As the economic good times roll in Russia, foreign banks are either bolstering their current operations or looking for a way in, says Geraldine Lambe.

Superlatives can easily lose their potency with overuse. But the term bonanza is surely warranted to describe Russian capital markets growth. According to Moscow- based Brunswick UBS, the gain on holding a 2028 sovereign bond from January 1999 has been 773%. Against the backdrop of swingeing bear markets elsewhere, the Russian equity market, albeit limited in the number of companies, is up 863% over the same period.

This potential is not lost on foreign investment banks. Those already on the ground are beefing up their Russian resources and those without a presence are opening offices – such as the representative office announced by Merrill Lynch in February. But are the laggards too late to join the party?

Established reputation required

One foreign banker, based in Moscow for the last eight years, says: “It takes a long time to build a track record with clients here and the bureaucracy involved in setting up can be very long-winded. It’s not enough to just turn up now when the going is good – clients want to see that you have been investing here during the tough times. It’s too late for Merrill’s rep office to pay off.”

Sources close to Merrill admit that it will be at least three months before the Moscow office is fully operational, and that it will “not be a sizeable presence”.

Most economists agree that while returns may not be as stellar as for the previous five years, they will still be formidable and few board-level discussions can now ignore such a dynamic story. This increased visibility at senior management levels within banks’ global franchise is a key driver behind the big push. Rair Simonyan, managing director and head of Morgan Stanley’s Russian business, says: “We used to have to compete for resources; it was almost impossible to get resources for anything other than oil and gas. Vladimir Putin has made us less ‘exotic’ and colleagues’ clients are now very interested in Russia’s other assets. Our visibility has gone up as a consequence.”

Morgan Stanley has about 20 people in Russia focused on M&A, and debt and equity capital markets. The bank is not willing to discuss plans, but Russian market participants believe the firm is gearing up to seriously boost its presence, particularly its focus on the burgeoning domestic markets. Mr Rair says a banking license is already in the pipeline.

Mr Simonyan did acknowledge that changes were likely. “Our business model needed to change to reflect the new environment – the rouble market is growing and the client universe is expanding. Without expansion, the bank will not be able to compete and will lose business – not just miss opportunities,” says Mr Simonyan.

No longer an emerging market

The picture is the same at JP Morgan. Miklos Kormos, senior country officer for Russia and in charge of investment banking for central and eastern Europe, says the bank now classes Russia as a European challenge, not as an emerging market opportunity. “JP Morgan Russia’s performance is now benchmarked against other European countries, not against emerging markets,” he says. As an indication of the changed perception, he adds: “Russia has become a place where bankers believe they can develop their careers best.”

The bank, which has trading, investment banking, treasury and securities services, including a local custody operation, already has about 55 people in Moscow. It too is looking towards the potential of the domestic markets and the bank aims to augment local trading operations – where Mr Kormos says the bank already commands a leading position. “The rouble bond market is growing at a phenomenal rate. We are already a big rouble bond trader, but we aim to play a bigger role in rouble origination,” says Mr Kormos.

Recognising importance

Deutsche Bank too has serious designs on increasing its share of the Russian pie. Alex Rodzianko, managing director and head of Deutsche’s Russian subsidiary, says all the international banks have recognised that Russia will be a major market in its own right with its own sphere of influence and independent trends. A serious local presence is thus mandatory. “If you look at the potential size of the market, you need to be here in force. We are a European bank, it may be OK for us to be number five in Latin America, it is totally unacceptable for us to be number five in Russia.”

Deutsche’s plans are far reaching. It already has about 120 people in Moscow. Alongside a considerable back office staff, the bulk of the headcount goes to cash management operations, and the rest is split between investment banking and capital markets; there are an additional 135 dedicated to financial software development and outsourcing, which Mr Rodzianko says is an increasingly lucrative business. Its Russia strategy, however, outgrew organic growth and the acquisition at the end of last year – a 40% stake in domestic Russian house United Financial Group (UFG) for £75m, adding 225 staff to the headcount – filled a crucial gap.

“UFG is a good business and cultural fit. We had the banking and fixed income piece of the puzzle, but no presence at all in the equity markets. There is an increasing realisation that without a local presence, the bank would not win local M&A business or IPOs. This would have been an extremely hard sell to most board rooms as recently as 2000,” says Mr Rodzianko.

