RISK BUFFER

Despite the ongoing reluctance of developing countries in Europe, the Middle East and Africa (EMEA) to introduce sustainable banking regulation mechanisms, Azerbaijan is to be commended for its leadership in implementing reforms in the region, according to the assessments of international organisations. Analyses of S&P Global Ratings and International Monetary Fund (IMF) reports indicate positive dynamics in reforming the country's banking system, despite persistent structural vulnerabilities.

Strengthening control and sustainability

S&P has observed that Azerbaijan has made notable progress in establishing and implementing mechanisms for resolving bank insolvency. These mechanisms refer to the set of measures that are put into action in the event of the insolvency of systemically important banks. This is particularly important in light of the fact that many countries in the region lack effective legal mechanisms for regulators to intervene in a timely manner in troubled financial institutions. In many jurisdictions, regulators continue to rely on interim measures, which increases the risk of financial crises spreading to other segments of the system.

S&P's analysis indicates that the Azerbaijani model exhibits a propensity towards institutionalised regulation. One of the key achievements was the implementation of the Risk-Based Supervision (RBS) model, which was piloted in early 2025. The new approach allows supervisors to focus on the most risky institutions and promptly identify potential threats to financial stability.

Nevertheless, the IMF acknowledges the presence of ongoing vulnerabilities, many of which are systemic in nature. Firstly, the banking sector continues to rely heavily on corporate deposits, which are primarily driven by oil revenues. This structure renders the financial system vulnerable to external commodity shocks and domestic structural imbalances.

The rapid growth of unsecured consumer lending poses a significant risk, particularly in the event of a decline in household incomes or a deterioration in the macroeconomic situation. IMF analysts have identified a further significant issue: the high dollarisation of deposits and assets. This has the effect of increasing the sector's sensitivity to exchange rate fluctuations.

According to the Central Bank of Azerbaijan's report on financial stability, the trend towards dollarisation decreased in 2024. Consequently, the share of US currency in the loan portfolio decreased by 2.7 percentage points, reaching a historical low of 16.1%, and in the deposit portfolio, it fell by almost 1% over the year, to 37.5%. The CBA anticipates that this trend will persist, given the present stability of the exchange rate of the national currency and the absence of significant risks for its fluctuations in the near future.

According to the IMF's latest Financial Sector Assessment Programme (FSAP), stress tests on solvency have demonstrated that, in general, Azerbaijan's banking sector is resilient to significant external shocks. However, 8 out of 23 banks, which account for more than a third of total banking assets, could face a capital deficit in an unfavourable scenario. The aggregate deficit in this case may reach 0.5 per cent of GDP. A similar picture emerges in terms of liquidity, with adequate reserves generally in place, though individual banks may require support.

Both international organisations have emphasised that Azerbaijan is making positive progress. However, for the reforms to become irreversible, it is necessary to expand the set of macroprudential instruments, strengthen the legislative framework for bank resolution, strengthen the CBA's role as lender of last resort, and increase disclosure and transparency requirements.

Capital growth and resilience to stress

According to the CBA's Financial Stability Report, the capital adequacy ratio (CAR) of the banking sector is projected to reach 20.3 per cent in 2025 and 22.9 per cent in 2026 in the baseline scenario. Even under the most pessimistic of scenarios, the ratio will remain above the minimum regulatory level, reaching 15.6 per cent in 2025 and 14.7 per cent in 2026.

The CBA has noted that current capital levels provide a significant buffer to absorb potential losses. However, stress tests indicate that the main pressure on capital is driven by rising credit risks as well as an increase in risk-weighted assets (RWAs), which will reduce CAR by a combined 4.2 p.p. in 2025.

The primary factor contributing to the rise in RWAs was active credit expansion, with a volume growth of 10.3% (by ₼3.3 billion) over the year, surpassing the overall growth of bank assets, which stood at 7.8% (by ₼3.8 billion). Consequently, the share of RWAs in total assets reached 67 per cent, indicating an increase in the riskiness of the loan portfolio.

According to the CBA's assessment, the structure of risks in the banking sector is distributed as follows: 93.3% of the risks are of a credit nature, 5.9% are operational risks and 0.8% are market risks.

In order to ensure the continued success of this configuration, it is essential that capital strengthening policies are continued, risk management is strengthened and asset quality is carefully controlled, especially in the context of accelerated credit growth.

The verified analysis indicates that the banking sector of Azerbaijan continues to show a trend towards moderate concentration. The three largest banks in the country control 54.1% of the loan portfolio, 67.4% of the deposit portfolio and 63% of total assets, with this figure remaining stable.

Notwithstanding the 14.9% growth in operating income in the first quarter of 2025, net profit of the banking sector in Azerbaijan decreased by 18.7% to ₼253.3 million. The primary factors contributing to this decline were a substantial increase in operating expenses (+27.1%) and higher provision charges (+34.6%). This may indicate a more conservative assessment of credit risks by banks, given the increasing stress and growth in lending activity.

Therefore, as of 1 April 2025, the banking sector's assets totalled ₼54.9 billion, which is 12.2% more than the same period last year. Of this amount, ₼26.28bn were net loans to customers. Over the past year, the sector's loan portfolio has expanded by 15.7%, with the proportion of loans to total assets increasing from 46.4% to 47.9%. Concurrently, the banking sector's liabilities rose by 12.6% to ₼47.96bn, with the deposit portfolio increasing by 7.1% to ₼37.3bn.

As you are aware, on 1 March 2025, the Central Bank introduced a new norm for banks: a countercyclical capital buffer at the level of 0.5% of total and primary capital. This decision is based on an analysis of the credit "gap" - the difference between the actual credit-to-GDP ratio and its long-term average. According to the latest estimate, the credit gap was 2.9 per cent, which exceeded the prescribed threshold of 2 per cent. This was the basis for activating the buffer.

CBA head Taleh Kazimov has stated that the introduction of this norm is intended to establish financial stabilisation mechanisms, which will be implemented at the expense of banks' profits during periods of economic growth. He emphasised that the current level of 0.5% does not have a restraining effect on lending activity: "Such a measure creates space for the accumulation of reserves in favourable periods, without reducing the pace of lending. Modelling has shown that raising the buffer to 1% could lead to a reduction in lending and an increase in interest rates."

The CBA also does not anticipate a negative impact on borrowing costs. "The rise in rates is not due to the introduction of a buffer, but rather to the increase in market interest rates, which has been caused by a decrease in liquidity. The latter is attributable, in part, to the rise in the balances of the government's free funds on bank accounts," Kazimov stated.

In summary, given the emerging regional trends and global interest in strengthening the resilience of financial systems, Azerbaijan has the opportunity to establish itself as a model of sustainable banking regulation in the post-Soviet space. The successful implementation of the remaining reforms will strengthen investor confidence and enhance the stability of the financial system in the long term.