Hit by global and domestic crises, Russia's banks have also suffered mismanagement, leading to massive bailouts. The system appears to be recovering, albeit under greater state control. Andrew MacDowall reports.

VTB Flag

Three multi-billion-dollar bank bailouts in just five months in 2017 seemed to spell a renewed crisis for the Russian financial system. The central bank stepped in with huge sums to save first Otkritie, then B&N Bank, then Promsvyazbank (PSB) – all privately owned lenders.

Nearly a year on, the Central Bank of Russia (CBR) has had to commit further funds to the banks, but the sector as a whole has pulled through thus far largely unscathed. After extensive restructuring, two new healthy banks are expected to emerge, while the CBR has pledged to crack down on 'banksters'. Following a tough recession, business is picking up again, with consumer and mortgage lending racking up double-digit growth in the first half of 2018, and the stronger banks riding a wave of technological development.

Nonetheless, Russia is left with an even more state-dominated banking industry, and the crises highlighted issues of related-party lending, fraudulent accounting and political influence in the private banking sector.

A long time coming

The crises at private banks date back a decade to the global financial crisis. Prior to this, private banks had enjoyed bumper growth on the back of enthusiastic lending. Partly because state banks tended to attract better quality clients, private counterparts increasingly pushed towards riskier segments to sustain growth. This was unsustainable following the crisis, and many banks started to falter.

The problems were exacerbated by the second – domestic – crisis, which began in 2014 with the Russian annexation of Crimea and incursions into Ukraine, and led to US and European sanctions. At the same time, the fall in the global oil price put mounting pressure on the economy, due to the country’s dependence on hydrocarbons as a contributor to gross domestic product, state finances and export earnings. The combination of sanctions and the falling oil price contributed to a sharp drop in the rouble, and overall investor confidence in Russia plunged.

While smaller banks struggled, some bigger players saw the crisis as an opportunity to build up their asset base through taking over their troubled rivals via the 'financial rehabilitation programme'. Under this scheme, banks could acquire stricken counterparts – and save them from bankruptcy – financed through cheap long-term loans from the central bank.

All three of the bailed-out banks had participated in the programme as investors – and all three poorly managed the process, says CBR deputy governor Vasily Pozdyshev. In some cases, according to Mr Pozdyshev, the CBR funds were used by the three for purposes other than those intended, while toxic assets were shifted to the banks undergoing the rehabilitation process in order to hide financial difficulties faced by the investors.

Cash machines

While Otkritie acquired more than 10 banks in a post-crisis buying spree, its 'rescue' of mid-sized lender Trust Bank in late 2014 was particularly troublesome. The bank originally received Rbs30bn ($456m) from the CBR to acquire Trust, but within days this spiralled to Rbs127bn as the extent of the latter’s problems became clear. Trust’s advertising campaign had featured actor Bruce Willis and the slogan 'When I need money, I just take it!', which came to seem like a bleakly appropriate motto for parts of the Russian banking system.

Also in 2014, B&N took over struggling Rost Bank, while PSB led the rescue of Avtovazbank. B&N’s questionable deals with Rost led to non-recoverable interbank loans totalling 63% of the former’s assets before provisions.

The three banks had other questionable business practices. Drawing in deposits through high interest rates, they all then doled out cash to companies linked to their owners.

“The owners of these D-SIBs [domestic systemically important banks] used their banks as a source of personal funding, including regular financing of their other non-banking businesses,” says Mr Pozdyshev. “The real number of such ‘side’ businesses and projects was much higher than what the regulation allowed, but for a while they were concealed by complex financial and legal schemes. The ‘side’ non-banking businesses and investment projects of the three banks’ owners were highly overleveraged.”

Lacking liquid assets, the banks’ owners were unable to service their debts, while trying to hide these problems and dodge requirements to provision their liabilities and replenish their capital shortfall. Separately, Otkritie secretly amassed a stake of nearly 20% in VTB, Russia’s second largest bank, becoming the second biggest shareholder after the government. The purchases, through a range of Otkritie subsidiaries, seemed designed as a 'short squeeze' to push out short-sellers, and raised eyebrows, given that VTB had a 10% stake in Otkritie’s parent company – written off when the bank was nationalised.

