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Assessment of Azerbaijan Banking System.doc

  1. 1. FINAL REPORT I. INTRODUCTION Purpose The following assessment of the Azerbaijan banking system has been produced under contract to the United States Agency for International Development/Azerbaijan by Michael Borish and Company, Inc. The banking sector assessment has been carried out as a diagnostic for USAID to serve as a basis for developing a revised assistance strategy that would possibly include increased resources and activities in support of a viable commercial banking system. It should be noted that the work conducted by Michael Borish and Company, Inc. in this regard is based strictly on the firm’s own assessment of developments in Azerbaijan, and does not in any way bind USAID to those recommendations. A separate document related to USAID projects, performance indicators and recommendations can be found in a separate volume entitled “Volume II: Recommendations for USAID Financial Sector Assistance to Azerbaijan: 2004-2009”. Organization of the Report The report is structured as follows: • The Main Report serves as the summary of the diagnostic with the ratings applied • Annex 1: Description of the individual ratings criteria by sub-category • Annex 2: Review of financial sector infrastructure • Annex 3: Review of macroeconomic developments, economic structure, and private sector development issues • Annex 4: Review of the banking sector, as well as the limited role of non-banks • Annex 5: Review of risk issues for the banking system • Annex 6: Comparative indicators (Azerbaijan and Newly Independent States) • Annex 7: Bibliography • Annex 8: List of meetings As noted, a second report is presented for USAID for its internal strategic planning purposes related to possible bilateral assistance for Azerbaijan in the coming years. This includes a summary of gaps and vulnerabilities, as well as specific areas where USAID assistance is considered to be most potentially useful and effective. Acknowledgements Michael Borish and Company, Inc. would like to thank William McKinley (USAID/Azerbaijan Country Director), Jeffrey Lee (Deputy Country Coordinator), Catherine Trebes (Program Officer), and Rena Effendi (Program Management Specialist) of USAID/Azerbaijan for their kind support and guidance. Michael Borish and Company, Inc. would also like to thank the many people who provided time and documentation for this assessment to be carried out with effectiveness. A list of the people with whom the team met is found in Annex 8. Michael Borish visited Azerbaijan from January 15-23, 2004, in conjunction with this project. MICHAEL BORISH AND COMPANY, INC. 1 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  2. 2. FINAL REPORT II. METHODOLOGY OF THE BANKING SECTOR ASSESSMENT RATING SYSTEM The rating system utilized to assess the banking sector of Azerbaijan is based on a methodology developed with USAID support in 1998 to evaluate banking systems and assign ratings based on standardized definitions of performance, capacity and depth. The methodology reviews more than 200 issues and topics in a systematic fashion. In its simplest form, the rating system is focused on four general areas of activity—based on 28 “sub-categories,” and subject to five general classifications. The activities and sub- categories include the following: Banking Sector Rating System Components General Areas of Activity Sub-Categories Financial Sector • General policy and system Infrastructure • Legal framework • Regulatory and supervisory capacity • Payments system • Accounting framework • Rating agencies • Financial media • Professional associations • Academic institutions • Miscellaneous areas relevant to financial sector infrastructure—telecommunications, postal, safekeeping Economic Factors and • General trends Indicators • Economic structure • Private sector development issues • Monetary and related savings and credit matters • Fiscal considerations • Exchange rates • Balance of payments issues Banking Structure and • Overview of the system and financial measures System Profile • Profile of ownership structures, consolidation and concentration • Trends in financial intermediation and balance sheet structures • Governance and management issues • Non-bank financial institutions Banking Sector Development • Capital and capital adequacy Based on Prudential Issues • Asset quality and concentration • Earnings • Liquidity • Sensitivity to credit and market risk • Country risk MICHAEL BORISH AND COMPANY, INC. 2 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  3. 3. FINAL REPORT Some modifications have been made in the Azerbaijan assessment relative to earlier evaluations.1 This includes breaking out economic structure and private sector development issues into two sub-sections, consolidating the discussion of banking supervision and bank management sub-sections from four to two, combining some of the transparency and disclosure issues with accounting and audit standards as well as in governance and management, breaking out trends in banking around more specific themes, and adding a brief country risk sub-section. Likewise, the format has been modified slightly to make it easier to read. However, in general, the assessment methodology is virtually unchanged in terms of substance and ratings determinations. The following classifications are utilized to provide a scoring for the individual issues assessed, as well as in developing a composite rating for the banking sector as a whole. Annex 1 provides greater descriptive detail about how the ratings apply by sub-category. Essentially, the methodology matches the description of the rating for each of the 28 sub- categories, assigns a rating for each, synthesizes the collection of ratings by each of the four areas of activity, and then ultimately arrives at a composite rating for the country. No effort is made to weight individual variables, or to quantify ratings along mathematical lines, although some variables are considered far more important than others. (For instance, the financial sector infrastructure rating is far more influenced by legal framework, regulatory and supervisory capacity, payment and settlement system, and accounting and audit issues than by credit rating agencies, financial media, universities and training institutes, and miscellaneous criteria.) Rather, 28 major sub-categories of the four main groupings are all rated within the five-point rating system, with allowances for pluses and minuses in the event that the direct numerical classification does not fully match with performance. The evaluation is both qualitative based on trends and assessments, and quantitative to the extent the figures are useful and meaningful. Banking Sector Rating System Scoring Description 5 Outstanding; world class; state-of-the-art; best practices; virtually no serious systemic risks 4 Solid; strong; satisfactory; competitive; few systemic risks or problems, and those are manageable 3 Adequate; favorable trend; improvement needed; potential for major systemic risks 2 Inadequate; weak; significant improvements needed; major potential for destabilization via systemic risks 1 Dismal; monopolist; resistant to competition and change; no confidence; widespread corruption; weak institutions More detailed annexes are found in the report to support the ratings. 1 Earlier evaluations using the methodology have been conducted at least once in Bulgaria, Bosnia- Herzegovina, Georgia, Hungary, Macedonia, Poland and Ukraine. MICHAEL BORISH AND COMPANY, INC. 3 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  4. 4. FINAL REPORT III. THE AZERBAIJAN RATING The composite score awarded for Azerbaijan in 2003 is 2+, which can be categorized as better than rudimentary, but not yet adequate for sustained market development and competition under stable conditions. This rating generally reflects improving but still weak financial sector infrastructure, sound macroeconomic fundamentals but deficiencies at the structural (microeconomic) level that detract from competitiveness and income growth, a concentrated and undercapitalized banking system characterized by low levels of investment and poor earnings, and very limited risk management capacity for anything but very basic risks. The trend is favorable, as the authorities are aware of reforms that need to be made. They have already accomplished some needed reforms, such as recent adoption of anti- corruption and banking legislation, modern management techniques at the State Oil Fund, stable macroeconomic policies, and adherence to the terms of Production Sharing Agreements that have led to involvement in the oil and gas sector by some of the world’s top multinationals and high levels of foreign direct investment. However, persistent weaknesses relate to institutional deficiencies, partly reflecting vested interests and insufficient openness and competition in the marketplace. The judiciary is considered weak and vulnerable to political influence and/or bribery. This constrains risk-taking by financial institutions due to the weaker legal environment for lending and investment. Public administration has long been criticized for corruption, which has also contributed to a poor reputation for the business environment. In banking, there is a high level of concentration, and the sector as a whole shows limited competitiveness. Non-bank financial markets show the same characteristics. Strong points or favorable trends that impact Azerbaijan’s banking system include: • Recent adoption of sound banking legislation • Improving capacity at the NBA to supervise the banking system • Recent capacity enhancements in the payment and settlement system • Decisions to move towards IAS • Continued sound macroeconomic policies that have stabilized inflation and exchange rates, and kept fiscal deficits low • Stable balance of payments (notwithstanding high current account deficits) reinforced by high levels of reserves and direct investment into the oil and gas sector, and a prudent debt profile • Increasing growth of the private sector • Plans to privatize the last two state banks • Willingness to further consolidate the banking system • Plans to increase minimum regulatory capital in the banking sector • Improvements in recent years in asset quality, including autonomy of bank management in making lending decisions, and tightening financial discipline in many state enterprises MICHAEL BORISH AND COMPANY, INC. 4 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  5. 