Document o f The World Bank FOR OFFICIAL USE ONLY Report No: 46443-TR PROJECTPAPER ONA PROPOSEDADDITIONAL FINANCELOAN INTHE AMOUNT OFUS$60MILLIONAND 109.1 MILLION {US$200MILLIONEQUIVALENT} TO THE TURKIYE HALK BANKASIA.S. (HALKBANK) WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR THE ACCESS TO FINANCEFOR SMALL AND MEDIUMENTERPRISESPROJECT DECEMBER 9,2008 Privateand FinancialSector DevelopmentDepartment Turkey CountryUnit Europeand CentralAsia Region This document has a restricted distribution and may be usedby recipients only inthe performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (ExchangeRateEffectiveOct 3l*, 2008) EURO 1 = 1.2835US$ US$1 = 0.7791EURO FISCALYEAR January 1 - December31 ABBREVIATIONSAND ACRONYMS BEEPS BusinessEnvironmentandEnterprise Performance Survey BDDK BankingRegulationand SupervisionAgency CBT Central BankofTurkey CPS CountryPartnershipStrategy DC Direct Contracting ECA Europe& CentralAsia (Region) EFIL ExportFinanceIntermediationLoan EU EuropeanUnion FIL FinancialIntermediationLoan FSL Fixed SpreadLoan FMR FinancialMonitoring Reports FMS FinancialManagementSystem FX ForeignExchange GOT Government ofTurkey IFRS International FinancialReportingStandards ICA InvestmentClimateAssessment ICB InternationalCompetitiveBidding ICR ImplementationCompletionReport IF1 InternationalFinancialInstitution ISA InternationalStandardsonAuditing ISR ImplementationStatus Report ISP InternationalShoppingProcedures NCB NationalCompetitiveBidding N S National Shopping OECD Organizationfor EconomicCooperationand Development OM Operational manual PIU ProjectImplementationUnit SME Small andMedium Enterprises SPO State PlanningOrganization SOE Statement of Expenditure TSKB Tlirkiye SinaiKalkinma Bankasi Thisdocumenthas a restricteddistributionandmaybe usedby recipients only inthe performanceof their officialduties. Itscontentsmaynot otherwisebedisclosedwithoutWorld Bankauthorization. FOR OFFICIAL USE ONLY PROJECTPAPER Republicof Turkey ACCESS TO FINANCEFOR SMALL AND MEDIUMENTERPRISESPROJECT ADDITIONAL FINANCING TABLE OF CONTENTS I. Introduction .............................................................................................................. 3 11. BackgroundandRationalefor AdditionalFinancing .................................................................................................. .......................................... 3 111. ProposedChanges 11 IV. Consistency with Countrypartnershipstrategy ................................................. 12 V. Appraisalof Scaled-upProjectActivities 12 VI. ExpectedOutcomes: .............................................................................................. ........................................................... 15 Annex I:HalkbankAssessment........................................ ..................................... 19 This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not be otherwise disclosed without World Bank authorization. REPUBLICOF TURKEY ACCESS TO FINANCE FOR SMALL AND MEDIUMENTERPRISES PROJECT ADDITIONAL FINANCE Europe and Central Asia Region Private and Financial Sector Development Department PROJECT PAPERDATA SHEET Date: Dec gth2008 Team Leader: Isfandyar Z. Khan Country: Turkey Sector Manager: Lalit Raina Project Name: Access to Finance for Small Country Director: UlrichZachau and MediumEnterprises Environmental Category: FI Borrower: Tiirkiye Halk BankasiA.S. (Halkbank) Responsibleagency: Tiirkiye Halk BankasiA.8. (Halkbank), Guarantor: Republic of Turkey Bankpolicies? oYes X N o Have these beenapproved by Bank management? Revisedproject development objectives/outcomes Not applicable. The originalproject objective will remainthe same, that is, to increase Turkish SMEs' access to mediumterm finance Doesthe scaled-up oject trigger any new safeguardpolicies? No - For Additional Financing [X ] Loan [ ] Credit [ ] Grant For Loans/Credits/Grants: Total Bank financing (US$): U S $ 200,000,000 equivalent (US$60,000,000 109,100,000) Proposedterms: Flexible Loanwith fixed spread, level repayment ofprincipal, the final maturityofthe loanis 30 years includinga 5.5 year graceperiod. Financing Plan (US$m.) Source Local I Foreinn I Total 2 I.INTRODUCTION 1. This Project Paper seeks the approval of the Executive Directors to provide an additional loan in an amount of US$ 200 million equivalent (US$60 million and 109.1 million) to Halkbank guaranteed by the Republic of Turkey for the Access to Finance for SmallandMediumEnterprises Project, which is being successfully implemented. 2. The Access to Finance for SMEs project, a financial intermediation loan (FIL) in Turkey, is implementedby two borrowers: Halkbank and Turkiye Sinai Kalkinma Bankasi (TSKB), each supported by a loan of 100 million equivalent Additional financing is sought only for Halkbank and not for TSKB; reason being that Halkbank has already completed disbursement of its loan funds to sub-borrowers whereas TSKB has disbursed about halfof its funds thus far. 3. The Access to Finance for SMEs project has proven effective in achieving its objectives by providing financing to 178 small and medium firms so far. The loans are well dispersed both sectorally and geographically. SMEs representing more than twenty sectors from varied areas such as printing, plastic processing, solar energy, tourism and food processinghave utilized funds from the project. The geographicalcoverage extends to most parts of Turkey with an emphasis on underservedareas such as the North, East, South East and the Center. The loans have also led to creating more than 3,200 jobs. The additional financing for Halkbank will enable further expansion of the sectors covered and broaden the coverage of the project thus enhancing the impact by improving access to finance for SMEs. 11. BACKGROUND AND RATIONALE FOR ADDITIONAL FINANCING Project Background 4. The existing Access to Finance for SME project is supported by a loan in an amount of 100 million for TSKB (Loan 7390-TU) and a loan inamount of 100 million to Halkbank (Loan 7389/7462-TU). The project was approved by the Board in June 2007 andthe loans became effective inJuly 2007l. Macroeconomic Background 5. Having performed relatively well through the summer of 2008 against a headwind of adverse global developments and domestic political uncertainty, Turkey now faces much lower growth and substantial downside risks as a result of the ongoing full- global economic and financial crisis. 1The project was originally structuredwith support oftwo loans --lo0 million ( 60 millionand $48.1 million) for TSKB, and -450 millionfor Halkbank, and such was approvedby the Board inJune 2006. Prior to signing, the banks have requestedcertainchangesto the project and Halkbank has requestedan increase of the loanamountto 100, so the project was re-submittedto the Board inJune 2007. 3 6. Global developments have already affected Turkish markets adversely, in line with other emerging markets. Spreads on Turkish sovereign bonds have widened from lows in the 170-180bps range inmid-2007 to 530 basis points as of November 6, 2008. Figure 4 illustrates how Turkish sovereign spreads have approximately tracked the EMBI+ average of emerging markets: as of November 6, the Turkish EMBI spread was 82 basis points lower than the EMBI+. On other indicators Turkey has also been affected in line with emerging marketsas a class. Between end-2007 andNovember 6,2008, the IstanbulStock Exchange declined by 51 percent, in comparison with 42 percent in Sao Paulo, 67 percent in Shanghai, and 68 percent in Moscow. Over the same period the Turkish lira has depreciatedby 31percent against the U S dollar. 7. Economic growth has begun to show the effects of declining investor confidence and scarcer finance. September industrial production was 5.5 percent lower than one year earlier and low growth i s expected to continue into the fourth quarter, possibly mitigated by the relatively stronger performance of the agricultural sector than in2007, when Turkey suffered a major drought. 