Ben Aris in Moscow -
Banks epitomise capitalism, but not in Russia. The financial industrial empires of men like JP Morgan, Rockefeller, Rothschild and Harriman are intimately tied up with creating the vibrant no-holds-barred capitalism in the US. In Russia the top five banks are all state-owned and their power comes largely from one man – Russian President Vladimir Putin.
The Russian economy is in recession and most of the important state-owned banks are under sanctions imposed by the US and Europe. Never particularly well run, the current environment means the tide has gone out for Putin's “state capitalism“ system and it is apparent that several of these banks were not wearing swimming trunks. As the first quarter reporting season comes to an end, all Russia's large state-owned banks admitted they are struggling.
Russia's state-owned banks (SOBs) have the veneer of real banks. They have the posh offices and an army of men in nice suits. They have trading desks and tight security. But unlike their peers in the West, they also have access to free government money and have to take calls from ministers with a pet project to fund. Thanks to state support none of these banks is likely to go bust, and the implicit state guarantee that they all enjoy (an explicit guarantee in Sberbank's case) gives them a real competitive advantage in the form of a lower cost of borrowing.
But state-directed lending also means they will never be particularly efficient or profitable either, especially in leaner times. It is notable that the bulk of the RUB1 trillion (€16bn) the government has allocated to helping out struggling banks has gone to SOBs and all of it is tied to supporting specific “import substitution” sectors.
Chink in the armour
Russia’s banking system has long been considered the weakness in the state capitalism system that Putin has been busy building. The generally underdeveloped nature of Russian banks is precisely why Western sanctions targeted them.
Four of Russia’s largest banks (Sberbank, VTB, Gazprombank and Rosselkhozbank, also known as the Russian Agricultural Bank) have been on the US Treasury department’s “sectoral sanctions” list for the better part of a year. Officially, the sanctions prohibit “transacting in, providing financing for, or otherwise dealing in” either equity or any debt with a maturity longer than 90 days. Essentially, they cut off Russian banks from the Western financial system, which previously acted as a major source of cheap, long-term funding. Now that all of the 2014 full-year financial reports have been published, we have a chance to survey the damage absorbed by the Russian financial sector. The results aren’t pretty.
While Sberbank managed to remain profitable in 2014, VTB's profit for the year was negligible and Gazprombank and Rosselkhozbank actually fell into loss. But headline figures do not adequately describe just how bad the situation has gotten – something that can be gleaned from the performance of the shares in the two listed state banks, Sberbank and VTB.
The shares of both banks have been hammered by the selloff that accompanied Russia's litany of woes in recent years. Of the two, the fall in VTB's shares has been the more dramatic, with its share price down by 61% from the high they hit in 2011, when Russia’s economy was sailing along and the banking sector booming. Sberbank’s shares are down 32% from the high they posted in 2011.
VTB Bank takes the biscuit as the worst offender. It reported a 56% decline in profits in the first quarter year on year that led to a loss of $370mn, after spending massively on charitable projects. That follows on from a terrible 2014 when the bank's return on equity – a key measure of profitability – fell to 0.1% from 11.8% in 2013. The bank reported a profit of a mere RUB800m ($13mn) for the whole of 2014 – lunch money.
Russia's second biggest lender, VTB spent a massive RUB15.5bn ($300mn) on charities while booking losses of RUB5.1bn, according to the business daily Vedomosti. The bank's balance sheet is in such a mess that it has asked the state for a RUB300bn ($5.6bn) bailout – the first state bank to formally ask for help – which is a third of the RUB1 trillion that the government has put aside to help struggling sector.
Accounting is never particularly transparent to outsiders, but looking at banks’ financial statements can be especially tricky. Banks are strongly impacted by many factors (such as relative changes in the value of foreign currencies) that don’t really give much insight into their “true” profitability. But ultimately, a bank’s fundamental business model depends on taking money from depositors and loaning that money out at a higher interest rate.
