June 2009: 'Substance' over 'form' in Islamic finance: analysis of murabaha and ijara contracts
01 July, 2009
June: ‘Substance’ over ‘form’ in Islamic finance: analysis of murabaha and ijara contracts
Muhammad Ismail, financial controller at Sony Europe and the company’s trainer for its UK accounting team, examined the issue of ‘substance’ and ‘form’ of murabaha and ijara contracts, which at present constitute around 80 per cent of Islamic finance transactions. He compared them with secured loans and leasing, respectively, in the conventional financial system. He then commented on the areas that may bring credibility to Islamic finance and ensure its mainstream relevance, and that would facilitate in establishing Islamic finance identity as an alternative to current financial problems.
Ismail is an Associate Fellow of the IIBI. He has over 20 years of experience in various finance and accounting roles, and developed the finance function and team for the Pepsi plant in Baku, Azerbaijan.
The recent financial crisis has sparked debates among the regulators, governments and bankers to review current banking practices. There are calls for tough actions by the regulators for supervision of financial institutions and evaluations of their accounting practices. In some markets, short selling was suspended temporarily due to its harmful effects in further destabilising the financial markets in crisis times. The financial sector bailout of trillions of dollars was justified on the premise that the costs of financial system collapse are far greater than bailout costs to the public purse.
Ismail mentioned that the crisis has provided supporters of Islamic finance an opportunity to present the industry as a viable alternative. They argue that Islamic finance is inherently stable and ethical and links financial activity with real sector activity. Islamic finance does not have a money multiplier mechanism as in the case of the conventional financial system and there are certain restrictions on debt creation and its trading which facilitates the stability of the Islamic financial system.
He pointed out that in order to substantiate these claims of the Islamic financial system’s stability, it is time to examine the Islamic finance products and their underlying contracts. As mentioned above, around 80 per cent of the underlying contracts today are murabaha or ijara. Murabaha is a contract in which an Islamic bank buys an asset from a vendor and then sells it on to its client with a mark-up. Ijara is similar to conventional leasing except that the ijara asset must be used for Shari’ah-compliant activities.
Then, Ismail went on to discuss ‘substance’ over ‘form’; this concept has been much debated in professional circles. Tax laws normally rely on the substance of a transaction instead of its legal form. He described the text below of the International Accounting Standards Framework, which emphasises the importance of substance over legal form:
‘If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.’He explained that ijara and murabaha are Islamic debt-based contracts resulting in similar financial impacts for a customer as those of leasing and asset-based financing in the conventional financial system. In these contracts, debt creation is based on real economic activity. He then explained the following key differences of ijara and murabaha respectively with conventional leasing and secured loans:
- Murabaha transactions are always asset- based, while this is generally not the case in secured loans. Conventional banks extend finance based on the creditworthiness of the client with an asset as collateral, without any reference to utilisation of funds extended to client.
- Ownership of asset: Islamic banks bear the ownership risk in case of murabaha and ijara transactions which justifies their returns. However, this is not the case in conventional banks’ financing.
- Insurance of leased assets: the lessee is normally responsible for insuring assets obtained through conventional lease. However, the lessor is required to pay insurance costs of the assets which are provided on an ijara basis as per AAOIFI Shari’ah standard No.9.However, the insurance cost may reflect in ijara rentals, and therefore the financial impact of an ijara transaction may appear similar to that of a conventional one.
- Prohibition of late-payment penalties: in Islamic banking, such penalties act as a deterrent, to discipline the clients, and are not considered a source of income. Islamic banks have to give away late payment charges to charity; however, this is not the case for conventional banks.
- Prohibition of securitisation of debt: in the majority of jurisdictions where Islamic finance is practiced, this prohibition stops Islamic banks from selling financial assets to pass on the default risk created by irresponsible investment. This forces Islamic banks to evaluate risks carefully by carrying out proper due diligence processes instead of relying on securitisation and credit default swaps.
- Prohibition of dealing with assets and activities which are not allowed under Shari’ah principles, such as gambling, sale of pork and alcohol. Murabaha and ijara contracts cannot be used for financing any prohibited activities.
- Asset ownership in murabaha vs a charge on assets in the case of a secured loan: an Islamic bank takes ownership of an asset, even for a very short period, before selling it to the customer. This ownership period (by the bank) is an insignificant part of the total useful life of the asset. However, the ownership risk is covered by insurance. Therefore, it does not constitute a major difference with the charge on assets in case of conventional loan which extends bank’s right to asset used as collateral.
At the close, Ismail emphasised that intellectual discussion of Islamic finance as a viable solution, to get rid of the weaknesses of conventional finance, is mainly limited to theoretical debate. The main reason for this is that practitioners have not yet developed flagship products and solutions not available in conventional finance. The creativity of Islamic finance practitioners should be invested in development of products and structures which are based on profit-and-loss sharing, and risk-sharing products in ‘substance’ as well as ‘form’. According to him, these products will unveil the real potential of Islamic finance to minimise the severity and frequency of financial crises.