Chapter

8 Strengthening the Russian Banking System: The International Standard Banks Program

Editor(s):
Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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Author(s)
Millard F. Long and Samuel H. Talley1 

In Russia, financial reform has lagged behind privatization. Concern is now developing that the advantages of privatization may be reduced and the economic recovery slowed by the absence of adequate financial services. Signs of this are already apparent. The payment system has not been able to cope with the expanded number and changed nature of payments. Interrepublican trade has been greatly hampered by payments problems, but payments problems are even apparent in intrarepublican trade where clearance may take weeks.

Payments are simply illustrative. Problems abound in all areas of finance. The growth of interenterprise arrears in 1992 had multiple causes but highlighted the inadequacies of interindustry trade finance. Household savings were traditionally and still are primarily held as deposits in Sberbank. Other banks are dependent on enterprise deposits and borrowing from the Central Bank, leaving them with uncertain sources of funding and a volatile deposit base. Bank credit as a percentage of GDP has fallen very sharply since the end of 1991. Inflation has provided substantial relief to debtor enterprises but at the expense of deposit holders. Because of highly negative real interest rates, banks are not able to mobilize new deposits. Without further credits from the Central Bank, enterprise and household liquidity is at a minimum. Nor does the banking system have the resources to provide large reconstruction credits. Even if the funds were available, the banking system lacks the expertise to judge credit risk or to monitor and supervise enterprises to which loans are extended.

Another problem is the structure of the banking system. The large state banks are not true banks, but rather act as conduits for directing Central Bank and budgetary funding to selected enterprises. At the other extreme, 1,600 small, mostly new banks do little more than provide treasury services to their founding enterprises. A large number of banks are either already technically insolvent or will become insolvent when the Government eventually cuts back on subsidies and credit to enterprises. The infrastructure of the banking system is deficient. The commercial banking law has serious shortcomings, the bank supervisory capacity of the Central Bank is minimal, and the banking system does not employ proper accounting standards. The lack of proper accounting standards and adequate disclosure of bank financial statements largely eliminates market discipline from the Russian banking system. In sum, the financial system in Russia is ill prepared at present to serve the newly emerging private sector.

The problems are so serious that various proposals are appearing to establish what would essentially amount to alternative banking systems: for example, the proposal to pass large amounts of foreign assistance for reconstruction through nonbank government institutions or newly established development banks. During the 1970s, governments in developing countries (often supported by the international donors) attempted to use draft measures to develop the real sectors of the economy, at the cost of financial sector development. Experience shows that this procedure was a mistake. Moreover, although the banking system in Russia is behind in terms of preparation for market activity, it may not be far behind. Most of the newly privatized firms will take some time to formulate their strategy, and by the time the firms have well-developed plans for reconstruction, the banks could be prepared to make and supervise loans. The evidence from some of the other East European countries (Poland, the Czech Republic, Hungary) suggests that with the proper incentives the banks can prepare themselves for the market as rapidly as the enterprises. An important reason for a lack of progress in Russia has been the absence of any central authority interested in and able to tackle the problems of financial reform on a systemic basis. We would like to suggest that development of the regular banking system should not be neglected in terms of policy and assistance even though some supplementary institutions may be needed to handle the financing of the largest and most problematic enterprises.

That reforms in finance have lagged behind those in privatization should not be taken to imply that little has changed or that no progress has been made. The structure of the banking system in Russia has gone through turbulent change over the past five years from the transformation of the monobank into several large state banks and then the breakup of those state banks into many independent banks coupled with the proliferation of new banks sponsored by enterprises. The existence of so many new and small banks is in fact one of the problems. But in other areas change has been more constructive. Considerable effort has gone into drafting new banking and other business laws (most of which are yet to be enacted), developing better systems for financial accounting, preparing plans for payment system reform, training bankers, initiating a system for bank supervision, and developing a program for limited deposit insurance. But even in these areas, although plans have been drafted, little has yet been implemented.

