Russian Federation
Targeted Detailed Assessment of Observance of Basel Core Principles for Effective Banking Supervision

This paper focuses on targeted detailed assessment of observance of the Basel Core Principles for effective banking supervision. The selection of the principles to be reassessed was made by the mission team based on an analysis of the risks and vulnerabilities of the Russian Federation. It was revealed that the Central Bank of Russia (CBR) Law does not establish requirements for banks to seek prior CBR approval when making domestic investments in nonbank financial institutions.

Abstract

This paper focuses on targeted detailed assessment of observance of the Basel Core Principles for effective banking supervision. The selection of the principles to be reassessed was made by the mission team based on an analysis of the risks and vulnerabilities of the Russian Federation. It was revealed that the Central Bank of Russia (CBR) Law does not establish requirements for banks to seek prior CBR approval when making domestic investments in nonbank financial institutions.

I. Summary, Key Findings and Recommendations

Executive Summary

1. A targeted assessment of the Basel Core Principles for Effective Banking Supervision (BCP) was conducted which revealed some improvement since the 2007 assessment. The principles reviewed covered the following risk areas: major acquisitions, capital adequacy, risk management process, credit risks and provisions, exposure to related parties, abuse of financial services, remedial actions and consolidated supervision. Although the CBR continues to improve its supervisory process and issue recommendations to banks on monitoring and managing risks, it lacks the supervisory framework to support enforcement of those recommendations and that inhibits improvement in BCP compliance. CP-9 on problem assets and provisioning was upgraded to largely compliant but CP-11 on exposure to related parties was downgraded to materially noncompliant.

A. Introduction

2. This assessment of the BCP was conducted from March 30 through April 12, 2011 as part of an FSAP Stability Assessment. As agreed with the authorities, the supervisory framework was assessed against the BCP methodology issued in October 2006 and the scope was targeted based on a risk-based review of the results from the most recent (2007) FSAP. The assessment was conducted by Mr. José Tuya, consultant.

B. Scope

3. The selection of the principles to be reassessed was made by the mission team based on an analysis of the risks and vulnerabilities of the Russian Federation. The risks and vulnerabilities were identified through the findings from previous assessments, as well as country work, bilateral, multilateral, and regional surveillance. The process followed for the identification of the principles that needed reassessment did not suggest the need to reassess other principles.

4. The scope was set to include CPs 5, 6, 7, 8, 9, 11, 12, 18, 23, and 24. Principles 5, 9, 12 and 24 were graded materially noncompliant at the previous assessment and the others, although graded largely compliant, were selected for review as they represent areas of important risks in Russia.

5. Relevant information from the 2007 FSAP was incorporated into the current assessment, and the principles that were not covered by this targeted assessment were carried over from the 2007 DAR to the annex of this DAR.

C. Information and Methodology Used for Assessment

6. The assessment was performed in accordance with the guidelines set out in the 2006 BCP Methodology and is based on several sources: (i) a preliminary self-assessment prepared by the CBR; (ii) meetings with the Heads and staff of the CBR supervisory departments; (iii) review of laws, regulations, and other documentation on the supervisory framework and on the structure and other developments in the Russian financial sector; (iv) supervisory directives and guidelines, where available, on-site supervision reports and documents following-up on deficiencies noted on inspection reports. We are grateful for the generous assistance of all those without whose support our work would not have been possible.

7. The assessment of compliance with each principle is made on a qualitative basis. A four-part assessment system is used: compliant; largely compliant; materially noncompliant; and noncompliant. To achieve a ”compliant” assessment with a principle, all essential criteria generally must be met without any significant deficiencies. A “largely compliant” assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authority’s ability to achieve the objective of that principle. A “materially noncompliant” assessment is given when the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance, but substantive progress has been made. A “noncompliant” assessment is given when no substantive progress toward compliance has been achieved. In addition, a Principle will be considered not applicable when the Principle does not apply given particular circumstances as described in the 2006 BCP Methodology.

D. Institutional and Market Structure—Overview

8. The CBR Law and the Law on Banks and Banking Activities (BL) assign responsibility for the licensing and supervision of banks to the CBR. The law empowers the CBR to grant banking licenses, approve permissible activities, issue regulations, supervise and enforce compliance with laws and regulations.

9. As part of the Russian Federation’s Development Strategy for the Banking Sector through 2015, the CBR is in the process of overhauling the supervisory, legal and operational landscape to enable the implementation of supervision by risk; including an enhancement in the scope of consolidated supervision. A published strategic plan to strengthen capital requirements and strengthen banking supervision is comprehensive and candid in recognizing shortcomings in the banking supervision framework. The strategy proposes to strengthen the CBR’s legal supervisory powers, and improve transparency, asset valuation, and corporate governance in banks. Adopting the proposed agenda and pending legislation will enhance the CBR’s ability to conduct more intensive supervision, identify risks, and take timely corrective action.

