Although there are positive trends in many areas of banking there is the threat of a very serious problem, which could negate progress. This is the extremely low level of capitalisation, which significantly restricts further opportunities for the banking business. The capital of each of the top 10 worldwide banks exceeds the total capital of the Russian banking sector.
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 Russian banks are increasing their equity too slowly. From 2007 every bank must have capital of no less than €5m but currently only 40% (500 of the 1300 Russian banks) hit this target. Capital concentration in the banking sector is such that the top five banks account for 35% of the total banking capital, the top 20 banks account for half of the total and a quarter of Russian banks (about 330) account for almost 90% of the total capital.
If asset growth continues to outpace the growth of capitalisation, the banking sector may face a tough problem in the near future – that of capital inadequacy. Banking capital grows very slowly (see figure 4) – its proportion to GDP and to banking assets even declined in 2004.
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As a result, the capital adequacy ratio has floated at a very low level for the past few years. This problem is especially vital for the largest banks since their equity already balances on the edge of the minimum capital adequacy level of 10% set by the central bank.
Nevertheless, this year the central bank took further steps towards tightening capital adequacy requirements. Currently, it has to take measures to improve a bank’s financial position if its capital adequacy ratio falls below 10%, revoking its banking licence if the ratio sinks below 2%. Now, the central bank proposes to revoke licences when the adequacy ratio falls to 10%. This requirement, if approved, will be stricter than the Basel Committee’s recommendation of 8%. It will also reduce the banking sector’s competitiveness and suppress its opportunities for rapid growth of capitalisation. Such innovation would restrain lending, resulting in a decline in profitability, shareholder return and profit reinvestment opportunities. Russian banks would become much less attractive to foreign investors.
Taxing concerns
Frankly speaking, the banks face a shortage of realistic alternatives to raise their equity. Reinvestment of retained profits remains the principal source. Retained earnings account for 11% of the banks’ total equity so their main efforts should be focused on increasing banking capital return. But this way banks may face a number of problems. High taxation remains an important issue. Although the tax on profits has decreased significantly since 2002 – from 43% to 24% – it is still considered high due to the additional taxation of selected banking transactions. There is also double taxation of profits used for capital investments, in the form of profit tax and dividend income tax, which also limits the growth of banks’ capitalisation.
One way to resolve the problem of low profitability is to cut excessive bank expenditure. For instance, Russian banks are obliged to submit about 4000 reports a year to the central bank. Besides that, extra reports are prepared for other governmental bodies. Although the central bank plans to complete the transition to electronic submission of financial reports, it will hardly help to mitigate the substantial tangible and human expenses. Moreover, starting from this year, banks will have additional expenditure relating to IFRS reporting and Retail Deposit Insurance System reporting. The frequency of some reporting has also increased. Other expenses remain high as well, although the authorities are promising to simplify and lower the cost of branch establishment and registration procedures, abolish state duty for branch establishment, and simplify the requirements on the protection and equipment of banking premises.
Another source of increasing a bank’s capital is subordinated deposits. But here the banks also face some problems. One is the regular decrease of the amount of deposits that qualify as equity due to the necessity of their monthly amortisation as defined by the CBR’s regulations. For example, a five-year subordinated deposit will qualify as equity in one year’s time at only 80% of its size.
Finding a strategic investor to purchase a shareholding in a bank is another way to raise capital. However, in practice, there have been few successful deals. It appears that current owners and shareholders are not ready to dilute their holding and lose their control over the banks. Moreover, Russian practice shows that conflicts of interest are highly likely in the cases when new participants arrive.
If the existing problems deter Russian investors and they are not attracted by the poor profitability in the banking sector compared with other sectors of the economy, will foreign investors feel the same? Unfortunately, figures show that in the past five years, the share of foreign capital in the Russian banking sector has shrunk from 10.7% to 6.2%.
Foreign capital
The government believes foreign capital is important for banking development in Russia because it may introduce modern technologies and new financial products to the market, increase the level of corporate governance, promote competition among credit institutions and improve the banking business as a whole. To increase the confidence of the Russian banking sector’s foreign partners, the government plans to improve legislation that protects investors’ rights; raise the quality of corporate governance; create conditions for mitigation of non-commercial risks; secure free profit repatriation; and ensure effective implementation of IFRS principles. It also plans to simplify the procedure and conditions for the formation of share capital by foreign investors that would make it similar to the common procedure applicable for domestic banks.
However, keeping in mind the need to maintain equal competitive conditions for all credit institutions operating in the banking market, the government is still not ready to permit foreign banks to open branches in Russia.
Another way to increase capital is through an initial public offering. Some larger banks have investigated this possibility but none, apart from Sberbank, has yet achieved such a deal. This may be due to the necessity of substantial reorganisation of the business structure and management system and the achievement of maximum transparency. With shares freely trading in the market, the management would also need to manage thoroughly any risks arising from market volatility.
The simplification of merger and acquisition procedures is also on the central bank’s ‘to do’ list and will help in capital concentration and the expansion of operating activities. However, it is clear that consolidation of the banking sector and concentration of capital do not automatically result in growth of the total banking capital. Only if one of the merging banks has a large capital adequacy will the united institution have the possibility to expand its business.
There are still grounds for optimism about the Russian banking sector’s prospects. Government forecasts predict that by the end of 2008 the sector will achieve the following results: assets/GDP – 56%-60%; capita/GDP – 7%-8%; loans to non-financial sector/GDP – 26%-28%, with the largest banks maintaining the fastest growth rates. In 2001, there were 12 on The Banker’s Top 1000 list of world banks; by 2003 this had risen to 21.
Alexander I. Sobol is deputy chairman of the management board of Gazprombank
