Professional Documents
Culture Documents
Islamic Leasing Ijarah
Islamic Leasing Ijarah
WHAT IS ISLAMIC FINANCE?................................................................................................... 5 Shariah (Islamic Law)................................................................................................................. 6 Halal and Haram........................................................................................................................ 6 Takaful (Islamic Insurance)........................................................................................................ 6 Basic Principles of Islamic Finance............................................................................................ 7 Support Institutions for Islamic Finance................................................................................. 8 IJARAH (ISLAMIC LEASING)................................................................................................... 10 Introduction............................................................................................................................. 10 Terms and conditions of the Ijarah Contract.........................................................................12 Standard Features of Ijarah Contracts Offered by Financial Institutions.......................... 14 Example of Ijarah Financing Calculations............................................................................. 16 Comments on Differences and Similarities between Conventional Lease contracts and Ijarah.......................................................................................................17 Sale of the Leased Asset......................................................................................................... 18 Independence of Ownership................................................................................................. 18 Timing of Lease Payment........................................................................................ 18 Ijara of Non-existing Assets..................................................................................... 18 Period of Ijara........................................................................................................... 19 Determination of Rent............................................................................................. 19 Insurance and Maintenance Expenses................................................................... 19 Securitization of Assets Subject to Ijarah Contract............................................... 20 Legal Opinion Regarding Securitization................................................................ 20
Ijarah Transactional Issues................................................................................................. 20 AL-IJARAH THUMMA AL-BAI (AITAB).................................................................................. 21 Example of AITAB Financing Calculations............................................................................ 22 Documentation for AITAB...................................................................................................... 22 Comments on Differences Between Conventional Lease Contracts and AITAB.............. 23 Tax Benefits of AITAB............................................................................................................. 23 Legal Issues to Consider.......................................................................................................... 23 Examples of the Impact of Shariah Rulings in Four Countries .......................................... 24 Shariah Supervisory Board (DPS)........................................................................................... 27 Ijarah Transaction Examples................................................................................................... 28 Example of Car Leasing.......................................................................................................... 28 Ijarah Home Finance............................................................................................................... 30 Forward Ijarah (Real Estate Financing)................................................................................. 32 Islamic Leasing for Micro, Small, and Medium Enterprises (MSMEs)................................. 34 AAOFI....................................................................................................................................... 35 IFRS vs AAOIFI and the Malaysian Accountings Standards Board (MASB)........................ 35 Accounting under AAOIFI...................................................................................................... 36 Malaysian Accountings Standards Board (MASB)................................................................ 37 Accounting Treatment under AAOIFI................................................................................... 39 Classification and Recognition of Ijarah under AAOIFI20...................................... 39 FOUR MAIN SCHOOLS OF ISLAMIC THOUGHT: HANAFI/JAFARI, MALIKI, SHAFIE, AND HANBALI............................................................................................ 41 Sunni and Shia........................................................................................................................ 42 Ijarah Under the Four Schools................................................................................................ 42 Dispute Resolution.................................................................................................................. 43
PROJECT FINANCING USING IJARAH.................................................................................... 43 Ijarah with Istisna.................................................................................................................... 44 Risks to Avoid in Project Financing........................................................................................ 44 Project Financing Examples.................................................................................................... 45 IJARAH SUKUK........................................................................................................................ 46 Sukuk........................................................................................................................................ 46 Sukuk Trust Certificates............................................................................................. 47 Disadvantages of the Ijarah Sukuk Structure....................................................................... 48 Sukuk Trading Options .......................................................................................................... 48 Ijara and Project Finance........................................................................................... 49 Sample Transaction Structure Leasing Assets..................................................... 49 STANDARD & POORS RATINGS OF IJARAH SUKUK........................................................... 52 Ijarah Sukuk Ratings.................................................................................................. 52 Criteria Guidelines...................................................................................................... 54 ISLAMIC FINANCIAL SERVICES BOARD IFSB 9.0.................................................................. 57 Guiding Principles on Conduct of Business for Institutions Offering Islamic Financial Services........................................................................................................ 57 ISLAMIC FINANCIAL GLOSSARY........................................................................................... 58 References............................................................................................................................. 61 General Bibliography...................................................................................................... 63
Unlike the segregation of duties and responsibilities that exists in the western, non-Muslim world, in the Muslim world there is no division between religion, business, the family, and the state. The values, morals, norms, behaviors, and ethics applicable in one situation permeate all the others, and this carries to the issues of finance. This construct binding the parts to create the whole is referred to as Shariah, which can be translated to mean the way, referring to the way Muslims should live. The way is well represented below in diagrammatic form in terms of its impact on financial issues. Source: Islamic Finance and Global Financial Stability, 20102
Overarching Principles
Towards achieving the objectives of Shariah (Maqasid al-Shariah) Protection of religion, life, lineage, intellect and wealth High ethical valuesjustice, fairness, trust, honesty and integrity More equitable distributor of wealth
Embedded Governance
Source: Islamic Finance and Global Financial Stability, 20101
Sanctity of contracts.
Islamic finance upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard.
Risk sharing.
Because interest is prohibited, suppliers of funds become investors, rather than creditors.
Social justice.
Any transaction leading to injustice or exploitation is prohibited.
Sovereign Ratings and Credit Ratings assess the likelihood that an entity will repay its debt obligations in a timely manner.
Shariah Quality Ratings assess the level of compliance with the principles of Shariah.
Corporate Governance Ratings are based on an entitys practices, and assess the demarcation of rights and responsibilities among different stakeholders as well as their compliance with prevailing rules and procedures for making decisions.
A Shariah Quality Rating differs from a Credit Rating in that the latter is an evaluation of the solvency of a financial institution and its capability and willingness to repay its obligations. A Shariah Quality Rating, on the other hand, is not related to the solvency or financial capability of the institution or to the credit quality of its securities or financial products. Rather, it represents an independent opinion about the Shariah Quality of a financial institution or of a security or financial product.
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As of November 2009, the 193 members of the IFSB include 49 regulatory and supervisory authorities as well as the International Monetary Fund, World Bank, Bank for International Settlements, Islamic Development Bank, Asian Development Bank, the Islamic Corporation for the Development of the Private Sector, Saudi Arabia, and 138 market players and professional firms operating in 39 jurisdictions. Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act 2002, which gives the IFSB the immunities and privileges that are usually granted to international organizations and diplomatic missions.
Shariah Board
One distinct feature of the modern Islamic banking industry is the role of the Shariah board, which forms an integral part of an Islamic financial institution. A Shariah board monitors the workings of the Islamic financial institution and has to clear every new transaction from a Shariah standpoint. These boards include some of the most respected contemporary scholars of Shariah, and the opinions of the boards are expressed in the form of fatwas. The International Association of Islamic Bankers, an independent body, supervises the workings of individual Shariah boards, while the associations Supreme Religious Board studies the fatwas of the Shariah boards of member banks to determine whether they conform with Shariah. Shariah law is open to interpretation, and Shariah boards often have divergent views on key Shariah issues. In this regard, there is no practical guide as to what constitutes an acceptable Islamic financial instrument. A document or structure may be accepted by one Shariah board but rejected by a different Shariah board.
Islamic Finance assets have grown to in excess of 800 bn The Sukuk bond market has grown to $70 bn Total wealth of HNWI1 in Middla East is about $1.4 trillion Growth in total wealth tracks increase in oil price
1 High Net-Worth Individuals
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In the Ijarah Aina contract, there is no option for the lessee to acquire the asset at the end of the lease. However, there is another type of Ijarah contract, referred to as Al-Ijarah Thumma Al-Bai (AITAB), wherein the lessee can acquire the asset at the end of the lease. This second type is addressed in the second part of this paper. In Ijarah Aina (hereafter, Ijarah), the lessor rents the assets to benefit from their use without having ownership transferred to the lessor. The legal term for this arrangement in English is usufruct, and the price for this use is referred to as rent. There is no element of interest in the transaction, since ownership of the asset always remains with the lessor, and there is no option for the lessee to gain title to the asset.
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Since title (ownership) to the asset is not being transferred, there is no sale of a tangible asset, only the sale of an intangible asset, namely the right to its use for a specific period of time. This right to use or usufruct is known as manfaah in Arabic. Unlike the conventional lease, an Ijarah is a contract whereby a financial institution, using Islamic principles, purchases and then leases the asset required by the client in exchange for a rental fee that is not related to interest. Under the contract, the lessor owns the property and may have the right to renegotiate the lease payments at various intervals agreed to in advance in the contract with the lessee, thereby ensuring that the rental payments are equal to the residual balance value of the asset as well as the opportunity cost of the lessor, that is, his forgoing the use of the assets. The risks of ownership of the asset stay with the lessor. In this structure, Ijarahs legal characteristics are similar to those of a sale-and-purchase transaction, with the exception that the physical asset is not transferred and there is a specific time limit on the use of the asset. It should be noted that the source of funds used by the financial institution to finance Ijarah transactions must be halal. Ijarah can be contracted on an asset that is yet to be constructed or manufactured, as long as it is fully described in the contract, provided that the lessor should normally be able to acquire, construct, manufacture, or buy the asset being leased by the time set for its delivery to the lessee.
