Russia: Rebuilding confidence

For a country enjoying one of the strongest growth rates on the planet, it was astonishing how quickly the whiff of crisis spread through the Russian banking system. The May decision by the Central Bank of the Russian Federation to strip the license from Sodbiznesbank, an obscure institution that ranked as the country's 88th-largest bank, in the wake of criminal allegations unleashed a wave of speculation and market turmoil that rapidly ensnared much bigger rivals. Guta Bank, Russia's No. 22 bank, with $1.2 billion in assets, collapsed in early July, and panicky depositors began a run that threatened the country's largest commercial institution, Alfa Bank.

Finally, the authorities intervened -- effectively, if belatedly. "Alfa Bank does not have any problems with liquidity," declared Sergei Ignatyev, the conscientious but reclusive career bureaucrat who heads the central bank, in a July 7 appearance before the Duma. "The bank has enough resources to satisfy depositors' demands."

Ignatyev and his deputy, Andrei Kozlov, then sprang into action that was as energetic as their rhetoric. Over the following week they cut reserve ratios in half to bolster banking liquidity, folded failed Guta Bank into No. 2 state-owned Vneshtorgbank and shepherded emergency legislation through the Duma guaranteeing all bank deposits up to 100,000 rubles ($3,400) until January 2006.

The central bank's decisiveness, coupled with the considerable resources of oil-rich Alfa Group, whose founding oligarch, Mikhail Fridman, pledged up to $1 billion in new capital for his bank, worked. The runs on deposits stopped, at Alfa and elsewhere, and by July 19, Moody's Investors Service and J.P. Morgan Chase & Co. both had declared the crisis of confidence over.

Halting a crisis is one thing. Transforming Russia's sprawling and shaky system of 1,300 banks into a healthy industry that can finance the country's economy and earn the trust of savers is another. And on the latter front, the authorities have their work cut out for them.

Consider Andrei, a 27-year-old Muscovite who sold an apartment in Moscow in July, cashing in on the capital's real estate boom. Putting the $65,000 windfall into a Russian commercial bank never occurred to him. "You never know when 1998 is going to happen again," says Andrei, recalling the financial crisis, triggered by a government bond default, that wiped out most of Russia's private bank savings. After long discussions Andrei and his family deposited their cash in Citibank's Moscow subsidiary, with an eye to transferring it to the U.S.

Russia's ordinary consumers aren't the only ones who don't trust the banks. A builder who puts up $500,000 dachas in Moscow's toniest outskirts, and who spoke on condition of anonymity, shrugs when asked how his wealthy clients pay. "Somebody who lives out of town can always find some secret spot to hide his money," he says. "The risk of someone finding it is less than the risk of losing it all in some bank."

A July survey by the Moscow-based All-Russian Public Opinion Research Center provided devastating confirmation of such attitudes: Seven out of ten Russians said they would keep any savings they amassed at home. Another 27 percent chose an account with Sberbank, the giant, state-controlled institution that holds more than 60 percent of Russian deposits. Only 2 percent opted for a deposit in a private Russian bank. No wonder Russians have as much as $80 billion -- mostly in U.S. dollars -- hidden at home, compared with total bank deposits, corporate and retail, of about $30 billion.

Such a lack of faith in the banking system at a time when the economy is roaring ahead and the central bank's coffers are stuffed with a record $88.6 billion in reserves testifies eloquently to the need for structural change -- for fewer but better-regulated banks, a credible state guarantee on retail deposits and a healthier balance between the state and private sectors. As Andrei Saveliev, chief executive of Moscow-based MDM Bank, puts it: "The government and central bank were successful in calming volatility, but the origins of the crisis have not been addressed. That is, the nonexistence of banking reform from 1992 right up to 2004."

Talk of privatizing Sberbank, which circulated vaguely during President Vladimir Putin's first term, has receded in the climate of resurgent statism that prevails following the government's crackdown on Yukos Oil Co. CBR deputy director Kozlov said in July, "We won't even think about what to do with Sberbank until 2007." Long-simmering plans to privatize Vneshtorgbank, with help from the European Bank for Reconstruction and Development, also appear to have stalled indefinitely. The betting in Moscow is that Andrei Kostin, the ambitious CEO of the trade finance bank, will expand into consumer banking through the newly acquired Guta Bank, which has more than 80 branches and some 400,000 retail accounts.

