Clean-up of IBA black hole reveals cost of Azerbaijan's crony capitalism

Clean-up of IBA black hole reveals cost of Azerbaijan's crony capitalism
By bne IntelliNews December 13, 2015

The recent arrest of the former chairman of Azerbaijan’s largest bank has shone a spotlight on the country’s biggest banking scandal, which has cost the state AZN2bn (€1.7bn) so far, though the final bill may be many times larger.

The Azerbaijani banking sector was already in very fragile health before the scandal at majority state-owned International Bank of Azerbaijan (IBA). The sector is small, with assets of just 31% of gross domestic product (GDP), fragmented into 41 banks, and undeveloped – many of the banks in the market lack basic operations such as functional websites and ATMs.

This year a steep drop in oil prices and a 34% devaluation of the national currency in February have led to mounting problems with asset quality, depressed lending, a skyrocketing dollarisation in the entire sector, and scarcity of local currency liquidity in the market.

The financial problems at IBA, which holds 35% of the banking sector’s assets, were the result of a flawed business model and crony capitalist practices that are rampant in the Azerbaijan economy.  IBA borrowed internationally in foreign currency and lent to politically well-connected local businesses in manats. Many of these loans are now unlikely to be ever recovered.

A foreign diplomat explains that IBA followed a common pattern in Azerbaijan but on a much larger scale. "Banks here are family businesses,” he says. “Imagine that I want to build something and I need money. I can ask my relatives to start a bank, to borrow money from the central bank at preferential rates, I get the loan, and then I never pay it back. My relative's bank goes out of business, but that's ok because the only reason why it was set up in the first place was to finance me."

Local media have speculated that the bank’s problems are not just domestic. "In an effort to prove himself as a successful manager, the chief banker of Azerbaijan [Jahangir Hajiyev] began investing in construction projects in Moscow in collaboration with the Chechens, as well as in a metallurgic project in [the United Arab Emirate of] Fujairah," Azerdaily wrote in a March 20 editorial. The arrest of IBA's Dubai branch manager also points to the fact that something went amiss in the emirate.

The hole in IBA’s balance sheet became insupportable when the manat was devalued in February, reportedly leading to a 20% increase in the debt service cost of the bank's international borrowing.

Soon after, the scandal at IBA was triggered when Chairman Jahangir Hajiyev quit unexpectedly in March, citing health reasons. Hajiyev had worked for the bank for 14 years and had even been tipped as a future central bank governor, so his resignation came as a shock.

However, observers soon began whispering about the banks’s asset quality problems. Over the following two months, the state took full control over the bank, hundreds of employees were fired, and many prominent Azerbaijani businesspeople were arrested in connection with unpaid loans to IBA, and their assets seized.

The scandal has taken down some of the wealthiest Azerbaijanis, including Ibrahim Nehramli, a quixotic tycoon who has been trying to build an ecosystem of glitzy islands and a 1km-high tower off the shores of Baku; Nizami Piriyev, owner of the largest methanol plant in the country, Azmeco, and reportedly friend of former British prime minister Tony Blair; Rashad Mammadov, co-founder of trading company Azimport and head of the State Flag Square Complex, a large plaza on Baku's seaside promenade; Mehdi Aliyev, director of construction company Azerinshaat; Murad Jabbarli, former head of the northern region of Sheki; as well as some IBA managers, such as Ilgar Abdullayev, director of the bank's central branch, Kanan Orujov, director general of its transport business, Adil Huseynov, director of IBA's Dubai branch, and Ibrahim Huseynov, director of administrative buildings.  

Hajiyev himself was eventually arrested on December 5 and subsequently dismissed from his position as chairman of the Baku Stock Exchange. In light of the recent developments, the relatively young Hajiyev's health might not be his biggest concern at the moment. He is charged under various articles of the Criminal Code of Azerbaijan, including-large scale misappropriation, abuse of office, fraud causing serious damage, embezzlement, abuse of power, and bribery.