In the early stages of the debate on financial reform in Eastern Europe, the question was raised whether to attempt to restructure, reform, and recapitalize the existing banks or to scrap the existing institutions and establish new banks unencumbered with problem portfolios and bad banking habits. In practice, all of the governments opted to restructure the existing institutions, although some have created new development banks or issued licenses to new commercial banks. Even if an appropriate legal framework could be developed for the Russian banking system, the Central Bank does not now have an adequate supervisory capacity to enforce the laws or monitor the banking system to root out unsafe and unsound banking practices. In part, this is due to Russia having over 1,700 banks—the result of the Government not implementing appropriate licensing standards. After an initial analysis of the situation in Russia, we discussed with the authorities delicensing the many small banks that were acting only as funding agents for their founding enterprises. These banks represented pathological examples of insider lending. The authorities preferred an alternative solution, which has come to be known as the international standard banks program. During 1992, the World Bank worked with the Central Bank of Russia on the development of this program. In the opinion of the World Bank, as well as a number of officials at the Central Bank, this program could make a significant positive contribution to the development of the Russian banking system during these extremely difficult times.

In this paper we will describe the international standard banks program. This program is not a complete program in that it does not directly deal with the three major state banks—Rosselkhozbank, Sberbank, and Promstroibank—which hold roughly 25 percent of the banking system’s assets. Moreover, only by implication does the paper deal with the smallest 1,600 banks that hold about 10 percent of the system’s assets. With regard to these banks, the Government recently raised the minimum capital requirement for banks to 100 million rubles, effective July 1, 1993. Most of these 1,600 small banks have capital that is far below this new requirement. Consequently, unless these banks raise a significant amount of capital very quickly (which is unlikely) or engage in mergers, many of them face the prospect of losing their banking license.

International Standard Banks Program

The international standard banks program is a voluntary, incentive-based program that would confer specific benefits on those banks that agree to conduct their operations in accordance with a set of “good” banking standards that are now widely employed in the developed world. The program, which is still in the draft stage, has four primary objectives: (1) to increase the mobilization of resources by the banking system; (2) to improve the allocation of credit by the banking system, primarily by decreasing the present widespread insider lending; (3) to allow the public to differentiate between “good” and “bad” banks—something that the public basically cannot do under current conditions; and (4) to provide the country with a core group of good banks that would become the nucleus of the future Russian banking system. The proposed program would not eliminate the need to proceed with efforts to improve the infrastructure of the Russian banking system, including needed amendments to the banking law, strengthening bank supervision, improving bank accounting and auditing standards, and upgrading the quality of bank management.

The proposed program essentially consists of three parts. The first part establishes the banking standards that international standard banks would be required to meet. The second involves the development of a package of benefits that would be conferred on these banks. The third part establishes the procedures that the Government—in this case, the Central Bank—would follow in administering the program.

Standards

Based on the latest draft, which was completed in late 1992, the international standard banks program would contain the following eight standards:

• The bank must have capital of at least Rub 400 million (this amount probably will have to be adjusted upward to account for the inflation that has occurred in Russia in recent months). To avoid excluding good small banks from the program, however, any small bank that could meet all of the program standards except the minimum capital requirement would be granted all of the benefits of the program except the ability to use the designation of an international standard bank.

In addition to the Rub 400 million minimum capital requirement, the bank must meet capital adequacy standards that closely parallel those of the Basle Committee. The capital adequacy standards would require the bank’s total capital to equal at least 8 percent of its risk-weighted assets and off-balance-sheet exposures. One can legitimately question whether an 8 percent standard is sufficient for Russian banks, given current economic conditions in that country. On the other hand, merely getting some banks to an 8 percent standard would represent a major achievement, given the current very low capital ratios of many Russian banks.

• The bank would be prohibited from having a risk exposure to any single borrower or group of related borrowers that was in excess of 25 percent of the bank’s capital. In addition, the aggregate amount of all risk exposures to single borrowers that equal or exceed 10 percent of the bank’s capital could not exceed eight times the bank’s capital. Finally, the bank would be required to submit to the Central Bank a quarterly report on its single borrower exposures, as well as the aggregate amount of all large exposures (those equal to 10 percent or more of the bank’s capital).

• The bank would be prohibited from having a risk exposure to any single connected party (or parties related to the connected party) that is in excess of 10 percent of the bank’s capital. In addition, the aggregate amount of risk exposure to all connected parties could not exceed 20 percent of the bank’s capital. Finally, all bank credit transactions with connected parties would have to be made on commercial terms, and the bank would have to submit quarterly reports to the Central Bank on credit extended to connected parties. As a matter of supervisory policy, the Central Bank would closely review all connected lending transactions during its periodic on-site bank examinations.

