Fitch Ratings has downgraded the Long-Term Foreign-Currency Issuer Default Ratings (LTFC IDRs) of 20 Turkish banks and their subsidiaries, the rating agency announced on October 1. The outlooks were given as negative.

Fitch also downgraded the Viability Ratings (VRs) of 12 banks.

The Erdogan administration is tackling a Turkish lira (TRY) devaluation crisis which analysts consider could still spark a banking crisis.

The downgrades of the banks' VRs reflected increased risks to their stand-alone credit profiles. In Fitch's view, the banks' performance, asset quality, capitalisation and liquidity and funding profiles are now more likely to come under pressure as a result of the further depreciation of the Turkish lira (by around 20% against the USD since the last rating review on July 20), the spike in interest rates (driven by the increase in the policy rate to 24% from 17.75% on September 13) and the weaker growth outlook.

Fitch revised its forecasts for GDP growth downwards to 3.8% in 2018 and 1.2% in 2019.

The rating agency also observed that near-term pressure on the banks' ratings has moderated as a result of the orthodox monetary policy response that was eventually seen in Turkey, the stabilisation of the lira exchange rate, recent evidence of external market access - albeit at a higher cost - and the absence of significant deposit outflows since mid-August.

The downgrades of foreign-owned banks' LTFC IDRs to 'BB-' from 'BB', one notch below the sovereign rating, reflected Fitch’s revised assessment of the risk of a marked deterioration in Turkey's external finances, and therefore of the risk of government intervention in the banking sector. Fitch now views the risk of restrictions that would prevent banks from servicing their obligations to be slightly higher than that of a sovereign default.

The downgrades and revisions of the LTFC IDRs and Support Rating Floors (SRFs) of state-owned commercial banks, state-owned Vakif Katilim Bankasi and the private development bank Turkiye Sinai Kalkinma Bankasi (TSKB) to 'B+' from 'BB-' reflected Fitch's view of greater risks to the ability of the Turkish authorities to provide support in foreign currency given the increased potential for stress in the country's external finances.

The affirmation of the LTFC IDRs and SRFs of two state-owned development banks, Turk Eximbank and Turkiye Kalkinma Bankasi (TKB), at 'BB-' and 'BB', respectively, reflected the banks' ownership, policy roles and, in the case of TKB, almost entirely Treasury-guaranteed funding base.

Fitch plans to resolve the outstanding Rating Watch Negatives (RWNs) on the VRs of smaller foreign-owned and participation banks at a further review in the coming weeks.

High-risk operating environment
The 'b+' VRs of Ziraat Bankasi, Halkbank, Vakifbank, TSKB, Akbank, Garanti Bankasi, Yapi Kredi Bankasi, Isbank, Turk Ekonomi Bankasi (TEB), ING Bank Turkey, QNB Finansbank and Denizbank reflected their exposure to the high-risk Turkish operating environment. They also reflected, to varying degrees, the banks' solid franchises, and in most cases records of stable and sound performance and moderate non-performing loans (NPLs).

The banks' risk profiles have deteriorated significantly as a result of local-currency depreciation and higher interest rates, which have, and will continue to, put pressure on asset quality, margins and capitalisation. In addition, there is a material risk of a reduction in access to foreign funding markets, and of volatility in deposit levels, resulting in heightened refinancing and liquidity pressures. Risks to financial stability remain significant, given potential unpredictability in the policy framework and Turkey's large external financing requirements.

Asset-quality risks for banks have increased given the weaker growth outlook, generally high foreign currency lending (equal to about 45% of sector loans as of mid-September 2018, up from 39% at end-1H18 due to the impact of local-currency depreciation) and the potential impact of depreciation on often weakly hedged borrowers' abilities to service their debts. Significantly higher interest rates following the increase in the policy rate are likely to negatively affect lira borrowers' debt service capacity, and also weigh on loan performance. Exposures to the construction and energy sectors and high borrower concentrations are also significant sources of risks at many banks.

The banks' reported NPL ratios have remained broadly stable in recent quarters and at manageable levels. The sector NPL ratio (loans overdue by 90+ days; unconsolidated basis) was a still moderate 3% as of mid-September 2018. However, NPLs have grown in absolute terms and the emergence of some big-ticket problematic exposures, growth in Stage 2 loans (partly explained by banks' transition to IFRS 9 in 1Q18) and the loan restructuring framework agreement being implemented in Turkey suggest the potential for NPL increases. Reserves coverage of NPLs is reasonable, but taking into account Stage 2 loans - which averaged 8% at the larger banks in the sector at end-1H18 - is significantly weaker.

Profitability expected to weaken
Fitch expects sector profitability to weaken in 2019 due to higher funding costs following the increase in the policy rate, slower credit growth and higher impairment charges. Performance could deteriorate significantly in the case of a marked weakening of asset quality.

FY18 performance should remain reasonable, notwithstanding slower growth in 2H18, supported by a strong performance in 7M18 (return on average equity of 15.6%), loan repricing, expected gains on CPI-linked securities at some banks and some flexibility in impairment recognition and provisioning.

