A troublesome few years have hit Azerbaijan's banking sector hard but now its banks are emerging in better shape. Peter McGill assesses the challenges they are facing.
Azerbaijan’s banking industry is still recuperating from a bout of poor health, triggered by plummeting oil prices and a halving of the manat’s value. While structural problems persist, years of intensive care have at least resulted in some encouraging signs.
For example, bank capitalisation levels have increased significantly relative to 2017 and 2013 to 2015, and are now the among the highest in the Commonwealth of Independent States (CIS). State-owned International Bank of Azerbaijan – which was saved from going bust at the end of 2016 when its capital adequacy was negative – boasted a robust Tier 1 capital ratio of 32% as of March 31, 2019.
Non-performing loans (NPLs), which at the height of the Azerbaijan financial crisis in 2015 exceeded 30% of all loans, will likely stabilise this year at about 20% – though rating agency Standard & Poor’s (S&P) stresses that Azerbaijan’s large shadow economy makes it difficult to assess NPL levels accurately.
At the end of February 2019, president Ilham Aliyev signed a decree aimed at resolving the problem loans of small retail borrowers hit by the manat depreciation of 2015. Individuals who took out personal foreign currency loans of less than $10,000 before the manat nosedived against the dollar will receive government compensation.
The central bank is also lending banks 682m manat ($400m) in five-year loans at almost zero cost, to restructure non-performing personal loans of up to $10,000 (or 17,000 manat), which were taken out before January 1, 2012. Accumulated interest payments and fines will be written off, and the loans will be restructured at just 1% interest per year, following a one-year grace period.
Worries persist
Such developments do not mean Azerbaijan’s banking industry is no longer in need of help, however. Credit rating agencies and international financial institutions, such as the European Bank for Reconstruction and Development (EBRD), remain concerned that the industry still suffers chronic weaknesses. Fragile confidence has prompted the government to extend an unlimited guarantee for deposits with specified interest rates until March 2020.
Top of the worry list is the rate of dollarisation, which for deposits in recent years has been higher in Azerbaijan than in Serbia, Croatia, Georgia, Kazakhstan, Turkey or Russia. The plunge of the manat led to a massive shift in bank deposits into safer foreign currencies. Since December 2015, Azerbaijan has operated a floating currency regime, and the manat has been very stable against the dollar since early 2017. Yet the share of foreign currency deposits, which had been declining from a peak of more than 80% in 2015, has started to increase again, and reached 66% of all deposits at the end of March 2019.
Foreign-exchange loans still accounted for 38% of all domestic loans in Azerbaijan at the end of December 2018, compared with an average of less than 30% in 2012 to 2014. This leaves bank balance sheets vulnerable to any further sharp depreciation of the manat. Currency risk could again easily transform into credit risk, with Azerbaijani banks unable to service their foreign currency loans.
Hans Krohn, Commerzbank’s head of financial institutions for the CIS, has seen several similar cases in other countries besides Azerbaijan. “If foreign currency borrowing is allowed in a country and if, say, you have very low interest rates in euros or Swiss francs compared with the local currency, then obviously if the local currency appreciates during a boom period, it will seem like a very sweet deal to take credit in hard currency,” he says. “Later, however, when there is a dramatic devaluation, the positive effect of lower interest rates is nullified.”
Greater optimism
Among foreign observers of Azerbaijan banking, some regard the glass as half empty while others see it as half full. George Orlov, EBRD director for financial institutions in Russia, central Asia, Caucasus and Turkey, is firmly in the latter camp.
“Lessons have been learned,” says Mr Orlov. “Local bankers now are much more careful about risk, such as interest rate risk and risks related to hard currency borrowing and concentration. [This is evident] when talking to the local bankers. They are much more careful. I think the quality of banks’ balance sheets in Azerbaijan is stabilising as well, and there is more understanding about NPLs and impaired loans, and new portfolios of better quality have started to build up. So, recovery is clearly there, and I hope that with the support of stronger macroeconomic parameters, the sector will resume its growth and will completely recover.”
Moody’s praises institutional progress in Azerbaijan that will “increase the quality of prudential policy-making, bank supervision and information sharing, allowing banks to better access and manage credit risks”. It cites the establishment of the Financial Market Supervisory Authority (Fimsa) as evidence of this.
