A solid banking sector is a must for the sake of the real economy. It was the self-devotion of the banks that limited the damages during the 2008 crisis.

The Central Bank of Turkey (CBT) recently has been stressing how important maintaining financial stability is. But since it does not state explicitly what it means by this, a failure in communication has emerged. Today let me explain my understanding of financial stability and how I assess the past and present decisions of the CBT, which seem to be contradictory. I think the latest decisions by the CBT imply an attempt to "revert to the known world." If you wonder why, please read on.

After the 2001 crisis, Turkey made important achievements in three key pillars. First, the modus operandi of the Ministry of Finance changed and public accounts became more transparent. We can now see more clearly how many resources and via which programs the public sector transfers them. It is now possible to conduct analyses on government debt securities (GDS). Before, you had to spend hours to access the data that are easily accessible today. Second was the change in the modus operandi of public and private banks. Bank accounts as well as transactions between public and private banks became more transparent and easily traceable. Third, with the transparency of public accounts and the banking system, the business climate in which the corporate sector operates automatically changed. A climate in which the accounts of the corporate sector would become more transparent was created. Financial stability must be placed in this three-pillar framework.

The first step to protect financial stability is to be aware of the damage price movements in the financial markets might cause to the balance sheets of banks and the corporate sector. This was why I said at the outset, when the CBT Governor Erdem Başçı first talked about the new policy framework at the end of the last year, that "therefore, under these circumstances we should expect the central banks to go beyond the standard inflation-targeting framework and be more sensitive to current account deficits, deficit finance and exchange rates. In such a milieu, central banks have to expand their set of tools and use constructive uncertainty as an effective policy tool."

If the corporate sector, aware that the exchange rate has not changed for a good while, cannot see the difference between borrowing in TL and borrowing in FX, this bad for the future of their  balance sheets. This reinforces the risk of structural damage. Similarly, it is even worse if banks have started to forget the difference between the TL and FX. This is bad for financial stability, which does not relate simply to price volatilities in financial markets. Whether structures that might cause damages to balance sheets due to any price volatility are present or not is of greater importance. Hence, maintaining financial stability is at the same time a medium-term and a short-term issue. The short-term aspect works as follows: If companies have restructured their balance sheet with a logic that says "the exchange rate has not changed in the last decade and it appears that it will not change for some time. Interest payments are low, too. Maybe I should borrow in FX terms," the rapid depreciation of the TL will bring instability. In such a climate, banks will transfer the exchange rate risk to the corporate sector and make it manage the capital risk, and channel their capital towards credits. The current monetary policy that regards financial stability must be assessed from this perspective as well.

By the end of 2010, the increasing uncertainties about the exchange rate could have been considered as a constructive uncertainty. However, the process was prolonged and no concrete measures were introduced. Yes, there was a general election approaching, but normalization could have been attempted after the elections. When the markets stepped in, thinking that the "squeaky wheel gets the grease," the CBT increased interest rates, giving the message that they wanted hot money to inflow and started to provide cheap funds to the banking sector by reducing borrowing interest in order to increase the profits of banks.

A solid banking sector is a must for the sake of the real economy. It was the self-devotion of the banks that limited the damages during the 2008 crisis. Since the consequences of a shock in the corporate sector are shouldered also by the banking sector, it would be wise to strengthen the latter without wasting time.

This commentary was published in Radikal on 19.08.2011