Basel III liquidity requirements and the potential effects of the liquidity coverage ratio on Turk Eximbank

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University of Amsterdam

Amsterdam Business School

Master in International Finance

Master Thesis

“Basel III Liquidity Requirements and The

Potential Effects of The Liquidity Coverage Ratio

on Turk Eximbank”

Author

Kaan Taşyürek

Thesis Supervisor

Drs. J. F. Jullens

August 2015

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ACKNOWLEDGEMENTS

First of all, I would like to present my gratitude to Jean Monnet team for offering Turkish professionals such a unique opportunity. I appreciate their continuous and kind support from the very first day of my studies.

In addition, I want to thank to my advisor, Prof. Dennis Jullens, for his patient guidance as well as for his open-minded approach to my questions.

Last but not the least, I am grateful to Mr. Murat Şenol, the CRO of Turk Eximbank, not only for answering all my questions open-heartedly, and also for his invaluable contributions to my thesis with his broad experience in risk management.

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ABSTRACT

This thesis examines the global liquidity framework introduced by Basel Committee on Banking Supervision (BCBS) and discusses the potential effects of implementing the Liquidity Coverage Ratio (LCR) on Turk Eximbank. Considering the interview with Mr. Murat Şenol, the Chief Risk Officer (CRO) of Turk Eximbank, we believe that the Bank will increase its LCR by enlarging its treasury portfolio mostly via Turkish Treasury bond purchases. As a result of such action, the Bank’s lending supply to Turkish exporters would be reduced and the funding cost of Turkish exporters would increase. Yet, since return of Turkish Treasury bonds is higher than lending rate of the Bank, switching sources from lending to investing in Turkish Treasury bonds will increase the Bank’s profit. In addition, the total risk of the Bank will decrease because of lower risk of Turkish Treasury bonds than the risk of lending activities. However, the asset size of the Bank would become more dependent on the price of Turkish Treasury bonds and thus, the growth of the Bank would be adversely affected in the case of depreciation of Turkish Treasury bonds.

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ABBREVIATIONS

ABCP : Asset-Backed Commercial Paper

BCBS : Basel Committee on Banking Supervision BRSA : Banking Regulation and Supervision Agency CBRT : Central Bank of the Republic of Turkey CRO : Chief Risk Officer

EBA : European Banking Authority ECA : Export Credit Agency

ESBG : European Savings Bank Group EU : European Union

FSB : Financial Stability Board G10 : Group of Ten

HQLA : High-Quality Liquid Assets IMF : International Monetary Fund LCR : Liquidity Coverage Ratio NSFR : Net Stable Funding Ratio

OECD : Organisation for Economic Co-Operation and Development PSE : Public Sector Entity

RCAP : Regulatory Consistency Assessment Programme RMBS : Residential Mortgage-Backed Securities

RoA : Return on Assets RoE : Return on Equity

SIV : Structured Investment Vehicle SME : Small and Medium Enterprise SPV : Special Purpose Vehicle SVaR : Stressed Value-at-Risk

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1. INTRODUCTION

The main reason for the financial crisis in 2008 was the defaults on subprime mortgage-backed securities and the financial institutions’ not having sufficient liquidity to overcome the adverse effects of the crisis at that time. As a result, several banks had bankrupted while the lucky few were bailed out by the governmental authorities. This incident showed that Basel II Accord had never sufficiently addressed some major risks embedded in the financial sector, such as liquidity risk.

In response to 2008 crisis, Basel Committee on Banking Supervision (BCBS) has introduced Basel III Accord in 2010. The recent regulatory framework is not a brand new concept but is an improvement of Basel II, particularly in terms of capital, liquidity and leverage requirements (BCBS, 2010a).

In terms of liquidity regulation, BCBS introduced two global frameworks: The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), both of which aim at reducing banks’ reliance on short-term funding by requiring them to hold a liquidity buffer that is sufficient enough to survive a stress scenario over 30 days and 1 year, respectively (BCBS, 2013).

In this context, this study commences with brief introduction of the Basel Accords as well as the liquidity regulations. The study then proceeds forward to its key objective, providing a foresight about the potential effects of the LCR implementation on Turk Eximbank. Considering the arguments on the effects of the LCR on the smaller banks, particularly in terms of growth and lending supply; with its total assets of 14,5 billion USD and very high total credits/total assets ratio of 95% (Annual Report of Turk Eximbank, 2014), Turk Eximbank seems to be a felicitous sample to study.

The literature review shows us that the effects of the LCR on the banks have mostly been discussed and analyzed in terms of growth, lending supply and/or profitability.

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Since Turk Eximbank is a non-profit oriented development bank, the profitability analysis is not one of the main objectives of this thesis. However, considering the mission of Turk Eximbank, the potential effects on the growth and lending supply of the Bank will be the main focus of the interview held with the Chief Risk Officer (CRO) of Turk Eximbank.

According to non-public reports, Turk Eximbank maintains lower LCR than that of the commercial banks do as of June 2015 and therefore, the Bank will have to increase its LCR in the case of implementation of the LCR.

In this context, this study predicts that implementing the LCR will force Turk Eximbank to decrease its lending volume. Besides, the funding cost of Turkish exporters is expected to increase in this regard. Since there are various ways to increase the LCR, such as replacing long-term assets with short-term assets, increasing the stock of the high-quality liquid assets or decreasing the total net cash outflows, the effects of the LCR varies depending on the strategies of the banks. Hence, investigating Turk Eximbank’s strategy for increasing its LCR and discussing the probable outcomes of that strategy are the other objectives of this thesis.

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2. LITERATURE REVIEW

The aim of this section is not only to provide introduction to the Basel accords and the liquidity requirements, and also to reflect the literature review on the discussions on the effects of the LCR.

In this context, this section consists of three subsections of “The Basel Accords”, “The Liquidity Coverage Ratio” and “The Effects of The LCR”.

2.1. The Basel Accords

Upon the collapse of Bretton Woods System, a global foreign exchange regulation introduced by International Monetary Fund (IMF), many banks incurred heavy losses due to large foreign exchange exposures. As a response, the central bank governors of the Group of Ten (G10) countries established The Basel Committee on Banking Supervision (BCBS) in 1974 (BCBS, 2014a).