8. Bank staffs growth forecast for Turkey in2009 has now been revised to around 2 percent, with the possibility o f a significant economic downturn. Furthermore, economic activity is subject to a high degree of risk given global uncertainty. The main question facing Turkey i s whether capital inflows can be maintained to avoid a disorderly unwinding of foreign exchange exposure, which lies mostly in the corporate sector. Were this to occur, the key mitigationmeasures would be the rapid adoption of financial-sector measures to protect liquidity and confidence in the banking sector plus fiscal measures to protect private-sector access to limited domestic credit and limit the impact on economic activity and employment. 9. Analysis by Bank staff indicates the wide range of scenarios that are possible for 2009. The main driver of the growth rate i s the external adjustment required by assuming different rollover ratios on existing external debt amortizations. Current market reports suggest that corporations expect to roll over a large bulk of remaining 2008 amortizations. Nonetheless, further shocks to global liquidity could lower this ratio significantly in the near term, and this potential variability was capturedinthe simulations runby staff. These scenarios would involve varying adjustments to asset allocations (e.g., reserve accumulation, public versus private debt issuance, and household holdings of foreign exchange), the exchange rate, inflation, andnominal and real interest rates. 10. Inthe assessment of Bank staff, the bulk of the probability lies with the Turkish economy maintaining modestly positive, though much reduced, GDP growth through 2009-reflecting the underlying strengths in Turkey's financial sector (see below), spot and forward market trends to date, and provided macroeconomic policies remain strong. Nonetheless, the high degree of uncertainty facing emerging markets in general, combined with Turkey's external financing needs, imply that government preparedness to respond rapidly to a worsening environment is key to risk mitigation. 11. The government is aware of the extent of downside risk to the Turkisheconomy in the near term and has prepareda series of measures inresponse. At the institutional level, 4 the government intends to make use o f the Economic Coordination Board to enable swift decision-making ifneeded inresponse to rapidly evolving circumstances. 12. In the financial sector, a number of measures have already been taken or announced, including encouraging banks to retain profits, smoothing liquidity pressures in the foreign exchange interbank transactions through CBRT's intermediation in the "FX deposit " market, and increasing banks' FX transaction limits. In addition to this, it is already announced that CBRT may also enhance FX liquidity by further increasing the limits of banks for foreign exchange deposit transactions, reducing FX borrowing rates that banks can borrow directly from the CBRT, extending the maturity o f FX deposit transactions, decreasing required reserve ratios, and extending the maturity o f rep0 funding. 13. Fiscal policy remains overall consistent with debt sustainability and macroeconomic stability, but has become more accommodative in recent months. InMay 2008, as part o f the preparation o f Turkey's medium-termfiscal framework (MTFF), the authorities revised the target for the primary fiscal surplus o f the total public sector for 2008 to 3.5 percent o f GDP (from 4.2 percent o f GDP) and set the 2009 target at 3.0 percent o f GDP. The authorities now forecast a primary budget balance o f 2.7 percent o f GDP in2008. At the same time, the expected central government's overall deficit, forecast at about 1.4 percent o f GDP (versus the target of 2.0 percent), will lead to a further fall in the public debt-to-GDP ratio in2008 (to below 40 percent from 41.5 percent in2007). In the 2009 budget submitted to parliament, the authorities have kept the public sector primary budget surplus target at 3 percent, consistent with the MTFF. However, revenue raising measures or expenditure reductions are expected to become important for Turkeyto reach this target, and building sufficient flexibility into public spending will be key to reducing the crowding out o f private-sector access to domestic finance in downside scenarios. One o f the main measures i s to link spending to revenues in light o f downside riskto growth andrevenue projections. Furthermeasures aimto reduce the contribution o f municipalities to the overall public-sector borrowing requirement, including a claw-back mechanism on transfers from central government. 5 Table 1: Key Economic Indicators MAlh' MACROINDICATORS GDP Growth -57 6 2 5 3 9 4 8 4 6 9 4 5 4 0 4 0 5 0 5 5 CPIInflation(Dec-Dec) 685 297 184 9 3 7 7 9 7 8 4 107 7 5 6 4 5 3 NominalInterestRate 99 1 63 5 44 1 249 162 180 183 Realex-anteInterestRate3/ 355 303 302 154 6 0 85 108 UnemploymentRate 8 4 103 1 0 5 i o 3 i o 3 9 9 9 9 Unit Wage Index(1997=100) 711 729 858 961 1083 1075 1137 - PUBLIC SECTOR PnrnaryBalance(% GDP) 1 8 3 1 4 9 5 5 5 1 4 6 3 5 2 7 3 0 2 7 2 5 Gross PublicDebt(%GDP) I/ 789 733 654 595 541 482 415 394 3 8 3 364 345 (EUdefinition) 776 737 674 592 523 461 388 EXTERNALBALANCE Current account balance(?YO GDP) 1 9 -03 -25 -37 -46 -61 -57 -64 approx -40 Expons(fob, $ bn) 41 347 407 524 685 724 936 1154 1472 1587 1769 1987 Tourism($ bn) 8 1 85 132 159 182 169 185 231 241 257 274 ExternalDebt(%GDP) 577 563 473 412 350 390 375 397 425 454 490 CBT Reserves($ bn) 51 198 281 352 377 525 633 765 828 854 892 960 MsmQ GDP (YTL billion) 2402 3505 4548 5590 6489 7584 8564 9943 1,ini.o 1,234.5 1,375.0 14. Public debt has been brought downto manageable levels, with limitedvulnerability of gross debt to exchange rate risk, and is sustainable. Analysis carried out by Bank staff indicates that, even under severe stress testing, public debt remains on a stable or downward-sloping trajectory (see Table 1and Figure 1). Figure 1: Gross Public Debt Confidence Intervals Figure 1.2: Total External Debt Projection 60 45 40 $4 25 e 35 30 I Source: Stafprojections Source: Staff projections 15. External debt has risen slightly since 2005 (see Figure 1.2). The external debt-to- GDP ratio declined considerably between 2001 and 2005 but has since increased, driven by corporate-sector external borrowing. Assuming the continued availability of credit on external markets, Turkey's gross external debt ratio would increase gradually in the near term, mainly reflecting continuing current account deficits, now assumed to be of the order of 4 percent o f GDP given recent falls in oil prices. Gross external financing needs in 2008-12 are projected to increase as private-sector non-bank amortizations increase, and corporate external borrowing are expected to continue to be the main driver of increasing external debt ratios (Figure 1.2). A sharp depreciation or a fall in non-debt creating 6 inflows would place the external debt ratio on a steeper upward path. Still, the composition of external debt has improved, with the share o f short-term debt outstanding in gross external debt declining to about 16 percent as o f mid-2008 (as o f October 2008, the private sector accounted for almost 90 percent of short-term external debt). 16. External debt sustainability depends in the longer term on reducing the current account deficit. In the longer term, reducing the current account deficit by increasing aggregate saving-both through strong fiscal policy and through improvements inthe trade balance -will be necessary to limit the growth o f external debt. The recent fall inthe price o f oil provides some relief to the current account deficit in the short time: a rise/fall o f US$10 inthe price o f a barrel o f oil i s estimated to imply a rise/fall by about 0.5 percent o f GDP inTurkey's current account deficit. Inthe long term, improved energy efficiency and the further diversification o f energy sources will be important to help reduce the country's external energy dependence. (Turkey's energy sector reform program, with planned support by the Bank's upcoming programmatic energy development policy lending, aims to improveenergy efficiency and security.) 