Durmuş Yılmaz: Islamic finance - during and after the global financial
crisis
Speech by Mr Durmuş Yılmaz, Governor of the Central Bank of the Republic of Turkey, at
the Conference on "Islamic finance - during and after the global financial crisis", IMF-World
Bank Annual Meetings 2009, Istanbul, 5 October 2009.
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Distinguished Guests,
I want to begin my speech with expressing my heartfelt condolence to the loss of lives by
earthquake in Indonesia.
I am honored to address such a distinguished audience in Istanbul. It is a great pleasure for
us to host this conference. In my presentation today, I will address the growing interest in
Islamic finance, which has been proven to be relatively immune to financial crisis during the
current episode, especially compared to the conventional financial institutions.
Increasing popularity of Islamic finance can be attributed first to the enormous volume of
loanable funds that accumulated in geographies that host Islamic practices of living. Islamic
finance as yet another alternative to mainstream finance can be mentioned as a second
reason.
It is by now a de facto practice and this makes enough motivation to study, talk about and
assess Islamic finance.
Dear Guests,
Islamic financial institutions have started to emerge in the second half of the twentieth
century and become one of the fastest growing segments in the global financial system over
the past three decades. Although, Islamic finance institutions are mainly founded in the
Middle East and South-east Asia, the interest has extended to Europe and the United States.
Today, the size of Islamic banks around the world is estimated to be more than USD 250
billion and expected to grow by about 15 percent annually.
Due to the growing importance of the Islamic finance, the Islamic Development Bank (IDB)
was established in December 1973. The purpose of the Bank is to foster economic
development and social progress of Muslim communities individually as well as jointly in
accordance with the principles of Islamic Law. The number of members to the Bank is
steadily enlarging and currently consists of 56 countries.
The primary functions of the IDB are to participate in equity capital and grant loans for
productive projects and enterprises besides providing financial assistance to member
countries in other form for economic and social development. The Bank is also required to
establish and operate special funds for specific purposes including a fund for assistance to
Muslim communities in non-member countries, in addition to setting up trust funds.
The Bank is authorized to accept deposits and to mobilize financial resources through
Shari'ah compatible modes. It is also charged with the responsibility of assisting in the
promotion of foreign trade especially in capital goods, among member countries; providing
technical assistance to member countries; and extending training facilities for personnel
engaged in development activities in Muslim countries to conform to the Islamic Law.
Ladies and Gentlemen,
In the Turkish context, the Islamic finance practices are embodied in a uniquely defined
compartment of the banking system. These banks are called as the "participation banks" in
Turkey and they constitute an integral part of the Turkish banking system. There are four
Islamic banks categorized as participation banks, and 45 conventional banks in Turkey as of
September 2009. It is crucial to highlight that the participation banks are not considered as
an alternative to the conventional banks. While they are functioning similar to deposit banks,
their fund collecting and lending processes differ significantly.
Participation banks are authorized by the Turkish Banking Act to collect funds from the public
under the "profit and loss participation accounts" and the "special current accounts". The
profit and loss participation accounts are essentially a version of the Islamic financial
instrument, where the bank utilizes the funds deposited by account holders to fund specific
business activities. Any profits earned are shared between the account holder and the bank,
in proportion to an agreed ratio.
Participation banks in Turkey mainly offer two types of lending. The first type of financing is
Murabaha, which is a transaction consisting of two sales contracts. The first contract involves
a bank client requesting the bank to undertake a Murabaha transaction and promising to buy
the commodity specified by him or her if the bank acquires that commodity. The second
contract involves the client purchasing the commodity acquired by the bank on a deferred
payment basis and agreeing to a payment schedule. The second type of financing is financial
leasing or Ijara, with terms similar to those offered by other leasing companies.
Participation banks currently constitute only a small part of the Turkish banking sector,
accounting for 3.7 percent, 4.2 percent, and 5.2 percent of total banking sector assets,
deposits, and loans, respectively, at the end of 2008. However, they have been expanding
rapidly in recent years. The share of participation banks' assets in total banking sector rose
from 1.9 percent in end-2002 to 3.7 percent in end-2008. They have provided finance to
mainly small and medium size dynamic firms. At present, participation banks are regulated
according to the same standards as conventional banks. Accordingly, they are regulated and
supervised by the Banking Regulation and Supervision Agency.
