Economic Modelling 54 (2016) 187–194

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Economic Modelling

journal homepage: www.elsevier.com/locate/ecmod

Is small the new big? Islamic banking for SMEs in Turkey

Ahmet F. Aysan a, Mustafa Disli b,⁎, Adam Ng c,d, Huseyin Ozturk a
a
Central Bank of the Republic of Turkey, Turkey
b
Department of General Economics, Ghent University, Belgium
c
International Centre for Education in Islamic Finance (INCEIF), Malaysia
d
Global Economic Governance Programme, University of Oxford, United Kingdom

a r t i c l e i n f o a b s t r a c t

Article history: While SMEs constitute the backbone of many economies, many SMEs have limited access to finance. Yet,
Accepted 30 December 2015 banks in some countries are actively financing SMEs. This paper examines whether this is true in the case
Available online xxxx of Turkey, a G20 economy that has a significant SME sector. We study the determinants of banks' willing-
ness to finance SMEs and banks' processing ability of SME financing portfolio in Turkey based on a unique
Keywords:
quarterly small business panel data set of 40 commercial banks from 2006 to 2014. Employing pooled
Islamic banks
Small business lending
OLS and fixed-effects estimators, we find that Islamic banks (known as Participation banks in Turkey) are
more inclined toward financing SMEs than conventional banks. We also find that the quality of Islamic
banks' SME loan portfolio is comparable to that of conventional banks. The results are fairly robust to differ-
ent bank ownership forms (state owned, private, and Islamic banks) and alternative model specifications.
Our findings provide further support to the notion of “small is the new big” in that banking for SMEs can
be a viable venture.
© 2016 Elsevier B.V. All rights reserved.

1. Introduction
In his book Small is Beautiful, E.F. Schumacher grieved over that
his generation suffered from “an almost universal idolatry of gigan-
tism,” and called for “production by the masses, rather than mass
production.”1
Small and medium-sized enterprises (SMEs) constitute the backbone
of economic systems and are the key drivers of long-term economic
growth. With an estimated contribution of 43.5% to global employment,
SMEs command the largest shares of job creation in many developed
and developing countries (Ayyagari et al., 2011). Despite such impor-
tance, SMEs traditionally face higher obstacles to their operation and
expansion than large enterprises. Foremost among these obstacles is the
lack of access to external financing for business activities (Beck et al.,
2005, 2006). Because of their opaque nature, SMEs generally cannot re-
sort to financial markets to raise funds, rendering them largely dependent
on bank financing. The vulnerability of the SME sector to changing condi-
tions has also become more evident in the aftermath of the 2008 global
financial crisis (OECD, 2015). These issues have brought the concerns of
SMEs' access to finance under closer scrutiny of policy makers and
academics in recent years.2
Country case studies that focus on the domestic context have
become increasingly relevant for the formulation of specific policies
and financing tools to alleviate the financing constraint of SMEs (Beck
and Demirgüç-Kunt, 2006). Increased attention has been accorded to
research on the ownership structure of the banking sector and its conse-
quences on SMEs' access to finance given the evolving structure of the
banking industry: developing countries, most notably in Latin America
and Eastern Europe, have experienced an increase in foreign bank par-
ticipation and a decline in government bank ownership (Cull and
Martinez Peria, 2013). In parallel with these developments, especially
in Muslim-majority countries, Islamic banking has emerged as an alter-
native way of financial intermediation. While there is a growing body of
research on the impact of bank ownership on financing, the effect of
Islamic banks on SMEs' access to credit has not been extensively
explored. To fill this gap, we examine whether Islamic banks differ
from conventional banks in their financing decisions toward SMEs in
Turkey by controlling for bank-specific characteristics.3
Islamic banking refers to the provision of financial services in accor-
dance with the Shariah, the Islamic legal rules. The most salient

⁎ Corresponding author at: Department of General Economics, Faculty of Economics

and Business Administration, Ghent University, Tweekerkenstraat 2, 9000 Ghent,
Belgium. Tel.: +32 9 264 89 75; fax: +32 9 264 35 99.
E-mail addresses: ahmet.aysan@tcmb.gov.tr (A.F. Aysan), mustafa.disli@ugent.be
(M. Disli), adam@inceif.org (A. Ng), huseyin.ozturk@tcmb.gov.tr (H. Ozturk).
1
Shumacher's (1973) 'Small is Beautiful: Economics as if People Mattered'.
2
For example, the “High-level principles on SME financing” draft by the G20/OECD
(2015) and the Joint World Bank—Islamic Development Bank Policy Report on “Leverag-
ing Islamic Finance for SMEs” (October 2015).
3
In Turkey, Islamic banks are known as participation banks. “Islamic banks” will be
used in this article due to the relative familiarity of readers with this term.

