Fundamentals of Islamic Finance Lecture 1, 2, 3, 4 PDF

ْ َ ُ ‫ش‬ ‫خ‬ ‫ي‬ ‫و‬ ‫ه‬ ‫سول‬ َ ُ ‫َّللا َو َر‬ َ َ َ ‫َو َمن يُ ِط ِع ه‬ َ ‫َّللا َويَت ه ْق ِه فَأ ُ ْولَ ِِ ََ ُُ ُُ ل ْلََئ ِِ ُُز‬ ‫ون‬ َ‫ه‬ And he who obeys Allah and His Messenger, and fears Allah, and is careful of (his duty to) Him, these it is that are the achievers. [24:52] Fundaments o...

ْ َ ُ ‫ش‬ ‫خ‬ ‫ي‬ ‫و‬ ‫ه‬ ‫سول‬ َ ُ ‫َّللا َو َر‬ َ َ َ ‫َو َمن يُ ِط ِع ه‬ َ ‫َّللا َويَت ه ْق ِه فَأ ُ ْولَ ِِ ََ ُُ ُُ ل ْلََئ ِِ ُُز‬ ‫ون‬ َ‫ه‬ And he who obeys Allah and His Messenger, and fears Allah, and is careful of (his duty to) Him, these it is that are the achievers. [24:52] Fundaments of Islamic Finance Lecture 1, 2, 3, 4 Learning Objectives ◼ Primary and Secondary Functions of a bank ◼ Understand how funds are used by Islamic Banks ◼ Shariah Compliant Modes of Finance ◼ Participatory Modes of Finance Mudarabah ◼ Musharakah ◼ Reading List ◼ AAOFI, 2004 ◼ Wahba Zuhaili, Fiqlul Islami Wa Adilatuhu ◼ Wahba Zuhaili, Financial Transactions in Islamic Jurisprudence. ◼ Moore, Philip, “Islamic Finance” ◼ Al-Mawsu’ah al-Fiqhiyyah (pp. 33-92) ◼ Hassan, Hussain Hamid (1992), The Jurisprudence of Financial Transactions, published in ‘Lectures in Islamic Economics’, IDB/IRTI, pp.105-108. ◼ Durani & Boocock (2006), “Venture Capital, Islamic Finance and SMEs” Functions of Bank ◼ Primary Functions ◼ Demand deposit ◼ Savings and Time deposits ◼ Making loans and investments ◼ Secondary Functions ◼ Money Transfers ◼ Agency Service ◼ Venture capital ◼ Letter of Credit Shariah Complaint Modes of Finance ◼ Participatory Modes of Finance ◼ Mudaraba ◼ Musharaka ◼ Trade Based Modes of Finance ◼ Bai Mu’ajjal ◼ Bai’ Salam and Istisna’a ◼ Bai’ Murabaha and Musawamah ◼ Leasing ◼ Ijarah. ◼ Some Accessory Contracts ◼ Wakalah (Agency) ◼ Tawarruq ◼ Ji’alah Mudaraba ◼ The term Mudarabah is interchangeably used with Qirad and Muqaradah. ◼ An investor or group of investors (Rabul-Mal) provide the capital. ◼ The profit is shared according to the pre-agreed proportions, ◼ While the loss has to be borne exclusively by the investors. ◼ Mudarib is only responsible for the management. Rab-ul-Mal Mudharib (Lender/Financier) (Borrower/Entrepreneur) EFFORTS INVESTMENT Profit (In agreed Ratio) Mudharabah (Partnership) Loss (To be borne by the Rab-ul-Mal only) Mudaraba ◼ Amount of Profit can not be fixed; ◼ Profit cannot be any percentage of the capital invested; ◼ Any ambiguity or ignorance regarding capital or ratio of profit makes the contract invalid. Types of Mudaraba ◼ Mudaraba al-Muqayyaddah (Conditional) ◼ Conditions must not be prejudice to the interest of the business or counterproductive. ◼ Mudaraba al-Mutlaqah (Unconditional) Mudaraba – Rabul-Mal ◼ Will provide all the capital required. ◼ No say in the running of the business. ◼ Can ask for guarantee to return funds, which can only be enforced if: ◼ Mudarib is negligent; ◼ Capital should preferably be in the form of legal tender money. Why? ◼ Capital given for Mudaraba must be free from all liabilities. ◼ Not allowed to work for the business. Mudaraba – Mudarib (Entrepreneur) ◼ An agent to the Rabul-Mal he undertakes the business and shares the profit. ◼ He works in different capacities: trustee, agent, indemnifier/liable and wage earner. ◼ Freedom to act according to his discretion. ◼ Sole responsible for managing the Mudarba. Mudaraba – Treatment of Profit/Loss ◼ Both parties in Mudaraba are at liberty to agree on the proportion or ratio of profit-sharing. ◼ Different proportions can be negotiated upon the different situations. ◼ Reserves can be created by mutual consent. ◼ If losses occur, the loss be can be compensated by the profit of the future operation or the reserves created. ◼ Profits are shared when they accrue. ◼ Please look at the last handout! Mudaraba – Condition of the contract ◼ Before the work starts: ◼ Contract should be clearly stipulated ◼ Capital should be quantifiable and liquid money ◼ Profit sharing ration should be clearly stipulated ◼ When the work starts: ◼ Rabul-Mal should hand over the capital. ◼ The Mudarib should abide by the terms of the contract. Mudaraba – Condition of the contract ◼ When the work starts generating the profit: ◼ Profits are shared when they accrue. Mudaraba – A Critique ◼ Asymmetric Information ◼ Entrepreneur has more information about his abilities, objectives and business ideas than the investor. ◼ Adverse Selection ◼ Risk of choosing a bad company to invest in requires careful investigation and relevant credit check ◼ Moral Hazard ◼ Risk that once entrepreneur receives the funds he may engage in immoral or harmful behaviour motivated by slef-interest. Musharaka ◼ Musharaka is derived from the term Sharikah (partnership). ◼ “The Musharaka contracts are based on a partnership process in which several parties contribute to the financing and the management of a Sharia’a compliant project.” (Ref.?) ◼ A man who shares in profit must also bear the risks. (Hadith: Earning are concomitant to risks.) Musharaka - Forms ◼ Partnership in Ownership (Shirkatulmilk) ◼ Two or more people are joint owner of one thing. ◼ Mixing of ownership, either mandatory or by choice. ◼ Optional ◼ Compulsive ◼ Not for sharing of profit but co-owners may use the property individually or jointly. ◼ It is lawful for one partner to sell his share to other partner. Musharaka - Forms ◼ Partnership by Contract (Shirkatul’Aqd) ◼ Created by offer and acceptance ◼ “It is an agreement between tow or more persons to combine their assets, labour or liabilities for the purpose of making profit.” (AAOIFI, 2004 p. 200) ◼ Partners are agents