Banking on a Purge

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After a number of smaller banks went bust or lost their licenses, Russia's banking system hit fresh problems last week when Guta Bank -- ranked No. 22 in the country by assets -- said it was unable to meet payments, including on retail accounts. This was followed by media reports that Alfa Bank, Russia's fourth-largest by assets, was also facing difficulties -- though this probably owed more to malicious gossip than reality, as the bank enjoys extensive financial backing from its shareholders.

Russian depositors have lost all or part of their savings three times in the past 14 years, most recently in the 1998 financial crisis. Thus a rumor, whether true or not, is enough to spark panic among savers and create a run on banks.

Moreover, it is no secret that Russia has long had too many banks. The root of the problem dates back to the late 1980s, when, under perestroika, banks could be set up with a minimum capital requirement of a few thousand dollars. The stock joke back then, if you were a businessman, was: Should you opt to buy a fancy car or set up a bank? The answer: Establish a bank and within a few months you'll be able to buy all the fancy cars you ever wanted. The system was allowed to continue after the breakup of the Soviet Union, and by the mid-1990s Russia had 2,600 banks.

Now Russia has about 1,200 banks licensed to take deposits, many of which still have few assets and rely on a small number of clients -- often the banks' owners. Given that these banks carry a high risk of insolvency, the authorities are imposing a minimum capital requirement of 5 million euros ($6.1 million) that comes into effect in 2007, although whether it will actually be enforced is far from clear, as only about 350 credit institutions currently meet that requirement. The minimum capital requirement for Russian banks is currently a meager 1 million euros ($1.2 million) and yet almost 400 credit institutions have capital of less than $1 million, not even meeting that requirement.

Meanwhile, the Central Bank has produced so many reform strategies in the past decade that a small rain forest has probably been felled to meet its paper needs, but it has done almost nothing to tackle financial sector reform in practice. The Central Bank also suffers from a major conflict of interest due to its role as supervisor and regulator of the banking system, while being majority owner of Sberbank, Russia's largest retail bank. The Central Bank could and should have dealt with undercapitalized banks several years ago instead of allowing the current messy situation to unfold, with the resulting loss of confidence in a sector that is already short of trust.

Central Bank Chairman Sergei Ignatyev responded to last week's problems by announcing the lowering of the mandatory reserve requirement from 7 percent to 3.5 percent of deposits in a bid to increase liquidity. Although this looks like a good idea, it would be better if it were just a temporary measure and only available to sound banks. With the banking sector poorly regulated, and many banks conducting excessively risky operations and having a small number of clients, lowering the reserve requirement could simply serve to encourage more risky operations.

The good news is that the impact of a wider banking crisis would be fairly limited, as the banking sector remains small compared to those of other countries. Total private-sector loans in Russia's banking sector amount to approximately 20 percent of GDP, compared to 50 percent for the Czech Republic and 80 percent-plus for developed market economies; while nonperforming loans amount to approximately 5 percent of Sberbank's balance sheet.

In picturing an unlikely worst-case scenario, it would be reasonable to assume that the actual nonperforming loan figure across the sector as a whole is double that of Sberbank, i.e. 10 percent. Based on the safe assumption that state-backed Sberbank would not be significantly affected in the event of a crisis, we arrive at a maximum cost to the taxpayer of 1.3 percent of GDP. To put that into perspective, the Swedish banking crisis of the early 1990s cost 12 percent of GDP.

However, Russia's banking woes could well have an impact elsewhere. Coming on top of the Yukos affair and probable delays in electricity sector restructuring, banking sector problems could finish off any residual hopes that ratings agencies Standard & Poor's and Fitch might award Russia investment grade this year.

Looking ahead, the situation will probably worsen before it gets better, with other small and medium-sized banks likely to face problems. Private banks will face an uphill struggle to restore customers' trust, and many depositors are likely not to return.

The major beneficiaries, no doubt, will be state-owned banks and the few foreign banks that have retail licenses for the Russian market.

Putting gloom to one side, there may yet be a silver lining to the banking sector's problems. If the Central Bank can summon the political will and make a clean break with the past, a clean-out of the system's deadwood might well see the emergence of a better banking sector that would provide strong support to long-term economic growth.

Let's hope we are entering a period of what Austrian economist Joseph Schumpeter called "creative destruction."

Peter Westin, chief economist at Aton Capital, contributed this comment to The Moscow Times.