When two people or businesses enter into a financial agreement, trust is important. The person providing the money, goods, or service needs to know that the other party will fulfil their obligation. Sometimes, however, they may want an additional layer of assurance.
This is where Kafalah comes in.
Kafalah is a Shariah-based guarantee arrangement in which one party agrees to guarantee the obligation of another party. In simple terms, a guarantor agrees to stand behind someone else’s obligation, giving the other party greater confidence that it will be fulfilled.
But how does this work in practice, and what does it have to do with non-interest banking?
What is Kafalah?
Kafalah can be understood as a contract of guarantee or surety.
There are usually three parties involved. There is the person who has the original obligation, the person or institution to whom the obligation is owed, and the guarantor who provides the guarantee.
The guarantor’s role is to assure that the obligation will be met. If the original party fulfils their obligation as agreed, the guarantee may never need to be called upon. If they fail to do so, the guarantor’s responsibility comes into effect according to the terms of the guarantee.
The concept is not limited to one type of transaction. AAOIFI’s Shariah Standard No. 5 specifically covers guarantees and their applications in Islamic finance, including letters of guarantee and other modern financial arrangements.
How does Kafalah work?
Let’s say a business wants to enter into an agreement with a supplier, but the supplier is unsure about extending credit to a new customer.
A third party could provide a guarantee for the customer’s obligation. The supplier now has an additional level of assurance that the obligation will be fulfilled.
The original customer is still responsible for the obligation. The guarantor does not simply replace them. Instead, the guarantor provides a commitment that can be relied upon if the circumstances covered by the guarantee occur.
This is why the terms of a Kafalah arrangement matter. The parties need to understand what is being guaranteed, who is providing the guarantee and what happens if the original obligation is not fulfilled.
Where can guarantees be useful?
Guarantees can be useful in situations where one party wants additional reassurance before entering into a transaction.
For businesses, this could come up when seeking financing, purchasing goods on credit or entering into certain commercial agreements. A guarantor can provide additional confidence to the party taking on the risk.
Think of a small business that wants to expand but needs financing to purchase new equipment or stock. Depending on the financing arrangement, the financial institution may require a guarantor as part of its security or eligibility requirements.
For example, some of alt bank’s business financing facilities include guarantor requirements. AltBiz lists a guarantor’s form and an undated cheque among the required documents, while some other business facilities specify personal or individual guarantors.
This doesn’t mean every such guarantee should automatically be described as Kafalah. Rather, it shows how guarantees can form part of the practical requirements surrounding business financing.
What makes Kafalah different?
At first glance, Kafalah may sound similar to a conventional guarantee. Both involve one party providing assurance for another party’s obligation.
The difference is the framework in which the guarantee operates.
Kafalah is a Shariah-based contract, so its structure and application have to comply with the relevant principles of Islamic finance. This is part of what makes understanding the contract important. It is not simply about having someone sign as a guarantor; the arrangement itself needs to be properly structured.
This also highlights an important point about non-interest banking. It isn’t simply conventional banking with the interest removed. Different contracts are used to structure different financial relationships, each with its own purpose and requirements.
Does the guarantor get paid?
This is one area where Kafalah can get more technical.
Under the traditional Shariah treatment of a guarantee, the guarantee itself is generally not treated as a contract for earning a fee. However, there can be charges for genuine services connected with issuing or administering certain guarantees.
For example, AAOIFI’s standard distinguishes between remuneration for the guarantee itself and fees that may be charged for services involved in issuing a letter of guarantee.
This distinction is important because the purpose and structure of a payment can matter in Islamic finance.
Why does Kafalah matter in non-interest banking?
Financial transactions involve risk. A business may need financing to grow, while the financial institution needs reasonable assurance that its obligations will be met. Guarantees can help create that additional layer of confidence.
For customers, understanding concepts like Kafalah can also make non-interest banking easier to understand. When you see requirements such as a guarantor attached to a financing facility, you can better appreciate the role that assurance can play in a financial transaction.
At alt bank, for example, business financing options are structured around different non-interest financing contracts, with requirements varying according to the facility. Some facilities focus on assets being financed, while others include guarantees among their requirements.
The key is to look beyond the terminology and understand what each requirement actually means for you.
What should you consider before becoming a guarantor?
Being a guarantor is not something to agree to casually.
If you are asked to guarantee someone else’s obligation, make sure you understand what you are agreeing to and the circumstances under which you could become responsible.
Ask questions such as:
- What exactly am I guaranteeing?
- How long does the guarantee last?
- What happens if the original party fails to meet the obligation?
- What responsibilities will I have as the guarantor?
- Are there any documents or conditions I need to understand?
Getting clear answers before signing anything can help you understand the potential responsibility involved.
Understanding what you’re agreeing to
Kafalah may sound like a complicated financial term, but its basic idea is fairly straightforward: one party agrees to stand behind another party’s obligation.
For anyone exploring non-interest banking, understanding how guarantees work can make financial products and their requirements easier to navigate. Whether you are considering financing for your business or being asked to act as a guarantor for someone else, it is important to understand the role you are taking on and the responsibilities that come with it.
The more you understand the contracts behind a financial arrangement, the easier it is to make informed decisions about your money.