Types of Ijarah
Islamic financial institutions use the lease for the usufruct as an instrument of financing. They purchase the assets and rent them out to customers in return for rental. They use two models, namely Ijarah and Al-Ijarah Muntahiya Bittamleek.
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Normal steps in the transaction of an Ijarah contract are as follows: 1. The client of the financial institution approaches a seller or vendor of an asset, and obtains price and product details. 2. The client then approaches the financial institution with the asset price and details and negotiates with the institution to use the Ijarah contract. The client promises the institution to execute the Ijarah contract, which contains the terms that will apply after the institution buys the asset. 3. The financial institution buys the asset from the seller based on the information provided by the seller to the client. The institution pays cash, and ownership of the asset transfers to it. 4. The seller delivers the asset to the client of the financial institution according to the terms and conditions agreed to by the institution and submits proof of delivery, with the acceptance of the client, to the institution. 5. The client pays the agreed rental, based on the payment plan in the Ijarah contract, to the financial institution. 6. Upon expiration of the time limit specified in the Ijarah contract, the client returns the asset to the financial institution. The legality of this type of combined structure, under Islamic Shariah law as interpreted by fatwas, needs to be carefully considered depending upon the jurisdiction in which the contract is developed and entered into.
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Benefits (Usufruct)
1. A value to the lessee for the benefits of using the asset can be established. 2. The lessor must have the legal right to use and lease the asset. 3. The use of the asset and the asset itself must be permissible under Islamic law. 4. The way that the lessor of the asset will use the asset must be known. 5. The duration of the lease must be clearly defined. 6. It is prohibited for benefit to be derived from the consumption of any material part of the asset; benefit may be derived only from its use.
2. Different amounts of rent or lease payments can be set for different parts of the rental agreement. 3. The lease period begins upon delivery of the asset to the lessor. Whether the lessor is using the asset or not is irrelevant. 4. It is prohibited for the lessor to unilaterally increase the rent or lease payment.
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General Terms
The Ijarah leasing contract transfers the benefits or use of an asset acquired by the financial institution (FI) for the use of the lessee at an agreed price or rental amount payable for an agreed period of time (lease period). The total amount of the lease or rental paid over the life of the contract includes the original cost of the asset to the financial institution (including all related costs) and the institutions profit margin. Below is a diagram that shows the standard Ijarah transaction.
Assets Leased to Customer Title does not pass at end of Lease Term
Vendor
Customer (Lessee)
Ijarah Installments
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Acceptable Lessees
1. Individuals 2. Sole proprietorships 3. Corporations 4. Government entities 5. Clubs, societies, and associations
Termination
If the terms of the contract are not met by the lessee, the lessor has the right to unilaterally terminate the contract. However, if there are no defaults, the lessor cannot terminate the lease without mutual agreement.
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Calculations:
1. Profit (P) = Purchase price x profit rate x period of financing $1,000,000 x 0.10 x 5 = $500,000 2. Total lease rental = Purchase price plus the profit
Assumptions:
1. The financial institution determines that it wants to have a profit rate (PR) of 10 percent. 2. The purchase price (PP), including all costs, is $1,000,000 (cost borne by the financial institution). 3. The term (T) of the lease is 5 years.
$1,000,000 + $500,000 = $1,500,000 3. Monthly rental = Total lease rental divided by the term (in months) $1,500,000/(5 x 12 months) = $25,000 per month
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Comments on Differences and Similarities Between Conventional Lease Contracts and Ijarah
Differences
Cost bearing In Ijarah, the lessor is required to bear all the costs incurred in the process of purchasing the asset, although these costs may be included in the calculation of the rental amount payable by the lessee. These include items such as registration charges, import expenses, and customs duties. Loss responsibilityThe lessor is fully responsible for losses that are beyond the control of the lessee, while the lessee is only responsible for losses to the asset from misuse or negligence. Late payments The lessor may charge late-payment penalties, but these may only be amounts that cover the lessors costs due to the late payment. The lessor cannot benefit from the late payments. Insurance The costs of insuring the leased asset are borne by the lessor, and the insurance used is Islamic insurance or Takaful.
Similarity
The rental or lease payments under the lease start when the lessee takes possession of the asset being leased, not from the date the lessor purchases the asset for the lessee. The lessee is not liable for the rental payments during the period of the assets delayed delivery to the lessee.
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Independence of Ownership
An asset whose ownership is shared by many people can be leased, either individually by each owner leasing his or her owned share of the asset or together by all the owners in one contract and under the same conditions. Persons who share the ownership of a leased asset can dispose of their property, for example by selling it to new owners, individually or collectively, as they may desire. In other words, the owner of a share of an asset can sell that share, or part of it, to a new person independently of the other owners. This characteristic of Ijarah also facilitates the securitization of leased assets, and allows benefitting from the market conditions with regard to the negotiability of the bonds.
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Period of Ijara
An Ijarah contract is not restricted to the short, medium, or long term. It can be set to any term, as long as the asset which is its subject remains in existence and renders its usufruct for the duration of the contract. For example, assets for which a suitable amortization schedule could be made may be given on lease for a period of one year, renewable permanently, because the assets are replenished through the amortization funds. Similarly, for land, the Ijarah may be for one year renewable on a permanent basis.
Determination of Rent
In an Ijarah contract, the rent must be made known. There are many ways to put a known rent into an Ijarah contract. For instance, actual rent payable by the lessee may increase, decrease, or remain constant as long as the formula for increments, or subtractions, is known either at the beginning of the renewal period for which the increase or decrease applies or at the time of contract. The rent may also be determined for the first period. For each subsequent period, rent may be related to a variable that will be known before the beginning of the renewal period, such as a periodically announced price index, rate of return on capital, or any other variable.
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IjarahTransactional Issues
The following is a point-form summary of Ijarah transactional issues: Collateral: The financial institution may accept land, buildings, or any other property as collateral. Guarantees that can be taken to support the transaction include both personal or individual guarantees and corporate guarantees. The margin may be up to 100% of the current price of an asset or the valuation price of an asset.
Guarantees:
Margin of financing:
Prepayments in Ijarah
Security deposit: Advance rental: 1 to 3 monthly installments are the norm. First rental of the lease. Islamic banks may use the monthly lease rental to offset against the final rental of the lease.
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1. Total lease rental = amount of financing + profit margin. 2. Total lease rental is determined using available methods of calculation, such as the constant rate of return (CRR) and Rule of 78s (sum of digits). Use of asset: Asset ownership: Takaful coverage: Assets leased may not be used for activities that contravene Shariah. Ownership remains with the financial institution. To reduce the burden if losses occur. Suitable coverage is a comprehensive All Risks type.
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7. When the time limit in the Ijarah contract expires, the financial institution enters into the al-Bai (sale) contract with the client, whereupon the institution transfers ownership of the asset to the client as either a gift or a sale, whichever are the terms of the original agreement. In some cases, the final payment of the Ijarah contract may be taken as the agreed sale price of the asset under the al-Bai contract. The essential terms and conditions of the AITAB contract are the same as those of the Al-Ijarah contract, simply an agreement for sale and purchase as added (al-Bai).
Lesson Learned
The difference between the profit calculation made under an AITAB contract and the profit calculation under a conventional lease (as described in Section III, Part 1, of the base toolkitLeasing Mathematics) is this: The time value of money does not apply. There is no return on money in Islam, therefore it is impossible to apply the principles of the time value of money, including Net Present Value, to the profit calculation under an AITAB contract. Since the earning of interest (riba) is not allowed, the use of Internal Rate of Return to express yield does not exist in an Ijarah transaction.
Assumptions:
The financial institution determines that it wants to have a profit rate (PR) of 10 percent. The purchase price (PP) to the financial institution, with all costs, is $1,000,000. The term (T) of the lease is 5 years.
Calculations:
Profit (P) = Purchase price x profit rate x period of financing $1,000,000 x 0.10 x 5 = $500,000 Total lease rental = Purchase price + profit $1,000,000 + 500,000 = $1,500,000 Monthly rental = Total lease rental divided by the term $1,500,000/(5 x 12 months) = $25,000 per month Sales price = amount agreed, as zero (i.e. gifted)or equal to last months lease rental, or such other amount as agreed.
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Calculation of Profit
Charges Related to the Purchase of the Leased Asset Late Payments Acceptance Letter (Aquad) Asset Being Financed Insurance Warranties (Expressed or Implied) Cancellation
A fixed charge must be specified in the contract. Interest may be applied (1% per month, for example) to late payments. Lessee must enter into an acceptance letter. Must be Shariah compliant. Must be insured using Islamic Takaful insurance. May be transferred from lessor to lessee. Lease can be cancelled if equipment is lost or destroyed. Same. Shariah compliance not necessary. Shariah compliance not necessary. Always for the benefit of the lessee. Lease is non-cancellable.
