Chapter

6 Banking Crisis and Recovery

Author(s):
David Robinson, and David Owen
Published Date:
September 2003
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Author(s)
David O. Robinson

The August 1998 crisis had an immediate and significant impact on the banking system. The combination of the government’s de facto default on its domestic debt and the sharp devaluation of the ruble provided the visible classic triggers for a collapse of the system. Much of the system became formally insolvent, though it continued to operate—in a fashion. Indeed, the crisis only brought into focus the underlying weaknesses of a banking system proliferated by weak institutions that held banking licenses but possessed few of the characteristics of typical commercial banks. Nonetheless, these institutions were exceedingly vulnerable to asset quality, foreign currency, and counterparty risks. These weaknesses and exposures can in large part be traced to Russia’s poor record of macroeconomic stabilization and to failures to address structural weaknesses of the financial sector and of the economy at large.

Although prompt action was taken after the crisis to relieve the short-run liquidity constraint faced by the banking sector, the subsequent design of an appropriate bank restructuring strategy was a painfully gradual process. This process was hampered by a lack of meaningful financial data on the banking system and by basic disagreements, including with the international financial institutions, about the causes of the crisis and the scope of the required reforms. The focus during the first year after the crisis was therefore on establishing the legal framework and institutions for banking system restructuring while determining the underlying financial condition of the banks and reaching a consensus on the overall reform strategy.

Progress was made on establishing the overall framework, but actual bank restructuring was modest. Much of the legislation necessary to permit effective bank restructuring was established within the first year after the crisis. However, additional amendments designed to enhance the laws’ effectiveness and prevent subsequent challenges were significantly delayed and, as a result, lost most of their immediate impact in responding to the 1998 crisis. Consequently, the use of this framework was tentative and the court system proved to be an impediment to rapid action.

Injections of public funding to support the banking system have been very modest. The Central Bank of Russia (CBR) provided significant liquidity support but, with the exception of the state banks and those banks working with the Bank Restructuring Agency (ARCO), there was no attempt to provide public funds to recapitalize the banks. Similarly, no blanket guarantee on deposits was extended although depositors at some of the largest banks were given an option to transfer their deposits to a state bank that had such a deposit guarantee. While this partly reflected the tight budget constraint at the time, it was also part of a strategy to provide the banks with breathing space to recapitalize themselves. In the event, the strength of the postcrisis economic recovery, coupled with the improvement in secondary market prices for government debt and other Russian assets, has improved the liquidity and solvency of many banks and the sector is being recapitalized, albeit at a slow pace. However, the banking system remains small by international standards, including in comparison with other transition countries, with a few state banks playing a substantial role, and assessment of the banks’ financial position remains difficult.

Failure to restructure the banking system has, however, had few immediately visible detrimental impacts on the economy; 1999–2002 was the first period of sustained economic growth since the beginning of the transition. The somewhat paradoxical coexistence of a largely malfunctioning banking system and vigorous economic growth stems from the historically marginal role that the Russian banking system has played in the real economy. The banking system provides payments services but it has not been a source of finance to the economy, particularly for investment. But the costs of inaction are likely to be significant over the longer term, as sustainable economic growth founded on a diversified economic base with a dynamic small and medium-sized enterprise sector will only be realized through a deepening of the financial system, at the heart of which will have to be a sound competitive banking system that can efficiently intermediate between savings and investment.

Banking reform received fresh impetus in 2001. In February, the CBR formulated and made public a draft strategy paper for developing the banking system. A revised version of this paper—incorporating comments from a range of government agencies, bankers’ groups, and the international financial institutions—formed the basis of a joint government-CBR strategy paper approved in December 2001. The proposed strategy addresses many of the issues that have to date constrained the emergence of a well-functioning banking sector. In many areas, the ideas incorporated into the strategy paper had been discussed earlier but strong vested interests had been able to resist their implementation. Overcoming these interests and effectively implementing the strategy will not be easy but it is essential for the emergence of a deep dynamic financial sector to underpin growth.

Prelude to the Crisis

Many of the vulnerabilities that were exposed at the time of the crisis can be traced to the initial development of the banking system and its interrelations with the macroeconomic and structural reform efforts. In particular, a system emerged in which there were many banks, with the vast majority providing scarcely more than payment services and very little in the way of traditional banking activity. Household deposits were concentrated in a state bank, Sberbank, which unlike private banks was provided with deposit insurance. The private banks invested heavily in government securities, which provided a high rate of return, and in loans to related parties—the latter can be interpreted either as a rational response to concerns over the enforcement of creditor rights in an uncertain legal environment or as a reflection that the bank’s true goal was to channel financial resources to a few select clients. Banking supervision was formally in place, but relatively ineffective owing to weaknesses in the quality of data reported, stemming from underdeveloped accounting and auditing standards and shortcomings in the legislative basis for banking supervision. The existing vulnerabilities were compounded by large capital inflows that banks, exploiting the limited effectiveness of banking supervision, used to create substantial ill-managed off-balance-sheet exposures.

In the late 1980s, the banking system consisted of only five state-owned banks: the Gosbank and four specialized banks.1 However, a combination of initial confusion as to whether it was the CBR or the remnants of Gosbank that had the authority to license banks and relatively lax licensing criteria produced a surge in the number of operating banks to 2,457 at end-1994. This number has been significantly reduced since then, principally because of stricter criteria for the issuance of licenses since 1995 and the removal of licenses from institutions with financial difficulties (Table 6.1). At end-1997, 1,697 banks were operating (Figure 6.1).

Table 6.1.Process of Consolidation
1988–19941995199619971998199920002001Total
Licenses revoked7121627532922712733121,290
Mergers and acquisitions25281211343
New banks2,4908526129817202,667
Source: Interfax.
Source: Interfax.

Figure 6.1.Total Number of Operating Banks

Source: Bulletin of Banking Statistics, Central Bank of Russia.

The large number of banks notwithstanding, the banking system was undersized and underdeveloped. M2 stood at only 18 percent of GDP in Russia at end-1997, compared with an average of 42 percent in the transition economies of Eastern and Central Europe (see Table 6.2). Russia’s currency-to-deposit ratio was more than double the average level in these transition countries, implying that a large part of the monetary transactions that did take place occurred outside the banking system. Household deposits were mainly used by commercial banks to finance the government deficit: credit to the government from commercial banks, expressed as a share of total deposits, stood at over 60 percent in Russia, almost double the average in the Eastern and Central European transition countries. Little credit was provided to the private sector that had emerged following the privatization of most of the economy during 1992–96. Outstanding credit to the private sector was under 10 percent of GDP in Russia (with about half of it denominated in foreign currency), one-third of the level in the Eastern and Central European transition countries.2

Table 6.2.Transition Economies: Key Indicators for the Commercial Banking Sector, 1997(Percent)
M2/GDPNFA/Total DepositsClaims on General Government/Total DepositsClaims on Private Sector/GDPCurrency-to-Deposit Ratio
Bulgaria33.637.756.712.629.7
Czech Republic69.95.97.065.211.3
Estonia30.3-33.77.325.830.9
Hungary46.544.1102.724.316.5
Kazakhstan10.26.331.67.1115.9
Latvia27.429.320.010.558.9
Lithuania19.06.739.410.954.0
Poland37.67.236.217.118.7
Romania24.812.632.38.426.8
Russia18.1-9.860.69.440.6
Slovenia42.59.532.228.56.8
Ukraine13.60.428.62.496.6
Average, Eastern and Central Europe144.315.942.128.716.0
Average, Baltics225.60.822.215.747.9
Source: IMF, International Financial Statistics.

