Annex I. Asset Quality Reviews
72. Asset quality reviews (AQR) are key diagnostic tools to better assess capital adequacy and the economic condition of banks, reduce uncertainty, and support confidence. Comprehensive AQRs are useful to understand the health of banks’ balance sheets, particularly when asset underperformance becomes systemic. Such cases can threaten the long-term viability of the banking system. In deep economic contractions, excessive debt burdens and the lack of viability of many projects can become apparent. Banks may take unrealistic views of underperforming assets to avoid loan loss provisioning, increases in regulatory capital requirements, and funding costs. AQRs can help better establish the value of assets against a rigorous standard, and identify whether banks have sufficient financial resources to absorb medium-term losses. They can also be used to inform decisions on bank restructuring and private sector debt resolution.
73. Loans, almost always the largest asset item, should be the primary focus of AQRs. AQRs shed light on the extent to which the loan portfolio can deteriorate and on losses incurred. This depends on many factors, including the scale of deterioration of the macroeconomic environment, the strength of the bank’s credit administration, and the legal environment for effective resolution of underperforming assets. Onsite analysis is essential to review individual loan files and to accurately assess the valuation and enforceability of collateral.
74. The design and implementation of the AQR must be credible and be perceived as such by market participants. This is usually achieved through a rigorous design, transparent public disclosure of procedures and results, and engagement of independent third-party expertise to conduct and/or oversee the AQR. The experts’ tasks may include advising on setting scope and methodologies, drafting terms of reference, and overseeing the conduct of the AQR.
75. Operationally, the AQR can be conducted in one go or in phases, using a risk-based approach to prioritize banks. For each bank, the review should provide a comprehensive assessment of capital needs that can support decisive supervisory actions. Two approaches could be considered, individually or as a combination:
Independent external auditors: Banks are required to hire independent external auditors (different from their normal auditors) from a pre-approved list of reputable firms to perform the AQR. Large and complex banks could be required to use international firms or audit partners based in other countries.
Bank supervisors: Supervisory staff conducts the AQR, with independent external advisors participating in designing the terms of reference, and discussing and challenging the results of the review. The experts could be domestic and/or international.
Before the AQR, the authorities should formulate a strategy to address any weaknesses that the AQR may reveal. The strategy should include a method for assessing banks’ viability on a forward-looking basis, based on the AQR’s results and, usually, a business plan and possibly stress tests using the results of the AQR as a starting point. Audited accounts often do not pick up the true extent of asset quality problems, as they do not allow for a forward-looking viewpoint. Eligibility criteria for banks to receive public solvency support, if justified due to systemic risks, and under strict conditions, also need to be thought through before the results are announced.
Undercapitalized but viable banks should be required to submit time-bound recapitalization plans. Advance preparations for orderly resolution should be made for banks that are not deemed viable.
CBR moved to a free floating exchange rate in November 2014 and tightened monetary policy, including through an emergency 650 bps rate hike in December 2014 to 17 percent.
Thirty banks were under open bank resolution at end-February 2016, with total assets amounting to 6.4 percent of system assets. (The number of credit institutions that had their licenses revoked (214) is as of end-April 2016.)
Breach of anti-money laundering legislation was among the reasons for license revocation in 84 cases, and the exclusive ground in 20 cases. (The corresponding data for 2012–13 was nine and two licenses, respectively.)
Within CBR, all key supervisory decisions (licensing, revocation, sanctioning, restrictions) are made by the Banking Supervision Committee (BSC), except for decisions involving the extension of CBR loans and the issuance of regulations, which are made by the CBR Board based on BSC’s recommendations.
There are two separate proceedings for liquidating banks in Russia, that is, liquidation proceedings apply when the bank is solvent (for example, its license was revoked based on anti-money laundering issues), and bankruptcy proceedings apply when the bank is insolvent.
In an open bank resolution, which is referred to as “bankruptcy prevention measures with DIA participation” in Russian legislation, shareholders and subordinated creditors are written down, management is suspended or replaced, and the bank is sold to new investors in a competitive bidding process. DIA may provide financial assistance to the failed bank or the investor to close the negative balance, achieve the minimum capital adequacy ratio, and support liquidity needs. In addition, regulatory forbearance may be applied during the rehabilitation process of the bank, which may last for 10 years. In Russian legislation, P&A is referred to as “settlement of obligations with DIA participation.”
