Azerbaijan's banking sector amid global risks Analysis by Caliber.Az

It was possible to overcome the recent banking crisis in the United States and Europe, preventing it from escalating into a large-scale financial collapse akin to the 2008 mortgage crisis. However, experts fear that banks in developing countries, which are under pressure from the recession and rising prices, will face a tightening of monetary policy as central banks attempt to contain high inflation, which could lead to severe problems.

At the same time, according to recent data from Moody's rating agency, this March, the number of corporate defaults in the world, including in the banking sector, rose to the highest since December 2020. Against this negative background, Azerbaijan’s banking system recorded growth in basic indicators and demonstrated risk tolerance in the first quarter of 2023.

The banking crisis observed this March in the United States and Europe caused a number of analysts to fear the beginning of bankruptcy of loan structures on a global scale, similar to the well-known events of 15 years ago. In particular, it was about the problems of three fairly large US banks – Silicon Valley Bank, Signature Bank and First Republic Bank, as well as the largest Swiss bank – Credit Suisse. But this negative did not grow into something large-scale due to the reserve of financial stability of the credit system of Western countries, which underwent large-scale reforms after the financial crisis of 2008, as well as due to the timely response of financial regulators. In particular, the American First Republic Bank was provided with $30 billion in assistance from a pool of 11 large American banks, as well as US financial regulators promised to return their funds to depositors in full. The burnt-out American banks decided to take a risk and play on the cryptocurrency market and with startup investments. In Switzerland, the bank was not allowed to go bankrupt at all - its resale is being carried out there today. One way or another, the crisis was overcome thanks to the prompt actions of regulators: they seized problem banks from their owners for external management, and depositors were guaranteed a refund - this way out of the situation was recently announced by finance ministers and heads of central banks of the G7 countries.

"The collapse of three medium-sized American banks and the financial tensions that followed will not be a ‘big problem’ for the US economy. The banking system has indeed stabilised, but we will closely monitor the situation, as the recent banking crisis has increased uncertainty about the prospects for the economy," said John Williams, president of the Federal Reserve Bank of New York, in an interview with Yahoo Finance published on April 18.

However, the still serious risks are evidenced by the data of the Moody's rating agency: "The number of corporate defaults in the world in March increased to the highest since December 2020, fifteen corporate issuers, including Silicon Valley Bank and Signature Bank, announced a default on debt obligations in March. The stress experienced by some of the medium-sized American banks last month serves as a reminder that a change in monetary policy can provoke risks that would not otherwise manifest themselves”.

In the first quarter of 2023, the number of corporate defaults reached 33, which is the highest since the end of 2022, according to Moody's.

International Monetary Fund (IMF) Managing Director Kristalina Georgieva also says that banking crises for a number of new reasons may soon recur since there is currently a rapid transition from low to much higher interest rates in the world. "Inflation inevitably creates turbulence for the banking sector of some economically developed countries," the IMF managing director said.

The presence of such risks is indirectly confirmed by recent statements by  European Central Bank (ECB) President Christine Lagarde, who believes that the geopolitical confrontation between the United States and China can accelerate global inflation by 5 per cent. The ECB president drew attention to some signs of an increase in the share of the yuan and the rupee in international trade, the weakening of the dollar and the euro, as well as an increase in interest in gold as an alternative reserve asset.

High inflation and the weakening of traditional international reserve currencies have a negative impact on monetary stability and indirectly affect the banking sector. The fact is that since the end of last summer in the USA, the European Union, Canada, Switzerland, Israel, the countries of Southeast Asia, and South Africa, in order to curb galloping inflation, a gradual increase in interest rates has begun. In particular, the refinancing rate in the United States reached 4.5 per cent by mid-December 2022, and on March 22, 2023, the Fed raised the rate by 25 basis points — from 4.5−4.75 per cent to 4.75−5 per cent per annum. Following America, the Bank of England took similar steps on March 24, raising the discount rate by 25 basis points to 4.25 per cent, with the prospect of bringing its level to 5 per cent in May this year. Finally, the EU Central Bank (ECB), which raised the discount rate several times from zero in May to 2.5 per cent by mid-December last year, in mid-March 2023 was also forced to raise the interest rate to 3.5 per cent, and also with a forecast of further growth in May. Regulators of most post-Soviet countries are following the same path, consistently raising refinancing rates: in particular, last year the Central Bank of Azerbaijan (CBA) repeatedly increased refinancing rates and at the end of March 2023 once again decided to raise the discount rate by 0.25 percentage points to 8.75 per cent.