Putin himself has been enigmatic, trying to dampen fears of a systemic banking crisis but failing to commit to reform. "I beg you to act precisely," he told Ignatyev during a televised June 15 meeting with the central banker. "You are not planning, I hope, any imminent mass purges of the banking system."

The Duma, after years of populist opposition to anything that smacked of credit, is just starting to grapple with essential legislation on mortgages and the right to seize collateral, which bankers view as essential for the industry to thrive. Mortgage regulations were included in a 27-point omnibus housing bill that passed its first of three required readings in June. From there to final passage and implementation could take years.

Against this background Ignatyev and Kozlov -- academics-turned­civil servants with little political flair or real-world business experience -- are struggling to tighten regulatory control over a flabby, opaque industry. The two men have been busily preparing the introduction of a permanent deposit-insurance system and the adoption of international accounting standards. Whether they can implement those reforms effectively remains to be seen.

The Sodbiznesbank affair sent mixed signals. The central bank removed the institution's license on May 14, after a yearlong investigation indicated it had laundered criminal funds, including ransom money for two managers at the Kamaz truck plant in Tatarstan, who were kidnapped and later murdered. But the CBR failed to seize physical control of Sodbiznesbank's offices. Instead, its Moscow headquarters was occupied by masked gunmen who locked the doors against both depositors and the police -- and, it turned out, shredded records. Interior Ministry troops finally ended the standoff on May 31. But by then Viktor Zubkov, head of a new, Finance Ministry­linked watchdog called the Federal Financial Markets Service, had sown panic by telling journalists that the authorities were preparing similar actions against ten other unnamed banks.

International technocrats like Kurt Geiger, head of the financial institutions group at the EBRD, applaud Ignatyev and Kozlov for cracking down on Sodbiznesbank and urge them to use the deposit insurance certification process to weed out other weak or dodgy banks. "What happened this summer was good," Geiger says. "Banks now know that controls are going to get tighter. It's a process the country has to go through."

Many Russian reformers, however, worry that the shock of the recent banking crisis, combined with Putin's warning against any banking purges, will cause the central bank duo to hold back. "The crisis started because with Sodbiznesbank the central bank finally started doing what they had to do, separating real capital from artificial capital and cleaning out the banking system," says Oleg Vyugin, who was a deputy chairman under Ignatyev at the central bank before becoming head of the market watchdog agency in March. "Now that they've seen their first resistance, I hope they won't freeze."

The reasons for closing Sodbiznesbank seemed unassailable. The central bank acted on information from the police in Tatarstan, and the Interior Ministry launched a criminal investigation against unnamed bank officers. But in a country where the financial health -- and even ownership -- of many banks is hard to assess, Ignatyev and Kozlov's action, combined with Zubkov's "black list" gaffe, fueled a rash of rumors about who might be next.

Early indications are that Russians who withdrew their money from banks this summer did not redeposit it elsewhere. Total banking deposits, which had been growing by 3 percent a month until May, slowed to just 0.7 percent in June, and July's numbers will almost surely be negative.

"The biggest winner in this process was the infamous mattress bank," says Ilkka Salonen, chairman of the management board of International Moscow Bank, Russia's eighth-largest bank, with $3 billion in assets, controlled by HVB Group of Germany and Nordea Bank Finland. "This makes the economy less efficient, and long-term growth rates will be affected."

The banking spasms won't immediately affect Russia's 7 percent-a-year economic growth, because the oil and metals companies driving the expansion don't depend on the country's banks. They are awash in cash and can easily raise international financing through Eurobond offerings and syndicated loans.

Still, it's hard to see how Putin can achieve his ambitious goals of diversifying the economy away from raw materials and doubling GDP by 2010 without fundamentally reforming the country's fragile and murky banking system. The service and light manufacturing firms that must expand to fulfill Putin's goals will need credit from Alfa and its competitors. For the banks, however, the fallout from the spring-summer crisis has just begun.

