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RUSSIAN FEDERATION Selected Issues

Author(s):
International Monetary Fund
Published Date:
October 2005
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IV. Russian Banking Sector: Recent Developments and Remaining Challenges88

A. Introduction

1. The strong macroeconomic environment continues to underpin banking sector developments. In 2004, banking sector assets increased by 27 percent, with total credit to the private sector growing by about 47 percent in nominal terms. Credit to households, leading the expansion, increased by 107 percent, reflecting continued robust growth in real incomes. Despite the banking sector turmoil in the summer of 2004, confidence in the banking sector improved with household deposits expanding by 30 percent in 2004. However, in international comparison, the progress in financial sector deepening appears less impressive (Figure 1).

Figure 1.Russia: Features of the Financial System

2. The Russian banking sector continues to operate well below its full potential. With solid growth rates over the last couple of years, financial sector intermediation has increased; however, it is still low in both absolute and relative terms. Despite strong profitability, robust capital adequacy ratios, and an increase in capital, the banking system is still small with total capital amounting to about 6 percent of GDP at end–2004 (Table 1). The government controlled banks, led by Sberbank and Vneshtorgbank (VTB), continue to dominate the system (Figure 1).

Table 1.Russia: Financial Soundness Indicators 1/

(In percent)

20012002200320042005

Q1
Capital
Regulatory capital to risk-weighted assets20.319.119.117.017.6
Regulatory capital to risk-weighted assets (Top 30)22.019.716.813.212.6
Asset quality
Nonperforming loans to total gross loans6.25.65.03.83.7
Sectoral exposures
Sectoral distribution of loans to total loans
Industry40.136.733.328.024.4
Agriculture1.82.22.42.72.9
Construction4.24.44.44.54.3
Trade and public dining19.621.620.618.822.6
Transport and communication4.54.65.14.85
Others22.522.422.724.926.2
Individuals7.38.011.516.214.6
Regions
Russia37.941.154.254.042.9
U.K.13.523.49.06.68
U.S.18.96.28.26.79.9
Germany6.05.92.47.210.1
Austria6.45.76.86.16
France2.71.51.63.13.3
Italy2.41.61.01.81.1
Others12.214.516.814.518.8
Profitability
Return on assets2.42.62.62.9
Return on equity19.418.017.820.3
Liquidity
Liquid assets to total assets40.839.136.130.330.5
Liquid assets to short-term liabilities87.490.690.478.078.4
Market risk
Net open position in foreign exchange to capital22.618.58.45.85.6
Other FSIs
Loan loss reserves to total gross loans6.76.35.95.35.1
Large exposures to capital216.1228.6241.0242.8233
Interest rate risk to capital4.06.99.913.311
Net open position in equities to capital5.611.712.412.611.9
Source: Central Bank of Russia.

Credit and depository institutions.

Source: Central Bank of Russia.

Credit and depository institutions.

Share of Large State-owned Banks in Total Banking System Assets, 2004

3. A number of recent policy measures are expected to give additional momentum to banking system development. Reforms, such as introducing the Deposit Insurance Scheme (DIS), adopting international financial reporting standards (IFRS), and changing the Bankruptcy Law for Banks, will likely boost competition and increase transparency in the medium term.

B. Earnings, Capital, and Efficiency

4. Financial soundness indicators remain at healthy levels and were little changed over 2004 (Figure 2 and Table 1). The indicators, which are based on Russian accounting standards (RAS), show that banks are, on average, profitable and have relatively good assets.89 This should not be surprising given the strong economic performance and the rapid growth in the sector. Capital ratios have moderated in recent years as internal capital generation has failed to keep pace with rapid loan growth. The average risk-weighted capital adequacy ratio, albeit declining from 2003 levels, remained robust at 17 percent as of end-2004. Based on RAS, banks’ profitability increased in 2004 after a slight decline in 2003.

Figure 2.Russia: Banking Sector Financial Soundness Indicators 1/

Source: CBR.

1/ For all credit and depository institutions. Based on Russian Accounting Standards.

5. The general trends are broadly similar for a smaller subset of banks—the top 30 or so—which produce IFRS-consistent data (Figures 35). On the one hand, equity, assets, and loans have continued to grow at a vigorous pace since the financial crises in 1998. However, banks’ profitability has declined as measured by the IFRS, indicating that competition pressures may well be rising. On the other hand, banks have cut marginal costs, leading to improvements in the banking system efficiency ratio. Asset quality has deteriorated slightly, but loan loss reserves have remained adequate.

