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Central & eastern EuropeSeptember 1 2017

Adapting to the ‘new normal’ in Russian banking

As the Russian economy recovers, the new equilibrium brings fresh challenges to the financial sector. Stefanie Linhardt finds out how the management at many of the country's leading banks are adapting to this environment at the International Financial Congress in St Petersburg.
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Bank of Russia

Russia’s economy is set to recover in 2017 – but the new state of affairs brings new challenges for the banking sector. After two years of recession, the Russian government and international organisations are forecasting a mild increase in gross domestic product for the year.

The International Monetary Fund (IMF) expects 1.4% growth in the country in 2017, putting the economy back to pre-2013 levels at constant prices. Economic growth is estimated to remain slow, with rates at similar levels going forward, but this still is a welcome change.

An improvement in economic indicators and stabilisation in the exchange rate have allowed the central bank, the Bank of Russia, to lower interest rates from a record high 17% at the end of 2014 to 9% in June 2017 in line with falling inflation.

Tough environment

Yet this means that, uniquely for the country, Russian banks must adapt to a 'new normal' of low inflation (3.9% in July 2017 compared with nearly 17% in March 2015, according to data from the Organisation for Economic Co-operation and Development [OECD]) and falling interest rates. While lending is expected to see a boost from lower rates, banks will likely be faced with stronger competition for deposits and, through that, higher funding costs at a time when Western sanctions imposed upon large parts of the Russian economy have still not been lifted.

At the 26th International Financial Congress in St Petersburg, president and chairman of VTB 24 Mikhail Zadornov said that, historically, Russians invested their money in two kinds of investment: deposits and real estate.

The money invested in deposits will be flowing into other instruments as interest rates go down, said Evgeny Dankevich, chairman of the management board of Otkritie Financial Corporation Bank. This will especially apply to the more affluent individuals, who thanks to the high interest rates have in the past often kept their wealth in deposits. And with fewer deposits bolstering banks’ capitalisation going forward, regulatory requirements, which are already under fire by some, will look even more costly in the future.

Andrey Kostin, president and chairman of the managing board at VTB Bank, said during an International Financial Congress panel discussion that in the current climate, with 16 Russian banks under sanctions, the implementation of Basel III should be reconsidered, as banks cannot borrow on the international market.

“Where can we get [additional capital] from? It is only from the profits,” he said, adding that because Basel III was initially drafted for Western banks, some of its requirements make it more costly for banks in Russia. “We calculated the price of Basel III [for VTB and it] is Rbs14bn ($236m) from our profits,” said Mr Kostin.

The bank is cooperating and obliging with this, he said, but appealed for some reconsideration, adding: “We as a bank do not see anything positive in fulfilling Basel III requirements.”

And these high costs come at a time when profits among Russia’s banks are only just returning.

The profitability challenge

Russian banks have struggled to be profitable since the country's economic crisis in 2014 and 2015, which put pressure on the oil price and Russian rouble. Year-end 2016 figures for Russia’s 16 largest banks by capitalisation have shown show a 369% increase in profits to post a total $14.65bn equivalent, according to data from The Banker’s Top 1000 World Banks 2017 ranking.

And while banking sector profits in the first half of 2017 have improved further to “double that of the first half of 2016”, according to Ms Nabiullina, profitability is bound to come under increasing strain going forward, according to senior management across leading Russian banks.

At the International Financial Congress, Herman Gref, chief executive officer and chairman of the executive board at Sberbank, said that banks’ return on equity (ROE) is “under pressure”, adding that in Russia the margin is going to shrink because of factors such as “competition, lower inflation and regulatory aspects”.

Sergey Monin, chairman of the board at Raiffeisenbank in Russia, said that at non-risk rates of 9%, the cost of capital and the profitability of capital should be about 20% for the banks “to attract capital to be able to develop”. He added that while it is easy to attract capital when a business posts high ROE, “if there is no high ROE, those companies will have to undergo quite a substantial transformation. And in my opinion, the Russian banking community is not under transformation.”

A need for transformation

In a quest to remain profitable, difficulties are emerging, especially for Russia’s small and medium-sized banks, in an already competitive market. Thus, the central bank is urging small and medium-sized institutions to focus their operations to support the stability and viability across all Russian banks.

