Case Studies in Islamic Banking and Finance E-Book

Brian Kettell

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 282

Veröffentlichungsjahr: 2011

Beschreibung

Case Studies in Islamic Banking and Finance is a pioneering resource that provides practical insights into the real world of Islamic financial transactions, and illustrates the complexities of this rapidly growing mode of modern finance.

Based around 12 individual cases, the book stimulates discussion and develops the reader's understanding of Islamic finance by contrasting the theoretical concepts discussed in the author's companion text Introduction to Islamic Banking and Finance with practical real world situations. The cases cover core Islamic banking and finance topics including the Ijara, Mudaraba and Musharaka contracts; Islamic mortgages for home finance; leverage; and issues involved in opening an Islamic bank. Financial statement analysis for Islamic banks, the implications for fund management for equity investing and the impact of loan defaults on Islamic and conventional banks are also included. Each chapter concludes with a set of questions designed to test the reader's understanding of each case, with suggested solutions at the end of the book.

This book is a must have resource for those wishing to apply their understanding of this complex subject and is an essential read for anyone seeking practical examples of how to apply the concepts in a real world environment.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Preface

WHAT IS A CASE STUDY?

THE CASE METHOD AS A LEARNING TOOL

HOW TO DO A CASE STUDY

Introduction

WHAT ARE THE PRINCIPLES OF ISLAMIC BANKING AND FINANCE?

About the Author

Chapter 1: Case Study 1: Ijara Contract

1.1 LEARNING OUTCOMES

1.2 ROLE OF IJARA IN ISLAMIC FINANCE

1.3 THE IJARA CONTRACT AS A MODE OF ISLAMIC FINANCE

1.4 APPENDIX: IJARA FATWA

1.5 CASE STUDY QUESTIONS

Chapter 2: Case Study 2: Musharaka Contract

2.1 LEARNING OUTCOMES

2.2 ROLE OF MUSHARAKA IN ISLAMIC FINANCE

2.3 SUMMARY OF MUSHARAKA

2.4 SHARIA’A RULES FOR PROFIT AND LOSS WITH MUSHARAKA

2.5 MANAGEMENT OF MUSHARAKA

2.6 SHARIA'A RULES FOR MUSHARAKA

2.7 CASE 1

2.8 CASE 2

Chapter 3: Case Study 3: Diminishing Musharaka Contract

3.1 LEARNING OUTCOMES

3.2 DIMINISHING MUSHARAKA AS A MODE OF ISLAMIC FINANCE

3.3 SUMMARY OF DIMINISHING MUSHARAKA

3.4 SHARIA’A RULES FOR A DIMINISHING MUSHARAKA CONTRACT

3.5 WHAT IS THE DIFFERENCE BETWEEN IJARA WA IQTINA AND DIMINISHING MUSHARAKA?

3.6 APPLICATIONS OF DIMINISHING MUSHARAKA

3.7 CASE ASSUMPTIONS

3.8 SHARIA’A CONSIDERATIONS TO BE NOTED

3.9 PRACTICAL SHAPE OF THE TRANSACTION

3.10 CASE STUDY QUESTIONS

Chapter 4: Case Study 4: Mudaraba Contract

4.1 LEARNING OUTCOMES

4.2 MUDARABA AS A MODE OF ISLAMIC FINANCE

4.3 MUDARABA AND PLS – PURE ISLAMIC BANKING

4.4 CASE 1: SHARIA’A ISLAMIC BANK

4.5 MUDARABA CONTRACT WITH VARIOUS PARTNERS

Chapter 5: Case Study 5: Murabaha, Musharaka, Ijara and Ijara wa Iqtina Contracts

