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The middle way

Reform is altering Russia’s banking landscape and, by leveraging innovation, entrepreneurship and product development capability, Russia’s mid-sized banks appear well-armed to profit from change.
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The 30 or so mid-sized institutions that comprise Russia’s second-tier of homegrown universal banks are well practiced at beating the odds. They are over-shadowed by state-owned giants that can raise capital at preferential rates and are largely unable to break the hammerlock that their Western counterparts hold on the country’s largest capital-hungry corporates. However, not only have they separated themselves from a crowded field, most have emerged from the turmoil of the 1990s to occupy important – and profitable – positions among leading agents of wealth transfer in the country’s crude-driven economic renaissance.

To be sure, these banks do have concerns that go well beyond heady sector competition and the threat of yet another potentially bank-breaking currency crisis of the type that hit the sector in June and July. Constrained by higher capital costs, their balance sheets burdened by short-term liabilities, and coping with the demands of an increasingly price-sensitive corporate client base, Russia’s medium-sized banks have, of late, also been forced to manage skyrocketing growth.

“Our assets have doubled in the last year,” says Maxim Druzhinin, the chairman and CEO of Moscow-based ConversBank, which has seen the value of its balance sheet rise to $500m. “But it causes some difficulty because our liabilities are really quite short and there is considerable volatility in current accounts. We’ve seen some turmoil in the sector over the last year, so we are in the process of consolidating those accounts to relieve some of the pressure they are putting on the balance sheet.”

Challenging environment

While many bankers would agree that it is a nice problem to have, the reality is that the environment for medium-sized banks promises only to become more challenging. The introduction of a government-backed deposit insurance scheme, aimed at restoring consumer confidence in the banking system, has increased their customer numbers. The share of accounts held by state-owned Sberbank, by far the market’s largest, has declined by some 10 percentage points – to around 61% – in just six weeks.

As many smaller banks are being left out, the scheme also should reduce the number of banks in the market from the current 1200. Still, the consolidation process could be a drawn out one. Legal impediments make mergers and acquisitions a resources-sapping process. And the banks that succeed in creating critical mass will be quick to press their advantage, forcing margins down as they do.

Meanwhile, until reforms are extended to create true term deposits, the balance sheets of universal banks will remain over-burdened by short-term liabilities. With currency stability leading more of their corporate clients to demand cheaper long-term capital, banks will face increased costs or risk – and probably both – to keep them in the fold.

“The liquidity gap is a problem because banks lack the sources of long-term funding that would allow them to lend at longer terms,” says Andrew Keeley, a bank analyst at Moscow-based Renaissance Capital. “Banks already are being squeezed on the commercial side – and that is going to increase as they consolidate.”

Mortgage reforms

Mortgage market reforms that take effect this year should begin providing balance sheet ballast at some point in the future. And though it will be welcome, the fact remains that medium-sized banks still must pay higher prices than their state-backed and Western competitors – and even some customers – for extending the maturities of their own capital raisings. Though spreads are narrowing in the sector, the higher costs will continue to impede both balance sheet restructuring and profitability.

“Of course, we face something of a disadvantage because our borrowing costs are higher than banks with a state guarantee,” says Alexander Popov, chairman of Rosbank, which has lowered its funding costs and extended its liabilities five years through issuance on international loan and bond markets. “That means we must use the capital we raise more efficiently. Our competitive advantage comes from knowing our customers and knowing how to provide them with banking solutions that meets their needs. It is not only about price.”

Which way to turn?

Hemmed in from above by state-owned and Western giants, constrained at the roots by funding costs and bounded on all sides by like-minded competitors, mid-sized banks in Russia face critical choices about how to extend their reach.

Fortunately, the lessons learned in the tumult of the1990s about the value of diversification are serving medium-sized banks well in the current era of prosperity.

Unlike their larger competitors, mid-size banks are demonstrating that they can adapt more quickly to market shifts and the needs of customers. And by pioneering new segments and business lines, increasing the emphasis on customer service and developing new products, they are aiding sector development as they work to safeguard their franchises.