Wary now of their depositor base, Russia's leading commercial banks have slowed loan activity to a crawl. Private sector bank credits rose by just 3 percent in the first half of this year, compared with a torrid 21 percent growth rate in 2003. Such credits amount to only 20 percent of GDP, compared with 50 percent in the Czech Republic.

"All banks are implementing the same strategy: not lending money," says Alfa Bank's chief economist, Natalya Orlova. "The only exceptions are the state banks, Sberbank and Vneshtorgbank."

The perils of a lending slowdown are exacerbated by the short-term nature of most Russian credit. Private Russian banks are too thinly capitalized and have too little faith in either their clients or economic conditions to lend for more than a year. "Companies need capital for three to five years, but they can only borrow for nine months," says Bernard Sucher, chairman of Alfa Capital, Alfa Group's asset management arm. "That means investment by medium-size companies is taking place under the assumption that they can always roll the credit over."

The fast-growing ruble bond market, which has provided many companies with financing over the past two years, is also highly vulnerable to the mood swings of commercial banks, the biggest holders of those bonds, according to securities regulator Vyugin. Bond yields jumped as banks conserved their cash in reaction to the crisis. An issue by phone company Uralsvyazinform used as a second-tier benchmark climbed from 8 percent in mid-April to 12 percent in mid-August, according to Moscow investment bank Nikoil. New issues, which peaked at 30 billion rubles in April, slid to 18 billion rubles for the next three months combined.

All this comes as Russia's vast, scraggly herd of banks is bracing for the introduction of a new federal deposit insurance system. The scheme, which will guarantee savings of up to 100,000 rubles when it takes over from the emergency insurance program in 2006, is the centerpiece of the improvements Ignatyev has been preparing since his appointment in March 2002. The initiative is designed to bolster savers' confidence in private banks. Just as important, the plan will give the central bank a tool for weeding out the many institutions that analysts believe are unworthy of public trust.

That will be no small job, says Garegin Tosunyan, head of the Association of Russian Banks. "Out of 1,300 banks, there are at least several hundred that do not do banking and shouldn't be taking deposits," he says. MDM's Saveliev characterizes most of these nonbanks as mostly "aggressive hedge funds" that borrow on interbank markets or lure depositors with elevated savings rates, then punt the money on securities markets or real estate.

Today's sprawling and unwieldy banking sector is a legacy of years of regulatory imprudence. Simply put, the authorities licensed many more banks than they could properly supervise and required them to publish only the barest of financial data. Sberbank's 2003 profit, to take a prominent example, came to $1.2 billion under Russian accounting, but just $470 million under IAS, thanks to different methods for recording securities sales. Further down the food chain, regulators didn't even know who owned Sodbiznesbank when they shut it down.

Russian lawmakers and Viktor Gerashchenko, the former CBR chairman who was famously dubbed the "world's worst central banker" by Harvard University economist Jeffrey Sachs, allowed any Russian with $10,000 to establish a bank. About 2,600 of them did, and half of those entities survived 1998. Roughly 400 banks are still capitalized at less than $1 million, notes Peter Westin, chief economist at Aton Capital in Moscow. By comparison, Turkey, a country with about one third of Russia's GDP, has 45 banks.

"The Russian central bank could regulate the 50 true banks in the country effectively," says MDM's Saveliev. "It is inconceivable that it could regulate the 1,300 institutions that call themselves banks."

Ignatyev's appointment as central bank chairman promised a change for the better, even if he had no banking experience. An economist with a doctorate from Moscow State University, Ignatyev, now 56, earned his reformist spurs as a deputy Finance minister in Yegor Gaidar's 1992 "shock therapy" government. He later served as deputy Economics minister and presidential adviser before returning to the Finance Ministry as a deputy minister in 1997. He helped manage Russia's relations with the World Bank and the International Monetary Fund through the desperate days of 1998, and as the economy recovered he became an early advocate of tightening tax loopholes for oil companies. "He's a professional bureaucrat, though I suppose in the best sense of the word," Alfa Bank's Orlova says.

