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o make depreciatory remarks about the Russian banking sector seems to have become a sign of decency. The grounds for such remarks are insufficient capitalization of the banks, their allegedly excessive number and a low ratio of credit sums they have allowed and their aggregate assets vs. GDP in comparison with banking performance of western countries. Assuming these parameters a conclusion is made that Russian banks are unable to be a “pusher” of the investment process and economic growth.

A biased nature of such accusations is obvious. Firstly, they completely ignore the specific economic and political circumstances under which the current Russian banking system got formed that was the time of state economy collapse, galloping inflation, a nosedive in production and a severe currency and financial crisis. Secondly, a 15-year period is too short to compare Russian banks with those of western countries, which formed their existing financial and credit systems for decades or even centuries.

Thirdly, they don` t take into account the fact that legal and institutional conditions for development of the banking sector, the competitive environment and mechanisms to protect interests of investors, creditors and depositors are just being formed. Fourthly, they don` t give due consideration to the investments into fixed assets and model of economic growth which have been formed in Russia. Finally, the main emphasis is made on absolute measures of the banking sector while an objective analysis should have also allowed for dynamics, which is pretty promising now (see table 1).

An unbiased analysis of the situation shows that the Russian banking system keeps on developing at an outstripping rate. In 2003 the banking sector assets increased by 28.1% in real terms at a 7.3% growth in GDP while the volume of credits allowed for enterprises (excluding credits granted to private persons and banks) increased by 38.2%. A direct result of this has been a narrower gap between key performance of Russian banks and an average performance of the world banking system. In particular, while in June 1998 the volume of credit facilities allowed for non-financial sector amounted to 8.5 % of GDP, in early 2004 it reached as much as 17 %. Assuming credits given to private persons and banks this figure totals about 20 %. Such a significant performance has been achieved within a record short time of six years, including lapses of currency crisis followed by periods of banks rehabilitation.
There are solid grounds to believe that lending is the key component of commercial banks` operations. By June 2004 an aggregate debt due to banks had reached 58.9% of the total assets of the banking sector. Having graded up to other industrial countries in terms of the share of an advances portfolio in the assets structure, the Russian banking sector is still lagging behind only in terms of the absolute volume of credit facilities granted.

Higher investments of banks into securities, of which corporate bonds and discounted bills constitute the most significant share, should also be taken into account. Allowing for this the debt due to banks totals about 75 % of the aggregate banking assets.

Credit facilities for the nonfinancial sector constitute in the structure of commercial banks` aggregate advances portfolio a major share of 75%, with only 13.2% being attributed to credit facilities for the financial sector and non-resident banks and 11.2% for private persons. Key borrowers are industrial, construction, transport and communication enterprises. Opinion surveys regularly kept by the Bank of Russia show that the share of credit liabilities to banks is steadily growing among other commitments of the enterprises. For 200 major enterprises –borrowers this share amounts to 43.3%.

A tendency has distinctively shown up towards longer crediting periods and lower credit interest rates. In January 2004 an average weighted interest rate for Russian Ruble credits for a credit payment period shorter than 1 year amounted to 12.2% for enterprises of the nonfinancial sector that, according to the 2003 economic results, was a little bit higher than the inflation rate. For comparison in 2001 an average annual interest rate on bank credits reached 17.9% against 15.7% in 2002. In January 2004 an average weighted interest rate for USD denominated credits allowed by Russian banks accounted for 8.9 %.

Sure, the scope of crediting is still insufficient to meet in full the demand of market agents and private persons. The existing level of risks and, that is more important, a shortage of stable liabilities limit the aggregate advances portfolio build up. Suffice it to say, that the share of major credit risks in the banking sector assets steadily remains at a level of 32 to 35%. Another important factor is that the capital base of the Russian banks is pretty "thin" to meet in full all the standards and requirements set by the Central Bank of Russia.

