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Saturday, July 13, 2024

Leasing as a Financial Model in Islamic Finance

The term used in Islamic law for rent/leasing is Ijarah, which lexically means “to lend or lease something”. Ijarah has two forms and can refer to services and products. In the first case, it refers to the hiring of a person or company to perform certain services in return for the pre-agreed compensation. In the other hand, it refers to the use (usufruct) of assets or products, and not to services. Considering this, Ijarah refers to the transfer of the usufruct of a product or asset to another person or business entity in exchange for rent. Ijarah derives its legality in Islamic law primary sources. According to its purpose and form, Ijarah corresponds to the concept of leasing, which is a very widespread and used financing model in conventional banking. Similar to Murabaha (cost-plus trade), Ijarah is not originally a financing model like Musharaka or Mudaraba which are models based on partnership, but due to its profitability, applicability and tax benefits, it is used as a form of financing and investment in Islamic banking, especially in Western countries.

The concept of leasing is that instead of interest based loans in the form of money, profitable assets are leased in exchange for paying rent to the owner for as long as the lease period lasts. The amount of the rent is determined by adding the amount of interest that could have been earned in the case of a cash loan to the total value of the assets acquired and dividing that total amount by the duration of the lease. Rent is paid on a monthly basis. This is in the case of an operating lease where the equipment is eventually returned to the owner. In the case of financial leasing, where the loaned equipment eventually changes ownership, then the rent calculation can be similar to the interest loan calculation. Although they are almost identical in meaning, there is an important difference between conventional leasing and Ijarah. In the conventional concept, especially in financial leasing, all risks related to the property being leased are transferred to the lessee. In an Ijarah contract, any attempt to shift the risk entirely to the lessee undermines the Ijarah contract because there must be a risk sharing. The mentioned risk most often relate to credit risks, risks related to the amount of the margin that can be eaten up over time by losing the value of money, operational risks from equipment damage to complete destruction, liquidity risks and other risks related to this and similar models.

It is important to note that Islamic banks, especially those that operate within the framework of Western legislation, have developed the concept of Ijarah wa Iqtin, which refers to buying and selling with rent.

For example: a client to the bank with a request to buy an apartment for which he does not have enough funds. The price of the apartment is 100,000 EUR. The client is able to pay his participation in the amount of EUR 1000 (1%). The bank and the client jointly buy that apartment in the amount of EUR 100,000, with the bank paying EUR 99,000 and thus becoming the majority owner of that apartment (99%). The bank rents its 99% share of the apartment to the client for the duration of the rental period. The cost of buying an apartment, as well as the price of the rent, are included in the amount of the rent. The client and the bank enter into an apartment rental agreement for a period of 10 years. For that period, the client will pay the principal amount of EUR 99,000, plus the rent price according to the agreement. At the end of the tenth year of the lease, the client becomes the full owner of the apartment and the bank completely withdraws from the contract. This transaction is thus halal, and the client ended up with a property in his ownership. This concept can be called a combination of Musharaka (partnership) with Ijarah (leasing).

It is similar to the concept of financial leasing with the important note that the risk cannot be completely transferred to the lessee, but must be shared. Theoretically, it is not difficult to implement this model, while in practice there are a lot of issues, especially in the legal dimension.

IJARAH
IJARAH

In order for an Ijarah contract to be valid, it must meet several conditions:

  • The object of the lease must have usufruct, that is, the possibility of use. Anything that does not have a usufruct cannot be the subject of a lease. Also, the subject of the lease cannot be products that are consumed by consumption, such as: food, fuel, etc.;
  • The subject of the lease must remain the property of the lessor while the right of use is transferred to the lessee;
  • All obligations related to property ownership are borne by the lender, and all obligations related to use by the borrower;
  • The rental period must be clearly specified and the funds can only be used for the purpose agreed upon in the contract;
  • Rent or annuity must be determined in advance and valid for the entire rental period. It is allowed for the rent amount to be vary in different periods, but it is important that it is determined at the time of the lease agreement and cannot be changed after the agreement is signed.
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