41137 FOR OFFICIAL USEONLY FINANCIAL SECTOR ASSESSMENT TURKEY SEPTEMBER 2007 EUROPE CENTRAL ASIAREGION & VICE PRESIDENCY FINANCIAL AND PRIVATESECTORDEVELOPMENT PRESIDENCY VICE BASEDONTHEJOINT IMF-WORLDBANKFINANCIALSECTORASSESSMENTPROGRAM A joint InternationalMonetaryFund-WorldBankteam conductedan assessmentof Turkey's financial system inconnectionwiththe FinancialSector Assessment Program (FSAP) throughmissionsinApril, August-September2006 andMarch, 2007.' The main objectives ofthe FSAPwere to assist the authorities inassessingpotentialvulnerabilities in Turkey's financial system, andto identifypriority areas for financial sector development. This reportprovides a summaryofthe mainfindings ofthe assessment andthe policy prioritiesidentified. 'Staffparticipatinginthe FSAP from the IMF includedMessrs. Charles Enoch(Mission Chief, IMF), DanielHardy(Deputy Division Chief, IMF), Luis Cortavarria, ChristianKeller, Peter Kunzel, W. Lee, and Jay Surti, andMmes Allison Holland, GretaMitchell-Casselle, NadaOulidi, andAdrianaRota(Administrative Assistant). Staff from the World BankincludedMessrs. James Hanson(Mission Chief, WorldBank), SteenByskov, TadishiEndo, RobertKeppler, RodneyLester, DimitiVittas, andMmes.NagavalliAnnamalai and Susan Marcus.The FSAPbenefited from the participationof consultants with a variety of expertise: h4r.Dankers (NetherlandsAuthority for FinancialMarkets, Securities Regulation), Mr.Demuynck(French CommissionBancaire, Stress Testing), Mr.Jaffee (UniversityofCalifornia,Berkeley, HousingSector), and Ms.Nieto(Bank of Spain, BankingSupervision).Not all individualsparticipatedin all missions. i Contents Glossary .................................................................................................... .. 11 I.OverallAssessment................................................................................................................ A.Banking Sector Resiliency andVulnerabilities....................................................... 1 B.Financialsector regulation. supervisionandinfrastructure..................................... - 1 -2 C . Deepening andBroadeningthe Financial Sector ...................................................... 3 MainRecommendations ............................................................................................................ 5 I1.Macroeconomic DevelopmentsandVulnerabilities ............................................................ -6 I11. The Financial System .......................................................................................................... 6 A. Financial Soundness B.Financial Sector Regulation, Supervision, andInfrastructure ................................ ................................................................................................. 9 10 D.BankIntervention andResolutionandDeposit Insurance ..................................... C . The Bank Regulatory and SupervisoryFramework ................................................ 11 E.Anti-money laundering andcombatingthe financing ofterrorism (AML/CFT) ....12 F Nonbanking Regulation, Supervision, andInfrastructure....................................... . 13 14 IV. Financial Sector Development Issues................................................................................ 15 A The Banking Sector 16 B Housingfinance D.The InsuranceSector andthevoluntary Private PensionSystemfor Individuals..17 C Securities Markets and Corporate Governance .. . ...................................................................................................... ................................................................................................ 17 ....................................................... E.Access to Financial Services and Credit Information............................................. 19 F Legal Issues............................................................................................................. . 20 21 Annex Tables ........................................................................................................................... 23 Figures Figure 1Composition of Commercial Credit and ConsumerFinance...................................... 7 Figure 2 .Private Credit and Incomeper Capita ...................................................................... 16 Boxes Box 1Implementation of Base1I1 ........................................................................................... 12 Annex Tables Table 1 SelectedEconomic Indicators. 2001-06 .................................................................... 23 Table 2 ofthe Financial System 2001-06 ............................................................... 24 Table 3 Table 4 FinancialRatios for the Nonfinancial Corporate & Household Sectors, 2001-06 ..Financial . Structure Soundness Indicators for the Banking Sector, 2001-05 ...............................25 26 .. 11 Glossary AML/CFT Anti-Money LaunderingKombating the Financing of Terrorism ATM Automated Teller Machine BRSA Banking Regulationand SupervisionAgency BCP Base1Core Principles for Effective Bank Supervision BKM Bank Card Center CAR Capital Adequacy Ratio CBRT Central Bank of the Republic of Turkey CPSS Committee on Paymentsand Settlement Systems EU EuropeanUnion FSI Financial Soundness Indicators IOSCO International Organization of Securities Commissions IPO Initial Public Offering ISE IstanbulStock Exchange KKB Credit Bureau of Turkey MOU Memorandum ofUnderstanding NBFIs Nonbank Financial Intermediaries NPLs Nonperforming loans SDIF Savings Deposit Insurance Fund SMEs Small and MediumEnterprises TOKI Housing Administration of Turkey YTL New Turkish lira 1 I.OVERALL ASSESSMENT 1. Turkey's economy and financialsystem haveimprovedsubstantiallysince the 2001 crisis. Growthrebounded quickly from the crisis andaveraged over seven percent per year in2003-2006 (Annex Table 1). Inflationhas beenreduced to less than ten percent per year. The banking sector has been developing and provides greater access and more financial products; its capital ratios are highandnonperformingloans (NPLs) are low relative to loans. The capital market i s once again providing investable resources; the private pension system created in2003 is growing; and financial regulationand supervision have improved. Foreign direct investmentincreased sharply in2005 and 2006, reaching nearly five percent o f GDP in 2006, including flows into the capital o f financial institutions. Gross international reserves have roughly tripledsince the crisis and now exceed US$65 billion. 2. Notwithstandingthe government'sstrongcommitmentto sound macroeconomic policies, macroeconomicrisksstill exist. The current account deficit in2006 was nearly 8 percent of GDP. Much o f the financing o f the current account deficit has come from strong foreign investment, but a significant portionhas beenpotentially volatile financial flows. Despite strong fiscal performance, the public sector's gross debt was still about 65 percent of GDP at the end of2006. About 75 percent was domestic debt, over halfof which was linked to foreign exchange or had a floating interest rate. Moreover, the legacy o f past volatility hindersfinancial development. Saving hasrisenonly slowly, deposit maturitiesare still limited, andthe share of foreign currency deposits, though lower thanin2002, remains over 35 percent. Turkey suffered more thanmost countries inthe May/June 2006 "turbulence" in emerging markets.The Central Bank (CBRT) responded by raisinginterest rates sharply and, with the revival of international investors' interest inemerging markets,a quick recovery occurred. Reflectingthese issues, the economy remains vulnerable to declines inglobal liquidity andinvestor sentiment. 3. Turkey is engaged inaccession talks with the EuropeanUnion(EU) and is integratingfurther into the world economy. These processeswill require a strong financial sector and strong financial regulation and supervision, as well as sound corporate governance. While considerable progress has been made inthese areas, continuing efforts will be needed. A. BankingSector Resiliencyand Vulnerabilities 4. The Turkish bankingsystem is muchstrongerthan inthe past, but it faces various challenges andvulnerabilitiesthat deserve close monitoring.Regardingrisks in banking, interest rate risk is an issue because o f a durationmismatch betweendeposits relative to banks' holdings o f government securities and some o f the housing loans. Exchange rate risk is less o f an issue becausebanks have only a small net foreign exchange position andhedges are generally considered to be with strong institutions.Banks' direct credit risk on lending inforeign exchange i s reduced by restrictions against such loans to nonexporters, althoughthis rule does not apply to foreign-exchange indexedloans. Large corporations have relatively highforeign-exchange liabilities often to foreign lenders. Inthe banking system, NPL ratios have fallen. Bank capitalization ratios have risen substantially since the crisis, althoughthey declined somewhat recently because o f rapid loan growth and large dividendpayouts by some banks, including the state banks. 