The Evolution of the Use of Ijarah in Islamic Banks

How to work in Islamic Banking:Islamic finance

The Rise of Ijarah

In a business world marked by economic uncertainties and rising costs of operations, leasing is widely regarded as the easiest, safest, and most effective means to finance production processes. In Islamic finance, Ijarah too is rooted in the sound financial principles laid down by Shari’ah.

Primarily, Ijarah is a mode of finance where the Islamic bank purchases an asset and leases it to the client at a price that includes a fair return for the bank. Ijarah, however, had undergone numerous and complex transformation in order for Islamic banks to efficiently compete and battle in a market that is marked with well rooted conventional peers.

Two Modes of Lease Financing

Ijarah is classified into operating Ijarah, which doesn’t include a promise to transfer the legal title of the leased asset to the lessee at the end of the lease, and Ijarah muntahia bittamleek, which is concluded by passing the legal title of the leased asset to the lessee.

Operating Ijarah

In an operating Ijarah, the asset has to be returned to the lessor at the end of the leasing tenure. The lessor, which may be a bank or any other financial institution, can again lease the asset, if it is functioning, to another individual or business entity.

Ijarah Muntahia Bitamleek

The acquisition of assets is a major commitment for many businesses. Asset acquisition financing makes it possible for business owners to acquire the asset without needing to invest the total cost in a lump sum payment and thus provides greater flexibility in terms of financing to meet individual business requirements. Moreover, financial leasing has become popular due to tax advantages as the rental can be offset against corporate tax by the lessee.

In an Ijarah Muntahia Bitamlek, the lessor would make a unilateral promise to sell the asset to the lessee or make a gift of the leased asset to the lessee at the end of the leased period. Yet, some attributes must be sustained for the Ijarah Muntahia bitamleek to be Shari’a compliant most importantly that the ownership of the asset should remain with the lessor and its usufruct is simply transferred to the lessee. Accordingly, all the liabilities emerging from the ownership shall be borne by the lessor. And thus general maintenance and insurance is the sole responsibility of the lessor.

Variable Rentals in Ijarah

Some contemporary scholars have allowed in long term leases to tie up rental with a variable benchmark which is well known and well defined and does not leave room for any disputes. Therefore, IBs would use the interest rate of a certain country or LIBOR as a benchmark to determine the periodical increase in the rent. The purpose is to provide a rental rate that is similar to the rate that is earned by conventional banks. Yet, it should be noted that the rate of interest is merely a benchmark and thus this does not render the transaction interest based.

Securitization of Ijarah

The arrangement of Ijarah has a good potential of securitization which may help create a secondary market for the financiers on the basis of Ijarah. Since the lessor in Ijarah owns the leased assets, he can sell the asset, in whole or in part, to a third party who may purchase it and replace the seller in the rights and obligations of the lessor with regard to the purchased part of the asset.

These certificates being an evidence of proportionate ownership in a tangible asset, can be negotiated and traded freely in the market and can serve as an instrument easily convertible into cash. Thus they may help in solving the problems of liquidity management faced by the Islamic banks and financial institutions.

Ijarah Fund

In this fund the subscription amounts are used to purchase assets like real estates, motor vehicles, or other equipment for the purpose of leasing them out to their ultimate users. The ownership of these assets remains with the fund and the rentals are charged from the users. These rentals are the source of income of the fund which is distributed pro rata to the subscribers. The prices of these certificates will be determined on the basis of the market forces, and are normally based on their profitability.

Ijarah Overdraft

In this structure, the client must have an asset (land/ building) which is split into a certain number of units (say a building with 100 units each for 10,000 USD). When in need for overdraft the client sells units of the asset to the bank and get the payments for price. After owning the units, the bank leases the units for the client for a specified rent. Once the contract period is over, the bank sells back the asset to the client.

Sukuk al Ijaraah

Asset Backed Sukuk

In asset-backed Sukuk, investors enjoy asset-backing, they benefit over some form of security or lien over the assets, and are therefore in a preferential position over other, unsecured creditors. In other words, in the event the issuer was to default or become insolvent, the note holders would be able to recover their exposure by taking control of and ultimately realizing the value from the asset(s). It also requires the element of securitizations to be present-true sale, bankruptcy remoteness and enforceability of security etc.

