Retail banking came of age in Turkey during the 1990s, its growth fueled by consumer lending and the popularity of credit cards (Exhibit 1). With state-of-the-art distribution systems, including ATMs and Internet accounts, Turkish banks offered services few other European banks could match. But the financial crisis of 2000 and 2001, followed by the country’s worst recession in more than 20 years, has laid the sector low. Many banks closed, and even the big four—Akbank, Garanti Bank, Isbank, and Yapi Kredi Bank (YKB)—have suffered.

Tough times expose flaws in the banking systems of many emerging markets. In Turkey, the worst of these flaws were weak regulatory supervision and weak corporate governance. This bad state of affairs was made worse by political and macroeconomic instability, which brought rising budget deficits and government debt. Profitability thus came to depend on government lending and on trading income rather than on core banking activities. The cost of restructuring private and public banks now comes to more than $20 billion, much of it to be borne by the taxpayer.

Unless the regulatory and governance gaps are closed, any progress banks make in rebuilding confidence by modernizing their operations or offering more attractive services could be undone by the activities of management, the owners, or the government. A crucial issue is whether the regulatory changes already made will be enforced. Besides encouraging more investment from international banks, many of which have avoided the country, a stable and well-regulated financial system is essential for Turkish membership in the European Union.

A tumultuous period

The financial crisis of 2000 and 2001 quickly turned into a banking disaster requiring 18 bank interventions by regulators during the past three years. But weak supervision had begun to wreak damage before the crisis. The industrial conglomerates that controlled the banks used them as a source of seemingly free cash to finance expansion and then failed to service the loans. Many banks also burdened themselves with large, open foreign-exchange positions and lost a substantial share of their capital when the lira was devalued. Problems were hardly limited to the private sector. Government after government used the state-owned banks to make politically motivated loans to special-interest groups (such as farmers) and to subsidize loss-making state-owned companies.

Even so, Turkey has undoubtedly restored some confidence in the system. A government economic stabilization program halved inflation in 2002, from more than 60 percent a year, and a new banking watchdog took over the weakest institutions, including larger ones such as Demirbank and Pamukbank. Supervision has improved, and the new regulatory agency is persuading banks to strengthen their finances by disposing of noncore assets (mostly industrial and real-estate assets) and by raising their capital base. Most important of all, the new government has vowed to respect the agency’s independence—remarks by officials had raised doubts about their intentions and caused negative reactions in financial markets—and to support further reform.

Overall, the structure of the banking sector hasn’t changed significantly since the crisis. The three large state banks¹ controlled a bit more than 30 percent of all banking assets by the end of 2001, while the four largest private banks have increased their share, to almost 40 percent of banking assets. The market share of the midsize and smaller banks has declined, since regulatory intervention and mergers have reduced their number.

The corporate-governance imperative

Regulation and supervision are not enough to stop the misuse of funds and excessive risk taking

Without better corporate governance, Turkey’s banking system is destined to remain unstable: regulation and strict supervision are not enough to prevent the misuse of funds and excessive risk taking. The weakness in governance arises mainly from family ownership of banks and from their close ties to industrial conglomerates. Not that governance was a problem at all banks before the crisis; indeed several, including Akbank (the largest of the big four) and Türk Ekonomi Bank, are widely recognized for prudent management. But the failure of banks such as Egebank and Interbank dented confidence in the system, and the new banking regulator subsequently took the owners to court for misuse of funds. These highly publicized legal proceedings not only raised concerns about the health of the sector as a whole but also strongly suggested an earlier lack of proper supervision.

Turkish banks can now improve their corporate governance in two main ways. First, they must ensure that their financial results are reported adequately. New, inflation-adjusted reporting standards will help create greater transparency by making it possible for managers, investors, and regulators to understand whether a bank has actually made money or is merely benefiting from inflation. Greater transparency assured by independent auditors and strict supervision is essential as well.

A second step would be to unravel the ownership connections between banks and industry. To ensure that banks dispose of their equity stakes in nonfinancial companies and don’t lend to related parties, banking authorities are exerting pressure through tougher regulation. But regulators can do only so much; it is essential, among other things, for bank owners to ensure that the interests of outside shareholders are represented by appointing independent, nonexecutive board members—perhaps former chief executives of European banks.

Moreover, several Turkish banks are publicly listed but in effect controlled by family-owned conglomerates. Strict separation between the roles of owners and managers would be a significant move toward better governance. Yet there has been little progress on this or other corporate-governance issues because it would be seen as undercutting the owners’ power—a short-sighted point of view, since transparent banks are ultimately more valuable.

Nonetheless, regulations already in place would help keep order in the banking system. The question is whether regulators will enforce them. Today there seems to be a commitment, but achieving bank stability is a long-term pursuit that will require the government to be patient and diligent. Improved corporate governance will certainly be essential if Turkish banks are to win over the international strategic investors they need to bolster their position; one example of the possibilities is the recent financial-services joint venture between UniCredito of Italy and Koc Holding.² The less Turkish banks are trusted, the less likely are foreign ones to accept partnerships; instead, they might try to buy Turkish institutions outright.

HSBC, the only overseas bank to enter the Turkish market in a big way, could become the first foreign player to threaten the dominance of the four large retail banks; so far it has acquired the failed Demirbank from Turkey’s Savings Deposit Insurance Fund and bought Benkar, the country’s largest consumer finance firm. Other foreign banks have entered the retail market more cautiously. Citibank has built a small branch network and continues to expand its credit card business but so far hasn’t bought a large retail bank. Portugal’s BCP (through its Greek subsidiary, NovaBank) purchased the license of a defaulted bank and is building a small branch network with the goal of entering the market later this year.

Focus on performance

While Turkish banks try to strengthen their corporate governance, they must also concentrate on the performance of their core banking operations in order to reinforce what should be their main goal: doing what is right for the organization. Performance has received short shrift because for many years Turkey’s banks made fat, easy trading profits from their treasury departments—until the financial crisis brought these profits to a screeching halt.

Poor cost controls currently handicap most Turkish banks. Their sales-management practices emphasize volume over profitability; information systems leave managers in the dark about profitability and costs; and compensation policies are not linked to performance. Even the best-managed institutions tend to set volume targets for their branch networks instead of defining sales targets by profitability and market potential. And most fail to monitor frontline performance through indicators tailored to specific banking services and individual job descriptions. The upshot is that even in the strongest banks, good performance management often owes more to conscientious CEOs than to institutional capabilities. Given the decline of trading income and the narrowing of profit margins, banks need to make their business performance more transparent by calculating the cost of funds properly and by correctly allocating costs to products and customers. Only then can banks create meaningful performance targets and effective incentive systems for employees.

True, the larger private banks’ operating efficiency compares well with that of other banks in emerging markets; Garanti and YKB, for example, have centralized most of their back-office operations. But the productivity of Turkish banking is quite uneven (Exhibit 2). It is lower, for example, in the state banks—which suffer from outdated organization, including insufficient centralization—and in the midsize banks, which should pursue economies of scale by outsourcing processing activities such as credit card operations. Moves of this sort could help these banks overcome their cost disadvantages.

While executives struggle to address the host of problems that emerged after the crisis—capital restructuring, more nonperforming loans, and volatile financial markets—they must also improve the operations and the performance of their banks’ core activities. To meet such challenges, banks need favorable economic conditions, which would help them rebuild their capital. But above all, they need sound corporate governance, strict supervision, and rigorous enforcement to ensure that their capital, once accumulated, is prudently managed.