Fitch Ratings has affirmed International Bank of Azerbaijan's (IBA) Long-term Issuer Default Ratings (IDRs) at 'BB', and Kapital Bank (KB) and Pasha Bank (PB) at 'B+'. All three banks have Stable Outlooks. Fitch has also upgraded KB's Viability Rating (VR) to 'b' from 'b-'. A full list of rating actions is at the end of this commentary.

KEY RATING DRIVERS - ALL BANKS' IDRS AND VIABILITY RATINGS (VRs)

The rating actions reflect the stability of the broader economy and the sovereign credit profile to date; Azerbaijan is rated BBB-/Stable. In Fitch's view, the strong sovereign balance sheet and sizable State Oil Fund provide a significant cushion against the decline in oil prices. Despite lower oil revenues, the goverment's policy response is expected to be relatively modest, so that growth will continue to benefit from fiscal support in the form of high public capital expenditure. However, a prolonged period of low oil prices could ultimately result in significant reductions in budget spending, which has been the major growth driver for the non-oil economy and supported bank lending and asset quality to date. Liquidity in the sector is adequate, underpinned by banks' reasonable deposit collection capacity and limited market wholesale funding (with the notable exception of IBA).

The relatively high risk operating environment constrains the VRs of local banks at quite low levels. Fitch assesses the environment as high risk in light of Azerbaijan's weak institutional development, reflected in a challenging business climate and limited financial transparency of the corporate sector, and potentially high cyclicality of the economy as a result of its commodity dependence. Banks' risks are further heightened by their often long-term and concentrated loan exposures, sometimes with significant grace periods and bullet repayments, including for project and acquisition finance purposes. In Fitch's view, these weaknesses are likely to translate into high and volatile levels of credit losses at most of the country's banks. The higher VRs of PB (b+) and KB (b) relative to IBA reflect their greater resilience to potential swings in asset quality and performance as a result of their larger capital buffers.

For more details and Fitch's outlook on the Azerbaijani banking system see "2015 Outlook: CIS and Georgian Banks: Geopolitics and Oil Key to Prospects for Region's Banks" dated 10 December 2014 at www.fitchratings.com

KEY RATING DRIVERS - IBA

The affirmation of IBA's IDRs, SR SRF and senior debt rating reflects Fitch's view that there is a moderate probability of 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 (AZN1.1bn or 14% of end-1H14 liabilities); (ii) the bank's majority (51.07%) state ownership; (iii) its fairly small size relative to the sovereign's available resources (assets and equity equal to 15.1% and 1.2% of GDP at end-1H14); and (iv) the potentially significant reputational damage for the authorities in case of IBA's default.

However, Fitch views the sovereign's propensity to provide support as only moderate due to the recent track record of quite slow (and limited in volume) capital support in 2011-2012 - when the bank breached minimum regulatory capital requirements - and weaknesses in the bank's corporate governance. Fitch views as moderately positive the IBA's recapitalisation plan, which provides for total equity injections of AZN500m by end-2016, including AZN200m already contributed in 2013-1H14. However, in the agency's view, planned loan growth means that this is unlikely to result in a significant improvement in capital ratios.

IBA's 'b-' VR primarily reflects its weak capitalisation and asset quality. The Fitch Core Capital (FCC) ratio was a low 8% at end-1H14, and the bank has no capacity to absorb losses through the income statement, given that pre-impairment profit, net of accrued interest not received in cash, was negative in 1H14 and only marginally above break-even in 2013.

Reported NPLs (non-performing loans, 90 days overdue) were a moderate 6.2% at end-1H14. However, in Fitch's view, high risk loans among IBA's largest exposures, including lending to start-up businesses and construction loans exposed to non-completion risks, were equal to a sizable 1.7x of end-1H14 FCC. Additional potential pressure on capital stems from the legacy promissory notes portfolio (around 1x FCC net of loan impairment reserves; LIR), which is largely exposed to construction projects in Russia. Fitch has limited information on the current status of these projects and their non-completion/impairment risks; however, past disclosures suggested the recoverability of these assets could be lengthy and may require absorption of considerable additional credit losses.

Positively, near-tear term financing risks are manageable following the USD500m Eurobond placement in 1H14 and recent funding rollovers. In assessing IBA's liquidity position Fitch also views as moderately positive the stickiness of IBA's customer funding and potential liquidity support from the authorities in case of need.

RATING SENSITIVITIES - IBA

IBA's Long-term IDR and senior debt may be upgraded by one notch, to 'BB+', if: (i) the authorities continue to contribute equity, in line with the announced capitalisation plan; (ii) the sovereign's credit profile and ability to provide support does not suffer any marked impairment as a result of the decline in the oil price; and (iii) IBA's asset quality and solvency do not deteriorate significantly as a result of the potential negative impact of the lower oil price on the Azerbaijan economy. IBA could also be upgraded in case of a sovereign upgrade.

Downside pressure on IBA's IDR could stem from either a sovereign downgrade or a weakening in the authorities' support stance.