Bulgaria, the Czech Republic, Hungary, Poland, Romania, and Slovenia.

Estonia, Latvia, and Lithuania.

Source: IMF, International Financial Statistics.

Bulgaria, the Czech Republic, Hungary, Poland, Romania, and Slovenia.

Estonia, Latvia, and Lithuania.

The banking system could be grouped into four broad categories: (1) state-owned banks; (2) large private banks that, for the most part, had limited branch networks and retail banking-based businesses; (3) subsidiaries of foreign banks licensed to operate in Russia; and (4) small and primarily regional banks. Banks of types (2) and (3) were mainly based in Moscow; at end-1997, all but 4 of the top 50 banks (in terms of assets) were based in Moscow and 3 of those 4 were based in St. Petersburg. The heart of the banking system was the combination of the largest state bank, Sberbank, and the large Moscow-based private banks.

Sberbank—whose majority owner is the CBR—accounted for one-fourth of all banking system assets at end-1997 and for close to half of the 4,500 full-service bank branches in the country. While it was historically the only bank for household savings, Sberbank’s share of total household deposits declined steadily in the early years of transition as other banks were able to attract a share of the market for retail deposits (Figure 6.2). However, this trend was reversed in 1994, thanks to the formal introduction of an explicit guarantee on deposits held in state banks combined with a reevaluation of risk following the collapse of several financial pyramid schemes (like the MMM).3 The banking crisis of 1995, which involved a collapse of the interbank credit market, producing uncertainty about the liquidity position of many private banks, resulted in a further increase in Sberbank’s share. Enterprise deposits, on the other hand, are less concentrated because private banks have been able to compete in terms of the quality of service provision and because many of the enterprises had created their own banks. The bulk of Sberbank’s assets was invested in government securities; in mid-1998, prior to the financial crisis, government securities accounted for 55 percent of the bank’s assets, while loans to businesses were only 14 percent of total assets.

Figure 6.2.Sberbank’s Share of Total Individual Deposits

The large Moscow-based private banks accounted for the bulk of the remaining assets of the banking system. With the exceptions of SBS-Agro (the former Agroprombank, which had an extensive branch network) and a few other private banks that sought to mobilize household savings, most of these banks derived their client base from enterprises within their own financial-industrial group. The pattern of holdings and cross-holdings between industrial enterprises and commercial banks within a financial-industrial group made the ownership structure of these banks extremely opaque. Nevertheless, most major banks were widely acknowledged to belong to a particular group controlled by an “oligarch”—a magnate that ultimately owned the largest portions of groupings of linked enterprises. These financial-industrial groups represented strong vested interests and were politically very powerful.

The banks within a particular group typically acted as the treasury vehicle for their sister enterprises. In addition, they were major players in their own right in the government securities market and they also played a large role in channeling foreign resources both to the government securities market and to enterprises. Following the large inflow of foreign capital into the Russian government securities and stock markets beginning in 1995, the large Moscow-based banks became heavily engaged in the market for off-balance-sheet foreign currency forward contracts as nonresidents sought to hedge their Russian investments. In contrast to these investment-banking types of operations, the large Moscow-based banks were involved only to a very limited extent in providing traditional retail banking services to the general public.

Supervisory authority was established in the CBR in 1993 and a regulatory structure was put in place, but it was relatively ineffective. The formal regulatory structure was broadly consistent with international practices: prudential regulations covered the key areas, including capital adequacy, lending activities, minimum liquidity, concentration, and exchange risks. However, supervisory practices suffered from a series of limitations. First, accounting norms differed from international accounting standards: Russian accounting practices had evolved little from Soviet-era systems that were geared toward bookkeeping practices rather than providing risk-based information about the true financial conditions of banks. Off-site analysis was based on unreliable data and focused excessively on compliance with established norms and procedures rather than on analysis of risks and the actual financial conditions of the banks. Second, on-site examinations were relatively infrequent and focused on verifying the banks’ statistical reports. No judgments were made about the true value or risk of particular assets or the quality of management. Third, the complex ownership structures of the financial-industrial groups and weak disclosure requirements made it virtually impossible to accurately measure key prudential requirements such as limits on lending to connected parties. Finally, supervisors made insufficient use of their existing powers to require changes in unsafe practices and lacked experience in how to make real improvements in bank safety and soundness.

According to published data, the banking system was highly capitalized and sound at the end of 1997. Capital of the top 200 banks amounted to 16 percent of unweighted assets and both the largest 100 and the small and medium-sized banks had healthy capital ratios of 15 percent and 26 percent, respectively. Virtually all banks in the system were reported to be meeting the supervisory regulations as prescribed by the CBR.

These published figures vastly overstated the financial health of the banking system. The unstable macroeconomic conditions since the transition had produced a difficult business environment, as the profitability of the corporate sector was weak and banks had difficulties identifying reliable and profitable borrowers. These conditions were aggravated by nontransparent corporate accounting, disclosure, and auditing standards as well as weaknesses in the legal system, which made enforcement of loan contracts difficult. Banks responded to these risks with a combination of three strategies. The first was to concentrate their lending in related borrowers, where more information about the true conditions of the enterprises was known and where the bank had some possibility of having loans repaid. The second was to concentrate their portfolio in government securities. These securities generated significant interest income, carried zero risk weights in the calculation of the prudential norms, and were extremely flexible financial instruments. The supervisors treated banks with heavy investments in such securities as following appropriately risk-averse practices. The third was to engage in speculative foreign exchange dealings, counting on the continued stability of the ruble.

Deficit financing in the form of domestic sales of ruble-denominated treasury bills took on an increasingly important role following the passage of the Central Bank Law in April 1995 prohibiting the CBR from direct lending to the government. The treasury bill market, which had its inception in 1993, took off in 1995 and the stock of outstanding bills increased from about 1.2 percent of GDP at end-1994 to over 12 percent of GDP at end-1997. While nominal yields on treasury bills fell during 1995–97 as success was achieved in reducing inflation, yields—adjusted for inflation and the depreciation of the ruble—remained high owing to the government’s voracious appetite for financing.

Treasury bill holdings of Russian commercial banks—including the subsidiaries of foreign banks—increased steadily, reflecting the attractive terms of lending to the government and the problems of lending to the real sector. Banks also purchased, in the secondary market, substantial amounts of foreign currency-denominated Russian government debt instruments that were initially floated abroad. Thus, while at end-1993 commercial banks had a net liability position vis-à-vis the government reflecting government deposits held at banks, by August 1998 they had a net asset position equivalent to over 40 percent of M2. In contrast, the real stock of credit to the nongovernment sector declined sharply in 1995 and, by and large, remained at that level until mid-1997, when a substantial rise in foreign currency-denominated credit occurred in conjunction with increases in commercial banks’ foreign liabilities.

Favorable developments in both Russia and in international capital markets contributed to a sharp increase in foreign liabilities of commercial banks. The relative macroeconomic stability from 1995 onward facilitated the entry of Russian banks into world capital markets. The stability of the exchange rate also contributed to commercial banks’ increasing complacency toward taking on on-balance-sheet foreign currency risks, and the large Moscow-based banks began to access foreign syndicated loans and to issue their own bonds abroad. The across-the-board fall in interest rates on emerging market debt during 1995–97 made this source of financing attractive while discouraging the banks from mobilizing household savings domestically since the government guarantee on Sberbank deposits represented a competitive disadvantage to private banks. Consequently, on-balance-sheet foreign liabilities of the Russian commercial banking sector increased by 350 percent during 1995–97, while total deposits in the banking system grew by only 69 percent.

