Turkey - Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P 7356 TU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN IN THE AMOUNT OF US$777.78 MILLION DOLLARS TO THE REPUBLIC OF TURKEY November 27, 2000 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency Equivalents (Exchange Rate Effective November 8, 2000) Currency IJnit = Turkish Lira Turkish Lira 1 = US$0.000001 US$1 = 685,549 Turkish Lira Government Fiscal Year January 1 - December 31 Abbreviations and Acronyms AMU - Asset Management Unit BRSA - Bank Regulation and Supervision Agency CAS - Country Assistance Strategy CPI - Consumer Price Index EFIL - Expoit Finance Intermediation Loan ERL - Economic Reform Loan EU - European Union FDI - Foreign Direct Investment FSAL - Financial Sector Adjustment Loan GNP - Gross National Product IAS - International Accounting Standards IFI - International Financial Institutions IMF - International Monetary Fund NBFI - Non-Btank Financial Institutions PSAL - Public Sector Adjustment Loan SBRPP - State Bank Restructuring and Privatization Project SDIF - Savings Deposit Insurance Fund (SDIF) WPI - Wholesale Price Index Vice President: Johannes F. Linn Country Director: Ajay Chhibber Sector Director: Paul Siegelbaum Program Team Leader: Lalit Raina  - iii - FOR OFFICIAL USE ONLY PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: The Republic of Turkey Amount: US$777.78 million Terms: Payable in 17 years including 5 years of grace and level principal repayment at six months LIBOR for US Dollars plus variable spread for Variable Single Currency Loan Front end fee: 1 percent of Loan amount Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver. Objectives and Description: The main objective of the proposed Financial Sector Adjustment Loan will be to address the Govemrnent's financial sector reform priorities in order to lay the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level. The reform actions required to achieve this objective in this FSAL would include creation of a competent and independent Banking Regulation and Supervision Agency (BRSA); bringing all the prudential regulations up to intemational best practice standards; empowerment of the bank failure resolution entity, the Savings and Deposit Insurance Fund (SDIF) with a new set of legal tools and operating guidelines; and making a major tangible push towards restructuring and privatization of state-owned banks. Benefits: The principal benefits of the Loan will be to: (i) strengthen the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level; (ii) reduce the vulnerabilities of the banking system and enhance its capacity to withstand external shocks, and thereby reduce systemic failure risk; and (iii) position Turkey's banking sector for EU accession. Risks: The Government's reform program in the financial sector, to be supported by the proposed FSAL, is exposed to significant implementation and performance risks due to a potential lack of political consensus and institutional weaknesses. The three main potential risks are related to: (i) weaknesses in bank supervision in the early stages of operation of the new BRSA, due to transition problems; (ii) the institutional capacity of the SDIF to undertake satisfactory bank failure resolution efforts; and (iii) the This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.  - iv - lack of political will to implement the reform of the state-owned banks. Schedule of Disbursements: First Trarche: US$392,778,900, including a 1 percent fee to be paid to the IBRD - expected January 2001. Second Tranche: US$385,001,100 - expected January 2002 Poverty Category: N/A Rate of Retum: N/A Project ID Number: PE-P0665 11 The Team for this operation consists of Lalit Raina (Team Leader/Lead Financial Sector Specialist), Marie-Renee Bakker (Lead Financial Sector Specialist), Vince Polizatto (Chief Credit Officer), Margery Waxman (Director), Biagio Bossone (Financial Policy Adviser), Gurhan Ozdora (Operations Officer), James Lacey (Bank Restructuring Consultant) and Ross Delston (Bank Failure Resolution Consultant). Dilek Barlas (Senior Legal Counsel), Rohit Mehta (Senior Disbursement Officer) and Michael Gascoyne (Financial Management Specialist) provided legal, disbursement and financial management support. The Team also received important contributions on macroeconomic issues from James Parks (Lead Economist). The Team worked closely together with an IMF Monetary and Exchange Affairs Department Team, including through joint missions, as well as with IMF Area Department Staff responsible for the preparation of the IMF Standby Arrangement.  - v - REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF TURKEY TABLE OF CONTENTS I. INTRODUCTION .............................................................1 A. Macroeconomic Context .............................................................1 B. The Government's Economic Reform Program .............................................................2 C. Bank Support for Economic Reform .............................................................2 II. TURKEY'S FINANCIAL SECTOR REFORM PROGRAM ..........................................3 A. Financial Sector Profile--Predominance of the Banking Sector .......................................3 B. Strengthening Banking Sector Legal, Regulatory and Supervisory Infrastructure ...........6 C. Upgrade Prudential Banking Regulations to Meet EU/Basle Standards ..........................7 D. Strengthening Problem Bank Failure Resolution Capacity ............................................ 11 E. State-Owned Banks' Commercialization and Privatization ............................................ 14 F. Reform of Deposit Insurance ............................................................ 16 G. Consolidated Supervision of Banks and Non Bank Financial Institutions ..................... 17 III. THE PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN ...............9............. 19 A. The Bank's Financial Sector Assistance Strategy .19 B. FSAL Objectives, Board Conditions and Tranche Triggers .21 C. Project Implementation .23 D. Financial Management and Monitoring .24 IV. BENEFITS AND RISKS .25 A. Project Benefits .25 B. Project Risks .25 C. Lessons Learnt From Past Adjustment Operations .26 V. RECOMMENDATION ..27 ANNEXES: Annex I: Timetable of Key Processing Events Annex II: Financial Sector At a Glance Annex III: Letter of Development Policy Annex IV: FSAL Policy Matrix Annex V: Environmental Data Sheet Annex VI: Turkey at A Glance  - vi - TABLES: Table 1: Consolidated Balance Sheet 3f the Turkish Banking System 1990-June 2000 .........5 Table 2: Assets and Deposits of State-.owned Banks as of end-June 2000 ............................ 14 Table 3: Duty Losses of State-owned Banks ............................................................... 15 List of Background Documents in the Files: 1. Banking Sector Review November 1998 Aide-Memoire 2. FSAL Identification Mission November 1999 Aide-Memoire 3. IMF Standby Agreement Letter of Intent, December 1999 4. Turkish Banking Law amendment, December 1999 5. ERL Initiating Memorandum, December 1999 6. Export Finance Intermediation Loan, July 1999 Project Appraisal Document  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF TURKEY 1. I submit for your approval the following Report and Recommendation on a proposed Financial Sector Adjustment Loan (FSAL) to the Republic of Turkey for US$777.78 million to address the Government's financial sector reform priorities in order to lay the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level. The proposed loan will be in US Dollar Single Currency at the standard IBRD terms. The loan will be disbursed in two tranches of approximately US$392.8 million and $385 million, respectively. The first tranche will be disbursed immediately upon effectiveness and the second tranche will be disbursed upon completion of the second tranche release conditions. 2. Beginning in 1999, the Government of Turkey has undertaken a major macroeconomic and structural reform program in consultation with the Bank and the International Monetary Fund (IMF). The key elements of the program currently underway include: (i) large up-front fiscal adjustment yielding sustained sizeable primary and operational fiscal surpluses; (ii) adoption of an aggressive disinflation program with a shift to forward indexation of wages and salaries; (iii) robust external financing plan including substantial support from IFIs; (iv) strong privatization, including major state banks and loss making state enterprises, energy and telecommunications; (v) coherent, comprehensive reforms of public expenditure, the tax system, social security, the financial sector, and agricultural support policies; and (vi) adoption of regulatory and other institutional frameworks to promote private investment and operation of infrastructure. The 1997 Country Assistance Strategy (CAS) for Turkey (Report No. 16992-TU) anticipated the possibility of such reforms, and the Bank's technical assistance has helped Turkey prepare its economic program. The Bank has also triggered the High Case scenario after almost one year of implementation of the above strong up front reforms with an adjustment loan of US$759.6 million (Economic Reform Loan) under the last CAS. The new CAS (FYO1-03), presented to the Board along with this loan, continues with a High Case program with up to US$2.4 billion of additional adjustment lending to help complete the reforms. As spelled out in the new CAS, the proposed US$777.78 million FSAL will address all the priorities for the first phase of the Government's multi-year financial sector reform effort. The new CAS also envisages that the FSAL will be followed by a State Bank Restructuring and Privatization Project and a second Financial Sector Adjustment Loan (FSAL II) to complete the second phase of the financial sector reform program. I. INTRODUCTION A. Macroeconomic Context 3. Successive governments have struggled to address Turkey's vulnerability to internal and external shocks stemming from unsustainable fiscal policies and structural weaknesses in its economy. Despite implementing a major adjustment program in the 1980s, Turkey's economic performance remained well below that of the fastest growing emerging markets. The economy continued to experience periods of rapid growth followed by sharp declines, and volatility actually increased during the 1 990s.  Inflation remained persistently high, driven by an oversized public sector and large off-budget losses in state-owned enterprises and banks resulting from extensive Government intervention in the economy notably in agriculture and the infrastructure sectors. While the domestic market for Government securities developed rapidly over the past decade, high inflation prevented financial deepening. The dependence on short term debt instruments exacerbated macroeconomic instability and pushed real interest rates to excessively high levels, thereby crowding out private investment and distorting resource allocation. The result has been a vicious circle of financial sector distortions and dependence on money creation and the inflation tax to finance public sector deficits. Underlying fiscal problems have been exacerbated by an underdevelcped tax system, weaknesses in public sector governance and postponement of structural fiscal measure-s such as reform of the public pension system. Structural problems and low productivity in key sectors including agriculture have contributed to unstable growth rates below Turkey's potential. Macroeconomic imbalances have left the country vulnerable to periodic crises, as in 1994 and again in 1$98, resulting in further Government intervention, such as the introduction of 100 percent deposit insurance, that restored short-term stability at the cost of increased Government liabilities and longer-termn sustainability. These problems came to a head in 1999 when the economy contracted by 6.4 percent under the weight of 70 percent inflation and 40 percent real interest rates. B. The Government's Economic Reform Program 4. Following the April 1999 parliamentary elections, the new Government launched a sweeping economic reform program designed to tarie inflation and restore the economy to a stable path of high growth. The program combines: (a) tighter fiscal policies, designed to put public finances on a sustainable path, with (b) a nominal exchange rate anchor designed to lower inflationary expectations, (c) tighter incomes policies centered on ihe adjustment of civil service salaries to targeted inflation, and (d) structural reforms aimed at restorinig growth and underpinning fiscal adjustment. The program emphasizes structural reforms in six critical areas: (i) structural fiscal reforms to support fiscal adjustment; (ii) policy and administrative/institutional reforms to ensure a fair and financially sustainable social security system; (iii) financial sector reform to eliminate distortions, protect the integrity of the financial sector and improve the efficiency of financial intermediation; (iv) rationalization of agriculture support policies and privatization of state-owned enterprises in agriculture to promote agricultural growth and rural income generation; (v) structural reforms to deregulate the energy and infrastructure sectors and promote private sector participation; and (vi) decisive steps to accelerate privatization efforts. The reform program encompasses structural measures to strengthen the social safety net, including the introduction of a direct income support program in agriculture, which will benefit small farmers and the establishment of national unemployment insurance. The program's macro-economic framework has been endorsed by the IMF through a multi- year, US$4 billion Standby arrangement aproved in December 1999. The second program review for the Standby was successfully completed in July 2000, and a combined third & fourth review is likely to be successfully completed in December 2000. The Bank and IMF have collaborated closely on the structural measures in the program, including those supported by the proposed FSAL, through intensive day-to-day cooperation between the two institutions, participation by Bank staff in the Standby program discussions, and joint IM F/Bank missions on financial sector reform issues. C. Bank Support for Economic Reform 5. The proposed FSAL is part of a broader package of Bank support for the Government's economic reform program under the high case. The US$759.6 million Economic Reform Loan (ERL) approved in May 2000 kicked off this support after the Government had convincingly demonstrated  - 3 - the ability to implement its reform commitments. In addition to Turkey's disinflation effort, the ERL supports implementation of structural reforms in five strategic areas: * Structural fiscal reforms and improvements in public expenditure management to underpin the fiscal adjustment and raise the quality of public spending; * Social security reforms geared to ensure medium-term financial sustainability and improve inter-generational equity of the pension system; * Agriculture reforms to promote growth and income generation in rural areas by: (i) introducing a unified national program of direct income support targeted to poorer farmers; (ii) phasing out price and credit subsidies for agriculture; and (iii) initiating privatization of state enterprises in agriculture; * Structural measures to modernize the legal and regulatory framework for private participation, privatization and competition in the energy and telecommunications sectors; and * Acceleration of Turkey's privatization program including the sale of companies in the Privatization Administration's portfolio, opening the capital of Turk Telecom to private participation together with the sale of additional GSM licenses, and a shift to economic privatization in the energy sector. 6. Further support for the Government's reform program is planned under the new CAS high case lending scenario. This support will accompany implementation of key reforrns under the ERL and FSAL, and build on the results of these operations. A privatization social support project (FY01) would focus on strengthening social protection mechanisms for groups affected by the reform program. An agricultural reform implementation project (FY01) will assist the Government in carrying out core aspects of the agriculture reform program supported by the ERL. The State Bank Restructuring and Privatization Project (SBRPP) (FY02) will support the restructuring and privatization of the state- owned banks. A second phase of adjustment lending is also envisaged consisting of a Public Sector Adjustment Loan (PSAL) which will build on the results of the ERL and support the initiation of broader institutional reforms to modernize the public administration; and a second FSAL to support completion of the financial sector reform agenda. II. TURKEY'S FINANCIAL SECTOR REFORM PROGRAM A. Financial Sector Profile--Predominance of the Banking Sector 7. The Turkish financial sector consists of a predominant banking sector of about 76 banks, complemented by 60 life and non-life insurance companies, 141 securities trading companies, 198 mutual funds, 70 leasing and 85 factoring companies, and a limited number of hitherto unfunded private pension funds run by the banks for their own staff. Most of the financial institutions are part of financial conglomerates, with the main group commercial bank at the center of such conglomerates, and other bank and non-bank financial institutions formed and managed as subsidiaries. Issues related to consolidated regulation and supervision, financial reporting and comprehensive risk management are increasingly gaining more relevance because of this group structure. However, even though the non-bank financial institutions (NBFI) sector has begun to grow in Turkey in terms of size and economic importance in recent years, and the regulatory oversight and sectoral development issues are increasing in importance, its relative size and economic impact compared to the banking sector is still rather small (for further details, see Annex II). The Turkish Government, therefore, considers that the  - 4 - banking sector reform should receive a hig,her priority at this time, and should be followed by reform of the NBFI sector in future. The proposed Bank strategy in support of Turkey's financial sector reform program reflects this sequencing priority. 8. So far as the banking sector is concerned, beginning in the early 1980s the initial emphasis has been on the development of a basic legal and regulatory infrastructure to facilitate ease of entry, and increase competition and growth. This triggered a rapid expansion of banking system assets in Turkey during the 1990s, and in spite of the 1994-95 banking crisis, total system assets in absolute terms more than doubled from US$52.0 billion in 19)4 to US$135.5 billion as of end 1999, and also increased substantially as a percentage of GNP from 39.24 in 1994 to an estimated 61.25 in 1999 (see Table 2 below). The introduction of 100 percent deposit insurance for household deposits in response to the 1994-95 crisis, coupled with the growth in demand for Government securities, has permitted the banks to generate a relatively high risk free real r eturn on a large part of their asset base during the last four- five years. During the period 1994-1999, the total deposit base grew from 24.79 to 40.99 percent of GNP. 9. However, the rapid growth in the size of the banking sector has also had some negative consequences. Prudential regulations and enforcement capacity have lagged behind considerably, and there has been a significant proliferation or connected and insider lending and excessive concentration of exposure and default risks. The explosive asset growth has allowed banks to hide the deteriorating quality of a major proportion of their crecit portfolios; while at the same time credit risks have been significantly understated due to previous lenient loan loss provisioning rules. Excesses in foreign currency exposures and in maturity transformation generating significant duration mismatches have also created enhanced foreign currency artd liquidity risks in addition to the credit risks. Continued macroeconomic instability (persistently hi;gh inflation, real interest rates, fiscal deficits and sovereign debt service burden), coupled with the liquidity squeeze, higher risk premiums, and intensified international competitiveness resulting from the East Asia and Russian crises, have further added to an overall riskier banking environment. In view of the ongoing stabilization program, which in itself poses major additional risks (e.g., rapid decline in interest rates), in the near future there is, therefore, an increasing need to enhance the safety and soundness of the banking system and to improve the quality of bank intermediation.  - 5 - Table 1: CONSOLIDATED BALANCE SHEET OF THE TURKISH BANKING SYSTEM, 1990-June 2000 (US$ millions) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 June _______ _______ ________ ________ ________ 2000 * Assets Liquid 18,762 20,586 24,732 29,893 20,396 25,249 30,347 31,683 38,074 47,882 49,620 Loans 26,877 25,413 26,925 29,849 20,315 29,072 35,906 43,037 45,019 40,206 47,017 Fixed 4,574 4,917 5,065 5,139 4,133 5,183 6,109 6,312 9,237 12,490 14,078 Other 7,016 6,981 7,695 7,245 7,082 8,894 10,975 13,612 25,069 32,955 29,993 Total 57,230 57,898 64,418 72,126 51,926 68,398 83,337 94,645 117,399 133,533 140,648 Liabilities Deposits 32,173 32,615 35,526 37,506 32,795 44,431 57,165 61,273 77,097 89,361 96,571 Non-deposit 11,017 10,570 13,635 18,796 8,911 9,664 11,851 15,724 18,218 22,934 24,227 funds Other 8,243 9,166 9,715 9,086 5,863 8,196 6,886 8,719 11,595 13,398 10,732 Liabilities Shareholders 4,455 4,151 3,890 4,791 3,218 4,187 5,028 6,120 6,786 9,359 9,006 Equity I I Retained 1,342 1,396 1,6521 1,947 1,139 1,919 2,406 2,809 3,703 (1,520) 112 Eaings Total 57,230 57,898 64,418 72,126 51,926 68,398 83,337 94,645 117,399 133,533 140,648 GNP (US$ 150,758 150,168 158,122 178,715 132,302 170,081 183,994 194,300 203,800 187,770 million) I Total Assets 37.96 38.56 40.74 40.47 39.24 40.21 45.29 48.71 57.60 71.12 (% of GNP) I Total 21.34 21.72 22.47 20.99 24.79 26.12 31.07 31.54 37.83 47.59 Deposits (% of GNP) . *Unaudited 10. To assist the Government in identifying sectoral vulnerabilities and consequent reform priorities, the Bank along with the Government undertook a banking sector review in November 1998. This review identified weaknesses in the legislative, regulatory and institutional infrastructure for the banking sector, as well as confirmed the seriousness of some of the aforementioned risks. The review also further emphasized the need for structural reform in the banking sector by undertaking the commercialization and privatization of the state-owned banks. More recent discussions between the Bank and the Government during preparation of the proposed FSAL have further confirmed that some of the banking system-wide structural weaknesses identified earlier by the Bank's November 1998 banking sector mission have become more serious, and if left unattended, carry the risk of resulting in a banking crisis in the near future. Such a crisis would be especially disruptive at this time, when the banking regulatory authority has just been transferred to a new agency, the economy has weakened, and a macro-stabilization program is being implemented. The Government has, therefore, reached an internal consensus on the need to urgently carry out an overall banking sector reform program with the specific purpose of reducing the crisis vulnerability of the banking system. Critical elements of such a banking sector reform program are elaborated below.  B. Strengthening Banking Sector Legal, Regulatory and Supervisory Infrastructure 11. Banking legislation. A new bankng law No. 4389 was passed by the Parliament on June 23, 1999 to replace the earlier decree law (provisions of which were struck down by the constitutional court as being unconstitutional). The new law was a significant improvement from the previous version in terms of supervision authority and prudential regulations. It called for the creation of a new Banking Regulation and Supervision Agency (BRSA), governed by a seven-member Board. The new BRSA, which very recently (in September 2000) became operational, has taken over the dual bank regulation and supervision responsibilities which were previously fulfilled by the Central Bank of Turkey and the Treasury. However, there were still critical remaining deficiencies in the June 1999 law related to: (i) formation of the Board, and the independence of the new BRSA; (ii) prudential regulations, especially concerning loan classification and provisioning, and large exposures/connected lending; and (iii) problem bank and bank failure resolution actions and authority under Article 14. The constraints caused bv these deficiencies are briefly explained in the sections below. The Government recognized these constraints and drafted a set of amendments to the banking law in consultation with the Bank and the IMF. The Parliament ratified these amendments by the Act No. 4491 on December 19. 1999. 12. Creation of and transition to the new BRSA. The new banking law required the Government to appoint the Chairman and Members of the new BRSA Board within three months of its effectiveness (i.e., by end September 199C'). The Government was unable to do so. This seriously undermined its credibility and commitment to the banking law and the underlying financial sector reform premises it encompasses, and created confusion in the sector. As per the Government, the delay was primarily caused by the provisions of Article 3-5 of the new banking law No. 4389, which stipulated that any newly appointed Member of the Board would, upon completion of his/her term, be prohibited from employment as a senior executive in the banking sector for a period of three years from the date of such completion. This discouraged professionally active, qualified, experienced and respected banking sector professionals from being nominated as Members of the BRSA Board, thereby seriously reducing the pool of eligible and suitable candidates for the Board. In view of the fact that procrastination on this issue and further delay in the appointment of the Board had the potential to be highly disruptive at the time when strong regulatory and supervisory capacity in the sector was critically needed, the Government included a change to this Article in the amendment to the Banking Law which envisaged that the new Board would be appointed latest by March 31, 2000 (and the BRSA Board was indeed appointed by that date). '[he banking law, as amended, also required that the BRSA be satisfactorily constituted with an appropriate organizational structure, operating rules and procedures, staffing, salaries and financial resources by August 31, 2000. This deadline also was successfully met with the new BRSA becoming operational on September 1, 2000. To ensure proper information exchange and policy coordination in the financial sector, the BRSA has signed a Memorandum of Understanding with the Central Bank of Turkey and other relevant agencies specifying the details of the day-to-day cooreration among them. 13. Independence of the new BRSA. One of the principal objectives of the new BRSA is to create a regulatory and supervisory body v%hich is independent, professionally objective, and has the authority under the law to function free from day-to-day political interference. Under the banking law prior to the December 1999 amendment the independent functioning of the BRSA was compromised by the fact that the authority for: (i) issuing and revoking banking licenses; (ii) resolution of problem banks; and (iii) issuing of critical loan loss provisioning regulations had been retained by the Council of Ministers. This carried the risk of the banking sector entry and exit, bank resolution and critical loan loss provisions issues and decisions to remain political rather than professional matters. The  Government acknowledged that the banking law needed to be amended to vest this authority with the BRSA rather than the Council of Ministers, and the amendment that was passed by Parliament in December 1999 incorporated such revisions. C. Upgrade Prudential Banking Regulations to Meet EU/Basle Standards 14. The previous regulatory regime for banks contained several serious flaws that almost certainly contributed to the emergence of a relatively large group of problem banks in the banking system. The most serious flaws concerned the excessively weak loan loss provisioning rule and the overly lenient large exposure and connected lending limits. Immediate and strong remedial action in these two areas are a precondition for the success of the overall banking sector reform program. Appropriate prudential requirements in line with international standards and international best practices will: (i) allow the magnitude of existing loan portfolio problems to be accurately revealed and addressed; (ii) facilitate problem bank/bank failure resolution efforts through more realistic valuations of loan assets; and (iii) introduce the necessary discipline in banks' lending policies going forward. Other related areas where additional regulatory action to upgrade and modernize the current rules, as well as proactive enforcement of these rules would be necessary in the near future are: (i) capital adequacy; (ii) foreign exchange exposure; (iii) risk management; and (iv) accounting standards applicable to banks for prudential reporting and financial disclosure purposes. 15. Loan loss provisioning. Under the June banking law, prior to its amendment in December 1999, the Council of Ministers, rather than the BRSA, approved the loan loss provisioning rule. In response to the global turmoil of the last two years (Asia/Russia crises), the Council of Ministers relaxed the loan loss provisioning rule twice, first in February 1998 and then in August 1999. However, even before these two rounds of relaxation, however, the Turkish loan loss provisioning rule was already much less stringent than international best practice standards. The practice of regulatory forbearance under political influence, while on the surface appears to provide short-term relief to bank debtors, is extremely damaging to banking sector health and thereby ultimately to the debtors' interests in the long term, by dramatically magnifying the risk of a banking crisis. Specifically, the loan loss provisioning rule before it was replaced by a new rule in late December 1999 suffered from the following flaws: * loan classification and provisioning requirements were exclusively perforrnance (debt service track record) driven and there were no borrower creditworthiness criteria; * there were only two classes of loans (performing and non-performing) rather than the more elaborate multiple class structures used internationally (e.g., standard-substandard-doubtful- loss or pass-watch-substandard-doubtful-loss); * the required specific provisions for non-performing loans could be built up by banks over a two year period rather than having to be constituted immediately once a loan became classified (non-performing under the previous rule); * specific loan loss provisions were only tax deductible for a portion of non-secured claims; * several types of security (collateral) which in practice are very difficult to realize quickly (e.g., commercial enterprise pledge) were allowed to be deducted from loan exposures for provisioning purposes; also, collateral for which market prices are not readily available could be deducted from loan exposures at book value without mandatory independent third party valuations; * off balance sheet exposures were exempted from specific provisioning requirements;  -8- * several loan exposures, such as subsidized agricultural credits, were exempted from specific provisioning requirements; * loans with overdues up to 60 days could be rescheduled and remain unclassified; and * selected non-performing loans could be rescheduled for up to five years and be immediately reclassified as performing loans inot subject to any specific provisioning requirement. Taken together, these provisions implied that loan quality was not adequately recorded and monitored, and that the values of banks' loan portfo ios were significantly overstated. The Government agreed that there was a need to: (i) immediately issue a much more stringent loan loss provisioning rule in line with international best practice standards; (ii) amend the banking law to delegate the authority for determining and issuing loan loss provisic ning rules (previously with the Council of Ministers) to the BRSA; and (iii) amend the tax regime to allow all specific provisions to be treated as tax deductible expenses. In order to implement these ref orms, the Government issued a new regulation on loan loss provisioning in December 1999 that addrzssed most of the above weaknesses, followed up with the issuance of all the necessary supporting documentation in March and June 2000 (revised report formats & disclosure requirements and a communique detailing borrower creditworthiness criteria); amended the banking law to vest the authority to de.ermine loan loss classification and provisioning policy with the BRSA: and plans to introduce tax dedactibility of all specific loan loss provisions required under the applicable Loan Loss Provisioning Rulz in a phased manner starting from year 2001. Furthermore, the December 1999 rule will be further upgraded to: (i) introduce a satisfactory specific provisioning requirement for watch loans (which as of yet remain unprovisioned). based on an up-to-date assessment by the BRSA of the credit risks associated with such loans: (ii) lift the exemption from specific provisioning requirements for all agricultural support loans, except for those loans for which the Government explicitlv (i.e., as documented by applicable Government decrees) has issued a guarantee and carries the credit risk; (ii) include a specific provisioning requirement for equity exposures; and (iv) introduce more prudent collateral classification. The implementation of the revised requirements of the loan loss provisioning iule will be completed by the end of December 2002. 16. Large exposure/connected lending limits. All lending limits for banks are embedded in the banking law, rather than in prudential regulations issued by the regulatory authority. The large exposure and connected lending limits, prior to the December 1999 amendment, were quite lenient as compared to EU standards and Basle re,ommendations, and with the proliferation in Turkey of powerful industrial groups owning one or multiple banks and non-bank financial institutions, the potential of abuse and excessive exposure -isks were quite high. Specifically, the lending limits were flawed in the following areas: * the limits did not apply on a consolidated basis to banks and their financial subsidiaries, allowing banks to circumvent the limits applicable to themselves by channeling funding through their foreign bank subsidiaries and domestic non-bank subsidiaries; * the limits did not contain proper dzfinitions of "exposure" (lending and equity ownership and off balance sheet exposures combined) and "connected clients" (e.g., in line with EU Directives); * several distinct exposure limits for a group of connected clients, in combination, allowed banks to run up connected exposutes of more than three times their capital; * exposures to domestic banks were excluded altogether from the limits (i.e., without regard to the maximum one year maturity limit specified in the EU Directive, and without specification of the treatment of exposures of/to parent banks and subsidiaries and multiple banks owned by the same industrial group);  - 9 - * increases in exposures beyond the specified limits which are the result of bank refinancing of overdue loans, accrued unpaid interest and currency depreciation were exempted; * the law did not prescribe regulatory reporting and monitoring requirements for the banks to adhere to. The Government agreed to address all of these deficiencies through amendments to the banking law that introduced revised exposure limits fully consistent with applicable EU directives (e.g. maximum exposure-lending and equity ownership and off balance sheet exposures-to a single client or group of connected clients-of 25 percent of a bank's capital, on a consolidated basis). The amendment envisages that banks will have a maximum period of six years to come into full compliance with the new lower limits. To operationalize the new banking law provisions, the new BRSA will shortly issue the regulation called for in the amended Banking Law which clarifies the new limits and defines key underlying concepts such as 'exposures' and 'group of connected clients.' The BRSA will also initiate close monitoring of the banking system's compliance with the 75 percent maximum exposure limit applicable as of January 1, 2001 as specified in the amended Banking Law, and will initiate corrective actions in cases of non-compliance. 17. Accounting and disclosure standards. The main areas where Turkish accounting standards applicable to banks until recently were, or still are, out of line with International Accounting Standards (IAS) are: (i) adjustments for hyperinflation (IAS 29); (ii) securities valuation (no clear delineation of trading and investment portfolios and freedom to choose from among four interest rate accrual calculation methods, allowing banks to use their securities portfolios to manipulate income); (iii) disclosure requirements (IAS 30 - "Disclosures in the Financial Statements of Banks and Similar Financial Institutions" and IAS 32 - "Financial Instruments: Disclosure and Presentation"); and (iv) pension provisions, leading to a significant understatement of pension cost and the pension liability of banks which operate employee pension schemes. The bank regulatory authority has the power to amend the accounting rules for prudential reporting and disclosure purposes specifically applicable to banks through the issuance of regulations. Tax considerations should be set aside, and if need be, separate accounting standards for prudential reporting and tax reporting should be introduced. The Government has agreed that revised accounting standards remedying the aforementioned deficiencies should be introduced, and has already taken action steps in this respect concerning items (ii) and (iii) above. However, in view of the ongoing macro stabilization and disinflation program, introduction of IAS 29, Hyperinflation Adjustment, would send contradictory expectational signals to the markets. The relative benefits to be derived from the introduction of IAS 29 at this stage would be minor compared to the potential damage, and the standard therefore is not going to be introduced at this stage. Further steps to conclude the reform effort in this area are planned to be taken during 2001. 18. Capital adequacy. The Turkish capital adequacy rule during the last few years has substantively been in line with BIS standards except for the following: (i) there was no capital adequacy requirement applicable on a consolidated basis (e.g., for banks and their financial subsidiaries combined), thus the bank regulatory authority was not in a position to assess the capital adequacy of financial groups, and how any weaknesses in group capital might affect parent banks; and (ii) there are currently no capital charges for market risks (securities price fluctuation risk, foreign exchange risk, and interest rate risk). The authorities have been working on new regulations that will remedy these deficiencies as well as associated regulations that will upgrade existing consolidated regulatory reporting requirements, but due to the BRSA Board not being appointed until end March 2000 and the BRSA itself not becoming operational until September 1, 2000 the issuance of these new regulations has been delayed. In late December 1999 the Government issued a first revision to the  - 10- capital adequacy rule requiring its application on a consolidated basis. Additionally, in July 2000 the previous six monthly consolidated reporting requirement was upgraded to a quarterly reporting requirement. However, in view of the sophistication required on the part of the banks to comply with new rules for calculating market risk charges, the BRSA intends to introduce such charges during 2001. During 2001 the consolidated financial reporting requirement will also be further amended to extend coverage of the consolidated reporl ing requirement to horizontal conglomerates. 19. Foreign exchange exposures. D)uringl998-99, the maximum open currency position was reduced in a stepwise fashion from 50 percent of regulatory capital in June 1998 to 20 percent in September 1999. While this was an encouraging step forward, the foreign exchange exposure rule still remained characterized by several weaknesses: * before the issuance of an amendment to the rule in late December 1999, the rule was not applied on a consolidated basis (e.g., for banks and their foreign bank subsidiaries and domestic non-bank subsidiaries combined), allowing banks and their subsidiaries to incur aggregate exposures far beyond prudential limits; * there is no capital charge for foreign exchange exposures; * the net aggregate open FX posit:on is calculated as the absolute value of all short positions less all long positions, rather thar, using either of the more conservative measures of the gross aggregate position (the sum of all net short and net long positions) or the short hand position (the greater of the sum of the short positions and the sum of the long positions); and * the capital base which forms the denominator of the foreign exchange exposure ratio was, before the issuance of the revised loan loss provisioning rule in late December 1999, overstated due to the weaknesses in the existing loan loss provisioning rule, thereby understating the true foreign exchange risk incurred by banks. The Government introduced a revised regulation by end December 1999 addressing the first weakness. The new loan loss provisioning rule issued in late December 1999 has addressed the fourth issue. Finally, the authorities intend to introduce market risk charges for foreign exchange exposures in the context of the planned revision of the capital rule during 2001 to introduce generic market risk charges. The BRSA will also announce its intent to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary (i.e., for banks with foreign branches/subsidiaries), to verify compliance with consolidated FX open position limits between reporting dates. 