Islamic Banking in Turkey, Indonesia and Pakistan: A Comparison with Malaysia

The Islamic finance industry is developing rapidly worldwide. While it makes sense for Islamic financial institutions to foster growth and to regularly compare themselves against the financial market as a whole, sometimes it is worthwhile to keep an eye on developments in different countries.

It is easy to talk about ‘market shares’ and ‘deposits’, but what do these terms really mean? And what can be expected in the near future? For a better idea, we will examine the Islamic banking system in some countries: Turkey, Indonesia and Pakistan.

Turkey and Indonesia are secular republics where Muslims form the majority of the population, but Islamic finance developed differently in the two nations. With a population that is roughly half that of both countries; the Islamic Republic of Pakistan is used as an outside comparator. To put all that into better perspective, I have included some data from Malaysia as a benchmark.

Turkey

Beginning in 1985, when Albaraka Türk commenced operations, Turkish participation banks (known then as special finance houses) were aimed at the domestic market as a whole. Therefore, they did not really target the small niche of the ‘convinced’ Muslim population in particular. This, of course, influenced marketing and product development.

Partly as a consequence of this strategy (and compared to Indonesia), Turkish participation banks were able to flourish and they now hold roughly 3.5% of total assets in the country’s banking industry. One should also note the strong growth of the sector, which has been outperforming its conventional counterpart for eight consecutive years now.

The collapse of Ihlas Finans House (then the largest finance house in Turkey) in 2001, allegedly due to fraudulent insolvency, meant the loss of 40% of the deposits held by the sector at that time. This sent depositors at other special finance houses into a panic. Many withdrew their money, resulting in another loss of 35% in deposits.

Because of their ties to the ‘real economy’, the special finance houses were unscathed by the big financial crisis that hit Turkey in 2001 and quickly recovered. Following the Ihlas collapse, the Turkish government decreed that all banks were to participate in the country’s deposit guarantee fund to prevent shock withdrawals. Participation banks were allowed to set up a parallel Islamic deposit insurance scheme, identical to the conventional system, save for one aspect – the Islamic scheme invests in compliance with Shariah principles.

Other differences to note: there is no specific government aid to the sector nor is there Islamic bond (whether government or corporate), although it has been rumored for some time that the issuance of a government Sukuk could be in the making. Talks on the projected rent (Ijarah) certificate are progressing slowly, due to inactive local financial markets, cheap conventional international funding and political factors. Neither is there access to money markets, so one can hardly talk about a level playing field, as compared to conventional banking.

Furthermore, as there are no Islamic windows, foreign players can only enter the market via shareholdings in existing participation banks. Alternatively and given the present legal framework, they would have to start their own participation bank.

A well thought-out strategy of decentralisation – for instance, using tax incentives and privatisation – created substantial growth of several cities throughout the country.

Indonesia

In Indonesia, the world’s most populous Muslim nation, with its first established Bank Muamalat in 1994, the situation differs profoundly. From the start, products and marketing were targeted at that very same group of ‘convinced’ Muslims (with a market share of roughly 1.5%).

While the current impressive government initiatives aim to widen that base (a potential ‘floating market’ of approximately 75% of the population would be within reach), Bank Muamalat continues to adhere to its strict policies and target market. This means the other Islamic finance market players could see greater potential for growth.

The need to mobilise internal capital and attract foreign investments require special measures, and so Bank Indonesia announced in July that, subject to full implementation of the ‘blueprint for development of the Indonesian Shariah banking system’, total assets of the Islamic banks (and Islamic business units) are expected to triple by the end of 2008 (growth of approximately US$6bn) to reach an overall volume of 5% on the total Indonesian banking assets. When deposits/loans follow the same development, it will be clear that opportunities are at hand (growth potential of approximately US$5bn).

Foreign banks have yet to make their presence felt in the Indonesian Islamic finance market. HSBC was the first big international institution to establish a Shariah head office in Jakarta. The projected growth potential is enormous: HSBC calculated that roughly half of their clients would be willing to use the products if priced competitively. Recently, Al Baraka announced the intention of expanding business there.

The first government Sukuk (plans to raise US$500m to US$1bn have been announced for a while now) is in the pipeline. Actual issuance could, however, be postponed pending parliamentary approval. Indonesia already recognizes corporate Ijarah and Mudarabah Shariah bonds. Access to the money markets has been opened.

Conventional banks that want a piece of the ‘Islamic pie’ need to dedicate 5% of their assets to the venture. This commitment, together with other incentives, will be instrumental to the rapid growth anticipated over the next two years.

Pakistan

Since the late 1970s, Pakistan has had a protracted history of Islamic banking. From 1 July 1985, all commercial banking in Pakistani rupees became interest-free. The sudden conversion and a lack of preparedness posed difficulties for the implementation of this practice, however. As from 2001, an evolutionary process took effect in order to nurture acceptability and development in a more structured approach. The first ‘Islamic bank licence’ went to Meezan Bank (founded in 1997) in 2002. But as mentioned earlier, Islamic banking has been in existence since the mid-1980s.

More noteworthy is the present Islamic banking policy (December 2001), under which Islamic banking is promoted parallel to conventional banking. Implementation of Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board standards is on the way. Besides a draft for the new Government Securities Bill, Draft Risk Management and Draft Shariah Compliance guidelines have been published. A growth of 40% per year is expected and a 15% market share is targeted.

Conventional banks are allowed to operate Islamic bank subsidiaries or even ‘standalone Islamic banking branches’ alongside full-fledged Islamic banks. A vast concentration of Islamic banking in the cities (for example, Karachi and Lahore) is evident. There are government and corporate Sukuk on the market.

