| Russian banks ranked by net worth (base case) | ||
| Net worth (Rb m) | Capital/assets | |
| Mezhprombank | 374 |
3% |
Probusinessbank |
113 |
12% |
Chelindbank |
105 |
14% |
Uralvneshtorgbank |
-458 |
-99% |
Petrovski |
-1,069 |
-97% |
Pomstroibank St Petersburg (ICB) |
-1,683 |
-38% |
Bank of Moscow |
-4,172 |
-79% |
Vozrozhdenie |
-5,974 |
-133% |
Alfa-Bank |
-6,287 |
-78% |
Mosbusinessbank |
-6,788 |
-106% |
Mezhcombank |
-8,403 |
-475% |
Promstroibank Russia |
-9,363 |
-316% |
Avtobank |
-10,538 |
-215% |
Rossiisky Kredit |
-13,905 |
-125% |
Bank Menatep |
-16,008 |
-82% |
Unexim Bank |
-27,854 |
-246% |
SBS-Agro |
-32,310 |
-184% |
Inkombank |
-67,434 |
-450% |
| Source: World Bank/Central Bank of Russia | ||
When crisis hit Russia last August, most analysts expected the country’s financial empires to disappear, after all the banking system was insolvent and the central bank had failed to act as lender of last resort. However, virtually all the old banks are still extant. It is unclear what is going on in their buildings, but they still have their banking licences. A critical due-diligence study of 18 banks, including the biggest ones, suggests that many of these licences should be revoked. The investigation, conducted on the initiative of the World Bank but presented as a study requested by Russia’s central bank, shows that the surveyed banks’ total liabilities are Rb348 billion ($13.9 billion) against Rb137 billion in assets.
The review, based on international accounting standards, is intended to serve as a guideline for bank restructuring. “The due diligence confirmed the view that some of the bigger Russian banks are so deficient in capital, and have so compromised their reputation with creditors, both foreign and domestic, that their situation is beyond repair,” the audit says.
Best available figures
The surveyed banks’ overall capital shortfall of Rb157 billion mainly springs from bad loans (34%), losses on forward currency contracts with foreign institutions (28%) and losses on short-term government debt (13%) on which Russia defaulted in August, when it also implemented a moratorium on the payment of commercial debt and decided to let the rouble float.
“This auditing exercise is subjective,” admits an official closely involved with it. “but it gives you a very good idea of the situation. These are the best available figures.”
In worst shape is Inkombank, which is in liquidation after the central bank revoked its licence last year. Its creditors are, however, trying to relaunch it.
Formerly one of the largest commercial banks, it was the darling of foreign bankers and analysts as a result of its serious attempts, unusual in Russia, to lend money to businesses. Its downfall resulted from speculation and lack of political clout. The survey shows that it had negative capital of Rb67 billion, two-thirds of which result from losses on currency futures.
Other big banks still operating have smaller but still enormous shortfalls. SBS-Agro, for example, has a capital shortfall of Rb32 billion (based on 30 September 1998 figures). Unexim Bank was Rb28 billion negative and Rossiiski Kredit Rb14 billion (both based on 31 October 1998 figures). Menatep Bank, whose licence was revoked by the government last month, had negative capital of Rb16 billion (30 September 1998 figures).
The only banks with positive net worth are three smaller entities: Probusinessbank, the International Industrial Bank (Mezhprombank) and Chelyabinsk Industrial Bank (Chelindbank). The audit has identified several “apparently insolvent” banks that, however, have a fair chance of continuing operations, and have so far received minimal government support. These are Mezhkombank, Avtobank, Alfa-Bank, Vozrozhdenie, Bank Petrovsky and Uralvneshtorgbank.
Bank of Moscow, the audit says, appears to be in a category of its own. “Its fate probably depends on the ability of Moscow government to meet its obligation,” the audit says. “If nothing else, this is a big concentration of risk.” Another of the bigger banks, Most Bank, which the auditors wanted to include, declined participation.