5. FINAL REPORT • Adherence to conservative liquidity management policies and practices These strengths are offset by many weaknesses which include: • A poor reputation for judicial capacity • A weak framework for property rights and contract enforcement, all of which undermine prospects for secured transactions • An underdeveloped insolvency framework • Emerging but still underdeveloped capacity at NBA and in the banks to operate a soundly regulated banking system • Still limited usage of the payment system • Poor quality, timeliness and availability of financial information • General lack of tradition of open disclosure and transparency to make markets function effectively and competitively • Absence of meaningful credit information flows for credit risk evaluation and risk management purposes • Weak electronic infrastructure outside of Baku • Limited financial sector coverage outside of Baku • High levels of poverty • Low levels of productivity and competitiveness at the structural level • Very limited foreign direct investment outside the oil and gas sector • Delays in privatization, and methods of privatization that have not encouraged new or strategic investment • A poor reputation for corruption in public sector management and the judiciary • Insufficient reforms to date in making the business environment conducive to formal investment and trade • High levels of informal activity • Documentary issues of title to properties that stoke judicial corruption and often discriminate against women and poorer parties disputing a claim • Presence of dominant vested interests in many sectors, reportedly including in banking, that distort the competitive environment • Low levels of capital in total, and on average, neither of which are sufficient for modern banking • Low levels of earning assets and earnings • A lack of public confidence that keeps funding in the banking system low • Weak corporate governance • Limited management capacity to operate banks (and enterprises) according to international standards and norms • Very limited development of risk management systems for credit risk, market risk, and general portfolio management • Weak back office operations, including internal audit and controls, that make banks vulnerable to misuse for financial crime—money laundering and other activities—all of which undermine the reputation of Azerbaijan and add a risk premium to investment MICHAEL BORISH AND COMPANY, INC. 5 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  6. 6. FINAL REPORT • Substantial underdevelopment of the capital markets, with no corporate bonds, municipal bonds, mortgage bonds, or active equities trading • Unsustainable pay-as-you-go pension system (albeit slated for reform) • Barriers to foreign investment in the underdeveloped insurance sector • Past problems with mismanagement in credit unions • Nascent leasing activity, with only $1 million in reported contracts Basic banking and non-bank financial sector indicators include the following: • There are 46 banks, of which two are state-owned and the rest are private • Planned privatization in 2004-05 for IBA and BUS Bank will make the system wholly private in ownership • IBA, which is state-owned, is the dominant bank with more than half of loans, assets and deposits in the system • Foreign investment in the banking system remains relatively low, and there are no major international banks in Azerbaijan apart from Société Générale (with a representative office) and UniCredit (via ownership in Koch Bank); HSBC has departed from the market, although it retains a small office to recover on outstanding items • Total assets approximate $1 billion, more than half with IBA; the average bank has $21 million in assets • Total loans approximate $681 million before reserves for loan losses; the average bank has $15 million in loans • Total deposits approximate $621 million; the average bank has $13.5 million in deposits • Total capital approximates $151 million; the average bank has $3.3 million in capital • Regulatory capital is less than Tier I and Tier II capital, and it remains to be seen if adjustments will need to be made as banks begin to account increasingly for off- balance sheet items, and on a consolidated basis for affiliates, subsidiaries, and other connected/related parties. • Asset quality has improved in recent years, but overdue loans are 10 percent of total, and reserves for loan losses are about 20 percent of total loans • Reserves for loan losses approximate 78 percent of Tier I and Tier II capital • Earnings are weak due to limited loan volume, and few services offered and used; projections for 2003 approximate $25 million or so for the system as a whole, or about $550,000 on average per bank • Banks’ costs are not high, but productivity is low as is income, resulting in very small earnings that are insufficient as a source of meaningful and needed capital increases • Access to borrowings from abroad is not reported to be widely available, although significant reserves are held abroad in correspondent accounts • Liquidity ratios are satisfactory in terms of deposit coverage • Management capacity and governance are considered weak, and risk management capacity and systems are underdeveloped and untested MICHAEL BORISH AND COMPANY, INC. 6 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  7. 7. FINAL REPORT • There is little market and systemic risk in Azerbaijan’s banking sector due to the low level of banking penetration and intermediation • There is virtually no development of the contractual savings (pension and insurance), securities, leasing and factoring markets • Country risk is largely due to perceptions of political instability in the region, corruption in the business environment, weak judicial institutions, low levels of purchasing power, and an uncompetitive economy by international standards outside the oil and gas sector A more detailed assessment of financial sector infrastructure is attached as Annex 2. A review of economic issues and trends can be found in Annex 3. The discussion of the banking sector is found in Annex 4. Risk issues in the banking sector are found in Annex 5. Readers are encouraged to read through Annexes 2-5 for supporting information and data to justify the findings and ratings applied. In addition, comparative indicators with CIS banking systems are presented in Annex 6. This presents context for Azerbaijan relative to peers. MICHAEL BORISH AND COMPANY, INC. 7 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  8. 8. FINAL REPORT IV. THE AZERBAIJAN ASSESSMENT AND RATINGS A. FINANCIAL SECTOR INFRASTRUCTURE Financial Sector Infrastructure Composite Rating 2+ Summary: Azerbaijan is making clear progress in some areas of banking sector reform. The system benefits from macroeconomic stability, including a stable monetary policy that has helped to keep inflation rates low and the exchange rate fairly stable. Legislation is increasingly market-based. NBA supervisory capacity is improving. The payment and settlement system has become more effective in recent years, and fairly substantial payments can now run through the system. There is also slow but gradual movement towards implementation of IAS, and general recognition of the need for more and better information in support of market development. Some of the universities and training institutes will be able to help with ongoing professionalization of the banking system. However, on the down side, the legal framework is severely undermined by weak judicial capacity—judges are civil servants and reported to be vulnerable to influence peddling, bribes and other forms of unprofessional behavior; registries are incomplete, sometimes inaccurate, and inconsistent in their use for secured transactions; the insolvency framework is underdeveloped—largely the result of decades of practices that have not been geared to a fully functioning market economy. Banking supervision still lacks sufficient personnel (notwithstanding progress made in the last year or two), and is greatly weakened by the lack of capacity in the banking sector with regard to systems, procedures, controls, and general quality of financial information. The payment system is being used increasingly by retailers, but is not used by the general public, limiting the benefits of recent improvements. Accounting standards are weak and underdeveloped in most of the economy, and rarely of use for management purposes. Credit information is in short supply, and generally informal. Financial media are limited in their coverage. Electronic infrastructure is limited outside of Baku. Description Rating Policy & Partly supportive of stable, safe and sound banking, but major 2+/3- System improvements are needed: Public administration not viewed as effective or as professional as it needs to be, although recent reforms (decompression and better pay) indicate positive trends and macroeconomic policy has been stable for years. Adequate laws and regulations are increasingly in place, but institutional capacity for implementation is not always there. Marginally competitive and highly concentrated economy dependent on oil and gas. Underdeveloped systems of support for banking and financial services. High level of concentration in one bank, and cartels reported in other sectors of the economy. Commercial banking and market principles are relatively recently adopted traditions. Legal Fairly supportive of stable, safe and sound banking, but 2+ Framework implementation deters meaningful levels of risk-taking: Harmonization needed in some areas of commercial legislation. Weak judicial institutions and absence of out-of-court mechanisms undermine effectiveness. Guidelines re contracts, property rights remain problematic, and the environment for secured transactions is weak. Registries are incomplete and not always effective in commercial dispute resolution. Real estate property and vehicles registries exist and can be enforced in courts when these items are used to secure loans, although enforcement is not always consistent. Insolvency regime underdeveloped. MICHAEL BORISH AND COMPANY, INC. 8 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  9. 