5.1 LEARNING OUTCOMES

5.2 CASE 1: MURABAHA CONTRACT

5.3 CASE 2: MUSHARAKA CONTRACT

5.4 CASE 3: IJARA: OPERATING LEASE CONTRACT

5.5 CASE 4: IJARA WA IQTINA: FINANCE LEASE CONTRACT

5.6 CASE 5: MUDARABA WITH MURABAHA CONTRACTS

Chapter 6: Case Study 6: Islamic Home Finance

6.1 LEARNING OUTCOMES

6.2 SHARIA’A-COMPLIANT MORTGAGES

6.3 SHARIA’A-COMPLIANT STRUCTURES FOR ISLAMIC HOME FINANCE

6.4 APPENDIX 1: MANZIL HOME PURCHASE PLANS (MURABAHA)

6.5 APPENDIX 2: DEVON BANK

6.6 APPENDIX 3: MANZIL HOME PURCHASE PLANS (IJARA)

6.7 APPENDIX 4: DEVON BANK

6.8 APPENDIX 5: MEEZAN ‘EASY HOME’ DIMINISHING MUSHARAKA AGREEMENT

6.9 CASE STUDY QUESTIONS

Chapter 7: Case Study 7: Sources of Finance for Islamic Banks

7.1 LEARNING OUTCOMES

7.2 WHERE DO ISLAMIC BANKS GET THEIR MONEY FROM?

7.3 SOURCES OF FUNDS FOR ISLAMIC BANKS

7.4 CASE STUDY QUESTIONS

Chapter 8: Case Study 8: Financial Statement Analysis for Islamic Banks

8.1 LEARNING OUTCOMES

8.2 HOW DO THE FINANCIAL STATEMENTS OF ISLAMIC BANKS DIFFER FROM THOSE OF CONVENTIONAL BANKS?

8.3 CASE STUDY ACTIVITIES

8.4 CASE STUDY QUESTIONS

Chapter 9: Case Study 9: Islamic Investment Prohibitions

9.1 LEARNING OUTCOMES

9.2 MUSLIMS HAVE STRICT RULES ABOUT WHAT THEY ARE ALLOWED TO INVEST IN

9.3 ISLAMIC INVESTMENT PROHIBITIONS

9.4 THE PROHIBITION OF INTEREST (RIBA)

9.5 ZAKAT AND ISLAMIC PROHIBITIONS

9.6 CASE STUDY QUESTIONS

Chapter 10: Case Study 10: Opening an Islamic Bank Within a Western Regulatory Framework

10.1 LEARNING OUTCOMES

10.2 FIRST ISLAMIC BANK IN THE EUROPEAN UNION

10.3 ISSUES IN CREATING AN ISLAMIC BANK WITHIN A WESTERN REGULATORY FRAMEWORK

10.4 CASE STUDY QUESTIONS

Chapter 11: Case Study 11: Leverage and Islamic Banking

11.1 LEARNING OUTCOMES

11.2 LEVERAGE AND ISLAMIC BANKING

11.3 WHAT IS FINANCIAL LEVERAGE?

11.4 FINANCIAL TERMINOLOGY: A GUIDE

11.5 CASE STUDY ASSUMPTIONS

11.6 CASE STUDY QUESTIONS

Chapter 12: Case Study 12: Impact of Non-performing Loans on Islamic and Conventional Banks

12.1 LEARNING OUTCOMES

12.2 ISLAMIC BANKING PRINCIPLES INVOLVE RISK SHARING, WHICH SHOULD MAKE THEM LESS VULNERABLE THAN THEIR CONVENTIONAL COUNTERPARTS

