Islamic Finance: Different roles, responsibilities of conventional banking

This week we will conclude our discussion on the situations a conventional bank finds difficult to put up with when participating with an Islamic bank in a Sharia based financing transaction.

Role

A conventional facility arrangement may amalgamate different roles of the bank(s), customer and the other parties into few agreements. It may include combining dual roles two parties may play into one agreement.

However, Sharia declares that if the parties are assigned different roles and responsibilities in a facility arrangement, these must not be mixed but covered in separate agreements.

As such, in an Ijara Islamic financing facility, if the lessor appoints lessee as it's service agent, the arrangement will be covered under two separate agreements, viz. lease agreement between lessor and lessee covering the lease and subsequently between principal (lessor) and agent (lessee) for service agency. This is to put different roles and responsibilities of both parties in clear perspective.

It is worthwhile to note that Sharia requires both agreements to run independently. It will means that in case of lease agreement coming to an end, it is not necessary that the service agency agreement will also cease to exist, and vice versa.

Conditionality

Conventional bankers are used to seeing in their facility arrangement that one agreement may be conditional upon another one. For example, a conventional lease agreement may state that the lessee agrees to take the asset on lease subject to the lessor purchasing it from a third party. Such conditional agreement is termed void by the Sharia scholars.

Moreover, it is commonly seen in the conventional banking environment that an agreement may have reference to a clause in another agreement, though signed by the same parties.

Sharia is against the practice of making one agreement dependent upon a clause in another agreement. It emphasises that each facility agreement should be independent and complete on its own. This is to ensure fair play and to protect the rights of all parties at all times.

Rise in facility amount

Often at customer's request the conventional banks allow lending against the revalued amount of an asset, such as a building. There is provision of such accommodation in conventional lending agreements which these banks would like to also find in an Islamic financing transaction. What is the Sharia point of view in this kind of situation?

Please note that under an Islamic financing transaction, the asset has already been acquired by paying the purchase price to the seller and the title transferred to the Islamic bank. Even if the value of the underlying asset subsequently increases, the Islamic bank will not be in a position to accommodate customer's request for additional financing.

This is due to an Islamic financier is barred by the Sharia to adjust the purchase price of an asset retroactively and allow the benefit to customer.

Moreover, the asset is owned by the bank and not the customer, as such any benefit emanating from its revaluation should rightly belong to the financing bank.

Indemnities

Conventional banks routinely seek all sorts of indemnities from the customer if they finance an asset in order to completely eliminate the credit risk. The issue of seeking indemnities therefore becomes central in a co-financing environment.

From an Islamic bank's point of view, there should be no need for such indemnities simply because the asset is owned by the syndicate of banks and seeking indemnities from a lessee will be unfair.

Consider that Ahmed agrees to lease his vehicle to Bader and seeks indemnity from Bader against the failure of engine. Would that be fair? Of course not. Maximum Bader can do is to provide an indemnity to cover the damage if it is caused due to his negligence.

As such, an Islamic bank will not be in a position to seek various indemnities generally demanded by the conventional banks from their customers.

Market disruption

Conventional facility agreements normally contain a provision relating to a situation where the bank may find it difficult to fund its participation amount due to non-availability of sufficient dollars in the London interbank market on the required funding date due to some reason. The provision allows the bank to postpone its funding till the situation normalises.

The writer is head of risk management at Dubai Islamic Bank