2 5. Another set of issues relates to the possiblerisksof new activities and the rapid credit expansioninvolvingnew borrowers. The rapid credit growth inthe recovery from the 2002 crisis may have increasedrisksinthe banks, especially asthey enterednew activities and faced increased competitive pressures insome market segments, such as housing loans. As banks sought to increase their market share and attractiveness to foreign buyers, profitability andconditionality on some types of loans declined. The slowing of credit growth after June 2006, inthe context o f higher interest rates, has given the bankstime to improve their approachesto their new activities. 6. Improved risk-assessmentis spreading, with the entry of foreign banks complementingactivities by domestic banks and BRSA inthis area. The Mortgage Law, passedduring the FSAPprocess, will provide a sounder basis for mortgage lending and a framework for securitization. This securitization will allow banksto transfer risks on mortgages to capital market investors, especially as standardmortgage contracts develop and titling improves. B. Financial sector regulation, supervisionand infrastructure 7. Bank regulation and supervision has improved and was strengthenedby the 2005 Banking Law, the accompanyingregulations and, recently,the increasedcapital adequacy and provisioningrequirements.The BankingLaw andthe adoptiono f associatedregulations in2006 represent major improvements inregulation. The challenge now i s to fully implementthem. Further improvements insupervision would be desirable in the areas ofBRSA independence, loan evaluation, loanloss provisions, on- andoff-site supervision, consolidated supervision and surveillance o f conglomerates, remedial measures that require banksto correct deficiencies uncovered by supervision, and arrangements to supervise foreign banks operating inTurkey incooperation with the supervisors intheir home countries. Bankingsupervision also will need to keeppace with the rapid changes in banking, such as newbanking activities andrisk modeling. Duringthe FSAP process, the BRSAraisedbank capital adequacy requirements to twelvepercent for banks seekingnew branches and doubled general provisionrequirements, to one percent. 8. Improvements have been made inproceduresfor the exit of failing banks, but further enhancements are needed.The authorities will needto bepreparedfor any further bank exits as the sector consolidates and handlethem smoothly to maintain confidence. The BRSA has extensive enforcement powers, but it may face challenges inexercising those powers ina decisive and timely fashion inthe absence o f pre-set trigger points. The Savings Deposit Insurance Fund(SDIF) now has stronger powers to resolve problem banks, and it protects depositors up to the statutory limit. However, SDIF could be more involved ininter- agency contingency planning, especially during difficult periods. Inaddition, a bank transferredto SDIF may be kept open for 270 days, or more ifdeemed necessary, while the authorities seek to resolve it. Inthis period, depositor withdrawals would have to be fully paid by SDIF, unless the bank was closed. Moreover, some marketparticipants argue that a bank kept open by SDIF is legally a state bank andperceived to have full deposit insurance. Finally, it i s not specified that SDIF bank resolutions should take into account the minimizationof fiscal cost. Experience worldwide suggeststhat the lack o f specific triggers for action anddelays before removing problembanks from the systemraise the cost o f resolving intervenedbanks. 3 9. Capital market regulation and supervisionare broadly satisfactory.The Capital Markets Board (CMB) is implementing anactionplanto improve convergence with European practices. A new Capital MarketsLaw, drawing on the CMB's twinning arrangement with its Germancounterpart, is scheduled to be presented in2008. Extensiono f the improvementsinaccounting to smaller firms and strengthening o f the regulations regardinglarge shareholders' market activities and their interactions within financial conglomerates would be desirable. 10. Regulation and supervisionof nonbank intermediaries and financial intermediation are also good. Boththe private pensionsystem for individuals andthe payment and security settlement systems are well regulated. The real-time, gross settlement payments system represents a modernapproach and infrastructure for payments between financial institutions. The new Insurance Law will strengthen sectoral regulation inareas such as capital, reserves, provisioning, and licensing. 11. Coordination betweenthe various financial sector regulatorswill become even more critical as Turkey's financial system becomes broader. Banksdominate the financial system. Although the nonbank sectors are relatively small they are likely to grow, andbankowned firms have a largepresenceinsome o fthem, inparticular incapital markets. C. Deepeningand Broadeningthe Financial Sector 12. The continuationof the government's strong commitment to macroeconomic stability will support financial development and economic growth. Continuedeconomic stability will gradually increase public confidence inthe financial sector and encourage the growth o f instruments with longer maturities denominated innew Turkish lira (YTL). Capital marketswill benefit, and their growthwill reduce the current dominance ofbanksinthe Turkishfinancial sector. Financialtransactions taxes represent a negative incentiveon financial development. 13. The bankingsector is shiftingtoward moreintermediationwith the private sector, especiallyconsumer lending, and access to finance is improving. Bankcredit to theprivate sector has grownrapidly inthe lastthree years andnow exceeds 30 percent of GDP. Lendingto small- and medium-sizedenterprises (SMEs) has increased. Banks have also increased their consumer and mortgage lending, as well as the facilities for consumer banking such as branches and ATMs. The new Mortgage Law will help reduce the risks for thebanks ingrantingmortgages, for example by allowing banksto use pre-payment penalties. It will also support securitization o f mortgages, which will increase the funding base for mortgages and allow banks to shift risksto the capital market. A good credit information system i s widening its coverage. As inmany countries, strengtheningrural finance remains an issue. 14. The capital market is growing again, and changes inthe status ofthe Istanbul Stock Exchange (ISE) would support future growth. The ISEfunctions well. However, allowing it greater budgetary flexibility and clarifying the supervisory relationship between the CMB andthe ISEwould behelpfulfor future growth. Inaddition, resolvingthe issues delaying the ISEprivatization would help maintainthe quality o f its operations inthe future. 4 15. The privatepensionsystem for individualshas grownrapidly since it beganin 2003; further growthwill benefitretireesand capitalmarketdevelopment. Some improvements could be made inthe pensionsystem along the lines o f allowing greater portfolio diversification, including overseas diversification, and improved governance of pensions that now are linkedto economic sectors andindividual corporations, as well as integratingthese pensions into the existingprivate pensionsystemfor individuals. The government i s contemplating changes inthese areas. 16. The legalframework for financehas beensubstantiallyimproved, most recently with the 2005 BankLaw andthe new MortgageandInsuranceLaws; further improvementsinthe legalframeworkwould support further financialandeconomic growth. The new MortgageLaw and the Insurance Law will benefitthose sectors andthe economy. Regulations for both laws will needto be completed to make them effective. The legal system for collateral has a relatively good reputation, but further reductions inthe costs o f establishing and foreclosing collateral as well as improving the speed with which the judicial system handles financial cases would support greater access to credit and, more generally, sound credit growth. Improvedtitling would support and strengthenthe growth of mortgage finance. Inaddition, it may be desirable to examine ingeneral the enterprises' recent experience with the bankruptcy law and make changes as appropriate. 17. Improvementsin transparencyand corporategovernancewould providea strongstimulus to financialmarkets.Despiteconsiderable progress inmany areas, a significant agendaremains. Action would help overcome the legacy of past problems inthe minds of investors. Corporate ownership is still fairly concentrated, anda highdegree o f cross-ownership exists, which is often difficult to track. Corporate boards and minority shareholders' rightscould be strengthened. Regulatory differences exist with respect to the treatment o f large shareholders incapital markets (major shareholders are not legally considered insiders inevaluations o f market conduct, althoughthey andboard members must issue statements of "significant events") andbank lending (the limits on lendingto shareholders are not parallelto general limits on lending, though by law lendingto shareholders cannot be on favorable terms). Transparency o fthe balance sheets o f nonlisted companies could be improved further. 18. The table on the nextpage summarizes the mainFSAP recommendationsthat are explainedin more detailinthe text. "Short term" actions are those that would be desirable to undertake as soon as possible. "Medium term" actions are those that are less time-critical or require a longer leadtime, inwhich case it would be desirable to begin preparations inthe short term. The main text also describes the many important government actions that have occurred during the last 12months. 