Essentials of Islamic Banking and Finance Al Ijarah Essentials of Islamic Banking and Finance IRSHAD AHMAD AIJAZ irshad786@gmail.com

Contents Definition of Ijarah; Explanation; Features of Ijarah; Difference with conventional lease; Practical application; Q & A

Definition of Ijarah Ijarah is an Arabic word whose origin is 'Ujrah' (compensation/fee/fare); Ijarah means giving something to other for use against a fee or rent or fare; In conventional finance concept of Leasing is similar to Ijarah; Conventional lease is defined as 'a right to use or occupy a property given by owner of the property (lessor) to another person (lessee or tenant) for a period of time, whereby the lessee obtains exclusive possession of the property in return for payment of fixed or determinable (floating) consideration (fee or rent) to lessor'; So it is act of giving a physical thing to other person for use against a return (rent or fee); Leasing does not include employment which means “activity or service performed by a person (employee) for another person (employer) for compensation (fee) or as an occupation (salary);

Definition of Ijarah This concept of Ijarah is broader than of the leasing; Its literal meaning is to give something on rent; In Islamic Fiqh the term of Ijarah has two meanings: To employ the services of a person on wages or fee (Ijarah al-Shakhsiyyah – services Ijarah); and To give a right to use a property or an asset to a person for a period of time against payment of a rent/charges/fee; In Islamic finance second type of Ijarah is discussed;

Expalnation of Ijarah Ijara in simple terms, implies leasing or hiring of a physical asset; It is a popular product in which the Islamic bank assumes the role of an aajir or moojir (lessor) and allows its client to use a particular asset that it owns; The client or mustajir (lessee) receives through Ijarah the benefits associated with ownership of the asset against payment of predetermined rentals (ujrat); There are two famous types of lease: Operating lease; Operating lease is a contract that allows the use of an asset, but does not convey rights of ownership of the asset to lessee; Finance lease/Capital lease; A lease contract that allows the use of an asset and considered to have the characteristic of ownership during the period of lease and automatically convey rights of ownership of the asset to lessee at the end of lease period. Islamic financial system recognizes only Operating Lease while capital lease is not allowed;

Expalnation of Ijarah Capital lease has two basic problems: Two contract of different nature (sale and lease) are use combined. Therefore it is neither a sale nor a lease contract completely; Two different types of contract have different types of effects; Proper distribution of rights and obligation of ownership is necessary according to Islamic law; No such distribution is present since it is a mixture of two different contracts: hire and purchase; As a rule of thumb Islam does not allow combining to different contract in one contract in a manner that each of them is dependent on the other; Like rent agreement and sale are merged in one contract in the manner that both are dependent on each other.

Features of Ijarah Ijara is for a known time period called Ijara period; Since operating lease is the only allowed way of leasing the rules of operating lease shall apply; Bank acquires ownership upon receiving a request from its client. Title or equitable ownership of the asset will remain with the bank as owner of the asset; Right of use of the property is transferred to the lessee; Ijara rentals are also paid in installments over time, and are supposed to cover the cost of the asset or value of investment for the bank and to provide a fair return on investment;

Features of Ijarah In Ijara, the bank continues to be the owner throughout the Ijara period while the client receives the benefits of ownership or the benefits of using the asset; As such, risks associated with ownership of the asset remain with the bank and the asset is supposed to revert back to the bank at the end of the Ijara period; The rentals could be fixed or flexible and be made to reflect the changing economic and business conditions;

Rules of Ijarah As per the Islamic laws of contract the: Subject matter of Ijarah should be Valuable, Identified and Quantified; The period of Lease must be determined in clear terms; Any damage to the asset not caused by the Lessee’s neglect, is to be borne by the Lessor; Lessee will be responsible for Normal maintenance; The Lessee is responsible for damage to the asset caused by fraud or negligence; The lease period starts when the asset has been delivered to the lessee in usable condition whether or not the lessee has started using it; Lease rentals for the entire lease period should be fixed (element of Gharar); Rent can be fixed on periodic basis (periodic revision/floating) but periodic increment should be agreed upon; The rent may be tied to a known benchmark, acceptable to both the parties.

Rules of Ijarah Termination of Lease: The lease will suspend if the leased asset becomes unusable; The lease will terminate if the leased asset is destroyed; However, if it is due to fault of the lessee, he is liable to compensate the lessor for the loss; Contravention of any term of the lease agreement gives right to lessor for unilateral termination of the agreement; Conventional Leases are of two types: Sale & Leaseback Leasing the asset which has already purchased by the lessee; The Lessor purchases the asset from the Lessee and leases it back to him; This is a kind of implicit interest; Direct lease Leasing an asset which is not already owned by lessee; Lessor purchases the asset from the supplier (open market or a third person) and then leases it to lessee;

Rules of Ijarah Both types of leases are possible under Ijarah; However, as discussed before Sale & Lease Back arrangement may be a kind of implicit interest therefore it is a less preferred option according to Islamic Shari'ah; However, if the mode is employed, then following restriction should be strictly adhered: Sale deed should be completely independent of the Ijarah agreement; Sale Deed should be executed before the execution of Ijarah Agreement; The assets should be sold back to the customer after a reasonable time; A year may be good time difference.

Rules of Ijarah Variable rentals in Ijarah: Fixed and floating rate rentals are possible in Ijarah like lease; This rate will be effective for whole period; Agreeing on a fixed rent for a long-term lease may not be feasible for lessor and he may wish to adopt market changes; Floating rates are allowed with certain conditions; The whole period should be divided into different periods (10 year may be divided into 10 equal periods); The rent should be set for a period before its start; After start of period the rental can not be changed because of any reason (delay in payment, market rate change etc. etc.);

Rental payment to owner Practical application ISLAMIC BANK Application for asset on Ijarah basis CUSTOMER Agreement to Ijarah Submission of initial deposit At the end of lease period customer buys the asset from owner/bank through a separate agreement Delivery to bank or as per its order to customer Transfer of ownership with delivery to owner (the bank) . Payment or Order to vendor/seller Delivery or time of delivery Rental payment to owner VENDOR

Practical application Consumer Finance: Automobile; Machinery; Corporate Sector: Investment Banking;

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