The Azerbaijani banking sector has had a busy week.  Six small banks lost their licences (bringing the total number down from 43 to 37), while two medium-sized banks, Demirbank and Azerigasbank (AG Bank) announced they intended to merge, and there was a flurry of rumours about tie-ups involving three of the largest banks - Pasha, Kapital and Ata.

The flurry of activity indicates the stresses the banking sector is now under, after fat years of oil-fuelled prosperity, high public spending, monetary stability and generous lending. The economic downturn, together with the sharp depreciation of the national currency, are likely to lead to increased defaults on loans, and growing dollarisation at a time when finding foreign funding is becoming more difficult, particularly after Standard & Poor's downgrade of Azerbaijan's credit rating to junk on January 29. Further bank failures are inevitable, as well as mounting pressure for the survivors to consolidate.

The sector has been under a great deal of pressure ever since February 2015, when the Azerbaijani central bank (CBA) dropped the manat's peg to the dollar, leading to a 34% depreciation of the currency. Faced with higher prices and cost of loans, as well as smaller incomes and revenues, clients began to default on their foreign-currency denominated loans.

The latest figures available to bne Intellinews indicate that AG Bank was the champion at non-performing loans: NPLs represented 29% of AG’s total loans at end-June 2015; IBA had an 18.5% NPL ratio at end-June; Pasha Bank 14.6% at end-September; followed by VTB Bank (11.7% at end-June), Unibank (11% at end-June), Bank Respublika (10.9% at end-September), and Demirbank (10% at end-June).

In addition many banks struggled to stay in the black in 2015, with the highest profit the meagre AZN7.6mn (€4.2mn) posted by Pasha Bank in the first nine months of the year; others, such as the local branch of Russia's VTB Bank and Bank Standard, posted losses of AZN4.2mn (€2.3mn) and AZN2.3mn (€1.3mn) respectively.

State-owned IBA, the country’s largest by assets, got into the worst trouble of all the banks, because it had borrowed externally in dollars, and lent in manats, a practice that, together with its dubious lending criteria, brought it to the verge of default until it was rescued by the government. Baku bailed out IBA with AZN3bn (€1.6bn) in 2015 and had to allocate another AZN600mn (€336.2mn) for 2016, which it argued was enough to help the bank back on its feet.

Banking insiders, however, contend that IBA’s bad loan portfolio was closer to AZN10bn (€5.6bn), and that Baku has had to write off a huge part of this. Data from the Economist Intelligence Unit, which shows a 25% drop in total domestic loans to AZN15bn (€8bn) between July and November, appears to support this theory, although a decline in lending across all the banks likely contributed to the drop as well.

The next blow was when CBA floated the manat in December, in what observers commended as a wise, although belated decision, after the central bank had spent $10bn up to that point on futile attempts to prop the currency up.

Banks have tried to profit in the short term from the depreciation by setting opportunistic exchange rates to profit from consumers' frenzy to exchange their manats into foreign currencies in order to protect their savings. But banking sources told bne IntelliNews that they are preparing for the worst in 2016.

At 40% of loans and 75% of deposits, dollarisation in the sector is high, and more borrowers are bound to default on their loans because of the depreciation. Besides, the depressed economy, which contracted by 7.8% in nominal terms in 2015, contrary to the official figure of 1.1%, is expected to have spillover effects in the sector.

Furthermore, the manner in which CBA handled the two big depreciations in 2015 – by keeping consumers and banks in the dark until the very last moment – has eroded the regulator's credibility and the trust in the national currency.

As late as February 18, on the eve of the first devaluation, CBA president Elman Rustamov reassured Azerbaijanis that the currency would not devalue. Two days later, it did, and so did his credibility. "Elman Rustamov has arranged a cold shower for the Azerbaijani people," MP Vahif Admadov ranted on February 21, his feelings echoed by many.

Almost a year after his initial reassurance, on January 27 Rustamov told reporters that "the situation is under control...Except for one or two banks with weak performance, the level of capital and liquidity is high”. If past experience is anything to go by, this is not a good omen.

Closing banks

The central bank has made some efforts to strengthen the banking sector. Prior to January 2014, the minimum capital requirement for banks in Azerbaijan had been AZN10mn (€5.6mn), but CBA had notified banks as early as 2012 that it would increase it fivefold.

Authorities say that the six banks that had their licenses revoked this week – United Credit Bank, Bank of Azerbaijan, NBC Bank, Caucasus Development Bank, Atrabank and Gancabank – had violated the minimum capital requirement of AZN50mn (€28.8mn) for over two years.