The Committee not only sets minimum standards for the regulation and supervision of the banks, and also introduces prudential ratios in order to increase the resilience of the global banking system. Since the Committee has no legal force, the members are not obliged to implement the Basel standards. However, the Committee encourages and monitors its members for the implementation of Basel standards (BCBS, 2014a).

In this context, the Committee released three main global frameworks, namely Basel I, Basel II and Basel III, so far. In addition to Basel II.5, which revised Basel II in terms of risk management, several amendment documents were published with the aim of timely and consistent implementation of the accords. The following subsections provide brief information on the evolution of the abovementioned Basel accords.

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2.1.1. Basel I

The Latin American debt crisis in the early 1980s, drew BCBS’s attention to inadequate capital ratios of the banks. As a result of several years’ work, the Committee introduced a capital measurement system for the banks in July 1988. This multinational accord is known as Basel I (BCBS, 2014a).

According to Basel I, the minimum capital ratio of capital to risk-weighted assets is 8% and the banks should meet this requirement by the end of 1992 (Elizalde, 2007). In the calculation of capital adequacy ratio, only the credit risk was taken into account. The credit risk is grouped in five categories and the risk-weight for the debts from the Organisation for Economic Co-Operation and Development (OECD) members are 0% (Ward, 2002). However, the crises in Turkey and Mexico showed that the OECD members could be risky and the banks should be resilient to interest rate and exchange rate shocks as well. Hence, market risk was also incorporated into the calculation of the capital adequacy ratio in 1996 (Çölgezen, 2013).

As in line with the rapid diversification in financial products, the risks embedded in the financial sector have increased. Hence, Basel I was amended several times most importantly in terms of redefinition of the underlying risks and the models to be used in calculation of the capital adequacy ratio (BCBS, 2014a).

Subsequent to the publication of three consultative papers in 1999, 2001 and 2003, the Committee released the second accord, known as Basel II, in June 2004 (Bakiciol et al., 2008).

2.1.2. Basel II

In addition to improving capital requirements and harmonizing national implementations, one of the most important innovations of Basel II is its intention to enhance the quality of risk management and supervision (Bakiciol et al., 2008).

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Basel II consists of three pillars, which were introduced as minimum capital requirements as the first pillar, supervisory review process as the second pillar, and market discipline as the third pillar.

The first pillar introduces the calculation of minimum capital ratio for credit, market and operational risks. And so, for the first time, operational risk was included as an underlying risk. The minimum capital ratio of 8% remained as the same with Basel I. The second pillar is related to key principles of supervisory review and transparency as well as to risk management guidance. The third pillar aims at complementing the first two pillars. In this regard, this pillar introduces disclosure requirements for the banks in order to increase market discipline (Yıldız et al., 2010).

Since the first release of Basel II was focused on the governance of the banking books of the banks, the Committee published a consensus document that incorporates governance of the trading books of the banks into the new framework. The incorporated document, namely, Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version, was released in June 2006 (BCBS, 2014a).

The financial crisis in 2008 increased the criticisms on Basel II for being a capital-based regulation and ignoring liquidity and leverage issues. In this regard, the Committee accelerated its efforts to strengthen the regulatory framework.

2.1.2.1. Basel II.5

The financial crisis in 2008 was one of the biggest financial shocks after the Great Depression. Although many factors were involved, the financial sector has always been considered as the main reason (Dullien et al., 2010).

Whatever were the main causes of the crisis, the Committee was aware that banking sector was unprepared for such turmoil. The excess growth in the sector had been fed

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by quite high leverage and also, the liquidities of the banks were inadequate. Furthermore, fundamental risks such as credit risk and liquidity risk were underestimated. Therefore, the Committee made some additions to Basel II in order to strengthen the regulation and supervision of the banks. The new amendments are known as Basel II.5 (BCBS, 2014a).

Basel II.5 is mostly about risk management and stressed value-at-risk (SVaR) was introduced in this context (Hassan, 2009). Moreover, Basel II.5 strengthened Basel II in terms of off-balance sheet vehicles, trading book exposures and securitization positions.

However, the Committee recognized that further revisions were needed in order to strengthen the current framework, particularly in terms of risk measurements. In this context, both internal-based approaches and standard approaches for risk measurement were put under the microscope (BCBS, 2012a).

2.1.3. Basel III

On 16 December 2010, the Committee published “Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring” and “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems”. With the addition of this reform package to Basel II.5, Basel III was born.

The main purpose of Basel III is to strengthen global capital and liquidity regulations so as to increase the resilience of the banks in the event of a financial shock. In this context, the Committee targets to increase banks’ ability to absorb financial shocks so as to limit the impacts of such crises to the real economy. Thereby, contagiousness of the impacts of the crises will be diminished (BCBS, 2010b).

Basel III is not only a revision for the previous versions, but also sets out new rules. A capital conservation buffer of 2.5% has been introduced and thus, minimum 8% of

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capital requirement has increased to 10.5%. In addition to that, the definition of capital has been tightened. Moreover, a leverage ratio of 3% of Tier 1 capital has been introduced with the aim of mitigating uncertainties that can arise from risk-based approaches. Furthermore, global liquidity standards were set out via the Liquidity Coverage Ratio (LCR) that aims at improving banks’ short-term liquidity risk profile and the Net Stable Funding Ratio (NSFR) that requires banks to maintain a more stable funding profile (ICAEW, 2011).

Since several revisions and innovations were incorporated into the framework at once, the Committee provided national authorities with a schedule for the implementation of the abovementioned requirements. In this way, the Committee also aimed at minimizing the possible adverse effects of the tightened regulations on the real economy (BCBS, 2014a). The schedule for the main implementations of Basel III is provided in Table-1 below:

Table-1. The Schedule for the Main Implementations of Basel III

Introduction Year Full Implementation Year

Definition of Capital 2013 2018

Capital Conservation Buffer 2016 2019

Leverage Ratio 2013 2017

The LCR 2015 2019

The NSFR - 2018

In this regard, although the new definition of capital was introduced in 2013, it will be fully implemented from 2018. The capital conservation buffer will be gradually implemented from 2016 and will become fully effective from 2019. The test period for the leverage ratio was commenced in 2013 and the full implementation will take place from 2017. The LCR was introduced on 1 January 2015 with a minimum requirement of 60% and will be increased 10% each year so as to be implemented as 100% from 2019. The NSFR will be introduced from 2018 (BCBS, 2014a).

