REVIEW

Cautious but Confident

With deepening financial intermediation functions and an expanding geographic coverage of banking infrastructure, Azerbaijan’s banking sector is providing an engine of economic diversification.

Following a period of rationalization that saw the Central Bank of Azerbaijan (CBAR) revoke two banking licenses in December 2010 and one in January 2011, Azerbaijan now has 44 banks and credit institutions, 23 of which have foreign equity investments and nine of which have international operations.

As of April 1, 2011, no bank had a charter capital of less than AZN3.5 million, while 41 out of 44 banks had capital in excess of AZN10 million, the minimum equity capital requirement according to the CBAR’s rule book.

Despite having three less banks than in the previous period, overall capital in the banking system increased by 3.3% in the first quarter of 2011, signaling a healthy level of rationalization. As of 1Q 2011, Azerbaijani banks’ overall capital stood at AZN2.21 billion. Total assets reached AZN12.6 billion, up from AZN12.03 billion the previous year.

Of these assets, AZN7.76 billion represented loans to customers, AZN1.4 billion were funds in correspondent accounts, AZN1.4 billion were investments, and AZN520 million were placed in financial sector loans and deposits.

The banks’ overall liabilities were AZN10.426 billion, including AZN4.28 billion in financial sector loans and deposits and AZN5.46 billion in deposits.

In a nod to Azerbaijan’s increasing emphasis on sector diversification, the ratio of bank assets to non-oil GDP is on the rise. By the beginning of 2010, the ratio reached 74.4%, up from 67.6%. Likewise, the ratio of equity to non-oil GDP increased from 9.8% to 11.2% in the same period. Loans to the non-oil sector rose from 46.2% to 52.5%, while the deposits of individuals outside of the oil and gas sector increased from 12.5% to 14.9%.

SHELTER FROM THE STORM

Although overheating from external funding and the local real estate market was an issue for Azerbaijan, the banking system remained relatively sheltered from the impact of the global financial crisis. This is due in large part to a prudential framework that was strengthened in 2007.

“The Central Bank strived to provide a counter-cyclical presence in its prudent regulatory policy,” says CBAR Governor Elman Rustamov.

As a result of pre-crisis regulation, banks maintained a robust capitalization, boasting an average 16% capital adequacy. Reserve ratio to non-performing loans (NPLs) remain as high as 98%, while share of liquid assets in total assets is 17%.

In addition, a tradition of conservative banking and an interest in classic instruments meant that Azerbaijani banks had extremely limited exposure to toxic assets.

“The Central Bank’s pre-crisis and ‘in-crisis’ prudential regulatory framework was key in the formation of the potential for the resilience of the banking sector to a stress situation,” Rustamov told TBY.

NON-BANK CREDIT CORPORATIONS

A new Law on Non-Bank Credit Organizations has been developed in parallel to a significant organic growth in non-bank credit institutions in Azerbaijan, including leasing and factoring companies as well as credit unions and credit institutions financed by international humanitarian organization. The number of these institutions is now 96, with 71 branch offices. Both figures are expected to continue their steady rise following the new regulations.

The charter capital of all non-bank credit corporations reached AZN38.4 million at the end of 1Q 2011, up from AZN34.5 million for the same period 2010. Within this sub-sector, credit unions have seen the largest growth. Charter capital for credit unions reached AZN9.89 million in the first quarter with assets totaling AZN33.81 compared to AZN6.53 million and AZN23.47 million in 1Q 2010, respectively, marking a 66% growth in charter capital and a 69% growth in credit union assets.

Credit corporations financed by international humanitarian organizations have roughly the same amount of charter capital—AZN9.98 million—but with significantly higher assets of AZN2 billion.

CATCH-UP POTENTIAL

Despite growth and rationalization, Azerbaijan’s banking system is still relatively small, with the ratio of total assets to GDP currently around 35%. At present, an estimated $1 billion is still held in cash outside the banking sector, spelling opportunity for rapid increases in retail banking penetration rates.

