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Journal of Financial Services Research

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25-04-2016

Islamic Banks, Deposit Insurance Reform, and Market Discipline: Evidence from a Natural Framework

Authors: Ahmet F. Aysan, Mustafa Disli, Meryem Duygun, Huseyin Ozturk

Published in: Journal of Financial Services Research | Issue 2/2017

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Abstract

Although it has been intensively claimed that Islamic banks are subject to more market discipline, the empirical literature is surprisingly mute on this topic. To fill this gap and to verify the conjecture that Islamic bank depositors are indeed able to monitor and discipline their banks, we use Turkey as a test setting. The theory of market discipline predicts that when excessive risk taking occurs, depositors will ask higher returns on their deposits or withdraw their funds. We look at the effect of the deposit insurance reform in which the dual deposit insurance was revised and all banks were put under the same deposit insurance company in December 2005. This gives us a natural experiment in which the effect of the reform can be compared for the treatment group (i.e., Islamic banks) and control group (i.e., conventional banks). We find that the deposit insurance reform has increased the market discipline in the Turkish Islamic banking sector. This reform may have upset the sensitivities of the religiously inspired depositors, and perhaps more importantly it might have terminated the existing mutual supervision and support among Islamic banks.

previous article A Survival Analysis of Islamic and Conventional Banks

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The impact of deposit insurance on the disciplining behavior of conventional depositors is well-documented. The existence of deposit insurance entails a trade-off between bank stability and moral hazard. Using cross-country data, Demirgüç-Kunt and Detragiache (2002) provide evidence that explicit deposit insurance significantly increases the incidences of financial crisis. Demirgüç-Kunt and Huizinga’s (2004) finding show that this increase in financial fragility mainly stems from reduced depositors' incentives to monitor and discipline banks. In developing countries, however, it is frequently observed that deposit insurance schemes are not fully credible. Martinez Peria and Schmukler (2001) proved that depositors are also concerned about the solvency of the insurance fund by showing that small-insured depositors still react to bank risk. Prean and Stix (2011) and Disli et al. (2013) show that the credibility of generous deposit insurance schemes are especially affected in turbulent economic environments.

We refer to Aysan et al. (2013) for an overview of the developments in the Turkish Islamic banking sector.

Decree No. 83/7506, issued by the Council of Ministers, allowed Islamic banks to operate in Turkey. This decree, however, could just as easily be revoked by the same authority (Brown 2014).

In order to contain budget deficits, the government introduced measures such as caps on Treasury bill rates, and shifted towards deficit financing through monetization. The curbing of interest rates in the weekly tenders for Treasury bills produced anxiety in financial markets and a loss of confidence in the government. The drop in interest rates caused a decline in the profits from uncovered arbitrage opportunities and banks started to close their open positions by buying foreign exchange in domestic markets. In order to contain the loss of foreign currency reserves, and to defend the Turkish lira, the Central Bank was forced to heavily intervene in the interbank market and raised the overnight rate to record levels. These developments undermined an already fragile system, and the banking sector faced panic withdrawals of bank deposits. In order to restore confidence and prevent further capital outflows, the government had to institute a blanket deposit guarantee.

The problem was compounded in October and early November with rumors of malpractices of some nationalized banks. In October two more banks – Etibank and Bank Kapital – were brought under the management of the Savings Deposit and Insurance Fund (SDIF). Moreover, not met privatization targets, due to ideological differences within the ruling coalition, caused the IMF to postpone a scheduled fund transfer.

The fierce turmoil, between President Ahmet N. Sezer and Prime Minister Ecevit in February 2001, completely agitated the financial markets. Because of the massive capital outflows, the overnight interest rates skyrocketed on February 21 and the Central Bank had no choice but to abandon the peg. We refer to Akyüz and Boratav (2003) for a detailed discussion about the development of the Turkish banking sector during the crisis.

In May 2015, Ziraat Participation Bank, was authorized by the country’s banking regulator (BRSA) to start its operations as Turkey’s first state-owned Islamic bank, increasing the number of Islamic banks to five.

