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Emerging Markets

Turkey enjoys warm welcome to covered bond club

Competition is becoming much fiercer in the Turkish banking sector. After years of rampant loan growth in many markets, banks will have to fight much harder to find new customers and bigger margins in the future.

Familiar problems remain, and in some cases are becoming more acute. Banks are too exposed to a strengthening US dollar, they do not have a domestic investor base to rely on and they are still at the mercy of general investor sentiment around emerging markets.

But their operating environment is a strong one. Turkey’s economy is growing and its young population is said to produce some one million newly ‘bankable’ clients every year.

As margins slim, banks will have to focus more on cost of funds, and they are now striving to reach new investors. Euro denominated covered bonds have been opened up, while a global squeeze on yields is making the spread on Turkish bank bonds increasingly attractive.

The challenges, for now, are dwarfed by the opportunities.

Participants in the roundtable were:

Levent Cem Egritag, senior vice president, international banking division, Akbank

Hulusi Horozoglu, assistant general manager, managing director, head of wholesale banking, HSBC Turkey

Wasif Kazi, director, structuring and solutions group, UniCredit

Tim Kennedy, head of CEE and Turkey debt capital markets, ING

José de Léon, senior vice president manager, covered bonds EMEA, Moody’s Investors Service

Mert Oncu, assistant general manager, treasury and financial institutions, Yapi Kredi

Fatih Saglik, deputy head of institutional investors department, Capital Markets Board of Turkey

Batuhan Tufan, senior vice president, head of financial institutions, Garanti Bank

Mustafa Turan, senior vice president, international banking and investor relations, Vakifbank

John Wright, FIG and emerging market syndicate, Barclays

Tom Porter, moderator, GlobalCapital


GlobalCapital: Mustafa, Vakifbank has opened the euro covered bond market for Turkish banks. Could you give us your view on the deal and how you see this market developing?

Mustafa Turan, Vakifbank: It was obviously a very successful transaction with more than two years of work behind it, and we are glad to have opened the door for Turkish covered bonds. I care the most about the number of investors, which was around 300 in the order book, and we achieved our main target of diversifying our investor base through core covered bond accounts. Putting together a new structure for your existing investor base still has value, for sure, but it was not our ultimate target and I am glad to tell you that most of the big covered bond investors were in there.

GlobalCapital: Let’s bring in the people who structured, rated and sold the deal, then. John, could you give us your experience from your discussions with investors?

John Wright, Barclays: On the investor side I completely echo the comments that Mustafa made, in terms of successfully getting into the investment grade covered bond investor base. That was always a key target, not only for diversification but also for pricing power. There was clearly a lot of focus on exactly where it would price versus senior unsecured, but also versus the sovereign curve. The success in genuinely reaching those investor bases, including central banks as well as the pure covered bond investors, was very important as that’s what delivered the pricing power, which is what makes this space particularly interesting. 

The final spread was arguably only 10bp back of the Turkish sovereign curve, which tells you all you need to know about the success of this deal. Looking forward, it goes without saying that with an order book of over €3bn there’s more capacity for other names to come should they choose. It opens up a new funding tool that’s been very widely used by European and other issuers around the world, and this is the first step in opening that up for the Turkish banks. 

Batuhan Tufan, Garanti Bank: For me there were two important questions for this transaction to answer. The first was where the pricing should be. What should be the reference? Should it be the sovereign and whereabouts around the sovereign? And the second one was whether the traditional covered bond investors would show interest. These two questions were answered with this transaction. 

Wasif Kazi, UniCredit: The question was would covered bond investors like Turkey? Would they like the Turkish legislation? Would they like the way Turkish mortgages worked? The answer was affirmative for all three. There were no real concerns on the legislation. On the mortgages, it was very clear that investors were influenced by the fact you have many low loan-to-value mortgages in Turkey. And you have watertight legislation, which follows the conventions of the covered bond space in terms of things like statutory ringfencing, independent auditors, careful monitoring and statutory stress tests. 

José de Léon, Moody’s: We believe Vakifbank’s transaction has set a strong precedent, not only for Turkish issuers but also for other emerging market issuers. It’s not only that they have issued in euros; it’s they have set up a template of issuance and they have solved some of the key risks that investors would face in a foreign-denominated covered bond from an emerging market, such as transferability and convertibility risks. That is the most relevant part for us, as rating agency.

GlobalCapital: Mustafa, you said this deal was two years in the making. Why has it come about now? Do we have the European Central Bank to thank for squeezing spreads in the core euro covered bond market?

