Russian Banking System the Current State and the Prospects for the Future Developments During the

e last decade the Russian banking system passed through the several stages of its development, including its establishments, a period of a rapid growth, an acute crisis and the recovery. The growth of the national banking system was predetermined by the demand for the banking services in the transition period to the market economy. The Russian banking system developed in 1992-1998 under the unfavorable macroeconomic conditions, including social and political instability, continuous decline in production and investment and high inflation. The banking crisis was an inseparable component of the 1998 system financial crisis. That crisis was rooted mostly in the growing of the domestic problems rather then in the international crisis. The major part of the Russian commercial banks were inefficient (compared with their foreign counterparts) and could exist only under the conditions of the high profitability of the banking operations. Banking profits were insured by the redistribution of the enterprises between different sectors, delays in the transfer of the clients funds and the extremely high yields of the federal bonds. The results were the default on the federal bonds, external debt and the sharp ruble rate depreciation. As the consequences the largest Russian commercial banks were in crisis (on the eve of bankruptcy) along with the sharp cut of the volume of the households deposits. Meanwhile the real sector had the impulse for the future developments from the ruble rate depreciation. Directly after the system financial crisis in August 1998 the further development of the Russian banking system could be proceeded according to the three basic scenario (or some combinations of them): the governmental support of the banking reform, the attraction of the foreign capital on the domestic market or the recovery through the using own banking capital and its own activity. As a result the development of the national banking system in the post-crisis period (1998-2002) was followed the last scenario (the recovery of the banking system through their own funds and activity). The first features of the recovery appeared only in 2002. The Russian banking system can covered the accumulated losses only in the middle of 2002. Exactly in that year the involvement of the Government of RF into national banking system increased. Firstly, the shares of the Central Bank of RF in some banks (mainly Sberbank of RF and Vneshtorgbank of RF) had been transferred to the Government (as the exchange to the nonmarket bonds transferred to the Central bank of RF portfolio). Secondly, the state controlled financial institutions captured the federal bonds market (the domestic and external debt markets). Thirdly, the state controlled banks expanded their credit activity on the domestic markets (using state guaranties on the private deposits for the attraction relatively cheap liabilities). The further developments of the Russian banking system will be strongly depended on its current condition, the external factors (the oil price levels, the state of the developed economy and financial markets and the level of the international money interests rates, the emerging markets conditions and others) as well as on the domestic economic policy. In any case the set of the different parameters will affect the national banking system conditions. The Russian banking system being the key sector, that will determine in the great extent the possibilities of the keeping the steady positive economic growth in the medium-run (or depression). The possible opening of the domestic financial market (for example, as under the WTO process) forms some scenarios of the Russian banking system developments, which can change the key parameters as inside the banking system as in the structure of the financial flows in the Russian economy.

1. The Developments of the Russian Banking System in the Transition Period The transition period of the market reforms in Russia allows the selection of the three phases of the national banking system developments. Each phase is characterized by the state of the national banking system connects with the certain model of the Russian economic developments. The contents of the first phase (1988-1998) were the appearance of the private banks, their developments under the provided privatization process and the rapid growth of the domestic debt market. Exactly the debt model of the Russian economic development determined the system financial crises in August 1998, which governed the crisis of the national banking system and led to bankruptcy of the some biggest commercial banks. Thus the second phase connects with the process of the national banking system recovery after that crisis. Third phase assumes the further positive developments of the national banking system under the task of the production rates acceleration exactly this aim turns to be the key for the Russian economy in the medium-run. Phase 1. The Appearance of the Russian Banking System in the Transition Period (1988-1998) Russian banking system has its roots in the Soviet era. The economic reform course announced in the middle of the 1980s required that cardinal changes be introduced in the existing banking system. The first step towards reform of the banking system was made in 1987, when several special state banks were established in the Soviet Union. The first commercial bank was registered a year later, in 1988. A few years later, in 1991 through 1992, a wide network of commercial banks was created in Russia on the basis of special state banks' branches. This was done under guidance of the Central Bank of Russia, which assumed responsibilities of the USSR State Bank after the collapse of the Soviet Union. In this way a one-level banking system that actually existed under Soviet conditions was transformed into a two-level system consisting of a central bank (Bank of Russia) and a ramified network of commercial banks in a very short time. The reason for the rapid growth of the number of commercial banks in Russia was that banking sector provided ample opportunities to make significant profits. In view of this, a number of circumstances should be pointed out. First, there was an acute shortage of banking services in Russia, while the number of private business entities was growing rapidly. Even the simplest operation, such as the opening of a current account, often became a formidable problem. This made it possible for the banks to pay very low or even zero interest rates on account holders' balances (and thus reduce costs of liabilities) and charge high commissions for payment handling (and thus increase incomes). Second, since inflation in Russia was high in the early 1990s and the existing mechanism for fixing interest rates on borrowed funds was not tied to inflation, the long-term borrowings often devalued before the repayment day (devaluation of deposits at Sberbank of RF is a typical example). This meant that the actual costs of commercial banks' liabilities were low. Third, Russian banking legislation was rather liberal. For instance, it did not provide for direct control over interest rates that banks offered on deposits and charged for loans, while indirect regulation was possible only through changing the refinancing rate). Moreover, neither the Central Bank of Russia nor the Russian government exercised tight control over the structure of lending institutions' assets and liabilities. For instance, lending institutions made independent decisions on what share of attracted funds should be provided in loans to economic entities. Forth, Russian banks made money from the redistribution of the centralized loans. The mechanism was very simple: banks received funds intended that the monetary authorities provided to particular companies or sectors. The profitability of that operation was determined by the lending margin (the spread between interest rates paid on borrowed funds and charged on loans provided). Lending institutions often delayed the distribution of these funds between end borrowers. For a rather long time, banks could use these free resources (they were actually free 2

