The Turkish banking system was highly concentrated at the end of the 1990s. Three large state banks represented about 27 percent of total assets, while the five largest private banks accounted for almost 40 percent. The remaining one-third of the system was made up of other private domestic banks (14 percent), intervened banks (12 percent), foreign branches (3 percent), and investment banks (5 percent).
A combination of weak banking practices, poor regulation, and lack of corporate governance had increased the vulnerability of the banking system. Most private banks were not publicly traded and many were run as de facto treasuries of their corporate groups. Throughout the 1990s, banks were relatively free to lend to their owners and to related companies (reflecting lax definitions of related parties and ample limits in relation to capital). Relaxed accounting rules in general and loan valuation rules in particular also allowed banks to inflate asset values and overstate their capital. Many of these private banks had heavily borrowed short-term funds in international capital markets and invested them in longer maturities in either government securities or loans to insiders or related parties, making them vulnerable to interest rate and exchange rate shocks.
The operations of state banks posed particular difficulties. Public banks were allocated to political parties for the purpose of providing subsidized credit to political constituencies. Bank losses generated by this activity were to be covered by the government. Rather than receiving income-earning assets, however, the banks booked claims on the government (duty losses). The accumulation of such duty losses made these banks highly vulnerable to liquidity and interest rate shocks. Chronic undercapitalization added to the distortions (Table 9.1).
Precrisis Vulnerabilities in the Banking System, December 2000
Precrisis Vulnerabilities in the Banking System, December 2000
| In Billions of U.S. Dollars | In Percent of Capital | |
|---|---|---|
| Foreign currency open positions | 18.2 | 3,300 |
| Accumulated duty losses in state banks | 19.0 | 3,400 |
| Short-term liabilities of state banks | 22.4 | 4,100 |
Precrisis Vulnerabilities in the Banking System, December 2000
| In Billions of U.S. Dollars | In Percent of Capital | |
|---|---|---|
| Foreign currency open positions | 18.2 | 3,300 |
| Accumulated duty losses in state banks | 19.0 | 3,400 |
| Short-term liabilities of state banks | 22.4 | 4,100 |
Concerned about the supervisory weaknesses that had allowed these vulnerabilities to develop, the government took steps in mid-2000 to establish a legal and regulatory framework consistent with European Union and international standards. A revised banking law strengthened loan classification, loan loss provisioning, and collateral valuation rules. Loan concentration exposure limits were introduced; connected lending rules were defined, foreign currency exposure rules were tightened; new rules for consolidation, risk management, fitness, and propriety of owners and managers were established; and new accounting standards were set. New rules were also introduced to facilitate the exit of banks that were insolvent or illiquid. Prudential rules for private banks were extended to the state banks. An independent Banking Regulation and Supervision Agency (BRSA) was established in September 2000, and the Savings Deposit Insurance Fund (SDIF), which had been managed previously by the Central Bank of Turkey, was transferred under the BRSA.
Crisis Outbreak and Containment
In late 2000, disturbances in international capital markets and deteriorating economic conditions in Turkey resulted in significant losses in the banking system. During the year, deposit maturities shortened while consumer lending grew rapidly, with longer maturities and fixed interest rates. This widening maturity gap exposed banks to significant interest rate risk. Exposure of the state banks was particularly large, as they had become dependent on overnight funding. A sharp increase in domestic interest rates in late 2000 dramatically reduced bank profitability. In November 2000, Demirbank, a medium-sized financial institution, was unable to roll over its overnight liabilities and liquidated large quantities of government securities. The ensuing collapse in the value of government bonds prompted creditors to refuse to roll over overnight credit, resulting in a capital outflow and a sharp fall in Turkey’s international reserves.
In response to these developments, the authorities introduced a strengthened economic policy package in December 2000, supported by an augmented program from the International Monetary Fund. The package made the implicit guarantee protecting depositors and other bank creditors explicit until the banking system had been rehabilitated. Specific loan provisions were also made tax deductible. The financial crisis eased temporarily. The key vulnerability indicators, however, remained weak and the deeper problems were left unaddressed.