Branch expansion is currently driving the banking sector’s high catch-up potential. In 2010, 28 banks opened 63 new branch offices. Signaling increasing regional and rural penetration, 39 of the 63 new branches were opened outside of the capital city Baku. As a result, the total number of branches is now 626, with 48.1% operating in the country’s regions.

The fruits of this expansion are beginning to show themselves in deposit terms. Personal deposits hit AZN3 billion at the first-quarter threshold. This marks a 37.3% increase over the previous year. According to Elman Rustamov, Governor of CBAR, the same trend is being observed in 2011. Overall, deposits have increased 36 times within the last 10 years.

“If the population rather than professional players of the market entrust their savings to banks, it displays confidence in the banking sector,” says Rustamov. “The sustainability and stability of the banking sector during the global crisis enhanced its credibility.”

Exponential growth in the use of transactions with debit and credit cards also sends strong signals of an increasingly banked population and a growing demand for retail banking products. In 2010, there were 44 million debit card transactions amounting to AZN5.4 billion. This represents a 41% increase in transactions and a 24% increase in transaction amounts compared to 2006 levels.

ISLAMIC BANKING

Islamic finance, in which banks share profit and loss for the money they lend rather than charge interest, is the fastest growing financial sub-sector in the world. While Azerbaijan is a secular country and its laws do not authorize a full range of Islamic banking services, many Azerbaijani banks are beginning to offer loans structured in accordance with the principles of Islamic finance.

The establishment of an Islamic banking unit by the International Bank of Azerbaijan (IBA)

may be a harbinger of change. The state-owned lender has offered a limited range of sharia-compliant products for seven years, mainly aimed at SMEs. Now, however, it is launching 20 new retail banking products, including savings, checking, personal loans, project financing equity funds, and remittance products. With the current lack of a legal framework for non-conventional banking, the evolution of new products may be the driving force behind an expanded regulatory environment.

IBA is not alone. In 2011 Russian-owned Nikoil Bank began offering interest-free deposits that it invested into sharia-compliant business ventures. Amrahbank, another mid-sized bank partly owned by the Bahrain-based International Investment bank, has also announced plans to offer sharia-compliant financial products.

Although Azerbaijan is a steadfastly secular country, Islamic finance has the potential to make inroads within the conventional banking segment as long as loan interest rates stay above the 20% level.

REGULATORY ENVIRONMENT

Azerbaijan has a two-tiered banking system, with the Central Bank making up the first tier and the remaining banks making up the second. In addition to setting monetary policy, CBAR exercises independent supervisory control of the banking sector.

The current regulatory framework is dictated by the 2004 Law on Banks. The recent adoption of an additional Law on Non-Bank Credit Organizations marks a significant policy shift. The legislation states that non-bank credit organizations may conduct only certain types of banking operations, such as factoring, forfeiting, leasing, and issuing guarantees, but they are expressly prohibited from accepting deposits.

CBAR is solely responsible for issuing licenses to banks and non-bank credit organizations as well as for independently establishing minimum charter capital, reserve fund levels, net worth, and other requirements. It also regulates professional qualifications for the senior management and accounting personnel of commercial banks, including branches of foreign banks.

Banks in Azerbaijan must be established by at least three individuals or legal entities in the form of an open joint-stock company. Political parties, social unions, funds, and other non-commercial organizations may not be shareholders.

Foreign banks may operate representative offices, branches, joint ventures, and wholly owned subsidiaries in Azerbaijan. However, foreign entities registered in specific offshore areas as well as foreign banks and bank holding companies may not be founders or shareholders of local banks or founders of local subsidiary banks, branches, or representative offices.

Foreign entities that are not banks may set up or acquire shares in Azerbaijani banks. The concept of a “bank with foreign participation” is not defined by the law, therefore, regardless of the extent of foreign ownership, the term broadly applies to all banks with foreign capital. Banks with foreign capital face additional regulation, such as the requirement that one board member and one branch manager must be an Azerbaijani citizen.

The 2008 law on the “Stimulation of Increase of Capitalization Level of Banks, Insurance and Reinsurance Companies” has created significant tax exemptions. Starting in 2009, the law states that the profits of banks and insurance companies used to increase charter capital will be exempt from corporate income tax in the course of the next three years.