of each other and a partner cannot sell his share without the other partners consent and cannot sell his share without the other partners’ consent and cannot guarantee capital or any profit of the other partner. Partnership by Contract (Shirkatul’Aqd) ◼ Shirkatulamwal All the partners invest some capital into a commercial enterprise. ◼ The own the enterprise as per their share in the capital ◼ ◼ Shirkatula’mal ◼ Partners are jointly undertake to render some services to their customers and share the fee charged by them according to the agreed ratio and each partner bring his own resources. ◼ Shirkatulwujooh ◼ Partnership in creditworthiness Partnership by Contract (Shirkatul’Aqd) ◼ Shirakah-al-Mufawadah ◼A partnership where two persons, being the equal of each other in respect of property, privileges, and religious persuasion, enter into a contract of partnership. ◼ Shirak al ‘Inan or General Partnership ◼ Where any two persons become partners in any particular business or where they become partners in all matters of commerce indifferently. ◼ Involves collective capital of the partners Musharaka ◼ Three common conditions: 1. 2. 3. Agency (hand of trust) Qualification (age, sanity,…) Specification of profit sharing ratio (no fixed profit for any partner.) ◼ Malikite consider it as irrevocable while others consider Shiraka contract a revocable. Shirak al ‘Inan in Banking ◼ Suitable for joint business, ◼ adaptable to any situation ◼ Practicable in current advanced commercial practices ◼ “A joint enterprise formed for conducting any business with the condition that all partners shall share the profit according to a specified ratio, while the loss will be shared according to the ratio of contribution to the capital of the joint business.” Shirak al ‘Inan - Conditions ◼ Capital can be invested in any proportion ◼ Power of appropriation in the property and participation in the affairs of the Shirakah may be different and; ◼ disproportionate to the capital invested by partners. ◼ Profit may be divisible unequally and disproportionate to the capital invested ◼ Profit sharing ratio may be pro rats ration (in proportion to capital contribution) ◼ Loss is to be shared in proportion to the capital invested. Shirak al ‘Inan - Conditions ◼ Each partner is an agent (Wakil) to the other partner ◼ No partner is responsible for indemnification of the acts of commissions and omissions on the part of the other partner (s). ◼ Bank can keep control and supervision rights over the project and leave the dayto-day project work to the second partner. Musharik -1 Musharik-2 (Financier) (Entrepreneur) Investment + EFFORTS INVESTMENT Profit (In agreed Ratio) Musharaka (Partnership) Loss (To be borne by the in the ratio of Capital Invested) Musharaka - Types ◼ Permanent or Continuous Musharaka ◼ The partnership process continues until the project is finished. ◼ Each partner retain their share in the capital ◼ Partner can sell his share to a third party ◼ Diminishing Partnership ◼ Musharaka Muntahiya Bittamleek ◼ One partner agrees to gradually sell parts of its capital shares in the Musharaka project to other party against a specific amount of money. Share in profit also decrease in line with the share in capital. ◼ Musharaka - Guarantees ◼ All partners in Shiraka maintain the assets of the partnership as a trust. ◼ No one is liable except in cases of breach of the contract, misconduct or proven negligence, such as: 1. 2. 3. A partner does not abide by terms and conditions; A partner work against the norms of the concerned business; The established ill-intention of a partner. Musharaka –Third Party Guarantee ◼ The third party should not be legally and financially related to Musharaka by owning more than 50% of the capital of the guaranteed joint venture. ◼ The guaranteed joint venture should not own more than half of the capital of the guarantee-providing entity. ◼ The Musharaka contract should not conditional on such a guarantee. ◼ Fulfilment of promise by a third party is not a condition for validity of the contract. Musharaka – Application in Banking ◼ Partnership ◼ Limited Liability companies and bodies corporate ◼ Term financing to customers in order to finance the project ◼ Make sufficient liquidity available ◼ Housing finance ◼ Fixed asset financing Musharaka – Letter of Credit ◼ What is a Letter of Credit ◼ ◼ ◼ ◼ ◼ “Letter of Credit” is derived from the French word “accreditation”, a power to do something. Latin word “accreditivus”, meaning trust. “A letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.” Often referred to as a documentary credit; The source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. After a contract is concluded between buyer and seller, buyer's bank supplies a letter of credit to seller. Seller consigns the goods to a carrier in exchange for a bill of lading. Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from buyer. Buyer provides bill of lading to carrier and takes delivery of goods. Musharaka: The Letter of Credit ◼ A Mushraka contract is signed between the bank and his client showing ◼ the Musharaka capital, ◼ the type of trade, ◼ the profit-sharing ratio, and ◼ other related provisions ◼ The L/C is opened in the name of both bank and his client. ◼ The margin that is paid by the client is treated as his share in the Musharaka capital. Modern Corporations ◼ Joint Stock Companies al ‘Inan ◼ Combination of Musharakah and Mudarabah ◼ Shirakah Musharaka – Venture Capital ◼ What is Venture Capital Finance? ◼ An activity by which investors support entrepreneurial talents with finance and business skills to exploit marker opportunities and thus obtain long term capital gains. ◼ An equity based investment activity particularly tailored for solving the financing problems of SMEs. ◼ Musharaka is an ideal for Venture Capital financing; Musharaka – Venture Capital ◼ SME’s cannot not provide necessary collateral/security to enjoy finance from conventional system. ◼ SME’s typically suffer from inability to access conventional banking funds at the start-up or sometimes the post start stage. ◼ Because of very low liquidation values and vulnerability to debt-servicing crises. ◼ SME is ideally suited to equity rather than debt financing, therefore, Musharaka is an ideal basis for Venture Capital Finance. Musharaka – Venture Capital ◼ Features of Venture Capital Finance ◼ Equity Finance ◼ Long term investment in young startup companies ◼ Managerial assistance to talented entrepreneurs ◼ Capital gains Musharaka – Venture Capital ◼ Types of Venture Capital Finance ◼ ◼ ◼ ◼ Business Angels: or informal equity suppliers targeting running SMEs rather than start-ups Corporate Venture Capital: led by cash-rich corporations to satisfy various strategies of their own; Social Venture Capital: geared to community needs. Corporate Venture Capital Funds: The primary source of post war start-up equity finance for technology-oriented firms like Microsoft, Apple Computers, Intel etc. Musharaka – Venture Capital ◼ Venture Capital Finance Properties ◼ Mostly closed-end funds with maturities ranging between 10-15 years. ◼ Fundamentally addressed to resolving Adverse Selection and Moral Hazard. Questions 1. Why should management of mudarabah be left to the 2. 3. 4. 5. sole discretion of mudarib without interference from the financier [rabb al-mal]? Given that rabb al-mal cannot give directions to the mudarib in the management of commercial operations, what is the jurist description of the alternative arrangement which permits this condition? What is the empirical relationship between return and risk? Given the provisions of risk-sharing in mudarabah, which of the following three characteristics is typical of an Islamic economic agent: risk-aversion, riskneutral or risk-loving? Why is it not possible to treat the fixed interest rate as a ‘share in profit’? Trade Based Modes of Finance ◼ Trade ◼ Based Modes of Finance Bai’ Mu’ajjal ▪ Bai’ Murabaha ▪ Bai’ Musawamah Bai’ Salam (Trust Sale) and ◼ Bai’ Istisna’a (Order Sale) ◼ Basic Principles of Trade ◼ The commodity or asset being sold or the purpose of such sale should not be against the basic injunctions of Islamic Shariah. ◼ The sale should take place with the free and mutual consent of the seller and buyer ◼ Subject of the sale, Price, date and place of delivery, time of payment of price must be agreed. ◼ Seller must be either owner/agent. ◼ The subject of sale (Mabi’) should be Transferrable to the ownership of another person. ◼ The subject of sale must exist at the time of sale ◼ The Mabi’ should be well defined in and in the ownership of the seller. ◼ The Mabi’ must be in the physical or constructive possession of the seller. ◼ Sale must be instant and absolute. ◼ A certain price is stipulated once and for all. ◼ The subject of the sale should be specifically known and identified to the buyers. ◼ The sale must be unconditional. Bai’ Mu’ajjal ◼ Sale on credit i.e. creating receivables. ◼ Musawamah ◼ Normal sale where parties bargain on price, goods delivered and payment is deferred. ◼ Murabaha “Cost-Plus Sale”, parties bargain on the margin of profit over the known cost price. ◼ The seller has to reveal the cost and provide all cost-related information. ◼ Murabah – A Bai’ Al Amanah ◼ Declaration of the cost to the seller. ◼ Tawliyah (resale at the stated original price, no profit, no loss.) ◼ Wadhi’ah (resale at discount price) ◼ Murabaha (sale with a fixed profit margin over the cost.) Murabaha ◼ “the sale of anything for the price at which it was purchased by the seller and an addition of a fixed sum by way of profit”. (Al-Hidaya by Al-Marghinani, 1957, p.282) ◼ “the sale at capital cost plus a known profit, the knowledge of of capital cost is a precondition in it”. (Ibn Qudamah) ◼ “Murabah is conducted and completed by exchanging goods and price including a mutually agreed profit margin, then and there.” (Imam Malik, Kitab al Fiqh al Mazahib al-Arbaia, p. 559) Murabaha _ Conditions ◼ Goods to be treated should be real, but not necessarily tangible. ◼ Currency and monetary units which are subject to Bai’ al Sarf cannot be sold through Murabaha. ◼ Credit documents that represents debt owed by someone cannot be traded. ◼ The seller must state the original price and the additional cost incurred on the sale item and true to his words. ◼ The margin of profit on the price so reached has to be mutually agreed. ◼ Any Majhul price cannot become a basis for Murabaha. ◼ What happens if the Seller gives incorrect statement about the price/cost of goods? Murabaha - Conclusion ◼ Murabaha is lawful kind of sale but has its own limitations. ◼ The Medieval Murabaha was not a mode of finance, it was a kind of trade. ◼ Contemporary jurists have accepted it as a mode of business and an alternative to financing with certain limitations. ◼ Level of transparency and Justice. Murabaha and Credit Sale ◼ Murabaha-Mu’ajjal ◼ Sale with profit on Deferred payment basis. ◼ Lump sum payment or instalments ◼ “Sale with an agreed profit margin over the cost price along with deferred payment.” ◼ “A sale is valid either for ready money or for a future payment provided the period be fixed, because of the words of the Holy Quran “Trading is lawful” and