5 MAINRECOMMENDATIONS All High Complete and implement the regulations associated with the new Mortgage Law and the Insurance Law. Inparticular, establish prudential norms for mortgage lending, and assign relatedoversight responsibilities. Banking High Implement the regulations o f the new Banking Law promptly. Develop, and implement, a comprehensive planfor the BRSA to supervise banks inline with the new legal andregulatory framework, includingtheir risk management Banking High Review and amend procedures for handling failing banks, and ensure active involvement by relevant agencies, to ensure timely and cost-effective action. Banking High Ensure that domestic-currency loans indexed to foreign currency are subject to constraints similar to those on foreign currency loans. Corporate High Review any differences inregulations between major corporate shareholders governance and other shareholders and remove any residual privileges. All High Phase out transaction taxes. Banking High Conclude Memoranda o f Understanding(MOUs) with foreign supervision counterparties o f foreign banks inTurkey. Banking High Continue privatization o f state-owned banks. Banking Medium Refine data collection and analysis to meet market developments Banking Medium Review mechanisms to ensure financial independence o f supervisory agencies. Insurance Medium Establish mechanisms to generate more reliable data on insurance companies' provisions and capital. Capital markets High Resolve problems regardingprivatization o f the ISE. Capital markets High Pass the Capital Markets Law in2008. Access to finance Medium Reducethe costs of creating and realizing collateral. Access to finance Medium Improve credit information system by adding noncredit data. Housing finance High Improve titling o f collateral and develop standard mortgage contracts Housingfinance High Continue to limit financial activities of government housing agencies. Pensions Medium Gradually relax investment limits and lower caps on fees. Payments High Improve the legal certainty o f settlement and the arrangements for unwindinginthe check clearing system. Corporate High Strengthenminority shareholders' protection and raise board members' governance accountability. Corporate High Furtherstrengthen accounting and auditing, especially insmaller governance nonfinancial firms. 6 11. MACROECONOMIC DEVELOPMENTS VULNERABILITIES AND 19. TheTurkisheconomyhasimprovedsubstantiallysince the 2001 crisis (Annex Table 1). Duringthe crisis, GDP fell and inflation was high. Several private banks were intervened and the state-owned banks received a large recapitalization. Underthe government program, supported by the InternationalMonetary Fundandthe World Bank and inthe context o fafavorable international environment for emerging markets, the economy rebounded quickly. Growth inGDP averaged over seven percent per year from 2003-2006 andannual inflationhas fallen belowtenpercent per year. 20. The large government debt and current accountdeficit remainimportant macroeconomicvulnerabilities. Public sector debt (gross) remains about 65 percent of GDP. About 75 percent i s domestic. The risk profile o f public sector debt has improved. Nonetheless, its short average maturity and its large foreign currency linked component implysignificant exchange rate, interest rate, androll-over risks. The current account widenedto nearly 8 percent o f GDP in2006, inthe context of strong growth andinvestment, lack o f savings growth, highoil prices anda trend appreciation o f the Turkishlira (YTL) reflectinghighcapital inflows. Although foreign direct investment(FDI) also has grown sharply, reachingnearly 5 percent o f GDP in2006, the residualreliance on portfolio and short-term inflows makes the economy vulnerable to changes inglobal liquidity and investor sentiment. 21, The marketturbulenceofMay-June2006 highlightedTurkey's exposureto a reversal inmarketsentiment but also the resiliency of the system. The emerging market sell-off inthis periodhit Turkish markets hard. The central bank (CBRT) responded to the shock by raising interest rates and, with the return o f confidence inemergingmarkets, the impact o f the turbulence largely passed. Longer-term FDIdecisions, particularly inthe financial sector, do not seem to have been greatly affected. Nonetheless, domestic interest rates remainhighand GDP growth slowed in2006. The financial turbulence inindustrial countries' markets inJanuary 2007 was largely confined to them and did not have a major effect on Turkey. 111. THEFINANCIAL SYSTEM 22. Banks dominatethe financialsystem, and foreignbanks' interestinTurkey is growing.Banks hold about 85 percent o f financial sector assets directly and controlthe majority o fnonbank institutions (Annex Table 2). Three major banks are still effectively in the public sector, but two ofthem have made initial public offerings (IPOs) recently. The state banks face increasing competitionfrom private banks. Foreignbanks have recently have beenpurchasing majority or minority positions inthe capital ofTurkishbanksa2 * Turkey has beenattractive to foreign banks because of its growth, the room for deposit growth and expansion o fbankingservices, and the possibility o f full entry into the EU.Despitethe recent rapid increase inforeign banks, they still have a smaller penetrationinTurkey than inCentral and EasternEurope, or the EU-25. 7 23. The banksappear fairly strong, but some issues exist. Broadly speaking, bank capital ratios are high but have declined somewhat recently withthe growth of credit andthe payout of large dividends by some banks, including state banks.Nonperforming loanratios are low, but partly this reflects loan growth andthe strong economy. Smaller banks show larger deviations from these averagesthanmajor banks. Insome banks, pension liabilities may reduce capital when the banks fully convert to InternationalFinancial Reporting Standards. 24. With the returnof stability and growth, bankcredit rose rapidly(Figure l).3 Credit to businesses has grown andconsumer credit grew evenfaster, albeit from a low base. Banks rapidly expandedtheir consumer credit and mortgagesbothto take advantageof new techniques and economies of scale andto make themselves attractive to potential foreign partners.Since the turbulence ofMay-June 2006 andthe relatedrise ininterest rates, growth of credit, especially mortgage credit, has slowed. Government securities holdings still represented about one-third of banks' assets at the end of 2006 and were especially important inthe recapitalized statebanks.Sovereignriskcorrespondingly exists. Figure 1Composition of Commercial Credit and Consumer Finance (Share of GDP) 30.0 I 20.0 25'0 2002 2003 2004 2005 Construction e3 Industry 0Transportand tourism Financial Other Consumerfinance Source: Turkish authorities, and staff estimates. 25. Depositgrowthalso revivedafter the crisis, but averagedeposit maturityis still only about three months.Bankshave relied on foreign inflows to finance some ofthe credit expansion, and these were often hedged;4the banks' net foreign exchange position was The trendrise indeposits and credit beganinthe mid-199Os, but was interrupted by the 2001crisis. Inpart because average deposit maturity is very short, banks borrowedlonger-term abroad andhedgedthe loans through swap operations, in order to finance longer-term corporate and housing loans. The swap counterparties appear to be well-known foreign banks. Since the May-June 2006 turbulence, costs o f swaps have gone up and credit growth has slowed, reducing the importance o f this process. 8 roughly zero at the end o f 2005. The inter-bankmarket i s only moderately active and repurchase operations (repos) are low, inpart because o fthe attractiono f the central bank deposit facility, inpart because o f legal and contractual issues. Transactions taxes discourage domestic intermediation; the authorities planto remove these taxes as fiscal space develops.' 26. Foreigncurrency deposits and loanshavedeclinedin relativebut notabsolute terms since the crisis, similarly to developmentsin other countriesthat havestabilized. The share of foreign currency deposits has declinedbecause YTL deposits have grown faster thanforeign currency deposits, andthetrend appreciation ofthe YTL has bothreducedthe YTL value of foreigncurrency deposits andcreated anincentive for a shiftto YTL deposits. Foreign currency credits have also declined inrelative terms for similar reasons, as well as the growth o f consumer credit that i s almost always inlira. A large percentage o f loans to large corporations remain inforeign currency or indexedto foreign currency. Some o f the foreign currency loans are done offshore, with Turkishbanks' branches or foreign banksS6 Since June 2006, the rise inthe share o f YTL deposits has reversed to some degree. 27. The governmentdebt marketis activeandthe Treasury has been reducingits risks.The markethadanannual turnover ofmarketable debt ofabout 4 times relativeto the stock of marketable debt outstanding (including the primary dealers' operations) in2005. Government debt i s heldlargely by banks. Itrepresents the majority o f the assets of mutual funds, investmentfinds andthe private pensionsystem. The Treasury has extendedthe debt's duration andmaturity and decreasedits reliance on foreign currency-indexed and currency-denominated debt, although much o f its debt still has floating rates. 