IBA's VR may be upgraded if the bank manages to significantly strengthen its loss-absorption capacity and gradually reduce the volume of weaker exposures to its loan book. Renewed deterioration in asset quality and solvency could result in a downgrade of the VR.

KEY RATING DRIVERS AND SENSITIVITIES - IBA MOSCOW's SENIOR DEBT

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. The rating of IBA Moscow's senior debt is sensitive to any change in the rating of IBA's senior debt.

KEY RATING DRIVERS - KB

KB's IDRs, Support Rating and Support Rating Floor reflect the limited probability of support from the Azerbaijan authorities in case of need. Fitch's assessment of the authorities' support propensity is based on (i) KB's systemic importance due to its social function of distributing pensions and other budget transfers through the largest branch network in the country, and (ii) KB's active involvement in state-funded agency lending. However, the support probability is only limited, in Fitch's view, given the bank's private ownership and still modest commercial franchise (albeit fairly strong in retail).

The upgrade of KB's VR reflects the bank's improved performance and stronger capitalisation. The latter benefitted from net equity injections of AZN100m in 2013-1H14, resulting in the FCC ratio increasing to 27% at end-1H14 from 14% at end-2012. Fitch estimates that KB could now withstand additional credit losses equal to a high 17% of gross loans before breaching minimum regulatory capital requirements. Capital is also supported by KB's solid pre-impairment profitability (equal to 7.4% of average loans, annualised, in 1H14) which has improved considerably as a result of KB's fast growth in general purpose retail lending (by 56%, non-annualised, in 1H14).

At end-10M14, KB's unreserved NPLs were equal to a moderate 6.5% of FCC. At the same time, KB's corporate book is still burdened by concentrated construction and other project finance loans (0.6x FCC at end-10M14) which may require additional loss absorption capacity in a stress case. Retail credit risks have been fairly low to date due to still modest credit penetration, small loan tickets and KB's ability to directly debit loan instalments from borrowers' incoming salary and budget transfer payments. KB's liquidity position is healthy, supported by the absence of material non-government wholesale borrowings and decent deposit collection capacity.

KEY RATING DRIVERS - PB's IDRS AND VR

The affirmation of PB's ratings reflects its solid capitalisation, comfortable liquidity and manageable asset quality metrics. However, the ratings remain constrained by (i) the weak operating environment, (ii) the bank's still limited franchise and short track record and so far quite high credit losses; (iii) potential contingent risks arising from the construction business of the broader group and the bank's planned international expansion, which will require significant capital investment; and (iv) uncertainty with respect to the long-term sustainability of the bank's sizeable related party funding (41% of end-1H14 liabilities).

A new AZN105m equity injection in 1H14 lifted PB's FCC ratio to a high 51% at end-1H14. However, the bank's plan to open a foreign subsidiary in 1H15 could reduce capital flexibility, as it will be deducted from PB's regulatory capital thereby reducing loss absorption capacity at the parent bank level. PB's loan growth is moderate (10%, annualised, in 1H14), but it results in capital consumption as it is above the bank's return on equity (2%, annualised, in 1H14).

PB's NPLs stood at a low 4.3% of gross loans at end-1H14; however, restructured loans comprised a further 18%, and during 1H14 the bank also wrote off 10% of its starting loan balance, indicating significant asset quality weaknesses. PB's total available liquidity, net of potential wholesale funding repayments, comfortably covered 37% of its end-1H14 liabilities. However, the funding profile is weakened by significant single name concentrations and considerable funding from related parties.

PB's SR of '5' and SRF of 'No Floor' reflects its limited systemic importance and the absence of any policy role.

RATING SENSITIVITES - KB AND PB

KB's support-driven IDRs could be downgraded if the sovereign is downgraded, or if its systemic importance markedly decreases or the banks fail to receive timely support, when needed. However, these scenarios are currently regarded as unlikely by Fitch. Upside potential for KB's support-driven ratings may emerge as a result of notable improvement of its systemic importance. The latter could also result in PB's SR and SRF being revised upwards.

KB's VR could be upgraded if (i) the bank is able to maintain sound asset quality in its retail portfolio, enabling it to continue to perform well; and (ii) a moderation of growth rates allows it to maintain sound capital ratios.

Upside potential for PB's VR is limited at present; however, the rating could be upgraded if (i) loss absorption capacity at the parent bank level remains strong after the planned foreign expansion; and (ii) the bank improves significantly its asset quality track record and profitability.

Downside risks for the banks' VRs could stem from any marked deterioration in the operating environment, for example as a result of prolonged period of low oil prices, if this results in a marked weakening of banks' asset quality and capitalisation.

The rating actions are as follows:

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

IBA-Moscow
Senior unsecured debt: affirmed at 'BB' and 'BB(exp)'

KB
Long-term foreign currency IDR: affirmed at 'B+', Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Viability Rating: upgraded to 'b' from 'b-' 
Support Rating: affirmed at '4'
Support Rating Floor: affirmed at 'B+'

PB
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'