Banking system was prepared for Turkish market’s instability

The recent upheaval in the Turkish financial markets comes as no surprise, and the banking system is now much better prepared to resist such trauma compared with previous financial crises, Standard & Poor’s Ratings Services noted in a report published today, titled «The Turkish Banking System Shows Resilience to Recent Instability in Turkey.» «Similar turbulence had cost the system dearly in the past, compared with the current mild instability, which proves the increased resilience of the Turkish banking system,» said Standard & Poor’s credit analyst Magar Kouyoumdjian. As with the severe crisis in 2000-01, problems started with weakened confidence originating at the highest levels of government. The delayed appointment of the new governor of the central bank and the murder of a prominent judge, coupled with the blocking of several articles of the social security reform laws by the president, questioned the political independence of the central bank. «This came amid an environment where the Turkish lira had been considered to be overvalued for some time, after appreciating significantly during the past five years,» added Kouyoumdjian. The currency’s vulnerability is exacerbated by the government’s heavy interest and debt burden (both external and internal), reliance on short-term capital inflows, and growing inflationary pressure during 2006. Hence, its recent devaluation was hardly surprising. The loss of investor confidence led to the unwinding of positions, triggering the fall. This was accompanied by a drop in the stock market. The fall was exacerbated by the general withdrawal of investors from emerging markets in the expectation of higher interest rates in the US, which led to interest rate hikes in Turkey designed to restore confidence in the Turkish lira. Banks no longer maintain large short currency positions as seen previously – emanating from lucrative arbitrage opportunities – which should minimize foreign-exchange losses. Furthermore, significant reform of the banking system, with the elimination of problematic related-party lending among some private banks along with subsidized lending and insolvencies at some of the large state-owned banks, the system is financially stronger to cope with mild short-term stress. The system had been on a strong positive trend until recently, benefiting from sustained economic growth and reduced inflation. This, coupled with structural reform, privatization and Turkey’s EU accession prospect, has attracted considerable investment in the banking system from large Western European banks since 2005. Standard & Poor’s believes this trend has not yet been seriously damaged, as recent reforms and the large potential of the market still make Turkey attractive to foreign investors.