Lessons Learned Use of Acceptance Letter In both AITAB and conventional lease transactions, use Acceptance Letters. Under both types of transactions there is no obligation on the part of the lessee until an Acceptance Letter is executed by the lessee. Therefore, in this particular case, the principal of arms length does apply. CancellationUnder AITAB, if the equipment is
lost or destroyed the lease may be cancelled, regardless of whether or not the lessor has property or casualty insurance. When the equipment is lost or destroyed, the lessee is no longer able to generate usufruct from using the equipment, and the lessor must rely on Takaful insurance for compensation. Under conventional leasing in the West, leases are non-cancellable. As we have seen (in Part III of the Base Toolkit), the lessee is responsible for obtaining property and casualty insurance and naming the lessor as a loss payee.
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A case in point is that the contractual structuring and the wording of the contracts must be such as to comply with Shariah law and with associated fatwas in the country of jurisdiction and operation.
Iran
Products that can be offered by banks have been defined in regulations issued by the Council of Ministers under the Usury Free Banking Act 1983. The Council of Guardians performs the function of a central Shariah board and provides guidelines to the central bank and commercial banks. Commercial banks do not have a Shariah board for guidance and/or supervision in their day-to-day operations.
Malaysia
As part of the effort to streamline and harmonize the Shariah interpretations among banks and takaful companies, Bank Negara Malaysia (BNM) established the National Shariah Advisory Council on Islamic Banking and Takaful (NSAC) on May 1, 1997, as the highest Shariah authority on Islamic banking and takaful in Malaysia. Among NSACs primary objectives are these:
To act as the sole authoritative body to advise BNM on
and schemes submitted by banking institutions and takaful companies. The Shariah Advisory Council (SAC)14 of BNM was established on May 1, 1997, as the authority for ascertaining Islamic law for the purposes of Islamic banking business, takaful business, Islamic financial business, Islamic development financial business, or any other business. It is based on Shariah principles and is supervised and regulated by Bank Negara Malaysia. In Malaysia, the Islamic banks are advised and provided guidelines by SAC. As the reference body and advisor to Bank
13 14 Please see end notes at the end of this focused toolkit Please see end notes at the end of this focused toolkit
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Negara Malaysia on Shariah matters, SAC is also responsible for validating all Islamic banking and takaful products to ensure their compatibility with the Shariah principles. In addition, it advises BNM on the Shariah aspects of the operations of these institutions, as well as on their products and services. The Malaysian Judiciary and the Regional Center for Arbitration Kuala Lumpur15 uses SAC as the reference point in the event of disputes involving Shariah issues on Islamic banking and finance. The Central Bank of Malaysia Act of 1958 was amended in 2003 to enhance the role and functions of SAC, which was accorded the status of a sole authoritative body on Shariah matters pertaining to Islamic banking, takaful, and Islamic finance. To preserve its independence, members of SAC are not allowed to participate in any Shariah committee of any financial institution. Shariah committees are formed internally by Islamic banking institutions. A Shariah committee plays a complementary role
15 Please see end notes at the end of this focused toolkit
to that of SAC. Its duty is to advise the banking institution on the Shariah compliance of its banking operations; however, the Shariah Advisory Council is the ultimate arbiter. The Guidelines on the Governance of Shariah Committees for Islamic Financial Institutions were issued by BNM in December 2004. These aimed at achieving uniformity of Shariah decisions, in addition to creating and expanding the pool of competent Shariah personnel in Islamic banking and takaful. The guidelines set out the rules, regulations, and procedures for establishing a Shariah committee and the role and scope of duties and responsibilities of the committee, as well as the relationship and working arrangement between the committee and SAC. The requirement to establish the committee covers all Islamic banks and all banking institutions that participate in Islamic banking schemes, takaful operators, and development financial institutions that provide Islamic banking facilities. Duties and responsibilities of a Shariah committee are as follows:
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tion
To endorse Shariah compliance manuals To assist related parties on Shariah matters for advice, upon
request
To advise the Islamic financial institution to consult it on
In particular, the committee prepares written Shariah opinions in the circumstances (1) where the Islamic financial institution makes reference to SAC for advice; or (2) where the Islamic financial institution submits applications to Bank Negara Malaysia for new product approval in accordance with guidelines on product approval issued by BankNegara Malaysia. The Shariah committee is also expected to assist SAC on any matters referred by the Islamic financial institution. Upon
any Shariah matters that have not already been resolved or endorsed by SAC, and
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obtaining any advice from SAC, the Shariah committee shall ensure that all of SACs decisions are properly implemented by the Islamic financial institution. With regard to the reporting structure, the Shariah committee reports functionally to the board of directors of the institution. This reporting structure reflects the status of the Shariah committee as an body that is independent of the Islamic financial institution.
Bahrain
The Central Bank of Bahrain requires all banks to establish an independent Shariah Supervision Committee complying with AAOIFIs governance standards for Islamic financial institutions. All banks must comply with all accounting standards issued by AAOIFI as well as the Shariah pronouncements issued by the Shariah Board of AAOIFI. The National Shariah Board of the Central Bank of Bahrain serves and verifies the Shariah compliance of its own products only. There is no restriction that the members of the National Shariah Board must serve any financial institution, and no limitation requiring them to serve only one institution. Each bank must have a separate Shariah review function to verify compliance, which may be located in the banks internal audit function.
Indonesia
In Indonesia, the National Shariah Board formed by the Indonesian Council of Ulemas in 1999, is an independent body duly recognized by the Bank of Indonesia and is responsible for issuing Shariah rulings on the products of Islamic banks. The Bank of Indonesia issues regulations for Islamic banking products based on a fatwa issued by National Shariah Board. The National Sharia Council (DSN) possess the power of positive law. In 2005, the Bank of Indonesia also issued a regulation on Standards of Contract, which is periodically evaluated to stay relevant with the Islamic banking industry. So far, the regulations (released in 2006) are concerned with Ijarah, Istisnaa, and Salam contracts. Apart from coordinating with the Bank of Indonesia, DSN also takes a role in the Shariah Supervisory Board selection process.
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the permissibility of certain modes and practices, like bai al dain (debt trading), bai al inah, tawatruq, hibah on current accounts, and commodity murabaha.
Example of Car Leasing Shariah-Compliant Car Financing Based on the Principles of Ijarah Thuman Al-Bai (AITAB)17
Margin of Finance Up to 90% Financing Period Up to 9 years
New passenger car, 4WD, MPV and SUV (CBU and CKD units): Maximum of 90% of sellers invoice Maximum 108 months Second-hand passenger car, 4WD, MPV and SUV: Maximum of 85% of sellers invoice Maximum 108 months Unregistered reconditioned (imported) vehicle: Maximum of 90% of sellers invoice Maximum 108 months *All terms and conditions are subject to the financing guidelines by Bank Negara Malaysia and Maybank. Malaysia
Benefits
Based on the principles of the Ijarah contract (leasing/
online
Renewal of road tax and motor insurance
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Required documents
Photocopy of national ID Photocopy of driving license Copies of last 2 years income tax returns (J form or EA) Copies of latest 2 months salary slips Confirmation of Letter of Employment (latest) Last 3 months bank statements (if self-employed) Photocopy of sellers national ID and driving license
Repayments
Payments must be made for the complete installment amount. Partial payments or incomplete installment payments are not be accepted.
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landscape, sublet, or basically utilize the property for any legal purpose that it is zoned for. The only exception may be if you engage in an activity that could harm the value of the property, such as demolishing a garage without rebuilding it. For all practical purposes, your role is the same as that of a homeowner, because once your have fulfilled your obligations under the lease or promise to purchase, you become the owner of the property.
Tenant or Homeowner?
In an Ijarah transaction, you are technically a tenant. You sign a lease that obligates you to a rent payment over a period of time. However, unlike in a typical rental property lease, you are responsible for all the maintenance of the property and you have all the rights and duties of a homeowner. You can sell the property any time you wish, you can remodel, decorate,
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Terms of Financing:
Type of property: Freehold. Cash contribution: Minimum of 40% to 50% of total
project cost.
Qualified Assets:
Residential, Office Buildings & Villa Complexes Documentary Requirements: 1. Copy of valid passport. 2. Full details of personal financial information supported with documents. 3. Personal bank statements for the last six months. 4. Completed finance application form. 5. Copy of site plan. 6. Copy of title deed. 7. Comprehensive feasibility study prepared by reputed consultant. 8. Project specification and approved drawings. 9. Copies of the consultant / contractor agreements. 10. Copy of approval of electricity connection date. 11. Payment of the applicable fees for the projects technical assessment by the banks in-house engineers.
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Terms of Financing:
Type of property: Freehold. Advance rent: Minimum of 40% to 50% of the
purchase price.
Financing tenor: Up to 8 years. Age of property: Should not exceed 20 years, includ-
villa complexes.
21 20 Please see end notes at the end of this focused toolkit 22 Please see end notes at the end of this focused toolkit Please see end notes at the end of this focused toolkit
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AAOFI
Although AAOIFI standards are widely followed (without obligation) across many countries, they have been officially adopted only by Bahrain, the Dubai International Financial Centre (DIFC) in the UAE, Jordan, Lebanon, Qatar, Sudan, and Syria.
