TURKISH BAN KS BNP PARIBAS Duygun Kutucu

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1 TURKISH BAN KS BNP PARIBAS 12 APRIL 2017 SECTOR REPORT TURKISH BANKS One-hit wonder EPS growth momentum persists, but medium-term outlook challenging Following 44% EPS growth in 2016, we anticipate 22% more growth in 2017 thanks to solid TRY loan growth backed by the Credit Guarantee Fund (CGF) as well as lower general provisions and tamed opex. We expect flat NIMs, flat specific CoRs and 17% loan growth y-y to inflate the sector s ROE by 100bp to 15% in Nevertheless, we think the medium-term outlook is more challenging. We expect EPS to fall 3% in 2018 on lower NIMs, higher CoRs and lower loan growth given the elevated base. We find the banks fairly valued at an average 0.8x 2017E P/B. CGF boosts loan growth while funding side complicates its sustainability The sharp 7.3% q-q TRY loan growth in 1Q17 financed through FX deposits is unsustainable and increases currency risks, in our view. The positions are hedged predominantly via very short term weekly/monthly swaps. The TRY LDR surged 10pp q-q to 134% at end-march. We expect price competition in the deposit market to heat up as banks try to gain share in the inadequate TRY deposit pool. The CGF and loan restructurings should keep asset quality under control in 2017, though NPL formation is likely to pick up in 2018 unless economic growth gains pace. Revising estimates/tps; Isbank down to HOLD; top picks are Akbank, Garanti and Vakifbank We adjust estimates and target prices for our coverage, taking into consideration unexpectedly strong PL performances triggered by the TRY250b CGF collateralization scheme, which pulls down loan risk weightings to almost zero and saddles the NPL load on the Treasury. We like Akbank and Garanti due to strong capitalizations, higher profitability and comfortable provisioning. Our top state bank pick is Vakifbank on appealing multiples accompanied by stronger ROE prospects. We downgrade Isbank to HOLD from Buy on valuation grounds. BNPP recommendations Rating Target price Company BBG code Share price Current Previous Current Previous %change Up/downside TSKB TSKB TI 1.44 BUY Buy % +23.9% Akbank AKBNK TI 9.03 BUY Buy % +16.5% Vakifbank VAKBN TI 5.84 BUY Buy % +15.8% Garanti Bank GARAN TI 9.50 BUY Buy % +14.7% Al Baraka Turk ALBRK TI 1.22 HOLD Hold % +10.2% Isbank ISCTR TI 6.89 HOLD Buy % +6.1% Yapi Kredi Bank YKBNK TI 3.99 HOLD Hold % +6.1% Halkbank HALKB TI HOLD Hold % +4.8% Note: Priced at close of business 11/4/2017. Share prices and TPs are in listing currency. Sources: FactSet; BNP Paribas estimates Mete Yuksel duygun.kutucu@tebyatirim.com.tr mete.yuksel@tebyatirim.com.tr Our research is available on Thomson One, Bloomberg, TheMarkets.com, FactSet and on Please contact your salesperson for authorisation. Please see the important notice on the back page. PREPARED AND PUBLISHED BY NON-US BROKER-DEALER(S): TEB INVESTMENT. THIS REPORT IS DISTRIBUTED IN TURKEY BY TEB INVESTMENT AND OUTSIDE TURKEY JOINTLY BY TEB INVESTMENT AND BNP PARIBAS. THIS MATERIAL HAS BEEN APPROVED FOR U.S DISTRIBUTION. ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES CAN BE FOUND AT APPENDIX ON PAGE 52

2 Investment thesis Banks finished 2016 on a high note, with the sector s net income growing 44% with the help of NIM expansion, decline in trading losses and improvement in cost ratios. Despite rising funding costs, we anticipate a very strong 1Q17 from banks with more than 40% y-y growth. Nevertheless, on a longer term horizon we consider outlook for banks to be cloudier. High TRY LDR will keep deposit costs high and we forecast loan-deposit spread to start sliding down from 1Q17 due to higher deposit costs. Asset quality issues appear to be deferred to 2018 and beyond. We foresee 22% EPS growth on average for banks in our coverage in Nevertheless, we find medium term outlook for the banks to be more challenging and expect EPS to fall 3% in 2018 due to lower NIM and higher CoR, bringing ROE down to 13.2%. Banks are currently trading at 0.8x P/B on our FY17 estimates, which we find unattractive considering risks the banks are facing and low ROE outlook medium term. We expect banks share prices will be contained by low economic growth, rising interest rates and a volatile FX rate in the coming months. We prefer banks with strong capital position and low risk profile in this environment. We thus select Akbank, Garanti and Vakifbank as our top picks. Catalyst Better-than-expected global liquidity: We are expecting rollover ratios in international wholesale borrowings to remain at or below 100%, and costs to increase. Nevertheless, higher-than-expected fund flows to Turkey would back the sector s loan growth and easing in funding costs would support NIM Improvement in consumer confidence and economic activity following referendum: End of political uncertainty may result in a pickup in economic activity, which will support asset quality of the banks Risk to our call While banks were the beneficiaries of the Government s recent actions to support loan growth, we believe there is a risk that government may push for lower loan rates. State banks are pursuing a more aggressive strategy in lending which may distort market pricing. The Government introduced a maximum limit on interest to be paid to state deposits in Dec 16. State banks are paying around 300bp less to state deposits as compared to regular time deposit rates in the market according to our calculations. They reflect this cost saving to their loan prices, enforcing other banks that do not want to lose share to cut down their loan yields, which ultimately hurts core spreads. CONTENTS Investment theme... 3 A closer look at fundamentals... 9 Historical multiples Company profiles Forecast Revisions for coverage Revised Old Change FY17E FY18E FY17E FY18E FY17E FY18E (TRY m) (TRY m) (TRY m) (TRY m) (%) (%) Net interest income 63,249 69,177 60,381 63, Net fee income 15,463 17,194 14,944 16, Specific provisions 13,700 17,207 13,715 14, Opex 32,943 36,286 32,195 35, NIM (%) (4) 4 Reported net profit 28,254 27,633 25,416 26, Source: TEB Investment/BNP Paribas estimates Key assumptions for coverage E 2016E 2017E (%) (%) (%) (%) NIM Specific CoR Loan growth-fx adj Deposit growth-fx adj Sources: Company financials; TEB Investment/BNP Paribas estimates 2 BNP PARIBAS 12 APRIL 2017

