Ijarah is a term of Islamic fiqh. Basically the term Ijarah means to give something on rent, and is used in two instances, as follows:
(i) To employ the service (‘amal) of a person on wages given to him as a consideration for his hired service. This is called Ijarah al-a’mal (employment).
(ii) To transfer the usufruct (manfa’ah) of a particular property to another person in exchange for a rent payable to the owner of the property. This is called Ijarah al-manafi’ (leasing).
In Islamic finance generally, Ijarah refers to leasing.
Types of Ijarah
Ijarah or leasing can be divided into operating and financial. Operating Ijarah is a lease agreement that does NOT include a promise that the legal title of the leased asset will pass to the lessee at the conclusion of the lease. Financial Ijarah is a lease that concludes with the legal title of the leased asset being transferred to the lessee at the end of the lease.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) refers to a financial lease as Ijarah Muntahia Bittammleek and recognizes four ways to transfer the legal title: (1) as a gift; (2) for a token consideration; (3) for a price equivalent to the remaining Ijarah instalments; and (4) through the gradual transfer of legal title of the leased asset.
Ijarah practices in Malaysia
Ijarah is widely practiced by Islamic banks in Malaysia. The two most common products to adopt the Ijarah concept in their implementation are Islamic hire purchase (HP-i) and Sukuk Ijarah. HP-i is primarily used to finance motor vehicle purchases and Sukuk Ijarah is a type of Islamic bond used to raise funds in the capital market.
Hire purchase-i, also known as Ijarah Thumma Bai, comes under the purview of the Hire Purchase Act 1967. According to Bank Negara Malysia, “the Ijarah principle in Ijarah Thumma Bai underlines that the finance company as the rightful owner of the asset will bear a reasonable risk.” But in practice, Islamic banks have successfully reduced the “reasonable risk” to the risk of non-payment only. In this respect, the risk borne by the Islamic banks in HP-i is no different from that of conventional financiers. While this can be hailed as a superb risk management feat by Islamic banks (but truly, all praises go the regulator who specified such practices!), the current inequities do not bode well for Islamic finance. Lest we forget, Islamic finance is about establishing a just financial system.
Sukuk Ijarah case study – ABS Logistic
To illustrate the practice of Sukuk Ijarah, we shall look at the RM300 million (US$86.55 million) 10-year issue by ABS Logistic (ABS) completed in May this year.
According to ABS termsheet: “the role of the subscribers will be to subscribe or procure subscription, on a best effort basis, for 100% of the Sukuk to be issued. The issue of the Sukuk is conditional upon 100% of the Sukuk being fully subscribed. Once the yield to maturity and final issue size is finalized, Deutsche Bank (Malaysia) and HLIB will inform the Securities Commission prior to the issuance of the Sukuk.”
The practice of Sukuk Ijarah is almost identical to asset-backed securitization. The differences lie in the details. For example, each Sukuk (trust certificate) represents an undivided beneficial ownership in the assets, and not simply to evidence indebtedness. Additionally, the sale of the assets to the SPV is structured as a “true sale,” meaning there is no buy-back agreement with any of the parties.
Apart from issuing Sukuk, ABS will also collect rental from the lessee for periodic distribution to the Sukuk holders. At the maturity of all Sukuk issued, which coincides with the end of the lease period, the lessee has the option but not the obligation (call option) to purchase the leased assets. If the call option is not exercised, the trustee for the Sukuk holders will initiate proceedings to sell the assets to third parties.
The interests of Sukuk holders in this case are represented by Pacific Trustees, an independent trustee, to ensure that ABS performs and discharges its duties and obligations under the Sukuk scheme.
The proceeds from the asset sale will be used to redeem the Sukuk and each Sukuk holder will get back their initial investment, thus completing the investment cycle.
Conclusion
Despite the far-from-perfect state of HP-i currently, the successful application of the classical Ijarah al-manafi’ concept to the Sukuk Ijarah scheme is an innovation that Islamic finance proponents can be proud of.