In February 2001, a much more serious crisis erupted that resulted in substantial losses for the banking system. Despite the December 2000 package, investor confidence was still shaky, reflecting the continued deterioration in the economy and weak policy implementation. The February crisis was ignited by the public airing of tensions between the president and the prime minister. Fearing a reversal of the stabilization policies, investors withdrew from the Turkish market. The resulting increase in domestic interest rates led to substantial losses, particularly for the state banks. The Central Bank of Turkey declared a two-day bank holiday, but when banks reopened, overnight interest rates spiked to about 5,000 percent. While Central Bank liquidity injections reduced interest rates to 700 percent, the magnitude of the injection destabilized the crawling peg exchange rate regime. The authorities were forced to float the Turkish lira on February 22, 2001, to avoid further loss of reserves. Deposit runs were averted because of the blanket guarantee protecting depositors and other creditors in banks (except shareholders’ equity and subordinated debt), which had been made explicit the month before.
Bank Restructuring Strategy
A strengthened stabilization plan was introduced on May 15, 2001, to address, among other things, the financial sector’s more fundamental weaknesses. The worsening economic environment and prospects for larger loan losses than earlier envisaged prompted authorities to refocus their strategy to deal with the core part of the banking system, which up until then had been considered sound. The revised banking sector strategy included the restructuring of the state banks, resolution of the SDIF banks, strengthening of the capital position of private banks, and asset management.
State Banks
The overnight exposure of public banks (state- and SDIF-owned intervened banks) was a major source of vulnerability in the banking system. The rollover of these liabilities at very high interest rates resulted in sharply growing losses and liquidity problems. As part of the restructuring of state banks, the government injected about $19 billion (13 percent of GNP) of securities into the state banks to eliminate the duty losses.
Two state banks (Ziraat and Halk) were operationally and financially restructured, while one insolvent bank (Emlak) was liquidated. Through the injection of $2.9 billion (2 percent of GNP) in government securities, the capital adequacy ratios of Ziraat and Halk were raised above the 8 percent regulatory requirement. Emlak had its license revoked and its banking assets and liabilities were transferred to Ziraat. Ziraat and Halk were operationally restructured and by end-2003, 820 branches had been closed and the number of employees reduced by 30,000 (Table 9.2).
Operational Restructuring of Ziraat and Halk
December 2003 versus March 2001.
Operational Restructuring of Ziraat and Halk
| March 2001 | June 2002 | December 2002 | December 2003 | Difference1 | |
|---|---|---|---|---|---|
| Number of branches | |||||
| Ziraat | 1,673 | 1,141 | 1,139 | 1,131 | −542 |
| Halk | 805 | 549 | 546 | 527 | −278 |
| Total | 2,478 | 1,690 | 1,685 | 1,658 | −820 |
| Number of personnel | |||||
| Ziraat | 45,132 | 22,923 | 22,099 | 21,794 | −23,338 |
| Halk | 14,699 | 14,956 | 8,300 | 7,993 | −6,706 |
| Total | 59,831 | 37,879 | 30,399 | 29,787 | −30,044 |
December 2003 versus March 2001.
Operational Restructuring of Ziraat and Halk
| March 2001 | June 2002 | December 2002 | December 2003 | Difference1 | |
|---|---|---|---|---|---|
| Number of branches | |||||
| Ziraat | 1,673 | 1,141 | 1,139 | 1,131 | −542 |
| Halk | 805 | 549 | 546 | 527 | −278 |
| Total | 2,478 | 1,690 | 1,685 | 1,658 | −820 |
| Number of personnel | |||||
| Ziraat | 45,132 | 22,923 | 22,099 | 21,794 | −23,338 |
| Halk | 14,699 | 14,956 | 8,300 | 7,993 | −6,706 |
| Total | 59,831 | 37,879 | 30,399 | 29,787 | −30,044 |
December 2003 versus March 2001.
In addition, the separate boards of Ziraat and Halk were replaced by a joint board of professional bankers with instructions to restructure their operations in preparation for privatization. The resulting privatization plan addressed how to scale down the banks’ holdings of government securities and increase their operational efficiency. The plan also took into account Ziraat’s important role as a provider of rural banking services.
SDIF Banks
There has been substantial consolidation of the banking system in Turkey over the past several years (Table 9.3). Since 1997, 21 private banks have been taken over by the SDIF, 18 of them since December 1999. Most were relatively small, but altogether they accounted for 20 percent of banking system assets. Although efforts to privatize the banks did not always succeed, as of end-April 2004, the SDIF had been successful in resolving all of them except one, which has acted as a bridge bank. Resolution methods included merger (seven banks), liquidation (seven banks), and privatization (six banks).
