Moscow skyline

Big bank failures because of Covid-19 look unlikely as a result of sweeping regulatory reforms implemented since the financial crisis.

Like much of the world, the Russian economy has been plunged into a deep recession by Covid-19, but unlike in previous crises its banking system has yet to buckle, with analysts claiming the cycle of boom and bust that has dogged its financial system for many years may have been overcome.

The tentative stabilisation of the financial system in Russia over the last decade has been led by sweeping regulatory reforms, far beyond those implemented by western countries following the 2007-9 global financial crisis.

The reforms instigated a ruthless culling of weak and fraudulent banks and ensured better supervision and more stringent capital requirements based on the Basel framework.

“[Covid-19] is the first crisis in Russian history when there are no fallen banks. We do not have a problem coming from the financial sector,” says Sergey Khotimskiy, first deputy chairman and co-owner at Sovcombank

Previous Russian banking crises were typically accompanied by interest rate rises and a collapse in the rouble. But this time around, interest rates have been cut, which helps protect the quality of loan portfolios – particularly real estate, which has proved troublesome for banks in the past.

Mirroring measures taken globally, the Russian authorities have temporarily relaxed certain capital measures and have supported the economy and banks. For instance, the government is subsidising mortgages for newbuild homes until July 1, 2021. The Central Bank of Russia (CBR) moderately decreased risk weights for certain categories of unsecured loans issued after September 1.


Elvira Nabiullina, CBR

Moscow real estate is booming, worrying officials that it could later become a source of problems for the banking sector. But according to Moody’s Investors Service big bank failures are unlikely this time around.

Many bankers trace the current resilience back to 2013 when Elvira Nabiullina was appointed as chair of the CBR. Once in office she started initiating reforms to strengthen the financial system, including getting banks to comply with the Basel rules to ensure they were property capitalised.

“The central bank has been very successful in promoting financial stability,” says Mr Khotimskiy, adding that when Ms Nabiullina took over there was essentially no supervision, forcing her to start from scratch.

“After two to three years she realised the scale of the problems,” he says, adding that around three out of five banks at the time had no real capital and were often producing false financial statements.

“The central bank has dramatically improved and increased the level of supervision,” says Konstantin Balandin, deputy chairman of the management board at Bank of St Petersburg.

“[The CBR] is doing a much better job. They have a lot more insight into what the banks are doing and enforce [the rules] a lot more than they used to.”

The great purge

Knocking the banking system into shape has been helped by a purge of bad banks. During the 1990s, the number of Russian banks swelled to more than 4,000. There are now just under 500 banks operating in Russia, according to the Bank of Finland Institute for Economies in Transition, with the 14 largest lenders accounting for 80% of banking assets, according to analysts.

Many banks were either heavily under-capitalised, primarily lending to companies within the same group, or were outright frauds. And though the closure or nationalisation of some of these banks was justified, there were some controversial cases.

The year 2013 was a ‘big bang’ moment for the CBR, as it morphed into a super-regulator with oversight of most of the financial sector. This gives it a holistic view of risks across the financial system, with many Russian bank activities spanning the financial sector.

The CBR’s mandate made it harder for banks to park risks in non-bank financial subsidiaries. And as Ms Nabiullina noted in speeches, the boundaries between financial institutions are blurring because of digitisation.

2013 was a ‘big bang’ moment for the Russian central bank, as it morphed into a super-regulator with oversight of most of the financial sector.

In 2017, the CBR nationalised several banks, including Otkritie Bank and B&N Bank. Both had grown rapidly in the run-up to 2017 and then ran into severe financial problems.

“[The central bank] had to do something rapidly and take some decisive actions … otherwise you would have seen a lot of ripples throughout the [financial] system,” says Mr Balandin.

A private sector solution such as a capital-raising would probably not have been possible because the banks were under severe stress and investors would have been too nervous to bail them out, Mr Balandin adds.

Dmitry Mints, whose family co-founded Otkritie Bank, says the bank had a strong balance sheet until the CBR’s actions undermined it. He adds that in 2017 the Russian economy was recovering from the 2014-15 banking crisis and that there were no issues with the bank.

Mr Mints believes its problems stem from a new rule stipulating that state-controlled companies and private pension funds can only make deposits with banks with a minimum A~(RU) credit rating issued by ACRA or RAEX, the only two credit rating agencies accredited by the CBR. Mr Mints explained that ACRA gave Otkritie Bank a BBB- rating on July 3, below ratings issued by the international rating agencies. At the time, international rating agencies were pulling back from Russia due to Western sanctions and a new requirement by the CBR to share their confidential methodologies in exchange for recognition.

