Abstract
Russian Federation: Selected Issues
Fostering Financial Sector Contribution to Growth1
Raising capital investment in Russia is key to achieving higher growth in the future. This paper diagnoses the state of the financial sector in Russia, using a comprehensive index of financial development, to identify potential bottlenecks. It finds that Russia’s financial markets are relatively deep, accessible and efficient, but that financial institutions, in particular banks, have much to do to improve their efficiency and create further depth. Russia could potentially gain up to 1 percentage point in GDP growth on average over the medium-term from further deepening and efficiency improvements. Policies towards this outcome include reducing banking sector fragmentation through consolidation via increased supervision and tightening capital standards; strengthening the role of credit bureaus and collateral registries to reduce information asymmetries; and removal of interest rate rigidities to foster competition.
A. Introduction
1. Raising capital investment in Russia is key to achieving higher growth in the future (Figure 1). Russia has been experiencing a structural slowdown since 2012, caused in part by a slowdown in investment. Lately, the prospects for a pick-up in investment to the levels needed to sustain robust growth have become dim.
Capital Utilization and Investment
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Haver Analytics and IMF staff calculations.Capital Utilization and Investment
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Haver Analytics and IMF staff calculations.Capital Utilization and Investment
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Haver Analytics and IMF staff calculations.2. The financial sector could potentially play a bigger role in financing investment (Figure 2). Russian companies rely much less on external financing in general and on bank financing in particular, to finance investment compared to their peers in Eastern Europe and Central Asia or in their upper middle income group. Typically, internal resources, state funds and controlling entities are responsible for financing up to 80 percent of business investment. As a result, banks contribute only 6 percent of funding for business investment, with the bulk of investment financed from retained earnings.
Firms’ Financing Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: OECD, Haver Analytics and IMF staff calculations.Firms’ Financing Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: OECD, Haver Analytics and IMF staff calculations.Firms’ Financing Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: OECD, Haver Analytics and IMF staff calculations.3. The financial sector could also channel more savings to SMEs (Figure 3). Although more lending has been extended to SMEs over the past few years, Russia still lags behind in terms of resources flowing to SMEs. Loans to SMEs have averaged around 8 percent of GDP, lower than South Africa (15 percent) and Brazil (13 percent). Although this trend might reflect both demand and supply factors, the asset expansion of the banking sector in the last few years has disproportionally gone to consumers, missing on opportunities to promote the needed diversification of the economic base.
SME Financing
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Moody’s Analytics, Central Bank of Russia and IMF staff calculations.SME Financing
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Moody’s Analytics, Central Bank of Russia and IMF staff calculations.SME Financing
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Moody’s Analytics, Central Bank of Russia and IMF staff calculations.4. There are few bottlenecks that could unleash further financial development. This paper uses a newly developed tool, the financial development index, to pinpoint specific areas where Russia could make further gains in financial development. Section 2 dissects the financial system performance and discusses the areas lacking developments using the lenses of the financial development index. It finds that Russia’s financial markets are relatively deep, accessible and efficient, but that financial institutions, in particular banks, have much to do to improve their efficiency and create further depth. Section 3 provides estimates of the growth dividends from a more developed financial system. Russia could potentially gain up to 1 percentage point in GDP growth on average over the medium-term from further deepening and improvements in efficiency. Policies towards this outcome include reducing banking sector fragmentation through consolidation via increased supervision and tightening capital standards; strengthening the role of credit bureaus and collateral registries to reduce information asymmetries and fostering more lending to SMEs; and removal of interest rate rigidities.
B. Dissecting Russia’s Financial System Performance
5. Russia’s financial sector is analyzed through the lenses of a broad-based measure of finance development. Financial development is defined as a combination of depth (size and liquidity of markets), access (ability of individuals to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets). Sahay et al (2015) developed a financial development (FD) index which encompasses these dimensions applied to both financial institutions (FI), such as banks, insurance companies, mutual funds, pension funds, and to financial markets (FM), which include mainly stock and bond markets (Figure 4). A list of indicators is chosen to measure each sub-index at the bottom of the pyramid of Figure 4. The full list of indicators is shown in Table 1. Each indicator is then normalized between 0 and 1 and aggregated using weights obtained from principal component analysis reflecting the contribution of each underlying series to the variation in the specific sub-index.2
Financial Development Index
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Financial Development Index
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Financial Development Index
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Components of the Financial Development Index
Components of the Financial Development Index
| FINANCIAL INSTITUTIONS | FINANCIAL MARKETS | |
|---|---|---|
| DEPTH |
|
|
| ACCESS |
|
|
| EFFICIENCV |
| 1. Stock market turnover ratio (stocks traded/capitalization) |
Components of the Financial Development Index
| FINANCIAL INSTITUTIONS | FINANCIAL MARKETS | |
|---|---|---|
| DEPTH |
|
|
| ACCESS |
|
|
| EFFICIENCV |
| 1. Stock market turnover ratio (stocks traded/capitalization) |
6. Russia’s financial market s are relatively developed but financial institutions lag behind in terms of efficiency and depth. Russia’s FD index (0.58) is higher than the average EM (0.37) and slightly lower than the average BTICS (0.64), a group of countries composed of Brazil, Turkey, India, China, and South Africa. Nonetheless, the components of the index show large disparities between levels of development of FM versus FI. Russia scores much higher than the comparator groups for FM developments as it features higher degrees of access and efficiency in the operations of its financial markets. Although the depth of financial markets is slightly lower than BTICS countries, it remains much higher than the average EM. Nonetheless, along the dimension of FI, Russia lags behind both comparator groups in terms of efficiency and depth while access to financial institutions is about the same.