Funds raised from abroad were, in turn, channeled by the banks into loans to the government and to selected enterprises—the latter often in foreign currency. While the market for ruble-denominated loans remained relatively depressed, enterprises needed foreign currency to settle transactions with nonresidents.

Large external capital inflows to the government and to enterprises also had repercussions for commercial banks’ off-balance-sheet positions. Access to the treasury bill market for nonresidents was liberalized and foreign investors purchased, on a net basis, about $ 11 billion of the government’s local currency debt instruments in 1997, on top of $6 billion of such net purchases in 1996. The Moscow stock exchange was the best performing equity market in the world in mid-1997, as foreign investors purchased the stocks of selected “blue chip” companies. The increase in ruble-related exposures of nonresidents gave birth to a large market for foreign currency derivatives and commercial banks engaged in heavy trading of such instruments. Given the stability of the ruble and weak prudential supervision, banks did not, however, ensure that their own exposures were adequately hedged. Commercial banks’ off-balance-sheet forward foreign currency obligations stood at a staggering $83 billion, or 150 percent of M2, in mid-1998. While, in principle, this exposure was hedged by the banks’ own forward foreign currency claims on other Russian banks or enterprises, such claims were typically of very doubtful quality—as soon became clear.

The August 1998 Crisis and Its Impact

When the crisis hit, it effectively crippled the banking system.

  • Given the share of treasury bills in bank portfolios, the banks lost access to a significant portion of their assets. They also lost the major liquidity management instrument as secondary market trading was halted. Most of the commercial banks’ portfolios of government paper eventually became subject to the restructuring scheme at a fraction of the face value of the instruments (see Chapter 7). The secondary market price of Russian sovereign debt originally issued in international markets also collapsed, further weakening Russian banks, given their sizable holdings of such instruments.
  • Banks’ foreign currency loans to enterprises with limited or no foreign currency earnings became for the most part uncollectible.
  • The chain of forward foreign currency obligations also unraveled. Many nonresidents had purchased forward foreign currency contracts and options from larger banks, which, in turn, had hedged their exposure with smaller banks and with enterprises. These hedges were, however, of dubious quality and their legal status was particularly weak. Under Russian law, forward contracts entered into in Russia are governed by Russian gaming laws that provide limited opportunities for creditors seeking to enforce collections. On the other hand, the obligations of the larger banks to nonresidents were often covered under English law, providing creditors with a broad range of instruments to attempt to enforce collections in international courts.

The combination of the above factors made many of the large banks insolvent. However, the main criterion for revoking a bank’s license under the Russian banking legislation was illiquidity—as measured by the inability of a bank to process payments. Thus, as long as banks could preserve sufficient liquidity, for example, by discouraging sufficient transactions, the bank could remain in operation even if its capital—as measured by international standards—was massively negative. Thus, many of the large Moscow-based banks either stopped or significantly slowed the processing of clients’ payment orders, and the immediate impact of the banking crisis was a collapse of the payment system exacerbated by the loss of the principal instrument for liquidity management. Payments made through commercial banks’ correspondent accounts at the CBR more than halved in nominal terms as banks attempted to hoard liquidity. Owing to widespread uncertainties among banks about the true state of the finances of their counterparts, the interbank money market also dried up. At the same time, the large Moscow banks, which were used to managing their liquidity through sales and purchases of the government’s ruble debt instruments, were left without collateral to obtain funds from the CBR’s regular facilities, as trading of ruble-denominated government debt was stopped by government mandate.

Deposits were drawn down but the outflow was more limited than might have been expected. Between end-July and end-September 1998, ruble deposits in the banking system declined by 8 percent while foreign currency deposits decreased by 20 percent in dollar terms. The limited nature of the drawdown in deposits, particularly ruble deposits, reflects a variety of factors. First, the bulk of household deposits was held at Sberbank and covered by government guarantee; the large Moscow-based banks that were most adversely affected by the crisis held only limited amounts of households’ and unconnected clients’ deposits. Second, the low monetization of the economy meant that a large portion of the deposits in the banking system was maintained to meet payments needs rather than as a store of value. As these payments needs would continue to exist in the future, unconnected enterprises sought to transfer their working balances from private banks to Sberbank and to subsidiaries of foreign banks rather than withdrawing them totally from the banking system. Third, a large part of the drawdown in balances in excess of what was required for working capital had already occurred during the months leading to the crisis: ruble deposits had declined by about 6 percent in nominal terms during January-July 1998. Finally, in the immediate aftermath of the crisis, banks introduced substantial restrictions on deposit withdrawals. For example, Sberbank required advance written notice for withdrawals of foreign currency deposits, the second-largest bank in the system only allowed withdrawals by households through cash machines (which were usually conveniently empty), and for a period of time no withdrawals from at least two of the other five largest banks were possible at all for households.

Initial Policy Response

In framing the policy response to the de facto default, the debate focused on whether the banking system was fundamentally sound and just suffering from a liquidity shortage, or whether there were serious deep-rooted insolvency problems. The Russian policymakers strenuously supported the illiquidity interpretation on the basis of the generally positive prudential reports from commercial banks, indicating that the banking system was highly capitalized. Acknowledging, however, that there were issues surrounding the solvency of key players in the system, the CBR also moved toward strengthening the framework for bank restructuring and undertook more detailed examinations of some of the larger Moscow based banks.

Addressing the Illiquidity of the Banking System

The immediate policy response was aimed at alleviating the illiquidity of the banking sector while avoiding a run on deposits and preventing a rush of creditor claims against the banks. Five key steps were taken:

  • a massive injection of liquidity into the banking system in various forms;
  • an option for individuals to transfer their deposits from certain private banks to Sberbank;
  • regulatory forbearance for banks;
  • the announcement of a moratorium on the repayment of private external debt, including forward contracts, for a period of three months (announced as part of the August 17, 1998, package); and,
  • an effort to address the issue of banks’ exposure in forward contracts by linking its resolution, in talks with creditors, to the terms for restructuring the government’s ruble debt.

This package of measures was largely successful in reversing the immediate manifestations of the banking crisis—namely, the blockage in the payments system and pressure on deposits—but at substantial cost both to the state and to the depositors and creditors of the banks. The injections of liquidity, both before and after the exchange rate adjustments, also served to add to the pressure on international reserves. Furthermore, these measures, by themselves, did not directly address the fundamental causes of the banking crisis, nor did they succeed in resolving the weaknesses of the affected banks. The nature of the measures, along with the manner in which some of them were implemented, also raised questions about transparency and equality of treatment.

In terms of liquidity injections, CBR support of ailing banks had already been stepped up before August 17. During the following month, injections of liquidity accelerated and took three forms: (1) direct extension of ruble liquidity support through a combination of the existing Lombard facility and other facilities where feasible, as well as through special rehabilitation credits; (2) successive rounds of reductions in reserve requirements; and (3) large-scale purchases of frozen government securities from commercial banks’ portfolios. Injections of liquidity in various forms into the banking system during the month-and-a-half beginning on August 4 amounted to about one-fourth of all ruble deposits in the banking system at end-July.

Existing CBR instruments—largely designed to provide liquidity against the collateral of either government securities or CBR bonds—were inadequate for the task of injecting large-scale liquidity. As the secondary market for GKOs (short-term treasury bills) had collapsed—and the CBR wisely refused to accept defaulted securities as collateral—and the stock of CBR bonds was close to zero, little liquidity could be injected through traditional means. Thus the CBR established a special facility through which it could extend rehabilitation loans to selected “systemically important” commercial banks on a case-by-case basis at substantially below market interest rates. In return for these loans, banks had to provide the CBR with a “rehabilitation plan” and 75 percent of their shares as collateral. The principles used in selecting banks for the extension of support, or the specific terms governing individual agreements with banks, were, however, not disclosed.

