The Russian banking system is currently stable partly due to the speedy response of the Central Bank of Russia (CBR). But that only delays the inevitable, experts warn.
“I don’t think they can avoid a severe banking crisis. There’s going to be severe dislocation in the economy, and, as a bank, you live and die by the economy you operate in,” says Marco Troiano, head of financial institutions at Scope Ratings.
Several Russian bankers told Global Risk Regulator, sister publication of The Banker, that the situation is now very difficult. “The banks have gone into the crisis in quite good shape,” says Yaroslav Sovgyra, associate managing director at Moody’s Investors Service. “The problem is that this crisis is unprecedented.”
Russia-focused rating agency RAEX Europe said on March 7 that banks are deteriorating rapidly. It said the spread between the central bank reference rate and the interbank lending rate has widened, signalling concerns over failing collateral values. “[This] could translate into a blowout financial crisis in the country,” it said.
Dmitry Mints, whose family co-founded Otkritie Bank, is more sanguine about the prospects of a banking crisis, seeing it as more about the creditworthiness of the country given that it already controls most banking assets. “The quality of the banking system is the quality of the state’s finances,” he says. “I think with the state banks, the central bank will print money and give it to them, and that’s going to be reflected in future inflation in the country.”
Wide-ranging sanctions
The West and its allies responded to Russia’s invasion of Ukraine on February 24 by slapping sanctions on its economy and banks.
The EU threw seven large banks, including Sovcombank, Otkritie Bank and VTB Bank, off the Swift messaging system. The last time this happened was in March 2012 when Iran’s banks were kicked off Swift due to EU sanctions. This makes it much harder for banks to conduct business abroad.
However, the EU spared Sberbank and Gazprombank because it needs a conduit to pay for Russian energy. However, Sberbank lost its EU-based subsidiaries and VTB Bank is pulling out of Europe. Other countries such as the US and UK have also targeted Russian banks and state entities.
The Iranian banks found ways around the Swift ban through non-EU banks. However, S&P Global Ratings thinks this will be harder for Russian banks because the current sanctions are so comprehensive. Meanwhile, the rating agencies have slashed Russia’s credit rating to junk status.
In an unusual move, the CBR’s reserves and those of other state entities held in Western countries have been frozen, accounting for more than half their total of $640bn. The US took similar action against Iran in February 2011. Even Russia’s 2300 tonnes of gold reserves might prove hard to shift given the country’s pariah status in the West.
“This is definitely a big blow,” says Mr Mints. RAEX Europe said the lack of access to its financial assets will limit Russia’s ability to mitigate the impact of the sanctions. “Russia’s external position is quite strong, but without the possibility to use those buffers and/or convert commodities into fiat [currency], the potential to keep up with the sanctions appears dim,” it added. S&P Global Ratings said it will limit the CBR’s ability to act as lender of last resort.
Mr Mints says an indication of the toughness of the sanctions is that Russia recently removed the value-added tax on gold sales. He believes this is so some of the gold can be sold to the public. The alternative, he says, would be to sell gold to China, but probably at a steep discount given the lack of international buyers.
Also damaging for banks are the trade sanctions and the rapid retreat of Western companies from the country. The Western alliance is suspending normal trading relations with Russia. This will lead to reduced trade between Russia and the West.
The West is now weaning itself off Russian hydrocarbons, meaning the country will gradually lose some of its biggest customers. Commodities account for about 60% of Russia’s total exports.
But soaring commodity prices will keep hard currency flowing into Russia, with the EU sourcing around 40% of its gas from the country, worth more than $30bn annually.
Also, the assets of Russian oligarchs suspected of close ties with president Vladimir Putin have had their assets frozen in Western alliance countries.
Big economic impact
Nonetheless, the banks go into the crisis in a strong position. According to a Fitch Ratings note on December 23, 2021, excluding CBR-managed bad banks, the sector made a return on equity of 18%. It said the sector’s average core Tier 1 capital ratio was 10.3% and the total capital ratio was 13.9%.
Fitch Ratings said all 12 systemically important banks (SIBs) met minimum capital requirements at the end of the third quarter of 2021, while Promsvyazbank did not disclose its ratios. These requirements were 8% for core Tier 1 and 11.5% for total capital. Three SIBs had modest cushions on some of their consolidated capital ratios, the rating agency said. VTB had a core Tier 1 capital ratio of 8.6%, Russian Agricultural Bank stood at 8.9% and Gazprombank at 8.9%.
At the end of 2020, Russia had 366 banks with assets of $1.4tn, according to the Black Sea Trade & Development Bank (BSTDB), a regional economic organisation. It said banks account for around 87% of the total assets in the financial sector. Loans comprised 62% of bank assets, with 30% in liquid assets. The loan-to-deposit ratio stood at 91%. The BSTDB explained that deposit funding increased significantly after Russia’s 2014 Crimea invasion, when Russian banks faced Western restrictions on accessing EU and US capital markets.
Analysts are finding it difficult to quantify the impact of the sanctions as they are so wide-ranging. This is reflected in the extreme disparity in economic forecasts. For instance, Moody’s expects a 7% contraction while S&P Global Market Intelligence forecasts a 22% economic crash this year. This contrasts with pre-invasion forecasts for 2% growth. Russia’s last very deep recession was in 2009 when gross domestic product (GDP) plunged by 7.8%. If S&P’s forecast becomes a reality, then it would be the worst recession since the fall of the Soviet Union in the early 1990s.
In 1990, 1991 and 1992 GDP fell by 3%, 5% and 14.5%, respectively. S&P does not see the economy regaining its 2021 level until the 2030s. Mr Mints believes the recession could be worse than in the early 1990s because at that time Russia was opening up to the world economy.
