Islamic Banking :

A Journey to the Basics

Istanbul

2011

MURAT ÇETİNKAYAExecutive Vice President Kuwait Turkish Participation Bank

Agenda

1. What does “Islamic banking” stand for?

2. What relevance does Islamic banking have in the modern financial system?

3. What are the current trends and areas of growth?

4. Where does Turkish experience stand in Islamic banking?

5. Kuwait Finance House (KFH) and Kuwait Turkish Participation Bank

Increasing market presence

From niche to critical mass

− Growing at 15 to 20% per annum− Size estimated at USD 900 billion globally

− New markets welcoming Islamic banks and products

Market-driven proposition

− Retail demand has historically the backbone of the industry− Sensitivities to principles more visible on retail deposit − But corporates and even sovereigns showed appetite for the products− Market-driven product development proved to be successful− Self-regulating organisations accompanied global Islamic banking boom

Global scale− More than 250 Islamic banks worldwide operating in over 75 countries

− A wide range of interest varying from U.K. to Singapore− Widening customer base including sovereigns to top global corporates

to tap Islamic finance markets

.

Reach and richness

Niche presence

Mainstream relevance

Conceptual exploration

Engaging with regulators

Reach and richness

Islamic finance industry is developing a global reach…

Singapore: Active in developing Islamic finance

Germany: Kuwait Turk received licence for a branchSaxony issues E100m Sukuk (2004)

UK: Five active IslamicbanksSukuk on its way

Kuwait & UAE: Hub for Islamic banking

Malaysia: Islamic product and industry, development and sophistication leader

China: Active member of IslamicFinancial Services Board (2004)

Bahrain: Leading Islamic financial centre, and housing regulatory bodies

Saudi Arabia: 95%+ of new consumer lending is Islamic (2006)• Retail market rapidly

converting to Islamic (2006)

…with worldwide momentum

Each region is contributing in a unique way

Japan: JBIC exploring Islamic financing opportunities (Dec. 2006)

Turkey: 25 years of Islamic banking experience

Russia: Increasing interest VTB – KFH/LMH partnership

France : Recent declaration of Islamic Banking interest

Industry has developed a comprehensive product offering over its young history

1950s

60s

70s

80s

90s

2000s

− First institutions emerged to test the market

− Development of theoretical framework− First attempts to structure Islamic banking

products

− Islamic Development Bank (1974) and DIB− One country-one bank setup

− Advancement of Islamic products− Turkish market to welcome Islamic banking− Full “Islamization” of banking in some

countries (Pakistan, Sudan etc.)

− Entry of global institutions & Islamic windows− İncreasing global coverage of Islamic banking

− Islamic banks achieving strong and stable growth globally,

− New products in international markets− Sukuk market to boom

1970s

insurance

1980s syndications

structuredand trade financeequity

private equity

projectfinance

structured products

1970s

1980s

Evolving richness in productsDevelopment of industry

Industry has near like-for-like parity with conventional offering

commercialbanking

1990s

2000s

Global Deployment of Islamic Products

Mainstream relevance

Engaging with regulators

Bre

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Ban

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Com

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t A

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W

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ide (

20

08

)

Source: KFHR Global Islamic Finance Directory 2008

Islamic banking86.9%

Sukuk7.0%

Islamic equity funds2.5%

Islamic mutual funds3.5%

Takaful0.1%

Bre

akd

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f Is

lam

ic B

an

kin

g

Pri

ncip

les

Com

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t A

ssets

W

orl

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20

03

)

Niche presence Conceptual exploration

The industry has not yet reached its potential

Still new markets exist that did not yet meet with Islamic banking and finance

The global Islamic insurance (Takaful) market is estimated to reach USD 20 billion

Most Islamic financial institutions are highly liquid, and seek new asset classes and markets to diversify

– New treasury products and investment securities are to emerge

– Capital markets developments: New sukuk issuances expected to tap the market

Islamic finance has also gained popularity in Muslim-minority countries

– Germany issued the first Islamic Eurobond (2004)

– Five Islamic banks in UK

Trends of convergence and conversion– Islamic banks introducing new products and services to compete with the conventional

banks,

– Conventional banks aiming to tap Islamic banking markets and expand their product base

