Mark Adomanis in Philadelphia -

The most basic part of any bank's business model is the extension of loans to consumers and corporations. Clients need money, to expand their business, buy a home, or, in a less sunny scenario, to re-finance existing borrowing, and the bank gives it to them while charging interest. Assuming that the loan is paid back on time (which, in certain circumstances, can be a very big assumption!), the bank profits on the difference between the rate at which it can borrow money and the rate that it charges its clients. It’s a simple and often quite profitable line of work.

However a bank, even the best-run and most capable of all banks, knows that not 100% of the loans it extends will be paid back. Businesses go bankrupt, people lose their jobs, and repayment terms that once seemed reasonable can quickly become unrealistic. Banks thus need to create a "provision" to guard against bad debts – those loans that the bank reasonably expects will not actually be paid back. There are more or less accurate ways of estimating these provisions, but there's no single "right" answer. Because the process of estimating provisions is forward-looking there is a certain amount of inherent subjectivity.

Looking at its 2014 IFRS results released on March 13, we can see that VTB's basic business of lending money to people and charging them interest on that money isn't doing very well. The bank’s provision for bad loans more than doubled, going from RUB96.9bn in 2013 to RUB255.4bn in 2014. This essentially means that VTB expects that RUB255.4bn worth of loans that it extended will not actually be paid back. Not to get too far into the technical weeds, but an increase in a provision is essentially a decrease in net income: the bank originally thought it would collect on the loan, but no longer does and it needs to adjust its profit accordingly.

The deterioration in the quality of VTB’s loan portfolio caused its net interest income (the amount it actually earned minus the amount it had to set aside for provisions) to plummet from RUB226.1bn to a mere RUB98.9bn. VTB's core business, then, suffered a 56% decrease in profitability from 2013 to 2014.

Other lines

But that’s not all: in the dazzling world of modern finance banks don’t just limit themselves to the, rather boring, business of loaning money and charging interest; they invest in other financial vehicles (stocks, bonds, derivatives, etc.) or foreign currencies. As the value of these investments ebbs and flows, banks can record huge profits or, when the economy enters a down cycle, enormous losses.

VTB's other lines of business performed even worse than its loan portfolio. In 2013, VTB gained RUB13.2bn from its investments in various "financial instruments." In 2014? It lost RUB3.0bn. It also had to record a RUB20bn asset impairment charge, essentially a formal recognition that assets it thought were worth X were, in fact, worth a lot less. Had VTB not been able to book a RUB99.2bn gain from the deposit insurance agency, basically an extension on a super-favorable government loan that helped it absorb Bank of Moscow, its "other operating income" for 2014 would have been -RUB80.7bn (for comparison's sake, in 2013 it was positive RUB9.6bn).

Compared with most Russian banks, VTB is generally regarded as well-run and well-capitalized. If the damage from 2014 was this bad for VTB, and it was really bad, the only thing that prevented the bank from recording a large loss was that very generous loan from the deposit insurance agency, then it is going to be much worse for the still-large number of poorly run Russian banks. Certainly the deposit insurance agency can’t give everyone RUB100bn.

Additional IFRS results will trickle out over the next several weeks. But if even the largest state-run banks like VTB are witnessing such huge deteriorations in their performance, it seems as if the Russian banking sector is on the verge of systemic crisis.