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Western EuropeJune 22 2022

Lenders challenged by Turkish central bank’s new rules

In the choppy waters of the Turkish economy, where soaring inflation and exchange rate volatility are a growing menace, the country’s banks are facing a new complication: a wave of regulation. James King reports.
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Lenders challenged by Turkish central bank’s new rules

Since the start of June, the Turkish central bank has imposed a slew of new rules on the banking system in an effort to tighten interest rates and shore up the lira. This expanding regulatory horizon has the potential to stimulate new, long-term challenges for some lenders at a time when the macroeconomic environment is deteriorating quickly.

On June 10, the Central Bank of the Republic of Türkiye announced plans to double the reserve requirement ratio for lira-denominated commercial cash loans from 10% to 20%, following the imposition of the initial 10% requirement in April. This move was accompanied by a rule to increase the weight of Turkish lira fixed-rate securities in the central bank’s collateral pool, in exchange for maintaining foreign currency deposits, to be enforced from June 24.

Collectively, these measures reflect the authorities’ efforts to stabilise the economy without turning to conventional monetary policy tools. Since president Recep Tayyip Erdoğan proclaimed a new economic model in 2021, which emphasises investment, production and exports, monetary policy has been constrained to favour looser conditions, despite sky-high inflation and the tumbling value of the lira.

Rising pressures

“The different set of [banking sector] policy measures introduced over the past few weeks have to be understood in the context of trying to address rising pressures on the economy without hiking interest rates,” says Erich Arispe Morales, senior director with Fitch Ratings. “These pressures include high inflation and a wider current account deficit leading to a weaker lira and, in turn, putting pressure on international reserves.”

But in the first half of 2022, the war in Ukraine and tightening financial conditions have multiplied the pressures facing the Turkish economy. The country’s consumer price index hit a 23-year high of 73.5% in May, while the value of the lira had fallen 23% in the year to June, following a 44% drop in 2021.

“The world has changed,” says Mr Morales. “We have a war and also a much more aggressive tightening of global financing conditions. And what has happened is that the Turkish government has not altered its policy direction or priorities in response to these pressures.”

Impact on banks

As a result, the central bank is now pursuing its broader policy objectives via the regulation of the banking sector. This approach, however, is generating a new set of difficulties for the country’s banks, which could potentially impact their performance over the long term.

“Overall, what we can say is that there are significant downside risks facing the banking sector. From a macro perspective, this includes volatility in the exchange rate, high inflation and new regulatory requirements, which the banks are having to navigate and have implications for banks’ credit profiles,” says Lindsey Liddell, head of Turkish bank ratings at Fitch Ratings.

Overall, what we can say is that there are significant downside risks facing the banking sector

Erich Arispe Morales

For instance, the central bank’s requirement that domestic lenders hold local government bonds against eligible foreign exchange (FX) deposits could create an asset and liability mismatch on their balance sheets over time.

“The collateral that banks are now having to post in the form of lira long-term government debt against their eligible FX liabilities is a challenge. Banks could earn higher interest on lira loans, while from an asset and liability management perspective, it will also mean that they are holding long-term fixed rate Turkish lira government debt when they are predominantly short-term funded,” says Ms Lidell.

Yet, according to Ms Liddell, the mismatch will in part be moderated by the small size of the reserve requirements in relation to total liabilities. Even so, it represents an added complication for the country’s banks as uncertainty over the macroeconomic outlook grows.

For now, however, most Turkish banks are being lifted by a recent surge in profits, linked in part to the fact that many lenders have switched to consumer price inflation-indexed bonds over the past few years, while widening net interest margins and higher loan growth have also helped. This means that the full effect of the latest regulatory changes will not be felt for some time.

“When you’re looking at these latest regulations, you have to view them in the context of where the banks have been coming from in terms of profitability and performance, with strong returns year to date buoyed by the inflationary environment,” says Ms Liddell. “It will take some time for the full impact of these regulatory changes to be felt across the banking system.”

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Read more about:  Regulations , Western Europe , Turkey