OREANDA-NEWS. Fitch Ratings has affirmed the Long-term foreign currency Issuer Default Ratings (IDRs) of Expressbank (EB), Unibank's (Uni) and Demirbank's (Demir) at 'B', and Atabank (AB) at 'B-' The Outlooks on all four banks are Stable.

At the same time Fitch has downgraded the IDR of Azerbaijan-based AGBank (AGB) to 'CCC' from 'B-' and removed it from Rating Watch Negative (RWN). Fitch placed AGB's ratings on RWN in March 2015 due to a breach of regulatory capital adequacy as a result of a sharp 34% Azerbaijani manat devaluation against foreign currencies. A full list of rating actions is at the end of this commentary.

KEY RATING DRIVERS - ALL BANKS IDRS AND VIABILITY RATINGS (VRS)
The affirmation of Uni, Demir, EB and AB's ratings with Stable Outlooks reflects the only moderate deterioration of their financial profiles amid weaker commodity-driven economic environment suffering from an oil price shock. There are signs of asset quality deterioration in the banking sector, with further downside risks stemming from (i) an anticipated reduction in government spending; (ii) the significant dollarisation of loans (Uni - 48% of end-1H15 loans; Demir - 34%, more moderate at the other two banks), which should be viewed in context of the 34% local currency devaluation in February 2015; and (iii) expected seasoning of retail and micro-loan portfolios rapidly originated in 2013-2014. However, in the agency's view, these four bank's solid pre-impairment profits and capital buffers would be sufficient to cover heightened asset quality risks in the near term. Also, some cyclicality in asset quality and performance is already factored into the banks' relatively low ratings.

The one-notch higher rating at Uni, Demir and EB relative to AB reflects the somewhat stronger loss-absorption capacity at these three banks due to either healthier pre-impairment profitability (Uni, Demir) or a more solid capital buffer (EB).

The downgrade of AGB's ratings to 'CCC' reflects further aggravation of deep asset quality problems, negative pre-impairment profitability on a cash basis, and a significant weakening of the capital position (the bank uses forbearance for being incompliant with minimal regulatory capital requirements) as a result of manat devaluation, which in the currently difficult operating environment threatens the viability of the bank's business model.

For Uni and EB, the main credit risk stems from their large unsecured consumer finance loan books with respective non-performing loans (NPLs, 90 days overdue) origination (defined as increase in NPLs plus write offs divided by average performing loans) surging to 10%-11% in 1H15 from 3%-4% in 2014. However, their solid pre-impairment profitability of 12% and 7% of average loans, respectively, was sufficient to cover these risks. The banks' end-1H15 NPLs were 11%, 96% well covered by reserves in Uni, and 1.4%, 114% covered by reserves in EB. Credit risks at EB are also mitigated by it sizeable capital buffer (Fitch Core Capital (FCC) ratio of 45% at end-1H15), although it is somewhat undermined by a lumpy related party exposure (67% of end-1H15 FCC). Uni's capitalisation is moderate with an FCC ratio of 11% at end-1H15.

Demir focuses on SME and micro-loans with small average tickets and reasonable collateral coverage and therefore its asset quality has so far been relatively resilient, as reflected in NPL origination of around 5.5% in 1H15-2014. This compares with its pre-impairment profit of 7.2% of average performing loans in 1H15. End-1H15 NPLs were 10%, 70% reserved. Demir's capital buffer is only moderate, with the end-1H15 FCC ratio equalling 10%.

AB's NPLs were broadly flat in 1H15 at 6.6% and 32% reserved. However, its asset quality is potentially vulnerable due to significant exposure to construction and other project finance loans (11% of loans) with sizeable grace periods on principal and a limited track record of loan redemptions. AB's pre-impairment profitability (if adjusted by AZN10m translation gain) is rather modest with 2.9% of average loans. Capital is adequate, as expressed by a reasonable 17.5% FCC ratio at end-1H15.