Turan, Vakifbank: There is a clear ECB distortion in the covered bond market but it is not simple to say how it impacted our deal. Our programme was ready to go last July, but as José mentioned, the swap and the regulatory process also took further time and on top of that, Turkey was passing through local political discussions between June and November. That is why we stopped last year and now, this year, there was no specific reason for bringing the deal in April. The ECB effect probably helps, but it’s hard to say how much help it was putting on the table.

As you know, this is not an ECB eligible bond. This is not a liquidity coverage ratio eligible bond. So I’m quite confident that even without the ECB distortion to the market, we could achieve similar results.

Tufan, Garanti Bank: It’s also fair to say that it took a fair amount of time to align what we have from a regulation point of view and what the market expects. We have had to work together to align regulation with what providers expect, what rating agencies may expect or what we face as we go around structuring a programme. The support of the Capital Markets Board has also been important.

Fatih Saglik, Capital Markets Board of Turkey: We worked a lot with the potential issuers and got feedback from the banks, mostly from the banks around the table, and thanks to their guidance and help, we changed the regulations. Our board wants to provide the banks with the opportunity to diversify their funding resources as much as possible, to help decrease their cost of funding so that the real economy can get the real benefit of that.

Turan, Vakifbank: We were not trying to make a debut deal for €500m in credit. This was a strategic product for us, investing for the future. The CMB showed a commitment, from the more junior level to the chairman. They also see this as a strategic product and that’s why they were being proactive and working together with the banks. So on this occasion I would like to thank the CMB for their really strong participation in the process. They chose to align the structures to the market needs, as well as the rating agency models. 

Kazi, UniCredit: It’s unusual to see the degree of diligence and attention that the CMB gave to this product. For many years they have wanted to put together something that was best practice for looking after creditors’ interests. In our interactions with investors, what was noticeable was the legislation wasn’t a big topic of discussion, because there was nothing in there that made investors raise their eyebrows. There were the usual familiar features for those covered bond investors, which meant that, in their thinking and approach, they could clearly put this squarely within the covered bond universe. 

De Léon, Moody’s: I concur completely with what you said about the active role of the CMB and how that was reflected in the regulation, as that has helped us in our analyses. There was a good balance from the CMB between the goal of creating a strategic product for issuers and protecting the strength of the covered bond and ultimately covered bondholders. 

It was crucial how the swap was treated in the regulation, and how counterparty risk is mitigated in the regulation, since only investment grade swap counterparties are eligible. The regulation really helped to strengthen the product. 

Saglik, CMB: Our regulations are quite in line with the European Banking Authority’s best practices. We do some things a little differently but they are just tweaks here and there and we believe that the regulations should be evolving all the time because we are talking about a dynamic product. That’s why we designed the regulations based on the needs of the investors and market participants and we will continue to do so. 

Hulusi Horozoglu, HSBC Turkey: The regulatory support, as Mustafa mentioned, is key for this kind of new product, or for any first of its kind product, I’ve seen the same situation with confidence in Turkey; for example when the CMB was working on the sukuk legislation or with regards to any other structured financing legislation for Turkish issuers. They always try to support the innovative capital markets debt structures for Turkish issuers while looking at and covering domestic or international investor angles as well.

GlobalCapital: What accounts for the large spread difference between Turkish covered bonds and periphery covered bonds? Is it rating, structure, a view on emerging market credit?

Wright, Barclays: If you’re referring to the periphery of Europe then it’s mostly the ECB. It’s quite obvious that the distortions of the purchase programme have been meaningful, and as Mustafa mentioned, it probably helps the incentives for those investors to take a look at Turkey. I think, that’s undeniable, just in terms of the almost non-existent return they’re earning and peripheral bonds, which are quite often rated comparable or worse than the deal in question. That distortion is going to be interesting to test over the coming years. There’s no sign that that’s going to go away in the short term.

GlobalCapital:José, Moody’s outlook on the Turkish banking sector is negative for the next 12-18 months. What do you see in terms of ratings and how this could affect covered bond spreads?

De Léon, Moody’s: There is a negative outlook both for the government rating and the banking system. But there’s some leeway for the banks that issue mortgage covered bonds to maintain their covered bond ratings. They could withstand up to one notch counterparty risk assessment downgrade without affecting the ratings of the notes — currently at A3, all other things being equal. But, of course, we have to bear in mind the challenges facing the banking system’s operating environment, which underpin our negative outlook. 

Tufan, Garanti Bank: But specifically on this, for example, I had a discussion with one investor and they were happy that the covered bonds actually do get the benefit of these additional margins to take the bond’s ratings far away from the simple investment grade level to a single-A category. That gives confidence to investors that they can put these bonds into their maturity portfolios, whereas maybe it is not so easy for them to do that with simple euro bonds on the senior side. 

