Difference Between Ijara And Conventional Lease

NUST Business School

Mehwish Shams BBA-2K8-A

Table of ContentsINTRODUCTION...........................................................................................................................................1

Objective.................................................................................................................................................2

Methodology:..........................................................................................................................................2

Research limitations/implications...........................................................................................................2

Literature Review........................................................................................................................................3

Ijara.............................................................................................................................................................5

Ijara contract:..........................................................................................................................................5

Conventional lease......................................................................................................................................6

Conventional lease contract....................................................................................................................6

COMPARISON BETWEEN IJARA AND CONVENTIONAL LEASE......................................................................7

FINDINGS.....................................................................................................................................................8

ABSTRACT

Financial institutions all over the world are constantly under evolution and continue to strive for

better services for their customers and clients. After a century of growing under capitalist

theories, now it is interacting with the Islamic theology of finance and banking to bring about

new products which are more Sharia compliant so that the huge market of Islamic communities

can be captured. This includes International players as well as local banking institutions. This

study looks at two characteristics of the Islamic and conventional banking that are Ijara and

conventional lease. The paper discusses in detail the concept of Ijara, similarities in Ijara and

conventional leasing, differences between the two, various options and applications of Ijara as

well as conventional leasing and other issues related to both.

1

INTRODUCTIONA healthy banking system is the heart of every successful economy. It helps to strengthen the

economy of the country, the stronger the financial system the stronger the country is. There are

two types of banking systems, one is Islamic banking and the other is Conventional banking.

Islamic banking differs from conventional banking in several important ways; some of them will

be discussed in this report. The report discusses an important characteristic of the banking

system that is lease.

Leasing can be traced back to before 2000 BC. Sumerians used leasing for agricultural

equipment and hand tools. There were detailed guidelines first drawn up in Roman for operation

of lease. Modern day leasing dates back to 1840s when the rolling stocks were leased and the

leasing companies were known as wagon companies. The world’s first registered leasing

company, the Birmingham Wagon Company, was registered in 18551. Over the centuries, leases

have served many purposes and the nature of legal regulation has varied according to those

purposes and the social and economic conditions of the times.

In Islamic bank the lease is called Ijara and in conventional banks it is referred as conventional

lease. Ijara is a Shariah compliant alternative to Conventional lease. In both type of lease Bank

acts as a Lessor and the person to whom the asset is leased acts as a Lessee. The Bank requires

the lessee to pay a monthly rent for the use of the asset. The ownership of the asset remains with

the Bank, only the rights of use is transferred to lessee.

1 Dr. Zeinab Mohamed El-Gawady Lecturer of Economics Faculty of Business & Economics Misr University for Science and Technology 6th October University Giza – Egypt

2

Objective

The objective of the report is to develop a better understanding of Ijara banking and find the

differences and similarities between Ijara and conventional lease.

Methodology:

The report is prepared by studying various characteristic of Ijara and conventional lease

contracts. Various sources of information and review of literature were used to collect

information including internet, research papers of various researchers, online journals and

websites of different banks. Websites of the different Islamic and conventional bank also

provided information related to Ijara and conventional lease.

Research limitations/implications

The paper deals with concepts, information and other facts on Islamic banking that are not

supported by any statistical analysis and empirical evidence. Thus this paper may be regarded as

being subjective in its real essence.

3

Literature ReviewIn the process of research and analysis the literature on Islamic and conventional banking was

reviewed and evaluated to find about both types of banking with special focus on leasing. The

study takes into account from the available literature some specific aspects of leasing and Ijara

draws a comparison of both highlighting similarities and differences. The paper drew its main

source of information from websites of various Pakistani financial institutions and the studies

undertaken by various economists

Khalid (2008) found out that Ijara i.e. Islamic lease is a classical concept in Syariah financing

based on Islamic principles. Ijara has emerged as an increasingly popular financial structure in

asset financing and has found its way into transportation financing. It is one of the most easily

recognizable Islamic asset financing techniques which are commonly used in a singular leasing

transaction and, increasingly, as a building block in larger and more complex transactions. Being

one of the simplest asset-based Islamic financial instruments, Ijara has steadily gained

prominence as an alternative financing tool to conventional financing structures.

