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Vladimir Sidorovich
Russian Banking System in 2005. Material Attributes and Outlook for Future.

This paper states and analyzes the current Russian banking system attributes, forecasts its prospects for future development and proposes actions that will allow to channel its evolution in the direction that's good for the society.

The strategies for the development of the Russian banking system prepared by the Central Bank and the Russian Banks Association (RBA) are documents showing the “way to the future”. They contain a set of important and requisite task which are necessary for the improving of the Russian banking system. On the other hand, these strategies are devoid of the historical analysis of the underlying reasons for the current state of affairs, whereas actions outlined therein mostly bear vague and declarative nature and show no specific ways of their implementation.

The modern banking system parameters are there due to a number of reasons; an unbiased analysis of these reasons will help outline the ways of carrying out the needed and realistic changes.

  

Today

There are over one thousand banks in Russia today. The exact number does not matter, because the number of real banks that engage primarily in the classical banking services on the market like the ones listed in the Law on Banks and Banking Activities is significantly lower.

The banking system in Russia in 2005 has the following main attributes :

1) Increasing domination of the government sector represented by Sberbank and VTB banks.

2) Increased share and importance of banks with foreign participation.

3) Increased interest in the retail business and increased number of the specialized financial institutions, first and foremost, in the area of consumer lending.

4) Low technological level of and low quality of services in most Russian banks as compared with the banks in the developed nations.

5) Low management level in most banks.

6) Moral faults and high share of “informal” business in bank transactions.

7) Low banking system capitalization level. The official numbers of the aggregate banking capital constitute an abstraction, which has nothing to do with reality.

8) Lack of proper corporate governance.

9) Shrinking number of the Russian banks.

10) Irrelevant functions and activities of the regulator (Central Bank) within the modern economic context.

It is easy to notice that many of these attributes are interrelated.

The essence and rationale of these attributes need to be analyzed in order to be able to influence them and channel them in the direction that is good for the society. The strategies under consideration fail to do this.

In a way, the technical backwardness of the Russian banks is caused by the dominating interests of their founders back in the 1980s and 1990s. Were the banks really established with a mission to provide banking services and make money out of the classical banking transactions, such as lending or settlements? A naïve thought. The main motives, goals and interests of the bank founders were quite different, namely, accumulation of funds for further participation in the privatization, carving up of the federal budget etc. The banks were doing a really sloppy job in the area of service quality and banking technologies.

Nothing stays in place, the world goes through changes, and so does the banking system. It is evident that today the technology becomes more and more important, and the managers look into it with increasing attention. However, the ability to influence the technology part is significantly limited by the historical framework and regulatory climate.

The role of the Central Bank , which is set forth by the law, hampers the banking system development. In 1990, when the banking legislation was being developed, they took EVERYTHING with the word “bank” in it, including the technology, and placed it within the Central Bank's terms of reference. Everybody got so used to it that the situation doesn't look unnatural anymore. Would you go for a surgical operation with the surgeon being issued the instructions by a bureaucrat who has no medical expertise whatsoever? Would you eat at a restaurant where the chef must follow the recipes by a bureaucrat with zero experience in cooking?

This situation did not contradict the aforementioned interests of the banks. They were not concerned by any of these legislative frameworks. Why would they deal with the technologies when the technical development level did not impact the implementation of the real goals pursued by the banks in any way?

The existing bank system is in many respects the brainchild of the Central Bank. Due to a number of historical reasons and legislative conditions, the Central Bank performs a clear paternalist function with regard to the financial institutions.

Both the technical backwardness and “the orientation of the banks toward providing doubtful services and the conduct of unfair commercial practice” as is stated in the government strategy can be mostly attributed to the Central Bank and its licensing policy.

Low quality and efficiency can be accounted for by the young age of the Russian banking system and lack of the hundred-year old Western banks expertise. On the other hand, this young age has its advantages. The Russian banks didn't have to deal with the utilization of outdated technologies. They could use the best and the latest developments right away. Unfortunately, the excessively paternalist role of the Central Bank hampered this process. The technical (in a broad sense of the word) foundations of the banking business were actually inherited from the USSR State Bank and gradually and slowly underwent transformation. This is the reason why the level and quality of the services provided by the Russian banks are not competitive.

