Turkey - Non-Bank financial institutions and capital markets report

Report No. 25467-TU Turkey Non-Bank Financial Institutions and Capital Markets Report February 2003 Private and Financial Sector Development Department Europe and Central Asia Region u Document of the World Bank  Currency Equivalents Currency Unit = Turkish Lira (TL) US$1 = TL 1,634,501 (as of February 18, 2003) Acronyms and Abbreviations A&A Accounting and Auditing ACWI All Country World Index BITT Banking and Insurance Transaction Tax BRSA Bank Regulation and Supervision Agency CBT Central Bank of Turkey CCP Central Counter Party CMB Capital Markets Board CML Capital Markets Law CPA Certified Public Accountant CPI Consumer Price Index CRI Central Registry Institution C&S Clearing and Settlement DB Defined Benefit DC Defined Contribution DDI Domestic Direct Investment EU European Union FDI Foreign Direct Investment GAAS Generally Accepted Auditing Standards GAAP Generally Accepted Accounting Principles GDI General Directorate of Insurance GDF General Directorate of Foundations ICF Investor Compensation Fund IA Independent Accountant IAS Intemational Accounting Standards IAIS Intemational Association of Insurance Supervisors IASB Intemational Accounting Standards Board IFAC Intemational Federation of Accountants IOSCO Intemational Organization of Securities Commissions IPO Initial Public Offering ISA Intemational Standards on Auditing ISE Istanbul Stock Exchange M&A Mergers and Acquisitions MSCI Morgan Stanley Capital Intemational MOF Ministry of Finance MOIT Ministry of Industry and Trade MOU Memorandum of Understanding NBFI Non-Bank Financial Institution OTC Over the Counter PC Pension Company PD Primary Dealer REIT Real Estate Investment Trust RUSF Resource Utilization Support Fund SBA Swom Bank Auditor SCPA Swom Certified Public Accountant SDIF Savings Deposit Insurance Fund SMEs Small and Medium Sized Enterprises SOE State Owned Enterprise SRO Self Regulatory Organization SSK Social Security Organization of Workers TASB Turkish Accounting Standards Board TB TAKAS Bank (securities clearing and settlement agency)  TCIB Turldsh Catastrophe Insurance Board TCIP Turkish Catastrophe Insurance Pool TMUDESK Turkish Accounting and Auditing Standards Board TPL Third Party Liability TSPAKB Turkish Association of Capital Markets Intermediary Institutions TURMOB Union of CPAs and Sworn CPAs TUSIAD Turkish Association of Industrialists and Businessmen UCITS Undertakings for Collective Investment in Transferable Securities VAT Value Added Tax VCC Venture Capital Company VCIT Venture Capital Investment Trust WAN Wide Area Network Vice President: Johannes Linn Country Director: Ajay Chhibber Sector Director: Paul Siegelbaum Team Leaders: Lalit Raina and Marie-Renee Bakker   - iii - Contents CHAPTER I IMPORTANCE OF A BROAD BASED FINANCIAL SERVICES INDUSTRY .........4 A. Why is a Broad Based Financial Services Industry Necessary9 ........................................................4 B. Outlook for the Turkish Financial Services Industry .........................................................................7 Financial Services Industry Overview ............................................................................... 7 Prominence-of Government Debt Securities in the Investment Agenda ................................9 Financial Intermediation to the Private Sector- Cross Country Comparison ....................... 10 Future NBFI and Capital Market Growth Prospects in Turkey ............................................1 I C. The NBFI And Capital Market Development Strategy Going Forward . . 12 CHAPTER II MOBILIZING SAVINGS ...................................................................... 13 A. Bringing Infornal Savings into the Formal Financial System ......................................................... 13 Informal Savings Generators .............................................................................. 13 Magnitude of the Informal Savings or Potential DDI .......................................................... 14 Policy Recommendations for Facilitating Mobilization of DDI .......................................... 15 B. Attracting Foreign Portfolio Investment .............................................................................. 16 Current Situation .............................................................................. 16 Medium Term Targets and Policy Recommendations ......................................................... 17 C. Developing an Effective Investor Compensation Scheme ............................................................... 18 Current Situation .............................................................................. 18 Policy Recommendations .............................................................................. 19 D. Developing an Investor Education Program .............................................................................. 19 Policy Recommendation .............................................................................. 20 CHAPTER m BUILDING AN INSTITUTIONAL INVESTOR BASE . . 21 A. Developing the Insurance Industry .............................................................................. 21 Current Situation .............................................................................. 21 Policy Issues .............................................................................. 24 Medium Term Targets and Policy Recommendations ......................................................... 26 B. Developing the Private Pension Fund Industry .............................................................................. 28 Current Situation .............................................................................. 28 Medium Term Goals .............................................................................. 33 Policy Recommendations .............................................................................. 33 C. Developing the Mutual Fund Industry .............................................................................. 36 Current Situation .............................................................................. 36 Medium Term Targets .............................................................................. 