VTB said claims of “problematic links” between VTB and Otkritie were “unsubstantiated”, adding that it took the stake in Otkritie Holding as part of a pledge on a debt transaction with third parties. “As a minority shareholder of Otkritie Holding, we had no information about the company’s operations and learned about the issues related to Otkritie from public sources together with the rest of the market,” the banks stated.

Otkritie controversy

Otkritie was also involved in controversial repo funding involving Russian sovereign bonds – the bank acquired nearly three-quarters of a 2030 Eurobond issue and, according to the CBR, manipulated prices – and helping state-owned energy company Rosneft service dollar debt.

Taking over the operational management of the three banks, the CBR deployed a range of measures to prevent collapse, including bail-in, bail-out, liquidation, transfer of assets and liabilities and liquidity support. Large liquidity packages were extended to prevent bank runs, and the personal accounts and other assets of previous management and shareholders were written off at a cost of €500m. After previous shareholders’ stakes were reduced to a single rouble in each bank, the banks issued new shares, acquired by the CBR.

These measures have come at some cost to the central bank. In late June, the CBR announced it would spend an extra Rs127bn recapitalising the three banks. This meant the total cost of saving the banks surpassed the Rs2600bn initially estimated as the cost of letting the three institutions fail.

The bailouts have shone a spotlight on some of the more nefarious and risky activities that have taken place in the Russian banking sector since 2008, from the deployment of banks as pseudo hedge funds to stock and bond price manipulation, associated business lending, and the use of creative accounting to hide losses. This has led to some criticism of the central bank, particularly given its role in financial rehabilitation, and its failure to spot the inflation of asset prices.

Andrey Movchan, a senior fellow at the Carnegie Centre in Moscow, writing in the Financial Times in January, called for the establishment of a separate regulatory authority, saying that the “unscrupulous and ineffective” sector as a whole “must be rebuilt from the ground up”. Mr Movchan sees the failure of Otkritie, B&N and PSB not as isolated incidents but symptomatic of the system’s illegality, poor risk management and patchy regulation. The fact deposits are guaranteed up to $25,000 is regarded as reducing moral hazard, and encouraging unscrupulous banks to suck in savings with high rates.

“The main challenge is political connections and corruption, while another is lending to affiliated parties,” says one banker, who asked not to be named. “There was overconfidence before 2008 and now a lot of banks are sitting on non-performing assets. There are healthy and reasonably well-managed banks, which are reasonably conservative, but other parts of the system are rotten.”

CBR's show of strength

However, the CBR’s approach under governor Elvira Nabiullina, appointed in 2013, is generally well regarded in the sector. That same year, the CBR launched a clean-up of the sector designed to eliminate weak, fraudulent and corrupt banks, with 399 licences to date revoked, according to Mr Pozdyshev.

“The CBR has a reputation as a good and tough supervisor,” says Gunter Deuber, head of economics, fixed-income, and foreign exchange research at Raiffeisen Group International. “So the high-profile bailouts in 2017 definitely have left some question marks with regards to banking sector supervision. However, in the end the CBR handled all the bailouts in a highly professional and predictable way without any material market fallout. Therefore, on a net-net basis one could say that the CBR has handled the challenging situation very well.”

The CBR has also been praised for its proactive approach to the currency crisis, hiking rates to 17%, and introducing foreign exchange swaps to ease liquidity pressures.

Mr Pozdyshev himself is blunt in his assessment of the challenges that the central bank faces in tackling powerful “banksters”. “Banking supervision in Russia sometimes resembles the work of law enforcement authorities or a financial investigation unit,” he says. “Malicious owners of banks are secretly diverting deposits of the general public to fund their own assets, villas, yachts, private jets. The banksters we fight are experts in business conflicts, and they always have strong teams of lawyers, auditors, value appraisers, investment banks and so on.”

While in the wake of last year’s bail-outs there was intense speculation about whether further dominos would fall in the sector, Mr Pozdyshev is adamant that there will be no more bailouts on this scale, with the vast majority of troubled banks already under CBR supervision or liquidated. The central bank says it is undertaking a large-scale reform of the supervision framework, shifting towards proactive monitoring of banks. The CBR deputy governor is confident that within two or three years, “the Russian financial industry will be dominated by banks striving for development and expansion in the conditions of sound competition”.

