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. Last Updated: 07/27/2016

Thirsty Banks Chase Masses and Mattresses

MTMillions of people lost their life savings in 1998 after the government defaulted on its domestic debt and devalued the ruble.
When thieves broke into this reporter's apartment last week, the cot they overturned was not just a telltale sign of the burglary, it was a sign of the times.

What the looters were looking for was quite literally the proverbial "mattress money" that constitutes the life savings of millions of bank-weary Russians.

In this case, the perpetrators came up empty handed, despite the odds being staked in their favor: By some estimates, Russians keep as much as $55 billion tucked away at home, more than all the money parked in all the personal accounts in all the land.

If you look at America, the fast-charging locomotive of the world economy where personal savings rates are often negative, it stands to reason that Russia's economy is in for a significant boost if it can lure dormant stashes of cash out into the open and put to productive use. The ratio of retail deposits to gross domestic product in Russia stands at just 11 percent, versus the 40 percent found in fellow transitional economies like Poland and the Czech Republic. And the ratio is more than 60 percent in Germany, which not so long ago annexed a huge Soviet satellite state.

"This," says Chris Weafer of Alfa Bank, the nation's largest private bank, "shows you how immature Russia's banking system is."

But how to coax the cash belonging to people burned in the 1998 meltdown back into the system?

The government is hoping that a new bill guaranteeing personal bank deposits will be a start.

The deposit insurance bill, one of the lynchpins of the government's banking reform strategy, unexpectedly passed a first reading in the State Duma last month after languishing in the corridors of power for more than a decade.

In its current form, the bill would make banks contribute to a fund that would fully insure all deposits under 20,000 rubles ($657) and guarantee 75 percent of deposits between 20,001 rubles and 120,000 rubles, capping the maximum pay-out at 95,000 rubles.

Although less than in many countries, it would cover most individual accounts. State-controlled Sberbank, currently the only bank that enjoys a government guarantee on all its deposits, would lose its monopoly within four years of the law taking effect, thus leveling the playing field in the sector.

The Great Bill Debate

Richard Hainsworth, a banking analyst at Renaissance Capital and CEO of bank rating agency RusRating, said he expects the bill will clear all three readings in the Duma by the end of November.

Most observers, however, reckon the chances of that happening are close to zero, and doubt the likelihood of the bill ever being passed at all.

"I am absolutely sure that it won't pass," said one leading specialist who asked not to be named.

If and when it does pass, however, the bill could end up being a major catalyst for transforming the banking sector -- if it is not watered down.

Many deputies, for instance, want Sberbank to retain its 100-percent deposit guarantee until its share of the retail deposit market falls from its current level of roughly two-thirds to below 40 percent.

Opponents of this strategy, including Andrei Ivanov of Troika Dialog, say giving Sberbank and Sberbank alone that privilege would let the quasi-monopolist retain its position for much longer than market forces would allow.

"Guarantees at Sberbank should be placed on the same footing as all other banks," Ivanov said.

Some legislators also want as many banks as possible to participate in the fund scheme, irrespective of their fundamental health.

"The main idea of the guarantees was [for the Central Bank] to implement stricter measures, to conduct due diligence and sift out ineffective banks," Ivanov said. "This is now threatened."

Too Many Banks

Lax supervision by the Central Bank has been one of the largest problems for the sector.

Banking analysts across the board say the Central Bank simply allows too many banks to operate. They say that dozens, if not hundreds, of the 1,331 banks currently operating in Russia should be shut down. Some 20 percent of all licensed "banks" are nothing more than the internal treasuries of the industrial groups to which they belong, and another 30 percent or so are government-owned or controlled.

"More than half of the sector is not there to make profit," Ivanov said.

In theory, the Central Bank can revoke the licenses of banks whose ratio of capital to risk-weighed assets is less than 2 percent.

In practice, however, a lot of the capital that banks show is shamelessly inflated. Natalia Orlova, an analyst at Alfa Bank, says this is done in two ways. The first involved the bank granting a credit to a company that immediately returns that money to the bank's capital via various middlemen. The second is for a bank to simply inflate the value of its assets on its balance sheet. As a result of these gimmicks, analysts estimate that up to a third of all banking capital is purely fictitious. "For the Central Bank, this is exceedingly hard to catch," Orlova said.