20. Risk management. The absence of a requirement for banks to have credit risk monitoring systems has contributed to weaknesses in the loan portfolios of all but the most sophisticated banks that have introduced such systems at thexr own initiative. Also, in Turkey's volatile interest rate environment, the absence of consolidated interest rate, foreign exchange and market risk monitoring and measurement systems has made banks very vulnerable to unexpected interest rate movements, and can inflict large, unexpected losses. There is, therefore, a need for the banking system to build comprehensive risk management systems and market risk charge measurement models. The new banking law includes a requirement for all banks to have proper risk management systems. While this is a major step forward, this requirement will not have any effect until the BRSA issues a regulation outlining the specifics. However, even though the introduction of market risk charges for capital adequacy are urgently required, it would b - necessary to first educate the banking sector on the need and specific attributes of the comprehensive risk management approach, and to develop a consensus on the types of models to be adopted for measurement of such risks (the pre-commitment model, the standard model or the internal model approach, or a combination of these models as applicable in  individual banks), prior to issuing such regulations. The BRSA, therefore, plans to issue a regulation on risk management standards during the year 2001. D. Strengthening Problem Bank Resolution and Failure Resolution Capacity 21. The Government has recently been faced with an urgent problem of a pipeline of problem/failed banks, representing a significant portion of the banking system's total assets. The cost of full rehabilitation of the ten banks currently under the authority of the Savings Deposit Insurance Fund (SDIF) has been estimated by the Government at around US$8.0 billion. Because of such a significant number and scale of banking assets involved, the past and current banking supervision practice in Turkey, as well as the strategies and tools available for resolution of problem banks under the banking law, have come under a sharp focus. The overall conclusion is that the classification as well as actions related to problem banks have been used somewhat broadly in Turkey, and because the Treasury until September 2000 when the BRSA became operational had the overall jurisdiction over both the bank supervision function in the Treasury, and the functions of the SDIF, there was blurring of the roles and sequencing of actions between the Banking Supervision Department and the SDIF. As a result of the December 1999 banking law amendment, there now is a clearer separation of roles between the BRSA and the SDIF even while they both are now under the jurisdiction of the BRSA Board. The BRSA will deal with "problem banks," i.e., those banks whose capital adequacy has fallen below the minimum standards and need supervision intervention, but are not yet insolvent or "failed banks." The SDIF will, under the guidance of the BRSA Board, act as the authority to deal with the resolution of insolvent banks or "failed banks" only. Details of what such demarcation of roles and responsibilities mean in the Turkish context are provided below. 22. Problem bank supervision actions. The BRSA will develop and implement a special supervisory regime for problem banks. This regime will include intensified supervisory efforts to bring about the corrective actions necessary to rectify problem banks before they deteriorate into insolvency. These actions will include: - timely and formal identification of the banks as problem banks; D more frequent examinations and visits to follow-up on identified weaknesses; * regular meetings with the banks' boards of directors; * frequent reporting from the banks to the bank supervisors regarding the status of identified weaknesses and corrective actions; * the use of memorandums of understanding and "cease and desist" orders to establish the legal and financial responsibilities of the board of directors, managers, and principal owners for taking or bringing about corrective actions for unsafe and unsound banking practices; and * the use of other enforcement measures to establish discipline and incentives for appropriate corrective action, e.g. prohibitions on dividends, denials of new branches and other corporate actions, restrictions on lending to classified borrowers, removals of incompetent or abusive directors, managers and owners, etc. In many countries, supervisors have adopted the concept of "prompt corrective actions" which impose mandatory corrective actions on bank management as capital declines below certain predetermined thresholds, culminating in a declaration of insolvency when capital reaches a level anywhere between 1-3 percent. Regulatory forbearance should not be allowed as it usually weakens discipline and the incentives to take corrective action. The Government has agreed that the principles and actions behind the use of "prompt corrective actions" triggers by the BRSA should be fornalized through the issuance  - 12 - of an internal procedure manual for use by BRSA staff. In addition. Article 14 in the banking law has been amended to include clearly defined insolvency triggers due to inadequate capital, or excessive illiauidity. To administer a special supervisory regime for the handling and treatment of problem banks, the BRSA will establish a special anit that will deal with problem institutions. The members of this unit should consist of some of the best and toughest examiners and should also include lawyers and other appropriate supporting personnel. The idea is to focus the best supervisory resources on the remediation of problem, but still solvent tbanks, before they deteriorate into insolvency. By the time a bank is insolvent, corrective actions, incliding recapitalization by the bank's owners, should already have been exhausted. To ensure satisfactc ry implementation of the new special supervisory regime for problem banks, the BRSA will adopt a pie-failure prompt corrective action manual for use by BRSA staff, which predefines mandatory pre-failure intervention triggers. 23. Failure resolution and the role of the SDIF. Before the latest banking law amendment, the role of the SDIF under the law was ins itutionally very complex and very broadly defined as the primary liquidity provider to illiquid banks, capital provider to insolvent banks, and generally to act as the banking rehabilitation agency. This led to the undesirable outcome of an ease of entry situation, whereby it was rather easy for a conmnerc ial bank to enter the SDIF with all the incentives supporting such an entry, but where no clear and quiek exit strategy for the banks to be removed from the SDIF existed. Thus the banks tended to continue to stay in the SDIF until such time a buyer could be found. The Government agreed that the role of the SDIF should be restricted to dealing with only "failed banks." that is banks that are insolvent. aad that Article 14 of the banking law should be revised to clarify this role of the SDIF. as well as define insolvency of a bank. The SDIF should cease to have the role of liquidity provider to illiquid but still solvent banks. This role of the lender of last resort should appropriately be the role of the Cenwlral Bank. Banks that remain illiquid in spite of the liquidity support provided by the Central Bank shouild be declared insolvent and transferred for resolution as a "failed bank" to the SDIF. The new Decernber 1999 banking law amendment numbered 4491, Article 16 incorporated these principles in the law. According to this law the Central Bank can extend credits to the banks which fall under Article 14 of the banking law No. 4389, and to the banks faced with sudden liquidity needs as a result of large scale deposit withdrawals caused by a lack of confidence in the banking system. The amount of such unds and the terms and conditions would be determined at the discretion of the Central bank. 24. The SDIF should undertake the resol ition of banks under the principle of "least cost resolution", that is at least cost to the SDIF in order to ensure the protection of the insured depositors as envisaged under the banking law. Under Article 14 of the banking law (after its amendment), the losses suffered will be applied immediately to the shareholders' capital and the shareholders' rights will be revoked in all cases. The available failure resolution techniques include: * Deposit Transfer. When good zssets are sufficient to cover insured depositors. Insured deposits and good assets are simply transferred to another bank, and the remaining shell is liquidated by the SDIF. * Purchase and Assumption. When good assets are not sufficient to cover insured depositors or protected liabilities. Bonds and/or cash are used to carve out bad assets to balance good assets and protected liabilities. The good assets (along with bonds and/or cash) are purchased by another bank that also assumes the liabilities. Ideally, the "purchase and assumption" transactions would occur over a weekend or a very short span of time. However, if a buyer cannot be found, the good assets and protected liabilities are moved into a newly licensed bank (a "bridge" bank) until a b'dyer can be found. Importantly, the split of assets (i.e.,  - 13 - "good" and "bad" banks) will occur immediately whether or not a buyer is found. The actions are taken secretly in order to avoid further depletion/depreciation of assets by shareholders/borrowers. The remaining shell of the original bank with the bad assets and remaining liabilities is liquidated by the SDIF. * Depositor Payoff. There are so few good assets that the simplest and quickest means of resolving the failure is for the SDIF to pay insured depositors and liquidate the failed bank's assets. 25. Resolution of the present pipeline of problem banks. In view of the large funding requirement associated with the resolution of the current pipeline of problem banks, and the availability of limited funding of approximately US$0.7 billion in the SDIF, the Government has asked the World Bank to provide assistance to deal with this problem. It is generally agreed by the Government that the issue of a sizeable pipeline of problem banks and resulting high estimated resolution costs have been primarily caused by the inadequate legal and regulatory provisions, and weaknesses in the supervision and failure resolution principles and entities. The problems were exacerbated by a lack of explicit wiping out of shareholder rights due to insolvency (until the December 1999 banking law amendment only permitted under shareholder misuse situations), and an implicit protection of all uninsured depositors and other creditors in the past as a result of previous bank rehabilitation efforts undertaken by the SDIF. It is, therefore, imperative that the above reform package of proposed objectives, principles, and legal and institutional infrastructure for problem bank and bank failure resolution be implemented as soon as possible, in order to avoid a potential wide-scale deterioration of the banking sector capital and solvency leading to a systemic banking crisis. In order to address the above reform objective of strengthening the overall problem bank resolution capacity, the Government, with the help of the Bank and the IMF, has prepared amendments to Article 14 of the new banking law that now have become law, and has initiated implementation of a comprehensive action plan to resolve the complete universe of problem banks. As a first step, immediately after the banking law amendment was approved by the Parliament in December 1999, the authorities intervened in five deeply insolvent banks and transferred these banks to the SDIF for resolution using the SDIF's enhanced resolution mandate under the amended banking law, and revoked the license of a sixth bank to be liquidated. The supervisory authorities at the same time also initiated corrective action programs for the remaining known problem banks, using the enhanced supervisory authority provided by the banking law amendment. Immediately after their takeover, the SDIF during January-March 2000 initiated a detailed portfolio audit of the eight banks to determine more accurately the extent of non- performing assets, and the capital gap in these banks. In addition to the technical assistance provided by the Bank and IMF teams, the SDIF also hired a consulting firm in June 2000 to formulate a resolution implementation strategy and develop detailed closure/sale/merger options for these banks. 26. Shortly after the BRSA became operational on September 1, 2000 as part of its resolution plan for the banks under the SDIF, the BRSA created a new Asset Management Unit (AMU) within the SDIF. The non-performing assets on the books of the intervened banks have been transferred to this AMU for asset recovery purposes. These non-performing assets in the intervened banks will be replaced with Government securities. The Government has so far given a loan in an amount of US$6.1 billion to the SDIF on a ten-year term with a two-year grace period for the purpose of recapitalization of the intervened banks. In addition to the eight banks already under the SDIF, the BRSA has during September 2000 revoked the license of the branch of a foreign bank in Turkey and during October 2000 intervened in two more banks bringing the total number of banks under the SDIF to ten. With the institutional and funding structure in place, the BRSA is now proceeding rapidly towards implementing a comprehensive action plan for resolution of the banks currently in the SDIF. In this  - 14 - regard, "fit and proper" criteria for potential bidders interested in acquiring any of the SDIF banks were already issued in the first week of November 2000. The pre-qualification of potential bidders for the first set of eight SDIF banks should be completed by the end of December 2000, and expression of interest in specific banks or groups of SDIF banks would be sought by the middle of January 2001. By the middle of January all pre-qualified bidders will be given basic information on the available banks, and the potential bidders must confirm iheir interest in specific banks or groups of banks by the beginning of February 2001. After a few wveeks given to the buyers for carrying out due diligence, the finals bids will be required to be submitted by the end of April 2001, and the selection of the final buyers completed before the end of May 21001. The remaining two SDIF banks intervened in October 2000 will follow the same process as above with a lag of about two months. The above action plan expected to be completed by the end of the third quarter of 2001 E. State-Owned Banks' Commercialization and Privatization 27. Any financial sector reform prograrm in Turkey is unlikely to succeed without an accompanying reform of the banking sector structure. This implies that specific reform actions are necessary regarding the governance and ownership restructuring of the state-owned banks (representing approximately 40 percent of banking systern assets and deposits). Continued Government governance and ownership of the three fully state-owned commercial banks, Ziraat, Halk and Emlak, and the state- controlled commercial bank Vakif have contributed to the build-up of enormous losses in the banking system in recent years as a by-product :f subsidized, directed lending for agriculture and small business development. These losses have been hidden under the umbrella of illiquid Government "duty losses" (paper claims on the Goverunent carried on the banks' books) for the last five years. The distortions in the money markets and in the administration of monetary policy which are caused by the enormous liquidity shortfalls experienced by these state-owned banks from time to time, (especially Ziraat and Halk), can no longer be ignored for the sake of the safety and soundness of the banking system and the quality of bank intermediation. The total assets and deposit base of these four banks is as given in Table 2 below: Table 2: Assets and Deposits of State-owned Banks as of end June 2000 Total As:sets Percent of Deposits Percent of US$ million Total US$ million Total Ziraat Bank 22,359 15.9 17,931 18.6 Halk Bank 13,414 9.5 10,731 11.1 Emlak Bank 5,711 4.1 3,039 4.2 Vakif Bank 6,565 4.7 4,698 4.9 Turk Exim Bank 3,457 2.5 - - Iller Bank 1,085 0.8 Kalkinra Bank 397 0.2 - 52,988 37.7 37,399 38.8 28. The total duty losses in the books of Ziraat and Halk for the years 1995 to the end of 1999 are presented in the table below. The losses have increased from US$2.8 billion at the end of 1995 to nearly US$19.2 billion at the end of 199'). It is, therefore, vital for the Government to develop restructuring strategies to: (i) gradually reduce the stock of duty losses over a number of years or  - 15 - freeze the amount through the issuance of interest paying Government bonds; (ii) budgetize the payment of annual interest on the accumulated duty losses (or on the bonds issued) with effect from the budget year 2001 to avoid the further compounding of such losses; and (iii) budgetize the flow of any additional duty losses every year to avoid further accumulation of the principal amount of duty losses. The phase out of credit subsidies to reduce the associated fiscal cost, which was initiated during 1999, was implemented ahead of schedule as a result of a sharper than expected decline in interest rates in late 1999 early 2000, and has sharply slowed down the further build-up of new flow losses. Table 3: Duty Losses of State-Owned Banks 1995 1996 1997 1998 1999 2000 1/ TL Billion Ziraat 92,678 409,550 945,562 2,395,610 6,123,841 6,518,990 Halk 76,484 221,844 570,471 1,586,645 4,232,839 4,768,000 Total 169,162 631,394 1,516,033 3,982,255 10,356,680 11,286,990 US$ million Ziraat 1,519 3,792 4,618 7,660 11,338 10,532 Halk 1,254 2,054 2,786 5,074 7,837 7,703 Total 2,773 5,846 7,404 12,734 19,176 18,235 As percent of GNP 2.15 4.22 5.16 7.51 9.82 8.48 I/Estimate 29. The Govenment has agreed that the restructuring of the duty loss arrears and addressing the future flows of such losses are vital, and as a first step towards resolving them, has included all the anticipated duty loss flows for the year 2000 in the annual 2000 budget. Furthermore, the Government, as part of the reform actions agreed in the IMF Standby Arrangement Letter of Intent, will bring down the cost of new credit subsidies from 1.2 percent of GNP in 1999 to 0.6 percent of GNP in 2000 and will eliminate them in 2001. This reduction is currently taking place through a new mechanism for Ziraat and Halk to determine credit subsidy rates, which temporarily freezes and subsequently links subsidy rates to 1.05 times the average 12-months Treasury bill (auction) rate (or the closest maturity during the preceding three months), which has already declined sharply as a result of the Government's stabilization policies. The Government has agreed to develop a time bound action plan to resolve the stock of duty losses on the books of both Ziraat and Halk, and to issue Government bonds and provide for interest payments in cash on these bonds in line with the agreed action plan. 30. Secondly, the Government supports a policy of commercialization and eventual privatization of all state-owned commercial banks including Ziraat and Halk. Discussions with the Government have clarified that there are no major technical obstacles to the privatization of Vakif, Emlak and Halk. The Government has confirmed its intention to undertake the complete privatization of Vakif fairly soon, and legislation allowing divestiture of the Government's 75 percent ownership stake in the bank has already been enacted. Additionally, investment advisers have already been hired to sell an initial 20  - 16- percent ownership stake in the bank. It is the Government 's expectation that the privatization of Vakif can be completed during 2001, through the granting of a mandate for the complete sale of the bank to an investment bank or similar privatization intermediary. The Government has further confirned that it has begun the commercialization and financial restructuring of Emlak by removing the stock of housing from its books during late 1999 aird early 2000. The Government also has ensured enactment of legislation that: (i) allows Halk and Emlak to be completelv privatized; (ii) selectively removes the application of state economic enterprise egislation (Decree Law No. 233 and related laws) to both banks in preparation for their privatization: and (iii) allows the Government to undertake any restructuring actions necessary to prepare these two large banks for privatization. Such actions may include hiring of professional firms to p epare privatization plans (including the development of a comprehensive strategic plan and detailec. corporate action plans for Halk) that can subsequently be implemented. It is anticipated that all the -re-privatization planning, preparation and restructuring will be completed, and the privatization proce,s initiated for both Emlak and Halk, during 2001, through the granting of a mandate to an investment bank or similar privatization intermediary. In view of the fairly large size of the banks involved the privatization is expected to be completed, depending upon the implementation timetable, by December 2003 at the latest. 