Global Finance: Russian roulette

COUNTRY UPDATE RUSSIA's BANKING SECTOR

Over the past two years Russia has made impressive progress on a number of fronts, including the tax system, land ownership, and natural monopolies. Its efforts have significantly improved Russia's investment environment and rescued it from the pariah status it earned in the August 1998 financial crisis.

While the progress of Putin's program has been remarkable, Russia's economic system and the reform program have an Achilles' heel: the stagnant banking sector. Russian banks are not converting savings into loans, the fundamental role of banks in bringing about economic growth. Just 3% of total domestic investment funds comes from banks, which means that small and midsize enterprises, which should be the engine of economic growth, are starved for funds. Roughly 85% of Russia's 1,300 banks (with average total assets of a paltry $68 million) are so-called pocket banks-little more than glorified treasury operations for the companies and governmental entities that control them.

"The banking sector is not linking the need for capital in small and midsize companies, which drive growth in other transition economies," says Christof Ruehl, chief economist of the World Bank in Moscow.

The future of sustainable economic growth may depend on Putin and his reformers tackling the banking sector in earnest.They must create an environment in which banks are encouraged to lend to bona fide borrowers.

Mixed Results

Indications thus far are mixed. In late September, Putin's cabinet rubber-stamped a comprehensive banking reform strategy intended to attract foreign investment, increase sector transparency, make a distinction between full-scale banks and credit organizations, and create a foundation for a system of credit bureaus. The proposed legislation, however, would have only limited impact without a wide range of enabling measures in judicial reform, corporate transparency, and the bankruptcy code.

The urgent need for banking reform is well recognized at the highest levels of government. "The banking sector should become the locomotive of economic development," Prime Minister Mikhail Kasyanov commented recently. But the historical lack of political will and a reluctance to step on the toes of powerful interests may mean Russia's banking sector will remain unreformed for a while longer.

This won't immediately derail the remarkable resurgence of the Russian economy, which is expected to grow almost 6% in 2001 and roughly 4% in 2002, but it may act as a drag on economic growth.

An Inscrutable Black Box

The problems of Russia's banking sector are not unusual: Levels of transparency and the quality of financial data are low, so risk becomes an inscrutable black box for depositors, lenders, and borrowers alike. Bankruptcy laws are weak, and the judicial system is corrupt so potential borrowers have little faith they will be able to call on the assistance of the legal system if a loan goes bad. The well-developed role of state-controlled banks (which account for more than a third of total system assets) distorts the role of the market.And banking reform inherently has few natural advocates and is politically unpopular.

The overriding impact of all these factors is that banking in Russia is far behind much of the rest of the developing world. This is illustrated by the fact that banks in Russia aren't so good at converting savings into loans: Domestic credit as a percentage of GDP stands at just 12% in Russia, compared with 25% in Argentina and Hungary, and 57% in the Czech Republic.

Russia has, however, made solid progress in excising and radically revamping other parts of its command economy past. And there has been no shortage of good ideas about what to do with the banking sector, both from the World Bank and the IMF and from other international financial institutions.Within Russia itself proposals have been coming thick and fast, most notably from the Economic Development and Trade Ministry, headed by German Gref.

It is the lack of political will to force changes to its banking sector that is holding back reform, though. Banks are integrally linked to the state through historical, economic, and political ties, the severing of which is likely to upset many well-connected people.

A Bogus Bond Market

Indeed, a range of efforts throughout the 1990s, ostensibly intended to promote the development of the sector, in fact were little more than thinly disguised mechanisms to enrich favored institutions.The government bond market was little more than a way of supporting the banking sector. Subsequent efforts to restructure the system amounted to pouring rubles into the black hole of the sector to the benefit of a few well-placed bank managers.

Meanwhile, the central bank of Russia, which is responsible for regulating the banking sector, has been asleep at the wheel. Headed by Soviet-school banker Viktor Gerashchenko, famously called the "the worst central banker in the world" by economist Jeffrey Sachs in 1994, the bank has cultivated an environment in which bank owners feel minimal accountability for the risks they assume. In the aftermath of the August 1998 collapse Gerashchenko and his colleagues turned a blind eye to massive asset stripping of the institutions that were hit in the crash.

"The central bank's track record on sector regulation under Viktor Gerashchenko, to put it mildly, has been poor," the Moscow Times wrote in a recent editorial.

Gerashchenko is unapologetic.Weeks after its release in the spring of 2000, Gerashchenko was asked his opinion of a major reform program by German Gref that tackled banking-sector reform. His response was telling:"I haven't read it. The end of Gerashchenko's term in September 2002 is viewed as a potential turning point in the battle for reform.

In the meantime, it's heartening that banking-sector reform is at least on the agenda, even if its implementation will have to wait. There are some signs of a healthy consolidation in the sector, with two of the stronger up-andcoming market-driven banks, MDM Bank and Bashkreditbank, leading the way. Skill levels of professionals are improving."The quality of the pool of potential credit analysts is significantly better than it was just a few years ago says Richard Hainsworth, general director of RusRating, a Russian bank rating agency. "It's a positive sign for the future of the sector."

Kim Iskyan is a Moscow-based correspondent for Global Finance and an analyst for Renaissance Capital investment bank. E-mail: editorial@gfmag.com