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. Last Updated: 07/27/2016

Bank-Managed Funds Fail Investor Risk Test

The recent collapse of a bank-managed mutual fund in St. Petersburg has raised investor concerns about poor regulation. Lena Berezanskaya reports.

Russia now offers scores of local mutual funds that allow investors to tap the local market using the skills of qualified managers. But beware, they are not all the same.

There are two fundamentally different products on the market, regulated by different agencies and with radically different levels of risk.

PIFs, usually operated by brokerages and regulated by the Federal Securities Commission, have so far survived the recent turmoil on the markets without any scandal. The 22 that have so far been licensed operate under stringent -- some would say too stringent -- guidelines that require that the manager of the fund, the depository that holds the shares and the broker that trades the stocks bought by the fund all be independent legal entities. The FSC also sets strict limits on investment in high-risk securities and on the rules for redeeming cash from the fund.

Maxim Yevdokhimov, an analyst at Skate financial information agency, said there are 263 million rubles ($44 million) currently invested in PIFs.

OFBUs, on the other hand, have only existed since last July, and are managed by banks and regulated by the Central Bank. They have grown fast. According to Anna Kuprina from the Central Bank's section overseeing the funds, as of the beginning of February, 74 OFBUs had been registered.

The recent collapse of an OFBU in St. Petersburg, however, has brought to the fore investors' concerns about the regulation of such funds. Critics of the funds say both the regulations governing OFBUs and the Central Bank's monitoring are inadequate.

OFBU managers acknowledge that there are teething problems, but say they have hope for the future. "When the Central Bank started to sell [T-bills], it was also [a] horrible mess, but now it is a very well regulated market," one manager said.

Even from inside the Central Bank, which is responsible for the legislation governing the funds, there is criticism.

"The person [who wrote the regulations] had a poor understanding of how to operate on the market and created what is in practice a useless thing," said Konstantin Korishchenko, the Central Bank's head of open-market operations.

While PIFs face tomes of regulation to limit investment risk, for OFBUs, on the other hand, the only requirement is that a bank wishing to run a fund must open an account with the Central Bank and run all its transactions through that account. There are no external trustees and few rules limiting investment risk.

"Frankly speaking, OFBUs now are very wild," said Nikolai Klekovkin, the head of Credit Suisse Investment Funds, which runs the biggest PIF in Russia. "They have to be washed, brushed and taught good manners."

The presidential decree in July that gave the Central Bank regulatory control over all bank-managed mutual funds did at least bring some order to the market. Previously, the few funds that were operated by banks were completely unregulated. The only recourse open to disgruntled investors was to complain to Russian courts that there had been a breach of the Civil Code.

But as the fund collapse in St. Petersburg shows, even with OFBUs the protection for investors is not much better.

After the Central Bank ordered Petroagroprombank, a subsidiary of SBS-Agro, Russia's third largest bank, to suspend banking operations, investors began to pull out of the OFBU, fearing an imminent collapse of the bank.

The fund, claiming that the 5 million rubles ($827,000) it owed was largely invested in illiquid second-tier St. Petersburg enterprises, left some 1,200 small-time investors stranded.

Part of the blame for the collapse seems to lie with lax supervision by the St. Petersburg branch of the Central Bank. Even though it registered the OFBU in December, it never worried that the manager, Petroagroprombank, had not opened the required account with the Central Bank.

"We didn't know [the fund] had started to work," said Tamara Shumitskaya, deputy head of the Leningrad Region Central Bank. "They hadn't opened a 484 account and therefore we had no control over them."

Analysts questioned the wisdom of granting an OFBU license to a bank that was already showing signs of distress and closed down a few months later. In their defense, the local branch of the Central Bank said Petroagroprombank was sound but was driven under by rumors .

Anna Kuprina, of the Central Bank's OFBU department in Moscow, said that the Petroagrombank incident would have been impossible in the capital. "We registered OFBUs only in highly reliable banks," she said.

But industry players questioned whether the problems went deeper than the failures in St. Petersburg and reflected fundamental flaws in the OFBU structure.

Compared to PIFs, the rules for OFBUs are skimpy. According to Credit Suisse's Klekovkin, the Federal Securities Commission has already issued some 300 to 400 pages on PIFs, compared with 15 pages on OFBUs by the Central Bank.

Klekovkin said there are numerous holes in the OFBU regulations. For one thing, he said, there is no standard form to follow when creating a fund.

"For an investor it is very important to have a standard product," he said. "When you buy a car you know it should have wheels, brakes, etc. Here you may buy a car without brakes."

He said that the Central Bank rules do not define such basic aspects of mutual funds as what constitutes an "open," "closed" or "interval" fund -- terms that refer to when investors are allowed to buy into or remove their money from a fund. "Investors do not know what they are buying," he said.

Andrei Orekhov, director of asset management at MFK-Renaissance, agreed. He said that investors buy shares in OFBUs at banks thinking the risk is no greater than bank deposits.

"The problem is that not everyone understands how it works," he said.

Klekovkin said taxes could also be an area of difficulty. "In the [draft of] the new tax code OFBUs are not even mentioned," he said. "Do you understand what it means for investors? For PIFs we have special instructions."

While the OFBUS face no restrictions on the sorts of illiquid stocks that caused problems for Petroagroprombank, they cannot yet buy into the huge treasury bill market, one of Russia's safest and most lucrative investments.

Though OFBUs are governed by the Central Bank, the bank's depository department has ruled that OFBUs do not meet standards needed to open "depo" accounts for trading T-bills on the Moscow Interbank Currency Exchange.

All of the fund managers contacted for this article said they were promised access two months ago, but so far it has not been granted.

Credit Suisse's Klekovkin predicted that regulations will become more flexible for PIFs and tougher for OFBUs. "It will not be an outright victory for one or the other," he said.