Insolvency Law Article 189.48(2).
The DI Law provides that the DIA Board shall include 13 members, that is, seven representatives of the Federal Government, five representatives of CBR, and the DIA’s director general (Article 18(1)). Currently, the DIA Board is chaired by the Minister of Finance, and the members representing the Federal Government include: First Deputy Head of the Office of the Federal Government, Referent of the Expert Directorate of President of the Russian Federation, Deputy Minister of Finance, Deputy Minister of Economic Development, Director of Financial Policy Department of the MoF, and Director of Department of Finance-banking Operation and Investment Development of the MOED.
The FSC is currently chaired by First Deputy Prime Minister and comprises 11 other senior officials, including the CBR Governor, the Minister of Finance, the Minister of Economic Development, and the DIA General Director.
The FSC also serves as a forum to discuss legislative reforms relating to financial stability issues, including legislative reforms to introduce resolution tools recommended in the FSB KAs.
In the past, there have been instances in which DIA has declined to participate owing to the risks identified by a subsequent joint inspection with CBR (for example, off-balance sheet commitments, money laundering activities, and so on), or owing to the outcome of a least-cost test analysis. In such cases, the banks were liquidated and insured deposits paid out (see also footnote 24). Such an approach, however, could be problematic when the bank has systemic implications that necessitate the continuity of critical functions.
DI Law Article 27.
Insolvency Law Article 189.47.
DIA staff advised that criminal activities by bank owners and managers were detected in more than 80 percent of bank bankruptcies. Criminal activities often observed are asset stripping; splitting deposits of individuals (in order to increase deposit insurance coverage); changing the status of the depositor from a legal entity to an individual (to make them insured deposits); artificial records to form balances of accounts of individuals; destruction of IT servers and databases, and so on. Due to such illegal actions by the bank owners and managers, the asset recoveries in liquidation are on average fewer than 10 percent for all creditor claims.
The DIA conducts an investigation of circumstances of the bank’s bankruptcy, and shares its findings with law enforcement agencies. In addition, the Criminal Code was amended to make intentional false reporting to the CBR a criminal offense punishable by up to four years’ imprisonment.
CB Law Article 51, Article 511, Banking Law Article 26.
The law prohibits the CBR from disclosing any information received from a foreign authority to third parties, including law enforcement bodies, except with the consent of the corresponding foreign authority. This, however, does not apply when transmitting such information to a court based on a criminal court proceeding.
Sixteen foreign banks hold 7 percent of system assets in Russia (7 percent of GDP). Russian banks’ foreign subsidiaries are primarily located in Austria, Cyprus, and Turkey with total exposures of 2–3 percent of Russian GDP.
The CBR plans to start discussions on coordination arrangements with relevant foreign authorities once it has adopted regulations on recovery and resolution plans (see paragraph 26).
Triggers (caps and floors) are set for each indicator. Banks’ actual data is analyzed in comparison with these triggers, and a bank breaching a trigger is categorized as being in a “risk zone.” Special supervisory attention is paid to institutions that are in the “risk zones.”
CBR Direction No. 3855-U of November 30, 2015.
In late 2013, DIA, in cooperation with the CBR, assessed the financial position of a number of banks in order to determine whether open bank resolution would be feasible. The assessment showed that this would be economically infeasible, in that the funding needed would exceed the DIF’s funding liability in liquidation. The banks were consequently liquidated without causing financial instability (Novokuznetskiy Municipalniy Bank, Smolensk Bank, and Evropeisky Investment Commercial Bank).
Consequently, the CBR reduced the regulatory minimum capital adequacy ratio from 10 to 8 percent, the level equivalent to Basel guidelines for minimum capital. The new definition of eligible capital will strengthen the quality of banks’ reported capital because of higher required common equity (Tier1); the overall minimum effective capital, however, will be temporarily reduced. The CBR estimates that the stricter definition of capital lowered the sector reported capital by 0.6 percentage points compared with the definition in place.
For other banks, the timeline is 2017 for solo and 2018 for consolidated.
