Indicators of Banking Fragility of Participation Banks in Turkey

*Ayşegül Aytaç Emin*

### **Abstract**

This study examines the significant variables of banking fragility of participation banks in Turkey. For this aim, a model is constructed by employing probit model over the time period 2008 and 2018. The results suggest that asset growth, capital adequacy ratio, financing to total deposits ratio (FDR), return on asset and cost to income ratio are significant banking level indicators of the banking fragility of participation banks in Turkey.

**Keywords:** banking sector fragility, participation banks, banking crises, Probit model, Islamic finance

### **1. Introduction**

With the increasing integration and interaction of the financial markets, the number of financial crises has considerably increased especially since 1990s. With the contagion effect, on the other hand, the impacts and consequences of the financial crises go beyond the national level by causing significant international costs. In this context, an important part of those crisis is stem from the problems experienced in the banking sector, which is one of the leading sectors that have significant impact on the world economy.

As the importance of the banking sector on economies increases, the risk factors that has to managed by the sector has also increased considerably. Laeven and Valencia [1] emphasized that there were 151 banking crises worldwide between 1970 and 2017 where the duration of these crises is different with respect to the income levels of the countries. Accordingly, while the banking crises in highincome countries are considerably consistent and continue for 5 years or more, in low- and middle-income countries, banking crises continue for 4 years or less. In term of its outcomes, on the other hand, banking crises have devastating effects such as persistent output losses, economic activity, welfare, asset prices, unemployment, government debt, tax revenue [1–4].

As one of the fastest growing sectors of the global financial industry, participation banking sector accelerated its development especially as of the 1990s and become an important part of the banking sector for significant number of countries worldwide. Furthermore, the financial crisis experienced in 2008 shed doubts on the conventional banking system and draw attention to participation banking. The financial crisis of 2008 is considered to be the second most serious breakdown since the 1930s. The crisis, started in the USA, spread to many other countries in a short time and turned to a global crisis. As a consequence, the banking sector in those countries has adversely affected. In this regard, the interest in participation banks has increased, as they were more resistant to the financial crisis compared to conventional banks in terms of profitability, liquidity and asset quality [5, 6].

The breakdown of 2008 also triggered the efforts to investigate the impact of banking crisis on participation banks. However, most of these efforts aim to compare the impact of the crisis on participation banks and conventional banks, or investigate the performance of participation banks before/during/after the global financial crisis [7–10]. Despite those attempts, there is no prior study investigates the early warning indicators of banking fragilities of participation banks. Early warning indicators are crucial since they provide opportunity to detect the fragilities of the banking system and take precautions against a forthcoming banking crisis. In this regard, although there are number of studies in the literature on the significant indicators of banking crisis in Turkey, there have been no attempts to examine the indicators of banking fragilities of the participation banks. For instance, Tosuner [11] developed an early warning system to investigate the banking crisis in Turkey. The author reveals that domestic credit, M2, international reserves, real exchange rate and international trade are leading indicators of banking crisis of Turkey. To identify the causes of bank crises and determine the crisis indicators, Tunay [12] develop an early warning model for Turkey. The results show that exchange rate position, terms of trade, capital adequacy, interest rate risk and market risk are important factors of the banking crisis in Turkey. In addition, Cergibozan and Arı [13] develops a model specific to Turkey to examine the determinants of banking crisis over the time period 1990 and 2013. According to the results, increasing inflation and interest rate, depreciation rate, excessive fiscal deficit, increasing bank loans and bank short positions, liquidity mismatch and decreasing bank reserves are important determinants of banking crisis of Turkey. Furthermore, research on the subject on the participation banks and crisis has been mostly restricted to analyzing the financial performance of participation banks or limited comparisons of the financial performance of conventional banks and participation banks [14–16].

Motivated by the literature, this study constructs a model specific to participation banks in Turkey to identify the leading indicators fragility towards banking crisis. In addition, apart from the existing literature, this study considers banking level explanatory variables over a recent time period 2008 and 2018. This paper has been divided into five sections. The first part of this study gives the introduction. The second section presents an overview of the Islamic financial system and development of participation banks in Turkey. The third part highlights the key concepts of banking sector fragility. The fourth section is concerned with the data and methodology employed for this study. The fifth section presents the results of the study and the last section concludes the study.

### **2. Overview of the Islamic financial system**

The Islamic financial system is constructed on the basis of Shari'ah principles (Islamic Law). In other words, Islamic financial system can be defined as a system in which all financial activities and transactions are carried out within the framework of Islamic rules. The main motive behind the emergence of Islamic financial system is the demand for a system that are based on Islamic principles. In other words, Islamic financial system has primarily arisen to stimulate the unused funds of Muslims with high religious sensitivity to evaluate their investments and further