12.3 EQUITY-BASED VERSUS DEBT-BASED BANKING

12.4 CASE STUDY ASSUMPTIONS

12.5 CASE STUDY QUESTIONS

Case Study Answers

CASE STUDY 1: IJARA CONTRACT

CASE STUDY 2: MUSHARAKA CONTRACT

CASE STUDY 3: DIMINISHING MUSHARAKA CONTRACT

CASE STUDY 4: MUDARABA CONTRACT

CASE STUDY 5: MURABAHA, MUDARABA, IJARA AND IJARA WA IQTINA

CASE STUDY 6: ISLAMIC HOME FINANCE

CASE STUDY 7: SOURCES OF FINANCE FOR ISLAMIC BANKS

CASE STUDY 8: FINANCIAL STATEMENT ANALYSIS FOR ISLAMIC BANKS

CASE STUDY 9: ISLAMIC INVESTMENT PROHIBITIONS

CASE STUDY 10: OPENING AN ISLAMIC BANK WITHIN A WESTERN REGULATORY FRAMEWORK

CASE STUDY 11: LEVERAGE AND ISLAMIC BANKING

CASE STUDY 12: IMPACT OF NON-PERFORMING LOANS ON ISLAMIC AND CONVENTIONAL BANKS

Glossary

Bibliography

BOOKS

AAOIFI PUBLICATIONS

ARTICLES AND PAPERS

ALSO PUBLISHED BY THE AUTHOR

Index

For other titles in the Wiley Finance series please see www.wiley.com/finance

This edition first published in 2011 © 2011 Brian Kettell

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ISBN 978-0-470-97801-6 (paperback) ISBN 978-1-119-99056-7 (ebook) ISBN 978-1-119-99057-4 (ebook) ISBN 978-1-119-99128-1 (ebook)

A catalogue record for this book is available from the British Library.

To my wife Nadia, our son Alexei and daughter Anna. Nadia keeps the whole fleet on an even keel with only the occasional shipwreck.

Preface

The Islamic finance industry is in the midst of a phenomenal expansionary phase, exhibiting average annual growth rates of about 15 per cent in recent years. This rapid growth has been fuelled not only by surging demand for Sharia'a compliant products from financiers from the Middle East and other Muslim countries, but also by investors around the world, thus rendering the expansion of Islamic finance a global phenomenon. Besides its wide geographical scope, the rapid expansion of Islamic finance is also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments.

Educational and training material for the Islamic banking and finance industry is, however, lagging far behind the speed at which the industry is evolving. Indeed the lack of quality educational and training material has now become a serious obstacle to effective training and education. This book, the first ever case study book on Islamic banking and finance, is designed to enable students and practitioners to test their understanding of the underlying principles. Emphasis is placed on case studies and tests of the basic concepts. Suggested answers are provided.

The case study method was pioneered at Harvard Law School. A case study is expected to capture the complexity of a single case, and the methodology which enables this has developed within the social sciences. Such methodology is applied not only in the social sciences, such as psychology, sociology, anthropology, and economics, but also in practice-oriented fields such as environmental studies, social work, education, and business studies but has, until now, not been available to the Islamic finance industry.

WHAT IS A CASE STUDY?

A case study is a description of an actual business situation involving a decision to be made or a problem to be solved. It can be a real situation that actually happened just as described or where portions have been disguised for reasons of privacy. Most case studies are written in such a way that the reader takes the place of the manager whose responsibility is to make decisions to help solve the problem. In almost all case studies, a decision must be made, although that decision might be to leave the situation as it is and do nothing.

A case study is a research methodology common in social science. It is based on an in-depth investigation of a single individual, group, or event. Case studies may be descriptive or explanatory. The latter type is used to explore causation in order to find underlying principles. Rather than using samples and following a rigid protocol (strict set of rules) to examine a limited number of variables, case study methods involve an in-depth, longitudinal (over a long period of time) examination of a single instance or event: a case. They provide a systematic way of looking at events, collecting data, analysing information, and reporting the results. As a result the researcher may gain a sharpened understanding of why the instance happened as it did, and what might become important to look at more extensively in future research. Case studies lend themselves to both generating and testing hypotheses.

THE CASE METHOD AS A LEARNING TOOL

The case method of analysis is a learning tool in which students and Instructors participate in direct discussion of case studies, as opposed to the lecture method, where the Instructor speaks and students listen and take notes. In the case method, students teach themselves, with the Instructor being an active guide, rather than just a talking head delivering content. The focus is on students learning through their joint, co-operative effort.

Assigned cases are first prepared by students, and this preparation forms the basis for class discussion under the direction of the Instructor. Students learn, often unconsciously, how to evaluate a problem, how to make decisions, and how to orally argue a point of view. Using this method, they also learn how to think in terms of the problems faced. In courses that use the case method extensively, a significant part of the student's evaluation may rest with classroom participation in case discussions, with another substantial portion resting on written case analyses. For these reasons, using the case method tends to be very intensive for both students and Instructor.

HOW TO DO A CASE STUDY

While there is no one definitive “Case Method” or approach, there are common steps that most approaches recommend are followed in tackling a case study. It is inevitable that different Instructors will do things differently; this is part of life and will also be part of working for others. This variety is beneficial since it will show participants different ways of approaching decision making.