Figure 3.Russia: Recent Developments in the Largest Banks 1/

Source: Bankscope

1/ Calculated from the aggregated balance sheets of the top 30 banks that have data over the period. Based on international finacial reporting standards.

Figure 4.Russia: Recent Developments in the Largest Banks (continued) 1/

Source: Bankscope

1/ Calculated from the aggregated balance sheets of the top 30 banks that have data over the period. Based on international financial reporting standards.

Figure 5.Russia: Recent Developments in the Largest Banks (continued) 1/

Source: Bankscope

1/ Calculated from the aggregated balance sheets of the top 30 banks that have data over the period.

6. Increasing competition is expected to compress banks’ profits as spreads have narrowed in recent years. Competition pressures are giving additional impetus for banks to enter new market segments, as evidenced by growth in credit cards, auto loans, and mortgages. While these pressures asset diversification which even kept spreads from narrowing in 2004 have led to more they bring new challenges and risks, particularly given the limited risk-pricing and management abilities. However, with competition weighing particularly on small and medium-sized banks, it remains to be seen how well they can adapt to market volatilities and to the needs of the customers—by pioneering new segments and business lines—without exploiting economies in scale.

7. Banks are increasingly turning to foreign capital markets to fund their rapid expansion and reduce costs. During the first four months of 2005, banks issued about US$ 3 billion worth of Eurobonds, mostly with maturities from two to five years, and received syndicated credits for almost US$ 2 billion. While foreign capital has helped banks to diversify their funding base, wholesale capital markets can be volatile and remain poor substitutes for deposit-based funding over the longer term.

8. The overall performance of Russian banks compares favorably with peer banksin terms of common performance indicators (Table 2). However, data quality and timeliness are issues, and there are significant differences in performance within the group.

Table 2.Russia: Largest Banks in the International Context 1/
BanksNet Interest

Margin
Return on

Average

Equity

(ROAE)
Return on

Average

Assets

(ROAA)
Cost to

Income

Ratio
Liquid Assets/

Customer &

Short-term

Funding
Loan Loss

Reserve/

Gross Loans
Min0.30.20.020.016.72.0
25th percentile3.14.60.940.628.44.5
50th percentile4.614.61.758.836.46.2
75th percentile8.122.03.373.651.27.9
Max9.435.18.8173.389.418.4
Average for Transition Peers 2/3.69.90.968.223.30.0
Source: Bankscope.

Based on audited 2003 financial statements which were prepared in accordance with the IFRS.

Sample of 22 banks from Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia.

Source: Bankscope.

Based on audited 2003 financial statements which were prepared in accordance with the IFRS.

Sample of 22 banks from Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia.

C. Banking System Structure

9. Increasing competition, stronger enforcement of prudential and supervisory requirements, including anti-money laundering/combating the financing of terrorism and the DIS enrollment process have led to a decline in the number of banks. The number of operating banks decreased from 1,329 to 1,299 in 2004, with 33 licenses being withdrawn by the CBR.90 However, the system remains fragmented, with several large state-owned or controlled banks, a few larger private banks, about 100 or so medium-sized private banks, and a large number of small private banks.

10. At the same time, the banking sector has become slightly more concentrated.91The share of the five largest banks by assets increased from 41 percent in 2003 to 43 percent in 2004 (Table 3). However, with the exception of Sberbank and the VTB, no single bank has a share of more than 5 percent of total loans or deposits. Only six other banks have more than a 1 percent share of household deposits. The number of banks that have capital below EUR 5 million (Rub 180 million) continues to be high—close to 700—although they make up only about 5 percent of total banking sector capital.

Table 3.Russia: Structure of the Banking System, end-2004(In percent of total)


Sberbank
Top 4 state

banks 1/
Top 5 banks

2/


Top 30 banks
Assets28404366
Credit to the economy303844
Deposits42525472
Of which: Household deposits
Memorandum items:
Number of banks1,299
Of which: state-owned6
Of which: fully foreign-owned32
Source: Central Bank of Russia; and Fund staff estimates.

Includes Sberbank and VTB as well as state-controlled Gazprombank (owned by Gazprom Group) and Bank of Moscow (63 percent owned by Moscow government).

In addition, includes Alfabank.

Source: Central Bank of Russia; and Fund staff estimates.

