Disposing of Liquidity

I. Velieva, B. Dereviagin

Assorted M&A deals along with two large-scale banking IPOs have served to mitigate the problem of low capital levels featured by Russian banking system. From now on sustainability of economic expansion will be resting on the availability of solid vehicles designed to manage liquidity positions.

For a number of years now Russian banks have been growing their weightings in the Expert-400 rankings. The current year has seen the emergence of a new trend: the domestic banking sector has also improved its weighting in the Capitalization-200 index, while accounting for 12.6% of the market value achieved by Russia’s top-200 companies. Notably, Sberbank and VTB - the two top-line domestic market makers – have launched IPOs to raise $8.85 and $8 billion respectively, thereby laying a solid groundwork for future expansion.

In the last year the banking assets had grown by more than 40%, and they are currently standing at more than $658 billion. To point out, the quality of expansion has been changing. On the one hand, the principal driver is now made by the lower-risk consumer (mortgages, car loans and plastic cards) and SME lending, rather than by the rapid retail funding. On the other hand, the sector’s entire resource base has grown more diversified.

Meantime, just a few good banks can boast of the enviable funding profile, the under-capitalization challenge remaining to be a pressing drag. Apart from VTB and Sberbank, it is for the most part foreign-participation banks that manage to do without capital caps while pursuing their business expansion objectives.

Another major indicator of the new quality of expansion was made by the banking system being stress-tested in real time last summer by the US sub-prime mortgage crisis and excessive turbulence in global capital markets. The Bank of Russia, while having proved its capability to sustain the right liquidity and put out all panicky sentiments hitting the inter-bank credit market, infused a good measure of confidence in bankers and market watchers. However, the storms in world capital markets have not fully subsided, with major banks continuing to be closer to liquidity sources than their smaller-sized peers. So it is yet to be seen whether the banking system manages to sustain high growth rates next year.

Stalling Effects

Chart 1. Bank assets will make a repeat of the last year's record growth rates at best

To point out, lack of available funding for rapid business expansion has always been the key stumbling block for Russian banking sector. Admittedly, this kind of challenge has not been as conspicuous in the legal entity-related funding segment. Firstly, corporate funding dynamics have not been very brisk, and secondly, the segment itself appears to be less prone to inherent risks, with banks requiring lower provisions to cover assumed risks. This observation hardly applies to the retail-funding segment where capital availability has, indeed, become a critical impediment.

To be more specific, in 2006-2007 the consumer financing market’s expansion rates have declined because of low funding availability and meaningful impacts from some wildcards. To add, relatively mature rapid-funding schemes, swiftly ascending plastic cards and mortgage loans have likewise had their effects. Of course, get-tough regulatory policies (to govern shaping bank provisions and disclosure of effective interest rates) have yet to make their impacts, with the Rules entering into force starting July 1, 2007. However, there are solid grounds to believe that in the second half-year the market would be sort of “slipping” because of lower-rate losses and the Russky Standart Bank openly refusing to charge carried interest on consumer loans following R. Tariko, the Bank’s owner, paying a visit to the General Prosecutor’s Office.

Overall, funding constraints have most meaningfully impacted the market’s dynamics. As far as Sberbank and VTB go, they have effectively defeated the problem by way boosting their capital holdings and running dedicated public offerings. Interestingly, while other high-visibility market players continue to suffer from capital shortfalls, they plan to improve their standings through getting their earnings capitalized and, possibly, minority stakes sold out, rather than by way of launching IPOs or attracting strategic investors.

Then, second- and lower-tier banks appear to be even in a less enviable situation: for all practical purposes they pose as M&A targets either for their larger Russian peers or foreign investors. As a matter of fact, any M&A wave comes to lift both sides, with foreigners getting access to the fast-expanding and highly-attractive marketplace where 25%+ IRR levels are nearly the order of the day. To add, Russian owners have an excellent opportunity to sell off their assets at a good profit: the current demand is high and deals for the most part can be completed with the P/BV multiplier being close to a factor of 4.

Fashioning Crisis Management Capability

Chart 2. Following IPO bank assets found their way into Bank of Russia bonds

Large volumes of funds taken through the banking system early in the year following two major IPOs and Yukos assets sell off have eventually been cleaned up and found their way into Bank of Russia bonds (see Chart 2). Apparently, it is not easy to conclude whether this circumstance or still fresh memory of the 2004 crisis has contributed to the regulator’s being able to use pertinent refinancing tools to back up the banking system in the summer of 2007 when the liquidity shock erupted. Clearly, the very fact of the regulator coming to bolster the system is of some relevance.

The recent US subprime loan market meltdown set off by a landslide of defaults on mortgage loans and further sapped by ripple effects in the MBS (mortgage-backed securities) market served to upset stability in the financial services sector that had already grown to be global in magnitude by that time. To point out, the crisis has tangentially hit the Russian banking sector, with some financial institutions starting to feel a degree of liquidity pinch not in the middle of last summer. However, the Bank of Russia, while being mindful of the lessons learned from the 2004 crisis, responded very swiftly and put out the unwelcome “flames” caused by a shortfall of cash by way of injecting unprecedented amounts of RUR interventions. Over the last two weeks of August the Central Bank of Russia (CBR) had the domestic banking system energized by shelling out nearly $55 billion, thereby assuring a measure of the desired stability and functionality.

Notably, CBRF has even gone further than that. Mid-sized banks, that had been actually barred from securing CBR loans in the past, have now had their loan collateral requirements slackened a bit, with larger banks being bailed out in a more direct manner. Also, last August CBR had bought out a portion of its bonds totally valued at RUR 100 billion. To be more specific, CBR completed that transaction in the over-the-counter market, meaning the deal was not in the public domain and was primarily exercised in support of selected banks. The bonds for the most part had been snapped up by Sberbank and VTB, so it appears to be an easy guess as to who primarily gained from the arrangement.

Though a number of banks have temporarily halted their originating cash loans, the putative liquidity shock effects so far are unlikely to be devastating. Notwithstanding the circumstance, all developments unfolding in the inter-bank sector from the very start of 2007 would lead one to making the following cheerless conclusion: liquidity concentrations have only been on the rise. Clearly, the banking system has incrementally been turning from a two-tier set-up into a multi-tier one, with you can only get the requisite aid from the last resort funder (CBR) after going though a chain of other creditors that in aggregate provide for the system’s liquidity. Should a larger-scale crisis break out, third- and fourth-tier banks (their repo-based finance capability notwithstanding) would still be short of funds to make up for a liquidity shortfall. Hence, Russian larger banks have once again moved to beef up their edge and create a framework for their rapid expansion.

You Play No Role in Shaping the Future

One has yet to see whether in the course of 2008 domestic banks would be able to make a repeat of record growth rates. A lot depends on the external market sentiment and applicable regulatory particulars. The matter is that the “jittery” inter-bank lending bank along with heightened uncertainties might at any time interfere to upset the ongoing growth of bank assets. Interestingly enough, bankers continue to be very ambitious despite treacherous traps nearly emerging at every turn.

To add, inefficient regulatory practices and unproven refinancing vehicles likewise can serve to get the banking business expansion slowed down. Given that market hazards are also gathering (with the resource base growing less affordable, pressures on the part of foreign players escalating and credit risks invariably mounting), it is already at the close of 2007 or in early 2008 that bankers would be required to seriously rally their forces to assure expansion of assets in the order of 40+%. However, one should underscore that under any scenario, with the market increasingly getting tighter, banks would be eventually compelled to sacrifice their margins of profit and IRR levels.

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