However, in a May 2019 report into Azerbaijan’s banks, S&P took a sterner view, finding an “extremely high risk” in the institutional framework. Fimsa, established in 2016, has a “limited track record”, it said, and the “effectiveness of its regulation has not yet been established”, while “banking regulation and supervision in Azerbaijan is weak” and similar to other CIS member states, such as Armenia, Belarus, Kazakhstan, Uzbekistan and Ukraine.
Governance questions
Azerbaijan’s banks also fall short on international standards of corporate governance. “Many aspects of ownership, management and governance may be opaque and lead to high risks,” say S&P analysts Sergey Voronenko, Dmitry Nazarov and Benjamin Young. On the plus side, banks’ foreign investors support the corporate governance and risk management functions of the banks they control, and all banks in Azerbaijan now report under International Financial Reporting Standards, at least annually.
The analysts note, however, that some banks are reluctant to disclose their ultimate beneficiaries, saying: “We believe that Azerbaijan has significant governance issues, with a ‘pervasive’ perceived level of corruption, which is exacerbated by the significant shadow economy.”
Fimsa lists 30 banks operating in Azerbaijan; S&P estimates that five dominate the market, with about 65% of total banking assets, while another five account for a further 13%. As of April 1, 2019, the top five, by market shares of assets, were International Bank of Azerbaijan, or IBA (27%), Pasha Bank (15.6%), Kapital Bank (12%), Xalq Bank (7.4%) and Bank Respublika (3.6%).
Of these, all but Bank Respublika are “ultimately owned by the government or controlled by the ruling elite,” according to Mr Voronenko and Mr Nazarov. IBA is state-owned, while IFRS disclosures have named two daughters of the president as the ultimate owners of Pasha, Kapital and Xalq banks.
(According to Moody’s, Bank Respublika is majority owned by a local family, who hold more than 74% of the bank’s shares, while 21% is owned by two German public-sector financial institutions, DEG and the Sparkassen International Development Trust.)
Mixed picture
A report by Moody’s shows a decidedly mixed picture. Xalq Bank reported sound capital buffers at the end of January 2018: 13.3% in regulatory Tier 1 capital and 15.7% in total capital adequacy ratios (CAR), well in excess of the respective regulatory minimums of 5% and 10%. On the other hand, the bank has a high level of dollarisation, with foreign exchange loans accounting for 74% of the total gross loans at the end of 2018, up from 67% a year earlier.
“The currency structure of the bank's loan portfolio mirrors that of its funding base, where foreign exchange deposits also prevail,” Moody’s said in April. In 2015 to 2016, “up to half of the bank’s foreign exchange borrowers did not have sufficient foreign exchange revenue to serve these loans”, it added. Asset quality improved in 2017 to 2018 as high, stable global oil prices helped stabilise Azerbaijan’s economy. Still, Xalq Bank’s loan book appears to remain vulnerable, mainly due to its high foreign exchange loan exposure.
Kapital Bank passes muster for Moody’s thanks to its “robust capitalisation”, “strong profitability” supported by a healthy net interest margin, and “ample liquidity buffers”, while a solid market position is “underpinned by its large customer franchise, a countrywide branch network and close ties with the government”. Kapital Bank is 99.9% controlled by Pasha Holding, which also controls Pasha Bank, the second largest bank in Azerbaijan.
There is the smaller Bank of Baku, with “very weak capital”, according to Moody's, “a large stock of problem loans, exceeding 40% of gross loans”, and “still weak” profitability. Its loan book is dominated by unsecured consumer loans and credit card loans. Since mid-2017, Bank of Baku’s nominal capital has been below the regulatory minimum, and the bank is banned from adding new individual deposits, according to Moody’s.
Then there is the largest bank in the country, with one-quarter of all banking assets: state-owned IBA. The bank was at the vortex of the 2015 to 2017 financial crisis and still dominates much discussion where Azerbaijan finance is concerned. An embezzlement scandal that resulted in the bank’s former chairman, Jahangir Hajiyev, being jailed for 15 years in 2016 by a court in Baku, even spread to London. Mr Hajiyev’s wife, Zamira Hajiyeva, became the subject of the UK’s first ‘unexplained wealth order’ – a new anti-corruption tool – in relation to £22m ($26.75m)-worth of London properties, including an £11.5m house in the high-end area of Knightsbridge.
