Islamic Finance: Agency plays key role in Istisna, Wakala financing

The last two articles dealt with various agency roles in different Islamic financing structures.

We discussed that in Murabaha (sale of an asset with disclosed profit) an Islamic bank appoints the customer as its agent in selecting the goods to be financed by it, in order to alleviate the risk of goods being declared unfit by the customer at the time of purchase.

We also learnt that in Ijara (leasing of an asset to a customer) and Musharika (co-ownership in an asset with a customer) an Islamic bank appoints its customer as service agent to conduct major repair and maintenance besides keeping the asset properly insured.

Continuing with our study of the agency role in various Islamic financing structures, today we will examine its implication under Istisna and Wakala.

Istisna rules

Istisna is a transaction where an asset can be sold before it comes into existence. However, the asset must be developed or manufactured from scratch. This condition portrays the literal meaning of the word 'Istisna', i.e. to manufacture or build.

In other words, Istisna is a contract where an Islamic bank undertakes to manufacture or build an asset according to a certain pre-agreed specification and at a pre-fixed price.

The bank releases finance in phases commensurate with the progress in developing the asset. Istisna may include any process of manufacturing, construction, assembling or packaging.

Islamic banks commonly adopt Istisna for providing finance to construct a building, develop an industrial concern, build a vessel or an aircraft, among others.

Do Islamic banks possess the necessary arrangement and expertise to carry out timely completion of any type of asset according to a pre-agreed specification and at a fixed price?

Of course not, since it will require huge investment to maintain the necessary infrastructure and hire experts to accomplish the job, which is financially not viable.

Furthermore, there will always be room for argument by the client that the completed asset does not fully conform to the agreed specification, thus leaving the bank exposed to the risk of refusal by the client to take delivery of the asset.

An Islamic bank overcomes this gray area by appointing the client as its agent. The scope of such an agency includes manufacturing or building the required asset as per specification and delivering it to the bank upon completion, which will then sell it to the client.

Since in reality it is the client who is going to acquire physical possession of the asset upon completion, he will obviously ensure full adherence to the required specification in building the asset.

Under the agency agreement, if the agent (client) fails to comply with the required specification, he will be responsible to the principal (bank) for damages.

As such, this built-in safety valve in Istisna financing adequately protects the bank from any risk of refusal by the client on the grounds that the asset has not been built according to his required specification.

Wakala financing

As evident from the name, financing under Wakala takes place when an Islamic bank nominates the client as its agent for investing funds to earn profits.

The Islamic bank undertakes this type of financing on a select basis and most of the time as part of a package, mainly in order to meet a client's working capital requirements.

The Wakala financing agreement contains clauses to state that the agent (client) will deploy funds into a specific business activity where he holds the necessary expertise and anticipates annual profitability in a certain percentage range (e.g. between 10–15 per cent).

The client is also required to submit a realistic feasibility study projecting such return.

The agent is required to deploy the principal's funds in a judicious manner and within the agreed parameters.

In case of deviation, the agent will be held fully responsible for financial loss, if any, caused to the principal due to the agent's wilful misconduct, negligence or default.

However, if the loss did not occur due to the agent's negligence, the principal will be required to bear the same in full.

In the normal situation, the bank may agree to obtain part of the income and allow the agent (client) to retain the rest as an incentive for prudent deployment of funds.

Agency Fee

According to Sharia, it is necessary that the principal pay a certain amount as fee to the agent in compensation for his agreement to act as agent.

An agency arrangement without provision of the fee cannot be considered irrevocable under Sharia, thus allowing an agent the right to terminate it at any time.

Obviously a principal would not like to be in a situation where an agent can just walk away leaving his obligations unfulfilled and he cannot be held responsible for anything.

Therefore, Islamic banks make it a point to insert a fee clause in an agency agreement in order to hold the agent responsible.

As the agency fee is purely an expense on the bank's part and cannot be recovered from the client, banks keep the amount to a minimum.

The writer is head of risk management at Dubai Islamic Bank