ONE GOOD TURN DESERVES ANOTHER

Regardless of the quality of the loan portfolio and the methods used in the management of credit risks, all banks in one way or another are faced with non-repayment of loans. Against the backdrop of the global financial crisis, the proportion of problem loans has naturally grown in all the worlds' banks and Azerbaijan, in this case, is no exception. Although the impact of the crisis on the economy of Azerbaijan has been minimal on the whole, declining indicators around the world and the relatively restrained growth curve in our country's statistical data have a corresponding negative impact at a  psychological level, which eventually persuades people to curtail their spending as much as possible. This often affects their ability and willingness to make credit payments in a timely and accurate manner. Hence, the growth of bad debts in bank portfolios.

The necessity of timely analysis...

Problem loans are those for which one or more payments are not made on time, whose market value has fallen significantly or in which there are circumstances causing the bank to doubt that the loan will be repaid.

As mentioned above, every bank has bad loans in its portfolio and, therefore, the main issue is to establish the permissible level of such loans with regard to the total value of loans disbursed. For foreign banks, the following proportions are admissible: the number of loans written-off, as a percentage of the total amount paid - 0.25-0.75 per cent; the share of overdue loans (over 90 days) of the total issued - 0.5-3 per cent. If the latter figure rises to 7 per cent, the bank's position is defined as critical.

According to the Central Bank (CBA), since March last year, the proportion of overdue loans in the total loan portfolio in Azerbaijan has not exceeded 3.8 per cent. By the end of last year, the amount of overdue loans and subsidies had reached 303.5 million manats (3.6 per cent of the loan portfolio) against the 159.8 million manats of 1 January 2009. At the same time, during 2009 Azerbaijani banks increased lending to the economy by 17.4 per cent - to 8,407.5 million manats. That is to say the situation cannot be called dangerous, but many experts believe that it is necessary to strengthen control over this segment of the country's financial market.

In any case, the CBA itself also says that it is going to intensify its efforts to reduce problem assets, including overdue loans, even further this year. According to the first deputy chairman of the CBA, Alim Quliyev, "the Central Bank has already undertaken measures to improve the quality of problem assets and preventive measures were aimed at halting the growth in the issue of credit and assets and improving the risk management system."

In this respect, one of the best methods for evaluating credit risk is internal scoring. According to the chairman of the Azerbaijani Risk Professionals Association (ARPA), Rufat Mahmud, banks face challenges due to the lack of a single scoring standard in the sector. Thus, it may be necessary to combine the efforts of all banks to create a single model or standard. We should note that scoring helps to estimate the probability of the future insolvency of a potential client or borrower who has already received credit. This evaluation method can be applied at various stages of the relationship between the company and the client: at the time of the application, during an assessment of the client's behaviour and during the return of the loan. Scoring in one form or another has already been introduced in many credit institutions in other countries. And their most pressing problem today is reconfiguring scoring models while changing the loan policy of the bank.

Experts say that, in most cases, bad loans do not arise suddenly. In practice, there are many signals indicating a borrower's deteriorating financial condition and an increasing probability of non-payment of a loan: the cessation of contact with employees of the bank, unexplained delays in financial reporting, unexpected and inexplicable sharp changes in balances in the client's accounts etc. Thus the international auditing company PriceWaterhouseCoopers (PWC) recommends that Azerbaijani banks conduct a detailed analysis of overdue loans in their balance of payments. According to Vuqar Aliyev, a spokesman for PriceWaterhouseCoopers, following the introduction by the Central Bank of Azerbaijan of international financial reporting standards, it is necessary to provide more detailed information on problem loans in reports. "A detailed analysis of these loans will allow time to calculate the probability of their return," said Aliyev. He believes that it will help the bank to sell its troubled assets in a timely manner, if necessary. "The longer the asset remains on the balance, the lower the price for its sale, which is why banks need time to do calculations on each overdue loan," he said.

According to him, if a loan is overdue by 60 days or less, it can be sold for 55 per cent of its cost, but by 150 days or more - then for less than 23 per cent. "For a timely response, a bank needs to establish the appropriate electronic data base of credit operations," Aliyev concludes.