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Regarding the importance of full, timely and consistent implementation of Basel III, the Committee adopted the Regulatory Consistency Assessment Programme (RCAP) in April 2012. The main purpose of this program is to monitor members’ timely adoption and consistent implementation of Basel III (BCBS, 2012b). In addition, the Committee cooperated with the Financial Stability Board (FSB) for the coordination of the monitoring process.

2.2. The Liquidity Coverage Ratio

As the financial crisis hit the markets, even the banks with adequate capital had rough times due to poor liquidity management. Since the markets were very liquid during the pre-crisis period, the funding terms were also relatively better. Hence, the financial institutions did not care about the liquidity management as much as they should do.

In this context, Basel III introduced two global standards in order to limit the liquidity risk. The first one, the Liquidity Coverage Ratio (LCR) was introduced on 1 January 2015 with a minimum ratio of 60%, which will increase by 10% each year and reach 100% by 2019. The table for the gradual implementation of the LCR is provided below.

Table-2. The Schedule for the LCR Implementation

2015 2016 2017 2018 2019

Minimum LCR 60% 70% 80% 90% 100%

The second one, the Net Stable Funding Ratio (NSFR), which is reviewed in the next section, will be a minimum standard from 2018 (European Banking Authority, 2013a).

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According to BCBS (2013), the formula for the calculation of the LCR calculation is given below:

Stock of High-Quality Liquid Assets ≥ 100% Total Net Cash Outflows

The assets are considered high-quality liquid assets (HQLA) if they are liquid in times of stress and ideally central bank eligible, as the central banks have acted as liquidity providers in times of crisis. In other words, HQLAs can be rapidly converted into cash with little or no loss of value even under stressed market conditions. In this context, the HQLAs are assets that have certain valuation, low duration, volatility and correlation with risky assets (BCBS, 2013).

The HQLA stock may consist of two categories. While there is no limitation for the inclusion of Level 1 assets (such as cash, qualifying central bank reserves), the inclusion of Level 2 assets (such as qualifying corporate debt securities rated AA- or higher, qualifying covered bonds rated AA- or higher) is limited to 40% of the total HQLA stock. Supervisors may also include Level 2B assets (such as qualifying corporate debt securities rated between A+ and BBB-, qualifying common equity shares) within Level 2. In this case, the inclusion of these assets is limited to 15% of the HQLA stock and Level 2B assets must be included within the overall 40% cap on Level 2 assets (BCBS, 2013).

Since the asset classes within the HQLA stock differ in terms of liquidity and riskiness, certain haircuts are applied for the calculation of the total HQLA amount. In this context, while there is no haircut for Level 1 assets, 15% haircut and 50% haircut are applied for Level 2A and Level 2B assets respectively (BCBS, 2013). For further information on the multipliers for the calculation of the total value of the HQLA stock, please see Appendix 1.

Total net cash outflows are defined as the total expected cash outflows minus total expected cash inflows for the next 30 calendar days in a specified stress scenario.

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Considering the run off probability, the total expected cash outflows are multiplied by prescribed run-off rates (such as 5% for stable deposits, 0% for secured funding transactions with central bank counterparty) (BCBS, 2013). For further information on the run-off rates for the calculation of total expected cash outflows, please see Appendix 2.

The expected cash inflows are also multiplied by the rates at which they are expected to flow in, with a cap of 75% of total expected cash outflows (BCBS, 2013). For further information on the expected rates for the calculation of total expected cash inflows, please see Appendix 3.

As a result, Total Net Cash Outflows = Total Expected Cash Outflows – Min {Total Expected Cash Inflows; 75% of Total Expected Cash Outflows}

Consequently, the LCR is a profound measure that aims to increase the resilience of the banking sector in the event of short-term liquidity shocks. However, there are also several empirical studies that show us: A quantitative liquidity requirement may cause some adverse effects on growth, lending supply, funding cost or profitability of the banks (European Savings Bank Group, 2014). In this context, the next chapter provides literature review on the debates on the effects of the LCR.

2.2.1. The Effects of the LCR

As a very short-term (30 days) liquidity measure, there have been several debates on the impacts of the LCR on banking sector and also on real sector. In fact, the LCR was revised in January 2013 by BCBS and Hesse and Schmitz (2014) criticized this revision as a dilution of the standard.

According to Becker (2013), Michaela Erbenova, Division Chief of Financial Supervision and Regulation Division of International Monetary Fund (IMF), raises concerns on the adverse effects of the LCR on the banks in smaller countries. Since the LCR requires

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banks to hold high-quality liquid assets, the banks in smaller countries may start to pile the securities and this may lead deterioration in long term lending. In this context, Erbenova states that the LCR is a specific regulatory framework mostly fine-tuned for the banks in larger countries and less effective for the emerging markets.

Moreover, in their empirical study, Bonner and Eijffinger (2012) revealed that if the banks are just above or below the minimum requirements of the LCR, they increase borrowing volume and thus, have higher cost of funding. Also, they decrease lending with maturities longer than 30 days and thus, provide higher lending rates in unsecured interbank market. In addition to this study, Bank for International Settlements (BIS) Quarterly Review (2012) suggests that there may be an additional premium for interbank loans that extend beyond 30 days due to implementation of the LCR.

In European Savings Bank Group (ESBG) Paper, Tourdjman (2014) has also stated that since the LCR forces banks to increase their high-quality liquid assets (HQLA), they have already started to invest more in central bank deposit facilities and sovereign bonds and hence, this will lead a reduction in credit provision. Therefore, the profitability will also diminish due to the decline in credits.

On the other hand, according to the study of Hesse and Schmitz (2014), empirical evidence suggests that EU banks did not significantly reduce lending and an increased demand for LCR-eligible assets is likely to be small, also the macro-economic costs of the LCR are likely to be minimal. Hence, the benefits of the LCR outweigh the costs by far.

This idea is supported by the impact reports of EBA (2013b) and EBA (2014). The first impact report of EBA presents that the European Banks already have sufficient liquidity buffer (the average LCR is 115%) and the cost impact of implementing the LCR is negligible (around 3bps in long term). In addition, according to the sensitivity analysis of the study states that after the revision of the LCR in January 2013, this standard has become more appropriate for the global implementation.

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Likewise, the second impact report published in 2014 states that although the average LCR of the European Banks has increased, an adverse effect is not expected particularly in terms of lending supply of the banks. Even if some banks need to adjust themselves for the LCR requirements, the other banks meet the excess demand in the economy. In other words, the report claims that the implementation of the LCR does not have adverse effects on the banks in terms of bank lending, business model or risk profile of the institutions in the EU.

