Current Legal Issues Affecting Central Banks, Volume IV.
Chapter

Chapter 15 Banking Law Developments in the Former Soviet Union

Author(s):
Robert Effros
Published Date:
April 1997
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Author(s)
TONY SHEA

Economic and Banking Environment

Paying special regard to events in the Russian Federation, this chapter briefly examines some of the developments in banking laws in the Baltic countries, the Russian Federation, and the other countries of the former Soviet Union. It is necessary to recall the environment in which banks in the region operate. Originally, there were a few large, specialized banks. Some of these, in one form or another, still exist. Where the large banks had branches in republics other than Russia, they were taken over by the newly emerging countries. In addition to those original banks, the system now has a number of smaller banks, some very small indeed. In Russia, there are over 1,700 banks, but 65 of these make up two-thirds of the system.1 Many cannot meet the existing capital requirements, which were recently increased, and some closures or mergers are expected.2 The largest bank in Russia, in terms of assets, was the savings bank, Sberbank, but this is now second or third in that category.3

There are some joint-venture banks, co-owned by Russians and foreigners, and a handful of Western banks have full banking licenses. The previous Parliament had proposed that new foreign banks should not be permitted in Russia, that existing foreign licenses should be reviewed, and that existing foreign banks, if allowed to stay, should be permitted to deal only with foreigners. This proposal was supported by many Russian banks, on various grounds, most of which amounted to fear of competition, but it was resisted by the Central Bank, the Government, and the banking subcommittee of Parliament, on the grounds that such competition—and new ideas, skills, and capital—were just what the system needed.4 President Yeltsin originally vetoed the Parliament’s decision, but then passed decrees limiting by law the total capital of foreign banks to 12 percent of all Russian banks and imposing geographical restrictions on such banks.5 A freeze on new licenses was also imposed, although the Central Bank seems to some extent to have circumvented this. These restrictions were introduced shortly before a referendum in April 1993. They were the subject of some discussion, particularly with the European Community (EC), with which Russia subsequently reached an economic agreement.6 In 1995, the law restricting foreign access was scheduled to be abolished, and the 1993 decree immediately ceased to apply to the five banks operating already. Newcomers and existing banks now receive national treatment (with some exception, such as the level of minimum capital). After five years, the 12 percent limitation will be reviewed. Similar restrictions have not been imposed in most other countries of the former Soviet Union, which are far more welcoming of foreign bank capital.

The securities market is only embryonic, and most enterprises raise funds from the banking system, which, in turn, is funded largely by the Government or central bank credits. However, since 1992, one of the main sources of financing of enterprises has been mutual default on payments. Most large enterprises in most of the countries are heavy loss-makers, although few have so far been made insolvent—either from inertia, fear of unemployment and unrest, or the simple lack of appropriate laws and skills.

In developed market economies, the public—ordinary people as well as private businesses—is the major source of the funds that are allocated by the banking system. Most people and businesses have bank accounts into which they put their savings. This is not yet the case in the Commonwealth of Independent States (CIS). Only in a few regions are significant amounts of bank funds collected from ordinary people and private businesses. Most people with bank accounts have them with Sberbank, although in some regions other commercial banks are acquiring deposits from the public.

Although the situation is changing now and will change more rapidly with increasing privatization, most bank funding in Russia has come from the Central Bank, which channels funds through commercial banks to particular state enterprises.7 The Central Bank, in turn, gets its money either from the Government or Sberbank, or by printing money. A limited amount of funding is obtainable from an interbank deposit market. Largely because of high inflation rates and the manner in which banks fund themselves, lending is very short term and at high rates of interest, which, however, lag behind the inflation rate.

Sberbank has been the organization best known to ordinary people and the one in which they have traditionally saved their money. This institution is subject in Russia to direction from the Central Bank, which has also controlled its lending activities.8 The deposits of Sberbank have a significant advantage because they are guaranteed by the state, while those of other banks are not.9 Sberbank has 40,000 branches (90 percent of the branch network of all banks) and over 90 percent of household deposits.10 It offers a variety of services that other banks do not offer.11 Public familiarity, plus its unlimited guarantee and its branch network, gives Sberbank a huge potential advantage over other banks in reaching the ordinary public.

In the CIS as a whole, judging creditworthiness has not been required of banks. Banks have usually allocated central funds to state enterprises by direction. If the funds were not repaid, they were routinely written off. This practice is now changing, but establishing proper procedures to assess credit is very difficult because of the lack of professional experience in judging creditworthiness and the lack of the accounting standards and experience needed to facilitate risk assessment. Change is also difficult because, with much bank lending tied to the founders of the banks, there is no incentive (or ability) to judge their creditworthiness.

