INTEREST RATES TO REMAIN

Compensation of problem loans is going to end in Azerbaijan soon and the justice will be finally met for more than 600,000 borrowers. The idea behind this unprecedented move of the government was, among other things, to stimulate an increase in public confidence in the banking sector and, as a result, to revive the credit market.

To make this happen, however, it is extremely important to ensure low interest rates for both the borrowers of consumer loans and businessmen. But the rates of commercial loans do not decrease, despite all the efforts of the Central Bank and other market regulators.

Growth factors

The economy of Azerbaijan has almost completely survived the post-devaluation shock and has been able to return to the previous development rate. But the banking sector, most affected by fluctuations in the exchange rate of the manat, still cannot decide on simpler loaning terms, although the Central Bank has reduced the interest rate seven times since 2018 from 15% to 8.75%.

According to Samir Aliyev, expert of the Centre for Support of Economic Initiatives, 70% of banking assets before devaluation were credits, while today this figure is 40-43%. "This means that banks decided to change their policies. If earlier investments in securities reached 1-2%, today banks invest in securities more than 20% of their assets. But as the credit portfolio has decreased, bank incomes have decreased too," S. Aliyev said. But how did this affect loan rates? According to CBA, as of April 1, 2019, the average interest rate on individual loans has increased from 16.31% to 17.04% since the beginning of 2018. In other words, discount rate decreased, while interest rates rose. How and why?

In fact, interest rates are formed from several components. The first is the cost of the resource. This is the main cause of the paradox. After all, refinancing rate, according to which CBA lends to commercial banks, is declining. But commercial banks receive a very small share of loans from CBA. Therefore, reduction of the discount rate does not play a significant role in the credit policy of banks. "The loan portfolio of the Central Bank is about ₼400 million. This is a very small amount of total bank assets, which no central bank can influence the market with. The impact of CBA is on the value of money that banks transfer to each other through a change in the discount rate," the Chairman of CBA, Elman Rustamov, noted.

Interest rates on loans depend much more on rates of deposits attracted by banks, which today reach 14-15%. Next factor is the bank's profit, which, according to recommendations, should not exceed 1-2%. Many Azerbaijani banks indeed follow these recommendations.

Finally, one of the most significant components in recent years is the risk pay. The reserves for possible losses on loans that banks are required to allocate in accordance with the requirements of the Azerbaijan Financial Market Supervision Chamber and determine the current high interest rates.

Limiting of rates?

Eventually, high interest rates began to worry both the government and the parliament, when a group of deputies severely criticised the banks and demanded them to reduce the loan rates. Several possible solutions were proposed, one of which was the possible limitation of interest rates by introducing an upper limit. The idea has been actively discussed since the beginning of 2019 and was made publicly available in the end of March - beginning of April.

At the annual conference of Fitch Ratings on Azerbaijan held in Baku in early April, Ayten Mammadova, head of the risk management department of the Financial Market Supervision Chamber, noted that the regulator is considering the possibility of limiting interest rates of bank loans. "We agree with the opinion that the rates are quite high, but legislation currently does not allow us to restrict banks in this matter. We have proposals for limiting interest rates, but this issue is still under discussion," Mammadova said.

However, the proposal was negatively received already at the conference. Some bank representatives said that this is a restriction of banks' freedom, and noted that this step will lead to a sharp reduction in interest rates on deposits. For example, a member of the board of the PASHA Bank Azerbaijan, Bahruz Naghiyev, said that banks can reduce interest rates, but this will also decrease deposit rates as well. "If everyone agrees to keep funds in banks at the rate of 6-7%, then banks will also be ready to provide loans at lower rates," he said. In other words, the banker once again confirmed that deposits are the main source of loans, which makes one wonder: are depositors willing to moderate their appetite and receive lower interest payments on deposits for cheaper loans? Indeed, otherwise such a move could lead to an outflow of deposits and another problem in the banking sector.

Thus, in early May, Elman Rustamov said at a press conference that they would not introduce upper limit on interest rates. At the same time, the head of CBA noted that the issue was solved at a higher level. "The position of the Central Bank on this issue has always been negative. The decision to limit interest rates would not be entirely correct in the light of the reforms implemented in Azerbaijan," Rustamov said. He noted that at this stage it will lead to lower interest rates on deposits, which will reduce the incomes of population and in the future may cause the emergence of shadow banking, which will create a new series of problems.

In fact, limits on interest rates are practices in a number of countries, but these are countries with very low income. At the same time, this restriction is adopted only for consumer loans, not as a tool of economic policy, but to combat artificially high interest rates to protect consumers.

Reforms are required

Limiting interest rates and regulating them outside market laws can lead to negative economic consequences, such as the shadow banking and, as noted above, an outflow of funds from the banking sector. How can one deal with high interest rates then? Naturally, it is necessary to ensure reduction in some components. For example, a further reduction in the discount rate and its return to the pre-devaluation level will have a certain impact on interest rates. On the other hand, it is possible to introduce certain reduction in the cost of deposits, but it is important not to overreact and run into a negative reaction of the population, which does not really trust the banking sector anyway.

A good factor on deposits is the reduction of the upper limit on the interest rates of insured deposits from the Deposit Insurance Fund of Azerbaijan (ADIF), which currently stands at 15% for deposits in national currency. In addition, experts note the positive impact of increasing bank lending by the CBA, because even with the current refinancing rate, these resources are cheaper than deposits.

Banks will not reduce their margins, so the second option could be the change in approach to creating reserves for loans. The regulator has already announced plans to adopt new rules for banking regulation by 2020. In addition, from February 13, new rules for managing credit risks came into force, according to which Azerbaijani banks should develop a new system in this area. They also noted the parameters of the internal risk rating system, which banks will have to prepare, the process of loan restructuring, etc. So the regulator also began to act in this direction.

Another necessary element to solve the problem should be competition, as only in a competitive environment will the banks be able to increase interest rate for fear of losing the customer base.

Considering all the above, it is necessary to look for a compromise and develop painless mechanisms to reduce interest rates, using international experience. After all, unilaterally made decisions will not bring positive results and may harm the existing stability in the financial system of Azerbaijan.