Consequently, a literature review provides mixed results on the effects of the LCR on the banks as well as on the private sector. While some of them reveal empirical evidences on the adverse effects of the LCR, some others don’t agree with those results.

2.3. The Net Stable Funding Ratio

Abundant liquidity during the pre-crisis period stimulated excess growth and high leverage in the banking sector and hence, sustainable funding became crucial in terms of liquidity management. As being aware of that, the Committee believed that the LCR should be complemented by another standard that focuses on funding risk so as to further strengthen the liquidity requirements of the framework. Therefore, the Net Stable Funding Ratio (NSFR) was introduced in 2010 with the aim of promoting stable funding. The framework was revised in 2014 (BCBS, 2014b).

The NSFR is the ratio of available stable funds (ASF) to the required stable funds (RSF). The minimum requirement for this ratio is 100%. The NSFR requires banks to fund their activities with more stable funds. In this way, the Committee aims at reducing the maturity transformation risk. The NSFR will be a minimum standard starting from the year 2018 (IMF, 2014).

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According to BCBS (2014b), the NSFR is calculated as follows:

Available Amount of Stable Funding ≥ 100% Required Amount of Stable Funding

The ASF is the portion of a bank’s reliable funds for a 1 year period (IMF, 2014). For the calculation of the ASF, the capital and liabilities of the banks are categorized in five. Each category has a multiplier, called ASF factor, and the amount of each category is calculated by being multiplied by the relevant ASF factor. The total amount of the ASF is the sum of all five categories (BCBS, 2014b). The ASF factors issued by the BCBS are provided in the Appendix 4.

The RSF is the portion of a bank’s assets and off-balance sheet exposures that are considered to be illiquid for a period of 1 year (IMF, 2014). For the calculation of the RSF, the assets and off-balance sheet exposures are categorized by the BCBS and each category is multiplied by the specific RSF factor that is assigned by the BCBS. Afterwards, the amounts calculated for each category are summed up in order to acquire the total amount of the RSF (BCBS, 2014b). The categories and the relevant RSF factors are provided in the Appendix 5.

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3. METHODOLOGY and DATA

3.1. Methodology

The introduction of the LCR is a very recent development and thus, empirical studies are very limited. In addition, data collection from the banks is quite difficult. Therefore, this thesis is a systematic case study that investigates the strategy of Turk Eximbank for increasing its LCR and also discusses potential effects of the LCR implementation on the Bank in accordance with the chosen strategy.

First of all, the academic basis for the Basel accords as well as for the liquidity requirements of Basel III were provided. Moreover, the academic discussions on the effects of the LCR on the banks were reflected. Furthermore, the impact reports of the European Banking Authority (EBA) were scanned in order to acquire quantitative data on the subject. In this way, the framework for the discussion on the LCR was established.

Afterwards, the case study was conducted in the light of the data gained from the CRO of Turk Eximbank. The probable strategy of Turk Eximbank for increasing the LCR and the potential outcomes of such strategy were not only provided, but also compared and blended with the global implementations via literature review. Although, the author is not allowed to provide some of the data such as monthly-calculated LCRs of Turk Eximbank, the liquidity shortfall (high-liquid assets – net outflows) of the Bank in the case of full implementation, the interpretation of the figures was reflected.

Consequently, Turk Eximbank’s probable strategies regarding the potential LCR requirements of BRSA for development banks in 2016 were encapsulated in accordance with the collected data from Turk Eximbank officials.

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3.2. Data

The theoretical data provided on Basel accords and the LCR are mainly based on Basel Committee on Banking Supervision (BCBS) publications, most of which are the foundation documents of the Basel accords. European Banking Authority (EBA) publications as well as several publicly available academic articles are the other sources of this thesis.

As working for Turk Eximbank, I could access to data and official reports, some of which are not public. In addition, the data regarding to Turkish banking sector were collected from the publications of the Banking Regulation and Supervision Agency (BRSA) and the Central Bank of the Republic of Turkey (CBRT). Furthermore, Annual Report of Turk Eximbank for 2014 and 2014 year-end Financials of Turk Eximbank were used in order to gather specific data.

Finally, an interview with the Chief Risk Officer (CRO) of Turk Eximbank, Mr. Murat Şenol, was conducted in order to discuss the projections and strategies of the Bank regarding the LCR implementation. Besides, the CRO’s estimations on the potential effects of the full implementation of the LCR on Turk Eximbank were obtained during the interview.

3.3. Assumptions and Ethical Concerns

As of the date of this thesis, the Banking Regulation and Supervision Agency (BRSA) of Turkey has not revealed the minimum LCR for the development banks. Therefore, the discussions of the potential effects of the LCR on Turk Eximbank were mainly based on the full implementation, for which BCBS requires minimum of 70% LCR for the year 2016.

In addition, since the interview contains several strategic and classified data, the author is not allowed to disclose full version of it. However, non-public data has been interpreted and conveyed by the author as objective as possible.

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Finally, this thesis contains few Turkish sources and the author is not native in English. Therefore, some of the content was translated into English at the author’s best efforts.

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4. CASE STUDY

4.1. Introduction to Turk Eximbank

In order to reduce current account deficit as well as to decrease inflation, the Turkish Government promulgated a set of measurements on 24 January 1980. In this context, the government adopted export-led growth strategy and export subsidies in order to enhance the competitiveness of Turkish exporters (Taban and Aktar, 2008). This strategy has also been pursued by the successive governments and considerably increased the total amount of Turkish exports from 2 billion USD to 157.6 billion USD from 1980s to 2014 (Turkish Statistical Institute, 2015).

As a crucial part of this strategy, Türk Eximbank was established in 1987 with an important mission of supporting Turkish exports in various ways. In this context, the Bank provides direct and indirect financial products, such as credit, insurance and guarantee schemes to its customers. Since the main objective of the Bank is to promote Turkish exports, it offers favorable terms and competitive rates to Turkish exporters as well as to Turkish contractors doing business abroad. Besides, the Bank encourages exporters’ and contractors’ penetration to new markets and also promotes diversification of the export goods and the services. Moreover, Turk Eximbank also provides Turkish commercial banks with export insurance and guarantee programs in order to encourage their support to exports. In these ways, the competitiveness of Turkish exporters and contractors are being enhanced (Turk Eximbank, 2015a).

