Richard Hainsworth in Moscow -
With the losses in the US sub-prime market mounting, how does Russian consumer lending stack up?
Superficially, the two categories are similar: high interest rates, high risk, banks growing rapidly as consumers borrow. But the situations are worlds apart. In the US, the consumer lending market is mature and well-segmented. Banks have been accumulating data on borrowers for decades, leading to good models of risk. But as banks have competed strongly for less-risky borrowers (the prime markets), gradually competition has led them into ever-higher risk categories.
In Russia, by contrast, the consumer lending market is only just being established. Risk models are not good, but banks can still choose to whom they want to lend. Statistical data is sparse, so risk models are unsatisfactory. One consequence of this is that all non-performing loans (NPLs) in Russia are lumped together. When NPLs are studied by category, it appears that some categories of consumers (mortgage borrowers, car loans) are very disciplined and the NPLs are low. The problem is that Russian banking accounting for the regulator does not separate out these categories of borrower. Any study by category requires a large number of assumptions (eg. any individual loan over five years in duration is a mortgage) that while reasonable, aren't sufficient for a firm analysis.
Russia also differs from the US in the way that interest rates and NPL's are related. A fairly simple model we have developed to study what is needed for a loan portfolio to remain profitable shows that the NPLs (as a percentage of the loan book) must be greater than the net interest margin (the interest rate on lending less the funding rate) divided by the funding rate. Essentially, this is because a profit is made on a portfolio when revenue is generated when the good loans are multiplied by the interest margin, but bad loans still have to be funded (the argument is actually more complex). Given that effective lending rates (the nominal rates plus the various non-interest fees) are constrained by the market, say to around 20%, banks have to maintain either good net interest margins or low NPLs.
The profitability of the sub-prime market in the US collapsed because the increasing interest rates in the financial markets compressed the margins, or if the bank tries to pass on the increased funding rate, the NPLs rose. In Russia, effective interest rates are in excess of 40%. Even though Russian banks have much higher funding rates than US banks (about 7% for Russian banks), still the net interest margin is massive. Russian banks can tolerate much higher NPLs or more easily accommodate compressed margins.
Finally, there is still evidence that finance to the Russian consumer lending market (the supply of money) is far lower than the demand for credit (demand for money). Moreover, total retail borrowing is still a much smaller proportion in Russia than it is in more mature markets. Taken together, the net interest margins look set to remain high and consumers will tolerate the higher lending rates.
The conclusion is that the fears in the US over sub-prime lending are not completely applicable to the Russian market. However, where there are super-normal profits, markets tend to readjust. Look to see more lending by foreign banks into the retail lending sector in Russia. But watch the difference between the lending and funding rates. As more capital flows in, lending rates will fall. And those Russian banks which have been relying on very profitable retail lending portfolios and not monitoring their NPLs will suddenly find problems hitting them in the face.
Richard Hainsworth is the CEO of Global Rating, the leading bank rating agency covering the CIS financial sector
To visit Global Rating website click here
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