Instructors seeking to apply the case study methodology should follow an organised format as discussed below.

Beforehand (usually a week before), the participants get:

1. the case study,

2. (often) some guiding questions that will need to be answered, and

3. (sometimes) some reading assignments that have some relevance to the case subject.

Participants then work in completing the case and the procedure can be divided up into three components:

1. what participants need to do to prepare before the class discussion,

2. what takes place in the class discussion of the case, and

3. anything required after the class discussion has taken place.

For maximum effectiveness, it is essential that the instructor manages all three components.

It must be stressed that the newness of the industry means that designing quality educational and training material is fraught with problems, particularly with case studies. In addition to this newness the industry also faces the challenge of changing Sharia'a interpretations of many of the products. In addition the existence of different schools of Islamic jurisprudence (Fiqh) combined with controversies revolving around sukuk (Islamic bonds) has certainly created some uncertainties as to how the contracts are being applied. Recent high profile court cases have also created uncertainties about the applications of some of the contracts.

These factors lead to the potential for controversy over some of my suggested case answers. No doubt some of the answers will be disputed. I cannot claim to have universal answers and would ask that readers please assume that these may change over time.

If readers do feel strongly that they have an alternative case answer I would certainly welcome a dialogue. Indeed if anyone wishes to provide me with reasons for their proposed alternative solutions I would urge them to please do so. It is this dialogue which is so important for the health and future of the industry and I look forward to an active debate with the readers. My email is [email protected]

No answers to Case Studies 8 and 10 are provided. In one case it involves an Excel spreadsheet which should be simple to set up and the second case has the answers within the case itself.

Companion texts, Introduction to Islamic Banking and Finance and The Islamic Banking and Finance Workbook are available from the publishers.

Introduction

WHAT ARE THE PRINCIPLES OF ISLAMIC BANKING AND FINANCE?

Islamic financial institutions are those that are based, in their objectives and operations, on Qur'anic principles. They are thus set apart from ‘conventional’ institutions, which have no such religious preoccupations. Islamic banks provide commercial services that comply with the religious injunctions of Islam. Crucially, these banks provide services to their customers free from interest, (the Arabic term for which is riba), and the giving and taking of interest is prohibited in all transactions. This prohibition makes an Islamic banking system differ fundamentally from a conventional banking system.

Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. In earlier, historical times there was a fierce debate as to whether the term riba relates to interest or usury, although there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.

In Islamic law (the Sharia'a), riba means an addition, however slight, over and above the principal. According to the Federal Sharia'a Court of Pakistan the concept covers both usury and interest; is not restricted to doubled and redoubled interest; applies to all forms of interest, whether large or small, simple or compound, doubled or redoubled; and the Islamic injunction is not only against exorbitant or excessive interest, but also against even a minimal rate of interest. Financial systems based on Islamic tenets are therefore dedicated to the elimination of the payment and receipt of interest in all forms, and this taboo makes Islamic banks and other financial institutions different in principle from their conventional counterparts.

There is a range of modern interpretations of why riba is considered haram (forbidden) but these are strictly secondary to the religious underpinnings.

The fundamental sources of Islam are the Holy Qur'an and the Sunnah, a term that in Ancient Arabia meant ‘ancestral precedent’ or the ‘custom of the tribe’, but which is now synonymous with the teachings and traditions of the Prophet Mohammed as transmitted by the relaters of authentic tradition. Both of these sources treat interest as an act of exploitation and injustice and as such it is inconsistent with Islamic notions of fairness and property rights. Although it is often claimed that there is more than this to Islamic banking, such as its contribution towards economic development and a more equitable distribution of income and wealth, its increased equity participation in the economy and so on, Islamic banking nevertheless derives its specific raison d'être from the fact that there is no place for the institution of interest in the Islamic order.

This rejection of interest poses the central question of what replaces the interest rate mechanism in an Islamic framework. Financial intermediation is at the heart of modern financial systems. If the paying and receiving of interest is prohibited, how do Islamic banks operate? Here profit and loss sharing (PLS) comes in as a substitute for interest as a method of resource allocation and financial intermediation.

