Inherent risks in Ijara transactions

Having completed our comparison of the differences between Islamic and conventional banks, we can commence an examination of risk assessment and mitigation in an Islamic financial context.

Technically, the new subject may be considered an extension of our earlier discussion about the differences between Islamic and conventional financial institutions the two perceive and mitigate risk in quite different ways.

Risks

We will start by looking at the various risks faced by an Islamic financial institution in an Ijara (leasing) transaction and how these are mitigated within the parameters of the transaction ie, without resorting to external support elements such as guarantees and collaterals.

Leasing is the most commonly used structure in IFIs after Murabaha (sales transaction). Generally, the leasing transaction is preceded by a request from a client who desires the IFI to lease certain identified asset to him.

The asset could be readily available or may need to be created. In case of an existing asset, the lease will be called Ijarat Ain (lease of an existing asset). If the asset needs to be built from scratch, the lease will be termed Ijara Fil Zimma.

We have earlier discussed how Islamic leasing can take two forms operating leases and financial leases. To recap, in the case of an operating lease, the leased asset goes back to the lessor upon completion of the lease term.

One example of an operating lease could be the renting of a car for a specified period, upon conclusion of which the lessee is required to return the car to the rent-a-car company.

Financial lease

In contrast, a financial lease necessitates that the leased asset is retained by the lessee and its title transferred to the lessee at the end of the lease period. The lease rent for the financial lease is structured so the IFI can recover its original investment in acquiring the asset, as well as its desired return.

Process

Upon receiving the request from a customer, the IFI can purchase the asset from an identified third party or from the customer. The asset is leased to the customer by the IFI for an agreed term at a lease rent which is pre-determined for the first lease period. The rent can be based on a certain formulae for the subsequent periods.

The customer continues to pay the lease rent until the lease term is completed. At this stage, the IFI transfers the asset title to the customer.

What are the risks involved in such type of leasing and how these are mitigated by an IFI? Let us try to understand. I am sure readers with some experience in the financial services industry will easily be able to identify the following risks in the transaction.

Mitigating factors

We will discuss the mitigating factors relevant to each risk available within the parameters of the transaction.

1. What if the customer does not lease the asset upon the IFI purchasing it from a third party?

2. If the asset is bought by the IFI from the customer, what is the assurance that it is worth the value the IFI is being asked to pay?

3. What about the issue of the physical possession or delivery of the asset? Will the asset continue to remain in the custody of the customer?

4. The IFI may not have the technical expertise to maintain a high-value asset such as an aircraft or a vessel. How can it ensure that the asset is maintained so it can operate smoothly?

5. Who will bear the cost of such maintenance?

6. Being the owner of the asset, it will be the IFI's responsibility to keep the asset fully insured at all times. How can the IFI manage the insurance costs and still make a profit?

7. What remedy or recourse is available to the IFI if the customer defaults in payment of the lease rent?

8. How would the IFI safeguard its interests in case of partial damage to or total destruction of the asset?

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