Improving Risk Management in the Russian Banking Sector

By Judit Burucs, Project manager, Russian Banking Advisory Program, IFC Journal: Eastern Europe and Central Asia: World Finance Review, page 44, May 2009 http://www.finetime.net/last_four/WFR%20May%202009.pdf At the end of 2007, parallel with its investment in Russian banks, IFC, a member of the World Bank Group, launched its Russian Banking Advisory Project. The reason was as follows: risk management had not received enough attention in Russia. The Projects broader objective was to help a pre-selected group of medium-size, predominantly regional Russian-owned banks strengthen their internal control and risk management systems and improve their capacity to formulate coherent business strategies and practice sound underlying capital management. The Project foresaw direct consulting work with the banks, a series of public seminars, disseminating information, and consulting with the authorities. Characteristics of the Russian banking sector After 10 years of accelerated growth, the banking sector has been seriously impacted by the global financial crisis. There were 1,136 Russian banks by the end of 2007. Since then the number has continuously decreased, and by March 2009 there were 1,100. Since mid-2008, 25 banks have gone bankrupt or have been rescued by the state. The system is dominated by five leading stateowned banks, which together hold about 46 percent of assets. The largest, Sberbank, still maintains about a 50 percent share of retail deposits. The other banks are small: only 50 Russian banks have total balance sheets that exceed $2 billion. Fragmentation of the private sector made it difficult for many medium-size and smaller banks to develop franchise, achieve scale, and diversify risks and revenues. In 2008, Russian banks held $954 billion in total assets, which corresponds to 67 percent of the Russian Federations GDP in that period. However, the Russian market still remained largely underpenetrated compared with markets of other CEE and CIS countries. The asset mix had gradually changed, with the loan/assets ratio growing to 59 percent at the end of 2008, from 42 percent at the end of 2002. Corporate lending was the major driver of this growth, but retail grew in importance, amounting to 24.3 percent of total loans at the end of 2008. Yet retail loan/GDP remained at only 9.7 percent, which was significantly below the level of many emerging European countries. Banks have stopped their lending operations, thus transferring the crisis to the real sector of the economy. The banking sector is funded mainly by customer balances, which made up 52.4 percent of liabilities at the end of 2008. Russian laws stipulate that retail term deposits can be withdrawn on demand, making liquidity potentially vulnerable. This was especially the case during the 2004 liquidity crisis and has been the case during this crisis. The local bond market developed rapidly, but remained insufficient. International funding, namely Eurobonds and loan syndications, therefore became widely used by larger banks until the crisis hit. Since October 2008 inter-bank liquidity has frozen and refinancing possibilities have dried up. The government took action to help the banking system and restore client confidence by increasing the deposit insurance level. Unfortunately, most of the liquidity injections have been used for currency speculation instead of for supporting the lending system. By the end of 2008 the Russian government had injected around $160 billion into the banking sector and it has reserved an additional $200 billion for further action. Capitalization was pressured by rapid asset growth and remained adequate at most banks before the crisis. The total capital adequacy ratio is 1011 percent, depending on capital size and deposit insurance system membership. Net interest margins started to tighten because costs increased. Banking supervisions role Despite significant improvements in recent years, banking supervision in Russia remains focused to a significant degree on formal compliance with guidelines rather than on substantive analysis. The standards that the Central Bank of Russia (CBR) established for Russian banks have been brought in line with global banking standards in order to comply with Basel II, but most of them are not compulsory. The CBRs role is very important. Most SME banks in Russia employ only the compulsory requirements and standards because they still lack the necessary skills, experience, and resources for certain core aspects of bank governance and

management. In particular, they are not yet adept at applying state-of-the-art risk management techniques, for which the guidelines offer little help. Risk management infrastructure in midsize Russian banks The Russian Banking Advisory Project prepared a survey on risk management practice in Russia. The objectives were to understand: What internationally recognized and applicable risk management best practices midsize Russian banks are implementing in their dayto-day activities; How midsize banks want to develop their risk management systems; and Which types of additional products, activities, measures, and regulations are missing? Based on Project experience and the pre-selected 27 regional and non-regional banks answers, the risk management infrastructure in the Russian bank sector can be characterized the following ways: The corporate governance and organizational structures of SME banks in the Russian market generally conform to best practice, but committees and risk management departments do not work appropriately. Banks do not always recognize the necessity for advanced risk management methodologies. Most banks have considerable internal regulations, (sometimes they amount to a copy of the CBR guidelines), but they do not follow them in daily practice. Russian midsize financial institutions seem satisfied with the performance of their risk management systems as long as they meet the basic CBR requirements in the short term. Midsize banks monitoring and reporting systems are insufficiently developed because the banks have no IT systems that support risk management. These banks cannot afford the best-known and most advanced international IT systems. Most banks plan changes to their risk management processes. Mainly, they plan to develop credit rating/scoring systems, use stress test models, and elaborate reporting and risk exposure measurement. The banks also want to implement new IT systems. The vast majority of banks would welcome bank guarantees and funding opportunities from regulators, especially long-term funding. Some small banks, and midsize banks in particular, would also like to see more guidelines, credit rating models, and informational resources from regulators. Some banks made suggestions to regulators in response to the crisis: they included listing swap opportunities, repo with foreigncurrency-denominated assets, more proactive

