Causes and solutions for the stagnation of Islamic banking in Turkey

Introduction

The Ernst & Young World Islamic Banking Competitiveness Report (EY, 2016, p. 10) reveals that international participation banking assets reached US$882bn and have spread widely from the Gulf to the Far East. There are more than 900 Islamic financial institutions (IFIs) according to Thomson Reuters Islamic Finance Development Report 2014 (ICD Thomson Reuters, 2014, p.34).

While Islamic banking, which is called “participation banking” in Turkey, started there in 1985, at roughly the same time as other Muslim countries, it has failed to reach the market share levels of other successful countries. Islamic banking in Turkey was initially established under the name “Special Finance Houses” (SFHs) without making any reference to Islamic requirements because of the secular political culture of the country. Islamic banking stayed at a crawling stage for a long time because the secular sensitiveness hampered the improvements required to catch up with the global practices of Islamic banking (Asutay, 2013). In 2002, the Justice and Development Party, which has a strong bond with the Islamic heritage, won the majority in Parliament, whereupon conditions for Islamic banking started to improve. In 2005, a new banking law brought a legal framework which is deemed more sound, entitling the SFHs to be recognised as participation banks (PBs)[1]. Recently, two state banks established Islamic banking subsidiaries with very ambitious targets.

Even though both the political and economic situations have substantially improved[2] over the past 15 years, the market share of Islamic banks (IBs) has stagnated at around 5 per cent, which is quite small compared to countries such as Malaysia (21 per cent), Qatar (26 per cent) and Kuwait (45 per cent). Thus, Islamic banking in Turkey still remains as a “big potential”.

The purpose of this study is to critically review the global Islamic banking practices and identify how Islamic banking in Turkey resembles or differs from Islamic banking in other prominent countries. This study also examines a large number of key ratios reflecting business models and efficiency of conventional banks (CBs) and IBs in Turkey between 2005 and 2015 to provide a more comprehensive picture of the problems and to recommend workable solutions.

The rest of the paper is organised as follows:

• the next section summarises the global practices of Islamic banking;

• this is followed by an explanation of the progress of the Turkish Islamic banking experience along with a comparison of financial and efficiency ratios of PBs; and

• the final section then concludes the paper.

Islamic banking practices

The progress of the Islamic banking industry has followed different paths in different countries/regions, based on their diverse political, cultural, religious environments and financial structures. Full-fledged IBs were first launched in Saudi Arabia (1974), the United Arab Emirates (UAE) (1975), Kuwait (1977), Bahrain (1978) and Malaysia (1983). While Islamic banking has been spreading over the world, Iran (1979), Pakistan (1980) and Sudan (1984) tried to convert their banking systems into Islamic. However, Sudan and Pakistan left off and turned back to a dual banking system later (Imam and Kpodar 2010). Even though Iran banned interest-related transactions, it is said that it is said that interest has not been fully removed from the monetary and banking system (Hassani, 2010). The UK’s interaction with Islamic banking started with wholesale banking. UK banks provided deposit accounts with murābaḥah markup to IBs in the Gulf region based on London Metal Exchange rates. Afterwards, the first IB of the UK was established in 1982 (Ainley et al., 2009).

The annual growth of international participation banking assets is 15-20 per cent, and, between 2010 and 2014, assets increased from US$490 to 882bn (EY, 2016, p. 10). In terms of market share, Figure 1 reports the changes in domestic markets. It is noted that even with a very small base level, changes in market share in Turkey are far from satisfactory compared with other countries.

Islamic banking in Turkey

Islamic banking began under the name of SFHs in 1985. However, for a long time, IBs had to operate within a minimal legal and regulatory framework and even without mentioning interest-free banking principles. The lack of necessary framework was mainly because of the dominant secular sentiments that prevailed within the state, businesses and media. Any sign of religious symbols could easily ignite irritation and anger at the Islamic banking system. Between 1985 and 1991, six interest-free finance companies, namely, Al Baraka, Kuveyt Türk, Faisal Finans, Anadolu Finans, İhlas Finans and Asya Finans, were established. In 2001, Turkey experienced a devastating economic crisis, during which İhlas Finans – the key player – went into bankruptcy because of a liquidity problem. On the conventional banking side, over 20 banks also failed during the crisis (Hardy, 2012). Because deposits of IBs were not covered by a deposit insurance scheme, the bankruptcy of İhlas Finans caused a chain reaction such that many customers of the remaining IBs rushed to withdraw their monies (Tunç, 2010). The market share of Islamic banking was thus reduced by 50 per cent, and the necessity of the deposit insurance scheme became undeniable. Thus, in 2001 the Union of SFHs was established and at the same time a deposit insurance scheme was launched among IBs.

In 2002, the Justice and Development Party gained a majority in the November election, which eased pressures on Islamic institutions. At the same time, the economic situation as well as Islamic banking started to normalize and then to improve. A new banking law issued in 2005 altered the name of SFHs to “Participation Banks” and finally provided an acceptable legal framework for Islamic banking. Further, the Union of SFHs changed its name to Participation Banks Association of Turkey (PBAT, 2016).

