COMMENT: Quality not quantity in Russian banking

By bne IntelliNews December 11, 2008

Richard Hainsworth of RusRating/GlobalRating -

Assessing the asset quality underlying a bank or banking system is an essential prerequisite for making a judgment about its strength. The irrational exuberance of the early 2000s has given way to equally irrational pessimism currently afflicting traders.

The facts are certainly clear: there is a wave of corporate defaults, and Russian banks are having their liquidity and operational risk system tested. Some have failed. Nevertheless, the interpretation of these facts needs to be rational.

Two structural factors need to be considered in such an interpretation. First, the Russian economy has a single tax year, ending on December 31. This means that all contractual obligations, trade transactions and long-standing loan agreements tend to be tied to the year-end. The pressure on all banks and corporates to close operations is always highest in November and December. Consequently, any economic activity peaks at this time, which also means that the strain in a period of turbulence will be severest at this time. It is analytically incorrect to take data points from November and December and extrapolate them linearly into January and February.

Secondly, Russia - just like all the countries of the CIS - does not have any significant source of medium to long term (viz., over a year) funding. At the same time, companies in a period of expansion need funding for three to five years because it takes that long for a new piece of plant or project expansion to be bought, installed and start generating cash. The result is that the real economy needs three-to-five year funding, but the banks can only provide short-term lending. The result is a maturity gap between the needs of the economy and the abilities of the banking sector.

Ordinarily, this is no problem. A functioning economy is a dynamic system and short-term funding is constantly being replenished with interest income and repayments from the real sector. Banks are willing to lend to corporates for longer periods, but for compliance purposes request one-year loan contracts. Corporates hedge their refinancing risks by establishing lines with several banks. However, when there is a liquidity crunch, the banking system as a whole retains liquidity and corporates cannot refinance. Since the loans are one-year long, they come due. They cannot be refinanced, so the corporate defaults. In ordinary times, a default means that the company is weak or mismanaged. But in a time of crisis, the corporate may be strong, but without liquidity. A default in a time of crisis does not mean that the underlying corporate is weak.

Deeper questions

This leads to a much deeper question of finance and economics. If an enterprise or bank is judged to be strong solely on the grounds of its liquidity in a time of global crisis, then what should it do in a time of normality? If it retains levels of liquidity in reserve that would be adequate in times of crisis, then it will be unable to lend those resources for any long period of time. This will reduce the rate at which a banking system can lend to the economy and the ability of the economy to grow and develop.

Returning to Russia, the inability of companies to repay the principle on loans that do not match their borrowing requirements is more about their levels of liquidity going into the crisis. Those loans may still be performing in terms of interest being paid and would not be considered to be in default had the legal form matched the economy substance.

Taking these two factors (intense year-end contractual activity and a contractual mismatch in funding) into consideration, a wave of corporate defaults during a global crisis in November and December does not mean that the Russian economy or the banking system is inherently weak, or that it's inevitable the crisis will continue into 2009.

Richard Hainsworth is CEO of RusRating/GlobalRating, CFA

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