9. FINAL REPORT Regulatory & Adequate regulatory framework for prudently managed and 3- Supervisory supervised banking, but significant strengthening needed: New System legislation will provide NBA with clear legal mandate for licensing and supervision. Clear guidelines and requirements for bank licenses. Reporting to NBA now more effective due to reasonable chart of accounts and electronic UBPRs. Prompt corrective action being introduced based on CAMEL. Problems attracting needed personnel to staff all needed supervisory functions. Significant outreach with banks required for more effective implementation. Use of external audit firms extensive to supplement supervisory effort. Use and disclosure of penalties/fines limited. Payment & Adequate, but less than efficient systems, support increasing 2+ Settlement integrity of banking system: Large value payment system in place and being used. However, small (low) value payments used sparingly through formal system (about 30 times a month). Low level of deposits and transactions (e.g., ATM use, direct payroll, international transfers) reduce beneficial effects to banks on credit/liquidity risk management practices regarding settlement. Reportedly safe depository practices, largely based on reserves (including abroad) and daily liquidity reports. Management, information systems and technologies reported to be adequate. Accounting & Significant improvement is needed in the framework for banking, 2 Transparency and even more so in the real sector: Standards only now becoming consistent with IAS. Fundamentals weak in the real sector, apart from oil and gas and some other large enterprises with borrowings from abroad. General absence of market depth and breadth. Most banks still do not present statements according to international standards of audit, although the largest ones generally do. Useful and meaningful information from IAS not utilized for management purposes. Annual audits viewed more as formalities for correspondent banks or creditors abroad. Inadequate laws and regulations in the real sector, with significant differences between domestic and international standards. Very limited market for accounting systems and services, although the Big 4 and at least one other mid-sized firm (from the UK) are represented in country. Rating Generally unsupportive of banking sector development: No real 2 Agencies & presence of professional rating agencies, even for sovereign debt. Systems Wholesale underdevelopment of formal credit risk evaluation procedures along with virtual absence of capital markets, commercial finance, insurance and other non-bank activities has meant there has been no real catalyst for development. Current development of a credit registry for NBA and banks is limited in scope. Absence of useful information makes it virtually impossible for banks to determine risk on market basis apart from character assessments and other informal sources. Confidentiality concerns constrain disclosure. MIS, technologies and general infrastructure lacking. Financial Generally unsupportive of banking sector development and 2 Media growth: Limited coverage from print and broadcast media. Press environment still considered restrictive by some. MICHAEL BORISH AND COMPANY, INC. 9 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  10. 10. FINAL REPORT Professional Marginally supportive of banking sector development and growth: 2 Associations Limited capacity and influence of banking association and Chamber of Auditors. Absence of tradition of professional market-based trade associations limits their role in current environment, although future prospects are increasingly favorable. Academic Marginally supportive of banking sector development and growth: 2+ Institutions Limited resources and capacity, and few experienced and trained staff. However, capacity is increasing, and many graduates are finding jobs in the energy sector as well as with banks. Bank training center appears well managed and effective as a focused vehicle for banking sector development and modernization. Miscellaneous Generally unsupportive of banking system; significant 2 improvement needed: Slow privatization in telecommunications has limited expansion of capacity in this sector. Inadequate levels of public confidence in the safekeeping capacity of banks. Postal system reported to be limited in infrastructure capacity, and will need major investment to be incorporated into broader distribution of financial services outside Baku. A.1 Policy/System (2+/3-) Azerbaijan’s financial system is increasingly market-oriented in legal orientation, but still suffers from weak institutions and a tendency towards concentration, monopolization, and patronage. Legislation is now favorable, and gains have been made in recent years in strengthening supervision. Nonetheless, the banking sector remains heavily dominated by one bank, no major foreign banks are in Azerbaijan (apart from two representative offices and UniCredit via Koch Bank ownership), and the other banks are generally small. The net result is very low levels of intermediation and penetration, with the vast majority of funds and economic activity outside the banking system. Other financial services remain underdeveloped. The insurance sector is miniscule, and barriers to foreign investment remain (although they should be removed later in 2004). The securities market shows virtually no activity in terms of volume and turnover. Even the government securities market is exceedingly small. Other segments of the financial sector, such as commercial finance, housing finance, leasing and factoring are nascent. General levels of institutional support and infrastructure development are only partly achieved. The payment system has improved in recent years, yet most transactions occur outside the formal payment system. A significant amount of economic activity related to Azerbaijan occurs offshore, namely in the oil and gas sector. While the four largest international accounting firms are all located in Azerbaijan, international standards have only been introduced for the largest of enterprises. Broader application of international accounting standards (IAS) awaits broader development of the non- hydrocarbon sector of the economy. MICHAEL BORISH AND COMPANY, INC. 10 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  11. 11. FINAL REPORT Other supporting institutions, such as financial media, credit rating agencies, business associations and training institutes are relatively nascent due to underdevelopment of the financial sector and most other sectors of the economy. There is an active press that reports basic information, yet active public involvement in financial sector matters is virtually non-existent. There are no credit rating agencies in Azerbaijan, and international ratings for sovereign paper or businesses are scarce. In the banking sector, only IBA has received a rating from one of the international rating agencies. There are universities, business associations and training facilities, many of which have potential to assist with market development. However, to date, their contribution has not been as strong as found in other economies where markets are more developed. Many of the constraints to financial market development are found in the broader economy. There have been long standing criticisms of excessive centralization and concentration, pervasive levels of corruption, and a weak institutional and judicial framework. These characteristics persist and will take time to reform, notwithstanding recent progress in some areas and reported recognition of these problems in high circles. A.2 Legal Framework (2+) Recently, a new Law on Banks was submitted to parliament in 2003 and adopted in early 2004 to bring legislation in line with international standards. The new Law on NBA was also submitted to parliament, and adoption is expected by March 2004. The Laws will bring Azerbaijan closer to compliance with the Basle Core Principles for banking supervision. While there are fairly generous provisions permitting ownership of banks by non- banks and real sector enterprises/conglomerates, there are restrictions on banks being engaged in non-bank activities. NBA will need to introduce policies and procedures to carry out consolidated supervision, and banks will need to disclose information on their affiliates and subsidiaries. Fortunately, the new laws strengthen NBA’s mandate to carry out these requirements. Recent changes eliminate the cap on foreign investment in the banking system, previously restricted at 50 percent. This may reflect an effort to attract more capital and better technologies into the banking system, increase competition, improve quality and service, and facilitate bank privatization. New banking legislation will help to advance and modernize the system, but many of the problems associated with financial sector development are closely related to problems in the broader legal and economic framework of the country. There are still major problems in the legal system for banks with regard to secured transactions, the insolvency framework and creditors’ rights, general enforcement through the court system, out-of-court vehicles for dispute resolution, political patronage and vested interests, and weak infrastructure in the form of property registries. Key issues and challenges are closely related to an improved framework for secured transactions, and MICHAEL BORISH AND COMPANY, INC. 11 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  12. 12. FINAL REPORT eventual development of a modern framework for bankruptcy and liquidation in support of clear creditors’ rights. A.3 Regulatory/Supervisory System (3-) There is virtually no potential for systemic risk in the banking sector. This reflects the underdevelopment and general detachment of the banking system to the economy, with IBA the only institution whose failure would have any possible material effect on the economy. However, the detachment of the public from the banking system reflects low levels of confidence in it. Thus, failure of other institutions may reinforce that negative perception. The process of strengthening regulatory and supervisory capacity has been ongoing for several years. New legislation drafted and adopted in 2003-04 (and associated regulations) is designed to move Azerbaijan from a less unstable system to one that is substantially larger, more able to identify, quantify and manage risk, and more similar in orientation with international standards and practice. Since 1994, a net 164 banks have closed down. There are still numerous weaknesses concerning asset classification and valuation, as well as larger legal framework issues that affect the underlying quality of assets (and financial information) and the ability of NBA to adequately supervise the banks. As such, new legislation and regulations are under way to ultimately have a better reading of capital and capital adequacy, asset quality, realized earnings and gains, liquidity management practices, and a host of other considerations needed for a stable financial system. Capital adequacy is expected to now be at least 12 percent based on BIS guidelines. New legislation requires compliance with international accounting standards (IAS), and this will likely lead to a more accurate picture of the capital position of the banks after subsidiaries, affiliates and off-balance sheet items are taken into account. Other measures regarding loan loss provisioning, related party exposures, liquidity requirements, and foreign exchange exposures will also be consistent with international norms. NBA has about 42 staff focused on banking supervision. NBA faces challenges in hiring and retaining qualified staff due to the superior compensation provided by private companies active in the oil and gas sector, banks and international donors. The off-site surveillance and on-site inspection functions are combined, rather than being separated. Off-site reports are adequate for fundamental supervisory needs, but they are not fully understood or utilized by the banks. As the system evolves, the UBPRs are considered adequate for the identification of risks that could trigger targeted inspections and corrective actions. Given the low level of intermediation in the economy, neither banks nor NBA are fully prepared for more complex risks that might eventually be assumed under more developed conditions. NBA, with legal backing, has restricted banks from aggressively MICHAEL BORISH AND COMPANY, INC. 12 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  13. 