IJARAH

1. IJARAH • Ijarah simply means leasing (or renting). • In the classical literature, Ijarah is defined as sale of usufruct (Bai al-manfa’ah). Usufruct refers to the right to use an asset (without owning it). • Ijarah in Shariah refers to two concepts; rental of an asset • and also a hire contract (rental of ones skill).

2. IJARAH • Firstly, Ijarah does not transfer ownership to the client. • In Ijarah, the bank (the lessor) is the owner and it only transfers the usufruct to the client. • Therefore, the risk of ownership remains with the bank throughout the period of Ijarah. • Compare this to Murabahah where ownership is transferred to the client on the day of the sale. • Another point that differentiates Ijarah from Murabahah is the fixing of price. • In Ijarah, the rentals could be flexible and reflect the changing economic and business condition.

3. Types of Ijarah • In practice there could be two types of lease: • Operating lease – where the asset is returned at maturity. • Financial lease – where the client has the option of owning the asset at maturity.

4. In general, Ijarah is an operating lease. • It could be carried out in the following manner: • Example Case 1: Operating lease • Ali and Ahmad is planning to start a new cyber cafe and would like to lease 10 computers for 6 months as a trial run for their business. They approached an Islamic bank to seek financing. The bank bought 10 computers from the supplier and leased it to Ali and Ahmad for a monthly rental of RM3,000. After 6 months, Ali and Ahmad decided continue the business and entered into another lease contract with the bank for 2 years. • In the case above, the bank is the owner of the computers. At the end of the lease period, the asset must be returned to the bank. • In the case where the client would like to own the asset at maturity, the bank will first lease the asset to the client and at maturity the bank can either sell or give the asset as gift to the client for a nominal price. • In this case, there will be two separate contracts – first a lease contract (Ijarah) throughout the lease period followed by a sale (al-Bai) or a gift (hibah) at maturity. The mechanism may take the following form:

5. Bank purchases the asset Bank leases to client At maturity, asset reverts to bank Operating Lease Client Bank 2. 1. Supplier

6. Bank purchases the asset Bank leases to client. MV and consumer good - HPA 1967. Unilateral promise to sell. At maturity, bank sell to client. AITAB(Al Ijarah Thumma Al-Bai). Lease followed by sales. A form of finance lease. Client Bank 2. 3. 1. Supplier

7. Client has existing asset and sells to the bank. The bank then leases the asset to the client. At maturity, bank transfer ownership via sale or gift. Ijarah for liquidity purpose Client Bank 1. 2.

8. Financial lease • Example Case 2: Financial lease • A shipping company would like to lease a new vessel costing RM500,000. It approached an Islamic bank to gain financing. The bank bought the vessel from the manufacturer and leased it to the shipping company for 10 years with a monthly rental of RM8,500. • At maturity, the shipping company would like to own the vessel. Thus, the bank made a unilateral promise to sell the vessel to the shipping company at the end of the lease. The last installment would be the selling price of the ship.

9. Financial lease • The original position in a Ijarah financing, there would be no ownership transfer. • If the client would like have ownership at the end, then the bank as the owner of the asset has the right to sell or transfer the asset to anyone it likes. • However, this ownership transfer must be made independently from the Ijarah contract to avoid gharar and 2 in 1 contracts. • The ownership transfer must be executed at maturity so the relationship between the parties remain clear during the Ijarah period. • Thus, from Day 1 until maturity it would be very clear that bank is the owner of the asset. • Only at maturity, ownership transfers to the client. This would have vital implications on risks borne by each party in the contract. • Financial lease is known in Islamic finance with alternative names such as AITAB – Al Ijarah Thumma Al-Bai (Lease then sale), IMBT- Ijarah Muntahiyah Bi Tamlik (Lease ending with ownership) and Ijarah wa Iqtina (Lease and purchase).

10. Conditions of Ijarah • To qualify as a rental contract, Ijarah financing needs to observe the following conditions: • Assets must exist and the lessor has full ownership over the asset. • Asset to be leased must not be consumable. It must be returned to the lessor in the orginal form. Therefore, consumable assets like petroleum, fruit etc would not qualify for Ijarah financing. • Liabilities and risks of ownership will be borne by the lessor. This means that the owner (the lessor i.e. the bank) must pay for insurance and maintenance of the asset. The lessee is only liable to the expenses regarding the usage of the asset.

