Home Ownership with Options in Islamic Finance

11/21/2011 12:07:17 PM

Salman Ahmed Shaikh

Current Home Financing Structure in Islamic Finance

In home financing using declining equity ownership structure, the customer approaches the bank for joint purchase of an asset/property. The seller of the property is paid by the bank and the bank and the customer enter into a Joint Property Purchase Agreement.

In this arrangement, the ownership stake of the tenant increases and that of the bank decreases or diminishes with the passage of time. The rent decreases as the ownership stake of tenant increases.

The share of the bank in asset/property is divided into units. These units are purchased by the customer periodically until he/she has purchased all units and become the sole owner of the asset/property. Rent is not charged immediately and is charged at the end of the month for the use of asset/property. Rent for at least one period is fixed. Unit price fixed for a period is not changed during that period. The rent is calculated based on 1 year LIBOR. The floor rate (minimum rate) and the ceiling rate (maximum rate) are stated based on which the rentals rate can vary. In agreement, it is stated that if payment is made on time, the transfer of ownership will take place accordingly.

The risk of damage to the property is borne by the bank and the customer, according to the stake in the property at the time of loss due to accident. Just like in conventional mortgage, a penalty is charged if a customer withdraws from the contract that is paid to charity. The logical argument presented for such a penalty is that the contract involves a promise/undertaking to pay rent and purchase units of the asset/property and if a customer withdraws from the promise/undertaking, he/she can be asked to pay a penalty for maintaining financial discipline. The penalty can’t be taken as income by the bank because change in price after the execution of sale can’t be made as per Islamic scholars. That is why; the penalty collected from customers is paid to charity.

Critical Analysis of Current Islamic Home Financing

In home financing using equity ownership concept in Islamic finance, two contracts i.e. tenancy and sale are included as two separate components of a contract. Both these contracts are separated by way of a unilateral undertaking in place of the actual simultaneous sale/purchase of units of the asset/property. Upon close inquiry, one can notice that unilateral undertaking or promise makes the contract conditional. This argument is further substantiated by the fact that if the client refuses to undertake or promise to buy the asset (in units), the bank will not make contract with him/her. Furthermore, the promise gives the legal cover to the bank and is acceptable in a court of law.

Following table compares the conventional mortgage and ‘Diminishing Musharakah'.

OIC Fiqh Academy rendered ‘Organized Tawarruq’ impermissible, but the ‘unilateral undertaking’ in almost all prevalent Islamic finance contracts - including Murabaha, Ijarah, Diminishing Musharakah, Salam, Istisna, Musawamah etc - is an ‘organized’ way of avoiding price and market risk (the only relevant risks and the only dividing line between trade and lending for interest). Hence, with the same logic, OIC Fiqh Academy should have rendered ‘unilateral undertaking’ an ‘organized’ tool for avoiding price and market risk and the Fiqh ruling of ‘no return without taking risk’.

Options in Islamic finance are not allowed due to the ruling that transactions should be Gharar free i.e. free from ambiguity and uncertainty. In the opinion of this author, the concept of “Gharar” (uncertainty) should not be used as a shield to avoid price/market risk. 1400 years ago, the economy was agricultural and the agricultural yield was not predictable and homogenous. In Options contract, the obligation rests on one party and the other has an option. Therefore, it does not have any element of Gharar (uncertainty). Call premium is also charged to create financial discipline. If there is no call premium, then one will buy an unlimited number of options contract to hedge for each date for a same or similar price.

Hence, options could be used in fixed asset/property financing to separate sale and tenancy contracts.
In the practiced Islamic banking, taking an undertaking from the financee is just like buying a put option from the financee who is acting as a put option writer. If this is reversed, the financee would buy the call option and the bank will sell the call option i.e. acts as a call option writer.

The alternative is as follows:

a) The bank buys the asset/property paying the asset owner the full amount of the asset. The Bank is now the owner of the asset.

b) It gives the asset/property on rent to the financee and the bank also enters into an option contract as the call option writer. In a European option contract (exercisable only at expiration date), the financee buys that call option which gives him/her the right to buy the asset at call expiration. He/She has the right but not the obligation to buy. The option writer however, is obliged to sell the asset if the call buyer (financee) decides to exercise the contract. For short term options contracts, American style call options contracts (exercisable on or before expiration date) could also be used.

c) If the call buyer does not exercise, the option contract expires and the bank is in a position to give the asset/property on rent again.

d) If the call buyer exercises the contract, the bank gets the asset price plus the rental income for the period before the expiration of the contract.

The rent could be benchmarked using House Rent Index. The issue arises whether a fixed premium could be added or not. Due to the fixed premium, even if the property for any reason reaches a value equal or close to zero, there is some rent charged greater than or at least equal to the fixed premium. However, since the contract itself does not have any connection with interest or interest rate benchmark and the rent is charged as long as the asset is in usable condition, it does not contradict with any of the Islamic principles.

This is not a new proposed avenue for investment to the investors. Hence, it is neutral to the issue that whether it should have a secondary market or not. We have lived without securitization of mortgages and in a much better way than in Great Recession.

