Turkish Banks – Turkish Market News

How Banks Benefited From Easy Money Policy

One immutable rule in developing nations is the existence of politicians who palpably need fast economic activity to keep its voter base strong. In Turkey, this is absolutely proven to be right by the President Erdogan whose repeated pro-growth economic views are well known ─which include very dissenting opinions to generally accepted theories such as high interest rates cause high inflation. It is also not a secret that Turkish President has been piling pressure on the central bank and other financial institutions and pushing for lower interest rates.

Well, the chart above tells us an interesting story (might be even more interesting for the Presidential economy team). The colorful lines show the evolution of commercial lending and deposit rates implied by Turkish banks, and lines in grey show the policy rates (or average cost of funding) of Turkish central bank and the inflation rate where the lighter one shows the ‘real cost’ of money and the dark one is the inflation. Important point to gleam from the chart is that Turkish central bank had clearly maintained tight monetary policy as it has turned more and more accommodative following the global financial crisis.

Now here is thing: As Turkish central bank loosens its monetary policy, banks become more dependent on collecting deposits and deposit rates fall to extremely lows that they even provide negative returns in real terms as they remain below inflation rate. On the other hand, commercial lending rates, that could be considered as a critical source for the economy, do not track other the so-called policy rate as much as deposits do, and create a huge spread (between lending-borrowing) for banks to benefit (also need to note the QE impact here). Eventually, ‘interest rate lobby’ seems to have enjoyed the low rate environment much more than some think it would have.

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.

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.

Do Turkish Banks Add Economic Value?

Time and time again I have been directing sharp criticism for the relatively poor financial performance, and more importantly, for the industry’s lack of focus on low profitability. In September, return on equity, or ROE, for the whole industry, came down to a level that made it even lower yielding than the riskless Treasury bonds (September RoAA was at 10.41% versus average 10Y bond yield at 10.44%). The situation is even more severe once the other elements of costs of equity such as equity risk premium are considered. These all reveals an important finding: Turkish banks are deeply struggling to add economic value.

The chart above shows the return on equity for the industry and the cost of equity. Return on equity is derived from 12-month trailing net income and 12-month average total shareholder’s equity. On the other part, the cost of equity, the threshold for generating positive economic value, is derived from average Turkey 10Y government bond yield, an estimated equity risk premium of 6%, and beta of 1.0x. Importantly, the chart reveals why we have seen lots of discount to book value valuation in the equity market and M&A deals.

However, it is also worth to point that October data may be signaling a turning point for banks as RoE and CoE both showed signs of convergence. RoE was up by 4 basis points to 10.45% m/m as well as 10Y bond yield significantly decreased 46 basis points to 9.98%. The industry posted 5.6% and 15.5% growth in earnings and total equity, respectively.

The important part of earnings growth came from the net interest income that were up by 18.5% y/y to 62.8 million liras. The growth is fees was relatively slower with 12.2% increase while expenses grew by 19.2%. On a negative note provisions extended significantly in October.

With banks’ 3Q financial statements and first month of 4Q stats at the table, Akbank (BIST:AKBNK) seems to be a good candidate to be an outperformer in my view, as the bank is poised for fast loan growth due to its strong liquidity and core liabilities.