The graph below shows net income for the four largest state banks that has been adjusted to remove the distortive impact of foreign exchange translations. Additionally, a one-time book gain in VTB’s 2014 income statement (RUB99bn from a loan from the deposit insurance authority) has been removed. As should be clear, outside of Sberbank, 2014 was basically a disaster for the other three banks.
VTB spent wildly throughout the worst of last December's crisis, with the bulk of the expenditures on good works being booked in the fourth quarter of 2014. In something of an understatement, VTB CEO Andrei Kostin called the period “one of the most difficult” in the bank's history.
The bank does not disclose who the lucky recipients of its largesse were, but the database of state tenders shows about a third of the spending went on a sponsorship package for football club Dynamo Moscow, which VTB owns, and it is due to spend another RUB4.5bn on the club this year, Vedomosti reported. Another RUB750mn is due to be spent on sponsoring the hockey club Dynamo Moscow, as well as smaller sums on other sports sponsorship deals.
That leaves another RUB10bn of VTB charitable spending unaccounted for, and it is exactly this opaqueness that makes letting state-owned banks rule the roost so dangerous and has earned VTB the title of “Russia worst bank” in some circles.
The picture at Sberbank, which reported its first-quarter figures only a few days after VTB, is considerably better, even if its results still weren’t that great. Profits in the first quarter were down by 19% year on year, which wasn’t bad given the battering the Russian economy received in December and was a lot better than analysts had been expecting.
“The difference between the two banks is enormous,” says one senior investment bank research officer, who didn’t want to be named. “Sberbank has its own problems, but its commitment to corporate governance and transparency is reflected in the way it is run and makes all the difference.”
As Russia's biggest retail bank, Sberbank’s core business of loaning people money and charging them interest remained profitable and significant. 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%).
Provisioning for pain
Still, falling profitability at the state banks is to be expected in the broader context of the crisis that is squeezing the entire financial system. A slowdown in growth and investment, compounded by a currency crisis, has predictably led to a serious deterioration in the loan portfolios of the entire Russian banking sector.
Adjusted for revaluation, the sector's corporate lending growth slowed to 6.4% year on year in April from 7.6% in March, but retail lending – which drove the explosive growth in banking sector assets for years – has completely collapsed. The Central Bank of Russia (CBR) tightened regulations at the start of 2014 to head off an obvious consumer credit bubble that was starting to form. The growth in retail lending contracted again in April, falling to 3.2% from 5.8% in March. What that means in practical terms is the number of loans issued in Russia in the first quarter fell by more than half (58%) compared with the same period in 2014, according to Russia's United Credit Bureau.
However, the decline in loan portfolios has not been uniform across the Russian financial sector. The graph below shows the provisions that banks had to record as a percentage of the net interest income their received in 2013 and 2014. A “provision” is a technical accounting term that basically means the amount that a bank expects it will eventually be unable to collect. So if a bank receives $100 in interest income but its provision is $50, it basically means that the bank thinks that it won’t be able to collect on $50 of other loans on which it is eventually due payment. It’s an effective proxy for loan portfolio strength. Sberbank was by far the best performer by a substantial margin, while Rosseklhozbank, which finances Russia's farms, was the worst.
As bne IntelliNews has reported, Russia's agricultural sector is struggling as farmers find themselves in a vice between falling grain prices and the rising cost of things like fertilisers. This is putting Rosseklhozbank under even more pressure than its peers. “The Rosseklhozbank loan book is rotten to its core,” says one agricultural fund manager, adding that the due diligence the bank makes on loans is not particularly rigorous.
Comparing Sberbank's and VTB's respective provisions: VTB’s provisions wiped out 72% of the interest income it received in 2014, while for Sberbank the equivalent figure was only 35%.
At first glance, then, Sberbank’s loan portfolio held up much better than VTB’s. But digging a little deeper into the weeds and even Sberbank's numbers look a bit iffy too. The bank reports three tiers of assets with Level 1 the best and Level 3 the most risky and illiquid – things like buildings or artworks for which there is no obvious market. The problem is how to assess the value of these questionable loans and assets for the accounts, which are, by definition, “not based on observable market data”.