regulation of financial market liquidity, and irrevocable deposits. Clearly, Russian banks would prefer to see their regulators as a resource rather than as policemen. Using seminars to increase awareness of the benefits of higher risk management standards The Project found that additional training is needed to increase awareness of the benefits of higher risk management standards. It therefore launched a seminar series in Russia to help improve the banking sectors risk management and capital allocation practices. The first seminars, under the title Liquidity and Interest Rate Risk Management in International Practice, were held in Moscow, St. Petersburg, and Yekaterinburg in Q208. Experts from IFC, the KBC Group, Citigroup, OTP Group, KPMG, Reuters, PRMIA, and other institutions made presentations on international best practices and on their own organizations recent experiences. More than 200 bank managers and specialists from 100 banks participated in the seminar. The second seminar subject was risk management during the crisis. The Project organized a public seminar under the title The Future of Risk Management in the Banking Sector: Where to From Here? in Moscow in December, attracting 67 participants from 42 financial institutions. Experts from the World Bank, IFC, S&P, and the Association of Regional Banks of Russia, and renowned international consultants, spoke at the seminar. The first half of 2009 will see additional seminars about risk management in the crisis, particularly focused on non-performing loans, take place in Nizhny Novgorod, St. Petersburg, and other towns. Increasing awareness of advanced management with Web site and articles risk

The Project increased awareness through its Web site (www.ifc.org/rbap). The Web site contains the most important local and international regulations and useful articles that the Project published in different magazines, in Russian and English. Users can also download information about events, seminars, and presentations from the Web site. The Project has also published articles that highlight various topics. An article on fund transfer pricing summarized the difficulties of applying fund transfer price methodology in the Russian market. It put special emphasis on the difficulties of building a yield curve based on the Russian market. The article Market Risk Management in SME Banks: Status Quo or a Step Into the Future discusses issues pertaining to forming risk management systems at small and medium-size banks.

An article entitled Basel II Advantages for Leaders focused on risk-based pricing. The Project wanted to help small banks build their own systems in cases where they could not afford consulting companies. To that end, it drafted the manual How Can a Medium-Size Bank Develop Its Own Asset/Liability Risk Management System? Those interested can download it in English and in Russian free of charge from the Project Web site.

the Project completed implementation of the risk management system at a Moscow-based mediumsize bank. In cooperation with IFC headquarters, the Project has, in the short-, mid-, and long-term perspectives, been developing new crisis response tools, such as a Risk Assesment Framework. The short-term focus is on non-performing loans and other distressed assets.

Conclusion: public-private dialogue Direct consultant work with banks The Project intended to use direct consultancy work to help a pre-selected group of midsize Russianowned banks to strengthen their internal control and risk management systems and to improve their capacity to formulate coherent business strategies and practice sound underlying capital management. Since its launch in September 2007, the IFC Russia Banking Advisory Project has developed a toolkit on working with banks. It prescribes a two phase approach, broken down into diagnostic and implementation phases. IFC has also designed a risk management operations analysis questionnaire for banks, covering areas such as risk management, asset and liability management, internal controls, and capital management. The questionnaire not only provides guidance for any diagnostic team in analyzing a particular bank, but it also helps a banks management perform a selfassessment. The Project has been working with four banks and is proceeding as follows. First it completes a comprehensive diagnostic of the risk management situation. Based on the findings, the Project helps the bank find the best solution to its problems. If the bank has inappropriate internal risk management regulation, the Project prepares templates of the guidelines for managing different types of risk as well as a general risk management policy template. The Project organizes workshops and helps to find the IT or other external companies necessary to developing the appropriate systems. Most recently, The crisis has highlighted the urgent need for improved enterprise-wide risk management procedures. Sooner or later the crisis will disappear, and the Project is convinced that in the mid and long-term perspective, banks will recognize the need for modern risk management tools and an integrated risk management approach and seek out IFCs advisory support. . Banks should bring greater judgment to bear on decision making, and base their behavior on a thorough understanding of the products and risks involved. The banks need assistance. The Central Bank should help them not only with possible funding but also with practical guidelines on managing risk.. The Project will approach the Central Bank to start discussions about the current risk management requirements for small and medium companies. The Project and its partners plan to prepare a proposal based on the above-mentioned survey about what tools banks need from the CBR to mitigate their risk exposure.