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Sukuk as an alternative funding source for Islamic leasing (Ijarah)

By Dr. Shahinaz Rashad, and Executive Director, Financial Services Institute - Financial Regulatory Authority, and President, Egyptian Leasing Association

ISLAMIC FINANCE IS GOVERNED by the following key Shariah finance principles known as Fiqh al-Muamalat (Islamic rules on transactions), originating from Quran, Sunnah or Hadith as fol­lows:

  • Prohibition of interest/usury or 'Riba': Islamic lease struc­tures should not be debt/interest based, i.e. money should not be generated from money. Instead, rentals are paid against usufruct.

  • Prohibition of uncertainty or 'Gharar': Avoiding any specula­tion or uncertainty in the leasing contract. There must be full disclosure (e.g. certainty as to the subject matter or price of a contract).

  • Risk sharing: To encourage 'tangible' co-investment, and risk/returns should be shared.

  • Type of assets and ownership issues: Assets are Shariah com­pliant. Owner/lessor bears total loss risk, depreciation, insur­ance, maintenance, taxes, etc., related to the asset. Exploring differences between traditional lease structures

  • and Islamic finance structures.

  • Traditional lease structures often violate the aforementioned Shariah principles.

  • Conventional leases are prohibited as they require the bor­rower to pay back not just the amount borrowed but addi­tional interest payments that are considered to be debt/interest based; giving and receiving of interest money (Riba).

  • Conventional leases are not permitted from a Shariah per­spective, as they either invest in a prohibited activity or asset (alcohol, gambling, etc.).

  • Conventional leases may allow some degree of uncertainty or speculation; keeping one party disadvantaged.

  • Conventional leases violate shared risk/return. Thus, the lessee may bear total loss risk, depreciation, insurance, mainte­nance, taxes related to the asset.

The concept of Ijarah. Ijarah is defined by Muslim jurists simply as the transfer of the usufruct (right to use) of a particular Shariah compliant asset or property by one entity to another entity in exchange for a rental payment. In other words, it involves an arrangement to lease, hire or the transfer of ownership of a service for a specified period for an agreed upon lawful consideration.

The main difference between conventional lease and Ijarah is in meeting Shariah compliance aspects as mentioned earlier. Also, the underlying asset of an Islamic Ijarah structure must be Shariah compliant.

Common types of Ijarah. Ijarah Thumma Al Bai’. These are variations on a theme of purchase-and-leaseback transactions. There are two contracts involved in this concept. The first con­tract, an Ijarah contract (leasing/renting), and the second contract, a Bai contract (purchase), are undertaken one after the other. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price.

In effect, the bank/lessor sells the product to the debtor, at an above market-price profit margin, in return for agreeing to receive the payment over a period of time; the profit margin on the lease is equivalent to interest earned at a fixed rate of return.

Ijarah Muntahia-bi-tamleek (A.K.A. Ijarah-Wa-lqtina). A con­tract under which an Islamic bank/lessor provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership of the leased asset can be transferred to the lessee either without any additional charge or at a nominal price or even as a gift.

Table 1: Comparison of conventional versus Islamic lease

 

Conventional lease

Islamic lease

Rental payments

At time of funding through term of contract

Only when asset is delivered. No payments if asset is impaired

Risk of destruction

Often transferred to leesee

Remains with lessor, except in case of negligence or misconduct

Insurance and maintenance cost

Both often on the lessee. Conventional insurance

Has to be on the lessor, except periodic maintenance. Takaful insurance (recovery on premium)

Pricing

Variable or fixed

Variable or fixed

Penalty for late payment

Yes and income for lessor

In enforced as a preventive mechanism, has to be paid out in charity.

The unilateral undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such a manner that the bank gets back its principal sum along with profit over the period of lease.

In Ijarah Muntahia-bi-tamleek, the asset in which the investment is made is not purchased by the actual user (the customer), but by the bank as a financial intermediary, and is made available to the customer, sub­ject to payment of an agreed rental for the right of use of the asset for an agreed period, ending in the transfer of the ownership of the leased asset to the customer. The rental represents the investment return for the bank associated with the use of the leased asset and not a return on the money invested.

Basic principles of Ijarah.

  • The benefit of the Ijarah contract must be doable and realis­tic.

  • Benefit from the Ijarah contract cannot be perishing by usage.

  • The subject matter of any transaction including the underly­ing assets must be Shariah compliant.

  • The leased item or premises must be well known, specified and identifiable in a way that does not give a reason for fight­ing over it.