17. In the short term, while Turkey's total external debt position should remain with high likelihood at levels consistent with long-term sustainability, rapid currency movements create the risk o f rapidly increasing external debt ratios. Furthermore, a capital reversal could both disrupt trade finance and force many firms to turn to scarce domestic sources for longer-term finance, hurting growth and employment, and highlighting the need for the government to avoid raising bond finance for additional deficit spending in downside scenarios. 18. In conclusion, Turkey faces considerable macroeconomic risks in the near term, particularly to its corporate sector's ability to maintain investment and growth in difficult global conditions. But deep structural progress since 2001 and continued strong economic management should allow the country to weather most external shocks. The main risk is o f further tightening international liquidity starving emerging markets o f capital and worsening investor sentiment, leading to an abrupt capital outflow and a significant economic downturn. Were this to happen, stronger balance sheets inthe public and financial sectors should help Turkey avoid a systemic crisis, but growth and employment inthe non-bankingprivate sector would suffer. Key to mitigating this risk i s preparedness on the part o f the government for downside external financing scenarios. Banking Sector Background 19. Turkey's banking sector i s substantially more resilient than before the 2001 crisis and is in a better liquidity position than banking sectors in many other countries in the Region. Despite the recent credit expansion, the overall capital adequacy ratio for the sector, at 17 percent, is well above the regulatory minimum o f 8 percent (Table 1.1). Return on equity and assets in excess o f 20 and 3 percent, respectively, point to strong profitability for a sector with solid growth. Asset quality remains good with relatively low non-performing loans (NPL) at 3.01 percent (Oct. 2008) and high provisioning levels at 87.3 percent (Oct. 2008). Government securities still account for about a third of banks' total assets. 7 Table 1.1: Banking Sector FinancialStrength Indicators August Percent 2004 2005 2006 2007 July'O8 '08 GrossNon-performing loans/ Total loans 4.7 3.7 3.7 3.1 3.2 ProvisionsINPL 88.7 88.7 89.7 89.7 82.0 80.9 ROA /1 2.5 2.7 3.3 3.3 3.2 3.1 ROE11 13.4 12.1 21.0 21.0 22.8 21.9 Loansldeposits 51.0 65.7 74.3 74.3 86.8 89.9 CAR 27.6 23.7 21.9 21.9 17.4 17.7 Source: BRSA, Monthly Bulletin (various). /I Theelimination of inflation accounting at theendof 2005makes theincomedatanot comparable across time 20. The banking sector is less exposed to shifts in global sentiment today than several years ago, while exposure to foreign capital outflows in the non-banking sector is more pronounced. Capital inflows have mostly come through the government securities market, investments in the ISE, and more recently directly to the corporate sector (Figure 1.3). While forty percent of the banking sector's liabilities are in foreign currency, they mainly stem from domestically collected deposits rather than direct borrowing from abroad. This modest reliance on foreign borrowingprovides a measureof resilience against areversal of capital flows. The banking system's net foreign currency position i s now almost in balance, amounting to about half a percent of capital. Moreover, the banking sector itself provides the market with more detailed information about on- and off-balance balance sheet currency positions. There i s market recognition that, contrary to 2001, counterparties holding a share of the sector's exchange rate risk are more reputable and financially stronger. A possible shift in investor sentiment would affect the banking sector only indirectly through a possible deterioration in the banks' loan portfolio and, to a lesser degree, marked-to-market lossesintheir securities' holdings. Figure 1.3:External Debt by Borrower Figure 1.4: Bank Ownership I I 100 Hasagreed 80 Remains in domestic Y) 560 hands -240 e 12% 20 ' 0 Foreign Statebank- , banks I - - CorporateSector -Public Sector -Financial Sector-,CentralBankI 33% 6% Source: CentralBank of Turkey. Source:BankersAssociationof Turkeyand the WorldBank. 21. More than 50 percent of banking sector assets is now held by banks with some degree foreign ownership, and the state remains in control of banks holding more than third of banking sector assets (Figure 1.4). The new ownership structure is leading to a more competitive industry, with enhanced transparency and reduced scope for lending to relatedparties 8 22. Domestic bank credit has grown at a good pace since the 2001 crisis, but it has grown from a small base and, at a modest 29 percent o f GDP, is still well below that o f similar income level countries (Figure 1S). Also, much o f the recent credit expansion has beento consumers as opposed to firms. Moreover, involume terms about half o f the credit expansion has been to consumers rather than to firms, and consumer credit has changed from being a marginal to a main line o f bankingbusiness2(Figure 1.6). Figure 1.5: DomesticCredit to Private Sector Figure 1.6: DomesticBank Claims by Sector 150 7 . -- - - _. -- - - 5 1 Claims on Public Sector, fl Firmloans ,- .&'' A1 2007 Source: IMF,International Financial Statistics. Source: Central Bank of Turkev. SMEAccess to CreditBackground 23. The SME sector remains underserved interms o f credit, and it will be up to Turkish financial institutions to provide credit to SMEs. As mentioned above, the corporate sector has benefitted from increased direct borrowing from abroad inthe amount o f 15 percent o f GDP as an alternative to domestic bank financing. However, as with capital market funding, this is not an alternative for smaller businesses, and it remains up to the domestic financial sector to serve this segment. 24. Evidence has shown that smaller firms and firms outside the major urban ,Figure 1.7: Share of Firms with Loans areas have less access to credit. As it is 70 often the case, smaller firms use credit less 60 frequently than larger ones. In addition, 50 regardless o f firm size, firms in major cities E840 are more likely to have a loan than others a 30 are. Even when grouping firms by size, it 20 remains true that firms in cities with populations o f one million or more have 10 loans more frequently than do firms in 0 Small Medium Large smaller cities and towns (Figure 1.7). It is ILargecities(>1millionpeople) Smallerciiles andtowns possibly a result o f bank branches being Source: Turkey Investment ClimateAssessment concentrated in major urban areas, and this /20071. 2It is recognized that the distinction between small business andconsumer credit is not so clear, because business owners will often use personal loans to finance their commercial activities. However, even with this possible bias, the point remains valid that muchofthe credit has gone to finance consumption. 9 bias may therefore reflect a physical barrier to accessing loans for the firms outside the cities. Rationalefor Bank Involvement 25. An effective financial sector that provides investment credit to firms supports economic development by enabling firms to invest intechnology and capacity. That raises output and productivity thereby fueling growth and employment opp~rtunities.~ In addition, evidence suggests that a well-functioning financial system enables the poor to benefit proportionally more from economic growth (Le.; growth i s pro-p~or).