...and good governance

By the way, on the sale of problem loans. Since it is impossible to completely avoid credit losses, they are sometimes regarded as the cost of doing banking business. But this does not mean that the bank must put up with such a loss because, in this case, the damage caused to the bank is much higher than the sum of bad loans. A large number of overdue loans leads to a loss of confidence in the bank among depositors and shareholders, problems with solvency and liquidity and a deterioration in the bank's reputation. In addition, the bank must bear the additional costs associated with the requirements for loan repayment, and some of the bank's assets are frozen in non-productive business. Such losses may be far greater than the direct losses from unpaid loans.

Therefore, one of the main indicators of successful bank management is the adoption of effective policies for the management of problem loans. And although, according to Garth Bedford, Financial Market Crisis Response Project Manager of the International Finance Corporation, Azerbaijan was least affected by the global financial crisis and the level of problem assets in the country was maintained at a satisfactorily low level, the introduction of best practice in the management of problem assets will do no harm to Azerbaijani banks, because there are still problems in this sphere.

There are three basic ways today to remove problem assets from the balance sheet - private placement, auction and limited auction. "Since securitization is a fairly new concept in Azerbaijan, the removal of bad assets by the placement of securities has not yet been applied, but in the long-run, this could improve the effectiveness of the management of banks' liquidity," he said.

The most commonly used method in Azerbaijan is that of private placement, which is fast but not always effective, because banks do not always sell assets at sufficiently high prices. "Further, there no companies in the country providing services for buying and selling problem assets," says Bedford.

In international practice, collection agencies are set up to deal with such problems - independent organizations professionally involved in returning overdue debts. By signing an agreement with a creditor, such organizations may collect information about the debtor, in particular about his welfare and whereabouts, including from official sources, contact him by phone or email and meet him in person. A collector is entitled to formulate and implement schemes for the benefit of the creditor and construct agreements on debt settlement and restructuring.

The establishment of such agencies is also becoming relevant for Azerbaijan. In Russia, Kazakhstan and 

Ukraine, the issue of bad loans has been dealt with by collection agencies since 2007-2008. Moreover, these organizations specialize in working with problem debts, not only with banks but also insurance companies, credit unions, municipal enterprises, small and medium-sized businesses and they have the financial capacity to purchase large debt portfolios from banks.

Risk is a not banking business

However, almost all international financial institutions and analytical agencies recommend that banks, in principle, should take a very careful approach to the issue of credit, in order to avoid the growth of problem assets. According to Nienke Oomes, head of the IMF mission in Azerbaijan, "last year Azerbaijan saw high economic growth and, consequently, there was an increase in the volume of credit in the economy. Now it is difficult to maintain high rates so, in Azerbaijan, it would be imprudent to maintain high rates of credit."

With increasing lending, there may be problems with the repayment of loans, and the trend towards moderate lending will continue this year, she said.

The banks increased lending to the economy of Azerbaijan by 0.3 per cent in January 2010 and, compared with the same period of 2009 - by 17.1 per cent. As of 1 February, the banks had granted credit worth 8,431.2 million manats. The Central Bank of Azerbaijan says, concerning deterioration in bank loan portfolios, that it is in control of the situation in the country's banking sector. According to the chairman of the CBA, Elman Rustamov, "the deterioration of bank loan portfolios is to be expected against the backdrop of a global financial crisis, because there are certain difficulties in business, particularly in trading sectors. However, stress tests conducted in banks show that the situation will remain under control in 2010 and we will preserve stability in the country's banking sector."

In his view, this is confirmed by the satisfactorily high level of capitalization and liquidity in the banking sector.

Within the framework of the CBA's anti-crisis measures, last year the country's banking sector was provided with liquidity in direct and indirect forms to the tune of about $2 billion. This allowed the banking system to function normally and comply fully with both internal and external obligations. But how long the CBA will manage to maintain stability in the market if the world crisis persists, is a moot point. And therefore, competent risk management and the minimization of problem assets are still the main determinant of the future of any bank.