Structure of the Banking System
Structure of the Banking System
| 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|
| Number of branches | 80 | 68 | 54 | 50 |
| State | 4 | 3 | 3 | 3 |
| Savings Deposit Insurance Fund | 11 | 9 | 2 | 2 |
| Private | 29 | 20 | 20 | 18 |
| Foreign and investment banks | 36 | 33 | 29 | 27 |
| Market shares (in percent) | 100 | 100 | 100 | 100 |
| State | 35 | 32 | 32 | 33 |
| Savings Deposit Insurance Fund | 11 | 6 | 4 | 3 |
| Private | 48 | 55 | 56 | 57 |
| Foreign and investment banks | 6 | 7 | 8 | 7 |
Structure of the Banking System
| 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|
| Number of branches | 80 | 68 | 54 | 50 |
| State | 4 | 3 | 3 | 3 |
| Savings Deposit Insurance Fund | 11 | 9 | 2 | 2 |
| Private | 29 | 20 | 20 | 18 |
| Foreign and investment banks | 36 | 33 | 29 | 27 |
| Market shares (in percent) | 100 | 100 | 100 | 100 |
| State | 35 | 32 | 32 | 33 |
| Savings Deposit Insurance Fund | 11 | 6 | 4 | 3 |
| Private | 48 | 55 | 56 | 57 |
| Foreign and investment banks | 6 | 7 | 8 | 7 |
Private Banking Sector
The authorities’ initial strategy was to require proper valuation of bank assets and have shareholders recapitalize undercapitalized banks. In July 2001, six banks were unable to raise needed capital and were taken over by the BRSA. About a dozen other undercapitalized banks were required to strengthen their capital base through increases in paid-in capital, mergers, or participation of foreign investors. About $1.1 billion of new capital was raised. However, the authorities thought that these efforts were insufficient.
To protect the core private banking system, the authorities then introduced a support scheme that made public funds available to help banks recapitalize. They believed that banks would face additional losses given the adverse economic environment and would not be able to raise needed capital on their own. A public support scheme was therefore developed to ensure the solvency of the banking system and the continued confidence of depositors and other creditors. The scheme was designed to maximize private sector participation and limit the costs to the public sector (Box 9.1).
As a precursor to the recapitalization exercise, private banks were subject to a special audit. The objective was to identify all existing losses through a rigorous and targeted valuation exercise, and to ensure that this exercise was seen as transparent and technically sound. Particular emphasis was placed on establishing guidelines for the technical assessments, and on the choice of auditors to carry out the assessments and the third parties to conduct the back-up evaluations of the auditor assessments. Once the audit reports were submitted, the BRSA would recommend a course of action to any banks that required additional capital.
The public support scheme was completed by August 2002. Only one bank (the state-owned Vakifbank) needed Tier 2 capital assistance from the SDIF, amounting to $137 million. One other bank (Pamukbank) was intervened, since the owners could not raise about $2 billion in capital needed. The low demand for public resources reflected the incentives built into the program for shareholders to invest their own resources rather than to give the SDIF a role in managing their bank (Table 9.4).
Financial Indicators for Private Banks
(In percent)
Financial Indicators for Private Banks
(In percent)
| 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|
| Capital adequacy | 18.3 | 9.0 | 19.6 | 23.5 |
| Nonperforming loans/total loans | 3.5 | 27.6 | 8.9 | 6.5 |
| Provisions/nonperforming loans | 63.0 | 31.0 | 53.0 | 80.0 |
| Return on assets | 2.3 | −7.5 | 2.0 | 2.1 |
| Return on equity | 16.2 | −97.9 | 15.9 | 13.9 |
| Net profit (trillions of lira) | 1,276 | −7,383 | 2,409 | 2,917 |
Financial Indicators for Private Banks
(In percent)
| 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|
| Capital adequacy | 18.3 | 9.0 | 19.6 | 23.5 |
| Nonperforming loans/total loans | 3.5 | 27.6 | 8.9 | 6.5 |
| Provisions/nonperforming loans | 63.0 | 31.0 | 53.0 | 80.0 |
| Return on assets | 2.3 | −7.5 | 2.0 | 2.1 |
| Return on equity | 16.2 | −97.9 | 15.9 | 13.9 |
| Net profit (trillions of lira) | 1,276 | −7,383 | 2,409 | 2,917 |
Asset Management
Despite many attempts, the sale of assets of intervened banks has been slow. Nonperforming assets of intervened banks or assets that were rejected by the acquirers of former intervened banks were transferred to a special collection department within the SDIF, while performing assets were transferred to Bayindirbank, which acted as a bridge bank. The IMF and the World Bank provided technical assistance to the SDIF collection department regarding the best procedures to maximize the values of these assets and to minimize the cost to the taxpayer for bank restructuring. Special legislation was also passed which gave the SDIF strong powers to recover the assets of former bank owners. Despite all these efforts, the first auction of loans held by the SDIF was only completed in August 2004.