Includes Sberbank and VTB as well as state-controlled Gazprombank (owned by Gazprom Group) and Bank of Moscow (63 percent owned by Moscow government).

In addition, includes Alfabank.

11. The share of state-controlled banks has remained broadly stable (Box 1). In total, 21 state-owned or controlled banks operate on the market while four of the top five banks by assets are state owned or controlled. The state-controlled banks constituted about 38 percent of total assets, 42 percent of credits, and 66 percent of household deposits of the banking sector as of end-2004 (compared with 36 percent, 38 percent, and 68 percent, respectively, in 2003). Among the largest state-controlled banks, the gradual decline in Sberbank’s position—where the share of household deposits has declined from 75 percent in 2000 to 60 percent in 2004—has been offset by expansionary policies of other state-controlled banks, particularly by the VTB.92

Box 1.State-owned Banks

The Russian banking sector continues to be dominated by state-owned banks. Federal or regional authorities have stakes in more than 20 banks. Such banks account for about 70 percent of retail deposits and about 40 percent of credits outstanding. In addition, many banks are owned by state-owned enterprises. Many regional banks are practically in monopoly positions on local markets through official backing. Moreover, Sberbank has 500 times more branches than the second-biggest retail bank in Russia.

The banking strategy paper for 2005−08 does not propose any significant steps to reduce the dominance of state-owned banks. While the government intends to complete the procedures to reduce the share of government-owned entities in some of the commercial banks by 2006, it remains assured that the state should retain its share in the banking system if this objective is supported by the strategic goals set by the country’s economic policies. However, the authorities will refrain from establishing new state-owned banks and avoid giving any new preferences to the existing ones.

Sberbank’s market share is expected to remain large. Having by far the largest branch network, pension and other social payments are expected to continue to flow through Sberbank for some time. As to Vneshekonombank (VEB), the government plans to focus VEB on servicing the official external debt. The government intends to keep its control over the VTB to the extent the implementation of government policies is ensured. The recently established Development Bank and Agricultural Development Bank will operate to finance certain areas of the economy and to recover the bad assets it inherited from the government and some failed banks.

International experience shows that relying too much on state banks to provide financial intermediation generally hampers the development of the financial system and economic growth in general. The combination of politicized lending and weak management operating under greater regulatory forbearance—reflecting weaknesses in the oversight exercised by government supervisors of the banks owned by the government or by the central bank—has led to severe fiscal losses even in more developed countries. State-owned banks should exist, if at all, only to correct market failures: their activities should be specialized in sectorial and other niches that the market will not address on its own. In practice, however, many state-owned banks in Russia operate as universal banks. Moreover, as in the case of Sberbank and, increasingly, the VTB, they use their protected positions to extend their businesses in other market segments.

12. Foreign banks form a small but increasingly important group. As of end-2004, 131 banks had some kind of foreign participation, and 33 banks were 100 percent foreign owned. Among the 30 largest Russian banks, 3 are controlled by foreign credit institutions. The share of nonresidents in the capital of the banking sector rose in 2004 to 6.2 percent (from 5.2 percent in 2003)—a sign of the growing foreign interest in Russian banks, although this share was even higher in 2000 at 10.7 percent.93 A number of foreign banks have fostered competition, including in consumer lending, by becoming, at least in the major cities, viable alternatives to state-owned banks. Moreover, the access to cheaper funding through their parent companies or through international capital markets have given them a strong competitive edge over the domestic banks. Thus, foreign banks accounted for more than 50 percent of the foreign capital attracted by the Russian banking system in 2004.

13. The CBR has mostly finished its assessment of banks entering the DIS (Box 2). The first phase of enrolling banks in DIS was completed in March 2005, with 824 banks, representing 98 percent of household deposits, admitted. Banks that applied but failed to gain acceptance have the opportunity to appeal the CBR’s decision; final results are due by September 2005. While it is expected that the introduction of DIS will eventually help level the playing field for all state-owned and private banks, including Sberbank, the latter will retain its state guarantee on existing deposits until 2007 (or until its market share falls below 50 percent, whichever comes first).

Box 2.Deposit Insurance

The promotion of confidence, a level playing field for private and public banks, and a sound banking system were the main objectives behind the introduction of the Deposit Insurance Scheme (DIS). The coverage provided under the new system is rather limited. Only physical persons’ deposits are covered (up to Rub 100,000 or about US$3,500), excluding deposits with exceptionally high interest rates and those held in the foreign branches of Russian banks. This compares with the per capita GDP of US$3,800. According to initial estimates, more than 90 percent of all depositors are now fully covered owing to a large number of small deposits in the system. Given the current threshold for the maximum coverage, the potential DIS liabilities are equal to about 40 percent of all deposits.

