ED: this is the first in a series of three pieces looking at the collapse of Russian commercial bank Financial Corporation Otkritie and the implications for Russia's banking sector.

 

Russia’s banking sector came close to a meltdown in August as Otkritie Financial Corporation, the second biggest private bank in the country and one of ten “systemically important” banks, was taken over by the Central Bank of Russia (CBR). Had Otkritie gone to the wall it could have taken the whole system with it.

A joke doing the rounds at the end of August said Otkritie, which means “discovery” or “open” in Russian, should change its name to Zakritie, which means “closed”.

What happened? Russia’s banking system has been making next to no money for much of the last two years, but over the first half of this year it returned to profit and nearly all the major banks have enough capital.

A combination of hubris, ambition and mismanagement are probably to blame for Otkritie’s collapse. The insider nature of Russian business where the elite play by different rules from the hoi polloi is a cancer that continuously undermines the system. Otkritie was owned by well-connected insiders and its supervision was lax, while abundant funds were available from both the central bank and state-owned banks allowing it to make a string of deals that lead to explosive growth.

The immediate causes of Otkritie’s collapse were two bad deals — the acquisition of leading insurer Rosgosstrakh and the attempted rescue of Trust bank.

Another contributing factor is the barely reported fact that for years Otkritie was widely seen as the pocket bank for one-time young reformer Anatoly Chubais, who became a shareholder while still running Rusnano, the multi-billion dollar technological promotion agency. Moreover, Chubais is close to CBR governor Elvira Nabiullina, who worked as his deputy in the Yeltsin administration in the 1990s. Some commentators have suggested that part of the reason for the CBR’s obviously lax supervision of Otkritie is that Nabiullina remains loyal to her old boss.

At the same time the bank also has a strangely close relationship with state-owned behemoth VTB Group, which owns a 10% stake in Otkritie and has funded many of the deals that lead to its meteoric rise. While other banks have to grind away at their margins to make money, Otkritie has enjoyed generous access to state capital that has paid for much of its growth – much of which was provided by VTB.

But digging into the story a bit deeper, it was the state itself that started Otkritie’s death spiral: in July the newly formed domestic rating agency ACRA downgraded the bank to BBB-, below the level where it is allowed to hold state and pension funds. That started an outflow of deposits that ultimately killed the bank.

The whole Otkritie story is part of the government’s fight against corruption. President Vladimir Putin, ever the pragmatist, has gone after the sectors where the stealing is greatest. In 2014 he called the utilities sector “one of the most corrupt” in the country. A few months later power companies had to cancel 60% of contracts with state utilities because of a new rule that demanded the beneficial counter party in any such contract had to be a real person. Several managers of major power plants were sacked or even arrested. 

The sums disappearing from banks into the pockets of their owners are even larger than in the energy sector, and the current sector clean-up also started in 2014. The CBR has been aggressively closing banks for several years, but with Otkritie the campaign has gone up a level to banks that the state can no longer afford to bail out as they are simply too big.

And the move on Otkritie has not come out of the blue: the CBR was well prepared for it. A series of new bank bankruptcy laws, including new bail-in rules, were passed earlier this year. The number of domestic ratings a bank needs to hold state money has been raised from one to two. And when the CBR took over Otkritie it used a new Banking Sector Consolidation Fund, which conveniently had also been created earlier this year and was waiting on the shelf.

Until now the well-connected have assumed they can get away with daylight robbery, but the game just changed. Now everyone is nervous. Is yet another financial crisis around the corner? Probably not. But Russia’s other commercial banks scrambled to built up cash war chests in August — just in case.

The next stage is to clean Otkritie’s books up and assess the damage, which will take about six months. At the end of the day the central bank may still be left with a bill that breaks the previous Bank of Moscow bail out record of $14bn, but the cost of the CBR’s takeover will be immeasurably less than the cost of dealing with a full blown systemic banking crisis.

