Islamic Banking or Islamic Finance: Which Are We Building?
Discover why Islamic finance's focus on banking might be holding back market development. A 27-year-old warning reveals critical insights about Takaful's role in building robust capital markets.
In the January 1996 issue of New Horizon magazine, an article posed a question that should make every Islamic finance professional pause:
Why has the industry neglected Takaful despite its potential?
It was highlighting a fundamental misalignment in how we're building Islamic finance—one that continues to shape our industry's development today.
Consider this: In conventional markets, insurance companies, not banks, are the largest contributors to capital markets. They're the primary source of patient capital, the backbone of long-term investments, and the key drivers of market depth.
Yet in Islamic finance, we've built our entire ecosystem around banking, celebrating each new banking product while overlooking the sector that could fundamentally transform our capital markets.
This isn't just about developing more Takaful operators or expanding insurance products. It's about understanding how this 27-year-old oversight continues to influence our market structure, limit our growth potential, and possibly hold back the entire Islamic finance ecosystem.
- Why do Islamic capital markets struggle with depth and liquidity?
- Where will long-term investment capital come from?
- How can we build robust markets without strong institutional investors?
The question posed in 1996 remains startlingly relevant: In our rush to develop Islamic banking, have we overlooked the foundational elements needed for a robust Islamic financial system? Are we building Islamic banking, or are we building Islamic finance?
The article's warning was clear: "It is strange that while propagating the Islamic financial system, our experts have concentrated far more on the banking sector than on a sector which, in fact has ever greater potential."
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The 1996 Warning: A Historical Perspective
To understand the weight of this warning, we need to consider the state of Islamic finance in 1996.
Islamic banking was gaining momentum. Major conventional banks were opening Islamic windows. Regulators were developing frameworks. The industry was celebrating its first successes in creating Shariah-compliant banking alternatives.
In this atmosphere of banking-driven growth, the article made two observations that challenged the prevailing wisdom:
First, the conventional insurance sector had become "the most effective vehicle for mobilising savings for capital formation and for long term investments." This wasn't just about risk protection—it was about building market infrastructure.
Second, while experts debated banking products and regulations, they were overlooking a crucial truth: without a robust Takaful sector, Islamic capital markets would struggle to develop the depth and sophistication needed for long-term growth.
The article identified two barriers that shaped this oversight:
The Banking Priority
The conventional banking sector's size and immediate needs demanded attention. Scholars, regulators, and practitioners focused on creating Shariah-compliant banking alternatives—a natural but limiting response to market demands.
The Misconception Challenge
A prevailing impression among Muslim communities that insurance itself wasn't permissible in Islam created resistance. This despite Takaful's clear alignment with Shariah principles of mutual cooperation and social solidarity.
What makes this historical context crucial isn't just what was said, but what happened next: the industry largely continued on its banking-centric path. The warning went unheeded, and the implications of this choice continue to shape Islamic finance today.
Understanding the Core Issue: Beyond Risk Protection
The relationship between insurance and capital markets reveals why the 1996 warning was so crucial.
Think about how insurance companies operate in conventional markets:
They collect premiums today for obligations that may come years or decades later. This creates vast pools of patient capital—money that can be invested long-term without immediate withdrawal pressure.
This unique position makes insurance companies the natural buyers of:
- 30-year infrastructure bonds
- Long-term corporate debt
- Large-scale project financing
- Patient equity investments
In developed markets, insurance companies hold trillions in long-term investments. They're not just participants in capital markets—they're foundational pillars that enable:
- Market depth through consistent trading
- Price discovery through large-scale transactions
- Stability through long-term investment horizons
- Risk absorption through diversified portfolios
Now consider Islamic finance:
Without developed Takaful institutions, who plays this role? Commercial banks, with their shorter-term liabilities, can't deploy capital for decades. Investment funds, subject to redemption pressures, struggle to maintain truly long-term positions.
This gap creates a structural weakness in Islamic capital markets:
- Infrastructure projects face funding challenges
- Secondary market liquidity remains limited
- Long-term investment options stay restricted
It's not just about the size of Takaful operators—it's about their fundamental role in market structure. Without strong Takaful institutions, we're trying to build capital markets missing a crucial foundation.
The issue isn't that we haven't developed Takaful. It's that we haven't recognized its systemic importance in building robust Islamic financial markets.
The Cost of Our Banking-Centric Approach
The consequences of prioritizing banking development over Takaful go beyond just having fewer Islamic insurance options.
Look at how this imbalance affects Islamic finance today:
Capital Market Development
Islamic banks, with their need to maintain liquid assets, can't be the primary buyers of long-term Sukuk. Yet we keep wondering why our secondary markets lack depth. We've created a market structure where our largest institutions are inherently short-term focused.
Infrastructure Financing
Major infrastructure projects need funding that spans decades. Islamic banks, managing deposits that can be withdrawn on short notice, can't commit capital for 20-30 years. Without strong Takaful institutions, who will fund the long-term development needs of Islamic economies?
Market Stability
When markets face volatility, we need institutions that can take long-term positions—buyers who see past temporary disruptions. Banks, with their asset-liability matching requirements, often can't play this stabilizing role.
Product Development
We've excelled at creating banking products, but consider what we're missing:
- Long-term savings vehicles
- Pension solutions
- Patient capital for venture investment
- Sustainable finance instruments
The real cost isn't measured in lost Takaful premiums or market share. It's in the kind of financial system we're building—one that excels at banking transactions but struggles to provide long-term economic value.
When we focus solely on banking innovation, we're not just neglecting Takaful. We're limiting the entire potential of Islamic finance.
Rebalancing Islamic Finance
The 1996 article concluded with a challenge: "Let it not be said that they lacked the vision, will and ability to harness and exploit this rich field."
Today, addressing this imbalance requires more than just developing Takaful products. It demands rethinking our approach to Islamic finance development:
Regulatory Evolution
The focus needs to shift from just regulating existing activities to actively developing institutional capacity:
- Frameworks that encourage long-term institutional investors
- Regulations that recognize Takaful's unique market role
- Policies that promote institutional development
- Incentives for long-term capital deployment
Market Structure Development
Building deeper markets requires:
- Creating conditions for institutional investor growth
- Developing long-term investment instruments
- Encouraging market-making activities
- Supporting secondary market development
Education and Awareness
We need to move beyond basic product education to:
- Understanding Takaful's role in market development
- Recognizing the importance of institutional investors
- Appreciating the link between Takaful and market depth
- Seeing Islamic finance as an integrated system
The question now isn't whether to develop Takaful, but how to rebuild our development approach to create truly robust Islamic financial markets.
Conclusion: From Warning to Action
Twenty-seven years later, we face a choice:
We can continue celebrating banking innovations while wondering why our capital markets lack depth. We can keep developing new banking products while struggling to find long-term institutional investors. We can maintain our current path while watching the gap between Islamic finance's potential and reality persist.
Or, we can recognize that building Islamic finance means more than replicating banking services.
It means:
- Creating robust institutional foundations
- Developing deep, resilient markets
- Enabling long-term investment
- Building comprehensive financial infrastructure
The question from 1996 remains relevant: "Let it not be said that they lacked the vision, will and ability to harness and exploit this rich field."
Today, we must ask ourselves: When future generations look back at our era of Islamic finance development, what will they say? Will they see a generation that recognized and corrected this fundamental oversight? Or will they find another warning, unheeded?
The choice is ours. Are we building Islamic banking, or are we building Islamic finance?
The answer will shape not just Takaful's development, but the future of Islamic finance itself.
Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.
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