Between 2014 and 2015, the Islamic banking sector faced another internal hardship. It was no secret that Bank Asya, the leader of the market, had a direct relation with the Gulenist movement[4], and a significant amount of deposits was withdrawn by the public because of hostile actions of Gulenists against the Turkish government in late 2013. Afterwards, Bank Asya rejected to share information about its privileged shareholders and its control was transferred to the Saving Deposit Insurance Fund in 2015. This issue significantly disturbed the Islamic banking sector and considerably reduced its total market share.

One significant development in Turkey was the recent entry of two state banks to the Islamic banking sector. Two state banks – Ziraat Bankası and Vakıflar Bankası – established Islamic banking subsidiaries in 2015 and 2016, respectively.

Figure 4 shows the market share of Islamic banking assets as a percentage of the total banking sector in Turkey. For the first 15 years (1985 to 2000), the share of Islamic banking rose to around 2 per cent. During the 2001 economic crisis, in which Ihlas Finans went bankrupt, Islamic banking lost almost half of its market share. Since then, the share of Islamic banking has been steadily but slowly increasing to 5.5 per cent until 2013. While the disenchantment of Bank Asya caused a negative effect on the increasing trend, the entrance of two large state banks into the sector is expected to put the trend on the right track. It is noted that in 2015 PBAT issued a strategy document that covers 2015-2025 to achieve 15 per cent domestic market share until 2025.

The institution/education side of Islamic banking is quite underdeveloped in Turkey. Graduate/undergraduate programmes targeting participation banking or Islamic economics are at the initiation level. Currently, there are three graduate (master) level programmes offered by Sakarya University, Istanbul Sabahattin Zaim University and Istanbul University. Istanbul University (PhD level) and Karatay University (undergraduate level) each have a department of Islamic economics and finance. The International Islamic Economics and Finance Research Centre was established under Istanbul Sabahattin Zaim University in 2012, and the World Bank Global Islamic Finance Development Centre has been operating at Borsa Istanbul. The current academic performance of Turkish scholars on Islamic economics is quite poor. According to Thomson Reuters Islamic Finance Development Indicator (IFDI), Turkish scholars published only 10 research papers between 2011 and 2013 and 33 papers between 2013 and 2015. The numbers for Malaysia are 421 and 833 respectively (ICD Thomson Reuters, 2014, p. 21; 2016, p. 31).

Studies regarding Turkish Islamic banking are very rare. Savaşan et al. (2013) investigate the demand side of Islamic banking by surveying a large sample of conservative businessmen. The results are very interesting and have significant repercussions. They report that 54 per cent of businessmen choose banks to work with based on the cost of financing regardless of the bank type. Only one-third of the businessmen consider IBs to be Sharīʿah-compliant, which is another sign of the poor perceptions of Islamic banking. Another 34 per cent of them declare that they have no idea whether IBs are Sharīʿah-compliant or not.

Ongena and Şendeniz-Yüncü (2011) show that IBs mainly deal with young, multiple-bank, industry-focused and transparent firms. Aysan et al. (2016) demonstrate that IBs are relatively more involved in SME financing. Hassan et al. (2016) utilise stress tests to determine how capital adequacy ratios of IBs and CBs react to credit, market and operation risks and find that IBs in Turkey are more sensitive to stress compared to CBs.

Way forward

The problems or concerns inhibiting an expansion of the Turkish Islamic banking sector can be summarised as follows:

• Lack of Sharīʿah governance causes misperceptions. Except for Saudi Arabia, all Muslim countries have Sharīʿah governance frameworks at the bank level and some even have nationwide boards. It is hard to standardize practices among IBs without the jurisdiction of a higher board.

• There is a lack of regulatory institutions focusing specifically on Islamic banking constraints and legal improvements.

• Lack of instrument variety pushes IBs to operate almost solely on murābaḥah transactions. Only Saudi Arabia has achieved high Islamic banking penetration by using murābaḥah schemes dominantly. All other prominent countries have introduced various instrument schemes.

• The perception of Islamic banking is very weak within the society. A significant portion of the society thinks that IBs are not necessarily interest-free and makes choices based on cost-benefit considerations. IBs have to express their moral merits more and be cost-efficient at the same time.

• The operational efficiency of IBs is lower compared with CBs. Worse, the gap is not closing.

• The lack of academic research and educational institutions to study the aforementioned problems further aggravates them.

PBAT issued a strategy document in March 2015 regarding how to expand the market. PBAT selected five strategic domains, notably:

• industrial coordination;

• instrument variety;

• Sharīʿah advisory boards;

• education/HR/certification; and

• perception and strategic targets.

Actions in the strategy report cover almost all critical fields of Islamic banking. After 30 years of existence, Islamic banking finally has a solid roadmap. There are 84 actions defined in total; 40 per cent of these are PBAT’s responsibility, whereas 60 per cent are the government’s responsibility. The actions mostly address the problems highlighted in this paper such as establishing a nationwide advisory board, setting up a Sharīʿah governance framework for IBs, increasing instrument variety, improving education and perception of Islamic banking. Although PBAT commits to restructure itself to be more proactive and effective, its role will apparently remain advisory and not binding.

