Launching a meaningful reform of Russia’s woeful banking system has become as difficult as organizing the croquet game in Alice in Wonderland. The players assemble and wander off; so do the wickets; and the problems, like flamingo mallets, stretch up and goggle back at the players.
The lack of focus starts with the team captain. Well aware that his goal of 8 to 10 percent annual growth is impossible without a bona fide banking system, President Vladimir Putin told a cheering Duma last April, “We must overcome the lag in bank reform.” Since then, he hasn’t broached the subject in public. Meanwhile, Central Bank first deputy chairman Andrey Kozlov, the point man in the bank overhaul campaign, insists that there is “no sense of urgency.”
In an interview with Institutional Investor, Kozlov says he has set 2005 as the target date by which banks will have to reveal just who their owners really are, comply with international accounting standards and qualify for deposit insurance that might persuade Russians to exchange their dollar stashes for ruble savings accounts.
This unhurried pace has international agencies and private sector bankers wondering how high a priority the government has assigned to bank reform. “The reforms could and should be done sooner, but they involve stepping on the toes of powerful people,” says Christof Ruehl, chief economist at the World Bank’s Moscow office. “So I imagine Kozlov’s timetable is determined by a political calculus.” The International Monetary Fund’s top official in Russia concurs, suggesting that the government drive to modernize the banks and other economic sectors is already losing momentum, because of concern over presidential elections in March 2004. “With some of the hardest reforms to come, I am not surprised we are seeing signs of a preelection slowdown,” Poul Thomsen, the IMF’s senior representative, told the Moscow Times in September. Yet according to Richard Hainsworth, a bank analyst at Renaissance Capital, a Moscow-based investment bank, “a weak banking system is the single most tangible restraint on the economy.”
That economy has nonetheless performed surprisingly well lately. Fueled by exports of oil and other natural resources, GDP is expected to rise about 3.5 percent this year -- the fourth consecutive annual expansion since the 1998 financial crisis that led to a government debt default, numerous bank failures and a steep recession. Still, with a GDP of $316 billion last year, Russia’s economy is barely larger than Belgium’s. Per capita income won’t match levels in the European Union for another century unless economic growth rates increase dramatically. And that won’t happen without a modern banking sector.
Among the litany of complaints about the financial system, the most serious ones cited by government officials, bankers and economists include the following:
* Widespread fraudulent accounting practices that scare away potential depositors and investors, who much prefer to keep their savings and profits in offshore or under-the-mattress dollars.
* A deep-seated distrust among banks that prevents them from loaning money to each other or syndicating loans to large corporate clients.
* The near-absence of credits for small- and medium-size enterprises, relegating them to a more marginal economic role than in other former socialist countries, where they have been the engines of growth.
* A virtual monopoly on retail deposits by Sberbank, the state-controlled savings bank, which then offers the funds to favored clients as corporate loans at below-market rates that crowd out commercial banks.
* A virtual absence of mutual funds, mortgages and car and other consumer loans.
What it all adds up to is a banking system that fails in its basic task of “effectively intermediating between savers and investors,” says Michael Marrese, a Russian banking analyst at J.P. Morgan’s London office.
The appointment in April of a new team at the Central Bank, led by chairman Sergei Ignatiev and his first deputy, Kozlov, the key official in the bank reform program, initially sparked a surge of optimism, especially because the previous chairman, Viktor Gerashchenko, had turned his back on reform so resolutely. Kozlov received high marks from the international finance community for an earlier stint at the Central Bank, where he helped ensure that the banking system didn’t entirely collapse during the 1998 crisis. In June he excited participants at an annual banking conference in St. Petersburg by vowing to press forward with a comprehensive reform program.
But Kozlov has followed up the tough talk with a plodding, bureaucratic style. His promise to audit all of Russia’s 1,330 banks and assign each a Central Bank supervisor to continuously monitor accounts has aroused doubts that he can meet his own 2005 deadline. “It’s virtually impossible to find that many capable or honest supervisors,” says Mikhail Matovnikov, deputy director of Interfax Rating Agency, which specializes in credit risk analysis of Russian banks.