also because there is a tradition of the holy Prophet (SAW) who purchased a garment from a Jew, and promised to pay the price at a fixed future date by pledging his iron breast-coat. It is indispensably a requisite of business but the period of payment should be fixed. Uncertainty in the period of repayment may occasion a dispute and jeopardise the execution of the transaction since the seller would naturally like to demand the payment of the price as soon as possible, and the buyer would desire to defer it.” [p.242] Prompt Payment vs. Deferred Payment ◼ The receipt of the agreed price is the sole right of the seller. ◼ The difference between cash and credit price is allowed if provided one price is settled at the finalisation of the contract. (Hanafi, Shafi and Hanbalis) ◼ It is in accordance with the Fiqh principle, profit goes with loss (“AlGhunm bil Ghurm”). Murabaha vs. Conventional Loan ◼ The banker in a Murabaha must have some form of actual ownership, registered or not, constructive or physical. ◼ The closing date for Murabaha transaction may be extended but the extension or rollover may not result in an increase in the mark-up or a penalty. ◼ If the payment is late no form of penalty may be charged for the profit of the creditor (i.e. Bank) ◼ Most Islamic scholars do not agree early payment discounts etc. Murabaha in Practice ◼ Short-Term financing for financing of working capital needs. ◼ Long-Term financing requirements for financing of fixed assets. ◼ Housing Finance ◼ Murabaha Sale of securities and commodities which may be used by the client as a Tawaruq or Reverse Murabaha. Murabaha – How ? ◼ Direct Trading by Bank Management ◼ Bank Purchases Through a Third Party/Agent ◼ Murabaha Through the Client as Agent Deferred Payment CLIENT Cash Payment Goods BANK SUPPLIER Goods Murabaha To Purchase Order ◼ Modern Murabaha transaction by banks takes the form of Murabaha to Purchase Order (MPO) ◼ Murabaha lil ‘amri bil Shira/Murabaha li Wa’da bi Shira. ◼ Purchase in response to customers request. ◼ Promise to purchase is a part of the requisition. ◼ Client can nominate the Supplier but bank needs to ensure that the supplier is in associated with client. MPO – A Bunch of Contracts ◼ A master contract which stipulate the overall facility to be availed, followed by an agreement to purchase or promise by the client to purchase the article when offered by the bank. ◼ An agency contract whereby the agent, who could be client or any third party has to purchase the items from the marker. ◼ The actual Murabaha contract. 1 NEGOTIATION (To determine the needs) BUYER SELLER First Purchase 2 4 3 Appointment of agent for Delivery, payment or both. Promise to Purchase (PO) 5 Murabaha Sale FINANCIAL INSTITUTION Bai Murabaha –Risks for the Bank ◼ Customer refuses to purchase goods after taking possession as agent. ◼ Client has already purchased goods and needs finance (Bai al ‘Inah). ◼ Goods/assets already consumed by client. ◼ Overdue/Missed payment ◼ Default risk ◼ Supplier may not perform his obligations. ◼ Purchase from or resale to associate or subsidiaries. MPO – Unresolved Questions ◼ Should the promise be unilateral or bilateral, binding or nonbinding? ◼ What is remedy if the client backs out? ◼ What should be the sequencing of the various actions of the bank and the client? ◼ When the actual Murabaha is to be executed what happens if the client makes early payment or delays in making payment of the agreed price? ◼ What structure and modus operandi of Murabaha can be adopted to fulfil the needs of various stakeholders along with ensuring Shariah compliance? Bai’ Salam/Bai; Salaf ◼ “Price paid in advance at the time of making the contract for prescribed goods to be delivered later”. ◼ The parties stipulate a certain time for supply of goods of specified quantity and quality. ◼ “Forward transaction of a defined nature.” ◼ “..who ever pays money in advance (for fruit) (to be delivered later) should pay it for a known quality, specified measure and weight of course along with the price and time of delivery.” Bai’ Salam – Economic Role ◼ The period of delivery ranging from one year to three years suggests that the amount of advance was not small. ◼ Buyers were not the consumers of the goods; they were traders or prospective traders. ◼ The price received in advance might have met both the productive and consumptions requirements of the farmers. ◼ Money could also be used for fixed investment (three years). Bai’ Salam - Features ◼ Subject Matter of Salam any thing that can be determined in Quantity and quality. ◼ Payment of Price – Salam Capital ◼ ◼ ◼ ◼ Any legal tender Could be in terms of goods as well Salam capital should be advanced in full. ◼ Period and Place of Delivery ◼ Due date and place delivery ◼ Khiyar (Option) ◼ Amending or Revoking the Salam Contract ◼ Penalty for Nonperformance Goods Produced BANK CLIENT CASH PAYMENT NEEDS Revenue Goods Produced Goods Market Financing NEEDS Salam – In Practice CLIENT Purchase against Advance Cash Payment and Deferred delivery. BANK Sale against advance Cash payment and deferred delivery BUYER Bai’ Salam – Case Studies ◼ Agriculture Finance ◼ Salam For Working Capital (Steel Mill) Bai’ Salam –Risks for the Bank ◼ Counterparty and delivery risk ◼ Commodity – Price Risk ◼ Commodity – Marketing Risk Bai’ Istisna (Order to Manufacture) ◼ An asset is transacted before it comes to existence. ◼ A commodity is transacted before it is manufactured. ◼ Legalised o the basis of Istihsan (Public interest) “Istisna is evolved into Islamic jurisprudence due to specific needs in the area of manual work, leather