In the West, the notion that banks are more highly regulated than ordinary commercial companies is familiar. Banks are not controlled, but they are highly regulated. This concept is either not widely understood by bankers in the CIS, or, if understood, it is often not accepted. A common complaint of bankers is that, now that there is a free market, banks should, like other companies, be free. Although the bankers in one sense are underregulated, there is perhaps some justification for some of the complaints, as even the Central Bank of the Russian Federation will agree that it has introduced many new requirements and changed others with little notice, causing great resentment among the commercial banks.

Specific Prudential Rules

Capital

The minimum capital for banks in Russia was increased, roughly in line with the twentyfold increase in prices, from Rub 100 million to Rub 2 billion.12 This amount is still low, but it is aimed before the end of the century to increase it to the EC standard of E CU 5 million.13 In other newly emerging countries, the figure for bank capital is often much lower. Often, moreover, the definition of capital is highly unsatisfactory. Although initial capital may have to be deposited in cash with the central bank or elsewhere, on an ongoing basis, contributions in kind, such as buildings or equipment, can often be counted as bank capital, and such contributions can be valued by the bank itself at shareholders’ meetings. (The idea behind this practice is that capital forms the basis for the distribution of dividends.) Furthermore, intangible property, such as know-how, may be counted as capital. In addition, capital forms the basis of a gearing ratio for lending exposures of about 20:1. The idea now commonly accepted in the West, that a fund of capital should be retained to meet losses, is not applied in the countries of the former Soviet Union. All of the capital not tied up in buildings and equipment can, therefore, be loaned to customers. Furthermore, in many of these countries—and perhaps in the Russian Federation—there is a confusion about entitlements to capital in case of insolvency. In some countries, there is a concept that shareholders in financial difficulty can call for the return of their capital. The concept of capital, however, depends on the setting of priorities for repayment in case of bankruptcy, which, in turn, depends on the establishment of bankruptcy principles. Clearly, these principles have not yet been established in all countries.

Owners

The rules relating to the qualifications of owners of banks in all CIS countries are rudimentary. Sometimes, owners are required to prove their creditworthiness, which is perhaps based on an imprecise understanding of the legal separation between shareholders and a joint-stock company, and perhaps also on the above-mentioned idea that the capital of a joint-stock company in some sense belongs to the contributors. A common requirement is that the managers of the bank must be fit to hold their positions, but there is usually no similar requirement for the owners of the bank. Allegations that Russian banks are owned by unsuitable persons are numerous. Furthermore, many banks are owned by industrial companies that (especially in the absence of suitable controls on connected lending) may manage the banks for their own purposes.

Risk Recognition

The essence of Western prudential rules is to leave banks generally free to make their own lending decisions, but to take steps to recognize and limit risks. The following list compares the rules applicable to Western banks with the rules applicable to banks in the CIS:

  • Western banks are commonly required to show that they have lending policies and procedures to evaluate the risks of lending and that they follow their own policies and procedures; there is no such requirement in the CIS.
  • Western banks are often limited in their ability to engage in nonfinancial activities, either directly or through daughter companies. If they are allowed to engage in such activities, these may be strictly limited in volume. Comparably, the limitations in Russia and other CIS countries are ineffective. A bank may be prohibited from engaging in industrial activities directly, but it is entitled to own a company that engages in such activities. Also, a bank can be (and often is) owned by an industrial company.
  • Banks in the West are often controlled in their ability to lend to persons connected with them, because lending decisions in such cases may not be rational (based on risk assessment and likely returns) but rather directed by the “parents.” The rules that are imposed may be “arms-length” rules, as in the United Kingdom, a quantitative limit, as in the United States, a simple prohibition, or other means (such as capital penalties).14 In the CIS, however, there are usually no special limits for connected persons, and, as a consequence, a large number of the banks lend most of their funds to their founders, which may be regional councils, insolvent state-owned enterprises, or even private enterprises.
  • Western banks have imposed on them strict limits on the size of their exposures to particular borrowers, so that the failure of single persons will not cause banks to collapse. These limits must also apply to persons that are financially interlinked. In the CIS, the limits are set at levels that are quite high, and there are no rules applying to persons connected with one another, so that in effect the rules are worthless.
  • Finally, Western banks are required to identify debts that are recognized to be nonperforming and to keep special internal reserves or “provisions” against such “bad debts.” These provisions come either from profits or are deducted from capital. Such deductions will, in turn, affect banks’ gearing ratios and lending ability. In most or all of the CIS countries, there are no such requirements. Clearly, given the difficult financial position of so many of the enterprises, the amounts of nonperforming loans are very high, but this is not shown on the books of the banks. Even though there is no legal requirement to identify bad debts, banks tend to disguise them from their supervisors in any case, either by rolling over the loans (extending their terms if borrowers cannot repay) or by adding unpaid interest to the principal amounts outstanding (capitalizing the assets and giving the impression of a healthily expanding balance sheet). The result is that the supposed capital base of the banks is largely illusory, although, admittedly, it is often very difficult to prove this in individual cases because of the lack of accounting skills and reliable accounts. It seems a reasonable conclusion, however, that, if banks in the CIS were subjected immediately to Western rules—and it is not suggested that they could be or should be—nearly all banks would be, in Western terms, bankrupt.

