Banking Features

Ijarah – Charting New Frontiers In Consumer Banking

The banking and finance sector is often pictured as ruthless, ruled by cold, hard contracts that show no sympathy for those facing troubled financial situations. The picture gets scarier as stories of auctioned properties, confiscated assets, bankruptcy and legal proceedings hover over the industry. The roles of creditors and debtors have always been scripted clearly by conventional financial institutions, where customers and financial institutions stand to bear certain risks respectively.

Unravelling the history of Islamic finance
In 1983, the cold, hard picture of banking and finance gradually took a turn for a warmer and more humanising temperature with the entry of Islamic banking. That year, the first Islamic financial institution (IFI) was established in Malaysia, offering Muslims an alternative to conventional banking. A decade later, the Islamic financial sector witnessed commercial banks, merchant banks and finance companies offer an attractive menu of Islamic banking products and services under the Islamic Banking Scheme (IBS).

The IBS offered a separate banking platform for Islamic transactions from conventional banking. In 1997, under the purview of Bank Negara Malaysia, the Syariah Advisory Council (SAC) was established – the highest Syariah authority for Islamic finance in Malaysia – to decide on the thread work of regulations and legislation in compliance to Syariah principles as well as the liberalisation of the financial sector by the government and the entry of foreign financial services providers. Between 2005 and 2006, Ijarah financing was introduced through the entry of foreign Islamic banks into Malaysia, namely, Kuwait  Finance House and Al-RajhiBank. Since then Islamic finance in Malaysia has painted a colourful picture with the entry of more players and the diversification of current players offering a wide range of Islamic banking products and services.

The dynamics of Islamic finance
The rise of Islamic finance has done wonders to meet the needs of Muslims around the world, who are seeking a pure form of financial control and stewardship, in line with their religious convictions and the precepts of Syariah.In the past, IFIs have been perceived to just provide a riba-free banking system – consumers failed to understand the basic concepts encapsulated by Islamic finance. Although Islamic finance is into the business of making money through lending activities, similar to conventional banking, it is generally asset-based or asset-backed with risks (and rewards) shared between the customer and the bank. This is especially evident in the structure of Musharakah and Mudharabah. Musharakah is the term used to define a joint enterprise or partnership with profit and loss sharing implications. The dynamics of Musharakah allows for each party involved in the business to share portions of profits and risks. On the other hand, Mudharabah is the concept where one party offers the funds whilst the other party provides the expertise needed to run the business. The one extending the funds stands to bear the loss in the event of a failed venture. In the consumer market, the most widely sought-after product is property financing which is offered through BaiBithamanAjil (BBA). BBA is the deferment of payment for a sales transaction whereby, an IFI purchases the asset for the customer at a cost price and sells it back to the customer at the same cost price plus a pre-determined profit margin (sale price). BBA is a two-party arrangement, which is based on the highly controversial baiinah structure – some Islamic scholars deem BBA to merely facilitate a financing transaction by buying and selling to the same party. In the current BBA practice, a customer who desires to purchase a property, pays a deposit first, after which, the rights of the property are transferred to the IFI. The customer is then required to pay the total sum comprising of the property price and the profit margin through instalments over several years. In a controversial turn of events involving a Malaysian banking Group and a customer several years ago, the perception of IFIs making more than conventional banks, due to the structural form of BBA financing, emerged, leading to BBA structures phased out.In that particular case, the sale price was fixed during the financing period.However, a Malaysian court decided that in the event of a default before the end of the financing period, the
customer is required to pay the total sale price, including unearned interests, burdening the customer more than a conventional loan. The court ruled that this was akin to a conventional loan. Unfortunately, the granting of ibra (rebate) for early settlement of default cases was not even considered or applied. This sent jitters down the spines of industry players who were exclusively using BBA for asset and property financing. As a result, BBA was quickly phased out in favour of BaiInah or Ijarah structures for the financing of property. Incidentally, the decision was overturned by a higher court stating that BBA was indeed a valid contract and had no resemblance to a conventional loan.

