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RECONSTRUCTING LEASE-TO-OWN CONTRACTS: A CONTEMPORARY APPROACH TO ISLAMIC BANKING STANDARDS: REVIEW

This paper is written by Uus Ahmad Husein under the title The Variable Effects of Murabahah in Islamic Commercial Banks. A country's economy has two key sectors: the real sector, which involves manufacturing and services, and the monetary sector, primarily linked to the banking industry. Islamic economic principles emphasize maintaining a balance between these sectors, ensuring that financial growth is aligned with the development of the real sector. [1] In Islamic countries, including Palestine, the banking system is divided into conventional and Islamic banking. Conventional banks operate on an interest-based model, while Islamic banks adhere to Sharia principles and focus on profit and loss sharing. [2]Islamic banking emerged as a response to Muslim economists and banking professionals' demands to provide ethical financial services aligned with Islamic law. [3]

This paper emphasize that Islamic financial institutions offer various Sharia-compliant financial products, avoiding conventional bank interest by playing a significant role in the market economy and promoting Islamic cooperation, including practices like Zakat (charitable giving). The Islamic finance sector has grown substantially, with assets reaching nearly $4 trillion in 2021.[4] Islamic banks provide a range of financing services, including Murabaha (cost-plus financing), Musharaka (partnership contracts), and Mudaraba (profit-sharing investment).  In Palestine, financial support from Islamic banks increased significantly between 2018 and 2021 [[5]][[6]]. Ijarah, a rent-to-own financial product, is frequently used to finance high-value assets. Despite the growth, Islamic transactions in Palestine lack specific legal governance, and the Palestinian Monetary Authority (PMA) does not issue special instructions for these transactions. However, the PMA ensures that Islamic banks adhere to capital adequacy requirements that are aligned with standards issued by the Islamic Financial Services Council. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) provides crucial standards for Islamic financial transactions. These standards are widely implemented and ensure Islamic banks operate by Islamic principles. The development of AAOIFI standards involves a meticulous process to ensure their quality and effectiveness. Given the unique nature of Islamic financial transactions, there is a need for complementary standards derived from Islamic jurisprudence (Fiqh Muamalat) [7]. This research explores non-compliance with AAOIFI standards and general doctrinal rules in the Ijarah financing practices of Islamic banks in Palestine. The goal is to help the Islamic banking industry in Palestine bridge gaps and reduce discrepancies in compliance.

  1. Literatur Review

The literature on leasing, particularly Ijarah Muntahiyah bi-t-talk (lease-to-own) contracts, reveals varied definitions across Islamic schools of thought. The Hanafi, Maaliki, Shaafa, and Hanbali schools offer distinct interpretations, with the Hanbali definition being the most comprehensive [8] Ijārah Muntahiyah bi-t-tamlīk is defined as an agreement where an Islamic bank acquires an asset upon a client's request, leases it to the client, and commits to transferring ownership once all payments are fulfilled[9]. This contract type is crucial for financing small and medium-sized enterprises (SMEs), which face difficulties accessing funding from financial markets and commercial banks due to high interest rates and unfavorable terms. Ijarah Muntahiyah bi-t-talk offers a Sharia-compliant solution, ensuring equitable contractual terms.

Islamic Policy in Governing Ijarah Muntahiyah bi-t-tamlik Transactions

The Ijārah Muntahiyah bi-t-tamlīk differs from financial leasing by commercial institutions, where ownership is transferred to the lessee upon full payment of installments without a separate contract. [10] . In Ijārah Muntahiyah bi-t-tamlīk, the lease contract governs the relationship, and a separate sales promise commits the owner to transfer the property after all financial obligations are met. The contract must adhere to Sharia principles, avoiding elements of manipulation (gharar) by ensuring the bank owns the goods before leasing them. [11].

  • Hybrid contracts and Legal Considerations: Hybrid contracts combine multiple distinct contracts to achieve a specific outcome, treated as a unified whole under Islamic finance principles. This approach ensures lessees are not burdened with obligations that should fall on the owner. However, combining sale and lease contracts within a single document is deemed unlawful by the Council of Islamic Senior Scholars due to their distinct nature and implications. A sale contract necessitates complete ownership transfer, while a lease contract transfers only property benefits without ownership responsibilities [12].
  • Controversies and Scholarly Opinions : Scholarly opinions vary on the legality of these contracts. Some scholars, like Abū Ḥanīfah and Abū Yūsuf, permit the sale of goods before receipt based on istiḥsān (juridical preference), while others, like Muḥammad, Ja’far, and al-Shāfi’ī, oppose this practice. The misinterpretation of a hadith prohibiting "two contracts in one transaction" has sparked controversy, potentially hindering the development of new Islamic banking products [13]
  • Legal Framework and Regional Interpretations : The legal framework in Arab countries often categorizes financial lease contracts as installment sales. For example, Egyptian law treats lease transactions transferring ownership as sales, aligning with general contract principles. This interpretation ensures that legal relationships are defined by the agreed obligations rather than declared tittles [14] The review concludes that despite challenges, Ijārah Muntahiyah bi-t-tamlīk is a Sharia-compliant alternative to conventional leasing, satisfying customer needs while adhering to Islamic principles

