The article provides evidence that the Basel Accord-based IMF mandated regulatory reforms that have been enacted into law in Turkey are neither necessary for the safety and soundness of the Turkish banking system nor sufficient to provide it. There are two reasons for this. First, the diversification and security analysis stressed in Basel Accord-mandated risk management plans is not an important source of risk reduction in portfolios containing only Turkish assets. Second, a 10% ratio of equity to Turkish assets is too risky to provide a sound banking system there. This position is argued a four-step chain of reasoning: 1. Diversification as a risk management tool in equity portfolios is ineffective in Turkey due to the high relative volatility of and high covariance among Turkish common stocks. Diversified portfolios have comparable volatilities to a one stock portfolio. During crises the diversified portfolio is substantially riskier than a managed portfolio constructed here. 2. Diversification is also no help in market-traded asset portfolios containing Turkish Treasury bills and common stocks. Because Turkish common stocks are so risky on a relative basis and because of their high covariance with Treasury bills, risk-minimizing portfolios of Turkish market-traded securities contain only Turkish Treasury Bills, risky themselves but safe on a relative basis. 3. Diversification using bank direct loan assets are also not important in minimizing risk in portfolios of Turkish assets. They appear only in relatively small amounts in minimum risk portfolios of Turkish assets. Thus minimum-risk portfolios of Turkish assets contain primarily Turkish Treasury bills. 4. Risk minimizing banks holding only Turkish Treasury bills are too risky under the currently required 10% leverage ratio. Therefore, all Turkish banks are too risky to be consistent with a safe and sound banking system under the 10% requirement. On the other hand, the article also provides evidence that Turkish Treasury Bills, when combined with foreign mature market securities, do provide reduced risk through diversification. This suggests that foreign banks will find fertile ground in Turkey.
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