Islamic Finance: Differences with conventional banks in joint-financed deals

Major differences exist between a conventional bank and an Islamic bank in a jointly financed transaction.

In a conventional leasing agreement of large value, it is common to find a clause relating to the potential of increase in the cost of the asset being leased.

The clause stipulates that if later-on the lessor (lead bank) determines that any of the banks forming part of the lessor group has incurred any increased cost as a result of the introduction of any new tax in its area of operation making the financing expensive, or any new tax on the asset with retrospective effect or enhanced capital adequacy ratio leading to making the lending less attractive or for any other reason, then the lessor bank(s) will have the right to add such increased amount to the lease rent.

Moreover, the lessor bank(s) shall not be obliged to disclose any calculation to the lessee while claiming the increased costs.

Conventional bank would like to see this point in the lease agreement while participating in an Islamic financing transaction. However, from a Sharia scholar's perspective, the point falls under the category of Gharar or element of uncertainty which makes an agreement null and void.

It may not be correct to assume that Sharia is rigid to accommodate subsequent increase in the cost of financing an asset. Following are the Sharia parameters to address such a situation:

The lessee must undertake in the lease agreement that it will be willing to pay higher lease rent to allow the lessor to be able to bear the increased cost related to the financed asset in future, if any.

The undertaking should include, inter-alia, the foreseeable elements of increased cost such as insurance expense, major repair and maintenance, ownership and income taxes, etc. All this may have been paid by the lessor or the lessee in the capacity of lessor's service agent.

Lessee will not be obliged to pay for the increased costs to lessor if it is uncertain and cannot be arrived at with the help of a formulae or if the lessor declines to provide the details of such increased costs, claiming it to be confidential. In short, any element of uncertainty is knocked down by the Sharia Supervision Board of an Islamic bank and which act is not looked with favour by a conventional bank.

It is a practice unanimously adopted by the conventional banks to charge penalty on the amounts delayed for payment by the client. They insist to include this clause in an Islamic facility agreement since they always have it in their own documentation and hence find it difficult to live without it.

Whilst Islamic banks are not allowed by Sharia to charge any such penalty since it will tantamount to Riba (interest), they usually accommodate this demand from conventional banks but add the phrase that such penalty amount will not be taken by them to their profit and will be donated to charity organisations of non-religious nature.

Penalty amount

Why emphasis on non-religious charity? Because penalty amount being usurious in nature cannot be compared to Zakat money which is spent on supporting widows, orphans, religious students, Islamic schools, marriages and the likes. This less contentious issue works in favour of Islamic banks as it discourages the customer from intentionally delaying the payment.

In a conventional financing scenario, a long list of the events of default is provided which includes several events outside the borrower's control, such as, force majeure, nationalisation, requisition, etc.

To the contrary, in an Islamic financing transaction, imposing something on the customer over which he has little or no control is disallowed by Sharia.

Sharia accepts those events as default which are caused by the customer's own fault or negligence or which could have been prevented by him. In a co-financing situation, events of default outside the control of the customer are redefined as 'events of mandatory prepayment' and are covered under a separate document, rather than in the main facility agreements.

The author is head of risk management at Dubai Islamic Bank.