In fact, the basic idea of Islamic banking can be stated simply. The operations of Islamic financial institutions primarily are based on a PLS principle. An Islamic bank does not charge interest but rather participates in the yield resulting from the use of funds. The depositors also share in the profits of the bank according to a predetermined ratio. There is thus a partnership between the Islamic bank and its depositors, on one side, and between the bank and its investment clients, on the other side, as a manager of depositors' resources in productive uses.

This is in contrast with a conventional bank, which mainly borrows funds, paying interest on one side of the balance sheet, and lends funds, charging interest on the other. The complexity of Islamic banking comes from the variety (and nomenclature) of the instruments employed, and in understanding the underpinnings of Islamic law.

Six key principles drive the activities of Islamic banks:

the prohibition of predetermined loan repayments as interest (riba);risk sharing is at the heart of the Islamic system;making money out of money is unacceptable -- all financial transactions must be asset-backed;prohibition of speculative behaviour;only Sharia'a approved contracts are acceptable;the sanctity of contracts.

The principles as applied to Islamic banking and finance are set out below in the following sections.

Predetermined Payments are Prohibited

Any predetermined payment over and above the actual amount of principal is prohibited. Islam allows only one kind of loan and that is qard al hassan (literally ‘good loan’), whereby the lender does not charge any interest or additional amount over the money lent.

Traditional Muslim Jurists have construed this principle so strictly that, according to one Islamic scholar, ‘the prohibition applies to any advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower's mule, eating at his table or even taking advantage of the shade of his wall’. The principle derived from the quotation emphasises that any associated or indirect benefits that could potentially accrue to the lender are also prohibited.

Profit and Loss Sharing

The principle here is that the lender must share in the profits or losses arising out of the enterprise for which the money was lent. Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are manufacturing industries, service sector companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures.

This is unlike the interest-based conventional banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

The principle, which thereby emerges, is that in order to try and ensure investments are made into productive enterprises Islam encourages these types of investments in order that the community may ultimately benefit. However, Islam is not willing to allow a loophole to exist for those who do not wish to invest and take risks, but are instead intent on hoarding money or depositing money in a bank in return for receiving interest (riba) on these funds for no risk (other than the bank becoming insolvent).

Accordingly, under Islam, either people invest with risk or suffer loss by keeping their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective here is that high-risk investments provide a stimulus to the economy and encourage entrepreneurs to maximise their efforts to make them succeed.

Risk Sharing

As mentioned one of the most important feature of Islamic banking is that it promotes risk sharing between the providers of funds (investors) and the user of funds (entrepreneur). By contrast, under conventional banking, the investor is assured of a predetermined rate of interest. Since the nature of this world is uncertain, the results of any project are not known with certainty ex ante, and so there is always some risk involved.

In conventional banking, all this risk is borne by the entrepreneur. Whether the project succeeds and produces a profit or fails and produces a loss, the owner of capital is still rewarded with a predetermined return. In Islam, this kind of unjust distribution is not allowed. In Islamic banking both the investor and the entrepreneur share the results of the project in an equitable way. In the case of profit, both share this in pre-agreed proportions. In the case of loss, all financial loss is borne by the capital supplier with the entrepreneur being penalised by receiving no return (wages or salary) for his endeavours.

Emphasis on Productivity as Compared to Credit-worthiness

Under conventional banking, almost all that matters to a bank is that its loan and the interest thereon are paid on time. Therefore, in granting loans, the dominant consideration is the credit-worthiness of the borrower. Under PLS banking, the bank will receive a return only if the project succeeds and produces a profit. Therefore, it is reasoned, an Islamic bank will be more concerned with the soundness of the project and the business acumen and managerial competence of the entrepreneur.

Making Money out of Money is not Acceptable

Making money from money is not Islamically acceptable. Money, in Islam, is only a medium of exchange, a way of defining the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via fixed interest payments, simply by being put in a bank or lent to someone else.

The human effort, initiative and risk involved in a productive venture are more important than the money used to finance it. Muslim Jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital; as such, it is not entitled to any return (i.e., interest).