http://dx.doi.org/10.1016/j.econmod.2015.12.031
0264-9993/© 2016 Elsevier B.V. All rights reserved.
188 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194
characteristic of Islamic finance is that all transactions must be conduct-
ed via al-bay (exchange contract) rather than through al-riba (interest
rate-based debt contract). Although the Islamic banking model pro-
motes risk sharing in theory, the most commonly used method of fi-
nancing arrangements between suppliers and users of funds is
Murabaha. By using the Murabaha contract, Islamic banks buy assets
on behalf of their customers and then sell the assets in return to their
customers at a markup price on a deferred payment basis. According
to Shaban et al. (2014), since the bank maintains the ownership of the
asset until the maturity of the contract, the Murabaha contract signifi-
cantly eases the collateral obstacle faced by small businesses. Therefore,
the structure of a Murabaha contract would reduce the problems of
asymmetric information associated with financing to more opaque bor-
rowers. In contrast, pledging collateral is a defining feature of the con-
ventional loan agreement.
The recent CIBAFI (2015) Global Islamic Bankers' Survey highlights
that “SME financing has emerged as a leading driver across all regions,
partly due to the potential profitability of the segment once critical
mass has been achieved” and that many Islamic banks are turning to
building SME lines of business. Financing SMEs is viewed as an impor-
tant aspect of Islamic banks' moral obligation to intermediate funds
for the good of the society. However, there is lack of awareness in rela-
tion to Islamic finance and banking culture amongst the under-served
sectors of the society, weakness of regulations on securities/collateral,
lack of support from the public sector, and unfavorable prudential stan-
dards. Islamic bankers are also concerned with the issue of high sensi-
tivity of SMEs to macroeconomic shocks, lack of transparency and
quality in SME business process, over leverage and poor credit rating
of SMEs, and the need to restructure the secured transaction law to
bring SMEs into the value chain. These issues underscore the impor-
tance of understanding the potential constraints on Islamic banks' will-
ingness and ability to finance SMEs.
The Turkish banking system provides a fertile testing ground for the
comparative analysis of conventional and Islamic banks' financing
behavior toward SMEs. In Turkey, Islamic and conventional banks oper-
ate side by side and under equal regulatory conditions. Further, efforts
in fostering SME development in Turkey have been commended by in-
ternational bodies and could serve as an example for countries seeking
to strengthen their SME sector (WB-IDB, 2015). Indeed, according to the
2013 results of the European Commission's (2013) SMEs' Access to
Finance Survey, access to finance is not the main concern for Turkish
SMEs compared to the high costs of production, sourcing for customers
and skilled staff. Using quarterly bank-level data from 2006Q4 to
2014Q2, this paper analyzes banks' willingness to lend, particularly
whether bank type (Islamic or conventional) affects the levels, averages,
growth, and the shares of bank financing of small businesses. Further,
we examine whether Islamic banks differ from conventional banks in
their processing ability of the SME portfolio by looking at the non-
performing loans. To the best of our knowledge, this is among the first
studies that integrates such a diverse spectrum of SME financing charac-
teristics in the context of an emerging G20 country.
This study draws insights from and contributes to three related
strands of literature. First, this paper is related to the importance of
relationship lending to small businesses. According to Petersen and
Rajan (1994), relationship lending refers to informal but influential
private debt arrangements between financial institutions and their bor-
rowers. Stein (2002) predicts that the transmission of soft information,
which is qualitative and more difficult to codify, through hierarchical
levels is costly, whereas hard information can be credibly transmitted
across physical or organizational distances. Hence, the comparative
advantage in the processing of soft or hard information depends on
the distance between the center of decision-making authority and the
point of information collection. The findings of Berger et al. (2005) sup-
port this theory by showing that larger banks lend primarily to larger
firms with good accounting records, while small banks lend to small
and informationally opaque firms. However, Berger and Udell (2006)
dispute the idea that larger institutions are disadvantaged in lending
to opaque SMEs. The authors argue that in the absence of informative fi-
nancial statements, larger banks are often able to resort to other types of
hard information (such as better collateral appraisal and adequate cred-
it scoring mechanisms) in determining repayment prospects. Further,
Uchida et al. (2012) showed that loan officers at large banks are capable
of producing as much as soft information than their counterparts in
small banks, but it appears that large banks do not actively use this in-
formation channel. This observation is in line with previous findings
that empowerment of lower levels of decision making in larger institu-
tions is likely to be more soft information intensive (Liberti and Mian,
2009; Agarwal and Hauswald, 2010).
The second strand of literature is related to the impact of bank
ownership on small business lending. Partly because these institutions
are typically large, foreign banks are believed to have a comparative
advantage in transaction-based lending technologies. Detragiache
et al. (2008) argue that, in developing countries, the distance (both
geographic and cultural) between headquarters and local subsidiaries
may force foreign-owned banks to rely more on hard information in
their lending decisions. They add that even when market entrance oc-
curs through acquisition of local banks, both local market knowledge
and tacit knowledge may be lost because of formal accountability impo-
sitions on local loan officers. Another argument for favoring transaction
lending is that foreign banks (headquartered in developed countries)
are able to import better information technologies for collecting and
assessing hard information (Berger and Udell, 2006). Given the massive
influx of foreign banks over the past decades in emerging countries,
their impact in these countries on credit allocation has come increasing-
ly under scrutiny. Concerns remain that foreign banks benefit high-end
customers (Mian, 2006; Detragiache et al., 2008; Beck and Martinez
Peria, 2010), although the evidence is far from being clear-cut (Berger
et al., 2001; Clarke et al., 2005; Bruno and Hauswald, 2013). With
respect to the role of state-owned banks in SME funding, theoretical ar-
guments and empirical evidence, in general, document unfavorable ef-
fects of state ownership. Previous research suggests that large shares
of state bank ownership are associated with less credit availability
(Beck et al., 2004), unfavorable financial and economic development
(La Porta et al., 2002), and higher levels of non-performing loans
(Barth et al., 2004).
The third strand is the literature about the role played by Islamic
banks in financing businesses. Although research related to the impact
of Islamic banking and its role on financing small business is scarce,
there is considerable suggestive support that Islamic banks have more
relationship lending in their loan portfolio. In particular, the asset-
backed finance and risk-sharing feature of Islamic financial products
are expected to strengthen socio-economic development through the
promotion of entrepreneurship (WB-IDB, 2015). From the empirical
perspective, Imam and Kpodar (2015) provide evidence that, notwith-
standing its relatively small size compared to the overall size of the
financial system, Islamic banking indeed contributes to the economic
growth. In the same vein, Naceur et al. (2015) show that Islamic
banking presence is adding to greater inclusion in the credit market.
By specifically investigating the potential role of Islamic banking in the
promotion of SME lending, Shaban et al. (2014) find that Islamic
banks operating in Indonesia are more inclined to small business financ-