Based on legal powers acquired in 2013–14, the CBR issued regulations in 2015 to strengthen banks’ risk management and governance, and the CBR’s risk-based supervision. These include CBR Ordinance No. 3883-U on the Assessment of Quality of Risk and Capital Management Framework and Capital Adequacy of Credit Institutions and Banking Groups performed by the Bank of Russia (December 2015) and Ordinance No. 3624-U on the Requirements for the Risk and Capital Management System of a Credit Institution or a Banking Group (April 2015). The intended prudential outcomes will critically depend on the regulations’ effective implementation, monitoring, and supervision.
FSB, “Principles on Loss-Absorbing and Recapitalization Capacity of G-SIBs in Resolution Total Loss-Absorbing Capacity (TLAC) Term Sheet” (November 2015).
CBR Law Article 57.
Letter No. 193-T, December 29, 2012, on Methodical Recommendations for the Development of Plans for the Restoration of Financial Stability of Credit Institutions. As of end June 2016, 15 other banks have submitted financial stability recovery plans.
A detailed overview of the essential elements of Recovery and Resolution Planning (RRP) is provided in Annex 3 of the FSB KAs.
The criteria for determining banks’ systemic importance in resolution are based on the now invalid CBR Direction No. 2106-U. The regulation has been under revision since the adoption of the new resolution framework in December 2014.
For example, in European countries with SOBs, resolution plans for such banks assume that they would be resolved in line with private banks, including the application of statutory bail-in.
The Banking Law, CBR Law, Insolvency Law, and AML Law (115-FZ, August 7, 2001, on Combating Money Laundering and Terrorist Financing).
See also BCP Assessment CP 11.
The law binds the CBR, when certain conditions are detected, including the bank’s failure to meet mandatory norms within six months, to ban banks from accepting deposits from natural persons, in compliance with the decision of the BSC. DI Law Article 48.
CBR staff advised that the recent amendments to the Criminal Code, which make intentional false reporting a criminal offense, were already having positive effects. See footnote 17.
Insolvency Law Article 189.47.
The CBR often applies this criterion to revoke the license, before waiting for mandatory license revocation criteria to be met, by subjecting the bank to remedial measures after the bank falls below the minimum capital adequacy ratio or other prudential requirements.
No framework of regulatory intervention or resolution can be effective if the data on which the supervisor relies are fraudulent. Therefore, it is of the utmost importance to ensure strong supervision, starting with vigilant implementation of recent regulations on risk management and supervision, and addressing the deficiencies identified in the BSC assessments. (See also section on early intervention.)
It should be noted that the definition of “bank holding companies” in Russia refers to the bank holding company group rather than the parent entity of the bank holding company group (Banking Law Article 4). In this note, however, the term “bank holding company” is used to refer to the parent entity of the bank holding company group, as is typically the case.
Numbers for bank holding companies are as of July 2015. In addition, there are over 110 banking groups (that is, groups of legal entities that are headed by a bank) as of end-March 2016.
A draft law has been prepared that provides that the CBR and the DIA shall perform an analysis of the financial conditions of legal entities that form part of the same banking group (including heads of bank holding companies) when performing an analysis of a bank’s financial condition to determine whether the DIA should participate in the resolution process. The draft law, however, does not provide the CBR with direct resolution powers over the head of bank holding companies.
The CBR has developed an assessment methodology for designating domestically systemically important insurers (D-SIIs) (internal methodology, not published) and systemically important financial market infrastructures (FMIs) (Ordinance No. 3341-U). The CBR has designated 22 D-SIIs (not published) and two systemically important FMIs (published).
Insolvency Law Article 189.47(1). The condition provided in the law differs from the condition provided for DIA participation in P&A transactions in that the former includes the condition “and/or the stability of the banking system.” The provision is unclear, however, as to whether the risk to financial stability is an essential criterion for bankruptcy prevention measures with DIA participation.
The guidelines are spelled out in the now invalid CBR Direction No. 2106-U. The regulation has been under revision since the adoption of the new resolution framework in December 2014.
Insolvency Law Article 189.49(8)–(12).
The DIA used this power to purchase the failed banks’ bad assets during the previous crisis in 2008, but has not done so in the current crisis. The authorities noted that this is because of the large amount of resources necessary to manage and collect from the bad assets acquired by the DIA, and their assessment that this function is better performed by other banks.