Fooling Central Bank supervisors or getting them to look the other way has been all too easy. One of the most prevalent banking sins involves secret loans to shareholders who then fraudulently return them to the bank as injections of additional capital from new investors. The practice, known as “bloated capital,” hides the identity of the bank’s owners and later allows them to draw large business loans out of proportion to the bank’s real capital. According to Kozlov, more than half the banks engage in these shenanigans.
One of the more notorious recent examples involved Investment Banking Corp., which had gone to great lengths to portray itself as a paragon of financial responsibility. Founded in 1994 by investors linked to ZAO Corp. Sintez, an energy producer, IBC was the 50th-largest bank by January 2002, with assets of $140 million. It was the first Russian bank to be given a corporate governance rating by Standard & Poor’s and was among the first to use international accounting standards, hiring PricewaterhouseCoopers as its auditor. Moreover, IBC had two reputable Americans on its board of directors: Scott Blacklin, former president of the American Chamber of Commerce in Russia, and Thomas Moran, a former executive at the U.S. Export-Import Bank with long experience in Eastern Europe and Russia.
But in April, only days after assuming his Central Bank post, Kozlov ordered an investigation of IBC. Within weeks the bank was charged with fraudulent accounting and put out of business. “Unfortunately, in this case, bookkeeping was an art, not a science,” says Kozlov.
It will take a number of other high-profile cases to impress analysts, though. “The reform process won’t work unless you have more banks shut down for engaging in questionable lending practices -- and people know which banks those are,” says J.P. Morgan’s Marrese. But for Julia Kochetygova, S&P’s corporate governance analyst in Moscow, the IBC case underscores how “very difficult it is to monitor a bank that is determined to hide its real books.”
Some critics believe that the reform process would be better served by getting the Central Bank to concentrate on issuing clean bills of health to the largest 50 or 60 financial institutions, enabling them to emerge within two years as full-fledged commercial banks backed by deposit insurance. “The other banks would just have to accept a more limited role as treasuries for the business groups that own them,” suggests Renaissance Capital’s Hainsworth.
Skepticism over the reform process becomes even more pronounced whenever the subject of Sberbank arises. The state-controlled behemoth -- the government owns almost two thirds of Sberbank’s stock, with private investors holding the rest -- accounts for more than one quarter of the $103 billion in total assets held by Russian banks. Few other financial institutions can claim even $100 million in assets. More important, Sberbank receives 73 percent of retail deposits and provides 32 percent of corporate loans -- market shares that allow it to run roughshod over its competitors.
There is no mystery about Sberbank’s appeal to ordinary savers. With more than 20,000 branches, it is everywhere in this vast country, spanning 11 time zones from the Polish border to the Pacific Ocean, and it is the only bank in villages and small towns. As the sole bank with federal deposit insurance, it accommodated every client who wished to withdraw savings during the 1998 crisis, when hundreds of banks foundered and only a handful were able to service depositors. These advantages allow Sberbank to pay annual interest rates of 8 to 13 percent on deposits while the average for the entire bank sector is 16.5 percent.
With its low-cost savings pool, Sberbank can then offer loans to big corporate clients at an 18 percent annual interest rate, compared with the 25.3 percent average for the banking industry. Critics point out that Sberbank extends few loans to small businesses. According to a World Bank study released in July, such businesses account for only 12 percent of Russia’s GDP, compared with more than 50 percent in the U.S. and much of the EU. “It doesn’t seem fair that Sberbank should take money from ordinary people’s savings accounts and subsidize giant energy producers like Lukoil and Gazprom,” says Mikhail Fridman, chairman of Alfa Bank, which despite being the largest Russian private bank has just 4 percent of deposits.
Some Sberbank minority shareholders agree with Fridman. According to a report released in July by Hermitage Capital Management, a Moscow-based fund that owns 3.5 percent of Sberbank, Russia’s nine largest corporations received what amounted to a $780 million subsidy last year from below-market interest rates on Sberbank loans. “That’s ridiculous -- these businesses don’t need subsidies,” says William Browder, Hermitage’s CEO, who complains that the money should have been used to boost Sberbank’s 2001 net profits of $860 million and its lagging share price.