In addition, reserve requirements were relaxed in various rounds. One of the effective reductions in reserve requirements stemmed from the CBR’s immediate efforts to clear blockages in the payments system—banks were allowed to use funds in their required reserve accounts at the CBR to execute clients’ payment orders. Following the success of this scheme, additional operations of this nature were conducted by the CBR during the fourth quarter of 1998. Other reductions in reserve requirements during this period were, however, aimed at providing general support to banks rather than specifically to clear the payments system, and these were implemented either across the board or for specific banks whose frozen assets (government securities) exceeded a certain threshold (in particular, the large Moscow-based banks).

The amount of liquidity injected into the banking system through these facilities is illustrated in Table 6.3. The liquidity situation of the banking system improved fairly rapidly and balances both in correspondent accounts held at the CBR and in the CBR’s deposit facility—effectively a risk-free asset—increased sharply in September and October. While the level of these balances is difficult to interpret, as they may largely reflect the concentration of liquidity in the stronger banks, the CBR started to curtail its liquidity injections into the banking system in October and November before a significant loosening occurred in December. Beginning in mid-March 1999, the CBR started to raise reserve requirements.

Table 6.3.Liquidity Injections into the Banking System
Net Liquidity OperationsRequired Reserve BalancesDeposit FacilityOBRs1Gross Credit to BanksCorrespondent Accounts
TotalRubleForeignTotal2LombardRehabForex2Other
Billions of rubles
1996 Dec-30.925.922.33.611.40.06.417.7
1997 Dec-26.936.427.58.90.40.09.96.531.4
1998 June-26.338.125.512.60.20.012.07.914.0
July-36.737.324.812.53.40.04.01.413.9
Aug-10.532.420.911.60.20.022.25.310.0
Sep-5.720.213.46.81.11.517.21.720.8
Oct-19.018.013.05.08.01.98.91.222.4
Nov-20.119.014.14.810.11.910.80.627.7
Dec1.420.812.58.34.72.229.10.07.413.38.432.6
1999 Jan-7.923.713.99.811.12.629.50.07.413.78.429.1
Feb-6.224.714.110.715.10.033.70.07.914.711.132.9
Mar-16.135.119.415.715.40.034.40.09.312.812.344.4
Percent of base money
1996 Dec-23.619.817.02.78.70.04.913.6
1997 Dec-16.322.116.75.40.20.06.03.919.1
1998 June-16.123.315.67.70.10.07.34.88.6
July-22.723.115.47.72.10.02.50.98.6
Aug-6.520.112.97.20.10.013.73.36.2
Sept-3.211.57.63.90.60.99.81.011.9
Oct-10.29.67.02.74.31.04.70.612.0
Nov-10.59.97.42.55.31.05.70.314.4
Dec0.79.85.93.92.21.013.80.03.56.34.015.4
1999 Jan-3.911.66.84.85.41.314.50.03.66.74.114.3
Feb-3.012.06.85.27.30.016.30.03.87.15.415.9
Mar-7.816.99.47.67.50.016.60.04.56.25.921.4
Sources: Central Bank of Russia; and IMF staff estimates.

Central Bank of Russia bills.

Excludes credits to Vneshtorgbank for government debt service.

Sources: Central Bank of Russia; and IMF staff estimates.

Central Bank of Russia bills.

Excludes credits to Vneshtorgbank for government debt service.

The CBR’s efforts to inject liquidity into the system took other less transparent avenues. The CBR made outright purchases of frozen government securities from Sberbank to ensure that the bank had sufficient liquidity to meet demands for withdrawals of ruble deposits by households. The prices at which such transactions took place have not been disclosed, making it difficult to gauge the net financial flows between the CBR and Sberbank during this period.

Given the concentration of deposits at Sberbank and the special liquidity support provided to the bank, only limited additional measures were necessary to reassure depositors. Specifically, the CBR implemented a limited scheme to transfer household deposits from a number of Moscow-based banks to Sberbank on a voluntary basis. While the full value of ruble deposits was transferred (with the proviso that balances could not be withdrawn until after November 15), foreign currency deposits were transferred in rubles at a rate of Rub 9.33 per U.S. dollar, substantially below the average market rate of Rub 16.6 per U.S. dollar during the fourth quarter of 1998. In return, the private commercial banks had to either (1) provide government securities valued at the price in effect prior to the crisis to the state-owned Sberbank or, if they were unable to do that, (2) provide the CBR with promissory notes. The CBR, in turn, provided such government securities from its own portfolio to Sberbank. By end-1998, Rub 7.1 billion in deposits had been transferred to Sberbank under this scheme.

The CBR exercised substantial regulatory forbearance in the aftermath of the crisis. In October 1998, the CBR took the decision to effectively freeze the valuation of key indicators of banks’ soundness—required to calculate compliance with prudential regulations—at the levels prevailing before the crisis. Under this scheme, 168 banks were eligible, for several months, to continue to value their capital at the level existing prior to the crisis, and to use the exchange rate in effect before the devaluation of the ruble in assessing compliance with prudential regulations. Given a system of prudential oversight that relied primarily on banks’ own reporting of key data, the implementation of this scheme further enabled banks to mask any irregularities in their operations.

The debt moratorium and the prolonged uncertainties concerning the resolution of how banks’ liabilities on account of foreign currency forwards would be resolved also facilitated asset-stripping by private banks.

With regard to the foreign currency forwards, because the chain of forward contracts eventually culminated in claims on major (including state-owned) banks held by the same nonresidents that held the government’s ruble debt, the authorities initially sought to link the forward claims to the terms for restructuring the ruble debt. Under the authorities’ proposal, as part of the restructuring of the debt, nonresidents would relinquish their forward claims on the major Russian banks to the authorities. The authorities then planned to conduct an offsetting exercise for forward claims and liabilities held between banks in the system. The discussions on this issue were protracted as the nonresidents sought to delink the issue of the forwards from the terms for restructuring the government’s debt, and ultimately they prevailed. In the interim, however, while the state-owned banks reportedly continued to honor their maturing forward liabilities to nonresidents owing to concerns about maintaining their long-term goodwill in international markets, a large portion of other banks did not honor their own liabilities to the state-owned banks.

Addressing the Solvency of the Financial System

The authorities focused their initial efforts on three objectives.

  • First, to conduct reviews of the financial condition of 18 large, mostly Moscow-based, banks based on western accounting standards—the critical role played by the choice of accounting standards is highlighted in Box 6.1. Banks found to be insolvent and nonviable would be closed and liquidated or, if judged to be of systemic importance, would be candidates for state-assisted restructuring.
  • Second, to establish an adequate legal framework to permit banking system rehabilitation. In particular, a bank bankruptcy law and a bank restructuring law were needed, as well as necessary amendments in related laws.
  • Third, to create an appropriate institutional framework, including by strengthening of the CBR’s supervisory capacity and by establishing an institution to oversee the rehabilitation of viable, but undercapitalized, banks.

There was no attempt to recapitalize the banking system through the use of public funds. The extraordinary support provided to distressed private banks was limited to the liquidity support provided by the CBR in the form of rehabilitation credits. Even for the state banks, there was only a very modest injection of capital into Sberbank in 1999 (Rub 0.6 billion) and a somewhat larger capital injection into Vneshtorgbank (VTB, Russia’s second-largest bank) of Rub 21.5 billion.4 As noted earlier, there was also a series of partially disclosed operations conducted by the CBR with Sberbank that complicates the calculation of the effective transfer between the CBR and Sberbank during this period.

