The North Cyprus banking sector: the effect of a speculative attack on the Turkish Lira.

Abstract

Purpose--The purpose of this research is to investigate the effect of a speculative attack on the Turkish Lira in the North Cyprus banking sector during the period 1984-2002.

Design/methodology/approach--A mutivariate logit model is the empirical methodology employed in this analysis that allows us to identify the determinants of the probability of bank failure. In the model, the existence of contagious currency crises is constructed as an index of exchange market pressure, which is a weighted average of changes in interest rates, international reserves and the nominal exchange rate.

Findings--The empirical result reveals that the a speculative attack on the Turkish Lira in 1994 and 2001 put stress on banks operating in North Cyprus and led to banking sector distress. The findings also suggest that bank-specific weaknesses, high interest rates, high credit, low trade and the fixed exchange rate policy significantly increased the bank fragility.

Research implications/limitations--For further research this paper may better distinguish contagion if it uses economic and financial ties from Turkey that are practically susceptible to bank failure in North Cyprus.

Practical implications--This paper presents a practical application of a currency crisis model in the North Cyprus banking sector. In addition to the risk of currency crises, risk under fixed rate regimes, interest rate risk, trade risks and credit risk are also used to encourage correct risk management behaviour in the North Cyprus banking sector.

Originality/value--This analysis would appear to be the first systematic evidence that investigates the effect of a speculative pressure on Turkish Lira in the North Cyprus banking sector.

Keywords Cyprus, Turkey, Banking, Foreign exchange, Market forces, Financial risk Paper type Research paper

Introduction

After the division of Cyprus in 1974, the North Cyprus Government started to be persistently, economically and financially dependent on Turkey. As the official currency in North Cyprus is Turkish Lira, the monetary policy of the Turkish Cypriots tends to be geared to the economy of Turkey, with little reference to the situation in North Cyprus. In this sense, due to the unstable economic situation in Turkey, the North Cyprus economy has also suffered from the continuous deterioration of macroeconomic fundamentals (such as destabilizing, rapid devaluation and high inflation) for many years.

The North Cyprus economy has experienced two banking sector distress periods. The first took place in 1994 and the second took place between the years 2000 and 2002. In early 1994, the economic fundamentals in Turkey were deteriorating. Particularly, there was a continuing devaluation of the TL, which resulted in a serious currency crisis. As there is a close monetary and economic link between Turkey and North Cyprus, as a consequence of the financial distress experienced in Turkey in 1994, banks in North Cyprus were also affected. In 1994 two banks, namely Everest Bank Ltd and Mediterranean Guarantee Bank Ltd, were placed under the control of the TRNC Ministry of Finance. Later, these banks had to be bailed out by the Government.

The North Cyprus economy also experienced severe economic and financial problems between the years 2000-2002. In particular, the onset of the Turkish currency crises during 2000/2001 appears to have had a negative impact on the NC banking sector and led to contraction of the economy. In December 1999, the International Monetary Fund (IMF) supported the pegged exchange rate base anti-inflation programme implemented in Turkey. However, after fourteen months from the start of the programme, i.e. in February 2001, the programme had to be abandoned with the collapse of the TL. During the period of 2000-2002 ten financial banks were forced by the Government of North Cyprus to suspend their operation. In 2000, five banks, namely the Cyprus Credit Bank Ltd, Cyprus Liberal Bank Ltd, Everest Bank Ltd, Kibris Yurtbank Ltd and Cyprus Finance Bank Ltd, were put under the Saving Deposit Insurance Fund (SDIF), and then these banks were closed in the year 2001. The bankruptcy of these five banks started a serious banking crisis in North Cyprus. Another four banks, namely Cyprus Commercial Bank Ltd, Yasa Bank Ltd, Tilmo Bank Ltd and Asia Bank Ltd, were put under the SDIF in 2001, and Cyprus Industrial Bank Ltd was put under the SDIF in 2002. Furthermore, Finba Ltd was taken over by Artam Bank Ltd in 2000 and Med Bank Ltd and Hamza Bank Ltd were taken over by Seker Bank Ltd in the years 2001 and 2002 respectively. During 1999 there were 37 surviving banks in North Cyprus. However, towards the end of 2002 ten of these banks suspended operations, two banks were taken over by another bank, and only 25 banks remained. The increase in the failure of commercial banks in North Cyprus increased attention on efforts to investigate the determinants of bank failure.

Review of literature

The last two decades have witnessed an unprecedented increase in the number of financial distress episodes, both in developed and developing countries. Therefore, the issue of analyzing the determinants of the financial crises have become increasingly important for economies. In general, the financial problems that have received the most attention in the literature are currency and banking crises. For instance, in the early 1980s, several Latin American countries including Mexico, Brazil and Chile experienced a banking crisis. In particular, the 1990 s were marked by an …