The automobile financing using Islamic contracts

by : Fatima Abalhareth

  1. Introduction

Shop around before you make a decision about buying or leasing. Consider the offers from different dealers and several sources of financing, including banks, credit unions, and finance companies. Comparison shopping is the best way to find both the vehicle and the finance or lease terms that best suit your needs as an example of our project today is a vehicle specifically Islamic Vehicle Financing.

This study will attempt to investigate tow big ideas; first what is the Islamic vehicle financing done with the Saudi Arabia Banks. To achieve the objectives of the study, we shall compare between the conventional finance and Islamic finance, especially on the process of vehicle finance on details. Second, we’ll move to the calculation part which is how Islamic banks in Saudi Arabia provide these services in their contracts to enhance the study.

1.1 The Vehicle financing

The vehicle financing is in direct lending, when get a loan directly from a bank. After the agreement to pay, over a period of time, the amount financed, plus a finance charge. Once enter into a contract with a dealership to buy a vehicle, you use the loan from the direct lender to pay for the vehicle. In Other hand, it is in dealership financing, which is another common type of vehicle financing, getting financing through the dealership, and a dealer, enter into a contract where you buy a vehicle and agree to pay, over a period of time, the amount financed plus a finance charge. The dealer may retain the contract, but typically sells it to a bank, finance company or credit union — called an assignee — that services the account and collects your payments.

Before we buy or lease a vehicle should be attention on these 3 points:

  1. Consider Federal and State Laws. b. Determine How Much You Can Afford. c. Monthly Spending Plan. Also, if we want to lease a vehicle must be considered the monthly payments on a lease usually are lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease period, plus a rent charge, taxes, and fees. But at the end of a lease, you must return the vehicle unless the lease agreement lets you buy it and you agree to the purchase costs and terms.

However, to determine if leasing fits your situation:

  • Consider the beginning, middle and end of lease costs.
  • Compare different lease offers and terms, including mileage limits.
  • Consider how long you may want to keep the vehicle.

For instant:

Term 3 Years – 36 months 5 Years – 60 Months
Purchase Price $31,000 $31,000
Down Payment (20%) $6,200 $6,200
Amount Financed $24,800 $24,800
Contract Rate (APR) 5.00% 5.00%
Finance Charge $1,958 $3,280
Monthly Payment Amount $743 $468
Total of Payments $26,758 $28,080

 

  1. Difference between Islamic & Conventional Financing

The basic difference between Islamic Banking and conventional banking is the contractual relationship. This fundamental difference posed a totally different outlook on what happens after that. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon. But look at an Islamic contract. The contract defines the relationship, the responsibilities, the subject matter, and the sequencing and ownership requirements for the use in an economic transaction. However, the transaction explains the rewards and returns on the completion of the contractual obligation by the regulators of the Shariah Committee; Cause and effect, risks and compensating return, action and rewards. The deployment of Islamic Banking funds is not for charity. It is still a business that should not charge interest. Moreover, the return on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah, the Muamalat defined within Shariah-compliant transactions. The main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant to ensure conventional banking to the line to protect customer’s interests.

  1. ISLAMIC VEHICLE FINANCING Vs CONVENTIONALVEHICLE FINANCING

With the increasing demands of everyday life, vehicle ownership has shifted from a mere luxury to a vital necessity. Purchasing a car is often the second most expensive, yet important purchase, after buying a home. While doing so, an individual has two options available: either to make a hand on hand (cash) purchase or to go for Vehicle financing. However, due to the exorbitant car prices and lack of the funds available, many individuals prefer the latter option and approach the various financial institutions, which provide this facility at different rates.

Vehicle Ijarah’ has been designed according to the principles of Islam and is completely interest-free. Moreover the Ijarah contract and other documentation also comply with Shariah requirements. On the other hand, a conventional car-financing scheme is actually an Interest based loan given by the financial institution and interest is charged on that loan. Also, in conventional car-leasing arrangements, the lease contract is not in compliance with Islamic Shariah and has Riba and other un-Islamic elements in it.

In ‘Car Ijarah’ the asset remains in the ownership and risk of the bank and the customers only pay the rentals for use of the asset; just like house rent. These basic differences are described in detail as the first term is (leasing or financing) that traditional systems provide financing for purchasing car, i.e. In essence, they are giving loan and earning interest. The Islamic car financing – It is not a financing scheme rather it is a lease contract. Ijarah is based on a lease contract. It is not a mixture contract. IJARAH is an Arabic term with origins in Islamic Fiqah, meaning to give something to rent. Leasing is a contract are transferred from the lessor, to another person is the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of the lease that is a second term (rental or installment).

