When Turkey's economy boomed in the last decade, so did bank lending, much more explosively than in other emerging markets.

That is at the heart of the concerns about the falling lira, which is now down 82 percent against the dollar year to date. The lending spree has created two potential problems, according to Capital Economics. One is that Turkish banks looked to foreign wholesale markets as a way to fund the credit boom, instead of relying on more steady domestic deposits.

Now, the expense of servicing those loans has jumped with the lira's decline, and they will be much more difficult for banks to roll over. The second risk is the possible sharp rise in nonperforming loans, including those made in foreign currencies, mostly to businesses.

"I think the risk is more you get a rise in bad debts," said William Jackson, chief emerging markets economist at Capital Economics. In a telephone interview, he said Turkey could see "a quite severe credit crunch" but less likely a "2001 Turkish banking crisis," when banks needed a significant bailout and GDP fell by 6 percent.

"There has been a significant improvement in bank lending," he said. Yet, the value of nonperforming loans has risen since the lira began its rapid descent in May, and it's unclear how well Turkish borrowers will deal with payments after the steep drop in just the last couple of days.

Nonperforming loans, averaging about 3 percent, should also increase as the economy takes a hit from the falling lira. Turkey was sanctioned by the U.S. last week for refusing to turn over an American pastor it says was involved in terrorism.

President Donald Trump cracked down further on Turkey by doubling tariffs on steel and aluminum. The lira, off about 8 percent Monday, has lost more than 35 percent against the dollar in the past week.

Turkey's ballooning loan growth was fine before the lira crashed, and when the economy was growing at a more than 7 percent pace, as it did in 2017. Capital Economics said one plus for the Turkish banks is that they seem to hedge all of their on-balance sheet foreign exchange mismatches, limiting their exposure to the crashing lira.

"The bigger risk, instead, seems to be that currency weakness, rising borrowing costs and the ensuing recession causes non-performing loans to jump," wrote Capital Economics economists. They said Turkey's credit boom, one of the largest of any emerging market country during the past decade, was mostly driven by an increase in lira-denominated lending.

"It's not about growth. The reason they're growing so fast is its debt fueled and their current account. The growth by itself looks good only on the surface," said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman.

The worries about Turkey's banks are spilling over to the European banking system, since several major euro zone banks have operations in Turkey. The banks viewed as most impacted are Spain's BBVA and Italy's Unicredit, which own large stakes in Turkish banks, and France's BNP Paribas, which has operations there.

"When people think about the costs, they're panicking. They only think about Unicredit's loans. What they haven't done is though about what Unicredit has done to hedge itself. These banks are risk managers and people only want to focus on the liabilities side of the balance sheet," said Chandler. "That's why I still think it's being exaggerated. Turkey is bad for Turkey, but not necessarily the systemic risk of the Asian crisis of 1998/99."

Unicredit holds a more than 40 percent stake in Turkish bank Yapi Kredi, and BBVA owns nearly half of Garanti Bank.

On Monday, Turkey's central bank announced a series of measures to help lenders by easing capital requirements and to "provide all the liquidity the banks need."

"They're papering over the cracks," said William Jackson, Capital Economics' chief emerging markets economist.

Chandler said the steps were not what was required. "I would say they haven't hit the pain threshold. They didn't cry uncle yet. They haven't really done anything to stop the bleeding," he said. Compounding the problems are that Turkish President Recip Tayyip Erdogan acquired powers over the banking system and economy in the June election and has politicized policy.

Turkey needs to "raise interest rates sharply, like Argentina just did, like 500 basis points. Turkey's got to do more because they're behind the curve," Chandler said. "They could put capital controls on. They could go to the IMF. They could get a white knight, like Russia or China. Their policies have repelled investors and they haven't reversed that yet."

Capital Economics said the banks have adequate capital but would have to raise more as bad loans multiply.

"It would probably take a sharp rise in the non-performing loan ratio to cause severe stress. The aggregate non-performing loan ratio is currently 3.4% and the banking sector is well capitalised—the Tier 1 capital adequacy ratio of the banking sector stands at 13.9%, comfortably above the Basel III minimum of 6%," Capital Economics wrote.

In its report, Capital Economics said the government's budget deficit is about 2 percent of GDP, and public debt is about 30 percent. Much of the lending during the boom was lira-denominated.

Jackson said total bank lending is 60 percent of GDP, on the domestic side. The external debt, from banks and businesses borrowing from abroad is about 50 percent of GDP. Most of the external debt is foreign and one-third of domestic debt is in foreign currencies.

"You had this big accumulation of private sector debt rather than public debt," Jackson said. But Turkey, in part due to lessons from the 2001 currency crisis, has also been a fairly strict regulator of banks. During the financial crisis, its nonperforming loans jumped to just 5 percent, versus a 16 percent nonperforming ratio in Hungary, Latvia and Bulgaria.

If Turkish nonperforming loans rose to a similar level as Eastern European countries experienced, tier one capital ratio would be 2.4 percent and a recapitalization of 2.9 percent of GDP would be required.

"Of course, some banks are more vulnerable to a rise in NPLs than others. But the overall picture is that recapitalization should be manageable, not least given that the public sector balance sheet is strong," Capital Economics said.

The firm, in a note, said in the "extremely acute crisis" in 2001, the banks required a recapitalization of 30 percent of GDP, but this crisis could still cause severe economic pain.

"Obviously there's been a credit risk since then, and there's a credit risk that could go much higher. ... Even if nonperforming loans went to 15 percent, the actual amount of capital that would be needed by the banking system is in the high 2 to 3 percent," said Jackson.