Participating banks are obliged to pay each quarter a premium of no more than 0.15 percent of the average value of their insured deposits in the preceding quarter. The maximum potential contribution will fall to 0.05 percent after this fund has accumulated 5 percent of the insured deposits. The actual payment is set by the DIS board. If the fund is not in a position to meet its obligations, it may apply to the government for budgetary support. The DIS system began with a Rub 3 billion contribution from the government of which two-thirds will be allocated to the fund and the rest for institutional expenses.

The authorities had planned to use the introduction of DIS to consolidate the banking system by revoking licenses to collect household deposits from unsound and imprudently managed banks. As the number of banks accepted into the system is relatively large, the full benefits of the reform will be achieved only if DIS encourages further consolidation of the banking sector and helps level the playing field for state-owned and private banks.

Also, cooperation between DIS and the authorities should be well established. The exchange of information on banking sector developments between DIS and the CBR, as well as a detailed contingency plan, developed with the government, to cover unexpected liquidity gaps in the course of bank liquidations, is essential for the successful operation of DIS.

The creation of DIS has enhanced the supervisory and regulatory standards of the banking system. However, moral hazard issues should be taken seriously. In countries like Russia with an undeveloped legal system, deposit insurance schemes could actually increase financial instability. Therefore, further improvements in banks’ transparency, prudential regulation, and the administration of justice are essential to make DIS fully effective and the banking sector more attractive.

D. Risks

14. The strong economic growth and rapid increase in loan portfolios may actually hide increasing risks. This is especially true in light of the well-known weaknesses in accounting, auditing, corporate governance, and legal frameworks. Stress tests conducted by the CBR and Fund staff show that liquidity and credit risks rose slightly in 2004. Equity and interest-rate risk also increased, reflecting a rise in banks’ trading activities. Foreign exchange risk declined.

15. Rapid credit growth continues to reduce banking sector liquidity, although, on average, liquidity indicators seem adequate (indeed, high compared with other countries). The share of total assets that are liquid has declined as the loan portfolio has expanded, shrinking the coverage of deposits and short-term funding (Table 4). The liquidity stress test, based on aggregate maturity gaps, continues to point to an increasing exposure to liquidity risks, as the negative asset gap at one month or less has kept widening (Tables 5 and 6). Liquidity issues are likely to remain central given the segmented interbank market, uneven distribution of assets, and increasing demand for longer-term funds.94

Table 4.Russia: Selected Liquidity Indicators 1/(Ratios, in percent)
200220032004
Highly liquid assets to total assets22.320.617.0
Liquid assets to total assets39.136.130.3
Highly liquid assets to demand deposits68.668.156.2

As compiled by the CBR.

As compiled by the CBR.

Table 5.Russia: Liquid Assets to Customer and Short-term Funding(In percent)
200220032004
Average 1/41.840.936.0
Average for top 3 banks 2/57.645.9
Median 1/37.438.0
Average for Transition Peers 3/23.322.7
Source: Bankscope.

Based on 15 banks constituting about 50 percent of banking sector assets without Sberbank.

Sberbank, Vneshtorgbank, Gazprombank.

Sample of 22 banks in 2002 and a subset of 18 in 2003 from the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia.

Source: Bankscope.

Based on 15 banks constituting about 50 percent of banking sector assets without Sberbank.

Sberbank, Vneshtorgbank, Gazprombank.

Sample of 22 banks in 2002 and a subset of 18 in 2003 from the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia.

Table 6.Russia: Stress Test for Liquidity Gap up to One Month
200220032004 1/
In percent of GDP−3.4−4.2−4.4
In percent of banking system assets−8.8−9.9−10.1
Source: Author’s calculations.

Preliminary data.

Source: Author’s calculations.

Preliminary data.

16. Credit risk, although also on the rise, remains fairly low. Stress tests conducted by the CBR and Fund staff demonstrate that the credit risk faced by the banking system increased moderately through 2004, even if nonperforming loan ratios stayed low (Table 7).95 Some credit quality issues will be addressed by the opening of credit bureaus starting in late 2005, although it will likely take some time to get them fully operational.