~ 26. SMEs remain underserved in terms o f credit and in addition there is evidence of spatial inequality in the provision o f credit, and the project has been successful in addressing these issues. Domestic bank credit i s still a modest 29 percent o f GDP and half o f the expansion has been to consumers rather than firms. The corporate sector has benefitted from increased direct borrowing from abroad in the amount o f 15 percent o f GDP as an alternative to domestic bank financing, but SMEs are typically not able to access this source o f funds and must rely on the domestic financial sector for financing. The Turkey Investment Climate Assessment showed that firms outside the major urban areas have less access to credit. Regardless o f firm size, the investment climate survey showed that firms in major cities are more likely to have a loan than those companies in smaller towns. The project has proven successful in reaching SMEs, including in the eastern part o f Turkey, where credit i s less developed. In addition the Bank i s engaged in systemic reforms inthe bankingsector through the CDEPL series. Impact of the Current Financial Crisis 27. The international credit crunch has the most impacts on the Turkish real/corporate sector. Within the real sector, SMEs are most affected by any increase in overall liquidity. In addition the increased risk aversion will affect export demand and domestic economic growth. A large part o f Turkey's businesses rely on European export markets, which are contracting. Moreover, the capital flows that have contributed to Turkey's economic recovery will slowdown, domestic demand will decrease thereby reducing demand for SMEs products. As a result, the growth o f the Turkish SME sector will slow and this in turn will reduce demand for credit line financing. The credit crunch is exacerbating SMEs credit constraints thereby makingthe project more relevant. 28. Halkbank's financial strength i s strong. As explained in detail inAnnex I,the bank remains instrong condition. It attains the position o f strength due to a mix o f core deposits that buffers against adverse market movements, limitedmarket exposure and a highcapital adequacy ratio. Inthe current financial crisis where highly leveraged financial institutions are finding it unable to lend, Halkbank's past risk averseness has placed Halkbank in a strong position to remain active in the SME sector whilst other banks are restricting lending due to liquidity constrains. 3The positive associationbetweenemployment and credit was establishedinthe Turkey ICA (2007), andthe importanceof finance for competitivenesswas hrther discussedinthe Turkey CEMI1(2008). 4See Beck, DemirgUpKunt, and Levine (2007). 10 Rationalefor Additional Financing 29. The additional financing will scale-up the project's impact and development effectiveness and continue to support the project's development objectives Itto increase Turkish small and medium enterprises (SME) access to medium-term finance". It will scale-up the achievements of the original project not only during the implementation period (2008-2012), but also beyond that period as the Borrower will use the reflows repaid from the initial sub-borrowers to finance new investments before the funds are returnedto the World Bank.Inaddition, given the reducedfinancing available as a result of the current crisis, the additional financing will ensure continued access to finance for SMEs 30. The project has achievedimpressive results to date with a broad spectrum of SMEs using the funds as investment loans to improve their productivityandworking capital loans to complement their investments and scale-up their operations. Fifty seven percent of the loans made by Halkbank have been for investment purposes. The geographical dispersion of the borrowers and the wide range of industries included confirm Halkbank's ability to reach SMEs. Commitments and disbursements since effectiveness have proceeded at a rapid pace. As of June 2008, less than a year after effectiveness, Halkbank disbursed99.9 million (out of a loan amount 100 million) to 154 SMEs, confirming boththe demand for credit by SMEs and Halkbank's ability to implement the project. The average loan size for Halkbank is 650,000 and average maturity 69 months. TSKB has disbursed $13 million and 20.7 million (out o f a loan amount $48 million and 60 million) to 24 SMEs. The average loan size for TSKB i s $2 million and the average maturity is 69 months. Total employment impact of the project to date has been 3243 jobs, with 2411jobs created by SMEs financed by Halkbank and 832jobs created by SMEs financed by TSKB. 31. The implementation performance of the existing project is strong. The implementation performance ratings for all categories are either highly satisfactory or satisfactory in the last ISR, and Halkbank and TSKB is in compliance with all legal covenants including prudential and eligibility requirements. There are no outstanding fiduciary or safeguards issues. The project is currently rated satisfactory on financial management and procurement aspects as well as on social and environmental aspects. 111. PROPOSEDCHANGES There are no proposedchanges to the project design. 32. The additional loan will finance a credit line intermediated by Halkbank. The SMEs will be the final beneficiaries of the credit line. For purposes of this additional financing, SMEs will continue to be definedas firms employing fewer than 250 people and having annual sales of less than US$20 million. To ensure that the project covers geographical regions in which SMEs are particularly underserved, Halkbank plans to allocate a portionof the loan to the areas as defined inthe Loan Agreement. The credit line will finance medium-termworking capital (e.g. raw materials) and investment loans (e.g., machinery, equipment, and civil works) with no sector restrictions. Sub-loans will be provided on the same terms and conditions as stipulated in the original Loan Agreement. 11 The lending rates would be approximate to what sub borrowers would pay in the market for similar money, taking into account, as relevant, maturities, risks, and scarcity o f capital. Institutional and implementation management 33. The project has a current closing dateofApril 30,2012. The implementation period for the additional loan will not require an extension, and the closing date will remain unchanged. 34. For purposes of the project there is an existing operational manual which will continue to be usedand will reflect the additional amount. Implementation shall be carried out through the existing Project Implementation Unit (PIU). The PIU at Halkbank is fully staffed and operates under the overall supervision of an Assistant General Manager. The PIU includes experienced management and staff including representatives of the financial analysis, financial control, credit, administrative, and operational departments. Annex I provides a summary evaluation of Halkbank including an analysis of the Bank's financial soundness, its implementation capacity and specific considerations on the bank's ability to meet the World Bank requirementincluding OP 8.30 on Financial Intermediation Monitoring and evaluation of outcomes/results 35. Halkbank will evaluate progress on the proposed indicators with supervision from the Bank through regular reporting and through implementationmissions. Halkbank has agreed to submit yearly reports including output and outcome indicators and semi-annual financial managementreports to the World Bank. The financial monitoring reports (FMRs) are included inthe operational manuals. The data will come from internal Halkbank reports andthe PIUhas sufficient capacityto ensure provisionofthe monitoring data. IV.CONSISTENCYWITH COUNTRY PARTNERSHIPSTRATEGY 36. The additional financing is well aligned with the CPS, which calls for improving access to finance to improve competitiveness and employment opportunities. The CPS suggests a new credit line for SME productivity and competitiveness in FY10/11 while also mentioning that the timing ofprojects will be flexible. V. APPRAISALOF SCALED-UPPROJECTACTIVITIES Economic andjnancial analyses 37. As there is no clear way of defining the project costs, a traditional economic/financial analysis cannot be conducted. The approach taken is to measure the development results inrelation to the amounts intermediated as shown inthe development framework. Technical 38. Provisions are includedinthe project to ensure that lending rates reflect the cost of intermediating the funds including an appropriate credit risk margin as required by OP8.30. The financial condition of Halkbank i s good, it has proven its ability to maintain 12 low non-performing loans ratios, and the capacity to implement the project is viewed as strong. Fiduciary 39. Halkbank has satisfactory financial management (FM) arrangements for the Access to Finance for SMEs Project. The FM arrangements were assessed during the July 2008 F M supervision mission and rated as satisfactory. The supervision included the examination of project accounting and reporting arrangements, staffing, internal control procedures,planning andbudgeting, financial manual and external audits. 