because rates charged by central lenders were often below market rates) for making extra profits on various segments of the financial market, such as the interbank and foreign exchange markets. Further developments of the national banking system had been followed by the transition process the privatization of the major enterprises and the fast growth of the domestic debt market. The development of the domestic debt market determined the growth of the national banking system, which was formally isolated from the real sector. As the result the default on the federal bonds and the sharp ruble devaluation push the largest banks on the eve of bankruptcy. Russian households and the foreign investors faced the large scale losses, the financial markets were depressed. The prospects for the Russian real sector had been indefinite. Phase 2. The Recovery of the Russian Banking System After the System Financial Crises in August 1998 (September 1998 -2002) The crisis in August 1998 in Russia was the system financial crisis by its nature, including the foreign debt payments, foreign currencies, banking and financial markets crises. As the result the payments on the public and private external debts had been temporary frozen, the sharp devaluation of the ruble rate was observed, the biggest national commercial banks faced the liquidity problems, the turnovers and liquidity of the circulated financial instruments drastically dropped. Russian real sector had been relatively fast adapted to the new economic environment the domestic and external. Moreover, starting from the 1999 the positive rates of growth were fixed by the most of the economic fundamental indicators. In fact the Russian economy captured the steady growth trajectory due to the follow factors: - the sharp devaluation of the ruble rate. Russian enterprises used the advantages of the low real ruble rate for the stimulation of the import substitution process. As the consequences were the growth of the domestic production, especially oriented on the domestic demand; - the growth of the export revenues. The sharp increase of the world market prices for the crude oil and other raw materials (which are dominated in Russian export) improved the financial position of the export-oriented enterprises and the federal budget, increased the aggregate demand resulted in the retail turnover and capital investments growth and finally in domestic production growth; - the government regulation of the prices for the natural monopoly products (the prices on the electricity, natural gas and transportation), that was in fact the state subsidies for the real sector and also stimulated the domestic production. Directly after the system financial crisis in August 1998 the further development of the Russian banking system could be proceeded according to the three basic scenarios (or some combinations of them): the governmental support of the banking reform, the attraction of the foreign capital in the domestic banking sector or the banking recovery through the using the own banking capital and the banking own activity for its survival. As a result the development of the national banking system in the post-crisis period was followed the last scenario (the recovery of the banking system through their own funds and activity) and the first features of the recovery appeared only in the middle of 2002 compare with the 1998 (pre-crisis level). The scenario of the banking system recovery through their own resources after the financial crisis was quite comfort for the Russian monetary authorities, but its prospects are quite limited. In fact we should pointed out, that the potential of such scenarios realization was over the total banking assets had been grown on 33% in the real terms on 01.01.2003 compare with the pre-crisis level (using the PPI deflator) and the total own banking capital was only $18.3 bln. on January 1, 2003 ($20.8 bln. on August 1, 1998). It is evident, that the Russian banks by themselves could not get over the negative consequences of the financial crisis. As the best results the realization of this scenario would lead to the recovery of all the key indicators of the 3

banking system compare with the pre-crisis level, but they were not corresponded with the demand of the Russian real sector on the banking services level and their disposable resources. Table. Russias Banking System Key Indicators (as on the beginning of the period, in USD according to the market exchange rates)

Year

Assets

Charter Capital

Own Capital

Enterprises' Loans 34,0 14,5 16,8 27,5 39,8 50,8

Market Exchange Rate, RUB/$ 6,1 20,7 27.0 28,2 30,1 31,8

1998* 1999 2000 2001 2002 2003

112,2 45,9 53,7 76,7 95,7 120,2

7,7 3,0 5,3 7,5 9,0 10,0

20,4 5,2 7,1 10,4 15,0 18,3

* data for the financial indicators as on 01.04.98. Source: CBR, State Statistic Committee, EU Vedi estimates

The formal improvements of the financial position of the Russian banking system in 2002 had been reached mainly due to State Saving Bank (Sberbank of RF controlled by the state). This states controlled bank occupies the monopoly position on the households deposit market, owning the state guaranties for the private deposit insurance, and thus has the comparatively cheap and long-term liabilities. Conducting the active policy of the providing banking loans to the enterprises the Sberbank of RF gained the profits as about $1 bln. in 2001 and about $2 bln. in 2002. Such volume of the profits was significantly high compared with the total of the Russian banking system and changed the trend of the aggregate profitability of the national banking system. In case of exclusion the Sberbank of RF the aggregate profit of the commercial banks has been much lower. Chart. The Profit of the Russian Banking System (quarterly, bln. RUB)
40,0 30,0 20,0 bln. RUB 10,0 0,0 -10,0 -20,0 -30,0 -40,0 IIIQ 99 IQ 00 IQ 99 IIQ 00 IIIQ 00 IIQ 99 IVQ 99 IVQ 00 IIIQ 01 IIQ 02 III . IIIQ 02 IV . IVQ 02 IQ 01 IIQ 01 IVQ 01 I . II . IQ 02

