Richard Hainsworth of Global Rating -

Someone else's crisis dominated the banking scene in both Russia and Kazakhstan, but it looks increasingly likely that there won't be a negative aftermath for any institution. The "crisis" was just a word in the foreign sections of newspapers in Georgia, Armenia and Azerbaijan - the other countries I visited during the year. The foreign funding risk was recognised by regulators, especially in Kazakhstan, who took immediate and appropriate action. The absence of a single failure of any bank in Russia or Kazakhstan resulting directly from the global liquidity storm is very strong evidence of well-managed banking systems. All in all, a good year to look back on.

The global liquidity crunch has put a temporary curb on bank pricing multiples in Russia and completely depressed Kazakh prices, but I expect even they will recover in the early part of 2008, and then soar in the second half of the year. Georgian banks are following Bank of Georgia, becoming more competitive and profitable, and Armenian banks are all looking for external investors. The problem there for most investors is that the banks are small.

Starting with the more interesting situation of Kazakhstan, by the middle of last year, Kazakhstan's regulators were concerned by the trans-border risks being built up by the Kazakhstan banks. Some 60% of liabilities came from external sources, and banking assets/GDP (a measure of banking penetration into the economy) was running at 90%. Since this latter ratio is at a level seen in mature economies, whilst it is clear from other evidence that Kazakhstan's banks are not supporting their local economy in the way West European banks do, the conclusion is that the banks have grown too reliant on foreign money. They are also placing money abroad by investing in other CIS countries. Hence, there is trans-border risk on both the liability and asset sides of the balance sheet. The regulator's efforts to curtail foreign borrowing were short-circuited by the banks, whose owners went directly to the president and suggested that the regulator was preventing them from expanding their operations beyond the country's borders.

The global chill in the capital markets gave the major Kazakh banks a cold. The regulator was vindicated and the Kazakh banks won't be able to short-circuit the regulator in the future. Although one name (Alliance) was seen to be weak relative to the other banks (towards the end of September), it has had no shortage of "special situation" funds knocking at the door offering liquidity for a price. It now seems extremely unlikely that the bank will have a problem surviving until the global markets recover their equilibrium. At the same time, Kazakhstan's banks are beginning to see a local problem due to over-lending in the construction market (a classical cause of bank crises). However, it's possible that the global liquidity crisis has actually flushed out the problems before they became unmanageable.

The Russian situation was considerably different. Prior to 2007, Kazakh banks were considered to be better than Russian banks, and the Kazakh banking system stronger than Russia's. Investors flocked to provide ever more debt to Kazakhstan, whilst Russian banks were charged higher interest rates. In consequence, total bank borrowing from foreign sources (the figure is attributed in the papers to Gennady Melikian, first deputy chairman of the Central Bank of Russia) to be about 30% of funding. Other evidence suggests that foreign funding may only be 10% of total liabilities. In any case, given the length of the funding (3-5 years), the liquidity consequences for the Russian banks are not large.

At the same time, liquidity in the Russian banking system declined rapidly. Deposits held with the Central Bank fell from a peak in August, and very short-term interbank lending rates rose by around 2%. Even so, deposits with the central bank equalled in October the levels in January - so no real shortage of liquidity existed. Moreover, there were no "black holes" into which the liquidity could have gone. Effectively, banks were simply retaining whatever liquidity they had and they stopped trading money. Money could be attracted, but only for a high price - MDM Bank was forced to buy back an 8% ruble bond (investors executed an embedded put) and refinanced it by issuing a one-year bond for an 11% yield.

For a well-known name, this was without any question about credit quality. Another name - Tinkoff Finance - went to the ruble debt market with a debut issue, but the issue is perceived to have tanked and it's not clear why in the midst of a global liquidity crisis neither the bank nor its advisors decided to discontinue the offering. Moreover, Tinkoff Finance is pioneering a very different banking business model based around credit cards and internet interaction - no expensive bricks and mortar. Perhaps this issue was "a bridge too far."

Another consequence of the liquidity crisis is a reappraisal of the relative strengths of the Kazakh and Russian banking systems. Whereas Kazakhstan's banks have looked far better than Russian banks for a considerable period of time, sentiment amongst foreign analysts is changing. The ability of the Kazakh banks to get an amelioration in the regulator's constraints indicated that the banks themselves were unwilling to recognise the inherent risks in their positions.

Kazakh banks have probably grown as far as they can, given the domestic economy. They will need to decide whether to continue an active growth policy outside Kazakhstan, or to find ways to grow intensively. I expect to see Kazakh banks becoming more involved in the Russian economy going forward.

By contrast, Russian banks have got a lot more room to grow (and hence the attractiveness of the Russian banking market for Kazakhstan's banks). The chill in the capital markets, both domestically and abroad, caused a number of banks to delay further debt issuance. Consequently, 2008 will probably see a large number of issues and the depth and liquidity of the ruble bond market is likely to rocket up to take up the slack.

The funding delays have caused all Russian banks to cut back on their growth plans. Even so, all the targets for 2007 look to have been met and well-managed small banks are looking at over 80% year-on-year growth. The funding delays will affect 2008 targets.

This combination of factors (changing analyst sentiment and opportunities for growth) would suggest that Russian banks are going to be getting more foreign funding than ever before.

What lies ahead?

Almost certainly the ruble-denominated bond market is going to take off. Given the predilection of Russian bureaucrats to shoot themselves in the foot, a debt boom could be cut off cold by excessive regulatory or tax-driven zeal - an instruction or new tax interpretation to cream off more for the treasury.

At the same time, the predominant instruments are going to change. Until now, Russian issuers needed to sweeten their offerings by embedding puts into the bond, making the effective durations around one year. As more bonds are issued, the puts will become less frequent.

The "virtual call options" that banks include in the bonds seems likely to last a bit longer. Russian law does not allow for an explicit call option. However, coupons after the second year are specified as being in excess of 1%. Hence, if a bank needs to call a bond, it sets the continuing coupon at 1%, allowing investors to sell back the bonds at par. The existence of these "virtual call options" in nearly all Russian bonds indicates that banks expect market interest rates to fall in the next two-three years. It does not seem that the market is yet pricing the call option into the trading price of the bonds. I would expect to see a more sophisticated approach to pricing develop over the next year.

Bank equity will become increasingly more traded. Even though many banks are too small to be traded separately, it's reasonable to foresee that one or more of the bank-focused funds will collect sufficient minority stakes in several banks, and then sell off interests in the fund, thus making bank equities more liquid.

Sometimes a little crisis can be a good thing - for those that survive. But since all the Russian and Kazakh banks have survived, the global liquidity crisis will serve them very well indeed. A note of caution: Russia has seen periods of success leading to arrogance and then to crisis. The imminent euphoria will probably be good for the next two to three years.

Richard Hainsworth is CEO of Global Rating, the leading bank rating agency covering the CIS financial sector

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