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IJARAH Presented by: MAHMOOD SHAFQAT Joint Director Islamic Banking Department At AlHuda CIBE Workshop The views expressed in this presentation are those of the author and do not necessarily represent State Bank of Pakistan
Overview • Introduction and Brief Perspective of Islamic Banking • Ijarah • Essentials of Ijarah • AAOIFI Standard • Mechanism and Usage • Risks and Issues • Comparison with Conventional Leasing • Documentation • Ijarat ul Ashkhaas • Some Common Misconceptions
BRIEF HISTORY OF ISLAMIC BANKING IN PAKISTAN • Efforts for economy wide elimination of Riba started during 1970s and most of the practical steps were taken in early 1980s, which are considered as pioneering work in the Muslim world. • Banking and other relevant laws and regulations were amended to facilitate interest free banking system. • Two important areas kept outside the purview of interest free banking system mainly due to lack of research in these fields, viz. Government borrowings (both local and foreign) and foreign exchange.
FAILURE OF PREVIOUS EFFORTS Reasons • Absence of Shari’ah compliance mechanism in financial institutions. • Non-availability of Shari’ah compliant government securities. • Ineffective enforcement of contracts and inefficient system for early recovery. • Ineffective code of conduct for professionals. • Lack of continued research and development in the field of Islamic finance and economics. • Inadequate training to the staff of SBP and banks. • Disoriented education system devoid of Islamic principles. • Lack of public awareness about Islamic economic system. • Adoption of free market economic (capitalistic) policies. • Social and cultural factors. • Weak Political resolve of successive governments for Islamization of economy.
CURRENT STRATEGY • Gradual approach for Transformation of economy • Full fledged Islamic banks be established in Private sector • Islamic banking Subsidiaries in existing banks be allowed • Stand alone branches for Islamic banking be allowed in existing banks
POLICY OBJECTIVES • Introduce, promote and implement Islamic Banking in Pakistan • as a parallel banking system • comparable and compatible to conventional banking system and • Shariah compliant • In the long run let people “vote through their wallets”
SBP APPROACH • Parallel banking system offering users similar • Functionality & Profitability • In line with their beliefs • Provide a level playing field to Islamic Banking • Regulations • Taxation
SBP APPROACH • Parameter based vs. Straight jacketed system • Model vs. Standard Agreements • Essentials of Islamic Modes • PLS Mechanism • Modes of Finance • Shariah compliance mechanism • Essentials of Islamic modes • Shariah Advisor • Internal Shariah Review • Report of Shariah Advisor • SBP Shariah Compliance Inspection • SBP Shariah Board
INDUSTRY PROGRESS • Sept 2003 One full fledge bank and one conventional bank with one stand alone Islamic banking branch • Currently six full fledge Islamic banks and 12 conventional banks with Islamic Branches. • Islamic banking is available through over 200 branches in 32 cities of all four provinces and AJK expected to reach over 270 till Dec. 2007. • Meezan Bank – 78 in 23 cities, Al Baraka Islamic Bank with 12 in 6 cities, Dubai Islamic with 17 in 9 cities, BankIslami with 16 in 6 cities, Emirates Global with 9 in 4 cities and Dawood Islamic with 5 in 2 cities. • 12 Conventional banks (MCB, HBL, Bank of Khyber, Soneri, Bank Alfalah, Bank Al Habib, Habib Metropolitan, Standard Chartered Bank, Askari, NBP, UBL and ABN AMRO) with 72 Islamic Banking Branches (IBBs).
Rs. in Billion Industry Progress and Market Share
SBP Shariah Board • A central Shariah Board established at SBP and is fully functional • Current membership consists of five persons • Two Shariah scholars • A Chartered accountant • A lawyer • A banker representing the industry as well as SBP • A consultant to the Shariah Board, a scholar from Qum.
Global Perspective • The size of Islamic Financial Industry is around US$ 900 Bln. and its growing annually @ 15% per anum. • Over 70 countries have Islamic Banking Institutions • Muslim countries including Bahrain, UAE, Saudi Arabia, Malaysia, Brunei, Pakistan, Sudan, Iran, Indonesia, etc. • Non-Muslim countries including USA, UK, Canada, Switzerland, Singapore, South Africa, Australia, etc.
Global Perspective • In Feb 1999, Dow Jones introduced the Dow Jones Islamic Market Index (DJIM) of 600 companies world wide whose business complies with Islamic Shariah laws • At present there are more than 105 Islamic Funds operational through out the world with a total fund base of over USD 3.50 billion
Global Perspective • Governments of Bahrain ,Malaysia and Pakistan have issued Islamic Bonds (Sukuk) in order to facilitate Islamic Banks in managing their liquidity. • Issuance of these bonds has also paved the way for Shariah compliant Government borrowings.