31. So far as Ziraat is concerned, the bank presently combines three separate activities into one entity: (i) agricultural finance, (ii) general commercial banking; and (iii) payment and collection services for the Government. Any rapid privatization (within the next three years, for example) of Ziraat without careful consideration of structural and economic implications and feasible alternative solutions to the above functions will in the Government's opinion be very disruptive. The preferred approach of the Government is to restructure Ziraat in stages, beginning with: (i) enactment of legislation that will allow Ziraat to be Irivatized, will remove the application of state economic enterprise legislation (Decree Law No. 23 3 and related laws) to the bank, and will allow Ziraat to be transformed into a joint stock company to create operational and governance autonomy for Ziraat: (ii) contracting for a first time IAS audit of Ziraat as of year end 1999; (iii) initiation of the commercialization of Ziraat's operations including organizational and financial restructuring. divestiture, and finding alterative solutions for the present public policy functions of the bank; and (iv) completing the implementation of such restructuring plans. Actions to implement the steps outlined in (i) and (ii) above have already bzen completed. It is expected that finalization of the full set of measures will take a period of about thre. years up to December 2003. F. Reform of Deposit Insurance 32. Turkey has had an explicit deposit insurance scheme since the mid 1980s. The scheme in its current form is administered by the Savings Deposit Insurance Fund (SDIF) and, prior to the December 1999 banking law amendment which introduced the option for the Government to finance any funding shortfalls, was exclusively funded with deposit insurance premiums paid by the banking system. Participation is mandatory for all banks. There is no separate deposit insurance law as the legal framework for the scheme is embedded in existing central and commercial bank legislation. During the 1994-95 banking crisis, in an attempt to stem deposit withdrawals and restore depositor confidence, the Turkish authorities introduced 100 per ent deposit insurance coverage for household depositors (previously coverage was limited to a fixed TL amount). It was the authorities' intention to retain the full coverage only for a limited period of time, and to reform the deposit insurance scheme as soon as the banking crisis was over to bring it into compliance with applicable EU Directives. However, as a result of high Government turnover and in attention to the matter, the 100 percent coverage was not lifted until June 1, 2000 (see below), and its continued presence has over time led to imprudent  - 17- banking practices and competitive distortions as a result of the moral hazards involved, and has encouraged weaker banks to expand their deposit base by offering above market interest rates. 33. The authorities have been very much aware of the need to reduce the coverage to eliminate these distortions, but believed they could not afford to do so while a major intervention in a sizeable number of problem banks was ongoing. Revoking the 100 percent coverage in the midst of a major intervention action would most likely have resulted in a serious erosion of depositor confidence, and possibly system-wide bank runs. Therefore, the Government decided to undertake this particular reform action with effectiveness as of June 1, 2000 once the take-over of most of the problem banks by the SDIF was completed, macro-economic stabilization had taken hold, and the banking system had started to adjust to the new economic, legal and regulatory structure that was put in place during previous months. The 100 percent coverage is being lifted in stages: as of June 1, 2000 coverage has been reduced to TL 100 billion (approximately US$150,000), and it is the Government's intention to further reduce coverage to TL 50 billion as of January 1, 2001. The overall aim of reform efforts in this area remains to bring the Turkish deposit insurance scheme in line with the applicable EU Directive on deposit guarantee schemes. G. Consolidated Supervision of Banks and Non Bank Financial Institutions 34. As described in paragraph 7, the Turkish financial sector consists of financial-industrial conglomerates with commercial banks in the center of such groups, surrounded by a number of financial subsidiaries in the areas of insurance, leasing and factoring, capital markets, and mutual funds. Many of these financial subsidiaries as well as the parent bank have both loan and equity exposures to the same groups of clients. At the same time, the prudential lending limits that normally apply to a commercial bank's exposure to its clients do not apply to its exposure to its financial subsidiaries. It is, therefore, critical that prudential rules, including capital adequacy, large/connected exposure limits, overall exposure to market and non-market risks across the range of products and services, financial accounting, information disclosure, reporting and monitoring requirements are applied and supervised on a consolidated basis for such financial conglomerates. The Government has recognized the need for such consolidated regulation and supervision, and has already introduced consolidated reporting and regulations for the banks along with their subsidiaries in selected areas (e.g., capital adequacy. large exposure and foreign exchange open position limits) as part of the December 1999 banking law amendment and subsequently issued addenda to the capital rule and the foreign exchange exposure rule. 35. However, the overall process of consolidated regulation and supervision is quite complex because of the current existence in Turkey of a number of different regulatory and supervisory bodies; e.g., the banks are now regulated by the new BRSA; the insurance sector is regulated by the Insurance Supervisory Office of the Treasury; leasing and factoring activities are supervised by the Non Bank Financial Institutions (NBFI) department of the Treasury, investment and brokerage companies, mutual funds and investment trusts are regulated by the Capital Markets Board; and new private pension funds are to be regulated by the Ministry of Employment and Social Security, the Capital Markets Board and the Insurance Supervisory Office of the Treasury jointly. This dispersion of regulatory and supervisory responsibility across multiple Government agencies carries the risk of creating insufficient, overlapping or even conflicting regulations and operating standards, thereby reducing regulatory efficiency and imposing an unnecessary burden on the financial institutions concerned. There is, therefore, a need to consider during the coming 2-3 years the feasibility of gradually bringing some of the regulatory entities under the single umbrella of the new BRSA, in order to create an integrated regulatory and supervisory approach to financial sector activity. The  - 18 - Government recognizes the value in considering this approach, but along with the Bank team agrees that a further analysis of the NBFI sector and its development constraints needs to be carried out before conclusions and action plans can be formulated. It is therefore planned that a NBFI sector review will be carried out in early/mid 2001, and the Government intends to incorporate applicable recommendations and conclusions from this review in the latter part of its multi-year financial sector reform program.  - 19 - III. THE PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN A. The Bank's Financial Sector Assistance Strategy 36. Background. Turkey and the Bank have had a long relationship in the financial sector since the early 1980s through a series of SALs (I-V) during the 1980-85 period and two FSALs during the late 1980s. A number of policy and institutional reforms were undertaken during this period. The focus of both the FSALs was on financial policies, financial institutions and regulations, and money and capital markets. The FSAL programs were, however, only partially completed, as Turkey's political and economic arena remained caught up in ad hoc short term choices during most of the 1 990s, making it difficult to engage in long term policy and institutional development decisions. Thus, actions on better banking regulations and supervision and on bank privatization still remained on the agenda in the late 1990s. 37. Assistance strategy. After some years of lower intensity interaction during the early and mid 1990s, the level, nature and quality of the dialogue on the financial sector policy and institutional issues between the Bank and the Government has recently substantially increased, and has been quite high during the last 24 months. The evolving situation in the Far East, followed by the August 1998 crisis in Russia, necessitated a further review and analysis of the policy and regulatory framework and a vulnerability assessment of the banking sector. Such a review was undertaken by a Bank mission in November 1998, and based on the assessment of this mission, a financial sector reform agenda and the Bank's financial sector assistance strategy for Turkey was developed. This assistance strategy was further reviewed and updated during 1999 and early 2000 as part of ongoing Comprnsive Non-b a risk management financial 4 Banking > ~~~~audits - 4 other institutions sector reviw bak review Comprehensive Workshop - risk management comprehensive audit - / V rsmagement Figure I - Financial Sector Strategy. sector dialogue and the new Country Assistance Strategy. The strategy consists of carrying out: (i) a banking sector review to determine the vulnerabilities and policy and institutional reforms required in the sector; (ii) a top down financial sector policy-based first FSAL to address the most pressing banking sector reform priorities: (iii! a bottom up financial intermediarv operation Export Finance Intermediation Loan (EFIL). approved by the Board in July 1999, to build up dialogue and consensus for reform directly with a core group of healthy commercial banks: (iv) a comprehensive risk management workshop and Pilot Risk Management Audits of selected banks to enhance awareness in the sector of the latest developments and tools and techniques in the area of bank risk management; (v)  - 20 - a Non Bank Financial Institutions (NBFI) Review to determine the risks and vulnerabilities, as well as development priorities of the NBFI sector: (vi) a State Bank Restructuring and Privatization Project to suport the restructuring and privatization of the state-owned banks: and (vii) a follow-up second Financial Sector Adjustment Loan (FSAL II) to address the remaining reform agenda in the banking sector and urgent reform priorities for the NBFI sector. Elements of the Bank's strategy of lending and nonilending assistance as a context for the proposed FSAL is presented in Figure I and described below: Banking Sector Review (November 1998). The November 1998 Banking Sector Review carried out a review of the legislative, regulatory and banking supervision infrastructure, problem bank and bank failure resolution issues, the regulations related to management of interest rate, foreign exchange, liquidity, credit, market and operational risks in the banking sector, and the restructuring requirements of the state-owned banking sector. The policy and sectoral reform recommendations of the Bank were well received by the Treasury and the Central Bank, and succeeded in laying a consensus foundation for the Govern nent's reform effort in the sector. The sectoral review also helped in preparing a draft FSAL policy matrix, which has formed the basis of the subsequent discussions currently being undertakeni during FSAL preparation. Export Finance Intermediation Loan (EFIL - July 1999). The EFIL was undertaken in response to the liquidity squeeze in the export sector post Russia crisis. The EFIL structure enables a strategic dialogue and close interaction with the major private commercial banks and the Bankers Association in Turkey, through setting up of stricter and upgraded prudential eligibility criteria and banking standards for capital adequacy, foreign exchange exposure, large/connected exposures and risk management systems. Besides the prudential criteria, a comprehensive review of the existing risk management systems and pract ces at a pilot group of five banks, intended to enhance awareness and the application of best practice standards and techniques in the management of banking risks, is being carried out for ihe participating banks under EFIL. The EFIL will therefore, through a bottom up sectoral consensus building approach, complement the top down policy dialogue to be undertaken in the context of the proposed FSAL I. Comprehensive Banking Risk Management Workshop (February 2000). This workshop was held in Istanbul under the joint sponscrship of the Bank and the Basle Financial Stability Institute, and locally hosted by the Bankers Association to discuss the latest issues related to comprehensive and dynamic risk management in the banking sector, and the regulatory approaches towards risk management in different countries. The workshop has raised the awareness of the banking eommunity to the critical need for a comprehensive and dynamic approach to risk management in their institutions, and will facilitate the drafting of a new regulation on risk management best practices and market risk charge calculations for capital adequacy purposes. FSAL (Board - December 2000). Tlhe FSAL focuses on strengthening the legislative, regulatory and supervision infrastructure for banks, updating bank prudential regulations to EU/Basle standards, strengthening problem bark and bank failure resolution capacity, and initiating the restructuring/ privatization of state-owned banks (details are given below). NBFI (Non Bank Financial Institutions) Review -- Fiscal 2001). A formal Non Bank Financial Institutions Review will be undertaken during fiscal year 2001, to analyze the existing development issues and future priorities related to: (a) financial markets--Governnent securities, money markets, bond markets, equities, commodities antd derivatives; and (ii) non bank financial intermediaries like secirities firns, investment comparnies, contractual savings institutions such as insurance conmpanies, mutual funds and pensic n funds, and the near-banks like leasing, factoring and ,cons-arer finance companies.  - 21 - * SBRPP (State Bank Restructuring and Privatization Project - Fiscal 2002). To support the restructuring and privatization of the state-owned banks Emlak, Halk and Ziraat, the SBRPP is planned to be undertaken during fiscal year 2002. The project will be designed to provide financing and/or technical assistance for this effort, in an amount of US$500 million. * FSAL 1I (Financial Sector Adjustment Loan II - Fiscal 2003). The FSAL II is planned to build up on the first FSAL and address the remaining reform agenda in the financial sector, especially issues related to: (i) the privatization of Ziraat and some of the other state-owned development banks, (ii) further reform of the deposit insurance scheme; (iii) regulatory issues related to capital markets, insurance and other non-bank financial institutions like leasing, factoring, mutual funds and private pension funds; and (iv) creation of a consolidated supervision entity. The FSAL 1I is intended to be another US$750 million adjustment loan and will be implemented during fiscal year 2003. B. FSAL Objectives, Board Conditions And T'ranche Triggers 38. Objectives. The main objective of the proposed first Financial Sector Adjustment Loan will be to address the Government's reform priorities as laid out in paragraphs 12-35 in order to create the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level. The reform actions required to achieve this objective in FSAL include creation of a competent and independent Banking Regulation and Supervision Agency (BRSA); bringing all the prudential regulations up to international best practice standards; empowerment of the bank failure resolution entity, the Savings Deposit Insurance Fund (SDIF) with a new set of legal tools and operating guidelines; and making a major tangible push towards restructuring and privatization of state-owned banks and getting the Government out of the business of owning and running commercial banks. 39. Specific actions to be taken under the FSAL. The specific actions to be undertaken have been divided into two parts, as follows (for further details, see the policy matrix in Annex II). (i) Actions undertaken prior to Board presentation: These are actions that are absolutely vital for kick starting the banking sector reform program, especially in the area of the restructuring and privatization of state-owned banks. Many of these actions have been designed and planned during the FSAL I preparation period. Some of these actions have also been included as part of the action plan supported by the IMF Standby Arrangement. They include: * Passage of the new agreed amendment to the banking law (the amendment to enhance the independence and strengthen the authority of the new BRSA, put in place tightened large/connected exposure limits, and clarify and strengthen the problem bank and the bank failure resolution roles and authorities of the BRSA and the SDIF respectively) (completed in late December 1999); * Appointment of the Board members of the BRSA (completed in March 2000); * Issuance of a substantially overhauled loan loss provisioning rule (completed in December 1999), including supporting documentation (revised regulatory report formats & disclosure requirements and a communique detailing borrower creditworthiness criteria) (completed in March and June 2000); * Issuance of an addendun to the FX exposure rule applying FX exposure limits on a consolidated basis (completed in late Decemrber 1999);  - 22 - * Issuance of an addendum to the capital adequacy rule applying the minimum capital adequacy requirement on a consolidated basis (completed in late December 1999); * Initiation of an action plan by Treasuiry covering all problem banks encompassing corrective action programs administered by the bank regulatory authority and SDIF interventions (initiated in late December 1999); * Enactment of an amendment of the existing law on Vakif to enable the bank's full privatization (completed in November 2000); * Passage by the Board of Directcrs of a decision to initiate the privatization of Vakif to allow for its privatization (completed i 1 August 2000); * Introduction of the new mechanism for the determination of credit subsidy rates to be used by Ziraat and Halk (completed in late December 1999); * Budgetizing the flow of duty losses arising from new subsidized lending by Ziraat and Halk in 2000 (completed with the ado ntion of the year 2000 budget); * Enactment of legislation that uA ill: (i) allow Emlak, Halk and Ziraat to be privatized; (ii) remove the application of state economic enterprise legislation (Decree Law No. 233 and related laws) to Emlak, Halk and Ziraat; and (iii) allow Ziraat to be transformed into a joint stock company (completed in N(vember 2000); * Passage by the Council of Mini ,ters of a decision to initiate the privatization of Emlak and Halk, that will allow the Treasury a limited, predetermined period of time to undertake pre- privatization restructuring and formulate privatization strategies, and upon expiry of such time, commit the Government to subsequent divestiture in accordance with the agreed privatization strategies (to be cor-lpleted in December 2000); and * Contracting for a first time IAS audit for Ziraat for year-end 1999 (completed in November 2000). (ii) Actions to be completed prior to the release of the second tranche: These are mostly actions that will take longer to prepare and implement and include: * Satisfactory creation and full operationalization of the BRSA, with proper operational policies and procedures, organizational structure (including a special unit to deal with problem banks), budgets, staffing and salaries; * The BRSA to issue internal supervisory guidelines for "Prompt Corrective Actions" for banks falling below specific capital adequacy levels; * Signing of a Memorandum of Ur derstanding between the BRSA, the Central Bank of Turkey and other relevant agencies to ens;ure proper information exchange and policy coordination in the financial sector; * Further revision of the loan clas,ification and loan loss provisioning rule to: (i) introduce a satisfactory specific provisioning requirement for watch (Category 2) loans; (ii) lift the exemption for agricultural support loans for which the Government has not explicitly assumed the credit risk; (iii) include a specific provisioning requirement for equity exposures; and (iv) introduce more prudent collateral classification; the implementation of this revision to be gradually phased in up to the end of 2002; * Introduction of full tax deductibility of specific loan loss provisions; the implementation of tax deductibility to be gradually phased in beginning in 2001; * Issuance of a BRSA regulation that will fully operationalize the new large/connected exposure limits introduced through the December 1999 Banking Law amendment;  - 23 - * Satisfactory monitoring by the BRSA of the banking system's compliance with the 75 percent maximum exposure limit applicable as of January 1, 2001 as specified in the amended banking law, and initiation of corrective actions in cases of non-compliance; * The BRSA to announce its intention to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary (i.e., for banks with foreign branches/subsidiaries), to verify compliance with consolidated FX open position limits between reporting dates; * The BRSA to further revise the consolidated financial reporting requirement for banks and their financial subsidiaries to extend coverage of the consolidated reporting requirement to horizontal conglomerates; * Issuance of a risk management system best practice regulation for banks; * Introduction in the bank capital adequacy rule of market risk charges (for securities price fluctuation risk, FX and interest rate risk); * Revision of accounting rules for banks to bring them substantially in line with IAS (i.e., securities valuation, pension accounting and disclosure requirements for banks in line with applicable IAS); * Satisfactory resolution of all known problem banks by Treasury/BRSA/SDIF; * The Government to develop a time bound action plan to resolve the stock of duty losses on the books of Ziraat and Halk and to issue Government bonds paying cash interest in line with the action plan; - Initiating the process of developing and implementing commercialization, restructuring and institutional development measures for Ziraat, through the development of a comprehensive strategic plan and detailed corporate action plans for the bank; - Complete the privatization of Vakif; and - Complete the pre-privatization restructuring activities for Emlak and Halk (including the development of a comprehensive strategic plan and detailed corporate action plans for Halk), and give a mandate to completely privatize both banks to an investment bank or similar privatization interrnediary. 