Robert Anderson in Prague -

Raiffeisen Bank International (RBI) has become the sick man among the international banking groups that dominate Central and Eastern Europe.

RBI was the banking pioneer in the region, leading Austrian and other multinational companies into the new markets that opened up after the collapse of communism in 1989. It still ranks second in terms of assets among the (non-Russian) banks in the region and it has the most wide-ranging network, with operations in 15 countries, many of them frontier markets such as Kosovo and Belarus.

But after making its first loss last year, RBI announced plans in February to scale back its operations, in an attempt to boost its core capital ratio to keep up with its peers. The disposals will relegate it to fourth place among the non-Russian banks operating in the region in terms of assets and could push it into another full-year loss after it books the bulk of the €550m of restructuring charges.

The restructuring plan has steadied RBI’s share price – which had hit a low of €8.81 at the end of January – though it is still a third down on a year ago at around €12.53. This gives it a market capitalisation of just €3.67bn, a multiple of 0.45 times its book value. Austrian rival Erste Bank Group currently has a market cap of €11.85bn, with its shares trading at a multiple of 1.1 times its book value.

Making your own luck

RBI’s woes are partly a result of bad luck. In Ukraine, the annexation of Crimea by Russia has forced it to sell its branches there and shutter those in the east where the conflict is raging, which has helped make 52% of its loans in the country non-performing. High levels of problem loans in other key markets such as Croatia, Romania and Hungary, together with adverse currency movements in Russia and Ukraine, plus bank levies and forced conversion of Swiss franc loans in Hungary, have all led to losses that the rest of the network could not counter-balance. Excluding all these impairments, analysts were relatively positive about the first-quarter performance.

But sometimes you make your own bad luck. The sheer diversity of the bank’s operations has become a weakness, something that the disposal programme starts to address. “A bank of our size should be more focussed,” Karl Sevelda, RBI’s chief executive since June 2013, told bne IntelliNews recently, while adding "what we want is a more balanced structure".

RBI claims that its diversity helped it stay profitable in the past, notably during the global financial crisis, as not all its markets turned down at the same time or pace. But today RBI is exposed to several of the most problematic markets in the region at the same time, putting severe pressure on management resources. Jiri Stanik, founder of consultants Helgi Analytics, argues that RBI is spread too thinly. “Right now that looks a potential problem,” he says.

Its current crisis has also demonstrated that, despite its diversity, in reality it is dependent on a few key markets, notably Russia. Even in 2014 Russia provided almost a quarter of group net interest income. “They are extremely dependent on a few markets,” says Patrick Rioual of Fitch Ratings, which cut its rating for RBI to 'BBB' with a negative outlook in May.

The contrast with Erste’s strategy is revealing. Austria's second largest bank started expanding into CEE much later than Raiffeisen, making its first big step only in 2000 with the acquisition of Czech retail bank Ceska Sporitelna. It has remained focused on retail banking in Central Europe, and is among the largest banks in the Czech Republic, Slovakia and Romania.

RBI grew by setting up grassroots corporate-focused operations throughout the region and only belatedly tried to follow Erste’s fast growth by switching to acquisitions and prioritising retail banking. Among the mid-sized or larger markets in the region, it only ranks among the top three banks in Slovakia. “You have to have scale in this business,” says Stanik. “And the biggest growth is in the retail business. Overall the strategy of Erste was the right one.”

The rating agencies reflect this verdict in their ratings of the two banks. Fitch – which rates Erste one notch higher at 'BBB+' – said in its downgrade announcement: “We view RBI's company profile as slightly weaker than those of Erste and Bank Austria due to RBI's less developed retail franchise in stable mature markets”.

RBI has finally been forced into a long overdue strategic rethink by the higher capital requirements imposed by European and Austrian regulators in the wake of the global financial crisis, and the growing incredibility of its claim that it could meet these requirements purely by profit retention at a time when it is not making any.

The key questions now are whether it has done enough to satisfy investors and regulators, and will it be able to keep its place among the leading banks in the region?

Shrinking plans

Under its restructuring plan, RBI will sell its Polish and Slovenian operations, as well as internet bank Zuno, and will scale back lending in Russia, Ukraine and Hungary. This will raise cash and help rebalance the bank’s lending portfolio, but more importantly it will lower RBI’s risk weighted assets (RWA). This in turn will improve its Tier 1 capital ratio – core capital (common equity and retained profits) divided by risk-weighted assets (loans) – which is the key yardstick used by regulators to measure a bank’s balance sheet strength.

RBI says that implementation of all these measures should result in a reduction in its RWA of approximately €16bn by the end of 2017, from its total of €68.7bn at the end of 2014. RBI already cut some €10bn from its RWA during the fourth quarter of 2014.

Following the restructuring, the bank expects to have a fully loaded Tier 1 capital ratio of 12% at the end of 2017, up from 9.9% in the first quarter of 2015.

But the cuts will be painful and could crimp long-term profitability. Polbank, the core of RBI’s Polish operations, was only bought in 2012 and is now the bank’s biggest foreign subsidiary – with RWA of €8.7bn – in one of the most promising CEE markets. However, the bank ranks only number eight in Poland and further growth would require capital that RBI can no longer afford.

In Russia RBI will cut its RWA by approximately 20% until the end of 2017 at a time when the country remains the group’s profit centre. “It’s still the most profitable part of the group and it will still be profitable this year,” says Sevelda. But the market has turned down since the annexation of Crimea and support for rebels in Ukraine and, even though RBI is focused on blue-chip clients there, discretion appears to be the better part of valour.