 

Requirements for Valid Ijarah Muntahiyah bi-t-tamlik Transactions

Ijarah Muntahiyah bi-t-tamlik, a lease-to-own contract used by Islamic banks, involves leasing an asset to a client who gains ownership after fulfilling the lease period and financing terms [15] AAOIFI's Standard No. 9 outlines the guidelines for these transactions, divided into sections covering various aspects like the scope of the standard, obligations, procedures, contract modifications, and ownership transfer [16]

Key element for valid ijarah :

  1. Contracting Parties : The lessor (owner) and lessee (user) must have the legal capacity to enter the contract. Multiple parties or agents can be involved, and co-owners' consent is required if the asset is co-owned.
  2. Ijab (offer) and qabul (acceptance)  : The contract is established through oral, written, or other Shariah-approved means, with agreed-upon terms binding both parties.
  3. Asset and usufruct : The leased asset must comply with Shariah, being valuable, identifiable, accessible, deliverable, non-debt-based, and non-perishable.
  4. Rental terms : Rental payments can be cash or in-kind, upfront or deferred, with fixed periods. The rental rate cannot be unilaterally increased by the lessor but can be revised jointly by both parties [17]

Legal Provisins in standard no. 9 :

  1. Contractual relationship : the standard ensures balance by prohibiting clauses that allow unilateral contract termination or modification without mutual consent. It also mandates a separate document for ownership transfer, district from the lease agreement.
  2. Ownership transfer : The standard allows ownership transfer through a promise to sell at a nominal or real price, a donation promise, or upon installment completion without a new contract. This approach aligns with some Islamic jurists' views, permitting future conditional sales if they serve the parties' legitimate interests.

 

Categories of leasing :

  1. Material leasing : involves paying for using tangible assets like real estate or transportation.
  2. Work leasing : entails hiring someone to perform a specific task for a known wage

Islamic jurisprudence and AAOIFI standards validate unilateral promises based on certain Islamic jurists' opinions, allowing contractual conditions unless explicitly forbidden by Islamic law [18] The lease contract governs the relationship throughout its term, preventing conditions that contradict lease requirements. This provision protects tenants from being burdened with obligations that should remain with the seller (original owner) during the lease period. Overall, these requirements ensure that Ijarah Muntahiyah bi-t-tamlik transactions are Sharia-compliant, balancing the interests of both parties and adhering to Islamic principles.

  1. The Analysis Article

Main Problem : From an economis perspective, the main problem identified in the text revolves around the conflict between Islamic banking principles and the practical application of penalty clauses in financial contracts. Thisn conflict has several economic implications :

  1. Risk Management and Creditor Protection
  • In conventional banking, penalty clauses for delayed payments help manage credit risk by discouraging late payments and compensating creditors for the time value of money and additional administrative costs
  • In Islamic banking, the prohibition of penalty clauses that increase debt (considered usury) limits the tools available for managing credit risk. This can potentially increase the risk for Islamic financial institutions, as they cannot impose additional financial penalties on delinquent debtors
  1. Cost of Financing :
  • The inability to impose penalty fees might lead to higher costs of financing in Islamic banking. To mitigate the higher risk of defaults, banks might need to charge higher upfront fees or profit margins on their financing products.
  • This could make Islamic financial products more expensive compared to conventional ones, potentially reducing their competitiveness and attractiveness to customers.
  1. Liquidity and Profitability :
  • Delays in payment without effective penalty mechanisms can impact the liquidity and profitability of Islamic banks. Banks rely on timely payments to maintain their cash flow and meet their own financial obligations.
  • Without penalty clauses, banks might face increased instances of delayed payments, leading to liquidity strains and reduced profitability, affecting their overall financial stability and growth
  1. Economic Efficiency :
  • Penalty clauses in conventional banking incentivize timely payments, contributing to overall economic efficiency by ensuring that resources are available when needed.
  • The absence of similar mechanisms in Islamic banking might lead to inefficiencies, where borrowers have less incentive to prioritize timely payments, potentially disrupting financial planning and investment cycles
  1. Charitable Contribution as as Alternative :
  • The requirement for charitable contributions in case of delayed payments offers a non-profit alternative that aligns with Islamic principles. However, this does not compensate the banks directly and might not be as effective in discouraging late payments.
  • The indirect nature of this penalty might reduce its deterrent effect, leading to more frequent delays and the associated economic costs.
  1. Legal and Operational Complexity :
  • The need to navigate and comply with both Islamic jurisprudence and local laws adds complexity to the operational and legal frameworks of Islamic banks
  • This complexity can increase administrative costs and require additional legal and financial expertise, further raising operational expenses and impacting the economic efficiency of these institutions.