While official financial information on the current state of the six banks is not available, the unofficial data that bne Intellinews has seen shows that the banks had just over the minimum capital requirements at the end of 2015. Caucasus Development Bank reported a capital of AZN54.3mn (€30.4mn) at end-2015, NBC Bank had AZN50.1mn (€28.1mn) and Atra Bank AZN50.5mn (€28.3mn). This seems to indicate that the floating of the manat in December finally pushed them over the edge.

In revoking their licenses, the regulator also cited a failure to meet their obligations to creditors and manage finances reliably and in a prudential manner, but did not elaborate.  

An immediate problem arising from the closure of the banks will be reimbursing depositors, most of whom were uninsured. According to the abc.az website, the six banks has 222,916 retail depositors, only 31,266 of whom were insured. The Azerbaijani Deposit Insurance Fund (ADIF) will spend half of its funds, or AZN68mn (€38mn) on reimbursing insured depositors, ADIF Executive Director Azad Javadov told abz.az, meaning that some 190,000 would be left without their savings.

Until a week ago, Azerbaijan lacked a compulsory deposit insurance scheme, a staple weapon in any regulator's fight against financial instability, but parliament adopted a deposit insurance law that will come into force in February and safeguard all deposits up to AZN30,000 (€16,850) for the next three years. That scheme looks a wise precaution as the sector heads into turbulent times.

Merging trouble?

As well as more failures, further consolidation of the Azerbaijan banking sector looks inevitable, given that even the remaining 37 banks is too many for a country with a population of 9.5mn, and with total banking assets of just AZN28.5bn (€16.4bn), or 53.7% of GDP in 2015. However, consolidation may not necessarily lead to stronger banks, given the lack of transparency over their ultimate owners, the lack of reporting of their financial position, and the already parlous state of some of them.

The merger announced between the country's 13th and 15th largest banks, AG Bank and Demirbank, could entail more financial costs for Baku. The two banks are of similar size, so the merger is expected to take place on equal terms, but they were both placed on negative watch by rating agency Fitch in December over a "weakened loss absorption capacity after devaluation".

Dmitri Vasiliyev of Fitch Ratings told bne IntelliNews that the two banks had not notified them about the merger and that commenting on the topic would be premature. However, he suggested that a merged bank would likely need financial support from the Azerbaijani government to cover AG Bank's bad assets.

But there may be a political ulterior motive behind the decision to merge the two banks: removing AG Bank's founder, chairman and big (23%) shareholder Chingiz Asadullayev from his management position. A banker with some 36 years of experience and a former MP who served in the Azerbaijani parliament between 2005 and 2015, Asadullayev's name came up repeatedly in recent months in a scandal involving his cousin, former Security Minister Eldar Mahmudov. After it was revealed that his bank allegedly helped Mahmudov to funnel extortion money out of the country, Asadullayev lost his parliamentary portfolio in the November 2015 elections.

Mahmudov, together with numerous security and telecommunications officials, was sacked for allegedly extorting money from private businesses, and for crossing President Ilham Aliyev. While Asadullayev declared himself an unwavering " soldier of [President] Ilham Aliyev", even after he lost his position as an MP, he may have to pay a higher price yet.

Asadullayev founded AG Bank in 1992, and has sold shares of the bank to other investors in the decades since. With assets worth AZN514mn (€295.8mn) at end-2014, AG Bank now lists the International Finance Corporation (17.5%), private company Kazimir Partners (10%) and Farzulla Yusifov (17.7%) among its largest shareholders.

According to Trend news agency, AG Bank's ATMs have been replaced by those of Demirbank in a number of districts in Baku, an unusual and precipitate move given that AG Bank representatives have said that there is no action plan for the merger yet.

Meanwhile, on January 27 the Report news website announced that Pasha, Kapital and Ata Banks were discussing possible merger plans as well. The information has not been confirmed by any other source, but it makes sense given rumours over the ultimate ownership of the three banks.

On the face of it the banks belong to different holdings: Kapital and Pasha Banks to Pasha Holding, which is connected to the family of first lady Mehriban Aliyeva (nee. Pashayeva), while Ata Bank belongs to Ata Holding, which is ostentatiously controlled by the family of Tax Minister Fazil Mammadov. Sources in Baku, however, told bne IntelliNews that Mammadov acts as a figurehead for Aliyev at the helm of Ata Holding. Therefore if a merger does take place between any of the banks, it would simply confirm suspicions that the owners behind the three banks are in effect the same. "Only 10 people truly know what is happening behind the scenes in Azerbaijan," a source confided to bne IntelliNews.

That there is so little official information about such an important sector of the economy as banking is troubling, and the overall lack of transparency adds to public distrust and fear. And fear can beget serious crises, for the banks and the whole Azerbaijani economy.