Islamic Banking: Case of Turkey

Ahmet ERTÜRK
President of SDIF

6th IADI Annual Conference

Malasia, 1-2 Nov 2007

1
 Outline

1 –Need for DIS

2 – Risks of Participation Banks

3 – Challenges and Conclusion

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1-2 Nov 2007 6th IADI Annual Conference
 Share of Participation Banks in the Banking Sector

3,5
0,8% of the %1,05 3,14
3 drop due to İhlas
2,75
Percentage Share

Finans House
2,5 2,44
2,34
2,13
2 2,01
1,87 1,83
1,5

1 1,08
1995

2000

2001

2002

2003

2004

2005

2006

2007/6
Years

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.

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 Levels of deposits at participation banks

Revoke of the Introduction of

license of IFH DIF

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.
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 Percent decline in deposits at participation banks

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

Concerns due to İhlas Finans caused a decline of 63% in the participation funds in
the period between 31/12/2000-30/6/2001.
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 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  The Fund was established in May 2001 among
management participation banks and managed by The
Participation Banks Association of Turkey
 After December 2005, management was
transferred to SDIF

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 Growth of participation funds

(Million USD)

12.000

10.000

8.000
İhlas Finans
6.000

4.000

2.000

0
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

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 Deposit classification in Turkey

Participation Deposit
JUNE 2007 Banks 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.

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 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.

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 Example of profit sharing

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

Asset Liability Deposit =(20-10)/(100-10)

Credit 100 Demand deposit 20 banks CAR=11,1%
Time deposit 60
Capital 20 Participation =(20-10*20%)/(100-10)
banks CAR=20,0%
Total 100 Total 100
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 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

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 Challenges for the supervisory authority

• Due to the differences in the assets and liabilities structure

participation banks are subject to higher level of credit risk and
liquidity risk.

• As participation funds holders are less sensitive to interest income,

participation banks have a substantially lower level of interest rate
risk.

• 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.

• 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.
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 Challenges for the deposit insurance fund

• 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.

• 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.

• 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.

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

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 Conclusion

2. Growth of participation funds is very high in Turkey and fund

owners require sound supervision and strong deposit
insurance.

4. 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.

6. 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.

8. For development of participation banks, innovation for new

instruments needed.
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