Elements of the Bank Recapitalization Program
Public sector recapitalization programs must be designed taking into account specific circumstances and government policies. Not all programs will be alike. The availability of shareholder resources, the extent of recapitalization needed, and the legal structure will all affect program design. In 2001, Turkey initiated a public sector recapitalization program that included the criteria and conditions listed below.
Last resort: A public solvency support scheme should be viewed as a last option when there are no other alternatives available.
Private participation: For a bank to be eligible for public support, existing shareholders or new private investors must be willing to inject at least half of the Tier 1 capital needed.
Operational restructuring: To qualify for support, banks must present an acceptable operational restructuring plan, including measures to strengthen internal control and risk management, increase revenues, cut costs, and deal with nonperforming loans.
No bailout of existing shareholders: Capital needs in banks must be thoroughly assessed and all losses imposed on existing shareholders before public funds are injected. The assessment of capital needs should be verified by a third party. Ideally, the shares held by the government should have preferred status to shares held by the old shareholders. Thus, if there are additional losses over a given period of time, say six months, those losses should be absorbed by the old shareholders.
Positive net worth: To be eligible for support, a bank must have a positive net worth. If not, existing owners or new private investors must bring the capital adequacy ratio (CAR) to above zero before a bank can be eligible for public support.
Shareholders’ rights: The government should have the right to appoint at least one board member irrespective of its capital contribution. Such board member(s), who should have documented experience in banking, should have veto powers on matters material to the soundness of the bank.
Price: The government should pay net book value for the shares. There is also a provision for buybacks. When the government wants to sell its shares, existing shareholders should have the right of first refusal for a given period, say two years. The price should be the highest of (i) the government’s investment cost (principal and interest); (ii) net book value; and (iii) market price (including third-party offers).
Pledge: To protect the public investment, majority shareholders in the bank should be required to pledge as collateral to the government shares held in the bank equal to the government’s capital contribution. The shares will be used as collateral if the government faces losses when it sells its shares in the bank.
Payment: The government should pay for the shares in tradable government bonds issued on market terms.
Convertibility: If the government provides Tier 2 capital, it should automatically be converted into Tier 1 capital if the CAR falls below a certain ratio, say 8 percent, and the private shareholders do not immediately bring it up to above 8 percent.
The separation of the SDIF and BRSA boards should help the SDIF focus on asset recovery. The new SDIF board established in January 2004 made it a priority to reassess the value of its assets in order to ensure that unrealistic expectations about recovery rates would not prevent asset sales. The new board also initiated development of a revised strategy for the resolution of assets of intervened banks, including claims against former bank owners and shares and companies taken over. The first asset disposal auction was completed in August 2004.
Corporate Restructuring
The market-based and voluntary scheme for corporate debt restructuring that was set up to strengthen the asset quality of banks is coming to an end. Loans that were classified on January 31, 2002, are eligible for restructuring under the Istanbul approach, provided certain conditions are met. An application for having the loans restructured must be submitted within three years (January 31, 2005) and all restructurings must be completed before June 2005, when the Framework Agreement on Financial Restructuring that governs the Istanbul approach expires. As of end-April 2004, 270 firms had $5.6 billion in loans restructured (Table 9.5), and nine applications totaling about $600 million were still pending. A significant amount of the restructuring is concentrated in a few groups. Of the group of large firms, 47 percent of the debt restructured ($5 billion) was owed by one group, while for smaller firms, 66 percent ($600 million) belonged to one group.