An additional problem that the banking systems in the CIS face is that the central banks lack sufficient staff, even (within Russia) taking all of the numerous branches into account, to supervise the commercial banks. What regulatory staff members there are in the central banks are often overworked and have themselves been unable as yet to obtain full training in the techniques of banking supervision. Furthermore, as soon as staff members gain these skills, many are tempted away to commercial banks that can offer higher wages. Finally, there is evidence in some areas of either intimidation or corruption of some central bank staff.

Reforms

What measures might be taken to improve the situation?

Better Prudential Rules

All of the above matters will eventually have to be addressed—the sooner the better. In Russia, an experiment is being sponsored by some of the international organizations, called the International Standards Bank (ISB) program.15 The idea of this program is that, because it is difficult to force banks to comply with prudential standards, these banks might instead be encouraged voluntarily to adopt higher standards.16 In return for the accelerated introduction of banking standards closer to Western standards by a selected group of banks, these banks would be offered incentives reflecting the reduced risk that they posed to the system.17 Implementation of such a program by some banks does not imply that over time all Russian banks will not have to move to higher standards. It is merely an attempt to produce more quickly a core of identifiable banks that will have—and will be recognized to have—higher standards.18

The World Bank has recommended that new bank licenses should be issued only to ISBs and that, meanwhile, licensing processes should be tightened and supervisory capacities strengthened.19 To promote general competition in the banking sector, the World Bank also recommends a properly designed deposit insurance program, limited in coverage to small deposits.20 (The premiums would be lower for ISBs than for other banks.)21

Substantial Recapitalization

It is clear that substantial recapitalization of the banking system, or at least that part of it that is identified for development, will be required.

New Banking Laws

New banking laws or clarifications of the old will be required.

Bank Closures

Bank closures will be inevitable (a number of licenses have now been revoked by the Central Bank of the Russian Federation). Such closures (or mergers) will be prompted by the capital increases already mentioned or by the effect of the bankruptcy law (discussed below) on many bank customers, which will force the banks to recognize the many defaulting loans. In particular, consideration must be devoted to Sberbank. There are two main options. First, it could be treated more like an ordinary commercial bank and allowed to lend freely to enterprises (it is presently controlled in this activity).22 Because Sberbank takes most household deposits, this option would require most of the supervisory resources to be directed to it.23 If this option is taken, it might also be desirable to sell off a number of the branches of Sberbank to other commercial banks, in order to reduce its effective monopoly on household deposits.24 The second option is to continue Sberbank’s role as the primary taker of household deposits and to prohibit it from lending to enterprises, and to restrict the size or conditions of its lending in the household and interbank market.25 Its other deposits would then be used to purchase government bonds.26 Sberbank could then perhaps retain the government guarantee of its liabilities.

Good Accounting Rules and Practices

Good accounting rules and practices need to be introduced as a matter of urgency, both to assess the creditworthiness of enterprises and to verify the state of the banks themselves.27 The training needs here, as in other areas, are enormous.

Law of Collateral for Lending

A good law of collateral for lending, coupled with an adequate registration system, is required, so that banks can reduce the risks to themselves and their depositors and so that persons can use their property as a lever to obtain funding, thus freeing the economic potential inherent in property.28 Property laws must also be changed to clarify ownership rights.29 Without such a law of collateral, it will be particularly difficult to end the system of agricultural subsidies, as farmers will be unable to borrow freely from the banking system.

