These are tough times for Turkey’s $820bn banking industry. Loan books expanded rapidly in recent years, even as profits flagged. New regulations and higher taxes undercut earnings growth, while an enfeebled currency has heaped pressure on costs and capital adequacy ratios.
To compound problems, banks face the need to pay customers for allegedly imposing inflated fees on services stretching back years, creating a new cost burden. Add an uncertain election result, rising inflation, and slowing economic growth, and the result is a pretty bleak outlook for a once-thriving sector.
It is hard to find solid cause to be positive. In a May 26 research note, Citi banking analyst Simon Nellis said the US lender had “become more bearish on the sector. This reflects our concern that liquidity conditions, which have generally been tighter this year than we anticipated, remain tight and drive downside risk to margins.”
Rising costs and provisioning, coupled with a more challenging external environment in the form of a flagging economy and the prospect of near-term interest rate rises by the US Federal Reserve, “lead us to be cautious” about the industry’s prospects, Nellis said.
Earnings, or the lack of them, remain a core concern. True, profits at Isbank, Garanti Bank, Yapi Kredi, and Halkbank, four of the six largest domestic lenders by total assets, beat consensus analyst forecasts in the first quarter of the year. Garanti outpaced profit estimates by 8%. Halkbank beat estimates by 9%, thanks to better-than-expected fee income, which accelerated 24% year-on-year in the first three months. Vakifbank, which posted earnings growth of 24% in the first quarter, saw fee growth jump by 58% in the same period.
Elusive earnings growth
Yet four swallows do not make a summer, and earnings growth remains both intermittent and elusive. Since 2010, Turkey’s largest lenders have seen their loan books more than double in size. Yet over that period, notes one London-based, Istanbul-focused banking analyst, “profits have barely moved, suggesting that there is a wider and more general malaise affecting and undermining the industry”. Earnings growth was flat in 2014, according to data from Turkey’s banking watchdog, the BDDK, at $10.2bn.
Regulators have sought to quell or discourage consumer borrowing, introducing measures that made it more expensive for banks to extend retail loans.
To an extent it has worked. Consumer loans as a share of total bank lending slipped to 27% at the end of 2014, from 33% three years ago, BDDK data show, while the ratio of business loans to total lending rose to 73%, from 67%.
But like Whac-a-Mole, every time one problem vanishes, another rears its head. These measures, while deemed inevitable and unavoidable by regulators, also curtailed industry profitability. Analysts reckon that without them, lenders’ return on equity would have been up to 3 percentage points higher than the current rate of 10%-11%.
Nor did general elections on June 7 offer much cause for optimism. That poll, a de facto referendum on president Recep Tayyip Erdogan’s desire to rewrite the constitution, merely muddied the waters. With no clear winner emerging, politicians face up to 45 days of haggling that will end with either a new government or a second, snap election.
That uncertainty has also weighed heavily on the financial services sector, notes Valentina Stoykova, a banking analyst at Barclays in London. “Before the elections, we thought the headwinds would rapidly ease,” she tells GlobalCapital. “But that isn’t going to happen now. We are still likely to see further compressions on net interest margins.”
Getting back in
In recent months, investors have been wondering whether and when to buy shares in leading listed Turkish lenders. Prices have fallen across the sector since the start of the year, with Turkish banks underperforming their emerging market peers by 36% between January 22 and June 9, according to Datastream. This is normal behaviour in Turkey: local lenders outperformed emerging market banks in the previous 11 months to January 2015 by 49%. The industry has endured five such super-cycles over the past decade, the longest stretching from mid-2008 to the end of 2011.
Little wonder then that investors are so keen to buy back in at the right time. In a June 9 research note titled “Buying opportunity or wait till the dust settles?” Barclays sought to determine whether the latest down-cycle had run its course. Its prognosis: soon, but not yet. “There is still room for further underperformance, given that right now the markets are pretty much driven by political noise and what the new government is going to look like,” says Stoykova. According to data from Barclays, the average down-cycle sees Turkish lenders underperform emerging market peers by 45%.
Rebates are perhaps an even greater concern for local lenders, in part because the full cost of reimbursing customers for imposing added or inflated fees on products and services has yet to be fully assessed. Some compare the problem to the payment protection insurance scandal that has so far cost British lenders nearly £20bn ($31.1bn) in compensation and fines.