Sberbank’s market capitalization is proportionately far lower than that of banks in neighboring countries. While Sberbank has a price-to-book value ratio of 1.0, former state savings banks such as Hungary’s OTP Bank, Poland’s Bank Pekao and the Czech Republic’s Komer(breve)cní Banka have ratios of 2.0 to 2.5. “Subsidized” low-interest corporate loans aren’t the only reason for Sberbank’s lackluster share price. It hasn’t carried out the labor cutbacks that have taken place at Eastern European banks. With 200,000 employees, Sberbank is not far behind Citigroup’s workforce of 272,000, but the U.S. bank’s $1.05 trillion in assets last year dwarfed Sberbank’s $26 billion. “Sberbank isn’t really driven by commercial concerns,” says Renaissance Capital’s Hainsworth. “It acts more like a government agency, motivated by what it thinks is good for the economy rather than by shareholder value.”
To be sure, Sberbank has plenty of defenders, starting with its chairman and CEO, Andrei Kazmin. Fully privatizing Sberbank “would be a big mistake,” says Kazmin in an interview with Institutional Investor (see box, page 24), because the bank has been one of the few pillars of stability for the financial system during these years of tumultuous transition from a state-controlled to a market economy.
Despite charges of unfair competitive advantages enjoyed by Sberbank, Kazmin knows he has little to worry about. Sberbank has strong backing in the Finance Ministry because it is by far the largest purchaser of government debt, holding 62 percent of federal bonds. And Sberbank’s biggest shareholder, with 64 percent of its stock, is the Central Bank, the very agency that is supposed to impose bank reforms, including an eventual end to Sberbank’s monopolistic practices.
Rather than rein in Sberbank, says Kozlov, czar of the reform process at the Central Bank, “we want to stimulate the growth of bigger competitors, both domestic and foreign.” When the government extends state deposit insurance to banks deemed financially healthy, other institutions will eventually vie with Sberbank for household savings, he asserts.
But few bankers believe that the playing field will be leveled so easily. “The Russian savings market is very small in comparison to the size of the economy,” says Neil Withers, a Canadian consultant at Vozrozhdeniye Bank, a private bank headquartered in Moscow. IMF and World Bank figures bear him out: In 2001 Russia’s total bank deposits of $48 billion equaled barely 15 percent of GDP, compared with 38 percent in Poland, 39 percent in Hungary and 56 percent for the EU.
Moreover, even Sberbank’s $35 billion in ruble deposits falls far short of the dollar amounts held by Russians. By some estimates, as much as $80 billion is hidden away in homes. Perhaps twice that total is kept in bank accounts abroad, to be repatriated as needed -- which is why tiny Cyprus, a tax haven, is listed as the third-largest foreign investor in Russia ($4.5 billion at the end of 2001) after Germany and the U.S.
Although it’s easy enough to blame the government for not acting more decisively, bank reform also depends on the willingness of Russia’s oligarchs -- the much-maligned, superrich entrepreneurs of the post-Communist era -- to embrace the rule of law and operate their banks more transparently. Many of these institutions were created a decade ago to finance the acquisition of state companies by private business groups. Known contemptuously as “pocket banks” -- because they are in the pocket of one oligarch or another -- most of these institutions continue to operate largely as treasuries for the business groups that own them rather than as true commercial banks. “They exist to provide loans to their main shareholders,” says Matovnikov, of the Interfax Rating Agency.
But in off-the-record interviews, some pocket bankers insist that there is a more benign explanation for their behavior, based on onerous tax considerations rather than sheer greed. They say banks are essential to manage the liquidity of their business groups. For example, if profits from one company are passed on as a loan to another company in the same group, the transaction would be taxed three times: The first company’s profits would be taxed, a value-added tax would be levied when the loan was made, and interest paid by the company receiving the loan would have to be reported as taxable income by the lending company. “No business group could survive that sort of tax burden,” says a banker. “But by placing a bank in the middle of this process, the whole picture changes.” The first company deposits its profits in the bank, which then loans that money to another company in the group without having to pay the VAT. And the second company gets a tax write-off on interest payments to the bank.