ing than their conventional peers. This is plausibly due to the mitigating
role of the Murabaha contract in information asymmetries between bor-
rowers and lenders. In addition, the risk-sharing features of Islamic
banks provide a supplementary protective buffer and ease the collateral
obstacles faced by bank-dependent small business borrowers which, in
turn, stimulate economic growth and development.
Applying pooled OLS and fixed-effects estimations, we find that
bank type is an important driver of SME financing decisions. More
specifically, once we control for bank-specific characteristics, we find
that Islamic banks are more inclined toward financing small businesses.
In addition, we show that the quality of the SME loan portfolio of Islamic
 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194
Table 1
SME importance in Turkey and EU-28.
Number of enterprises Number of employees
Turkey EU-28 Turkey
Number Proportion Proportion Number
Micro 2,326,148 97.3% 92.4% 5,019,845
Small 42,641 1.8% 6.4% 1,327,077
Medium 18,132 0.8% 1.0% 1,830,242
SMEs 2,386,921 99.9% 99.8% 8,177,164
Large 3506 0.1% 0.2% 2,626,790
Source: European Commission's's, 2014 SBA Fact Sheet Turkey. According to the Turkish Statistical institute: businesses with fewer than 10 employees or annual sales of less than 1 million
TL are classified as micro-sized enterprises; businesses with 10–49 employees or annual sales of 1–5 million TL are identified as small businesses; and businesses that have 50–249 em-
ployees or annual sales of 5–25 million TL are categorized as medium-sized businesses. Turkey and EU use equal staff headcount ceilings for the definition of different SME categories.
banks is comparable to that of conventional banks. In line with the con-
ventional paradigm of relationship lending, this study also show that
larger banks are less inclined to engage with SME customers. Our results
are fairly robust to different bank ownership forms (i.e., state, private,
and foreign) and alternative model specifications.
The remainder of this paper is structured as follows. Section 2
outlines the data, summary statistics, and empirical strategy. Section 3
presents the empirical results on the effects of Islamic banking on
banks' willingness to finance SMEs and their processing ability of the
SME portfolio. In Section 4, we compare Islamic banks' behavior with
respect to different conventional bank ownership forms and verify the
robustness of our results. Finally, Section 5 provides concluding remarks.
2. Data and empirical methodology
2.1. Data
The Turkish banking sector was heavily concentrated on the financ-
ing of government deficits in the 1990s. Since the Turkish banking crisis
in 2001, structural economic reforms and lower interest rates on gov-
ernment bonds within a stable political environment have encouraged
banks to diversify their loan portfolio toward small business financing.
Bank funds were effectively directed toward SMEs as a result of the
reduction of provisioning ratios on SMEs by the Banking Regulation
and Supervision Agency (BRSA). Several government incentive pro-
grams, including tax incentives and R&D grants, have further stimulated
the growth of SME business.
Turkey has a significant and sizeable SME sector (see Table 1):
according to the 2011 figures, this particular category accounts for
99.9% of all businesses, provides most of the jobs (76%), and represents
53% of the value addition in the whole economy.4 These figures are
consistent with the historical patterns of the Turkish economy, which
is still heavily dominated by a less productive SME sector compared to
large enterprises. Table 1 also provides the EU-28 averages: Turkey
has relatively more SMEs, and they are significantly more important
for jobs than in the European Union. However, the contribution of
Turkish SMEs to the GDP is lower than in the EU due to the concentra-
tion of small businesses in the form of micro-SMEs.
To analyze conventional and Islamic bank financing to small
businesses in Turkey, we use a unique small business data set from
the Central Bank of the Republic of Turkey comprising 40 commercial
banks for the period 2006Q4 to 2014Q2. The unbalanced panel com-
prises 36 conventional banks and four Islamic banks. The four Islamic
banks are Bank Asya, Türkiye Finans, Albaraka Turk, and Kuveyt Turk.5
4
According to the Turkish Statistical Institute, businesses with fewer than 10 em-
ployees or annual sales of less than 1 million Turkish lira (TL) are classified as micro-
sized enterprises; businesses with 10–49 employees or annual sales of 1–5 million TL
are identified as small businesses; and businesses that have 50–249 employees or annual
sales of 5–25 million TL are categorized as medium-sized businesses.
5
In May 2015, Ziraat Participation Bank was authorized by the regulator (BRSA) to start
its operations as the first state-owned Islamic bank, increasing the number of Islamic
banks to five.
189
Value added
EU-28 Turkey EU-28
Proportion Proportion Billion € Proportion Proportion
46.5% 29.1% 29 19.6% 21.6%
12.3% 20.6% 19 12.7% 18.2%
16.9% 17.2% 30 20.6% 18.3%
75.7% 66.9% 78 52.9% 58.1%
24.3% 33.1% 69 47.1% 41.9%
Balance sheet and income statement information for conventional
banks are derived from the Banks Association of Turkey, and those of
Islamic banks are from the Participation Banks Association of Turkey.
2.2. Empirical methodology
We examine the degree to which Islamic banks and conventional
banks differ in their willingness to finance SMEs and the performance
of the SME loan portfolio. Our baseline empirical model to verify the
impact of bank type (Islamic or conventional) on SME financing is as
follows:
Y i;t ¼ α 0 þ α 1 Islamici;t þ α 2 X i;t1 þ α 3 C i;t1 þ α 4 T t þ εi;t ð1Þ
where i refers to the bank in quarter t and Y captures aspects of the SME
financing portfolio. We classify the dependent variables into two cate-
gories, namely, banks' willingness to finance and banks' ability to pro-
cess their SME financing portfolio. In the first category, we examine
whether bank type (Islamic or conventional) has an effect on SME fi-
nancing decisions. The second category comprises non-performing
loans (a measure for the quality of the SME financing portfolio). For
both loan commitments and non-performing loans, we focus on the
levels, averages, growth, and the shares of financing to the SME sector.
Growth rates and the shares of financing are important elements to
analyze (Clarke et al., 2005): if financing of small businesses grows at
a slower pace than other financing segments, it is possible that we ob-
serve a positive growth rate of the level, while the share of financing
to this sector could be dropping. Our analysis extends beyond these
two dimensions to include the levels and the averages. The combined
analysis between levels and growth in the levels would inform whether
there is convergence or divergence in the volume of financing to the
SME sector across bank types. Finally, the analysis of average SME
financing would give us insight into the average financing size
processed by Islamic versus conventional banks.
The dummy variable “Islamic” is equal to 1 for Islamic banks and 0
for conventional banks. Xi ,t-1 represents a matrix of bank fundamentals
that might potentially affect the reaction variables. Ci ,t-1 contains other
bank-specific control variables that might influence banks' SME financ-
ing and processing behavior. In all specifications, quarterly time dummy
variables Tt are included to account for nation-wide shocks that affect all
banks but change over time. The parameter of interest is α1, the coeffi-
cient on the variable differentiating between Islamic and conventional
banks. To reduce endogeneity issues, we measure the bank fundamen-
tals and controls one quarter earlier than the dependent variable. The
regressions are estimated using pooled OLS. Reported standard errors
are robust to the presence of heteroscedasticity and serial correlation.
Table 2 presents the descriptive statistics of the variables used in our
empirical analysis for both types of banks. The last column of the table
shows the results of a t-test for equality of means between Islamic and
conventional banks for the variables used in the models. Turkish Islamic
banks generate more SME financing both in terms of volumes and
shares. Some of these differences are striking: Islamic banks assign
190 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194

