This article is the latest in a series of articles focused on basic Islamic finance concepts and structures. This article will focus on Ijara transactions.
What is Ijara?
Ijara is an islamic finance technique used to finance the acquisition of assets. A minimum of three parties will be involved. The first will be the supplier, who owns the asset that the customer intends to lease. The second will be the financier, who is often a bank. The third will be the customer. The financier will purchase the asset from the supplier and then lease it to the customer, in return for a rental payment. This rental payment will be paid at regular intervals, and the amount to be paid on each payment date can be fixed for the term of the lease or be variable (for example if the rental payment is linked to a benchmark rate).
What makes an Ijara different to a conventional lease? In a conventional lease, there will usually be a range of obligations on the customer to maintain the asset and insure the leased asset. However, under Ijara arrangements the financier has to bear this risk. To mitigate against this, the financier will require that the customer enters into a service agreement with the financier, which will include obligations on the customer to maintain the asset and to obtain insurance.
How is it structured?
There will be at least two stages to an Ijara transaction and at least two contracts, although there can often be more.
Firstly, the customer will request to enter the arrangement with a financier in relation to a specified asset and the financier will purchase the asset from the supplier (first contract).
Secondly, once the financier has purchased the asset, it will lease this to the customer (second contract). If the financier requires the customer to maintain and insure the asset, the financier and the customer will enter a service agency agreement (third contract).
These contracts will then be supported by a series of options and documents to cater for two scenarios: firstly, where the customer wishes to acquire the asset for the outstanding financing amount; and secondly, to permit the financier to sell the assets to the customer in order to recover the financing amount if there is an event of default.
Periodic rental payments are made, usually quarterly, by the customer to the financier, on set payment dates. The customer is required to comply with a suite of covenants, representations and warranties and events of default under Ijara arrangements, which are usually similar to what is found in conventional finance agreements.
When is Ijara most often used?
Ijara is most often used in order to finance assets, which are typically high-value assets such as property, ships and aircraft.
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