STAYING AFLOAT

This summer has been quite hot for Azerbai-jan's banking sector. The developments rapidly unfolding around the bankruptcy of two banks and the nearly fateful decisions of the Central Bank (CBA) have been somewhat surprising but not unexpected. Thus, we can safely assume that a qualitatively new stage in the development of the banking sector has set in, and in the next couple of years we will witness very interesting trends and developments here.

The first step is not always the hardest

It all began with the Central Bank of Azerbaijan revoking the license of the RoyalBank on 12 July because of the latter's failure to deliver on its obligations. More specifically, the CBA statement said the decision was taken due to "the bank's failure to comply with the requirements on capital adequacy, the amount of equity, defaults to the creditors, breach of prudential norms and lack of confidence in the implementation of activities". As early as on 13 July,  a temporary administrator of RoyalBank was appointed. In addition, the Central Bank asked the judicial authorities to declare the bank insolvent and unable to fulfill its obligations to creditors. By a decision of Administrative and Economic Court of Baku No 1 dated 25 July, RoyalBank JSC was declared bankrupt and the Azerbaijan Consulting Company LLC appointed as liquidator of the bank.

RoyalBank was established as a joint commercial bank OZ Bank on 2 August 1993 and at the time of bankruptcy had 32 branches in Baku and the rest of Azerbaijan. It also owned a RoyalCard processing center. The bank's shareholders were two Azerbaijani businesses and 79 individuals. However, RoyalBank had been the lowest rated national bank for a long time and was barely able to make ends meet. Despite that, more than 6,000 people continued to hold their deposits there.

And it is their fate against the backdrop of the bank's failure, or rather the fate of their deposits, that is the most interesting point in this story. RoyalBank was a member of the Azerbaijan Deposit Insurance Fund (ADIF). This is the first bankruptcy instance in its history and, in fact, the first opportunity to show its effectiveness and ability to respond quickly.

We must pay tribute to the ADIF as it has passed the first test successfully. The return of the deposits is not yet complete, but the fact that the necessary decisions and measures have been

taken promptly and the actual process started just a couple of weeks after the announcement of the bank's bankruptcy is a good indicator for the fund.

On 18 July, a special meeting of the ADIF board of trustees approved agent banks through which compensation of RoyalBank's insured deposits will be paid. The selected agent banks include Muganbank, Bank Respublika and AGBank. According to the ADIF, the fund has insured 98 per cent of RoyalBank deposits, while those in the amount of up to 30,000 manats, in accordance with existing rules, will be compensated in full. We recall that deposits in ADIF member-banks at an annual interest rate of over 12 per cent are not insured by the Fund.

The payment of compensations began on 1 August 2012, and the deposits were distributed among the said three banks. For people's convenience, booklets with addresses of bank branches were also prepared showing their location on the map and the list of required documents. In addition, application forms were handed out together with the guidelines on how to fill them in.

According to the ADIF executive director, Azad Cavadov, compensations worth a total 17.223 million manats will be paid to 6,255 investors. The deposits in 33 RoyalBank branches will be transferred to 27 branches of the three agent banks. The currency breakdown of the deposits portfolio is as follows: deposits in national currency are worth 9.620 million manats, in

US currency $8.281 million and in European currency 1.141 million Euros.

Considering the rapid pace that the repayment process, it is likely to take only about a month and end by September. This is a good indicator especially given the fact that the fund had no experience in this area. The repayment of the remaining deposits (uninsured by the ADIF) and all other creditor requirements will be funded from RoyalBank assets.

In late July, a couple of weeks after the decisions on RoyalBank, Administrative and Economic Court of Baku No 1 declared Birlikbank bankrupt and announced the start of its bankruptcy procedure. The International Auditing and Consulting Company RR-VAM was appointed as liquidator. But Birlikbank is not a member of the ADIF. Moreover, its license was revoked by a CBA decision of 28 January 2011 due to the bank's failure to comply with prudential rules and regulations of reliability, which led to a deterioration of Birlikbank's financial standing. Although the CBA had officially notified the bank of the violations of law and various regulations, it did not meet the instructions on improving its financial position and institutional development. As a result, Birlikbank lost its solvency.

The CBA statement also said that Birlikbank's license was revoked due to its inability to meet its outstanding obligations to the banking sector and public authorities and the fact that the quality of its assets and their management was at unacceptable levels. We recall that this bank, as well as DebutBank whose license has also been revoked by the CBA, has arrears on the loans issued by the National Fund on Entrepreneurship Support, which is why the latter has even appealed to the Prosecutor-General's Office.