Wright, Barclays: This is a really interesting point as well because going back to Europe, if you use that as a proxy, when we went through the crisis, the covered bond funding tool was particularly useful for riding out volatility and periods where senior unsecured spreads were under pressure. So to continue that point, this does open up not only a new product, that not only gives you far better pricing than senior unsecured, but also, hopefully, provides you with a less volatile, more reliable instrument for funding. One where you don’t have to sit out a quarter or two while you wait for broader macro themes to calm down or volatility to ease. The rating is part of it, but that is something I am hoping for when you look forward for this space. 

GlobalCapital: So is this going to be quite a window-driven market? There are many things at play for Turkish banks — ratings, the currency swap, the sentiment around emerging markets…

Wright, Barclays: This is my point really. That used to be the case for senior unsecured, but this product probably does take a significant step away from that and becomes a much lower beta, lower volatility product in general, partly because of the ratings, as mentioned, but partly because of the asset quality. We’ve seen covered bonds survive many very difficult crises around the world but away from Turkey — my point is the instrument is just that much more reliable. It is higher quality. It is better rated. Your investor’s ability to still invest in that product through broader periods of volatility is going to be there. 

Turan, Vakifbank: As an issuer that has issued everything from covered bonds to tier two, we have different spots in the risk profile of the bonds. One of the ultimate targets was a diversified investor base, and just like John said, we are trying to also have different products. This is clearly a defensive product from an EM country, at the end of the day. 

Turkey is a triple-B minus, barely investment grade country and we wish for the best always but we have to be prepared for the worst also. 

There will be difficult times when you don’t have your senior unsecured window of opportunity open but a covered bond may still work. That’s exactly what we experienced through the DPR insurance from Turkey. 

The DPR kept working even in difficult times, with a relatively attractive spread, therefore our ultimate target was diversifying investors but also diversifying our chances to continue to issue through volatility.

Kazi, UniCredit: From the issuer’s perspective, the relationship between senior unsecured and covered bond spreads is going to change from time to time. But the covered bond market, as John was saying, has shown this stickiness so the number of issuers in the covered bond market is constrained by countries that have the legislation, and also issuers that have the relevant asset size, to do a benchmark deal. It’s not something that’s open to everyone so once you have a benchmark issuer and name recognition in the covered bond market, the perception would be that that issuer is able to come to the market even when, in the EM space, generally, the senior unsecured situation may be a bit more difficult. So I think from the issuer’s perspective it will be a window-driven market as they will have the opportunity to go to the covered bond market when things are more difficult.

GlobalCapital: How soon are we expecting follow-on deals? How much supply could we see this year, for instance?

Levent Cem Egritag, Akbank: When you compare the price of covered bonds to euro denominated senior unsecured funding, the advantage is clear. But for a bank that needs to swap the proceeds into dollars, the benefit at the moment is not that obvious and therefore it is harder to take a clear decision. So, for this year, Akbank will focus on the more traditional products like DPR securitization, which allows us to issue in dollars, where we can save around 50bp versus printing a covered bond in euros due to basis, and which allows us to raise funding that is at more favourable spread levels additionally.

Tim Kennedy, ING: Yes, if you swap the Turkish sovereign euro curve back to dollars there is about a 30bp differential in five years in favour of dollars at the moment. While that differential moves up and down, it has not in recent years been positive in favour of euros. However, that extra cost for Turkish banks of diversifying their funding into euros is completely removed by issuing covered bonds.

Mert Oncu, Yapi Kredi: The question on our side is more on the availability of these mortgage funds, and how much of them can be used for covered bonds. So this is not as easy a product as a senior bond. So you have one or two potential transactions per bank which we can use, mainly due to a couple of issues. One of them is the increased growth of mortgage portfolios with an amortisation schedule on the outstanding. Second, the eligibility of the portfolios, which can be put under the covered bond, which is around 45% of the outstanding. Plus, the availability of the hedging counterparty is also another issue. There are not many banks which do these swap transactions for the covered bonds like we see today. How to handle these three issues, plus the pricing aspect, where still a senior seems to be much more doable? We can do a senior deal on the phone, without doing a roadshow. This is a very important product, for sure, but there has to be a balance on the timing of it.

Turan, Vakifbank: If I may jump in here, we put together the programme last year. It was ready. We had the luxury to use the programme for private placements from various counterparties but we didn’t follow that route. Why? Because we believed that, first, bringing a benchmark deal may give us better options in the future, like we did with senior unsecured. 

