RISK PROTECTION

Azerbaijan's financial sector has historically been a leader in the introduction of new instruments and products. It is considered by many to be the most innovative sector of the economy.

One of the latest innovations in the financial market is the hedging mechanism. On 1 August, the Central Bank of Azerbaijan (CBA) launched a three-year programme to provide banks and non-bank credit organisations (NBCOs) with access to this new financial instrument.

Transferring risks

Hedging is a popular instrument in today's global financial market. It is especially useful in trading currencies, stocks or commodities with frequent price changes. While it does not ensure profit, it does ensure financial stability.

Hedging can be defined as a method of risk management that involves the use of insurance to offset potential losses. This approach ultimately contributes to the mitigation of losses in the event of fluctuations in market prices, exchange rates or interest rates. Should a company import raw materials from abroad, for example, it may fix the exchange rate using options or forwards. This approach will ensure stable costs, even in the event of an exchange rate fluctuation. In effect, when an investor engages in hedging, they transfer the associated risk to intermediaries who are willing to assume it. In this case, the investor can be considered a hedger. Hedgers receive a guarantee that prices will not change, and intermediaries profit by assuming the risk. This is achieved by the use of specialised hedging instruments, commonly referred to as derivatives or derivative instruments. These options allow investors to mitigate the impact of unfavourable price changes in an asset.

Depending on the type of risk, there are different types of hedging. Currency hedging is used to protect against currency fluctuations; interest rate hedging is used to stabilise the cost of loans or bonds when interest rates change; credit risk hedging is aimed at protecting against possible borrower default; and commodity hedging is used to fix prices for raw materials or products.

Each of these types of investment helps to minimise certain types of risk and maintain financial stability, which is especially important in the volatile global currency market.

When applied to the financial market, it functions as follows. If a bank anticipates a substantial change in interest rates over a specified timeframe, which might have a negative impact on its loan portfolio, it will seek to mitigate this risk by utilising a hedging mechanism on predetermined terms. This mechanism does not eliminate the risk completely, but reduces it to a manageable level.

Hedging for banks

The new three-year programme will see funds raised by banks and NBCOs from non-resident financial institutions hedged with a financial instrument provided by the CBA after conversion into manats. The hedged funds are intended to provide financing for micro, small and medium-sized businesses, family farms and the self-employed through loan and leasing arrangements.

The favourable environment created by reforms to strengthen macroeconomic stability, enhance monetary policy transmission and regulate the financial sector has laid the foundation for the implementation of a programme that will promote financial accessibility.

In light of the country's upgraded sovereign rating, the financial resilience of credit institutions is also influencing rating decisions in a favourable manner. Consequently, this positive situation is increasing the capacity of national financial institutions to attract funds from external markets. In order to ensure the efficient use of attracted resources within the country and to guarantee sustainable financing, the CBA considers it necessary to provide support through appropriate financial instruments.

It should be noted that the three-year programme will also cover funds raised during the previous three months, until 1 August, which have already been used to finance the specified target groups. In such cases, banks and non-bank credit institutions are permitted to cancel existing active hedging instruments and benefit from the opportunities presented by the CBA. Concurrently, 50% of the savings will be allocated to enhancing lending conditions for customers.

All banking institutions and non-bank credit organisations will be able to utilise the new mechanism without restrictions. However, as CBA Chairman Taleh Kazimov has noted, the size of the capital or the volume of the loan portfolio in the financed area will be taken into account. Hedged funds may account for up to 5% of the bank's total capital or 20% of its loan portfolio. Please find below the details of the meeting.

"Taking into account market conditions, the costs for banks will be 3-4%. At the same time, no high credit risks are expected," emphasised the country's chief banker.

He anticipates that credit institutions will be able to attract approximately $600 million through the hedging system. "We did not set any goals in this regard; we simply offered this tool as an incentive. This system is a recent addition to our suite of offerings, and we are currently in the testing phase. The costs to banks associated with this system may amount to about $18 million, which is not a significant amount for the banking sector and the CBA," added T. Kazimov.

Advantages and prospects

The programme will facilitate the influx of external financial resources into the Azerbaijani economy, thereby expanding the opportunities available to credit institutions to borrow on the global markets.

Experts in the field believe that both banks and NBKO should be interested in acquiring this instrument, as for a small commission they will be able to protect their resources from currency and other risks. For instance, banks will be able to more actively attract loans on external markets at lower interest rates, and then hedge the exchange rate of the attracted funds using a hedging instrument, convert them into manats and issue loans. Experts have observed that this may, to a certain degree, hinder an escalation in interest rates on loans denominated in manats. Please find below the details of the meeting.

The introduction of the new hedging mechanism can be regarded as a reform with the aim of proactive risk management in the economy of Azerbaijan. This is of strategic importance, especially in terms of financing the non-oil sector, strengthening credit institutions and ensuring financial stability in general. Please find below the details of the meeting.

The successful implementation of this mechanism could also give Azerbaijan an additional advantage in terms of improving the financial sector's position in international ratings.

The application of this instrument is thus pivotal in achieving the goals of diversifying and expanding the economy, as well as increasing financial accessibility.