assessment of azerbaijan banking system.doc

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.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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-CategoriesFinancial Sector Infrastructure

General policy and system 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, safekeepingEconomic Factors and Indicators

General trends Economic structure Private sector development issues Monetary and related savings and credit matters Fiscal considerations Exchange rates Balance of payments issues

Banking Structure and System Profile

Overview of the system and financial measures 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 Based on Prudential Issues

Capital and capital adequacy Asset quality and concentration Earnings Liquidity Sensitivity to credit and market risk Country risk


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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 Description5 Outstanding; world class; state-of-the-art; best practices; virtually no serious systemic risks4 Solid; strong; satisfactory; competitive; few systemic risks or problems, and those are

manageable3 Adequate; favorable trend; improvement needed; potential for major systemic risks2 Inadequate; weak; significant improvements needed; major potential for destabilization via

systemic risks1 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.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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

Adherence to conservative liquidity management policies and practices


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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

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)


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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 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


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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.


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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 RatingPolicy & System

Partly supportive of stable, safe and sound banking, but major 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.

2+/3-

Legal Framework

Fairly supportive of stable, safe and sound banking, but 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

2+


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underdeveloped. Regulatory & Supervisory System

Adequate regulatory framework for prudently managed and supervised banking, but significant strengthening needed: New 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.

3-

Payment & Settlement

Adequate, but less than efficient systems, support increasing 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.

2+

Accounting & Transparency

Significant improvement is needed in the framework for banking, 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.

2

Rating Agencies & Systems

Generally unsupportive of banking sector development: No real presence of professional rating agencies, even for sovereign debt. 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.

2

Financial Media

Generally unsupportive of banking sector development and growth: Limited coverage from print and broadcast media. Press environment still considered restrictive by some.

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Professional Associations

Marginally supportive of banking sector development and growth: 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.

2

Academic Institutions

Marginally supportive of banking sector development and growth: 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.

2+

Miscellaneous Generally unsupportive of banking system; significant 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.

2

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.


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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


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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


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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)


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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.


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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.


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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.


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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 RatingGeneral Condition

Adequate macroeconomic fundamentals assist with banking 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

3-

Economic Structure

Weak economic structure slows banking development: High 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.

2

Private Sector Development

Private sector development is continuing, but major 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

2+


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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, Savings and Credit

Adequate monetary fundamentals boost confidence, but improvement needed: Policy fundamentals are sound, as shown in 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.

3-

Fiscal Policy and Results

Adequate fiscal fundamentals boost confidence, but 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.

3

Exchange Rates

Exchange rate fundamentals boost confidence and exports: 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.

3

Balance of Payments

The balance of payments position reflects the growing 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

3


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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


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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


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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


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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.


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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 RatingGeneral Condition

Poor reputation re competitiveness in the banking system: 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.

2-

Ownership & Consolidation

Traditionally closed banking system is only beginning to 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.

2


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Financial Intermediation

Very modest levels of intermediation and banking 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.

2-

Governance & Management

Weak governance and management undermine banking 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.

2-

Non-Bank Financial Sector

Very limited competition from non-banks provide little pressure on banks to exercise financial discipline: Virtually 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 advantage of macroeconomic fundamentals.

1+/2-


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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.


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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,


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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


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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.


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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.


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D. BANKING SECTOR DEVELOPMENT IN RELATION TO PRUDENTIAL ISSUES

Banking Sector Development and Prudential Risk Composite Rating 2Summary: 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 RatingCapital and Capital Adequacy

Inadequate capital: Banks are very small, and in some cases insolvent. Measures of capital adequacy in many cases are thought to 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.

2

Asset Concentration & Quality

Poor asset quality: While asset quality has improved in recent years, reserves for loan losses are still very high relative to the low capital of 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.

2+

Earnings Weak or unstable earnings: The base of earning assets is small for 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

2-


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weak. No evidence that excess risk is taken in trading activities, as these are low volume. However, there is a risk of this happening in the future in an effort to increase earnings. Tax rates are reasonable.

Liquidity Adequate liquidity position, but room for strengthening: Funding is highly dependent on deposits, and these are low in the aggregate. Capital is very low, and other sources are limited. On the other hand, net liquid assets and securities investments are high enough to cover for deposit withdrawals. Banks appear to manage maturities, exchange rates and interest rate sensitivities on prudent and cautious terms. Reserve requirements are generally observed without incident, and forbearance has not been reported. Exposure and maturity positions are considered generally acceptable.

2+

Credit & Market Risk

Poor reputation for sensitivity to market risk under market conditions: While fundamentally cautious for now, banks generally lack systems for credit and portfolio management under competitive conditions. Internal systems and audit capacity are weak in terms of consolidated financial information, autonomy, and the ability to use such information for risk management and strategic planning purposes. Legal and regulatory compliance is generally the case with banks, although capacity to detect illegal activities and the incidence of corruption raises questions about whether legal and regulatory compliance are at lower rates than thought.

2

Country Risk Improving reputation for political, economic and social stability, although several concerns persist: Uncertain reputation for stability, although macroeconomic policy has been stable for many years. Corruption and weak capacity in government hurt Azerbaijan’s reputation. Ongoing conflict in Nagorno-Karabakh adds political risk to the equation, as does more general regional concerns. Weak economy at the structural level, partly the result of cartels and vested interests, raises concerns about investment opportunities outside the oil and gas sector. While socially cohesive and considered tolerant towards minority groups, Azerbaijan still faces problems of poverty, including the plight of refugees/IDPs resulting from the conflict with Armenia in N-K. Reputation for recognizing property rights and honoring contracts is poor outside the oil and gas sector, and judicial reform is needed to correct this. Fairly high risk premium associated with investment or exposure to the country, although PSAs have reportedly been honored without major problems. Thus, performance in this regard should reduce some investment-related concerns.

2+

D.1 Capital and Capital Adequacy (2)

Minimum capital for the banks has been $2.5 million since July 2002, and is expected to rise to $5 million by 2005. While some of the banks with less than this figure are not expected to have a problem reaching and exceeding this requirement when imposed, others are expected to have difficulties complying.


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Average regulatory capital was $2.6 million in late 2003, barely above the minimum. An estimated 39 banks were below the 2005 target in late 2003. While there is still time to attract additional investment and/or merge operations, many banks are expected to fail as a result of regulatory non-compliance.

There are several approaches that could be taken to reconfigure the system on more stable foundations. One would be to re-license the “banks” that are technically solvent, legally in good standing, and basically demonstrating movement towards sound standards of management and governance as non-bank credit organizations, and essentially function as commercial finance companies. This would permit them to continue as businesses, but not as banks. This would also eliminate their prospects for membership in the deposit insurance scheme once introduced.

De-licensing “banks” that are insolvent and deficient in other ways (e.g., legal, operational, managerial) should be closed. Other issues related to efforts to reduce money laundering and other financial crimes should be considerations in how the banking system consolidates. “Pocket” banks often remain suspect in terms of criminal financial activity. They frequently detract from economic competitiveness and financial stability by taxing regulatory resources and time while conducting low levels of intermediation.

Capital adequacy for the banking system was estimated to be about 19 percent in late 2003. However, these figures are imprecise due to problems associated with asset classification, off-balance sheet risks, etc.

Non-performing loans to net capital have ranged from 56.5 percent in 2000 (after the bad asset transfer from troubled state banks) to 78 percent in late 2003. This suggests that risk-adjusted capital coverage of loans is diminishing, although the ratios are still conservative when compared with more active credit markets.

Greater capital and capacity is needed to modernize the system and increase intermediation. One of the challenges in the coming years will be developing capacity to manage increasing resources in and through the banking system. When that occurs, there will be higher levels of monetization, intermediation and banking penetration. However, until then, intermediation figures will remain low. Perversely, this will reduce the potential for systemic risk.

D.2 Asset Concentration and Asset Quality (2+)

Banks’ asset quality has improved in recent years. Given that loans are the main asset on the balance, the main indicator of asset quality for the Azerbaijan banking system is the status of the loan portfolio. Overdue loans are still high at about 10 percent of total loans, and reserves for loan losses are about 20 percent. However, they have generally come down since 1999.

In terms of institutions, the main concern for systemic stability is IBA. Its special and general reserves for loan losses are consistent with the system as a whole as a share of


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loans. They are also about three times Tier I and Tier II capital. Should more than 15 to 20 percent of IBA’s loan portfolio completely collapse in performance, the bank would face significant stress. However, to date, there has been no information that would suggest this is even a remote possibility.

Sector trends indicate some diversification in lending patterns, although most appear to focus on high turnover, short-term activities. Some private banks are actively seeking industrial activities, and this may continue as private foreign banks become more active in the market, and as the business environment improves for SMEs. Such diversification will help offset concentration risks should asset quality in a particular sector decline.

Average loan size is small, largely due to the low level of capital of the banks and regulatory restraints on the size of individual loans. Based on late 2003 data from the NBA, the average bank net of IBA would not be able to make a loan larger than about $650,000. While this is large for most banks in Azerbaijan, it is small for most large-scale enterprises and many medium-sized enterprises. In general, these companies need larger loans for longer periods. While the small scale of banks’ lending resources is negative for overall economic growth, it does mean that when individual loans turn bad, they are generally not large enough to materially impact the overall portfolio. Most loans are reported to be far smaller than $650,000.

The banking system shows that a high proportion of overall assets are held in reserves and safe securities investments abroad. This suggests that the impact of any deterioration in loan quality could be partly contained by liquid assets available offshore.

D.3 Earnings (2-)

Although about 60 percent of total assets are loans and loan quality has improved in recent years, the actual base of earning assets is small in value. Estimates (in late 2003) of after-tax earnings for the banks in 2003 were about $25 million, a very small amount by global standards. With assets of about $1.1 billion, this is about a 2.35 percent after-tax return.

Because banks offer very little in the way of non-lending services, non-lending sources of income are limited. Banks make some money on guarantees and money transfers, but these fees are not high value. There is little money made in foreign exchange trading. Direct payroll is rarely used, if ever. There is virtually no use of banks for custodial services, although this may change in the future as pension funds eventually emerge later in the decade. There are fees from plastic cards and electronic payments/transfers, and these will grow in the coming years. However, for now, there is little income derived from such services.

While banks are not high in cost, they are also not high in productivity. Many banks appear to have high staffing levels relative to income. This is partly because most banks are manual in their orientations, and there are more support functions than direct


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marketing functions. Investment in more advanced systems and technologies to introduce new products and augment earnings sources will change this. However, for now, operations are still very manual.

D.4 Liquidity (2+)

Liquidity is stable on a regulatory basis, although the system as a whole is poorly funded. Meanwhile, from a liquidity management standpoint, banks are under less pressure than from a few years ago. The refinancing rate has been 7 percent since September 2002. Reserve requirements have likewise come down in recent years from 15 percent to the current 10 percent. The payment system has become more efficient in the last few years, reducing the large cash balances banks needed to hold for transactions. Thus, conditions are better in 2003-04 than they were a few years ago. However, most banks are located only in Baku and do not have extensive branch networks. Funding is low. Investment opportunities are limited. All of this detracts from efficient liquidity management.

Key liquidity measures indicate that net liquid assets (net position in domestic inter-bank market, net position overseas, net position with NBA plus vault cash) approximated 60 percent of deposits. This suggests the banks were sufficiently liquid in 2003. Meanwhile, gross securities were valued at 14 percent of total deposits, providing additional cushion in the event of banks facing major deposit withdrawals. However, given that most people and enterprises bypass the banks in the first place, this is not considered to be much of a risk.

D.5 Sensitivity to Credit and Market Risk (2)

There is limited market risk in the Azerbaijan banking system. In one sense, this reflects the stable macroeconomic fundamentals of the country, including the managed float and relative exchange rate stability. Interest rates have gradually come down, the exchange rate has not fluctuated wildly against major international currencies, most exposures are short-term (up to one year), and the outlook for continued strong earnings from the energy sector remain favorable. Thus, there is little risk of major maturity, interest rate, or exchange rate mismatches (although there is an opportunity cost to banks for issuing dollar-denominated loans or making dollar investments given its slide in the last year).

Likewise, for the economy, there is little risk of bank failure having an impact. The only major bank is IBA, with assets equivalent to about 7.5 percent of GDP. Unless there has been non-disclosure of major investments, exposures, transactions or other risks, there is no risk of IBA failing and creating a broader problem for the economy. While IBA needs strengthening and higher capital, it has received a reasonable rating (2002), external audits have confirmed a reasonably stable institution, and the risk of failure appears to be very low. Meanwhile, the total banking system is only 15 percent of GDP in terms of assets-to-GDP. Loans are only 10 percent of GDP, and household deposits are only 3 percent of GDP. The failure of any institution may have an effect on public confidence,


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but no bank failure apart from IBA would have any material impact on the economy based on available information.

What could potentially be an issue at some point unless corrected in the coming years are weak operations ultimately culminating in a major misuse of funds. Back office operations, information systems, and internal controls are all considered fairly weak and underdeveloped by global standards. There have been improvements, largely triggered by regulatory pressures and prudential requirements. This is a critical issue in implementing systems to identify money laundering and fraud, and other financial crimes, as well as broadly making the system more competitive, stable and efficient.

D.6 Country Risk (2+)

The country risk associated with Azerbaijan appears to be structural and political, the former due to the slow reform of the financial and enterprise sectors, judiciary, and public administration. Political risk is primarily that the unresolved conflict in Nagorno-Karabakh would resume, that a macroeconomic downturn would create a reaction due to a worsening of poverty (more people affected, and those currently affected becoming more deeply affected), and that resentment towards corruption, patronage and other characteristics of public administration would spill over. There have been complaints from some human rights groups that prisoners’ rights and press freedoms are sometimes infringed on.

The government appears to be moving to reduce prospects for political and country risk. Anti-corruption legislation has been adopted. The macroeconomic framework remains sound on the condition that oil and gas prices do not radically plummet. There are ongoing efforts through the Minsk Group of the OSCE to mediate the dispute with Armenia over Nagorno-Karabakh. Thus, while far from ideal, the country risk associated with Azerbaijan is largely related to weaknesses that have been identified by all parties concerned.

Country risk can be overcome if there is progress with policy reforms at the structural level. However, if Azerbaijan is slow to reduce corruption, reform the judiciary, improve corporate governance, and open up the economy to greater competition and investment outside the energy sector, then perceived country risk will remain high.


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ANNEX 1: SEE OTHER FILE DUE TO LANDSCAPE FORMAT


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ANNEX 2: FINANCIAL SECTOR INFRASTRUCTURE

2.1 Policy/System

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. The banking sector enjoys a sound legal framework, particularly with the most recent legislation passed (Banking Law) or on the verge of passage (Central Bank Law) in parliament. This upgrades earlier banking legislation, and provides Azerbaijan with banking legislation that is consistent with international best practice at both the central bank and commercial banking levels. Moreover, gains have been made in recent years in strengthening supervision, albeit with major challenges that remain. Nonetheless, the banking sector remains heavily dominated by one bank,2 no major foreign banks are in Azerbaijan (apart from two representative offices3 and UniCredit’s ownership of Koch Bank), 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. Should there be any movement to promote capital market development, the State Securities Commission is likely to be a worthy counterpart. Nonetheless, for the time being, there is little prospect for capital markets to develop. 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. Thus, many of the financial measures that affect Azerbaijan are to be found offshore, including lending activities for pipeline development, and financial advisory services regarding operations in Azerbaijan. 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. The banking sector will likely be the first sector of the economy to actually implement IAS, and this will take some time.4

Other supporting institutions, such as financial media, credit rating agencies, business associations and training institutes are also relatively nascent due to underdevelopment of the financial sector and most other sectors of the economy. There is an active press that 2 Newly adopted legislation includes anti-monopoly provisions with an eye to increasing competition.3 One is for HSBC of the UK, which has technically exited the market from earlier participation, but remains to clear up outstanding exposures and issues. The second is Société Générale of France.4 As of 2003, 18 of 46 banks presented financial statements based on international standards of auditing.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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. Key legal framework weaknesses include the following:

Inadequate framework for secured transactions. This explains some of the unwillingness of banks to lend, and the virtual lack of lending outside of Baku.

Inadequate insolvency framework. Bankruptcy and liquidation practices are rarely utilized as a means of restructuring debts and/or liquidating firms unable to meet their obligations to a range of stakeholders.

Underdevelopment of judicial and extra-judicial capacity to resolve commercial disputes and enforce contracts. This is reflected in the wholesale view of the courts as unreliable and vulnerable to influence-peddling, as well as in the general absence to date of legally recognized out-of-court vehicles.

Competition and enforcement of anti-monopoly provisions. Many key sectors are monopolistic and/or monopsonistic, and this distorts the economy as a whole, including trends in the financial sector.

Trade and investment barriers. Trade is affected by non-tariff barriers, including the presence of cartels. Investment is sometimes constrained by legal barriers (e.g., insurance), and in other cases by entrenched interests. Both explain much of the reason for very low levels of foreign direct investment in any part of the economy outside of the oil and gas sector, and also why many of the financial services related to oil and gas development occur offshore.

All of these weaknesses adversely affect banking and financial sector development because they add to risk and the potential cost of financing, and remove the sense of security that returns generated will be worth the risk and costs assumed. Moreover, such constraints limit the real sector opportunities for lenders and investors, as they restrict the number of viable companies and opportunities. All of this is reinforced by the broad context of a relatively small market (8 million people), low per capita incomes and purchasing power, and opportunities in other markets where uncertainty and risk are not as great or the potential return is higher. The following table provides a synopsis of key


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environmental factors and challenges related to financial sector development, all of which are discussed more fully below. Box 1: A Snapshot of Environmental Challenges in the Financial SectorIssues ChallengesLegal & Judicial

Collateral enforcement weak due to the absence of a unified registry for moveable items, centralization of all related immoveable registry issues in Baku, and title issues related to the ownership of property

Bankruptcy/liquidation underdeveloped as a vehicle for debt restructuring

Judicial capacity inadequate due to issues of orientation and experience, corruption, insufficient capacity and support in the system, and time required to adapt to new legislation

Alternative dispute resolution and arbitration new and underdeveloped Economy and governance (public and private) still largely accustomed

to monopoly and patronage, resulting in distortions and still high levels of corruption

Business environment still broadly unfavorable for trade and investmentRegulatory & Supervisory

Risk-based techniques new to Azerbaijan Mandate for supervision being strengthened with new legislation, but

will require time to develop Only partial compliance with many Basel Core Principles in banking

supervision Securities and insurance regulators have had little market experience

Payment & Settlement

Low levels of usage relative to number and volume of transactions as a whole

Most transactions occur outside the formal system Small (low) value payments relatively new and underutilized

Accounting & Information Disclosure

No real tradition of transparency or disclosure of information No real tradition of use of accounting information for management uses Limited capacity of the domestic accounting/audit profession Tradition of widespread tax avoidance

Rating Agencies & Systems

Independent credit bureau and/or agency not present NBA credit information limited in terms of utility as tool of credit risk

evaluation for banksFinancial Media

Small presence of media, but limited financial intermediation and capital markets activity reduces the flow of information and role played by financial press

Professional Associations

Associations exist (including in banking), yet their involvement in practical enforcement of legislation has been limited or partial at best

Academic Capacity

Universities have capacity in some areas of legal framework Management training in business and finance relatively new Training institute in banking and finance exists and has helped with

initial outreach for market reforms, but additional resources neededOther Telecommunications sector opening up to competition (wireless), but

electronic systems underdeveloped (particularly outside Baku) Postal network lacks capacity as point of outreach for financial services

in areas where banks not present


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2.2 Legal Framework 5

The legal framework for banking is based on three key pieces of legislation and about 50 or so “normative acts”, by-laws or procedures that define the scope of practice for banks based on prevailing legislation.6 Azerbaijan adopted the Law About the National Bank of the Azerbaijan Republic (henceforth Law on NBA) in August 1992, which was subsequently revised in January 1996. This coincided with adoption of the Law About Banks and Banking Activity (henceforth Law on Banks), also in August 1992, which was subsequently revised in January 1996. Legal revisions to the banking laws were followed by stricter licensing standards and new prudential regulations, although these enhancements still fell short of international standards. Nonetheless, they reflected improvements from the earlier period characterized by low minimum capital to encourage entry and competition, but prior to when adequate regulation and supervisory structures, corporate governance standards, and risk management systems were established for financial stability. These remain challenges to the present day, and will remain so for the foreseeable future.

More 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. Major changes in the new legislation relative to earlier legislation include a strengthening the mandate of NBA to supervise banks, more comprehensive scope for defining and resolving problem banks, introducing procedures for corrective action, and providing supervisory authorities with the right to investigate malfeasance and require corrective actions as needed. In general, the Law brings Azerbaijan closer to compliance with the Basle Core Principles for banking supervision. At the commercial bank level, ownership restrictions on foreign investment have been eliminated, minimum capital is being raised, governance standards are being tightened, and adherence to anti-money laundering and terrorism financing provisions are included.

In addition to core banking legislation, the Law on Currency Settlement was passed in 1994, putting the NBA and State Customs Committee in control of foreign exchange. With regard to the payment and settlement system, “Procedures On Arrangement of Transactions Between the Credit Organizations” provides the procedural framework by which banks and other financial institutions can participate in the inter-bank settlement system. This is essentially done by banks setting up settlement accounts with the NBA for clearing and settlement. New provisions in the Law on NBA address ownership and operation of the payment system. This supercedes earlier procedures on the payment system.

Key legislation and by-laws for banking as of end 2003 included the following:5 This section deals with banking only. References to legal and regulatory issues for non-banks are dealt with on a limited basis in Annex 4.6 The estimate of by-laws is based on what is highlighted on the NBA web site. Another 14 or so new regulations are being put in place to be consistent with new legislation adopted in 2004. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Law on the National Bank of Azerbaijan Law on Banks and Banking Activities Law on Currency Settlement 16 procedures related to licensing and prudential control, including capital,

liquidity, reserve requirements, loan classification, internal audit and control, collateral for secured transactions, acquisition of shares by banks, and off-balance sheet items

12 procedures related to currency regulation and control, including licensing requirements for banks permitted to conduct foreign exchange transactions, correspondent banking accounts, repatriation abroad, open currency positions, and currency exchange operations within Azerbaijan

9 procedures related to accounting and disclosure, including the chart of accounts, required reporting of assets and transactions, and transactions through the payment/settlement system

11 procedures related to cash and electronic transactions, including banknotes, coins, plastic cards, and payment/settlement

As noted, additional implementing regulations are being drafted or have already been approved to be consistent with new legislation.

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. Banks are permitted to establish brokerages and underwrite securities, in keeping with merchant bank legislation. Meanwhile, in terms of banking supervision, 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.

The Law on Banks and Banking Activities makes it easy for foreign banks to obtain a license in Azerbaijan. As of late 2000, there was a 30 percent aggregate system-wide cap on banks with foreign participation as a percent of total share capital. This was later increased to 50 percent, and more recently (November 2003), it was announced that the cap was lifted, effective January 1, 2004. This partly reflects an effort to attract more capital and better technologies into the banking system, increase competition, improve quality and service, and facilitate bank privatization.7 This is part of a larger effort to redefine licensing standards, establish risk-oriented operating standards and requirements, and make the exit of banks less cumbersome when they are unable to meet prudential requirements, all of which are included in the newly adopted Law on Banks and the Law on NBA presently with Parliament.8

While new banking legislation will clearly help to advance and modernize the system, many of the problems associated with financial sector development are closely related to problems in the broader legal and economic framework of the country. As noted above,

7 See “Azerbaijan to Lift Restrictions on Foreign Participation in Banks”, Azerbaijan Oil & Gas Press Review, December 4, 2003. 8 See “The Bill on Banks is Submitted to Parliament”, AzerPress News, December 11, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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 eventual development of a modern framework for bankruptcy and liquidation in support of clear creditors’ rights.

Collateral and Creditors’ Rights : In the past, state guarantees reportedly served as effective collateral, although the level of arrears in the state enterprise sector on loans (and other kinds of credit) were exceedingly high in the late 1990s, and ultimately led to the collapse of major state banks.9 Since then, increased macroeconomic discipline has reduced the use of these guarantees. However, legislation regarding pledges and banks’ ability to recover on credit claims is weak, and the non-existence of a moveable property registry (apart from vehicles) undermines the development of secured lending. Even if a registry existed, as it does for immoveable assets, gender complications and legal verification issues related to title on personal property (e.g., residential properties) add to the risk due to “social” considerations regarding ownership.10 In the case of companies and commercial property, such risks are reported to result from the use of “fronts” (e.g., shadow representatives, shell companies), and the ability of the controlling interests (visible or not) to exert influence with governmental and judicial authorities. In either case, these problems add to the risk of credit exposures when banks or others extend loans, resulting in very little lending as a result. Given the traditionally strong loan default culture in the banking system and the inability to collect on pledges and other forms of collateral, it is safer for banks to simply not lend. However, due to limited alternatives to generate earnings, banks have few income-generating options apart from lending. All of this contributes to a distorted and stunted banking environment.

Insolvency, Default and Creditors’ Rights : Legislation strengthening NBA’s mandate to close down banks under formal bankruptcy is included in new legislation. To date, closing down banks has not been a problem, as the number of banks has declined significantly in recent years. However, the use of bankruptcy and liquidation in the real sector for debt or corporate restructuring is underdeveloped, with only a few cases going to the courts. The lack of reliability

9 As of end 1999, NPLs were 62 percent of total claims on state and private enterprises, up from 52 percent in 1998 and never below 16 percent since 1993. (See “Azerbaijan Republic: Recent Economic Developments and Selected Issues,” IMF Staff Country Report No. 00/121, September 2000.) Other sources reported lower levels of non-performing loans. In either case, the level of non-performance was so high that the state-owned industrial and agricultural banks failed, and efforts to impart greater financial discipline in the utilities sector and elsewhere among state enterprises were introduced. All of this raises questions about how secure government guarantees were as a form of collateral in the domestic economy. 10 Personal property issues are reported to be complicated by gender issues and enforcement of women’s legal rights to property ownership. In some cases, fraudulent signatures have been reported. In other cases, disputes have emerged in divorce and inheritance cases, with payments to judges determining the outcome rather than legal rights. This draws a direct link between judicial corruption and discrimination against women. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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of the courts is a problem, related to experience, training, vested interests, corruption, and the general lack of tradition and precedent. This undermines the ability of creditors to recover on loans. With such a lack of protection, this has resulted in lower levels of lending than would otherwise be achieved. This, in turn, has kept the economy small and largely informal.

2.3 Regulatory/Supervisory System

As noted above (see 2.2 Legal Framework), since adoption of the Law on NBA in August 1992 (and since revised in January 1996 and then again in 2003-04), NBA has been empowered with the design and implementation of monetary policy. This has included responsibility for monitoring banks’ (non-)compliance with prudential norms, and general supervisory responsibilities.

