ECONOMIC BENEFITS of ISLAMIC LEASING
Mohammad Nejatullah Siddiqi
INTRODUCTION
Finance is very important for the economic welfare of people, next only to division of labor. It is finance that enables one to produce what one expects others to buy, thus enabling one to earn a living. With greater specialization, longer periods of production and larger markets, finance grows in importance.
Finance inheres in one wealth owner’s money being made available to another for use, i.e., for acquiring goods and services needed for consumption or production. With the exception of charity or gift, finance always involves two things; repayment and return on the money given.
The theory of Islamic finance in its early days focused on profit sharing. Experience soon added trade based modes of finance, beginning with murabaha /bay ‘ mu’ajjal. To this list was soon added ijarah (leasing),
Salam (pre-paid orders) and istisna ‘ (ordering manufactured goods with promise to pay on delivery, or even earlier). It is interesting to note that these ‘Islamic’ contracts (given this name because of there having been adapted early by Muslims despite their pre-Islamic origins) were not originally for financing. They were only recently adapted to play that role. In fact they have a double role. Each one of them can be practiced, and sometime is actually practiced, in its original, simpler way, as a mode of trade. But they are discussed in the theory and practice of Islamic finance in their more developed, modern-Islamic sense of being a means of financing.
Trade Based Modes of Finance
Let us pause and try to answer the question: How a mode of trade is adapted to serve as a mode of financing?
Finance has always been closely related to trade. In fact it emerged out of trade, as evidenced by trade credit—goods supplied on the promise of price to be paid later. Salam and istisna ‘, are obverse to trade credit, price paid against the promise of supplying goods later. The contract of ijara allows both the supply of the relevant asset-based benefits and payment of price to take place in the future. Since the benefits, like the benefit of residing in a house, flow only gradually and the rent may be paid once for all in advance, ijara too may involve financing. So there is no inherent conflict between trade and financing. There is no reason further adaptation or sophistication be ruled out, insofar as using trade for financing is concerned. What is unacceptable is trading money paid now for money paid in future with an increment. It is not difficult to see that some of the above mentioned contracts are capable of being used as a smoke screen for doing so. That will of course be unacceptable. And that is what Islamic finance has to prevent.
A direct deal between producers and consumers/users of goods or assets rarely takes place. There are intermediaries between producers and users/consumers. We call them traders. Traders in fact never intend to use the goods they buy. Their purpose is making a profit by selling what they purchased, often to its user/consumer. In the same manner, salam, istisna’ and ijara may well take place between an intermediary and the user/consumer.
In some cases this intermediary is a financial intermediary. An Islamic financial intermediary enters into well known Islamic contracts ( e.g., bay ‘ mu’ajjal, salam, istisna ‘ and ijara) with a view to making some profits by providing finance to those who need it. They do so not by handing out money to the user /consumer but by paying for the needed goods or assets to its supplier and handing over the asset or good to the user/consumer, price or rent to be paid in future.
Mohammad Nejatullah Siddiqi
INTRODUCTION
Finance is very important for the economic welfare of people, next only to division of labor. It is finance that enables one to produce what one expects others to buy, thus enabling one to earn a living. With greater specialization, longer periods of production and larger markets, finance grows in importance.
Finance inheres in one wealth owner’s money being made available to another for use, i.e., for acquiring goods and services needed for consumption or production. With the exception of charity or gift, finance always involves two things; repayment and return on the money given.
The theory of Islamic finance in its early days focused on profit sharing. Experience soon added trade based modes of finance, beginning with murabaha /bay ‘ mu’ajjal. To this list was soon added ijarah (leasing),
Salam (pre-paid orders) and istisna ‘ (ordering manufactured goods with promise to pay on delivery, or even earlier). It is interesting to note that these ‘Islamic’ contracts (given this name because of there having been adapted early by Muslims despite their pre-Islamic origins) were not originally for financing. They were only recently adapted to play that role. In fact they have a double role. Each one of them can be practiced, and sometime is actually practiced, in its original, simpler way, as a mode of trade. But they are discussed in the theory and practice of Islamic finance in their more developed, modern-Islamic sense of being a means of financing.
Trade Based Modes of Finance
Let us pause and try to answer the question: How a mode of trade is adapted to serve as a mode of financing?