40. Amount of the loan and timing of implementation. The proposed FSAL in the amount of US$777.78 million equivalent would be made to the Republic of Turkey represented by the Treasury. The loan would be a LIBOR-based Variable Rate Single Currency product and would provide quick disbursing balance of payments support. It would be released in two tranches; a first tranche of US$392,778,900 including a 1 percent front end fee of US$7,777,800 equivalent upon effectiveness provided macro-economic stabilization efforts remain satisfactory, and a second tranche of US$385,001,100 upon fulfillment of the specific tranche release conditions, as long as general progress on implementation of the Letter of Development Policy (including achieving macro-economic stabilization objectives) is also satisfactory. Procurement and disbursement arrangements would be consistent with standard Bank policy. The loan is expected to be fully disbursed within one month of the release of the second tranche. The closing date of the loan would be March 31, 2002. C. Project Implementation 41. The FSAL will be implemented in accordance with standard Bank procedures for adjustment loans. The financial sector program will be implemented by the Undersecretariat of Treasury and the new BRSA. Implementation arrangements will be fully consistent with Bank practice for adjustment loans. Upon notification by the Bank of loan effectiveness and second tranche release, the proceeds of the first and second tranches respectively of the loan will be deposited by the Bank into the designated  - 24 - Deposit Account at the request of the Borrower. In accordance with the Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sector Adjustment Loans (February 8, 1996), disbursements will not be linked to specific purchases. Therefore, there will be no procurement requirements. D. Financial Management And Monitoring 42. The Undersecretariat of Treasury will have in place adequate accounting and financial management reporting systems for the Deposit Account. The Undersecretariat of Treasury will maintain records of all transactions under the loan in accordance with sound accounting practices. The Government will submit to the Bank a monthly receipts and payments account showing the transactions on the Deposit Account, starting with the first receipt of Bank funds, and ending when Bank disbursements on the loan have ceased, wkhen no more money is expected from the Bank and when the balance on the Deposit Account has been reduced to nil. The Borrower shall: (a) have the Deposit Account audited in accordance with apprcpriate auditing principles consistently applied by independent auditors acceptable to the Bank; (b) furnish to the Bank as soon as available but in any case not later than three months after the date of the Bank's request for such audit, a certified copy of the report of such audit by said auditors of such scope md in such detail as the Bank shall have reasonable required; and (c) furnish to the Bank such other information concerning the Deposit Account and the audit thereof as the Bank shall have reasonably requested. The audit will be carried out at quarterly intervals as agreed with the Bank, calculated from the date of first tranche release, with suitable adjustments of timing depending on the dates of subsequent tranche releases and the funds left in the Deposit Account at any point in time. The terms of reference for the audit will be agreed between the Bank and the Borrower. Audits would end once all traniches have been released and all funds have been transferred from the Deposit Account. In addition lo the above, the Bank may request that its own staff (or a specialist contractor working on its behall) carry out special reviews of the Deposit Account. If, after deposit into the Deposit Account, the proceeds of this loan are used for ineligible purposes, the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes, or (ii) refund the amount directly to the Bank,  - 25 - IV. BENEFITS AND RISKS A. Project Benefits 43. The principal benefits of the Loan will be to: * strengthen the foundation for an efficient, sound and healthy banking system which can be competitive in quality and performance at the international level; specifically, the enhanced strength of the banking system that will be the result of the implementation of the financial sector reform measures supported by the proposed loan will improve the quality of financial intermediation, to the benefit of the real sector of the economy; furthermore! the resolution of the banks currently under the administration of the SDIF will expand the universe of healthy banks in the system; * reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; to the extent that the proposed financial sector reform program will help avert the risk of a financial crisis, Turkey will be able to avoid the costs normally associated with the resolution of such a crisis; and - position Turkey's banking sector for EU accession; by starting the process of aligning the prudential regime for the banking system with applicable EU banking sector directives now, Turkey will ensure that the banking sector will not become a bottleneck in the EU accession time table. B. Project Risks 44. The Government's reform program in the financial sector, to be supported by the proposed FSAL, is exposed to significant implementation and performance risks due to a potential lack of political consensus and institutional weaknesses. The three primary areas of weakness are: * Satisfactory operationalization and initial functioning of the new Bank Regulation and Supervision Agency (BRSA). To create a new entity from scratch, develop its operational policies and procedures, procure its budgetary funds, finalize its organization structure, hire all staff and put in place all the information and accounting hardware and software, and to function at full strength as a smooth running organization in a fairly short period of time is a task of significant complexity. The new BRSA Board also has to make a credible effort to integrate the banking supervision staff of the Central Bank of Turkey and the Treasury into the new entity. In view of such a complex task, there is a significant risk of slippage in the quality of rezulatorv oversight of the banking system during the early period of operation of the new BRSA. The Bank has indicated the same during its discussions with the Government, and has offered to arrange technical assistance in planning and smooth implementation of such a transition; * Satisfactory Failure Resolution Efforts by the Savings and Deposit Insurance Fund (SDIF): In view of a significant number of fair sized banks currently under the purview of the SDIF, the SDIF is at risk of being overburdened by the scale and scope of resolution tasks. Handling a large portfolio of failed banks would be a considerable task for any resolution entity anywhere in the world, and will definitely be a major undertaking for the SDIF. The past performance of the SDIF with regard to a quick resolution of the three banks that were  - 26 - already under its control befoie the latest intervention action in an additional seven banks does cast some doubt on the SDIF's ability to dispose of the problem banks as easily as would be required. There is. therefore, the risk of the BRSA (to which the SDIF now reports) and the SDIF being bogged down with these resolution problems. These problems, if not resolved quickly. can create further capital losses through attrition and make a bad problem worse. The Bank has repeatedly brought to the attention of the Turkish authorities the need to mobilize additiona resources including extemal technical assistance to mitigate this risk, and the authorities have already responded by hiring external advisers to help them develop specific resolution strategies for the current case load of banks in the SDIF; and * Lack of Political Will to Follcw through on the Reform of The State Owned Banks: The commercialization and privatization of the state-owned banks will be a major political and organizational challenge for ihe Government. Besides the political hurdles, there are significant fiscal and social implications in the rapid privatization of Emlak and Halk, and the commercialization and sibsequent full privatization of Ziraat. Development of restructuring and privatization plans, and implementation of such plans will also require a significant amount of technical expertise, and there is a risk that because of both of these factors, there can be slippage in the performance of these reform actions. The Bank has offered a new US$500 million State Bank Restructuring and Privatization Project to the Government to provide technical advisory and implementation assistance for the reform of the state owned banks to mitig te this risk. C. Lessons Learnt From Past Adjustinent Operations 45. Based on the Project Completion Reports for the earlier financial sector adjustment loans undertaken in the late 1 980s, the critical le ,sons from the two operations are summarized below: * A serious macroeconomic stabilization program for the overall economy, which is successfully implemented and adhered to by the Government is essential for the success of financial sector reforms; * a high degree of political ownership and consensus behind the reform program are necessary preconditions for the successful adoption and implementation of financial sector reforms. In an environment like Turkey, where the counterparts are often not the decision makers but are answerable to elected officials lik ely to change at relatively short intervals, there is a problem of continuing ownership of refornns; and * there is sometimes a risk of overestimating the institutional capacity, and future programs need to be designed with a sharT er focus on institutional issues and better preparatory work needs to be conducted to prevent similar occurrences. 46. These lessons are valid, and the timing and design of the operation has taken into consideration these lessons. The fact that the Governmernt has recently embarked on a serious stabilization program supported by a multi-year IMF Standby Arrangement creates the overall macroeconomic reform environment required for the FSAL in line with the above recommendation. Similarly, a much greater degree of political ownership and consensiis and commitment of the Government have been achieved as a result of the combination of several rez:ent external and internal developments in Turkey. First of all, the East Asian and Russian financial crises have significantly raised the general awareness and concern of the Government and entities in the financial sector about: (i) the urgency to address serious vulnerabilities in financial sector regulation and supervision; and (ii) the potential for serious and  - 27 - disastrous economic consequences of neglecting these vulnerabilities. Secondly, the possibility of EU accession in the not too distant future has created a consensus and generated momentum in favor of achieving prudential regulatory standards in the financial sector in line with applicable EU directives. Finally, the present coalition Government, comprising three center and center-right parties, has achieved internal political consensus in favor of economic policy reforms and has the parliamentary majority to legislatively implement them. The recent Government actions in the field of pension reform, international arbitration legislation, taxation measures and recent banking law amendments to strengthen bank regulation, supervision and failure resolution confirm the will and capacity of the Government to carry out the necessary tough reform measures. 47. The Bank Team has also specifically focused on the institutional capacity and better preparation of reform components, and a need for technical assistance to specific institutions has been identified. The main counterpart in the initial stages of project preparation has been the Under- secretariat of Treasury, and the Bank Team along with support from IMF MAE staff have provided technical assistance to the Government in preparing: (i) the banking law amendment; (ii) the necessary prudential regulations; and (iii) action plan to deal with problem banks. Going forward, the Bank team and consultants funded by the SBRPP will provide technical assistance to the Government in: (i) strengthening the institutional capacity of the SDIF to deal with resolution of failed banks; (ii) operationalization and initial functioning of the new BRSA; and (iii) developing commercialization and privatization plans of the state owned banks. The above actions, to the extent they have already been implemented, have already significantly strengthened the preparatory effort and institutional capacity and mitigated the shortcoming and risks involved, and further reform steps as envisaged under the proposed FSAL will act to enhance their impact. V. RECOMMENDATION 48. I am satisfied that the proposed loan complies with the Articles of Agreement of the Bank and I recommend that the Executive Director approve the loan. James D. Wolfenshohn President By Sven Sandstrom Washington, D.C. November 27, 2000   Annex 1 Page 1 of 1 TURKEY FINANCIAL SECTOR ADJUSTMENT LOAN TIMETABLE OF KEY PROCESSING EVENTS 1. Time Taken to Prepare and Process this Loan 18 months 2. Loan Prepared By Government of Turkey with IBRD assistance 3. Appraisal Mission February 1, 2000 4. Technical Discussions February 16, 2000 5. Negotiations November 14, 2000 6. Planned Board Presentation December 21, 2000 7. Planned Date of Effectiveness January 15, 2001 8. Planned Closing Date March 31, 2002   Annex II Page 1 of 1 TURKEY: FINANCIAL SECTOR AT A GLANCE BANKING INSURANCE EQUITY INVESTMENT MUTUAL FUNDS/ LEASING/ PENSION MARKET COMPANIES/ INVESTMENT FACTORING BROKERAGES TRUSTS Number of * 36 Turkish * 60 companies * Istanbul Stock * 141 intermediaries * 198 mutual funds (as * 70 leasing * 3 State Institutions * 18 Foreign (17 life and Exchange authorized to trade of beginning 1999), companies controlled * 5 State Owned 43 non-life) (ISE) has about on ISE including: (in 1997) social * 12 Development of which: 300 listed * 1 16 brokerages, 55 * 97 Type A funds * 85 security Banks (7 * 46 private companies commercial banks, (25% of assets factoring funds Turkish, 3 * 11 Foreign and 12 investment invested in companies (PAYG) Foreign, 2 State) * 3 State banks authorized Turkish equity (in 1998) * Limited Owned to trade in the with some tax private bonds and bills advantages) pension market * 101 type B funds funds (less restrictive and 80% of total market net asset value) * 17 investment trusts (all Type A) * 5 Reties (real estate) Total Assets US$122 billion * Total Market Cap of Daily trading volume Total net asset value of * Volume of premiums in US$48 ban (1998); ranges from US$300 mutual funds is US$1.2 leasing 1997- free float is about man to US$1 ban. ban transactions US$1.8 ban 20% of market cap is US$2.5 * Total assets of ban insurance * Factoring companies - turnover US$3.5 ban was US$3.3 ban in 1997 Major Ziraat Bank, Halk Millie Reassurance Foreign portfolio Ata Invest Not applicable Players Bank, IS Bank, Yap (all insurers investment accounts Credo Bank, obliged to reinsure for large demand in Guaranty Bank, AK a fixed percentage equity market (more Bank, Pam Bank with them) than 50% of equity in early 1998) Regulator CBOT/Ministry of Insurance Capital Markets Capital Markets Board Capital Markets Board Ministry of Ministry of Treasury to hand Supervisory Office Board Treasury Employment and over to new (Ministry of Social Independent Banking Treasury) Security/Capital Regulation and Markets Board Supervision Agency (BRSA) ___   Annex III Page 1 of 13 REPUBLIC OF TURKEY PRIME MINISTRY THE UNDERSECRETARIAT OF TREASURY Ref: B.02.1.HM.O.DEl.01.05-Mali-93977 Ankara, November 23, 2000 Mr. James D. Wolfensohn President The World Bank Washington DC 20433 Dear Mr. Wolfensohn, 1. Following the latest Parliamentary elections in early 1999, the current new coalition Government has decided to pursue a comprehensive multi-year macroeconomic stabilization and structural reforrn program that will put Turkey back on a sustainable growth path, will once and for all eliminate high inflation, and will contribute to a more equitable distribution of income and further alleviation of poverty. 2. We are currently implementing a medium-term macroeconomic stabilization program which envisages to: (a) rebuild macroeconomic stability through appropriate fiscal and monetary measures; (b) ensure the integrity of the financial sector and improve the efficiency of financial intermediation; (c) promote private sector investment and private sector participation in infrastructure; (d) promote agricultural growth and income generation; and (e) ensure a fair and financially sustainable social security system. We have received an Economic Reform Loan from the Bank in May in support of our planned reform efforts in all of the areas under (a), (c), (d) and (e) above, and we have an ongoing agreement with the IMF for a three year Stand-by arrangement. 3. So far as the financial sector reform effort ((b) above) is concerned, given the size and overarching importance of the health and competitive strength of the banking sector, we have structured a multiyear reform effort in the financial sector to focus first and foremost on addressing the most urgent banking system issues, to be followed by a series of reform steps to more fully integrate the banking sector into the money and capital markets and non-bank financial institutions sector. In support of our multi-year financial sector reform program as described below, we would at this stage like to request the Bank to provide a first Financial Sector Adjustment Loan (FSAL I) to support the first phase of our financial sector reform program. Subsequent to the successful implementation of the first phase, we would like to request the Bank's assistance through a follow up State Bank Restructuring and Privatization Project in 2001-02 and a second Financial sector Adjustment Loan (FSAL II) in 2002-03.  Annex III Page 2 of 13 Background 4. Beginning in the early 1980s, our initial reform emphasis in the financial sector has been on development of a basic legal and regulatory infrastructure for the banking system to facilitate ease of entry, and increase competition and grow:h. This triggered a rapid expansion of banking system assets in Turkey during the 1990s, and in spite of a banking crisis which occurred during 1994-95, total system assets in absolute terms more thai doubled from US$52.0 billion in 1994 to US$133.5 billion as of end 1999, and also increased substantially as a percentage of GNP from 39.24 in 1994 to an estimated 61.25 in 1999. 