Also, the term of (down payment or security deposit) that is in Ijarah the buyer is required to keep a security deposit at the bank. The minimum requirement for security deposit is 20% of the car value and the maximum is 50%. The requirement is different in the case of conventional car financing is a down payment made by the buyer of the car. The amount required for the down payment is 20% of the price plus the installment for the first year. Both the down payment and the security deposit mentioned above are one-time payments. However, the return in the Islamic mode of financing, the buyer has the right to return the car anytime during or at the end of the lease period, but in a conventional car financing the customer cannot return in any case.

  1. The Contracts used for Islamic Vehicle financing

-Murâbaḥah contract; the seller informs the buyer of his cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.

-Ijārah (Lease, lease purchase); A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Ijārah and murâbaḥah have many similarities and differences. In both financing modes, the bank is not a natural owner of the asset, but acquires it upon receiving a request from its client. Like murâbaḥah, ijārah rentals are paid in installments over time, and are supposed to cover the cost of the asset or the value of an investment for the bank and to provide a fair rate of return on investment. Thus, both contracts create debt. However, in murâbaḥah, the benefits and risks of ownership of the asset are transferred to the client along with ownership, ijārah rentals can be made flexible to reflect changing vehicle business conditions, especially if the rental period is very long. Murâbaḥah and ijārah are easily understood because of their close similarity to conventional financing (installment sales and leasing). Other contracts as Salam (Prepayment, deferred delivery) the buyer pays the seller the full negotiated price of a product that the seller promises to deliver on a future date.

-Istisna’ (Deferred payment, deferred delivery) A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to Salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

-Salam and istisna’ are less frequently used debt-based Islamic financing instruments that do not meet the condition of physical possession of the asset for sale; these are the only two exceptions to the principle that one cannot sell a commodity before it comes into existence.

There are four main differences between istisna’ and salam contracts. (i) istisna’ involves the sale of unique manufactured goods as opposed to salam that can be used in standardized goods. (ii) Unlike salam who requires the payment of the full price up front, istisna’ allows for spot, deferred, or even installment payments. (iii) An istisna’ contract can be cancelled unilaterally until the date that the manufacturer starts working on the goods, while the salam contract can be cancelled only before the contract signature. (iv) The time of delivery is fixed in salam, whereas istisna’ can specify a maximum time for delivery after which the purchaser is no longer bound to accept the vehicles.

  1. Islamic vehicle financing by Five Saudi Arabian banks and their products

— Al Rajahy Bank, Car Ijarah is simply a rental agreement under which the car is given to the customer on rent for a period agreed at the time of the contract. The customer is required to deposit an initial amount (security deposit) with the Bank. Upon completion of the lease period the customer has two options, either to return the car and take away the security deposit or take ownership of the car against his security deposit or any other agreed amount via separate sale transaction.

— Bank Al Riyad, Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.

— The National Commercial Bank (NCB), Murabaha is a Shariah-compliant form of financing where the Bank, based on requests from its customers, purchases specific commodities and sells them to the customers at an agreed-upon price equal to the Bank’s cost plus a specified profit margin, which is payable on a deferred basis in agreed-upon installments. The main uses of Murabaha are in residential, commercial real estate, and trade finance.

— Arabi N Bank, Istisna’a is a contract for the acquisition of assets to be manufactured in accordance with the specifications of the one who requests the assets to be manufactured / procured. In this product the Bank can either be the manufacturer/ procurer (Saani) or the party who is seeking the assets to be manufactured/procured (Mustasni). In project finance, the Bank takes the role of Mustasni and agrees with the customer to deliver specified assets for an agreed upon price. The Bank pays for the asset in staged payments. At the same time, the Bank enters into a forward Ijara and leases the assets to be created to the customer with promise to transfer ownership.  The main use of Istisna’a is in project finance combined with forward Ijara to finance the construction of new projects.

–Bank Al Balad, All the above Shariah-compliant financing products are accounted for in conformity with the accounting policies described in these financial statements. They are included in the financing and advances.

