Joachim Bald holds a Doctorate from the School of Economics and Business Administration at Ruhr-University in Bochum, Germany. His dissertation is entitled "The Role of Joint Ventures in the Transition Process of Eastern Europe - the Case of Russia" (1995). From 1992 to 1995 he served as Assistant Area Manager for the former Soviet Union with Commerzbank AG, Frankfurt, Germany. He is currently Co-Director of the Oregon International Internship Program for the Oregon State System of Higher Education and Finance instructor at the College of Business, Oregon State University.

Jim Nielsen is a Professor of Banking and Finance at the College of Business, Oregon State University. He holds a Ph.D. from the University of Colorado, Boulder. He has been the Director of Education of the Northwest Intermediate Banking School and the Northwest Intermediate Commercial Lending School as well as Director of Education of the California Banking School. In addition to publishing articles in banking and finance journals, he has worked on several special projects for the American Bankers Association and conducted seminars on commercial lending in the Northwest.

In the United States, hardly a used car is sold without a no-money-down financing scheme. At the same time in Moscow, Rolls Royce and Mercedes Benz operate some of the most expensive cash-and-carry stores in the world. And in Moscow, cash still means cash, suitcases full of clean $100 bills. Bankers are among the most prominent customers, particularly when it comes to the bulletproof vehicle varieties.

It is no surprise that many Russians feel banking is just another form of stealing the country’s riches and that many in the West wonder whether this is what the IMF and the World Bank are spending our billions on. It is time for a sober look at the developing Russian financial sector in the context of the transition from a socialist economy to a modern capitalist system.

Financial institutions should be conducive to the development of efficient capital markets and display incentive structures that stimulate the allocation of savings to the most productive investments. This is a novelty in a formerly socialist economy, but a crucial building block for a viable market order. The development of the financial sector ranks high on any to-do list for economic transformation and is generously supported by multinational development agencies. This article will focus on banks as the predominant institution in the Russian financial sector today.

As much as anywhere else in the world, banks in Russia are largely a product of the economic and regulatory environment they operate in. Therefore, a realistic analysis of Russian banking must begin with a look at the Central Bank of Russia as the primary force defining the framework for commercial banking.

Modern banking in Russia began in December 1990 with the introduction of a two-tiered banking system and an attempt to delineate the classic functions of a central bank and a competitive commercial banking system. In a market economy, central banks are commonly in charge of (1) monetary policy, (2) safety and soundness regulation and (3) the development of efficient payment systems.

Monetary Policy. Until 1990, the Central Bank of Russia had basically acted as the accounting department to Gosplan, the central planning agency. Money was passive and simply followed administrative allocation decisions denominated in material units. Monetary policy, thus, was a new and poorly understood concept among central bankers, who also had little political support for a rigorous monetary approach aimed at price stability and real growth.

Since January 1992, when most price controls were lifted and systemic transformation began in earnest, Russia has experienced a typical transition adjustment crisis. For more than three years, inflation ran at monthly rates of 15 - 25% while the industrial output in real terms shrank to less than half between 1992 and 1996. To some extent, inflation was inevitable in order to release accumulated money overhang and to establish price structures that reflect relative scarcity. Unfortunately, the massive emission of directed credits to state industries and the agricultural sector continued to fuel inflation.

It took until early 1995 to break out of the cycle of monetary emission campaigns, hyperinflation and negative real interest rates. This finally became possible as a result of a substantial injection of foreign exchange reserves by the IMF and the development of a government bond market. The funds raised in the bond market allowed the Russian government to discontinue the inflationary practice of directly financing the budget deficit with central bank credits.

Initially, the main conduit for monetary policy was a program of direct individualized loans by the Central Bank to the commercial banking sector as well as to large state owned enterprises. This is a rather inflexible and intransparent approach that inevitably leads to a situation where political motives supersede monetary policy considerations. In fact, the survival of entire sectors of the economy depended on such central bank credit programs, which were seen more as grants than loans by the recipients. Today, monetary policy instruments include a liability-based minimum reserve requirement, modern credit auctions, as well as open-market operations on the developing bond market.

