February 6, 2015

Bank Asya incident: systemic risk and rule of law

Taptuk Emre Erkoç*

Turkey's Banking Regulation and Supervision Agency (BDDK) announced on Feb. 3 that it is transferring 63 percent of Bank Asya's preferential shares to the Savings Deposit Insurance Fund (TMSF) due to the lender's breach of the provision requiring “transparent and clear partnership structures and organization schemes that will not prevent active audit of the institution," although the Banking Regulatory Act does not allow it to do so. Furthermore, independent auditing firm Ernst and Young did not point out any sign of structural irregularities in its recent report on Bank Asya.

Following corruption investigations that were defined by President Recep Tayyip Erdoğan as a coup attempt by the Gülen movement, Bank Asya was alleged to have gone bankrupt. Political figures themselves have transgressed fundamental legal and economic regulations since the very early weeks of 2014, as detailed below:

1. The interior minister implied in a live interview on state channel TRT that Bank Asya had prior knowledge about the corruption investigations and gained $2 billion during the investigations, which was immediately proved false by the Central Bank of Turkey as well as the bank itself.

2. In a number of his speeches, President Erdoğan publicly made derogatory comments about Bank Asya's transactions, which is unquestionably against laws protecting banks and their customers.

3. Deputy Prime Minster Ali Babacan, also responsible for economic affairs, stated to the media that one of the state banks -- Ziraat Bankası -- is in the negotiations with Bank Asya for the purchase, while the prime minister's adviser denied it the same day. Accordingly, Bank Asya's stocks faced ebbs and flows in a very short period of time, which dramatically hurt customers and investors in the bank.

It is important to echo here that the 2008 financial crisis was a critical moment for Western economies and reminded economists of the notion of “systemic risk” in the banking sector. Systemic risk basically refers to the destructive impact of any individual actor's failure on the overall financial system. It is a highly interesting topic in economic and financial research. Accordingly, well-known universities around the world, including LSE, Princeton University and ETH Zurich, have already established research centers to work on systemic risk, and a number of countries introduced new sets of rules and procedures to regulate their financial systems on the basis of systemic risk analysis.

The two salient characteristics of an actor that has the potential to pose a systemic risk to a financial market are being too large (too big to fail) and having intensified transactions with other players. Thus, to prevent a domino effect on other players in the financial system, governments usually bail out a player that assumes a “too large” and “too interconnected” a role in the market. For instance, due to General Motors' relatively large share in the automotive industry and its interconnectedness with other sectors, the US government opted to deliver financial assistance to GM to save it from going bankrupt. In a similar vein, American International Group (AIG), one of the largest insurance companies in the world, received state support to overcome a significant crisis in light of heavy criticism from a number of economists.

In the case of Bank Asya, the circumstances are apparently different from the cases above. This time, the government is allegedly trying to lead a bank toward bankruptcy mainly for political reasons. This piece examines the case of Bank Asya in light of the concepts of “too big to fail” and “too interconnected to fail.” In sum, the Justice and Development Party (AK Party) government's endeavor to seize Bank Asya by purchasing it through state banks would have a number of repercussions on the overall banking sector and financial markets -- predominantly the Islamic ones -- Turkey's image for the international investors, and finally real sector investments and manufacturing.

According to the Association of Turkish Participation Banks (TKBB) report for the last quarter of 2013, Bank Asya has the largest share (25 percent) in this particular sector among the four Islamic banks and the largest amount of assets and number of branches/staff. Hence, if the government succeeds in subduing Bank Asya, which has a remarkable stake and network in the sector, this would not only cause a systemic risk to the Islamic financial system but would also lead to the termination of Islamic banking in Turkey, which has already become a lucrative market for financial investors from Gulf countries.

The BDDK report published in December 2013 reveals that the share of Islamic banks in the banking sector amounts to 5-6 percent. Thus, it is highly likely that a noteworthy failure in the Islamic banking sector would put an additional risk premium on the Turkish banking sector, if not induce a systemic risk. Correspondingly, conventional banks would reduce their shares in the sector and stop allocating funding to Islamic financial institutions.

Islamic banking significantly differs from conventional banking in that its financial operations are confined to real sector investments. Based on Islamic principles, these Islamic banks do not invest in interest-based financial instruments such as hedge funds. Instead, they provide funding for real economy-related investments through sukuk, mudarabah and murabaha. In this regard, Islamic banks' current relationship with the construction sector in Turkey means that any systemic crisis in the Islamic banking sector would result in a chaotic environment both for the construction sector and its sister industries.

The Bank Asya incident has sent a clear message to the actors in the financial system: Turkey is suffering from the lack of an accountable government, a politicized legal system and dysfunctional regulatory and supervisory agencies, which has become apparent to international organizations and investors. Therefore, it would not be a surprise if Turkey were to confront unbearable difficulty in attracting financial investments from abroad to finance its increasing current account deficit in the coming months.

*Taptuk Emre Erkoç is director of the Turkey Institute and a visiting research fellow at the Queen Mary University of London.

Published on Today's Zaman, 06 February 2015, Friday