Turkish banks are unlikely to need to provision to that kind of level, analysts say. But these allegedly inflated fees stretch back to 2005, and lenders are concerned that the need to refund customers in full will merely exacerbate cost pressures. Banks are “increasingly worried about the spectre of fee rebates”, says Barclays’ Stoykova. “Rebates expanded at double the normal rate in the first quarter of 2015, and that will create new pressures on earnings, and probably lead to a profits downgrade sooner or later.” In its May 26 report, Citi noted that at Vakifbank alone, a 17% year-on-year rise in costs in the first quarter was largely the result of a sharp increase in fee rebates, which came in at a “higher than expected” Tl 53m ($19.5m). “Elevated fee rebates are putting pressure on operating costs,” warns Citi analyst Nellis.
NPL focus
Lenders are also keeping a watchful eye on the prospect of a rise in soured lending, with economic growth likely to only match last year’s rate of economic expansion.
The World Bank expects gross domestic product to expand by 3% in 2015, against growth of 2.9% in 2014. Yapi Kredi in May tipped GDP to come in at just 2.5% in 2015, having previously forecast growth of around 4%.
Lower and slowing growth, the country’s fourth largest private sector lender warned, would lead to a rise of around 0.4 percentage points in non-performing loans (NPLs). Citi’s Nellis downplays fears of a sectoral shift toward higher rates of dud loans, but warns that the industry should look out for future troubles stemming from “accelerated levels [of NPLs] at Yapi Kredi and, to a lesser extent, at Vakifbank”, in the first quarter of the year.
Going forward, the banking sector faces yet more challenges, and even a few opportunities. HSBC’s June 10 announcement that it planned to sell its domestic retail operations in an attempt to cut annual costs by up to $5bn, opened the door to new entrants, or to existing players looking to expand their footprint. Investment bankers point to a host of names likely to be interested in buying the British lender’s local assets, including Beijing-based Industrial and Commercial Bank of China, as well as European peers ING Group and BNP Paribas.
Regulation overload
Lenders may also come to profit from a change in government. The Justice and Development Party (AKP), which lost its outright majority following the June 7 poll, remains widely seen as pro-business. But not all banks viewed the AKP as a force for good, pointing to lending restrictions imposed by Ali Babacan, the outgoing head of Turkey’s economic administration.
Babacan remains one of the country’s most widely respected and influential financial thinkers. Yet in May, just weeks before the election, Huseyin Aydin, chief executive officer of the country’s second largest lender, Ziraat Bank, warned that the industry was being throttled by burdensome rules. “Banks have had to deal with new banking regulations almost every day,” Aydin said.
He called for the government to slash taxes, cut risk weightings on loans, and to push through new measures designed to free up capital. Only by doing so, he said, would the government succeed in shoring up growth and spurring lending across the economy. Analysts hope a fresh government, unclouded by previous decisions and commitments, is just what the banking sector needs.
There is still good reason to remain a believer in the industry’s broader long-term potential, and more specifically in its standout constituents. Barclays’ Stoykova remains a fan of several lenders, most notably Akbank, controlled by the wealthy Sabanci family. “Akbank has a good franchise and good management,” she says. “They’re very efficient, and you want that when your top line isn’t growing.” It is also one of the country’s more conservative and defensive banking brands, in terms of both its NPL coverage and provisioning policies, helping to ensure that as of June 9, the lender boasted a price-to-book ratio of 0.99 times, against an industry average of 0.86 times.
But too many worries remain. The industry faces tighter liquidity conditions, coupled with higher operating costs stemming from a weaker Turkish lira. In May, Citi downgraded its aggregate annual earnings forecasts for major Turkish lenders by between 5%-7%. And though analysts believe local lenders are likely to face further ratings downgrades before the end of the third quarter, a host of other doubts continue to weigh on the troubled sector’s outlook. “Clearly, net interest margins are going to be closely monitored, particularly if the central bank looks to tighten monetary policy as a result of renewed economic weakness,” says Barclays’ Stoykova. “And then there’s the issue of fee rebates, which are accelerating. It’s something I don’t think banks were fully prepared for. It creates a new key risk for the bottom line of banks.”