Alfa Bank in Moscow -

The three largest CIS economies with the most developed stock markets are offering equity market opportunities to enter the banking sector. Responding to economic growth, their banks are facing a strong increase in assets and will have a huge appetite to raise money for capital.

All three countries delivered strong asset growth in 2006. Russia is expected to post 57% growth for FY2006, accelerating from 32% in 2005. Kazakhstan is likely to deliver a 99% y-o-y increase for 2006 vs. 63% in 2005. Ukraine is likely to run 62% growth in 2006, which will be just marginally below 65% in 2005, but above Russia's rate.

While all three countries started from banking assets of 20-30% of GDP in 2000, Kazakhstan made the most impressive progress, reaching 80% of GDP in 2006.

Ukraine, which has accelerated dramatically since 2004, will post assets at 69% of GDP, while Russia's total banking assets are just 53%. Given these figures, Russia clearly has the highest growth potential in catching up with its peers.

All three countries offer different advantages for potential investors. Ukraine has the strongest focus on loans - over 70% of assets - and the lowest exposure to financial markets. With 31% of total loans attributable to retail customers, Ukrainian banks are more focused on corporate clients and mainly on SMEs. The share of financial instruments comprises only 5% of total assets.

Kazakhstan has 56% of assets in loans and a very high 18% allocated to financial assets. Kazakh banks are actively penetrating the retail market. In Kazakhstan, retail loans account for 33% of the consolidated lending portfolio vs. 31% of total loans in Ukraine and 27% in Russia. However, in all three countries the main source of revenues is still corporate loans.

As for Russia, we believe the 57% of assets due to loans is weak enough to signal strong growth potential. In the meantime, while exposure to financial instruments is as high as 17%, only one-fifth of this represents exposure to the equity market, the rest is due to the more stable bond market.

Growth in the banking sectors of all three countries remains driven by retail.

While banking assets in Russia, Ukraine and Kazakhstan are expected to post 2006 growth of 57%, 62% and 99%, respectively, these countries' retail lending markets are likely to expand by 91%, 138%, and 142%, respectively.

We believe that of all three countries, Russia's retail sector has the highest upside potential, particularly because retail loans account for just 136% of monthly salaries, and nominal salaries in Russia are expanding at the fastest pace of the three countries. Also, the increase of retail deposits in Russia implicitly indicates the population's increasing solvency. In contrast to Russia, retail growth in Kazakhstan seems to be constrained by the low deposit base; retail loans in the country already substantially exceed the deposit base. Like to Russia, Ukraine keeps strong upside potential in retail.

An important difference between Russia, Ukraine and Kazakhstan lies in the area of their liabilities structure. While Russian banks benefited from the country's investment grade ratings, the share of foreign liabilities in funding total assets did not exceed 16%. Ukraine runs an even lower level of foreign banking borrowing - just 14%. Kazakhstan is substantially different, with around 45% of total assets being financed with foreign borrowing.

Ukrainian banks take their main source of funding from retail savings, with retail deposits representing 30% of total assets and staying high as a share of GDP. This indicates strong upside that the banking sector has in case of increased ratings. Russian banks have virtually the same share of retail deposits in total assets of 27%. This confirms that private savings growth in Russia is a strong prerequisite for faster asset growth. Kazakh banks suffer from a strong pension fund system, and retail deposits finance only 12% of total Kazakh banking assets. One point to mention here is that while savings in Kazakhstan are concentrated in the pension system, Russia runs a confidence problem and should attract savings to the banks.

Despite significant difference in their liabilities structure, both Kazakh and Russian banks are looking to raise capital from the equity market. In the case of Kazakhstan, IPO plans reflect banks' intention to diversify into neighboring CIS countries, including Kyrgyzstan, and also the need for capital to continue foreign borrowing. In Russia, the main appetite for IPOs in 2007 is coming from state banks, which hold monopolist positions in the sector and need to satisfy the increasing demand for loans. Ukrainian banks seem to be less active in the IPO field, as their owners are rather looking to sell their business to international majors to gain access to international debt markets. This is explained by the relative openness of the Ukrainian economy which, in contrast to Russia and Kazakhstan, follows the CEE model of banking sector growth.

Profitability: Higher protection, higher returns

The banking sector's relative profitability suggests that the two countries with relatively protected banking sectors - Kazakhstan and Russia - run higher return on equity. In Ukraine the average traded bank's ROE was just 13.6% in 2005-2006 vs. 22.2% in Russia and 24.7% in Kazakhstan.

However, a more detailed look indicates that the level of competition on the banking market does not affect interest margin. For example, Ukrainian banks run a net interest margin of 5.4% vs. 5.3% in Kazakhstan and 4.4% in Russia.

One explanation of this divergence is rather due to the concentration of banking sector assets. While in Kazakhstan the two largest banks (Kazkommertsbank and Bank TuranAlem) control 45% of total banking assets, in Russia the share of the two largest (Sberbank and VTB) is just 30% and in Ukraine this figure is just 19%. Another explanation is that Ukrainian banks are more retail-focused and thus retail lending justifies higher net interest margins.