40. Halkbank is in compliance with the FM provisions of the legal documents of the Access to Finance for SMEs Project. The semi-annual FMRs have been submitted on a timely basis in the agreed content and format. Halkbank also submitted the entity audit report for the year-ended December 31, 2007, and the project audit report for the period from effectiveness until July 31, 2008 on time. The audit report on entity financial statements prepared in accordance with the International Financial Reporting Standards (IFRS) is unqualified (clean). The project audit report has two qualifications on exceptions to compliance with loan covenants relating to the eligibility criteria, for which the Bank has grantedwaivers. Bothaudit reports were assessed as satisfactory by the project FMS. 41. Halkbank will continue to use its existing systems and staff for the financial management of the additional financing. The same accounting, reporting and internal control procedures will apply. The financial monitoring report templates will be used unless additional information i s requested from the task team. FMRs will be prepared semesterly and will be submitted to the Bank no later than 45 days after the end of the semester. The entity IFRS financial statements and project financial statements will be audited by private external auditors on an annual basis. The terms of reference of the audit have to be acceptable to the Bank. Both reports will be submitted to the World Bank no later than six months after the closing of the year. The disbursement procedures, as followed under the originalproject, would continue to be usedfor the additional loan. Procurement 42. Procurementfor the proposedadditional financing will continue to be carried out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IDA Credits" dated May 2004 revised in October 2006 (Procurement Guidelines); and the provisions stipulated in the original Loan Agreement. Anti-Corruption Guidelines approvedby the Bank on October 15,2006 will applyto this additionalfinancing. 43. For goods and works contracts below 2.5 million equivalent, established local private sector commercial practices may be followed inaccordancewith paragraph3.12 of the Procurement Guidelines. International Competitive Bidding (ICB) would be required for individual contracts above 2.5 million for goods and works in accordance with Section I1of the World Bank's ProcurementGuidelines. 44. The Ankara basedprocurement specialist carried out an assessment of the capacity of the Halkbank to implement procurement actions for the project. The assessment 13 reviewed the organizational structure for implementing the existing project and the interaction between the project's staff responsible from the procurement activities. Specialists assigned for the procurement arrangements within Halkbank's PIU, established in the existing SME project, will be responsible for all procurement oversight for the management o f the additional financing. The overall risk for procurement is average in Halkbank. In order to reduce the procurement risk, Halkbank plans to support PIU with additional staff and assist PIU with staff experienced inprocurement. 45. The World Bank will conduct regular post reviews o f the contracts not requiring a prior review on a random basis, one in ten contracts. The procurement arrangements will be reviewedannually Social 46. The project does not have any potentially negative social implications. By increasing access to finance and growth o f SMEs, it is expected that the operation will have a positive impact on employment. Environment 47. Halkbank was found to be in compliance with the environment procedures described in the loan agreement based on the review done in October 2008. It was confirmed that (i)the sub-projects files o f Halkbank's branch and beneficiaries' were conducted with respect to defined methods and environmental screening forms' specified issues in the loan agreement and, (ii)provisions related the environment (waste management, hygiene, personal protective materials, etc.) has been satisfactory from supply o fraw materials to the final products invisited sites. 48. Halkbank will continue to use its existing systems for the environmental screening procedures. The project has been assigned "Category FI" in accordance with World Bank safeguard policy OP/BP/GP 4.01 (Environmental Assessment). 49. Halkbank has prepared environmental review procedures documents acceptable to the World Bank. The frameworks define environmental review procedures to be used in sub-project evaluation. These framework documents have been posted on Halkbank's websites and i s included as separate chapters inthe bank's operations manual. 50. Halkbank has decided to include the possibility o f financing sub-projects that may, by Turkish environmental regulations, require an Environmental Impact Assessment (EIA) report. The environmental review procedures defined by Halkbank i s consistent with Government o f Turkey Environmental Assessment requirements, World Bank Environmental Assessment policies, and procedures utilized in previous Financial Intermediary operations inTurkey Safeguard policies 51. Environmental Assessment Policies will apply to the proposed project. Halkbank and sub-borrowers will have to comply with these policies. No other policy i s expected to be triggered by the project. The possibility o f other policies being triggered by specific 14 sub-loans made to SMEs will be assessed when conducting the loans' environmental assessments. SafeguardPolicies Triggeredby the Project Yes No Environmental Assessment (OP/BP/GP 4.01) [XI [I Natural Habitats (OP/BP 4.04) [I [XI Pest Management (OP 4.09) [I [XI Cultural Property (OPN 11.03, being revised as OP 4.11) [XI [I Involuntary Resettlement (OP/BP 4.12) [I [XI Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI Forests(OP/BP 4.36) [I [XI Safety of Dams (OP/BP 4.37) [I [XI ProjectsinDisputedAreas (OP/BP/GP 7.60)* [I [XI Projectson International Waterways (OP/BP/GP 7.50) [I [XI Policy Exceptions and Readiness 52. The project complies with all applicable World Bank policies. There is no specific policy exception. The project is ready for implementation. Specific conditions that have beenmet andthat are sufficient to start with project implementationinclude: h Fiduciary (financial management and procurement) arrangementsare satisfactory h Outcome and output indicators and monitoring and evaluation procedures have been agreedupon with the counterparts and are inplace. VI. EXPECTED OUTCOMES: Enhancedaccess to medium-termfinance for SMEs i s the expectedoutcome. The projects outcomes are expectedto be scaled-up proportionally to the already achieved outcomes. Specifically, 0 an additional US$ 200 millionworth of sub-loans will be disbursed; sub-loanmaturity will exceed 1year for 90 percent of the loans; and 0 non-performing loans will be less than 5 percent ofthe disbursedamount. VII. Risks: Risk Risk Mitigating Measures Rating Country and External Risks (To Project Development Objective) Macroeconomicframework: - Government is puttinginplace measuresto link Fiscaland other macroeconomic spendingto revenuesinlight ofdownsideriskto * By supportingtheproposedproject, the Bank does not intend toprejudice thejnal determinationof theparties' claims on the disputedareas 15 policies face particular challenges growth and revenue projections inthe 2009 budget inthe context ofongoing global projections. financial turmoil andthe economic - Monetary targets have been adjusted to reflect greater downturn. - realism (2009 inflationtarget i s now 7.5 percent). Government is committed to implementation o fmulti- Rating prior to mitigation 3 year medium-term fiscal framework. Rating of residual risks 2 - EUaccessionprocesscontinues to anchorreform - process and economic program. 