The first credit auction in Russia was held in February 1994. The maturity of the auctioned credit is three months, which is quite long by international standards, but appears appropriate in light of the unsophisticated treasury management at most Russian banks. The loans are fully secured, but allow for an unconventionally wide range of collateral such as hard currency deposits with foreign banks and current balances in domestic correspondent accounts, in addition to government securities. With the further development of the domestic security market, the credit auctions are expected to evolve into a regular repo market.

Currently, there is only one liquid, ruble-denominated debt instrument: the short term government obligation known by its Russian acronym as GKO. These 3 and 6 month zero-coupon treasury bills, and a floating rate variant known as OFZs that come in one and two year maturities, are actively traded on a secondary market organized by the Moscow Interbank Currency Exchange. Total outstanding volume was Rbl 363 trillion in September 1997 ($62 billion), with the Central Bank acting as the registrar, selling agent for the Ministry of Finance and single most important trader on the secondary market. It is widely accepted that the Central Bank has moved beyond market making for the Ministry of Finance into active pursuit of monetary policy on the GKO market.

There is also a discount facility for commercial banks provided by the central bank on the basis of the 1990 banking laws. In reality, the discount window has been used almost exclusively for uncollateralized lending to commercial banks as part of directed credit to ailing industries. As a monetary policy instrument, the discount window is negligible because commercial bills of exchange are not commonly used in Russia and other acceptable collateral is in short supply.

With pressure from the IMF and with its improved set of monetary instruments, the Central Bank has been able to sustain positive real interest rates since early 1995 and has brought down inflation to a mere 14.7% in 1997. In parallel, the tumultuous devaluation of the ruble has been tamed to follow the modest current inflation in a crawling peg approach moderated by central bank interventions. The crawling peg was introduced in May 1996 to release some of the devaluation pressure that had built up under the previous fixed corridor regime.

Despite the impressive recent successes on the monetary stabilization front, the Central Bank still lacks political independence. As a pre-election handout in 1996, the Central Bank has had to accept new inflationary credit programs and, as it is the tradition in the fall and winter months, the siege by lobbyists from the agro-industry and the hard-hit Northern and Far Eastern regions continues. It could take as little as another strike in the coal mines to have the central bank governor removed for failing to finance wage arrears at privatized companies.

Safety and Soundness Regulations. When it comes to the safety and soundness of the commercial banking system, Russia today is still a truly anarchic market. Compared to the lax minimum capital requirements and prudential ratios ("economical norms") originally devised by the Central Bank in 1991, substantial progress has been made over the last three years. Capital adequacy standards now mandate a 4% capital to asset ratio, compared to 8% recommended by the Bank for International Settlements. In reality however, the capitalization of most Russian banks is much worse than the 4% figure suggests. Russian regulations allow to weigh assets used in the capital adequacy calculations with significantly smaller risk coefficients than the Basle guidelines require, even though a typical Russian loan portfolio is undoubtedly exposed to very high default risk. It should be noted that only few Russian banks actually comply with the current standards, because the central bank has granted generous transition periods for smaller banks and has so far acted only on some of the most drastic violations of the prudential ratios.

Other problem areas are loans to connected parties, insufficient thresholds on exposure to a single borrower and lax write-off requirements on dubious and non-performing loans. Despite these defects, much could be gained by at least enforcing the existing bank regulations. Progress on this front is slow, regardless of the support provided by the World Bank, the EBRD and the European TACIS program in such areas as training and the introduction of international accounting standards and audit practices.

Considering that the Central Bank is only slowly gaining some measure of control over a largely anarchic commercial banking sector, it may come as a surprise that the most common complaint of Russian bankers for years has been the alleged over-regulation of the commercial banking industry. There has indeed never been a quantitative lack of reporting requirements and supervision. Rather, the Central Bank has had difficulty in doing away with tediously detailed information requirements more apt for exercising communist-style total control than ensuring the stability of the financial sector. Bank regulation has to become less subjective and more predictable than is currently the case in Russia. If more than half of all banks at times are in violation of prudential ratios and local administrations are authorized to set diluted capital and prudential requirements, then commercial banks are again largely at the mercy of individual central bank administrators who can selectively enforce the rule of the day.

