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WorldOctober 1 2013

Turkish banks face a genuine stress test

Having enjoyed a highly profitable first half of the year, Turkish banks are now having to change strategy due to US monetary policy and turbulence closer to home.
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Turkish banks face a genuine stress test

It has become something of a mantra that the Turkish banking sector has been so well managed and regulated over the past decade that it managed to sail through the successive global economic and eurozone crises that have sent banks tumbling across the Western world. Not only had the adverse effects of this time been limited, but indeed Turkish banks were a picture of rude health; enjoying growing profits and an expanding customer base.

As recently as the first six months of this year, the sector boasted a healthy bottom line, reporting half-year profits of Tl13.9bn ($6.96bn), up 16.4% on the same period in 2012. Those figures include healthy profit rises for Turkey's big players, with Isbank posting half-yearly profits of Tl1.9bn (up 14.5%), Garanti reporting Tl1.8bn (up 19.6%), Akbank  Tl1.7bn (up 63.4%) and TEB and Yapi Kredi reporting profit rises of 38.5% and 35.2%, respectively.

The news from the untraded state banks Ziraat and Vakif was equally positive, with the former posting profits of Tl1.7bn (up 41%) for the first half of the year and the latter Tl905m (up 28.5%). Other sector indicators are no less encouraging, with the sector's total asset size increasing Tl157bn to Tl1528bn over the first half of the year, and the ratio of non-performing loans (NPLs) falling from 2.9% at the end of last year to 2.8% by June.

Liquidity squeeze

But as ever in Turkey, such a picture of health and profitability can be easily disturbed both by external factors and by Turkey's own internal problems, and can have significant effects on strategy.

The announcement by the US Federal Reserve in May that it would begin 'tapering' its bond purchases may not have been entirely unexpected, but any end to quantitative easing would hit Turkey harder than some countries.

"Turkey was a key beneficiary of the cheap ample liquidity," says Simon Nellis, bank equity analyst for central and eastern Europe, Middle East and Africa at Citi. "The question is whether this is just a natural cycle where risk has to be repriced or whether we are going to have a liquidity crisis." He adds that, with the Turkish lira having dropped close to 15% during August and September this year, and interest rates climbing, the Turkish economy is not in as great shape as it was prior to the global economic crisis.

At the same time, Turkey has faced a more unexpected challenge in the form of the civil unrest that hit the country during June and more sporadically since. This situation continues to affect the banking sector, both directly and indirectly.

Interest rate rhetoric

Turkish prime minister Tayyip Erdogan chose to blame the protests on, among others, a previously unknown body he dubbed "the interest rate lobby", which he claimed wanted to profit by forcing a rise in Turkish interest rates, which were at the time at a historic low.

This comment was clearly political rhetoric, primarily aimed at Mr Erdogan’s core Islamist electorate, which recognises interest rates only as proscribed in Islam. But Mr Erdogan's accusation was repeated by several senior ministers. Bankers wonder if it also increased the initial reluctance of Turkey's central bank to raise its rates, even when the lira subsequently came under strong pressure in the wake of the Fed’s announcement.

This impression was reinforced in July, when Mr Erdogan publicly criticised the high interest rates and commissions charged by credit card issuers. This in turn raised concerns over the direction of government policy towards the banking sector, especially when tighter regulations were announced for credit cards.

Reputational risks

More worryingly, perhaps, the unrest also spread the perception of partisan leanings on the part of some bank-owning holding companies. Dogus Holding, which owns Garanti Bank, was widely criticised in anti-government circles after its television news channels failed to mention the erupting protests for several days after they had started.

Unusually, and somewhat bravely, Garanti chief executive Ergun Ozen responded to reports that supporters of the protests were closing accounts at Garanti by meeting with one group and expressing sympathy with the protests. This move may have helped his bank retain some of its customers, but it also earned him criticism from government officials.

More pointed criticisms were levelled at Koc Holding (which owns Yapi Kredi Bank) for allegedly supporting the protests – accusations that Koc group chairman Mustafa Koc finally denied in mid-September. And, of course, Isbank remains in a delicate position, with 28.09% of its equity held by Turkey's main opposition, the Republican Peoples' Party. The party has repeatedly been accused by the government of inciting the protests.

"It is a worry for foreign investors that the relationship between the government and the banks has become somewhat more tense," says Mr Nellis. But he tempers this concern, noting that it is difficult to know the extent of any tensions that may exist.

However, of the new credit card regulations, he is actually relatively favourable and seeks to dispel alarm. A planned new consumer protection law had long been expected to herald changes aimed at protecting consumers, and so is not necessarily politically motivated.

"Consumer credit has been growing very rapidly – a concern that has been voiced by the central bank," says Mr Nellis. Given the role excess leverage played in the global economic crisis, he believes the new regulations can be viewed positively.

