By: Graeme Laing is the head of leasing at BLME.
In the Middle East, Ijarah has been used as a method of fi nancing for hundreds of years as it allows individuals and businesses to use equipment that they would have been unable to purchase outright themselves due tocapital constraints. In more recent history however, the use of Ijarah has broadened to encompass the leasing and acquisition of all physical assets. It is a similar story for the conventional finance world, where leasing is well established in both the commercial and private spheres.
As with Ijarah most conventional leases are asset-backed and as such individuals and businesses that have previously leased assets in a conventional manner are comfortable making the transition to Ijarah structures. Ijarah is no different from other Islamic transactions which are also are asset-based, meaning that there is always an asset with an inherent value sitt ing behind the contract. This is one of the main reasons why leasing so naturally lends itself to Islamic fi nance. Consequently Ijarah is one of the most commonly used structures in Islamic finance products.
Ijarah has a familiar ‘look and feel’ to conventional leasing products, and businesses and customers accustomed to conventional fi nancing methods (many of whom are unused to Islamic financial products) are comfortable using Ijarah. Additionally, Bank of London and The Middle East (BLME) has found that counterparties find the process and the documentation of Shariah compliant leases very similar to those in the conventional world.
Leasing market in the UK
Leasing is a growing industry in the UK and the Islamic finance industry is well placed to take advantage of this opportunity. In order to service this growing market and take advantage of the opportunities, Islamic finance institutions offer two main Ijarah structures:
Operating Ijarah
The owner takes a residual value risk on the equipment. This means that when the lease comes to an end the equipment may not be worth enough to cover the original capital investment plus profit. An operating Ijarah is treated off -balance sheet for the lessee. This Ijarah can also be structured so that the lessee has an option to buy the asset at the end of the Ijarah.
Finance lease
The lease rents and any balloon payments cover the full capital investment plus profit. The lessee owns the asset and it is treated as on-balance sheet for the lessee.
Key features of Ijarah
• The period and conditions of usage of the leased items must be detailed within the contract.
• The amount and timing of Ijarah payments must be agreed in advance. However despite the requirement to agree to a schedule, the amount, frequency and timing of Ijarah payments do not need to be uniform.
• To finance Ijarah transactions, as long as the asset is fit for use, the lessor and the lessee can stipulate in the contract that the ownership of the asset can be transferred to the lessee on completion of the lease agreement.
• The asset that is leased in an Ijarah contract must be used for an economic activity; a perishable or consumable object, such as food, cannot be leased.
• Upon acquisition of the leased goods or upon utilizing the leased goods the lease payment schedule becomes active.
• The lessor must have full possession and legal ownership of the asset prior to leasing it.
• The leased asset must continue to exist throughout the term of the lease. Items which are consumed in the process of usage, such as seeds and petrol for instance, cannot be leased.
• In contrast with most conventional finance leases, the responsibility for maintenance and insurance of the leased item remains that of the lessor throughout the period of the Ijarah.
• In the event of a late payment of rental, the Ijarah agreement may be terminated immediately.
• The lessor may claim compensation for any actual damage caused to the leased assets as a result of negligence on the part of the lessee.
Differences between Ijarah and conventional leasing
In an Ijarah structure, the lessor is required to bear all the costs incurred in the process of purchasing the asset and as the lessor is the owner of the asset all liabilities resulting from the ownership of the asset are the responsibility of the lessor including maintenance and insurance.
However once the lessee has received the asset they are responsible for any losses incurred due to misuse or negligence. Generally, the maintenance and insurance obligations are assigned to the lessee to perform as an agent for the lessor. Another difference between Shariah compliant leases and conventional ones is that under Shariah, the lessor leases the usufruct and not the asset, of which he remains the owner. As such, the subject of the lease must be identifiable and quantifiable.
Sukuk
Ijarah is becoming more popular as a basis for Sukuk structures as leasing income which is paid periodically to Sukukholders provides a steady and reliable income stream. As with Ijarah financing the conventional market is comfortable with the structure of Sukuk Ijarah, with one of the most successful issuances over the last year being the Nomura Sukuk. By issuing this US dollar Sukuk, Nomura was able to actively enter the Islamic market and diversify its funding sources.
This issuance held an additional benefit for the Islamic finance industry, as it brought Sukuk to a conventional audience and promoted Islamic finance as an additional and diversified source of financing. Sukuk Ijarah can also be structured as a shorter-term Sukuk similar to conventional papers.
Sukuk Ijarah structured in this way permits short term funding and shorter-term liquidity for Islamic financial institutions. The Central Bank of Bahrain has issued several short-term Sukuk Ijarah with its June 2011 issuance being significantly oversubscribed.
The use of Sukuk Ijarah will continue to grow due to its accessibility and flexibility. 2011 has seen Turkey implementing new legislation ensuring tax neutrality for Sukuk Ijarah, for example.
Key features of a Sukuk Ijarah structure
• Lease payments can be fi xed or variable but they must be detailed in the contract.
• There must be a fixed maturity date.
• The ownership of the leased equipment remains with the originator or issuer.
• Sukuk Ijarah is usually issued on a sale and leaseback arrangement.
• The issuer applies the Sukuk proceeds to purchase the assets from the originator and then leases it.
• The originator undertakes to repurchase the assets at maturity or upon early settlement.
• The issuer is required under Shariah to undertake the maintenance of the assets, but it will often appoint the lessee as its agent to do so under the terms of the contract.
Economic benefits of Islamic leasing
Islamic leasing is increasingly thought to have considerable benefi ts relative to conventional banking. While the nature and scale of these benefi ts is the subject of debate, Islamic leasing is commonly regarded to be more advantageous because:
• It aways involves real assets, strengthening the linkage between the financial sector of the economy and the real economy in general. This relationship contributes to economic stability.
• It creates great potential for Shariah compliant securitization for Sukuk in Islamic finance. Sukuk Ijarah can be traded in the market, affording a convenient instrument for investment.
• It is suitable for some sectors of the economy where sharing-based modes provided can be relatively difficult to practice, e.g. the consumer sector and the public sector, particularly infrastructure.
Despite the progress and the potential market, Islamic leasing is still nascent, particularly in Europe. A lack of understanding of Islamic leasing by potential customers, as well as the limited off ering by both Islamic banks and Islamic windows of conventional banks, means that the market remains a large growth opportunity which has not yet reached its full potential.
Nevertheless, the fact that several institutions are actively able to grow their leasing business across Ijarah and conventional leasing with strong interest in both, suggests a bright future for leasing and Ijarah.
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