AAOIFI FAS 8 also embodies a classification of the instrument into two categories. If the contract refers to a promise that the legal title would ultimately pass on to the lessee (mustajir) at its expiration, it is referred to as Ijarah Muntahia Bittamleek (IMB) or ITAB. In IMB/ITAB, which is loosely considered as equivalent to the conventional finance lease, at the expiration of the term the passing of the legal title to the lessee could occur either 1. on transfer of the payment of the balance rentals 2. as a gift 3. on payment of a token or for an amount specified in the contract, or 4. on the gradual transfer of the title. Following AAOIFIs Juristic Rules on the fulfillment of a promise, for the transfer to be effective a contract distinct from the Ijarah contract should be executed. The lessee has an option, which he may or may not exercise. Thus IMB/AITAB would have the characteristics or the substance of a conventional lease only if the lessee exercises the option. Otherwise, IMB/ITAB for all intents and purposes is an operating lease. Hence in both legal form and concept IMB/AITAB and a conventional finance lease are not identical. The key distinction between the IMB/AITAB and the conventional finance lease is that in the Islamic version the lessor undertakes the full ownership risks of the corpus of the leased asset. In the Islamic version, the risks remain with the lessor (mujir). The passing of the risk to the lessee is a prerequisite for a lease to be classified as a finance lease under International Accounting Standards. One might view it this way: In Ijarah, the risk follows the legal title unless damage is caused by the negligence or misconduct of the lessor. Since IAS looks at substance over form for accounting purposes, when passing the risks and rewards of the asset to the lessee the asset is recorded in the books of the lessee coupled with the right to claim depreciation. Major repairs, maintenance, and insurance remain on the account of the lessor in an Ijarah contract, whereas these costs are passed on to the lessee in a conventional lease.
International Financial Reporting Standards (IFRS) vs AAOIFI and the Malaysian Accountings Standards Board (MASB)
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Depreciation Allowance
In certain countries, like Sri Lanka, though the local tax statutes do not explicitly allow the lessor to claim capital allowances under operating and finance leases, nevertheless under the presumption that the leased assets are deemed to be used in the lessors business of leasing, the lessor enjoys the right to claim capital allowances. In these countries, the same status quo ought to prevail for Ijarah and IMB regarding capital allowances. In a scenario involving a cross-border Ijara, the lessor (mujir) should also be cautious about possibily creating a permanent establishment in the lessees (mustajirs) jurisdiction.
Source: Islamic Finance TodayPioneer Publications (Pvt) Ltd 23
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If the lessee can cancel the lease, the lessees losses associated
The journal entries to record the lease in the lessee book for the period would be as follows:
of the asset;
Where the present value of the minimum lease payments
(excluding execution costs) is greater than or equal to substantially all of the fair value of the asset; and
Where the leased assets are not of a specialized nature such
that only the lessee can use them without major modification being made. FRS 117 further lists indicators of situations which individually or in combination could lead to a lease being classified as a finance lease, as follows:
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The journal entries to record the lease in the lessor book for the period would be as follows:
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The journal entries to record the lease in the lessor book in the AAOIFI for the period would be as follows: DR Equipment CR Cash (Cash purchase of equipment for Ijarah financing) DR Ijarah Financing Asset CR Equipment (Provides Ijarah financing to lessee) DR Cash CR Profit & Loss (Repayment received from lessee and income recognition) DR Profit & Loss CR Depreciation (Depreciation cost of Ijarah financing asset)
Under the AAOIFI, in the case of initial direct cost, two alternative treatments were proposed for the Islamic banks share of the initial direct cost (as a lessor or a lessee): 1. Charging these costs as a period expense to the period in which they occur, or 2. Recording these costs as deferred costs to be allocated (equally) over the lease term. Alternative (2) has been chosen, because it is consistent with the concept of matching revenues and expenses, which is stated in the Statement of Concepts. However, if the initial direct costs were immaterial, the entire amount would be charged to the period in which it occurred. This is consistent with the materiality concept. Unlike the materiality concept in conventional accounting, the materiality concept in Islamic accounting is not subject to any minimum amount that can materially affect the company transaction. Materiality in Islamic accounting must disclose even small or insignificant amounts received or related to non-halal income or expenditure.
The Findings
The differences in the accounting treatment of Ijarah between the Financial Reporting Standard (FRS) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an interesting topic worth discussing. FRS 117 clarifies that the financial statements of lessees, in the initial recognition, shall recognize finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. Any initial direct cost to the lessee is added to the amount recognized as an asset. A finance lease gives rise to depreciation expenses for depreciable assets as well as finance expense for each accounting period. By contrast, the financial statements of lessors, during the initial recognition shall recognize assets held under a finance lease in their balance sheets and present them as receivables at an amount equal to the net investment in the lease. Costs incurred by manufacturers or dealers in connection with negotiating and arranging leases shall be recognized as expenses when the selling profit is recognized.
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FOUR MAIN SCHOOLS OF ISLAMIC THOUGHT25 Hanafi/Jafari , Maliki, Shafie, and Hanbali
There are four main schools in classical Sunni Islamic legal thought: Hanafi/Jafari, Maliki, Shafie, and Hanbali. The schools, named after their main contributing thinkers, were developed largely in order to provide rigor, predictability, and hierarchical structure to Islamic lawmaking (or fiqh) at an early point in the Islamic empires history. While there are few major theological or ideological differences remaining between the four schools today, they continue to hold geographic
25 Please see end notes at the end of this focused toolkit
dominance in particular parts of the Muslim world and do create subtle differences in codified texts, marriage and family law, and some criminal punishments. The main school of thought in the Shia school is the Jafari school. Legal doctrinal differences between the Jafari and Hanafi schools are mostly of the same order as those between the Hanafi school and other Sunni schools, with the chief exception being constitutional and inheritance law. The Hanafi school prevails in Turkey, Syria, Lebanon, Iraq, Jordan, Egypt, and the Sudan. Maliki has governed the Muslim populations of North, West, and Central Africa. Shafie has prevailed in East Africa, Malaysia, and the southern part of the Arabian Peninsula.
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son-in-law of the Prophet), a civil war erupted. That conflict was ultimately settled by the assassination of Ali, with the consequence that Islam fractured into two components: Sunni and Shia (or Shii). The latter were the followers of Ali.
Maliki SchoolThe Maliki school of fiqh defines Ijarah as a contract that relates to permissible usufructs for a particular period and a particular consideration not arising from usufruct. Shafie SchoolThe Shafie school of fiqh defines Ijarah as
a contract for a defined intended usufruct liable to utilization and accessibility for a particular recompense.
Hanbali SchoolThe Hanbali school of fiqh defines Ijarah as a contract for a particular permissible usufruct that is taken gradually for a particular period and a particular consideration.
Hanbali is the basis for the codified law of the Kingdom of Saudi Arabia. Although there are various definitions of Ijarah given by the scholars of Islamic jurisprudence via their various schools of thought, it is agreed among them that Ijarah is a contract on the use of benefits or services in return for compensation. The definition of Ijarah according to AAOIFI (FAS 8) is the ownership of the right to the benefit of using an asset in return for consideration. While in Financial Reporting Standard 117 (FRS 117), a lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. In summarizing all the definitions, Ijarah may be regarded as a 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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Dispute Resolution
Islamic finance cases are adjudicated by the state courts of various countries, thus falling under the purview of national law. There are countries where Shariah is (a) a supreme source of law, as for example in Saudi Arabia, Iran, Sudan, and Pakistan, (b) one of the sources of law, as in Malaysia, Kuwait, and UAE, or (c) not part of the legal system. The issues arising in relation to Islamic dispute resolution vary depending on the category to which the country belongs. The majority of legal systems are not based first and foremost on Shariah and, as a result, courts will apply Shariah law in the context of its interplay with the national laws. This raises issues both in relation to the status of Shariah law within the contract and in the court adjudication process and also in relation to the enforcement of overseas judgments. In the Middle East, many Islamic finance transactions name the courts of England and Wales as the applicable forum and the law of England and Wales as the governing law. The English courts have addressed the extent of applicability of Shariah law to certain contracts. In cases where parties are considering choosing a specific national law, the legal system of which includes Shariah law, they must ensure that there is a reciprocal enforcement treaty in place between both countries. However, in certain circumstances, even when such arrangements are in place, a successful enforcement may be impossible. For example, if the decision of a foreign court involves payment of interest, such a decision will not be enforced in Saudi Arabia, since it contravenes the basic precepts of Shariah. Thus, submitting an Islamic finance matter to a state court of any jurisdiction may evince various challenging issues, include challenges in enforcement, adjudication in accordance with Shariah law, lack of competent training of judges, and conflicts among laws.26
26
27
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the construction part can be financed through an istisna (see the next section), and once the asset/project is finished, the bank can lease it or sell it on deferred payment terms to the company that will operate it. This is similar to the back-to-back istisna, but with the important difference that the buyer can make his final payments after the asset has been constructed and delivered to him. As an example, this structure was used in a deal for $77 million in project financing for the Bakri Group to build two chemical tankers that were to be chartered by Saudi Basic Industries Corporation. The first tranche of the financing consisted of disbursements under an Istisna, and this was replaced by an AITAB on delivery of the tankers.
and it can also be structured as a securitization. Banks often use back-to-back transactions:
Under the first Istisna, a customer agrees to purchase an
asset from the Islamic bank upon completion. The purchaser can pay the financial institution in advance, at completion, or over time based on a set of predetermined completion milestones.