38 Policy Recommendations .............................................................................. 39 CHAPTER IV DEVELOPING SECURITIES MARKETS ................................................................. 40 Section 1. Deepening And Broadening Securities Markets ............................................................. 40 A. Deepening and Broadening Equity Markets .............................................................................. 40 Current Situation .............................................................................. 40 Medium Term Goals .............................................................................. 43 Policy Recommendations .............................................................................. 43 C. Developing Corporate Debt Markets .............................................................................. 47 Current Situation .......... 47 Medium Term Targets ........................... 47 Policy Recommendations ........................... 48 D. Creating A New Companies Market ........................... . 48 Current Situation ........................... 48 Medium Term Targets/Goals ................... ' 49 Policy Recommendations ................... 49 E. Developing Hedging Instruments and Formal Derivatives Markets ................................................. 50 Current Situation ..................................................... 50 Medium Term Goals and Policy Recommendations ..................................................... 50 Section 2. Enhancing The Efficiency Of Existing Markets ..................................................... 51 A. Enhancing the Efficiency of the Government Securities Market ..................................................... 51 Current Situation ..................................................... 51 Medium Term Goals and Policy Recommendations ..................................................... 53  -v V- B. Governance Reform and Privatization of the ISE ...................................................................... 54 Current Situation ...................................................................... 54 Medium Term Targets and Policy Recommendations ......................................................... 55 C. Ownership and Governance Reform of Key Market Infrastructure Institutions .............................. 56 Current Situation ...................................................................... 56 Medium Term Targets and Policy Recommendations ......................................................... 56 D. Enhancing The Efficiency of Clearance, Settlement and Registration Systems . . 57 Current Situation ...................................................................... 57 Medium Term Targets and Policy Recommendations ......................................................... 57 E. Developing the Broker-dealer Industry ...................................................................... 58 Current Situation ...................................................................... 58 Medium Term Targets and Policy Recommendations ......................................................... 60 CHAPTER V DEVELOPING OTHER NON-BANK SOURCES OF FINANCE .. 61 A. Developing the Leasing Industry ...................................................................... 61 Current Situation ...................................................................... 61 Medium Term Targets and Policy Recommendations ......................................................... 62 B. Developing the Factoring Industry ...................................................................... 65 Current Situation ...................................................................... 65 Medium Ternns Targets ...................................................................... 66 Policy Recommendations ...................................................................... 67 C. Developing the Venture Capital Industry ...................................................................... 69 Current Situation ...................................................................... 69 Medium Term Targets ...................................................................... 70 Policy Recommendations ...................................................................... 70 CHAPTER VI STRENGTHENING CONFIDENCE IN FINANCIAL MARKETS .. 73 Section 1. Market-W ide Objectives ...................................................................... 73 A. Improving Corporate Governance ...................................................................... 73 Current Situation ...................................................................... 73 Medium Term Target and Policy Recommendations ........................................................... 73 B. Strengthening Accounting and Auditing Standards and Practices ................................................... 76 Context ...................................................................... 76 Current Situation ...................................................................... 77 Medium Term Objectives ...................................................................... 81 Policy Recommendations ...................................................................... 83 Section 2. Strengthening Financial Sector Regulation and Supervision .......................................... 86 A. Strengthening Regulation and Supervision of the Securities Markets . . 86 Current Situation ...................................................................... 86 Medium Term Goals ...................................................................... 88 Policy Recommendations ...................................................................... 88 B. Strengthening Regulation and Supervision of Insurance .................................................................. 90 Current Situation ............................................ 90 Policy Recommendations ............................................ 92 C. Strengthening Regulation and Supervision of Pension Funds ............................................ 94 Current Situation ............................................ 94 Medium Term Goals ............................................ 95 Policy Recommendations ............................................ 