Kozlov, 39, joined the central bank in 1989, fresh from his studies at the Moscow Financial Institute, and climbed the ladder there until 1999, when the U.S.-based Financial Services Volunteer Corps hired him as a consultant and Russian director. In 2002 Ignatyev brought him back to the central bank as first deputy director. The CBR duo's most important regulatory reform is deposit insurance, the details of which Ignatyev finally hammered out and pushed through the Duma in December 2003 after a decade of fumbling by his predecessors. This bill, which was meant to take effect in January 2005 once the central bank had decided which banks qualified, was temporarily superseded by this summer's emergency legislation, which covers all deposits until January 2006.

The CBR also is requiring that all Russian banks report according to IAS as of the first quarter of 2004. The first batch of these reports is expected to be released this autumn. Russian accounting standards are highly manipulable, and the introduction of IAS reporting should give investors and regulators the first true assessment of banks' financial health, just as it is already doing in Russian industry. In addition, the central bank is theoretically committed to raising the minimal capital requirement, to E5 million ($6.2 million) in 2007. If enforced today, that rule would cut the number of Russian banks at a stroke to 350.

On paper, these three reform measures should create a healthier and more transparent banking system trusted by more than the current 2 percent of the Russian population while risking an insignificant sliver of depositors' wealth. But good ideas have foundered before. Sergei Dubinin, Russia's central banker in the mid-1990s, also promised to raise the capital threshold to about E5 million, but the 1998 economic crisis and well-connected supporters of small banks combined to thwart his efforts. The next few months will give a strong indication of whether Ignatyev and Kozlov's carefully crafted improvements will suffer the same fate.

"The central bank spent 2003 in very intensive work on regulatory norms, which were in need of complete repair," securities regulator Vyugin recalls. "Now comes the time to introduce them into the marketplace."

The challenge for Ignatyev and Kozlov, contends MDM's Saveliev, is to separate the speculative players from the genuine banks so that the former can go under without the public panicking about their savings. On paper, that looks like an achievable task. The country's 30 biggest banks control 70 percent of the system's capital and more than 95 percent of deposits. By contrast, most of the hedge fund­style banks, as Saveliev calls them, are tiny. But the closure of Sodbiznesbank, which had all of $210 million in reported assets, proved that in Russia's prevailing climate of paranoia, you don't have to be a big fish to start a dangerous wave.

Deputy central bank head Kozlov blamed the banks themselves for inciting the panic by allegedly spreading rumors about their competitors. "Until recently, the Russian banking sector was spared industrial battles because our businessmen knew that throwing stones in a glass tower is a dangerous game," he was quoted as saying in a postcrisis newspaper interview. "This was the first time they started attacking each other on the banking front."

Bankers and analysts acknowledge the industry rumormongering, but many contend that the greater fault lies with the central bank. They criticize it for poor judgment in closing down Sodbiznesbank at a time when capital flight had resumed and banks were on edge about qualifying for deposit insurance, and for waiting too long to reassure the market. "The central bank showed the worst possible timing in their action against Sodbiznesbank," says Mikhail Matovnikov, head of research at Moody's Interfax Rating Agency in Moscow. "Then they basically told everyone to calm down and have a good weekend, which was not what bankers were expecting to hear."

Russian bankers had little trouble believing that Sodbiznesbank laundered money, as the central bank alleged, but they question the CBR's motives. As in the case of Yukos, bankers believe the state could find plenty of other guilty parties if it were so inclined. "Almost any bank in Russia could be charged with money laundering when you come down to it," remarks Moody's Matovnikov.

Speculation about motives was rife after the sudden collapse of Guta Bank. The bank's parent, Guta Group, was a loose alliance of two dozen industrial enterprises, the key shareholders of which were three Moscow-based chocolate and candy producers. "The word on the street is that people in the government wanted to force Guta out of its holdings in the confectionery business," says Alfa Capital's Sucher. "Also, Guta was supposed to be a Luzhkov-related structure, which raised speculation about whether the mayor was able to defend his turf anymore." Moscow Mayor Yuri Luzhkov was Putin's chief political rival before his first election in 2000, and the president has been presumed ever since to have his eye on direct control of Moscow, Russia's economic engine.