Table 2
Summary statistics.

Conventional banks Islamic banks Difference

Variable Obs. Mean SD Obs. Mean SD

Banks' willingness to lend

SME financing
Total 1003 13.2276 2.662 122 14.5808 0.986 1.3531⁎⁎⁎
Average 1003 5.6856 1.483 119 5.6589 0.558 −0.0267
Growth 963 0.0542 0.398 118 0.0799 0.262 0.0257
Share 1036 0.2353 0.170 122 0.3418 0.119 0.1065⁎⁎⁎

Banks' SME processing ability

SME non-performing loans
Total 926 10.2071 2.629 122 11.1682 1.320 0.9611⁎⁎⁎
Average 917 4.4418 1.412 119 4.6508 0.636 0.2089
Growth 886 0.0755 0.550 118 0.1230 0.441 0.0475
Share 1003 0.4489 5.510 122 0.0412 0.026 −0.4077

Bank fundamentals
Equity ratio 994 0.2247 0.205 116 0.1176 0.022 −0.1071⁎⁎⁎
Liquidity ratio 994 0.0663 0.040 116 0.1200 0.041 0.0536⁎⁎⁎
Deposits ratio 994 0.4490 0.283 116 0.7507 0.057 0.3017⁎⁎⁎
Profits ratio 958 0.0053 0.006 112 0.0041 0.008 −0.0012⁎

Bank controls
Branch size 994 58.1227 112.180 116 20.2198 3.031 −37.9029⁎⁎⁎
Bank age 994 4.8100 0.744 116 4.3447 0.275 −0.4653⁎⁎⁎
Bank size 994 15.5549 2.126 116 16.0223 0.593 0.4673⁎⁎

Note: Total SME loans is equal to the natural logarithm of the volume of SME loans. Average SME loans is calculated as the natural logarithm of the ratio volume of SME loans to the number
of SME borrowers. Growth in SME loans is the first difference of the log of SME loans. Share of SME loans is the ratio of SME loans to total bank credits. Total SME non-performing loans is
the natural logarithm of the volume of non-performing SME loans. Average SME non-performing loans is the natural logarithm of the ratio of non-performing SME loans to the number of
defaulting SME borrowers. Growth SME NPL is the first difference of the log of non-performing SME loans. Share SME non-performing loans is the ratio of non-performing SME loans to
total SME loans. Equity ratio is calculated as the book value of equity to total assets. Liquidity ratio is calculated as liquid assets (cash and central bank reserves) to total assets. Deposits ratio
is calculated as deposits to total assets. Profits ratio is calculated as bank profits to total assets. The control vector contains Bank size, Bank age, and Branch size. The Bank size variable
is computed as the natural logarithm of total assets. The Bank age variable is the natural logarithm of quarter-years the bank exists. The Branch size variable is the average number of
employees per branch. The last column refers to the difference between Islamic and conventional banks.
⁎⁎⁎ Significance level at 1%.
⁎⁎ Significance level at 5%.
⁎ Significance level at 10%.

