Mark Adomanis in Philadelphia -

Following on the heels of VTB, where profits dropped by more than 90% and where a loss was avoided only through the extension of a generous government loan, Russia’s largest lender Sberbank released its 2014 IFRS financial statements on March 26.

The results weren’t great by any stretch of the imagination, but they weren’t nearly as bad as many people had been expecting: profit was down by roughly 19%. In an ordinary year that kind of performance might cause an outcry, but 2014 was a crisis year. Given how grim the outlook was for the Russian economy in general and the finance sector in particular, Sberbank’s performance can actually seem pretty good.

As usual when it comes to financial reporting, however, the devil is in the detail: spend enough time looking at the financial statements and you realize that there’s a lot more going on behind Sberbank’s headline numbers.

Sberbank’s core business of loaning people money and charging them interest remained profitable. After accounting for provisions, Sberbank’s net interest income went from RUB727bn (€11.7bn) in 2013 to RUB658bn in 2014, a less than 10% decrease (in comparison, VTB’s net interest income after provisions fell by a whopping 57%).

A brief comparison of the two banks’ respective provisions, the amount by which they reduce their current income because of the likelihood that their future income will be lower than expected, is particularly instructive. VTB’s provision wiped out 72% of the interest income it received in 2014. For Sberbank the equivalent figure was only 35%.

At first glance, then, Sberbank’s loan portfolio held up much better than VTB’s. But particularly when it comes to large banks, there is a need to dig a little deeper into the weeds. And when you dig into the weeds you see that the picture is a bit more complicated.

What’s fair about that

A (very brief!) digression into accounting is necessary before proceeding further. An asset's "fair value" is the price that it would fetch in an orderly transaction in the marketplace. However, different kinds of assets have very different kinds of markets: some of which are much more liquid than others. Assets are placed into one of three categories based on how their “fair value” is determined. Level 1 assets are the most liquid: cash, cash equivalents and things (like US Treasuries or German Bund) that trade on very large, liquid and high-functioning markets. These assets can be easily “marked to market” with great precision: there’s no need for a fancy model, everyone knows what a US Treasury or German bund is worth.

Level 2 assets get a bit more complicated. These assets are occasionally bought and sold on markets, but the markets aren’t very deep or liquid. More often they’re not traded on markets at all but their value can be determined using “observable measures” (eg. the price of an asset that trades on a liquid market). These assets are, in the lingo of finance, “marked to model”: their fair value is what a model says. There's a bit more uncertainty than in Level 1, but there's nothing particularly esoteric going on.

Level 3 is where things get tricky. These assets are extremely illiquid, and fair values can only be calculated using estimates or risk-adjusted value ranges. Level 3 assets are, by definition, “not based on observable market data.” It might sound a bit crude, but they’re essentially “marked to whatever”. There are no universally agreed upon methods of valuing Level 3 assets: each company comes up with its own, proprietary estimates and hopes that its auditor is willing to sign off. A Level 3 asset’s “fair value” is an inherently subjective estimate.

At the end of 2014, Sberbank had RUB25,200bn in assets. Of that total, it disclosed fair values for RUB18,196bn. Of that RUB16,791bn (or 92%) were Level 3. In other words, the value of 66% of Sberbank’s total assets was determined through ways that were “not based on observable market data”. That’s an awful lot of value tied up in assets whose value is highly subjective.

Sberbank’s liabilities tell a broadly similar (if slightly less extreme) tale. Of the RUB21,660bn of liabilities for which the bank disclosed fair values, fully RUB13,540bn (or 62%) were Level 3. The bank’s liabilities, then, were a bit more liquid and predictable than its assets, but there was still a high degree of uncertainty about their value.

What does all of this mean? Well, what it doesn’t mean is that Sberbank has pulled a fast one on its investors. Everything it did in its 2014 financial statement is completely allowed by the relevant regulations. There’s nothing inherently wrong with placing assets in Level 3 – it just means that the company is acknowledging that they are very hard to value with any level of precision.

What the above does suggest, however, is that Sberbank’s management has an extremely high level of discretion in determining the worth of its assets and liabilities, and thus in presenting the company’s ‘real’ value.

Again, nothing in Sberbank’s financials shows anything untoward, much less any kind of illegality. But investors should be aware of the level of discretion afforded to Sberbank’s managers and of the bank’s admission that getting to the true value of its assets and liabilities is extremely difficult, even in the best of circumstances.