28. The capitalmarkethas improvedsubstantiallysince the crisis.Equitymarket capitalizationrose to 45 percent o f GDP inDecember 2005, compared to 20 percent in2002, although during2006 it declined slightly to 41 percent o f GDP. Trading reached 1.4 times market capitalization. Listings declined after the 2001 crisis but beganto rise again in2004 andhave reached 315 companies, puttingTurkey inthe middleofemerging equity markets interms oflistings.The majority ofinstitutionsthat operate inthe capitalmarket, interms of assets, are linkedto banks. IPOshave resumed, andthe first domestic YTL corporate bond in many years was issued inAugust 2006. Continuedmacroeconomic stability i s a prerequisite to development o f the private capital market. 29. Nonbankfinancialintermediaries(NBFIs) are growingrapidly,but remainvery smallcomparedto banks.The insurance sector, for example, is reviving after having been badly affected by chronic highinflation and the 2001 crisis. The new Insurance Law will contribute substantially to the sector's further development. A system o f voluntary individual private pensions was created inOctober 2003 and many o f the largest life insurance companies converted to combination life-pension firms at that point. This pension system has These include the BankingTransaction and Insurance Tax, which generates revenue of 0.5 percent o f GDP, and the Resource Utilization and Support Fund, which generates revenue of 0.3 percent of GDP. Turkishbanks' offshore branches represent less thanten percent oftheir assets and are part ofBRSA's consolidated supervision. 9 grown rapidly, albeit from a small base. Its continued growth would improve incomes for future retirees andsupport capital marketdevelopment, as ithas inother countries. A. FinancialSoundness 30. Banks' financialsoundness indicators(FSIs) haveimprovedsubstantiallysince the crisis (Annex Table 3). They are currently broadly comparable withthose inother emerging markets. On average, Turkish banks' capitalizationandprovisionratios have risen substantially. At the same time, their NPLs rates have declined substantially since the crisis.' However, N P L rates on credit cards recently began to rise; any impact o fthe 2006 rise in interest rates on borrowers will only showing up gradually; and the sub-regulations inthe newBankingLawmay lead to recognitionof more problemloans. Newriskshave come with the growthofconsumer andhousingloans. Banks andtheir risk management staffhave had to adjust to these new activities. Inaddition, the competitive pressures inmortgage markets in2005 ledto bothdeclines inlendingratesto nearlythe cost offundingas well asto loans withhigher ratios o f loan-to-asset value andhigher debt service to income, thoughthese ratios are still less than inother countries. Partly as a result o f these developments and the general increase incompetition, banks' profitability, which had rebounded after the crisis, beganto decline.* In2006, however, profitability seems to have risen again. Bankshave been careful to maintainliquidity buffersand limit their net open foreign currency positions; their hedgingcounterparties seem to be well-known internationalinstitutions. Nonetheless a significant durationmismatch exists, with average maturities o f deposits lengthening less than the average maturities of government debt and credits. The major banks' FSIs are similar to the overall averages, butthere are larger deviations from the averages among the smaller banks, some o f which have low and variable profits. 3 1. The marketturbulenceof May-June2006 ledto a temporary reductionin banks' capitalizationand slowed credit expansionin the latter half of 2006. Some banks experienced accounting falls incapitaljust after the turbulence as fixed-interest rate government securities were marked-to-market at the lower prices associated with the higher interest rates. These accounting declines incapital were reversed as assets maturedand were rolled-over at the new, higher interest rates. Growth incredit to households was slowed by thehigher interest rates that have prevailedsince mid-2006 andbankshave tightened conditions on consumer credit and mortgages. This slowdown has also giventhe banks a respite to improve their approaches inthese new areas. The episode illustrates the risks associatedwith the duration mismatch inbanks but also the banks' resiliency. The turbulence inindustrial country equitymarkets inthe first quarter of2007 hadonly amarginalimpact on Turkey. ~~~~ Immediately after the crisis, the decline reflected the substantial loan restructuring was allowed under the "Istanbul approach." The grace periods under this rescheduling are ending, but some banks have already made the necessary provisions against these loans. * Bank profitability rose after the crisis because of large interest rate spreads, valuation gains, and the improved inloanquality. Comparisons over time ofprofitability measures are complicatedby various idiosyncratic events at individual banks and changes in accounting practices, such as elimination of the allowances for inflation after 2004. 10 32. The limited FSIs available for nonbanksare broadly satisfactory.For example, most insurance companies seemto be reasonably capitalized and report highprofits, although the adequacy and appropriateness o f reservingpolicies are difficult to assess, as is the case in most co~ntries.~ 33. The corporatesector hasbeenrebuilding its financial strength, but foreign exchange exposure remains a concern inthe larger firms (Annex Table 4). A strong improvement incorporate sector performance has characterized the Turkisheconomy since 2001. Nonetheless, an analysis o f a representative group o f 20 largeTurkish listed firms reveals relatively large exposures to credit inforeign currency and at short maturities." On the aggregate balance sheet of these companies, 70 percent o f liabilities are short-term and 50-60 percent of liabilities have beendenominated inforeign currency or are exchange-rate indexed. Ofcourse, these figures reflectthese firms' accessto credit internally and ' externally, which i s much better thansmaller firms' access. More detailed analysis does offer some reassurance. The 20 largest corporations' debt servicing capacity appears strong, as evidenced by a ratio o ftotal liabilities to assets o f about 50 percent, debt-equity ratios o f 0.9, andan interest coverage ratio o fabout 5, all strong figures by internationalstandards. 34. Stress test resultsindicated that the banking sector as a whole has substantial capital buffers, but some banks are vulnerable to large interest and credit-quality shocks. Bankingprofits, andeventually bank capital, appear sensitive to a large rise in interest rates on YTL and domestically-issued non-YTL instruments according to the stress test scenarios. A large deterioration incredit quality would have a substantial impact on profits and, to a lesser extent, on regulatory capital, althoughmost largebanks would seem able to absorb these losses without falling below the requiredminimumCAR. Liquidity risk appears to be small, although this hinges crucially on the liquidity o f the sovereign bond market should liquidity conditions deteriorate within the banking system. Stress test scenarios suggest that with a sudden stop o f capital inflows or a persistent, large increase in oil prices suggest some institutions' profitability could be threatened and, eventually, capital injections would be needed. B. Financial Sector Regulation, Supervision, and Infrastructure 35. Turkey has made significant strides in financial regulation and supervision and in financial infrastructure since the crisis. Major achievements include the 2005 Banking Law, the sub-regulations to the BankingLaw issued inOctober-November 2006, and, earlier, the creation ofthe BRSA andthe SDIF, a new Capital MarketsLaw (2002), andthe sound regulationo f the newprivate pensionsystem for individuals. Regardingpayments infrastructure, Turkey i s infull observance o f almost all o f the provisions o f the Committee on Payment and Settlement Systems (CPSS) Core Principles for Systemically Important Inmost countries, profitable insurancecompanies tend to overstate reserves and lower reportedprofits to save taxes, while struggling companies tend to understate reserves to hide their weakness. loThese companies account for 37 percent o fthe market capitalization of listednonfinancial companies; their net sales are equivalent to 13 percent of GDP. 11 Payments Systemsandthe real-time, gross settlement system for payments between financial institutions i s very modern. 