Competitors acknowledge that, should the integration of the two firms’ offerings be successful, the partners will make a formidable force in Russia.

Credit Suisse First Boston also approaches Russian growth in a different way to other emerging markets. Three years ago, CSFB decided to focus all its European emerging markets teams in London, but Russia was an exception to this rule; its operations remained local and will now be expanded – particularly in equities.

Diana Gindin, managing director and president of CSFB’s Russian operations, says: “We expect the bull market to continue; there are some world class assets here, and not just in natural resources, also in brewing and retail, for example. To build the business, local market knowledge is crucial. It is very difficult to spot trends in London and build trusted relationships without a local presence.”

CSFB, which was an early Russian devotee, was hit by the 1998 crisis when the GKO (treasury bonds) market died. Its massive 300-person presence was cut after the crisis and has now been rebuilt to around 95. But, Ms Gindin says the common notion that CSFB “pulled back” from Russia is a misconception. She says that the bank always maintained its presence there and plans further expansion in selective areas.

“CSFB made the best out of a very difficult situation. We continued supporting our local client base and were there throughout the liquidity crunch. We established some of our strongest client relationships during that time. It proved our commitment to the country and to our clients,” says Ms Gindin.

History means business

Ms Gindin makes what many see as a crucial point for any foreign banks with Russian ambitions: that those firms which have a history of Russian involvement and which maintained operations during difficult times, will probably secure the lion’s share of future investment banking and capital markets business. Those arriving now may have missed the boat.

One Moscow-based, foreign banker says: “Firms like Goldman Sachs, which pretty much shut up shop after the crisis, lost a lot of reputation in Russia, and those that are just now dipping their toes in the water will miss out on the majority of the growth that this market is witnessing.”

His view is supported by other anecdotal accounts, which present Goldman’s Russian presence as intermittent. Market participants say the firm opened an office in the early 1990s and closed it in early 1995 – just before the markets began to take off. “With exquisite timing”, it reappeared in early 1998, only to close it three months later. Now it is rebuilding, but with very limited resources in Moscow, say sources.

Goldman defends position

Goldman Sachs, however, vigorously denies this account, and says it has had a continuous presence since 1997. Elena Titova, managing director and head of Russia and CIS, states: “We opened our office 1991 and closed it in late 1994 because there was then not enough business to justify it. We reopened it in 1997 [but had the official opening in 1998] and have been present ever since. At one point we did re-deploy a couple of people to other offices. Now we have nearly a dozen people in Moscow across all kinds of activities.”

Whatever the perception of Goldman, however, it doesn’t seem to have hurt its performance in M&A, for example. According to Thomson Financial data, Goldman has figured somewhere in the Russian top 10 for the last five years, and was third last year. And it is unlikely that many Russian CEOs would exclude Goldman from the deal table – particularly if it is the sort of prestige deal that Goldman does so well.

Ms Titova says that Goldman anticipates considerable growth in advisory and finance, and derivatives and commodities, and will be gearing up to meet the demand, but she declines to flesh out plans. “It will be a substantial expansion,” she says.

Lehman Brothers’ strategy has also perplexed some observers. “It’s surprising that firms like Lehman Brothers, that are pretty strong in other European countries and are big debt players, have no local presence at all,” says one banker. “But they will find it increasingly difficult to win business from London.”

Lehman Brothers declined to contribute to the feature, but sources close to the firm say discussion of its Russian strategy is very sensitive as the bank was badly burnt in 1998. The source says that there are currently no plans to open an office, and since some other markets in Europe that are considered just as important as Russia operate with only satellite offices, then its unlikely that Russia will get a more significant presence. “For the time being, we will continue to offer access to Russia for our clients from London,” says a Lehman spokesperson.

Confidence for the future

Late or not, banks’ Russian expansion is rooted in the seeming confidence that the liberal reforms which characterised President Vladimir Putin’s first term in office, will be continued in his second. The signal sent by his proposal of Mikhail Fradkov as prime minister was that he was putting in place an obedient and experienced administrator without an independent power-base. Mr Fradkov’s selection of economist Alexander Zhukov as his deputy cements hope for a continued liberal agenda.