  1. Case Study

All banks apply the simple interest formula to calculate the total amount of the loan, then divide the total amount by the number of months. Example: Loan amount is 100000. The profit margin percentage rate is 2%. Number of financing years is 5. The total loan with profit margin is 100000* (1+2%*5) =110000. Monthly installments equals 110000/60=1833.33

Risk Management; in addition to facing common risks with conventional financial institutions, Islamic banks also face their own unique risks. The Shari’ah-compliant nature of assets and liabilities distinguishes them from conventional banks while at the same time exposing them to similar market, credit, liquidity, operational, and legal risks. Notably, differences in opinion among equity risk arise when Islamic banks enter into musharakah and mudârabah partnerships, as providers of funds and they share in the business risk of the activity being financed.  The mark-up risk tends to rank highly for Islamic banks. However, All in all, profit-sharing investment accounts (PSIA), diminishing musharakah, mudârabah, Salam, and istisna’ tend to be considered riskier than murahabah and ijārah. To mitigate risks, Islamic banks use a variety of prudential reserves.

For example, trade-based contracts (murabaha, Salam and istisnaa) and leasing are exposed to both credit and market risks. For example, during the transaction period of a salam contract, the bank is exposed to credit risk and at the conclusion of the contract it is exposed to commodity price risk. However, the unique nature of Islamic financing, with a diverse set of instruments used as sources and uses of funds, calls for the development of new techniques, processes, institutional setup, and procedures to further improve risk management practices and challenge Islamic finance–specific risks.

Further standardization for Shari’ah compliance would benefit Islamic financial institutions. Unlike conventional banking where a unified set of international standards help agents to identify risks associated with the bank’s activities, Islamic financial institutions often face difficulties presenting internationally accepted Islamic instruments to their customers, while it seems challenging to standardize different interpretations of certain religious matters across jurisdictions and Shari’ah scholars.

For example, if a customer is interested in a new car costing Rs. 300,000 for a tenure of five years and is willing to pay a 50% security deposit, the monthly rental would be Rs. 300,000 × 0.014067 = Rs. 4220 per month for five years.

If a customer wants to buy a second hand car, is interested in a car costing Rs.300, 000 for tenure of five years and is willing to pay a 50% security deposit, the monthly rental can be calculated from Table 1.2. The monthly rental would be Rs. 300,000×0.014230 = Rs. 4261 per month for five years. Table 1.3 demonstrates the difference between a Car Ijara and a conventional car lease.

Table 1.1 Rental calculations for new cars

15 0.030399 0.024789 0.021590
20 0.028821 0.023533 0.020515
25 0.027242 0.022277 0.019440
20 0.025664 0.021021 0.018366
35 0.024085 0.019765 0.017291
30 0.022507 0.018508 0.016216
45 0.020929 0.017252 0.015142
40 0.019350 0.015996 0.014067

Security deposit (%)                           3 years                          4 years                                5 years

 

Table 1.2 Rental calculations for used cars

Security deposit (%) 3 years 4 years 5 years
20 0.029412 0.023940 0.020726
25 0.027799 0.022660 0.019639
30 0.026186 0.021379 0.018552
35 0.024572 0.020099 0.017465
40 0.022959 0.018819 0.016378
45 0.021346 0.017539 0.015290
50 0.019732 0.016259 0.014230
 

The Ijara contract is binding under the Sharia’a and does not contain any conditions that make the contract void.

  1. Conclusion

Islamic finance has expanded rapidly and is spreading across many regions. Islamic financial assets grew, on average, about 20 percent annually over the past decade. Despite this growth, Islamic finance still represents a very small share of global financial assets. To this end, several factors still constrain the realization of the full potential of Islamic finance. A few are discussed in this paper, such as lack of liquidity management instruments and underdevelopment of appropriate safety nets, notably Shari’ah-compliant deposit insurance scheme and lender of last resort facilities.

Islamic banks operating in many conventional systems do not have access to Shari’ah compliant tradable short-term treasury instruments to channel excess funds to other Islamic financial institutions. The absence of such instruments restricts growth, forces banks to hold excessive reserves, and also curtails the central bank’s ability to conduct monetary policy operations.

