H THE WORLD BANK 24972 XSeptember 2002 p2. ,-y,. ~~~ ,f f§ ; Ft -_oE ,-t, B1JJ1 I .KeV, ' -.Jsi0 Deeopn th RusanFnncaSco W= i - kUw Building Trust Developing the Russian Financial Sector THE WORLD BANK Washington, D.C. C) 2002 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 Telephone 202-473-1000 Internet www.worldbank.org E-mail feedback@worldbank.org All rights reserved. First printing September 2002 1 2 3 4 05 04 03 02 The findings, interpretations, and conclusions expressed here are those of the author(s) and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank cannot guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. Library of Congress Cataloging-in-Publication Data Building trust: developing the Russian financial sector. p. cm. "This book was produced by a World Bank team led by Michael Fuchs who planned, coordinated, and edited the book." Includes bibliographical references. ISBN 0-8213-5161-3 1. Finance-Russia (Federation) 2. Banks and banking-Russia (Federation) 1. Fuchs, Michael J. (Michael Joseph), 1951- II. World Bank. HG186.R8 B75 2002 332'.0947-dc2l 2002027221 Contents Foreword ix Acknowledgments xi Abbreviations and Acronyms xiii Executive Summary xv Chapter 1 Building Trust for Financial Sector Development: An Overview Introduction 1 Trust, Financial Sector Development, and Growth 3 Legal and Accounting Infrastructures 6 The Banking System: Structure and Performance 13 Regulation and Restructuring of Banks 21 Improving Enterprise Financing 33 Conclusion 42 PART I Legal and Accounting Infrastructures 49 Chapter 2 Creditor Rights 51 Introduction 51 The Framework for Secured Transactions 53 Enforcement Mechanisms 56 Information Mechanisms 64 Other Obstacles Related to the Use of Pledged Assets 67 Annex 2.1. Creditor Rights: The International Experience 70 Chapter 3 Framework for Corporate Insolvency 83 The Role and Function of Insolvency Systems in Market Economies 83 iv BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Overview of Russian Corporate Insolvency Practice 86 Legal Framework for Corporate Insolvency 91 Implementation of the Insolvency Regime 97 Assessment of Key Features of the Bankruptcy Regime 102 Framework for Corporate Workouts and Restructurings 106 Conclusion 107 Chapter 4 Disclosure and Transparency 115 Introduction 115 Accounting Standards and Disclosure 116 Auditing Standards and Disclosure 118 Enforcement and Disclosure 120 Recommendations 121 Comparison of Russian and International Accounting and Auditing Standards 122 PART II The Banking System: Structure and Performance 127 Chapter 5 The Role of the Financial System 129 The Importance of the Financial Sector for Economic Development 129 The Key Role of Banking System Reform 131 Size and Structure of the Russian Banking Sector 133 Domination by State Banks 136 Roles and Ownership Structure of the Banking Sector 137 Conclusion 139 Chapter 6 Analysis of Banking Practices 143 Introduction 143 Asset Structure and Quality 145 The Structure of Bank Liabilities 150 Schemes That Distort the Structure of Liabilities 152 Assessing Bank Capital 153 Profitability 153 Conclusion 155 Chapter 7 Reforming the Role of State Banks 159 Influence of State-Owned Banks on Performance and Growth 160 The Trend Away from State Banks 161 State Banks in the Russian Federation 162 The Role of Sberbank 164 The Government's Management of Sberbank 165 The Strategic Review of Sberbank 171 Restructuring Sberbank 175 Vneshtorgbank 176 CONTENTS v Vnesheconombank 178 New Development Banks 179 Conclusion 181 Annex 7.1 Reforming State Banks 184 Chapter 8 Encouraging Foreign Entry to the Banking Sector 205 Introduction 205 The Presence of Foreign Investment and Foreign Banks in Russia 206 The Regulatory Environment for Foreign Investment in Banking 208 The Survey and Opinions of the Foreign Bank Subsidiaries in Russia 211 Future Plans 215 Conclusion 216 PART m Regulation and the Restructuring of Banks 227 Chapter 9 Building Trust through Effective Banking Supervision 229 Improving the Enabling Environment 231 Political Will 232 Role of the Banking Sector 234 Establishing the Role of Banking Supervision 235 Improving Supervisory Effectiveness 238 Chapter 10 Does the Russian Federation Need Deposit Insurance? 249 Introduction 249 Deposit Insurance in Other Countries 252 The Benefits and Risks of Deposit Insurance 252 Introducing Deposit Insurance in Russia 255 The Design of Deposit Insurance Schemes 257 Leveling the Playing Field? 258 Creating Trust through Incentives 259 Conclusion 260 Chapter 11 Bank Restructuring and Liquidation 263 Legal Protection of Depositor Interests 263 Depositor Preference 264 Effective Resolution of Troubled Banks 266 Restructuring of Banks in Bankruptcy Proceedings 271 Compromise of Depositor Claims in Restructuring 276 Judicial Bank Liquidation 277 Administrative Aspects of Bank Liquidation 281 Conclusion 284 vi BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Chapter 12 ARCO 287 Introduction 287 Overview of ARCO's Operations 291 ARCO's Experience in the Rehabilitation of Banks 294 ARCO Deposit Insurance Scheme 297 ARCO's Experience of the Bank Liquidation Process 301 Privatization of ARCO Banks 303 Conclusion 305 PART IV Enterprise Financing 311 Chapter 13 Enterprise Access to Financing 313 Commercial Credit 313 Bank Financing 316 Veksels 318 Leasing 320 Other Financing Instruments 321 Conclusion 321 Chapter 14 Capital Market Development 327 The Mass Privatization Program 327 Reform of the Russian Banking and Payments System 334 Developing the Government Debt Market 335 Mobilizing Savings 338 Improving Corporate Governance 340 Legislative Initiatives 345 Enforcement of the Law 348 Capital Markets Supervision 351 The Role of the Capital Markets Supervisor 354 Transparency and Disclosure 356 LIST OF BOXES Box 1.1 Financial System Development and Economic Growth 4 Box 1.2 Consolidation of the Banking Sector: The Government/CBR Joint Strategy 16 Box 1.3 Sberbank and Its Restructuring 18 Box 1.4 Restructuring of State Banks Other than Sberbank 20 Box 1.5 Strengthening Banking Supervision: The Government/CBR Joint Strategy 23 Box 1.6 Problem Areas in ARCO's Approach to Bank Restructuring 34 Box 1.7 Overcoming Constraints on Lending to the SME Sector 35 Box 1.8 Summary of the Joint Government/CBR Program for the Development of the Russian Banking System 43 Box 1.9 Priority Trust-Building Measures 46 CONTENTS vii Box 2.1 Positive Features of Pledge under Russian Law 55 Box 2.2 Recommendations for Expanding Access to Credit 71 Box 2.3 Principles and Guidelines for Effective Insolvency and Creditor Rights Systems: Secured Transactions Recommendations (Extract) 72 Box 2.4 EBRD Core Principles for a Modern Secured Transactions Law 74 Box 5.1 The Main Functions of the Financial Sector 132 Box 5.2 The Post-1998 Crisis Period: A Missed Opportunity for Consolidating the Banking System? 135 Box 5.3 Consolidation of the Banking Sector: The Government/CBR Joint Strategy 139 Box 7.1 State Export Credit Agencies 180 Box 8.1 Where Is Russia in Foreign Bank Presence? 209 Box 8.2 Large Foreign Bank Entry during the 1990s: Some Case Studies 217 Box 8.3 The Generally Accepted Guidelines for the Supervision of Foreign Banks 221 Box 10.1 The Design of the Proposed Russian Deposit Insurance Scheme 250 Box 12.1 ARCO's Deposit Insurance Scheme 298 Box 13.1 Arrears and Noncash Settlements 314 Box 13.2 Safeguards in Managing Credit Risks 323 LIST OF FIGURES Figure 1.1 Sequencing of Financial Sector Reforms 45 Figure 5.1 Number of Operating Banks 136 Figure 7.1 Development of the Brazilian Financial System 188 Figure 7.2 Development of the Chinese Financial System 191 Figure 7.3 Total Deposits of Sectors within the Chinese Banking System 195 Figure 7.4 Development of the German Financial System 197 Figure 12.1 Impact of the Introduction of Deposit Insurance on Member Banks 299 Figure 14.1 Sources of Corporate Finance in Russia 331 Figure 14.2 Enterprise Use of Equity Finance 332 LIST OF TABLES Table 1.1 Financial Market Depth (2000) 5 Table 3.1 Number of Bankruptcy Cases 91 Table 4.1 Rules Missing in RAS and Present in IAS 122 Table 4.2 Discrepancy between RAS and IAS Disclosure Requirements 123 viii BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 4.3 RAS Rules That Differ from IAS 124 Table 4.4 The 39 Approved Russian Standards on Auditing and the Equivalent International Standards on Auditing 125 Table 5.1 Monetary Survey Data on the Russian Banking System 134 Table 5.2 International Comparison of the Banking System Depth 134 Table 5.3 Number of Credit Organizations by Paid-in Capital 134 Table 6.1 Key Statistics on the Asset Composition of the Russian Banks 146 Table 6.2 Loan-loss Provisions as Percentage of Gross Loan Books 149 Table 6.3 Share of Nonearning Assets in Total Assets 150 Table 6.4 Key Statistics on the Composition of Liabilities 151 Table 6.5 Key Statistics on the Profitability of the Reviewed Banks 154 Table 7.1 Government Ownership Stake in the 10 Largest Banks 160 Table 7.2 Data on Various Segments of the Banking Market 163 Table 7.3 Sberbank Share of the Russian Banking System (according to RAS) 167 Table 7.4 Market Share within the Chinese Banking System 194 Table 7.5 Comparison of Market Share of Assets in Public Banks, 1995 196 Table 7.6 Market Share of Different Bank Groups in Germany, 1999 198 Table 7.7 Comparison of Banking System Structures 199 Table 7.8 Comparison of Public Bank Structures 200 Table 8.1 Foreign Banks Operating in Russia, as of October 2000 207 Table 8.2 The Size of Some of the Foreign Banks in Russia 209 Table 8.3 Major Assets and Liabilities of Some of the Foreign-owned Banks in Russia, as of December 2000 213 Table 12.1 Banks in ARCO's Portfolio as of December 31, 2000 291 Table 12.2 ARCO Amicable Settlements in which Corporate Depositors Benefited 297 Table 12.3 Insurance Coverage of Deposits in the ARCO Scheme 299 Table 12.4 Deposit Growth per Quarter in Insured Banks Relative to the Region as a Whole 300 Table 13.1 The Role of Commercial Credit 315 Table 13.2 Credit to Private Sector 317 Table 13.3 Interest Rate Spreads 317 Table 13.4 Structure of Payments for Goods, Works, and Services in Russia 319 Table 14.1 Financial Market Depth, 2000 330 Table 14.2 Reasons for Inability to Attract Outside Investors 333 Table 14.3 Corporate Governance Scorecard for Russia 341 Table 14.4 Fines for Administrative Offenses in 2001 349 Foreword T he Russian financial sector has come a long way in the first years of transition. At the inception of the transition process 10 years ago, there was virtually no functioning financial system. Since then, the foundations of the legal, regulatory, and institutional infrastruc- ture have been established, and the system has had to adapt and evolve under the weight of periodic economic, financial, and political instability. Key to developing the financial sector in a market economy is the process of building trust among market participants. This process was severely tested during the 1998 financial crisis, which revealed many shortcomings in the implementation of financial sector reforms. Since the 1998 crisis, the authorities have succeeded in stabilizing the financial system, but much remains to be done to reap the potential ben- efits of market-based intermediation in promoting efficient resource allo- cation and enabling the Russian economy to achieve stable and sustain- able growth. Savers need to gain confidence in the solidity of financial institutions and entrust them with their financial savings. These financial institutions need to improve their intermediation skills and be comfort- able lending to productive enterprises without being the controllers or owners of those enterprises. In December 2000, the Government and the Central Bank approved a joint strategy for the reform of the banking system. This initiative, along with other initiatives-such as enactment of important amend- ments to the banking legislation and publication of a corporate gover- nance code by the Federal Commission for Securities Markets-provides a welcome sign that a new era of financial reform is about to begin. ix x BUILDING TRUST: DEVELOPING THE RUSSIAN FiNANCIAL SECTOR This book, a product of the World Bank's ongoing work in support of the Russian financial system, assesses current developments within the fi- nancial system and provides a road map for implementation of high- priority improvements. The book's purpose is to support the process of creating a broader understanding of and consensus on high-priority re- form measures among interested parties within the Government (the Federation Council and the Duma), regulatory authorities, the judiciary, and the financial community at large. Cesare Calari Vice President Financial Sector World Bank Acknowledgments T his book was produced by a World Bank team led by Michael Fuchs, who planned, coordinated, and edited the book. Contribu- tors were Noritaka Akamatsu, Laura Ard, Thorsten Beck, Sally Buxton, James Foster, Marina Frolova, Richard Hands, Gordon John- son, Cliff Isaak, Andrew Lovegrove, Jo Ann Paulson, Susan Rutledge, Sergei Shatalov, Phil Smith, Mark St. Giles, Esen Ulgenerk, Marius Vis- mantas, Kirill Vorobiev, Mark Walker, and Igor Yashenko. We express our special gratitude to the peer reviewers: Lajos Bokros, Millard Long, and Larry Promisel, who made valuable comments and suggestions. In addition, Christof Ruehl provided substantive inputs. Particular thanks are also due to Patrick Honohan and Alexander Flem- ing, who reviewed the entire text prior to its completion. The team gratefully acknowledges the support of the Central Bank of the Russian Federation and Government officials without whom produc- tion of this book would not have been possible. Comments provided by the Central Bank and Government agencies on an earlier draft of the book-which have been incorporated in the current text-are also most gratefully acknowledged. Considerable credit is also due to background material and analyses provided by the staff of the European Bank for Re- construction and Development and other donor representatives. Several people provided invaluable assistance: Anahit Adamyan, Zeynep Kantur, and Irena Tchoukleva, data analysts; Frank Kenefick, Tatiana Segal, and Anna Sukiasyan, technical editors; Marina Kuznetsova, team coordinator; Susan Graham, developmental editor; Melissa Ede- burn, production editor; and Bennet Akpa, print coordinator. xi Abbreviations and Acronyms AMC Asset management companies ARCO Agency for Restructuring of Credit Organizations BIS Bank for International Settlements CBR Central Bank of Russia EBRD European Bank for Reconstruction and Development EU European Union FCSM Federal Commission for Securities Market FIAC Foreign Investor Advisory Committee FIDP Financial Institution Development Project FIG Financial-industrial groups FSFR Federal Service on Financial Rehabilitation and Bankruptcy GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product GKO Short-term Federal Government Securities IAPC International Auditing Practices Committee IAS International Accounting Standards IASB International Accounting Standards Board IBRD International Bank for Reconstruction and Development IFAC International Federation of Accountants IFC International Finance Corporation IMF International Monetary Fund IOSCO International Organization of Securities Commission ISA International Standards on Auditing IPA Institute of Professional Accountants KPB Kuzbassprombank xiii xiv BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR LLP Loan-loss provisions MoF Ministry of Finance NCS Noncash settlements NPL Nonperforming loans OECD Organisation for Economic Co-operation and Development OTC Over-the-counter markets RAR Russian Audit Rules RAS Russian Accounting Standards RDB Russian Development Bank RSA Russian Standards on Auditing RTC Resolution Trust Corporation SME Small and medium-size enterprises SoE State-owned Enterprise TACIS Technical Assistance to Commonwealth of Independent States USAID United States Agency for International Development VEB Vnesheconombank VTB Vneshtorgbank WTO World Trade Organization Executive Summary A sound, efficient financial sector does not necessarily guarantee long-term growth, but long-term growth is difficult to achieve without a sound, efficient financial sector. In the immediate aftermath of the financial crisis in August 1998, the Russian authorities focused their efforts on macroeconomic stabilization and the consolidation of government finances. Because these efforts were so successful, and because the devaluation of the ruble and the rise in raw material prices provided an economic impetus, the Russian Federa- tion's economic growth in 2000 and 2001 was impressive. Although certain sectors of the Russian economy-especially those re- lated to raw material exports and import substitution-have experienced impressive growth in recent years, this growth has a narrow base, which is vulnerable to raw material price and exchange rate fluctuations. Broad- ening this base depends upon improving the availability of financing to a much wider group of enterprises-many of them small or medium-size enterprises that are unrelated to larger industrial groups. While consider- able effort has gone into stabilizing the Russian financial sector since 1998, a lengthy agenda remains regarding the restructuring of the sector. Trust is key to promoting the growth of market-based financial intermediation-to encourage savers to entrust their financial savings in the form of deposits to financial institutions and to encourage financial institutions to lend to enterprises without being the controllers or owners of those enterprises. The fundamental theme of the Russian financial system's recent his- tory has been that of lack of trust. Trust has been undermined by both xv xvi BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR market participants and government authorities. Those in control of failed banks have shifted assets to avoid obligations to creditors, includ- ing depositors; financial disclosure has been weak; enforcement of con- tract rights has been unpredictable; state banks have received preferential treatment; corporate governance has lacked accountability; and regula- tory oversight has been insufficient. Banks currently are undercapital- ized, and their lending is primarily with connected parties. The essential function of financial systems in market economies-to support the process of resource allocation-has gone unfulfilled. In building greater trust, special attention will need to be paid to maintaining the confidence of those providers of funds-be they retail depositors or minority share owners-who are at present provided with the least legal protection and information. Any comprehensive strategy designed to enhance trust in Russian banking will need to focus on four major themes: (1) encouraging finan- cial intermediation by improving the legal and accounting infrastructure for financial sector development; (2) improving the current structure and performance of the banking system; (3) improving the effectiveness of bank regulation, bank restructuring, and liquidation; and (4) enhancing enterprise access to finance. LEGAL AND REGULATORY INFRASTRUCTURE Russian banks are currently unable to engage in sufficient lending to an enterprise sector that is starved for working capital and long-term fi- nance. Most enterprises rely on intragroup finance and on various forms of informal finance, such as payment and tax arrears, and veksels as sources of working capital finance. On the whole, banks-be they domes- tic or foreign-are reluctant to expand the scope of formal intermedia- tion, given the weak protection afforded to them as creditors. Strengthening creditor rights depends in part on improving the legal framework that protects creditor interests and ensures effective discipline. Needed legislative improvements include establishing greater clarity in the priorities of creditor claims as well as introducing simplified enforce- ment procedures (both judicial and nonjudicial). Also necessary is the in- troduction of better notification procedures, such as a centralized regis- ter of collateral on movable property and a credit-reporting system. Creditor rights are also closely linked to the insolvency system, which provides an orderly and equitable debt collection mechanism for failing or failed enterprises. The key issues related to the insolvency system are EXECUTIVE SUMMARY xvii connected with the system's implementation, particularly taking measures to avoid the manipulation of claims to the advantage of management or particular creditors. Resolving these implementation issues will require improving the quality of judges and creating specialized insolvency judges, strengthening insolvency criteria to avoid bad-faith filings, and providing for more creditor participation in the insolvency proceedings. Market-based financial systems depend on the timely exchange of re- liable information to third parties. Current disclosure, accounting, and auditing standards in Russia provide insufficient insight into the finan- cial and governance situation of enterprises and banks. Weak accounting and disclosure requirements allow enterprises and banks to camouflage financial and nonfinancial information with the purpose of evading tax- ation, minimizing harassment, undermining the position of minority shareholders, etc. Consequently, phased implementation of International Accounting Standards (IAS) is imperative, as is the need for corporate fi- nancial and nonfinancial disclosure in compliance with international standards (e.g., information about ownership based on effective control rather than nominal ownership). STRUCTURE AND PERFORMANCE OF THE BANKING SYSTEM Creating greater trust in the Russian banking system depends on taking steps to consolidate the banking system and to improve the structure and performance of Russia's state banks. The performance of the sector could also be enhanced by greater entry on the part of foreign banks. Many of Russia's 1,300 licensed banks are not financially viable or ad- equately capitalized, at least when measured by IAS. Also, the majority of Russian banks do not actively solicit deposits from the public; they are es- sentially "pocket banks" that exist to perform certain convenience func- tions for their owners. However, as licensed deposit-taking institutions, these banks are authorized to accept deposits from the public; if these banks are not financially sound, trust in the banking system will be un- dermined. The danger to system stability could be accentuated by the in- troduction of a deposit insurance system that would support even the weaker banks in attracting household deposits. Under current circum- stances, supervising such a large number of deposit-taking institutions may be impossible for the Central Bank of Russia (CBR). Thus an im- portant step toward improving trust in the banking system would be to consolidate the banking system by: (1) encouraging bank mergers, xviii BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR (2) gradually increasing the minimum capital threshold for all banks, and (3) removing banking (i.e. deposit-taking) licenses from the many institu- tions that have no intention of soliciting deposits from the public. Reform of the state banks is the first priority in creating greater trust in the financial system. Assisted by liquidity and the capital support pro- vided by the authorities, the share of new lending provided by state banks in Russia has increased significantly since the 1998 crisis. World- wide experience suggests that state banks cannot be expected to allocate resources efficiently in the long term, and this in turn hampers growth. State bank lending tends to be politically motivated rather than based on sound market principles; it tends to be concentrated on large influential or state-owned enterprises, thereby depriving credit to small and medium- size enterprises. As a result, state banks tend to accumulate significant losses that can ultimately become a serious fiscal burden. Although the medium-term focus should be to ensure an orderly pri- vatization of state banks to reputable strategic investors, poorly executed privatization may exacerbate-rather than resolve-governance defi- ciencies. In particular, the pivotal role played by Sberbank, by far the largest of the Russian state banks, in the payment system and in the pro- vision of social payment services means that any immediate, radical change in its operations could have negative and far-reaching conse- quences. The authorities will therefore need to proceed with caution. In the interim, measures can be taken to improve state bank opera- tions so that the playing field is leveled between state and private banks. Many of these measures involve dismantling the privileges enjoyed by Sberbank and the other larger Russian state banks, Vneshtorgbank and Vnesheconombank. Sberbank enjoys a number of financial advantages, such as deposit insurance for household deposits and ready access to fi- nancial support. Sberbank's disclosure requirements regarding the bank's governance and finances are minimal and need to be enhanced. Strategic choices for Sberbank's future role-whether it be a fully commercialized bank or a savings bank investing in a narrow set of safe assets-will have an impact across the country. While the strategic options are being ex- plored, quantitative limits should be placed on Sberbank's rapidly ex- panding, and potentially risky, corporate lending portfolio. Vneshtorgbank (VTB) does not have a pivotal position in the banking sector, nor does it perform critical agency or social functions on behalf of the government. VTB should be prepared for privatization to a reputable strategic owner as soon as practicable. Although Vnesheconombank (VEB) does perform some banking functions, its main role is the adminis- trator of the government's foreign liabilities. Recently VEB has considered EXECUTIVE SUMMARY xix taking on a new agency function for export/import guarantees. Although current plans are to make VEB into a fully fledged state bank, little would be gained by establishing yet another state bank. Channeling subsidies through state banks-such as the Russian Development Bank and the Russian Agricultural Development Bank-confuses the business of bank- ing with the provision of state subsidies. Subsidies would be better and more transparently administered by government agencies than through banks. One means of jump-starting lending to the private sector and instilling greater trust in financial intermediaries might be to allow foreign banks to use their expertise, technology, and capital to expand the availability of credit to Russian enterprises. Foreign banks have, however, demon- strated a reluctance to increase their lending exposure to enterprises in the current Russian credit environment. Thus foreign entry depends cru- cially on improving transparency and disclosure for banks and enterprises, and on improving the implementation of the legal framework, especially as it relates to protection of creditor rights and the process of corporate insolvency. REGULATION AND RESTRUCTURING OF BANKS While a banking license provides bank owners and managers with the privilege to solicit deposits from households, retail savers do not have the capacity or knowledge to understand the condition of the banks in which they place their deposits. Creating trust in banks therefore depends on developing the banking supervision function. Although the legal foundation for banking supervision and banking regulations are generally well developed in Russia, developing trust in the banking system depends on the willingness of the authorities to en- force disciplinary action. Improvements in the effectiveness of banking supervision are needed regarding on-site supervision, bank licensing re- quirements (including scrutiny of financial structures and business plans), enforcement of "fit and proper" requirements for shareholders and management, stricter enforcement of capital requirements, and su- pervision of banking groups on a consolidated basis. While it is true that introducing deposit insurance in private banks- even if only partial insurance-would go some way toward leveling the playing field between state-owned and private banks, it would be prema- ture to introduce deposit insurance before steps are taken to upgrade the structure and performance of the banking industry, the CBR's supervisory xx BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR effectiveness, and the overall environment for information and contract enforcement in the economy. One crucial precondition to introducing de- posit insurance is the capacity of the banking supervisor to limit the risks of the insurance scheme: to prescreen banks for entry into the insurance scheme and provide ongoing monitoring of insured banks. If deposit in- surance is introduced for weakly supervised banks, some reckless or dis- honest bank owners/managers may take advantage of enhanced access to insured deposits to fund dubious banking ventures, which when they fail result in bailouts to be paid from the insurance fund. Such behavior would undermine rather than build trust in the sector. Building procedures and rules for bank restructuring and liquidation that protect the position of creditors are also crucial. Currently, retail de- positors lack adequate protection because of delays in restructuring ef- forts, liquidation efforts, or both; the adoption of restructuring efforts based on weak assessment of true business viability; and ineffective judi- cial liquidation proceedings. All of these factors can compromise deposi- tor interests. Problem banks should be identified sooner (for instance, by using 1AS); restructuring plans should be based on an evaluation of busi- ness viability rather than on conformance with formal criteria; liquida- tion proceedings should be streamlined and administrative processes in- troduced; and liquidation of banks should not be. side-tracked into efforts to reach settlements that compromise the legitimate rights of cer- tain classes of creditors. FINANCING ENTERPRISES The small and medium-size enterprise sector is normally the locomotive of growth in transition economies. It is therefore important that banks are encouraged to channel a larger part of their lending to this sector. While this process can be assisted by measures designed to enhance col- lection of debts-such as those adopted by foreign credit lines-as well as measures (outlined above) to improve the functioning of the financial system, a significant contribution will also come from developing the capital market. The basic framework of capital markets exists in Russia, but these markets remain underdeveloped, in part reflecting a lack of trust in the banking industry, which has responsibility for services such as custody, payment, and settlement functions related to capital market transac- tions. Underdevelopment of capital markets also reflects poor corporate governance, particularly a failure to honor minority shareholder rights; EXECUrIVE SUMMARY xxi an underdeveloped market for government debt, a key benchmark for other financial markets; complicated and diffuse legislation, which results in confusion as well as overlap and conflict between regulatory agencies; and a lack of credible enforcement of legal rights and obligations. The focus of capital market reforms in the coming period should be to develop the domestic government debt market; to create specialized se- curities courts, or arbitration proceedings; to improve judicial enforce- ment of minority shareholder rights; and to improve coordination among regulatory agencies. The task of building trust in the Russian financial system is a difficult and complex one involving the interaction of many interrelated variables and players in the financial, governmental, and judicial sectors. The issues of financial sector reform are highly interdependent. The subsequent chap- ters illustrate this interdependence and expand on and develop in detail measures that support the reform process. Although reform of the Russian financial sector will be a long-term task, measures can be taken today to strengthen the sector so that its role in supporting sustainable growth in the Russian economy can be enhanced. CHAPTER I Building Trust for Financial Sector Development: An Overview INTRODUCTION In the immediate aftermath of the financial crisis in August 1998, the Russian authorities focused their efforts on macroeconomic stabilization and the consolidation of government finances. As a result of the success of these efforts, as well as the impetus provided by the devaluation of the ruble and the rise in raw material prices, economic growth in 2000 and 2001 has been impressive. Sustained economic growth in the Russian Federation, just as in other market economies, will depend on the development of a sound financial sector. While certain sectors of the Russian economy-especially those related to raw material exports and import-substitution-have experi- enced dramatic growth in recent years, this growth has a narrow base and is vulnerable to raw material price and exchange rate fluctuations. Broadening this base depends on improving the availability of financing to a much wider group of enterprises-many of them small or medium- size and unrelated to larger industrial groups. Although considerable ef- fort has been made to stabilize the financial sector since the crisis, much remains to be done if the sector is to better support investment and growth in the next phase of Russia's transition. The demise of the financial sector in 1998 was accompanied by a complete loss of confidence and trust. Trust in the Russian financial sys- tem has been repeatedly broken during the last decade, most notably by hyperinflation in the early 1990s, and by the government's default on its own liabilities in 1998. Trust has remained low in the period following 1 2 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR the 1998 banking crisis, in which failed banks avoided obligations to de- positors and other creditors by shifting and hiding assets. It has been damaged by the lack of transparency in banking operations, resulting from vague or incomplete financial information. It has been weakened by a legal environment that is unpredictable with respect to enforcement of contract rights. It has been further weakened by favored treatment for state banks, inefficient capital markets, inadequate corporate gover- nance, and insufficiently vigorous financial market supervision. Building trust takes time in any environment, but establishing trust in Russia will be especially difficult against the backdrop of the current situation. At issue now is how to instill trust in the financial system. Establishing trust requires working on several dimensions of the fi- nancial sector. First, developing the financial system depends on estab- lishing the basic legal and accounting infrastructure to support transac- tions on market-based terms (i.e., between unrelated third parties); participants (intermediaries and customers and providers of finance) must have confidence that their interests will be adequately protected. Second, establishing trust depends on improving the structure and per- formance of the financial sector to ensure that financial services are pro- vided reliably and efficiently. Third, especially to protect the interests of the weakest participants (small depositors and minority shareholders), regulation of the financial system will need to be strengthened to ensure that imprudent and illegal behavior by participants is detected and effec- tively inhibited, and that steps are taken to restructure nonviable institu- tions. Finally, the process of building trust will need to encompass broad- er aspects of enterprise financing, including the development of the Russian capital market. Success in all these dimensions will be needed to deepen financial intermediation and improve its efficiency. These various dimensions of trust-building will be crucial for the necessary reconfigu- ration of the financial system. This chapter, which summarizes the book, first explores the relation- ship between trust, financial sector development, and economic growth. It then summarizes the four parts of the book, which focus on measures that will help build trust by (a) encouraging financial intermediation by improving the legal and accounting infrastructures for financial sector development, (b) improving the current structure and performance of the banking system, (c) improving the effectiveness of bank regulation and restructuring, and (d) enhancing enterprise access to finance. The chapter concludes with a summary of the measures that should be taken to rekin- dle trust in the financial sector so that it can more ably support the re- structuring of, and investment in, the enterprise sector. AN OVERVIEW 3 TRUST, FINANCIAL SECTOR DEVELOPMENT, AND GROWTH Development of financial systems requires building trust in institutions, an exercise that takes time even under the most favorable circumstances. While it does not necessarily guarantee long-term growth, such growth is difficult to achieve without a sound, efficient financial sector. The benefits of developing the financial system are likely to be consid- erable, especially in circumstances such as those in Russia, because lack of trust in the Russian financial system has stimulated the development of value-detracting and inefficient activities (see Box 1.1). The challenge going forward will be to engineer a change from the negative to the pos- itive contributions of the financial system, to escape from the vicious to a beneficial cycle, and to reap the benefits of reversing the substantial cap- ital outflows of the past decade. Trust in, and development of, the Russian financial system was se- verely jolted by the crisis of August 1998. Even prior to the crisis the sys- tem was small, and growth since then has only returned it more or less to its pre-crisis level. The total deposit base (M2) of the country's banking system at end-2001 amounted to no more than 23 percent of gross do- mestic product (GDP), and claims on the private sector amounted to only 15 percent of GDP. All 1,300 Russian banks together have assets equivalent only to those of a medium-size Western bank. Table 1.1 pro- vides an international comparison for year 2000 of the size of financial systems in various countries, including Russia. One response to the small size of the current financial system might be to argue that it is just as well that the system is no bigger. A bigger system could have posed a greater threat to economic stability during the crisis of 1998 and might have delayed or dampened the subsequent economic revival. In as far as banks are conduits for value-subtracting activities, such as directed lending, shrinkage of the banking system may have re- sulted in less lending to economically nonviable enterprises and thus have benefited the post-crisis economic expansion. But the question now arises as to the sustainability of this economic growth in the absence of a more effective financial system and a broaden- ing of the economic base. While the ruble depreciation and rising raw ma- terial prices provide a welcomed one-time growth stimulus, their effect was most markedly felt by narrow segments of the economy-especially the exporting and import-substituting sectors-and they have already both been partially reversed. Currently the Russian economy is character- ized by a dual structure. The flow of savings is concentrated in a small number of large companies, which rely on raw material production and 4 BUILDING TRUST: DEVELOPING THE RussLAN FINANCIAL SECTOR Box 1.1 Financial System Development and Economic Growth A well-developed financial system promotes growth in the following ways: * It ensures a more efficient allocation of resources by increasing investment in growing in- dustries and decreasing investment in declining industries. Ratherthan increasing the sav- ings rate in the economy, a better-developed financial system would laster growth in the fastest growing segments of the economy and those industries most heavily dependent on external finance. * It lowers the volatility of economic growth by helping to diversify the production base and moving away from heavy dependence on natural resource industries. * It works to alleviate poverty by raising the level of economic growth, reducing the impact of economic shocks (by providing households and small entrepreneurs safe institutions in which they can place their savings and access credit) and reducing the potentially onerous fiscal cost of financial crises. Well-functioning financial systems in market economies also contribute to economic growth by lowering transaction costs, improving the allocation of scarce resources and thereby in- creasing productivity, and reducing system vulnerability. In particular, they effect this through: * Payments intermediation. Lowering the cost of transactions by providing cost-efficient payment service. * Savings mobilization. Providing households and enterprises with financially sound and trusted savings vehicles. * Resource allocation. Facilitating the collection of information about enterprises and allo- cating capital to sound, productive investments. * Governance. Monitoring enterprise managers so that funds allocated will be spent as en- visaged and result in timely repayments. * Risk transformation. Transforming risks through aggregation and ensuring that they are carried by those most capable of bearing them. In all of these functions, financial systems perform as agents working on the behalf of others to support economic growth. On the other hand, the absence, or abuse, of these functions in a poorly functioning system can detract from growth. Some examples of negative functioning are: * Lack of payments intermediation. Encouraging nontransparent and costly payments processes and preserving soft enterprise budget constraints through inefficient forms of noncash payments, such as barter. * Poor savings mobilization. Stimulating insecure and inefficient savings forms (mattress savings) and capital flight, often amplified by tax evasion and money laundering. * Resource misallocation. Preserving inefficient enterprise structures through noncommer- cial, intragroup lending and lending by state-owned banks (on other than transparent and commercial terms), resulting in less-than-optimal allocation of resources and mounting fiscal liabilities. * Malfeasance in governance. Allowing bank and enterprise managers to manipulate results and maintain patronage (pocket banks), thus preserving the influence in enterprises of shareholder groups. * Concentration of risk. Hindering the financing and growth of firms and, because other agents are unwilling to take on the burden of risk transformation, concentrating risks with state-owned banks. resulting in the accumulation of contingent fiscal liabilities. For further discussion of the potential contribution of the financial system development to eco- nomic growth, see Chapter 5. AN OVERVIEW 5 Table 1.1 Financial Market Depth (2000) M2 (money and Bank claims on quasi-money) private sector Total bonds' Total equity US$ % of US$ % of US$ % of US$ % of Country billions GDP billions GDP billions GDP billions GDP Russia 55 22 31 12 9 4 39 16 Czech Republic 37 76 25 50 8 15 11 23 Hungary 20 44 11 26 13 28 12 26 Slovak Republic 18 94 6 31 2 13 1 4 Poland 68 41 41 26 20 12 31 19 France 656 51 942 73 716 55 1,475 114 Germany 1,179 63 2,280 122 1,178 63 1,432 76 Italy 599 56 775 72 941 88 728 68 Netherlands*- 326 89 501 137 197 54 695 190 United Kingdom 1,570 111 1,899 134 565 40 2,933 207 Japan 5,797 126 5,175 112 4,967 108 4,547 99 United States 6,084 61 4,846 49 10,768 108 16,635 168 *Bonds are defined as debt securities with maturities of greater than one year. Total bonds comprise Government Bonds and Corporate Bonds. For all developed countries and Russia, bonds data are as of September 2000. **Data for the Netherlands are for bank claims on the private sector for all residents of the Euro Area. Sources: IFC Emerging Markets Bonds Electronic Database; IFC Securities Market Development Group Database-2001; IMF-International Financial Statistics (IFS) January 2001; IMF-IFS Electron- ic Database (SIMA); BIS Quarterly Review, March 2001; IMF-Report on Post Program Monitoring Discussions; Deutsche Bundesbank Monthly Report-April 2001; EIU-Country Profiles-Russia (2000); Central Bank of Russia electronic database. processing as their main source of earnings and then re-deploy consider- able resources abroad-in the form of capital flight. Based on the recent resurgence in their earnings, these companies have also broadened their domestic interests by, inter alia, acquiring stakes in related sectors of the economy. Experience from other settings suggests that vertically integrat- ed companies are notoriously inefficient in allocating resources. At pres- ent, other sectors outside these large groups-often dominated by smaller companies-have only very limited access to external financing. Thus, if Russia is to experience sustainable growth based on a diversified industri- al and service economy over the coming years-as opposed to "islands of growth" financed by a few large conglomerates-the authorities need to focus on developing an enabling environment for broad-based intermedi- ation between savers and investors. So sustained economic growth in Russia will depend critically on the de- velopment of a sound financial system. Development of financial systems 6 - BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR requires building trust in institutions, an exercise that takes time even under the most favorable circumstances. A start should now be made to kindle this trust through implementing measures to strengthen the legal and ac- counting infrastructures, improve bank performance, strengthen bank reg- ulation, and lay the foundations for capital market development. LEGAL AND ACCOUNTING INFRASTRUCTURES Financial intermediation among unrelated third parties depends on the existence of a supporting enabling environment. Only when the enabling environment is conducive to financial intermediation among unrelated third parties would it be reasonable to expect a deepening of the inter- mediation process. There are three key aspects to improving the enabling infrastructure: strengthening creditor rights, establishing sound corpo- rate insolvency and workout practices, and improving disclosure and transparency. Enhancing Trust by Strengthening Creditor Rights A modern, credit-based economy must be supported by a legal frame- work that provides for the creation of security interests in all types of property: immovable and movable; tangible and intangible; present and future; and on a global basis, by all types of borrowers in favor of all manner of lenders. In turn, the effectiveness of this framework is predi- cated upon straightforward, inexpensive registration mechanisms; the predictable, swift, and affordable enforcement of secured claims outside of insolvency; and a sound insolvency system that provides an orderly and equitable debt collection mechanism for failed or failing enterprises. When these elements are in place, borrowers gain broad access to credit on more favorable terms, lenders are able to reach informed credit deci- sions based on more accurate assessments of the risk inherent in the un- derlying transaction, and financial discipline is generally instilled in mar- ket participants. However, a number of major shortcomings in the Russian legal frame- work have been identified and must be addressed in order to capitalize on the gains already achieved, to unlock the potential economic benefits of the reforms implemented to date, and to enhance the trust of market participants. Current shortcomings (which are further discussed in Chapter 2) include: AN OVERVIEW 7 1. Problems with the enforcement system. Russian law generally does not allow creditors to enforce collateral security through nonjudicial self-help remedies, but instead generally requires en- forcement through court or arbitral proceedings, followed by sale at public auction. The process is lengthy and expensive and is used by debtors for delay. It is unpredictable due to inconsisten- cies between courts (general as compared to commercial courts, and regional variances) and a lack of qualified court bailiffs to ex- ecute the court orders. As a result of these problems, creditors generally seek to limit their risk by reducing the supply and availability of credit ("cred- it rationing"), requiring additional collateral ("over-collateraliza- tion"), increasing the applicable rate of interest, and/or reducing the term of the credit. 2. Shortcomings of the system of priorities of claims. Upon liquida- tion or bankruptcy, both secured and unsecured creditors' claims are equally satisfied from the aggregate proceeds of sale, in the order of priority established by law. Secured creditors are not paid in relation to the value of the security they hold; they are simply lumped into a single creditor class and paid pro-rata as members of that class. This unfairly favors creditors who are under-secured. Another problem is that while as a class secured creditors are given priority over unsecured creditors, they are nevertheless subordi- nate to wage claimants. In many instances these wage claims are significant. The result is that secured creditors can easily receive payment on their claims in an amount less than the value of their collateral. As a result, creditors are, when considering a decision to lend, unable to rely on the collateral security that debtors may provide. In addition, under Russian law, the precise ranking of the pref- erence of a secured claim will depend upon the timing of when the claim is enforced; the result will be different depending upon whether it takes place during the ordinary course of the pledgor's business, in the context of a liquidation of the pledgor, or in bank- ruptcy proceedings relating to the pledgor. A consistent approach ought to be taken in each of these circumstances. In addition, the number of claims ranking ahead of those of secured creditors should be reduced to the absolute minimum, and their claims should be capped. 3. Absence of a registration system for collateral security in mov- ables. Russian law does not provide for the registration of S BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR nonpossessory pledges of movable property. Security in movable property is critical for the financing of small and medium enter- prises (SMEs). By the nature of their businesses, SMEs will own movable property such as equipment, inventory, and receivables. Currently, the only means of publicity of nonpossessory pledges on movable property in Russia is through manual entry in a pledge record book that must be maintained by pledgors themselves, if they are either a company or a natural person registered as an en- trepreneur. This system is rife with abuse and is viewed with wide- spread and justifiable skepticism by creditors generally. 4. Absence of a credit reporting system. There has never been a credit reporting system in operation in the Russian Federation. Without access to reliable information on the financial condition of a debtor, a creditor is unable to properly assess the credit risk that it would assume in the context of the proposed debtor or transaction. In the absence of reliable financial information, a creditor is likely to im- plement one or more of the risk mitigation measures mentioned above (such as over-collateralization or credit rationing). Establishing Sound Corporate Insolvency and Workout Practices The second aspect of strengthening the enabling infrastructure for finan- cial intermediation relates to the restructuring and exit mechanisms ap- plied to enterprises. Insolvency systems, like general systems for debt re- covery and enforcement, stabilize commercial relationships by enabling market participants to more accurately price, manage, and control risks of default and corporate failure. While general noninsolvency enforce- ment systems (creditor rights) provide a vehicle for resolving individual disputes between creditors and debtors, insolvency procedures offer a means for collective resolutions when failures in an enterprise's perform- ance raise questions about that enterprise's viability. Consequently, an in- solvency system plays a vital role in maintaining commercial and market confidence and in stabilizing the financial system, serving as a discipli- nary mechanism for both the financial and corporate sectors. An effec- tive insolvency process encourages prudent lending and a sound credit culture by (a) establishing a mechanism (such as rehabilitation) for the fi- nancial restructuring of firms whose going-concern value exceeds their liquidation value, thus preserving both value and employment; (b) pro- viding an orderly exit mechanism for failed enterprises; (c) ending un- productive uses of business assets and transferring them through liquida- tion to more efficient market participants; (d) providing a final and AN OVERVIEW 9 equitable debt collection mechanism for creditors; and (e) improving the enforcement of creditor rights to expand credit flows. Sufficiency of the legal framework/implementation for corporate insol- vency. Following the adoption of a new bankruptcy law in 1998, the legal framework for corporate insolvency law in Russia is now fairly well con- ceived, relatively comprehensive, and generally consistent with interna- tional standards of best practice. The 1998 bankruptcy law replaced and improved upon the 1992 legislation, which was poorly designed and drew on a mix of different legal systems. In recent years, the increase and effi- ciency in cases handled has demonstrated that the new system is better conceived and understood. Nevertheless, the regime does not perform as it should, with one major criticism being the lack of consistency in its imple- mentation (rather than in its content). Implementation problems center upon manipulation of the system to inequitably favor management or par- ticular creditors to the detriment of creditors in general, and include: "stacking" representation on creditor committees and disenfranchisement of other creditors; wrongful disallowance of valid claims and allowance of fraudulent claims; collusion between external managers and manage- ment/judges; use of bankruptcy proceedings as a form of hostile takeover; corrupt/irresponsible external managers paying no heed to demands/inter- ests of creditors. The institutional framework for implementing the insolvency regime remains fragmented and inconsistent with respect to its capacity for han- dling insolvency cases. Cases are handled by the arbitration courts, which have a wide range of responsibilities. In a few jurisdictions (including Moscow) where there is generally a high caseload and relatively sophisti- cated matters are dealt with, certain judges have been designated insol- vency specialists and are handling proceedings with greater consistency. Most complaints about implementation relate to practices outside Moscow, where court capacity and sophistication vary dramatically. The abuse of discretion has been cited as a key problem. There should be a focus on the criteria for selection, qualification, and training of judges as specialized insolvency judges; there should also be an enhancement of continuing education programs. Emphasis should furthermore be placed on developing greater transparency within the sys- tem, on improving creditor access to information, and on establishing le- gitimate creditor involvement as a necessary counterbalance to the dis- cretion of judges and administrators/external receivers. The lack of regulation and potential for arbitrage in the system has continued to foster distrust of the process. The primary agency involved 10 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR in a regulatory capacity is the Federal Service on Financial Rehabilitation and Bankruptcy (FSFR). The FSFR has been responsible for training, qualifying, and supervising the activity of external receivers. To date, it has issued more than 12,000 licenses-a major achievement, but one that suggests that licensing standards are low and that there is a glut of poorly trained and unqualified receivers. Given the ratio of licenses to the num- ber of cases filed, one can in fact reasonably conclude that many licensed receivers are inactive in the bankruptcy process. More importantly, the process for weeding out and delicensing incompetent receivers, or for ad- dressing abuses in the system, is poorly implemented and developed. Fi- nally, in light of alleged abuse in many areas, the system must be exam- ined to ensure that independence and impartiality are maintained between the courts and administrators and receivers, and to ensure that conflicts of interest are avoided. Impediments to rehabilitation and corporate workouts. With respect to enterprise rehabilitation in the context of court insolvency pro- ceedings, the process is being abused to keep insolvent businesses out of bankruptcy and to enable hostile takeovers of solvent ones. A more legit- imate rescue culture is needed, directed toward the salvaging of viable businesses. The weaknesses and unpredictability in the current environment gener- ally discourage all parties, with few exceptions, from relying on formal in- solvency proceedings. Lenders in Russia consequently prefer self-help measures, such as direct repossession of collateral, although this reposses- sion is done outside the legal framework. Also, lenders favor out-of-court workouts, because such workouts are viewed as providing the path of least pain and uncertainty. However, the legal environment currently is in- adequate to allow participants to develop consensual arrangements that can restore an enterprise to true financial viability. The result is that most, if not all, of the informal workouts amount to no more than restructur- ings of debt. This limited result can only postpone the inevitable day of the enterprise's failure, because the parties have not been able to take ad- vantage of a number of other restructuring options commonly available in international practice. An enabling environment for legitimate restruc- turing should include laws and procedures that 1. Require disclosure of or ensure access to timely, reliable, and ac- curate financial information on the distressed enterprise 2. Encourage lending to, investment in, or recapitalization of viable, financially distressed enterprises AN OVERVIEW 11 3. Support a broad range of restructuring activities, such as debt write- offs, reschedulings, restructurings, and debt-equity conversions 4. Provide favorable or neutral tax treatment for restructurings. Although informal workouts are accomplished outside of a formal ju- dicial setting, for these workouts to succeed, there must be an adequate formal backup in terms of effective legal enforcement of the mutual rights agreed upon in the course of the workout. If the plan fails, then there must be a reliable framework of insolvency procedures. In Russia, where creditor rights and insolvency systems can be broadly categorized as weak, legitimate consensual resolutions of troubled enterprises are dif- ficult if not impossible to achieve. (Strengthening corporate insolvency and workout practices is the subject of Chapter 3). Disclosure and Transparency In addition to establishing a sound legal and judicial system that provides protection to creditors, a crucial component of the enabling infrastructure for market-based financial intermediation is the disclosure of information about banks and their enterprise customers. Unless outside, nonrelated third parties have access to timely, reliable, and comparable information about the financial and governance structures of corporations and banks, it will be impossible to establish any trust in the financial system, and the basic functioning of a market economy will remain thwarted. Russian enterprises and banks have been reluctant to apply interna- tionally recognized financial reporting and disclosure standards, in part because of the perceived costs associated with compliance, as well as the inherent fear that disclosure and transparency would lead to a loss of power-an understandable concern in an environment where parties have historically used access to information as a means to maintaining their power base. However, the economic costs of camouflaging financial and nonfinancial information about enterprises and banks are enor- mous. Lack of transparency results in inefficient resource allocation in an economy where risk capital is in particularly scarce supply. A few Russ- ian enterprises and banks are improving their transparency and reporting since they now realize that their access to external funding is improved. Disclosure and transparency, however, need to be greatly enhanced, even if only based on Russian accounting standards. Strengthening regulatory requirements. A concerted effort by a broad- based constituency of regulators, shareholders, board members, and 12 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR corporate managers, together with accounting and auditing profes- sionals will be required to change the historical concerns about disclo- sure. In the Russian environment, the lead in imposing broader and more reliable disclosure will have to be taken by two key regulators, namely the Federal Commission for Securities Markets (FCSM) and the Central Bank of Russia (CBR). In addition to ensuring that financial reporting is in compliance with international standards, these bodies will need to in- sist on detailed compliance reporting, and must be prepared to impose severe penalties on directors and management for material misstatements and omissions. Disclosure. Insufficient disclosure of financial and nonfinancial infor- mation remains one of the main deterrents to investment by nonrelated parties-be they shareholders, creditors, or depositors-in Russian en- terprises and banks. Current Russian disclosure requirements are inade- quate. For example, the "lower of cost or fair market value" principle is not applied to all categories of assets, barter transactions are often not recorded at fair market value, and inter-company or non-arm's length transactions are often concealed. The rules and standards of reporting must be strengthened to ensure that reporting is based on effective con- trol rather than ownership, thus protecting shareholders, creditors, and depositors from loss of value incurred by incomplete or inadequate dis- closures. Accounting and auditing standards. The quality of financial informa- tion is directly affected by the quality of standards under which it is com- piled and disclosed. The Russian Accounting Reform Program, adopted in 1998, envisaged a gradual move to International Accounting Standards (IAS), but the process has stalled. Issues related to professional capacity, legislative and taxation barriers, as well as fears about the effects that adoption of full IAS would have on the Russian economy are some of the reasons for the delay. The policy of rewriting Russian Accounting Stan- dards (RAS), rather than adopting IAS in full, has diverted scarce re- sources away from the actual implementation and training needs. It is worth noting that a number of transition countries have already moved to IAS rather than go through the protracted process of gradually modifying national accounting systems based on Soviet-era concepts. Financial state- ments according to IAS should be adopted as the starting point for any tax computation with a limited number of reconciling items in those areas where tax rules and IAS differ. The implementation of IAS should be phased, focusing first on publicly listed companies and all banks. AN OVERVIEW 13 An important component in ensuring that the financial reporting re- quirements under IAS are effectively and correctly implemented will be to require the full support of the auditing profession. The opinion of a professional and independent auditor, and their liability for their audits, will be a key part of adding assurance to the users of financial reports. International Standards of Auditing (ISA) provide the auditor with stan- dards to guide the audit process as well as professional ethics related to professional conduct. Accounting for banks. While the CBR has agreed in principle that IAS guidelines and reporting formats will be introduced for all banks starting January 1, 2004, there are many hurdles to full implementation, including tax and legal impediments, training, preparation of guidance and conver- sion procedures, regulatory changes, and, of course, the pressure from banks unwilling to adopt IAS. Many banks already produce IAS audits and the question is to what degree the CBR will implement corrective and other actions based on these numbers. The reality of the situation is that the transition to IAS may reveal that a significant number of Russian banks do not meet the CBR capital adequacy ratios and are not safe in- stitutions in which Russians can deposit their money. On the other hand, unless the authorities are willing to fully recognize the financial fragility of many banks in the system and take action regarding the weak banks, it is inconceivable that outside parties will gain trust in the financial sys- tem. (Transparency and disclosure and the transition to lAS are discussed in greater depth in Chapter 4.) THE BANKING SYSTEM: STRUCTURE AND PERFORMANCE Developing trust in the banking system is critical for broader-based finan- cial sector development. It would, for example, be difficult to conceive how investors will gain confidence in securities markets when banks are not trusted to deliver reliable payment, custodial, and settlement services. The development of a well-functioning banking sector will need to pre- cede the development of other parts of the financial system. While a bank- ing system may be able to function efficiently without a capital market, it is impossible to conceive that a capital market could function efficiently without the services of a well-developed banking system. Any comprehensive strategy for improving trust and spurring devel- opment of the banking system in Russia needs to be based on a solid un- derstanding of current trends and practices in the banking industry. An 14 BUILDING TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR integral part of the strategy for developing the banking system will be (a) improving the structure and viability of the banking sector, including removing privileges/burdens available to or imposed on state banks, and (b) consolidating the private banking sector by imposing higher supervi- sory standards and greater supervisory stringency. Finally, consideration should be given to the role that greater participation by foreign banks might play toward building trust in the banking system. The Structure and Viability of the Banking System A World Bank analysis done immediately following the 1998 crisis con- firmed that, even before the government's default on its obligations and on the devaluation losses attributable to uncovered currency forward po- sitions, the biggest factors contributing to the crisis of the banking sys- tem were the poor quality of loan portfolios, large concentrations in lending, and disproportionate exposures to related parties (a fallout of the loans-for-shares privatization auctions). Remarkably little has changed since 1998 in the business attitudes and substance of many Russian banks, and the actions of the authorities have had an insufficient effect on them. Consolidation of the banking system. The Russian banking system is highly concentrated, with just 30 banks accounting for more than 67 percent of system assets and 53 percent of system capital. Given the ag- gregate size of the system, it is clear that the overwhelming majority of Russian banks are very small: at end-2001 (based on their submissions to the CBR developed under Russian Accounting Standards) only 230 banks have capital above 150 million rubles, which is slightly below the EU minimum capital requirement of 5 million euros (equivalent to 170 million rubles). Although the financial situation of banks has generally improved since 1998 and the system is more stable, most banks are still caught in a vicious cycle: their capital is too small to generate sufficient earnings to fund the investments needed to help them grow independently. Thus, the future viability of Russia's many banks depends on being able to attract new capital and/or becoming party to mergers to form more viable bank- ing institutions. It is difficult to conclude that many of these banks are anything but clearing and settlement centers, which primarily perform treasury func- tions for enterprises or for local and regional governments. Their work also commonly includes activities that clearly cannot be regarded as AN OVERVIEW 15 "legitimate" banking business, such as the issuance and discounting of veksels for such purposes as avoiding reserve requirements, tax evasion, money laundering, and facilitating capital flight. The continued presence of these entities as "banks" stifles the process of building trust in the Russian financial system. The CBR's difficulties in supervising such a large number of banks would be aggravated if the authorities introduce even a minimal general deposit insurance scheme. Such insurance would augment the ability of the many small, inadequately monitored banks to attract deposits from the public, which would create potentially sizeable fiscal liabilities. Thus an important step toward improving trust in the banking system-and an important precondition for introducing deposit insurance-would be to take decisive action to expedite consolidation of the banking system by replacing full banking licenses with limited ones for institutions that do not actively solicit deposits from the public. Several complementary measures should be implemented: 1. Allow those institutions that do not actively solicit deposits from the public to continue functioning, but only as regulated and su- pervised finance companies. 2. Introduce a higher minimum capital threshold for those institu- tions wishing to maintain a license for the provision of the full spectrum of banking services. 3. Tighten the accounting and disclosure requirements and imple- mentation of supervision as a means to identify nonviable institu- tions for delicensing. The authorities have recognized the need to undertake measures to promote the consolidation of the banking sector, although current pro- posals would appear to result in undue delay (see Box 1.2). The current situation of the Russian banking industry and a review of measures to encourage consolidation within the industry are discussed in Chapter 5. The results of an analysis of the performance of a sample of Russian banks-including many of the top 30 banks-since the 1998 crisis are provided in Chapter 6. This analysis is based on information published by the CBR and provided by banks under the auspices of the World Bank's Financial Institutions Development Project. The analysis raises concerns regarding the (a) viability of many of the banks included in the sample (especially if international rather than Russian accounting stan- dards were applied to such items as their loan loss provisioning); (b) rapid expansion of the banks' loans portfolios-especially those of state banks-and their high levels of loan concentration; (c) inadequacy of the banks' internal risk management systems; (d) widespread use of schemes 16 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 1.2 Consolidation of the Banking Sector: The GovernmentlCBR Joint Strategy The joint GoR/CER program* for the development of the banking system recognizes that there is a need to consolidate the sector. A step was taken in this direction in the fall of 2001 when the minimum capital level for newly licensed banks was raised to 5 million euros (the mini- mum capital level applied within the European Union). The joint strategy recognizes the need to establish "nonbanking lending institutions," thereby allowing the authorities to limit the li- censes of certain banks so that they can no longer solicit deposits from the general public. Nonetheless, the joint strategy in effect further delays the implementation of actions for the ex- isting 1,300 banks. The following measures were proposed in the joint strategy: * As of 2005 a rule will be applied whereby the licenses of banks betow 5 million euros are automatically revoked if their capital adequacy falls below 10 percent. Currently similar ac- tion can be applied to all banks, but only if their capital adequacy is below 2 percent (see Chapter 9). * In 2007 a minimum capital requirement of 5 million euros will be applied to all banks irre- spective of the size of their capital, which in effect removes any "grandfathering" of current lower capital requirements for existing banks. The joint strategy states clearly that any reorganization of banks-including any merger with other banks-must be "based on the principle of voluntary participation. " In this respect the strategy reflected continued hesitancy on the part of the authorities to use the powers already at their disposal to consolidate the banking system. These powers include stricter accounting and reporting requirements, more effective use of supervisory powers, and full implementa- tion of the recently tightened legal framework for bank liquidation. *Joint Govemment/cBR Strategy for the Oevelopment of the Banking Sector of the Russian Federation (fi- nalized in December, 2001). designed to evade the CBR's supervisory regulations; and (e) the opaque- ness of current corporate governance structures in the banking industry. In addition to drawing attention to the fragility of the banking system, this analysis lays out the agenda for many of the actions related to re- form of banking supervision (discussed subsequently in Chapter 9). Reforming state banks. The relative importance of the state banks in Russia expanded in the aftermath of the 1998 crisis because of the gov- ernment's preferential treatment of state banks and the decline of the pri- vate banking sector. The increased share of new lending undertaken by the state banks raises serious concerns about the viability of these banks going forward and about the possibility of increasing contingent fiscal li- abilities. In fact, managing and containing the role of state banks is prob- ably the most important aspect of any concerted effort to build trust in the Russian financial system. International experience shows that relying too much on state banks to provide financial intermediation generally hampers growth. Countries with relatively large state ownership of the banking sector experience less AN OVERVIEW 17 financial sector development, lower growth, and smaller gains in pro- ductivity than countries in which private bank ownership predominates. The reason for this lower growth is that state banks do not generally al- locate capital to its most economically efficient use. As lending by state banks tends to be concentrated on the largest (often state-owned) or most influential firms, they do not support more efficient, diversified dis- tribution of credit. In recent years the combination of politicized lending and weak management operating under greater regulatory forbearance -reflecting weaknesses in the oversight exercised by government super- visors of the banks owned by government-have led to cases of spectac- ular fiscal loss in such countries as diverse as Brazil and France. The find- ings from international studies also confirm that the negative effects from state ownership are greatest in low-income countries with poorly developed financial sectors and weak protection of property rights- countries not unlike Russia. If trust is to be instilled in the financial system, the government must move to contain the detrimental impact that these state banks can have on economic growth and financial sector development. As illustrated in Box 1.3, and elaborated further in Chapter 7, Sberbank-which controls 75 percent of the market for retail deposits-poses a particular challenge for the stability of and balance in the banking sector. Although the medium-term focus should be to ensure an orderly pri- vatization of relevant state bank functions to reputable strategic in- vestors, given the public policy functions played by state banks, any such strategy needs to be carefully conceived and implemented. Ill-conceived privatization may exacerbate, rather than resolve, governance complexi- ties. When privatization is not a near-term prospect, the immediate focus should be to ensure effective governance and a more level playing field between state-owned and private institutions. These issues as they relate to state-owned banks other than Sberbank are summarized in Box 1.4 and further discussed in Chapter 7. The dominance of state banks in Russia is likely to persist unless con- comitant measures are taken to strengthen the institutional framework for private banking and financial market development. Any restructuring of the banking system will thus require a broad-based and concerted ef- fort. Measures will need to be taken to improve the effectiveness of banking supervision, implement improved accounting and disclosure practices, and strengthen the rights of creditors to support lending by banks to unrelated third parties. Additionally, financial markets will need to be deepened-in the first instance the interbank and government debt markets-to provide alternative asset disposition options for those state is BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 1.3 Sberbank and Its Restructuring Before the 1998 crisis, Sberbank invested most of its assets in government securities, but since the crisis it has aggressively expanded its lending to the corporate sector. The bank has established itself as the dominant source of loans to large Russian corporations, such as oil, gas, electricity, chemicals, construction, and trade enterprises, and to state and municipal bodies. In the year 2000 alone Sberbank expanded its loan portfolio by 60 percent and by Jan- uary 2001 Sberbank accounted for almost 30 percent of aggregate outstanding loans extend- ed by the banking sector. On a regional level, the dominance of Sberbank in lending operations might sometimes be even higher. Sberbank currently has several operating advantages: a large, geographically dispersed retail branch network; state guarantee of household deposits; the status of being "too big to fail"; a strong internal payments system; and a key role in the distribution of state pensions. These advantages, however, come with significant costs to the efficiency of the banking system as a whole, including a possible detrimental impact on competition resulting from Sberbank's dominance of the retail market; the conflict of interest inherent in the CBR's roles as bank owner, regulator, supervisor, and authority responsible for monetary policy; and the risk inher- ent in being "too big to fail"-i.e., that the bank through complacency may accumulate contin- gent fiscal liabilities and need to be rescued by the government. While there may be an argu- ment for keeping a state savings bank as a transitional institution, international experience demonstrates that state banks, like Sberbank, hamper the ability of the financial system to con- tribute to efficient resource allocabon and thereby reduce the economy's growth potential. Keystrategic issues need to be addressed: Given Sberbank's dominant position in the Russian banking sector, key issues related to its business strategy, interest groups, and ownership ur- gently need to be addressed. Unless these issues are addressed, Sberbank will continue to dominate the sector in an unfair way and the role of private agents in the financial system will remain peripheral, thus undermining the processes of building sustainability and trust. The government needs to decide what type of medium-term business strategy Sberbank is to pursue. Some options are discussed in Chapter 7. While the final decision will need to be based on more information than is currently available-based on international experience with the restructuring of state banks-a medium-term option for restructuring Sberbank would be: * To preserve Sberbank's functions as the nationwide savings bank, * To reduce the risks associated with the public service function of the bank as a savings in- stitution for small savers by requiring the bank to invest in safe assets such as government securities, and * To carefully privatize the bank's corporate lending portfolio as a separate commercial op- eration. In implementing such a medium-term option it would be important that the privatization and/or restructuring plans be carefully and thoroughly prepared before being put into effect. The strategic plan for Sberbank needs to consider the bank's future competitive position- such as the need for the government to level the playing field by equalizing any financial or other privileges and obligations enjoyed by or imposed on the bank, and the possibility for at- tributing monetary value to such privileges and obligations. Alternative ownership structures and their influence on the various interest groups also need to be considered. Among the alternatives to be considered are maintenance of the status quo, with the CBR as majority shareholder as an interim solution, despite serious concerns regarding (Box continues on next page) AN OVERVIEW 19 Box 1.3 (continued) conflict of interest which this entails; a return to full government ownership; appointment of an independent board of trustees to manage the government's interest in the bank; and possible partial or full future privatization. Immediate safeguards and next steps: Privatization of at least parts of Sberbank should be a medium-term goal, and while strategic options are prepared and considered, interim meas- ures-including placing constraints on the growth of the bank's lending portfolio-urgently need to be taken to minimize the damage that Sberbank's operations potentially could inflict on the economy and the financial system. These measures are essential to setting in motion the self-reinforcing process of building trust. It is important that these safeguards are put in place immediately, to contain unsound busi- ness practices and to provide time for a thorough evaluation of the bank's plans for future business development. In the short-term the appropriate emphasis would be on strengthening the governance of the Sberbank and ensuring that the bank is run according to commercial principles, thereby allowing more emphasis to be placed on the return on capital and gradual- ly reducing the need to monitor such factors as the bank's lending growth and interest rates. At the same time, however, plans for the medium-term restructuring of Sberbank need to be identified and carefully designed with a view to their staged implementation. banks that are rapidly expanding their loan portfolios. Of particular sig- nificance will be the institutional reform of the market for domestic gov- ernment borrowing. As discussed further below, reforms in government debt management are crucial, not only for the development of financial markets, but for the structural reform of the banking sector as well. Encouraging foreign bank entry. One means of jump-starting lending to the private sector and instilling greater trust in financial intermediaries might be to allow foreign banks to use their expertise, technology, and capital to expand the availability of credit to Russian enterprises. Foreign banks have, however, demonstrated a reluctance to increase their lending exposure to enterprises in the current Russian credit environment. The Russian authorities could take steps to encourage the expansion of for- eign interest in the Russian banking sector by formally removing limita- tions on the share of foreign capital in the banking sector and by actively seeking foreign strategic investors for state-owned banks. Implementation of the supervisory reforms-placing less emphasis on observance of su- pervisory norms and more on proactive assessment of bank viability- will also be important in providing a more level playing field for competi- tion by foreign banks. Foreign banks, which are already subject to stringent supervision by their home countries, stand to benefit from 20 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 1.4 Restructuring of State Banks Other than Sberbank Vneshtorgbank Vneshtorgbank (VTB), Russia's second-largest bank, has received several sizable capital injec- tions from its owner, the CBR, since the 1998 crisis. Like Sberbank, VTB has expanded the sphere of its activities beyond its traditional business-of providing trade credits-to provid- ing commercial lending to large Russian corporations. The government has announced its in- tention to privatize the bank and is considering a proposal by the European Bank for Recon- struction and Development (EBRD) to provide some initial outside capital with a view to prepare the bank for further privatization to strategic investors. Unlike Sberbank, VTB does not fulfill agency or social functions on behalf of the government. This bank is thus well-suited for privatization to a reputable strategic owner. Sale to a reputable foreign bank would provide capital, experience, and reputation in governance, and technical know-how. In preparation for privatization to strategic investors, VTB will need to prepare a strategy regarding its future business plans, thus increasing its value to future prospective owners. Even if full privatization is a few years away, this strategy should be announced soon so as to provide the foundation for an assessment of VTB's ongoing business decisions. It is, for example, far from clear that VTB's acquisition of international banks formerly owned by CBR, or its plans to expand its do- mestic branch network, would enhance the bank's value in privatization. Vnesheconombank Vnesheconombank (VEB) manages the government's foreign debt and-although it does not have a banking license-performs some banking functions, including taking deposits and lending to some large Russian corporations. This situation needs to be resolved and various options are under consideration. The government has announced its intention to establish a debt management agency to manage domestic and foreign sovereign liabilities, and has an- nounced also that a strategy for VEB will be decided in the near future. One plan being consid- ered is to transfer VEB's banking operations to another government-owned bank, such as Ro- seximbank, and provide additional capital to the newly consolidated bank. Once the process of separating VEB's debt management business and other government- related transactions has been completed, the key issues that still need to be assessed are (a) whether VEB should continue as a government agency providing export/import guarantee support to Russian enterprises and whether it should receive a banking license and (b) whether the stand-alone commercial activities of VEB provide the foundation for a viable busi- ness operation. A case might be made for supporting foreign trade through partial guarantees provided by a government agency, but this business does not require the agency to have a banking license. Given that there has already been considerable expansion of the role of state banks in Russia in recent years, and the need to create a more level playing field, any step to- ward expanding VEB's role as a banking institution should be taken with caution, and be pre- ceded by thorough analysis and justification. New State Banks Two new state banks have been established since the 1998 crisis: the Russian Development Bank (RDB) and Rosselkhozbank (the Russian Agricultural Development Bank). Both banks in- herited bad assets from the government or other institutions (notably SBS-Agro), and the in- centive within these institutions to operate according to commercial principles is therefore al- ready compromised. Government intervention to subsidize interest rates or guarantee credits should not be allowed to compromise the functioning of financial markets. Where such trans- fers can be justified, other instruments, such as transparent budgetary subsidies, should be considered rather than interventions that tend to distort financial markets. AN OVERVIEW 21 measures bringing supervisory practices in Russia closer to international standards. A survey of foreign banks already active in Russia revealed that the main factor inhibiting greater foreign investment in the Russian banking industry is the risk associated with making credits in an environment characterized by weak legal enforcement. While foreign banks have on the whole been able to collect on their credits, they have also had to invest considerable resources in managing their credit risks. In seeking to con- tain those credit risks, foreign banks, like their domestic counterparts, have focused on lending to the leading, large Russian corporations. Recent international studies have confirmed the economic benefits of admitting foreign-owned banks, and identified their capability both to stimulate operational efficiency and competition and to eventually help stabilize the financial sector. The entry of foreign banks has generally been associated with improvements in the quality of both regulation and transparency, particularly where the entry of those banks is accompanied by the introduction of international standards of accounting and audit- ing. While the pressure of competition from foreign banks can encourage local banks to take higher risks, the entry of disreputable foreign banks could weaken the banking sector. Both risks emphasize the urgent need to strengthen prudential regulation of the banking sector. (The survey of foreign banks and issues related to encouraging foreign entry are the sub- ject of Chapter 8.) REGULATION AND RESTRUCTURING OF BANKS Building trust in the financial system depends on developing banking su- pervision with the primary goal of protecting the financial standing of the weakest participants in the financial system, the retail depositors. Build- ing trust in the Russian financial system will also depend on establishing a reliable framework for bank restructuring and liquidation. Here again a key concern is that trust is defrayed due to the less than full satisfaction of depositor claims. Only once effective bank regulation, supervision and resolution mechanisms are in place would it be advisable to introduce de- posit insurance, thereby formally protecting smaller depositors. Banking Supervision A banking license provides bank owners and managers with the privilege of soliciting deposits from households. Retail savers, however, do not have the capacity or knowledge to understand the condition of the banks 22 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR in which they place their deposits. In addition, troubled banks are often able to maintain their liquidity (by generating new deposits) for some time after they have eroded the cushion of security provided by their cap- ital base. Thus, creating trust in the financial system depends crucially on developing a banking supervision function with the primary goal of pro- tecting the financial standing of the weakest participants in the financial system, the retail depositor. The status of banking supervision. The CBR has made significant progress in establishing a bank supervision role, particularly considering that the principle of bank supervision has been introduced into and built in Russia only within the last decade. All the key functions of banking supervision are in place, and they are supported by a comprehensive set of laws, regulations, and internal rules, providing the supervisors with broad powers of enforcement. The bank supervision staff has had to learn how to apply new laws, regulations, and procedures. Furthermore, although the CBR's reputation for supervision was savaged by the 1998 banking crisis, it has survived the experience, and all the key staff will have gained valuable practical experience from it. These are formidable strengths on which to build. Moreover, improvement in the overall eco- nomic environment has helped the banking sector to somewhat improve its viability, which should make dealing with weak banks and toughen- ing the supervisory system easier. In addition, the continuing low usage of banks (by international standards) should enable the taking of hard decisions on weak and problem banks without significant economic con- sequences. However, despite the strengths and opportunities listed above-as well as the significant effort that has gone into upgrading the banking regulation and supervision framework-banking supervision still has quite a number of weaknesses that need to be addressed. This is especial- ly important if a deposit guarantee system is to be introduced as planned by the authorities, since such a system would not be capable of providing reasonable protection for depositors, without accumulating dispropor- tionate contingent fiscal liability, unless underpinned by strong and effec- tive supervision. Unsafe and unsound banks should be kept out of a sys- tem underpinned by deposit insurance. As noted in Box 1.5, the Russian authorities are committed to strengthening the banking supervision func- tion in the coming period. The enabling environment for bank supervision. In the final analysis, everything rests upon the willingness of the major market players (both AN OVERVIEW 23 Box 1.5 Strengthening Banking Supervision: The GovernmenVCBR Joint Strategy A joint GoR/CBR program* for development of the banking system has put together a com- prehensive program for improvement of the bank supervision function, which includes the fol- lowing main areas: * Improvement of the licensing process, including tightened requirements for financial strength and fitness and properness of bank owners; * Continued introduction and implementation of Basel Core principles of effective bank su- pervision, focusing on assessment of risk management systems and internal controls in banks rather than on compliance checks; * Development of proactive approaches to bank supervision and improvement of early warning systems; * Tightening of prudential requirements with a view to a better reflection of risk profiles; * Strengthening definition and role of capital adequacy; * Strengthening oversight of banking groups on a consolidated basis; * Increasing emphasis on on-site supervision (inspections), focusing inspection efforts on problem banks, banks involved in high risk-taking and/or those with inadequate risk man- agement systems and weak internal controls; * Improvement of bank supervision process through transition to international accounting standards and adjustment and streamlining of bank reporting requiring amendment of the Law on Accounting as well as adjustment of laws regulating taxation; * Reorganization of the bank supervision function, with a view to finding an optimal balance between centralization and decentralization of the supervision process; * Enhancing bank rehabilitation and liquidation procedures; * Improvement of corporate governance in banks, including enhancement of the role of bank external auditors in line with best international practice. Recognition by the CBR of the need to improve banking supervision along these lines is an im- portant step forward. Implementation of such improvements is in line with the recommenda- tions that the World Bank and IMF have previously proposed to the Russian authorities. A high-level assessment of the effectiveness and efficiency of CBR supervision function, which was carried out by the World Bank at the request of the CBR in autumn 2000 may have con- tributed to the development of such plans by the CBR, especially regarding the enhancement of the role of the on-site inspection process. *Joint Government/CBR Strategy for the Development of the Banking Sector of the Russian Federation (fi- nalized in December, 2001). state and private banks) to conduct their business in a prudent and trust- worthy manner. They must be willing to submit to rigorous supervision in the interests of the market as a whole. In addition, development of the en- abling environment depends very much on support from the political sys- tem, as represented by constituents including the government, the Duma, the management of the CBR, the court system, and large corporations. The support of all these parties is needed if banks are to evolve into a po- sition of financial and economic strength. The failings of this "enabling environment" in Russia have been well documented but include: 24 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 1. Lack of transparency. Weak application of accounting standards, and deliberate "window dressing" of regulatory reporting make it difficult to ascertain the financial condition of banks and enter- prises, and leave the supervisor without adequate information on which to act. There is little acceptance among banks that such be- havior is inappropriate. 2. Confluence of stakeholder interests. While ownership links con- tinue to exist between banks and enterprises, the ties to govern- ment interests remain so strong, and disclosure regarding these entangled stakes remains so weak, that it would not be possible to establish the foundation for a market-based banking system that is dependent on monitoring by outside stakeholders. 3. Limited enforcement of responsibility and accountability for im- prudent banking behavior. There is a lack of willingness within the business environment to make bank managers, controllers, and shareholders answerable for their misdeeds and mistakes, the costs of which continue to be forced on depositors and creditors. It has been accepted that many individuals associated with failed banks, for example, have resurfaced in bridge banks or newly chartered banks. These shortcomings are well understood by the Russian authorities. However, until the issues are fully addressed, it will be impossible for good banks to effectively and profitably perform their key functions of intermediating savings and of contributing to the efficient allocation of resources and growth of the economy. The efforts of banking supervisors to support the development of a safe and sound banking system and to protect trust in the system will similarly continue to be thwarted, unless the recommended changes are made. If banking supervisors are to play a leadership role in protecting de- positors and ensuring the stability of the banking system, their mandate will need to be changed and strengthened. Given the current condition of the banking system and the established behavior of many bank man- agers, controllers, and shareholders, which focuses on circumventing laws and rules, the nature of banking supervision will need to shift. Staff and management of the supervisory function must be able to switch the emphasis of their supervisory efforts from an exhaustive and bureaucratic verification of compliance with technicalities, to a more forward-looking assessment of the current financial condition of the banks, the integrity of their operations, their vulnerability to shocks, and their capacity to man- age risk. The supervisors must be able to implement timely and effective actions to correct shortfalls. They will need to be able to exercise greater AN OVERVIEW 25 authority in requiring swift corrective actions in cases of bank abuse (in- cluding inaccurate reporting), financial deterioration, and capital insol- vency; and in identifying and assigning responsibility to bank owners, controllers, and managers. Now that need for these further changes has been recognized in the joint strategy of the government of Russia and the CBR, the urgent priority is for effective implementation of the declared principles. Implementation of bank supervision. Effectiveness in implementation depends primarily on the content of supervision-less on the organization of that supervision. Effectiveness cannot be achieved without a sustained shift in the attitudes and working culture of both the supervisors and the banks. This shift will need to be repeatedly confirmed and demonstrated by senior CBR management. As part of this cultural change, a start should be made as quickly as possible on advising noncompliant banks that ac- tion will be taken against them, and on subsequently taking action against continuing abusers. As many cases as possible must be brought into the public domain: nothing will boost public confidence (and improve super- vision itself by encouraging conformance by other banks) as much as see- ing action being taken against banks-particularly high-profile ones-that violate banking laws and regulations. As appropriate, the international financial institutions and donors can assist in supporting key efforts to improve the effectiveness of banking supervision-in particular as regards protecting the savings of retail de- positors and supporting the process of building trust in banks-in the following areas: 1. Increased emphasis on on-site supervision. It is important to im- prove the accuracy and truthfulness of regulatory reporting and this will involve the introduction of improved reporting and ac- counting standards. However, while compliance with accounting procedures and regulatory ratios are important-and skills in these areas were to some extent inherited from the Soviet peri- od-going forward, much greater emphasis needs to be placed on developing on-site supervision in order to verify asset values, as- sess the operational capacity of individual institutions, and pre- pare timely and effective supervisory interventions. 2. Strengthening bank licensing requirements. Given that the bank- ing system is burdened with an abundance of severely distressed banks, increased supervisory attention should be devoted to pre- venting the entry of new problematic banks and ensuring the suit- ability of new managers and shareholders. When licensing banks 26 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR -rather than just ensuring that the bank meets certain minimum requirements and that its shareholders and managers meet fit and proper criteria-the CBR should place much more emphasis on evaluating a bank's ongoing business strategy, internal controls, and risk management systems, and safeguard margins on capital and liquidity to ensure that the bank is viable and therefore de- positors can withdraw their funds in full and on a timely basis. 3. Fit and proper requirements. Increased effort is needed to hold shareholders, controllers, and managers of failed institutions ac- countable for their actions and to prevent them from reentering the banking sector. Requirements regarding the regular disclosure of shareholders and the granting of approvals for share acquisi- tion should be tightened and expanded to include indirect as well as direct shareholder interests. Consideration also needs to be given to tightening the definition of imprudent activities and strengthening enforcement actions against criminal misconduct. 4. Strengthened definition and role of capital adequacy. The focus on preserving bank capital as a readily available cushion to ab- sorb potential losses needs to be strengthened. Measures need to be taken to (a) improve due diligence on the true nature and avail- ability of bank liabilities qualifying as bank capital, (b) strengthen the ability of supervisors to charge equity capital down to the value ascertained as part of on-site bank inspections, and (c) sub- stitute capital insolvency for illiquidity as the criterion for bank bankruptcy. Legislative amendments addressing the last two of these points were enacted in 2001. Their effectiveness now de- pends on how they are implemented. 5. Strengthened oversight of banking groups on a consolidated basis. Oversight of banking groups is particularly important, given that so many banks are parts of groups. The recently enacted amend- ments to the Law on Banks and Banking have introduced the no- tions of "banking groups" and "bank holding." Although the ad- vantages of consolidation should be considered when assessing the potential risks arising within a financial-industrial group, the fact of its consolidation should not be used to camouflage the capital weakness of an individual bank within a group simply be- cause of the strong standing of the industry balance sheets within that group. 6. More expeditious bank rehabilitation process. The current reha- bilitation process is highly procedural, involving long delays and allowing even badly distressed institutions to continue operations. AN OVERVIEW 27 To engender depositor and public confidence, the supervisor will need to be much more proactive in evaluating bank safety and soundness and, faced by a deteriorating institution, should act rapidly t6 implement corrective action. In its supervisory func- tion, the CBR should focus its activities on (a) obtaining and ana- lyzing information related to the core elements of bank distress, (b) encouraging mergers among banks to reduce the number of nonviable or only marginally viable banks, and (c) where appro- priate, targeting its rehabilitation efforts only on potentially vi- able banks. In all of these areas, bank supervisors will need to continue the process of learning how to take prompt corrective actions and will need the polit- ical backing to take such actions. Clear guidelines will be needed for the delegation of the exercise of judgment to designated on-site supervisors and for ensuring the collective endorsement by senior management of final decisions. A commitment to continued training is also essential to upgrade knowledge of best practices and to ensure even-handed imple- mentation of the revised supervisory practices in the diverse regions of the Russian Federation. Finally, banks themselves should have primary responsibility for legal compliance, monitoring, and responding to changing risk profiles. Trust in banking systems in a market economy does not depend on an extensive system of monitored controls. It depends instead on the acceptance and application of a set of supervisory standards (applied to bank owners and managers themselves), good business plans, strong internal risk manage- ment, and legal and policy compliance systems. (Strengthening the effec- tiveness of banking supervision is further discussed in Chapter 9.) Deposit Insurance In 1999, a Deposit Insurance Law was passed by the Duma, only to be turned down by the Federation Council. At the same time, the Agency for Restructuring Credit Organizations (ARCO) introduced a deposit in- surance scheme modeled on the rejected 1999 law for a subset of the banks under its administration. Recently the authorities are again seri- ously considering the introduction of deposit insurance. The motivation for such proposals seems to be an attempt to increase trust in the financial system and attract more deposits into the formal banking system by formally protecting small depositors with the hope of fostering banking sector stability. By guaranteeing the savings of small depositors, the authorities might hope that deposit insurance would 28 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR encourage small savers to entrust their savings to banks, discourage bank runs in times of crisis, and thereby promote stability and the long-run development of financial intermediation. Furthermore, in the Russian context it has been argued that if deposit insurance were available to pri- vate banks, the competitive advantage currently enjoyed by state-owned banks could be expected to diminish and a more level playing field would thus emerge. These are laudable goals-fully consistent with the theme of this book regarding instilling trust in the financial sector. However, the question is whether deposit insurance is likely to be an effective means of achieving those goals. There are significant risks associated with introducing de- posit insurance; controlling these risks requires a sufficient regulatory and supervisory infrastructure, which is still in its developmental stages in Russia. Introducing deposit insurance can exacerbate risk-prone bank- ing behavior by reducing the incentive of large as well as small creditors to monitor banks' fiscal soundness. A banker can rely on deposit insur- ance, not the quality of the bank itself, as a marketing draw for attract- ing new deposits. If the bank is unsound, meaning it has little if any cap- ital, the owners have nothing at stake, and they will use the newly acquired deposits for high-risk lending. This undermines the benefits of deposit insurance for developing financial intermediation. Creditor/depositor complacency about the bank's financial condition can result even if the deposit insurance guarantee is only limited to cover the funds of small retail depositors. Large depositors may well perceive implicit coverage extending to them in times of crisis. This is particularly true for the most recent proposals in Russia, which provide for an ex- plicit government guarantee of the deposits. This guarantee is not delim- ited by moneys available in a deposit insurance fund, and so the tenden- cy is to believe that its coverage will, in other respects, extend beyond its explicitly stated limits. Given the lesser role played by creditors in moni- toring their risks, the introduction of deposit insurance places a greater onus on the supervisory and regulatory authorities. In order to reap the benefits of deposit insurance and minimize the risks-including the potential fiscal liabilities faced directly by the gov- ernment associated with paying out insured depositors in a systemic cri- sis-the authorities will first need to upgrade other aspects of the bank- ing system safety net as well as wider elements of governance. This will in particular involve reforming the current regulatory and supervisory environment, implementing expeditious bank failure resolution mecha- nisms, and introducing a commercial framework for the operation of state banks. The agenda related to reforms in these areas is considerable and will take time to implement. AN OVERVIEW 29 The design of a deposit insurance scheme is also essential to its success. A poorly designed deposit insurance scheme can undermine rather than contribute to trust in the banking system. The authorities should not look to deposit insurance as a "quick fix" to instilling trust in the banking sys- tem. At this stage, introducing deposit insurance would likely create a siz- able fiscal liability and increase banks' appetite for risk-taking, thereby contributing to bank fragility. (The issues relating to deposit insurance are further elaborated in Chapter 10.) Bank Restructuring and Liquidation Rebuilding trust in the Russian financial system will depend in part on a framework for bank restructuring and liquidation that first and foremost protects the savings of retail depositors. There are, under the current Russian legislation, sufficient measures to provide depositors with ade- quate protection of their interests in the event of liquidation. Retail de- positors are classified by law as first-priority creditors, and if a failed bank is liquidated promptly, there should likely be sufficient assets to sat- isfy their claims. However, depositors have often received less than full payment of their claims or have had to wait for years before receiving payment. The key problem of Russian bank liquidation and restructuring is that depositors are often not afforded a sufficient capital cushion in the bank for satisfaction of their claims. In a liquidation setting, this is caused by ineffective execution of existing bank liquidation procedures, resulting either in depriving depositors of their full share of bank assets, or else in diminishing those assets due to delays. In the context of restructuring, the cushion can also be undermined; Russian accounting standards, used to measure the success of restructuring efforts, do not provide an accu- rate picture of the bank's capital structure. Also, existing regulatory cri- teria do not allow for a sufficiently broad evaluation of the bank's finan- cial health or the overall viability of a bank's rehabilitation plan. Consequently, banks that should realistically qualify for liquidation are considered "rehabilitated" and remain open. As a result, and by the time such banks fail, their assets are more than likely depleted to the point where they are unable to satisfy the claims of their depositors. Bank restructuring framework. Two entities in Russia are currently responsible for bank restructuring. One is the CBR, which is responsible for overseeing the provisions of the bank bankruptcy law relating to measures to avert bankruptcy. The other is ARCO, which is governed by the provisions of the Law on the Restructuring of Credit Organizations. 