36. A generalregulatoryhupervisory issue is the needfor better coordinationamong the various financial sector regulatorsas Turkey's financial system becomes more diverse.Coordinationo fregulators will be increasingly important withthe intensification of the multiplelinks among financial intermediaries andthe existing links between intermediaries and nonfinancialcorporations inTurkey. MOUs exist regarding information- sharing across some o fthe Turkishregulatory agencies, but stronger implementation is needed. The establishment o f the high-level Financial Sector Committee, involving the Treasury, the BRSA, the CBRT and the Capital Market Board (CMB), i s a good start, but it shouldmeet more frequently andbe usedmore intensively duringtimes o f pressure on the financial system. Creationo f subcommittees to take technical work forward withmore frequent interactions would be a useful improvement, as would formalization ofthe schedules and the agenda for the committee and its subcommittees. C. The BankRegulatory and SupervisoryFramework 37. Turkey has made impressiveprogressin bringing its bank regulatory and supervisory framework inline with international practice. The BankingLaw andthe sub- regulations issued inOctober-November 2006 were major steps, as noted. However, full implementation o fthe regulations will take time. During the FSAP process the authorities had already taken steps to improve supervisory practice. The BRSA now prepares an annual supervisory cycle for each bank, and is developing capacity to conduct information systems and technology audits. 38. The authorities have raisedthe capital adequacy requirement (CAR) to twelve percent for banks that wish to open new branchesand doubled generalprovisionson new loans to one percent." A desirable next step would beto introduce a specific provision requirement on "special mention" loans.l2 39. The BaselCore Principles(BCP) assessment indicates a number of strengths but also some issues. Furtherimprovementsinsupervision would be desirable insuch areas as the independence o f the BRSA inits budget13and its ability to set regulations; fonvard- looking loan evaluation; and large exposures, consolidated supervision and surveillance o f conglomerates. Supervision o f cross-border bankingalso deserves more attention, particularly giventhe growth of foreign bank interest inTurkey. Informal procedures allow international cooperation, but more formal relationships and MOUs would be desirable with l1The 12percent CAR already existed for banks with offshore branches. For other banks, the CAR is 8 percent. The forthcoming introduction o f Basel I1will establish a fi-amework for supplemental capital requirements. l2Currently, loans that exhibit weaknesses, such as cases when the debtor faces negativetrends inpaymentcapability or substantialfinancial risksbut is performing, are termed "special mention" and require no specific provisions. l3Banks and leasing, factoring, and consumer finance institutions pay fees for supervision butthe revenue need not accrue to the BRSA. 12 supervisors inthe home countries o f foreign banks operating inTurkey, or countries inwhich Turkish banks have branches. 40. Inaddition, major challengessimilar to those facingsupervisorsworldwide face the BRSA. These include ensuring that supervisory practice keeps pace withthe rapid changes inbanking, information use improves, newtypes o f informationare gathered on new developments inthe financial system, and information i s appropriately shared with other regulators. The BRSA needs to ensure that it maintains the capacity to evaluate the increasinglycomplex risk management procedures and risk models usedby banks. The demands on its capacity inthis areawill increase as banks adopt more sophisticated models, motivatedby bothmarket forces andthe introduction o f Basel I1(Box 1). Box 1Implementationo f Basel I1 The Turkish authorities plan to implement Basel I1as o f January 2008, with the model-based approaches to be implemented one year later. The authorities will also take this opportunity to implement VaR models for the valuation o f market risk. The implementation o f Basel I1will affect banks' capital adequacy ratios and incentives. Usingthe Basel I1risk weights o f residential mortgages and other consumer credits will reduce the capital needed for the retailportfolio. This reduction may prompt expanded lending inthese areas. Additional capital will be needed to cover significant investments incommercial interests, Banks have already begun to divest these investments to reduce their capital costs. Ifthe authorities choose to impose some riskweight on claims on the public sector, then capital requirements could increase on average, and the spread between bondyields and lending rates could decrease. Attention to capital allocation on maturity mismatches may also be desirable. Generally speaking, the authorities may wish to make use o fthe flexibility afforded under Pillar I1to address those risk factors that are especially relevant to Turkishbanking. D. BankIntervention and Resolutionand DepositInsurance 41. The Turkish authoritieshavemade substantial efforts to establisha more effective banking sector safety net and crisis management.However, some areas require further strengtheningto ensurethat bank interventionandresolutionare expeditious and efficient, and have no systemic effects. Good procedures are needed, ifonly to handle any exit of banksthat might develop as the sector evolves. Experience worldwide suggests that slow resolutionof weak banks increase the costs o f resolutions. 42. The BRSA has legalauthority and capacityto identify unsafeand unsound practices in banks and requestcorrectiveactionsby these banks. During the 2001 crisis, delays inthe resolution o f several weak banks, inpart reflecting a lack o f mandatory triggers, increased the ultimate cost o f bank resolutionto the government. The BRSA needs to further buildits reputation for rigorous correctionof deficiencies uncoveredduringsupervision. To this end, itwould bevaluable to defineexplicit criteria for timely and graduatedaction, and to ensure good coordination betweenthe BRSA andthe SDIF. 43. The BankingLaw specifies that the BRSA may transfer a failing bank, either open or closed, to the SDIF, but the process for such transfers should be improved. For 13 example, the decision process for makingsuch transfers could be made more specific, based onwell specified criteria andmore agile. Good cooperation with SDIF prior to any transfer will be essential. 44. The SDIF is responsiblefor deposit insuranceand for dealingwith failing banks and their assets once they receivethem from BRSA. Limiteddeposit insurance, managed by the SDIF, replaced the blanket deposit guarantee in2004. The further development o f procedures to ensure a fast repayment process o f insureddeposits would be desirable. Once confidence inthe bankingsystemhas built up further, the government may wish to review the level ofinsurance. 45. SDIF has the optionto keepa failing bankopen, but the currentproceduresmay end up increasingthe costs to the government of bank resolution.The SDIF can ask BRSAto revoke atransferredbank's license, but itcan also keep the bank open to seek its rehabilitation, sale, or resolutionfor up to 270 days (with a possible 90 day extension) without a clearly-specified rationale. Keepingthe bank open without a clearly-specified rationale or solution could create a flight o f the depositors, who would have to be paid infull by SDIF.Moreover, marketperceptions are that ifa weak bankwere to be kept operating under the SDIF, and later closed, its depositors would be protected infull, since the bank would have become a state bank. Thus keepinga bank open under the SDIF may effectively generate a blanket guarantee for the bank, potentially leading to large costs to the government. To addressthese weaknesses, regulatory measures should be adopted to ensure that a transferredbank would remain open only inspecified, limited cases - for instance, if an investor is at handor ifextraordinary circumstances exist under which the closure o f the bank could clearly put the stability of the whole banking sector at risk. Internationalpractice suggests that bank resolutionagencies should make explicit the objective o f finding a solution that minimizes the cost to public funds andmaintainsthe smooth functioning o f the system. The efficient resolutiono fevensmall banks is important to maintainconfidence. 46. The capacityof thejudicial branchto interfere in, and evenreverse,withdrawals of bank licenses and liquidationprocesses remains an issue.14The bankingauthorities' decisionto withdraw a bank's license andundertake its liquidation shouldbe a definitive and irreversible administrative process. E. Anti-money launderingand combatingthe financingofterrorism(AML/CFT) 47. The governmentrecentlypassed a number of key lawsrelatingto AML/CFT; the FinancialAction Task Force notedprogressinits recent assessment. A newmoney laundering offence was introducedinJune 2005, and the stand-alone terrorist financing offence was introduced inJuly 2006. The new AML law (Law 5549 o f October 2006) provides, among other things, for a new and more comprehensive system for disclosures o f cross-border movements o f cash andmonetary instruments to be implementedinthe near future.Nonetheless, the new legislationhas not beeninplace longenough to fully demonstrate its effectiveness. As a result: l4Past experience with legal challenges to supervisory actionjustify this concern. 