As the sole official export credit agency (ECA) of Turkey and the major export incentive instrument of Turkish Government, Turk Eximbank has tripled its asset size in the last 3 years and increased its total support to Turkish exports to 19.7% as of December 2014 (Turk Eximbank, 2015b).

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On the other hand, since Turk Eximbank is a non-profit oriented development bank, the profitability has never been the main goal. Therefore, the RoA and the RoE are lower than the average of Turkish banking sector. While the average RoA of the sector is 1.7%, the RoA of the Bank is 1.3%; and while the average RoE of the sector is 12.23%, the RoE of the Bank is 9.9% for the year 2014 (BDDK, 2014).

Consequently, it is important to mention that while most of the ECAs don’t provide direct lending, Turk Eximbank is one of the few that conducts direct lending activities. In fact, 64.5% of the Bank’s support to Turkish exports is direct loans. Hence, Turkish government attaches utmost importance to the lending performance of Turk Eximbank (Turk Eximbank, 2015b). Therefore, while discussing the potential effects of the LCR on Turk Eximbank, the impacts on lending supply of the Bank is one of the most important issues to be focused on.

4.2. Basel Implementations in Turk Eximbank

The Banking Regulation and Supervision Agency (BRSA) of Turkey regulates and monitors the transition processes of Turkish Banks to Basel accords. In this context, BRSA sets the rules and requires several reports from the banks for monitoring purposes as well as to make amendments if necessary.

In this context, Turk Eximbank has been regularly submitting several reports related to market risk, credit risk, operational risk and capital adequacy to BRSA within the scope of Basel II. Moreover, as the second structural block of Basel II requires, Turk Eximbank is about to complete the establishment of its own risk management system (Turk Eximbank, 2015b).

With regard to Basel III, Turk Eximbank meets the minimum liquidity, leverage and capital adequacy ratios set by BRSA. In addition, considering the reporting obligations related to capital requirements of Basel III, the Bank already prepared the technical infrastructure of the reporting systems (Turk Eximbank, 2015b). Besides, according to

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credits and does not have complex products, the IT infrastructure and necessary algorithms for the LCR reporting were completed in a short time.

4.2.1. The LCR Implementation in Turk Eximbank

As in line with Basel III transition process of Turkey, the Banking Regulation and Supervision Agency (BRSA) of Turkey requires Turkish Banks to report their LCR from January 1, 2014 and maintain the minimum requirements of the LCR since January 1, 2015 (Official Gazette no. 28948, March 21, 2014). In this context, the minimum LCR requirement for Turkish commercial banks is 60% for the year 2015 and will increase to 70% percent for the year 2016.

On the other hand, since development banks have a mission and different financial structure than that of the commercial banks, BRSA decided to implement the LCR as 0% for the development banks until 2016. During 2015, the development banks, including Turk Eximbank, have been reporting their LCRs to BRSA and BRSA will later determine the minimum level of the LCR that the development banks will implement from 2016 (Turk Eximbank, 2015b).

According to the interview with Mr. Şenol, the CRO of Turk Eximbank, the LCR of Turk Eximbank is below the minimum requirement of 70%, which is set by BCBS for 2016. Although the Turkish BRSA will determine the minimum ratio for the next year, it seems that the Bank will have to increase its LCR by the end of 2015.

Mr. Şenol explains the reasons for the low LCR of the Bank as follows: “Turk Eximbank

has governmental mission to support exports and allocate its sources completely to exporters. In other words, the Bank does not keep its liquidity in idle position and lends nearly all its sources to Turkish exporters. Moreover, Turk Eximbank is an investment and development bank, so it doesn’t have deposit reserve requirement, which constitutes major part of the HQLA. Furthermore, Turk Eximbank has a small treasury portfolio that consists of insignificant amount of securities. Due to Bank’s

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governmental mission of allocating all sources to Turkish exporters, the treasury portfolio of the Bank as well as the LCR of the Bank have been diminishing particularly since December 2014’’.

Mr. Şenol has also stated that Turk Eximbank expects BRSA to keep the implementation of 0% as a minimum requirement for development banks in 2016 and hence, Turk Eximbank will keep reporting its LCR to BRSA and will not take any further action until BRSA introduces a higher ratio for the LCR for the forthcoming years.

4.2.1.1. The Potential Effects of The LCR on Turk Eximbank

Turk Eximbank and other Turkish development banks have been reporting their LCRs to Turkish BRSA since 2014, and BRSA will consider the reported ratios and determine the minimum LCR for development banks by 2016.

At this point, there are several alternatives so that BRSA may keep implementing the LCR as 0% for development banks in 2016, or increase the requirement at an uncertain level, or require development banks to fulfill LCR requirements as the commercial banks do, in other words requires 70% LCR for 2016.

Although Mr. Şenol, the CRO of Turk Eximbank, expects BRSA to hold the minimum LCR at 0% for the next year, he also agrees that BRSA will require a higher LCR from development banks in the following years. Hence, this section discusses what will be the potential impacts of implementing the LCR, particularly on Turk Eximbank.

According to Mr. Şenol, although BCBS intends to increase the resilience of the banks against a financial crisis, namely in order to avoid a short-term liquidity crisis, there may be several adverse effects of the LCR implementation on the banks.

First of all, increasing the incentives for banks to hold lower-risk, more liquid assets and implementing such regulations may also reduce loan supply and may increase cost

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of funding. This kind of adverse effect of the LCR on credit provisions has also been strongly supported by Tourdjman (2014) in his working paper for ESBG. In addition, the empirical study of Bonner and Eijffinger (2012) revealed that if the banks are just below the minimum liquidity requirements, they increase borrowing volumes and end up with an increased cost of funding.

In this context, as the banks will have greater desire to hold government debt and/or bonds in order to comply with the liquid assets definition of the LCR, there could potentially be a scarcity in the availability of such sources, which will also lead an increase in funding cost. Erbenova (2013) also supports this prediction as she states that the banks in smaller countries may start to pile the securities and this may lead deterioration in long term lending. Hence, she claims that the LCR is less effective for the emerging markets, such as Turkey.