Loans Restructured Under the Istanbul Approach, as of April 2004
Loans Restructured Under the Istanbul Approach, as of April 2004
| Large Firms | Small Firms | Total | ||||
|---|---|---|---|---|---|---|
| (In millions of U.S. dollars) | ||||||
| Amount | 5,000 | 582 | 5,582 | |||
| Of which: | (In percent) | |||||
| Private banks | 63 | 88 | 66 | |||
| Public banks | 18 | 10 | 17 | |||
| Savings Deposit | ||||||
| Insurance Fund | 14 | 1 | 12 | |||
| Other | 5 | 1 | 5 | |||
| Total | 100 | 100 | 100 | |||
Loans Restructured Under the Istanbul Approach, as of April 2004
| Large Firms | Small Firms | Total | ||||
|---|---|---|---|---|---|---|
| (In millions of U.S. dollars) | ||||||
| Amount | 5,000 | 582 | 5,582 | |||
| Of which: | (In percent) | |||||
| Private banks | 63 | 88 | 66 | |||
| Public banks | 18 | 10 | 17 | |||
| Savings Deposit | ||||||
| Insurance Fund | 14 | 1 | 12 | |||
| Other | 5 | 1 | 5 | |||
| Total | 100 | 100 | 100 | |||
The outcome of these restructurings is still unclear, since significant grace periods have been granted. Restructuring was typically done by extending maturities and granting grace periods. For larger firms, the maturity was extended to nine years on average, with an average grace period of more than 34 months to repay the principal and 22 months to honor interest rate payments. Thus, it will take roughly until mid-2005 before the first indications are available as to whether borrowers will be able to fulfill their commitments, or if most of the loans will turn nonperforming again. Moreover, the success of the Istanbul approach will to a large extent depend on the repayment capacity of one group, whose loan dominates.
Outcome of the Bank Rehabilitation Program
The authorities have been successful in resolving the immediate problems facing the banking system. The measures to prevent destabilization of the financial system—including the blanket guarantee to depositors and other creditors, elimination of short-term liabilities of public and intervened private banks, resolution of intervened banks, and implementation of prudential regulations in line with European Union standards—all achieved their objective. The authorities were also successful in recapitalizing private banks, which have now returned to profitability and have the financial resources to support the real sector and contribute to economic growth.
However, the cost to the government of restructuring the banking system amounted to about $47 billion (32 percent of GNP). This includes $6 billion to compensate depositors in Imar and an estimated $2 billion for the recapitalization of Pamukbank. Public sector costs have been borne primarily through the issuance of government securities. Government debt rose substantially as a result of the debt swap in restructuring the state banks ($22 billion or 15 percent of GNP) and the resolution of intervened banks ($25 billion or 17 percent of GNP). On average, banks hold about 43 percent of their assets in government securities (state banks hold 70 percent) and banking system solvency in the medium term is therefore tied to the success of the government’s fiscal program and the country’s economic performance.
The banking system’s capital position and profitability have improved substantially in recent years. With the economic recovery and some loan restructuring, nonperforming loans have declined to an average of 7 percent for private banks (12 percent for the system). Capital adequacy ratios have grown from 19 to 24 percent in private banks (32 percent for the system) and return on equity increased in the system to an average of 9 percent by end-2003. Despite the increase in lending to the private sector in the past year, however, both assets (53 percent) and earnings (47 percent) are still concentrated in the holdings of government securities. Thus the banks remain highly sensitive to the financial position of the government.
Stress tests indicate that banks’ high capital adequacy ratios (CARs) now provide a significant cushion to shocks. While banks have a small short open position, banks accounting for 87 percent of system assets would remain solvent even if there were a 30 percent devaluation. Interest margins are adequate and all banks could withstand a 500-basis point reduction in margins. The system is least resilient to a deterioration in asset quality, but even here, given the levels of provisioning in the system, if 25 percent of performing loans were to become bad, banks accounting for 83 percent of the system would remain solvent. The system is also resilient to a combined shock of a depreciation and associated deterioration of asset quality. Stress tests indicate that this dual shock would leave systemwide CARs at around 20 percent.