Over the recent four years the Russian banks` resource base dynamics has been determined mainly by growing sums on deposits and other accounts of private persons. Owing to a higher rate of growth in population income and shifts in saving patterns of households the banking system has started tending to a classical model of a financial intermediation when private persons` deposits are the key source of the attracted funds. From January 2001 until June 2004 the volume of household deposits demonstrated a four fold increase. By the mid-2004 private deposits constituted 28.3% of the total liabilities of the banking sector. Changes in the resource base of the banking sector serve as evidence to restoration of confidence in commercial banks after the 1998 default. A tendency to longer credit payment periods has been distinctly secured. While in 2002 private deposits for longer than one year constituted only 25% of the total deposit volume, now they amount to about 50%. Confidence in national currency is getting stronger as well. One can see that increment of growth on Russian Ruble deposits is higher than that on private accounts denominated in foreign currency. Thus, over the recent three years a share of Russian Ruble deposits has grown from 61% up to 70%.
The higher share of private deposits in the structure of attracted funds produces a two-way influence on the banking sector. On one hand, minimum balance on private deposits is kept at a higher level compared to that on accounts of companies and enterprises. On the other hand private deposits are an extremely volatile component. Occasional rumors set afloat or statements made in a rush are quite enough to provoke a massive outflow of deposited funds. Moreover, banking of private clients is associated with high costs.

The debt operation structure reveals a number of tendencies, which under certain circumstances can also improve banking risk potential. Thus, in particular, one can discern steady slowing down of growth or even reduction in the share of funds placed on operating, current and other accounts of enterprises and companies. It is remarkable that this process is gaining momentum against a background of their better financial performance, which can probably be explained by an expansion of transboundary financial service practice, so that now the most solvent clients reduce to minimum balances on their accounts with Russian banks.

In May-July 2004 the Russian banking system experienced a shock, which took by surprise both market operators and analysts. At that moment macroeconomic conditions of the financial intermediation seemed to be the most favorable for the whole period of economic reforms while Russian banking system performance looked even better compared to other countries. However, withdrawal of a license on May 13 from Sodbusinessbank, which ranked 57th in terms of capital and 104th in terms of assets, followed by suspension of banking activity of Credittransbank, which ranked 69th and 68th respectively, gave rise to collapse of confidence and outflow of funds of depositors and clients. Most of mid- and small size banks especially those operating in regions temporarily lost their ability to control current liquidity through resources available on the inter-bank market. With banks short in liquid assets being the first victims, the problem also affected normally operating credit institutions so that at the height of the crisis (from late June until early July) it didn’t spare even the top 20 major banks, which ranked as the mainstay of the Russian banking system both in terms of their capital and assets.

A sluggish response of the Central Bank of Russia to the events was partly explained by significant balances on correspondent accounts of credit institutions at that moment. It is very probable that it was the reason why both representatives of the parliament and the government also initially ignored the first signs of the crisis impending in the banking sector. Later, when banks had raised the alarm, amendments and addenda were promptly introduced into the law on insurance of private deposits to reduce the reserve requirement more than twice from 7% down to 3.5% and expand an excess to the refinancing scheme for banks.

The events have been the first case of quasisystems crisis in the short history of the Russian banking system. Though affecting the whole banking sector, the crisis has strengthened rather than weakened positions of many banks especially those with foreign capital and state participation.
Consequences of the crisis will undoubtedly effect further development of the Russian banking system. Right now one can outline some key sort-term trends, which begin to show.

The first tendency is associated with temporary strengthening of the role of state owned banks and those with participation of foreign capital. Depositors will try to hedge themselves and very likely prefer foreign currency in cash or transfer their savings to state owned banks. More solvent clients will start leaving for subsidiaries of foreign banks or funnel their money from the country.
However, a preference to the state owned banks is a temporary tendency as a competitive environment has already got formed. At the same time, as a part of private deposits have been diverted to the insurance system, a number of the existing banks will decrease, with the survivors getting stronger to successfully compete with state owned financial institutions.

Consolidation of the banking business, the second tendency, has already showed up and will obviously expand. The consolidation means formation of banking groups through integration and merger. Many small and mid-size banks, especially those operating in regions, need re-capitalization. To a significant extent it is due to higher operating, general and administrative costs associated with expansion of banking retail business, which implies new subsidiaries and offices, more cash machines, bank card issues, development of INTERNET-banking and more lending officers to service a growing number of borrowers.

All this means higher costs especially at the initial stage. Hence, there appears a necessity of consolidation: it is much easier to buy an effective bank with a network of subsidiaries than to spend time on creating it anew. Major banks including subsidiaries with foreign capital, which set themselves a target to become major financial supermarkets, will actively buy credit institutions together with their subsidiaries including those in regions.