Although the institution of BRSA was not successful in preventing the crisis at the end of 2000, it is considered as the first of subsequent reforms in the regulation of the banking sector. In May 2001, the BRSA launched the Banking Sector Restructuring Program (BSRP) to recover fundamental fragilities in the banking sector, and for building a strong base for the system by clearing it from weak banks (see BRSA 2010).The structural reforms in the banking industry and the political stability after 2002 have facilitated a significant improvement in overall economic performance. In the period between 2002 and 2010, Turkey’s public sector debt-to-GDP ratio firmly declined from 70 % to 42 %, a ratio that is since 2004 consistently below the Maastricht criterion. The conducive economic environment in the period 2002-2007, with abundant global liquidity, also made Turkish treasury instruments very attractive, and massive capital inflows steadily helped to reduce interest rates.

For purposes of completeness, Islamic banks with higher risk profiles could end-up paying 0.26 % on their end-of-quarter deposit liabilities.

From 2009 onward, the SDIF has implemented for both banking models a more risk weighted deposit insurance premiums with a premium ratio varying between 0.11 % and 0.19 %. The maximum deposit insurance coverage for both Islamic and conventional bank deposits was set at 50,000 TL, but was in February 2013 doubled to 100,000 TL.

For both Islamic as well as conventional banks, these figures includes adjustments for mergers & acquisitions by generating a new bank after tracing such an event.

Conversely, depositors will punish banks with a lower capital ratio by decreasing the supply of funds, i.e., raising the average yield on deposits and reducing the quantity of deposits.

The estimation results for the sample composition of private and Islamic banks, columns 4 and 8 of Table 3, reveal that while the signs of the estimated coefficients for the capital ratio and for its interactions are similar to those of alternative sample compositions, most of them are not statistically significant.

Although conventional banks with high performing loans (NPL) face deposit withdrawals, it also appears to decrease the interest rate that depositors demand from these banks. A similar finding was observed in the Columbian banking sector (Barajas and Steiner 2000). In the post-reform period, our findings indicate that the conventional deposit growth sensitivity to NPL has been reversed. On the other hand, albeit heavily reduced in the post-reform period, Islamic depositors were sensitive to non-performing loans in the manner predicted by the market discipline hypothesis. The effect of liquidity (LIQ) on the reaction of depositors, Islamic as well as conventional, is not consistent with the market discipline hypothesis.

The liquidation process of Ihlas would drag on and, as of today, has still not been settled in full. Profit and loss sharing participation accounts were fourth in line for repayment after debts owed to the government, personnel payments and current account debts. On December 31, 2013, 20,780 depositors were still waiting to be serviced. Further details about the payout schedule can be found at http://www.ifk.com.tr/ (last visited on May 25, 2015).

Full results are available upon request. Disli et al. (2013) and Karas et al. (2013) employed a similar projection of their results in their analyses of market discipline in the Turkish and Russian banking sector, respectively.

Fueda and Konishi (2007) show that depositor sensitivity in Japan was most significant in the period 1997-2001 despite the presence of a blanket guarantee. Likewise Forssbæck (2011), who analyzed several hundred banks worldwide over the period 1995-2005, could not find evidence of increased depositor sensitivity during financial crises.

A notable exception is the sample composition of foreign and Islamic banks (columns 3 and 7 of Table 4): although the sign of the coefficient of CAP x ISL x CRIS is similar to those of other sample compositions, it is not statistically significant.

We refer to Cubillas et al. (2012) and Berger and Turk-Ariss (2014) for evidence about the weakening impact of government intervention on market discipline.

Likewise no bank panic occurred when banking regulators took over management of Bank Asya in February 2015.

In order to facilitate the interpretation of the results, we only report the coefficient estimates of CAP and its interactions with ISL and/or time frame dummies (Period 2 and Period 3) since the other fundamental variables do not allow us to draw clear conclusions concerning their influence on market discipline.

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Title: Islamic Banks, Deposit Insurance Reform, and Market Discipline: Evidence from a Natural Framework
Authors: Ahmet F. Aysan
Mustafa Disli
Meryem Duygun
Huseyin Ozturk
Publication date: 25-04-2016
Publisher: Springer US
Published in: Journal of Financial Services Research / Issue 2/2017
Print ISSN: 0920-8550
Electronic ISSN: 1573-0735
DOI: https://doi.org/10.1007/s10693-016-0248-z

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