30 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR The credibility of both institutions in their restructuring actions is critical to rekindling trust in the banking system at large. The CBR and ARCO have differing mandates in their responsibilities for bank restructuring. The CBR is required to become involved in the rehabilitation of a bank at the first sign of financial difficulty. The CBR is responsible for over- seeing the development of a rehabilitation plan by the bank, or if the bank fails to develop a plan on its own initiative, to order the bank to de- velop such a plan. If the bank still fails or refuses to undertake rehabili- tation efforts, the CBR can appoint a temporary administrator. The ob- jective of the rehabilitation is to bring the bank back into compliance with regulatory guidelines relating to-among other factors-capital ad- equacy and liquidity. This process does not provide for a sufficiently early or effective intervention by the CBR, because the criteria for initiat- ing the process and for measuring its success are calculated using RAS. Banks usually fall below capital adequacy thresholds long before they be- come illiquid, but the meaningfulness of the law's 10 percent capital ade- quacy standard is undermined by the lax standards applied under RAS and weak supervisory stringency in applying these standards. These weaknesses are compounded by the fact that the regulatory criteria used to measure the success of the rehabilitation tend to focus on discrete as- pects of the bank's condition, rather than on the overall financial viabili- ty of the bank. Thus a "rehabilitated" bank may in reality still be in fi- nancial trouble. The likely result is that depositors will be inadequately provided for in the event that the bank fails and is liquidated. The CBR should adopt a revised approach-undertaking early inter- vention, based upon IAS, and using an approach that considers the inter- relation of the bank's financial fundamentals as a whole, thus evaluating each bank restructuring for its realistic business viability. Given the ex- cessive number of banks in Russia, the CBR should wherever possible fa- cilitate the restructuring process by exploring and supporting restructur- ing options that involve bank consolidation or merger. Bank liquidation practice. The Russian legislation basically provides a sufficient framework for bank liquidation, and this framework has been enhanced by recently enacted amendments to the banking laws. However, there have been a number of stumbling points when bank liquidation is carried out in practice. The problems have been the net result of actions of the many parties involved in bank liquidation/bank bankruptcy pro- ceedings, and the effect of these actions is a diminishment of the retail de- positors' ability to recover their funds. Problems include: 1. Judicial backlogs and delays. There are many delicensed banks awaiting liquidation through the courts, in cases that are being AN OVERVIEW 31 delayed by judicial docket congestion and a shortage of experi- enced and licensed arbitration receivers. Compounding the delay in many instances is the use by bank owners of procedural loop- holes and redundancies to challenge CBR action in multiple ap- peals. For instance, it has been possible for bank owners to appeal the CBR's delicensing decision in the bank bankruptcy proceed- ings, as well as in separate arbitrage court proceedings at any point up to several years later. The recently enacted legal amend- ments should provide some relief for the court system by reducing the possibility for repeated legal challenge of CBR actions. Pur- suant to these amendments, a delicensing decision must be ap- pealed within 30 days of the announcement of that decision. 2. Inadequate level of expertise. Members of the judiciary and arbi- tration receivers alike suffer from a lack of experience and/or knowledge of the pertinent laws and procedures. There have been some calls to establish specialized commercial or bankruptcy courts to handle cases such as bank bankruptcy. More seriously, both judges and arbitration receivers have been accused of being influenced by powerful creditor groups, producing inconsistent or biased results. There have also been allegations of self-dealing and of financial interests between judges, arbitration receivers, and certain creditors. There is a pronounced need for general en- hancement of the quality of the judiciary, including education of judges and structural reform. The system of arbitration receiver- ship is also in need of sweeping change, possibly by replacing the use of individual receivers with the use of a private corporate or a quasi-governmental entity as liquidator. There may be significant hurdles to enabling private corporations (such as "Big 5" account- ing firms) to act as liquidators, not the least of which is the need for amendment of the existing law before they can legally act in such a capacity. Their high cost presents another impediment. At present, there are discussions among the Russian authorities about the possibility of creating a governmental or quasi-governmental entity dedicated to bank liquidation. This concept merits further exploration. A public entity such as this would be advantageous in that it would allow for the rapid development of a group of persons trained and competent in bank liquidation. It would also promise greater accountability than the current system of individ- ual arbitration managers. 3. Amicable settlements. Despite the fact that amicable settlements are by law prohibited in bank bankruptcy proceedings, they have been a feature of a number of bankruptcies, particularly those 32 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR involving large Moscow banks. Rather than a prompt liquidation of the bank, the result is a compromise agreement in which all creditors receive some type of reduced payment. Sometimes this is characterized as a tradeoff for allowing the bank to continue in business, and there are instances in which the CBR has reinstated the license of a bank placed into bankruptcy proceedings. The re- sult for retail depositors (who are first priority creditors) is typi- cally that they receive less than they would have in a straight liq- uidation. They may receive a partial cash payment immediately, with a balance to be paid over a number of years. This assumes that the bank will have the financial resources to make those pay- ments in the future. Even if a settlement is not ultimately entered into, nevertheless the depositors are stalled in payment, some- times for over a year, as the parties discuss and consider the possi- bilities of settlement. This problem is completely avoidable, requiring only the appli- cation of the existing legislation as written. As noted above, the Law on the Insolvency (Bankruptcy) of Credit Organizations pro- vides an explicit procedure for the restructuring of banks in Rus- sia. These procedures have been supplemented and detailed by regulations issued by the CBR. There are sufficient opportunities for restructuring of the bank under the existing restructuring leg- islation to obviate the need for restructuring negotiations during liquidation proceedings. The need for prompt liquidation of the bank is tied to the need for taking advantage of existing bank as- sets which can be applied toward depositor claims. This is partic- ularly true now that legislation has been enacted that allows for prompt payment of depositors in bank liquidation from cash held by the bank in its reserve account at the CBR. This payment can be made early in the proceedings, without awaiting the formal process of collecting and then liquidating the bank's assets. Con- sequently there needs to be improved enforcement of the provi- sions of the bank bankruptcy law that prohibit these kinds of set- tlements. 4. Undue court involvement. Under the Russian law prior to July 2001, before a bank could be liquidated it had to be found bank- rupt by a court. The recent amendments allow, in several in- stances, for liquidation of a bank based solely upon defaults in regulatory standards. For instance, a bank can now be liquidated, whether technically "bankrupt" or not, for failure to maintain a capital adequacy ratio of 2 percent. A new judicial procedure has AN OVERVIEW 33 been created that governs the liquidation of banks under these nonbankruptcy circumstances. This represents a significant im- provement in the legislation, as it supports the CBR's prerogative as a regulator to determine that a bank is unsound before it reach- es the level of insolvency, and thus to preserve an adequate capital cushion for the satisfaction of depositor claims in the event of liq- uidation. This change in the legislation corrects an undue empha- sis on judicial involvement in what should otherwise be an ad- ministrative decision made by the CBR as regulator. However, there are a number of other facets of bank liquidation that could benefit from enhanced administrative procedures. One in particu- lar is the role of the court in overseeing the liquidation process. There is no need to have the court continually reviewing the dis- position of assets if an equally, if not more, effective administra- tive oversight system could be put in place. One possibility could be the creation of a public entity designated for bank liquidation. This concept has been endorsed in the joint government/CBR strategy paper. There are a number of other aspects of bank liqui- dation that might benefit from implementation of administrative, as opposed to judicial, processes. These processes are in evidence in much of international practice, and the possibilities of adapting this international practice to the Russian context should be given greater examination. While the CBR's role in restructuring is based upon early intervention, ARCO becomes involved in the restructuring of a bank at a later stage, and then only if the bank meets certain additional criteria. The bank must be referred to ARCO by the CBR, and ARCO must evaluate it and accept it for administration. But there are also difficulties associated with ARCO's role in bank restructuring (see Box 1.6). (Improving bank restructuring and liquidation practices is the subject of Chapter 11 and the involvement of ARCO is discussed in Chapter 12.) IMPROVING ENTERPRISE FINANCING To broaden the base for financial intermediation and help create trust in the financial sector, the authorities will need to take measures to improve the access of enterprises to finance. These measures will involve strength- ening the foundation for capital market development. 34 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 1.6 Problem Areas in ARCO's Approach to Bank Restructuring The following briefly summarizes problem areas encountered in bank restructuring initiatives undertaken by ARCO in recent years: * Timing of intervention: Because of the application of the dual criteria of illiquidity and capi- tal insolvency, as specified in the Law on Restructuring of Credit Organizations, by the time a bank meets the criteria for ARCO eligibility it will be in a fairly advanced state of financial decay and restructuring will be difficult. Added to this is the fact that the criteria are meas- ured by RAS, rather than IAS, and so the problem of delayed intervention is magnified. * Measurement of restructuring success: RAS also cause problems inasmuch as they are used in measuring the success of ARCO restructurings (i.e., profitability). The banks that are currently shown by ARCO to be profitable may still be in financial trouble. * Restructuring of banks in bankruptcy: ARCO's involvement in some instances has come so late that the banks were already involved in bankruptcy proceedings. Restructuring efforts in these cases amounted primarily to compromises of creditor claims in lieu of liquidation, wherein creditors, including depositors, were obliged to take pro rata, reduced payment on their claims rather than receive full cash payment. Though restructuring of debt can be one element in a viable restructuring plan, it is not-alone-sufficient as a total restructuring plan. ARCO is entitled, pursuant to legislation, to employ a number of tools in restructur- ing a bank, including amicable settlements. However, it is not clear that such settlements were effectively or equitably employed in these cases. * Deposit insurance: ARCO provides deposit insurance for accounts at some of the banks that it is restructuring and this coverage has been extended to continue for an initial peri- od of 18 months after ARCO has privatized the banks concerned, which may serve as a precedent encouraging other, non-ARCO banks to demand similar deposit insurance. This insurance is being developed in an ad hoc manner and does not take into account regula- tory and supervision issues relating to the banking sector as a whole. There is significant potential that initiation of this deposit insurance coverage will set a bad precedent; provi- sion of deposit insurance in Russia should await improvement in the climate of supervi- sion and financial reporting (see the discussion of deposit insurance in Chapter 10). * Bank privatizations: ARCO undertook the privatization of several banks in 2001, but the procedure used for these privatizations unduly narrowed the range of strategic investors participating in the sales and did not provide for adequate review of purchaser qualifica- tions. As a result there is a risk that privatization will simply return ownership to the types of investor likely to mismanage a bank. The authorities should consider measures de- signed to strengthen the governance of restructured, potentially viable banks currently ad- ministered by ARCO. One possibility might be to create a state trust operated under the governance of respected and independent individuals to assume, for a specified period, stewardship of the remaining (and any future) ARCO banks. Stimulating Lending to the Private Sector Due to lack of trust in financial intermediaries and to the small size of the Russian banking and capital markets, Russian enterprises have very little access to financing from the formal financial sector. This problem was even more acute prior to the 1998 financial crisis, when the incentive for banks to lend to unrelated third parties was limited; less risky returns were possible by lending to related parties and by investing in government AN OVERVIEW 35 treasury bills (GKOs) and foreign exchange products. Although the in- centive structure for the banks changed following the 1998 crisis, there is still a shortfall in lending by banks and other financial intermediaries, such as leasing companies, to unrelated third parties, and especially to the small and medium-size enterprise (SME) sector. The SME sector is nor- mally the locomotive for broad-based and sustainable growth in transi- tion economies. As illustrated in Box 1.7, a significant contributor to this problem is the lack of a sufficient legal framework for the enforcement of creditor rights. Thus only a narrow segment of large, usually raw material-producing and exporting enterprises has relatively easy access to formal bank and capital market financing. Many enterprises continue to rely on payment and tax arrears as their predominant source of financing. Veksels also provide some short-term financing for large- enterprises and banks. Re- liance on these informal financing tools has, however, declined since the late 1990s in response to improved corporate profits resulting from the ruble devaluation and higher prices for raw materials, as well as the im- position of harder budget constraints by producers of public utilities. Box 1.7 Overcoming Constraints on Lending to the SME Sector Given the unwillingness of banks to lend to the SME sector and the crucial role of SMEs as the engine of sustainable growth in transition economies, experience with credit lines to support this sector opened by the European Bank for Reconstruction and Development and the World Bank is pertinent. Experience with these credit lines has demonstrated that high collection rates can be maintained, provided that they include tested credit enhancement safeguards as an integral part of their closely monitored administration, including the following: * Undertaking extended pre-lending due diligence to ensure proposal soundness and ex- plore such factors as the true (rather than nominee) ownership of the borrower, in order to minimize connected- or related-party lending * Exploring, through careful monitoring of cash flows, the borrower's commitment and abil- ity to repay loans * Insisting on cash-generating assets as collateral and ensuring that collateral is adequately documented and properly assigned * Locking in the cash flow of borrowers and their affiliates for debt repayment through the pledges and guarantees of managers and related companies. Experience shows that such safeguards can provide protection even in an environment in which repossessing and foreclosing on collateral is time-consuming and notoriously unreli- able, in part as a result of asset-stripping, and where little reliance can be placed on bankrupt- cy proceedings to provide fair or expeditious protection of creditor claims. However, while these measures help protect creditors and support credit availability, they reflect underlying lack of trust and weaknesses in the infrastructure for bank lending. The need for such safe- guards significantly limits the expansion of credit and increases its cost. 36 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR These factors have resulted in greater cash payment for goods and serv- ices. If, however, these structural improvements are to be sustained it will be crucial to supplement implementation of the banking reform agenda with measures designed to facilitate the access of enterprises to capital market financing. (Chapter 13 discusses the role of alternative, nonfor- mal financing instruments for the enterprise sector and hindrances to en- terprise access to finance.) Strengthening the Foundations for Capital Market Development Capital market infrastructure. While the fundamental market infra- structure (including trading systems, security registers and depositories, and several exchanges) is in place and has been strengthened in recent years, the capital markets in Russia are still in their infancy. Stock ex- change capitalization and turnover are still very small, even in compari- son with other emerging markets. A number of factors are at play in seriously constraining the develop- ment of the capital market. One of the more significant problems relates to corporate governance. Past experience in the Russian investment arena has left many investors wary-the result of poor regard for minor- ity shareholder rights, lack of transparency in company financial deal- ings and ownership structures, management conflicts of interest, and sur- reptitious corporate asset shifting by management. The problem is compounded by the lack of a viable judicial forum for enforcement of rights due to inefficiencies in the judicial system, which have been noted in relation to other aspects of the Russian financial system. Investors are reluctant to participate in a system that has historically proven to be a trap for the unwary, and so Russian capital markets are stunted because of the lack of trust reposed in them. Another area in which trust is key is that of capital markets. supervi- sion. A considerable amount of securities legislation and regulation is al- ready in place, although its effectiveness is weakened by the fact that it is spread throughout a number of laws and can consequently suffer from lack of clarity and consistency. This also impedes enforcement efforts as the lines of demarcation between supervisory authorities tends to blur, re- sulting in poor coordination of supervisory efforts. Enforcement is also hampered by the lack of familiarity of the judiciary with the body of se- curities legislation, as well as securities and financial principles in general. Capital markets supervisors are hampered by poor reporting on the part of capital market participants; and for the data that they do possess, they are in need of improved systems for its efficient quantitative analysis. AN OVERVIEW 37 There is also a need for further improvement of analytical, as opposed to formalist, approaches to regulation in general. Added to this is the chron- ic underfunding of the regulatory agencies. Another issue related to trust in capital markets is that a well- functioning capital market depends on a well-functioning banking sys- tem to act as a sound temporary depository of funds, as a custodian for securities, and as the mechanism for ensuring timely and secure payment for, and settlement of, security transactions. The Russian capital market does not have a well-functioning banking system on which it can rely. Development of the equity and corporate bond markets in Russia also depends on the development of a well-functioning government debt mar- ket. Broader development of capital market instruments and institutions depends on market confidence in the good credit standing of the govern- ment. Related to this is the adoption of sound debt management practices by the government. This has consequences not only in terms of the gov- ernment's absolute and continued commitment to honoring its own obli- gations in a reliable and timely fashion, but in preventing undue recourse to government-issued debt, the yield of which can be greatly inflated in re- sponse to crisis borrowing. Development of a sound government debt market also has the benefit of providing the marketplace with a risk-free benchmark asset against which to measure a spectrum of higher-yielding corporate instruments, thereby assisting in the development of the market for these instruments. A well functioning government securities market is an essential first step toward developing a capital market where in- vestors-be they banks, retail, or institutional investors-can both as- sume and diversify risks. Development of institutional investors, such as the insurance industry, mutual funds, and a system of nonstate, mandatory "second-pillar" pen- sion funds, is also critical for the success of a capital market. Their devel- opment depends on the existence of a market with a sufficiently large and diversified number of reliable investments in which to place the accumu- lating funds. Without reform of the enabling environment for capital mar- ket activity, premature establishment of such investor institutions would most likely result in either downward pressure on yields, as fund managers pursue a similar, scarce supply of investment instruments, or the assump- tion of undue risks by fund managers. In addition, to encourage expansion of the institutional investment industry, it is necessary to develop collective investment institutions and the components of a market-based infrastruc- ture, including securities rating agencies. And, again, it is critical that the interests of small minority investors (as administered by pension funds) are protected in a manner that encourages the development of confidence in 38 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR investing in the capital market. Given the social importance of institution- al investors-for example, in securing an income in old age-there is con- siderable risk that underperformance by the investment fund industry would result in demands for compensation and thus a fiscal liability for the government. Given the amount of work required to establish a banking system in Russia, much less a capital market, it might be concluded that Russia would be best advised to abandon its attempts to develop a domestic capital market and to rely instead on the efficient and cost-effective pro- vision of capital market services from abroad. This might be seen as par- ticularly feasible in light of the ease with which international financial transactions can be made via the Internet. However, while certain major Russian enterprises already raise capital on the international market, it would not be practical to require all Russian-based capital markets transactions to be carried out abroad. To require enterprises seeking cap- ital market financing to adhere to the legal and regulatory requirements of foreign markets would pose an insurmountable burden for all but the largest Russian enterprises. In addition, if capital market transactions were predominantly foreign-based, all foreign currency controls would need to be dismantled. Additionally, Russian savings-particularly pen- sion savings-for the most part would have to be invested abroad, sub- jecting Russian savers to additional costs and risks from foreign currency exchange. Clearly, facilitating access to finance and developing domestic investment vehicles must depend on the development of the domestic capital market. Reforming the government debt market. The importance of a trusted government debt market in providing a benchmark for the pricing and trading of other security market instruments and a safe investment for bank excess liquidity and institutional investors cannot be overem- phasized. Three years after the government's default on its liabilities in 1998, confidence in Russian sovereign debt issues remains low. Although there has been considerable improvement in the Federation's fiscal situation and in reducing reliance on budget funding by debt issuance, very little progress has been made in addressing the structural issues related to the government debt market. Addressing these structural weaknesses is cru- cial both to support the development of financial markets and to enable Russia to cover its future funding needs at a reasonable cost. Many of the needed measures can be regarded as good housekeeping measures and are under the direct purview of the government; they are essential to efficient AN OVERVIEW 39 debt management and to the process of re-instilling trust. These measures include the following: 1. Developing and announcing a clear debt management strategy based on consolidated management of the Russian Federation's domestic and external debt 2. Installing risk-management and information systems to facilitate the measurement and management of the consolidated debt, including forecasting and funding related to treasury cash management 3. Identifying and empowering a single unit to manage the consoli- dated domestic and foreign debt according to guidelines agreed upon periodically with the government 4. Establishing transparent debt issuance policies and communica- tion channels with market participants concerning Russia's debt management policies. Although the Ministry of Finance has received technical assistance in the area of debt management for a number of years, the government has preserved a shroud of nontransparency in its debt management practices, thus seriously hampering the process of developing Russian financial markets. The corporate governance agenda. If financial markets are to play any significant role in supporting enterprise financing and sustained growth in Russia, it will be crucial to establish that the rights of majority share- holders and larger creditors do not have preference over the rights of the minority investor. This is as important to the process of instilling trust in the financial system as protecting the primary status of the claims of re- tail depositors in bank failures. There are signs that this corporate gover- nance problem is being recognized, but much more needs to be done to support the enforcement of improved practices. Important amendments to the Joint Stock Company Law and the Securities Market Law that ad- dress a number of corporate governance lapses have been enacted, and various initiatives to improve company governance, such as the intro- duction of a code of corporate conduct for company directors, are being supported by the Federal Securities Commission. The priorities related to improving corporate governance-which apply to both enterprises and financial intermediaries such as banks-in- clude the need to ensure transparency in ownership and control struc- tures and to improve the quality of financial information available to company stakeholders, as follows: 1. Information should be regularly recorded in a publicly available registry for all listed companies as regards company charters, lists 40 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR of shareholders, company directors, debt issues, and assets used as collateral. Disclosure of both direct and indirect ownership should be mandatory for shareholdings over a minimum size (say, 5 or 10 percent of a company) and the Federal Securities Commission should be empowered to identify entities lying beyond nominee owners and trusts, whether onshore or offshore. The public should be given access to this information and disclosure should be man- dated by law. 2. Measures should be taken to improve the quality of financial in- formation. The authorities should make the immediate adoption of International Accounting Standards obligatory for all publicly traded companies and banks, and-as officially announced by the government-obligatory by 2004 for all large and medium-size enterprises. 3. Other measures include strengthening the roles and responsibilities of boards of directors, encouraging the creation of audit commit- tees (within boards of directors), increasing the liability of audi- tors, and strengthening the ability of the Federal Securities Com- mission to apply sanctions. Supervision and enforcement. While future amendments to the Joint Stock Company Law and the Securities Market Law will need to be con- sidered by the Duma, the more pressing concern is the enforcement rather than the amendment of the law. The focus should therefore be on instilling trust in the marketplace by minimizing the abuse of existing laws and ensuring the effective punishment of abuses. Several reform areas require attention: 1. Judicial reform. An important measure for improving the enforce- ment of the law would be the establishment and empowerment of an independent arbitration court to adjudicate capital markets disputes and to strengthen sanctions to ensure the enforcement of court judgments. Any inadequacies in the current legal system with regard to enforcement of the law will need to be identified and addressed. 2. Coordination among regulatory agencies. Law enforcement also depends on improved supervision of the market by the regulatory agencies and better coordination among those agencies. The differ- ent parts of the Russian capital market are supervised by different government agencies, including the Federal Securities Commission, the Ministry of Finance, the Ministry of Social Protection, the Min- istry of Anti-Monopoly Policy, and the Central Bank. Enforcement AN OVERVIEW 41 actions also require coordination with the courts and the police. Given the weak capacity of the agencies and a history of competi- tion among certain agencies, there is an urgent need to improve cooperation. Where there is overlapping authority or the potential for the fragmentation of authority, one regulator should explicitly be given lead authority. 3. Public administration reform. Improved regulation depends on public administration reform. Regulatory agencies need to be pro- vided with a secure funding base, need to be able to pay market- based salaries to retain qualified staff, and must be made account- able for regulatory failures. 4. Information requirements. The Federal Securities Commission has embarked on a program of installing new computer systems to improve its market surveillance capacity. While the installation of new information technology (IT) systems will assist the Com- mission in collecting information and will support the introduc- tion of improved enforcement practices, the successful implemen- tation of new enforcement practices will depend crucially on a shift in the focus of supervision from compliance-based obser- vance of norms to supervision based on the assessment of materi- al risks. This will strengthen the role of supervision in protecting investors and containing systemic risks. The success of the Com- mission's IT project thus depends on simultaneous reform of its business practices as market supervisor. Prior to the designing of software for the new IT system, a review of current reporting standards should be undertaken to determine the extent to which they provide adequate information or are in need of revision. In addition, generated reports need to be systematized so that they provide automatic alerts and differentiate between material and immaterial abuses. 5. Redefining the role of capital markets supervision. In redefining the role of the Federal Securities Commission as securities market supervisor and ensuring that market participants observe best practices, the Federal Commission has embarked on the process of undertaking a self-assessment of observance with the principles promulgated by the International Organization of Securities Commissions (IOSCO). The principles provide guidelines for pro- tecting investors; ensuring fair, efficient, and transparent markets; and reducing systemic risks. They thus provide an excellent benchmark for measuring current capacity and future develop- mental requirements. 42 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR (Further discussion of the issues related to development of the capital market is to be found in Chapter 14.) CONCLUSION The task of building trust in the Russian financial system is a difficult and complex one, which involves the interaction of many variables and play- ers in the financial, governmental, and judicial sectors. This chapter has provided an overview of the extent of the problem and identified the gen- eral directions in which reform efforts should be made. The ensuing chap- ters in this book provide in much greater detail a diagnosis of the prob- lems of the financial sector and proposals for measures to address them. Although there are crucial differences in some key areas-such as in the role envisaged for state banks, the measures for consolidating the banking system, and the introduction of deposit insurance-much that has been recommended in this book corresponds to the broad objectives set by the Russian government and the Central Bank of Russia in their joint banking strategy paper, summarized in Box 1.8. It is hoped that this book will be utilized to further develop the strategy for the development of the finan- cial sector, and that the recommendations for implementation of the re- form process contained herein will provide guidance for further action. The sequencing of reform. Financial systems are complex. Hence defining and sequencing the reform process is by nature difficult. Some sequencing and prioritization of the process is nonetheless necessary in order to provide focus for the reform effort and to measure progress. The key function of financial systems in providing services is to process infor- mation about third parties, be they payment agents, depositors, lenders, or borrowers. Depending on the sophistication of the financial service being provided, the demands placed on the service provider in processing information will differ. As a rule, shorter-term financial instruments re- quire less sophistication in forecasting financing costs and investment outcomes than do longer-term instruments. This approach is illustrated in Figure 1.1 below. In the figure, the vertical axis measures the key function of the finan- cial system-i.e., its capacity to intermediate information among borrow- ers and lenders. Developing this capacity requires commitment by the au- thorities and market participants over a number of years. As this capacity gradually develops, participants will gain trust in financial markets and be encouraged to develop the technical and institutional knowledge to AN OVERVIEW 43 Box 1.8 Summary of the Joint GovernmentlCBR Program for the Development of the Russian Banking System Objectives: Establish a competitive banking system based on international best practices to improve stability and preclude systemic crises, improve the intermediation of savings, strengthen confidence, limit unfair commercial practices, and provide quality services con- ducive to economic development. The key areas of focus are outlined below. Time frame: Approximately 5 years. I. Increase Competition Issues: Restrictions on, and political interference in, bank activities. Lack of a level playing field between state banks and private banks, and domestic and foreign banks. Solutions proposed: Improve supervision and implement without discrimination-Develop legislation in line with international norms. Bring role of external audit in line with international practices, Simplify but strengthen quality of risk assessment, with greater focus on the quality of intrabank man- agement and internal control. Regulatory bodies to be vigilant against political pressure and the influence of large economic entities on banking activities. Greatertransparency-Adoption of international standards of accounting and consolidated re- porting requirements. Requirement to publish balance sheets and financial statements on quarterly basis. Develop, assess, and publish macro-prudential indicators. State participation--Government to divest stakes in banks where it holds less than 25 percent of shares and to raise efficiency in its participation in those lending institutions where it will re- tain ownership. Activities of specialized state banks, such as the Russian Development Bank and Rosselkhozbank to be constrained to their area of specialization. Enhanced control of Sberbank's activities to carried out by the bank's Supervisory Council. The CBR to initiate di- vestiture of its share in Vneshtorgbank by end-2002. The government intends to separate Vnesheconombank into a debt-servicing agency and a bank. Structure of the banking system-Gradually increase the level of required minimum capital (to EU minimum level of 5 million ECU for all banks by 2007). The role of banks with foreign cap- ital to increase following easing of any constraints on access. Issue [limited] licenses for enti- ties attracting and investing only enterprise funds. Create conditions for expanding banking activities to regions. Deposit insurance6-Phased introduction envisaged-voluntary in the first instance and oblig- atory only after the introduction of IAS in 2004. Sberbank to participate on special terms. Legislation-Strengthen investor rights. Level playing field between domestic and foreign credit organizations, and bank and nonbank sectors. Clarify foreign exchange regulation and control. Step up implementation of anti-monopoly regulation. II. Improve Intermediation and Efficiency Issues: A general lack of confidence in the banking system stemming from high credit risk due to lack of reforms and transparency of enterprises, high liquidity risk due to mismatch of asset-liability structure, weak legislative protection of creditor and lender rights, low capital- ization, lack of liquid financial instruments, poor risk management, and high operational costs. (Box continues on next page) 44 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 1.8 (continued) Solutions proposed: Attract deposits-Introduce deposit insurance. Foster greater transparency about the financial condition and ownership of banks. Improve management and reduce financial crime and crim- inal activities by approving a law on money laundering. Reduce credit risk-Banks to better manage and control risks by closely tracking financial conditions of borrowers, including through credit bureaus. Develop quasi-banks, with limited licenses, to take corporate deposits and lend to corporations. Improve transparency of enter- prises, including through reporting on IAS basis. Protect creditors' rights. Reduce liquidity risk-Enhance bank liquidity management through better monitoring and di- versification of risks, wider range of refinancing instruments, ensuring adequate provisions against losses, and legislative changes. Develop domestic capital markets, including the is- suance of mortgage securities. Reduce costs-Improve taxation system by allowing exclusion from tax base of all reserves against risks generated by standard legal bank operations and transactions, revaluation gains/losses, costs of mergers/acquisitions, capital expenditures, and so forth. Ill. Strengthen Financial System Stability Issues: Poor supervision and regulation, poor and inefficient risk management and internal audit practices, a low level of capitalization, nontransparent property structure, and a lack of sophisticated technology. Solutions proposed: Strengthen regulation-Simplify and tighten licensing procedures. Develop fit and proper cri- teria for managers, large shareholders, and chief accountants of credit organizations. Raise penalties for noncompliance. Strengthen liquidation procedures-Complete restructuring or liquidation of bankrupt banks following an improvement in the procedures for bank restructuring. Reduce scope for asset stripping by making managers and founders more accountable for actions leading to bank- ruptcy, banning transactions and intensifying monitoring by temporary administrator after li- censes revoked. Improve payments system-Expand scope for noncash settlement and ensure effective and reliable service. Introduce a real time gross settlements system for large, urgent, high- priority payments generated by interbank and securities markets. Strengthen corporate management-Strengthen internal control and risk management on both an individual and a consolidated basis. Increase professional skills and level of ethical standards of management, associates, and founders. process more sophisticated products (as reflected on the horizontal axis). Russia should be regarded as still being in the first phase of developing its financial system. According to this financial development framework, Russia will need to develop sound, deep, and liquid markets for shorter- term instruments before it is able to develop a meaningful and reliable AN OVERVIEW 45 Figure 1.1. Sequencing of Financial Sector Reforms High E0) Fntermediate Pae 5 Frs Pase Low _________________________ "ot 0/,L market for more sophisticated financial products with less well-defined income flows. Reform of the Russian banking system is an essential first step in permitting full and effective development of the financial system. The scope of possible reform actions required to deepen and broaden the Russian financial system is quite extensive, as evidenced by those meas- ures described earlier in this chapter (and elaborated further in the subse- quent chapters of this book). Priority measures for financial reform. Many aspects of financial sec- tor reform are for the longer-term, such as improvement of the judicial system. But there is also a substantial existing framework on which to build, and improvement can be realized, provided there is sufficient re- solve on the part of the authorities to the agenda outlined in this book. Though reform of the Russian financial sector will be a sizable task, a number of measures-outlined in Box 1.9-can be made immediately. It is clear that the current state of the Russian financial sector is hampering the advancement of the development of the Russian economy as a whole. The constraint of a weak financial sector will become more and more ev- ident as the real economy tries to revive. In comparison to the develop- ment of many other aspects of the Russian economy, the financial sector 46 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR has seriously lagged behind. Further delay will not only impede the fur- ther development of the economy as a whole; it may undermine the progress that has been made since the 1998 crisis. While enactment of these measures will provide a sound basis for the first phase of reforms and prepare the Russian financial system for the subsequent phases of reform, there are no quick-fixes. Financial sector reform depends on institutional development both within the sector as it Box 1.9 Priority Trust-Building Measures Legal and Accounting Infrastructures * Introduce International Accounting and Auditing Standards and enhanced disclosure for banks and enterprises, especially as regards ownership * Establish enterprise credit reporting system * Establish centralized registration for movable collateral * Streamline procedures for foreclosure on movable collateral Banking System Structure and Performance * Insist on transparency and improve corporate governance of state/CBR-owned banks * Complete strategic review of Sberbank * Limit the expansion of corporate lending by state banks * Desist from providing new capital support to public banks * Insist that state-owned banks work toward market-responsive pricing in the provision of services/loans Regulation and Restructuring of Banks * Through improved effectiveness of CBR banking supervision, encourage consolidation of the banking system * Raise minimum capital requirements for banking license * Replace banking license with finance company license for any institutions not actively so- liciting deposits from the public * Enhance administrative processes in bank liquidation * Strengthen requirements as to the integrity and accountability of bank management and shareholders/controllers * Develop on-site supervisory capacity and demonstrate willingness to take timely correc- tive actions * Strengthen bank management and financial condition as well as banking supervision as a precondition to the introduction of any general deposit insurance system Financing Enterprises * Establish consolidated management of all sovereign debt * Introduce full and timely public disclosure of government liabilities and planned debt issuance * Establish public registry of information on all listed enterprises * Undertake public administration reform designed to support coordination among financial sector supervisors and ensure well-qualified staffing AN OVERVIEW 47 relates to banks, investment houses, security dealers, and so forth; devel- opment of strong government administration in supervision of the sec- tor; and development of a sound legal and judicial system. As pursuit of these institutional goals will take time, success in development of the fi- nancial sector will be a measured process and should be assessed against reasonable goals. Establishing trust will depend on learning from and adopting the lessons of experience. One of the greatest threats to this process may prove to be the expectation that development of the finan- cial system can move by leaps and bounds. The danger is that exaggerat- ed expectations may lead to disappointments and postpone the process of building trust. PART I LEGAL AND ACCOUNTING INFRASTRUCTURES uilding a financial system depends on providing the institutional B infrastructure to support transactions among unrelated third par- ties. Unless this basic infrastructure is in place, and enforcement has been well-tested and proven to be reliable, there will be no founda- tion on which to build trust in the financial system. Thus, if the role of fi- nancial intermediaries to provide finance to the private sector is to be en- hanced, the protection offered creditors will need to be strengthened considerably. Three areas of critical importance for the development of this institu- tional infrastructure-the building blocks of financial sector develop- ment-are the subject of Part I. They relate to improving creditor rights, strengthening enterprise insolvency practices, and reforming the disclo- sure and accounting practices for banks and enterprises. Reforms in these areas will provide crucial support for building trust in financial in- termediation between unrelated third parties-be it on the part of banks or bond-holders as secured creditors in enterprises, or minority share- holders investing in enterprise equity. Chapter 2 focuses on the strengthening of creditor rights. The pre- dictable, swift, and inexpensive enforcement of secured creditor claims is important for facilitating lending decisions, instilling market discipline, and thereby reducing borrowing costs. Chapter 2 provides recommenda- tions in the areas of improving the enforcement of creditor claims, strengthening the standing of secured creditors, and introducing registra- tion systems for collateral on movable property and credit-history reporting. 49 While protection of creditor rights provides a vehicle for resolving dis- putes between creditors and debtors, insolvency procedures offer a means of collective resolution of claims when enterprise viability is threatened. An effective insolvency process supports the financial re- structuring of viable enterprises, the orderly exit of failed enterprises, and the improvement of debt collection mechanisms for creditors. Chap- ter 3 outlines a number of implementation problems related to current insolvency practices. There is a need to strengthen the qualifications of the judiciary and judicial practices, to increase the involvement of credi- tors in the insolvency process, and to remove impediments to rehabilita- tion of enterprises through corporate workouts. An overarching theme of this book is that building trust in financial transactions among unrelated third parties depends on improving trans- parency and disclosure. The provision of reliable and timely information on the governance and financial situation of enterprises and banks is cru- cial to building financial intermediation in market economies. As out- lined in Chapter 4, disclosure and transparency would be considerably enhanced by the adoption of International Accounting and Auditing Standards. The adoption of these international standards would, howev- er, require careful planning as well as a concerted effort to ensure their implementation. This implementation involves the support of the regula- tory authorities, enterprise and bank stakeholders, and the auditing and accounting professions. CHAPTER 2 Creditor Rights INTRODUCTION On January 1, 1995, with Part I of its new Civil Code in place,' the Russ- ian Federation took an important step toward providing the necessary legal foundation for its newly emerging market economy. On March 1, 1996, Part II of the Civil Code took effect. These measures together marked a turning point in the development of Russian civil law. They also represented a significant departure from old Soviet civil law,2 which had been more concerned with the implementation of state plans rather than with contracts (Vitrianskii 1994, 6:649) and the relationships be- tween state enterprises and other economic units directed by the central economic planning authorities (Vitrianskii 1994, 6:237, fn. 4). Under the Soviet system, there were only two types of debtors: private citizens and entities participating in the centrally planned economy- mainly state enterprises and collective farms (Vitrianskii 1994, 6:242, fn. 4). Ensuring the performance of obligations and the related provision of priorities in favor of certain creditors over others were matters that were neither necessary nor particularly relevant in the context of a command and control economy. As a result, Russian civil law as it then existed was largely undeveloped. In a modern market economy, however, the implementation of the rule of law, including honoring the law established between contracting parties pursuant to the terms of the contracts that they freely conclude, is paramount. Equally vital are the means to enforce these contractual 51 52 BuILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR arrangements and the ability of creditors to efficiently and predictably execute any collateral security given in support of such arrangements, and to be preferred recipients on the proceeds of realization in accor- dance with their priority ranking. The justification is purely economic: the provision of collateral securi- ty, combined with an efficient debt enforcement system, reduces credit risk, which in turn leads to more favorable financing conditions (the "price effect") and/or broader or deeper access to credit markets (the "quantity effect") (BIS 2001, 19). The increase in the supply of credit in turn contributes to greater capital investment and increased productivity, and it facilitates nonbank financial intermediation. Reduced dependence on bank credit in turn lessens the potential impact of a banking crisis on the real economy (and thus on overall macroeconomic performance), and enhances the stability of the entire financial system, rendering it bet- ter able to withstand external shocks (Working Group on International Financial Crises 1998).3 A reduction in credit risk is theoretically achieved as a result of three factors (BIS 2001, 18). First, collateral security reduces the possible loss in the event of debtor default, by an amount equal to the liquidation value of the collateral. Second, collateral security reduces the likelihood of default: the giving of collateral should reduce the possibility that the debtor, despite the ability to do so, will arbitrarily delay or refuse to dis- charge its obligation ("moral hazard"), and should give the debtor an in- centive to incur a lower level of risk than would otherwise be the case (the "incentive effect"). Third, in theory, collateral requirements enable debtors to signal their creditworthiness and therefore overcome prob- lems of asymmetric information that would otherwise result in their ac- cess to credit being rationed (the "signaling effect"). In sum, therefore, collateral security, combined with an effective and efficient debt enforcement and insolvency system, instills financial disci- pline in market participants in the commercial and corporate sectors, re- sulting in greater trust and greater efficiencies in the market itself. In addition to legal research concerning creditor rights and collateral security in the Russian Federation and elsewhere, this chapter draws on two weeks of intensive consultations with local and foreign commercial banks, state-owned banks, the Regional Banks Association, local and for- eign business lawyers, members of the judiciary, academics, accountants, multilateral development banks, and nongovernmental organizations. CREDITOR RiGHTs 53 THE FRAMEWORK FOR SECURED TRANSACTIONS This chapter is generally limited to the treatment under Russian law of creditor rights4 and collateral security in movable, as opposed to immov- able,S property. (The consultations in fact established that banks may take immovable property as collateral security for loans.,) One of the key objectives of interviewing the many groups and indi- viduals involved with creditor rights and collateral security was to deter- mine the principal constraints in the current legal framework, if any, that prevent or discourage lenders from providing small and medium-size en- terprises with access to external financing. In this regard, apart from the high cost of notarial fees-which were the object of frequent complaints as constituting a disincentive to the use of mortgages and enterprise charges, and of concerns expressed over the timing of the passage of the new Land Code-no other material concerns were raised specifically re- lated to the treatment of creditor rights or collateral security in respect to immovable property. The same cannot be said for movable property. A number of issues common to both movable property and immovable property, particular- ly related to the enforcement of collateral security, were mentioned time and time again. In light of these results, and given the widespread attention by policy- makers at the international, regional, and national levels and by multi- lateral development banks and nongovernmental organizations in the area of collateral security over movable property, this chapter and the policy recommendations that it contains focus primarily on issues related to movable property. The Principal Elements of Reform Ahead of the other countries of Central and Eastern Europe and the Commonwealth of Independent States, the Russian Federation began its reform of collateral security laws in 1992 with the adoption of Federal Law No. 2872-1 On Pledge (Pledge Law). The Pledge Law (as amend- ed)7 was complemented by the introduction in 1995 of Part I of the Civil Code, more particularly Chapter 23 (articles 329-381) on "Securing Per- formance of Obligations," which includes articles 334-358 on the con- tract of pledge. The adoption in 1998 of Federal Law No. 102-FZ On Mortgage (Pledge of Immovables) (Mortgage Law) supplemented the few rules on 54 BUILDING TRUST: DEVELOPING THE RUSSiAN FINANCIAL SECTOR mortgages contained in the Civil Code and introduced detailed provi- sions governing the procedure to mortgage immovable property. The provisions of the Mortgage Law prevail over any inconsistent provisions of the Civil Code or the Pledge Law. A recent presidential decree on mortgages (Mortgage Decree) further provides for the establishment of a single state register of proprietary rights and immovable property trans- actions at the federal level (Zerev 1998, 296). Types of Collateral Security Available In addition to addressing pledge and mortgage, the Civil Code sets out in article 329 various means to secure the performance of obligations. These are penalty, suretyship (third person guarantee), earnest money (deposit), the retention of property (withholding), and the bank guaranty,8 the latter two of which had been introduced with the adoption of the Civil Code. This list is not exhaustive, however, and article 329 CC expressly ac- knowledges that the fulfillment of obligations may be contractually se- cured by means other than those contemplated by the Civil Code.9 Of the foregoing, only the contract of pledge creates a charge over movable property. Hence, the following analysis will limit itself to the provisions governing pledge. Positive features of pledge under Russian law are summarized in Box 2.1. Principal Shortcomings of the Framework for Secured Transactions Given the breadth of the law that the Civil Code covers and the exten- siveness of its provisions, the Drafting Committee of the Civil Code achieved a remarkable accomplishment. The committee only began its work in earnest in the spring of 1992; Part I was adopted by the State Duma in October 1994 and Part II just 15 months later. When viewed, for example, through the prism of the International Bank for Reconstruction and Development's (IBRD) Principles and Guidelines or the EBRD's Core Principles,10 however, certain shortcomings of the framework for secured transactions under Russian law become apparent. The ruble crisis of August 1998 has served to heighten some of the is- sues that have emerged as a result of these shortcomings, and it has re- vealed the relative immaturity of the Russian credit culture, both in re- spect to debtors and to creditors. And yet, perhaps ironically, anecdotal evidence obtained from many of the financial institutions confirms that, in addition to its deleterious effects, the crisis appears to have had a bene- ficial effect,"' at least insofar as the credit culture of financial institutions CREDITOR RIGHTS 55 Box 2.1 Positive Features of Pledge under Russian Law Positive features of the contract of pledge under Russian law include: * Available collateral. Virtually any property may be the object of pledge, including movable property, immovable property, property rights (including rights under contracts), and ne- gotiable instruments (including promissory notes or veksels) and shares (art. 336 CC; art. 338 [41 CC). Exceptions and restrictions include certain national assets, licenses (includ- ing licenses to explore or extract natural resources), and personal rights. * Available collateral-Goods in circulation (inventory). While remaining in possession, a pledgor may grant a pledge of its inventory of supplies, raw materials, semifinished goods, and finished goods (art. 357 CC; art. 341 [2] CC; art. 338 11] CC). The goods become sub- ject to the pledge as soon as they are acquired by the pledgor and cease to be pledged when they are sold to a purchaser (art. 357 [2] CC). * Available collateral-Enterprise. An enterprise (defined as a property system used for the conduct of entrepreneurial activity-a business, in other words) can be pledged (mort- gaged) either as a whole or in part only (art. 132 [2] CC). The enterprise can include land. buildings, equipment, inventory, materials, products, claims, debts, intellectual property, and other exclusive rights, unless otherwise provided by statute or contract (art. 132 [3] CC). Among other advantages (including, particularly, the right of the creditor to sell the enterprise or business as a going concern, subject to arts. 349-350 CC), an enterprise charge allows greater operational flexibility to sell or retire machinery or equipment and place into use new machinery or equipment without requiring a new charge or an amend- ment to the mortgage documents. * Available collateral-Future acquired property. Property not yet owned, but that the pled- gor will acquire in the future, may be pledged (art. 340 16] CC; art. 341 [2] CC). * Parties. Both individuals and legal entities may grant and receive pledges. In addition, both debtors and third parties (e.g., sureties [guarantors]) may secure their obligations using a pledge (art. 335 CC). * Possessory v. nonpossessory. Both possessory and nonpossessory pledges are recog- nized under the Civil Code (art. 338 CC; art. 343 [1] CC). * Secured debt. There does not appear to be any restriction on the type of obligation that can be secured by a pledge (art. 334 [1] CC; art. 4 [1] Pledge Law). * Scope. Unless the contract otherwise provides, the pledge will extend to the full amount of the claim at the time of satisfaction, including the principal amount of the underlying obli- gation, interest, damages for delay or nonperformance, and maintenance and enforcement costs and expenses (art. 337 CC). * Proprietary right The pledge will remain in effect notwithstanding the sale or other dispo- sition of the pledged property by the pledgor (right in rem: art. 353 [1 ] CC; also art. 347 [11 CC). * Claim for deficiency. The creditor will retain a (unsecured) claim against the remaining property of the debtor in Ihe event that the proceeds of realization of the pledged property are insufficient to satisfy the obligations secured under the pledge (art. 350 [51 CC). operating within the Russian Federation is concerned. Prior to extending a credit, greater emphasis apparently is being placed on a thorough and careful analysis of a debtor's financial condition.'2 Greater care is also being taken in the preparation of collateral securi- ty documentation, and an awareness seems to be taking root that the 56 BUILDING TRUST: DEVELOPING THE RuSSIAN FINANCIAL SECTOR mere fact of having taken collateral security in respect to a credit can in no way dispense with the need for close monitoring and supervision by a financial institution of the financial health and general business condi- tion of a debtor over the life of a credit that it has provided. While in the short term this may result in a general tightening of the supply of credit, particularly for small and medium-size enterprises (SMEs), which al- ready have had to contend with a dearth of credit to support their oper- ations,"3 in the long term this can only be a positive factor for the Russ- ian economy as a whole. Small business lending can be conducted successfully in the Russian Federation;14 however, this has less to do with the framework for credi- tor rights and collateral security (and the related insolvency system) than it does with the establishment, and the steadfast and methodical imple- mentation, of internal methods and systems. These methods include a considerable up-front investment in training (primarily lending officers and, to a lesser extent, back office staff) and the establishment of a cli- mate of trust between lender and borrower, built on a thorough investi- gation of a potential borrower's actual (as opposed to official'5) financial condition and the gradual ramping up of available credit over time. However, though small business lending can in fact be conducted suc- cessfully in Russia, this is in spite of, rather than as a result of, the exist- ing framework for enforcement of creditor rights. The scope of such suc- cess will remain limited because the self-protection efforts required of lenders are considerably greater than would be necessary in an environ- ment with a well-functioning regime of creditor rights laws. Lenders are required to make greater-perhaps excessive-scrutiny of their borrow- ers' circumstances because there is no dependable framework for en- forcement of their rights in the event of a borrower default. This situa- tion continues to hamper the development of SME lending in Russia. Although there has been significant reform in the development of the laws themselves, numerous problems exist in the implementation of those laws and in the procedures used for enforcement of creditor rights. These problems are discussed in detail below. ENFORCEMENT MECHANISMS In efficient and well-functioning systems of secured transactions, lenders or creditor-sellers can seize and sell collateral rapidly. This is crucial in the case of movable property: many types of inventory perish rapidly, ei- ther through spoilage or through becoming obsolete; the collection of CREDITOR RIGHTS 57 accounts receivable becomes increasingly unlikely beyond 30-45 days from the date of their origin; and machinery typically depreciates more rapidly than real estate. All factors potentially can cause a substantial reduction in the liquidation value of the collateral. Enforcement problems are not only severe (in practice, court proce- dures are generally too slow, expensive, and uncertain); they also serve as a significant constraint on the supply and availability of credit"6 and they are the single greatest concern of the lenders that were canvassed. There is therefore a pressing need to address this issue in a satisfactory manner if lenders' trust is to be restored in the system of enforcement of collater- al security. Unless otherwise stipulated in a pledge agreement (art. 349 [2] CC), Russian law does not provide pledge creditors with nonjudicial self-help remedies over movable property following a debtor's default. Rather, en- forcement of a pledge (levy of execution) must begin with the institution of court or arbitral proceedings. Thereafter, and regardless of whether prior resort to a court or arbitral panel has been effected for purposes of enforcement, the pledged movable property is necessarily17 realized through sale at public auction (arts. 349-350 and 447-449 CC) con- ducted by a specialized organization and appointed by a court bailiff. Anecdotal evidence indicates that these enforcement and realization proceedings are often the object of interlocutory (interim) motions and appeals brought by debtors (frequently, it appears, for dilatory purposes) that result in considerable additional delay to the ultimate disposition of the proceedings,"8 that increase cost and expense, and that add substan- tial uncertainty to their outcome.19 As a result, when considering a deci- sion to provide credit, a creditor must generally expect a lengthy and ex- pensive judicial proceeding prior to realizing on the property pledged to secure repayment of the credit. Lenders' trust in the system of enforcement is also negatively influ- enced by the following factors: 1. Postponement of public auction. Upon application of the pledgor, a court may postpone by up to one year the public auction sale of the pledged property (art. 350 [2] CC). No criteria are established to guide the court in the exercise of its discretion, and these appli- cations are apparently granted systematically. Such delay would be likely to have a material adverse effect on the creditor's ability to obtain market value for the pledged property. 2. Court establishment of public auction sales price. The initial bid price at the public auction is determined by the court (art. 350 [3] CC). There is no compelling reason to believe that a court would 58 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR be in a better position than a creditor-pledgee to determine the market value for the pledged property at the date of auction. In ad- dition, the setting of the initial bid price is both relevant and mate- rial to a creditor as it can influence directly the outcome of the auc- tion process: set too high and the creditor may not receive any bids for the asset, thus frustrating the realization process; set too low and, in the absence of sufficiently interested parties at the auction to bid the price up, the asset may be sold at an undervalue, again negating the utility of the auction process for the creditor. 3. Treatment of security upon liquidation or bankruptcy. Although a validly constituted pledge is effective upon the liquidation of the pledgor and in bankruptcy proceedings relating to the pledgor, se- cured creditors lose their proprietary (in rem) rights against the pledged assets. Instead, they are provided with the priority given by law to creditors whose claims are secured by a pledge. This does not mean that their claims will be satisfied directly from the value of the particular property that had been pledged in their favor. Rather, such pledged property is grouped together with all the other assets of the pledgor, which are sold, and the claims of all the creditors, both secured and unsecured, will be satisfied from the aggregate proceeds of sale, in the order of priority estab- lished by law. If the claims of all the creditors of a particular rank exceed the amount of the proceeds of sale available to satisfy their claims, all their claims will be prorated, regardless of whether any particular creditor had enjoyed collateral security in the pledged property that had been primary or subsequent vis-a-vis other creditors.20 In sum, therefore, this system results not only in the loss for the secured creditor of its right to exercise its security, but also the loss of its right of first priority (subject to other collateral security) in the pledged property ahead of all other creditors. In practice, this also means that it is more important for a creditor to ensure that the nature of its claim is one secured by a pledge of the debtor's property-any property-than it is for the creditor to be con- cerned with the quality, or the leveraged value, of such property; or in- deed, whether the pledged property previously had been pledged by the debtor in favor of one or more other creditors (i.e., whether its pledge was first-in-time).2' While such a system may have the advantage of at least being internally consistent with one that does not require the regis- tration of a nonpossessory pledge of movable property (see below), it certainly runs counter to generally recognized principles of prudent lend- ing and secured lending orthodoxy. CREDITOR RIGHTS 59 1. Inconsistent treatment of priority of pledgeholders' claims. Under Russian law, the precise ranking of the preference that a claim se- cured by a pledge will enjoy by virtue of article 334 (1) of the Civil Code in the proceeds of realization of the pledged property will depend upon whether the claim is enforced outside of the pledgor's insolvency or bankruptcy, in the context of a liquida- tion of the pledgor, or in bankruptcy proceedings relating to the pledgor. * If the pledge is enforced in the ordinary course of the pledgor's business, then such enforcement can only take place if the value of the pledgor's other (unencumbered) property is insufficient to satisfy the full amount of the claim of the pledgee and the claim of any other enforcing creditors.22 Assuming this is the case, a pledgeholder's claim will rank after the payment in full of the following four prior claims:23 (1) claims for alimony, and (tort) claims of individuals for loss of life and harm to health; (2) em- ployment-related wage claims, legal costs incurred in connec- tion with wage claims, and royalties for the use of intellectual property; (3) claims related to the payment of pension, social in- surance, and unemployment contributions; and (4) all claims of the state budget (i.e., taxes) other than those provided in (3). Only if there are surplus proceeds after the payment of all of these prior claims will the pledgee be able to realize any value from its pledge. If, on the other hand, the surplus is insufficient to discharge all other claims that are enforced at the same time, then all of these claims will be prorated. * If the pledge is enforced in a liquidation of the pledgor, a pledgeholder's claim will only rank after the payment of the following two claims:24 (1) (tort) claims of individuals for harm to health or life; and (2) employment and work-related sever- ance and wage claims, as well as claims under publishing con- tracts. However, the pledgeholder's claim will rank ahead of claims for social contributions and taxes and ahead of the claims of other (unsecured) creditors. * If the pledge is enforced in bankruptcy proceedings relating to the pledgor, the same order of priority as that applicable in liq- uidation proceedings will apply, except that a superpriority is added for the repayment of bankruptcy administration-related fees, expenses, and claims.25 The above priority scheme raises several issues. First, from a policy perspective, it seems inconsistent and hard to justify that the 60 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR claim of a secured creditor should rank after claims for social con- tributions and taxes if enforcement takes place during the ordinary course of the pledgor's business but not if enforcement occurs in the context of the pledgor's liquidation or bankruptcy. Expressed differently, it is difficult to understand why the Government would be prepared to rank after secured creditors when a pledgor is ei- ther in liquidation or bankrupt, but not so during usual circum- stances. A consistent approach should be taken in all circum- stances, preferably with as few claims as possible ranking ahead of those of secured creditors. Second, the current approach introduces a significant element of uncertainty into the enforcement process and therefore into the original credit decision-making process, since the position of a se- cured creditor relative to other claimants (particularly the Gov- ernment) cannot be known at the outset and will vary as a direct function of the timing of enforcement. In the cases of liquidation and bankruptcy, this may be something over which any particular secured creditor has little or no control. Third, it is important to note that each of the priorities that rank ahead of a secured creditor is uncapped. This is particularly noteworthy since arrears of taxes and salaries are generally high in Russian companies and there are no means available to credi- tors to determine quickly and reliably at any time the outstanding amount of any of these prior claims. Also, given the absence of a filing system for security interests in movable property, the Gov- ernment is not required to file its claim covering unpaid social contributions and taxes following a taxpayer's default, which would at least provide notice of these claims. Fourth, the superpriority provided for the repayment of bank- ruptcy administration-related fees and expenses is particularly problematic from a secured creditor's perspective, since the se- cured creditor is required to submit its claim in the pledgor's bankruptcy proceedings. If a secured creditor could enforce its claims independently of such proceedings, it could avoid these claims, which can be quite substantial. In the final analysis, secured creditors cannot be certain whether they will be able to rely on their security, and, if they can, to what extent it will reduce their risk of loss in the event of a debtor's de- fault. The result of this priority scheme is that creditors reduce the amount of credit they are prepared to make available, and they re- quire overcollateralization for the credit that they do advance. CREDITOR RIGHTS 61 2. Efficiency of court bailiffs. Several reports called into question the efficacy with which the court bailiff service discharged its respon- sibilities pursuant to the Enforcement Law to execute judgments. Judgments not uncommonly failed to be executed. Although de- tails are limited, it seems that the situations that were mentioned arose as a result of undue influence, the lack of effective enforce- ment mechanisms, a lack of experience with enforcement pro- ceedings generally, and inadequate training. Further complicating factors are that court bailiffs are not required to search for a debtor's assets, and that the costs associated with any searches that may be conducted must be met by the creditor. Possible Solutions There are several broad options, including the following, that could be considered by the authorities. 1. Introduce more expeditious procedures for the prompt enforce- ment of pledge. The authorities could accelerate the levying of ex- ecution by introducing procedures that would not require judicial intervention. Procedures that could be considered include simple repossession, administrative repossession, and receivership. Sum- mary procedures for court-approved seizures would also acceler- ate enforcement, as would restrictions on the right to file inter- locutory motions and appeals, unless it could be established that a judgment was manifestly wrong. The grounds to lodge interlocu- tory motions and to file appeals should otherwise be narrowed to very limited and specific grounds, and appealing interlocutory de- cisions should not suspend their execution. Any contract that would purport to waive these provisions would be void as con- trary to public policy. The right of a pledgor to seek postpone- ment of a public auction sale should be abolished, or the law should provide clearly defined and narrow grounds upon which a court could exercise its discretion to grant such a request. Suitable amendments could be introduced to the Civil Code or to the Law on Enforcement Procedure. 2. Allow creditors to control the sale of pledged property. Generally speaking, Russian law makes no provision for private sale, where- in a creditor, without further recourse to a court, could dispose of the pledged movable property provided by the debtor. All realiza- tions take place by means of court-authorized sale at public auc- tion, which involves substantial costs and delays. To address this, 62 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR new rules for creditor-controlled sale of collateral could be con- templated. These rules would apply uniformly to all creditors, and judicial intervention during the process would be minimal. Should judicial issues arise, the law would maximize the value of movable property as collateral by postponing their resolution until after the collateral has been sold and the creditor has been paid. The main revisions to provisions on private sale should ensure that * The debtor receives the maximum sale price from the sale of the collateral. . The debtor receives any surplus remaining after the creditor has been paid. * The law maximizes scope for private action and minimizes court intervention. * The procedure has broad application to all secured transactions. A creditor-administered sale lowers the cost of collection to the creditor. This is because the creditor is paid first, without his claim being offset by the other claims on the collateral that usual- ly arise in a court-administered sale. Moreover, the sale can occur when the creditor desires, without expensive delays. The policy framework for these rules should balance a debtor's rights to due process against the need for expeditious foreclosure. To protect debtors against unfair disposition of the pledged prop- erty, a standard of commercial reasonableness should be enacted to which secured creditors would be held. For example, this stan- dard would require a creditor to sell goods in the customary man- ner for dealers in that type of goods. Delay in the disposition of perishable collateral, or of goods likely to reduce in value rapidly, may constitute failure to act in a commercially reasonable man- ner, and the creditor would lose any rights to collect a deficiency if the sale did not in such circumstances cover the creditor's claim. The law would also require creditors to notify debtors and jun- ior secured creditors before any resale of the collateral. The law must always provide the debtor with a redemption period during which the pledged property can be reclaimed following payment of the debt or other discharge of the secured obligation. The law should void any stipulation allowing the debtor to waive its right to redeem the collateral before foreclosure. The debtor should also be allowed to recover damages arising from any wrongful seizure, including cases where the debtor actually did not default or where the creditor in fact did not have a valid pledge of the seized property. CREDITOR RIGHTS 63 Once the secured creditor recovers the pledged property, the creditor should be allowed to retain it in satisfaction of the se- cured debt (strict foreclosure). As a policy matter, the law may provide that the parties may not agree to strict foreclosure in ad- vance of a debtor's default and after notice. 3. Permit a secured creditor to continue to exercise its proprietary (in rem) rights in an insolvency or bankruptcy. The loss by a cred- itor of its ability to exercise its security at this time strips the pledge of its value at precisely the time when it is most required by a creditor. 4. Provide a consistent regime for the priority of claims across all stages of a debtor's business cycle (ordinary course of business; liquidation; bankruptcy). This would eliminate a significant ele- ment of uncertainty in the enforcement process. 5. Enforce the rank of priority of collateral security and avoid the distribution of proceeds of realization of the pledgor's property without regard to the primacy of the security held by the pledgees. The pooling of the proceeds of realization of a pledgor's property and their pro rata distribution among unsecured and secured creditors is inconsistent with provisions of the Civil Code that es- tablish the preference of claims secured by pledge. 6. Consider the merits of introducing a requirement for legal enter- prises and entrepreneurs to take out and maintain private third- party liability insurance against (tort) claims of individuals for loss of life and harm to health caused by their activities in lieu of the existing priority for such claims. A requirement of this nature would be more efficient from an economic point of view than the current system, which effectively shifts the liability for damaging behavior from the party responsible for such damage (the legal enterprise, its officers and shareholders, or the individual entre- preneur) to the creditors of such party. Enterprises and entrepre- neurs engaged in risky activities are more likely to cause harm or damage and will correspondingly be required to pay higher insur- ance premiums. In order to avoid paying these higher premiums, they would have the option to either discontinue these practices or amend them. 7. Following a careful analysis of the most effective manner to value and resolve all currently outstanding employment and wage-related claims and, once done, settling such claims, also consider the merits of enacting a first-priority ranking enterprise charge equal to unsat- isfied employment and wage-related claims of employees and 64 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR workers, up to an agreed maximum (e.g., three months' arrears), subject to the usual perfection and registration requirements of en- terprise charges.26 Employees and occasional workers of failing en- terprises who are not paid their due are unwilling creditors. In tran- sition economies in particular, they may have limited alternative employment options to pursue. When wage arrears become signifi- cant, they can effectively become economic captives of their em- ployer, as leaving to seek work with another would likely result in their assuming a total loss in terms of their unpaid wages. To com- pound matters further, employees and occasional workers usually have little, if any, access to information regarding their employer's financial condition or business prospects. As a result, they can un- wittingly fall victim to unscrupulous owners and managers. A registered, first-ranking enterprise charge would protect the legitimate interests of employees and occasional workers. It would also provide the means for prospective secured creditors to assess the impact of unpaid wages on the creditworthiness of the enterprise. Employees' and occasional workers' claims would no longer be a drain on the collateral security system and their trust in the marketplace would be significantly enhanced. INFORMATION MECHANISMS The ability for a creditor to have at its ready disposal complete, reliable, and up-to-date information upon which it can rely in order to reach an informed decision whether to provide credit to an individual or to a legal entity in support of a proposed transaction or other economic activity and, if so, on what terms and conditions, is a vital and necessary condi- tion for the prudent and efficient operation of a modern financial system and a modern market economy. Without access to reliable information on the financial condition of a debtor, a creditor is unable to properly as- sess the credit risk that it would assume in the context of the proposed debtor or transaction. Armed with the necessary information, however, creditors are able to perform the credit and other analyses that are required in the circum- stances. Riskier debtors or transactions may still be able to obtain credit, but generally will obtain less credit, will pay more for the credit that they are offered, and will be required to pay it back sooner; the credit itself will be subject to more stringent conditions. Creditworthy debtors, on the other hand, generally will be rewarded with a greater amount of CREDITOR RIGHTS 65 credit, will pay a correspondingly lower rate of interest, and will be able to pay it back over a longer period; the credit also will be subject to more liberal conditions. In other words, the reduction of informational asym- metry allows the financial system to operate more efficiently. In the absence of reliable financial information in respect to a debtor, and assuming a creditor is prepared to provide some credit, that creditor is likely to do one or more of the following in order to limit its exposure both to the debtor and to a proposed transaction: (a) reduce the amount of the credit (to limit its downside risk); (b) increase the rate of interest (to reflect the heightened risk); (c) shorten the term of the credit (to in- crease the rate at which repayments are made and to reduce the time dur- ing which the creditor will be exposed); and (d) as a percentage of the credit that it is prepared to advance, require an increase in the aggregate value of the collateral property to be provided by the debtor to secure re- payment of the credit (to decrease its loss in the event of a default). Any of these steps, if taken individually, or all of them if applied to- gether, would not only significantly increase the economic impact of the credit upon the debtor, but would also correspondingly either increase the cost or reduce the return of the underlying transaction supported by the credit. That is assuming, of course, that the debtor is able to assume the credit on these terms; i.e., that it can both afford to service such a debt and to provide the greater amount of collateral required by the creditor. While the Civil Code requires that a pledge of immovable property, the pledge of an agreement which itself must be registered, and the pledge of an enterprise (which by virtue of article 132 CC is deemed to be an immovable) are all to be registered, no such requirement is provid- ed in respect to nonpossessory pledges of movable property.27 In most jurisdictions, pledge agreements that stipulate that the debtor will be dispossessed of the pledged property are not required to be regis- tered, since it is felt that the creditor's possession provides sufficient no- tice; however, the generally prevailing view among jurists and legal com- mentators is that such mechanisms should not be encouraged, as they prevent the debtor from using the collateral while the credit is outstand- ing, thus preventing its use for productive purposes. The only means of publicity that is required for nonpossessory pledges of movable property is their manual entry in a pledge record book, which must be maintained by a pledgor if it is either a company or a nat- ural person registered as an entrepreneur.28 It is not apparent that any penalties are contemplated if a pledgor fails to keep faithful records in its pledge record book, or if it fails to permit the inspection of the record book by any interested party (a frequent occurrence). 66 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Not surprisingly, the consultations provided repeated examples of ma- nipulation and fraud of the pledge record book system. Such abuse al- legedly occurs most commonly at times of a pledgor's financial distress, and typically takes the form either of the addition of creditors not previ- ously known to have provided credit (and, on closer inspection, which are frequently determined not to be at arm's length with the pledgor), or the deletion of prior entries that had been properly made, or both. Allowing a debtor to have control over the only available means of publicity of collateral security interests in its movable property results in a serious moral hazard, particularly since the current scheme of claim priorities benefits those that have obtained the status of pledge-creditors. This is not a system designed to inspire trust among creditors. This is a crucial flaw in the framework for creditor rights and secured transac- tions, and together with the resolution of the enforcement-related issues previously discussed should be addressed by the Government as a matter of priority. The Russian Federation has never had a credit reporting system, whether operated by private companies on a for-profit basis; by financial institutions themselves on a proportional-usage, cost-recovery basis (or some other formula); or otherwise. The collection of and easy access to reliable and transparent credit information on commercial and corporate enterprises29 are vitally important, as they provide crucial information upon which creditors can, in part, safely base their credit decisions. If Russia were to institute such a credit reporting system, appropriate safe- guards would need to be implemented in parallel to protect the legitimate interests of debtors. For example, the functions of credit bureaus and the standards to be applied by them in their operations, debtors' rights to privacy and access to their credit files, issues regarding the accuracy of information and the debtor's right to correct errors, and time limits for keeping information on file would all need to be addressed. Possible Solutions The following are some possible solutions to the problems surrounding information mechanisms. 1. Replace the pledge record book system with a first-in-time priority system based on registration in a public registry and amend the current scheme of claim priorities to provide for priority among se- cured creditors based on the new system. The necessary first step in providing for a public registration system involves enacting pri- ority rules that grant a rank of priority to the first to register. Then CREDITOR RIGHTS 67 and only then is it sensible to invest in modernizing the function of registries. The new provisions should be contained in an amend- ment to the Civil Code. 2. Undertake an economic and technical evaluation of and subse- quently.establish a computerized system for the public registra- tion of collateral security in movable property that would give creditors an easy and inexpensive way to publicly assert the exis- tence of collateral security granted in their favor. Establishing a public registration system for collateral security in movable prop- erty would require an economic and technical evaluation of the many options. Should public or private parties operate the reg- istries? Should multiple registries exist and compete? How should registries structure registration fees? What technical configuration would they need? What is the least information to register that would balance privacy rights, economic usefulness, and public ac- cess? What cost-saving designs, if any, should be considered, in- cluding, for example, making use of any existing infrastructure es- tablished for the registration of other information?30 These and other related issues should be addressed in separate studies. 3. Conduct studies for terms of reference, draft rules, and introduce legislation for the establishment and operation of credit bureaus. A framework for the operation of credit bureaus could be insti- tuted separately from other reforms. Corresponding banking and other financial regulation must proceed in parallel with credit bu- reau legislation. Regulations must require that banks and other credit providers supply regular credit reports in respect to their account debtors to the entity or entities that will operate the cred- it bureaus. OTHER OBSTACLES RELATED TO THE USE OF PLEDGED ASSETS Pledge of Bank Accounts/Rights Russian law presents obstacles to the pledge of a debtor's bank ac- counts-a common form of collateral security taken in international practice. The principal difficulty results from the requirement previously noted under Russian law that pledged property or rights are to be sold at public auction if the pledge is to be enforced. A decision of the Russian Supreme Arbitration Court in 1996 concluded that rubles cannot be sold 68 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR at auction and, therefore, cannot be pledged. In 1998 there was a further ruling that money in a bank account is not a "res" and cannot be the subject of a pledge. At law, the relationship between a bank and a depos- itor is one of debtor and creditor, the depositor having a right to claim back from the bank the money it deposited. As Russian law allows the pledge of rights, legal practitioners have begun to use a pledge of the right to claim money deposited in a bank account. The practice has not been tested before the courts, however, and is accordingly uncertain. An alternative approach relies on the assignment of a right to a claim, which is recognized by Russian law, but for reasons previously discussed, an as- signment of the bank account may not enjoy the same priority that is af- forded to a pledge. One solution to this problem is to amend the Civil Code to provide for the pledge of rights under a bank account and realization by means of an assignment of the pledged rights by the secured creditor to a third party. Another solution is to amend the priorities established under article 78 (2) Enforcement Procedure Law (for "ordinary" enforcement), article 64 (1) CC (in the event of liquidation), and article 106 (2) Bankruptcy Law (in the context of bankruptcy) to include security by way of assignment. Notarization Fee A mortgage of immovable property and a pledge (mortgage) of an enter- prise (which is deemed to be an immovable for the purposes of Russian law) require notarization, which attracts a fee of 1.5 percent of the value of the underlying transaction disclosed in the relevant document (which fee is payable to the notary, not to the public purse). This can represent a significant sum of money and serves as a disincentive to the use of these forms of security. Although untested before the courts, as Russian law does not stipulate that such notarization must take place in the Russian Federation or before a duly qualified Russian notary, a practice has devel- oped in some cases to sign and notarize the mortgage agreement abroad. To solve this problem, the Civil Code could be amended to eliminate the requirement for notarization of mortgages and enterprise charges, and thus render the treatment of these transactions consistent with that for the sale of immovable property.3" Approval of Material Transactions Under Russian law,32 a transaction involving a sale or other disposal of assets whose value exceeds 25 percent of the value of the company's total CREDITOR RIGHTS 69 assets requires prior approval by the board of directors or at a general meeting of shareholders. There is apparently a fairly widespread practice among companies to intentionally understate the book value of their as- sets for official purposes in order to reduce tax payables. Since many businesses in the Russian Federation are established as companies, this requirement for approval is frequently applicable. In practice, however, few companies fulfill the requirement, with the result that a great num- ber of transactions are at risk of invalidation at the behest either of the company or of any of its shareholders (participants). Actions to invali- date such transactions are regularly instituted before the courts, particu- larly when a company is in difficult financial circumstances. In addition, the Supreme Arbitration Court has rendered an opinion33 subjecting the conclusion of loan agreements to this requirement and, as a matter of practice, courts subsequently have extended this to the granting of col- lateral security. While there can be little argument that a substantial sale of a compa- ny's assets (presumably outside its normal course of business) warrants Board approval or approval of its shareholders at a general meeting, such requirements essentially address governance issues internal to the company, for the protection of its members. However, it should not be open to a company that has, wittingly or otherwise, failed to follow these requirements to raise such failure itself in an attempt to defeat a valid claim of a third party with whom the company has dealt and who has no knowledge of the failure. To provide otherwise legitimizes an inequitable trap for the unwary. It was precisely to avoid situations such as these that English corpo- rate law over a hundred years ago adopted the so-called "indoor man- agement rule" in order to safeguard the interests of innocent third parties against attempts by owners of companies that a particular transaction was beyond its authority and hence null (the ultra vires doctrine). Under the indoor management rule, unless a company can establish that a person dealing with a company or who has acquired rights from a company had actual knowledge, or by virtue of its position with or rela- tionship to the company ought to have had knowledge, that the compa- ny had failed to comply with the terms of its charter documents, the company cannot assert such failure against that person. The indoor management rule has been enshrined in many corporate statutes around the world and frequently expanded to include protection against other corporate acts or omissions.34 To the extent that the Civil Code, the Law on Joint Stock Companies, or the Law on Limited Liability Companies does not already make 70 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR provisions for analogous safeguards, Russia could consider adopting measures at law similar to the indoor management rule for the protection of third parties. ANNEX 2.1. CREDITOR RIGHTS: THE INTERNATIONAL EXPERIENCE International Bank for Reconstruction and Development The International Bank for Reconstruction and Development (World Bank), as part of its financial sector and private sector development ef- forts, has conducted economic and sector work and has financed a num- ber of projects to reform secured transactions laws.35'36 Other such proj- ects are underway or planned in a number of its member countries. For example, the World Bank published a comprehensive report in De- cember 1994 analyzing the shortcomings of the Bolivian system of collat- eral security laws and their effect on access to credit in that country, and formulated a number of specific recommendations for reform (World Bank 1994). A similar report was published in June 1997 in respect to Pe- ruvian secured transactions laws (World Bank 1997) (see Box 2.2). In March 2001, the Board of Executive Directors of the World Bank approved the Principles and Guidelines for Effective Insolvency and Creditor Rights Systems,37 an important milestone in promoting interna- tional consensus on a uniform framework to assess the effectiveness of insolvency and creditor rights systems, offering guidance to policymak- ers on the policy choices needed to strengthen them. The principles set forth in the Principles and Guidelines were devel- oped against the backdrop of earlier and ongoing initiatives to promote cross-border cooperation on multijurisdictional insolvencies, the mod- ernization of national insolvency and secured transactions laws, and the development of principles for out-of-court corporate workouts. The principles draw on common themes and policy choices of those initia- tives and on the views of staff, insolvency experts, and participants in re- gional workshops sponsored by the World Bank and its partner organi- zations (see Box 2.3).38 The consultative process used on the Principles and Guidelines is among the most extensive of its kind, involving more than 70 interna- tional experts as members of the Bank's Task Force and working groups, and with regional participation by more than 700 public and private sec- tor specialists from approximately 75 mostly developing countries. The CREDITOR RIGHTS 71 Box 2.2 Recommendations for Expanding Access to Credit In no particular order, the following were among the legal reform recommendations formulat- ed by the World Bank in these various projects and reports to expand access to credit in the relevant member countries: * Allow all tangible and intangible movable property to serve as collateral in possessory and nonpossessory security interests, including fixtures, deposit accounts, and intellectual property; permit security interests to continue automatically in the proceeds of collateral; permit floating security interests by allowing a security agreement to "generally describe" the collateral; and increase the use of accounts receivable as collateral by avoiding notice- and-notarization requirements. * Improve the technical functioning of existing registries, through computerization and full public access. * Establish a central, computerized public registry for security interests in movable property that permits inexpensive and rapid registration of security interests, as well as information retrieval. * Abandon requirements for notarization of documents or the delivery of certificates or other supporting documents. * Use standard forms and model contracts for commonly registered documents. * Bypass slow procedures for obtaining judgment and permit nonjudicial self-help to repos- sess collateral upon default in order to provide secured creditors with an expeditious way to enforce collection. Appropriate safeguards should include monetary damages for wrongful repossession, including repossession cases where the debtor actually did not default or where the creditor in fact had no security interest in the repossessed property. * Permit creditor-controlled sale of collateral, whether by public sale (for example, an auc- tion arranged by the secured creditor, not by the court) or by private sale, subject to a re- quirement that the sale take place in a commercially reasonable manner. * Following repossession, allow a secured creditor to keep the collateral in satisfaction of the secured debt (strict foreclosure), possibly subject to notice requirements or prohibi- tions where, prior to default, a debtor has repaid a minimum percentage of the original se- cured debt. * Establish a credit reporting system that pools information about commercial or corporate debtors. World Bank also included papers and consultative drafts on its website to obtain feedback from the international community. European Bank for Reconstruction and Development Recognizing the importance of laws on secured transactions for business development and economic growth and their essential role in achieving successful reform to a market economy, in 1992 the European Bank for Reconstruction and Development established a Secured Transactions Project to encourage and assist the introduction of workable laws on se- cured transactions in the former socialist countries in central and eastern 72 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 2.3 Principles and Guidelines for Effective Insolvency and Creditor Rights Systems: Secured Transactions Recommendations (Extract) The following are the main recommendations contained in Principles and Guidelines for Effec- tive Insolvency and Creditor Rights Systems with regard to secured transactions systems (paragraphs 48-66): 1. The legal framework should provide for the creation, recognition, and enforcement of se- curity interests in movable and immovable (real) property, arising by agreement or opera- tion of law. 2. The legal regime should recognize security over all types of assets-movable and immov- able, tangible and intangible, including inventories, receivables, and proceeds. 3. Lenders should be able to take security interests in future property and on a global basis. 4. Security should be available for any or all of a debtor's obligations to a creditor, present or future, and between all types of persons. 5. The law should permit both possessory and nonpossessory security interests over tangi- ble assets. 6. Secured credit systems should encompass all types and uses of property, participants, and transactions. 7. Methods of notice should sufficiently publicize the existence of security interests to credi- tors, purchasers, and the public generally. 8. Creation of security interests should be easy and cost-effective. 9. A security system should set rules of priority on competing claims or interests in the same assets and minimize the number of priorities that come ahead of secured interests in col- lateral. 10. There should be an efficient and cost-effective means of publicizing secured interests in movable and immovable assets, with registration being the principal and strongly pre- ferred method. Access to the registry should be inexpensive and open to all for both recording and search. 11. Enforcement systems should provide efficient, inexpensive, transparent, and predictable methods for enforcing a security interest in property. Enforcement procedures should pro- vide for prompt realization of the rights obtained in secured assets, ensuring the maximum possible recovery of asset values based on market values. Europe (Simpson and Rover 1994). This was followed by the publication in 1994 of a Model Law on Secured Transactions (MLST).39 Since the publication of the MLST, the EBRD has supported many projects foster- ing legal transition in the field of secured credit (Simpson and Menze 2000). The principal objectives of the MLST were to harmonize the approach to security rights legislation among international investors and lenders and to provide guidance as to the expectations of those investors and lenders (EBRD 1994, App. I, v), with a view to assisting the subject countries in their transition from a planned to a market economy (Simp- son and Rover 1994). It was not intended that the MLST be adopted di- rectly into domestic law, but rather that it form a starting point for such legislation. CREDITOR RIGHTS 73 The MLST sought to produce a text compatible with the concepts of the civil laws that form the roots of the legal systems of many of the countries concerned (Ajani 1995, 97-99),40 while also drawing on com- mon law legal systems that have developed useful solutions to accommo- date modern financing techniques (Ajani 1995, 21, fn. 89).41 The MLST was prepared by a civil lawyer and a common lawyer assisted by an in- ternational advisory board drawn from 15 different jurisdictions. The MLST creates a single, consensual security right (a "charge") in respect to anything capable of being owned as collateral,42 including fu- ture assets, a changing pool of assets (including inventory), and all the assets of an enterprise ("enterprise charge"). The distinction between various traditional types of security devices, such as pledges of movables, pledges of rights, and mortgages, are merged into one charge. There is a distinction between registered charges, which have to be registered at a charges registry, and possessory charges, for which registration is not re- quired but according to which the secured creditor takes and must retain possession of the collateral. The MLST also provides for charges in favor of an unpaid vendor. A written document is required to create these charges. Priority is mainly determined in accordance with the time at which a charge was created (in the case of a registered charge, the time of registration; in the case of a possessory charge, the later of the time men- tioned in the written document or the delivery of possession; and in the case of an unpaid vendor's charge, the time at which title is transferred). Secured creditors are provided with broad self-help enforcement rights, including the right to sell the collateral without judicial intervention, subject to prior notice and damages in the event of wrongful or abusive enforcement. Special provisions are made for the realization of a charge that covers the entirety of an enterprise and that entitles the creditor to sell the enterprise as a going concern. Drawing on experience gained from its support since the inception of the Secured Transactions Project of secured transactions legal reform, the EBRD has published 10 core principles for a modern secured transac- tions law (see Box 2.4). The core principles reflect the provisions of the MLST and aim to give, in condensed form, a general formulation of the goals to be pursued and the principles to be applied if secured transac- tions reform is to foster economic development. They do not seek to im- pose any particular solution; rather, they seek to indicate the result that should be achieved (Simpson and Menze 2000, 25). The principles thus should aid the assessment of a country's secured transactions laws. Finally, the EBRD has recently published the results of a regional survey conducted by members of the Secured Transactions Project, the purpose of 74 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 2.4 EBRD Core Principles for a Modem Secured Transactions Law 1. Security should reduce the risk of giving credit, leading to an increased availability of cred- it on improved terms. 