 

 

 

 

 

 

 

  1. Reference list

 

  • Krasicka and Nowak (2012) for more discussion on actions taken by Malaysia to ensure level playing field for the Islamic finance industry.
  • AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions (1999), Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks, Bahrain: AAOIFI.
  • The National Commercial Bank, Annual Report 2014.
  • Ahmad, Ausaf and Khan, Tariqullah (1997). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IDB, IRTI.
  • Ahmad, Ausaf and Khan, Tariqullah (eds) (1998). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IRTI.
  • Sole, Juan, 2007, “Introducing Islamic Banks into Conventional Banking Systems,” IMF Working Paper 07/175 (Washington: International Monetary Fund).
  • Abedifar, P., P. Molyneux, and A. Tarazi. 2013, “Risk in Islamic Banking.” Review of Finance, No. 6 Vol. 17, pp. 2035–2096.
  • Ahmad,Ausaf (1993),‘Contemporary practices of Islamic financing techniques’,research paper no.20,Islamic Research and Training Institute, Islamic Development Bank, Jeddah.
  1. Introduction

Shop around before you make a decision about buying or leasing. Consider the offers from different dealers and several sources of financing, including banks, credit unions, and finance companies. Comparison shopping is the best way to find both the vehicle and the finance or lease terms that best suit your needs as an example of our project today is a vehicle specifically Islamic Vehicle Financing.

This study will attempt to investigate tow big ideas; first what is the Islamic vehicle financing done with the Saudi Arabia Banks. To achieve the objectives of the study, we shall compare between the conventional finance and Islamic finance, especially on the process of vehicle finance on details. Second, we’ll move to the calculation part which is how Islamic banks in Saudi Arabia provide these services in their contracts to enhance the study.

1.1 The Vehicle financing

The vehicle financing is in direct lending, when get a loan directly from a bank. After the agreement to pay, over a period of time, the amount financed, plus a finance charge. Once enter into a contract with a dealership to buy a vehicle, you use the loan from the direct lender to pay for the vehicle. In Other hand, it is in dealership financing, which is another common type of vehicle financing, getting financing through the dealership, and a dealer, enter into a contract where you buy a vehicle and agree to pay, over a period of time, the amount financed plus a finance charge. The dealer may retain the contract, but typically sells it to a bank, finance company or credit union — called an assignee — that services the account and collects your payments.

Before we buy or lease a vehicle should be attention on these 3 points:

  1. Consider Federal and State Laws. b. Determine How Much You Can Afford. c. Monthly Spending Plan. Also, if we want to lease a vehicle must be considered the monthly payments on a lease usually are lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease period, plus a rent charge, taxes, and fees. But at the end of a lease, you must return the vehicle unless the lease agreement lets you buy it and you agree to the purchase costs and terms.

However, to determine if leasing fits your situation:

  • Consider the beginning, middle and end of lease costs.
  • Compare different lease offers and terms, including mileage limits.
  • Consider how long you may want to keep the vehicle.

For instant:

Term 3 Years – 36 months 5 Years – 60 Months
Purchase Price $31,000 $31,000
Down Payment (20%) $6,200 $6,200
Amount Financed $24,800 $24,800
Contract Rate (APR) 5.00% 5.00%
Finance Charge $1,958 $3,280
Monthly Payment Amount $743 $468
Total of Payments $26,758 $28,080

 

  1. Difference between Islamic & Conventional Financing

The basic difference between Islamic Banking and conventional banking is the contractual relationship. This fundamental difference posed a totally different outlook on what happens after that. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon. But look at an Islamic contract. The contract defines the relationship, the responsibilities, the subject matter, and the sequencing and ownership requirements for the use in an economic transaction. However, the transaction explains the rewards and returns on the completion of the contractual obligation by the regulators of the Shariah Committee; Cause and effect, risks and compensating return, action and rewards. The deployment of Islamic Banking funds is not for charity. It is still a business that should not charge interest. Moreover, the return on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah, the Muamalat defined within Shariah-compliant transactions. The main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant to ensure conventional banking to the line to protect customer’s interests.

  1. ISLAMIC VEHICLE FINANCING Vs CONVENTIONALVEHICLE FINANCING

With the increasing demands of everyday life, vehicle ownership has shifted from a mere luxury to a vital necessity. Purchasing a car is often the second most expensive, yet important purchase, after buying a home. While doing so, an individual has two options available: either to make a hand on hand (cash) purchase or to go for Vehicle financing. However, due to the exorbitant car prices and lack of the funds available, many individuals prefer the latter option and approach the various financial institutions, which provide this facility at different rates.

Vehicle Ijarah’ has been designed according to the principles of Islam and is completely interest-free. Moreover the Ijarah contract and other documentation also comply with Shariah requirements. On the other hand, a conventional car-financing scheme is actually an Interest based loan given by the financial institution and interest is charged on that loan. Also, in conventional car-leasing arrangements, the lease contract is not in compliance with Islamic Shariah and has Riba and other un-Islamic elements in it.