So what would induce pocket banks to become full-fledged commercial banks? Partly, there is the desire by oligarchs to legitimize the business and banking empires they have built up, often through illegal means (Institutional Investor, October 2002). Kidnappings and contract killings of rivals, which were commonplace in the mid-1990s, have become relatively rare in recent years as the struggle for ownership of former state companies has neared an end. According to a report last December by Peter Boone and Denis Rodionov, economists for Brunswick UBS Warburg, one of Moscow’s biggest brokerages, eight business groups now control Russia’s 64 largest private companies. “This new elite has become a key lobby for strengthening property rights and implementing policies that improve Russia’s investment climate, reduce sovereign risk and generally raise the value of their tradable property,” wrote the authors.
Some oligarchs are hoping their banks can evolve from treasuries and tax shelters servicing their industrial groups into increasingly profitable commercial enterprises reaching a broader corporate clientele. Perhaps the former pocket bank farthest along in this transformation is Alfa Bank, the flagship of Alfa Group, one of Russia’s largest privately owned financial-industrial conglomerates, with interests in oil, commodities trading, insurance, food processing, supermarkets and telecommunications. “Of course, when we established the bank in 1991, the other companies in the group were its most important clients,” says Fridman, the billionaire chairman of both Alfa Group and its bank. “Nothing was known about other companies’ credit ratings, so it was logical to lend money to our own companies rather than give it to firms with no track records.”
But more recently, Alfa, the largest private bank, with $2.7 billion in assets and net profits of $85.4 million in 2001, has significantly reduced its exposure to its group’s companies and accepted international accounting standards to impress rating agencies and potential investors. According to Fridman, non-Alfa companies now get most of the bank’s loans. Meanwhile, Alfa is receiving a growing volume of interbank deposits from foreign banks, a rarity for Russian institutions, most of which aren’t transparent enough to attract foreign funds.
But organic growth won’t be enough to make Alfa or any other private bank competitive with Sberbank. Mergers would seem the logical alternative. “For an efficient banking system, we need 30 to 50 banks -- not 1,300,” says Fridman. The problem, he concedes, is that rival business groups still distrust each other too much to become bank partners. In fact, there is no sharing, trading or diversification of risk among Russian banks. “In any normal country, if a bank has a large client who wants a loan bigger than the bank can afford, it would syndicate the loan,” says Renaissance Capital’s Hainsworth. “But in Russia a bank would be afraid to invite other banks to share the risk out of fear that they would steal the client.”
Fridman -- who admits he is already thinking about an exit strategy -- would much prefer a foreign strategic investor to a Russian as a partner. That’s not only because he considers a large foreign bank more trustworthy, but also because it could offer Alfa more capital, technology, professional know-how and access to international markets. “I’m an investor, not a professional banker,” he says. “At the end of the day, we will sell our bank if the price is right. We can’t compete with the big boys.”
But the big boys -- the foreign banks -- aren’t interested. In the Czech Republic, Hungary and Poland, foreign capital bought majority shares in large state banks that were privatized. In Russia, by comparison, the only banks up for sale are private ones that are puny by global standards. “At the moment, there isn’t a lot to buy,” says Allan Hirst, who runs Citibank’s operations in Russia. “Our institution has a little over $200 million in capital here, and it’s the ninth- or tenth-largest bank in the country.”
There is one Russian bank with the potential to draw foreign investors right away -- Vneshtorgbank, or VTB, the state bank for foreign trade, which last year had assets of $6.1 billion and net profits of $300 million. There has been a spate of local news reports suggesting that VTB will soon be merged with another state bank, Vneshekonombank, and then offered for sale to domestic and foreign investors. The merged, privatized VTB might be large enough to compete with Sberbank in the corporate loan market. “It possesses enough resources, and its brand name is quite good,” says Kozlov.
But as with all the other proposed reforms, there just doesn’t seem to be any rush. “The government still hasn’t decided what to do with Vneshtorgbank,” says Kozlov.
“Curiouser and curiouser,” as Alice famously remarked about the Wonderland she fell into.
