Ben Aris in Baku -

With Unibank hiring market leader Bank of Baku's head of retail at the end of March, the gloves are coming off as Azerbaijan's banking sector gets more competitive.

Azerbaijan's banking sector was hurt by the 2008 crisis like everywhere else, but the effects have been relatively mild so far. "The crisis did not affect the Azerbaijan banking sector dramatically. There were no bank defaults, no queue of depositors at bank doors, oil prices went bank soon enough, and employers paid salaries on time. Less than 20% of bank borrowings were foreign debt large portion of which came from development financial institutions. " says Elchin Gadimov, vice chairman of Rabitabank in Baku. "But the music did stop for some time. Lots of banks realized there were things they should have been doing that they weren't."

The greatest damage was inflicted on the real estate sector, which remains both moribund and the source of the worst non-performing loans (NPL). One large bank in Azerbaijan was forced into the red by its Russian subsidiary's forays into the real estate market there. There are no official statistics, but experts estimate bad debt at Azerbaijan's banks is 20-35% of total loan portfolios. Still, now the sector is growing again, banks should be able to grow their way out of the hole. Corporate lending remains depressed, but the high-margin consumer segment is booming and rapidly becoming more competitive.

Consumer lending only appeared about two years ago, but Bank of Baku quickly built up a large market share and today earns some 90% of its profits from making small loans. Now Unibank, another top five bank, is getting in on the action.

The consumer segment is one of the few places banks, flush with cash, can go. Expanding small loans also makes sense in terms of matching assets with liabilities: interest rates are currently flat, but expected to become negative later this year, as deposits are rising faster than loans and banks are already starting to cut interest rates to slow the inflow of cash. "Azerbaijan managed to avoid the situation that Kazakhstan got itself into where foreign debt was around $100bn and debtors started calling in their debt. The central bank tried to minimize the effect of the crisis by lowering the refinancing rate to 10% from 14%," says Gadimov.

The upshot is that competition is rapidly developing between the banks with a knock-on effect for customers, who are enjoying increasingly better service and lower costs. The change in mentality is highlighted by Rabitabank's ongoing negotiations to sell a stake to the European Bank for Reconstruction and Development and the World Bank's IFC, expected to be completed before the summer. "The deal is 90% done," says Gadimov. "Access to cheap funding that the deal will bring still matters, but it is not as important as two years ago. The key benefit now is the enhanced reputation and the competitive advantage from increased trust by customers in a bank with foreign participation."