The fact that the crisis then shifted to Alfa Bank may have been lucky for Russia. Alfa is the Moscow bank most experienced in Western-style public relations, and one of its most deep-pocketed. Alfa CEO Petr Smida and his deputies made the rounds of all the news shows in early July after depositors lined up for their cash -- a novelty in a country where public figures still tend to hide when they are in trouble. Mikhail Fridman and Pyotr Aven, Alfa Group's ranking partners, pledged up to $1 billion, according to a statement issued on the bank's Web site. The floodwaters receded. The bank also tackled the confidence issue head-on in an extraordinary postcrisis television advertising campaign. "Come and take your money if you want to," Smida told savers. "We want to work with those who trust us."

The central bank's Ignatyev also played a vital role in stopping the panic. "In backing Alfa and rescuing Guta, the CBR showed that it can act to save banks," says Richard Hainsworth, senior banking analyst at Renaissance Capital in Moscow and founder of the rating agency RusRating Co. "That's in marked contrast to 1998, when they refused to save anybody." Hainsworth believes the show of strength should forestall fresh episodes of hysteria while Ignatyev rolls out his regulatory reforms.

In the wake of the crisis, leading private banks like Alfa and MDM hope to see a move toward consolidation. Depositors are likely to pull back from so-called pocket banks, most of which are propped up by companies or local governments, and put their funds in professional institutions that conduct genuine financial intermediation, banker and analysts contend. "We definitely expect medium-size banks with one or two shareholders to experience more problems," says Alfa Bank's Orlova. "A bank like ours might then take over those one or two shareholders' accounts without needing their whole banking infrastructure."

Already, interbank credits have resumed flowing freely between the top 30 to 50 banks, forming an effective cordon sanitaire that also could favor consolidation. "We understand we need to work together," concludes Jyrki Talvitie, head of international banking at UralSib. "Ten years ago we all would have been bad-mouthing each other."

This newfound civility is a striking departure for Russia's top commercial bankers, a group formerly fond of so-called black PR, such as paying journalists to write derogatory articles about competitors. Alfa did claim it was the victim of a slur campaign in July, but it blamed "the telecommunications market," where Fridman's group is locked in a Byzantine struggle for cellular assets with Telecominvest, a St. Petersburg holding company co-founded by Communications Minister Leonid Reiman.

By contrast, Alfa Bank economist Orlova is eager to vouch for the creditworthiness of most major banking rivals. MDM chief Saveliev tips his hat back to Alfa, calling the giant a "good competitor."

Another salutary by-product of the crisis has been to prompt bankers to focus on growing assets, particularly in consumer lending, rather than competing for deposits to fuel speculation on stocks and real estate. "The wise strategy is a niche strategy that focuses on growing consumer assets, like loans and credit cards, more than consumer liabilities," says MDM's Saveliev.

Commercial banks have a natural customer base: upper-middle-class Russians who prefer to bank by Internet rather than huddle in a Sberbank line, and the small or medium-size businesses that pay their salaries. These vanguard customers may distrust banks in the abstract, but they are starved for financial services like credit cards and car loans, which can cement a banking relationship. The trick is offering these products in a country where no one has a credit history and the law is equivocal on the right to seize collateral.

Bank Russky Standart, Russia's 40th-largest bank, believes it can execute this trick through volume and interest rates that reflect the risk. The bank has installed booths in appliance stores and writes loans on the spot for the purchase of new refrigerators and dishwashers, requiring nothing but a passport. The loans aren't cheap -- rates are roughly 30 percent annually, and maturities are a year or less. But the magic of no-money-down financing attracts Russians nonetheless.

Russky Standart's aggressive strategy also caught the eye of French giant BNP Paribas, which bought 45 percent of the Moscow bank at the end of July for about $270 million. GE Consumer Finance followed in early August with an outright acquisition of DeltaBank, one of Russia's leading issuers of Visa cards, for an estimated $100 million. "Russky Standart has return on equity of close to 80 percent today," says Jean Clamon, COO for retail banking at BNP Paribas. "We expect that to come down as they get more competition. But it convinces us that Russia is worth the risk as a way to diversify our resources."

According to Clamon, loans to individuals total 2.2 percent of GDP in Russia, 20 percent in Eastern Europe and 74 percent in the U.S. Closing that gap spells enormous opportunity for Russia's financiers -- and the chance to create crises that will dwarf this summer's. All the more reason to get the structure of the banking system right now, before most Russians actually start to use it.