Abstract:

Islamic finance is based on Islamic canon law known as the Shariah. Each Islamic bank employs a group of religious experts known as a Shariah board to ensure that their products concur with Islamic laws. Best known is the prohibition on charging interest (Riba).

Full Text:

Copyright Euromoney Publications PLC Feb 1997

Making money is encouraged by Islam, which lays down a cohesive set of laws governing business. Islamic finance is based on Islamic cannon law known as the Shariah. Each Islamic bank employs a group of religious experts known as a Shariah board to ensure that their products concur with Islamic laws.

Best known is the prohibition on charging interest (Riba). As a result, loans are made on an interest-free (Qard Hasan) basis. Islam also bans profits from speculation, instead stressing a commitment to the real economy particularly through dealing with assets. As a result, Islamic financing is well-suited to aircraft financing, most frequently through leasing structures (Ijara and Ijara Wa Iqtina). Ijara is used when a bank purchases goods on behalf of a client and leases them to the client for a rental fee, while maintaining ownership. The rental fee and the duration of the lease are agreed in advance. In a Ijara Wa Iqtina, the client purchases the goods from the bank at the end of the lease period for a predetermined price, with fees paid forming part of the price. Despite the ban on interest, most Islamic banks use market interest rates as a yardstick for setting lease rentals.

Aircraft financing can also be incorporated into Mudaraba. This is an area which projects significant growth. it is an agreement between two parties, one of whom provides 100% of the capital. The second party, Mudarib, brings only entrepreneurial skills to the project, over which the Mudarib has complete control. Profits are distributed according to a predetermined ratio, while the provider of capital is liable for losses.

Mudaraba can include fund management with the investor providing the capital while the fund manager acts as the Mudarib. Funds incorporating airline leasing include The International Investor’s Global Lease Fund which acts as an umbrella fund investing in leases for equipment, including a special purchase company leasing aircraft engines to Kuwait Airways Corporation (KAC). The Islamic finance division of ANZ Banking Group’s London office also plans to launch a leasing and medium-term asset closed – end Mudaraba fund through a limited company, to be established in the Channel Islands and listed in Bahrain. “ANZ will be involved in arranging and participating in aircraft financing for carriers in target markets of the Middle East and Asia.” says Richard Duncan, director of the Islamic banking division.

A third product, known as Murabaha, which involves the purchase of goods by a bank as requested by the client, is also being used increasingly to finance the purchase of equipment and even commodities, including jet fuel financing.

Airlines which have been floated may also be indirectly affected through Islamic equity funds. However, because a part of many airlines’ income is generated through inflight alcohol sales, Shariah boards have mixed views on whether airline stocks are acceptable. Iqbal Khan, director of the Bahrain-based Islamic Investment Company of the Gulf (HCG). says that “although leasing structures are acceptable, ownership of an asset that profits from the sale of alcohol is off limits”.

Each Islamic bank employs its own Shariah boards with the result, according to Lora Lu of Al Rajhi in London, that “no two deals need be the same”. But lack of uniform Shariah interpretations has been art obstacle to the development of new products and Islamic financing, in general. While moves towards uniI1 Shariah boards in Malaysia will alleviate the problem there, significant differences exist between Malaysia and the rest of the world.

Tough religious criteria has meant Islamic financial institutions have traditionally struggled to generate sufficient investment opportunities. Shariah boards are also criticized for their poor understanding of applied banking, which has again hindered the development of new products. All Islamic institutions have to factor in the obligatory Zakat payment (a welfare tax of about two-to- three per cent) which makes high yields in a deal even more crucial.

Despite such constraints, the volume of funds under management in the Islamic financial sector have shot up to about $80 billion, and with private liquidity in the Gulf states alone reckoned at more than $300 billion, market observers claim Islamic banking’s still comparatively modest deposit base will exceed the $100 billion mark by the year 2000.

On the asset side, strict religious criteria has prompted significant interest in aircraft leasing because it is a clearly defined asset. Ijara’s appeal is heightened by the similarity with the conventional structure. According to Dermot Mannion, Emirates’ finance director, Ijara is also “relatively straightforward to administer”.

Michael Clode, a partner at Freshfields, says “while Ijara does not charge interest, the underlying structure is very similar to conventional leasing. However, more conservative Shariah boards stipulate that management, insurance and maintenance is the responsibility of the lessor unlike in conventional operating leases”.

Despite the similarities, there are also crucial differences. Clode says: “The complexities lie with a default. More flexible Shariah boards such as in Malaysia will go close to incorporating default interest, but more conservative Shariah boards will find this is unacceptable and tend to fudge the issue. Although the lessor can sell the aircraft, this poses a problem, especially in the early part of lease term when the goods would have undergone heavy initial depreciation, but the lessor would have received little by way of payment.”