                 

In summary, the main economic problem is the challenge of balancing compliance with Islamic principles with effective risk management and economic efficiency in the financial operations of Islamic banks. The restrictions on penalty clauses for delayed payments introduce higher risks, potential liquidity issues, and increased operational costs, which can impact the competitiveness and profitability of Islamic financial institutions.

Das Sain: Current Situations: Islamic banks in Palestine are growing but face challenges due to prohibiting penalty clauses for delayed payments. This increases credit risk, impacts liquidity and profitability, and adds operational complexity.

Das sollen: Desired Situation: The development of Sharia-compliant risk management tools, competitive financing products, improved liquidity solutions, supportive legal frameworks, customer education, and robust accountability mechanisms can help mitigate the economic challenges Islamic banks face while adhering to Islamic principles.

Research Methodology. This pioneering research examines the legitimacy of Ijarah Muntahiyah bi-t-tamlīk (lease-to-own) contract terms issued by Islamic banks in Palestine. The study provides practical recommendations for best practices to ensure these transactions align with mandatory rules, filling a gap in specialized legal studies.

Research Novelty. This research offers significant contributions to Islamic banking and finance by addressing the gap in specialized legal studies on Ijārah Muntahiyah bi-t-tamlīk contracts. It guides Palestinian Islamic banks to enhance their practices per Sharia principles and legal requirements. The paper delves into Islamic banks' challenges in implementing AAOIFI standards for lease-to-own contracts.

Two major challenges are highlighted :

  1. Alignment  with National Contract Law: Assessing the compatibility of Islamic banking principles with national contract law fundamentals
  2. Use of Pre-drafted Contracts: Evaluating the impact of standard-form contracts, which can disproportionately burden the customer, potentially contradicting Islamic finance principles of fairness and balanced duty sharing.

The research critically examines these challenges and proposes alternative approaches to better align with the principles of Islamic banking.

Result and Discussion: The research analyzed the Ijarah Muntahiyah bi-t-talk contracts of Islamic banks in Palestine and highlighted several economic and operational challenges :

  1. Legal and Jurisprudential Inconsistencies: a fundamental contradiction between the Islamic standards these contracts should adhere to and the traditional Hanafi jurisprudential influences in the Al-Majjahllah Code. This inconsistency creates legal uncertainties and operational challenges for Islamic banks.
  2. Non-binding Promises. The Ijarah Muntahiyah bi-t-talk contracts involve a promise by the bank to transfer ownership to the lessee after all rent installments are paid. However, according to Al-Majjahllah, this promise is not legally binding, undermining the contractual security and potentially leading to disputes.
  3. Non-compliance with Real Estate registration Laws. Palestinian law requires real estate transactions, including promises of sale, to be registered with land registry departments. Islamic banks' failure to comply with these requirements renders their promises legally ineffective, increasing legal risks and reducing trust in these transactions.
  4. Deviation from AAOIFI Standards. The contracts issued by Islamic banks in Palestine do not meet AAOIFI standards. Specifically, they improperly transfer maintenance costs, government fees, and property risks to the tenants rather than the banks bearing these obligations. This deviation increases the financial burden on tenants and may reduce the attractiveness of these financial products.
  5. Excessive Penalty Clauses. The contracts include penalty clauses that exceed the actual damages incurred by the bank due to tenant breaches. Such clauses are against AAOIFI standards and the general legal principles in Palestine, potentially leading to legal challenges and financial disputes.
  1. The Opinions :