The banking system capitalization issue , which the Central Bank and banking associations enjoy discussing so much, is simply ludicrous, and the accuracy of the numbers quoted, in all likelihood, does not raise any doubt only with them. Many banks have their capitals only on paper. The stamp by the international auditors does not guarantee correctness. There is a conflict of interest in the work performed by the auditors, because the auditee is the one who pays the auditor. The audits are limited to a formal comparison of the accounting and reporting numbers to the legal requirements. That is the reason why the official data of the aggregate bank capital to GDP ratio have little to do with reality.

Speaking about the banking system issues, evolution, reforms, etc. one has to mention the morality level as a major factor influencing the banking system. Certainly, this problem is not specific to the banks; it confronts the entire Russian society.

Up until now, although, certainly, to a lesser extent than “at the dawn of the banking business” many banks are used as a means of illegal money-making for the shareholders and the managers who finance their own projects using the bank funds. Just read interviews by former and current bankers in the newspapers, or simply go over the privatization history. They sincerely believe that they haven't done and are not doing anything improper. Deformation of moral values is obvious. This is a material banking system attribute.

Banks that make money from the “informal” transactions do not employ natural villains. These people would like to do the “clean business”. But formidable barriers, such as lack of skills, bad habits and temptations, hinder the access. Refusal to engage in gray or black transactions may result in losing part or all of the business.

Obviously, given the foregoing reasons there are not many banks that are capable of saying no to the “black and gray” business. The goal of the government, including the Central Bank, is to remove this contradiction and use its authority to oust the “informal” institutions from the market.

The issue of lack of proper corporate governance in the context of deficient basic ethical standards is of secondary and subordinate nature. Formally correct corporate governance structures can be used as a mask hiding the true face. At the same time, aggressive (including the use of legislative tools) imposition of modern corporate governance standards is an important educational measure that encourages the financial institutions to conduct business in a more ethical manner.

The shrinking number of the Russian banks is a natural process. The issue is not that there are “too many banks”. This trend can be explained by the change in the circumstances and interests, the shift of the banking activities toward the banking business proper, orientation toward classical banking services, which many banks were not even designed to offer. The mass privatization is over, and engaging in the “informal” business is no longer as lucrative as it used to be and more dangerous than it used to be. Accordingly, the sales volume of the banks is increasingly dependent on the market (money-backed) demand for the classical (legitimate) services, which cannot be offered on a competitive basis by all banks.

 

Outlook

The future is made today. The analysis of the above-mentioned current processes allows to develop relatively dependable scenarios for the near future.

1) Two state-run banks, Sberbank of the Russian Federation and Vneshtorgbank, will dominate the Russian banking system. These two banks will have to provide support to the strategic sectors of the Russian economy. Lack of transparency and low efficiency, as well as the prevalence of politics over professionalism in making important managerial decisions are the deficiencies of these institutions. The outlook for their long-term development greatly depends on the quality of the management and supervision provided by the government authorities and the banks themselves.

2) The subsidiaries of foreign financial institutions will increase their market presence as the second-largest group of the banks. Most of them are professional, technologically advanced entities with access to inexpensive funding, which gives them a significant competitive edge. Foreigners can choose the customers they are interested in dealing with, which creates additional problems for the Russian banks, including Sberbank and VTB, because they'll have hard times withstanding this kind of pressure by the foreign banks.

3) The Russian private banks have the following outlook:

- Become larger. Merge with each other or participate in takeovers. This is a viable option for very few banks. Incompatible technologies, lack of proper corporate governance, low skill level, and zero value combined with unbridled ambitions of the owners make such deals highly unlikely.

- Leave the market.

- Find a niche of their own on the market of classical banking services (develop their own customer base) and provide the universal bank services. Given the geographical features of Russia , such a prospect looks more realistic for the regional banks mid-term, but not for the banks located in Moscow or St. Petersburg , with a few exceptions.

