bne IntelliNews -

Profits are tumbling amongst Russia's leading banks as the financial sanctions imposed by the West really begin to bite. Almost all of Russia's retail-orientated banks are currently losing money and 170 of 828 banks were in the red in October 2014, according to the Central Bank of Russia (CBR). 

The bad news is coming in a steady stream. Last week state-owned VTB admitted that its earnings were down by 87% to RUB6.1bn ($139m) in the third quarter, only to be followed  a week later by its sister bank, the retail giant Sberbank, which reported earnings have fallen by just over a quarter (27%) to RUB71bn ($1.6bn). All in all the Central Bank of Russia (CBR) predicts that profits in the banking sector as a whole will fall by 10% this year or more.

Russia's banks are  caught between the rock of being cut off from external sources of funding because of western financial sanctions and the hard place of a stagnating economy. VTB has already asked the state for RUB250bn ($5.4bn) in subordinated loans from the National Welfare Fund (NWF) to cover its funding needs. The state said 'No', preferring to keep its power dry for the moment. 

"Management guidance after the third quarter results carried the unsurprising message that the fourth quarter is likely to be as painful as preceding quarters this year," says Andrew Keeley, a bank analyst with Sberbank CIB. "Elevated corporate risk costs will continue to eat up profitability, even as delivery improves in retail banking and cost control."

Moody's was similarly downbeat in a recent report on Russia's banking sector. The ratings agency predicted total lending growth will fall to 5%-10% in 2015 in nominal terms, down from 17% in 2013. Likewise non-performing loans could increase from 7% of total loans at the start of this year to 9.5% next year, says Moody's.

Russia's banking sector is currency almost entirely reliant on the CBR for funding and the regulator recently reduced bank's access to ruble liquidity as all the banks were doing was taking the central bank's cash and using it to speculate on the FX market: the ruble's fall and the CBR's efforts to manage the fall with market interventions created a one-way bet for bankers, who were making easy profits using the state's own money.

"The funding profile of the system continues to principally rely on domestic customer deposits (about 55% of total liabilities) and other domestic sources," Moody's said in its report. "Among these domestic sources, the role played by the CBR and its ability to replace diminishing international funding and minimise currency volatility will remain crucial for the stability of funding [in 2015]."

The share of the central bank's money in the liabilities of the sector is creeping up steadily and was 10% in August and will only increase from there, says Moody's. The slow bleed of gross international reserves, which have fallen from about $500bn to $420bn as of November, has led some to estimate that Putin has about two years to achieve his goals in Ukraine before the money runs out and spawns another big crisis.

However, the lack of cash is already showing up in bank's capital adequacy ratios (CAR), a measure of solvency.  Russian banks typically used to have a healthy CAR of 20% but as the funding dried up increasingly banks have been forced to use their own capital to fund their lending operations. Banks' CAR has been falling steadily towards the mandatory minimum of 10% and edged down from 13% at the start of this year to 12.8% as of the start of November – still on a par with Russia's emerging market peers, says Moody's. The closer banks get to the minimum 10%, the more vulnerable they become to collapse if a panic causes a run on their accounts.

On the other side of the coin, the CBR's decision to curb retail lending, the most profitable business line available to banks in the current depressed market, has also wounded banks.

More Russians were becoming over-extended because of the high interest rate consumer loans and started to get into trouble. At the start of this year the volume of repayments of credits overtook the volume of new loans for the first time ever and non-performing loans were starting to rise alarmingly. Overdue retail loans reached RUB652.3bn ($14.8bn) for the first 10 months of 2014, up by more than 48.1% since the start of this year – a record increase over the past few years, according to a survey by collection agent Sequoia Credit Consolidation Collection Agency. "Borrowers started to default on the payment due on a loan for the first time twice as early than they were 18 months ago," the survey found.

The CBR increased prudential reserves a bank has to put aside to cover bad debt, weighing these heavily towards banks offering unsecured loans. In effect the regulator threw a bucket of ice water over the whole business, which has slowed considerably this year.

Retail loans grew just 1% month-on-month in October, the second-lowest increase this year. Retail lending growth continued to decelerate on a year-on-year basis, slowing to 16.6% from 18% in September.

"This, in our view, is a reflection of the trends in the Russian economy as a whole, where industrial production is relatively healthy (partly due to import substitution), while retail trade and real wages remain under pressure. The RAS figures also showed a divergence in the overdue trends: the corporate ratio was down 10 bps month-on-month to 4.1%, while the retail ratio was up another 10 bps month-on-month to 5.8%. However, we expect to see more conservative provisioning on the corporate side under IFRS compared to what the RAS methodology calls for," says Alfa Bank.

