Carmen Valache in Istanbul -

A investment magnet since 2005, the Turkish banking sector has been hit by a perfect storm of external pressures this year, which include the tanking of the Turkish lira, weak exports, low consumer and investor confidence, a high reliance on external financing, and a worrisome political and security situation in the country.

But bright days are still ahead for Turkish banks, according to rating agency Fitch, which at its annual conference in Istanbul on October 22 sought to put the sector into perspective, highlighting its solid foundations, while acknowledging its vulnerabilities.

The news on October 27 that Garanti Bank, Turkey's third largest bank by assets and an investor darling, posted weak margins for the third quarter, with profits halving year-on-year (y/y) to €160.3mn, did little to restore confidence in the banking sector's profitability, just a few days before Turks are due to vote in fresh elections that are expected to result in another hung parliament. Other large banks, like Akbank and Yapi Kredi Bank, Turkey's second and fifth largest banks by assets respectively, also posted weak net profits for July-September, with y/y declines of 12% and 35%.

Declining margins are just one of the challenges that Turkey's banking sector, the second largest in Emerging Europe after Russia's with an estimated $833bn in assets, is facing. Some hurdles, like the sector's high dependence on external financing that helps Turkey fund its stubbornly high current account deficit, are old, structural and persistent. Others, like the depreciation of the Turkish lira in the last year, political uncertainty, security concerns, slowing economic growth, and an expected interest rate hike by the US Federal Reserve, to which Turkish banks are highly susceptible, are new and largely out of their control.

But while it might seem that bad news is coming at Turkish banks from all sides these days, things are not that grim – at least not according to rating agency Fitch. The Turkish banking sector continues to run on strong fundamentals and the country has many virtues, such as its unwavering fiscal discipline and low debt/GDP ratio, the rating agency said.

“The vulnerabilities of the Turkish banking sector have been there for a long time, and the country and its banks have proven to be resilient in the past. Turkey has ridden waves of rough economic patches, with high external financing needs in the past,” Paul Gamble, senior director of the sovereign group at Fitch, told the audience gathered at the rating agency's yearly conference in Istanbul on October 22.

Gamble and Lindsey Liddell, Fitch's director of financial institutions for Turkey, were of the same mind in that, while Turkish banks rely on large amounts of external financing, a lot of which is short term, they have been able to access capital and timely repay debt in tougher times. “Fitch's best case expectation is that external funding markets will remain open for Turkish banks, as they have been throughout the last six years,” Liddell said.

The picture painted by the foreign analysts at the Fitch conference was clearly rosier than many in the largely Turkish audience expected to hear. Perhaps the moment that best encapsulated this mismatch between the analysts and the audience took place during a Q&A session, when one attendee told Gamble: “You said that the political uncertainty and security situation are not dire enough for Fitch to take any rating actions on Turkey. You are aware that the country just experienced its worst terrorist attack two weeks ago, when 100 people died. What does it take for Fitch to consider the security situation in Turkey a threat to the country's economy and its investment-grade rating?”  

As the question reflects, Turks are scared, which is affecting confidence in the banking sector, in the national currency and in the economy, But whether this sentiment will persist past the November 1 snap election largely depends on the result and the ability of the winning party or parties to form a stable government.

Meanwhile, a pragmatic look at the Turkish banking sector shows obvious vulnerabilities and a weaker performance this year, but a reasonable performance and strong fundamentals nevertheless.

Turkish banking in numbers

The Turkish banking sector has already undergone one major crisis in the 21st century, and came out of it stronger, leaner and better governed. The crisis took place in 2001, and took down 11 banks, digging a $39bn hole in Turkey's budget that year. The stock exchange plummeted by 14% on February 21, 2001, with the interbank rates skyrocketing to 8,000%. Almost a third of banking sector employees lost their jobs that year.

But a sector overhaul under the watchful eyes of the Banking Regulation and Supervision Agency (BDDK), and the fiscal discipline of the first Justice and Development Party (AKP) government of Recep Tayyip Erdogan helped the banking sector and the economy back to its feet by 2005, and left the former well prepared to deal with subsequent crises, such as the 2008 global financial crisis.

However, 2015 has brought a new series of challenges for Turkey's 47 banks; the Turkish lira has fallen by 30% against the dollar since January; economic growth has slowed to a forecasted 2.8% in 2015, down from 4.1% in 2013; elections in June failed to produce a government; and the deteriorating security situation in Turkey - the surge in refugees from Syria, a series of terrorist attacks that culminated with the October 9 one in Ankara, and the renewed the conflict with the militant Kurdistan Workers' Party (PKK) have eroded consumer and investor confidence.