Bankruptcy Law

A good bankruptcy law is required.30 Such a law will help to establish the conceptual framework for other legislation on businesses. Key concepts, such as limited or unlimited liability, corporate personality, or even the definition of capital, can depend upon the provisions of the insolvency law. It may also be invoked as part of the privatization process in deciding whether to liquidate an enterprise on a breakup basis or on a going-concern basis, and it can be used in the restructuring of insolvent enterprises. It is necessary for the financial health of the banking system that banks (and other creditors) be able to recover some part of unpaid debts in a timely manner. A good bankruptcy law is also essential to spur the efficient management of enterprises and to assist in gaining fair treatment for lenders and other creditors. Its economic function is to enable assets that are not being put to profitable use to be recirculated and used efficiently. Finally, a good bankruptcy law can help to prevent certain abusive trading practices, such as continued trading when a company has no reasonable prospect of success or the granting of security when a company is insolvent.

Payment Systems

Laws for payment systems are required to deal with all the methods by which payments are made. These systems can be debit based (as with checks, bills of exchange, letters of credit, direct debits, and similar instruments); credit based (as with credit transfers, giro payments, and most electronic payments); or card based.31 Each of these instruments of payment requires a clear legal basis, which is often missing at present (especially in the case of credit transfers).

Dispute Resolution Procedures

Dispute resolution procedures need to be improved. In particular, arbitration procedures, if backed by sound legislative rules, may help to assist where court procedures are slow, unskilled, expensive, or not objective.

Conclusion

The range of issues affecting banking laws in the former Soviet Union is large, and the foregoing discussion is merely a brief indication of some of them. The problems facing the banking system in the former Soviet Union are great and will take years to solve.

COMMENT

DEBORAH K. BURAND

This comment examines (i) the challenges facing the evolving banking system throughout the Baltic countries, Russia, and the other countries of the former Soviet Union, (ii) the rules that are being developed to respond to those challenges (the who, what, and where of banking laws and regulations), and (iii) the how of banking regulation, namely, How are these laws and rules going to be enforced?

Challenges Facing the Banking System

Early analysis of banking reform in the former Soviet Union tended to produce agreement about the challenge that was facing each of the countries. In 1992, the challenge often was described as the challenge of turning centrally administered, monopolistic banking systems that were insensitive to credit risk into competitive, efficient allocators of resources. That challenge remains in most countries of the former Soviet Union. Many of the banking systems within the former Soviet Union continue to be dominated by the direct successors of the old, state-owned Soviet banks. These banks often continue to have a monopolistic hold on sector-specific lending practices and are also characterized by large portfolios, uncollectible assets (sometimes so large that they give rise to a negative net worth), and a resistance to portfolio diversification.

Decentralization and fostering competition have presented many of the countries of the former Soviet Union with yet a new challenge: a proliferation of new banks. These new banks are attracted by low reserve requirements and anticipated profits. They are sometimes set up by state-owned enterprises, such as Aeroflot or the AvtoVAZ car company; sometimes, they are set up by private companies to attract deposits for relending to their owners. Consequently, a second generation of banking laws and regulations is being implemented in the countries of the former Soviet Union that responds to both of these challenges—the need to decentralize and encourage a competitive environment within the banking sector and the risks posed by a proliferation of new and often inexperienced entrants into the banking sector.

Responding to the Challenges

Turkmenistan presents an example of how this second generation of banking laws and regulations is evolving. This is certainly not to suggest that Turkmenistan has a banking law that can be used as a model or one that is better than that of any other former Soviet republic. Turkmenistan’s population is only 4.5 million. As a result, the banking needs of such a country will be vastly different from those of Russia or many of the other former republics. However, some of the issues that confronted the drafters of Turmenistan’s commercial banking law are common to the issues confronting other former Soviet republics.

In May 1992, Turkmenistan enacted a commercial banking law.1 In October 1993, a new commercial banking law was put into place in anticipation of the introduction of the country’s new currency, the manat.2

Who Is Being Regulated?

Determining who should be regulated by the new commercial banking law is the first of these issues. In answering this question, three areas of Turkmenistan’s commercial banking law are noteworthy: the banking law’s definition of a commercial bank,3 the application of the banking law, and the entry of new commercial banks.

First, with respect to the definition of a commercial bank, the drafters of Turkmenistan’s new commercial banking law were faced with a balancing act. On the one hand, drafting an overly broad definition of the term “commercial bank” would strain Turkmenistan’s limited supervisory and regulatory resources. On the other hand, an overly narrow definition would permit parties to conduct banking activities outside a commercial bank and thereby escape adequate supervision and regulation by Turkmen regulatory authorities. In the end, the Turkmen authorities chose a definition of a commercial bank that included only those institutions licensed to take deposits and perform other banking operations. Those “other banking operations” are enumerated in Article 13 of the new commercial banking law. Expressly excluded from those permitted banking activities is the provision of most types of insurance. Also, commercial banks in Turkmenistan are expressly prohibited from engaging in general commercial activities.