Sberbank

Commercial Banks

Source: CBR, EU Vedi estimations

Chart. The Accumulated Banking Profit (minus accumulated losses), bln. RUB
40 30 20 10 bln. RUB 0 -10 -20 -30 -40 -50 02/ 99 04/ 99 06/ 99 08/ 99 10/ 99 12/ 99 02/ 00 04/ 00 06/ 00 08/ 00 10/ 00 12/ 00 06/ 01 04/ 98 08/ 98 10/ 98 12/ 98 02/ 01 04/ 01 08/ 01 10/ 01 12/ 01 02/ 02 04/ 02 06/ 02 06/ 98 08/ 02 10/ 02 12/ 02

Source: CBR, EU Vedi estimations

The reaction of the commercial banks on their poor financial position was the initiating of the merge procedure for the increasing the disposable assets. As a result the size of the average assets of the Russian commercial bank had been increased from 2.2 to 2.9 bln. RUB during the 2002 (or on 32%), the average charter capital from 205 to 240 mln. RUB (on 17%), the own capital from 342 to 438 mln. RUB (on 28%), the average volume of the enterprises loans from 0.9 to 1.2 bln. RUB (on 34%). Note, that the merge procedures in the Russian banking system were as the single deals, but not as the sustainable trend. Russian private bank is still characterized by low capitalization. Table. The Increase of the Relative Indicators of the National Banking System in the Post-Crisis Period
The Average The Average The Average Volume of the Volume of the The Average Volume Volume of the Assets per Bank, Charter Capital per of the Own Capital Loans per Bank, mln. RUB Bank, mln. RUB per Bank, mln. RUB mln. RUB 418 643 1075 1647 2186 2875 29 42 106 162 205 240 76 72 142 223 342 438 127 203 336 590 909 1216

Date 01.04.1998 01.01.1999 01.01.2000 01.01.2001 01.01.2002 01.01.2003

Number of the Banks 1641 1476 1349 1311 1319 1329

Source: CBR, EU Vedi estimations

Phase 3. The Current State and the Prospects for the Future Developments of the National Banking System (2003 - 2006) The key parameters of the Russian banking system reached their pre-crisis level only in the middle of 2002 due to the own banking activity, the shareholders investments and positive 5

economic environment. The participation of the government and foreign investors had been insignificant. Formally the achievement of the main banking indicators the pre-crisis level means the recovery of the banking system, but the domestic market already formed the new higher demand on the potential volume of the banking loans and the range of the banking services. The national banking system developments in the current moment are significantly depended on the external and internal factors. As the external factors we select the follows: - the high level of the world oil prices, which provides the stable financial state of the national enterprises (mainly exporters) and federal budget; - the low level of the interest rates on the developed capital markets, which is determined the low cost of the international loans and the high level of the investment demand from the international investors; - the growth of the demand on the energy resources ( in the physical terms), which determines the stable real level of the Russian fuel-energy sectors export (not only in money terms); - the permanent growth of the Russias international investment ratings (including the sovereign and corporative ratings). As the domestic factors the following indicators affect the state of the national banking system: - the positive state of the Russias fundamental indicators (GDP, industrial production, capital investments rate sand others); - the ruble rate appreciation toward the main world currencies: - the growth of the money supply (which was higher than the money demand from the real sector and households). As a result the volume of the free money resources (placed on the Central bank of RF deposits) was relatively high about the $15 bln. in the beginning of 2004; - the shortage of the financial instruments circulated on the national market. The fundamental indicators of the Russian economy had been strongly positive during last five years. The growth rates of the produced GDP, industrial production, capital investments had been positive in the real terms, the ruble exchange rate has been stable, the federal budget surplus had been fixed and the inflation rates fell. Table. Key Indicators of Russian Economic Developments in 1995-2003
1995 Real Sector GDP, % growth rates YOY Industrial Production, % growth rates YOY Capital Investments, % growth rates YOY Financial Sphere CPI (Dec. to Dec.) PPI (Dec. to Dec.) Money Supply (M2) Exchange Rate, RUB/$, end of period Foreign Trade Exports, $ bln. Import, $ bln. BoT, $ bln. External Public Debt, $ bln. -4.0 -3.3 -10.0 1996 -3.4 -4.5 -18.0 1997 0.9 2.0 -5.0 1998 -5,3 -5.2 -12.0 1999. 6.4 11.0 5.3 2000 10.0 11.9 17.4 2001 5.1 4.9 10.0 2002 4.7 3,7 2,8 2003 7,3 7,03 12,5