3 Investment theme Banks finished 2016 on a high note, with the sector s net income growing 44% with the help of NIM expansion, decline in trading losses and improvement in cost ratios. Nevertheless, 2017 started with caution as CBRT increased the weighted average cost of funding 320bps YTD to defend TRY following c.10% depreciation in January with TRY/USD rate reaching the 3.90 level. TRY/USD rate since then recovered by 4.8% YTD, vs. the 3.6% recovery of EMFX. Despite rising funding costs, we anticipate a very strong 1Q17 from banks with more than 40% y-y EPS growth on the horizon. Higher CPI linker yields should be supportive predominantly for NIMs of state banks and we foresee a decline in general provision expenses as banks are setting aside general provisions at lower rates following BRSA s amendment in Sep 16. We think there is no visible deterioration in asset quality. Thanks to the Credit Guarantee Fund, loan growth gained pace with total loan book expanding 5.5% q-q in 1Q17, TRY loans being the driver at 7.3% q-q. Nevertheless, we consider outlook for banks to be cloudier long term from a funding and asset quality point of view. While TRY loan growth is very strong, deposit growth came from FX side (4.6% q-q deposit growth in 1Q17, TRY: -0.3%, FX: +7.4% in USD terms) and consequently TRY LDR climbed by 10pp q-q to reach 134% in the sector. We believe this high growth in TRY loans is not sustainable on funding limitations. Despite ample, unused CGF reserve, either the loan growth should cut pace on stretched LTD ratios or funding costs should go up to eventually curb down the NIMs. We expect competition in the deposit market to heat up as banks try to gain market share in the inadequate TRY deposit pool. External conditions are also not supportive of banks as USD rates are rising with FED s exit strategy kicking in. Turkey s downgrade to junk by Moody s and Fitch are pushing up the cost of wholesale funding even higher for Turkish banks. We expect loan-deposit spread to start sliding down from 1Q17 due to higher deposit costs as well as contracting yields on CGF loans on intensifying price competition. We expect quarterly spread to come down to 4.2% in 4Q17 from 4.8% in 4Q16. Nevertheless, we expect y-y contraction in core spread to be limited to 10bp in 2017 as we started the year on a high point following the four consecutive quarter of spread expansion in We expect higher CPI linker yields to compensate for lower core spreads, leading to a flattish NIM for the sector in Asset quality is another concern for the sector as slowdown in economic activity, volatility in FX rates and weak consumer sentiment are likely to drive NPL formation up. Nevertheless, we do not expect a significant deterioration in asset quality in 2017 as the CGF and restructuring of problematic loans are likely to delay any weakening in asset quality to 2018 and The inflated denominator of the NPL ratio is also keeping that from going north. We foresee 22% EPS growth on average for banks in our coverage in 2017, with average ROE of the banks in our coverage coming up from 14.2% in 2016 to 15.2% based on our estimates. Nevertheless, we believe medium term outlook for the banks is more challenging and expect a 3% decline in EPS in 2018 due to lower NIM and higher CoR, bringing ROE down to 13.0%. Banks are currently trading at 0.8x P/B on our FY17 estimates, which we believe is not attractive considering risks the banks are facing and low ROE outlook in the medium term. We are using a CoE of 16.2% for a bank with a β of 1. We see almost no potential for decline in our CoE assumption as we believe TRY bond rates will remain elevated. This is in view of the increasing domestic debt rollover rates of the Treasury due to SCT cuts, more state support for recruitment, transfer of dividend paying public enterprises to the sovereign wealth fund and tightening bias of the CBRT on the back of rising inflation trajectory. We assume a 1pp increase in CoE would decrease our target prices by 7% on average. While we acknowledge the short term opportunity window driven by the unexpectedly solid 1Q17 P/L evolutions, we think risks are growing long term on liquidity constraints, increasing rate trajectory both locally and globally, postponed asset quality issues, and inflated loan base that should hamper future lending growth. We 3 BNP PARIBAS 12 APRIL 2017