Box 6.1.Russian Accounting Standards and International Accounting Standards

A key constraint on the design of an appropriate policy response to the crisis was the difficulty in assessing the magnitude of the financial losses incurred by both banks and enterprises. While such assessments are difficult in any crisis, the uncertainty was compounded in the case of Russia by the use of Russian Accounting Standards as a basis for the preparation of financial statements (including reporting by banks for the purposes of assessing compliance with prudential standards). There are a number of key differences between Russian Accounting Standards and International Accounting Standards for banks:

  • Asset valuation. Under Russian Accounting Standards, domestic government and corporate securities can be valued at either market value or at cost. Under International Accounting Standards, a fait market value has to be determined for all financial assets, and where fair values fall below market or acquisition cost the unrealized loss needs to be disclosed.
  • Recording income and expenses. Under Russian Accounting Standards, receipts and payments are recorded on a cash (not accrual) basis.
  • Consolidation of subsidiaries (domestic and foreign). There is no consolidation requirement in Russian Accounting Standards. Under International Accounting Standards, the accounts of a bank, as well as its subsidiaries, would be presented as a single set of accounts.
  • Stricter disclosure requirements. International Accounting Standards require extensive disclosure of items relevant to an evaluation of the financial position of an entity and the risks it faces, such as risk management objectives and policies, and exposure to exchange rate, interest rate, and credit risk.

To illustrate the significance of these differences between the two sets of standards, the ability to continue to value government bonds that were in default on a cost basis meant that Russian banks did not have to acknowledge capital losses from defaulted debt instruments on their balance sheets as long as they held the bonds. Thus, even a bank with the majority of its assets in defaulted securities could show a strong capital position. The magnitude of this effect can be seen from the calculations in Aleksashenko and others (2000), where it is estimated that the available capital of the entire banking system—after deducting risks that have already materialized—was just $0.4 billion or 0.7 percent of assets at end-1998, compared with the balance sheet position of 10.5 percent of assets.

Immediate consequences were as follows.

  • The information reported to the Central Bank of Russia for banking supervisory purposes provided little insight into the underlying financial position of banks;
  • Banks were unable to assess the true financial position of counterparties, which caused problems in clearing payments and resulted in the drying up of the interbank market; and
  • The reemergence of a secondary market in government debt—previously an important tool for liquidity management—was delayed as any bank selling the security would need to recognize the capital loss.

Initial results during the first year following the crisis were decidedly mixed. The assessment of the true underlying financial position of the banks, so as to identify insolvent banks, was a time-consuming exercise. Efforts to subsequently close and liquidate clearly insolvent and nonviable banks were often frustrated or drawn out to such an extent that even the remaining assets were stripped. Important progress was achieved in establishing an appropriate legislative framework, although some additional amendments were required, which took an exceptionally long time to adopt. Enforcing the legislation has, however, been a problem as it has taken time to ensure the application of the laws in the courts. Progress was also made in establishing the institutional framework.

Assessment of the True Financial Position of Banks

One of the most important priorities for the CBR was to determine the true state of the financial system. The CBR conducted financial reviews of 18 large Moscow-based banks, representing almost 50 percent of the assets of the privately owned banking system.5 The reviews found that, given stringent assumptions about the value and collectibility of securities and outstanding loans, nearly all of the banks were deeply insolvent. Only three of the banks had positive capital and several banks had negative leverage ratios in excess of -400 percent.

A key result from the financial reviews was that in most cases the insolvency of the banks was caused by insufficient provisioning over the years for the growing nonperforming loan portfolio as much as by the losses incurred from the default or the exchange rate depreciation. Moreover, the financial reviews revealed that many of the 18 banks followed exceptionally risky practices. Many banks were not as well capitalized as reported in their financial statements. Also, many others had excessive lending to related counterparties or to shareholders where loan servicing was not enforced. The reporting by banks was frequently inaccurate and incomplete, limiting the ability of the supervisory authorities to identify unsafe and unsound banking practices on a timely basis. Finally, banks relied on speculative sources of income, including foreign exchange trading, as well as significant short-term borrowing from foreign banks to fund domestic clients. This practice exposed the banks to exchange rate risk and, to the extent that the banks lent dollar-denominated loans to clients without dollar income, it exposed the banks to heightened credit risk. In sum, the financial reviews pointed to an underlying systemic insolvency, which was brought to light by the impact of the August 1998 crisis on bank liquidity.

The authorities decided to immediately de-license at least six of the banks for which financial reviews had been conducted. However, concern about the consequences of large-scale bank closure slowed progress. Of the six, bankruptcy proceedings were initiated for only three of them; one bank managed to persuade the courts to overturn its license revocation; and two were able to negotiate amicable settlements with their creditors. The 12 other banks either entered into a voluntary restructuring agreement with a specialized Bank Restructuring Agency (ARCO) or simply continued to operate under enhanced supervisory oversight by the CBR.

The CBR has moved somewhat more aggressively against smaller, regional banks with financial problems than against the largest banks, which had strong political connections in Moscow. During 1999, the CBR withdrew the licenses of 127 banks and ARCO initiated the restructuring of 3 major regional banks. Even in the cases of the smaller banks, however, the pace of consolidation was slower in 1999 than in previous years.

Establishment of an Appropriate Legal Framework

The legal framework for bank restructuring had two major weaknesses. First, bank bankruptcy was covered under the general bankruptcy legislation, which was slow and gave considerable authority to the bank owners. Second, no legislation existed governing the restructuring of banking institutions. A new bank bankruptcy law was enacted in March 1999 and the bank restructuring law was passed into law in June 1999.

Both laws constituted significant improvements in the legal framework for bank restructuring, but additional amendments were needed to strengthen the authorities’ ability to deal with insolvent banks and these were significantly delayed. Amendments to the law on bank bankruptcy, the general law on bankruptcy, the law on banks and banking activity, the law on the central bank, and the civil code were enacted in June 2001 that (1) introduce capital adequacy as a criterion for determining insolvency; (2) require the mandatory write-down of banks’ charter capital to reflect actual value; (3) allow for early regulatory control of a bank’s operations when it begins to fail; and (4) strengthen licensing requirements as regards “fit and proper” criteria to restrict the scope of former owners and managers of failed banks to participate in new banks. The passage of these amendments significantly strengthened the legal framework for bank restructuring. However, by the time that the amendments were approved, most banks had been able to rebuild their capital base.

Creation of an Appropriate Institutional Framework

Important institutional changes were introduced. First, the specialized Bank Restructuring Agency, ARCO, was created. Second, the CBR consolidated its supervision functions and initiated the reform of its supervisory regulations.

ARCO was established in November 1998 and took its first measures to become operational in January 1999. It was quickly staffed and full operational guidelines were approved by ARCO’s board. Prior to the enactment of the new bank restructuring law, ARCO was limited to facilitating the restructuring of banks on a voluntary basis, which severely restricted its ability to undertake difficult restructuring measures or penalize shareholders and managers of failed banks. In that capacity, it assumed responsibility for 14 regional banks. Following passage of the restructuring law, ARCO moved to the more difficult task of restructuring large and insolvent banks. In the second phase, it took responsibility for an additional six banks.