34% of their loan portfolio to SME financing, whereas this figure is only
23% for conventional banks.
At first sight, when we consider the shares of non-performing
loans, it seems that Islamic and conventional banks similarly man-
aged their SME loan portfolio. In the estimation models, we control
for possible sensitivity of small business financing to bank health
by using the following bank fundamental variables (Cull and
Martinez Peria, 2013): capital ratio, liquidity ratio, deposits as a
source of funding, and profitability. The impact of some of these fun-
damentals on banks' SME financing is, a priori, unclear. For example,
profitable and capitalized banks might be better positioned to ad-
vance know-how and specialization in specific areas such as small
business financing. On the other hand, banks facing insolvency risk
might be encouraged to take excessive risk by entering into high-
risk segments like small business financing (Clarke et al., 2005). Liq-
uid banks might try to offset the opportunity costs of high cash hold-
ings by increasing their rates in their lending to borrowers (price
effect) or rebalance their loan portfolio exposures by concentrating
more on small business lending (quantity effect). Deposit liabilities
can be a stable source of bank funding relative to wholesale funding,
although the effects on SME financing is difficult to determine. In
sum, healthier banks do have better opportunities to focus on small
business financing, but they can also shy away from riskier activities.
The bank-control variables are Bank size, Bank age, and Branch
size. The Bank size variable is computed as the natural logarithm of
total assets. The Bank age variable is the natural logarithm of
quarter-years of the bank's existence. The Branch size variable is
the average number of employees per branch. Table 2 shows that Is-
lamic banks are on average younger, bigger, and have fewer em-
ployees per branch (another proxy for relationship lending) than
conventional banks.
3. Estimation results
The regression results on the determinants of banks' willingness to
finance SMEs and their processing ability of the SME portfolio are
provided in Sections 3.1 and 3.2, respectively. We focus our discussion
on whether Islamic banks differ from their conventional counterparts
with respect to SME financing decision.
3.1. Banks' willingness to finance SMEs
Differences between conventional banks and Islamic banks can be
derived from the coefficient on Islamic since conventional banks are
the omitted category. The results in Table 3A indicate that the coefficient
Islamic is positive and significant in the total, average, and share regres-
sions. Controlling for other factors, the average Islamic bank is more in-
clined toward financing small businesses. Islamic banks do not only
have larger volumes of SME financing, they also extend more credits
per borrower. The coefficient Islamic in the growth regression is not
significant, suggesting that there is no convergence in the difference of
between Islamic and conventional banks' SME financing decisions.
Consistent with the view that SMEs are opaque borrowers, our findings
suggest that Turkish Islamic banks attach greater importance to soft in-
formation in their lending decisions.
Our findings concerning the influence of bank fundamentals on SME
financing decisions reveal that capitalized banks are more tentative,
i.e., the average financing size and the share of SMEs in total financing
both enter the regression models negatively. Turkish banks are possibly
constrained to raise equity to offset declines in their capital, and there-
fore pursue an active asset management strategy in order to maintain a
constant capital ratio (e.g., Berrospide and Edge, 2010). Although banks
with a relatively large share of deposits have a larger volume of SME
 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194 191

Table 3
Banks' SME financing and performance – Islamic versus conventional banks.

Panel A Panel B

SME financing SME non-performing loans

Total Average Growth Share Total Average Growth Share

Bank ownership
Islamic 0.6905⁎⁎⁎ 1.0502⁎⁎⁎ 0.0419 0.0607⁎⁎⁎ 0.4985⁎⁎⁎ 0.9090⁎⁎⁎ 0.0130 −0.7059
(0.095) (0.099) (0.036) (0.014) (0.136) (0.108) (0.070) (0.479)

Bank fundamentals
Equity ratio −0.0547 −3.1544⁎⁎⁎ 0.0393 −0.2090⁎⁎⁎ 2.6633⁎⁎⁎ −3.9029⁎⁎⁎ −0.2032 1.7436
(0.463) (0.310) (0.214) (0.042) (0.585) (0.364) (0.188) (2.377)
Liquidity ratio −3.4492⁎⁎⁎ −6.7963⁎⁎⁎ 0.2543 −0.0907 −1.0247 −8.7384⁎⁎⁎ −0.6321 −4.4750
(1.289) (1.027) (0.457) (0.162) −1.596 (1.336) (0.882) (6.475)
Deposits ratio 0.8939⁎⁎⁎ −2.4843⁎⁎⁎ −0.0807 0.1819⁎⁎⁎ 1.5668⁎⁎⁎ −2.2107⁎⁎⁎ 0.0607 3.9134⁎
(0.302) (0.223) (0.139) (0.030) (0.365) (0.249) (0.147) (2.160)
Profits ratio −32.1746⁎⁎⁎ −2.2432 −1.2877 −0.8337 −30.0984⁎⁎⁎ −18.3388⁎⁎⁎ 1.1832 94.4120⁎⁎
(10.037) (5.257) (3.184) (0.908) (9.823) (7.024) (3.297) (47.045)

Bank controls
Branch size 0.0009⁎ 0.0026⁎⁎⁎ 0.0000 0.0004⁎⁎⁎ 0.0039⁎⁎⁎ 0.0017⁎⁎⁎ −0.0000 0.0048⁎⁎⁎
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.002)
Bank age −0.2779⁎⁎⁎ 0.0438 −0.0148 −0.0037 −0.3159⁎⁎⁎ −0.2958⁎⁎⁎ −0.0617⁎ 0.1724⁎
(0.062) (0.074) (0.021) (0.007) (0.094) (0.069) (0.036) (0.104)
Bank size 1.1014⁎⁎⁎ −0.3735⁎⁎⁎ 0.0087 −0.0159⁎⁎⁎ 1.1279⁎⁎⁎ −0.1888⁎⁎⁎ 0.0093 −0.2399
(0.038) (0.021) (0.015) (0.004) (0.051) (0.038) (0.018) (0.232)
Time fixed effects Yes Yes Yes Yes Yes Yes Yes Yes
Observations 1040 1039 1038 1070 979 970 970 1040
R2 0.808 0.717 0.034 0.201 0.671 0.461 0.067 0.048

Note: Dependent variables: total SME loans is equal to the natural logarithm of the volume of SME loans. Average SME loans is calculated as the natural logarithm of the ratio volume of
SME loans to the number of SME borrowers. Growth in SME loans is the first difference of the log of SME loans. Share of SME loans is the ratio of SME loans to total bank credits. Total SME
non-performing loans is the natural logarithm of the volume of non-performing SME loans. Average SME non-performing loans is the ratio of non-performing SME loans to the number of
defaulting SME borrowers. Growth SME NPL is the first difference of the log of non-performing SME loans. Share SME non-performing loans is the ratio of non-performing SME loans to
total SME loans. Independent variables: Islamic is a dummy variable that equals to 1 when a bank operates according to Islamic principles, and 0 otherwise. Equity ratio is calculated as the
book value of equity to total assets (lagged). Liquidity ratio is calculated as liquid assets (cash and central bank reserves) to total assets (lagged). Deposits ratio is calculated as deposits to
total assets (lagged). Profits ratio is calculated as bank profits to total assets (lagged).The control vector contains Bank size, Bank age, and Branch size. The Bank size variable is computed as
the natural logarithm of total assets. The Bank size variable is computed as the natural logarithm of total assets (lagged). The Bank age variable is the natural logarithm of quarter-years the
bank exists (lagged). The Branch size variable is the average number of employees per branch (lagged). For time fixed effects, quarter-year dummy variables are included in all specifica-
tions but their coefficient estimates are not reported. Cluster-robust standard errors (to account for both heteroskedasticity and autocorrelation) are in parentheses.
⁎⁎⁎ Significance level at 1%.
⁎⁎ Significance level at 5%.
⁎ Significance level at 10%.