• The bank would have to maintain a loan-loss reserve that would be adequate to absorb potential losses from nonaccruing loans. The Central Bank would develop a schedule that relates the amount of reserves required to the length of time that a loan has not been accruing interest.

• The bank must agree to adopt a “code of conduct” that would govern its relationship with its customers. This code, which would be developed by the Central Bank, would be based on the code now used in the United Kingdom. The code would be designed to provide customers with certain essential information about the bank’s services and prices and ensure that customers would receive fair treatment by the bank. This fair treatment would include assurance that the bank would handle customer information confidentially.

• The bank must employ proper accounting standards and procedures and must submit reports to the Central Bank that would permit the Central Bank to monitor adequately the international standard bank’s financial condition.

• The bank would have to agree to submit its senior officials to a “fitness and suitability” test conducted by the Central Bank and agree to remove any officials who failed the test. The Central Bank would evaluate the integrity of the officials and their competence to carry out the responsibilities of their present positions. The competence standards employed by the Central Bank would have to reflect the fact that few banking officials in Russia have had the types of experience possessed by banking officials in western banking systems.

• The bank must submit to an annual external audit conducted by a responsible auditing firm. The Central Bank would maintain a list of auditing firms deemed to be qualified to perform high-quality audits. The Central Bank staff believes that this list initially would have to be confined largely to western auditing firms until local auditing firms have gained enough experience to perform high-quality audits.

The above list of standards certainly would not seem formidable to banks in the developed world. But in Russia at this time, these standards would be so demanding that probably only a very small number of banks could meet them. Consequently, one of the major policy questions involved in establishing the international standard banks program is whether to require banks to meet all of the standards immediately, or phase in certain of the standards over time, particularly those standards that almost all banks would have difficulty meeting. For example, it might be reasonable to phase in required capital ratios to give banks time to adjust their operations. Actually, even in the developed world banks were given several years to meet the Basle capital requirements.

Benefits

To induce Russian banks to become international standard banks, the program would grant these banks certain benefits that would not be available to other banks that either would not or could not meet its standards. The development of an appropriate benefits package is clearly the most difficult part in the design of the international standard banks program. The following are the major criteria that should be employed in the selection of individual benefits:

• The benefit should act as a significant incentive for banks to become international standard banks. Also, the total package of benefits should produce approximately the “right” number of international standard banks—enough such banks to create the beginning of a “good” bank sector, but not so many that the Central Bank would be unable to supervise them effectively.

• If possible, each benefit conferred should contribute to strengthening the banking system and improving the allocation of credit through the banking system.

• The benefit should not involve high costs to the Government or present the Central Bank with serious administrative problems.

• The benefit should have no unintended adverse side effects on the financial system or the economy and would not adversely affect the implementation of other important government policies or programs, such as the conduct of monetary policy.

During our discussions with the Central Bank in 1992, it became increasingly apparent that individual benefits could be viewed as falling into three groups. The first group included those benefits that should be explicitly included in the program at the time the program is initiated. The second group included those benefits that might be explicitly included in the program at some later date, if and when future conditions made their inclusion feasible. The third group included benefits that probably could not be explicitly included in the program, either initially or later, but might be extended to international standard banks on an ad hoc basis. For example, if the Government should ever decide to break up Sberbank and sell off its pieces to commercial banks, it might logically give international standard banks preferential access to the bidding process.

Based on extensive consideration of the benefits package, the following is a list of individual benefits that we now favor for inclusion in the international standard banks program:

• Give qualifying banks the sole right to be designated an international standard bank—a designation that the bank could use in its advertising to the public. In our judgment, this designation could constitute the greatest benefit in the program because it would give these banks better access to funding and a lower cost of funds than other banks. In combination, these two factors should allow international standard banks to gain market share at the expense of the rest of the banking system, thereby increasing the portion of the system that would be in the “good bank” sector.

• Allow international standard banks to borrow from the Central Bank discount window at a lower rate of interest than that available to other banks. This benefit would be logical because international standard banks would expose the Central Bank to less credit risk than other banks.

