IJARAH

1
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
2
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

3
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.

4
FAILURE OF PREVIOUS EFFORTS

• Reasons
• Absence of Shariah compliance mechanism in
  financial institutions.
• Non-availability of Shariah 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.

5
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

6
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

7
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

8
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

9
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).

10
Rs. in Billion
Industry Progress and Market Share
Description Jun 07 Dec 06 Dec-05 Dec-04 Dec-03
Total Assets (Rs. in Bn) 159 119 72 44 13
age of Banking Industry 3.2 2.8 2.1 1.4 0.5
Deposits (Rs. in Bn) 108 84 50 30 8
age of Banking Industry 2.9 2.6 1.9 1.2 0.4
Financing. Invest. (Rs. in Bn) 90 73 48 30 10
age of Banking Industry 2.5 2.3 1.8 1.3 0.5
No. of Branches 167 150 70 48 17
11
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.

12

• The size of Islamic Financial Industry is around
  US 900 Bln. and its growing annually _at_ 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.

13

• 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

14

• 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.

15
IJARAH
16
IJARAH (LEASING)

• IJARAH AL ASHKAAS
• IJARAH AL AIYAN
• Ijarah (Operating Lease)
• Ijarah Muntahia Bittamleek

17
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.

18
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

19
ESSENTIALS OF IJARAH
20
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

21
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.

22
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.

23
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.

24
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.

25
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.

26
AAOIFI SHARIAH STANDARD
27
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
  customers 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.

28
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.

29
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
  others 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.

30
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
  lessors cost. The lessee should carry out
  operating or periodical (ordinary) maintenance.

31
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.

32
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.

33
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.

34
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.

35
MECHANISM
36
Leasing (Ijara Wa Iqtina)
Beneficial use of asset
Transfer of asset
Entrepreneur (Lessee)
Financier (Lessor)
Vendor
Lease rentals
Payment of purchase price

• 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

37
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

38
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

39
USAGE OF IJARAH
40
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)

41
IJARAH (LEASING)

• Ijarah Muntahia Bittamleek Examples
• Vehicles Ijarah Financing
• Plant and Machinery
• Consumer Durables
• House Financing
• Project Finance, etc.

42
RISKS AND ISSUES
43
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.

44
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

45
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?

46
Leasing/Ijarah Contract
Conventional Leasing Car Ijarah
There are two types of contracts, Financial lease and loan for car financing. Both these contracts contain conditions that are contravenes with the Islamic Sharia'h. Financing lease contains conditions of hire purchase, which is not permissible by Sharia'h. Car financing or loan agreement contains conditions of interest. Interest is considered Riba by Sharia'h The Ijarah contract does not contain any condition that makes the contract void under Sharia'h perspective.
47
Rights Liabilities of Lessor and Lessee
Conventional Leasing Car Ijarah
In Conventional Leasing Products, the Customer is responsible for all kinds of losses or damages to the Leased asset, irrespective of the circumstances. If the insurance company does not compensate the entire outstanding amount in case of total loss, the customer is liable to pay the balance. All risks pertaining to ownership are borne by Lessor.Customer only bears usage-related risks Lessor bears the risk of Insurance claim settlement.
48
Rentals recovery in case of theft and loss
Conventional Leasing Car Ijarah
If the Leased Asset is stolen or completely destroyed, the conventional leasing company or Bank would continue charging the lease rent till the settlement of the Insurance claim Under the Islamic Ijarah, rent is consideration for usage of the leased asset, and if the asset has been stolen, destroyed or temporarily out of order and not in use of Customer, the concept of rental becomes void. In such situations rental is not charged from the lessee.
49
Penalty for late payment
Conventional Leasing Car Ijarah
In most contemporary financial leases, an extra monetary amount is charged if rent is not paid on time. This extra amount is the considered Riba and is Haram. This amount is taken by the leasing institution into their income. Under Ijarah, the Lessee may be asked to undertake that if he fails to pay rent on its due date, he will pay a certain amount to a charity Fund, which will be administered through the Islamic Bank. For this purpose the bank maintains a charity fund where such amounts may be credited and disbursed for charitable purposes.
50
Insurance premium
Conventional Leasing Car Ijarah
Insurance is independent of the lease contract. The insurance expense of the asset is directly borne by the lessee Takaful / Insurance should be at the expense of the Lessor and not at the expense of the lessee. The Lessor may increase the lease rent to recover any costs incurred by him in connection with the asset. However, as a matter of principal, the cost should be paid for by the Lessor.
51
Registration Charges
Conventional Leasing Car Ijarah
Lessee is responsible for the Registration of Leased Vehicle. The Leased Asset(vehicle) is registered in the name of the Bank and registration charges are paid by the Bank (Lessor). The Lessor may increase the lease rent to recover any costs incurred by him in connection with the asset
52
Purchase of asset
Conventional Leasing Car Ijarah
Under conventional leasing contracts, the vehicle is automatically transferred in the name of the customer upon completion of the lease period, whether or not he wants to purchase it. There is not such clause in the Ijarah Agreement that Leased Asset will automatically transfer to Lessee. Separate sale agreement is required to execute sale transaction at the end of lease term.
53
Commencement of Rentals
Conventional Leasing Car Ijarah
In case of Booking of Leased Asset, recovery of Lease installment commence after the payment of cost of Asset to manufacturer/dealer. In case of Car Ijarah, the recovery of rentals is associated with delivery of Leased Asset. Rental recovery should not be commenced before the delivery of Asset.
54
Signing of Lease Contract
Conventional Leasing Car Ijarah
Lease Agreement can be signed by the Lessee and Lessee any time even if the Leased Asset is not owned by the Customer. In case of Ijarah, the Ijarah Agreement can not be signed by the Lessor and Lessee unless Asset has come in to existence Assets is in the ownership of the Lessor Lessor has taken possession of the Asset
55
Termination before delivery
Conventional Leasing Car Ijarah
The customer will suffer loss of interest paid during the booking period because installment commence immediately after payment of cost of asset to the Manufacturer/Dealer. The loss of customer is only limited to actual loss, if any, suffered by the Lessor on sale of asset in the open market. Since the customer has not paid any rental during the booking period, no other cash loss is expected under Ijarah.
56