products, shoes, carpentry etc. However, it has grown in the modern era as one of the contracts that make it possible to meet major infrastructure and industrial projects such as the building of ships, aeroplanes and other large machinery……..” ◼ Sale is executed at the time of entering into the Istisna contract. ◼ Therefore, no need to renew an exchange of offer and acceptance after the subject matter is prepared. Bai’ Istisna - In Practice ◼ Financing manufacturing/ ◼ Construction of houses ◼ Building of Bridges, roads and Highways Istisna –Case Studies ◼ Housing Finance ◼ Export ◼ Government Projects Bai’ Istisna – Risk for the Bank ◼ No claim in case of non-performance. ◼ Delivery Risk ◼ Sale not permissible before delivery ◼ Asset Risk ◼ Price Risk ◼ Marketing Risks ◼ Quality Risks Bai’ Salam vs. Bai’ Istisna ◼ The subject of Istisna is always a thing which needs manufacturing, while Salam can be effected on any thing, no matter whether it needs manufacturing or not. ◼ It is necessary for Salam that the price is paid in full in advance, while it is not necessary in Istisna. ◼ The contract of Salam, once effected, cannot be cancelled unilaterally, while the contract of Istisna can be cancelled before the manufacturer starts the work. Bai’ Salam vs. Bai’ Istisna ◼ The object of the Salam is a liability on the seller to deliver, thus should be in the form of fungible goods i.e. easily replaced from the market should the seller be unable to deliver. Under the Istisna, the asset manufactured must meet specification of the order and the buyer has the right not to take possession of the asset if the specifications are not met. ◼ The time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna that the time of delivery is fixed. Any penalty for charged late delivery can reduce the price of an Istisna contract but in a Salam, the penalty amount is paid to charity (not taken as benefit for the buyer). Islamic Financial Instruments LEASING Leasing - Conventional ◼ A lease is an agreement between you (the lessee) and the finance company (the lessor). You will pay a periodic fee, usually monthly, for the use and possibly ownership of equipment. ◼ “Asset finance or leasing is a way of purchasing equipment, machinery or other assets without having to pay the full amount upfront.” ◼ The Finance and Leasing Association (FLA) estimates that some 15% of office equipment is financed through a lease. Hire Purchase ◼ Hire Purchase is a loan linked to a specific purchase, such as a car. It’s a way of obtaining the use of an asset before payment is completed - once you sign the agreement you can drive the car away the same day. Hire Purchase - Features ◼ You don't legally own the goods until you've paid back all the money you owe. This means that you cannot modify or sell them without the lender's permission ◼ Your contract is with a finance company (not the retailer) who will own the goods until the final payment is made ◼ The finance company can take the goods back if you don't keep up your repayments ◼ You will be liable for any damage caused to the goods during the contract period. Ijara - Definition ◼ Derived from al-’Ajr and means compensation, substitute, consideration, return or counter value (al’Iwad) ◼ It refers to hiring or renting any asset/commodity to benefit from its usufruct. ◼ Kira and Istijar are also used for the same meaning. Ijara - Definition ◼ “Ijara is a contract of a known and proposed usufruct of a specified asset for a specified time period against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended.” [Zuhayli, 2003, pp. 386-387] ◼ “Ijara is the sale of usufruct (not of ‘Ain) of any commodity in exchange of Ujrah, wages or rent, and covers houses, shops, riding/work, animals, jewellery, clothes etc.” BASIC RULES OF LEASING ◼ Transferring of usufruct not ownership To another person for an agreed rent, at an agreed consideration. ◼ Subject of lease Valuable, Identified and Quantified ◼ Consumable things cannot be leased out Anything which cannot be used without consuming cannot be leased out; e.g., money, wheat etc. BASIC RULES OF LEASING ◼ All Liabilities of ownership are borne by lessor Since corpus of leased property remains in the ownership of the seller. ◼ Period of lease Must be determined in clear terms at the time of contract ◼ Lease for specific purpose only If no specific purpose is identified in the agreement, then it can be used for any purpose for which it is used in normal course BASIC RULES OF LEASING ◼ Lessee as Ameen The lessee is liable to compensate the lessor for every harm to the leased asset caused by any misuse or negligence. The leased asset shall remain in the risk of the lessor throughout the lease period. ◼ Lease of jointly owned property Is permitted and rentals shall be distributed between all the joint owners according to the proportion of their respective shares in the property. BASIC RULES OF LEASING ◼ Determination of Rental The rental must be determined at the time of contract for the whole period of lease. Ijara – Shariah Rulings (Al-Kasani) ◼ The contracted usufruct has to be ascertained to avoid any dispute. ◼ The lease period must be specified. ◼ Benefiting from the hired goods should be possible ◼ The handing over of the assets for their benefit is essential ◼ The usufruct of the asset must be lawful ◼ The usufruct must be tradition of the people. Ijara - Conclusion ◼ Ijara is only valid for things which possess Manafa’ah (Usufruct) and which can be hired or utilised but their corpus or substance (‘Ayn) is not consumed. ◼ All those assets taking benefit from which is not possible