NATURAL SELECTION

The Central Bank of Azerbaijan (CBA) has begun to implement a new phase of reforms in the republic's banking sector.  The main idea and purpose is to reduce the risks which were found to exist in the country's banking system during the global financial crisis, in particular, by eliminating the small players in the market.

As is known, during the crisis the Azerbaijani banking sector has managed to avoid bankruptcies or closures by supervisory bodies, although even the CBA representatives predicted that a drop in the number of lending institutions, perhaps on a large scale, was possible. At the same time, the CBA has set as its main goal the development of a strategy to consolidate and optimize the banking system.  And the elimination of weak banks from the market is part of this strategy. Work in this direction started on 1 December, when the CBA made public its decision to revoke the licenses of two banks, the Debutbank (founded in 1994) and Kovsarbank (founded in 1992).

Rehabilitating the system

Previous reductions in Azerbaijan's banking market took place in 2008, when licences were recalled from Poctbank, which had effectively been defunct for a long time, and Atlantbank which failed to meet capitalization requirements.  But back then, the "vacancies" were filled very quickly by issuing licences to the Naxcivanbank Joint Stock Company and Azfinans Bank (now AFB Bank).

Today, the CBA's main objective is to upsize banks and increase capitalization in the banking system.  It is practically impossible today to predict how many banks will remain after the reforms, or how effective the policy will be.  The experience of a number of countries shows that if a bank has found a niche in the market and occupies it confidently, size is not so important; the main point is its ability to operate without breaking the law or violating industry standards.  A good example is Switzerland, a relatively small country, where large and small banks coexist peacefully and there are an "indecent" number of banks, so that you see a bank no matter where you go.  There is work for everyone there, and every bank is in demand.

Of course, the situation in Azerbaijan is different, and the number of credit institutions needs to be reduced here, firstly to keep in the market the more professional players who are able to supply quality banking services; and secondly to reduce banks' operational expenses and, accordingly, interest rates for customers.

However, the pace of rehabilitation in the banking sector must coincide with the general economy's rate of recovery:  enforced closures over a short period would cause panic among the banks' main consumers.  In this respect, three paths were chosen to reduce the number of banks:  consolidation, limited licensing and changes of status to non-banking credit organizations and, finally, elimination from the market.

The strategy of consolidating banking organizations will give them some time to reach appropriate decisions - be it to merge with another bank, change status to non-banking credit organization, or liquidation. This process will be long-term.  And the CBA's main goal will be to guarantee personal deposits in banks, which is very important for maintaining trust in the sector.  If a decision is made to consolidate banks, then deposits will either be transferred to healthier banks or compensation will be paid by the Deposit Insurance Fund, of which 43 of the nation's 45 banks are members.

CBA Board Chairman Elman Rustamov said, when commenting on the closure of Debutbank and Kovsarbank, that the CBA had no plans to reduce the number of banks further.  However, the CBA had noted problems at those two banks for a long time. They had lost liquidity and solvency and did not have the potential for consolidation or change of status to non-banking organizations. The point is that these banks had considerable credit liabilities, whereas only sound banks that have no liability problems can be consolidated. Therefore, in accordance with the law, their licenses were revoked.  At the same time, the country's chief banker stressed that revoking these licenses would not lead to loss of deposits, although there were only a small number of personal deposits. The CBA is already conducting research and implementing measures in accordance with the provisions of the law to return deposits.

Mr. Rustamov confirmed that the CBA is pursuing a policy of eliminating weak banks to avoid problems in the banking sector. This was done in the United States and Russia, so this is a standard procedure. He once again urged banks to consolidate because, to conduct operations properly, they must have broader business potential and better corporate management standards.

Happy together

In the international markets at present, banks with a broad customer base, networks of branches, proprietary unique risk management technology, internet technology, competent sales policies, sound personnel structures and so forth are considered most attractive for takeovers and mergers.

It has to be said that the Azerbaijani banking sector also has successful examples of bank consolidations with the participation of the European Bank of Reconstruction and Development.  The present-day UniBank was created in a 2002 merger of two commercial banks, MBAnk and Promtexbank, in which the EBRD owned a 15% share. Then in 2005, the Bank of Baku merged with IlkBank. The CBA made statements about an intensification of the process of bank consolidations in 2010, but the year is drawing to an end and there has not been a single merger yet.