5. Although this expansion of the bank ing system has been conducive to the rapid economic growth we have experienced during recent years, the risks and vulnerabilities of the banking sector have considerably increased at the same time. Until the very recent creation of the new Banking Regulation and Supervision Agency, our regulatory and supervisory infrastructure, with key responsibilities for on and off-site supervision being spread across different Government agencies, had not kept pace with the quick expansion and increasing complexity of the banking sector, and our prudential regulations and enforcement capacity also lagged behind considerably. In addition, the complex ownership and govemance linkages between the banking sector, non-bank financial institutions and the real sector of the economy, has led to the existence of dominant financial-industrial groups with excessive concentration of exposure and default risks and significant proliferation of connected and insider lending. The credit risks have been quite often significantly understated due to past lenient loan loss classification and provisioning rules. The rapid asset growth has allowed banks to hide the deteriorating quality of a major proportion of their credit portfolios. Excesses in foreign currency exposures and in maturity transformation generating significant duration mismatches have also created enhanced foreign currency and liquidity ri ,ks on top of the credit risks. 6. Continued macroeconomic instability, coupled with the liquidity squeeze, higher risk premiums, and intensified international competitiveness resulting from the East Asia and Russian crises, have further added to an overall riskier banking environment. Against this background and also taking into account our ongoing stabilization efforts, we believe it is of critical importance to enhance the safety and soundness of the banking system anid to improve the quality of bank intermediation through implementation of a series of targeted legal, regulatory and supervisory infrastructure improvement measures. Additionally, we also intend to undertake comprehensive reform of the state-owned banks which comprise around 40 percent of the Ibanking system's asset and deposit base. Finally, in light of the recent decision taken at the Helsinki summit, we are keenly aware of the need to start positioning our banking system for EU accession and to initiate the process of bringing in line relevant laws and regulations with applicable EU banking system directives. Our Financial Sector Reform Program 7. Our financial sector reformn program er compasses reformn efforts in the following areas: 8. Banking legislation. A new banking law was adopted on June 23, 1999 to replace the previous decree law (parts of which had been declared invalid by the Constitutional Court) and also to introduce major reforms in our existing fragmented banking regulatory infrastructure. The new law has mandated the creation of a new independent Banking Regulation and Supervision Agency (BRSA),  Annex III Page 3 of 13 governed by a seven member Board, to take over the bank regulation and supervision responsibilities previously fulfilled by the Undersecretariat of Treasury and the Central Bank, and to integrate the supervisory staff of the two institutions. 9. The new law as passed still contained some deficiencies related to: (i) the independence of the new supervisory agency, and the formation of the Board of the BRSA; (ii) prudential regulations, especially concerning loan classification and provisioning, and large exposures/connected lending; and (iii) problem bank and bank failure resolution actions, and authority of the BRSA and the Savings Deposit Insurance Fund (SDIF) under Article 14. To remedy these weaknesses, we prepared an amendment to the banking law that was passed by Parliament in late December 1999. 10. Independence of the new BRSA. One of our principal objectives in establishing the new BRSA was to create a regulatory and supervisory body which is independent, professionally objective, and has the authority under the law to function free from day-to-day political interference. We have recognized that in order for the BRSA to be truly independent, it will also be necessary for the Agency to have the authority over key decisions related to bank entry and exit policies (i.e., the issuance and revocation of banking licenses), resolution of problem banks and issuing of critical loan loss classification and provisioning rules. The June, 1999 banking law had still left decision making authority in these areas with the Council of Ministers as opposed to the independent BRSA. In order to remove this remaining potential political influence in banking supervision and regulation, the December 1999 amendment to the banking law has transferred full authority in all these areas from the Council of Minister to the BRSA. As a result, the BRSA will be able to function autonomously, and to exercise its functions independently and objectively in the best interest of banking system safety and soundness. 1 1. Creation of and transition to the new BRSA. The June 1999 banking law envisaged that we would appoint the Chairman and Members of the new BRSA Board by end September 1999. However, due to a restriction on prospective Board members in the June 99 banking law, preventing them from accepting a senior position in the banking sector upon completion of their tenure with the Board for a period of three years, suitable candidates for Board membership could not be appointed by September 1999. With the December 1999 banking law amendment, however, the aforementioned limitation was reduced to two years, the qualification and experience requirements of candidates was strengthened, appointment of the Board was completed by end of March 31, 2000, and the Agency became operational by August 31, 2000. During the months ahead, we intend to work closely with the World Bank to ensure that the organizational structure, operational policies and procedures, staffing, salaries and budget arrangements for the new Agency are appropriate to the Agency's mandate and effective functioning. To ensure proper information exchange and policy coordination in the financial sector, a Memorandum of Understanding detailing the practical day to day aspects of their cooperation has already been signed between the BRSA, the Central Bank and the Undersecretariat of the Treasury. 12. Upgraded Prudential Banking Regulations to Meet BasletEU/IAS Standards. While Turkey made substantial progress during the late eighties/early and mid nineties towards modemizing its prudential and accounting standards to incorporate intemational best practice standards embodied in the Basle capital rules, EU Banking Sector Directives and Intemational Accounting Standards, we have recognized that until the very recent overhaul of several key prudential regulations, our regulatory  Annex III Page 4 of 13 regime for banks still contained several weaknesses. These weaknesses, also taking into account the predominance in Turkey of interrelated financial industrial groups, in all likelihood have contributed to the emergence of a sizeable pipeline of problem banks in the banking system. . Actions required to address these weaknesses included: (i) a revised regulation for loan classification and loan loss provisioning in line with international best practice standards; (ii) new connected and insider lending limits in line with EU standards; (iii) intrduction of market risk charges for banks, and supplemental capital adequacy rules and foreign exposure rules applicable on a consolidated basis; (iv) revised accounting standards to bring securities v Aluation and pension accounting rules in line with applicable IAS, and financial disclosure requirements for banks in line with IAS 30 and 32; and (v) regulations related to better risk management standards and practices. Some of these have already been implemented and work on the remaining i, under way. These are described below. Loan Loss Provisioning 13. We already have issued a revised loan classification and specific loan loss provisioning rule in December 1999 that puts an end to the previous practice of regulatory forbearance in response to real sector pressures. The new rule requires banks to classify their exposures primarily on the basis of creditworthiness considerations, although debt service track record considerations will also be taken into account. The banks have been given a period of four years to build up the increased loan loss provisioning balances mandated by the new rule for all loans outstanding prior to the date of the latest amendment to the banking law (i.e., late December 1999), but the new provisioning requirements apply immediately (i.e. as of January 1, 2000) to all new and rescheduled loans. To fully operationalize the new regulation, we have also issued in March and June 2000 all necessary supporting documentation, including: (i) revised regulatory report formats; (ii) revised disclosure requirements, mandating immediate disc Losure of the full amount of specific provisions required (whether already set aside or not) for baniks' total loan portfolios, and (iii) a communique detailing borrower creditworthiness criteria, providing practical guidance to the banks on the new loan classification structure. We will closely rmonitor the banking system's compliance with the new rule and promptly take corrective action as necessary to deal with any discrepancies. Additionally, we intend to further revise the rule to: (i) introduce a specific provisioning requirement for watch loans taking into account the credit risks assoc ated with such loans; (ii) lift the exemption from specific provisioning requirements for all agricultural support loans except for those loans for which the Government explicitly (i.e., as documented by applicable Government decrees) issues a guarantee and carries the credit risk; (iii) include a specific provisioning requirement for equity exposures; and (iv) introduce more prudent collateral classification. The implementation of the revised requirements of the loan loss provisioning rule will be carried out with a phase in period not extending beyond December 31, 2002. Finally, the tax deductibility of specific loan loss provisions will be extended to cover all specific loan loss provisions required under the applicable Loan Loss Provisioning Rule in a phased manner starting from year 2001. Connected/Insider Lending Limits 14. With regard to large and connectec/insider lending limits, the December, 1999 banking law amendment brings these limits fully in line with applicable EU standards, and grants banks a period of six years, with clearly specified interim tirgets, to bring their existing exposures within these new limits. The law as amended requires barks to bring their total exposures (lending, equity and off  Annex III Page 5 of 13 balance sheet commitments) to a single client or a group of connected clients on a consolidated basis down in steps from 75 percent of their capital by the beginning of 2001 to 25 percent by the beginning of 2007. We intend to shortly issue a detailed regulation to clarify key underlying concepts referred to in the law such as 'group of connected clients'. This regulation will also specify how off balance sheet commitments are to be treated for purposes of calculating overall exposures. Once this regulation is issued, the BRSA will closely monitor the banking system's compliance with the 75 percent maximum exposure limit applicable as of January 1, 2001, as specified in the amended Banking Law, and will promptly initiate corrective actions in cases of non-compliance. Capital Adequacy & Foreign Exchange Exposure Rules on Consolidated Basis 15. We also have already issued in December 1999 revised capital adequacy and foreign exchange exposure rules that apply capital adequacy ratio requirements and foreign exchange exposure limits on a consolidated basis, ensuring that parent banks together with their financial subsidiaries maintain adequate capital and maximum foreign exchange exposures on a group basis. To allow the BRSA to verify compliance by banks with the new consolidated capital adequacy requirement, we have already revised the existing consolidated financial reporting requirement for banks to increase the reporting frequency from bi-annually to quarterly. We intend to further amend the existing rule to extend coverage of consolidated reporting requirement to horizontal conglomerates. To ensure compliance by the banking system with the new consolidated foreign exchange exposure rule, the BRSA will announce its intention to undertake surprise on-site examinations, in coordination with foreign supervisors where necessary (i.e., for banks with foreign branches/subsidiaries), to verify compliance with consolidated FX open position limits between reporting dates. Introduction of IAS Accounting Standards 16. We have already addressed several key deviations from best practice standards in our regulatory and accounting regime for banks. Updated prudential regulations regarding accounting standards to be used by banks in line with IAS have already been issued in the following areas: (i) revised securities valuation rules that clearly delineate trading and investment portfolios and restrict banks' freedom to choose from among four different interest rate accrual calculation methods to manipulate income; and (ii) disclosure requirements in line with IAS 30 ("Disclosures in the Financial Statements of Banks and Similar Financial Institutions") and IAS 32 ("Financial Instruments: Disclosure and Presentation"). Furthermore, we intend to issue revise existing pension accounting rules to bring them in line with applicable IAS and to eliminate the understatement of pension cost and the pension liability of banks which operate employee pension schemes. Risk Management Regulation 17. While the June 1999 banking law introduced a requirement for all banks to have proper risk management systems, this requirement will only become effective once a regulation outlining the specifics is issued. We have already prepared a first draft of a new regulation requiring banks to develop risk management capacities and appropriate risk management policies and procedures on a consolidated basis, and are in the process of consulting the banking industry on this new regulation. Such consultation is necessary to accurately assess the amount of time banks will need to put in place the new internal systems, organizational structures and policies and procedures for modem risk  Annex III Page 6 of 13 management on a consolidated basis. Once this consultative process is completed, we intend to issue the new regulation. Similarly, although we recognize the urgency of introducing capital charges for market risk given the very high volatility of Turkey's financial markets, we believe it is imperative to first raise the awareness of the banking sector on the need for, and the specific attributes of a comprehensive and dynamic risk managemrent approach, and to develop a consensus on the types of models to be adopted for measurement of such risks, prior to issuing such regulations. For this reason, we worked closely together with the World Bank on the organization of a seminar on this topic in February 2000 to stimulate discussion and enhance the banking community's knowledge in this area. Once the risk management regulation is issued, we will also introduce a requirement for banks to maintain capital against market risks. Tle capital adequacy rule will be revised to introduce such market risk charges for banks to protect themselves against securities price fluctuation, foreign exchange and interest rate risk in addition iO the more traditional credit risks. 18. Strengthening Problem Bank and Bank Failure Resolution Capacity. Due to the combination of continued macro-economiz instability, severe external shocks and weaknesses in the previous regulatory and enforcement regirr e for banks, the financial condition of a sizeable segment of the banking system significantly deteriorated in 1999 and required urgent regulatory intervention in some cases. The June 1999 banking law d d not contain sufficiently strong "prompt corrective action" mechanisms for the Banking Supervision Department at the Treasury to strengthen and discipline problem banks before they deteriorated imno insolvency. Also, after intervention, the legal resolution mechanisms available to the SDIF were limited in scope, and imposed an unnecessarily high cost on the Government and the banking system at large. Furthermore, the law did not permit the removal of the shareholders of insolvent banks in all cases, and did not provide clear guidelines about intervention triggers and authority of the SDIF. Finally, the roles of the Treasury as the bank regulator, the SDIF as the failure resolution entity and the Central Bank of Turkey as lender of last resort were not as sharply defined as necessary to ensure legal and regulatory transparency, minimize failure resolution costs and optimize the behavioral incentives sent to :he banking system. These weaknesses have been broadly addressed by the recent December 1999 am -ndment to the banking law and are explained below. 19. Pre-failure Problem Bank Resolution and the Role of the Bank Regulator. The December 1999 banking law amendment has introduced the concept of prompt corrective action arrangements to be used by the bank regulator, now the new BRSA. To implement this new "prompt corrective action" approach to problem bank resolution, the BRSA will develop and implement a special supervisory regime for problem banks. This regime will include intensified supervisory efforts to bring about the corrective actions necessary to rectify problem banks before they deteriorate into insolvency. The BRSA Board will also adopt an internal procedures manual for BRSA staff formalizing the tools and techniques to be used in this context. Such tools and techniques will include, among others: (i) timely and formal identification of the banks concerned as problem banks; (ii) more frequent examinations and visits to follow-up on identified weaknesses; (iii) regular meetings with the banks' boards of directors; (iv) frequent reporting from the banks to the bank supervisors regarding the status of identified weaknesses and corrective action5 taken; (v) the use of memorandums of understanding and "cease and desist" orders to establish the le ,al and financial responsibilities of the board of directors, managers, and principal owners for taking or bringing about corrective actions for unsafe and unsound banking practices; and (vi) the use of other enforcement measures to establish discipline and incentives for appropriate corrective action. To administer this special supervisory regime, the BRSA will  Annex III Page 7 of 13 establish a special unit with properly trained staff that will deal exclusively with problem institutions. These actions will be completed in early 2001. 20. Failure resolution and the role of the SDIF. The December 1999 amendment to the banking law also has introduced a more sharply defined role for the SDIF. From now onwards, the SDIF's mandate is limited to dealing with only "failed banks", that is banks that are insolvent. Article 14 of the banking law has been revised to clarify this new mandate of the SDIF, and also has introduced clear insolvency triggers to determine when a bank should be intervened by the SDIF. The SDIF can no longer provide liquidity support to illiquid but still solvent banks, and this task will be the function of the Central Bank. The SDIF is required to undertake the resolution of banks under the principle of "least cost resolution", that is at least cost to the SDIF in order to ensure the protection of insured depositors. Under the revised Article 14, the losses suffered will be applied immediately to the shareholders' capital and the shareholder rights will be revoked in all cases. The new menu of failure resolution techniques of the SDIF will include: (i) insured deposit transfers; (ii) purchase and assumption transactions, including where appropriate through the creation of temporary bridge banks; and (iii) depositor payoff and liquidation of the remainder of the failed bank. This new mandate is already effective. 