MATURITY TEST

The Central Bank of Azerbaijan (CBA) has recently initiated a major reform of the country's banking system. This pertains to the transition to the Basel III international standards, which establish requirements for banks' capital and their capacity to withstand financial turbulence.

A transitional period has been established for adaptation: throughout 2026, banks must align their internal processes and calculations with the new requirements, and from 1 January 2027, the rules will become mandatory for all market participants.

Why transition matters

Past financial crises have demonstrated that formal compliance with regulations does not always guarantee a bank's real stability. While on paper capital appears sufficient, in practice it proved incapable of covering losses. This was primarily due to a substantial portion of capital being of substandard quality, while risk levels were overestimated.

The Basel III standards have been developed to address this issue. In the new regulatory model, the focus is on the actual ability of capital to absorb losses and maintain bank stability under stress conditions, as opposed to merely the amount of capital.

Accordingly, following the decision of the CBA Board dated 16 December 2025, amendments were made to the "Rules for Calculating Bank Capital and Its Adequacy". These changes affect not just individual norms but the entire structure of prudential regulation, including the composition of regulatory capital and capital buffers, and risk assessment approaches. In essence, this is not a technical adjustment of figures, but rather a revision of the logic behind the banking system's overall resilience.

The new regulations stipulate that bank capital is to be divided into two tiers. The first tier includes the most reliable part, which is the bank's own funds and disclosed reserves. This capital is primarily used to cover losses, effectively serving as a "safety cushion" for the company.

Tier two capital is supplementary. It is also accounted for within the overall capital structure, but it is considered to be less stable and to lack the same ability to absorb losses.

In accordance with the standards set out in Basel III, a bank is required to maintain a total capital ratio of no less than 8% of its risk-weighted assets, with a minimum of 6% derived from tier one capital. In the past, requirements were less stringent, and the quality of capital was of secondary importance.

Capital buffers

As well as minimum requirements, Basel III introduces special "strength reserves" – capital buffers that banks must build during favourable periods.

In essence, this fund serves as a financial reserve to be used in times of economic uncertainty. In the event of a slowdown in the economy or a crisis, a bank can utilise this reserve without significantly reducing lending.

It is imperative that capital buffers are constituted exclusively from the highest quality tier one capital, i.e. funds with the capacity to directly absorb losses.

A key element of the new system is the countercyclical capital buffer, which can be considered a "rainy day fund" for banks. Its size can vary between 0 and 2.5% of risk-weighted assets, and it is introduced during economic upturns. This enables financial institutions to accumulate capital in advance, thereby safeguarding against potential losses during periods of economic downturn or recessions.

When minimum requirements and capital buffers are taken together, the total capital burden on banks can reach 10.5%.

The Azerbaijan Banks Association (ABA) observes that the transition to Basel III standards establishes a more dependable framework for addressing both anticipated and unanticipated losses, while enabling a more precise alignment of capital volume with the actual level of risks assumed.

"As a result, tier one capital becomes central to regulation, the importance of capital buffers increases, and leverage and liquidity requirements complement the classic adequacy indicators. For banks, this means a stricter but more transparent stability model where formal compliance yields to economic substance and real ability to withstand stress," ABA emphasised.

With regard to the reform's potential impact on banks' credit policies, some short-term effects may be anticipated. The ABA anticipates that, as part of the adaptation process, banking institutions may adopt a more cautious approach and temporarily temper their appetite for risk, particularly in specific loan categories.

One of the most sensitive issues is how new requirements affect financing of the real sector. The ABA acknowledges that, during the transition period, there is a possibility that banks will adopt a cautious approach, which may result in a temporary review of conditions or credit volumes in specific segments.

However, the long-term objective of the reform is contrary to this. Strengthening the capital base should enable banks to maintain lending during crises, thereby ensuring their capacity to finance businesses and individuals is not affected.

A more robust capital position can help to mitigate the impact of economic downturns by reducing the likelihood of sudden credit contractions. It can also make financial flows more predictable and reduce reliance on external economic factors.

To summarise, the objective of the reform is not to restrict credit activity in itself, but rather to mitigate its susceptibility to external shocks. In the context of macroeconomic volatility, banks with robust capital reserves are well-positioned to sustain lending, thereby averting the abrupt "breaks" that often exacerbate economic downturns.

Controlling debt and liquidity

In addition to capital requirements, Basel III imposes further restrictions designed to mitigate hidden vulnerabilities in banking institutions.

Firstly, there is a limit on excessive debt burdens. Even if a bank's assets are formally deemed "low-risk", it is prohibited from excessively expanding its balance sheet through borrowings. This approach ensures that bank stability is not based on overestimated risk assessments, thus preventing illusory stability.

Secondly, liquidity requirements have been significantly tightened. It is imperative that banks maintain sufficient high-quality liquid assets to meet obligations to depositors and counterparties, even in stressed scenarios. This measure is intended to mitigate the risk of sudden bankruptcies and market panic.

A key protective measure is the minimum leverage ratio requirement. Pursuant to the requirements of Basel III, tier one capital is required to be maintained at a minimum of 3% of total bank assets, irrespective of their risk profile. This non-risk-weighted indicator is designed to limit excessive balance sheet growth, even in circumstances where formal risk assessments appear favourable.

Concurrently, mandatory liquidity ratios are being implemented. The liquidity coverage ratio ensures a bank can survive a 30-day stress scenario, while the net stable funding ratio evaluates funding stability over a one-year horizon. The implementation of these tools is intended to minimise the probability of liquidity crises and involuntary asset sales, which are recognised as primary conduits for the propagation of systemic shocks.

One-year transitional period for banks

The adoption of Basel III standards necessitates not only the allocation of supplementary resources by financial institutions, but also a comprehensive internal restructuring process. This includes upgrading IT systems, reporting frameworks, internal risk management methods, as well as staff training and development.

In light of these considerations, regulatory authorities have instituted a transitional period. Until formal requirements come into effect later, banks will be required to calculate capital according to new rules and report to the CBA throughout 2026. This approach allows for the early identification of potential weaknesses and ensures a smoother, more controlled transition.

As clarified by the American Bankers Association (ABA), no bank currently formally falls under the new regulations since the foundations for the future banking sector model are still being laid at this stage.

Completing the Basel III transition is important for both the bank's internal resilience and its external reputation. Aligning regulation with international standards enhances the transparency and comparability of prudential systems for foreign investors and rating agencies.

In the medium term, this will make it easier to assess the capital quality and risk profiles of banks. This will have a positive effect on borrowing conditions, risk premiums and access to external capital markets. In essence, this contributes to an overall enhancement of confidence in the financial sector of the country.

Thus, moving to Basel III is not an attempt to complicate banking operations but a tool for protecting the economy from abrupt and costly banking crises. With steady implementation of reforms, the banking system will become more resilient while businesses and individuals will benefit from more reliable access to finance—including during periods of economic instability.