53. Political stability: The single-party Government andits strong Political risks to the reform parliamentary majority favor political stability and program include (i) continuing create a findamentally positive environment for domestic political differences; (ii) reforms. upcoming municipal elections; and - Uncertainties created by the recent Constitutional (iii) tensionsand border Court case against the Justice and Development Party geopolitical events inneighboring (AKP) have passed, with the verdict not to ban the regions. . AKP or any o f its members from politics. - The government places priority on managing emerging 2 tensions ahead o f the municipal elections in March Rating prior to mitigation 2 2009. Rating of residual risks External economic andfinancial developments: High external financing needs and Reduced government debt (less than 40 percent o f GDP; current account deficits make gross, EUdefinition), modest bank credit to the private Turkey vulnerable to international sector, and a strong domestic deposit base should help liquidity problems, an abrupt avoid a systemic crisis. Keyto risk mitigation is capital outflow, and a significant government preparednessfor downside external financing economic slowdown. scenarios, including: ---- strongfiscalpolicy; a flexible exchange rate; prolonged maturity o f government debt; potential additional fiscal measuresto makeroom for - private-sector access to finance; measuresto protect FX liquidityand confidence inthe Ongoing global financial sector banking system; developments may have adverse - maintainingdomesticpoliticalstability. effects on the banking sector in Turkey. Turkishbanks benefit from modest reliance on international wholesale finding due to a modest domestic credit generation combined with a strong domestic deposit base. The system has become more resilient to volatility since the severe economic and financial crisis o f 2001. The quality o f capital has improved with strengthened regulation and supervision, reduced market risk, and improved loan underwriting systems. The impact o ftightening international liquidity conditions would mostly come through the domestic corporate sector as it loses access to foreign currency and draws on foreign currency deposits and credit lines from Turkishbanks. This will affect sustained growth and earnings, but is not expected to cause a crisis. The much strengthened position o f Turkish banks with 2001 mitigates the external financial risks to the achievement o fthe objectives o fthe project. Significant Rating prior to mitigation 4 credit to SMEs under the SME project andthis Additional Rating of residual risks 3 Financing is expected to be available even inan adverse 16 .............................................................................................................................................................................. ........................................................................................................................................................................................... scenario. "...................................................................................... Project-Specific Risks Economic slowdown: Credit to SMEs remains modest in Turkey, and the current Developmentsinthe local and demand for medium term fmancing is high. An economic global economy may reduce the slow down would depress demand, but given overall need demand for productsby the of the sector the finds are expected to be utilized in the SMEs. project timeframe. Rating prior to mitigation 3 Rating of residual risks 2 ............................................................................................................................................................................................. ...................................................................................................................................................................................................................................................................... Improvedfinancing conditionsfor The project would be crowded out if the market failure it Turkish financial intermediaries attempts to address diminishes, i.e. if medium- and long- and a loss of competitivenessof term financing became available at competitive costs to the credit line. Turkish SME. In this case, the development objective would already be served by the private sector, and it is therefore not a risk to the developmentobjective, but only a Rating prior to mitigation 1 risk to project implementation. Considering the current Rating ofresidual risks 1 ............................................................................................................................................................................................................................................................................ appetitefor credit inthe SME sector this risk i s low. Credit risk of SMEs. The SME Credit risk with SMEs will increase as the economy slows. sector is a risky segment ofthe However, Halkbank has a well developed credit appraisal credit market, and care mustbe procedure, which has been reviewed in detail by the team. taken inselectingSMEs and Halkbank currently has no non-performing loans in the managingthe risk project and a net non-performing loans ratio of 0.4 percent, which is marginally lower than the sector average of 0.5 Rating prior to mitigation 3 percentas of June 2008. Rating ofresidual risks 2 Political influenceon Halkbank's The team has reviewed the lending procedures and lending decisions. As a state monitored the lending under the project and i s hlly ownedand controlled bank, satisfiedthat lending decisions inthe project are made on a Halkbank could be proneto commercialbasis and basedon sound credit evaluation. political influence. Rating prior to mitigation1 2 Rating of residual risks 2 ................................................................................................................................................................................................................................................................Ç Delays due to World Bank The procedures have been streamlinedbased on experience fiduciary and safeguard and Halkbank has proven its ability to effectively requirements implementthem while successfilly disbursingthe loan. Rating prior to mitigation 2 ............................................................................. Rating ofresidual risks 1 Overall risk ratingprior to 3 ................................................................................................................................................................................................................................................................¦ mitigation Overall rating of residual risks 2 aRatingon four-point scale accordingto probability of occurrence and magnitudeof adverse impact where 4 representshighrisk while 1represents low risk. 17 VIII. FINANCIAL TERMS AND CONDITIONS FOR THE ADDITIONAL FINANCING 54. The loan to Halkbank i s in the amount of US$ 200 million equivalent (US$60 million and 109.1 million). The loan is a flexible loan with fixed spread, level repayment ofprincipal, the final maturity of the loanis 30 years including a 5.5 year grace period. The loans will be guaranteedby the Republic of Turkey. 55. The conditions of the original project will continue to prevail for the additional financing. Terms and Conditions between Halkbank and the Sub-Borrower SMEs 56. SMEsmust meet the eligibility criteria identifiedinthe original project inaddition: 0 At least $40 millionequivalent worth of sub-loansshall bemade ineasternand central regions as definedinthe original project. 