10. Current oversight of banking activities by the CBR relies on an integrated process combining offsite reviews with on-site inspections. In the course of supervision exercised by the CBR’s territorial offices, as well as by the CBR’s central staff with respect to SIFIs, frequent contact is maintained with bank management. Since the last FSAP, the CBR has been working on legislative changes required to enable the CBR to appoint resident inspectors at SIFIs.

11. Legislation, granting the CBR increased professional judgment to implement international best practices without always requiring a revision of existing legislation would enhance the safety and soundness of the banking system. Currently, the CBR is unable to require banks to implement best practices in many areas of corporate governance, and risk management or to perform consolidated supervision because of a lack of regulatory authority. Authority, within an approved legislative framework, to rely on professional judgment to implement best practices as prescribed by international standard setters, adjusted to the local market, is an essential element of supervision.

12. The Russian banking sector is dominated by state-owned banks. As of January 1, 2011 there were 1,012 banks operating in Russia, a decline of 46 from January 1, 2010. The number of banks is expected to decline further as a result of increased minimum capital requirements. As of January 2010, minimum capital was raised to Rub 90 million and will be raised to Rub 180 million on January 2012. The 50 largest banks control 80 percent of assets and the top five (all state-owned) control 48 percent.

13. The level of nonperforming loans and overdue loans has declined. As of January 1, 2011 banking system assets totaled Rub 33,805 billion and the capital adequacy level was 18.1 percent. Nonperforming loans (NPL), which are defined as loans classified in categories IV and V, amounted to 8.2 percent of total loans, a decline from 9.6 percent on January 1, 2010. Total loan provisions currently cover 102 percent of total NPLs but seem inadequate to cover possible losses in the remainder of the loan portfolio. Profitability has increased over the last year, with a return on equity moving from 5 percent in 2009 to 12.5 percent in 2010.

E. Preconditions for Basel Core Principles Assessments

14. The Russian economy is emerging from a sharp recession with lower growth potential, at least in the near-term. The economy contracted by almost 8 percent in 2009, reflecting plunging oil prices and a sharp reversal of capital inflows. A recovery started in mid-2009 led mostly by domestic consumption, which, in turn reflected a policy stimulus. The recovery remains modest, with growth projected at the 4–4 1/2 percent range in 2010–12. While risks appear manageable in the short-run, the combination of a more modest pace of economic growth and abiding regulatory and governance shortcomings cloud the outlook for Russian banks.

15. Russian standards and the application of international accounting and auditing standards are improving but further measures are still required. Approval of new draft laws on consolidation, accounting and audit would benefit the effectiveness of supervision and regulation. In the meantime, progress has been made to converge Russian and international accounting standards, but important differences remain, for instance on revenue recognition, consolidation, employee benefit and pension accounting, impairment testing, the application of fair value accounting, and related party transaction disclosure requirements. Proposed laws on consolidation and accounting envisage the mandatory use of IFRS in the consolidated financial statements of banks, listed companies, insurers, pension funds and other public companies. All in all, a roadmap exists to enhance the quality of financial reporting in Russia. The CBR requires all banks to prepare supplementary IFRS financial statements, although there is no requirement to publish. Improving transparency and reliability of financial information is an important element of the strategy of the government to develop the financial system reporting and bring supervisory standards to meet international best practices. An extensive legislative agenda is being developed to achieve those goals.

16. The CBR’s response to the financial sector turmoil confirmed its ability to respond to the liquidity stresses in the system. The CBR has powers to require early remedial action, mandate change of management and intervene in a failed bank. A system for early intervention would enhance the CBR’s powers, as well as powers to take action against individual managers and directors. Since 2005, Russia has a Deposit Insurance Agency, which has improved the level of confidence of depositors in the system.

F. Main Findings

17. Overall, there has been some improvement in compliance with the BCPs. However, the CBR remains limited to issuing “recommendations” that lack enforcement powers in critical areas such as corporate governance and related party supervision and identification. The CBR Law and the BL do not give the CBR sufficient authority to implement many of the BCP requirements. Proposed amendments to the CBR Law and the BL are pending at the Duma that when approved will address deficiencies noted at the previous and current BCP assessment concerning consolidated supervision and related party supervision.

18. Legislative amendments are pending before the Duma that would enhance the CBR’s ability to conduct consolidated supervision by amending the CBR Law to expand the CBR’s supervisory authority to regulate bank holding companies and to take supervisory actions to mitigate risks to the bank from affiliate operations, including the ability to limit or not allow them. Additionally, the amendments will expand the definition of control to capture not only direct ownership but also economic dependency.