13. FINAL REPORT engaging in non-bank activities. While this has been a controlled exercise that has stymied “universal” banking sector development and earnings opportunities, it has contained the risk of banks venturing off into activities in which they have insufficient experience and systems for prudent risk management. The elimination of ceilings on foreign investment in domestic banks may be a harbinger of near- and medium-term opportunities for banks to increase the range of products and services based on a more flexible range of activities in which they can participate. However, this also means that banks will be responsible for developing consolidated accounting systems, and NBA will pursue a consolidated supervisory approach in its regulatory oversight of the banks. Deposit insurance has wisely been deferred until a future date. Banks are currently undercapitalized, and wholly unaccustomed to what is required to ensure safety and soundness in the banking system. Any premature introduction of deposit insurance and subsequent failure of banks would weaken confidence that has not existed in the banks by the public for about a decade. To get to the point where a stable and solvent deposit insurance scheme can be administered on a sustainable basis, banking supervision and banks will both need more capacity to identify, evaluate, and contain risks that could be damaging to the financial condition of banks and reputation of the sector at large. A.4 Payment and Settlement System (2+) Azerbaijan’s payment system in Azerbaijan was outdated until fairly recently, and this stunted development of the financial sector. Systemic inefficiency, combined with other problems in the business environment (including cumbersome bureaucracy and corruption in public administration), served as incentives for informal sector transactions bypassing the formal payment system. A modern electronic system has been developed in the last few years to introduce a modern, electronic, and properly supervised payment and settlement system to operate. The Azerbaijan Inter-bank Payment and Settlement system is a real time gross settlement system (RTGS) that allows inter-bank settlement to be confirmed within 30-60 seconds for large value payments. It is based on a central accounting system that conducts payment functions, with links to SWIFT for real time international payments. A central interface module links the central accounting system with SWIFT. The next step for NBA has been to move forward with a small (low) value payment system that is more efficient. The system is mainly used for large value payments, although small value payments have increased in 2003. In 2002, there were only 436 payments that ran through the system, of which 416 were classified as large-value, or in excess of Manat 75 million (about $15,000). In 2003, there were approximately 670 transactions, nearly half of which were small value. The average transaction size was about $11.6 million-equivalent. A.5 Accounting and Transparency (2) MICHAEL BORISH AND COMPANY, INC. 13 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  14. 14. FINAL REPORT IAS is relatively new in Azerbaijan, and the banking sector will likely be the first sector of the economy to convert to such standards, possibly apart from large-scale enterprises active in the oil and gas sector. External audits of banks by licensed firms are compulsory, but most banks are audited by local firms with little or no experience with ISA/ISA. The “Big 4” accounting firms audited the top 18 of 46 banks in 2003 (2002 statements). New legislation now requires that banks present their financial statements according to IAS, and that audits be compliant with ISA. Accounting capacity and information disclosure has traditionally been weak in Azerbaijan, although progress has been made in the last few years. A new chart of accounts that is considered broadly in line with IAS was introduced in 2000, and has since been modified and improved. This has improved the quality of information provided by banks to NBA for regulatory purposes. New legislation, regulations and outreach from the NBA will help to provide banks with more guidance in terms of what is required of their own internal audit, controls and MIS. As elsewhere in the CIS (and transition countries in general prior to conversion to IAS), local accounting standards have been tax-oriented, and the domestic accounting/audit profession is underdeveloped. There are reported to be less than 10 Azeris trained and certified in IAS/ISA. Much of the problem in accounting and audit relates to the lack of professional/institutional capacity. Recommendations to strengthen internal audit functions at banks and enterprises (and government), ensure the independence of auditors, enforce a code of conduct that is consistent with international standards, and observe more open standards of disclosure and transparency will contribute to more and better information for market purposes. However, this will also require time and money. The costs of an annual audit based on IAS/ISA are expensive for most firms in Azerbaijan, including most of the banks. Nonetheless, as the economy moves forward, these will be necessary costs if banks want to remain licensed and compliant with prudential norms, and if enterprises (including financial institutions) want to increase their access to debt and equity in domestic and international markets. Transparency will remain a challenge for the foreseeable future. There is no real tradition of transparency or disclosure of information, nor is there an established tradition of use of accounting information for management uses. Meanwhile, there has been a long standing tradition of tax avoidance. Such patterns are clearly inconsistent with transparency and disclosure norms needed for overall market development. MICHAEL BORISH AND COMPANY, INC. 14 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  15. 15. FINAL REPORT A.6 Rating Agencies/Systems (2) There are plans to introduce an improved credit information registry among the banks (and with NBA) to serve as a basic information bureau to document the payment performance and creditworthiness of borrowers. This may help with credit risk evaluation and potential prospects for syndicated lending. However, this will take time, and the current system is underdeveloped and not considered effective. There are no domestic rating agencies in Azerbaijan. Thus, any banks or securities that are rated are done so by the major international rating agencies. Only IBA has been rated among the banks. A.7 Financial Media (2) Limited financial intermediation and capital markets activity reduces the flow of information and role played by the financial press. There are several newspapers in Azerbaijan, including some English-language newspapers for the business community (domestic and expatriate). However, the level of financial information is limited due to general limitations on information disclosure and activity. Most bank web sites are limited in useful and timely information. The NBA has a monthly bulletin that provides useful data, and many monetary and banking indicators are presented electronically with a lag of about one month. A.8 Professional Associations (2) Associations exist (including in banking), yet their involvement in practical enforcement of legislation has been limited or partial at best. The Association of Banks of Azerbaijan (ABA) is organized to represent the banks in Azerbaijan, and it was consulted on issues related to recently adopted and submitted banking legislation. As elsewhere in the CIS, the role of the Chamber of Auditors has been relatively modest in efforts to move the system increasingly to IAS and ISA. A.9 Academic Institutions and Human Capital Formation (2+) There are several universities and institutes that provide degrees and training in banking, finance, and related areas. They are potentially a resource for institutional development, capacity building, consulting, etc. However, formal business management and executive training courses are also relatively new to Azerbaijan, and the impact has likely been less in the banking sector than in the private companies that are active in the oil and gas sector. MICHAEL BORISH AND COMPANY, INC. 15 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  16. 16. FINAL REPORT A.10 Miscellaneous (2) Telecommunications capacity has improved in Azerbaijan in recent years with the presence of mobile phones, satellite systems, and improvements in the fixed line network. This has been essential to strengthening of the payment and settlement system. However, the telecommunications system remains state-owned, and there has likely been an opportunity cost to not opening up the system to foreign investment several years ago. ATMs are common in Baku, and most banks offer plastic cards. Better electronics have helped with debit/credit card clearing. As of late 2003, 26 banks issued plastic cards in Azerbaijan, mainly debit cards. Several offer internet banking as well. However, in general, retail banking remains underdeveloped in Azerbaijan. Outside of Baku, electronic services are not widely available. As of 2003, apart from BUS and IBA, there were very few branches outside of Baku. There are plans to increase the number of functioning bank branches as well as non- bank outlets (e.g., postal outlets) outside of Baku that could offer basic financial services. If this occurs, it should include ATMs and plastic cards. However, as of early 2004, reaching targets of 500-600 functioning branches and outlets appeared optimistic. The government has also set a goal of increasing non-cash (electronic) payments of at least five times from 2002-03 to 2005. This would be equivalent to about $30 billion- equivalent in payments (based on 2002 figures). However, getting to the point where enterprises are using electronic payments efficiently for cash collection, cash management and planning is likely to be a long-term challenge rather than something that will occur in the next year or two. The postal network is considered limited in terms of infrastructure capacity. There are currently plans being considered to provide financial services through the postal system. However, this would require significant increases in electronic capacity, as well as a clear work plan to sort out ownership, agency relationships, security requirements, and suitability of products/services rendered. As of 2003, the postal system’s only financial activities for the public involved relatively small money orders. MICHAEL BORISH AND COMPANY, INC. 16 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  17. 