4 prefer banks with strong capital position and low risk profile in this environment. We thus select Akbank, Garanti and Vakifbank as our top picks. We like Akbank and Garanti for their low risk profile, strong capitalizations, high provisioning policies and profit-focused management approaches. Among state banks, we prefer Vakifbank on its sector-low multiples despite above-average ROE we envisage for this year. Exhibit 1: International peer comparison Mkt cap P/BV (USD) P/E (USD) ROE (USD) EPS growth (%) Current Target Upside E 2018E E 2018E E 2018E 2017E 2018E 2017E 2018E (USD) (USD) (%) (x) (x) (x) (x) (x) (x) (%) (%) (%) (USD) (USD (LC) (LC) Turkey 39,834 43, (14.1) Argentina 10,375 11, Brazil 161, , Chile 31,228 31, Colombia 18,587 20, Peru 16,735 19, Mexico 26,795 27, Czech Republic 7,129 7, (13.3) 4.3 (11.2) 4.3 Hungary 8,002 8, Poland 41,462 39,897 (4) (1.3) 12.3 (0.5) 12.3 Russia 79,425 90, Israel 14,639 16, South Africa 42,475 49, Egypt 4,978 4, (32.6) Morocco 8,095 8, China 979,609 1,135, (1.6) Indonesia 91,086 89,802 (1) India 36,183 37, Malaysia 17,330 17,292 (0) Philippines 24,433 24,370 (0) Thailand 56,094 57, Turkey 39,834 43, (14.1) Turkey (TEB/BNPP) 40,122 47, (0.8) (2.2) 21.8 (2.2) EM EMEA excl. Turkey 180, , nm nm EM EMEA excl. Turkey&Russia 101, , nm nm EM EMEA* 220, , nm nm EM Asia** 1,204,734 1,361, (0.2) 7.1 nm nm EM LatAm*** 254, , nm nm EM**** 1,722,366 1,923, nm nm EM excl. Turkey MSCI WORLD BANKS 3,704,302 na na MSCI EMRG MKT BANKS 1,490,476 na na * : Czech Rep., Hungary, Poland, Russia, Egypt, Morocco, South Africa, Turkey ** : China, Indonesia, India, Malaysia, Philippines, South Korea, Taiwan, Thailand *** : Brazil, Chile, Colombia, Mexico, Peru ****: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey Sources: Bloomberg; TEB Investment/BNP Paribas estimates 4 BNP PARIBAS 12 APRIL 2017

5 Exhibit 2: Sector multiples Stock Price mth REC Reported P/E P/BV Gross div yield ROE TP T. Up 16 17E 18E 16 17E 18E E 18E 16 17E 18E (TRY) (TRY) (%) (x) (x) (x) (x) (x) (x) (%) (%) (%) (%) (%) (%) Sector AKBNK BUY GARAN BUY HALKB HOLD ISCTR HOLD VAKBN BUY YKBNK HOLD ALBRK HOLD TSKB BUY Priced at close 11 Apr 2017 Source: TEB Investment/BNP Paribas estimates 5 BNP PARIBAS 12 APRIL 2017

6 Exhibit 3: Banks comparison AKBNK GARAN ISCTR YKBNK HALKB VAKBN ALBRK TSKB (TRY/USD) Mcap (USD m) 9,728 10,746 8,350 4,671 3,680 3, Target Mcap (USD m) 11,335 12,327 9,287 4,958 3,856 4, Price (TRY) Number of shares 4,000 4,200 4,500 4,347 1,250 2, ,050 Mcap 36,120 39,900 31,005 17,345 13,663 14,600 1,098 2,952 Daily return (%) 5.9 (1.4) (1.9) (0.8) 1.6 (1.7) (0.8) 1.4 Return (w-w %) Return (y-y %) (4.1) (22.6) 5.8 Float (%) Major shareholder SAB 49 BBVA 49 PF 40 KC/UC 42 PA 50 FOU 59 ABG 57 IS 50 NUMBER OF BRANCHES , Number of personnel 13,843 19,689 24,756 18,366 16,956 15,615 3, Target price (TRY) Upside 17% 15% 11% 6% 5% 16% 10% 24% Rating BUY BUY BUY HOLD HOLD BUY HOLD BUY Type of Financials B.Only B.Only B.Only B.Only B.Only B.Only B.Only B.Only 2016 P/BV solo E P/BV solo E P/BV solo P/E solo E P/E solo E P/E - solo Book 30,655 35,539 35,961 26,119 21,317 19,239 2,280 2, E Book 35,219 40,537 40,284 29,568 24,436 22,540 2,471 3, E Book 39,698 44,388 43,956 32,995 27,094 25,337 2,780 3, Net profit 4,529 5,071 4,701 2,933 2,558 2, E Net profit 5,465 6,248 5,499 3,450 3,381 3, E Net profit 5,845 6,038 5,046 3,431 3,380 2, Reported NIM (%) Reported NIM (%) E Reported NIM (%) ROA (%) ROA (%) E ROA (%) ROE (%) ROE (%) E ROE (%) Loans 161, , , , , ,619 21,316 17,319 Securities 58,226 47,059 53,269 31,963 33,576 27,611 2,117 4,826 Deposits 158, , , , , ,838 23,155 0 Sh. Eq. 30,655 35,539 35,961 26,119 21,317 19,239 2,280 2,928 Assets 271, , , , , ,540 32,851 24,002 net profit 4,529 5,071 4,701 2,933 2,558 2, Priced 11 Apr 2017 Sources: Company financials; TEB Investment/BNP Paribas estimates 6 BNP PARIBAS 12 APRIL 2017