14 0 the number o f suspicious transaction reports and convictions for money launderingis relatively low, and confiscationmeasures have also not yet produced substantial results; 0 preventivemeasuresrequiringfinancial institutionsto undertakecustomer identificationand certain other measures do not fully meet the FATFstandards for ongoing customer due diligence (CDD), identificationo fthe beneficial owner, and CDD for high-riskcustomers and operations; 0 a comprehensive AML/CFT obligations statement i s neededfor the DesignatedNon FinancialBusinessesand Professions inorder to comply with the FATF standards; and 0 althoughthe framework for international co-operation i s adequate, some limitations inthe coverage ofthemoney laundering andterrorist financing offences could provide a technical limitationto such assistance. F. NonbankingRegulation,Supervision,andInfrastructure 48. The CMB hasstrongsupervisorypowersto monitormarket institutionsand marketpractice.It hasachieveda highdegreeof compliancewith the International Organizationof SecuritiesCommissions(IOSCO) principles.In2005, the CMB approved andbeganimplementinga well-designed Action Plan. Itis harmonizingregulations withthe EUover the next two years under atwinning arrangement withthe Germanfinancial regulator. Major amendments to the Capital Markets Law are expected to be submittedto parliament in2008. Infrastructurefor settlements inthe capital market and its regulation are excellent according to the IOSCO and CPSS-IOSCO Securities Settlement assessments, as i s the infrastructure inthe government debt market. 49. Key capitalmarketregulatoryissuesrelateto the treatment of large shareholdersandthe improvementcorporategovernance.Currently, large shareholders are legally excluded from treatment as "insiders" for purposes o f regulating market conduct, althoughthey must file declarations o f "significant events" andtheir actions are tracked by the CMB. The CMB has initiatedmajor efforts to improve corporate governance. Nonetheless, improvements incorporate governance inpublicly owned corporations, for example inthe quality and independence o f their boards, and insecurities market firms that are often linkedto banks, remain an issue. Another issue i s improving the current systemfor valuing illiquid assets inthe balance sheets o f mutual funds andpension funds inorder to ensure better comparisons o f investment performance. 50. The insuranceregulatoryframeworkhasbeenimprovedinrecentyears. An early warning systemintroducedin 1997 has beenusedto identi@ financially weak companies and undertakeintervention actions. Several weak insurance companies have been forced to exit the market by regulatory action -through license suspension, termination, liquidation, or bankruptcy. Legal challenges to interventions have been largely rejected by the administrative courts. More recently, a regulationon risk-based capital requirementshas been adopted and insurance companies have been obligedto establish internal control systems and to constitute reserves. Most insurance companies now seem to be reasonably well capitalized andreport highprofits, althoughthe adequacy and appropriateness of 15 reservingpolicies remains difficult to determine, as is the case w0r1dwide.I~Inthis regard, new rules have beenadopted on technical reserves, andfurther regulations are inpreparation. 51. The new InsuranceLaw will further strengthen the sector. The law will strengthen regulations inareas such as minimum capital; reserves and provisions; fit and proper requirements; licensing; andchanges incontrol. Regulations for the law will needto be draftedand implementedinthe future. Steps have beentaken to introduce full EU solvency requirements and a close approximationto IFRS accounting. Regulatory matters that still need improvement include conglomerate supervision; market conduct; and coordinationbetweenlicensing, offsite supervision, onsite inspections andenforcement. It will also be critical to improve dataon the insurance firms further; the new Insurance Monitoring System is a good initiative inthis area. 52. The system of private pensions for individualsis supported by a strong regulatory framework and effectivesupervision. Inthe combinedpension-life insurance companies, the assets o f the pensionfunds are completely segregated from the life insurance business. The Central Register Agency keeps the records o f all dematerialized securities and provides safe custody. The creation o fthe PensionMonitoring Center, a computerized systemthat i sjointly-owned by Treasury andthe pensioncompanies has enhanced supervision.l6 53. Nonetheless,some regulatory changes should be consideredas the system grows. Inparticular, itwould bedesirable to compile andpublishanalyticaldata onthe size, role and performance o f existingpensionschemes o f "first pillar" substitutes andthe various supplementary occupational pension schemes. Over time, the current supervisory focus on rule compliance can be replaced by an emphasis on internal control systems and ex-post assessments o f good conduct. The investment limits could be gradually relaxed andthe existing caps on fees lowered. IV. FINANCIAL SECTOR DEVELOPMENT ISSUES 54. Furtherfinancial deepeningand broadeningwill increaseaccess to financial services, raise the efficiency of investment allocation, and ultimately enhance growth and stability. Private credit from bankshas grown since the 199Os, reboundingto a much higher levelthanbeforethe 2001crisis. Nonetheless, acomparisono fthe Turkishfinancial systemwith those o f other emerging market countries suggests that considerable scope exists for further financial deepening (Figure 2). Similarly, while the equity markethas recovered but itremains inthe middleo fthe largercountries inthe emergingmarket group interms of listings andmarket capitalization. Future deepeningandbroadeningo fthe financial system Reportedprofitsof insurance companiesare affectedby reservingpolicies.Inmost countries, profitable companiestendto overstate reservesto savetaxes, while strugglingcompaniestendto understatereservesto hide weakness. Detailedactuarial audits, following standardizedmethodologies,are neededto verify the correctness ofreservingpolicies. l6System-widedataare available on the website o fthe monitoringcenter within three businessdays. 16 will depend, first ofall, onthe government's maintenance o fits current strong commitment to macroeconomic stability. A. The Banking Sector 55. The banking system is intransition from a focus on financing the government and a few major enterprisesto a focus on greater intermediation with the private sector. In2004 and 2005, bank credit grew substantially to firms and, especially, to consumers. (Figures 1and 2). While banks' government debt holdings remainlarge, their share inbank assets has declined. Banks have focused on consumer banking-more branches, ATMs and credit-to take advantage o f newtechniques and economies o f scale in the use ofcredit informationsystems and credit scoring. The growth inthe consumer segment is mainly due to the activities of the large private and foreign banks.Although credit growth slowed with the higher interest rates and tighter credit conditions that have prevailed since the turbulence o f May-June 2006, the banks' focus on consumer banking continues. Figure2. Private Credit and Incomeper Capita (GDP per capita inUS$ purchasing power parity, all observations for 2005 except as noted) 12,500 Poland Croatia 10,000 + Mexico + Chile c m 7,500 +Turkey (2006) + + L Bulgaria(2005) l!3aa Turkey (2003%key + Tunisia Thailand (2000) + Bulgaria (2000) Ukraine (2005) a 5,000 a + Ukraine (2000) 2,500 0 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 CredWGDP Source: IFS, World Bank, and staff estimates. 56. The increaseinforeign banks' participation incapital of the banking sector will have numerous positiveeffects. For example, foreign bankshave brought new risk assessmenttechnology, which i s spreading through the system, which will complement the efforts that the BRSAhas made inthis area. Foreign banks also bringnew capital, permitting an expansion o f lending. 57. State banks still have a substantial portion of Turkish bank assets but have been limited intheir new lending.Mucho ftheir assets continue to be government debt-they have a much higherproportion o f government debt thanprivate banks- as a legacy o f the large volume o f nonmarketable recapitalizationbonds they received. Although the proportion of loans inthe state banks' portfolio has risen, these bonds have limitedthe rise inlending, as have the state banks' recent large dividendpayouts. 17 58. State banks are beingput on a more commercialfooting and are inthe IPO process; privatization will enhancethese banks contribution to development. State banks are losing their privileged access to public sector deposits andthe higher-than-market rates paid on their recapitalizationbonds. Their lending, particularly agricultural lending, has been puton afull commercialfooting bylaw. The foundation-owned bank recentlymade anIPO that will helpit move more into the mainstream withrespect to bank corporate governance.l7 B. Housingfinance 59. Mortgage lending grew rapidly in2004 and 2005 but slowed in 2006. Mortgage lending i s concentrated inthe larger private banks, which tend to have more sophisticated analyses ofthe risks and which are developingthis capacity further during the current slowdown inthis lending. Mortgages are still only four percent o f bank assets, leaving substantial room for sound growth as the framework for mortgages i s developed. 