Progress has been made in restructuring the regional banks that voluntarily submitted to ARCO oversight, but progress in dealing with the large Moscow-based banks, on the other hand, has proven to be far more difficult and less effective. Consolidation and restructuring of the banking system in the Kamerovo region, as well as the streamlining and strengthening of some medium-sized Moscow-based banks, was undertaken. The limited effectiveness in dealing with the larger banks can be traced to the delays in the approval of the restructuring law, as well as the authorities’ unwillingness to use existing powers aggressively, providing a window for asset-stripping in many of the insolvent banks.6 Even after the passage of the bank restructuring law, ARCO was slow to deal with the large and politically connected banks. This sluggish response reflected a lack of political will to take on vested interests, a lack of consensus on how these large banks should be treated, and the limited financial resources available for bank restructuring.

One reflection of a lack of political will is the difficulty that ARCO has had in closing and liquidating insolvent and nonviable large Moscow banks. Promstroibank, for example, was found to be nonviable and was designated to be closed. The CBR withdrew its banking license; the courts supported the action, but the government decreed that Promstroibank should be rehabilitated by ARCO, before ultimately reversing its decision. Similarly, the bank SBS-Agro, which was created from the former state-owned Agroprombank, has been closed, but its assets and liabilities have been transferred to two newly created state banks (the Rehabilitation Bank and an Agricultural Bank). It is unclear how the state banks will be able to effectively manage the assets of SBS-Agro and whether the creation of new state-owned banks is the least costly or most effective solution. In the interim, the fate of SBS-Agro’s creditors, including significant household deposits, remained in doubt more than four years after the crisis.

The CBR also introduced institutional modifications within the CBR by consolidating the supervision functions and initiated the reform of its supervisory regulations. In 1998, the departments responsible for on-site and off-site supervision, as well as the departments responsible for licensing of banks and bank auditors and for bank rehabilitation, were consolidated under a single deputy chairman. Furthermore, a high-level committee was established to ensure that the CBR’s supervisory efforts were fully coordinated. Resulting improvements in the regulatory framework have focused on four principal areas: strengthening loan-loss provisioning, improving licensing procedures, moving supervision onto a consolidated basis, and greater focus on the quality of capital.

Developments after 1999

Despite the slow pace of the reforms taken by the authorities to restructure the banking system, the key financial indicators of commercial banks have recovered strongly. This improvement can be largely attributed to the strength of the macroeconomic recovery, the massive injection of liquidity into the economy from the energy sector, and the modest losses ultimately incurred on the government securities held prior to the crisis. However, the system remains small by international standards and provides limited intermediation, particularly to small and medium-sized enterprises. Credit to the economy has increased rapidly—albeit from a low base—but unaddressed issues relating to weaknesses in accounting, disclosure, banking supervision, connected lending, the true quality of capital, and concerns on risk management practices at commercial banks suggest that the improved financial indicators need to be treated with caution.

Banking sector assets, which were increasing sharply as a ratio to GDP before the 1998 crisis, have not recovered since then, amounting to only 33 percent of GDP at end-2001, well below the levels in other middle-income transition and emerging market economies (Figures 6.3 and 6.4). There has been a significant change in the composition of assets. Claims on government have declined sharply—reflecting both the impact of the restructuring and the subsequent strong improvement in fiscal balances—and a reduction in gross foreign assets linked to a sharp reduction in foreign liabilities, as external credit lines were closed, and the real appreciation of the exchange rate since 1999. Credit to the private sector has increased very rapidly—by more than 35 percent in real terms in both 2000 and 2001. The growth in lending has been strongest in Sberbank and VTB, but private banks have also increased lending to the private sector.

Figure 6.3.Decomposition of Banking Sector Assets

(Percent of GDP)

Source: IMF, International Financial Statistics.

Figure 6.4.Total Assets, end-2001

(Percent of GDP)

Source: IMF, International Financial Statistics.

Total deposits in the banking sector have increased but remain low by international standards, amounting to 17 percent of GDP at end-2001 (Figures 6.5 and 6.6). Deposits have risen sharply in real terms since 2000 as real incomes including pensions have increased sharply (and have been paid in a timely manner) and the profitability of the enterprise sector has been high. At end-2001, household deposits were 27 percent higher in real terms than at end-1998 and enterprise deposits were 350 percent higher. The increases have occurred despite consistently negative real interest rates, and have been accompanied by a switch from foreign currency to ruble deposits as confidence in the ruble has recovered and the near-term risk of a large depreciation of the exchange rate has disappeared.

Figure 6.5.Total Deposits, end-2001

(Percent of GDP)

Source: IMF, International Financial Statistics.

Figure 6.6.Real Deposits

(Constant 1995 prices)

Source: IMF, International Financial Statistics.

The health of the banking sector—as measured by both prudential indicators and profitability—has also improved sharply (Table 6.4). Banks have been able to increase their capital both in absolute terms and relative to assets.7 Nonperforming loans have declined sharply, related to the strength and breadth of economic recovery, and loan-loss provisions have been built up to a level that, since 2000, has exceeded the stock of nonperforming loans. Profitability of the banking sector has also improved sharply. The data are, however, for the banking system as a whole and there is significant variation between banks.

Table 6.4.Indicators of the Health of the Banking System(Percent)
1998199920002001End-June 2002
Capital adequancy
Capital to risk-weighted assets11.518.119.020.319.9
Capital to assets7.310.612.114.414.3
Asset quality
Nonperforming loans to total loans17.313.47.76.26.5
Doubtful and bad loans minus loan loss reserves to capital71.916.3-1.0-1.6-3.1
Profit and profitability
Return on assets-3.5-0.30.92.43.1
Return on capital-28.6-4.08.019.422.4
Sources: Central Bank of Russia, and IMF (2003).
Sources: Central Bank of Russia, and IMF (2003).

The structure of the banking system has not changed significantly since the crisis. The system remains dominated by Sberbank, which has retained its key role in the retail deposit section of the market. The vast majority of Russian banks remain very small.8 Excluding Sberbank, the Russian banking sector is not very highly concentrated relative to transition economies or to other large countries, which typically have few large banks—as evident from Figures 6.7 and 6.8. While the share of banking sector assets concentrated in the largest bank is higher in Russia than in most other comparable countries, the share of assets concentrated in the second- to fifth-largest banks is a lot smaller.

Figure 6.7.One-Bank Concentration Ratios

(Percent of banking sector assets)

Sources: BankScope; Sberbank Annual Report, and IMF, International Financial Statistics.

Figure 6.8.Concentration Ratio for Second- to Fifth-Largest Banks

(Percent of banking sector assets)

Sources: BankScope; Sberbank Annual Report, and IMF, International Financial Statistics.

State-owned banks continue to dominate the financial sector (Table 6.5). In addition to Sberbank and Vneshtorgbank—the two largest banks in the system measured either by assets or by capital—federal and regional authorities hold equity in an estimated 881 banks, including majority stakes in 23 banks (Goryunov, 2001).

Table 6.5.Sberbank and VTB(End-2001, billion of rubles)
AssetsDepositsCapitalProfitsBranches
Sberbank77348996221,598
(percent of total)27722132
Vneshtorgbank1446455
(percent of total)51108
Banking system2,90267845569
Source: Interfax.
Source: Interfax.

The role of Sberbank within the banking system is a source of great debate and is key to the future development of the banking system.

