I had explained in the last article how the treatment to a customer is different in Ijarah home finance compared with conventional home mortgage in case of delays in payment of installments.
While a conventional bank applies a penalty interest instantaneously upon the occurrence of default, there is no such Shariah permissibility in Ijarah home finance. This is because the Islamic bank has not granted a term loan to the customer; instead it has leased the property to it. As such, the question of applying a penalty interest in a default situation does not arise.
Some Islamic banks have adopted the practice of applying a similar penalty amount to their customers as the conventional banks do, on the pretext that they are actually “disciplining” the customers and that the amount so collected shall be donated to charity after deducting the “recovery expenses”.
Let me be very clear here. In my research, I have failed to discover the Shariah permissibility on charging any kind of penalty by a creditor to a defaulting debtor. This so called “deterrent” has never been permitted by any renowned Islamic scholar of Islam’s golden era or found in any book of Islamic jurisprudence currently studied at the educational institutions.
If any Islamic bank is trying to justify it by claiming that the penalty so recovered is “permissible” since the bank is donating the amount to charity “after deducting the recovery expenses”, it is violating its own memorandum and articles of association as well as the license granted by the apex bank. The pretext of donation to charity pursuant to deducting the recovery expenses is fabricated since out of an amount of 100 recovered from a customer as the penalty amount, almost 90 to 95 are retained by the Islamic bank as recovery charges.
Here, there are two serious Shariah issues: first, the function of recovering the defaulted amounts is part and parcel of a bank’s business model and hence must be absorbed as routine administrative expense, similar to any other cost center in the bank.
To further illustrate, when the founding shareholders apply for the Islamic bank license, they submit a professionally prepared feasibility study to the central bank whereby such a function is also mentioned along with the other cost and profit centers.
It means that the projected income statement submitted as part of the feasibility study has already absorbed the recovery expenses for delinquent assets, thereby leaving no justification for charging any extra amount to a defaulting customer and retaining a majority of such a penalty amount before donating the meager residual to charity. Hence, if any Islamic bank applies any penalty to a defaulting customer, 100% of it must be donated to charity if the intention is to use it purely as a deterrent.
Secondly, the shareholders and depositors of an Islamic bank trust the senior management of the bank to provide them with Halal and Tayyeb (permissible and pure) profits. Any element of penalty interest, no matter collected on whatever pretext and how small, cannot be allowed to be mixed with such Halal and Tayyeb profits since it will certainly distort the Shariah status of such profits.
If the stakeholders of the Islamic bank — which is recovering and retaining the penalty interest from customers — wanted to earn interest, they have varied choices to invest in any conventional bank. Therefore, their objective of earning Halal and Tayyeb profits is defeated by the Islamic bank’s senior management if it applies the conventional banks’ practice of charging a penalty interest on defaulted amounts and does not donate 100% of such penalty amounts to charity. Another critical aspect to evaluate is that the abrupt application of the penalty interest by the Islamic bank on a defaulting customer directly violates the spirit of Quranic verse 280 of Chapter 2 (Al Baqara) even if it is donating 100% of the penalty to charity: “And if the debtor is having a hard time, then grant him time till it is easy for him to repay; but if you remit it by way of charity, that is better for you if you did but know”.
In fact, instead of applying any additional amount on the debtor in the shape of a penalty, God Almighty is counseling the creditor to consider waiving the debt altogether. As stated in the verse, by so doing, the creditor will earn charity with God Almighty for each day of relaxation granted to the debtor.
Therefore, even if an Islamic bank has adopted the practice of collecting a penalty interest and donating 100% of it to charity, it cannot do it immediately upon the occurrence of a default but only after examining the circumstances of the default. If there is a genuine difficulty such as job loss or illness, etc, the penalty should not be applied.
In this clear backdrop, how can the management of an Islamic bank justify the application of a penalty interest on a defaulting customer, that too instantly and on top of that retaining part of it toward increasing the Islamic bank’s bottom line?
It was important that I clarify the penalty issue one more time since I was asked to do so by a few readers I met recently at an Islamic finance event in the context of Ijarah home finance.
Next week, I will resume discussing the Shariah application of the property getting damaged or destroyed during the lease term.
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.
Next week: The discussion on Ijarah to continue.