What next?

Meanwhile, the restructuring of the three rescued banks continues. Trust Bank has been designated a bad bank, and in July Rost Bank (which is burdened with non-core and distressed assets) was merged into the former Otkritie subsidiary. Toxic assets from Otkritie and its other subsidiaries, as well as B&N, are being transferred to Trust, with the process due to be finalised by the end of 2018. PSB’s toxic assets were transferred to Avtovazbank , which will be merged into Trust in 2019, finally creating a 'distressed assets and private equity fund' (DA&PE) to optimise the value of recoverable assets. The CBR plans to sell or liquidate the DA&PE fund’s assets in three to five years. But Irina Nosova, associate director of the bank ratings group at Russian ratings agency ACRA, says the estimated recovery rate of 40% to 60% of assets may be optimistic.

The central bank hopes that hiving off bad assets will give the remaining businesses a boost. Otkritie and B&N are due to be merged in January, creating the sixth largest bank on the market, with assets of about €22bn, according to Mr Pozdyshev. He emphasises that the CBR is not a strategic investor, but a temporary ordinary shareholder.

The CBR expects a sale within three to five years, and is aiming for a diversified shareholding structure given the size of the institution, with an initial public offering or secondary public offering as potential options.

PSB is fully recapitalised, with €14bn of assets, making it the 10th largest bank on the Russian market. Regarded as the healthiest and most professionally run of the three banks before the bailout, it is being repurposed as a state-owned institution focusing on the defence sector (which currently has limited access to private and foreign-owned banks due to sanctions).

“These banks will start life again with a clean slate,” says Ms Nosova. “They have a chance to set up as good businesses and to become operationally efficient.”

Limited impact

While the crises at the three banks may have lifted the lid on malpractice in the banking sector, most analysts and bankers agree the impact on the system as a whole has been limited.

“The sector wasn’t hurt,” says Mikhail Matovnikov, chief analyst at Sberbank. “These were large banks, but their systemic importance wasn’t that large. They were financial companies acting like hedge funds, which was the primary reason for their failure, and not too many clients were affected.”

Perhaps the biggest change has been the further increase in the proportion of the sector in the hands of the state. Government-owned institutions now account for 65% to 70% of assets, and the only privately owned bank in the top 10 banks by assets is Alfa Bank, owned by Mikhail Fridman, who is regarded as a close ally of president Vladimir Putin. The dominance of state institutions has led to concerns that private banks will face a further competitive squeeze.

“On one hand, the sector became more stable,” says Ms Nosova. “On the other hand, [nationalisations] kill competition inside the sector as private banks are not able to compete with state banks, which have access to relatively cheap funding and non-financial support from the government.”

But Raiffeisen’s Mr Deuber argues that the market share of state and ‘state-near’ banks broadly reflects the structure of the Russian economy. He adds that after years of decline, foreign-owned banks have been able to stabilise their market share on the back of local lenders’ restructuring.

Credit demand

With the crisis seemingly over and the banks under restructuring, attention is now turning to the future, and the growing hope of a better outlook for Russian banks as a whole.

“The whole process of banking sector clean-up has passed the equator, but it is not over and is set to continue through 2019,” says Mikhail Shlemov, senior analyst at VTB Capital. “On the positive side, the clean-up [presents] a chance to build a much better capitalised, profitable and well-functioning financial system, which will be better at capital allocation in the economy. We think Russian banks still benefit from [being at] an early stage of the credit cycle, with loan growth sustainable at high single digits, and mid-teens [for] return on equity.”

Following a two-year recession, Russia’s economy returned to growth in 2017. However, the recovery is sluggish, with sanctions and uncertainty weighing on the outlook. In September, economic development minister Maxim Oreshkin said that growth in the last two quarters of 2018 was unlikely to top 1.9%, following a 1.7% expansion in the first half.

Nonetheless, demand for credit is strong. Mr Pozdyshev expects the sector-wide corporate loan portfolio to grow by 6% to 7% in 2018, with retail lending – including mortgages – rising by more than 20%.

Corporate lending recovered slowly in the first seven months of the year following a setback in the second half of 2017, growing 2.7%, against 2.2% in the first half of 2017. Lending to small and medium-sized enterprises (SMEs) grew by 10.8% between January and July 2018. As with other emerging markets, Russian banks have shown increasing interest in SMEs in recent years, though in many cases largely providing accounts and transaction services rather than loans; Sberbank earns more than half its corporate commissions from SMEs.