  • On the one hand, Sberbank can be viewed as the cornerstone of the system, providing both stability and the payment system during the crisis, providing essential government services for which it is not directly compensated, and serving as a dynamic competitor responding to new opportunities. During the crisis itself, there is little doubt that Sberbank played an important role in maintaining some measure of depositor confidence as, given its state connections, it was seen as a safe haven attracting both household and corporate customers. Indeed, the CBR encouraged the transfer of private deposits to Sberbank from large private banks experiencing difficulties. Sberbank also continues to maintain an extensive branch network that ensures the provision of basic financial services to remote regions, including for the payment of pensions, even though many of these branches would likely be closed if evaluated on purely economic grounds. The combination of the government debt default and the massive turnaround in the fiscal position since the crisis has meant that Sberbank’s traditional business—taking household deposits and investing them in government securities (at the time of the crisis almost 50 percent of Sberbank’s assets were held in government securities)—is no longer an option. Thus Sberbank has had to broaden its asset allocation, including through increased loan operations.
  • On the other hand, Sberbank can be seen as an effective monopolist that, through special advantages conferred on it, has prevented the emergence of a competitive private banking system. The provision of an explicit and unlimited guarantee on household deposits provides Sberbank with a clear cost edge over private banks. Sberbank’s competitive advantage is enhanced by its relatively stable funding base, resulting from its dominance of the household ruble deposit market (including a disproportionate share of pension deposits).9 As a result, Sberbank is able to offer loans of a longer maturity than other banks. Moreover, its large capital base has allowed Sberbank to make larger loans, given the prudential restrictions on banks’ exposure to individual borrowers. The combination of larger loans at a longer maturity at a lower cost of funds provides Sberbank with a distinct competitive advantage, particularly for dealing with larger enterprises.

A key concern, not just at Sberbank, is whether the rapid increase in credit to the economy has resulted in a buildup of risk within the banking system or whether banks have been able to develop adequate risk management practices, which, given the rapidly growing economy, have enabled rapid credit expansion with limited risk. Banking ratios calculated from audited financial statements for 2000 suggest that there has been a buildup of risk in the large private banks and that smaller banks are not profitable (see Table 6.6). Bank earnings, although still low by international standards, have recovered in line with GDP growth and the lower loan loss reserves associated with the better cash flow of borrowers. While this has helped most banks restore capital to precrisis levels, it is unclear whether the better returns reflect the higher credit risks incurred by the banks while expanding lending or a fundamental improvement in core profitability. With the exception of Sberbank—whose ready access to financial support allows it to operate with less capital and liquidity—returns on bank capital for the larger banks (about 12 percent) appear low given the risks in the Russian environment. While the larger banks have aggressively lent to the Russian “blue chip” companies, often related to bank owners, the apparent lower credit risk in these blue chip exposures is potentially outweighed by the concentration of risk. Moreover, these exposures are typically high relative to equity and some banks could be vulnerable to defaults of large borrowers in the event of a downturn.10 The large banks’ dash for market share in the corporate market seems to be abating. However, risk management practices need to be closely monitored by banking supervisors and the audit profession. Profitability of the smaller banks (on the order of 1 percent) remains insignificant, even in the current benign environment, and clearly indicates a need to rationalize the market.

Table 6.6.Micro-Prudential Indicators for Sample of Russian Banks1(Percent)
199719992000
Sberbank
ROEA223
ROEE152530
LLR/gross loans1186
Liquid assets/liquid liabilities142117
Net interest income/net income-651654
Expenses/income366672
Top 11 banks
ROEA323
ROEE151212
LLR/gross loans1464
Liquid assets/liquid liabilities264345
Net interest income/net income221139
Expenses/income (median of 11 banks)613854
19 smaller private banks
ROEA1-51
ROEE4-131
LLR/gross loans4148
Liquid assets/liquid liabilities256249
Net interest income/net Income35-224
Expenses/income (median of 19 banks)708385
Source: IMF (2002).

ROEA: return on end-of-period assets; ROEE: return on end-of-period equity; LLR: loan loss reserves.

Source: IMF (2002).

ROEA: return on end-of-period assets; ROEE: return on end-of-period equity; LLR: loan loss reserves.

The liquidity of bank balance sheets has increased across the board. To some extent, this reflects the banks’ inability or caution in expanding beyond relationship lending. There is as yet little lending to middle-market corporate borrowers and to individuals, although there appears to be scope for risk and income diversification from lending to these under-leveraged and under-banked borrowers. The increase in balance sheet liquidity is also precautionary: poor perceptions of counterparty credit risk mean that banks cannot rely on the wholesale funding market. Operating expenses have grown sharply for Sberbank as it modernizes its network, and they remain too high for the smaller banks. The relatively better efficiency of the large private banks reflects their minimal retail network. In line with the growth of lending, net interest margins have risen substantially except for the smaller banks, which continue to rely on trading and fee income.

Reform Agenda

The banking system has to date played only a marginal role in the economic recovery—as a payments system rather than a source of investment finance. While this may not yet have had a clearly detrimental impact on the economy, the lack of diversification of the economic base, the insignificant role played by the small and medium-sized enterprise sector, and the growing chaebolization of the economy are all signs—directly attributable to the low level of development of the financial system—that Russia may not reach its growth potential over the medium term (see Chapter 2).11

Box 6.2.Summary of the Government’s and Central Bank’s Concept Paper for Banking System Reform

Objectives: Establish a competitive banking system based on international best practices to improve stability and minimize the risk of a systemic crisis, improve the intermediation of savings, strengthen confidence, limit unfair commercial practices, and provide quality services conducive to economic development. The aim is to increase the ratio to GDP of banking sector assets (45–50 percent), capital (5–6 percent), and credit to the private sector (15–16 percent). Key areas of focus are discussed below.

Time frame: Approximately five years.

I. Increase Competition

Main problem: Restrictions on, and political interference in, bank activities. Lack of a level playing field between state and private banks, and between domestic and foreign banks.

Proposed solutions:

Improve supervision and implement it without discrimination. Develop legislation in line with international norms. Bring role of external audit in line with international practices. Simplify but strengthen quality of risk assessment, with greater focus on the quality of intrabank management and internal control. Require regulatory bodies to be vigilant against political pressure and the influence of large economic entities on banking activities.

Greater transparency. Adopt international standards of accounting and consolidated reporting requirements. Implement requirement to publish balance sheets and financial statements on quarterly basis. Develop, assess, and publish macro-prudential indicators.

State participation. Allow Central Bank of Russia (CBR) and the government to participate in bank capital if it is considered to be of strategic importance for meeting economic policy objectives. Have government decide whether or not to maintain its shares in banks where various government entities are currently stakeholders, and list and provide a timetable for the disposition of the institutions in which it will divest its shares. Allow minority participation of state-owned enterprises if this would strengthen their finances. Permit state banks to focus on specialized activities to address government policy objectives only if they are already limited by their corporate charters to do so (Russian Development Bank and Rosselkhozbank). Require the CBR to divest its share in Vneshtorgbank. Do not allow new state banks to be established and extend no new privileges to existing banks.

Structure of banking system. Allow market forces to determine the degree and manner of consolidation and location and range of services provided. Increase role of banks with foreign capital following the creation of a level playing field. Issue limited licenses for entities attracting and investing only enterprise funds. Create conditions for expanding banking activities to regions.

Legislation. Strengthen investor rights. Level playing field between domestic and foreign credit organizations, and bank and nonbank sector. Clarify foreign exchange regulation and control. Step up implementation of antimonopoly regulation.

II. Improve Intermediation and Efficiency

Main problems: General lack of confidence in the banking system stemming from high credit risk because of lack of reforms and transparency of enterprises, high liquidity risk owing to mismatch of asset-liability structure, weak legislative protection of creditor and lender rights, low capitalization, lack of liquid financial instruments, poor risk management, and high operational costs.

Proposed solutions:

Attract deposits. Introduce deposit insurance. Foster greater transparency about the financial condition and ownership of banks. Improve management and reduce financial crime and criminal activities by approving a law on money laundering.

