Islamic Finance: Why Ijara lease rent is based on conventional benchmarks

So far four articles on Ijara have appeared in these pages. In line with expectations, many readers have sought further clarification on the rental aspects of Ijara.

It would be appropriate to discuss this issue before proceeding to conclude our chapter on this subject.

A question has been raised as to why Islamic banks, more often than not, base the Ijara lease rent on fluctuating conventional benchmarks such as London Interbank Offered Rate (Libor) or Emirates Interbank Offered Rate (Eibor)? Why not pre-fix the lease rent at the outset for the entire lease term?

There are two main reasons for doing so:
a) Absence of an internationally acceptable Islamic profit benchmark, as compared to Libor in the conventional banking

b) Apprehension in the customer's mind that he may end up paying higher lease rent if it is fixed, compared to the fluctuating benchmark-based interest rate charged by a conventional bank.

As there are few Islamic banks in the Gulf region as against a very large number of conventional ones, it becomes important on the part of Islamic banks to remain competitive and, as such, adjust their profit earnings close to the 'market'.

By not adopting to market standards, they may not be able to achieve the purpose of adding value to the trusted investments of their shareholders and depositors as Mudareb (fund manager).

Therefore, the Ijara agreements adopted by the Islamic banks provide that for the sake of clarity and ease of understanding, the rental will be equal to a benchmark rate at the start of an Ijara period (such as 3/6-Month Libor/Eibor) plus a spread called margin.

The rent is readjusted for each Ijara period on the same basis in order for the Islamic banks to remain in line with market.

The objection raised against this practice is that, by subjecting the rental payments equal to a rate of interest, the transaction may be rendered akin to an interest-based financing.

The reply to this argument is that so long as all the other Sharia parameters discussed earlier in these pages are fulfilled, the Ijara agreement may use any benchmark for merely determining the amount of periodical rental.

Please remember that the main difference between conventional financial leasing and Ijara is that in Ijara, the lessor assumes full ownership risks of the corpus of the leased asset.

If the asset is destroyed during the lease period without lessee's negligence, the lessor will bear the full loss besides also losing the right to continue to earn rent. In addition, the lessor will be required to refund any prepaid rent to lessee.

It is thus clear that mere use of the conventional benchmark does not render the contract invalid from Sharia perspective since it is simply meant to determine the rent for the underlying asset and is not the interest on lending since nothing is lent by the bank.

Another question has been raised that future variation in Libor/Eibor rate being unknown, the rent thus tied up to it may be uncertain (element of Gharar), which is not allowed under Sharia since all considerations in a contract must be clearly known and understood to the parties entering into it.

It is true that Sharia does not condone a contract with the element of uncertainty in it, primarily to avoid any dispute in future. However, this aspect is absent in Ijara based on a well defined benchmark since both parties agree in writing upon it which will serve as criterion for determining the rent. As such, whatever rental amount is ascertained by lessor based on this benchmark, will be acceptable to lessee.

In any case, the lease rent of an asset is always variable, depending on the market conditions. As such, a property can be rented at a good amount in bullish market conditions whereas the same house can be difficult to rent in the opposite circumstances.

The writer is vice-president, Sharia structuring, documentation and product development, Dubai Islamic Bank.