Strong growth of GCC economies

Retail customer commitment

Development ofIslamic capital markets

Liberalisation of capital markets

Innovative product development

Market developments urging countries and customers

to diversification

EXPLOSIVE GROWTH OF ISLAMIC FINANCE

Industry is driven by fundamental factors

Why Islamic financing is flourishing

Islamic framework provides solutions for key limitations of conventional banking system

IFI solutionsConventional banking issues

• Growing consumer indebtedness− Growing and unhedged risks pose systemic

problems

• Speculation leading to crises− 1997 East Asia Crisis− 1998 Russia− 1999 Argentina

• Channeling the funds to “real” investment needs

• Prevention of speculation− Ownership is prerequisite of sale− Excessive risks are prohibited

• Equitable distribution of risk and reward

• Asset/need-based approach to financing

An alternative banking model in development

Liabilities Assets

Investments

Deposits

Equity financing

mudaraba & musharaka

Debt financing

ijarah, murabaha, salam, istisna‘

Profit, not interest, becomes the basis for financial intermediation

Su

pp

liers

of

cap

ital

Productive economic

actors with capital needs

• Reducing debt-based products− Islam permits commercial debt for productive ends− Debt-based consumer products permitted on basis of need

• Building income-sharing products− Musharaka is preferred form of financing

Key internal issues that need addressing…

Tested strength in the financial crisis

Islamic banking, a booming $US1 trillion global industry that prohibits speculation and high levels of debt, has been relatively unscathed by the credit crunch.

Islamic banking model’s basic principles of

– financing “real” trade and economic activities,

– no financing of speculation

– No engagement in debt trading

– Asset backed and project-financing approach to help hedging risks

As a result, the lessons from the crisis;

– Islamic banking is inherently stable

– Islamic banks outperformed the conventional financial institutions

Banking and finance needs

Right positioning and definition of Islamic banking - 1

Principles filter

Islamic banking and finance solutions

• Prohibition on:

– Interest

– Speculation

– Religious basic sources

– Ijma’ (jurist consensus)

– Qiyas (analogy)

– Ijtihad (reasoning)

– Musharaka (Partnership)

– Mudaraba (Fund management)

– Murabaha (Purchase-resale)

– Ijara ( Lease)

– Istisna’ ( Manufacturing contract)

– Salam -(Forward sale)

• Asset-backed transactions with investments in real, durable assets

Standart contractsPrinciples sources

• Prohibition of certain investments:− Sectors (e.g.: alcohol, armaments

etc.)− Instruments (e.g. Leveraged

interest products, toxic assets type of derivatives etc.)

• Credit and debt products are not encouraged

Banking and finance needs

Right positioning and definition of Islamic banking - 2

Principles filter

Islamic banking and finance solutions

– Religious basic sources

– Ijma’ (jurist consensus)

– Qiyas (analogy)

– Ijtihad (reasoning)

– Musharaka (Partnership)

– Mudaraba (Fund management)

– Murabaha (Purchase-resale)

– Ijara ( Lease)

– Istisna’ ( Manufacturing contract)

– Salam -(Forward sale)

Standart contractsPrinciples sources

• With the development and boom of Islamic banking, it became clear that :

− Islamic banking has roots in religion and ethics but it is not a “religion activity” and “not confined to Muslim population”

− Islamic banking is not something “from and for GCC or Muslim world”, it is a global concept− Islamic banking has some limitations and border lines, but it is acknowledged that it can

provide solutions in a wide scope of areas ranging from retail banking to investment banking.

