a cost related to ownership of the assets And therefore should be borne by the Lessor However, the Lessor may build this factor into the asset’s cost, while calculating the lease rent and increase the lease rent

IJARAH AND IJARAH MUNTAHIA BITTAMLEEK Process of Ijarah MECHANICS Transfer of Title . VENDOR ISLAMIC BANK Agreement-1 CUSTOMER Payment of Purchase Price The customer approaches the Bank with the request for financing and enters into a promise to lease agreement. The Bank purchases the item required for leasing and receives title of ownership from the vendor IJARAH AND IJARAH MUNTAHIA BITTAMLEEK The customer approaches the Bank with the request for financing The client approaches the Bank showing interest in purchase of the commodity. He will present full description and detailed specification including the source of supply. The Bank will run a credit valuation, the same way its done in conventional banking. If the customer is a good risk, then the Murabaha margin (i.e. Bank’s profit on the market-up price) for him will have to be decided. The margin will be quoted, most probably as a per annum flat rate based on the total cost of acquiring the commodity by the Bank including the price and all related expenses. If the customer agrees, he will be asked to sign a pledge agreement, committing him to buy such commodity once it is under the possession of the Bank. As part of the Murabaha transaction, the client will asked to present some securities to the Bank at the time of signing the pledge. These securities could be in the form of cash or any other liquid asset, equivalent to about 5% to 10% of the value of the deal. The Bank purchases the item and makes payment to the vendor The Bank will contact the vendor of the commodity specified by the customer and make arrangements for the acquisition. The Bank will make the required payment to the vendor for receipt of the commodity. The Bank receives title of ownership from the vendor The Bank is only able to execute the Murabah deal when the commodity’s ownership is completely transferred over to the Bank from the vendor. The customer makes payment up-front or on a deferred basis The customer will either pay the Bank the whole amount of the Murabaha contract (including a mark-up) up-front of make payments on a deferred basis. The Bank transfers the title over to the customer upon payment The Bank will transfer the ownership title of the commodity to the customer once the payment is received from the customer. The Bank makes payment to the vendor

IJARAH AND IJARAH MUNTAHIA BITTAMLEEK Process of Ijarah MECHANICS Transfer of Title Transfer of Title . VENDOR ISLAMIC BANK Agreement-2 CUSTOMER Payment of Purchase Price Payment of Rental Fees The Bank leases the asset to the customer after execution of lease agreement. IJARAH AND IJARAH MUNTAHIA BITTAMLEEK The customer makes periodic payments as per the contract The customer approaches the Bank with the request for financing The client approaches the Bank showing interest in purchase of the commodity. He will present full description and detailed specification including the source of supply. The Bank will run a credit valuation, the same way its done in conventional banking. If the customer is a good risk, then the Murabaha margin (i.e. Bank’s profit on the market-up price) for him will have to be decided. The margin will be quoted, most probably as a per annum flat rate based on the total cost of acquiring the commodity by the Bank including the price and all related expenses. If the customer agrees, he will be asked to sign a pledge agreement, committing him to buy such commodity once it is under the possession of the Bank. As part of the Murabaha transaction, the client will asked to present some securities to the Bank at the time of signing the pledge. These securities could be in the form of cash or any other liquid asset, equivalent to about 5% to 10% of the value of the deal. The Bank purchases the item and makes payment to the vendor The Bank will contact the vendor of the commodity specified by the customer and make arrangements for the acquisition. The Bank will make the required payment to the vendor for receipt of the commodity. The Bank receives title of ownership from the vendor The Bank is only able to execute the Murabah deal when the commodity’s ownership is completely transferred over to the Bank from the vendor. The customer makes payment up-front or on a deferred basis The customer will either pay the Bank the whole amount of the Murabaha contract (including a mark-up) up-front of make payments on a deferred basis. The Bank transfers the title over to the customer upon payment The Bank will transfer the ownership title of the commodity to the customer once the payment is received from the customer. Title transfers to the customer at the end

Comparison of Ijara and Murabaha   Ijarah Murabaha Title Holder Financier Customer Rate Fixed/Variable Fixed Prepayment Allowed Yes No/Controversial Refinance Available No Asset Risk Late Payments Controlable Loss to the Bank  

IJARA

MUDARABAH

Definition This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise. The investment comes from the first partner who is called “Rabb-ul-Maal” (Investor) while the management and work is an exclusive responsibility of the other, who is called “Mudarib” (Working Partner) and the profits generated are shared in a predetermined ratio.