Under the second Istisna (the hire to produce contract),
the Islamic financial institution agrees to pay the manufacturer to build the asset in question. As an intermediary, the Islamic financial institution accepts the manufacturers performance risk and the buyers payment risk.
Back-to-back with the Istisna with the manufacturer (con-
tractor), the bank could also use an Ijarah (lease) contract with the buyer, if he wishes the buyer to pay in installments after delivery of the assets.
Risk of Loss/Destruction
Taking out property insurance may be difficult for Islamic financial institutions, depending on the specific interpretation of the relevant Shariah court. Still, in order to classify as an Ijara, the risks of loss or destruction have to stay with the bank, unless when caused by the lessee. If the bank can take out insurance, this should be paid (in advance) by the lessee. The risk of loss or destruction has to be carefully evaluated. It should also be noted that under western leases, the lessee has to continue paying even if the assets have been destroyed; under Islamic finance, this is not possible. As in Islamic finance, the lessee cannot be asked to continue paying under the lease if the property has been destroyed or otherwise loses its economic value. Ways to deal with such problems have to be built into the contract with the lessee. Normally, the way this is done is by requiring the lessee to purchase the leased property (with all obligations, liabilities and insurance policies attached to the property). However, the Shariah principle is that the purchase price should be the fair market value, and this value for a destroyed property is not very high. So in practice, this remains a very difficult issue to deal with. Normally, the Ijarah contract
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requires detailed undertakings by the lessee that it will use the leased goods for normal business use, that it will ensure that the use of the goods will not vitiate the insurance policy, that it will not sublease or hire out the goods, that only properly trained personnel will use the goods, that the goods will be properly operated and maintained, and that it will return the goods at the end of the lease in good condition, fair wear and tear excepted.
At least, it should limit its own liability by the indemnities received from the seller. Also, in the Ijarah contract, the lessee should agree to indemnify the lessor for all costs, liabilities, and obligations linked to the goods, whether or not due to its fault.
Timing of Payments
Like most western leases, payment under the Ijarah can only start once the good (or at least, an economically useful part thereof) is effectively transferred to the lessee.
Legal Liability
As the owner and lessor of the goods, the financial institution is exposed to certain legal risks. The financial institution should include in the contract a disclaimer, to the extent possible.
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Ijarah Sukuk
What is Sukuk?29
Sukuk30 is the plural of sakk, which means legal instrument, deed, check, so sukuk is the Arabic name for a financial certificate, though it can also be understood as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam, hence sukuk are securities that comply with Shariah and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and nontradability in the secondary markets. This concept was used during the medieval period of Islam, when it was related to the recording of financial and other obligations. The word sakuk, with this same meaning, was also used in western Europe during the period, and later evolved to what is presently known by the English words cheque and check. In modern Islamic financial terms, sukuk is defined as an Islamic or Shariah-compliant bond. Another Arabic term for sukuk, when translated, is Islamic investment certificate.
29 30 Please see end notes at the end of this focused toolkit Please see end notes at the end of this focused toolkit
According to AAOIFI Standard No. 17, investment sukuk are certificates of equal value representing, after closing subscription, receipt of the value of the certificates and put to use as planned. They therefore represent common shares and rights in the underlying assets or their usufructs and services5. AAOIFI has classified sukuk into 14 types, depending on the contracts used. Among them, Sukuk Al-Ijarah (lease-based certificate) is the most widely used type of sukuk.
31 32
Please see end notes at the end of this focused toolkit Please see end notes at the end of this focused toolkit
Sale undertaking
Subscription proceeds
Subscription proceeds
Originator
Title to assets
Issuer
Investors
Originator aslessee
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The MGS issue was rated by Moodys and by Standard and Poors33. and the Sukuks were listed on the Luxembourg Stock Exchange. The lease payments are determined based on a spread over LIBOR. Islamic scholars are comfortable with the use of LIBOR as a lease pricing reference mechanism but not as a means of calculating interest. A floating lease price has been considered acceptable by Islamic scholars, since landlords and tenants (in the traditional sense) can agree on raising or lowering lease payments on land over the period of a tenancy. Ijara Sukuks are freely tradable. As trading in debt above or below par would obviously breach the Islamic finance principle of not charging interest and the ability to trade freely in capital market instruments is critical to investors, there is a potential further problem. However, since the Ijarah Sukuks represent an interest in the underlying assets and not debts, they can be traded above or below par freely without breaching any Islamic principles.
33
Malaysia will purchase the land parcels at the end of the term Purchase price for land parcels Lease Payments
Land parcels
Lease of Land
Federation ofMalaysia
&
Sukuks
Sukuk holders
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underlying asset, depending on the jurisdiction where the asset is located, stamp duty and taxation costs associated with introducing the asset into the structure could make such a transaction unviable.
Since the asset is tied up for the term of the transaction, the
Sukuk Al-IjarahThe owner of an existing tangible leased asset may sell such assets through Sukuk. Sukuk Ijarah Mowsufa BithimaThe owner of a tangible asset to be acquired and subject to a lease contract may mobilize the acquisition cost of such an asset through Sukuk issues. Sukuk Manfaa IjarahThe owner of leasehold rights
of existing leased assets may sell the usufruct of such assets through Sukuk issues.
owner of the asset cannot divest it freely and there could be negative pledge implications in putting the asset into the transaction.
There could be ongoing Shariah audits in connection with
the asset. This can be time consuming and costly for the issuer.
Sukuk Manfaa Ijarah Mowsufa BithimaThe owner of leasehold rights of an asset to be acquired and subject to lease contract may sell the usufruct of such an asset through Sukuk issues.
Sukuk holders
(2) Leased the assets toobligator (1) Sell certain titles ofland to SPV (8) Obligator make periodic lease payment to SPV (9) SPV pays coupon toInvestors
Originator as seller
SPV
(3) Issued Trust Certificate (6) Payments received from investors by SPV
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(government). (1)
The assets purchased by the SPV are funded by the issuance
of sukuk (trust certificates) which represents beneficial ownership in the assets and the lease. (3)
Government receives cash proceeds. (7)
distributions/coupons
Stage 4: At maturity
SPV sells the property to the government at an agreed price. Government pays cash to SPV. SPV simultaneously pays investors cash for sukuk redemp-
Credit Agreement
This credit agreement sets out the terms and conditions precedent, representations and warranties, covenants, events of default, and payment provisions on broadly identical terms to the obligations in the non-Islamic-compliant documents, other than for the payment of interest and procurement of insurance. In the example, this agreement operated during the construction phase. The borrower agreed to develop, construct, and deliver the project assets according to certain specifications and to sell the project assets to the Islamic SPV.
tion.
Islamic SPV
The Islamic SPV agreed to pay for the project assets by phased payments (equivalent to advances of finance) to the borrower. If the borrower failed to deliver the project assets by the due date, it was liable to pay liquidated damages. Subject to the inter-creditor agreement (and therefore the relationship with the non-Islamic financing documents), acceleration of the Islamic facility agreement would lead to termination of the Istisna. Upon termination, the borrower was to reimburse to the Islamic SPV all payments received less the amount of any liquidated damages paid, and the Islamic SPV was to waive all its rights and claims to ownership and title to the assets.
