islamic banking: case of turkey

1

Islamic Islamic BankBanking: ing: Case of TCase of Turkeyurkey

6th IADI Annual Conference

Malasia, 1-2 Nov 2007

Ahmet ERTÜRK

President of SDIF

1-2 Nov 2007 6th IADI Annual Conference2

Outline

1 –Need for DIS

2 – Risks of Participation Banks

3 – Challenges and Conclusion


Share of Participation Banks in the Banking Sector

1,872,13

1,08

1,832,01

2,34 2,44

2,75

3,14

1

1,5

2

2,5

3

3,5

1995

2000

2001

2002

2003

2004

2005

2006

2007/6

Years

Per

cent

age

Sha

re

As of the end of June 2007 total assets of participation banks rose to USD 12.869 million while share of participation banks in terms of total assets rose to %3,14.

0,8% of the %1,05 drop due to İhlas Finans House


Levels of deposits at participation banks

Source: Yılmaz, Rasim, Bank Failures and Deposit Insurance in Emerging Market Economies: The Case of Turkey, 2007

Concerns due to the revoke of the license of İhlas Finans, IFH, caused further withdraw of funds from participation banks. Introduction of Deposit Insurance Fund, DIF,

stabilized the market and reduced the withdraw of funds.

Revoke of the license of IFH

Introduction of DIF


Percent decline in deposits at participation banks

Concerns due to İhlas Finans caused a decline of 63% in the participation funds in the period between 31/12/2000-30/6/2001.

Yılmaz, Rasim : Bank Failures and Deposit Insurance in Emerging Market Economies: The Case of Turkey, 2007


Deposit insurance for participation banks

Membership Compulsory

Co-insurance No

Coverage Special current account and participation account belonging to real person

Amount 50.000 YTL (38.226 USD)

Premium system Risk based similar to deposit banks 15-28 bps quarterly on covered deposit

Ownership and management

The Fund was established in May 2001 among participation banks and managed by The Participation Banks Association of Turkey

After December 2005, management was transferred to SDIF


0

2.000

4.000

6.000

8.000

10.000

12.000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007/6

Participation funds have grown %40 annually during 2001 - 2007

(Million USD)

Growth of participation funds

İhlas Finans


Deposit classification in Turkey

JUNE 2007Participation

BanksDeposit Banks

Insured Deposit / Total Deposit %41 %31

Time Deposit / Total Deposit %81 %84

Up To 1 Month Deposit / Total Deposit %62 %28

Between 1-3 Months Deposit / Total Deposit %12 %46

Between 3+ Months Deposit / Total Deposit %7 %10

Since customer base of participation banks is broader, SDIF gives more protection to their customers. 62% of funds in participation banks have less than one month maturity,

whereas maturity of deposits in conventional bank is longer.


Ratios to total assets

June 2007 Participation Banks Deposit Banks

Cash %13 %14

Credit %81 %46

Securities %0 %31

Deposits %76 %64

Capital %12 %11

Capital Adeq. Ratio %16 %17

Participation Banks are exposed to much higher credit risk relative to deposit banks. Their funding is from mostly short term deposits.


Example of profit sharing

Asset Liability

Credit 100 Demand deposit 20Time deposit 60Capital 20

Total 100 Total 100

Deposit banks

=(20-10)/(100-10)CAR=11,1%

Participation banks

=(20-10*20%)/(100-10)CAR=20,0%

Question: In the case of 10% of credit defaulted, what will be capital adequacy ratios for participation banks and deposit banks?

Assumptions:- Same credit portfolio and similar liability portfolio is hold. - Under Basel-I, 100% risk weight applied. No collateral.- Current Capital Adequacy Ratio is %20(=20/100)- For time deposit in participation banks, 20% of return hold by bank for management and 80% paid to customer


Risk comparison to deposit banks

Risk Category Case Reason

Credit risk Higher Credit/asset ratio is 81%

Market risk Lower Almost no security instrument

Operational risk Same Similar operations carried out

Liquidity risk Higher Assets mostly funded by short term participating funds

Interest rate risk Lower Customer base is less sensitive to interest rates


Challenges for the supervisory authority

1. Due to the differences in the assets and liabilities structure participation banks are subject to higher level of credit risk and liquidity risk.

2. As participation funds holders are less sensitive to interest income, participation banks have a substantially lower level of interest rate risk.

3. Since 62% of participation funds have less than one month maturity, liquidity risk is higher. To give enough confidence to customers, sound supervision and strong deposit insurance systems are required.

4. Deposit banks deduct provisions for non-performing loans (NPL) from bank’s capital, which causes a decrease in the capital adequacy ratio (CAR), whereas provisions for non-performing loans of participation banks are shared with customers and have limited effect on their CAR.


Challenges for the deposit insurance fund

1. Participation banks and deposit banks are subject to the same risk based premium system. However, their assets and liabilities structure and risks require differentiated risk factors to be identified.

2. Participation banks have a small market share in Turkey and contain high correlation of default risk, which increases the total risk of deposit insurance system. Therefore, insurance funds for participation banks and deposit banks are managed in the same pool.

3. Moreover, as participation funds are the only instrument bearing no interest in Turkish financial system, their deposit insurance funds could not be managed in a different pool.

4. In case participation banks need public funds due to systemic risk and liquidity risk, there are no non-interest financing tools.


Conclusion

1. Growth of participation funds is very high in Turkey and fund owners require sound supervision and strong deposit insurance.

2. Ihlas Finans is the first participation bank revoked its license. Concerns on its default became contagious to other participation banks and turned out to be a systemic risk. Establishment of DIS gave confidence to the fund owners.

3. Participation banks are subject to the same supervision and regulations as deposit banks. However, due to significant differences in assets-liabilities structure and risk exposures, supervision and risk based DIS should be differentiated.

4. For development of participation banks, innovation for new instruments needed.

islamic banking: case of turkey

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