Now that monetary stabilization has arrived and the years of risk-free banking profits are over, a shake-out among the weaker institutions is inevitable. Therefore, the Central Bank not only has to set and enforce safety standards but also has to develop crisis management skills in order to contain the effects of bank failures. During the interbank market liquidity crisis of August 1995, the Central Bank emerged as an effective and discriminating lender of last resort and successfully walked the fine line between a general bail-out and a looming complete collapse of the interbank market. The August 1995 crisis has also highlighted the need for a credible deposit insurance system. An early attempt had been made to install a deposit insurance scheme in 1992-93 but it was abolished in late 1993 by a presidential decree to make room for a new and better system which unfortunately has not materialized to the present day. Without such a safeguard, future bank failures may lead to a very counterproductive loss of confidence in the banking system, at a time when it is only slowly beginning to mobilize some of the private savings potential.

Payment Systems. Undoubtedly, the most essential mission of any central bank is to maintain the functionality of the national currency as a readily accepted transaction medium. Much damage has been done to the ruble in this respect. As a consequence of hyperinflation and a series of confiscatory bill exchanges, it seemed in 1992 and 1993 that the ruble had been lost to an irreversible dollarization process. With inflation on the retreat, the ruble has recently made a surprising come-back as a transaction and value storage medium that is exemplified in the declining number of the formerly ubiquitous exchange booths.

In addition to providing basic legal tender, it is widely agreed that the central bank should assume responsibility for maintaining a system for safe and rapid clearing of interbank balances, or at least establish standards and supervise the execution of interbank clearing by privately organized clearinghouses. Here, the need for improvement is urgent, because fraud has been a massive problem and execution is painfully slow. The resulting excessive settlement float absorbs a significant and erratically varying amount of the monetary base, which has negative repercussions on the effectiveness of monetary policy.

With regard to small value and retail payments, it has been of crucial importance to reassert ruble banknotes as an acceptable transaction medium. Russia is a traditional cash society and in comparison to other developed countries with a high cash preference, it seems that the Russian retail market could still go a long way before the absence of non-cash retail transactions would become a major impediment for economic growth. Since there is good reason for distrust between economic agents, checks do not offer a viable non-cash alternative as they lack the immediacy and finality of cash settlement. Widespread use of POS instruments and credit cards could provide a convenient and reliable form of non-cash payment but will not be a realistic alternative for some time, simply because of the immense hardware cost and the poor Russian telecommunications.

It is in the area of high-value inter-enterprise payments and bank-to-bank transfers that there is need for immediate action. The old system of 1,400 Cash Settlement Centers operated by the Central Bank of Russia provides paper-based payment services throughout Russia. It has a reputation of being terribly inefficient and unreliable. Moreover, many commercial banks appear to add to the dilemma by extending the processing float of commercial payments to their advantage.

Interbank settlements and high-value payment systems have therefore been made a priority for technical assistance by the World Bank, the EBRD and TACIS. Substantial progress is underway towards standardization and automation of payment systems. In parallel, a growing share of the payment volume is now handled by private regional clearinghouses and major commercial banks without using central bank accounts. This has introduced healthy competition in an extremely bureaucratic monopoly and has at the same time relieved some of the overload at the central bank payment hubs. However, the development of private clearinghouses will likely lead to multilateral netting of funds transfers which requires highly sophisticated risk management beyond the realities of the Russian financial sector.

The example of Tveruniversalbank drastically highlights the potential destabilizing effect on the entire financial industry, if one of these private clearinghouses were to default. Tveruniversalbank rapidly rose from a privatized branch of Shilsozbank to 17th place in Russian banking and built up a large correspondent network in the CIS and abroad, through which it offers ruble and hard currency clearing and settlement for smaller regional banks. In July 1996, Tveruniversalbank found itself in an acute liquidity crisis due to losses in the Russian bond and Wechsel market and had to be placed under central bank supervision for several months. Without emergency lending from the Central Bank, a collapse of Tveruniversalbank could have easily taken with it a sizable share of uninsured transaction deposits and may have set off a domino effect in the fragile banking system.

At the current rate of investment and foreign technical assistance, payment systems should see significant improvements in the next few years. It will play to the advantage of Russia, that traditionally the main non-cash payment instrument is a payment order, a credit transfer instrument. Compared to checks, payment orders offer greater finality of settlement, allow for an easier transition to electronic payment processing and can reduce the risks associated with private netting-based clearing systems.