19. Without appropriate regulatory support to conduct consolidated supervision, the CBR is not able to efficiently monitor and limit risks created by related party abuse. The narrow definitions of related parties makes it difficult, if not impossible, to: (i) identify all the lending relationships of each related party with the bank; (ii) identify all of the bank’s affiliates to monitor transactions and measure risk to the bank’s financial condition from affiliates, and (iii) be able to capture all related risks under the lending limits as a percent of capital to limit concentrations.

20. The CBR lacks authority to set key requirements to prevent abuses arising from exposures to related parties and to address conflict of interest. The CBR also lacks the authority to sanction individual Board members. The CBR lacks the power to: (i) establish a comprehensive definition of related parties, (ii) require that exposures to related parties be granted on the same terms as those offered to non-related parties, and (iii) require that directors recuse themselves from voting on issues affecting them.

21. In an effort to continue strengthening the supervisory framework while the legislative process grinds on, the CBR has been issuing letters of recommendations to banks for implementing international best practices on risk management and corporate governance. However, without the regulatory support, the CBR lacks enforcement authority over the recommendations made in the letters. Currently, the CBR lacks regulatory power to require banks to implement the internal capital adequacy assessment process (ICAAP) under Pillar 2 of the Basel II framework so the CBR is planning to issue a recommendation letter to banks in 2011 on implementing the Pillar 2 requirements. Other areas where the CBR lacks enforcement authority and has issued recommendation letters include: “Up-to-date Approaches to the Organization of Corporate Governance in Lending Institutions,” “On Carrying out Transactions with Parties Related to a Bank and the Assessment of Risks Arising in carrying them out,” and “On International Approaches (Standards) to Organizing the Management and Supervision of Country Risks.” The CBR reports that through moral suasion, and the fact that the banks are aware that regulations are in process, it has been able to make progress in having banks implement some of the recommendations.

22. Progress is noticeable in the risk supervision practices applied by the CBR. Pursuant to Directive No. 2005-U, the assessments of banks’ financial condition is based on the analysis of quantitative indicators for the adequacy/quality of capital, assets, profitability and liquidity, and qualitative indicators characterizing the status of risk management systems, internal supervision systems, strategic risk management systems, and transparency of ownership structure. With a view to identifying problems in the operations of banks at an early stage, projected values for capital and profitability are reviewed using forecast values projected 12 months out, based on data for the two previous years and on trend models. Based on the results, banks are assigned to one of five risk categories.

23. The enforcement actions/tools provided by the CBR Law do not allow sufficient options or flexibility to address imprudent practices at an early stage. The CBR is provided with a number of supervisory tools to encourage banks to address violations or unsafe banking practices. However, the corrective actions set by Art. 74 of the CBR Law and Art. 20 of the BL have limitations. The CBR lacks enforcement authority to: (i) penalize or otherwise sanction individual bank directors at open banks; (ii) suspend1 some or all of the shareholders from participation in the management of the credit organization, including their right to vote or accept dividends; (iii) establish limits on salaries and bonuses paid out to directors and key bank personnel; (iv) require additional capital levels to be maintained against the risks specific to the bank, except to impose higher CAR as sanction for violations of federal law and limited to a six-month period, and (v) require prior consent of the supervisory authority to incur a major expenditure or take on a new liability.

24. The following summarizes the main findings of the detailed assessment of compliance with the BCP.

Objectives, independence, powers, transparency and cooperation

Licensing and structure (CP 5)

25. The CBR Law does not establish requirements for banks to seek prior CBR approval when making domestic investments in nonbank financial institutions. Foreign investments by Russian banks require prior approval by the CBR, when they lead to the establishment of a subsidiary abroad, or acquisition of the status of parent company of a non-resident entity. A domestic acquisition of shares in a bank above a 20 percent ownership requires prior CBR approval. Acquisitions of over one-percent share require ex- post notification to the CBR. There is also an aggregate 25 percent limit on investments in banks and other entities. However, bank investments in nonbank financial firms do not require prior CBR approval. The CBR relies on the 25 percent aggregate limit to control that risk. Licensing regulations should provide for an approval/notification process for bank investments in non-banking institutions. Without such requirement the CBR is not able to measure the possible impact of acquisitions on a bank’s condition or to determine whether the acquisition will affect the transparency of the bank’s organizational structure and affect the ability of the CBR to supervise it.

Prudential Regulations and Requirements (CPs 6, 7, 8, 9, 11, 12 and 18)

26. Capital adequacy rules generally meet Basel II, Pillar 1 guidelines but the CBR lacks a legal authority to implement the Pillar 2 component. The standardized, simplified approach is being implemented but the CBR lacks the regulatory authority to implement the supervisory review process prescribed by Pillar 2. Under Pillar 2 the CBR plans to issue recommendations in the second quarter of 2011 on minimum standards for organizing internal procedures for assessing the adequacy of internal capital to cover potential and assumed risks and to provide for future capital needs based on stress testing, strategic plans and risk evaluation. Without legislation specifically stating the authority of the CBR to stipulate standards for risks and capital management, the CBR may not oblige credit institutions to implement said recommendations, to develop internal capital adequacy assessment procedures and to implement them.