96 D. Rationalizing the Financial System Regulatory and Supervisory Agency Structure . . 96 Current Situation ............................................................ 96 Policy Recommendations ............................................................ 98 E. Extending Consolidated Supervision to Conglomerates ............................................................ 99 Current Situation and Rationale ............................................................ 99 Policy Recommendations ............................................................ 100  Tables Table 1: Overview of the Financial Sector ............................................................................8 Table 2: Public Sector Debt ............................................................................9 Table 3: Financial Sector Depth-Cross Country Comparison ........................................................................... 10 Table 4: Projected NBFI and Equity Market Growth Based on Key Economic Indicators ........................................ 11 Table 5: Overview of The Insurance Industry ........................................................................... 21 Table6: Insurance Sector Premium Volumes ........................................................................... 21 Table 7: Insurance Sector Loss Ratios ........................................................................... 22 Table 8: Insurance Industry - Risk Sharing Characteristics ........................................................................... 22 Table 9: Insurance Industry Asset Allocation ........................................................................... 24 Table 10: Cross Country Comnparison of Premium Volumes, Insurance Density and Penetration . . 24 Table I 1: Overview of Private Pension Schemes ........................................................................... 31 Table :12: Cross Country Comparison - Private Pension Fwud Assets as % of GDP . . 33 Table j13: Open Ended Mutual Funds in Turkey and Comparator Countries ............................................................. 37 Table 14: The Turkish Govermment Debt Market ........................................................................... 40 Table 15: The Turkish Equity Market ........................................................................... 41 Table j16: Market Capitalization - Cross Country Comparison ........................................................................... 42 Table17: Free Float of Largest ISE Listed Companies ....................................................... 43 Table 18: Domestic Debt Securities - Cross Country Comparison ...................................................... 47 Table 19: Shares of On- and Off-ISE Government Securities Trading ...................................................... 52 Table'20: ISE Transaction and Registration Charges for Government Debt .........................................................52 Table 21: Equity and Government Debt Market Tumover ...................................................... 59 Table!22: Number of Broker Dealers ...................................................... 59 Table'23: Lease Penetration - Cross Country Comparison ...................................................... 61 Table'24: Development of the Turkish Leasing Industry ...................................................... 62 Table'25: Factoring - Cross Country Comparison ...................................................... 65 Table' 26: Development of the Turkish Factoring Industry ...................................................... 66 Table 27: Annual Growth Rates of Factoring Tunover ...................................................... 67 ]Figures Figure 1: Financial Depth and Per Capita Income .......................................................4 Figure 2: Ratio of Bank Assets to Market Capitalization and Per Capita GDP ....................................................... 5 Figure 3: Growth of Mutual Fund A ssets ...................................................... 38 Figure 4: ISE National 100 Index Return ...................................................... 41 Figure 5: The Turkish Efficiency Frontier ...................................................... 42 Figure 6: Venture Capital - Private Equity Investment as % of GDP in 2001 - Cross Country Comparison ............ 69 Boxes Box 1: Tax Structures for Private Pension Schemes ............................................................................ 35 Box 2: Potential for Listing Turkish Companies ............................................................................ 44 Box 3: Avoiding Double Taxation of Equity Investments ............................................................................ 46 Box 4: Self Regulation ............................................................................ 57 Box 5: State of Development and Advantages of Leasing ............................................................................ 63 Box 6: State of Development and Advantages of Factoring ............................................................................ 66 Box 7: Venture Capitalist Funding ............................................................................ 71 Box 8: Discrepancies between Turkish and International Accounting and Auditing Standards ................................ 82 Box 9: EU Accounting and Auditing Requirements ............................................................................ 84 Box10: The New EU Directive on Prudential Supervision of Financial Conglomerates . ........................... 