More gentle treatment
The review was conducted on stricter conditions than usual “to reflect current economic realities and future uncertainties”, the audit says. But these terms were much too exacting for the central bank and it demanded an alternative study. In this softer approach, the value of the short-term debt portfolio (with a market price of a few kopeks to the rouble) was increased to 50% from 10% of face value. And the provisions for bad loans were lowered.
Even under these more lenient terms all banks that were marked down as insolvent in the hard approach were still so under the soft conditions. Total negative capital for the banks amounted to Rb88 billion under this methodology.
In early March, the audit’s results were handed over to the central bank. It decided to keep the results secret. A central bank spokesman told the Russian press in April that publication could be disastrous because of already low levels of confidence in the sector.
At central bank headquarters in Moscow, the report was received with “an aggressive silence”, says an official present at the meeting. He claims the report has split the bank’s board. “There is a fierce battle going on.” Chairman Viktor Gerashchenko is determined to ignore the report, the official says, while his less influential deputy, Tatyana Paramonova, is reportedly impressed with the results.
Inaction plan
So, will the central bank act upon the due diligence? “We will use the results,” says Alexei Simanovski, the bank’s director of the prudential banking supervision department. But, he adds, the existing legislation prevents the bank from taking any drastic steps. “We give some special attention to the results of this diagnosis …. But at the same time, when we have to take a decision on withdrawing licences, we have to take into consideration only our internal legislation. We cannot withdraw a licence if a bank, according to our bankruptcy law, is liquid or when there are no signs of bankruptcy.”
Simanovski claims that over 1,000 of Russia’s 1,450 banks are in stable financial condition. These are mostly smaller and medium-size banks in the regions. “A number of larger banks are not in a good condition,” he confirms. He says that the process of withdrawing licences is under way. This year, 150 more licences could be withdrawn, he estimates, on top of the nearly 100 that have been revoked so far. “These might include bigger banks,” he says.
But many believe it will not. So far, there are no criteria for reforming the sector, apart from the central bank’s statement that it is official policy to keep strategically important banks alive. In practice, this will mean that politically well-connected banks will be allowed to limp on.
Running out of patience
International institutions such as the World Bank and the European Bank for Reconstruction & Development, which have tried to help Russia’s banking sector become more professional and which were aware of the flaws in the system well before the crisis, are running out of patience with the central bank’s inactivity.
First vice-president Charles Frank of the EBRD, which lost tens of millions of dollars on direct investments in Russian banks, says his organization is “urging” the central bank to use its powers “to put [bankrupt] banks into administration, to withdrawal of their licences if necessary”.
Frank continues: “Quite frankly, I think [the central bank] could be more aggressive. We are very concerned that the authorities are not intervening more to ensure openness and transparency in the process.”
After the August crisis, the IMF and the World Bank began putting more pressure on the central bank and the government, says an official with the World Bank. A few months ago, the two multilateral institutions were determined to make all further lending dependent on Russia reforming the banking sector according to their demands. They found prime minister Yevgeni Primakov on their side. But with the premier’s power fading – he was dismissed on May 12 – once again the multilaterals are trapped in the cogs of Russia’s political cycle.
A priority for the World Bank and the IMF is to prevent Russia from defaulting on its debt to them. “Now is not the right time to push for anything as radical as cleaning up the banking system,” the World Bank official says. Shortly after Primakov’s sacking, the World Bank announced it would put all further loans on hold.
The impact on banking restructuring of a new government, the fourth in just over a year, is unclear. The EBRD’s Frank says: “I do not think there is an immediate negative impact on the economy in general or on the banking sector in particular. But I think it will delay any resolution of the problems and allow the problems to get worse.”
Analysts in Moscow argue that the political changes could trigger an unintended restructuring if banks lose their political protégés in the cabinet. The most likely victim is SBS-Agro, which depends on political connections for its survival. It had vice-premier Gennady Kulik as its main ally. It is, however, likely to be resurrected in some form, since it has the best branch network in Russia and has installed world-class technology.
Back-room deals
But it will be difficult for any new government to unravel the intricate web of dependencies between commercial banks and the central bank that was woven shortly after the August crisis. The central bank handed out Rb18 billion of stabilization loans to get the payment system going. Among the recipients were SBS-Agro, Promstroibank, Vozrozhdenie and Avtobank, which all pledged 75%+1 share of their capital to the Central Bank as collateral. They get their shares back once they repay their loans – or arrange new deals in cases where they cannot repay. For this reason alone, these banks are likely to survive.
