How total loss is addressed in Ijarah financing transactions

In-Depth Analysis

After covering the treatment of partial loss to a leased asset in the last article, the discussion now turns to explaining how the total damage to the Ijarah asset is treated in Shariah from the financial lease perspective. 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? 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 (as in purchase and leaseback). 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. The variable element (b) represents the profit the Islamic bank would like to earn from its investment 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: (i) fixed rate (percentage) for the entire lease term, where 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, where 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. 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 Fatwa endorsed by the Shariah boards of the other Islamic banks partaking in the same syndication transaction provided great opportunity. This approach was also endorsed by AAOIFI's Shariah board and is now part of the AAOIFI Shariah Standard on Ijarah. The supplementary element (c) is the third component of the rent paid by the lessee under a financial leasing Ijarah transaction. It comprises the cost of major maintenance incurred by the owner in providing the leased asset to the lessee in perfect working condition during the course of the entire financial lease.