100 Annexes Annex 1: Free Float Requirements - Cross Country Comparison Annex 2: Tax Integration Systems for Income on Equity Investmnents Annex 3: Electronic Bond Trading Platforms Annex 4: Suggested Changes to Selected CMB Communiqu6s Annex 5: Models for Cooperation Among Financial Sector Regulatory/Supervisory Agencies Annex 6: Financial Conglomerates - Issues and Approaches  -vi - Acknowledgements This report was prepared by Lalit Raina (FSD/PSD Program Team Leader for Turkey/Lead Financial Sector Specialist, ECSPF) and Marie-Renee Bakker (Task Team Leader for the NBFI/Capital Markets Study for Turkey/Lead Financial Sector Specialist, ECSPF). Noritaka Akamatsu (Lead Financial Economist, OPD), Donald McIsaac (Lead Specialist, OPD), John Hegarty (Manager, ECSCS), Sue Rutledge (Senior Private Sector Development Specialist, ECSPF), Gurhan Ozdora (Senior Operations Officer, ECSPF), Tanis MacLaren, Serap Oguz Gonulal, Graham Glenday and Amaijeet Singh (Consultants) all provided input into the report. Field visits were made in July and December 2001 and June 2002. The report was prepared in close consultation with the Turkish Capital Markets Board and the Undersecretariat of Treasury, who are the main counterparts for the NBFI/Capital Markets Study. Several other public and private institutions were also consulted, including the Bank Regulation and Supervision Agency, the Ministries of Finance, Industry & Trade and Justice, the Istanbul Stock Exchange, TAKAS Bank, the Association of Insurance and Reinsurance Companies, the Association of Leasing Companies, the Association of Factoring Companies, the Association of Turkish Capital Markets Intermediary Institutions (TSPAKB), the Union of Certified Public Accountants and Swom Certified Public Accountants (TURMOB) and the Association of Turkish Industrialists and Businessmen (TUSIAD), as well as several Turkish and foreign owned banks, insurance, reinsurance, leasing and factoring companies, pension funds and securities furms.  Executive Summary Turkey's financial services industry is in an early stage of development, with credit markets dominated by banking (accounting for over 85% of financial system assets in 2001), and capital markets dominated by Government securities (accounting for over 90% of trading). Non-bank financial institutions (NBFIs) such as insurance companies, private pension and mutual funds, leasing, factoring and venture capital firms together account for less than 15% of financial system assets and just over 10% of GNP. The equity market has shrunk in recent years and market capitalization accounted for only around 30%.of GNP in 2001; it is estimated that this percentage fell further to around 20% in 2002. Corporate debt markets don't exist and organized derivative markets are still in their infancy. Lack of depth and breadth has made the financial services industry vulnerable to shocks resulting in repeated crises, and has reduced its intermediation efficiency to the detriment of private sector growth. Longstanding macro-economic instability and inflation have discouraged investment in financial assets, and a persistently high Public Sector Borrowing Requirement has crowded out, funding for the private sector. The Government's ongoing stabilization and structural reform efforts, however, are improving the prospects for development of the financial services industry. To capitalize on this opportunity, and to ensure that rapid 'catch-up' growth of selected parts of the financial system does not create new vulnerabilities, a series of key policy issues should be addressed. This study identifies these issues and formulates recommendations for addressing them. The study is organized as follows. Chapter I outlines the advantages of a broad based, diversified financial services industry, lays out the evidence of a clear correlation between financial system development and per capita income, and analyzes the outlook for the financial services industry over the next 3-5 years. Based on historic growth trends, estimated future economic growth and the experiences of other emerging and developed economies, it is argued that NBFI assets have the capacity to more than double to around 16.5% of GNP. While equity and corporate debt markets are likely to take somewhat longer to develop, they are also expected to grow very rapidly from their current low/zero base. Chapters II-VI focus on the key elements of a strategy for developing NBFIs and capital markets: (i) mobilizing savings; (ii) building an institutional investor base; (iii) broadening, deepening and enhancing the efficiency of securities markets; (iv) developing other non-bank sources of finance; and (v) strengthening confidence in financial markets. Chapter II (mobilization of savings) describes the extent to which macro-economic uncertainty, chronically high inflation and ill-suited tax policies have driven a significant portion of savings into real estate, gold, mattress money and overseas bank accounts. Key recommendations to redirect savings into the formal financial system include: (i) developing a tax system that creates a more level playing field for all types of investment assets, and that encourages the investment of savings in longer term/risk based instruments; (ii) phasing out, circumstances permitting, the Dresdner accounts at the Central Bank used for mobilizing savings of Turkish citizens living abroad, to allow these savings to be mobilized through the'regular financial system; (iii) mobilizing gold deposits into the banking system; (iv) educating the public on investments in financial instruments and their rights in case of financial institution failures; and (v) extending the coverage provided by the newly created Investor Compensation Fund (ICF) to debt instruments, and equalizing the compensation of retail depositors by the Savings Deposit Insurance Fund (SDIF) and retail investors by the ICF once the blanket guarantee currently in place for all bank creditors has been lifted. A targeted public relations campaign should support these measures. Chapter mIl (building an institutional investor base) lays out the key issues in developing the insurance, private pension and mutual fund industries. Insurance penetration (premiums as percent of GNP) and density (premiums per capita) are very low in Turkey, at 1.3% of GNP and US$30 respectively (2001). Key recommendations to develop the insurance industry include: (i) upgrading the legal and  regulatory framework to EU and IAIS' standards; (ii) enhancing the quality and independence of insurance supervision; (iii) addressing the high level of industry fragmentation and the captive agency system; (iv) proactively promoting the use of new types of insurance (e.g., for earthquakes and agriculture); and (v) rationalizing the taxation of both insurance companies and insurance products. Chapter m also documents the little noticed existence of a multitude of private pension schemes with estimated