Islamic finance is embedded within values

Synthesis of Islamic law and contemporary finance

Islamic finance is more than financial contracts

Client affinity

Fulfils aspirations

Integrates a wider range of customer base with certain sensitivities

Alternative paradigm

– Stability from linking financial services to the productive, real economy

– Moral compass for capitalism

Responsible finance

Builds systematic checks on financial providers

Inclusive proposition

– Open to all-faith clients

– Available to Islamic and conventional issuers

Parallel trends

Ethical investment

prohibited sectors

NGOsnot-for-profits

SOCIALIMPERATIVE

ZONE OFSUSTAINABILITY

Islamicbusinesses

ECONOMICIMPERATIVE

• Market-driven yet values-based

• Gradualist and evolutionary nature

• Symbiotic and synergistic relationship with mainstream finance

Islamic Financial Institutions are positioned in a “zone of sustainability”

Islamic finance characteristics:

GCIBFI (2001)Bahrain

Promoting industry in theory and practice− Disseminating Shariah concepts & multilateral understanding between IFIs and public− Improving IFI practices, cooperation, professionalism and transparency

IIFM (2001)Bahrain

Development of global Islamic capital and money market− Promoting active and regulated trading and capital flows− Catalyzing trading infrastructure, product innovation and information flows

Self-regulatory organizations bring credibility through standardization of practices

AAO-IFI (1991)Bahrain

Benchmark of Islamic accounting standards− 56 accounting, auditing, governance and Shariah standards− Enhancing clarity, transparency and harmonisation

IIRA (2005)Bahrain

Reference point for IFI ratings− Issuing sovereign, credit, Shariah quality and corporate governance ratings− Providing effective tool for informed investment decision-making

IFSB (2002)

Malaysia

Standard-setting body of regulatory and supervisory agencies− Complementing Basel II Capital Accord − Key standards: risk management, capital adequacy & corporate governance

LMC (2002)Bahrain

Creation of active Islamic inter-bank market− Creating secondary market for short-term Shariah-compliant treasury products− Enabling IFI management of liquidity mismatch

Industry is reaching mainstream relevance in global financial system

Relevance to new-comersRelevance in countries with already developed Islamic banking

• Reaching a broader market • Alternative source of funding

− Debt issuance with the widest acceptance− Attract “new-to-industry” investors

• Gateway to OIC markets− Regional preference of Islamic investors− Infrastructure investment opportunities

• Widens the bankable population and customer base

− Increases bankable population of economy− Increases product base in the system− Attracts more deposits/funds from the

customers

• Enhances stability of financial model− Asset-based framework links financial services

to real economy

Need for co-ordination to enable further development

A number of factors need to be engaged to bring success

Key enablers

• Dedicated people− Greatest intangible to enable Islamic finance and build its future− Human capital development: bankers and scholars

• Committed sponsorship− Academic input to formulate visionary framework and development− Capital sponsorship to bring plans to life

• Proactive engagement− Regulators, practitioners and scholars to set a common agenda

We must preserve what is distinctive about Islamic finance

– Industry regulations and governance heading towards mainstream globalization

– Balancing different elements of Shariah credibility

The way ahead …..

Current expanding reach and richness of Islamic finance

– Despite the absence of an enabling framework

– But at a cost: culture of exceptions, Shariah credibility, competitive disadvantages

To build an enabling framework requires concerted efforts

– Collaboration between IFIs, endowed industry institutions and regulators

– Exploration of narrow banking principles

Overview of Kuwait Finance House

Key

Facts

• Kuwait Finance House K.S.C. (KFH) was established in the State of Kuwait in 1977, as the first bank operating in accordance with the Islamic Banking principles.

• KFH is listed with the Kuwait Stock Exchange (KSE), with a market capitalization of US$ 9.55 Billion as of 22 June 2009. Assets total US$ 37 Billion and deposits amount to US$ 24 Billion as at Q1 2009.

• In the global Islamic arena, KFH is in the forefront of the industry in terms of international presence, spectrum of activities, strategic alliances, networking and innovation.

• KFH has been awarded by the Banker Magazine as the World’s Best Islamic Financial Institution, and for third successive year it has been awarded by Euromoney magazine as the best Islamic Bank in the Middle East.

• KFH is engaged in providing Islamic banking services, and its spectrum includes consumer banking, corporate finance, Islamic capital markets, real estate finance, structured finance, investment portfolios, and other products and services.

Overview of Kuwait Finance House

Key

Facts

• One of the largest Islamic banks in the world• Listed on the Kuwait Stock Exchange:

• Government of Kuwait - 43.0%• General Public - 57.0%

• Specializing in Corporate, Investment, Private, Commercial and Retail banking • Direct investment portfolio of approximately US$ 800 million• Through the direct investment portfolio, KFH has interest in aviation, shipping,

takaful insurance, information technology, real estate construction and development, logistics, oil and gas and healthcare

• Co- Lead arranged first Euro denominated Sukuk for the German State of Saxony Anhalt.