Regarding the potential cost-increasing effects of the LCR on the banks, Mr. Şenol states that due to abovementioned implementations, the borrowers will not only have less access to credit products, and also bear relatively higher funding costs. In his working paper on the economic impact of the liquidity ratios in particular for SME lending, Tourdjman (2014) also stated that the liquidity regulations make banks more dependent on governmental funding sources. In case of a depreciation of sovereign bonds, the balance sheets of the banks will shrink. The adverse effect on the growth will also have an impact on credit provisions and the banks may have to limit their lending activities. In fact, as a worst-case scenario, the impact may be even bigger because of reducing credit provisions when the institutions need funding more in these days. This also may cause a credit crunch or recession.

According to Annual Report of Turk Eximbank for 2014, 76% of the companies benefited from short-term export credits were SMEs (Turk Eximbank, 2015b). Therefore, a negative impact on lending performance of Turk Eximbank may have a substantial impact on the economy.

In addition, given the impact of the LCR rule on liquidity and funding, most banks need to operationally expand their treasury and/or liquidity management functions so as to

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include LCR-specific considerations, for example, the cost of extra liquidity buffers in product pricing. This may also lead an increase in lending rates. In Turk Eximbank case, increasing lending rates is contrary to the mission of the bank.

According to Mr. Şenol, if BRSA requires development banks to fulfill the LCR requirements as the commercial banks do, Turk Eximbank will need to increase its treasury portfolio by buying mostly Turkish Treasury bonds. Since some part of the resources will be allocated for this action, the Bank’s credit support to Turkish exporters would be reduced. On the other hand, since Turk Eximbank has a mission and provides credit programs to Turkish exporters at very low rates, investing some of the funds into Turkish Treasury bonds will increase the Bank’s profit. For instance, according to the official website of Turk Eximbank (2015c), lending rates of Turk Eximbank for Turkish Lira is around 6%, while Turkish Treasury bond yields for the similar maturity fluctuate over 9% (CBRT, 2015). Therefore, bank’s total profit will increase and total risk will decrease because of low risk of Turkish Treasury bonds. However, as abovementioned, in the case of a depreciation of Turkish Treasury bonds, the growth of Turk Eximbank would be adversely affected.

In this respect, full implementation of the LCR for Turk Eximbank does not seem to have a significant adverse effect on the Bank’s financial situation in short term. However, the impact will be mostly on the customers and thus the economy may be adversely affected. Therefore, Mr. Şenol thinks that full implementation of the LCR by development banks is a crucial macroeconomic decision rather than to be a specific one for development banks.

On the other hand, according to impact report of EBA (2013b), the European Banks already had sufficient liquidity buffer and the cost impact of implementing the LCR is negligible. In addition, the second impact report of EBA (2014) does not expect an adverse effect particularly in terms of lending supply of the banks. According to the report, if some banks reduce lending in order to achieve the minimum LCR, the other banks meet the excess demand in the economy. In other words, the report claims that

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bank lending. Besides, the empirical study of Hesse and Schmitz (2014) suggests that EU banks did not significantly reduce lending and an increased demand for LCR-eligible assets is likely to be small, also the macro-economic costs of the LCR are likely to be minimal.

In Turkey case, the Turkish BRSA has been implementing liquidity requirements that are very similar to Basel III since 2006. Thus, Turkish commercial banks were already ready for the LCR implementation. In fact, the Turkish liquidity regulation is considered to be more prudential than that of the LCR requirements. For example, while the run-off rates are 5% for stable deposits and 10% for less stable deposits in Basel III, those rates are 20-30% and 30-50% respectively in BRSA regulation (Saltoğlu et al., 2011). According to Arıcan (2013), 70% of Turkish banks were reporting their LCR and the liquidity ratios of Turkish banks are above the legal requirement by the end of 2012. Hence, the study expects that the impact of the implementation of the LCR on Turkish banks as well as on Turkish economy will be insignificant.

However, Mr. Şenol underscores the unique position of Turk Eximbank regarding the macroeconomic impact of implementing the LCR for development banks. Turk Eximbank offers export credit products to Turkish exporters at lower rates with longer maturities than the commercial banks do. Therefore, if Turk Eximbank reduces its credit provisions in order to meet the LCR requirements, the excess demand will not be met by the commercial banks with the same terms. This would increase financing cost of exporters and weaken competitiveness of them. Hence, any decrease in lending supply of Turk Eximbank cannot be identically substituted by the commercial banks and the exporters would have to pay an implicit compensation for the LCR implementation.

Besides, regarding the run-off rates introduced by the LCR, Mr. Şenol expects that Turkish banks will compete for retail deposits, particularly for insured retail deposits, through product diversification, aggressive pricing and enhanced distribution channels. However, once the banks compete more aggressively for retail deposits because of the “value’’ placed on such deposits as a means of meeting both the LCR

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and the NSFR requirements, the retail depositors would chase the best rates and hence, the retail deposits may become more expensive and less stable. As a development bank, Turk Eximbank does not collect deposits and thus, would not be exposed to any adverse effect in that sense.

Apart from all, Mr. Şenol also draws attention to the collateral impacts of liquidity regulations on the other regulations. He states that, liquidity requirements may also interact with other current regulations such as capital regulations in a way that was not intended. The effects of an institution’s liquidity strategy on other risks and return would be highly dependent on both its current balance sheet structure and its business strategy. For some institutions, there could be a minimal change in their current liquidity strategy with only a nominal impact on other forms of risk and return. However, for some other financial institutions, the potential impact of the liquidity strategy on other risks and return could be dramatic. Therefore, the institutions should carefully select their strategies in order to meet the liquidity requirements.

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5. CONCLUSIONS

The Banking Regulation and Supervision Agency (BRSA) of Turkey will determine the minimum LCR to be implemented by development banks by 2016.

In this context, three alternatives were discussed: The minimum LCR will remain to be implemented as 0% as it has been implemented during 2015; it will be increased to an uncertain rate, it will be required to be implemented as 70% as the commercial banks will do.

All three alternatives were discussed with Mr. Murat Şenol, the Chief Risk Officer (CRO) of Turk Eximbank, and his expectations and plans were conveyed.

In the case of the continuation of the current implementation, which requires 0% of LCR, Turk Eximbank will not take any further action and keep reporting its LCR to BRSA regularly.

Considering the other scenarios, of which impacts will almost be the same, if BRSA increases the LCR to an uncertain level or to 70% for 2016, Turk Eximbank will increase its High-Quality Liquid Assets (HQLAs) mostly via Turkish Treasury bond purchases. Since, Turk Eximbank does not collect deposits, the Bank does not have a chance to increase its HQLAs by means of deposit reserves held in the Central Bank of the Republic of Turkey (CBRT).