7 Major highlights for 2017 are as follows: Flat margins: We expect higher deposit rates to lead to a contraction in core spread on a q-q basis in each quarter of Nevertheless, we expect y-y contraction in core spread in 2017 to be limited to 10bp as we started the year on a high point following four consecutive quarters of spread expansion in We expect NIM to remain flat y-y, supported by higher yield on CPI linkers which will compensate for high TRY costs. Mild loan growth to continue: FX-adjusted loan growth was 10% in 2016 and we forecast FX-adjusted loan growth to remain at a similar level in The government took several actions to support loan growth, including increasing guarantee limits provided by the Credit Guarantee Fund to TRY250b. These actions seem to reach its desired goal in 1Q17 with q-q loan growth reaching 5.5% and TRY loan growth going up to 7.3%, the highest q-q growth since 2Q13. Nevertheless, we believe funding will be a limiting factor for loan growth. Despite the government s push for higher loan growth, we believe banks will be reluctant to further extend their LDRs, which reached 110% for the sector in the end of The situation is more acute on the TRY side, as LDR reached 134% with the recent shift to FX in currency mix of deposits. Credit Guarantee Fund and restructurings to limit NPL formation: Despite volatility in FX rates, weak consumer confidence and increase in unemployment rate, NPL ratio remained stable YTD at 3.2% as of end-mar. We believe easing of restructuring rules, extension of consumer loan maturities and Credit Guarantee Fund will limit NPL inflows this year. We expect specific CoR to remain stable in 2017 on average for banks in our coverage, thanks to supportive measures of the government. A significant depreciation and/or weaker-than-expected GDP growth are the main risks that would raise specific CoR. On the other hand, we expect a drop in general provision expenses as banks started setting aside general provisions at lower rates for new loans following BRSA s decision to lower general provision rates for certain loans. Consequently, we forecast total CoR will fall 20bps in Opex growth to remain below inflation: Opex growth of the banks in our coverage remained below CPI in 2016 at 5% thanks to slowdown in fee rebates and banks attempts to optimize their cost structure. We expect further decline in fee rebates (to almost zero) and cost optimization trend to continue limiting opex growth this year. We forecast 8% opex growth in 2017, though we believe depreciation of TRY remains to be a major risk for opex. Net trading line to turn to negative: The banks in our coverage had TRY40m net trading gains in aggregate in We expect the banks to have significant trading losses in 2017 as both swap book and swap rates will likely rise. We also do not expect material gains from bond trading this year considering the increase in bond yields. Changes in regulations to support banks CARs: Following a sharp TRY depreciation and Fitch s downgrade, average CAR of the sector declined from 16.0% in Sep 16 to 15.1% in Jan 17. BRSA first allowed use of ratings given by IIRA (which still has an investment grade rating for Turkey) in CAR calculations, then lowered risk weighting of FX reserves deposited to CBRT to 0% (from 50% at end-2016, though it would rise to 100% if banks continued to use Fitch s ratings). With these changes the sector s CAR almost fully recovered back to Sep 16 level. The Credit Guarantee Fund should also support the sector s CAR as amount collateralized by CGF will have 0% risk weight. We do not expect CAR to be a major issue for banks this year unless we see a significantly sharper depreciation of the TRY. Catalysts Better-than-expected global liquidity: We are expecting rollover ratios in international wholesale borrowings to remain at or below 100%, and costs to increase. Nevertheless, higher-than-expected fund flows to Turkey would back the sector s loan growth and easing in funding costs would support NIM. 7 BNP PARIBAS 12 APRIL 2017

8 Improvement in consumer confidence and economic activity following referendum: End of political uncertainty may result in a pickup in economic activity, which will support asset quality of the banks. Risks While banks were the beneficiaries of the Government s recent actions to support loan growth, we believe there is a risk that government may push for lower loan rates. State banks are pursuing a more aggressive strategy in lending which may distort market pricing. The Government introduced a maximum limit on interest to be paid to state deposits in Dec 16. Accordingly, state banks are paying around 300bp less to state deposits as compared to regular time deposit rates in the market according to our calculations. State banks reflect this cost saving to their loan prices, which enforces other banks that do not want to lose market share to cut down their loan yields, which ultimately hurts core spreads. Courts may decide against banks in cases related to Competition Board fine: Competition Board fined 12 banks in 2013 including Akbank, Garanti, Isbank, Yapi Kredi, Halkbank and Vakifbank for collusion in determining loan and deposit rates. Subsequently, some consumers went to court demanding compensation for higher interest charged for loans or lost interest in deposits. A negative outcome from these court cases may trigger a spree of reimbursements similar to fee rebates we had seen in BNP PARIBAS 12 APRIL 2017

9 A closer look at fundamentals TRY loan growth stronger than expected with government support Loans expanded 5.5% YTD as of end-mar with 7.3% growth in TRY loans and 1.1% decline in FX loans in USD terms. Mortgages (+5.4% YTD), commercial instalment loans (+18.3%) and commercial & corporate loans (+6.3%) are the main drivers of TRY loan growth. We believe growth in commercial instalment loans and commercial loans are led by SME loans. Newspaper reports suggest there is a strong demand for loans collateralized by the Credit Guarantee Fund guarantees, and utilization of the fund exceeded TRY108b with appetite picking up in the last couple of weeks. Exhibit 4: Y-y loan growth reached the 20% level thanks to higher TRY loans and depreciation (%) Loan growth TRY loan growth FX loan growth (USD) Nov '16: CGF raised to TRY20b Mar '17: CGF raised to TRY250b 0 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Sources: BRSA; TEB Investment/BNP Paribas The government is trying to incentivize lending, especially to SMEs with various actions: 1 The government set up a Credit Guarantee Fund that will provide guarantee for loans up to a total of TRY250b with a focus on SMEs. The banks will prepare portfolios of loans that the Fund will provide guarantee. The Fund will bear 90% of the burden of NPLs until the NPL ratio reaches 10% (raised recently from 7%) for each portfolio of loans. Reportedly, the government is working on a separate scheme that would provide 100% guarantee for cooperative loans that Halkbank provides. The guarantee will not just lower CoR for banks, but also reduce risk weightings used in CAR calculations (risk weighting will be 0% for guaranteed amount). 2 General provision rates are lowered (for Group I loans, from 4% to 1% for GPLs, from 1% to 0.5% for commercial loans, from 0.5% to 0% for SME loans) until end BRSA also extended the definition of SMEs to companies with annual sales up to TRY125m (previously TRY40m). 9 BNP PARIBAS 12 APRIL 2017