2. The law should enable the quick, cheap, and simple creation of a proprietary security right without depriving the person giving the security of the use of his assets. 3. If the secured debt is not paid, the holder of security should be able to have the charged assets realized and to have the proceeds applied toward satisfaction of his claim prior to other creditors. 4. Enforcement procedures should enable prompt realization at market value of the assets given as security. 5. The security right should continue to be effective and enforceable after the bankruptcy or insolvency of the person who has given it. 6. The costs of taking, maintaining, and enforcing security should be low. 7. Security should be available over all types of assets, to secure all types of debts, and be- tween all types of persons. 8. There should be an effective means of publicizing the existence of security rights. 9. The law should establish rules governing competing rights of persons holding security and other persons claiming rights in the assets given as security. 10. As far as possible the parties should be able to adapt security to the needs of their partic- ular transaction. which was to monitor and assess the state of collateral laws in the 26 member countries (Fairgrieve and Andenas 2000). Asian Development Bank In April 2000, the Office of the General Counsel of the Asian Develop- ment Bank (ADB) published the results of a joint session on secured transactions and insolvency law reforms. This session, which included participants from two symposia, was held in October 1999. In December 2000, the Office of the General Counsel published the re- sults of a survey of the legal framework for secured transactions laws in the People's Republic of China, India, Indonesia, Pakistan, and Thailand (ADB 2000b, 144). Its main conclusion is that the laws and legal processes in each of the five countries largely prevent debtors from using movable property as collateral that is acceptable to creditors. The legal regime for creating secu- rity with movable property is costly, complex, lengthy, and uncertain. Prob- lems arise at each stage, from creation to enforcement, in some cases in all countries and in others in a subset of countries (ADB 2000b, xiv, fn. 98). The result is that creditors and debtors pay a huge price in lost opportuni- ties from the inability to use movable property as collateral. The report sets out a baseline policy model for an economically use- ful framework favoring secured credit (ADB 2000b, 19, fn. 98).43 The CREDITOR RIGHTS 75 economic requirements for a regime with the single goal of promoting secured credit are (a) creation that is cheap, simple, comprehensive; (b) publicity that is public, inexpensive to file, easy to research; (c) priority based on a simple and unambiguous rule; and (d) enforcement that is fast and cheap. ENDNOTES 1. Ranking second only to the Constitution of the Russian Federation in terms of hierarchy of statutory instruments, the Civil Code is at times referred to as the "Constitution of the Economy"; vide A.L. Makovsky, "Preface to the English Translation of the Civil Code," The Civil Code of the Russian Federation, Parts I and II, Moscow, International Centre for Financial and Economic Develop- ment, 1997, p. 71. 2. For example, the Basic Provisions of civil law contained in Subdivision 1, Division 1 of the First Part (articles 1-16) "demonstrate the enormous distance between the present Code and its Soviet predecessor. Article 1 stipulates several principles which were explicitly rejected by Soviet law, such as the equality of all who participate in civil law relationships and the freedom of contract." - F.J.M. Feldbrugge, "The New Civil Code of the Russian Federation," 21 Review of Central and East European Law 1995 No. 3/4, 237-243 at p. 240. 3. In response to the Asian financial crisis, finance ministers and central bank governors from 22 systemically significant economies met in April 1998 to ex- amine issues related to strengthening the international financial architecture; the Working Group on International Financial Crises was one of three groups formed to study in greater depth certain key areas where it was felt action was needed. 4. As part of their framework of creditor rights, many jurisdictions have adopted legislation for the protection of consumers. Some have also adopted spe- cific legislation for certain economically significant sectors of their economies (e.g., forestry, agriculture). For the purposes of this report, neither have been in- vestigated in or considered for the Russian Federation. 5. For a general survey of the regulation of immovables under Russian law since the introduction of Part I of the Civil Code, see O.M. Kozyr, "The Legal Treatment of Immovables under the Civil Code of the Russian Federation," 44 McGill Law Journal 1999, 327. 6. When immovable property is taken as collateral security for a loan made to an enterprise, it is not uncommonly by way of pledge of a residential apart- ment owned by an individual, majority shareholder of the enterprise (to secure a surety provided by such individual in respect to repayment of the loan). It is not necessarily a pledge of the immovable property of the enterprise itself, although such pledges can be and are also taken. 76 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 7. The Pledge Law remains in effect to the extent that its provisions are not in- consistent with those of the Civil Code. In practice, only a few of its provisions continue in effect. However, there is considerable uncertainty among legal practi- tioners as to precisely which provisions of the Pledge Law continue to apply-a matter that needs to be addressed. 8. Modeled after the rules on demand guaranties established in 1992 by the International Chamber of Commerce, this is somewhat of a misnomer since it is available not only to banks but also to other credit institutions and insurance or- ganizations. 9. As to the principle of freedom of contract generally, see art. 1 CC and art. 421 CC. Nevertheless, and notwithstanding that parties to a contract may estab- lish other security mechanisms since the various provisions that establish the pri- orities of claims (i.e., art. 78 [2] Enforcement Procedure Law [for enforcement in the "ordinary course of business"]; art. 64 [1] CC [in the event of liquidation]; art. 106 [2] Bankruptcy Law [in the context of bankruptcy]) only refer to securi- ty by way of pledge, there remains considerable doubt among local legal practi- tioners and academics that participated in the consultations whether such mech- anisms would be effective under Russian law. 10. See Box 2.4. 11. If experience of credit institutions in developed financial markets can serve as a guide (at least in those markets where there is a degree of competition within the financial sector during "normal" periods), this is unlikely. In the after- math of a crisis, once an economy has stabilized and some measure of growth and competition has resumed, experience has shown that most institutions devel- op myopia and short-term memory loss, generally leading to an increase in cred- it supply and a relaxing of the terms upon which credit is available. 12. This takes place within the considerable constraints imposed on a system that is forced to operate within an environment offering a minimum of financial transparency, due not only to the failure to adopt international accounting stan- dards, but also apparently due to the incentive for enterprises to understate their assets as a result of taxation imposed on, among other things, fixed assets. 13. A fact that can only be attributed in part to the issues raised in this paper; other factors, of course, are at play, including the difficulty for Russian financial institutions themselves to raise capital and, prior to August 1998, their prefer- ence to invest in GKOs. 14. See Chapter 13. This conclusion was primarily drawn from interviews with the EBRD's Russia Small Business Fund and KMB Bank concerning their considerable experience in making loans to micro- and small enterprises across the Russian Federation, both pre- and post-August 1998. 15. The consultations confirmed an apparent practice among some borrowers to intentionally understate the fixed assets of their enterprises in order to avoid the payment of certain taxes. CREDITOR RIGHTS 77 16. The Russian Federation is not alone in this: enforcement emerges as the most intractable problem for the five Asian countries reviewed in the ADB's survey (ADB 2000b, 131). Similarly, in its regional survey of secured transactions laws (Fairgrieve and Andenas 2000, 28-36), EBRD concluded that lawyers and academics familiar with local pledge laws perceive the implementation of collateral laws "as the major impediment in all of the countries surveyed," reinforcing the need, in their opinion, "for governments in the region to give greater priority to ensuring that resources are made available so that modern pledge laws are made effective." 17. In light of art. 28 (2) Pledge Law that contemplates sales other than by public auction, and art. 350 (1) CC that contemplates procedures other than public auction sales if established by statute, there is some doubt as to the mandatory nature of realization through court-authorized public auction sale. However, Resolution No. 7965/95 of February 2, 1996 of the Supreme Arbitra- tion Court has established that parties to an agreement cannot avoid an auction procedure by providing otherwise contractually, a decision which seems at odds with art. 349 (2) CC. 18. Delays of 6 to 18 months are apparently not uncommon. 19. A distinction must be drawn here between the courts of general jurisdic- tion and the arbitration (commercial) courts. Disputes involving individuals not registered as individual entrepreneurs are resolved in the courts of general juris- diction, while economic disputes between legal entities are resolved in the arbi- tration courts. Although quite clearly neither a scientific sampling of users nor a precise examination of results obtained, participants in the consultations ex- pressed general dissatisfaction with the results of proceedings before the former (greater unpredictability of outcome; longer delays), and general satisfaction with the results of proceedings before the latter (greater uniformity among decisions rendered; shorter delays), although regional differences in both court systems were reported, which added to the unpredictability of outcome. 20. Art. 64 (3) CC; art. 114 (3) Federal Law No. 6-FZ of January 8, 1998 On Insolvency (Bankruptcy) (Bankruptcy Law). 21. Art. 342 contemplates the possibility of multiple pledges and establishes priority as a function of the time of creation of the pledge. 22. Art. 49 (1) Federal Law No. 119-FZ of July 21, 1997 On Enforcement Procedure (Enforcement Law). How a creditor is meant to be in a position to make this assessment is not clear, but the law would seem to require a valuation of the debtor's entire assets, which is not practical. 23. Art. 78 (2) Executive Procedure Law. 24. Art. 64 (1) CC. 25. Art. 106 Bankruptcy Law; including court costs, remuneration of the bankruptcy manager, current utility and operating expenses of the debtor, and the satisfaction of claims incurred after the commencement of the bankruptcy proceedings, which may well exceed the value of the bankrupt's estate. 78 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 26. Other than the application of the 1.5 percent notarial fee which, in any event, should be abolished in all circumstances. 27. Exceptions are also provided for pledges of aircraft, sea and river vessels, and other means of transport (art. 40 Pledge Law). 28. Art. 18 Pledge Law. 29. Including, for example, the amount and type of outstanding credit and other liabilities, the identification of the providers of credit, the payment per- formance record of the debtor, the existence and nature of any collateral security encumbering the assets of the debtor, and whether any collection actions have been brought against the debtor: when, for what amount, and with what result. 30. It would appear that there are systems currently in operation in the Russ- ian Federation for the registration, for example, of cars, weapons, etc. 31. Art. 550 CC. 32. Art. 78 Law on Joint Stock Companies; art. 46 Law on Limited Liability Companies. 33. Information Letter No. 62, dated March 13, 2001. 34. For example, against attempts to assert that a person held out by a com- pany as a director or officer of the company has not been duly appointed or has no authority to exercise the powers and perform the duties that are customary in the business of the company or usual for such director or officer. 35. See generally, United Nations Commission on International Trade Law, Report of the Secretary-General, April 27, 2000 (A/CN.9/475), Security Inter- ests: Current Activities and Possible Future Work, Thirty-third session, June 12-July 7, 2000, United Nations, New York, 2000, p. 18. 36. These include Argentina, Bangladesh, Bolivia, Bulgaria, Peru, and Uru- guay. See, generally: (1) H. Fleisig, "The Power of Collateral: How Problems in Securing Transactions Limit Private Credit for Movable Property," World Bank Viewpoint, Note 43, World Bank, Private Sector Development Department, Washington, D.C., April 1995; and (2) H. Fleisig, "The Right to Borrow: Legal and Regulatory Barriers that Limit Access to Credit by Small Firms and Busi- nesses," World Bank Viewpoint, Note 44, World Bank, Private Sector Develop- ment Department, Washington, D.C., April 1995. The teams that conducted the research for purposes of the Bolivian and Peruvian reports were led by Dr. Hey- wood Fleisig, director of research at the Center for the Economic Analysis of Law (CEAL), a nonprofit research institute that provides legal and economic analysis of public policy issues, and also included Prof. Ronald C.C. Cuming, College of Law, University of Saskatchewan (Canada), the chief architect of the Canadian PPSAs; see also: H. Fleisig, "Economic Functions of Security in a Mar- ket Economy," Emerging Financial Markets and Secured Transactions, J.J. Nor- ton and M. Andenas, editors, London, Kluwer Law International, 1998, chap. 3, pp. 15-38. 37. The paper can be accessed in the "Best Practice" directory on the Global Insolvency Law Database at http:/Hwww.worldbank.org/gild. CREDITOR RIGHTS 79 38. The Principles and Guidelines was prepared by World Bank staff in collab- oration with the African Development Bank, Asian Development Bank, European Bank for Reconstruction and Development, Inter-American Development Bank, International Finance Corporation, International Monetary Fund, Organization for Economic Cooperation and Development, United Nations Commission on International Trade Law, INSOL International, and International Bar Association (Committee J). 39. The MLST is available at http://www.ebrd.org/english/st.htm. 40. Although the substratum is primarily derived from Roman-Germanic law, the legal cultures of these countries were subject to continental influences (schol- arly and statutory) that were sometimes French, sometimes German, sometimes Italian and Austrian. 41. However, the MLST was most influenced by UCC Article 9. 42. It should be noted that article 2 MLST excludes charges by a natural per- son other than as part of his or her business activity, although the commentary to such article provides that nonbusiness activities could be covered if a jurisdiction has adequate consumer protection legislation. 43. This is based upon criteria set by J.A. Spanogle, Proposed Polish Charges Act (1992), cited in ADB 2000b. REFERENCES ADB (Asian Development Bank). 2000a. "The Need for an Integrated Approach to Secured Transactions and Insolvency Law Reforms." Law and Policy Re- form at the ADB Vol. I, 2000 Edition. At http://www.adb.org/Documents/ others/Law_ADB/lpr_2000-l.asp?p=lawdevt. 2000b. "Secured Transactions Law Reform in Asia: Unleashing the Potential of Collateral." Law and Policy Reform at the ADB Vol. II, 2000 Edition. At http://www.adb.org/Documents/others/Law_ADB/lpr_2000_2. asp?p=lawdevt. Ajani, G. 1995. "By Change and Prestige: Legal Transplants in Russia and East- ern Europe." The American Journal of Comparative Law 43: 93-117. BIS (Bank for International Settlements). 2001. Collateral in Wholesale Financial Markets: Recent Trends, Risk Management and Market Dynamics, Washing- ton, D.C. EBRD (European Bank for Reconstruction and Development). 1994. Model Law on Secured Transactions. At http://www.ebrd.org/english/st.htm. Fairgrieve, D., and M. Andenas. 2000. "Securing Progress in Collateral Law Re- form: The EBRD's Regional Survey of Secured Transaction Laws." EBRD, Law in Transition (Autumn 2000), Focus on Secured Transactions. London: EBRD. 80 BUILDfNG TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR Feldbrugge, EJ.M. 1995. "The New Civil Code of the Russian Federation." Re- view of Central and East European Law 21: 237-243. Fleisig, H. 1995a. "The Power of Collateral: How Problems in Securing Transac- tions Limit Private Credit for Movable Property." World Bank Viewpoint, Note 43. Washington, D.C. . 1995b. "The Right to Borrow: Legal and Regulatory Barriers that Limit Access to Credit by Small Firms and Businesses." World Bank View- point, Note 44. Washington, D.C. . 1998. "Economic Functions of Security in a Market Economy." In J.J. Norton and M. Andenas, eds., Emerging Financial Markets and Secured Transactions. London: Kluwer Law International. Kozyr, O.M. 1999. "The Legal Treatment of Immovables under the Civil Code of the Russian Federation." McGill Law Journal, 44: 327. Makovsky, A.L. 1997. "Preface to the English Translation of the Civil Code." The Civil Code of the Russian Federation, Parts 1 and 2. Moscow: Interna- tional Centre for Financial and Economic Development. Simpson, J., and J. Menze. 2000. "Ten Years of Secured Transaction Reform." EBRD, Law in Transition (Autumn 2000), Focus on Secured Transactions. London. Simpson, J.L. and J.-H. M. Rover. 1998. "General Principles of a Modern Secured Transactions Law." In J.J. Norton and M. Andenas, eds., Emerging Financial Markets and Secured Transactions. London: Kluwer Law International. . 1998. "EBRD Model Law on Secured Transactions. A Response to Comments by John A. Spanogle." (September). Washington, D.C.: World Bank. U.N. (United Nations). 2000. Security Interests: Current Activities and Possible Future Work. United Nations Commission on International Trade Law, Re- port of the Secretary-General (A/CN.9/475). New York: United Nations. Vitrianskii, V.V. 1994. "Contract as a Means for Regulating Market Relations: The Draft Civil Code (First Part) of the Russian Federation." 20 Review of Central and East European Law 6: 649-656. Working Group on International Financial Crises. 1998. Report. Submitted to Managing Director, IME (October 5, 1998). Washington, D.C. World Bank. 1994. "How Legal Restrictions on Collateral Limit Access to Cred- it in Bolivia." Report No. 13873-BO. Washington, D.C. . 1997. "Peru: How Problems in the Framework for Secured Transac- tions Limit Access to Credit." Report 15696-PE. Washington, D.C. . 2001. Principles and Guidelines for Effective Insolvency and Credi- tor Rights Systems. At http://www.worldbank.org/gild. CREDITOR RIGHTS 81 Zerev, A. 1998. "Security Issues under Russian Law." In J.J. Norton and M. An- denas, eds., Emerging Financial Markets and Secured Transactions. London: Kluwer Law International. CHAPTER 3 Framework for Corporate Insolvency THE ROLE AND FUNCTION OF INSOLVENCY SYSTEMS IN MARKET ECONOMIES Insolvency systems, like general systems for debt recovery and enforce- ment, stabilize commercial relationships by enabling market participants to more accurately price, manage, and control the risks of default and corporate failure. Where general enforcement systems (creditor rights) provide a vehicle for resolving individual disputes between creditors and debtors, insolvency procedures offer a means for collective resolutions when performance failures raise questions about an enterprise's viability. An insolvency system can therefore play a vital role in supporting com- mercial and market confidence and stabilizing the financial system, serv- ing as a disciplinary mechanism both for the financial and the corporate sector. An effective insolvency process encourages prudent lending and a sound credit culture by 1. Establishing a mechanism (such as rehabilitation) for the financial restructuring of firms whose going-concern value exceeds their liquidation value, thus preserving both value and employment. 2. Providing an orderly exit mechanism for failed enterprises, ending unproductive uses of business assets and transferring them to more efficient market participants (through liquidation). 3. Providing a final and equitable debt collection mechanism for creditors. 4. Improving the enforcement of creditor rights to expand credit flows. 83 84 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Insolvency systems stabilize commercial expectations and enable lenders to better manage financial risk. The evaluation of Russia's insol- vency systems cannot be separated from the assessment of the treatment of rights of debtors and creditors generally. Insolvency law affects parties and interests at every level of a society, in almost every context and in a variety of ways-some of them subtle and indirect. There are important connections between laws governing debtor-creditor relationships and those regulating insolvency. The efficiency and effectiveness of the proce- dures for individual enforcement by creditors can have a vital bearing on the approach to insolvency procedures with respect to the creditors' debtors. For example, stringent enforcement of individual debts can be balanced by the availability of insolvency proceedings to assist compa- nies in temporary difficulty. On the other hand, insolvency law should limit adjustments of rights and interests previously established outside insolvency so as to maintain legitimate pre-existing expectations. Promi- nent among these expectations is the ability of various types of security to remain effective relative to the encumbered assets, despite the com- mencement of formal insolvency proceedings against a debtor. The existence or perception of weak creditor rights influences a credi- tor's approach to all stages of a commercial relationship. Conversely, creditors who perceive that insolvency will reinforce their economic rights will exploit the process to their advantage. An insolvency law that is too difficult for creditors to invoke or that too much favors debtors will tend to reduce the availability of credit and raise its cost, while an in- solvency law that is too easy to invoke or too harsh is subject to creditor abuse. The Russian insolvency practice has, to an extent, been vulnerable to both of these problems. The stability of the overall credit culture among financial institutions can likewise be undermined by imbalances in the debtor-creditor relationship. Effective enforcement and insolvency systems balance incentives and disincentives to encourage responsible corporate behavior. An effective system for enforcing creditor rights and managing business insolvency encourages high standards of corporate governance, including financial discipline. In this way, important social objectives are advanced- including the maintenance of public confidence in the corporate and fi- nancial sectors. Prior to insolvency, the behavior of managers is governed by general corporate law, but this is superseded by insolvency law at the point of in- solvency or when insolvency is declared. Under general corporate law, incompetent or negligent managers may be sanctioned or divested of their duties under both nonbankruptcy and bankruptcy procedures, such FRAMEWORK FOR CORPORATE INSOLVENCY 85 as through the appointment of a receiver, bankruptcy administrator, or trustee. Under the more exacting provisions of insolvency law, conduct and transactions that occurred before the start of formal insolvency pro- ceedings (in some cases, several years before) can be reexamined in light of what subsequently transpired. Not only may certain transactions be impeachable (even at the expense of disrupting commercial certainty), but managers may be held personally responsible for part of the compa- ny's losses. In serious cases, managers may be subject to criminal liability and may be barred from managing companies for a prescribed period. These sanctions-whose elements and operation vary considerably from system to system-supply a necessary backbone to the proposition that the limited liability and greater access to credit enjoyed by companies be balanced by corresponding responsibilities, imposed to maintain public confidence in the credit culture in which companies operate. Insolvency systems provide an efficient exit mechanism for unprof- itable businesses and help rehabilitate viable ones. Insolvency procedures are a way of dealing with the casualties of market competition. When businesses are incapable of competing profitably, the logical move is to provide a means for their voluntary dissolution or exit from the market. Company laws often contain voluntary exit procedures, but such proce- dures are generally accessible only for solvent companies that can repay their debts from assets liquidated in the windup of the business. These laws should coexist alongside formal insolvency procedures. When an enterprise cannot repay its obligations as they come due, or it cannot raise enough money from asset sales to repay all its obligations, assump- tions about enterprise activity, governance, and ownership change; and when a distressed or insolvent enterprise is unable to uphold commercial agreements, market confidence falls. This situation should be resolved through a collective procedure that ensures prompt resolution and maxi- mum recovery by creditors. This procedure must be flexible enough to provide a range of options, including rehabilitation for viable enterprises and liquidation for nonviable enterprises. Liquidation can occur by selling the business as a going concern, in productive units, or through the more conventional sale of assets. Alter- natives to outright liquidation may vary in terms of formality and the de- gree of involvement of the courts and other official agencies, but they share the common goal of giving the debtor an opportunity to exit from relative (or even absolute) insolvency and to enjoy the prospect of a more balanced existence for the future. For the honest casualties of competi- tion, then, the insolvency process provides a means for enterprise reha- bilitation or an exit mechanism to quickly transfer assets and businesses 86 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR to more efficient market participants. Unlike the insolvency of a bank, where the prospects of rehabilitation are constrained by policies promot- ing depositor confidence, policies supporting corporate rehabilitation are predicated on preserving jobs and maximizing enterprise value-which is higher if the enterprise is a going concern rather than one in liquidation. Rehabilitation also avoids the broader knock-on effect of insolvency; that is, it minimizes the impact on creditors who rely on the enterprise as a source of business and revenue. OVERVIEW OF RUSSIAN CORPORATE INSOLVENCY PRACTICE The 1992 Bankruptcy Law Russia's first insolvency law following its transition to a market econo- my-the Law on Insolvency (Bankruptcy) of Enterprises-was enacted in 1992 and proved to be completely ineffectual.' As in the early stages of transition in most of the other Central and Eastern European coun- tries, early efforts at developing an insolvency system proved ineffective and inefficient, with laws failing to properly take account of capacity and regulatory shortcomings. The 1992 Russian Bankruptcy Law also suffered from a number of defects that distorted incentives and disincen- tives.2 The law contained an ineffective trigger for commencing proceed- ings based on the balance sheet approach (as opposed to a liquidity or cash flow test). According to one authority on Russian insolvency law, commercial players unable to pay their debts were allowed to continue in operation, while other top managers and enterprises able to pay debts were emboldened not to do so, using surplus funds for personal gain. The system invited abuse and bad-faith filings.3 To make matters worse, courts were obliged to evaluate the debtor's assets and liabilities to deter- mine balance sheet insolvency-a procedure that was extremely time consuming and prone to arbitrary decision-making. Courts often refused to apply a liquidity (or cash flow) test, notwithstanding the failure of the enterprise to pay its debts.4 Accounting practices that were out of step with international accounting standards and unreliable data and infor- mation combined to produce skewed and unpredictable results that could be easily manipulated. The 1992 Bankruptcy Law also failed to distinguish between the finan- cial status of enterprises (whether no-asset or potentially viable) or be- tween the distinct kinds of legal entities or persons seeking bankruptcy. It FRAMEWORK FOR CORPORATE INSOLVENCY 87 instead treated all debtors the same, applying the same complex proce- dures to each, whether a legal person, an individual entrepreneur, a major enterprise, or an intermediary holding company with no assets, a com- mercial or peasant (farm) enterprise, or an industrial entity or bank.5 Gaps in the law were in part the result of drawing on aspects of different legal systems and in part the adoption of many incoherent legal acts. These acts ultimately numbered more than 30 Edicts of the President of the Russian Federation, Resolutions of Government, and departmental regulatory acts, which were often incoherent and at times contradictory.6 The 1998 Bankruptcy Law To rectify the mistakes of the 1992 Bankruptcy Law, work on a new in- solvency law began in 1995. This eventually led to Federal Law No 6-FZ of January 8, 1998, On Insolvency (Bankruptcy) (called the 1998 Bank- ruptcy Law), which became effective in March 1999. The new law is also supported by Resolution No. 478 establishing procedures that increase the efficiency of the application process.7 The 1998 Bankruptcy Law is a substantial improvement over its pred- ecessor: it simplifies rules and procedures; invests exclusive jurisdiction in the arbitration (arbitrazh) courts; encompasses all forms of business entities; allows creditors (including secured creditors) to initiate proceed- ings; and by permitting such mechanisms as observation proceedings, ex- ternal management, and amicable settlements, it provides a more flexible and balanced approach to support rehabilitation. Unlike the 1992 law, the 1998 Bankruptcy Law also contains special provisions for dealing with different entities, rather than applying the one-size-fits-all ap- proach. It uses a unitary system, similar to that of the new German in- solvency law, allowing for observation and evaluation of a business's prospects before deciding whether to liquidate assets or rehabilitate the enterprise. The new law adopts a novel but problematic approach to the treat- ment of claims of secured creditors. The balance struck is intended to protect the payment expectations of secured creditors, and thereby en- courage secured lending, while at the same time facilitating enterprise re- habilitation. To do this, assets of secured creditors are now brought within the estate and made subject to the proceedings, and the liens of se- cured creditors are stripped from the collateral to allow sale of pledged assets without restraint.8 In exchange, the claims of secured creditors are aggregated in the third category for payment and are satisfied pro rata from the sales proceeds from all assets sold.9 The approach is novel in 88 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR that it reduces all secured creditors to the same level, irrespective of the quality of the collateral securing their debt, and then seeks to protect them by affording a higher priority on distribution. On the surface this approach seems logical, but it raises a number of issues that could inhibit the creation of market confidence in secured lending practices. First, the approach renders meaningless the use of col- lateral in bankruptcy, increasing the risk to creditors of nonperformance and at the same time making that risk more difficult to measure and manage. For better-secured creditors, bankruptcy is not strategically use- ful. Such creditors would prefer instead to seek nonbankruptcy foreclo- sure or seizure of property. For less secured creditors, there is an incen- tive to use bankruptcy as a threat to other creditors (rather than to the debtor) in an attempt to improve their position, at the expense of such creditors, should bankruptcy subsequently occur. Second, the approach could potentially undermine the significance of registration systems. Such systems encourage parties to take prompt ac- tion to record their security interests or to otherwise face the subordina- tion of their claims to earlier-recorded interests-even though these may have been obtained later in time. The first-in-time, first-in-right concept is a cornerstone of registration systems, but is completely eroded by the treatment of secured creditors under the 1998 Bankruptcy Law. Finally, the approach is not a fair exchange for the bargained-for risk. The right to repayment of a secured creditor is effectively subordinated, and to the extent insufficient assets exist, such creditors must give up their collater- al or value to administrative, personal injury, employee, and royalty claims. The proposed treatment of secured creditors is also potentially preju- dicial to unsecured creditors. Some secured creditors undoubtedly will be only partially secured, meaning their collateral is worth less than the amount of their claims. Giving partially secured creditors priority over unsecured creditors, with respect to the unsecured portion of the partial- ly secured creditor's claim, violates a cardinal principle of bankruptcy known as the pari passu principle, which holds that similar creditors should be treated the same in bankruptcy. While a secured creditor is clearly not the same as an unsecured creditor, an "undersecured" credi- tor is a hybrid of both; that is, this creditor is secured to the extent of the value of the collateral or pledged assets and unsecured for any claim or debt that exceeds the collateral's value. To give full payment to a partial- ly secured creditor would be to give funds to that creditor that should rightfully be distributed to the state and unsecured creditors. One prob- lem with this result is that it distorts normal commercial relations and FRAMEWORK FOR CORPORATE INSOLVENCY 89 lending practices by rewarding less diligent creditors and penalizing other similarly situated parties. Similarly, it promotes inefficiency in management practices by encouraging management to take on debt well in excess of asset values. Overleveraged or heavily leveraged companies are unable to compete effectively (Altman 1993).10 And even for unse- cured creditors, the result could lead to higher or distorted pricing prac- tices to avoid increased and uncertain repayment risk. Notwithstanding the significant improvements that the 1998 Bank- ruptcy Law has introduced to the system, the regulatory void has created a fertile environment for abuse, such as hostile management buyouts or takeovers of otherwise viable enterprises (primarily in the lucrative oil and gas and metals industries)." In addition, some commentators main- tain that distortions in use among particular industries is the result of im- proper collusion among companies and local officials, while in other cases management may collude with phantom creditors and external managers to seize control of or to channel assets to third-party insiders or affiliated companies."2 And while the new system provides a measure of discretion for judges-a mark of a more mature system-some have argued that discretion can be (and likely is being) abused where there is political pressure on judges to avoid liquidation of businesses or where there is an inclination to salvage an enterprise (and jobs) despite the in- ability of the enterprise to be returned to viability.'3 Recent Developments On March 12, 2001, the Constitutional Court of the Russian Federation issued Resolution No. 4-11 on the constitutionality of certain sections of the Bankruptcy Law.14 Various provisions of the Bankruptcy Law were invalidated by this decision, resulting in greater procedural protection of creditors and debtors in the bankruptcy process and the increased ac- countability of the arbitrazh courts.'5 The Constitutional Court made the following findings about the constitutionality of the Bankruptcy Law: 1. Provisions restricting the possibility of appealing determinations is- sued by arbitrazh courts on disputes between creditors and debtors are invalid. These provisions were deemed to contravene the consti- tutional right to judicial protection. The effect of this determination is that judicial review of such decisions is immediately allowed until the legislature provides new rules on the subject. 2. Provisions requiring that a debtor be placed under supervision from the moment a petition for the debtor's bankruptcy is filed with an arbitrazh court are also inconsistent with the constitutional right to 90 BUILDING TRUST: DEVELOPING THE RuSsIAN FINANCIAL SECTOR judicial protection, and are therefore invalid. These rules allowed the debtor to be placed under supervision solely on the basis of an application of the petitioning creditor, without a court hearing or a summoning of the parties. This meant that courts could not effec- tively control the bankruptcy procedure and ensure procedural fair- ness. Now the issue of placing the debtor under supervision may only be decided after the debtor has presented its explanations and objections. Also debtors now have a right to appeal this determina- tion to a higher court. These findings are a positive step in reducing the power of individual judges over the bankruptcy process. Previously the arbitrazb court sum- marily determined a broad range of matters, including the introduction of supervision, the amount of monetary obligations, creditor and em- ployee complaints about the external manager, and reductions or exten- sions of the period of external management. Some of these issues are le- gitimate areas for the arbitrazh court to exercise discretion, as they involve issues of a more administrative nature. Conversely, the ability of creditors and parties to exercise rights of appeal invariably will lead to delays in the process. This is an area that should be closely monitored and reviewed to find ways of promoting efficiency without sacrificing or undermining constitutional rights. Statistical Performance of the Insolvency System Under the 1992 Bankruptcy Law, although instances of insolvency were systemic, the courts considered only about 100 cases in the first year. This gradually increased over a five-year period to more than 4,300 cases in 1997, for a total of approximately 8,386 cases. Over this period, ap- proximately 46 percent of cases were directed to liquidation (about 3,854 cases), and roughly 16 percent (some 1,398 cases) were external manager proceedings. The ratio of liquidation cases to external manage- ment proceedings during 1995-97 was three to one. While this may sug- gest an increasing trend toward the use of externally managed proceed- ings, possibly with a view to salvaging the business, there is no indication that these proceedings resulted in effective operational restructurings or led to more efficient use of assets and businesses by market players. In the three years since the introduction of the 1998 Bankruptcy Law, there has been a steadily increasing trend in the use of the insolvency system, but with proportionately fewer proceedings in which an exter- nal manager is appointed. In 1999, only 11 percent of cases were exter- nal management proceedings, and in 2000, the number dwindled to 7 FRAMEWORK FOR CORPORATE INSOLVENCY 91 Table 3.1 Number of Bankruptcy Cases Type of proceedings 1993 1994 1995 1996 1997 1998 1999 2000 Claims submitted n/a n/a n/a n/a n/a 12,781 15,583 21,034 Proceedings initiated 100± 240 1,108 2,618 4,320 8,337 13,543 18,057 Liquidation ordered 50 n/a 469 1,035 2,200 4,747 10,247 16,601 External mgmt. ordered n/a n/a 135 413 850 1,041 1,669 1,544 Total cases completed n/a n/a n/a n/a n/a 10,504 Bankruptcy cases 7,460 Returned to solvency 67 Out-of-court settlements 654 percent. Liquidation cases, in contrast, accounted for 60 percent of total cases in 1998 and 76 percent in 1999, reflecting a substantial increase. In 2000, total new cases initiated reached about 18,057, a more than 116 percent increase over 1998. Again, without access to the underlying outcomes for proceedings, it is difficult to say whether the results led to a more efficient use of the insolvency system in transferring assets and businesses to market players or in successfully restructuring businesses. The numbers nonetheless indicate a continuing increase in the use of bankruptcy proceedings and an apparently greater efficiency in han- dling cases; these facts are no doubt attributable to the better law and procedures adopted in 1998. Table 3.1 contains data for insolvency, in- cluding financial sector, from 1993 through 2000. LEGAL FRAMEWORK FOR CORPORATE INSOLVENCY Access and Applicability of Bankruptcy Law The Bankruptcy Law applies broadly to the following entities: (a) com- mercial entities (except for wholly state-owned enterprises), (b) noncom- mercial entities (except those that operate in the form of consumer coop- eratives, charitable foundations, or funds), (c) citizens (including those registered as individual entrepreneurs), and (d) banks and credit organiza- tions (also regulated separately by the bank insolvency law, as discussed below).'6 The law contains special rules governing the bankruptcy of (a) town-forming organizations, (b) agricultural organizations, (c) insurance organizations, (d) bank and credit organizations, (e) professional partici- pants in the securities market, (f) citizens, (g) individual entrepreneurs, 92 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR and (h) farm enterprises. Town-forming organizations and banks/credit organizations merit special attention. Town-forming organizations. Town-forming organizations are defined as legal entities whose employees constitute at least half of a populated lo- cality or that employ more than 5,000 people.17 Special provisions relat- ing to such organizations include 1. The local government is deemed to be a party to the case, may make a petition for external management, and may extend the pe- riod for external management. 2. Various governmental bodies may guarantee the debtor's obligations. 3. Various mandatory conditions of liquidation, such as preserva- tion of jobs, are imposed. 4. The period permitted for restructuring is extended to 10 years. Banks and other credit organizations. The bankruptcy of banks and other credit organizations is regulated by a separate regime in addition to the general Bankruptcy Law. The other important pieces of legislation here are Federal Law No. 40-FZ, On Bankruptcy of Credit Organizations, dated 25 February 1999 (Bank Bankruptcy Law), and Federal Law No. 144-FZ, On Restructuring of Credit Organizations, dated July 8, 1999 (Bank Restructuring Law). Below is a brief overview of the processes in- volved when undergoing bankruptcy and restructuring processes. Indicia of bankruptcy. Bankruptcy is defined as the inability of a debtor to pay a creditor's monetary claim or to make an obligatory pay- ment in full where such obligation has been outstanding for at least three months after the due date.'8 If the debtor is an individual, it is also nec- essary that the total amount of his liability should exceed the total value of property owned.'9 Filing a bankruptcy petition. A bankruptcy petition may be filed with an arbitrazh court located in the region or city in which the debtor is lo- cated. Petitions can be either voluntary (filed by the debtor) or involun- tary (creditor initiated). In voluntary liquidations, the debtor may make an application for the recognition of itself as bankrupt whenever the in- dicia of bankruptcy are present, and even absent the indicia of bankrupt- cy where the circumstances indicate that the debtor will be unable to per- form monetary obligations or an obligation to make compulsory payments within the established time period.20 Furthermore, the debtor's executive or an individual entrepreneur is obliged to file a debtor's application within one month of the emergence of one of the following circumstances: FRAMEWORK FOR CORPORATF INSOLVENCY 93 1. The payment of the claim of one or more creditors may result in the company's inability to fulfill its obligations to other creditors. 2. The shareholders or board of directors resolve to liquidate the company.2' An entity's executive members personally suffer heavy penalties for failing to meet obligations to creditors. These penalties include: 1. Joint and several liabilities for the debtor's obligations to creditors that arose after the mandatory time for filing 2. Deprivation of the right to occupy management positions or to con- duct business activities relating to the management of legal entities 3. Criminal penalties.22 The following persons may file a petition to commence an involuntary liquidation, having the debtor declared bankrupt: 1. Creditor or group of creditors (including foreign persons) 2. Tax authorities (or other authorized governmental bodies) 3. The public prosecutor 4. The debtor.23 The arbitrazh court must accept an application for the recognition of the debtor as bankrupt if the aggregate claims against the debtor amount to at least 500 times the minimum wage rate (equivalent to about US$5,000) if the debtor is a legal entity, or at least 100 times the mini- mum wage rate (about US$1,000) if the debtor is a citizen.24 Preventive measures. The Bankruptcy Law contains provisions aimed at preventing the bankruptcy of organizations. A duty is imposed upon founders or participants of a legal entity debtor and property owners of a debtor that is a unitary enterprise to take timely measures directed to- ward the financial recovery of the debtor.25 In addition, criminal and civil penalties are imposed upon debtors and their executive for "fictional" bankruptcy. These penalties apply where the debtor has the ability to sat- isfy creditors' claims in full but its executives send the firm into bank- ruptcy anyway, presumably to obtain the firm's assets.26 While such pro- visions in theory should be an incentive for good corporate behavior or a disincentive to misconduct, in reality they appear to have little or no im- pact on corporate behavior, because these provisions are not routinely, if at all, enforced. Bankruptcy Procedures In examining a bankruptcy case concerning a legal entity, the following bankruptcy procedures apply: 94 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 1. Observation proceedings. Following the court's ruling accepting an application of recognition of a debtor as bankrupt, the court will ap- point a temporary administrator to supervise the operations of the company.27 The temporary administrator will notify creditors of the liquidation, supervise the actions of the company's management, an- alyze the financial condition of the company, determine the amount of creditors' claims, and call the first creditors meeting.28 Proprietary claims against the debtor may be presented only in compliance with procedures established in the Bankruptcy Law, and all proceedings of cases associated with the recovery of mon- etary resources and other property from the debtor must be sus- pended. To enforce these measures, the court's ruling accepting an application for the recognition of the debtor as bankrupt shall be sent to banks and other credit organizations with which the debtor has bank account agreements.29 The debtor is prohibited from executing transactions transferring or disposing of immov- able property and adopting various decisions, such as reorganiza- tion or payment of dividends, without the consent of the tempo- rary administrator.30 In addition, the court has the right to remove the debtor's executive if it does not take steps to ensure the con- servation of the debtor's property or if it hinders the temporary administrator in the performance of his duties.3' An important role of the temporary administrator is the calling of the first creditors' meeting. Creditors, tax authorities, other au- thorized bodies whose claims have been established by the arbi- trazh court, and employee representatives have the right to attend these meetings, but creditors alone have voting rights.32 The first creditors' meeting elects a creditors' committee and makes a deci- sion as to whether to petition the arbitrazh court to institute ex- ternal management or to commence competitive proceedings. However, the arbitrazh court has the right to override any such petition and make its own determination.33 2. External management. External management may be instituted for no longer than 12 months, with the possibility of being ex- tended to 18 months. The institution of external management proceeds with the following events: * The creditors' meeting elects an external manager (although the arbitrazh court may override this selection34). * The debtor's executive is removed and power over manage- ment of the debtor's business affairs is assigned to the external manager. FRAMEWORK FOR CORPORATE INSOLVENCY 95 * The powers of the debtor's executive are transferred to the ex- ternal manager. * The debtor's property may be seized and other limitations im- posed to protect the debtor's assets. * A moratorium is imposed on the satisfaction of creditor claims.35 The external manager has various powers and rights, including the right to * Take measures to recover debts to the debtor.36 * Dispose of the debtor's property.37 * Conclude an amicable agreement on behalf of the debtor.38 * Refuse to perform contracts of the debtor for a period of three months after the institution of external management.39 * In certain circumstances, invalidate transactions executed by the debtor before the institution of external management.40 The creditors' meeting and committee remain involved in the process. The creditors' meeting must approve the external man- agement plan41 as well as any major transactions of the debtor.42 (The external management plan must provide measures for the restoration of the debtor's solvency, which may include a sale of the enterprise.) The creditors' meeting may also remove the exter- nal manager and file a petition with the arbitrazh court for recog- nition of the debtor as bankrupt and commencement of competi- tive proceedings (liquidation).43 3. Competitive proceedings. The arbitrazh court's adoption of a deci- sion recognizing the debtor as bankrupt entails the commencement of competitive proceedings, the effects of which are the following: * All monetary obligations and deferred compulsory payments of the debtor are considered due. * All previous seizures of the debtor's property and other restric- tions on the disposal of the debtor's property shall be lifted. * The management bodies of the debtor are removed from their duties if such removal has not already taken place. * The arbitrazh court appoints a competitive proceedings manager. * A notice of recognition of the debtor as bankrupt and of the commencement of competitive proceedings is published.44 The competitive proceedings manager has powers and duties. similar to those of the external manager. In addition, the compet- itive proceedings manager shall conduct an inventory and valua- tion of the debtor's property and then sell it by open tender. Cred- itors' claims will then be settled in accordance with the priorities described below. 96 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 4. Amicable agreement. The debtor and creditors have the right to conclude an amicable agreement at any stage of the arbitrazh court's consideration of the case,45 subject to the approval of the court. However, any such agreement may only be concluded after the claims of first- and second-priority creditors have been settled. The arbitrazh court's approval of an amicable agreement is grounds for termination of proceedings on the bankruptcy case and a lifting of the moratorium on the satisfaction of creditors' claims. 5. Accelerated bankruptcy procedures. An alternative procedure was introduced by the Decision of the Government of the Russian Federation No. 476 of May 22, 1998, On Measures to Increase Efficiency of Applying Bankruptcy Procedures. Pursuant to this decree, the debtor's creditors may consolidate their claims and be represented by the Federal Service of Russia for Insolvency and Fi- nancial Rehabilitation, an agency of the Russian government. The service may vote at the creditors' meeting to proceed directly to external management and use accelerated procedures. Under these accelerated procedures the debtor's business is subject to re- organization, including the establishment of a new joint stock company that will acquire the debtor's assets and retain the com- pany's jobs. Stock in the new company is sold, and proceeds from the sale are used to pay the debtor's debts. If proceeds from the sale of stock are insufficient to satisfy all creditors' claims, the ar- bitration manager files an application with the arbitrazh court to terminate the external management, rule the debtor bankrupt, and institute disposal proceedings. This accelerated procedure is only useful where the sale of stock in the joint stock company generates sufficient funds to pay off all creditors. This would only happen when the debtor's assets are greater than its liabilities; since for most debtors this is not the case, this procedure has limited application. 6. Voidable transactions. Once the arbitrazh court accepts a petition to initiate bankruptcy proceedings, the following transactions may be invalidated by the court upon the request of the tempo- rary administrator or creditor: * Transactions entered into by the debtor with an interested party, if such transactions would cause losses to other creditors * Transactions entered into by the debtor company after, or six months prior to, the initiation of bankruptcy proceedings, if such transactions caused preferential payments to certain cred- itors to the disadvantage of other creditors FRAMEWORK FOR CORPORATE INSOLVENCY 97 * Transactions involving a return of equity to a shareholder en- tered into by the debtor after the initiation of bankruptcy pro- ceedings, or in the six months prior to proceedings.46 7. Creditors' claims. Individual creditors may not directly pursue any of their own remedies. They must act through the creditors' meet- ings. Creditors' claims may be submitted at any stage of the bank- ruptcy process by filing a notice with the debtor company and with the arbitrazh court. Unless contested by the debtor within seven days, the amount of the filed claim will be entered into the register of creditors' claims. If the debtor contests the creditor's claim, the creditor will need to appeal to the arbitrazh court.47 In order to be allowed to participate in the first creditors' meet- ing, the claims must be submitted within one month of the receipt of notification of the proceedings from the temporary administra- tor. Also, in order to be included in one of the five established pri- orities of creditors' claims, a claim must be filed before the date of closure by the temporary administrator of the register of credi- tors' claims. If a claim is filed after this date it will only be satis- fied after all other priority creditors are paid. 8. Priorities. Court expenses, the administrator's remuneration, the current utility payments of the debtor, and creditors' claims that arose after the initiation of bankruptcy proceedings take first pri- ority and must be satisfied before other claims can be addressed. All other claims fall into one of five categories. Claims at each level must be satisfied in full before claims at the next level of pri- ority are considered. These categories are . Personal injury claims * Severance, salary payments, and remunerations under royalty agreements * Claims of secured creditors * Governmental claims (i.e., tax and social security payments) * All other creditors' claims.48 Creditors' claims that are unsatisfied due to the insufficiency of the debtor's property are considered discharged.49 IMPLEMENTATION OF THE INSOLVENCY REGIME A strong institutional and regulatory framework is crucial to an effective insolvency system. The framework encompasses three main elements: (1) the various institutions with responsibility for and jurisdiction over 98 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR insolvency proceedings; (2) the operational system through which cases and decisions are processed; and (3) the fundamental requirements need- ed to preserve the integrity of these institutions, recognizing that the in- tegrity of the insolvency system is the linchpin for its success or failure. Institutional Framework (the Arbitrazh Court) The role, responsibility, organization, and services of the governing judi- cial institution (in Russia, the arbitrazh court) are central to an effective, efficient, and fair insolvency process. A well-functioning and predictable insolvency process provides for the quick disposition of insolvency cases, preserving assets and maximizing their value. Russia has no separate spe- cialized bankruptcy courts. Bankruptcy cases are considered by the arbi- trazh courts in accordance with the rules established by the Code of Ar- bitrazh Procedure of the Russian Federation, dated May 5, 1995 (Code). Bankruptcy cases are not heard by specialized bankruptcy courts but by regional arbitrazh courts, whose judges require no special bankruptcy training. The wide discretionary powers given to judges of the arbitrazh courts have been criticized as being open to abuse and corrupt influ- ences. In addition, the lack of federal financing of arbitrazh courts and the distance-both political and physical-from the federal center make arbitrazh courts highly dependent on regional politics.50 These problems have the potential to undermine the bankruptcy regime. Russia has endeavored to strengthen its capacity to handle insolvency cases by having specially trained bankruptcy judges. In some countries, judges are specialized and have exclusive responsibility for insolvency proceedings. In others, judges may have wider jurisdictional authority. Given the specialized nature of enterprise insolvency and the issues that arise in bankruptcy proceedings, there is significant value in having inde- pendent, specialized commercial and bankruptcy courts (where possible) or judges who have been specially trained in insolvency matters within the commercial courts. The insolvency process is highly complex and de- mands a specific understanding of and familiarity with financial and business arrangements and with commerce and finance standards and practices. Specialization ensures greater competence and higher-quality decision-making, quickens the pace of proceedings and decision-making, and promotes consistent decision-making on similar issues and in similar situations. In addition, specialization tends to decrease unnecessary liti- gation by increasing predictability in the outcome of decisions. Where there is little or fragmented insolvency expertise in the judiciary and de- cisions are inconsistent, parties are often tempted to litigate in the hope FRAMEWORK FOR CORPORATE INSOLVENCY 99 of gaining a different or novel decision. The same is also true of appeals courts that have no expertise in insolvency. Given the numerous allegations of collusion and corruption in the process, procedures should be adopted and measures taken in Russia to ensure that the courts are free of conflicts of interest, bias, and lapses in judicial ethics, objectivity, and impartiality. Clear legal rules should estab- lish remedies to address improprieties, including complaint and investiga- tion procedures. Written standards, guidelines, advisory opinions, com- plaint and investigation procedures, and tools to redress impropriety should all be vested in an independent and respected judicial or ancillary authority. The court, including judges and court employees, must meet these standards and be perceived as doing so by interested parties and the public alike. Currently, however, Russia has not yet developed and does not enforce such investigative and supervisory procedures. Regulatory Framework There are enormous gaps in Russia's regulatory framework, and these threaten to undermine the insolvency process. This is perhaps the single most important area for future capacity building if the system is to ma- ture and play the role envisioned for an insolvency system. An insolven- cy system should provide firm and public rules and regulations to pre- vent the corruption and exertion of undue influence that undermine public confidence in the system. Preferably an independent but account- able department, committee, or body should be responsible for establish- ing, monitoring, and enforcing standards of conduct for judges and other participants. Maintaining ethical and professional standards for judges and, where appropriate, other court employees is also essential for in- stilling public confidence in the bankruptcy court. Allegations of fraud and other criminal conduct related to bankruptcy should be investigated and redressed promptly, firmly, and uniformly by an authority vested with the power to investigate and take appropriate measures. Miscon- duct short of criminal conduct also should be addressed promptly by the bankruptcy court or another independent agency invested with the power to investigate and take appropriate measures, including imposing sanctions. Russian Federation Federal Service on Financial Rehabilitation and Bankruptcy (FSFR). The FSFR serves as the primary regulatory body for the insolvency process. As of 2001, the FSFR comprised a main head- quarters in Moscow, 13 interregional territorial agencies, and 2 territorial 100 BUILDING TRUST: DEVELOPING THE RUSSIAN F1NANCIAL SECTOR agencies; it employed more than 900 employees. Ninety percent of its em- ployees are graduates of higher learning institutions; approximately 11 percent have a second higher education degree, and roughly 6 percent hold a Ph.D. The primary duties of the FSFR include the development of pretrial procedures, the analysis of financial and economic conditions of enterprises that are economically and socially vital to the economy, and the initiation of proceedings to collect state debt or rehabilitate/restruc- ture vital enterprises. Additional duties include the training, licensing, and supervision of the activities of arbitration receivers, external managers, and various experts. Training of arbitration receivers. In 2000, a key objective of the FSFR was to provide the arbitrazb courts with an adequate number of licensed receivers, while adopting and implementing stiffer licensing require- ments. In 2000, approximately 6,000 arbitration receivers were trained through a crisis managers' training program, as compared to 8,456 re- ceivers in 1999. Two model training programs are used to train receivers for "first-tier" cases involving absent debtors, citizens, business people, and small enterprises, and "second-tier" cases involving citizens, busi- ness people, and medium-size enterprises. A new three-tier system has been launched to match categories of arbitration receivers, including those with respect to large enterprises, and a provision for upgrading of skills. To promote more widespread training, FSFR has accredited 74 ed- ucational establishments to conduct seminars on FSFR programs, and is now working on the development of a practical manual for receivers under a TACIS-funded technical assistance program.5' Licensing and license revocation of arbitration receivers. As of 2001, the FSFR had issued 12,238 arbitration receiver licenses, of which 5,168 were issued in 2000. Tier-one licenses constitute 81 percent of all licenses, with the remaining 19 percent being Tier-two licenses. Some 133 licenses (mainly Tier one) in total have been invalidated for various reasons, in- cluding failure to register in the capacity of an individual businessman, expired certificates following passing of exams, lack of requisite six- month minimal experience as a receiver, failure to publish data on bank- ruptcy proceedings, and violations in the election of the creditors' com- mittee. During 2000, FSFR received 44 applications to revoke the licenses of receivers, which resulted in a revocation of 12 licenses. Supervision of arbitration receivers. The FSFR is also responsible for supervising the activities of arbitration receivers to ensure compliance FRAMEWORK FOR CORPORATE INSOLVENCY 101 with license requirements. In 2000, the FSFR launched a supervisory sys- tem over activities of arbitration receivers.12 Under this program, over 600 complaints against actions by receivers were examined. By 2001, a total of 1,137 complaints had been lodged, of which 614 were accepted for further review. The remainder were found to be without merit. In response to the complaints accepted for review, 232 warnings were issued to arbitration receivers, and 114 receivers had their licenses suspended or revoked. In the remaining cases, no violations were found after further review. It is worth noting that employees of the FSFR also serve in the capac- ity of state arbitration receivers and are routinely appointed as receivers in cases. For example, 150 FSFR employees have been appointed as re- ceivers in 808 cases, of which the vast majority concerned absentee debtors, and in 56 of the 112 cases concerning large, economically and socially vital enterprises. Accreditation of experts. The FSFR has also been tasked with develop- ing criteria for and accrediting various experts, including experts on fi- nancial condition and solvency (98), enterprise business plans (61), mar- ket value appraisals for enterprise assets (77), and actions of managers and receivers (30).53 Expert opinions are relied upon as a source of inde- pendent information to assist the FSFR in its decision-making. There has been no indication of impropriety in this area, but the fact that the FSFR is a consumer of evaluations prepared by experts who are beholden to the FSFR for their accreditation raises the specter of a conflict of interest that could potentially cast some doubt over the objectivity and integrity of evaluations, i.e., evaluation results could be tailored to meet results per- ceived to be desired by FSFR. This is especially true given that an accred- itation can be revoked. In 2000, expert evaluations were carried out to * Establish signs of intentional or fictitious bankruptcies (388 cases) * Identify signs of intentional or fictitious bankruptcies (156 cases) * Review external receivership plans (456 cases) * Review measures of bankruptcy proceedings (1,006 cases) * Assess out-of-court settlements (158 cases). Role in reviewing vital enterprises. As indicated above, one of the du- ties of the FSFR is the monitoring of the financial condition of the record- keeping and solvency of large, economically and socially vital enterprises. In 2000, there were 1,714 enterprises included on the list of vital enter- prises. During the first three quarters of 2000, the FSFR conducted sur- veys of 1,529 vital enterprises (employing more than 7.2 million people), of which 242 were fully state-owned, 151 had a greater than 50 percent 102 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR state ownership, and 217 had state ownership of 25-50 percent. The state held less than a 25 percent interest in the remaining 919 enterprises. Bankruptcy proceedings were instituted against 112 vital enterprises, in which 56 state arbitration receivers (FSFR employees) were appointed. In some 5,000 other cases, the central and regional interagency bal- ance commissions examined debts owed to the federal budget and state interbudgetary funds, recommending the commencement of bankruptcy proceedings in approximately 700 cases, debt restructuring in roughly 1,300 cases, and financial rehabilitation in about 150 cases. The actions taken resulted in repayments to the budget of approximately 133.5 bil- lion rubles from 1998 to 2000. ASSESSMENT OF KEY FEATURES OF THE BANKRUPTCY REGIME At the outset of this section, it was noted that insolvency systems (to- gether with nonbankruptcy enforcement procedures) play a vital role to promote commercial confidence in three significant areas: (1) stabilizing commercial expectations and fostering better financial risk management; (2) balancing incentives and disincentives for responsible corporate be- havior; and (3) providing an efficient exit for business failures and a means for salvaging viable enterprises, and with them jobs and other commercial activities and relationships. It is essential to evaluate the im- plications of Russia's insolvency system in each of these areas. Stabilizing Commercial Activity The bankruptcy laws in Russia appear to be comprehensive, and for the most part they comply with international insolvency principles. Howev- er, the regime does not in many respects perform as it should, suggesting that there are major problems in its implementation rather than its con- tent. The continuing lack of regulation and the potential for arbitrage in the system have continued to foster distrust of the process. For example, a number of reports have suggested that the system is susceptible to countless forms of manipulation that disenfranchise certain creditors, in- fluence the membership and representation on creditors committees, dis- allow dividends or distributions to legitimate creditors, and allow fraud- ulent and illegitimate claims.54 While the external manager was intended to provide for neutral representation, in fact a high degree of abuse was represented in regions outside Moscow, where incumbent management FRAMEWORK FOR CORPORATE INSOLVENCY 103 had prearranged with certain creditors to appoint external managers who would favor them. There have also been some general reports of collusion between judges and external managers. Some degree of abuse is current in all insolvency systems, but it tends to be at its worst in envi- ronments with ineffective or lax regulation. In Russia, most lenders still will choose not to use the insolvency system to recover debt, even in cases where the borrower's business is viable. Inadequate Corporate Governance There are several ways in which the insolvency system promotes good corporate behavior. First, it may impose liability for the failure of man- agers to respect the rights of creditors and when they continue to trade the business after insolvency. Laws imposing such liability diverge in the degree to which directors are sanctioned for inappropriate conduct, with the consequences ranging from a mere caution to criminal sanctions. The Russian system imposes personal liability on directors for irresponsible corporate behavior, but its provisions are minimal and ambiguous. For example, directors are obliged to file for bankruptcy when it emerges that the payment of the claim of one or more creditors may result in the company's inability to fulfill its obligations to other creditors. Often it will be unclear whether these circumstances have emerged, but more im- portant, the law appears to have no teeth: there are no reported cases in which directors and officers have been held liable under these provisions of the law, despite the fact that there have been numerous reported ac- counts of abuse and wrongful trading. A second way in which the law imposes discipline on management is through its ability to remove management from its place in the business or to displace owners of their control and ownership of the business when it is poorly managed and becomes insolvent. The provisions of the 1998 Bankruptcy Law allow creditors (including secured creditors) to petition for insolvency under reasonable access requirements,"5 with the prospect of removing the owners and former managers in favor of an ex- ternal manager. Finally, the bankruptcy trigger has been redefined to provide for a liq- uidity approach to determining insolvency, in place of the former balance sheet test. In theory, the combination of these three features should result in an effective tool for disciplining managers. Reports of abuses of the ap- pointment of external managers and of the treatment of creditors have, however, undermined confidence in the system and consequently also un- dermined the effectiveness of these tools. 104 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR A number of companies have taken advantage of low access criteria to effect hostile takeovers of valuable companies at an undervalue. One ex- ample involves the takeover of the Russian oil company, Sidanko. A rival company, TNK, acquired the debts of one of Sidanko's more valuable subsidiaries (Chernogorneft) from other creditors, in order to launch bankruptcy proceedings. TNK installed its own external manager, who plundered Chernogorneft, causing a huge increase in its debts despite a boom in oil prices. Chernogorneft, which had an output the previous year of US$1.2 billion, was ultimately auctioned off for only US$176 million (The Economist 1999). In terms of management, there is no choice under the Bankruptcy Law but to remove the debtor's executive during external management proce- dures. No provision is made in the law for their involvement whatsoever. To get around this, and because of the insufficiency of accredited exter- nal managers, judges will often appoint the current manager as external manager, regardless of the law. Creditors' interests are clearly insuffi- ciently protected in this process, with too much power being given to both the arbitrazh judge and the external administrator. A judge may override both the decision of creditors to liquidate or restructure the company and the creditors' selection of an external manager. The Sidanko case illustrates this point. In Sidanko, nearly all of the creditors voted to nominate an Arthur Andersen executive as external manager, yet the Moscow Arbitrazh judge handling the matter picked another can- didate not backed by the creditors. External managers often just ignore creditors' wishes. The court-ap- pointed manager of the Svyavsky lumber company, for example, refused to follow creditors' instructions to sell the company's assets to investors led by Sweden's IKEA, which was prepared to pay US$7 million; instead, the manager sold the assets to a local company for US$1 million (see Matlack 1999). The new right of creditors to appeal the findings of arbi- trazh judges should provide greater protection of their interests while the debtor business is under external management. It is nonetheless difficult for creditors to have confidence in the system and unlikely that managers will feel threatened by it as long as there are so many opportunities for abuse, and while self-serving conduct continues to go unpunished. Efficient Exit Mechanisms and Promotion of Rehabilitation The rights of creditors to maximum dividends, through maximizing asset values, is again recognized in the law but lacking in practice. Upon the arbitrazh court's acceptance of an application for bankruptcy, the FRAMEWORK FOR CORPORATE INSOLVENCY 105 operations of the company are supervised by a temporary administrator whose responsibility is to protect the company's assets. Enforcement of all creditors' claims (including those of secured creditors) are stayed upon the initiation of bankruptcy. This is designed to preserve the company's assets so that maximum value can be realized by selling the business as a going concern, and provides for equal treatment among similarly situated creditors. Both of these justifications are strongly recognized principles of best practice. Once external management commences, however, company assets are reportedly often dissipated because creditors have little actual control over or input in the process. The priorities accorded to the various creditors appear to be fair and in accordance with general principles of international best practice. There are, however, a few exceptions to this observation that pertain to the perverse effect created on market expectations by the treatment of se- cured creditors. Once a debtor is declared bankrupt, secured creditors lose pledge rights against the specific assets of the debtor, and they rank behind personal injury and wage claimants. As has been suggested above, "secured" creditors are often given an advantage over the body of general unsecured creditors if the debt that they hold is only partially se- cured, because such debt is given priority in repayment regardless. In practice, however, the loss of previously bargained-for rights in collater- al by secured creditors will often lead to reduced recovery, due to the high arrears in wage payments of many companies that must be paid be- fore secured creditors. This situation clearly diminishes predictability in commercial relationships. Performance indicators suggest a decline in rehabilitation cases. Ar- guably, this is again attributable to weaknesses in regulation. Most small and medium-size enterprises are unlikely to be capable of rescue, but the prospects are generally better for larger enterprises because of their greater market share and better access to capital and credit, and because they have more options for both operational and financial restructuring. Larger cases are the most susceptible to abuse, however, because of their inherent value. Bankruptcy statistics in Russia reveal that 90 percent of SMEs submitted to investigation are relegated to liquidation, while ex- ternal management procedures are used mainly in the case of larger busi- nesses. Moreover, in most functional systems, creditors play an impor- tant role, acting as a check and balance against potential abuses by the trustee, administrator, or others. In the Russian system, however, credi- tors are still marginalized and lack sufficient control over the process. Until recently, many of the avenues for appeal were foreclosed. In addi- tion, the provisions relating to town-forming organizations give too 106 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR much control over the rehabilitation process to local governors by giving them the power to extend the process for up to 10 years. These provi- sions are particularly problematic given that about 41 percent of indus- trial production falls within the definition of town-forming organiza- tions. This fact helps explain why larger firms are far more likely than firms with fewer than 5,000 employees to undergo external management rather than liquidation. It also explains the geographical concentration of externally managed companies in regions whose governors are rela- tively strong. FRAMEWORK FOR CORPORATE WORKOUTS AND RESTRUCTURINGS Corporate workouts and restructurings should be supported by an en- abling environment that encourages participants to engage in consensual arrangements designed to restore an enterprise to financial viability. An enabling environment includes laws and procedures that require disclo- sure of or ensure access to timely, reliable, and accurate financial infor- mation on the distressed enterprise; encourage lending to, investment in, or recapitalization of viable financially distressed enterprises; support a broad range of restructuring activities, such as debt write-offs, reschedul- ings, restructurings, and debt-equity conversions; and provide favorable or neutral tax treatment for restructurings. Because informal workouts take place in the shadow of the law, consensual resolution requires reli- able fallback systems in the form of legal mechanisms for individual en- forcement and debt collection or through collective insolvency proce- dures. As such, the most conducive environment for informal workouts is having effective insolvency and enforcement regimes, as reflected in the foregoing sections of this chapter. In addition, the ability to implement a restructuring plan relies on the existence of a legal framework that can accommodate the restructuring plan at a fundamental level; for example, by allowing debt-equity swaps, forgiveness of bank debt, and the taking of collateral. The legal frame- work must also provide incentives for the parties to accept treatment that will render the restructured business viable (for example, favorable off- setting tax treatment for debt forgiveness). Participants must be provided with sufficient information on a borrower's operations and related finan- cial criteria as well as information about the ultimate judicial or nonjudi- cial enforcement process. Concerns and issues relevant to informal work- outs are often addressed in the context of formal frameworks for FRAMEWORK FOR CORPORATE INSOLVENCY 107 rehabilitation procedures, but often are overlooked or ignored in the context of informal arrangements. While there are a variety of different policy choices on the substantive and procedural nature of laws and the allocation of risk among participants, these rules must be clearly speci- fied and consistently applied to encourage consensual workouts. In Russia, lenders particularly tend to favor the out-of-court workout process where possible. This does not imply that the process is problem- free. Because workouts take place in the shadow of the law, the law itself should be reasonably clear and predictable. It is not. Rather, its weak- nesses generally discourage all but a few parties from relying on court-di- rected insolvency. Where possible, creditors tend to prefer to exercise di- rect collateral enforcement. In most cases, the tax laws are not conducive to write-downs and restructurings, with the result that the overwhelming share of so-called restructurings are in fact debt reschedulings. In rare in- stances, debt-equity swaps involving sophisticated enterprises and play- ers, often including foreign stakeholders, have been achieved. CONCLUSION The legal framework for corporate insolvency is generally sound, but contains a number of areas that make risk management less predictable and that constrain optimum commercial activity. Following adoption of the 1998 Bankruptcy Law, the legal framework for corporate insolvency law in Russia is fairly well-conceived, relatively comprehensive, and gen- erally consistent with standards of best practice internationally. The 1998 Bankruptcy Law replaced the 1992 legislation, which was poorly designed and contained a mix of different legal systems. The new law corrected many of the mistakes of its predecessor and better aligns with creditor rights created under other laws. In recent years, the increase in cases and the efficiency in handling cases has demonstrated that the sys- tem is beginning to mature, with better trained judges and professionals and greater efficiency in the administration of proceedings. Nevertheless, the regime does not perform as it should in a number of respects, and has been criticized for the lack of consistency in its implementation rather than its content. Particular implementation problems pertain to the ma- nipulation of the system to inequitably favor the interests of management or certain creditors to the detriment of creditors in general. A number of abuses have been reported, including 1. "Stacking" of creditor committees 2. Disenfranchisement of certain creditors 108 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 3. Wrongful disallowance of claims 4. Allowance of fraudulent claims 5. Wrongful trading and collusion to avoid filing obligations 6. Collusion between external managers, management, and judges 7. Use of bankruptcy proceedings as a form of hostile takeover, uti- lizing a colluding external manager as a means of gaining control of the bankrupt company's assets 8. Corrupt/irresponsible external managers paying no heed to the demands or interests of creditors. A recent decision by the Constitutional Court addresses a number of ambiguities in the law and should lead to more uniform interpretation of a number of key issues. The law nonetheless requires improvement in a number of fundamental areas, as follows: 1. Treatment of secured creditors should be properly harmonized with bargained-for secured rights, to promote maximum efficien- cy in lending and to create proper incentives for adopting risk management practices by lending institutions. Conversely, treat- ment should similarly promote effective incentives and disincen- tives for prudent corporate behavior in managing debt levels, to avoid the consequences of insolvency. Three basic amendments are recommended: * The provision for lien stripping should be enforced at the point of sale, not before, and only with respect to pledged assets that are essential to a sale of the business as a going concern. Where the business is to be rehabilitated, interests should naturally re- main in tact. Likewise, where pledged assets do not advance the liquidation process, secured creditors should be entitled to exercise their legitimate foreclosure rights. * The relative priority of interests should be respected. This would encourage holders of collateral to act promptly in regis- tering claims so that all parties are placed on better notice of the debtor's financial condition. This would also penalize those who delay in acting on their rights. * Secured creditors should only be entitled to priority for that portion of their claim that is properly secured. This would re- quire partially secured creditors being treated as having a se- cured claim only to the extent of the value of their collateral, and as having an unsecured claim for the remainder. 2. The criteria for initiating involuntary bankruptcy need to be re- examined to avoid bad faith or fictitious filings by those intent on using the process for self-gain through inappropriate hostile FRAMEWORK FOR CORPORATE INSOLVENCY 109 takeovers or as a safe haven from liability where the enterprise assets have been stripped, tunneled, or fraudulently transferred. Amendments in this area are more complex and require a close examination of the various system weaknesses that invite such activity, and the solutions for rectifying them. Proposed amend- ments should consider the adoption and enforcement of harsh penalties (potentially even criminal sanctions) for those who abuse the process. 3. Amendments should be made to ensure that genuine creditors are not disenfranchised and have a real voice in the process. This can be done by tightening procedures for assessing disputed claims at the outset of cases, and by promoting stronger involvement and participation by creditors at all critical stages of the proceedings. 4. Priorities of state interests over private claims should be reexamined in the context of the need to promote greater commercial activity. This would shift the burden to the state to adopt stronger debt col- lection practices outside of bankruptcy and discourage reliance on the insolvency process as a failsafe collection mechanism. Where applicable law establishes a legitimate priority for state claims over private claims, these should be recognized in bankruptcy. The institutional framework for implementing the insolvency regime remains fragmented and inconsistent with respect to its capacity for han- dling insolvency cases. Cases are handled by the arbitration courts, which have a wide range of responsibilities, not solely insolvency. In a few jurisdictions where there is generally a higher caseload, such as Moscow, certain judges have been designated as specialized judges to handle bankruptcy proceedings, and are doing so with greater consisten- cy. Most complaints about implementation concern practices outside Moscow, where court capacities and sophistication vary significantly. Moreover, although greater judicial discretion is viewed as a hallmark of a more advanced system, instances of abuse of discretion have been a major criticism and key impediment to implementing an effective and re- liable process. Recommendations include the following: 1. Efforts to improve capacity should focus on the criteria for the se- lection, qualification, and training of judges as specialized insol- vency judges, and should include continuing education programs. 2. Emphasis should be placed on achieving greater transparency in the system, specifically with a view to improving creditor access to information. There is also a need to encourage the involvement of genuine creditors, as a necessary counterbalance to the wide discretion of judges and administrators/external receivers. 110 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 3. Clear procedures should be established for investigating and ad- dressing allegations of conflicts of interest, abuse, and corruption among judges. The continuing lack of regulation and potential for arbitrage in the system has continued to foster distrust of the process. The primary regu- latory agency is the Federal Service on Financial Rehabilitation and Bankruptcy, which is responsible for training, qualifying, and supervising the activity of external receivers. To date, the FSFR has issued more than 12,000 licenses. This is a major achievement, but it also suggests that li- censing standards are low and that there is likely to be a glut of poorly trained and qualified receivers. A simple comparison of the number of li- censes awarded with the number of cases filed leads logically to the con- clusion that many licensed receivers are inactive in the bankruptcy process. Recommendations include the following: 1. The processes for weeding out and delicensing incompetent re- ceivers and for addressing abuses in the system should be closely monitored and studied for improvement. The FSFR has revoked or suspended relatively few licenses. 2. Criminal procedures and sanctions should be more rigorously en- forced. The number of criminal actions to date is inconsistent with the reports of widespread abuse and corruption, suggesting little appetite or ability to enforce criminal measures. 3. In light of the alleged abuses in many areas, the system must be examined to ensure that independence and impartiality are main- tained between the courts, administrators, and receivers, and to ensure that conflicts of interest are avoided. 4. The FSFR wears many hats and has many responsibilities, some of which create potential conflicts of interest or a potential threat to the agency's accountability. It is imperative that the FSFR be accountable to an independent body or board to avoid conflicts of interest and self-serving decision-making. The insolvency process will otherwise remain vulnerable to the sort of inappropriate po- litical interference that could tilt the balance in favor of state in- terests over private commercial interests, which invariably gives rise to unpredictability and distrust. Russia's current strategy and approach to enterprise rehabilitation does not effectively separate viable companies that can survive in a mar- ket economy from those loss-making enterprises that cannot. The new insolvency law is more accommodating to rescue through prebankruptcy measures, amicable settlement, and external receivership procedures than the prior law, but distortions and abuses in the application of the FRAMEWORK FOR CORPORATE INSOLVENCY 111 law reveal that the process of rehabilitation is being undermined and abused to keep insolvent businesses out of bankruptcy and to put solvent businesses in, for purposes of conducting hostile takeovers. While the promotion of a more active rescue culture is important, policies need to be properly aligned to ensure that viable businesses are salvaged. In this regard, there is a continuing need for training and capacity development, and other laws will need to be reviewed and reformed to better encour- age rehabilitation (an example is tax loss treatment on debt write-off). In addition, the laws must be closely examined with a view to enabling eq- uitable out-of-court workouts that avoid the high costs of the system, and a view to promoting a more efficient credit culture for the manage- ment of financial distress. ENDNOTES 1. RF Law No. 3929-1 of November 19, 1992, On Insolvency (Bankruptcy) of Enterprises (the "1992 Bankruptcy Law"). 2. See generally C. Sonin and E. Zhuravskaya, "Bankruptcy in Russia: Away from Creditor Protection and Restructuring," The European Commission Rev. 6-12 (2000). 3. See Vitrianskii 1999. The author states: "Such conditions allowed top man- agers of commercial organizations who had no reason to fear bankruptcy to withhold debt payment and use the available money as their own enterprise funds, ensuring only that the total amount of accounts payable did not exceed the asset value of the enterprise. From this, it is obvious that the legal concept and characteristics of bankruptcy that used to be applied protected bad faith debtors and were thus destroying the principles of commerce." 4. See World Bank. 1999. International preference for a liquidity test in cor- porate insolvency (as distinguished from a balance sheet test in bank insolvency) is tied to an evolving concept of business. Where a business cannot pay its debts as they come due, the business may not necessarily be balance-sheet insolvent. The effect of being illiquid, however, implies that the business is inefficient and imposes an economic burden on other market players that transact business with the enterprise. If the business is viable and sound, in a normalized market it should be able to obtain financing and/or capitalization from alternative sources. This theory does not necessarily hold in a destabilized market and one where eq- uity and credit markets are insufficiently evolved. On balance, however, the liq- uidity test is now widely embraced as a better indicator of corporate insolvency or financial distress than the balance sheet test. 5. See Vitrianskii. 1999. at 413. 6. See Vitrianskii. 1999. at 413-14. 112 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 7. Resolution of the Russian Federation No. 478 "On Measures to Increase Efficiency of Bankruptcy Procedures Application" (May 22, 1998). 8. For an interesting discussion of the lien-stripping issues and microeconom- ic policy considerations, see Averch 2000. 9. Claims having priority and paid before secured claims include (1) adminis- trative expenses and claims; (2) personal injury claims (category 1); and (3) sev- erance, back pay, and royalty claims (category 2). Claims paid after secured claims include government or budget claims (e.g., taxes and pension claims), fol- lowed by claims of unsecured creditors. 10. This discusses the so-called "zeta" principle on appropriate levels of debt to equity. 11. See Matlack 1999. 12. See, e.g., Lambert-Mogiliansky, Sonin, and Zhuravskaya 2000. 13. See generally World Bank 1999. 14. "On examining the constitutionality of various provisions of the Federal Law on Insolvency (Bankruptcy) relating to the possibility of appealing determina- tions issued by arbitrazh courts in bankruptcy cases and its other provisions, Arti- cle 49 of the Federal Law on Insolvency (Bankruptcy) of Credit Organizations, as well as articles 106, 160, 179, and 191 of the code of Arbitrazh Procedure of the Russian Federation in connection with the request from the Chelyabinsk Oblast Arbitrazh Court and complaints of citizens and legal entities." 15. Art. 5(1) BL. The arbitrazh courts are commercial courts dealing with commercial disputes, including bankruptcy cases. They are neither arbitration nor arbitrage courts in the strict sense. Rather, they are more closely akin to com- mercial courts. 16. Art. 1, 1998 Bankruptcy Law [hereinafter cited as "Art. - BL"]. 17. Art. 132 BL. 18. Art. 3(2) BL. 19. Art. 3(1) BL. 20. Art. 7(2) BL. 21. Art. 8(1) BL. 22. Art. 9 BL. 23. Art. 6 BL. 24. Art. 5(2) BL. 25. Art. 26(1) BL. 26. Art. 10 BL. 27. Art. 41(3) BL. 28. Art. 61 BL. 29. Art. 57(2) BL. 30. Art. 58(2) BL. 31. Art. 58(3) BL. 32. Art. 12-14 BL. 33. Art. 67 BL. FRAMEWORK FOR CORPORATE INSOLVENCY 113 34. Art. 68(1)-(2) BL. 35. Art. 69 BL. 36. Art. 74(2) BL. 37. Art. 74(1) BL. 38. Art. 74(1) BL. 39. Art. 77 BL. 40. Art. 78 BL. 41. Art. 82 BL. 42. Art. 81 BL. 43. Art. 96 BL. 44. Art. 98 BL. 45. Art. 120 BL. 46. Art. 78 BL. 47. Art. 75 BL. 48. Art. 106(2) BL. 49. Art. 114(5) BL. 50. One commentator and researcher refers to the problem as being one of capture of the courts by the local governments. See supra Lambert-Mogiliansky (discussing the distortions on bankruptcy performance and constraints on effec- tiveness resulting from political interference and external influences on the bank- ruptcy process). 51. Other facets of the TACIS program have resulted in the development of methodology for analyzing the financial condition and market prospects of insol- vent enterprises, and for enterprise restructuring. 52. This was done pursuant to Resolution of the FSFR of Russia No. 23 of August 7, 1999. 53. Numbers in parentheses represent the total number of experts accredited in each of these categories. 54. Creditors have voting rights at the creditors' meeting proportionate to the amount of their debt. Such rights do not take into account the priority of the cred- itor. Therefore secured creditors are treated like any other creditor when it comes to voting rights. A creditor's right to vote in a creditors' meeting to determine im- portant decisions in the case can be thwarted by the temporary administrator's de- cision to leave the creditor's claim off of the claims list, or by objecting to its legiti- macy. Because the legitimacy is called into question and is subject to resolution through appeals, the case marches on with decisions being made by other creditors. These types of abuses were reported as being intentional and frequent in order to skew the results of voting at the creditors' meetings. It was also reported that some large claims were fabricated to give insiders a voice or control in the process. 55. Debtors and creditors have easy access to the system. A debt of US$5,000 outstanding for three months is all that is required to initiate bankruptcy proceedings against a company. The growing number of bogus bankruptcies indi- cated in the performance data suggests that the access criteria are in fact too low. 114 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR REFERENCES Altman, Edward. 1993. Corporate Financial Distress, 2d ed. New York: Wiley. Averch, C. 2000. Lien Stripping under Russian Bankruptcy Law: Is it Fair? 105 Comm. Law Journal 77. Lambert-Mogiliansky, Ariane, Constantin Sonin, and Ekaterina Zhuravskaya. 2000. "Capture of Bankruptcy: Theory and Evidence from Russia." Center for Economic Policy Research Discussion Paper Series No. 2488: 1-41. United Kingdom. Matlack, C. 1999. "Russia's Boom in Bogus Bankruptcies." Business Week. New York (May 31) 3631: 46. Sonin, C., and E. Zhuravskaya. 2000. "Bankruptcy in Russia: Away from Credi- tor Protection and Restructuring." The European Commission Review 6-12. The Economist. 1999. "Rules of War." (December 4) Vol. 353, 8148: 65. Vitrianskii, V. V. 1999. "Insolvency and Bankruptcy Law Reform in the Russian Federation." McGill Law Journal. World Bank. 1999. "Russian Enterprise Reform: Policies to Further the Transi- tion" 67 World Bank Discussion Paper 400. Washington, D.C. CHAPTER 4 Disclosure and Transparency INTRODUCTION A strong disclosure regime is a key feature of the market-based monitor- ing of companies, and it is central to the ability of shareholders to exer- cise their voting rights and investment decisions. Shareholders and po- tential investors require access to timely, reliable, and comparable information in sufficient detail for them to make informed decisions. A strong disclosure regime is likewise essential for the banking sector, where not only the shareholder of the bank requires full disclosure, but also the depositor who is focused on the security of funds deposited within the bank. Thus, improving disclosure and transparency are essen- tial pre-conditions for increasing the flow of deposits into banks and for increasing the flow of lending to the private sector. Although it is far from being either perfect or complete, the legal basis does exist for obtaining basic information about a listed or publicly trad- ed company in Russia. The Russian Law on Joint Stock Companies con- tains a list of documents that a joint stock company is required to dis- close. The Securities Market Law establishes additional information disclosure requirements that are supplemented by numerous regulations of the Ministry of Finance (MoF) and the Federal Commission on the Se- curities Market (FCSM). The Central Bank of Russia (CBR) directs the reporting requirements for banks and, in the role of regulator and supervisor of the banking sec- tor, details the reporting and disclosure requirements. As regulator the 115 116 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR CBR monitors and evaluates the reports from Russia's almost 1,300 commercial banks. However, the regulatory role played by the CBR pro- vided little warning of the August 1998 financial crisis in Russia, which again caused the public to lose confidence in the financial sector of the economy. Since 1999, the law On Protection of the Rights and Legal Interests of Investors has provided the FCSM with the authority to fine publicly traded companies and their managers for violating information disclo- sure rules. The FCSM is required to report every penalty it imposes. Im- portant corporate events such as major transactions, changes in the exec- utive and supervisory structure, and board of director decisions must be announced in the regular FCSM newsletter. Moreover, the law explicitly requires the broker to provide shareholders with a complete set of docu- ments that detail the structure, activities, and policies of the company. In 2000, the FCSM imposed a total of 32 million rubles (US$1.2 million) in fines on 1,769 companies that violated the Investor Protection Law; the average fine of 18,090 rubles (US$695) can hardly be considered com- mensurate with the potential risk of the investor, however. The disclosure requirements of the FCSM and the CBR are not in themselves sufficient and adequate to protect the investor and depositor. Effective disclosure-based regulation requires a rule-of-law environment, interested and engaged investors and depositors, and strong regulatory institutions. It will take the whole constituency of state regulators, in- vestors, corporate managers, board members, accounting/audit profes- sionals, and public interest groups to change historical notions about transparency and to introduce new corporate objectives of disclosure and transparency. ACCOUNTING STANDARDS AND DISCLOSURE Financial statements are the means of communicating financial informa- tion about a company or bank. The balance sheet provides a dated snap- shot of assets, liabilities, and equity; the statement of operations reports on the period's revenue, expenditures, and profits; and the statement of cash flow provides a summary of the sources and uses of cash for the pe- riod. The notes to the financial statements provide additional descriptive information, including information on the accounting policies used by the reporting entity, further details about the assets and liabilities, disclo- sure of related-party transactions, reporting of material events, and key informational details of the entity and its operations. DISCLOSURE AND TRANSIARENCY 117 Financial statements are prepared in accordance with accounting stan- dards, which provide the framework and underlying foundation to the statements. Historically, the accounting standards in Russia were de- signed specifically to meet the needs of an economic system in place under a communist regime, and included a detailed and prescriptive chart of accounts, prescribed financial statement formats, and extensive accounting rules. These Russian Accounting Standards (RAS) have been under pressure to change, given the country's transition to a market- based economy. Worldwide, there is a shift toward using International Accounting Standards (IAS), a single set of standards issued by the Inter- national Accounting Standards Board (IASB). IAS is gradually becoming the benchmark for accounting standards, as evidenced by its recent en- dorsement by the International Organization of Securities Commissions (IOSCO), the European Union, the World Bank, and other key stake- holders in the financial sector.' The transition from RAS to IAS has been a continual topic of discus- sion within Russia. There are two main viewpoints on the issue, favoring either "evolutionary" or "revolutionary" change. The MoF has recently announced that it aims to transfer to IAS by 2004 through the yearly adoption of five or six accounting standards. This approach to rewriting the RAS is considered evolutionary, and is intended to allow for the nu- ances of the Russian economy to be incorporated into the rewriting of the standards. The second approach, as recently articulated in the min- utes of the Foreign Investor Advisory Committee (FIAC), favors the full adoption of IAS with a phased compliance requirement for various cate- gories of enterprises. This approach has been termed revolutionary, as the focus is on full and immediate compliance with IAS. There are many arguments supporting both sides of the standards transition debate. The evolutionary supporters would argue that it is im- possible to move quickly to IAS given the current legal and taxation laws, the training requirements for accountants and auditors, and the lack of supporting guidance and methodology for recordkeeping and ac- counting tasks. The revolutionary supporters argue that it is too costly to have to prepare financial statements in accordance with two sets of stan- dards; and that there would be continual change and ambiguity with evolving RAS; this would create a problem that would be exacerbated by the fact that IAS is also in the process of continual revision. A recently completed study by seven major accounting and audit firms highlights the differences between RAS and IAS. (The results of the study can be found in Table 4.1.) It should be noted that many of the differ- ences relate to disclosure of information. 118 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR Two of the main obstacles to the transition to IAS are the taxation and legislative requirements. Compliance with tax laws is of highest priority for companies, given the detailed and rigorous compliance and policing reality. The primary focus of tax reporting thus takes precedence over fi- nancial reporting. To resolve this impasse there will have to be a legally approved format of reconciling profit, as determined under IAS, with the taxable profit, as detailed under the Tax Code. This reconciliation would adjust for differences in the timing and deductibility of expenditures and other transactions. The legislative requirements, including those related to statistical reporting, and normative acts would need to be amended to facilitate a speedy transition to IAS. With respect to the banks, it is the CBR that is charged with the re- sponsibility for the development and regulation of accounting standards. These standards, while specific to the banks, cannot under law be in con- tradiction to those issued by the MoF. On the other hand, the CBR can require banks to report for supervisory purposes on the basis that it chooses. The CBR has recently announced plans to transition to IAS by January 1, 2004, and will be using IAS-based reporting for supervision purposes as well. The banks are faced with a similar dilemma as enter- prises with respect to taxation and the need for taxation to be based on IAS versus RAS. The self-regulating accounting profession in Russia comprises more than 90 different associations and membership organizations. The Insti- tute of Professional Accountants (IPA) is the largest, and has begun a 40-hour IAS training course for members. However, none of the ac- counting associations has initiated an attestation or certification of members in accordance with the International Federation of Accoun- tants (IFAC) educational guidelines. The issues of IAS training and at- testation must be urgently addressed, in order to provide the necessary professional cadre of accountants that will be needed for companies and banks to transition to IAS. AUDITING STANDARDS AND DISCLOSURE The external auditor has an important role in providing an opinion on whether or not the financial statements are prepared, in all material re- spects, in accordance with the identified standards of accounting. The auditor is required to follow a set of standards that provide the funda- mental framework for the work and opinion; he or she must also follow a code of ethics with respect to professional conduct. According to the DISCLOSURE AND TRANSPARENCY 119 Russian Securities Law, auditors are appointed at the annual general meeting. Historically, Russian Audit Rules (RAR) were used as the basis for the auditor's work; these have been replaced by Russian Standards on Auditing (RSA). International Standards on Auditing (ISA) are devel- oped and issued on behalf of the International Federation of Accountants (IFAC) by the International Auditing Practices Committee (IAPC). Table 4.4 lists the 39 approved Russian audit standards and provides the ISA equivalent. The RSA is similar to the ISA, but there is a fundamental difference re- lated to the liability of the auditor with respect to negligence or error. The laws of the Russian Federation allow for a legal claim by the client against the auditor; however, the damages are limited to the amount of the audit fee only. There is therefore limited liability risk for an audit firm and no provision for an outside third party to claim damages against a negligent auditor. While the litigious fervor that has developed in some countries is not desirable in Russia, the audit firm must nonethe- less be held accountable to a high professional standard. The audit profession in Russia is government-regulated through the issuance of audit licenses, with the CBR responsible for the issuance of audit licenses for banks. However, on June 18, 2001, the Duma banking committee recommended that the lower house pass the bill On Auditing Business on its second reading. If the Duma approves the bill, the CBR would lose the right to regulate the banking audit market. The bill pro- poses that a federal body for the state regulation of auditing business control the banking audit market and the other three market segments, namely, the audit of insurance companies, a general audit, and the audit of exchanges, ex-budget funds, and investment institutions. The ministry responsible for this federal body has not been identified, but is thought to be the Ministry of Finance. The self-regulatory audit profession is in the early stages of develop- ment. The Collegium of Auditors became a member of IFAC in 2000; however, it does not have a comprehensive training and certification pro- gram based on ISA, and to date does not conduct peer reviews of audit firms. For the audit profession to become credible in the world's market- place, there must be a concerted training initiative with respect to ISA, coupled with an intensive and professionally recognized examination process. Peer review of audit firms will also be a key step in achieving the desired competency recognition. The recent World Bank review of audit firms in Russia indicates that there is a lack of understanding of the audit process and of the documentation requirements with respect to audit working papers as required under IAS. This may in part be explained by 120 BUILDING TRUST: DEVELOPING THE RussJAN FINANCIAL SECTOR the historical background, where the audit was traditionally focused on a documentation audit rather than on an audit of financial statements. ENFORCEMENT AND DISCLOSURE The preparation of financial statements in accordance with ISA, and the engagement of an auditor to express an opinion on the financial state- ments and conduct the audit in accordance with ISA, are two important steps to disclosure and transparency. In addition to the auditor, there are several other key groups involved in the enforcement of accounting standards. First, there must be a self-enforcement by the company or bank itself. The management and board of directors are responsible for the financial statements. In Russia this is often misunderstood, because historically the chief accountant had been responsible for the financial statements. There is continual reluctance on the part of management to sign a management representation letter as required under section 580 of ISA-that is, for management to acknowledge its responsibility for the financial state- ments. Second, the shareholders play a role in the enforcement of disclo- sure, because the financial statements must be approved at each annual meeting. The preparation of glossy shareholder reports tends to hide the financial statements and mask their importance. Third, the regulators (the FCSM and the CBR) must play a greater role in enforcement. To be effec- tive, the FCSM and the CBR will need a sufficient number of trained per- sonnel to monitor compliance with the disclosed requirements. Also es- sential are a variety of disciplinary mechanisms to sanction companies and banks whose disclosures contain material misstatements or omis- sions. Fourth, there must be changes in the various laws, including the Code on Corporate Governance, to articulate the requirements and con- sequences for noncompliance. Fifth, the public must become engaged in the demand for full disclosure. The use of rating agencies to monitor and report on corporate governance compliance would be an important step toward increasing the amount of information available to the public. In addition to the disclosure of financial information, recent reform efforts by Russian regulators are an indication that the importance of nonfinancial information is starting to be recognized. In 2000, a MoF regulation set out new rules for disclosing information that is not pre- sented in the financial statements but is necessary to assess the financial position of, performance of, and changes in a company's financial situa- tion. This includes information on accounting policies, changes in equity, DISCLOSURE AND TRANSPARENCY 121 details of the number of shares issued, extraordinary events, and affiliat- ed undertakings. There is also an optional provision to include informa- tion on environmental policies and material foreseeable risks. It is too early to say if this regulation will be fully complied with, and to what ex- tent companies and banks will consider it necessary to disclose this re- quired information. With the help of the United States Agency for International Develop- ment and the European Union TACIS, two technical assistance projects have gotten underway at the CBR to improve the reporting requirements of the commercial banks. This in turn should improve the off-site super- visory capacity of the CBR. Training of supervisory staff has focused on the shift from merely compliance review to risk assessment and bank per- formance analysis. RECOMMENDATIONS 1. There should be a full and immediate adoption of IAS, rather than a gradual transitional rewrite of RAS. The gradual phase-in of companies and banks required to report according to IAS is un- derstood, especially with respect to privately owned or closely held companies. 