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Western EuropeDecember 30 2009

The participation principle

Yunus Nacar, CEO of Türkiye FinansTurkey's Islamic participation banks are becoming more ambitious, but are still looking for a model that competes more effectively with the conventional market. Writer James Gavin
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The participation principle

Turkey's unique status as a Muslim-dominated yet overtly secular republic has delivered a highly individual take on Islamic finance.

There are only four no-interest banks active in the market - termed 'participation banks' in Turkish financial parlance, rather than Islamic banks. Though they have racked up some impressive profit performances in recent years, they still only account for a small fraction of total Turkish banking assets.

Yet with heavyweight support from Gulf-backed shareholders, Turkey's participation banks are now looking to attract a significantly larger share of idle funds into the banking system, as customers wise up to the possibilities of the no-interest model.

Administering more than Tl28.3bn ($18.7bn) in assets in the first quarter of 2009, representing some 4% of the Turkish banking system's assets, the Islamic banking sector aims to double its share within the next 10 years.

The participation banks were conceived 25 years ago as a 'third way' between commercial banks and investment and development banks. Although functionally similar to conventional depository banks, their collecting and lending methods of funds are different: Funds are collected through special current accounts or participation accounts, where profits or losses are shared after the run of invested funds.

Interest-free banking principles require that credit activity is fashioned in a structure that would require only real transactions to be financed. To that effect, the financing modes are either based on profit-and-loss participation (mudarabah and musharakah) similar to joint ventures, or on the financing of real transactions through purchase and reselling (murabaha) or financial leasing.

Retail banking potential

Bank Asya, one of Turkey's four participation banks, offers an 80:20 participation rate to its customers. "We use deposits as a loan so if we make a return, 80% of that goes to depositors and 20% belongs to the bank," says Ünal Kabaca, CEO of Bank Asya. The model offers distinct advantages. For example, lending against invoices supports more rational behaviour among clients by preventing enterprises from using more credit than they need. Given high-frequency repayment mechanisms, invoice lending is acutely sensitive to changes in economic conditions.

Participation banks' lending instruments shadow those of the conventional sector, focusing on corporate finance and retail banking. Retail finance is developing as a business line, says Seyfullah Demirlek, head of investor relations at Albaraka Türk, whose retail credits stood at about 7% of its total credit portfolio as of September 30, 2009.

"We see good business prospects in retail banking; hence, we are planning to grow in this area. Our retail strategy is based on financing the housing purchases of our retail customers. Albaraka Türk has been able to establish itself in this area, especially due to its participation in several large land development real estate projects," says Mr Demirlek.

The participation banks' profit performance has matched or exceeded that of conventional Turkish banks and in general they have been able to fund commercial and industrial sectors at lower costs than their rivals.

In 2008, net profit growth of the four banks averaged 22.5%, exceeding the banking sector's 16.7% profit growth rate. They showed an 18% rise in net profits in the third quarter of 2009 to $353m, according to the Participation Banks Association of Turkey. That participation banks have grown faster than the conventional banks over the past decade is mainly due to the rapid roll-out of branches, which has helped the public to understand this mode of banking, says Mr Demirlek. "Overall, participation banks have grown in assets size, funds collected and funds utilised at about 31%, 29% and 38%, respectively, per year between December 2002 and December 2008. We believe there is a potential market share of 10% to 15% for these banks," he says.

The banks are looking to compete more effectively with their conventional counterparts in future. "I believe that the impetus we have gained in growth will also continue in the coming years and participation banks will soon become a significant player in the Turkish banking industry," says Yunus Nacar, CEO of Türkiye Finans, majority owned by Saudi Arabia's National Commercial Bank.

Turkey - Participatory banking assets, 2000-Q1 2009

Turkey - Participatory banking assets, 2000-Q1 2009

Tough competition

The banks have little option but to keep up the pace of growth. "The participation banks have posted the same growth figures as conventional banks in Turkey, however, to catch up with their competitors they need to grow faster than the rest of the system and this is still not feasible," says Goeksenin Karagoez, Standard & Poor's Turkey banking analyst.