Table 7.Russia: Comparison of Results of Stress Tests for Credit Risk
Total lossCoverage
(In percent

of GDP)
Number of

banks
In percent

of assets
FSAP (end-2001 data)
Bank-specific NPL ratios3.46475
Uniform NPL ratios3.76475
Staff update for Article IV 2004
(end-2002 data)
Uniform NPL ratios4.43870
Staff update for Article IV 2005
(end-2003 data)
Uniform NPL ratios5.61062
Source: FSAP; and Fund staff estimates.
Source: FSAP; and Fund staff estimates.

17. Foreign exchange risk has declined significantly in the banking sector as the net open position in foreign currencies has narrowed. The recent ruble appreciation alongside the higher yelds of ruble assets led banks to switch from short positions to long positions in rubles in 2004. The CBR stress test, based on end-2004 data, shows that a ruble appreciation of 30 percent would lead to losses of less than 3 percent of banking sector capital.

18. Large exposures remain a concern in many banks. Assets highly concentrated around a few large borrowers and related lending are common, reflecting the structure of an economy where a handful of business groups represent close to half of the GDP. The ratio of aggregated large credit risks (large exposures) to capital has stabilized at around 240 percent for the system as a whole, after falling slightly in recent years. The systemic risks may be somewhat mitigated, as banks exhibit concentration toward those large entities on both sides of the balance sheet. On the other hand, the current credit concentration indicators may actually understate the problem, as the regulations and limits for connected lending affect only entities with legal ties, and not with economic ties. Somewhat relatedly, the CBR is powerless to regulate banks on a consolidated basis if a bank is not the parent—but only a branch—of a financial-industrial holding group.

19. Growing competition and declining margins are changing the risk profile faced by the banking sector. As the traditional sources for bank revenues—mostly trading gains from foreign exchange, equities, and, most recently, fixed income—have diminished, the banks are moving into new markets. Consumer and mortgage lending is picking up. The share of credits to households increased to 16 percent in 2004 from 11 percent in 2003. Also, the current legislative framework governing the new market segments, including the Law on Mortgage-Backed Securities, adopted in late-2003, has yet to be tested.

20. In an increasingly competitive environment, establishment of transparent ownership structures and management practices is becoming crucial for reducing capital cost and improving competitiveness. Transparency has improved as a growing number of banks are turning to international capital markets for cheaper and larger funding. Furthermore, it is becoming apparent that shady ownership structures may restrict access to even domestic interbank credit markets in times of market tightness based on developments in the summer of 2004. Anecdotal evidence suggests that a number of larger Russian banks are making efforts to improve corporate governance, in part to attract foreign capital. For instance, the banks are bringing in overseas managers and streamlining operations. However, continued distrust within the banking sector is still prevalent.

21. The banks’ rights to long-term deposits remain unsecured. The Civil Code gives clients the right to break term deposit contracts before maturity, thus negating them as a source of long-term funding and aggravating the banking sector liquidity profile.

22. In sum, well-known banking system weaknesses remain, exposing banks to various types of risks. These include, for example, connected lending, concentrated balance sheets, nondiversified income sources, and inflated capital—all of which reflect a history of weak regulation, nontransparent practices, a narrow economic base, and a weak legal environment.96 These weaknesses are largely part of the structural problems facing the Russian economy and will take time to resolve. Meanwhile, they make the banking system vulnerable to adverse shocks.

23. These weaknesses are well recognized and reflected in private sector views of the banking sector. For example, credit rating agencies have upgraded Russia’s sovereign rating to investment grade but they remain cautious about the banking sector. Banks continue to be a source of vulnerability over the medium term.97 Russian banks, as a group, continue to be rated among the riskiest among emerging-market economies.

E. Prudential Regulation and Supervision

24. The legal infrastructure for the banking sector has been strengthened, and the CBR’s credentials as a prudential regulator have improved. Particularly, the establishment of compulsory DIS membership was combined with an intense examination of all banks. The banks were tested with respect to the quality and adequacy of their reported capital and management quality, along with their ownership transparency, risk management and internal control, and liquidity. The process put the CBR into a stronger position than ever to assess the “true value” of banks’ capital as well as to identify the banks’ “real” owners.98 As to ownership transparency, no requirements are in place yet that would make the information on ownership available to the general public.

