Buried Under Central Bank Bureaucracy

Last year, there was an overwhelming amount of talk about banking reform, something akin to a river in the spring thaw. The flood, however, abated in December leaving a bland document on reform of the banking sector signed by Prime Minister Mikhail Kasyanov and Central Bank chairman Viktor Gerashchenko. Moreover, despite all the verbiage, nothing was said about the single most important banking institution in Russia: the Central Bank. And yet it is the institution most in need of reform.

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Whenever changes take place at the top, the hope is that the new broom will sweep clean, but the battle to reform the Central Bank will require huge political will, combined with tremendous organizational and leadership skills. In short, we should not expect too much too soon.

The banking sector does not form a single coherent system, as is the case in other economies. Banks are collectively failing in their primary macroeconomic task: They are not providing an effective mechanism for channeling the funds of depositors to businesses in the form of loans -- and thereby assisting economy growth.

Russia has a large number of banks that are small by international standards, and the demand for credit at all levels of the economy far exceeds banks' lending capabilities.

However, looking at the size and activities of individual banks, it becomes painfully clear that -- given the economic, regulatory and legal environment in which they operate -- it is entirely rational for banks to remain small and restrict their lending to a very select group of borrowers.

All commercial banks, including the subsidiaries of foreign banks, generate profits from much the same kinds of activities. If foreign subsidiaries are not substantially increasing their capital from external sources in order to take advantage of increased business in Russia, there is no obvious reason why Russian banks should be doing so.

That Russian banks are small and do not lend extensively are both symptoms of a much deeper malaise in the economy as a whole. It is inherently difficult to operate a bank in Russia because of the tax, regulatory, and legal hurdles. The tax authorities look upon banks as cash cows, the regulatory authorities burden them with endless forms and rigid instructions and banks have difficulty getting rapid rulings in the courts.

The Central Bank, which is responsible for regulating the sector, has a head office with 22 departments and 79 regional divisions and is hugely overstaffed. It has more than 80,000 employees, compared with the U.S. Federal Reserve's 10,200 and the Bank of England's 4,650.

Some caveats are in order here, however, as there are some problems with access to data in Russia, and the most up-to-date figure comes from an interview given in May 2001.

Furthermore, the Central Bank is responsible both for the national currency and regulation of the banking system, while in other countries these tasks are split between different agencies. For example, the figure for the United States includes the Federal Reserve system, the Comptroller of the Currency, and state banking departments; while the figure for Britain contains some departments of the Financial Services Regulator together with the Bank of England.

Even so, the stark fact remains that the Central Bank's bureaucracy is eight times larger than its U.S. counterpart, responsible for regulating the largest economy in the world.

A second urgently needed change is to get the Central Bank to focus on the substance of regulation and look at what is actually going on inside banks and in the sector, rather than concentrating on irrelevant dots and commas. A couple of examples to illustrate my point:

"Why," asked the chief bookkeeper of a Siberian bank during an bank analysts' conference in September, "do Central Bank inspectors not take materiality into account when making their reports?"

"What's materiality?" was the Central Bank departmental head's response. For a lay person with no accounting training the term may be somewhat unusual, however a departmental head of the Central Bank should be well-versed in such terminology, to say the least.

So the provincial bookkeeper proceeded to explain to the Moscow bureaucrat: "If we miscalculate the value of our mandatory reserves [a figure in the millions of rubles] and transfer 240 rubles too few to the Central Bank, then the mistake is not 'material,' especially if we discover the mistake ourselves and rectify it soon after."

"Ah, but if you have made a mistake" came the bureaucrat's retort, "it has to be reported."

It did not seem to matter to him that the error was so small that it could not have any affect on the financial condition of the bank or undermine the purpose of mandatory Central Bank reserves. All he could see was the formal error.

In another incident in 1999, a major bank was forced to transfer back to its shareholder a sum less than $5 because between the transfer of capital to the bank and the registration of the capital by the Central Bank, the exchange rate had changed and the "extra" capital had not been registered. One of the criticisms of Russian banks is that they are undercapitalized, but it can take many months -- if not years -- to register new capital with the Central Bank, and the delays are normally caused by irrelevant objections such as a stamp being in the wrong place on the page.

The real irony is that it is common knowledge (Central Bank officials have complained about it publicly) that Russian banks regularly paint a distorted picture of their financial condition in their monthly reporting to the Central Bank. And this rarely leads to problems for the banks concerned from the regulatory authorities, but woe betide any bank that gets the spacing wrong in one of its reports. The sheer volume of resources required by each bank to comply with every dot and comma of every last Central Bank instruction is a burden on costs. And the absurdity of it all is that -- despite the volume and detail of reports -- there is little evidence that the banking system is any the safer for it. Here a fundamental breakthrough is needed in approach and mentality.

In the short term, the simplest reform would be to consolidate the Central Bank's regional divisions, along the lines of President Vladimir Putin's grouping of the country's 89 regions into seven federal districts or the rationalization of Sberbank's structure (which has reduced the number of regional sub-divisions from 80 to 18). This should be combined with a dramatic reduction in staff down to U.S. levels (i.e. downsizing by more than 85 percent). This would allow the Central Bank to retain its best staff and pay them more realistic salaries.

The implementation of such measures, however, will require considerable political and leadership leadership skills.

Richard Hainsworth is CEO of RusRating, a Russian bank rating agency (www.rusrating.ru). He contributed this comment to The Moscow Times.