After doing our senior benchmark, we were pretty quickly able to issue an enormous number of short dated, small, very valuable private placements. So my point is, this is a natural evolution of every product. That’s why we first waited to make a benchmark issuance and thereafter, different currencies, private placements, different maturities, they all opened to us. These are all now possible, it’s not an easy process but you have to start from somewhere.

De Léon, Moody’s: There are natural incentives for Turkish banks to issue covered bonds. In terms of volume and size, if you look at the experience of new markets, in three or four years we could see something 

like 10% of the mortgage market refinanced by mortgage covered bonds. Turkey has a moderate ratio of mortgages to GDP, it’s only 7.3% but it’s still growing. It’s perhaps also a question of more swap players coming into this kind of business, facilitating more issuance in foreign currency. We could see five or seven players active in the market and maybe in three years have €5bn of outstanding covered bonds in Turkey.

GlobalCapital: How is the mortgage market? Are we seeing loan growth there, and is it a profitable business for Turkish banks?

Tufan, Garanti Bank: The mortgage market is still strong. Only last year, for example, Garanti’s mortgage book grew more than 20%, so yes there is plenty of demand.

Oncu, Yapi Kredi: Mortgage is a tough product actually, worldwide, I don’t mean just in Turkey. Still what we see in Turkey is that mainly house sales are more on the cash side and not yet on the bank borrowing side. Especially in the first quarter of this year, much more is done by cash. People do not want to borrow that much, depending on the interest rates. It is an unfamiliar investment product for Turkish people. For us it’s a good product, the non-performing loans are zero, or close to zero, it is a high quality product, but a low profitability product for the banks. However, with the help of this type of funding structure it will be a more juicy product for the banking system, but still it is a baby product, like José said, there are very small margins there.

Turan, Vakifbank: When we first pushed this covered bond project in 2013 my first question to the board was, do we see mortgage lending as a core business, rather than just a fashion business? Vakifbank is one of the biggest mortgage lenders, we are probably number three now. But we have the support of our board of directors and we know that for the foreseeable future this will be a key business area for us. So like you mentioned, Wasif, this is not open for everybody and this is not the right product for all the banks. If you are a mid-size bank and you do not see mortgages as part of your core growth in the next 10 years then you shouldn’t work on the mortgage covered bond. If you do not have that support you shouldn’t work on it because it’s a costly process, it’s a very long process, and you need lots of dedication.

Saglik, CMB: From this conversation I am becoming a little more pessimistic about the potential supply of covered bonds, I mean, after the Vakifbank deal we thought everybody would follow suit because they tested the water successfully, and the situation in the traditional covered bond market in Europe is already creating incentives to issue. The banks and the ECB are kind of crowding out the covered bond market in Europe, so the other institutional investors are coming to emerging markets like Turkey. We expect that trend to continue.

Tufan, Garanti Bank: The willingness to issue is still there among the banks, there’s no doubt about that, but I think the bigger question mark is once we get the 

funding for the bank where do we use the proceeds? In my opinion this product is going to be one of the biggest competitors to senior Eurobonds. Each bank that has the right scale in mortgages can now be looking at issuing covered bonds over senior. But first I think we need to see some more loan demand, that’s something we’re missing.

Egritag, Akbank: We don’t see it as a product for financing mortgage lending, actually, it’s not possible at this pricing level, it is not something reasonable when you take into account cross-currency rates. It’s just an alternative to other funding products. When we need funding it’s going to be an important competitor to senior unsecured. Even though on pricing the benefit isn’t that large, there is still a diversification benefit, so I believe we are going to see more but it’s going to take time — not because of the product, but because of the funding needs of the banks.

Horozoglu, HSBC Turkey: When you look back at 2011, 2012 and 2013, in terms of pipeline transactions, jumbo transactions, infrastructure and project financing, acquisition financing deals, they were mostly financed through the local banking system or local bank-led syndications or club facilities. Banks were in need of much more 

long-term wholesale funding for these sizeable financings in Turkey.

Eurobonds and any other kind of long-term capital markets issuances like covered bonds have been always good options for Turkish banks to fund themselves for the longer term financing transactions and address their maturity mismatch issue. Now we don’t see a huge pipeline of sizeable financings compared to couple of years ago. In addition, banks are quite liquid in foreign currency as there has been a shift from Turkish lira deposits to foreign currency deposits and also the starting repayments of previous sizeable hard currency financings resulted in comfortable levels of FX liquidity for most of the banks. Turkish banks’ FX loan-to-deposit ratio is still at comfortable levels when compared to Turkish lira loan-to-deposit ratios and they do not see imminent reasons for tapping the markets for foreign currency long term funding, which happened in 2015, also given the increased cost for an international capital markets issuance compared to early 2013 where the pricing levels have widened on average around 150bp-200bp for Turkish issuers.