Today, there are about 1,850 banks in Russia with a total network of 39,170 branches. The largest 100 Russian banks represent combined assets of about $98 billion. However, the state-owned giant Sberbank alone accounts for 34,400 branches and assets of almost $26 billion. By international comparison, Sberbank would rank among the 30 largest banks in the US, and in Germany, for example, would make it to 27^th place. Uneximbank, its nearest true commercial rival with assets of $3.8 billion, would rank 103rd in the US or 80th in Germany.

Until 1987, banking in Russia was strictly monopolized in the hands of the traditional socialist Gosbank or State Bank. As part of the restructurings during Perestroika, the non-central bank functions of Gosbank were broken up into large state owned sector banks: Sberbank, the savings bank; Shilsozbank, the bank for housing, retail and social service; Promstroibank, in charge of the industrial sector; Agroprombank, serving the agroindustrial sector and the rural communities; and a foreign trade bank, called Vnesheconombank.

Except for Sberbank, these banks have undergone a wild privatization process since 1991, in the course of which the banks were first split up among the independent former Soviet Republics. Then individual branches or entire regional structures of Shilsozbank, Promstroibank and Agroprombank declared themselves independent, often changing their names and issuing new equity to outside industrial partners and private investors. At the prevailing rate of inflation and in the absence of rights offerings and appropriate inflation accounting, state ownership simply vanished from the books. About one third of today’s banks and the majority of the larger institutions have thus originated from the spontaneous implosion of the state banking sector.

Vnesheconombank has been stripped of most assets but legally remains in existence and now serves as the clearinghouse for the foreign debt of the former Soviet Union. All its new commercial business and the sovereign Russian currency reserves have been moved to a newly created Bank for Foreign Trade or Rosvneshtorgbank.

Since these former state banks took with them the existing banking personnel, equipment and client base, most analysts, as well as the regulatory authorities, have generally made a distinction between privatized banks and entirely new establishments, so-called zero banks. Many of these zero banks, particularly the very small institutions set up under the cooperative charter of 1988, have already disappeared or have been absorbed by more successful competitors. A small number, however, have managed to retain a solid client base, have established international correspondent and branch networks and have grown to be realistic competitors to the largest of the former state banks.

Meanwhile, the days of easy on-lending of directed central bank loans are over, and the close affiliation between most of the former sector banks and the ailing Russian industry has become more of a burden than an asset. Therefore, the categories of former state bank versus zero-bank have lost much relevance when analyzing the Russian commercial banking landscape.

Three new classes of banks appear to be emerging: a group of 20 - 30 elite banks, consisting of former state banks and parvenus zero banks, a second layer of less than 100 smaller regional or specialty banks, and the remaining 1,700 institutions representing the struggling rest, most of which are likely to disappear within the next few years. This pattern is now widely recognized by the international development community. It is reflected in the approach of the World Bank, the EBRD and TACIS who tend to focus their various consulting, trade finance, Twinning, International Standards Bank and SME Loan programs on a group of 20-40 properly audited, well managed and sufficiently well capitalized leading institutions. Names on this list include: Tokobank, Inkombank, Menatep, Uneximbank, Mosbusinessbank, Avtobank, Imperial, Stolichny, Promstroibank St. Petersburg, and Moscow Industrial Bank.

Some limited support is granted to a second tier of probable survivors among the regional and specialized institutions. Some prominent names in this group are Uralpromstroibank, Russian Project Finance Bank, Investmentbank of Kuban, and Tveruniversalbank.

Foreign Banks in Russia. Foreign banks have so far been cautious to convert their representative offices into operative banking units. Among the few western institutions who maintain operational subsidiaries or branches in Russia are Crédit Lyonnais, Dresdner Bank/BNP, Bank Austria and Citibank. Others have obtained licenses but have been caught between the front lines of a battle between the Central Bank, in favor of a liberal foreign access to the Russian financial markets, and the influential Association of Russian Banks, which wants to limit the range and scope of services provided by foreign owned institutions. Under a presidential decree from November 1993, foreign banks opening after 1993 are subject to a number of severe restrictions and are notably not allowed to take deposits from residents.