The Central Bank claims that it has begun to get tougher. It plans to audit all banks within two years, and has already inspected 180 banks for "window dressing," or inflated capital. Of these 180, at least 60 were discovered to have inflated their capital, but the Central Bank has yet to act on its findings.

All these problems -- and many more -- mask a positive development: retail deposits and lending have actually been growing at an unprecedented pace.

Central Bank figures show that personal deposits have swelled 21.5 percent since the start of the year, though this is somewhat inflated by a growing monetary base. Personal lending, meanwhile, has grown even faster, by 48 percent, and now stands at $7 billion for the year. Even if adjusted for the growth in the monetary base, the volume of personal loans are more than double what they were in February 2000, according to Hainsworth.

But Standard & Poor's believes the real amount of retail lending to be much less. A recent report by Renaissance Capital suggests why: Many companies set up intricate payroll schemes in which an employee gets paid via an interest difference arising out of back-to-back loans and deposits -- thus increasing the official, but not real, figure for both.

But this only means that the potential for lending is even higher than the numbers would suggest, Renaissance concluded. Though absolute volumes are overstated, the growth in personal lending is real, and comes as interest margins -- the difference between what a bank pays on its deposits and what it earns from lending to corporations -- are shrinking. Large corporations are increasingly being forced to choose between domestic and foreign banks offering to fund them. In addition, shrinking yields on corporate bonds this year has made securitizing debt even more attractive.

Spreads between interests on individual deposits and loans, however, remain tantalizingly high. In May, a Renaissance study found that ruble loans to individuals were twice as profitable as loans to corporations, earning 18 percent interest versus 9 percent, respectively.

"This 'individual' premium is clearly greater than the level of risk, indicating a source of super-normal profits for banks lending to individuals," Renaissance concluded.

Banks have begun to take notice, but significant problems remain with lending either to individuals or to small businesses, two distinct categories considered one under Russian accounting standards.

One problem is that there is no credit-rating system to speak of, because the need for it is relatively new, making risks harder to gauge, said Andrew Keeley of Renaissance.

Another problem is that the small and medium-sized enterprise sector so crucial for sustaining macroeconomic growth is struggling to attract credit. "Banks are picking between retail and SME, and SME is considered far riskier because of loopholes in bankruptcy laws," lack of transparency in accounting and problems with collateral, Orlova said.


Critics say the Central Bank has done nothing to cut the number of licensed banks, of which there are now more than 1,300.

On the deposit side, there is no way to guarantee the nature of long-term liabilities. All deposits, in effect, are "on demand," since the account holder has the right to withdraw his or her money upon request. With the recent volatility in the euro-dollar relationship, many depositors have been pulling out their cash, or at least opening up only short-term accounts in order to avoid committing their savings to a currency that might later slide, Orlova said.

"Banks need more deposit certainty," said Hainsworth. "If they are lending for two years, they have to fund the assets with two-year deposits. With no sources of long-term funding for banks, they cannot lend long-term, either."

Banking on Homeowners

This problem is especially pronounced in the mortgage market, which amounts to less than 1 percent of total lending, according to Yekaterina Trofimova, financial institutions specialist at Standard & Poor's.

Only a handful of banks, such as Delta Credit, have a developed mortgage program. Because of the excessively complicated regulation of this type of lending, most of the housing loans in Russia are issued through long-term notes, particularly by Sberbank, Trofimova said. Total accumulated mortgage lending in Russia, she added, amounts to no more than $400 million, a paltry amount for a country of 150 million.

The main problem with mortgages is Russia's Germany-inspired Civil Code, in which rights cannot be changed by contractual agreements, Hainsworth said.

"The Civil Code greatly protects flat dwellers, and rightly so, in a sense," Hainsworth said. "You just can't throw someone out" for not paying a mortgage. "You can provide alternative dwelling," but the high costs of such an arrangement rule it out. Hainsworth suggested changing the Civil Code to allow individuals to enter contracts that would limit some of their rights.