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Islamic SPV to repair, reinstate, or replace project assets that were damaged or destroyed, save to the extent that such damage or destruction was caused by the borrowers willful misconduct or gross negligence. The Islamic SPV remained responsible for the major maintenance (maintenance of a capital nature) of the project assets so that they continued to provide the service for which the borrower rented them, although it was acknowledged that these maintenance obligations (and the procurement of insurance) would be subcontracted to the borrower under the service agency agreement (see below). As with the operational covenants contained in conventional financing of this nature, the borrower was responsible for ordinary maintenance, such as inspections of the project assets, maintenance of the assets in good and serviceable repair, and maintenance of records. The Islamic finance providers and the Islamic SPV authorized the Islamic facility agent to act on their behalf to exercise their respective rights and perform their respective obligations under the Islamic finance documents. The Islamic finance providers, the Islamic SPV, and the borrower acknowledged that the payments made by the Islamic facility agent directly to the borrower (sourced from the Islamic finance providers under the Islamic facility agreement) were payments satisfying the Islamic SPVs obligation to pay consideration for the project assets under the Istisna agreement. The Islamic SPV owned the assets and appointed the borrower as its service agent to operate and maintain the leased project assets, keep such assets fully insured, and pay any applicable ownership taxes, thereby restoring certain of the risks of asset ownership to the borrower. The Islamic SPV undertook to sell the leased assets to the borrower upon payment of a lease termination payment (a discharge of all outstanding amounts owed, effectively allowing prepayment of the Islamic facility and release of the rights of the Islamic finance providers upon discharge of the Islamic financing). The borrower undertook to purchase the leased project assets from the Islamic SPV upon payment of a lease termination payment (effectively an acceleration of the Islamic facility). Given the principles behind Islamic financing outlined above, the Islamic finance providers were not party to the other finance documents. However, each of the Islamic finance providers was, through the Islamic facility agent, bound by the inter-creditor agreement with the non-Islamic lenders and was
The Ijarah would also not come into effect. This operated after completion of the construction. Following delivery of the project assets under the terms of the Istisna, the Islamic SPV agreed to lease the project assets to the borrower for the period of the lease and the borrower agreed to pay lease payments (equivalent to debt service) to the Islamic SPV. As owner of the assets, the SPV had de facto security over them. Akin to the restrictions and covenants placed upon the borrower according to conventional debt facilities, the borrower undertook to use the leased project assets solely for the purposes contemplated in the Islamic facility agreement. Furthermore, The Islamic SPV and the Islamic facility agent made no representation or warranty as to the project assets so that risk of title, defects, and so on all rested with the borrower, who waived any claim caused by the project assets. The Islamic SPVs rights to take any enforcement action (e.g., remedies following events of default) were governed by the terms of the inter-creditor agreement. The borrower was entitled to terminate the Ijarah voluntarily by giving notice. Upon termination, including payment of the final lease payment (i.e., maturity), the Islamic SPV was to sell the project assets to the borrower according to the sale undertaking (see below) and the Islamic facility agreement. Subject to the terms of the inter-creditor agreement and the other non-Islamic documents, the Ijarah could be terminated following certain events of default. During the term of this Ijara, the ownership of the project assets remained with the Islamic SPV. The borrower could require the
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therefore subject to the inter-creditor provisions governing the relationship between the lenders. These provisions included the method of voting and decision-making; arrangements for joint consultation and actions regarding approval rights and waivers; limitation of the parties rights of enforcement upon default; and the application of proceeds upon enforcement. This Islamic facility agreement contained various representation and warranties, covenants and events of default by the borrower. Unlike conventional financing, the Islamic facility agreement did not provide a guaranteed interest rate of return, as the prohibition of interest is a significant principle of Islamic financing. As an alternative, the Islamic finance documents provided for advance amount payments (providing an effect similar to interest calculated on the outstanding principal on or before the lease began) and a lease variable element (providing an effect similar to interest calculated at any time after the lease began). While the Islamic finance documents did not contain any express provision for the payment of default interest, failure by the relevant party to pay any amount owing under the applicable Islamic finance document resulted in an obligation
to make a payment connected to the delay. If an Islamic finance provider received a payment that was solely attributable to the borrowers delay in payment, that participant was required to hand over the net amount (after deducting the actual costs and expenses suffered or incurred by it as a consequence of the borrowers failure to comply with the applicable Islamic finance document) to such charitable foundation or scientific or medical institution as it selected. The diagram below illustrates a typical project finance transaction that incorporates an Islamic financing structure. Construction phase 1The borrower develops, constructs, and sells project assets to the Islamic SPV. As consideration, the Islamic SPV makes phased payments to the borrower (equivalent to loan advances). Post-construction phase 2The Islamic SPV leases project assets to the borrower. The borrower makes lease payments (equivalent to debt service).
Intercreditor agreement
Non-Islamic lenders
Purchase undertaking
Islamic SPV
Sale undertaking
Borrower
Project assets
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the adequacy of the lease payment stream that will service the rated Ijarah Sukuk, and, where the underlying obligor is a government, its commitment to such transactions as an important and continuing source of financing. Standard & Poors has rated Ijarah Sukuk transactions backed by various types of underlying credit lessees, including sovereign governments, regional governments, corporations, and multilateral lending institutions. Standard & Poors also rates financial institutions that provide Islamic banking and insurance services. In most cases, Standard & Poors has assigned Ijarah Sukuk the same ratings as it assigns to the lessees creating the payment stream. This practice reflects the unconditional, irrevocable nature of the lease, any third-party lease guarantees, sale and purchase agreements, and/or financial hedges that are found in the transaction. Ratings lower than those given to the lessee are assigned where there are diminished recovery prospects, greater risks associated with lease payments, or other factors supporting such a distinction. Higher ratings are unlikely without additional risk-mitigating features, in the case of sovereigns, although for corporates Ijarah Sukuk may resemble certain characteristics of secured loans and be notched up accordingly.
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for a determined price (the purchase price). 2. The SPV raises financing to purchase the assets by issuing Ijarah Sukuk to investors in an amount equal to the purchase price. The Ijarah Sukuk represent an equity interest in the SPEs assets, which may be indirect or direct depending on the type of SPE. 3. The SPV then leases the assets to the lessee, an affiliate of the seller, or directly back to the seller itself, in exchange for periodic lease payments. These lease payments should match the obligations of the SPE under the Ijarah Sukuk. 4. At maturity, or on a dissolution event, the SPE sells the assets back to the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijarah Sukuk. Other transaction configurations are possible. For example, the SPE may sublease back to the lessee the assets that have been first leased to the SPE by the same lessee. Typically, the head lease has a longer maturity than the sublease. Such configurations do not include the sale of assets and may be preferred when the sale of an asset is difficult, either legally or for political reasons (for example, a sovereign may not wish to sell the countrys main airport). Additionally, depending on the extent of Shariah compliance, prior to maturity the lessee may have the right to call for the assets upon certain amounts due under the Ijarah Sukuk as well as other expenses, and the SPE might have the right to tender the assets back to the lessee. The lease may also be supported by affiliate guarantees. Currency or other hedges may also play a part in transaction dynamics.
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Criteria Guidelines
Standard & Poors criteria for rating Ijarah Sukuk take into consideration four main elements, which can be expressed in the form of questions, as follows.
1. Do the lease and repurchase payments from the lessee to the SPE have the same credit quality as the lessees conventional debt?
Standard & Poors analyses the lease and repurchase obligations to determine whether they are timely, irrevocable, and unconditional. If a government is the lessee, Standard & Poors also gauges appropriation risk (the risk that the legislature will allocate funds to meet the lease obligation). An important factor in determining if the Ijarah Sukuk may be rated the same as the lessees conventional debt is whether the lease and other relevant obligations rank on an equal basis with the lessees conventional debt. Should the lease obligation be subject to budgetary appropriation or other risks that, by comparison, weigh less heavily in issuances of conventional debt, Standard & Poors might notch the Ijarah Sukuk down from the credit rating of the lessee. Other factors that suggest lower credit quality include these:
Situations under which the lessee may not have to redeem
of outcomes in a Shariah court, with the possibility of Shariah principles overriding otherwise valid commercial contractual obligations. Indeed, certain Shariah-compliant transactions have specifically disavowed Shariah jurisdiction as a matter of form, although they may satisfy Shariah requirements as a matter of substance.
What are the rating implications if Islamic authorities do not recognize a transaction as Shariah-compliant?
If a sovereign or an Islamic legal authority declares (at the time of issuance or during the life of the Sukuk) that Ijarah Sukuk do not comply with Shariah, there might not necessarily be any credit implications, although such a result could influence market liquidity. Most Ijarah Sukuk transactions involve contractual agreements, subject to commercial law; the enforceability of the transaction in a commercial court should not be affected by any adverse determination by a Shariah court. Most, if not all, conventional debt structures from Islamic nations do not comply with Shariah, yet this has not curtailed their bond issuance. However, to the extent that Ijarah Sukuk are governed by Shariah and are subject to the jurisdiction of the Shariah courts (which is not the case with any Ijarah Sukuk currently rated by Standard & Poors), then a declaration by such a court that the Ijarah Sukuk do not comply with Islamic law could render the Ijarah Sukuk void and unenforceable.
outstanding principal by repurchasing the assets at maturity or in a dissolution event; and any other conditions that allow exceptions for timely payment or for lower recovery prospects.
The essentiality of the asset to the lessee is also considered
2. Is the SPE a single-purpose pass-through vehicle between the lessee and the holders of Ijarah Sukuk?
Creditworthiness might be impaired relative to the lessees rating if the issuer is not an SPE, for example, or if it has purposes other than engaging in the bare necessities for implementing the transaction. Loans to the issuer from parties other than the holders of the Ijarah Sukuk are of particular concern, especially if the third parties could interfere with the lease payment stream destined for the Ijarah Sukuk. Furthermore, if the issuer maintains a sinking fund, the credit exposures of the SPE will be considered. Ownership and management of the issuer is also evaluated. Finally, if the lessee owns the issuer and there are potential conflicts of interest, these would be taken into account in the analysis.
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3. Do the transactions cash flows provide for the full and timely payment of the obligations to holders of Ijarah Sukuk?
Standard & Poors compares the terms and conditions of the asset lease and those of the Ijarah Sukuk, analysing how potential shortfalls are covered in the transaction. For example, shortfalls that might arise from foreign currency exposure can be covered by the lease (as supplemental rent), by a lease guarantee from another creditworthy entity, or by a hedge. Usually, government lessees agree to cover, on a timely basis, any additional expenses related to taxes, levies, duties, fees, and charges, whenever they arise. Another important credit consideration is whether the sold assets are free of any lien, pledge, mortgage, security interest, deed of trust, charge, or other encumbrance. Risks to the leased assets from loss or damage can be mitigated by insurance, though the terms and exceptions, as well as risk of insurers default, must be examined carefully.