assets under management of around 2.3% of GNP. Most of these schemes are not properly regulated and supervised, as a result of which some have excessive asset concentrations (e.g., Is Bank's pension fund is over 90 percent invested in Is Bank shares) or inappropriate equity holding structures (e.g., Oyak - the army pension fund - is a financial-industrial conglomerate rather than a portfolio investment vehicle). Key recommendations to develop the private pension fund industry include: (i) further reforming the state social security scheme to create more room for contributions to private pension schemes; (ii) bringing pension fund regulation and supervision up to best practice standards (as outlined by the OECD), and applying these standards to all types of private pension schemes; (iii) creating an integrated, independent private pension fund regulatory structure to replace the current system with multiple agencies having jurisdiction over separate schemes or elements thereof; (iv) reducing the minimum capital requirement for pension companies to the amount required for life insurance companies, to allow the latter to compete with pension companies on a level playing field; and (v) rationalizing and harmonizing the tax regimes applicable to the different types of schemes. The mutual fund industry in Turkey is still very small (around 3% of GNP in 2001) and highly fragmented, with a few players accounting for the majority of assets under management. Key measures to further develop the mutual fund industry include: (i) encouraging fund consolidation; (ii) harmonizing regulations with the UCITS directives of the European Union (EU); (iii) strengthening corporate governance provisions to ensure directors and managers act in the best interest of investors; and (iv) rationalizing taxation. Chapter IV describes the current state of development of the equity, debt and derivatives markets, and points to a large potential for the corporate sector to enhance the use of the equity market as a source of long term investment finance. Key policy recommendations to exploit this potential include: (i) increasing the minimum free-float requirement, including for majority state-owned enterprises (some of which have been exempted from the current already very low 5% minimum free float requirement); (ii) streamlining IPO clearance procedures and abolishing the tax on IPOs; (iii) simplifying and strengthening enforcement of Istanbul Stock Exchange (ISE) listing rules, especially conceming information disclosure; (iv) educating issuers on their ability to maintain control with less than majority ownership; (v) using privatization to deepen equity markets; (vi) developing a market segment on the ISE dedicated to small/new companies; and (vii) reducing the tax burden on equity investments through a tax integration structure that avoids the double taxation of dividend income. The key policy recommendations for developing corporate debt markets are: (i) lengthening of the maturity profile of Government debt, to create room initially for a short term commercial paper market and subsequently a corporate bond market, (ii) establishing a tax level playing field between Government and corporate debt, (iii) developing credit rating, securities registration and disclosure systems, and (iv) further strengthening of creditor rights through upgrading of collateral and bankruptcy legislation. To allow better hedging of risks by financial institutions, investors and issuers (including the Government itself), the Istanbul Futures and Options Exchange should be operationalized and the range of exchange traded instruments should be expanded to include interest rate/Treasury security futures. Capital rules for broker-dealers should provide appropriate credit for risk reduction through use of derivative positions. Investment restrictions for capital market participants should be reviewed to ensure that they do not unnecessarily limit the use of derivatives. To further enhance the efficiency of market infrastructure institutions and trading systems the following measures should be considered: (i) abolishing the registration fees for off-ISE trades in Government securities; (ii) organizing over-the-counter (OTC) trading in Government securities through an electronic bond trading platform; (iii) developing a strategy for privatization and subsequent I Intemational Association of Insurance Supervisors.  -3 - demutualization of the ISE; (iv) addressing potential conflicts of interest in the monopolistic nexus of market infrastructure institutions (i.e., ownership linkages between the ISE, Takas Bank (the securities clearing & settlement agency) and the new Central Registry Institution); (v) shortening the time frame for achieving full dematerialization of securities; (vi) creating a National Clearing House to further simplify and reduce the costs of securities registration; (vii) encouraging consolidation of the fragmented securities industry; and (viii) reviewing the role of TSPAKB, the organization of broker-dealers, as a self-regulatory organization. Chapter V focuses on the current state of development and best ways to further develop the leasing, factoring and venture capital industries - all important sources of finance for small and medium sized enterprises (SMEs). Market penetration of leasing (percent of fixed asset investments financed through leasing) is still low in Turkey at around 3.9% (2001). Key recommendations to develop the leasing industry include: (i) upgrading the leasing law and regulations to allow more modern forms of leasing; (ii) encouraging industry consolidation; and (iii) rationalizing taxation. While export factoring is fairly well developed in Turkey, the overall factoring volume at around 2.5% of GNP (2001) is still low. Key recommendations to develop the factoring industry include: (i) new legislation to separate factoring from money lending; (ii) encouraging industry consolidation, (iii) rationalizing taxation; and (iv) further upgrading creditor rights to allow faster foreclosure on factoring receivables. Export insurance coverage by the Turkish Export-Import Bank for important Turkish export destinations where a local factoring industry does not exist could also be considered. Venture capital is almost non-existent in Turkey, with