We believe that the high cost/income ratio in Ukrainian banks is related to the nature of their business. First, Ukrainian banks are much more concentrated on SMEs which calls for a stronger numerical presence and hence an increase staff costs. Second, a higher share of revenues in Ukrainian banks comes from retail loans, which is also a costlier area of business. An interesting point is that Vozrozhdenie, a Russian bank focused on SMEs and retail, also runs a high 60-70% cost/income ratio. We believe that low cost/income ratios in Russia and mainly in Kazakhstan reflect the high concentration of both economies on commodity companies.

The high share of fees income in total revenues, which in the case of Ukrainian banks represents 27%, is due to the same retail exposure of the country's banks. As for Russia and Kazakhstan, the modest 19%-22% share of fees incomes in total revenues indicates once again the strong concentration on specific clients, in particular on commodity producing companies. It is also important to mention that Russia's banks seem to be more dependent on the financial markets than Kazakhstan, where net interest income and fees income together represent more than 80% of total revenues vs. 70% in Russia.

Foreign investor regulation: becoming more friendly

The regulation of the local market was previously a big issue for all three countries. In Russia foreign investors were not allowed to buy banking shares without CBR permission; only so-called blessed shares were available for them. In Kazakhstan holders of ADRs were not authorized to participate in AGMs or execute their preemptive rights. Ukraine does not run any restriction on foreign participation in its banking stocks.

In 2006 the countries made significant steps to improve the regulation of foreign participation. In December 2006, Russia approved amendments to the law on banks and banking regulation, offering equal rights to local and foreign investors to banking stocks. Both residents and non-residents will be allowed to buy up to 1% stakes on the market without informing the CBR, the purchase of 1-20% should be reported to the CBR, while special permission is needed to execute the purchase of a stake of above 20%. This will substantially improve the secondary trading of all banking stocks.

Some barriers were eased with regards to IPOs. Both resident and nonresident investors had to present evidence that their planned investment in banking stocks during primary placements corresponds to their net assets. In other words, banking equity capital can not be increased with the help of leveraged capital. According to the new rules, portfolio investors can buy up to a 1% stake during banking IPOs without informing the CBR.

The key impediment to purchasing Kazakh banking stock used to be the legal problem with the status of ADR holders. As a result of complicated securities market legislation, ADR holders were "invisible" for the ultimate issuer, as long as the nominal holder had no means of disclosing real beneficiaries to it. This made ADR holders unable to vote or use preemptive rights in the course of an additional share offering. This problem was recognized in the course of Kazkommertsbank's secondary placement in mid-2006, when ADR holders were not allowed to exercise pre-emptive rights. The Kazakh financial watchdog established a procedure for such participation. Voting rights still remain restricted under Kazakh legislation; however, issuers tend to establish voting procedures for ADR holders in the placement prospectuses.

Recently the main shareholders of some Kazakh banks - Kazkommertsbank and Halyk - sold their stake in ADRs on the international market. The revenues from this transaction were injected back into the banks' capital. In the case of Kazkommertsbank, the entire $0.8 bln received from international placement contributed later to the capital growth. Halyk Bank, however, took $0.6 bln from the international market but increased its equity capital by only $0.2 bln. The difference was taken by main shareholders and reallocated to different business. In total Kazakh banks that have their shares traded took around $1.4 bln from the international market.

One word should be said about the reporting standard. In Kazakhstan all banks are reporting in accordance to IFRS, which simplifies their analysis substantially. In Russia the IFRS publication is an important guidance in judging a bank's transparency. Bank of Moscow just started to release twopage annual IFRS reports, while Vozrozhdenie provides IFRS results on a quarterly basis. In Ukraine the majority of banks provide annual IFRS statements.

In Ukraine the important market catalyst will be the approval of the amendment to the law on joint stock companies. The IPO regulation has been elaborated since 2001, but still not approved. In the very best case they will be passed this year that will open way for new banks to come to the market.

While previously Ukrainian banks had to pay taxes on capital injections, the regulation has been changed since January 2007. The return from the new share placement will no longer be subject to taxation. We expect this will stimulate banks' appetite for share placements to the market.

The banks' comparative balance sheets and the openness of their sectors to foreign banks explains why Ukrainian banks are traded at an average 2007 P/BV of 3.8 vs. 3.3 for both Russia and Kazakhstan. In our view, the expected higher valuation for Russian banks is justified by the low penetration of banking services in the country and thus by strong revenue upside. The high valuation of Ukrainian institutions is due to their retail growth potential and expected sales to foreign buyers; however, returns could be improved by stronger costs control. Kazakh banks are likely to deliver lower ROE in 2007 following capital raising, which is expected to become massive if additional restrictions on foreign borrowing are introduced.