• Give international standard banks preferential treatment regarding deposit insurance, which has been mandated by Russian banking law. This preference could involve sole access to such insurance, or access on more favorable terms and conditions than those granted to other banks. Again, granting international standard banks preferential treatment would be logical because they would represent lower risk to the insurer.

• Provide that any interbank borrowing by international standard banks would carry a lower risk weighting for calculating the capital requirements of lending banks. This factor should lower international standard banks’ cost of funds relative to other banks.

• Facilitate the expansion of international standard banks by granting them authority to branch without applying for supervisory approval. In addition, they would be given preferential access in bidding for any failing banks—a logical procedure because the Government would want good banks to acquire the business of any failing banks.

• Give international standard banks broader activity powers, such as the exclusive right to engage in international banking operations (which now requires a special license) or engage in certain securities activities.

• Give international standard banks preferential access to managerial and operational support funded by the international organizations. This support could include so-called twinning arrangements with foreign banks.

Administration of the Program

The international standard banks program would presumably be administered by the bank supervisor, which in Russia would be the Central Bank. This agency would receive applications from banks desiring to become international standard banks and would have to determine within a specified time whether the bank met the program’s standards. If the bank met the requirements, the Central Bank would designate the bank as an international standard bank and begin to confer benefits on it in accordance with the provisions of the program.

A bank that had been granted the international standard bank designation might subsequently fail to comply with one or more of the program’s standards. In this event, the bank would be given a specified period of time, not to exceed three months, to come back into compliance. During this interval, it would be denied all program benefits, except the international standard bank designation. If the bank failed to come into compliance by the end of the period, such designation would be revoked.

Anticipated Results

It is of course difficult to anticipate precisely the results of implementing the international standard banks program. We do not regard the part of the program relating to standards to be a policy variable, except for the possibility of phasing in some particularly difficult standards over a reasonable period of time. But the benefits could be altered to make participation in the program more or less desirable. The objective is to build a workable banking system that could provide needed financial services to the private sector and obviate the need for building a new state-run banking system.

Based on the World Bank’s work in Russia over the past year, we believe that there are perhaps 20-30 sizable banks with roughly one-third of the banking system’s assets that are already working on strengthening their balance sheets and their banking skills, and some are also trying to reduce their single borrower and connected lending exposure. These banks are the most likely candidates to participate initially in the international standard banks program. Over time, as the international standard bank concept catches on and banks begin to realize that such banks may represent the “wave of the future” in Russian banking, we expect many of the remaining top 100 banks to join the program.

As suggested earlier, we also expect that the benefits extended to international standard banks would allow them gradually to capture market share at the expense of the rest of the banking system, thereby expanding the “good bank” sector. Moreover, if the Central Bank begins to close down some insolvent banks and impose losses on depositors, this could result in at least some “flight to quality”—that is, a shift of business from banks that were not international standard banks to those that were. Although this shift would be somewhat destabilizing, it would be part of the inevitable process of transferring from a “bad” banking system to a “good” (or at least “better”) system. Moreover, a shift of deposits within the banking system would be better than a shift of deposits out of the system and into currency, foreign exchange, or goods—a result that seems likely if the public cannot readily identify good banks.

As stated earlier, the international standard banks program is only a partial solution to the current problems in the Russian banking system. It does not deal directly with the three large state banks nor the large number of small banks that either would not want or would not be able to participate in the program. Therefore, other policies will have to be developed to deal with that part of the banking system, including how to terminate the existence of many of these banks in a manner that would be least disruptive to the banking system and the emerging market economy.

Potential Shortcomings of the Program

In our judgment, there are several potential shortcomings or risks associated with the international standard banks program. First, the program could turn out to be “stillborn”—that is, virtually no banks would choose to participate in the program. To minimize this risk, the benefits package must be made attractive enough to act as a real incentive for banks. In addition, it may be necessary, or even desirable, to phase in some of the more rigorous standards over time, thereby giving banks a greater opportunity to adjust their operations to the new requirements.