The CBR is still concerned enough about the danger of consumer loans that from next year it intends to introduce new regulations that will cap the amount of interest banks can charge on the various sorts of credits made to consumers. The authorities recently published the "full cost of credit" (PSK) calculation for different types of loans and from January 2015 the pricing of loans may not deviate by more than 30% from this average PSK.

"This implies downside risks for the credit card segment (where Sberbank, with its lower risks and lower rates, continues to gain market share) and [online credit card specialist bank] TCS in particular. However, there could be amendments to the regulation, as banks are lobbying for state banks to have a lower weighting in the calculation. Thus, we have not yet incorporated additional pressure on yields in our base case," said Alfa Bank in a note.

But the good news is corporate lending is accelerating on the back of strong state support and growing demand. Although the 3.7% month-on-month growth in corporate loans in September-October becomes just 2.4% after adjusting for the revaluation of foreign currency loans, this was the highest month-on-month growth in adjusted terms this year, reported Alfa Bank. Year-on-year the growth in corporate loans came in at 13.4% in adjusted terms (versus 20.7% in nominal terms), slightly above September’s level, but lower than most months this year.

Cut off from almost all the alternative sources of funding, banks have been forced to return to the traditional way of funding lending: by attracting more deposits. Here the CBR's decision to dramatically hike interest rates to over 9% a month ago will help.

Retail deposits grew 2.2% month-on-month in October, but depositors fear of more ruble devaluation was obvious as the share of deposits made in foreign currency rose much faster to nearly 22% from 20% in September.

"However, after the CBR’s 150 bps rate hike in late October, we will likely see higher deposit rates going forward, and in the absence of further shocks to sentiment, we expect Russians to gradually switch into savings mode, so retail deposit growth may accelerate somewhat next year," said Alfa Bank in a note.

Corporate deposits are doing much better and continue to grow twice as fast as retail deposits (24% year-on-year in nominal terms in October compared to 10% year-on-year for retail). But this is partly due to the fact that the state is pumping money into the economy to keep it going: the share of funding from the CBR rose to 9.2%, a new post-2009 high.

For most banks 2014 will be a complete business write off. But what about 2015? What are the prospects for a recovery after the holidays?

Much depends on external factors and here there is little good news to report. Following the OPEC meeting in Vienna on November 25 there is little prospect for price-supporting oil production cuts. Indeed the Russian Finance Minister Anton Siluanov warned on the same day as the OPEC meeting that Russia's three-year budget should be adjusted to account for $80 oil instead of the $100 it currently assumes in the next two years.

Likewise, the prospect of sanctions being lifted was fading rapidly. Following initial hopes that Europe would remove its sanctions at the start of November, by the end of the month German Chancellor Angela Merkel said explicitly that sanctions, including the financial sanctions, will remain in place for the foreseeable future.

“We’re working on a diplomatic resolution to this crisis,” Merkel said on November 25. “As long as Russia contributes very little or nothing to overcome this crisis, we need economic sanctions. They’re unavoidable, although I know they impact the German and the European economies.”

On top of these external problems are a raft of domestic difficulties. First, the high risks are driving up the cost of borrowing. Secondly the net interest margin (NIM, or the difference between what banks charge in interest and what they pay as interests for their deposits) is being constantly squeezed as the competition for new depositors amongst banks intensifies. The NIM has already fallen 15 basis points year-on-year over the first nine months of this year and will fall more next year with another 18 basis point fall to 4.1%, estimates Sberbank's Keeley.

In the tougher more competitive environment the key factors for banks' success will depend on their access to cheap state money and their ability to control costs.

The current situation is not sustainable but Russia has plenty of money in reserves and can keep propping the sector up for several years still. But the CBR has already started anticipating a further deterioration and has been discussing supportive measure to reassure both bankers and customers.

The Russian government could acquire more preferred shares of banks, such as VTB, using resources from the National Welfare Fund, the Finance Minister Anton Siluanov earlier this month, but if it happens then it is likely to be confined to the leading Russian state-owned banks.

However, the regulator is still confident that the situation is under control. In its worst cast scenario there could be a RUB84bn ($1.9bn) liquidity crunch next year, the CBR said in November, under its "shock" scenario for the new year, and that amount lies easily within the CBR's ability to cover with cash. This scenario includes a falling number of counter-agents as shrinking confidence in small banks results in a halt of unsecured lending and a freezing of trading on the interbank market.