Advanced Islamic Banking and Finance

Islamic Financial Contracts

Ijarah
 Learning Objective 3.3
Concept of Service-Based Contract Understand how service-
based contracts are used as
financial instruments in
Islamic finance

• Service–based contracts, such as Ijarah, involve hiring or

employing another person or renting premises for a specific
purpose in line with the payment of certain wages, rental fee,
or commission.

• The service-based contracts include:

• ijarah (leasing)
• ijarah muntahia bi al-tamlik (financial lease)
• ijarah thumma al-bay (leasing and subsequent purchase)
• ujrah (fees)
• ju’alah (commission)
 Learning Objective 3.3
Concept of Service-Based Contract Understand how service-
based contracts are used as
financial instruments in
Islamic finance
Ijarah (Leasing)
• Like Murabaha, Ijara is a debt-based contract widely used by
Islamic Banks
• Ijara is the arabic word for providing goods or services for
temporary use against a wage. Literally, one sells 'usage', or
'usufruct', for a period of time, but the asset ownership
remains with the lessor.
• The Islamic bank assumes the role of an muajir or mujir
(lessor) and allows its client to use a particular asset that
he/she owns. The client or mustajir (lessee) is in need of the
asset. Through ijara, he/she receives the benefits associated
with ownership of the asset against payment of pre-determined
rentals (ujrat).
• Ijara is for a known time period called ijara period.
 Learning Objective 3.3
Concept of Service-Based Contract Understand how service-
based contracts are used as
financial instruments in
Islamic finance
Basic rules regulationg Ijarah (Leasing)

1. Ijarah is a contract whereby the owner of something transfers

its usufruct to another person for an agreed period, for an
agreed consideration.
2. The subject of Ijarah must have a valuable use.
3. The corpus for the leased property must remain in the
ownership of the seller (lessor) and only its usufruct is
transferred to the lessee. Thus, anything that cannot be used
without consuming cannot be leased out (money, eatables,
fuel).
4. As the corpus of the leased property remains in the ownership
of the lessor, all the liabilities emerging from the ownership
shall be borne by the lessor, but the liabilities referable to the
use of the property shall be borne by the lessee.
1 - Ijara : Definition and Principles

Ijara financing structure

$ 3 $

1
Customer Bank
2

1. Client approaches a Bank and identifies an asset;

2. Bank leases out the asset to Client, allowing him to take possession and put
into specified use;
3. Client pays known rentals over future (known) time period(s).
4. Asset reverts back to Bank

5
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

• Modern application of ijarah are:

- Al-ijarah thumma al-bay’ (a contract of lease ending
with sale)-operating lease
- Ijarah muntahia bi al-tamlik (leasing ending with
ownership) financial lease
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ijarah Muntahia Bi al-tamlik (Financial Lease)

• Ijarah Muntahia Bi al-tamlik is a typical lease contract,

which culminates in a transfer of legal title and confers
ownership on the lessee.
• ● Al-ijarah muntahia bi al-tamlik contains two main words:
ijarah, which means lease, and tamlik, which is ownership.
• ● Essentially, in simple terms, al-ijarah muntahia bi al-
tamlik is ownership of the usufruct in an identifiable asset or
property within a specified period followed by the granting
of the ownership of such property at the maturity of the
lease contract.
2 – Ijara wa Iqtina / Muntahia Bi atmleek

1
3 2
Vendor Client Bank
4 6
7

8
1. Agreement of mutual promise between Bank and Client whereby the Bank promises to lease and
the Client promises to take on lease the asset against predetermined rentals for a definite time
period; 2. Bank appoints Client as its Agent; 3. Client identifies the vendor, selects the asset on
behalf of the bank and advises its particulars, including the vendor's name and its purchase price to
the bank in writing; 4. Vendor makes physical delivery of asset to Agent (Client) of Bank; trained
staff from bank oversee the process of client taking physical possession of asset; 5. Bank makes
arrangement for payment of purchase price to Vendor; 6. The agency contract comes to an end;
Bank leases the asset on the basis of the agreement of mutual promise, transfers possession and
right of specified use to Client; 7. Client pays known rentals over future (known) time period(s).
8. Bank transfers ownership of asset to client at the end of ijara period either through a gift or sale.

8
 Learning Objective 3.3
Understand how service-based contracts are
Concept of Service-Based used as financial instruments in Islamic
finance
Contract

Ijarah thumma al-bay (Leasing and Subsequent

Purchase)

• Ijarah thumma al-bay: a contract of lease subsequently

followed by a sale contract
• Two separate contracts are concluded under this chain
transaction
- The ijarah contract
- The purchase contract
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance
Figure 3.8: Ijarah Thumma bay’ Contract
 Learning Objective 3.3
Understand how service-based
Concept of Service-Based Contract contracts are used as financial
instruments in Islamic finance

Ijarah mausufah fi dhimmah (Forward Lease)

• Ijarah mausufah fi dhimmah lease agreement is concluded

on a contract not in existence

• The lessor delivers the asset to the lessee in accordance

with agreed specifications

• The modern application of forward lease is diverse; it can be

used in:
- medical treatment
- education
- tourism
4 – Ijara : Key Issues

• Risk and Return : the leased asset remains in the risk of the lessor throughout the ijara
period, in the sense that any loss, damage or loss caused by the factors beyond the
control of the lessee shall be borne by the lessor.