ACRA’s rating led to a flood of deposit withdrawals. Private sector attempts were made to save the bank, but to no avail as the situation rapidly deteriorated. Finally in August the CBR intervened.

“To stop that [bank run], they could easily have said that everything with the bank is alright, that they would provide liquidity support if necessary,” says Mr Mints. “Instead they waited for two months saying nothing. They waited until the bank ran out of liquidity.”

The Russian authorities have accused the Mints family, who live in London, of embezzlement, and are seeking the arrest of Boris Mints and his sons, Dmitry and Alexander, pursuing them for more than $500m. The family deny all the charges, and are currently pursuing an arbitration case through the London Court of International Arbitration against Bank Otkritie. Also, Boris Mints has served a substantial counterclaim against Bank Otkritie for damages resulting from the actions taken against him and businesses in which he has an interest.

Mr Mints says bankruptcy cases in Russia are often accompanied by criminal charges even if a firm failed due to challenging business conditions rather than criminal behaviour. He says the authorities might seek to prove their case by revaluing assets downwards and then claiming that loans made against them were part of a fraudulent scheme.

In the case of Otkritie Bank, he believes it was ultimately nationalised because financial services are seen by President Vladimir Putin as a strategic industry like oil and gas and therefore need to come under state control. Most of the Russian banking system is now under state control, reflecting the trend across the rest of the economy.

“The Russian economy is becoming more and more nationalised year after year,” says Mr Balandin.“It would have been strange for Russia to have a privately-owned banking sector whereas the economy is not privately-owned.”

moscow sunset 16x9

Changing dynamics

Reforms to the Russian banking system along with government economic policy have resulted in substantial changes in ownership away from the private sector. Banks are not simply directly owned by the state, some are also owned by state-owned corporations.

This shift raises questions over the dynamics of Russia’s banking system. State dominance of most industries is often associated with underperformance, cronyism, under-capitalisation, poor service and inefficiency.

But maybe Russia has defied this stereotype. “The competition is real, market-based, digitalisation is proceeding at a fast pace, the return on capital is decent and not always inferior to the profitability of private banks,” says Dmitry Koorbatskiy, managing partner at boutique investment bank Dmitry Donskoy. “Competition in the banking market is now the highest among the largest market participants, regardless of whether the bank is private or state-controlled.”

According to Russian bankers, state-owned Sberbank, the country’s biggest lender, is a leader in digitisation similarly to privately owned digitally-driven neobank Tinkoff Bank.

But far from creating just a handful of mega-banks that do all banking business, Russia appears committed to maintaining a large number of state-controlled banks and some private ones. It allows three foreign banks: Société Générale, UniCredit and Raiffeisen Bank, to operate in the country. All these banks compete for business.

According to the Bank of Finland Institute for Economies in Transition, in 2019 the four largest state-owned banks held more than 55% of the sector’s assets. In total, state-controlled banks hold around two-thirds of the sector’s assets. Overall, the state comprises more than 70% of GDP.

Mr Koorbatskiy estimates there are about 30 state-controlled banks in Russia.

In early 2017, Andrei Vernikov of the Institute of Economics at the Russian Academy of Sciences published a paper analysing the impact of state-controlled banks on the Russian economy.

Reforms to the Russian banking system along with government economic policy have resulted in substantial changes in ownership away from the private sector

He wrote that, contrary to what might be expected from some theoretical literature, Russian state-controlled banks display higher, not lower, profitability and efficiency than other participants. “The key to this phenomenon may lie in the competitive position of these banks and in the nature of operations they carry out on behalf of the government, such as policy-lending, acquisition of industrial assets and their subsequent disposal, etc…,” he wrote.

Mr Khotimskiy says Sberbank is an issue for the competition. “I don’t think the other state-owned banks are a problem for the market because the strongest privately-owned banks are in a position to compete,” he says. Though Sberbank enjoys a lower cost of funding, its growth is constrained by the large dividends it pays to the state. This limits the amount of accumulated capital to support further lending.

Mr Balandin says there is strong demand for private bank services especially among corporates and smaller businesses. Profitability for most private banks comes down to finding a niche or building up specialist expertise.

Another area of controversy is over the CBR directly owning certain commercial banks raising potential conflicts of interest. However, bankers say there has been no evidence of this and that these banks operate normally. Ms Nabiullina said in a speech that the CBR is seeking to treat all banks equally in terms of regulation and supervision.

The CBR is attempting to unwind the situation, such as recently selling Sberbank to the state. There is talk that Otkritie will be sold off in 2022, but whether it is to be floated or sold to a state operator is unknown at this point.

However, not everyone is impressed with the state of Russian banking. Mr Mints is sceptical that all these governmental entities are doing as good a job as private ones would, possibly with the exception of Sberbank.