The third tendency is associated with expansion and diversification of demand for banking services. In an effort to maintain their soundness small- and mid-size banks, if they manage to position themselves right, will occupy their niches on the market. Thus, under conditions of fair competition free of any jowbone a banking system configuration will start to get formed based on diversity of forms and types of financial intermediation institutions. It is the market-oriented scenario of development, which will strengthen confidence in the banking system on the part of investors, creditors, clients and depositors.

The state will keep on producing its influence on banking in Russia. Moreover, there is a number of very important issues, including insurance of citizens` deposits and protection of creditors` rights, which need to be addressed without a delay. However, one should probably resist a widely spread superstition that the seat of all the troubles rests with an excessive number of the existing banks and refrain from making them merging. Many other countries have even more credit institutions per 1000 citizens than Russia does, with USA, Germany, Japan and China leading in terms of an absolute number of such institutions. However, these countries don` t rush either to administratively pare down the number of their financial mediators or to discriminate them by functions they perform. Moreover, major banks are far from being the best standard of soundness and solvency.
Capitalization of the Russian banking system is an important task actually. Yet, it would be inadvisable to solve the task by means of inflow of budget funds. The current financial state of banks and the effective taxation system significantly handicap quick re-capitalization at the expense of internal sources. Attraction of investments, first of all foreign ones, into the Russian banking sector is retarded by a low level of confidence in it and its low profitability, especially when compared with investments into enterprises of the fuel and energy sector. Mergers and integrations can ensure an increase in capital of an individual bank, not the whole banking system. Moreover, under non-transparency of books and records such methods not always ensure positive results.

Under such conditions minimum capital requirement for commercial banks should be tightened as economic circumstances allow doing so. A proposal to segregate banks based on the size of their capital into banks with general licenses and regional banks with a administratively limited scope of banking functions permitted is not only a non-market proposal but also contradicts the modern practice of credit institution activity. If implemented this initiative can destroy the incipient partnership between nonfinancial and financial sectors of the Russian economy, increase costs of transactions and borrowing. As a result small banks may become hostages of some major banks, which are "too huge to be forced into bankrupt".


Table 1.
Banking Sector Performance Grwoth Rates in Real Terms, in % per annum
1998 1999 2000 2001 2002 2003

Assets -45,2 13,4 31,8 17,4 17,8 28,1
Capital -63 61 41,7 33,6 11,3 25,2
Credit and other Facilities Placed or Allowed for Nonfinacial Organizations and Enterprises
-40,2 4,8 47,2 34,3 20,9 38,2
Deposits and other Raised Private Funds -45,3 10,5 31,1 33,2 36,6 39,7
Funds Attracted from Enterprises and Companies -35,9 24,5 36,3 9,5 8,4 19,8
Actual GDP -5,3 6,4 10 5,1 4,7 7,3
__________________
Source: the Central Bank of Russia

Fig. 1. Profitability of Key Branches of the Russian Economy and Bank Crediting Requirements in Q1 2004, in %

Nonferrous-metals industry
Communication
Oil Production
Foreign Trade
Steel Industry
Transport
Retail Sale
Machine Building
Construction

11,6 %
Average Weighted Interest Rate on Credits for Enterprises Allowed for a Period Longer than One Year.

0 % 10 % 20 % 30 % 40 %

_____________________
Source: Goskomstat (Russian State Statistics Committe), the Central Bank of Russia

Fig 2. Dynamics in Credit Funds Borrowed by Enterprises, in bln. Rubles


1800
1600
1400
1200
1000
800
600
400
200
0

July 1998 January 2001 January 2002 January 2003 January 2004 June 2004

Money of Budget and State Non-Budget Funds
Inter-bank Credits, Deposits and Other Raised Funds
Bonds Issued
Funds on Accounts of Legal Entities
Funds on Private Accounts
____________________
Source: the Central Bank of Russia


Fig. 4. Structure of Citizens` Deposits, %

June 2004
January 2004
January 2003
January 2002

0 % 10 % 20 % 30 % 40 % 50 % 60 %

longer than 1 year
from 31days to 1 year
up to 30 days
____________________
Source: the Central Bank of Russia