- Narrow product specialization (consumer lending, mortgage). Sharp turnover and re-orientation is an unlikely outcome for the existing banks, because they operate within the framework of established habits and relations between the owners and the managers. It is clear that the newly founded specialized institutions show the best results in such narrow niches.

- Switch to the investment services sector (including the asset management services) and cut personnel and infrastructure. In theory, this is a good way out for the mid-size corporate banks. In practice, given the skill level and habits of the personnel, such a transition is unrealistic for the majority of the banks.

- Take up the “informal” business. This is what many mid-size and small banks are doing now. Russia has a rather evolved shadow business, well-established traditions of “informal” business and widespread corruption. It is only natural that the banking system fully corresponds to the existing conditions in the country.

Speaking about the prospects for the Russian banking system it is impossible to ignore the need for a national banking system .

Unique geographical position of the country (its size), availability of the strategically important industries, such as the nuclear energy and aircraft industry need adequate financing at a national level.

As is shown above, banks with the government capital will dominate this market, and their low efficiency will be offset by the (protectionist) government support justified, among other things, by the accomplishment of social and government objectives.

As for the development of the private national banking capital, it has only one thing it can do within the current framework (legislative and social) in order to gain substantial positions within the sector in addition to certain niches. This one thing is becoming more efficient than the Western banks, which, by the way, pay their employees much more than 4,000 rubles a month and pay more taxes than their Russian counterparts. In addition to that, the foreigners do not indulge into the taxation scheming and tax evasion and prefer to make money from classical banking transaction thus voluntarily depriving themselves of a certain “competitive edge”.

As was mentioned above, the actions taken by the government and the bankers have resulted in weakening of the national banking system, rather than its development. The issue is not about insufficient protectionism, but 1) deficient (mostly in the past) licensing and regulation and 2) deformed morality in conducting business.

Is it in the national interests that a Russian bank counterfeits the reporting papers in order to cheat the customers and other people, fails to pay taxes and helps others to evade taxation? There are many banks like that, and they all provide strong backing for the national banking system protection, thus defeating the purpose by doing what they do.

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Popular questions about the investment appeal of the Russian banks and related PR-dreams are not quite relevant. The specialized banks with simple and understandable product without a murky past can rank first on the list of the potential foreign investment recipients.

It is not realistic to expect quick eradication of the captive nature of the majority of large private financial institutions, because it has strong links to specific financial and political risks. Therefore, any major takeovers in the mid-term perspective are unlikely.

On the other hand, we know that the rather insignificant investment decisions, such as the choice of a strategy or allocation of resources, result from corporate skirmishes inside the foreign banks, and the outcome of these fights depend not only on the rational, but also personality factors. That is why any forecasts in this area bear a very tentative nature.

 

Actions

The implementation of the above forecasts can hardly be significantly adjusted by anybody. They flow directly out of the current situation and do not depend on the really possible rather than declarative actions by the government, regulator and banks.

This is not to say that any actions are useless or that everything is predetermined. There is a choice, it is meager, but it is available.

Any strategy should answer some basic questions, and certain effort (actions) should be made in order to bring solution to these questions. The questions are as follows: 1) which scenarios should be encouraged and which should be “subdued” and 2) which actions by the regulators and legislators will cost less to the banking system and the economy as a whole if these scenarios are implemented. Put differently, which actions (or inactions) will be useful, and which not.

For example, the support (even tacit one in the form of inaction) for shadow banking business will lead to 1) tainted reputation and increased loss of credibility with regard to entire banking industry, 2) deeper moral crisis of the society, 3) lower aggregate market capitalization of the Russian banking system, 4) further corruption of moral values, etc. In this particular case lower cost for the society is achieved through the use of corresponding measure that are shown below. Inaction is criminal and dangerous for the future.

 

Following actions are all-important:

1) The Central Bank

- The language of para. 4 and 5 of Article 4 of the Law on Central Bank of the Russian Federation should be substantially modified. The issue is not about the liberalization, deregulation or weaker supervision, etc. As is known, the cobbler should stick to his last, or else nothing good is going to happen. Everybody should stick to their own business. The Central Bank actually prescribing the business process technologies looks absurd.

