After covering the treatment of partial loss to a leased asset in the last article, today I will start explaining how the total damage to the Ijarah asset is treated in Shariah. My explanation shall be from the financial lease perspective.
Let me first explain how the periodic rent in a financial lease transaction is structured, keeping in view that, being the lessor, the Islamic bank not only aims to earn a profit but is also required to get its investment in the leased asset redeemed. How will this be impacted in case of the total destruction to the leased asset owned by the Islamic bank?
But first let me elaborate on how the financial lease rent is structured. The components of rent in an Islamic financial leasing transaction are as follows:
a. Fixed element: This is the part embedded within the amount of periodic rent the customer pays to the Islamic bank and represents the recovery of the investment made by the Islamic bank in purchasing the asset from the third party, or from the customer. It has been explained in detail in the earlier articles that the Islamic bank can also purchase the asset from its customer and lease the same to it.
The fixed element is arrived at by dividing the total amount invested by the Islamic bank in purchasing the asset by the total number of installments so as to get the equal amount for all installments. It is also possible that the Islamic bank would tailor this amount lower in the first few years and subsequently increase it so as to encourage or facilitate the customer, or it could also be vice versa.
b. Variable element: This is the profit the Islamic bank would like to earn from the investment it has made in purchasing the leased asset. The variable element is determined by applying the agreed rate (a percentage) on the outstanding fixed element amount related to a certain period. There are two approaches to ascertaining the amount of the variable element:
i. Fixed rate (percentage) for the entire lease term: Here, the agreed percentage is applied on the outstanding fixed element during the entire lease term based on the agreed amortization model. The benefit of a fixed rate is that the installment for each period for the entire lease term can be determined at the outset.
ii. Floater rate: In this approach, the Islamic bank and the customer agree in the lease contract that the Islamic bank shall calculate the variable element based on a reference rate plus a margin. While the daily local reference rate is determined by the central bank of the country, the global reference rate known as LIBOR is calculated by the Atlanta-based Intercontinental Exchange.
Some quarters had raised their eyebrows when the Islamic banks had newly started to get help from the conventional benchmark toward calculating the variable element during the last decade. It was done at the insistence of some corporate customers who had been dealing with conventional banks and were used to the floater rate. They wished to divert their funding requirements to Islamic banks provided they are not exposed to the risk of the market rate.
I was handling a large syndication transaction related to a power project for an Abu Dhabi-based corporate customer for the Islamic bank I had joined a year ago and got stuck on this point. A special Shariah board meeting was called to seek guidance since it had become a dealbreaker.
The learned Shariah scholars exhibited great maturity and depth of knowledge by allowing the use of a conventional pricing benchmark for calculating the variable element with the reason that as per Shariah, the lessor and lessee must agree on the basis of calculating the rent and that basis could be anything, even a conventional floater rate, since what the lessee will pay is the price to use the underlying asset which has been taken on lease by it and not the interest on loan. The scholars had also realized at the time that the market is overwhelmingly conventional and in order to promote Islamic finance, there is a need to be flexible without compromising on the Shariah principles.
The Fatwa endorsed by the Shariah boards of the other Islamic banks partaking in the same syndication transaction provided a great opportunity for Islamic banks and financial institutions to also participate in the other big ticket club and syndication transactions besides attracting a large number of clients from the retail sector, particularly from the home finance segment. This approach was also endorsed by AAOIFI’s Shariah board and is now part of the AAOIFI Shariah Standard on Ijarah.
To conclude this point, the Islamic bank being the lessor uses the market floater rate relevant to the rental period and adds an agreed margin to arrive at the profit rate which is then applied to ascertain the variable element. As the floater rate keeps varying based on the market conditions, the customer remains content that it is not paying anything more than the market rate as the lease rent.
c. Supplementary element: This is the third component of the rent paid by the lessee under a financial leasing Ijarah transaction. As we have run out of space, I will explain what it is in the next article.
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 mitigating the Ijarah risks to an Islamic bank shall continue next week.