• Lead managed first local Kuwaiti sukuk issue for The Commercial Real Estate Company

Overview of Kuwait Finance House

Ratings (JAN ‘09)Key Facts

• Headquartered in Kuwait with 175 branches locally and worldwide

• Market Capitalization of US$ 9.55 Bn (June ‘09)

• Asset Size of US$ 37 Bn (31 March ‘09)

• Deposits of US$ 24 Bn (31 March ‘09)

• Total shareholders’ equity of US$ 4.10 Bn (31 March ’09)

Agency Short Term Rating

Long Term Rating

Capital Intelligence

A-1 A+

Fitch F-1 A+

Moody’s P-1 Aa3

S&P A-2 A-

Overview of Kuwait Finance House

Competitive Strengths

• Ability to structure and close transactions rapidly due to bank’s seasoned expertise, network, strategic partnerships, financial strength and sound liquidity position.

• A deeply entrenched brand franchise with subsidiaries in Bahrain, Turkey, Malaysia, Singapore, Australia, Jordan and Saudi Arabia and affiliates in UAE and Oman

• Strong underwriting ability: unrivalled access to Islamic deposits in the domestic & regional market.

• Formation of Liquidity House as an investment house fully dedicated to Sukuk issuances.

• Strong links with regional and international financial institutions• presence in the domestic and regional real estate market and proven

transactional expertise in the international arena.

• Recognized and respectable Advisory Board and structuring expertise; KFH Advisory Board clearances and approvals on structures are in most, if not all, cases taken for granted by other fellow participants in deals and transactions.

Overview of Kuwait Finance House

One-Stop Islamic Financial Solution Provider

Overview of Kuwait Finance House

Collectively KFH has the expertise and value-added services, capable of delivering the objectives of the client

STRENGTH & EXPERTISE DISTRIBUTION CAPABILITIES WEALTH OF EXPERIENCE

• Specialist in ICM

• Strength in the Middle East

• Strong and experienced leadership team

• Expertise in Islamic banking principles compliant products

• Strong distribution team

• Extensive distribution network including GCC, Europe and Asia

• Middle East distribution advantage

• Strong relationships with other Islamic and International banks and

investment houses for placements

• 30 years of experience including global sukuk issuance

and placements

• Client-centric approach for every deal/issuance

• Ability to innovate and structure Islamic financing solutions for

clients

Our ClientOur Client

KFH RESEARCH LIMITED

KFH Research Ltd is the world's first Islamic investment research arm to be established by an Islamic Bank. A direct subsidiary of Kuwait Finance House, KFH Research was established in 2007,

comprising industry professionals and 'star' research analysts with broad experience in Islamic finance & global markets. Below is a sample of their reports:

KFH GROUP: A SAMPLE

Next Steps

SOVERIEGN SUKUK ISSUANCES ARRANGED BY KFH

Saxony Anhalt

EUR100 Mn Sukuk

Co-Lead Arranger 2004

Dubai Civil Aviation UAE

US$ 1 Bn Sukuk

Joint Lead Manager2004

Government of Qatar

US$700 MnSukuk

Co-Lead Manager2003

Bahrain Monetary Agency

US$ 250 MnSukuk

Lead manager 2003

KHAZANAH NASIONAL

US$ 750 MnSukuk

Co-Lead Manager2006

Overview of Kuwait Finance House

Ratings (JAN ‘09)Key Facts

• Headquartered in Kuwait with 175 branches locally and worldwide

• Market Capitalization of US$ 9.55 Bn (June ‘09)

• Asset Size of US$ 37 Bn (31 March ‘09)

• Deposits of US$ 24 Bn (31 March ‘09)

• Total shareholders’ equity of US$ 4.10 Bn (31 March ’09)

Agency Short Term Rating

Long Term Rating

Capital Intelligence

A-1 A+

Fitch F-1 A+

Moody’s P-1 Aa3

S&P A-2 A-

Overview of KT

Shareholder structure

62.23%18.72%

9.00%9%

1.05%

Kuwait Finance House (62.2%)

General Directorate of Foundations, Turkey (18.7%)

Social Security Institution Kuwait (9.0%)

Islamic Development Bank (9.0%)

Others (1.1%)

• Kuveyt Turk began operations in 1989 .