Muslims are encouraged to spend and/or invest in productive investments and are discouraged from keeping money idle. Hoarding money is regarded as being Islamically unacceptable. In Islam, money represents purchasing power, which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

Uncertainty is Prohibited

Gharar (uncertainty, risk or speculation) is also prohibited, and so any financial transaction entered into should be free from these aspects.

Contracting parties should have perfect knowledge of the counter values (goods received and/or prices paid) intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of ‘uncertain gains’, which on a strict interpretation does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions, given that forward rates are determined by interest rate differentials.

Only Sharia'a-approved Contracts are Acceptable

Conventional banking is secular in its orientation. In contrast, in the Islamic system, all economic agents have to work within the moral value system of Islam. Islamic banks are no exception. As such, they cannot finance any project that conflicts with the moral value system of Islam. For example, Islamic banks are not allowed to finance a distillery, a casino, a night club or any other activity prohibited by Islam or known to be harmful to society.

Sanctity of Contracts

Many verses in the Holy Qur'an encourage trade and commerce, and the attitude of Islam is that there should be no impediment to honest and legitimate trade and business, in order that people earn a living, support their families and give charity to those less fortunate.

Just as Islam regulates and influences all other spheres of life, so it also governs the conduct of business and commerce. Muslims have a moral obligation to conduct their business activities in accordance with the requirements of their religion. They should be fair, honest and just towards others. A special obligation exists upon vendors because there is no doctrine of caveat emptor in Islam. Monopolies and price-fixing are prohibited.

The basic principles of the law are laid down in the four root transactions of (1) sales (bay), transfer of the ownership or corpus of property for a consideration; (2) hire (Ijara), transfer of the usufruct (right to use) of property for a consideration; (3) gift (hiba), gratuitous transfer of the corpus of property; and (4) loan (ariyah), gratuitous transfer of the usufruct of property.

These basic principles are then applied to the various specific transactions of, for example, pledge, deposit, guarantee, agency, assignment, land tenancy, waqf foundations (religious or charitable bodies) and partnerships.

Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard, potentially major problems for Islamic banks.

About the Author

Brian Kettell has a wealth of practical experience in the area of Islamic banking and finance. He worked for several years as an Advisor for the Central Bank of Bahrain where he had numerous Islamic banking responsibilities.

Subsequently, Brian taught courses on Islamic banking and finance at a range of financial institutions including the World Bank, National Commercial Bank (Saudi Arabia), Global Investment House (Kuwait), Noor Islamic Bank (UAE), the UK Treasury, the Central Bank of Iran, the Central Bank of Syria, the Chartered Institute for Securities and Investment, the Institute for Financial Services and Scotland Yard.

Brian's vast academic expertise in Islamic finance is highlighted by his role as former Joint Editor of the Islamic Finance Qualification Handbook and his past teaching work at a number of top universities worldwide including the London School of Economics, the City University of Hong Kong, the American University of the Middle East in Kuwait and London Metropolitan University Business School.

Brian's impressive list of publications include over 100 articles in journals, business magazines and the financial press including Islamic Business and Finance, Islamic Banking and Finance, the Central Banking Journal, Euromoney, the Securities Journal and the International Currency Review. He has also published 16 books on Islamic banking and financial markets.

1

Case Study 1: Ijara Contract

1.1 LEARNING OUTCOMES

After working through Case Study 1 you should be able to do the following:

Define the Ijara contract.Define the Ijara wa Iqtina contract.Distinguish a conventional loan from Ijara.Describe the elements of an Ijara transaction.Contrast Ijara with the other modes of Islamic finance.Identify the reasoning behind the Sharia’a rulings on Ijara.Describe the different forms of Ijara.Explain the practicalities of implementing Ijara.Identify the Arabic terminology used in Ijara.Describe the Sharia’a rulings on Ijara.Contrast conventional leasing with Islamic leasing.Explain the role that interest can play within an Ijara transaction.Identify problems associated with applying Ijara.Explain the importance of deferred sales within Islamic finance.Contrast the role of penalty defaults within conventional and Islamic finance.Explain how Ijara can be used for home finance.Define LIBOR and explain its application with an Ijara contract.Identify the deferred sale versus profit and loss share contracts.Test that you have fully understood the principles that underlie the Ijara contract.

