Ben Aris in Baku -

With liquidity in Azerbaijan's financial sector at well over 50% - and higher at the leading banks - the main problem that bankers in Baku face today is what to do with the growing piles of cash that depositors are dropping into their coffers.

Azerbaijan suffered a crisis-lite compared with the rest of the world. Low exposure to international debt (the credit boom of 2008 was just creeping into the Caspian region), large oil money reserves and ballistic economic growth in double digits, the country was, nevertheless, too early in its development to be badly winded by the global economic collapse.

Now oil prices are back over $70 per barrel, public finances are in the black as the state functions at an oil price of $50 a barrel, the level which is in this year's budget. And the country ended last year as the fastest growing country in the world - albeit at a much reduced 8%, down from 25% a year earlier.

The rapid development of the banking sector was brought to a halt by the crisis, which was particularly hard hit by the collapse of the real estate sector. But almost no one got into trouble and the central bank immediately refinanced the $2.4bn odd of external debt the sector did have as soon as the financial dam burst. But the sector's main strength is the fact that it is still stepping off square one: bank assets are about 25% of GDP, which is way below 100%-plus of GDP that's normal in more developed markets.

Like elsewhere, Azerbaijan's banks recapitalised and slowed lending to shore up their position while they waited to see just how bad the storm would get. But as the world came out the other side at the start of this year, all the bankers interviewed for this article said they were cautiously planning to go back to growth and development in 2010.

Despite the crisis, deposits have continued to flow into the banks and stood at an all-time high of AZM11.7bn ($14.6bn) as of the end of 2009. Likewise, assets have continued to climb, rising 13.5% over 2009 to record highs, while those in other countries' banking sectors have gone backwards. "The biggest problem with the banking sector is most banks are suffering from over-liquidity now, as they are all in a conservative mood. Consumer loans are still there, but most people stopped car loans; these are just starting again, but the volumes are still less than half what they were a year ago," says Elchin Gadimov, vice-chairman of Rabitabank. "Micro-lending is also doing well, but SME [small and medium-sized enterprise] lending is still lagging; no one wants to finance other people's bad debtors."

The crisis is clearly over, but what is holding banks back is that some businesses are still in trouble: all the aggregate indicators are up, but that doesn't mean individual companies are out of danger. Azerbaijan is walking again after being given a dead leg by the crisis, but bankers are still worried a few of their customers have broken their fibula and just aren't telling anyone else yet. In the meantime, the state has stepped in to prop up the economy. "Last year, the government realised that the local banks are too small to finance really large projects, so it decided to lend directly to the economy," says Gadimov.

This spending has (unsurprisingly) been done through the biggest state-owned companies: the State Oil Company of Azerbaijan (Socar) was given $800m to invest into projects and the state-owned aluminium plant got another $400m, to name the biggest loans. The result was a shot in the arm for economic growth, which is helping to lift everyone out of the mire.

Interest rates and liquidity

Now the banks are recovering, the biggest issue they now face is what to do with all the money they have. While there are no official statistics on the liquidity levels of banks (the sector remains opaque and few want to say publicly how much money they hold), all the big banks interviewed for this article said they have liquidity levels in excess of 70% and market players in Azerbaijan say that the average for the sector is almost certainly well over 50% - far in excess of the central bank's normative minimum of 30% of total assets.

In the last few months, banks have started to act to slow down the inflows by cutting interest rates in an effort to encourage their customers to spend more; most of the leading banks have cut rates between 1-2 percentage points, leaving the average rate on one-year deposits at about 15%.

While Azerbaijan's banks are still in the red, profits in the last year have fallen. Pasha Bank, which was one of the fastest growing banks in the country in 2009, is typical. It reinvested its profits last year to take advantage of new tax breaks designed to encourage banks to boost their capital, but now intends to go back to a more aggressive lending policy. "We are going to open more branches this year and go back to lending - if not aggressively, at least more actively," says Pasha Bank's CFO, Shahin Mammadov. "In Azerbaijan, there was no crisis. The first phase completely passed us by. There was a liquidity crunch, but this last year was more of a downturn than a crisis here."

A high level of liquidity is good in times of crisis, but as retail deposits are the most expensive form of funding, this situation can't last for long. Banks need to bring down their liquidity levels by upping the volume of business, but it's just that no one wants to go first. "Now most banks are waiting to see who will start lending again aggressively and once someone does, the others will probably follow," says Gadimov.

Lessons learnt

The crisis did come with a silver lining. Azeri bankers were already talking about improving risk management before the crisis and the country's central bank is said to be one of the most progressive in the region in this regard, but post-meltdown banks are acting as well as talking. "After the Baku-Ceyhan oil pipeline was opened [which delivers Caspian oil to a Turkish port and came online in 2006], a huge wall of cash hit the country. It started a boom and business and government were experiencing a euphoria with so much money about," says Pasha Bank's Mammadov. "On the other side of the crisis, the main priority has become risk management. If you don't have the tools to follow the flows of money on a daily basis, then you will be in danger in the next crisis."

Azerbaijan's prudent regulation of the bank sector was already pretty good before the crisis by regional standards. But in the wake of the crisis, the central bank has done another round of tightening up its supervision of the sector - the main difference now being the emphasis has shifted from simply making sure banks follow the letter of the law to trying to assess the risks that a bank is running, say bankers in Baku. As a result, the number of inspections has increased and the frequency of reporting has been raised.

At the same time, the government has set up a new body, the Financial Monitoring Unit (FMU), which is specifically tasked with following the development of the sector, and even transferred some of the central bank's powers to the new agency to give it some real teeth.

The FMU has been well received and in December its creation prompted the Council of Europe to withdraw a warning issued about a year ago that criticised Azerbaijan's weak anti-money laundering regime. Banks like Pasha are running well ahead of the regulator and have already set up corporate governance and compliance units to bring the bank's supervision up to international best practices.

Lending support

Now the stage is set for a resumption of (more cautious) lending that will give legs to the oil money-driven economic recovery the country is already enjoying.

Kapital Bank is the former state-owned savings bank and was privatised in 2000 by Pasha Holding. With the biggest retail branch network in the country, Kapital Bank is in a strong position. The government uses the bank as the vehicle for its social support programmes and, ironically, it has actually increased the amount of treasury work it does for the government since beings privatised. But its bread-and-butter work remains lending to individuals and this year it plans to significantly upgrade its retail network ahead of pushing more loans. "There are two main problems," says Samira Sharifova, director of strategic planning and marketing at Kapital Bank. "First, Azerbaijan is only just emerging from transition. People are steadily taking money out of their mattresses and bringing them to banks. Second, the transactions of individuals (not businesses) in the market are cash based. The majority of merchants are still reluctant to get paid through plastic cards, preferring rather to get cash, thus in some cases minimizing their tax withholdings."

Kapital Bank's revamp is multifaceted. Firstly, all the branches are getting a makeover to make them more attractive as well as their IT systems being beefed up. "The positioning of the Kapital Bank is close to that of the McDonalds: no frills, but rather standardized, understandable, convenient and next-door," says Sharifova.

Secondly, the power to make lending decisions will be devolved to the local branch managers, which should result in an increase in credit volumes. Finally, new risk management and bad loans departments have already been set up to monitor these credits. Kapital Bank's non-performing loans are still well below the 5% level and, like many others, its liquidity levels are well over 60% - so high that the bank is now actively discouraging deposits. "We were the first bank in Azerbaijan to decrease interest rates on deposits," says Sharifova. "But even that didn't impact our number of deposits. Now people are less interested in high deposit rates, and more interested in the stability and reliability of the bank."