The Banking Sector’s False Alarm: Despite Changes in the System, Old Fears Are Hard to Overcome

The inter-bank liquidity crisis in June that followed the withdrawal of licenses from two banks for money laundering provoked, perhaps inevitably, much speculation about a banking crisis, and once again threw the spotlight on Russian banking reforms.

Taking advantage of its supervisory powers and new money laundering laws to clamp down on shady operations and clean up the banking system, the Central Bank of Russia, on May 13, went after Sodbiznesbank and, a few days later, KreditTrust. Sodbiznesbank was accused of conducting suspicious transactions worth about $1 billion in 2003, while the Russian police said that it was also under suspicion of accepting money from ransom payments in the kidnapping and subsequent murder last year of two managers from the Russian truck manufacturer KamAZ. Who the beneficial owners, those who call the shots and reap the profits, at Sodbiznesbank and KreditTrust are is unclear, although it was widely reported that the two banks were linked through common owners.

But, while the Central Bank’s move to close down banks allegedly involved in criminal activities appeared to be laudable at first sight, it unsettled many Russian institutions, because this was the first time the Central Bank had withdrawn licenses from banks before they had actually defaulted.

Russian banks were therefore unsure about the new rules of the game and how the Central Bank would apply its new powers to them in the future. They were particularly worried that the legality of some of their operations, such as their tax-optimization schemes, might be called into question.

Facing the threat of having their licenses withdrawn, Russian banks stopped lending to each other for fear that, should the licenses of their borrowers be revoked, lenders would be unable to recover their loans to other banks.
The result was an inevitable liquidity crunch on the inter-bank market, which finally prompted the Central Bank of Russia to step in on June 11 to provide liquidity and assuage market fears by reducing the refinancing rate from 14 percent to 13 percent and the mandatory reserve requirement from 9 percent to 7 percent.

Russian television also showed President Putin and Central Bank Chairman Sergei Ignatiev discussing the problem, with Putin seeking assurances that the Central Bank was not planning a “mass purge” of the banking system.

At first sight, the liquidity crisis on the inter-bank lending market does not seem like much of a surprise but, instead, just another symptom of the Russian banking system’s underdevelopment and its many weakness.

Before the collapse of the financial system in August 1998, Russian banks were making huge and very easy profits by investing in Russian government debt, the notorious GKO and OFZ markets, which were tantamount to money machines. Since then, however, Russian banks have had to become much more reliant on normal banking business, i.e. the allocation of money and credit. Even so, the Russian banking system remains undeveloped compared to Western countries. An electronic clearing and settlement system has only been in place for some three months, while the dominance of the state-owned national savings bank Sberbank distorts the banking market, making the system very lopsided.

The Central Bank of Russia has long been aware of the problems, and the required solutions, and announced plans several years ago to improve and rationalize the banking system, including a reduction in the number of smaller banks with low levels of capital and questionable operations.

Reform of the banking system has, however, been slowed by inadequate legislation, preventing the Central Bank from pushing ahead as fast as it would like. The Russian Civil Code, for instance, makes mergers and acquisitions among banks virtually impossible. The reform thrust also ran into opposition from powerful vested interests, including some banks, which managed to hold up important reform legislation when it was initially put forward in October 2002.

But with the legislation finally passed by the State Duma in October 2003, reform has been back on track in recent months, and the underlying situation in the banking sector is, in fact, better than the current mini-crisis would suggest, with the claims in some of the Russian media that the crisis is systemic appearing to be exaggerated.

In addition to the currency-regulation law, which took effect on June 18, and a law on bankruptcies among banks due to come into force by the end of 2004, the Central Bank is also in the midst of a raft of important changes that bode well for the further development of the country’s nascent banking system.

A well-publicized deposit-insurance scheme has been established to encourage the population to use banks more, thus bringing some of the huge sums kept “under the mattress” into the financial system. In order to qualify for the scheme, interested banks had to undergo far more stringent audits on their accounts than had been the case in the past. The list of participating banks was to be announced in time for the official introduction of the scheme on July 1. The initial group of 17 banks has already passed the first audit, with a further batch of 17 to follow.

