This Shakeout Can't Come Soon Enough

In July, managers at Moscow's Alfa Bank noticed a worrisome trend in Russia's money markets. Banks that had been borrowing and lending to each other for three-month terms suddenly began to do seven-day deals. "That was a sign that they were having liquidity problems," says Pavel I. Gorbatsevich, Alfa Bank's acting chairman. So at the end of July, Alfa Bank opted to do money-market deals with only the 25 healthiest of its 100 banking partners.

Alfa Bank's decision proved prescient. On Aug. 24, Russia's money markets ground to a halt when worried bankers stopped doing business with each other after a few banks failed to repay loans. Thanks to intervention by the Central Bank, the money markets began to return to normal a few days later. But the crisis highlighted the flimsy foundations of Russia's banking system and is likely to spark a shakeout (table).

It's about time. Largely unregulated, Russia's banking industry is plagued by fast-buck artists, greedy industrialists, and organized crime. By some estimates, up to 50% of Russian bank loans are now past due--and often nearly impossible to collect. Given Russia's inadequate legal system, some bankers look to the mafia for help. Others don't even try to collect because the biggest defaulters are the bank's own shareholders.

Another reason for the banking crunch is that back when inflation was raging, banks could earn enough from high interest rates to cover losses from bad loans. But the Central Bank's tight money policies have cut inflation from 17.8% in January to 5.4% in July. In addition, banks can no longer earn easy profits from currency speculation now that the government has fixed the ruble rate in a narrow band. A three-month test setting the ruble at 4,300 to 4,900 to the dollar has been extended an additional three months, to Dec. 31.

IN THE COLD. Deprived of the opportunity to make money from high-interest loans and currency speculation, many small- and medium-sized banks turned to the money markets to fund operations. When some had trouble repaying loans, big banks panicked and withdrew from the market. On Aug. 24, about 300 banks couldn't close their books because they didn't get overnight funding from other banks. Says Maartin Pronk, general manager of ING Bank (Eurasia) in Moscow: "Major banks stopped giving credit to other institutions blindly, regardless of credit quality."

The Central Bank reacted quickly to inject liquidity into the market. On Aug. 25, it purchased $300 million in Treasury bills from banks to give them a source of rubles. It also offered $68 million in seven-day credits to the largest and healthiest banks. By Aug. 28, such leading banks as Sberbank, Vneshtorgbank, and Imperial signed a deal to do business with each other, and the interbank lending market began to revive.

Still, smaller banks with poor balance sheets are likely to be left out in the cold. Acting Chairwoman Tatiana Paramonova has made it clear that the Central Bank will not bail them out. Even before the August crisis, the Central Bank had already closed 548 small banks that were insolvent. Paramonova is predicting that an additional 100 banks are likely to shut down in the wake of the latest liquidity crisis.

Indeed, Paramonova started squeezing the banks early this year by quadrupling the amount of money they have to set aside for reserves. While banks opposed the move, Western analysts say it was a smart decision because most Russian banks have low capitalization and are engaged in high-risk activities. The analysts also give the Central Bank high marks for the way it handled the money-markets crisis. Says Miljenko Horvat, head of Citibank's Moscow office: "The Central Bank is everybody's favorite whipping boy. But it stepped in and provided liquidity in the right way and in the appropriate amounts."

The Central Bank faces a tricky task over the next few months. The $300 million credit line it issued to the banks is too small to fuel inflation in Russia's huge economy. But in the runup to the December parliamentary elections, the government will not want to be embarrassed by a string of bank failures. Russia's parliament, the Duma, has refused several times to confirm Paramonova as Central Bank chairwoman because of heavy lobbying by banks. They're now pushing President Boris Yeltsin to replace her with someone more compliant. The great Russian banking showdown is far from over.


-- New regulations have forced a quadrupling of reserves

-- Currency trading profits are plummeting as economy stabilizes

-- Up to half of all loans are now nonperforming

-- New loans are less profitable as slowing inflation reduces interest rates

-- A wave of mergers and bankruptcies expected among Russia's nearly 2,600 banks


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