IJARAH (LEASING) IJARAH AL ASHKAAS IJARAH AL AI’YAN Ijarah (Operating Lease) Ijarah Muntahia Bittamleek
IJARAH (LEASING) Ijarah is to offer for a consideration the usufruct of a thing of value from which benefit can be derived without consumption, while retaining the ownership of the leased assets and assuming risks pertaining thereto.
Ijarah Muntahia Bittamleek • This is a lease that ends with the ownership of the asset. • There are several types of Ijarah Muntahia Bittamleek. These are characterized based on the method by which the ownership transfers to the user: • For no consideration (through a gift) • For token consideration • For price specified in the lease • For remaining amount (if lease is terminated before period) • Gradual transfer
IJARAH (LEASING) The corpus of leased commodity remains in the ownership of the lessor and only its usufruct is transferred to the lessee. Any thing which cannot be used without consuming the same cannot be leased out like money, edibles, fuel, etc. Only such assets which are owned by the lessor can be leased out except that a sub-lease is effected by the lessee with the express permission of the lessor. Until such time that assets to be leased are delivered to the lessee, lease rentals do not become due and payable
IJARAH (LEASING) During the entire term of the lease, the lessor must retain title to the assets, and bear all risks and rewards pertaining to ownership. If any damage or loss is caused to the leased assets due to the fault or negligence of the lessee, the consequences thereof shall be borne by the lessee. The consequences arising from non-customary use of the asset without mutual agreement will also be borne by the lessee.
IJARAH (LEASING) The lessee is also responsible for all risks and consequences in relation to third party liability, arising from or incidental to operation or use of the leased assets. The insurance of the leased asset should be in the name of lessor and the cost of such insurance borne by him. A lease can be terminated before expiry of the term of the lease but only with the mutual consent of the parties.
IJARAH (LEASING) Either party can make a unilateral promise to buy/sell the assets upon expiry of the term of lease, or earlier at a price and at such terms and conditions as are agreed, provided that the lease agreement shall not be conditional upon such sale. Alternatively, the lessor may make a promise to gift the asset to the lessee upon termination of the lease, provided the lessee has fulfilled all his obligations. However, there shall not be any stipulation in the lease agreement purporting to transfer of ownership of the leased assets at a future date.
IJARAH (LEASING) The amount of rental must be agreed in advance in an unambiguous manner either for the full term of the lease or for a specific period in absolute terms. Assignment of only the lease rentals is not permissible except at par value. Contract of lease will be considered terminated if the leased asset ceases to give the service for which it was rented. However, if the leased asset is damaged during the period of the contract but is capable of being repaired, the contract will remain valid.
IJARAH (LEASING) A penalty can be agreed ab initio in the lease agreement for delay in payment of rental by the lessee. In that case, lessee shall be liable to pay penalty calculated at the agreed rate in percent per day/annum. However, that penalty shall be used for the purposes of charity. The banks can also approach competent courts for award of damages, at discretion of the courts, which shall be determined on the basis of direct and indirect costs incurred, other than opportunity cost. Also, security or collateral can be sold by the bank (purchaser) without intervention of the court.
Ijarah and Ijarah Muntahia Bittamleek Scope. This standard is applicable to operating leases of properties or to Ijarah Muntahia Bittamleek. Whether the institution is the lessor or the lessee. This standard is not applicable to the employment persons (labor contract). Promise to lease (an asset). It is permissible for the institution to require the lease promisor (customer) to pay a sum of money to the institution to guarantee the customer’s commitment to accepting a lease on the asset and the subsequent obligations, provided no amount is to be deducted from this sum except in proportion to the actual damage suffered by the institution.
Ijarah and Ijarah Muntahia Bittamleek Acquisition of the asset to be leased. For the validity of an Ijarah contract concerning a specified asset, the lease contract should be preceded by acquisition of either the asset to be leased or the usufruct of that asset. (a) If the asset or the usufruct thereof is owned by the institution, which should in principle be the case, an Ijarah contract may be executed as soon as agreement is reached by the two parties. (b) however, if the asset is to be acquired from the customer, or from a third party, the Ijarah contract shall not be executed unless and until the institution has acquired that asset.
Ijarah and Ijarah Muntahia Bittamleek Concluding an Ijarah contract. • The lease contract is a binding contract which neither may terminate or alter with out the other’s consent. • The duration of an Ijarah contract must be specified in the contract must be specified in the contract. The period of Ijarah should commence on the date of execution of the contract, unless the two parties agree on a specified future commencement date, resulting in a future Ijarah, that is, an Ijarah contract to be executed at a future date.
