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.
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.
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.
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.