Turan, Vakifbank: I agree, there is not strong loan growth in the hard currency book on the corporate lending and project finance side. Turkish banks are extremely liquid net currency, both dollars and euros, in almost every duration. As I said, we didn’t do this covered bond for €500m of liquidity. My treasurer is not happy to have that €500m of liquidity. When we closed the deal, one week earlier I told him that we may end up closing the deal after the cut-off time. He said ‘great, it’s not a problem I can get my euros one week later, I don’t care when you close the deal’.

We are looking for duration at the end of the day, rather than the liquidity. No big Turkish bank needs either dollar or euro liquidity, which is burning your hand at the end of the day. We should increase our duration profile in order to reflect that duration upside to the Turkish balance sheet.

It’s almost not possible to have long-term Turkish liabilities. So what we’re trying to do is we get long duration hard currency, swap it to cross-currencies and try to decrease the duration mismatch in the Turkish balance sheet. Covered bonds are very good too because they give you the lowest cost for that extra duration compared to the other debt capital markets.

De Léon, Moody’s: If we look at the full picture of the banking system, most of the foreign currency liabilities are short term. So building the investor base out to traditional covered bond investors will mean that banks will have the opportunity to expand duration.

You expand the opportunity to have both senior unsecured and covered bonds, and therefore the net effect is stabilisation and lowering of the funding cost while expanding the maturity. This strategy makes sense for Turkish banks now, because it is going to be difficult to change the dependency on external funding, as the Turkish lira bond market is still developing.

GlobalCapital: Is there anything that can be done to improve the domestic investor base? Is that something the CMB is working on?

Saglik, CMB: Six months ago, we celebrated the occasion that our domestic institutional investor base had passed $100bn, so it is growing and growing quickly. As you all know, the pension funds are growing quickly, thanks to recent reforms. If you do basic maths on the back of an envelope, right now, the pension fund size is around $55bn, and they are investing close to 10% in corporate bonds, which are much riskier than covered bonds.

So we have more than TL5bn on the pension fund side. As for the mutual funds, they are investing almost half of their assets in corporate bonds, and that is around TL20bn. My point is that right now, we have almost $25bn devoted to corporate bonds, and that is a riskier product. Covered bonds could be a better alternative for many of those investors, and you want covered bonds to be available to everybody as an alternative.

Therefore, in that sense we see, maybe not right now but in the future, covered bond allocation on the institutional investor side. We definitely see demand for the covered bonds growing.

Egritag, Akbank: If you look back at our five year Turkish lira Eurobond issuance in 2013, the demand from local investors was around 1% or something. Longer tenors are challenging for them. Secondly, domestic investors are looking for yield while covered bond issuers are aiming to achieve a cost as low as possible. Due to this mismatch, I don’t expect to see much interest from domestic investors for the product. Covered bonds have a higher rating of A-, which is the main reason or justification for the lower yield, by offering higher security, but I believe this rating advantage will not be enough to make domestic investors switch from higher yielding unsecured bonds to covered 


Horozoglu, HSBC Turkey: When you look at the local currency bond market, it is mostly dominated by banks and sovereign transactions. Turkish banks are issuing three month or six month short term bonds and most of the local investors are buying these bonds. These investors, which are extensively asset management companies, pension funds and insurance companies, are also buying corporate bonds where the tenor is maximum two to three years. Five year issuance currently would be extremely challenging. The market needs to deepen enough to attract these kind of transactions.

In developed markets, for example, you can even get 25 year PPP financing through bond issuances. Anything over two years in local currency corporate issuances in Turkey is challenging. The government has been investing in and supporting the growth of the pension fund system, but I think we still have a long way to go in terms of our domestic investor base, which will be crucial to see further growth of domestic corporate issuances. Turkish corporates can easily get loan financing through banks in the country, which also results in a still low need for domestic capital markets activity, particularly for large corporates.

Saglik, CMB: I totally agree. But in a high risk environment some of the funds will probably try to change their portfolio allocations to more secure investments.

Turan, Vakifbank: I personally see a different value in the Turkish investor base, which is not the most secure one, but a more risky one. As Hulusi mentioned, they are looking for better yields if possible. Unfortunately, Turkish legislation does not allow us to issue hard currency onshore. If we were allowed to issue onshore 

hard currency bonds, especially capital products, I am a 

strong believer that existing yields may go substantially down. Some other developing markets are a good example of this.

Chinese banks can issue capital products, tier one, tier two, well below the potential pricing from international investors, thanks to a strong local bid. And when I look at the secondary bondholders of our capital products, we see huge Turkish secondary buyers.