Most important to note, outside of the religious and political allure of Islamic banks, is that people are choosing their services for the safety they are perceived to offer. However, in order for Islamic financial institutions to be competitive with conventional products and attractive to customers, Islamic financial products must meet the risk/ reward profiles of investors and issuers, while fulfilling the tenets of Sharia and remaining sufficiently cost-effective. Additionally, Islamic financial institutions must educate their personnel to understand the tenets of Islamic law that pertain to finance, and must train them to comply with Sharia as they serve their Islamic customer population. While the size of Islamic finance and banking activities, estimated to range from $500 billion to $1 trillion, is still a fraction of conventional banking and finance activities, estimated annual growth rates of 10 to 15 percent seen in recent years emphasize the potential market for such activities. Amidst this growing market opportunity there are several inherent risks, not the least of which is the attraction of reverse engineering traditional financial products to become Islamic financial products. If this is done by personnel not well versed in the Islamic financial system, then risks abound. The most well-known aspect of an Islamic financial system is the prohibition against paying or receiving interest (riba) on capital. Essentially, any positive, fixed, predetermined rate tied to the maturity and the amount of principal, which is guaranteed irrespective of the performance of the investment, is considered riba and is therefore prohibited. This prohibition is not to be confused with a rate of return or profit on capital, since earning and sharing profit is very much encouraged within Islam. Moreover, profit, determined ex post, symbolizes the creation of additional wealth through successful entrepreneurship, whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations, and may create wealth even if there are business losses. It is within this context that one should consider the development of new Ijarah products. To provide further clarity in terms of development of new products as well as new institutions to market Ijarah products one should take into consideration IFSB 9.0.
4. If the lessee is a government, is its commitment to its Ijarah Sukuk similar to its commitment to other types of debt financing?
Willingness-to-pay considerations are of particular importance for sovereign lessees. Historically, financially distressed sovereign lessees have occasionally discriminated among their pari passu financial obligations. Standard & Poors examines the extent to which the government includes Ijarah Sukuk in government accounts as debt obligations, indistinguishable in terms of priority from conventional debt. Willingness considerations are supported by Ijarah Sukuk financing being designed to target investors interested in Shariah-compliant instruments, rather than to create a new stratum of obligation.
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Guiding Principles on Conduct of Business for Institutions Offering Islamic Financial Services
The Guiding Principles on Conduct of Business for Institutions offering Islamic Financial Services (hereafter Guiding Principles) are applicable to all institutions offering Islamic financial services (IIFS) in the banking, Takaful (Islamic insurance), and capital market segments, including windows of conventional firms. In accordance with the objectives of the IFSB, the Guiding Principles will not reinvent the wheel but will instead, wherever appropriate, reinforce the existing internationally recognized frameworks or standards for the conduct of business. Principles of business conduct are defined as those principles that are intended to govern the activities of financial services firms with regard to (a) the protection of the interests of their customers, and (b) the integrity of the market. For IIFS, a code of ethical business conduct derives from principles of the Shariah as set out in the Holy Quran.
Principle 3: Capabilities
An IIFS shall ensure that it has in place the necessary systems and procedures, and that its employees have the necessary knowledge and skills, to comply with these principles and other IFSB standards.
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al Maqasid al Shariah: The objective of Shariah. amana/amanah: Literally means reliability, trustworthiness, loyalty and honesty, and is an important value of Islamic society in mutual dealings. It also refers to deposits in trust, sometimes on a contractual basis. bai/bay: Contract of sale, sale and purchase. bai al-salam: Advance payment for goods. While normally
the goods need to exist before a sale can be completed, in this case the goods are defined (such as quantity, quality, workmanship) and the date of delivery fixed. Commonly applied in the agricultural sector where money is advanced for inputs to receive a share in the crop.
ijarah/ijara: Lease, hire or the transfer of ownership of a service for a specified period for an agreed lawful consideration. This is an arrangement under which an Islamic financial institution leases equipment, a building or other facility to a client for an agreed rental. ijarah muntahla bittamleek/ ijarah wa iqtina: A leasing contract used by Islamic financial institutions that includes a promise by the lessor to transfer the ownership of the leased property to the lessee, either at the end of the lease or by stages during the term of the contract. ijtihad: Literally effort, exertion, industry, diligence. As a
legal term, it means the effort of a qualified Islamic jurist to interpret or reinterpret sources of Islamic law in cases where no clear directives exist.
fiqh: Practical Islamic jurisprudence. Can be regarded as the jurists understanding of the Shariah. There are four Islamic schools of jurisprudence: al-Shafie, al-Hanafi, al-Maliki and al-Hanbali. gharar: Uncertainty in a contract or sale in which the goods
may or may not be available or exist. Also, ambiguity in the consideration or terms of a contractas such, the contract would not be valid.
Istisna/istisnaa: A contract of sale of specified goods to be manufactured with an obligation on the manufacturer to deliver them on completion. It is a condition in istisna that the seller provides either the raw material or the cost of manufacturing the goods. maisir/maysir: The forbidden act of gambling or playing
games of chance with the intention of making an easy or unearned profit.
mudaraba/mudarabah: A form of contract in which one party (the rab-al-maal) brings capital and the other (the mudarib) personal effort. The proportionate share in profit is determined by mutual consent, but the loss, if any, is borne by the owner of the capital, unless the loss has been caused by negligence or violation of the terms of the contract by the mudarib. A mudaraba is typically conducted between
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an Islamic financial institution or fund as mudarib and investment account holders as providers of funds.
mudarib: The managing partner or entrepreneur in a mudaraba contract (see above), see also rab almal. murabaha: A contract of sale with an agreed profit mark-up on the cost. There are two types of murabaha sale: in the first type, the Islamic financial institution purchases the goods and makes them available for sale without any prior promise from a customer to purchase them, and this is termed a normal or spot murabaha. The second type involves a promise from a customer to purchase the item from the financial institution, and this is called murabaha to the purchase order. In this latter case, there is a pre-agreed selling price that includes the pre-agreed profit mark-up. Normally, it involves the financial institution granting the customer a murabaha credit facility with deferred payment terms, but this is not an essential element. musharaka/musharakah: An agreement under which
the Islamic financial institution provides funds that are mingled with the funds of the business enterprise and possibly others. All providers of capital are entitled to participate in management but are not necessarily obliged to do so. The profit is distributed among the partners in a pre-determined manner, but the losses, if any, are borne by the partners in proportion to their capital contribution. It is not permitted to stipulate otherwise.
qard al hasan/qard hassan: A virtuous loan in which there is no interest or mark-up. The borrower must return the principal sum in the future without any increase. rab-al-maal: The investor or owner of capital in a mudaraba contract (see above). rahn: A mortgage or pledge. riba: Interest. Sometimes equated with usury, but its
meaning is broader. The literal meaning is an excess or increase, and its prohibition is meant to distinguish between an unlawful exchange in which there is a clear advantage to one party in contrast to a mutually beneficial and lawful exchange.
riba al-buyu: A sale transaction in which a commodity is exchanged for the same commodity but unequal in amount or quality, or the excess over what is justified by the countervalue in an exchange/business transaction. sadaqa: Voluntary charity. salam: A contract for the purchase of a commodity for
deferred delivery in exchange for immediate payment.
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Shariah /Sharia/Shariah: In legal terms, the law as extracted from the sources of law (the Quran and the Sunnah). However, Shariah rules do not always function as rules of law as they incorporate obligations, duties and moral considerations that serve to foster obedience to the Almighty. shirkat al-aqad: A joint-venture partnership. shirkat al-milk: A co-ownership partnership. saak: Participation securities, coupons, investment
certificates.
Shariah compliance
The Islamic finance industry has adopted the practice of appointing Shariah scholars to determine compliance with Shariah. Since Shariah can in certain areas be general and implicit, appropriately qualified scholars are relied upon to determine the relevant rules for financial transactions. These scholars are appointed to the Shariah Supervisory Boards of financial institutions and investment funds to approve Islamic product lines and individual transactions as well as to audit these institutions and funds to ensure continuing compliance. Recently, Shariah consultancies have been established to provide a similar service. Shariah Supervisory Boards (or, for smaller operations, a single Shariah Scholar) evidence their opinion on compliance by issuing a fatwa (an Islamic legal opinion). Fatwas are important documents and are often a condition precedent to the effectiveness of a transaction. Indeed, many offerings, such as Islamic funds or Sukuk (see section 7.5) sometimes append the fatwa issued to the relevant offering documents.
sukuk: Plural of saak (see above). Sunnah: The way of the Prophet Muhammad including his
sayings, deeds, approvals, and disapprovals as preserved in the hadith literature. It is the second source of revelation after the Quran.
tawarruq: Literally monetisation. The term is used to describe a mode of financing, where the commodity sold is not required by the borrower but is bought on deferred terms and then sold to a third party for a lower amount of cash, so becoming monetised. The reverse of murabaha. ummah: The community or nation. Used to refer to the
worldwide community of Muslims.
urf: The customs of a community. wad: A promise or unilateral undertaking. wadiah: A deposit. wakala: Agency, an agency contract that generally includes
in its terms a fee for the agent.