Types of Mudarabah Al Mudarabah Al Muqayyadah (Restricted Mudarabah) Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah)

Al Mudarabah Al Muqayyadah (Restricted Mudarabah)    Rabb-ul-Maal may specify a particular business or a particular place for the mudarib, in which case he shall invest the money in that particular business or place. This is called Al Mudarabah Al Muqayyadah (restricted Mudarabah).

Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah) Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit, this is called Al Mudarabah Al Mutlaqah (unrestricted Mudarabah) However, he is not authorized to:   a) keep another Mudarib or a partner b) mix his own investment in that particular Mudarabah without the consent of Rabb-ul Maal.

Authority of Rabb-ul-Maal Rabb-ul-Maal has authority to:  a)  Oversee the Mudarib’s activities and b) Work with Mudarib if the Mudarib consents.

Different Capacities of the Mudarib Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are held by him as a trust. Wakeel (Agent) : In purchasing goods for trade, he is an agent of Rabb-ul-maal. Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rrrrrabb-ul-maal who shares the profit in agreed ratio.

4. Zamin (Liable): If the enterprise suffers a loss due to his negligence or misconduct, he is liabel to compensate the loss. 5. Ajeer (Employee): If the Mudarabah becomes Void due to any reason, the Mudarib is entitled to get a fee for his services.

Capital of Mudarabah The capital in Mudarabah may be either cash or in kind. If the capital is in kind, its valuation is necessary, without which Mudarabah becomes void.

Distribution of Profit & Loss It is necessary for the validity of Mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. They can share the profit at any ratio they agree upon. However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios. Some incentives my be given to the Mudarib.

Distribution of Profit & Loss Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah. The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

Distribution of Profit & Loss EXAMPLE If the capital is Rs.100,000/-, they cannot agree on a condition that Rs.10,000 out of the profit shall be the share of the Mudarib nor can they say that 20% of the capital shall be given to Rab-ul-Maal. However they can agree that 40% of the actual profit shall go to the Mudarib and 60% to the Rab-ul-Maal or vice versa.

Distribution of Profit & Loss If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed between the parties according to the agreed ratio.

Termination of Mudarabah Mudarabah can be terminated any time by either of the two parties by giving notice. If Mudarabah was for a particular term, it will terminate at the end of the term. Termination of Mudarabah means that the Mudarib cannot purchase new goods for the Mudarabah. However, he may sell the existing goods that were purchased before termination.

Distribution at Termination If all assets of the Mudarabah are in cash form at the time of termination, and some profit has been earned on the principal amount, it shall be distributed between the parties according to the agreed ratio. If the assets of Mudarabah are not in cash form, they will be sold and liquidated so that the actual profit may be determined.

If there is a profit, it will be distributed between Mudarib and Rab-ul-Maal. If no profit is left, Mudarib will not get anything.

Collective Mudarabah “Collective Mudarabah” means a joint pool created by many investors and handled over to a single Mudarib who is normally a juristic person. Collective Mudarabah creates two different relationships: Relationship between investors inter se, which is Shirkah or Partnership. Relationship of all the investors with mudarib, which is mudarabah.

When Mudarib is a Juristic Person Who is the Mudarib? Shareholders? Management or Directors? Juristic Person Expenses of Mudarabah Direct expenses are borne by the Mudarabah pool. Indirect expenses are borne by the mudarib.

Running Mudarabah Investors come in and go out at different dates Profits are calculated on daily product basis. Redemption before maturity If the assets of mudarabah are in illiquid form, an investor may redeem his share by selling it to the pool.. If the assets are in liquid form, a provisional amount may be given to him subject to final settlement

Musharakah

Musharakah Musharaka is a form of partnership between two parties Where each party contributes to the capital of the partnership in equal or varying proportions Either to establish a new venture or share in an existing one.

Musharakah Principles for Distribution of Profit Profit of each partner can be agreed as a % of the return from the business. Profit should be identified as a % of the actual return and not in absolute terms. Share of active partners can be more than share of sleeping partners. The share of the sleeping partner cannot be more than the share of the active partner.