Meanwhile, Goldman Sachs expects inflation to hit 20% by the year’s end, which will bleed consumer purchasing power. On March 23, the CBR said households’ expectations were for inflation to reach 18.3% over the next 12 months. It is not making an inflation forecast, other than to say it expects to return to its 4% target rate in 2024.
Sharp rise in bad loans
The Moscow rumour mill suggested that the CBR’s well-regarded governor Elvira Nabiullina wanted to resign, but Mr Putin made her stay. She could spend the rest of this year and beyond in fire-fighting mode.
An increase in non-performing loans is certainly on the cards. “I expect a sharp increase in the number of arrears, while some of the businesses will be able to survive through some measures of state support,” says a Russian banker on condition of anonymity.
He says the country faces a perfect storm of rising unemployment, soaring costs on floating-rate loans, deteriorating private sector businesses, supply chain gaps, distrust and even a winding-down of some federal support programmes. News of the sanctions saw many Russians withdrawing their cash from banks. The CBR increased interest rates to 20% from 9.5%, stemming bank runs.
“The banking system is operating smoothly,” declared Ms Nabiullina in a speech on March 18. “The liquidity situation has stabilised. We provide liquidity to banks in the amounts they need.” She said at its peak the funds provided hit Rbs10tn ($130bn), and the Rbs7tn structural liquidity deficit that emerged in early March has halved.
“When interest rates went to 20%, people realised two things,” says Moody’s Mr Sovgyra. “You can get 20% on your deposit, which you cannot get if your money is in a safety deposit box. And there is no problem getting roubles, so there’s no point keeping physical cash.”
However, this comes at a price for the banks. “It’s very difficult to imagine an enterprise which can pay a 20% interest rate in a declining economy,” says Mr Mints. “In reality, the smaller banks need to charge close to 30%. Now I don’t believe this is a sustainable model. And I think, as previously, they won’t be properly supported [by the CBR]. So they are going to be taken over.”
Mr Sovgyra says there will be pressure on net interest margins because banks have to find funding. And they find it difficult to attract new borrowers able to pay interest rates of more than 20%. These effects are likely to be delayed. “Most loans are done at a fixed rate, which provides some shelter, but problems will occur when they need to refinance them,” he says.
The CBR said it will cut interest rates as soon as the situation permits. Nonetheless, Mr Sovgyra believes it is impossible to forecast the scale of loan defaults because it depends on how long the sanctions last.
And there are secondary impacts to consider. “So when Taiwan stops supplying semiconductors to Russia, it may seem like a small matter. But it may lead to some Russian manufacturers stopping the production [of goods],” says Mr Sovgyra. “We need to better understand the degree to which these sanctions will disrupt production in the Russian economy.”
The sanctions leave Russia’s banks in a lonely place, with the CBR being their only real support. One Russian banker says the banks will not be able to raise fresh capital in the West; he does not expect much help from China and India on that front, either.
“Even greater nationalisation is inevitable, which will be accompanied by a merger of banks with state participation (of which there are about 30 now, controlling most of the assets of the entire system) and job cuts to optimise costs,” he says.
The banker explains that the looming recession will probably see banks engaged in crisis management until the end of 2023.
Battle stations
But the CBR has not been idle. Other than hiking interest rates, many of its emergency measures resemble those taken by central banks to support their banking systems when the Covid-19 pandemic struck.
“Elvira Nabiullina is one of the leaders of central banks in Europe and one of the best leaders in Russia, trying to stay out of politics, as far as possible. I think the set of measures to support the banking system will increase and have an unprecedented volume,” says Dmitry Koorbatskiy, managing partner at boutique investment bank Dmitry Donskoy.
He notes that the CBR is already helping the banking system, especially the large banks, by providing liquidity and various regulatory reliefs, including the creation of reserves for loans and investments in securities, which will support capital ratios and reduce pressure on capital.
The CBR has relaxed risk weightings for certain consumer loans and some reserve ratios to make an extra Rbs2.7tn available to firms and households. According to RAEX Europe, retail loans make up a third of total bank loans.
Other forbearance measures include allowing banks not to classify loans to borrowers affected by sanctions as problem loans, and not to increase reserves on such exposures. The latter measures run until the end of 2022. The CBR also imposed some capital controls to preserve foreign exchange reserves.
So far, so good. Shares even rose on March 24 on the reopening of the Moscow Exchange (MOEX) following a three-week closure. However, there were numerous restrictions such as banning short-selling. One US security advisor dismissed the rally as a “charade”, saying it comes on the back of promises of pumping liquidity into the MOEX market. The CBR said it will buy an extra Rbs500bn of Russian government bonds on the exchange.
Along with the government, the CBR will also make Rbs500bn available to encourage small and medium-sized enterprise lending. And it will look to mitigate the impact of refinancing fixed-rate loans once their terms expire.
Moody’s estimates that Russia’s private sector debt will remain modest at around 70% of GDP over the next 12 to 18 months.
However, there is a key difference between Covid-19 and the sanctions shock. “You had [public sector support] with Covid and you will probably have it with this crisis,” says Scope’s Mr Troiano. “The big difference is that with Covid, it was a concerted global effort. With this particular crisis, you have to ask: will action by the Russian public sector be enough to engineer a V-shaped recovery?” He thinks it unlikely given that so many countries are punishing Russia for the Ukraine invasion.
Most economists believe the sanctions will radically reshape Russia’s economy. It will now become much more state-controlled, with the private sector increasingly marginalised. Its banking system will effectively serve the state’s economic goals.