Significant challenges and potential areas for improvement exist within the Palestinian Islamic banking sector. There are positive aspects of this research. Growth Potential from Islamic banks in Palestine. Showed remarkable growth in net assets and financial facilities. This indicates a strong demand for Islamic financial products and a significant market potential. Then, there is the effort to align banking practices with contemporary Islamic jurisprudence and AAOIFI standards, which is a positive step towards modernization and international compliance and can attract more customers and investors. There are different points of view regarding challenges and economic concerns. The non-binding nature of promises in Ijarah Muntahiyah bi-talk contracts reduces the security of these transactions. This increases the risk of defaults and legal disputes, harming the banks' financial health and customer trust. Non-compliance with Registration Laws. Noncompliance with registration laws can undermine the legal validity of transactions. This results in significant financial losses and legal complications, impacting the banks' operational efficiency and profitability. Deviation from AAOIFI Standards from shifting costs and risks to tenants makes the financial products less attractive, potentially reducing demand and increasing default rates. This case can lead to customer dissatisfaction and damage the bank's reputation, affecting long-term growth. Imposing excessive penalties can result in legal challenges, increase litigation costs and harm banks’ competitive edge.

            My recommendation for Economic Benefits is to implement a modern Civil Code aligned with contemporary Islamic jurisprudence, which will reduce legal uncertainties and enhance contract enforceability. This will attract more customers and investors, promoting a stable and predictable banking environment. Then, mandating compliance with registration laws will reduce legal risks and potential financial losses, improving the credibility and reliability of Islamic banking contracts. Revising standard contracts by aligning with AAOIFI standards and removing excessive penalty clauses will make financial products more attractive, increasing demand and customer satisfaction. This will enhance the banks’ growth and profitability. Enhancing regulatory oversight will ensure consistent adherence to standards, reducing legal and financial risks and promoting a stable financial environment. Addressing the highlighted challenges through the recommended measures can significantly improve Islamic banks' economic viability and stability in Palestine. Palestinian Islamic banks can foster a more secure, attractive, and competitive banking environment by resolving legal inconsistencies, ensuring compliance with contemporary standards, and enhancing regulatory oversight. This will lead to sustainable growth, increased customer trust, and a stronger position within the broader financial sector.

Reviewer: Ema Saswita Cania: (Sharia Economics Masters Student, Faculty of Islamic Economics and Business, North Sumatra State Islamic University) (3004233027)

 

Bibliography

A. Al-Qura Aghi. (2008)  Leasing in the benefits of persons in comparison in Islamic jurisprudence and labor law, in: Arabic: Alajarat Fi Manafie Al’ashkhas Muqaranatan Fi Alfiqh Al’iislamii Waqanun Aleamal), Dar Al-Masira for Publishing and Distribution, Amman

A.M. Alkhan. (2020)  An analysis of mur¯ abahah and ij¯ arah muntahiyah bi-t-taml¯ık: how do islamic banks choose which product to utilise? Arab Law Q. 35 (4) (2020) 444–465.

C.P. Lumban Gaol, G. Hansrainer, B. Rainey (2023) Bank interest in islamic law, At-Tasyrih: jurnal pendidikan dan hukum Islam 9 (1) (2023) 34–43

D. Demina, T. Rexy, A. Danyl (2022) The use of quranic learning strategies through the wafa method in elementary schools, J. Int. Inspire Educ. Technol. 1 (2) 62–73. Aug 14 [cited 2023 Jul 20]. Available from: https://ejournal.staialhikmahpariangan.ac.id/Journal/index.php/JIIET/article/view/91

I.M. Lawal (2019)  The role of cash waqf in achieving a mechanized agriculture in Nigeria, J. Islam. Bank. Finance 36 (2) 68–79

K. Al-Rawi (2020) Financial analysis of the financial statements and accounting disclosure, in: Arabic: Altahlil Almaliu Lilqawayim Almaliat Walafisah Almuhasabii), first ed., Dar Al Masirah for Publishing and Distribution, Amman

M. Al-Momani (2015)  Leasing ended with ownership between theory and practice in the islamic banks, Int. J. Bus. Soc. Sci. 6 (8) 192–203. Available from: www.ijbssnet.com.

M. Daoud (2000) Sharia and legal controls for differences in landlord and tenant, in: Arabic: Aldawabit Alshareiat Walqanuniat Liakhtilaf Almuajir Walmustajar), New University Publishing House, Alexandria

M.I.S. Mihajat (2015) Hybrid contract in islamic banking and finance : a proposed Shariah principles and parameters for product development, Islamic Manag Business 7 (16) (2015) 89–100.

M. Hasan (2020) Murabaḥa ¯ reconstruction: its application in the electronic journal in Indonesia, Al-Ahkam. 30 (1) 77–94.

M.Z. Md Nor, A.M.A.A.H. Mohamad, N.I. Abdul Jalil (2021) Legal issues of ijarah contract and rent to own scheme, J. Leg. Ethical Regul. Issues (JLERI) 24 (5)1–8.