7. Financial intermediation lags behind (Figure 5). Looking at the specific indicators of financial depth shows that financial institutions in Russia are comparatively dominated by the banking system, with fewer to non-existent assets, in percent of GDP, in pension funds, mutual funds and insurance industry. Moreover, the banking system lacks depth with domestic credit at about 50 percent of GDP being the lowest in the BTICS group.
Financial Depth
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: World Bank and IMF staff calculations.Financial Depth
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: World Bank and IMF staff calculations.Financial Depth
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: World Bank and IMF staff calculations.
Financial Development Index
(2013)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: IMF staff calculations.Financial Development Index
(2013)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: IMF staff calculations.Financial Development Index
(2013)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: IMF staff calculations.8. The depth of the banking system is hampered by its structure (Figure 6). With some 850 banks operating, the Russian banking system is highly concentrated at the top, and fragmented at the bottom. The top three banks (state-owned) accounted for more than 50 percent of total sector assets at year-end 2014 while the top 20 banks accounted for 75 percent of total sector assets. Lending is highly concentrated among the top 10 bank groups making about 850 banks contribute only 15 percent of total lending. In other words, VTB Group alone with 16 percent share of lending accounts for a similar share as the 830 remaining banks. Most of the banks are small and act as treasury accounts for local firms, operating in particular in mono-cities. The proliferation of small banks undermines lending to companies and SMEs as their ability to both extend credit and diversify across companies is limited while lending to consumers is usually the dominant form of credit. In addition, the nature and activities of the large number of small banks adds little to competitive pressure, while taxing the supervisory resources of the central bank and making it difficult to deal with weak banks that are often involved in fraudulent activities, which has a negative effect on public confidence in banks in general. Many of the small banks are below any plausible minimum efficient scale, and their smaller size also tends to make them more concentrated both on the deposit and lending sides (OECD, 2009).
Banking System Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.Banking System Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.Banking System Structure
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.9. Efficiency of intermediation is relatively low (Figure 7). Some indicators of efficiency, including lending-deposit spreads, are close to the average observed in comparator groups. However, most other indicators of efficiency, in particular non-interest income to total income and overhead costs to total assets, show that the banking system is much less efficient in its operations than comparator countries. Banks appear to be mostly profitable thanks to fees and other revenues unrelated to their main lending activity or to the spread gained between lending and borrowing rates. In addition, bank operations are taking place at a high cost with overhead costs about 5 times higher than the BTICS group. These findings might stem from the fragmentation of the system, discussed above, but also from the moderate concentration of the banking system on the deposit side which hinders competition. Other studies have found that the top 20 banks and state-owned banks seem to be able to exert more market power than the smaller banks and the privately-owned institutions (Anzoatequi et al., 2010).
Measures of Efficiency of the Banking System
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.Measures of Efficiency of the Banking System
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.Measures of Efficiency of the Banking System
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Source: Central Bank of Russia and IMF staff calculations.C. Reaping the Benefits of More Financial Development
10. Financial development dividends could be large. A deeper and more efficient financial system would expand and improve the allocation of capital thereby enhancing economic growth. Financial deepening would also help unlock the potential of SMEs, which typically lack own funds to finance investment projects and are key for the diversification of the economy. Using the regression results of Sayeh et al. (2015) shows that Russia could potentially gain up to 1 percentage point in GDP growth on average over the medium-term from further deepening and improvements in efficiency by moving Russia’s FI index, at 0.38 percent, to the maximum attainable level of about 0.6 percent. Other studies reached similar results, albeit using different approaches. For instance, EBRD (2006) found that growth could improve over the medium-term by close to 1.2 percentage points in case financial intermediation matches the level prevailing in the top 25 percent countries in a CEE sample.
Financial Institutions Development and Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Financial Institutions Development and Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
Financial Institutions Development and Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 212; 10.5089/9781513521893.002.A003
11. Fragmentation of the system could be addressed via policies that promote consolidation without hindering competition. Consolidation will help lift more banks above a minimum efficient scale, which is necessary to contribute to effective competition. Policies include intensification of supervision and the adoption of more stringent minimum capital requirements. This process should be done in a way that nonetheless fosters competition by limiting the involvement of the largest players in the consolidation process when mergers and acquisitions are the result of the winding up process. To the extent that banks in a consolidated system are on average larger than those in a diffuse system, they may benefit from greater diversification and/or economies of scale.