• Market share of Kuveyt Turk among participation banking sector is currently 22.5%

• Asset size of Kuveyt Türk is TRL 5.72bn as of 31/12/2008

• Shareholder Equity:TRL689m

Fitch Ratings

Foreign Currency

Long Term BB

Short Term B

Outlook Stable

Local Currency

Long Term BBB-

Short Term F3

Outlook Stable

National

Long Term AAA(tur)

Outlook Stable

Individual D

Support 3

Sovereign Risk

Foreign Long Term BB-

Local Long Term BB

Outlook Stable

Supportive anchor shareholder

Funding

Know-how

International banking

Corporate governance

• Supportive shareholder through difficult times

• Access to and superior understanding of the Middle East market (instruments and customers)

• Access to Middle East institutions and liquidity

• Rating agencies look favourably on support

• Better asset-liability mismatch management

• Coordination between KFH group treasuries enables better hedging of FX exposure at lower costs

• Product innovation

• Investment in product development

• Provision of commercial guidance

• Beneficiary of strengthening ties between Turkey and the rest of the world, especially with Middle East

• Foreign trade services

• Turkey as a destination of oil-driven capital

• Professional reporting systems at international standards

• Global expertise at board level

• Best-in-class management techniques

KFH network

Total assets : US$38.3bnShareholder equity: US$5.8bnGross Profit: US$1.39bnNet Profit to Shareholders US$ 633mBranches: 46

Supportive anchor shareholder (2008)Kuwait Finance House (“KFH”)

KFH Subsidiaries

• 16 subsidiaries

Kuwait

• 1 subsidiary: Kuveyt Turk• Total assets: US$3.8bn

Turkey

• 1 subsidiary: Kuwait Finance House (Bahrain) B.S.C.

• Total assets: US$3.4bn

Bahrain• 1 subsidiary:

Kuwait Finance House (Malaysia) Berhad

• Total assets: US$2.7bn

Malaysia

Pop.: 74mGDP1 (US$): 659bn

Turkey

Pop.: 3mGDP1 (US$): 111bn

Kuwait

Pop.: 27mGDP1 (US$): 186bn

Malaysia

Pop.: 1mGDP1 (US$): 17bn

Bahrain

Strategic benefit

Source: EIU, Central Bank of Kuwait(1) Nominal GDP

Source: KFH Annual report

Financial overview - profit and loss (IFRS1)

Operating income (TRLm) Net income (TRLm)

18.1

40.0

67.0

91.2

0

10

20

30

40

50

60

70

80

90

2005 2006 2007 2008

(1) Income includes foreign exchange gains / loss

CAGR: 47.8%

CAGR: 71.4%

Cash loans by segment – 2008 (%)

Kuveyt Turk overview

International & Investment Banking

• Project finance

• Corporate finance

• Capital markets

• Syndicated Murabaha

• First international Murabaha syndication of US$200m raised for Kuveyt Turk in 2006

• Operating in 96 countries with more than 1,000 correspondent banks

Retail

• Deposits (current / participation acc’s)

• Loans

• Card business

• Moneygram

• 800,000 retail customers

• 59,000 retail SME customers

Total: TRL 4.0 bn

Corporate

• Murabaha / Istisna’as

• Financial leasing

• Letters of Guarantee

• Foreign trade finance (Letters of Credit)

• Foreign trade services

• 39,000 corporate customers

• 13,000 active credit customers

Products

Highlights

Breakdown of total cash

loans

120 branches: 119 in branches in Turkey, 1 in Bahrain and 1 Financial Services Branch in GermanyDistribution

Financial overview – balance sheet (IFRS1)

RoAA and RoAE Capital adequacy ratios (TRYm) - CAR

Total assets (TLm) Total liabilities (TLm)