Finance has always been closely related to trade. In fact it emerged out of trade, as evidenced by trade credit—goods supplied on the promise of price to be paid later. Salam and istisna ‘, are obverse to trade credit, price paid against the promise of supplying goods later. The contract of ijara allows both the supply of the relevant asset-based benefits and payment of price to take place in the future. Since the benefits, like the benefit of residing in a house, flow only gradually and the rent may be paid once for all in advance, ijara too may involve financing. So there is no inherent conflict between trade and financing. There is no reason further adaptation or sophistication be ruled out, insofar as using trade for financing is concerned. What is unacceptable is trading money paid now for money paid in future with an increment. It is not difficult to see that some of the above mentioned contracts are capable of being used as a smoke screen for doing so. That will of course be unacceptable. And that is what Islamic finance has to prevent.
A direct deal between producers and consumers/users of goods or assets rarely takes place. There are intermediaries between producers and users/consumers. We call them traders. Traders in fact never intend to use the goods they buy. Their purpose is making a profit by selling what they purchased, often to its user/consumer. In the same manner, salam, istisna’ and ijara may well take place between an intermediary and the user/consumer.
In some cases this intermediary is a financial intermediary. An Islamic financial intermediary enters into well known Islamic contracts ( e.g., bay ‘ mu’ajjal, salam, istisna ‘ and ijara) with a view to making some profits by providing finance to those who need it. They do so not by handing out money to the user /consumer but by paying for the needed goods or assets to its supplier and handing over the asset or good to the user/consumer, price or rent to be paid in future.
Like all intermediaries, Islamic financial intermediaries too are not interested in the goods or assets they acquire. They eye the profits expected when these goods or assets are passed on to those who needed them but did not have the money to buy or hire them. What distinguishes them from ordinary traders is that their assets are money. Their stock in trade is not goods and services, as in case of traders. But they cannot trade in money, such trade being prohibited in Islam. So they adapt trade for the purpose of financing and profiting thereby. Like all other traders, heir profits are not guaranteed. They may even lose. Default by debtors is not the only risk they face. They face almost all kinds of business risks too. This is a distinctive feature of Islamic financial intermediation. It always involves some risk. But we cannot go into the subject of risks facing Islamic financial intermediaries in this paper.
The Islamic financial intermediaries are spending their money now to acquire these goods and assets in expectation of getting more money than they paid for them from their clients, in future. This distinguishes Islamic financial intermediaries from their conventional counterparts who are trading in money now for more money in future. To be able to earn a profit on the money they have, the IFIs have to buy a real asset and then sell it for money. They run the risk of having to sell at a price that leaves them no profit or even involves a loss. They may be exposed to other business risks too, but we need not discuss them here.
Most of the money Islamic financial intermediaries have comes from the public who deposited it with these intermediaries for making profits for them. But, don’t forget what was noted above: all these contracts are also in use for their original purposes .In case they are used for their original purpose, .e. for acquiring goods and services to be used or consumed, they are modes of trade. It is only when used by an Islamic financial intermediary for supplying finance that they become ‘trade based modes of finance’.
Islamic Leasing
This brief paper will deal with leasing in the framework of Islamic finance and banking. I try to argue that leasing affords a convenient method of financing. This method is capable of serving almost all kinds of needs, e.g., financing businesses, consumers, governments, etc. A comparison with other methods of financing will be made. Then, leasing will be examined in the light of the distinctive features of Islamic finance, such as fairness, stability, and efficiency. I will argue that Islamic leasing needs to abide by certain norms in order to be truly serving the ideals of Islamic finance. Given this, the induction of leasing in the armory of Islamic finance is a welcome development likely to widen its scope and strengthen the case for Islamic finance.
Before discussing leasing as a means of financing, let us discuss leasing itself, i.e. operational lease. The economic role of leasing proper is facilitating sale and purchase of usufruct of tangible things like lands, buildings, vehicles, vessels, aircrafts, equipments, etc. The lessor, who owns the asset and wants to make money out of it without losing its ownership, can do so by leasing the asset. The lessee who needs to use the asset but cannot afford to buy it, or does not want to own it permanently, can fulfill his need by acquiring the asset on lease, paying a rent. In a freely competitive market rents and rentals will be determined like any other prices. If these markets are also free of immoral practices (like fraud and deception, hoarding, etc.) these prices, rents and rentals will be fair, stable and efficient in the sense that they clear the market as well as ensure steady supplies, other things remaining the same. As the main purpose of the user, firm or individual, is served well by leasing, the choice between owning and leasing will depend on the costs involved.