131 175 125,8 4,6

22 25,6 33,9 5,6

11 7,5 29,8 6

84,4 23,2 19,8 20,7

36,5 67,3 57,2 27

20,2 31,6 62,4 28,2

18,6 10,7 39,2 30,1

15,1 17,1 32,3 31,78

11,44 12,3 50,5 29,46

82.9 62.6 20,3 128

90.6 68.1 22,5 143,3

89.0 72.0 17 153,5

74.9 58.0 16,9 166,4

75.7 39.5 36,2 155

105.0 44.9 60,1 143,4

101,9 53.8 48,1 130,1

107,3 61 45,7 119

135,9 75,4 60,5 108,9

Source: State Statistic Committee of RF, CBR

The listed above factors (including the fundamental indicators) stimulated the developments of the Russian banking system. Most of them had the positive effect, but some formed the basis for the different local crises. In general the key current trends of the banking system after its formal recovery can be described as the following tendencies: 1. 2. 3. 4. 5. 6. 7. 8. the rates of the banking assets increased, which were based on the improvement of the enterprises and households financial positions; the rates of the individuals banking deposits growth had been on the high level, which increased the role of the Russian population as the investor; the process of the dedolarization of the banking deposits (due to ruble real rate appreciation) was observed the share of the banking ruble accounts reached the pre-crisis level; the growth of the volume of the foreign loans to the Russian banks (the maximum level for the transition period as about $9 bln. had been fixed in 2003); the growth of the volume of the banking loans to the real sector as long as the term of the banking loans; the shift of the banking loans structure toward the second echelon enterprises the financially stable enterprises, which are not belong to the fuel-energy sector; the high growth of the volume of the banking deposits in the Central Bank of RF as the excess liquidity volume in the national financial sector; the increase of the volume of the banking loans to the individuals and corporate bonds (in spite of the higher risks and due to the weak national financial markets);

Formally the key indicators of the Russian banking system state in 2003 corresponded with the macroeconomic indicators and showed not only the recovery, but also the improvement. Table. The Key Indicators of the Russian Banking System, end of period
Assets/GDP, % Capital/GDP, % Loans/GDP, % Banking Deposits/GDP , %* M2/GDP, % Spread in the Interest Rates, % per annum**

1998 1999 2000 2001 2002 2003

36,07 30,07 29,56 31,89 35,17 39,14

4,04 3,98 4,01 4,99 5,36 5,85

11,41 9,40 10,59 13,26 14,87 17,06

16,36 14,62 15,12 16,47 18,48 20,29

17,05 14,61 15,66 17,73 19,51 23,80

24,74 26,03 17,93 13,06 10,75 8,63

* banking deposits legal and individuals deposits; ** - spread between the average rates between the banking assets and liabilities. Source: Central Bank of RF, EU Vedi estimations.

Note, that in spite of some improvements the role of the banking system in the national production has been insignificant in the post-crisis period. The international comparisons show, that the steady growth of the emerging economies had been fixed only in case of the banking loans exceeding 40% GDP. Contrary Russian enterprises now mainly use their own recourses for the capital investments and the banking loans are only about 5% from the total capital investments. Further, the downward trend of the banking spread (the spread between average deposits and credit interest rates) partly stimulate the increases the volume of the banking loans to the real sector, but decreased the profitability of the banking business. The cut of the average margins of the banking operation (along with the low banking capitalization) potentially provokes the new banking crisis/instability. 7

The further developments of the national banking system will be connected with the necessity to open domestic market of the banking services. Now the foreign financial institutions formally face with some restrictions in their invasion to the Russian banking services market. The Law on the banking system activity regulation in Russian is quite liberal, but regulated by the different instruction of the Central Bank of RF. For example it was the Instruction in the early 90-s, which limited the foreign capital participation in the total capital as 12%. Now such limitation had been withdrawn, but in fact the share of the foreign capital is about 10%. Further, there is the restriction for the opening the branches of the foreign banks (which can follow the foreign regulations and thus have the preferable position on the required reserve demand and others). There are some other restrictions (for example, the two years experience of the working in Russia before serving the individuals and others). Such restrictions are not follow from the Laws, but regulated by the CBR instructions, which can be principally changed due to the different political aims. In general the problems of the liberalization of the foreign banks access to the domestic financial market (including the problem of the Russia entrance to WTO) are hardly discussed within the possible positive and negative impacts. Between the positive factors are: the access of the Russian enterprises to the more cheap and long-term financial resources; the increase of the trust of the Russian households and enterprises to the national banking system after the foreign capital invasion; the increase of the total banking assets - as the basis for the loans increase to th real sector and for the support of the steady positive growth of the industrial production.

As the negative factors of the domestic banking service market liberalization the follows have been strongly discussed: the shift of the Russian legal and individuals deposits in the favour of the foreign banks; the decrease of the competitiveness of the Russian commercial banks and the activization of the process of the national commercial banks sales to the foreign financial institutions in the context of the national banking system security and independency.

These set of the factors can principally change the appearance and structure of the Russian banking system in the nearest future thus the political decision on this topic is so important.

2. The Structure of the Financial Flows in Russian Economy in Post-crisis Period

Banking system is turned to be the key distributor of the disposable financial resources in the national economy. The estimations of the volume of the distributed financial flows as well as the net balance between the banking system and other economic agents can be the key point for the structural analysis of the national financial system. For this purpose we divided the structure of the financial flows in the national economy into 7 main groups (according to the set of the main economic agents): the Government (federal government), Enterprises, Regions (local administrations), Households, Central bank of RF, Rest of the World (non-residents or foreign investors) and the Commercial Banks.
Government. The account of this category is defined by the financial resources of the federal government, which are placed in the commercial banks as the budgets and off-budgets

deposits and received as the loans in form of the federal bonds domestic (GKO and OFZ) and external (Minfin, eurobonds and others); Enterprises. The account of the category enterprises includes the demand and time banking deposits placed in the national banks and the loans to the Russian real sector, received from the banking sector. Moreover this account includes the resources attracted by the enterprises through the bonds issue (corporate bonds, promissory note and others). Regions (Local Budgets). This account contains the deposits of the local budgets minus banking loans to the regional administrations and the resources from the municipal bonds issues. Households. The category households includes the individuals demand and time banking deposits minus the commercial loans to the Russian households (as for the real estate or commodity loans). Central Bank of RF. This balance forms by the all deposits of the commercial banks placed in the CBR, the required reserves (on the national and foreign currency) minus the refinancing banking loans provided by the CBR. Non-residents (foreign investors). This category includes the deposits and other claims of the Russian commercial banks to the foreign banks minus the claims of the foreign banks to the national banks (in the form of the bonds, loans, forward contracts and others). Russian Commercial Banks. This account includes the interbank loans, the own banking capital and other resources, which cannot be identified as of certain accounts.