1.2 ROLE OF IJARA IN ISLAMIC FINANCE

Those who take riba (usury or interest) will not stand but as stands the one whom the demon has driven crazy by his touch.

Qur'an Sura 2: 275–280

Case Abstract

Ijara is an Arabic term, with origins in Islamic Fiqh, meaning to give something to rent. Leasing is a contract whereby usufruct rights to an asset are transferred by the owner, known as the lessor, to another person, known as the lessee, at an agreed-upon price, called the rent, and for an agreed-upon period of time, called the term of the lease. This case study describes the rationale and application of the Ijara financing technique. The example provided is that of car finance but it could have equally will have been applied to any physical capital asset used in business.

1.3 THE IJARA CONTRACT AS A MODE OF ISLAMIC FINANCE

1.3.1 What is The Ijara Contract?

Ijara is an Islamic mode of finance adopted by Islamic banks. Ijara (leasing) is a medium to long-term method of financing capital equipment or property. Under this contract, the customer selects the capital equipment or property (assets) to be financed by the bank and the bank then purchases these assets from the manufacturer or supplier and then leases them to the customer for an agreed period.

In conformity with the Sharia’a, the owner of the assets (in this case the bank) must be paid rent (fixed or variable, as agreed by the lessor and lessee) and must exercise all the rights and obligations that are incidental to ownership such as maintaining, insuring and repairing the assets.

The lessee, on the other hand, obtains the use of the asset for the period of the lease subject to paying the rent. The lessee may assume the obligations, such as maintaining, insuring and repairing the asset, in return for a reduced rent.

1.3.2 What is Car Ijara?

As mentioned above Ijara is basically the transfer of usufruct (defined below) of a fixed asset to another person for an agreed period, for an agreed consideration. Under a Car Ijara agreement the car will be rented to the customer for the period agreed at the time of contract. Upon completion of the lease period the customer in the Meezan case discussed below, gets ownership of the car against his initial security deposit.

Car Ijara is a Sharia’a-compliant car-leasing scheme. It is based on the principles of Ijara and is completely free from the element of interest. This product is designed for interest-averse individuals, looking for a car-financing scheme that helps in avoiding interest-based transactions. So Car Ijara is simply a rental agreement under which the car will be given to the customer in exchange for rent for a period, agreed at the time of the contract.

Meezan Bank, based in Pakistan and a pioneer in this area, purchases the car and rents it out to the customer for a period of three, four or five years. Upon completion of the lease period the customer gets ownership of the car against his initial security deposit.

Somewhat confusingly, the Meezan Car Ijara scheme has elements of Ijara wa Iqtina within it. In this case study I propose to follow the Meezan assumption in using Ijara in the sense that it involves car ownership at the end of the maturity of the deal. This is in line with Sharia’a methodology and terminology.

1.3.2.1 What is Usufruct?

Usufruct is the right of enjoying a thing, the property of which is vested in another, and to draw from the same all the profit, utility and advantage that it may produce, provided it be without altering the substance of the thing. Items without usufruct cannot be leased. It is necessary for a valid lease contract that the corpus of the leased asset remains in the ownership of the seller, and only its usufruct is transferred to the lessee.

1.3.3 In what Sense is Car Ijara Interest Free?

In Car Ijara, the asset remains under the ownership and at the risk of the bank and the customer only pays the rental for the use of the asset, just like the rent of a house.

Under leasing or lease purchase, the Islamic financial institution buys the financed asset and retains the title through the life of the contract. The customer makes a series of lease payments over a specified period of time, and may have the option at the end to buy the item from the lessor (and owner) at a pre specified residual value.

Leasing was not originally a mode of financing. It was simply a transaction meant to transfer the usufruct of a property from one person to another for an agreed period and an agreed upon consideration. Leasing can be used as a mode of financing, in Islamic banks, as an alternative to conventional car financing. However, the consideration of leasing as a mode of financing should be based on certain conditions. It should be understood, by all using it as a mode of financing, that it is not sufficient to substitute the term ‘interest’ with the term ‘rent’, and use the term ‘mortgage’ instead of the term ‘leased asset’. There must be a significant difference between leasing and an interest-bearing loan.