Ms Hajiyeva is also alleged to have spent £16.3m at Harrods department store between 2006 and 2016. The government in Baku has applied for her extradition to stand trial as an alleged co-conspirator in defrauding IBA between 2001 and 2015.
An awkward rescue
The rescue of IBA saved a systemically important bank but the way it was done has raised awkward questions about future government support. At the time of the crisis, IBA accounted for about 40% of all banking assets in Azerbaijan, and prior to the government-managed bailout its NPLs had reached what some estimated to be about 80%. To clean up the bank, the government arranged for 14bn manat-worth of problem assets – equivalent to 23% of Azerbaijan’s gross domestic product in 2016 – to be transferred to a government-owned company called Agrarkredit, which was funded by the central bank. IBA missed a bond coupon payment and in May 2017 announced a restructuring, managed by Lazard Frères, of $3.3bn of foreign liabilities, including foreign trade facilities, Eurobonds and a $1bn deposit by the state oil fund, Sofaz.
Mr Krohn of Commerzbank described the IBA restructuring as a “very painful process” and told The Banker that the Baku government should have tapped Sofaz to fill the shortfall in liquidity at the bank. Failure to do so, he suggests, has left a legacy of ill will with export credit agencies (ECAs) caught up in the restructuring. “If you look at commercial banks, they had to accept a haircut, they took a hit, and after a couple of years they have come back and keep doing business," he says. "That is something we have seen on many occasions in other countries, and the fact has been used when governments make decisions on how to handle a crisis, or the liquidity shortfall in a bank.
“When it comes to ECAs, the implications are much further reaching and longer lasting. A good example is the German ECA, Euler Hermes. It was forced to take a haircut in Kazakhstan more than 10 years ago, in the BTA Bank restructuring, and it has still not reopened completely in Kazakhstan, and that’s a decade down the line.”
Mr Krohn continues: “The memory of ECAs, if they have to take a hit, can be very, very long” with the consequence that “you don’t get coverage, for many years, of export credits. ECAs are used to finance projects that are very large and have long tenors. It could be anything: agriculture, energy, power plants, you name it. Dozens or hundreds of millions of euros are involved and tenors are long.”
S&P also notes that government support “was not timely and sufficient for all groups of IBA’s senior creditors”, concluding: “Future government support for systemically important banks in the country will likely be more unpredictable than we previously assumed.”
Possible privatisation
Sofaz CEO Shahmar Movsumov, who has also been chairman of the supervisory board of IBA since 2016, rejects such criticism (see box on Sofaz). IBA is also embroiled in controversy over its future. Consultant McKinsey has been hired to advise on IBA’s longer term business strategy, but one crucial element is missing: the bank’s planned privatisation.
“Corporate governance should be strengthened, and steps were taken in that direction, but there is a lack of clear will of the government to privatise after that. We advised it to be braver in this process and to be faster in privatisation because it has spent a lot of money, at a huge cost to the tax payer, to save this bank,” says Dimitar Bogov, EBRD lead economist for Ukraine, Moldova and the Caucasus. “It should be privatised, to avoid the potential of a new debt portfolio being created, because with state ownership, and weak corporate governance, the risks of that are quite high.”
Mr Orlov of the EBRD says work is still necessary to prepare the bank for sale. “Privatisation means sale and investment, and before selling the bank there must be some value creation and it must be a good bank. Otherwise no one will pay decent money for it, whether it’s IBA or any other bank,” he says. “To make it of value to a private investor and to maximise the value, it has to undergo significant reorganisation, and that is exactly what is happening, including the development of strategies, internal processes, corporate governance and cleaning up the balance sheet – which is probably one of the things completed so far. Privatisation is only the end of the process.”
Underbanked opportunities
The challenges of sorting out IBA can easily divert attention from other structural issues facing Azerbaijan’s banking industry. None is bigger than the finding, in the World Bank Global Findex 2017 survey, that only 29% of Azerbaijani adults have a formal bank account. This is one of the lowest rates of account penetration in the whole of Europe and central Asia. It could be a result of a lack of bank branches, especially in remote areas, low financial literacy, or one of the knock-on effects of Azerbaijan’s large shadow economy.
Mobile and digital financial services could be the solution. According to a World Bank spokesperson, with mobile phone subscription in Azerbaijan exceeding 100%, “a wonderful opportunity” has opened up.
