The Turkish banking system successfully averted a severe crisis during 2006. This shows the improved situation of the system following restructuring and five years of transformation and growth. This is underpinned by stronger capitalization, reduced market risk, stronger liquidity and better loan underwriting systems, Standard & Poor’s Ratings Services noted in a report titled «Bank Industry Risk Analysis: Turkey (Republic of),» published on October 31. Increasing interest rates elsewhere had already made emerging market debt less attractive by mid-2006, which resulted in some investors withdrawing from Turkey. The situation was exacerbated by a loss of confidence in the Turkish lira due to inflationary pressures and political tensions. Similar turbulence had cost the banking system severely five years earlier, leading to deteriorated asset quality, large financing costs and large foreign-exchange losses, ultimately resulting in 20 bank closures. ‘Turbulence is past’ «Despite the recent turbulence, the benefits of strong economic growth, lower inflation and higher political stability have established a solid base for the banking system,» said Standard & Poor’s credit analyst Magar Kouyoumdjian. However, despite significant improvements and major reforms, the Turkish banking sector retains a high-risk profile. The main risks are still the product of the country’s fragile economic and financial environment. If the positive momentum is retained in the financial and economic environment, however, the banking sector’s creditworthiness will continue to improve. Some key risk factors have been reduced, particularly those stemming from the high interest rate and currency exposure of the private banks and the subsidized lending of the state banks. The competitive environment is fairer owing to the failure of numerous small and mid-size private banks, which used to distort competition. Attractive for investment Turkish banks have continued to attract significant foreign investment since 2005, given Turkey’s large underbanked population and an economy that is undergoing fast growth and modernization. Several large Western European banks have bought into this lucrative market, including BNP Paribas, UniCredito Italiano SpA, Fortis Bank and Dexia Bank SA. Banks are continuing to develop their commercial business away from investing in government paper, particularly in retail banking, where they compete using sophisticated technological infrastructure. Despite the rapid loan growth of the past two years, the level of financial intermediation remains among the lowest in emerging markets. Interest rate hikes could somewhat hamper the growth momentum of credits and the profitability of banks in the medium term. Asset quality is expected to suffer somewhat, although it has demonstrated significant improvement in the past five years, with strengthened provisions. The rapid increase in lending highlights the need for a strong credit-underwriting culture and systems, which some Turkish banks still lack. The sector’s liquidity is considered to be satisfactory, with the removal of the short-term financing needs of state banks. The largest private Turkish banks are also increasingly using structured transactions to access overseas funds, which allow them to raise long-term debt on attractive terms. The Turkish banking system is only adequately capitalized, considering the fast loan growth and risky operating environment, leaving the sector with a limited cushion to absorb large unexpected losses. Capitalization strengthened rapidly with the recapitalization of the sector after the 2001 crisis, but has been weakening with fast loan growth since 2003. «Standard & Poor’s considers that further strengthening of capitalization and asset quality is needed, along with revenue diversification and the reduction of intragroup exposure,» added Kouyoumdjian. The privatization of the large state-owned banks, mainly Turkiye Halk Bankasi AS (Halkbank; not rated) and TC Ziraat Bankasi AS (BB-/Stable/B), is another challenge, even though their restructuring has made significant headway. Finally, corporate governance, accounting, auditing, regulation and supervision need to be strengthened further.