• Gharar in Contractual Structure : Ijara wa Iqtina

• Fixed and Floating Rates : i.e 3/6-Month Libor/Eibor plus a spread called margin for
each Ijara period.

• Default Risk and its Mitigation : The bank is not allowed to charge an additional amount
in case of delays in payment of the rentals. It may however, ask the client-lessee to
undertake to contribute a certain sum to a charity fund maintained by itself, should
there be a default or delinquency.

• Nature of the leased Asset

• Termination of Ijara : Possibility of khiyar.

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Conventional VS. Islamic Lease
Conventional Islamic

At time of funding through .Only when asset is delivered •

Rental payments term of contract No payments if asset is out of order •

Remains with lesser, except in case of

Risk of Destruct. / loss Often transferred to lesseenegligence or misconduct or breach of
contract

Has to be on Lesser, except minor

Ins. & Main. cost Often on lessee expenses not essential for performance
of leased asset

Variable or fixed (first rental payment

Pricing Variable or fixed
has to be fixed)

Penalty For late

Yes If enforced has to be paid out in charity
payment

No such thing as a finance lease in pure Islamic nominate contracts

www.bibf.com
Comparison- Murabaha and Ijarah

Murabaha Ijarah

Prior promise to buy Promise not necessary

Sale of Assets Sale of usufruct

Mark-up on the cost Profit is realised from rent

Short term financing mechanism Long-term financing mechanism

The price is fixed The rent may be revised

www.bibf.com
Comparison- Murabaha and Ijarah

Murabaha Ijarah

Asset not yet bought or benefit may be

Asset Ownership necessary leased

The cost must be disclosed It is not necessary

Necessary to show rental of the first

Necessary to disclose full mark-up period: in case of Floating rate

Ownership is transferred when contract Is signed Ownership should be transferred later-in

case of Ijaram Muntahia B.

The terms and profit are not changeable The period and rental may be adjusted

No obligation for rebate for early payment Obligation to give discount possible
www.bibf.co
m
 Conventional VS Islamic Home
Finance
Conventional mortgage finance Islamic home finance
Ownership with the customer · Structured only as an operating lease where ·
where the financier holds the ownership of the asset remains with the
mortgage over the asset financier
Late payment penalties or penal · No late payment penalties – no income for ·
interest is levied the lessor (A flat fee to cover collection
charges can be levied)
Early settlement fees and · terminationor fees settlementearlyNo ·
termination charges are charges
applicable
by borne cost Insurance · Only Life Insurance paid by the customer or ·
the by the Company and recovered from the
customer customer - either as a lump sum or with
monthly installments (i.e. customer
preference)
No recovery on premium under · Insurance to be under Takaful whereby the ·
conventional insurance customer may be able to recover a certain
portion of the premium in case th e Islamic
www.bibf.com
insurance company makes profits
Home Finance Based on Ijara Wa Iqtina – 5

Example of Home finance where the total cost of the asset is USD 1.2 Million.
The Customer makes a downpayment of USD 200 000 and the Islamic Bank finances the
balance.

Bank will lease the asset to the client for a period of 5 years rent against monthly rentals
including the rent against the usufruct and the payment towards the bank’s finance.

Rent is calculated on the Net Asset Value of the leased asset and a 5 % p.a profit margin.

Find the Bank’s total profit

Find the Bank’s monthly profit
Find the monthly rent
What happens at the end of the lease period.

17
Home Finance Based on Ijara Wa Iqtina – 5

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Home Finance Based on Ijara Wa Iqtina – 5

Example of Home finance with floating rate, where the total cost of the asset is USD 1.2
Million.
The Customer makes a down payment of USD 200 000 and the Islamic Bank finances the
balance.

Bank will lease the asset to the client for a period of 5 years rent against monthly rentals
including the rent against the usufruct and the payment towards the bank’s finance.

Rent is calculated on the Net Asset Value of the leased asset and a 2 % + USD 12 Months
LIBOR + 150 basis points p.a profit margin.

Given the USD 12 Months LIBOR for the next fives years are : 1, 1.5, 2, 0, 0.5,
respectively

Find the Bank’s total profit

Find the Bank’s monthly profit
Find the monthly rent
What happens at the end of the lease period.

19
6 – Ijara : Syndication

Syndication is a financing facility granted by a group of investors (Banks) to meet a huge

finance requirement. In Ijarah Syndication huge capital is pooled together from the
different investors (Banks) and invested in Ijarah business. The term Ijarah means leasing
of property pursuant to a contract under which a specified permissible benefit in the form
of a usufruct is obtained for a specified period in return for a specified permissible
consideration.

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 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ujrah (Fees) 

• Ujrah: a payment for usufruct in the use of another

person’s property or payment for service in contract of
ijarah

• Most Islamic financial institutions charge service fees for

services rendered to customers. Services fees should be
paid for through the ujrah scheme

• Ujrah has been used by a number of banks for Sharī‘ah-

compliant credit card schemes
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ju’alah (Commission or Reward)

• In the juristic sense, ju’alah is a one-sided contract where
reward/commission is given for accomplishment of a task

• Literally means the act of doing any job or rendering a

certain service for a specific purpose that is uncertain will be
accomplished.
• Ju’alah in terms of an Islamic financial contract is one that
is unilateral and whereby a reward or commission is
promised for the accomplishment of a specific task.