2. 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

3. 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

4. 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.

5. 4 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.

6. 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

7. 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”

8. 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

9. 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

10. 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).

11. 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) 159119724413 %age of Banking Industry3.2%2.8%2.1%1.4%0.5% Deposits (Rs. in Bn) 1088450308 %age of Banking Industry 2.9%2.6%1.9%1.2%0.4% Financing. & Invest. (Rs. in Bn) 9073483010 %age of Banking Industry2.5%2.3%1.8%1.3%0.5% No. of Branches167150704817

12. 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.

13. 12 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

14. 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 Global Perspective

15. 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. Global Perspective

16. 15 IJARAH

17. 16 IJARAH (LEASING) IJARAH AL ASHKAAS IJARAH AL AI’YAN Ijarah (Operating Lease) Ijarah Muntahia Bittamleek

18. 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.

19. 18 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 Muntahia Bittamleek

20. 19 ESSENTIALS OF IJARAH

21. 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

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 26 AAOIFI SHARIAH STANDARD

28. 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 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.

29. 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.

30. 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 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.

31. 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 lessor’s cost. The lessee should carry out operating or periodical (ordinary) maintenance.

32. 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.

33. 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.

34. 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.

35. 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.

36. 35 MECHANISM

37. 36 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 Financier (Lessor) Financier (Lessor) Entrepreneur (Lessee) Entrepreneur (Lessee) Vendor Transfer of asset Beneficial use of asset Payment of purchase price Lease rentals

38. 37 Ijarah Muntahia Bittamleek 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 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 GENERAL MECHANICS C USTOMER I SLAMIC B ANK V ENDOR.. Agreement

39. 38 Ijarah Muntahia Bittamleek 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 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 GENERAL MECHANICS C USTOMER I SLAMIC B ANK Agreement V ENDOR..

40. 39 USAGE OF IJARAH

41. 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)

42. 41 IJARAH (LEASING) Ijarah Muntahia Bittamleek Examples: Vehicles Ijarah Financing Plant and Machinery Consumer Durables House Financing Project Finance, etc.

43. 42 RISKS AND ISSUES

44. 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.

45. 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

46. 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?

47. 46 Leasing/Ijarah Contract Conventional LeasingCar 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.

48. 47 Rights & Liabilities of Lessor and Lessee Conventional LeasingCar 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.

49. 48 Rentals recovery in case of theft and loss Conventional LeasingCar 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.

50. 49 Penalty for late payment Conventional LeasingCar 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.

51. 50 Insurance premium Conventional LeasingCar 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.

52. 51 Registration Charges Conventional LeasingCar 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

53. 52 Purchase of asset Conventional LeasingCar 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.

54. 53 Commencement of Rentals Conventional LeasingCar 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.

55. 54 Signing of Lease Contract Conventional LeasingCar 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

56. 55 Termination before delivery Conventional LeasingCar 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.

57. 56 DOCUMENTATION OF IJARAH

58. 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.

59. 58 ADDENDUMS TO IJARAH AGREEMENT Description of the Ijarah Asset Schedule of of Ijarah Rentals Receipt of Asset Demand Promissory Note

60. 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.

61. 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.

62. 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.

63. 62 PROMISSORY NOTE After signing of Ijarah Agreement, the amount of rentals become Debt (Dyan) to the Lessee. Promissory Note is Lessee’s acknowledgement to Debt amount and its promise to pay.

64. 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.

65. 64 OTHER DOCUMENTS Undertaking for Personal use of Ijarah Asset Trust Receipt Authorization to Take possession of Leased Asset Sale Deed

66. 65 Ijarah delivers legitimacy from the Qura’an and the Sunnah. On the level of Qur’an, 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 ) Shari’ah legitimacy Ijara-tul-Ashkhas

67. 66 According to Shari’ah, 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 Shari’ah 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. Ijara-tul-Ashkhas

68. 67 “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 Common Misconceptions

69. 68 “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 Common Misconceptions

70. 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

71. 70 for You are the Grantor of bounties without measure. Surah Ali ‘Imran 8 Our Lord let not our hearts deviate now after You have guided us but grant us mercy from Your own Presence

72. 71 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 Our Lord! Lay not on us a burden greater than we have strength to bear Our Lord! Lay not on us a burden Like that which You put on those before us Our Lord! Condemn us not if we forget or fall into error

73. 72 THANK YOU Ph: 021-9212509, Fax: 021-9212472 Email: mahmood.shafqat@sbp.org.pk mahmood.shafqat@sbp.org.pk http://www.sbp.org.pk/departments/ibd.htm