The central bank also allowed a number of unnamed banks, but reportedly including all the bigger ones, to swap some of their frozen short-term government debt for at least Rb65 billion in Lombard credits to provide liquidity to the sector. These back-room deals, paid for with taxpayers’ money or specially printed roubles, basically ensure all these banks’ future existence and make a major overhaul less likely.
Also, reform cannot start before the matter of the currency future contracts has been resolved. Between them, the 18 banks in the audit have Rb54 billion in losses on contracts and they owe some $2 billion to foreign institutions.
The audit suggests the Russian authorities should abrogate the domestic forwards. But central bank director Simanovski points out that the current civil legislation does not allow these contracts to be cancelled.
Analysts claim there is too much money at stake for the state itself to cancel the contracts. The government’s Sberbank and Vneshtorgbank, and central bank-controlled Eurofinance would loose their hedge if internal contracts were scrapped. These three banks are owed $787 million by the surveyed banks, the audit says. Finding a solution on outstanding forwards with foreign partners is a matter of bilateral negotiations between Russian banks and their counterparties.
“These forwards are hanging over the banks like the Sword of Damocles. You might now think that some banks are viable, but winding up the outstanding forwards could kill them,” says Holger Mueller, director investment banking at Fleming UCB in Moscow.
The central bank has come up with half-hearted attempts to reform the sector. Last November, it produced a restructuring plan. But it was not heard of later and a new proposal circulated in February. This entails sweeping most of the banking sector under government and central bank control. Primakov’s cabinet rejected that proposal late in February.
Shortly after the August crisis, the central bank promised to set up Arko, an agency for the reconstruction of credit organizations. It recently started work but is underfunded and has central bank managers at the helm. It has announced that 85 banks in 60 regions have been chosen as the core of the regional-based banking sector.
The criteria are unclear. Many of the banks are closely connected to regional authorities. Some might be taken over by the state, some restructured, others will stand alone. But with Rb5 billion available, Arko is unlikely to make a difference. And it is not touching the bigger banks.
In principle, Arko is not a bad idea, says Moscow-based Daniel Wolfe, chief operating officer at investment bank Troika Dialog. “Helping regional banks is the right way to go, because it is easier to figure out what is going on in smaller banks. I’m not sure if we should focus on the bigger banks. It is smarter to build a base with smaller banks, with managers who love banking and actually understand it.” Wolfe warns that Arko should not take over banks. “Then they face a problem: there are no buyers.”
To gain more influence over restructuring, the World Bank and the IMF demanded that an inter-departmental committee for the co-ordination of technical assistance be set up, in which the EBRD, ministries, members of parliament, the government and the central bank would also take part. It was meant to function as a think-tank for restructuring. But since its inception in mid-March there has been little evidence of urgency. Only two of five planned working groups are active: one on banking supervision and another on accountancy standards.
“In fact, nobody is in control of the restructuring process,” says Moscow-based analyst Margot Jacobs of investment bank United Financial Group. “There is a huge political power vacuum and that filters down to the banking system,” she said, just before Primakov was sacked. A central bank official recently told her that the bank has no strategy on banking restructuring, because its officials do not know what politicians want.
In this vacuum, larger commercial banks took it upon themselves to resurrect their empires. They moved their assets to new entities, called bridge banks or shadow banks, leaving their liabilities in the old shells.
SBS-Agro has set up the Soyuz Group and the First Mutual Credit Society where its VIP clients can park assets. The significance of the government’s having revoked Menatep’s licence is blunted by the fact that the bank had already transferred assets to Menatep St Petersburg as well as to the Trust and Investment Bank. At the time it lost its licence Menatep had been negotiating with foreign creditors and had agreed with them that a possible debt repayment would be taken over by its affiliates Rosprom and Yukos. Uneximbank created a new entity called Rosbank, which received a new banking licence from the central bank within two weeks of applying. Rossiiski Kredit transferred its assets to Impexbank. The moves are not reflected in the due diligence.