M. Ishaq Bhatti and M. Mansoor Khan found out that Islamic banking is one of the latest

instruments of financial management which is gaining foothold. Islamic banking refers to

Shariah-compliant tools and mechanisms to replace interest-based financial intermediation with

the risk-sharing and interest-free paradigm. It primarily relies on equity modes to conduct its

affairs. This ensures the most efficient, ethical and equitable use of economic resources of the

polity. Islamic banking relies on PLS modes, namely, mudarabah and musharakah as major, and

murrabah, ijarah, bai salam, bai istisna as secondary instruments to perform lending, borrowing

and investment functions.

4

Llewellyn, D.T. (2001) found out that the main difference between Islamic banks and

conventional banks is the exclusion of interest. While the operations of Islamic banks seem

similar to those of conventional banks, there are major differences. He lists these as; the mix of

contracts on the liabilities side of the balance sheet, the quasi-equity nature of investment

deposits implying that some depositors share in the risk of the bank, a wider variety of modes of

financing and asset mix of banks, and the risk sharing characteristics of the contracts issued and

who bears risk.

Gafoor A.L.M (1996) found that Islamic jurists are only concerned that the element of risk

should not be excluded from the financial transactions. Otherwise, it would no longer be one of

business and trade, but of usury. The depositors have to be mentally prepared for risk of money

diminishing as a result of losses incurred by the bank in its efforts to generate income. Gafoor

further argued that the profits would have accrued from one year to another according to the

performance of the bank, not according to changes in interest rates.

Zineldine (1990) found out that leasing is a financing technique which is allowed under Islamic

law. It is a contract based on profit sharing between the bank and the client. The leasing is done

for an agreed upon sum by installments and for a mutually agreed upon limited period of time

into a savings account held with the same bank.

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IjaraIjara in Arabic literally mean 'to give something on rent'. The term Ijara has two meanings in

Islamic perspective

One meaning of Ijara is “to employ the services of a person on wages given to him as a

consideration for his hired services." The employer is called 'musta’jir' while the

employee is called 'mu`jir'.

Second meaning of Ijara relates to the usufructs of assets and properties, and not to the

services of human beings. 'Ijara' in this sense means 'to transfer the usufruct of a

particular property to another person in exchange for a rent claimed from him.' In this

case, the term 'Ijara' is analogous to the English term 'leasing'. Here the lessor is called

'Mu’jir', the lessee is called 'musta’jir' and the rent payable to the lessor is called 'ujrah'.

Note: For this report the second type of Ijara is more relevant, because it is generally

used as a form of investment, and as a mode of financing also.

Ijara contract:

Ijara is a lease agreement under which a certain asset is leased out by the lessor to a lessee

against specific rent or rental for a fixed period. Ijara contract is used to finance lease for items

such as real estates, buildings, equipments, machineries, computers, motor vehicles, and other

goods; except the things that are haram or prohibited in Islam. Also the things that cannot be

used without consuming cannot be leased out e.g. money, edibles, fuel, etc. Two fundamental

principles of Islamic finance are:

It has to be asset-based financing: The first fundamental principle of Shariah is that

as opposed to conventional financial dealing, profit is generated when something

having intrinsic utility is sold or offered for use. Money has no intrinsic value. As

such dealing in money cannot generate profit unless converted into real assets.

There has to be an element of risk: The second basic element of Shariah is that one

cannot claim a profit or fee for a property/transaction, the risk of which was never

borne by him.

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Conventional lease

“It is a process by which a firm can obtain the use of a certain fixed assets for which it must pay

a series of contractual, periodic, tax deductable payments. The lessee is the receiver of the

services or the assets under the lease contract and the lessor is the owner of the assets.”

Conventional lease contract

It is a contract between a Lessor and a Lessee for the hire of a specific asset. The lessor retains

the ownership of the asset but the right to use the asset is given to the lessee for an agreed period

of time in return for a series of payments paid by the lessee to the lessor.

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COMPARISON BETWEEN IJARA AND CONVENTIONAL LEASEIjara and conventional lease both are types of lease, and are two similar concepts. However there

are some specific prohibitions which render conventional lease to be forbidden under Shariah.

Following characteristics were studied to find the differences and similarities in both types of

leasing contracts:

Ownership: Who owns the asset after the lease contract?

Risk bearer: After the agreement on lease contract, the risk of ownership lies with

whom?

Starting time for rental obligation: When would the rental obligation start, after the

agreement on lease contract?

