Inflation, not liquidity, is the real problem
NO DOUBT IT is the boomtown traffic clogging Moscow’s wide roads that suggests the simile to the senior Russian banker. He has abandoned his car and arrives for the meeting with Euromoney short of breath and sweating from the brisk walk in the spring sunshine. "The financial system may slow or even stall in Russia but there’s one fast lane that is still open – and that’s for the state-owned corporations and banks to speed along. They still have access to free money."
As a private-sector banker, it’s not a situation he approves of. People and institutions that have been administered a course of free money grow dependent on it: it will be the source, he suggests, of, at worst, corruption, at best, misallocation of funds into unproductive investment. But it’s a fact of life in Russia. The state has got its power back: and that applies to the banking industry just as much as to oil.
Watch out for Russia’s state-owned banks. The crisis in western financial markets has handed them a huge advantage in their own large and fast-growing home market – one that until last August seemed ripe for foreign banks and private-sector players to exploit. The Russian banking system has evident vulnerabilities and a mild dose of the US sub-prime flu. But this only plays into the hands of the state-owned banks.
Protected by their ownership from the global liquidity squeeze, encouraged by the government and with new, capable and ambitious senior management teams plus talent arriving from the private sector, they will reverse recent losses in market share at home. While western investment banks are preoccupied with balance sheet repair, the Russian state-owned banks are all beefing up in investment banking and corporate finance. They will do more high-margin business for Russia’s blue-chip companies, accompany them into international finance and M&A markets and look to use domestic dominance as a platform for growth abroad.
And even if curtailed access to, and higher cost of, international funding slows them down a little, that’s no bad thing. The Russian banks have been growing assets and loans at such an extraordinary rate – banking system assets grew 55% last year, corporate loans grew 63% and retail loans 68% in 2007 – that, even allowing for the natural catch-up of an under-banked and fast-growing economy, the potential for overheating and rising non-performing loans was already clear even before the sub-prime spoke broke in the fast-racing wheel of western finance.
"Breakneck expansion of credit is rarely a good thing," says Andrey Ilyin, deputy chairman of the managing board of MDM Bank, one of the country’s top private banks. "From a low base, growth on the retail side was very rapid in 2006 and also in 2007. One has to question – and the Central Bank of Russia is questioning – just how ready banks are in their credit risk management, general internal controls, and collection and recovery systems to handle this fast increase in retail loans. We certainly were quick into retail in 2003 and found a couple of years later that we hadn’t scaled up our collection function adequately – something that has now been addressed. We have also discontinued a rapid-approval car loan product.
"In this respect, the unprecedented dislocation in international markets, acting as a natural constraint, may even prove beneficial to the Russian banking system."
No safe haven
Russia should be a safe haven in the global credit crunch. Yet the country suffered a net capital outflow of some $22.08 billion in the first quarter of this year, reversing the $20.8 billion inflow in the fourth quarter of 2007, according to preliminary estimates from the Central Bank of Russia. The bulk of that outflow came in January and February and reduced in March. It certainly doesn’t feel like a safe haven on the executive floors of the big private and state-owned banks in Moscow.
The sudden freezing of western financial markets last August immediately spread disquiet among banks in Russia: not because of any exposure to problem sub-prime mortgages or structured credit assets but because Russian banks had made increasing resort to western funding markets. And although that disquiet has not degenerated into the type of panic that spread in 1998 and briefly threatened runs on the banks again in 2004, neither has it been assuaged. Russian bankers are as nervous today as they were in August 2007.
Why? Because the country has an Achilles heel. Russia lacks domestic sources of long-term financing: bank loans and rouble bonds tend to be short-term. Denis Gaevski, managing director and head of capital markets at Bank of Moscow, studied the corporate loan portfolios of Russian banks intensely while setting up a securitization financing business at previous employer MDM. His discovery: "The average duration of the typical corporate loan portfolio is less than a year – a clear competitive disadvantage. For a Russian bank, corporate banking is less of a priority compared with retail or direct investments requiring longer funding."
Other market sources suggest that the typical duration of corporate loan portfolios is closer to seven months.
It’s intriguing that, having spotted this problem while working at one of the country’s largest privately owned banks, Gaevski should now be pursuing his efforts to solve it for Russian corporates inside the newly created investment banking arm of a publicly owned one. The City of Moscow owns a majority stake in the bank. "We have state capitalism in Russia," Gaevski notes simply. "Sooner or later the state banks will prevail and Bank of Moscow is the most flexible of those." His suggestion is: "Investment banking at a Russian bank should primarily increase the turnover of the balance sheet and increase the margin through repackaging of illiquid assets into euro-clearable securities, leveraging out the positions, and distribution capabilities".