without consuming them cannot be given on lease. ◼ The genus of the asset leased and the rent should not be the same. Features of Ijara Contract ◼ It is a contract. ◼ Known usufruct is transferred. ◼ Of a particular asset ◼ For a specified time period ◼ Against agreed-upon rental Ijar vs. Bai’ ◼ In Bai’ ownership of the corpus of the asset is transferred while in Ijara the corpus of the asset remains in the ownership of lessor and only its usufruct is traded. ◼ Ijara is always time bound, while sale implies definite transfer of ownership of the sold asset just after the sale is executed. Determination of rent ◼ Aggregate cost incurred in the purchase, construction or installation of the asset by the lessor. ◼ The lessor cannot increase the rent unilaterally. ◼ There can be different rates for different phases based on any agreed benchmark during the lease period. ◼ Lease period or rent both could be reviewed. ◼ In a long term lease rent could be tied with a variable and well defined reference rate or benchmark or enhancing the rent periodically. ◼ The rate of inflation, any price index, growth rate or any well-defined returns rate in real sectors of an economy can be used for benchmarking. ◼ Scholars suggest that the relation between the rent and the reference rate should be subjected to a ceiling or limit. ◼ Sub-lease by the Lessee ◼ Security/Guarantee in Ijarah ◼ Liabilities of the Parties ◼ There is no liability on a lessee (or employee) ◼ All liabilities emerging from the ownership shall be borne by the lessor, but the liabilities relating to the use of the property shall be borne by the lessee. ◼ The leased property shall remain in the risk of the lessor. ◼ Ijara is a binding contract therefore, cannot be revoked/amended unilaterally. ◼ If the leased asset is damaged to the extent it is no more usable the contract is terminated. ◼ If the lessee stops using the asset without the lessor’s consent, accrual of the rental will continue. ◼ Death of either party. ◼ Failure in Payment of Due rent ◼ Rent is a debt payable by the lessee. ◼ Shariah Scholars allow that a donation or any amount of penalty payable to charity. ◼ Enforce collateral to cover the rent. LEASE AS A MODE OF FINANCING ◼ Leasing should not be interest-based loan or replacing interest with rent, rather it should comply with all of the following conditions of Islamic leasing: LEASE AS A MODE OF FINANCING 1. The commencement of lease Unlike the contract of sale, the agreement of Ijarah can be effected for a future date. Hence, it is different from Murabaha. 2. Rent should be charged after the delivery of the leased asset to the lessee and not from the day the price has been paid. If the supplier has delayed the delivery after receiving the full price, the lessee should not be liable for the rent of the period of delay. LEASE AS A MODE OF FINANCING 3. Different relations of the parties There are two separate relations between the institution and the client: one of an agent and the other of a lessee. LEASE AS A MODE OF FINANCING 4. Difference between Murabahah and leasing ◼ A Murabaha can not be transacted on a future date as the sale would be executed simultaneously after taking delivery from the supplier and seller would never bear its risk which Shariah does not permit. But in leasing it is permissible, because in leasing the asset remains under the risk and ownership of the lessor throughout the leasing period. LEASE AS A MODE OF FINANCING 5. Expenses consequent to ownership to the lessor As the lessor is the owner of the asset, he is liable to pay all the expenses incurred in the process of its purchase and its import to the country of the lessor for example expenses of freight and customs duty etc. 6. Lessee as Ameen The lessee is responsible for any loss caused to the asset by his misuse or negligence. He can also be made liable to any normally occurring LEASE AS A MODE OF FINANCING 7. Variable Rentals in Long Term Leases In this case the lessor has two options: ◼ A lease contract can have a condition that the rent shall be increased according to a specified proportion (e.g. 5%) after a specified period (like one year). ◼ He can contract lease for a shorter period after which the parties can renew the lease at new terms and by mutual consent LEASE AS A MODE OF FINANCING 8. Penalty for late payment of Rent The lessor cannot charge an additional amount in case the lessee delays payment of the rent. 9. Penalty of late payment is given to charity by lessee LEASE AS A MODE OF FINANCING 10. Termination of Lease If the lessee contravenes any term of the agreement, the lessor has a right to terminate the lease contract unilaterally. If not then it can be terminated through mutual consent only. However, in such a case he cannot charge rentals of remaining period. 11. Insurance of the assets If the leased property is insured under the Islamic mode of Takaful, it should be at the expense of the lessor and not at the expense of the lessee LEASE AS A MODE OF FINANCING 12. The residual value of the leased asset Through a mutual agreement of Lease, after the expiry of the lease period, the corpus of the leased asset cannot be transferred to the lessee, otherwise it becomes hire purchase. It is a well-settled rule of Islamic jurisprudence that one transaction cannot be tied up with another transaction so as to make the former a pre-condition for the other. However, the lessor may enter into a unilateral undertaking to sell the leased asset to the lessee at the end of the lease period. This undertaking will be binding on the lessor only. LEASE AS A MODE OF FINANCING 13. Ijarah Wa Iqtina The lessor may sign a separate promise to gift the leased asset to the lessee at the end of the lease period, subject to his payment of all amounts of rent. The validity of this arrangement is subject to two basic conditions: Firstly, the agreement of Ijarah itself should not be subjected to signing this promise of sale or gift. Secondly, the promise should be unilateral and binding on the promisor only. LEASE AS A MODE OF FINANCING 14. Sub-Lease If the leased asset is used differently by different users, the lessee cannot sub-lease the leased asset except with the express permission of the lessor. 