Russia's Ponzi problems

By bne IntelliNews August 4, 2011

Ben Aris in Moscow -

It's going to be pretty hard for Moscow to become an international financial centre (IFC) if the country's banks and investment funds keep stealing small investors' money. Igor Kostikov, former chairman of the stock market regulator, claims pyramid schemes masquerading as funds are widespread in Russia and not only are there no laws to stop these scams, no-one in government is responsible for overseeing these funds.

The Kremlin's IFC plans have gone to the top of the agenda, as Russia badly needs to develop a much broader investor base. But in typical fashion, the reforms so far like July's Micex/RTS stock exchange merger have all been top-down; the state has completely ignored the bottom-up reforms essential to building trust within the population to get them to actually invest in all the new investment vehicles the Kremlin is trying to encourage.

The Warsaw Stock Exchange is emerging as a regional investment hub and much of the reason for its success have been the successful reforms that led to a vibrant domestic pension and mutual fund industry; some two-thirds of the total stock market capitalisation is made up by domestic mutual and pension funds, as well as individuals investing directly into stocks. In Russia, this huge pool of capital is almost entirely missing.

"Creating an IFC is not just a question of having a state-of-the-art stock exchange," says Kostikov. "Just as important - more important - is building a relationship with the small investors where they trust the markets and funds to look after their money. That is still missing in Russia. Here people invest once, get ripped off, and walk away never to return."

While Kostikov was heading up the Federal Securities Market Commission (as the stock market regulator was then known) between 2000-2004, he already had the idea of setting up a consumer protection association for financial services. Thanks to a change in the law on non-governmental organisations last year, he was finally able to established the Union Of Financial Services Consumers (better known by its Russian name of FinPotrebSoyuz) in February this year. FinPotrebSoyuz has no official standing and is funded by a few private sponsors, while Kostikov gives his time pro bono. Its job is to help people who have been ripped off by unscrupulous investment fund scams.

"There are hundreds of FX clubs that are little more than pyramid schemes," says Kostikov. "Nothing can be done to stop them, as they are completely legal at the moment and there is no government regulation on cross-border trade."

The pyramids

The way it works is this: an FX club advertises in the press promising handsome returns to small investors, who then get in touch with the Russian office and sign a contract before investing their savings. When they come to withdraw their money, they are told, "Sorry, the investment club made some mistakes and has lost all your money."

Given the Russian market has been among the best performing in the world and the ruble has been appreciating against the other major currencies, investors are understandably incredulous. But if they start digging into why the fund went bust, they will quickly hit a brick wall. "The investor can't sue the Russian office, which it turns out has no legal connection with the club. The Russian end of the operation is acting as an 'agent' and reselling the services of the fund that is registered in Cyprus, British Virgin Islands or somewhere," says Kostikov. "It is nothing more than a post box and is closed down when it has collected enough money. For most people, to pursue a claim against the company overseas is just too expensive and even if they did, the contract that they signed in Russia probably has no legal standing overseas."

No-one is sure how much retail investors have in these funds. According to the Russian daily Kommersant, Russia's mutual funds started taking in money again in the first half of this year for the first time in four years, but still only hold a pathetic $200,000 of total assets under management. Kostikov says there are no official figures, but estimates the value of the total retail investment business at about $300m.

The scams are already generating tens of millions of dollars if not more, says Kostikov, but the state has done nothing to regulate the business; there is still no organ or laws to oversee or license FX deals and investment clubs. In the meantime, the sharks are left to operate with impunity - and can even run high-profile advertising campaigns in the local media, as technically they are doing nothing wrong.

What makes these scams so insidious is that the operators don't screw everyone over. The bigger clubs make some real returns and pay back the bulk of their investors (with no reporting regulations, the investors have to simply trust the managers' returns report), but they bolster the bottom line by simply stealing some of their investors money and using it to pay the rest.

Moreover, this practice of padding profits by simply helping yourself to a small proportion of investor's money is widespread, even among the established banks and funds, claims Kostikov, who named several well-known Russian high street banks as being guilt of the practice.

Slightly less egregious, but still unethical, are overly aggressive sales people in established banks selling more traditional products like mortgages and car loans. The absence of regulation and a supervisory body means salespeople push these products on customers even though they know many can't afford them, simply to earn their bonus. Even the giant state-owned Sberbank is prone to this sort of problem.

"Sberbank has been one of the few banks that have fully cooperated with us [FinPotrebSoyuz]. The consumer complains to the regional branch, but if they don't get anywhere, they come to us. We took these cases up with the head office here in Moscow. And in each instance, the consumer was refunded their money in a matter of days," says Kostikov.

As the bank of last refuge, ironically it turns out that the state-owned Sberbank, with its famously atrocious customer service, is one of the few Russian banks that really cares about its reputation for reliability.

Ignorance is not bliss

The root of the problem is the average Russian's almost total ignorance of their rights when dealing with financial services. Companies prey on the punter and intimidate them when things go wrong.

Following the financial crisis in 2008, non-performing loans at Russian banks soared. The official level of the banking sector's bad debt stayed in single digits, but in smaller banks and in the regions it could top half of the bank's assets, according to anecdotal evidence.

Most of the established consumer credit banks have a well established routine for dealing with problem loans. The account is passed to a special department, which then offers to restructure the terms and pesters the clients with calls. As the average personal debt in Russia is on the order of $900 - equivalent to a bit more than one month's average salary - the recovery rate is fairly high, as most people can raise this sort of money from friends and family. However, if a loan is deemed "irrecoverable", the bank's often sell them (at a deep discount) to a debt collection agency. That's where the problems start.

As you might imagine, Russian repo men are not fun people to deal with. "There is no such thing as a 'bailiff' in Russia and there are no licenses. There is no regulatory authority and there is nothing in the personal bankruptcy law that covers debt collectors. They are completely illegal," says Kostikov.

"Who are these people? Mostly they are not the sort you would want to bump into on a street corner at night. They turn up at 7am in the morning or a 1am during the night. The passing of your information to them is also a breach of the law on personal information. And they often hugely inflate the size of the debt immediately to cover a commission, interest and their costs - all of which is illegal. But almost everyone is unaware of this," says Kostikov.

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