Ben Aris in Moscow -

Dark storm clouds of administrative interference in Russia's banking industry are gathering over Ulitsa Neglinaya, the home of the Central Bank of Russia.

The Kremlin is in a rush to fix Russia's banking system. A raft of financial sector reforms have been rushed through the Duma, but in its impatience to make Russia's anaemic banks fulfil their traditional role as financial intermediaries, the Kremlin looks like it is revving up to use "administrative means" to force a badly needed consolidation on the sector.

Pensioners demonstrate outside the CBR headquarters on Ultisa Neglinaya in 1998. The sign reads: "Mr Gerashchenko, have a heart. Give us back our money"

President Vladimir Putin launched the second phase of the Kremlin's effort to accelerate bank reform - arguably the only sector in the economy being reformed - by lambasting collected officials and banking CEOs at a meeting with the State Council in the second week of November.

Putin trotted out a string of well known complaints: only one Russian in four actually has a bank account, one in 10 has a bank card and most people can't afford to pay the 11%-plus interest rates most banks charge for a mortgage. However, in the closed part of the meeting the bankers took the opportunity to air their biggest complaint.

"They told the president that we need to close the 1,000 smallest banks. And we need to do it quickly," says one senior bank official who was involved in the meeting. "These banks account for about 1% of total banking assets so they add nothing and no one will notice them if they are closed. All they do is add to the corruption and undermine the sector."

Rush to reform

The Kremlin is getting frustrated with the slow pace of bank consolidation and has been quietly tightening its control of the sector. The danger is, in its impatience to force the pace, the state will undermine confidence and spark another crisis.

When the central bank (CBR) tried to exercise its regulatory power and closed a bank for the first time ever in May 2004 - Sodbiznesbank was shut for breaking money-laundering rules - it sparked a mini-banking crisis that ended with the failure of Guta bank, a second-tier universal bank, and nearly brought down Alfa Bank, a top five commercial bank, to its knees.

Mikhail Fridman, Alfa Bank's owner, was forced to fly in $800m in cash from Germany, which sat in crates in a warehouse just outside Moscow, to prevent nerves breaking into a full-fledged run on deposits. The whole episode showed just how fragile the banking sector is and how little faith average Russians have in their financial system.

Russia's banking sector has been attracting a lot of attention with a string of foreign acquisitions, where big name international banks are paying top dollar for access to the flourishing market. With banking sector assets worth about 45% of GDP - half Western European levels - Russia's banking sector clearly has a lot of growing to do. Banking M&A has undoubtedly begun, but there have only been a few dozen deals so far.

The big banks are growing fast and assets are slowly consolidating in the household names, but even this welcome progress is causing problems. As the small banks see their margins squeezed by the rapidly increasingly competition they are tempted to bend the rules in an effort to hang onto their customers.

The rising pressure on banks to change their ways has been manifest in a string of assignations of senior bankers in recent months - something not seen since the end of the 1990s. At least half a dozen bankers have been gunned down in the last year in professional contract hits.

The most notorious of these was the death of CBR Deputy Chairman Andrei Kozlov last month, who was responsible for implementing the crackdown, and Alexander Slesarev, the chairman of Sodbiznesbank, who died in a hail of bullets a year ago this month along with his wife and youngest daughter.

And that pressure is about to become even heavier after the Kremlin finally signed off on a deal to join the World Trade Organisation (WTO) in the middle of November.

"The banking industry doesn't have much time to become more competitive [before Russia's accession to the WTO] in the case the accession takes place," Putin said on the eve of striking the WTO deal.

Putin went on to call for big banks to merge into large conglomerates to deal with the rising competition. "It's clear that the strengthening of domestic banks implies their becoming more powerful and the creation of large financial and banking conglomerates in Russia," Putin said.

Pensioners demonstrate outside the CBR headquarters on Ultisa Neglinaya in 1998

Despite the general perception of "creeping statism" that the re-nationalisations in the oil sector has caused, the Kremlin has made it clear it will gradually reduce its holdings in the bank sector. Sberbank will make a second placement of shares worth $6bn-8bn in the first quarter of next year followed by VTB's IPO of about 20% of the bank's capital sometime after May. Russia's Finance Ministry said mid-November that the state's stake in VTB would be further reduced to 51% by 2009.

The push to create big banks - which means getting rid of the little ones - is also part of the Kremlin's industrial policy of promoting national champions, quietly introduced in about 2004. The main thrust of this is to create a series of Russian corporate giants that can do battle (and win) in the international marketplace.

The introduction of the deposit insurance scheme in 2004 marks the end of the first phase of Russia's bank reform, which was used to tighten supervision and make the rules stick for the first time. Over the last six months, the central bank has been going through a shake-up of personnel as it gets ready for the next more aggressive stage.

Give with the left...