Central Bank’s Kozlov reflects on reform Housed in an 18th-century palace in downtown Moscow, the Central Bank of Russia has been beautifully restored, with polished marble, sparkling chandeliers and rich carpets over inlaid wood floors. Equally impressive: The expansive hallways are now virtually absent of chairs, which used to be occupied by supplicants from the business and banking community.
The symbolism is clear: Don’t bother trying to influence the current Central Bank leadership, especially first deputy chairman Andrey Kozlov, the man in charge of the bank reform program, who takes pride in having no links with Russia’s notorious financial-industrial groups.
Recently, the 37-year-old technocrat sat down in his office for an interview with Institutional Investor Contributing Editor Jonathan Kandell.
Institutional Investor: Why has banking reform taken on such urgency?
Kozlov: First, I would say there is no sense of urgency -- rather, we are acting out of need. After the 1998 financial crisis, there was a period that lasted about three years during which our main goal was simply to stabilize the banking system and regain the trust of clients. Now we are at a stage where economic growth is generating demand for banking services.
What are your priorities in banking reform?
The key process in the modernization of the banking system is the introduction of government-guaranteed savings deposit insurance. But before this can happen, we intend to reaudit all 1,330 banks over the two years beginning in January. It would not look good if shortly after being accepted for deposit insurance a bank failed. And before these audits can take place, the Central Bank will have to train many more supervisors. Even after the audits take place, each bank will be assigned a supervisor who will continue to monitor its finances.
What will the supervisors be looking for?
The biggest problem in the banks is “bloated capital” -- loans made to interested parties who then use this money to buy shares in the bank. More than half of all banks have used this sort of technique to conceal the identity of their real owners. Our goal is to bring the real owners to light and show clients who is really in charge at those banks.
Besides more supervision, what will it take to create a modern banking system?
We have to recognize that our own regulations often impose unnecessary burdens on commercial banks. So the Central Bank must find ways to reduce costs for normal, honest, transparent banking business.
Bank owners complain that Sberbank, the giant, state-controlled savings bank, is crowding them out of both retail and corporate banking. What do you intend to do about Sberbank’s dominance?
As you know, the Central Bank has a controlling share in Sberbank, so we can exert pressure. Sberbank will be subject to the same regulations as any other bank. We are also looking into the quality of Sberbank’s loans and the interest rates it charges. But Sberbank is the backbone of the banking system and the only bank we consider too big to fail. Whatever public trust remained in the banking system after the 1998 crisis was thanks to Sberbank, which guaranteed the savings of people who deposited there. So there are no plans to limit its activities. We think the best way to eliminate Sberbank’s monopoly is to create competition. That’s why deposit insurance for other banks is important.
Do you sense any profound change in the behavior of bank owners?
Some of the so-called oligarchs who own large financial-industrial groups seem to be diversifying their banks’ activities away from their own companies. They also say they want to expand the shareholder base in their banks. But they are still fearful that rivals might buy enough shares to take control of their banks.
Will foreign banks ever reach the market shares they have achieved in Eastern Europe?
I doubt it. We make no distinction between domestic and foreign investors in banking. But Russia is huge, with lots of regions and niches where foreigners won’t ever feel comfortable. And I don’t think that large financial-industrial groups are so eager to sell their banks to foreigners.
Why are small and medium enterprises so deprived of credits?
The growth of small and medium-size businesses would be a real breakthrough for our economy. But banks are reluctant to loan them money because they don’t have credit histories. Also, because the required paperwork to meet Central Bank regulations is the same for all bank clients no matter what their size, it is more profitable for banks to make loans only to bigger clients. So we have to reduce this paperwork and provide incentives for banks to loan to smaller businesses.
Why did you agree to return as first deputy chairman of the Central Bank?
The first time -- back in late 1997 -- I was brought in to try to keep the banking system from collapsing. That was a constant struggle with problems and very stressful. This time I’m here to help create a new banking system. I find that a much more interesting job.
Sberbank’s Kazmin defends monopoly The headquarters of Sberbank, the state-owned savings goliath, looks -- aptly -- like the sort of fortress where Soviet-style banking would make its last stand. A sprawling, 25-story building of smoked glass and steel, it rises between Lenin Prospect and the heroic monument to cosmonaut Yuri Gagarin, the first man in space.