25. The CBR has started to move to “substance-over-form” regulation. This will help to limit the scope for manipulating the computation and reporting of prudential norms, particularly the calculation of capital and loan provisioning; it will also reduce the number of forms the banks have to fill out for supervision purposes.99 As a start, the CBR has cut the number of mandatory norms from 14 to 7. The changes made to loan loss provisioning rules in 2004 allow the banks to exercise “professional judgment” in assessing their assets. However, because the general legal system is unfamiliar with practices based on professional judgments, rather than specific rules, implementation issues are likely to remain. Also, the greater discretion allotted to supervisors in this matter raise some concerns within the banking community.

26. The authorities have taken measures to build up the framework governing the resolution of problem banks. Particularly, the recent amendments to the Bankruptcy Law for Banks made the Deposit Insurance Agency responsible for liquidating the banks, thereby bringing much-needed change by accelerating the liquidation process. More generally, however, the resolution strategies available to the CBR are very limited, making it difficult for it to handle banking problems flexibly and efficiently. The CBR also lacks sufficient authority to remove management and to take enforcement actions against the misappropriation of funds by bank shareholders and management.

27. Although IFRS-based accounting became mandatory for banks in 2004, their short-term effect will be limited. Only a handful of banks provide reports fully consistent with international accounting standards and very few banks provide them on a consolidated basis. For most banks, the IFRS compliance is achieved by using a “correspondence table,” provided by the CBR, which transforms the RAS-based accounts into the IFRS. Moreover, since RAS will stay in use in the rest of the economy and for tax purposes, the IFRS-based reports will be used for analytical purposes only.100 However, while the IFRS are clearly preferable to RAS, neither can curtail opportunities for “window dressing” in the absence of better corporate governance. The extent to which the IFRS makes the system more transparent depends on the incentives for the banks to become more transparent.

28. The minimum risk-weighted capital requirement (CAR) will be set at 10 percent starting in 2007. The strategy also makes clear that should CAR fall below 10 percent, the banking license will be revoked instantly. However, the authorities have not reached a consensus on whether some grace time should be given for banks to comply with the requirement. At the same time, the minimum paid-in capital level will be set at EUR 5 million—in line with the requirements in the EU—with a clause to grandfather existing banks as long as their capital does not fall below their 2007 level.101

29. The recent banking sector strategy paper focuses on a number of ambitious targets for 2008. Among others, the strategy seeks to (i) enhance banking sector competitiveness; (ii) increase the efficiency of financial intermediation; (iii) protect creditors; (iv) level the playing field for all banks and ensure the transparency of individual banks; and (v) improve public confidence in the financial sector.

30. Russia’s capital account appears fairly open and is much liberalized. A new foreign exchange transactions law was implemented in June 2004, removing the existing cumbersome system of ad hoc permits and controls and empowering the CBR and the ministry of finance to impose unremunerated reserves requirements (URRs) on capital flows. The new law provides for a removal of restrictions on residents opening accounts in nonresident banks from the summer of 2005 onward. Anecdotal evidence suggests that because earlier restrictions had been widely circumvented, their removal may not have a significant effect on the banking system.

F. Challenges

31. Strong macroeconomic fundamentals provide a window of opportunity for an extensive restructuring of the banks. A number of weaknesses that make Russian banks vulnerable to adverse shocks remain unaddressed and the banks are to a large extent still exposed to sudden shifts in market conditions and public confidence. The authorities have implemented only a part of the recommendations in the 2002 FSAP (Box 3).

Box 3.A List of Recommendations from the 2002 FSAP

The FSAP report highlighted several areas in the financial sector calling for improvements. The key recommendations more closely related to the banking system were the following:

Banking system

  • Tighten the definition of capital and transparency of ownership structures (immediate).

  • Provide supervisors with enhanced training and move to risk-based supervision (ongoing).

  • Address the uneven playing field in part caused by the large size of Sberbank and by the 100 percent guarantee of household deposits for state banks (medium term).

  • Hold Sberbank to the same standards as other banks operating on a fully commercial basis with a hard budget constraint (immediate).

  • Develop medium-term options for Sberbank in the context of a comprehensive strategic review (immediate).

  • Press ahead with the privatization of the VTB (immediate).

  • Close (or restrict licensing to no longer allow soliciting of household deposits) those banks which are nonviable, overburdened with connected lending, or in transgression of supervisory norms (ongoing).

  • Ensure that only viable banks enter into the proposed mandatory deposit insurance scheme (medium term).

Payment systems

  • Adopt a revised payments system concept paper and submit it for a limited period of public consultation before the launch of a properly managed and resourced project (immediate).