In ‘Car Ijarah’ the asset remains in the ownership and risk of the bank and the customers only pay the rentals for use of the asset; just like house rent. These basic differences are described in detail as the first term is (leasing or financing) that traditional systems provide financing for purchasing car, i.e. In essence, they are giving loan and earning interest. The Islamic car financing – It is not a financing scheme rather it is a lease contract. Ijarah is based on a lease contract. It is not a mixture contract. IJARAH is an Arabic term with origins in Islamic Fiqah, meaning to give something to rent. Leasing is a contract are transferred from the lessor, to another person is the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of the lease that is a second term (rental or installment).

Also, the term of (down payment or security deposit) that is in Ijarah the buyer is required to keep a security deposit at the bank. The minimum requirement for security deposit is 20% of the car value and the maximum is 50%. The requirement is different in the case of conventional car financing is a down payment made by the buyer of the car. The amount required for the down payment is 20% of the price plus the installment for the first year. Both the down payment and the security deposit mentioned above are one-time payments. However, the return in the Islamic mode of financing, the buyer has the right to return the car anytime during or at the end of the lease period, but in a conventional car financing the customer cannot return in any case.

  1. The Contracts used for Islamic Vehicle financing

-Murâbaḥah contract; the seller informs the buyer of his cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.

-Ijārah (Lease, lease purchase); A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Ijārah and murâbaḥah have many similarities and differences. In both financing modes, the bank is not a natural owner of the asset, but acquires it upon receiving a request from its client. Like murâbaḥah, ijārah rentals are paid in installments over time, and are supposed to cover the cost of the asset or the value of an investment for the bank and to provide a fair rate of return on investment. Thus, both contracts create debt. However, in murâbaḥah, the benefits and risks of ownership of the asset are transferred to the client along with ownership, ijārah rentals can be made flexible to reflect changing vehicle business conditions, especially if the rental period is very long. Murâbaḥah and ijārah are easily understood because of their close similarity to conventional financing (installment sales and leasing). Other contracts as Salam (Prepayment, deferred delivery) the buyer pays the seller the full negotiated price of a product that the seller promises to deliver on a future date.

-Istisna’ (Deferred payment, deferred delivery) A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to Salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

-Salam and istisna’ are less frequently used debt-based Islamic financing instruments that do not meet the condition of physical possession of the asset for sale; these are the only two exceptions to the principle that one cannot sell a commodity before it comes into existence.

There are four main differences between istisna’ and salam contracts. (i) istisna’ involves the sale of unique manufactured goods as opposed to salam that can be used in standardized goods. (ii) Unlike salam who requires the payment of the full price up front, istisna’ allows for spot, deferred, or even installment payments. (iii) An istisna’ contract can be cancelled unilaterally until the date that the manufacturer starts working on the goods, while the salam contract can be cancelled only before the contract signature. (iv) The time of delivery is fixed in salam, whereas istisna’ can specify a maximum time for delivery after which the purchaser is no longer bound to accept the vehicles.

  1. Islamic vehicle financing by Five Saudi Arabian banks and their products

— Al Rajahy Bank, Car Ijarah is simply a rental agreement under which the car is given to the customer on rent for a period agreed at the time of the contract. The customer is required to deposit an initial amount (security deposit) with the Bank. Upon completion of the lease period the customer has two options, either to return the car and take away the security deposit or take ownership of the car against his security deposit or any other agreed amount via separate sale transaction.

— Bank Al Riyad, Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.

— The National Commercial Bank (NCB), Murabaha is a Shariah-compliant form of financing where the Bank, based on requests from its customers, purchases specific commodities and sells them to the customers at an agreed-upon price equal to the Bank’s cost plus a specified profit margin, which is payable on a deferred basis in agreed-upon installments. The main uses of Murabaha are in residential, commercial real estate, and trade finance.

— Arabi N Bank, Istisna’a is a contract for the acquisition of assets to be manufactured in accordance with the specifications of the one who requests the assets to be manufactured / procured. In this product the Bank can either be the manufacturer/ procurer (Saani) or the party who is seeking the assets to be manufactured/procured (Mustasni). In project finance, the Bank takes the role of Mustasni and agrees with the customer to deliver specified assets for an agreed upon price. The Bank pays for the asset in staged payments. At the same time, the Bank enters into a forward Ijara and leases the assets to be created to the customer with promise to transfer ownership.  The main use of Istisna’a is in project finance combined with forward Ijara to finance the construction of new projects.

–Bank Al Balad, All the above Shariah-compliant financing products are accounted for in conformity with the accounting policies described in these financial statements. They are included in the financing and advances.