The financial resources received by the economic agents from the banking system were fixed as the assets of the banking system (with the sign +) and the attracted resources by the banking system from the agents were fixed as its liabilities (with the sign -). For example, the Russian enterprises keep their deposits on the banking accounts (-) and receive the loans from the banking system (+) the difference reflects the net balance between the banking system and real sector. The difference between assets and liabilities on each account characterizes the certain economic agent as the net-lender of the banking system (if the investments of the certain agent into national banking system exceed volume of the resources gained from the banks) or net-borrowers (if the financial resources received from the national banks exceed the resources placed in the banking system). Table. The Net Balances of the Financial Flows Between Russians Banks and Main Economic Agents
01.04.1998 01.01.1999 01.01.2000 01.01.2001 01.01.2002 01.01.2003 01.01.2004

Bln. RUB
Commercial Banks CBR Government Regions Enterprises Househods Non-Residents % GDP Commercial Banks CBR Government Regions Enterprises Households Non-Residents

-69,54 52,31 167,42 13,95 52,45 -177,48 -39,10 -2,97 2,23 7,15 0,60 2,24 -7,58 -1,67

-68,32 49,23 169,39 13,78 26,60 -187,46 -3,22 -2,60 1,87 6,44 0,52 1,01 -7,13 -0,12

-46,75 122,63 189,13 4,13 -88,43 -278,38 97,67 -0,97 2,54 3,92 0,09 -1,83 -5,77 2,03

-138,73 258,99 244,32 -20,48 -106,59 -410,02 172,51 -1,90 3,54 3,34 -0,28 -1,46 -5,61 2,36

-144,98 255,63 262,09 -20,22 97,75 -600,69 150,40 -1,62 2,86 2,93 -0,23 1,09 -6,72 1,68

-140,61 409,86 325,17 8,66 199,51 -907,51 104,92 -1,30 3,78 3,00 0,08 1,84 -8,38 0,97

-153,11 657,23 362,91 36,80 481,66 -1 244,66 -140,83 -1,15 4,95 2,73 0,28 3,63 -9,37 -1,06

Source: CBR, EU Vedi estimations Notes: + denotes the net borrower of the banking system, - denots the net creditor of the banking system

The net creditors of the Russian banking system in the post-crisis period (1998-2004) have been the households and the non-resident. The households exceeded the pre-crisis level on their investments into national banking system only in 2002 and now provide the net credit to the national banks as above 9% GDP. The foreign investors directly after crisis in 1998 withdraw their investments from Russia, but starting from the 2003 again have being as the net-creditors of the Russians banks (through the banking loans, portfolio investments and participation in the banking charter capital). The structure of the financial flows in Russian economy has been significantly changed due to as financial crisis in August 1998 as the current state of the national real sector (particularly, due to the switch from the domestic debt to the export-oriented model of the national economy development). The main creditors of the Russian banking system were households and foreign investors in the pre-crisis period. These agents had the maximum losses after financial crisis in 1998. And if the foreign investors fixed their losses and changed their status from the net-creditors to net-debtors (through the withdraw the portfolio investments and the increase the Russian banks deposits in foreign banks), than the households are still remain the main donors of the banking system (moreover, the individuals savings in banks in rubles and foreign currency increased compare with the pre-crisis period). Russian enterprises had been active participators in the banking system recovery (which corresponded with their economic interests). Directly after crisis exactly the enterprises resources (demand and time deposits) induced the recovery of the banking system. Starting from the 2002 the national enterprises switch their status for the net-debtor the shortage of the instruments circulated on the financial markets stimulated the growth of the banking loans to the enterprises. Local authorities traditionally have the insignificantly financial relations with the banking system. And if inside the debt-oriented economy in 1997-1998 the regional budgets issued the significant volume of the municipal bonds, which exceeded the regional authorities banking deposits, than the issue of such bonds after crisis was near zero and the local budgets turned to be the net-creditor of the banking system. Russian monetary authorities have been the sustainable net-debtor toward national banking system. The Ministry of Finance of RF has the negative balance with the banking system (due to federal bonds issues) as well as the Central bank of RF (which balance also has been negative during last decade). Such position illustrated the key direction of the monetary policy, under which the main goals of the monetary authorities are to attract the free financial resources (to the CBR deposit) but not spread the activity in the refinancing commercial banks. As can be seen from the table below the major part of banking liabilities had been providing through the households deposits. In spite of the negative real interest rates the volume of the individuals deposits has been increasing (especially in the rubles). The enterprises deposits were the main resources directly after financial crisis (in 1999-2001), provided the stability of the private banks in that period and formed the basis for the recovery of the banking system. Thus the net-lenders of the Russian banking system during the post-crisis period have been the households and non-residents. The volume of these resources has been changed during that period (due to the mistrust of the Russian populations as well as the volume of the foreign investments). In some periods the enterprises deposits provided the stability of the banking system. But as the medium-term tendency exactly the individuals and the foreign investors has been formed the main part of the liabilities of the national banking system. The key sources of the banking liabilities the individuals deposits and foreign loans/investments determine the advantages of the certain banks on the domestic market the state control banks (which position on the private deposits is near to the monopoly and 10