Yet, even those early banks that have managed to avoid major restrictions of allowable operations have not been able to resolve the basic contradiction that appears to stall the progress of foreign banks in Russia. The Russian economy is illiquid. There is little legal basis and even fewer appropriate assets for collateral, and there is virtually no viable legal recourse for the enforcement of private contracts. Therefore, even indigenous banks hardly make loans. The little financing that is provided is short term and based on insider information and personal trust. Foreign banks not only lack the ability to collect at gunpoint, they also are at a distinct informational disadvantage in a market as intransparent as the Russian corporate scene. According to normal credit standards, foreign banks would not be able to make a single loan without the backing of first-class western guarantors.

This leaves foreign banks with a very limited service spectrum mainly revolving around international payments and documentary transactions. Yet, international wire transfers, collections and letters of credit represent one of the few areas where Russian banks can also offer efficient and reliable service at a fraction of the cost of foreign banks. The cost disadvantage is mainly explained by the high ratios of expatriate staff maintained by foreign institutions. Delegated foreign staff can easily cost ten times a competitive local bank salary. Thus, the occasional stories of big money made in Russia generally relate not to commercial banking but to the few western investment banking operations in Moscow, most notably CS First Boston.

Range and Quality of Russian Bank Services. Banks have been among the first Russian businesses to discover advertising. Even the smaller regional banks boast the full range of universal banking services: from trade finance to brokerage, from factoring, leasing and mortgage lending to tax consulting and operations in gold and precious stones. This is generally far from the reality of banking in Russia today.

All noteworthy banks have at least an internal foreign currency license that allows them to conduct current accounts in local and hard currency, provide ruble and foreign currency banknotes and effect domestic and international credit transfer payments. Within the limitations of the current payments system discussed above, these services are reasonably priced and reliable. It is interesting to note that international payment execution is generally more reliable and speedy than domestic payments, thanks to the large number of direct correspondent relationships that most banks have established with western institutions. Most banks in Moscow and St. Petersburg and the larger regional banks are now members of the European based S.W.I.F.T. financial communications network, while the smaller banks operate on the basis of telex wire transfers or use the services of the emerging domestic clearing banks for their international payment needs.

Most banks can accept international credit cards for cash advances, will cash traveler checks and are able to collect ordinary foreign drafts on a credit-after-final-payment basis. The larger institutions also issue international credit cards as well as a range of proprietary debit cards with very limited acceptance networks.

Since the collapse of the Vnesheconombank monopoly in December 1991, confirmed letters of credit have been the standard payment stipulation for foreign trade contracts in Russia. With massive training assistance from western correspondent banks, conventional documentary transactions are now reasonably well mastered by the larger Russian banks. All Russian banks with at least a limited foreign currency license offer forex spot transactions within the scope of the currency regulations, which do not allow the purchase of hard currency other than to settle current import invoices. This is as far as the realistic service spectrum goes for most Russian banks.

A few institutions provide some limited short-term trade finance to Russian clients. This is extremely risky business as the difficulties over the trade firm Olbi at Inkombank show, which sent the fifth largest Russian bank into a severe liquidity crisis in 1994. Without doubt, trade finance is a pressing need even for the few internationally competitive Russian exporters such as steel mills and aluminum smelters, due to the widespread shortage of working capital. Unfortunately, the modest uncollateralized credit lines provided to the elite group of Russian banks by international development banks and a small number of private western institutions, bring little relief in regard to this trade finance shortage. In fact, given the shaky condition of most Russian corporate clients, only an inexperienced bank would pass on the privilege of such a trade finance facility to their clients by waiving cash cover requirements.

Mid-term and long-term lending are practically non-existent. Most Russian bankers used to attribute this phenomenon to the rampant hyperinflation. Now that inflation is under control and long-term lending still does not occur, it has become obvious that the obstacles lie in effect more in the area of unclear property rights, lacking means for contract enforcement and a shortage of skilled personnel to manage a loan portfolio.

Finally, when it comes to investment banking, there is much noise but little real achievement. Only a handful of politically connected Russian banks have made some actual deals, with Uneximbank the most prominent and the most criticized player. While virtually all lucrative mandates for international bond or stock issues go to big name western firms, Russian investment banks try to carve out a niche in providing access to the often intransparent privatization process and the ruble denominated debt and equity markets.

