As in the other newly independent states of the former Soviet Union, the history of banking in Azerbaijan is short but filled with thrills and spills. Even before the collapse of the Soviet Union in 1989-90, the first commercial banks emerged in Azerbaijan poised to take advantage of the nation’s independence at the end of 1991.

After the collapse of the former Soviet Union, Azerbaijan, like the other successor republics, faced a severe economic crisis accompanied by hyperinflation. These factors conspired to destroy the accumulated savings of ordinary Azerbaijanis in the nation’s banks. That in turn eliminated the population’s confidence in the financial system, including the newly created banks. In the following years, however, much newly unleashed entrepreneurship was channeled into banks or institutions which passed for banks.

The government was not able to control the wild activity of these many new “pocket” banks, most of which engaged in high risk activities unassociated with banking, in the strict definition of the term. These banks advertised interest rates payable on deposits at 240-300% per annum, and promised payment in hard  currency. In addition to these unprecedented and implausible rates, interest was compounded and paid on a monthly rather than an annual basis.  These banking pyramid schemes could exist because of inadequate oversight and regulation of the banking sector. Studies of various multilateral development agencies which looked into the problem in Azerbaijan consistently confirmed this.

Role of the National Bank

Thus pressure from the financial crisis and the recommendations of reform experts served as a warning to the National Bank of Azerbaijan to take its regulatory mission more seriously. The first significant step was an adoption of the Law on Banks and Banking and Law on the National Bank of Azerbaijan. For the first time the National Bank (“NB”) was declared an independent financial institution with a mission focused on monetary and financial policy. Under the Soviets, the Central Bank had functioned as the personal treasurer of the executive. In a comparison of the Azerbaijani structures and those in the United States, the NB exercises most of the authority of the Office of the Comptroller of the Currency and the Federal Reserve Board. The NB is empowered to charter banks and other credit organizations. There is no analogue to credit unions and savings and loan associations in Azerbaijan; therefore, the NB is the only state agency which exercises supervision and regulation over lending institutions. In addition, the NB serves as the exclusive clearing house for all accounts in local currency in banks.  The NB also underwrites Treasury bonds issued by the State and submits results from the auction to the Ministry of Finance.

Controlling the circulation of national currency is another duty of the National Bank. The Law purports to make the National Bank a structure independent of the government. As in other CIS countries, of course, some observers have questioned the extent to which the National Bank does in fact act independently. According to the Law on Currency Regulation, the NB has the power to intervene in foreign currency trading in Azerbaijan in order to support the national currency. NB also has the right to set a maximum margin for resale of foreign currency by the banks it regulates. Currently that margin is 5%.

The Law on Banks also introduced to Azerbaijan the notion of banking secrecy. Among the provisions to further strengthen the financial industry are:  a prohibition against interference by any state agency, including the  District Attorney’s office (Generalnaya Prokuratura) in both customer accounts and the bank’s own reserves without a court order;   the requirement to obtain a court order by tax authorities before attachment of taxpayer’s account in bank;  and  guarantee of secrecy of bank accounts to depositors.

All lending organizations are accountable only to the NB. Furthermore, the law requires financial institutions to undertake an annual audit conducted by independent auditors, another important innovation.  The NB also has comprehensive regulatory authority patterned after the model of the Bank for International Settlements (BIS). The so-called Basel standards on prudential ratios prescribed by BIS have also been adopted by NB as a goal to aspire to in forming a strong and sound financial industry.

Obviously, this task will take time. Even in highly developed economies like Japan’s, it was a lengthy process for the domestic banking sector to achieve the required prudential ratios. These ratios include, but are not limited to capital/assets ratio, liquidity ratio, restrictions on the amount of loans to individual customers and provisions for bad loans, etc. Many of these ratios were introduced for the first time in the banking industry of the country. Regulations of the NB set forth several preliminary stages required to achieve the desired ratios.