In view of the improvements in the financial sector, the BRSA announced in July 2003 that the blanket guarantee protecting all depositors and creditors in banks would be replaced by a limited deposit protection scheme, which was implemented in July 2004. The authorities have decided to replace the guarantee in one step, rather than phasing it out. Under the new scheme, savings deposits up to TL 50 billion ($37,000) will be fully protected (about 40 percent of total deposits). Before the guarantee was abolished, the BRSA informed the government in detail about the condition of the banking system and of any remaining risks that the banks might face. A summary of these findings was published.
The SDIF’s losses need to be recognized. To finance the resolution of intervened banks, the SDIF has had to borrow a substantial amount of government securities from the Treasury. As of end-December 2003, SDIF liabilities amounted to $36.2 billion, including $13.6 billion of accrued interest. Recapitalization of Pamukbank would add another $2 billion. It is highly unlikely the SDIF will ever be able to repay the Treasury the full amount through asset resolution or the collection of deposit insurance fees. Thus, the Treasury will have to write off its claims on the SDIF. To create confidence and to ensure that the SDIF will be able to meet all its commitments, there are benefits to providing this up front.
Challenges Ahead
With crisis resolution having been successful, implementation of medium-term structural measures should now be at the center of the agenda. Structural issues such as the privatization of state banks, asset sales, correcting weaknesses in the legal system, and reducing distortionary taxes have been delayed. Addressing these issues will enhance confidence in the financial system and complete the reforms.
State Banks
Restructuring and privatization of the three state banks—Ziraat, Halk, and Vakif—has proved difficult. Progress has been limited because of the banks’ high exposure to government securities and political uncertainties, which have discouraged outside buyers (Table 9.6). Vakif is conducting its own diligence as a first step toward diluting its existing ownership through a public offering of new shares. Halk has been integrated with Pamuk, which should enhance its information and computer systems, and strengthen its competence in providing banking services. For Ziraat, any privatization strategy would need to respect its social function, since in many rural areas it is the sole provider of banking services. For each of the state banks, the need to improve the balance sheet structure, especially the predominance of government bonds, is a key challenge for successful privatization.
Assets and Liabilities of Ziraat and Halk
(In percent)
Assets and Liabilities of Ziraat and Halk
(In percent)
| 2001 | 2002 | 2003 | |
|---|---|---|---|
| Assets | 100 | 100 | 100 |
| Liquid assets | 11 | 9 | 13 |
| Nonperforming loans | 2 | 1 | 2 |
| Holdings of securities | 69 | 74 | 0 |
| Loan portfolio | 7 | 5 | 70 |
| Other assets | 11 | 11 | 10 |
| Liabilities | 100 | 100 | 100 |
| Deposits | 70 | 76 | 77 |
| Interbank | 7 | 5 | 3 |
| Equity, including profit | 9 | 11 | 13 |
| Other liabilities | 14 | 8 | 7 |
| Market share in lending | 8 | 7 | 8 |
| Market share in deposits | 29 | 30 | 32 |
Assets and Liabilities of Ziraat and Halk
(In percent)
| 2001 | 2002 | 2003 | |
|---|---|---|---|
| Assets | 100 | 100 | 100 |
| Liquid assets | 11 | 9 | 13 |
| Nonperforming loans | 2 | 1 | 2 |
| Holdings of securities | 69 | 74 | 0 |
| Loan portfolio | 7 | 5 | 70 |
| Other assets | 11 | 11 | 10 |
| Liabilities | 100 | 100 | 100 |
| Deposits | 70 | 76 | 77 |
| Interbank | 7 | 5 | 3 |
| Equity, including profit | 9 | 11 | 13 |
| Other liabilities | 14 | 8 | 7 |
| Market share in lending | 8 | 7 | 8 |
| Market share in deposits | 29 | 30 | 32 |
Asset Recovery
The sale of assets of the intervened banks has proceeded very slowly. For the most part, this can be explained by (i) lower than hoped for recovery rates, (ii) the need to make more realistic asset valuations, and (iii) the poor legal protection for BRSA and SDIF staff in the event that they are accused of selling assets below value. In addition, the considerable overlap between the compositions of the BRSA and SDIF boards may have weakened the SDIF’s focus. The decision to appoint a new and independent SDIF board in January 2004 should overcome this difficulty and help speed up asset sales.