27. The existing risk management regulatory framework is complex and multi-faceted. However, it does not provide the foundation necessary for full implementation of supervision by risk. The CBR has issued numerous regulations, instructions and recommendations which directly or indirectly support banks’ strengthening their internal risk management processes. The nature of existing regulations enable a compliance approach to supervision but limit the ability of the CBR to exercise professional judgment to rate the adequacy of risk management systems or Board of Director policies and governance. Addressing these deficiencies is an area where the CBR is focused but needs amendments to existing legislation.

28. The concept of related parties has been identified in the regulations and the CBR collects reports on related parties. However, the definition of related parties is narrow and based on legal relationships. Legislation is being reviewed by the Duma that would expand the definition of related parties and allow the CBR to make judgments based on economic relationships or evidence of ability to influence decisions. The regulatory framework for related party transactions is also deficient in that it does not require that lending to related parties be on same terms and conditions as those generally offered to the public. The CBR has issued recommendations to banks on related party lending, however, they lack enforcement capacity.

29. The CBR is considering amending Regulation 254-P to address country and transfer risk. The current system does not impose country risk limits or provisions, except for operations with residents of offshore centers. The CBR has issued recommendations to credit organizations on the management of risk country based on the approaches specified in the BCBS document “Management of Banks’ International Lending (Country Risk Analysis and Country Exposure Measurement and Control)” and also includes BCP requirements.

30. The supervisors do not have the authority to directly share client information with other agencies and regulators, at home or abroad, which constitutes a serious deficiency. However, it can share such information with the FIU. Also, the CBR is aggressive and very successful in closing banks that are involved in money laundering.

Corrective and Remedial Powers of Supervisors (CP 23)

31. The legal regime for corrective and remedial actions is clearly addressed in the regulations. Enforcement powers are broad and clearly spelled out. The remedial powers of the CBR are deficient in some key areas, such as the inability to sanction Board members and to prevent transactions between the bank and its affiliates.

Consolidated supervision (CP 24)

32. An inability to limit transactions between affiliates, and request information from holding companies limits the ability to conduct consolidated supervision. Legislation is pending with the Duma to amend the CBR Law and the BL that will extend the supervisory authority of the CBR to cover bank holding companies. The amendments will also expand enforcement authority over banking groups and bank holding companies by granting the CBR authority to limit transactions between affiliates. The CBR will be able to dictate the types of consolidated information that bank holding companies will need to provide. The CBR actively collaborates with foreign supervisors and the amendments will enable the CBR to exchange customer-specific information. Finally, the definition of direct and indirect influence is expanded. Absent such powers, the ability of the CBR to monitor transactions between affiliates is severely hampered, increasing risks that losses are hidden through affiliate operations or off-balance sheet transfers. In defining bank holding company the EU standard (to be a bank holding company, over 40 percent of the company’s activities must be in banking) will be applied. However, in Russia that definition may not be adequate as a large banking group would not be included. The definition should be reviewed and adjusted to the Russian market and ensure that all SIFIs are covered.

Table 1.

Summary of Compliance—Detailed Assessment

Only principles 5, 6, 7, 8, 9, 11, 12, 18, 23 and 24 have been reassessed.

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II. Recommended Action Plan and Authorities’ Response

A. Recommended Action Plan

Table 2.

Recommended Action Plan to Improve Compliance of the Basel Core Principles

Only principles 5, 6, 7, 8, 9, 11, 12, 18, 23 and 24 have been reassessed. In order to provide a complete view, grading for the other principles has been carried over from the assessment conducted in 2008.

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B. Authorities’ Response

The authorities were in general agreement with the conclusions and observations in this assessment. Written comments provided have been incorporated in the report.

III. The Detailed Assessment Report (DAR)

Table 3.

Detailed Assessment of Compliance of the Basel Core Principles

Only principles 5, 6, 7, 8, 9, 11, 12, 18, 23, and 24 have been reassessed. In order to provide a complete view, the description, comments, and grades for the other principles have been carried over from the 2007 assessment to the annex of this DAR. The selection of the principles that have been reassessed was done by the mission team based on an analysis of the risks and vulnerabilities of the Russian Federation, informed by the findings from previous assessments, as well as country work, bilateral, multilateral, and regional surveillance. The process followed for the identification of the principles that needed reassessment did not suggest the need to reassess other principles.

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Appendix. Principles Assessed in 2007 not Covered in the 2011 Targeted Assessment

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