  • The lessor retains the risk of total loss (where the loss is not the fault of the lessee).

  • All risks, depreciation, insur­ance, maintenance of the asset must be borne by the lessor/owner during lease period.

  • Interest-based late payment penalties are considered Riba and cannot be charged.

Tapping the Sukuk market could help improve the capital structure and liquidity profiles of Asian and Gulf Cooperation Council companies.

Table 2: Comparison of Sukuk versus conventional  

Conventional bonds

Sukuk

Asset ownership

Bonds do not give the investor a share of ownership in the asset or project, but a debt obligation from the issuer to the bond holder

Sukuk give the investor partial ownership in the asset or project on which the Sukuk are based

Investment criteria

Bonds can be used to finance any asset, project or business

The asset on which Sukuk are based must be Shariah-compliant

Issue unit

Each bond represents a share of debt

Each Sukuk represents a share of the underlying asset

Issue price

The face value of a bond price is based on the issuer’s credit worthiness (including its rating)

The face value of Sukuk is based on the market value of the underlying asset

Investment rewards and risks

Bond holders receive regularly scheduled (and often fixed rate) interest payments for the life of the bond, and their principal is guaranteed to be returned at the bond’s maturity date

Sukuk holders receive a share of profits from the underlying asset (and accept a share of any loss incurred)

Effects of costs

Bond holders generally are not affected by costs related to the asset, project or business they support. The performance of the underlying asset does not affect investor rewards  

Sukuk holders are affected by costs related to the underlying asset. Higher costs may translate to lower investor profits and vice versa

Sukuk as a new source of liquidity and alternative funding source. A Sukuk is an Islamic bond(s) or certificate of invest­ment(s) backed by Shariah compliant tangible assets granting the holder beneficial ownership.

Consequently, Sukuk holders are entitled to a share in the revenues generated by a proportionate share in the Sukuk assets.

Sukuk created as an alternative to corporate bonds as interest-bearing instruments are not permissible under Islamic investment principles.

In the case of conventional bonds, the issuer has a contractual obligation to pay to bond holders, on certain specified dates, interest and principal. In contrast, under a Sukuk structure, the Sukuk holders each hold an undivided beneficial ownership in the underlying assets.

The Sukuk model is effectively a derivation of the conven­tional securitisation process, where a special-purpose vehicle acquires control of the originator's real assets and issues financial claims on the associated cash flows.

Sukuk acts as a new source of liquidity and alternative fund­ing source. The key selling feature of an Islamic Sukuk is its involvement in the funding and/or production of real assets. Tapping the Sukuk market could help improve the capital struc­ture and liquidity profiles of GCC and Asian companies, particu­larly those operating in capital-intensive industries such as infrastructure. It could provide such companies with the longer- term funding they need via a different funding source. This source is becoming more liquid as it reaches across border and becomes more global and grows in scale.

Types of Shariah compliant Sukuk assets.

  • Assets may include land, property, Ijarah portfolios (rental receivables), Shariah compliant investments and tangible objects rather than consumables.

  • Size of Sukuk issuance is restricted by the value of the assets transferred to the SPV.

  • Once the assets have been transferred for the purposes of a Sukuk issue, they cannot be used for any other purpose until the Sukuk issue has matured.

Sukuk Ijarah structures. Sukuk Ijarah is one of the most commonly used of 14 types of Sukuk described in the AAOIFI Shariah standards, as it represents almost 70% of the global Sukuk issuances. It is certificates of investment in a leased asset supported by underlying assets, usually by real estate or equipment that gen­erates future cash flows.

Sukuk Ijarah reflects the sale of the asset followed by the lease contract. It requires the originator or the party that requires the funding to sell his assets to the Sukuk Ijarah investors.

Thus, the Sukuk holders will have the claim on ownership/usufruct/services over the underlying asset through­out the tenor of the Sukuk while benefiting from income in the form of rental payment.

Key principles of Sukuk Ijarah.

  • Shariah compliant lease and underlying asset or rent receivables.

  • Lease rental payments "mirror" the profit payments under the Sukuk Certificates.

  • Obligation to undertake capital maintenance of leased asset remains with lessor (SPV).

  • Obligation to insure the leased asset remains with the lessor (SPV).

Lessor appoints a service agent (usually the lessee) to carry out servicing duties pursuant to a servicing agreement.

Types of assets: Asset based or asset backed?

  • The majority of recent Sukuk structures are asset based, i.e. upon insolvency, investors will only have recourse to the obligor (credit risk).

  • Sukuk structures can be adapted to provide additional secu­rity for investors by providing dual recourse to both the obligor and the assets, i.e. asset backed.

  • Legal analysis is required to ensure that investors can enforce any security provided by the structure.

  • Most investors prefer asset-backed Sukuk (69.4%) rather than asset-based (21.4%).

Sukuk lease programmes.

  • Sukuk programmes is essentially an uncommitted facility between a borrower (the "issuer") and a panel of investment banks (the "dealers").

  • Leasing companies may seek alternative funding by issuing Sukuk against their lease portfolios and the investment banks may purchase and place Sukuk Certificates from time to time on general terms.

  • The Sukuk programme enables a number of Sukuk issues for the leased assets portfolios to be effected through (essentially) one set of documentation.

  • The purpose of the Sukuk programme is to enable Sukuk issues to be effected quickly, economically and efficiendy as the detailed terms (ex: pricing) relating to any issue of Sukuk Certificates will only be agreed at the time of a particular issue.

How can lessors enter new markets and use Islamic finance deals? Leasing companies can make use of some of the 14 differ­ent types of Sukuk described in the AAOIFI Shariah standards such as Sukuk Ijarah and Sukuk Wakalah (Agency). A word of Caution: most Sukuk issued to date are asset based, where redemption monies are payable in accordance with purchase undertakings or repurchase agreements.

It is preferred by Shariah Scholars that the redemption monies depend on the actual performance of the underlying assets.

Leasing companies are certainly recommended to rely more on asset backed.

Leasing companies started to pay more attention to Shariah compliance in leasing contracts to meet the growing demand of Shariah adherents.

Multinational banks are obtaining licences for Islamic bank­ing and Ijarah from Central Banks in developing countries for Islamic finance syndications. Multinational banks are participating in cross-border Sukuk issuances.

Islamic banks and leasing companies that offer Islamic bank­ing products and services are establishing Shariah advisory com­mittees to advise them and to ensure that the operations and activities of the bank comply with Shariah principles.

Case study: Egypt. Sukuk is expected to play an important role in both creating added value for the Egyptian national econ­omy on a macro level and to the leasing industry on a micro level as some Islamic leasing (Ijarah) companies shall be seeking Shariah compliant funding.

In 2018, the Egyptian Parliament approved the most com­prehensive amendments (the "Amendments") to the Capital Markets Law No. 95 of 1992 (the "Capital Markets Law") since its enactment. The Amendments establish a legislative framework for Sukuk issuance and trading in Egypt.

The Financial Regulatory Authority (FRA) has set the reg­ulatory framework for Sukuk issuers - who will operate special- purpose vehicles (SPVs) that exclusively issue Sukuk. The framework outlines regulations for licensing and establishing SPVs, whose activities under the framework will be limited to investing on behalf of Sukuk holders who get paid on a profit/loss basis rather than a fixed coupon rate. The issuers are permitted to invest only in sectors compliant with Shariah law.

The framework also regulates Sukuk tenors, investment durations, expected return rates, dividend sharing, and the Sukuk exchange and return mechanism. The issuer is also responsible for obtaining credit ratings, asset management, and conducting feasi­bility studies on an asset.

Those seeking a Sukuk issuer licence must have a paid-in capital of at least EGPlOm, with 50% coming from a single share­holder and 25% from a financial institution. Most board members of a Sukuk SPV must have at least three years of experience as finance professionals and must have neither a direct nor indirect stake in the investments of the SPV.

In July 2019, the Financial Regulatory Authority issued a guide on the trading of Sukuk — a newly developed financial tool in the capital market — in line with recent legislative amendments. The guide is meant to shed light on the Sukuk system, especially after its regulatory framework has been outlined.

Moody's Investors Service had expected Egypt to become one of the Islamic Sukuk issuers during 2019.The FRA is hoping to start the issuance of Sukuk, seeking a good position for Egypt in the global Sukuk market.

Author.

Dr. Shahinaz Rashad, Financial Expert and Executive Director, Financial Services Institute Financial Regulatory Authority Founder, and President Egyptian Leasing Association (ELA) 28 Talaat Harb - 3rd floor Down Town Cairn, Egypt Tel: +202 257 83 905

Email: dr.shahinaz@gmail.com

Website: www.fra.gov.eg

Source: World Leasing Yearbook 2020, 41st Edition.