Banks in the occupied areas combine high growth with serious risks

By Michalis Persianis

The banking system in the occupied areas has gone through major changes in recent years, mostly regarding how its regulatory and supervisory frameworks operate. At the same time, reliance on the public sector has decreased, or at least shifted form, while inflation has taken center stage. Despite recent deceleration, inflation continues to run hot at over 30%.

The overall system operates with assets of around 569.2 billion Turkish liras (10.7 billion euros), which equals roughly 170% of the local GDP. The sector maintains strong capital adequacy ratios of 20.52% against a 10% minimum regulatory baseline, while NPLs sit at just 2.56%.

However, clear differences exist between local banks, state-owned institutions, and foreign branch operations, mostly from Turkish parent banks. For instance, local bank NPLs run higher at 4.64%, and loan portfolio distributions vary significantly across categories. Foreign bank branches show stronger adequacy metrics across the board. They effectively function as a backstop for the entire system, since parent companies can absorb potential shocks without needing extra capital injections.

A major point of concern is the system's reliance on foreign currency loans, which make up the bulk of all lending at 73.3%. Foreign currency deposits also hover near 66% in recent figures. Using foreign currency helps manage high inflation, but it creates serious vulnerabilities. As the Turkish lira continuously loses value, borrowers struggle to repay debt, which weakens overall portfolio quality.

An analysis of NPLs, which remain manageable for now, shows noticeable differences between bank types. Construction loans account for 20% of all NPLs, while tourism drives another 10%. The main stress comes less from GDP growth trends and more from the gap between lira-based incomes and foreign-currency debt obligations.

An even bigger weakness stems from deposit maturity: about 71% of deposits are short-term (sight deposits or under one month), while two-thirds of loans stretch beyond one year. This maturity mismatch between short-term liabilities and medium-term assets leaves the system exposed.

The banking sector shows fast credit expansion paired with slower deposit growth over the last 12 months. Nominal credit rose 44.5% compared to last June, while deposits grew 33.2%. However, high inflation distorts these numbers. Inflation recently cooled to around 34% after peaking at 94% in previous months. After adjusting for inflation, real credit expansion runs near 4.4%, while real deposits actually shrank by 4.2%. High nominal liquidity is steadily eroding under inflationary pressure.

Still, the funding structure remains conservative, with deposits funding roughly three-quarters of total assets. The loan-to-deposit ratio sits at just 57.4%. This strong liquidity helps support stability, though questions remain about maturity risks, foreign currency dependency, and high market concentration.

Credit and deposits

Even with persistent inflation, lending activity remains positive, though real growth runs far slower than nominal data suggests. Liquidity stays adequate, but questions linger over future deposit inflows and currency breakdown.

The lending mix also reveals interesting trends: business loans make up roughly 71% of total debt, which leaves open the question of whether this leverage funds productive investment or everyday operations. Available data does not offer a clear answer. Consumer credit represents another 18% of total lending, pointing to potential pressures on household balance sheets.

The main question is whether credit funds productive ventures or simply fuels domestic consumption. If it mostly fuels consumption, underlying macroeconomic weaknesses remain present.

Bank deposit structure requires close tracking alongside credit trends. The gap between deposit and loan profiles represents the second main challenge after currency mismatch. Foreign currency lending (mostly euros and dollars) creates exposure when inflation is high, because borrowers earn liras while owing debt in euros or dollars. As the lira falls, incomes buy less foreign currency, leaving borrowers vulnerable.

From the banking perspective, short-term deposits mean customers can withdraw funds at any time, while bank assets remain tied up long-term. If nervous depositors demand their money quickly, banks could face liquidity squeezes and capital erosion. Deposits with maturities under one month account for just over 70% of total deposits, a common pattern during high inflation. Meanwhile, loans with terms over one year make up 66% of total lending.

These factors suggest that strong headline supervisory metrics may mask real structural issues. High capital adequacy (20.52%), solid return on assets (around 6%), strong return on equity (53%), and high net interest margins (8.63%) suggest banks can absorb initial losses. Yet these figures are distorted by bank size, portfolio distribution, and inflation.

Relationship with the public sector

Bank exposure to a financially fragile public sector has improved in recent years. In the past, official bodies relied on heavy direct borrowing that went unpaid and was simply renewed using funding from Ankara. That dynamic has lessened. Semi-state and local entities remain exceptions, though their absolute size stays limited and manageable.

Data remains incomplete, making firm conclusions difficult beyond a few key points.

Direct credit to the state is relatively low at roughly 10% of total loans, down notably from previous years. At the same time, public sector deposits represent a major liquidity source. Treasury bills (DiBS) and Development Bank bonds also tie banks to the public sector, while a large bucket labeled "Other Securities" lacks detailed disclosures.

Overall, measurable connections between the public sector and banks look manageable. Academic research warns about governance flaws, political influence, and poor oversight at state-controlled banks, but recent changes show progress. New regulations and directives focus on large exposures, internal audit independence, and corporate governance. Active supervisory penalties also show ongoing efforts to strengthen the system. Still, questions remain about data quality at state-controlled banks and the actual risk distribution behind average metrics.

At first glance, the banking system looks stable, profitable, and well-capitalized, with enough backing to absorb shocks or rising NPLs.

Behind that surface, the continuous decline of the Turkish lira, potential shifts in depositor confidence, and broader macroeconomic pressures could test banks severely, with local institutions facing the greatest risks. Academic studies and World Bank analysis both point to this concern: while the system as a whole holds up for now, it carries notable opacity, high structural risks, and uneven financial health across individual banks.