OREANDA-NEWS. June 16, 2015. Prolonged political uncertainty in Turkey, which could aggravate tensions over economic policy, would create additional risks for the country's banks, says Fitch Ratings. Slower economic growth, lira depreciation, higher interest rates and weaker investor sentiment towards Turkey could all weigh on banks' credit profiles. At the same time, our base case is that the deterioration in the operating environment will be moderate and the banks have capital and liquidity buffers to absorb mild shocks.

The banking sector's core and total capital ratios were a sound 12.9% and 15.1% at end-April 2015. These ratios are likely to have fallen since then due to the depreciation of the lira against the US dollar. In a stress scenario involving a further 20% fall in the local currency, core ratios could weaken by another 100bp. (Depreciation weakens capital ratios because it inflates the local-currency value of foreign-currency assets, while core capital is entirely lira-denominated). However, this is likely to be offset partly by Turkish banks' ongoing internal capital generation, and capital ratios should remain sound, in our view. These would only come under significant pressure in case of material loan losses.

Foreign-currency (FC) loans comprise 31% of the sector's total lending. FC lending to retail customers is prohibited and is limited in the SME segment. However, FC exposures comprise a large part of lending to the corporate sector, and this represents a considerable risk given the risk of further lira depreciation against major currencies.

To date in 2015, lira depreciation respectively against the US dollar and the euro has reached 15% and 9%. Fitch expects losses on these exposures to increase, in particular on loans to companies with no access to FC earnings, such as the construction and energy sectors. However, banks' risks are partially offset because some FC loans are made to exporters, or to companies that are parts of broader groups with access to FC revenues. Losses on loans to more exposed FC borrowers will be slow to materialise as many of these facilities are long term, and companies often take out short-term currency hedges to support upcoming payments.

If lira weakness leads to an interest-rate hike, this will hit banks' margins and capital. Margins will contract due to deposits repricing faster than loans, and capital would be impacted by negative revaluations of securities portfolios. However, narrower margins tend to be relatively short-lived in Turkey as lira loans reprice quickly (over two to three quarters, in most cases) and the impact of rates on securities books is softened by banks' large holdings of floating-rate and inflation-linked bonds.

Banks' external funding has increased rapidly in recent years, rising to USD176bn at end-1Q15, with a majority of this comprising short-term borrowing. A shift in investor sentiment towards Turkey, as political uncertainty prevails and US monetary tightening draws closer, could result in significant pressure on banks' FC liquidity. However, our base case remains that banks will retain good market access, with negative sentiment more likely to affect pricing than funding availability. Turkish banks' available FC liquidity (funds placed under the reserve option mechanism with the central bank; balances on foreign correspondent accounts; and maturing short-term currency swaps) broadly matches the USD80bn-85bn, which we estimate they would need to service foreign debt over 12 months in the extreme case of a complete market shutdown.

The ruling Justice and Development Party (AKP) last weekend lost its parliamentary majority for the first time in 13 years, resulting in significant uncertainty on the composition of the new government and near-term economic policy.