only one company active at the moment. To develop the venture capital industry, it will be necessary to address the capital markets development issues oullined above, to ensure easy exit for venture capital investments once they mature. Additional policy recommendations for developing the venture capital industry include: (i) allowing institutional investors such as insurance companies, private pension funds and mutual funds to invest a certain percentage of assets in venture capital companies; (ii) undertaking a study of the most appropriate form of venture capital company and of programs successfully used in other countries to 'seed' the industry; and (iii) putting such a 'seed' program in place in Turkey. Finally, Chapter VI focuses on ways to strengthen confidence in financial markets, by improving corporate govemance, accounting & auditing standards and practices, and financial services industry oversight. In the area of corporate governance, the key recommendations are: (i) faster operationalization of the new Central Registry Institution and modernization of company registers; and (ii) strengthening of the roles of Boards of Directors and general shareholders meetings, and training of directors. The current 'stove pipe' approach to accounting & auditing, where each regulatory agency sets accounting standards and approves auditors for the entities under its jurisdiction, should be replaced with a common, pure IAS accounting platform for all financial institutions and listed/publicly held institutions. Financial sector regulatory agencies should supplement this platform with industry specific prudential reporting requirements as necessary. A Chamber of Auditors tasked with certification and enforcement responsibilities for the use of ISA-based standards should be created to oversee the audit profession. Chapter VI, while containing specific recommendations for further strengthening of regulation and supervision of capital markets, insurance, and private pension funds, also points to the need to rationalize the atomized oversight structure, where multiple regulatory agencies are responsible for regulating and supervising an increasingly integrated financial services industry dominated by large financial-industrial groups. As a first step, consolidated supervision across traditional industry boundaries should be developed to identify and address risks inherent in such conglomerates. Consideration should also be given to developing a holding company regime for financial and mixed conglomerates. In the longer term, integration of all financial sector regulatory agencies into one common oversight structure may be desirable.  CHAPTER I IMPORTANCE OF A BROAD BASED FINANCIAL SERVICES INDUSTRY A. Why is a Broad Based Financial Services Industry Necessary? 1. Financial Sector Depth and Breadth is Essential for Economic Growth. The experiences of a series of financial crises around the world in recent years in East Asia, Russia, Latin America and Turkey have clearly demonstrated the rather devastating economic consequences of weak financial systems in these countries. Failed financial institutions and extreme macroeconomic volatility have often led to widespread loss of wealth, and negative economic growth in the aftermath of those crises. On the other hand, during stable non-crisis periods, an effective financial infrastructure competently delivering essential services can, and often has, made a large difference to a country's economic development. Deep and broad financial markets have invariably enhanced access to finance for more firms and individuals at acceptable cost, and reduced volatility, distortions and risk by improving transparency, competition and diversity of products and services. Improvements in financial architecture therefore quite often precede and contribute to economic performance in most countries. In all advanced economies, for example, sophisticated financial systems efficiently delivering a broad range of financial services have been a critical pillar in contributing to macroeconomic stability and sustained economic growth and prosperity. Growth in private credit volumes and equity market capitalization as a percent of GDP have consistently been correlated with growth in per capita income (Figure 1). Thus, robust growth and effective functioning of a full service financial system is essential for economic development and prosperity2. Figure 1: Financial Depth and Per Capita Income Private credit as percent of GDP Market capitalization as percent of GDP (median and quartiles by income (median and quartiles by income level) level) 100% 125% 80%- 100% 60%- 75%- 40%- 50%- 25% 2 20% - 0% 0% Low Low Upper High Low Low Upper High income middle middle income income middle middle income income income income income Source: World Bank (Beck Demirguac-Kunt, and Levine (BDL) database). Note: This figure represents the average of available dates in the 1990s for each of 87 countries. 2. There should be a structural balance between bank and non-bank financial Intermediation in a financial system-they are both equally important and are complements, not substitutes. Banks, securities markets, and a range of other types of intermediary and ancillary financial firms like insurance, leasing, factoring and venture capital comnpanies, and mutual and pension funds all contribute 2 The relationship between finance and econornic growth has been explored in detail in the World Bank Publication "Finance For Growth" by Caprio and Honahan (2001), and applicable research findings have been reproduced here.  - - to a balanced financial sector able to successfully meet a wide variety of financing needs of individuals, businesses and the public sector. Banks dominate financial systems in most countries, but in some of the most advanced countries the ratio of equity market capitalization to banking system assets is very high, and there is a general tendency for the market-to-bank ratio to increase with the level of development (Figure 2). Firms in successful economies reach a mixture of bank and equity market development that suits their own particular financing needs and institutional structures; the higher the level of income and revenue growth, the more likely that mixture will be weighted toward equity. Development of different segments of the financial system challenges the other segments to innovate, to improve quality and efficiency, and to lower prices. Thus, the correct policy choices should include promoting an appropriate degree of diversity in channels for financing, along with a balanced set of incentives for complementary development of banling and non-bank financial institutions (NBFI) and markets in promoting economic growth. 