Print Email Download Reference This Send to Kindle Reddit This
submit to reddit

Islamic finance


The concept of Islamic finance means the financial transactions which follow the rules of shrai'a or Islamic law. There are four main principles that distinguish the Islamic finance from the conventional finance. They are the prohibiting of interest (riba), prohibiting of realising a gain from speculation (mayseer), uncertainty (gharar) and all activity adhering the transaction must be for permitted purposes (halal)[1]. There are three fundamental sources of Islamic law which are the Qur'an, Suna and Ijma'. The Qur'an is the Muslim's Holy Book; the Suna is Prophet Mohammed's (pbuh) utterance, deeds and approvals that are reported in Hadith. Ijma' additionally means the total agreement upon a religious decision which had not expressed in the previous sources by all Islamic scholars in on period of time or an era. There are other important sources in Islamic law such as Qiyas[2]. Islamic finance had appeared for the first time 1,400 years ago during the life of Prophet Mohammed (pbuh). However, the modern Islamic finance has emerged in the 1970s due to many reasons. They are, for instance, the emergence of oil in the gulf countries and the need for Muslims to have financial products that are complied with the Shari'a law[3]. There has been a huge increase in the implementation of Islamic finance during the last teen years and it is predictable to continue. Islamic finance during that period has not spread over the Islamic countries only; it has spread over the western countries as well[4]. In modern Islamic finance there are many financial instruments such as Mudaraba, Musharaka, Murabha, Ijarah and Bai' salam. Each of those has its own terms and conditions as an Islamic financial technique. This essay will look at the case by indicating the concept of Ijarah as an Islamic way of finance and the issues that should be looked at according to this method of financing. Then it will show the differences between Ijarah and the conventional leasing in regard to the potential risks that could appear in the transaction. Additionally, it will attempt to provide solutions which would mitigate the potential risks on Ijarah. Finally, the essay will examine the suitable term of choosing the applicable law.

Ijarah as an Islamic technique of finance

Ijarah is an Arabic word which has the same meaning of lease. This means that an owner of an asset will transfer his right of usufruct to a lessee in a specific period of time for a specific amount of money. There are many rules for Ijarah as a transaction in the Shari'a law that must be satisfied. First, there must be an agreed consideration and period of transferring the usufruct in the Ijarah contact and the subject of lease must be specified. Also, the prepared asset for leasing must have a value use and the ownership of the asset must remain in the lessor. In addition, all liabilities appear from the ownership and the risks of any loss or harm which are caused by elements that not under the control of the lessee will be upon the owner of the asset. However, the lessee will be liable for any loss or harm that resulted from a misuse or negligence from him and any costs arise for the case of using the asset such as a utility bill. Moreover, the leased asset must be used for the same propose which has been specified in the Ijarah contract. Finally, the owner cannot raise the rent unilaterally, so there must be an agreement upon any changes in the contract. Ijarah in this form is the traditional transaction that has been used for more than 1400 years between different entities and it did not used as a way of finance until recently. In order to use Ijarah as a method of Islamic finance under the technique called (ijarah wa-iqtina) which means that a person will rent an asset for a long period and then own it, many issues should be highlighted and explained.

The beginning of the transaction

In lease transaction and under Islamic law it is allowed to have an agreement of lease for a future date. According to this the lessee specifies an asset that he wants to lease to the lessor to buy it. The lessor has two options in this case. First, he could go himself and buy the asset from the supplier. Second, he could appoint the lessee to be as an agent and buy the asset on behalf of him. In this case there will be a different relationship between them since the lessor will be the principal and the lessee will play the role of an agent. Most financial institutions (lessors) prefer this way to avoid the hassle that would be a long the sale agreement of the asset. When the financial institution owns the asset they must deliver it to the lessee. The relationship between the lessee and the lessor under the Ijarah agreement will start when the lessor transfers usufruct of the asset to the lessee. The rent must be counted on that time and not when the bank owns the asset.

The leasing agreement

In this stage all rules of agreement that has been explained before must be satisfied in order for the transaction to be Shari'a complied. As both parties have agreed to the Ijarah contract before the asset being owned by the lessor, both parties will start the performance of the contract as soon as the asset has been delivered to the lessee. The lessor as an owner of the asset is liable for any costs that would appear upon the purchase of the asset or the delivery to the lessee. However, he can by an agreement with the lessee add this costs to the rental cost which will be payable by the lessee. The liabilities of any loss and harm as stated before have two situations. First, if the loss or harm caused to the asset occurred by the lessee as a result of misuse or negligence then he would be liable. The other situation is that when a loss or harm happens to the asset by factors that beyond the control of the lessee then the lessor would be liable since he is the owner of the asset. In addition, since parties in this transaction have chosen ijarah as an Islamic financial technique some legal actions must be performed in the same time of signing the lease contract. Parties are not allowed under shrai'a law to include the ijarah contract a term which says that when the lessee performs his all duties and pays the rent under ijarah contract, the ownership of the asset shall be transferred to him. It is not allowed because there is a future agreement of sale or gift and these are not Shari'a complied transactions. There a solution for this case that has been adapted by some contemporary scholars. It is allowing the lessor to give a promise to gift or sale the asset at the end of the lease period. This promise must have the condition that the lessee will have completed his duties under the ijarah contract. This promise, in addition, must be in a single document and not in the same for the ijarah. It must as well be unilateral and not bilateral to avoid having a sale or gift contract for future date.

