10 Lecture - Ijarah-2

Contents

• Definition of Ijarah;• Explanation;• Features of Ijarah;• Difference with conventional lease;• Practical application;• Questionable practices• Q & A

Al IjarahAl Ijarah

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;

Explanation 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 (Not allowed-HARAM); • 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 (HARAM);

Explanation of Ijarah• Capital lease has two basic problems:

– Two contract of different nature (sale and lease) are 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 of 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 (sellor);– Lessee (user) 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 be suspended 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 cannot be changed because of any

reason (delay in payment, market rate change etc.);

Practical application

• Consumer Finance:– Automobile;– Machinery;

• Corporate Sector:– Machinery;– Automobile;

• Investment Banking;

Ijarah – Questionable

practices• Rent computed on interest rate (benchmarking)

• Floating rate even more dangerous; in inflatory economies interest rate increase, while leased asset depreciates

• INTENSION: Not really interested in Ijarah (leasing) –but selling with markup

• Sale & Lease back Haram because of implicit interest; only allowed as a necessity under exceptional circumstances; but marketted as most popular Islamic product !

Ijarah – Questionable

practices• All maintenance cost – responsibility of customer; normally maintenance the responsibility of landlord; but NOT here

• Islamic Bank requires INSURANCE, which is HARAM

• Insurance is considered a maintenance cost – responsibility of customer

• Customer required to do all paper work, police report, etc

• Bank keeps proceeds of insurance! Is the Islamic bank exploiting the customer ?

Questionable practices -ExampleMr Gharib Leases a car worth 600,000, to run as a TAXI

He is told that is would cost him• Rps 8,500 if he leases it for 20 years (approx with

floating benchmark)

• Rps 11,000 if he leases it for 10 years (approx with floating benchmark)

• Rps 16,000 if he leases it for 5 years• Rps 22,667 if he leases it for 3 years• Rps 56,000 if he leases it for 1 yearHe is surprised !His own rental income running a Taxi is only Rps

15,000He was expecting the ISLAMIC BANK to charge Rps

2,000 to 3,000 for renting the car as a TaxiHow is the car rental computed ?

Questionable practices -ExampleSimple Straightforward “Rent” computation:

Cost Months Rate ProfitRent

600,000 240 20% 1,440,000 8,500600,000 120 20% 720.000 11,000600,000 60 20% 360,000 16,000600,000 36 20% 216,000 22,667600,000 12 20% 72,000 56,000

Mr Gharib asks: “Are you selling me the car on interest or just renting it to me for a time duration?”

Questionable practices -ExampleMr Gharib buys a 1 year HARAM premium insurance for Rps 25,000 in the name of the Islamic bank, because the car is the property of the bank; this is the requirement of the Bank!

In addition he pays 56,000 rent on the car, even though the TAXI earns about 15,000 per month

After 2 months the car is stolen! Mr Gharib runs around and does the paper work – police report

The Insurance company pays the Islamic Bank!

Questionable practices -ExampleMr Gharib in 2 months makes a LOSS of:

Insurance 25,000Registration 10,000Rent, 1st month 56,000Rent, 2nd month 56,000=============================Expenses in 2 months 147,000Less income in 2 months (30,000)=============================LOSS in 2 months 117,000

He entered into the Islamic Ijarah contract because of dire necessity (daroorah), otherwise he would die, & now a loss of 117,000…