Direct contact between the asset owner and the asset user may not occur easily. There is a role for intermediaries. Another problem arises when the asset user does not have the money to pay the rent or rental. He hopes to be able to pay when he sells the products for whose production the asset is needed. Here is a role for a financial intermediary who can invest some money to acquire the needed asset and provide it to the user at a deferred rent or rental that takes care of the cost of acquisition yet leaves a return for the money invested.
Let us remind ourselves about the economic role of financial intermediaries. They intermediate between wealth owners who have money they want to invest and those who need money for business. But the money needed for business is ultimately destined for acquiring some assets needed by the business. Out of the different kinds of assets businesses need some are in the nature of tangible goods mentioned above. Financing the acquisition of lease-able assets by businesses that need to use them is one possible way of financial intermediation.
A financial lease implies that ultimately the lessee will own the asset leased. A return of the leased asset to the lessor is not envisaged, sometime not permitted at all. Financial lease in its conventional form evolved out of the society’s needs over a period of time, gaining prominence in 1960s and becoming popular in the following decade. As the IT sector boomed in the nineteen nineties, leasing computer hardware and other IT accessories was found to be more convenient than owning them, in an environment of rapid technological change and fast obsolescence.
Modern Islamic jurisprudence grappled with the special issues raised by financial leasing for quite sometime as it involved a number of things unacceptable in Islamic law. As of now the issues have been sufficiently thrashed out to enable the Accounting and Auditing Organization of Islamic Financial Institutions to put forward a set of standards.
The AAOIFI STANDARDS
The standard relating to financial leasing (characterized as ijarah muntahiah bittamleek) aim at guarding against the danger of financial lease degenerating into ‘inah. It does so by separating the lease contract from the contract transferring the ownership of the leased asset to the lessee. It also lays down that the promise to transfer ownership of the leased asset to the lessee is binding only on one party, the lessor. The lessee remains free to buy or not to buy the asset. Standard 8/5 relies on the passage of ‘a (reasonable) period of time’ between ‘the lease contract and the time of the sale of the asset to the lessee’ in order ‘to avoid the contract of ‘inah.’ It further stipulates that: ‘This period must be long enough so that the leased property or its value could have changed’.Unfortunately, the vagueness built into the standard is likely to make it ineffective in realizing its purpose. What is a reasonable period of time? What is meant by a change in property? What amount of change in value will be acceptable, and who will arbitrate on the issue? The history of the practice of ‘inah ought to have made us wiser!
The rational reaction to granting the lessee freedom to buy or not to buy the asset would be, on part of the lessor, to assume the worse, that the lessee will not buy the asset. Assuming no value could be realized for the asset after the lease period, the lessor would try to realize the full value of the asset, in the form of rentals, during the (binding) period of lease. This raises serious questions about the rationale of this provision. It is not clear whose interest it serves. The lessee, whose freedom of choice it supposedly seeks to protect, hardly stands to gain by this provision.
Economic Benefits of Islamic Leasing
Let us proceed to discuss the economic benefits of Islamic leasing. Five distinct benefits of Islamic leasing can be mentioned:
1. As noted above, Islamic leasing necessarily involves real assets. This ensures and strengthens the linkage between the financial sector of the economy and the real sector contributing to economic stability. In this way lease finance relates to a distinctive feature of Islamic finance, a feature missing in the conventional system. Proliferation of financial assets without any counterpart in the real sector of the economy makes the financial markets vulnerable to speculative games threatening to turn these markets into a casino. It also engages a large number of highly skilled people into maneuvers that have nothing to do with production of goods and services. Incomes generated by these activities have contributed to the increase in the inequality in the distribution of income and wealth in the society.
2. Islamic leasing creates a great potential for securitization. Sukuk based on ijara can be traded in the market, affording a convenient instrument for investing savings to the people of small incomes who constitute the overwhelming majority in the developing countries in general and in the Muslim countries in particular.
3. Islamic leasing is especially suitable for some sectors of the economy for which sharing-based modes proved to be rather difficult to practice, e.g. the consumers sector and the public sector. It can take care of the public sector projects related to infrastructure building, e.g., roads and bridges, airports, irrigation systems, hospitals, schools, etc. As a matter of fact most of the leasing based sukuk issued recently belong to this category.
4. Lease finance is easier to practice as it involves less documentation and takes less time to conclude a deal. Unlike lending, it does not need collateral and no thorough enquiries into the creditworthiness of the lessee are called for. The physical presence of a tangible asset, the subject of the lease, whose ownership may remain with the lessor, makes these formalities unnecessary. This may make it especially suitable for the rural sector, where formalities may hamper operations.
5. Lease finance has some of the good features of debt finance and, at the same time, is free of some of the weaknesses of sharing-based modes of finance. There is less possibility of moral hazard/adverse selection than the sharing modes. There is no agency relationship between the lessor and the lessee, as is in the case of mudarabah (profit sharing), for example. The payment obligation of the lessee, the rent, is fixed, as in case of debt. It is not a case for adverse selection as no part of unforeseen losses/costs can be passed over to the lessor.
A WORD of CAUTION
Exchange of a sum of money given now for a larger amount of money to be paid after a period of time is prohibited in Islam, being riba. The prohibition also applies to arrangements that intersperse an asset, formally, just to change appearances of the contract. An example of this is ‘inah in which an asset is purchased on credit then sold to the seller, from whom it was purchased, for cash. In this case what has really happened is an exchange of money for money. The money owed, and to be paid after sometime, is larger than the money obtained now, in cash. The asset stays where it was. It is, once again, owned by the dealer using it as a means of ‘inah.
A lease contract in which an asset is sold for a sum of money paid in cash now, only to be acquired back on lease by the seller from the buyer for a larger sum of money to be paid over a period of time as rents, looks similar to the above transaction. The asset stays where it was. What has changed hands is money: the asset owner has obtained cash against the obligation of repayment with an increase over a period of time. However there is one difference. Though the asset is back in possession of the original owner, he does not own it, being merely a lessee. He can lease it to others but he cannot sell it, starting another cycle of ‘sale with lease back’ financing. That makes it different from tawarruq, in which an asset is purchased on credit to be sold back for (a smaller amount of) cash. That asset can once again enter another cycle of tawarruq. Not so in lease finance as currently practiced by Islamic financial institutions. Perhaps it is this difference that has persuaded some to allow the transaction. But the crucial point is the economic impact, is it any different from a money loan?
It is very difficult to answer that question. It is especially difficult in the absence of empirical data. All that this writer can do is to emphasize the relevance as well the importance of this question. It must be discussed. Discussion on the issue is necessary to probe into the maslaha (benefits) involved. Without such a discussion we cannot be sure that the type of lease transaction described above does not involve mafsadah(bad effects ) that over whelms any benefits involved. Sale with lease back has become an essential feature of some of the sukuk being traded in the Islamic financial market. They are likely to proliferate. These sukuk afford new investment opportunities. But is their economic role benign? Is it any different from the securities based on interest-based mortgages, or from the ordinary interest based bonds? How to expand the sukuk market in a competitive environment without losing the distinctive features of Islamic finance? These are some of the challenging questions we face today.
Any source
The Islamic financial intermediaries are spending their money now to acquire these goods and assets in expectation of getting more money than they paid for them from their clients, in future. This distinguishes Islamic financial intermediaries from their conventional counterparts who are trading in money now for more money in future. To be able to earn a profit on the money they have, the IFIs have to buy a real asset and then sell it for money. They run the risk of having to sell at a price that leaves them no profit or even involves a loss. They may be exposed to other business risks too, but we need not discuss them here.
Most of the money Islamic financial intermediaries have comes from the public who deposited it with these intermediaries for making profits for them. But, don’t forget what was noted above: all these contracts are also in use for their original purposes .In case they are used for their original purpose, .e. for acquiring goods and services to be used or consumed, they are modes of trade. It is only when used by an Islamic financial intermediary for supplying finance that they become ‘trade based modes of finance’.
Islamic Leasing
This brief paper will deal with leasing in the framework of Islamic finance and banking. I try to argue that leasing affords a convenient method of financing. This method is capable of serving almost all kinds of needs, e.g., financing businesses, consumers, governments, etc. A comparison with other methods of financing will be made. Then, leasing will be examined in the light of the distinctive features of Islamic finance, such as fairness, stability, and efficiency. I will argue that Islamic leasing needs to abide by certain norms in order to be truly serving the ideals of Islamic finance. Given this, the induction of leasing in the armory of Islamic finance is a welcome development likely to widen its scope and strengthen the case for Islamic finance.
Before discussing leasing as a means of financing, let us discuss leasing itself, i.e. operational lease. The economic role of leasing proper is facilitating sale and purchase of usufruct of tangible things like lands, buildings, vehicles, vessels, aircrafts, equipments, etc. The lessor, who owns the asset and wants to make money out of it without losing its ownership, can do so by leasing the asset. The lessee who needs to use the asset but cannot afford to buy it, or does not want to own it permanently, can fulfill his need by acquiring the asset on lease, paying a rent. In a freely competitive market rents and rentals will be determined like any other prices. If these markets are also free of immoral practices (like fraud and deception, hoarding, etc.) these prices, rents and rentals will be fair, stable and efficient in the sense that they clear the market as well as ensure steady supplies, other things remaining the same. As the main purpose of the user, firm or individual, is served well by leasing, the choice between owning and leasing will depend on the costs involved.
Direct contact between the asset owner and the asset user may not occur easily. There is a role for intermediaries. Another problem arises when the asset user does not have the money to pay the rent or rental. He hopes to be able to pay when he sells the products for whose production the asset is needed. Here is a role for a financial intermediary who can invest some money to acquire the needed asset and provide it to the user at a deferred rent or rental that takes care of the cost of acquisition yet leaves a return for the money invested.
Let us remind ourselves about the economic role of financial intermediaries. They intermediate between wealth owners who have money they want to invest and those who need money for business. But the money needed for business is ultimately destined for acquiring some assets needed by the business. Out of the different kinds of assets businesses need some are in the nature of tangible goods mentioned above. Financing the acquisition of lease-able assets by businesses that need to use them is one possible way of financial intermediation.
A financial lease implies that ultimately the lessee will own the asset leased. A return of the leased asset to the lessor is not envisaged, sometime not permitted at all. Financial lease in its conventional form evolved out of the society’s needs over a period of time, gaining prominence in 1960s and becoming popular in the following decade. As the IT sector boomed in the nineteen nineties, leasing computer hardware and other IT accessories was found to be more convenient than owning them, in an environment of rapid technological change and fast obsolescence.
Modern Islamic jurisprudence grappled with the special issues raised by financial leasing for quite sometime as it involved a number of things unacceptable in Islamic law. As of now the issues have been sufficiently thrashed out to enable the Accounting and Auditing Organization of Islamic Financial Institutions to put forward a set of standards.
The AAOIFI STANDARDS
The standard relating to financial leasing (characterized as ijarah muntahiah bittamleek) aim at guarding against the danger of financial lease degenerating into ‘inah. It does so by separating the lease contract from the contract transferring the ownership of the leased asset to the lessee. It also lays down that the promise to transfer ownership of the leased asset to the lessee is binding only on one party, the lessor. The lessee remains free to buy or not to buy the asset. Standard 8/5 relies on the passage of ‘a (reasonable) period of time’ between ‘the lease contract and the time of the sale of the asset to the lessee’ in order ‘to avoid the contract of ‘inah.’ It further stipulates that: ‘This period must be long enough so that the leased property or its value could have changed’.Unfortunately, the vagueness built into the standard is likely to make it ineffective in realizing its purpose. What is a reasonable period of time? What is meant by a change in property? What amount of change in value will be acceptable, and who will arbitrate on the issue? The history of the practice of ‘inah ought to have made us wiser!
The rational reaction to granting the lessee freedom to buy or not to buy the asset would be, on part of the lessor, to assume the worse, that the lessee will not buy the asset. Assuming no value could be realized for the asset after the lease period, the lessor would try to realize the full value of the asset, in the form of rentals, during the (binding) period of lease. This raises serious questions about the rationale of this provision. It is not clear whose interest it serves. The lessee, whose freedom of choice it supposedly seeks to protect, hardly stands to gain by this provision.
Economic Benefits of Islamic Leasing
Let us proceed to discuss the economic benefits of Islamic leasing. Five distinct benefits of Islamic leasing can be mentioned:
1. As noted above, Islamic leasing necessarily involves real assets. This ensures and strengthens the linkage between the financial sector of the economy and the real sector contributing to economic stability. In this way lease finance relates to a distinctive feature of Islamic finance, a feature missing in the conventional system. Proliferation of financial assets without any counterpart in the real sector of the economy makes the financial markets vulnerable to speculative games threatening to turn these markets into a casino. It also engages a large number of highly skilled people into maneuvers that have nothing to do with production of goods and services. Incomes generated by these activities have contributed to the increase in the inequality in the distribution of income and wealth in the society.
2. Islamic leasing creates a great potential for securitization. Sukuk based on ijara can be traded in the market, affording a convenient instrument for investing savings to the people of small incomes who constitute the overwhelming majority in the developing countries in general and in the Muslim countries in particular.
3. Islamic leasing is especially suitable for some sectors of the economy for which sharing-based modes proved to be rather difficult to practice, e.g. the consumers sector and the public sector. It can take care of the public sector projects related to infrastructure building, e.g., roads and bridges, airports, irrigation systems, hospitals, schools, etc. As a matter of fact most of the leasing based sukuk issued recently belong to this category.
4. Lease finance is easier to practice as it involves less documentation and takes less time to conclude a deal. Unlike lending, it does not need collateral and no thorough enquiries into the creditworthiness of the lessee are called for. The physical presence of a tangible asset, the subject of the lease, whose ownership may remain with the lessor, makes these formalities unnecessary. This may make it especially suitable for the rural sector, where formalities may hamper operations.
5. Lease finance has some of the good features of debt finance and, at the same time, is free of some of the weaknesses of sharing-based modes of finance. There is less possibility of moral hazard/adverse selection than the sharing modes. There is no agency relationship between the lessor and the lessee, as is in the case of mudarabah (profit sharing), for example. The payment obligation of the lessee, the rent, is fixed, as in case of debt. It is not a case for adverse selection as no part of unforeseen losses/costs can be passed over to the lessor.
A WORD of CAUTION
Exchange of a sum of money given now for a larger amount of money to be paid after a period of time is prohibited in Islam, being riba. The prohibition also applies to arrangements that intersperse an asset, formally, just to change appearances of the contract. An example of this is ‘inah in which an asset is purchased on credit then sold to the seller, from whom it was purchased, for cash. In this case what has really happened is an exchange of money for money. The money owed, and to be paid after sometime, is larger than the money obtained now, in cash. The asset stays where it was. It is, once again, owned by the dealer using it as a means of ‘inah.
A lease contract in which an asset is sold for a sum of money paid in cash now, only to be acquired back on lease by the seller from the buyer for a larger sum of money to be paid over a period of time as rents, looks similar to the above transaction. The asset stays where it was. What has changed hands is money: the asset owner has obtained cash against the obligation of repayment with an increase over a period of time. However there is one difference. Though the asset is back in possession of the original owner, he does not own it, being merely a lessee. He can lease it to others but he cannot sell it, starting another cycle of ‘sale with lease back’ financing. That makes it different from tawarruq, in which an asset is purchased on credit to be sold back for (a smaller amount of) cash. That asset can once again enter another cycle of tawarruq. Not so in lease finance as currently practiced by Islamic financial institutions. Perhaps it is this difference that has persuaded some to allow the transaction. But the crucial point is the economic impact, is it any different from a money loan?
It is very difficult to answer that question. It is especially difficult in the absence of empirical data. All that this writer can do is to emphasize the relevance as well the importance of this question. It must be discussed. Discussion on the issue is necessary to probe into the maslaha (benefits) involved. Without such a discussion we cannot be sure that the type of lease transaction described above does not involve mafsadah(bad effects ) that over whelms any benefits involved. Sale with lease back has become an essential feature of some of the sukuk being traded in the Islamic financial market. They are likely to proliferate. These sukuk afford new investment opportunities. But is their economic role benign? Is it any different from the securities based on interest-based mortgages, or from the ordinary interest based bonds? How to expand the sukuk market in a competitive environment without losing the distinctive features of Islamic finance? These are some of the challenging questions we face today.
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