From today I will begin my explanation of the documentation for an Ijarah transaction in the context of an Islamic bank. However, in order to appreciate the full set of Ijarah documentation obtained by an Islamic bank from customers, it will be important to first distinguish various applications of the Ijarah contract in contemporary Islamic banking.
The Ijarah structure is used by Islamic banks in a wider perspective which includes retail banking, wholesale banking, capital markets and asset management. As I had mentioned in an earlier article, although the Ijarah was perfected in 7th century AD, its effectiveness was meant to be realized in full during our time.
On the retail banking side, an Ijarah contract plays an important role in financing individuals’ need to acquire residential premises. This is the Islamic alternate to a conventional mortgage facility. Let me explain how Islamic home financing based on an Ijarah contract is different from a conventional mortgage facility.
When a retail customer approaches a conventional bank with a request to grant him or her the home mortgage facility, after the successful completion of the customary requirements, the conventional bank grants an interest-bearing term loan facility equal to the funding needs of the customer.
Here, the bank does not purchase the property but disburses the loan to the customer and the funds are credited to the customer’s current or savings account. The bank commences the charging of the agreed rate of interest on the disbursed amount from that day onwards.
In order to prevent the customer from misusing the loan proceeds, the bank simultaneously debits the customer’s account and makes a manager’s crossed cheque in favor of the property seller based on the pre-arranged formalities. Upon the receipt of the bank’s cheque at the land registry department, the seller facilitates the transfer of the property title in the customer’s personal name on the completion of the sale and purchase transaction of the property.
In some countries, the pre-printed sale and purchase contract prescribed by the land registry department is adopted in order to streamline the process. Where such a template is not available, the market standard documents are used which are attested by the land registry department along with the issuances of a new title deed in the buyer’s name.
Again, as per the formalities completed beforehand, the conventional bank obtains a mortgage over the property in favor of the bank as security for the term loan.
In a nutshell, in this example the conventional bank is simply lending an interest-bearing loan to the customer, similar to any other loans such as personal loans, car loans or credit cards. The registered mortgage in favor of the bank is something over and above the lending and borrowing transaction and is not the core transaction between the customer and the bank.
The customer will continue to pay the periodical installments along with interest to the conventional bank until such time that the entire outstanding is squared up. In case the customer fails to pay any installments, the bank will apply an additional layer of interest as the penalty for default.
What if the property gets damaged or destroyed during the mortgage period? The customer shall be required to continue making the repayment of the principal and interest to the conventional bank. Why? Simply because the conventional bank has accorded an interest-bearing term loan to the customer and has no real exposure on the property, except having a first-degree mortgage as security.
Let us now examine how the Islamic banks will support the same customer in acquiring a residential property. The customer’s request shall pass through a similar routine approval process as in any conventional bank. This is to comply with the regulatory framework of the central bank of that jurisdiction. However, the similarity ends here.
Once the customer has been found eligible for the Ijarah financing, the Islamic bank will not disburse any term loan to him or her in the account. Instead, the Islamic bank will directly purchase the property in the name of the Islamic bank.
Readers will recall the discussion in this series where the primary requirement to be able to lease a property to a lessee is either the lessor should hold the ownership or the usufruct related to the property. As such, to enable an Islamic bank to lease the housing unit to the customer, the Islamic bank shall directly acquire its ownership by making payment to the seller before the land registry department and obtaining the title deed in its own name. This eliminates the need to obtain a registered mortgage since the property is in the bank’s own name.
Having acquired the property title, the Islamic bank shall start the lease for a defined period of time whereby the customer shall pay a certain amount to the Islamic bank on a periodical basis which is termed as rent.
The agreed rent shall continue to be paid by the customer to the Islamic bank until the successful completion of the lease term. What if the customer defaults in payment of any rental during the lease term? The standard Shariah position in such a situation is that, being the lessor, the Islamic bank shall provide extra time to the customer to pay the defaulted rent without charging any additional amount as opposed to a conventional bank’s penalty.
What if the property gets damaged or destroyed during the lease term? Think about it and I will return next week to explain.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next week: The discussion on Ijarah to continue. We shall examine more applications and related Ijarah documentation.