The process of strengthening regulatory and supervisory capacity has been ongoing for several years. The revised Law on Banks and Banking Activities (1996) led to a strengthening of regulations and supervision, including tightened licensing and minimum capital requirements. This made it possible to introduce a framework for better assessment of the underlying condition of banks. This included more regular and timely information to assess liquidity management practices and capital adequacy, tighter asset classification standards, and movement towards more accurate provisioning requirements. However, these improvements were relative to original legislation and requirements, and enhancements made in 1996 were still far short of what was required for a stable and well capitalized banking system. Moreover, while the law and prudential norms appeared reasonable, implementation was undermined by basic fundamentals like poor financial information, weak systems and governance, and a general lack of tradition of, capacity in and exposure to market-based practices. Today, the system is still far from being able to implement as accurately and consistently as is needed for a stable financial system. The changes introduced in 1996 ultimately led to less inaccuracy and distortion in regulatory financial reporting than in earlier years. As a result of this legislation, the system has undergone restructuring and gradually become less unstable over time. On the other hand, 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. About 60 percent of Azerbaijan’s banks were not in compliance with minimum capital requirements in late 2000, and distorted and inaccurate financial information may also mean that most banks were not really in compliance with minimum CARs. Recognizing such weaknesses, the NBA became stricter in measuring risk-weighted capital, while also increasing the minimum regulatory capital requirement from $2 million (for existing banks) to $2.5 million in July 2002. (By 2005, this is expected to be $5 million for all banks, which is also expected to trigger some additional consolidation.) Non-performing loans, traditionally high in the 1990s, began to decline in 2000, also the result of tighter prudential requirements as well as the transfer of


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bad assets to what is today AgrarCredit.11 However, there are still numerous weaknesses concerning asset classification and valuation, as well as larger legal framework issues (see above) 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.12 In general, banks are thought to have under-provisioned due to improper asset classification or valuation, leading to higher capital calculations. 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.13 In time, it is likely that NBA will need to double compensation, and possibly replicate other parts of public administration which have experienced compression in numbers but increased pay among those retained. To be effective, this is likely to require additional computers and software training.

The off-site surveillance and on-site inspection functions are combined, rather than being separated. Each bank is visited at least once per year for an on-site inspection. Off-site surveillance relies on regular reporting based on electronic unified bank performance reports (UBPRs). While this helps with surveillance, it is also reported that input data are subject to error, and output is not effectively used as a management tool at the banks. In general, training in IAS is needed at NBA as well as in the banks.14 While off-site reports are adequate for fundamental supervisory needs, 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.

11 EBRD data (reportedly sourced from NBA) reports NPLs as ranging from 15.7 percent of total loans in 1994 to as high as 37.2 percent in 1999. IMF reports estimated NPLs at much higher levels in 1999. (See “Azerbaijan Republic: Recent Economic Developments and Selected Issues,” IMF Staff Country Report No. 00/121, September 2000.) Based on IFS data, total assets in 1999 approximated $730 million, of which loans to enterprises (state and private) equaled $485 million. Thus, 37.2 percent of $485 million in loans = $180.4 million, which approximates 24.7 percent of the total asset figure. Based on these data, NPLs approximated one quarter of total bank assets for several years. 12 This includes a minimum of 6 percent Tier I capital, and a minimum of 6 percent Tier II capital. 13 Average salaries for supervisory staff are $150-$250-equivalent per month. NBA can pay up to $1,500-equivalent per month. This compares with up to $2,500-equivalent per month in the private sector.14 A pilot project involving a cross-section of seven banks is beginning 1Q 2004. The banks involved are Atabank, Azdemiryolbank, Bank of Baku, BUS Bank, Standard Bank, Teknikabank, and Unibank.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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 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.

Key regulatory and supervisory provisions include the following:

Box 2: Regulation and Supervision Framework for Banking in AzerbaijanSupervisory Authority:

The NBA is the licensing authority for banks, as well as the supervisory authority (department of Commercial Bank Supervision). The head of banking supervision and other directors are appointed by the President from the Board of Directors of NBA, and confirmed by parliament. Removal follows the same process. As of early 2004, there were 42 professional bank supervisors. However, only about half were considered sufficiently trained and skilled to be effective in a more complex or developed banking system.

Entry: Minimum capital is $5 million-equivalent for new banks and $2.5 million for existing banks. Required information includes draft by-laws, organizational structure, financial projections for the first three years of operations, financial information on shareholders, and background and experience of the proposed bank’s managers. All applications for a license must include information on sources of capital. New legislation will now require that sources of funds used as capital are verified, and that law enforcement authorities are consulted. This will mean that new owners of banks meet “fit and proper” standards. While new legislation tightens these standards, NBA has generally frozen licensing in recent years. Only one new bank (Microfinance Bank) has been licensed in the last two to three years, and that bank has equity participation from the international donor community.15

Ownership: Legislation from 1996 required that single owners and related parties obtain NBA approval to own as much as 20 percent or more of a bank. Non-financial firms have been permitted to own banks, and non-bank financial institutions could own as much as 100 percent of a bank (with NBA approval). In general, most of the banks are small and closely linked to family and friends.16

Disclosure: Bank directors are legally liable for presenting erroneous and misleading information to the public. When this occurs, penalties are in force, and include job loss and possible criminal prosecution. Supervisors can also require changes

15 The licensing process for Microfinance Bank reportedly took 15 months, indicating that NBA was in no hurry to license new banks.16 As of July 2001, 8.8 percent of capital in the 10 largest banks was owned by conglomerates, implying that concentration of related-party ownership was kept within reasonable bounds. However, it is commonly reported that ownership records are falsified, with “fronts” and “shell companies” obfuscating the real controlling interests.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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in a bank’s organizational structure, a power that has been utilized. New legislation will also now require that external auditors report alleged misconduct to the NBA.

Off-balance sheet items are disclosed to supervisors, and new legislation and regulations will provide a framework for classification. This information, as with risk management procedures, will now be publicly disclosed. However, as all of this is new to the banks, there will be an interim adjustment period, with external auditors likely playing an important role.

There are no domestic credit rating agencies to assume rating responsibility for smaller banks. Only IBA has received a rating from an international rating agency.17

Audit: While annual external audits are compulsory for banks, audits consistent with IAS and international standards of audit (ISA) are only done for about 18 of 46 banks. Requirements on the extent of the audit exist, and auditors are required to be licensed.

The NBA receives annual external auditors’ reports on banks. NBA is also empowered to meet with the auditors to discuss the report without bank approval. As a result of these meetings, NBA can require banks to make changes to their organizations. Auditors will now be legally required to report misconduct, which will presumably provide supervisors with a better idea of the actions of bank managers and directors.

Surveillance and Oversight:

Any infractions of prudential norms detected by a supervisor must be reported, in which case mandatory actions are theoretically triggered. For instance, if regulatory capital falls below the 12 percent minimum, NBA sends out a letter prescribing options on how to become compliant. However, in practice, there is little corrective action that occurs, and it is not prompt when it does occur. New legislation and regulations will provide a framework for better defining problem banks and implementing a systematic approach to prompt corrective action.18

Off-site surveillance is ongoing and continuous, with regular CALE19 reports generated from required information submitted by the banks to NBA. Banks are inspected on site at least once a year, as mandated by law. Targeted inspections also occur as needed based on off-site findings. In addition, supervisors rely heavily on the annual bank audit reports prepared by the licensed external auditors.

Administrative and Corrective Actions:

The NBA is legally mandated to issue cease and desist orders for serious violations of laws and regulations. However, more generally, prompt corrective action is just beginning to evolve. Civil and penal sanctions on directors and managers are being developed, although it is unclear if they will be applied. In the past, NBA has removed directors and managers, but often these actions have been too late to prevent financial losses or asset stripping. NBA is legally mandated to order directors and managers of banks to constitute provisions to

17 Fitch IBCA gave IBA a Long-term B+ rating and a Short-term B rating as recently as January 16, 2003. Both are sub-investment grade, but not problematic. See www.fitchibca.com. 18 This will be based on the CAMEL (Capital, Asset quality, Management, Earnings, Liquidity) approach. The more common CAMELS (CAMEL + Sensitivity to market risk) approach will be adopted afterwards when CAMEL is better grounded at NBA. 19 CALE = Capital, Asset Quality, Liquidity and Earnings.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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cover actual and potential losses when identified. This includes the right of the supervisory agency to suspend dividend payments, although the law does not empower NBA to suspend bonuses or management fees.

NBA is empowered to declare a bank insolvent, as well as to suspend some or all ownership rights when a bank is insolvent and/or considered a problem bank. A schedule of prompt corrective action is being put in place for actions to be taken to restore solvency. These will include suspending (temporarily or permanently, and partly or fully) shareholder rights, replacing some/all management and directors, and implementing forbearance as needed with regard to prudential norms.

Capital and Capital Adequacy:

Minimum regulatory capital is $5 million-equivalent for new banks and $2.5 million for existing banks. This will become uniform $5 million for all banks by 2005. Minimum capital-to-assets on a risk-weighted basis (capital adequacy) is 12 percent, with risk weights consistent with Basle guidelines. As noted, financial information is subject to high levels of doubt and error due to the lack of experience banks have with IAS, asset classification, appropriate risk-related judgments, etc.20

Liquidity: Mandatory reserve requirements are in effect, at 10 percent of total deposits up to one year in maturity. This has been in effect since November 1999. Up to one half of mandatory reserve requirements were permitted to be invested in short-term T-bills. However, this was rescinded in 2003, and the entire requirement must now be met in the form of cash. This eliminates the partial remuneration of reserves that had basically served as a subsidy to IBA and BUS, as these were the only commercial banks active in the small and non-transparent T-bill market.21 There are guidelines from NBA on asset diversification for banks to manage liquidity.

Deposit Insurance:

There is no explicit deposit insurance protection, although implicit deposit insurance has long been thought to be in effect for state banks. Nonetheless, the public has no real confidence in the banks, irrespective of ownership, as indicated by the low levels of deposits. The government has drafted a design for deposit insurance, and this will eventually be submitted in some form to parliament at some future date. However, explicit deposit insurance is considered premature as of 2004, and will likely not be introduced until the banks and supervision at NBA are both strengthened.

Loan Quality and Provisioning for Loan Losses:

Non-performing loans are defined as non-working loans, or those that are non-accrual, and/or with interest and/or principal past due more than 90 days, and/or interest that is refinanced/capitalized/rolled over, and/or overdrafts with interest payments past due more than 90 days and principal that has no pre-defined repayment schedule. There are five categories of classification—satisfactory (performing), watch (up to 29 days in arrears), unsatisfactory (30-59 days in arrears), critical (60-89 days in arrears), and bad assets (90 days or more in arrears). Minimum provisioning requirements are: satisfactory (0 percent), watch (6 percent), unsatisfactory (25 percent), critical (50 percent), and bad assets (100 percent). Non-performance of one particular loan does not trigger a

20 As of mid-2001, CAR for the system was reported to be 17.8 percent. This included deductions for loan loss provisions, as well as unrealized securities and foreign exchange losses. However, CAR calculations did not account for overall credit and market risk, and the calculations were not considered accurate because of flawed information.21 AgrarCredit also purchased T-bills.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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reclassification of other loans for multiple-loan customers, although this may change with new prudential requirements.

Income and Expenses:

Income statement does not include accrued but unpaid principal and interest when loan is non-performing. Loan loss provisions are expensed and deductible.

Sources: NBA-IMF survey (October 2001); IMF Article IV Consultation (June 2003); discussions with NBA 2.4 Payment and Settlement System

Azerbaijan’s payment system in Azerbaijan was outdated until fairly recently, and this stunted development of the financial sector. For banks, this served as a disincentive to efficient liquidity management, while it made banks less able to efficiently render services to clients. For capital markets, it meant limited liquidity and turnover, and low levels of capitalization. In the enterprises sector, it indirectly contributed to the build-up of arrears and slowed restructuring. Such 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.

To remedy the problem, 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. AZIPS—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. A small value payment system has been put in place. Eventually, once it is more widely used, it will help to reduce the cost of financial services, increase the service offerings (and profits) of the banks, facilitate automatic payments to/from utilities and the tax authorities, and bring a significant portion of the “unbanked” into the system. Given the predominance of small businesses combined with low incomes outside the oil and gas sector, development of a small value payment system is more of a challenge. This is largely due to the size of the informal sector and widespread use of cash for small transactions. Initiatives to improve incentives in the system will change these habits over time. However, for the time being, most people and businesses will stay outside the formal system. In the enterprise sector, there has been a low level of investment in telecommunications, systems and related company infrastructure that would make these enterprises run more efficiently. Part of this is related to the build-up of arrears in many inefficient, uncompetitive, unrestructured or non-viable enterprises that has led to reduced use of the electronic payment system for payables. Weak telecommunications infrastructure in Azerbaijan, above all outside of Baku, has slowed development of the small value payment system. However, with changes in process, many of these weaknesses are expected to be reversed with time. This should make the economy more competitive, and make it possible for some of the non-energy


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private sector to benefit from increased banking sector efficiency via the improved payment system. However, before any of this occurs, public confidence and cash balances will need to be restored.

According to the central bank’s web site, there are 44 credit organizations that participate in the AZIPS system. This includes most of the banks. Banks that are excluded from this list participate in the system through the NBA Service bureau, which was established to attend to such problems while the banks qualify to become members of the system.

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 75,000 million (or about $15,000). With a total value of Manat 28,870 billion ($5.94 billion-equivalent), the average payment value approximated $13.6 million. This is reasonably large, and appears to apply to Production Sharing Agreement (PSA)-related outflows in the oil and gas sector and/or purchases of equipment, technologies and services. In 2003, the figures showed an increase in usage, including for small value payments. As of December 1, 2003, 614 payments had run through the system for a value of Manat 34,978 billion. On an annualized basis, this would approximate $8 billion-equivalent). With an annualized total of about payments, the average was $11.6 million. Interestingly, small value payments accounted for nearly half of total transactions,22 suggesting that retailers are now beginning the use the payment system.

2.5 Accounting and Transparency

Accounting standards in Azerbaijan are based on the Law on Accounting, as well as provisions in the Civil Code. As elsewhere in the CIS (and transition countries in general prior to conversion to IAS), local accounting standards have been tax-oriented. Some basic differences between local and international standards, as well as exceptions to these found in the banking sector, include23:

Policies do not require as much information disclosure (e.g., footnote disclosures) as required by IAS (or generally accepted accounting principles, or GAAP)

Asset valuations are based on differing standards than “mark-to-market” standards; new banking legislation requires IAS, so this will change in the banking system

Allowances for asset impairment are not permitted against the carrying value of the asset; this differs in the banking system, as loan loss provisions and reserves for loan losses are intended to reflect asset impairment

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. New

22 Of the 614 payments made for 11 months (as of December 1, 2003), 297 were small value payments averaging Manat 4.13 billion, or about $839,800 on average. 23 General differences are based on “Business Guide to Azerbaijan”, Ernst & Young, 2003. Exceptions to these as they apply to the banking sector are from the author.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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.

An additional benefit to the banks has been the migration of some of the supervisors at NBA to the commercial banking system, where they receive higher compensation. As in other markets, many banks have found it beneficial to hire away supervisors to assist with their own internal organization, operations, financial management and reporting. This has helped banks to comply with prudential requirements, contributing to better loan classification, improved provisioning practices, and more adequate capital, although it also detracts from NBA’s own supervisory capacity.

The Law requires that banks be audited by a licensed external auditor. Over the last few years, the “Big 4” accounting firms have audited the top 15 or so banks.24 There are no provisions that restrict the number of years in which an audit firm can carry out the external audit. However, NBA just recently announced that it was awarding its annual audit to Deloitte Touche after using Price Waterhouse Coopers the prior three years. This may set a precedent for banks to change auditors every three years, although nothing formal has been adopted requiring such a policy. Annual reports are reviewed by the NBA. It is expected that these will be made public, although banks have not been required to make earlier annual reports available to the public.

Meanwhile, 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. Meanwhile, 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.

24 In general, the audits have been carried out by Price Waterhouse Coopers (PWC). For the financial year 2002 (audits conducted in 2003), 18 banks were audited by international firms. Of these, PWC audited 10, Deloitte & Touche audited four, KPMG audited three, and Ernst & Young audited only one.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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2.6 Rating Agencies/Systems

The NBA maintains a basic credit information registry, although it is not considered particularly useful. 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.

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.

2.7 Financial Media

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.

The NBA and most banks have web sites where additional information is made available. However, 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.

2.8 Professional Associations

The Association of Banks of Azerbaijan (ABA) is organized to represent the banks in Azerbaijan. These interests are not always consistent with the interests of IBA, or for that matter BUS, the two state banks. When privatized, it is possible that the association will play more of a role in legislation, regulation, training, and general outreach to bankers, enterprises and households. In some countries, bankers’ associations have also jointly financed (as equity investors) products that have helped to enlarge the role of banking in the economy. In other cases, they have played a role in coordinating banks’ involvement in clearing houses. It remains to be seen if the ABA will play any of these roles, or do so effectively. On a positive note, the ABA was consulted on issues related to recently adopted and submitted banking legislation.

The Chamber of Auditors is set up to oversee and develop the domestic accounting and audit profession. As elsewhere in the CIS, its role has been relatively modest in efforts to move the system increasingly to IAS and ISA.

2.9 Academic Institutions and Human Capital Formation

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


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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.

There is a bank training institute (Azerbaijan Bank Training Center, or ABTC) that has provided significant training to banks, as well as provided some needed consulting services. Established in 2000, ABTC has had nearly 4,000-equivalent bankers attend courses in a variety of topics touching on banking fundamentals. This has been supported by a variety of donors, although some costs are defrayed by those attending courses. In addition, ABTC has helped several banks with strategic planning, budgeting and marketing on a consulting basis, which has also generated revenue. The center appears well managed, and able to work with NBA, ABA, donors and others with needed training in the banking sector.

2.10 Miscellaneous

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, given the links to SWIFT and the capacity to confirm payment and settlement within 60 seconds for international transactions. 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.25 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). Improvements in the payment system should improve the financial performance of enterprises and utilities by reducing the number of days required to collect on receivables, thereby helping with cash management and investment planning in critical sectors. However, as noted above, 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.

25 See “Country Assistance Strategy”, IBRD, April 29, 2003. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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.


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ANNEX 3: ECONOMIC AND STRUCTURAL FACTORS

3.1 General Overview and Condition

3.1.1 Macroeconomic Summary

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. The following table shows the steady and increasing discipline of macroeconomic policy management in recent years, and consequent high levels of real GDP growth.

Table 1: Macroeconomic Indicators (1998-2003)($ in millions) 1998 1999 2000 2001 2002 2003GDP $4,446 $4,581 $5,273 $5,708 $6,124 $7,124Real GDP Growth 10.0% 7.4% 11.1% 9.9% 10.6% 9.2%CPI Rate -0.8% -8.5% 1.8% 1.5% 2.8% 3.6%Manat to $1 (Average) 3,869 4,120 4,474 4,657 4,834 4,908Fiscal Deficit/GDP -3.9% -4.7% -0.6% 0.9% -0.5% -1.9%Merchandise Exports $678 $1,025 $1,799 $2,046 $2,305 $2,685Foreign Direct Investment $1,024 $550 $149 $299 $1,048 $2,074Notes: 2003 figures for real GDP growth, fiscal deficits, merchandise exports and FDI are preliminary results or projections; 1998-99 GDP figures from local currency data divided by average exchange rates with US dollar; 2003 GDP and CPI are as reported by NBASources: IMF, National Bank of Azerbaijan, World Bank, author’s calculations

3.1.2 Financial Sector Developments

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 in a relatively small country with a population of less than 8 million and per capita incomes of about $3,500 on a purchasing power parity basis.26 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. The average for the system is only $3.3

26 Purchasing power parity income figures were $3,100 per capita in 2001.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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million. Netting out IBA, the average is $2.6 million, barely above the required $2.5 million for existing banks (and below the $5 million minimum required for new banks). As recently as 2000, about 40 of the country’s then 70 banks had problems complying with (then) minimum $2 million capital requirements,27 and only a handful exceeded $5 million. Since then, a net 24 banks have been closed or merged. However, as of late 2003, total capital in the banking system was only about $151 million, equivalent to an average of only $3.3 million.

Banks are faced with a number of problems. Unrestructured state and former state enterprises have long been a major problem, and this has reduced lending opportunities in light of tightening prudential requirements imposed on banks. In 1999, about three quarters of loans were outstanding to the state sector, yet 62 percent of loans were non-performing.28 This triggered a bank rehabilitation plan that included the transfer of bad assets from troubled state banks to the Ministry of Finance, the consolidation of the industrial, agricultural and savings banks, development of a bank rehabilitation plan, and bad asset recovery efforts initiated in 2000-01.29 Nonetheless, apart from the small fraction of loans kept on the books of the successor bank (now BUS Bank), the underlying assets remained non-performing, and recovery efforts (through AgrarCredit) have yielded only modest amounts in proceeds relative to earlier loan amounts outstanding.30 As of end 2003, overdue loans approximated 10 percent of loans and about 6.4 percent of total bank assets. However, using another measure, special and general reserves for loan losses approximated 20 percent. These ratios remain high, although they are lower than in the late 1990s.

As elsewhere, such patterns particularly hurt state banks or “pocket banks”, as their earlier decision-making was based more on political patronage or other non-commercial criteria.31

However, the broader impact of high levels of NPLs was to bring down earnings overall, and to drive up intermediation spreads/costs. These problems persist to this day, although net intermediation spreads have come down from a nominal 11.25 percent in 2001 to

27 See “Economic Trends: Azerbaijan”, EU-TACIS, July-September 2000.28 Figures cited from “Azerbaijan Republic: Recent Economic Developments and Selected Issues,” IMF Staff Country Report No. 00/121, September 2000. However, with the transfer of bad assets from troubled state banks to the Ministry of Finance, it is possible that these figures declined. For instance, figures derived from NBA never exceeded 24.6 percent, which was less than half the IMF figure that was derived from deposit-taking banks’ financial statements and the Azerbaijani authorities. In either case, the NPL ratios were very high and costly to banking sector development. This has since led to a strengthening of supervisory capacity and tougher regulations, as well as bank capacity to monitor for risk. 29 In early 2000, Azerbaijan’s three remaining state banks were consolidated into United Universal Bank (known as BUS Bank) after bad assets were transferred to the Ministry of Finance (via Agroprom, leading to the establishment of AgrarCredit), and rehabilitation programs came to closure.30 About Manat 3 billion (about $650,000) were recovered in 2001. See “Banking and Business”, 2002. Discussions with BUS Bank indicate that about 20 percent of the loans they kept on the books following the earlier bank failures were ultimately not recovered. This resulted in provisions and write-downs on the BUS Bank balance sheet of about Manat 2 billion in loans in 2002. See “Auditors’ Report and Financial Statements at 31 December 2002” for BUS Bank. 31 Changes since then in provisioning standards and requirements have brought home the problem associated with NPLs. A stricter approach to loan classification since 1999-2000 had a particularly strong effect on the financial condition of two large state banks (formerly Prominvestbank and Agroprombank, which merged with Savings Bank to form the new United Universal Bank), and also hurt the earnings of smaller banks.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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about 8.37 percent at the end of 2003.32 (In real terms, these net spreads were 9.75 percent and about 8.07 percent, respectively.) The extent to which the spreads are perceived to be high relates to high nominal rates charged to SMEs, the weakness of collateral and contract enforcement in secured transactions, generally low volume of business (driving up per loan operating costs), and still high levels of NPLs (albeit far lower than a few years ago). In terms of rates charged to SMEs, they are reported to be higher than rates received by larger firms. 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 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. Since then, per capita incomes have risen to about $871, while the funding base has broadened considerably as a result of expansion of the oil and gas sector. As such, the funding base has increased, with banks’ deposits now about twice levels in 1998-99 and three times levels in 1995-96. However, the overall level of funding is still low in the aggregate, as a percentage of GDP, and on a per capita basis.

Macroeconomic policies have led to price and exchange rate stability in recent years. In fact, inflation rates were negative in 1998-99, and had not exceeded 2.8 percent since then until 2003, when CPI was reported to be 3.6 percent due to rising food prices in the last four months of the year. However, the method of control enforced by the NBA has tied up liquidity and reduced investor interest in the securities markets (T-bills). The benefit to the approach has been to squeeze out hyperinflation, maintain a relatively stable exchange rate, and reduce country risk to soft currencies (e.g., Russian ruble). However, as for the banks, the impact has been felt in terms of tight liquidity. This was particularly difficult for banks when non-performing loans were high, as these reduced the overall earning asset portion of their balance sheets. More recently, earning assets are still relatively small in value, although overdue loans have been reduced.

Tight liquidity in the late 1990s reflected a run-up of inter-enterprise arrears, with particular problems in the state enterprise sector. This is where about 75 percent of banks’ loan exposure was until 2000, significantly reducing their stock of earning assets and reducing return measures to low levels. Such problems in the state enterprise sector served as a catalyst for high intermediation spreads (e.g., around 10 percent), as banks sought to generate earnings from performing loans to make up for problems associated with non-performing assets. Since then, banks’ exposure has been primarily to the private sector.

32 This is a blended rate based on weighted average of nominal rates on local and foreign currency loans and deposits.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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However, most private businesses are small in size, with limited assets to collateralize for secured loans. This makes banks wary of lending, or lending sufficient amounts for long enough periods to meet SME needs for investment and growth, particularly as collateral enforcement is difficult even when the enterprises have the assets to pledge. Meanwhile, collection rates in key state-owned utilities sectors still remain inadequate, suggesting that collections and arrears remain problematic.

Outside the banking sector, there is virtually no capital markets activity. Larger enterprises are able to borrow from abroad. In some cases, this is because the prudential norms limiting the size of individual loans to 25 percent of capital have meant that loans are not large enough for enterprise investment needs. However, most enterprises are small and cannot borrow. The result is that lending to the enterprise and household sectors as a whole by banks in Azerbaijan only approximated $678 million in 2003, or 9.5 percent of GDP. About 80 percent of most enterprises’ financing (working capital and investment) comes from internal sources and retained earnings, and another 5 percent or so comes from family, friends or other private sources. There is very limited credit from banks, suppliers, or other sources. About 40 percent of sales transactions are reportedly prepaid.

The following table illustrates some fundamental measures of financial sector depth. From the trends, it shows that Azerbaijan’s economy and banking system have strengthened since 1998 due to the large influx of foreign currency deposits. However, intermediation rates are low at 14.5 percent of GDP. As an example, and by contrast, only a few transition countries (e.g., Georgia, Uzbekistan, and possibly Serbia and Montenegro and Tajikistan) have broad money-to-GDP figures lower than those in Azerbaijan (see Table 10 in Annex. 4).

Table 2: Monetary Indicators (1998-2003)1998 1999 2000 2001 2002 2003

Broad Money (M3) in billions of Manats 1,886 2,050 2,606 3,434 3,926 5,094 o/w currency outside banks 926 1,136 1,350 1,469 1,669 2,041 o/w domestic currency deposits 465 329 278 286 358 551 o/w foreign currency deposits 494 585 978 1,679 1,900 2,052Broad Money (M3) in $ millions $484 $468 $571 $719 $802 $1,035Total GDP (billions of local currency) 17,203 18,875 23,591 26,578 29,602 35,053Broad Money/GDP (%) 11.0% 10.9% 11.0% 12.9% 13.3% 14.5%Sources: IMF, National Bank of Azerbaijan, author’s calculations

3.1.3 Incomes, Poverty and Development

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. Average real growth from 1998-2002 was been 9.8 percent, and 9.2 percent was projected for 2003.33

This has translated into a sizeable percentage increase in per capita incomes, rising from about $400 in 1995-96 to $871 in 2003 and at least $917 in 2004.34 While impressive in

33 It is likely that real GDP growth was higher than 9.2 percent despite higher inflation.34 For 2003-04 figures, see “GDP Per Capita Makes Up $917.1”, Trend – Daily News, December 15, 2003. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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terms of growth, Azerbaijan still remains far behind most countries in terms of per capita GDP. For instance, even its projected figure for 2004 is higher only than Armenia, Georgia, Kyrgyz Republic, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan when compared with 2002 data from the other transition economies. Meanwhile, 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.35 The latter group is frequently found in provincial towns, and often consists of the nearly 1 million or so refugees or internally displaced persons following the conflict in Nagorno-Karabakh from a few years ago.36 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.37 This conflict also interfered with traditional trade patterns and transport routes, and has led to fairly substantial regional variation in incomes.

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—about four times GDP per capita figures at $3,500—the economic base is still small and largely informal.38 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. Notwithstanding some favorable trends in recent years, basic financial indicators show relatively limited financial sector development, particularly in terms of funding net of what has been received from the oil and gas sector. As such, poverty remains widespread, and the economy remains heavily dependent on hydrocarbon exploitation and exports. These, and some of the reasons for this situation, are discussed below.

