The U.S.-based International Finance Institute (IIF) said Turkish banks remain well-capitalized and their profitability is set to increase in the Turkey section of its September 2019 Central and Eastern Europe, Middle East and Africa (CEEMEA) report released this week. The report indicates that growth concerns and declining credit expansion prompted Turkish officials to introduce a set of measures to boost bank lending. "With the reduction in funding costs, banks were able to lower their lending rates markedly to 15% in early September from a recent peak of 28% in early July," the IIF said.

The reduction in the central bank's key policy interest rate by 425 basis points to 19.75% in late July and lower reserve requirements for banks with an annual credit growth above 10%, the introduction of longer tenor foreign currency (FX) swaps, which allow banks to acquire lira liquidity from the central bank at a cost lower than the key policy interest rate of 19.75%, have been among the measures geared toward easing monetary supply in the market.

After the central bank cut the required reserve ratio for banks with an annual loan growth above 10% and raised the remuneration rate on those reserves from 13% to 15% in late August, profitability of such banks should improve in the near term. One reason why banks remain well capitalized is that their lending pace has not matched the central bank's pace to lower rates.

"During periods of declining interest rates, the maturity mismatch between Turkish banks' funding and lending has a positive impact on profitability. With the Fed [U.S. Federal Reserve] and ECB [European Central Bank] set to ease their stances further, Turkish banks' funding costs from abroad will likely decrease as well, which should help improve not only profitability but also external debt rollover rates, which have already risen to 95% from a recent low of 80% in January," the report explained.

The IIF also observed that the slowdown in the ongoing dollarization is one of the results of the pickup in banks' external rollover rates.

"The rise in FX deposits since mid-2018 was coupled with sharply weaker demand for FX loans, allowing banks to lower their rollover ratios for external debt at times of significant market volatility and wider risk spreads in the second half of 2018," the IIF said.

This indeed allowed the banks to reduce their short-term FX debt.

"With rollover rates remaining below 100% since mid-2018, banks have reduced their short-term external debt from a recent peak of $73 billion in April 2018 to $58 billion in mid-2019, reducing the amount of short-term external liabilities in need of frequent rollover," the report read.

The report also noted that the intention to clean up banks' balance sheet of problematic loans, particularly those borrowed by the energy and the construction sectors, may further constrain the banks' ability to inject more loans as the non-performing loans may rise, albeit slightly.

The current debt stock of Turkey's electricity generation and distribution sector is around $47 billion, while the loan portfolio in need of restructuring stands at around $12 billion to $13 billion, the Banks Association of Turkey (TBB) said on Tuesday in a statement.

"To the extent that those attempts will be successful in creating room in banks' balance sheets for new lending without depleting capital buffers, more bank lending should be in the pipeline, which would in turn boost economic activity," the report said and continued, "Such a push for more credit to fuel output growth, however, will likely require larger external borrowing by banks to finance new lending, which would increase banks' and corporates' leverage risks and potentially put renewed depreciation pressure on the Turkish lira."