financing, the average financing size they make is smaller, suggesting
that these banks reach a larger pool of borrowers. Further, liquidity
and profitability negatively influence the volumes of SME financing,
but have no significant effect on the shares in financing portfolio.
The Branch size variable, which is measured as the average number
of employees per branch, seems to affect positively SMEs access to fi-
nance (see, e.g., Disli et al., 2013). We find that older Turkish banks
are more reluctant to be engaged with SME financing, which is against
the belief that older banks may have a comparative advantage in the
processing of soft information and specialization in relationship lending
(e.g., Zarutskie, 2013). The bank size variable has a negative influence
on the averages and share of SMEs financing, confirming the predictions
that banks with fewer hierarchical layers are more advantageous in the
collection of soft information useful for financing decision.
of non-performing loans and income from SME financing, but their
portfolio is more risky in relative terms.
Looking at the coefficient estimates of bank controls, we find that
banks with larger branch sizes performed significantly worse in terms
of SME financing portfolio quality (both in absolute and relative
terms). Older banks record lower non-performing financing in absolute
terms, but more relative to the SME financing portfolio. The negative
sign of the coefficient in the growth regression, however, indicates
that older banks' share of non-performing loans is dropping. Larger
banks extend in total more credits to the SME sector, but not in
terms of average loan size. Furthermore, in relative terms, it seems
that larger banks SME loan portfolio is not more risky than their smaller
counterparts.
4. Extensions and robustness

3.2. Banks' processing ability of the SME portfolio
Based on Table 3B, Islamic banks record more non-performing SME
loans both in terms of total as well as per SME borrower. This result is
mainly driven by Islamic banks' larger exposure to the SME sector.
However, column 4 of Table 3B (on the determinants of the relative
share of non-performing SME financing) indicates that Islamic banks' fi-
nancing portfolio quality is on average similar to that of conventional
banks. When we examine the impact of bank characteristics, our result
reveal that capitalized and deposit-funded banks record higher volumes
of non-performing loans, and a higher number of delinquent borrowers.
On the other hand, we find that profitable banks have lower volumes
To verify the robustness of our main results, we (1) extend our anal-
ysis by comparing Islamic banks with different conventional ownership
forms and (2) explore the impact of fixed effects. The results from these
robustness checks are summarized below.
4.1. Islamic versus different conventional bank ownership forms
In the previous section, we compared the SME financing behavior
and processing performance of Islamic banks with those of conventional
banks. However, as noted in the introduction, it is likely that there are
differences in SME financing between ownership categories within the
pool of conventional banks. Therefore, in this section, we compare
192 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194

Table 4
Banks' SME financing and performance – Islamic versus different forms of bank ownership.

Panel A Panel B

SME financing SME non-performing loans

Total Average Growth Share Total Average Growth Share

Bank ownership
Islamic −0.0446 0.9545⁎⁎⁎ 0.0467 −0.0358⁎⁎ −0.1391 0.6264⁎⁎⁎ −0.0183 −0.5242
(0.095) (0.104) (0.041) (0.016) (0.141) (0.111) (0.064) (0.397)
State −0.5853⁎⁎⁎ −0.2635⁎⁎⁎ 0.0399 −0.0730⁎⁎⁎ −0.2867⁎⁎ 0.3705⁎⁎⁎ −0.0208 −0.7574⁎⁎
(0.098) (0.071) (0.028) (0.018) (0.121) (0.079) (0.036) (0.326)
Foreign −1.0835⁎⁎⁎ −0.1169⁎ 0.0025 −0.1419⁎⁎⁎ −0.9531⁎⁎⁎ −0.4911⁎⁎⁎ −0.0465 0.3834⁎
(0.081) (0.061) (0.035) (0.011) (0.133) (0.087) (0.047) (0.204)

Bank fundamentals
Equity ratio −0.5899 −3.1465⁎⁎⁎ 0.0279 −0.2793⁎⁎⁎ 2.1858⁎⁎⁎ −4.2839⁎⁎⁎ −0.2257 2.2486
(0.420) (0.311) (0.204) (0.040) (0.565) (0.358) (0.199) (2.302)
Liquidity ratio −3.4490⁎⁎⁎ −6.8483⁎⁎⁎ 0.2643 −0.0975 −1.6071 −8.9066⁎⁎⁎ −0.6676 −4.7266
(1.163) (1.034) (0.460) (0.163) (1.561) (1.381) (0.892) (6.567)
Deposits ratio 1.6283⁎⁎⁎ −2.3588⁎⁎⁎ −0.0913 0.2805⁎⁎⁎ 2.2988⁎⁎⁎ −1.9679⁎⁎⁎ 0.0977 3.8762⁎
(0.291) (0.224) (0.153) (0.029) (0.364) (0.260) (0.141) (2.124)
Profits ratio −32.2246⁎⁎⁎ −1.8751 −1.3602 −0.8153 −31.8874⁎⁎⁎ −20.4420⁎⁎⁎ 1.1095 96.2377⁎⁎
(8.912) (5.303) (3.196) (0.824) (9.840) (6.997) (3.285) (47.659)