3.2 Economic Structure

3.2.1 Sector Distribution of the Economy

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. Azerbaijan signed Production Sharing Agreements (PSAs) with major oil companies in the 1990s, and this has led to a substantial amount of growth and investment. Development of two major fields, one in oil and the other in gas, accompanied

35 See “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.36 According to the World Bank (2001 figures), 56 percent of urban residents were living in poverty, as compared with 42.5 percent in the rural areas. However, rural areas have less access to social services for those who are poverty stricken.37 These are 2001 figures from “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.38 The World Bank estimates informal activity at about 61 percent of GDP. (See “Doing business in 2004”, World Bank.) However, other sources have put informal activity at 3-4 times official GDP. There are more than 20 million ethnic Azeris living in Iran and other neighboring countries, 2.5 times the population proper of Azerbaijan. However, as with other informal estimates, these figures relative to GDP are difficult to verify or validate.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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by two major pipelines39 scheduled for completion in 2005 will transport oil and gas through Georgia to Turkey for onward sale to the international market. This has led to a corresponding increase in the share of industry, with a proportional decline in importance of agriculture and services. The following table shows shares of GDP in dollars by sector, as well as general sector distribution.

Table 3: Economic Structure (1998-2003)(millions of US$) 1998 1999 2000 2001 2002 2003Agriculture $777.3 $785.8 $835.7 $842.1 $858.3 $1,011.7Industry $951.2 $1,216.9 $1,890.6 $2,135.2 $2,111.6 $2,305.5 Oil and Gas $0.0 $866.5 $1,599.5 $1,816.8 $1,788.8 $1,906.3 Manufacturing/Processing $0.0 $188.2 $127.3 $234.7 $242.4 n/a Electricity/Gas/Water $0.0 $158.5 $161.4 $82.6 $78.4 n/aConstruction $560.3 $469.0 $342.7 $331.9 $651.6 $702.0Transportation/Communications $405.2 $461.9 $631.2 $575.5 $593.9 $805.2Trade $254.1 $305.2 $350.5 $419.9 $481.6 $461.1Social Services $1,084.7 $902.6 $875.5 $924.7 $890.0 $1,596.6Taxes/Subsidies $413.5 $440.0 $349.0 $478.4 $502.9 n/aTOTAL $4,446.4 $4,581.3 $5,275.3 $5,707.6 $6,089.9 $6,882.0As percent of GDP:Agriculture 17.5% 17.2% 15.8% 14.8% 14.1% 14.7%Industry 21.4% 26.6% 35.8% 37.4% 34.7% 33.5% Oil and Gas 0.0% 18.9% 30.3% 31.8% 29.4% 27.7% Manufacturing/Processing 0.0% 4.1% 2.4% 4.1% 4.0% n/a Electricity/Gas/Water 0.0% 3.5% 3.1% 1.4% 1.3% n/aConstruction 12.6% 10.2% 6.5% 5.8% 10.7% 10.2%Transportation/Communications 9.1% 10.1% 12.0% 10.1% 9.8% 11.7%Trade 5.7% 6.7% 6.6% 7.4% 7.9% 6.7%Social Services 24.4% 19.7% 16.6% 16.2% 14.6% 23.2%Taxes/Subsidies 9.3% 9.6% 6.6% 8.4% 8.3% n/aTOTAL 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Notes: dollar figures derived from GDP figures in local currency and distribution by sector from local currency figures (1998-2002), and derived from MED sectoral figures for 2003 Sources: IMF, Ministry of Economic Development, author’s calculations

Net of oil and gas, the major sectors in Azerbaijan are social services, agriculture and construction. In services, the transportation and communications sector is relatively sizeable, followed by retail trade. Financial services are estimated to contribute only a small fraction to GDP, as reflected in the very low levels of penetration (e.g., bank assets-to-GDP) and intermediation (e.g., M3-to-GDP). Nearly all financial services are from banking.

39 These are the Shah-Deniz gas field, Azeri-Chirag-Guneshli oil field, Baku-Tbilisi-Ceyhan pipeline, and a gas pipeline from Baku to Turkey.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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3.2.2 Employment and Productivity

In terms of official employment, 3.7 million people have been employed fairly consistently since 1998, with slight variations year on year. These figures account for almost the entire labor force in Azerbaijan, with official unemployment rates little more than 1 percent of the labor force. A mere 51,000 were registered as unemployed in 2002 in a labor force of nearly 3.8 million. This may suggest a high level of underemployment and delayed restructuring in the enterprise sector, with some large state enterprises still holding on to employees. In fact, part of the assistance provided by donors to the government is to help with labor market reform, including development of a strategy to offset the impact of layoffs in companies that have not yet sufficiently restructured to compete without major payables arrears and subsidies. In the latter case, subsidies on goods and services have declined significantly since 2000, indicating that some financial discipline is being required of state enterprises and recently privatized enterprises. However, there is still room for containment, and the government’s objective is to further reduce subsidies in the energy and water sectors by 35 percent between 2002 and 2005 (see 3.3.3 below). Meanwhile, several state and ex-state (privatized) enterprises still have excessive head count, and they are expected to shed many of their employees as restructuring programs are implemented. In addition to improved employment services and better targeting of unemployment-related benefits and assistance, the government appears to be looking at the SME sector as the engine for future employment (as is true in most economies), with a target of a 10 percent increase in the number of jobs in the SME sector by 2005 (roughly estimated at 250,000-300,000 new jobs). This will help over time with productivity, and will give more meaning to the employment statistics that are published.

Based on existing employment data, agriculture and services are the main sectors of employment, accounting for 2.7 million people, or 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. This is only about 7 percent of employment. As for trends, a significant number of people (re-)entered the agricultural markets after 1998, while there has been a decline in many of the services. Government employment has increased, and industrial employment has remained fairly constant.

Accounting for these trends and shifts in GDP structure, overall productivity has increased significantly in industry and non-Government services. Outside of oil and gas, there is not reported to be major progress. For instance, there has been little development of agro-processing and other manufacturing industries. In services, per capita output has likely increased in construction and transport, largely due to investment in these sectors as they have related to oil and gas sector development. The following table highlights employment, productivity and labor force trends.


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Table 4: Employment, Productivity and Labor Force Trends (1998-2002)1998 1999 2000 2001 2002

Total Employed by Sector (thousands):Agriculture 1,140 1,566 1,517 1,482 1,495Industry 251 259 250 247 252Government 656 728 745 682 759Other Services 1,655 1,154 1,193 1,304 1,221TOTAL EMPLOYED 3,702 3,707 3,705 3,715 3,727Proportional Share of Employment by Sector:Agriculture 30.8% 42.2% 40.9% 39.9% 40.1%Industry 6.8% 7.0% 6.7% 6.6% 6.8%Government 17.7% 19.6% 20.1% 18.4% 20.4%Other Services 44.7% 31.1% 32.2% 35.1% 32.8%TOTAL EMPLOYED 100.0% 100.0% 100.0% 100.0% 100.0%GDP per Employee per Sector:Agriculture $681.8 $501.8 $550.9 $568.2 $574.1Industry $3,789.7 $4,698.4 $7,562.5 $8,644.5 $8,379.4Government $1,653.5 $1,239.8 $1,175.2 $1,355.9 $1,172.6Other Services $737.0 $1,071.1 $1,110.2 $1,017.9 $1,414.6WEIGHTED AVERAGE $1,201.1 $1,235.9 $1,423.8 $1,536.4 $1,634.0General Demographic and Labor Figures (thousands):Total Population 7,949 8,016 8,081 8,141 8,203Working Age Population 4,513 4,615 4,730 4,858 4,895Total Labor Force 3,744 3,748 3,748 3,763 3,778Registered Unemployed 42 41 43 48 51Unemployment Rate 1.1% 1.1% 1.1% 1.3% 1.3%Pensioners 1,177 1,202 1,219 1,245 1,276Notes: In GDP per Employee per Sector, taxes are not included as part of Government employees’ output measureSources: IMF, author’s calculations

One additional point regarding the labor force is the number of pensioners. As of 2002, there were nearly 1.3 million of them. This approximates 15.5 percent of the total population, and points to the need to consider pension reform for future generations. While pension costs have generally ranged from 3-4 percent of GDP since 1998, which is not high, the actual amount of benefit paid to the average pensioner is relatively low. Unlike many other countries in the CIS and transition Europe, Azerbaijan has experienced slight population growth (rather than declines), and many people outside the official labor force subsist on agriculture, small trade and light services. This provides a bit of a social safety net. However, with per capita incomes still relatively low and life expectancy (at birth in 1999) of 71.5 years,40 such reforms should be contemplated early to allow for planning and capital build-up. This is included as part of the State Program on Poverty Reduction and Economic Development (SPPRED).

40 More recent figures indicate life expectancy has declined to 65 years. See “Transition report 2003”, EBRD.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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3.3 Private Sector Development

3.3.1 General Strategy for Private Sector Development

The Government has adopted a poverty reduction strategy known as the State Program on Poverty Reduction and Economic Development (SPPRED) that encompasses several areas of relevance to private sector development. These primarily include the establishment of an environment that will be conducive to economic growth and income generation, maintaining a stable macroeconomic environment, and strengthening economic infrastructure (e.g., roads, utilities). Additional features of the SPPRED include a commitment to strengthen quality of and access to social infrastructure (e.g., health, education), better design and implementation of social protection, and assistance to refugees and internally displaced persons (IDPs). Many of the targets are ambitious, particularly in areas where institutional development will require significant investment, technical assistance, and experience. For instance, implementation of legal reform requires an effective judiciary, and this does not occur within a short time frame. Reducing corruption in the public sector and establishing a fair, efficient and honest tax system takes time. Corporate governance is relatively new to Azerbaijan, and having the people, systems, information and oversight capacity in place is a long-term endeavor. Thus, accomplishing stated objectives is feasible, but only on the condition that there are improvements in the business environment, that a more competitive market opens up, that vested interests are less able to influence government decisions, and that public confidence is restored so that the economy is increasingly and steadily monetized through formal channels.

3.3.2 Constraints to Private Sector Development

As for the three primary areas related to private sector development, 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. While the government has initiated macroeconomic reform and, to a lesser extent, structural reforms for several years, 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. In response, the government has streamlined licensing and permit procedures since 2003 to make it easier for small businesses to get started. However, 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 interests and institutional constraints remain in place.

Traditionally, the government has received moderate scores in terms of government intervention in the economy and wage-setting, but poor scores for protecting property rights, corruption, and incidence of black market transactions.41 High levels of corruption

41 As an example, see “2003 Index of Economic Freedom”, Heritage Foundation, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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have slowed permit and licensing processes, added to their costs, and had a negative impact on FDI outside the oil and gas sector. Azerbaijan has frequently been cited by groups evaluating such issues as a major offender.42 In response, the government submitted anti-corruption legislation to parliament in 2003 which was subsequently adopted. However, even if adequate legislation is adopted (as has often been the case), the ability to implement has been called into question. Such weaknesses have led to estimates of informal sector activity being more than 61 percent of total gross national income. Disinvestment has also resulted partly from these problems.43 Aware of these problems, the government is in the process of adopting reforms to make it easier for SMEs to develop. However, it remains to be seen if there will also be concerted efforts to promote an environment that is more conducive to open competition.

Until now, bureaucratic intrusions have made it difficult for many companies to operate. This is reflected in the limited FDI in the non-oil and gas sector of the economy. Even with such investments, FDI was only $6.3 billion from 1997-2003, or $113 per capita per year. Outside the oil and gas sectors (and including investment in the BTC pipeline44), the ratio is close to zero. For example, figures for 2002 indicate that foreign investment outside of these areas was only $45.6 million, or less than $6 per capita.45 (The figures increased in 2003 to about $100 million.) When investments from foreign sources have been made outside the energy and pipeline areas, they have been mainly in beverages, cement and construction, mobile telephony, hotels and banking.

All of this has been reflected in the cost of doing business being substantial for domestic entities.46 Procedures for establishing businesses are reported to take 106 days, and the average cost of registration is nearly 17 percent of per capita incomes, high enough to be prohibitive for most households. Contract enforcement is cumbersome and subject to the corruption of the courts, adding to both time and money costs. Insolvency proceedings likewise require significant time, reportedly two to three years, and are also vulnerable to judicial corruption. As such, the courts are rarely used for insolvency and debt restructuring. There is little if any use of alternative dispute resolution or out-of-court

42 In 2003, Transparency International ranked Azerbaijan 125th in the world (along with Angola, Cameroon, Georgia, and Tajikistan), and ahead of only Myanmar, Paraguay, Haiti, Nigeria and Bangladesh among 133 countries in terms of corruption. Finland, Iceland, Denmark and New Zealand were #1-4. (See 2003 Corruption Perceptions Index, www.transparency.org ). This has been a reputational problem for years in Azerbaijan. Of 99 countries ranked by perceptions of corruption in 1999, Azerbaijan ranked 96th (along with Indonesia). By contrast, Denmark and Finland were first and second, while Nigeria and Cameroon were 98th and 99th, respectively. This put Azerbaijan close to the bottom among the countries surveyed. See Transition, October 1999. 43 For instance, HSBC, the world’s second largest bank (by assets), withdrew from the market due to its inability to generate sufficient earnings to justify its presence. This was largely due to weaknesses in the business environment and the bank’s unwillingness to assume credit risk due to problems associated with a weak legal and business environment. 44 According to figures reported by the State Statistics Committee, investment in the BTC pipeline is recorded as part of transportation/telecommunications, and not as part of the energy sector figures. See “Investment Climate Statement—2003”, US Department of Commerce. 45 Figures published by the IMF put preliminary estimates for other net direct investment for 2002 at $64 million. (See “Azerbaijan Republic: Article IV Consultation”, IMF, June 2003.) This would still only be about $8 per capita, and likely includes some domestic investment. 46 See “Doing business in 2004”, World Bank, 2004.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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mechanisms, although recent efforts appear to be making inroads towards more effective use of arbitration within Azerbaijan. Nonetheless, effective policy reform will take time. As a result of these constraints, the formal economy is small, and the informal sector is estimated to account for at least 61 percent of GDP. However, the government also recognizes that the economy suffers from underemployment, and that an easing of these costs and burdens is needed to increase employment in the private sector and, by extension, expand the fiscal base to diversify the economy and reduce its dependence on oil and gas.

While foreign investment does not need any specific government approvals and the licensing regime has been streamlined, Azerbaijan still has barriers to investment as well as some protection in trade. This has mainly involved non-tariff barriers related to the political influence of sector-specific monopolies. As with domestic firms, the government recognizes it needs to streamline the business environment to encourage non-oil FDI. By 2005, it is seeking to increase non-oil FDI investment by 15 percent from 2003 levels, which would be only about $15 million. However, given projected overall declines in FDI after 2004,47 attracting investment in non-oil segments of the economy will be important. Accomplishing this is feasible, but only on the condition that the business environment improves. To achieve this, the government plans to expand SME access to new technologies, encourage regional development and partnerships, set up incubators and industrial parks, and encourage greater investment and private sector involvement in agriculture, agro-processing and related rural sub-sectors. Accelerated privatization will help. However, in the end, economic diversification and growth will depend on an improved environment for investment and business development.

Many of the existing problems are a throwback to earlier state-driven structures that resulted in inefficient production methods, excessive head count (and low productivity), outmoded technologies, an absence of innovation, monopolistic production and distribution systems, controlled prices, the widespread use of barter, the build-up of substantial arrears, limited financial discipline and management capacity, and a general lack of interest in consumer markets. For instance, in 1992 as Azerbaijan was emerging from Soviet control, services accounted for only 29 percent of GDP.48 At the time, private sector share of the economy was estimated to be 10 percent.49 As elsewhere in the former Soviet Union (and many non-Soviet countries), there was a systemic bias in favor of state farms and heavy industry, with little attention to consumer goods and services. Combined with hyperinflation, the break-up of traditional trade ties, and the conflict in Nagorno-Karabakh, it took several years for Azerbaijan to initiate reforms that would make the environment more conducive to private sector development.

Despite recent progress, much of the reason for the low level of monetization in the economy is because of the sluggish pace of structural reform to date. This is true in banking and finance, enterprises and the judiciary. Thus, there is still substantial structural reform required for Azerbaijan to achieve its objectives of private sector growth and 47 For instance, the IMF projects net FDI to be $1.591 billion in 2005 (see “Azerbaijan Republic: Article IV Consultation”, IMF, June 2003), $483 million less than 2003 figures. 48 See “World Development Report 1994”, World Bank.49 See “Transition report 1999”, EBRD.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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diversification, reduced poverty, and sustainable development. Corruption is still perceived to be widespread, notwithstanding improvements in recent years.50 However, undoing corruption requires a major transformation and professionalization of capacity in the government and judiciary, as well as strengthening standards of management and governance in the private sector. In general, governance remains weak, although there have been improvements in some of the banks and several state enterprises. Governance at SOFAR also stresses transparency, accountability, and professional management standards. However, governance and management in the former state enterprise sector is reported to be weak.

3.3.3 Infrastructure

In the field of infrastructure development, although improvements have been made since 2000, the utility sector continues to be burdened by inefficient performance and unsustainable losses. The energy sector was reported to benefit from fiscal and quasi-fiscal subsidies of 22 percent of GDP in 2000, resulting from arrears on payments, under-priced tariffs that do not recover costs or reflect full economic costs, cross-subsidization from one sector to another, and operating losses that were covered by other sources.51 These figures have come down to 11 percent of GDP (2002), and possibly further (in 2003).This is a long standing problem that reached unsustainable proportions in 1999 and was largely responsible for the failure of the three state banks that are now being restructured as BUS Bank.52

The government’s objective is to further reduce subsidies in the energy and water sectors by 35 percent between 2002 and 2005. Methods to be used include increased collections and prices, particularly among major suppliers whose collection rates have been at or below half the value of supplies/services rendered.53 Transfers from the state to end users are not being utilized, nor are schemes to reduce liabilities to the state. Thus, the measures taken are intended to reinforce financial discipline and cost recovery, with state budget-funded institutions intended to be fully current on utility payments by 2003. However, initial assessments are that collections by the electricity and gas companies were poor, at about 50 percent. To the extent that direct subsidies have been introduced, these have been 50 As an example, recent reports suggest bribery has declined as a share of company revenues (from 3.7 percent in 1999 to 2.7 percent in 2002), and the incidence of frequent bribe payments has been cut in half (from 60 percent of firms in 1999 to 28 percent in 2002). See “Transition report 2002”, EBRD. 51 See “Azerbaijan Republic: Article IV Consultation”, IMF, June 2003, and “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.52 Arrears built up in the utilities sector, namely water, oil and electricity sectors, and were equivalent to nearly 50 percent of 1999 GDP on a cumulative basis, or nearly $2 billion. Since then, there has been some tightening, although progress has still been slow in collections. Nonetheless, there are now fewer opportunities to negotiate arrears, and the only alternative is for these companies to toughen collection practices and/or raise tariffs. 53 As an example, the collection rate for Azerigaz for gas supplies was only 5 percent from SOCAR and 15 percent from Azerenergy in 2002. While SOCAR paid arrears in 2001, in general, collection rates from these two sources have generally been low. Collection rates were 51 percent in 2002, as compared with 28-41 percent from 1998-2001. More recent figures indicate the collection rates at Azerigaz have increased to 53.4 percent in 2003. As another example, Azerenergy collection rates for electricity supplies have ranged from 16-35 percent from 1998-2002. More recent figures suggest that collections have vastly improved to 55 percent in 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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intended to assist the most vulnerable segments of the population as tariffs increase and stricter collection practices are enforced.

Future initiatives to correct these weaknesses will also include private sector participation in power generation and distribution. As of 2005, the government plans to have a legal and regulatory framework in place so that its major utility companies—SOCAR, Azerigaz and Azerenerji—can utilize private sector companies for transmission and distribution of electricity, home heating and gas. Professional management contracts have already been signed with four private companies (two domestic, and two Turkish) to manage electrical distribution. Private sector enterprises are also expected to play a growing role in water and sewage treatment via concessions and management contracts. Water and sewerage is of questionable quality, with water shortages common and public perceptions of drinking water as unsafe.

Transport infrastructure is also not as developed as needed, rural roads are in poor condition, and the areas around Nagorno-Karabakh (East-West Highway) need rehabilitation. Azerbaijan’s mountainous terrain adds to the challenge. Meanwhile, there are no privatization plans for port facilities. With regard to aviation, the government is reported to favor the private provision of various services, although physical airport facilities would remain state-owned.

3.3.4 Planned Government Reforms and Prospects for Private Sector Development

Looking ahead, the government is aware of changes that are needed to improve the business and investment climate. Some changes have already been made, and more reform is expected to provide a conducive environment for investment and growth. Key targets include (i) a general increase of 7.5 percent of the share of the private sector in the economy; (ii) growth in the non-oil sector of 5-7 percent per year in the coming years, and a reduction in the tax burden of non-oil sector firms; (iii) a 15 percent increase in FDI in the non-oil sector; (iv) a 10 percent increase in the number of jobs in the SME sector; (v) a 10 percent increase in the value of SME exports; and (vi) a 20 percent increase in the value of rural SME production.54 To achieve these and other objectives, priority reforms are expected to be:

Improving the business environment, including licensing and registration procedures, land acquisition and site development procedures

Developing the legal framework and judicial capacity to enforce contracts, resolve disputes, and respect property rights

Strengthening public administration and governance Increasing access to finance and business services for SMEs and rural enterprises Reforming utilities via better regulation, tariffs that achieve cost recovery and

more, collection rates that reflect efficiency, and visible increases in service quality and access based on increasing private sector participation

Restructuring SOCAR, Azerenerji and Azerigaz, including design of a legal and regulatory framework to promote private sector participation in the utility sector

54 See “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Strengthening financial discipline in state enterprises Introducing trade market reform, namely export-friendly tariffs, membership in the

WTO, increasing access to the EU and other regional markets, streamlining administrative procedures, and strengthening customs capacity

Designing and introducing pension reform Introducing labor market reform Improving transport infrastructure

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 2008.55 Thus, the landscape for private sector growth and development is significantly different from what it was in the early and mid-1990s. Moreover, there is clear strategic recognition that this sector has to grow and diversify for economic development to be sustainable. With oil revenues expected to decline after 2011 and then decline considerably from 2018 on (barring any new major discoveries of oil and gas reserves),56 Azerbaijan’s long-term economic growth prospects are dependent on a vibrant private sector emerging. Key reforms that have occurred in recent years include the establishment of the State Oil Fund (SOFAR) to finance economic development in a coordinated and transparent manner,57 better governance and management in the banking sector, reduced public sector subsidization for enterprises,58 modernization of the tax code, and new accounting and audit standards.

3.3.5 State Enterprises

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. While the banks are less directly exposed to state enterprises (possibly apart from IBA, which accounts for about 52 percent of total loans), there is a risk that off-balance sheet risks could emerge through the use of guarantees and derivatives. Beyond that, the use of the State Oil Fund for development purposes is critical 55 See “Private Sector’s Share of Azeri GDP to Grow”, Novecon Press Digest, December 18, 2003. 56 Production is expected to peak at 65 million tons in 2011, and then fall to about half that level in 2018 and one quarter 2011 levels in 2024. See “Country Assistance Strategy for Azerbaijan Republic”, IBRD, April 29, 2003.57 The institutional framework for SOFAR includes structures to support transparency and accountability, explicit rules and standards of supervision and control, and investment policy guidelines that are prudent and conservative. 58 As a share of GDP (at market prices), subsidies for goods and services have declined from 2.7 percent in 1998 to 0.3 percent in 2002. Since 2000, such subsidies have been inconsequential to the economy. See “Selected Issues and Statistical Appendix”, IMF, April 29, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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to the long-term growth and structural diversification of the economy. This is particularly important on a medium- and long-term basis, as much of the initial revenue generated in the first decade (through about 2010) will be transferred abroad in the form of capital repatriation, profits and dividends. Keeping the management of this Fund on a technocratic basis will be necessary to contain the opportunity costs and economic losses that have resulted from more patronage-oriented systems elsewhere.

3.4 Money, Savings and Credit

3.4.1 Macroeconomic and Monetary Policy

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.

Monetary policy has been based on relatively low growth in money supply since 1999 after a decline in 1998. Money supply growth is projected to approximate 15-16 percent from 2002-06.59 The policy has also included a measured increase in broad money to GDP, ranging from 11-13 percent from 1997-2002. This increased slightly in 2003 to 13.6 percent, and is projected to increase again to about 14 percent from 2004-06. The policy to date has resulted in modest inflation rates (changes in CPI), ranging from negative rates in 1998-99 to no more than 3.7 percent in all other years since 1997.60 The unweighted average from 1997-2003 was a mere 0.7 percent, although the fluctuations over the six-year period reflect some volatility, particularly with the 3.6 percent figure in 2003.61 A 2.5 percent rate is projected for 2004-06.62

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. Particularly given the serious challenges of the early 1990s which culminated in hyperinflation, a breakdown in traditional production and distribution relationships, and the tragic conflict with Armenia in Nagorno-Karabakh, resisting such political pressures has been a challenge. At a minimum, 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

59 Growth of M2 was 14.8 percent in 2002, and was estimated to be 15.1 percent in 2003. Projections for 2004-06 are 13.8 percent, 16.4 percent and 15.3 percent, respectively. See “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.60 The peak was 3.7 percent in 1997, followed by 3.3 percent in 2002. Rates were negative 8.5 percent in 1999, and negative 0.8 percent in 1998. Rates were 2.2 percent and 1.3 percent, respectively in 2000 and 2001. Preliminary estimates for 2003 were 2.2 percent.61 The State Committee for Statistics preliminarily estimated average CPI at 2.2 percent for 2003.62 See “Azerbaijan Republic: Article IV Consultation” IMF, 2003, and “Country Assistance Strategy for Azerbaijan”, IBRD, April 29, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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.

3.4.2 Savings

While there has been fluctuation, the general movement towards stability has helped to increase monetary savings in the economy. Gross national savings were projected to be 25.6 percent of GDP, which would approximate $1,824 million in 2003. This compares with 20.2 percent of GDP in 2002, or $1,237 million. Thus, national savings appear to have increased substantially in 2003 by about $587 million, or a 47 percent increase. These figures compare with 17.1 percent of GDP in 2000, or $902 million. Thus, national savings have doubled between 2000 and 2003 as a result of investment into the hydrocarbon sector.

3.4.3 Credit

Meanwhile, as savings have increased, credit has also increased. Monetary survey data indicate that domestic credit (prior to other items, net) was Manat 3,382 billion in 2003, or about $687 million. Most of this was provided by banks to the real sector, whereas claims on government were only about 10 percent of total. The aggregate figures compare favorably with 2002 figures, when domestic credit approximated $537 million, of which $436 million went to the real sector of the economy. This represents a 41 percent year-on-year increase in credit to the real sector. This trend has been ongoing, as indicated by 2000 figures: $375 million in domestic credit, of which $356 million went to the real sector. Thus, 2003 figures indicate credit to the enterprise and household sectors of the economy had access to about $257 million-equivalent more in domestic credit than in 2000, a 72 percent increase. While these figures are small, they at least indicate the trend is positive.