The consumer loan portfolio of Russia's bank grew by 11.6% to Rs6700bn, a sharp acceleration that led the CBR to lift risk weight ratios for consumer loans issued at high interest rates. 

A mortgage mainstay

Housing mortgages in Russia grew by 12.6% in the first seven months of the year, with the total portfolio of mortgage loans reaching Rs700bn, according to Mr Pozdyshev. The mortgage segment has proved one of the most robust and dynamic for the country's banks.

“Mortgage lending didn’t stop growing, even during the most difficult months of the crisis – Sberbank never had a month in which its mortgage portfolio decreased,” says Mr Matovnikov. “With low penetration and low unemployment, it’s going to be a long trend of growth.”

While non-mortgage lending penetration is already reaching levels comparable to central and western Europe, mortgages have lagged behind. State-owned banks in particular are benefiting from a government mortgage scheme partly designed to reinvigorate the real estate sector, which has seen a slump in demand. However, one banker, speaking on condition of anonymity, warned of risks from the “corrupt and under-regulated” construction sector, as well as depressed real incomes.

Profitability in the banking sector remains rather low, with an average net interest margin (NIM) of about 3%, according to Elena Tsareva, senior banking analyst at BCS Global Markets. Sector leader Sberbank achieves around double this, VTB about 4%, while Tinkoff, which ranks first in the market in return on assets and return on capital, has an NIM of 25%.

Launched in 2007 as a credit card company, Tinkoff is an online-only bank which chief executive Oliver Hughes describes as “basically a tech company with a banking licence”. Having initially faced the challenge of a system regulated for bricks-and-mortar banking, Tinkoff is now adding an average of 400,000 new accounts every month, and expects its customer base to reach 10 million accounts by the end of 2018.

It is also expanding its portfolio of businesses. These include an insurance company, a virtual mobile operator, an online travel agency and stakes in other lifestyle businesses including an online ticket sales company and an online payments aggregator.

Digital potential

With margins in conventional banking low, the model of diversified product offerings is increasingly appealing. Unsurprisingly, Mr Hughes sees technology as the future of the banking sector, but argues that many Russian banks’ capacity to develop is limited. “If you have the right business model with a strong brand, which can develop technological products that are very strong and execute them, it’s a fantastic market,” he says. “It’s a growth market with many under-served segments. But you see the leaders breaking away like a peloton from the rest of the pack and others falling behind.”

Use of technology is advancing in a range of areas. About 35% of transactions by individuals are cashless, with the rate growing by 3 to 4 percentage points a year, bringing rising commission income to banks. Meanwhile, leading players are rapidly pushing ahead with robotisation, including customer service chatbots.

“There is a lot of potential in the digital space in the Russian market given the digital sophistication of the Russian consumers in increasing parts of the country,” says Raiffeisen’s Mr Deuber. “Moreover, Moscow has a vibrant fintech scene and we are seeing an increasing interest in the utilisation of blockchain technology locally, including for capital markets transactions and international business.”

A pariah state? 

Nonetheless, geopolitical risk is a persistent challenge for the country's banking sector. Thus far, Russian banks have managed to weather the impact of sanctions relatively well, with most of the impact coming from the macro and rouble downside, according to BCS Global Markets’ Ms Tsareva. Sberbank insists its recent $3.2bn sale of Turkish subsidiary Denizbank (its largest asset outside Russia) was driven not by sanctions but by a desire to focus on its more profitable business in its home market.

Nonetheless, there has been an impact on liquidity, and Russian banks’ cost of capital has risen as international investors have shied away. Meanwhile, major European banks are avoiding aggressively increasing their Russian operations, and some European markets are reaching limits for Russian exposure, according to Mr Deuber.

Banks are keeping a close eye on the threat of tougher sanctions from the US, including the potential 'nuclear option' of punitive unilateral banking sanctions that could put $50bn to $350bn of Russia-linked financial flows at risk, according to Raiffeisen. While the bank does not see this as the base-case scenario, the unpredictability of the Trump administration and looming US mid-term elections could change the picture.


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