Following two crisis-ridden years that wrecked havoc among Azerbaijani lenders, the country's banks are still far from being out of the woods. Quite the opposite. According to a report issued by ratings agency Fitch on February 24, the sector continues to be the Achilles heel of the Azerbaijani economy and has an unenviable viability rating of 'ccc'.

Banks still face uncertainty related to the unstable exchange rate, while at the same time they try to regain their feet after the deep recession. The fall in the price of oil caused the manat to depreciate and plunged the economy into recession last year, with GDP contracting by 3.8% y/y. This has led to worsening asset quality and sluggish growth in lending, particularly in the construction and real estate sectors.

The banks will continue to weigh on the Azerbaijani economy and the state budget. So much so, that much of Azerbaijan's projected government deficit in 2017, which is expected to amount to 8.4% of GDP, will be due to funds provisioned to support the banking sector, Fitch writes, shedding light on earlier reports about an unusually large amount of funds provisioned to be transferred from sovereign wealth fund Sofaz to the central bank.

But while Baku will likely be left to pick up the tab for potential banking defaults in 2017, some of its monetary policies are aggravating the lenders' plight. Take the 10% appreciation of the Azerbaijani manat that took place over 10 days in February, for instance. The appreciation came out of the blue after two years of relatively steady depreciation and only one month after the central bank announced that the manat had been floated freely – a move that was expected to bring further depreciation – leaving banks and their customers scrambling to reconvert foreign currency into manats.

The uncertainty around how it was possible for the manat to appreciate so much so quickly is symptomatic of the lack of transparency with which Ilham Aliyev's regime is choosing to manage its monetary policy and banking sector. Banking sources in Baku told bne IntelliNews that the appreciation may have been the result of underhanded foreign exchange transactions between the central bank and some lenders.

This lack of transparency, however, is unsurprising. More than half of the country's banking assets rest with the state-owned International Bank of Azerbaijan (IBA) and two other large banks – Kapital and Pasha – that are owned by a politically well connected holding. And while the government will likely continue to shelter these three institutions from the economic adversities affecting the country, the remaining 29 lenders are navigating a very uncertain environment in the near term.

2016 was a bad year for Baku bankers. Over the course of the year, 10 out of the 42 lenders in the country lost their licenses, after the banking regulator summarily revoked the licenses of those banks that did not meet prudential norms or were insufficiently capitalised.

But the real source of troubles for banks can be traced to a surprise devaluation of the manat in February 2015, following years of monetary stability and a predictably dollar-pegged local currency. Lenders, which had extensively given out loans in dollars to borrowers whose incomes were in manats (expecting an eternal dollar peg), were caught by surprise. The problem was compounded by questionable lending practices at some lenders, which had reportedly given out loans on political rather than financial feasibility criteria.

It did not take long until these two factors brought IBA, which accounts for a third of banking assets in the country, to its knees. Baku, which had previously owned 51% of the bank, increased its stake to 80% and began cleaning up its balance sheet of non-performing assets, which are believed to have accounted for 80% of its loan portfolio at the time. Azerbaijani authorities have never confirmed or denied this figure.

However, in November, Rufat Aslanli, chairman of the country's financial regulator, said that his agency was working on a privatisation plan for IBA that would be made public as early as 2017. Previously, the estimated timeframe for the lender's privatisation – the authorities' ultimate goal – was believed to be five years.

Also in November, Fitch Ratings issued a report downgrading IBA's viability rating from 'b-' to 'f', a sign that the bank had "failed" and was now dependent on state support. The downgrade was prompted by the discovery that the Azerbaijani government had transferred AZN10bn (€5.33bn) to the lender in the first half of 2016, three times more than it had originally estimated.

According to Dmitri Vasiliev, director at Fitch Ratings, IBA still needs "additional capital support (at end-2016, its regulatory capital was negative) and some measures to hedge its substantial balance sheet open currency position". Just like other lenders in the country, the dollarisation of IBA's balance sheet is believed to stand at more than 60% for loans and 80% for deposits, a sign that confidence in the national currency is far from being restored.

In an email to bne IntelliNews, Vasiliev added that "even after these measures are taken, IBA may remain structurally lossmaking in the near term, in the absence of insufficient loan production. The bank has significant foreign liabilities, large amounts of funding from local depositors, and after it sells the remaining problem loans to the authorities [after its government takeover, IBA was to sell its bad assets to a state entity called Agrarkredit], IBA will need to build up a new loan book. But there is currently limited visibility about IBA's new lending strategy, as the demand for credits is limited given the slowdown in the economy."

Looking ahead

Local banking sources in Baku have told bne IntelliNews that they remain wary of the outlook for their banks. "At the moment, businesses are exchanging dollars to manats to pay their taxes for last year – the tax payment deadline is at the end of March. Starting in April, we expect the depreciation to continue," a banker that asked to remain unnamed said.

The source mentioned that there are still some banks that do not meet the minimum regulatory capital requirement of AZN50mn demanded by the regulator – among them Rabita Bank, Nikoil Bank, the local subsidiary of Iran's Bank Melli and BTB Bank. Whether or not those lenders will have their licenses revoked, joining the 10 that lost their licenses in 2016, is unclear. Furthermore, more than a dozen lenders missed the February deadline to submit their financial results to the central bank, which, in the past, has indicated that those lenders were in some sort of financial trouble.

Vasiliev says that Fitch also does not know what to expect in 2017. While the agency predicts renewed capital shortfalls in the sector this year – the ratio of non-performing loans (NPLs) in the banks' lending portfolios stands at more than 20% at the moment – whether or not banks will lose their licenses over this appears to be a matter of having the right connections.

"Regulatory forbearance from the central bank used to be available for many banks in the sector, including smaller lenders, and the banking resolution mechanism is not transparent. We believe that the decision on whether to revoke a [lender's] license or not may be largely based on the relations between banks' shareholders, its management and largest creditors with the authorities. As such, smaller banks may be at greater risk of license withdrawal in case of capital shortfall," he writes.

Meanwhile, a report seen by bne IntelliNews detailing the number of branches that lenders have in the country indicates that some are either consolidating or planning their exit. The local subsidiary of Russia's VTB Bank, in particular, saw a dramatic decline in the number of branches from 17 to 9 over the course of 2016.

The number of branches, however, is not always indicative of the lender's standing. Accessbank, a lender majority owned by international financial institutions (IFIs), largely preserved its branches in 2016 (the number went down by one to 40), but is, according to Fitch, another bank that has "failed".

The good news, according to analysts, is that the Azerbaijani banking sector remains small enough at slightly over 50% of GDP for any clean-up to be manageable. And Baku, which rests on savings of over $33bn in its sovereign wealth fund, should not have major issues bailing out lenders if and when needs be.

While that may be reassuring for the country's economic stability, the fact that the government can swallow them up in the event of a default, is, of course, little consolation for the small banks in the country.