In Russian, the acquirer is referred to as the investor.
Signs of the instability of the bank’s financial position endangering the interests of its creditors (depositors) shall include, in particular (1) evidence from the bank’s own reports and/or as established by the CBR, DIA, or other persons, showing [without doubt] that the bank’s financial condition is (or will be) in breach with the conditions for participation in the DIF; and/or (2) meet the criteria for measures aimed at bankruptcy prevention measures; and/or (3) other documented proof that the interests of creditors/depositors are endangered.
The joint assessment is based on a fair value methodology, as stipulated in CBR Instruction 3691-U. For P&A transactions, additional work is conducted and presented in accordance with Instruction 3707-U.
Insolvency Law Article 189.51(2) and 189.52(7). The law does not specify that assets be evaluated based on book value. This requirement is established in CBR guidelines.
Insolvency Law Article 189.52(10) and 189.55(2)–(4).
Insolvency Law Article 189.56(4).
Insolvency Law Article 189.52(1).
In the limited cases in which banks were resolved with P&A transactions, the P&A transaction did not necessarily capture the benefits usually associated with such transactions; that is, minimal disruption of financial services and preservation of the banks’ franchise value (see also Box 2). For example, in the case of Nota Bank, which was one of the two banks resolved with a P&A transaction in 2015, the P&A took place two months after the bank was put under CBR’s provisional administration. A moratorium was imposed, and by the time the P&A transaction was announced and conducted, 50 percent of insured depositors had already received insurance payouts, and borrowers had been instructed to make payments through other banks to honor their obligations.
The power of the provisional administrator appointed without DIA participation is limited, and requires the approval of the Board of Directors and/or the general assembly of shareholders in order to conduct certain business transactions. Participation in the management of troubled banks can therefore create reputational risk for CBR and/or a contingent fiscal liability. CBR rarely appoints provisional administrators without DIA participation.
In 2015, voluntary bail-in was used in two cases of bankruptcy prevention measures with DIA participation (Tavrichesky Bank and Fundservice Bank). Both involved writing down the capital to 1 ruble, converting current deposits of large corporate depositors to subordinated long-term (20 and 10 years, respectively), below-market rate (0.51 percent) deposits, and bringing in Rossiysky Capital as a temporary owner until an investor is found.
The authorities plan to develop a draft bill by end-2016.
The authorities noted that the change of creditor hierarchy is currently not being discussed.
Such effect, however, could also be observed in the case of introducing an effective P&A framework.
While the DIA could currently possibly use its subsidiary, Rossiysky Capital, to perform bridge functions, it would be desirable to provide the legal power to establish bridge entities to enable the authorities to conduct temporary transfers, regardless of the ownership stake in a failed bank.
In its discussions with CBR and DIA staff, banks, and consulting firms, the mission was advised that outsourcing of domestic as well as foreign banks’ essential functions was rare due to concerns about fraud and security issues.
Banking Law Article 23.1.
Insolvency Law Article 189.32.
The requirement for obtaining prior consent of the creditors is made inapplicable for P&A transactions conducted with DIA participation.
If creditor consent is considered necessary from the perspective of creditor protection, the authorities could consider introducing a procedure for creditors to oppose the transfer ex post and make the transfer null, retroactive for opposing creditors.
Insolvency Law Article 189.29. Furthermore, bankruptcy receivers are required to insure for losses that they could cause creditors participating in the bankruptcy case above a certain amount (Insolvency Law Article 189.77(10)).
In 2014, 14 cases of bank license revocation were challenged in court, and one was overturned (in 2015, 22 were challenged with no overturns). When the license revocation order is overturned, the CBR is required to reinstate the license. As for orders against credit institutions (regional branches), 23 were challenged in 2014, 2 of which were overturned. In 2015, 3 cases were overturned out of 46.
For example, the CBR recently faced a situation in which it had doubts regarding the quality of the subordinated debt issued offshore and whether it would qualify as Tier 2 capital. The subordinated debt in question, which was raised to fulfill CBR’s call for additional capital to cover capital deficiency discovered during onsite inspection, involved transactions involving multiple countries, and it was unclear to the CBR whether there was a beneficial owner. Confronted with such difficulties, the CBR is now in the process of revising Regulation No. 395-P (On the method of determining the value and evaluating the adequacy of own funds (capital) of credit institutions (“Basel III”)) to require the banks to demonstrate the quality of the subordinated debt for Tier 2 purposes.
