When the Central Bank of Russia (CBR) revoked the banking licence for International Industrial Bank (IIB), also known as Mezhprombank, on October 4, 2010, it ended a three-month battle to save Russia's ninth largest bank by Tier 1 capital.
IIB is the largest Russian bank to fail since the aftermath of the 1998 Russian financial crisis, and leaves behind two Eurobond issues totalling $400m, unsecured loans from the CBR worth Rbs32bn ($1bn), and several blue-chip companies trying to recover their deposits from the bank.
On the surface, IIB was a highly successful institution, which recorded a return on assets of more than 6% in 2009 - the highest among Russia's top 10 banks. It also appeared a relatively safe institution, with Tier 1 capital at more than 30% of assets, giving it the highest capital adequacy ratio among the top 10.
However, the headline numbers do not tell the whole story. IIB was what Russians call a 'pocket bank', oriented towards lending to parties related to its principal shareholder, in this case Sergey Pugachev. The owner of at least 70% of the bank, Mr Pugachev is a senator for the southern Siberian Tyva region and is also the majority shareholder of United Industrial Group (OPK), which has interests including ship-building, aeronautics, mining and infrastructure development.
The bank appeared relatively open about its activities. Its 2008 annual report disclosed related-party lending of about 9% of total loans, equivalent to 36% of its Tier 1 capital. But events in 2010 suggest that the raw numbers understated the risks. In the first nine months of 2010, interest arrears on IIB's loan books jumped from Rbs500m to Rbs15bn.
"This is close to the whole interest income due to the bank for the period, meaning that there was almost no cash interest payment on its loan book. This is evidence that almost the whole loan book had become non-performing," says Elena Redko, a credit analyst who covered IIB for ratings agency Moody's.
The correlation in the loan book was therefore much higher than the 9% of the book disclosed as related-party lending would have implied, and Ms Redko says Russian audit reports can be relatively opaque in their classification of borrower categories. The largest category in the loan book (22% in 2008) was simply marked as lending to "trading companies". The definition of this category in Russia is rather elastic, and could include the financing of resources and industrial companies indirectly through their trading arms.
The surge in impaired loans also calls into question the bank's high capitalisation. The constrained cash flow of the bank's majority owner meant that its capital was not strictly capable of absorbing losses - and even less capable of being replenished afterward.
Funding squeeze
In addition to loan concentration, the concentrated nature of IIB's funding base became clear during 2010. The bank was highly leveraged, with the loan-to-deposit ratio rising to 181% in 2009, from 162% the previous year, and it became dependent on the unsecured lending extended by the CBR in the wake of the global financial crisis in October 2008.
The bank's problems accelerated in May 2010, when a Russian appeal court rejected IIB's attempt to overturn a January 2010 judgment ordering it to pay $66.5m to oil company Bashneft, in a dispute over alleged unpaid interest on an investment trust managed by IIB for Bashneft.
Bashneft obtained an injunction on IIB's accounts with the CBR, which prevented the CBR from rolling over or renegotiating its own Rbs32bn unsecured lending to IIB. The judgment and the credit rating downgrades that followed apparently triggered a run on the bank's almost exclusively corporate deposit base, draining about a quarter of IIB's deposits in the space of a few weeks, according to one banker.
OPK attempted to provide liquidity for IIB by selling its naval shipyards Severnaya Verf and Baltiysky Zavod to the state-owned United Shipbuilding Corporation. However, bankers familiar with the attempted deal say it foundered because the government valued the yards at $1bn, whereas Mr Pugachev was seeking about $3bn. As a result, the bank had no means to free up cash to repay a $200m Eurobond maturing in July 2010.
The bank, advised by Credit Suisse, negotiated a one-year maturity extension on the Eurobond, in return for a consent fee and higher interest rate, as well as granting extra security. For this security, a ring-fenced vehicle was created in the British Virgin Islands into which the proceeds of any sale of the two shipyards would be placed, with the Eurobond holders having first claim on the funds.
However, large corporate depositors continued trying to withdraw their money. Aircraft manufacturer Sukhoi launched a suit to recover $20m, which it won in early November 2010. And steel giant Severstal filed a claim to recover a $62m deposit. In September, it appeared that Severstal hoped to keep the bank viable, teaming up with Russia's second largest bank, VTB, to offer a refinancing package for IIB. But "VTB and Mezhprombank did not reach agreement on the terms of credit", according to a spokesman for VTB.
Wider implications
The Eurobond restructuring in July and failure of IIB in October did not significantly affect Russian financial markets, as the bank's narrow client base meant it was not systemically important, despite its size. A banker familiar with the restructuring talks says bondholders were mostly represented by private bankers, indicating that those exposed to IIB bonds were wealthy individuals rather than other institutions.