21. Resolution of the Present Pipeline of Problem Banks. With the latest amendment to the banking law now enacted, we have formulated and initiated implementation of a comprehensive action plan for resolving deficiencies and problems of the existing universe of problem banks. These included, the banks that were undercapitalized and subject to enhanced supervision under Article 14 of the banking law, and the eight banks under the administration of the SDIF. The main elements of the action plan included: (i) immediate examination by Sworn Bank Auditors of any capital deficient banks in order to determine their solvency; during the period of their examination, these banks will be permitted to increase their capital, and other steps to improve their net worth will be taken into account in determining their capital deficiency and insolvency; if they are assessed to be insolvent and are unable to improve their capital position, they will be taken over by the SDIF for resolution; (ii) takeover by SDIF of five deeply insolvent banks, four of which have also incurred abuse by some of their owners; (iii) liquidation of a sixth insolvent bank; and (iv) recapitalization and sale of the three banks already owned by the SDIF or, in case there is little asset and franchise value left, a transfer of their liabilities to another bank and the sale or liquidation of remaining assets. 22. Intervention action has already been initiated regarding all of the above banks. Five deeply insolvent banks mentioned above have already been taken over by the SDIF in December 1999, and in a clear break with the practice in the recent past, the take over of insolvent banks is being conducted so that the entire stake of the existing owners is lost. In addition, the decision to close and liquidate an additional sixth bank has been taken. During January-March external auditors and Sworn Bank Auditors were employed to determine more accurately the extent of non-performing loans and the capital gap in each of the intervened bank. Subsequently during June 2000, the SDIF has hired external consultants to advice it on appropriate resolution actions for all of the banks under its responsibility. Having also at their disposition the consultants' recommendations, the SDIF which, since the beginning of September 2000, is operating under the responsibility of the new BRSA, is currently in the process of finalizing specific resolution actions for each individual bank. The BRSA will prepare quarterly reports, assessing compliance with prudential regulations by problem banks. This report will also be made available at the same time each quarter to the IMF and the World Bank.  Annex III Page 8 of 13 23. After the operationalization of BRS X in August 31, 2000, BRSA has intervened and revoked the license of the branch of a foreign bank in Turkey, and has intervened in two additional banks in the month of October, 2000, bringing the tctal number of banks to ten under the jurisdiction of SDIF. Additionally, BRSA has created a new As.set Management Unit (AMU) in the SDIF to handle the asset recovery and liquidation all the non-performing loans from intervened banks. In view of the large funding requirement associated with the resolution of the current pipeline of problem banks, and the availability of limited funding of approximately US$ 0.7 billion in the SDIF, the required funding to the tune of US$6.1 billion has been made available to SDIF through the provision of Government securities to ensure that the SDIF can resolve the existing universe of failed banks in a fast and efficient manner. The December 1999 banking law amendment has specifically introduced the authority for the Government to provide sach financial support to the SDIF. Such support has ensured the credibility of the SDIF interventions in the market. With the institutional and funding structure in place, the BRSA is now proceeding rapidly towards implementing a comprehensive action plan for resolution of the banks currentlv in the SDIF. In this regard, "fit and proper" criteria for potential bidders interested in acquiring any of the SDIF banks have already been issued in the first week of November, 2000. The pre-qualification of potential bidders for the first set of eight SDIF banks should be completed by the end of December 201)0, and expression of interest in specific banks or groups of SDIF banks would be sought by no later than the middle of January , 2001. By the middle of January all pre-qualified bidders will be given basic information on the available banks, and the potential bidders must confirm their interest in specific banks or groups of banks by the beginning of February, 2001. After a few weeks given to the buyers for carrying out due diligence, the finals bids will be required to be submitted by the end of April 2001, and the selection of the final buyers completed before the end of May 2001. The remainia-g two SDIF banks intervened in October 2000 will follow the same process as above with a lag of about two months. The action plan is expected to be fully completed by the end of third quarter 2C'01. Additionally, the new BRSA is committed to arrange expeditious SDIF intervention in, and resolution of, any other bank in the system whose capital adequacy falls below the new prompt corrective action triggers embedded in the new banking law. 24. State-Owned Banks' Commercialization and Privatization. The state-owned banks--Ziraat, Halk, Emlak and Vakif--are a dominant fcrce in Turkey's banking system, comprising approximately 40 percent of total system assets and depcsits. As a result of previous Governments' policies to use these banks as channels for subsidized, directed lending to specific sectors (e.g., agriculture, housing) and segments of society (e.g., micro and small enterprises), enornous losses have accumulated on the books of these banks, especially Ziraat and Halk. These losses to date have been hidden under the umbrella of illiquid "duty losses" (paper claims on the Government carried on the banks' books). While such claims on the Government carTy a zero risk weighting and therefore do not threaten the banks' solvency, their presence has repeatedly created major liquidity problems, forcing these banks to raise huge sums of money in the interbank market. The funding needs of the state banks have occasionally been so large as to severely distort the administration of the Central Bank's monetary policy. 25. We are fully aware of the need to addr, ss the underlying causes of which these liquidity needs are symptomatic, and understand that the magnitude of the problems of the state banks, if they are not addressed, have the potential to undermine the health and stability of the remainder of the banking system. We are therefore committed to a reform strategy for these banks that would result in full  Annex III Page 9 of 13 divestiture of our ownership stakes in all four banks in the medium term. Given the complexities and the magnitude of the funding shortfalls involved, however, and also taking into account that some of these banks perform public policy functions that cannot simply be abolished, we will need some time to develop and then implement properly designed governance, organizational and financial restructuring plans before we can embark on the outright sale of these banks. This is especially true for Ziraat, as this bank currently combines three separate activities into one entity: (i) agricultural finance, (ii) general commercial banking; and (iii) payment and collection services for the Government. Any rapid privatization of Ziraat without careful consideration of structural and economic implications and feasible alternative solutions to the above functions will be very disruptive. Privatization of Vakif Bank 26. Our multiyear strategy for the restructuring of the state banks comprises the following governance and ownership change oriented actions. For Vakif, an amendment to the law covering its operations has been adopted, modifying its special trust status so that the remaining 75 percent ownership stake of the State (Trust Funds Administration Department of the Governrment) can be fully divested in two stages. The Board of Directors of the bank has issued a decision to carry out the sale of the 20 percent Class B shares of the bank to private owners, and has already hired investment advisers to assist it with the implementation of this sale. Once this sale has been completed, the Council of Ministers will issue a decision to sell the remaining 55 percent Class A shares controlled by the state. The sale of Vakif Bank is planned to be completed during 2001. Operational and Governance Autonomyfor Emiak, Halk & Ziraat Banks 27. For Emlak and Halk, as well as for Ziraat, legislation has been enacted that: (i) removes the application of selected state-owned enterprise law provisions (Decree Law No. 233 and related legislation) in order to enhance operational and governance autonomy for these three banks in the period prior to their privatization, (ii) allows Ziraat's transformation into a joint stock company, and (iii) calls for the full divestiture of State ownership in all three banks within a three year period, with a possibility for a one time extension of this period with one-and-a-half year. Furthermore, we have contracted an international audit firm to undertake a first time IAS audit of Ziraat bank for the year 1999. Privatization of Emiak and Halk banks 28. For Emlak and Halk, in accordance with the above referenced new legislation enabling their privatization, Treasury will be given the mandate to (i) develop pre-privatization operational and financial restructuring strategies as necessary to prepare these banks for privatization, ; and (ii) subsequently privatize these two banks. The Treasury will, if necessary, hire professional firms to prepare privatization plans that can subsequently be implemented. We are committed to ensure that these plans will be finalized, and the associated funding requirements be put in place as further explained below, before expiration of the three year period specified in the enabling legislation, so that these banks can subsequently be sold. We anticipate that all the pre-privatization planning, preparation and restructuring for both Emlak and Halk will be completed, and the privatization process initiated for these two banks by December 2001 at the latest, through granting the mandate for the sale of these  Annex III Page 10 of 13 banks to an investment bank or similar pivatization intermediary. In view of their fairly large size, the actual sale is expected to be completed by fourth quarter of 2003. Commercialization and Restructuring of Ziraat Bank 29. For Ziraat Bank, in accordance wilh the legislation enabling its complete privatization, a similar mandate will be given to the Treasury to prepare the bank for sale. However, as the pre-privatization restructuring steps required for Ziraat are more complex, our approach to the governance and ownership restructuring of Ziraat, beside s the measures outlined above, envisages the following reforn steps: (i) development of a comprehensive strategic plan and detailed corporate action plans for the commercialization and restructuring of the operations of the bank, (ii) development of alternative solutions for the present public policy %unctions of the bank; and (iii) the implementation of such strategic/corporate action plans, and the actual transfer of public policy functions to third parties. We anticipate that these steps will take a period of about three years, latest by December 2003. Transparent Budgetized Funding and Phased Reduction of Subsidized Lending 30. The Government of Turkey has decided to gradually phase out all subsidized agricultural and small enterprise lending, and in the in,Lerim to finance the costs (duty losses) of such subsidies transparently through the budget. In order to resolve the flow problems arising from past and new subsidized lending by Ziraat and Halk, vie have included an allocation in the year 2000 Government budget to finance all the anticipated duty loss flows for the year 2000. Second, we have already taken action in order to gradually phase out subsidized credit, through the introduction of a new mechanism for the determnination of credit subsidy rates to be used by Ziraat and Halk, which has first frozen and subsequently linked the credit subsidy rate to 1.05 times the average 12 months Treasury bill rate. As Treasury bill rates have already declined sharply a result of our strong macroeconomic stabilization efforts, this new mechanism has allowed us to reduce the cost of credit subsidies from 1.2 percent of GNP in 1999 to an estimated 0.6 percent f GNP in 2000 (and to zero percent thereafter). Finally, we will develop a time bound action plan to resolve the stock of duty losses outstanding on the books of these banks, and issue Government bonis and provide for cash interest payments on these bonds through proper budgetary allocations in line with this plan. As a first step, we have already included funding in the 2000 budget to service Government bonds to be issued to Ziraat and Halk in an amount equal to 15 percent of the stock of duty losses outstanding as of year-end 1999. To ensure that the time tables outlined above for the sale of Emlal. and Halk banks can be met, we intend to include funding in the 2001 budget to service additional Go-ernment bonds to be issued to these two banks during 2001 in an amount sufficient to retire their full stock of outstanding duty losses. For Ziraat and Halk, we intend to issue Government bonds in 2001 (some of which may be marketable as required) in line with the time table laid down in the overall restructuring and pre-privatization strategy for Halk and Ziraat. 31. Reform of Deposit Insurance. Turcey has had an explicit deposit insurance scheme since 1983. The scheme is administered by the SDIF and was, prior to the December 1999 banking law amendment which introduced the option for the Government to finance any funding shortfalls, exclusively funded with deposit insurance premiums paid by the banking system. Participation is mandatory for all banks. There is no separate deposit insurance law as the legal framework for the scheme is embedded in existing central and commercial bank legislation. During the 1994-95 banking crisis, in an attempt to stem deposit withdrawals and restore depositor confidence, we introduced 100  Annex III Page 11 of 13 percent deposit insurance coverage for household depositors (previously coverage was limited to a fixed TL amount). It had been our intention to retain the full coverage only for a limited period of time, and to reform the deposit insurance scheme as soon as the banking crisis was over to bring it into compliance with the applicable EU Directive. However, as a result of high Government turnover and inattention to the matter, the 100 percent coverage was not lifted until June 1, 2000, and its continued presence has over time led to imprudent banking practices and competitive distortions as a result of the moral hazards involved, and has encouraged weaker banks to expand their deposit base by offering above market interest rates. 32. We have been very much aware of the need to reduce the coverage to eliminate these distortions, but believed we could not afford to do so during a major intervention in a sizeable number of problem banks. Revoking the 100 percent coverage at the time of a major intervention action would most likely have resulted in a serious erosion of depositor confidence, and possibly system-wide bank runs. Therefore, we decided to undertake this particular reform action with effectiveness as of June 1, 2000 once the take-over by the SDIF of most problem banks was completed, macro-economic stabilization had taken hold and the banking system had started to adjust to the new economic, legal and regulatory structure that was put in place during the previous months. The 100 percent coverage is being lifted in stages: as of June 1, 2000 coverage has been reduced to TL 100 billion (approximately US$150,000), and in 2001 coverage will be further reduced to TL 50 billion as we study the developments in the sector. The overall aim of reform efforts in this area remains to bring the Turkish deposit insurance scheme eventually in line with the applicable EU Directive on deposit guarantee schemes. 33. Consolidated Supervision of Banks and Non Bank Financial Institutions. The Turkish financial sector consists of financial-industrial conglomerates with commercial banks in the center of such groups, surrounded by a number of financial subsidiaries in the areas of insurance, leasing and factoring, capital markets, and mutual funds. Many of these financial subsidiaries as well as the parent bank have both loan and equity exposures to the same groups of clients. Until very recently, the prudential lending limits applicable to a commercial bank's exposure to its clients also applied to its exposure to its financial subsidiaries, but capital adequacy and foreign exchange exposure rules did not apply to banks on a consolidated basis. As explained earlier, we have rectified these shortcomings in the prudential framework for banks through the introduction of consolidated large and connected/insider lending limits, and capital adequacy and foreign exchange exposure rule requirements. 34. The next logical step would be to start monitoring the implementation of these new rules on a consolidated basis for such financial conglomerates. We recognize the need for such consolidated supervision. However, the overall process of consolidated regulation and supervision is quite complex because of the current existence in Turkey of a number of different regulatory and supervisory bodies; e.g., the banks will be regulated by the new BRSA; the insurance sector is regulated by the Insurance Supervisory Office of the Treasury; leasing and factoring activities are supervised by the Non Bank Financial Institutions (NBFI) department of the Treasury, investment and brokerage companies, mutual funds and investment trusts are regulated by the Capital Markets Board; and pension funds will be regulated jointly by the Ministry of Employment and Social Security, the Insurance Supervisory Office of the Treasury and the Capital Markets Board. This dispersion of regulatory and supervisory responsibility across multiple Government agencies carries the risk of creating insufficient,  Annex III Page 12 of 13 overlapping or even conflicting regulations and operating standards, thereby reducing regulatory efficiency and imposing an unnecessary burden on the financial institutions concerned. 35. We understand the value in therefore improving consolidated supervision in the financial sector, and as a first step towards its implemeniation have already brought special finance companies under the purview of the new BRSA through the latest banking law amendment. At the same time, we believe that a further analysis of the non-bank financial institutions sector and its development constraints needs to be carried out before we are in position to reach firm conclusions and develop concrete action plans in this area. We plan to undertake such a non-bank financial institutions sector review with the assistance of the World Bank in late 2000/early 2001, and we intend to incorporate applicable recommendations and conclu,ions from this review in the latter part of our multi-year financial sector reform program. Summary 36. We would like to summarize all the above objectives and details of our Financial Sector multiyear reformn program in the context of our request for the Bank's support for two consecutive Financial Sector Adjustment Loans as follows: Phase I December 2000-December 2001 Supported by FSAL Objectives & Proposed Actions: Reform of the Banking, law, Satisfactory creation of an independent Banking Regulatory and Supervisory Agency, Upgrading of all prudential regulations to international best practice or EU standards, Strengthening of Banking supervision, problem bank and failure resolution, strengthening of SDIF, carrying out of successful resolution of pipeline of insolvent banks, privatization of Vakif Bank, introducing autonomy in operations and governance in Emlak, Halk and Ziraat banks, launching of the privatization process for Emlak and Halk banks, phasing out of the subsidized lending through Halk and Ziraat banks, and launching the commercialization of Ziraat bank. Phase II December 2001-December 2003 Supported by State Bank Restructuring and Privatization Project and FSAL II Objectives & Proposed Actions: Completion of Privatization of Emlak and Halk Banks, Implementation of the commercialization and restructuring plans of Ziraat, Further Reformn of the Deposit Insurance Scheme, Intro(luction of broad consolidated regulation and supervision including regulatory actions required for non-bank financial institutions, and other critical financial sector reform priorities that may be necessary but not specifically identified at this time.  Annex III Page 13 of 13 37. The Government of Turkey believes that the policies and measures described above are adequate to achieve the objectives of our financial sector reform program, but it stands ready to take additional measures, if necessary to achieve the success of our program, in regular consultation with the Bank. Sincerely yours, Recep Onal Minister of State   Annex IV Page 1 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN POLICY MATRIX Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Objectives Presentation 1. MACROECONOMIC ENVIRONMENT Address main macro- * The GOT has developed a major macro- Satisfactory implementation of the macro- Satisfactory implementation of the macro- economic imbalances (e.g., economic and structural reform program, economic reform program. economic reform program. fiscal deficit and associated supported by a 3 year IMF Standby policy issues, high inflation). Arrangement. * The GOT has received an Economic Reform Loan (ERL) from the Bank that will support several structural reform measures including an overhaul of the public pension system, acceleration of privatization and reform of agricultural support policies. 