the international ratings are near he sovereign one) and the foreign banks (which have the access to the foreign loans and have the relatively low cost deposits). Thus exactly the state controlled banks and the foreign banks will have the advantages on the liability side. On the assets side the leading position will capture the banks, which have the most liquid and less risky instruments also the state controlled- and foreign banks. The private domestic banks are in the ambush connects with the expensive liabilities and the risky and low liquid assets. 3. The Scenarios of the Russian Banking System Developments in the Medium-Run (Under the Possible Integration Into the World Financial System) The problems of the keeping steady and highly positive growth rates of the Russian economy (as the growth of the real GDP, industrial production, capital investments and others) are considered as the strategic task for the medium-term Russian developments. Such task had been determined in the Presidential Message to the Russian Parliament in March 2003. The Russian financial sector (mainly the banking system and financial markets) has to be the key instrument for the solving these tasks. Russian banking system has been recovered after the financial crisis in August 1998 (at least the major banking indicators reached the pre-crisis level in 2002-2003). The current state of the banking system allows the division of the existing banks into three segments. Each segment is characterized by the certain structure of the liabilities, position on the financial markets and different possibilities for the future developments. First segment is composed by the state controlled banks Sberbank of RF (the State Saving Bank), Vneshtorgbank of RF (Bank for the Russian External Trade Service), Gazprombank and other smaller banks. Such banks dispose the significant financial resources, the governmental support and associate with the Federal Government. Moreover, such banks have the relatively high international credit ratings (near the sovereign ones). Respectively, these banks can provide the loans to the real sector (relatively large volumes and for the mediumterm), attract the external loans and the risks of their bankruptcy is near zero. As a result these banks capture the close to monopoly position on the market of the individuals deposits, fully control the domestic debt market and are the major participants on the Russian external debt market. In fact the state controlled banks dispose the cheap liabilities (as the major part of the foreign credits and pension savings), seized the lowest risks segments of the national financial markets and provide the loans to the most profitable enterprises. Moreover, their deposit and credit rates are the indicates for the interest rates in the national economy, the Federal Government uses these banks for the interest rates control and in cases of the possible financial instability.

11

Table. Russian Banks the Largest Recipients of the Foreign Loans

Bank The Foreign Liabilities ($ mln.) 1.1.2003 Sberbank of RF* Gazprombank* Vneshtorgbank* International Industrial Bank MDM-bank Alfabank Commerzbank (Eurasia) Trust bank Total for the 8 banks Other Banks Total 116 506 749 552 468 492 345 25 3254 6475 9729 1.1.2004 1211 1444 1505 1299 1131 1107 778 431 8910 9771 18681 Growth Rates (%) 1044 201 285 225 235 242 226 1693 151 274 193 Increment ($ mln.) Including: through the Total Eurobonds Issue 1 095 1000 938 1050 756 300 747 663 125 614 50 433 405 300 5655 2825 3297 395 8952 3220

Source: CBR, commercial banks reports, CMAEF Note: * - Russian commercial banks controlled by the government

The second sector of the Russian banking sector consists now from the domestic private banks. These banks are mainly small, major of them are affiliated with the industrials enterprises/holdings. Russian private banks have to conduct the aggressive interest rates policy on the banking service market for the deposits attraction as to compete with the state controlled and foreign banks. Respectively the structure of their assets is constantly shifting toward the more risky financial instruments (on the fixed income and equity markets as well as in providing loans for the less financial stable enterprises). Such policy along with the low capitalization and expensive liabilities of these banks determines the high risks and instability inside the second sector. The third group includes the banks, which shareholders are the foreign banks (but these banks are not the branches in the common sense). Such banks have a positive reputation on the domestic market between the private and legal clients (in spite of the big losses after financial crises in August 1998 all these banks discharged all the claims toward their clients). Thus the margin between the deposit interest rates between foreign banks and even state controlled Russian banks is about 4-8% (in rubles or in the foreign currency), but the volume of their volume of the individual and legal deposits is constantly rising. The foreign banks are realizing large-scale company in providing credits (for the households and the most reliable and stable enterprises). As an example, the foreign banks are providing loans to the individuals (as the nontired loans, the commodity and mortgage loans). Moreover, the financial results of the foreign banks activity much higher compare with the domestic ones. The profitability of these banks exceeded the same indicators of the domestic commercial banks. Table. The Financial Results of the Selected Banks on the Russian Market (thnd. RUB).
2002 Own Capital Domestic Banks Sberbank of RF* Vneshtorgbank of RF* Gazprombank* Alfabank Profit Profit/Cap ital 30,2% 22,1% 13,2% 1,6% 2003 Own Capital Profit Profit/Cap ital 26,7% 17,9% 19,6% 1,3%