18 HalkbankAssessment' Annex I Overview of Halkbank Halkbank is a large deposit-taking state bank primarily serving SME customersthroughout Turkey. It is the 7`h largest bank inTurkey by assets and has the 6thlargest branchnetwork (see Table 4.1 for key indicators). The bank currently has the Turkish Government as its main stakeholder with a 75% share. With 25% of its shares now quoted, Halkbank has strengthenedits corporate governance policies, with the creation of an audit committee and other locally recommended guidelines. Following IPO process, the strategic and operational decisions are increasingly made on a commercial basis. Substantialfinancial and operational restructuring over the past few years have contributed to the banknow being financially sound as well as profitable. The board approves policies, strategies, and principles for the bank. In line with industry practice, the bank has a risk management unit reporting directly to the board. An organizational chart for the bank is included inFigure 4.1 at the end ofthis Appendix. Table 4.1:Halkbank key indicators June 2008 Billion Share of System/ US$ percent Assets 37.6 793 Deposits 30,l Loans 18,5 Securities 14,5 Branches (number) 612 735 Source: Independent Auditors, BAT and staff calculations. 4.2 Suitability of Halkbank as Counterpart Halkbank has been selected as counterpart for the Project, which will provide credit to SMEs all over the country. One of Halkbank's key strategic objectives is to expand its SME business. Halkbank's vision reads, "Becoming the leading SME bank of the country.. .." Infact, Halkbank's portfolio is already dominated by commercial credit (with a significant share of SMEs slightly over 50%), while the bank extends less consumer credit (23 percent of loans). Halkbank has a relatively strong presence in the East and Center of the Country where credit is less developed. While the Turkish banking system only has 10 percent of its loan portfolio inthe eastern and central region, Halkbank has 20 percent of its loanportfolio (or US$ 3.129 billion) inthis area. Details on the loans inthe two relevant parts of the country are provided inTable 4.2. Unless otherwise noted, data inthis section reflect end-December 2007 and are from the The Banks Association o f Turkey. 19 Table 4.2: Halkbank loan Dortfolio bv region Million US$ Western Targeted Total end-year, 2007 region region Total credits 12,427 3,129 15,556 NPLs 951 82 1,033 Source: Halkbank. Halkbank's sustaining participation in the project is thus well aligned with its strategy. Halkbank is seeking to further strengthen its position as an SME bank by increasing its product range and growing its portfolio to that segment. Halkbank's portfolio of non- tradable investment securities (40% of total securities) weighting USD 5.8 1 billion as of end-June 2008, shifts towards tradable securities and loans in the recent years. Halkbank has a low but inreasing loans-to-deposit ratio in Turkey, at 61 percent, compared to an average loans-to-deposit ratio of 83 percent in the banking system. This suggests that Halkbank has a large customer base that is currently not exploited in terms of extending credit. While the loanto asset ratio of the sector is 53%, Halkbank's ratio is slightly below the average with 49%. By taking into consideration the loan to deposit ratio, loan to asset ratio displays the strong deposit structure o f Halkbank. 4.3 FinancialSoundnessandRiskExposures Halkbank is a well-capitalized and profitable bank with relatively small market risk exposures. The bank's liquidity is strong enough to protect it against adverse market movements. Furthermore, since the great portion of Bank's liabilities is composed of deposit which is the stickiest liability item in crisis, strengthens the liquidity structure of the Bank. The loanportfolio has performed well inthe past four years, and the bank i s run in a sound manner. Table 4.3 includes Halkbank's financial statements compared with those of the Turkish banking system. The section below includes a detailed evaluation of Halkbank's financial and operational performance. 20 Table 4.3: Summary balance sheet and income statement for Halkbank andthe bankingsystem I Millioii US $,Julie 2008 ASSETS YTL FX TOTAL YTL FX TOTAL CASH AND BALANCES WITH THE CBT 2,018 475 2,493 28,310 7,670 35,98C TRADING SECURITIES (NET) 484 131 615 9,163 4,713 13,87E BANKSAND OTHER FINANCIAL INST. 323 670 992 9,558 29,675 39,23: INVESTMENTSECURITIES AVALIABLE FOR SALE (NET) 9,592 2,653 12,245 116,100 37,301 153,401 LOANS 21,867 5,608 27,474 300,887 106,345 407,23; Loans under follow-up 1,265 0 1,265 12,358 85 12,44: Spesific provisions(-) 1,145 0 1,145 10,349 76 10,42E INVESTMENTSECURITIES HELD TO MATURIY 8.736 0 8.736 46.599 8.761 55.36C RESERVE DEPOSIT 56 1,108 1,164 OTHERASSETS 1,659 429 2,089 TOTALASSETS 44,737 11,074 55,810 LIABILITIES YTL FX TOTAL YTL FX TOTAL DEPOSITS 31,141 13,634 44,775 315,830 175,208 491,03E INTERBANKMONEY MARKET 644 1,580 34,950 8,581 43,531 FUNDSBORROWED 506 1.121 1.626 13,981 69,479 83,46C I,379 .~9360 1,279 4,995 0 5,092 582 12 595 11,557 712 12,26E OTHER LIABILITIES 1,117 164 1,281 20.523 10.902 .~~~ 31 027 ~~ SHAREHOLDERSEQUITY ~ 4,575 97 4,672 101:415 -399 l0l:OlE TOTAL LIABILITIES 39846 1596d 55810 503,252 264,581 767,831 INTEREST INCOME 3,789 46,841 Of which interest on loans 2,072 28,520 Of which interesr on securities 1,571 15,473 INTERSTEXPENSE 2,507 28,639 NET INTEREST INCOME 1,282 18,202 NET FEES AND COMMISSIONS INCOME 220 5,096 NETTRADING INCOME -92 474 OTHER OPERATING INCOME PROVISIONFOR LOAN LOSSES OR OTHER RECEIVABLES (-1 315 3,452 209 3,900 OTHER OPERATING EXPENSES(-) 558 12.071 NET OPERATING INCOME 984 121119 PROFIT/LOSSES FROM ASSOCIATES AND SUBSIDIARIES 0 0 NET MONETARY POSITIONGAIN/LOSS 0 n U INCOME BEFORE TAXES 984 12,119 PROVISIONFOR TAXES ON INCOME -205 -2,410 NET OPERATING INC./EXP.AFTERTAXES 779 9,709 EXTRA ORDINARY INCOIME/EXP.AFTER TAXES NET PROFIT/LOSSES 779 9,709 Source: Banking Regulation and Supervision Agency andStaff Calculations. Solvency. With a capital adequacy ratio of 14.08 percent (see Table 4.4)' the bank i s solvent when measured against risk-weighted assets. The much lower capital-to-assets ratio of 8.31 percent reflects the bank's large holding of government debt securities with 0 percent risk weighting. Table 4.4: Solvency Banking System Halkbank JUn Percent 2008 Jun2008 Dec 2007 Jun2007 Tier l/risk weighted assets 16.35 14.54 19.44 20.32 Capital adequacy ratio 16.79 14.08 20.03 20.25 Capital/total assets 12.64 8.31 10.64 9.60 Source: BAT and staff calculations. 21 Credit risk and loan porqolio performance. The bank's gross NPL-to-total loans ratio i s at 4.4 percent (see Table 4.5). However, it largely reflects old non-performing loans that have been fully provisioned for but not written off. Current portfolio performance is sound. A substantialportion o f the NPLs are carried over from Emlak Bank, which failed during the crisis and was merged with Halkbank. Specific provisions are made for 90 percent o f gross NPLs, and no loans have been written off inthe past five years. New non-performing loans (including sub-standard) net o f collections during the period 2005 to 2007 amounted to less than 2 percent o f the bank's current loan portfolio. The recent performance o f Halk's loan portfolio is thus sound. Halkbank's borrowers are widely dispersed, and concentrations are not a concern. In contrast to private banks, Halkbank extends 83.5 percent o f loans in local currency and therefore does not expose itself to indirect currency depreciation risk such as i s otherwise common inTurkey. Halkbank has a well diversified portfolio in respect of sectors and regions. Current developments are testing the creditworthiness o f SME clients however separate rating systems are used for corporate and SME loanportfolio o f the Bank and the loan customers are subject to internal rating process, so the firms' credibility is assessed correctly. Given Halkbank's experience with the SME sector it has adequate in house procedures and expertise to ensure good health o f the SME portfolio. The bank has been generating default statistics in house and the PD rates are lower than the other banks (peer group) in the Turkish banking sector, for the last 3 years. The internal rating system i s validated and the economic capital requirement o fthe Bank i s measured periodically, thus the credit risks are managed effectively, by the department o f Risk Management. Table 4.5: Credit risk Banking System Halkbank JUn Jun Dec Percent 2008 2008 2007 Gross NPLs/grossloans 3 5 6 GrossNPLdcapital 13.7 27.0 23.5 Loanprovisions/NF'Ls (incl. substandard) 84.4 90.5 98.7 Loanprovisions/capital 11.6 24.4 23.2 Source: BAT and staff calculations. Profitubility. The bank is highly profitable by both Turkish and international standards, with real ROA of 3 and real ROE o f 32.6 (see Table 4.6). As the Turkish bankingmarket evolves, new sources o f profits must be developed. Halkbank's non-marketable securities are currently being remunerated above would-be-market prices, and as they mature they will be partially replaced with lower yielding assets. Halkbank has a greater portion of its assets invested in Government securities than private Turkish banks, and return on this position is declining. Halkbank's ability to sustain its current highlevel o f profitability will depend on its ability to shift its portfolio in response to changing profit opportunities. However, even a lower level o f profitability would not endanger Halkbank's financial soundness. 