No Echo of 1998 in Current 'Banking Crisis'

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Contrary to the feverish hyperbole of some commentators, Russia has not been experiencing a banking crisis, let alone anything comparable with the scale of the 1998 financial meltdown. Nevertheless, the nerves of depositors and companies, still raw from the trauma of 1998, have been so shaken by hype and rumors that one or two banks have been hit by runs on their deposits.

However, there is virtually no point of similarity between now and 1998, either in terms of the economic situation or in terms of the banking system. In 1998, the government had almost no control over spending, tax revenues were completely inadequate and an expanding budget was financed by "riskless" short-term debt. Russia's main exports -- its commodities -- were at record lows with demand hit due to economic problems in the Asian tigers. From the vantage point of 2004, Russia has experienced a tax reform that has resulted in increasing government revenues, the budget is under control and inflation is falling. Oil prices are at an all-time high, the economy is growing and, with it, the demand for banking services.

In 1998, Russian banks faced the double-edged sword of devaluation. For over two years, they had been attracting loans from global capital markets, arbitraging between low interest rates globally and high ruble interest-rates (borrowing in dollars and lending in rubles). Any ruble devaluation would wipe out their capital. At the same time, devaluation served the interests of the raw materials exporters which, in fact, owned most of the banks. Adding fuel to the fire, banks had been playing wildly with derivative contracts and taken massive bets that the Central Bank would not devalue the national currency. Today, there is no derivative overhang, no currency mismatch, lending by foreign investors to Russian banks has only just started, and there is a freely floating currency that is appreciating rather than devaluing.

On the regulatory side, the Central Bank in 1998 had just taken strides towards international accounting standards, introducing a new system. However, it remained a triumph of form over substance and was a long way from any sort of convergence with international best practice. In 1998, Russian banks had found that central bankers were willing to overlook infringements of Central Bank-imposed prudential ratios. It was even discovered that the Central Bank itself was profiteering on government bonds by recycling the country's foreign reserves through a Russian-owned foreign bank. Given that the Central Bank also managed the short-term government debt trade, some bureaucrats almost certainly made small fortunes. The Central Bank had established a currency corridor with the aid of the IMF, and the ruble exchange rate was forced into a narrow trading band, so derivative contracts could be written for just that narrow band. The Central Bank controlled the currency trades and the exchange rate, and future rates became known to selected players in the market ahead of time.

Today, by contrast, the general consensus of economists working for global agencies, such as the World Bank, the IFC and the OECD, is that while there may be differences of emphasis regarding banking reform, the Central Bank's overall strategy adheres to international best practices. All the main agencies have praised the Central Bank's emphasis on substance (the economics being described in the financial statements) over form (not just whether certain prudential ratios are met on paper) and on good-quality capital -- both of which lie at the heart of good bank regulation.

The greatest criticism has come from banking theorists who are opposed to deposit insurance per se on moral hazard grounds. Yet the model the Central Bank has backed, with a strong regulatory stick alongside the insurance carrot, is one that only rigid purists can object to. Moreover, the Central Bank has been implementing its reforms in a systematic and careful manner. If the pace is slow -- a common complaint -- that is the speed dictated by the political process, and is no bad thing if that is the price to be paid for ensuring that the country's leadership is committed to the reforms.

Finally, in 1998 a crisis was expected. The currency had to be devalued; it was only the timing that was unclear. Consequently, when the news broke, there was no fundamental surprise. However, as soon as one bank failed, there was a domino effect. Only very strong, smaller banks escaped the chaos. Now there is no sign of systemic crisis. There has not been a single case of bank failure. Indeed, virtually all the 43 banks covered by RusRating have continued to do business with barely any negative impact.

However, when the Central Bank pulled the license of Sodbiznesbank without waiting for a triggering default event -- moreover, citing money laundering issues for the first time -- it effectively changed the rules of the game. Although supervisors had long been warning they would be act on the basis of substance not form, there had only been words up until then.

The reaction amongst Moscow bankers was to panic. If Central Bank action could occur without a concrete default, who would be next? Since nearly all -- if not all -- banks had at one time offered "exotic services," where was the line between acceptability and action? If the Central Bank revokes a bank's license, any money lent to that bank on the very short-term interbank market is as good as lost. In the newly risk-conscious world of Russian banking, the knee-jerk reaction was to stop doing business except where the counterparty was well understood. Russia's interbank market contains about 30 core banks and 170 second-tier banks. When the jitters infected the market, core banks stopped working with the second-tier. Smaller and more dependent on interbank funds, the second-tier banks frantically bid up the cost of money that was available to them.

So what remains to be done in the banking sector?

The current "almost" crisis can be put down to excessive reliance on rumor; the obvious solution is for bankers to find ways of getting and utilizing sober economic analysis.

A real crisis may well occur in the future for a related reason -- namely excessive optimism in the face of real economic weaknesses. Strong growth, which must happen given the government's plans to double GDP, leads to weaknesses in any loan portfolio. These weaknesses will materialize when there is an economic contraction. Such a banking crisis can be averted if the Central Bank continues to act firmly, as it has done with Sodbiznesbank, and Russian banks learn to think independently about their risks and asset quality.

Richard Hainsworth, banking analyst at Renaissance Capital and CEO of RusRating rating agency, contributed this comment to The Moscow Times.