My point is, rather than going and buying Vakifbank Turkish lira covered bonds for five years, we may have big local investor support for capital products. Why? We are a state bank. I believe almost none of our possible investors onshore would tell me that they are not comfortable with our strength, and to put up more collateral.

Turkish banks have such a strong reputation among local people that they could go simply with more deeply subordinated products with very little extra yield expectation, rather than having to use more secured products. Hopefully this will happen in 10 years’ time, but in the near future, there is a big potential from the Turkish bid, maybe not on the covered side but on the more subordinated side.

Oncu, Yapi Kredi: It’s about the level of savings in the banking system as well. To grow GDP 4% per year, you need around 20% funding, of which 13% is coming from savings. The remaining 7% we need from external net funding from outside, from other countries with higher savings. We are a young country. In Europe there are much older countries and they have much higher savings than us. When you do not have the savings then the issue becomes a price competition on the funding side on the banks. So not only the covered bonds, there are many other things you need to look at.

GlobalCapital: Does TSKB’s recent green bond debut open up another alternative funding source for Turkish banks, another way to reduce overall costs?

Horozoglu, HSBC Turkey: We priced the transaction yesterday [May 12] and it represents the first green bond issuance in CEEMEA. The offering received great interest from accounts across Europe and Asia. The transaction size was $300m, but if you look at the final order book it was nearly $4bn, demonstrating a massive, 13 times oversubscription with an extremely well diversified investor base in terms of geography and investor type. We have seen many specialised green investors, plus other investors, that are usually buying Turkish paper. So again it shows how an alternative funding base would be possible for Turkish issuers. And the pricing of the issue achieved a negative new issue premium.

For Turkish issuers, I think green bonds could be an option for the state-owned banks. It is obviously a function of a number of other parameters and obviously use of proceeds. The underlying strategy should be focusing on a number of sectors that, in any project finance transaction, any bank would be involved in. All the prerequisites are there, so really any bank can look at this alternative. 

Alternative currencies would be another option to tap different sources of funding. Garanti issued an Australian dollar Eurobond a few years ago. Two years ago a number of banks, on an annual basis, were raising almost $1bn of funding through private placements in various currencies under their MTN programmes. Turkish banks can still look at short term or long term international funding, in different currencies and different formats.

Kennedy, ING: TSKB was the obvious candidate, given its development bank nature, to be the first Turkish green bond issuer. You can see the impact of the deal’s investor diversification in the pricing, which was at least 10bp inside fair value. At about 40%, asset managers’ contribution to the final order book was much lower than for typical Turkish bank senior unsecured deals. That’s because of the much greater than usual demand from private banks, multilaterals, other official institutions and, of course, dedicated green investors. 

While prior to this issue the jury may have still been out regarding what financial benefits issuers could realise from a green bond, this transaction clearly demonstrated a pricing benefit.

GlobalCapital: Is capital building now the focus for Turkish banks, rather than expansion? How are the regulations impacting your business?

Turan, Vakifbank:Turkish banks have faced a lot of amendments to the regulations, but they are finally in line with Basel III and the road map is clear — full implementation will happen in January 2019. The buffer has been announced and since March 2016, we have been compatible with Basel III. The main challenge for the banking system in Turkey is the hard currency asset side. Different banks have different ratios but around 30%-35% of risk-weighted assets in the big banks are coming from hard currency.

Therefore you need some hard currency capital for the volatility of the currency and by legislation you cannot hedge your capital. In Turkey all the capital has to be in Turkish lira. So that’s a challenge, and many banks, like my bank, have issued hard currency capital to at least absorb some of this negative impact. And going forward I’m confident that it will continue, you will see more tier two from Turkish banks and thereafter it will move into additional tier one issuance for 2019.

It is quite early for seeing additional tier one issues, given the extremely high tier one ratios in the system. It is not needed in the short term but it will happen eventually. You have to diversify your sources of capital.

Horozoglu, HSBC Turkey: Compared to other emerging markets, Turkish banks’ capital adequacy ratios are still at comfortable levels. Capital ratios have been coming down in the last couple of years because of the depreciation of currency but are still relatively strong.

Egritag, Akbank: I agree. The average capital ratio was around 19% in 2010, and now it is around 15.5% so it is still strong. We are well capitalised, and loan growth is not like the past. This year a loan growth around mid-teens is expected. For a loan growth at mid-teens, the return on equity needs to be at mid-teens as well to keep the capital adequacy ratio stable. Therefore, as long as we can maintain that level of profitability we will not need much tier two in the near future.