Thus, the central banks of the leading and developing countries of the world are quite clearly signalling that the period of "cheap" money and affordable loans is far behind, and strengthening monetary stability and reducing inflation today is a more important task than supporting banks and investors with cheap loans. This is also stated in a recent IMF report, which notes that an unfavourable scenario in the US financial sector and other developed economies will lead to a sharp reduction in bank lending.

"In an unfavourable scenario, bank borrowing in the United States and other developed economies may sharply decrease. And this can result in a number of negative macroeconomic effects, including a deterioration in the ‘confidence level’ of households and businesses, an increase in savings and a reduction in investment," the Fund's report says. The IMF believes that in the event of an increase in inflation, an intensification of the recession and a decrease in demand for borrowed funds, the banking crisis threatens primarily developing markets: not all developing countries have deposits insured by the state, not everyone has the money to save busted banks, in addition, borrowers in poor countries are usually riskier and less reliable.

Fortunately, the negative observed in the USA and Europe has so far affected the financial sector of Azerbaijan to the least extent, and no serious risks have yet been identified for the banking system of our country. At one time, Azerbaijan learned lessons from the crisis situation in 2008 and especially in 2015 and large-scale rehabilitation and reforms were carried out in the banking sector, which removed the weakest players from the market. The country has developed all the necessary mechanisms to protect depositors' deposits, tightened prudential standards, very strictly controlled credit conditions, created a database on the credit history of borrowers, reduced dollarisation of deposits, etc.

The state of Azerbaijan's banking sector has undoubtedly improved in recent years, as stated in a recent report by the international rating agency Fitch Ratings. "The share of non-performing loans decreased to 2.9 per cent at the end of 2022 from 6.1 per cent at the end of 2020, which was facilitated by strong growth in the sector's credit investments. The return on average capital was 17.3 per cent in 2022 and is likely to remain above 15 per cent this year, the level of adequacy of the first-tier capital is 15.2 per cent, and the Russian presence in the banking sector of the republic is small. Also, the deposit dollarisation coefficient decreased to 48 per cent at the end of 2022 from 60 per cent at the end of the first half of 2020," the agency's experts point out.

A similar opinion is shared by the Association of Banks of Azerbaijan, where they believe the rumours about the "freezing of deposits" and other far-fetched problems are groundless and, on the contrary, claim that the development observed in the country’s banking sector continues on an upward trajectory, and the credit system remains stable in 2023.

The latest CBA information on the state of the country's banking sector is a clear confirmation of this: the net profit of 25 Azerbaijani banks in the first quarter of 2023 increased by 54 per cent and reached 267.9 million manats [$156.9 million]. In turn, in January-February of this year, the assets of the banking sector increased by 18.8 per cent and exceeded 45.7 billion manats [$26.8 billion]. Over the two months of this year, banks have slightly increased their loan portfolio (0.8 per cent), which exceeded 19.757 billion manats, including mortgage growth of 2.4 per cent - more than 3.3 billion manats, and consumer loans of 1.9 per cent - over 5.8 billion manats. It is noteworthy that banks have created a target reserve of 1.4 billion manats to compensate for possible losses on loans.

Despite the global vicissitudes - imported inflation, recession and other risks, the population of Azerbaijan retains confidence in the banking system as a whole and the exchange rate stability of the manat. This is evidenced by the fact that in January-February of this year, the bank deposits of the population (including funds of individuals engaged in individual entrepreneurial activity) increased by 1.4 per cent to almost 11.9 billion manats. The steady trend of reducing the dollarisation of household deposits continued: during the reporting period, deposits in foreign currency decreased to 38.7 per cent, and in the national currency - the manat, on the contrary, increased by 2.2 per cent to 7,298 billion manats, or 61.3 per cent of all deposits.

Relatively high prices for hydrocarbon raw materials and prospects for their further growth, given the recent decisions of OPEC+ to significantly reduce oil production, give reason to believe that Azerbaijan's balance of payments surplus will remain in a positive zone, and will strengthen even more from the second half of the year. And this is a key condition for maintaining monetary stability and the stability of the manat exchange rate – the most important components of the effective operation of the country's financial system. In turn, the stable development of the non-oil sector, supported by steady exports and contracts within the framework of the Great Construction in the Karabakh region, will continue to support the demand of the private sector for bank credit resources, reducing the negative impact of the excess liquidity factor, even taking into account the CBA's policy of raising the discount rate in order to combat inflation.