60. The recently- assed Mortgage Law will substantially improve the framework for mortgage loans.1.rThe law will allow mortgages to carry floating interest rates and prepayment penalties. It will also facilitate mortgage securitization, thereby allowing risks to be transferred out o fthe banks to others who are willing to take them, and increasing the fundingfor mortgages. The law also provides for the establishment ofmortgage finance companies that can raise nondeposit funds and intermediate the securitization process. 61, Securitizationwill nonethelesstake time to develop. Only mortgages with good titles and standard contracts will be attractive for securitizations at reasonable interest rates. Thus, the development ofmortgage securitization will dependonthe speedwithwhich better titles and standard contracts develop. 62. The governmentwill needto continueto monitor the operations of the Government HousingAdministration (TOKI) carefully. TOKI constructs and sells homes, mainly to families inthe lower 40 percent of the income distribution but also to higher income families. While TOKI's current activity is restricted to rolling-over funds from the repayment o f existing housing loans, it can issue bonds and mortgage-backed securities, which could allow it to expand its operations. Italso is planningto establish a mortgage finance company. TOKI contributes significantly to the supply o f housing inTurkey, but it should not be allowed to dominate the mortgage market or crowd out private lenders. C. Securities Markets and Corporate Governance 63, Security market developmentwill depend on sustained macroeconomicstability and further microeconomic and regulatory changes.Participationremains low, despite improvements inmacroeconomic stability, regulation, market-related information, market conduct, market infrastructure and corporate governance. Investors probably are deterred by ~~ ~ "In May 2007, one ofthe state-ownedbanks completeda public offering of 25 percent of its share capital. l8 The CMB is developingthe supportingregulationsto make the law effective. 18 long memories o f deficiencies inthese areas. The choice o f capital market products is narrow and government securities are by far the principle fixed income instrument. 64. The government and the CMB have attempted to improve information quality. However, companies -particularly nonlisted companies - still often needto improve their accounting practices to reach CMB standards, which inmost areas reflect international practice. Also, investors remainconcerned about possible inter-company transactions that mightnot bewell disclosed, despite the improvedconsolidationofaccounts. Ina related area, identifying the ownership and locus o f decision-making incorporations i s often difficult, despite the CMB's attempts to increase transparency. 65. Potential investors may also be concerned by the legal exemption of large shareholders from CMB rules on insider trading and the degree of protection for minority shareholders. Although large shareholders andboardmembers must disclose "significant events," these disclosures may leave room for interpretationand be delayed slightlycompared to transactions. Moreover, large shareholders are not subject to penalties for insider trading -most countries use disclosure of significant events as a complement, not a substitute, for penalties on insider trading. Inaddition, effective penalties are ingeneral often low, as it i s often difficult to successfully prosecute complicated insidertrading inthe cloggedjudicial system. Furthermore, market participants cite concerns that minority shareholders still have difficulty inidentifyingcontrolling shareholders andbeingprotected from their actions. 66. The CMB and other regulators needto continue to support improved financial reporting and corporate transparency and apply regulatory and civil penalties as warranted. Although the authorities have set standards inthese areas, implementation needs improvement, particularly for companies that have the potentialto be listed. Strengthening corporate boards could help improve corporate governance. 67. The proposed new Commercial Code, or amendments to the existing code, could address some of the issues of corporate governance. These issues include: silence onthe consequences o f noncompliance or violation o f the laws provisions on corporate governance; the low levelof accountability o fboardmembers; lack ofpresumptionof due diligence on the part ofboard; the lack offit andproper criteria for boardmembersother thanlevel of education; the inability o f mutual funds to exercise voting rights related to equity shares they hold; andthe narrow interpretationo f minority shareholders' protection. 68. Market development could also be stimulated by encouraging greater competition between mutual funds and by improving the money market. For example, banks could be required to allow easy transfer o ftheir depositors' funds to mutual funds and other market intermediaries that are not connected to the bank, inorder to increase competition. The development o f the money market i s limited by issues o f the standardization o f rep0 contracts andthe legal framework, as well as by the attractiveness o f the CBRT's depository facility to banks. 69. The status of the Istanbul Stock Exchange (ISE) as an autonomous government agency could create regulatory issues and limit its future ability to provide low cost services. The government needs to ensure that: (i) governance of the ISEallows it to remain 19 competitive andcost-effective; (ii) sufficient capital i s available for investment intechnology and related areas; and (iii)the regulatory function remains strong -the possibility exists for some overlap betweenthe CMB andthe ISE. Issues surrounding the privatizationo f ISE need to be resolvedsoon. Otherwise, it may be difficult to keep pace with technological improvements and maintain its current good performance. D. TheInsuranceSector andthe Voluntary PrivatePensionSystem for Individuals 70. The insurancesector exhibitssome structuralstrengthsbut is less developed than comparator companies.Premiumspaidper capita, one measureo f sectoral size are less than incomparator countries. The taming o f inflation promises to be an impetus to the sector's growth. The new Law will enhance the sector's growthpotential and its ability to provide sound service the public. Followingthe crisis there was a substantial shake-out o fthe smaller, weaker companies. Many ofthe remainingdomestic companies are now affiliates o f banks. Inaddition, interest inthe Turkishmarket has grown among foreign companies with global operations. As a result, further consolidationmay occur. Other than compulsory third- partymotor liability, most lines ofnonlife business operate with low loss-claimratios and produce positive results that are further enhanced by investmentincome on accumulated reserves. The new computerized network on insurance policies, motor accidents and motor claims promises to lower costs and improve information availability and efficiency. 71, A voluntary privatepensionsystem for individualsbeganin October 2003 and has grownrapidly. The system's assets reachednearly YTL 2.7 billioninDecember 2006 (nearly 0.5 percent of GDP); it hasalmost one millionparticipants. Contributionsand investment returns benefit from modest tax incentives and withdrawals are less heavily taxed iftheyoccur after the contributorreachesretirementage. Asmentionedabove, ten ofthe eleven providers are combination life insurance-pension companies which were large life insurance firms that added pensions business whenthe system began. Smaller companies have been deterred from convertingby the highcapital requirement imposedon pension business andthe needfor expensive, on-line computerizedsystems. 72. Further improvementsinthe pensionsectorwould contributeto improved pensionsfor the publicand developmentof the financialsystem andthe economy. Greater portfolio diversification, including greater offshore diversification, would reduce risks to participants. Allowing the existing company- and sector-based systems to shift into the private pension system for individuals would improve pension regulation, supervision, andtransferability and increase coverage ofthe voluntary systemsubstantially. Inaddition, pensionvesting arrangements inthe company- and sector-pension systems could be improved. The government i s considering reforms along these lines. 