Ben Aris in Moscow -

Russia's economy is clearly on the mend and lending is rising, but banks are also seeing non-performing loans (NPLs) rise. What's up with that? Are the banks recovering or getting sicker?

This time last year, Standard & Poor's banking analyst, Ekaterina Trofimova, was doing the rounds predicting doom and gloom in the banking sector. Her point was that whatever the official NPL numbers were, the true number was far higher as banks were simply rolling over debt they had no chance of getting back, effectively moving them out of the "non-performing" column and into the "performing" list - despite the fact they were not actually getting any money from these debtors.

Trofimova's prediction that banks would run out of money and the state would have to step in with massive bailouts half came true - Putin said earlier in September that the government had spent RUB2 trillion ($67bn) on supporting the bank sector - but the scary bits about a systemic financial crisis failed to appear.

The situation now is that the best banks are back in growth mode, but the majority of banks are only just beginning to deal with the damage caused by the crisis.

Rising loans and bad debts

The overall NPLs for the sector fell slightly to 6.5% in June from 6.7% in May, as corporate NPLs dropped about 20 basis points from the month before to 6.3%, while retail NPLs remained flat at 7.5%. However, the volume of NPLs in Russia will rise and could reach $70bn by the end of 2010, according to the International Finance Corporation (IFC).

On the other hand, growing confidence in the recovery has seen corporate loans rise by 1.2% in August, making a year-to-date growth of 5.5%, and retail loans comfortably outpaced corporate growth in August, rising 2.0% for the sector as a whole, giving year-to-date growth of 5.7%.

What's going on is that those banks which took the blow on the chin and used the courts and arm-twisting to make debtors pony up are now in robust health and regaining market share fast. Those banks that decided to "extend and protect" credits - ie. wait until the debt was almost due and then roll it over for year - are only now starting to put the bad debt on their accounts and so are seeing NPLs rise.

Alfa Bank is the best example. In February 2009, Sberbank said in a report it was in the worst shape of any bank in the sector. NPLs hit a peak of 29% in August 2009, but the level of bad debt has been falling steadily since then; by the end of 2009, NPLs had fallen to 21%, then down to 12% by the end of the first quarter of this year, and now the bank expects the level to fall to 5% by the end of this year, the CEO of Alfa Bank, Ed Kaufman, tells bne in an interview.

"It was bad, but we didn't do extend and protect. Despite the bad mouthing Russia gets, we found that you could use the courts to get your money back and collateral worked," says Kaufman. "Our NPLs are falling, but those at other banks are rising as banks are now starting to deal with the bad debt problem."

Alfa Bank's credit portfolio took a drubbing at the start of the crisis, dropping 20% to the end of the first half of 2009 and then it fell another 3% in the second half of that year. But now it is starting to recover again and lending is up 5% over the first half of this year, and Kaufman is hoping to see 10% growth in the second half of the year.

The falling level of bad debt is rapidly improving the bank's position, multiplied by all the cash the bank hoarded in case things turned out worse than they actually did. As bad debt falls, the bank has not really reduced its provisions for bad debt: provisions have fallen from $1.55bn at the start of this year to $1.46bn now. And more and more of this huge pile of cash is being freed up for lending. "NPLs have fallen from 21% to 7% over the course of this year, but we have only reduced provisions by $90m. We want to lend more than we are, but lending is starting to recover," says Kaufman.

There is now a good chance that Russia's best banks will come out of the downturn faster than expected. Kaufman says that in the long term probably the biggest benefit to come out of the crisis is that the bank has trimmed all its fat: the cost/income ratio has fallen from 56% to 40% and in investment banking it has fallen to 30% - an extremely low number, even by international standards.

The crisis has delivered another big benefit for the leading banks - money is cheaper than ever: international markets may be closed for many international banks, but they are doing a very brisk business with the best Russian borrowers.

Alfa bank was one of the pioneers in tapping the Eurobond market to raise funds to finance its retail operations in the middle of last decade, and it has led the return to international capital markets again post-crisis.

The bank offered a bond in July 2008, just before the storm broke, raising $500m at about 9%, but since the crisis the bank has issued two more bonds, which are getting bigger, longer and cheaper: the bank issued a five-year bond in March for $600m at 8% and another 7-year note in the middle of September, raising $1bn at 7 7/8%. "The capital markets are open for the blue chips and first-tier companies, but it remains closed for everything in the third and fourth tiers (although there is some movement now in second tiers)," says Kaufman. "But I think it will be a long time before we go back to no-name regional banks raising the $100m-150m that we had in the last boom."