Over the last 18 months, Turks have taken out $20bn worth of Turkish lira-denominated savings and turned them into dollars, forcing banks to pay astronomical interest rates for Turkish lira deposits – 11% for three-month term deposits in October, according to Bloomberg. Over 45% of Turkish savings are now in foreign currencies, and 90% of the $168bn worth of lira-denominated deposits in June were short term, according to the BDDK.

That said, Turkish banks remain highly capitalised, with a 55% deposit/asset ratio and a 115% loan/deposit ratio in June; asset quality remains good, with a 2.9% rate of non-performing loans (NPL); and the sector continues to have good growth prospects thanks in part to the large proportion of the unbanked population.

The sector is dominated by five large banks: Is Bank ($72bn in assets), Ziraat Bank ($68bn), Garanti Bank ($64.3bn), Akbank ($60bn) and Yapi Kredi Bank ($46.4bn), which account for over a third of banking assets between them, and pose a great deal of competition to new market entrants. The sector has been on a consolidation trend this year, with some foreign banks – HSBC and Citigroup – selling off their subsidiaries in Turkey.

Meanwhile, multilateral lenders like the European Bank for Reconstruction and Development (EBRD) and the International Financial Corporation (IFC) are looking to harness the sector's growth potential,having recently acquired a 19.9% stake in one of the smallest banks, Fibabanka. As are other multinational banking groups, such as Spain's Banco Bilbao de Vizcaya Argentaria (BBVA), which increased its share in Garanti Bank by 15% last November, bringing its total stake in the publicly listed lender to 40%.

Like in the rest of the economy, Turkey's banking sector is subject to political interference. Bank Asya, the country's largest Islamic lender, with the strongest financial standing in the Turkish banking sector as measured by its Tier 1 capital ratio (17.6%), in February was taken over by the Savings Deposit Insurance Fund (TMSF), the body that guarantees bank deposits. This following a year-long smear campaign by the ruling Justice and Development Party (AKP) and other government allies over its ownership that resulted in public institutions and state-owned companies removing deposits held at the bank. Bank Asya's majority shareholder was billionaire preacher Fetullah Gulen, a former ally of Erdogan's who fell out with the then prime minister in December 2013. However, the publicly listed bank also has foreign minority shareholders, and Ankara's move to take over such a lender did little to boost investor confidence in the Turkish banking sector.

Fitch's take

Despite the aforementioned risks on bank asset quality and foreign exchange liquidity this year, Fitch's Liddell considers Turkish banks to have “credit profiles as still commensurate with investment grade ratings and stable outlooks” and their “financial metrics – profitability, asset quality, capitalisation, and liquidity, for the sector in aggregate, and at the major banks – as still reasonable”.

Sector return on equity (ROE) increased slightly to 12% in January-June, but has fallen gradually from 18% in 2010. Margins have contracted due to competition, regulation and rate volatility, but remain reasonable at 3.9%. Loan growth has slowed to 13% in January-June, down from 19% a year ago. Regulatory curbs on retail lending, which accounted for 27% of sector loans, have prompted banks to refocus portfolios on corporate and lending to small and medium-sized enterprises (SMEs). Meanwhile, project financing is on the rise, particularly for the energy and construction sectors, a trend supported largely by the big banks.

Furthermore, the asset quality metrics remain high – a moderate NPL ratio of 2.9%, adequate reserve coverage at 74%, and low net NPL/equity ratio (4.5%). And while the rating agency expects Turkish banks to face some losses on their foreign currency-denominated loans, “the corporate sector's foreign exchange exposure is not quite as bad as sometimes suggested”.

The red flag, however, is the banks' large dependence on external funding, as the loan/deposit ratio increased to 123% in January-June, compared with 100% at the end of 2011.

Summarising Fitch's take on the state of the Turkish banking sector, James Watson, managing director of financial institutions, told bne Intellinews in an interview that: “In our view, there are two major systemic risks for Turkish banks, relating to asset quality and external debt. With regard to the former, we expect banks’ loan losses to increase... but these losses should be manageable relative to banks’ pre-impairment profits and capital. As regards the latter, Turkish banks are exposed to negative changes in investor sentiment because of their large volumes of short-term foreign borrowings. However, our base case scenario is that the banks will continue to enjoy good market access, and they can also accumulate significant foreign currency liquidity, if needed, from placements with the Central Bank and maturing foreign exchange swaps.”

As for the November 1 election, Ozgur Altug, chief economist at brokerage firm BGC Partners, believes that it needs to deliver a “reform-oriented and pro-business government that will push for structural reforms, get rid of instability and solve the security problems facing the country.”