Presiding over this financial empire from his rooftop office, with a panoramic view of Moscow, is Sberbank’s chairman and chief executive officer, Andrei Kazmin. A tall, cherub-faced economist, the 44-year-old Kazmin wields an urbane wit to belie his bank’s reputation as a stronghold of statist, antifree market notions.
On one wall of his office hangs a calendar with whimsical caricatures of President Vladimir Putin. On the opposite wall is a portrait of Che Guevara made from bits of worthless pesos. “Che was the first chairman of the Cuban National Savings Bank,” says Kazmin, suggesting unlikely common ground with the bearded revolutionary icon.
In a rare press interview, Kazmin spent an hour with Institutional Investor Contributing Editor Jonathan Kandell, defending Sberbank against charges that it is a monopoly stifling development of Russia’s stunted private banking sector.
Institutional Investor: Given the momentous changes in Russia’s economy during the past decade, why should Sberbank remain under state control?
Kazmin: First, I want to point out that since 1991 we have been a joint-stock company, about two thirds owned by the state and one third in private hands. That’s why we have been so successful in transforming ourselves from a simple savings institution into a universal bank. But I also think it has been very important for society, the government and the stability of the banking system that Sberbank has remained under state control during this very turbulent period of economic transition. We suffered through very high inflation in the first half of the 1990s and then the collapse of many banks and enterprises in the 1998 crisis. With scenarios like these, it would be a big mistake to eliminate state control over Sberbank. It has almost three fourths of household savings deposits in Russia and 40 percent of the credit market. It has a huge branch network -- more than 20,000 outlets everywhere, including isolated places where it is the only bank.
Doesn’t this monopoly over savings enable Sberbank to offer corporate loans at much lower interest rates than private commercial banks?
Clients come to us because our interest rates are reasonable. Maybe our competitors are just too greedy. Frankly, I’m amazed at the exaggerated interest rates they are charging. The time for that sort of “pirate” banking is over. We are also competing with foreign banks that provide loans to the biggest Russian exporters at interest rates that are often below ours because of lower inflation in their countries -- yet amazingly, our critics think this is acceptable.
There is a widespread perception that Sberbank’s loan policies favor Russia’s largest corporations.
True, it’s difficult to come across a big enterprise that isn’t our client. That’s because their capital needs can only be met by a bank of our size, and other Russian banks don’t have such resources. But we have been actively looking for smaller corporate clients. In the first half of this year, we extended about $1.3 billion to small and medium enterprises. That’s about 9 percent of our total credit portfolio. That share is growing as we train our personnel -- and hire new people -- in risk management.
Does it worry you that in the next few years many private banks will receive the state-guaranteed deposit insurance that only Sberbank now enjoys?
“Worry” is the wrong word. We are aware of the need to constantly upgrade our services. Also, having a big network of branches can be a disadvantage, because it involves a lot of overhead costs. Our competitors have the luxury of operating only in a few big cities, so they don’t have these headaches. The introduction of state guarantees for savings deposits at other banks will end charges of Sberbank’s monopoly. So it’s a step we actively support.
How will the profile of your retail customers change over the next few years?
Until recently, our bank has been mainly for people with low incomes and an average age of about 60 -- in other words, pensioners. But in the past year, we have developed products for more upscale clients -- credit cards, bill payments, safe deposit boxes, investment consulting. We are also opening branches for VIP clients who don’t like to stand on long lines.
Will Sberbank continue to be the greatest purchaser of government debt?
As long as it remains a profitable business, we shall continue to buy government debt. We don’t do it just because the “motherland” asks us to.
What can be done to persuade Russians to put their dollars into ruble savings accounts?
Well, according to a recent poll, about 40 percent of respondents said that they kept their savings in dollars, about 31 percent said that they preferred Sberbank, and only 2 percent favored private bank accounts. So I guess our real competitor is the dollar [he chuckles].
Is there any possibility that Sberbank will soon be offering American depositary receipts?
That’s a rumor started by some of our minority shareholders who would like to engage in more speculation with our stock. But issuing ADRs would be premature, because Russia’s corporate securities market is very shallow and still hasn’t recovered from the 1998 crisis.