Al Breach, chief economist and strategist at one of the Russian market’s leaders, Brunswick UBS, says the firm remains bullish about the future, from both a policy and an economic standpoint. “Mr Putin did a fabulous job in the first period; we are waiting to see if he will build on those foundations in the next. We may have hoped for someone with stronger liberal credentials, but Mr Fradkov looks like a good administrator, and that’s what we need to push reform through. The fact that the government is being seen to enforce legislation and that it is reducing oligarchs’ influence will send positive signals to international markets. But Mr Putin must be careful not to throw out the baby with the bath water – he must not crush the entrepreneurial spirit.”

More growth ahead

Citigroup is also bullish. Steven Fisher, managing director and head of corporate finance for Russia and CIS, says: “The economic picture is stable. We think there has been a lot of progress already and that Mr Putin has all his ducks in a row. It is clear that there is going to be continued strong growth in Russia. For example, this is probably the most exciting emerging market telecom sector at the moment – it grew by almost 100% last year. That is a clear indicator of growing consumer strength and one bellwether of economic health.”

Citi is making a big push into Russia and already has 250 people on the ground spread across corporate and investment banking and capital markets (and the same number in its retail operations). Mr Fisher declines to detail Citi’s firm expansion plans. “The bank will expand in line with the expansion of its local business and also in relation to the growth of international business flows to Russia,” he says.

Citi is putting its balance sheet to work in Russia (significantly over $1bn and expanding all the time, says Mr Fisher) and sees lending as crucial in gaining capital markets business. “More and more clients are seeking additional and broader support by working with financial institutions that can provide both capital market solutions and access to a strong, deep and sophisticated balance sheet,” he says.

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Rair Simonyan: ‘Our business model needed to change to reflect the new environment’

Strategic lending

The corporate sector’s growing thirst for funding for new business and upgrading of equipment and infrastructure, married to the blockage in Russia’s fragmented banking system – which does not always efficiently channel capital to where it is needed – is clearly an opportunity for foreign banks. ABN AMRO (with 200 on the ground split across financial markets, cash management and corporate finance) is a sizable lender, though unwilling to reveal the size of its Russian balance sheet. So too is HSBC (with 70 staff, including 25 split between corporate and investment banking and capital markets).

At Dresdner Kleinwort Wasserstein (DrKW), managing director and head of investment banking in Russia, Bob Foresman, says it is flexing its balance sheet, again on a strategic basis. “Our lending is very focused. We do not lend for the sake of it; it is there to support capital markets transactions,” he says.

Mr Foresman says that like all foreign banks, it relies heavily on DrKW’s international franchise for product and sector support. But, at DrKW too, which has 20 staff in Moscow dedicated to investment banking, the Russian business has an increasingly high profile. “Russia is seen as a very important part of the DrKW story. We feel that we have a very good franchise here.”

As an illustration of Russia’s place at Dresdner’s high table, a recent reorganisation adds muscle to the bank’s investment banking presence there. The commercial banking operations of Dresdner Bank have been integrated with DrKW and they both now report into DrKW CEO Andrew Pisker.

Mr Foresman says that while the bank is “not definitely planning” to grow the headcount, it is targeting the domestic markets and intends to be more active in lead managing and originating rouble bonds, where it is already an active trader. “Our history here sets us up for this sort of growth. If you don’t trade much, you can’t originate, ” he says.

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Alex Rodzianko: ‘Without a local presence, the bank would would not win M&A business or IPOs’

What’s left for Russian banks?

What does this mean for the future of Russian banks, with such powerful invasion forces not only at the gates but sitting in their offices and looking towards domestic issuance? Can they compete against Morgan Stanley et al for investment banking and capital markets business? The cost of funding alone prevents them from working with the giant oil and gas players.

Like many of the foreign banks, they see the first of their two key weapons as the balance sheet. “It gives us serious leverage,” says Guerman Aliev, deputy chairman of the executive board and head of investment banking and capital markets at Rosbank, which has been third in financial data firm Dealogic’s rouble bond league tables for the last two years. “The domestic banks are the biggest local lenders and the biggest players in the rouble bond markets. Bond issues are often exits from a loan situation so we have a captive market to a degree,” he says.

The second big gun, he says, is the different risk profile held by domestic and foreign players. “We can do deals and work with companies that a firm like Morgan Stanley wouldn’t be able to do. Not because we’re overly aggressive, but because we have a different risk view.”