120 439 461 59 476 316 25 878 705 23 159 282

36 417 237 13 133 254 3 415 365 371 553

147 791 041 65 911 718 28 501 567 23 238 239

39 454 927 11 825 657 5 582 985 301 333

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International Industrial Bank Rosbank MDM-bank Moscow Bank Industrial Construction Bank Foreign Banks Citibank International Moscow Bank Raiffeisenbank Eurofinance Moskovsky Narodny Bank Commerzbank (Eurasia) ABN AMRO (Eurasia) Deutshebank ING (Eurasia) CSFB

27 324 522 10 226 765 8 610 272 9 877 283 4 057 048

517 921 1 685 134 144 577 1 011 489 1 844 603

1,9% 16,5% 1,7% 10,2% 45,5%

28 745 555 11 485 665 8 931 581 10 982 559 5 224 389

550 570 1 102 099 667 004 1 979 044 2 059 850

1,9% 9,6% 7,5% 18,0% 39,4%

6 646 753 3 877 053 2 843 364 3 188 074 711 839 1 721 858 2 716 507 1 861 801 2 169 561

2 635 425 1 221 864 1 404 762 793 917 239 181 825 960 503 534 208 956 782 473

39,6% 31,5% 49,4% 24,9% 33,6% 48,0% 18,5% 11,2% 36,1%

8 210 531 5 739 453 4 137 752 5 013 254 943 828 2 336 095 3 019 263 2 220 462 2 615 559

2 542 781 3 031 774 2 758 368 879 767 617 967 840 755 1 238 117 559 672 570 373

31,0% 52,8% 66,7% 17,5% 65,5% 36,0% 41,0% 25,2% 21,8%

Source: banking reports, EU Vedi estimations. Notes: the average profitability of the foreign banks had been steady higher than the Russian commercial banks

Thus the key trend of the Russian banking system in the medium-run seems to be the strengthening position of the state-controlled and foreign banks. These banks have the evident advantages on the liability side (mainly the excess to the relatively cheap deposits and the foreign loans) and capture the most attractive segments of the domestic financial markets. Moreover exactly these banks have the potential to support the positive growth of the Russian economy. Inside this trend we can select some scenarios of the national banking system developments in the short- and medium-run. The specification of the different scenarios facilitates to assess the key banking indicators. The set of the scenarios is determined by the external factors (the oil price level, the condition of the developed economy and financial markets and the state of the emerging markets) and internal factors (the political risk in Russia, the state of the economic fundamental indicators, the parameters of the fiscal and monetary policies, the conditions of the structural reforms and others). Depending on the listed above factors we select three basic scenarios of the banking system developments: the optimistic, conservative (and the most probable) and pessimistic. Additionally, the developments of the Russian banking system will depend on the different institutional factors, mainly on the pension reform and foreign capital inflow/outflows. We are strongly believe, that the current state of the Russian banking system will be characterized as the transition period in the next 1-2 years. The Russian monetary authorities have no certain strategic plan for the national banking system and financial markets reforms, the pension reform is on the initial stage and the possible foreign capital inflows can be expected not early than at the end of 2004. The Russian banking system (in spite of some disadvantages) is quite stable in the current moment as well as the Russian monetary authorities disposes the enough resources for the neutralization the internal and external shocks. Thus the probability of the domestic financial crisis in case of the sharp drop of the world oil prices is near zero. The main threat for the national financial system is not in the losses due to the financial crisis, but as the potential losses from the drop of the economic growth rates. In this case the Russian enterprises will find the credit resources on the external markets. If the world oil prices will be stable we expect the 13

stable share in the national banking system (but on the corporate bonds segment the foreign financial institution can capture the dominant position). The banking investments into the Russian real sectors will not significantly support the possible economic growth in the medium-run, but the impact of the banking sector will be increased. The share of the banking loans in the total working capital has been increased from 14% in 1999-2000 to the 46% in 2003 and can be increased up to 55-60% in 2005-2006 (even under the moderate GDP growth as 4.5-5.5% per annum). Table. The Key Scenario Parameters of the Russias Macroeconomic Indicators.
2002 GDP Growth Rates, % Annual Average Oil Price for Urals, $/bar Industrial production Growth rates, % Capital Investments Growth Rates, % Exchange Rate, end of period, RUB/$ CPI (Dec/Dec) Money Supply 2 Growth Rate (Dec/Dec) Real Disposable Income Growth Rate, % Federal Budget Surplus (-)/ Deficit (+), % GDP Capital Outflows, $ bln Source:Development Center 4,7 23,6 3,7 2,8 31,8 15,1 32,3 10,9 -1,4 -24,7 2003 7,3 26,8 7,0 12,5 29,5 11,4 50,5 9,1 -1,4 -28,9 2004, forecast Opt 4,4 24,3 4,7 11,5 29,4 10,9 33,3 7,5 -1,7 Cons Pess 4,0 22,0 3,6 8,1 30,0 10,3 29,0 6,8 -0,8 2,7 18,0 3,0 5,3 30,8 8,7 23,5 5,0 0,8 2005, forecast Opt 5,0 23,3 5,2 13,3 29,5 9,9 26,2 6,1 -2,1 -30,1 Cons 4,5 22,0 4,0 11,3 30,4 10,5 25,9 5,5 -1,5 Pess 2,3 15,0 1,7 2,4 31,9 8,7 20,9 3,1 1,3