3. Development of the securities markets-equity as well as debt-and of leasing, factoring, and venture capital is likely to provide sufficient competition against excess profits in banking. In developing economies with lower per capita income, the banking system is more deeply entrenched than NBFIs and securities markets, and the value of bank assets tends to be a larger multiple of equity market capitalization than in higher income countries (Figure 2)3. With so much of Figure 2: Ratio of Bank Assets to Market Capitalization the borrowings by firms coming from and Per Capita GDP banks, the borrowing cost depends on the operational efficiency and 10 competitiveness of the banking market. In many developing economies, interest rate liberalization, 8 especially if not accompanied by large-scale ownership change and enhanced banking sector competition, 6 has often been associated not only with' higher wholesale interest rates, 4 but also with a widening of intermediation spreads-at least partly reflecting increased exercise of market 2 power by banks. One path to lower * * * - financing costs through increased 0 - $40,000 competition in financial markets is S200 S3,000 $40,000 through the development of securities GDP per capita (ratio scale) markets-both debt and equity--and leasing/factoring and venture capital Source: World Bank financing. 4. , NBFIs provide alternative financial services, and therefore improve general system-wide access to finance, facilitate longer term investments, and match funding sources with investments based on appropriate risk-return characteristics. Since banking is financed mostly by depositors and there are limitations to the type and nature of financing risks that banks can easily undertake, bank-credit is more appropriate for trade finance, retail consumer finance, short term working capital and medium term investments with clear secured collateral arrangements. However, in cases where the creditworthiness of borrowers cannot be clearly established, or adequate collateral may not be available, 3~~~~~~~~~~~~~~~~~~~~ High growth economies are most often middle income countries rather than low income ones because successful import-substituting/export-promoting industrialization accelerates economic growth. If an economy has an equity market, its capitalization as an indicator of future income growth grows exponentially at that stage. That is why there tend to be outliers among middle income countries.  - 6 - or the viability of proposed ventures may be uncertain, leasing4, equity and venture capital financing may be the most appropriate mechanism to match financiers to the type of ventures being undertaken. These are also key to ensuring that smaller-scale firms can get access to financing at reasonable cost. Development of such altemative financing vehicles adds to the liquidity and diversity of the financial system, thereby increasing its effectiveness as an engine for economic growth and enhancing the financial system's capacity to absorb shocks. 5. The growth of contractual/coflective savings institutions, like insurance companies, pension funds and mutual funds, widens the range of savings media available to persons of moderate wealth, and provides competition for bank deposits, thereby mobilizing long term funds necessary for the development of equity and corporate debt markets and leasing, factoring and venture capital financial services. By creating a pool of long term capital, they also generate demand for long- term investments (required by life insurance providers and firms selling annuities if they are to match their obligations with assets of comparable maturity), thereby providing a market-based solution to a perceived financing gap and rendering costly and distorting Govemment financing and subsidy programs unnecessary. Similarly, private pension funds in need of long term, lower risk fixed income securities to match their liabilities are often a positive force for the development of broader and deeper sovereign and corporate bond markets. In fact, the development and strengthening of the capital markets and of managed funds often go hand in hand. In addition, in both mature and emerging markets, contractual savings institutions and collective investment vehicles have been central in supporting numerous market- based financial innovations, such as asset-backed securities and the use of structured finance and derivative products, including index-tracking funds and synthetic products that protect investors from narket declines. Catastrophic risk bonds placed by insurance companies are yet another example of the financial innovations emerging from this segment, and the process is likely to continue, with an apparent market gap in longevity-based derivatives. The associated learning and human capital formation, as fund managers tool up to employ such techniques, helps to enhance the quality of risk management throughout the economy. Thus, contractual savings institutions expand the range and depth of financial services provided not only to their own policyholders/unit holders and plan participants, but to a much wider range of financial and real sector actors. 6. Contractual savings institutions, because of their financial strength, can be a significant driver of market reforms in the areas of quantitative and qualitative information disclosures and corporate governance. Mutual funds and pension funds constitute large blocks of significant investors with the muscle to expect and demand comprehensive rules and legislation for improving market integrity, efficiency of trading mechanisms, and corporate governance including better information disclosure to, and protection of, minority shareholders. However, the impact of such block ownership is not usually effective until their equity holdings have reached a critical mass of, say, 20 percent of the market, a level that may take some time to be achieved: in particular, the accumulation of block ownership by pension funds is a gradual process5. While the emergence of private pension funds is neither necessary nor sufficient for a well-functioning equity market, it is thus well worth ensuring that the preconditions for contractual savings development are in place. This is true not only for the longer- term benefits that will accrue to pensioners, policyholders, and other customers, but also for the spill-over effects that can result for financial sector development if the pension fund industry is competitive and innovative. 