August woes

Russian crises always seem to happen in August. It was in August 2004 that Russia had its last and very similar bank crisis. The CBR had just taken its first step towards cleaning up the banking sector by pulling the license from the aptly named Sodbizness bank — the first time the CBR had ever cancelled a license — accusing the bank of money laundering and stealing depositors’ money.

The closure sent shockwaves through the system. Rumours circulated in the market that the CBR had a “blacklist” of dodgy banks that would be closed down next. The interbank lending market froze and precipitated a real crisis. Banks began to fold. Middle class specialist Guta Bank’s owners pulled the plug rather than fork out billions to recapitalise it and it was taken over by VTB, eventually becoming the basis of the state-owned bank’s highly successful retail operation VTB24. Ironically, VTB24 was so successful that the CBR turned to its CEO Mikhail Zardornov and asked him to take over Otkritie in the last week of August.

The current crisis has followed a similar path. bne IntelliNews issued the first report of problems on August 4 after market sources said Otkritie was “in trouble”. Commercial banks had spent the previous week cutting their exposure to Otkritie. That weekend the bank’s ATMs stopped working, which Otkritie blamed on “technical problems”, and things snowballed from there.

The market was already nervous after the CBR closed down major commercial bank Jugra in July and press reports on Otkritie’s troubles only made things worse. Clients withdrew over RUB520bn ($9bn) from the bank from July 3 through August 24, with corporate clients withdrawing RUB389bn and individuals withdrawing RUB139bn, according to the director of the central bank’s department for supervision of systemically important credit institutions Mikhail Kovrigin. That is 20% of the bank’s total assets. By the middle of August, reports appeared that even the owners were taking their own money out of the bank.

As summer wore on it became clearer and clearer that Otkritie was desperate for cash and selling everything. The bank dumped half of its Russian 2030 Eurobonds, selling RUB395bn ($6.9mn). The parent company Otkritie Holding owned RUB831.96bn of the Eurobonds, or 74% of the entire issue, as of December 31, 2015.

It also sold off its bad loan portfolio and was aggressively tapping the CBR’s repo facility – the very expensive short-term financing facility offered to banks by the regulator. Otkritie was largely responsible for a spike in repo deals that rose to RUB516bn, of which Otkritie accounted for RUB330bn.

Four bankers told the Financial Times that the central bank also gave Otkritie an emergency unsecured loan of an undisclosed amount as things started to get really hairy about two weeks after Otkritie’s problems became public. Otkritie and the central bank declined to comment on the details of the loan.

Loans are a last ditch measure for the regulator to stop a bank going bust. The logic is that it is far cheaper to give a bank a loan to shore up its capital than it is to pay for the mess that occurs if a big bank goes bust.

Predictably the bank’s shares and bonds started to tank. Otkritie’s $500mn of subordinated bonds due in April 2019 slumped 41.72 cents on the dollar on August 25 to 50.24 cents, the lowest level on record after Russian press reported that the CBR was considering nationalising the bank and transferring it to a new bailout fund in the last week of August. The notes were the worst-performing corporate dollar bonds in emerging markets this quarter after Petroleos de Venezuela SA, reported Bloomberg.

Then on August 29 the CBR had had enough. The situation was deteriorating rapidly so to nip a full-blown crisis in the bud, the CBR announced a rather unorthodox fix to the problem. It has imposed temporary administration and taken over 75% of the bank’s equity, placing it into the new Bank Sector Consolidation Fund. Instead of placing a moratorium on the bank’s credits and using the Deposit Insurance Agency (DIA) to bail out insured deposits, the regulator has made itself a bank owner. The logic is that if the bank is owned by the most solid owner any bank could wish for then Otkritie can continue business as normal. In all likelihood the CBR’s action will work and the nerves will fade. Crisis over.