2. In order to meet the economic demands of investors and deposi- tors, there is an urgent need for all listed companies and all banks to use IAS as the sole basis for the preparation of financial state- ments. To facilitate a smooth transition process, there will need to be an orderly phased process, beginning with the largest banks and the Tier-one listed companies. The optional use of IAS should be extended to all small and medium-size enterprises. 3. The legal framework of laws and normative acts must be amend- ed quickly to facilitate the move to full IAS. 4. Changes in the tax code are necessary to recognize IAS as the legal basis for taxation, ensuring that taxpayers will not be required to contend with two sets of different requirements. 5. The role of the regulators (the FCSM and the CBR) must be en- hanced to ensure full compliance with all reporting requirements. As the primary regulators of the disclosure of financial informa- tion, the FCSM and the CBR must focus on training and enforce- ment and on the exercise of their authority to impose substantial sanctions in the case of noncompliance. 122 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 6. The accounting and audit profession must be strengthened through appropriate training, testing, and certification. The self-regulatory nature of the profession means that it must focus on becoming credible in the global forum and must ensure, through their adher- ence to a code of ethics, that its members are not only technically competent but also professionally responsible. COMPARISON OF RUSSIAN AND INTERNATIONAL ACCOUNTING AND AUDITING STANDARDS Russian Accounting Standards can differ from International Accounting Standards because certain areas of business do not have rules or stan- dards in RAS. Table 4.1 lists IAS standards that are not reflected in RAS. Table 4.1 Rules Missing in RAS and Present in IAS Standards Standards absent in RAS present in IAS The classification of business combinations between acquisitions IAS 22 and pooling of interest Provisions in the context of business combinations accounted IAS 22.31 for as acquisitions The restatement of financial statements of a company reporting in the IAS 29.8 currency of a hyperinflationary economy in terms of the measuring unit current at the balance sheet date The translation of the financial statements of hyperinflationary subsidiaries IAS 21.36 Impairment of assets IAS 36 The recognition of operating lease incentives IAS 17.25; SIC 15 Accounting for defined benefit pension plans and some other types IAS 19.52 of employee benefits Accounting for deferred tax IAS 12 Accounting for an issuer's financial instruments IAS 32.18/23 The treatment of exchange differences resulting from severe devaluation IAS 21.21; SIC 11 or depreciation of a currency The notion and definition of cash equivalents IAS 7.6-9 and detailed IAS 7 guidance on the preparation of cash flow statements Consolidation of special purpose entities SIC 12 Recognition of a decline, other than temporary, in the carrying amount of IAS 25.23 long-term investments, other than marketable equity securities DISCLOSURE AND TRANSPARENCY 123 Table 4.2 Discrepancy between RAS and IAS Disclosure Requirements Disclosures required under Disclosures not required under RAS IAS A primary statement of changes in equity IAS 1.7 A primary statement of cash flows IAS 7 The FIFO or current cost of inventories valued on the LIFO basis IAS 2.36 The fair value of financial assets and liabilities IAS 32.77 Related parties information except by certain reporting companies with IAS 24.1-4 specific legal form (joint stock companies); fellow subsidiaries under common control do not qualify for consideration as related parties Discontinuing operations IAS 35 Certain segment information (e.g., a reconciliation between the information IAS 14.61/67 by reportable segment and the aggregated information in financial statements, significant noncash expenses, other than depreciation and amortization, that were included in segment expense and, therefore, deducted in measuring segment result-for each reportable segment). Russian standards have different requirements than IAS concerning disclosure. Table 4.2 lists those areas of disclosure required under IAS but absent from RAS. The inconsistencies between RAS and IAS rules, listed in Table 4.3, have implications for many enterprises. Russian auditors now use Russian Standards on Auditing (RSA), which replaced Russian Audit Rules. International Standards on Auditing were developed and issued on behalf of the International Federation of Accoun- tants by the International Auditing Practices Committee. Table 4.4 com- pares the 39 approved Russian audit standards to the ISA equivalent. 124 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 4.3 RAS Rules That Differ trom IAS RAS rules IAS rules Research costs can be capitalized IAS 38.42/51 Goodwill is calculated by reference to the book values of acquired net assets IAS 22.40 Proportionate consolidation may be used for subsidiaries in which the IAS 27.15 parent has 50 percent or less of the voting power Revaluation of property, plant, and equipment is allowed but gives different IAS 16.29 results than IAS and need not be kept up-to-date The period of depreciation of property, plant, and equipment is in a number of lAS 16.6/41 cases prescribed by the Government and is longer than the period over which an asset is expected to be used Finance leases are generally defined in legal terms and capitalization is allowed IAS 17.3/12.28 but not required Lessors recognize finance lease income differently IAS 17.30 The completed contract method can be used for the recognition of revenues on lAS 11.22 construction contracts when the outcome of a construction contract can be estimated reliably Provisions can be established more widely or less widely than under IAS, IAS 37.14/45 and there is no requirement for discounting Own (treasury) shares are shown as assets SIC 16 Classification of cash flows between investing and financing activities in the IAS 7.6/16/17 cash flow statement may be different from IAS Cash flow statements reconcile to cash rather than to cash and cash equivalents IAS 7.45 The correction of fundamental errors is included in the determination IAS 8.34/38 of the net profit or loss for the reporting period, but separate disclosure and pro-forma restated comparative information are not required Revenue recognition rules do not differentiate between exchanges of IAS 18.12; goods of similar nature and value and exchanges of dissimilar goods, IAS 16.21/22 and do not discuss adjustment for the amount of cash or cash equivalents transferred in exchange for dissimilar goods The definition of extraordinary items is broader IAS 8.6/12 Some parent companies do not prepare consolidated financial statements lAS 27.7/11 In the definition of control, the ability to govern decision-making is not IAS 27.6 required to be accompanied by the objective of obtaining benefits from the entity's activities Investments in certain securities held for the short term are not required to be IAS 25.19/23 carried at the lower of cost and market value or at market value Certain subsidiaries may be excluded from consolidation IAS 27.13 A subsidiary that is a bank may be excluded from consolidation if it is dissimilar IAS 27.14 from the rest of the group Certain set-up costs that have been paid by a company's founder can be IAS 38.57 capitalized The realizable value of inventories can be measured without deduction of costs IAS 2.6 DISCLOSURE AND TRANSI'ARENCY 125 Table 4.4 The 39 Approved Russian Standards on Auditing and the Equivalent International Standards on Auditing RSA ISA 1 The auditor's report on financial statementsa ISA 700 2 Planningb ISA 300 3 Audit engagement letter ISA 210 Terms of Audit Engagements 4 Audit evidence ISA 500 5 Using the work of an expert ISA 620 6 Audit sampling ISA 530 7 Documentation ISA 230 8 Fraud and error ISA 240 9 Evaluation of accounting system and internal control ISA 400 Risk Assessments during the audit and Internal Control 10 Date of audit report and subsequent events ISA 560 Subsequent Events 11 Management letter 12 Glossary of terms ISA 110 13 Auditing in computer information systems environmentc ISA 401 14 Materiality and audit risk ISA 320 Audit Materiality 15 Analytical procedures ISA 520 16 Education of the auditor 17 Going concern assumptiond ISA 570 18 Quality control ISA 220 19 Considerations of laws and regulations in an audit of ISA 250 financial statements 20 Initial engagements-opening balances and comparatives ISA 510 21 Management representations ISA 580 22 Related audit services, 23 Related parties ISA 550 24 Communications with management ISA 1007 25 Using the work of another auditor' ISA 600 26 Knowledge of business ISA 310 27 Considering the work of internal auditor ISA 610 28 Objective and general principles governing an audit of ISA 200 financial statementsg 29 Other information in documents containing audited ISA 720 financial statements 30 Audit of accounting estimates ISA 540 31 Examination of prospective financial information ISA 810 32 Requirements for the internal audit standards of the audit firm' 33 Rights and obligations of the auditor and the client 34 Procedures for preparation of audit contracts 35 The auditor's report on special-purpose audit engagements ISA 800 (Table continues on next page) 126 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 4.4 (continued) RSA ISA 36 Risk assessment and internal control-CIS characteristics and considerations' ISA 1008 37 Computer-assisted audit techniques 1009 38 Tax audit and other related tax services; communications with tax authorities 39 Particular considerations in the audit of small business a. RSA 1 Approved by PCAA 02/09/96 Protocol 1. b. RSA 2-12 Approved by PCAA 12/25/96 Protocol 6. c. RSA 13-16 Approved by PCAA 01/22/98 Protocol 2. d. RSA 17-21 Approved by PCAA 07/15/98 Protocol 4. e. RSA 22-24 Approved by PCAA 03/18/99 Protocol 2. f. RSA 25-27 Approved by PCAA 04/27/99 Protocol 3. g. RSA 28-31 Approved by PCAA 08/20/99 Protocol 5. h. RSA 32-35 Approved by PCAA 10/20/99 Protocol 6. i. RSA 36-39 Approved by PCAA 07/11/00 Protocol 1. ENDNOTE 1. For an introduction to the principles and terminology of IAS, see van Greuning and Marius Koen (1999) and (2001); the first edition was published in English and Russian, the second edition in English only. REFERENCES van Greuning, Hennie, and Marius Koen. 1999. International Accounting Stan- dards: A Practical Guide. Washington, D.C.: World Bank. . 2001. International Accounting Standards: A Practical Guide, 2nd ed. Washington, D.C.: World Bank. PART II THE BANKING SYSTEM: STRUCTURE AND PERFORMANCE I nternational experience reveals that the financial sector has an impor- tant role to play in economic development. After identifying the key contributions that the financial sector can make to stimulate broad- based economic development, Chapter 5 focuses on the development of the Russian banking sector. Development of the banking system is criti- cal for broader-based financial sector development. For example, it is dif- ficult to conceive how investors will gain confidence in securities markets when banks are not trusted to deliver reliable payment, custodial, and settlement services. Thus, the development of a well-functioning banking sector will need to precede the development of other parts of the finan- cial system. While a banking system may be able to function efficiently without a capital market, it is impossible to conceive that a capital mar- ket could function efficiently without the services of a well-developed banking system. The subsequent chapters in Part II focus on specific features of the re- form program that relate to the banking system. Chapter 6 analyzes the performance of several subgroups of Russian banks since the financial crisis in 1998, and it outlines a number of banking practices related to the financial reporting undertaken by Russian banks. This analysis draws attention to several weaknesses that need to be addressed because they defray trust in the sector. Improving banking regulation would mend these weaknesses, thereby enhancing trust in the sector. Based on international experience with state banks, Chapter 7 address- es the issue of reforming the state banks in Russia. Experience from a 127 number of other countries reveals that state banks have been the source of often sizeable fiscal liability. Given their growing dominance in the Russ- ian financial sector since the 1998 crisis, state banks could threaten the stability of the sector. Reforming these banks is thus crucial to building trust in the Russian financial system. Chapter 8 addresses the issue of entry by foreign banks, basing its conclusions on a survey of the foreign banks currently operating in Rus- sia. International experience reveals that entry by foreign banks can be beneficial, even crucial, to building trust in financial intermediation. The results of this survey reveal that, rather than being constrained by re- strictions of a supervisory nature, foreign banks are restrained in their ef- forts to expand in the Russian market by weaknesses in implementation of the law-especially as it applies to creditor rights. Thus implementa- tion of the legal and accounting infrastructures may hold the key to the development of a sound and trusted banking system. CHAPTER 5 The Role of the Financial System THE IMPORTANCE OF THE FINANCIAL SECTOR FOR ECONOMIC DEVELOPMENT Russia would likely have grown faster over the last decade if it had had a better-developed financial system. Financial intermediary development has a causal impact on economic growth (see Levine, Loayza, and Beck 2000).1 While a sound, efficient financial sector is not sufficient to guar- antee long-term growth, long-term growth is difficult to achieve without a sound financial sector. Based on international experience, this chapter outlines the major benefits that a well-functioning financial system can have for economic development. A well-developed financial system would allow Russia to transform more easily into a market economy and to restructure its industrial base. Cross-country comparisons show that countries with a more developed financial system allocate their resources more efficiently and enjoy faster productivity growth.2 On the other hand, there is no significant relation- ship between financial intermediary development and private savings rates, and the causal link between finance and capital stock growth is tenuous at best (see Beck, Levine, and Loayza 2000).3 Rather than filling an investment gap, a well-developed financial sector supports the effi- cient allocation of resources. Countries with more developed financial systems invest more in growing industries and decrease their investment in declining industries (see Wurgler 2000). Sectoral investment is thus more responsive to sectoral output growth in those economies that are more financially developed. 129 130 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR A well-developed financial system channels resources to the sectors that need them to enhance firm growth. It also fosters, disproportionately, the growth of industries that rely heavily on external financing (see Rajan and Zingales 1996). Financial development thus alleviates the constraints im- posed by market frictions on industries that depend on outside finance. Furthermore, financial development helps firms grow beyond the limits imposed by internal cash flow and short-term lending (see Demirgiiu-Kunt and Maksimovic 1998). Countries with higher levels of financial develop- ment have more firms that grow faster than those that are supported by in- ternal cash flows and short-term debt. Financial development thus would enable Russian enterprises to grow beyond the constraints imposed by in- ternal resources and would benefit the industries that are most dependent on external finance. A developed financial system would also have lowered the recent growth volatility of the Russian economy, and helped Russia move away from a natural resource-based economy. Recent research has shown that countries with better-developed financial systems experience less volatility in their GDP per capita growth rates, and that such a finan- cial system can help dampen the impact of terms-of-trade shocks on eco- nomic growth (see Easterly, Islam, and Stiglitz 2000; and Beck, Lundberg, and Majnoni 2001). This is especially important for a resource-based economy such as Russia. While the recent oil price surge has helped Rus- sia's fiscal situation and economic growth, a price slump would have the same degree of impact, albeit negative. A better-developed financial system can help diversify the industrial base, dampen the effect of price shocks on consumers and producers, and help Russia's growth rate become less de- pendent on commodity price swings. Also, cross-country studies have shown that economies with better-developed financial systems have higher export shares and trade balances in manufactured goods, and that a well- developed financial sector helps countries increase the share of manufac- turers in overall exports (see Beck 2001). A well-developed financial sector is also important for poverty allevi- ation. While there is limited statistical evidence demonstrating the direct effect of financial development on poverty alleviation, there is substan- tial anecdotal evidence and a strong argument for an indirect impact. First, recent cross-country studies suggest that growth in real per capita GDP raises almost one-for-one the income of the poor (see Dollar and Kraay 2001). Second, as mentioned above, financial systems help economies absorb shocks better; a more efficient financial system that of- fers large parts of the population a safe outlet for its savings and better access to credit helps households and small entrepreneurs protect them- selves against shocks. Third, financial crises entail large fiscal costs that THE ROLE OF THE FINANCIAL. SYSTEM 131 crowd out social spending; while the small size of Russia's financial sys- tem reduced the impact of the financial crisis in 1998 on the real sector and thus on economic growth, the costs of the private banks' losses were to some extent borne by the Central Bank and the Government. These losses and further hidden losses in the banking sector constitute a contin- gent fiscal liability that will have a negative impact on social spending by the Russian government. Over the last two years, Russia has shown a strong growth performance despite the lack of a significant contribution from the financial sector. Sus- tainable growth and a successful transition to a market economy are not feasible, however, without a sound and efficient financial sector. Without a financial sector, the Russian economy will remain concentrated on natural resources and will be susceptible to commodity price swings. Furthermore, the recent real appreciation due to commodity price increases subjects other sectors of the economy to the "Dutch disease," whereby high com- modity prices lead to appreciation of the currency and thus reduce the competitiveness of nonresource-based exporters placing them at a disad- vantage internationally. While some improvement in productivity has been achieved over the last two years, a better-developed financial sector would help the economy improve resource allocation and increase productivity growth. Box 5.1 summarizes the main functions of a well-functioning fi- nancial system (for more information, see Levine 1997). THE KEY ROLE OF BANKING SYSTEM REFORM Financial sector reform takes time and therefore needs to be carefully se- quenced. Part I of this book outlined a number of legal, judicial, and ac- counting reforms that are the building blocks for lending by banks to un- related third parties. Not until these reforms are implemented will the environment be conducive for lending by banks. Banks perform a num- ber of other functions that are crucial to any well-functioning financial system, such as providing efficient payment services, ensuring the liquid- ity of accumulated savings (especially for small savers), and undertaking custodial and settlement functions for security market transactions. Development of the financial system also entails developing new non- bank financing mechanisms, such as leasing and factoring, and the devel- opment of the capital market. The Russian authorities started establish- ing the basis for a capital market in the early 1990s, but these endeavors were initiated mostly to provide a mechanism for transferring property 132 BUILDING TRUST: DEVELOPING THE RUssIAN FINANCIAL SECTOR Box 5.1 The Main Functions ot the Financial Sector Payment services: Financial institutions facilitate the exchange of goods and services by pro- viding efficient payment services. A monetized economy with a readily accepted means of ex- change eliminates the need for double coincidence of wants, economizes on transaction costs, and thus enables greater specialization than does an economy based on barter. Financial insti- tutions can lower the costs of transactions further by offering a trusted, timely, and efficient payment system that reduces the geographic and time barriers to monetary exchange. By of- fering trusted, timely, and efficient payment services, financial institutions can increase the public's confidence, attract funds, and thus increase inside money; that is, the resources that are intermediated through the financial system. An economy based on a monetary means of exchange also facilitates the formation of prices and thus efficient resource allocation. Com- pared to a barter economy, a monetized economy offers greater transparency, efficiency, and fairness in price setting. Mobilizing savings: Financial institutions mobilize and pool savings. By aggregating small sav- ings from individuals, financial institutions can make possible large-scale investments and the adoption of better technologies. The capacity of the financial sector to attract savings, howev- er, depends on the trust and confidence that savers have in their financial institutions. Risk diversification: Financial institutions facilitate risk amelioration. Specifically, they help de- crease the liquidity risk stemming from investment in long-term illiquid projects. By trans- forming callable deposits into long-term loans, banks can offer liquid assets to savers, and long-term financing to investors.* Liquid capital markets allow savers to hold assets that they can easily and quickly sell, and at the same time they offer long-term resources to firms. Fi- nancial markets also help diversify the risks facing individual firms, industries, regions, or countries, and thus foster innovation and technical change. Resources allocation: Financial institutions facilitate the acquisition of information about po- tential investment projects and thus resource allocation. A major role of the banking industry is to develop expertise in the process of collecting and analyzing the collection of information about investment opportunities and thus more efficiently identify the most promising entre- preneurs and the projects most deserving of investment. This function is especially important in a transition economy that needs to redefine its industrial structure in order to transform to a market economy and integrate with the global economy. Corporate control: Financial intermediaries can exert corporate control over inside owners and managers. This serves not only to protect the capital provided by outside investors but also to ensure efficient resource allocation. Again, this function is especially important in a transition economy that is in need of industrial restructuring. -Long-term" in this context does not refer to a specific maturity, but rather to all loans that, unlike de- posits, cannot be easily recalled overnight. from the control of the state to private parties. Only recently have the authorities turned their attention to laying the key building blocks for the capital market, such as ensuring corporate governance and thereby encouraging the domestic mobilization of savings. While capital market development is an integral part of the process of developing the financial system, it is difficult to conceive how the capital THE ROLE OF THE FINANCIAL SYSTEM 133 market would develop without the foundation of a solid and trusted banking system. The use of capital market instruments generally involves commitment on the part of creditors and debtors to more complex, longer-term payment profiles-as would be the case with investment in enterprise equity-while bank deposits and loans have shorter maturities and relatively simple payment profiles. It would not be possible for capi- tal markets to function efficiently as long as banks are unable to deliver their services efficiently, and trust in banks remains weak. Banking sys- tem development (further covered in Part III of this book) lays the foun- dation for the broader agenda of financial sector development. The re- mainder of this chapter provides a brief overview of the size, structure, and functions of the Russian banking system. SIZE AND STRUCTURE OF THE RUSSIAN BANKING SECTOR The Russian banking sector4 at the end of 2001 had approximately US$104 billion total assets, which represents 34 percent of GDP. Prior to the 1998 crisis, the sector's total assets were 27 percent of GDP, indicat- ing real growth in the banking sector post-crisis. At the end of 2001, Russian domestic credit was 24.3 percent of GDP, or US$76.0 billion, and the deposit base was 17.0 percent of GDP, or US$52.9 billion. Credit to the private sector was 15.4 percent of GDP (see Table 5.1). As illustrated in Table 5.2, the Russian banking system is small by re- gional standards and underdeveloped compared with countries with sim- ilar per capita income. Declining Numbers of Banks and Increasing Bank Capitalization Levels Table 5.3 summarizes the trend in the number of banks and their capital- ization. Rather than being accentuated by the 1998 crisis, the rationaliza- tion in the number of banks has actually slowed in recent years and even risen slightly in 2001 (see Figure 5.1). Based on their submissions to the CBR-developed under Russian Accounting Standards-at end-2001, only 230 Russian banks have paid-in capital of more than 150 million rubles, which is slightly below the ruble equivalent of the EU minimum capital requirement of 5 million euros (RUR 170 million at end-2001 ex- change rates). If the EU standard were to be applied in Russia today, 134 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 5.1 Monetary Survey Data on the Russian Banking System (percent of GDP) Monetary survey 1997 1998 1999 2000 2001 Bank deposits 13.0 16.1 15.5 15.9 17.0 Money and quasi-money (M2) 18.4 23.3 21.7 22.0 23.5 Domestic credit 26.5 41.1 32.7 23.9 24.3 of which: Claims on general Government (net) 15.4 26.8 19.9 10.4 7.8 Claims on nonfinancial public enterprises 1.3 1.2 1.0 1.0 0.9 Claims on private sector 9.5 12.8 11.5 12.3 15.4 Claims on other financial institutions 0.3 0.3 0.3 0.2 0.2 Nominal GDP, US$billion 428.5 277.8 184.6 251.1 311.0 Source: CBR, and International Financial Statistics (IMF). Table 5.2 International Comparison of the Banking System Depth (percent of GOP) 1997 2000 Private credit Deposits Private credit Deposits Russia 10 13 12 16 Eastern Europe average 18 24 21 30 Czech Republic 67 63 50 65 Hungary 24 35 26 39 Poland 17 31 26 38 Ukraine 2 7 11 11 Lower-middle-income countries 50 33 54 38 OECD countries 123 55 128 56 Source: International Financial Statistics (IMF), and World Development Indicators (World Bank). Table 5.3 Number of Credit Organizations by Paid-in Capital Credit institution 1997 1998 1999 2000 2001 Under RUR 3 mln (US$0.1 min) 806 817 230 174 128 RUR 3-30 mln (US$0.1-1 mln) 685 453 678 595 535 RUR 30-60 mln (US$1-2 mln) 206 201 253 256 255 RUR 60-150 mln (US$2-5 mln) n/a n/a 93 126 171 RUR 150-300 min (US$5-10 mln) n/a n/a 43 69 97 Over RUR 300 mln (US$10 mln) n/a n/a 52 91 133 Total number 1697 1471 1349 1311 1319 n/a = not available. Source: CBR Internet site: Monthly Bulletin of Banking Statistics. THE ROLE OF THE FINANCIAL SYSTEM 135 Box 5.2 The Post-1998 Crisis Period: A Missed Opportunity for Consolidating the Banking System? Following the 1998 crisis, the authorities succeeded in stabilizing the Russian banking system, but they failed to use the opportunity of widespread distress in the sector to consolidate the number of banks. The number of banks remains almost unchanged in the years following the crisis (see Figure 5.1). While the situation of the banks has improved since 1998, weak bank- ing practices and inadequate supervision continue to conceal serious banking system fragility (for further discussion, see Chapters 6 and 9). In countries with deep financial systems, financial crises can be seriously disruptive and fi- nancially very costly. However, in shallow financial systems-such as in Russia-the disrup- tion and attendant costs caused by financial crises are likely to remain quite small. Under these circumstances financial crises may actually be beneficial, especially if such practices as the provision by banks of subsidized loans to politically "favored" customers are discontinued as a result of the crisis. In addition, in those countries where noncash payments and barter are tolerated as alternative sources of short-term working capital finance, the effects on the enter- prise sector of interrupting financial intermediation through official channels will be muted. Thus, in transition economies financial crises provide an opportunity for systemic change de- signed to increase the efficiency of the financial system and increase its depth. Several stages of the financial deepening process in the transition economies of Eastern Eu- rope and the former Soviet Union have been identified (Peachey and Roe 2001). According to this analysis the ability of the financial system to achieve genuine stability depends on * Reducing tolerance for noncash payments: Nonpayments-often representing tax privi- leges-allow inefficient enterprises to survive and provide alternatives to more conven- tional payment and credit arrangements. Noncash payments became much more prevalent in Russia immediately following the 1998 financial crisis, but they have declined signifi- cantly in recent years (see the discussion in Chapter 13). In part the decline in nonpay- ments reflects improved enterprise payment capacity (stemming from rising raw material prices) and the 1998 devaluation rather than structural changes. Thus, it is not certain that the greater use of official payment mechanisms will be maintained in less conducive eco- nomic circumstances. * The willingness of the authorities to consolidate the banking system: Consolidation can only take place if the authorities are willing to drop protection of weak, nonviable banks. In achieving genuine stability there are sizeable gains to be made from consolidating the do- mestic banking system to concentrate on the better-managed, lower-cost banks, thus im- proving the overall efficiency of intermediation. As the failure to consolidate raises the cost of intermediation, there is a risk that without the closure of nonviable banks, the real preservation of domestic savings that has been achieved in Russia since 1998 may be un- dermined. The real cost of borrowing is unlikely to fall to credible levels until the interme- diated financial savings of the economy are consolidated around a smaller number of banks with a significantly reduced cost base. Thus, while the Russian authorities have managed to maintain the stability of the banking sys- tem in the post-1 998 crisis period, they did not address the necessary process of system con- solidation. Going forward, the consolidation process will depend on the adoption of increas- ingly low supervisory tolerance of high operating costs and low earning-to-asset ratios that characterizes many banks-both private and state-owned-and the adoption of explicit su- pervisory policies to accelerate bank consolidation and concentrate a bigger percentage of banking business in lower-cost banks. This will include a lower degree of supervisory toler- ance of marginal performance by smaller banks as well as explicit efforts to broker mergers. 136 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Figure 5.1 Number of Operating Banks 1996 1997 1998 1999 2000 01 2,500 2,250 1,000 10m , 4/ 00 I/,, 40, °ir/ 01 Vol li, °n, 0 9, , °-%9,Q a Source: CBR Internet site: Monthly Bulletin of Banking Statistics. about 1,100 banks would thus require merger or recapitalization. At the beginning of 2001 only 76 banks had assets in excess of US$100 million, with the largest bank (Sberbank) dominant with assets of US$20 billion, or around five times the value of the assets held by the second-largest bank, Vneshtorgbank at US$4 billion (CBR 2001). The small size of Russian banks means that they cannot take advan- tage of economies of scale, and are consequently inefficient. Banks in Rus- sia today are caught in a vicious cycle: they need to grow to increase their retained earnings but lack the retained earnings that would enable them to grow. For most of the smaller banks, long-term survival will depend in- evitably on their ability to raise capital or merge with other banks. DOMINATION BY STATE BANKS While the concentration of the Russian banking system is not unusual in- ternationally, the dominance of state banks in Russia is high and has been increasing since the financial crisis in 1998. As of January 1, 2001, the top 30 Russian banks, including nonstate banks, controlled around 67 percent of total bank assets and accounted for more than 53 percent of paid-in capital (CBR 2001).5 The top 50 banks, including Sberbank, hold 76 percent of total assets, 89 percent of retail deposits, and 78 percent of loans within the system. Sberbank alone THE ROLE OF THE FINANCIAL SYSTEM 137 holds around 75 percent of the household deposits in the system. The larger state-owned banks control around 32 percent of banking sector assets.6 If the banks that are majority-owned by regional governments are included in this calculation, the proportion of banking sector assets con- trolled by the state rises to at least 40 percent. Since the demise of the gov- ernment securities market in 1998, state banks have emerged as impor- tant providers of loans for Russia's largest corporations. ROLES AND OWNERSHIP STRUCTURE OF THE BANKING SECTOR While Russian banks have not been particularly effective as financial in- termediaries, they have learned to rely on alternative sources of earnings, such as the following. 1. Providing financial services to specific enterprise-owners. A large number of banks have served as the financial arm of a large enter- prise or group of enterprises rather than providing banking servic- es to unrelated third parties. Many banks perform such functions as settling payments for shareholders and the client enterprise; providing banking services to the enterprise's managers and em- ployees; and engaging in investment activities on behalf of the en- terprise. One factor supporting the development of such "clearing center" banks is the tax treatment of interest payments. According to the Russian Civil Code, interest payments on intercompany lending, including trade credit, are not tax-deductible. It therefore serves the interests of business groups, in the event of one or more companies within the group generating excess liquidity, to transfer that liquidity to another part of the same group through a bank. This has led to a number of groups and companies setting up their own banks to handle their interenterprise trading and intercompa- ny liquidity management. 2. Facilitating quasi-money operations. Many Russian banks are en- gaged in managing or supporting Russia's quasi-money and/or nonmonetary system, issuing veksels for tax and/or regulation- evasion purposes or structuring and brokering transactions to help companies and government agencies manage the intricate operations of barter and receivable offsets. Some banks that are owned by regional governments or municipalities are active in these transactions. 138 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 3. Acting as lender to federal and local government. Prior to the 1998 crisis some banks held as much as 70 percent of their assets in gov- ernment paper. With the demise of the government securities market and lack of trust in the interbank market, many banks now hold large clearing balances with the CBR. 4. Performing treasury functions for federal and local government. A major source of earnings coveted by Russian banks is the provi- sion of treasury functions for federal and local governments-that is, banks acting as repositories and/or transfer agents for govern- ment funds, including budget subsidies; salary, wage, and pension payments; tax payments; various budgetary funds; and customs revenues. 5. Provision of short-term financing. Banks provide short-term work- ing capital loans (up to three months on average) for import and export finance. However, the role of nonformal finance, such as tax arrears and barter transactions is still considerable. Other financing vehicles, such as factoring and leasing, are only beginning to emerge (for a further discussion see Chapter 13). 6. Facilitating capital flight. An attractive source of earnings for banks is the capacity to facilitate capital flight through foreign and offshore accounts and subsidiaries, particularly those based in Cyprus. As a result of the limited role of the banking system, very little inter- mediation is provided to the benefit of unrelated third parties. Russian enterprises finance themselves mostly with retained earnings and budget arrears. Although the economy has a serious need for finance to support investment and restructuring, capital continues to flow to safer, more trusted havens abroad. One important result of the financial sector re- form agenda outlined in this book would be the reversal of this drain on economic wealth. As a result of Russian banks' unwillingness to expose themselves to lending to unrelated third parties, financing is allocated within financial industrial groups (FIGs) rather than through the financial system. This allocation within financial groups is usually not optimal, because (a) a clear measure of the opportunity cost of capital remains unidentified; (b) there is no internal market discipline within such groups to mirror the obligation to compete, which would exist on an external market; and (c) powerful business groups often create barriers to entry and thus pre- vent competition. Particularly in economies with weak legal and institu- tional environments-such as in Russia-these financial groups often serve the purpose of facilitating asset stripping, working to preserve THE ROLE OF THE FINANCIAL SYSTEM 139 current enterprise structures, and maintaining subsidies and privileges. The consolidation of the number of banks should lead to the dismantling of such structures and thereby diminish these economic costs. The joint Government/CBR strategy agreed upon in December 2001 does address the consolidation of the number of banks. However, although certain steps to raise minimum capital levels have already been taken, the strate- gy postpones for several years the implementation of key measures relat- ed to consolidation of the banking system (see Box 5.3). CONCLUSION The August 1998 crisis did not result in a consolidation of the Russian banking sector; instead the authorities chose not to manage the resolu- tion of many of the failed banks. In many cases the principals of the major failed banks simply transferred the assets of those banks to other so-called "bridge" banks, leaving an empty shell to honor the bank's out- standing liabilities. Given ten years of high inflation and devaluation, the Box 5.3 Consolidation of the Banking Sector: The Government/CBR Joint Strategy In the joint GovernmenV CBR "Strategy for the Development of the Banking Sector" (finalized in December 2001) the authorities recognized that there remains a need to consolidate the sector. A step was taken in this direction in the fall of 2001 when the minimum capital level for newly licensed banks was raised to 5 million Euros (the minimum capital level applied within the European Union). The joint strategy recognizes the need to establish "nonbanking lending institutions," thereby allowing the authorities to limit the licenses of certain banks so that they can no longer solicit deposits from the general public. Nonetheless, the joint strategy in effect further delays the implementation of actions for the existing 1,300 banks. The following meas- ures were proposed in the joint strategy: * As of 2005 a rule will be applied whereby the licenses of banks below 5 million Euros are automatically revoked if their capital adequacy falls below 10 percent. Currently, similar ac- tion can be applied to all banks, but only if their capital adequacy is below 2 percent (see Chapter 9). * In 2007 a minimum capital requirement of 5 million Euros will be applied to all banks irre- spective of the size of their capital, which in effect removes any "grandfathering" of current lower capital requirements for existing banks. The joint strategy states clearly that any reorganization of banks-including any merger with other banks-must be "based on the principle of voluntary participation." In this respect the strategy reflected continued hesitancy on the part of the authorities to use the powers already at their disposal to consolidate the banking system. These powers include stricter accounting and reporting requirements, more effective use of supervisory powers, and full implementa- tion of the recently tightened legal framework for bank liquidation. 140 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR failure of the authorities to actively manage the crisis only confirmed the population's general distrust of the banking sector. As outlined in this chapter, many institutions holding banking licenses in Russia today exist mostly to fulfill the internal, treasury-related needs of their associated companies, rather than to actively solicit deposits from the public. One course of action, which would contribute signifi- cantly to building trust in the Russian banking system, would be to re- view the principal business of each bank to see whether the bank requires a public deposit-taking license. If rapid action were taken to reduce the number of marginally viable or less efficient institutions holding full banking licenses, gains could be made by (a) reducing the costs of inter- mediation, (b) restricting the privilege of holding a banking license to only those institutions interested in soliciting deposits from the public, and (c) focusing the efforts of banking supervisors on effectively upgrad- ing the remaining reduced universe of banks. Given the growth in the relative importance of the state-owned banks, steps will need to be taken concurrently to limit the expansion of the loan portfolios of these banks, and to lay the groundwork for their reform into fully commercial institutions (further discussed in Chapter 7). Issues re- lated to applying supervisory actions and implementing bank restructur- ing and liquidation are discussed further in Chapters 9 and 11. ENDNOTES 1. This study controls both for other determinants of economic growth and for reverse causality and the simultaneous determination of growth and financial development. 2. Productivity growth is measured as the residual of real growth per capita minus 0.3* capital per capita growth, where 0.3 is the estimated share of capital in the production function. Taking into account human capital as an additional production factor does not change the conclusions. 3. This implies that while there is a correlation between capital accumulation and financial development, this does not necessarily imply causality flowing from financial development to faster capital accumulation. 4. This description of the state of the Russian banking sector is largely based on RAS statistics. As further discussed in Chapter 6, these statistics have signifi- cant flaws, including somewhat overoptimistic assets valuation and thus overes- timated capital bases, and a "form over substance" approach to the classification of certain categories of balance sheet and income statement data, which leads to inadequate reflection of banking risks, and so forth. THE ROLE OF THE FINANCIAL SYSTEM 141 5. Statutory capital per Russian regulations. The paid-in capital can be in cash, up to 25 percent real estate and up to 25 percent in pre-1998 government paper. The paid-in capital in foreign currency is recognized and maintained in foreign currency. 6. The CBR owns 58 percent of Sberbank; 99.99 percent of Vneshtorgbank; the Government owns 100 percent of Vneshekonombank, the Russian Develop- ment Bank, the Bank for Agricultural Development, and Roseximbank. REFERENCES Beck, Thorsten. 2001. "Financial Development and International Trade: Is There a Link?" Policy Research Working Paper 2609. World Bank, Policy Research Department. Washington, D.C.: World Bank. Beck, Thorsten, Ross Levine, and Norman Loayza. 2000. "Finance and the Sources of Growth." Journal of Financial Economics 58: 261-300. Beck, Thorsten, Mattias Lundberg, and Giovanni Majnoni. 2001. "Financial De- velopment and Economic Volatility: Does Finance Dampen or Magnify Shocks?" Policy Research Working Paper 2707. World Bank, Policy Research Department. Washington, D.C.: World Bank. CBR (Central Bank of Russia). 2001. Monthly Bulletin of Banking Statistics at website: http://www.cbr.ru Demirguc-Kunt, A., and V. Maksimovic. 1998. "Law, Finance, and Firm Growth." Journal of Finance 53: 2107-2137. Dollar, David, and Art Kraay. 2001. "Growth is Good for the Poor." Policy Re- search Working Paper 2587. World Bank, Policy Research Department. Washington, D.C.: World Bank. Easterly, William, Roumeen Islam, and Joseph Stiglitz. 2000. "Shaken and Stirred: Explaining Growth Volatility." Presented at the ABCDE conference, World Bank. http://orion.forumone.com/ABCDE/files.fcgi/154-easterly.pdf Levine, Ross. 1997. "Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature 35(2): 688-726. Levine, Ross, Norman Loayza, and Thorsten Beck. 2000. "Financial Intermedia- tion and Growth: Causality and Causes." Journal of Monetary Economics 46(1): 31-77. Peachey, Stephen, and Alan R. Roe. 2001. "Financial Deepening and the Role of Financial Crisis." In Lajos Bokros, Alexander Fleming, and Cari Votava, eds., Financial Transition in Europe and Central Asia. Washington, D.C.: World Bank. 142 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Rajan, Raghuram G., and Luigi Zingales. 1996. "Financial Dependence and Growth." Working Paper Series 5758. Boston: National Bureau of Economic Research. Wurgier, Jeffrey. 2000. "Financial Markets and the Allocation of Capital." Jour- nal of Financial Economics 58: 187-214. CHAPTER 6 Analysis of Banking Practices INTRODUCTION For the purpose of analyzing the Russian banking sector, a sample of 35 larger banks was reviewed. The banks were divided into three subsets as follows: 1. Subset 1: Larger banks owned by the Government and local/re- gional governments. This subset is composed of the two largest state banks, Sberbank and Vneshtorgbank (VTB), plus Bank of Moscow, Bashcredit, and Eurofinance. All these banks are in the Central Bank of Russia's (CBR's) list of top 30 banks. 2. Subset 2: Large, domestic, privately owned banks. This subset in- cludes a number of banks from the CBR top 30 list. 3. Subset 3: Private, domestic banks living up to more stringent re- porting requirements. This subset includes some banks that are in the CBR list of top 30 banks as well as a number of smaller banks.' The review sample includes most of the domestic banks in the CBR's list of top 30 banks, plus a few others that have worked with the Finan- cial Institutions Development Project (FIDP). These banks account for roughly half of the total assets of the banking system as measured by the Russian Accounting Standards. Data for four years were retrieved, starting with 1997 RAS numbers. Compilation of a four-year time series is intended to provide some idea of the trends characteristic of the entire reviewed sample.2 To make the trends analysis more meaningful, the numbers were translated into U.S. 143 144 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR dollars.3 An attempt was also made to do some peer group analysis, de- spite the fact that the peer group subdivision was quite superficial and was used with the sole purpose of checking for any features or trends that might be unique to a particular subset of banks. Subsets 2 and 3 were combined to compare major trends in privately owned banks against government and quasi-government banks. It was not easy to de- cide to which subset of banks Gazprombank should belong for analysis purposes, because it is majority-owned by an entity that is perceived to be government-owned or -controlled. Because it has a business profile that is reminiscent of a financial industrial group structure, the bank was ultimately included in subset 2. It should be noted that the 2000 data on some of the banks became available very late-toward the end of April 2001. Audited IAS financial statements are generally released even later than RAS numbers. Past ex- perience shows that most of the banks that commission such audited ac- counts make them publicly available toward the end of the second quar- ter or even into the third quarter.4 Since many of the operations of Russian banks continue to be conducted on a short-term basis, these de- lays limit the usefulness of such audited financial statements. However, audited IAS accounts, largely because of the more conservative IAS ap- proach to loan valuation, can in some cases give an earlier warning of potential problems facing the reporting entity. For example, the low level of Sberbank's capital, which became public knowledge toward the end of 2000, was exposed much earlier by the bank's IAS audited accounts than by its RAS accounts. Systemwide comparisons are not possible based on IAS accounts, be- cause IAS data on the whole banking sector do not exist. Moreover, com- parison of RAS and IAS data on those banks that do publish their audited IAS accounts is not possible for the end of fiscal 2000, because of the ap- plication of IAS 29 (hyperinflationary accounting). Furthermore, applica- tion of IAS 29 has rendered trend analysis very difficult, because IAS 29-adjusted numbers for most banks exist only for two years. Peer group analysis is also complicated, because some of the international audit firms chose to issue IAS accounts not adjusted for IAS 29. Finally, any further trend and/or peer group analysis based on IAS accounts is bound to be even more difficult because as of mid-2001 some banks began to intro- duce IAS 39 (fair value accounting). This standard has caused significant international debate and raised serious supervisory concerns. While trend analysis of the reviewed sample is difficult using IAS data, RAS data are characterized by significant distortions. These include ANALYSIS OF BANKING PRACTICES 145 overoptimistic assets valuation and thus overestimated capital bases, and a "form over substance" approach to the classification of certain cate- gories of balance sheet and income statement data, which leads to inade- quate reflection of banking risks. More detailed comments on distortions under RAS can be found in the following sections of this chapter. Thus, although a large quantity of financial information on the reviewed banks was processed in order to substantiate the observations presented in this chapter, these observations are inevitably only general in nature. More in-depth analysis would require on-site verification and adjustment of the banks' numbers to ensure that they provide a more accurate reflec- tion of the banks' risk profiles. Obviously the scope of this exercise does not include such verification for the whole reviewed sample, although many of the bank weaknesses described below have been noted during on-site reviews carried out under FIDP. ASSET STRUCTURE AND QUALITY By the end of year 2000, the banking sector had recovered approximately 70 percent of its pre-1998 crisis asset value, as measured in U.S. dollars. Key statistics on the asset composition of the sample banks are pre- sented in Table 6.1. Between 1997 and 2000, the banks of subset 1 suf- fered a decline in asset values of approximately 25 percent. The recovery of the banking system as a whole toward its pre-crisis levels appears to be accelerating with year-on-year growth reaching 43 percent in 2000, compared with 17 percent in 1999. Highest Asset Growth in Bridge Banks The highest pace of asset growth in 2000 among the 35 banks of the re- view group was recorded by the private banks of subsets 2 and 3, which saw their assets increase by more than 60 percent. Subset 2 demonstrat- ed growth of almost 40 percent from pre-crisis levels, primarily through the contribution of the so-called "bridge banks." Assets were transferred to these banks by banks formerly associated with FIGs after they de- faulted on their creditors in the aftermath of the 1998 crisis. The audited IAS accounts of such banks are not publicly available, but there is cause for concern that these bridge banks may adopt the same poor banking practices that caused their predecessors to fail. 146 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 6.1 Key Statistics on the Asset Composition of the Russian Banks (millions of U.S. dollars) Percent Percent Percent Percent change change change change in 1998 1997 1998 in 1998 1999 in 1999 2000 in 2000 to 2000 Total assets ot the banking system 114,581 50,270 -56 58,653 17 83,710 43 -27 Total assets of the sample reviewed 51,576 23,431 -55 30,923 32 46,913 52 -9 Subset 1 (including Sberbank) 35,115 14,948 -57 18,673 25 26,541 42 -24 Sberbank alone 29,764 11,427 -62 13,963 22 19,668 41 -34 Subset 2 9,615 5,712 -41 7,922 39 13,339 68 39 Subset 3 6,846 2,771 -60 4,328 56 7,033 63 3 Gov. debt securities of the banking system 26,180 8,765 -67 7,915 -10 11,032 39 -58 Gov. debt securities of the sample reviewed 19,144 6,828 -64 6,799 0 9,428 39 -51 Subset 1 (including Sberbank) 17,087 6,516 -62 6,415 -2 8,249 29 -52 Sberbank alone 15,982 6,236 -61 5,429 -13 6,239 15 -61 Subset 2 1,379 148 -89 226 53 857 279 -38 Subset 3 678 164 -76 .158 -4 322 104 -53 Total loans of the banking system 49,693 24,079 -52 25,668 7 38,380 50 -23 Gross loans of the sample reviewed 19,962 11,466 -43 16,356 43 25,862 58 30 Subset 1 (including Sberbank) 9,812 5,221 -47 8,650 66 13,399 55 37 Sberbank alone 6,870 2,711 -61 6,282 132 9,980 59 45 Subset 2 5,988 4,259 -29 5,272 24 7,937 51 33 Subset 3 4,162 1,986 -52 2,434 23 4,526 86 9 Source: CBR website, individual bank reports. State Banks Expanding Their Lending Portfolios The asset structure of the reviewed banks has changed quite dramatical- ly, with loans to customers accounting for 50 percent of total assets at end-2000, compared with 36 percent in 1997. This trend is most visible among the government banks, which increased their loan-to-assets ra- tios from 25 percent in 1997 to 46 percent in 2000. The volume of lend- ing also rose: aggregate gross loans to customers of the total review sam- ple increased by US$5,900 million over the review period. Government ANALYSIS OF BANKING PRACTICES 147 and quasi-government banks accounted for 61 percent of this increase, with Sberbank alone accounting for 53 percent. In 2000 Sberbank increased its loan portfolio by US$3,698 million, or by 60 percent. Given the time it takes to acquire credit risk assessment skills, this increase in loan volume is cause for concern, especially given the concentration of credit risk in Sberbank's loan portfolio and the bank's weak capital base. As of January 1, 2001, Sberbank accounted for almost 30 percent of aggregate loans extended by the banking sector. Some of Sberbank's larger loans, which from time to time receive a cer- tain amount of publicity, have been extended to companies that have ex- perienced difficulty in honoring their financial obligations on time and in full. It is worth noting also that the failure of certain corporations to service their debt was the most significant element in the demise of the largest banks in 1998-99. Particular attention needs to be paid to influ- ences beyond the borrower's control, such as the movements of com- modity prices and changes in local tariffs. Significant Concentration in the Banks' Loan Portfolios At the end of 2000, government and quasi-government banks accounted for 35 percent of aggregate loans of the Russian banking sector. Audited IAS accounts of two subset 1 banks show their loan concentrations to be badly unbalanced. According to audited IAS financial statements, as of December 31, 2000, Sberbank had 16 borrowers with aggregate loans above RUR 2.2 bln (US$78 million). The aggregate value of these loans was RUR 89.7 bln (US$3,185 million) or 32.6 percent of the loan port- folio. Loans to the two largest borrowers amounted to RUR 43 bin (US$1,527 million) or 15.7 percent of the loan portfolio. Vneshtorgbank had 15 borrowers with aggregate loans above US$15 million. The aggre- gate amount of these loans was US$732 million or 62 percent of the bank's loan portfolio. The two largest borrowers had outstanding loans totaling US$272 million or 23 percent of the total loan portfolio. Audit- ed accounts of other banks in the subset are not publicly available, but it seems unlikely that the concentration of loan portfolios held by these banks would be much different. This concentration of loans by govern- ment banks is a significant contingent fiscal liability, and an indicator of the highly skewed distribution of enterprise financing. There is even less information available in the public domain on the loan portfolio mix of the banks in subset 2. It is entirely possible that the loan portfolios of banks such as Rosbank, DIB, and Menatep St. Peters- burg are as concentrated as those of their failed predecessors. Many of 148 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR the loans of these banks may also be to related parties. The loan portfo- lios of subset 3 are similarly highly concentrated. It is not unusual for fewer than 10 borrowers to account for 50 percent of the loan books held by these banks. Use of Schemes to Avoid Official Loan Concentration Limits Loan concentrations are often established in violation of CBR concentra- tion limits. Banks also often circumvent CBR rules by creating. sophisti- cated schemes that may involve "friendly" counterpart banks. One com- mon scheme involves one bank placing significant balances on its correspondent account with another bank. The second bank then con- veys these funds to the designated borrower. This scheme has the effect of both disguising the liquidity positions of the participating banks and distorting the aggregate data on the liquidity of the system. A second common scheme involves the purchase of veksels of a number of shell en- terprises, which in turn transfer the funds gained to the borrower. It should be noted that veksels are a particularly convenient instrument for schemes. As they approach a CBR reporting date, some of the banks that have high concentrations of veksels from a single issuer will execute fake sales of the veksels for deferred consideration, and will subsequently nul- lify these deals, once the reporting date has passed. Banks can, of course, be seen on both sides of such schemes: one bank extends loans against the matching deposit of another bank. In this case the first bank artifi- cially inflates its balance sheet and the second bank avoids proper recog- nition of concentration of its loan book. The spreading of risk that such schemes entail might be interpreted fa- vorably and as similar to the syndication of large risks seen in developed market environments. However, these schemes are dangerous because of (a) the relatively small size of the banks involved, (b) the fact that the counterparty banks are often little more than shells, (c) the relative size of this type of business compared with the banks' other lending, and (d) the concentration of lending to relatively few borrowers. The development of a credit bureau covering the borrowings of large corporations and obliga- tions in the form of veksels could provide an important contribution to- ward a solution of this problem. Underprovisioning for Loan Losses, Especially under RAS Official statistics demonstrate improvements in the quality of loans across the banking sector after the 1998 crisis, based on the level of ANALYSIS OF BANKING PRACTICES 149 Table 6.2 Loan-loss Provisions as Percentage of Gross Loan Books (percent) 1997 1998 1999 2000 Loan-loss provisions/gross loans of the sample reviewed 7 10 9 7 Subset 1 (including Sberbank) 10 14 9 9 Sberbank alone 11 15 8 6 Subset 2 3 6 7 4 Subset 3 4 10 14 8 Source: CBR website, individual bank reports. loan-loss provisions (LLPs) (see Table 6.2). While there may have been some improvement, the low level of provisioning shown by many banks under RAS would not appear to fully reflect the poor quality of credit. In this respect VTB is a unique and interesting case. As of end- 2000 VTB's recorded LLPs equaled 25 percent of its gross loan book (in 1999 it was 20 percent). This level of provisions is probably a more accurate reflection of the true credit risk of the bank's loan portfolio than of other banks in the sample, or indeed in the sector at large, es- pecially because VTB has many of the bigger and more successful com- panies among its borrowers. Applied to the total sample, a 25 percent provisioning rate would be equivalent to almost five times the profits recorded by the banks. Many banks have had to recognize larger provisions under IAS than under RAS. For example, in their 2000 IAS accounts the LLPs of subset 3 banks accounted for 11 percent of their gross loan books (in 1999 it was 18 percent), while their RAS provisions accounted for only 8 percent (in 1999 it was 14 percent). RAS/IAS discrepancies are also evident among state-owned banks. For example, under 2000 IAS, Sberbank's LLPs were approximately 12 percent of gross loans (in 1999 it was 18 percent), while under RAS they accounted for some 6 percent of gross loans (in 1999 it was 8 percent). This situation is further aggravated by the large share of nonearning assets in the balance sheets of the reviewed banks. As of January 1, 2001, these accounted for almost one-fifth of total assets-a figure similar to the end-1997 level (see Table 6.3). 150 BUILDING TRUST: DEVELOPING THE RuSSIAN FiNANCIAL SECTOR Table 6.3 Share of Noneaming Assets in Total Assels (percent) 1997 1998 1999 2000 Nonearning assets/total assets of thesamplereviewed 22 17 17 18 Subset 1 (including Sberbank) 24 19 18 20 Sberbank alone 25 21 18 20 Subset2 12 11 15 16 Subset3 26 19 18 19 Source: CER website, individual bank reports. THE STRUCTURE OF BANK LIABILITIES During 2000 the total liabilities of the reviewed sample increased by US$13,662 million, or 53 percent. The fastest growth, 80 percent, was recorded by the subset 2 banks. Over the four-year period of the review, the subset 2 banks recorded total growth of almost 40 percent, or rough- ly US$3,045 million, in their liabilities. This rapid growth may be large- ly attributed to customers (many of which might be related parties) transferring their accounts from failed banks into "bridge" bank entities. Despite this growth, the liabilities of the entire review sample, as meas- ured in U.S. dollar terms, have not yet returned to pre-crisis levels, in large part due to a 30 percent decrease from the pre-crisis level of Sber- bank's liabilities (see Table 6.4). Issued debt securities is one liability item that has been growing in all three subsets and across all banks of the sample. During 2000, issued debt securities (including veksels) of the entire reviewed sample increased by US$1,786 million, with year-on-year growth of almost 70 percent. Overall, since 1997, debt securities issued by the sample banks grew by US$2,106 million, or more than 90 percent. There is a widespread perception that issued veksels are a good tool for liquidity management, since they are, in theory, fixed-term instru- ments that cannot be exchanged for cash before maturity. As of January 1, 2001, however, on-demand veksels accounted for approximately one-quarter of all issued bank veksels, with on-demand veksels issued by Sberbank accounting for roughly one-half of all on-demand veksels in circulation. ANAIYSIS OF BANKING PRACTICES 151 Table 6.4 Key Statistics on the Composition of Liabilities (millions of U.S. dollars) Percent Percent Percent Percent change change change change 1998 1997 1998 in 1998 1999 in 1999 2000 in 2000 to 2000 Total liabilities of the sample reviewed 43,688 20,318 -53 25,637 26 39,299 53 -10 Subset 1 (including Sberbank) 30,273 13,475 -55 16,317 21 23,091 42 -24 Sberbankalone 26,386 10,289 -61 12,746 24 18,153 42 -31 Subset 2 7,726 4,441 -43 5,934 34 10,711 81 39 Subset 3 5,689 2,402 -58 3,386 41 5,497 62 -3 Interbank deposits of the sample reviewed 5,026 3,240 -36 3,533 9 4,219 19 -16 Subset 1 (including Sberbank) 1,792 1,557 -13 1,337 -14 1,108 -17 -38 Sberbank alone 620 179 -71 283 58 176 -38 -72 Subset 2 2,236 1,062 -53 1,365 29 1,957 43 -12 Subset 3 998 621 -38 831 34 1,154 39 16 Customer deposits of the banking system 48,293 20,113 -58 23,192 15 34,337 48 -29 Sample reviewed 33,417 14,635 -56 18,506 26 28,806 56 -14 Subset 1 (including Sberbank) 25,756 10,749 -58 13,178 23 19,337 47 -25 Sberbank alone 23,671 9,198 -61 11,278 23 16,432 46 -31 Subset 2 4,213 2,506 -41 3,366 34 6,365 89 51 Subset3 3,448 1,380 -60 1,962 42 3,104 58 -10 Household accounts included in customer deposits of the banking system 28,253 9,724 -66 11,128 14 16,094 45 -43 Sample reviewed n/a n/a n/a 9,293 n/a 13,559 46 n/a Subset 1 (including Sberbank) n/a n/a n/a 8,583 n/a 12,371 44 n/a Sberbank alone n/a n/a n/a 8,392 n/a 12,103 44 n/a Subset 2 n/a 188 n/a 368 96 610 66 n/a Subset 3 n/a 244 n/a 342 40 578 69 n/a Issued securities of the banking system 7,037 2,177 -69 4,316 98 7,130 65 1 Sample reviewed 2,267 988 -56 2,587 162 4,373 69 93 Subset 1 (including Sberbank) 806 457 -43 1,419 211 2,140 51 166 Sberbank alone 627 378 -40 954 152 1,243 30 98 Subset 2 845 378 -55 733 94 1,329 81 57 Subset 3 616 153 -75 435 184 904 108 47 Source: CBR website, individual bank reports. 152 BUILDING TRuST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR SCHEMES THAT DISTORT THE STRUCTURE OF LIABIL1TIES In four years, customer deposits of the sample, as measured in U.S. dol- lar terms, have dropped by US$4,611 million, or 14 percent, with Sber- bank alone losing customer deposits equivalent to US$7,239 million. Al- though this decrease in customer deposits is largely attributable to the movement of the ruble/U.S. dollar exchange rate, another contributing factor would appear to be the widespread practice of circumventing the CBR mandatory reserve requirements by using schemes with friendly, usually off-shore, banks. The purpose of these schemes was to turn cus- tomer deposits into interbank funds, to which mandatory reserve re- quirements were not applied. The information on household deposits is significantly distorted by a variety of salary schemes. The substitution of veksels for deposits may also account in part for the movement in the banks' deposit base. All in all the widespread use of schemes allows banks to manipulate their funding base and makes it almost impossible to analyze the level, trends, and structure of the banks' liabilities. The fact that the bulk of bank liabilities are still of a very short maturity sug- gests a continued low level of depositor trust. Maturity Mismatch between Banks' Liabilities and Assets The mismatch between short-term liabilities and long-term assets is rec- ognized by many parties, including the CBR, as one of the main prob- lems facing the banking sector. In certain banks, the liquidity gap in the time band of 0 to 30 days is cause for concern. One of the worst liquidi- ty gaps is reported by Sberbank. While it can be argued that Sberbank has a core of individual depositors that are loyal to the bank, the consid- erable negative mismatch of the bank's liabilities is of serious concern, es- pecially against the background of an underdeveloped interbank market and an overall lack of trust in the system. If public confidence in the banking system were to fall further, the liquidity situation might become unmanageable. Under such circumstances, undue pressure could develop on the lender of last resort. Mechanisms for Window-Dressing Banks' Liquidity Positions There are several banks in the reviewed sample whose maturity mis- matches appear to be less of a problem. It is common practice, however, for banks to achieve a balanced liquidity position through artifice. Bank X, for example, might do this by maintaining a large NOSTRO balance ANALYSIS OF BANKING PRACTICES 153 (a foreign exchange balance held offshore by a commercial bank), usually with a second-tier bank that in turn invests the incoming funds in loans or securities of parties designated by Bank X. This provides apparent liquidity, but not genuine unencumbered liquidity that would be readily available for depositor payouts. In other examples, banks will report, under RAS, significant NOSTRO balances with offshore banks, but the balances will disappear in IAS consolidation. Such schemes achieve the objective of disguising a bank's true liquidity position. These are the most common examples, but probably not the only ones, of devices aimed at misleading the general public and even statistical analysts. Another problem facing some of the banks under review is that of concentration of corporate deposits. Such concentrations are normally not easily traceable in RAS accounts. They are usually only revealed in audited IAS statements, which may or may not be publicly available. IAS audits often show that as few as 10 or 15 depositors or creditors account for the bulk of the deposit base. In some cases, concentration of the de- posit base is disguised by yet another common scheme, which involves the bank persuading some customers to make their deposits with a sub- sidiary or a friendly bank; the deposit will then show up in the first bank's books as an interbank account. ASSESSING BANK CAPITAL As a result of the above observations it follows that capital can be one of the most illusory quantities in the Russian banking environment. There are many ways in which banks can manipulate their capital positions, and many of them take advantage of the available opportunities. Until 1999, IAS financial statements tended to give a more conservative assess- ment of the bank capital than RAS, but the introduction of IAS 29 as of end-2000 has reversed this situation in many banks. As past experience shows, the viability of a bank ultimately depends on the intentions of its beneficial owners and/or controllers in choosing whether to keep their bank alive or to transfer any good assets the bank might have to another "bridge" institution and start anew. PROFITABILITY Profitability is one area that is showing signs of improvement (see Table 6.5). In 2000 there was a significant increase in the share of net interest income in the overall income stream recorded by many of the banks in 154 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR the reviewed sample. This represents a significant change over previous years, when the bulk of the profits was derived from securities trading (1997) or from foreign exchange trading and translation gains (1998 and 1999). However, the increase of net interest income is clearly the result of growth in lending volumes, which in turn entails significant credit risks. As many of the banks are underprovisioned in relation to the risks they are taking, it is to be expected that the positive trends in profitability will eventually be compromised by the need to increase provisions. Without incurring undue risks, banks probably also have little room for improv- ing their net interest margins. Due to the on-demand nature of their de- posit base, bank interest expenses are already low. Detracting from profitability are the high operating costs of many banks. These numbers obviously vary from bank to bank, but the most Table 6.5 Key Statistics on the Profitability of the Reviewed Banks (millions of U.S. dollars) Percent Percent Percent Percent change change change change 1998 1997 1998 in 1998 1999 in 1999 2000 in 2000 to 2000 Net profit of the 990 70 -93 404 477 985 144 -1 sample reviewed Subset 1 (including Sberbank) 742 147 -80 326 122 652 100 -12 Sberbank alone 492 318 -35 310 -3 451 45 -8 Subset 2 203 -53 -126 166 -413 311 87 53 Subset 3 45 -24 -153 -88 267 22 -125 -51 Return on assets of 1.9% 0.2% 1.5% 2.5% the sample reviewed Subset 1 (including Sberbank) 2.1% 0.6% 1.9% 2.9% Sberbank alone 1.7% 1.5% 2.4% 2.7% Subset 2 2.1O% -0.7% 2.4% 2.9% Subset 3 0.7% -0.5% -2.5% 0.4% Net interest income/ -8.7% -15.2% 25.5% 85.5% pre-tax profit before provisions of the sample reviewed Subset 1 (including Sberbank) -34.9% -30.7% 37.6% 97.2% Sberbank alone -64.2% -33.2% 27.9% 131.8% Subset 2 44.8% 26.5% 10.9% 63.4% Subset 3 70.2% 23.6% -2.3% 41.6% Source: CBR website, individual bank reports. ANALYSIS OF BANKING PRACTICES 155 extreme examples report cost-income ratios in excess of 80 percent. It must also be noted that the use of a variety of salary schemes means that the actual level of overheads is in many cases disguised under RAS. Overall, the return on assets has improved between 1999 and 2000 and has basically exceeded the pre-crisis level. Finally, it should be noted that profitability has always been an area where there are quite significant variations between RAS and IAS. In part this reflects generally higher provisioning expenses under IAS. In addi- tion, IAS auditors tend to reclassify some income and expense items to reflect their economic function rather than their legal form. While com- parisons of RAS and IAS numbers in this area have previously proved to be quite revealing, since the introduction of inflation-adjusted IAS audits for financial year 2000, such comparisons are no longer possible. CONCLUSION The following conclusions can be drawn from the off-site review of RAS data and audited IAS accounts of some of the major banks, supplement- ed with information from on-site reviews of some banks under FIDP: 1. Banks continue to be inadequately capitalized for the risks they are taking. 2. Sustainable profitability remains elusive. 3. Most of the banks still either fail to recognize or tend to conceal the risks inherent in their loan portfolios, and thus remain signifi- cantly underprovisioned. Thus the contribution to earnings pro- vided by improvements in banks' net interest margins may even- tually be compromised by the need to set up more provisions. 4. Excessive concentrations in the loan portfolios continue to be a major problem for most banks. This asset concentration is often mirrored by large concentrations of deposits on the liability side. 5. On the surface, there is ample liquidity in the sector, but the banks' core business still does not provide them with an adequate inflow of cash. Under these circumstances banks will continue to suffer from periodic liquidity crunches. 6. Most banks claim that they maintain covered foreign exchange positions and thus are not vulnerable to currency risks. However, currency risk is often passed on to bank customers (or the Gov- ernment, in the case of large holdings of foreign-denominated government debt), and this makes the banks vulnerable to any ad- verse movement of the currency. 156 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 7. Internal controls and management information systems remain inadequate. Risk management systems still fail to send proper warning signals to bank managers, especially regarding large con- centrations. 8. Banks persist in schemes to circumvent CBR regulations-for ex- ample, on concentration limits, mandatory reserve requirements, and limits on open currency positions-and to optimize their taxes. 9. Disproportionate foreign borrowing and large positions in deriva- tives-two of the major contributing factors behind the 1998 cri- sis-may have all but disappeared, but this is a consequence of the crisis itself rather than a calculated decision by banks. Some banks are once again starting to tap foreign markets. However, access to these markets is very limited as indicated by the amounts, terms and conditions, and dubious counterparties' names related to these borrowings. Concerns Related to Bank Corporate Governance By far the biggest problem related to Russian banks is weak corporate governance. Opaque ownership structures are a characteristic feature of Russian banks. Bank ownership structures typically contain a number of shell entities with unclear business profiles and ownership. Moreover, ownership lists are constructed in such a way that the disclosure of most names is optional, because in many banks none of the owners has an ownership stake exceeding the threshold set for mandatory legal disclo- sure. The degree of influence of each of the shareholders or shareholder groups is also unclear, because affiliations between shareholders are not disclosed, and information on related-party transactions is incomplete. Corporate governance is weak even in those banks that are majority- owned and/or controlled by the authorities (as further discussed in Chapter 7). Standards regarding financial disclosure and transparency are also far from adequate. Even where audited IAS financial statements are pre- pared, they are rarely publicly disclosed. The scope of the auditors' role is sometimes unclear, making it difficult to assess their independence. An- nual reports of many banks often lack sufficient information on risk management systems and controls. There is also a need to develop proper policies and procedures in the banking industry. The role of bank managers in relation to the bank's owners and/or controllers often remains unclear or undefined. Proper ANALYSIS OF BANKING PRACTICES 157 policies and procedures in key risk management areas are either nonex- istent or can be overruled by stakeholders. This situation persists, al- though many bank failures in 1998-99 were the direct responsibility of bank owners. The owners, when faced with a choice of which part of their empires to save, stood behind their industrial interests at the ex- pense of their bank's creditors and depositors. Under such circumstances the purpose of the analysis of bank financial statements is drawn into question for much more fundamental reasons than whether they repre- sent a true and fair picture of the bank's financial situation. Despite these caveats it appears that the authorities-primarily bank regulators-have managed to preserve a certain degree of stability with- in the sector following the crisis in 1998. Now the major challenges are to create an environment that would support those banks that are pre- pared to address the above weaknesses, and to continue to rid the system of those institutions that are not willing to work toward achieving the necessary improvement. ENDNOTES 1. This subset includes those banks that regularly report to the World Bank's Financial Institutions Development Project. 2. Although the end-2000 numbers do not always reflect the most recent de- velopmenrs (e.g., further growth of loan portfolios), the next set of comparable annual data would not be publicly available until April/May 2002. 3. Translation into U.S. dollars was done at CBR's official exchange rates as of reporting dates, as follows: January 1, 1998-RUR 5.96 = US$1; January 1, 1999-RUR 20.65 = US$1; January 1, 2000-RUR 27 = US$1; October 1, 2000-RUR 27.75 = US$1; January 1, 2001-RUR 28.16 = US$1. 4. According to estimates by international auditors, international audits of IAS accounts are commissioned by some 130 banks, or approximately 10 percent of credit institutions operating in Russia. CHAPTER 7 Reforming the Role of State Banks W hen developing financial systems in transition economies, it is important to identify the appropriate role of state banks in providing financial services. The purpose of this chapter is to examine options for reforming the Russian state banks against the backdrop of experience in other countries with extensive state banking. International experience has shown that state-owned banks are not efficient in providing financial services and, although government own- ership of banks is common internationally, their numbers are declining over time. A study by La Porta, Lopez de Silanes, and Schleifer (2000) sampled the ten largest commercial and development banks in 92 coun- tries and found that up to 42 percent of banking assets were in publicly owned banks as of 1995.' In 1970 the average had been 59 percent; the average is much higher in the former socialist countries (62 percent) (see Table 7.1). While comprehensive data are not available, the decline of state banks since 1995 has been quite sharp in many parts of the world. The sharpest decline has been in the former socialist economies, but a decline is also evident in other countries. Many claims have been made about the benefits and advantages of state banks; these are balanced by reports of costs and damages made by state banks. Two recent studies have used a broad cross section of countries to evaluate the accomplishments and drawbacks of state banks. 159 160 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 7.1 Government Ownership Stake in the 10 Largest Banks (percent) 197 0 1995 Total sample of 92 countries Mean 58.9 41.6 Median 57.1 33.4 Nonsocialist countries Mean 52.7 38.5 Median 53.0 30.0 Former socialist countries Mean 100 61.8 Median 100 60.0 Median for all 92 countries 70.4 35.8 Source: La Porta, Lopez de Silanes, and Schleifer 2000. INFLUENCE OF STATE-OWNED BANKS ON PERFORMANCE AND GROWTH La Porta, Lopez de Silanes, and Schleifer (2000) investigated the claims that state banks can foster growth in a financiat system and economy, es- pecially in low-income countries. The study also addressed the claim that state banks reach a broader clientele than private banks. Economic costs from public ownership of banks have been high and the benefits less than expected. The authors found that countries with high state ownership of banks in 1970 had less financial sector development, lower growth, and lower productivity in subsequent years than those countries with private banks.2 The channel from state ownership to lower growth is through productivity; state banks generally do not allocate capital to its highest use. State banks do not have a positive impact on capital accumulation, and countries with large state ownership of the banking sector do not have a widespread distribution of credit. Credit allocation was more con- centrated in those countries with state-owned banks; typically the largest 20 firms, which often included inefficient state enterprises, received more credit the greater the degree of state ownership. The negative effects of state banks were greater in low-income coun- tries where there was less financial sector development and weaker prop- erty rights protection. Conversely, high state ownership of banks caused fewer problems in economies with high incomes, greater financial sector development, and strong protection of property rights. REFORMING THE ROLE OF STATE BANKS 161 Another cross-country study, by Barth, Caprio, and Levine (2000), found similar (negative) results for state banks. Systems with greater state ownership of banks tend to have higher interest rate spreads, less private credit, and more concentrated credit, with a higher proportion going to the largest 20 firms. The countries with high state ownership also had slower financial sector development with less activity on the stock ex- change and less nonbank credit. In the systems where state ownership is greater, more applications for bank licenses are rejected, and there are fewer foreign banks. These results held after taking account of real GDP per capita, corruption, expropriation risk, bureaucratic efficiency, and the law and order tradition of the country; all of these variables can influence financial development. The Barth, Caprio, and Levine study also suggest- ed that greater state ownership is associated with financial instability. Barth, Caprio, and Levine (2000) found that state banks contribute to instability, and that monitoring by the market tends to be significantly weaker with higher state ownership. Monitoring by official supervisors is expected to be weaker because governments are exposed to incentive conflicts when one part of the Government is charged with monitoring another. THE TREND AWAY FROM STATE BANKS Designing and implementing a plan to reform state banks by introducing trusted private sector governance is an integral part of a viable strategy to develop the financial system. Consistent with international evidence that state ownership of banks is not a desirable strategy over time-be- cause it slows development of the financial system and the economy- countries are moving away from state banking. However, a quick exit from state banking may not be feasible. International experience has also shown that poorly executed or premature bank privatization programs create additional problems. Chile in the late 1970s and Mexico in the early 1990s both sold state banks into weak regulatory environments. In both cases the banks were sold to industrial groups. This led to the next generation of problems, which is related to lending within the groups, or "connected lending," a problem that Russia is familiar with in their cur- rent structure of banking. Given the potential problems with inappropriate and premature pri- vatization, it may be prudent to adopt an approach to privatization that is moderate and spans several years. The strategy should carefully pre- pare banks for privatization, address weaknesses in the overall incentive 162 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR environment, allow new entry by credible safe banks (including foreign private banks), improve financial infrastructure, and importantly, con- trol the damage done by state banks to the competitive environment (e.g., in preserving quasi-monopoly rents and accumulating contingent fiscal liabilities). Additional material regarding international experience in reforming state banks is provided in the annex to this chapter. STATE BANKS IN THE RUSSIAN FEDERATION Although a government working group set up in early 2001 by President Putin and chaired by Prime Minister Kasyanov concluded that the state, at both the federal and regional levels, holds equity in up to 400 Russian banks, most of these holdings are minority shareholdings. At the time the state held more than 50 percent of shares in only 19 banks, 15 of which were under the supervision of the Agency for Restructuring Credit Orga- nizations (ARCO).3 The remaining substantial government holdings were in a handful of banks. CBR holds majority stakes in Sberbank and the Bank for Foreign Trade (Vneshtorgbank), while the Federal Property Fund has stakes in RoseximBank, the Russian Development Bank, and Rosselkhozbank. In 1991, following the collapse of the former Soviet Union, the foreign trade-related banking operations of Vnesheconom- bank (VEB) were transferred to VTB, which at the time was a new entity established by the CBR. VEB continued to manage the sovereign liabili- ties of the former Soviet Union remaining under government ownership. However, in the ensuing years VEB also built significant banking opera- tions in its own name. In addition, some banks are owned by either re- gional or municipal authorities. As of end-2001, the two largest banks, Sberbank and VTB, together accounted for almost 30 percent of total system assets. Overall, approximately 39 percent of banking system as- sets were on the balance sheets of state banks (see Table 7.2). As a result of the Government's preferential treatment of state banks, as well as the decline in the private banking sector, the relative importance of state banks in Russia expanded in the aftermath of the 1998 crisis. State banks received many privileges, including more favorable treatment in government debt restructuring, and (until recently), lower reserve re- quirements. Both Sberbank and VTB enjoyed major recapitalizations in the aftermath of the 1998 crisis.4 VTB had major capital injections during 1999 and 2000. Sberbank's capital injection took the form of shares predominantly sold to the CBR. Amendments to Sberbank's charter approved by the AGM in the summer of 2001, authorize the bank to issue REFORMING THE ROLE OF STATE BANKS 163 Table 7.2 Data on Various Segments of the Banking Market (percent) Market share Market share Interest RoA RoE of assets of capital spread (RAS) (RAS) State banks 38.7 40.6 7.2 2.2 15.2 Foreign banks 4.9 5.7 12.1 6.9 54.4 Large banks 41.1 41.1 9.6 1.7 11.3 Medium banks 9.2 6.9 12.4 2.5 12.4 Small banks 5.8 5.7 9.0 0.2 1.1 RoA Return on assets. RoE Return on equity. Source: Troika Dialogue 2000. Notes: The calculations are based on RAS accounts as of July 2000. Large banks are the top 100 commercial banks in terms of assets (excluding state and foreign banks). Medium banks are banks rated 100 to 200. Small banks are the remaining 1,000 banks. The large bank category includes the banks in ARCO. Annualized profitability is for the first half of year 2000 (based on pre-tax profits). Interest spreads are calculated for interest-bearing assets and lia- bilities and therefore include securities. The numbers for RoE and RoA may be overestimated where equity is overestimated. This reflects under-provisioning under RAS. yet more shares, and the CBR will probably have to participate in further subscriptions, if for no other reason than to keep its stake above the min- imum 50 percent level prescribed by the law. Also new specialized banks for agriculture and development have been established. Discussions are under way on the future role of VEB. If it is granted a full banking license, then yet another fully fledged state-owned banking institution will be ex- ploiting a market niche, in which it already has certain competitive ad- vantages. Thus despite the avowed intention of the authorities-as stated in the joint CBR/government strategy for the Development of the Banking System-that the state intends to reduce its presence in the banking sector, the current trend runs contrary to those intentions. As to smaller banks, the joint CBR/government strategy states that the Government plans to disengage from minority shareholdings. This strat- egy builds on the findings of the working group set up by the Govern- ment in early 2001. The working group concluded that it would be ad- visable to reduce state ownership in the form of minority stakes in about 400 state banks, and to focus on relatively few banks in which the Gov- ernment would continue to own at least 25 percent of the banks' share capital. Consistent with this strategy, the state is already in the process of withdrawing from the capital of banks under ARCO management. 164 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Thus, even though the Government seems to be poised to divest some of its holdings in smaller banks, Russia will almost inevitably face many of the same issues as other countries in the region when they reduce the dominance of state banks. These issues include the detrimental impact of state bank dominance on economic growth and financial development both in the near term and the long term (see the annex to this chapter). In this respect the following key issues will need to be addressed: 1. What to do about the market dominance of Sberbank? Should Sberbank be allowed to continue expanding into a full-service commercial bank? 2. When and how to privatize VTB? 3. Should VEB become a bank, an export credit agency, or a debt management agency without a banking license? 4. Is there a role and a justification for institutions such as the Russ- ian Development Bank and Rosselkhozbank (the Russian Agricul- tural Development Bank)? THE ROLE OF SBERBANK The Central Bank of Russia holds a 62 percent stake of Sberbank's vot- ing stock. Sberbank dominates financial markets in many business lines. Especially in the corporate loan business, its market share has grown considerably since the 1998 crisis.5 Sberbank continues to control ap- proximately 75 percent of total retail deposits and 23 percent of banking system assets. Sberbank has several advantages: a large branch network with broad geographic distribution, a perceived state guarantee on de- posits, a strong internal payment system, and a key role in distributing state pension payments. Sberbank also has a monopoly on the processing of settlements on certain municipal services and the receivables/payables of the state pension fund. As of end-2000, Sberbank had 21,778 outlets: 17 territorial banks, 1,511 branches, and 20,250 internal structural sub- divisions. Sberbank has considerable market power, accounting for up to 75 percent of commercial lending in some regions. Until mid-1998, Sberbank had the bulk of its assets invested in gov- ernment securities. Prior to the financial crisis, gross loans to companies were only 20 percent of total assets, while government securities were 54 percent. Despite the reduced share of Sberbank's assets placed in govern- ment securities after the crisis, Sberbank is still the largest holder of gov- ernment securities.6 REFORMING THE ROLE OF STATE BANKS 165 Since the crisis, Sberbank has aggressively expanded lending to the corporate sector. Although in dollar-adjusted terms there appears to be a reduction of the size of the loan portfolio as of end-1999 compared with end-1997, the share of lending in total assets increased from 20 percent (1997) to more than 40 percent (1999). Measured in dollar terms, there also appears to be dramatic growth of the loan portfolio in 2000- almost 60 percent. As of end-2000, the gross loan portfolio was equiva- lent to almost US$10 billion, accounting for almost 50 percent of total as- sets. Almost all of this loan growth is in the form of lending to the corpo- rate sector. Loans to individuals represent less than 4 percent of the loan portfolio7 and inter-bank lending is not a major activity. Sberbank ac- counts for almost 30 percent of aggregate loans of the banking sector (see Table 7.3). A large part of the Sberbank's credit portfolio is in lending to the gas, oil, and chemical industries, construction, trade enterprises, and state and municipal bodies and institutions.8 Sberbank is poorly capital- ized for the expansion in its activities, especially against the background of the concentrated nature of its loan portfolio. Before the new capital in- jection in 2001, Sberbank struggled to meet the CBR's capital adequacy requirement of 10 percent. Under RAS the capital-to-asset ratio was 7.7 percent as of end-1999 and 8.72 percent as of end-2000. Although the bank came into compliance with capital adequacy requirement after the capital injection in 2001,9 it was still in violation of the CBR's large lend- ing limits. Thus, while benefiting from the forbearance of the supervisory authorities, Sberbank continues to be engaged in an aggressive expansion plan, which will result in further capitalization needs. In the past, regional governments have politicized credit allocation undertaken by Sberbank's territorial banks. In Dagestan, for example, 90 percent of the credits extended by the regional Sberbank were said to be overdue in late 2000 (Oxford Analytica Brief 2000). During 2000, the system of territorial bank offices was consolidated from 71 to 17. This may lessen the problem of local government influence on Sberbank, but this political influence will most likely remain an important factor even after the restructuring and amalgamation of territorial banks. THE GOVERNMENT'S MANAGEMENT OF SBERBANK While it is probably too strong a statement to say that the population "trusts" Sberbank, it may well be trusted more than other Russian banks, and does therefore play a significant role in savings mobilization. 166 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR Factors benefiting Sberbank are its internal payment system, which eases inter-regional payments and thereby facilitates internal trade and the processing of state pension payments-these account for a considerable part of Sberbank's deposit base. However, these benefits come with cer- tain costs, including the moral hazard of a bank that is state-owned and considered too big to fail; the conflicts of interest inherent in CBR own- ership; the detrimental impact on competition of market dominance by a state bank that gets preferential treatment from CBR; and the risks asso- ciated with its aggressive business strategy, etc. The rapid growth and re- capitalization of the bank, largely with public funds, has taken place while major public policy issues are still unaddressed. While the Govern- ment has been planning to undertake a strategic review of Sberbank for some time, it still appears to be uncommitted to the value of this process. The following issues would need to be resolved on the basis of that strategic review: 1. Balance between risk and reward. While the events of 1998 proved that holding government securities was not a riskless ac- tivity, the Government restructured its debt so as to reduce the im- pact of the government default on Sberbank. Both corporate and consumer lending are higher risk activities than the previous strat- egy of holding public securities. As Sberbank has focused pre- dominantly on expansion of its corporate lending since the 1998 crisis-a period of relatively good economic performance-any estimates of credit risk will have to take into account more repre- sentative estimates of borrower performance in terms of corpo- rate debt and not just the experience of the recent past. A broader evaluation of alternative business strategies should be undertaken before Sberbank continues to expand its corporate lending and, as a result, increase its capital base. Because corporate lending is one of the riskiest business areas in banking-particularly in the Russ- ian environment-extreme caution would seem advisable when expanding a portfolio of concentrated corporate loans, especially for a bank that is supported by a full government guarantee on its deposits. In the course of deciding on a business strategy, the authorities and/or Sberbank will face a variety of trade-offs-for example, be- tween risk and profitability of corporate lending and government securities. They will also need to consider the trade-off between providing public services and increasing efficiency and lowering costs. Maintaining a large branch network is an important public service, but the current structure is unlikely to be cost efficient. REFORMING THE ROLE OF STATF BANKS 167 Sberbank also undertakes public service activities that are not commercially oriented, such as issuing low-interest mortgages and educational loans. Sberbank may want to spin off some activi- ties/branches/services, and downsize some branches to agencies, but this can only be decided when a more thorough, overall strate- gic analysis has been undertaken. Sberbank's business strategy should be decided in the context of the longer-term reform strategy for the bank. This reform strategy should involve improving the governance of the bank, which would be best achieved by privatizing the bank to reputable, strategic investors. While privatization may be a medium-term ob- jective (taking up to five years as suggested in the joint CBRJgov- ernment strategy paper), the privatization strategy should be de- cided as soon as possible to guide the efficient use of resources and to improve the prospects for successful privatization over the medium term. 2. Lack of competition in the banking sector. Sberbank far outstrips other banks in many business lines, most dramatically in the mar- ket for individuals' (households') deposits (see Table 7.3). Sber- bank's market dominance appears to rest on the government guarantee of its deposits, the bank's quasi-monopoly in paying pensions, and the bank's extensive branch network. Sberbank does not appear to have a competitive advantage in working with enterprises, in which quality of service is important. Sberbank is perceived as being extremely slow with loan approval (taking 6-9 months), so its market dominance is obviously not based on qual- ity of lending services. Table 7.3 Sberbank Share of the Russian Banking System (according to RAS) (percent) 1997 1998 1999 2000 Gross loans (banks, enterprises, individuals) 14 11 24 26 Government debt securities 61 71 69 57 Total assets 26 23 24 23 Deposits of individuals n/a n/a 75 75 Issued securities 9 17 22 17 Source: CBR. 168 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Clearly this type of market dominance will slow the develop- ment of the private banking sector. The following suggestions are offered to reduce the preferential treatment that Sberbank enjoys: * Identify and quantify the value of preferential treatment by and subsidies from the Government and implement a pro- gram for removing unjustified subsidies. * Compensate Sberbank for the costs related to undertaking quasi-fiscal activities, such as paying pensions (or acting as a payment agent for the MoF). . Introduction of a generalized deposit insurance scheme might encourage competition, but would impose a poten- tially high fiscal cost. As discussed further in Chapter 10, deposit insurance is not feasible at this time in Russia due to the lack of credible banking reforms. Introduction of a generalized deposit insurance scheme would not be advis- able prior to a strengthening of the disclosure, accounting, and supervision applied to Russian banks. Another prereq- uisite for a deposit insurance scheme is the effective en- forcement of fit and proper requirements as applied to bank owners/controllers and executive management. Fi- nally, a necessary precursor for instituting a deposit insur- ance scheme in Russia would be to develop a strategy for Sberbank. As an interim step and as a means to encourage the leveling of the playing field, consideration will need to be given to whether Sberbank should function as a "nar- row" bank, which would invest in "safe" assets such as government securities, or whether it should operate as a fully fledged commercial bank (see further discussion below). Sberbank's large deposit base gives the bank a significant ad- vantage in lending. As the only bank able to lend large amounts within the large exposure limit, Sberbank may be in a position to exercise undue control over the distribution of credit to large firms. Also, as mentioned above, because many banks only oper- ate in Moscow, Sberbank has considerable power over the corpo- rate sector in some regions. Other banks complain of unfair competition from Sberbank on lending rates.'0 Many loans are reportedly priced below market value. There appears to be an increasing tendency to perceive Sberbank's massive deposit base as a source of cheap funding to support "strategically important" industries. Sberbank's lower REFORMING THE ROLE OF STATE BANKS 169 lending rate may reflect lower funding costs or less pressure to generate returns, implying that Sberbank is treating its capital base like a free resource. The bank's funding costs are low because it handles state pensions and has implicit deposit insurance. Also, in the past, the reserve requirement for Sberbank was lower than for other commercial banks (5 percent vs. 7 percent), but the re- quirement has been equalized at 10 percent recently. The low lending rates set by Sberbank may be forcing competitors to mod- erate rates so that they can hold onto clients. Given its privileged position, Sberbank should not be allowed to undercut market lending rates if that forces other banks to charge rates below what is needed to adequately cover risks. Undercutting market lending rates and paying deposit rates above the rates offered by competitors would be consistent with a strategy for sacrificing returns in order to build market share. Cur- rently the interest rates paid on "social deposits" is higher in Sber- bank than in other banks, which would hardly appear to reflect the bank's cost base, because providing depository facilities through an extensive network of outlets is a high-cost activity for Sberbank. Deposit rates should be lowered to enable a fuller cost recovery, while simultaneously supporting the competitive posi- tion of other banks and giving Sberbank an extra margin to com- pensate the owner-the Government-with a return on capital and/or for the benefits provided by deposit insurance. Establishing a more rational pricing policy should be a high priority for Sber- bank, regarding both the bank's assets and the bank's liabilities. 3. CBR ownership results in serious conflicts of interest, but further privatization should be undertaken with caution. The Central Bank Law and the charter of Sberbank currently mandate that at least 50 percent of Sberbank's shares must be held by CBR. Fol- lowing the issue of new shares in 2001, the CBR now holds 62 percent of Sberbank's shares. The remainder of the shares are held by a wide range of enterprises and private investors, including a number of other banks. More than 25 percent of shares are in pri- vate hands.11'12 An important part of any medium-term strategy for the reform of Sberbank will be to improve the governance of the bank and hence the market participants' trust in the bank; it is also crucial that any further privatization of the bank takes place to reputable, private investors. However, it cannot be stressed enough that privatization of Sberbank is not a short-term objec- tive. Prior to privatization Sberbank needs to be restructured into 170 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR a viable commercial entity. Any privatization to insiders or enti- ties controlled, for example, by financial industrial groups will only cement the opaqueness of the bank's governance and further defray trust in the financial sector. There are clearly some potential conflicts of interest with the CBR being both owner of Sberbank and responsible for monetary and liquidity policy as well as the regulation and supervision of Sberbank. If there were another appropriate agency in the Gov- ernment with sufficient political independence and financial ex- pertise to exercise ownership role, then the Government should consider transferring the responsibility for exercising the owner- ship role. The most likely candidate is the Ministry of Finance. Regardless of which government agency exercises the ownership role, the operations and management of Sberbank should be made more transparent. As discussed in further detail below, given the potentially seriously compromised role of the CBR, disclosure re- quirements should go considerably beyond the current practice of just posting the bank's financial statements on the website. The question of ownership was pushed to the forefront in 2001 by the issuance of five million new shares for US$140 million that had been authorized in 1996. This new issue will allow Sberbank to further expand its lending operations and still maintain a capital ad- equacy level just above the minimum level of 10 percent. Although Sberbank did not violate Russian law, the new share issue was struc- tured inappropriately according to international practice: existing private shareholders should have been given right of first refusal for the new shares. The open subscription disposal of the shares could have resulted in a new domestic shareholder emerging with 19 per- cent of the shares, thus diluting the position of current shareholders. There are, however, more fundamental problems with share issues of this kind, and there have been recent proposals to issue another 10 million shares (expanding the share issue base by another 53 per- cent). Additional shares should not be issued until fundamental de- cisions are made regarding the reform of the bank, including deci- sions on implementing a business strategy for Sberbank that is consistent with establishing a more level playing field in the banking sector. Such decisions will affect the amount of capital the bank will need to have and the timeframe and strategy for privatization. In the meantime, it would seem appropriate that Sberbank should adjust the asset side of its business to raise the capital-to-asset ratio or, if need be, improve its capitalization by issuing subordinated debt. REFORMING THE ROLE OF STATE BANKS 171 THE STRATEGIC REVIEW OF SBERBANK Taking into account the dominant position of Sberbank in the Russian banking sector, the Government should restrict Sberbank's further growth or its taking on new risks until the following issues are satisfac- torily addressed within the framework of the envisaged strategic review. Business Strategy The Government needs to decide what type of business strategy Sber- bank is allowed to pursue in the medium term. The following options should be considered: 1. Limit Sberbank's activities to those of a state savings bank. This means transforming public savings (in the form of banking de- posits) into a specific range of investments (first of all, govern- ment securities), which will limit operations on the asset side of the balance sheet. The bank would focus on providing savings and payments products to its (predominantly individual) clients. 