“What Russia risks with all this nationalisation in the banking industry, is that all the eggs are in one basket,” he says. “They might be creating a ‘too big to fail’ problem.”

He explains that in a diversified market with more small banks, there is less of an issue if one of them fails. He adds: “I think it is bad for any industry to be concentrated in government hands; it reduces competitiveness.”

He also has doubts over the independence of the remaining privately owned banks and says their owners are often closely associated with President Putin.

The Russian authorities have stated their intention to return many of these nationalised banks to private ownership. Some bankers do not believe this will happen because domestic capital markets are not large enough to absorb so many new shares. Others think it depends on a change of attitude by the US towards Russia, meaning that foreign investors might be freer to participate in any bank initial public offerings. Still others do not see privatisation as part of Mr Putin’s economic agenda.

There are also differing views on whether the banking consolidation will continue. Some bankers do not see much more to come, while others do. “The banking sector of Russia expects a reduction in the number of banks to between 250 and 275 over the next four to five years, and the situation with the pandemic can only accelerate the withdrawal of weak players from the market both through licence revocation and through self-liquidation deals or joining stronger players,” says Mr Koorbatskiy.

A tough 2021 ahead

Despite their resilience, Russia’s big banks nonetheless face a tough year this year as outlined by the credit rating agencies, with the number of bad loans expected to soar. This is reflected by the hit to the economy from pandemic-related social restrictions and the fall in oil prices.

Moody’s, for one, foresees the Russian GDP shrinking 5.5% this year and recovering just 2.2% in 2021.

However, the banks face 2021 in good shape. According to the CBR, the capital adequacy ratio of Russian banks stood at 12.7% in August 2020, the same as in the previous month.

What Russia risks with all this nationalisation in the banking industry is that all the eggs are in one basket

Dmitry Mints, Otkritie Bank

Fitch Ratings said in September that the 10 systemically important banks, minus Promsvyazbank because it had not yet disclosed consolidated ratios, complied with the minimum requirements, including buffers. At the end of the first half of 2020, these requirements were 8% for core Tier 1 capital, 9.5% for Tier 1 and 11.5% for total capital.

For example, Sberbank said in its quarterly report on October 29, compiled to IFRS standards, that on September 30 its common Tier 1 capital ratio was 13.39%, compared with 14.78% in June. Over the same period, its Tier 1 capital adequacy ratio was 13.84%, compared with 14.78%, its total capital adequacy ratio was 14.22% compared with 15.23% and its leverage ratio was 12.7% and 13.7%.

However, S&P Global Ratings estimates that under IFRS 9 accounting rules, between 12% and 15% of total loans at the largest Russian banks could become non-performing by the end of 2020, compared with 7.5% for 2019. The most vulnerable area is the private sector.

“On our base-case scenario, we also anticipate that Russian banks could recognise credit costs of between 2.5% and 3.0% of their average amortised loan books, compared with 0.84% for 2019. This implies that some banks would report only break-even financial results,” the rating agency said in a note.

The impact of bad loans and rising funding costs is already being registered in bank results. S&P Global noted that the 14 largest Russian banks reported, under IFRS, a 21% decline in bottom-line financial results for the first half of 2020 compared with the same period last year, reflecting provisioning for bad loans.

No drama expected

Mr Balandin does not expect any dramatic developments around non-performing loans next year. He explains that this is because the state dominates the economy and that state-controlled corporates and the Russian government have strong balance sheets. He is, however, more concerned about household leverage. “It might be a problem in a year or two, but you have to keep in mind that mortgages are a pretty low share of bank books, so I think the banks are going to manage,” he says.

Moody’s maintains a negative outlook for Russian banks for the next 12 to 18 months due to suppressed economic activity hurting asset quality and profitability. It warned that the banks’ internal capital generation will be insufficient to cover moderate growth in risk-weighted assets, while several large institutions will keep paying dividends, contributing to a fall in the sector’s capital adequacy.

Meanwhile, margin contraction due to low rates and large-scale loan restructuring will see declines in income from fees and commissions due to social restrictions. Credit costs will increase as asset quality weakens, eroding net profits.

Moody’s is also concerned that prolonged loan growth could outpace deposit growth, which will tighten banks’ funding conditions. This means they will have to raise their deposit rates or rely on the CBR for short-term funding. So far, bankers believe that these problems are manageable and are a far cry from what happened during previous crises.

Thanks to extensive regulatory reforms, compliance with the Basel framework and better supervision, Russia’s banks increasingly resemble well-run banks elsewhere. Where its banks differ from much of the rest of the world is that they are becoming increasingly government-controlled. The long-term impact of that development has yet to become apparent.

This article first appeared in The Banker's sister publication Global Risk Regulator.


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