Gaining frontiers
The advent of foreign IFIs on Malaysian shores has resulted in a wide array of innovative and cutting-edge banking products and services. Today, the Islamic banking industry is abuzz with shining new ideas and the introduction of attractive financial structures in the form of Murabha(or Murabahah), Salam and Ijarah, aside from Musharakah and Mudharabah.

What is Ijarah?
For instance, in Malaysia,Ijarah was introduced to finance assets ranging from property to airplanes and ships. Essentially, under Syariah principles, Ijarah means “lease” – an operating lease to facilitate Islamic finance. Under this term, leasing of assets under specific terms and conditions are allowed, with the payment of rental over a pre-determined time period. Two commonly practiced Ijarah concepts in Malaysia include Ijarah Mausufah Fi Zimmah – a forward lease, and IjarahMuntahiah Bi Tamlik – an operating lease. The former is used for financing assets under construction, whilst the latter is used for completed assets. Similar to Murabha, Ijara is a debt-based financing whereby the bank is not a natural owner of the asset, instead it acquires ownership upon receiving a request from its customer. In Ijara, the rentals are paid in instalments over time to cover the cost of the asset including a fair return on investment. Risks associated with the asset remains with the bank, whilst ownership of the property also remains with the bank. The customer receives the benefits of using the asset. In Murabha, the benefits and risks of ownership of the asset are transferred to the customer along with the ownership. Both these products involve cash outflows for the customer and cash inflows for the bank. The liberal terms of Ijarah have made it an attractive facet of Islamic banking encompassing viable terms encapsulated in conservative principles. Thus far, Ijarah has received rave reviews and encouraging response across the world, and has been given the stamp of approval by the Account and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The wide use of Ijarah and other structures approved by AAOIFI in Malaysia, is indeed, a boon for syndicated products and Sukuk instruments, as participation will not be limited to only Malaysian IFIs. In regulating the concept of Ijarah, Bank Negara Malaysia has provided significant guidelines to ensure a certain degree of uniformity between IFIs and to protect customers, whilst making these financial structures more Syariah-compliant. Ultimately, these developments and the continuous improvements implemented are stepping stones to Malaysia’s aspirations to become a major Islamic banking hub in the region.

Why Ijara and not Murabha?
There are various reasons as to why customers may prefer Ijara over Murabha in an effort to purchase an asset. These reasons include the ease in leasing than borrowing where short-terms needs are concerned; the avoidance of different types of risks; ijara does not require credit evaluation processes; Ijarah offers flexibility in the age of technological advances and the ease in obtaining financing through leasing companies with credit standing, with reasonable interest rates. Aside from that, in many instances, leases can be advantages for taxation purposes, whereby the equipment leased remains under the ownership of the lessor leaving the lessor to pay the required taxes. In many countries, leasing is deemed as an of-balance-sheet financing, whereby the asset is kept on the lessor’s balance sheet and the lessee is only required to report on the rental expenses for the usage of the asset. Companies often utilise of-balance-sheet financing to maintain their debt to equity (D/E) and leverage ratios low, especially when the inclusion of a large expenditure is able to break negative debt covenants.

IjarahSukuk is based on the Ijarah concept of “sale and lease back” – a structure that is commonly used in the Middle East. In 2006, Bank Negara Malaysia (BNM) issued the first IjarahSukuk sized RM400 million, through a special purpose vehicle, BNM Sukuk Berhad. The proceeds from the issuance is purposed for the purchase of assets for BNM, which is then leased to BNM for rental payment consideration. The proceeds of this is distributed to investors as a return on a semi-annual basis. Upon the maturity of the IjarahSukuk, which coincides with the end of the lease tenure, BNM Sukuk Berhad then sells the assets back to BNM at a pre-determined price. BNM issues this instrument on a regular basis with subsequent issues ranging from RM100 million to RM200 million.

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