Turkey's big lenders will likely suffer declines in annual profits as May elections spur government efforts to force banks out of US dollar assets.

The government's "increasingly burdensome" de-dollarization drive "will put downward pressure on profitability" in 2023, according to an April 13 banking risk analysis by S&P Global Market Intelligence. Rules were tightened further in April, with new obligations to buy local-currency government bonds and higher reserve requirements for foreign-currency deposits.

De-dollarization at banks forms part of President Recep Tayyip Erdoğan's unorthodox push to cool high inflation, while still cutting interest rates, by making the lira the only medium of exchange in domestic commercial transactions. The populist policies have fueled a currency collapse, as well as pressing banks' earnings, and the drive could lead to even tighter restrictions if Erdoğan's AK Party prevails in the upcoming polls, according to Serhan Gok, an Istanbul-based economist and fund manager at Arista, a recently launched investment fund.

An Erdoğan win could leave the banking sector "in its current limbo state for longer than expected," Gok told Market Intelligence. Continuing populist measures may lead to severe capital controls, he said.

These challenges mean that net income at Turkiye Garanti Bankasi AS, which is owned by Spain's BBVA, will likely fall 18% to 44.15 billion lira this year, according to analyst estimates compiled by S&P Global Market Intelligence. State-owned Türkiye Halk Bankasi AS will see a 15% decline and state-owned Türkiye Vakiflar Bankasi Türk Anonim Ortakligi will have a 33% slump, the data shows. Estimates for the largest state-owned bank, Türkiye Cumhuriyeti Ziraat Bankasi AS, were not available.

Garanti Bank, Halkbank, Vakiflar Bank and Ziraat Bank did not respond to requests for comment. Turkey's banking association declined to comment.

The government aims to raise the percentage of lira deposits in the banking system to 65% in the first half. They were just 59.2% at the end of March, according to bank regulator figures cited by Bloomberg News. Banks boosted lira deposits significantly in 2022, Market Intelligence data shows.

Liraization was invented "as a clever way of avoiding a system failure," Gok said. It helps "to convince depositors to remain in lira deposits despite sharply negative real lira interest rates," he said.

The accelerated shift in the deposit mix will be costly for banks and threatens "to intensify risks during the transition," according to a Jan. 4 banking risk analysis by Market Intelligence. Still, it will be "risk-positive" once accomplished, the note said.

The most recent rule changes mean that banks must buy seven percentage points of additional local currency-denominated government bonds if less than 60% of their total deposits are in lira. Depositors are encouraged to save in state-backed depreciation-protected lira accounts.

The flurry of new banking rules is unparalleled micro-level management that includes boosting credit to preferred small businesses and individuals, as well as capping interest rates amid soaring funding costs, Gok said.

Requirements for high rates on savings accounts and caps on loan rates are squeezing banks' net interest margins. Net interest income (NII) — the difference between interest earned on loans and that paid on deposits — is set to decline 39% in 2023 at Halkbank, according to analyst estimates. Garanti Bank's NII is expected to fall in dollar terms, while slightly rising in lira. Data for Vakiflar Bank and Ziraat Bank was not available.

Challenges for overseas owners of Turkish banks are exacerbated by the lira's 80% slump since 2018, as this cuts the repatriated value of units' profits. Qatar National Bank QPSC, Emirates NBD Bank PJSC and Kuwait Finance House KSCP all have Turkish subsidiaries, along with BBVA.

These foreign-owned banks still lend to their major customers because they will need them "when this nightmare ends," Arda Tunca, an independent Turkish economist, told Market Intelligence. "Banks' pricing mechanism is totally frozen," he said.

Government support for state-owned banks, which have explicitly removed profitability from their strategies, is a further challenge for lenders. State banks get yearly capital injections to support growth strategies, which creates "unfavorable competitive dynamics" and a "politically driven, inefficient banking system," Gok said.

Turkey's sovereign wealth fund also provided 111.7 billion lira in combined funding to Ziraat Bank, Halkbank and Vakiflar Bank on March 29, with the trio expected to increase their lending ahead of the election, including help rebuild areas affected by a 7.8-magnitude earthquake that struck in February.

"Those banks are playthings of the government," Tunca said. "When it needs to support certain industries or parts of society, [they] are out in full force."

As of May 1, US$1 was equivalent to 19.46 Turkish lira.