-27,1 -27,4 -27,4

-29,8 -27,0

Table. The Key Scenarios Parameters of the Russian Banking System

As % of GDP Banking Assets Banking Loans to the Economy Federal Bonds Investments Corporate Bonds Investments Banking Deposits in CBR Own Capital Households Deposits Enterprises Deposits 2002 38,1 17,1 3,9 3,0 8,6 5,5 9,5 10,0 2003 40,7 18,8 4,2 3,7 8,2 6,1 11,2 10,1 2004 Opt 45,2 21,1 5,0 4,5 8,4 7,1 13,6 10,7 Cons 44,5 20,7 4,9 4,4 8,4 6,6 13,8 10,2 Pess 42,0 18,6 4,7 4,4 8,4 5,4 14,2 9,5 Opt 47,0 22,7 4,1 5,0 8,9 7,6 15,8 10,9 2005 Cons 46,4 22,4 4,1 4,9 8,8 7,1 15,8 10,4 Pess 44,5 19,9 4,5 5,0 9,1 5,5 16,7 9,7

Source: The Development Center, EU Vedi Notes: Opt optimistic scenario, Cons conservative scenario, Pess pessimistic scenario.

Finally let us one more time emphasize, that the politically formed the medium-term goals for the Russian economic policy (which is listed above and traditionally seems to have the significant impact on all the decisions of the Russian bureaucrats) imply the acceleration of the economic growth and claim the follow demands to the national banking system: - the providing wide set of the banking services to the domestic economic agents; - the accumulation of the enterprises and households savings in the form of banking deposits; - the transformation of the national savings into investments in the real sector; - the keeping financial stability and the stimulation of the positive economic developments.

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The structure of the national banking system formed in the post-crisis period has some advantages and disadvantages in this context. As the positive features of the current state of the Russian banking system are the follows: - the possibility of the optimization/decrease the production cost as the tax payments cut; - the including of some banks into the structure of the industrial-financial group; - the managements experience in the current activity with the domestic clients, including loan providing and the intermediators services; - the traditional trust of the Russian population to the governmental financial institutions. At the same time the current condition of the national banking system has the following disadvantages: - the low capitalization of the banking system; - the short-term structure of the banking liabilities, which is limited the possibilities to provide the medium- and long-term loans to the real sector; - the low solidity and high risks. The low level of the interbank trust between national banks restricts the developments of the domestic financial markets; - the relatively low access of the domestic banks to the international capital. The listed above weak places of the national banking system seem to be the restriction for the future growth of the Russian economy. Exactly due to these reasons the national banking system will shift toward the trend of the strengthening of the state controlled and foreign banks role. The impact of these banks is high even now and its growth will depend on the different scenarios. But if the growth rates can be different, than the change of the main trend will betoken the eve of the next crises or the change of the pattern of Russian economic developments.

Conclusions Russian banking system developments during the transition period to a market economy (1992-2004) have been closely connected with overall economic conditions. Fall of the economic production, high inflation rates, conducted economic policy, the impact of the different external impulses all these factors significantly determined the national banks evolution. Directly after the system financial crisis in August 1998 the further development of the Russian banking system could be proceeded according to the three basic scenarios (or some combinations of them): the governmental support of the banking reform, the attraction of the foreign capital in the domestic banking sector or the banking recovery through the using the own banking capital and the banking own activity for survival. As a result the development of the national banking system in the post-crisis period was followed the recovery of the banking system through their own funds and activity and the first features of the recovery appeared only in the middle of 2002 compare with the 1998 (pre-crisis level). The formal indicators of the Russian banking system state (as in 2002-2004) proclaimed the limitation of such scenario. At best this scenario will lead to the achievement of the key banking indicators with the pre-crisis level, but they are already not corresponded with the current demand of the Russian real sector on the level of the banking services. The households and non-residents have been the net creditors of the Russian banking system in the post-crisis period (1998-2004). The state controlled and foreign banks have the great advantages on the liabilitys growth these banks capture the close to monopoly position on the individual deposits markets as well as in the excess to the foreign loans. State banks have the dominated position on the most liquid and less risky segments of the domestic financial markets. These banks along with the foreign banks is increasing their shares

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of the total banking loans to the Russian real sector (due to cheaper and long-term liabilities as well as the higher volume of their capital). The problem of the increasing the growth rates of the Russian economy will be solved (between others) mainly through the state and foreign banks developments. Russian private banks will have the narrow room for the future existence only through the merge procedure and/or through the merging/sale to the foreign banks. The possible opening of the domestic financial market for the world financial institutions (for example, as under the WTO process) forms the set of the scenarios of the Russian banking system developments, which can change as the key parameter inside the banking system as the structure of the financial flows in the Russian economy. Three different scenarios (pessimistic, conservative and optimistic) are determined by the different external and internal factors and allow to assess the key indicators of the national banking system in the short- and medium run. But we expect the realization of all these scenarios inside the common tendency of the Russian banking trend the strengthening of the state controlled and foreign banks. The private commercial banks will occupy only specific segments (some regional projects, operation with the risky instruments and some others) under the intensive process of merging and sale their shares to the foreign investors. The Russias entrance to WTO will have insignificant effect on such process mainly because the movement of the national banking system toward world capital market has to be accelerated irrespective the WTO discussion, but for the economic growth support.

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