17. FINAL REPORT B. ECONOMIC AND STRUCTURAL FACTORS Economic and Structural Composite Rating 3- Summary: Azerbaijan’s macroeconomic fundamentals are sound, as reflected in low inflation rates, low fiscal deficits, a stable exchange, and low levels of debt and debt service. While its current account deficits are high, there are sufficient reserves and export earnings to cover for these in the interim according to PSAs. However, structurally, the economy is weak. There is a high reliance on oil and gas revenues for the budget, as a source of investment and exports, and as the basis for real GDP growth. Apart from this sector, the economy is weak and uncompetitive. Poverty is high, at 50 percent, and deep poverty is nearly 20 percent. Privatization has been slower than in many other countries, and privatization methods have not culminated in major investments apart from the energy sector. Corporate governance and management are considered weak, partly due to the preference for employee buyouts rather than strategic investment. Many large-scale enterprises remain state-owned, which is also a reason for low levels of investment outside the oil and gas sectors. While the private sector now accounts for most GDP and employment, most businesses are very small. A substantial amount of the economy is informal. Thus, macroeconomic policy is prudent and sound, yet there is enormous work to be done at the structural level to achieve sustainable growth, economic diversification, a reduction in poverty, and income convergence with middle income countries. Description Rating General Adequate macroeconomic fundamentals assist with banking 3- Condition sector stability: Strong growth prospects driven by oil and gas, but questions about sustainability unless the economy diversifies. Outside the oil and gas sector, the economy is weak and poverty is widespread. Uncertain how competitive businesses are outside of oil and gas. Banks are cautious and generally undercapitalized, although macroeconomic fundamentals provide underlying stability for growth Economic Weak economic structure slows banking development: High 2 Structure levels of dependence on oil and gas combined with cartels in other areas have slowed diversification and competitiveness. Macroeconomic policy is sound, but the economy would be vulnerable to a material decrease in oil and gas prices. The informal sector provides a safety net for many people, but poverty is widespread. Most output is low or limited in value added. Wealth creation is limited to the oil and gas sector, as well as a few monopolies controlled by vested interests. Overall, incomes are low and poorly distributed. Investment outside the oil and gas sector is very low. The lack of competition and investment has likewise limited innovation. As a result, banks have a weak market in which to lend. Services are limited. Most economic activity bypasses the banks (apart from IBA). Consequently, bank earnings are very low. Private Sector Private sector development is continuing, but major 2+ Development improvements and investments are needed: The private sector accounts for about three quarters of GDP and most employment. However, most enterprises are very small, and often informal. Governance and management of large enterprises are improving, particularly at SOFAR and a few other high profile enterprises. However, overall, corporate governance is considered weak. There MICHAEL BORISH AND COMPANY, INC. 17 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  18. 18. FINAL REPORT are low levels of investment apart from the oil and gas sector. As a result, market links, systems, technologies and knowledge transfers are very limited. Much more is needed to improve competitiveness and innovation. In such a market, banks are generally unable to manage anything but basic risks. There is still insufficient competition in the banking sector, and private sector enterprises do not use banks very much as a result of costs or problems accessing credit. Money, Adequate monetary fundamentals boost confidence, but 3- Savings and improvement needed: Policy fundamentals are sound, as shown in Credit the low inflation rates since 1996. However, structural weaknesses in enterprises and banks slow competitiveness. Savings and credit trends are favorable, but still very limited in overall impact on the economy due to a lack of confidence and poverty. Fiscal Policy Adequate fiscal fundamentals boost confidence, but 3 and Results improvement needed: Policy fundamentals are sound, as shown in the low fiscal deficits of recent years. There is no crowding out of private investment as a result of fiscal deficits or excessive debt loads. Rather, the securities markets hardly function for the government or private sector. Recent tax and customs reforms will help with administration, and as the fiscal base expands, there may be more scope for rate reductions or increased spending for investment and social purposes. Regional and global issues are taken into account as the economy is dependent on oil and gas, and internal or cross-border conflicts would further weaken the investment climate. Budget systems and MIS are improving. However, corruption is considered problematic in Azerbaijan, albeit less so now than in recent years. Exchange Exchange rate fundamentals boost confidence and exports: 3 Rates Policy fundamentals are sound, keeping the Manat relatively stable in real terms with the dollar via a managed float regime. However, apart from the oil and gas sector, there is not much formally recorded trade internationally. Structural weaknesses in enterprises and banks slow earnings and the build-up of capital and reserves. The dependence of the economy on oil and gas has increased Azerbaijan’s link to regional and global markets, and this has led to a disciplined exchange rate policy. There is adequate risk management of liquidity and reserve positions, with SOFAR assets professionally managed and reportedly held in low risk assets. NBA policy has been cautious and prudent. Balance of The balance of payments position reflects the growing 3 Payments importance of the oil and gas sector, but otherwise reflects weaknesses: The current account is heavily in deficit at about 25 percent of GDP. However, this is due to extraordinary levels of profits and capital repatriation, part of the negotiated PSAs. There are ample reserves, and projected cash flows in the coming years will more than cover for basic financing needs. Back-up lines of credit are available if needed. However, Azerbaijan’s debt profile is modest, which also bodes well for its future prospects. Portfolio flows are virtually zero due to the weak securities markets. Direct MICHAEL BORISH AND COMPANY, INC. 18 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  19. 19. FINAL REPORT investment is substantial as a result of the major oil and gas projects under ways. However, for future competitiveness, Azerbaijan will need to attract investment to other sectors of the economy. To date, its performance in this area has been poor. B.1 General Overview (3-) Since 1995-96 in the aftermath of severe hyperinflation and the collapse of pyramid schemes (in 1994), the Government of Azerbaijan has embarked on a reform program geared to achieving monetary (pricing) and exchange rate stability. As an extension of a stable macroeconomic framework, GoA policy has included strict monetary management focused on bringing down the inflation rate, foreign exchange controls to support a stable exchange rate, limited budget deficits, and legal restrictions on bank financing of fiscal deficits. Combined with buoyant oil prices (which has attracted significant investment in recent years, despite a drop from 1999-2001) and a substantial increase in merchandise exports, this has generated high real GDP growth rates averaging 10 percent (unweighted basis) per year from 1998-2003. Azerbaijan has benefited from very substantial increases in real GDP growth since 1997, largely on the strength of oil prices and petroleum sector-related investment. This has translated into a sizeable percentage increase in per capita incomes, rising from about $400 in 1995-96 to $871 in 2003 and a projected $917 or more in 2004. While impressive in terms of growth, Azerbaijan still remains far behind most countries in terms of per capita GDP. Income distribution remains a challenge, as an estimated 49 percent of the population remains below the poverty line, with 17 percent living in extreme poverty. Based on consumption patterns, the highest quintile account for 44 percent of consumption, whereas the lowest quintile accounts for only 7.5 percent of total consumption. As a function of more disciplined financial management, GoA has moved forward with fundamental banking sector reforms, although this has not proceeded as quickly as originally planned. For instance, more than three quarters of banks have disappeared, been closed down or merged with others since 1994, providing some needed consolidation. However, most of the remaining banks have very little capital, and are still generally well below the minimum of $5 million that will come into effect for all banks by 2005. High intermediation costs have resulted from the banks’ limited funding base, which emanate from low incomes of ordinary households (which limits savings), the long standing lack of public confidence resulting from earlier pyramid schemes and hyperinflation (keeping deposit levels low) as well as general mistrust of the safety of banks and honesty of bank management, limited linkage of the microenterprise and SME sector with the formal banking system (also keeping deposits low), and a weak securities market (which limits borrowing and investment opportunities). The lack of competition, as reflected in high concentration of banking sector measures with IBA, as MICHAEL BORISH AND COMPANY, INC. 19 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  20. 