S. Aliyu, M.K. Hassan, R. Mohd Yusof, N. Naiimi (2023) Islamic Banking Sustainability: A Review of Literature and Directions for Future Research. Emerging Markets Finance and Trade, 2017 Feb 1 cited 2023 Jul 21];53(2):440–70. Available from: https://www.tandfonline.com/doi/abs/10.1080/1540496X.2016.1262761

S. Al-Fenisan. (2001) Lease to ownership (in Arabic: alayijar almuntahi bialtamlik), J Contemp Jurispru Res 12 (48)

S. Saleem, F. Mansor. (2020) Exploring compliance of AAOIFI Shariah standard on ijarah financing: analysis on the practices of islamic banks in Malaysia, J. Risk Financ. Manag. 13 (2) (2020) 29

U.A. Husaeni. (2016) The variables effects of murabahah in islamic commercial banks, Int. J. N. Innovat. 4 (2) 1–16. Available from : https://journal.uinsgd.ac.id/index.php/ijni/article/view/1446

[1] M. Al-Momani, Leasing ended with ownership between theory and practice in the islamic banks, Int. J. Bus. Soc. Sci. 6 (8) (2015) 192–203. Available from:

www.ijbssnet.com.

[2] ibid no. 1

[3] C.P. Lumban Gaol, G. Hansrainer, B. Rainey, Bank interest in islamic law, At-Tasyrih: jurnal pendidikan dan hukum Islam 9 (1) (2023) 34–43

[4] D. Demina, T. Rexy, A. Danyl, The use of quranic learning strategies through the wafa method in elementary schools, J. Int. Inspire Educ. Technol. 1 (2) (2022) 62–73. Aug 14 [cited 2023 Jul 20]. Available from: https://ejournal.staialhikmahpariangan.ac.id/Journal/index.php/JIIET/article/view/91

[5] A.M. Alkhan, An analysis of mur¯ abahah and ij¯ arah muntahiyah bi-t-taml¯ık: how do islamic banks choose which product to utilise? Arab Law Q. 35 (4) (2020) 444–465.

[6] I.M. Lawal, The role of cash waqf in achieving a mechanized agriculture in Nigeria, J. Islam. Bank. Finance 36 (2) (2019) 68–79

[7] S. Aliyu, M.K. Hassan, R. Mohd Yusof, N. Naiimi, Islamic Banking Sustainability: A Review of Literature and Directions for Future Research. Emerging Markets Finance and Trade, 2017 Feb 1 cited 2023 Jul 21];53(2):440–70. Available from: https://www.tandfonline.com/doi/abs/10.1080/1540496X.2016.1262761.

[8] Ibid 2

[9] Ibid 6

[10] K. Al-Rawi, Financial analysis of the financial statements and accounting disclosure, in: Arabic: Altahlil Almaliu Lilqawayim Almaliat Walafisah Almuhasabii), first ed., Dar Al Masirah for Publishing and Distribution, Amman, 2000.

[11] M. Hasan, Murabaḥa ¯ reconstruction: its application in the electronic journal in Indonesia, Al-Ahkam. 30 (1) (2020) 77–94.

[12] M. Daoud, Sharia and legal controls for differences in landlord and tenant, in: Arabic: Aldawabit Alshareiat Walqanuniat Liakhtilaf Almuajir Walmustajar), New University Publishing House, Alexandria, 2000

[13] M.I.S. Mihajat, Hybrid contract in islamic banking and finance : a proposed Shariah principles and parameters for product development, Islamic Manag Business 7 (16) (2015) 89–100.

[14] S. Al-Fenisan, Lease to ownership (in Arabic: alayijar almuntahi bialtamlik), J Contemp Jurispru Res 12 (48) (2001)

[15] Ibid 6

[16] S. Saleem, F. Mansor, Exploring compliance of AAOIFI Shariah standard on ijarah financing: analysis on the practices of islamic banks in Malaysia, J. Risk Financ. Manag. 13 (2) (2020) 29

[17] M.Z. Md Nor, A.M.A.A.H. Mohamad, N.I. Abdul Jalil, Legal issues of ijarah contract and rent to own scheme, J. Leg. Ethical Regul. Issues (JLERI) 24 (5) (2021) 1–8.

[18] A. Al-Qura Aghi, Leasing in the benefits of persons in comparison in islamic jurisprudence and labor law, in: Arabic: Alajarat Fi Manafie Al’ashkhas Muqaranatan Fi Alfiqh Al’iislamii Waqanun Aleamal), Dar Al-Masira for Publishing and Distribution, Amman, 2008


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