2. Let Sberbank maintain its present business mix, which is weight- ed toward lending to large corporations resulting in a highly con- centrated loan portfolio. 3. Increase further Sberbank's range of operations as a fully fledged commercial banking operation in line with international practice, in both wholesale and retail markets, with a full range of clients. 4. Break up the bank into viable (maybe regional) autonomous units, thus reducing the dominance of the bank and preserving the social functions associated with the bank's large number of local outlets. There needs to be clear identification of the risks in each of the above strategies. For example, there may be certain risks related to funneling Sberbank's deposits into financing the Government through the purchase of government debt instruments. Were Sberbank obliged to undertake sizeable new purchases of government securities, this strategy would need to be carefully coordinated with the upgrading of the Government's debt management capacity. If conducted in a coordinated fashion, this path would incur suitably low levels of risk for an institution whose lia- bilities are believed to be guaranteed by the state. On the other hand, were Sberbank to continue to pursue its preferred option of expanding its corporate lending, a thorough assessment would need to be made as to whether the bank has the effective management ability and autonomy as well as institutional capacity to continue along this route without ac- cumulating sizeable contingent fiscal liabilities for the Government. 172 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR The time dimension associated with implementation of these various strategies also needs to be considered very carefully. The first proposal- preserving Sberbank as a "narrow" savings bank-may be expedient in the short term while other reform measures related to improving the gov- ernance and viability of the bank as well as reforms related to the en- abling environment (e.g., the legal and judicial framework) are imple- mented; this option is likely to be an appropriate transitory measure rather than a medium-term strategic choice. Interest Groups Consideration of the above options needs to be based on the analysis of how the various scenarios affect the following interest groups: 1. Federal Government. Sberbank is the dominant savings institu- tion with deposits, which are perceived to be guaranteed by the state. Thus the GoR has to recognize the contingent fiscal liability arising from any course of development adopted by Sberbank. 2. Regional governments. Consideration needs to be given to the ex- tent of the influence of regional governments on the activities of Sberbank. 3. The CBR as shareholder, regulator, supervisor, and provider of lender of last resort liquidity facilities. There is a serious potential conflict of interest between the CBR's influence on the policy of Sberbank and the CBR's roles as banking regulator and supervi- sor, majority shareholder in Sberbank, and the CBR's responsibil- ity for liquidity support (lender of last resort) to preserve the sta- bility of the banking system. 4. Private minority shareholders. The ability of private minority shareholders to consolidate and coordinate the actions as a block- ing shareholder. Private shareholders may gain the ability to siphon funding to their own industrial interests as well as to re- ceive gains from their investments guaranteed by the state. 5. Management and the Board of Directors. An analysis will need to be undertaken of the forms of direct interests of bank management and the Board of Directors in developing the bank, including the influence/patronage exercised by management on local industrial development. Consideration also needs to be given to any link be- tween the financial results of Sberbank and the amount of the man- agement remuneration (including the possibility of share options). 6. Customers. An assessment will need to be undertaken of the service requirements placed on Sberbank by the large number of individual customers, of the ability of larger customers to exert influence on REFORMING THE ROLE OF STATE BANKS 173 the bank to receive easy credits, and of the consequences of any de- velopment strategy to be adopted by the bank on its ability to serv- ice its large retail depositor client base. Ownership Assessment of and decisions regarding the Government's strategy on the future development of Sberbank require careful consideration of a num- ber of possible ownership structures. Each ownership structure will need to be considered objectively in terms of the advantages and disadvan- tages for each of the different interest groups outlined above. There should be no rush to privatize the bank; it will be crucial to coordinate the timing/sequencing of any change in ownership structure with imple- mentation of the operational restructuring of Sberbank: 1. Maintain the status quo; that is, preserve the current ownership structure with CBR being a major stakeholder. 2. Return to full state control. 3. Privatize, and decide whether to continue deposit insurance. 4. Consider other options for future ownership structure, such as management contracts, based on international experience. Competitive Position An assessment of the current and future competitive position of the bank and analysis of how this affects the (potential) viability of Sberbank will contribute to answering the following questions: 1. Does the bank need the government guarantee of its deposits to continue its activity? 2. Is it possible to attribute any monetary value to this guarantee? 3. What other competitive advantages does the bank have? As part of the process of evaluating different strategy options, Sberbank will need to undertake a due diligence review including the following: 1. A full portfolio review, adjusting for losses, to evaluate the returns on different types of assets and activities 2. A comprehensive evaluation of the cost and returns on different lines of business, including the cost effectiveness of the branch net- work, the bank's automation systems, the management structure, and so on. Although a financial assessment was undertaken in 2000, in the form of a financial review of the bank performed by its international auditors, this assessment is now largely outdated. Such a review needs to be repeated at 174 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR regular intervals. In any event the review performed in 2000 failed to ad- dress a number of fundamental questions, including the following: General Management 1. What are the actions recommended by Sberbank management to improve the general operations, performance, and financial struc- ture of the organization? 2. What was the substance of the advice of the auditors as possibly contained in the Management Letters which they submitted to Sberbank's management, and how did management view this advice? Bank Operating Cost and Risk Structures 3. A description of the earnings potential and operational cost struc- ture of Sberbank: How does the bank generate its cash flow/net income to support its headquarters group and extensive branch network? What are the staffing and cost implications thereof? 4. Have Sberbank's retail deposit volumes increased or decreased be- cause of market/currency fluctuations or interest accruals? Is the bank's cash flow relatively stable or does it fluctuate positive/neg- ative on an annual basis? 5. Does Sberbank have to subsidize the cost of its branch network from earnings on government securities and loans, currency trad- ing, etc.? 6. Does management have an appropriate internal loan review func- tion, which regularly conducts a comprehensive review of Sber- bank's assets portfolio and the majority of outstanding loans, in accordance with BIS/IAS guidelines? Potential Operating Advantages/Burdens 7. Has there been a thorough review of Sberbank's liabilities and a comparison with the marketplace? Has there been an analysis of influence of a lower reserve requirement relative to other banks resulting from possible tolerance on part of the CBR (in particu- lar, at the regional level) for delays in compliance? 8. Is Sberbank affected by implicit positive or negative subsidies, for example, as sole distributor of pension payments and low-cost gov- ernment deposits? Are there specific areas where Sberbank opera- tions and/or profitability benefits are penalized by special circum- stances, such as post-crisis funding and/or government securities REFORMING THE ROLE OF STATE BANKS 175 provided to the bank, informal encouragement to entities to work with Sberbank, etc.? 9. Are there special areas where Sberbank's character and/or posi- tion regarding the rest of Russia's banking sector give it a com- parative advantage or pose a threat to its sustainability/profitabil- ity/competitive posture? Developing materials that answer these fundamental questions will pro- vide the backbone for in-depth strategic work, thereby allowing the au- thorities to adopt a development strategy for Sberbank that both pre- serves the bank's valuable features and contributes to leveling the playing field between Sberbank and privately owned banks. RESTRUCTURING SBERBANK While privatization of Sberbank should remain a medium-term goal, it will take time to prepare and consider strategic options. In the meantime, interim measures urgently need to be taken to minimize the damage that Sberbank's operations could inflict on the economy and the financial sys- tem. These measures are essential to setting in motion the self-reinforcing process of building trust: 1. Perform a full ongoing assessment of Sberbank's financial situa- tion. Meaningful assessment of strategic options cannot be under- taken without further analysis of Sberbank's operations and fi- nancial situation. In particular there is a need to conduct a full portfolio review, adjusting for losses, to evaluate the return on different types of assets and liabilities. Given Sberbank's expan- sion of its lending to the corporate sector combined with recent, relatively good macroeconomic performance, it will be particular- ly important to scrutinize Sberbank's lending risks. A comprehen- sive evaluation is needed of the costs, returns, and risks within various business functions, including the cost-effectiveness of the branch network, the automation systems employed by the bank, and the bank's management structure. As outlined above, the fi- nancial review undertaken in 2000 is in need of being updated, and it failed to address a number of Sberbank's potential weak- nesses, including issues related to the bank's management struc- ture, the bank's operating costs and risk structures, the benefits associated with operating privileges enjoyed by the bank, and the cost of servicing obligations imposed on the bank. 2. Improve governance. The operations and management of the bank should be made much more transparent. In addition to 176 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR releasing timely annual external audit material, the bank should publish a full annual loan portfolio review; provide notification of all decisions affecting the bank's business strategy; undertake rig- orous due diligence regarding the suitability of the bank's private owners; and provide full disclosure on decisions related to new share issuances, which should include providing pre-emptive rights to minority shareholders. Given the conflicted role of the CBR as majority owner, regulator, supervisor, and provider of liq- uidity/capital support to Sberbank, the importance of these imme- diate measures cannot be overemphasized. These would be the first steps toward improving the governance of the bank; these steps are essential for the strategic restructuring of the bank. 3. Limit emphasis on corporate lending. As Sberbank benefits from capital infusions and availability of a stable funding base, at least as an interim measure, some form of constraint (i.e., moderation and/or independent oversight) needs to be applied to the rapid ex- pansion of Sberbank's corporate lending. Given the risks inherent in this rapid expansion-for example, the political pressures poten- tially placed on the bank in making lending decisions-quantitative limits should be placed on Sberbank's corporate lending function. 4. Take measures designed to establish a more commercial frame- work for Sberbank's operations. This might involve establishing arrangements to compensate Sberbank for quasi-fiscal activities such as processing the payment of pension services. It is important that these safeguards are put in place immediately, to contain unsound business practices and to provide time for a thorough evaluation of the bank's future business development plans. In the short- term, the appropriate emphasis should be on strengthening the gover- nance of Sberbank and ensuring that the bank is run according to com- mercial principles. This new focus would allow more emphasis to be placed on the return on capital and it would gradually reduce the need to monitor such factors as the bank's lending growth and interest rates. At the same time, however, plans for the medium-term reform of Sberbank need to be agreed upon and carefully designed. These plans need to in- clude time-bound measures to ensure their staged implementation. VNESHTORGBANK At the time of its creation in 1991, Vneshtorgbank took over the foreign trade operations of Vnesheconombank, the old Soviet foreign trade bank. It is 99 percent owned by the Central Bank of Russia.13 Although REFORMING THE ROLE OF STATE BANKS 177 it is the second largest bank in Russia in terms of capital, it is consider- ably smaller than Sberbank. VTB accounted for about 5 percent of the banking system assets and 5 percent of total banking system loans as of end-1999, but it is expanding rapidly. Largely through capital injections undertaken by the CBR, the RAS capital increased from US$199 million at end-1998 to US$1,643 million by end-2000, making VTB one of the best capitalized Russian banks (IAS capital of minus US$514 million at end-1998, plus US$821 million as of June 30, 2000). Unlike Sberbank it does not have a large network of branches in the country, but the net- work of its subsidiary banks is still quite extensive. VTB is in the process of taking over the overseas banks owned by CBR.14 In early 2002 VTB confirmed its intention to expand its corporate banking services and the size of its branch network, but it is still not yet clear whether VTB will become a business competitor for Sberbank. According to audited IAS accounts as of year-end 2000, over 30 per- cent of the VTB portfolio was in securities. As of the same date, net loans were about 20 percent of assets. VTB's lending is primarily to the energy and manufacturing sectors (51 percent of total loans) with the trade and commerce sector accounting for 16 percent of total loans. The loan port- folio is highly concentrated with two-thirds of the loans to the bank's 15 largest borrowers, and with just two of these loans accounting for 23 percent of the total loan portfolio. In the joint CBR/government strategy paper of December 2001, the authorities announced their intention to divest the CBR of its ownership stake in VTB by January 1, 2003;1' the intention of the Government is to ensure its presence in influencing the bank's policies by assuming part- ownership of the bank; that consideration will be given to privatizing a portion of the bank. There would appear to be a strong case for privatiz- ing VTB to a strong international bank as strategic buyer to bring in new skills, international quality technology, and introduce more competition into the market. However, the significant capital increases of 1999 and 2000 will make it more difficult to find an appropriate buyer, at least until the bank's surplus capitalization is absorbed in the form of sound, high-yielding assets. Also, recent history in Russia has shown that poor- ly executed privatization strategies entail large risks. For example, the loan for shares deal for the corporate sector led to the emergence of oli- garch structures in the enterprise and financial sectors that have serious adverse repercussions. The Government has announced that it is considering a proposal by EBRD to purchase an equity stake in VTB. Any such investment by EBRD would most likely entail a time-bound commitment by the Government to further privatization of VTB to strategic investors. While the first steps 178 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR toward privatization involving the EBRD may take time to finalize, and the Government's commitment with regard to further privatization may be of a medium-term nature, a strategy regarding restructuring and fur- ther privatization of VTB needs to be agreed upon by the Government and announced as soon as possible. Only if the restructuring and privati- zation of VTB is based on a comprehensive strategy will it be possible for potential strategic investors to evaluate the bank's potential. For example, it is now unclear how the recent acquisitions of the CBR's foreign sub- sidiaries will contribute to the bank's viability and the prospects for its successful privatization. Setting the strategy would help to provide a framework for evaluating the influence of market developments on the bank's future viability and therefore the prospective benefits available to potential strategic investors. VNESHECONOMBANK Vnesheconombank, the former Soviet foreign trade bank, is owned by the Government. Its main activity is managing the Russian foreign debt incurred during the Soviet period. VEB does not have a banking license, but it is performing some banking functions. VEB is now violating the banking law by taking deposits, and this situation needs to be resolved. There are several options for resolving the question of VEB's business strategy and structure: 1. VEB could function as a debt management agency, paying market- based salaries, which would not be possible were this function to be performed by a department of the MoF. 2. VEB could become an export credit agency. The debt manage- ment services now performed by VEB could be put into other banks on a fee basis. 3. VEB could get a commercial banking license, and make an agency agreement to manage the foreign debt for a fee. 4. VEB could be merged with VTB and manage debt for a fee. 5. VEB's commercial banking functions could be merged with Ros- eximbank with the establishment of a separate debt management function. Once the process of separating VEB's debt management business and other government-related transactions has been completed, the key is- sues that still need to be assessed are (a) whether VEB should continue as a government agency providing export/import guarantee support to Russian enterprises, and whether it should receive a banking license; and REFORMING THE ROLE OF STATE BANKS 179 (b) whether the stand-alone commercial activities of VEB provide the foundation for a viable business operation. A case might be made for supporting foreign trade through partial guarantees provided by a gov- ernment agency, but as illustrated in Box 7.1, this business does not re- quire the agency to have a banking license. Given that there has already been considerable expansion of the role of state banks in Russia in recent years, and that there is a need for a more level playing field, any step to- ward expanding VEB's role as a banking institution should be taken with caution and be preceded by thorough analysis and justification. The weak performance of state banks in other countries suggests that using significant budget resources for capitalization of yet another large state bank would not be beneficial to the development of the Russian banking system. NEW DEVELOPMENT BANKS Two new state-owned banks, an agricultural bank and a development bank, were formed on the basis of the assets and branch network of the banks closed in the aftermath of the 1998 crisis. However, neither has fully developed its operations yet. Experience with national development banks has on the whole been negative. Examples of good development banks are hard to find.16 Moral hazard problems almost always swamp such banks within a few years. Development or policy banks are normally funded from the budget or from borrowing, usually from the commercial banks under some type of government guarantee. With no bottom line and with guaranteed fund- ing, it is almost impossible to mandate reasonable performance. The problems do not end with the losses generated by development banks. International experience also clearly shows that government intervention to guarantee credit or subsidize interest rates will inhibit the functioning of financial markets. Other instruments for government intervention, such as direct government subsidies, should be considered rather than in- tervention through financial markets. Many national development banks were closed in the 1980s. Those that survived usually drifted off into commercial banking activities to try to improve their earning capacity. Given poor international performance that has led to widespread questioning of the development bank model, it must be asked whether it is a good use of resources for Russia to try and develop such banks. Direct government lending might be more efficient because it keeps the 180 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 7.1 State Export Credit Agencies The first state Export Credit Guarantee Department (ECGD) was formed in the United Kingdom in 1919. Similar export credit insurance and/or guarantee programs were founded in France, Italy, Spain, and in the United States in the 1930s, and in Germany in the early 1950s. The In- ternational Union of Credit and Investment Insurers, or the "Berne Union," was established in 1934 to facilitate cooperation in the development of underwriting techniques and to exchange information on payment practices. The following table summarizes the programs offered by some of the large developed country export credit agencies. Types of Government-Supported, Export Financing Assistance Export Credit Export Loan Direct Interest Rate Country Provider Insurance Guarantee Loans Subsidies U.S. Eximbank yes yes yes no France Coface yes yes no no Germany Hermes yes yes no no KfW no no yes no Italy SACE yes yes no no Netherlands NCM yes yes no no U.K. ECGD yes yes no yes Over the years many state export credit agencies have been privatized, and many private in- surers have entered the export credit insurance market. The Berne Union has 45 state and pri- vate members and 3 observers from 40 countries. The members of the Berne Union provided coverage for US$397 billion of exports in 1998, nearly as high as the private credit insurance provided worldwide. The Berne Union members include almost all state export agency busi- nesses, some surety and direct lending businesses. The main services provided by the Berne Union members are: Investment insurance--normally covering only political risks. Limited recourse finance-also known as project finance, limited recourse finance is a tech- nique for the export credit agencies to finance or insure major projects on the basis of the eco- nomic viability of the project and its cash flow, rather than on the basis of the financial strength of the buyer and/or the seller. The earnings of the project thus provide the security for the lender and the insurer. Until the 1990s the state export credit agencies faced little or no competition because they were the only providers of export credit in their respective countries. Increasing competition from the private sector and the privatization of some of the large export credit agencies (ECGD most notably) raise some questions about the future of the state-owned export credit agen- cies. Governments expect state export credit agencies to provide insurance to exporters not insured by the private sector, and also to remain financially solvent. How the state export cred- it agencies will be able to cope with these challenges remains to be seen. Source: Sigma No.7 2000 and the national export credit agencies. REFORMING THE ROLE OF STATE BANKS 181 budgetary impact transparent. Furthermore, as development banks rep- resent re-adoption of government-directed lending, it is highly question- able whether such banks can efficiently address the issues associated with the dearth of enterprise-financing, the so-called investment gap. As de- scribed in Part I of this book, these issues relate more to the poor en- abling environment than to the supply of finance per se. The Russian Development Bank (RDB) was established in early 1999, but its business strategy and mandate have not yet been clarified. The initial capitalization was RUR 660 million subsequently increased to RUR 4 billion (equivalent to US$160 million at that time). The bank is 100 percent owned by the Russian Federal Property Fund, with rep- resentation of the Government, Ministry of Finance, CBR, Ministry of Economic Development, and other government agencies on its supervi- sory board. There is a strong likelihood that the RDB will merely dupli- cate functions that could just as well be undertaken by the Economics Ministry directly; that is, redistributing budget and foreign assistance to industry. The Russian Agricultural Bank (Rosselkhozbank) was established by ARCO to assist in the process of restructuring SBS-Agro. Although the business strategy of this bank is not completely transparent, it appears to be based on directing subsidies made available through the agricultural support fund. The fund is an on-lending facility for government funds to agricultural producers through selected commercial bank(s) (e.g., through SBS-Agro, prior to the crisis). However, it appears unclear whether the fund will survive, which makes the future of the bank even more uncer- tain. It is not clear that the fund should survive. Cross-country evidence suggests that the economic benefits of loan programs to the agricultural, heavy-industry, or other sectors of the economy have proven dubious and may just lead to an expansion of the role of state banks and future fiscal liabilities. CONCLUSION International experience shows that dependence on state banks slows economic growth and financial sector development. As described with references to a number of country cases in the annex to this chapter, it is hard to find examples of countries that have done well for long periods with state banks. China is one country cited as having had impressive economic growth with state banks. However, now that the process of cleaning out the state banks has started, it is clear that the losses are large 182 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR and the operation of those banks unsustainable. Furthermore, the policy initiatives to make the banks commercial or to encourage the growth of competitors are proving difficult to implement. In Russia, in the near term, there appears to be an argument for main- taining the safe depository facilities provided by Sberbank. It appears that the public mistrust of state banks is less than that of private banks. But while there may be an argument for keeping a state savings bank as a transitional institution, there is not a strong argument for aggressively expanding the role of that or other state banks. In order to keep Sberbank as a state bank until the private banking system is reformed and deserves more public confidence, and to mini- mize the potential damage to the development of the financial system (the unlevel playing field) and the economy (inter alia in the form of con- tingent fiscal liabilities), the following issues will need to be resolved: 1. It should be a top priority to make the operations, business strat- egy, and share issue decisions of the banks transparent. An annu- al audit should be required, and it should include a full portfolio review to BIS/IAS standards. Publishing the financial statements is not enough. Given weaknesses in their governance structures, state banks need to live up to high disclosure requirements. 2. The preferential treatment of state banks should be discontinued. The Government should, as far as possible, remove noncompeti- tive features in order to level the playing field. Sberbank should pay a lower interest rate on deposits that are guaranteed by the state, and compensate the Government for the value of the insur- ance. The public perception that Sberbank is a safer bank rests on other types of preferential treatment, not just deposit insurance. While a medium-term strategy for the reform of Sberbank is de- veloped and implementation measures are agreed upon, interim measures should be taken to contain the contingent fiscal liability associated with the bank's current status. Sberbank should in- crease its holdings of safe assets, such as public securities. Lending to corporates, even the largest corporates in the economy, is a high-risk activity when compared with investing in government securities. 3. Sberbank should pay for the benefits it enjoys, but the Govern- ment should also remunerate Sberbank for services that it pro- vides, such as the payment of pensions. It would be premature in the near term to allow other banks to bid on undertaking pay- ment services for the Government. Devolving responsibility for REFORMING THE ROLE OF STATE BANKS 183 such services to the private sector should await the upgrade of banking supervision as described in Chapter 9 of this book. 4. International experience has shown that banking supervision is less effective when applied to state banks because it is asking one arm of Government to supervise another arm. This problem be- comes even more acute when the state bank is considered "too big to fail." This is an argument for limiting corporate lending by Sberbank in the short term and adopting a strategy for the medi- um term that reduces the bank's market dominance. 5. Even though Sberbank may not be privatized for several years, and should probably be the last state bank to be privatized, the strategy for the future development of Sberbank should be devel- oped now. That strategy would provide a framework for evaluat- ing Sberbank's business development. It would also help in pro- viding guidelines for the bank's business plans, such as whether to dilute state ownership through new share issuance. Private own- ership of Sberbank shares should be subject to rigorous fit and proper tests supervised by the CBR. 6. There is no argument for keeping VTB as a state bank. It should be privatized to a reputable international bank that can offer a strong brand name, new skills, and new technology. 7. VEB should not be conducting banking business without a bank- ing license. The role and organization of the bank should be re- solved as soon as a feasibility study can be done. Experience with state banks in other banking markets would speak against estab- lishing a new, large state-owned bank in Russia. 184 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR ANNEX 7.1 REFORMING STATE BANKS Countries have used a variety of monitoring, supervisory, and incentive packages to try to control the damage done by state banks. Unfortunate- ly, there are more examples of failures than successes. The severity of the problems with government oversight, prudential supervision, competi- tion, protection of depositors, and potential for fiscal losses depends to a large measure on the business strategy pursued by the bank and the role it plays in the market. Business Strategy for State Banks Traditionally, public banks have been savings banks, development banks, or commercial banks. Recently some countries, like China, have estab- lished policy banks. Many savings banks were originally considered "nar- row banks," thus limiting the potential fiscal losses. Postal savings banks in most countries and savings banks in the United Kingdom and France were required to invest all deposit funds in government debt. In other countries, such as Germany, Italy, the Netherlands, Sweden, Switzerland, and the United States, savings banks are also allowed to lend to firms and households, although in the United States regulations differ from state to state (Vittas 1995). The problems of adverse impact on competitive con- ditions in the market, conflicts of interest between the role of owner and supervisor, potential fiscal losses, etc., are easier to deal with, the more narrow the range of services available through the bank. In recent years, the tradition of public savings banks that invested in safe securities is giving way to commercial and universal banks; savings banks are losing their distinct identity. In many countries the need to change has been accelerated by the development of insurance plans and mutual funds that pulled much of the business from savings banks. Now globalization of banking services is adding another layer of competition for deposits. In many higher income countries, savings banks are being ab- sorbed by larger universal groups and are no longer publicly owned. The speed of change varies considerably between countries. The Trustee Sav- ings Bank in England is now part of Lloyds-TSB Bank. Many of the build- ing societies, especially the larger ones, have become banks and now play a key part as retail banks (Halifax, Abbey National). Similar trends exist in Holland (Rabobank, for rural savings banks, and ING, for the postal bank), and in Nordic countries as well as Australia. Even the savings and cooperative banks in Germany, which long maintained a separate identity REFORMING THE ROLE OF STATE BANKS 185 but with broad commercial lending powers, have been merging and grad- ually mutating toward the universal bank model. In the Czech Republic, the large savings bank has been taken over by First Erste Bank of Austria, which itself is a mutation of the traditional savings bank. In Switzerland some regional and cantonal banks, which replicate the functions of the German savings banks, have been taken over-actually rescued-by larger commercial banks. The question in Russia is whether it is premature for Sberbank to move away from the role as a traditional savings bank. Many development banks were closed during the 1980s and early 1990s as the model failed to produce the expected benefits, and most de- velopment banks had accumulated significant losses. Dozens were closed in Latin America, Africa, and Asia. The development banks that remain, like savings banks, are migrating to become commercial or even universal banks.17 Others are shifting to become bankers for households offering depository facilities and small loans, like BRI in Indonesia. These bankers for households are now more like the traditional savings banks than the ambitious development banks of the 1970s and 1980s, which were trying to support infrastructure and industry, or the specialized banks that fo- cused on sectors that were difficult to serve, such as agriculture. As state banks have expanded their role (most are now commercial), difficult issues regarding supervision and government oversight are being raised, and the potential for severe fiscal losses is recognized. The combi- nation of politicized lending and weak management, which operated under greater regulatory forbearance, have led to cases of spectacular fis- cal losses in recent years. Two well-known examples occurred in France and Brazil: Credit Lyonnais, the French bank nationalized in 1945 and privatized in 1999; and the Brazilian bank, Banespa, owned by the state of Sao Paolo before it was purchased by the Spanish bank, BSCH. In 2000 each ran up losses estimated in the range of $22-28 billion under government ownership. There are, of course, cases of expensive private bank failures, and the costs frequently fall on the public sector, but in the private bank failures there is at least some private capital to help absorb losses, and regulatory forbearance is usually not as generous. In many countries the losses in state banks continue to grow. For example, in China the expenditures on the four state banks are already up to about 20 percent of GDP, and may go as high as 40-50 percent of GDP as the cleanup continues. In addition to the explicit costs, state banks frequently receive implicit or explicit subsidies to prevent financial problems from becoming public. This increases the fiscal drain, distorts financial mar- kets, and may prevent the growth of viable competitors. The full extent of the vulnerability of state banks to financial problems, and the cost of implicit subsidies are rarely made public. 186 BUILDING TRUST: DEVELOPING THE RuSSIAN FINANCIAL SECTOR Oversight, Prudential Supervision, and Competition The business strategy of public banks will influence the options and sever- ity of supervision and the responsibility for losses. For example, the prob- lems of credit quality and potential for fiscal losses are clearly worse for development or commercial banks than for "narrow" savings banks. Sim- ilarly, the problems of establishing a level playing field to encourage safe competition is likely to be more important for a public commercial bank than for a development bank that targets only very large long-term infra- structure projects. Some of the issues to be addressed, in light of the busi- ness strategy chosen, are listed below. Issues related to monitoring and supervision would include the need to 1. Clearly assign and exercise an ownership role. 2. Make explicit and minimize the conflict of interests between the roles of regulator/supervisor (avoid regulatory forbearance) and owner (safeguard equity). 3. Make explicit and rationalize the conflict of interests between the public sector provider of services and its effort to minimize fiscal costs. Remove taxes or other implicit benefits to show true fiscal costs. Issues related to corporate governance would include the need to 1. Separate the government agency functions from traditional com- mercial banking. 2. Corporatize specialized state banks. Issues related to establishing the framework for safe competition in banking would include the need to 1. Level the playing field by removing competitive advantages, sub- sidies, or other unfair advantages for the state banks. 2. Liberalize trade in financial services if it is consistent with other macroeconomic strategy. Agree on a business plan that is consis- tent with government objectives and eventual privatization plans. 3. Encourage the entry and growth of safe private banks. 4. Consider limitations on Government's ability to absorb risk and to inject additional capital to cover potential losses. 5. Formulate and approve the privatization strategy. 6. Set objectives for improvement in governance, competitiveness, and profitability. (Performance agreements with state banks tend to work when reputation matters and the system is transparent; they do not work as well when the system is not transparent.) 7. Monitor efficiency. 8. Enforce strong disclosure rules with transparent accounts. REFORMING THE ROLE OF STATE BANKS 187 9. Set the incentives needed to motivate management and staff; for example, in Poland the compensation for senior managers was linked to the future privatization value of the bank through stock options (Caprio and Honohan 2001). Country Experience In order to review some of the key issues related to public banks identi- fied above, the following sections draw on the experiences of Brazil, China, and Germany. These country cases were chosen to highlight dif- ferent business strategies in state commercial banks. The public banks in Brazil, at both the federal and state levels, have played the role of devel- opment, as well as commercial, banks. The distribution of credit has been highly politicized. In the decade since their inception, the state com- mercial banks in China have lent to public enterprises, and have been slow to move away from their traditional clients. The banks have been asked to provide commercial and project finance and even to take the kinds of risks that would have been funded in equity markets in a more advanced financial system. The public banking system in Germany is de- centralized under local control and primarily lends to local markets. Ger- many also has an efficient contract enforcement system, and creditor rights are strong. These factors help explain why Germany has not had as many problems with their public banks as have the other European countries like France and Italy. The case studies show the important dif- ferences in the business strategies in these banks and the costs and prob- lems with attempted reforms during the 1990s. Public Banks in Brazil Brazil has had public banks since the 1890s. Public banks owned by both the federal and state governments have been assigned quasi-fiscal, politi- cal, redistributive, and development functions. The system of federal banks includes the Bank of Brazil (the largest Brazilian bank, heavily in- volved in agriculture and export credit); the National Economic and Social Development Bank, which provides project finance to both the private and public sectors; the Federal Savings Bank (Caixa Economica Federal), which lends for housing and local government infrastructure; and regional banks in the Northeast and Amazon, which have both commercial and de- velopment functions. By the 1970s, there were also 24 commercial banks controlled by the state governments, so each state had at least one devel- opment bank, and several states had financial complexes with several 188 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR banks. Most state banks have had private participation in their capital, and shares of 20 of the 23 state banks were traded on the Brazilian stock exchanges. In the federal system, the Bank of Brazil, Bank of the North- east, and the Bank of the Amazon have private shareholders, and their shares are traded on the stock exchanges. After the 1970s, public banks made up about half of the Brazilian sys- tem. During the 1980s and early 1990s, banks rapidly expanded their bal- ance sheets using the "float" of high inflation"8 and low-cost liabilities, such as tax receipts and government deposits (see Figure 7.1). The high inflationary environment made savers unwilling to hold term deposits, and the public banks stepped in to fill this investment gap, making term loans to both the public and private sectors. High inflation and bad accounting helped hide the losses that came from highly politicized lending, including the use of state-level banks to support employment-generating projects and to fund large infrastruc- ture projects. Inflationary revenues accounted for over a third of rev- enue in the early 1990s. While losses were usually disguised, financial problems periodically bubbled to the surface. During the 1980s and 1990s, the Central Bank was forced to intervene on behalf of almost all public banks, as the several generations of programs put the state banks temporarily under Central Bank control. The banks were audited and restructured, and sometimes Central Bank debt was removed. Figure 7.1 Development of the Brazilian Financial System 140o I I T _ _ A ! I _ X _-3,500 1 6 _ _ 3,000 100 ~ ~ ~ ~ ~ ~ ~ ~ - - 2,500 - 80200 60 ~~~~~~~~~~~~~~~~~~1,500 40 ~~~~~~~~~~~~~~~~~~1,000 20 500 COCO a, 0 CO LO 0)- 0 c 0 m 0 0c a, a, a, a a, ~-mizrj Inflation Domestic credit Deposits Source: International Financial Statistics (IMF). REFORMING THE ROLE OF STATE BANKS 189 As of end-1993-the beginning of the "real" stabilization program- public banks had a 55 percent market share of lending while private banks had a 45 percent share. Almost all term loans were in public banks. The difference in loan performance was marked. In the public banks, 45 percent of loans were nonperforming loans (NPLs), while in private banks, the figure was only 2 percent (Ness 2000). With the ex- ception of the state bank, Banespa, lending to state government was not the main cause of NPLs per se. The problems were more fundamental; there were bad incentives for public banks, weak credit analysis for both public and private projects, high operating costs from excessive branch- ing and overstaffing, etc. Almost all state banks were insolvent. Having private shareholders in the state banks did not control their poor per- formance. Private banks were more stable because they had more money invested in securities. Private banks had 25 percent of assets in securities, while public banks had only 15 percent. The public banks were depend- ent on low-cost public sector funding; that is, public deposits and move- ment of public funds through the accounts (Ness 2000). The public banks deteriorated noticeably after the currency was stabi- lized in 1995. Even with bad accounting standards, over 60 percent of the public banks lost money each year in the 1995-98 period after infla- tion slowed and the "float" disappeared from the system (Ness 2000). All public banks had periods of substantial losses, with the exception of the Bank of the Northeast, which had very low returns. An examination of 12 state banks for which data are available reveals losses in excess of Rub 1 billion (US$1.089 billion) in the period 1994-95, and NPLs to the public sector accounted for 5 percent of total loans. The four federal banks lost close to Rub 5 billion (US$5.45 billion) in 1995 as loan-loss provisions for the private sector loans increased from 8.6 percent in 1995 to about 14 percent in 1996 (IMF 1997, cited in Baer 2000). But the explicit costs understate the burden of the public banks on the economy. There were numerous effective subsidies by federal and state governments in the placement of loans and deposits, low returns on public deposits, etc. After 1995 economic liberalization and stabilization made the burden of the public banks more apparent and unsustainable. With the deterio- ration of the state banks, the need to restructure state government debt to the federal Government,"9 and the need for the federal Government to reduce the recurrent fiscal drain from public banks became crucial. Polit- ical support for state banks weakened. In 1996 a more aggressive pro- gram was introduced to allow the federal Government to step into finan- cial institutions at the state level to privatize them or to convert them 190 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR into nonbank development agencies. Only occasionally was the decision made to restructure the state banks. If the state government wanted to recapitalize the state banks for continued operation, this had to be done with state funds. Federal assistance was available only if the state banks were to be privatized or turned into development agencies. The process of resolving the state banks was interwoven with the process of restructuring the state governments' debt to the federal Gov- ernment. Federal debt replaced state debt on the balance sheets of the state banks. Also, the state banks were no longer to fund state govern- ments. The Federal Savings Bank took over the task of lending to state governments, and the federal Bank of Brazil held an increasing share of state government securities. While an attempt was made to deal with the state banks over the period from 1997 to 2000, the federal banks continue to operate, and they will be even more difficult and expensive to resolve. Given the history of account- ing irregularities, regulatory forbearance, and political use, making up the missing capital in these banks is going to be extraordinarily costly. The remaining public banks still have substantial market share in var- ious commercial banking activities, and they continue to distort the com- petitive banking landscape. The public banks control over 49 percent of the core funding and 40 percent of managed assets in the system. As of March 2000, public banks had 57 percent of lending, but only 31 per- cent of the earnings in the system. The intrinsic inefficiency and poor asset quality of the public banks impairs profitability and capital (Moody's Investor Service 2000). State Banks in China China established four large state banks in the late 1980s: the Bank of China, the Industrial and Commercial Bank of China, China Construc- tion Bank, and the Agriculture Bank of China. The state banks (SoCB) have been the core of the financial system, which has grown rapidly since the two-tier system was reestablished. Domestic credit grew from 67 percent of GDP in 1985 to 141 percent in 2000 (see Figure 7.2). Over the same period, total deposits grew from 40 percent of GDP to 132 per- cent. Even though other financial institutions have been licensed, the four large state banks continue to dominate the banking system. As of end-2000, these four banks accounted for about 70 percent of both loans and deposits. They employ nearly 2 million people in about 103,000 branches across China. But while the Chinese state banks are large, they are not strong. REFORMING THE ROLE 01 STATE BANKS 191 Figure 7.2 Development of the Chinese Financial System 150 25 100 20 o 15 10 U, (0 f' m3m. 0 5~ ~~ f 0r.~O 0 1 1 1 1 0 (0 (0 I~ I o-5 ~ ~ 0 Ln CD rl coD w CD " q -,r LO to (D _ co 0 a) ax o a oz o~ ow dw a7 cn o~ 0w ow o~ o~ ar c 00 co 0c D smm m mC - Inflation Domestic credit - - Deposits Source: International Financial Statistics (IMF). Source of savings. China has one of the highest household savings rates in the world, thanks to the economic reforms in the 1970s and 1980s, which shifted the flow of surplus income from enterprises to households. Much of that surplus has been channeled into financial sav- ings in the public banks. The deposit base is US$1.6 trillion. The local- currency deposit base is $1.5 trillion, with more than half the money from households. In addition, on-shore U.S. dollar deposits total $130 billion, of which $75 billion is owned by individuals. There are several factors that have helped the domestic banks attract deposits. There are few alternatives available for holding savings: access to securities mar- kets has been limited and capital controls are still enforced and are fairly effective at holding savings in the country. Until last year interest on de- posits was not taxed, and the population could place money in no-name accounts without revealing their identity.20 Interest rate policy has been generous during certain periods, including an indexing provision during periods of high inflation. While China does not have explicit deposit in- surance, the Government has provided implicit deposit insurance, and the population perceives greater safety in the big state banks. Unfortu- nately much of the deposit base has been lost through inefficient politi- cized lending. Portfolio problems. In the mid-1990s the Government tried to make the state banks into commercial banks, or at least to make them more commercial. The state set up three policy banks in 1994 to take pressure for policy lending off the four SoCB, but the strategy was not successful. The policy banks were too small to take over the insatiable demand for 192 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR policy lending, and in some cases bad loans from the policy banks were transferred back into the state banks. The law was changed in 1995 to make the SoCB responsible for lending on commercial principles. How- ever the SoCB-frequently with official encouragement-continued to direct credit to state and public enterprises.2' This led to the accumula- tion of bad assets on the banks' books through the 1980s and 1990s. As the growth rate slowed and the state sector continued to decline under reforms, many firms were unable to service debts, owing to general inef- ficiencies, difficult markets, and increased competition. While loans to state-owned enterprises (SoEs) were a major part of the problem, it has not been the only problem. In general the lending policies of the SoCB re- flected the perception that they were too big to fail, and they did not face hard budget constraints. Credit analysis had been perfunctory. The SoCB took on excessive risk and, for example, lent heavily into the real estate bubble in the mid-1990s. The SoCB stepped in to lend to high-risk ven- tures that would have been funded by venture capital or equity in better- developed financial markets. Also, regional and local governments en- couraged local branches of the SoCB to lend to "favored" local public enterprises.22 While the magnitude of the portfolio problems has never been revealed, and may never be known with any accuracy because of weak loan classification practices, it is understood that several of the large banks have significant losses, and three of them would probably be insolvent under international accounting practices. Pressure to reform. Internal and external pressure to reform the banks intensified in the late 1990s and continue without any assurance of suc- cess. Economic growth slowed and the state banks did a poor job of serv- ing the growing parts of the economy in the private sector. A dispropor- tionate share of credit continues to flow to large enterprises that are stagnant or declining. While some businesses in the new private sector may be better credit risks, those businesses are less likely to have audited accounts and do not yet have years of financial records, so the SoCB ends up concentrating credit in declining industries. Also with moral hazard, the Government has been seen as more likely to cover the losses of lend- ing to SoEs. This perception is accurate and will be almost impossible to dispel as long as both banks and enterprises are state-owned. As the prospect that China could join the World Trade Organization (WTO) increased during the 1990s, pressure was added to clean up the banks to prepare for international competition. China agreed with the United States and the European Union that within five years of accession, the domestic banking sector would be opened substantially to direct REFORMING THE ROLE OF STATE BANKS 193 foreign competition. This would allow foreign banks access to local cur- rency business and expose the still rudimentary domestic institutions to competition from the sophisticated marketing and risk-assessment skills of international banks. On entry, foreign banks would be allowed to set up joint ventures with Chinese partners, and wholly owned foreign banks would be able to operate after five years. These agreements add urgency to the reform process. Fiscal burden. The cost of cleaning up the state banks has already been high, and it will definitely go higher. In 1998 the Government injected cap- ital of US$32 billion into the four state banks. In 1999 four asset manage- ment companies (AMCs) were set up and charged with acquiring-and, if possible, disposing of-nonperforming loans. To improve the balance sheets of the banks, the assets were transferred to the AMCs at face (not market) value. In 1999 and 2000, the AMCs bought assets worth US$170 billion, and 580 SOEs had agreed to swap a further US$41 bil- lion for equity. The assets transferred to the AMCs accounted for about 20 percent of the combined loans of the SoCB. The amount spent in the 1998 recapitalization and the move to the AMC was about 20 percent of 1999 GDP. The process of cleaning up the balance sheets is not yet finished; only loans made before 1995 have been transferred to the AMCs. All loans after that date, even those to the same companies, are still in the banks. The full extent of the remaining problems is not publicly known, but it is clear that the losses are large, and that the fiscal implications will be sig- nificant. One estimate suggests that there is an additional US$150 billion in bad loans that must still be written off.23 The cost of cleaning the state banks may total as high as 40 percent of GDP before it is finished. Fur- thermore, there are other losses in the system. The three policy banks have not been cleaned up yet. Also many of the smaller financial institu- tions are owned by local or provincial governments that can not cover the losses in those institutions; the central Government is being forced to cover the losses when those institutions fail. In general, banking supervi- sion allows insolvent financial institutions to continue operating because many public owners are unwilling or unable to cover the losses. Continuing market dominance. Government efforts to introduce credi- ble competition into the financial system and to lower the dependence on the four state banks have not succeeded. The Government started licensing other financial institutions in 1986. Since that time, the Government has established ten national joint stock commercial banks,24 approximately 90 194 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR city-based commercial banks, about 3,000 urban and 42,000 rural credit cooperatives, and some finance companies.25 While these financial institu- tions are not owned directly by the central Government or the Central Bank, the stockholders are, almost without exception, state-owned or pub- lic sector entities. There is only one private bank, Minsheng Bank, which was founded in 1996 with about 85 percent of the shares held outside the public sector. The strategy for shrinking the market share of the four big banks through competition has not worked (see Table 7.4). The other financial institutions have not offered enough competition to discipline the state banks. Especially in the late 1990s, after the failure of a development bank, the population continued to depend on the big banks for deposito- ry facilities. It is clear that the four state-owned banks have implicit guar- antees from the Government, because they are regarded as too big to fail. Even though the Government has covered all depositors in other banks and credit cooperatives that did fail, the population perceives that the big banks are safer. This perception has made depositors less willing to place their savings in the smaller banks. During the 1990s, the state banks con- tinued to hold approximately 70 percent of all deposits.26 Especially disappointing was the continuing modest market share of the joint stock commercial banks. Most of the inroads of these commercial banks have been in urban areas along the eastern seaboard. Their com- bined share of total deposits and lending is growing, albeit from a very low base. At the end of 2000, their combined share of total lending amounted to 7.9 percent, while their share of deposits stood at 8.6 percent. Most of the increase in deposits has been in the four big banks (see Figure 7.3). Table 7.4 Market Share within the Chinese Banking System (percent) Deposits Domestic credit Market share 1993 2000 Change 1996 2000 Change State commercial banks 67.9 68.8 0.9 77.5 68.2 -9.3 Other commercial banks 5.6 8.6 3.0 3.7 7.9 4.2 RCCs 15.5 13.1 -2.4 9.5 9.9 0.4 UCCs 4.8 5.9 1.0 2.6 4.6 2.1 Finance companies 0.4 1.5 1.1 0.5 1.3 0.8 TICs and policy banks 5.7 2.1 -3.6 6.2 8.0 1.8 Note: RCCs are rural credit cooperatives; UCCs are urban credit cooperatives; TICs are trust and in- vestment companies. REFORMING THE ROLE OF STATE BANKS 195 As accounting is nontransparent and disclosure weak, it is difficult to evaluate the financial position or performance of the joint stock commer- cial banks. Analysis of the available data by Moody's Investor Services suggests that the joint stock banks are comparatively healthy in the Chi- nese context; the return on assets amounted to 0.6 percent in 1999, com- pared with just 0.1 percent for the state commercial banks. The joint stock banks have lower cost bases because they have fewer employees and branches than the SoCB. With less policy-based lending to the state sector, the ratio of nonperforming loans is probably smaller. However, the reper- cussions of the ongoing process of industrial state-owned-enterprise re- structuring have also exposed these banks to rising nonperforming loans. The few joint stock banks that disclose data on asset quality have report- ed a deterioration in the loan portfolio since 1997. Many of the rural credit cooperatives are in desperate financial trou- ble and only survive because of political pressure on the Government to keep any credit cooperatives from failing. The 90 city commercial banks were formed by merging weak, often insolvent, urban credit coopera- tives-often to avoid failures. Many of banks will not be viable and the losses must be recognized. Thus, while the best hope for competition for the big state banks are the joint stock banks, their ability to attract mar- ket share has been disappointing. Figure 7.3 Total Deposits of Sectors within the Chinese Banking System Total deposits 140 120 ,M 100 '~ 80 40 20 co L co- I aw~ ~~. a> N-w O oz a 0 O 0 O~ O~ 0' 0> - Total deposits * State banks - Other banks - - - Rural co-ops * Urban co-ops IMF (internal material). 196 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Negative Impact on Economic Development The Government now faces some difficult options. Accurate and trans- parent bank financial records are needed to hold the banks accountable for their performance, but a move to reliable accounting would reveal the depth of losses, and probably insolvency. This might shake the confidence of the population in the safety of depository facilities. While banking su- pervision has been strengthened, it is far from effective, largely because the big state banks are more politically powerful than the supervisory authority. In the last year or two, the big SoCBs have started competing among themselves for the largest and most lucrative accounts. However, the ma- jority of enterprises are too weak to switch banks and are therefore cap- tive clients. The quality of service is low with very little credible competi- tion from the joint stock banks to stimulate greater efficiency. This imposes heavy costs on the economy from bad banking services. Public Banking in Germany In most of Europe state banking is declining rapidly. It is in particular de- cline in Germany, falling from 52 percent of assets in 1970 to 36 percent in 1995 (La Porta, Lopez de Silanes, and Schleifer 2000), but that market share is still high compared with the rest of Europe (see Table 7.5). The gradual deepening of the German financial system is reflected in Figure 7.4. Germany is frequently cited as a country where state banks have been less problematic than the norm. Some structural characteristics of the economy, as well as the business strategies and corporate governance of the public banks have been important in keeping those banks viable. The cross-country studies cited above (La Porta, Lopez de Silanes, and Schleifer Table 7.5 Comparison of Market Share of Assets in Public Banks, 1995 (percent) Market share of public banks Germany 36 European Union 25 OECD 28 Note: The share of public banks is defined as the percentage of the ten largest banks in each coun- try owned by the Government divided by the total assets of these banks in 1995 (cited in Beck 2001). Source: La Porta, Lopez de Silanes, and Schleifer (2000). REFORMING THE ROLE OF STATE BANKS 197 Figure 7.4 Development of the German Financial System 160 _. _____ __- 6 140 5 -- 4 -- 120 _ _ L l- -4 100 ___ 80 <80 _ ^ ^ S ] | _2 a60 - aS D.--X__1 40 20 0 C l 0 0 l a 1 u cc r- co X0 CO co CO O au c) 0 a) 0) 0) 0) a~~~~~0 0)) 0) ox°0 ) 0u ) 0) 0) 0) 0s -I Inflation - Domestic credit - - Deposits Source: International Financial Statistics (IMF). 2000) found that state banks tend to be less problematic in higher income countries with better-developed financial markets. Other authors have suggested that countries with a strong institutional environment and a dis- persed political process may have more success in controlling state banks (Caprio and Honohan 2001). There are strong enforceable creditor rights and little state ownership in the enterprise sector, so there is not the usual problem of state banks lending to state enterprises. Also the public bank- ing system in Germany, like Austria, is decentralized and built on local rather than nationwide banks.27 Most public banks, both savings and cooperative banks, were started at the city or county level, and almost all continue to be owned by local mu- nicipalities and serve a specified geographic area. Now these local banks are connected through the state savings banks, which serve as clearing- houses for the local savings banks, as well as banker to the state. There is also a central savings bank, which serves as the central clearing bank to the savings bank system and holds the liquidity reserves. Of the three types of banks, savings, cooperative, and commercial, the savings bank system has the largest market share of assets and deposits (see Table 7.6). The domi- nant funding source for local savings banks is household deposits. While savings banks are now universal, the asset policies of the savings banks have been conservative, holding government paper and lending against 198 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 7.6 Market Share of Different Bank Groups in Germany, 1999 (percent) Total assets Total deposits Savings banks 36.1 39.4 Cooperative banks 13.0 18.7 Commercial banks 25.2 24.6 Of which: largest four 14.4 12.8 Other banks 25.7 17.2 Source: Deutsche Bundesbank 2000. real estate. About half of assets are in long-term loans to households, mu- nicipalities, and some nonbank firms. Local savings banks have had only limited exposure to industry and large commercial ventures, but the re- gional organizations may have some exposure to medium and large firms. The cooperative banking system is organized in tiers like the savings bank system. Cooperative banks are important for providing services to small and medium-size businesses in their localities. Restrictions limiting lending to members have been relaxed. In recent years, the differences among the savings, cooperative, and commercial banks have narrowed. The long-pre- served separate identity of the savings and cooperative banks are gradual- ly moving toward a broad commercial bank model. Local ownership and control make the banks more transparent and have contained the fiscal losses. But it should be noted that the impor- tance of state banks in Germany, with their implicit guarantee, may have hurt competition in the markets. Germany has a lower level of foreign penetration than most European countries, which may bear out the gen- eralization that economies dominated by state banks tend to attract and admit fewer international banks.28 Summary The banking system in Brazil has been mixed, with private banks com- peting with the public ones. The public banks are known to be weak, and the fiscal costs of restructuring have already been substantial. The Gov- ernment started to privatize the state-level banks in the second half of the 1990s, but the public federal banks remain, and they are going to be very expensive to resolve. China is cited as a country that has achieved strong financial growth with dominant state banks. The reality is that the Chinese banks are in REFORMING THE ROLE OF STATE BANKS 199 bad financial condition. Reform efforts since the mid-1990s have been very expensive and have not yet succeeded in cleaning up the banks. The strong financial growth probably had more to do with the high savings rate in the economy than the banks. The public banking system in Germany is decentralized under local control and its primarily lending is in local markets. Germany also has an efficient contract enforcement system and creditor rights are strong, thus limiting any possible accumulation of contingent fiscal liabilities. Tables 7.7 and 7.8 summarize the structural characteristics of the economies and public banking sectors in the country cases reviewed in this Annex. Based on these country cases and on the international studies cited in the introduction to this chapter, there is a significant risk that the expan- sion of state-owned banking in Russia since the 1998 financial crisis will result in increased financial fragility and the accumulation of fiscal liabil- ities. In building a sound and trusted banking system in Russia, the re- form of state banks is therefore of the highest priority. Table 7.7 Comparison of Banking System Structures Chinaa Brazil Germanyb Russia Per capita income US$750 US$4,630 US$26,570 US$2,260 Quasi-liquid liabilities 124.3 29.7 20.2 Interest rate spreads 2.6% 6.1% 12.3% Gross domestic savings / GDP 42.6% 16.6% 22.8% 21.2% Credit to private sector / GDP 112.8% 34.6% 119.10% 12.9% Creditor rightsC 2 Contract enforceabilityd 2.02 Assets in public banks,1970e 100.0% 70.1% 51.9% 100.0% Assets in public banks,1995' 99.5% 31.7% 36.4% 33.0% a. Four "big" state banks have about 70 percent of both loans and deposits. Joint stock banks have 9 percent of deposits and 8 percent of loans. b. Public banks have controlled about half of the system for several decades. c. Creditor rights: Index of secured creditor rights, with values between 0 (worst) and 4 (best) (La Porta, Lopez de Silanes, Schleifer, and Vishny 1997). d. Contract enforceability: Indicator of the degree to which contracts are honored, with values be- tween 1 (worst) and 4 (best) Source: Business International Corporation. e. La Porta, Lopez de Silanes, and Schleifer 2000. f. La Porta, Lopez de Silanes, and Schleifer 2000. Table 7.8 Comparison of Public Bank Structures Brazil federal commercial, China state savings, and German savings/ commercial banks China joint stock banks development banks Brazil state banks cooperative banks Ownership MoF Provincial/local Government Federal Government. State Governments. Most Local Governments role or public entities. Possible to Several have private have private shareholders, have some private shareholders, shareholders, and shares and shares are traded on but almost all owners are public are traded on the stock the stock exchange. sector, exchange. Traditional Lending to public Lending to public entities. Commercial and Commercial and develop- Depository facilities business entities. The SoCB May be able to provide better specialized ment. Public banks had for households/ strategy have all of the large service to attract better access to low-cost public local businesses clients. clients, but not large enough sector liabilities. and lending to local to serve the largest clients. enterprise. o Responsibility Central Government Local Government owners are Federal Government Losses repeatedly passed Separate deposit 0) for losses nominally responsible, but to the Central Bank and insurance for savings implicit deposit insurance federal Government. and cooperative means that central Government banks, independent frequently has to pick up some scheme for or all of losses. commercial banks. Restructuring Partial recapitalization Regulatory forbearance Has not started yet. 1997-2000 state banks in 1998. 20% of loan of losses. privatized or converted into portfolio passed to development agencies. AMCs in 1999/2000. Cost so tar US$202 bin (20% of GOP). Remaining losses estimated at additional 20% of GDP. Restructured 1995 banking law Smaller SoEs and some Moving toward business mandated commercial private businesses. broader range of strategy lending but client base services. is still many SoEs. REFORMING THE ROLE OF STATE BANKS 201 ENDNOTES 1. In almost all countries, the top ten banks, which include development banks, capture about 75 percent of total banking claims on the private sector. 2. This result held after controlling for differences in the initial levels of per capita GDP, different measures of financial development, inflation, the black market premium, an index of government intervention, taxes and subsidies, and a variety of variables. 3. Several ARCO banks were privatized during 2001; see further discussions in Chapter 12. 4. While the exact extent of government and/or CBR support to these banks in the aftermath of the 1998 crisis is not public knowledge, it is perceived that re- capitalizations (apart from outright capital injections) took place in the form of liquidity support, assistance in settlement of foreign exchange forwards with nonresidents at off-market rates, and so on. 5. CBR used Sberbank as a safe haven for deposits in the aftermath of the 1998 crisis. CBR encouraged the transfer of household deposits from a number of failing Moscow-based and regional banks to Sberbank on a voluntary basis while explicitly announcing the deposit guarantee for this bank. Some RUR 10 bln (representing around 70 percent of local currency and 30 percent of foreign currency deposits of the largest commercial banks in Russia) were transferred out of the commercial banks through this scheme. In addition to the household de- posits, many enterprises also shifted their accounts from other banks to Sberbank during 1998-99. Sberbank emerged from the crisis with 85 percent of local cur- rency and 46 percent of hard currency deposits. Many of those deposits have since been moved, so the advantage for Sberbank was to some extent temporary. 6. As of end-2000, three state banks, Sberbank, VTB, and VEB, held over 70 percent of government securities placed with banks. Sberbank held about 56 per- cent of government securities placed in Russian banks and about 32 percent of Sberbank assets were in government securities. 7. While this is a small percent of Sberbank assets, and because this type of lending is rarely done by Russian banks, Sberbank controls up to 20 percent of total credit to households. Sberbank is the largest intermediary for the EBRD small business lending. The management has indicated that they have provided loans to 6,000 SME and micro-borrowers utilizing EBRD funds, and to another 40,000 small enterprises through their own funds that utilize crediting methodol- ogy learned from the EBRD project. 8. Some noted transactions in 2000 were lending US$300 million to Tyumen Oil Company in March; a loan for the equivalent of US$200 million to UES (Unified Energy System of Russia) to finance its arrears to Gazprom and tax au- thorities in June; a planned loan for US$80 million to Vympelkom and one for US$50 million to Severstal. 202 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 9. If the Basel methodology for risk-weighting were to be applied, Sberbank's capital adequacy would be much lower, even despite recent capital injection. 10. The Minister of Antimonopoly Policy (MAP) launched an investigation of the interest rate policies of Sberbank in November 2000. 11. "The recent abolition of the 5 percent limit on foreign holdings of Sber- bank shares (which had, in any case, been breached via various 'grey' schemes) may provide a further line of defense against any pressure to break up the bank." Although officially nonresidents hold only 0.11 percent of Sberbank shares, at least 15 percent is held by Russian companies that are 100 percent foreign-owned. Still more Sberbank shares are held by entities that are substantially foreign- controlled. Sberbank's management believes that further foreign investment would increase the bank's capital and provide further protection from any re- structuring efforts (both by increasing the range of interests opposing change and raising the costs of restructuring). The CBR has indicated that the CBR may sell some of its stake, possibly to nonresidents (Oxford Analytica Brief 2000). 12. Any sale of Sberbank's shares should be subject to a stringent "fit and proper" test. 13. Following capital increases in June and September 1999, the majority stake of the Central Bank of the Russian Federation in Vneshtorgbank increased from 97 percent to 99.9 percent of the shares. 14. At the breakup of the U.S.S.R, the CBR inherited five banks abroad: Eu- robank (Paris), Moscow Narodny Bank (London), Ost-West Handelsbank (Frankfurt-am-Main), Donau Bank (Vienna), and East-West United Bank (Lux- embourg). The consolidated assets of these banks were about $3 billion. 15. These intentions have been reconfirmed in a series of press statements by Prime Minister Kasyanov in January 2002. 16. Reportedly the Caribbean Development Bank has been adequate. Anoth- er development bank that performed reasonably for a while was TSKB, the Turk- ish Industrial Development Bank, which was owned by the commercial banks. Over time, performance deteriorated, reportedly because of corruption. Now the bank has diversified into investment banking. 17. Universal in the sense of offering a broader range of services, not neces- sarily taking equity in enterprises. 18. Inflation averaged 17 percent in the 1950s, 45 percent in the 1960s, 34 percent in the 1970s, over 350 percent in the 1980s, and 1660 percent in the first half of the 1990s, falling to 7.7 percent over the period 1996-99. 19. Two states banks, Sao Paulo and Banespa, were responsible for much of the state debt. 20. This policy has now ended, partially because of concern over corruption. 21. Chinese economic reforms decentralized economic power, but kept it in the public sector. The Government allowed provincial and local governments and cooperatives to start public enterprises. REFORMING THE ROLE OF STATE BANKS 203 22. This problem was eased but not eliminated by the 1997-98 reforms, which reorganized the SoCBs so that their business service areas did not corre- spond with political boundaries and limited lending authority at the local level. 23. Sye Ping, director of the People's Bank of China's Policy Research Bureau, estimate reported by Zhou Jamila. "Mainland has to write off RMB 2.5 trillion in bad debts." 24. Some of these banks, including Bank of Communications, CITIC Industrial Bank, and China Everbright Bank, are national in scope, while others-such as the Guangdong, Pudong, and Shenzhen development banks-have a regional focus. 25. A range of nonbank financial institutions were also allowed after the mid- 1980s, including trust and investment companies. Some 160 foreign banks have branches or representative offices, but their activities are currently restricted and their share of the market is tiny. 26. The market share of the state banks in lending fell slightly from 78 percent in 1993 to 68 percent in 2000, primarily because the state banks were under pressure to cut high-risk lending. 27. This can be contrasted with France and Belgium, who had centralized state institutions. 28. The German markets may not attract foreign banks because British banks earn a return on equity of about 19 percent, while the return for German banks is in the single digits. REFERENCES Baer, Werner. 2000. "Privatization and Restructuring of Banks in Brazil." Quar- terly Review of Economics and Finance 40(1): 3. Barth, James, Gerard Caprio, and Ross Levine. 2000. "Banking Systems around the Globe: Do Regulation and Ownership Affect Performance and Stability?" World Bank. Processed. Washington, D.C. Beck, Thorsten. 2001. "Deposit Insurance as Private Club: Is Germany a Model?" Working Paper 2559. World Bank Policy Research Department, Washington, D.C. Caprio, Gerard, and Patrick Honohan. 2001. Finance for Growth: Policy Choices in a Volatile World. Washington, D.C.: World Bank. CBR (Central Bank of Russia). Monthly Bulletin of Statistics. Website: http:// www.cbr.ru. Deutsche Bundesbank. 2000. Monthly Report (February): 24-25. IMF (International Monetary Fund). 1997. World Economic and Financial Sur- veys: International Capital Markets Development, Prospects and Key Policy. Washington, D.C. 204 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR La Porta, Rafael, Florencio Lopez de Silanes, and Andrei Schleifer. 2000. "Govern- ment Ownership of Banks." Harvard University. Cambridge, Mass. Processed. La Porta, R., F. Lopez de Silanes, A. Schleifer, and R.W, Vishny. 1997. "Legal De- terminants of External Finance." Journal of Finance 52: 1131-1150. Moody's Investor Service. 2000. "Brazil: Banking System Outlook." Ness, Walter L., Jr. 2000. "Reducing Government Bank Presence in the Brazilian Financial System: Why and How." Quarterly Review of Economics and Finance 40(1): 71. Oxford Analytica Brief. 2000. Website: http://www.oxan.com. Sigma No. 7. 2000. "Trade Credit Insurance: Globalization and e-Business Are the Key Opportunities." Zurich: Swiss Reinsurance Company. Website: hrtp://www. swissre.com. Troika Dialogue. 2000. "Russian Banking Reform." Website: http://www.troika.ru. Vittas, Dimitri. 1995. "Thrift Deposit Institutions in Europe and the United States." Policy Research Working Paper 1540. World Bank, Policy Research Department, Washington, D.C. CHAPTER 8 Encouraging Foreign Entry to the Banking Sector INTRODUCTION An informal survey among foreign banks, a list of the regulations re- garding foreign bank entry, and a review of operations in the Russian Federation have revealed that foreign bank subsidiaries face no major ex- plicit barriers to entry or operations in Russia. However, there is concern that future regulatory action may limit the share of foreign capital in banking relative to the total banking sector capital. The perceived high Russian sovereign risk and the nontransparent and uncertain banking environment in Russia are the reasons cited that for- eign banks have not increased their activities in Russia. Only a few for- eign banks have applied for banking licenses. Foreign bank subsidiaries at present hold about 10 percent of the total banking sector capital and assets. The Russian authorities should encourage the entry of foreign banks by removing limits on the share of foreign capital in the banking sector, and also by seeking foreign strategic bank shareholders for the state banks to be privatized. Increased foreign bank presence, however, would require collaboration with home country supervisors to minimize the risks of contagion from crises and bank failures. Recent studies have confirmed the economic benefits from admitting foreign-owned banks (Caprio and Honohan 2001). Introduction of for- eign banks can provide a powerful means of stimulating both opera- tional efficiency and competition and eventually stabilizing the financial sector. The entry of foreign banks has generally been associated with 205 206 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR improvements in the quality of both regulation and transparency, partic- ularly if the entry of foreign banks is accompanied by the introduction of international standards of accounting and auditing. The pressure of com- petition from foreign banks may encourage less than reputable local banks to take higher risks, thereby weakening the banking sector. This emphasizes the urgency in strengthening prudential regulation of the banking sector.' THE PRESENCE OF FOREIGN INVESTMENT AND FOREIGN BANKS IN RUSSIA By end-2000, 22 banks in Russia had 100 percent foreign2 ownership, while 31 banks reported over 50 percent foreign ownership. In addition, more than 150 Russian resident banks had reported some percentage of foreign capital. Precise figures for the share of foreign capital in the Russian banking sector is not available. However, Tables 8.1 and 8.2 show the status of the major foreign banks in Russia as of October 2000 and January 2001, respectively. Accordingly, the 31 banks with more than 50 percent for- eign ownership (Table 8.1) hold approximately US$6.7 billion in assets and US$0.7 billion in equity. As of end-2000, these banks had approxi- mately 10 percent market share in total capital and assets of the Russian banking sector. Some of these Russian banks with majority foreign ownership rank among the top 20 Russian banks. Table 8.2 shows relative ranking by as- sets of the top 20 Russian banks as well as the rankings of the largest for- eign banks in Russia. Accordingly, four banks with more than 50 percent foreign ownership rank among the top 20 banks, and most of the major foreign banks are in the top 50 Russian banks by asset and capital size. Relative to many developed and transition countries, the penetration of foreign banks into Russia ranks lower than many, but about the same level or higher than some of the industrialized countries (see Box 8.1). Table 8.1 Foreign Banks Operating in Russia, as of October 2000 Bank Foreign Shareholder Type of Entity Total Assets (bin. RUR) Total Capital (bin. RUR) Profit/Loss (bin. RUR) International Moscow Bank Merita Bank, Hypovereinsbank Joint venture 60.4 0.98 -0.149 Citibank LTD. Citigroup Subsidiary 22.1 3.00 0.839 Eurofinans BCEN-Eurobank Subsidiary 13.2 1.99 0.290 BNP-Dresdner BNP, Dresdner Bank Subsidiary 12.5 0.05 -0.141 Raiffeisen Bank Austria Raiffeisen Zentralbank Oesterreich Subsidiary 11.5 0.65 0.047 ABN-AMRO Bank ABN-AMRO Bank Subsidiary 9.9 1.05 0.161 ING Bank (Eurasia) ING Bank Subsidiary 8.6 1.44 0.534 Deutsche Bank Deutsche Bank Subsidiary 7.7 2.41 0.646 Bank Austria Kreditenstaldt Bank Austria Subsidiary 6.6 1.29 0.029 Credit Lyonnais Rusbank Credit Lyonnais Subsidiary 5.6 0.45 0.069 Credit Suisse FB CSFB Subsidiary 5.6 1.55 0.765 Westdeutsche LandesbankVostok Westdeutsche Girozentrale Subsidiary 3.0 0.59 0.119 Societe Generale Vostok Societe Generale Subsidiary 2.5 0.14 -0.075 Commerzbank (Eurasia) Commerzbank Subsidiary 2.4 0.21 -0.044 Chase Manhattan Bank Ltd. Chase Manhattan Bank Subsidiary 2.2 0.74 0.044 Mosnarbank Moscow Narodny Bank Subsidiary 2.1 0.74 -0.029 9 Garanti Bank-Moscow Turkiye Garanti Bankasi Subsidiary 1.7 0.47 0.041 -I RN Bank of New York Bank of New York Resident office 1.3 0.37 0.043 Yapi Kredi Moskva Yapi ve Kredi Bankasi Subsidiary 1.1 0.34 0.142 HSBC Bank HSBC (from B of America) Subsidiary 1.3 0.43 n.a. Finansbank Moscow Finansbank Subsidiary 0.9 0.08 0.005 Bank of China (Elos) Bank of China Subsidiary 0.9 0.157 0.011 KMB Bank EBRD, Soros Fund Joint venture 1.5 0.049 n.a. AIG Investment Bank AIG Russia/NIS Financial Services Joint venture Iktisat Moskva lktisat Bankasi Subsidiary 0.1 0.042 Western Union DP Vostok Western Union First Czech Russian Bank lnvesticni a Postovni Banka Subsidiary 0.8 0.221 JP Morgan Morgan Guaranty Int. 0.9 0.466 Investment Bank of Kuban EBRD, Soros Fund Michinoku Bank Michinoku Subsidiary 0.4 0.3 Cuban Investment Bank 0.09 0.07 186.89 20.275 TOTAL In USD 6.7 BLN 0.7 BLN n.a. Not available. 208 BUILDING TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR THE REGULATORY ENVIRONMENT FOR FOREIGN INVESTMENT IN BANKING Currently CBR's regulations and some parts of the Law of Foreign In- vestment define the regulatory framework for the entry and operation of foreign investment in Russian banking.3 The CBR's written instructions indicate that: 1. Foreign banks cannot directly open branches but need to be in- corporated as a foreign-owned subsidiary of the parent company for domestic operations in Russia. 2. Foreign banks that want to establish subsidiaries in Russia need prior approval/protocol. CBR has the right to refuse if there are conflicting customs or tax issues with the home country, or CBR may request reciprocity from the home country of the bank. 3. CBR has the right to limit the volume of foreign capital relative to the total bank capital in Russia.4 4. The licensing process after the protocol for a majority foreign- owned bank or a Russian-owned bank are the same, except that foreign bank subsidiaries have to put in 10 times more charter/ paid-in capital than Russian banks.5 5. The composition of the paid-in capital (cash, up to 25 percent federal loan bonds, up to 20 percent real estate) is treated similar- ly for foreign and domestic banks. 6. Both foreign and local banks need the prior permission and licens- ing of the regional CBR authorities in order to open branches.6 7. Both foreign and local banks are precluded from collecting house- hold deposits before the lapse of two consecutive years of prof- itable operations. 8. Any resident Russian bank that wants to sell up to 1 percent of its paid-in capital to a nonresident bank has to get the approval of its regional CBR prior to the capital issue. If the nonresident partici- pation in the bank capital is going to exceed 1 percent, the bank has to get the permission of the CBR Head Office.7 9. A minimum of 75 percent of the employees and at least 50 percent of the Board of the foreign subsidiaries must be Russian citizens. 10. The profit remittance of foreign bank subsidiaries are treated in the same way for all foreign direct investment in Russia under the relevant legislation. ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 209 Table 8.2 The Size of Some of the Foreign Banks in Russia (billions of rubles) Bank TotalAssets Total Capital Profit/Loss 1 Sberbank 553.9 42.7 16.5 2 Vneshtorgbank 111.6 46.3 0.6 3 Gazprombank 83.4 18.6 0.6 4 Alfa-Bank 71.3 22.3 0.0 5 Meshdunarodny Promshelenny Bank 74.0 29.6 0.5 6 Meshdunarodny Moskovsky Bank 71.8 2.24 -0.0 7 SBS-AGRO (ARCO) 22.6 -35.6 -8.6 8 Surgutneftebank 53.9 0.7 0.0 9 Doveritilny i Investitsiony Bank 48.8 2.9 1.0 10 Bank Moskovy 43.0 2.4 0.3 11 Rosbank 46.9 7.5 3.2 12 Citibank 27.8 2.8 2.1 13 Rossisky Credit (ARCO) 13.2 -21.4 . -14.0 15 MDM 25.3 4.3 0.3 17 Menatep-St. Petersburg 22.4 1.6 0.6 18 Globeks 16.2 5.7 0.0 19 Raiffeisen Austria 15.1 1.1 0.1 29 ABN AMRO Bank 12.3 1.2 0.4 33 Credit Lyonnais Rusbank 8.2 1.3 0.1 34 ING Bank 8.1 1.5 0.6 35 Deutsche Bank 6.6 2.5 0.8 36 Westdeutsche Landesbank 2.5 0.6 0.1 40 Credit Suisse First Boston 6.7 1.6 0.9 43 Bank Austria Kreditanstalt 8.5 1.3 0.0 70 Commerzbank 2.7 0.3 0.0 Note: All figures as of January 1, 2001. Foreign banks are shown in bold text. Numbers on left re- flect CBR ranking in banking system according to asset size. Source: Central Bank of Russia. Box 8.1 Where Is Russia in Foreign Bank Presence? A study on the role of foreign banks in domestic banking systems was conducted based on the scale of foreign bank operations in 80 countries, including all OECD countries, as well as many developing and transition countries (Claessens and Jansen 2000)* Data from about 7,900 in- dividual commercial banks from these countries were gathered according to the BankScope database provided by IBCA during 1988-1995. The data summarize the scale of foreign bank operations in the table below. (Box continues on next page) 210 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 8.1 (continued) The study views the percentage of a number of foreign banks (with more than 50 percent for- eign ownership) among the total, as well as the percentage of assets held by foreign banks to total banking assets as measures of banking sector penetration and control. Russia's figures are added for comparative purposes for end-2000. Number of Foreign Banks Foreign Bank Assets as Percent of Total as Percent of Total Africa 0.31 0.27 Asia 0.28 0.30 Latin America 0.25 0.28 Middle East and North Africa 0.26 0.19 Transition economies 0.54 0.52 Industrial economies 0.25 0.15 Russia 0.02 0.10 A comparison using the same methodology and time periods for selected economies in terms of shares of more than 50 percent foreign ownership to total banking sector assets is given below: Country Share of Foreign Bank Assets to Total 1988-95 Average France 8.0 Netherlands 10.0 Spain 31.0 United Kingdom 19.0 United States 3.0 Italy 1.0 Russia (2000) 10.0 Japan 21.0 Canada 7.0 Economy Share of Foreign Bank Assets to Total 1988-95 Average Brazil 30.0 Malaysia 11.5 Chile 25.0 Argentina (as of 1999) 48.6 Mexico (as of 1999) 33.4 Taiwan, China 9.0 Poland (as of 1999) 52.8 Indonesia 16.0 India 1.0 Democratic People's Republic of Korea 4.3 Thailand 5.6 *See article "How Does Foreign Entry Affect the Domestic Banking Market?" by S. Claessens, et al. ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 211 THE SURVEY AND OPINIONS OF THE FOREIGN BANK SUBSIDIARIES IN RUSSIA An informal verbal survey was conducted with 11 Russian subsidiaries of the foreign banks based in Moscow from February 15 to March 2, 2001. The purpose of the informal survey was to determine if the foreign banks in Russia found the present environment suitable to expanding their investment in Russia, and also whether the foreign banks felt that there were major gaps in the regulatory framework that discriminated and discouraged foreign bank entry to Russia. A summary of survey re- sponses is given below. Entry All of the foreign subsidiaries indicated that the minimum amount of entry capital, although higher than for local banks, was not a deterrent to their entry into Russia. There are few banks with less than the mini- mum amount. Except for some of the Turkish banks (Iktisat, Finans) where there is uncertainty as to whether the banks are direct branches or subsidiaries of the parent banks, the rest of the banks interviewed indi- cated that they are in the process of registering additional capital to meet the minimum capital requirement either because of losses from the 1998 crisis or because they are in the process of entry. All of the interviewed banks indicated that they had prior approval from the CBR, and some have expressed an awareness of reciprocity agreements between their home countries' supervisory authorities and the Russian CBR. All have emphasized long delays (1 to 1.5 years on av- erage) for getting the final license for operations after the pre-approval period-this period is far shorter for the local banks. The paperwork for the licensing process was reportedly just as detailed as in some other countries. Poland was frequently cited as a case in point. All the banks interviewed indicated that the decision of their parent banks to enter into Russia as a subsidiary was part of their corporate strategy. Several banks already had representative offices dating back to the U.S.S.R. Contrary to the perception that foreign banks follow their home country clients, all of the subsidiaries stated that the parent banks' decision to enter Russia was based on (a) the desire to be close to their Russian client-banks and corporations, and (b) the need to tap into the perceived potential of Russian business. As for branching, the answers were different depending on the corpo- rate strategy of the subsidiaries. Those that want to go into retail banking 212 BUILDING TRUsT: DEVELOPING THE RussiAN FINANCIAL SECTOR did complain about the long and SOMetiMes restricting approach of the CBR (especially in the regions) and that of the regional authorities to open branches outside of Moscow. Few mentioned a limit of two branch- es per subsidiary, but it was not clear whether this was a restriction for banks within Moscow or for banks all over Russia because no written in- struction was found about this issue. There also appeared to be no re-. strictions from CBR on the limit of ATMs or cash-service branches. Those that have a strategy to go into retail banking indicated that the licensing restriction for a minitmum two years' operation prior to accept- ing household deposits and a written instruction from CBR limiting the total size of household deposits to the capital of the bank was noncom- petitive. However, the same restrictions or noncompetitive attitude apply to Russian banks as well. Operations All eleven interviewed banks indicated that CBR's supervision process is not discriminatory. They all intimated that the quantitative and rules- oriented approach of CBR is time- and labor-intensive and sometimes uncoordinated within the CBR. However, they all try to comply with the prudential requirements because of their culture of compliance. All are unhappy about the noncompliant culture of the Russian banks for which CBR does not take proactive correction. This is a matter that they find noncompetitive for their operations. Table 8.3 shows the main balance sheet structure of some of the major foreign subsidiaries. Commercial lending is a major activity for the over- whelming majority of them. Prior to the 1998 crisis, foreign subsidiaries in Russia were active in the government securities markets. However, since the crisis-where all banks lost considerable sums of money and capital--corporate lending has been increasing. Some of the subsidiaries have a policy of doing business with only the multinationals and large Russian export corporations. There were two subsidiaries interviewed that have indicated they have no plans to go into large scale lending in the near term unless compelled. Those who are in the lending business all indicated that they find the Russian corporate risk better than the Russ- ian sovereign risk; that is, they have never experienced a default from a Russian corporation. However, lending subsidiaries have all expressed a preference for lending to the top 100-200 and reputable Russian corpo- rations. Three banks also stated that they eventually want to go down- market to lend to small and medium-size Russian enterprises. Table 8.3 Major Assets and Liabilities of Some of the Foreign-owned Banks in Russia, as of December 2000 (thousands of rubles) Securities Clients'Accounts Commercial Loans Portfolio Share in Share in Share in Total Household Eaming Eaming Bank Name Assets Capital Total Liabilities Deposits Total Assets Total Assets CitibankT/O 25,019,243 2,648,269 10,423,636 41.7% 377,512 14,294,614 64.2% 4,971,439 22.3% RaiffeisenbankAustria 14,582,198 966,152 8,960,668 61.4% 1,472,992 7,447,685 60.8% 595,306 4.9% ABN Amro Bank A.D. 13,824,684 1,117,917 9,360,048 67.7% 426,850 4,463,569 36.5% 289,950 2.4% BNP-Dresdner Bank 11,352,301 376,689 3,976,582 35.0% 268,239 1,359,054 13.6% 552,473 5.5% Bank CSFB A.D. 9,544,537 1,623,054 3,253,431 34.1% 543,292 947,744 13.8% 91,697 1.3% Austria Kreditanstalt (Russia) 8,205,621 1,333,988 4,364,033 53.2% 1,646,282 1,378,554 19.1% 805,167 11.1% ING Bank (Eurasia) 8,154,297 1,566,708 2,777,797 34.1% 288,906 4,574,475 69.9% 492,895 7.5% , Deutsche Bank 7,439,741 3,450,517 1,617,545 21.7% 0 814,989 13.2% 0 0.0% Credit Lyonnais Rusbank 6,611,235 1,048,005 3,449,584 52.2% 37,433 3,258,930 58.7% 526,349 9.5% Chase Manhattan Bank International 3,458,254 983,141 1,163,555 33.6% 16,398 1,858 0.1% 19,441 0.8% Garanti Bank-Moskva 3,397,418 434,783 239,703 7.1% 69,504 347,235 11.1% 2,027,814 64.9% Westdeutsche Landesbank Vostok 2,720,404 661,851 557,863 20.5% 6,560 858,849 37.0% 66,064 2.8% Banque Societe Generale Vostok 2,344,888 346,125 1,242,586 53.0% 84,076 1,138,330 60.9% 0 0.0% Kommerzbank (Eurasia) 2,185,918 261,930 691,559 31.6% 0 962,572 49.3% 0 0.0% KMB-Bank 1,477,235 49,808 123,109 8.3% 9,973 1,259,893 90.8% 0 0.0% HSBC Bank (RR) 1,290,370 432,806 86,365 6.7% 0 69,263 5.9% 973,189 82.2% Financebank (Moskva) 1,085,119 81,516 629,062 58.0% 126,984 335,797 43.2% 64,761 8.3% Bank of China (Elos) 966,042 132,722 712,299 73.7% 461,328 62,074 13.1% 187,869 39.7% J. P. Morgan Bank 895,563 466,640 0 0.0% 0 0 0.0% 169,443 22.2% First Czech-Russian Bank 809,354 221,512 96,751 12.0% 6,343 234,277 35.8% 111,522 17.0% Michinoku Bank (Moskva) 411,809 313,824 34,454 8.4% 0 2,900 0.8% 136,103 35.2% Iktisat Bank (Moskva) 117,638 42,840 31,771 27.0% 0 0 0.0% 0 0.0% Cuban Investment Bank 85,856 71,359 0 0.0% 0 61,772 76.0% 0 0.0% Source: Izvestiya 2001. 214 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR All the lending banks indicated that pre-lending decision-making is the critical step in the credit process. In other words, nonfinancial and qualitative information (like the true ownership of the enterprise and the commitment of the borrower) were more important than the financials submitted to them. The majority of the large Russian corporations, which are the borrowers of many of the subsidiaries, present IAS finan- cials. Most of the lending is short-term (less than one year) and some subsidiaries engage only in pre-export finance, whereas others also pro- vide working capital loans. Apparently CBR does not recognize variable rate lending and revolv- ing credit lines as products. Trade finance processing is limited to spe- cially licensed banks-foreign or local-due to the foreign exchange regulations in place. All of these create additional costs to doing busi- ness in Russia but are not discriminatory because Russian banks face the same difficulties. One authority that has been implicitly discriminat- ing against foreign subsidiaries for accepting customs guarantees is the Customs Authority. Some of the banks also indicated that Russian en- terprises (state or private, although mostly state enterprises or those en- gaged in doing business with the state) are either not allowed to work or are directly discouraged from working with foreign banks. State entities are apparently prohibited from opening accounts with foreign sub- sidiaries. Given this background, foreign banks have not made further efforts to introduce other new products and services. One main reason is that CBR neither encourages nor discourages the introduction of additional or bet- ter services and products to the banking sector. In terms of being able to seize collateral and to resolve disputes through the courts, all the inter- viewed banks implied that, provided they have the correct documentation and good Russian legal support, the processes are not discriminatory and can be settled even though they may be time-consuming. Doing business in Russia requires an in-depth understanding of the legal and regulatory intricacies and the necessity of taking preventive measures to avoid pit- falls. This level of scrutiny is a time-consuming and costly process. The multi-branch banks explained that the fixed costs of operating a branch are very high. Operating costs to income ratio for those inter- viewed were around 65 percent, which some banks stated are much high- er in Russia than in other large transition or developing countries. None of the foreign banks interviewed considered Sberbank's monopoly posi- tion with explicit state guarantees on deposits a competitive factor for their activities. As for lending, the complaint against Sberbank was not because of its volume-since there is no capital in the Russian banking ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 215 sector to satisfy the borrowing needs of some of Sberbank's borrowers like UES, Gazprom-but rather because Sberbank was offering lower in- terest rates. The subsidiaries that have been inspected by their parent offices and/or supervisors have indicated that CBR did not block access to rele- vant data. All interviewees suggested that there is a psychological resist- ance to foreign bank entry and expansion in Russia at all levels of regu- latory and administrative branches; this resistance is a reflection of public opinion. FUTURE PLANS All the subsidiaries preferred to call themselves "Russian Banks with for- eign ownership" meaning they are here to stay for the long term and that they look at the Russian domestic market for future growth. There has been one exit-Bank of America-since the crisis, but that was due to the internal global strategy of this bank, not the Russian market's dynamics. There are four new entrants among the banks listed in Table 8.1, and li- cense applications for three more banks are pending. All banks that have suffered during the 1998 crisis have recapitalized or are in the process of increasing capital. Most of the recapitalization funding came from inter- nally generated earnings when the parent contribution has varied. All the subsidiary banks interviewed indicated that their parent banks would rather have a controlling share of a Russian Bank than to buy, merge with, or form a joint venture with a Russian Bank. However, at the current time foreign banks are hesitant to invest in Russian banks. The majority of the banks interviewed indicated that there is limited potential for corporate banking business growth in Russia. This is due to (a) the competitive lending and servicing of multinational corporations; (b) the capability of large Russian enterprises to tap either international credit lines/bond markets, etc., or to have their own banks; (c) the limited number of creditworthy or transparent Russian corporations; and (d) the slow growth in the real sector except in specific industries. The foreign subsidiaries indicated that the present Russian corporate banking system consisted primarily of a few state-owned banks and themselves. Private Russian banks are too small either in capital or oper- ations to suit their shareholder needs, and thus are not competitive with them. Growth potential in retail banking or SME lending is limited not because of the banking sector constraints but because the average Russ- ian does not yet trust the ruble after repeated crises during the 1990s. 216 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR All the interviewed banks indicated that their parent banks see long- term potential for banking business in Russia. However, the Russian sov- ereign risk is considered to be high and thus none have near-term plans to commit substantial amounts of additional capital to their subsidiaries. CONCLUSION Russian regulatory authorities have allowed direct or indirect foreign capital entry to the Russian banking sector since the early 1990s. Despite implicit resistance to foreign bank entry and fears that the Russian bank- ing sector would be dominated by foreigners, no major explicit discrimi- nation or discouragement of foreign capital entry exists. The fears of for- eign banks leaving Russia in a crisis have proven wrong; all of the foreign banks that suffered major losses during the 1998 crisis have recapitalized their operations. In fact, the foreign bank subsidiaries hold around 10 percent of the assets and the equity of the banking sector in Russia. This figure may be higher if one adds to it minority shares held by foreign in- vestors in the banking sector in Russia.8 Historically, the foreign banking presence had followed the trade fi- nance business, where banks that have global trading customers and/or that represent the global trading interest of their home countries, would open branches or establish subsidiaries in selected countries. There has also been the traditional banking left over from the colonial days in many developing countries (e.g., British and French banks in African countries and the Middle East, Italian banks in Libya, Dutch banks in In- donesia, Australian banks in Papua New Guinea and the Pacific Islands, U.S. bank branches in China and Japan). Some U.S. and European banks decided to expand internationally during the 1970s and 1980s partly to service the petrodollars, partly to diversify their domestic risk, and part- ly to become global banks. The 1990s also saw an emergence of internationalization of financial services, in which foreign banks and foreign strategic investors were keen to invest in the equity of emerging and transitional country banks as well as to increase their domestic presence through branches or subsidiaries in many countries. The increased interest and investment of foreign banks in these countries has been both supply- and demand-driven. On the supply side, the globalization and the liberalization of financial services under GATT/WTO, NAFTA, EU, etc., have encouraged foreign banks to penetrate the new markets. On the demand side, many large developing countries that were restricting foreign presence in their domestic markets ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 217 have liberalized the entry of foreign banks. Box 8.2 summarizes experi- ences of some countries from Southeast Asia, Latin America, and Central Europe that opened up their domestic banking sectors to foreign strate- gic investors during the 1990s either after a major currency and banking crisis (as part of their banking sector restructuring strategy; i.e., Latin Box 8.2 Large Foreign Bank Entry during the 1990s: Some Case Studies The 1 990s have seen large increases in the foreign bank ownership and control of total bank- ing sector assets in the major countries of Central Europe, Latin America, and southeastern Asia. Central European countries opened up their banking markets to foreign investors through the privatization efforts of the state banking sector inherited from the 1980s. The South American and Southeast Asian countries encouraged foreign bank entry after the major systemic crises in the banking sector in their respective countries. Share of Foreign Banks' Share of Foreign Banks' Country Assets in Total, 1994 Assets in Total, 1999 Hungary 26.8 56.6 Poland 39.4 52.8 Argentina 17.9 48.6 Brazil 8.4 16.8 Mexico 1.0 18.8 Republic of Korea 0.8 4.3 Malaysia 6.8 11.5 Thailand 0.5 5.6 'A foreign bank is defined as 50 percent or more foreign ownership. Source: IMF 2000. Central Europe Poland-Initially the foreign investors were only allowed to purchase minority stakes in large Polish ex-state banks. The Polish authorities also favored consortia of investors rather than single strategic investors. Direct foreign bank entry through branches is not permitted. Some foreign banks entered the Polish banking market through establishing their own locally incor- porated subsidiaries. Gradually, foreign investors increased their stakes as state ownership in the banks was divested and decreased through public offerings or stock market sales. As of end-2000, 71 percent of the banking system was foreign. Hungary-The Government decided to allow foreign strategic investors who are "fit and prop- er" to have unlimited access to the purchase of existing banks in 1995. The foreign bank entry came through the outright purchase of bank shares. Foreign banks are also permitted to di- rectly enter the market through establishing branches. By end-2000, more than 90 percent of the Hungarian banking sector was foreign. Both Hungary and Poland are also committed to fully opening their financial markets to EU country origin financial institutions as part of EU accession. (Box continues on next page) 218 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 8.2 (continued) South America Argentina-Foreign bank entry was not restricted by the type or the amount of capital, and foreign banks have always had a strong presence in Argentina as reflected in the high 1994 figures above. Foreign bank entry, primarily Spanish banks, accelerated during 1997-98 as these institutions started buying out the family-owned large domestic banks. The existing for- eign banks also increased their presence through purchases benefiting from low stock valua- tions of the banks during 1998-99. Brazil-No visible or explicit barriers to entry were in place, but Brazil always had several large well-capitalized and well-managed private Brazilian banks that had control over the mar- ket. Nevertheless, foreign bank entry in the form of subsidiaries increased since 1995 in the context of two bank restructuring programs. The sale of the Banespa shares to Banco Bilbao Vizcaya Argentina (BBVA) in 2000 has increased the foreign bank ownership in total assets to 25 percent. Mexico-By law, foreign banks were restricted to owning no more than 20 percent of local banks. Foreign bank branch operations were allowed selectively. Subsequent to the 1994 de- valuation, the authorities allowed the acquisition of local banks up to 51 percent-the full con- trol limit, with the approval of the Ministry of Finance. In December 1998, the Mexican Con- gress lifted the historical restricticn of buying up the local banks, and by end-2000, the share of foreign ownership had increased to 40 percent. Southeast Asia Thailand-Foreign bank participation in Thailand was restricted to 25 percent of total sector eq- uity and only one branch for foreign banks. By tradition, local banks have been closed to foreign banks because large and important tamilies owned and ran the local banks. The 1997 crisis changed that situation. Ownership restrictions were lifted, and the five intervened banks were of- fered to foreign banks for sale. The existing family-owned local banks started seeking interna- tional strategic partners and/or investors. Some of these banks raised Tier-two capital in foreign markets. Four banks (one private, three intervened) were sold to foreign banks during 1998-99. The waning interest by foreign buyers and/or investors in Thailand resulted in the government transfer of ownership of the other two intervened banks to the Thai Pension Fund in 2001. Malaysia-After a very liberal period up to 1971 when foreign banks controlled up to 90 per- cent of the banking market, Malaysia implemented a series of prohibitions of foreign bank ex- pansion-30 percent shareholding limit, prohibition to open new branches, ATMs allowed only on existing branch premises, etc. As a result, foreign banks now control about 23 percent of the total assets and concentrate primariiy on corporate banking. However, Malaysia has a commitment under the General Agreement on Tariffs and Trade (GATT) to liberalize its finan- cial services. Democratic People's Republic of Korea-DPR Korea had allowed only foreign bank branch entry on a selective basis since 1967. In September 1987, there were 52 foreign bank branch- es with a total market share of 2 percent of banking sector assets. Foreign bank participation in the DPR Korean banks has been allowed since the 1997 crisis where one large intervened bank was sold and two others had negotiations terminated during 1998-99. Some other DPR Korean banks have used Global Depository Receipt programs or raised Tier-two capital in the international subordinated debt markets. The foreign involvement as a strategic shareholder has stayed as minority shareholder investments in general. Sources: IMF 2000, and Caprlo and Honohan (2001). ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 219 America and southeastern Asia) or during a transition to a market econ- omy and EU accession (Central Europe). Arguments in favor of increasing foreign ownership in the domestic banking sectors can be grouped into three broad areas. First, foreign bank presence is argued to increase the amount of funding available to domestic projects because foreign banks not only bring in capital but can also act as conduits for additional international capital flows. Foreign bank presence may also increase the stability of available domestic lend- ing by diversifying the sources. Second, foreign banks are said to im- prove the quality, pricing, and availability of financial services both di- rectly as players in the domestic markets and indirectly through increasing domestic bank competition. Third, foreign bank presence is argued to improve financial system infrastructure, including accounting and transparency, supervisory practices, and risk management. The recommendations to the developing countries to increasingly open up their domestic-banking sectors to international banks gained new momentum during 1998-2001, after the Asian, Russian, and Turk- ish crises. The emergence of global banking capability, in all geographic regions of the world (directly or through internet connections) and the interrelated capital flows in all financial sector activities (through merg- ers and acquisitions in the banking and nonbanking financial industries) also encouraged this pattern. The need to develop international stan- dards for best practices and compliance to these standards will be sup- ported by the international regulatory and financial institutions (BIS, OECD, IMF, and the World Bank under the Global Stability Forum) so that future crises can be avoided. These institutions also support the idea that more foreign banking presence would introduce best practices or good examples to the developing banking markets. There are three arguments against increasing foreign ownership in do- mestic markets. First, foreign bank presence is said to decrease financial stability of domestic credit by providing additional sources of capital flight or by rapidly withdrawing from the market during times of crisis. Second, foreign bank entry is argued to increase the risk of the domestic banks, since the foreign banks choose the best customers and leave less competitive distributors to move to more risky areas of business. Third, some argue that financial services are a strategic industry and should therefore be controlled by domestic interests.9 Empirical research on the benefits of increased foreign bank presence in the developing countries has recently started, given the fact that in- creased foreign bank entry into developing markets is a new trend. The research results all support the benefits of foreign bank entry: they show 220 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR that the competitive pressures created by increased foreign bank owner- ship lead to improvements in banking sector efficiency; the local banks are generally not left at a competitive disadvantage in lending, and the funding base for the real sector is increased and diversified. Some country- specific empirical research has also shown that increased foreign bank presence increases the technology, human skills, and product diversifica- tion in the domestic banking markets (Goldberg, Dages, and Kinney 2000; IMF 2000; Claessens and Jansen 200010). However, there is not yet enough empirical evidence to show whether increased foreign bank pres- ence provides a more volatile or a less volatile supply of credit, and whether greater foreign bank presence increases the stability of the do- mestic financial system. Given the low level of capital and the size of the Russian banking sec- tor, the authorities may consider encouraging further foreign bank entry in all forms-directly through branch openings, and indirectly by remov- ing all explicit and implicit restrictions for foreign bank ownership- where foreign banks can be the controlling shareholders of Russian banks, including the state banks that will be privatized. In addition to technology, human resource skills, and competition, the entry of foreign banks might be another source of much needed investment and lending capacity to the real sector in Russia. In short, increased foreign bank presence could be viewed as a complement to the domestic banking sec- tor rather than a competitor. The following are major policy issues that would face the supervisory and the regulatory bodies due to increased foreign bank presence: 1. The need to develop effective prudential supervisory capability and arrangements, especially for large complex banking institu- tions and their products and instruments 2. The need to get proper assurance for the degree of parental sup- port that would be required in support of local establishments in cases of own or systemic failures 3. The need to take proper precautions that increased foreign bank entry does not increase systemic risk in the banking system from contagion effects 4. The need to decide on the coverage of official and explicit safety nets. Supervision All foreign bank entities in a host country are expected to comply with the prudential requirements of the host country's supervisory authorities ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 221 in addition to their home country requirements. However, increased for- eign bank presence brings with it more responsibility to the host country supervisors to oversee not only the local foreign entities but also their parent institutions. Box 8.3 summarizes the accepted division of supervi- sory responsibility between the host and home country supervisors for Box 8.3 The Generally Accepted Guidelines for the Supervision of Foreign Banks The activities of the representative offices of foreign banks in the host countries have not been an issue for cross-border banking supervision since these offices are considered to be mar- keting units for the parent banks overseas. Accordingly, any business generated by the repre- sentative office is booked by the head office falling under the supervision of the home country supervisors of the parent. The consolidated supervisory responsibility for the overseas affili- ates of the banking group or banks falls under the responsibility of the home country of the bank/group. As for the subsidiaries, equal ownership joint ventures and branches, the initial Basel "Con- cordat" in 1975 states that the host supervisory authority would have the primary responsibil- ity for the solvency of the foreign subsidiary and the joint ventures, whereas the home super- visor would be responsible for the branches. In 1983, the Concordat was revised to introduce the principle of consolidated supervision and to make the solvency of foreign subsidiaries the joint responsibility of the host and home countries. Following the failure of BCCI, the Basel Committee on Banking Supervision issued four mini- mum standards for the supervision of cross-border banking in 1992: 1. All international banking groups and banks should be supervised by a home country au- thority that capably performs consolidated supervision. 2. The creation of cross-border banking establishments should receive the prior consent of the host and home country supervisory authorities. 3. Home country supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks for which they are the home coun- try supervisor. 4. If a host country authority determines that any one of the foregoing minimum standards is not met to its satisfaction, that authority could impose restrictive measures necessary to satisty its prudential concerns consistent with these minimum standards, including the prohibition of the creation of banking establishments. Further recommendations were issued to supplement the above four minimum standards in 1996. These standards and recommendations have led to a set of practices for the effective supervision of cross-border banking activities. The most important of these are 1. The licensing of cross-border banks should require the informed and explicit consent of both the host and home country authorities. Moreover, the host country authority should evaluate the level of support that the parent is capable of providing to the proposed es- tablishment. 2. The home country supervisory authority has the responsibility for the consolidated supervi- sion of the bank or banking group on a global basis. Host countries are primarily responsi- ble for the liquidity of a foreign bank. Moreover, the host country is responsible for the sol- vency and supervision of foreign subsidiaries. Despite the division of responsibilities, the host and home country supervisors need to be in close contact and cooperate effectively. (Box continues on next page) 222 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Box 8.3 (continued) 3. The flow of information between the home and host country supervision authorities should be of both quantitative and qualitative natures. Together with data, the host country should permit home country on-site inspections. 4. If the host country is not convinced that the home country supervisory standards are suffi- cient to maintain the above standards, it has the right to prevent the creation in its jurisdiction of any cross-border establishments by banks or banking groups from that home country. The above guidelines specifically cover the cross-border banking establishments where banks based and supervised in a home country are the majority or sole or equal partner in host coun- try banking establishments. Special problems can be posed by so-called shell-banks-li- censed or registered in one center but effectively controlled or managed from another juris- diction-or parallel-owned banks, where a bank in one jurisdiction is under the same nonbank ownership as a bank in another jurisdiction. It is generally understood that host country supervisors have the full responsibility for the proper supervision of the subsidiary banks and/or joint ventures banks established with non- bank foreign ownership. The supervision of foreign bank branches is left to the home country under the assumption that a branch has no independent legal personality distinct from its parent, and the claims on the branch constitute claims on the parent. Historically however, some foreign banks have not been able to honor deposits in their overseas branches due to the imposition of capital con- trols or expropriation (i.e., China, Cuba, Vietnam). Recent episodes of "ringfencing" of the obligations of the local branches of some major inter- national banks in Asia for derivatives and foreign exchange obligations also raised questions about the commitment of the parent banks to their branch obligations in times of crisis or dif- ficulty. Despite the home country supervision principle, many host countries continue to su- pervise the activities of the host country branches separately. Source: IMF 2000. different types of foreign bank presence. Accordingly, the Russian super- visory authorities have to increase cooperation with the home country supervisory authorities as more complex forms of foreign banks or bank holding companies increase their presence in Russia. Given all the weak- nesses in Russian banking supervision, foreign entry would likely bring renewed trust to the Russian banking system because of the home coun- try supervision principle. Parental Support Legally the parent institution is expected to be fully responsible for the commitments of its branches, because a branch does not have a distinct legal personality. The parent bank is expected to stand behind its branches in times of difficulty so that its reputation can be maintained. However, the ENCOURAGING FOREIGN ENTRY TO THIE BANKING SECTOR 223 recent episodes of "ringfencing" and historical precedents (see Box 8.3) have proven that, under certain circumstances, the parent may not fully stand behind its branches. Most of the host country authorities allow bank branch entry when the parent is obligated to allocate a minimum specified amount of local- ly paid-in capital for the operations of the branch. This capital limit is generally used to limit the lending size of the branch, which will protect domestic banks and give the assurance that this capital is the minimum parental support for the local branch. As for the subsidiaries and the joint ventures with foreign bank share- holding, the parent bank's commitment is legally limited to the amount of capital it has subscribed to the entity since these entities are legally in- dependent and locally incorporated entities. Many host country regula- tors would insist on a letter of comfort and/or an explicit guarantee that the parent bank would support the subsidiary in case of insolvency or major losses. Information-sharing with the home country supervisory bodies would also ensure timely recognition of the parental capability to continue sup- porting its subsidiary in the host country. Systemic Risk The systemic crisis or large-scale failures in the home country banking sys- tems may have a contagious effect on the host country if the parent bank resorts to the funds of its subsidiary to support its position, and if that sub- sidiary has a dominant position in the host country banking sector. This is particularly true for small countries with a limited number of banks. There does not seem to be a major parent bank that holds a large mar- ket share in the Russian banking market today that would cause a con- cern for the contagion of systemic risk from a home country. However, the authorities might carefully monitor the overseas exposures of the for- eign and domestic Russian banks to minimize any risks in the asset qual- ity deteriorations of these banks should a crisis occur in those countries (see Box 8.3). In general, the subsidiaries are expected to be under the deposit insur- ance coverage of the host country, and should contribute accordingly. Branches have the option to pick either the home or the host country de- posit insurance coverage. For example, in order to minimize regulatory arbitration, EU countries are expected to have the same deposit insur- ance coverage at a minimum. EU accession will imply "single license" 224 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR where the foreign banks will have the choice to enter not only as sub- sidiaries but also directly as branches. Host country regulatory bodies would have to decide on the treatment of foreign bank deposit insurance coverage as well as the costs and bene- fits associated with it. The Central European countries that have opened up their domestic markets to foreign banks have opted to align their de- posit insurance programs to meet the minimum EU requirements until accession. Most of the other non-EU countries in Europe are also taking this route. All of the countries that have opened up their domestic banking sector to foreign capital assume that the lender-of-last-resort facilities are available to all of the banks that operate in that market. The foreign banks in a host country face the same risks of systemic failures as the rest of the sector. ENDNOTES 1. See article "How Does Foreign Entry Affect the Domestic Banking Mar- ket?" by S. Claessens, et al. 2. Excluding those banks owned 100 percent by Russian banks domiciled overseas: Eurofinans, Mosnarbank. 3. The following CBR instructions have direct implications for foreign invest- ment in banking in Russia: Instruction No. 02-195 of April 1997; No. 75 of July 1998; No. 559-Y of May 5, 1999; No. 586-Y of June 24, 1999; No. 589-Y of June 28, 1999; No. 829-Y of August 28, 2000; No. 895-U of January 3,2001. In addition, all of the banks in Russia, regardless of ownership, are obliged to com- ply with all CBR regulations. 4. There was an assumption in the market that this was 12 percent. However, it was never implemented since (a) it is not clear whether this would imply direct and indirect foreign capital and (b) the share of more than 50 percent foreign banking capital had never exceeded this ratio in the past. There is a mention of another 25 percent limit in the CBR Policy Paper with unclear definition. 5. According to the January 2001 Decree, the minimum paid-in capital for a foreign bank subsidiary is 261.5 million RUR (10 mm Euro) versus 2.6 million RUR for a Russian bank (1 mm Euro). 6. Although some foreign banks mentioned a limit of two branches per for- eign subsidiary, no such limit is expressly written. 7. Again there is a verbal argument that the foreign ownership in a nonforeign subsidiary Russian bank cannot exceed 46 percent; i.e., foreign investors cannot own majority or controlling shares in Russian banks. That was not implemented for EBRD's and International Finance Corporation's (IFC's) equity investments ENCOURAGING FOREIGN ENTRY TO THE BANKING SECTOR 225 in Russia-nor for the AIG Russia and nonresident Russian banks that have con- trolling ownership in Russian banks (see Table 8.1). 8. If the Russian banking statistics were presented under lAS, the share of for- eign capital would also increase substantially. 9. Some also cite the "infant industry" argument to protect the small domes- tic banking sectors from foreign competition. 10. See the following articles: "How Does Foreign Entry Affect the Domestic Banking Market?" by S. Claessens, et al.; "Lessons from European Banking Lib- eralization and Integration" by X. Vives et al.; "The Opening of the Spanish Banking System: 1985/98" by J.M. Pastor et al.; "On the Kindness of Strangers? The Impact of Foreign Entry on Domestic Banks in Argentina" by G. Clarke et al.; "Foreign Entry in Turkey's Banking Sector, 1980/1997" by C. Denizier; "For- eign Direct Investment in the Banking Sector: A Transitional Economy Perspec- tive" by L. Papi et al. REFERENCES Caprio, Gerard, and Patrick Honohan. 2001. Finance for Growth: Policy Choic- es in a Volatile World. Policy Research Report. World Bank, Policy Research Department, Washington, D.C. Claessens, Stijn, and Marion Jansen. 2000. "The Internationalization of Finan- cial Services: Issues and Lessons for Developing Countries." A joint publica- tion by WTO and World Bank. Boston, Mass.: Kluwer Academic Publishers. Goldberg, Linda, B. Gerard Dages, and Daniel Kinney. 2000. "Foreign and Do- mestic Bank Participation in Emerging Markets: Lessons from Mexico and Argentina." Working Paper 7714. NBER Working Paper Series, National Bu- reau of Economic Research, Cambridge, Mass. Website: http://www.nber.org/ papers/w7714. IMF (International Monetary Fund). 2000. International Capital Markets. Washington, D.C. September 11, 2000. Izvestiya. 2001. Website: http://www.izvestiya.ru. PART III REGULATION AND THE RESTRUCTURING OF BANKS H aving outlined the building blocks of financial sector reform as it relates to the legal and accounting infrastructure (Part I), and identified the restructuring needs of the banking sector (Part 11), Part III focuses on the implementation of legal and regulatory measures to support bank restructuring. Building trust in the financial system depends on developing banking supervision with the primary goal of protecting the financial standing of the weakest participants in the financial system, the retail depositors. As outlined in Chapter 9, the CBR has made considerable progress in estab- lishing a banking supervision function, but a number of measures still need to be made to improve the effectiveness of banking supervision. Crucial to improving trust in banks will be a switch in emphasis by bank supervisors away from exhaustive and bureaucratic verification of com- pliance with technical norms, to a more forward-looking assessment of the financial condition of banks, the integrity of their operations, and their capacity to manage risks. While the motivation for introducing deposit insurance may be to in- crease trust in the financial system by formally protecting smaller depos- itors and also creating a more level playing field between state and pri- vate banks, the question raised in Chapter 10 is whether deposit insurance is an effective means of achieving these laudable goals. There are significant risks associated with introducing deposit insurance-not least in the form of encouraging risk-taking activities by banks and the accumulation of contingent fiscal liabilities by the Government-and 227 controlling these risks requires a sufficient regulatory and supervisory in- frastructure, which is still in its development phase in Russia. Building trust in the Russian financial system will depend on estab- lishing a reliable framework for bank restructuring and liquidation. Chapter 11 reviews measures to improve this framework, and Chapter 12 provides an assessment of the application of bank restructuring meas- ures by the Agency for Restructuring Credit Organizations (ARCO). The key problem of bank restructuring in Russia is that trust is defrayed due to the less than full satisfaction of depositor claims. This results from de- layed bank restructuring actions that are often based on unreliable or un- realistic assessments of bank viability. Improvements are also recom- mended in the liquidation process, including reducing judicial delays, doing away with the use of amicable settlements, improving the expertise of those responsible for bank liquidation, and reducing court involve- ment by creating a public entity responsible for bank liquidation. CHAPTER 9 Building Trust through Effective Banking Supervision A banking license provides bank owners and managers with the privilege of soliciting deposits from households. However, small, retail savers cannot have the capacity or knowledge to under- stand the condition of the banks where they place their deposits. In addi- tion, troubled banks are often able to maintain their liquidity (by gener- ating new deposits) for some time after they have eroded the cushion of security provided by their capital base. Thus, creating trust in the finan- cial system depends crucially on developing a banking supervision func- tion with the primary goal of protecting the financial standing of the weakest participant in the financial system, the retail depositor. The Central Bank of Russia has made significant progress in establish- ing a bank supervision role, particularly considering that the principle of bank supervision has been introduced to Russia only within the last decade. All the key functions of banking supervision are in place, and they are supported by a comprehensive set of laws, regulations, and in- ternal rules, which provide the supervisors with broad powers of en- forcement. The bank supervision staff have had to learn how to apply new laws, regulations, and procedures. Furthermore, although the CBR's reputation for supervision was savaged by the 1998 banking crisis, it has survived the experience, and all the key staff will have gained tremen- dously valuable practical experience from it. These are formidable strengths on which to build. Moreover, improvement in the overall eco- nomic environment has helped the banking sector to improve its viabili- ty somewhat, which should make dealing with weak banks and toughen- ing the supervisory system easier. Continuing low usage of banks (lack of 229 230 BUILDING TRUST: DEVELOPING THE RUssIAN FINANCIAL SECTOR depth in the financial system by international standards) should make it easier for the authorities to make difficult decisions in dealing with prob- lem banks. Bank restructuring and/or liquidation should result in rela- tively small consequences for the economy as a whole. However, despite the strengths and opportunities, as well as the significant effort that has gone into upgrading the banking regulation and supervision framework, banking supervision still has quite a number of weaknesses that need to be addressed for banking supervision to fulfill its primary goal of pro- tecting individual depositors and equally ranking creditors, and thus contribute to reforming the banking system into a viable, legitimate sys- tem capable of supporting economic growth. This is especially important if a deposit guarantee system is to be introduced as planned by the au- thorities. A guarantee system could provide reasonable protection for de- positors without accumulating disproportionate contingent fiscal liability, but only if it is underpinned by effective supervision capable and willing to keep unsound banks out of the system. The CBR appreciates that it still has some way to go to achieve this goal, and the Joint CBR/GoR program for development of the banking system has put together a comprehensive program for improvement of the bank supervision function, which includes the following main areas: 1. Improvement of the licensing process, including tightened re- quirements for financial strength and fit and proper characteris- tics for bank owners 2. Continued introduction and implementation of Basel Core princi- ples of effective bank supervision, focusing on assessment of risk management systems and internal controls in banks rather than on compliance checks 3. Development of proactive approaches to bank supervision and improvement of early warning systems 4. Tightening of prudential requirements with a view to better re- flection of risk profiles 5. Strengthening definition and the role of capital adequacy 6. Strengthening oversight of banking groups on a consolidated basis 7. Increasing the emphasis on on-site supervision (inspections), fo- cusing inspection efforts on problem banks, banks involved in high risk-taking, and/or those with inadequate risk management systems and weak internal controls 8. Improving the bank supervision process through the transition to International Accounting Standards and the adjustment and streamlining of bank reporting. (As discussed further below, BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 231 transition to IAS will require amendments to the Federal Law on Accounting as well as the adjustment of laws regulating taxation 9. Reorganization of the bank supervision function, in order to find an optimal balance between centralization and decentralization of the supervision process 10. Enhancing bank rehabilitation and liquidation procedures 11. Improvement of corporate governance in banks, including en- hancing the role of bank external auditors in line with best inter- national practice. Recognition by the CBR of the need to improve banking supervision along these lines is a very important step forward. These plans are in line with the recommendations that the World Bank and the International Monetary Fund have previously proposed to the Russian authorities. The high-level assessment of the effectiveness and efficiency of the CBR supervision function, which was carried out by the World Bank at the re- quest of the CBR in autumn 2000, may have contributed to the develop- ment of such plans by the CBR, especially the consolidation of off-site monitoring and on-site inspection functions into one department, which could streamline the supervision process. At the same time, development and implementation of bank supervi- sion principles based on international approaches is fraught with signifi- cant risks. Such approaches have been developed for less volatile banking environments, and assume far more deep and liquid markets for assets than those available in Russia. They provide wafer-thin margins of safe- ty for a typical Russian bank, requiring constant on-site supervisory reappraisal. Now is the time for the CBR to implement its plans, which will re- quire a lot of support, both external and internal, to be successful. IMPROVING THE ENABLING ENVIRONMENT In the final analysis, everything rests upon the willingness of the major market players (both state and private banks) to conduct their business in a prudent and trustworthy manner. They must be willing to submit to rigorous supervision in the interests of the market as a whole. Even when a comprehensive legal framework and a well-developed supervisory function exist, the mechanisms for banking reform and oversight will not be effective if the enabling environment does not support that reform and oversight. The government and supervisory authorities must have the political will to enact change, for example, as demonstrated in part in 232 BUILDING TRUST: DEVELOPING THE RuSSIAN FINANCIAL SECTOR the economic role that they set for the banking sector and the role that they set for banking supervision. The political will to uphold and enforce the tenets of a properly func- tioning market economy is at the root of reform and of building a safe and sound financial system. The surrounding legal framework and polit- ical system must have market and commercial rules that recognize crimi- nal and noncommercial activities as a threat to the country's overall eco- nomic well-being-and that explicitly define, enforce, and penalize such activities. The roles of both the banking sector and of banking supervi- sion must be well established, and a certain level of economic health and viability must exist to provide the balance of risk and reward that can motivate healthy investment and banking activities. In Russia, the enabling environment has yet to be developed to the point where it can support a strong banking sector and effective bank su- pervision. In fact, it remains extremely weak, and efforts to reform the banking system into a viable, legitimate system have in consequence been largely unsuccessful. The infrastructure is not complete, and it is implic- itly designed and operated to accommodate vested interests that have noncommercial and nonmarket motivations. Likewise, reform of the po- litical and economic climate, which is severely constraining the ability of banking supervision and regulation to reform the financial system, ap- pears difficult. POLITICAL WILL The various constituents of the system-the Duma, CBR, court system, large corporations, and especially the banks themselves-have demon- strated little inclination to address the root problems of the banking sec- tor. While political will is difficult to quantify, the byproducts or the symptoms of its absence can be easily described. They include: 1. Lack of transparency. The financial condition of banks and enter- prises, in part due to their use of Russian Accounting Standards, is difficult to ascertain. Financial disclosure requirements are weak, and in many cases the ownership structure of the banking system is ambiguous. Given the absence of reliable information, the activities and economic health of the system are not easily de- termined. Rapid implementation of selected aspects of IAS would be a major step forward, but full transparency will require more than the application of minimum levels of disclosure and rote compliance with new standards. BUILDING TRUST THROUGH EFFECTIVE BANKING SU1PERVISION 233 2. Unreliability of bank reporting to the CBR. Although the CBR rigorously enforces the technical accuracy of reporting (including the imposition of fines, although these are often only nominal amounts), the more serious problem is when banks engage in de- liberate actions to conceal the economic nature and risk structure of their transactions. As a result, the CBR does not possess ade- quate information to detect and act in the case of deteriorating bank and systemic conditions. 3. CBR reticence to apply the full extent and spirit of the law. Some improvements are needed, but Russia's banking laws and regula- tions generally are adequate. The compliance and enforcement environment, in contrast, is so weak that it renders the legal framework ineffective by its lack of application. 4. Bank linkages with big business and government. A large portion of the banking sector is connected to the government or to government-owned enterprises. The legal requirement that corpo- rate business transactions, such as intracompany cashflow and transfer pricing, must occur through a bank-like institution means that many other banks are directly connected to financial indus- trial groups. Until there is some separation of interests and moti- vations, until market-driven incentives are permitted to stimulate banking and economic activity, and until banking supervision is permitted to occur objectively and independently, the banking sector will remain unreformed. 5. Responsibility and accountability for prudent banking behavior. Bank managers and shareholders have not been forced to answer for their misdeeds and for the losses incurred by the system and by depositors and creditors. Many of the managers and share- holders of banks that failed in the 1998 crisis continue their in- volvement in the sector by way of bridge banks and newly char- tered banks. Until the system can be freed of the influence of the individuals and corporations whose conduct led in large measure to that crisis, there will always be a fundamental instability of, and lack of confidence in, the banking system. 6. Suspicious and criminal activity. The practice of asset stripping and misallocation of funds goes on unabated, and is even publicly ac- knowledged by its perpetrators. The lack of coordinated, con- certed, preventive, and punitive action by the authorities-or even of adverse comment-suggests a tacit approval of this activity. 7. Lack of a coordinated, concerted effort to reform and restructure the banking sector. Many banks on the brink of bankruptcy are 234 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR left to negotiate their own, inequitable creditor workouts. There is no attempt to rationalize the number of banks or to withdraw deposit-taking abilities or licenses, even from those institutions that have no intention of using depositors' funds for any purpose other than to support their shareholders' activities. 8. Government participation in the banking sector and conflicts of interest. A large portion of the banking sector is owned by the Government, rendering governance and accountability issues even more complex. The ability of supervision to objectively and inde- pendently assess state-owned banks and to mandate remedial ac- tion is clouded and ambiguous. 9. Personal benefit. Politicians and legislators have implied through their actions that they would rather focus on the short-term bene- fits of holding office than make the decisions that would challenge powerful vested interests and that are necessary to promote long- term reform actions. The best way for Russia's banks to promote depositor confidence would be to demonstrate a genuine commitment to the honest and pru- dent conduct of their business. However, both the banks and the author- ities alike seem more focused on developing detailed normatives, stan- dards, and structures that would create the appearance of systemic normality to outside parties. All parties, it seems, should be reminded that integrity and prudent banking practice are not the automatic prod- ucts of a set of accounting standards or of legislation. Individual institu- tions must also be seen to act in a manner appropriate to their position and responsibilities. ROLE OF THE BANKING SECTOR The banking system to date has existed largely for the benefit of large corporations and powerful business interests. The vast majority of banks are associated with Government, Government-owned entities, and/or large corporate groups for which they facilitate corporate cash flows, payments, transfer pricing, and credit access. Banks in Russia do not ef- fectively perform the traditional role of intermediation. The retail de- posit base is miniscule, lending to small and medium-size enterprises is seriously underdeveloped, and the overall size of the system is extremely small when compared internationally. Without a sound enabling envi- ronment and legitimate profit incentives to encourage banks to provide the necessary financial services and to support economic growth, the role BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 235 and existence of banking institutions will continue to be ambiguous, thereby contributing to the delay in establishing a true market economy. Economic growth, equitably distributed throughout the country and population, will continue to be stifled. Since the role of the banking system remains inconsistent with other typical market economies, and since the sector does not engender the confidence of a well-developed retail deposit base and creditor participa- tion, the role of supervision is likewise problematic. In Russia, the bank- ing system does not significantly perform the traditional role of public deposit taker and intermediator of funds in the economy at large, but is instead founded on relatively self-contained entities with limited focus, vested interests, and goals that do not extend beyond those of immediate personal benefit. Under such circumstances, when the banks do not play a significant role in the larger public/national economy, the role of the su- pervisor to regulate activities to protect the public trust and promote sta- bility is undefined. Since the banks have little interface with public inter- ests, the regulator's role is marginalized and becomes increasingly difficult to fulfill. Since the infrastructure of the enabling environment is flawed, the expectations of the authorities, the public, and international constituents that bank supervision should lead and ignite banking sector reform and restructuring are misplaced. Any evaluation of banking supervision in Russia or of any develop- mental program must be considered in light of the marketplace and envi- ronment in which the function must operate. Notwithstanding these challenges, the review that follows focuses on selected key elements that, if further enhanced, could potentially add value to the needed banking sector reform. ESTABLISHING THE ROLE OF BANKING SUPERVISION For bank supervision to fulfill its responsibilities and duties, the supervi- sor must first understand and explicitly acknowledge its proper role in fi- nancial sector oversight. This role must also be understood and generally accepted by the Government and be promulgated throughout the banking industry. Ultimately the banks must accept the supervisor as an equitable arbiter of law and good practice, who acts in the interests of the system as a whole and not in a capricious or authoritarian way. The supervisor must possess the freedom to act without undue influence from Govern- ment, bank owners, or other special interests. He/she must assume a 236 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR leadership role in restructuring the financial sector and in maintaining the sector's safety and soundness. He/she must also possess the tools to ad- dress any activity that threatens this safety and soundness. The supervisor must have the ability to interpret legislation as it applies to individual bank cases and as the sector evolves and introduces new risk configura- tions. And the supervisor must be prepared, when required to do so, to exercise his/her authority to the fullest extent of the law. Anything less, and the supervisor is not fulfilling his/her responsibility to protect the public trust, depositors, and ultimately the general public. In Russia, the role of bank supervision is not fully understood by the range of vested interests within the financial system, including the public and government authorities. The role of protecting depositors and ensur- ing the safety and soundness of the banking system does not appear to be the motivating factor in much of the supervisory practice or philosophy. This view is supported by the strict, legalistic manner in which supervi- sion is conducted; the large amounts of time expended in identifying the need rather than requiring swift bank corrective actions; and the appar- ent continuing abusive banking practices conducted by banks, their own- ers, and various vested interests. It is further demonstrated by the lack of responsibility and accountability charged to owners, directors, and man- agers for lack of management of their institutions, and by the supervi- sors' reluctance to consistently apply the full force of the existing legal framework. These factors, together with the lack of a well-defined role for the banking sector in Russia's economic landscape, further compli- cate and cloud the focus and mission of bank supervision. The role and objectives of supervision must be established and serve as the focal point for all supervisory policy, procedures, and activity if the function is to guide the banking system through the reform process. Es- tablishing the role of the supervisory function and ensuring that the re- quirements of the new role are truly fulfilled will require that the existing culture and management process in bank supervision fundamentally change. The motivations and focus of supervision will have to shift to make banks the first line of defense for legal compliance, for monitoring, and for responding to existing and changing risk profiles; to focus super- vision on the proactive identification of banking problems; and to ensure that responsibility and accountability are properly assigned to bank own- ers, management, and boards. In short, the supervisory culture of the CBR and the banks themselves must change in order to meet the per- formance expectations a market economy places on bank supervision. One of the first steps necessary to more clearly focus supervisory ob- jectives and to clarify the supervisors' role within the CBR, Government, BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 237 banking sector, and public is to establish the protection of depositors as the primary objective of banking supervision; without this objective, supervision cannot ensure systemic stability. The supervisor must have the power to interpret the substance of transactions-rather than just the form-and to enforce supervisory norms and guidelines on that basis. A set of operational-level principles and objectives could rapidly be prepared that emphasize the most critical issues or actions to be taken for the supervisor to accomplish that mission. This set should include guidance on the compliance culture that needs to be inculcated in the banking system and on the manner in which the supervisor should inter- pret key aspects of regulations and laws. Although there are exceptions, most Russian banks seem to have internal systems and policies to ad- dress their day-to-day activities. Such systems are used to ensure that the banks fulfill the objectives of their controllers; they are not necessarily constructed in accordance with sound banking principles. The guidance to supervisors might therefore include the need to ensure 1. the commitment of hank owners, controllers, and managers to the spirit (rather than the letter) of supervisory requirements 2. responsible ownership by bank shareholders, which defines and prohibits conflicts of interest and abusive practices and requires business practices and behavior that allow the institution to conduct legitimate banking activities in a safe and sound manner, thereby helping to build a sense of confidence in the banking system 3. core risk management and control processes 4. requirements to establish strong legal, regulatory, and internal policy compliance systems 5. prompt corrective actions by the supervisor in cases of bank abuse (including fictitious or inaccurate reporting), financial deteriora- tion, capital insolvency, or legal infractions. Triggers for action should be based on substance rather than on formal, technical compliance with normatives, particularly in the areas of large ex- posure reporting, related-party exposure concealment, capital cre- ation schemes, and loan-loss provisions. Although the compilation of a set of operational objectives should help the supervisors to measure their performance internally, a similar statement of principles should be published and made available to the banking community. Ultimately the supervisor should issue public re- ports detailing his/her performance against the stated objectives. This would add an increased level of accountability to the statements made by the CBR in its annual report. 238 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR The difficulty of accomplishing such a cultural shift in the Russian fi- nancial system should not be underestimated, but failure to achieve this shift would undermine and invalidate all other proposed reforms. A start should be made, in the shortest possible time, on the process of advising banks that their conduct, if not actually illegal, is generally unacceptable. Attempts should be made to bring as many cases of abuse as possible into the public domain, preferably by actions leading to the withdrawal of licenses and therefore the authority to take public deposits. Nothing would boost public confidence as much as seeing appropriate action taken, particularly against high-profile banks. The CBR must accept and not be deterred by the fact that its actions may result in court cases. It is essential that the matter of addressing the abuses being perpetrat- ed by banks be brought into the public domain. If this can be done, pub- lic opinion may begin to make the shift required for Russia to take its place in the global economy. IMPROVING SUPERVISORY EFFECTIVENESS Establishing a new role for supervision necessarily implies that bank su- pervision must substantially improve its effectiveness. To achieve this, the organizational arrangement of supervision should be evaluated to en- sure that it is aligned to deliver the highest and best use of its resources. Given the overall condition of the sector and the predisposition of bank managers and shareholders to circumvent the laws and rules, the nature of the supervisory practice must shift. Staff and management can no longer be permitted to merely assess strict technical compliance with rules and ratios, but must proactively and aggressively assess the operat- ing condition and integrity of the banks in the system. Improving the effectiveness of bank supervision requires change at all levels, from the supervisory management level to the regional staff level; in policies and procedures; and in the supervisory actions ultimately taken with banks. Effective and successful supervision cannot be achieved with- out a sustained shift in the attitudes and working culture of the function, repeatedly confirmed and demonstrated by executive and senior CBR management, nor can it be achieved without a commitment to continued training. The effectiveness of supervision depends to a much greater ex- tent on its content than on its organization. The first priority in improving effectiveness is to ensure that the purpose of supervision is clear to all, and that it is reinforced by every component of the structure, policies, proce- dures, and management of the process. The ultimate aim is to ensure that BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 239 bank depositors and lenders have confidence in the banking system and in its supervision, such that the failure of one bank does not significantly di- minish the confidence of depositors in other banks. For example, at the licensing stage most attention is given to merely ensuring that minimum requirements are met. Little attention is given to evaluating the proposed bank's business strategy, internal controls and risk management plans, and safety margins of capital and liquidity-that is, the factors that determine whether or not depositors will be able to withdraw their money in full and on time. Ongoing supervision appears to focus more on compliance with required accounting procedures, regu- latory ratios, and other procedural requirements than on the proactive evaluation of safety and soundness of the institution and therefore also on depositors' ability to withdraw their deposits as contracted. History further demonstrates that the rehabilitation process is highly procedural, involving considerable delays and allowing even very distressed institu- tions to continue operations in the marketplace. The initiative to restruc- ture or rehabilitate a bank is virtually passed back to the bank while the CBR awaits remedial plans and management action. The necessary steps to strengthen and improve the effectiveness of bank supervision are many and detailed, and span the need for cultural change at the highest levels of CBR management to the need for change at the furthest outreach of the supervisory process. The thrust of supervi- sion must become more proactive, using more qualitative analysis, judg- ment, and decision-making. For example, the CBR should be empowered to make licensing decisions based on qualitative fit and proper testing for bank owners, directors, and management. The on-site examination process, off-site monitoring, and early warning analysis should be focused on a qualitative assessment of the safety and soundness of institutions and of the potential threats to their operational status. Qualitative assessment and judgment should form the basis of the CBR's supervisory response-that is, whether to monitor, rehabilitate, or close the institution. While a number of strengthening steps are evident, certain of them are key to shifting the culture and focus of the function. The supervisor needs to become accustomed to exercising judgment, but judgment reached following a structured assessment of the institu- tion. Banks should not face serious supervisory sanctions simply on the basis of the opinion of one official. Clear guidelines for the delegation of the exercise of judgment should be developed, giving appropriate powers to appropriate levels. Ultimate authority over issues such as licensing, delicensing, and findings of improper conduct in banks should probably be left to a committee, but to a committee that includes an element of 240 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR real debate and an assessment of the proposals of individual officials, rather than to one that simply endorses a previously prepared resolution. Clear supervisory responsibility for each bank in the system must be delegated to an individual official, who will coordinate and oversee all aspects of a bank's operations, including licensing, on-site and off-site su- pervision, disciplinary action, and delicensing. The examiner or supervi- sor in charge should be supported by the various supervisory functions that bear on the subject institution. The official should also be protected from political and other pressure, external and internal to the CBR, in order that he or she might execute the responsibility of the position in a fair and objective manner. For the CBR to shift from reactive responses to bank and system dis- tress to a proactive, anticipatory oversight function, the true economic health of each bank must be known. Acquiring this knowledge must be the primary aim of supervisory monitoring as it must form the basis for the supervisory decision-making that follows. Full knowledge of each banks' condition allows the supervisor to anticipate events and their im- pact; to make informed and early supervisory decisions to protect the de- positors and the system; and, above all, to avoid surprises. This, in and of itself, is one of the best ways to promote confidence in the system. Regulatory Reporting: Importance of Accurate Information On the most basic level, financial and regulatory information reported by the banks, their management, directors, and owners must be truthful and reliable. However, in Russia the truthfulness of bank reporting con- tinues to be suspect. It is widely acknowledged that a large majority of the reporting to the CBR is deliberately structured to avoid regulation. Even if reports are prepared reliably and according to instructions, the chance that meaningful economic information is conveyed is relatively low. This is in part due to the fact that the markets for banking assets in Russia are rarely liquid or deep, and that reported values in terms of asset classification, loan-loss provisions, liquidity, and capital therefore have only limited relevance. The lack of adequate information constrains the CBR's ability to proactively monitor banks and the system at large, with the result that corrective action by the CBR comes late and banks operate while distressed-at the expense of depositors and creditors. Transparent, full, and accurate information regarding shareholders, particularly beneficial owners and/or controllers, is at best difficult to obtain. The lack of reliable information has recently facilitated the move- ment of unsuitable owners through the system as additional banks have BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 241 been activated or changed the terms of their licenses to accommodate the needs of those seeking shelter from the 1998 crisis. In the worst cases, it has even permitted such people to seek licenses for new banks. It is im- portant therefore that the CBR enforce and expand the requirements for truthful regulatory reporting at all levels. Given that the integrity of financial information reported to the CBR is questionable, and given the need for an effective supervisory process to produce a comprehensive picture of the economic value and financial standing of the banks in the system, proper emphasis on the on-site ex- amination process is critical. There is no substitute for on-site inspection by well-trained inspectors who can rigorously judge the realizable value of bank assets in the current marketplace. Strengthen the On-Site Inspection Process and Priority The CBR, similar to the central banks of other countries, uses a mix of both on- and off-site monitoring. The weight afforded to each form of monitoring varies from country to country, but for developing and transi- tion economies the value and importance of the on-site examination process cannot be overemphasized. In Russia, given that the integrity and accuracy of bank reporting is known to be deficient, the use of the on-site examination process is key to effective bank supervision and ultimately, therefore, to protecting the safety of the deposits. Exercised in a risk- prioritized manner, the process can be used to (a) verify information and asset values, (b) assess the overall operating condition of the subject insti- tution, and (c) provide certain key supervisory decision-making input on the depth and level of distress and on any needed rehabilitation measures. The implementation in Russia of a rigorous on-site examination process will require that (a) adequate numbers of suitably trained inspec- tors are available to conduct the inspections, (b) banks are placed on a risk-prioritized schedule, and (c) the schedule is flexible enough to ac- commodate change as risk indicators shift. The on-site process and the inspectors should be the focal point of the supervisory process. This requirement raises important issues concerning the delegation of the supervisory process; it raises the role of the inspec- tor in the decision-making process for actions taken with a bank; it re- quires sufficient expert resources; and it requires an overall quality con- trol process to ensure the integrity of the reports and procedural consistency. Coordination between the findings of inspectors and the other elements of supervision is vital, and appropriate delegation, as pre- viously discussed, is also essential. 242 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Banking Regulation Good laws, regulations, rules, and procedures alone will not create an ef- fective supervision process; good executive judgment and application of those rules are also needed. Russia's existing regulations appear general- ly comprehensive, and are set to be enhanced by the enactment of certain amendments to the banking laws that have recently passed third reading in the Duma. Bankruptcy, liquidation, and accounting legislation are also in the process of being amended. Some areas of regulation nonetheless still require strengthening. In particular, the rules addressing licensing, bank exit procedures, capital adequacy, corporate governance, corrective action and enforcement pro- cedures, asset classification, ownership thresholds, and approval author- ities must be improved, specifically for licensing, "fit and proper" stan- dards of ownership and control, acquisition and control, etc. Licensing. Given that the system is burdened with an abundance of unsafe and unsound banks, more supervisory attention should be given to preventing the entry of problematic banks and their shareholders. The management and shareholders of failed banks additionally have rarely been called upon to take responsibility and account for their actions, with many of those responsible for distressed institutions continuing to circulate in the banking sector, post-1998 crisis. The phenomenon of the bridge bank provides perhaps the most striking evidence of this problem. The bridge banks allowed managers and shareholders of distressed banks to continue in business using new or changed banking licenses, thus effectively aiding the stripping of assets from failed institutions. It is imperative that the CBR escalate its efforts to purge the system of prob- lematic banks, to hold their management and shareholders accountable for their actions, and to prohibit them from reentering the banking sec- tor in the future. If such steps cannot be effectively ensured, those and similar banks will continue to be a source of ongoing system instability. "Fit and proper" standards of ownership and control. The "fit and proper" requirements made of bank managers, shareholders, and con- trollers are among the most important safeguards of the safety and soundness of a bank or banking system. They allow regulators to block participation in the banking system by those whose past actions have demonstrated a proclivity for mismanagement, fraud, and inappropriate self-dealing. This is particularly germane in the Russian context, in which the owners and managers of numerous failed banks have almost BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 243 immediately established new banks using the assets of the old. The result is a continuation of the same substandard business practices in the new bank, and the cause of the failure of the old bank is likely to be repeated in the new. "Fit and proper" standards are not based on a generalized de- sire for respectability in the banking profession. They are designed to prevent recurring bank failures resulting from the malfeasance of those who have historically proven their inability or unwillingness to soundly manage their businesses. In Russia, guidance on fit and proper tests and requirements is dis- seminated through selected laws and instructions. Limited requirements for managers include evidence of legal or economic education and/or ex- perience as a bank manager and possession of a "business reputation"; rejection can be made based on the prior commission of certain offenses, on unsatisfactory job performance, or on submission of incorrect infor- mation. Previous bank managers determined by a court to have been re- sponsible for bringing a bank into bankruptcy are precluded from hold- ing any other bank managerial positions for a period of five years. Requirements placed on shareholders are less restrictive and include sat- isfactory financial standing, compliance with antimonopoly rules, fulfill- ment of tax obligations, notification to the CBR of a 5 percent purchase, and approval from the CBR for a 20 percent purchase. Persons who pre- viously owned shares in a failed bank and are determined by a court to have contributed to that bank's failure are precluded for 10 years from owning more than 5 percent of the shares of any other bank. The gap between the scope of requirements for controlling sharehold- ers (i.e., any holdings over 5 percent) and that for management should be addressed. It is not clear how the CBR currently could act against unsuit- able indirect shareholders, how it could exercise an effective licensing pol- icy if a court judgment were needed to keep former owners of bankrupt banks from obtaining approval to own large blocks of shares, or how managers that have been convicted of crimes can be prevented from re- turning to the system (legally, all they need to do is wait for a year to pass after conviction). Management abuses rarely lead to court convictions. To assess an individual in terms of his or her probity, competence, soundness of judgment, diligence, and potential danger to depositors, while critical, is counter to the culture of Russia and Russian banking. Worse, the establishment of norms of what is fit and proper-for exam- ple, for the percentage of equity that a shareholder should control before becoming subject to testing-risks raising the already high levels of con- cealment of ownership. Full implementation of the fit and proper test will clearly be difficult for Russia, but it is a part of the real key to 244 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR progress-the exercise of judgment in the supervisory process-and must be pursued. Acquisition and control. The approval requirements for share ac- quisition do not capture indirect shareholders, despite the potential of such shareholders to form a controlling interest. The law governing the Central Bank and the Law on Banks and Banking should be amended to define "control" more broadly and subjectively; specifically, to capture those entities or groups that alone or collectively can influence a bank's decision-making activity or that may act to control the bank with less than a 20 percent ownership. Banking legislation should also require CBR approval on shareholders, direct or indirect, acquiring 5 percent or more of a banking institution (the current threshold is 20 percent); and should require the periodic disclosure of all beneficial shareholders, di- rect and indirect, to the CBR. Steps should be taken to improve the over- all transparency of bank ownership throughout the system. Streamlining the licensing process. Currently, a plethora of licensing requirements exists for the array of activities conducted by banks. Such activities include those by which a bank constitutes a de facto corporate treasury for associated companies or FIGs. Steps should be taken, both through law and in practice, to streamline the licensing requirements, and these should be complemented by more rigorous supervisory re- quirements to ensure that banks establish strong and effective internal risk management systems to monitor and approve new activities and new products. There should also be a sharper distinction between those institutions that request a license in order to take public deposits and those that re- quire a license in order to fulfill the internal (treasury-related) needs of their associated companies. In other words, the principal business of each bank should be reviewed to see if it requires a public deposit-taking license. Rapid and urgent action should be taken to reduce the number of institutions that hold a full banking license. The reform of banking su- pervision should then concentrate on those banks that remain, rather than on the present universe of 1,300 "banks." This would radically im- prove the chances of success in the development of effective supervision. To further improve the possibility of increasing public confidence, there should be obvious indication in the name of financial institutions of their status. Although the best alternative would be to restrict the use of the word "bank" to those institutions allowed to take public deposits, there are presumably other options. BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 245 Capital Adequacy Definitions of capital and capital insolvency. Information on the avail- ability of true capital-that is, funds readily available to absorb and cush- ion loss-is confused in Russia by the generous definition of qualifying capital, by the well-developed concealment of capital inflation schemes and valuation rules, and by an ineffectively enforced provision against using borrowed funds as capital. Also, under current law a bank's insol- vency is measured in terms of its liquidity position rather than its capital adequacy. This has the effect of allowing a bank, which may technically be capital-insolvent, to continue to operate in the marketplace, tapping various sources of funding, potentially depleting all forms of asset liquid- ity, and stripping the bank of its remaining value for depositor and credi- tor compensation. To allow such institutions to continue to operate esca- lates the costs to depositors and creditors, undercuts confidence in the system, and perpetuates the present environment of mistrust. Supervisors are currently unable to take action against banks that have for all intents and purposes experienced capital insolvency and failed. Basing the measure of solvency on capital adequacy would refocus the supervisor and the marketplace on a more proactive measure of bank soundness. It is critical that this be done to enable more proactive risk detection and prompt corrective action. Amendments to the Law on Banks and Banking that have passed third reading in the Duma would introduce a minimum capital adequacy ratio of 2 percent as the threshold for license revocation. Pursuant to the pro- visions of these amendments, if a bank's capital adequacy ratio falls below 2 percent, the CBR is required to revoke the bank's license and to commence liquidation proceedings. However, the measurement of this 2 percent threshold remains an issue. The level of capital sufficient to operate in a financial environment such as the one in Russia should be continually reviewed. The recom- mended 8 percent level suggested by international standards is intended for banks operating in a viable economic setting that possesses relative operating health. An argument easily can be made for requiring a higher absolute level of capital to cushion against systemic shock in Russia's less stable environment. The authorities should work to establish a higher level of required capital based on the historical experience of the banking sector and the relative instability of the current environment. Capital write-down. Under the recent amendments Russian banks are now required to write down or decrease authorized capital to the actual 246 BUILDING TRUST: DEVELOPING THE RUSSIAN FrNANCIAL SECTOR level of equity capital, and the supervisor is now empowered to charge down equity capital to real value based on the results of a fair and objec- tive on-site inspection. These requirements and powers will allow the true economic picture of an institution to be conveyed, and will enhance the ability of the supervisor to ascertain a true and accurate picture of the safety and soundness of the institution and of the need for remedial ac- tions. The adoption of IAS would provide a starting point for supervisors in their efforts to make accurate assessments of an institution's capital strength. But because very few banks could pass a rigorous test of the amount and quality of their capital, the further write-downs necessary could initially be made only in supervisory calculations, with remedial action instituted. Full publication could follow at a later date. A near- term date should be set to ensure that banks do not continue to postpone full compliance. Corporate Governance The ability of the CBR to hold owners, directors, and management di- rectly responsible, accountable, and liable for mismanagement and/or abuse of their subject institutions continues to be weak. Many of the ex- isting corrective and enforcement actions address the bank itself but not the individuals responsible for unsafe and unsound business activity. The supervisor must have the full capacity to address the key parties who are responsible for and determine how the business of banking is conducted. Since the banking business involves the public trust and re- sponsibility to manage the public's money in a prudent manner, the re- sponsibilities and accountability of such persons must be clearly defined. Furthermore, the supervisor must be provided with and must use the re- medial tools to address activity that threatens this trust. A review of the legal provisions in this area should be undertaken, and the necessary amendments introduced. Suspicious or Criminal Activity Neither the framework nor the mechanisms are in place adequately to define what constitutes misappropriation of funds, personal benefit, and other illegal actions in the financial sector. Furthermore, the supervisory and financial police do not have the capacity or, as demonstrated by the significant asset stripping and abuse of the system, the will to hold re- sponsible parties accountable and liable for desecration of the system. Consequently, criminal statutes need strengthening. They should be re- viewed and changed to ensure that the scope of prosecutable crimes is BUILDING TRUST THROUGH EFFECTIVE BANKING SUPERVISION 247 broad enough to be effective in the current environment and that rigor- ous enforcement actions are provided and sufficiently linked to banking law and laws addressing corporate governance. Ideally, operating proce- dure should allow the supervisor to be informed of the disposition of any criminal referrals passed to the police, but it may be some time before such practice is possible in Russia. A comprehensive definition of "imprudent activities," which have the potential for prompt, significant enforcement action, should be provided within the context of the banking law. For example, this might include inaccurate statements to the supervisor, lack of rigorous "know your cus- tomer" (real name) procedures, misstatement of the financial condition, and subsequent inaccurate or untruthful public disclosure. Consolidated Supervision and Associated Powers The legislative framework should be expanded to address and empower the supervisor to oversee banks in consolidated groups. Provisions creat- ing the notion of "banking groups" and "bank holdings" in amendments to the Law on Banks and Banking have passed third reading in the Duma but have not yet been enacted into law. However, this is only one part of the process and just one of the possible options to approaching consoli- dated supervision. There is one major problem that should be borne in mind in the im- plementation of consolidated supervision: the plethora of institutions as- sociated with FIGs. The potential risks and ownership ramifications to banks in these groups can be many. Although these FIG banks act essen- tially as corporate treasuries, their use of a banking license means that their actions are liable to influence the trust of the public, depositors, and creditors in the banking system as a whole. The supervisor must have the authority to assess all potential risks facing a bank in a consolidated group. However, it would be wrong to consolidate industrial companies with financial ones for overall supervision, particularly if the industrial balance sheets tend to improve the financial standing of the whole group. Consolidated supervision implies the collation and consideration of all risks to a bank, and should not permit the capital weakness of a deposit- taking institution to be concealed. Exit and Consolidation Depositors and the public will gain confidence from witnessing the super- visor taking timely and necessary corrective steps with a deteriorating in- stitution. In Russia, remedial action has been slow at best, and a number 248 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR of highly distressed institutions continue to operate in the system. Chal- lenges by vested interests to the CBR's attempts to revoke a license abound in the court system, and when a license is revoked the liquidation process is frequently lengthy and slow, further reducing the opportunity of depositors and creditors to recoup any remuneration. The scope and nature of these problems are discussed in detail in Chapter 11. While the CBR acknowledges that much must be done to clean the system of the existing distressed and insolvent banks, it is hampered by a weak enabling environment and by the momentum and focus of the su- pervisory process itself. A shift of focus to obtaining and analyzing more timely and accurate financial information would significantly improve the CBR's ability to deploy prompt corrective action. However, the CBR should also continue its efforts to strengthen the remedial process; to place greater emphasis on the core problems of bank distress, including mismanagement; to encourage consolidation of the system; and to seek out economically viable banks for rehabilitation. CHAPTER I 0 Does the Russian Federation Need Deposit Insurance? INTRODUCTION Recent cross-country comparisons of explicit deposit insurance schemes have exposed the risks inherent in such schemes, especially when they are deployed within a deficient regulatory and supervisory environment. Al- though deposit insurance schemes have come into increasing use in re- cent years, poorly designed schemes can reduce the market discipline ex- erted by bank depositors, increase the likelihood of banking crises, and impede financial development. These effects are strongest in countries that fail to enforce adequate regulations, to thoroughly supervise their banking system, and to intervene promptly when banks fail. Given the deficient regulatory and supervisory framework in Russia, the lack of possibilities and incentives for depositors to exert market dis- cipline in banks, and the bailouts of well-connected bank owners after the 1998 crisis, the introduction of a deposit insurance scheme seems a premature undertaking that might increase financial fragility and impede further financial development. Improvements in these various areas- resulting inter alia in the consolidation of the sector-as well as reform of the state banks should be seen as pre-conditions for the successful im- plementation of deposit insurance. Cross-country comparisons have shown that the design of a deposit insurance scheme can affect financial development and fragility. A scheme that offers limited coverage and that is privately managed and funded would have lower moral hazard risks and would align incentives between the owners and managers of the scheme. As described in Box 249 250 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 10.1 below, the proposed Russian scheme does envision limited coverage -although, given the recent history of select creditor bailouts (such as the use of amicable settlements in the context of ARCO's restructuring), this might not be very credible. On the other hand, the insurance fund is to be managed by the Government, which opens the door for political capture. And while funding through premiums levied on banks is planned for the future, the initial capital would come from the Govern- ment, raising concerns of potential abuse by banks. Furthermore, the limited power of the deposit insurer in relation to its member banks re- stricts its ability to minimize potential insurance losses. Box 10.1 The Design of the Proposed Russian Deposit Insurance Scheme The major aspects of the design of the proposed Russian deposit insurance scheme refer to: Limiting the coverage of the insurance:The proposed coverage limit of RUR 143,600 and the coinsurance of 10 percent for deposits between RUR 2,000 and 20,000 and of 50 percent for deposits between RUR 20,000 and 143,600 produces a maximum reimbursement of RUR 80,000, a sum that is one and two times GDP per capita and thus around the international av- erage. Only household accounts would be covered, while it seems unclear whether insider ac- counts would be excluded*-although the lack of transparency of the ownership structure of banks would make enforcement of such exclusion difficult. Furthermore, the precedence of previous bailouts of bank owners and creditors by the CBR after the 1998 crisis makes the lim- itation of the coverage to household deposits not very credible, especially given that a signifi- cant share of the initial capital of the scheme will come from the Government. Overall, while the suggested coverage seems incentive-compatible, transparency and credibility of the au- thorities are needed to make it effective in fostering market discipline. Insuring incentive-compatible governance: The proposed governance structure of the Russian deposit insurance system increases the risks of political and regulatory capture and poses sig- nificant moral hazard risks. The proposed law calls for public management of the deposit in- surance scheme, which bears the risk of political capture of the deposit insurer. According to international experience, it would be preferable to have the scheme managed by representa- tives of the banks, who have the strongest incentives to avoid losses through failing banks, if they are the main financing source. Private versus state funding: Given the currently weak institutional environment and the lack of markets for bank debt, the introduction of risk-based premiums would seem premature. How- ever, the option should be kept open for the future. The current arrangement of premiums based on insurable deposits seems therefore appropriate. While funding of the scheme by banks is envisioned as the long-term goal for the scheme, the Government will provide the initial funds. The ex ante funding of up to five percent of insured deposits by the government-an arbitrarily chosen numbert-eliminates the incentives for the participating banks to minimize the loss rate stemming from bank failures. Rather, it amounts to a state guarantee of the insured deposits. Instead of providing liquid assets to the deposit insurer, the authorities should insist on exclusive funding by member banks and pro- vide the deposit insurer with the capacity to access a contingent line of credit through the CBR. This would make the member banks liable for any losses incurred even after a bank failure and (Box continues on next page) DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 251 Box 10.1 (continued) thus give them better incentives to monitor each other. Further, the provisions to raise addition- al contributions in the event of a shortfall of resources should be extended to ensure the finan- cial viability of the fund except for a systemic crisis.t The investment strategy spelled out in the proposed law seems sufficient to guarantee the liquidity and safety of the investment funds. The regulatofy and supervisory authority of the insurer: The proposed law does not give the insurer any regulatory or supervisory rights beyond information-sharing with the CBR. On the contrary, the deposit insurer would have to accept any bank licensed by the CBR to collect household deposits without being able to check its financial viability. While recent proposals call for a substantially higher screening and monitoring of licensed banks, this should be im- plemented before proceeding with deposit insurance. According to the proposed law, no ac- tions could be imposed on banks to prevent them from aggressive risk taking, and member banks could not be excluded should they jeopardize the financial position of the bank, and thus the insurer, through reckless lending. While not duplicating CBR's supervisory and regulatory work, the deposit insurer should have a role in both the licensing and the supervisory process. It should be given the option to (1) reject any new applicant if the decision is based on objec- tive criteria, (2) order (via subcontracting) extraordinary audits of banks it perceives to be un- sound, and (3) be allowed to threaten expulsion (and therefore de-licensing) of banks that are recklessly managed. These rights do not require the build-up of a substantial supervisory de- partment within the deposit insurer, but are important, since the deposit insurer (if financed by its member banks) has the largest incentives to minimize insurance losses and thus monitor and discipline banks. Giving the deposit insurer a role in the regulatory and supervisory process does in no way reduce the urgent need for an improvement in supervision by CBR; it rather reinforces it, since the deposit insurer's decisions might be based on information ob- tained from the CBR. Inclusion of state banks: Finally, it is recommended that Sberbank and other state-owned banks not be included in a deposit insurance scheme in their current form. Including them would not limit their competitive advantage unless they are subject to an effective hard budg- et constraint. Thus, the decision to introduce a deposit insurance scheme encompassing the state banks would have to be linked to strategic decisions regarding the reform of these banks (as discussed in Chapter 7). *In the most recent versionof the draft law, there is only reference to "deposits on favorable terms." This should be spelled out in detail. tA much more thorough analysis of the size distribution of deposits and failure rates would be necessary to determine a reasonable target rate. tDeposit insurance schemes are typically not designed to cover systemic crises, but rather individual bank failures. In the event of a systemic crisis, government involvement might be necessary. However, it might be best to make this event unpredictable in order not to raise market expectations. While the introduction of a deposit insurance scheme seems currently an inadequate instrument to increase trust in the banking system, the in- stitutional framework and enabling environment should be a priority for Russian policy-makers. Among other measures, a sound regulatory and supervisory framework should be put in place, and private agents should be given the means and incentives to monitor banks. This would lead to the development of efficient and sound financial intermediation and could eventually allow the introduction of a deposit insurance scheme. 252 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR DEPOSIT INSURANCE IN OTHER COUNTRIES The last two decades have seen a rise in explicit deposit insurance schemes around the world, as part of the overall financial safety net- work. Most OECD countries and an increasing number of developing countries have adopted some form of an explicit deposit insurance scheme, and in 1994, the European Union adopted a mandate to intro- duce deposit insurance schemes in all member countries. Many of the transition economies have introduced schemes, and while Russia has never had an industrywide explicit deposit insurance scheme, there are now plans to establish one. ARCO, the bank-restructuring agency, has already created a deposit insurance scheme for five of the banks in its portfolio. Depositors will often perceive the implicit existence of deposit insur- ance even where there is no formal provision for it. Except for countries such as New Zealand, where the state is legally prohibited from provid- ing funds to depositors and creditors of failing banks, depositors and other creditors will often assume an implicit deposit guarantee extended by the Government. This assumption is supported by the fact that, in times of crisis, many countries have chosen to extend an unlimited de- posit guarantee for the whole banking sector in an attempt to prevent a systemic bank run. The assumption is particularly strong in the case of state-owned banks. Those who advocate deposit insurance give the establishment of trust and the creation of a level playing field as the main objectives behind the proposed introduction of a Russian deposit insurance scheme. By intro- ducing such a scheme, Russia would hope to increase trust in the finan- cial system, attract more deposits into the formal banking system, reverse capital flight, develop financial intermediation, and thus foster economic development. It is also believed that the extension of deposit insurance to all banks could reduce the competitive advantage that the state-owned banks hold over private banks. THE BENEFITS AND RISKS OF DEPOSIT INSURANCE Deposit insurance aims to protect small depositors and foster banking sec- tor stability. By guaranteeing the savings of small depositors, deposit in- surance encourages small savers to entrust their savings to banks and dis- courages them from bank runs in times of crisis. Thus a deposit guarantee not only protects small savers, but could also foster banking stability and DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 253 the long-run development of financial intermediation. These benefits have often been stressed when introducing deposit insurance. To understand the risks of deposit insurance, one has to consider the incentive structure of bankers. Even in the absence of deposit insurance, bank owners, particularly those working with low levels of capital, can face strong incentives to lend aggressively, ignoring risk management. The lower their capital base, the less they have to lose and the more they can gain through aggressive lending. Market discipline exerted by credi- tors and regulatory discipline from the authorities aim to reduce this form of aggressive risk-taking. Bank creditors can withdraw funds or de- mand a risk premium if observing a decline in banks' liquidity and sol- vency. Large creditors and depositors, such as other banks or nonfinan- cial enterprises, have the capacity to follow closely the banks in which they entrust their deposits. Since small creditors, such as retail deposi- tors, do not have the ability or incentives to monitor banks carefully, they are reliant on a strong supervisory authority that is willing to take prompt action against weak banks. This is important since banks usual- ly turn insolvent long before they become illiquid. There are several risks inherent in deposit insurance schemes. By en- couraging the confidence of depositors in the safety of their deposits, they can make depositors complacent and decrease their interest in mon- itoring banks. Especially the large depositors that are the most likely and most able to monitor banks might reduce their efforts if they perceive the introduction of a deposit insurance scheme for small depositors as a sig- nal that the coverage will be extended to them in times of crisis. The ex- istence of a deposit insurance scheme and the resulting reduced market discipline can also change the incentive structure for bank owners and managers. In the presence of insured deposits, negative shocks to a bank's capital base reduce the downside of risk even more, and when hit by a negative shock a bank is therefore more likely to take large aggres- sive risks. Generous deposit insurance has the effect of subsidizing this aggressive risk-taking. Deposit insurance thus has the potential to induce greater risk-taking by banks, especially in a weak supervisory and regulatory environment. Since deposit insurance decreases the incentives of bank creditors to monitor and discipline banks, the regulatory and supervisory authorities take on greater responsibilities. This, however, requires transparency (i.e., the ability of supervisors to detect when banks take on aggressive risk), and deterrence (i.e., the ability to convince bankers that rules will be enforced). Deterrence in turn depends on the accountability of both deposit insurance officials and regulatory and supervisory authorities 254 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR regarding the taxpayer, who often has to pick up the bill for bank fail- ures. Other components of the financial safety net, such as lender-of- last-resort facilities and bank failure resolution are also important for the success of a deposit insurance scheme. The absence of an effective lender-of-last-resort that can provide immediate liquidity to sound banks undermines the safety net's function of preventing bank runs. The lack of prompt action in the case of failing institutions, of a quick-exit strategy, and of clear and transparent resolution procedures encourages owners and managers of insolvent banks to take additional risks, thus increasing bank fragility and the strains that are put on the deposit insurance scheme. The success of deposit insurance thus crucially depends on the other elements of the financial safety net-prudential regulation and su- pervision, lender-of-last-resort facilities, and bank failure resolution. Recent cross-country comparisons have shown the risks of adopting explicit deposit insurance schemes. International comparisons have shown that the likelihood of a banking crisis tends to increase in the presence of a poorly designed deposit insurance scheme (see Demirguc- Kunt and Detriagache 2000). This likelihood is even greater in countries with deregulated interest rates and an institutional environment that lacks transparency. The U.S. savings and loan crisis of the 1980s has been widely explained by the coexistence of a generous deposit insurance scheme, financial liberalization, and the failure of regulators to intervene promptly in failing institutions. Deposit insurance can undermine market discipline exerted by depos- itors. Evidence supports the existence of banking market discipline exert- ed by depositors and other creditors in many countries, both developed and developing (see Demirgiiu-Kunt and Kane [2001] for a literature overview). Cross-country comparisons, however, have shown that such market discipline is weaker in countries with explicit deposit insurance and lower levels of institutional development (see Demirguic-Kunt and Huizinga 1999). The introduction of deposit insurance is not a panacea for financial sector development; on the contrary, it has substantial risks. The intro- duction of a poorly designed deposit insurance scheme in a weak institu- tional environment would not only increase the probability of a banking crisis by diminishing market discipline, but would also hurt financial de- velopment (see Cull, Senbet, and Sorge 2001). Cross-country studies have shown that in weak institutional environments more generous de- posit insurance schemes are related to greater subsequent financial sector volatility and to lower subsequent growth in financial development. Fur- thermore, while an explicit deposit insurance scheme might encourage DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 255 savers to entrust more of their savings to banks, these additional re- sources are typically not intermediated effectively. INTRODUCING DEPOSIT INSURANCE IN RUSSIA The potential introduction of a deposit insurance scheme should be pre- ceded by an "audit" of the institutional framework and environment of the country. Do depositors have the means and incentives to monitor and discipline banks? Do bank supervisors have the ability to detect aggres- sive risk-taking by banks and enforce the rules to prevent them from doing so? Can the authorities make the credible commitment to limit the deposit insurance in the event of a bank failure to insured deposits? Are the other elements of the financial safety net in place? In Russia there are both limited capacity and few incentives for bank creditors to monitor and exert market discipline. Even if depositors had the incentives to impose market discipline on the banks, they have only limited means to do so. The financial information provided by banks is of notoriously low quality, in part because of the use of Russian Accounting Standards that tend to overestimate assets and thus profitability; and in part because of the lack of enforcement of truthful reporting by the Cen- tral Bank. Bank directors, moreover, are not legally liable for erroneous or misleading information. The regulatory and supervisory environment in Russia does not dis- courage banks from aggressive risk-taking. The CBR, as regulatory and supervisory body, takes a passive rather than a proactive attitude to pro- tecting depositor interests. There is an emphasis on form over substance- it is compliance with rules that is checked rather than the viability of bank activities that is considered-and supervision is not sufficiently based on on-site inspection. Furthermore, the CBR does not use its powers to inter- vene early in troubled banks. The decision to intervene or not often seems to be based more on political considerations than on the financial situation of the bank. The discretionary and selective provision of liquidity support during the 1998 crisis, which was done without disclosure of the criteria on which the receiving banks were chosen, and regulatory forbearance have set a bad precedent that might encourage banks-especially political- ly connected ones-to bet on another bailout should the need arise. Given the extremely weak supervisory and regulatory framework and deficiencies in the other elements of the financial safety net, the introduc- tion of a deposit insurance scheme at this stage seems premature. Given the substantial and undefined banking risks in Russia, it would be difficult to 256 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR contain the risks to be borne by the insurer of such a system. Establishing a deposit insurance scheme for Russia's nontransparent and fragile bank- ing sector could create a large contingent liability, and one that might go beyond even the Government's resources. Defaulting on this contingent li- ability in the case of a crisis would again destroy what little trust remains in the banking sector. The lack of serious supervision and prompt supervi- sory action additionally means that such a scheme would pose a high risk of moral hazard to the system. In the absence of the necessary market and regulatory discipline, the increased ability that an insurance scheme would give to private banks to attract additional resources would likely encour- age those banks to lend aggressively and imprudently. Given current regu- latory and supervisory weaknesses, it is of serious concern that ARCO has embarked on providing deposit insurance to some of the banks that it owns and is even extending this insurance for a period of 18 months after these banks have been privatized (discussed further in Chapter 12). Be- cause the scheme launched by the ARCO is very similar to that outlined in the 1999 draft law, which was eventually rejected by the Federation Coun- cil, ARCO would appear to be trying to introduce deposit insurance for se- lected banks "by the back door." This does not imply that Russia should not consider the establishment of a deposit insurance scheme. It implies rather that in order to fulfill its promise of providing stability and enhancing trust, savings, and financial intermediation, a number of pre-conditions have to be fulfilled. First, the transparency of banks should be ensured so that both bank creditors and bank supervisors have the ability to detect aggressive risk-taking by banks. Second, the supervisory authorities have to enforce the already existing regulatory rules. This not only implies a much more thorough supervisory process, including both off- and on-site inspections, but also prompt action when detecting violations of the rules, including interven- ing and closing insolvent and nonviable banks. Both measures would most likely result in consolidation and strengthening of the banking sys- tem, a prerequisite for a successful deposit insurance scheme. It has been proposed that the deposit insurance scheme be used as a tool in the process of leveling the playing field and consolidating the banking sector. By restricting entry into the scheme to well-capitalized and viable banks, a large number of undercapitalized and unviable banks would be de-licensed. By forcing government-owned banks into the scheme and into contributing to the fund, the deposit insurance scheme would impose a payment on state banks for the privilege of accessing deposit insurance, thus creating a more level playing field between government-owned and private banks. However, restricting membership to well-capitalized and DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 257 viable banks requires a well-developed supervisory and regulatory frame- work. As mentioned above, such a framework seems currently not to be in place in Russia. Further, historic experience suggests that politically well-connected bankers can easily abuse such a process. Finally, the effect of the deposit insurance scheme on the relative competitive position of government-owned compared with private banks depends on a hard budget constraint being imposed on the government-owned banks, so that they price risk correctly and function according to fully commercial terms. Rather than using the deposit insurance scheme as a tool in this process, such a process should precede the introduction of a deposit in- surance scheme. THE DESIGN OF DEPOSIT INSURANCE SCHEMES The design of deposit insurance is important for its impact on banking sector stability. Recent cross-country comparisons have shown that well- designed deposit insurance, applied in an efficient regulatory and super- visory environment, can reduce the moral hazard of banks taking aggres- sive risks (Demirguc-Kunt and Detriagache 2000; Demirgiuc-Kunt and Huizinga 1999). It is important for the impact on banking sector stability and financial development that a deposit insurance scheme provide limited coverage; it is important to assign a margin of loss to private parties to force them to monitor banks, and thereby to increase market discipline. The objective is to identify the group that is best able and most likely to exert market discipline when forced to do so. A limit to the coverage makes the insur- ance incomplete, and forces large depositors to monitor banks. Coinsur- ance might force depositors to bear a share of any losses, if reimbursed for less than 100 percent of their deposits. Excluding interbank deposits from the insurance forces banks to monitor each other, and thereby also fosters market discipline. Excluding insider accounts-that is, the de- posits of management and influential owners-reduces moral hazard by making owners and managers participate personally in the downside risk of the bank business. It is important that the management and funding of the scheme be de- signed in an incentive-compatible way. Making the scheme compulsory can decrease adverse selection. If voluntary, strong banks might have in- centives to leave the scheme in order to avoid cross-subsidizing weak banks. Funding and management by the participating banks gives them the necessary incentives to monitor each other carefully and thus decrease 258 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR the insurance risks they are paying for. Industry-based management and funding, however, can only work effectively if accompanied by certain regulatory and supervisory powers of the deposit insurer in relation to member banks. The design of premiums can be important to limit aggressive risk-taking by banks. Risk-based premiums offer several advantages over flat premi- ums. They contribute to better risk-pricing by banks and help avoid un- derpricing the deposit insurance. They raise awareness about the variation in the risks banks are taking and strengthen incentives for member banks to monitor each other more carefully. However, the calculation and ap- plication of risk-based premiums pose practical problems. If based on the regulators' judgment and disclosed to the market, risk-based premiums can compromise supervisory independence and might even give rise to legal problems for the supervisory agency if a highly rated bank fails. Using market prices to measure risk requires the existence of deep mar- kets for bank stock or for bank uninsured liabilities, or very capable rat- ing agencies. Using formula-based approaches has advantages: if formu- las are objective and nondiscretionary, they can be easily disclosed and understood by the market. But they also have significant limitations: ac- curacy in ratings cannot be guaranteed by mechanical application of nu- meric ratios,' and the choice of quantitative indicators and weights al- ways has elements of arbitrariness. Finally, the issue of whether and when to disclose risk ratings is important in terms of maintaining confi- dence in the banking system. LEVELING THE PLAYING FIELD? Deposit insurance is not a suitable tool for leveling the playing field be- tween public and private banks. On the contrary, a deposit insurance scheme should be restricted to private banks, for several reasons: 1. Public banks are perceived as already enjoying the full backing of their owner-the Government. As a result, and as long as the Government's solvency is not in doubt, the depositors and other creditors tend to behave as if their claims on public banks do not face default risk. There is, thus, no obvious need for a deposit in- surance to help prevent runs on public banks. 2. Including public banks in the deposit insurance scheme does not automatically level the playing field, as is often assumed. Only if the hard budget constraint is enforced on public banks will the lending risk and the insurance premium be priced into the lending and deposit interest rates, respectively. DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 259 3. Even then, public banks would be at a competitive advantage since, given the state ownership, all deposits are insured, not just small or a fractional part of household deposits. 4. The above-recommended industry-based management of the scheme is made more difficult since the management of public banks is generally subject to different incentive constraints. Finally, ex post funding combined with easy access to contingent funds might be preferable to ex ante funding. On the one hand, ex ante funding increases the confidence of the insured depositors to be reimbursed rapid- ly in the event of a bank failure. On the other hand, accumulating a large fund of liquid assets by a deposit insurance scheme carries the risk of abuse and looting if the institutional environment is weak. Ex post fund- ing has the advantage of creating incentives for member banks to monitor and discipline each other since they have to share the insurance loss.2 In the case of a scheme that is at least partially funded ex ante, the assets should be invested in safe and liquid assets. Furthermore, the value of the assets should be preserved even in the midst of domestic financial turbu- lence. This would point toward investing any resources in international reserves. (The design features of the deposit insurance scheme being con- sidered by the Russian authorities are outlined in Box 10.1.) CREATING TRUST THROUGH INCENTIVES Instead of attracting depositors with the promise of a deposit insurance scheme, the authorities can create trust by creating a conducive incentive structure: (a) enforce rules and regulations effectively, (b) allow only sound and viable financial institutions to operate, (c) offer depositors a safe outlet for their savings (one option would be to turn Sberbank into a narrow bank, while at the same time actively encouraging foreign bank entry), and (d) give private agents the ability and the incentives to moni- tor banks and exert market discipline. Regulation and supervision of the banking sector must be made more efficient, and this can in part be achieved by limiting banking licenses to real financial intermediaries. This does not necessarily imply the liquida- tion of the "pocket" banks, but the license to collect deposits should be strictly limited to banks that serve as financial intermediaries.3 These in- stitutions should be thoroughly supervised, not just on form but also on substance. Intervention in troubled banks should be fast, and should occur before they become insolvent. Imposing regulatory discipline on banks and thus avoiding excessive risk-taking would have a greater posi- tive effect on depositor confidence than the promise of deposit insurance. 260 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR It would especially protect smaller, retail depositors by allowing them-as the first in order of priority-to recover their savings during the liquida- tion process. The possibilities and incentives for the monitoring of the banking sec- tor by private agents should be created. There is a long list of financial and other relevant information, such as off-balance sheet items and risk management procedures, that should be disclosed to the public. The dis- closure of correct financial information and transparency of ownership structure should be enforced, and the role of external auditors has to be strengthened. Furthermore, directors and major shareholders have to be made liable for erroneous and misleading financial information. Finally, by sending clear signals that bank creditors will not be bailed out, the necessary incentives to carefully monitor and exert market discipline should be created. To provide a safe outlet for retail savings, the activities of government banks may need to be restricted in an interim period while reform plans are prepared and implemented. In the case of Sberbank this would entail increasing the bank's investment in government bonds and other low risk assets, thereby curtailing the rapid expansion in the bank's corporate lending (see further discussion in Chapter 7). The outlined agenda is challenging, but promises to set the stage for the development of a sound financial sector that contributes to the long-run economic development of Russia. The developed economies in Western Europe have achieved high levels of financial development without an explicit deposit insur- ance scheme. The introduction of such a scheme came at the end of the process, not at the beginning. Similarly, Russia should focus on creating a sound incentive framework before introducing deposit insurance. CONCLUSION On the one hand, it seems doubtful whether Russia would be able to gain any real benefit from introducing deposit insurance at this stage. On the other hand, there does not seem to be any cost associated with delaying the adoption of a deposit insurance scheme. The premature introduction of such a scheme, however, would seem to be a risky undertaking if the adequate regulatory and supervisory framework is not in place. Only after the other elements of the financial safety network are able to effi- ciently fulfill their functions should the introduction of a deposit insur- ance scheme be considered. Instead of using the deposit insurance scheme as an instrument to level the playing field and consolidate the banking DOES THE RUSSIAN FEDERATION NEED DEPOSIT INSURANCE? 261 sector, these actions should be first priority and pre-conditions to estab- lishing a deposit insurance scheme. In this connection the precedent set by ARCO in introducing deposit insurance for a number of the ARCO- owned banks-which it intends to extend for a period of 18 months after the banks are privatized-is of particular concern (see Chapter 12). In the event that Russia nevertheless were to decide to introduce de- posit insurance, the Russian Federation should carefully consider the structure of such a scheme. Apart from the proposed limited coverage, insider accounts should be excluded. Bankers should play a larger role in both the financing and the management of the scheme. Most important- ly, the scheme should be given a supervisory and regulatory role in rela- tion to its members. While not duplicating the work of the CBR, it should have a decisive voice in the decision to accept and expel member banks and in imposing prompt action against banks that do not comply with regulatory norms and thus increase the risk for the scheme. When establishing deposit insurance, the Russian Federation should consider different models that are used around the world. One possible model might be a scheme managed and financed completely by the banking in- dustry.4 Most importantly, the deposit insurance scheme has to be de- signed in a way that maximizes market and regulatory discipline and minimizes the potential abuse. It has to be part of a financial safety net that is designed to foster banking stability and financial development. ENDNOTES 1. Furthermore, bank-specific, CAMEL-type indicators (i.e., capital, assets, management, earnings, and liquidity) alone would be insufficient. Any rating should also take into account macroeconomic and sectoral indicators. 2. Ex post funding might have the shortcoming that banks are not capable of contributing after a crisis. However, deposit insurance schemes are typically not designed to handle systemic crises. 3. This certainly does not imply that nonbank financial institutions, such as fi- nance companies, are left without supervision. The experience of the East Asian crisis has shown the risk of such an approach. 4. In the United States, before the creation of the Federal Deposit Insurance Corporation, the primary source of assistance against a depositor run was other banks. That assistance, however, was not guaranteed, but rather depended on the willingness of those other banks to help out (see Calomiris 1997 and the litera- ture he quotes). Germany provides an example of a private deposit insurance scheme that has worked relatively successfully over the last 25 years (see Beck 2001). 262 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR REFERENCES Beck, Thorsten. 2001. "Deposit Insurance as Private Club: Is Germany a Model?" Working Paper 2559. World Bank Policy Research Department, Washington, D.C. Calomiris, Charles W 1997. "The Postmodern Bank Safety Net. Lessons from Developed and Developing Economies." American Enterprise Institute, Wash- ington, D.C. Cull, Robert, Lemma W. Senbet, and Marco Sorge. 2001. "Deposit Insurance and Financial Development." Financial Sector Policy Department. World Bank, Washington, D.C. Processed. Demirguc-Kunt, Ash, and Enrica Detriagache. 