Turkish Banks: Differentiating Rapidly

At a time when some argue that Turkey is on a path to being more state-sponsored economy owing to the Treasury guaranteeing large scale projects, the performance comparison of public and private banks gains importance. Thus, we aim to compare both groups in terms of lending growth, funding capacity, capital adequacy, and liquidity position in order provide some insights.

Loan Growth

Public v Private Banks - Loan Growth

Public commercial banks have been outperforming the private peers in lending growth since May 2013 when the so-called taper tantrum hit emerging markets as well as Turkish assets. The gap between lending growth rates has seemed to remain steady. However, there are clear signs of lending recession as the volume growth has slackened systemwide.

Loans-to-Deposits Ratio

Public v Private Banks - LoansToDeposits

Remember that TRY loans-to-deposits ratio for private banks currently stands at a record high of 140%. Despite their strong FX deposit base, private banks apparently feel more constrained to finance their assets when compared to public banks. With a lower l/d spread public banks enjoy their strong local currency deposit base which is primarily compromised of retirement and civil servant salaries.

Capital Position

Public v Private Banks - CET1 Ratios

Having been way stronger than private banks regarding the capital adequacy for a long time, public banks posted a lower figure for the first time in March. This demonstrates public banks are on the ball when the market is in the doldrums.

Liquidity Position

Public v Private Banks - LiquidityRequirements

It is easy to relate this to l/d spreads given above, but, public banks interesting have been weak set of results for liquidity requirements as they have been under the threshold of 100% which all the banks in Turkey must comply. Public banks can’t be given a pat on the back for their maturity management.

To sum up, Turkish government might play hardball to support the economy through state-run banks as it already has the capacity due to its perfect debt metrics. The differentiation explained between private and public banks would be prognosticating.

You can view the charts and the official data here (PDF).

Turkish Banks: What Went Wrong?

Turkish banks which have spent years with high profits generated in the past, only managed a ROE of 10.6% (10-year average was 16.1%), well below the business’ cost of capital of at least 15% and the returns which investors aspire. Unlike their peers around the world, financial institutions in Turkey are not in a regulatory cycle either. We have mentioned recurrently the rising risks of earning recession in Turkish banks. Not surprisingly, today only two of the six major bank stocks trade with a premium to its book value in Istanbul. Additionally, in January 2016, systemwide ROE was up by only 6 bps to 10.7% from 10.64% and did not no improvement is in on the horizon.

Turkish Banks - Valuations

Below is the trend in ROE versus COE which is estimated with monthly average yield of 10-year Turkish government bonds, equity risk premium of 5.5% and 1.0x beta. Simply, banks’ earnings do not justify premium valuations since they are capable of adding economic value.

Turkish Banks - ROE v COE

We previously published sufficient number of articles mentioning the declining profits in banks, and now think it is better to look beyond the metrics and try to analyze what actually went wrong and what are the underlying factors that drove earnings downside.

Turkish Banks - Summary Financials - 2015-2005

Above is a financial summary of Turkish banking universe for the last ten years. 2010 was the year when the industry started to experience ROE deterioration, the same period when Turkish central bank lowered interest rates to historic low levels in order to support the recovery process following the global financial crisis. Remember that Turkey was the second fastest growing major economy in the world after China in 2010-11 when the country recorded high single-digit digit real GDP growth rates. The strategy paid out well in the short-term, however, caused concerns around overheating thereafter. Turning back to the banks’ financial performance, NII posted for those two fiscal years in the industry was even lower than that for 2009. Banks seemed to struggle to price the loans desirably in a low interest rate environment. But more importantly, they needed new funding sources to finance the lending growth as keeping cash deposited in a bank was less attractive. That was the time the industry began to issue bonds and it had a new line on the interest expenses side. Interestingly, Turkish banks did not fully benefit from the zero-interest policy rates implied in developing economies until the very first phase of extreme money printing known as quantitative easing. Borrowing costs had remained relatively high until the liquidity injections of the Federal Reserve were in progress.

Banks enjoyed the QEs effect until mid-2013, when the Fed Governor Bernanke signaled a downshifting of his printing press. That meant a massive sell-out in emerging markets, and Turkey had environmentalist uprising to boot (Murphy’s Law). Then, the second source of profit erosion showed itself, the melting down in local currency. Banks recorded a loss of TRY7.1 billion due to the volatility in foreign exchange rates in 2013. That being said, they also were obliged to borrow via the repurchase agreements this time since the capital started to flow out of emerging markets this time. In a recent post, we shared our views on the funding challenges of the banks with warnings about the Turkish central bank doubling its overnight lending. This type of funding is also not cheap needless to say, and ultimately putting pressure on the bottom-line across the board.

Interestingly, banks have failed to grow their fees from loans over the past two years which led weaker revenues. During the same period, total non-interest income increased by 12% which was below the long-term growth rate of 15%. This has been partly due to the new regulations that have restricted fees.

A simple analysis of trends in income statement presents the key findings to walk through as to what actually went wrong. On the other hand, having investigated the sector-level balances, a bigger picture is easily seen. “…And then like a lot of dreams, there’s a monster at the end of it.” After a quote from a beloved TV series, let us present the crucial point at the end. The real trouble with Turkish banks is the leveraging ending up with lower gains, in other words, taking more risks for earning less, which is also an ominous data point for the economy in general. “Cautiously lowering our guidance” is the kind of a key phrase you might hear in earnings calls this year.

Turkish Banks: Funding Challenges Ahead

Time and time again, we concerned ourselves with volume growth trends in Turkish banking spectrum. As is the case with any emerging market, credit growth in Turkey has been phenomenal since interest rates cut to near zero in developed economies. That being said, deposit growth has been weak mostly due to the fact that interest rates on savings have remained subdued. Turkish central bank has failed to keep the equilibrium real interest rate at a level that would boost savings and reduce inflation.

At the end of January 2016, L/D ratio for all Turkish banks reached a record level of 115%. Particularly, the spread has been widening since mid-2013, highlighting that local currency depreciation expectations led a shift in sentiment in deposit market. Turkish Banks Loans to Deposits Ratio

Banks have inevitably faced instability on shake-up of funding base, which pushed them to diversify. It was December 2010 when Turkish lenders almost had not debt securities issued on their accounts. Then Turkish corporate bond market started to show first signs of life as the financial institutions pioneered. Now outstanding debt issued roughly amount to 100 billion in Turkish lira terms (of which only 30% were local currency denominated).

Outstanding Debt Securities Issued by Turkish Banks

But we believe the crucial point lies in the relationship with the central bank. For the past twelve months, we have seen CBT funding increasing significantly, helping the banks to meet their short-term obligations and ultimately preventing a lack of liquidity. It is also interesting to see total volume in interbank markets slowly rising.

Turkish Banks Borrowing From Central Bank and Interbank Market

This may be underpinning Turkey’s inexpugnable M2 money stock growth which we somehow call Turkish quantitative easing. Having a great respect for CBT without fail, things are getting heavier for the bank’s hard task ahead.

Finally, remember that average cost for CBT funding has risen above 9% recently which would curb the bank’s earning through higher interest expenses. In interbank market, the rates are standing at 10.75% where the banks are becoming more reliant on. With all that, average of interest expenses incurred by Turkish banks will eventually rise, and, more importantly, bond yields unlikely to fall below 10%, that will continue to put pressure on asset prices.