Compliance with Shariah requirements is a prerequisite in ensuring the legitimacy of Islamic financial products and services. In meeting this expectation, it is essential for an Islamic financial institution (IFI) to establish the necessary operational framework and infrastructure to ensure that the conduct of Islamic financial transactions is consistent with Shariah.
The Shariah contract-based regulatory policy is intended to ensure end-to-end compliance with Shariah and therefore enhance the integrity and sustainability of the IFI.
The policy document contains two distinctive parts, namely the Shariah requirements and operational requirements. The former highlight the salient features, essential conditions and optional practices of the ijarah contract, including arrangement of the contract with other Shariah contracts or concepts. The latter outline the operational requirements based on the core principles of good governance and oversight, proper product structuring, effective risk management, fair business and market conduct and sound financial disclosures. These operational requirements are aimed at complementing and promoting sound application of the Shariah principles.
An ijarah refers to a contract that transfers ownership of usufruct or service for a specified period in exchange for a specified consideration. There are two main structures of ijarah in the context of Islamic financial transactions, namely primary ijarah and ijarah financing.
Under the primary ijarah structure, the customer intends to obtain benefits from the leased asset instead of committing to own the asset. As such, the ownership of the asset may remain with the IFI, which is the lessor, subsequent to the completion or termination of the lease contract. Ijarah financing is structured to transfer the ownership of the asset to the customer at the end of the lease period. For this, the ijarah would be structured with supporting arrangements and/or other contracts to enable the transfer of the ownership of the leased asset from the IFI as the lessor to the customer as the lessee, for example, using the mechanism of hibah (gift) or bai` (sale).
It is pertinent for the IFI to make an assessment on the suitability of the types of ijarah structure to be applied given that each ijarah structure has different risk and return profiles which correspond to the degree of responsibilities and level of risk borne by the IFI and the customer.
The inherent risks in a primary ijarah structure include the operational risk arising from the ownership of the asset, for example, maintenance costs relating to the ownership, market risk associated with the potential loss in value of the asset owned by the IFI, and credit risk arising from the losses associated with the potential failure of the customer to pay the rental following the transfer of usufruct.
For an ijarah financing, the IFI is mainly exposed to the credit risk whereby the customer may potentially fail to pay the rental instalments. The operational and market risks can be mitigated given that there is a commitment from the customer to purchase the asset, which enables the IFI to shift the other risks to the customer.
In order to ensure that a customer under an ijarah financing contract will be accorded the same standard of protections as provided under the Hire-Purchase Act 1967 in the event of a repossession, this policy document also incorporates requirements to ensure that, among others, consumer protection elements in the Hire-Purchase Act 1967 relating to repossession are reflected in the ijarah financing contract between the IFI and its customers.
This policy document aims to:
(a) set out the Shariah rulings associated with an ijarah contract;
(b) set out key operational requirements with regards to the implementation of an ijarah contract; and
(c) promote end-to-end compliance with Shariah requirements, which include adherence to sound Islamic banking practices and safeguarding customers’ interest.
This policy document sets out the following:
(a) the mandatory Shariah requirements and permissible optional practices of ijarah under Part B; and
(b) the operational requirements on governance and oversight, structuring, risk management, business and market conduct, and financial disclosure for both ijarah financing and primary ijarah (referred to in these Parts as ‘ijarah’) under Parts C and D respectively. The Parts describe the following five key principles for sound management and operationalisation of ijarah and ijarah financing:
(i) Principle 1: The IFI shall establish a comprehensive governance and oversight framework to ensure that an ijarah transaction is conducted based on sound banking practices and is in compliant with Shariah;
(ii) Principle 2: The IFI shall ensure that the structuring and implementation of an ijarah is supported by robust policies, procedures and processes, adequate infrastructure and robust documentation;
(iii) Principle 3: The IFI shall institute and implement a sound and integrated risk management system to effectively manage risks in line with the IFI’s risk appetite throughout the life cycle of an ijarah;
(iv) Principle 4: The IFI shall undertake an ijarah transaction in a fair and transparent manner in line with Shariah to protect customers’ interests; and
(v) Principle 5: The IFI shall provide adequate disclosure to facilitate stakeholders’ understanding and assessment of ijarah transactions.
This document belongs to Bank Negara Malaysia (BNM). Full access to the original source is available here: https://www.bnm.gov.my/banking-islamic-banking