In order to help the banks create the required capital reserves and provide for bad loans, the government exempted part of the income tax due from banks and required them to set it aside to cover bad loans. These measures were intended to reverse a weak banking industry weakened further by the recent crisis. Not only did they have a positive effect on strengthening the financial industry as a whole and on state owned banks in particular; they mitigated losses from the Soviet period.

The NB also has introduced a tight monetary policy to reduce hyperinflation. Special reserves, based upon a percentage of total deposits, have been established for all banks within the system. These reserves are to be kept with the NB in special accounts and allocated for purposes of refinancing and monetary regulation. Unlike in some countries, no interest is paid on these mandated reserves.

In order to restore trust toward banks and to increase the monetary reserves in banks, the government adopted special tax breaks on the personal income of individuals. The law on taxation of income of natural persons provides a special exemption on interest earned on savings accounts in state-owned banks. It is noteworthy that by a special decision of the Milli Majlis (parliament) this tax break has been extended to cover the income from savings and deposit accounts in private banks as well, for the 1995 and 1996 fiscal years.

Squeezing Out the “Pocket Banks”

 The government has taken steps to prevent the creation of “pocket” banks which have been established with the main purpose of financing the trade or investment activity of a single firm. Because they are totally dependent on the performance of a controlling business entity and are unable to implement a sound policy on risk diversifications, these banks have posed an unjustified risk to depositors. To counteract this effect, the Law imposes a limit on banks holding an equity stake in any other single commercial entity equal to or exceeding 10 percent of the equity of a bank (not its shareholder’s capital). This is provided that total participation in all such companies shall not exceed 40 percent of the bank’s equity.  The NB also issued regulations defining and prohibiting “related” transactions. As a result of such legislation, many Azeri banks with single customer-shareholders became more vulnerable to transactions with related parties and were forced to look for new customers and market opportunities. Most of these banks eventually merged with others or have been acquired.

The Door Opens for Foreigners

An essential element of Azerbaijan’s overall reform package for banks included an open door policy toward foreign investment in the sector. Legislation in place until the beginning of 1997 provided preferential tax treatment to banks in which 30 percent or more was owned by foreign capital. While local banks have been subject to a 45 percent income tax, banks with foreign participation were taxed at a 35 percent rate. Although this “introductory special” has since expired1, it serves as a good illustration of the range of measures undertaken by the NB to provide incentives for foreign banks to enter the Azeri market. The invitation was taken by a number of foreign banks, including a subsidiary of the British Hongkong and Shanghai Banking Corporation, Bank Melli Iran branches, and subsidiaries of Russian banks such as Most Bank and Rossiysky Credit, a representative office of Dresdner Bank and branches of several prominent Turkish banks.

Currency Control

 In the end of 1994, a relatively restrictive foreign exchange policy was introduced under the pretext of addressing continued hyperinflationary fears. Under the Law on Currency Regulation, the NB issued regulations on the special regimen of foreign currency accounts of residents and non-residents. These rules were strictly implemented by banks that are agents of the NB for the purposes of controlling foreign exchange under Azeri law. The NB continues to implement a policy of tight control over foreign currency transactions in an effort to improve balance of payments and convertibility of domestic currency. As a response to the requirements of the International Monetary Fund (“IMF”), the NB introduced a special report form requiring banks to provide information about payments made in foreign currency from Azeri entities to their foreign counterparts and vice versa. Using that information, balance of payment of Azerbaijan is being produced.

Azeri legislators also have chosen to promote overseas borrowing. Unlike Russian legislation which requires local entities to apply for permission from the Central Bank if they borrow foreign currency from non-resident entities, in Azerbaijan the process of outside borrowing is very liberal. Under Azeri law no permission is required if a local entity borrows money from a non-resident lender. There are also no regulations preventing or restricting the use of foreign loan funds. At the same time, and until recently, Azeri banks were precluded from lending to non-resident entities as a part of the foreign exchange policy.