MDM Financial, which also figures in the top 10 rouble bond players and has a $4bn balance sheet, agrees that lending is crucial in gaining capital markets business – through building long-term relationships with companies that fall below foreign banks’ radars.

“Foreign banks are not interested in funding the day-to-day needs of small to medium-sized firms or the emerging blue-chips in the regions,” says Andrey Dobrynin, director and head of international capital markets at MDM Bank. “Our niche is in the emerging blue chips that are in the first stages of development. We can nurture these companies and help them with their adoption of international practices. It is a very lucrative niche. There are about 250 of these sorts of companies across Russia – enough to keep us busy.”

Compliance barrier

Compliance – so much stricter in the post-Enron, post-Parmalat world – is clearly a key barrier to foreign banks’ penetration, but how long will it remain in place? Russian companies are becoming more transparent and adopting western accounting practices. As they conform to compliancy rules and grow in the blooming Russian economy, they will become targets for foreign banks’ coverage officers.

According to Sharon Thomas, president of Standard Bank in Russia, this is very much the case. The bank, which has 30 people on the ground, is also targeting new and second tier firms – albeit only in the natural resources sector. “We have long-term emerging market experience and are able to access products and structure deals that are particularly suitable for such markets,” she says. At Citigroup, Mr Fisher says that as Russian firms grow and become more sophisticated, the upcoming regional and high tier-two players will also have great potential for the bank.

Enough to share

It seems certain that competition will get increasingly tough for even the lower profile business. But Roland Nash, managing director and head of research at Renaissance Capital – a key player in Russia that happily sits somewhere between being a Russian firm with an international reach and an international firm with a focus on Russia – says the Russian market is big enough for everyone to share. And it is only going to get bigger – fast.

“The corporate rouble bond market was only the equivalent of $500m outstanding at the beginning of 2002. We estimate that it will probably reach about $10bn outstanding by the end of this year – and we are normally conservative so there is probably a bigger upside,” he says.

Equally, says Mr Nash, foreign banks are less inclined to cover the huge expanse that is Russia. “Even the largest Russian investment banks don’t yet have a Russia-wide franchise, so there is still plenty of scope for growth.”

Of course, many domestic banks are also positioning themselves to secure a large chunk of emerging business lines, such as asset management and other consumer products. MDM, for example, now has $300m in assets under management and has already established a car loan programme. Rosbank is targeting such areas and has $170m under management in its asset management group – growing at 20% a month, says Mr Aliev – in a mix of pension funds and other institutional contributions. Separately, Rosbank manages about $410m of high net worth money in its VIP-banking division. With pension reform underway and the mortgage market yet to emerge, there is massive potential in a country of 144 million people.

Consumer potential

“Rouble wages are rising by about 15% a year and the country is still massively under leveraged. The average debt per household is less than $20, compared to $20,000 in the US,” says Mr Nash. “Consumption is booming. There is a clear growth path for anything related to consumer demand.” Acting on its own forecast, Renaissance launched its own consumer credit product earlier this year.

So, on the consumer side, too, Russian banks face stiff competition from the likes of Citigroup’s retail and wealth management offerings, and the serious inroads being made by strong European players such as Raffeissen Bank and Société Générale.

With Russian banks having to compete so aggressively for domestic business, will we ever see a Russian investment bank playing a major role in the region? Like most Russian bankers, on this point Rosbank’s Mr Aliev is cautious. “Not for the foreseeable future. For example, we are the only Russian bank with a private banking presence in Switzerland. But what we can do is increase our domestic strength in retail operations and elsewhere.”

That said, Mr Aliev believes that Russian banks are increasingly giving foreign investment banks a run for their money in Russia. “With our research and brokerage capabilities, Rosbank can compete head to head with any Western firm when it comes to winning Russian business.”

Stephen Jennings, CEO of Renaissance Capital, agrees that Russian banks are “upping the ante”. He says that many talented Russians were hired by international banks several years ago and that their skills are now being “recycled” back into Russian firms. It has just hired Oleg Jelzko from CSFB to head up its new equity finance and structured product division, announced last month. “Russian banks are prepared to pay for the skills and many of the bankers want to be at a house that is really serious about this market.”

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