  1. Case Study

All banks apply the simple interest formula to calculate the total amount of the loan, then divide the total amount by the number of months. Example: Loan amount is 100000. The profit margin percentage rate is 2%. Number of financing years is 5. The total loan with profit margin is 100000* (1+2%*5) =110000. Monthly installments equals 110000/60=1833.33

Risk Management; in addition to facing common risks with conventional financial institutions, Islamic banks also face their own unique risks. The Shari’ah-compliant nature of assets and liabilities distinguishes them from conventional banks while at the same time exposing them to similar market, credit, liquidity, operational, and legal risks. Notably, differences in opinion among equity risk arise when Islamic banks enter into musharakah and mudârabah partnerships, as providers of funds and they share in the business risk of the activity being financed.  The mark-up risk tends to rank highly for Islamic banks. However, All in all, profit-sharing investment accounts (PSIA), diminishing musharakah, mudârabah, Salam, and istisna’ tend to be considered riskier than murahabah and ijārah. To mitigate risks, Islamic banks use a variety of prudential reserves.

For example, trade-based contracts (murabaha, Salam and istisnaa) and leasing are exposed to both credit and market risks. For example, during the transaction period of a salam contract, the bank is exposed to credit risk and at the conclusion of the contract it is exposed to commodity price risk. However, the unique nature of Islamic financing, with a diverse set of instruments used as sources and uses of funds, calls for the development of new techniques, processes, institutional setup, and procedures to further improve risk management practices and challenge Islamic finance–specific risks.

Further standardization for Shari’ah compliance would benefit Islamic financial institutions. Unlike conventional banking where a unified set of international standards help agents to identify risks associated with the bank’s activities, Islamic financial institutions often face difficulties presenting internationally accepted Islamic instruments to their customers, while it seems challenging to standardize different interpretations of certain religious matters across jurisdictions and Shari’ah scholars.

For example, if a customer is interested in a new car costing Rs. 300,000 for a tenure of five years and is willing to pay a 50% security deposit, the monthly rental would be Rs. 300,000 × 0.014067 = Rs. 4220 per month for five years.

If a customer wants to buy a second hand car, is interested in a car costing Rs.300, 000 for tenure of five years and is willing to pay a 50% security deposit, the monthly rental can be calculated from Table 1.2. The monthly rental would be Rs. 300,000×0.014230 = Rs. 4261 per month for five years. Table 1.3 demonstrates the difference between a Car Ijara and a conventional car lease.

Table 1.1 Rental calculations for new cars

15 0.030399 0.024789 0.021590
20 0.028821 0.023533 0.020515
25 0.027242 0.022277 0.019440
20 0.025664 0.021021 0.018366
35 0.024085 0.019765 0.017291
30 0.022507 0.018508 0.016216
45 0.020929 0.017252 0.015142
40 0.019350 0.015996 0.014067

Security deposit (%)                           3 years                          4 years                                5 years

 

Table 1.2 Rental calculations for used cars

Security deposit (%) 3 years 4 years 5 years
20 0.029412 0.023940 0.020726
25 0.027799 0.022660 0.019639
30 0.026186 0.021379 0.018552
35 0.024572 0.020099 0.017465
40 0.022959 0.018819 0.016378
45 0.021346 0.017539 0.015290
50 0.019732 0.016259 0.014230
 

The Ijara contract is binding under the Sharia’a and does not contain any conditions that make the contract void.

  1. Conclusion

Islamic finance has expanded rapidly and is spreading across many regions. Islamic financial assets grew, on average, about 20 percent annually over the past decade. Despite this growth, Islamic finance still represents a very small share of global financial assets. To this end, several factors still constrain the realization of the full potential of Islamic finance. A few are discussed in this paper, such as lack of liquidity management instruments and underdevelopment of appropriate safety nets, notably Shari’ah-compliant deposit insurance scheme and lender of last resort facilities.

Islamic banks operating in many conventional systems do not have access to Shari’ah compliant tradable short-term treasury instruments to channel excess funds to other Islamic financial institutions. The absence of such instruments restricts growth, forces banks to hold excessive reserves, and also curtails the central bank’s ability to conduct monetary policy operations.

  1. Reference list

 Krasicka and Nowak (2012) for more discussion on actions taken by Malaysia to ensure level playing field for the Islamic finance industry.

  • AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions (1999), Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks, Bahrain: AAOIFI.
  • The National Commercial Bank, Annual Report 2014.
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