11. LEGAL FRAMEWORK FOR BANKING ACTIVITY Strengthen Commercial The June 1999 Banking Law-which replaced Passage by Parliament of a set of Banking Law the previous decree law declared invalid by amendments to the Banking Law that will the Constitutional Court-still contained enhance the independence of the BRSA, major weaknesses (e.g., insufficient amend future banking sector employment independence of the new Banking Regulation rules for BRSA Board members so as to and Supervision Agency (BRSA), overly allow the best professional banking/finance restrictive rules for BRSA Board members experts to be appointed on the Board, tighten concerning future employment in the banking large/connected exposure rules and introduce sector, overly lenient large/connected efficient and cost effective mechanisms for exposure limits, and inadequate problem problem bank/bank failure resolution. bank/bank failure resolution mechanisms).  Annex VI Page 2 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Objectives Presentation I11. BANK REGULATORY AND SUPERVISION ENTITY Create a more independent In order to address the problems caused by * Passage by Parliament of amendments to * Satisfactory creation and full bank regulatory and significant political interference in the the Banking Law that will delegate operationalization of the BRSA by the supervisory entity. functions of the Treasury as the banking responsibility for bank entry/exit policy Government with appropriate operational regulator and supervisor, and to remedy the and loan loss provisioning policy to the policies and procedures, organizational duplication of responsibilities between the BRSA. structure, staffing, salaries and budgets. Central Bank and the Treasury, the June 1999 * Appointment of the Board of the BRSA * Signing of a Memorandum of Understanding Banking Law created a new independent by the Council of Ministers. between the BRSA, the Central Bank of Banking Regulation and Supervision Agency Turkey and other relevant agencies as (the BRSA), governed by a Board of necessary to ensure proper information independent professional banking/finance cxchaigc anid poiicy coordination in the cxpv[i. However, the independence of the financial sector.' new agency was somewhat compromised, as the law still left the authority for major issues such as bank entry/exit policy and loan loss provisioning policy in the hands of the political establishment (Council of Ministers). IV. PRUDENTIAL AND ACCOUNTING/DISCLOSURE RULES FOR BANKS Bring loan loss provisioning Existing Loan Loss Provisioning (LLP) rule Issuance by Treasury of a substantially * The GOT to allow full tax deductibility of policy in line with was flawed in several respects (e.g., overhauled loan loss provisioning rule all specific loan loss provisions as required international best practice exclusively performance rather than including supporting documentation (revised by the applicable LLP rule, with a phase-in standards. creditworthiness driven, allowing report formats & disclosure requirements and period beginning in 2001. inappropriate collateral to be deducted from communique detailing borrower * Further revise LLP rule to, with a phase-in exposures, using only two asset classes-- creditworthiness criteria) in line with period not extending beyond end 2002: (i) performing and non-performing loans--, international best practice standards, allowing introduce a satisfactory specific provisioning allowing certain rescheduled loans to be the banking system an appropriate period of requirement for watch (Category 2) loans, immediately reclassified as performing loans, time to build up the higher required taking into account an assessment by the etc.). Additionally, a large part of specific provisioning balances. BRSA of the credit risks associated with provisions are not tax deductible. such loans; (ii) lift the exemption from specific provisioning requirements for all agricultural support loans except for which the Government has explicitly (i.e., through This action has already been completed.  Annex VI Page 3 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Objectives _ Presentation applicable Government decrees issued) guaranteed the loans and assumed the credit risk; (iii) include a specific provisioning requirement for equity exposures; and (iv) introduce more prudent collateral classification. * Satisfactory compliance by the banking system with the requirement to build up specific provisioning balances in line with the time table specified in the new rule. Bring banking system single Existing limits, which were embedded in the Passage of amendments by Parliament to the * Issuance by Treasury/BRSA of the large/connected exposure Banking Law, were excessively lenient (e.g., Banking Law that will combine existing regulation called for in the amended limits in line with EU single large combined lending and equity lending and equity ownership limits into one Banking Law which clarifies the new limits standards. ownership of 40 percent of bank capital, use set of exposure limits, and will reduce and defines key underlying concepts such as of several separate connected lending and maximum single and group of connected 'exposures' and 'group of connected equity ownership limits which, in client exposures as a percentage of banks' clients'. combination, allow banks to run up connected capital in line with applicable EU Directives * The BRSA to monitor the banking system's exposures of more than 3 times their capital), (i.e. 25 percent of capital), allowing banks a compliance with the 75% maximum and not applied on a consolidated basis (for period of maximum six years to progressively exposure limit applicable as of January 1, banks and their financial subsidiaries reach these reduced exposure levels. 2001, as specified in the amended Banking combined). Law, and to initiate corrective actions in cases of non-compliance. Tighten FX exposure limits to The maximum open FX position limit was * Treasury to amend the existing FX rule Treasury/BRSA to announce its intention to reduce the banking system's reduced in steps from 50 percent of bank to apply it on a consolidated basis (i.e., to undertake surprise on-site examinations, in vulnerability to exchange rate capital in June 1998 to 20 percent in banks and their financial subsidiaries coordination with foreign supervisors where shocks. September 1999. However, the current FX combined) and to address other identified necessary (i.e., for banks with foreign exposure rule still suffered from several deficiencies. branches/subsidiaries), to verify compliance with weaknesses (e.g., not applied on a * Treasury to enhance the banking consolidated FX open position limits between consolidated basis, no capital charge system's compliance with the existing reporting dates. requirement, using the least conservative limit through corrective action programs method to define the maximum aggregate net for known problem banks/intervention in open position) and, in combination with the known failed (insolvent) banks. understatement of the capital base resulting from weaknesses in the loan loss provisioning rule, still allowed banks to incur major FX risks. Additionally, the rule was not consistently enforced, with several problem banks incurring excessively high exposures.  Annex VI Page 4 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Objectives Presentation Further Upgrade Capital Existing capital adequacy rule for banks is Treasury to amend the existing capital * Treasury/BRSA to revise the related Adequacy Rule. already largely in compliance with BIS adequacy rule to apply it on a consolidated consolidated financial reporting requirement standards, except that it is not applied on a basis (ie., to banks and their financial to: (i) allow quarterly verification of consolidated basis and there are no market subsidiaries combined). compliance by banks with the consolidated risk charges. capital adequacy requirement and (ii) extend coverage of consolidated reporting requirement to horizontal conglomerates. * Treasury/BRSA to amend the existing bank capital adequacy rule to introduce market risk charges for securities price fluctuation, FX and interest rate risk, satisfactory to the Bank. Strengthen Banks' Risk The June 1999 Ranking Ia introduced a BRSA to issue a risk management regulation Management. requirement for all banks to put in place requiring banks to build comprehensive risk adequate risk management systems. management systems for the management of However, this requirement does not take liquidity, credit, market, legal and operational effect until a regulation is issued which risk satisfactory to the Bank. outlines the specifics. Reform Accounting Rules for Existing accounting standards are already Treasury/BRSA to introduce revised securities Banks. largely in compliance with IAS. However, in valuation rules, pension accounting rules and some areas important to the banking system disclosure standards for banks in line with the rules are not yet fully compliant (e.g., applicable lAS securities valuation, IAS 30 and 32 disclosure requirements, and pension accounting rules).  Annex VI Page 5 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Objectives Presentation V. PROBLEM BANK/BANK FAILURE RESOLUTION Strengthen the problem bank The existing legal, regulatory and institutional Passage of amendments to the Banking Law * The BRSA to establish a special unit to deal and bank failure resolution infrastructure for problem bank and bank by Parliament that clearly define roles for all with problem banks. legal and institutional failure resolution (as embedded in the June institutions involved, clearly define * Adoption by the BRSA Board of a pre- framework 1999 Banking Law, the Central Bank Law and intervention triggers and provide the SDIF failure prompt corrective action manual for regulations on the Savings Deposit Insurance with a menu of resolution options allowing use by BRSA staff, which predefines Fund-SDIF) did not allow the authorities to least cost resolution. mandatory pre-failure intervention triggers resolve problem banks (both pre- and post- satisfactory to the Bank. failure) in a quick and cost effective manner without jeopardizing overall banking system stability. As a result, past SDIF interventions have occurred too late (due to lack of efficient pre-failure prompt corrective action mechanisms) and have taken an excessively long time to resolve at a very high cost. Resolve known universe of The above weaknesses, together with the Initiation of an action plan by Treasury Satisfactory resolution of all problem banks by problem/failed banks, using impact of the Asia and Russia crises and the covering all known problem banks, Treasury/BRSA/SDIF. the upgraded resolution resulting decline in GDP and exports, have encompassing corrective action programs mechanisms on a least cost resulted in the build-up of a sizeable pipeline administered by the bank regulatory authority basis in a quick time frame. of problem banks representing a significant and SDIF interventions. portion of total banking system assets. VI. STATE BANK COMMERCIALIZATION AND PRIVATIZATION Initiate a multi-year reform State banks account for about 40 percent of program to address issues total banking system assets and are plagued- The GOT to introduce a new mechanism for related to governance, albeit to a different extent in each bank---by a the determination of credit subsidy rates to be ownership and intermediation multitude of governance and financial used by Ziraat and Halk. efficiency of state-owned problems. Specifically, Ziraat (agriculture banks. bank) and Halk (small business bank) have for many years engaged in highly subsidized lending, resulting in a build-up of a major stock of unpaid 'duty losses' (paper claims on the Government) on their books. As a result, these two banks frequently experience liquidity shortages forcing them to bid up interest rates and distort money markets and  Annex VI Page 6 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Obiectives Presentation monetary policy. Additionally, there is a longstanding tradition in Turkey for the ownership rights in state banks to be exercised by different ministries along party lines, rather than by the Treasury as representative of the State. Vakif Vakif is a bank which is currently 75% owned * Enactment of amendments to the current The GOT to completely privatize Vakif Bank. by the State as represented by the law covering the special trust status of Government Trust Administration Department Vakif, allowing the bank to be fully on behalf of former, now extinct public and privatized. private trusts. The Government Trust * Board of Directors of Vakif to pass a Administration Devartment anpoints a!! the dJciaiuii Lu imitiate the privatization ot Directors and management team of Vakif, Vakif once the law covering Vakif s thereby in effect controlling all the operational special status has been amended to allow policies of the bank. for its privatization. Halk/Emiak For the year 2000, the GOT has budgetized * Enactment of legislation (applicable to * The GOT to develop a time bound action the flow of duty losses associated with new Ziraat, Halk and Emlak) which will plan to resolve the stock of duty losses on subsidized lending by Halk. Additionally, the remove the application of Decree Law the books of Emlak and Halk, and to issue GOT has taken action to phase out subsidized 233 and other related laws to both Emiak Government bonds and provide for interest credit, through the introduction of a new and Halk in preparation for their payments in cash on these bonds in line with mechanism for the determination of credit privatization, and that will allow the the agreed action plan. subsidy rates to be used by Halk, which has complete privatization of Emiak and * GOT to develop a comprehensive strategic first frozen and subsequently linked the credit Halk. plan and detailed corporate action plans for subsidy rate to 1.05 times the average 12 * Council of Ministers to pass a decision the commercialization and restructuring of months Treasury bill rate. As Treasury bill (unless otherwise already explicitly the operations of Halk. rates have already declined sharply a result of stated in the enacted legislation) to * The GOT to give an investment bank or strong macroeconomic stabilization efforts, initiate the privatization of Emlak and similar privatization intermediary a mandate this new mechanism has reduced the cost of Halk that would allow the Treasury a to completely privatize Emiak and Halk. credit subsidies (for both Halk and Ziraat) limited, predetermined period of time to from 1.2 percent of GNP in 1999 to an undertake pre-privatization restructuring estimated 0.6 percent of GNP in 2000 (and to and formulate privatization strategies, zero percent thereafter) and upon expiry of such time, commit the GOT to subsequent divestiture in accordance with the agreed privatization strategies.  Annex VI Page 7 of 7 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Policy Issues and Current Status Actions prior to Board Actions prior to Second Tranche Obiectives Presentation Ziraat For the year 2000, the GOT has budgetized * The GOT to contract for a first time IAS . the flow of duty losses associated with new audit for Ziraat for year-end 1999. * The GOT to develop a time bound action subsidized lending by Ziraat. Additionally, the * Enactment of legislation (applicable to plan to resolve the stock of duty losses on GOT has taken actions to phase out subsidized Ziraat, Halk and Emlak) which will the books of Ziraat, and to issue Government credit, through the introduction of a new remove the application of Decree Law bonds and provide for interest payments in mechanism for the determination of credit 233 and other related laws to Ziraat, in cash on these bonds in line with the agreed subsidy rates to be used by Ziraat, which has preparation for its privatization; allow action plan. first frozen and subsequently linked the credit Ziraat to be transformed into a joint stock * The GOT to develop a comprehensive subsidy rate to 1.05 times the average 12 company, and allow Ziraat to be fully strategic plan and detailed corporate action months Treasury bill rate, As Treasury bill privatized. plans for the commercialization, operational rates have already declined sharply a result of restructuring and financial restructuring of strong macroeconomic stabilization efforts, the operations of Ziraat. this new mechanism has reduced the cost of credit subsidies (for both Halk and Ziraat) from 1.2 percent of GNP in 1999 to an estimated 0.6 percent of GNP in 2000 (and to zero percent thereafter)  Annex V Page 1 of 1 TURKEY: FINANCI kL SECTOR ADJUSTMENT LOAN TURKEY - FINANCIAL SECTOR ADJUSTMENT LOAN ENVIRONMENTAL DATA SHEET ENVIRONMENTAL DATA SHEET FOR PROJECTS in the IBRD/IDA Lending Program Country: Turkey Project ID No: TU-PE-P0665 11 Project Name: Financial Sector Total Project Cost: US$ 757.58 million Adjustment Loani equivalent Appraisal Date: 02/01/2000 Board Date: 05/[18]/2000 Team Leader: Lalit Raina Managing Unit - ECA/ECSPF Sector: Financial Sector Est. date for receipt of EA by Bank: N/A EA Category (A/B/C): C Date Assigned: Date Sheet Prepared/Updated 4/21/1999 (Please do not leave any items blank: use "N/A" or "To be developed" when appropriate) Major Project Components: (presents description of project components) The proposed Financial Sector Adjustment Loan will provide quick-disbursing support against the Bank's standard negative list. The loan is designed lo help the Government to implement its financial sector reform program and to lay the foundation for an efficient, sound and healthy banking system capable of competing at an international level. The proposed loan is part of a larger package of adjustment lending from the Bank, including the ERL, which takes into account the support expected from the IMF and Turkey's other international partners. Major Environmental Issues: (describes major environmrental issues identified or suspected in project) None likely. Other Environmental Issues: (describes environmental i: sues of lesser scope associated with project) N/A Proposed Actions: (describes actions proposed to mitig ite environmental issues described in project) N/A Justification/Rationale for Environmental Category: (re. sons for environmental category selected & explanation of any changes from initial classification) The project will not directly finance physical investments; it will provide foreign exchange and general budgetary support. Status of Categorv A Environmental Assessment: (prese its EA start-up date, EA first draft, and current status) N/A Remarks: (gives status of any other environmental studies, lists local groups and local NGOs consulted, tells whether borrower has given permission to release EA, etc) N/A vLalit RainaSigned by: eam Leader Environment Sector Leader  Annex VI Page 1 of 2 TURKEY: FINANCIAL SECTOR ADJUSTMENT LOAN Turkey at a glance Europe & Lower- POVERTY and SOCIAL Central middle. Turkey Asba Income Development diamond' t1999 Population, mid-year (millions) 64.3 475 2,094 Life expectancy GNP per capita (Atlas method, USS) 2,900 2,150 1. 200 GNP (Atlas method, US$ billions) 186.6 1t022 25t3 Average annual growth, 1993-99 T Population (%) 1,5 0.1 1.1 G Labor force (%) 2.6 0.6 1t2 GNP primary per , rmr Most recent estiUmate (att year avaltable, 499349) capita enrollment Poveity (% of populatton below national poverty line) Ufban population (% of total Population) 74 S7 43 Life expectancy at bifrt (year) 69 69 69 Infant mortality (per 1,000 live births) 38 22 33 Child malnutrition (%ofchildren under5) 10 8 15 Access to safe water Access to improved water source (% otpoplation) .. . 86 Illiteracy f% ofpopulaton age 15+) 15 3 16 Gross primary enrollment (% otschool-age population) 107 100 114 -Turkey Male 111 101 114 Lower-middle-income group Female 104 99 116 KEY ECONOMiC RATiOS and LONG-TERM TRENDS 1979 4989 1998 1999 Economic ratios* GOP (US$ bdlions) 91.7 107.1 2012 18S.7 Gross domestic investmentlGDP 14 1 23.5 24.2 23.3 T Exports of goods and servicesvGDP 3.1 16.2 24.3 23.2 Gross domestic savings/GOP 11.5 21,9 20.6 19.8 Gross national savings/GDP 14.4 26t6 25.9 23.5 Current account balanceGDP .1.5 0.9 1,0 -047 Interest paymentsIGOP 0.3 2.5 1,7 24 Domestic Investment Total debtJGDP 17,4 38.8 48.2 54.8 Savings Total debt service/exports 28.7 32A 26.5 34.8 Present value of debt/GDP , 49. 49.9 Present value of debtlexports 160.9 Indebtedness 197949 19991 1 199 9 1999-03 (average annual gtowth) GDP 5.0 4.0 3.1 -$,I 55 - Turkey GNP per capita 2.4 2.5 2.3 -78 4 1 Lower-middle-income group Expootsf goods and servces 11.0 12.0 -7.0 5.9 STRUCTURE of the ECONOMY 1979 1989 1998 1999 Growth of Investment and GDP (%) (% of GDP) Agriculture 27.9 17.4 18.5 15 8 '