Second, the proposal meets following specific objectives:

a) To allow people to break free from conventional mortgage if they feel they are not able to keep paying installments. It is done by making them Call option buyers i.e. take a long position.

b) To achieve separation of tenancy and sale contract. It is a requirement in Islamic jurisprudence. This is achieved in Islamic finance currently through a unilateral undertaking which is legally enforceable. Hence, current mechanism to separate tenancy and sale are not ideal and are just legal solutions to the problem.

c) To propose a mechanism that still allows the bank to have reasonable returns even when future prices are low and when they are high. Future prices will influence the client’s decision to exercise or not exercise the call option contract.

d) To propose a mechanism that still allows the client to have a place for living and an option to purchase the house at a fixed price rather than paying fixed installments until maturity.

e) To propose a mechanism for setting rentals which reflects true market rent than linking it with an interest based benchmark. Hence, an alternative to LIBOR as a benchmark/pricing rule has also been provided by linking the rentals with House Rent Index.

Islamic financial services in Canada: Recent developments and long-term prospects

Stuart Carruthers  (http://www.stikeman.com/cps/rde/xchg/se-en/hs.xsl/11424.htm)


As in many Western nations, the awareness and availability of Islamic financial services in Canada continue to grow, although still at a relatively modest rate.  While some limited Shari'ah-compliant products are currently available, there has been limited activity to date, and no major financial institution yet offers a meaningful suite of Islamic financial products or services.  However, given the burgeoning Islamic population in Canada, the growing potential for Islamic financial services in Canada is being carefully followed by Canadian financial institutions, regulators, government agencies, professional advisors and media outlets. For additional background on Islamic finance, please see Stikeman Elliott's Financial Services Updates of April 2007 and January 2008. 


Much like in the United Kingdom, Canada's Muslim population has experienced significant recent growth - from an estimated 253,000 in 1991 to between 800,000 and 1,000,000 in 2006.  By 2017, Muslim Canadians are expected to comprise from 3.7% to 4.9% of the Canadian population.  Moreover, the Muslim population, which is younger and more educated than the overall population, is concentrated in Canada's largest cities.  Consequently, there is expected to be increased demand for Islamic financial services in Canada in the coming years, potentially providing a tremendous opportunity for financial firms prepared to serve this growing community.

The Canadian financial and economic environment

A number of other factors may also support the growth of Islamic finance in Canada in the longer term. Canada continues to enjoy a relatively stable economic and political environment and has generally avoided the level of turmoil currently being experienced in the United States with respect to subprime lending and restricted credit availability issues. Further, a world-class regulator, the federal Office of the Superintendent of Financial Institutions (Canada) (OSFI), regulates the solvency of most of the larger financial institutions, including the large banks and life insurance groups, while also regulating the market conduct of the large banks. Canada also benefits from a strongly multicultural and tolerant society, a rapidly appreciating currency, robust regulatory and legal systems, a neutral and balanced foreign policy and favourable tax treaties with certain Gulf states.

Activity to date

Despite significant recent media coverage of issues related to Islamic financial services in Canada, there has been limited meaningful activity to date.  As previously widely reported, an Ontario-based Islamic mortgage provider, UM Financial, has been indicating for some time that it expects to launch a suite of products in collaboration with a major Canadian financial institution. No further announcements in this regard, however, have recently been made.  One of the large banks offers Shari'ah-linked notes through its private banking division and in 2004 offered a similar retail investment product through its branches.  The Co-operators mutual insurance group, meanwhile, offers certain limited Islamic insurance products, and Islamic mutual funds have also been sold across Canada.  Many of the products, however, have been short-lived, including a group of funds, offered through a leading mutual fund group, which were discontinued in 2006 with only C$6.1 million in assets under management.
Overall, participation in the Islamic financial services sector is still rather peripheral and limited, and no major financial institution is currently offering a meaningful package of Islamic financial services.  It is suspected that the current significant credit crunch and subprime mortgage exposures, although not as significant an issue in Canada as in the United States, are currently more pressing priorities for the larger Canadian financial institutions.
A number of applications have recently been made to OSFI, however, for newly-incorporated Canadian banks offering Islamic financial services.  While some of the applications are understood to be quite far advanced, they appear to be on hold pending the response of a federal multi-agency task force established last year to consider issues related to Islamic finance in the Canadian financial services marketplace.  Interestingly, earlier this year, the Canada Mortgage and Housing Corporation, a federal Canadian crown corporation, also turned its attention to the issue of Islamic finance in the Canadian marketplace, issuing a Request for Proposal for a research report on the subject. As previously widely reported, the request generated some controversy and resulting media coverage, with UM Financial and others supporting the exercise and at least one other Islamic group in Canada criticizing the exercise.

Prospects for the future

Canada is still a number of steps behind the United Kingdom, where Islamic finance is in turn still growing slowly.  Major developments in Canada are likely some time away, although, as noted above, the demographic prospects are excellent.  The same structural issues are present in Canada as were identified in the U.K. by the Financial Services Authority's November 2007 discussion paper respecting developments in Islamic finance in that country.  While there is significant interest from a wide variety of stakeholders, the eventual products will need to be extremely competitive in order to achieve wide distribution in the Canadian marketplace. 
Future activity will likely include one or more of the major international financial institutions with Islamic windows offering retail home finance products in Canada, credit unions and mid-size banks offering home finance products in Canada, major existing Canadian banks breaking into the retail market, and, in the longer term, one or more newly-established Canadian Islamic banks.