Several regulatory and advisory entities are suggested to be established under various government institutions such as the Banking Regulation and Supervision Agency and Capital Markets Board. However, an Advisory Board[8] is proposed to be formed under PBAT. It is understandable not to set up this board under a finance-related government institution because of the secular sensitiveness. Yet, letting IBs select board members independently may further damage the perception and trust of Islamic banking within the society. It is noted that involvement of the Presidency of Religious Affairs can certainly be beneficial. Given the fact that there is no formal Sharīʿah governance framework in Turkey, the need for a framework is extremely high. However, the strategy document does not mention the IFSB or AAOIFI Sharīʿah governance standards. Instead, it claims that different practices are going to be examined and the framework is going to be decided. There is also no clue on the structure of the bank-level framework.

There are 45 actions in the instruments section; 29 of them target raising the efficiency of current instruments. Ṣukūk have the highest number of tasks (17). Actions for ṣukūk are quite specific, and, if implemented, they could reduce the operational effort and time for preparation to issue ṣukūk. There are no strong commitments for PLS instruments. Instead, proposals target improvement of the trade-based instruments. Establishing working groups for regulations and new instruments under PBAT is a right step with potential benefits.

PBAT is the main entity that is responsible for strategic actions regarding human resources and education purposes, and the required actions in the strategy document are reasonable. Regarding the perception side, the report indicates that a survey will be undertaken (actually it should have been implemented already) to gauge the attitude of the society. Currently, there are very few studies on the subject, and they are of narrow scope. Interestingly, the list of actions in the strategy document gives the impression that the main reason for the poor perception of IBs in the public derives from the lack of knowledge within the society. Required actions are listed such as increasing transparency, standardisation and utilisation of campaigns to inform and persuade the public. However, the possibility that people may not be convinced with the current business model is omitted. There should be further actions strengthening perception via improving the business model as well.

The biggest disappointment in the document is that there is almost nothing about improving the efficiency of IBs. It is important to note that IBs can take several actions to raise the efficiency of the sector. While CBs mostly benefit from economies of scale, IBs can also benefit from them in certain areas by acting as partners – that is quite in line with the nature of Islamic banking. For example, IBs can allow customers of other IBs to use their ATMs free of charge and increase penetration ratios to benefit from economies of scale. A shared credit card and point of sale system can allow IBs to reduce their costs and increase their efficiency and penetration levels in the market. These efforts do not require any new regulations or government support. Indeed, this can improve the overall perception of Islamic banking as well. Considering the efficiency and financial ratios shown above, the performance of IBs is not satisfactory, and solid actions and strategies are required. Moreover, there is no mention of alternative distribution channels and IT. The banking sector in 2025 will be much more in web/mobile applications rather than buildings, and IBs should pay more attention to the related technology to obtain a 15 per cent market share.

Conclusion

This study mainly evaluates the global Islamic banking practices and compares them with those of Turkey. The Turkish Islamic banking sector is also compared with the conventional banking sector by using a large number of efficiency and profitability measures. Successful practices of Islamic banking in the world mostly started with an introduction of the institutional framework. Establishment of IBs was followed by launching takāful, ṣukūk and Islamic funds. Afterwards, different institutions were set up to study various aspects of Islamic banking and finance. Turkey was not able to follow a similar pattern because of the lack of adequate political support. Turkey was able to set up a reasonable legal framework for IBs comparatively late, in 2005, and introduced takāful (2009), ṣukūk (2010) and a participation index (2011) quite late as compared to other prominent countries. Problems preventing Turkish IBs from expanding can be summarised in five dimensions:

1. Sharīʿah governance: No framework exists, and practices of IBs may widely differ.

2. Instrument variety: IBs rely almost totally on murābaḥah.

3. Perception of Islamic banking: The public seems to be not convinced of the Sharīʿah compliance of Islamic banking.

4. Inefficiency of IBs: The figures show that IBs are less efficient and the gap is widening.

5. Lack of academic studies and research institutions: There are not sufficient intellectual efforts to tackle the aforementioned problems.

PBAT issued a strategy document in 2015 that touches all the dimensions above except for efficiency. There are 84 actions regarding coordination, instrument variety, advisory boards, education/HR/certification. There are a number of proposed tasks meant to improve especially ṣukūk and to raise intellectual efforts on Islamic banking. Topics on efficiency improvements, technological developments, and coordination among IBs are largely omitted. It is noted that internal efficiency and utilisation of advanced technology must not be underestimated. Furthermore, the report does not sufficiently focus on the domains of PLS instruments and perception-related issues. It is extremely crucial for IBs in Turkey to understand the sensitivity and the expectations of the public correctly and to take necessary steps. Given the very strong political support from the current top policymakers for interest-free banking, complaining of past attitudes can no longer be used to justify the tiny market share of IBs. A reasonable Sharīʿah governance structure and enhanced instrument variety can indeed boost the growth of the sector.