3.4.4 Financial Intermediation Costs

The costs of intermediation are still considered high by the real sector, while banks consider their opportunities for profitability fairly limited. In particular, SMEs have traditionally complained of the high cost of bank credit resulting from high rates, high levels of collateral required, and insufficient amounts for long-term investment purposes.63

However, the averages below suggest that the rates charged by banks are not excessive. On the other hand, as these rates are averages, it is very likely that SMEs are unable to afford the higher rates charged by banks, whereas some of the larger companies may be able to obtain better terms by virtue of their asset size and access to loans or guarantees from abroad. In general, banks find that existing spreads barely cover deposits and operating costs. In the past, the high level of NPLs and reserve requirements weakened margins and substantially reduced earnings from what was already a limited asset base. The transfer of bad loans from what is now BUS Bank reduced the stock of NPLs of the banks in 1999. Reserves for loan losses are now about 20 percent of total loans, and

63 See “Azerbaijan: World Bank Considers Connection Between Banks and SME Progress in the Format of FSAP”, AzerPress News, December 4, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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overdue loans are currently about 10 percent. Reserve requirements have also come down steadily, from 15 percent in 1995-97 to 12 percent from 1997-99 to 10 percent since late 1999. However, earnings opportunities still remain limited. There is only a small securities market, reducing a relatively safe source of earnings. Weak liquidity management systems and earlier inefficiencies in the payment system cut into bank profitability, although these have improved in recent years (albeit without many opportunities in the domestic market apart from lending). Given the limited earning/investment opportunities and relatively narrow nominal net spreads between loans and deposits, banks still find it difficult to generate the kinds of profits needed to boost capital and become competitive.

Table 5: Nominal and Real Interest Rates (1999-2003)1999 2000 2001 2002 2003

Money and Quasi-Money/GDP 10.86% 11.05% 12.92% 13.26% 14.53%Treasury Bill Rate 18.31% 16.73% 16.51% 14.12% <8.00%Nominal Bank Rates: o/w deposits 12.08% 12.90% 8.46% 8.66% 8.89% o/w lending 19.48% 19.66% 19.71% 17.37% 17.26%Net Spreads on Nominal Bank Rates 7.40% 6.76% 11.25% 8.71% 8.37%Net Spreads less Inflation Rates 15.90% 4.96% 9.75% 5.91% 4.77%Notes: deposit and loan rates in 2003 are averages in foreign currency and manats at about a 2:1 ratio as of December 1; inflation rate in 2003 assumed to be 3.6 percent (figures from NBA)Sources: IMF, NBA, author’s calculations

3.5 Fiscal Policy

3.5.1 Fiscal Policy

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 hyperinflationary period along with structural dislocation, war and refugees/IDPs, this is no small matter. Nonetheless, the Government has demonstrated major seriousness in stabilizing the macroeconomic framework, as reflected in the low inflation rates since 1997,64 modest fiscal imbalances (or periodic surpluses) since 1995, and relative exchange rate stability since the mid-1990s.

Recent reforms have included adoption (May 2003) of a new budget systems law to integrate the state and oil fund budgets into one consolidated budget, allowing for better management of oil proceeds to meet overall budgetary requirements without experiencing destabilizing fluctuations. Another recent policy reform has been unification of the enterprise profit tax at 25 percent, and a reduction in the number of VAT exemptions. Both measures are intended to improve tax administration, broaden the fiscal base, increase revenue flow, and ease the average burden on households and enterprises.

64 Even at 19.8 percent in 1996, CPI was not severely destabilizing (unlike the period before 1996 when hyperinflation was present). However, single-digit or negative inflation rates did not occur until 1997.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Looking ahead to 2004, the government is expected to incur a slightly higher deficit than its 1.9 percent (of GDP) in 2003.65 This is due to the need for increased expenditure for infrastructure investment as well as social spending.

3.5.2 Revenues

Revenue sources are primarily from taxes, although about one quarter is derived from non-tax revenue sources, mainly SOFAR revenues. In 2002, tax revenues were 56 percent of total revenues (excluding grants, which were small). Meanwhile, SOFAR and other non-tax revenues contributed 18 percent. The balance was accounted for by an extraordinary tax credit for SOCAR energy subsidies, a line item not found in earlier years but to be permitted in 2003 and beyond.66 Thus, apart from the tax credit, tax revenues generally account for about three quarters of total fiscal revenues. Of these, VAT is the largest source of revenue, followed by income taxes on companies and individuals, social security contributions, excise taxes, and taxes on international trade.

Specific tax rates67 have come down to provide incentives for enterprises to comply with tax payment obligations, as well as to invest. For instance, profit taxes have come down to 25 percent from 27 percent. VAT remains 18 percent, which is more generous than many other transition economies where the VAT rate tends to be at least 20 percent. However, recent changes have included a reduction in many exemptions, including on such key imported items as electronics, computers and components, mining equipment, chemical products, aluminum goods, and forage for stock and poultry.68 Other tax rates include:

Simplified turnover tax (as substitute for VAT, profit, property and land taxes): 4 percent of gross turnover in Baku; 2 percent of gross turnover outside Baku; 10 percent of gross turnover for transportation

Payroll tax: 28.5 percent (down from 30.5 percent) Personal tax rates: 0-35 percent Property taxes: 0.01 percent of building value Royalty taxes: 26 percent on crude oil value; 20 percent on mineral gas; 3-10

percent on other minerals Export tax (SOCAR only): 20 percent of revenue markup (export value minus

export costs) compared with wholesale domestic prices

As for the specific role of SOFAR, it is being managed as a vehicle for macroeconomic stability to smooth out public expenditure needs (e.g., investment, social support) without

65 See “IMF Completes Third Review Under Poverty Reduction and Growth Facility Arrangement with the Azerbaijan Republic”, IMF Press Release, December 19, 2003.66 Since 2002, SOCAR has been granted a tax credit for fuel delivered to electricity and gas companies at domestic prices. These credits are allocated on a quarterly and disclosed publicly. See “Azerbaijan Republic: Article IV Consultation”, IMF, June, 2003.67 Information source: “Azerbaijan Republic: Selected Issues and Statistical Appendix”, IMF, April 29, 2003. 68 Twenty-one groups of imported goods have been included in the VAT system, with collection up front and paid to the customs authority. (See “Taxing the added values”, CBN Extra, January 14, 2004).MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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creating monetary instability. The non-oil deficit was projected to increase modestly, from an estimated 9.1 percent of GDP in 2002 to 10.2 percent of GDP in 2003. This was considered well below the sustainable level. The consolidated fiscal deficit, including quasi-fiscal energy sector revenues and expenditures, was projected to increase from 0.5 percent of GDP in 2002 to 1.9 percent of GDP in 2003. Thus, SOFAR is used partly to smooth out the impact of these imbalances.

There is an institutional framework in place that permits professional portfolio managers to be contracted out for the management of SOFAR resources. Investment portfolio guidelines include currency composition, proportion of liquid assets (up to 40 percent) and long-term investments (at least 60 percent), and the mix of debt and equity instruments. In the case of equities, these are handled by professional managers. Preference is reported to be in fixed income securities which are less risky, and more predictable for planning purposes.69

3.5.3 Expenditure

On the expenditure side, about 80 percent is current expenditure, and 20 percent investment expenditure. However, given the issue of the one-time SOCAR tax credit, the ratio apart from this would be about 75 percent current and 25 percent investment. Among current expenditures, the largest share is for social protection, goods and services, and wages and salaries. Subsidies are minor, although energy-related subsidies increased in 2003 after declines in 2001-02. Extra-budgetary figures have declined since 1999. Azerbaijan’s prudent fiscal and debt management policies have kept interest expense low. As a result, there is very little funding of government operations by the banking sector.

The government has recently implemented changes in state procurement that have signaled reform in the way government business is conducted. The State Procurement Law is being implemented reasonably well (according to recent procurement audits), and is designed to enhance the competitive environment. This has been accompanied by new management in tax administration, elimination of the earlier practice of negotiating tax liabilities, increased transparency, and measures to provide equal treatment on bids and offers. In addition, state sector entities are not formally required to purchase exclusively from state firms. This should also provide a stimulus for competition, including in the oil and gas sector where significant metallurgy, construction, and related services are required.

3.5.4 Institutional Capacity

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. These include:

69 This is a conservative strategy as returns are less than what is potentially achievable in portfolios more heavily weighted in favor of equities. However, they are safer and more predictable investments.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Improved revenue administration, including establishment of a large tax payer unit, consolidation of tax offices, introduction of bonded warehouses and customs brokers, and automation of some customs functions and procedures

Budget preparation, consolidation and management, including integration of extra-budgetary funds into the state budget

Sound management and transparency of the State Oil Fund, including quarterly publication of statements and annual audits according to international standards

Elimination of opportunities for state enterprises to negotiate arrears General strengthening of public procurement and audit Enhanced capacity to monitor poverty and to target appropriate assistance

3.5.5 Government Financing and the Banking System

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. The following table shows that the role of banks in financing government has been minimal.

Table 6: Commercial Bank Financing of Government Expenditure 1998 1999 2000 2001 2002 2003

Total GDP (billions of manats) 17,203 18,875 23,591 26,578 29,602 35,053Bank Financing of Gov't (billions of manats) -5 37 210 167 164 68Bank Financing of Government/GDP (%) 0.0% 0.2% 0.9% 0.6% 0.6% 0.2%Notes: bank financing = net claims on governmentSources: IMF; NBA; author’s calculations


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3.6 Exchange Rates

3.6.1 General Policy

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.

3.6.2 The Role of Oil Proceeds and Exchange Rate Stability

One of the key issues for exchange rate stability is management of oil proceeds. While the balance of the decade will see oil revenues effectively exported in the form of capital repatriation and profits to foreign investors, there should be sizeable revenues in the subsequent decade (notwithstanding declining output after 2011). Managing these resources will be critical for monetary, fiscal and exchange rate stability. The Oil Fund is currently holding accumulated savings in foreign assets abroad. This will help to preserve a stable exchange rate by maintaining substantial reserves abroad. For instance, gross reserves were about $650 million as of April 2003,70 yet State Oil Fund reserves were $810 million in July 2003.71 As the economy diversifies, maintaining such reserves should help to prevent a radical appreciation of the exchange rate that would jeopardize long-term prospects for international (export) competitiveness. As Azerbaijan develops its non-oil sector, its enterprises will need to rely on international transactions for sustained development. Thus, protecting the exchange rate from “excessive” appreciation will help provide some of the underlying stability needed for enterprises to be able to export. By operating the Oil Fund as a bit of a stabilization fund, this provides policy makers with an opportunity for sustained growth under stable conditions. Given the lessons from many other oil-rich countries in recent decades, this approach is prudent and sound by comparison.

3.7 Balance of Payments

3.7.1 General Trends

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.

70 The IMF projected gross official reserves to be $735 million at year-end 2003, equivalent to 3.7 months’ of non-oil imports. See “Azerbaijan Republic: Article IV Consultation”, IMF, June, 2003.71 For mid-year figure, see “Investment Climate Statement—2003”, US Department of Commerce. However, year-end 2003 projections were $748 million, roughly the same as projected gross official reserves. (See “Azerbaijan Republic: Article IV Consultation”, IMF, June, 2003.)MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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. The main challenge will be transforming the opportunities presented by the next 10-15 years of oil and gas development into broader possibilities in other economic sectors.

3.7.2 Current Account Developments

Current account deficits have been volatile in Azerbaijan due to the rising activity of the oil and gas sector. The range has been as low as 0.9 percent in 2001, to as high as 13 percent of GDP in 2000. In aggregate dollars, they have fluctuated, from a low of $50 million in 2001 to as high as $1.37 billion in 1998. Most recently, the deficit has increased substantially as payments have been made for oil rigs, drilling equipment and services, insurance, and related goods and services in the oil and gas sector. The current account deficit was estimated to be about $2 billion in 2003, and is projected to peak at $2.5 billion in 2004 and then decline considerably as the up-front investment costs of oil and gas exploitation give way to export earnings. If current projections hold, the current account deficit will be about 7.7 percent in 2006. While high, the subsequent trend away from high deficits combined with growing GDP will bring the ratios down further to more manageable proportions. Meanwhile, the State Oil Fund is used as a reserve to cushion the impact on the economy that would otherwise occur from current account deficits of the very high 35 percent figure projected for 2004. In general, current account deficits totaled $3.9 billion from 1997-2002, averaging 13 percent of GDP. From 2003-06, this is projected to increase substantially to $7 billion, or 22 percent on average.72 However, as profits and dividends are repatriated according to the terms of the PSAs, the balance of oil and gas exports will be retained in Azerbaijan, and the current account deficits and associated ratios will diminish substantially.

Merchandise exports have increased, mainly in the oil and gas sector. Total exports have ranged from $1 billion in 1998 to an estimated $3.1 billion in 2003. Of the 2003 figure, merchandise exports accounted for about 87 percent ($2.685 billion), of which nearly $2.4 billion was projected to be in oil and gas. These numbers are expected to continue to grow substantially in the coming years (net of 2004), as shown in Table 7 below. However, the projected growth in exports also shows continued and more intensive dependence of growth on the merchandise export sector, most specifically in oil and gas. Services and non-hydrocarbon exports are not expected to play much of a role in Azerbaijan’s international trade for some time. Current projections show these at $807 million in 2005, or 25 percent of goods and service exports, roughly the same proportion as the last few years.73

As merchandise exports have been rising and will continue to rise, merchandise imports have followed a somewhat different path. Merchandise imports fluctuated in the late

72 As of September 30, 2003, the current account deficit was $1.3 billion (see NBA Bülleten, November 2003). Annualized, this would approximate 25 percent of 2003 GDP.73 See “Azerbaijan Republic: Article IV Consultation”, IMF, June, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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1990s and into 2000-01, ranging from $1.9 billion (1999) to $2.4 billion (1998), with a fairly consistent pattern in all years from 1997-2001 except 1998. From 1998-2003, merchandise imports have accounted for about 68 percent of total imports,74 indicating that services have been a major import item. This has essentially consisted of transport, engineering, insurance, and related oil and gas services needed for resource development, as well as profit repatriation and dividends. Noteworthy in this is the limited role of the domestic financial sector in providing trade finance, insurance and other kinds of financial services. The relatively stable import figures increased dramatically in 2002 to $3.1 billion, and then $4.7 billion in 2003. These figures are expected to peak in 2004 at $5.0 billion, and then drop to $4.6 billion in 2005. In both years, non-merchandise imports (services) are expected to account for about one third of total imports.

Other current account items that are formally recorded by the authorities are fairly minor. Net current transfers have been and are projected to be a small portion of the current account, at $77 million in 2003, mostly public sector. This figure is likely understated, as remittances from Azeris abroad are thought to enter the country through informal channels. Neither customs authorities nor the banking system capture much of this in their data. The presence of Western Union and improvements in the payment system may provide better statistics in the future to assess the magnitude of remittances. However, even if the number of bank accounts increases in the next few years, evidence elsewhere suggests that most remittances are used as income supplements and will not stay in the banking system as long as poverty is widespread.

3.7.3 Investment and Debt

Investment has fluctuated since the late 1990s, following a concave pattern from 1997-2004 (assuming projections are accurate). As of 2002, cumulative private FDI from 1997-2002 approximated $4.16 billion, most of it for the energy sector. The early years (1997-98) were peak years, leading to dramatic declines for three years and then followed by increases in 2001-02. Estimates and projections show that FDI should approximate $6.9 billion from 2003-06, or 22 percent of GDP, roughly equivalent to projected current account deficits during the period.

Total debt outstanding (TDO) is relatively low. As of end 2003, TDO was estimated to be about 20 percent of GDP and 50 percent of exports. Total debt service was less than 6 percent of exports of goods and services in 2003, and had been less than 5 percent from 2000-02. These are all manageable ratios, and reflect prudent debt management strategies. Moreover, total debt and debt service ratios are projected to decline in 2004-05 when the major oil and gas projects are built and cash flow from sales increases.75 To date, the relatively low debt profile is due to a cautious approach to borrowing, plus the benefit of macroeconomic stability, which is both cause and consequence of manageable debt levels. However, for the next few years, total debt outstanding will rise, as this is the main source of financing for the four major projects under way—the Azeri-Chirag-Guneshli oil field, 74 See “Azerbaijan Republic: Article IV Consultation”, IMF, June, 2003, and “Azerbaijan Republic: Selected Issues and Statistical Appendix”, IMF, April 29, 2003.75 TDO/GDP and debt service/exports will decline from 2004. TDO/exports will decline starting in 2005. See “Country Assistance Strategy for Azerbaijan Republic”, IBRD, April 29, 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Shah Deniz gas field, Baku-Tblisi-Ceyhan oil pipeline, and Baku-Turkey gas pipeline. These four projects are estimated to cost $13 billion, equivalent to about 40 percent of 2003-06 GDP. This is roughly consistent with the government’s projected limit on foreign debt (as a share of GDP) from 2005 on. Reserves have generally been stable, with some fluctuation over the years, but most years characterized by fairly minor declines. From 1997-2002, reserves declined about $67 million per year. This is about the same level projected for 2003-06, with estimates in 2003 a bit less at $55 million.

Table 7: Debt and Investment Trends: 2001-2006($ figures in millions) 2000 2001 2002 2003 2004 2005 2006Total Debt Outstanding $1,170 $1,269 $1,384 $1,452 $1,541 $1,641 $1,737TDO/GDP 19.7% 20.5% 20.7% 20.1% 19.8% 19.0% 17.4%Total Debt Service $114 $118 $173 $141 $121 $103 $110TDS/Total Exports 4.2% 4.9% 4.4% 5.6% 5.0% 3.7% 2.4%Net Direct Investment $149 $299 $1,048 $2,074 $2,306 $1,591 $965 o/w Oil Companies $14 $197 $984 $1,974 $2,201 $1,470 n/a o/w Other $135 $102 $64 $100 $105 $121 n/aGross Official Reserves $718 $725 $721 $735 $788 $832 $849Gross Official Reserves in non-oil months’ imports

5.0 4.5 4.0 3.7 3.7 3.8 3.8

State Oil Fund Assets $245 $493 $693 $748 $875 $1,087 n/aNotes: Total exports include goods, services and workers’ remittances; Oil companies figures are net contracted investment plus bonuses less capital repatriation; 2000 reserve and Oil Fund assets derived from figures indicating changes from prior year; 2000 GOR to non-oil imports includes servicesSources: IMF; World Bank; author’s calculations


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ANNEX 4: BANKING STRUCTURE AND FINANCIAL SYSTEM PROFILE

4.1 General Overview

4.1.1 General Profile of the Banking System

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 banking system balance sheet values and about half of its earnings. The three largest banks—IBA, Bank Standard76

and BUS Bank—account for about two thirds of assets. The other 43 banks individually account for 2 percent or less of assets. Total assets among the 43 small banks are estimated to be no more than $25 million, with most of them having less than $5 million. In general, apart from IBA, the banks are small, often closely linked to families and friends, and/or centered on transactions in Baku. Only 18 of the 46 banks present their financial statements according to international standards. 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.

Some of this is changing, as payment system modernization has ushered in opportunities for plastic card use and other electronic services. Likewise, the tightening of prudential requirements has encouraged banks to begin to develop better risk management systems. However, given the limited amount of activity, there is little capacity in the system should there be an economic downturn. Likewise, 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. General reports indicate that 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.

76 Bank Standard recently changed its name. It was earlier named Most-Bank. Some bankers in Azerbaijan have claimed that Bank Standard’s assets are artificially inflated and that it is not as large as implied by the figures. However, based on the figures available in late 2003, it was the second largest bank in Azerbaijan based on assets. This should not be confused with being a large bank, as it is very small by international standards.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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The banking system has a total of about $1.1 billion in assets, equivalent to a low penetration ratio of about 14.9 percent of GDP (2003 figures). Of these assets, about $681 million is in the form of loans, 64 percent of total. On the funding side, deposits were about $621 million at end 2003, about 58 percent of assets. Capital was $151 million for a straight capital-to-assets ratio of about 14.2 percent.77

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

However, because of the high level of concentration, averages per bank apart from IBA, Bank Standard and BUS are much smaller. In fact, apart from IBA, none of the banks has any real size. The following table highlights the distribution of balance sheet values in the Azerbaijan banking system as of December 1, 2003:

Table 8: Balance Sheet Data for Banks in Azerbaijan (December 1, 2003)IBA Standard BUS Other 43 Banks

($ millions) $ % $ % $ % $ %Assets $515 53.0% $75 7.7% $40 4.1% $342 35.2%Loans $287 51.6% $30 5.4% $12 0.2% $238 42.8%Deposits $361 63.2% $28 4.9% $29 5.0% $154 26.7%Capital $24 16.9% $3 1.9% $7 4.7% $109 76.5%Notes: figures are from December 1, 2003; percentages are relative to total of that category (e.g., IBA’s loans were 51.6 percent of total loans to customers and banks) Sources: NBA; author’s calculations

Simply netting out IBA from the above figures (but including Standard, BUS and the other 43 banks), the banks would have had the following averages78:

Assets: $10 million Loans (to Customers and Banks): $6 million Deposits: $5 million Capital: $2.6 million

Thus, 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 is true on a regulatory capital basis as well.79 Even netting out regulatory and risk-related issues, Azerbaijan’s banks are generally small. This means there is very little potential for systemic risk, as the failure of any one or several banks would have little impact on

77 Regulatory capital is lower than this figure.78 This is based on December 1 figures. Distribution figures are not applied to year-end figures. 79 The regulatory capital figure is what is most important in this case, as it is $2.5 million in minimum regulatory capital that is required. There is reported to be little difference for the banking system between average capital and average regulatory capital figures, although there may be differences bank by bank.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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.

4.1.2 Summary of Banking Stability Indicators

Capital adequacy is required to be at least 12 percent in total. According to NBA, a minimum of 6 percent Tier I capital must be must available, and at least 6 percent of Tier II capital must also be available. As of 2001, the system’s CAR was reported to be nearly 18 percent, and more recent calculations put this at about 19 percent. However, until recently, such calculations have been based on dubious assumptions and unconsolidated (and incomplete) information. As such, they are not considered accurate. More recently, efforts have been made to begin to account for affiliates and subsidiaries (previously undisclosed or unaccounted for), as well as off-balance sheet items that represent contingent liabilities that need to be accounted for to arrive at more accurate capital adequacy ratios. Generally, NBA believes that several banks’ CARs are not compliant with the minimum 12 percent requirement due to weak financial information and systems, and general lack of experience in properly assessing risk based on market standards. Recently adopted legislation will require banks to be more accurate with their asset classifications, including for off-balance sheet items like guarantees. As has happened in other banking systems, this may lead to changes in balance sheet values, reported income, and general financial ratios.

In general, asset quality has improved since 1999 when non-performing loans were at least 37 percent of total loans. At the time, this was equivalent to about $200 million, or three quarters of banking system net capital. Overdue loans were 10.1 percent of total loans at year-end 2003, or about $68.5 million. However, while the proportion of overdue loans is lower than in 1999, the amount is still about 45 percent of bank capital.80 Special and general reserves for loan losses were about 20 percent of total loans in December 2003.

The negative side to these figures is that the low value of assets in the system reflects a general lack of risk taking. Banks are now providing loans to households and enterprises at about 9.5 percent of GDP, reflecting a limited contribution to economic growth. This is largely due to the small resource base available to the banks, particularly as individual loans are not permitted to exceed 25 percent of capital. Another major contributing factor is the poor legal/judicial framework that limits creditor rights in the courts, and the difficulty in enforcing collateral claims in the event of loan default. Under such circumstances, banks are generally going through a phase in which they also need to comply with stricter enforcement of prudential regulations. This appears to be the case in Azerbaijan, particularly as NBA is focusing on stricter adherence to capital adequacy than in the late 1990s (notwithstanding accounting and financial information deficiencies). As such, it is easy for banks to maintain asset quality. However, such an approach also results in little growth throughout the economy, which is true for Azerbaijan apart from the oil and gas sector. It also results in low levels of earnings, as the banks’ non-lending services are limited. This is reinforced by the strict level of fiscal discipline applied by the government, a positive factor for macroeconomic stability, but a negative factor in terms

80 Overdue loans are about half of regulatory capital. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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of development of a government securities market that would provide more earnings opportunities for banks. Preliminary estimates of earnings for the banking system indicate how small the earnings base is. Unaudited and preliminary 2003 earnings figures (after taxes and minority interests) for IBA were Manat 41 billion, or about $8.5 million. BUS estimated after-tax earnings at Manat 900 million, or less than $200,000. Separate sources reported net income for the banking system to approximate $25 million in total. Should such estimates be accurate, this would translate into the following for 2003:

Average earnings: about $550,000 RoAA81: 2.69 percent RoAE82: 17.87 percent

Thus, return ratios are reasonable by many measures,83 yet aggregate and average figures are exceedingly small.

Liquidity is stable on a regulatory basis, although the system as a whole is poorly funded. Banks are required to comply with 10 percent reserve requirements on all deposits of less than one-year term, including foreign currency deposits. The banks’ loan-to-deposit ratio was about 1.1:1 at the end of 2003. Key liquidity measures indicate that net liquid assets (net position in domestic inter-bank market, net position overseas, net position with NBA plus vault cash) are more than adequate for withdrawals, and securities provide additional cushion in the event of banks facing major deposit withdrawals. However, given that most people and enterprises bypass the banks in the first place, this is not considered to be much of an issue.

4.1.3 Human Capital

In terms of human capital, the banks are able to attract professionals for needed services. This includes former employees of the NBA, which is positive in terms of helping the banks comply with the prudential framework. In terms of compensation, banking and insurance are better paid than other sectors, possibly apart from oil and gas. Monthly wages in banking and insurance were 1,019,767 in 2002 ($210-equivalent), about 2.5 times per capita incomes on an annualized basis. These figures are about twice those in industry, and nearly four times those in government administration.

81 Average assets based on 2002 year-end asset figures from International Financial Statistics (IMF) and December 1, 2003 (NBA) figures.82 Average equity based on 2002 year-end capital figures from International Financial Statistics (IMF) and December 1, 2003 (NBA) figures.83 For instance, ROA and ROE figures were 1.3 percent 14.5 percent, respectively in the United States (2002); and 0.3 percent and 8.2 percent, respectively, in the Euro zone (2002). See “Global Financial Stability Report”, IMF, September 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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4.2 Ownership Structure and Consolidation

4.2.1 Overview

There were 53 banks as of 2001 and as many as 210 as of 1994. Thus, Azerbaijan has consolidated its banking system considerably since 1994, and particularly since 1999. Many of the banks that failed did so as a result of insider/connected lending and the inability of these banks to comply with prudential requirements.84 The only reason why most of the remaining banks have not merged or disappeared is because of the low $2.5 million minimum capital requirement to maintain a bank license. With this level slated to increase to $5 million, several additional banks are projected to merge or close by 2005. As elsewhere in the CIS, most of the small banks have traditionally operated as treasury departments for their shareholders (who are often family or close friends). Most failed as new regulations were introduced, and about half85 were unable to comply with prudential regulations as recently as 2000.

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. While CIS countries have lagged their non-CIS counterparts in foreign ownership of banks and other financial services, 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. This is beginning to happen with some banks, with the offer of internet banking, plastic cards, ATMs, and other modern services. However, much of this is restricted to Baku, and general levels of intermediation remain low. Thus, 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.

Meanwhile, increased competition may also 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 such 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-

84 Most were established by state enterprises, and have since disappeared as NBA/GoA has refused to bail them out.85 See “Azerbaijan Republic: Recent Economic Developments and Selected Issues,” IMF Staff Country Report No. 00/121, September 2000.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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.

As noted, there are currently plans to privatize the two state banks—IBA and BUS. This effort is supposed to be initiated in 2004, although the actual divestitures may not occur until 2005. At a minimum, one of the key objectives is that majority state ownership in the banking system will no longer exist. Meanwhile, recent changes in the law make the environment more conducive to foreign investment in the sector. However, IBA remains 51 percent state-owned, and BUS is wholly state owned. Thus, the banking system remains majority state-owned, a rarity by global standards in 2004.

