What needs to be cured on the legal and tax fronts: A proposal for a financial restructuring and NPL reform
In the last two decades, Turkish economic growth was supported by credit, especially foreign currency denominated funding. As of July 2019, total FX debt (long term and short term) owed by the private sector in Turkey was USD 211 billion (USD 103 billion is owed by financial institutions and USD 108 billion by the real sector). Following major fluctuations of TRY against USD in the beginning of 2018, Turkish companies with high FX exposure are now experiencing liquidity and solvency issues.
Further, the Banking Regulatory and Supervisory Authority (the “BRSA“) recently published a press release which rvealed that loans amounting to TRY 46 billion must be classified as NPLs. These NPLs mostly relate to energy and construction companies. In this respect, the banks notified by the BRSA were asked to reclassify these loans and set aside the required reserves by the end of 2019. The BRSA further stated that the global capital adequacy ratio of Turkish financial institutions fell from 18.2% to 17.7%, whereas the rate of NPLs increased from 4.60% to 6.3%.
The growing size of toxic assets on Turkish banks’ balance sheets is causing these banks’ liquidity to dry out, indicating that credit is not and may not be as available as it used to be. The banks’ ability to disburse new loans is negatively affected by the increase of NPLs in their balance sheets since they must maintain strict capital adequacy levels and set aside reserves for NPLs on an ongoing basis. This could be a major challenge for economic growth and sustainability, given the dominant role of credit in Turkish economic growth. Recovery is dependent on ensuring that Turkish banks resume lending, which is dependent on the removal of the troubled assets on bank balance sheets.
There are two alternatives to removing these troubled assets: either banks successfully restructure these loans, which would change their classification and diminish reserve requirements, or they dispose of these assets. In other words, creating a healthy and established financial restructuring and NPL market for Turkish banks.
Two decades after the 2001 Turkish financial crisis, the concept of “financial restructuring” was re-introduced in Turkey following the 2018 currency shock. Financial restructuring, defined as revising a debtor’s financial structure and re-determining its financial strategy, became a major agenda item for Turkish financial institutions. It is crucial not only to provide relief to the borrowers, but also to deleverage bank balance sheets to ensure that banks can continue to disburse loans. Therefore, an optimum solution acceptable to all stakeholders is needed and still needs to be reached in terms of financial restructuring. Regulators intervened immediately and began working to create a legal framework for financial restructuring.
The first step toward this was the introduction of the Regulation on Restructuring of Debts Owed to Financial Institutions (the “Regulation“) by the BRSA on August 15, 2018 which set out the path to the introduction of a ‘framework agreement’ to facilitate financial restructurings. Within a month, following the Regulation’s introduction, the Banks’ Association of Turkey (the “BAT“) prepared a framework agreement (the “First Framework Agreement“). Market players criticized the Regulation and First Framework Agreement because they failed to take into account international bank loans to Turkish borrowers and how the international banks might participate in the financial restructuring process. Therefore, the Regulation and First Framework Agreement was amended on November 21, 2018 and November 28, 2018, respectively, so foreign credit institutions were then able to be parties to the Framework Agreement by signing up on a case-by-case basis.
Not following the usual or a wholly coordinated approach to law making was understandable given the necessity to respond quickly to the significant impact of the fluctuations of TRY. However, considering that financial restructurings would take place over a longer term, it was necessary to provide a basis for financial restructuring in law. To achieve this, the BRSA prepared a Draft Law on the Restructuring of Debts Owed to the Financial Sector and distributed it to banks on May 13, 2019. The legislative preference, however, was to include a provisional article related to financial restructuring (the “Provisional Article“) in the Banking Law No. 5411 (the “Banking Law“), with an omnibus bill called The Law on the Amendment to the Income Tax Law and Certain Laws (the “Omnibus Law“), rather than having a standalone restructuring law. The Provisional Article will be in force for two years from the date of its publication, July 19, 2019, which can be extended by the president for another two years. The Provisional Article aims to incentivize financial restructuring by providing various tax exemptions and some comfort as regards possible allegations of regarding the crime of embezzlement, which has been a major concern for banks in the context of restructuring.
Recently, the BRSA amended the Regulation to align it with the Provisional Article. Further, the BAT divided the First Framework Agreement into two different framework agreements (i.e., a Large Scale Framework Agreement (the “Large Scale FA“), applicable to debtors with an aggregate principal debt equal to, or more than, TRY 25 million, and a Small Scale Framework Agreement (the “Small Scale FA“), applicable to other debtors who have less debt). The Large Scale FA and the Small Scale FA (together, the “Framework Agreements“) have been executed by a majority of Turkish banks and other financial institutions and entered into force.
Despite all these efforts, the Turkish financial restructuring and corporate NPL market has not become fully functional in the fifteen months after the 2018 currency shock. This paper elaborates on the necessary legal and tax infrastructure reform to establish a market that will help Turkish banks offload the heavy burden of troubled assets to other market players, including international investors.