20. FINAL REPORT well as the absence of an explicit deposit insurance scheme (considered premature as of 2004 by those focused on financial stability and long-term sustainability) also have the dual effect of keeping capital and funding low, thus driving up risks and per unit costs. Broad money approximates $1,035 million, about $127 per capita, a small base for economic development. While purchasing power parity figures show higher financial measures, the economic base is still small and largely informal. In effect, Azerbaijan has a bifurcated economy, one that is geared to the oil and gas sector, and the other composed of individuals and businesses that have traditionally bypassed the banking sector due to poverty at the base level and corruption/tax avoidance at the corporate level. B.2 Economic Structure (2) Azerbaijan’s economic structure is largely based on oil and gas extraction, processing and export, followed to a much smaller extent by agriculture and social services. Particularly since 2000 as major investments into the oil and gas sector have translated into preparation for or actual exploitation of resources, this sector has been the major driver of economic growth. Agriculture and services are the main sectors of employment, accounting for 73 percent of total employment in 2002. Agriculture has been a particularly important source of employment in recent years, notwithstanding the relative decline of the sector as a whole (due to the growing importance of oil and gas) since 1998. Government is also a large employer, with 759,000 employees in 2002, or 20 percent of total employment. By contrast, the industrial sector, which is responsible for about 35 percent of GDP, has only had about 250,000 people employed during the entire 1998-2002 period. Overall productivity has increased significantly in industry and non-Government services. Outside of oil and gas, there is not reported to be major progress. As of 2002, there were nearly 1.3 million pensioners, equivalent to about 15.5 percent of the total population. With per capita incomes still relatively low and life expectancy (at birth in 1999) of 71.5 years, such reforms should be contemplated early to allow for planning and capital build-up. B.3 Private Sector Development (2+) Azerbaijan has only succeeded in achieving macroeconomic stability, while making only partial progress in creation of an environment conducive to private sector development and infrastructure development. Overcoming the legacy of state control has proved difficult. This is indicated by SMEs that have complained of the time and money cost of licensing requirements, arbitrary nature and frequency of inspections (e.g., tax, fire), and general tax burden. There is widespread belief that corruption in government, the judiciary and the private sector remains pervasive, monopolies continue to distort the environment for competition and development, and financial sector development (banking and other financial services) is unlikely as long as such vested MICHAEL BORISH AND COMPANY, INC. 20 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  21. 21. FINAL REPORT interests and institutional constraints remain in place. Meanwhile, investment is limited outside of the oil and gas sector, and many key enterprises remain state-owned. Notwithstanding the significant work that remains to be done, the private sector is beginning to develop in Azerbaijan. Since 1997-98, most small-scale enterprises have been privatized, largely in the form of cash auctions. The private sector now accounts for about 80 percent of total employment. The private sector share of GDP is estimated to account for about 74 percent in 2003, with this percentage projected to increase steadily to about 83 percent by 2008. Thus, the landscape for private sector growth and development is significantly different from what it was in the early and mid-1990s. There is also clear strategic recognition that the private sector has to grow and diversify for economic development to be sustainable. There are still many state enterprises, including many in critical sectors of the economy (e.g., telecommunications, oil, gas, electricity, two banks). These enterprises account for a substantial share of GDP and employment, and are thought to have significant influence in many areas of the business environment that have stifled competition. The risks to retained state ownership in several of these sectors generally relate to the need to increase competition and productivity, and to stimulate sufficient investment to induce economic diversification so that the economy is more self-sustaining after oil and gas exports begin to diminish after 2018. B.4 Money, Savings and Credit (3-) Macroeconomic policy has been stable since 1996, underpinned by sound monetary and fiscal policies. A significant part of this has been disciplined monetary policy to bring down inflation rates, anchored by a relatively stable exchange rate with the US dollar. Notwithstanding relative exchange rate stability, the economy is substantially dollarized, with nearly half of total broad money held in foreign currency, mostly dollars and, to a lesser extent, rubles. Maintaining disciplined monetary policy has been a political challenge. Given the perceived windfall of oil and gas revenues, the government has had to maintain discipline to ensure political pressures for excessive public expenditure do not result. There have been strong calls for massive infrastructure investment, social assistance to help the poor and internally displaced, and funding to re-start production and distribution until a market economy can be patched together. The presence of oil revenues makes such political calls more powerful. Thus, developing a framework for sustainable growth for the period following peak oil and gas production is sound and politically bold. B.5 Fiscal Policy and Results (3) The Government of Azerbaijan has shown substantial fiscal discipline since 2000. Fiscal deficits did not exceed 1 percent from 2000-02, and they were reported to be less than 2 percent in 2003. Much of the reason for such discipline has been the willingness to cut expenditure, including social spending. Given the difficult circumstances following the MICHAEL BORISH AND COMPANY, INC. 21 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  22. 22. FINAL REPORT hyperinflationary period along with structural dislocation, war and refugees/IDPs, this is no small matter. Key efforts are under way to strengthen institutional capacity in a number of areas for continued sound fiscal management, both in terms of revenue generation and expenditure. Because of the fiscal discipline shown since 1995-96, banks have played a very minor role in government financing, even though government itself earlier recapitalized troubled banks. Monetary policy has been strict since 1995-96, and there has been virtually no bank or central bank financing of fiscal deficits. This is reflected in the low level of T-bill activity, which only amounted to about $27 million outstanding in late 2003, and not much different from that level since 2001. Fiscal deficits have been kept low since 1995-96, again in an effort to achieve and maintain price and exchange rate stability. Investment inflows have financed the generally small deficits. Privatization proceeds have been very minor as an extraordinary cash injection in the balance of payments. B.6 Exchange Rates (3) Azerbaijan’s policy towards exchange rates has been to use these, particularly regarding the US dollar, to serve as a nominal anchor for monetary policy. Azerbaijan’s currency has shown a gradual depreciation against the US dollar since 1999 after appreciating in nominal and real terms in 1998. In general, the approach has been to maintain relative exchange rate stability. Exchange rate movements operate within a narrow band, and underlying stability has been reinforced by keeping inflation rates down while reserves have built up. B.7 Balance of Payments (3) Azerbaijan’s balance of payments reflect growing investment into the oil and gas sector, and cash flows out of the country to compensate large investors to cover much of their sizeable project financing as a basis for oil and gas sector development. This is resulting in high current account deficits, yet is also helping to generate significant financial reserves. The long-term prognosis is that current account imbalances will diminish relative to GDP after 2004, and the balance of payments will strengthen thereafter due to merchandise export performance. Azerbaijan’s relatively low debt burden will also ease financial pressures in the coming decade. MICHAEL BORISH AND COMPANY, INC. 22 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  23. 23. FINAL REPORT C. BANKING STRUCTURE AND FINANCIAL SYSTEM PROFILE Banking Structure and Financial System Composite Rating 2- Summary: The banking system is opening up to competition with the privatization of the two remaining licensed state banks. Recently adopted legislation will harmonize Azerbaijan’s legal framework for banking with international standards. Improvements in banking supervision will help with implementation. However, confidence remains low, resulting in very low levels of intermediation and penetration. Loans are less than 10 percent of GDP, and 20 percent of these are reserved for losses. Assets are only 14 percent of GDP, placing Azerbaijan in the lowest range of transition countries. Deposits remain miniscule, at only $76 per capita. Netting out enterprises, deposits are $31 per capita. With an average of only $3.3 million per bank, the banking sector is severely undercapitalized. Most banks should not be licensed as “banks”, particularly as the government contemplates introduction of an explicit deposit insurance scheme. Meanwhile, with system earnings not expected to be much more than $25 million, the quantum of earning assets remains extraordinarily small and insufficient for needed levels of investment and intermediation for sustainable economic growth and effective poverty reduction. Attracting prime-rated foreign investment will be necessary to reverse these trends. Interim efforts by some donors to work with some of Azerbaijan’s better private domestic banks will also help. Description Rating General Poor reputation re competitiveness in the banking system: 2- Condition Azerbaijan’s banking system has been relatively monopolistic and limited in competition, with most transactions bypassing the banking system or being run through one bank. There have been gradual efforts to improve the legal and regulatory framework, but the market is really at the initial stages of structural adjustment in banking. Banks offer very few products/services. There has been very little foreign investment, and HSBC has already exited from the market (even though it stayed elsewhere in the Caucasus). Banks are generally small, and most are in fairly weak financial condition. Most banks are more like commercial finance companies than banks, as there is little effort to mobilize deposits. There is low confidence in banks by the public. There are no formal ratings for any of the banks apart from IBA, and most would be “junk” status if rated. Few banks have branches, and limited networks reflect limited service capacity. Ownership & Traditionally closed banking system is only beginning to 2 Consolidation open up to foreign competition and change: While there are 17 foreign banks, there has been little competition in the system. The major bank remains state-owned, and the system is inefficient. Most banks should be de-licensed as banks and re- licensed as commercial finance companies under limited licensing conditions that currently apply to non-bank credit organizations. Others are in need of liquidation. All need more capital than they have, including the largest bank. Private banks are frequently mismanaged, and operate on a closely held basis for one or a few controlling shareholders. MICHAEL BORISH AND COMPANY, INC. 23 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  24. 