Baku and IBA have been silent about what happened to the bank, and sources in the banking sector are too scared to comment on the case on record, so making sense of the bank's situation requires a great deal of speculation.

Hajiyev's level of involvement in politics remains unclear, but he is the brother-in-law of Eldar Mahmudov, the former security minister who was fired on October 17 for allegedly extorting funds from private businesses. The local media have suggested that Hajiyev gave out loans to his brother-in-law, but no proof of the allegation has yet surfaced.

Bad loans get worse

The quality of IBA's loan portfolio first raised the alarm several years ago, according to Dmitri Vasiliev, financial institutions director at Fitch. "The bank started to experience asset quality problems several years ago. In my view, the government gave some time to the former management to improve the situation in the bank and to recover some problem loans, but the former management did not succeed. Partially, this may be the reason behind the management team change this year," he tells bne Intellinews.

According to its financial statement for the first half of 2015, the vast majority of IBA's loan portfolio - AZN9.4bn (€8.4bn) out of AZN10.5bn (€9.2bn), was given out to corporate clients. Officially only 13.3% or AZN1.4bn (€1.2bn) of this portfolio was impaired or overdue, and this was covered by provisions equal to 11.4% of its loan portfolio.

The real picture is shown by the government’s plan to pay AZN3bn (€2.7bn) to IBA in several tranches this year, in exchange for taking over problem loans. The sum is enough to cover the official problem loans twice over.

According to a source who asked to remain anonymous, in fact IBA has racked up $10bn worth of bad loans, with some $6bn in Azerbaijan and another $4bn among its foreign subsidiaries, primarily in Moscow, Tbilisi and Dubai. Such an amount would be an overwhelming proportion of its loan book, and filling the hole could swell the country’s very low level of state debt of less than 15% of GDP.

Poor asset quality is one of the reasons behind Fitch's rating of IBA, which is rated as junk – ‘BB’ with a positive outlook. "It is unusual for us to have the rating of such a dominant, state-owned bank two notches below an emerging market sovereign," James Watson, managing director for financial institutions, told bne Intellinews in an interview in October. "This reflects the weak track record of support for the bank over the last few years."

"If the government completes the process" of cleaning up IBA's bad loans, Vasiliev adds, "we are likely to upgrade the rating by one notch. Moreover, if the bank sells problem loans, it is a positive sign for its intrinsic financial viability as well because asset quality is likely to improve. I do not think that IBA will require much more support after this any time soon,” he says.

The plan for IBA appears to be that state-owned non-banking financial institution Aqrarkredit will purchase AZN3bn (€2.7bn) worth of bad loans from IBA, which it will try to sell at book value. The purchase increases Baku's share in the bank from 51% to 81.8% in the first stage.

If Aqrarkredit manages to sell those credits at book value, it "would be a significant positive factor for the credit profile of the bank, both in terms of its stand-alone profile, and our view of sovereign support. That is why the bank's ratings are on positive watch," Watson explains.

However, local bankers doubt that Aqrarkredit will manage to recover even half the value of the bad loans. "A 50% recovery rate would be a total success," a local banker told bne Intellinews.

What will happen to the remainder of the AZN7bn (€6.1bn) loan portfolio is unclear, but Baku will have to clean this up as well if it is serious about privatising IBA in five years' time.

It will also have to transform the whole culture of the bank, a process that has hardly begun. "The group has commenced its restructuring process with the purpose of streamlining its operations (human resources and other areas), improvement of its corporate governance, implementation of renewed lending, attraction of new financing and returning the group to profitability," said IBA in its half-year financial statement.

Yet the fact that Baku is finally being forced to bail the bank out may indicate that it is no longer prepared to let IBA be used as a cash cow to finance untenable projects, giving hope for its future. Nevertheless, the lack of transparency and accountability in the way the government is bailing out the bank suggests that there is no assurance that the situation will not be repeated in the future.