• DOCUMENTATION OF IJARAH

57
IJARAH AGREEMENT

• Ijarah Agreement is the basic document which
  contains all terms and conditions pertinent of
  Ijarah of particular Asset(s).
• Ijarah Agreement shall be signed after the
  Lessor has taken the possession the Asset and not
  earlier.

58
ADDENDUMS TO IJARAH AGREEMENT

• Description of the Ijarah Asset
• Schedule of of Ijarah Rentals
• Receipt of Asset
• Demand Promissory Note

59
DESCRIPTION OF IJARAH ASSET

• This document contains the detailed description
  about the Leased Asset agreed between the parties
  e.g Name, Make ,Model,Engine No., Chassis No.,
  Registration No. etc etc.
• This documents shall be signed signed after
  Delivery of asset to the Lessee and not earlier.

60
SCHEDULE OF IJARAH RENTALS

• This schedule contains a table which shows
• Amount of rental (Monthly/Quarterly/Half Yearly)
• Date of Payment of each rental
• This schedule will also contain the date on which
  first rental is due.
• This documents shall be signed signed after
  Delivery of asset to the Lessee.

61
RECEIPT OF ASSETS

• This document confirms that customer has taken
  the possession of Leased Asset as described in
  the earlier document Description of Ijarah
  Asset.
• This document is only signed by the Lessee on
  receipt of Asset, as an acknowledgement of
  receipt of described asset under Ijarah Contact.

62
PROMISSORY NOTE

• After signing of Ijarah Agreement, the amount of
  rentals become Debt (Dyan) to the Lessee.
• Promissory Note is Lessees acknowledgement to
  Debt amount and its promise to pay.

63
UNDERTAKING TO PURCHASE LEASED ASSET

• This documents contains undertaking from the
  Lessee that he/it will purchase the Leased asset
  on the purchase Price corresponding to the
  Purchase Date.
• This document contains a schedule which shows
  Purchase Price(s) during the Ijarah term on which
  the Lessee can purchase the asset by making lump
  sum payment.

64
OTHER DOCUMENTS

• Undertaking for Personal use of Ijarah Asset
• Trust Receipt
• Authorization to Take possession of Leased Asset
• Sale Deed

65
Shariah legitimacy Ijara-tul-Ashkhas
Ijarah delivers legitimacy from the Quraan and
the Sunnah. On the level of Quran, Allah says
said one of them o my father engage him on
wages (Surah al-Qasas verse 26) The saying of
the Prophet Hazrat Muhammad (Sallallau Alihi
Wsallam) that whoever hired a worker must inform
of his wages (Ibn-e-Majah, Sanan Ibn-e-Majah
2/817 ) Give a worker his wages before his
sweet is dried (Ibn-e-Majah, Sanan Ibn-e-Majah
2/817 )
66
Ijara-tul-Ashkhas
According to Shariah, Ijarat-ul-ashkhaas which
is dealt with hiring the services/ expertise of a
person or a party which provides his/her/its
expertise. It depends upon the nature of the
transaction that how many parties are involved in
Ijarat-ul-Ashkhaas. For example, there may be
three parties, one is the services provider (the
principal lessor), second is Bank (the principal
lessee, which will avail these services on
spot/prompt or deferred payment basis) from the
principal lessor and the third is actual services
seeker (the sub lessee) According to the
aforesaid Shariah principle, Bank can devise
consumer as well as corporate products for its
clients from the services providers on either
prompt or deferred payment basis. If the
client fails to make payment on due dates,
according to pre-agreed schedule, then Bank will
be entitled to only receive charity from the
client for the defaulted period but this charity
will not be taken into Bank income rather Bank
will have to pay this charity amount to some
approved charitable institutions.
67
Common Misconceptions

• Islamic banking looks the same as conventional
  banking
• A halal meat and haram meat may look exactly the
  same but one is permissible while the other is
  not
• A fixed rate of return is not permitted under
  Islamic Shariah
• Fixed return does not make a transaction halal or
  haram
• For example
• Profit on trading
• Rent on property

68
Common Misconceptions

• Murabaha and Ijara are major modes being
  practiced
• Modaraba is major mode
• Only Documents certified by Shariah Scholars are
  necessary for Shariah compliance
• Execution of documents

69
ISLAMIC BANKING

• SUGGESTED STRATEGY
• Take a view
• Have the right attitude
• Make an active effort to learn
• Have a commitment to implement the change

70
Our Lord let not our hearts deviate now after You
have guided us but grant us mercy from Your own
Presence
for You are the Grantor of bounties without
measure. Surah Ali Imran 8
71
Our Lord! Condemn us not if we forget or fall
into error
Our Lord! Lay not on us a burden Like that which
You put on those before us
Our Lord! Lay not on us a burden greater than we
have strength to bear

• Blot out our sins, and grant us forgiveness Have
  mercy on us You are our Protector Help us against
  those who stand against faith
  Surah Al-Baqarah 286

72
THANK YOU
Ph 021-9212509, Fax [phone] Email
mahmood.shafqat_at_sbp.org.pk http//www.sbp.org.pk/
departments/ibd.htm