In the context of the abovementioned strategy of Turk Eximbank for increasing its LCR, the dependence of the Bank’s growth on Turkish Treasury bond prices would increase. In the case of a depreciation in the price of Turkish Treasury bonds will directly have an adverse impact on the asset size of the Bank. On the other hand, since the return of Turkish Treasury bonds is currently higher than the lending rates of Turk Eximbank, the profitability of the Bank would increase. Also, the total risk of the Bank will

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decrease since the risk of Turkish Treasury bonds are lower than the risk of Turkish exporters.

Another potential and crucial impact is related with the lending supply of the Bank. As a result of purchasing Turkish Treasury bonds instead of lending sources to Turkish exporters and contractors, the lending performance of the Bank will be adversely affected due implementation of the LCR.

As the sole official export credit agency of Turkey, Turk Eximbank credit products are of utmost importance for Turkish exporters as well as for Turkish contractors doing business abroad. Turk Eximbank offers lower lending rates with longer maturities than that of the commercial banks do and in the case of implementing the LCR, the customers of Turk Eximbank would be deprived of favorable terms of funding which would not be replaced by any other banks in Turkey. Therefore, Turkish exporters and overseas contractors would suffer increased cost of funding and thus, considering the export-led growth model of Turkey the LCR implementation might also have remarkable adverse effect on macroeconomics.

In this regard, BRSA should be meticulous in its decision of minimum LCR requirement for development banks. In fact, since this study does not examine the mission and structure of the other development banks in Turkey, maybe it is better to suggest BRSA specifically consider Turk Eximbank case while determining the minimum LCR for 2016.

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APPENDIX

Appendix 1. The Multipliers for the Calculation of Total HQLA Stock

Item Factor

Stock of HQLA A. Level 1 Assets

- Coins and Banknotes

- Qualifying Marketable Securities from

Sovereigns, Central banks, PSEs, and Multilateral

Development Banks 100%

- Qualifying Central Bank Reserves

- Domestic Sovereign or Central Bank Debt for Non-0% Risk-Weighted Sovereigns

B. Level 2 Assets (maximum of 40% of HQLA) Level 2A Assets

- Sovereign, Central Bank, Multilateral

Development Banks, and PSE Assets Qualifying for 20% Risk Weighting

85% - Qualifying Corporate Debt Securities Rated AA-

or Higher

- Qualifying Covered Bonds Rated AA- or Higher

Level 2B Assets (maximum of 15% of HQLA)

- Qualifying RMBS 75%

- Qualifying Corporate Debt Securities Rated Between A+ and BBB-

50%

- Qualifying Common Equity Shares 50%

Total Value of Stock of HQLA

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Appendix 2. Run-Off Rates for the Calculation of Total Cash Outflows

Cash Outflows A. Retail Deposits

- Demand Deposits and Term Deposits (less than

30 days maturity) 3%

- Stable Deposits (deposit insurance scheme meets

additional criteria) 3%

- Stable Deposits 5%

Less Stable Retail Deposits 10%

Term Deposits with Residual Maturity Greater than 30

Days 0%

B. Unsecured Wholesale Funding

- Demand and Term Deposits (less than 30 days

maturity) Provided by Small Business Customers 5%

- Stable Deposits 5%

Less Stable Deposits 10%

- Operational Deposits Generated by Clearing,

Custody and Cash Management Activities 25%

Portion Covered by Deposit Insurance 5%

Cooperative Banks in an Institutional Network (qualifying

deposits with the centralized institution) 25%

- Non-financial Corporates, Sovereigns, Central

Banks, Multilateral Development Banks, and PSEs 40% If the Entire Amount Fully Covered by Deposit Insurance

Scheme 20%

Other Legal Entity Customers 100%

C. Secured Funding

- Secured Funding Transactions with a Central Bank Counterparty or Backed by Level 1 Assets with Any Counterparty

0% - Secured Funding Transactions Backed by Level 2A

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- Secured Funding Transactions Backed by Non-Level 1 or Non-Non-Level 2A Assets, with Domestic Sovereigns, Multilateral Development Banks, or Domestic PSEs as a Counterparty

25%

- Backed by RMBS Eligible for Inclusion in Level 2B 25%

- Backed by Other Level 2B Assets 50%

- All Other Secured Funding Transactions 100%

D. Additional Requirements

Liquidity Needs (e.g. collateral calls) Related to

Financing Transactions, Derivatives and Other Contracts 3 notch downgrade Market Valuation Changes on Derivatives Transactions

(largest absolute net 30-day collateral flows realized during the preceding 24 months)

Look back approach Valuation Changes on Non-Level 1 Posted Collateral

Securing Derivatives 20%

Excess Collateral Held by a Bank Related to Derivative Transactions That Could Contractually Be Called at Any Time by Its Counterparty

100% Liquidity Needs Related to Collateral Contractually Due

from the Reporting Bank on Derivatives Transactions 100% Increased Liquidity Needs Related to Derivative

Transactions That Allow Collateral Substitution to Non-HQLA Assets

100% - ABCP, SIVs, Conduits, SPVs, Etc.:

- Liabilities from Maturing ABCP, SIVs, SPVs, etc. (applied to maturing amounts and returnable assets)

100% Asset Backed Securities (including covered bonds)

Applied to Maturing Amounts

Currently Undrawn Committed Credit and Liquidity Facilities Provided to:

- Retail and Small Business Clients 5%

- Non-Financial Corporates, Sovereigns and Central Banks, Multilateral Development Banks, and PSEs

10% for credit 30% for liquidity

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- Other Financial Institutions (include securities firms, insurance companies)

40% for credit 100% for liquidity Other Legal Entity Customers, Credit and Liquidity

Facilities 100%

- Other Contingent Funding Liabilities (such as guarantees, letters of credit, revocable credit and liquidity facilities, etc.)