Ijarah and Ijarah Muntahia Bittamleek Subject Matter of Ijarah • The leased asset must be capable of being used while preserving the asset, and the benefit from an Ijarah must be lawful in Sharia. • The lessor may not stipulate that the lessee will undertake the major maintenance of the asset that is required to keep it in the condition necessary to provide the contractual benefits under the lease. The lessor may delegate to the lessee the task of carrying out such maintenance at the lessor’s cost. The lessee should carry out operating or periodical (ordinary) maintenance.
Ijarah and Ijarah Muntahia Bittamleek Rules governing lease rentals. • In case the rentals is subject to changes (floating rentals), it is necessary that the amount of the rentals of the first period of the Ijarah contract be specified. It is then permissible that the rentals for subsequent periods be determined according to a certain benchmark.
Ijarah and Ijarah Muntahia Bittamleek Guarantees and treatment of Ijarah receivables. • Permissible security, of all kinds, may be taken to secure the rental payments or as security against misuse or negligence on the part of lessee. • It may be provided in the contract of Ijarah or Ijarah Muntahia Bittamleek that a lessee who delays payment for no good reason undertakes to donate a certain amount or percentage of the rentals due in case of late payment. Such donation should be paid to charitable causes under the co-ordination of the institution's Sharia supervisory board.
Ijarah and Ijarah Muntahia Bittamleek Termination of the Ijarah Contract. • The two parties may terminate the Ijarah contract before it begins to run. • It is permissible to terminate the lease contract by mutual consent but it is not permissible for one party to terminate it except in case of force majeure or there is a defect in the leased asset that materially impairs its use. Termination is also possible when one party secures an option to terminate the contract in which case the party who holds the option may exercise it during the specified period.
Ijarah and Ijarah Muntahia Bittamleek Transfer of the ownership in the leased property in Ijarah Muntahia Bittamleek. • In Ijarah Muntahia Bittamleek, the method of transferring the title in the leased asset to the lessee must be evidenced in a document separate from the Ijarah contract document, using one of the following methods. • By means of a promise to sell for a token or other consideration, or by accelerating the payment of the remaining amount of rental, or by paying the market value of the leased property. • A promise to give it as gift (for no consideration). • A promise to give it as a gift, contingent upon the payment of the remaining installments.
Leasing (Ijara Wa Iqtina) • Another popular instrument – 15% of the transactions • Right available to lessee to purchase • Asset ownership risk with owner; operational risks with lessee • Features close to a financial lease • Used for machinery, equipment, property, vehicles, aircraft etc. • Ownership usually transferred at the end Beneficial use of asset Transfer of asset Entrepreneur (Lessee) Financier (Lessor) Vendor Lease rentals Payment of purchase price
Transfer of Title CUSTOMER VENDOR ISLAMIC BANK Payment of Purchase Price Agreement . . Ijarah Muntahia Bittamleek GENERAL MECHANICS • The customer approaches the Bank with the request for financing • The Bank purchases the item required for leasing and receives title of ownership from the vendor • The Bank makes payment to the vendor
Transfer of Title Transfer of Title CUSTOMER VENDOR ISLAMIC BANK Payment of Purchase Price Payment of Rental Fees Agreement . . Ijarah Muntahia Bittamleek GENERAL MECHANICS • The Bank leases the asset to the customer • The customer makes periodic payments as per the contract • The asset title transfers to the customer based on the method disclosed in the agreement
IJARAH (LEASING) Ijarah (Operating Lease) Examples: Houses Rent-A-Car Agricultural Durables Aircrafts, etc. Issues Asset Price Risk Repair and Maintenance Running Expenses (depending upon contract) Credit Risk (Default in rental payment)
IJARAH (LEASING) Ijarah Muntahia Bittamleek Examples: Vehicles Ijarah Financing Plant and Machinery Consumer Durables House Financing Project Finance, etc.
Risks and Practical Issues • Proper documentation • Sequence of Documentation in Sale and lease Back. • Time of Transferring asset in Sale and Lease back • Islamic Lease covers the conditions of Finance Lease as described in IAS 17. • Accounting & Tax Depreciation Issues.
Risks • Credit Risk • Rate of Return Risk • Customer may decline to enter into Ijarah. • Damage to Asset • Overdue Rentals • Non-Compliance/Violation of contract. • Early Termination • Asset Price Risk
Risks and Practical Issues • How to treat insurance cost paid by the Lessor? • Treatment of Security deposits received from customers. • Treatment of Advance rentals. • Accounting rule/policy regarding repairs of Leased assets. • Securtization of Asset or Receivables?