Second, although the international standard banks program is largely designed to increase the soundness of the banking system and make credit allocation more efficient, the program by itself would not provide Russian banks with the types of skills necessary to operate an effective banking system. It is to be hoped that at least some foreign banks will invest in, or form joint ventures with, Russian banks and introduce modern bank management techniques. Alternatively, the international agencies and various national governments could provide technical assistance that would upgrade the skills and standards of Russian banks. But even if substantial foreign assistance is forthcoming, the learning process will take considerable time.

A different kind of risk could be created by the international community itself. At this time there is growing interest among the Group of Seven nations in creating a fund that would be used for lending primarily, but not exclusively, to newly privatized enterprises for purposes of reconstruction. This funding, which could amount to as much as $4 billion, presumably would be dispersed over a two-year period. To put this amount of possible lending in perspective, the total loans in the Russian banking system as of the end of April 1993 amounted to only about $8 billion at current exchange rates. If international standard banks are not included in the programs to handle the funds generated from international sources, they could be marginalized. If they are included, they could be overwhelmed. The banks that might qualify as international standard banks would have only a fraction of the $8 billion of loans currently outstanding in the Russian banking system. Moreover, these banks would have only a small amount of capital. Given the huge credit risks involved in lending in Russia, requiring international standard banks to make large amounts of term loans on an already small capital base would almost certainly result in the failure of many of these banks. Hence our advice would be to limit carefully the role that such banks play in the proposed reconstruction programs, giving due consideration to both their limited capital and managerial capacity.

In targeting the development of the real sector, international lending programs should be aimed as well at developing, and certainly not undermining, the financial system. That should be one of the lessons of past experience. In the rush to help with industrial restructuring, the donor community should not neglect the impact of its programs on the emerging financial system.

Comment

Peter Garber, Carl-Johan Lindgren, and Henry Schiffman

Millard Long and Samuel Talley’s paper describes a proposal by World Bank staff for Russia to define certain capital and prudential norms, which, if met by banks, would entitle the banks to be designated international standard banks. Any such bank would gain access to special privileges from the Central Bank, which would primarily improve the cost and quantity of its funding. Such a program is necessary, in their view, because of the inability of the Central Bank to conduct appropriate prudential supervision and the inability of the market to impose discipline. Thus, if there are not sufficient “sticks” to bring banks into compliance with appropriate prudential standards, the Government should offer “carrots” to induce proper behavior. They recognize that this program is not a comprehensive solution for weak banks in Russia; but they estimate that a core group of some 15 banks would cover some one-third of banking assets.

Notwithstanding these views, we intend this comment as a cautionary critique of the international standard banks program. In our view, the potential benefits of the international standard bank proposal are largely overstated, and serious shortcomings mar the scheme as it is currently proposed. We develop this view by considering a list of the most problematic issues.

Supervisory Capability Not in Place

The lack of supervisory capacity, which is the premise for the proposal, is also the reason that the proposal may not be feasible. Loan classification and auditing or accounting standards are not in place, nor are there auditors and bank inspectors to enforce them. This makes banks’ financial statements unreliable and capital ratios meaningless. The central banks are not able to determine which banks meet the international standard bank qualifications, and they lack the supervisory and enforcement capacity to identify promptly and to decertify banks whose financial condition has deteriorated. It may be some time before such supervisory capacity is available.

Detrimental Impact of Special Incentives

Giving special incentives (subsidies) such as lower reserve requirements, special access to cheap central bank credit, and greater potential for branching or acquisition of failed banks would highly distort competition and market development by favoring the international standard banks and increasing the failure rate of other banks. In addition, the differences in applying monetary policy instruments will greatly complicate short-term monetary control.

Implicit Official Approval Already Exists

A process already exists to identify strong, large banks through the selection by the Central Bank of Russia for participation in the Central Bank’s credit auction, the government securities market, and foreign exchange auctions. Thus, any additional informational benefits to the public of an international standard bank program would be small.

Implicit Deposit Insurance

As one of the more important potential adverse consequences, the Government may have to provide increased financial support to weak international standard banks. The seal of approval to international standard banks may be treated as an implicit guarantee of solvency. Such a seal would also complicate if not taint bank supervision, since supervisors might be reluctant to withdraw such status once awarded.