Bank controls
Branch size 0.0008⁎ 0.0025⁎⁎⁎ 0.0000 0.0004⁎⁎⁎ 0.0038⁎⁎⁎ 0.0017⁎⁎⁎ −0.0000 0.0048⁎⁎⁎
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.002)
Bank age −0.3772⁎⁎⁎ 0.0555 −0.0189 −0.0168⁎⁎ −0.4550⁎⁎⁎ −0.4304⁎⁎⁎ −0.0677⁎ 0.3155⁎⁎
(0.066) (0.079) (0.024) (0.007) (0.108) (0.069) (0.038) (0.132)
Bank size 1.0207⁎⁎⁎ −0.3746⁎⁎⁎ 0.0075 −0.0270⁎⁎⁎ 1.0508⁎⁎⁎ −0.2446⁎⁎⁎ 0.0058 −0.1752
(0.033) (0.020) (0.013) (0.003) (0.047) (0.037) (0.017) (0.209)
Time fixed effects Yes Yes Yes Yes Yes Yes Yes Yes
Observations 1040 1039 1038 1070 979 970 970 1040
R2 0.837 0.719 0.035 0.315 0.690 0.488 0.068 0.050

Note: Dependent variables: Total SME loans is equal to the natural logarithm of the volume of SME loans. Average SME loans is calculated as the natural logarithm of the ratio volume of
SME loans to the number of SME borrowers. Growth in SME loans is the first difference of the log of SME loans. Share of SME loans is the ratio of SME loans to total bank credits. Total SME
non-performing loans is the natural logarithm of the volume of non-performing SME loans. Average SME non-performing loans is the natural logarithm of the ratio of non-performing SME
loans to the number of defaulting SME borrowers. Growth SME NPL is the first difference of the log of non-performing SME loans. Share SME non-performing loans is the ratio of non-
performing SME loans to total SME loans. Independent variables: Islamic is a dummy variable that equals to 1 when a bank operates according to Islamic principles, and 0 otherwise.
State is equal to 1 when the bank is predominantly owned by the government, and 0 otherwise. Foreign is equal to 1 when the bank is predominantly owned by non-residents. Private
domestic banks serve as the reference group. Equity ratio is calculated as the book value of equity to total assets (lagged). Liquidity ratio is calculated as liquid assets (cash and central
bank reserves) to total assets (lagged). Deposits ratio is calculated as deposits to total assets (lagged). Profits ratio is calculated as bank profits to total assets (lagged).The control vector
contains Bank size, Bank age, and Branch size. The Bank size variable is computed as the natural logarithm of total assets (lagged). The Bank age variable is the natural logarithm of quarter-
years the bank exists (lagged). The Branch size variable is the average number of employees per branch (lagged). For time fixed effects, quarter-year dummy variables are included in all
specifications but their coefficient estimates are not reported. Cluster-robust standard errors (to account for both heteroskedasticity and autocorrelation) are in parentheses.
⁎⁎⁎ Significance level at 1%.
⁎⁎ Significance level at 5%.
⁎ Significance level at 10%.

Islamic banks' approach toward SMEs with the behavior of different
conventional bank ownership forms. Out of the 36 conventional banks
operating in Turkey, 18 banks are classified as foreign (more than 50%
of their shares are owned by non-residents), 15 banks are domestically
owned commercial banks (more than 50% of their shares are owned by
Turkish residents), and 3 of them are state-owned banks.
Results of these extended models are reported in Table 4, in which
the private domestic banks serve as the reference group. Focusing on
Table 4A, and more precisely on the share regression, our results on
the determinants of banks' willingness to engage in SME financing
reveal that bank ownership is an important driver. Specifically, the re-
sults from the share regression indicate that Islamic banks are financing
more than state-owned and foreign banks, but this is not the case when
compared with domestically owned private banks. The coefficient on
Islamic is −0.0358, which implies that the average Islamic banks' loan
portfolio consists of 3.58% less SME financing than the shares of private
banks. Since the coefficient on Foreign is more negative than others,
foreign banks tend to specialize the least in SME financing (e.g., De
Haas et al., 2010).
Concerning the banks' processing ability of their financing portfolio,
the results in Table 4B suggest that Islamic banks' have similar shares of
non-performing loans as private domestic banks. Surprisingly, after
controlling for bank-specific characteristics, state-owned banks record
the least shares of non-performing loans, while foreign-owned banks
the highest.
4.2. Fixed-effects estimation
Although our previous regressions include a variety of bank funda-
mentals and control variables to isolate the impact of bank type on
small business financing, the estimation results might still suffer from
omitted variables problems. The introduction of bank fixed effects
would capture the different attitudes among banks toward SME financ-
ing. However, in our case, the primary variable of interest (Islamic bank
dummy variable) does not change for Islamic banks during the sample
period. In fact, we face the same problem for state-owned banks.
Hence, the time-invariant nature of the bank type dummies does not
allow us to include bank fixed effects.
In solving this problem, we follow Clarke et al. (2005) and use a two-
step estimation procedure. In the first stage, we regress the parameters
of banks' SME orientation and performance on bank fundamentals, bank
controls, time dummies, and on a dummy variable for each bank
(i.e., bank fixed effects). In the second stage, we use the estimated
fixed effects from the first stage as dependent variables. The explanatory
variables include the dummy variable controlling for bank type (Islamic
vs. conventional) and/or dummy variables controlling for ownership
 A.F. Aysan et al. / Economic Modelling 54 (2016) 187–194 193

Table 5
Fixed effects regressions—second stage.