Altogether these and other measures undertaken in accordance with the recommendations and support of the World Bank and IMF achieved their main goal, namely the stabilization of the financial system and the creation of  the foundations for a sound banking system in Azerbaijan. Inflation dropped from 1000 percent a year to the present manageable level of 8-12 percent. As a result of strong monetary policy supported by bonuses from oil contracts, the Azerbaijani manat has been increasing in value against the U.S. dollar for 18 months. Many small banks have merged or been acquired by stronger banks. This trend was especially true in rural areas and cities of Azerbaijan where local banks switched to operate as branch offices of stronger banks rather than continue to function as weak independent institutions.

 For the first time the banking industry became independent of different state agencies, a significant positive change compared to practices which existed under the former Soviet Union. Today, the NB has exclusive authority to insure that the banks under its supervision meet the prescribed ratios and have a panoply of disciplinary tools to invoke in the event of violations. These include:    monetary fines imposed depending on the length and seriousness of violations; temporary freezing of assets with the NB; and revocation of licenses.

The last measure is used only in extraordinary circumstances, such as the systematic violation of prescribed ratios or insufficiency of shareholders’ capital.

Regulation of Foreign Participation in Banks

The following laws and legislative documents regulate the establishment andoperation of foreign banks in Azerbaijan: Law on Protection of Foreign Investments adopted on January 15, 1992;  Law on Banks and Banking Activity adopted on June 14, 1996; Law on Currency Regulation adopted on October 21, 1994;    Rules on Licensing and Organization of Activity of Lending Organizations issued by the  NB on November 9, 1996.

The Foreign Investment Law (“FIL”) is overarching legislation designed to provide incentives for foreign investment and to protect those investments. Foreign investors are defined as foreign legal entities and natural persons, stateless persons, foreign states, international organizations, and Azeri nationals who reside outside of Azerbaijan and are registered for commercial activity in the country of their permanent residence. The FIL contemplates protected foreign investments in banking in any of the following forms:

by establishing foreign interest in ventures created jointly with Azeri nationals and local legal entities (JV banks);
by creating companies wholly owned by a foreign investor (cases where a foreign citizen establishes a bank in Azerbaijan or establishes branches of foreign banks which cannot be considered legal entities);
by acquiring companies, buildings, facilities, shares, stocks, bonds, and other securities or properties that under Azeri legislation may belong to foreign investors (acquisition of shares in existing credit organizations);
by contracting with Azeri legal entities and nationals for other forms of foreign investment.

Article 6 of the Law on Protection of Foreign Investments states the general rule that an entity with foreign participation can undertake any kind of economic activity not prohibited by Azerbaijani legislation.  However, banking falls within the parameters of article 6 of the FIL as an activity subject to license as determined by the Cabinet of Ministers.  The Law on Banks and Banking Activity (“Banking Law”) sets forth general rules for registration and licensing of newly established local and foreign banks.

On November 9, 1996, the NB adopted the Rules of Licensing and Organization for the activity of lending organizations and their branches, describing rules for licensing in greater detail.  Article 7 of the Banking Law sets forth the procedure for applying for a license. The rules and procedures are identical for local and foreign banks; however, foreign banks seeking to obtain a license must submit a few additional documents. After incorporation, lending organizations are required to submit an application for a license to the NB. The following documents and information are required to be submitted along with application: copy of certificate of state registration certified by public notary; charter of the bank as approved in the state body which incorporated the company, or regulations for a branch of a foreign bank; incorporation agreement; minutes of adoption of charter of the corporation and minutes of appointment of managers of governing and managing bodies, except when the bank is being registered by a single shareholder; balance sheet of legal entities-shareholders for the last year and a profit and loss statement accompanied by an auditor’s opinion; information about the professional qualifications of candidates for positions of management and chief accountant, along with prior convictions, if any (must be signed by the Chairman of the Supervisory Board of the Bank or by the founder himself); completed questionnaire.

