GLOBAL RATING: The future of Russia's banking system

By bne IntelliNews October 21, 2008

Richard Hainsworth of Global Rating -

The current crisis has demonstrated that Russia's banking system is a good deal stronger than foreign critics have proclaimed. It is demonstrably stronger than the banking systems of the largest countries in Europe and the US. Barring a sudden loss of confidence by the Russian public, it will survive and very few - if any - more Russian banks will fail.

The biggest problem for the Russian banks during the first few weeks following the collapse of the Russian stock market in September was a massive loss in value of "liquid" assets. In normal practice, holding current liquidity as a combination of cash, nostro accounts and tradable shares and debt instruments is prudent. However, in the event of a systemic loss of confidence in the entire market, those instruments do not trade (which when referring to securities is termed a loss of liquidity) and lose value. Consequently, the steps taken by the Russian government to re-liquidise the stock market and sustain the value of blue-chip instruments removed the biggest single challenge for the Russian banks.

Confidence will return to the Russian banking system as bankers realize the worst is behind them. This will repeat a process seen in Kazakhstan. The country's banking system faced substantial pressure in 2007, but its banks were able to refinance their foreign borrowings from new sources, and the pressure is behind them. The Kazakh banks still face severe difficulties, in the form of reviewing their growth strategies and dealing with an economy that is far less transparent than the banks. However, these are manageable difficulties and will not require extreme measures or rapid decisions.

The next major challenge to be faced will be to avoid the arrogance that often comes after surviving disaster.

Learning curve

It is essential that the banks recognise and understand the factors that led to their survival. Unfortunately, it is human nature to look at the particular and ignore the general. Some Russian banks will view their survival entirely as due to their own individual strengths, their own risk management, etc.

In reality, the strength of the Russian banking system, just like the strength of the Spanish banking system and the current dominance of Spanish banks in Europe, is that both have gone through severe crises in the recent past - in Russia's case in 1998 and 2004. These crises gave to the Central Bank of Russia (CBR) and the regulators in Spain the political mandate to sustain draconian real risk-based regulation. The banks were unable to use their financial strength to buy political support within the bureaucracy and the central bank. Consider the US and weak European banking systems where decades of success in the financial markets have lead to deregulation and laxity.

The strengths of the Russian banking system come from a solid asset base, attention to liquidity and capital, and a complete absence of derivatives. This can only be said of the recent past. It was not the case 10 or more years ago when the entire economy was plagued by the residue of the Soviet system and Russian banks were more a means to acquire control over state-owned assets and to mask weaknesses than to act as financial intermediaries. The last 10 years have seen an excess of demand over the supply of finance in Russia (completely the opposite to the US and major European economies), and consequently banks were cherry-picking their lending opportunities. The asset-grabbing opportunities have all but disappeared, thus allowing banks to grow as businesses in the financial intermediation sector.

In regulatory terms, the capital adequacy measures enacted in law in Russia far exceed the nominal requirements in Europe and the US. The CBR extracted complete ownership transparency from the banks as a price for admission to the deposit insurance system, and the focus of all current regulatory rules has been the proper management and assessment of risk.

Finally, an obscure but far-reaching consequence of the 1998 crisis was a finding by the Supreme Arbitration Court that derivatives are a form of wager, and hence could not be held to the norms of the Civil Code. This meant that derivatives could not be embedded in contracts that could be defended in court (the opposite to the situation in Europe and the US). In hindsight, the decision was a deliverance for the Russian banks. I am convinced that had derivatives been made possible in Russia, the very clever and resourceful Russian mathematicians combined with the greed of the oligarchs would have created a system far larger than the one in the US.

Still inadequate

Despite the main argument in this article - that the Russian banking system is much stronger than many foreign financial observers previously believed - it remains wholly inadequate to the needs of the Russian economy.

There is, for example, insufficient ability to manage and diversify risks, with banks unable to sell down parts of their loan exposure to individual clients. There is insufficient monitoring of the corporate governance of borrowers - far too many clients are much larger than the banks who serve them. The supply of long-term finance is woefully inadequate - banks do not go to the local debt or capital markets to raise finance. Russian banks are far too concentrated - they remain too parochial, both in focusing on the big towns and within the country; they do not have the breadth of client types they should have within their home market (large client, medium client, small client, retail).

There are key changes that have to be made to the legal environment for Russian banks - the establishment of escrow accounts is a prime example. They is a fairly well understood collection of changes, and it seems reasonable to believe that they will be implemented in the aftermath of the crisis, thus enabling banks to develop in new directions.

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

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GLOBAL RATING: The future of Russia's banking system

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