  • • Develop a real-time gross settlement system (RTGS) operating on centralized principles, with appropriate liquidity and operational risk management features (medium term).

Corporate governance

  • Increase transparency of ultimate ownership and control structures (ongoing).

  • Adopt legislation requiring disclosure of related-party transactions (draft Law on Affiliated Persons) and to halt insider trading (draft Law on Insider Trading, and draft amendments to the Administrative Code and Criminal Code) (immediate).

  • Strengthen financial reporting by requiring publicly traded joint stock companies and other large-scale enterprises to prepare financial statements in accordance with IAS (medium term).

  • Establish a centralized securities depository (medium term).

Accounting and auditing

  • Identify and amend restrictive provisions in the Civil Code, Accounting Law, Banking Law, Law on Central Bank, and other laws to create an enabling legal framework for IAS-based financial reporting (ongoing).

  • Make necessary arrangements for preparing and disseminating official translation of the IAS and related interpretations on a timely basis (ongoing).

  • Develop the capacity of the CBR for monitoring and enforcing of the IAS requirements (medium term).

32. Further consolidation in the banking system—with the exits or mergers of small banks—looks inevitable and would increase confidence, as well as enhance efficiency by introducing economies of scale. By adopting necessary legislative and regulatory acts, bank merger and acquisitions costs could be lowered and financial sector deepening accelerated in the least disruptive way. The legal environment should be further amended to give the CBR authority to deal effectively with problem banks.

33. The continued large market share of state-owned banks could hamper the broad-based growth of the banking sector. Moreover, at worst, implicit government endorsement of some state-owned banks could lead to a renewal of politically-motivated lending and could slow financial sector development.

34. Further reforms to improve the operating environment faced by banks and their counterparts would reduce vulnerabilities in the banking system. One of the main reasons for the underdeveloped banking sector in Russia is related to the broader business and legal environment in which the banks operate. Improvements in accounting, auditing, corporate governance, and legal framework—including proper implementation of existing rules—would increase transparency and improve governance.

Prepared by Peter LÕhmus and Leslie Teo.

This paper draws mostly on two sets of data: the Central Bank of Russia 2004 aggregated reports (based on RAS) as well as on Bankscope data (based on the IFRS) for 2003 (30 largest banks), and for 2004 (10 largest banks). The weaknesses of RAS data are identified in previous work such as the FSAP and Selected Issues—The Russian Banking System: Recent Developments, 2004.

This includes eight banks out of the largest 200.

This is confirmed by the CBR calculations based on the Herfindahl-Hirschman concentration index. However, the index shows only moderated concentration levels for banking sector assets, capital, and credits, and very high concentration for deposits.

VTB expanded its assets by 1½ times in 2004. The government has announced its plans to inject an additional $1.5 billion of new capital in 2005.

This growing foreign interest is evidenced by GE Capital’s recent purchase of Delta Credit Bank, Banca Intesa’s acquisition of 75 percent of KMB-Bank, and Nova Ljubljanska Banka’s acquisition of Promsvyazbank. Svenska Handelsbanken has also announced plans to start operations in Russia.

For instance, Sberbank alone holds more than 70 percent of outstanding central government paper. With another large share held by the Pension Fund, the rest of the banking system is left with a very limited amount of eligible collaterals to be used to manage liquidity.

For the Fund stress test, see “The Russian Banking System: Recent Developments” in Russian Federation: Selected Issues, IMF Country Report No 04/316, (Washington: International Monetary Fund, 2004). The complete methodology for the stress-test conducted by the CBR was not available for 2004.

See the Russian FSAP for a discussion of these weaknesses.

See the Fitch Ratings announcement from November 18, 2004 as an example. In general, market indicators that might reflect private sector views of Russian banks are difficult to monitor. Some banks have issued debt but these are not widely traded.

In 2002, the CBR reported that about 60 percent of the top 100 banks had inflated their capital in one way or another.

See also W. Thompson, “Banking Reform in Russia: Problems and Prospects,” OECD ECO/WKP(2004)33 (available via internet: http://www.olis.oecd.org/olis/2004doc.nsf/linkto/eco-wkp(2004)33)

As regards the corporate sector, the Russian Duma gave preliminary approval to a bill requiring corporations with more than one subsidiary to publish financial statements that conform to IFRS in 2004; however, the legislation has stalled.

Currently, only newly established banks have to comply with this requirement.

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