Turan, Vakifbank: Do not forget that the whole Basel III mentality is based on this. You have to issue different qualities of capital, so eventually Turkish banks will start issuing tier one and tier two. Because if you use your tier two buffers and your core tier one thereafter you will end up with unhappy investors in five to 10 years’ time. So there is a balance, and it’s early for us, but five or 10 years from now you will see Turkish banks’ balance sheets more or less similar to our European peers. You will have different tier ones, tier twos and who knows, maybe thereafter tier three capital products as well.

This is an eventual transition. The good thing is nobody needs it as of today. But don’t forget when you need something desperately, you will start paying for it. You cannot issue a capital product when you’re in desperate need at comfortable levels. So you have to be planning two to five years down the line.

Kennedy, ING: In contrast to market conditions at the start of the year, when there were concerns that even major international banks like Deutsche Bank could not issue sub debt, investor risk appetite is currently very strong. While the top Turkish banks could currently issue tier two capital in dollars at around 7.5%, this is still quite high compared to previous new issue levels and so we may not see further opportunistic issuance until yields fall below 7%. Apart from cost, it is difficult to generalise about potential near-term sub debt supply as it depends on the situation of individual banks. While the CAR levels of the top 10 banks are generally comfortable, the expected asset growth, RWA and forex composition of some banks will lead them to issue tier two capital ahead of others. In the medium term, however, the additional regulatory capital requirements coming into force in developed markets (TLAC, etc) will lead to substantially increased Turkish bank capital supply. 

Wright, Barclays: Again, much like the covered bond market opening up here, what happened in Europe five or 10 years ago will be a good proxy. The whole capital situation is very similar, whereby your investor base has to learn to understand and not panic about the features within them, and that takes time. On the emerging market side we’ve got to a point now where we’ve seen a number of issues this year, which is great, and the levels are starting to improve and it’s about people gaining confidence and slowly starting to understand how these features work and how stable your capital positions are.

Tufan, Garanti Bank: I think in the broader scheme of things everyone would agree that we need some sort of foreign funding in our capital structures but the motivation as of today is not there to increase the absolute level of capital but it’s maybe to hedge against potential foreign currency fluctuations. And it has been at a relatively high cost during the past year but in the grander scheme of things everyone would like have some sort of FX denominated capital product.

GlobalCapital: Is the foreign currency element particularly problematic at the moment, given the policies of central banks globally? Is it frustrating, for instance, that the Turkish banking sector will be very exposed to the Federal Reserve’s actions this year?

De Léon, Moody’s: We’ve done our calculations on how foreign currency exposure will affect core tier one capital, and a 5% depreciation of Turkish lira versus the US dollar would mean a CET1 hit of around 15bp, which for each bank will be between 5bp and 25bp. So this is something to bear in mind. Yes, it could erode the high buffers or headroom that Turkish banks have. But banks are very conscious of that and that’s one of the reasons why banks here want to build up tier two capital in hard currency.

Horozoglu, HSBC Turkey: Lira depreciation would also have some indirect impact on the Turkish banks’ asset quality. That’s something to keep in mind. But still, NPL ratios of Turkish banks are at fairly comfortable levels.

GlobalCapital: What does Moody’s expect the trend of asset quality to be in the next 12 months or so?

De Léon, Moody’s: Well, if you compare it to the average of the last five years, there’s a slight slowdown in the economy. We forecast a growth in the economy of 3.4% in 2016 and for next year 3.6%, which is below the country’s average growth trends of 5.4% during 2010-2015. But nevertheless, we have our own estimates about a potential increase of around 40bp-60bp in non-performing loan ratios from 3.1% level at end-2015. The bulk of this will be on consumer loans and SME loans, but coming from low levels, so that is the positive in this situation.

Horozoglu, HSBC Turkey: And that is much better than other emerging markets, in your coverage as well?

De Léon, Moody’s: Yes, it compares well.

GlobalCapital: Bank profitability appears to be a global problem, and one that is particularly acute in Europe. What are some of the strategies that Turkish banks are looking at to try to improve returns?

Horozoglu, HSBC Turkey: If I may, on behalf of Turkish banks. As we discussed, in terms of the pipeline of sizeable transactions, we have not seen that much coming last year and this year in the corporate banking space other than a number of huge refinancings. Turkish banks have also been mostly focusing on growing their balance sheets, with consumer loans, SME lending and more around the commercial banking segment as well.

In terms of growing the revenues, the banks will be more and more focusing on how they can generate more ancillary income and non-lending fee income from their existing client base, because the market is a bit, in some segments of clients, overbanked. That’s why it’s getting more competitive. And especially for landmark transactions, sizeable transactions, in certain segments we see more and more competition, which makes it a bit more challenging to achieve the same revenue and returns compared to five or 10 years ago.