Legal Underpinnings
The final ruling by the General Assembly of the Administrative Court on April 24, 2004 that BRSA’s interventions in Demirbank and Kentbank were unlawful has complicated bank resolution. However, the consequences of the ruling are unclear, since the banks have since been taken over or liquidated (Demirbank was intervened in December 2000 and Kentbank in July 2001). This unpredictability undermines bank reform.
A commission has been established to look into the supervisory lessons from the Imar bank failure. Imar collapsed after the operating licenses of energy companies held by its owners were confiscated. Subsequent investigations revealed that the bank had $5.5 billion in unregistered but legitimate deposits that were not backed by assets on the bank’s balance sheet. The scandal weakened the BRSA’s credibility and raised questions about supervisory practices, including how the bank was able to operate like this for so many years. To avoid any repetition and to determine the supervisory lessons from the experience, the government set up a commission, chaired by a reputable international bank supervisor, which reported its findings in August 2004 (Box 9.2).
In response, the authorities are revising the Banking Act to bring it more closely in line with European Union standards and international best practices (Box 9.3). The need for such a comprehensive review has been brought to the fore by the experience of crisis management over the last few years, the separation of the boards of the BRSA and the SDIF, lessons from the Imar scandal, and the court rulings making the intervention in two banks unlawful. Lacking a review of the act, weaknesses in the judicial system could undermine banking reform and deter foreign investment.
The Imar Commission Report
After the failure of the Imar Bank, the government formed an independent commission to assess the supervisory lessons that should be learned from the scandal. The commission consisted of Jean-Louis Fort, former director general of the Banking Commission in France, and Peter Hayward, former secretary of the Basel Committee on Banking Supervision. In its report published in August 2004, the commission noted three requirements of any effective supervisory authority: a sound legal basis, adequate financial and human resources, and an effective organizational structure. To help meet these requirements, the commission recommended the following legislative changes:
-
Board members appointed to banks by the Banking Regulation and Supervision Agency (BRSA), should act as representatives of that agency and not as regular directors of the bank. The BRSA should also have the right to remove and appoint new members of the executive and auditing boards of such banks.
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The powers to conduct onsite examination and to request information should belong to the BRSA as a whole and not exclusively to sworn bank auditors. The commission argued that expertise and experience found elsewhere among BRSA staff should be used in onsite examinations. The legal requirement that only sworn bank auditors can perform onsite work removes a desirable element of flexibility, including the need to use outside expertise, and this can hinder effective supervision.
-
The role of the sworn bank auditors as tax auditors should be removed. The commission stated that “this is an extremely unusual element” and that in most countries it is felt important that supervisors should have no responsibilities in this area.
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External auditors should have the right to inform the BRSA of their findings.
-
Overly detailed legislation would reduce the flexibility of the BRSA. Detailed application of general requirements should be left to secondary legislation or regulations in a way that can be easily altered to meet changes in the market environment.
The commission also suggested ways to strengthen the BRSA’s day-to-day operations. Regarding resources, the commission found that BRSA has an insufficient number of staff with experience in banking, external audit, information technology, trading, and back office operations. The skill base could be strengthened by broadening the recruitment base, implementing a more flexible pay structure, creating short- and medium-term assignments, and seconding staff from the private sector.
In the organizational area, the commission firmly stressed the importance of better coordination of onsite and offsite supervision. According to the commission, officers from the offsite department should be given overall responsibility either for the supervision of one large bank or a group of smaller banks. The officer should ensure full communications between various functions in BRSA, prepare briefs and determine areas for inspection, follow up on corrective actions, and coordinate with external auditors.
Regarding the BRSA’s governance structure, accountability should be pushed down from the chairman to the officers in charge of supervision of individual banks. Procedures should also be in place that allow the board to assess the performance of the agency and its staff, including external reviews of BRSA’s efficiency.
There might also be scope for improving the performance of the BRSA board. The status of board members should be reviewed, particularly the appointment of full-time board members without executive functions. Consideration should be given to appointing at least some part-time members with private sector experience.
Priority Areas for Legal Reform
Scope of legislation: The Banking Act needs to specify the types of business operations that fall within the scope of the legislation and which require a banking license. Moreover, once a banking license is issued, the law should clearly define the permissible banking activities in which a bank can engage.
