Risk profile of Ijara structure

In our new subject on risk management in Islamic financing structures, we are in the process of examining the risks in an Ijara transaction and how they are mitigated from within the Ijara or leasing structure.

We have discussed the text of the 'Promise to Lease' which is obtained from the customer and effectively covers any probable situation where the customer may not be able to fulfill his promise, and therefore be accountable to make good any financial damage an Islamic Financial Institution (IFI) may sustain.

A question was raised by a reader relating to such a situation and what if the customer is unable to honour his promise to compensate the IFI? Will it therefore, be in order to obtain external guarantees or collaterals to secure the customer's obligations in terms of his promise?

The scholars have responded that whilst it will be appropriate to rely on the mere promise, which is absolutely binding on the promisor (customer), Sharia does not object on seeking additional securities in support of the execution of the customer's promise.

What's more, it is implied that the IFI will enter into such transaction only after having carried out its due diligence on the customer. This is because the IFI is Mudareb, and therefore a trustee for the funds it has acquired from the investors and is duty-bound to deploy those funds diligently.

The next risk an IFI may be confronted with in an Ijara transaction concerns the accuracy of the value of the asset if it is purchased by the IFI from the customer in a 'Purchase and Lease Back' structure. In other words, what is the guarantee that the asset is worth the value IFI has been asked to pay?

Contrary to the situation where an asset is purchased by the IFI from a third party for the purpose of leasing it to the customer, it is rather tricky at times to rely on the quoted value of the asset owned by the customer and which the IFI intends to purchase for leasing it back to the customer.

There are a variety of ways to allay such valuation risk. First, the IFI can opt for the independent valuation of the asset through professional surveyors of its choice. Of-course the cost of such survey will be borne by the customer.

Second, the purchase agreement signed by the IFI with the customer will contain several representations and warranties, one of them relating to the valuation of the asset being genuine. We know that the subsequent discovery of the customer providing a false warranty can make an agreement null and void, giving absolute right to the aggrieved party i.e. the IFI to claim damages from the customer.

Another mitigating aspect may be through the lease rent which as we have learned earlier in this column is comprised of the fixed element being the cost of the asset divided over the number of lease periods and the variable rent representing the IFI's return on investment in the leased asset.

First of all, by inflating the asset price to the IFI, the customer will not gain much since he will be required to pay the purchase price as part of the periodical rent, thus over-burdening himself for the entire lease period.

Moreover, in case of the occurrence of an event of default, the IFI will have the right to exercise the put option given by the customer to IFI by way of a purchase undertaking at the time of entering into lease agreement.

The customer may find it difficult at that time to wriggle out of his commitment and pooling in the necessary financial resources to purchase back the leased asset at an over-inflated value could become a nightmare for him.

We have thus observed from the above explanation that the structuring of a financing transaction on Sharia principles alleviates unwarranted risks without resorting to outside help.

To be continued.

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