Clean-up

Next the CBR will have to dig into Otkritie’s books to see just how bad the damage is. The rehabilitation process is supposed to take six to nine months. During the first stage (months one to three), the CBR will determine the real value of Otkritie's capital and its need for additional funding after scrutinising the asset base and loan impairments. The CBR has already said that the bank’s capital adequacy ration is likely to fall below the mandatory minimum as the temporary administrators make provisions for bad or fake loans and so the bank is almost certain to need a large capital injection in this period. In the second stage, the CBR will proceed with bankruptcy prevention measures intended to restore capital adequacy measures and credit ratings.

When VTB took over the last big failed bank, the Bank of Moscow, and did the same thing it had an unpleasant surprise.

“We knew it was bad, but we didn't know how bad it was until we saw the books,” VTB CFO Herbert Moos told bne IntelliNews in an interview. The bank’s former CEO Andre Borodin, who is now in “political” exile in London, had drilled a $9bn hole in the balance sheet. The staff had a “loan factory” on the second floor of the bank’s headquarters where they cut up loans into small sums so they wouldn’t trigger the supervisor’s money laundering flags, and made fake loans to related parties to the tune of billions of dollars. Ultimately the cost of the bailout ran to $14bn, more money than the CBR lent to the entire banking sector in the 2008-2009 financial crisis.

Experts worry that the bill for Otkritie could be even larger. The Russian press reported last year that Otkritie already had a $2bn capital hole due to related party lending, which has been reportedly rising for several years. In June 2015 the bank had RUB296bn of capital according to IFRS accounts, but the level of related party lending was already 85% of this according to some Russian reports. Other reports put the number at over 229%. That's equivalent to between $4.6bn and $12.3bn at exchange rates at the time.

As an example of the sort of deals Otkritie has been doing, last December the bank bought a diamond mine from Lukoil, its second-largest shareholder, for $1.4bn. The price was almost $1bn more than Alrosa, Russia’s state-run diamond monopoly, valued the mine, according to deputy chief executive Igor Sobolev. Other reports say Otkritie overpaid for the mine by 3.5 times.

It is still not clear how the CBR let Otkritie get into such a bad state. The CBR’s first deputy chairman Dmitry Tulin told journalists after the takeover that the regulator had been aware that Otkritie was having problems a year earlier, but didn't act. And there were other warning signs too.

Deposit withdrawals from Otkritie started after the CBR closed Jugra in July but accelerated after the Analytical Credit Rating Agency (ACRA), a new Russian credit rating agency, unexpectedly gave Otkritie a junk rating the same month. That automatically precluded the bank from holding state deposits or state pension funds and led to significant outflows of deposits as state entities started to pull their cash out of the bank. ACRA cited “significant” pressure on its creditworthiness from“weak” asset quality and risks to capital adequacy from its parent, Otkritie Holding.

When ACRA was first set up, it was widely written off as another move towards Russian autarky in its showdown with the west, and an effort to get away from the “politicised” western ratings agencies that dominate the business. The agency is headed by Ekaterina Trofimova, a former bank analyst with international ratings agency Standard & Poor’s (S&P), who complained heavily to bne IntelliNews in an interview several years ago about the way the Russian bank sector was run.

ACRA has greatly increased its credibility by calling the problems at Otkritie, taking on extremely powerful and well-connected businessmen well before the crisis was revealed. The western agencies were much slower to cite problems and mostly acted after the fact.

Otkritie is not the only bank in the sights of ACRA, which increasingly is looking like a new weapon in the clean-up campaign. Russia's largest private bank Alfa Bank could also lose the right to receive federal budget funding on its deposits, Vedomosti daily reported on August 6, as it is not rated by ACRA and has to be under recently introduced new rules.

And what should ring very loud alarm bells, earlier this year VTB refused to let ACRA publish its rating of the bank after a dispute over methodology. “They rate us even lower than the foreign rating agencies did, the ones whose politicised approach we complained about,” chief executive Andrei Kostin said in February.

If VTB loses its right to hold federal funds it could be in serious trouble. Alfa has $263mn of federal funds in its deposits, while state-controlled VTB held RUB1 trillion ($16.6bn) out of RUB1.3 trillion available. ACRA’s Trofimova is either very brave or has some serious political backing to take on the likes of Alfa’s owner Mikhail Fridman and VTB’s Kostin.