22 Table 4.6: Profitability Banking System Halkbank JUn Jun Dec Percent 2008 2008 2007 Returnon averageassets 1.3 3.0 3.2 Returnon averageequity 10.8 32.6 30.6 Net interest income less provisions/averageassets 2.1 5.0 5.2 Operatingexpensedaverageassets 1.6 2.2 2.1 Source: BAT andstaff calculations. Liquidity.Liquidity is monitored bothby the ratios defined by the BRSA andthe ratios set by the Bank within the context of Liquidity Contingency planning.This planalso includes early warning indicator ratios that enables bank to define organization and the procedures to provide commensurate liquidity on time. The Bank's strong core deposit base has been a good liquidity buffer against adverse market movements. As it can be understood the tables below (see table 4.7) Halkbank's liquidity ratios are far above the limits defined by BRSA. rable 4.7: Liquidity LIQUIDITY 193.22% 100% 250.97% 1 1 ADEOUACY RATIO (11. MATURITY 124.11% 100% 140.90% BAND) LlOUlDlTY ADEQUACY V T I O (ON THE BASIS OF 5% 783% STOCK VALUES) Source: BRSALiquidity Adequacy Reports. Market risk exposures. Halkbank's market risk exposures are very moderate. The bank hedged it's on balance sheet foreign currency position with off balance sheet items.(See Table 4.8). The amount of net foreign currency position i s negligible when we compared it with the amount o f total assets. Due to the fact that 78 percent of the TRY denominated securities held by Halkbank i s composed o f floating rate, the Bank carries low interest rate risk on it's balance sheet. Furthermore, the Bank measures the effects o f interest rate movements on its P/L and net economic value by using periodical stress tests and scenario analysis. Table 4.8: Exchangerate risk Banking System Halkbank Jun Jun Dec Percent 2008 2008 2007 Net foreign exchangeposition on bdcapital 23.9 70.4 29.8 Net foreign exchangeposition on and offbskapital 0.23 4.9 1.4 Foreigncurrency denominatedloadtotal loans 26.1 20.5 16.47 Foreigncurrency denominatedassetdtotal assets 28.6 19.8 18 Foreigncurrency denominatedliabilitiedtotal liabilities 34.4 28.6 24.4 Source: BAT and staffcalculations. 23 4.4 Subsidized Credits Halkbank extends two types of subsidized credits; "IF1 credits" and "cooperative credits," that account for 18 percent of total loans (see Table 4.9 for an overview of loans by type and region). The subsidy elements are fully financed by sponsors outside Halkbank, and the subsidized credits are structured in a way that does not distort Halkbank's credit decision or interest rate setting for other loans. Table 4.9: Halkbank loanportfolio by loantype andregion, end-June 2008 Million US$ Western Targeted region Total Coop credits 1,724 709 2,433 IF1loans 384 98 482 Other loans 12,596 2,986 15,582 Total credits 14,704 3,793 18,497 Source: Halkbank. Directly subsidized "cooperative credits '' Cooperative credits are extended to small individual borrowers under credit cooperatives, and only borrowers organized under these credit cooperatives are eligible. The borrowers are small, and the scheme is akin to microfinance schemes seen in many other places. Halkbank receives a 7 percent subsidy from the Government in order to reduce interest on the loans. Credit risk i s reducedby the joint liability of the cooperative and the borrower. When payment from a borrower i s late, the amount i s charged directly from the cooperative's account. This program is only offered by Halkbank, and it i s expected to be phasedout over time. The loans are carried on Halkbank's balance sheet. Indirectly subsidized "IFIloans" Fund loans are financed by below market rate liabilities provided in the form of loans from, for instance, IFIs includingEIB, CEB, AFD, IBRD,etc. Halkbank i s requiredto lend the funds according to certain criteria, such as location in specific zones or to special groups of borrowers such as SMEs. The proposed World Bank credit line will also fall in this category. The loans are priced fairly close to market prices, and Halkbank earns a normal spread, carries the credit risk for these loans, and has the loans recorded on its balance sheet. Some of the fund loans are available to other banks inthe market, including private banks, andHalkbank does not enjoy a favorable position vis-a-vis other banks with respect to these loans. Other loans The remaining balance of the total loans also includes another type of subsidized loans such as EXIMandKOSGEB. The sum of these loans is USD 407 million. 24 4.5 OperationalPolicy8.30 (OP 8.30) Considerations OP 8.30 applies to Halkbank for the proposed operation. In summary, the conditions are viewed as being met for Halkbank as an intermediary. Regarding the specific issues for financial intermediaries under OP 8.30: (a) Adequate profitability, capital, and portfolio quality, as confirmed by financial statements prepared and audited in accordance with accounting and auditing principles acceptable to the Bank Halkbank is profitable, well capitalized, and its loanportfolio has performed well over the past four years-sees the section on financial soundness and risk exposures. Halkbank prepares statements in accordance with regulations, and the statements are viewed as adequate. (b) Acceptable levels of loan collections Although Halkbank used to carry a large stock of old non-performing loans, current loan collections are good-see the section on credit risk and loan portfolio performance under the sectionon financial soundness andriskexposures. (c) Appropriate capacity, including staffing, for carrying out sub-project appraisal (including environmental assessment) andfor supervising sub-project implementation On appropriatecapacity, includingstaffing, see section (Implementation Capacity). Halkbank has US$3,793 million worth of loans to SMEs inthe targeted region, equaling more than 20 times the amount of credit to be extended to Halkbank under the proposed operation. NPLs inthe targetedregion are small-both net and gross NPL levels are less in the targeted region than for the bank as a whole. This evidence suggests that Halkbank is able to extend sound credit inthe targetedregion. (d) Capacity to mobilize domestic resources Halkbank has US$30.14 billion worth of domestic deposits, proving its ability to mobilize domestic resources. (e) Adequate managerial autonomy and commercially oriented governance Halkbank i s mainly owned by the Government by 75% of shares and about 25% of shares are privatized through an IPO. The Government will retain control until a private sector partner takes a majority stake in the bank. Since the Government still owns and controls the bank, it is clearly not totally autonomous and commercially oriented in its decision making. However, the team's assessment indicates that decisions are made sufficiently autonomously and that they are commercially oriented, as also evidenced by the sound financials of the bank. flAppropriateprudentialpolicies,administrativestructure,andbusinessprocedures. 25 Halkbank complies with the regulations, and its balance sheet has a low risk profile. Credit decisions are made on a commercial basis (see section on subsidized credits for details), and the bank has a risk management unit reporting to the bank's board of directors, according to international practice. 26 U !e U