Russian banks vulnerable to expansion and credit costs

— Structural weaknesses on the mend, says Moody’s

Moody’s sees positive rating pressure on Russian bank in the near- to medium-term driven by favourable macroeconomic environment in Russia, ongoing institutional reforms in the banking sector, diversification of activities and improving financial fundamentals. At the same time, Moody’s notes that ratings will continue to be constrained by generally opaque ownership structures, significant corporate governance issues, relatively high level of credit risk concentration and low economic capitalisation.

The Russian banks’ financial strength ratings (BFSRs) are currently in the E+ to D+ range, remaining low when compared to those of CEE countries. Moody’s notes that in Russia investment-grade ratings are assigned only to financial institutions controlled by the state or with dominant ownership by international banks. These banks’ ratings are based on assumptions of parental or systemic support.

“Due to the still fragmented nature of the banking system, consolidation is likely to speed up significantly in the coming years. Although state-controlled banks continue to dominate the Russian banking sector, their market share has stopped growing”, says Andrey Artyukhin, author of the report.

Foreign investors show great interest in entering the Russian banking market, resulting in a growing number of acquisitions of local banks by global players, says the rating agency.

Moody’s notes that the banking system is benefiting greatly from a robust macroeconomic environment and is developing dynamically. However, banking penetration in the country remains relatively low, leaving room for further significant expansion of both corporate and retail lending.

Further development of this sector will benefit from recent institutional reforms such as the introduction of a Deposit Insurance System and legislative measures facilitating mortgage lending.

Despite steady increase of foreign borrowing, local banks’ dependence on global wholesale market is limited and does not create a significant risk neither to the banking sector nor to its major players. Although Russian banks are unlikely to fully escape the consequences of the global liquidity crisis, the impact on the banks is likely to be limited to deceleration of credit growth and depressed earnings as funding will become more expensive and put pressure on margins. The situation could be more challenging in a case of a more prolonged and severe global credit crunch.

Nevertheless we believe that only a combination of many negative factors, could have a serious impact on Russian banks’ liquidity and financial standing.

In recent years the Central Bank of Russia, the country’s banking regulator, has achieved some positive results in implementing international best practices. The most visible progress has been reached in such areas as transparency of ownership and capital adequacy regulation. However, Moody’s notes that banking supervision in Russia to a significant extent remains focused on banks’ formal compliance with prudential ratios and less so on economic substance of their operations.

Nevertheless, growing international activity contributes to some progress in corporate governance, notably transparency and an appropriate role for the Boards of Directors.

Risk management systems, particularly of stronger banks, are improving, albeit slowly. However, the credit risk management function often remains rudimentary; thus loan portfolios continue to be highly concentrated, while related-party lending remains an area of special concern.

Moody’s notes that the banking system’s overall asset quality remains satisfactory, although the true level of problem loans could be somewhat understated, given the insufficient level of disclosure in financial reporting. The loan portfolio quality would be likely to decline if the macroeconomic situation were to worsen, while rapid growth of delinquencies on the current consumer loans could in the medium term become a systemic problem.

The profitability indicators of Russian banks remain relatively high, but are under pressure of shrinking margins and a continuing rise in costs related to aggressive development of the retail business. Meanwhile, substantial investments in regional networks, high demand for qualified staff and the need for modernisation of infrastructure make material improvement of the banks’ efficiency indicators unlikely in the near future.

Finally, the rapid pace of growth, which in most cases exceeds internal capital generation capacity to support it, and the inability of current shareholders to make new contributions, weigh on the banks’ capital adequacy, although the stronger players have a good chance of solving this problem through IPOs or placement of marketable subordinated debt.