1. the rental rate decided at the time of the agreement. 2. expenses under Ijarah are as follows: Lessor- expenses relating to the corpus of the asset i.e. insurance, accidental repairs etc. will be borne by the lessor Lessee- actual operating/overhead expenses related to running the asset will be borne by the lessee 3. two contracts into one contract is not permissible in Shariah therefore, we cannot have the agreement of hire and purchase into one agreement, only we can undertake/promise to purchase the leased asset Modern Forms of Leasing ◼ Financial Lease or Hire-Purchase ◼ Security or Financing Lease ◼ Operating Lease Potential of Ijara ◼ Ijara is conducive to the formation of fixed assets and medium and long-term investments. ◼ Payment of Ijara rental can be unrelated to the period of taking usufruct by the lessee. ◼ Ijara can be contracted on an existing asset or a building and even an asset that is yet to be constructed. ◼ The Ijara rate can be fixed or floating, providing a clear formula is mutually agreed with a floor and a cap. Risk Mitigation in the case of Ijara ◼ The bank has purchased the asset as per the undertaking by the customer, but the latter refuse to take the asset on lease. ◼ The customer may default in payment of the due rental. ◼ Asset risk of major maintenance/ destruction. ◼ Early termination of lease agreement. Risk Mitigation in the case of Ijara ◼ The lessee may use the assets carelessly, requiring the bank to bear major maintenance expenditure. ◼ Rate of return risk du to inflation. ◼ Sale of asset at maturity – the customer may not buy. Conventional Islamic Financing lease contain hirepurchase arrangements. The Ijara contract does not contain any condition. The lease remains subject to all Ijara rules; sale is not a part of it. Customer is responsible for all kinds of loss or damage. All risks pertaining to ownership are borne by the Islamic bank (the lessor). The insurance expense of the asset is borne by the lessee. Takaful at the expense of the lessor. Conventional Islamic If insurance company does not compensate the entire outstanding amount in the case of loss, the customer is liable to pay the balance. The lessor bears the risk of Takaful claim settlement. If the asset is lost are stolen lessee needs to pay rent until the settlement of the insurance claim. Rent is consideration for usage of the leased asset, and if the asset has been lost/stolen the concept of rental becomes void. The lessor is given an unrestricted power to terminate the lease unilaterally at his sole discretion. Ijara is binding contract and if there is no contravention on the part of the lessee, the lease cannot be terminated. Conventional Islamic Extra amount is charged if rent is No extra amount could be not paid. This amount is income charged. of lessor. On completion of the lease period asset are automatically transferred to the lessee. Customer is not obliged to buy these assets. He may purchase this asset through a formal sale deed if he considers it beneficial for him. Upfront payment has to be made in the form of down-payment, the first year’s insurance premium and other insurance, first month’s rental etc. Lessor normally take only a security deposit, which is refundable if the lease is not finalised. The bank has authority to recover only actual expenses not including the cost of funds. Ijara - Definition ◼ “Ijara is a contract of a known and proposed usufruct of a specified asset for a specified time period against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended.” [Zuhayli, 2003, pp. 386-387] ◼ “Ijara is the sale of usufruct (not of ‘Ain) of any commodity in exchange of Ujrah, wages or rent, and covers houses, shops, riding/work, animals, jewellery, clothes etc.” BASIC RULES OF LEASING ◼ Transferring of usufruct not ownership ◼ Subject of lease ◼ Consumable things cannot be leased out ◼ All Liabilities of ownership are borne by lessor ◼ Period of lease ◼ Lease for specific purpose only BASIC RULES OF LEASING ◼ Lessee as Ameen ◼ Lease of jointly owned property ◼ Determination of Rental Conventional Ijara ◼ Financial Lease – Hire Purchase ◼ Bank buy the asset either directly or through Lessee. ◼ Fix the rent. (How?) ◼ Long-term (75% of the assets useful life), non-cancellable rental agreement. ◼ ownership of the asset is transferred to the lessee at the end of the lease term; ◼ The lease commences on the day on which the price is paid by the bank ◼ The risk of ownership is borne by the lesse. Conventional Ijara ◼ Security or Financing Lease ◼ It involves a situation where a sale of goods is structured as a lease to avoid certain legal consequences, including the requirement to register a PPSA financing statement in some jurisdictions. ◼ It involves the effective transfer of all risks and rewards associated with the ownership to the lessee. ◼ Operating Lease ◼ Possession of the asset given to the lessee, ownership remains with the lessor, to have its use in return for rental. ◼ The lessor takes back equipment/asset when the lease ends. Ijara - Contemporary ◼ Ijarah Muntahia-bi-Tamleek ◼ Sale and Lease Back Arrangement ◼ Customer already owns an asset ◼ He sells the asset to the bank and then takes on rent for his use. ◼ Should only be used in exceptional circumstances. ◼ The sale agreement must be executed before entering into Ijara. ◼ Lease asset can be sold back to customer after a reasonable period. Case study ◼ Aristec Textiles in Leicester has requested and Ijarah facility for the following assets to Markfield Islamic Bank. (The client is willing to deposit 10% of the value of the Ijara asset as a security deposit/earnest money.) 