Second, with respect to the application of the commercial banking law, a goal in Turkmenistan was to level the playing field among banks, thereby fostering competition and breaking the concentration of sector-specific lending practices of some banks. Before the new banking law was put into place, banks had individual charters. The bank powers granted in those charters varied from bank to bank. Serious consideration was given to requiring existing banks to return those charters and to be relicensed under the new banking law, with a view to leveling the playing field for all banks. However, there was strong resistance from some of the former (and continued) state-owned banks, with the result that such a requirement was not included in the new commercial banking law. It is not surprising that existing banks would resist the introduction of a new regulatory scheme that would prevent them from conducting the kinds of activities and enjoying the kinds of privileges to which they have grown accustomed. On a going-forward basis, the commercial banking law enacted in Turkmenistan has taken steps toward setting forth a more level playing field for new banking establishments in Turkmenistan. It is less clear whether the new commercial banking law also has leveled the playing field for pre-existing banks—like the savings bank and the bank on foreign economic activity, which argued strenuously during the negotiation of the new commercial banking law that they should be allowed to be regulated by both their old charters and the new banking law, and, in the event of any inconsistencies, that their individual charters should govern.

Third, before enactment of the 1993 commercial banking law, the requirements for entry for those wanting to set up a bank in Turkmenistan were quite liberal, the application process for establishing a bank was murky, and the regulations governing these applications were ambiguous. Prospective banks were encouraged to concentrate their lending portfolios and were required to demonstrate to the Central Bank that they would meet the demands of a particular sector or client base. Also, there was a bias in Turkmenistan favoring all prospective entrants into the banking system.

This bias continues even today in the application process. For example, the new commercial banking law requires the Central Bank of Turkmenistan to pay financial penalties to bank applicants if it does not act on their applications within the time limits set forth in the commercial banking law.4

However, as the new banking law was being developed, the Turkmen authorities decided to impose a freeze on the licensing of new applicants in order to give Turkmen authorities time for a more careful consideration of the barriers of entry needed in the banking system and of the types of information required of the applicants. Although the commercial banking law that went into effect in 1993 has no defined grounds for refusing a bank license, it is to be hoped that the evolving system will become more transparent. One step in this direction is the requirement in the new commercial banking law that the Central Bank explain to rejected applicants its grounds for rejecting their applications.5

What Is Being Regulated?

Determining the scope of activities to regulate raises several issues, including how far to broaden the scope of permitted banking activities and how quickly to permit banks to take advantage of such expanded banking activites. An important consideration in determining the speed of change and the scope of change was a concern that the skills of both the commercial bank staff and the bank regulators should not be outpaced. Turkmenistan has not opted for a universal banking scheme; its banking law, however, does enumerate permissible banking activities that are similar to those found in the Russian banking law.6

Where Are Banks Regulated?

Where banks are regulated is an issue of growing importance in a world in which host countries increasingly look to comprehensive consolidated supervision by the home country before permitting a foreign bank to establish a banking presence. Turkmenistan’s commercial banking law permits Turkmen banks to open branches and offices outside Turkmenistan.7 Turkmenistan will apparently require reporting from those banks on a consolidated basis. How that will actually happen is uncertain, in part because of the accounting standards that are used in Turkmenistan. Moreover, the Central Bank’s authority to inspect and examine offices of Turkmen banks located outside Turkmenistan is unclear.

The “How” of Bank Regulation and Supervision

Once the commercial banking law—the skeleton on which bank regulations hang—is in place, the question becomes, What kind of regulations are going to be developed to implement the law? In Turkmenistan, the regulatory scheme that will be built around the new commercial banking law is not entirely clear. Regulations were being drafted as the new law was being put into place. Typically, there have been few chances for public comment on banking regulations, particularly for prospective bank applicants to look at the rules and regulations that could apply to them. Past practice in Turkmenistan has been to make banking regulations available only to those already in the banking business.

In Turkmenistan, both the reporting requirements and the supervisory authority of the Central Bank have been strengthened. The sanctions that the central bank authorities can impose upon banks provide varied means to address problem banks, including imposing fines, convening meetings of shareholders, removing management from the banks, and revoking banking licenses.

What type of incentives can be put in place to encourage compliance with the banking law? Besides market forces, which are a strong and useful tool for encouraging compliance, one tool often used elsewhere and likely to be seen in Turkmenistan is to allow banks that are strongly capitalized a greater scope for banking activity (within the statutory limits of what can be conducted as banking in Turkmenistan) than banks that are weakly capitalized.

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