AGB had significant asset quality issues even before the recent economic slowdown/devaluation with NPLs of 29% at end-1H15 (30% at end-2014) weakly 40% covered by reserves. The bank's pre-impairment profit on a cash basis (net of accrued interest which is not received in cash) has historically been negative, while its capital position is extremely weak as expressed by a low 6.6% FCC ratio at end-1H15 and total regulatory capital ratio (8.6%) being below the required minimum (the bank has utilised regulatory forbearance since February 2015). According to management, the shareholders are likely to inject AZN5m by end-2015 and another AZN5m in 1H16, which is still below an estimated AZN18m needed to bring the ratios in compliance.

Net profitability has dampened across the board. Uni and Demir posted some losses in 1H15, albeit mostly due to one-off translation losses, while on a recurring basis Fitch estimates that both were still above break-even. EB and AB showed moderate net profits, as they were less affected by manat devaluation. AG incurred a large foreign currency translation loss eating deeply into its equity.

There was a moderate 6% outflow (after adjusted for a 34% currency devaluation in February) of retail deposits from the sector in 1H15 with the reviewed banks being similarly affected. Dollarisation of deposits increased to 70% at end-1H15 from 40% at end-2014 resulting in a manat liquidity shortage. More importantly, it also resulted in a structural inability to hedge the short currency position by any other means except issuing foreign currency loans, increasing future credit risks. As a result, many banks in the sector operate with unhedged short FX positions being exposed to significant one-off translation losses in case of further manat devaluation. At end-1H15, the biggest short FX positions were in AGB (3x regulatory capital), Demir (46%) and Uni (38%), although Fitch estimates the latter two banks can withstand at least 30% devaluation before breaching capital requirements. In addition, Demir's open short currency position has subsequently reduced to below 20% the capital at the beginning of November. AB and EB have minimal open currency positions, so are least exposed.

Liquidity buffers are comfortable and sufficient to withstand moderate deposit outflows, although AZN-denominated liquidity in the sector is fairly tight at present due to the limited inflow of AZN-denominated funding. Refinancing risks are modest with fairly high loans/deposits ratios at Demir (187% at end-1H15) and Uni (145%) mainly reflecting funding from local state-related institutions and IFIs, which is relatively sticky.

RATING SENSITIVITIES - ALL BANKS IDRS AND VRS
Negative rating action could be triggered by significant asset quality deterioration at any of the banks resulting in considerable impairment losses should these exceed the pre-impairment profit and erode capital. Potential further currency devaluation could also lead to selective downgrades if it results in the capital base erosion and/or significant funding outflows.

Positive rating action would require an improvement of operating environment, moderation of downside asset quality risks, and an extended track record of reasonable performance through the credit cycle. An upgrade of AGB would also require a significant capital replenishment sufficient to bring the bank in compliance with regulatory capital adequacy rules.

KEY RATING DRIVERS AND RATING SENSITIVITIES - SUPPORT RATINGS (SRS) and SUPPORT RATING FLOORS (SRFS)
The SRFs of 'No Floor' and Support Ratings of '5' for each of the banks reflect their relatively limited scale of operations and market share. Although Fitch expects some regulatory forbearance to be available for these banks, in case of need, any extraordinary direct capital support from the Azerbaijan authorities cannot be relied upon, in the agency's view. The potential for support from banks' private shareholders is not factored into the ratings. Fitch believes that the revision of banks' SR and SRFs is unlikely in the near-term.

The rating actions are as follows:

Unibank:
Long-term foreign currency IDR: affirmed at 'B', Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: affirmed at 'b'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at No Floor

Demirbank:
Long-term foreign currency IDR: affirmed at 'B', Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: affirmed at 'b'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at No Floor

Expressbank:
Long-term foreign currency IDR: affirmed at 'B', Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: affirmed at 'b'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'

Atabank:
Long-term foreign currency IDR: affirmed at 'B-', Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: affirmed at 'b-'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at No Floor

AGBank:
Long-term foreign currency IDR: downgraded to 'CCC' from 'B-'; Off RWN
Short-term foreign currency IDR: downgraded to 'C' from 'B'; Off RWN
Viability Rating: downgraded to 'ccc' from 'b-'; Off RWN
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'.