In the mean time, interest from international institutions in banking sector consolidation in Azerbaijan has increased further:  besides the EBRD, the International Financial Corporation (IFC, part of the World Bank) has also expressed interest in participating in this process.  Aliya Azimova, IFC representative in Azerbaijan, said recently:  "We are ready to consider supporting the process of consolidation of Azerbaijani banks if it happens, but the corporation has received no such proposals yet."

Farhad Amirbeyov, manager of the Baku Interbank Currency Exchange, argues that the time has come for consolidation of assets and capital in the banking sector because capitalization is needed.  "Banks must increase capitalization to several times, if not dozens of times, greater than the minimum requirements of CBA standards. Having banks with capital of AZN 100 million or more, financial markets of AZN 2-3 billion and a stock exchange of AZN 5 billion - this is what will benefit the economy," said Mr. Amirbayov.

For now, the minimum permitted amount of a bank's own assets is AZN 10 million, as in the pre-crisis period.  Statistical data published by the CBA show that credit institutions with assets exceeding AZN 10 million numbered 41 banks in October, which is the same as in September and October 2009. This category of bank remained at 97.8% of aggregate capital of all banks in October.  Four banks (with 1.8% of total sector capital) own assets between AZN 5 million and AZN 10 million, and two banks (0.4%) had assets of AZN 3.5-5 million. It was the latter two banks that were removed from the market.  Accordingly, four more banks might face closure in 2011 unless they increase their capitalization.

Tighter supervision 

Among the main strategies towards greater stability in the banking system, the CBA lists increasing transparency, improved quality of banks' base capital, introducing stricter criteria for risk management and disclosure of information on risks, limiting financial levers and introducing countercyclical requirements for reserve capital (including provision formulation) and revising standards of liquidity. The CBA maintains that these measures will enable an increase in stability in the banking sector, the main channel of financial flow in a market economy and a stable source of long-term resources for economic growth.

Further measures will include changing requirements for capital, which involves improving the quality, stability and transparency of the banks' base capital, including the creation of reserve capital. In parallel, a supervisory body will continue to amend banking regulations to introduce the possibility of transforming a bank into a non-banking credit organization (NBCO).  In general, banks which do not accept consolidation as a way of increasing capitalization will be invited to transform into NBCOs.

The CA also intends to improve relations in the regulation of system-forming banks. Learning the lessons of the global crisis, the CBA argues for equality of approach to all banks in respect of prudential standards.  This is why post-crisis development and improvements to the effectiveness of supervision include the possibility of introducing a systemic, more integrated approach to the regulation of system-forming banks which could pose risks to the entire banking sector.

This means that the CBA is today preparing to introduce new regulatory frameworks in three areas:  regulation of adequacy of capital, liquidity management and financial reserves.  Let us note that under current law, the standard requirement for adequate capitalisation is 12%, and the liquidity coefficient is set at 30%. The minimum incorporation capital for current and future banks is AZN 10 million.

It has to be said that CIS countries tightened requirements for bank capitalization during the crisis. From 1 October 2009 the Kazakhstan National Bank introduced a capitalization limit of at least 5 billion tenge (US$34 million) and at least 2 billion tenge for regional banks.  From 1 July 2011, the banks' own capital will have to be at least 10 billion tenge and, for regional banks - at least 4 billion tenge.  For its part, the Russian Central Bank and Finance Ministry prepared a draft Strategy of Development for the Banking Sector to2015, in which they proposed to increase minimum bank capital to 250-500 million rubles (USS8-16 million).

During the years of crisis, the Azerbaijani Central Bank continued to implement a constrained and healthy growth policy.  Monitoring and assessments of measures to strengthen systems of risk management are conducted regularly at the banks. Depending on their results, proposals are prepared to improve and adjust ongoing and future measures to be taken by the banks.  As a result of these measures, the level of adequacy of Azerbaijani banks fluctuates within the 20% limit. Liquidity in the banking sector is also adequate and in some banks it is 100% or even more. Assets in the banking sector increased by 9.5% between January and October 2010 to AZN 12.768 billion, which is a historical high for the country's banking sector.  The launch of a new phase of reforms by the CBA inspires confidence that this record will be broken before long.