National Discretion

- Trade Finance 0-5%

Customer Short Positions Covered by Other Customers’

Collateral 50%

Any Additional Contractual Outflows 100%

Net Derivative Cash Outflows 100%

Any Other Contractual Cash Outflows 100%

Total Cash Outflows

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Appendix 3. Expected Rates for the Calculation of Total Cash Inflows

Cash Inflows

Maturing Secured Lending Transactions Backed by the Following Collateral: Level 1 Assets 0% Level 2A Assets 15% Level 2B Assets: - Eligible RMBS 25% - Other Assets 50%

Margin Lending Backed by All Other Collateral 50%

All Other Assets 100%

Credit or Liquidity Facilities Provided to the Reporting

Bank 0%

Operational Deposits Held at Other Financial Institutions (include deposits held at centralized institution of network of co-operative banks)

0% Other Inflows by Counterparty:

- Amounts to Be Received from Retail

Counterparties 50%

- Amounts to Be Received from Non-Financial Wholesale Counterparties, from Transactions Other Than Those Listed in Above Inflow Categories

50%

- Amounts to Be Received from Financial Institutions and Central Banks, from

Transactions Other Than Those Listed in Above Inflow Categories

100%

Net Derivative Cash Inflows 100%

Other Contractual Cash Inflows National Discretion

Total Cash Inflows

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Appendix 4. ASF Factors in the Calculation of the NSFR

Components of ASF Category ASF Factor

- Total Regulatory Capital (excluding Tier 2 instruments with residual maturity of less than

one year) 100%

- Other Capital Instruments and Liabilities with Effective Residual Maturity of One Year or More - Stable Non-Maturity (Demand) Deposits and

Term Deposits with Residual Maturity of Less than One Year Provided by Retail and Small Business Customers

95%

- Less Stable Non-Maturity Deposits and Term Deposits with Residual Maturity of Less than One Year Provided by Retail and Small Business Customers

90%

- Funding with Residual Maturity of Less than One Year Provided by Non-Financial Corporate Customers

- Operational Deposits

- Funding with Residual Maturity of Less Than One Year From Sovereigns, PSEs, and Multilateral and National Development Banks

50% - Other Funding with Residual Maturity Between

Six Months and Less than One Year Not Included in the above Categories, Including Funding Provided by Central Banks and Financial Institutions

- All Other Liabilities and Equity Not Included in the above Categories, Including Liabilities without a Stated Maturity (with a specific treatment for deferred tax liabilities and minority interests)

- NSFR Derivative Liabilities Net of NSFR

Derivative Assets if NSFR Derivative Liabilities are Greater than NSFR Derivative Assets

0%

- “Trade Date” Payables Arising from Purchases of Financial Instruments, Foreign Currencies and Commodities

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Appendix 5. RSF Factors in the Calculation of the NSFR

Components of RSF Category RSF Factor

- Coins and Banknotes - All Central Bank Reserves

- All Claims on Central Banks with Residual

Maturities of Less than Six Months 0%

- “Trade Date” Receivables Arising from Sales of Financial Instruments, Foreign Currencies and Commodities

- Unencumbered Level 1 Assets, Excluding Coins,

Banknotes and Central Bank Reserves 5%

- Unencumbered Loans to Financial Institutions with Residual Maturities of Less than Six Months, where the Loan is Secured against Level 1 Assets as Defined in LCR Paragraph 50, and where the Bank Has the Ability to Freely Re-hypothecate the Received Collateral for the Life of the Loan

10%

- All Other Unencumbered Loans to Financial Institutions with Residual Maturities of Less than

Six Months Not Included in the above Categories 15% - Unencumbered Level 2A Assets

- Unencumbered Level 2B Assets

- HQLA Encumbered for a Period of Six Months or More and Less than One Year

- Loans to Financial Institutions and Central Banks with Residual Maturities between Six Months and Less than One Year

- Deposits Held at Other Financial Institutions for Operational Purposes

50% - All Other Assets Not Included in the above

Categories with Residual Maturity of Less than One Year, Including Loans to Non-Financial Corporate Clients, Loans to Retail and Small Business Customers, and Loans to Sovereigns and PSEs

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- Unencumbered Residential Mortgages with a Residual Maturity of One Year or More and with a Risk Weight of Less than or Equal to 35% under the Standardized Approach

- Other Unencumbered Loans Not Included in the above Categories, Excluding Loans to Financial Institutions, with a Residual Maturity of One Year or More and with a Risk Weight of Less than or Equal to 35% under the Standardized

Approach

65%

- Cash, Securities or Other Assets Posted as Initial Margin for Derivative Contracts and Cash or Other Assets Provided to Contribute to the Default Fund of a CCP

- Other Unencumbered Performing Loans with Risk Weights Greater than 35% under the Standardized Approach and Residual Maturities of One Year or More, Excluding Loans to

Financial Institutions

85%

- Unencumbered Securities That are not in Default and do not Qualify as HQLA with a Remaining Maturity of One Year or More and Exchange-Traded Equities

- Physical Traded Commodities, Including Gold - All Assets That are Encumbered for a Period of

One Year or More

- NSFR Derivative Assets Net of NSFR Derivative Liabilities if NSFR Derivative Assets are Greater than NSFR Derivative Liabilities

- 20% of Derivative Liabilities as Calculated According to Paragraph 19 of the NSFR - All Other Assets Not Included in the above

Categories, Including Non-Performing Loans, Loans to Financial Institutions with a Residual Maturity of One Year or More, Non-Exchange-Traded Equities, Fixed Assets, Items Deducted from Regulatory Capital, Retained Interest, Insurance Assets, Subsidiary Interests and Defaulted Securities

100%

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Appendix 6. Interview Questions

This interview aims at collecting information on Turk Eximbank’s strategy with regard to implementation of the LCR.

Please be informed that the content will be disclosed as part of my research thesis.

1. As the CRO of Turk Eximbank, what are your opinions about the implementation

of the LCR, particularly about its impacts on Turkish banking sector, macroeconomics, global economy, etc.?

2. To what extent is Turk Eximbank ready for the implementation of the LCR in terms

of reporting systems, IT infrastructure, etc.?

3. How do you explain the drastic decline in the LCR of Turk Eximbank since

December 2014? What are the reasons for such a low LCR?

4. What is/are Turk Eximbank’s strategy/strategies for increasing the Bank’s LCR?

5. What is your guess for the minimum LCR that will be implemented by BRSA to

development banks in Turkey in 2016? Considering your estimation, how much is Turk Eximbank’s liquidity shortfall as of 30 June 2015?

6. Upon the full implementation of the LCR from 2016, what kind of potential effects

do you expect on Turk Eximbank, particularly in terms of growth and lending performance of the Bank?

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