Changing speed

Given such tricky operating conditions, it is no surprise analysts are warning that Turkish banks face a difficult year ahead, and will need to adopt new strategies to maintain profits and growth. Recep Demir, banking analyst at Garanti’s brokerage arm, says part of the problem is that the stellar results of the first half of the year were to some extent caused by a temporary phenomenon. "In the Turkish banking sector, 70% of external funding comes from deposits, which means margins are highly sensitive to deposit rate changes," he says.

Deposit rates plunged from 8% or 9% at the start of the year to about 6% by May, causing a spread widening during the six to 12 months that assets take to reprice. That left banks sitting on much higher net interest margins in the first half of the year.

At the same time, banks enjoyed considerable capital appreciation on fixed-income holdings as interest rates dropped. They even earned a windfall in the shape of commissions charged when mortgage holders exercised their right to rearrange mortgages to take advantage of lower interest rates on offer.

Now, however, with deposit rates rising again, banks face the challenge of declining profitability on their loan products over the next two to four quarters. And a highly competitive market in Turkey means it is harder to pass on higher interest rates to borrowers.

"Margins on new products are contracting because of the duration gap, so the loan market is not absorbing what is happening in the deposit market," says Can Demir (no relation to Recip), Turkish banking analyst at investment bank Renaissance Capital in Istanbul.

According to Mr Demir, this mismatch, coupled with new regulatory caps on retail and commercial overdraft products and credit cards, have caused banks to refocus their strategies. "The problem with the banking business in general is that you have to defend market share. If you do not do so, then the cost can be worse even than lower profitability," he says.

Seeking new business

With Turkey still widely held to be underbanked in terms of population coverage, one strategy banks could adopt is to attract new customers. "There is still a market to expand into,” says Mr Demir at Renaissance. “Penetration of mortgages and loans is not very high."

But he cautions that the rewards of expanding into underbanked regions may not be high. A high proportion of total Turkish economic wealth and output is located in Istanbul. There may be opportunities in the south and east of Turkey, but the profitability of operating there could be marginal.

Instead, he says banks are refocusing their attentions on their more profitable clients and on the still buoyant small and medium-sized enterprise (SME) loan market. In contrast with most of Europe, the Turkish economy continues to enjoy healthy growth. Gross domestic product rose 4.4% in the second quarter of 2013, exceeding the 3.5% anticipated, and is expected to come close to 4% for the year, with official estimates claiming 5% in 2014. "If this growth is realised, there will be demand for SME loans," says Mr Demir at Garanti.

In such a climate, SMEs need ready access to credit. But data suggests there is room to improve the availability of lending to SMEs. Since 2007, the portion of total bank loans extended to SMEs fell from 28% to 25%, and that of export loans (most of which are to SMEs) fell from 10% to 5%. Turkey's banking regulator, BDDK, recently cut the general provision requirement for SME loans from 1% to 0.5% and on export loans from 1% to zero, in the hope of stimulating this economically vital segment.

Key to the success of banks expanding their SME loan portfolios is providing funding and maintaining asset quality, according to Mr Demir at Garanti. At the same time, the fact that about 40% of corporate and commercial loans are foreign exchange-based itself presents a significant risk given the recent 15% depreciation in the value of the lira and fears the currency may slide further. "Lira depreciation puts a higher burden on the borrower and increases assets quality risk," he says.

It also affects funding costs for the banks. While Turkish banks normally have no problem rolling over their syndicated foreign currency loans, Garanti's Mr Demir points out that if funding costs increase greatly, banks could lose their appetite for expanding their loan portfolios. And what happens to funding costs, he points out, depends largely on forthcoming moves by the Fed. "If there is a huge outflow from emerging markets, there is not much anyone in Turkey can do," he cautions.

Curbing cards

Fed policy changes aside, the most significant change to affect the Turkish banking sector this year has been the newly introduced regulations governing credit cards. According to BDDK, the changes reflect the need to address a rapid increase in credit card use. The regulator cites a 43% increase in credit card receivables since the start of 2012, of which 84% was credit card instalment payments. At the same time, the share of credit card receivables among NPLs has risen to 46% by June this year.

In response, the regulator has increased the risk-weightings on cards that offer instalment payments, which means banks must hold higher capital against credit card receivables. BDDK also increased the general provision requirement and the minimum payment requirement, while linking the latter to the cardholder's income, as well as lowering the cap on credit card loans. While the changes will not adversely affect cardholders, they do curb the profitability of the card business.

"The logic is to curb credit card lending, but the normal way to do that would be to increase the rates and charges to disincentivise borrowing. Instead, what they have done is to curb the profitability of the banks in this business," says one analyst.

He believes that one possible result could be that banks allocate less capital to their card business and open fewer lines of credit. That strategy, though, has its limits. Banks are effectively stuck between a rock and a hard place, being forced to choose between allocating funds to a low profit business with potential asset quality issues or surrendering market share in what has been a very profitable business, and may yet be again.

"Introducing restrictions to hold back excess consumer credit growth can be viewed as positive. I just hope that they will relax those restrictions again if needed," says Mr Nellis.

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Read more about:  Western Europe , Turkey