Moscow regional bank Unikombank, another bank that lost its licence last month, formerly handled the budget funds for the Moscow regional government. When it got into difficulties its assets were swallowed by Guta Bank, an institution affiliated to the Moscow government.
Moving these assets is legal according to the letter of the Russian law, analysts say. But, says the central bank’s Simanovski, “in my personal opinion, it is against the spirit of the law”. He adds that these assets were paid for by the new entities. Was it a fair price? “Inspectors of the central bank are currently examining these deals. And as far as I know, we have no signs of unfair activities yet,” he says.
Debt for equity
The banks have hired foreign consultants to assist them in negotiations with foreign creditors. Warburg Dillon Read advises SBS-Agro, Fleming UCB helps Uneximbank, KPMG has been hired by Rossiiski Kredit. It is estimated that Russian banks combined owe foreign creditors $10 billion to $12 billion, apart from the up to $5 billion in forward contracts. Some analysts believe that foreign creditors could expect repayment offers of 25% of the outstanding debt.
Sergei Rudkovsky, director of Russian banking information agency Rating, doubts that bridge banks are serious about repaying foreign creditors. “If they do, it can only mean that they expect to gain more from paying than from not paying,” he says, implying that they need access to foreign credits.
So far, only one case is known where a Russian bank has agreed to swap its debt for equity. Mezhkombank is likely to be taken over by a US bank, analysts say.
Several bankers in Moscow allege that troubled banks have taken assets off their already bleak balance sheets by rewriting contracts. New contracts show a new owner, for example an offshore company controlled by the bank’s shareholders, while the bank’s balance sheet still shows the liability.
With creditors knocking on their doors, Russian bankers are as inventive in hiding their assets as they were in exaggerating these when they wanted loans. “The Russian banks have always inflated their capital. They did it because they wanted to look more important and because it made their ratios look much better. I estimate that in some instances capital was 50% to 80% overstated,” says an auditor. “This is the very essence of the Russian banking problem.”
The banks were also hiding risky investments. A widely used trick was to buy a stake in an affiliated fake company, which would then reinvest the money in high-yielding short-term debt or elsewhere. This would keep the banks’ published investments in markets under the required 10% limit.
These were well-known phenomena long before last year’s crisis. The World Bank and the EBRD knew. They had in-depth access to banks’ books through their Financial Institutions Development Project, which began in 1995. The programme was set up to help banks develop their structures and stimulate automation.
Before banks were admitted to the programme, they were checked on their fitness. This was done by the Bank Review Unit, a part of the FIDP. The review unit functioned as a mini central bank. The unit arranged banking inspections of its own.
Analyzing the programme, a World Bank official says the technology component was widely used and yielded good results. But not so on the development side. Russian banks were meant to team up with a foreign bank, a twinning bank, which would assist with its development.
“The beneficiaries were not willing to accept the support. Only three of the 41 banks in the FIDP have completed the twinning programme. In the final analysis the twinning system was a complete failure. This puts a lot of shame on the World Bank and the EBRD,” says the World Bank official.
In 1996, the review unit conducted a thorough study of the Russian banking system. “The picture was so horrible that nobody wanted to act on it,” says the official. The analysis was known to the World Bank, to the EBRD, and sent to the Russian central bank and finance ministry, as were all other reports of the unit that were to follow. These were classified documents – prooof if it were needed that secrecy and lack of transparency foster bad banking practice.
Fundamental flaws in the banking system were ignored, in the hope that they could be overcome later. After a slow start, the FIDP programme went ahead and signed up 41 commercial banks, representing nearly all commercial capital in the sector. These were destined to become the core of the new Russian banking system, setting them apart from the fly-by-night speculators that called themselves banks.
However, audits by the Bank Restructuring Unit indicated that most banks were not as reliable as their public picture suggested. “The central bank opposed these studies. It did not believe in IAS standards. The finance ministry was incapable of assessing the reports.” says the World Bank official. “The World Bank and the EBRD did not push them into action, because they did not want to infuriate their clients,” he claims. And they failed to raise the red flag for foreign investors.