2000. "Does Deposit Insurance Increase Banking System Stability?" IMF Working Paper. Washington, D.C. Demirguc-Kunt, Ash, and Harry Huizinga. 1999. "Market Discipline and Finan- cial Safety Net Design." Working Paper 2183. World Bank Policy Research Department, Washington, D.C. Demirguc-Kunt, Ash, and Edward J. Kane. 2001. "Deposit Insurance: Lessons on Design and Implementation." Financial Sector Policy Department. World Bank, Washington, D.C. Processed. CHAPTER I I Bank Restructuring and Liquidation LEGAL PROTECTION OF DEPOSITOR INTERESTS One of the fundamental objectives of banking regulation is to maintain depositor confidence in the banking system. This is supported by ensur- ing that banks generally operate in a well-run and sound manner. How- ever, in the event that a bank becomes troubled or fails, the need for pro- tecting depositor interests in the course of resolving the bank's problems becomes critical if depositor confidence is to be maintained. Two areas are of primary importance: first, it is necessary to ensure that banks maintain an adequate reserve of capital for payment of depositor claims in the event of liquidation. Second, it is imperative that bank failure be resolved in a way that preserves the continuity of depositors' access to their funds; the result otherwise can be panic and a run on the bank, which can spread to other banks in the system. In addition to maintaining confidence in the banking system generally, capital reserves and continuity of access are important because there are social dimensions to the protection of depositor interests in these circum- stances; many of the deposits may represent life savings and their loss would mean extremely dire consequences for the account holders. In Russia, confidence in the banking system was undermined after the Au- gust 1998 crisis, due in part to the outcome suffered by depositors in failed or failing banks. In many cases depositors lost their savings be- cause the failed bank had inadequate assets for payment during liquida- tion. In others, even in cases where funds were adequate for full payment 263 264 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR of deposit claims, payment was delayed for years, was made in install- ments, or was otherwise compromised. Had it existed, a system of deposit guarantee, such as state guarantee or deposit insurance, may or may not have ameliorated this situation. There are some arguments for creating wider deposit guarantee coverage than existed at the time of the 1998 crisis or that exists now (a broad- based deposit insurance scheme rather than Sberbank's exclusive govern- ment guarantee), but there are also many arguments against it (these is- sues are treated in Chapter 10). The focus of this chapter is on the possibility of providing full compensation for depositors from existing bank assets in accordance with existing Russian legislation. Adequately implemented, the regulatory and legal framework should provide a capi- tal reserve that can be readily utilized for satisfaction of depositor claims in the event of bank closure and liquidation. A corollary issue is the ade- quacy of the regulatory/accounting standards that are used for measur- ing this capital reserve. The objective of this chapter is to identify how the legislation might be better implemented or refined to ensure the equi- table treatment of depositors in the context of troubled banks. DEPOSITOR PREFERENCE Russian legislation and the Civil Code reflect a preference toward depos- itor interests in the event of a bank's liquidation. Pursuant to Article 49 of the Law on Insolvency (Bankruptcy) of Credit Organizations (here- inafter "bank bankruptcy law"): The claims of individuals who are creditors of the lending organ- ization under bank-deposit and bank-account agreements concluded with them, the claims of individuals to whom the lending organiza- tion is liable for harm caused to life or limb, and the claims of the Federal Mandatory Deposit Insurance Fund shall be the first to be satisfied from the lending organization's property that constitutes the bankruptcy assets. [Note: When the legislation was drafted it was expected that cre- ation of a deposit insurance fund would follow. To date, no such fund has been created.] Article 64 of the Civil Code similarly states that the claims of citizens who are creditors of the bank shall be given priority in satisfaction. (This is generalized, but would apply to individual depositors.) BANK RESTRUCTURING AND LIQUIDATION 265 This preference toward depositors pertains explicitly only to payment of depositor claims in bank liquidation, but it would be fair to infer an underlying public policy in favor of depositor interests generally. It is im- portant to note that this preference relates only to natural persons and not to commercial depositors, who are treated in the event of a bank liq- uidation as general, unsecured creditors of the fifth priority ranking. This is not to minimize commercial depositors' importance as creditors, but affording them a preference in payment is not needed like it is with indi- vidual depositors. Commercial depositors have greater sophistication in their dealings with banks and a greater ability to assess the soundness of a bank. Commercial customers of Russian banks tend to have close working relationships with bank ownership, and in some cases may themselves be the owners. Where this is true, they would clearly have early warning of financial trouble and, unlike retail customers, would therefore be able to protect themselves. Also unlike retail depositors, the greater size of their financial dealings means that commercial depositors are able to spread their risk across several banks. It should be noted that the same logic would apply to deposits of bank insiders; due to their knowledge of bank operations, they are better placed to protect themselves from any potential bank failures. Added to this is the fact that preferential payment of insider depositors could con- tribute to moral hazard in their operation of the bank. However, on the face of the statute, such insider depositors are not excluded from first priority payment. It would be useful to consider revisions to the statute to specifically exclude priority payment to insider depositors-either through a definition of what constitutes an "insider," or through limits of priority payment per account, such as found in deposit insurance pro- posals, which are designed to match the afforded protection with the tar- geted group (small retail depositors). Included with such amendments would be exclusions of accounts held by related parties to insiders, used fraudulently to increase protection of insider accounts. The fact that retail depositors are paid as first-priority creditors means that it should be possible even in the absence of a deposit guarantee sys- tem to fully satisfy their claims in a bank liquidation. This is contingent, however, on the existence of a reserve of capital adequate for payment of their claims. If the reserve is too low, steps should be taken to rehabilitate the bank to a viable business condition that would allow it to maintain this reserve. If the reserve reaches a low enough point, or if the bank's business viability is such that it cannot maintain an adequate reserve, the bank should be liquidated. 266 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Distortions produced by Russian accounting standards mean that it is difficult, however, to realistically monitor bank capital levels. Such dis- tortions will hamper restructuring and liquidation efforts, which should be triggered and guided by a realistic evaluation of a bank's capital level. (This topic is addressed in more detail in Chapter 4.) Although Russian bank restructuring and liquidation legislation and regulations are basi- cally adequate, their effectiveness can be significantly diminished because they are premised on flawed economic evaluations. EFFECTIVE RESOLUTION OF TROUBLED BANKS Resolution of a troubled bank entails either a restructuring/rehabilitation of the bank or the bank's liquidation. Early intervention in a troubled bank by the bank regulator is essential if the bank is to have any chance of a successful turnaround. Early intervention also minimizes the dissipa- tion of assets if the bank shows no promise of rehabilitation, thereby en- suring adequate funds for payment of depositors in a liquidation. Anoth- er important principle of bank restructuring is that license revocation and liquidation of the bank have certain consequences for lack of coop- eration by the bank owners. The success of restructuring is additionally tied to the manner in which liquidation is undertaken: if liquidation is equivocal or compromised in its execution, there is little incentive for bank owners to try to rehabilitate the bank. If the owners believe that liquidation proceedings will result in, at worst, a delay in the termination of their business and, at best, a settlement and reinstatement of the li- cense, clearly they will have little interest in undertaking early restructur- ing efforts. The Russian legislation that deals with bank restructuring is basically sufficient in responding to these principles, and the legislation with regard to liquidation is adequate, in light of certain recently enacted amend- ments. But implementation of these bank resolution laws has been unsat- isfactory with respect to depositors' interests. In both restructurings and bankruptcies, depositors have often come away with reduced and de- ferred payment-despite this being financially avoidable and in some cases contradictory to statutory requirements. Effective bank restructuring can prevent the crisis-mode resolution of bank problems and can promote the uninterrupted operation of a bank's business with minimal hardships imposed on creditors. Most important, it can enable the bank's deposit business to continue and can afford BANK REST RUCTURING AND LIQUIDAT'ION 267 depositors unimpeded and undiminished access to their funds. A poten- tial problem of restructuring, however, is that it may prolong the opera- tion of a bank beyond the limit of its commercial viability, thereby wors- ening the ultimate situation of depositors and creditors. The objective of restructuring should therefore be the rehabilitation of the bank to a com- mercially viable position. This necessitates the continuance of the deposit business throughout the restructuring period, as any interruption or compromise of this business would effectively undermine the validity of the bank as a going concern, hence undermining depositor confidence. Nonbank commercial enterprises are often restructured during the course of bankruptcy proceedings. This is typically not the case for banks, since they operate in a highly regulated environment, and the con- cern for adequate coverage for depositor claims requires more active ef- forts to ensure preservation of assets. These factors require the use of early, preemptive efforts to restructure the bank, directed not by a court but by an administrative entity such as the regulator. The Bank Restructuring Mandates of the CBR and ARCO According to Russian legislation, there are two possible ways for a bank to be restructured: one is directed by the Central Bank of Russia pur- suant to the provisions of the "measures to avert bankruptcy" of the bank bankruptcy law (Articles 3, 4, and 7 through 15); the other is through the Agency for Restructuring of Credit Organizations, pursuant to the provisions of the Law on the Restructuring of Credit Organiza- tions. The mandate of ARCO, which deals only with a selected portion of banks in need of restructuring, is more specialized than that of the CBR and is addressed in detail in Chapter 12. One significant difference between ARCO and CBR restructuring is the earlier intervention of the CBR in the affairs of a troubled bank. Under its mandate, the CBR can enforce measures to avert bankruptcy when (a) a bank is unable for three days to make payments, (b) when the level of a bank's own funds falls 20 percent in one year while the bank also violates one of the required regulatory ratios, (c) when a bank vio- lates the regulatory capital adequacy ratio (currently 10 percent), or (d) when a bank has violated the regulatory liquidity ratio by more than 10 percent (Article 4). ARCO is not able to begin restructuring a bank until significantly later, namely, when a bank's capital adequacy ratio is less than 2 percent, and the bank fails for seven days to make payments. 268 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Measures to Avert Bankruptcy The "measures for averting bankruptcy" contained in the bank bank- ruptcy law provide a fairly detailed list of measures that a bank may em- ploy when trying to restructure itself. The law sets forth measures for in- creasing capital, reducing expenses, restructuring assets and liabilities, and making changes to staff. If the bank does not undertake any of these measures itself, the CBR is entitled to direct it to do so and to require the submission of a restructuring plan to the CBR. Failure to comply with such a directive can result in the personal liability of the bank's director and in the imposition of regulatory sanctions. Additionally, failure of the bank to comply in a timely manner with a CBR directive can result in the appointment by the CBR of a conservator. A conservator can also be ap- pointed if, despite implementation of the plan, the bank's condition fails to improve. These restructuring measures basically match those of inter- national practice (Hawkins and Turner 1999). Informal Intervention by a Regulator In general, the Russian legislation tracks international legislative practice in terms of providing for early implementation of measures to avert bankruptcy. However, international practice also entails informal action on the part of the bank regulator, beyond the formal measures specified by law. For instance, legislation in the United States allows regulators to require formulation of a capital enhancement plan when a bank falls below its capital adequacy ratio. Prior to that point, however, the regula- tor may enter into an informal agreement with the bank for improve- ment of its financial condition, based on the bank's failure to meet guide- lines founded on a composite rating involving the adequacy of its capital, assets, management, earnings, and liquidity (CAMEL). In Germany, when a bank falls below a minimum capital adequacy ratio or fails to meet liquidity requirements, the regulator will require it to increase its capital and/or liquidity; if there appear to be sufficient grounds for concern, the regulator can also intervene in the management of the bank (Div. 4, Deutsche Bundesbank Bank Act). In practice, how- ever, rather than simply demand compliance, the German regulator will take an interactive role in the effort to ameliorate the situation. When a bank falls below the regulatory threshold, there begins a process of regu- lar discussion between the bank and the regulator in an effort to amelio- rate the bank's situation. The result may be a regulator-directed merger or break-up of the bank for sale to other banks. BANK RESTRUCTURING AND LIQUIDATION 269 Similar rehabilitative intervention by the regulator is found in France, although there it is spelled out more formally. French legislation allows the regulator to require a plan from the bank, including proposals for improvement of the bank's financial condition, changes in management methods, and assurance of the adequacy of the bank's general business plan (Article 43, Law on Activity and Control of Credit Establishments). Informal intervention by the regulator is nonetheless also common. Regulations for Early Intervention by the CBR The Russian legislation gives the CBR an apparently passive role in the measures to avert bankruptcy, specifying only that the CBR demand for- mulation of a plan if a bank does not undertake restructuring measures of its own initiative. In practice and pursuant to CBR regulations, how- ever, there is more interaction between the CBR and the bank than is ev- ident on the face of the statute alone. Although the statute itself does not specify what the CBR does once the plan is submitted by the bank, pro- cedures for this have been promulgated in Instruction 85 (i). Pursuant to this instruction, the CBR should review the bank's plan for adequacy and monitor its implementation. The CBR is, pursuant to this instruction, to be actively engaged in the bank's restructuring efforts even in the initial stages. It is not clear from either the statute or the regulation what crite- ria are evaluated in the CBR review of a restructuring plan, however. It is difficult to assess the success of early regulatory intervention in Russia because the Russian bank bankruptcy law, which provides meas- ures for rehabilitation, was enacted in March 1999, subsequent to the August 1998 crisis. By the time the CBR received the statutory ability to intervene for restructuring early, pre-crisis intervention was impossible. Most of the banks requiring the CBR's attention were already in an ad- vanced stage of financial trouble. Under such circumstances, the best that the CBR could hope to contribute was a series of stop-gap efforts to bring troubled banks into temporary regulatory compliance, even though the fundamentals of the banks were insufficient for long-term vi- ability. Many banks were in sufficiently bad shape to justify license revo- cation and bankruptcy. Development of Minimum Standards/Use of IAS A project has been proposed for the development of a set of minimum standards that would establish the threshold requirements for all re- structuring plans. This proposal would also include an evaluation of 270 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR restructured banks according to International Accounting Standards. The objective is to clarify for the banks what is expected of a restructur- ing plan, and to provide an objective basis to support CBR rejection of inadequate plans. These would be minimum standards only, and each bank's plan would need to be evaluated in the context of its individual circumstances. While this project would be useful, the CBR would nonetheless need to ensure that it exercises judgment in evaluating each plan as a whole for its commercial viability; otherwise, the review of each plan could become a formalistic exercise in which the standards are merely discrete checklist items. Repeated Restructuring A problem related to commercial viability is that a restructured bank might soon make a "return visit" to the process of trying to avert bank- ruptcy. That is, the measures taken during the restructuring may enable the bank to temporarily raise its capital standards and achieve regulatory compliance, but the fundamentals of its business remain flawed and the bank will likely fall again below regulatory standards. A bank that re- peatedly implements measures to avert bankruptcy is fundamentally un- sound, and further efforts to rehabilitate it only stall its inevitable col- lapse. It does not appear that the Russian legislation addresses this point. There does not appear to be a provision, for instance, requiring license revocation if a bank has implemented measures to avert bankruptcy more than once in a year. Such a provision is necessary to prevent the CBR from spending time and effort on banks that manage to bring themselves into compliance, only to fall back out of compliance a short time later. Criteria for Measuring Restructuring Success Evaluation of a restructuring plan should include consideration of a bank's track record and evidence of any long-term negative trends. For restructuring to make any sense, there must be an ability to conclude, where the circumstances justify it, that a bank is beyond rehabilitation and to liquidate it. The process of restructuring must not be permitted to become an exercise in propping up banks that are fundamentally un- sound, simply delaying the inevitable failure of the bank. It may be that the Russian criteria for measuring success in bank reha- bilitation are lax. Part of this is related to the use of Russian Accounting Standards, as noted above. Another part is a focus on the fulfillment of discrete regulatory standards that do not take adequate account of the BANK RESTRUCTURING AND LiQUIDATION 271 condition of the bank as whole. For instance, if a bank has been required to undertake restructuring efforts because of a lack of liquidity, it is rela- tively easy for the bank to enhance its liquidity position-for example, by borrowing funds-without affecting the fundamentals of its operations. There is a need to tighten up the regulatory criteria, or to include within those criteria a consideration of the bank's financial condition as a whole. Conservatorship Conservatorship, as set forth in the Russian legislation (Articles 16-31 of the bank bankruptcy law), allows the regulator to become more directly involved in the management of a bank in the attempt to rehabilitate it. A conservator may be appointed by the CBR in the event that a bank fails to comply with the CBR's demand for formulation of a rehabilitation plan. The conservator can be given authority ranging from simple over- sight of bank operations to usurpation of total control from bank man- agement. The conservator therefore potentially has the power to effect the same measures for restructuring the bank as the bank has itself, with the proviso that certain measures may require shareholder approval. From a legislative standpoint, this is generally in accordance with in- ternational practice, but it should be noted that in international practice conservators are typically not used even though the legislative frame- work provides for them-the rationale being that by the time a bank is eligible for a conservator it is probably too far advanced in its trouble to be rehabilitated. Another concern is that announcement of the appoint- ment of a conservator may have the same negative effect on depositor confidence as if the bank were simply closed. In practice, a conservator is not particularly useful for rehabilitation of a bank, but is instead used as a means for gaining control of and preserving the assets of a failing bank in anticipation of a more severe resolution-that is, liquidation. RESTRUCTURING OF BANKS IN BANKRUPTCY PROCEEDINGS Prior to enactment of the bank bankruptcy law, it was possible to re- structure a bank in the course of bankruptcy proceedings by means of "amicable settlements." These settlements are analogous to Chapter 11 reorganizations in the United States and are fairly common in bankrupt- cies of commercial enterprises. It is not, however, common international practice to restructure banks in the course of bankruptcy proceedings. 272 BUILDiNG TRUST: DEVELOPING THE RUSsIAN FINANCIAL SECTOR Once in bankruptcy, a bank can no longer legally transact banking busi- ness, since its license has been revoked, and from a regulatory standpoint a restructuring at this stage is futile. Early intervention by the regulator, both in restructuring and liquidation, is deemed essential for preserva- tion of the capital necessary to pay depositor claims. Prohibition of Amicable Settlements One of the major features of the Russian 1999 bank bankruptcy law was the incorporation of provisions for CBR-directed restructuring and a prohibition of amicable settlements in the course of bank bankruptcy proceedings. Prior to the 1999 law, such settlements were possible be- cause they are allowed by the general commercial bankruptcy code. (Bank bankruptcies are still governed generally by the corporate bank- ruptcy code, but specific provisions of the bank bankruptcy code over- ride conflicting provisions of the general corporate bankruptcy code.) The legislative intention was to shift the process of bank restructuring from a judicial context to a regulatory, administrative context, with re- structuring to be directed by the CBR rather than by a bankruptcy court. Article 5 of the bank bankruptcy law states that "the external man- agement and amicable settlement specified in the Federal Law on Insol- vency (Bankruptcy) shall not be applied to lending organizations." The rationale is that the CBR should intervene early, before the bank is insol- vent and its license revoked, to oversee the possible rehabilitation of the bank. If these attempts at preventive action are unsuccessful, then it can be concluded that the bank has no viability and it should be liquidated. Ad Hoc Settlements The practice of restructuring amid bankruptcy proceedings has nonethe- less continued to be applied to banks, even those whose licenses have been revoked after passage of the bank bankruptcy law. This has commonly been in response to pressure from large creditor groups and stockholders, particularly in the case of larger banks, where a straight liquidation would have given these creditors no repayment on their claim-and a set- tlement gave them at least something. Another argument used by credi- tors for amicable settlements has been the absence, up to the point of ini- tiation of the bankruptcy proceedings, of an opportunity for restructuring negotiations. As noted above, the timing of the 1999 bank bankruptcy law may have contributed to this problem, since it was enacted too far in BANK RESTRUCTURING AND LIQUIDATION 273 the wake of the 1998 banking crisis to realistically afford much, if any, prebankruptcy rehabilitation. The arguments for amicable settlements by bank creditors and owners may have had some merit, but a review of the effects of such settlements on depositor interests shows why they have been prohibited. The settle- ments are not legitimate bank restructurings (i.e., a reorganization with a viable business objective), but are simply exercises in compromise, seek- ing to afford certain groups of creditors greater repayment than they would receive under a straight liquidation. This is not unique to bank bankruptcies: there is evidence that most general, corporate bankruptcy restructurings in Russia are little more than debt reschedulings, with none of the characteristics of a legitimate restructuring designed for re- habilitation of the enterprise. (This issue is treated in more detail in Chapter 3 on general insolvency law in Russia.) The practice of restruc- turing during nonbank bankruptcy proceedings in Russia does not gen- erate truly productive results and it should come as no surprise that the country's bank bankruptcy proceedings have the same shortcomings. Impairment of Depositor Interests in Settlements Examples of the impairment of depositor interests in the event of amica- ble settlements are numerous. Uneximbank depositors, for instance, were required to take reduced and/or deferred payment on their claims in the settlement of the bankruptcy proceedings of that bank. Depositors were paid 10 percent cash, with the balance to be paid in the future by way of bonds-the same terms on which commercial creditors were paid. In other bankruptcy proceedings, depositors have for years suffered delayed payment of their claims as creditors and owners have negotiated and challenged delicensing decisions. The settlement discussions in the Inkombank case lasted approximately two years before a decision was made to give depositors an initial payment of 52 percent of their claims, with the balance to be paid after the completion of liquidation proceed- ings. The liquidation proceedings of the bank Menatep entailed months of initial delay because of a prolonged debate over the issue of liquida- tion versus restructuring, causing many depositors to take advantage of an opportunity to transfer their deposits to Sberbank, even though this entailed receiving a decreased amount due to the fall in the value of the ruble. Other depositors were later paid directly and in full by Menatep's owners, Yukos Oil and Rosprom. The balance of the depositors-those who neither transferred funds to Sberbank nor took payment from 274 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Yukos/Rosprom-were paid out of the liquidation proceedings. There was also considerable delay in the bankruptcy proceedings of Mezhkom- bank, as discussions on the "restructuring" of the bank were conducted among its large creditors, including American Express. According to the law, retail depositors are entitled to expect priority payment of their claims, but under these amicable settlements they typi- cally receive less than they should. In bankruptcy proceedings, the voting rights of each creditor are determined by the amount of the creditor's claim. This means that retail depositors, though perhaps greater in num- ber, are smaller in terms of actual influence. They are also less seasoned in commercial matters and are not unified in their efforts, so it is difficult for them to protect their interests against the claims of larger commercial creditors. The settlement proposals favored by large creditors invariably block full payment of retail depositor claims, because the larger creditors will not agree to a settlement that reduces their payment in order to repay retail depositors 100 percent. Just as inevitably, depositors will agree to the settlement out of frustration with the system, even though it pays them less than their full entitlement under law. To the private de- positor, it is better to get something than nothing. The involvement of retail depositors in the negotiation process, even to the commercial creditors that seek advantage at their expense, is frus- trating. Depositors, unable to present a united front and unfamiliar with the process, must individually present their claims, questions, and view- points. The delays can be considerable. Nonjudicial Amicable Settlements Although not strictly occurring in bankruptcy proceedings, there have also been amicable settlements in some ARCO restructurings that are analogous to the ad hoc settlements described above. ARCO restructur- ings are initiated at the point at which a bank is essentially insolvent. In some instances the bank may be in a sufficient state of decay to justify liquidation, and ARCO has the right to recommend this if restructuring appears futile. The settlement discussions orchestrated by ARCO are likely the first time that the different parties are brought together to deal with the bank's condition, and invariably there will be a strong, if im- practical, desire on the part of creditors to attempt to restructure the bank; if nothing else, they will hope to improve upon the position that liquidation would mean to them. Though ineffective as restructurings, some settlements orchestrated by ARCO resemble the ad hoc settlements of bank bankruptcy proceed- ings-from the perspective of retail depositors, at least. For instance, in BANK RESTRUCTURING AND LUQUIDATION 275 the restructuring of SBS-Agro, depositors are to be paid 10 percent of their claims in cash, with the balance to be paid in the future by way of bonds. This despite the fact that there are sufficient assets in the bank to pay depositors in full before making any payments to other creditors. A similar restructuring was proposed for Rossiyskiy Credit. Public Policy Concerns Regarding Amicable Settlements The problem with these settlements, quite apart from the fact that they are prohibited by statute, is that the purported restructuring of the bank takes place in the context of the "participatory democracy" of the bank- ruptcy proceedings; that is, the outcome is determined by the votes and power blocs of creditors and shareholders. These parties naturally will want to achieve the result that best favors their own interests, and in any other context this would be acceptable-this process is, after all, funda- mental to commercial bankruptcy reorganization in many countries, in- cluding Russia. The process will not necessarily take into account the rel- evant public policies relating to the banking sector, however. Specifically, there is no assurance that the votes of retail depositors will be sufficient to ensure that their interests are represented proportionate to the priori- ty they are given by statute. Furthermore, there have been repeated in- stances of creditor interests being thwarted by improprieties in the ac- tions of arbitration managers and courts, as discussed below. There is additionally no assurance that the outcome of an amicable settlement will be scrutinized by the court for compliance with public policies or for impact on the banking sector in general. The CBR participates in the bankruptcy proceedings, but it does not di- rect them. Pursuant to Article 35, any creditor can initiate a bankruptcy action after the CBR has revoked a bank's license. The CBR participates in the proceedings essentially as another creditor, based upon the existence of debt owed by the bank to the CBR. While the CBR may appoint a tempo- rary administrator, the liquidator is appointed by vote of the creditors' committee, and it is the liquidator and creditors that direct the settlement discussions, not the CBR. The CBR therefore does not have the ability in bank bankruptcy proceedings to direct the outcome of the bank's "reha- bilitation," which means that it cannot, as regulator, ensure compliance with the relevant public policies pertaining to the banking sector. Legislative Proposals for Amicable Settlement It has been proposed in some quarters that the law be amended to rein- state the amicable settlement into bank bankruptcy legislation. Such a 276 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR move would contravene the logical and policy underpinnings of the bank bankruptcy framework. If legislators were to pursue such a change, however, they should at a minimum make clear provisions to preclude any dilution of retail depositors' interests. Depositors should receive prompt and full payment of their claims in the same way that they would under a liquidation, and settlement negotiations should not be permitted to delay payment. Depositors, in other words, should es- sentially be exempted from the process and effects of any settlement discussions. COMPROMISE OF DEPOSITOR CLAIMS IN RESTRUCTURING A legitimate bank restructuring must preclude the possibility of any com- promise of the claims of depositors, either in an amicable settlement or in measures to avert bankruptcy. To engage depositors in discussions that could diminish their access to their funds would undermine the credibility of the bank as a going concern. Very few countries (among them Malaysia, Uruguay, and Thailand) permit negotiation of depositor claims in the course of restructuring. The Bank for International Settlements has noted that "such action is very uncommon as it leads to many of the same prob- lems as an outright default" (Hawkins and Turner 1999). Restructuring of a bank's debt is valid as a part of a general rehabili- tation plan, but retail depositors should be excluded from this process; they should, in fact, be afforded regular access to their funds during re- structuring. There are concerns that affording depositors unlimited ac- cess to their funds would spark a run on the bank, and proposals have been made that Russian legislation be amended to allow banks to place a moratorium on depositor access to funds in the event of serious prob- lems. There does not appear to be any analogy in international practice for this. Such a moratorium would, again, have the potential to actually cause the problem it aims to solve. In any event, if a bank reaches the point at which a run on deposits is likely, it should be placed into conser- vatorship, under which conditions Russian legislation already permits a moratorium on access to deposits. Furthermore, it should be noted that, in international practice, bank restructurings do not generally result in depositor runs. This fact provides another justification for early, infor- mal interaction between the regulator and bank. BANK RESTRUCTURING AND LIQUIDATION 277 JUDICIAL BANK LIQUIDATION The revocation by the CBR of a bank's license is a clear indication that the bank has no hope of rehabilitation. There are numerous justifications for license revocation, some being sanctions for regulatory noncompli- ance and others relating to the financial condition of the bank, but in each case revocation follows a series of actions by the bank that demon- strate it is irreversibly unfit for business. Not all banks that are liquidated have sufficient assets to pay deposi- tors in full. Full repayment, in fact, has been made in just 44 percent of the liquidations that have occurred to date. Had sufficient regulatory measures been taken beforehand, including realistic evaluation of each bank's capital position and early intervention to gain control of assets, this percentage would no doubt have been higher. Even in the cases in which depositors are paid in full, there can be problems of slow and in- efficient repayment. This is due largely to the judicial setting in which the liquidation takes place. Liquidators In the liquidation process, it is the creditor-appointed liquidator, not the CBR, who has direct control over the process. Though the liquidator is appointed by the creditor's committee and must file reports with the court, and though technically the creditor's committee has the power to remove him, in practice the liquidator is not particularly accountable to the parties involved. The experience with liquidators to date has not been good, with complaints made about their experience and qualifica- tions. While the CBR has promulgated regulations for the licensing of liquidators, there has been some lag in getting qualified, experienced per- sons into place. Part of the problem stems from the lack of an adequate pool of people from which to choose, and while proposals have been made for the training of liquidators there will inevitably be a significant lag time before the benefits of any training program are felt. There have also been complaints that each CBR license, necessary for appointment as a liquidator, is specific to a single court case rather than being issued as a general license applicable to any case. This delays the processing of license requests and again narrows the field of potential candidates. More serious than complaints about their credentials are the com- plaints about the liquidators' integrity. There have been complaints about self-dealing and cronyism, alleging that assets have been sold to 278 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR liquidators' colleagues for reduced prices; there have been kickbacks to liquidators from the purchasers of assets; and there have been instances of embezzlement, such as the $7 million embezzlement in the Tokobank case. These problems are aggravated by a lack of transparency, with the activities of the liquidator reported only in part to bank creditors. Complaints about liquidators are not unique to cases of bank bank- ruptcy. Since bank bankruptcy takes place more or less within the frame- work of general bankruptcy, the problems it suffers are similar to those endemic within the corporate bankruptcy framework. And within the realm of general corporate bankruptcy there are many complaints about improper liquidator behavior, as detailed elsewhere in this chapter. Courts Another weak point in the judicial bank liquidation process may be the judiciary itself. Complaints about the level of training and/or competence of judges are common, with the problem attributed in part to the fact that low pay rates for judges deter better-qualified people from joining the profession. The problem has also been attributed to the experience of the judiciary under the Soviet system, in which judges were uncritical functionaries answerable directly to higher powers. This has created a culture within which judges may see themselves as clerical functionaries rather than arbiters of judicial proceedings, and which discourages the making of bold or controversial decisions. The problem has also been linked to the fact that judges are now expected to interpret a set of new laws for which adequate commentary has not been issued by higher courts or scholarly bodies. There have also been complaints of judicial corruption, alleging the exercise through monetary or other incentives of undue influence on judges by creditors or shareholders. Another significant problem with judicial bank liquidation is judicial docket congestion. The system is overloaded with bank bankruptcy cases. The CBR has more than 600 delicensed banks that it needs to liq- uidate, and this is evidently more than the system can handle. Estimates suggest that the court system can adequately process only 12 bank bank- ruptcy cases per year, and while this may be an understatement, implying that the CBR's backlog of cases would take 50 years to clear, it is broad- ly acknowledged that there is much delay in court proceedings, there are long periods of inactivity in bank bankruptcy actions, and there are long waits for results. BANK RESTRUCTURING AND LIQUIDATION 279 Procedural Obstacles One of the problems shared by both the bank bankruptcy framework and the general corporate framework is that there is no special procedural code for bankruptcy, nor are there specialized bankruptcy courts. Judicial proceedings are undertaken in general arbitration courts governed by the general Code of Arbitrazh Procedure, as supplemented by the general bankruptcy or bank bankruptcy laws. (This is discussed in detail in Chap- ter 4.) Gaps and overlaps exist that can give rise to loopholes that impede the progress of bank bankruptcy proceedings. For example, it is possible to challenge the CBR's delicensing determination in one action pursuant to provisions of the Law on Banks and Banking (with a statute of limita- tions of 10 years), and to challenge it again in the bank bankruptcy ac- tion. The recently enacted amendments to the Law on Banks and Bank- ing, limiting the timeframe for challenges to delicensing to 30 days, will hopefully tighten up this area of the law. Furthermore, bank liquidation will in the future not be necessarily dependent on a finding of bankruptcy, thereby eliminating the problem of delicensing challenges in the bank- ruptcy court (described in more detail below). There should be some fur- ther tightening up of the procedures to limit appeal times, and possibly to limit the scope of review of CBR decisions. In the United States and the United Kingdom, for example, the standard of review is whether the reg- ulators abused their discretion in making the delicensing decision. Proposal for Expedited Payment to Depositors To address one part of this dilemma, an amendment has recently been made to the bank bankruptcy law. It provides for expedited payment to retail depositors in bankruptcy proceedings. Payment of retail depositors is made at the outset of court proceedings, prior to the complete collec- tion and liquidation of a bank's assets. Payment comes from funds kept by the banks in their CBR correspondent (i.e., reserve) accounts. This proposal makes sense because depositors are distinguishable from other creditors in at least two ways. First, depositors' claims are more easily verifiable. Bank records show the amount of the depositor's claim, and this should prima facie establish the depositor's claim without the need for the filing of proofs of claim or for undue scrutinizing by the liquida- tot. If the depositor were to dispute the amount, submission, and investi- gation of a counterclaim, it should certainly be permitted. Second, depositors are first-priority creditors. The amount paid to de- positors is in no way contingent upon the amount paid to other creditor 280 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR groups (in contrast, for example, to the amount paid to fifth-priority gen- eral creditors). This also has the advantage of eliminating depositors from the liquidation proceedings without adversely affecting the interests of the remaining creditors. The viability of the proposal would naturally be contingent in each case on whether the bank in question has sufficient funds in its CBR reserve account to cover the claims of depositors. Legal Entities as Liquidators In an attempt to address the evident inefficiency, lack of professionalism, and lack of accountability of individual liquidators, it has been proposed that legal entities be permitted to act in their place. The leading interna- tional accounting firms, for example, could currently perform this work, and it will inevitably take some time for the CBR to license enough indi- vidual liquidators to break the liquidation bottleneck. The bank bank- ruptcy law would need to be amended to permit this move, however, and although the Duma is discussing the proposal, realization of any change is not in the immediate future. And even should an amendment be ap- proved, it must be doubted that private firms would be willing to take on the work without various indemnification assurances. In many of the po- tential liquidations, too, the cost to these firms of performing the liqui- dation would exceed the amount available in the bankruptcy estate. Liquidation Agency There have also been proposals for the creation of an agency to liquidate failing banks, similar to the Resolution Trust Corporation (RTC) in the United States, which was created by Congress for the purpose of liqui- dating savings and loans in the aftermath of the savings and loan crisis of the late 1980s and early 1990s. These proposals recommend that agency employees serve as liquidators in the court proceedings. The perceived advantages of such a system would be the ability of the agency to set practice standards and uniform procedures to be followed in liquida- tions; greater accountability, as a result of the involvement of a public en- tity; and the ability of the agency to rapidly train and oversee the activi- ties of those of its employees appointed as liquidators. In the United States, the RTC was created more or less out of the framework and with the employees of the FDIC, the federal deposit in- surance agency. Since the FDIC had been previously involved in bank liq- uidations, although not on a comparable scale, it had a base of experi- ence on which to develop the procedures of the RTC. In Russia, it has BANK RESTRUCTURING AND LiQUIDATION 281 been suggested that ARCO's mandate be expanded to allow it to func- tion as an administrative bank liquidator. ADMINISTRATIVE ASPECTS OF BANK LIQUIDATION The problems that weaknesses in the Russian judicial system incur for bank liquidation will be resolved neither quickly nor easily. This is a com- plex situation and judicial reform is a long-term proposition. Because Russian bank bankruptcy is an offshoot of general corporate bankruptcy, it is heir to the problems found in general bankruptcy. Resolving the problems of bank bankruptcy will consequently entail resolution of the larger problems of general bankruptcy, unless the niche of bank bank- ruptcy is further defined so as to distinguish it from general bankruptcy. A successful effort to distinguish bank bankruptcy from general bank- ruptcy could both improve the efficiency of the process of resolving failed banks and take account of the public policies uniquely at play in the banking sector. In this regard, it would be beneficial to examine the role that administrative procedures could play in the bank liquidation process. Transferring certain functions away from a judicial and into an administrative setting could improve the efficiency of the process with- out adversely affecting the rights of the parties involved. Courts do not need to be involved in every detail or decision-making juncture of the liq- uidation process. Administrative procedures are found in varying degrees in international practice, and it would be useful to determine which as- pects of international practice could readily be incorporated into a Russ- ian setting. International Practice Administrative procedures in bank liquidation can encompass some or all of the steps of the process, from license revocation to initiation of liq- uidation to control of the liquidation proceedings. The United States, for example, uses an entirely administrative process. Regulators there make the delicensing decision, and the liquidation takes place in entirely extra- judicial administrative proceedings controlled by the regulators. It is pos- sible to judicially appeal the regulators' actions, but the court does not otherwise enter into the proceedings. A less extreme model of administrative bank liquidation is used by France, Germany, Japan, and Italy. In these countries, the regulator has the power to determine that a license be revoked, but liquidation of the 282 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR bank is handled by the court. The determination by the regulator is suffi- cient for the court to initiate liquidation of the bank without first making its own finding of insolvency. The liquidator, though answerable to the court, is appointed by the regulator. Bulgaria employs an administratively controlled liquidator in a judi- cial setting. This process was established through recent legislation, re- placing a strictly judicial process similar to that in use in Russia, wherein individual liquidators are essentially independent and overseen primarily by the court. The process was modified so that the liquidators, though still operating in a judicial proceeding with court oversight, are appoint- ed and supervised directly by a newly created deposit insurance fund. Administrative Developments in Russia Realistically, it is unlikely that Russia will adopt a completely administra- tive system such as that found in the United States. There is still a feeling that some determinations are "too important" for the CBR to make; specifically, there is resistance to the notion that any entity other than a court can declare a bank to be bankrupt. This sentiment may or may not be valid, but the larger question is whether a judicial determination of in- solvency should be a prerequisite for closing and liquidating a bank. Banking is a highly regulated industry, subject to specific public poli- cies. Fulfillment of these public policies can require closure and liquida- tion of a bank even though that bank may not, according to the criteria applied to commercial enterprises, be insolvent. Capital adequacy stan- dards for banks are, of necessity, of greater concern than those for com- mercial enterprises. While failure to maintain adequate capital may not be sufficient to determine insolvency under the general commercial law, it should be grounds for the closure and liquidation of a bank. If a regu- lator has made a determination, in accordance with legislative guidelines, that a bank is engaged in unsound practices and that its license should be revoked, it makes no sense to then require an additional finding of the bank's insolvency before the bank can be closed and liquidated. According to Russian legislation, however, while the CBR has had the ability to delicense a bank based upon a number of different criteria, it was not until recently that a bank could be liquidated without a judicial finding of insolvency. This resulted in the anomalous situation of banks meriting delicensing without a way to wind up their affairs and liquidate them. In such a case, the CBR's discretion as regulator was not being subjected to the checks and balances of judicial review as much as it was being shadowed by a redundant judicial decision-making process. BANK RESTRUCTURING AND LIQUIDATION 283 There has been some progress on the Russian legislative front with re- spect to this issue. Recently enacted amendments to the law on banks pro- vide for a new procedure for the liquidation of delicensed banks, according to which the banks may be liquidated regardless of whether they are insol- vent. If it becomes evident in the course of the liquidation proceedings that a bank is insolvent, it is then referred for bankruptcy proceedings. Should the bankruptcy court determine that the bank is not insolvent, this does not necessarily mean that the liquidation would cease; rather, the case would be sent back to nonbankruptcy liquidation proceedings. This amendment increases the weight given to the CBR's regulatory decision in delicensing the bank, and so contains an administrative as- pect similar to the legislation of the EU and Asian countries mentioned above. This provision will also eliminate one of the opportunities for multiple appeals that has repeatedly been used by bank owners to stymie CBR efforts at bank liquidation. Appeals in the past have been made of both the CBR's delicensing decision and of the bankruptcy court's deter- mination of insolvency. Under the new amendments, a challenge of the insolvency determination will not stop the liquidation proceedings, as is currently the case. The liquidation will continue, regardless of whether the court finds the bank to be insolvent. The only question to be an- swered is simply whether the liquidation takes place in a bankruptcy set- ting or in the setting of a nonbankruptcy, judicial liquidation. Administrative Bank Liquidation The proposal for the creation of an agency for bank liquidation presents the potential for the addition of another administrative dimension to the Russian legislation. The use of such an agency would be advantageous in that it would ensure greater uniformity and efficiency of procedures and would promote liquidation in a manner consistent with regulatory poli- cies. This would include fulfillment of the policy of expeditious and fa- vored treatment of retail depositor claims and avoidance of the diminu- tion of depositor rights through compromise and settlement negotiations. If such an agency were created that was neither the CBR nor an offshoot of the CBR, it would be necessary to ensure adequate interaction between the CBR and the agency during the course of a liquidation to ensure con- sistency of the agency's actions with the CBR's regulatory concerns. There is a large number of other details that would need to be worked out if such an agency were to be created, but the proposal sounds like a worth- while undertaking. 284 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR CONCLUSION The roles of the various bodies that deal with troubled banks need to be examined and evaluated, particularly with a view toward protection of retail depositor interests. Hitherto banks were placed in bankruptcy in exactly the same way as any other commercial enterprise. This process was not sufficiently observant of the special public policies relating to the banking industry. In the future the process of dealing with troubled banks would ideally reflect the following: 1. CBR should be the overseer of bank restructuring and rehabilita- tion. The current law on bank bankruptcy allows the CBR, as reg- ulator, to intervene early and attempt a salvaging of the bank. However, this new role brings with it the need for the CBR to for- mulate clear and coherent policies and objectives with respect to restructuring. Standards must be established against which reha- bilitation efforts can be realistically measured for success. Addi- tionally the CBR should expand its efforts at early, informal inter- vention in troubled banks. 2. Prompt liquidation of unsalvageable banks. If a bank cannot be saved, it must be liquidated in a manner that protects the rights of all creditors and recognizes the preeminence of retail depositor in- terests. After the CBR, as regulator, has determined that rehabili- tation is futile, then the bank should promptly be liquidated and the proceeds distributed to creditors in accordance with statutory priorities. There should be no additional "restructuring" efforts by creditors, shareholders, and courts under the guise of "amica- ble settlements." 3. Reduction of courts' active direction of bank liquidation. Courts should continue to provide checks and balances by being a source of review of bank liquidation activities, but to fulfill this role the courts needn't actively direct all stages of the proceedings. The de- cision to initiate a closure and liquidation of a bank should be the prerogative of the regulator, not the courts. The courts can effec- tively protect the rights of the parties by acting in an appellate ca- pacity. The liquidation process in Russia, though improved by re- cent legislative amendments, still overemphasizes the role of courts and judicial actors (i.e., judges, individual arbitration man- agers). This emphasis has had negative consequences in light of the disadvantage at which these actors are placed due to lack of training and to an excessive caseload. BANK RESTRUCTURING AND LIQUIDATION 285 4. Greater emphasis on administrative processes in bank liquidation. The problems faced by the courts in the areas of training, inade- quate staffing, and docket congestion will not soon be resolved. It would no doubt be easier to develop potential administrative mechanisms for handling the tasks of bank liquidation and allow the court system to focus on review of liquidation actions in an appellate capacity. By "administrative processes" is meant the as- signment of bank liquidation tasks to specialized public entities rather than courts or court-related personnel. One particular change that should be considered is the creation of a public agency to act as arbitration manager in bank liquidations. The de- velopment of administrative processes should take into account the particulars of the Russian legal system and need not be as ex- tensive as in, say, the United States; but there is considerable po- tential for developing these processes consistent with the Russian framework, and the result would significantly enhance the effec- tiveness of the bank liquidation process. REFERENCE Hawkins and Turner. 1999. "Bank Restructuring in Practice," Bank for Interlna- tional Settlements, Monetary and Economic Department, Basel, Switzerland. CHAPTER 12 ARCO INTRODUCTION The Agency for Restructuring of Credit Organizations was established in response to the systemic crisis of the Russian banking system in 1998. While recognizing the weak situation of many Russian banks prior to the crisis, the CBR had been considering setting up a separate agency to un- dertake the task of restructuring banks modeled on the experience of many other countries. Seen from the perspective of the CBR, the purpose of this initiative was to avoid the potential conflict of interest that would arise were the CBR-given its responsibilities as banking supervisor- also to provide banks with financial support to facilitate their restructur- ing. Thus ARCO's stated purpose was to provide a financing mechanism, governance, and operational structure within which the resolution of troubled banks' could be carried out. ARCO's Peers in Other Transition Countries As an institution established specifically for the purpose of conducting the "clean up" of a banking system, ARCO falls within a large group of special-purpose state institutions set up in most European transition economies. (Most European transition countries share, to some degree, the same structural problems inherited from the former Communist eco- nomic and legal system.) Such special-purpose institutions were given the following: specific but broad mandates to clean up the banking system; access to substantial funding; and the objective of completing their task 287 288 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR (generally defined as successful privatization of the restructured banks) in a relatively short period of time-typically three to five years. The banks to be rehabilitated or restructured were generally state-owned banks inherited from the Communist period, although in recent years some countries have made efforts to restructure privately owned banks. The experience with bank restructuring in transition countries has been varied. Some countries, such as Hungary (after repeated attempts), Poland, and Slovakia (on the second attempt) have completed the process of bank restructuring. In these countries, the restructuring ap- proach combined very large and costly carve-outs of nonperforming as- sets from the banks with capital injections, replacement of the former management teams, and privatization by means of sale to foreign strate- gic investors. Other countries, such as Slovenia and Croatia, are still in the process of implementing bank restructuring initiatives. In Slovenia, the final step of privatization was replaced by a long (and continuing) pe- riod of state ownership, which poses a challenge as European Union membership approaches and the state banks-while healthy by every measure-face the prospect of competition from EU-based giants. In Croatia, bank restructuring initiatives were successfully applied, but in 1998 and 1999, two private banks were taken into rehabilitation (while many other private banks were allowed to fail), and the costs of bank re- structuring rose dramatically. Finally, in some countries bank restructur- ing initiatives have not met with success. In the Czech Republic, for ex- ample, bank restructuring policies were pursued for an extended period of time, but only made systemic problems significantly worse and multi- plied the costs of restructuring to previously unseen levels.2 The types of policies pursued-repeated recapitalizations and carve-outs, constant failures to institute good governance at banks under state control, finan- cial and operational involvement of the central bank in bailing out pri- vate banks, resistance to privatization to reputable strategic investors, and hiding the costs of errors in off-budget institutions-provide a useful catalogue of policy errors and their costs. ARCO's peer institutions all functioned within a broad macroeco- nomic and institutional framework for systemic bank restructuring. Dif- ferences in the macroeconomic environment do not seem to provide a meaningful variable for the relative success of each group. For example, the macroeconomic performance of the Czech Republic in the mid-1990s was among the best in the transition countries, although it failed in its bank restructuring efforts. At the same time Slovenia was moving ahead with successful bank rehabilitation policies in an environment of rela- tively high inflation and currency depreciation.3 ARCO 289 However, a key distinction can be observed between groups at the level of institutional framework. In all successful cases, the responsibi'lity for restructuring was highly concentrated, and in most cases (Poland being an exception), the authority was concentrated outside the central bank. The cases of failure all demonstrate a high degree of involvement by the central bank in the restructuring process: in the Czech Republic (until 2000) there was direct operational and financial involvement in the restructuring of medium and small private banks; in Slovakia, the re- moval of central bank involvement and the transfer of authority to a spe- cial unit within the Ministry of Finance marked the beginning of the process that would rapidly lead to success. One conclusion to be drawn from this is that when central banks become the regulators, owners, liq- uidators, and rehabilitators of significant portions of the banking system, conflicts of interest cannot be successfully reconciled, and no single func- tion can be performed well. Liquidating Failed Banks The discussion above does not address ARCO's peers' success in the area of work-out and liquidation of bank assets (see Klingebiel 2000). Most recently, international financial institutions have favored separating the work-out and liquidation function from the bank restructuring function (Democratic People's Republic of Korea, Thailand, and Slovakia are re- cent examples). Worldwide experience indicates that, as a rule, bank re- structuring institutions have not been successful work-out institutions; there is little overlap between the skill sets required for bank restructur- ing and those required for work-out functions.4 Despite the negative implications of this assessment for ARCO, ARCO could be considered for the function of main liquidator of failed banks in Russia. The reasons are twofold: first, once the present portfo- lio of banks has been sold, ARCO should cease attempting to restructure banks and become a pure liquidator; second, the reality on the ground in Russia must be accepted. There is no other institution with any apparent capacity or inclination to assume the role of general liquidator, and the limited experience gained by ARCO, along with an institutional willing- ness to undertake a broader role, provides some foundation on which to build a liquidating institution. The Purpose of ARCO ARCO does not fit cleanly into any of the groups of peer institutions in transition countries. In terms of operational restructuring objectives, its 290 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR requirements for bank management after financial assistance is provided are in line with those pursued in the successful and mixed-results groups. In ARCO's approach to governance, it combines the best elements of the successful countries (strong oversight and control) with an acknowledg- ment of the failures in the less successful countries (the moral and finan- cial hazards in the Czech Republic when former management was left in control of assisted banks). However, because of ARCO's lack of a clear policy in favor of true strategic investor privatization, which presents the possibility that its rehabilitated banks may be returned to the same inter- est groups that mismanaged them previously, it is in danger of repeating the Czech experience.5 Similarly, the overall institutional framework within which ARCO operates-where the central bank is simultaneously playing the roles of regulator, owner, creditor, and restructuring institu- tion with respect to the banking system-is similar to the Czech and Slo- vak frameworks of the mid-1990s. ARCO is also separated from its peer institutions in the critical area of financing. In marked contrast to its peers, the funding allocated to ARCO (RUR 10 billion equivalent to US$330 million) was completely inadequate for undertaking any large-scale restructuring of the banking system. At the same time, this level of funding was reasonable given the absence of a fully developed legal framework for restructuring and the lack of adequate practices and powers with which to liquidate failed banks. To invest substantial public funds to attempt systemic restructur- ing in this environment would surely be an error. Table 12.1 provides a list of ARCO's ownership stakes as of the end of 2000. Under these circumstances it can be argued that achieving success in restructuring the Russian banking system is not feasible at the present time, at least as long as success is defined as the creation of a profitable and prudent system enjoying the trust of depositors. With only weak support in place for enforceable investor and creditor rights and weak bank supervision, creating any viable banking system (in the market economy sense) is not possible. The asset stripping by insiders that fol- lowed the 1998 banking crisis and the disregard of minority sharehold- ers' rights as exemplified by the Sberbank share issue in 2001 reveal Rus- sia's lack of readiness. And given this type of environment, reputable investors cannot be expected to risk their capital. Thus it is perhaps best to regard ARCO as a kind of laboratory-unique among institutions of this type-for testing restructuring policies, the effectiveness of bank liq- uidation as a restructuring tool, the concept of deposit insurance, and the concept of strategic privatization. ARCO's experience in all of these areas provides useful information that identifies strengths and weaknesses in the current framework for ARCO 291 Table 12.1 Banks in ARCO's Portfolio as of December 31, 2000 Bank Name Region ARCO Ownership Comments AvtoVAZbank Samara 88.1% Sold 2001 lnvestbank Kaliningrad 85.15% Sold 2001 Rossiyskiy Kredit Moscow 25% + 1 (+ 50% in trust) Kuzbassugolbank Kemerovo 90.9% Sold 2001 Kemerovo Kemerovo - Merged 2001 Kuzbassocbank Kemerovo Kuzbassprombank Kemerovo 99% In liquidation Eurasia lzhevsk 50% + 1 RNKB Moscow 46.09% Sold 2001 Vyatka Kirov 73.63% Peter the First Voronezh 96.6% Sold 2001 Bank Voronezh Voronezh 99% Merged 2001 ChelyabComZemBank Chelyabinsk 74.62% Sold 2001 Dalrybbank Vladivostok 99% SBS-AGRO Moscow 99.9% Amurpromstroybank Blagoveshensk 99% Tendering Bashprombank Ufa 97% Alfa-Bank Moscow 25%+ 1 in trust Vozrozhdenie Moscow - None. Source: ARCO. bank restructuring, and with this information Russian authorities can design new policies and laws to respond to the challenge of creating a vi- able banking system. This chapter discusses some of ARCO's key experi- ences in the areas of bank liquidation, bank rehabilitation, deposit insur- ance, and privatization. It draws conclusions from these experiences regarding lessons that can be learned and applied to the development of a comprehensive approach to restructuring the Russian banking system. OVERVIEW OF ARCO'S OPERATIONS ARCO's experience, although restricted to a relatively small sample of Russian banks, provides useful information-discussed in detail in the following sections-regarding a number of important areas and issues that have systemwide implications. The following specific experiences provided valuable information and data. ARCO's approach to governance of the restructuring and rehabilita- tion process provides insights that may be useful in designing a gover- nance scheme for the restructuring and ultimate privatization of state- owned banks. 292 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR ARCO introduced the first deposit insurance scheme in Russia, which provides initial data regarding the potential for mobilizing retail deposits through the introduction of a systemwide scheme. This scheme-while interesting as an experiment in determining the importance of an explic- it guarantee of deposits to establishing depositor trust-is also troubling. As those ARCO banks that have deposit insurance are being privatized, their deposit insurance coverage is being continued for a period of 18 months, which will create pressures on ARCO to further extend cover- age for these banks and to extend the scope of coverage by allowing other private banks to participate in the scheme. These decisions high- light the dangers of starting an ad hoc scheme without first establishing a national policy and legal framework for deposit insurance. ARCO has begun liquidating one bank in the Kemerovo region. The difficulties it faced in implementing the liquidation process have been useful in identifying weaknesses in the legal framework for bank liquida- tion and bankruptcy. ARCO has proposed amendments to a number of laws to strengthen the framework and to provide a clear exit mechanism for failed banks. If these amendments are implemented, they would give ARCO a central role in cleaning up the large backlog of delicensed but unliquidated banks that remain a legacy of the 1998 crisis. ARCO commenced the privatization process for banks in its portfolio in early 2001. While the initial results of this process were disheartening, the process has at least revealed that there is interest from domestic in- vestors in participating in the resolution of the system, and it also has highlighted the informal and formal barriers to entry that exist. Legal Framework and Funding ARCO's operations are governed by the Law on Restructuring Credit Organizations (July 1999). ARCO was founded by government decree in November 1998 and commenced operations in March 1999. At that time ARCO was provided with RUR 10 billion from state funds with which to restructure banks transferred to the agency. These funds could be used for equity investments in its banks, for loans to them for liquidi- ty purposes, and for purchases of low-quality assets to strengthen bal- ance sheets. ARCO is entitled to use the proceeds of bank privatizations and earnings from loans to undertake further interventions. Governance ARCO's operations are governed by a 13-member Board of Directors with the largest group (5) of members nominated by the CBR. The ARCO 293 Government and the Duma are also represented on the Board. Opera- tional management of the agency is carried out by an Executive Board, which consists of directors of the agency's departments. This structure does not fully conform to the more flexible and effec- tive governance arrangements seen in similar institutions in other coun- tries (a more typical board for this type of institution would have no more than 7 members). The size of the Board of Directors is inconsistent with the need for it to meet regularly and actively supervise and control the activities of management. In other-not just transition-countries, the central bank has recog- nized that there is a fundamental conflict of interest between its mone- tary and regulatory responsibilities, and its participation in the gover- nance of a state-funded bank restructuring agency. This became clear for two reasons: first, because of the conflict of regulating banks and simul- taneously (through the bank restructuring agency) owning and control- ling them; and, second, because (and this is true in Russia) the central bank may be a creditor of banks being liquidated by the bank restructur- ing agency. Other creditors of a bank will naturally question the fairness of a liquidation process where one creditor also has a degree of control over the institution responsible for administering the liquidation process. ARCO's Portfolio Banks that have a capital adequacy, by Russian Accounting Standards, of 2 percent or less, and that have been unable to make payments, can be referred to ARCO by the CBR.6 Banks must meet a number of tests to qualify for assistance from ARCO. ARCO can reject, and has rejected, CBR referrals if it determines that the following criteria are not met: I:. The bank must hold more than 1 percent of Russian aggregate household deposits or loans, or 20 percent of its region's house- hold deposits or loans. 2. An ARCO due-diligence process must conclude that the banks can be successfully restructured using ARCO's limited financial resources. 3. Due diligence performed by ARCO must reach the conclusion that there is scope for the bank to be rehabilitated. As a result of the application of these criteria, the agency has devel- oped a portfolio of small banks with a primarily regional character. Within the portfolio, there are, however, disturbing exceptions7 to the criteria established by the law. Prior to implementation of the Law on Re- structuring Credit Organizations, ARCO received and accepted a total of 15 applications from troubled banks (notably Alfa-Bank, Vozrozhdenie) 294 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR for assistance. These banks (all Moscow-based) were not referred to ARCO by the CBR but for unclear reasons were provided with assistance. As a result, there is a perception that the assistance provided to these banks represents another instance of the state bailing out well-connected oligarchs, and ARCO's continued involvement with them tends to under- mine the agency's credibility. The criticism directed at ARCO regarding these banks should provide a lesson that ARCO can apply in the future: ARCO cannot expect to be entrusted with a continuing and significant role in restructuring the banking system if its decisions are perceived to be in any way connected to special political or economic interests ARCO'S EXPERIENCE IN THE REHABILITATION OF BANKS ARCO follows two basic bank rehabilitation methodologies. The first ap- proach, which applies a conventional mix of measures designed to reduce operating costs, improve governance, and recover bad debts, is in line with the approaches used by other bank restructuring agencies in transition countries. The second approach, however, focuses on amicable settlements with creditors, which is not supported by international experience, and in certain cases, gives rise to questions about the purpose and usefulness of rehabilitation carried out in this way. ARCO argues, however-and the data regarding these settlements seems to support this argument-that given the realities of the bank liquidation process, the amicable settlements have produced much better and faster results for individual depositors than if the banks involved were to have been liquidated. ARCO's success or failure in restructuring banks will ultimately be de- termined by its ability to sell banks to reputable strategic investors. (Spe- cific issues related to privatization are discussed in a separate section below.) However, the agency should always bear in mind that there is a temptation to retain ownership of banks that have become profitable (Slovenia's experience bears this out). Experience worldwide shows that the state is rarely a prudent owner of banks over the long term and, in the Russian context where there are political pressures on state banks to direct lending to uncreditworthy borrowers, the need to move ahead as rapidly as possible with privatization is accentuated. Bank Rehabilitation ARCO's approach to bank rehabilitation is comparable to the methods used in many other countries, and the agency uses similar tools to control ARCO 295 the restructuring process. Banks that were referred to ARCO by the CBR after the ARCO law came in to effect are subject to a quantitative analy- sis to determine whether they should be rehabilitated using ARCO funds or liquidated (liquidation is seen as a form of resolution). On a bank's re- ferral, ARCO conducts due diligence to determine if rehabilitation is fea- sible and may reject the referral if it is not. The objective of the rehabilita- tion process is to privatize the bank concerned. The mechanism for exerting initial control over banks entering reha- bilitation is an ARCO capital (and sometimes debt) injection in exchange for a controlling share position. Existing shareholders' stakes are written down. Once control is established, ARCO works with the bank's man- agement8 to prepare and then implement a restructuring plan focused on four main areas: operational restructuring to reduce costs and rationalize and improve the bank's network; improvement of governance and con- trols (particularly on credit9); bad-debt recovery; and business develop- ment (both attracting new deposits and diversification'" of the credit portfolio)." Progress against objectives established by these plans is closely monitored by ARCO. During the bank rehabilitation process, ARCO has succeeded in exe- cuting some innovations in the Russian regional banking market: 1. In the Kemerovo region, the three steps have been taken to con- solidate the regional banking system: (1) branches of Kuzbass- prombank were sold to Kuzbassugol Bank in the process of Kuzbassprombank's liquidation; (2) Kemerovo Bank was merged into Kuzbassugol Bank; and (3) some-very limited-success was achieved on retaining retail deposits by using Kuzbassugol Bank as the paying agent for deposits of Kuzbassprombank. 2. In the Voronezh region, ARCO has merged two banks (Pyotr Per- vyi and Bank Voronezh) in order to create a larger and more viable bank, which was subsequently privatized. Of the 10 ARCO banks in rehabilitation, 3 achieved profitability in 2000, while the remaining 7 were operationally (before provisions for credit losses) profitable. By the end of 2000, 7 banks had been identified as ready for privatization. The aggregate profit (under Russian account- ing standards) of the regional banks was RUR 21 million at end-2000, and aggregate nonperforming assets were reduced from 22 percent to 1 0 percent of assets. Despite these results from the rehabilitation process, the continuing use of Russian Accounting Standards gives rise to skepticism regarding the accuracy of ARCO's claimed success; these accounting standards do not provide any confidence that results conform to reality. Accordingly, 296 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR ARCO could consider improvements to its present approach in the fol- lowing two areas: 1. ARCO could significantly increase its credibility with potential investors and the public by ensuring that International Account- ing Standards are used in parallel with Russian standards. IAS au- dits of the banks would provide assurance that the profits report- ed by the banks are real and enhance the aggregated reporting of results in the agency's communications with the public. 2. Greater efforts could be applied to replacing the management teams with new people not associated with a bank's failure. This would remove the moral hazard associated with recapitalizing banks without removing management (i.e., rewarding failure). This effort would ease the privatization process by removing the perception that former owners-or their affiliates-have an inside track in privatization tenders through their pre-existing relation- ships with management. Amicable Settlements At end-2000 ARCO had developed or was in the process of implement- ing a total of six amicable settlements'2 with the creditors of banks in which it had invested. The six banks fall into two groups: (1) four re- gional banks where ARCO acquired majority ownership and where am- icable settlements with creditors can be viewed as a legitimate bank re- structuring and rehabilitation technique by requiring private sector creditors to bear some of the costs of rehabilitation (see Table 12.2) and (2) two banks (SBS-Agro and Rossiyskiy Kredit) are the subject of pro- posed amicable settlements where the purpose and motivation for ARCO's involvement seems extremely unclear. Neither of these banks seems to qualify under the ability-to-rehabilitate standards required for ARCO assistance. If these banks will not be viable even after the amica- ble settlements (and what depositor or lender would put funds in institu- tions with such records?) for what purpose are taxpayer funds being used? These two cases suggest that a clear policy of least-cost resolution was not followed, which calls into question whether ARCO is well suit- ed to play a much larger role in the bank restructuring process. The data on the four amicable settlements where corporate depositors have also benefited support ARCO's argument that, despite the moral hazard inherent in such settlements, the settlements in fact provided indi- vidual depositors with a much better result in practice than if the theo- retically correct path of liquidation had been followed. ARCO argues that had the banks been placed in liquidation the inefficiencies of the ARCO 297 Table 12.2 ARCO Amicable Settlements in which Corporate Depositors Benefited Dalryb Bashprom Amurpromstroy Rossiyskiy- Bank Bank Bank Bank Kredit Date of Amicable Agreement effectiveness 29.12.00 08.02.01 03.01.01 25.09.00 Total liabilities to individuals (RUR x 000) 128,190 118,266 11,796 1,854,543 Maximum maturity for individuals (years) 1.5 1.0 1.5 1.5 Total liabilities to corporations (RUR x 000) 206,102 153,267 36,599 22,373,085 Prompt repayments to corporations (%) 10 10 5 10 Prompt repayments to corporations (RUR x 000) 20,610 15,327 1,830 2,237,309 Maximum maturity for corporations (years) 20 10 20 10 Notes: Bank "Voronezh"-no prompt repayments to corporations. Bank "SBS-AGRO"-no prompt repayments to corporations. Source: ARGO. process would result in very long delays in repayment and, most likely, at best only partial repayment (the discussion of the significant problems in the bankruptcy and insolvency framework in Chapter 11 also support this argument). This highlights the urgent necessity of reforming the framework for bank insolvency and liquidation to allow efficient liqui- dation to occur and obviate the need to reach amicable settlements with bank creditors. ARCO DEPOSIT INSURANCE SCHEME In 2000 ARCO developed and introduced a deposit insurance scheme for the benefit of banks in its portfolio. As of December 31, 2000, a total of five'3 banks were participating in the scheme (two applications from portfolio banks had been refused due to their failure to meet membership criteria). The ARCO scheme provides slightly higher levels of coverage (as discussed in Chapter 10 of this text) than those proposed by the Gov- ernment in June 2001. The deposit insurance scheme is both an interesting source of infor- mation regarding depositor attitudes to the use of explicit guarantees as a mechanism to restore trust, and a troubling development from a poli- cy perspective. As discussed more fully in Box 12.1, the scheme-while evidently successful in restoring depositor trust at the banks concerned- 298 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR has been introduced ad hoc without assessing its implications for the banking system as a whole or the potential long-term exposure of the taxpayer. The first steps in expanding the ARCO scheme are now being taken as a result of privatization of banks that are members of the scheme. ARCO has decided to continue insurance coverage for a period of 18 months post-privatization (with an increase in premiums). In addi- tion there is a significant danger that this ad hoc scheme will expand fur- ther (as other private banks seek membership of the scheme) without first putting in place an adequate legal framework to define and limit the state's liability and to provide the deposit insurer with adequate power to supervise banks that receive insurance coverage. Box 12.1 ARCO's Deposit Insurance Scheme The deposit insurance scheme provides individual (physical person) depositors with insur- ance on a sliding scale according to the total amount of their deposits in an insured bank (see Table 12.3 below). Criteria for membership in the scheme: ARCO applies membership standards for banks wish- ing to join the deposit insurance scheme. In order to be eligible to join, banks must (a) be more than 50 percent owned by ARCO, (b) have no overdue liabilities, (c) meet all CBR ratio requirements, and (d) be stable and profitable. Prior to accepting an application, ARCO undertakes a due-diligence process to ensure that these four criteria are met. The final decision on membership applications is made by the ARCO executive board. As noted above, of the seven ARCO banks to have applied to date, two have been rejected. An off-site review of the compliance of each bank with the membership criteria is carried out by ARCO; however, no policy is in place to address the issue of what consequences-such as withdrawal of insurance-would be taken against a bank that falls out of compliance (other than use of ARCO's powers to force a bank's management to take corrective action). Capital and premiums:The deposit insurance fund was capitalized with RUR 500 million from ARCO funds. Member banks pay a quarterly premium of 0.0025 percent of total individual de- posits, calculated on a yearly average basis (member banks that are privatized will pay a high- er premium of 0.1 percent). According to ARCO, the very low premium for member banks that have not been privatized is explained on the basis that it is the owner of the bank who pays this premium, and therefore has a very high level of control over the risk to the fund posed by its members. Depositorawareness: The agency has developed a good depositor information program to ex- plain the terms on which insurance is offered. Each member bank is required to display infor- mation about the program in each of its branches, and explanatory leaflets are also available to depositors in the branches. In addition, ARCO has developed a "road show" to explain the scheme through the local media when a bank first becomes a member. (Box continues on next page) ARCO 299 Box 12.1 (continued) Table 12.3 Insurance Coverage of Deposits in the ARCO Scheme Multiple of the Minimum Monthly Wage RUR Equivalent at Amount (Calculation Basis) December 31, 2000 Covered Up to 20 times 2,000 100 percent More than 20 times and up to 250 times 2,001-25,000 90 percent More than 250 times and up to 1,000 times 25,001-100,000 50 percent Source: ARCO. Impact of the Scheme on Deposit Mobilization As shown in Figure 12.1 and Table 12.4, the deposit insurance scheme has had a measurable impact on the mobilization of deposits by member banks. This impact indicates that Russian retail depositors are responsive to the introduction of explicit guarantees. It can be argued that the Figure 12.1 Impact of the Introduction of Deposit Insurance on Member Banks (rubles, thousands) Insured Deposit Growth 250,000 200,000 _ _ 150,000 n _ - _ 100000 l-l 50,000 L CD' CDJ CDJ CDJ CDJ C) C'. CJ C. CD CDJ CDJ C\J C~ CD .0 C) CD C > ) CD CD C 0 C C) .0jcl c) ~ C\ 0li ~cl =l " C\ 0 C ) C) ~C 8 8 L cm cm Z >w ca. ° - Viyatka - Kuzbassugol - Vosvashdenya Pyotr Pervyi Autovaz 300 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 12.4 Deposit Growth per Quarter in Insured Banks Relative to the Region as a Whole (percent) Bank/Region April to July '00 July to Oct '00 Oct '00 to Jan '01 Viyatka Bank -15.07 -2.05 0.32 Viyatka Region 13.96 8.55 9.96 Kuzbassugol Bank -1.55 35.46 14.53 Kuzbassugol Region 15.40 4.49 6.24 Vosvashdenya Bank 35.01 Vosvashdenya Region 13.67 Pyotr Pervyi Bank 19.09 Pyotr Pervyi Region 9.89 Autovaz Bank 28.76 Autovaz Region 7.80 Source: ARCO. ARCO-owned banks in any case operate under an implicit state guaran- tee (in the same way as Sberbank), but it is clear that depositors have re- sponded positively when this implicit guarantee is structured into a for- mal guarantee with well explained terms. The strength of this response'4 gives a possible indication of the benefits that could be derived if a sys- temwide deposit insurance scheme were to be introduced. Unresolved Issues While the ARCO deposit insurance scheme has been successful in in- creasing the volumes of retail deposits mobilized by member banks, the creation of the deposit insurance scheme has been criticized because it occurred ad hoc and outside the framework of a systemwide program. The ARCO scheme is, in effect, a private self-insurance program de- signed to make explicit the implicit guarantee of state ownership. ARCO has not established a definitive policy regarding the continua- tion or discontinuation of deposit insurance scheme membership once its share of ownership falls below 50 percent. Instead an interim decision has been made to extend coverage (with an increase in premiums) for 18 months after a bank has been privatized, ostensibly to allow time for in- sured deposits to run off and be replaced by uninsured deposits. The data does not make it clear that this is in fact happening, nor is it clear what ARCO's policy will be toward insured deposits that remain at the end of the "run-off" period. The explicit intention of this extension is to allow ARCO 301 time for a policy to be developed, or more likely superceded by imple- mentation of the proposed national deposit insurance scheme. The requirements of the privatization process have thus pushed ARCO to begin extending insurance to non-ARCO, majority-owned banks. Expanding the scheme in this way will also most likely increase the pressure on ARCO to allow completely unrelated private banks to become members, and additional pressure is likely to come from the owners of former ARCO banks to further extend the period of coverage. One option (discussed at the conclusion of this chapter) would be to for- malize ARCO's role as the deposit insurer and thus allow for the devel- opment and implementation of a scheme that can be applied systemwide. It should be strongly emphasized that the presentation of this option should not be viewed as a recommendation. Our conclusion is an em- phatic one: at the present time the condition of the banking system and the quality of bank supervision are in no way conducive to the establish- ment of any kind of deposit insurance program. ARCO'S EXPERIENCE OF THE BANK LIQUIDATION PROCESS The liquidation of Kuzbassprombank (KPB) has provided ARCO with insights into the weaknesses of the present legal framework for bank liq- uidation, and it helped to clarify how the law can be strengthened. Reso- lution of the problems raised by the KPB liquidation can provide a basis for ARCO to become the primary vehicle for liquidating the large stock of bankrupt banks in Russia. In accordance with the Bank Restructuring Law, ARCO attempted to initiate KPB's liquidation by requesting meetings of the bank's board and a general meeting of shareholders. ARCO had become the major creditor of KPB as a result of a payout of retail deposits using funds provided by a loan to the bank. The purpose of calling the meetings of the board and shareholders was to propose the creation of a liquidation committee, which would in turn petition the CBR for removal of the bank's license. Once the license is removed, a bank is able to start self-liquidation (this procedure is essentially voluntary liquidation). Only in the event that the liquidation committee determines that the bank will be unable to pay its creditors in full is a bankruptcy filing necessary. In KPB's case, the general meeting of shareholders adopted the neces- sary resolution in favor of liquidation, and ARCO was appointed interim liquidator. However, the board of directors of the bank refused to accede 302 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR to the shareholders' wishes; once the liquidation committee proposed bankruptcy, the board counterfiled in the local arbitration court to pre- vent acceptance of the bankruptcy petition. The board's suit was success- ful at the local level, but on appeal the federal arbitration court upheld the filing and the bank entered bankruptcy. On January 24, 2001, a receiver for KPB was finally appointed on ARCO's suggestion. The receiver is supervised by a creditor's committee of seven members: two appointed by ARCO, two by the Kemerovo re- gional authorities, and one each by the CBR, KPB's depositors, and Comerzbank (Germany). The receiver is required to provide monthly status reports and to have major decisions approved by the committee. Lessons Learned and Remedies Proposed The KPB case provided two important lessons that ARCO proposes be incorporated into amendments to the Bank Restructuring Law. First, the KPB experience highlighted the need to create uniformity and predictability in the operation of regional arbitration courts. The ability of parties to a bankruptcy (particularly management and shareholders) to introduce procedural delays or block a bankruptcy filing at the regional court level provides opportunities for asset stripping by insiders. Delays mean that the bank's assets are not "worked" to maximize returns to de- positors and creditors, and pressure is placed on depositors and creditors to agree to otherwise unjustified settlements to the benefit of shareholders who would otherwise receive nothing."5 Second, the role of ARCO in the liquidation process needs to be clari- fied, and in particular, the appointment of ARCO as the receiver (arbi- tration manager) in bank bankruptcy cases should become mandatory in liquidation of any ARCO-controlled banks. While the actions of the ARCO-suggested receiver in the KPB are considered to be satisfactory by ARCO, the legal prohibition on ARCO acting as a receiver opens the way for significant problems in other cases. There is no assurance that an arbitration court will accept ARCO's suggested candidate for receiver in all cases, and the use of unqualified or inexperienced receivers is entirely feasible within the present law. ARCO's experience in a single case of bank liquidation has, despite the delays, been positive so far, in the sense that at the federal level the rights of the general meeting of shareholders to decide upon liquidation were upheld, and ARCO was able to get its candidate appointed as re- ceiver. However, the experience also highlights the uncertainty of the process; that is, these favorable outcomes could quite well have gone the ARCO 303 other way, with negative consequences for the bank's creditors. If the broader problem of bank insolvency in Russia is to be resolved, the path to liquidation must be made certain and quick, and the execution of the liquidation process must be made professional and transparent. In this context, an amendment to the bank restructuring and bank- ruptcy laws to create a bank liquidation agency would be desirable, and ARCO could be considered for taking on this role. The development of strong liquidation skills by ARCO as a liquidation agency would assure creditors that their claims would be resolved in a professional and equi- table manner. PRIVATIZATION OF ARCO BANKS The privatization process for the ARCO banks provides useful lessons for the future regarding the fundamental issue of whether strategic invest- ment can be attracted to the Russian banking system. The privatization of the ARCO banks offers the authorities an opportunity to conduct a pri- vatization process that is transparent, has clear rules, and excludes simply returning these banks to the same owners. On the other hand, there is a real danger that the results of the privatization process could be seen as "more of the same," where legitimate investors are excluded for the ben- efit of insiders, and where the entire rehabilitation process is seen as one more bail-out of connected private interests by the state. The ARCO bank privatization process is made difficult by three factors: 1. The banks to be privatized are regional and small in absolute terms. These factors may make them unattractive to large strate- gic investors, and the dispersion of the ARCO portfolio makes the creation of a national network of ARCO banks unfeasible. 2. ARCO management has also made it clear that regardless of strategic investor interest, in certain cases the interest of regional authorities in acquiring banks will significantly reduce the interest of other investors (local authorities have sufficient legal and extra-legal means to ensure that any uninvited investor will have a difficult experience). 3. While ARCO reports that local investors are very interested in some of the banks, the question of whether such investors will be able to provide the governance these banks require once ARCO ceases exercising control is a good one. Also, can these local in- vestors provide the benefits of technology transfer and manage- ment skills that strategic investors can provide? There is a real 304 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR possibility that one result of the privatization process will be that in the future these banks may become troubled again. These factors raise the real possibility that ARCO-if it chooses to sell banks only to legitimate investors-could be faced with a situation where the banks are simply not privatizable for the medium term. At that point, the issue of state ownership, and the mechanisms by which gover- nance is exerted, will need to be revisited. A fundamental judgment may have to be made as to whether medium-term state ownership is in fact preferable to privatization under the particular circumstances of the Russian regions. One further option to address the problem of nonprivatizable ARCO banks might be the creation of some form of state trust to take over own- ership and control of banks after a specific period (say three or four years) from the date of ARCO's investment in a bank. If such a trust were to operate under the governance of respected and independent per- sons and with full transparency, an intermediate mechanism to continue state ownership without continuing the risks posed by state ownership could be successful. Results of the Privatization Process The four privatization transactions completed by June 1, 2001, do not provide a basis for a theory that ARCO could provide a useful model for the privatization of other state banks. While in all cases the letter of the law has been applied in the auction process, the ARCO process departs from that seen in other countries, in which the intent of the privatization process is to attract reputable strategic investors by providing adequate opportunities for investors to conduct due diligence; by screening in- vestors to ensure that only those capable of providing good governance, without conflicts of interest, and with the technical skills and financial strength to contribute to the development of the bank are qualified to tender; and to ensure the best price for the state's shareholding by maxi- mizing competition. A further and very disturbing issue from a supervisory perspective is that in two cases (Autovazbank and Pyotr Pervyi) the bank acquirers were permitted to use an unconsolidated affiliate vehicle to execute their acqui- sitions. Such a mechanism allows circumvention of accounting and re- porting standards for the consolidation of investments by banks, has the potential to allow imprudent violations of loan-to-one-borrower limits, and could result in a situation where the acquired bank in fact provides the financing for its own purchase."6 ARCO management explained this ARCO 305 as standard operating practice in Russia, but this should not justify the knowing participation of a public institution, and it casts doubt on ARCO's understanding of its public responsibilities. The four initial privatizations completed by ARCO were Chelyab- komzembank (April 2001), Investbank (May 2001), Autovazbank (May 2001) and Pyotr Pervyi (June 2001). CONCLUSION The results of ARCO's privatization efforts to date indicate that the process will need to be significantly restructured if there is to be any pos- sibility of attracting reputable strategic investors to the process. The present approach seems designed to actually exclude such investors and, by transferring ownership to investors of opaque origin or using highly questionable indirect and "anonymous" acquisition vehicles, may in fact simply result in the failure of these banks in the future at further cost to the taxpayer and to depositors. The following specific changes to the process could be considered: 1. Extending the period between announcement of a tender and the auction date: The legal minimum period of 30 days (ARCO states that up to 60 days is typical) is far too short to allow a reputable strategic investor-without prior inside information regarding upcoming tenders-to conduct appropriate due diligence or, in the case of foreign investors, to even mobilize an acquisition team. A period of six months to one year to complete the privatization process is typical in other transition countries and encourages rep- utable investors to participate by allowing adequate time for due diligence. 2. Retaining a reputable financial adviser to market banks and ad- minister the privatization process: ARCO has relied on its own re- sources for the tenders conducted so far. This contrasts with the practice in almost all countries of using a reputable financial ad- viser capable of delivering the widest possible market for each transaction. The participation of a reputable adviser also provides reassurance to investors that the tender process will be adminis- tered in a professional and impartial manner, thus fostering com- petition. 3. Implementing pre-qualification procedures and criteria designed to exclude investors who do not meet requirements to provide finan- cial strength, good governance, and a lack of conflicts of interest to 306 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR ensure the prudent operation of the bank post-privatization: The present practice, where ARCO either states that it has no knowledge of the business or ownership of the investors purchasing its banks, or allows the use of questionable acquisition designed to circumvent accounting and reporting rules, is indicative of a reckless disregard for well-established principles. Institutions of ARCO's type have a responsibility to the taxpayer to ensure that privatization does not simply return ownership to the types of investors likely to misman- age a bank (and particularly banks with deposit insurance). The future role of ARCO in the banking system needs to be defined by the Russian authorities. As an institution it presently has a limited man- date; however, it is developing skills in the area of bank liquidation, de- posit insurance, and privatization. For the longer term, a strategy for ARCO could take advantage of these skills by providing the institution with a mandate in deposit insurance and bank liquidation (two comple- mentary functions). In order to implement such a strategy, some basic building blocks must be in place: 1. ARCO should not attempt to restructure or rehabilitate any more banks. As discussed previously, experience of most countries shows that combining the liquidation and restructuring function has not been successful. 2. The process of privatizing ARCO's remaining banks should be halted until it can be redesigned to encourage the participation of reputable strategic investors. The privatizations executed so far encourage a belief that ARCO's banks are being sold in a way that does nothing to ensure the future stability of the system (and may further undermine it) and undermines any confidence that ARCO should be entrusted with a broader role in either bank pri- vatization or the sale of assets in the bank liquidation process. 3. ARCO should not prematurely introduce a system of deposit guar- antees. ARCO's limited experience indicates that deposit insurance can have some impact in building trust in the banking system and mobilizing deposits. However, the rules for participation in such a scheme and the powers of the responsible institution to control the risk of deposit insurance by supervising member banks must be es- tablished (ARCO's membership requirements and monitoring are useful experiments in this regard). How the scheme would be fi- nanced without placing an additional burden on the state must be determined, and the consequences for banks that do not qualify for insurance must be outlined. We emphasize that attempting to ARCO 307 rapidly expand the ARCO deposit insurance scheme under the present circumstances of the Russian banking system would be a mistake. Until the system is restored to solvency under IAS and ef- fective bank supervision is implemented, there is an overwhelming likelihood that the result of introducing deposit insurance will sig- nificantly increase costs to the state from bank failures. 4. The laws on bank restructuring and bankruptcy need to be amended to allow the process to become professional and effi- cient. For ARCO to function effectively as an institution responsi- ble for clearing the backlog of insolvent banks out of the system, and to allow rapid resolution of future bank insolvency, the legal framework for bank liquidation must be amended. The legal framework must remove the ability of shareholders and manage- ment to obstruct the liquidation process; it must allow the devel- opment and use of ARCO (as a legal entity) as a professional liq- uidator; and it must ensure that the process is made transparent and accountable to creditors. 5. Criteria should be amended to allow early intervention. The costs of intervention by ARCO are increased, and the proceeds avail- able to pay depositors and creditors are reduced, as a result of the combined capital insolvency and illiquidity threshold necessary for CBR referral to ARCO. The criteria should be amended to allow referral of a bank to ARCO when it becomes either capital- insolvent under IAS or becomes illiquid. 6. If ARCO is to be made responsible for liquidating a large number of banks,17 then it will require additional funding from the state. Under normal circumstances a liquidator is paid from the pro- ceeds of liquidation. However, under the extraordinary circum- stances of this type of mass liquidation, it is unlikely that in many cases the costs of liquidation can be recovered from the liquida- tion of remaining assets. The state will therefore have to provide ARCO with additional funding to cover this one-time cleanup cost. 7. ARCO's governance needs to be reformed. If ARCO is to function effectively as a deposit insurer and bank liquidator, its governance needs to be reformed to remove conflicts of interest and reduce opportunities for political interference. One solution, in conjunc- tion with the expansion of deposit insurance, would be to restruc- ture the ARCO board of directors by making it smaller and more effective in terms of supervising the agency's management; by pro- viding it with a majority of independent professional members; 308 BUILDING TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR and by reducing participation by the CBR to observer status. This would remove the inherent conflict of interest in CBR's nomina- tion of members to the ARCO board (discussed above) and help to mitigate the risk of politically influenced decisions. ARCO remains an experimental institution. As such it has made mis- takes-most notably in its approach to bank privatization-but its limit- ed successes should also be recognized. For the Russian authorities the key issue should be how to use the lessons learned from ARCO's experi- ments to design and implement policies in the areas of bank restructur- ing, privatization, liquidation, and deposit insurance. ARCO itself, while still a small institution, provides some foundation of skills and experi- ence on which a larger and significantly more powerful institution could be built. The success or failure of this larger institution will be deter- mined by the legal and governance framework that supports it, and this itself provides an opportunity to implement reforms that can eliminate conflicts of interest and build public trust. ENDNOTES 1. The term "banks" is used throughout to denote credit organizations. 2. Current estimates of the costs incurred in the Czech Republic for bank re- structuring are in the 55 to 60 percent of GDP range. The closest competitor in terms of cost is Croatia (about 30 percent of GDP), which incurred exceptional costs from war and the economic consequences of the breakup of the former Yu- goslavia. 3. It is often argued (by bankers) that the primary cause of bank failures is dramatic changes in the macroeconomic environment. This argument is used to support the idea that bankers are in some way not responsible for the failure of their institutions and therefore a penalty-free state-sponsored bail-out program is justified. In Russia's case, the change would have been the onset of the currency crisis in 1998 combined with default on state securities. However, this does not explain why some banks survived the same crisis. Research conducted by the U.S. Office of the Comptroller of the Currency in the mid-1980s clearly demonstrated that during periods of macroeconomic stress there was only one significant vari- able between banks that failed and those that did not: the quality of management and governance. 4. The U.S. Resolution Trust Corporation is often mistakenly cited as an ex- ample of an institution that was successful in combining these functions; in fact the vast majority of its assets were performing home mortgages and commercial real estate for which the work-out activities consisted of sale (performed by well ARCO 309 qualified contractors) into pre-existing and highly liquid markets. Similar types of assets requiring liquidation or work out and similarly liquid markets are not a feature of Russia or anywhere else in the region, and the experience is therefore irrelevant. 5. ARCO argues that the reality on the ground is that powerful regional au- thorities will block the sale of ARCO banks to strategic investors that are not a part of the regional power structure. There seems to be some merit to this argu- ment given the myriad powers (from tax raids to health and safety inspections) available to the authorities to harass any foreign (out of region) investor. This supports the conclusion that real reform of the banking system will have to wait until Russia conforms to the norms of the rule of law and impartial administra- tion required for a functioning market economy. 