11. Conditions of Ijarah • The rental payment commences after the delivery of the asset because then only the lessee would benefit from the usage of the asset. • Rental may be fixed or floating. If the rental is floating there must be an agreed upon formula on rental determination incorporated in the Ijarah contract. • The lease terminates only upon total destruction of the asset or by mutual consent of both parties. Upon termination, no more lease payment will be due to the lessor.

13. c) Salam • Deferred delivery (goods yet to exist) • Total payment must be done upfront • Quantity, time, place and mode of delivery made clear in contract • Only suitable for fungible goods (generic) • Application: commodity futures market, pre-shipment export finance

14. Client sell commodity to bank on forward basis. The bank pay full price. Client deliver commodity at agreed time and bank sell in the market for profit. Simple Salam Client Bank 1. 2.

15. Client sell to bank on forward basis for price P Bank sell to wholesaler on forward basis for price S. Client deliver commodity at agreed time. Bank deliver commodity to wholesaler Parallel Salam Farmer Bank 1. 3. 4. 2. Wholesaler

16. d) Istisnah • Construction/manufacturing contract (goods yet to exist) • Payment is flexible but price and mode of payment is fixed at time of contract. • Clear specification of the goods to be constructed or manufactured (unique goods) is required. • Application: project financing

17. Client asks bank to develop an asset with clear specification (SP). Bank ask developer to construct asset with same specification (PP). Developer deliver asset. Bank deliver asset to client. Parallel Istisnah Client Bank 1. 3. 4. 2. Developer

18. Issue in Istisnah • Who is liable for construction risk and non-conformity to specification risk? • Project management team & performance bond • Client as agent to oversee satisfactory completion of job • Client buy whatever completed and pay accordingly • Transfer of contractor

19. Natural Uncertainty Contract

21. NUC structure • Liability side: • Mudarabah Investment Account • Unit trust (Musharakah) • Asset side: • Mudarabah financing • Musharakah financing

22. Depositor place money in investment account (capital) and agree to PSR. Bank invests fund. At maturity share profit. If loss, borne by depositor. a)Mudarabah Investment Account Depositor Bank 1. 2.

23. Issues • Can the bank guarantee either the investment principal or return? • Indicative return.

24. Unit holders contribute capital in Islamic fund. Relation among them – musharakah. Fund mgmt invests the fund – agency, commission or mudarabah basis. b) Islamic Funds 1. Islamic Fund 2. Fund Mgmt Co

25. Bank and client enter into Mudarabah agreement and fix PSR. Client manages business. Profit is shared according to PSR. Loss is absorbed by bank. c)Mudarabah Financing Bank Capital Project Client Mgmt Project Revenue Profit Profit Loss

26. Bank and client enter into Musharakah agreement and fix PSR. Client manages business. Profit and loss is shared according to PSR. d)Musharakah Financing Client Bank Capital Capital Project Project Revenue

27. 4. Other common products • Wadi’ah Yad Dhamanah • Musharakah Mutanakisah • Commodity Murabahah

28. Wadi’ah yad dhamanah • Savings and current account • Wadiah: • Yad Amanah: safe keeping • Yad Dhamanah: safe keeping with guarantee • WYD – guarantee – behave like loan • No extra – only hibah allowed • No advertising of hibah (in cash or kind)

29. Bank and client co-own an asset. Client pays installment: Rental of the asset Redemption Musharakah Mutanakisah Client Bank 10% 90% Asset Monthly Payment Rental Redemption

30. Murabahah Commodity Tawarruq Bai al-Inah 1. Buy Deferred (C+P) 2. Spot (C) Ali Ahmad Client Bank 2. Sell Spot (C) 1. Deferred (C+P) Abu

31. Murabahah Commodity: Financing • Bank buy metal on spot basis from broker A • Bank sell the metal to client using Murabahah on deferred basis • Client sell the metal to Broker B on spot basis 1. Broker A Bank 2. Broker B Client 3.

32. Murabahah Commodity: Deposit • Client buy metal on spot basis from broker A • Client sell the metal to bank using Murabahah on deferred basis • Bank sell the metal to Broker B on spot basis 1. Broker A Client 2. Broker B Bank 3.