“We are trying to be more diversified,” says ConversBank’s Mr Druzhinin, explaining that the bank is building asset management and brokerage capability in a bid to attract high net-worth individuals, while at the same time increasing its focus on under-served small and medium-sized corporates. “Because we do not possess a large branch network, and because of the investment it would take to build one, it doesn’t really make sense to go in this direction. Our strategy is based on playing to our strengths.”

The focus on leveraging core competencies – in this case, trade finance and lending to a stable to credit-worthy corporates – is much the same. According to Yuri Lekarev of Nomos Bank, who works on the bank’s capital raising exercises, management has determined that the risks of expanding into new business lines outweigh the rewards, however tempting they may be.

“Deposit insurance is a positive step, but there is much left to be desired,” he says. “The central bank appears on the one hand to want to retain control of the banking system and on the other to liberalise it. As a result, legislation in the retail sector is still pretty weak. As we saw this summer, banks still bear the risk that when one gets squeezed, panic spreads through the system. So there is no provision for term deposits, the new rules only solve half of the problem.”

Mortgages: under construction 

With financial reform aimed at Russia’s housing sector beginning in earnest this month, bankers anticipate the wide-ranging changes to broaden the appeal of mortgages and the instruments that fund them

After 10 months and more than two dozen bills and amendments since the government made raising the country’s paltry level of private homeownership a lead priority, Russian bankers are gearing up for a wave of new securities issuance. It is anticipated that this will underpin an upward spike in mortgage lending as reforms take hold.

A push is on across the banking sector to create and capture mortgage flows and to sell them on to investors. Credit specialists stand to grow their portfolios and will need to raise capital to keep pace with demand and specialist investment banks will make secondary markets in the securities they and others originate; universal banks span those activities.

“Even though the market has roughly doubled in size each year since the concept of mortgage lending was formalised in 2001, the level of borrowing still accounts for only a minuscule fraction of the Russian economy,” says Svetana Aslanova, a senior corporate analyst at Moscow Narodny Bank who watches the market. “Reform of the mortgage market will create plenty of opportunity not only for lenders, but also in the area of refinancing those mortgage portfolios.”

While around $1bn of mortgages have been issued in Russia over the last four years, professionals and analysts agree that there is considerable room for growth. The figure is equivalent to just 0.2% of Russian GDP. But the International Finance Corporation, the private-sector lending arm of the World Bank, estimates that removing the impediments to mortgage lending – such as inadequate protection for lenders and borrowers and builders that tend to keep the supply of new stock both low and expensive – could lift that figure to as much as $30bn over the medium term.

Bolstered by UN estimates that show commercialisation of a country’s housing market can boost real GDP by as much as 25%, the Kremlin announced in May that it intends to raise homeownership rates to one-third of Russian citizens by 2010. In response, the Duma upped the pace of housing market reform and produced a raft of new legislation, much of which takes effect in March.

In addition to laying out the rights of lenders, borrowers and builders, the new codes also create tax and monetary incentives for borrowers and buyers and speed up the cumbersome approvals processes for new projects that has tended to keep prices for new homes high. The codes also simplify the restrictive legal framework for the issuance of non-government guaranteed mortgage-backed securities.

“Things are moving in the right direction,” says Alexander Popov, the chairman at Rosbank, a leading underwriter of domestic debt issuance that also has securitised its own credit card receivables in international markets. “Whether it takes place this year or next, there will be substantial growth and substantial opportunity, not only for ourselves but for many Russian banks.”

The federal and state housing authorities, that dominate the market, and private-sector specialist lenders already have issued bonds and sold portfolios. However, the number and volume of mortgage-related instruments on the Russian market reflects both the relative infancy of mortgage lending and the low uptake by borrowers. It is also an indication of the legal impediments to issuance that the new codes are intended to ease. The government has promised to reduce the value of guarantees on issues by the state Agency for Housing Mortgage Lending (the institution created in 2001 to purchase the loan portfolios of banks and regional housing authorities and by far the largest issuer of mortgage-backed bonds) in a move that should stimulate development of a competitive secondary market.

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Read more about:  Central & Eastern Europe , Russia