In 2007, ABN AMRO opened an Islamic branch in the country. Emirates Global Islamic Bank started a dedicated Islamic commercial bank while Qatar Islamic Bank has confirmed plans to set up a Shariah compliant banking unit soon. Citibank was another big foreign entry.

Malaysia

Starting off in 1983 with Bank Islam Malaysia, Malaysia now has separate Islamic legislation and banking regulations that co-exist with those for the conventional banking system. In order to create an efficient, progressive and comprehensive Islamic financial system, Bank Negara Malaysia recognised the need to:

• Attract a large number of global players.
• Develop a variety of instruments.
• Install comprehensive financial infrastructure.

Malaysian banks currently offer a variety of Islamic financial products and services (more than 100) that use various Islamic concepts – such as Mudarabah, Musharakah, Murabahah, Bai’ Bithaman Ajil (Bai’ Muajjal), Ijarah, Qard, Istisnah and Ijarah Thumma Bai’ – alongside the Islamic Interbank Money Market.

Probably subject to pressure from the Dubai International Financial Center, Malaysia recently opened up regulations to allow Sukuk issuance in foreign currencies and is competing with Singapore to be the prime Islamic finance hub in the Asian region. Hong Kong recently decided to join the race as well.

Observations

First of all, it has to be noted that the real entrance of foreign investments in Turkey, Indonesia and Pakistan still bounces on inadequate tax regimes.

Though it is difficult to distract far-reaching conclusions from table 1 below, at first glance, it is clear that Malaysia and Turkey share the following characteristics: relatively big concentration of the population in more prominent cities, lower portion of the population working in agriculture and a lower weight of that sector in the overall economy. The GDP per capita (calculated by the relative purchase power parity) in Malaysia and Turkey also is two to four times higher than in Indonesia and Pakistan.

Also in Indonesia and Pakistan, there is a remarkable concentration of the Islamic banking sector in the major cities. Islamic finance apparently flourishes first in the big cities and then branches out to smaller concentrations of population while the rural areas (probably simply because a lack of cash) appear to be dependant on micro finance. In both countries, the agriculture sector appears to attract socially important (statistically less so for the total economy) ‘rural Islamic banks’ targeting micro finance. There is no such sector in Turkey (neither conventional nor Islamic). Only recently, initiatives from the UNDP have been undertaken to introduce micro finance on a sustainable basis there.

Neither the percentage of the Muslim population (in Indonesia, Turkey or Pakistan) nor the respective government’s zeal to promote Islamic banking (in Indonesia and Pakistan) appears to be a determinant for success so far.

A marketing strategy of the Islamic banks based on religious notions proved to be successful for the loyal but small niche of ‘convinced’ Muslims, but did not appeal to the ‘public at large’.

Admittedly, Turkish participation banks are at a serious disadvantage because of the abovementioned differences from the conventional system (such as the lack of Sukuk and money markets, relatively few products, no government incentives and no Islamic windows). Nevertheless, they prospered thanks to a more neutral banking approach that was focused on financial advantages, with a slight emphasis on ethical merits.

Looking at the mix of relevant measures applicable to the different countries, perhaps the following can serve as guidelines in contributing to the success of Islamic banking:

• Dedicate sufficient means to Islamic rural banking/micro finance for agricultural areas.
• Create a level playing field in order for Islamic banks to compete with conventional banks (for instance, access to Sukuk and the money markets), without any specific need to issue prime conditions (that also distort the market).
• Open up markets for international institutions (this attracts financial power and innovation).
• Ensure possibilities for all financial institutions to create Islamic windows and/or branches (better product awareness and overall acceptance of Islamic banking would benefit the dedicated Islamic banks).
• Ensure conventional banks that want access to the market commit sufficient means from the start (the need to dedicate assets enhances market growth).
• Promote diversification of products (diversity is one of the handicaps of Islamic finance vis-à-vis the mature conventional counterpart).
• Try to spread wealth from existing bigger cities to smaller ones but do not focus on existing metropolises.
• Try to create sufficient liquid financial markets and stock exchanges, if necessary through strategic alliances.
• Give sufficient attention to international accounting standards, corporate governance, transparency and accountability.
• Build strong prudential controls.
• Give bank status and deposit protection without losing sight of the underlying Islamic principals focus on market competition, quality of products and pricing thereof.

Table 1 shows that Turkey has about the same market penetration as Pakistan but has approximately six times as much assets tied in the Islamic finance industry as compared to Pakistan. It also has twice as much points of sale (POS). When you notice that the Pakistani population is about twice as big, the gap becomes even wider.

On the other hand, Turkey’s overall GDP is more than three times as big as Pakistan’s and the same applies to the purchase power parity (PPP) per head. Also note the dominance of agriculture (both turnover and labour force) in Pakistan, and the lack of bigger cities.

With a market penetration half that of Turkey’s in terms of US dollars, the Indonesian Islamic finance market is still close to 3.5 times as small as Turkey with only half the POS. The population of Indonesia being three times as big, the scale appears to be even more distorted.

In spite of the bigger population, Turkey’s overall GDP is still 10% higher than Indonesia’s and the PPP per head has a multiplication factor of more than two. Indonesia also lacks big cities (38 on 231 million people, compared to 24 on 74 million people for Turkey) and there is greater reliance on agriculture.

Malaysia has by far the best POS coverage of all. The GDP in PPP per capita even exceeds Turkey’s with 20%. The comparative GDP divided by population is 10% higher than Turkey. Malaysia has moved away from agriculture and has twice as many major cities as compared to the Turkish population.

This article was originally published in Islamic Finance news, 19 October 2007.