The long term leasing agreement "rent"

The rent in this transaction should be consisting of part of the cost of the asset that the financial institution has purchased and the cost of the lease. It should be counted like that since at the end of the lease period the ownership of the asset will be transferred to the lessee. In this case he will have paid the cost of the asset and the benefit of the bank. The period of the ijarah transaction usually takes long time. During this period the economic situation would change a lot and it would not remain stable. For this purpose the amount of leasing should be change over the period. ijarah agreement under Islamic law gives the lessor two choices to chose from. The first option is that the lessor agrees with the lessee in the original contract of leasing that there will be an increase in the rent by a specific percent after a fixed period of time. For example, an increase of 5 percent of the rent every year. In The second option the lessor contract the lease agreement for a short period and then renew the lease for a different amount of money. In this case if the lessee agreed upon the new contract there will not be any problem. However, in case the lessee did not agree upon the new contract then the asset will go back to the owner who is the lessor, and he does not have the right to claim the lessee for not paying the rent or not agreeing with the new contract. In a long-term lease some modern scholars have stated that parties are allowed to agree to link the rent with a variable benchmark such as (LIPOR) that is famous and will-defined. As a result, there will not be any possibility of dispute. For example, if there is an increase of the tax rate, a lessor under this condition has the right to increase the amount of rent as the same percentage. Other scholars have disagreed with this opinion for some reasons. The first one is that any Islamic transaction should be away of the interest and should not be linked with its rate. so the transaction should be totally Islamic. Secondly, the rate of interest would be fluctuated during such long period of time. Then the rent which linked with it will be unknown. Unknown rent is an expressed conflict of the principles of Shrai'a law which is the prohibiting of "Gharar". Under Ijarah agreement the rent must be well known to both parties at the time of signing the contract. In addition, third group of scholars have a point of view that seems to be the solution. They state that to use a benchmark with avoiding "Gharar" might happen in one situation. The party could agree on the use of a well-known benchmark with specifying the fluctuation by having a maximum percentage and a minimum one to be use as a guide of rate. For example, parties agree to increase the rent or decrease it according to the benchmark until 10 percent in case of increase and 5 percent in case of decrease. So if the rate has increased more than 10 percent, the increased rent which will apply is just 10 percent and the same with decrease.

Late payment's penalties

Unlike the conventional financial system which allows a lessor to require interest for late payment, this way is completely not complied with shrai'a law. The reason for that is the interest that has been taking from the lessee for late payment is the "riba" which is expressly prohibited in Quran. In this case how a lessee should be encourage to pay on time or threatened to pay late. Some contemporary scholars have advanced a way which seems to be solution. They allow the lessor to take some money which is extra than the rent if the lessee pay late and spend them for a charity proposes. The extra amount of money that the lessee will pay might be different according to the period of time. A clause might be included in the agreement states that: "The Lessee herby undertakes that, if he fails to pay rent on its due date, he shall pay an amount calculated at . Per cent per annum to the charity fund maintained by the Lessor which will be used by the Lessor exclusively for charitable purposes approved by the Shrai'ah and shall in no case form part of the income of the Lessor" Such a clause would be pontifical for the lessor to prevent a possibility of a late payment from the lessee and it is allowed in Islamic law. Applying the terms and conditions of the transaction to the case In the case there are four parties The Islamic Bank of Translavia (IBT), East Airlines (EA) and Universal Airways (UA). IBT is considering entering into an ijarah transaction eith EA. Under this transaction the bank will advance US$50 million to buy 4 aircrafts that owned and operated by UA. In order to advice the bank in this transaction and to have the approval of the Bank's Shrai'a supervisory Board, some issues must be highlighted and indicated. firest, the assets have been already specified from the UA which are the four aircrafts. UA must promise the bank that they will rent the assets after purchasing them. IBT is highly recommended to appoint UA on behalf of them to purchase the aircrafts to avoid the hassle upon this transaction and to make sure that they are suitable for UA's use. When the bank owns the aircraft the Ijarah contract must be signed between IBT and UA. In this case we should examine that the rules of the leasing in this transaction. The assets which are the four aircrafts are valuable and cannot be consumed at the end of the leasing period so they will remain the same. IBT is the owner of the aircrafts and there will be a clear period of renting. Moreover, the rent should include the cost of the aircrafts and the benefit and they should be divided according to the period of renting. The risks upon IBT as an owner of the aircrafts will be discussed later on this essay as well as the ways of mitigating them under Ijarah agreement as an Islamic financial technique. As a solution of the Ijarah rate the benchmark way with limitations is highly recommended to be used since it has a high percentage of certainty and it is the way which with the "Ghara" would be avoided. IBT is advised to include a condition like the one in the late payment section in the contract to make the lessee under the pressure of paying more money than what is orgenally required.In addition, a promise from IBT should be written in a separate document than the lease contract.

