Moody's Investors Service is maintaining its negative outlook on Turkey's banking industry, reflecting its expectation of weakening financials over the next 12-18 months amid a challenging operating environment, the rating agency said on May 3.

Although Turkish banks' financials remained resilient across 2016 and early 2017, Moody's expects a combination of factors, including domestic political and geopolitical tensions, potential currency depreciation, and weakening investor confidence to take a toll going forward.

Moody's anticipates that economic growth in Turkey will slow to an average of 2.8% in 2016-2018. Although asset quality has so far held up, aided by non-performing loan sales and regulatory forbearance, the rating agency expects the challenging macro environment to drive problem loans to above 4% over the next 12-18 months from 3.2% at end-2016.

Turkish banks’ profitability will likely decline due to higher funding and FX hedging costs, slower lending growth and higher loan-loss provisions, according to Moody’s. “Capital will likely remain sound, however,” it said.

Despite political uncertainties, geopolitical risks and the slowing economy, the Turkish banking industry’s combined net income increased 65% y/y to TRY13.5bn (€3.5bn) in Q1 while the capital adequacy ratio rose to 16.05% as of end-March from 15.91% a month ago, according to the latest data from banking watchdog BDDK.

The Turkish government's capacity to support the banking system if needed is diminishing, in Moody's view. The central bank's net FX reserves of $34bn as of January were modest compared to short-term bank wholesale maturities of almost $80bn, according to the rating agency.

The combination of a polarised electorate, a turbulent geopolitical backdrop, ongoing uncertainty in policy and large external financing requirements suggests that Turkey's vulnerability to shocks continues to weigh on the country's creditworthiness, Moody’s previously said in a report published on April 19 after the April 16 referendum on bringing in an executive presidency.

Last month, Moody’s followed up with action on 17 Turkish banks after cutting Turkey’s rating outlook to negative from stable. The long-term debt and deposit ratings of 14 banks were affirmed and their outlook was changed to negative from stable. The ratings of one additional bank were downgraded with a negative outlook, while the ratings of two other banks were affirmed with outlooks unchanged.