24. FINAL REPORT Financial Very modest levels of intermediation and banking 2- Intermediation penetration: There is very little confidence in the banks, as shown in low levels of deposits, low intermediation ratios, and low levels of bank assets to GDP. Deposits are growing, but the banks still have a small deposit base, averaging only $13.5 million per bank. Net of IBA, the average is less than $5 million. Some banks have other sources of funding, but most do not. Capital is very low, averaging $3 million per bank. Some banks have correspondent relationships (or shareholders abroad) that might also provide lines of credit in a crisis. But few have these, or could be expected to source funds as needed under such circumstances. Loan levels are rising, but are still low at only 8 percent of GDP (after reserves). Asset quality is improving, but overdue loans are still about 45 percent of capital, and reserves for loan losses are nearly double this level. Asset classification practices distort balance sheet values and earnings, and only 18 of 46 banks had their statements presented according to international standards of audit for the 2002 financial year. Earning assets from loans or other sources are modest in aggregate value. Governance & Weak governance and management undermine banking 2- Management development despite recent but very marginal improvements: Laws and regulations are now being adopted to address needed governance and management provisions for safe and sound banking. However, this is the beginning of the process. Boards, management, systems, controls, and ethics are all considered deficient relative to international standards. Hard budget constraints by government in recent years have mitigated the impact of credit losses. However, the small size of the system has weakened incentives for sound governance practices. Minority shareholder rights are frequently ignored, serving as an additional disincentive to investment. Controlling interests are not always explicitly registered as shareholders. Internal audit and supervisory functions along market lines are new and unfamiliar. No real checks and balances exist in the system apart from efforts made to comply with prudential requirements and recommendations from international auditors. However, information and systems capacity are weak. Non-Bank Very limited competition from non-banks provide little 1+/2- Financial pressure on banks to exercise financial discipline: Virtually Sector no competition from non-bank credit organizations, although donor-supported MFIs have adopted good practices and provided some loans to compensate for the failure of banks to play a more active role. Generally inactive capital markets, with only a small T-bill market and some foreign exchange transactions regularly carried out. Part of the reason for weak capital markets is monetary and fiscal discipline, and the lack of demand from government for financing. However, there has been no framework for corporate bonds, municipal bonds, mortgage bonds, equities, and other instruments to take MICHAEL BORISH AND COMPANY, INC. 24 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  25. 25. FINAL REPORT advantage of macroeconomic fundamentals. C.1 General Overview and Condition (2-) There are 46 banks in Azerbaijan, down from 210 in 1994. This reflects significant consolidation in terms of the number of banks in the country. Yet, the system is highly polarized, with IBA alone accounting for more than half of most of the banking system’s balance sheet values and about half of its earnings. The three largest banks—IBA, Bank Standard and BUS Bank—account for about two thirds of assets. Apart from IBA, the banks are small, often closely linked to families and friends, and/or centered on transactions in Baku. There is limited branch coverage outside of Baku, and the services rendered by banks are generally narrow. For all intents and purposes, most banks are really commercial finance companies, with little effort (or desire) to mobilize deposits and develop corporate or retail financial services for the broader market. Governance is considered a weakness throughout the economy. Boards are not considered to satisfactorily play their roles in overseeing management performance. Autonomous and equipped internal audit systems are just beginning to form in the banking sector, and NBA is developing basic modules for outreach to the banks to help introduce adequate internal audit, systems and controls. Banking capacity is limited, and significant work is needed to ensure banks will be able to handle the increase in financial flows expected to result from oil and gas investment. Should they not, these resources are likely to go offshore at the expense of domestic investment and economic growth. That, in turn, would constitute a major problem for Azerbaijan, as these investments are needed in the coming 10-15 years to diversify the economy, increase jobs and incomes, and reduce the widespread poverty that exists. There is very little potential systemic risk. The banking system is small in total, very small on average, and highly concentrated in one bank. The average bank is also barely above minimum required capital. This means there is very little potential for systemic risk, as the failure of any one (even IBA) or several banks would have little impact on households or the economy. On the other hand, the low values are also a function of very low levels of banking sector depth and financial intermediation. MICHAEL BORISH AND COMPANY, INC. 25 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  26. 26. FINAL REPORT C.2 Ownership Structure and Consolidation (2) As of late 2003, Azerbaijan had 46 banks, of which 29 were domestic and 17 were foreign-owned. In the case of the latter, only four were majority foreign-owned at the end of 2003, while 11 had less than 50 percent ownership, and two banks were foreign branches. Thus, the banking system remains primarily Azeri in ownership and orientation. The recent announcement by the NBA to lift restrictions on foreign ownership in the banks, effective January 1, 2004, may portend a shift in these ratios, particularly as IBA and BUS are privatized. NBA recognizes the need for increased capital, improved technologies, and better management systems for the banking system to be competitive and to offer better products and services to the marketplace. The presence of foreign banks can be expected to grow on the condition that they view the Azerbaijan market favorably and are in a position to meet licensing requirements. Increased competition may portend further consolidation among domestic banks. With the planned increase and strict enforcement of minimum capital to $5 million for all banks by 2005, the government/NBA anticipates the number of banks falling to 38 or less. (Anecdotal reports are that the number could decline to as low as 15 or so banks.) Even with additional consolidation in the number of banks, the average bank would remain small. Such limited assets raises the question of whether these banks will be able to compete in anything but very small-scale lending (e.g., working capital financing), or in more specialized areas of financing such as trade finance. A second question is whether banks that barely meet minimum capital requirements should ever be permitted to be part of the eventual deposit insurance scheme, or if they should be re-licensed as non-banks (e.g., commercial finance companies) without the right to advertise as banks or to participate in the deposit insurance scheme when eventually introduced. While state-owned IBA dominates the banking system, private banks are slowly becoming more prominent on a balance sheet basis. In terms of total assets, private banks accounted for about 43 percent of total in 2003. This is in contrast to about 20 percent in 1997. However, all of these figures are small when compared with GDP as a whole. C.3 Trends in Financial Intermediation (2-) Building and restoring confidence in banking has been a difficult task in Azerbaijan. This is partly the result of the pyramid schemes that collapsed in 1994, and more recently the result of constrained resources in the household and enterprise sector, weak service delivery by banks, tax avoidance by citizens (which serves as a catalyst for keeping funds outside banks), and limited access to loans (which provides little incentive for households and businesses to place funds with banks). Money held outside of banks remains high, at 40 percent of total broad money. However, the ratio is down from as high as 55 percent in 1999, and an average of 47 percent from 1998-2002. Again, this is a favorable trend, MICHAEL BORISH AND COMPANY, INC. 26 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  27. 