There are plans to increase the presence of banks and other financial service providers in underserved areas outside of Baku. This target includes increasing the number of branches and other access points from about 75-100 in 2003 to about 500-600 by 2005-06. The large increase includes the possible use of the postal network as a distribution point for financial services. Other non-bank credit organizations may also be a part of this arrangement, including microfinance institutions and credit unions that could potentially provide basic safekeeping and lending facilities to farmers and those engaged in support activities in the rural economy (e.g., input distribution, commercial drying, storage, output marketing). However, this presents an issue of regulation and supervision, as NBA does not want to run the risk of such non-banks being misused in a manner that could undermine public confidence. This is reported to be a problem with credit unions in Azerbaijan, as it was with many banks in the 1990s. Confidence is already low, and any licensed financial institution that mismanages household deposits would send a negative signal that could reinforce the low confidence levels that currently prevail. Particularly as the government is contemplating the introduction of an explicit deposit insurance scheme at some point in the coming years, such non-banks will have to be regulated or self-regulated in a manner that does not detract from confidence-building measures in the banking system. For the moment, non-bank credit organizations have limited licenses and are not permitted to mobilize deposits.

4.2.2 Restructuring and Privatization Trends

The banking system has largely been dominated by the International Bank of Azerbaijan (IBA), which is the only domestic bank that provides meaningful corporate banking services. IBA is 49 percent privately owned, with the major shareholder of the bank being the government (51 percent). EBRD is currently negotiating the purchase of a 20 percent stake in the bank. IBA benefited from a $44 million government recapitalization in 1995, and has since been the major bank in Azerbaijan. To date, preparation for bank privatization has been slower than originally envisioned.86 However, the recent agreement between the government and IMF assigns a target of 2004 for privatization. IBA had assets of about $515 million in late 2003, or about 53 percent of the total system. (Audited figures from June 30, 2003 show total assets at Manat 2.4 billion, or about $492 million.) 86 As of early 2001, IBA was expected to offer a 20 percent stake to another IFI serving as “strategic investor”, a 25 percent stake sold through a public offering, with a 5 percent stake to be retained by government. The other 49 percent was already privately owned by individual shareholders and employees. Thus, plans in 2001 would have left IBA 95 percent private had they materialized.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Net of most balance sheet values (as shown above in Table 8), IBA also claims to be the market leader in plastic cards, commercial property, internet services (business networking) and insurance (as measured by capital). Other banks have attested to this as well, criticizing the market leadership as a function of monopoly and government preference. Once IBA is privatized, the banking system will be majority private. It will then remain to be seen if its comparative market predominance continues.

The other state bank is BUS. In the 1990s, three other state banks—Agroprombank, Prominvestbank, and Savings Bank—were prominent. All three were remnants of the earlier Soviet system, playing specialized financing roles in the agricultural and agro-processing, industrial, and household spheres. However, Agroprombank and Prominvestbank failed due to the high levels of non-performing loans in their portfolios, rendering them insolvent. While Savings Bank was not insolvent, its funding base was viewed as important for subsequent commercial viability of a restructured domestic bank that could compete with IBA and other banks. However, as a traditional savings bank, it did not have the asset management capacity and experience to operate as a diversified commercial bank on its own. Thus, with the failure of Agroprom and Prominvest, the government merged the bad assets of the two insolvent banks into Agroprom, set up AgrarCredit (loan collection agency), transferred the banks’ bad assets (with an estimated nominal value of about $200 million) to the AgrarCredit, revoked Agroprom’s bank license, initiated a restructuring plan to turn the residual assets in the combined BUS (all three banks) into a commercially viable institution, and then recapitalized the new bank with Manat 22 billion, or about $5 million. The rehabilitation program for the three state banks involved loan recovery efforts, branch closures, personnel retrenchment, and reduced overheads and operating expenses.87 In addition, the government provided guarantees on some of the directed loans that had been extended by the banks, helping to restructure their balance sheets. As of end 2003, BUS had about 4-5 percent market share in assets, deposits and capital (see Table 8). However, its position in the loan market is virtually nil as it has not been permitted to lend since it was established. Loans carried forward have either been collected or reserved, and less than $1 million in loans have been on the books since 2002.

Meanwhile, private banks are slowly becoming more prominent on a balance sheet basis. In terms of total assets, private banks accounted for about 45 percent of total in 2003. This is in contrast to about 20 percent in 1997.88 There are now 17 banks with foreign participation, of which only four are majority foreign-owned. Among the foreign banks, there are no major banks. HSBC, the world’s second largest bank based on assets, operated in Azerbaijan until 2002. However, it left partly due to its inability to implement its business plan and to generate adequate earnings. UniCredit of Italy has a presence by virtue of its ownership of Koch Bank. Other foreign banks include the Microfinance Bank (majority multilateral investment), Unibank (minority multilateral investment), Ata Bank (Turkey), Bay Bank (Turkey), Nikoil (Russia89), United Credit Bank (Russia), Caucasus

87 These objectives were partly accomplished by arranging for advisory services from foreign institutions, which included ABN-Amro with Prominvestbank and Crédit Agricôle with Agroprombank. No advisors were posted with Savings Bank.88 See “Banking System Report: Azerbaijan”, Thomson Financial Bankwatch, June 15, 2000.89 Nikoil is reported to be owned by Azeris living in Russia.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Development Bank (Russia), Milli Iranian (Iran), and CI Bank (Turkey). With some exceptions, the remaining banks are small and often considered to be in weak financial condition. Had NBA pursued its original policy of requiring banks to have minimum capital of $5 million (as opposed to $2 million and, now, $2.5 million), it is likely that no more than about 20 or so banks would be operating in Azerbaijan today. With plans to increase minimum regulatory capital to $5 million by 2005, current projections are that as few as 15 banks will be operational by then.

4.2.3 Concentration

As noted above, there is a high level of balance sheet concentration in the banking sector. IBA accounted for about 53 percent of total assets, 52 percent of total loans, and 63 percent of total deposits. IBA has a significant proportion of the foreign currency deposit market. Only IBA’s capital is relatively low as a share of total, at about 17 percent.

Some of the foreign banks are presumed to offer some fee-generating services (e.g., trade finance, credit cards), although these figures are low on a system-wide basis. This was one of the reasons for the departure of HSBC from the market. Meanwhile, the largest corporate firms (e.g., oil, electricity) have access to loans and other financing abroad, or they have benefited (when state-owned) from services provided by IBA. In general, intermediation levels are low. As elsewhere throughout the CIS region, banks (and formal financial markets in general) play a marginal role relative to the overall economy.

4.3 Trends in Financial Intermediation

4.3.1 Basic Trends in Financial Intermediation

Since 1998, there has been a proportional increase in the importance of foreign currency deposits as both a component of total money supply as well as relative to GDP. This has traditionally been grounded in concerns about a resumption of hyperinflation (rampant through 1995) and consequent manat value weaknesses that would result, notwithstanding the steady policy of the central bank for nearly the last decade. It may also be due to high levels of informal cross-border trade that often gets settled in dollars.90

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,

90 Through 2001, M2/GDP ratios declined, with some restoration of their share of GDP from 2002 on. Meanwhile, M3/GDP was fairly flat from 1998-2000, and then increased in 2001-03. Overall, the share of foreign currency deposits-to-GDP has increased from 1998-2003, from 2.9 percent to 7.1 percent in 2003.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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although the figures may also not be entirely accurate due to the high level of informal transactions in the economy.

Table 9: Indicators of Financial Intermediation (1998-2003)1998 1999 2000 2001 2002 2003

Broad Money (M3) in billions of manat 1,886 2,050 2,606 3,434 3,926 5,094 o/w currency outside banks 926 1,136 1,350 1,469 1,669 2,041 o/w domestic currency deposits 465 329 278 286 358 551 o/w foreign currency deposits 494 585 978 1,679 1,900 2,502Broad Money (M2)/GDP (%) 8.1% 7.8% 6.9% 6.6% 6.8% 7.4%Broad Money (M3)/GDP (%) 11.0% 10.9% 11.0% 12.9% 13.3% 14.5%Sources: IMF, National Bank of Azerbaijan, author’s calculations

Irrespective of trends, financial intermediation ratios remain low at 14.5 percent. For instance, among the transition countries, 17 of 25 selected countries had about two times or higher Azerbaijan’s level of intermediation. Thus, Azerbaijan’s overall level of financial intermediation is low by most transition country standards, and even below average relative to the CIS. As examples, in 2002, the average for seven CIS countries (Armenia, Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Tajikistan and Uzbekistan) was 18.3 percent. This is lower than the other five CIS countries (Belarus, Kazakhstan, Russia, Turkmenistan and Ukraine), which was 29.5 percent in 2002. The entire CIS is lower than southeast Europe (45.5 percent) and the eight countries joining the EU in 2004 plus Croatia (74.4 percent).91 The following table presents some ratios of financial intermediation based on broad money to GDP.92

91 Figures are from “Bridging the ‘Great Divide’”, Finance & Development, December 2003. 92 Figures are calculated from money and quasi-money as listed in IFS. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Table 10: Broad Money-to-GDP in Selected Transition Economies (1998-2002) 1998 1999 2000 2001 2002

Albania 52.00% 57.86% 60.11% 66.65% 63.31%Armenia 10.05% 11.09% 14.69% 13.45% 15.61%Azerbaijan 11.0% 10.9% 11.0% 12.9% 13.3%Belarus 32.80% 17.49% 17.68% 14.90% 15.43%Bosnia-Herz. 24.52% 27.03% 27.18% 48.04% 49.33%Bulgaria 29.60% 31.70% 37.32% 40.73% 37.88%Croatia 41.62% 39.40% 46.08% 64.92% 66.60%Czech Republic 67.53% 67.99% 75.66% 73.89% 74.70%Estonia 29.09% 35.05% 39.32% 42.25% 42.90%Georgia 7.59% 8.11% 10.32% 11.09% 11.80%Hungary 45.51% 46.32% 46.36% 46.98% 47.22%Kazakhstan 8.57% 13.58% 15.29% 14.58% 20.40%Kyrgyz Rep. 14.49% 13.58% 11.32% 11.14% 14.65%Latvia 26.71% 26.64% 30.44% 32.83% 36.47%Lithuania 19.37% 21.03% 23.27% 26.72% 29.27%Macedonia 14.95% 19.28% 21.04% 25.30% 28.32%Moldova 19.34% 20.41% 22.35% 25.51% 30.52%Poland 39.88% 42.81% 42.66% 45.22% 42.81%Romania 24.93% 24.87% 23.23% 23.18% 25.67%Russia 22.93% 20.70% 22.09% 23.48% 26.78%Slovak Rep. 59.65% 64.05% 67.79% 68.04% 65.28%Slovenia 45.36% 46.54% 49.55% 55.15% 55.53%Turkmenistan 14.90% 14.90% 20.30% 17.60% 16.60%Ukraine 15.16% 17.20% 18.06% 22.38% 30.21%Uzbekistan 15.40% 13.60% 12.20% 12.60% 10.60%Notes: figures calculated from money and quasi-money to GDP from IFS; when not available, EBRD figures are used Sources: IMF; EBRD; author’s calculations

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.

As discussed above, apart from IBA, banks are small in Azerbaijan. Some of the foreign banks have access to additional resources as needed, and may, in fact, be booking loans or off-balance sheet items abroad. However, the vast majority of domestic banks have limited funding (deposits plus capital), and their access to lines of credit abroad are also limited. A few banks have access to donor lines of credit inside Azerbaijan. However, for most banks, the resource base available for lending and investment is small to begin with. Additional requirements, such as the 10 percent reserve requirement, further narrow the resource base for lending. Most banks are relatively unsophisticated in terms of the services they offer, and their small base has also meant that resources available for investment in systems have been constrained. Apart from cash transfers and some trade


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finance, the larger banks provide very limited services. While IBA is an exception (as was HSBC), banks in Azerbaijan are currently not providing more than basic services. One analysis pointed to the absence of specialization in 2000,93 with virtually all banks seeking to become “universal” banks despite being undercapitalized. Such low levels of capitalization have prevented them from emerging as full-service banks. As elsewhere in CIS countries, one of the major challenges Azeri banks have long faced is generating a reasonable funding base to be able to provide a meaningful array of financial products and services.

As a function of the need for regulatory compliance while prudential norms have tightened, many of the small banks have also had to utilize their scarce resources for investment in new systems and controls. Thus, investment into these capacity-building functions has reduced funds available for revenue-generating activities such as plastic cards and ATMs. Thus, profits have been small, which has reinforced the cycle of weak earnings to be retained, weak capital, limited product/service offerings, a narrow base of operations, and a general inability to provide adequate amounts of term financing in large volumes to help generate a steady stream of earnings. As an offset to these low ratios, the government is channeling its investment resources through other channels outside the banks, namely in the form of SOFAR.

4.3.2 Traditional Constraints to Deposit Mobilization

Funds mobilization by Azeri banks has been sluggish, and the funding base is miniscule in per capita terms at about $76. There are several factors behind the banks’ weak funding bases. The public has had little confidence in the banks or limited resources to place, although recent trends regarding the payment of positive real interest rates on deposits backed by a stable exchange rate suggest that confidence may increase as reforms take hold. As found elsewhere in the CIS region, confidence has been undermined over the years by earlier hyperinflation and exchange rate instability. While these have abated since 1996 and the exchange rate has been stable in Azerbaijan, most people and small businesses have little perceived incentive to place their funds with banks.

The failure of so many banks in the 1990s94 and the absence of deposit insurance have kept people from depositing their funds with banks. As a possible shift since 2000, the number of failed banks has diminished, suggesting that many of the banking problems have been cleaned up. However, people still do not trust the banks, and are not likely to until they have more evidence that funds will be professionally managed and supervised. Meanwhile, the government has designed a deposit insurance scheme. However, its implementation will be delayed for the near term, as agreed between the government and IMF.95 Among other items, the launching of explicit deposit insurance is expected to occur

93 See “Banking System Report: Azerbaijan”, Thomson Financial Bankwatch, June 15, 2000. 94 A net 164 banks have disappeared since 1995. Among the largest failures that appear to have damaged public confidence are Azakbank, Vakhid, Tarana, Markhamat and Etimat. By contrast, IBA recapitalized in 1995, as did the three banks that led to the relatively new BUS Bank. See “Banking System Report: Azerbaijan”, Thomson Financial Bankwatch, June 15, 2000 for failures in the 1990s, when most of the banks were closed. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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after banking supervision has been further strengthened, and as better management systems are in place at the banks.

Banks’ weak service delivery and the general absence of an active retail network have provided little incentive to place funds in banks. While there are now 46 banks in Azerbaijan, most are located in Baku. Other regions of Azerbaijan are “under-branched”, even though the country is “over-banked”. The government’s objective of having at least 500-600 points at which the public at large can access financial services by 2005-06 is intended to address the “under-branched” part of the problem. Meanwhile, with minimum capital at least doubling by 2005, this may also reduce some of the “over-banked” part of the banking system.

Levels of tax avoidance by citizens and corporate entities have been high, and concerns about account confidentiality have likewise served as a disincentive to keep funds in banks. With informal sector turnover estimated to be high,96 many people and businesses have long kept cash out of the banks for liquidity needs as well as for tax avoidance purposes. Lower tax rates may provide an inducement to small enterprises and households to increasingly place their funds in banks. However, this will take time, particularly if there are still concerns about account confidentiality. The policy to not tax interest earnings from deposits is also an incentive for people to place funds in the banks. However, the limited access that most households and small businesses have had to loans provides them with little incentive to place funds with banks. The pyramid schemes that collapsed in 1994 damaged confidence, and the public has had little trust in the banks since.

The lack of effort on the part of banks to more fully develop retail banking also plays a role, with most of the population being relatively poor. Recent efforts by some banks to introduce plastic cards represent a change in direction. As of the beginning of 2002, 14 financial institutions offered plastic cards. This number has since increased to 27 as of late 2003. However, consumer banking is still generally underdeveloped in Azerbaijan. As an example, credit via plastic card operations were only $4.9 million-equivalent as of late 2003, which was less than 1 percent of bank credit to the real sector and less than 0.1 percent of 2003 GDP. Banks have been deterred from developing a retail network due to high costs, limited returns, and investment requirements for other purposes (e.g., internal controls and systems, risk management capacity). Only in Baku is there a significant choice of banks with retail options.97

95 Both parties appear to have agreed that the introduction of an explicit deposit insurance scheme is premature, and that significant strengthening of the banks and banking supervision are needed to ensure the insurance fund remains solvent once established. See “Azerbaijan Republic: Article IV Consultation”, IMF, June 2003.96 Estimates were three to four times formal GDP in the late 1990s. See “Banking System Report: Azerbaijan”, Thomson Financial Bankwatch, June 15, 2000. This estimate roughly correlates with PPP per capita income measures against standard GDP per capita measures. 97 Baku’s population is about 2 million, or about 25 percent of total.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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There is also the issue of the troubled condition of many enterprises, particularly state-owned or privatized. In the latter case, most of these were privatized via management-employee buyout (MEBO) or by voucher. In neither case have these kinds of privatization approaches been considered to strengthen competitiveness. Many of the MEBOs are relatively large or mid-sized firms that continue to face major restructuring and productivity problems. In some cases, they have been/were kept afloat from the build-up of arrears on various payments, including on utility bills as well as to employees and for taxes. More recently, the government has stepped up efforts to reduce these arrears, making it even more difficult for these enterprises to maintain positive cash balances. In many of the CIS countries, the broken link with the enterprise sector is a major problem for most domestic banks, with funding primarily from the household sector. In Azerbaijan, about two thirds of deposits are from the enterprise sector, largely due to deposits related to the oil and gas sector.

Table 11: Deposit Distribution by Source: 1999-2003(millions of $, %) 1999 2000 2001 2002 2003Households $59.3 $86.8 $118.0 $156.8 $256.0 o/w manat $12.6 $12.9 $12.6 $13.8 $19.3 o/w foreign currency $46.7 $73.9 $105.4 $143.0 $236.7Enterprises $135.8 $207.0 $293.5 $304.4 $364.5 o/w manat $48.7 $46.7 $47.4 $59.2 $92.8 o/w foreign currency $87.1 $160.3 $246.1 $245.2 $271.7Government $19.4 $40.6 $10.7 $5.3 $18.1Total $214.5 $334.5 $422.3 $466.5 $639.6Households 27.63% 25.96% 27.94% 33.61% 40.03% o/w manat 5.88% 3.86% 2.99% 2.96% 3.02% o/w foreign currency 21.76% 22.10% 24.96% 30.66% 37.01%Enterprises 63.32% 61.90% 69.51% 65.25% 56.99% o/w manat 22.71% 13.97% 11.23% 12.69% 14.51% o/w foreign currency 40.60% 47.93% 58.28% 52.57% 42.48%Government 9.05% 12.14% 2.54% 1.13% 2.83%Manat 37.64% 29.98% 16.76% 16.78% 20.36%Foreign Currency 62.36% 70.02% 83.24% 83.22% 79.64%Notes: Deposit figures from government taken from IFS figures for central government deposits, and are assumed to be local currency; 2003 figures are preliminary from NBA, and may differ when published in IFSSources: NBA; IMF; author’s calculations

Azerbaijan is similar to Russia and neighboring Central Asian countries in that it has been able to attract significant investment flows for its oil and gas sector. Nevertheless, this has resulted in a bifurcated economy in which the government earlier channeled funds directly to state enterprises, bypassing the banking sector and much of the domestic economy. More recently, the State Oil Fund has been used more explicitly and transparently to smooth out budgetary imbalances. Nonetheless, this has also meant much of the funding has bypassed the banks. Thus, until a more viable private sector emerges, it will be difficult for most banks to materially increase their deposit bases.


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4.3.3 Current Trends and Prospects for Deposit Mobilization

Despite all of the negatives, deposit trends have shown some favorable developments in recent years. Total deposits have increased (in manat and dollar terms) since 1997 as compared with deposit levels held in 1996 and earlier. End 2000 levels were more than double peak levels held at the end of 1997 as a result of foreign currency deposits placed with IBA. Since then, deposits declined in 2001, but have grown since 2002 to $640 million-equivalent (when including government deposits) at year-end 2003. This is nearly four times levels in 1996.

Meanwhile, the distribution of deposits (as measured in dollar values) shows that the share of time, savings and foreign currency deposits has increased in recent years, while demand deposit shares have decreased. This partly reflects traditional hedging patterns in dollars, initially against earlier hyperinflation,98 and later against foreign exchange risk as most foreign currency transactions are dollar-denominated.99 However, it also appears that depositors are reacting to recent trends from banks to pay positive real rates of interest on these deposits.100 The willingness to place funds with banks in the absence of a deposit insurance scheme would suggest that confidence may be returning, and that individual and corporate depositors are becoming less concerned about other issues noted above (e.g., account confidentiality). However, overall deposit levels remain exceedingly low, most people bypass the banks, and the placement of deposits with banks also reflects the lack of alternative investment opportunities for those willing to put their funds in formal financial institutions. The following table shows recent trends in deposit mobilization, with the most salient developments occurring in 2000 with the significant influx of time/savings and foreign currency deposits, and then the shift from local currency to foreign currency deposits continuing on in 2001-03.

Table 12: Year-to-Year Deposit Growth: 1998-2003 1998 1999 2000 2001 2002 2003

Domestic Currency 22.8% 211.7% -80.1% 25.0% 55.4%o/w Demand Deposits -37.3% 6.3% 1.1% 0.2% 33.8% n/ao/w Time/Savings Deposits -74.1% 42.7% 400.7% -94.6% -4.5% n/aForeign Currency n/a 18.5% 82.6% 57.0% 13.2% 31.7%Total -11.3% 20.4% 139.1% -21.2% 14.9% 35.4%Notes: figures exclude restricted deposits; 1998 figures for time/savings deposits also include foreign currency depositsSource: IMF; NBA; author’s calculations

98 Year end CPI rates were as high as 1,294-1,788 percent from 1992-94. Even 1991 and 1995 were high, at 126 percent and 85 percent, respectively. Rates have been in single digits since 1996. 99 About 57 percent of the volume of the foreign currency market (as of September 30, 2003) was for US dollars. This was followed by rubles, which accounted for 40 percent. Notwithstanding the decline in the value of the dollar against other hard currencies, there was little demand for Euro, British pounds, or other currencies. See “Bülleten”, NBA, September 2003.100 Banks were paying an average 6.5 percent annualized on manat deposits at year-end 2003, as compared with CPI of about 3.6 percent for the year. Meanwhile, because of the relative inactivity of the T-bill market and general securities market, there are limited alternative opportunities for investment.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Despite growth in recent years, deposits remain small. Total deposit levels at end 2003 were about $640 million-equivalent. Excluding government deposits, the level was about $621 million. The main characteristic was that foreign currency deposits remained prominent, although the total proportion leveled off at just under 82 percent of deposits. This does not mean a reversal of the continuous dollarization of the economy that has proceeded for years. Rather, it may signal some underlying confidence in the currency and the banking system, particularly after nearly a decade of sound macroeconomic policies that have kept inflation rates low and the exchange rate relatively stable. Holdings in local currency deposits were only about 18 percent of overall deposits in late 2003, as compared with more than 57 percent in 2000. However, the shift in currency composition resulted from oil and gas-related activities, and the hard currency orientation of most of these transactions. Since then, the figures for local currency deposits have been relatively low.

Table 13: Bank Deposits (1998-2003)(millions, manats) 1998 1999 2000 2001 2002 2003Domestic Currency 371,494 456,296 1,422,289 283,780 354,840 551,300o/w Demand Deposits 203,025 215,826 218,209 218,730 292,740 n/ao/w Time/Savings Deposits 168,469 240,470 1,204,080 65,050 62,100 n/aForeign Currency 494,000 585,600 1,069,200 1,678,500 1,899,800 2,501,000Total 865,494 1,041,896 2,491,489 1,962,280 2,254,640 3,052,900o/w Demand Deposits (%) 23.5% 20.7% 8.8% 11.1% 13.0% n/ao/w Time Deposits (%) 19.5% 23.1% 48.3% 3.3% 2.8% n/ao/w Foreign Currency (%) 57.1% 56.2% 42.9% 85.5% 84.3% 81.9%Notes: Time/savings deposit figures derived from total non-demand deposits less foreign currency deposits; figures exclude restricted depositsSource: IMF; NBA; author’s calculations

When measured in dollar terms, deposit mobilization trends were fairly stable from 1997-99, and then more than doubled in 2000. Since then, deposits declined in 2001, and then continued to surge forward since 2002. By end 2003, deposits had risen to about $621 million, more than 2.7 times levels in 1998. However, Azerbaijan’s banks are still working with a relatively small deposit base, equivalent to about $76 per capita in late 2003.101

Until these numbers increase, most banks will not come close to having adequate resources for effective intermediation. In fact, virtually all of the incremental change in deposits since 2000 has flowed to IBA, reflecting its position in the local economy. BUS, which includes the former Savings Bank, has experienced only a limited increase in deposits since restructuring began. For instance, the BUS balance sheet for year-end 2000 showed deposits of Manat 136 billion, or about $30 million-equivalent. This is slightly higher than estimated deposits at the end of 2003, with erosion particularly in the area of individual deposits where BUS should have a competitive advantage with its branch network being the largest in the country. Like BUS, the other banks remain tiny, and they have generally not benefited from the increase in deposits since 2000. It also reflects little to no change in the traditional domestic deposit market, suggesting that outside of oil and

101 This should not be confused with household deposits per capita. Deposits of “individuals” were $256 million at year-end 2003. This approximated $31 per capita. Individual deposits account for about 41 percent of total deposits in the banks.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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gas, there has been limited growth at best. Table 14 highlights aggregate deposit figures in dollars. Table 15 summarizes per capita and average bank deposit trends.

Table 14: Bank Deposits in US$ Values: 1998-2003(millions, US$) 1998 1999 2000 2001 2002 2003Domestic Currency $95 $104 $312 $60 $73 $112o/w Demand Deposits $52 $49 $48 $46 $60 n/ao/w Time/Savings Deposits $43 $55 $264 $14 $13 n/aForeign Currency $127 $134 $234 $352 $388 $509Total $222 $238 $546 $411 $461 $621Notes: Time/savings deposit figures derived from total non-demand deposits less foreign currency deposits; exchange rates are year-end rates; figures exclude restricted deposits and central government deposits with banks (which may explain the difference between this figure in 2003, and the total of $640 million estimated by NBA for year-end 2003) Source: IMF; NBA; author’s calculations

Table 15: Summary of Bank and Per Capita Deposit Trends: 1998-20031998 1999 2000 2001 2002 2003

Average Deposits per Bank (US$ millions) $3 $3 $9 $8 $10 $13.5Y-o-Y Growth in Average Bank Deposits 11.13% 20.72% 172.09% -16.18% 29.19% 34.73%Per Capita Deposits (US$) $28 $30 $68 $51 $57 $76Y-o-Y Growth in Per Capita Deposits -12.13% 5.99% 127.37% -25.24% 11.54% 37.06%Notes: figures do not include restricted deposits or central government deposits with banksSource: IMF; NBA; author’s calculations

4.3.4 Other Liabilities and Capital

Despite relatively low levels of deposits in the aggregate, deposits account for about 58 percent of total balance sheet funding for banks.102 This represents a major increase from end 1998-99, when deposits only accounted for about 30 percent of total funding. The major change, as noted earlier, has been the placement of foreign currency deposits from large enterprises and multinationals into IBA and, to a lesser extent, Koch Bank.

Other liabilities and capital now account for about 42 percent of total balance sheet funding for the banks. These other liabilities generally consist of foreign liabilities that are borrowings from banks abroad. These were about 14 percent of total funding. There are also restricted deposits amounting to about 5 percent of total funding. Liabilities to non-bank financial institutions are small, and were less than 1 percent at the end of 2003.

