In our previous article we introduced the general principles and prohibitions [1] of Islamic Finance and several of the most prevalent financing structures found in Shariah-compliant transactions. It is these structures, ijara, murabaha, musharaka, mudaraba and istisna'a, which we consider in more detail in this article.
Structure 1 - the Ijara
An ijara is the sale of the right to use and benefit from an asset for a specified period in return for specified consideration. It is referable to a conventional operating lease whereby a customer (lessee) may lease the use and benefit of an asset for a specified rental period in return for a rental fee. An ijara arrangement can be structured to include a sale of the specific asset to the lessee (ijara muntahia bitaamlek) and therefore replicate a conventional finance lease. Such structures can therefore be used as financing devices by the lessee by using a financier to acquire the specific asset and then lease it to the lessee pursuant to a finance lease style arrangement.
Because the financier owns the asset, thus bearing the risks of ownership, profit generated on the lease is regarded as profit derived from the asset and not simply, riba (interest).
The diagram below illustrates an example:
There are several key rules and issues that need careful consideration in relation to the use of ijara structures:
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the ijara contract may not be executed unless the financier (lessor) has acquired the asset, meaning the risk of ownership must pass to the financier;
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the leased asset may not be a consumable, ie. the asset must be capable of being used while preserving the asset;
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the benefit from an ijara must be lawful in shariah (ie. not haram) for example a house may not be leased for an impermissible purpose by the lessee; and
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responsibility for major maintenance of the specific asset must remain with the lessor. However, on a practical basis this is often carried out by the lessee on an agency basis.
Structure 2 - the Murabaha
A murabaha is the sale of a specific asset on terms which expressly include the cost price (of the seller) plus a defined and agreed profit mark-up. The distinguishing feature of the murabaha structure from an ordinary sale of goods is that the seller discloses this cost and profit mark-up to the buyer. Payment by the customer to the financier can be immediate but usually it will be deferred and paid over time in instalments. The murabaha is a very flexible structure in that it can be used for financing of assets, by acquiring the asset for whilst deferring the obligation to pay the purchase price.
Because the financier has actually owned the asset (even if only for a very short time), thus bearing the risks of ownership, profit generated on the marked up sale price is regarded as profit derived from the asset and not simply, riba (interest).
The diagram below illustrates an example:
There are several key rules and issues that need careful consideration in relation to the use of murabaha structures:
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the goods the subject of sale must exist at the time of contracting and be clearly identified prior to the purchase and must not be acquired from the customer;
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the goods must be in the physical or constructive possession of the financier before they are on-sold to the customer, thus ensuring the financier assumes the risks of ownership;
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the cost price must be known at the time of sale and declared to the customer; and
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the time of delivery of the goods and the time of payment must be specified.
Structure 3 - the Musharaka
A musharaka is a contractual partnership where two or more parties establish a joint commercial venture, each party contributing capital, labour and management duties. The profits that flow from the venture are shared among the parties based on a pre-agreed ratio, while losses are shared on the basis of the partners' respective capital contributions. Musharaka structures generally fall within two main categories: arrangements similar to conventional partnerships and equity stakes in companies.
In practice, one party (the financier) will contribute cash and the other party (the customer) will contribute land or other physical assets. In financing structures, the customer will be appointed the agent of the partnership to develop the land (or other assets) with the cash injected in the musharaka and then sell/lease the assets on behalf of the partnership. Typically financier will receive a return based on a benchmark plus a margin.
The diagram below illustrates an example:
Often the customer undertakes to purchase the musharaka interest of the financier at a pre-agreed price over time so that at the end of a set period the financer has no remaining interest in the venture. Alternatively, the customer may undertake to purchase the assets subject to the joint venture at a set date following which the joint venture will be wound up.
There are also several key rules for musharaka structures. The venture subject to the musharaka must be shariah compliant. Additionally, the parties must all be exposed to risk of loss on the joint venture.
Structure 4 - the Mudaraba
A mudaraba is a profit sharing contract, with one party providing capital and the other party (the investment manager or mudarib) providing its expertise to invest the capital and manage the investment project. Profits generated by the business venture are shared between the parties according to a predetermined ratio. However, the party provides the capital bears all financial losses, while the mudarib or investment manager bears the opportunity costs associated with managing the project/venture.
The diagram below illustrates an example:
Mudaraba structures are often used for investment funds and limited recourse financings whereby profits are again distributed as agreed, while losses remain the liability of the capital provider.
Structure 5 - the Istisna’a
An istina’a is a contract whereby a party undertakes to produce an asset according to certain agreed specifications at a specific price and for a fixed date of delivery. Istisna'a contracts are somewhat unusual in Islamic finance as they do not require the subject matter (eg. a construction project which has not yet commenced) to be in existence at the time of the contract.
Istina’a is used for the advance funding of major construction, industrial projects or large equipment manufacture, such as ship or aircraft manufacture. The financier funds the manufacturer, acquires title to the asset upon completion and, typically, immediately passes this title to the purchaser on agreed deferred payment terms or a leasing agreement (ijara).
The diagram below illustrates an example:
The price must be fixed at the time the contract is entered into and the specification of the asset must be clearly stated and, in the example above, the financier must bear ownership risk. The technique is particularly useful in providing an Islamic funding tranche element in the construction phase of a project.
Conclusion
While the descriptions of the above structures are, by necessity, brief overviews, some common themes arise. These structures all involve an asset basis, the assumption of risk in the asset by the financier and a profit and loss sharing between the financier and customer.
Notwithstanding these commonalities, many variations of such structures exist for various reasons such as different interpretations by Shariah scholars, local law variations of jurisdictions and a lack of market standardisation (such as little or no market consistent documentation standards). As a consequence, transactions are often bespoke with the consequence that those first to access this market in Australia will potentially set the domestic standard.
In the next article in this series on Islamic Finance, we will examine the use of sukuk (Islamic bonds) to raise financing in the capital markets.
[1] These principles include: (a) money in and of itself has no intrinsic value; (b) Islamic finance requires an asset basis; and (c) profit- and loss-sharing is fundamental to financing structures. The prohibitions include prohibitions on (a) interest (riba); (b) risk and uncertainty (gharar); (c) speculation (maisir); and (d) unethical investments (haram).
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