The Kremlin's strategy is to give with one hand and take with the other. During the State Council meeting Putin publicly pointed to the fact that despite accounting for about 12% of bank sector capital, foreign banks already account for 40% of all loans to the non-financial sector and suggested that the state could help with partial guarantees, but didn't elaborate.

Bankers at the meeting report that Putin then went on to float the idea of the idea of giving banks access to Russia's state pension funds. While the $70bn of Stabilisation Fund money has been effectively put beyond the reach of Russia's banks and politicians, Putin suggested that banks be allowed to tap into the state pension funds that would give them access to badly needed long-term capital.

The state pension fund has RUR270bn ($10bn) under management, which will grow to RUR2 trillion by 2012, according to the fund. The overwhelming part of this money is managed by the state-owned Vnesheconombank, which is forced to invest only in sovereign bonds and currency, which barely earns enough return to keep pace with inflation.

... and take with the right

On the other side of the coin the Kremlin, in the form of the CBR, is cracking down on the sector and for the first time trying to enforce the rules.

And the new tougher stance is not just aimed at banks, but the entire financial sector. The government agencies in charge of supervising this business are being given teeth and there is even talk about creating the long-mooted mega-regulator to supervise all the various financial sub-sectors by the end of next year.

For example, after bungling the pension reform two years ago and letting the oligarch-owned pension funds bribe their more professional peers out of business, the state has belatedly started to crack down on the excess number of asset management companies that registered in the hope of selling their licenses at a later date.

Russia's Federal Service for Financial Markets (FSFM) closed down 23 private pension funds at the start of November and in the middle of November FSFM Deputy Director Sergei Kharlamov said the financial market watchdog would suspend several dozen more non-governmental pension fund licenses in the near future.

The mini-bank crisis in 2004 gave everyone a nasty jolt and rather than risk undermining confidence further by closing more banks, the CBR let almost all of Russia's banks into the deposit insurance scheme in 2005 during what was, in effect, a complete re-licensing of the sector.

However, the CBR used entry to the scheme to significantly improve supervision by forcing banks to reveal their ultimate beneficial owners and stamp out the widespread abuse of rules covering the calculation of a bank's capital; up to a quarter of the banking sector's capital was so-called "virtual capital," created through creative book keeping scams.

Now the CBR is amassing even greater powers and has introduced several measures to increase its direct control over the banking sector.

In the third week of November, the CBR announced it would introduce new software that enables the central bank to look over the shoulder of bankers and see their daily operations in real time, rather than rely on the piles of paper that banks currently have to submit to the regulator.

"The Bank of Russia is considering whether to create software that would enable to control bank operations currently reported by banks to Rosfinmonitoring," said Deputy Chairman Viktor Melnikov, who recently took over the bank supervision job after Kozlov was killed.

The new system will give the central bank direct access to the electronic accounts of banks and analysts say it could also allow the CBR to actively interfere in a bank's operations.

The CBR also changed the rules governing the buying of bank shares in September, easing the restrictions on foreign investors but also lowering the reporting thresholds; amendments on the Banking Law, proposed in April, were adopted in September that ends the need for the CBR to "bless" bank shares.

Under the old rules, foreign investors had to always seek the CBR's permission to buy bank shares. However, this didn't affect the trading of Sberbank's shares (the only liquid bank shares on the market), as there were enough "blessed" shares in circulation to satisfy demand. Permission must be sought for a sale from a Russian to a foreigner but not each time shares are sold by a foreigner to a foreigner. Some 19% of Sberbank's shares are blessed, which is half the estimated free float of 37%, according to Deutsche UFG.

Under the new rules, investors - domestic or foreign - that buy less than 1% of a bank's shares can do so without asking the CBR's permission. Transactions involving 1-10% must be reported to the CBR, but don't need the CBR's permission. For transactions over 10% the CBR's permission must be sought.

However, once again the CBR took the opportunity to increase its control over trading in the shares of banks. Previously Russians could buy up to 5% of a bank without notifying the CBR and up to 20% without applying for permission from the CBR.

The pieces are being put in place. Under the former governor Viktor Gerashchenko, the CBR didn't really care what banks did as long as they didn't collapse. However, now the central bank is giving itself an arsenal of supervisory tools and in Putin's Russia accurate information is power.

The rules are increasingly being enforced, but the Kremlin has not only blurred the line between the state and business, it has removed it altogether and makes as much use of administrative levers as it does the law to shape business. It can be argued that this is the most pragmatic approach to solving Russia's problems in the banking sector as if the rules were stringently enforced so many banks would be closed that another banking crisis would be certain.

Much depends now on how far the Kremlin chooses to go with its heavy handed tactics in its haste to create a lean, efficient, and most importantly, large banking sector that can finance Russia's continued growth.

Ben Aris