At the end of 2014, Sberbank had RUB25,200bn of all three tiers of assets, of which it disclosed fair values for RUB18,196bn. Of that, RUB16,791bn (or 92%) were Level 3. In other words, the management were free to basically make up any value it liked for two-thirds of its total assets.
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. Exactly the same story is repeated at the other three state banks; directed lending and funding of government-backed projects means all the banks, but especially Rosseklhozbank, have made loans on Level 3 assets that have some value on paper but little in the real world.
None of this is illegal or even particularly unusual to Russia. But what it does mean is that the opacity and subjective nature of the state bank's accounts is an excellent way of sneaking very nasty surprises into the banks' books. That is the certain route to a banking crisis during the next shock. If you wanted to write a novel on how to blow up an emerging market's financial sector, then this is probably the best mechanism you could choose for the plot.
Not much security
In addition to their core business of taking in money and lending it out, modern banks also routinely engage in the proprietary buying, selling and trading of various kinds of securities with their spare cash. As you might expect given the turbulence in Russia’s stock and currency markets, 2014 was not terribly kind to this line of business and all Russia’s state banks (even the generally well-run and conservative Sberbank) saw a sharp deterioration in the profitability of their investments.
Both Sberbank and VTB have investment banking divisions, but while other banks lost more money on an absolute basis, VTB Capital's relative performance stands out as being particularly bad.
VTB’s investment banking arm was set up in the crisis year of 2008 and has sold itself as Russia's leading investment bank. Indeed, it does lead the tables for things like M&A transactions, bond issues and IPOs, but thanks to this emphasis, no other bank saw a more dramatic swing from year to year. At this scale the question doesn’t turn on particular investments or individual decisions: it’s not as if someone at VTB Capital made a bad stock pick or bought a particularly ill-advised corporate bond. Rather, it was a broad-based deterioration across the bank’s entire portfolio.
With the banks in such a terrible state, the question is what happens now? The CBR's emergency hike in interest rates to 17.5% in December made the cost of capital unaffordable to potential borrowers and while the central bank has reduced the rate several times since then into the low teens, it is still very expensive. Bank's lending business, their main form of income, has collapsed as a result.
So far, the CBR has stepped in to provide funding and seen its share of liabilities rise to 11% of the banking sector’s total (in 2008 at the peak of the crisis the CBR accounted for only 3% of total funding). And the lucky few that have access to the state-directed loans are enjoying subsidised loans well below market rates. But the CBR can't keep this up forever.
The Russian economy has been surprisingly robust in the face of Western sanctions and the ruble’s collapse, and it could even return to growth by the start of next year, so there is light at the end of the tunnel. If there is a “snap-back”, then many loans that were previously impaired could, once again, look profitable. On the other hand, if the outlook for the Russian economy remains bleak, then the situation in the financial sector could spin further out of control.
In the meantime, the non-performing loans (NPLs) ratio is rising in both the corporate and retail banking segments: corporate NPLs surged 50 basis points (bp) month on month in April to 5.4%, the highest level since 2010, while retail NPLs rose at the steady pace set in the last year of 20bp on month to 7.1%. However, neither of these results is at the level where they threaten the stability of the banking sector.
The banking sector’s losses are also manageable: the banks reported RUB23bn ($435mn) of net losses in April, but this is tiny compared with total assets of RUB74 trillion rubles ($1.5 trillion) at the beginning of April.
Out of all the results, the really crucial number to watch is the capital adequacy ratio (CAR) of the banking sector – the share of cash that banks hold back to pay out to depositors on demand. Cut off from wholesale funding, Russian banks are being forced to dip into their own capital to make loans and the CAR has fallen steadily from the low 20s to touch a low of 12% in December-January. However, the CBR has been doing its job and the recapitalization of the sector had lifted the CAR back up to around 13% by May. “Overall, it seems that the situation will normalize, in a fashion similar to that seen in 2009,” reckons Alfa bank's chief economist, Natalia Orlova. “However, some banks will struggle with funding that is beyond their means, particularly those that offered longer-term deposits during the winter months at the rate peak.”
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