The differences between Ijarah and conventional leasing in regard to the potential risks

Many differences are existing in between the conventional leasing and Ijarah. One of the main differences is the damage or destruction. In the conventional leasing the lessee is liable even though the cause is beyond his control whereas in Ijarah the owner of the asset will face the loss in such situation. Moreover, the insurance of the leased asset should be independent of the lease contract and should be paid and arranged by the lessee in the conventional lease. Hence, any clime related to insurance should be faced by the lessee. In Ijarah the owner is ought to arrange and pay for the Takaful insurance. However, the lessor can add this cost to the rent by agreement with the lessee to cover this expense. Accordingly, any dispute related to the Takaful insurance should be looked at by the owner since he is the party of this contract. In case of destruction the Islamic bank will stop charging the lessee for rent since the usufruct does not exist. In Ijarah contract the lessee pay rent for buying the usufruct from the owner of the asset for a specific period. So, if the usufruct does not exist there is no need of paying rent. In conventional leasing the lessee must pay the rent for the whole period regardless that there is no usufruct exists.

Mitigation of the risks in Ijarah

As discussed in the previous paragraph, there many kind of risks that might appear in regard to Ijarah transaction. One risk might rise at the beginning of the transaction that the customer refuses to rent the asset after the bank purchasing them for the purpose of lease. In order to mitigate this risk, two options might be obtained. First, the customer should give a promise to the bank to lease the appointed asset that will be bought by the bank. Second, the bank can sell the asset to a third party and clime the customer for the actual loss under the Islamic principle "Hamish Jiddiah". In case of late payment or default of paying the rent due, the bank could include the term stated earlier in this essay under the sup-title "late payment penalties" to avoid late payment. Thus, in the situation of default of paying the installment due, the bank has the right to take back the asset and sell it in the market and go back to the lessee under "Hamish Jiddiah" for the loss. Other risks should be pared in minds which are the risk of destruction, maintenance and the rate. In case of destruction the bank should manage insurance upon the asset by Takaful facility. However, if the harm occurs to the asset has been caused by a misuse on negligence from the lessee; he will be liable for compensation. The bank could mitigate the maintenance risk by managing a periodic maintenance and the costs of them could be added to the rent of lease by a term agreed upon by the parties in the leasing contract. The mitigation of the fluctuated rate risk has been discussed earlier in this essay under the sup-title "the long term leasing agreement "rent". IBT are highly recommended to follow the ways of mitigating the risks that might appear upon their signing an ijarah contract as an Islamic choice of financing the purchase of the aircrafts.

The choice of law

In regard to the governing law in this transaction there are two situations of applying the Shrai'a law as the governing on. First, in England, writing a clause that states impliedly that the governing law is the Shrai'a law is a void choice according to a recent case Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd and others[5]. In this case the judge refused to apply the principle of Shari'a as a governing law for two reasons. (i) there cannot be two governing law which are Sharai'a and English law applying on one contract (ii) according to the Rome Convention (1980) that allows the national laws to be chosen to govern a contract. Since shrai'a law is not a national law by itself, it cannot be chosen to govern any contract. However, any national law that adopted the Shrai'a law such as Saudi law can be chosen to govern a contract that based in Shari'a principles. Secondly, as it is assumed in the case that both parties wish to be govern by English law that would conflict with some of the principles of Shari'a there is one option which seems to be the best. This option states that the contract should be adjusted to an extent that it would prevent any conflict between English law as a governing law and the principles of Shari'a that the contract itself based on. Many terms of the contract should be explained sufficiently especially the ones that would conflict with English law. For example, the liability upon the owner of the asset in case of destruction and the penalties in case of late payment. When such terms have been explained clearly under the principles of Shari'a in this contract, the English law will apply the rules in the contract in case of any default. Consequently, the principles of shrai'a will impliedly govern the contract on the time of signing and during the life of it.


To summarize the advices to IBT it can be said that the Ijarah is an appropriate way of financing the purchase of the aircraft. Also, the rules of Ijarah are completely satisfied under this transaction. They should make sure that the procedures in this transaction follow the rules stated in this essay especially having separate documents for the leasing agreement and the promise of selling or gifting the aircraft at the end of the leasing period. In addition, the risks can be mitigated easily in Ijarah transaction as stated under the title (Mitigation of the risks in Ijarah). Finally, a very important advice for IBT that they should be careful on drafting the contract and make sure that every single term stated clearly and sufficiently especially the ones that might conflict with English law.

Print Email Download Reference This Send to Kindle Reddit This

Share This Essay

To share this essay on Reddit, Facebook, Twitter, or Google+ just click on the buttons below:

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.

More from UK Essays

Doing your resits? We can help!