6. The requirement that banks must meet both of these criteria drives up the cost of intervention by ARCO. Given the lax standards of Russian accounting and supervision, a bank may continue to avoid intervention long after it has be- come capital insolvent under IAS. This allows insiders additional time to engage in asset stripping and imprudent speculation, and encourages the dissipation of a bank's most valuable assets in order to maintain liquidity. All these factors tend to increase the cost of restructuring and reduce the value of assets remaining to pay depositors and creditors if the bank is placed in liquidation (see Chapter I] for a further discussion). 7. "Exceptions" may be the wrong term as ARCO accepted 15 banks on a voluntary basis before the enactment of the law and only 6 (out of 9 referred to it by the CBR) after the law became effective. 8. ARCO has generally not followed international practices by appointing new management teams to its banks. Old management teams have generally been retained on the basis of their knowledge of the portfolios, with the addition of a member of each team appointed from the ARCO Anti-Crisis Department. 9. All credits over RUR 10 million require approval by ARCO headquarters. In addition, ARCO has imposed uniform credit policies and procedures on the banks, and conducts regular field inspections of the banks' credit portfolios. 10. Most of the ARCO banks were "pocket banks" of an enterprise or indus- try in their regions. ARCO establishes targets for diversification away from these enterprises and industries, with an emphasis on SMEs. Geographical diversifica- tion remains a significant problem due to the location of the banks in the regions and the lack of opportunities to either sell or purchase loans from out-of-region banks in order to diversify. 11. ARCO might find the corrective action plan and monitoring standards used by the World Bank-funded Bank Review Unit to be of interest in further de- veloping its activities in this area. 12. Settlement proposals that had been approved by the respective arbitration court. 13. Autovazbank, Eurasia, Kuzbassugolbank, Pyotr Pervyi, and Vyatka-bank. 310 BUILDING TRuST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 14. An additional-but unquantifiable-point might be that the depositors concerned are located in the regions rather than in the Moscow and St. Peters- burg metropolitan areas. The lower levels of financial sophistication found in the regions may be the reason that making the guarantee explicit is important. 15. The same problems arise in the operation of the bank bankruptcy law (see further discussion in Chapter 11). 16. This type of fraudulent financing has been a common factor in many pri- vate bank failures in the transition countries. 17. On February 28, 2001, the CBR identified 758 banks as subject to liqui- dation and 468 as being in receivership with court-appointed interim trustees (Source: Bulletin of Banking Statistics No. 3 1941). Given that these numbers are the result of Russian Accounting Standards, the true number of insolvent banks in the system is most likely significantly higher. REFERENCE Klingebiel, Daniela. 2000. "The Use of Asset Management Companies in the Resolution of Banking Crises." Policy Research Working Paper 2284. World Bank Financial Sector Strategy and Policy Group, Washington, D.C. PART IV ENTERPRISE FINANCING I mproving trust in market-based intermediation will facilitate access to external financing for those enterprises providing the highest value- added, and thereby the largest, contribution to the growth of the econ- omy. Of particular importance in supporting creditors in assessing and se- lecting enterprises to be financed are those reforms related to improving creditor rights and insolvency practices, and strengthening transparency and disclosure (Part I). Building on these reforms, Part IV describes cur- rent practices in enterprise financing and outlines the agenda for further enhancing enterprise access to financing through the capital markets. Although the small and medium-size enterprises are usually the "en- gine of growth" in transition economies, the access of this sector to for- mal financing in Russia remains highly constrained. Chapter 13 describes the relatively poor access to finance of large segments of the Russian en- terprise sector. While a narrow segment of larger raw material- producing and exporting enterprises has access to formal bank or capital market fi- nancing, many enterprises continue to rely on barter and tax and payment arrears as their predominant sources of working capital. Essential as capital markets are to longer-term enterprise financing, instilling trust in the Russian capital market will require the fulfillment of a broad agenda and a concerted medium-term effort. As described in Chapter 14, this agenda includes reforming the market for debt issued by the Government; strengthening corporate governance, especially regard- ing transparency in ownership and control structures; improving the quality of financial information available to enterprise stakeholders; and strengthening supervision and enforcement of supervisory regulations re- garding the capital markets. 311 CHAPTER 13 Enterprise Access to Financing D uring the first decade of transition, major changes took place in the fully state-owned Russian enterprise sector. Today there is a small number of very large enterprises, mostly in the export- oriented oil, gas, and metal industries. There are also thousands of large industrial enterprises, primarily in the manufacturing sector, that have their origins in the pre-transition period. Next are the medium-size busi- nesses, a significant number of which are greenfield projects that were started during the transition. Finally, there are hundreds of thousands of small and micro-size companies, and several million individual entrepre- neurs, nearly all of whom emerged during the last decade. Notwith- standing the large absolute numbers, the importance of the Russian small and medium-size enterprises in the economy relative to the large compa- nies in terms of value added and employment is still smaller than in Western economies and their peer transition countries. SMEs are generally a very diverse set of companies with very differ- ent operating environments, goals, and constraints. Their financing re- quirements and sources differ as well. Chapter 13 provides an overview of the principal methods used by SMEs to raise the funds needed for their operations. COMMERCIAL CREDIT The Russian Federation presents a unique case among the emerging economies in terms of their structure of enterprise financing. The access 313 314 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR of enterprises to external finance has been very limited; many enterprises have had to rely on trade credits of various kinds-usually referred to as "commercial credit" (see Klepach 1999), This term includes overdue ac- counts payable as well as wage and tax arrears (see Box 13.1). The use of delayed payments as a source of enterprise financing also occurs in other transition economies, but became pronounced in Russia in the late 1990s. The chain reaction of nonpayments that led to high levels of overdue liabilities could have different origins, but this form of financing is particularly prevalent in countries where the state had a significant role in the economy and ran budget deficits. Although commercial credit, including conventional trade credit, has been the largest source of financing of large and medium-size Russian en- terprises for the duration of the transition period, the importance of this source of financing has declined since 1998. This is a positive trend that Box 13.1 Arrears and Noncash Settlements Tight monetary policy with soft budget constraints led to an increase in arrears and noncash settlements (NCSs) in the second half of the 1990s (see Pinto, Drebentsov, and Morozov 2000). After 1995, inflation decreased rapidly due to tight monetary policy, but the fiscal deficit was not addressed. Instead, inflationary budget financing was replaced with bond financing. This macroeconomic stabilization policy was combined with soft budget constraints for state- owned and recently privatized but nonviable enterprises. Implicit subsidies came in the form of arrears and NCSs for tax and energy payments. The energy monopolies, in turn, became the largest tax delinquents as well as the most important participants in the tax-offset schemes. At the same time, credit tightening and rising interest rates confronted enterprises with a liquidi- ty squeeze that required even larger subsidies. Tax arrears and offsets resulted in an increas- ing fiscal deficit and rising interest rates. This inconsistency between macroeconomic stabi- lization and soft budget constraints led to a vicious cycle of nonpayments and eventually to the crisis of 1998. While initially it was only nonviable enterprises that resorted to arrears and NCSs, over time profitable enterprises linked up with nonviable businesses to profit from the system of nonpayments. Overall, soft budget constraints and the resulting nonpayments de- creased the incentives for the enterprises to restructure themselves. NCSs and barter distort- ed prices and thus impeded efficient resource allocation. Nonpayments have decreased significantly in the last few years, as shown in Table 13.1 and through anecdotal evidence. This can be explained both by cyclical as well as structural changes. First, macroeconomic developments (commodity price increases and the currency devaluation) have led to a remonetization of the economy. Second, structural reforms have started. Hard budget constraints are enforced by the energy monopolies. Since the vicious nonpayment "chain" started with the energy monopolies, the virtual cycle of eliminating non- payments has had a positive effect on the whole economy. Tax reform has also resulted in bet- ter and larger tax collection (although the issue of tax arrears from pre-crisis years seems to continue to threaten the profitability of many companies). There are no longer any tax offsets at the federal level, and even at the regional level they are less prevalent than before. ENTERPRISE ACCESS TO FINANCING 315 Table 13.1 The Role of Commercial Credit 1995 1996 1997 1998 1999 2000 Bank credit to nonfinancial private sector on banks' balance sheets (billions of dollars) 29 28 38 16 19 31 Overdue liabilities of enterprises (billions of dollars) 54 97 131 62 54 59 Net accounts payable (percent of GDP) 8 14 17 22 16 12 Arrears (percent of GDP) 15 23 29 39 30 23 Noncash settlements/sales (percent) 22 35 42 51 51 43 Sources: Solntsev and Khromov 2001; and Pinto, Drebentsov, and Morozov 2000. Updates by the authors. reflects a move away from large and widespread nonformal indebted- ness. Table 13.1 compares the magnitude of nonformal commercial cred- it with bank lending to the cntcrprise scctor. Total ovcrdue entcrprisc lia- bilities exceeded bank credit to the corporate sector by a factor of three to five from 1995 until August 1998, but then declined sharply after the crisis, reflecting increased payments for cash and increased lending by banks. The same profile is reflected in the data for net accounts payable (accounts payable less accounts receivable), which grew steadily from 1.8 percent of GDP in 1993 to 22 percent in 1998, before declining to 12 percent in the year 2000. The recourse of enterprises to nonformal credit as alternative forms of working capital finance grew rapidly in the years 1995-98. During this period arrears rose from 15 to 39 percent of GDP, and the ratio of non- cash settlements to sales rose from 22 percent to 51 percent. After the crisis both these ratios declined quite sharply due to improved payment discipline and improved access to bank financing (see Commander, Dolinskaya, and Mummsen 2000). This could be explained in part by the banks' improved liquidity reflecting Russia's current account surplus, which was only partially sterilized by the CBR. Banks were also more willing to lend to the corporate sector after the 1998 financial crisis, be- cause other sources of earnings-such as investment in high-yielding government paper-were no longer available. Another important explanation of the decline in noncash payments was changed behavior on the part of the authorities. The Government was among the largest enterprise creditors through enterprise arrears to the budget and nonbudgetary funds. Efforts by the authorities since the 316 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR crisis to reduce customer indebtedness by utility companies-in the first instance by electricity suppliers-contributed significantly to the increase of cash payments across the country, and to a corresponding reduction in arrears.1 BANK FINANCING During most of the 1990s, and particularly before the financial crisis of 1998, banks did not have strong incentives to develop a program of lend- ing to the enterprise sector. FOREX operations, investments in GKOs, other high-yield securities, and provision of treasury-like products by in- sider banks to their financial-industrial group parents were the products of choice for the banking system. Not surprisingly, given the relative ease of earning sizable profits from these activities, banks viewed lending in general, and to the SMEs in particular, as a risky activity that required too much effort and provided uncertain rewards. Since the 1998 crisis, banks have turned more to enterprise lending (as outlined in Chapters 6 and 7), and this recent expansion in bank lending has been dominated by lending to larger, well-established enterprises by the state-owned banks. Bank lending continues to take the form of short-term commitments (up to one year, three months on average) with only a very small volume of loans of longer-maturity (up to three years). As a result only a very small share of enterprise investments in fixed assets is financed by bank credit, and most enterprises continue to rely on financing from internal funds (retained earnings). Bank credit to the private sector is at about the same level in Russia as it is in other Commonwealth of Independent States (CIS) countries but it is less than in the Baltics, and considerably less than in the more ad- vanced Central European economies (see Table 13.2). The reliance of en- terprises on internal funding can be explained in part by the large inter- est spreads required of Russian banks. Table 13.3 provides a cross-country comparison of the lending- deposit spread for 1998-2000. In addition to regulatory costs imposed on banks, such as reserve requirements, large interest rate spreads reflect the relative inefficiency of the Russian banking sector and point to the need for both greater competition within the sector-resulting in a re- duction of the dominance of state-owned banks-and the need for con- solidation (see the discussion in Part II of this book). Russian Accounting Standards provide banks with limited information on enterprise financials and very little disclosure on key components of ENTERPRISE ACCESS TO FINANCING 317 the structure of enterprise ownership and control (as discussed in Chapter 4). This reduces the appetite of banks to lend to the enterprise sector. There are also tax-related incentives for enterprises not to show their full financial results on their official books. Many businesses see the tax struc- ture and the intrusion of the tax inspectors as factors that prohibit them from usinig formal financing arrangements-although the importance of Table 13.2 Credit to Private Sector (percent ot GDP) 1998 1999 2000 Central Europe and the Baltics Czech Republic 58.7 54.3 49.8 Hungary 23.6 27.8 35.4 Slovak Republic 45.9 37.2 30.7 Poland 19.5 23.6 27.8 Estonia 25.3 26.2 26.8 Latvia 14.9 16.7 18.6 Bulgaria 12.7 14.6 15.6 Lithuania 11.3 13.0 11.6 CIS Countries Moldova 12.2 10.6 12.7 Ukraine 7.6 8.4 12.6 Russia 12.8 11.5 12.3 Source: International Financial Statistics (IMF), and national statistics. Table 13.3 Interest Rate Spreads (lending rate minus deposit rate) 1998 1999 2000 Central Europe and the Baltics Czech Republic 4.7 4.2 3.7 Hungary 3.1 3.1 3.0 Slovak Republic 4.9 6.7 6.4 Poland 6.3 5.7 5.8 Estonia 8.6 4.5 3.9 Latvia 9.0 9.2 7.5 Bulgaria 10.3 9.6 8.4 Lithuania 6.2 8.1 8.3 CIS Countries Moldova 9.1 8.0 8.9 Ukraine 32.2 34.2 27.8 Russia 24.7 26.0 17.9 Source: International Financial Statistics (IMF), and national statistics. 318 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR these factors will likely recede following the revision of the tax code im- plemented in 2001. The accounting, disclosure, and tax environments provide enterprises with incentives to sacrifice access to external financing (first of all, bank loans), and survive by (a) using internally generated funds, (b) drawing on nonformal sources of funds (such as arrears and noncash settlements) or (c) borrowing on the gray market-for example, by using financing provided by related counterparts.2 VEKSELS Veksels (short-term interenterprise debt obligations) have played an in- creasingly important role in corporate financing. The rapid growth of the veksel market took place in tandem with the growth of nonformal fi- nance in the mid-1990s. While in many ways similar to a commercial paper market, settlement for veksels usually takes the form of offsetting transactions-that is, the transfer of corresponding payment obligations. In many cases, veksels were used to avoid tax and to facilitate asset strip- ping. The veksel market can be divided into "financial" veksels issued by banks and large enterprises to raise funds, and "commodity" veksels is- sued by industrial companies to be used for mutual offsets with other holders of such veksels.3 The market pretty much dried up immediately following August 1998, but started to recover soon thereafter. During the last two years it has transformed itself from a market of mostly illiq- uid papers (heavy on commodity veksels) used mostly for offsets,4 to a much more liquid and transparent market of fixed-income financial in- struments in which almost all new issues are for the purpose of raising short-term cash (three to six months) for financing current operations of enterprises and banks. In part the growth of the veksel market can be considered a substitute for the government securities market that dried up after the 1998 crisis and is still relatively small (for further discussion, see Chapter 14). The transformation of the veksels market would also appear to be closely related to the growth of cash payments among en- terprises for their production and services. Cash payments grew from 30 percent of all interenterprise payments in 1997 to around 50 percent in 1999 to over 70 percent in January 2001 (see Table 13.4). Estimates of the size of the market vary substantially. The financial veksel market is valued at between US$150 million and US$18 billion (between 0.6 and 7.0 percent of GDP), and the nonfinancial, or com- modity, veksel market at about US$36 billion (14 percent of GDP). Ac- cording to IC Region, a brokerage house and an active veksel market ENTERPRISE ACCESS TO FINANCING 319 Table 13.4 Structure of Payments for Goods, Works, and Services in Russia (percent of total payments) November 1999 January 2001 Cash 53 75 Veksels 14 7 Mutual offsets 21 10 Barter 8 5 Other types of payments 4 3 Source: IC Region 2001. participant, during the last few years the financial veksel market has grown from 3 to 4 liquid issues in mid-1999 to some 20 to 30 liquid is- sues in 2001. Nonetheless, the market remains highly concentrated. Gazprom's veksels alone account for around 60 percent of all outstand- ing financial veksels. Bank issues (Gazprombank, Sberbank, Sobin Bank, MDM Bank, etc.) account for another 30 percent, with the remainder di- vided among large companies, such as Tumen Oil, Mezhregiongas, and Norilsk Nickel. IC Region estimates that there are some US$3.3 billion worth of financial veksels currently outstanding in the over-the-counter (OTC) market. Daily turnover ranges from US$80 million to US$115 million, which is similar or higher than the turnover of treasury paper and corporate stocks. In terms of their position in the narrow universe of bank and enter- prise funding sources in Russia, financial veksels are placed between the interbank market that channels very short-term funds among the banks (90 percent of the volume being overnight loans), and the bond market, where funds can be raised with maturities of over one year. Maturities of veksels range between two weeks and one year, with the most popular being three to six months.5 As suggested by their maturity, veksels are a source for working capital financing. According to participants, veksels are a cheaper source of finance than bank financing, even though veksels are at a disadvantage compared to bank loans or bonds, because veksel interest payments-in contrast to bond coupon and bank loan interest payments-cannot be expensed by the issuers for tax purposes. Veksels are also more popular with investors than bank deposits because collec- tion is relatively easy to enforce.6 However, the veksel market is current- ly accessible only to a handful of large financially strong companies whose credit history allows them to borrow more cheaply through vek- sels than through bank financing. 320 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR The financial veksel market remains an OTC market because only the securities registered with the Federal Commission of Securities (FKCB) can be publicly traded on the organized exchange. However, the Association of Veksel Market Participants (AUVER) is developing an organized veksel in- formation and trading system, which includes a common set of standards, including registration and disclosure of information by issuers. Standard- ization of the OTC market will contribute to the efficiency of the veksel market by reducing risks and transactions costs. According to the new Tax Code, the 0.8 percent veksel registration fee applied to other securities will also be applied to veksels, thus making veksels similar to other securities in terms of their formal status. Standard & Poor's, the rating agency, has started to work in the Russian market and intends to rate veksel issuers. All these steps work toward promoting a more organized veksel market. LEASING Given the continuing expansion of the SME sector, leasing companies have shown increasing interest in covering the deficit of longer-term funding to Russian businesses. The legal and knowledge environment for leasing has been developed during the last six to seven years, with close involvement of foreign know-how and fund suppliers, including the In- ternational Finance Corporation (IFC), which is active in providing legal advice in this area. The Law on Leasing, adopted in late 1998, regulates the industry, but needs a number of changes in order to make it internally coherent and to bring it into conformity with the Russian Civil Code and several other laws as well as customs legislation. While leasing provides the financier with additional security compared with conventional bank loans (because the asset ownership remains in the possession of a lessor), enforcement of creditor's rights in the case of a lessee's default is neverthe- less problematic. A court decision and order are needed to gain physical re- possession of a leased asset. This provides opportunities for a lessee-just like in the case of bank loans-to delay the repossession, thereby prompt- ing lessors to seek additional collateral security from a lessee. If leasing is to cover the vacuum in the market for longer-term, fixed-asset debt- financing, these and other legal/enforcement deficiencies will have to be rectified. Leasing as a source of asset-based financing is picking up, although it still only provides finance for 3 to 5 percent of total capital goods acquisi- tion in Russia, compared to up to 15 percent in some transition countries, and 20 to 30 percent in OECD countries. There are about 1,500 registered ENTERPRISE ACCESS TO FINANCING 321 leasing companies, with 75 to 100 of them active in the market. In 1999, only one-fifth of all leasing companies (and an even smaller percentage of the active ones) were owned by the banks, with the majority being owned by private nonbank companies, individuals, and regional governments. As a consequence of this ownership structure and, more generally, the very short horizon of the Russian lenders, the main problem is the lessors' ac- cess to long-term sources of funding. At the end of 1999, the leasing in- dustry was estimated to have US$400 million to US$800 million in total assets. The wide range of this estimate is due to differences in the treatment of some leases, which are one-off lease-buyback deals within FIGs. These leasing companies/subsidiaries are established exclusively for one deal. OTHER FINANCING INSTRUMENTS Factoring and forfeiting activities are currently almost nonexistent. The popularity of using consignment as the basis for many trade deals among the Russian counterparts and the very short history and uncertain credit- worthiness of the majority of Russian enterprises have prevented faster development of factoring in Russia. Warehouse receipts to a very limited extent serve the function of discounting receivables. Warehouse receipts are a new financial instrument, currently trading in a very thin informal market. They are issued by certified warehouses to an owner of the goods kept in the warehouses. The receipts then can be traded as short- term securities. Only the easily marketable goods, such as grain, oil, coal, and similar commodities can be used as a "collateral" for the warehouse receipts. Although efforts were made to strengthen the legal foundation for warehouse receipts, this legislation has not yet been enacted.7 Currently bond and equity markets are used as a method of raising funds only by the largest Russian blue-chip companies. In the medium term the growth of the capital market will be crucial to sustained growth in the provision of finance to the enterprise sector. Following the initial facilitation of the privatization process, capital market development in Russia has been slow. Reforms designed to stimulate the development of the capital market are further discussed in Chapter 14. CONCLUSION Given the lack of transparency and disclosure related to Russian enter- prises, lending to the enterprise sector is still perceived by creditors as a 322 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR risky endeavor. The lack of long-term funding sources coupled with inad- equate longer-term lending and credit analysis skills also contribute to the failure of the financial system to supply the private sector with various lending products. Overdue payables and arrears have been and still are important sources of credit. Only a handful of large, usually exporting companies have relatively easy access to bank and capital market financ- ing (veksels, bonds, and stocks) both in Russia and internationally using syndicate loans, eurocredits, and placement of stocks abroad. The vast majority of larger enterprises continue to rely on internal funds, payables, and arrears, and to a small extent bank (short-) term financing as the pri- mary sources of funds for sustaining and advancing their operations. In Western economies large banks have been changing their attitude towards SMEs, with the SMEs becoming one of the more important group of clients in their banking operations. This may be due to compe- tition from the rapidly deepening and globalizing capital markets, which allow more and more (typically large) companies to raise funds through bonds, stocks, and similar vehicles rather than the traditional bank loans (for example, securitization). Seeing their interest income, as a propor- tion of the total income, falling over a number of years, British, Dutch, German, French, and other banks are hard pressed to find new clients for their lending business. This development also reflects the growth of cred- it-scoring techniques, which have improved the capacity of banks to as- sess, monitor, and diversify SME credit risks. Thus, challenged by the growth of capital markets, Western banks have developed a wide array of flexible financing products to SMEs, including risk finance (such as convertible subordinated loans), as well as soft loans8 and lower banking fees for start-ups. Banks also set up special-purpose funds that provide equity (including seed capital) to young enterprises. It is unrealistic to expect that all large Russian enterprises will gradu- ate soon from bank financing and rely solely on capital markets for their external financing means, which would prompt the banks to look for new clients down the corporate hierarchy line. The large Russian firms will remain desirable clients of the banks for a foreseeable future. Ex- pansion of SME access to bank financing in Russia will thus depend on a number of factors, including the speed of saturation of the large corpo- rate lending market and the growth of the banks' deposit base. It can be expected that even in the medium term, trade finance and internal funds will remain the primary sources of funds for the SME sector. One of the major reasons for underperformance of the Russian bank- ing sector as an effective channel of private savings to the real sector has been the lack of a proper credit culture throughout the economy. While ENTERPRISE ACCESS TO FINANCING 323 bigger and financially stronger enterprises may see banks competing for their business, even these successful lenders indicate that the credit they provide is less in volume and worse in terms (higher interest rates, shorter maturities, larger collateral, etc.) than they could otherwise provide, had there been a safer legal and contract enforcement environment. There are positive examples of Russian banks working efficiently and profitably with small businesses and individual entrepreneurs, although this does re- quire astute management of credit risks. Box 13.2 provides some exam- ples of international financial institutions using safeguards to manage credit risks related to on-lending operations through Russian banks. Absence of a proper credit culture prevents the flow of private savings to financial intermediaries and further to the real sector of the economy. Box 13.2 Safeguards in Managing Credit Risks Both the World Bank and the European Bank for Reconstruction and Development have expe- rience in administering credit lines in Russia. On the whole the experience with these credit lines demonstrates that credit risks can be managed with minimal losses, even in an environ- ment where the institutional and legal framework is weak. This does, however, require that cer- tain safeguards are in place. In the case of the micro-credits provided by the EBRD, these safeguards include providing technical assistance in the form of long-term credit advisers. While the World Bank also provided services to the banks to support the upgrading of their in- stitutional capacity, the Bank relied predominantly on close prior technical review of the indi- vidual subprojects. This technical review process included clear guidelines, as illustrated below. * Related/connected party loans should be avoided, unless they are made on an arm's- length basis; otherwise they are losses by definition. * If local governments are to extend guarantees to the lenders in cases of socially important projects, such loan-securing guarantees must have the appropriate approval of the local legislature and must be supported by clearly assigned assets. * To properly secure a credit, cash-generating assets should be identified, discounted, and pledged. These assets usually take the form of machinery and equipment or real estate and buildings/constructions, depending on what is being financed. Legislation permits credi- tors to secure their rights based on the provisions of pledge agreements, and does not re- quire court procedures for foreclosing the collateral-as long as the pledge agreement is fully documented and the bank has undertaken full due diligence regarding the terms of the pledge. * Cash flow created by a borrower and its affiliates should be "locked" for debt repayment. For this purpose, and in addition to adequate collateral, such instruments as personal guarantees of the major owners and top managers and corporate guarantees of the com- panies related to the borrower should be provided. Good practice requires creditors to keep distinct within their organizational structure the re- sponsibilities for proper appraisal, documentation, and sale of collateral, in the case of non- performance of loans; banks should also ensure, for their self-interest, that collateral is always duly documented in accordance with Russian legislation. 324 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR As outlined in Chapter 2, Russian banks would lend more and cheaper funds to enterprises for a longer period of time if they were more certain that, in the case of a borrower's default, their legitimate secured claims would be enforced with minimum headache and possibility of losses to the lenders. The burden of proof should fall on the debtor. Enforcement procedures should be simple and quick to allow creditors to obtain expe- ditious recoveries of the impaired assets. ENDNOTES 1. Electricity suppliers were given a clear mandate by the authorities to reduce their accounts receivable and increase cash collections for the electricity by the users, which in turn triggered the business users to increase cash collections from their customers. See also Box 13.1. 2. These can be family and friends for smaller companies; medium-size com- panies may receive short-term financing from their financially stronger cus- tomers or peer enterprises belonging to the loosely organized informal business groupings. 3. For instance, a customer of a company-veksel issuer would purchase the veksels at a discount with an expectation to use them for paying the issuing com- pany for its production. 4. Veksels are used to facilitate offsets when one party trades an obligation (e.g., taxes due) to satisfy a debt owed by another party. 5. Gazprom even issues two-year veksels. 6. According to anecdotal evidence, veksels have to be protested formally through a notary public before they are sent to a judge. Bailiffs then enforce them. Although there are legal ways for the issuer to prevent immediate enforce- ment, veksels are reported to be more easily enforceable than other credit instru- ments. 7. A proposed federal law was rejected by the Federation Council in 2001. As of early 2002 a joint Duma and Federation Council commission was on the process of redrafting the law to reflect the changes proposed by the Federation Council. 8. Available through different schemes involving government support, or co- operation among banks and industry associations, chambers of commerce, etc. REFERENCES Commander, Simon, Irina Dolinskaya, and Christian Mummsen. 2000 October. "Determinants of Barter in Russia: An Empirical Analysis." Working Paper No. 00/155. IMF European II Department Series, Washington, D.C. ENTERPRISE ACCESS TO FINANCING 325 IC Region (Investment Company Region). 2001. Website: www.regnm.ru. IMF (International Monetary Fund). International Financial Statistics. Website: www.IMF.org. Klepach, Andrei. 1999. "Russian Economy on the Verge of Growth or Stagna- tion?" Institute of Economic Forecasting of the Russian Academy of Sciences, Moscow. Pinto, Brian, Vladimir Drebentsov, and Alexander Morozov. 2000. "Dismantling Russia's Nonpayments System: Creating Conditions for Growth." Technical Paper No. 471. World Bank, Washington, D.C. Solntsev, O., and M. Khromov 2001. "Banking system in 2000-2001: Trends and Perspectives." Center for Macroeconomic Analysis and Short-Term Forecast- ing. Institute of Economic Forecasting of the Russian Academy of Sciences. Moscow. Website: www.forecast.ru/_archive/analitics/Banks/ForBanks.asp. CHAPTER 14 Capital Market Development Since the beginning of the transition, considerable progress has been made in establishing the foundation for the Russian capital market. While market activity and capitalization suffered from the financial crisis in 1998, the market architecture-institutions and technical infra- structure-have proven to be robust. A network of regional stock ex- changes has been established. Trading systems for stock, bonds, and for- eign exchange have been established and are well-tested. Share registries and depositories now generally maintain reliable and accessible records. Regulatory authorities with responsibility for supervising various parts of the capital market are in place. More recently the authorities have also turned their attention to the complex tasks of upgrading regulatory en- forcement and introducing improved corporate governance practices. Al- though much has been achieved during the first decade of transition, there still is a considerable outstanding agenda because of the complex nature of capital market transactions. The purpose of this chapter is to describe the major components of this agenda. THE MASS PRIVATIZATION PROGRAM Capital market development in Russia originated with the Mass Privati- zation Program that began in Russia in 1992. Rather than developing the capital market, the primary objective of this program was to facilitate the transfer of ownership in business enterprises from the state to the private sector. It was expected that the new owners would promote restructuring 327 328 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR and good governance in ways that would maximize their returns. It was also assumed that the laws and regulations for governing commercial and financial markets would be developed and applied quickly in order to create an enabling environment for a free market economy. As far as development of the capital market was concerned, the Russian privatiza- tion experience was a mixed blessing for the following reasons: 1. As a result of the exercise of the second of three privatization op- tions (51 percent to management and worker's collectives), major- ity control passed to existing insiders, many of whom had no in- terest in delivering value to anyone but themselves. An average of up to 65 percent of the shares of privatized companies were under insider control, and only 22 percent were in the hands of external shareholders (Pistor and Spicer 1997). 2. The vouchers were in bearer form, enabling large investors with cash to acquire vouchers from citizens, and hence significant stakes in enterprises, at low prices. 3. Many larger enterprises, particularly in the commodity sectors, were held back for strategic reasons, but were later acquired in 1996 by financial and industrial groups via the loans-for-shares scheme. Government still owns more than 25 percent of the equi- ty in more than 2,500 joint stock companies, and a golden share in an additional 580 companies. This may have had a direct effect on the diminution of net worth of these companies (OECD 2001). Thus although the privatization effort was meant to spread the own- ership to many, it actually concentrated the ownership into the hands of management. This concentration has been the source of many of the ills in the Russian economy. The command economy had been dismantled without being replaced by the basic elements of a law-based economy, and the necessary underpinnings of a market economy had not yet been put in place. The following were some of the missing structural elements: an adequate legislative base to define the rights of owners, creditors, and shareholders, and the fiduciary duties of directors; the ability to enforce ownership rights and contracts in the courts, where decisions often went in the direction of the most powerful litigant; effective supervision-that is, the state control mechanisms that previously had been able to insist on compliance within a command economy, were totally unsuited to a market economy; and a fully operational banking and payments system. Due to lack of an adequate foundation, outside shareholders had no means to insist on good governance; creditors had no means to seize col- lateral in the event of defaults; and widespread abuses in corporate gov- ernance occurred. Some of the salient abuses of corporate governance are asset stripping (sales of assets to companies controlled by family and CAPITAL MARKET DEVELOPMENT 329 friends at: prices far below current market values); transfer pricing (sales of products at "fire-sale" prices to affiliated intermediaries, who then resold the products worldwide at attractive prices); and share dilution (is- suance ol new shares to dilute the voting rights of current shareholders). The new owner-managers had little enthusiasm to restructure their en- terprises, and were able to find few sources of outside finance available. Privatized enterprises at best stagnated; at worst, became insolvent. At the same time, the Government's budget deficit remained at around 7 percent of GDP from 1995 to 1997, with consolidated government ex- penditure remaining at around 44 percent. Unable to raise adequate rev- enue frorn taxes, the Government was forced to turn to borrowing in the market at ever-increasing real rates of interest. Even at their lowest rates, in 1997, yields on government paper averaged 25 percent to 30 percent, despite a fall in inflation to 15 percent. Banks borrowed heavily in foreign markets to finance their speculative activities in the government bond market. The culmination of this process was the default by the Govern- ment on its domestic debt in August 1998, which together with a weak- ening ruble, virtually destroyed the banking system and shattered the con- fidence of investors in the capital market, both foreign and domestic. Financing Void Missteps with the privatization program led to the present financing void; external financing of the Russian private sector is now largely non- existent. The following are some outcomes of that void: 1. Many of the internally generated earnings were stripped from en- terprises by new owners, which left many companies as just husks. 2. Banks did not develop as significant providers of short-term fi- nance, except to the Government and to the enterprises within their circle. 3. The corporate bond markets were initially crowded out by the Government's borrowing program and subsequently by the inabil- ity to identify and enforce collateral obligations-only during 2001 did several Russian companies start issuing corporate bonds. 4. The market for government debt has not yet been restored fol- lowing the 1998 crisis. 5. Equity markets are a complement rather than a substitute for these other forms of finance; they were simply unable to function in isolation following the crisis. The scale of the financing void is illustrated in Table 14.1, which com- pares the size of markets for bank finance, debt, and equity in different countries. It demonstrates clearly the sheer lack of scale of the Russian 330 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR financial markets as a source of finance for both Government and the private sector, even compared with other transition countries. The for- mal financial sector in Russia is still very small. As the Russian economy continues to recover from the 1998 crisis, en- terprises will have to rely more on outside finance than they have in the past. The failure to create an efficient system of financing enterprises in which lenders and investors will have the confidence to lend to or invest in third parties will severely curtail the ability of entrepreneurial and well-managed companies to grow. Indeed, if Russian enterprises are to expand effectively, they cannot continue to rely on internally generated funds and short-term borrowing (see Figure 14.1). Due to their reliance on debt financing, Russian enterprises are vul- nerable to sudden changes in interest rates, especially as enterprise debt is very short-term. As of December 2000, more than 80 percent of total loans outstanding to enterprises had maturities of less than one year, and Table 14.1 Financial Market Depth, 2000 M2 (Money and Bank Claims on Quasi-Money) Private Sector Total Bonds Total Equity US$ % of US$ % of US$ % of US$ % of Country billions GDP billions GDP billions GDP billions GDP Russia 55 22 31 12 9 4 39 16 Czech Republic 37 76 25 50 8 15 11 23 Hungary 20 44 11 26 13 28 12 26 Slovak Republic 18 94 6 31 2 13 1 4 Poland 68 41 41 26 20 12 31 19 France 656 51 942 73 716 55 1,475 114 Germany 1,179 63 2,280 122 1,178 63 1,432 76 Italy 599 56 775 72 941 88 728 68 The Netherlands-* 326 89 501 137 197 54 695 190 United Kingdom 1,570 111 1,899 134 565 40 2,933 207 Japan 5,797 126 5,175 112 4,967 108 4,547 99 United States 6,084 61 4,846 49 10,768 108 16,635 168 *Bonds are defined as debt securities with maturities of greater than one year. Total bonds comprise government bonds and corporate bonds. For all developed countries and Russia, bonds data are as of September 2000. **Data for the Netherlands are for bank claims on the private sector for all residents of the Euro Area. Sources: IFC Emerging Markets Bonds Electronic Database; IFC Securities Market Development Group Database-2001; IMF-International Financial Statistics (IFS) January 2001; IMF-IFS Elec- tronic Database (SIMA); BIS Quarterly Review, March 2001; IMF-Report on Post Program Moni- toring Discussions; Deutsche Bundesbank Monthly Report-April 2001; EIU-Country Profiles- Russia (2000); Central Bank of Russia electronic database. CAPITAI MARKET DEVELOPMENT 331 Figure 14.1 Sources of Corporate Finance in Russia (percentage of respondents using various financing forms) 0 50 100 = Equity Debt financing Internally generated Source: Russian Corporate Governance Round Table 2000. less than 7 percent had maturities of more,than three years. As a result of these developments, a number of directors have more recently shown a willingness to seek outside finance; but of.those who were interested, 76 percent said that they could not find ways to raise the capital they needed (see Figure 14.2). It may be that the respondents were unaware of the complexities of raising money through capital markets or unwilling to entertain the po- tential dilution of their controlling interests, which usually results from issues of new equity to outsiders. However, there are signs that enterpris- es are becoming more interested in outside finance, since in 1996 only 19 percent of surveyed companies were interested in raising money through private placement of new issues of shares, and only 17 percent were in- terested in public offerings. Much of the supporting technical infrastructure required to support the capital market has been created: banks exist, as do stock exchanges, foreign exchange and commodity markets, together with their associated clearing, settlement, and registration procedures. However, turning the 332 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR capital market into a reliable financing mechanism for industry and com- merce will require implementation of further reforms. While there is strong evidence of a correlation between economic growth and the development of financial markets in general,' there is less strong evidence that a bank-based or market-based financial system pro- duces a better result. In Caprio and Honohan's Finance for Growth (2001), the authors comment, "A radical preference in favor either of markets or of banks cannot be justified by the extensive evidence now available. Instead, development of different segments of the financial sys- tem challenge the other segments to innovate, to improve efficiency, and to lower prices." It is noticeable, however, that countries that have had the strongest bank-based systems, Germany and France, are moving increasingly to- ward more capital market-based systems. This may be influenced by the Anglo-American model, which tends to be more market-based. The Japanese or Korean model, on the other hand, tends to be more capital Figure 14.2 Enterprise Use of Equity Finance (percentage of respondents using equity finance) 120 100 80 - 60 40 20 0 I l Using equity Interested _ N°o YES Source: Russian Corporate Governance Round Table 2000. CAPITAL MARKET DEVELOPMENT 333 market-based and features a series of cross-ownership of companies with- in zaibatsu or chaebols (similar to Russian FIGs). When these systems failed, they left the banking system in both countries virtually insolvent. Regardless of whether a system is bank-based or capital market- based, there is evidence that "the proportion of firms that grow at rates that cannot be self-financed is positively related to development of both the securities markets and the banking system" (Demirguc-Kunt and Maksimovic 2000). Does Russia need to develop its own capital market? It is hard to be- lieve that any country looking to maintain an independent exchange rate can move ahead without a domestic capital market-the void would compel borrowers and issuers, including the Government itself, to seek all their financing abroad. Even though large companies can and do raise money in international markets, medium-size companies will still need a more accessible-and cheaper-domestic market to serve their needs. Equally important, investing institutions will need domestic instruments in which to invest, unless a country adopts the U.S. dollar as its currency and all exchange controls are dismantled. Weak Corporate Governance and Law Enforcement One of the most important reasons that investors are hesitant to invest in or lend to enterprises has been Russia's notable failure in the area of cor- porate governance. The inability to rely on enforcing rights either as shareholders or as lenders has been exacerbated by the opaque structures of many companies and the inadequate disclosure of financial data by them. Table 14.2 illustrates why the Russian enterprises have been un- able to attract outside investors. The lack of trust in Russia's corporate governance has been evidenced by the inability of the courts to enforce commercial contracts, the unwilling- ness of banks to lend to any but known customers within their affiliated Table 14.2 Reasons for Inability to Attract Outside Investors Reason % Past violations ol shareholder rights 95 Unfriendly attitude of local authorities toward investors 86 Absence of independent directors 67 Close relations with FIGs 57 Source: Russian Corporate Governance Round Table 2000. 334 BUILDING TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR group, reluctance (or inability) of investors to engage in the management of the companies in which they might invest, and unwillingness of the small savers to place funds with banks and other savings institutions. Policy Designed to Restore Trust There are many signs that the Government and the private sector are be- coming more fully aware of the defects that will continue to hamper eco- nomic revival if they are not tackled and corrected. These changes need to be far more fundamental than merely tinkering with capital market mechanisms or inventing new instruments. One of the key indicators of this new awareness is the program pre- pared by the new Government in 2000, based on the vision provided by the so-called Gref Plan. The Gref Plan recommends that general policy objectives should be as follows: Only the rapid development of national capital, the establishment of a favorable business climate, and efforts to ensure economic free- dom will make Russia a country that is appealing for investment. Starting conditions for shaping an effective economic system and a favorable business climate include affirmation of the rights of pri- vate ownership (primarily of land and real estate), the protection of these rights, the creation of equal terms of competition, and the de- velopment of stable and effective financial institutions. The Govern- ment must also strike an optimal balance in mutual relations with private enterprise by gradually abandoning the practice of excessive intervention in business affairs. This, in turn, will make it possible to clearly demarcate the sphere of Government regulation and enhance its effectiveness. REFORM OF THE RUSSIAN BANKING AND PAYMENTS SYSTEM No capital market can operate efficiently, if at all, without a banking sys- tem. The banking system in Russia is small in absolute and relative terms and underdeveloped relative to countries with similar per capita income. Underscoring low public confidence in the financial system is the fact that a large amount of savings is held outside the financial system in hard currency. Without a functioning banking and payments system, contributions cannot be made to pensions, insurance, or savings schemes; payments of CAPITAL MARKET DEVELOPMENT 335 pensions, insurance policy proceeds, dividends, or interest cannot be made; settlements cannot be reliably made for purchases or sales of as- sets; and temporary liquidity cannot be safely held. Reform of the Russ- ian banking and payments system is critical to the ability of capital mar- kets to function reliably and effectively and to encourage broader participation by the Russian public. Without a functioning banking and payment system, participants in the capital market will lack confidence that investment rewards will be received at a reasonable cost and within a reasonable period. DEVELOPING THE GOVERNMENT DEBT MARKET The development of capital markets depends to a large degree on the de- velopmerit of an efficient and trusted market for sovereign debt. Ineffi- cient government debt issuance creates a series of problems for capital markets. First, sovereign debt provides a risk-free asset for banks to in- vest in. A dearth of such assets lessens confidence in the banking system. Second, a well-functioning sovereign debt market acts as a benchmark for corporate debt issuance and provides a basis for stock exchange and OTC market development. Third, sovereign debt provides a risk-free asset for pension funds and insurance companies to match their liabilities and against which they can measure returns from other asset classes. While the current fiscal position of the Russian federal Government is strong, institutional and policy problems continue to prevent the Russian Federation from restoring its credit rating (currently B-), according to Standard & Poor's rating agency. Some of these factors are more technical and can be addressed with prompt institutional reform measures. Howev- er, a protracted period of good performance, which would allow every- body to forget about past experiences, is the only effective solution. The Government should make visible efforts to enhance its debt management practices and communicate that enhancement to market participants. Several weaknesses in sovereign debt management, which played an important role in triggering the sovereign default of August 1998, still re- main to be addressed. The following are key aspects of improving debt management practices: 1. Closer coordination between monetary, fiscal, and debt manage- ment policies 2. Switching from the short-term focus to a strategic focus in sover- eign debt management, improving coordination between issuance of external and domestic debt 336 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCLAL SECTOR 3. Improving treasury cash management procedures 4. Enhancing transparency in government borrowing policy 5. Strengthening portfolio risk management, improving controls on the borrowing operations of local Governments and state-owned enterprises 6. Installing better data management facilities to support decision- making and investor relations. During the 1990s, new debt management units were created in re- sponse to the emerging need to manage sovereign domestic and foreign debt policies, to manage foreign and domestic debt market sales and re- demptions, to manage the Treasury's cash position, etc. However, as a re- sult of this organic growth, the management of the Government's liabili- ties became fragmented, coordination among the units and agencies involved was inadequate, and their mandates overlapped. State liability management is still organized in the Ministry of Finance by product and not by function, as suggested by best international practice. Scenario analysis suggests that the debt situation in Russia, while tense, is far from catastrophic. It is set to improve in the absence of new shocks. Under the assumption that Russia's export growth slows down after its spectacular performance in 1999-2000, and stabilizes at a modest 2 percent in 2001-04, Russia's debt-to-GDP ratio is projected to decline below 50 percent after 2001, which indicates a fairly stable and improving solven- cy position. Russia's liquidity situation is also projected to remain stable under this conservative growth scenario. If structural reform progresses faster, and Russia succeeds in diversifying its exports beyond the energy sector, the debt ratios will decline even more quickly. However, should exports decline significantly-were oil prices to drop to $20-$22 per barrel and structural reforms to stall-the debt situation would deterio- rate again. Under this scenario the external liquidity problem would reemerge. In 2000, Russia's external debt stood at 74 percent of its GDP-a high, but not critical level if judged from the long-term solvency perspec- tive. Countries with less abundant and diversified resource bases than Russia have been known to carry debt burdens in excess of 100 percent of GDP without interrupting their debt service payments. However, in the short term, the regularity of debt service payments may be affected by a particularly disadvantageous profile of debt payments ("bunching" of large amounts of payments in a short period of time, which sharply in- creases the refinancing risk). Even if a country were solvent over the long term, it may experience serious short-term problems with servicing its debts. CAPITAL MARKET DEVELOPMENT 337 In 2000 the MoF started working on a new government debt manage- ment strategy, which is built around the idea of creating an independent debt management agency. This project, although still in the design stage, is probably the most important part of the work needed to restore the government debt market. Only by consolidating all the information needed to enable one agency to have a full overview of outstanding debt and the responsibility for managing it can real progress be made to re- store Russian sovereign debt as an investment instrument. From the perspective of private sector issuers, in industrial as well as transition countries, a government debt market is vital for a number of reasons apart from the need for the Government to finance itself: 1. Tthe establishment of a risk-free benchmark rate and a well-defined yield curve against which issuers may price corporate debt issues 2. Thie credit rating of government debt will affect the rating of cor- porate issuers 3. The trading and settlement facilities for government debt can also be used for corporate debt 4. The absence of a market for government securities will inhibit the development of institutional investors such as pension funds, in- surance companies, and mutual funds, all of which need to be able to invest in a risk-free asset class. Government debt stands at the top of the asset classes that are avail- able in developed markets, and if the market for government debt is inef- ficient, it is unlikely that other asset classes will flourish. The choice of domestic securities to be issued should be geared to offer a predictable supply of standardized securities, to facilitate the activities of dealers ready to place securities with nonfinancial investors, and to support. some selected points of the yield curve. Contrary to what had been the case in Russia prior to August 1998, the regular issue of a limited num- ber of standardized securities would be advisable. It is also important that the MoF develop refinancing techniques to manage the bunching of maturities and smooth its cash position. A strategy should be developed to better cope with the eventual recur- rence of serious market turbulence. Issuing, for as long as necessary and under a regular schedule, some very short-term T-bills (mainly four- week, but also one-week if necessary) would be one component of such a strategy. Auction procedures should be geared to maximum transparen- cy, leaving as little scope to discretion as possible so that maximum auc- tion participation is encouraged and the Government is perceived to be fully transparent in its efforts to finance its own activities and support the development of financial markets. 338 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Once primary issuance has been improved and confidence has been restored, additional work will be needed to support the development of secondary trading. Government Debt-Recommendations There is no doubt that public debt management is a crucial area of pub- lic policy. A strategy needs to be developed to address the following points: 1. A clear debt strategy should be formulated and supported by strong analytical capacity and with a requirement that the decision- making process become transparent. 2. Close coordination between internal and external debt manage- ment is needed within a single debt management office. 3. The legal foundation for sovereign debt issuance should be strengthened, clearly identifying the rights and obligations of is- suers and purchasers. 4. Investment should be made in a computerized and standardized debt information system. 5. A cadre of skilled debt management professionals should be trained and sustained. MOBILIZING SAVINGS While there is no lack of savings and investable funds available within the Russian market, the mobilization of these savings is undermined by lack of trust. The challenge facing the Government is to find ways to channel these funds into the formal financial markets, both for banking products and securities. In trying to stimulate investment in securities, investor compensation schemes have been considered from time to time. These are complex and difficult to devise without exposing the Government or the financial services industry to open-ended commitments. While compensation schemes may help to restore trust, in the long run only the existence of demonstrably honest and competent financial institutions will attract in- vestments. The Government has also embarked on creating a mandatory "second- pillar" pension fund. Significant volumes of funds would become avail- able to the market if such schemes were organized so that the funds were invested on the domestic market. An important concern here is that the CAPITAL MARKET DEVELOPMENT 339 capital market is not yet ready to receive such large flows. The success of such schemes depends on there being a sufficient number of reliable in- vestments in which to place accumulated funds. The danger is that the "elephant in the swimming pool" effect might be created, such as in Ka- zakhstan, where mandatory second-pillar schemes, introduced in 1998, have reached a value of $1 billion, and there are simply not enough in- struments in which the funds can invest. This has had the effect of driving down yields on bonds to unreasonably low levels. Creating pension schemes requires a great deal of work-actuarial, legislative, and regulatory-and, although the Duma has passed a Law on Mandatory Cumulative Financing of Pensions in the Russian Federa- tion, much more work on detailed regulations and implementation re- mains to be done. The law stipulates that the state will be the primary administrator of the scheme but outside asset managers and custodians will be used. As of October 1, 2001, there were 372 licensed nonstate pension funds with a value of around US$970 million.2 The five largest funds ac- counted for around 60 percent of total assets. At the end of March 2001, there were 39 investment funds in opera- tion, of which 22 were open-ended and 17 were of the closed-end type. There were a total of 35 licensed management companies, but only 24 were actually operating funds. The total value of these investment funds is arouncl $212 million.3 The Law on Investment Funds, approved in late 2001, is considered very important by the securities industry, as well as the Federal Commis- sion for Securities Markets, as laying the foundation for more wide- spread savings mobilization. Recommendations for Mobilizing Savings While various measures are under discussion presently-such as tax in- centives to invest in funds or other assets, and mandatory second-pillar pensions--the problem remains that successful investing in such institu- tions is dependent upon the availability of good quality assets to buy. These initiatives would contribute significantly to the pool of savings and could stimulate the issuance of new securities. Thus, it is important that the reforms suggested in this chapter be adopted so as to build confi- dence in the Russian capital market-ensuring that assets acquired by in- vesting institutions are of good quality and that savers earn reasonable and reliable returns. 340 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR IMPROVING CORPORATE GOVERNANCE The result of poor corporate governance practices in Russia has been seen in the reluctance of foreign investors to provide new equity or debt capital to the Russian corporate sector after the crisis of August 1998. For example, as of September 1999, the market capitalization of one major Russian oil company was less than one percent of western com- petitors (Black 2001). By the end of 2001, the company's market capital- ization was almost seven percent of western competitors. The scorecard in Table 14.3-developed by the World Bank-analyzes the current state of corporate governance in Russia. Despite weak corpo- rate governance practices, there are several recent measures (common business practices and legal and institutional reforms) that have helped to strengthen corporate governance in Russia. The measures include election of independent directors,4 accessibility to company charters, an initiative by the FCSM to introduce a code of corporate conduct for directors, cod- ification of liability for members of boards of directors as well as compa- ny managers, development of private sector-initiated ratings and scoring services on companies' corporate governance practices, and emergence of a corporate bond market. Work already in progress on corporate gover- nance issues includes work on the Joint Stock Companies Law and Secu- rities Law summarized in Table 14.3. Recommendations for Corporate Governance The two priority areas under corporate governance are (1) to increase transparency of the ownership and control structures of corporations and (2) to improve the quality of financial information made available to investors and other stakeholders. Clarification of the ownership position of a company's major share- holders would provide other stakeholders-minority investors, creditors, workers, and even the government tax collectors and FCSM-with the needed information on which to make decisions for investing time and capital in the company. Furthermore, full disclosure of ownership posi- tions would give stakeholders (and particularly investors) the important information needed to understand the motivation of company managers and controlling shareholders as they present their corporate restructur- ing plans. The Securities Law requires that investors with 20 percent or more of a company's shares must disclose their holdings, and the Law on Joint Stock Companies obliges companies to maintain (and make avail- able to shareholders) lists of affiliated persons. However, even for large CAPITAL MARKET DEVELOPMENT 341 Table 14.3 Corporate Governance Scorecard for Russia Market and Regulatory Overview Remarks Market capitalization (percent of GDP) $52 billion (20% of GDP) Number of listed companies on stock 102 246 companies traded on RTS (largest trading exchange system in Russia) Legal system (origin) Civil law Judicial system Weak Considered open to corruption and abuse Publication in English of company Yes Company laws available through commercial laws, listing requirements services, listing requirements on internet Powers of the capital markets regulator Weak Can suspend securities issue, delist securities. Limited ability to sanction Regulator established by special law Yes Stock exchange and other trading floors Yes RTS, Micex, other exchanges and trading floors in Moscow Cross shareholdings by companies No No restrictions on cross-holdings, but financial and banks restricted industrial groups are required to register as FIGs Shareholders' Rights One share, one vote Yes One-share, one-vote required for all common shares Proxy (mail-in) voting permitted Yes Voting by proxy permitted, including mail-in voting Cumulative (rather than proportional) Yes Mandatory for companies with 1,000+ share- voting mandatory for board of directors holders; optional for others Ouorum requires at least 50% of shares Yes But if not achieved, second meeting requires only 30%. Companies with 500,000+ share- holders may set by charter lower quorum for second meeting. Super-majority shareholder approval No Decisions made by 3/4 of shares participating at to amend company charter shareholders' meeting i.e., with quorum at 30%, decisions can be made by just 22.5% of shares. Super-majority approval for asset No 25 to 50% of company's asset book value can transfers/increase in charter capital be transferred by unanimous decision of board of directors. Larger assets require approval of shareholders' meeting. Capital may be increased by up to 25% by unanimous approval of board of directors, if charter so permits. Larger increases require approval of 3/4 of shares participating at shareholders' meeting. Right to call extraordinary shareholders' Yes Shareholders with 1 0%+ of voting shares may meeting call extraordinary meeting. Shareholder right to add to meeting Yes 2% of shares can propose items for the agenda agenda of shareholders' meeting. Disclosure of shareholder list Yes Available to shareholders with 1 % of shares. Redress against violations on minority Yes Derivative suits legally possible but never used. No workable mechanisms of class action to protect interests of unspecified number of shareholders. Take-over code Yes But limited to a single article in Law on Joint Stock Companies. (Table continues on next page) 342 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR Table 14.3 (continued) Market and Regulatory Overview Remarks Mandatory tender offer in change No But must offer to buy remaining shares after of control purchase of 30% of shares. Prohibition of deals using insider No Law on Securities has general prohibition on trading/code of ethics encouraged deals using insider trading, but no monitoring mechanisms available. No codes of ethics in place. Preemptive rights Yes Only applicable to open share subscriptions. For closed share subscriptions, preemptive rights available to shareholders not voting at meeting or voting against the share issue. Independent registrars Yes Mandatory if company has 50+ registered shareholders. Oversight of Management Clearly defined role for board members Yes Some definition in Joint Stock Company Act. Company charter may include more definition. Independent directors required No The law does not require independent directors, but limits executive management to less than 25% of the board of directors. Disclosure of board members Yes Names of board members required under Secu- rities Law to be specified in the prospectus and in quarterly reports. Periodic election of board members Yes At annual shareholders' meeting Audit committee required No Revision commission required but is not part of the board of directors. Minimum training/experience of No None required board members Disclosure and Transparency Partial Shareholders must disclose direct holdings of Disclosure of ownership/control 20%+ of shares and companies must keep lists structure of affilated parties. But there is no requirement for disclosure of indirect shareholdings under the securities legislation. Annual independent audit Partial External auditors approved by Yes But annual compensation approved by board of shareholders directors Public availability of company audits Yes Compliance with ISA Partial Auditing law close to ISA Compliance with IAS No Major differences from IAS. No write-off of obsolete inventory or bad debt. Assets listed at cost (not fair market value). No disclosure of guarantees. Consolidated statements Yes Disclosure of related-party transactions No Company officers-related disclosures Yes Disclosed in prospectus and quarterly reports Disclosure of price-sensitive information No Risk management disclosures No Public availability of company charters Yes Companies legally obliged to provide, but sometimes difficult to obtain CAPITAL MARKET DEVELOPMENT 343 publicly listed and actively traded companies, there are no effective re- quirements for disclosure of ultimate shareholding and control struc- tures, thus requiring that minority shareholders and other stakeholders rely on information available through foreign listings, or on rumors in the marketplace. In particular, the commonly used structure of "floating satellites" allows companies to transfer assets among affiliated firms and transfer profits among the subsidiaries without adequately informing shareholders and other stakeholders who have a keen interest in the fu- ture viability and profitability of the corporation. In Russia some information currently can be obtained by requesting the shareholder list from the share registrar. However, the information often includes only the direct shareholders and not the indirect and ulti- mate owners. The Transparency Directive of the European Commission requires disclosure to the company and the national authorities when a natural person or legal entity holds (directly or indirectly) more than 10 percent of the voting rights of a publicly listed corporation. The meas- ures described below are designed to improve the quality of corporate fi- nancial information. The intention is to define the roles, responsibilities, and obligations of the (supervisory) boards of directors; encourage the creation of audit committees within the (supervisory) boards of direc- tors; increase the liability for auditors; and strengthen the ability of the securities commission to apply sanctions. The FCSM has developed a Code of Corporate Conduct that would provide useful guidance to directors. The FCSM expects that the Code will provide a set of working guidelines for Russian joint stock compa- nies, as well as for investors, both domestic and foreign. The FCSM also anticipates that as the norms and principles in the Code become part of common business practice, they will become minimum requirements for corporate governance in Russia. In addition, it is expected that the Code will set an industry standard against which the liability of directors can be determined. In addition, it may be helpful to consider guidelines that are still more detailed than those in the Code of Corporate Conduct. Business advisory task forces ranging from the Dey Commission in Canada to the Cadbury Commission in the United Kingdom have recommended that the stock exchanges develop detailed guidelines for boards of directors. Based on best practices worldwide, the guidelines could provide detailed guidance on such areas as procedures in which board members are selected and re- moved, the procedures for setting agendas for the board meetings, meth- ods of establishing adequate compensation for board members, and re- quired experience and training for board members. As part of the 344 BUILDING TRUST: DEVELOPING THE RussIAN FINANCIAL SECTOR program, it may be helpful to also provide training for board members (as is planned as part of the emerging institutes of directors), particularly in the important aspects of new accounting and auditing laws. In addi- tion, audit committees should be established for joint stock companies whose shares are publicly traded. The Joint Stock Company Law does provide for the creation of an "audit commission" (also known as a revi- sion commission) but its responsibilities are limited. The proposed type of audit commission would be a committee within the board of directors that would report to the (supervisory) board of directors. The role of the audit committee should be to (a) review the financial audits prepared by the independent auditors and (b) meet several days a year with the inde- pendent auditors to discuss the financial audits, the management letter, and the auditor's recommendations on measures to improve the financial and management information systems used by the company. Generally the members of the audit committee should be taken from outside com- pany management or employees and should represent individuals with a good understanding of the international standards for accounting and auditing. Even with the introduction of International Accounting Standards and the use of International Standards of Auditing, additional reforms will be needed to ensure that independent audits provide meaningful financial in- formation to shareholders and other stakeholders. Consideration should be given to strengthening the minimum statutory liability of independent auditors, since by common practice the amount of an auditor's liability in Russia may be capped under the auditing contract. In some CIS countries, such as Kazakhstan, the amount of the auditor's liability is set relative to the amount of the company's share capital. However, most auditing firms have a small capital base and their assets are limited to office leases and computer equipment. In light of the crucial importance of the independ- ent audit, international best practice suggests that the amount of the audi- tor's liability should be a multiple of the auditing company's capital. Training of auditors will also be key, as will the interrelationship of the in- troduction of IAS with the basis of taxation of companies. While the Russian legal framework has been amended to strengthen the capacity of the FCSM, the Commission's ability to impose substantial fines is limited, which reduces the effectiveness of the Commission in su- pervising marketplace behaviors and compliance with the Commission's regulations. It may be helpful to increase the independence of the Commission from day-to-day political affairs, for example, by removing the legal status of the chairman of the Commission from that of a government minister and CAPITAL MARKET DEVELOPMENT 345 by establishing fixed terms for the members of the Commission. Strength- ening the ability of the Commission to apply economic sanctions would also help to ensure corporate compliance with the Commission's securi- ties regulations, but there must be checks and balances to ensure that such penalties are not applied for income to the Commission.5 In addition, it will be necessary to align the penalties that can be applied with the dam- age caused to investors-the higher the risk to investors, the higher the penalties should be-rather than administrative errors or failures that have no impact on investors. The Joint Stock Company Law gives some guidance to boards of di- rectors in establishing the price for the sale or transfer of large assets. The law states that the market value of the property should be "the price at which a seller, having full information about the value of the property and not obliged to sell it, would have agreed to sell it, and the purchaser, having fuill information about the value of the property and not obliged to acquire it, would have agreed to acquire it." It is proposed that transfers of corporate assets that represent more than 1 percent of company revenues should-on the instigation of mi- nority investors-be made subject to review by a specialist evaluation di- vision of the FCSM. If the decision of the FCSM is disputed, appeal could be made to the proposed independent capital markets tribunal (see below), with directors of boards being personally liable to pay fines and compensation if valuations are found to have been grossly against the in- terests of shareholders of the company concerned. LEGISLATIVE INITIATIVES The recent amendments to the Joint Stock Company Law, which came into effect on January 1st, 2002, are targeted at strengthening the pro- tection of shareholders. They include: 1. Provision of the preemptive rights to all shareholders for private placements as well as the public offerings (to prevent dilution of percentage ownership by placement of new equity only to major shareholders and/or their affiliates) 2. Fine-tuning procedures for notifying shareholders of shareholders' meeting and voting procedures at shareholders' meetings so as to improve protection of minority shareholders and reduce costs 3. Strengthening of the safeguards related to large transactions and with interested parties. 346 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR The Securities Market Law has also been amended extensively. Amend- ments important for improving corporate governance include (a) ra- tionalizing provisions regarding title registration for securities and recog- nition of ownership; (b) strengthening disclosure requirements for large open joint stock companies while relaxing those for small and/or closed companies; (c) enabling holders of depository receipts to participate in decision-making at shareholder meetings, which will be particularly im- portant in encouraging investment by foreigners and introducing corpo- rate governance practices commensurate with international best practice; and (d) clarifying identity and responsibilities of officials signing disclo- sure and offering documents. In addition, work is currently under way on the following: amend- ments to the Security Markets Law to support issuance of secured bonds and stock options; the Law on Investment Schemes, the Law on Regular- izing Relationships Connected with Placement of Securities Issued with- out Government Registration, the Tax Code, the Law on Issued Mortgage Securities, and the Law on Double and Ordinary Warehouse Receipts. As of January 2002, additional changes to the Securities Market Law were under consideration before the Duma. The changes sort out the problem of bond collateral. Currently a bond, as a security, simply repre- sents the right of a holder to receive repayment of their principal and in- terest, but not the right to take a borrower's assets, should a borrower default. The right of a holder to claim a borrower's assets is currently specified by a separate contract and is not embodied in the bond itself. This makes outcomes more complicated and unpredictable. Changes to the Securities Market Law will contain all the provisions to ensure that a bondholder has a right to claim the principal, the interest, and assets of a borrower in a case of default. One important step forward in encouraging the use of collective in- vestment funds in Russia is the enactment of the Law on Investment Funds. This law presents the legal foundation for collective investment vehicles, which previously had been governed only by a presidential de- cree and regulations of the FCSM. Recommendations for Legislative Initiatives It is suggested that focusing on broad measures that would improve trust by reducing the occurrence of abuses and ensuring effective punishment upon their occurrence would be productive interventions. Though such measures may be an extension of the FCSM's mandate, lobbying for such CAPITAL MAIRKET DEVELOPMENT 347 change and demonstrating the need for it would be an appropriate role for the C:ommission to play. There is a lack of clarity regarding the responsibility for enforcing par- ticular laws. Establishing greater clarity as to which agency is responsible for enforcement of particular (parts of) the law would strengthen the man- date of the agency and prevent duplication/confusion about initiatives re- lated to enforcement. The following is a broad range of high-priority leg- islative initiatives: 1. Laws such as the Joint Stock Company Law should clearly identi- fy a body responsible for their enforcement, how that body is ac- countable for such enforcement, and to whom (usually Parlia- ment or through a ministry to Parliament); and what that body's mandate is and what its powers are. These powers must be suffi- cient to make compliance an incentive. Responsibility for enforce- ment of the Joint Stock Company Law may be shared among sev- eral agencies, but this responsibility should in any event be clearly designated. 2. The Joint Stock Company Law should introduce a requirement for filing (for public access) all companies' charters, together with an- nual filing of all companies' reports and accounts, with a list of significant shareholders and directors, and a register of assets over which charges have been granted to lenders (i.e., where collateral has been given against loans). Certain other corporate information should also be required to be filed, upon occurrence of specific events, such as issuance of bonds or equities. Such requirements should be applied to all listed and traded companies by a certain deadline, and all companies, progressively graded by either share- holder capital or by turnover by a subsequent deadline. Penalties should be set for failure to comply with these requirements. 3. The Joint Stock Company Law should make disclosure of owner- ship, including indirect ownership of companies, mandatory, and it should empower company registrars to identify entities lying be- hind nominee holders and trusts whether onshore or offshore. 4. The rights of creditors regarding assets they have a claim to should be clarified; this applies both to credits secured in collateral (for further discussion, see Chapter 2) and in mortgage lending, where the lender is registered as the owner until the last mortgage pay- ment is made by the borrower. 348 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR ENFORCEMENT OF THE LAW A number of laws have been enacted in Russia to provide an enabling en- vironment for financial sector and private sector reform. However, many would argue that there is just too much new legislation leading to confu- sion in the interpretation of laws, given the many challenges faced by Russia's transition to a market economy. The sheer volume of legislation, decrees, and regulations, and the lack of clarity and consistency in many of them make it easier for the devious to find loopholes, and for the Gov- ernment to impose bureaucratic obstacles. Another problem lies in the inability of law enforcement officers to enforce the law and to be consis- tent and equitable. Russia's current taxation, judicial, and legal systems simply do not create sufficient incentives for fair and impartial applica- tion of the law. It is imperative that the Government and the private sector financial institutions support the implementation of legislation with actions, and that the rule of law prevails, not just the existence of laws. As noted in the OECD's publication, The Investment Environment in the Russian Federation (2001), "After all, the core element of the rule of law is that it applies in equal measure to the powerful and the non-powerful and that legal institutions have sufficient authority and independence to make meaningful the remedies imposed against the powerful." This is currently one of the greatest problems in the development of capital markets in Rus- sia, and recent comments by President Putin on the need for "a larger role and greater authority" for the judiciary are therefore to be welcomed. In 2001 the FCSM and its branches considered about 1,700 cases re- lated to breaches of legislation on protection of rights and lawful inter- ests of investors. More than 1,400 fine orders were issued for a total amount of 125 million rubles (see Table 14.4). Among other breaches re- viewed in the recent period, the FCSM had to impose sanctions in cases of failure to submit information to the FCSM by registrars, and failure to exclude the words "investment fund" from the names of several former voucher investment funds. For the first time in its practice, the FCSM considered cases where the share registrar illegally refused to record shareholders in the share registers. The FCSM claims that disciplinary sanctions have contributed to the improvement of information disclosure by company-issuers. So far the companies that have been fined have not repeated breaches, and virtual- ly all fines imposed by the FCSM have been upheld upon appeal. Effective enforcement requires effective coordination and cooperation between the regulator and the whole range of enforcement authorities. CAPITAL MARKET DEVELOPMENT 349 Table 14.4 Fines for Administrative Offenses in 2001 Number of Cases Number of Amount of Fine in Registration Office Considered Fine Orders Thousand of Rubles Central Office 216 216 64,790 Moscow 197 146 12,613 St. Petersburg 109 61 2,857 Sverdlovsk 86 49 3,404 Chelyabinsk 50 69 3,718 Omsk 86 59 4,088 Novosibirsk 210 143 3,092 Irkutsk 99 123 1,813 Primorye 78 29 7,438 Rostov 93 165 1,695 Nizhny Novgorod 21 21 2,720 Samara 44 24 4,960 Tatar 190 211 1,076 Saratov 88 47 4,425 Krasnoyarsk 84 65 4,681 Orel 34 33 2,319 Total 1685 1459 125,688 Source: FCSM. The FCSM has reached an agreement of cooperation with the Federal Service for Financial Recovery and Bankruptcy, which will allow for ex- change of information about market participants. Similar agreements will be signed with the ministries for justice, tax authority, tax police, and the interior. The FCSM and the General Prosecutor have sent brief- ings to prosecutors on the means of cooperation between FCSM and prosecutors in the area of administrative offenses. Cooperation is devel- oping between the FCSM and the Moscow Company Registration office. Given the size of the corporate sector and the nature of the corporate governance transgressions in Russia, the maximum fines that can be levied (at about $15,000) are not sufficient to encourage compliance with legislative requirements. Furthermore, effective July 2002, changes to the Code of Administrative Violations will reduce the maximum fine to just $5,000. Recommendations for Enforcing Legislation Although it will clearly take years to completely reform Russia's judicial system, in the context of capital markets the following recommendations are key: 352 BUILDING TRUST: DEVELOPING THE RussiAN FINANCIAL SECTOR It is clear that the current information technology (IT) infrastructure is inadequate. The FCSM regards the malfunction of the current IT envi- ronment as a cause of serious concern and embarrassment inasfar as mar- ket participants are aware of the current problems. The installation of new computer-based monitoring systems should assist the FCSM in col- lecting and processing information and thereby contribute to improved enforcement practices, provided that these systems are fully harmonized with the strengthened and refocused business practices of the FCSM. The proper financing of the FCSM is a priority. Elsewhere, securities commissions are able to cover many of their costs from contributions made by market participants in ways that include fees for licensing and license renewal; annual establishment charges related to the size of the participant; sale of compendia of rules and regulations; a small percent- age levy on issues of securities; and sale of market data to market partic- ipants, the media, and information providers. Fines should not form part of the Commission's retained income, since this encourages excessive penalization for trivial offences. This income should be remitted directly to the state budget and should not be offset against the FCSM's costs. Alternatively, the Government might establish an aggregate limit on the amount to be retained by the FCSM from penalty charges. Even in mature markets, such as in the United States, annual costs of operation of the Securities and Exchange Commission (SEC) are under- written by the Federal budget, but are mostly recovered from the fees and charges collected by the SEC. These fees and charges are paid direct- ly to a budgetary account and not to the SEC in order to avoid creating distorted incentives for the securities regulator. Such a degree of self-financing allows the SEC to set its pay rates above those for government service as a whole, and thus attract high quality pro- fessionals, who, while perhaps not earning what they might in the private sector, can regard their work at the SEC as a career opportunity, not a dead end. This may also help reduce the corruption in which civil servants may be tempted to indulge in order to supplement meager incomes. Although it is important to maintain the autonomy of securities regulators in emerging markets, it is unlikely that sufficient funding can be provided by market participants alone-budget support will continue to be needed. Recommendations for Supervision The primary recommendations for improved capital markets supervision are the following: CAPITAL MARKET DEVELOPMENT 353 1. Clear standards of public administration should be established and applied to all financial sector regulators; these should include accountability, transparency of decision-making, fairness, compe- tence, honesty, and professionalism. 2. Requirements for the conduct of regulatory personnel, including confidentiality of data, should be explicitly stated in their employ- ment contracts. 3. Financial sector regulators must be reliably financed at a level that is sufficient to enable them to fulfill their mandate effectively; also they must be able to pay salaries that will enable them to attract and keep competent professional staff. It is recommended that the U.S. SEC financing structure be used as a model. This model re- duces the potential for government capture of the regulator. 4. Potential for bias or distortion should be eliminated. On the one hand, financial regulators should be made independent from the Government. On the other hand, they should be made specifically accountable for the proper delivery of their mandate, through Parliament and the Government. Also, potential for regulatory ar- bitrage should be eliminated either through a requirement for reg- ulation only by function, or through a legal requirement that the standards set by the relevant functional regulator (securities regu- lator for securities markets, banking regulator for banking mar- kets, etc.) must be applied across that function, which introduces the concept of lead regulator. 5. Investment should be made in regulators' IT capacity with the aim of maximizing regulatory effectiveness (for instance, through computer analysis of certain reports and links with regional of- fices) and improving cost-effectiveness of regulation, together with transparency, ease, and speed of access to information. 6. Government and regulatory officials should be banned from membership on corporate boards and required to hold their assets through blind trusts during the period of their office; clear codes of conduct should be established through employment contracts to identify conflicts of interest that may arise, and how these must be handled (in particular, affiliated transactions). Clear penalties for breaches should also be established. 7. Regulatory penalties should relate to the damage or potential damage caused to those affected by the breach or breaches con- cerned; presently they relate more to administrative than to in- vestor protection concerns. 354 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR THE ROLE OF THE CAPITAL MARKETS SUPERVISOR It is suggested that in defining its strategic direction for the further work, the FCSM should, as a member of the International Organization of Se- curities Commissions, use the methods provided by IOSCO for conduct- ing a self-assessment of compliance with its principles. IOSCO has published self-assessment questionnaires for regulators and other more specialized questionnaires for specific parts of the securi- ties markets-accounting standards, broker/dealers, and collective in- vestments. The purpose of this assessment material is to provide regula- tors with benchmarks against which to assess their performance. The FCSM has already embarked on completing these self-assessments. The formal assessment of compliance with IOSCO principles is to be under- taken as part of the joint IMF/World Bank Financial Sector Assessment Program being conducted in 2002. At its 1998 Annual Conference, IOSCO adopted the Objectives and Principles of Securities Regulation, setting forth 30 core principles of se- curities regulation. As the global forum for securities regulators, IOSCO is committed to establishing and maintaining consistently high standards for the securities industry. The principles are based on three fundamental objectives of securities regulation: 1. Protecting investors-regulation of market conduct whose pri- mary aim is to protect both market participants and investors from suffering loss or disadvantage as a result of fraud, theft, or other malpractice 2. Ensuring that markets are fair, efficient, and transparent-market efficiency and transparency, which will lead to a broadening and deepening of financial markets 3. Reducing systemic risk-prudential regulation, designed to pro- tect the financial system from the systemic risks that may result from failures in any part of it. The Securities Commission should adopt these fundamental objec- tives, and measure all changes in legislation, regulation, and organization against them. The 30 core principles give practical effect to these three objectives. Together, the objectives and principles are intended to guide regulators and serve as a yardstick against which to measure progress to- ward effective regulation. All IOSCO members are asked to complete the survey to help IOSCO gain a better understanding of the extent to which, and the means by which, the securities regulatory system in each member jurisdiction is CAPITAL MARKET DEVELOPMENT 355 consistent with its objectives and principles and to identify areas in which more progress can be made. IOSCO recognizes that the means of implementation will vary across jurisdictions. The survey questions are designed to elicit an explanation of how principles are being implement- ed, not to imply that a particular method of implementation is mandated by the Objectives and Principles document. IOSCO anticipates that it will update the survey on a regular basis to help track its members' con- tinuing progress in meeting the Objectives and Principles. It is also in- tended that there should be other, more detailed surveys that would im- plement specific principles. When focusing on enforcement, for instance, the FCSM could ask a series of questions as follows, based on IOSCO: Detect. Does the FCSM have adequate capacity to detect abnormal price and/or volume movements in the market, whether through its own system or by effective reporting requirements? Investigate. When an abnormal transaction takes place on the ex- changes or the OTC market, does the FCSM have adequate legal author- ity to require the directly and indirectly involved parties to swiftly pro- vide information about or to explain the transaction? Enforce. If so justified, does the FCSM have adequate authority and means to enforce compliance or initiate court proceedings? Is the penal/ court process sufficiently supportive of the securities commission's authority? Such an approach would assist the FCSM in understanding the impact of particular legal initiatives. The focus of the legal work heretofore has been almost exclusively on legal drafting rather than on developing the capacity of the FCSM as the securities regulatory authority. The follow- ing principles should be observed: 1. All capital market regulators, including the Central Bank and self- regulatory organizations, must have sufficient powers to enforce full and timely reporting by entities in their jurisdiction; they also need a system of fines. 2. Standards of reporting must be capable of alerting the regulator to abuses and, as such, help the regulator track down violations with as little effort as possible. A review of the current standards of reporting by capital market players should be undertaken to determine the extent to which they provide adequate information. 356 BUILDING TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR 3. Since the regulator is supposed to use the reports to diagnose any abuse, the way the reports are dealt with should be systematized by means of a system of automatic alerts. The system needs to rely on ways of analyzing the reports that will differentiate between material abuses and immaterial errors. 4. All market regulators should set up and maintain an advanced re- lational database and computer systems to monitor the regulated organizations. Ideally, all regulators should have access to each other's systems, or share a single one. TRANSPARENCY AND DISCLOSURE Quality of financial information is crucial for investors and other stake- holders to make informed decisions.' While Russian accounting rules are slowly moving toward IAS, they remain weak in several key areas. Re- garding valuation of assets, Russian standards require no write-offs for bad debts or obsolete inventory. Thus assets are recorded at historical costs and revalued upward at the discretion of management, even when their historical cost has little relation to their fair market value. General and administrative expenses are added to inventory costs so that inven- tories may show an increase in value despite no increase in the market value for the goods. In addition, off-balance sheet items include not only guarantees and pledges of assets, but also property belonging to third parties but under the temporary administration of the company. Until 2000, Russian ac- counting rules did not require disclosure of related party transactions, that is, sales and purchases of assets among companies controlled by each other or by third parties. The new accounting rules will help, but in the absence of reliable disclosure of ownership and control structures, it may be virtually impossible for auditors to verify the nature of transac- tions among possibly affiliated parties. A handful of Russian companies file financial statements in accor- dance with U.S. GAAP or IAS. However, the thousands of remaining large companies in Russia provide information only in accordance with RAS, which fail to provide adequate information for investors. Thus a rapid move toward full adoption of IAS would provide valuable infor- mation for shareholders and other stakeholders. There is an argument that IAS should be adapted to RAS rather than simply translating the international standards into the Russian lan- guage. This approach creates a perennial delay and the risk of continued CAPITAL MARKET DEVELOPMENT 357 confusion, with difficulties in dissemination of the changes. Internation- al Accounting Standards are constantly being changed and modified and with each change, the Russian authorities will be required to sit and re- view the impact of the changes on the Russian version of International Accounting Standards. Full adoption of IAS, which are already available in Russian, would be much simpler to administer. Adoption of IAS would provide confidence to investors to come through with third party finance for Russian enterprises. Also foreign investors familiar with IAS will find the statements easier to understand and compare with similar companies internationally. Application of IAS may not be suitable for all companies, but it should be required for all large joint stock compa- nies, companies whose shares are publicly traded, and for banks and other financial institutions. Despite the existence of a register of companies operated through var- ious regional registration chambers, and the FCSM's register of issuers, it is very difficult to find out basic information about Russian companies- unless they are listed, in which case brokers have often compiled such data in order to service potential clients. The information that is made publicly available is very limited and does not assist in the evaluation of a company's equity or bonds; it is also very time consuming to obtain. Lack of access to information about issuers is a key factor in the failure to effectively develop portfolio of investment institutions in Russia. Nor- mally investors in market economies are passive investors needing access to good quality information in order to make investment decisions. Recommendations for Transparency and Disclosure It is suggested that a central source for information would be valuable, not unlike the British Companies House, where anybody is entitled to in- spect a company's file. This is common practice in all developed and many emerging markets; information registered with the securities regu- lator is available for public review, except such information that is specif- ically filed and accepted by the securities regulator as being confidential. These company files contain the whole historical record of the company, including its prospectus for past issues, a register of charges against its assets, the identity of major shareholders (share registers are also avail- able for inspection), the names of directors, the latest financial state- ments, and other relevant information. Information is also available on companies that are in insolvency, struck off (i.e., no longer registered due to serious transgressions), or dormant. 358 BUILDrNG TRUST: DEVELOPING THE RUSSIAN FINANCIAL SECTOR While Companies House has records of every limited company, it would only initially be necessary for the Russian version to hold the records of open joint stock companies that have made a public issue. There will be no immediate need to include private closed joint stock companies. Quite a lot of this information is already in the hands of the FCSM, and although it is available for inspection, it is not well organized and is difficult to access. The FCSM's current IT project should address this problem. The Law on State Registration of Legal Entities was approved in 2001, and its enactment is expected to open up access to companies' registration details. The passage of the Law is the trigger to set in motion the use of the Internet to provide access to consolidated company records in all re- gions. Although there is more work to be done, this would be a highly de- sirable development. Partial adoption of IAS is undesirable. The Russian Government should pursue a medium-term plan (over the next three years) to replace RAS with full IAS for all large enterprises. So as to facilitate consolida- tion on an IAS basis, the Government should also remove barriers that prevent subsidiaries of large companies from using IAS instead of RAS. Publicly traded companies, banks, and other financial institutions should immediately adopt IAS for reporting and preparation of their financial statements. All Russian joint stock companies and Russian subsidiaries of enterprises that prepare consolidated financial statements should have the option to prepare them in full compliance with IAS instead of RAS. All listed enterprises should fully adopt IAS by a specific deadline, such as 2004. International Accounting Standards should be used in the preparation and use of corporate prospectuses for sales of shares of state-owned or state majority-held enterprises. State-owned enterprises should be encouraged to adopt IAS as a basis for financial reporting in place of RAS. The Institute of Professional Accountants or a suitable alternative body should be developed into an effective, independent, professional as- sociation for accounting professionals in Russia. It should promote the integration of IAS into the Russian accounting system. It should also be responsible for training and certifying Russian accounting professionals in IAS, as well as administering an internationally recognized IAS com- petency examination. An adequate quantity of technical staff resources and funding should be dedicated to developing and implementing the re- forms, particularly within official government bodies that will need to develop new IAS-based procedures. CAPITAL MARKET DEVELOPMENT 359 ENDNOTES 1. See also further discussion in Chapter 1. 2. Source: Inspection of Non-state Pension Funds under Russian Ministry of Labor and Social Development. 3. Source: Centre for Collective Investments, Moscow, 2001. 4. By allowing shareholders to consolidate votes for a single member of the board of directors, the introduction of cumulative voting now allows minority shareholders the opportunity to elect at least one board member (see the score- card in Table 14.3). 5. One model, which might be a point of reference for developing the Com- mission's financing structure would be the structure adopted by the Securities and Exchange Commission in the United States. 6. See also discussion of these issues in Chapter 4. REFERENCES Black, Bernardn 2001. "The Corporate Governance Behavior and Market Value of Russian Firms." Emerging Markets Review, vol. 2 (forthcoming 2001). Caprio, Gerard, and Honohan, Patrick. 2001. Finance for Growth: Policy Choic- es in a Volatile World. Policy Research Report. World Bank, Washington, D.C. Demirguc-Kunt, A., and V. Maksimovic. 2000. Funding Growth in Bank-Based and Market-Based Financial Systems. Policy Reseach Working Paper 2432. Worlcl Bank, Policy Research Department, Washington D.C. OECD (Organization for Economic Co-operation and Development). 2001. The Investment Environment in the Russian Federation. Paris. Website: hrtp:// electradegfi.fr/cgi-bin/OECDBookShop.storefront/. Pistor, Katharina, and Andrew Spicer. 1997. "Investment Funds in Mass Privati- zation: Lessons from Russia and the Czech Republic." In 1. Lieberman, S. Nestor, and R. Desai, eds. Between State and Market: Mass Privatization in Transition Economies. World Bank, Washington, D.C. Russian Corporate Governance Round Table. 2000. "Survey Role of Independent Directors in Russian Enterprises." Website: http://www.oecd.org/EN/documents/ 0,EN-documents-28-nodirectorate-no-no-no-28,FEhtml. DUSSIA' S ECONOMY HAS COME A strengthening so that trust can be LONG WAY IN THE FIRST 10 YEARS restored within the marketplace. of transition to a market economy. That transition was slowed by the col- Building Trust: Developing the Russian lapse of the Russian financial sector Financial Sector is the product of the in 1998. Poor risk management, the World Bank's ongoing work in support accompanying devaluation of the of the Russian financial sector. It exam- ruble, failed loans, asset stripping, ines progress within Russia's financial and capital flight left the government, sector and provides a road map for pro- creditors, and millions of citizens- moting dialogue on and implementing especially the elderly-with substan- improvements. The book is intended to tial losses. Increased exports and fis- complement and support the joint cal and monetary reforms have since strategic plan of Russia's government helped to revive the Russian econ- and Central Bank for banking reform, a omy, but the banking sector remains plan that includes many already-imple- weak. Financial institutions need mented legislative and regulatory efforts aimed at strengthening the Russian > 0 7 L 9 financial sector as a whole. Although Building Trust addresses chal- lenges for the financial sector in Russia, the problems and potential solutions that it identifies will be of relevance to -- > n _ w _ 4 individuals and organizations charged with containment of banking risks, THE WORLD BANK improvement of financial intermedia- 1_77> w rtion, and the fostering of trust in bank- ing institutions-especially within 1!.- ' _ 5}w ' 1 1 other transition economies. |Sannette BNarie Sn-ith °°303 ISN HNTON DC ISBN 0-8213-5161-3 X THE WORLD BAN K 9 7810MU1 135 6' |"