Musharakah Principle of Loss Scholars in Islam have a consensus on the principle that in case of a loss the share borne by each partner cannot exceed his share in the investment. Hazrat Ali (RA): “Profit should be on a mutual basis and loss should be shared in the ratio of investment.”

The structure of a Musharaka Contract Musharakah The structure of a Musharaka Contract ISLAMIC BANK PARTNER (Customer) MUSHARAKA 60% Ownership 40% Ownership

Musharaka

Diminishing Musharaka

DIMINISHING MUSHARAKA Diminishing Musharaka involves taking share in the ownership of a specific asset and then gradually transferring complete ownership. Three components Joint ownership of the Bank and customer Customer as a lessee uses the share of the bank Redemption of the share of the Bank by the customer

DIMINISHING MUSHARAKA Joint Ownership Musharaka BANK CUSTOMER Rent The customer approaches the Bank with the request for Project/Machinery financing The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset. Customer pays rent for the use of banks share in the property

Gradual Transfer of Ownership DIMINISHING MUSHARAKA Joint Ownership Musharaka BANK CUSTOMER Gradual Transfer of Ownership The customer approaches the Bank with the request for Project financing The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset. Customer pays rent for the use of banks share in the property Ownership of the asset is gradually transferred to the customer upon payment of asset price.

DIMINISHING MUSHARAKA Housing Finance DIMINISHING MUSHARAKA Offers the most viable solution for housing finance. As discussed, under this mode, the Financial Institution and client jointly purchase the house. The share of the bank is divided into a number of units and it is agreed that the client will purchase the units of the share of the bank gradually, thus increasing his own share until all the units of the Bank are purchased by him so as to make him the sole owner of the asset after a specified period. During the financing period bank’s share is leased to the client who pays rent for using bank’s share in the asset

Ijarah is an Islamic alternate of Leasing. Housing Finance IJARAH Ijarah is an Islamic alternate of Leasing. Under the mode, Bank purchases property for the client and give the property on lease to the client for an agreed period against an agreed rent. After the agreed time period ownership of the asset is transferred to the client.

Murabaha is most commonly used mode of finance in Islamic Banking. Housing Finance MURABAHA Murabaha is most commonly used mode of finance in Islamic Banking. Financing under the mode is simple, Bank purchases property for the client from the market and sells the property to the client after adding profit thereon. Ownership of the asset is transferred to the client at the inception of the transaction .

Comparison of Three Options Comparison of Housing Finance Products Comparison of Three Options    Diminishing Musharaka Ijarah Murabaha  Title Holder  Joint Title  Financier  Customer Rate Fixed/Variable Fixed Prepayment Allowed Yes No/Controversial Refinance Available No Asset Risk Joint Financier Customer Late Payments Control able Loss to the Bank

Mudaraba

Mudaraba Mudaraba is a partnership agreement in which the investor (the Rab-ul-mal) provides the necessary finance While the recipient of the funds (the Mudarib or the Manager) provides the know-how towards carrying out the venture There are 2 types of Mudaraba Restricted Mudaraba Unrestricted Mudaraba

Mudaraba Restricted Mudaraba: Types of Mudaraba Mudaraba Restricted Mudaraba: Rubb-ul-maal may specify a particular business for the Mudarib, Mudarib can invest the money in that particular business only. Unrestricted Mudaraba: Rubb-ul-mal gives full freedom to Mudarib to undertake whatever business he deems fit.

Distribution of Profit Mudaraba Distribution of Profit It is necessary for the validity of Mudaraba that the parties agree at the time of entering into the contract on the ratio in which the actual profit will be shared Loss is borne only by Rabbul mal because the Mudarib does not invest anything. Mudarib’s loss is considered to be wasted effort

Salam

Salam Basic conditions for validity of sale (Bai’): 1. The asset must exist 2. The seller should own the asset 3. The asset should be in the physical or constructive possession of the seller All sale transactions should conform to this rule, except the following two exceptions: 1. Bai’ Salam 2. Bai’ Istisna Both these are sales of special nature and are exceptions to the general rules of sale

Salam Salam is where the seller undertakes to supply some specific goods to the buyer At a future date Against an advance price, fully paid at spot But the supply is deferred Salam was allowed by the Prophet (SAW) subject to certain conditions The basic purpose was to meet the needs of small farmers - Who needed money to grow their crops - And to feed their families till the time of harvest - Since, after the prohibition of Riba they could not borrow money on interest. Hence they were allowed to sell their agricultural products in advance

Salam Salam is beneficial to the seller Since he receives the price in advance And Beneficial to the buyer since the Salam price is lower than the spot price Purpose of Salam To meet the need of small farmers who need money to grow their crops and to feed their family up to the time of harvest. To meet the need of traders for import and export business.