1. 2. 3. 4. Company cars 20 £ 100K (L/C established) Trucks 20 £ 500k Dyeing plant £ 200K (already owned by client) Looms 50 £ 100K (operating for a year) Issues Which asset will the bank finance through a direct lease and which through sale and lease-back? What factors will it consider before allowing sale and lease-back transaction? 2. One year after leasing the looms for his factory, Aristec reports that 5 of the looms have broken and have to be repaired. The loss adjustor for the Takafol company, after inspection, reported that the looms broke down due to poor maintenance on the part of the client and will take a month to be repaired at a cost of £ 500 per loom. How should the bank calculate future rentals and the rental for the time when the looms are broken? 1. 3. The cars were leased for a tenure of five years and Aristec has used them to varying degree. Two years down the line Aristec requests the bank to sell him ten vehicles at a price of £ £ 4K each. Should the bank accept his offer and what consideration should determine the decision? The outstanding Ijarah investment is £ £3500 per car, and prepaid expenses, including Takafol outstanding are £ 200 per car. 5. In the same year, one of the car is destroyed in an accident. Police and loss adjustor reported that accident was not the fault of the client. The remaining outstanding is the same as given in previous question. The Takafol amount recovered by the bank is £ 4500 and the client deposited a security deposit £ 500. What amount is the bank legally bound under the Ijara agreement to give to the client? In view of the satisfactory payment behaviour, in what ways can the bank accommodate the client without burdening itself? Islamic Financial Instruments Learning Objectives ◼ Istijar ◼ Tawarruq ◼ Wakala Bai’ al-Istijar (Supply Contract) ◼ A repeat sale/purchase arrangement of normal sale in which a seller agrees to sell various amount/units of a commodity from time to time. ◼ Seller may deliver the commodity agreed upon once in a number of consignments and ◼ the price may be determined in advance, with every consignment or after the delivery Bai’ al-Istijar (Supply Contract) ◼ The terms and conditions of any normal cash or credit sale. ◼ An agreement between the buyer and supplier, whereby the supplier agrees to supply a particular product on an ongoing basis Wakalah (Agency) ◼ Literal meaning ◼ “Looking after” ◼ “Taking custody” ◼ “application of skills” ◼ “remedying on behalf of others” ◼ Tawkeel ◼ To appoint someone to take of charge of something. ◼ Delegate any job to any other person. Wakala ◼ What is Wakala? ◼ Wakala is a responsibility. ◼ Wakil must discharge his responsibility in the way a trustee discharge his responsibility in the case of Amanah. Types of Wakala ◼ Wakil-bil-Kusoomah (to take up various disputes/cases on behalf of the principal) ◼ Wakil-bil-Taqazi al Dayn (Receiving debts.) ◼ Wakil-bil-Qabza al Dayn (possession of debt) ◼ Wakil-bil-Bai’ (agency for trading) ◼ Wakil-bil-Shira (agency for purchase) Wakala - Conditions ◼ Subject matter of the Wakala or the act to be performed should be known. ◼ An act to be carried out by an agent should be one that admits representation. E.g. Sale and purchase, letting and hiring, borrowing and lending, assignment of debt, guarantee and pledges, taking and making payments etc. ◼ A Wakala contract may be specific or general. Wakala - Conditions ◼ The agent must perform according to the instructions of the principal. ◼ Agents will collect price and make payments on behalf of the principal. ◼ An action performed by the Wakil on behalf of the principal is deemed an action by the principal. ◼ A Wakala contract come to an end with mutual agreement, unilateral termination, discharging of an obligation, destruction of the subject mater death or loss of legal capacity. ◼ Wakaltul Istismar ◼ Funds management on behalf of investors ◼ Banks can get pre-agreed fee ◼ This fee can be fixed in a lump sum or as a monthly or annual remuneration in percentage of the amount of investment or the net value of the funds.. ◼ But fee must be agreed in advance. Tawarruq ◼ Hanbali and Shafi’s discussed it. ◼ To buy on credit and sell at spot value with the objective of getting cash. ◼ Transaction is not the need of the buyer. ◼ Shariah issues: ◼ Can sell to the third paty ◼ Cannot sell to the original seller ◼ Bai’Inah vs Tawaruq ◼ Qardal Hassan is more prefferable. Ju’alah ◼ A contract in which one party (the Ja’il) undertakes to give a specific reward (the Jua’l) to anyone who may be able to realise a specific or uncertain required reults. ◼ E.g. Finding a stolen car ◼ The determination of the end result of the transaction is considered to be sufficient to make it permissible. ◼ Jualah is useful tracsaction in events that cannot be accomplished through Ijarah. ◼ Parties of Juualah: ◼ Offeror ◼ Worker ◼ How Banks are using it? ◼ Collection of Debt ◼ Securing Permissible Financing Facility ◼ Brokerage