Indeed, it is somewhat of a paradox that the Islamic world--and the Middle East and the Gulf in particular--are one of the few remaining “frontiers” for equipment leasing. After all, it was in ancient Sumeria that the earliest known leases were recorded some 4000 years ago! And while the prospects for equipment leasing are growing and bright, the fact is that the market in this region tends to think of leasing more in the context of real estate and personal automobiles. Equipment leasing is still a minority portion of most “leasing activity.” Part of this phenomenon is historical in that large capital equipment demands in this area of the world were typically met with cash or conventional bank debt. However, the rapidly expanding and diversifying economies along with the creation of new range of capital formation structures and products (Islamic and conventional) signal that the basic underpinnings of a healthy and creative equipment leasing market are in place.

Given the newness of the market, Islamic leasing clearly has the opportunity to create a very strong footprint. Moreover, because Islamic and conventional leasing is so similar, those organizations that succeed in the “Islamic marketplace” will be well positioned to compete in the global market.

Background
The key difference between Islamic finance and conventional finance is the role of interest. Interest (riba) is prohibited in Islamic finance. The ban on interest is based on the concept that money is not a commodity in itself that can be used to create profit. Rather, money should be used for buying and selling assets. The transfer of those assets, on the other hand, is a legitimate profit making enterprise.

Unlike conventional finance, the payment stream of an obligation cannot be sold because one may not create a debt out of a debt. The assets involved in the same transaction can be resold, however.

There are some other features of Islamic finance, as stipulated under the Islamic sharia, which are different from conventional finance. The proscription on transactions related to prohibited (haram) asset classes (e.g., alcohol, tobacco, pork) is well known. The Islamic sharia also forbids activities or practices that are speculative or create uncertainty (gharar).

Ijara, or the concept of Islamic leasing
Because ijara is rooted in the concept of an asset rental (even if title will eventually pass or be sold to the lessee), there is no reference to “interest.” Any payments based on an interest rate--late fees, interim rent--are not permitted. That said, because Islamic leasing (ijara) is based on the lessor owning the underlying asset, there is more commonality between conventional asset based financing or leases than not. Islamic leasing offers lessor and lessee much of the same flexibility as does the conventional mode.

Because the ownership of the underlying asset in an ijara/lease is held by the lessor, the right to ownership can be resold by the lessor together with the right to receive payment of the lease rentals.

In conventional leasing, the lessor is a passive financier and thus transfers all responsibilities for maintenance, insurance and taxes to the lessee (“Triple Net, Hell or High Water Lease”). Under Islamic leasing (rental of an asset), the lessor has more retains the responsibility for major maintenance, insurance and taxes. However, Islamic leasing does utilize several structures—the most common of which is to appoint the lessee as agent for lessor—which ultimately and indirectly, transfer the requirement for maintenance, taxes, and insurance to the lessee.

Opportunities in Islamic Leasing
Although there are many Islamic finance structures that can be used as leasing products, the core instruments should be ijara: ijara (equipment rental or operating lease in conventional terms) and ijara wa iqtina (finance lease in conventional terms).

The normal progression of lease structures in new lease markets is that the operating lease follows the finance lease by some time in terms of use and popularity. Our experience at First Leasing Bank, for example, is that after fifteen months of educating potential lessees on ijara/operating leases, we are beginning to see serious interest.

Before ijara/operating leases are prevalent, however, the market will first need to evolve to an “unencumbered” ijara wa iqtina/finance lease as a standard. The unencumbered ijara wa iqtina/finance lease is one that follows the norms established in more mature leasing markets, e.g., financing 100% of the equipment, relying on the asset value in addition to the financial statements, and only requiring additional security when the circumstances so warrant.

Whether Islamic or conventional, the majority of the equipment finance leases transacted in the GCC to date have been done by traditional banks that tend to conduct equipment leasing as an extension of their normal banking activities. It is not surprising, therefore, that the murabaha is often the instrument of choice. A review of the available financial statements reveals that even the majority of the specialized leasing companies historically preferred murabaha as the favored “equipment lease.” (Commercial aircraft leases are a notable exception.)

The distinction between murabaha and ijara is important because the two are often confused or the outcome is assumed to be identical. In fact, the murabaha structure transfers title to the “lessee” at the beginning of the transaction and therefore the “lessor” has no further rights to sell or transfer the asset.

Recently, however, there is anecdotal evidence that the specialized leasing companies and some banks are increasing the use of ijara structures. The emergence of the asset based ijara structure in the GCC is probably due to a combination of pressure from sharia boards and because ijara is more liquid than murabaha.

Even in the ijara structure, the typical traditional banking equipment lease requires a minimum down payment of 20% (or collateral of at least 125%), insistence on guarantees – both personal and corporate, and several other banking covenants not usually demanded as a matter of course in the global market. Equipment leasing as a 100% financed product (or without additional collateral) is currently a rarity in the GCC—again regardless of whether structured by an Islamic or conventional bank. While in some countries there is legitimate concern that the security offered by the underlying asset is not satisfactorily secured and/or not well supported by the current legal system, there are clearly companies, governments, and lessees that merit “world standard” treatment. This excess collateral requirement coupled with longer turn around times, offers a great opportunity to efficient Islamic leasing companies and Islamic banks to establish a preeminent position in the equipment leasing market.

The full benefit of Islamic equipment leasing will be only realized with the widespread use of operating leases where lessors make real [and educated] equity investments [“residuals”] in equipment and assume true asset risk. Of course, that means that lessors will need to develop or tap in to the secondary equipment market. With that development, lessors will truly add a unique product to the capital formation alternatives which, when properly managed, will ultimately increase the Islamic lessors’ profitability.

The operating lease also works to the lessees’ benefit. First and foremost, the lessee only pays for the asset for the time the assets are utilized—usually two to five years, depending on the asset. Moreover, it is possible for the lessee to retain a full range of options at the end of the initial lease term. Typically, those lessee options are to 1) return the asset, 2) purchase the asset, or 3) renew the lease.

The reality is that if an entity is not interested in engaging in ijara/operating leases, that entity is not really in the equipment leasing business. Part of the road to ijara/operating leases is education—education of the potential lessees and, in some cases, education of investors and boards of directors. But the real commitment is that of the leasing company who must invest the time and talent to truly understand the economic value and future value of the assets they choose to lease. And after all, what could be more consistent with Islamic finance risk sharing than a lessor taking a residual position in equipment?

Conclusion
Islamic equipment lessors have a unique opportunity not only in the GCC but throughout the Islamic World to assume the position of leadership in the equipment leasing market. Conversations about the role and future of Islamic finance invariably deal with the questions of how Islamic finance can “catch up” with conventional finance and/or how Islamic finance can emulate or offer an alternative product to conventional finance. In the equipment leasing arena, however, neither Islamic nor conventional lessors have established a dominant position in the marketplace. Those lessors that offer international market standard terms for ijara wa iqtina/finance leases and move into ijara/operating leases will not only enjoy the profits of those decisions but continue to define the market—including the global market-- for years to come.