27. FINAL REPORT although the figures may also not be entirely accurate due to the high level of informal transactions in the economy. Irrespective of trends, financial intermediation ratios remain low at 14.5 percent. Among most transition countries, 17 of 25 selected countries had about two times Azerbaijan’s level of intermediation or higher. Thus, Azerbaijan’s overall level of financial intermediation is low by most transition country standards, and even below average relative to the CIS. Low levels of financial intermediation in Azerbaijan largely reflect underdevelopment of the banking sector, structural weaknesses in the non-oil and gas sector of the economy, an inadequate legal/judicial framework, and a continued unwillingness on the part of small businesses and households to place their funds with the banks. This generally reflects a lack of confidence in the system, limitations on resources, lack of access to formal financial services, and the desire to handle transactions privately to avoid taxes. The banking system has a total of about $1.1 billion in assets, equivalent to a low penetration ratio of about 15 percent of GDP (2003 figures). Of these assets, about $682 million is in the form of loans. On the funding side, deposits were about $621 million at end 2003. Capital was $151 million for a straight capital-to-assets ratio of about 14 percent. With 46 banks, this translates into the following averages per bank: • Assets: $23 million • Loans (to Customers and Banks): $15 million • Deposits: $13.5 million • Capital: $3.3 million Preliminary estimates of earnings for the banking system approximate only $25 million in total for 2003. Should such estimates be accurate, this would translate into the following for 2003: • Average earnings: about $550,000 • RoAA: 2.69 percent • RoAE: 17.87 percent Thus, return ratios are reasonable by many measures, yet aggregate and average figures are exceedingly small. In aggregate dollar terms, bank credit at the end of 2003 was higher than levels in 1998-2000, with positive trends commencing in 2002 and continuing on through 2003 in the form of substantially increased bank credit. In terms of recipients of bank loans, private sector enterprises now account for about two thirds (or more) of net domestic credit from the banks. This is roughly in line with estimates of private sector share of GDP, which has been the case since about 2001. Meanwhile, credit to SOEs continues to shrink as a percentage of total credit as well in aggregate figures, and bank credit to MICHAEL BORISH AND COMPANY, INC. 27 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  28. 28. FINAL REPORT government was about 15 percent of total bank credit in 2001-02. This declined considerably in 2003. In terms of sources of bank credit, private banks are now considered to account for about half of bank credit outstanding. State bank lending is essentially all related to IBA, as BUS Bank has not been able to make new loans since 2000, and its current loan portfolio is now valued at less than $1 million. When IBA and BUS are privatized, this will make the system fully private. However, until then, private sector banks’ loans outstanding will account for only about half of the system total. Based on NBA figures in late 2003, bank credit (to enterprises and households, but not including bank investment in government securities) showed the following characteristics: • Sector distribution of real sector credit was primarily to households (28 percent), commercial trade (21 percent), transport and communication (12 percent), industry (8 percent), agriculture (7 percent), and construction and real estate (5.5 percent). • Bank credit was about two thirds in foreign currency, and one third in manat. • Bank credit is primarily short-term (73 percent), and rarely for longer than one year. • As of year-end 2003, 10 percent of loans were overdue, equivalent to about 45 percent of capital. C.4 Governance and Management (2-) Corporate governance standards are not considered strong in Azerbaijan when compared with recommended practices. This is largely due to the underdevelopment of financial markets, lack of familiarity with IAS, lack of tradition with regard to autonomous internal audit functions, weak protection (to date) of minority shareholder rights, and a lack of tradition with regard to open information flows and disclosure of problems and potential risks. There is no active market in bank shares, so market scrutiny from an investor standpoint is limited and non-transparent. This may change a bit with the privatization of IBA and BUS, and as some of the IFIs consider investment in other banks. However, by and large, there is little market information on the banks. Only IBA has received a rating from an international rating agency among the domestic banks. C.5 Non-Bank Financial Institutions and Markets (1+/2-) As is common in most transition countries, the non-bank part of Azerbaijan’s financial sector is less developed than the country’s banking system. Notwithstanding banking sector weaknesses, Azerbaijan has virtually no securities/capital markets, no private pension funds, and a limited insurance sector. MICHAEL BORISH AND COMPANY, INC. 28 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  29. 29. FINAL REPORT The securities markets are very small, essentially comprised of the T-bill market. Total volume issued was $90 million (as of December 1, 2003), almost exclusively three- month securities. There is very little secondary trading reported. Contractual savings are underdeveloped. There are plans to develop a multi-pillar pension scheme in the coming years, but not imminently. Restrictions on foreign insurers have limited modernization of the insurance sector, although this is set to change later in 2004 or shortly thereafter when legislation is reviewed and revised. Based on 2002 statistics, insurance premium revenues were among the lowest in the world at less than $45 million-equivalent. By comparison, the 91st largest country in the world for insurance premium revenues was Bahrain, at $159 million. This translates into density per capita in Azerbaijan of about $5, and revenues per insurance company of about $1.5 million. There are 58 licensed non-bank credit organizations, mainly credit unions and micro-finance groups. These groups account for very little in the way of assets, and virtually zero in deposits. They have limited licenses, meaning that they are not permitted to mobilize deposits. As such, in most cases, they lend in small amounts to individuals and micro-enterprises. As of March 30, 2003, five of the largest MFIs had nearly $6 million in total assets, about 6 percent of the banking sector. There are currently very preliminary plans to provide financial services through the postal system. Initially, there were plans to have more than 600 postal outlets that would be able to render basic financial services to the public by 2005. These would include pension payments as the pension system’s records are brought up to date and automated. Other areas would presumably include linkage to the payment system to permit payment of bills—utilities, taxes, etc. However, the post office currently only offers money orders. Leasing is only beginning to develop in Azerbaijan. There are reported to be three leasing companies, with contracts of about $1 million. Most of the small level of activity to date has involved equipment leasing, such as copying machines and vehicles. Proposed new legislation provides more favorable accounting and tax incentives, including accelerated depreciation on all leasing assets as well as possible customs duty holidays for industrial machinery and related production activities (as leasing would be treated as a financial service not subject to duties). Factoring is nascent in Azerbaijan. As of late 2003, the banks had about $20 million in outstanding credit to factoring operations. This was about 3 percent of banks’ outstanding credit, and 0.3 percent of 2003 GDP. Such activity began in 4Q 2003. MICHAEL BORISH AND COMPANY, INC. 29 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN
  30. 30. FINAL REPORT D. BANKING SECTOR DEVELOPMENT IN RELATION TO PRUDENTIAL ISSUES Banking Sector Development and Prudential Risk Composite Rating 2 Summary: The banking system will benefit from new legislation. Prospects for foreign investment improve with IBA privatization to commence in 2004, and the possibility of a sound bank taking over BUS Bank as well. Some of the foreign banks (e.g., Koch Bank, Microfinance Bank) have good shareholders that can raise these banks’ profiles in the market. Likewise, some of the domestic private banks are considered professional and potentially sound with time as the market opens up to competition. In terms of existing risks, banks are now fairly cautious in terms of lending and the maturities/terms associated with such exposures. Liquidity is reported to be adequate. However, on the downside, capital is very low, CARs may be overstated due to the poor quality of financial information and risk capacity of the banks, assets are small, reserves for loan losses approximate 80 percent of capital, earnings are very low ($25 million for 2003), and overall capacity to manage risks is considered underdeveloped. Country risk persists due to a weak reputation for governance, management, legal and judicial framework, corruption, and general political instability common to the region. Description Rating Capital and Inadequate capital: Banks are very small, and in some cases 2 Capital insolvent. Measures of capital adequacy in many cases are thought to Adequacy be inaccurate due to poor information and lack of management capacity to assess risk. Significant changes are needed in governance, management, earnings sources, funding sources, and approach to the marketplace to achieve adequate capital levels re BIS standards. Restrictions on foreign ownership have been eliminated. However, it is uncertain how much investment from prime-rated institutions will enter the market to help strengthen capital and overall capacity. Asset Poor asset quality: While asset quality has improved in recent years, 2+ Concentration reserves for loan losses are still very high relative to the low capital of & Quality the system. Moreover, improvements in asset quality have largely come from very risk-averse positions towards lending, partly the result of weak funding and poor information. Loan portfolios are somewhat diversified, and terms/maturities appear relatively matched to protect against major gaps. Government discipline has increased financial discipline in state enterprise sector, and banks are now generally free from government intervention in credit decisions. Incentives are also in place to recognize losses and provision/reserve for them. This has been reinforced by gradually improving banking supervision, recently strengthened with new legislation. However, there is a general absence of fundamental risk management practices in the banks, and they are not tooled up for competition with major banks should they enter the market. Earnings Weak or unstable earnings: The base of earning assets is small for 2- the banks, and earnings are expected to be about $25 million for the whole system in 2003. Likelihood of unrecognized losses in many small banks. Revenue structure is generally weak and insufficiently diversified, with few non-credit services offered to boost earnings and efficiency. Controls and mandated lending no longer distort market patterns, but the level of loan volume is so small that earnings are MICHAEL BORISH AND COMPANY, INC. 30 USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN