This essay has been submitted by a law student. This is not an example of the work written by our professional essay writers.
Risk in islamic banking finance
The Islamic Bank of Translavia (IBT), while making the transaction under the Ijarah Islamic financing technique, needs to consider different laws and risks that can be brought in by this transaction. There are various issues that should be arranged by IBT so that they can make the correct decision that will not hamper their status. The financing under Ijarah to East Airlines (EA) will bring favorable results but should be handled along the lines of law in which they are going to make the transaction. The issues that might bring in risk as per the UK law must be complied with so that they can mitigate the risks that they might face in this transaction.
The focus of this paper will be on exposing and discussing the risks that might arise in case of financing aircraft purchase. The paper will focus on the risks that IBT will be exposed to through following Ijarah as compared to other conventional form of financing. The paper will highlight the measures that will help in mitigating the underlying risks. Finally, a law clause will be provided with regard to this transaction of financing four aircrafts under Ijarah.
What is “Ijarah?”
Ijarah is an Islamic financing technique used in Islamic banking as a mode of financing assets to the customers. In Islamic banking Ijarah is used in the form of leasing. Due to its varied advantages Islamic Banks use Ijarah so that they can better use their resources and funds. The asset is purchased by the Bank from the seller and thus, Bank holds the ownership of the asset. In this form of Ijarah, the asset is leased out to the customer by the Bank. The holder of the asset has to pay a specified amount of lease or rent to the Bank for using the asset. London Interbank Offered Rate (LIBOR) can be used as a leasing rate under this Ijara transaction. The payment of the lease can be made in parts. Under the Ijarah contract, the terms and conditions can guide the end-user to purchase the underlining asset at the end of the contract after making full payment as per the rules and terms of the contract. The end-user of the asset does not hold the right of ownership, although the asset is in its possession. Since the possession holder does not have the right of ownership, he has no right to transfer or sell the underlining asset.
Background to the transaction
Islamic Bank of Translavia (IBT) will purchase four aircraft for US $50 million from Universal airways as per the selection of the East Airlines. It can be presumed that the aircraft will be leased out to East Airlines for which it will pay rent to the bank. Thus, the real ownership of the aircraft will remain in the hands of the bank, although the possession of aircraft will be transferred to East Airlines under the Islamic financing technique.
Islamic Bank of Translavia (IBT) under Ijarah terms can also make the contract that the ownership shall be transferred to the possession holder at the end of the contract, in order to ensure that liability of the heavy investment in the four aircraft of about US $50 million does not go wrong.
Key Issues in the transaction under Ijarah terms
There are various issues and risks involved in dealing in terms of Ijarah for the Islamic Bank. IBT follows all rules and regulations of Islamic banking finance to govern terms of contract but as there is a difference between this system and English law there are attendant risks. Under the English law, if a lessee does not pay the lease amount, the banks can impose any monetary penalty on the lessee and uses it as operating income but under the Ijarah contracts, banks are stopped to use monetary penalty as its income. The monetary penalty amount is donated to society under the Islamic banking. Even the terms of Ijarah leasing is provided by the Islamic banks under the principles of Shari'a advisory board creates risks that are not found in the conventional lending made by the other conventional banks. On the other hand, lease holders reap many benefits of Ijarah. The terms and condition are considerably more limited in Ijarah contracts than in traditional leases contracts. All expenses of Ijarah contract are treaded as operating expense, so the lease holder and lease-lend can get teax benefits.
Islamic bank IBT which is established in London will have to face risks as the value of the aircraft may get reduced at the end of the contract which will lead to a fall in value that will hamper the profits of the bank, thus creating losses. Another risk is that if the East Airlines defaults on their contract, the Bank will experience heavy losses. The burden of credit and default risk might arise in this case and IBT has to feel the tough time due to big losses. Under Ijarah terms, IBT has to see the maintenance of the aircraft over the life of the contract which seems likely to incur significant maintenance costs as the assets are aircraft that demand maintenance of high level.
Another issue that might arise is related with the asset that is the aircraft that is taken as buying and selling transaction. The issue under the law will generate as in relation with the asset. Islamic Bank of Translavia has to find ways to make the situation appropriate so that such risk can be reduced or eliminated. The relation between the buyer and the seller should be cordial and there should be a clear discussion on the terms of the contract between the buyer and the seller.
A further issue that can make into the entry into the picture or the contract is that Islamic bank uses monetary funds for house financing and the outflow of the funds for aircraft purchasing can create an issue. Since this will make less liquidity and reserves in the hands of the bank. This can bring in issues between the bank and its customers as the liquidity risk spreads. This liquidity risk can create an operational risk as banks feel the pressure of liquidity crunch. This pressure can destabilize the financial stability of the bank and even hinder its business and funds.
The Ijarah leasing tax also applies on the same basis as on the conventional lease but the difference is that as Ijarah both include purchasing an asset for the customer and leasing the asset the tax applies twice on the Ijarah terms as it is not in accordance with the English law to make such an arrangement. The tax might be an issue in this condition for the IBT. Thus the Ijarah contracts should be clear that can explain, that the contract is purchasing of an assets or leasing contract.
Even the ownership risk taken by the Islamic bank under Ijarah terms are not taken by the conventional banks in their conventional lending. Islamic Banks offer financing with an ownership stake with them contrary to conventional banks that provide transfer of ownership through financing even in case of part payment and mostly in case of full payment. One of the issues that are clearly different from conventional lending are related to the penalty clause in case of default or untimely late payment of the installment.
Unlike conventional lending under Ijarah terms, one of the issues is that IBT will not lay out a penalty to East Airlines in case of late payment or in case of default of the payment taking extra money is not regarded fine under the Islamic financing technique. IBT has to understand that this might create heavy losses to the bank. Therefore in order to make the terms of the Ijarah contract better and to make such that it can be approved by the IBT's Shari'a Supervisory Board it can lay a penalty in case of default or late payment. It can be considered under a charity clause where the penalty received will be transferred to a charity. This will help IBT to stay tuned to get the approval of the board even in certain cases where the customers having a bad reputation to supplement the losses the board also gives approval to Islamic Bank to get an extra penalty but the issue is that it should not be exercised with the prior approval of the board.
In order to obtain the approval of the Shari'a board, IBT should disclose all the terms of the Ijarah contract clearly with the leasing terms of payment. The customer is liable to make free his obligations timely but still some real hindrances arises there are exemptions to that by the virtue of Islamic holy faith. Thus, in case of genuine financing difficult the customer should be given relief and payment can be taken when it becomes capable of paying such an amount. These are different from conventional lending as there is hardly any relief is given and even the high penalties are laid on the person in case of default.
The Shari'a board will not give the permission of keeping any financial security such as stocks or bonds as collateral as they are subject to interest payments. The terms of the contract under Ijarah should highlight that payment be made directly into the bank account. These matters and with the content of the Shari'a board the approval can be received on the transaction. A Shari'a board typically approves that instead of laying down interest that is a financial penalty in case of non- payment the bank can lay down other non-monetary penalties on the customer. Apart from taking the possession of the aircraft, they can also mark the customer as bad so that it cannot take any loan in the future also from any other bank. The transaction and such terms as discussed above are highly valuable in getting the approval of the board in this transaction.
There are certain risks and issues that are similar in Iajarah leasing by Islamic Banks and conventional lending provided by the conventional banks but still among various differences on the issues one of the issues is that as in case of Ijarah leasing contract the owner is the bank for the asset the insurance cover is also provided by the bank in contrast to conventional lending the same has to be cover by the customer.
Mitigation of the risks in the transaction
IBT can use a variety of ways to mitigate the risks that will arise from the Ijarah leasing. IBT has to make its focus on the English law and has to abide and make changes as per the English law in order to mitigate issues that will be there in case of Ijarah.
In order to mitigate the risks of maintenance and selling the aircraft to another party at the end of the contract, IBT can use ‘Ijarah Muntahia Bittamleek'. Ijarah Muntahia refers to a lease contract which is eand with transfer of ownership of lease property. This addition in the terms of Ijarah safeguards the interest of IBT. Under this IBT will not be liable for the maintenance of aircraft and even selling them at the end of the contract. This will shift this responsibility to East Airlines. As the possession is with the East Airlines, the maintenance cost and the burden of selling or acquiring the ownership at the end of the contract becomes the liability of the East Airlines.
The Bank and the customer can also go in for Ijara wal- Iqtina in Ijarah contract. In the Ijara-wal-Iqtina, the property and equipment are provided on the basis of pre-decided rent and unilateral undertaking of bank or client that after lease payment, the transfer of ownership of property will be transferred to lessee. This will avoid the risk as under this Bank can make a contract where the ownership will get transferred to the customer at the end of the contract. The bank is also based in London thus; it is perfect to make a transaction taking LIBOR as a standard rate.
The doctrine of privity is also an important matter that the bank should consider while making the contract. This doctrine reveals that other than the parties of contract third party can also make its interference, if required. Thus, the valuation and rights of the contract should be fair and as per the standards since government and legal bodies can create an issue in case of non-compliance of the rules of the commercial law. The law by its virtue can create hinders if it feels the amount or any other rules are inadequately followed by the parties to the contract. Thus, if a bank needs to make sure that they monitor and control their activities and make a transaction that could be free from such an issue.
A bank has to consider the various rules and regulations of the commercial law so that it can satisfy the provisions, which will help to mitigate risk. Before going into the contract and making the transaction happen, they should act as per the law and determine risks that might arise in between or at the time of contract. Since this will help it to analyze and evaluate the risk that causes problems. The evaluation and analysis of the problems and risks that is inherent in placing the transactions will help the bank to mitigate those risks before they arise or when they arise.
UK law demands that a contract is completed when a formal registration of transfer is made and duly affected by both the parties, whereas the Islamic law believes that ownership will merely get transferred when one party may purchase and other parties sells the asset. Islamic law believes that the contract is completed when one party makes an offer and another party accepts the offer. Thus, regardless of whether a formal registration is made or not the contract gets completed. This difference can also raise an issue and might create a risk. Bank in order to mitigate this risk should make a clear analysis of the rules and regulations of the UK law and should make and perform the contract on that basis. If the bank does so that will help them to understand the rules and acting accordingly will keep them away from the risk that might affect them.
All the risks such as of default or loss of the capital can be safeguarded by using a better credit rating system and deeply analyzing the credit worthiness of the customer before offering him the required asset as in this case the financing of the aircraft for East Airlines. Islamic banks under the provisions of English law and Islamic law can do this thing in order to mitigate this credit risk. Under both the law as discussed earlier, IBT can include such non-financial penalties in the terms of the Ijarah contract that are obligatory for both the laws as to the English law and the Shari'a board. Forward and derivatives contracts can be used by IBT to hedge the risk and in order to get approval of the Shari'a board a clause that facilities that if there are any extra benefits or interest received by the Bank other than compensation for the loss. Then all will be transferred to a charity under the charity clause. In this way, it can have a hedge against the risk and risk can be mitigated as to the point it can and even by complaining with the Shari'a board terms. Hedging of risk is very important in this uncertain world and IBT Bank in order to make and safeguard its financial stability has to make this step. Even the amount of financing is so big that it becomes at most essential to take a hedging instrument to make itself safe at any contingency in the coming future. The benefits in the general course should be shared between the Bank and the East Airlines as a partnership. This is one of the important terms of the Ijarah contract which makes contract executable in the court.
Choice of law clause for this transaction
In the case of Shamil Bank v Beximco the English court also revealed that the bank had met its contractual obligations as per the Islamic religious law and the customer has to abide by it and it is duly accepted by the English law . The court decided that the contract could be enforced by Islamic bank as per the Shari'a principle, and it made acceptable those terms under the English law, thus this became the governing law for Islamic Banks and their transactions. Therefore, the transaction of Islamic Bank of Translavia with East Airlines can also be made compatible with these laws of Islamic Banking and even with English law. In this way IBT can manage this transaction of financing aircraft without any hindrances in the future.
After the analysis of situation and all aspect of the Ijarah, the transaction between IBT and the East Airlines seems to be compatible with the Ijarah terms of Islamic Banking. The best of the laws that will be compatible with the Shari'a Board for Islamic Banking and its rules is likely to be English law and thus, the transaction is going to be governed by the appropriate law. Islamic law, which is governed by the Shari'a board, is quite a unique form of law that has different standards under Ijarah leasing arrangement in contrast to other conventional laws for lending on the lease. It is hard to find legal support for its principles in modern commercial dealings. A Shari'a board and the terms of the Islamic banking and Ijarah are governed by the holy faith. The principles of Shari'a can be fulfilled and governed in a systematic way by using certain specific clauses to reduce any sort of disagreement between Shari'a and English law.
The governing law clause for this transaction of financing four aircraft for East Airlines that is currently owned and operated by Universal Airways will be drafted in an appropriate manner so that no further issues and risks arise. ESUAs and Murabahah agreements also support the compatibility that is between the principles of Shari'a and English law. They state that English law is one such law that can support the principles accepted by the glorious Shari'a board for Islamic Banking. The law clause as per the best arrangement ,and if considering the wording given by the ESUAs and Murabahah agreement for this transaction, can be drafted with the assurance that the customer will act in good faith and its guarantee contract shall be governed by the clauses of English law without any modification in them. This should be done after receiving the approval of the Shari'a board. The complete contract and the structure of the contract shall be established as per the principles of Shari'a.
Both parties included in the transaction, the Islamic Bank of Translavia (IBT) and East Airlines (EA), should understand that the basic principles of Shari'a boards will be applicable on the Ijarah contract and issues like gaining the approval of RSB on the matters of the contract shall be included in the contract while making English law as an enforceable law in case of any disagreements. Thus, when the parties as per specific principles of Shari'a board approves English law up to the limit that will be best suited to them, to the extent that they can make a best fit contract.
This can bring in such smooth terms that will help the Bank to make and work at the transaction as it can avoid any further potential issues that might occur either as per the religious Shari'a advisory board or by the English law. Thus, the Bank shall be able to follow the Islamic religious principles even by operating in the international context and under the English law.
It can be said that the transaction between the IBT and East Airlines can be best formed under the governing law of England and Wales, as they are compatible with the principles of Shari'a advisory and religious boards. The different issues and risks that might arise due to Ijarah terms to the Bank can be mitigated and reduced, if they are analyzed and monitored in advance. The Bank can make certain terms and engage itself in making the transaction in good faith by analyzing the credit rating of East Airlines.
The transaction of financing four aircraft is a significant investment that can hinder the financial stability of the bank, if any disarrangement occurs in between the duration of the contract. The Ijarah terms of leasing are different from conventional lending and thus, utmost care is required that the transaction should be conducted after understanding both the Islamic law and English law as to avoid the extra risks and issues that are related to the Ijarah leasing arrangement. The law clause should be formed specifically after analyzing the risks associated with the Ijarah so as legal support of the English law can be availed in case of default.
A.J. Karimi, ‘Challenges facing Islamic banks'  <http://www.dawn.com/2006/12/04/ebr12.htm > accessed 9 January 2010.
Clarence J. Mann and Klaus Götz, Borderless Business: Managing the Far-Flung Enterprise (Greenwood Publishing Group, 2006).
Frank E. Vogel and Samuel L. Hayes, Islamic Law and Finance: Religion, Risk, and Return (BRILL, 1998).
Islamic Finance Weekly, ‘English law a safe haven for Islamic finance'  <http://www.zawya.com/pdfstory.cfm?storyid=ZAWYA20040225085244&l=085200040210> accessed 9 January 2010.
Islamic Finance, ‘Tax Briefing'  <http://www.revenue.ie/en/practitioner/tax-briefing/78/> accessed 9 January 2010.
Iwan Davies, Issues in International Commercial Law (Ashgate Publishing, Ltd., 2005).
Leslie Lang & Mahesh Uttamchandani, ‘Issues in Islamic Finance What Insolvency Practitioners Need to Know'  <http://www.turnaround.org/Publications/Articles.aspx?objectID=6931> accessed 9 January 2010.
Michael Freeman, Current Legal Problems 2002 (Oxford University Press, 2003).
Munawar Iqbal and David T. Llewellyn, Islamic Banking and Finance: New Perspectives on Profit Sharing and Risk (Edward Elgar Publishing, 2002).
Muhammad Ayub, Understanding Islamic Finance (John Wiley and Sons, 2007).
Mohammad Hashim Kamali, ‘Shari'a Issues of Islamic Leasing: Perspective of the Lessor'  <http://www.financeinislam.com/article/10/1/553> accessed 9 January 2010.
Rodney Wilson, ‘Credit risk management in Islamic Finance' . <http://www.newhorizonislamicbanking.com/index.cfm?section=academicarticles&action=view&id=10484> accessed 9 January 2010.
Robin Burnett & Vivienne Bath, Law of International Business in Australasia (4th edn Federation Press 2009)
Margaret Barron, Fundamentals Of Business Law (5th McGraw-Hill 2006)
‘The Muslim Diaspora partners in strategy'  <http://www.mcb.org.uk/downloads/5th%20WIEF%20Brochure.pdf > accessed 9 January 2010.
W Edwardes, ‘Ijara (Islamic Leasing) in the context of Islamic Finance'  <http://www.islamic-world.net/economics/ijara.htm> accessed 9 January 2010.
White Sally, Expressing Islam: Religious Life and Politics in Indonesia (Institute of Southeast Asian Studies 2008).
Cite This Essay
To export a reference to this article please select a referencing style below: