Downgrading Turkish banks; spotlight on capital

Until now, resilient financial performance of Turkish banks led to us to maintain Buy/High Risk ratings on all four Turkish banks under coverage, although we did anticipate that concerns with the outlook for the Lira led us to have low conviction and to prefer banks in other markets (see: Turkey Diversified Banks: Resilient financial performance amid currency uncertainty). Following recent strong share price performance (in TL terms at least) we downgrade our ratings on all four Turkish banks under coverage to Neutral/High Risk rating from Buy/High Risk. Our earnings forecasts and target prices do not change. However, we note that we see downside risks from the sharp depreciation of the Lira as this will negatively impact capital positions (more on this in the next section), potentially weigh on credit quality, and ultimately may require a large increase in interest rates to restore credibility, with negative implications for credit growth and margins. Impact of weaker Lira on capital The immediate impact of the weaker Lira is that it negatively impacts the capital position of Turkish banks. This is because regulatory capital is primarily denominated in Turkish Lira while a large portion of assets are denominated in FX, mostly US$. As the Lira depreciates, RWA assets grow faster than regulatory capital, leading to pressure on capital ratios. We estimate what 3Q21 reported capital ratios (excluding the impact of regulatory forbearance) would look like today adjusted for the 38% devaluation of the Turkish Lira seen since end September 2021. We crudely estimate this by calculating the FX-adjusted level of assets assuming that all FX denominated assets are denominated in US$. We then apply 3Q21 risk-weight density to FX-adjusted assets. We also adjust Tier 1 and total regulatory capital for any AT1 and subordinated regulatory capital that is denominated in foreign currency. Our analysis suggests that, at the current USDTRY exchange rate of 12.23, Akbank, Garanti, and Yapi Kredi have ample headroom over minimum capital requirements. However, Isbank is estimated to be just under its minimum tier 1 requirement excluding regulatory forbearance. We note that, including regulatory forbearance, Isbank would be just above the minimum tier 1 requirement. We also point out that the analysis does not take into account earnings that the banks are likely to generate in 4Q21 or any actions banks may take to mitigate the negative capital impact of the weaker Lira. For these reasons the actual FX- adjusted capital position is likely more favourable. Last, we note that Isbank could also improve its tier 1 capital position if needed by issuing additional subordinated debt. Still, Isbank’s capital weakness is a concern as, should the Lira continue to weaken, it would likely limit the bank’s ability to grow. In the figure below, we show at what USDTRY level each bank’s 3Q21 FX-adjusted capital requirement (either CET1, Tier 1, or CAR) would breach the minimum requirement. Due to Yapi’s lower minimum requirement, driven by its lower systemically important financial institution (SIFI) capital buffer of 1% vs. 1.5% for its other private peers, and its US$ denominated AT1 providing a partial hedge to its tier 1 position, Yapi Kredi looks best positioned to withstand further currency weakness followed closely by Akbank, while Isbank looks worst positioned. Indeed, as mentioned before, Isbank is estimated to be below its minimum tier 1 requirement excluding regulatory forbearance. Citi Research