The legal intervention by the Central Bank into absolutely all aspects of the banking activities, including the technological aspect of the bank-customer relations (payment order forms, signature sample cards, checkbooks, etc.) is the main hindrance on the way to further development of the banking technologies.

The Central Bank shall be in charge of providing corresponding services to the banks in order to secure continuous operation of the settlement system for example. In this case, the banks using the Central Bank's clearing service must certainly comply with the conditions for providing the service.

- Reform of the Central Bank with the view to improve its efficiency must be part of the actions aimed at further development of the Russian banking system.

The banking system problems are due not so much to the inefficient legislative and regulatory base, which is developing, albeit at a slow pace, but to a lack of rationality in the internal technological (business) processes inside the Central Bank that increase the unjustified (senseless) transaction (imputed) costs in the banking system and in the economy as a whole.

Drastic reduction in the personnel (by several times) that is unneeded for the Central Bank operations must be the principal avenue for such a reform. As a result, the Central Bank will rid itself of the “ministerial” habits, become more mobile, manageable, transparent and capable of meeting real needs of the country.

The actions to reform the Central Bank must help to remove the unjustified bureaucratic hurdles built by the Central Bank, which exert extremely negative influence on the evolution of the banking system. One of the things that lie on the surface is the need to reduce the complexity of the rules for participation in the capital of the banks. The Central Bank should encourage mergers and takeovers. The banks should have the right to open their subsidiaries without engaging in the painful process of coordinating things with the Central Bank or getting its approval for the nominated heads of subsidiaries (normally, bank managers are experienced adults who know better than the Central Bank who should run a bank subsidiary), etc.

The formal and shallow banking supervision, such as verification of the sample signature card accuracy, which is basically an unneeded transaction cost, must be replaced with the control over issues of essence.

There are no significant labor costs or methodological work involved into improving the situation. Modern research and practical work, including those performed abroad, have accumulated enough materials and methods that explain the way the business processes must be run within the central banks. The only things needed for that are proper management and strong will.

The actions encouraging the Central Bank to implement the appropriate reforms must come from the government, legislators and, let's say, the National Bank Council. The educational actions or discussions within the bank associations will not be enough. Of course, things have evolved, and the Central Bank now is a more efficient and “logical' entity than before, but expecting it to reform itself is naive.

2) Fighting “informal” bank transactions .

Government in the person of the Central Bank must put up a stronger fight against the informal economy in the banking sector, which it produced itself by giving away licenses to all those willing to get them.

Obviously, people who are used to make their living from a certain “informal” activity will not stop doing it just for nothing. Their consumption level depends on these earnings. Therefore, the goal of the government regulation is to counter such activities.

The recipes for such counteractions are described with sufficient detail in the books. As is known, fighting the shadow economy or corruption in general is a watchword adopted by, to put it mildly, not too clear-sighted politicians and officials. Success can be obtained only through stage-by-stage targeted actions in one economic sphere at a time. The banking industry, being strictly supervised and regulated, can be controlled relatively easily.

To increase the number of tools used in these counteractions, there is need to make creative use of the latest laws of the Western countries and adopt, for example, a law similar to the American Sarbanes-Oxley law that calls for the criminal liability for tampering with the financial reports.

In all fairness, we must note that certain progress in the banking sphere has been achieved owing to the efforts by the Central Bank. At the same time, more consistency and perseverance, as well as more explanatory work are needed. One must be able to openly acknowledge the mistakes made and call things by their proper names.

3 ) Further enhancement of the corporate governance in the state-run banks, particularly, more active participation of independent directors in their supervisory councils, who could become heads of the corresponding committees, such as audit or risks committees, thereby promoting increased transparency and professionalism.

 

The list of “strategic actions” scheduled in Central Bank's and ARB's strategies is quite extensive. There is an anxiety however that many of these tasks will remain on paper without modernization of basic conditions and general regulations as it stated in this research.

Copyright © 2005 Sidorovich & Partners
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