Insufficient Coverage of International Standard Banks

The thrust of the program is to concentrate the bulk of banking business in a few favored banks. Credit allocation and monitoring are usually a localized banking activities, however. In countries as vast as Russia, some two dozen banks that may become international standard banks cannot properly serve the whole country, especially in view of relative factor immobility. To withhold international standard bank status from localized banks may taint them sufficiently to increase their funding costs and impede credit allocations to localities.

Lag in Verifying Compliance

It may take a year or more for the Central Bank to verify whether the international standard banks have complied with the new standards and to implement appropriate accounting standards and adequate inspection procedures. During that time, there is no reason to believe that banks with this status would have incentives to conduct business in a sounder manner than banks lacking such status.

All Banks Should Publish Financial Statements

Two of the international standard bank requirements are for banks to adopt western accounting principles and to be subject to an annual audit by approved auditors. Independently of a special program, the supervisor should in any case require all banks to adopt appropriate accounting principles and publish transparent financial statements.1 Those banks that comply would be advised to follow the routine practice in the West of having an independent audit, and they can publicize this fact to gain the attention of the market. A simple publication in a newspaper of a bank’s financial statement and the opinion of the auditor, as is common in the West, can substitute for the central bank’s imprimatur.2 Financial statements will also indicate liabilities to the central bank that will attest to the central bank’s belief that the bank merited credit for such transactions, a fact that the market will be able to determine.

Deposit Shift Could Cause Illiquidity and Failures

Depositors may withdraw funds from banks that are not international standard banks, which could precipitate their illiquidity and failure. The increased deposits in the international standard banks may be invested substantially in loans to the same weak enterprises that are or were the customers of the other banks. The international standard banks must, after all, place the newly deposited funds into earning assets, and the old borrowers will be the most ready sellers of such claims.

Bad Banks Have Incentives to Become International Standard Banks

Designation as an international standard bank largely requires a commitment to abide by more stringent prudential rules in the future, rather than conformity with adequate standards at the time of designation. Owners of banks with enough capital to qualify may apply for international standard bank status out of fear of the competitive consequences of not applying, regardless of whether they intend to comply or are capable of complying with the new standards. Banks that lack the minimum capital could manufacture it by financial manipulations through the industrial firms with which they are related. In this way, the flight of deposits into international standard banks mentioned earlier will be accomplished through a reclassification of existing institutions without any change in underlying quality. Moreover, if a sufficient proportion of the existing banks act in this way, supervisory resources would again be diluted, and the prospective benefits from concentrating resources in a few international standard banks would be minimized.

Doubtful Ability to Comply with International Standards

The ability of international standard banks to comply with their commitments also must be considered. Presumably, there will be a phase-in period for compliance with stringent lending limits, including loans to related parties. In many cases, however, the borrowers may be unable to repay or refinance their excessive borrowing from international standard banks, and the international standard banks may be unable to organize lending syndicates to divest a portion of their credit exposures. The provisioning required for international standard banks by such assets, under new accounting rules, could result in negative net worth in some cases and severely impede the attainment of the capital adequacy standards in others. Indeed, the proposal recommends that provisions be based only on the amount of time in arrears, which may result in excessive provisions.3

Finally, the phase-in period of two to three years is too long. An initial requirement to meet the standards should govern the award of international standard bank status. Under the proposal, how would the program treat a bank that indicates its intention to meet the standards but then falls short intentionally or unintentionally? Would compliance be measured half-yearly or yearly, and what would be the sanction for noncompliance? Would international standard bank licenses be tolerated for banks that do not meet the standards?

The views expressed should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries.

The International Advisory Group on Accounting and Auditing for Banks has endorsed a model plan of accounts for commercial banks in the former Soviet Union that, according to World Bank staff, can be implemented in Russia in 6-18 months.

Sophisticated market participants will realize that the unqualified opinion of reputable auditors, which will initially be local affiliates of internationally recognized firms, is more significant than an endorsement by the central bank, since central banks are only beginning to develop capabilities in bank supervision and are less skilled at inspection than are experienced auditors.

The lending limits recommended by Long and Talley may also be too stringent. Limits on individual loans to insiders of 10 percent of capital and 20 percent of capital in the aggregate may be insufficient to accommodate requests for credit by creditworthy shareholder enterprises. Such strict limits also may discourage board participation in banks by qualified officers or directors of shareholders who may have important insights into real sector activity that are useful for a bank.

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