7. Opening equity markets to foreigners improves efficiency and transparency. For a country that has an active equity market, opening that market to foreign investors is a decisive step that can be expected to influence the level and dynamics of asset pricing. More than thirty sizable stock exchanges in 4 Leasing finances nearly one third of investments in some OECD countries. See also Chapter V: "Developing the Leasing Industry". 5 Block pension fund ownership impact also will not happen where the strategy of the funds is to take majority shares in affiliated firms, as is the case for the main pension funds in some countries.  emerging market economies implemented significant liberalization, mostly during the mid-1980s to the mid-1990s. Even though liberalization of capital flows, and increased participation by foreigners increases the possibility of hot portfolio money flows and perception of increased market volatility and instability, the overall results from emerging markets show that equity values in terms of price-earnings ratios have been brought up to the standards prevailing in developed markets over time, thereby lowering the co$t of capital, without an undue increase in volatility. Opening up has also accelerated improvements in disclosure and the efficiency of the local equity markets, even though these have lost some of their share of the increased business in the listing and trading of local equities to overseas markets. Similarly, ownership of domestic banks and NBFIs by reputable foreign financial institutions fosters innovation and brings enhanced competition and use of best practice risk management techniques to the domestic financial system, thereby enhancing both its efficiency and safety. 8. In conclusion therefore, the development of NBiIs and capital markets in parallel to the development of the banking system is vital because it enables: * Mobilization of savings (for which the outlets would otherwise be much more limited); * Accelerated economic growth through increased availability of funding and more efficient allocation of capital for productive investment by the private sector, and improved access to alternative sources of finance, including for small and medium sized enterprises (SMEs); * Better management of systemic financial risk (reducing it through aggregation and enabling it to be carried by those more willing to bear it); * Development of secondary capital markets, improving price discovery and valuation of financial assets and productive entities, and improving liquidity by facilitating efficient capital entry and exit; * Better corporate governance and monitoring of managers (so that the funds allocated will be spent as envisaged); * Building of a financial information and analysis service industry to assist investment management and research. B. Outlook for the Turkish lFinancial Services Industry FInancial Services Industry Overview 9. In spite of all of the macroeconomic and political instability In Turkey, the financial sector has grown both In absolute terms and as a % of GNP, although the sector is stiU dominated by banking (Table 1). Total assets of Turkish financial institutions in both absolute US$ terms and as percent of GNP increased during the period 1996-2001 (from US$93.5 billion to US$133.6 billion, and from 50.91 to 91.43% of GNP), and the year-on-year growth rate of financial system assets has been significantly above the year-on-year growth rate of GNP during the past five years (by the same token, the decline in financial sector assets in 2001 when GNP contracted sharply also has been less than the decline in GNP). The growth would have been even higher but for the macroeconomic and banking crises in 2000-2001 causing a severe shrinkage and loss of wealth in the financial sector. 10. The NBFI segment of the financial system grew from a low base of US$103 billion in 1996 to US$14.8 billion in 2001, and as a share of GNP it almost doubled from 5.63% in I996 to 10.1% In 2001. Within the NBFI segment, except for the recession year 2001, the insurance sector has displayed low' but steady growth. The leasing and factoring business has seen ups and downs with the economic cycle, while investment funds riding on the back of the rapid expansion of the Government securities market have been growing fastest. The assets of private pension funds6 are estimated to have grown rapidly as well, although the 2001 crisis inflicted serious losses on some of these funds. 6 There are several such funds in Turkey, including Oyak, the anny pension fund. See Chapter III: "Developing the Private Pension Fund Industry" for more detail.  -8 - Table 1: Overview of the Financial Sector (US$ million) 1996 1997 1998 1999 2000 2001 NUMBER OF FINANCIAL INSTITUTIONS 571 711 776 816 884 865 Banks (incl. inv. & dev. banks and special finance houses) 75 78 81 87 85 66 Insurance conVanies 62 65 68 66 68 68 Laing, factoring and consumer finance companies 112 169 182 199 215 210 Securities dealers 101 142 143 136| 133 130 Investment funds (open & closed end) 138 174 219 245 300 308 Pension funds 83 83 83 83 83 83 TOTAL ASSETS OF FINANCIAL INSTITUTIONS 93466 104,781 131,618 14942 17407l 193 Banks 83,123 94,417 117,483 133,214 154,582 118,837 NBFI-incl. 10,343 10,364 14,135 16,213 19,494 14,756 -Insurance companies 1,960 2,183 2,860 3,698 4,185 3,023 -Leasing, factoring & consumer finance companies 3,175 3,070 4,944 4,470 6,050 3,442 -Securities dealers 837 568 975 865 1,011 653 -Investment funds (open & closed end) 1,121 1,043 1,60 3,180 3,883 4,273 -Pension funds 3,250 3,500 3,750 4,000 4,365 3,365 PERCENTAGE DISTRIBUTION 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%