As a strategically important bank, Otkritie is too big to fail – or at least it is too big to bail out – which takes the clean-up operation to another level.

Clearly the CBR has been anticipating this change and prepared for it. Depositors have the first RUB1.5mn ($25,855) insured by the DIA, which pays out quickly and efficiently if a bank is closed. But this is an expensive way to proceed as typically the CBR’s targets have $1bn or more holes in their balance sheets. The DIA, which is funded by a small tax on retail deposits, has burnt through its capital several times already, going back to the CBR for top-ups each time it ran of money.

Otkritie seems to have slipped through the cracks and gotten into real trouble thanks to some combination of the Chubais-Nabiullina relationship, coupled with VTB’s interest in using it for its financial black ops, but the bottom line is the establishment appears to be extremely determined to clean up Russia’s financial sector.

Now the CBR is moving into the big league; the regulator is taking direct control of the process and Otkritie is being taken over by the Bank Sector Consolidation Fund. Previously the central bank helped rescue lenders through the more costly method of offering cheap loans to investors willing to take them over. The Russian authorities spent RUB1.1 trillion rescuing failed banks between 2014 and 2016, according to data from Fitch Ratings, which said in a report earlier this year Russia has now reached the point where it was cheaper to let the banks go bust than bail them out.

Not everyone is happy with the new mechanism. Russia’s ombudsman for business Boris Titov complained on August 30 that the new consolidation fund was simply a ruse by which the CBR will now pay for increasingly expensive closures by printing rubles. Against that, the clean-up is coming to an end. Russia has just under 700 banks left. Putin has suggested that Russia, like Germany, only needs 300 banks. If Nabiullina continues shuttering banks at the current pace Russia will reach that point in about three years.

The beauty of the CBR’s unorthodox decision to take direct control of Otkritie via the consolidation fund is it has neither gone bust nor has any money been spent — so far. However, once the books are examined the bank may need a significant capital injection. In this case again the CBR is prepared and has already tested out new legislation that allowed it to bail-in investors on Peresvet JSC, which had its license removed in April. As part of that deal, more than 70 Peresvet bondholders agreed to convert RUB69.7bn into low-yield subordinated debt, according to the regulator.

It depends just how bad shape Otkritie’s books are in; if they are really bad then some debt holders could get bailed-in.

“Should the temporary administration find that the bank's capital is insufficient to sustain CET1 capital adequacy triggers (5.125% and 2%, set for Tier 1 and Tier 2 subordinated debt by the CBR), its subordinated debt could be partially or fully written-off, or converted into equity. All subordinated debt, that has no specified conversion option, could be subject to write-down,” Aton said in a note.

Otkritie has approximately $1.2bn of subordinated debt, and the only actively traded Eurobond contributes 30% of that amount, Aton reports. It is an old-style subordinated debt that does not have a write-down option.

At the same time, the CBR's position as previously stated by Nabiullina is that all subordinated debt should be treated equally when implementing bankruptcy prevention measures — in other words it will be written down to cover any capital gap.

The closure of big banks is dramatic but all said and done Russia can still afford the multi-billion dollar clean up of a key sector of the economy.

“The relatively small size of the banking sector and the dominance of state owned and foreign banks, provides some durability to the sector and insulation for the sovereign,” Tim Ash, head of strategy at Bluebay Asset Management, said in a note. “The strength of the sovereign balance sheet, with $90bn in the [Ministry of Finance’s] two reserve funds (5.5% of GDP), with $420bn in CBR FX reserves, and a general government debt/GDP ratio of still less than 20%, suggesting that the sovereign balance sheet is still more than capable of absorbing potential losses from the clean up costs in largely second-tier Russian-owned banks.”

 

This article is part of the cover section in bne’s monthly free magazine. You can read the whole issue here and sign up to receive the magazine by email each month by filling in the form here. 

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