73. Developmentof the privatepensionsystem for individualscouldbe further enhancedby some additionalchanges. The growth ofthe systemwould benefit from campaigns to build confidence inits integrity, stability, efficiency and fairness. Such campaigns could also underscore the potentialbenefits from long-duration assets and structured products for retirement saving purposes and encourage the selection o fpension companies (and mutual funds) with low operating fees. Increasing the availability o f analytical reports that assess the overall performance o f the system andprovide detailed comparative data on investmentreturns and operating fees would be a crucial part o f such a 20 campaign. Inorder to clarify costs, operations o fthe pension-life companies could be segregated, inaddition to the current segregation o f assets. Loweringthe caps on operating fees could be considered as continued growth o fpension assets generates economies o f scale. Annuity regulationwill needto be streamlined as demandfor annuities increaseswiththe maturing of the pension system. Finally, better analytical data would be desirable on the size, role andperformance of pension schemes that are first pillar substitutes and remain as corporate or sectoral pension schemes. E. Access to FinancialServicesand Credit Information 74. Access to finance is growingwith stabilizationand the banks' recovery from the 2001 crisis. Turkey rated reasonably well interms ofthe number of deposit accounts (1,114 per 1000people in2003/4), relativeto comparators suchas Bulgaria and Romania, although Turkey's branchpenetration was low." The recent emphasison consumer banking should improve these figures, particularly inurbanareas -branchesincreased 5 percent inthe first six months of 2006 alone and the number o f ATMs is growing. 75. Credit access is improving, except inrural areas. Small-scale credits come mainly from banks, especially the state banks. There are almost no microfinance institutions, reflectingthe legal requirements for bank-likeinstitutions. Consumer lending-credit cards andhousing loans -now accounts for over 20 percent of banklending, comparedto only 8 percent in2002. Within commercial lending, small andmediumenterprises account for about 50 percent o f the total, compared to 48 percent in2002. However, agricultural lending has fallen to only 5 percent o f bank lending, reflecting the post-crisis fall inagricultural lending by the state banks andthe Agricultural Credit Cooperatives that traditionally depended onthe state banks for subsidized funding. The passage o f the long-pending law on Micro-Finance Institutionswould provide an enabling framework to encourage microfinance institutions. 76. Increasingagricultural credit ina sustainablemanner remains a difficult issue inTurkey, as it is inmany countries.After the crisis, the large volume ofnonperforming agricultural loans inthe state institutions was written off and replaced by government debt. New lendingby these institutionswas put on a commercial basis. State institutions still account for about 90 percent o f agricultural lending.The government policy o f using commercial rates eventually will help to bring innew lenders, although rural borrowers are accustomed to low rates. A related problem inattracting new lenders to the sector i s their wariness that new government decrees might unilaterally reduce debtors' obligations at their expense, despite the government's announcements that this will not occur. Although reductions indebtors' obligations helpthose particular debtors, they tend to reduce the access to credit for some time afterward. Other issues are the rural population's limited participation inthe formal economy, makingit difficult to obtain informationontheir potential creditworthiness. Improvedtitling would help lending, although many lenders are deterred by the general complexities of foreclosingon agricultural land. Weather andcatastrophic insurance would reduce the risks o f rural lending. Improvements inthe agricultural ~~ ~~ l9T. Beck, A. Demirguc-KuntandM.MartinezPeria, "Reaching Out: Access to andUse of BankingServices Across Countries" World Bank Policy ResearchPaper, #3754. 21 cooperatives' governance, transparency andaccountability would makethem more attractive as a way to channel bank loans to farmers. 77. Leasing improves access by reducingcollateral problems, and the leasing industry has grown rapidly. Leasingfirms raise their funds from banks, which are prohibitedfrom engaging directly inleasing. Since 2000, leasing has tripled indollar terms, to over US$4 billion inleases. The average lease is about US$100,000 and 75 percent o f leases are for machinery and equipment. Changes intaxation could be considered to facilitate new types o f leasing, such as operational leases. 78. Credit information is a key factor inaccess to credit by householdsand small and medium enterprises (SMEs).The Credit Bureauo f Turkey (KKB) generally performs Itprovidesbothpositiveandnegative information onconsumer credits and shares information among commercial banks, participation banks and consumer finance companies. The principal issues with its operations are the weaknesses o f the processes by which consumers can challenge ratings. The government plans to make some improvements inthis area through regulations that have given the BRSA authority to regulate the KKB. The KKB could also expand its sources o f information beyonddebt service to financial intermediaries. For example, the KKB could include data from utility companies. This expansion o f data would helpthose outside the financial system gain a reputationfor prompt repayment and qualify for bank loans. RegardingSMEs, the Credit Registry already provides data, and KKB plansto expand its operations to SMEs soon. Including data from leasing andcredit cooperatives, as well as the tax authorities, would be desirable. F. LegalIssues 79. Titling and the costs of creatingand executing collateral representissuesin expanding access. The TurkishCadastre andRegistrationGeneral Directoratecould improve titling by modernizing land titling and registrationsystems, completing the real estate cadastre, automating cadastral offices, and developing a property valuation system. Costs for creating collateral, including taxes, fees, andregistration seem highrelative to other countries inthe region.21Creditors are penalized by heavy taxes on collection and are prohibitedfrom reaching a mutually acceptable solution with defaulting borrowers by legal restrictions.22These issues are likely to become more important with the growth o f mortgage lending. 80. The delays inexecutionof collateral and bankruptcy proceedingsas well as in reachingdecisions in complex financial cases are a problem for the financial system. The Turkishjudicial system is generally well-regarded and seems as efficient as those in most comparable countries, but improvements would support Turkey's financial development and increase its attractionto internationalinvestors. The Ministryo f Justice has 2o See World Bank, Doing BusinessIndicators, various years. '' Ibid. 22 Article 873/2 o fthe Civil Code, the Lex Commissaria prohibition. 22 been attemptingto speed-up the process o f collateral execution, but court congestion, lack o f judges andinefficient process andcase management remainhindrances, suggestingthe need for expansionof court capacity. A perennial problemis the limitedexpertise o f thejudiciary regardingcomplicatedfinancial matters. 81, Bankruptcyproceedingsrepresenta further set of issues. A newbankruptcy law was put into effect in2003. It included the possibility o f suspending bankruptcyproceedings incases where companies might emergefrombankruptcy (similarto US.Chapter 11 Bankruptcy proceedings). However, some market participants have complainedthat difficulties have emerged inboththe determination o f the eligibility o f an applicant for this procedure, and the management o fthe assets while the applicant is underthis protection. Also, concerns have been expressedabout a lack o f understanding o f the law inthe corporate world, The authorities are encouraged to investigate these concerns, and on this basis possibly amendthe law or issue new regulations. 23 ANNEXTABLES Table 1 Selected Economic Indicators, 2001-06 (Inpercentexceptwhere indicated) 2001 2002 2003 2004 2005 2006 . GNP (US$ billions) 144.0 182.7 238.5 301.5 361.9 401.4 ... GNP per capital (in US$) 2,140 2,671 3,431 4,271 5,054 5,534 ... Population (in millions) 67.3 68.4 69.5 70.6 71.6 72.6 GNP (Turkish lira billions) 176.5 275.0 356.7 428.9 486.4 575.8 Nominal GNP growth rate 40.5 55.8 29.7 20.3 13.4 18.4 Real GNP growth rate -9.5 7.9 5.9 9.9 7.6 6.0 CPI (12-month, end-of period) 68.5 29.7 18.4 9.4 7.7 9.7 SavingslGDP 19.3 20.7 19.6 20.6 18.5 15.6 InvestmenVGDP 16.9 21.5 23.0 25.8 24.8 23.5 Public sector primary balancelGDP 5.5 5.1 6.2 7.2 6.8 6.6 Public sector overall balance/GDP -17.1 -12.5 -9.1 -4.6 -1.2 -0.8 Public sector net debt/GDP 90.4 78.4 70.3 64.0 55.3 44.8 of which: domestic 52.9 46.3 48.4 46.5 46.8 37.5 Nominal growth of M2Y broad money 87.5 25.4 13.0 22.1 24.5 24.1 Real broad money growth I / 11.2 -3.3 -4.6 11.7 15.3 13.5 Real credit to the private sector growth I / -27.5 -16.5 20.1 28.5 33.6 25.1 ... Base money/GDP 4.4 3.8 4.2 4.7 6.7 7.3 Broad money/GDP 60.4 48.6 42.3 43.0 47.2 50.7 Lira broad moneylGDP 26.8 22.5 23.2 25.3 31.5 32.9 Private crediVGDP 21.9 15.3 16.7 21.0 26.7 31.7 ... Average nominal treasury bill interest rate 93.6 64.6 45.1 24.7 16.2 18.1 ... Average nominal deposit rate (eop) 54.3 39.3 23.5 17.3 13.7 ... ... Average nominal lending rate (eop) 74.3 56.0 42.7 34.8 23.5 ... ... External current account balance/GDP 2.4 -0.8 -3.4 -5.2 -6.3 -7.9 Net foreigndirect investmenVGDP 1.9 0.5 0.5 0.7 2.4 4.8 Gross external debVGDP 93.1 77.3 56.4 50.1 46.7 50.5 Gross official reserves (US$ billions) 19.8 28.1 35.2 37.6 52.2 63.3 REER appreciation (CPI based, periodaverage) -17.6 11.4 8.9 5.1 11.5 0.4 ... Exchangerate (VTUUS$, eop) 1.45 1.64 1.40 1.34 1.35 1.41 ... Sources: Data provided by the Turkish authorities; and IMFstaff estimates and projections. I / Deflated by the CPI.