2,361

2,951

3,860

5,718

71%76%

75%69%%29

24%

25%

31%

0

1,000

2,000

3,000

4,000

5,000

6,000

2005 2006 2007 2008

Net loans Other assets

2,951

3,860

5,718

82% 81%80%

77%13%10%

9%

9%

9%

11%

5%

14%

2,363

0

1,000

2,000

3,000

4,000

5,000

6,000

2005 2006 2007 2008

Deposits Equity Other liabilities

(1) Audited IFRS accounts for 2004-2006-2007 and draft accounts for 2008

CAGR: 34.3%

Leading platform and innovator

Retail

• First mover advantage in the retail sector1

• Innovative product development

• First participation bank to segment its client base

• High customer service levels

• Focus on building long-term client relationships

• Strong brand name and sticky retail base

• 40% participation bank consumer loan market share

• Retail loans2 account for 25% of portfolio compared to participation banks average of 17%

• Offers one of the widest range of products amongst participation banks

Corporate

• Increased focus on small to mid sized corporates

• Development of portfolio management system

• Increased focus on letters of guarantee

• Higher margin business and reduced risk profile

• Increased quantity and quality of clients and improved profit per client

• Enhanced quality control delivering better returns

• Larger proportion of non-cash loans

International & Investment

Banking

• First and most advanced investment banking propositions

• Most dynamic participation bank funding structure

• Development of international network (branches & correspondent banks)

• Funding origination through Bahrain branch

• Executed the first and largest ever international Murabaha syndication among participation banks in Turkey (US$200m)

• International network to increase access to Gulf investors and funding opportunities for clients

• Facilitates increasing share of overseas trade flows

Key Achievements Results

(1) Amongst participation banks(2) Excluding retail SMEs

Performance drive and future upside

Category Actions taken Future upsidePerformance

2007 2008

• Target 25 new branches p.a.

• Target non-cash vs cash of 2:1 by

end 2010

• Diversify funding further

• Business partnerships

• Enhanced cross-sell

• Disposal of non-core assets

• Benefits from training

• Gulf market expansion

• Correspondent banking network

• Branch roll-out (Turkey)

• Bahrain branch

• Non-cash lending (↑)

• Retail loans (↑)

• Employee incentives

Growth

• Retail / SME loans (↑)

• Non-cash loans (↑)

• Centralised commission

• Risk management focus

Asset / income quality

Fee income3 %

NPL ratio4

79% 88%

4.2% 4.8%

Total cash loans1

(1yr)

Non-cash loans/Cash Loans1

29% 37%

61% %80

Loans / deposits2 108% 106%

Long-term target RoAE of 25%

Performance - RoAE 19.9% 16.7%• Focus on competitive

advantages

(1) Gross loans – Annual increase rates(2) Interbank Loans and Deposits not included.

(3) Fee & commission income (% of Financing income )(4) Total impaired receivables / total gross loans

Capitalise on advanced retail / SME franchise

Grow local customer base through branch roll-out

Leverage existing customer base through enhanced product range / offering

Enhance non-cash business

Improve operational efficiency through cost

control initiatives

Capture trade flows from overseas locations

Strategy

Become Turkey’s leading participation bank and one of Turkey’s top 10 banks

Strategy in International Banking

Key highlights

Key strategic goal

Means of achieving strategic goals

• Raised US$200m through a syndicated commodity Murabaha transaction for Kuveyt Turk in 2006

• Arranged US$240m of international syndications since 2006

• Correspondent banking relationship with around 1,000 financial institutions in 96 countries

• Increase market share in international syndicated facilities

• Leverage off KFH relationship and Bahrain branch to drive growth through increased access to Gulf investors

• Expand German representative office into full branch operation

• Focus on increasing quality and size of international syndications

• Expand treasury function

• Increase international services to retail and corporate customers

Products

• Dubai branch expected to be operational

• Germany representative office awarded Financial Services branch license in 2009• Expected to add value on fund mobilisation from

Turkish and Muslim population.

• Further expand correspondent bank network in line with demand for trade finance activities

International expansion

International expansion and access to Gulf investors key to growing ahead of the market

Thank you

Murat ÇetinkayaEVP, Kuwait Turkish Participation Bank

Let’s move together further ahead to explore new peaks and horizons of Islamic banking