This was a time of rapid transition in Russia. With volatility in the sector, foreign banks considered FIDP participants to be the most reliable partners in the country. Cunning Russian banks were eager to display their FIDP membership as an international seal of approval of reliability. With all parties eager to lend and to borrow, not too many questions were asked. “The FIDP programme became a licence to kill banks,” says the World Bank official.
One of the FIDP goals was to guide banks towards medium- to long-term lending to the corporate sector. In some cases it led to success, such as with Probusinessbank. Founded in 1993 and now operating from three modest offices in Moscow, it is liquid and solvent, with less than 5% bad loans in its portfolio. It has just bought the “business centre” of defunct Inkombank and has employed 20 of the centre’s specialists to strengthen its corporate finance division, says Pavel Busygin, the banks’ head of marketing and strategic development.
Central bank buying spree
The central bank was not interested in the FIDP’s western standards. Instead, it mirrored the activities of the Russian commercial banking sector. After acquiring its independent status following the break-up of the Soviet Union in 1991, the central bank began concentrating on buying assets, as did the commercial banks.
“The central bank has spent millions and millions of dollars on investment projects, on the construction of offices, on the acquisition of and participation in commercial banks and companies at home and abroad, on satellite launches, on the acquisition and financing of mass media, and on political lobbying,” writes the economist Andrei Illarionov in the Russian daily Nezavisimaya Gazeta.
The central bank invested on the Russian short-term debt market, and led the banking sector in hiding assets. Last February, Russia’s then prosecutor general Yuri Skuratov revealed that the bank had secretly used an offshore vehicle in Jersey to manage $50 billion in state reserves between 1993 and 1998. Financial Management Company, Fimaco, was set up when a western investor threatened to seize state assets following Russia’s default on Soviet-era loans.
Russian financial ethics are different from the west’s, and so is its system. “It is therefore difficult to base financial decisions on financial reports only,” says Rudkovsky of Rating, adding that his firm, apart from public information, works with a network of informants ranging from the tax police to the central bank. “If we hear from a contact, for example, that a certain bank did not bribe an official in the central bank, then we know that this bank will be in trouble in a month’s time.”
Even leaving aside the question of corruption, proper supervision of commercial Russian banks is virtually impossible. Any system of norms “is dependent for its success on the honesty and transparency of reporting banks,” says the due-diligence report, “… the largest banks … actually seem to have led the way in developing techniques for concealing basic imprudent conduct.” The report advises the Russian authorities to stop dealing with shareholders, managers and banks “that have been less than honest and trustworthy”.
Other steps have to be taken, such as better legislation and effective law enforcement, say analysts. And a bank restructuring will have to form part of an economic programme, which in turn will help restore confidence. Without a functioning banking system, there can be no economic growth, says Mueller from Fleming UCB. “Banks are the main nucleus for economic growth, and yet nobody does anything. So forget about any optimistic growth scenarios for Russia.”
Rebuilding confidence will be a cornerstone for a new Russian banking system. Although it will be politically hard to swallow, Russia will have to rely on foreign banks to restore trust in the sector. “Commercial banking is not going to be revived in this country unless international renowned banks such as Deutsche Bank or Citibank open a branch on Main Street,” says Troika Dialog’s Wolfe.
The rouble/dollar rate used is $1=R16.01 for Inkombank, Mezhkombank, Rossissky Kredit and Uneximbank, and $1=R16.06 for all the others. These four banks were review as at October 31 1998, the others were reviewed as at September 30 1998.
There are two sets of assumptions: a base case (hard) and an alternative case (soft). In the base case the GKO portfolios held by the banks were valued at 10% of face value and the loan loss provisions were extremely tough. (The loan classification remained the same, but the provisions were higher than in the soft-case scenario).
In the alternative case, the GKO portfolio was priced at 50% of face value and the bad loan provisions were softer.
Note that none of the banks that were insolvent under the hard case became solvent in the soft case.
The loan loss provisions are the biggest component of net charges to capital in the base case: 34% of the sample banks.
The FX and translation losses include the forward currency contracts: 28% of net charges to capital in the base case.
Government debt securities count for 13% in the base case.