Gennady Melikyan, the first deputy chairman of the CBR responsible for bank regulation, emphasised the distinctive nature of IIB in an interview with Russian news agency RIA-Novosti in November 2010, pointing out that it had never joined the country's deposit guarantee system. Nonetheless, the episode has implications for the 'pocket bank' model that is widespread in Russian banking.
The CBR raised the minimum capital requirement for Russian banks to Rbs90m in late 2009, and since then about 120 banks have been closed as a result. But Maxim Raskosnov, credit analyst at VTB Capital in Moscow, emphasises that hitting smaller banks will not solve the 'pocket bank' problem.
"There are a lot of smaller banks in the regions that are involved with many local small and medium-sized enterprises. They have limited asset concentration and actually had fewer problems after the 2008 financial crisis than some of the larger banks. On the other hand, IIB was a very large bank," says Mr Raskosnov.
In fact, most of the privately owned banks among the top 50 or so in Russia are closely held by small groups of individuals who also have extensive industrial interests. This could expose them to the risk of excessive asset and funding concentration - but not necessarily. Some banks provide a high degree of disclosure about any related-party lending, including Alfa Bank, Promsvyazbank and Bank Petrocommerce. The information they provide also shows that they have lowered related-party lending significantly in recent years.
Germany's Commerzbank and the European Bank for Reconstruction and Development both have sizable minority stakes in Promsvyazbank, which should provide further assurance on corporate governance. In addition, the related parties for Alfa and Petrocommerce include two of Russia's largest oil companies (TNK-BP and Lukoil, respectively), which generate massive cash flows and therefore pose limited credit risk.
For other closely held banks, information is sparser, but headline financial figures offer some indication of their business model. The charts (right) show available data for closely held banks among Russia's top 50 whose shareholders also have significant non-bank interests. Very high loan-to-deposit ratios can raise funding risks and might indicate a heavily leveraged client base. These risks can be mitigated if a significant proportion of a bank's lending is on the interbank market - as is the case for banks such as EvroFinance Mosnarbank and BIN Bank. Interbank loans typically have very short maturities, minimising the liquidity risk for the lender.
Recovery prospects
From July to September, the CBR seemed to give IIB room to achieve a commercially based restructuring to stay viable. But the CBR press release announcing the licence revocation cited "substantial misreporting of data" by the bank. Mr Melikyan's subsequent statements have become more critical of IIB's former management, including an allegation that the bank "used a lending scheme that allowed it to bypass the established requirements for limiting risk concentration". When contacted by The Banker, the former management of IIB declined to comment for this article.
The Russian authorities had opportunities to save IIB - either by moving closer to Mr Pugachev's asking price for his shipyard assets, or by instructing VTB (85.5% state-owned) to take a softer stance in its negotiations to refinance IIB. That they did not suggests that IIB may have been used as an example to other closely held banks to tighten their governance.
The real test of official intentions will be how the CBR handles the recovery process for IIB's creditors. Mr Melikyan has said that he expects the value of the bank's assets to outweigh its liabilities. However, both Mr Raskosnov and Ms Redko express concerns about the potential for recoveries through purely commercial channels.
The central bank has apparently taken the two OPK shipyards as collateral for its previously unsecured Rbs32bn loans, which values them in line with the government's $1bn June 2010 offer to OPK (coincidentally or otherwise). This effectively invalidates the British Virgin Islands security vehicle set up for holders of the restructured 2011 Eurobond.
According to Ms Redko, as much as 85% of IIB's loan book was not collateralised and in view of this, plus the high proportion of non-performing loans, Moody's now anticipates recoveries of less than 50% for the bank's commercial creditors. Mr Raskosnov warns that if the ownership structure of the assets resembles that of IIB itself - which was owned via an offshore trust in New Zealand - a commercial recovery process would be long and costly. This concern is reinforced by Mr Melikyan's comments to RIA-Novosti: "Of all the bank's bad loans, less than 6% can be attributed to credit for the real sector of the economy."
Presumably, these characteristics should in future act as warning flags for regulators, auditors and ratings agencies alike with regard to other banks.
One banker says that the strongest signal on corporate governance and creditors' rights in Russia would be for the CBR to bring criminal proceedings to recover assets directly from related parties rather than via the bank. Russian banking law allows shareholders and the management and supervisory boards of a bankrupt bank to be held personally and criminally liable if the bank is proven to have been deliberately mismanaged. Mr Melikyan has said that the CBR is in contact with the Russian federal prosecutors' office to investigate whether there is a case to answer.