10 Exhibit 5: BRSA lowered the general provision rates to support loan growth Group I Group II Old New Old New (%) (%) (%) (%) Corporate & commercial loans Export related & FX earning sectors Others SME loans Consumer loans Mortgages Other consumer loans * * For banks whose retail loans exceed 25% of total loan book Source: BRSA 1 A new law was enacted that allow deletion of credit history records of real persons and legal entities who could not pay their debts from the registry lists, provided that they will pay their debts within six months as of enactment date of the law. This allows banks to lend to people and companies that were previously on the blacklist, though banks appear to be reluctant to lend to previously blacklisted people and companies. 2 Restructuring rules were relaxed so that banks can restructure delinquent loans without classifying them to NPLs. 3 Conditions of embezzlement crime for bank managements are clarified so that managers will not be held criminally responsible for NPLs. 4 Following sharp depreciation of TRY and Fitch s downgrade, CARs of the banks were under pressure. Average CAR of the sector declined from 16.0% in Sep 16 to 15.1% in Jan 17. BRSA first allowed use of ratings given by IIRA (which still has an investment grade rating for Turkey) in CAR calculations, then lowered risk weighting of FX reserves deposited to CBRT to 0% (from 50% at the end of 2016, though it would rise to 100% if banks continued to use Fitch s ratings). With these changes the sector s CAR increased by 80bps m-m to 15.9% in Feb 17. Exhibit 6: The sector s CAR recovered in February with change in risk weights (%) The sector's CAR declined 50bps in Jan following Fitch 15.1 Then recovered 80bps in Feb thanks to lower risk weight of FX reserves Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Source: BRSA 5 General limit in credit card instalments was raised from 9 months to 12 months; maximum maturity in GPLs was extended from 36 months to 48. LTV in residential mortgages was increased from 75% to 80%. 10 BNP PARIBAS 12 APRIL 2017

11 Despite the government s push for higher loan growth, we believe banks will be reluctant to further extend their LDRs, which reached 110% for the sector in end The situation is more acute on the TRY side whose LDR reached 134% with recent shift to FX in currency mix of deposits. Consequently deposit growth will be a limiting factor for loan growth. Decline in global liquidity and rising global rates would not be supportive for loan growth either, in our view. We envisage 16.5% loan growth in 2017 with loan growth of 13% for TRY and 5% in USD terms for FX loans. We forecast 10% y-y loan growth in FX adjusted terms. Weak demand in FX loans Economic uncertainty and FX volatility appear to hit FX loan growth with FX loans declining 1.1% YTD as of end-mar. We see weak demand for new project finance and investment loans demand, though new government projects like recently tendered Canakkale bridge or forthcoming Kanal Istanbul may create some demand going forward. Exhibit 7: Y-y FX-adjusted loan growth now at c.11% (y-y %) Cash loans growth Cash loans growth (fx-adj) 25 Exhibit 8: Momentum still strong (%) 13-w total loan growth 13-w consumer loan growth Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Sources: BRSA; TEB Investment/BNP Paribas calculations Sources: BRSA; TEB Investment/BNP Paribas calculations Switch from TRY to FX deposits weigh on TRY LDR We had seen a shift to FX deposits following the volatility in FX rates as deposit holders used decline in FX rates as a buying opportunity following a sharp increase in the beginning of the year. FX deposits increased 7.4% YTD as of end-mar, while TRY deposits declined 0.3%. Overall sector deposits increased 4.6% YTD. Consequently, sector s TRY LDR increased from 124% in end to 134% as of end-mar, while overall LDR remained stable at the 110% level. We believe increase in TRY LDR was one of the factors pushing up the deposit rates recently. Exhibit 9: TRY LDR rising (%) LDR TRY LDR FX LDR Dec-14 Feb-15 Mar-15 May-15 Jun-15 Jul-15 Sep-15 Oct-15 Nov-15 Jan-16 Feb-16 Apr-16 May-16 Jun-16 Aug-16 Sep-16 Nov-16 Dec-16 Jan-17 Mar-17 Sources: BRSA; TEB Investment/BNP Paribas estimates Exhibit 10: TRY deposits still cheaper compared to swaps (%) Deposit costs Libor Swap cost TRY deposit Sources: Bloomberg; CBRT; TEB Investment/BNP Paribas estimates FX deposit + swap BNP PARIBAS 12 APRIL 2017

12 Exhibit 11: LDRs >100% for all large banks in our coverage (%) 140 Exhibit 12: Adjusted TRY LDR is lower than reported (%) TRY LDR (4Q16) TRY LDR (adj. for bonds) (4Q16) AKBNK GARAN ISCTR YKBNK HALKB VAKBN 60 AKBNK GARAN ISCTR YKBNK HALKB VAKBN Sources: BRSA; TEB Investment/BNP Paribas estimates Sources: Company financials; TEB Investment/BNP Paribas estimates Exhibit 13: On balance sheet FX short position of the sector expanded rapidly in the recent weeks driven by the shift to FX in deposits (USD m) On-balance sheet FX position Off-balance sheet FX position 50,000 Net FX Position 40,000 30,000 20,000 10,000 0 (10,000) (20,000) (30,000) (40,000) (50,000) Source: BRSA Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Exhibit 14: Banks net FX position is relatively low Akbank Garanti Halkbank Isbank Vakifbank Yapi Kredi (TRY m) (TRY m) (TRY m) (TRY m) (TRY m) (TRY m) BS. FX Position (4,996) (17,200) (716) (15,081) 1,768 (7,161) Net FX Position (540) 1,261 (67) (4,072) 1, BS FX /Sh.Eq. (%) (16.3) (48.4) (3.4) (41.9) 9.2 (27.4) Net FX /Sh.Eq. (%) (1.8) 3.5 (0.3) (11.3) Sources: Company announcements; TEB Investment/BNP Paribas Wholesale funding Higher costs, but not a collapse of funding Following Fitch s downgrade, Turkey is now rated as junk at all three large international rating agencies. We had seen a 25bps increase in syndicated loan spreads following Moody s downgrade in Sep 16, and the deals in 2H16 included a 15bps additional increase following Fitch s downgrade. In Akbank s recent syndication deal, spread over Libor/Euribor was 60bps above last year s deal, signalling a 20bps further increase following downgrades. We believe banks will face higher borrowing costs this year, though borrowing window is still open for banks as evidenced by recent bond issuances by Akbank (Tier II), Yapi Kredi and Garanti. According to CBRT data, total external debt of the Turkish banking sector (excluding deposits) was USD98b as of Dec 16, of which USD44bn was to be paid in We expect rollover ratio to remain slightly below 100% in syndications, though this should not cause a significant trouble for banks considering low demand in FX loans. The banks are also holding USD30b in ROM which will be a buffer in the case of a 12 BNP PARIBAS 12 APRIL 2017