Fateful decision of the CBA

As mentioned above, these banks have no liabilities on deposits because they operated on a restricted license, were not members of the ADIF and, consequently, their bankruptcy triggered less public outrage than RoyalBank's. However, these events put together certainly cast a shadow on the country's banking sector and raise some questions from ordinary citizens and depositors of other banks who are not well versed in the intricacies of the banking market.

The ADIF executive director, Azad Cavadov, is sure that the closure of RoyalBank will not in any way affect the market as a whole. "In fact, when people see that the tool for the insurance of bank deposits operates quite well in Azerbaijan, they will have more confidence in the system and be more cautious to invest more than 30,000 manats at an interest rate exceeding 12 per cent," he told reporters.

In fact, this statement can be regarded as a warning to investors. Obviously, RoyalBank is only the first robin of the new wave of reforms initiated by the CBA which may engulf a few other banks with a dubious reputation. On 25 July, the Central Bank passed a decision which can be regarded as crucial for Azerbaijan's banking sector: the minimum total capital of existing banks and the charter capital of newly established ones has been increased five times - to 50 million manats. The new standard for the minimum total capital comes into force on 1 January 2014.

The consistency of CBA decisions speaks for itself - the regulator wants to get rid of small market players. In its statement, however, the central bank was, of course, much more restrained: "The transition period provides banks with sufficient time to implement strategies for compliance with the new capital requirements and for a progressive realization of capitalization. The conducted studies have revealed a great potential in the banking sector to meet new requirement."

The CBA is sure that along with strengthening the Azerbaijani banks, the application of new requirements will promote equity and efficiency of financial mediation. As a result, the financial stability of the banking system will be further enhanced. "At present, Azerbaijan's banking system is entering a new phase of development. In order to strengthen financial mediation, facilitate integration into global financial markets and provide a new quality of banking services, it is necessary to continue capitalization at this stage. The strengthening of banks' capital base is of great importance to confidence in the banks and their international competitiveness."

It will also have a positive impact on the development of financial markets, in particular the interbank market, expand the access of businesses to financial services and the range of banking services proper, and make them more affordable. "All this will increase the financial depth of the banking system in line with the goals of doubling the economy and economic diversification," the CBA said.

It seems like a clear justification against the backdrop of the action plan on poverty reduction for 2011-2015 and on sustainable development for 2008-2015 approved by President Ilham Aliyev on 28 June 2011, which indicated that in order to develop the national banking system there are plans to continue increasing bank capitalization. Yet, the decision was unexpected in terms of the size of the increase and the deadlines. Of course, a number of existing banks cannot afford to execute it. Consequently, their number will significantly reduce in the next two years. This is acknowledged not only by local experts. A similar conclusion has been reached by the influential international rating agency Moody's Investors Service. "The measure that will impact existing and new banks is considered positive for the country's banking sector, as it will facilitate consolidation and ultimately increase competition among the larger banks," says a commentary on the agency's web site.

Moody's does not expect a significant increase in the capitalization of the banking system. It believes that very few small banks will be able to provide financial infusion from its shareholders and most will have to choose between consolidation and liquidation. "Since most of these small banks are weak institutions, their consolidation or liquidation will increase the stability of the banking sector," says the agency.

As of the end of 2011, only 11 out of 43 existing banks have the capital corresponding to the new requirements. These banks (about a quarter of all the banks in the country) hold more than 70 per cent of the assets in the banking sector. Of the 32 banks whose aggregate capital is below 50 million manats, we believe that only 13 medium-sized banks (21 per cent of the assets) will be able to capitalize to the level of minimum requirements using their internal funds and inflows from their shareholders or by consolidation. As a result, the new requirements are likely to prompt many of them to go for consolidation to create stronger financial institutions which will have a better financial position to compete with bigger banks. The remaining 19 small banks, which, as of the end of last year, accounted for only 6 per cent of total assets, will face difficulties associated with the necessary resources to capitalize both using their own funds and in the case of consolidation, according to the agency. "As a result, unless they are acquired by larger banks, we expect that they will be liquidated. The liquidation of small banks will make the banking system more stable because they are mostly opaque and high-stake lending entities with weak financial base and high risks" says Moody's conclusion.

It is rather hard to believe that the CBA decisions will have no negative impact on the general confidence in the banking sector. Of course, people will be more cautious in dealing with banks. Banks are likely to have to make additional touches to advertising their services, emphasizing their reliability. It must be noted that several banks have already announced their readiness to execute the CBA decision in an effort to stop clients leaving them. Most likely, the number of such statements will soon increase.

In other words, despite the obvious usefulness of CBA decisions for the future development and strengthening of the banking sector, the regulator needs to work with the banks to maintain public confidence in them. After all, confidence is a very fragile concept...