Islamic banks in Turkey, officially known as participation banks, have grown at a healthy clip in the past five years, and have ambitious plans for even faster growth. The sector increased its share of the overall banking market to about 7.2% of assets at year-end 2020 from 5.1% at year-end 2015. Meanwhile, sukuk issuance increased to $14 billion from $2 billion in the period. Such growth was achieved thanks to strong support from Turkish authorities, which have on several occasions asserted their view of the importance of Islamic finance as an additional tool to finance the Turkish economy.

Earlier this year, the Participation Banks Association of Turkey (TKBB) announced a revised strategy to expand the sector further, reiterating the objective of reaching a market share of 15% by 2025. S&P Global Ratings believes that such an objective could be challenging to achieve and would necessitate significant additional support, notably capital. Gulf shareholders of some participation banks might be somewhat reluctant to inject additional capital over the next two years given the difficult Turkish operating environment, the volatility of the Turkish lira, and the challenges some of them face at home. Therefore, we think that state-owned participation banks will drive most growth.

The updated strategy includes objectives to standardize existing products and spur innovation. Indeed, we believe that products aligned with environmental, social, and governance (ESG) factors as well as liquidity management products are likely to foster growth. The pandemic, the energy transition, and Turkey's ambition to produce electric cars could inspire the increased use of social and green Islamic finance products. About standardization, it remains to be seen to what extent Turkey would be involved in crafting or would be inclined to adopt global Islamic finance standards, while at the same time retaining the option of developing and enforcing its own domestic standards. Another strategic objective is development of digital banking products where Turkish banks tend to be relatively advanced. Although digital could create some future avenues of growth in the banking business, we think it will mostly come in the payments and money transfer businesses.

Islamic Banks Continue To Grab Market Share

The growth of Islamic banking in Turkey has markedly outstripped that of conventional banking over the past decade. At year-end 2020, market share for the country's participation banks reached 7.2%, compared with 5.1% at year-end 2015 and 2.5% in 2005 (see chart 1).

Chart 1

Since the inception of Islamic banking in Turkey in 1985, Islamic banks have largely grown thanks to privately owned capital, particularly through entities that are related to countries in the Gulf Cooperation Countries (GCC) such as Islamic banks in Kuwait and Bahrain. Government or public-sector banks had no Islamic lending operations until 2015 when the authorities decided to expand in this sector. At year-end 2020, public-sector participation banks accounted for 30% of total assets of participation banks and, more importantly, contributed to 47% of the growth in total assets of the sector (see chart 2).

Chart 2

Operating conditions for Turkish banks are likely to remain weak. We expect real GDP growth in Turkey to reach 6.1%, up from 1.8% in 2020, mostly due to a statistical carryover effect. Domestic demand is slowing due to adverse pandemic developments and tighter financial conditions, but exports are benefiting from the global economic recovery and depreciation of the Turkish lira. The vaccine rollout is accelerating, which could pave the way for an increase in tourism. However, we continue to expect only a very gradual recovery in international travel and see significant risks related to the development of the pandemic and the pace of the vaccination rollout.

We expect lending growth in the Turkish banking system to slow in 2021, averaging 15%, compared with 35% in 2020, due to government stimulus. State-owned banks are likely to generate most of the growth. In 2020, corporate lending increased due to heavy stimulus to households and small and midsize enterprises (SMEs) and the depreciation of the lira, which inflated borrowing in foreign currencies. Pockets of risks remain, though. The main one is our expectation that asset quality indicators will continue to worsen as regulatory forbearance measures are gradually lifted. We expect growth at participation banks to show similar trends as for the system.

We expect nonperforming loans for the banking system to exceed 10% of total loans by 2022 and cost of risk to rise to 320 basis points (bps) on average in 2021 and 2022, from an already high 290 bps on average in 2019 and 2020. For participation banks, the cost of risk has been slightly lower, averaging 200 bps in 2019 and 2020 due to strong entrenchment in the SMEs sector that benefited from government guarantees (covering 18% of total SME lending on April 30, 2021), their high exposure to the real estate sector, and, more generally, the asset-backing principle of Islamic finance that reduces the provisioning needs for some asset classes (see chart 3).

Chart 3

New Strategy Aims To Further Push The Sector Forward

The TKBB's updated strategy for 2021-2025 maintains the objective of achieving a 15% market share by 2025, and as the reports states this would require a 31% compound annual growth rate. Moreover, TKBB's projections assume that shareholder equity in the sector will increase from Turkish lira (TRY) 34 billion to TRY156.8 billion (see chart 4). We view this objective as challenging.

Chart 4

There are six participation banks in Turkey, three of which GCC financial institutions partly own and three that the government owns. The shareholders for the three banks controlled by GCC financial institutions are Al Baraka Banking Group, Kuwait Finance House, and Saudi National Bank. In our view, we think GCC shareholders might be reluctant to inject as much capital as the TKBB expects given the higher risks in Turkey than in their home countries and the somewhat limited return on assets (ROA) of the sector compared with those at home. The average ROA for the sector stood at 1.1% over the past five years, lower than the 1.4% for the top 45 GCC banks over the same period. Moreover, for some shareholders, injecting more capital into their Turkish participation bank subsidiaries would come down to their limited capacity to free-up resources. Given these constraints, we believe public-sector participation banks in Turkey will drive future growth of the sector. At year-end 2020, the average Tier 1 ratio for the three private-sector participation banks stood at 12.3%, compared with 19.8% for public-sector participation banks.

The main growth pillars the strategy identifies are aligned with our view of the main potential accelerators for the global Islamic finance industry. They are:

• Finding business opportunities related to ESG,
• Further standardizing Islamic financial instruments while leaving room for innovation, and
• Using fintech and digitalization to create new business.

The alignment between Islamic finance principles and ESG is no longer to be demonstrated. There are two main avenues for Turkey. On the one hand, the country is likely to use Islamic social instruments to help deal with the aftermath of the pandemic. On the other hand, the country could potentially tap the green sukuk market to lay the foundation for more sustainable growth. The country's objectives in terms of increasing the contribution of renewable energy contribution in its energy mix, as well as its plans for electric cars could benefit from that. Although more complex than typical sukuk, green sukuk could broaden the investor base by attracting both ESG and Islamic investors. It is worth mentioning that we have not observed any pricing advantage for issuing green sukuk versus typical sukuk or conventional bonds. In addition, the sukuk market in Turkey remains dominated by financial institutions and sovereign issuance (see chart 5). We are of the view that opening this market to private-sector corporate issuers and stepping up sukuk offerings as liquidity management instruments could unlock some growth in the Islamic finance industry in Turkey.

We believe that standardization of legal documentation and interpretation of Sharia (harmonized with other core markets' interpretation) could help attract more investors. It remains to be seen to what extent Turkey would be involved in crafting or inclined to adopt global Islamic finance standards, and whether it would want to keep the option of developing and enforcing its own domestic standards to drive local innovation.

Another area of growth lies in the digitalization and opportunities offered by fintech. Here, we are of the view that payment solutions and money transfers are the main growth areas in the next few years. Finally, it is important to mention that the strategy roadmap identifies clear deliverables and responsibilities, which is likely to help with its implementation and future success.

Chart 5

Related Research

• Islamic Finance 2021-2022: Toward Sustainable Growth Through Greater Standardization And Integration, May 3, 2021
• Global Sukuk Issuance Is Set To Increase In 2021, Jan. 12, 2021
• GCC Banking Sector: A Long Climb To Recovery, March 14, 2021