Branch offices of foreign banks, lending organizations wholly owned by foreign investors, and joint venture credit organizations with foreign capital must also submit the following documents:  the decision of the corresponding state organ regarding the establishment of a lending organization or branch in Azerbaijan; charter or any other document confirming the legal status of the entity; published annual balance sheets for the last 3 years; written consent for the establishment of a lending organization or branch office of a corresponding state entity in the country of its principal place of business (only if such consent is required by the laws of the country of its principal place of business).
The NB then has a 30-day period during which to evaluate and act on the application. If it rejects the application the NB is to provide the applicant with notice of and reasons for rejection. Unlike US legislation, however, the Banking Law does not provide an opportunity for a hearing and for notices from interested parties upon hearings to determine whether a new bank shall be chartered. Once granted, a license is valid for an indefinite period.

Among the reasons for rejection of a license application, those most likely for foreign banks are: excess capacity of foreign capital on the domestic market (Azerbaijani law presently provides that foreign capital shall not account for more than 30% of the total available on the domestic market); failure to appoint an Azerbaijani citizen as general manager or deputy of the bank or branch or to other positions within the bank; the failure of a foreign bank to secure licenses authorizing them to take and hold deposits or to conduct other essential banking activities under their jurisdiction.

Minimum Capital Requirements

The minimum required shareholders’ capital for newly established banks is set at the amount of $5 million dollars by the end of 2001. Capital increase schedules stipulate that by the end of 1998 existing and newly established banks shall have at least $1.5 million. Thus, investors should anticipate that the process of mergers and  acquisitions will continue in the banking industry in Azerbaijan.

Article 11 is solely devoted to the licensing regulation of activities of banks with foreign participation. Paragraph 3 of Art 11 states that a lending organization must get approval from the NB if it seeks to increase its capital for account of or by means of sale of part of its shares to non-residents. The Banking Law defines a situation where the NB may refuse to give its approval. That happens when, as a result of such a sale or increase in capital, the 30 percent limit on foreign capital is crossed.  Although the wording of the law suggests that this is the only case where approval may be withheld, the regulatory track record  it too short at this point to make such an assessment.

Paragraph 5 states that the NB has the authority to set forth additional requirements for banks with foreign participation in the areas of prudential ratios, rules of reporting, composition of management, banking activities which are being carried on, minimum required capital and the rules of placement of their capital abroad. Foreign banks must assume and undertake all obligations of their local branch.

Azerbaijan has no analogue to the FDIC, and the only protection for customer deposits is a special reserve amount, determined by the NB in accordance with Article 17 of the Banking Law. The NB also specially regulates certain other banking activities, including: operations with foreign currency; operations with precious metals and stones; operations with all kinds of securities; treasury operations; and operations with credit and debit cards.

Each of these operations may be subject to special licensing.  Restrictions on credit and debit cards are particularly important to foreign investors since most foreign banks have natural technological and financial advantages in this sector as compared with their domestic competitors. However, the limitation on foreign banks operating in the credit card arena is probably only of limited duration and is designed to give domestic banks an advantage in starting their card operations. The first credit card processing center has now opened in Azerbaijan and credit and debit card use is expected to become widespread in the Baku market in the coming years.

Article 34 introduces the notion of banking groups and holding corporations, a novelty for Azeri legislation. The law requires NB notice and approval for the formation of bank holding groups.

Limitations on Branch Banking

Azerbaijan does not have any geographical limitations on branch banking but instead limits such activities according to available shareholders’ capital. For example, lending organizations with shareholders’ capital in the amount of $1.25 million or less may not open more than 15 branches. No restrictions exist, however, for banks with shareholder capital in excess of $5 million. Since the limit was established at the end of 1996 the minimum required level of capital is now higher than $1.25 million. One may expect that these numbers will be changed too.

Art. 10 of Law on Protection of Foreign Investments in Azerbaijan has a grandfathering provision which protects foreign investments from changes in legislation which adversely affect foreign investors.  But it expressly does not apply to changes in tax legislation and credit and finances.  Current legislation sets forth a unified 32 percent income tax rate for all credit organizations operating in Azerbaijan.