Will a Wave of Bad Loans Wash Over the Banking Sector?

Last year, the Russian banking sector was rocked by two waves of financial crisis: the repo market collapsing in September and the deposit run on banks in October-November. And now a third wave, with rising bad loans and provisions eroding banks' profits and equity, is on its way.

In this environment, the valuations of Russian banks have become sensitive to a single factor, provisioning. This is very difficult to estimate: the financial authorities and bank managers themselves have voiced various estimates, from 5 percent to 15 percent. However there is little visibility over whether they will actually fall within this range. To start with, the anticipated credit crunch will be the first in modern Russian economic history and secondly, given the substantial differences in economic structure, asset ownership, degree of leverage and government policy, the financial crisis statistics from other parts of the world cannot really be considered a reliable guide.

Last year we outlined three possible scenarios for asset quality deterioration, which envisaged the amount of loans becoming overdue in 2009 at 3.5 percent (bull case), 6.5 percent (base case) and 10.5 percent (bear case). We are now assigning the highest probability to the bear case scenario and see NPLs rising through 2010. We do so based on a number of considerations.

First and foremost, the Russian economy continues to follow a negative trend, with production and consumption still declining. Hence, loans taken to finance capital investment have little chance of being paid off. Moreover, regions, which represent at least 62 percent of banks' aggregated loan books, see an even gloomier macro picture: most regional budgets are deeply in the red and have limited capacity to help regional companies and banks.

Secondly, some loans are being extended or rescheduled, but on substantially different terms (rates in excess of 20 percent) that make them difficult to service in an environment with little or no economic growth. Also, the loans are typically extended for one year (in other words, the asset quality deterioration date is effectively postponed by one year).

Thirdly, external debt repayments ($114 billion in 2009) will wipe out a substantial amount of the banking systems' funds, thus limiting banks' ability to refinance existing loans. Finally, both corporate and retail deposits are under pressure: the latter due to rising unemployment, while corporations tend to withdraw maturing deposits to repay their debt and/or finance working capital.

We have considered the outcome, both for the system as a whole and for separate banks, of our bear case scenario materializing. Although the extent to which asset quality will deteriorate remains the biggest unknown, our new base scenario, provisioning to reach 14 percent by 2010, is actually the breakeven for the sector with no system-wide recapitalization required. At the same time, our analysis shows that various banking system segments differ in the availability of an equity cushion, and our analysis suggests that, perhaps surprisingly, the top five state banks are the most vulnerable due to their ongoing increase in lending activities coupled with relatively low provisions, other than Sberbank, which has strong earnings momentum. As the state has pledged full support in terms of recapitalization for state banks, with a 200 billion ruble equity injection for VTB already on the way, we believe that this risk is addressed at this stage.

We applaud the Russian authorities for having followed a predictive rather than an adaptive policy when coping with the previous waves of the crisis and note that they continue to do so in preparing for the next one. In particular, a wide range of measures is being discussed to address banks' possible need for recapitalization as well as making them more comfortable with passing on financial aid to the real economy (state guarantees, subsidies etc.). Alternative ways, including the idea of creating a 'bad bank,' are also on the table. We estimate that this idea becomes viable should bad loans exceed 15 percent of total loans and it offers an opportunity both to clean up banks' balance sheets and revive lending as well as spur the consolidation process by creating a critical mass of 'good banks'.

The main challenge for the authorities is of course to find a proper balance between helping troubled companies and encouraging them to become and remain self-sufficient, efficient and competitive.