Conditions of Salam It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale. In the absence of full payment, it will be tantamount to sale of a debt against a debt which is expressly prohibited by the Holy Prophet. Moreover the basic wisdom for allowing Salam is to fulfill the instant need of the seller. If its not paid in full, the basic purpose will not be achieved.

Conditions of Salam Only those goods can be sold through a Salam contract in which the quantity and quality can be exactly specified eg. precious stones cannot be sold on the basis of Salam because each stone differ in quality, size, weight and their exact specification is not possible. Salam cannot be effected on a particular commodity or on a product of a particular field or farm e.g.. supply of wheat of a particular field or the fruit of a particular tree since there is a possibility that the crop is destroyed before delivery and given such possibility, the delivery remains uncertain. All details in respect to quality of goods sold must be expressly specified leaving no ambiguity which may lead to a dispute.

Conditions of Salam It is necessary that the quantity of the commodity is agreed upon in absolute terms. It should be measured or weighed in its usual measure only meaning what is normally weighed cannot be quantified and vice versa. The exact date and place of delivery must be specified in the contract. Salam cannot be effected in respect of things, which must be delivered at spot. The commodity for Salam contract should remain in the market right from day of contract up to the date of delivery or at least till the date of delivery.

Conditions of Salam The time of delivery should be at least fifteen days or one month from the date of agreement. Price in Salam is generally lower than the price in spot sale. The period should be long enough to affect prices. But Holy Prophet SAW did not specify any minimum period for the validity of Salam. It is all right to have a earlier date of delivery if the seller consents to it. Since price in Salam is generally lower than the price in spot sale; the difference in the two prices may be a valid profit for the Bank. A security in form of a guarantee, mortgage or hypothecation may be required for a Salam in order to ensure that the seller delivers. The seller at the time of delivery delivers commodities and not money to the buyer who would have to establish a special cell for dealing in commodities.

Benefits After purchasing a commodity by way of Salam, the financial institution can sell it through a parallel contract of Salam for the same date of delivery. The period of Salam in the second parallel contract is shorter and the price is higher than the first contract. The difference between the two prices shall be the profit earned by the institution. The institution can obtain a promise to purchase from a third party. This promise should be unilateral from the expected buyer. The buyer does not have to pay the price in advance. When the commodity is received by the institution, it can be sold at a pre-determined price to a third party according to the terms of the promise.

Parallel Salam In an arrangement of parallel Salam there must be two different and independent contacts; one where the bank is a buyer and the other in which it is a seller. The two contracts cannot be tied up and performance of one should not be contingent on the other. A Salam arrangement can not be used as a buy back facility where the seller in the first contract is also the purchaser in the second. Even if the purchaser in the second contract a separate legal entity but owned by the seller in the first contract; it would not tantamount to a valid parallel Salam agreement.

The structure of a Salam Contract ISLAMIC BANK CUSTOMER COMMODITY OWNER Delivery of asset at future date Delivery of asset At future date Advance payment of purchase price (P) Advance payment of purchase price The structure of a Salam Contract

Istisna

Istisna Istisna is the second exception where a sale is allowed without delivery of the goods sold It relates to goods that require manufacturing If the manufacturer undertakes to manufacture goods with material available with the manufacturer, the Istisna transaction is effected It is necessary for the Istisna transaction that price is fixed And necessary specifications of the product are defined

Differences between Istisna and Salam 1.Subject of Salam may be anything which fulfils the Salam conditions 1.The subject of Istisna is always something which requires manufacturing 2.Price may be paid under any agreed schedule 2.Price should be paid in full in advance 3.Contract may be cancelled unilaterally before the manufacturer starts work 3.Salam contract, once effected, cannot be cancelled unilaterally 4.Determining the time of delivery is an essential part in Salam 4.Not necessary in Istisna