As well as scaling back its network, RBI also plans to cut its €3bn cost base by 20% from 2014’s level by the end of 2017. Already in the first quarter, general administrative expenses have been cut by 8.5%.

The plan should lower its cost-income ratio, currently 56.5%, closer to 50% in the medium term. Below 50% has been traditionally seen as the sign of an efficient banking operation.

Cost cutting is something that has not been a priority until recently, admits Sevelda. “Until the crisis the target was ‘grow, grow, grow’,” he says. “The crisis forced us to reconsider our cost structure.”

RBI, like Erste, still has a lot of potential synergies to exploit by offshoring the group’s back office functions from Austria to lower-cost destinations in the region. “We have to concentrate these activities a lot more,” admits Sevelda.

Both groups are also trying to move faster into internet banking, which would allow more branch cuts. “We can still do a lot more on the customer side [to cut costs], including in Austria,” says Sevelda.

Wishful thinking

RBI’s half year results, due to be published on August 19, will be scrutinised as a progress report on the restructuring, but there are already signs that things are not going according to plan.

All the sales processes look as if they will take a long time unless RBI accepts fire sale prices for its assets.

In the sale of Polbank, by far the biggest asset on the block, RBI has admitted that the process is delayed, though there have been media reports that it has in fact been suspended. Both Pekao (owned by UniCredit Group of Italy, the largest non-Russian bank in CEE) and local insurer PZU have shown interest, but have said they would not pay book value (estimated at around €1.5bn).

The sale has been torpedoed by the government’s move to in effect force banks to compensate those who took out Swiss franc loans for the appreciation of the Swissie. The Polish regulator is also still insisting that RBI fulfils its pledge to float the bank on the Warsaw Stock Exchange, and has trumpeted its preference for any new owner to be new to the market and to have as high a credit rating as RBI itself.

Analysts also remain sceptical that the implementation costs of the restructuring programme will be only €550m by 2017.

RBI may also have been guilty of wishful thinking in predicting that profit retention will add some 1.2 percentage points to its core capital (compared to 2.7pp from cuts in RWA). Perhaps even more optimistically, in the medium term it also forecasts a consolidated return on equity (ROE) of 11%.

In the first quarter, consolidated net profits almost halved to €83m and RBI warned it may make another full-year loss because of elevated loan risk costs, while most of the restructuring costs will be booked this year.

Loan provisioning is robust at 65.9% of non-performing loans, while most of the losses from foreign-exchange loans have been booked or hedged. However, further operating losses are expected in both Hungary and Ukraine this year. “It will take time for Russia and Hungary to turn around,” says Rioual of Fitch Ratings.

At the same time, the rest of the network faces only limited profit growth because the low interest rate environment and weak lending growth have crimped net interest income. Meanwhile, fee and commission income, traditionally a significant portion of Western European banking revenues, remain small and undeveloped in the region.

According to the RBI’s own "CEE Banking Report" in June, the overall banking ROE for the region last year was the lowest since 2000 at 6.9%. For comparison, Western Europe’s ROE was around 5%, yet this year RBI predicts it could be higher than CEE’s, again for the first time since 2000.

Frustrating outlook

Because of the execution risks of the disposal programme, and the unexciting outlook for the CEE region, analysts therefore remain sceptical that RBI’s targets will be met.

Rating agency Moody’s Investors Service reacted to the restructuring programme by downgrading RBI to 'Baa', with a negative outlook. "In Moody's opinion, the strategic realignment carries execution risks in the current volatile market environment and will only benefit RBI's capitalisation over time. As a result, the group remains vulnerable to downside risk and volatility in key markets in Central and Eastern Europe and the Commonwealth of Independent States," it said.

RBI’s fundamental problem remains that it is undercapitalised compared to its peers in the new tougher regulatory environment. “We are slightly below the average of the competition with our large banking groups,” admits Klaus Kumpfmueller, executive director of the Austrian Financial Market Authority.

Not enough was put into capital as the bank was expanding during the boom years, and it had to be dragged kicking and screaming to raise €2.7bn in February 2014, long after its peers had woken up and smelt the coffee. “What was not sufficiently thought about before the crisis was to put more profit into capital,” says Andreas Ittner, vice governor of the Austrian central bank, about Erste and RBI. “It all went into market share. This is why they are suffering now, because of legacy issues.”

In June, Austria’s Financial Market Stability Board recommended that that the big banks should now aim for an 11% Tier 1 ratio, including the systemic buffer demanded by the European Central Bank, though this requirement will be phased in over two years.

RBI should be able to meet this requirement, but more difficult will be to meet the ever increasing investor expectations of what size of buffer it should hold. This could force the bank to keep shrinking itself to raise its capital ratio, further damaging long-term profitability. “The [capital ratio] gap between them and their big international peers will increase in the next few years,” says Rioual of Fitch.

Investor perceptions of RBI are unlikely to recover in the short term without further capital raising, which is unlikely to happen. Unlike Erste, RBI remains indirectly 60.7% owned by Austrian regional co-operative banks. They need to keep their majority to maintain their financial standing, but would struggle to participate in any capital raising. That is why RBI is forced to reduce its size in order to improve its capital ratio. “They are a bit stuck,” says Rioual. “They are close to the limit. They won’t get further capital from the [co-operative] group which is a bit stretched.”

That would normally make RBI a takeover target, but the breadth of its network, and its co-operative shareholding block, make it virtually indigestible as a whole.

Instead, RBI appears doomed to keep shrinking itself to improve its capital ratio until its luck changes again. For the early pacesetter in Central and Eastern Europe, it must be a deeply frustrating outlook.