Fitch upgrades rating of International Bank of Azerbaijan

Fitch Ratings has upgraded Open Joint-Stock Company International Bank of Azerbaijan’s (IBA) LongTerm Issuer Default Rating (IDR) to ‘B’ from ‘B-‘ and Viability Rating (VR) to ‘b’ from ‘b-‘, Trend reports on April 30 referring to Fitch Ratings.

“The Outlook is Positive,” the message said. “The upgrades reflect a moderation of risks stemming from the bank’s unhedged short open currency position (OCP), which nevertheless still weighs on IBA’s performance and capitalization.

The OCP was reduced to $0.5 billion (77 percent of regulatory capital) at end-1Q2021, from $0.8 billion (114 percent) at end-1Q2020,” the message said.

“We believe that IBA’s capital buffer is sufficient to withstand a severe currency shock, given the significant cushion of IBA’s regulatory Tier 1 capital ratio over the statutory minimum,” the message said.

“The upgrades also reflect our revision of the outlook on Azerbaijan’s ‘b+’ operating environment score to stable from negative, given modest pressure from the economic downturn on local banks’ asset quality and performance,” the message said. “We believe that residual pressure will be manageable.”

“Fitch expects real GDP growth to recover to 2.5 percent in 2021 after a 4.3 percent contraction in 2020, which should additionally support banks’ performance and business growth,” the message said.

“The Positive Outlook on IBA’s rating reflects Fitch’s expectation that IBA will be able to further materially reduce its OCP to 25 percent-30 percent of regulatory capital in the next 12-18 months,” the message said. “This expectation is based on IBA’s record of consistent OCP reduction in the past three years, and on likely additional capital build-up from healthy profit retention.”

“Such a reduction in IBA’s OCP would significantly reduce the vulnerability of the bank’s profitability and capital to currency risks,” the message said. “Other aspects of IBA’s credit profile are largely consistent with a ‘B+’ rating.”

“Key Rating Drivers IBA’s ratings are based on the bank’s intrinsic credit strength, as measured by the VR of ‘b’,”the message said. “The ratings continue to capture risks stemming from a volatile and cyclical operating environment in Azerbaijan and IBA’s still high direct exposure to currency risks.”

“Positively, the ratings capture IBA’s robust asset structure resulting in reasonable asset quality, strong profitability in the past two years, and large capital and liquidity buffers,” the message said.

“Currency risks are mitigated by the bank’s large capital buffers, with regulatory Tier 1 and total capital ratios equal to a high 30 percent and 29 percent, respectively, at end-1Q21,”the message said.

“According to the bank’s estimates, risk- weighted assets (RWAs) may see a sharp one-off increase due to the introduction of operational and market risks charges, which will likely bring capital ratios close to 20 percent at end-2Q21,” the message said.

“We estimate that this capital buffer would still be sufficient to withstand a severe currency shock of an exchange rate depreciation to 2.6 AZN/USD from 1.7 AZN/USD and to maintain Tier 1 and total capital ratios above the statutory minimums of 6 percent and 12 percent respectively,”the message said.

“IBA’s asset quality is supported by a low-risk asset structure,” the message said. “Liquid assets (cash, interbank placements and securities) were equal to a high 71 percent of total assets at end-2020 and were mostly of quasisovereign credit quality. The net loan book, which we view as the key source of impairment risks, amounted to a low 26 percent of total assets at end-2020.”

“Impact on asset quality from the pandemic has been manageable to date. Impaired loans (Stage 3 loans under IFRS) increased to 8 percent of gross loans at end-2020 from 7 percent at end-2019, and were 76 percent covered by total loan loss allowances,” the message said. “Stage 2 loans were a modest 3 percent of gross loans at end-2020. IBA’s profitability was resilient in 2020 with operating profit-to-RWAs at 5 percent, albeit down from 7 percent in 2019.”

“IBA’s pre-impairment profit moderated to 10 percent of average loans in 2020, from 14 percent in 2019, but still provided a significant buffer to absorb loan impairment charges, which were modest at 1.3 percent of average loans in 2020,” the message said.

“The decline in pre-impairment profit was caused by margin compression on non-loan exposures, lower fees and transactional income and a moderate increase in operational expenses,”the message said.

“IBA is funded mainly by customer accounts (73 percent of liabilities at end-2020) with an emphasis on state deposits (47 percent of liabilities),”the message said. “A high share of customer funds is interest-free, translating into IBA’s low funding costs (2 percent in 2020).”

“The bank’s wholesale debt is limited to a $950 million Eurobond issue, maturing in 2024, but this is held mostly by the state oil fund SOFAZ,” the message said. “IBA’s liquidity is comfortable with liquid assets (mainly, cash and cash-equivalents and placements with the Central Bank of Azerbaijan and foreign banks) covering customer accounts by 1.1x. Support Rating and Support Rating Floor State support is not factored into IBA’s ratings, following the bank’s default in 2017.”

“Accordingly, despite IBA’s state ownership and high systemic importance as the largest bank in the country with a 27 percent share in sector deposits, Fitch has affirmed IBA’s Support Rating at ‘5’ and its Support Rating Floor at ‘No Floor’,” the message said.

“Senior Unsecured Debt Rating IBA’s senior unsecured debt is rated ‘B’, in line with the bank’s Long-Term IDR, reflecting Fitch’s view of average recovery prospects, in case of default,” the message said. “Rating Sensitivities Factors that could, individually or collectively, lead to positive rating action/upgrade: -The ratings could be upgraded if the OCP is reduced to 30 percent of regulatory capital, resulting in a material reduction of currency risks to IBA’s earnings and capital.”

“An upgrade of IBA would additionally require the bank to maintain stable loan-quality metrics and large capital and liquidity buffers,” the message said. “Moderate upside for IBA’s Support Rating and Support Rating Floor may emerge on evidence of an improved record of state support to Azerbaijani banks.”

“Factors that could, individually or collectively, lead to negative rating action/downgrade: -IBA’s VR and Long-Term IDR could be downgraded if a combination of large currency losses, increased loan impairment and asset inflation result in considerable erosion of the bank’s capital position,” the message said.

“The rating Outlook could be revised to Stable from Positive if the bank is not able to materially reduce its OCP over the next 12-18 months,” the message said. “The senior debt rating is sensitive to changes in the bank’s Long-Term IDR.”

“Best/Worst Case Rating Scenario International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years,” the message said.