Reduce credit risk. Require banks to better manage and control risks by closely tracking financial conditions of borrowers, including through “credit bureaus.” Develop quasi-banks, with limited licenses, to take corporate deposits and lend to corporations. Improve transparency of enterprises, including through reporting on International Accounting Standards basis. Protect creditors’ rights.

Reduce liquidity risk. Enhance bank liquidity management through better monitoring and diversification of risks, wider range of refinancing instruments, ensuring adequate provisions against losses, and legislative changes. Develop domestic capital markets, including the issuance of mortgage securities.

Reduce costs. Improve taxation system by allowing exclusion from tax base of all reserves against risks generated by standard legal bank operations and transactions, revaluation gains/losses, costs of mergers/acquisitions, capital expenditures, etc.

III. Strengthen Financial System Stability

Main problems: Poor supervision and regulation, poor and inefficient risk management and internal audit practices, a low level of capitalization, nontransparent property structure and a lack of sophisticated technology.

Proposed solutions:

Strengthen regulation. Simplify and tighten licensing procedures. Develop fit and proper criteria for managers, large shareholders, and chief accountants of credit organizations. Raise penalties for noncompliance.

Increase capitalization. Increase the share of foreign capital in total capital of the banking system. Implement complete restructuring or liquidation of bankrupt banks following an improvement in the procedures for bank restructuring. Reduce scope for asset stripping by making managers and founders more accountable for actions leading to bankruptcy, banning transactions, and intensifying monitoring by temporary administrator after licenses revoked.

Improve payments system. Expand scope for noncash settlement and ensure effective and reliable service. Introduce a real-time gross settlements system for large, urgent, high-priority payments generated by interbank and securities markets.

Strengthen corporate management. Strengthen internal control and risk management on both an individual and a consolidated basis. Increase professional skills and level of ethical standards of management, associates, and founders.

The authorities recognize the importance of moving ahead with financial reform. To this end, the government and the CBR adopted in December 2001 a strategy paper on the development of the banking system (see Box 6.2, pp. 150–51). A draft concept paper had been made available for comments in February 2001 so that the approved version incorporates comments from many parties within society, which should ensure greater ownership of the strategy and reduce the political opposition that has frustrated banking reform in the past. The strategy paper seeks to address the areas that have so far constrained the emergence of a dynamic financial system.12

The strategy paper provides detailed recommendations on steps to strengthen the banking sector. Three key related issues are fundamental to the development of the banking system:

  • First, what, if anything, should be done with Sberbank? Echoing the debate above on how to interpret Sberbank’s role within the financial system, there are various views on whether it is necessary or desirable to take special steps to restrain Sberbank’s activities in some manner to permit private banks to compete more freely. Such steps could take the form of restrictions on the size of Sberbank’s lending portfolio to move the bank closer to the concept of a safe “savings” bank. The approach embodied in the strategy paper is to try to level the playing field between private banks and Sberbank including through the introduction of deposit insurance for private banks.
  • Second, the strategy paper envisages the introduction of deposit insurance for private banks. Legislation to introduce such a scheme was approved at end-2002. While the desire to stimulate competition is clear, the success of the scheme will greatly depend upon its implementation. Moral hazard risks from introducing deposit insurance are well known—particularly in an environment with weak banking supervision and issues with the governance of banks. However, access to the deposit insurance scheme can be used as a powerful screening device for banks and a clear stimulus for the introduction of reforms and possibly enhanced banking supervision.
  • Third, effective banking supervision is key to creating confidence in the banking system. The strategy paper contains many detailed measures that are designed to correct existing weaknesses. Enforcement of these measures will however require further strengthening of supervisory resources and improvements in the accounting and auditing frameworks. The limited resources available in these areas are stretched by the large number of banks that continue to operate and some consolidation of the banking system could contribute to more effective supervision.13

As is clear from the strategy paper, the reform agenda is vast and implementation will take time. Implementation will also require determined political will in support of the CBR in its attempts to fundamentally strengthen the banking sector and thereby both support growth prospects and reduce the possibility of future financial crises.

References

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    AvdashevaSvetlana and AndreiYakovlev2000“Asymetric Information and the Russian Individual Savings Market,”Post-Communist EconomiesVol. 12 (June) pp. 16585.

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    FriesSteven and AnitaTaci2001Banking Reform and Development in Transition Economies,”EBRD Working Paper No. 71 (London: European Bank for Reconstruction and Development).

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    GoryunovVladimir2001“The Russian Banking Sector in 2000,” in BIS Papers No. 4 (Basel: Bank for International Settlements) pp. 12327.

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    Government of the Russian Federation and Central Bank of the Russian Federation2001Strategy for the Development of the Banking System of the Russian Federation. Available via the Internet in Russian at www.cbr.ru.

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    IMF2002Russian Federation: Selected Issues and Statistical Appendix IMF Country Report No. 02/75 (Washington).

    IMF2003Russian Federation: Selected Issues and Statistical Appendix IMF Country Report No. 02/75 (Washington).

    JohnsonJuliet2000A Fistful of Rubles: The Rise and Fall of the Russian Banking System (Ithaca, New York: Cornell University Press).

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    La PortaRafaelFlorencioLopez-de-Silanes and GuillermoZamarripa2002“Related Lending,”NBER Working Paper No. 8843 (Cambridge, Massachusetts: National Bureau of Economic Research).

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    World Bank2002Building Trust: Developing the Russian Financial Sector (Washington: World Bank).

1Johnson (2000) contains a detailed description of the development of the banking system from 1987 through end-1998.
2Fries and Taci (2001) argue that while the ratio of private sector credit to GDP in Russia in 1999 was low, its performance was broadly in line with those of other transition economies when comparing a country’s performance to an estimated benchmark for a market economy at a comparable level of development.
3MMM, a Joint Stock Society, attracted 5 million investors and about $1 billion in assets on the basis of promises of huge returns. In July 1994, MMM was exposed as a pyramid scheme and collapsed.
4The capital injection into VTB may have been part of a broader strategy to strengthen VTB’s balance sheet, rather than a response to balance sheet weaknesses exposed by the crisis.
5The reviews were conducted according to a common set of internationally accepted practices and uniform assumptions to ensure consistency among bank reviews.
6For example, a number of those banks reportedly either purchased bank shells or licensed new banks and transferred the bulk of the performing assets to the new banks.
7Data on bank capital need to be treated with caution as the data can be inflated through a number of means—for example, by artificially revaluing fixed assets or by extending loans that are subsequently placed with the bank as a capital injection. Legislation approved in March 2003 permits the CBR in its banking supervision capacity to write down the value of capital on a bank’s balance sheet to exclude “improper sources”—the level of capital as assessed by the CBR would need to be shown in the next published accounts of the bank.
8At end-2001, the smallest 800 banks had total assets averaging Rub 30 million or roughly $1 million per bank (Source: Interfax News Agency).
9Pensioners account for almost half of all individual deposits in Russian banks.
10Related party loans were 33 percent more likely to default and had 30 cents a dollar lower recovery value in the case of post-1995 Mexico (La Porta, Lopez-de-Silanes, and Zamarripa, 2002).
11The large financial industrial groups in Russia are in many ways similar to the chaebols in Korea. In particular, following aggressive acquisitions of assets outside traditional areas in recent years, the financial industrial groups control a wide range of assets via opaque ownership structures that makes evaluation of corporate risk next to impossible.
12These issues are discussed in detail in World Bank (2002).
13The CBR had earlier attempted to force some consolidation in the sector by requiring banks with charter capital less than € 1 million to restructure as nonbanking organizations. The regulation was to come into effect at end-1998, but was abolished due to the crisis.

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