13 difficulty in FX liquidity. We also expect CBRT to support Turkey s banking system by lowering reserve requirements and possibly with other measures in case that international borrowings remain weaker than expected. Exhibit 15: Rollover calendar of major banks syndication deals Amount Total amount Signed Matures (EUR m) (USD m) (USD m) Vakifbank Apr-16 Apr Garanti Apr-16 May ,413 Yapi Kredi Bank May-16 May ,476 Isbank May-16 May ,417 Halkbank Jul-16 Jul Akbank Aug-16 Aug ,220 Isbank Sep-16 Sep ,040 Vakifbank Oct-16 Oct Yapi Kredi Bank Oct-16 Oct ,149 Garanti Nov-16 Nov ,282 Sources: Company announcements; TEB Investment/BNP Paribas Exhibit 16: Syndication costs are rising due to both increase in Libor and higher spreads (%) Libor Spread Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Mar-17 Sources: Company announcements; TEB Investment/BNP Paribas Changes in regulations to support banks CARs Following sharp depreciation of the TRY and Fitch s downgrade, average CAR in the bank sector declined from 16.0% in Sep 16 to 15.1% in Jan 17. BRSA first allowed use of ratings given by IIRA (which still has an investment grade rating for Turkey) in CAR calculations, then lowered risk weighting of FX reserves deposited to CBRT to 0% (from 50% at the end of 2016, though it would rise to 100% if banks continued to use Fitch s ratings). With these changes the sector s CAR increased by 80bps m-m to 15.9% in Feb 17. We do not expect CAR to be a major issue for banks this year unless we see a significant depreciation of TRY. 13 BNP PARIBAS 12 APRIL 2017

14 Exhibit 17: Impact of 0% risk weighting of FX reserves (TRY m) AKBNK GARAN ISCTR YKBNK HALKB VAKBN ALBRK FX Bonds 30,279 13,739 13,594 9,335 6,912 5,504 0 FX Required Reserves 28,943 15,501 24,556 22,124 25,902 19,433 3,600 Impact on RWAs 14,472 7,750 12,278 11,062 12,951 9,717 1,800 Total RWAs 229, , , , , ,308 22,830 Capital 32,856 37,655 40,996 32,567 23,013 23,408 3,073 A.CAR (4Q16) (%) B.CAR (After Fitch downgrade %) C.CAR (0% risk weight for FX reserves %) CAR Impact (bps) (C-B) Sources: Company financials; TEB Investment/BNP Paribas Exhibit 18: CARs are well above regulatory minimums (4Q16) (%) AKBNK GARAN ISCTR YKBNK HALKB VAKBN Source: Company financials Exhibit 19: YKBNK s Tier-I ratio is below its peers (4Q16) (%) AKBNK GARAN ISCTR YKBNK HALKB VAKBN Source: Company financials Exhibit 20: CAR sensitivity to interest rates and TRY depreciation TRY m AKBNK GARAN ISCTR YKBNK HALKB VAKBN Impact of 100bps increase in TRY interest rates * (32) (36) (42) (22) (37) (27) Impact of 10% depreciation in TRY ** (51) (66) (49) (27) (46) (35) * Economic impact, timing of accounting impact may differ ** Assuming 100% RW for FX assets excl. FX reserves Sources: Company financials; TEB Investment/BNPP calculations The Credit Guarantee Fund will likely support the sector s CAR as amount collateralized by CGF will have 0% risk weight. We calculatetry250b guarantee, if fully utilized, would increase the sector s CAR around 140bps. Margins to remain flattish CBRT s weighted average cost of funding going up: Following the volatility in FX rates in the beginning of the year, CBRT tighten the liquidity, limiting funding from one week repo auctions and O/N repo market, and pushing banks to borrow from CBRT s late liquidity window, normally an emergency funding line for banks. To further tighten the monetary policy, CBRT increased late O/N rate by 75bps to 11.75% on March 16. As of April 3, late O/N funding constituted TRY81b of CBRT s TRY91b total funding. Consequently, weighted average cost of funding surged 320bp to 11.5% as of end-mar 2017 from 8.3% at end We expect CBRT s tight stance to continue in the coming months as CPI could go up to 12% in April-May period, well above CBRT s targets. 14 BNP PARIBAS 12 APRIL 2017

