Guide to risk mitigation techniques in Ijarah for Islamic banks

In-Depth Analysis

Customers who have utilized Ijarah financing from Islamic banks must have had a field day after going through the previous article on the treatment of a partial or total loss of the leased asset, particularly the aspect that the rent ceases to exist upon the occurrence of a total loss of the Ijarah asset. At the same time, it must have been an eye opener for the customers who have taken conventional mortgages or financial leases from the interest-based lending institutions (banks and leasing companies). The proof of the pudding is in the eating: where is the evidence that Islamic leasing principles were ever applied genuinely in such circumstances, thus providing unheard-of benefits to clients of the Islamic banking industry in a jurisdiction? The author witnessed one such real-life example in his Islamic banking career. One such incident happened in 2012 when a 34-story residential tower at Dubai's busiest Sheikh Zayed Road was badly gutted. The fire started from a lower apartment and spread all the way up due to strong winds that night. Thank God that the ever vigilant Dubai Civil Defense quickly evacuated all the occupants safely. The residents were a mix of borrowers from conventional banks and customers of Islamic home finance under Ijarah from local banks and financial institutions. Acting on the instructions of their respective Shariah boards, the Islamic financial institutions took the following steps: (a) stopped applying the lease rent instantly under Ijarah financing to all those affected customers, and (b) arranged immediate free hotel accommodation for the families for a number of days followed by providing alternative residential units for a year at the institutions' expense. While the first act carried out by the Islamic financial institutions fulfilled the Shariah requirement explained in the previous article, the second one was purely a humanitarian gesture. Comparatively, the residents who took conventional mortgages from interest-based banks and financial institutions were the worst off. Not only did the lenders continue to recover the mortgage installments during the restoration period of four years, they also applied a penalty interest in case of delays in payment. The author pulled a quote from one of the residents who utilized a conventional mortgage so that readers can judge for themselves: 'Despite the fire, I had to continue to pay my mortgage to the bank on the flat I owned even as I had to rent another place to stay. So financially, it was a huge impact for the last four years.' Islamic banks manage depositors' funds for and on their behalf. As such, the profit or loss is owned by the depositors since they invest equity and do not lend money to the bank, as conventional bank depositors do. When it comes to transactional risks, Shariah principles do not allow the elimination of them altogether. However, these risks can be mitigated in a Shariah permissible manner. The Islamic financial institution is encouraged by the scholars to seek Takaful cover (Islamic insurance) for any asset financed by it. As such, if the leased asset gets partially destroyed due to no fault of the lessee, the Islamic financial institution will rely on claiming the amount spent on restoration from the Takaful cover provider. This will protect the Islamic depositors from getting hit for the cost of repairs. As for the loss of rent during the restoration period, the Islamic bank (and hence the Islamic depositors) will have to put up with a reduction or cessation of rent during the repair period which must be borne by the lessor.