Government financing sources are limited, with NBA credit equivalent to 4.5 percent and central government deposits even less, at no more than 2 percent. Bank borrowings from

102 These figures do not include off-balance sheet items, including unused lines of credit from other banks.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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NBA have been limited since 2001 when stricter monetary and fiscal procedures were implemented and financial discipline in the state enterprise sector began to be fostered. At the time, bank borrowings from NBA still accounted for a reasonable share of funding, at 14.2 percent at the end of 2000 and higher proportions in earlier years. However, the aggregate numbers show that borrowings from NBA have declined substantially since 2001. Likewise, the role of central government deposits has been relatively insignificant for most years going back to the mid-1990s.

Net of these funds, capital amounted to about 14 percent of the total funding base of the banks. In most years, banks have shown very little in the way of off-balance sheet items, such as guarantees, unused lines of credit, and derivatives. As such, gross capital has been fairly similar to net capital figures.103 However, as tighter accounting standards are introduced and consolidated accounting and supervision begin to take hold, these figures may begin to show more marked differences. For instance, gross capital was Manat 941 million at year-end 2003, or 18 percent of banks’ assets. However, net capital was Manat 744 million, or 14 percent.

The following table presents relative shares of banks’ balance sheet funding. Noteworthy since 1998 has been the rising importance of time, savings and foreign currency deposits, the absence of money market instruments, the declining role of government institutions (mainly NBA), and the limited role of NBFIs as a source of borrowings for banks. In the last case, this is due to the underdevelopment of other financial services in Azerbaijan.

Table 16: Relative Share of Commercial Bank Funding: 1998-2003 1998 1999 2000 2001 2002 2003

Total Deposits 30.8% 32.8% 54.0% 57.8% 57.9% 58.3%o/w Demand Deposits 7.2% 6.8% 4.7% 6.4% 7.5% n/ao/w Time, Savings, FC Deposits 23.6% 26.0% 49.3% 51.4% 50.4% n/aOther Liabilities 32.9% 30.9% 27.8% 22.3% 23.0% 27.5%Restricted Deposits 0.0% 0.0% 0.0% 4.5% 5.5% n/aForeign Liabilities 7.8% 9.5% 9.6% 13.0% 13.9% n/aCentral Government Deposits 2.9% 2.7% 4.0% 1.5% 0.7% 1.7%Due to NBA 22.0% 18.6% 14.2% 2.8% 2.2% 4.5%Liabilities to NBFIs 0.2% 0.1% 0.0% 0.5% 0.7% n/aCapital 36.2% 36.3% 18.2% 19.8% 19.1% 14.2%Sources: IMF; NBA; author’s calculations

In terms of aggregate numbers, the small size of banks becomes apparent. With 46 banks operating in Azerbaijan, total balance sheet funding per bank averages about $23 million-equivalent. Capital on average is $3.3 million, and regulatory capital is only about $2.6 million on average. Considering that IBA accounts for most funding, most banks are miniscule and unable to provide meaningful levels of intermediation. Exceptions to this are some of the foreign banks that have substantial resources outside of Azerbaijan (e.g., Koch Bank) by virtue of their shareholders and access to syndicated loan markets and

103 “Net” capital in this case is defined as gross capital plus other items (net). In most cases, the latter detracts from the value of capital on an accounting basis.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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capital markets. Netting out IBA, the other 45 banks show the following averages (based on December 1, 2003 data from the NBA):

Deposits: $4.7 million Other Liabilities: $2.6 million Capital104: $2.6 million

The following table highlights balance sheet funding for banks in Azerbaijan since 1998.

Table 17: Commercial Bank Liabilities and Equity: 1998-2003(millions of US$) 1998 1999 2000 2001 2002 2003Total Deposits $222 $238 $546 $411 $461 $621o/w Demand Deposits $52 $49 $48 $46 $60 n/ao/w Time, Savings, FC Deposits $170 $189 $498 $365 $401 n/aOther Liabilities $236 $223 $281 $159 $184 $293Restricted Deposits $0 $0 $0 $32 $44 n/aForeign Liabilities $56 $69 $97 $93 $111 n/aCentral Government Deposits $21 $19 $41 $11 $5 $18Due to NBA $158 $135 $143 $20 $18 $48Liabilities to NBFIs $1 $0 $0 $3 $6 n/aCapital $261 $264 $184 $141 $152 $151Total Liabilities and Equity $720 $726 $1,010 $710 $796 $1,064No. of Banks 79 70 59 53 46 46Average L+E per Bank $9 $10 $17 $13 $17 $23Notes: Figures in 2003 from NBA, whereas from IFS from 1998-2002, possibly resulting in some differences Sources: IMF; NBA; author’s calculations

4.3.5 Lending: Stocks and Flows

Patterns in the stock of loans show that bank lending is a large share of total bank assets (see Table 18 below), but remains small as a share of total GDP. Figures for 2003 indicate that net domestic credit, including the low figure for bank investment in government securities, was only $688 million, or 10 percent of GDP. These figures are equivalent to per bank averages of $15 million, as compared with $7 million in 1998. In both cases, the figures are small, although there has been clear growth. Apart from IBA, most banks have little credit exposure. IBA’s loans to customers were nearly $300 million in late 2003. After that, Bank Standard had about $30 million in loans, and another 10 banks had $10-15 million in loan exposure. Thus, 38 banks were below the $10 million threshold, of which 26 had roughly $5 million or less in loan exposure.

In general, bank credit has declined as a share of GDP from the mid-1990s, when bank credit-to-GDP was routinely in the 13-15 percent range. This has been due to the increasingly hard budget constraints imposed on state enterprises, as indicated by the precipitous year-to-year decline in bank credit to state enterprises. It is also because banks

104 Tier I plus Tier II capital.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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have often lacked alternatives outside of the oil and gas sector due to the weak legal framework and unwillingness to assume risk, and because of banks’ weak funding positions. Credit limits of 25 percent of bank capital on individual loans have also made banks irrelevant for many large and mid-sized firms, particularly as syndicated lending has not taken hold in Azerbaijan and because banks have generally been unwilling (or unable due to resource constraints) to lend on a long-term basis (more than one year).

In aggregate dollar terms, bank credit at the end of 2003 was roughly equivalent to levels in 1998-2000, with positive trends commencing in 2002 and continuing on through 2003 in the form of 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, combined credit to government and state enterprises105 continues to shrink as a percentage of total credit as well in aggregate figures.

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.106 However, until then, private sector banks’ loans outstanding will account for only about half of the system total.

105 There is likely some inaccuracy in the statistics, as the state enterprise share of bank credit is considered to have declined, not increased. 106 While the state may retain small ownership stakes in IBA, all banks will be majority or wholly private by 2004-05. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Table 18: Bank Financing of Government, Enterprises and Households: Stock Figures (1998-2003)

1998 1999 2000 2001 2002 2003(billions of manat)Total GDP 17,203 18,875 23,591 26,578 29,602 35,053Claims on Government 30 69 276 325 366 44Claims on State Enterprises 1,659 1,722 818 497 469 801Claims on the Private Sector 530 560 1,395 1,330 1,663 2,537Total Bank (Net Domestic) Credit 2,219 2,351 2,489 2,151 2,497 3,382Per Bank Credit 28 34 42 41 54 74(millions, US$)Total GDP $4,446 $4,581 $5,275 $5,708 $6,090 $7,124Claims on Government $8 $16 $60 $68 $75 $9Claims on State Enterprises $426 $393 $179 $104 $96 $163Claims on the Private Sector $136 $128 $306 $278 $340 $516Total Bank (Net Domestic) Credit $570 $537 $545 $450 $510 $688Per Bank Credit $7 $8 $9 $8 $11 $15Government Share of Bank Credit 1.4% 3.0% 11.1% 15.1% 14.7% 1.3%State Enterprise Share of Bank Credit 74.8% 73.2% 32.9% 23.1% 18.8% 23.7%Private Sector Share of Bank Credit 23.9% 23.8% 56.1% 61.8% 66.6% 75.0%Private Sector Share/GDP 45.0% 45.0% 69.6% 70.7% 72.0% 72.5%Total Bank (Net Domestic) Credit/GDP 12.9% 12.5% 10.5% 8.1% 8.4% 10.0%Notes: No figures available for credit to local government; 2003 figures preliminary, may differ from final figures when published in IFSSource: IMF; NBA; Ministry of Economic Development; State Committee for Statistics; EBRD; author’s calculations

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.

As for lending flows, the major change in the profile of bank lending has been the shift from high levels of exposure to state enterprises to that of the private sector. Until 1999, the majority of bank credit went to state enterprises, as indicated by the nearly three quarters of total bank credit outstanding to state enterprises in 1998-99. This situation reversed in 2000 as the majority of credit to state enterprises was removed from the books of the troubled banks that subsequently were reorganized and merged as BUS. By placing these non-performing loans in what is today AgrarCredit, the balance sheet of the banking system was effectively restructured. Meanwhile, changes of ownership in the enterprise sector also triggered a reclassification of credit to the private sector, as indicated by the


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substantial increase in the proportion of bank credit to the private sector from 1999 to 2000.

The following table shows the general shift in lending flows in recent years, which are consistent with changes in stock figures above. While year-to-year patterns show differences—increases in 1998, 2000, 2002 and 2003, compared with decreases in 1999 and 2001—the flow figures indicate that incremental lending has been virtually non-existent until very recently. Cumulative incremental bank credit figures (including investment in government securities) from 1998-2003 were $158 million, or an average of $26 million per year. However, the bulk of the increase has been since 2002. Netting out investment in government securities (claims on government), the figures show that bank lending to the real sector (enterprises and households) showed virtually no net increase from 1998-2001. As noted in other parts of this assessment, one of the key gaps and challenges facing the government and economy is the low level of bank lending to the real sector. On the other hand, the trend is currently favorable.

Table 19: Incremental Changes in Bank Financing of Government, Enterprises and Households: Flow Figures (1998-2003) (millions of US$, %) 1998 1999 2000 2001 2002 2003Increase/(Decrease) in:GDP $481.7 $134.9 $694.0 $432.4 $382.3 $1,034.0Claims on Government -$5.8 $8.1 $44.6 $7.5 $6.8 -$65.8Claims on State Enterprises $5.8 -$33.1 -$214.3 -$75.1 -$8.3 $68.0Claims on the Private Sector $36.8 -$8.4 $177.7 -$27.2 $61.4 $178.7Total Bank Credit $36.7 -$33.3 $8.1 -$94.7 $60.0 $180.8Increase/(Decrease) in:Government Share of Bank Credit -1.2% 1.6% 8.1% 4.0% -0.4% -13.4%State Enterprise Share of Bank Credit -4.1% -1.5% -40.4% -9.8% -4.3% 4.9%Private Sector Share of Bank Credit 5.2% -0.1% 32.3% 5.8% 4.8% 8.4%Net Bank Credit/Incremental GDP 7.6% -24.7% 1.2% -21.9% 15.7% 17.5%Notes: all figures are incremental as compared with prior year (increase = positive increment; decrease = negative increment) ; 2003 figures preliminary, may differ from final figures when published in IFSSource: IMF; NBA; author’s calculations

4.3.6 Other Assets

Total assets for the banks approximated $1.1 billion in late 2003, or about $23 million per bank. As noted elsewhere, IBA accounts for about 53 percent of assets. Thus, the other 45 banks average about $10-$11 million in total assets, infinitesimally small by global standards. More than a third of the banks had less than $5 million in total assets in late 2003.

Based on year-end 2003 figures, the largest component of bank assets was credit, or loans to customers. Net domestic credit (including bank investment in government securities) approximated $688 million, or about 65 percent of bank balance sheet values. Specific to enterprises, credit was about $400 million, or 40 percent of total assets. Households MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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account for the balance of private sector loans. The reason for the fairly low level of claims on government (e.g., banks’ investment in government securities) is due to the government’s low demand for bank financing, and the elimination of T-bill holdings as acceptable for reserve requirements. Most other investments in securities are in markets abroad, and therefore are included in foreign assets. While banks’ credit-to-total asset ratios were higher in 1998-99, many of these posted assets were non-performing.

Apart from loans, balance sheets are composed of reserves, foreign assets, and other assets that largely include premises. Reserves to total assets have been in the 8-10 percent range since 2000, mainly reflecting reserve requirement imposed by NBA. They were estimated to have increased in 2003 to about 16 percent of assets. Apart from this, the major component is foreign assets, essentially investments in safe (investment grade, usually OECD government) securities abroad that often serve as deposits held with correspondent banks abroad. Foreign assets account for about 62 percent of balance sheet values, and are mainly held by IBA and, to a lesser extent, some of the other foreign banks (e.g., Koch Bank).

Table 20: Asset Composition of Bank Balance Sheets (1998-2003)1998 1999 2000 2001 2002 2003

(billions of manat)Reserves 204 178 392 319 361 821Foreign Assets 378 666 1,732 922 1,036 1,030Credit to Government 30 69 276 325 366 44Credit to State Enterprises 1,659 1,722 818 497 469 801Credit to the Private Sector 530 560 1,395 1,330 1,663 2,537Total 2,801 3,195 4,612 3,391 3,895 5,233Average per Bank 35 46 78 64 85 114(millions, US$)Reserves $52 $41 $86 $67 $74 $167Foreign Assets $97 $152 $379 $193 $212 $209Credit to Government $8 $16 $60 $68 $75 $9Credit to State Enterprises $426 $393 $179 $104 $96 $163Credit to the Private Sector $136 $128 $306 $278 $340 $516Total $720 $730 $1,010 $710 $796 $1,064Average per Bank $9 $10 $17 $13 $17 $23Reserves/Total Assets 7.28% 5.57% 8.49% 9.39% 9.27% 15.69%Foreign Assets/Total Assets 13.51% 20.84% 37.56% 27.19% 26.61% 19.68%Credit to Government/Total Assets 1.07% 2.17% 5.98% 9.57% 9.40% 0.84%Credit to State Enterprises/Total Assets 59.22% 53.90% 17.73% 14.64% 12.03% 15.31%Credit to the Private Sector/Total Assets 18.92% 17.52% 30.24% 39.20% 42.69% 48.48%Notes: reserves and foreign assets are estimatesSource: IMF; NBA; author’s calculations


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4.4 Governance and Management

4.4.1 Overview

Corporate governance standards are not considered strong in Azerbaijan when compared with recommended practices.107 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. This is changing in some cases, such as standards applied to SOFAR, and newly adopted provisions in banking legislation. However, as of year-end 2003, the aforementioned weaknesses remained in effect.

4.4.2 Boards and Internal Oversight

Boards are reported to be relatively weak for several reasons. As elsewhere in the world, some board members are appointed to serve as allies of management or controlling shareholders, rather than to exert serious governance. In some cases, there are key weaknesses in terms of qualifications. In other cases, those qualified are unable to dedicate the time needed. Information is often incomplete or flawed. Independent board members and special advisers are not common. In the banking sector, there is momentum to require independent board members, particularly with regard to audit and supervisory functions. However, to date, this has not been the practice. Likewise, banks generally do not have special committees set up for legal, credit, audit, risk management, and other common functions addressed by boards.

Internal audit and controls are monitored by NBA as part of the supervisory function. In general, autonomy is a relatively new development for the internal audit department of banks. NBA is now preparing information for outreach to the banks concerning development of suitable internal audit systems and capacity. However, to date, this is underdeveloped in Azerbaijan.

MIS has improved in recent years as the banks have moved to strengthen the timeliness, accuracy and volume of financial information. This has been triggered by the NBA’s relatively new chart of accounts, and the preparation and electronic submission of uniform bank performance reports (UBPRs). There is also recognition that effective movement towards a market economy depends on such information, not just for external purposes, but for internal controls, risk management, portfolio management, and planning purposes. However, systems are still considered incomplete and underdeveloped. Moreover, reports prepared for the NBA are viewed as requirements and formalities by the banks, and are considered to be widely used by the banks for management purposes.

This is also the case for externally audited financial statements, with the 18 banks that do present their financial statements according to IAS/ISA generally doing so for their correspondent banks, and less for purposes of investment mobilization or market

107 See “OECD Principles of Corporate Governance” for guidance on fundamental principles.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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competition in Azerbaijan. However, the role of external audit has been used to supplement the regulatory/supervisory role as a basis for strengthening banks’ internal information systems, building up capacity to report regulatory financial information, and increasing capacity for banks to disclose financial information to the public. This should eventually make the transition to IAS less problematic. As banks mature, they will also begin to treat the external audit function as a strategic exercise, not just a reporting formality.

4.4.3 Management Capacity

Management has traditionally been strong in terms of “control”, but weak in terms of modern management practices, capacity and systems. Apart from IBA, most banks are small and do not have complex governance structures. Some of the foreign banks benefit from strategic investment and their experience in other markets (e.g., Koch Bank, Unibank, Microfinance Bank). However, most of the banks are geared to specific sectors (e.g., railways, telecommunications, gas) and/or to connected shareholders. In several cases, this is more focused on family and friends, and less on the public as a whole. Thus, given the relatively basic level of products and services offered and small number of clients, these banks resemble commercial finance companies or captive finance companies rather than banks.

4.4.4 External Non-Regulatory Oversight

Other parts of financial infrastructure are stunted. 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.

There is movement to develop a credit registry for information to be shared among the banks through the NBA. This may help with credit reporting and syndicated lending in Azerbaijan. However, there is no public information on individual borrowers. The NBA does present monetary and macroeconomic information (including some banking data) as well as a bulletin each month. This provides some basic information, but is not enough to do any serious evaluation of banks on a comparative or peer basis.

There is media coverage of major developments in the financial sector. However, the level of detail is limited. There are few specialized financial or business publications. The Azerbaijan Bankers Association has produced annual publications since 2002 and a directory of banks and basic financial information in 2003. There are also other publications in the legal, accounting and consulting fields that touch on issues related to banking. However, the volume of information is fairly limited.


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4.5 Non-Bank Financial Institutions and Markets

4.5.1 General Overview of NBFIs

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.

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. 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.

From a regulatory and institutional standpoint, structures and a framework are not yet in place. Meanwhile, where sound procedures and standards are in place, such as for the issuance of corporate securities, there are few firms that can fully comply with requirements. In the banking sector, Unibank was planning a small issue in early 2004, and a larger one for later in the year. However, to date, banks have not floated corporate bonds in the local market. Equities are not actively traded.

4.5.2 Securities/Capital Markets

There has been little activity in the securities markets, be it for debt or equities. Fiscal prudence and monetary control have constrained volume and turnover in the government securities market. Slow privatization in the medium- and large-scale SOE sector, the nature of most transactions (MEBOs and vouchers), and the weak financial condition of these companies has constrained development of a viable corporate bond and equities market. Local governments have no capacity to issue municipal bonds. Housing finance is underdeveloped, and neither market infrastructure nor inventory of loans is sufficient to introduce mortgage bonds or other instruments.

Securities markets are broadly underdeveloped for several reasons. Political disputes and control over economic policy and resources have been one of the most important factors. The State Securities Commission was established in late 1998 with adoption of the Securities Law in September 1998. However, its authority has long been challenged by both NBA and the Ministry of Finance. This may be less of an issue now than it was a few years ago. However, the absence of market activity makes the question somewhat moot.

Legal and regulatory infrastructure is weak. The number of potential issuers that are financially sound is limited, and few could comply with the listing requirements of the Baku Inter-bank Currency Exchange (BICEX). Commercial banks are expected to be among those that will be able to list as they implement reforms. Meanwhile, the corporate sector’s financing needs have traditionally been met by bank loans or from other channels.


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Thus, there is no active tradition of listing on securities exchanges, or meeting meaningful disclosure requirements to trigger corporate debt or equity activity.

Domestic investment in securities is generally limited to T-bills. Non-residents are permitted to participate in the T-bill market. However, given the small size of the market, there has been virtually no international investment in the T-bill market. Portfolio investment has been zero since 1999.

The government securities market had only Manat 445 billion (about $90 million) in issued volume as of late 2003. Nor is there great demand for T-bills, as only about Manat 405 billion of supply was purchased in 2003. At any one point, the value of T-bills outstanding was only Manat 140-160 billion, or about $30 million-equivalent. The number of market participants ranged from four to 15, reflecting the small number buyers in the market. The last seven issues had no more than eight participants. Most of the T-bill issues are for three month periods, with periodic six-month issues. As an extension, there is also no real secondary market for the small T-bill market. Thus, the T-bill market is generally illiquid. Weighted average yields declined steadily through 2003, and ranged from 7.27 percent at the end of 2003 compared with the higher 8.26 percent at the beginning of 2003. This compares with 7 percent refinancing costs of borrowings from the NBA. In general, weighted average yields were only a few basis points below the maximum offered, or equal to it, and only marginally higher than the NBA refinancing rate.

There are three main exchanges for foreign exchange—Baku Inter-bank Currency Exchange, Organized Inter-bank Foreign Exchange Market, and the Open Inter-bank Foreign Exchange Market. Banks are permitted to provide foreign exchange services outside of the three markets on the condition they have a special license to do so.

In terms of equities, privatization vouchers have been about the only securities traded. However, there is no organized market. Pricing is distorted and liquidity is low.

4.5.3 Insurance

In general, Azerbaijan is underdeveloped in terms of both life and non-life insurance. Barriers to entry have been in place for foreign insurers, and there is limited (albeit some) presence of foreign insurance companies among the 29 total companies engaged in insurance.

Based on 2002 statistics,108 premium revenues were Manat 210 billion, or less than $45 million. By comparison, the 91st largest country in the world for insurance premium revenues was Bahrain, at $159 million.109 This translates into density per capita in Azerbaijan of about $5,110 and revenues per company of about $1.5 million. The following characterize the insurance sector in Azerbaijan:

108 Figures provided by the Ministry of Finance.109 See “World insurance in 2002”, Swiss Re, No. 8/2003.110 Density is defined as premium revenues per capita. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Box 3: Summary of the Insurance Sector in AzerbaijanNumber of companies 29 companies.Ownership 1 is state owned, and the rest are private.Market share Based on premium revenues, compulsory insurance is a small

fraction of the market at only Manat 17 billion in 2002, or 8 percent. This is expected to grow as more motor vehicles enter Azerbaijan. Other compulsory insurance is being contemplated, including environmental-related insurance applicable to the oil and gas sectors.

Types of insurance Life insurance is available, as well as a wide variety of non-life insurance products. The latter include health, pension, fire, accident, transport, engineering, and agricultural insurance products.

Reinsurance Reinsurance outflows are reported to be high, particularly in the engineering sector focused on oil and gas development.

Claims Claims paid diminished in 2002 to Manat 33 billion (only 16 percent of premium revenues) as compared with Manat 50 billion (about 27 percent of premium revenues) in 2001.

Assets Assets were reported to be Manat 80 billion (about $16 million, or about $560,000 per company) as of September 2003. However, this is also the figure reported for statutory reserves. Assets were almost entirely cash, with a small fraction in offices.

Sources: Ministry of Finance

There is a Law on Insurance that provides a framework for insurance companies. However, the law is not consistent with international standards, and there are plans to revise the legislation and general insurance framework later in 2004. At the moment, the Ministry of Finance oversees the sector, although not very actively. Companies are small in assets, and limited in terms of premium revenue and earnings. A new framework will be required to ensure that companies adhere to sound regulations regarding solvency and liquidity, and that they honor claims based on the terms and conditions of the policies they market. From a policy standpoint, it will be essential to eliminate barriers to entry for reputable foreign firms, and to present a framework to make it possible to evolve to a multi-pillar pension system with well managed insurance companies playing a role in asset management

Minimum capital for entry is Manat 2 billion, or about $400,000. This will change as legislation is amended. New legislation will also expect to bring solvency ratios, investment policies, reserve management, consumer protection and related provisions into line with international standards.

The regulatory authority is in the Ministry of Finance. With an eye towards eventual pension reform, it remains to be seen how the insurance regulatory will be structured in the future, and where it will be placed institutionally.

4.5.4 Pension Reform

In the pension field, Azerbaijan has only one social insurance fund. In general from 2000, pension expenditure has risen steadily, but remained around 3 percent of GDP. For instance, social security expenditure was 3.2 percent of GDP in 1999 and in 2002,


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although it was lower as a share of GDP in 2000-01 (when it was an average 2.85 percent of GDP). Moreover, social security contributions are continuously in deficit. From 1998-2002, social security contributions were less than three quarters of expenditure,111 with the deficit nearly 1 percent of GDP per year. Should there be a downturn in the economy, this would only make it more difficult to finance. Major problems have been low collection yields, utilization of the state pension fund for social protection as well as social insurance, the absence of a central registry that is automated and up to date with information on contributions, and evasion. Recent changes have been adopted to correct these problems. Government has also managed to contain overall expenditure by gradually increasing retirement ages, ceilings on reference wage rates, and selective indexation rules. Demographics show the need to initiate pension reform in Azerbaijan. About one third of the population is under 15 years of age, only 9 percent is more than 60, and life expectancy was increasing until very recently. General trends in recent years have shown an increase in pensions paid due to increased retirement. While structural measures have been taken to streamline the pension system (e.g., increasing the retirement age), the growing cost has increased transfers from the state budget.

Given Azerbaijan’s fundamental demographics, the current structure will be unsustainable in the long run. Thus, from a long-term fiscal standpoint, pension reform is needed. The government has announced its intention to introduce pension reform in the next few years. This will require improvements in the way Azerbaijan’s securities and capital markets currently function (to the extent that they do), as well as broad improvements in overall governance, management, transparency, accountability, and consumer protection.

Pension reform is planned for the next few years. This includes changes in the traditional pay-as-you-go (PAYG) system to make the first pillar more sustainable, while also setting the foundation in the long term for movement to a second and third pillar. For the next few years, efforts are likely to be focused on new legislation addressing eligibility criteria (e.g., extending the age at which benefits are paid), payment requirements (e.g., within a specified time period), and value preservation (e.g., annual increases at least equivalent in real terms to the increase in non-oil GDP). Operationally, pension reform is likely to focus on building up more reliable information systems, namely individualized records so that all existing pensioners have computerized records by 2005. This will help provide a more stable foundation for social insurance. However, in terms of medium-term financial sector development, there is not likely to be much impact in terms of lending and investment. Privately managed pension funds are also expected to evolve over time as the system develops, and as barriers to entry and investment for foreign insurance firms decline.

111 Manat 2,664 billion in contributions compared to Manat 3,602 billion in expenditure from 1998-2002 = 74 percent. Thus, the deficit was 26 percent of expenditure, equivalent to Manat 938 billion. This was equivalent to about 0.8 percent of GDP.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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4.5.5 Non-Bank Sources of Credit: Credit Unions and Microfinance

There are 57 licensed non-bank credit organizations. 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.

Some entered the country to provide humanitarian relief. In other cases, the MFIs function as lenders in a competitive market based on best practice. As of March 30, 2003, five of the largest MFIs112 had nearly $6 million in total assets, about 6 percent of the banking sector.

4.5.6 Postal Financial Services

The postal network consists of 1,283 permanent post offices (2002 data), with coverage ratios of about 67.5 square km and 6,350 people on average.113 At the moment, the postal network is used for small money orders, but little else in terms of financial services. With total money order transactions of only 167,535 in 2002, this suggests that only one in 49 people engaged in a single money order transaction once in 2002 (on average). With the weighted average value of these money orders at $30, this indicates that the postal system is used infrequently for money orders, and that these money order transactions are for exceptionally small amounts. The largest money orders (on average) received from abroad are likely remittance payments that come in to remote areas from family members working or living overseas.114 The following table provides basic figures for 2000-02 on the volume and value of money orders:

Table 21: Money Order Transactions Through the Postal System (2000-02)2000 2001 2002

Number of Domestic Money Orders 132,315 133,390 155,904Number of Int’l Money Orders Sent 5,899 7,542 6,058Number of Int’l Money Orders Received 7,678 8,188 5,573Total Value of Domestic Money Orders $3,324,666 $3,296,248 $4,361,279Total Value of Int'l Money Orders Sent $323,075 $371,241 $329,934Total Value of Int'l Money Orders Received $369,337 $534,382 $396,709Avg. Value of Domestic Money Orders $25 $25 $28Avg. Value of Int'l Money Orders Sent $55 $49 $54Avg. Value of Int'l Money Orders Received $48 $65 $71Notes: dollar figures derived from SDR figures at average exchange ratesSources: Universal Postal Union; IMF; author’s calculations 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

112 ADRA, ASM, FINCA, CredAgro, and Shorebank. 113 These are 2002 data from the Universal Postal Union. See www.upu.int. 114 There is a very large Azeri population living in Iran, estimated to be as large as 15-20 million. There are also reported to be 1.5 million Azeris living and working in Russia. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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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. The number of mobile post offices (including for rural delivery) appears to have declined in recent years. If the postal network is to be used, these and other options would need to be explored.

4.5.7 Leasing and Factoring

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. The 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). The main challenge at the moment is to create a conducive environment to increase investment into the leasing sector. There is reported to be substantial demand, including from the SME sector as prospective borrowers would not have to provide collateral for the lease contract. Banks are also expressing interest as they view leasing as easier to manage than secured lending in the current environment.

Factoring is nascent in Azerbaijan. As of late 2003, the banks had about Manat 100,000 million ($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.


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ANNEX 5: BANKING SECTOR DEVELOPMENT IN RELATION TO PRUDENTIAL ISSUES

5.1 Capital and Capital Adequacy

5.1.1 Minimum and Average Capital

Minimum capital for the banks has been $2.5 million since July 2002, and is expected to rise to $5 million by 2005. There is a possibility that an interim increase to $3.5 million would be required in 2004, although there is no final determination as of yet. In the meantime, most banks’ regulatory capital was less than $5 million in late 2003. While some of the banks with less than this figure are not expected to have a problem reaching and exceeding this requirement when imposed, others are expected to have difficulties complying.

As noted elsewhere, the average bank in Azerbaijan is small. Average regulatory capital is $2.6 million, barely above the minimum. An estimated 39 banks were below the 2005 target in late 2003. While there is still time to attract additional investment and/or merge operations, many banks are expected to fail as a result of regulatory non-compliance.

Should this be the case, there are several approaches that could be taken. One would be to re-license the “banks” that are technically solvent, legally in good standing, and basically demonstrating movement towards sound standards of management and governance. Thus, such “banks” could be re-licensed as non-bank credit organizations, and essentially function as commercial finance companies. This would permit them to continue as businesses, but not as banks. This would also eliminate their prospects for membership in the deposit insurance scheme once introduced. Other issues related to efforts to reduce money laundering and other financial crimes should also be considerations in how the banking system consolidates. Those “banks” that are insolvent and deficient in other ways (e.g., legal, operational, managerial) should be closed. 5.1.2 Capital Adequacy

Based on NBA figures, capital adequacy for the banking system was 17.8 percent in 2001. In late 2003, the figure was estimated to be about the same, at about 19 percent. However, these figures are imprecise due to problems associated with asset classification, off-balance sheet risks, etc.

More generally, the level of banking sector penetration in the economy is so low that any bank failure would have little direct impact on the economy. The only exception might be IBA, whose assets were about 7.5 percent of GDP. Other banks are small, and off-balance sheet items are not reported to be of such magnitude that it would create major problems should there be a scandal or failure. In the vital oil and gas sector, most of the financing is arranged offshore. One of the challenges in the coming years will be developing capacity


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to manage increasing resources in and through the banking system. When that occurs, there will be higher levels of monetization, intermediation and banking penetration. However, until then, such figures will remain low. Perversely, this will reduce the potential for systemic risk.

5.1.3 Asset Quality and Capital

In terms of asset quality issues and the sufficiency of bank capital, the ratio of real sector loans-to-net capital115 has increased in recent years. This is due to a more accurate accounting of loan quality, as well as increased tightening and enforcement of capital standards by NBA following the financial restructuring of troubled state banks in 1999-2000. Total loans to net capital have increased from about two times net capital in 1999 to nearly four times capital116 in 2003. In general, since 2000, these ratios have increased, with a marked increase in 2000 that has been sustained since.

Using “overdues” as a proxy for non-performance, these ratios relative to net capital have ranged from 56.5 percent in 2000 (after the bad asset transfer from troubled state banks) to 78 percent in 2003. This suggests that risk-adjusted capital coverage of loans is diminishing, although the ratios are still conservative when compared with more active credit markets. Capital adequacy figures of about 19 percent in 2003 suggest that regulatory capital is adequate relative to risks incurred. However, as these loans grow, there will obviously need to be an increase in capital to reserve for existing and potential risks.

Table 22: Bank Loans to Enterprises and Households Relative to Net Bank Capital1998 1999 2000 2001 2002 2003

Loans/Net Capital 218.8% 203.8% 296.1% 320.3% 334.8% 450.6%Overdue Loans/Net Capital 42.3% 72.6% 56.5% 76.2% 61.3% 45.3%Net Loans/Net Capital 176.5% 131.2% 239.6% 244.1% 273.5% 405.3%Notes: 2003 data are calculated from NBA data and may change when presented in IFSSource: NBA; IMF; EBRD; author’s calculations

5.2 Asset Quality and Concentration

5.2.1 Asset Quality

General measures of banks’ asset quality have improved in recent years. Given that loans are the main asset on the balance, the main indicator of asset quality for the Azerbaijan banking system is the status of the loan portfolio. Overdue loans are still high at about 10 percent of total loans. However, they have generally come down since 1999 as a percentage of total loans, deposits and capital. As a share of total loans and total assets,

115 These figures do not include banks’ investments in government securities, which are assumed to be safe. Rather, these ratios only include loans to enterprises and households. Net capital is “capital” plus/minus other items (net), the latter of which have generally been minor in terms of overall capital calculations. 116 The 2003 figure is Tier I and Tier II capital, not necessarily “net” capital as reported in IFS. However, the differences are not thought to be material. Thus, loans to capital have increased in recent years.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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non-performing loans have shown the following trends, with 2003 figures based on overdue loans presented by NBA as of year end 2003: Table 23: Non-performing Loans in the Real Sector (1998-2003)

1998 1999 2000 2001 2002 2003Non-performing Loans/Total Loans 19.60% 37.20% 21.47% 28.03% 21.46% 10.06%Non-performing Loans/Total Assets 15.31% 26.57% 10.30% 15.09% 11.74% 6.44%Note: Overdue loans apply to real sector; loans to government (banks’ investment in government securities) are not included in the ratiosSource: NBA; EBRD; author’s calculations

Looking ahead, banks have begun to lend more than in recent years, as indicated by aggregate loan growth as well as the ratio of loans to GDP. This will make it all the more important for banks to be able to manage the credit risk they assume, particularly in the next few years if competition picks up and margins tighten.

Beyond loans, most of the other assets on banks’ balance sheets are reserves (in Azerbaijan or abroad) and properties. Some of the overseas placements may not be in investment grade paper, raising doubts about quality. However, much of this group of assets is reported to be in OECD countries with correspondent banks.

With regard to properties, it is difficult to know what the actual value of such properties is. In one sense, most banks have properties in Baku, which should be more valuable than structures outside the capital. On the other hand, in the case of bank premises, these are not always easy to refurbish or convert for other purposes. Thus, appraising “market value” may be difficult. Likewise, some properties are used for operations (and, therefore, are non-earning assets), whereas other properties may be held for investment. There have been restrictions on banks’ real estate activities in the past, so it is unclear the extent to which these issues are relevant. On the other hand, while banks have not necessarily engaged in a major amount of property development or construction,117 affiliates or other connected entities may have. These should be captured increasingly in the financial data as IAS is implemented, and both consolidated accounting and consolidated supervision come into effect.

5.2.2 Concentration

In terms of institutions, the main concern for systemic stability is IBA. Its special and general reserves for loan losses are consistent with the system as a whole as a share of loans. They are also about three times Tier I and Tier II capital. Should more than 15 to 20 percent of IBA’s loan portfolio completely collapse in performance, the bank would face significant stress. However, to date, there has been no information that would suggest this is even a remote possibility. The audited statements from mid-year 2003 only noted the potential vulnerability of banks in general should there be a severe deterioration in oil prices. Likewise, the current due diligence being performed in advance of the

117 Construction companies are reported to have greater resources than banks. Demand is also high in Baku, resulting in the ability of developers to pre-sell flats. This reduces their borrowing needs for property development.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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government’s sale of 20 percent of IBA to EBRD has provided information for the valuation of the bank’s shares. While these data have not been made public, there has been no reported concern that IBA’s loan portfolio is severely impaired in any way.

Sector trends indicate some diversification in lending patterns, although most appear to focus on high turnover, short-term activities. Some private banks are actively seeking industrial activities, and this may continue as private foreign banks become more active in the market, and as the business environment improves for SMEs. Such diversification will help offset concentration risks should asset quality in a particular sector decline.

Average loan size is small, largely due to the low level of capital of the banks and regulatory restraints on the size of individual loans. For instance, based on late 2003 data from the NBA, the average bank net of IBA would not be able to make a loan larger than about $650,000. While this is large for most banks, it is small for most large-scale enterprises and many medium-sized enterprises. In general, these companies need larger loans for longer periods. While the small scale of banks’ lending resources is negative for overall economic growth, it does mean that when individual loans turn bad, they are generally not large enough to materially impact the overall portfolio. Most loans are reported to be far smaller than $650,000.

The banking system shows that a high proportion of overall assets are held in reserves and safe securities investments abroad. This suggests that the impact of any deterioration in loan quality could be partly contained by liquid assets available offshore. Meanwhile, the gradual diversification of lending away from troubled state enterprises has helped with loan quality. The challenge for banks now is to be able to reorient their lending practices to accommodate smaller enterprises based on market standards. Given that most banks have limited experience in this domain, there is a risk that loan portfolio quality could decline in subsequent years as banks presumably take on greater risk to boost assets and earnings. In this regard, there are numerous techniques banks in market economies have perfected over the years that can help mitigate these risks. These include increasing loan limits and lengthening maturities of loans to preferred borrowers based on performance. However, even more importantly, banks that are able to offer a range of simple services (e.g., electronic payroll, cash management, custodial) are also in a position to monitor client cash flows. This is on the assumption that banks encourage the use of compensating balances118 and other incentives (e.g., demand deposit accounts that households and enterprises use for business operations) to attract as much potential business from borrowers as is possible. This, in turn, provides banks with additional information on the working capital patterns of companies (and households), their seasonal needs (if any), and over time, their capacity for larger loans and appropriate mixes of maturities, interest rate formulas and currency mixes. These and other techniques are particularly useful when the

118 Compensating balances are deposits placed by borrowers in the bank which are used to reduce their borrowing costs or fees. The bank can use these free balances for loans to others and/or investments in securities or other income-generating uses. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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secured transactions framework is weak and credit information is in short supply, as it is in Azerbaijan.

5.2.3 Asset Quality and Deposit Safety

In terms of asset quality issues and the safety of deposits, the ratio of real sector loans-to-deposits119 has declined in recent years as banks have made more loans (gross loan figures), and as more accurate accounting of loan quality has developed (net loan figures). This is reflected in loan-to-deposit ratios both before and after accounting for performance. Gross loans relative to deposits have diminished substantially, from 2.6 times deposits in 1998 to about 1.1 times in 2003. In general, since 2000, ratios have been relatively matched. Using “overdues” as a proxy for non-performance, loans have been less than deposits since 2000, but were about 99 percent in late 2003. This positive trend has continued since 2001, and can be interpreted positively in three ways. First, aggregate loans have increased, as have loans relative to GDP. Thus, while low, the trend is favorable. Second, a better accounting of problem loans is leading to a more accurate reporting of how assets are being managed. Third, deposits have increased in recent years. As with lending, deposit levels are low. Nonetheless, the trends are favorable. In terms of deposit safety, it appears that loan-to-deposit ratios are fairly closely matched, and that “safe” liquid assets would more than cover any withdrawals brought on by public knowledge of problem loans.

Table 24: Bank Loans to Enterprises and Households Relative to Deposits (1998-2003)

1998 1999 2000 2001 2002 2003Gross Loans/Total Deposits 256.4% 225.7% 99.9% 109.6% 110.8% 109.8%Non-performing Loans/Total Deposits 49.6% 81.5% 19.1% 26.1% 20.3% 11.0%Net Loans/Total Deposits 206.8% 144.2% 80.8% 83.5% 90.5% 98.8%Notes: Non-performing loans are figures for overdue loansSource: NBA; author’s calculations

5.3 Earnings

5.3.1 Earnings Constraints

Banks’ earnings are constrained for a number of reasons. Although nearly 60 percent of total assets are loans and loan quality has improved in recent years, the actual base of earning assets is small in value. Estimates (in late 2003) of after-tax earnings for the banks in 2003 were about $25 million, a very small amount by global standards. With assets of about $1.1 billion, this is about a 2.35 percent after-tax return. The ratio is not bad, but the total amount of earnings is very low despite what are considered to be reasonable net interest margins. Thus, with regard to interest income, the main source of earnings for banks, there is a question of volume.

119 These figures do not include banks’ investments in government securities, which are assumed to be safe. Rather, these ratios only include loans to enterprises and households. Likewise, on the deposit side, central government deposits placed with the banks and restricted deposits are also excluded from the equations.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Beyond that, there is an issue of non-credit sources of income. Because banks offer very little in the way of non-lending services, other sources of income are limited. There is no real securities market in Azerbaijan.120 This not only reduces potential earnings from securities, but it also makes it almost impossible for banks’ brokerages to make any money. This will change in the future, but for now, there is hardly any income derived from such activities. Beyond that, banks make some money on guarantees and money transfers, but these fees are not high value. There is little money made in foreign exchange trading. Direct payroll is rarely used, if ever. There is virtually no use of banks for custodial services, although this may change in the future as pension funds eventually emerge later in the decade. There are fees from plastic cards and electronic payments/transfers, and these will grow in the coming years. However, for now, there is little income derived from such services.

There is also the issue of costs. While banks are not high in cost, they are also not high in productivity. Many banks appear to have high staffing levels relative to income. For instance, BUS Bank in 2002 only averaged $2,859 in total income per employee and $81,983 per branch. The latter translates into only $328 per day in gross income, and barely more than $1 per day per employee.121 While BUS Bank may be an outlier due to its large branch network (89 branches in total) and inability to lend, most banks are considered to be relatively low in productivity and income generation. This is partly because most banks are manual in their orientations, and there are more support functions than direct marketing functions. Investment in more advanced systems and technologies to introduce new products and augment earnings sources will change this. However, for now, operations are still very manual, even when bank staff have access to computers and modern IT systems. Thus, if banks were more information systems-intensive in their operations, and/or if they deployed their staff more directly in income-generating activities, they would likely have higher earnings from increased income and/or lower costs.

5.3.2 Margins and Spreads

With nominal net spreads approximating 8.37 percent in 2003 and projected earnings of about $25 million, this suggests that banks’ total income approximated $300 million in 2003122 against assets of about $1.1 billion. Spreads have come down in the last few years, pointing to ongoing macroeconomic stability. As the banking system becomes more competitive, it is expected that margins and spreads would further compress in lending activities, providing banks with an incentive and need to increase non-lending services for increased earnings. This will require improved risk management capacity, as there will

120 One of the ironies of the market in Azerbaijan is that stable macroeconomic policies have kept fiscal deficits very low. This has meant the government has less need to issue securities to finance operations, depriving banks of a relatively easy and (often) comparatively safe source of earnings. All together, the banks had about Manat 340 billion in net claims on the central government at end 2002. See “Azerbaijan Republic: Selected Issues and Statistical Appendix”, IMF, April 29, 2003. Based on NBA figures, commercial banks had Manat 44 billion in net claims on the central government at the end of 2003. 121 Figures from 2002 audited statements and notes.122 This would translate into about $6.5 million per bank. MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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also be an incentive to increase lending so that volume can offset some of the decline in net spreads. It will also require investment in new systems and technologies for market research, and credit and portfolio risk management. In this regard, the operational and reputational characteristics of banks will become increasingly important, as will management and board capacity to ensure that operations are properly overseen.

5.4 Liquidity

5.4.1 General Liquidity and Liquidity Management Features

Liquidity is stable on a regulatory basis, although the system as a whole is poorly funded. Banks are required to comply with 10 percent reserve requirements on all deposits of less than one-year term, including foreign currency deposits. As of mid-2003, banks are not permitted to use government securities to meet these requirements. Until then, up to 50 percent of the requirement could be met via investments in government securities. This essentially served as a subsidy to IBA and, to a lesser extent, BUS and AgrarCredit, to generate earnings from securities. Other banks did not participate in the T-bill market, and transactions on the market lack transparency. In the case of BUS, the earnings helped due to their inability from 2000-03 to lend. Thus, BUS had no core earnings source, and basically made its limited profits from money transfers and low margin guarantee business with large state enterprises. In any event, the new policy on reserve requirements eliminates the de facto subsidy, and remuneration on the full 10 percent reserve requirement is now zero.

Meanwhile, from a liquidity management standpoint, banks are under less pressure than from a few years ago. The refinancing rate has been 7 percent since September 2002. Reserve requirements have likewise come down in recent years from 15 percent to the current 10 percent. The payment system has become more efficient in the last few years, reducing the large cash balances banks needed to hold for transactions. Thus, conditions are better in 2003-04 than they were a few years ago. However, most banks are located only in Baku and do not have extensive branch networks. Funding is low. Investment opportunities are limited. All of this detracts from efficient liquidity management.

5.4.2 Liquidity and Risk Indicators

The banks’ loan-to-deposit ratio was about 1:1 at the end of 2003. Key liquidity measures indicate that net liquid assets (net position in domestic inter-bank market, net position overseas, net position with NBA plus vault cash) approximated 60 percent of deposits.123

This suggests the banks were sufficiently liquid in 2003, partly due to the perceived absence of sound lending opportunities relative to risk. Meanwhile, gross securities were valued at 14 percent of total deposits,124 providing additional cushion in the event of banks facing major deposit withdrawals. However, given that most people and enterprises bypass the banks in the first place, this is not considered to be much of a risk.

123 NBA figures for year-end 2003 put net liquid assets at Manat 1,825 billion, and deposits at 3,053 billion.124 NBA figures for year-end 2003 put gross securities at Manat 419 billion, and deposits at 3,053 billion.MICHAEL BORISH AND COMPANY, INC.USAID BANKING SECTOR ASSESSMENT—AZERBAIJAN

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Only major withdrawals from IBA, with 63 percent of total deposits, would remotely constitute any semblance of market and reputational risk to the system as a whole. BUS Bank has 5 percent of the deposit market, and Bank Standard has nearly that amount. Thus, these three banks account for nearly three quarters of deposits. However, the risk of a panic run is limited. IBA has access to unused lines of credit, and the government or NBA would likely intervene if it appeared that its flagship state bank was in trouble. IBA was already recapitalized once before (1994), as was BUS Bank. Once privatized, the possibility of government or NBA intervention may be less. But the expectation is that privatization will also lead to any additional liquidity management capacity that needs to be introduced to mitigate this risk. With BUS Bank, its financial condition is stagnant and it has already taken its hit in recent years as deposits have declined. Depending on how privatization unfolds in 2004-05, BUS Bank should not pose much in the way of any systemic risk. However, any additional problems that would come to light would make it harder for the system to restore confidence as a whole. In the case of Bank Standard, there is risk in terms of its portfolio and possible low earnings (or losses) in 2003. Its deposits are primarily time deposits held by individuals, so there is an issue here. Any problems with this bank would make it more difficult to restore confidence in banks as a whole.

Under crisis conditions, net liquid assets plus a discount (haircut) of 25 percent on securities values would bring banks’ coverage of deposits to 70 percent. Likewise, withdrawals of 50 percent of total deposits, an extremely unlikely prospect, would still leave banks with a positive net liquid asset position.

5.5 Sensitivity to Credit and Market Risk

There is limited market risk in the Azerbaijan banking system. In one sense, this reflects the stable macroeconomic fundamentals of the country, including the managed float and relative exchange rate stability. Interest rates have gradually come down, the exchange rate has not fluctuated wildly against major international currencies, most exposures are short-term (up to one year), and the outlook for continued strong earnings from the energy sector remain favorable. Thus, there is little risk of major maturity, interest rate, or exchange rate mismatches (although there is an opportunity cost to banks for issuing dollar-denominated loans or making dollar investments given its slide in the last year).

Likewise, for the economy, there is little risk of bank failure having an impact. The only major bank is IBA, with assets equivalent to about 7.5 percent of GDP. Unless there has been non-disclosure of major investments, exposures, transactions or other risks, there is no risk of IBA failing and creating a broader problem for the economy. While IBA needs strengthening and higher capital, it has received a reasonable rating (2002), external audits have confirmed a reasonably stable institution, and the risk of failure appears to be very low. Meanwhile, the total banking system is only 15 percent of GDP in terms of assets-to-GDP. Loans are only 9.6 percent of GDP, and household deposits are only 3.6 percent of GDP. The failure of any institution may have an effect on public confidence, but no bank failure apart from IBA would have any material impact on the economy based on available information.


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There may be an opportunity cost at the moment for having a dollarized economy, as the dollar is likely to remain weak against the Euro and other hard currencies for the foreseeable future. However, the overall macroeconomic approach of the last several years has focused on and achieved underlying stability. The following summarizes key risks:

Box 4: Synopsis of Credit and Market Risks in the Azerbaijan Banking SystemCredit risk At least 60 percent of loans are to households, commercial trade and transport.

Therefore, banks appear to be somewhat diversified in relatively quick turnover businesses. Few banks are lending to the industrial sector. There is reported to be little exposure (about 13 percent) to the oil and gas sector, which means that banks are not particularly vulnerable to any pricing risk in commodity markets (except possibly IBA). Loan loss reserves are about 20 percent of total loans, which is fairly high. Overdues are about 10 percent. Credit risk is high, which is one of the reasons why banks have been reluctant to lend. Credit risk will also increase as the market becomes more competitive. However, improvements in the institutional framework (e.g., improved legal/judicial framework, secured transactions framework, better information) will help to mitigate these risks. Moreover, as the system opens up to competition, banks will be required to develop better systems of credit management as part of a larger effort to develop sound underwriting standards and adequate risk management capacity.

Interest rate risk

Interest rate risk is relatively low due to the stable monetary policy implemented in the post-hyperinflationary period. While there is criticism by SMEs that interest rates on loans are high, nominal rates have come down in recent years, and the inflation rate has been low. The short-term maturities of loans and deposits make interest rate management feasible for lenders and borrowers. However, if there is an increase in term lending by the banks (as needed for investment in the SME sector), this may introduce some interest rate risk.

Exchange rate risk

With about two thirds of loans in foreign currency (mainly dollars), any major shift in exchange rates could be destabilizing. However, banks actually had a $58 million surplus of foreign currency deposits compared with assets, and a sudden depreciation of the manat would trigger a rush to dollars, not local currency. The exchange rate has been fairly stable as a managed float regime. There is no evidence that such a policy will change. Likewise, reserves are strong, and earnings from the energy sector are projected to remain strong. Professional management of SOFAR funds and consolidation of this fund into the consolidated budgeting process should help with overall reserve and debt management as well as implementation of monetary and fiscal policy. Most international transactions are settled in dollars, and the Manat is not expected to fluctuate too much in value relative to the dollar.


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Maturity risk About three quarters of loans are short-term, and deposits are primarily demand deposits (52 percent). Banks are reported to follow fairly conservative matching strategies, although more developed asset-liability management practices are recommended. NBA plans to work with the banks in this regard. Over time, banks would be expected to develop modern treasury management practices, not only for liquidity management, but also to help develop more efficient portfolio management strategies. However, under current circumstances, there are few long-term instruments available. As such, banks themselves have kept maturities relatively short on most loans. (On the other hand, many enterprises and individuals have benefited from rollovers, which have effectively meant that short-term loans became long-term loans. In some of these cases, the long-term status of the loans resulted from inability to meet payment requirements.)

Pricing risk Given the short-term maturities that prevail, there is limited pricing risk. Variable pricing can be employed for longer-term loans. Where pricing risk is an issue (indirectly) is with regard to credit risk and exposures of banks in areas where prices on commodities may fluctuate. In general, the economy is vulnerable to such risk if the price of oil and gas were to decline dramatically.

Operational risk

Back office operations, information systems, and internal controls are all considered fairly weak and underdeveloped by global standards. There have been improvements, largely triggered by regulatory pressures and prudential requirements. However, some of the private banks also recognize the benefits of operational efficiency, and the need for a sound reputation to attract investment, deposits and borrowings, as well as to maintain correspondent banking relationships. This is also a critical issue in implementing systems to identify money laundering and fraud, and other financial crimes.

Reputational risk

As with operational risk, reputational risk in the market has an impact on correspondent banking relationships, risk premium of international borrowings, ability to attract investment, etc. Ensuring a reputation of safety and stability will be necessary if Azerbaijan is to diversify and develop its economy successfully. For this reason, low levels of capital and large numbers of small banks detracts from Azerbaijan’s overall banking sector reputation. Likewise, delays in privatization, weak corporate governance, slow movement to IAS, the absence of consolidated accounting, and a poor reputation on judicial matters and corruption have diminished Azerbaijan’s overall banking sector reputation. Successful implementation of policy reforms will be needed to correct this. Improvements in back office operations to prevent criminal activity will also be needed for a sound reputation to emerge.


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5.6 Country Risk

There is no current sovereign debt rating for Azerbaijan to use as a proxy for country risk (as well as a proxy for local currency risk). Fitch IBCA apparently rated Azerbaijan sub-investment grade in 2001-02 (BB-/Ba3), which put it roughly on par with Romania and Russia, but below Kazakhstan (see below for ratings as of December 2002 from major rating agencies).

Table 25: Peer Country RatingsStandard and Poors Fitch-IBCA Moody’s

Kazakhstan BB BB+ Baa3Romania B+ BB- n/aRussia BB- BB- B1Source: EIU data as published in “Transition”, World Bank, January-March 2003

Another proxy could be the EIU sovereign debt score. In this regard, Azerbaijan’s score was also comparable (at 50) to that of Kazakhstan, Romania and Russia. Azerbaijan’s rating of 50 was better than Macedonia, Moldova, Serbia and Montenegro, Ukraine and Uzbekistan (all between 55 and 75), but worse than countries acceding to the EU in 2004 (all generally from 25 to 40 if they received a rating).

The country risk associated with Azerbaijan appears to be structural and political, the former due to the slow reform of the financial and enterprise sectors, judiciary, and public administration. Political risk is primarily that the unresolved conflict in Nagorno-Karabakh would resume, that a macroeconomic downturn would create a reaction due to a worsening of poverty (more people affected, and those currently affected becoming more deeply affected), and that resentment towards corruption, patronage and other characteristics of public administration would spill over. There have been complaints from some human rights groups that prisoners’ rights and press freedoms are sometimes infringed on. However, in general, the government appears to be moving to reduce prospects for political risk. Anti-corruption legislation has been adopted, although there are reported doubts about capacity for implementation. The macroeconomic framework remains sound on the condition that oil and gas prices do not radically plummet. While relations with Armenia remain tense, there are ongoing efforts through the Minsk Group of the OSCE to mediate the dispute. Thus, while far from ideal, the country risk associated with Azerbaijan is largely related to weaknesses that have been identified by all parties concerned. Country risk can be overcome if there is progress with policy reforms at the structural level. However, if Azerbaijan is slow to reduce corruption, reform the judiciary, improve corporate governance, and open up the economy to greater competition and investment outside the energy sector, then perceived country risk will remain high.