Usefulness of property: What is the minimum useful life of the property?

Penalty: Can penalty be charged if lessee fails to fulfill the obligation?

Repossession of an asset: Is repossession of an asset allowed at predetermined

/bargain price?

Asset has value upon completion of leased period: Does asset hold value upon

completion of leased period?

Premature termination: Is premature termination allowed if the lessee has violated

or contravened the terms of the lease?

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Effect of premature termination: Are all the obligations that are still executory on

both sides considered discharged as a result of premature termination?

Sale and lease back as one transaction: Could sale and lease back be completed

under one transaction?

Determinant of rent: On what basis has rent been determined?

Equivalent to a sale: Is lease equivalent to a sale?

FINDINGSAfter comprehensive review of the collected article and analysis of literature the findings are as

follows:

Ownership :

Ijara: “Muajjir” (lessor) is the owner of the leased property.

Conventional Lease: In conventional leasing the creditor institution (banks, leasing

companies etc) retains the ownership of the asset throughout the term of the contracts.

Risk bearer :

Ijara: As Ijara is an asset based contract, and lessor or mu`jir has the ownership of the asset,

therefore all the ownership related rights and liabilities lie with the mu`jir and mustajir is

responsible for all the usage related rights and liabilities. Any loss or harm caused by factors

beyond the control of the “Mustajir” lessee shall be borne by the “Muajjir”.

Conventional lease: The lessor assumes and manages the risk of the asset.

Starting time for rental :

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Ijara: In Ijara the rental starts from the day the asset is handed over to the “Mustajir” so that

he is able to make productive use of that property or machinery.

Conventional lease: In conventional lease the rentals start from the day the lessee makes

payment for the asset/machinery/property.

Profit :

Ijara: In Ijara the profit is the rent for use of property/machinery.

Conventional lease: In conventional lease the profit is for money invested in the property/

machinery.

Valuable use :

Ijara: Asset to be leased should have valuable use.

Conventional lease: Asset to be leased must have a valuable use; things having no usufruct

cannot be leased.

Penalty of Late Payment of rent :

Ijara: The bank or financial institution is not allowed to charge the customer an additional

amount in case of delays in payment of the rentals since it is considered Riba. Islamic

scholars have found a solution customer could be asked to pay a certain amount to charity.

Conventional lease: The bank charges a certain amount as a penalty for late payment.

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Continuation of lease rentals in case of total loss or theft of asset :

Ijara: If the leased asset is lost or stolen the Islamic bank does not charge the lease rental

because in the Islamic system, rent is consideration for usage of the leased asset, and if

the asset has been stolen or destroyed, the concept of rental becomes void.

Conventional lease: If the leased asset is stolen or destroyed, the conventional lease

company or bank continues charging the lease rent till the settlement of the Insurance

claim.

Insurance of the asset :

Ijara: Asset is insured through Takaful (Islamic product of insurance)

Conventional lease: In conventional lease the asset is insured through insurance companies

Financing for :

Ijara: It provides financing for tangible assets such as property, machinery, vehicles etc.

Conventional lease: It also provides financing for tangible assets.

Time period :

Ijara: Ijara is commonly used for long and medium term fixed asset financing, project

financing and for retail products such as homes and automobiles.

Conventional lease: Conventional leasing is also applicable to long and medium term assets

like vehicles, houses and land.

lessees commitment :

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Ijara: Basic rule for Ijara financing is that the leased asset be used productively and in ways

permitted by Islamic law.

Conventional lease: It does not require any such commitment.

Securitization of asset :

Ijara: The mu`jir can sell the asset to a third party, as he is the owner of the asset. And all

the rights and obligations will then be on part of the third party with regard to the purchased

part of the asset.

Conventional lease: Leased item cannot be sold to another person by the lessor but lessee

can do it after meeting the lease obligations.

Repossession of an asset :

Ijara: There can’t be two contracts in one contract. Since the purpose of “purchase bargain

option” is entirely different than the purpose of transferring the usufructs of an asset.

Inserting the clause of “purchase bargain option” serves the purpose of another tract. On the

one hand it allows the lessee to avail the usufructs of the leased asset and on the other hand it

also gives the right to the lessee to purchase the same leased asset, which is not allowed in

Shariah.

Conventional Lease: The lease must not contain an option to purchase the asset at a bargain

price.

Valuation upon completion of leased period :

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Conventional Lease: The asset must have secondary value after the expiry of the primary

lease term.

Ijara: A leased asset must have a value upon completion of the agreed leased period.

Premature termination of lease contract :

Ijara: If any term of the agreement is violated by lessee then the lessor has the right to

terminate the Ijara contract unilaterally. However, if no term is violated then the Ijara cannot

be terminated without mutual consent.

Conventional Lease: Lease can be terminated in the event that the lessee fails to meet his

obligations, notably the obligation to pay rent. The lessor must then instigate legal

proceedings involving the bringing of a claim, where equipment is concerned. Lessee can’t

terminate lease if contract does not contain cancellation clause.

Service charges :

Ijara: Islamic bank charge fee or service charge for the services they provide such as

underwriting, letters of credits, letters of warranties, remittances and correspondence services

etc.(It is pertinent to indicate in this regard that no charge can be taken against financial

guarantees per se. Only management or agency charges can be taken.)

Conventional lease: Conventional bank also take services charges from its customers.

Effect of increase in cost of the asset :

Ijara: Mu`jir pays the same rate as when mu`jir began the lease even if the cost of asset goes

up.

13

Conventional lease: Same is the case with conventional lease, however, some of the

financial institution increase rate of interest as it changes.

Upgrading :

Ijara: Ijara do not offer any up-gradation options but for such undertakings new Ijara

contracts have to be negotiated

Conventional lease: The lessor can upgrade the asset as new equipment becomes available

in the market after paying some additional cost.

Change in rental :

Ijara: The lessor cannot increase the rent unilaterally, and any agreement to this effect is

void.

Conventional lease: In conventional leasing the market interest rates are passed on to lessee

especially if these are upwards

Payment in advance :

Ijara: The rent or any part thereof may be payable in advance before the delivery of the asset

to the lessee, but the amount so collected by the lessor shall remain with him as 'on account'

payment and shall be adjusted towards the rent after its being due.

Conventional Lease: similar situation prevails in conventional leasing.

Compensation :

Ijara: If the leased asset has totally lost the function for which it was leased, and no repair is

possible, the lease shall terminate on the day on which such loss has been caused. However,

if the loss is caused by the misuse or by the negligence of the lessee, he will be liable to

compensate the lessor for the depreciated value of the asset as it was immediately before the

loss.

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Conventional Lease: The loss or any other damage to asset is lessee’s responsibility

Effect of premature termination :

Ijara: From the time of termination, the lessee is not obliged for rental payment

Conventional Lease: On termination of lease contract, all obligations that are still executor

on both sides are discharged.

Sale and lease back as one transaction :

Ijara: Sale and lease back are allowed, but only as two separate transactions.

Conventional Lease: This transaction involves the sale of the property by one company to

another which in turn leases the same property back to the original seller.

Determinant of rent :

Ijara: Rent is determined by market given forces. In practice, the market rate of interest is

used to determine the rental rate, although this is not explicitly stated.

Conventional Lease: Lessors consider market related forces while scheduling lease

payments. The market rate of interest provides a basis for lease determination.

Equivalent to a sale :

Ijara: Leasing differs from sale in the way that it does not transfer the corpus or ownership

of the property, which remains with the transferor.

Conventional Lease: A manufacturer or dealer doesn’t recognize any selling profit on

entering into an operating lease because it is not the equivalent of a sale.

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REFERENCES

www.ijaraloans.com

www.meezanbank.com

http://www.darululoomkhi.edu.pk

http://staff.uob.bh

M. Mansoor Khan and M. Ishaq Bhatti, Development in Islamic banking: a financial risk-

allocation approach, Journal of Strategic Studies

Mohamed Ariff (September 1988) ,Islamic Banking, Asian-Pacific Economic Literature, Vol. 2,

No. 2, 46-62

Dr. Zeinab Mohamed El-Gawady, Monash Business Review Volume 3 Issue 1 – April 2007

Llewellyn, D.T., “A Regulatory Regime for Conventional and Islamic Banks.” Regulation and

Supervision of Islamic Banks: Current Status and Prospective Developments Seminar, IRTI, The

High Institute for Banking and Financial Studies, April 24, 2001, Khartoum

Gafoor A.L.M (1996), Interest Free Commercial Banking, A S Noordeen, Kuala Lumpur.