Dmitry Tulin, first deputy governor at Bank of Russia, said at the International Financial Congress that there was a need for “an asymmetric approach for smaller banks”, allowing them to “limit themselves to rather simple transactions” and giving them “some breaks and benefits”.

“Smaller banks should help small and medium-sized enterprises [SMEs] and the population because this country is quite diverse and our economy is very fragmented,” he said, adding that there needs to be “a proper environment” to ensure lenders “comply with the conditions of competition”.

In Russia, lending to SMEs is supported through government loan guarantees and subsidised interest rates, according to a SME financing report by the OECD. To further spur economic growth, the Russian financial sector also benefits from a reduced provisioning for SME loans, according to Rolf Behrndt, practice manager for the International Finance Corporation and International Bank for Reconstruction and Development’s joint global finance and markets practice.

“It is high time for banks to specialise,” Ekaterina Trofimova, chief executive at Analytical Credit Rating Agency (ACRA) said, adding that for banks it is necessary to be aware of their strengths and weaknesses. “What is going to be a factor of growth tomorrow? Adaptability and capability to change. Being too universal is a wrong choice,” she added.

All about capital

Yet Russia’s banking sector also needs to adapt to current and future challenges, especially in the context of its capitalisation. During the 2016 financial year, the number of Russian banks in the world’s 1000 largest by capitalisation increased from 11 to 16, with 13 of these institutions’ capital growth outstripping the rouble’s gains over the same period.

Still, during a panel discussion on banking for growth, ACRA’s Ms Trofimova warned that the Russian banking sector still remains undercapitalised, and she classified one-third of all Russian banks as “weak or critical”.

Russia’s central bank governor, Ms Nabiullina, is familiar with the issues of weak players among the country’s financial institutions. “Over the past four years we have already reduced the overall number of banks by one-third,” she told The Banker. “There definitely still are some unsustainable, weak banks in the market.”

Consolidation funds

A key way to support the resolution and turnaround of failing banks has been the Russian central bank’s so-called sanation scheme, which allowed the central bank to provide a loan on beneficial terms to a company taking charge of the rehabilitation and resolution of a failing bank. The business was then able to benefit from the difference of the rate to gradually increase the capital of the bank that was being rehabilitated.

“A major drawback of this procedure was how long the recapitalisation process took,” says Ms Nabiullina. “An undercapitalised bank would stay in the market for more than 10 years; the mechanism was quite costly for the regulator and its application was not always transparent.”

The answer is a new process of bank resolution: the consolidation fund, managed by the central bank.

“We haven’t yet applied it in practice. We are prepared, administratively and legally, but we haven't had the need for it yet,” says Ms Nabiullina. She adds that the fund would be able to “consolidate the assets of a number of banks should they be in distress and should they require intervention by the fund” and would allow the central bank to return fewer, larger and more resilient banks to the market.

“The major advantage is that the [rehabilitated] bank can return to the market with sufficient capital at once – and this is obviously cheaper for the central bank,” she adds.

Tech game changer?

The Russian central bank is gradually introducing higher capital requirements across the banking sector with a phased implementation of the Basel III rules, despite some complaints from market participants. But is the game changer not actually digitalisation, and how technologically advanced a bank is?

Oleg Tinkov, chairman of the board of directors at Tinkoff Bank and an International Financial Congress speaker, thought so, as he announced that Tinkoff had been recognised as the most profitable bank by return on assets in central and eastern Europe in 2016 by The Banker’s Top 1000 ranking.

Tinkoff has found its niche. Having started off as a credit card loan bank, it transformed itself into a serious contender for banking services, thanks to its low-cost branchless model and hi-tech strategy – and its founder, Mr Tinkov, has ambitious plans. “We believe in the internet,” he said. “In 10 years’ time we will be number three in the retail sector [in Russia] after Sberbank and VTB – it would be strange if that [didn't] happen.”

He added that when online retailer Amazon started out in the US and was seeking to meet with Walmart’s executive team, it was hard for Amazon to get an audience; within a few years, Amazon could buy out Walmart. “So the question is whether this kind of miracle is possible in [banking in] Russia,” he said.

But despite challenges all round, others will surely want a say in that matter, too.

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