"Decreasing inflation and interest rates have made it difficult for the banks to make profits," says Mr Nacar, who forecasts tougher conditions in 2010 for the sector. "Although the banks increased their profits by 50% in 2009 over the previous year, I believe 2010 will be different. They will have to develop different instruments to boost their profit margins," he says.

Participation banks need to develop new interest-free banking products and to adapt conventional banks' products to fit the system of interest-free banking. Credit cards, hedging and securitisation products may figure prominently. Given the secular political culture in Turkey, perhaps the biggest long-term challenge is convincing customers, for whom sharia compliance still takes second place, to diversify from conventional financial products and services.

There was a big expectation when authorities decided to let Islamic banks start operations in the mid-1980s that these banks would be able draw money out from under the mattress, particularly in the underbanked conservative Anatolian heartland. But this has yet to materialise in a significant way.

Given time, it may yet succeed, bankers predict. "As more importance is attached by participation banks to promotion, a growing awareness has started to form about participation banks among the Turkish people," says Mr Nacar.

Bank Asya's deposit growth in the first nine months of 2009 exceeded 50%, a potentially significant pointer to the growing uptake of the Islamic model.

But the participation banks acknowledge that customers will need encouragement and a better service offering. "It is becoming a more popular model, but it strongly depends on service quality and customer relationships. If you improve your product levels and service quality, then your bank can grow easily," says Bank Asya's Mr Kabaca.

"We are competing with all banks to attract these funds. So when interest rates come down, profit margins increase and we can distribute income to the depositors. These are the kinds of things that attract money to participation banks," he adds.

New funding models

It is not just domestic funds that participation banks are looking to capture. The banks can play an important role in drawing in excess capital from the Gulf region to Turkey.

All the participation banks are backed by Gulf entities as shareholders. They believe that if the Turkish Treasury could issue sukuk (Islamic bonds) alongside revenue-sharing bonds, known as GES, a large portion of Gulf capital could be attracted to Turkey's financial sector. The Treasury has so far launched two GES issues, which received strong interest from participation banks. The issuance of GES, rather than sukuk, reflects unresolved legislative and regulatory issues concerning Islamic paper issuance in Turkey.

The banks have already taken a serious role in murabaha financing in the form of syndicated loans from the Gulf. Mr Demirlek estimates that $1bn has been provided via this model. Mr Nacar says: "We all know that the Gulf region funds have been in search of a safe haven. The Turkish banking sector, having recovered from the crisis with no impact, stabilised economic indicators and our country being a rising power for the Middle East are all great opportunities for Gulf region funds to enter the country."

"Now it is time to build a secondary market for GESs, after which the participation banks could be in a position to easily market their GES holdings. I believe that this way, substantial funds from the Gulf region could be brought into our country," says Mr Nacar.

Foreign opportunities

Though banks will remain focused on growing their domestic footprint, with ambitious branch network roll-outs, they are also likely to consider external growth opportunities. To this end, Bank Asya's signing in October 2009 of a co-operation agreement with the Islamic Corporation for the Development of the Private Sector (ICD), a subsidiary of the Islamic Development Bank, to acquire a 40% stake in Senegal-based Tamweel Africa Holding, may prove significant.

ICD and Bank Asya will operate in the interest-free banking sector, with a focus on west Africa. Tamweel Africa Holding is expected to increase its stakes in the Islamic Bank of Niger, the Islamic Bank of Senegal and the Islamic Bank of Guinea to 66%, 77.5% and 100%, respectively.

Africa is a logical focus for the bank, says Mr Kabaca. "Africa's share of Turkish exports was 7% at the end of 2008, but has increased to 11% at the end of 2009 and in the next five years could grow to 25%. We follow the trade and introduce new products to them and hope that the banks will grow together."

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