12. The intensification of supervision underway should continue. With increased supervisory powers since mid-2013, the CBR has stepped up banking supervision which resulted in a wave of bank closures and license withdrawals, mostly for very small banks. The CBR revoked licenses for 30 small banks in 2013 and 73 in 2014 involved in dubious transactions, misrepresentation of financial statements and excessive credit risk along with fraud. The removal of small, fundamentally weak banks from the banking system should reduce competition for capital at the remaining mid-sized banks, allowing them to benefit from larger economies of scale and to better compete with larger banks.
13. The move to Basel III should support more stringent capital requirements but CBR should clarify the schedule of implementation. The CBR is moving ahead with the Basel III schedule of implementation of higher capital requirements and new liquidity prudential ratios. Stricter requirements for Tier 1 capital were applied starting in 2015 with the minimum requirement increased to 6 percent from 5.5 percent. Starting in 2016, capital conservation buffer of 0.625 could be introduced (gradually increasing to 2.5 percent by end-2018) and CET 1 surcharge of 1 percent could be applied to SIBs. Nonetheless, these measures have yet to be confirmed and the schedule of implementation formally announced.
14. The authorities should further strengthen the role of credit bureaus and collateral. SMEs identify collateral provision as the main impediments for credit (European Investment Bank, 2013). Strengthening the role of collateral registries by simplifying the procedures to recognize and price assets would allow banks to secure recovery through repossession and sale of collateral. In addition, many national-level credit bureaus are in operation in Russia but poor communication and networking across these bureaus hinder the efficient sharing of information. Currently, the law does not oblige the bureaus to exchange information on borrowers to avoid information leakage and many of these bureaus are affiliated to single banks. A better design of the network and legislative amendments to information sharing could strengthen the role of credit bureaus and give a more comprehensive access to a borrower’s credit histories thereby mitigating risks for banks, enhancing the efficiency of lending decisions and preventing fraud.
15. The authorities should remove interest rate rigidities, in particular on deposit rates. The CBR mandates banks to keep their deposit rates within 350bps above the maximum average deposit rates of the 10 largest banks. The average rate is determined once every ten days and published on the CBR website. This rigidity hinders competition by mid-size banks. CBR implemented this policy in 2008 to limit predatory behavior by some banks which offered very high deposit rates to attract consumer funding but had riskier business models. A better policy, which would not hinder competition, would be to link deposit rates to the deposit insurance contributions, in order to discourage predatory behavior while ensuring stability.
16. The privatization process should be rekindled when conditions allow it. One reform which would likely boost efficiency in the long run is the gradual withdrawal of the state from the banking sector. As advocated by the OECD (2009), there is no clear long-term rationale for state ownership, while there is substantial evidence for higher efficiency of private banks (e.g. La Porta et al., 2000). On the other hand, there is no urgent need in Russia for large scale privatization, especially in light of the fragmentary evidence that public banks in Russia are not less efficient than private ones (Karas et al., 2008). Moreover, there is clear evidence that state banks have been beneficial for systemic stability in periods of crisis, while a period of depressed asset prices is hardly opportune for divesting stakes in state-owned banks. In the near term, the priority is to work on leveling the playing field and bolstering effective competition. A plan for streamlining state involvement in banking when conditions are more propitious should be developed, however.
References
Anzoategui Diego, María Soledad Martínez Pería, Martin Melecky (2010) “Banking Sector Competition in Russia”. World Bank Policy Research Working Paper No. 5449.
European Bank for Reconstruction and Development (2006) “Transition Report 2006: Finance in Transition”, London.
European Investment Bank (2013) “Small and Medium Entrepreneurship in Russia”, Luxemburg.
Karas, A., K. Schools and L. Weill (2008), “Are Private Banks more Efficient than Public Banks? Evidence from Russia”, BOFIT Discussion Papers 3/2008, Bank of Finland, Helsinki.
La Porta, R., F. Lopez-de-Silanes and Andrei Shleifer (2002), “Government Ownership of Banks”, The Journal of Finance, Vol. 57, No 1, pp. 265–301.
Organization for Economic Cooperation and Development (2009) “OECD Economic Surveys: Russian Federation”, OECD Paris.
Ratna, Sahay, Martin Cihak, Papa N’Diaye, Adolfo Barajas, Diana Ayala Pena, Ran Bi, Yuan Gao, Annette Kyobe, Lam Nguyen, Christian Saborowski, Katsiaryna Svirydzenka, and Reza Yousefi, 2005, “Rethinking Financial Deepening: Stability and Growth in Emerging Markets.” Staff Discussion Note No. 15/8 (Washington: IMF).
Prepared by Nazim Belhocine. I would like to thank Katsiaryna Svirydzenka, Adolfo Barajas and Ran Bi for their helpful input regarding the data analysis in Sahay et al. (2015).
For a full description of the methodology and data, please refer to the original publication of Sahay et al (2005): http://www.imf.org/external/pubs/ft/sdn/2015/sdn1508.pdf.