Fit and proper criteria: The current act establishes “fit and proper” requirements generally consistent with international best practices. The key issue is to make sure that these criteria are not weakened in any way.
Criteria for licensing: The current act does not clearly specify the criteria that the Banking Regulation and Supervision Agency (BRSA) should employ in determining whether to approve or disapprove an application for a new bank authorization.
Large exposure limits: The application of the transitional arrangements allowing large exposure limits to exceed the limit of 25 percent of the bank’s own funds is not consistent with international best practices. The authorities intend to phase out these transitional arrangements by end-2005.
Lending to related parties: The limits on lending to related parties are not consistent with international best practices and need to be strengthened by broadening their scope of coverage.
Onsite inspections: The exclusivity of sworn bank auditors to examine banks should be abolished and BRSA given the right to use other experts (both internal and external experts) as well to conduct onsite inspections.
Legal protection for board members and staff of BRSA and the Savings Deposit Insurance Fund (SDIF): The Banking Act needs to be amended to fully protect board members and staff of these agencies from liability for actions taken in good faith in the normal course of their duties. Moreover, the BRSA and SDIF should be required by law to indemnify these individuals for legal expenses incurred in defending against civil actions or criminal prosecutions that are ultimately unsuccessful.
Delineation of BRSA and SDIF responsibilities: With the split of the BRSA and SDIF boards, the delineation of responsibilities between the two agencies will need to be addressed, including the resolution of insolvent banks, the operation of the deposit insurance scheme, and how to protect the independence of the agencies, particularly from unwarranted interference by the government and the judiciary.
Intermediation Capacity
Distortionary taxes on financial transactions—including the Banking Insurance and Transactions Tax (BITT), the Resource Utilization and Support Fund (RUSF), and a range of stamp duties—have increased loan-to-deposit spreads by approximately 10 percentage points during the period of high interest rates. The government’s weak fiscal position has made it difficult to eliminate these taxes, which discourage bank-financed investment and encourage offshore operations (Figure 9.1). Some stamp duties were abolished on January 1, 2004, but there is also a need to reduce the BITT and RUSF, although in a phased and gradual manner.
Offshore Loans as a Share of Total Bank Assets
(In percent)
Source: Banking Regulation and Supervision Agency.To circumvent these tax-induced spreads, loans are being booked in offshore branches of resident banks. The wedge in effective lending rates has amplified the role of offshore subsidiaries of domestic banks in the intermediation process. To avoid paying the BITT, RUSF, and some stamp duties, and to circumvent regulations governing bank lending in foreign currency, most large banks have established offshore branches to intermediate credits to onshore Turkish corporations. Branches for this purpose are mostly incorporated in Malta and Bahrain, and credit expansion is financed primarily through transfers from the onshore headquarters. Credit on the consolidated balance sheet of banks with offshore banks has grown by 70 percent in the past three years. Loans booked offshore have increased by 260 percent.
The characteristics of deposits are also being adapted. Banks are increasingly offering deposit instruments that, while contractually long term, take advantage of the associated lower withholding tax but have all the other characteristics of one-month deposits in terms of liquidity and repricing. To maintain the attractiveness of deposits compared to investing directly in government securities, banks offer investment (mutual fund) type facilities (Type B investment funds). Through this vehicle, depositors take advantage of the income tax exemption for mutual funds to realize higher yields.
The extensive use of transaction taxes in Turkey is a major obstacle to the development of a more diversified financial system. The costs of circumventing these may favor larger banks over smaller ones and discriminate against the establishment of nonbank financial institutions such as leasing and factoring companies. To avoid paying stamp duties, banks reportedly enter into informal arrangements rather than documented transactions, which weakens legal compliance.
Lessons Learned
A number of important lessons can be gleaned from Turkey’s postcrisis restructuring exercise:
While all of these lessons are important, and though there are many reforms still to be implemented, Turkey’s banking system is today much stronger than during the crisis. The economy is recovering and banks are better positioned to support and contribute to economic growth. Net profits of private banks rose by more than 20 percent in 2003, and with the decline in real interest rates, bank lending to the private sector has started to increase. To ensure the banking system’s continued strength, the key now is to maintain and build upon the financial sector reforms introduced over the last three years.