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ANNEX 6: COMPARATIVE INDICATORS WITH THE NEWLY INDEPENDENT STATES (NIS)

► Financial Intermediation: Broad Money to GDP NIS Trends: Financial intermediation rates have typically been low in the CIS countries, particularly since the collapse of the ruble in the very early stages of the transition. Over time, some progress has been made, most notably since 1998 (following the most recent ruble crisis in Russia) with more stable macroeconomic policies and significant price rises (and volume increases in output) of oil, gas and other commodities. In some cases, overall levels of broad money have increased on the basis of merchandise exports and the return of the some of the previous capital flight that occurred. In other cases, there has been substantial foreign direct investment. The former applies to Russia and, to some extent, Ukraine. The latter applies to Kazakhstan. Azerbaijan’s Position Within the NIS: Compared with NIS norms, Azerbaijan’s levels of intermediation are low compared to Moldova, Ukraine and Russia, but otherwise average for the other NIS economies.

1998 1999 2000 2001 2002Armenia 10.05% 11.09% 14.69% 13.45% 15.61%Azerbaijan 11.41% 11.93% 17.52% 12.92% 13.01%Belarus 32.80% 17.49% 17.68% 14.90% 15.43%Georgia 7.59% 8.11% 10.32% 11.09% 11.925Kazakhstan 8.57% 13.58% 15.29% 14.58% 19.32%Kyrgyz 14.49% 13.58% 11.32% 11.14% 14.65%Moldova 19.34% 20.41% 22.35% 25.51% 30.52%Russia 22.93% 20.70% 22.09% 23.48% 26.78%Tajikistan 7.08% 6.72% 8.17% 7.93% 8.37%Turkmenistan 14.90% 14.90% 20.30% 17.60% 16.60%Ukraine 15.16% 17.20% 18.06% 22.38% 30.21%Uzbekistan 15.40% 13.60% 12.20% 12.60% 10.60%Sources: calculations from IMF data; EBRD


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► Banking Penetration: Bank Assets to GDPNIS Trends: Banking penetration, as measured by bank assets to GDP, has been comparatively low. This is true when compared to most non-NIS transition countries, as well as many other middle-income and OECD countries. Most countries are showing gradual increases in banking penetration, with Russia, Moldova and Kazakhstan being the highest among the NIS. Kazakhstan and, to a lesser extent, Ukraine have shown the greatest increases in recent years. Azerbaijan’s Position Within the NIS: Compared with NIS norms, Azerbaijan’s level of banking penetration is low, higher than only the Kyrgyz Republic among countries for which data are available. In the case of Azerbaijan (and other NIS economies), most financing occurs outside the banking system.

1998 1999 2000 2001 2002Armenia 13.28% 15.27% 18.60% 15.90% 16.22%Azerbaijan 17.32% 17.20% 21.02% 12.74% 12.87%Belarus 48.80% 24.41% 24.18% 21.18% 21.66%Georgia 7.61% 8.92% 10.54% 11.93% 13.78%Kazakhstan 9.77% 15.00% 18.38% 24.82% 29.90%Kyrgyz 9.48% 8.67% 7.07% 7.01% 10.42%Moldova 23.56% 23.70% 25.02% 27.34% 31.82%Russia 34.04% 32.58% 31.99% 32.70% 35.62%Tajikistan 12.66% 11.77% 15.72% 16.66% 15.45%Ukraine 15.19% 16.64% 18.01% 20.09% 25.91%Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF data


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► Total Bank AssetsNIS Trends: Total banking assets are small in virtually all NIS countries apart from Russia. In 2002, Russia’s banking system assets approximated $119 billion. Nine other NIS economies’ banking system assets totaled $23 billion. Thus, among the 10 countries for which usable data are available, Russia accounted for 84 percent of the NIS total. Ukraine, Kazakhstan and Belarus accounted for most of the balance ($20.5 billion). Thus, six of the 10 NIS countries assets were less than $1 billion. Azerbaijan’s Position Within the NIS: Azerbaijan reached the $1 billion threshold in 2003. However, even that figure is well below 1 percent of the NIS total.(millions, $) 1998 1999 2000 2001 2002Armenia $243 $288 $348 $333 $376Azerbaijan $720 $730 $1,010 $710 $796Belarus $3,049 $2,205 $1,870 $2,306 $2,877Georgia $206 $255 $322 $385 $481Kazakhstan $2,020 $2,189 $3,302 $5,175 $7,246Kyrgyz $110 $93 $96 $108 $170Moldova $258 $252 $323 $397 $507Russia $45,185 $57,406 $80,233 $98,077 $119,028Tajikistan $133 $110 $129 $164 $172Ukraine $4,548 $4,056 $5,799 $7,655 $10,344Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF data


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► Average Bank AssetsNIS Trends: The average size of banks in the NIS is small, with only Kazakhstan and Russia averaging more than $100 million in assets per bank. In the case of Russia, this was only achieved in 2003. Prior to that, Russian bank assets were less than $100 million average. However, its top 20 or so banks have far more in assets on the average. What characterizes Russia’s system, like much of the NIS, is the continued existence of very small “pocket” banks, which generally have little more than $10 million in assets, and often less. Most NIS countries’ banks average less than $25 million, about the average for Azerbaijan in 2003. Azerbaijan’s Position Within the NIS: Azerbaijan’s banks are average for the smallest countries of the NIS. Netting out IBA from the system, the average bank in Azerbaijan would have about $10 million in assets (2003 figures). This would put the average bank in Azerbaijan on par with Armenia and Tajikistan, and larger only than banks in the Kyrgyz Republic (among the countries for which data are available). (millions, $) 1998 1999 2000 2001 2002Armenia $8 $9 $11 $11 $13Azerbaijan $9 $10 $17 $13 $17Belarus $82 $61 $60 $80 $99Georgia $5 $7 $11 $14 $18Kazakhstan $28 $40 $69 $118 $165Kyrgyz $5 $4 $4 $5 $9Moldova $11 $13 $16 $21 $27Russia $31 $43 $61 $74 $90Tajikistan $7 $6 $8 $10 $10Ukraine $26 $25 $38 $50 $68Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF data; EBRD


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► Total Bank Loans (to Enterprises and Households)NIS Trends: As with total bank assets, the bulk of loan exposure in the NIS is to from Russian banks to enterprises and, to some degree, households. Russia’s bank loans were more than $60 billion at the end of 2002, equivalent to about 79 percent of total lending. Ukraine, Kazakhstan and Belarus accounted for another $15 billion, or 19.5 percent of total. Thus, the remaining six NIS countries for which usable data are available accounted for only $1.4 billion in total loans, less than 2 percent of the relatively low NIS total. Thus, these six countries (as well as Turkmenistan and, likely, Uzbekistan) face major challenges in positioning banks to lend to enterprises and households as a basis for economic growth. Azerbaijan’s Position Within the NIS: Among the lower six NIS countries, Azerbaijan’s bank provide more loans to enterprises. As of 2002, this figure approximated $436 million, and in late 2003, the figure was about $556 million. However, the total as of 2002 was less than 0.6 percent of the NIS total. (millions, $) 1998 1999 2000 2001 2002Armenia $157 $173 $198 $173 $168Azerbaijan $563 $521 $485 $382 $436Belarus $1,864 $1,411 $1,256 $1,612 $2,123Georgia $133 $176 $226 $253 $307Kazakhstan $1,254 $1,132 $2,025 $3,638 $4,752Kyrgyz $61 $54 $55 $58 $67Moldova $172 $141 $184 $237 $303Russia $18,708 $21,541 $33,936 $49,459 $60,636Tajikistan $118 $99 $111 $141 $152Turkmenistan $885 $1,194 n/a n/a n/aUkraine $2,770 $2,481 $3,855 $5,569 $8,162Notes: data apply to bank loans to state-owned and private enterprises, households, and non-bank financial institutions, but do not include loans to or investment in government securities; data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Average Loans Outstanding per BankNIS Trends: The average NIS bank generally had no more than $10 million in outstanding loans at the end of 2002. Banks in Kazakhstan, Russia, Belarus and Ukraine were larger, ranging from $54 million in Ukraine to as high as $108 million in Kazakhstan. By global standards, these are small averages. However, Kazakhstan has shown significant growth since 2000, and it is slated to close the gap sooner than other banks in the region unless banking systems undergo consolidation. Current plans in Russia to tighten up on banks’ licensing requirements by harmonizing such practices with participation in the explicit deposit insurance scheme may trigger consolidation in the coming years. If so, averages in Russia should increase as well. A similar trend may unfold in Ukraine. However, the other banks throughout the NIS tend to be very small, and consequently have very small loan portfolios.Azerbaijan’s Position Within the NIS: Azerbaijan’s banks are small, and not much larger on average in loan exposure than their counterparts in Armenia, Georgia, the Kyrgyz Republic, Moldova, and Tajikistan. This is particularly true when taking IBA’s role into account. Netting out IBA, the average bank’s outstanding loans in late 2003 approximated $6 million. This figure is similar to averages in the lower six NIS countries. (millions, $) 1998 1999 2000 2001 2002Armenia $5 $5 $6 $6 $6Azerbaijan $7 $7 $8 $7 $9Belarus $50 $39 $41 $56 $73Georgia $3 $5 $8 $9 $11Kazakhstan $18 $21 $42 $83 $108Kyrgyz $3 $2 $3 $3 $3Moldova $7 $7 $9 $12 $16Russia $13 $16 $26 $37 $46Tajikistan $6 $5 $7 $8 $9Turkmenistan $68 $92 n/a n/a n/aUkraine $16 $15 $25 $37 $54Notes: data apply to bank loans to state-owned and private enterprises, households, and non-bank financial institutions, but do not include loans to or investment in government securities; data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Bank Loans to GDPNIS Trends: Consistent with the relatively low loan figures noted above, NIS banks rarely show bank loans exceeding 20 percent of GDP. The better performers are in double digits, and the lesser performers are not.Azerbaijan’s Position Within the NIS: Azerbaijan’s banks’ loans outstanding were only about 7 percent of GDP in 2002 and 8 percent in 2003. This places Azerbaijan in the lowest cohort among NIS countries, and higher only than the Kyrgyz Republic. The declining ratio in Azerbaijan partly reflects the write-off of bad loans from the troubled state banks in 2000, as well as GDP growth resulting from investment in and output from the oil and gas sector.

1998 1999 2000 2001 2002Armenia 8.60% 9.17% 10.61% 8.27% 7.22%Azerbaijan 13.53% 12.28% 10.08% 6.86% 7.04%Belarus 29.82% 15.62% 16.23% 14.81% 15.98%Georgia 4.93% 6.16% 7.41% 7.83% 8.80%Kazakhstan 6.06% 7.76% 11.27% 17.45% 19.60%Kyrgyz 5.28% 5.02% 4.10% 3.76% 4.12%Moldova 15.71% 13.26% 14.30% 16.32% 19.02%Russia 14.09% 12.23% 13.53% 16.49% 18.15%Tajikistan 11.29% 10.57% 13.56% 14.31% 13.64%Turkmenistan 51.54% 56.99% n/a n/a n/aUkraine 9.25% 10.18% 11.97% 14.61% 20.44%Notes: data apply to bank loans to state-owned and private enterprises, households, and non-bank financial institutions, but do not include loans to or investment in government securities; data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Total Bank DepositsNIS Trends: NIS deposits are highly concentrated in Russian banks, where deposit totals approximated $65 billion, or 82.5 percent of total. Russia’ performance has improved significantly in recent years, and deposits as of end 2002 were more than three times levels recorded shortly after the ruble crisis in 1998. Apart from Russia, Ukraine has also shown improvement after the government debt crisis of 1998-99. Ukraine, Kazakhstan and Belarus accounted for an additional $12 billion in deposits at the end of 2002, or 16 percent of the NIS total. The remaining six countries had about $1.3 billion in deposits, or less than 2 percent of the NIS total. Azerbaijan’s Position Within the NIS: Azerbaijan’s deposits are the highest among the lower six NIS countries. At $461 million at the end of 2002, this approximated 0.6 percent of total NIS deposits. The late 2003 figure approximated $572 million, a sizeable increase from 2002 levels, but still only about 0.7 percent of the NIS total. Outside of IBA, deposits in Azerbaijan’s banks are negligible.(millions, $) 1998 1999 2000 2001 2002Armenia $104 $127 $167 $165 $210Azerbaijan $222 $238 $546 $411 $461Belarus $1,780 $1,289 $1,156 $1,297 $1,711Georgia $87 $105 $156 $188 $229Kazakhstan $946 $1,215 $1,981 $2,815 $3,630Kyrgyz $72 $67 $68 $67 $90Moldova $150 $164 $235 $293 $232Russia $20,991 $26,156 $39,903 $50,284 $64,516Tajikistan $23 $19 $27 $34 $45Turkmenistan $72 $164 n/a n/a n/aUkraine $2,435 $2,349 $3,448 $4,828 $7,059Notes: data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Average Bank DepositsNIS Trends: The average bank in the NIS countries has only a small funding base, characterized by low levels of deposits, limited capital, and limited access to borrowings. Apart from Kazakhstan, Russia and Belarus, most banks do not have more than $50 million in deposits. In many cases, the average bank has less than $10 million in deposits. With reserve requirements and other prudential limitations, this reduces the quantum of available resources for lending or investment.Azerbaijan’s Position Within the NIS: Azerbaijan’s banks are characteristic of the smaller NIS banking markets. Late 2003 figures indicate that the average bank in Azerbaijan had about $12 million in deposits, a substantial increase from 2002, but still small on average.(millions, $) 1998 1999 2000 2001 2002Armenia $3 $4 $5 $6 $7Azerbaijan $3 $3 $9 $8 $10Belarus $48 $36 $37 $45 $59Georgia $2 $3 $5 $7 $9Kazakhstan $13 $22 $41 $64 $83Kyrgyz $3 $3 $3 $3 $5Moldova $7 $8 $12 $15 $12Russia $14 $19 $30 $38 $49Tajikistan $1 $1 $2 $2 $3Turkmenistan $6 $13 n/a n/a n/aUkraine $14 $15 $22 $32 $46Notes: data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Per Capita DepositsNIS Trends: When including enterprise deposits in the banks, per capita deposits are relatively small in all the NIS countries. The highest is Russia, at $447 per capita in 2002. This was nearly double figures in Kazakhstan, where growth has been substantial since 2000, but where levels are still fairly low. Apart from these two countries, only Belarus and Ukraine had per capita deposits above $100. In some cases, averages are below $20 per person (in Tajikistan and the Kyrgyz Republic). Azerbaijan’s Position Within the NIS: Azerbaijan’s per capita deposits were $70 in late 2003 and $59 in 2002. However, most deposits are placed by enterprises. Late 2003 figures suggest that per capita household deposits were only about $25. This is likely true as well in most of the other NIS countries. Azerbaijan, like Kazakhstan and some of the other resource-exporting countries, have attracted significant investment into the economy. Some of that has culminated in rising enterprise deposits with the banks. (actual $) 1998 1999 2000 2001 2002Armenia $27 $33 $44 $48 $70Azerbaijan $28 $30 $68 $51 $59Belarus $176 $129 $116 $130 $171Georgia $16 $19 $29 $36 $42Kazakhstan $63 $81 $133 $190 $252Kyrgyz $15 $14 $14 $14 $19Moldova $35 $38 $55 $68 $54Russia $143 $179 $274 $348 $447Tajikistan $4 $3 $4 $5 $7Turkmenistan $15 $34 n/a n/a n/aUkraine $48 $47 $70 $98 $145Notes: data apply to total deposits divided by total population, and thus are not the same as household deposits per capita, which would be far less in countries where enterprises deposits account for the majority of deposits; data not available for Turkmenistan after 1999, or for Uzbekistan in generalSources: calculations from IMF data; EBRD


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► Total Bank CapitalNIS Trends: Bank capital is low in virtually all NIS countries. Russian banks account for more than $20 billion in capital, or 83 percent of the NIS total. Kazakhstan and Ukraine have about $3 billion (2002 figures), or 13 percent. Thus, the other seven countries have only 4.5 percent of banking system capital, and Belarus accounts for more than half of this. Thus, the lower cohort of NIS banks is exceedingly small in terms of capital. Azerbaijan’s Position Within the NIS: Azerbaijan had about $152 million in bank capital (after accounting for other items on a net basis) in 2002, and even less in late 2003 at about $142 million. While higher than the smallest of the small (i.e., Armenia, Kyrgyz Republic, Tajikistan), Azerbaijan’s level of bank capital is insufficient for modern banking. This is a problem that affects most NIS banking systems. This problem is now only being corrected in a few of the countries (i.e., Russia, Kazakhstan, Ukraine), all comparatively large in terms of GDP and population. The smaller countries (including Azerbaijan) face major difficulties in boosting bank capital to satisfactory levels, partly due to the limitations of their individual markets. (millions, $) 1998 1999 2000 2001 2002Armenia $30 $36 $27 $24 $26Azerbaijan $261 $267 $184 $141 $152Belarus $325 $493 $377 $450 $633Georgia $69 $94 $100 $111 $124Kazakhstan $492 $598 $794 $1,099 $1,333Kyrgyz $17 $9 $11 $24 $29Moldova $45 $71 $90 $92 $88Russia $6,682 $10,179 $14,737 $17,613 $20,044Tajikistan $17 $16 $12 $12 $22Ukraine $1,022 $916 $1,225 $1,566 $1,801Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF data; EBRD


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► Average Bank CapitalNIS Trends: Average bank capital is microscopic in most NIS countries, and small in all of the countries. Even in Kazakhstan where the highest average is, banks have $30 million in capital. This is low when compared with EU accession countries, let alone middle-income and OECD countries. Kazakhstan’s trends have been favorable, and potential consolidation in Russia and Ukraine may also lead to increases in bank capital in the coming years. However, most NIS banks have capital of less than $5 million, making it virtually impossible to provide the cushion needed for aggressive risk-taking, let alone investing in the systems needed for modern financial services. The small pool of earning assets is partly related to the small average capital. Adverse selection and other hazardous positions taken by banks over the last decade have also been a cause as well as reflection of weak capital positions. In either case, weak earnings, low levels of retained earnings, and weak investment levels into the NIS banking system have also constrained capital growth. In general, most “banks” are really not banks, and should not be licensed to operate as banks. Their low levels of capital make them potentially harmful to public confidence, and their participation in foreign exchange markets and payment systems can make them vehicles of financial crime. Azerbaijan’s Position Within the NIS: Azerbaijan’s banks are small, with about $3 million in capital on average. This has not changed much over the years, and is inadequate. Even raising the minimum regulatory capital requirement to $5 million by 2005 will be a challenge for many banks, notwithstanding how low this level of capital is. (millions, $) 1998 1999 2000 2001 2002Armenia $1 $1 $1 $1 $1Azerbaijan $3 $4 $3 $3 $3Belarus $9 $14 $12 $16 $22Georgia $2 $3 $3 $4 $5Kazakhstan $7 $11 $17 $25 $30Kyrgyz $1 $0 $0 $1 $1Moldova $2 $4 $4 $5 $5Russia $5 $8 $11 $13 $15Tajikistan $1 $1 $1 $1 $1Ukraine $6 $6 $8 $10 $12Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF data; EBRD


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► Non-Performing Loans to Net Bank CapitalNIS Trends: Non-performing loans have traditionally been fairly high as a percentage of net capital in the NIS banking system. Recent tightening of prudential norms and supervision has brought these ratios down in recent years in most countries. NPLs are not currently thought to be too high relative to capital, generally being less than half in most NIS countries and about a third of net capital (or less) in many. Only Tajikistan and, to a lesser extent, Ukraine, appear to have a fairly significant burden imposed by NPLs. However, there are concerns in some countries that a downturn in commodity markets (e.g., oil, gas) would not only hurt some banking systems directly, but would affect countries that have become increasingly dependent on exports to Russia. For example, a downturn in commodity prices could dampen Russian demand for Ukrainian products, leaving banks there exposed to companies whose cash flow may significantly decline if the Russian market compresses.Azerbaijan’s Position Within the NIS: Azerbaijan’s overdue loans were only about 11 percent of total loans at the end of 2003. Banks had about 20 percent of total loans reserved for loan losses. As a percentage of capital this was about 77 percent of total in late 2003, a fairly sizeable share. NPLs have fluctuated in recent years as a share of capital. In general, banks in Azerbaijan require better credit risk management, and higher capital. Its asset quality position within NIS is fairly weak.

1998 1999 2000 2001Armenia 54.46% 20.72% 46.38% 42.70%Azerbaijan 42.31% 72.57% 56.50% 76.20%Belarus 94.47% 37.52% 50.56% 42.61%Georgia 12.58% 9.15% 16.34% 19.44%Kazakhstan 11.98% 10.42% 5.36% 6.95%Kyrgyz 0.71% 36.35% 84.98% 34.07%Moldova 123.26% 58.06% 42.43% 25.63%Russia 86.51% 54.60% 35.23% 33.98%Tajikistan 21.65% 100.68% 96.22% 146.38%Ukraine 93.81% 92.66% 102.32% 87.50%Notes: data not available for Turkmenistan or UzbekistanSources: calculations from IMF, EBRD and NBA data


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► Net Interest Spreads less Inflation RatesNIS Trends: Most NIS banking systems appear to charge high nominal rates for loans. However, when comparing loan rates with deposit rates on comparable maturities, and then factoring in inflation rates, about half of NIS banking systems receive negative real rates. This includes the largest banking markets in the NIS economies, including Russia, Kazakhstan, Ukraine and Belarus. Azerbaijan’s Position Within the NIS: Azerbaijan’s net bank spreads have been positive in real terms for many years, and have declined since 2000 in an environment of low inflation rates. In theory, this should be indicative of positive competitive trends. However, the limited competition in the banking system combined with overall low levels of lending mean that earnings are low, and the benefits of lower margins are having limited impact (e.g., reduced borrowing costs) on the real sector.

1998 1999 2000 2001 2002Armenia 14.88% -6.39% 4.83% 1.61% 10.42%Azerbaijan n/a 15.99% 4.96% 9.75% 5.91%Belarus -60.19% -266.48% -138.52% -48.30% -32.50%Georgia 25.43% -0.28% 18.48% 14.82% 16.46%Kazakhstan -7.13% -8.33% -13.17% -8.34% -5.89%Kyrgyz 27.14% -10.60% 14.81% 17.87% 16.77%Moldova 2.51% -37.94% -22.38% -2.02% 4.20%Russia -2.93% -59.64% -2.83% -8.43% -5.04%Tajikistan -2.13% -6.60% -8.57% -22.74% -7.21%Turkmenistan 17.60% -9.50% 3.00% -11.60% -10.60%Ukraine 21.67% 11.57% -0.39% 9.29% 16.62%Uzbekistan -9.00% -9.90% -21.10% -22.80% -27.60%Sources: calculations from IMF, World Bank and EBRD data


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ANNEX 7: BIBLIOGRAPHY

“Auditors’ Report and Financial Statements at 31 December 2002”, BUS Bank

“Auditors’ Report and Financial Statements at 30 June 2003”, IBA Bank

“Azerbaijan: GDP Per Capita Exceeded $850”, AzerPress News, January 5, 2004

“Azerbaijan: World Bank Considers Connection Between Banks and SME Progress in the Format of FSAP”, AzerPress News, December 4, 2003

“Azerbaijan Republic: Recent Economic Developments and Selected Issues,” IMF Staff Country Report No. 00/121, September 2000

“Azerbaijan Republic: Article IV Consultation”, IMF, June 2003

“Azerbaijan to Lift Restrictions on Foreign Participation in Banks”, Azerbaijan Oil & Gas Press Review, December 4, 2003

Banking and Business”, 2002----------------------------, May 2003

“Banking System Report: Azerbaijan”, Thomson Financial Bankwatch, June 15, 2000

“Bridging the ‘Great Divide’”, Finance & Development, December 2003

Bülleten, NBA, September 2003------------------, October 2003------------------, November 2003

“Business Guide to Azerbaijan”, Ernst & Young, 2003

“Commercial Legal and Institutional Reform, Phase II,” Booz Allen Hamilton, 2002

“Country Assistance Strategy”, IBRD, April 29, 2003

“Directory of Banks”, Azerbaijan Bankers Association, 2003

“Economic Trends: Azerbaijan”, EU-TACIS, July-September 2000

“Evaluation of Micro & SME Credit Activities in Azerbaijan”, MSI, August 2003

“GDP Per Capita Makes Up $917.1”, Trend – Daily News, December 15, 2003

“Global Financial Stability Report”, IMF, September 2003


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“IMF Completes Third Review Under Poverty Reduction and Growth Facility Arrangement with the Azerbaijan Republic”, IMF Press Release, December 19, 2003

“Index of Economic Freedom”, Heritage Foundation, 2003

International Financial Statistics, International Monetary Fund, (various dates)

“Investment Climate Statement—2003”, US Department of Commerce

“Oil & Gas Guide to Azerbaijan”, Ernst & Young, 2003

“OECD Principles of Corporate Governance”, OECD, 1999

“Private Sector’s Share of Azeri GDP to Grow”, Novecon Press Digest, December 18, 2003

“Selected Issues and Statistical Appendix”, IMF, April 29, 2003

Siegelbaum, P., Sherif, K., Borish, M., and Clarke, G., “Structural Adjustment in the Transition: Case Studies from Albania, Azerbaijan, Kyrgyz Republic and Moldova”, World Bank, 2002.

“Taxing the added values”, CBN Extra, January 14, 2004

“The Bill on Banks is Submitted to Parliament”, AzerPress News, December 11, 2003

“The Transition in Azerbaijan”, USAID/E&E/PO, November 2003

Transition, World Bank, October 1999-----------------------------, January-March 2003

“Transition report”, EBRD, 1999--------------------------------, 2002--------------------------------, 2003

“Transition report update”, EBRD, May 2003

“World Development Report”, World Bank, 1994

World insurance in 2002”, Swiss Re, No. 8/2003.

www.economy.gov.az

www.fitchibca.com


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www.nba.az

www.transparency.org

www.upu.int.


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http://www.transparency.org/

http://www.nba.az/

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ANNEX 8: LIST OF MEETINGS

Elchin Ahmadov, Deputy Project Manager for Leasing, IFC

Adil Aliev, Deputy Chief of Legislation and Legal Propagation, Ministry of Justice

Matanat Aliyev, BUS Bank

Rufat Aslanov, Director of Banking Supervision, National Bank of Azerbaijan

Elizbar Azimov, Chief of Economic Information Division, National Bank of Azerbaijan

Saida Bagirova, Country Representative for External Affairs, World Bank

Banking Supervision Department staff, National Bank of Azerbaijan

George Brittain, IAS Team Leader, EU TACIS

Raymond Conway, Head of Office, EBRD

David Eizenberg, Deputy Resident Representative, UNDP

Michael Gerlich, Leasing Project Manager, IFC

Adrian Golliff, IAS Deputy Team Leader, EU TACIS

Edward Guerrero, Director, Shorebank Overseas Azerbaijan

Faig Huseynov, Chairman of the Executive Board, Uni Bank

Namik Kasumov, Deputy Director, Azerbaijan Bankers Training Center

Beybala Khankishiyev, Chief of Analytical Department, Ministry of Finance

Thomas Langley, Principal Banker, EBRD

Eldaniz Mamedov, Deputy Chairman, Azerbaijan Bankers Association

Mahyaddin Mammadov, Head of Accounting and Finance Department, BUS Bank

Zakir Nuriyev, Chairman, Azerbaijan Bankers Association

John Porter, Chief of Party, ABA-CEELI

Mehman Rzayev, Chief of Privatization Department, Ministry of Economic Development


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Rauf Rzayev, First Deputy Chairman of the Board, International Bank of Azerbaijan

Terry Stroud, Chief of Party, BankWorld

Joerg Teumer, Bank Adviser to German-Azerbaijan Fund, Savings Banks Foundation for International Cooperation

Ilgar Veliyev, Senior Manager, Ernst & Young

Basil Zavoico, Resident Representative, International Monetary Fund

Zakir Zeynalov, BUS Bank


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assessment of azerbaijan banking system.doc

Documents

banking sector of azerbaijan

banking system annex

azerbaijan banking system

banking systems

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