Asset Based Sukuk

In asset-based Sukuk, the originator undertakes to repurchase the assets from the issuer at maturity of the Sukuk, or upon a pre-defined early termination event, for an amount equal to the principle repayment. In such a purchase undertaking, the true market value of the underlying asset is irrelevant to the Sukuk note holders, as the amount of the asset is predetermined. In such case, note holders have no special rights over the asset(s) and rely entirely on the originator’s creditworthiness for repayment. Thus, if the originator is unable to honor its obligation to repurchase the assets, the note holders are in no preferential position to any other creditors, or indeed in no weaker position to any other unsecured creditor. Accordingly, the purchase undertaking ranks pari-passu with any other of the originator’s senior unsecured obligations.

Asset Backed Structure and Difficulties Confronted

Although the structure of Sukuk, risk profile, and pricing rationale were quite appealing, sovereigns and corporate encountered several major challenges as the lack of suitable assets for the underlying Ijarah transaction. Most sovereigns were reluctant to part with public assets due to the apprehension that the disposal of public assets to foreign investors would create negative public outlook or the assets were not sufficient or already encumbered, or such disposal was subject to transfer taxes. The sovereigns preferred the conventional bond route which did not have suitable assets. Hence, although Sukuk al-Ijarah was structurally viable and legally possible, the product did not receive much interest in the Muslim world in the beginning.

Asset Based Sukuk as an Alternative

In 2002, the federation of Malaysia created history by issuing the first Islamic global Sukuk that complied with the U.S. Regulation. The Malaysian Sukuk al-Ijarah was the first Sukuk to be listed in the Luxembourg Stock Exchange and rated by Standard & Poor’s and Moody’s. The issue was hugely successful and was twice oversubscribed.

The asset-backed Sukuk structure created a major legal constraint for the federation of Malaysia. All international bonds have a standard negative pledge which restrains the bond issuers from issuing in future any bond that is not in pari-passu with the existing unsecured bonds. The proposed Sukuk issuance was seen as a direct breach of the negative pledge clause given that the Sukuk would be backed by the ownership of the underlying assets. Federation of Malaysia was advised not to proceed with the Sukuk until all the outstanding bonds were redeemed.

With the aid of some Sharia’a scholars, the Federation of Malaysia found a neat solution to avoid breaching the negative pledge. Under the revised structure, the Sukuk holders would have beneficial ownership[1] of the assets held through the Sukuk trustee during the life of the Sukuk.

This was deemed to meet Sharia’a requirements of asset ownership under Ijarah principles. However, in the event of default by the Federation of Malaysia, the Sukuk trustee’s sole resources to the assets would be to dispose of the assets only to the Federation of Malaysia and seek payment.

The Sukuk trustee would not have the power to retain or sell the assets to any third party. The revised Sukuk structure therefore was not seen as asset-backed securities although the Sukuk had underlying assets. The Malaysian Sukuk became known in the market as “asset-based” securities. Hitherto, most of Sukuk offerings were asset-based securities. Asset-based Sukuk were treated as senior unsecured securities similar to unsecured conventional bonds.

The Need to Develop PLS Products

Although, the evolution of the role of Ijarah has helped Islamic banks to sustain its role in a competitive environment and has aided them to overcome difficulties, especially with the development of a floating rate, Ijarah overdraft and asset based Sukuk, there is still a dire need to develop Profit Loss Sharing products. The (PLS) model, the hallmark of Islamic finance, is more efficient and equitable in distribution of wealth and income. Allocation of funds under risk sharing will be based on the viability and expected profitability of the proposed entrepreneurial undertakings rather than on the creditworthiness of competing entrepreneurs. Furthermore, risk sharing offers both entrepreneurs and investors incentives to be truly engaged in productive economic activities, wherein entrepreneurs will be encouraged by the prospect of seeing their ideas transformed into business entities, and financers will be obliged to assess the risk involved more cautiously, and effectively monitor the use of funds by the entrepreneurs. The appropriate implementation of such partnership contracts increases the likelihood of business success, injects more discipline into the financial market and reduces excessive lending. And thus, it should ultimately have positive implications for the socioeconomic welfare of society at large.


  1. Ahmed, Habib, Product Development in Islamic Banks. Edinburgh University Press, 2011.
  2. Nsouli, Zaher, Certified Islamic Executive Banker. General Council for Islamic Banks and Financial Institutions, Bahrain, 2012.
  3. Usmani, Mohammed Taqi, Introduction to Islamic Finance. Karachi, 1998.

[1] Beneficial Ownership is a legal term where a specific property rights (use and title) in equity belong to a person even though the legal title of the property belongs to another person.

This article appeared in Islamic Finance News – Special Report, Volume16. Issue20, Tuesday, 21 May 2019.

The views expressed in this article are the author’s own and do not necessarily reflect Saray Consultancy’s editorial stance.