Moody’s Forecasts Azerbaijani Banks’ Asset Quality to Deteriorate as loans Their Growth Slows
Azerbaijan, Baku, 23 May /corr. Trend A.Badalova / Azerbaijani banks have been enjoying high profitability due to rapidly developing loan bookin recent years, but the banking system remains rather fractured, Moody's Ratings report says. The Agency explains it through 70% of banking assets belonging to seven large banks.
The overall efficiency of Azerbaijani banks compares well with that of banks in other CIS countries and follows similar trends. Efficiency indicators were relatively stable in 2004-2007. The trend of increasing costs has been counterbalanced by the rapid growth in earning assets that resulted in improved income-generating capacity.
In general, the capitalisation of Azerbaijani banks is low compared to international norms. Capital injections from shareholders have been offset by rapid balance sheet growth, which exceeds internal capital generation. In addition, a significant level of single-name concentrations in the loan book and potentially understated levels of related-party lending are putting pressure on the banks' economic capital.
"The banking system's overall asset quality is good, but we view the trend as weakening. Asset
quality ratios have been diluted by a rapidly developing loan book and we also believe that the quality of the loan portfolios will be likely to decline due to the unseasoned nature of loans (especially to new segments such as retail and SME) and untested risk management tools," the report says. In Moody's opinion, the deposit ratings - which currently range from B2 to Baa2 - could be upgraded if the banks: (i) continue consolidating their market shares; (ii) maintain healthy financial fundamentals; and (iii) improve their SME, retail and deposit-taking franchises, reducing concentrations on both sides of their balance sheets. In addition, the ratings could benefit in event of sustained improvements in corporate governance, including (but not limited to) greater ownership transparency and independence in risk management function and management information systems.
Downward pressure on the banks' BFSRs is unlikely in the medium term. However, the deposit ratings of the state-controlled banks could be downgraded if Moody's were to assess the likelihood of systemic support for these banks as having lowered following the further reduction in their government ownership.
"Any potential mismanagement of the banks' growth strategies that resulted in a significant deterioration in their financial fundamentals or asset quality could also have negative rating implications," the report says.
The asset quality of the two state-controlled banks is currently satisfactory and has been on an improving trend in absolute and relative terms.
Strong overall profitability driven by buoyant economic conditions, supported by an increase in higher-yielding loan products
Azerbaijani banks have been enjoying high profitability in recent years. The median return on average assets reported by rated Azerbaijani banks was 2.84% for 2006, compared to 3.57% for 2005 and 2.1% for 2004. For 2007, we expect the banks' profitability to have improved as two of the six rated banks have already reported stronger IFRS results for YE 2007 on the back of widened interest spreads.
Interest income has been the major contributor to operating income, accounting for about 60% of the total at year-end 2007 (2006: 56%). This share is expected to increase going forward.
"We also note that, compared to their counterparts in the other CIS countries, Azerbaijani banks have a relatively strong fee and commission revenue-generating capacity that has historically supported their profitability and contributed 30-37% to operating revenues over the past three years. The increased demand for fee-generated services has made this core revenue stream reasonably diversified, with plastic card operations, transactions with foreign currencies and securities, cash and settlement transactions, issuance of guarantees and letters of credits accounting for the main fee-generating sources. On average, the rated banks earned almost 34.5% of their operating income from these operations based on year-end 2006 results. We expect this share to have declined in 2007 and to continue to do so going forward," mentioned by the report.
"Looking ahead, we expect Azerbaijani banks' profitability to remain good. Low banking intermediation, strong demand for credit and relatively weak competitive pressure will support wide interest spreads, which, in combination with rapid credit growth, particularly in the higher-yielding retail and SME sectors, will ensure the banking sector's high profitability," the report stated.
At year-end 2007, the Azerbaijani banking system had satisfactory liquidity positions, as evidenced by the sufficient amount of liquid assets accumulated, which accounted for 20-30% of total assets. This far exceeded the amount of repayments on foreign borrowings, a major portion of which (approximately US$706 million) is due in 2008.
System growth has been mainly funded by customer deposits, which accounted for 61% of total liabilities as of year-end 2007 (2006: 70%), while international funding is only starting to emerge and is mainly represented by bilateral and syndicated trade-related loan facilities.
Unseasoned loan portfolios in a period of high lending growth could result in higher NPLs
In Moody's view, the recent upward trend in the absolute balance of overdue loans, coupled with the fast-growing loan portfolios (especially retail and SME), could result in higher delinquencies in a maturing loan portfolio. The banks' growing focus on riskier retail lending in an environment where retail customers lack both credit history and experience in servicing credits could also bring additional credit risks.
"It is our opinion that banks' rapid growth in lending, together with the high level of borrower concentration, adds the potential for volatility in asset quality numbers going forward. It should also be noted that the bulk of loans was generated recently and is unseasoned and untested under an economic downturn. The adequacy of risk management tools and independence of banks' risk management function may also reveal weaknesses in a stress environment. Going forward, we expect Azerbaijani banks' asset quality to deteriorate as loans season and their growth slows," the report says.
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