15 Exhibit 21: WACF rising with use of late O/N window (TRY b) Total Funding (LHS) 1w Repo (LHS) 140 Late O/N (LHS) WACF (RHS) (%) Jun-12 Oct-12 Feb-13 Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16 Feb-17 Source: CBRT Limited pass through in deposit costs: Increase in CBRT s weighted average cost of funding also pushed deposit rates higher. Average TRY time deposit cost in our survey with leading banks (for 35 day deposits) increased 104bp YTD as of end-mar to 11.8%. CBRT s data show 55bp YTD increase in TRY deposit rates (all maturities, blended) to 10.2%. Increase in deposit costs remained more limited compared to the rise in WACF as the gap between deposit rates and WACF were already at a high level at the beginning of the year. State banks benefit from lower costs in state deposits: The government introduced a cap on interest to be paid to state deposits in Dec 16. Accordingly, interest rate paid to these deposits may not exceed a certain percentage (70% for maturities of 8-59 days, 75% for maturities days, the rate progressively rising for longer maturities) of average deposit rate with similar maturity as announced by the CBRT. As of Dec 16, state deposits under this context constituted 17% and 6.5% of Vakifbank and Halkbank s deposits respectively. We calculate lower deposit rates to have a positive impact of around 25bps and 10bps on NIM and 15% and 6% on net income for Vakifbank and Halkbank respectively. Exhibit 22: State deposit costs Maturity Max. interest calculation methodology Relevant weighted average deposit rate * Max. Interest that can be paid to state deposits Share of Halkbank's state deposits** Share of Vakifbank's state deposits ** O/N 60% of weighted average deposit rate (up to 1 mth) (%) (%) (%) (%) up to 7 days 65% of weighted average deposit rate (up to 1 mth) days 70% of weighted average deposit rate (up to 1 mth) days 70% of weighted average deposit rate (up to 3 mths) days 75% of weighted average deposit rate (up to 3 mths) days 85% of weighted average deposit rate (up to 6 mths) days 90% of weighted average deposit rate (up to 6 mths) days 95% of weighted average deposit rate (up to 12 mths) > 270 days 100% of weighted average deposit rate (up to 12 mths) Avg. weighted average deposit rate (all maturities) Avg. estimated state deposit cost (Halkbank) 8.48 Avg. estimated state deposit cost (Vakifbank) 7.81 * As of 31 Mar 2017; ** As of 31 Dec 2016 Sources: Company financials; CBRT; TEB Investment/BNP Paribas 15 BNP PARIBAS 12 APRIL 2017

16 Exhibit 23: Interest rates are on the rise (%) Average TL loan yield Average TL deposit cost 18 Average TL deposit cost (1-3 months) Exhibit 24: Mortgage rates still not reacted to higher funding costs (%) Commercial Mortgages GPLs Weighted Average Yield Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Source: CBRT Source: CBRT Commercial lending rates follow deposits: According to CBRT data, average lending rate of commercial and consumer loans rose 115bps and 28bp respectively as of March 24. While banks managed to raise rates in commercial loans and GPLs (+55bp YTD), stable rates in mortgages kept the increase on the consumer side limited. Exhibit 25: Spread between mortgage and deposit rates narrowing (%) Average TL deposit cost Mortgages Benchmark bond yield Aug-14 Nov-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 Source: CBRT We forecast TRY deposit rates to rise 100bp further in the remainder of 2017 as high LDR in TRY will likely push deposit rates higher along with higher WACF. On the other hand, we anticipate a 30-50bp increase in TRY lending rates. Given the slower growth of lending rates and duration gap in the sector, we forecast loan-deposit spread to start sliding down after 1Q17. Nevertheless, we expect y-y contraction in core spread in 2017 to be limited to10bp as we started the year on a high point following four consecutive quarters of spread expansion in BNP PARIBAS 12 APRIL 2017

17 Exhibit 26: Loan deposit spread in originations flattish (%) Marginal Spread Exhibit 27: We anticipate q-q contraction in spread through 2017 (%) L/D Spread Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar Q16 2Q16 3Q16 4Q16 1Q17E 2Q17E 3Q17E 4Q17E Sources: CBRT; TEB Investment/BNP Paribas Sources: Company financials; TEB Investment/BNP Paribas estimates Higher CPI linkers will support NIM: In 2017, our macro team expects Oct 16- Oct 17 CPI figure, which is the most widely used benchmark by banks for calculating the CPI linker yields, to be at 9.0% compared to 7.9% in This figure indicates TRY831m additional CPI linker yield for banks in our coverage assuming flat CPI linker volume. We believe there may be even an upside risk with our inflation estimates as CPI reached 11.3% in March. We calculate each 1ppt increase in CPI will add 5bps on average to the banks NIM and 2.5% to the bottom line (assuming all else equal). Exhibit 28: Higher contribution from CPI linkers expected for 2017 AKBNK GARAN HALKB ISCTR VAKBN YKBNK CPI Linkers, 4Q16 (TRY m) 14,673 16,729 9,233 15,501 9,948 9,500 as % of LC Sec. Port. (%) as % of Total Sec. Port. (%) as % of IEA (%) as % of Equity (%) CPI assumption used (%) Actuals CBRT surveys Actuals 8.8 Quarterly Annualized CPI base in 2016 (%) 7.9 CPI base in 2017 (%) 9.0 Expected CPI linker Income * Additional Income Quarterly NIM impact (bp) Additional Income (after tax) % of Equity (%) % of 17E NI (%) * Assuming 2% real yield Sources: Company financials; CBRT; TEB Investment/BNP Paribas 17 BNP PARIBAS 12 APRIL 2017