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References
1) Dr. Zeti Akhtar Aziz, Governor, Bank Negara Malaysia Islamic Finance: An Agenda for Balanced Growth and Development Publication: ENP Newswire Date: Monday, October 18, 2010 http://www.allbusiness.com/trade-development/ trade-development-finance-banks/15205013-1.html 2) 3) 4) 5) 6) 7) 8) 9) Islamic Finance and Global Financial Stability, 2010 http://islamicfinancenews.files.wordpress.com/2011/01/ifsb-irti-idb2010. pdf Graphic Page 15 State Bank of Pakistan, http://www.sbp.org.pk/ Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), www.aaoifi.com/keypublications.html The International Islamic Financial Market (IIFM), www.iifm.net The International Islamic Rating Agency (IIRA), www.iirating.com The Islamic Financial Services Board (IFSB), www.ifsb.org Basel Committee on Banking Supervision, http://www.bis.org/bcbs/ International Organization of Securities Commissions, http://www.iosco.org/
10) International Association of Insurance Supervisors, www.iaisweb.org 11) Source: Islamic Research and Training Institute, Islamic Development Bank.http://www.irtipms.org/PubDetE.asp?pub=213 &search=ijarah&mode=allwords, http://www.irtipms.org/PubDetE.asp?pub=216&search=ijarah&mode=allwords 12) Miles, Adrian (1993), An Introduction to Securitization of Lease in Adrian Hombrook, Studies in Leasing Law and Tax, London: Euromoney Publications, p.15. 13) Decision No. 5 of the 4th Annual Plenary Session of the OIC Fiqh Academy, held in Jeddah 18-23/6/1408H (6-11/2/1988G) International Islamic Fiqh Academy, www.fiqhacademy.org.sa 14) Shariah Advisory Council, Bank Negara Malaysia, http://www.bnm.gov.my/index.php?ch=7&pg=715&ac=802 15) Regional Center for Arbitration Kuala Lumpur, http://www.rcakl.org.my/ 16) State Bank of Paksitan, Shariah Rulings, http://www.sbp.org.pk/departments/pdf/StrategicPlanPDF/Appendix-C%20 Shariah%20Compliance.pdf 17) Shariah Compliant Ijarah Car Financing, Maybank Malaysia, http://www.maybank2u.com.my/mbb_info/m2u/public/ personalList04.do?channelId=LOA-Loans&programId=LOA03-CarLoans&chCatId=/mbb/Personal/LOA-Loans, http:// www.maybank2u.com.my/mbb_info/m2u/public/personalDetail04.do?channelId=LOA-Loans&cntTypeId=0&cntKey= LOA03.02&programId=LOA03-CarLoans&chCatId=/mbb/Personal/LOA-Loans, http://www.maybank-ib.com/services/ islamicproducts.html 18) Shariah Compliant Ijarah Home Financing, Ahli United Bank, http://www.iibu.com/buy_home/ijarahow.aspx 19) Forward Ijarah, Dubai Islamic Bank, http://www.dib.ae/en/personalbanking_home_finance_forward_ijarah.htm 20) Ijarah (Ending with Title Deed) Muntahia Bittamleek, Dubai Islamic Bank, http://www.dib.ae/en/realestate_lease.htm 21) Honohon, Patrick. 2007. Cross-Country Variations in Household Access to Financial Services. Presented at the World Bank Conference on Access to Finance, Washington, D.C., 15 March. 22) Karim, Nimrah, Michael Tarazi, and Xavier Reille. 2008. Islamic Microfinance: An Emerging Market Niche. Focus Note 49. Washington, D.C.: CGAP, August.
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23) Islamic Finance Today, http://www.sailanmuslim.com/news/ijara-a-more-compassionate-form-of-leasing-suresh-r-i-pererallb-attorney-at-law-acma-director-tax-regulatory-kpmg-sri-lanka/ 24) 13 Para 8, FRS 117, Malaysian Accounting Standards Board 2005, a) FRS 117 Leases, A Practical Guide to Financial Reporting Standards (Malaysia), page307, b) Para 2, FRS 117, Malaysian Accounting Standards Board 2005. c) Para 8, FRS 117, Malaysian Accounting Standards Board 2005 d) http://www.masb.org.my/ e) http://www.masb.org.my/index.php?option=com_content&view=article&id=321%3Afrs117-pg3&catid=6%3Amasb-excludeprivate&Itemid=32
25) Four Main Schools of Islamic Thought, http://www.islamic-banking.com/islamic-jurisprudence.aspx 26) The law firm of Agha & Shamsi, UAE , http://www.aghashamsi.com/mediacentre-publications.htm 27) Islamic Project Finance, Chadbourne and Parke LLP, Islamic Project Finance: Structures and Challenges, February 2010, http://www.chadbourne.com/files/Publication/c4ae820b-24ba-4e5b-9f7d-186814289e7e/Presentation/ PublicationAttachment/20d7847a-8644-4b0f-b3e7-19a496eebf22/pfn_Intl_0210.pdf 28) Dolfin Gas Project, Khaleej Times, Sept 12, 2005, http://www.khaleejtimes.com/displayarticle.asp?xfile=data/business/2005/ september/business_september257.xml§ion=business 29) Sukuk, Islamic Bonds (Sukuk): Its Introduction and Application, By Shariq Nisar, http://www.financeinislam.com/ article/8/1/546 30) Sukuk, http://www.inceif.org/_system/media/pdf/global_forum/speech_badlisyah.pdf 31) Ijarah Sukuk, Operatonal Models for Ijarah, Shariah Board Resolutions, Securities and Exchange Organization, Iran, www. rdis.ir, http://www.rdis.ir/RDFiles/IslamicFin/Operational_models_for_Ijarah46.pdf 32) Ijarah Sukuk Model Project Finance, Innovation in the Structuring of Islamic Sukuk Securities, Professor Rodney Wilson Durham University, Institute for Middle Eastern and Islamic Studies, http://www.assaif.org/content/download/586/4393/ file/Innovation%20in%20the%20Structuring%20of%20Islamic%20Sukuk%20securities.%E2%80%A6.pdf 33) Standard and Poors Ratings, http://www.standardandpoors.com/ratings, also How Standard and Poors Rate Ijarah Sukuk, http://www.zawya.com/Story.cfm?id=ZAWYA20050221073726&pagename=SukukMonitor
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Islamic Development Bank.(1999) Financing Trade in an Islamic Economy, Research Paper No. 51. Kahf, M., and Khan, T., (1992) Principles of Islamic Finance, Jeddah: Islamic Research and Training Institute, Islamic Development Bank. Kamali, M. Hashim (1999), Principles of Islamic Jurisprudence, Reprint, Petaling Jaya, Malaysia: Ilmiah Publishers. Kamali, M. Hashim (2000), Islamic Commercial Law, Cambridge: Islamic Texts Society. Khan, M. Fahim (1995), Essays in Islamic Finance, Leicester: The Islamic Foundation. Manan M.A (ed.).(1996). Financing Development in Islam, Islamic Research and Training Institute, Islamic Development Bank. Masood, Waqar (1984), Towards an Interest-Free Islamic Economic System, Leicester: The Islamic Foundation. Muhamad Umar Chapra. (2005). Objectives of the Islamic Economic Order, An Introduction to Islamic Economics and Finance, CERT Publication Sdn. Bhd. Kuala Lumpur, Malaysia. Phililp Moore, (1997), Islamic Finance: A Partnership for Growth, Euromoney Publications PLC: London Sayed Hassan Amin, 1985. Islamic Law in the Contemporary World, Tehran: Vahid Publications. Sheikh Abod, Sheikh Ghazali, S. O., Syed Agil, A. Ghazali (eds) (2005), An Introduction to Islamic Economics and Finance, CERT Publications: Kuala Lumpur. Siddiqui, M. Nejathullah (1985), Partnership and Profit Sharing in Islamic Law, Leicester: The Islamic Foundation. Sohail, Jaffer (ed) (2005), Islamic Retail Banking and Finance: Global Challenges and Opportunities, Euromoney Books: London Sundararajan, V. and Errico, L (2002), Islamic Financial Institutions and Products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead. IMF Working Paper, WP/02/192. Washington: International Monetary Fund. Thani N. A. et al, (2003), Law and Practice of Islamic Banking and Financial System, Sweet & Maxwell: Malaysia
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Usmani, Imran (2002), Guide to Islamic Banking, Karachi: Dar-ul-Ishaat. Vogal, Frank E. and Samuel L. Hayes (1998), Islamic Law and Finance: Religion, Risk and Return, The Hague: Kluwer Law International. Warde, Ibrahim (2000), Islamic Finance in the Global Economy, Edinburgh, Edinburgh University Press. Wilson, R. (1990), Islamic Financial Markets, London: Routledge. Zahar Ahmad Khan, (2000), Islamic Banking and Its Operations, Institute of Islamic Banking and Insurance,London.