Total Average Growth Share

Panel A: SME financing

Islamic 1.5878⁎⁎⁎ 1.2633⁎⁎ 0.6173⁎ 0.4914 0.3152⁎⁎ 0.3242⁎ 0.1404⁎⁎⁎ 0.1389⁎⁎⁎
(0.496) (0.601) (0.344) (0.375) (0.119) (0.175) (0.037) (0.045)
State 2.8030⁎⁎⁎ −1.2038⁎⁎⁎ 1.0609⁎⁎⁎ −0.0395
(0.647) (0.385) (0.195) (0.096)
Foreign −1.3826 −0.0784 −0.1775 0.0033
(0.958) (0.462) (0.231) (0.055)
Observations 42 42 42 42 42 42 44 44
R2 0.031 0.194 0.023 0.087 0.018 0.216 0.066 0.071

Panel B: SME non-performing loans

Islamic 0.5799 0.0573 −1.7840⁎⁎⁎ −2.3636⁎⁎⁎ −0.5623⁎⁎⁎ −0.6981⁎⁎⁎ −10.3201⁎⁎⁎ −11.8411⁎⁎⁎
(0.438) (0.467) (0.629) (0.595) (0.183) (0.171) (2.742) (3.329)
State −1.0197 −0.9247⁎ −0.1151 −16.2707⁎⁎⁎
(0.704) (0.546) (0.199) (3.089)
Foreign −1.1254⁎ −1.2925 −0.3494 −0.5615
(0.645) (1.069) (0.330) (5.358)
Observations 40 40 40 40 40 40 42 42
R2 0.011 0.115 0.045 0.100 0.053 0.098 0.044 0.127

Note: Coefficients reported are those from the second stage of a two-step estimation to control for fixed effects of the dependent variables capturing SME lending activities. The dependent
variables in the first stage: Total SME loans is equal to the natural logarithm of the volume of SME loans. Average SME loans is calculated as the natural logarithm of the ratio volume of SME
loans to the number of SME borrowers. Growth in SME loans is the first difference of the log of SME loans. Share of SME loans is the ratio of SME loans to total bank credits. Total SME Total
SME non-performing loans is the natural logarithm of the volume of non-performing SME loans. Average SME non-performing loans is the natural logarithm of the ratio of non-performing
SME loans to the number of defaulting SME borrowers. Growth SME NPL is the first difference of the log of non-performing SME loans. Share SME non-performing loans is the ratio of non-
performing SME loans to total SME loans. The independent variables in the first stage including bank and time fixed effects: Equity ratio is calculated as the book value of equity to total
assets (lagged). Liquidity ratio is calculated as liquid assets (cash and central bank reserves) to total assets (lagged). Deposits ratio is calculated as deposits to total assets (lagged). Profits
ratio is calculated as bank profits to total assets (lagged).The control vector contains Bank size, Bank age, and Branch size. The Bank size variable is computed as the natural logarithm of total
assets (lagged). The Bank age variable is the natural logarithm of quarter-years the bank exists (lagged). The Branch size variable is the average number of employees per branch (lagged).
In the second stage, the fixed effects are regressed on the Islamic bank dummy variable and dummy variables controlling for conventional bank ownership forms. Regressions allow for
cluster-robust standard errors (to account for both heteroskedasticity and autocorrelation) are in parentheses.
⁎⁎⁎ Significance level at 1%.
⁎⁎ Significance level at 5%.
⁎ Significance level at 10%.

forms (state-owned, foreign, and private conventional banks). Results
from the second stage regressions are shown in Table 5. Each dependent
variable is estimated under two model specifications. The first only in-
cludes the Islamic versus conventional bank dummy variable, whereas
the second one contains dummy variables controlling for Islamic
banks and different conventional bank ownership forms.
Although the number of observations significantly dropped corre-
sponding to the number of banks, the results substantially support our
previous findings. Islamic banks report more willingness to finance
small businesses in terms of financing activity.6 In particular, they
extend more SME financing, have a larger average financing size, have
higher SME financing growth rates, and have a higher share of SME fi-
nancing in their financing portfolio. Compared to our previous results,
Islamic banks demonstrate better competence in the management of
non-performing loans: the average volume and the share of non-
performing loans are lower. Furthermore, the growth regressions in
Panel B indicate that the wedge between Islamic and conventional
banks has grown over time.
5. Conclusion and policy implications
Understanding the economic impact of SMEs financing is crucial in
the “second age of small”. While we have demonstrated the viability
of Islamic banking for SMEs in Turkey, more strategic operational ad-
justments are needed to assist Islamic banks to target SMEs more effec-
tively in the case of both Turkey and other countries. These adjustments
include having a dedicated Islamic SME banking strategy and a business
model, broadening financing and non-financing services (e.g., cash
management, payroll management, trade finance, payments, and Inter-
net banking), a new Islamic SME banking model (e.g., banking
6
Depending on the availability of data, the number of observations can increase until 44
because we adjust our data structure for mergers and acquisitions by generating a new
bank after tracing such events.
correspondents and SME-specific branches in key SME clusters), better
risk assessment and in-house expertise for Islamic SME finance, adviso-
ry services (financial modeling, future planning and forecasting, and
rules and regulations), and streamlining financing application processes
(IFC, 2014). Industry infrastructure, such as credit bureau and innova-
tive idea incubators, is also important to promote SME financing
(CIBAFI, 2015).
As Islamic finance can play an important role in closing the financing
gap for SMEs, policy makers and stakeholders should promote risk-
sharing financial instruments and develop an enabling environment
for risk-sharing to thrive. Islamic finance also needs to contribute to
the broader global agenda to improve the SME financing landscape
(World Bank-Islamic Development Bank, 2015). Lessons and best
practices from more country studies that support financing of “small
as the new big” would complement this important case for action.
Acknowledgments
We gratefully acknowledge the helpful comments and suggestions
of Paresh Narayan (editor), Meryem Duygun, Shaheed Ebrahim, Iftekhar
Hasan, Mansor Ibrahim, Phil Molyneux, Koen Schoors, and Mohamed
Shaban, research fellows at Oxford Centre for Islamic Studies (OCIS)
and participants of the G20 Global Islamic Finance Conference, Istanbul,
September 1, 2015.
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