OREANDA-NEWS. August 11, 2015. Fitch Ratings has placed International Bank of Azerbaijan's (IBA) Long-term foreign currency Issuer Default Rating (IDR) and Viability Rating (VR) on Rating Watch Positive (RWP). A full list of rating actions is at the end of this commentary.

KEY RATING DRIVERS - IDRS, SUPPORT RATING, SUPPORT RATING FLOOR (SRF) AND SENIOR UNSECURED DEBT
The RWP on IBA's support-driven IDRs reflects the financial rehabilitation of the bank announced by the authorities in July (see "Fitch: Financial Rehabilitation Potentially Positive for IBA's Ratings" dated 21 July 2015 at www.fitchratings.com), and subsequent clarifications made by the bank's management to Fitch, that this will involve a substantial buy-out of problem assets at book value by end-2015. In Fitch's view, this would represent tangible sovereign support for IBA and a material enhancement of the support track record, potentially resulting in a positive change in our view of the sovereign's propensity to provide support. If the clean-up is completed as planned, Fitch is likely to revise IBA's Support Rating Floor up to 'BB+' and upgrade the bank's support-driven Long-term IDR and senior debt rating by one notch to the same level.

The balance sheet clean-up has been initiated in part to prepare IBA for privatisation. However, according to management, the preparation period for the privatisation may be as long as five years, meaning that the bank is likely to remain state-owned for at least the medium term. Furthermore, Fitch believes that even if privatisation takes place, IBA will remain systemically important as the largest bank in the country and will retain significant business with state-controlled entities. We do not therefore expect significant downside pressure on IBA's support-driven ratings because of the planned privatisation, although combined with the uneven support rack record, it will continue to justify at least a one-notch differential between the bank's ratings and those of the Azerbaijan sovereign (BBB-/Stable).

IBA's support-driven ratings continue to reflect potential support for the bank, if needed, from the Azerbaijan authorities. This view factors in (i) IBA's high systemic importance, stemming from its large domestic franchise (the bank accounts for 35% of sector assets) and substantial funding from state-owned corporations (AZN1.5bn or 15% of end-2014 liabilities); (ii) the bank's majority (51.07%) state ownership; (iii) IBA's fairly small size relative to the sovereign's available resources (assets and equity equal to 15% and 1%, respectively, of GDP at end-2014); and (iv) the potentially significant reputational damage for the authorities in case of IBA's default.

KEY RATING DRIVERS - VR
The RWP on IBA's VR reflects the potentially significant improvements in the bank's asset quality, capitalisation and liquidity position after the asset buy-out. Fitch may upgrade IBA's VR by one or two notches, depending primarily on the quality of the bank's remaining assets and Fitch's view of the bank's risk appetite and lending strategy following the asset transfer and recent change in management.

Fitch believes that IBA's problem assets are substantial, despite reported NPLs (non-performing loans, 90 days overdue) and rolled-over loans being equal to only a moderate 7.2% and 6.6% of end-2014 gross loans, respectively. Fitch estimates that other high risk loans among IBA's largest exposures, including project finance lending to start-up businesses and construction loans with sizeable grace periods, were approximately AZN1bn (11% of gross loans) at end-1Q15. Additional asset quality and corporate governance issues stem from the legacy promissory notes portfolio (around AZN700m, net of impairment reserves), which is largely exposed to construction projects in Russia with high non-completion risks. Reserve coverage of NPLs was a reasonable 135% at end-2014, but rolled-over loans, large high-risk exposures and the promissory note portfolio combined exceeded 3x end-2014 Fitch Core Capital (FCC).

However, the anticipated clean-up should result in a tangible improvement in the quality of IBA's assets and capital, although the extent of this will depend on Fitch's assessment of the remaining corporate loans in the bank's portfolio and the quality of new lending. Management has informed Fitch that IBA's balance sheet will not be used to help finance the asset buy-out (i.e. the bank will not buy the bonds to be issued by the government's buy-out vehicle).

The bad assets transfer will result, at least initially, in a significant reduction in risk-weighted assets, which will boost IBA's capital ratios. Additionally, in accordance with its recapitalisation programme the bank should receive a AZN200m equity injection by end-2015. Fitch estimates that as a result of these measures, and assuming only limited new lending in 2H15, IBA's Fitch Core Capital (FCC) ratio could increase to a reasonable 10%-12% (end-2014: 7.4%). In Fitch's view, IBA is unlikely to quickly consume this capital and increase its leverage, as loan growth prospects are muted against a background of more limited government spending and lower oil prices.

KEY RATING DRIVERS - IBA-MOSCOW
The rating of IBA Moscow's senior debt issues is equalised with that of IBA's senior debt. This reflects IBA's offer to purchase the bonds in case of a default by IBA Moscow, which represents an irrevocable undertaking and ranks equally with IBA's other senior unsecured obligations.

RATING SENSITIVITIES
After the problem assets sale is completed, Fitch is likely to (i) resolve the RWP on IBA's support-driven ratings with a one-notch upgrade to 'BB+'; and (ii) upgrade IBA's VR by one or two notches, to 'b' or 'b+'. Conversely, any changes in the authorities' intention to clean-up IBA's balance sheet, or disclosures which suggest asset quality problems remain sizable after the transfer (neither of which are currently anticipated by Fitch) would reduce the likelihood of upgrades.

The rating actions are as follows:

IBA
Long-term foreign currency IDR: 'BB', placed on RWP
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: 'b-', placed on RWP
Support Rating: affirmed at '3'
Support Rating Floor: 'BB', placed on RWP
Senior unsecured debt: 'BB', placed on RWP

IBA-Moscow
Senior unsecured debt: 'BB' and 'BB(EXP)', placed on RWP