Capital ratios have come under pressure from lira depreciation (which inflates FC risk-weighted assets) and higher interest rates (which result in negative revaluations of government bond portfolios). Potential asset-quality deterioration also represents a risk to capital positions. Pre-impairment profit (7M18 annualised: equal to about 5% of average sector loans) provides a moderate buffer to absorb losses through income statements, although this is likely to fall as a result of tighter margins. A number of banks also hold small amounts of free provisions.

The sector's average total capital ratio (on a solo basis) was 16.1% at end-July 2018, comfortably above the 12% recommended regulatory minimum. This was down only moderately from 16.9% at end-2017 as solid internal capital generation and the hedge offered by FC Tier 2 instruments have partially offset the impact of a weaker lira and higher rates. However, further sharp lira depreciation, and the interest-rate hike in August 2018, will have eroded banks' capital positions further. Nonetheless, forbearance measures introduced by the Banking Regulation and Supervision Authority to alleviate the impact on reported regulatory capital metrics reduce the risk of regulatory capital breaches, in Fitch's view.

Refinancing risks for the banks remain high given the sector's significant short-term maturing FC wholesale funding liabilities, and in light of the recent heightened market volatility and tightening global financing conditions (driven mainly by an increase in dollar interest rates). Banks typically have access to sufficient FC liquidity (comprising mainly cash and interbank placements, FC reserves held under the reserve option mechanism (ROM) and FC swaps) to cover their FC wholesale funding liabilities maturing with a year, mitigating the refinancing risk. Refinancing risks are less pronounced at most foreign-owned banks, given potential FC liquidity support from shareholders.

Fitch considers recent monetary policy action, along with Akbank's latest $980mn syndicated loan rollover (albeit at a significantly higher cost), to be mildly positive for investor sentiment. Nevertheless, FC wholesale funding rollover rates could decline given the weaker growth outlook, subdued investor sentiment and the rise in funding costs.

The sector loans/deposit ratio was a high 132% as of mid-September, and banks' external debt was $183bn at end-1H18, of which $102bn was to mature within 12 months. However, as some of the latter represents more stable funding (for example, from parent banks, subsidiary banks or offshore Turkish corporate entities), Fitch estimated banks' external debt servicing requirement over one year, in the case of a complete market shutdown, at about $50bn-$55bn.

Available FC liquidity of approximately $86bn (comprising mainly FC placed with the central bank under the ROM and short-term currency swaps with foreign counterparties) provides solid coverage of the banks' potential refinancing requirement. However, a scenario in which Turkish borrowers have to pay down foreign debt would result in a reduction in central bank's foreign-exchange reserves and add to pressures on the exchange rate, interest rates and economic growth. In addition, outflows of FC deposits, which fell by $12nn or 6% in July-August 2018, represent a further potential risk to banks' liquidity positions.

The RWN on Halkbank's VR reflects Fitch's view of a still material risk of the bank becoming subject to a fine or other punitive measures as a result of the US investigation, which resulted in the conviction of one of its deputy general managers for the violation of US sanctions directed at Iran. Such measures could materially weaken solvency, increase refinancing risks or negatively affect other aspects of the bank's credit profile.

The list of rating actions:

Akbank T.A.S (LTFC IDR: 'B+'/Negative)

Turkiye Is Bankasi A.S. (LTFC IDR: 'B+'/Negative)

T.C. Ziraat Bankasi A.S. (LTFC: IDR 'B+'/Negative)

Turkiye Halk Bankasi A.S. (LTFC: IDR 'B+'/Negative)

Turkiye Vakiflar Bankasi T.A.O (LTFC: IDR 'B+'/Negative)

Vakif Katilim Bankasi AS (LTFC IDR: 'B+'/Negative)

Turkiye Sinai Kalkinma Bankasi A.S. (LTFC: IDR 'B+'/Negative)

Turkiye Ihracat Kredi Bankasi A.S. (LTFC: IDR 'BB-'/Negative)

Turkiye Kalkinma Bankasi A.S. (LTFC: IDR 'BB'/Negative)

Turkiye Garanti Bankasi A.S. (LTFC IDR: 'BB-'/Negative)

Yapi ve Kredi Bankasi A.S. (LTFC IDR: 'BB-'/Negative)

Turk Ekonomi Bankasi A.S. (LTFC IDR: 'BB-'/Negative)

QNB Finansbank A.S. (LTFC IDR: 'BB-' /Negative)

ING Bank A.S. (LTFC IDR: 'BB-'/Negative)

Kuveyt Turk Katilim Bankasi A.S (Kuveyt Turk; LTFC IDR: 'BB-'/Negative)

Alternatifbank A.S. (Alternatifbank; LTFC IDR: 'BB-'/Negative)

Turkiye Finans Katilim Bankasi A.S. (TFKB; LTFC IDR: 'BB-'/Negative)

Burgan Bank A.S. (Burgan Bank Turkey; LTFC IDR: 'BB-'/Negative)

ICBC Turkey Bank A.S. (LTFC IDR: 'BB-'/Negative)

BankPozitif Kredi ve Kalkinma Bankasi A.S. (LTFC IDR: 'BB-'/Negative)

Denizbank A.S. (LTFC IDR: 'BB-'/Negative)