Distinguished Guests,
While Islamic finance is well settled as a mode of operation, with already living examples,
there is no consensus view on the role of Islamic finance on price and financial stability.
On the financial stability side, although there has been a wide consensus that the
establishment of a powerful regulation and supervision system is vital to resume financial
stability, there are contradictory views on the support of the Islamic financial institutions to
financial stability. On the other hand, the role of Islamic finance on price stability has not
been fully covered by the recent empirical studies.
The views supporting Islamic finance state that Islamic financial institutions are more resilient
to external shocks. Profit and loss sharing feature of the transactions in Islamic finance
provides a protection to these institutions, apart from the capital. This feature of the Islamic
financial institutions could transfer a negative shock on the asset side to the liability side.
Furthermore, due to the fact that the investors (depositors) take on some part of the risk and
do not have deposit insurance, they have more incentives to exercise tight oversight over
these institutions. In addition, as compared to conventional banks, they have held a
comparatively larger share of their assets in reserve accounts for the liquidity management.
Thus, even if Islamic financial institutions have risky investments, these buffers make them
more resilient to the negative external shocks.
On the other hand, the opposing views claim that Islamic finance does not need to
improve the financial stability. According to this view, profit and loss sharing feature of
Islamic finance transfers the credit risk from Islamic institutions to their depositors, and
therefore, motivates the excessive risk taking incentive of Islamic banks.
While capital value and earnings of customers are not guaranteed in Islamic finance, this
feature may increase moral hazard and motivation for excessive risk taking without adequate
capital.
During the recent financial crisis, Islamic financial institutions have demonstrated significant
resilience. They have been less affected compared to the conventional financial institutions
thanks to prohibitions on excessive leverage. The transfer of risks related with the debt is
prohibited in Islamic finance. Therefore speculative transactions such as derivative are
nonexistent. Transferring the risk related with the debt and speculative financial activities could
cause unnecessary booming of the financial transaction volume well above the size of the
real economy.
Moreover, linking credit supply to growth rate of the economic activity, Islamic finance acts as
a natural hedging scheme. In other words, financing extended by means of Islamic
institutions can be used only with the real economic activity, and thereby, help restrict
excessive credit boom. Credit is mainly extended for the purchasing of the real goods and
services. In Islamic finance, Islamic financial institutions should own and possess the real
goods and services and the buyers of the real goods and services should want to take
delivery. Therefore, stakeholders share profits in good times, and losses in bad times.
Distinguished Guests,
There is ample room to improve Islamic financial system, more specifically on regulatory and
supervisory side. While the high growth rate of the Islamic financial institutions is expected to
continue in the coming years, they maintain certain market risks such as reputation and
liquidity risk. Liquidity management is difficult under Islamic finance rules as practical
instruments in accessing liquidity are limited. However, Islamic financial institutions, being
aware of the limits in liquidity management, sustain higher liquidity ratios compared to
conventional banks. Similar case is valid for their capital ratios. Moreover, the lack of
technical and contract standardization seems to weaken the potential of Islamic finance, as
an alternative financing against the conventional financial institutions. Besides, the customer
base needs enlargement including household services. The regulation and supervision
framework of Islamic financial institutions should also be improved.
In conclusion, the current crisis has given an opportunity to Islamic financial institutions to
prove their potential. As their products limit the excessive leverage and the disruptive
financial innovations, they have confirmed their products' advantages to ensure
macroeconomic stability.
This may lead the way for Islamic financial institutions to expand and improve.
Dear Guests
As you may know, the Central Bank Governors of the Organization of Islamic Conference
gathered yesterday in Istanbul upon the invitation of the Central Bank of Turkey on the 40th
anniversary of the OIC and 25th anniversary of the Standing Committee for Economic and
Commercial Cooperation of OIC. The purpose of that meeting was to make a meaningful
contribution to the ideal of reaching a sustainable and stable global order based on the
principles of justice, equity, participation and freedom fort he humanity to reach peace and
prosperity that embraces differences between the civilizations as a source of richness and
not as a reason for clash. Our objective is to make these meetings permanent that convenes
regularly every year to stipulate our common views and decisions regarding the issues that
concern the member countries.
Once again I extend my warm welcome to all participants. I also want to thank the
distinguished participants for their valuable contributions. I hope you enjoy both the
conference and your stay in Istanbul.
Thank you.