Shares in Europe's biggest banks have weakened since the start of the Turkey crisis as investors fear that their exposure will lead to big losses. Many of these EU banks have affiliates in Turkey, a country facing spiralling inflation, a plunge in the currency, a surge in the current account deficit and tariffs imposed by the US.
The Turkish lira has lost more than half its value over the course of 2018, with the bulk of the decline occurring since the beginning of August. The decline in the value of the currency reflects concerns over Turkey's ever-growing current account deficit, combined with its heavy reliance on foreign-currency denominated lending.
The Turkish banking system is heavily exposed to foreign currency. Not only are 36% of bank loans denominated in foreign currencies, but banks also rely on foreign exchange deposits for 46% of their funding.
The presence of foreign currency deposits does little to safeguard against Turkish borrowers defaulting. A Turkish borrower that borrowed in euros two years ago will now have to repay more than double the amount in Turkish lira. If the firm earns the bulk of its revenue in lira, the risk of default has increased exponentially.
European banks also provide funding and liquidity support to their Turkish affiliates to varying degrees, which complicates an evaluation of the European banks' balance sheet exposure to their Turkish affiliates. Funding provided ranges across the full risk spectrum from overnight loans to subordinated debt. We acknowledge that the risk faced by a European bank on an overnight loan to its Turkish affiliate is very small under all but the direst of situations. However, there is always a risk.
What Happens Next? Three Scenarios for Turkey
Our base-case scenario is that the Turkish economy goes through a phase of painful rebalancing in which it weans itself off its reliance on foreign funding. It is likely that the Turkish economy will enter recession at some stage, especially considering the importance of property development and construction activities to the economy.
We believe that the Turkish banks' profitability and reasonably high levels of capital should ensure that the large Turkish banks will pull through the crisis. We do not discount the possibility of capital calls from the Turkish banks to bolster their capital adequacy, but we believe that all the European banks should be able to come up with the required capital internally without the need to come to market.
Our worst-case scenario calls for Turkey to enter a full-blown systemic crisis as spiralling loan losses require multiple recapitalisations of banks. European banks extend further short-term, hard-currency liquidity to their Turkish affiliates. The Turkish lira continues to tumble in value, and the Turkish government implements foreign exchange controls, effectively trapping the hard-currency funding from the European banks inside Turkey.
This extends the balance sheet risk of the European banks not only to the capital investments and longer-term funding, but also to short-term funding/liquidity provided to their Turkish affiliates. With losses mounting, the European banks will face the conundrum of essentially doubling down on their bets or cutting their losses. We stress that this is our worst-case scenario and the probability of it occurring is currently very remote.
Our best-case scenario still sees the Turkish economy slowing down, possibly even dipping into recession. However, credit quality proves to be stronger than anticipated and Turkish banks weather the storm without the need to call on their shareholders for fresh capital injections.
Profitability returns to the high previous levels and growth becomes more sustainable as the Turkish economy undergoes a relatively pain-free restructuring. The Turkish lira appreciates as the market takes a more benign view on the outlook for the Turkish economy.