In addition, there is no legislation allowing mortgage-backed securities, said Alexei Moisseyev, economist at Renaissance Capital. The lack of mortgage options constrains labor mobility and impedes the efficient functioning of the labor market, he said.


Besides making banks consider retail lending, shrinking margins could bring about another sea change that the government has been unable to achieve -- sector consolidation.

Interest margins tightened to 5.4 percent at the end of last year from 7.5 percent in 2001, according to S&P. Before the margins tightened, inflation was higher and the ruble more volatile, which boosted margins and gave banks an opportunity to reap large profits despite having few assets. In fact, it made sense to keep balance sheets small in order to manage risk, Hainsworth said.

Now, however, with margins narrowing, banks need to increase capital asset lending to keep up revenues, while increased economic stability means industrial investments have become more profitable than banking investments.

"For the first time since the emergence of the banking system in Russia in 1988, there is a microeconomic reason for consolidation to begin," Hainsworth said. "Managers of small banks recognize that things are changing and it is becoming more difficult for them to grow. We will begin to see a number of mergers."

We had better, warned S&P in a recent survey of Russia's 30 largest banks. Even these heavyweights carry inflated costs and unsustainable core revenues. The average return on assets -- a basic measure of profitability -- for these 30 banks fell a third between 2000 and 2002 to just 2.87 percent, S&P wrote in the study.

"The real evil of the Russian banking system is its inability to use economies of scale," said S&P's Trofimova, one of the authors of the study.

Many bank branches invest in their own hugely expensive IT platforms, maintain an army of lawyers and other redundant staff, and have trouble consolidating costs with other branches. The top 30 banks' average cost-to-income ratio jumped from 58 percent in 2002 to 70 percent now, she said.

A large chunk of bank revenues, meanwhile, comes from securities -- making them vulnerable to capital market cycles, S&P said. The market rally of the past three years has allowed banks to make money by simply holding their positions.

Andrei Dobrynin, international capital markets director at MDM Bank, said banks invest in between 80 percent and 90 percent of all Russian corporate debt issues.

Equity investment levels are harder to glean, since ownership of around 70 percent of all publicly traded shares on the Russian market is not disclosed. But at the end of 2002, gains from securities trading accounted for some 40 percent of the total revenues of the top 30 banks, according to S&P.

This means that if the market surge ebbs, the sector could easily find itself in trouble, Trofimova said. If the market stops going up, non-appreciating securities will cause the top 30 banks to lose almost 40 percent of their revenues, while operating expenses would remain at 70 percent of revenues. This spells losses.

"In fact, Standard & Poor's believes that many Russian banks would [already] report losses if forced to disclose their accounts under [international accounting standards]," S&P wrote. Even diversifying into retail lending could prove risky, pushing up operating costs while leaving gains to be realized in the future.

So the consolidation is sorely needed -- but S&P is not optimistic that it will start happening soon. "The appetite for consolidation is pretty low," Trofimova said.

The biggest obstacle, she said, is the financial-industrial group model. "Banks are not seen as profit centers for their owners, but as subsidiaries and servicing arms of the industrial groups," she said.

Another hurdle to consolidation is administrative constraints. Under current legislation, mergers that preserve both sets of shareholders are hard to pull off, and the consolidation process is slow and complicated.

"The Central Bank doesn't really welcome consolidation in the sector," Trofimova said. "Regional branches [of the Central Bank] are really set against larger Moscow banks buying smaller regional banks -- and they do everything possible to keep it from happening."

One Less Headache

Interestingly, a weak banking system might allow Russia to avoid one problem inherent in fast-growing economies -- bad debt. "When the economy expands, it is easier to repay debt -- so poor-quality borrowers cannot be easily distinguished from good borrowers," Hainsworth said. As loan portfolios increase so will defaults.

But with the exception of Sberbank, which has concentrated its lending to a few large companies, it is too soon to talk about a non-performing credit crisis that could bring down the system.

Hainsworth and MDM's Dobrynin both point to the relatively low ratio of assets to GDP -- under 40 percent, compared, for instance, to 128 percent in Britain.

"Loan portfolios can increase much more before you start lending to lower-quality borrowers," Hainsworth said.

But before this happens, far more cash must be liberated from mattresses than burglars alone can manage.