Despite the many unsolved institutional issues associated with share ownership, international fund managers have recently set off a wave of rather indiscriminate foreign buying to gain exposure to the illustrious emerging Russian capital market. This has driven the narrow Russian stock market to record heights during 1996 and early 1997 and has made Russian banks acutely aware of the money that can be made in the equity markets in the future. The stock market boom has also intensified the current debate about universal versus segregated banking and corporate governance in Russia.

Challenges and Success Factors for Russian Banks. What are the main challenges facing Russian banks that will determine how they will fare in the continuing shake-out that lies ahead?

Training is still a key success factor, even though most Russian bankers believe that they are over-consulted and under-invested. Even basic banking knowledge is still vested in too few key personnel. This has become a major obstacle to efficient delegation of responsibilities and prevents proper risk management procedures.

Banks must improve the mobilization of inexpensive savings deposits and reduce their dependency on central bank credit. In the absence of a deposit insurance scheme and with competing Sberbank deposits guaranteed and indexed against inflation by the Russian government, confidence in the private banking sector becomes an issue. There is evidence that the Sberbank monopoly on savings deposits is finally eroding as its market share has recently dropped to 60%. This trend is set to accelerate as Russian savers become more sophisticated and more of the flight capital returns to Russia.

Given the importance of personal relationships in Russian finance and the sheer size of the country, large branch networks will be important in order to establish a diversified client base and tap regional savings pools. However, most Russian banks have failed so far to properly integrate and control their branch network. In fact, most branches are actually not business locales of a single integrated bank. Instead, they are either loosely controlled subsidiaries, or more often, franchises which use the name of the parent bank but are financed and managed by local entrepreneurs. Obligations incurred by a branch in the name of the bank are not automatically honored by the head office.

As long as the average Russian has to spend nearly his entire disposable income on basic food products and the few nouveaux riches live it out on the French Riviera, domestic savings alone cannot meet the capital demands to rebuild the Russian economy. Those Russian institutions who are first to establish access to international capital markets will have a tremendous strategic advantage over smaller rivals. On a macroeconomic level, improved international capital market presence should provide an elegant way to win back much of the Russian flight capital. The first sovereign Russian Eurobond issue in November 1996 has managed to break the ice for international Russian borrowing and will allow private entities from the natural resources and financial sector to follow suit.

Russian banks with aspirations to develop into world class institutions will have to diversify into investment banking. In a financial market as intransparent as the Russian corporate scene, there is much potential for synergy in the production of financial information on industrial clients. Insights derived from maintaining transaction accounts and providing debt finance will be a significant advantage in managing industrial equity holdings.

Finally, one of the foremost challenges to successful banking in Russia remains the fight against criminal infiltration. Even high-ranking officials, including the President of the Association of Russian Banks, admit to the urgency of the problem. Any western bank in Moscow will confirm the countless and mostly poorly conceived scams revolving around government guarantees, promissory notes and letters of credit that passively or actively implicate Russian banks. Russia is now considered a money laundering paradise. Moreover, banks themselves are frequently the victims of organized crime. This may come in the form of outright extortion or of subtle influence on lending decisions and customer confidentiality exercised by criminal ‘holding companies’ called krisha, which many Russians have come to accept as a fact of life.

Despite the many obvious excesses and a growing number of inevitable collapses, the Russian commercial banking sector has seen a formidable development during recent years and has clearly been at the forefront of the economic transformation process.

The dynamism of the banking sector owes much to a new breed of young, intelligent bank executives, many of whom have been trained in the West. They stand in striking contrast to the communist style managers who still dominate most of the Russian industrial sector.

Yet, even with the brightest staff and massive foreign support, Russian banks cannot get too much ahead of the slow-boat transition process in the rest of the Russian economy. The larger banks could probably structure an equipment leasing deal by now. But who helps them repossess the excavator, if the construction company simply refuses to pay? How can even a well-trained loan officer underwrite a single deal with confidence during one of the most severe economic contractions in modern history?

All the development dollars will not be in vain though, once the economic tide turns. It has been said before in 1996 and 1997, but 1998 could actually be the year that it happens.