18 Exhibit 29: Incremental NII impact of higher CPI reading in 2017 (TRY m) Source: TEB Investment/BNP Paribas estimates 105 AKBNK GARAN YKBNK ISCTR HALKB VAKBN NIM to be flattish: We expect higher CPI linker yields to compensate for lower core spreads leading to a flattish NIM for the sector in The major risk to our call is higher-than-expected increase in deposit costs. We calculate every 10bps move in NIM will have a c.5% impact on the banks net income on average Exhibit 30: L/D spread to decline on high TRY funding costs (%) Exhibit 31: NIM to remain flat in 2017 thanks to CPI linkers (%) E 2018E E 2018E Sources: Company financials; TEB Investment/BNP Paribas estimates Sources: Company financials; TEB Investment/BNP Paribas estimates Government actions to limit deterioration in asset quality NPL inflows tame in 1Q17: Despite volatility in FX rates, weak consumer confidence and higher unemployment rate, NPL ratio remained stable YTD at 3.2% as of end-mar. We believe easing of restructuring rules, extension of consumer loan maturities and the Credit Guarantee Fund will limit NPL inflows this year. We expect a c.35bps increase in NPL ratio in BNP PARIBAS 12 APRIL 2017

19 Exhibit 32: No upward trend in NPL ratio Exhibit 33: Company loans are resilient (%) (%) Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 Source: BRSA Source: BRSA Exhibit 34: Impact of rising unemployment is not yet visible on retail NPLs Exhibit 35: Consumer confidence still weak (%) Unemployment rate (LHS) 14 Retail NPL ratio (RHS) Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 (%) Sources: TurkStat; BRSA Source: TurkStat Credit Guarantee Fund a big support for asset quality: The government increased the amount of guarantee it provides to TRY250b from TRY20b under the scheme of Credit Guarantee Fund and set aside TRY25b budget for this. For SME loans, the Fund will bear 90% of the burden until the NPL ratio reaches 7% for each portfolio of loans. There is a 3bps flat fee for use of CGF s guarantee that companies pay upfront to the CGF regardless of the duration of the loan. Press reports suggest the Credit Guarantee Fund provided close to TRY108b guarantee up until March 29, with utilization picking up especially in March. It should be noted that this amount is not all from new initiations, but also includes rollovers of existing loans. SME loans (TRY421b, 24% of total loans as of Dec 16) were one of the main drivers of higher NPLs in 2015 and 2016 as NPL ratio in the segment came up from 3.4% in Dec 14 to 5.1% in Dec 16. A slowdown in SME NPL inflows should support the sector s asset quality. Net NPL inflows in SME loans in 2016 were TRY5.8b, and assuming provision coverage ratio is similar to total loan book, we believe 90% guarantee of SME loans has potential to reduce the sector s CoR by c.25bp. While direct impact of CGF s guarantee should be visible mostly starting from 2018, higher flow of funding to SMEs will likely limit NPL formation this year. 19 BNP PARIBAS 12 APRIL 2017

20 Exhibit 36: NPL ratio of SME loans Exhibit 37: SME loans constituted half of total net NPL inflows in 2016 (%) (%) Corporate loans Credit cards Other retail Corporate loans Credit cards Other retail GPLs GPLs Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan % 0 SMEs SMEs Sources: BRSA Sources: BRSA, TEB Investment/BNPP calculations NPL formation in retail loans slowed down following extension in maturities: BRSA limited maximum maturity in GPLs and credit card instalments at 36 months and 9 months respectively in Dec 13 in the context of macro prudential measures. Introduction of these limits led to an initial increase in NPLs as some consumers that were rolling over their debt defaulted. In Sep 16, the Government extended these limits to 48 months for GPLs and 12 months for credit card instalments. We had seen a decline in NPL formation in retail loans following this change. Exhibit 38: NPL ratio declining since Sep 16 in GPLs (%) 7.0 Exhibit 39: Credit card NPL ratio going flat (%) Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 Source: BRSA Source: BRSA Restructured loans surged in 4Q16: Total restructured loans of the banks in our coverage increased 20% q-q in 4Q16 as banks took advantage of new restructuring rules. Share of restructured loans in total loan book rose from 3.0% in 3Q16 to 3.3% in 4Q16. We believe restructurings will be one of the factors that will limit NPL formation in BNP PARIBAS 12 APRIL 2017

21 Exhibit 40: Halkbank leads y-y growth in restructured loans (4Q16) (y-y %) Sources: Company financials; TEB Investment/BNPP calculations AKBNK GARAN YKBNK ISCTR HALKB VAKBN Exhibit 41: Restructured loans surged in 4Q16 (%) AKBNK GARAN YKBNK ISCTR HALKB VAKBN Sources: Company financials; TEB Investment/BNPP calculations Exhibit 42: Vakifbank has the lowest share of restructured loans/total loans (4Q16) (%) Sources: Company financials; TEB Investment/BNPP calculations AKBNK GARAN YKBNK ISCTR HALKB VAKBN Exhibit 43: YKBNK has the highest share of restructured+ Group II+ NPLs (%) Series5 NPLs 14 Restructured closely monitored loans Other closely monitored loans Sources: Company financials; TEB Investment/BNPP calculations 9.7 AKBNK GARAN ISCTR YKBNK HALKB VAKBN Specific CoR to remain stable: We expect specific CoR to remain stable in 2017 on average for banks in our coverage, thanks to supportive measures of the government. A significant depreciation and/or weaker-than-expected GDP growth are the main risks that would raise specific CoR, while improvement in consumer confidence and unemployment rate would support the banks asset quality. Exhibit 44: Specific CoR to remain flat; a decline at Garanti, highest growth at Halkbank (%) Specific CoR 2016 Specific CoR 2017E AKBNK GARAN ISCTR YKBNK HALKB VAKBN Sources: Company financials; TEB Investment/BNPP estimates 21 BNP PARIBAS 12 APRIL 2017