Ralf-Dieter Montag-Girmes, the chairman of the Board at Investment-Credit Bank ARQ, which is a member of the new deposit-insurance scheme and also worked closely with the Agency for Reconstructing Credit Organizations (ARCO) in the restructuring of Russian banks following the August 1998 financial crash, says that the situation is moving in a positive direction.

“I’m very optimistic going forward, because the Central Bank is very serious about reforming the banking system and has now put a lot of the structural building blocks in place,” Montag-Girmes said. “For instance, the Central Bank has not been averse to use its effective power of veto over membership in the Deposit Insurance Agency to put pressure on banks and bring them into line. It is very prestigious for banks to be members of the deposit scheme and they can’t afford to be left out, so this gives the Central Bank leverage over recalcitrant banks.”

“I’m also very encouraged by the efforts of the Central Bank to modernize its bank monitoring system to improve its supervisory capacity,” he added.

According to Richard Hainsworth, general director at Rus Rating, an independent bank-rating agency covering some 40 banks in Russia, the Central Bank has reversed its former policy under Russian Accounting Standards (RAS), where the CB used to emphasize form over substance with regard to the banks’ accounts.

“But now that the Central Bank is putting the stress on substance rather than form, we will have a much better idea about the true economic position of Russian banks,” Hainsworth said.

In other words, the Central Bank is now looking at the real economic position of banks, rather than just what is on the balance sheet. In the past, for example, Russian banks have been adept at using various technical methods to increase their capital by creating assets on their balance sheets without making the corresponding entries on the liabilities side.

As a result, banks could improve their prudential ratios, creating the impression of adequate bank-capital cushions. The Central Bank has tightened up its instructions on how capital is calculated, with the new rules designed to bring banks’ balance sheets and capital figures more in line with reality. The Central Bank has now audited all of the big banks and their loan portfolios and, beginning in October, all balance sheets will have to be prepared in accordance with international accounting standards.

The Central Bank is also pushing for more sophisticated risk regulation and management, which involves assigning differential risk weights to distinguish between broad asset categories. This approach is largely derived from Western banking practice but, due to the country’s low level of development and still relatively primitive banking system, the advanced risk management techniques used in the West are still unnecessary in Russia, where derivatives, for example, are virtually unknown.

As part of its general policy of making the banking system much more transparent, the Central Bank is working to improve areas such as corporate governance and is applying more rigorous definitions to questions such as beneficial ownership.

“I was very impressed by the rigor and professionalism of the Central Bank in investigating us at Investment-Credit Bank ARQ when we applied to participate in the deposit-insurance scheme,” said ARQ Chairman Montag-Girmes. “They asked us all of the right questions concerning the ownership structure of ARQ and checked up on our beneficial ownership abroad. This bodes well for the future because people are now beginning to realize that honesty does pay in the Russian banking sector.”

Rus Rating’s Hainsworth agrees that the current reforms auger well for the future of Russian banking and, thus, for the Russian economy overall.

“Contrary to popular belief, the Russian banks are in fact economic and commercial entities, and they operate on a rational basis,” Hainsworth said. “They look set for a lot of growth in the future as the economy grows.”
But questions remain, such as how will this future growth be financed and how will banks meet the increasingly stringent capital and reporting standards. In 2005, for instance, minimum capital requirements will be increased from 2 percent to 10 percent, and the minimum capital requirements for all banks in 2010 will be set at 5 million euros ($6 million).

Foreign models are not always appropriate to Russia. Poland and Hungary, for instance, allowed foreign banks in and auctioned off all their own banks, so that these countries now have large banks with plenty of capital.
But, as Hainsworth points out, Russia is unlikely to follow this path.

“Russians do not really want their banks to be owned by foreign nationals who are not subject to the country’s laws,” Hainsworth said. “In that sense, Russia is just as insular as the United States and the United Kingdom.”

Special to Russia Profile, an online and monthly print magazine dedicated to Russia and published jointly by RIA-Novosti and Independent Media, Moscow.

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