That is why the banks have been also focusing on their cost of funding through alternative sources of financing. So yes, you play with the revenue, you can do a number of new things and innovative things, but cost of funding and how you can manage your cost of funding is important. Plus obviously other cost items and efficiency measures that banks have been focusing more and more on in the last couple of years, to at least protect and increase their profitability.

Oncu, Yapi Kredi:There is always a limit in terms of the interest rate we can charge to a client, or the commission we can charge to a client. If there is a certain growth in a country, or sector, such as SME loans, then we need to manage that. But the growth story is the most important. Not only in Turkey, I am talking about in China, in the US, and in Europe. Where there is worldwide growth it will strengthen the number of transactions in terms of exports and imports, and there follow transactions where you can earn fee income. If you don’t have strong growth in the world it does not help the banks to increase on the offence side, if you like. So you start to look at defence. And what is defence? Funding, liability, diversification and asset quality as well.

Turan, Vakifbank: We are seeing the transformation of the system from 25% to 40% growth averages towards 15% growth averages. So the system is still growing quite nicely, and in the foreseeable future, this double digit growth seems to be continuing. The main reason behind this is the extremely favourable Turkish demographics. The average age in Turkey is now 30. Internally we call this the peak of demographic wave. It is not as low as India, for example. You need a lot of education. It is not high like European countries. 

I read some research from an international consulting agency recently, and they estimate that every year Turkey has one million new bankable clients. I mean, think about this, this is a huge potential. As a bank, we have around 10% average market share in different products. We can reach 100,000 new clients, mostly for retail of course, every year without being aggressive in the market. This kind of potential will continue to help the banking sector. Yes, maybe the era of 30%, 40%, 50% loan growth is over, which is not a bad story, by the way. We should maybe grow 15%, 20%. Not more than that, in order to have a more seasoned loan portfolio, rather than enormous growth appetite. 

We were just designing the branches to originate more loans, but now it is much more balanced. We are also looking for more of a deposit base. And the fee gathering side as well, as was just mentioned. Turkey is transforming. This is the nature of transformation towards a more mature market, I believe. You should not read these discussions as Turkish banks are starting to have difficulty. We are just coming to a second phase of a mediocre growth level. The first 10 years of extreme strong growth is over. The Turkish banking system is over TL2tr now.

GlobalCapital: How is current central bank policy affecting the banking sector, and should international investors be worried about the apparent political influence over the central bank?

Oncu, Yapi Kredi: Central banks globally have been using their power for how many years now? We are in year eight after the crisis. But it is not within the central banks’ power to change the cycle of the economy. It is more on the macro changes that are needed to be made. Each country has very different issues, looking at all emerging markets, from Brazil to South Africa. Across the emerging markets you don’t really see many nice outlooks other than for Turkey, which has had a much stronger trajectory after 2008. Central banks have limited powers in terms of tools. They are, of course, very powerful, but there is only a limited number of tools they can use. The ECB now is using negative rates, and it is the first time we have seen negative rates. Banks’ IT systems were not capable of putting in negative interest rates, and most of the Turkish banks were similar. 

These are one-off shortcuts that we do need to understand, but central banks are not the root of most of the challenges the banking sector faces now. Each sector has different issues. The commodity sector worldwide, for example. In Turkey we have our own issues, and they often cannot be solved by simply hiking or cutting the rates, but of course it will be a strong forward guidance to the banking system. 

In Turkey probably around 3%-5% of our funds come from the central bank. Of course, the central bank has other powers such as setting capital ratios. Turkey’s Treasury doesn’t need to borrow, the Treasury doesn’t sell the bonds so the rollover ratio is decreasing, but we have to find liquid assets to put on the balance sheet. Not to increase the size of the balance sheet but to maintain the liquidity of the balance sheet. 

The Fed seems to be a single giant power. If they start to hike the rates then that hits our currency, and there is typically depreciation of all emerging markets’ currencies, which hits the corporates that have unhedged foreign liabilities. This becomes a vicious cycle. But interest rates in Turkey, I don’t think that’s a Turkey-only issue. It’s more the issue for emerging markets with the depreciation of the currencies, and the increasing cost of international funding conditions. The costs may rise but we will manage to grow — smart growth will be the art for the coming years. 

Kennedy, ING: The independence of central banks has, over the last 20-30 years, become a central principle of economic stability. Any uncertainty about their independence therefore generates investor concern. The impact of this concern on currencies and bond yields can be particularly strong in emerging economies, as we saw in Hungary about four years ago. The recent negative market impact of political uncertainty in Turkey is therefore not surprising.    

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