CBR Law Article 46(7), introduced in June 29, 2015, by Federal Law No. 167-FZ. A similar program was used during the global financial crisis. The program has not been activated yet.
Insolvency Law Article 189.56(4).
If replaced with federal funds in the form of direct asset contributions, the amount necessary would be 1 percent of GDP, which is the subsidy embedded in CBR loans of 1.6 percent of GDP.
Insolvency Law Article 189.49(12).
Insolvency Law Article 189.57. The DIA currently holds all the shares in Rossiysky Capital, which entered into open bank resolution in 2009.
The bank can either be a D-SIB or have systemic implications in times of severe financial instability.
The failed banks’ critical functions (deposits, payment services, and the like) would be transferred to an existing healthy bank or to a bridge bank.
The two P&A transactions conducted in 2015 were decided after a joint CBR/DIA assessment revealed a large negative balance of the bank’s capital, which resulted in the open bank resolution measure failing the least-cost test.
The term “least-cost test” is usually used to compare the DIF outlays necessary for (i) P&A transfers; and (ii) deposit payouts (liquidation). It is not typically used in the context of the use of public funds.
Although the DIA formally incurs the credit risk of the restructured bank, the CBR has provided additional funding to the DIA to accommodate for credit losses arising from the deterioration of the bank’s financial condition based on the plan for DIA participation in bankruptcy prevention measures.
Insolvency Law Article 189.56(7).
Since the 2011 FSAP, the term of the DIA loans has been extended from five to 10 years, shifting their nature from liquidity to solvency support, prolonging the resolution process and increasing DIA’s financial risk.
The United States, for example, has opted to provide the FDIC, its resolution authority, with a credit line from the Treasury, subject to certain restrictions, and the ability to impose levies on the industry if recoveries from the distressed firm’s assets are insufficient to repay the Treasury. Germany and Sweden have decided to establish resolution funds that are to be gradually built up via industry levies. Also see FSB KA 6.
An insured deposit payout is triggered upon revocation of a bank’s license by the CBR or imposition of a moratorium by the CBR on honoring the claims of the bank’s creditors (DI Law Article 8). The DIA is obliged to prepare a list of insured deposits within seven days from the occurrence of an insured event, and to make payouts within 14 days (DI Law Article 12).
Quarterly insurance premiums paid in the 1st quarter of 2016 amounted RUB 25.5 billion, including RUB 0.04 billion—on additional rate and RUB 2.12 billion—on enhanced additional rate. 140 banks corresponded to the criteria for paying a higher premium for the 1st quarter of 2016. From the 2nd quarter of 2016, the rates are 0.1 percent (basic rate), 0.15 percent (basic plus additional rate), and 0.3 percent (basic plus enhanced additional rate). The rates will be 0.18 percent (basic plus additional rate), and 0.36 percent (basic plus enhanced additional rate) from the 3rd quarter of 2016, and 0.48 percent for basic plus enhanced additional rate from the 4th quarter of 2016.
The bank’s counterclaims to the depositor are subtracted in determining the insured amount of a depositor (DI Law Article 11(7)).
DI Law Article 41.
By end-June 2016, the credit line was expanded to RUB 420 billion, of which RUB 372 billion were drawn.
In addition to the CBR loan outstanding amount of RUB 137 billion, the DIF owed RUB 170 billion to agent banks for deposit payouts, and RUB 70 billion of insured liabilities for a deposit payout that had not yet commenced.
DI Law Article 36 (4) provides for a maximum quarterly premium of 0.15 percent. In addition, the DIA may increase the basic rate up to 0.3 percent for six months at most within 18 months for the purpose of restoring the DIF (DI Law Article 36(5), 41(4)).
Insolvency Law Article 189.84.
In line with the FSB KAs (KA 7), claims of creditors of a foreign branch of a Russian bank, if any, should rank pari passu with claims of creditors of the same class in a local branch.
Owing to such concerns, while deposit insurance coverage was expanded to cover individual entrepreneurs in 2014, such entrepreneurs were not provided first priority in the creditor hierarchy.