Challenging Environment For Banks In 2014

BMI View: Slowing real GDP growth, higher funding costs and lira depreciation will have a negative impact on growth and profitability in the Turkish banking sector, where we expect both supply and demand-side constraints to drive a pronounced deceleration in lending in 2014. We forecast client loan growth of 14.0%, down from 33.6% in 2013.

Rising US yields and waning demand for emerging market assets led to severe disruptions in Turkish financial markets in H213 and early 2014, forcing the Central Bank of Turkey (CBRT) to more than double its main policy rate in January, from 4.5% to 10.0%. After record-low interest rates and accelerating real GDP growth drove a rapid expansion of credit in 2013, we now expect weakening domestic demand, rising funding costs and political instability to make for a challenging operating environment for Turkish banks.

While relatively robust capital adequacy levels and low exposure to non-performing loans imply few inherent risks to stability, asset quality remains vulnerable to exchange rate volatility due to the banking sector's reliance on foreign borrowing to finance aggressive domestic loan growth. This dependence on non-traditional loan financing is illustrated by the loan-to-deposit ratio, which has seen a rapid rise since 2009, coinciding with a surge in foreign borrowing and domestic FX lending to the Turkish corporate sector. Total FX lending represented 26.5% of total loans in January, compared to 10.8% in Q308. The loan-to-deposit ratio surpassed 1.00 in early 2013, reaching an all-time high of 1.09 in January 2014.

Foreign Borrowing Funds Domestic Lending
Turkey - Banks' Foreign Liabilities, FX Lending And Loan-To-Deposit Ratio

Challenging Environment For Banks In 2014

BMI View: Slowing real GDP growth, higher funding costs and lira depreciation will have a negative impact on growth and profitability in the Turkish banking sector, where we expect both supply and demand-side constraints to drive a pronounced deceleration in lending in 2014. We forecast client loan growth of 14.0%, down from 33.6% in 2013.

Rising US yields and waning demand for emerging market assets led to severe disruptions in Turkish financial markets in H213 and early 2014, forcing the Central Bank of Turkey (CBRT) to more than double its main policy rate in January, from 4.5% to 10.0%. After record-low interest rates and accelerating real GDP growth drove a rapid expansion of credit in 2013, we now expect weakening domestic demand, rising funding costs and political instability to make for a challenging operating environment for Turkish banks.

While relatively robust capital adequacy levels and low exposure to non-performing loans imply few inherent risks to stability, asset quality remains vulnerable to exchange rate volatility due to the banking sector's reliance on foreign borrowing to finance aggressive domestic loan growth. This dependence on non-traditional loan financing is illustrated by the loan-to-deposit ratio, which has seen a rapid rise since 2009, coinciding with a surge in foreign borrowing and domestic FX lending to the Turkish corporate sector. Total FX lending represented 26.5% of total loans in January, compared to 10.8% in Q308. The loan-to-deposit ratio surpassed 1.00 in early 2013, reaching an all-time high of 1.09 in January 2014.

Foreign Borrowing Funds Domestic Lending
Turkey - Banks' Foreign Liabilities, FX Lending And Loan-To-Deposit Ratio

However, the loan-to-deposit ratio reaching a peak in January was not a reflection of accelerating loan growth. The value of the banking sector's FX-denominated loan book (which is reported in lira) has surged in conjunction with the drastic depreciation of the Turkish lira since May 2013. As such, exchange rate conversion effects drove up the reported value of FX loans outstanding. Adjusting for exchange rate movements, it appears that total lending activity has been in a downtrend since Q413, in line with the beginning of the Central Bank of Turkey's monetary tightening cycle - a trend we expect to continue throughout the year.

Depreciation Masks Lending Slowdown Since Q413
Turkey - Lira And Foreign Currency Lending

The banking sector's balance sheet appears well hedged from FX volatility, given that foreign liabilities are offset by FX lending to domestic clients. However, the non-financial corporate sector in Turkey is exposed to exchange rate movements given its massive net short FX position. With the lira depreciating by 24.4% and 32.5% against the US dollar and euro respectively since May 2013, rising debt burdens and slowing domestic demand will result in a spike in non-performing loans and a diminished appetite for fresh borrowing among indebted Turkish corporates. Vast policy uncertainty amidst a government corruption scandal and a busy election season will also serve to stifle corporate credit demand.

The CBRT's reserve option mechanism (ROM) allows for banks to replace required lira reserves with foreign currency reserves, which we believe will marginally support lending activity in 2014. Adjusting the parameters of this mechanism would allow the CBRT to release FX into the system if liquidity constraints became severe. Furthermore, the ROM allows banks to continue borrowing from abroad while lending domestically in lira, which is crucial given our expectation for waning demand for FX-denominated loans among Turkish corporates.

Corporate Sector Exposed To FX Volatility
Turkey - Net Foreign Exchange Position Of Non-Financial Corporates

The slowdown in lending will be most pronounced in the retail segment, which at end-2013 made up 31.7% of the banking sector's total loan book and 26.2% of total new lending during the year. Although household lending has already decelerated substantially, the full impact of higher borrowing costs has yet to fully filter through. Meanwhile, consumer confidence has fallen to multi-year lows on the back of rising social tensions, political uncertainty and lira depreciation that has sent inflation higher and chipped away at household purchasing power.

Rising Borrowing Costs To Stifle Demand
Turkey - Average Lending Rates, %, 4-Week Moving Average

Macro-prudential measures will also play a crucial role in curbing household lending. The Turkish banking regulator has specifically targeted a slowdown in consumer credit growth, part of the government's strategy to rein in the current account deficit. In October 2013 regulations were put in place to significantly increase risk weightings and provisioning ratios on credit card, overdraft and auto loans. Furthermore, minimum monthly payments on credit cards will be gradually increased through 2015 while restrictions were put in place linking credit limits to average monthly income. As these measures will limit the profitability of consumer lending at a time when household credit demand is waning, we expect banks to increasingly target small and medium sized enterprises in the coming year to grow loan portfolios.

Sharp Decline in Credit Card Lending
Turkey - Consumer Credit & Credit Card Lending, % chg y-o-y

We expect a visible deterioration in asset quality in 2014 as both corporates and consumers struggle to repay loans amidst slowing real GDP growth and rising debt burdens. That being said, non-performing loans represented just 2.7% of total loans at end-2013, implying that even a significant uptick in loan delinquency could be easily absorbed by the banking sector before posing a serious risk to balance sheet health. Nevertheless, this will lead to significant income losses and require increased NPL provision that will weigh on profitability.

Robust Despite Downtrend
Turkey - Capital Adequacy, %

The effects of lira depreciation will also be felt on banking sector capital adequacy levels, given that value of risk-weighted assets (reported in lira) have risen in line with lira depreciation. Furthermore, the regulatory changes applied to consumer loans dictating higher risk weightings will not just apply to new lending, but bank's total outstanding consumer loan book. That being said, capital adequacy in the banking sector remains robust relative to regional standards and Basel III regulations, despite a steady deterioration since end-2012.

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