Julian Schweitzer is the World Bank country director for Russia. He wrote this piece in connection with last week’s banking conference organized by The Russia Journal and Vremya Novostei.

Will Russia be able to build a banking system that enhances efficiency in the allocation of resources, thereby contributing to sustainable economic growth? Here’s a closer look at the issue.

1. Trust in the banking system has been continually undermined.

The size of the assets of the Russian financial system as a proportion of GDP is very small and the system is only providing limited financing of the private sector (by any international comparison) –see Figures 1 and 2.

Trust in the system has diminished repeatedly, because:

• Nominal savings evaporated in the hyperinflation of the early ’90s.

• Only partial depositor compensation (at best) following the GKO default in 1998.

• Widespread asset stripping since Aug. 1998 to the advantage of insiders and further weakening the position of depositors.

Immediate consequences of the 1998 crisis were:

• Temporary disruption of the payment system.

• Disappearance of the risk-free asset (government debt market).

• Losses due to exposure to insolvent counterparts to foreign exchange forward contracts.

• Loan losses due to overexposure to connected parties.

• Disappearance of foreign syndicated lending and euro-credits.

• Increase in relative importance of state banks.

• Renewed efforts to establish new state banks and more directed lending.

2. The current system – a conduit for illicit transactions.

Bankers have to engage considerable resources if they are to develop bona fide banking business – the weak legal and regulatory infrastructure result in a lack of bankable business. Information about enterprises is opaque and based on flawed Russian accounting standards (developed for planners rather than to give a true assessment of the financial situation and prospects of enterprises and banks). Protection of creditors provided by collateral and insolvency laws (the final recourse for creditors) is weak and relies on an inefficient judiciary, making it hard to write enforceable contracts. In general, it is difficult to make progress with banking reform without simultaneous efforts to reform the enterprise sector – the one cannot make progress without the other.

Rather than exposing themselves to lending to third parties, private banks provide in-house services for their owners. Earlier private banks speculated in foreign exchange gains (mid-’90s) and GKO investments (1995-1998). Since August 1998 – under pressure without lucrative sources of income – they have turned increasingly to providing services such as creative schemes for tax-avoidance, providing offsets of existing obligations to the government, etc. Only a few institutions trying to develop sound commercial banking activities survive — i.e. committed to improving transparency as regards their ownership structures and developing the knowledge base and systems for managing their exposures.

State banks and banks owned by regional authorities continue to provide financing of priority investment needs, but without skills in managing credit risks or transparent governance.

As natural resource prices and enterprise incomes have been rising, the situation in the banking system has superficially stabilized. However, given the lack of structural reform (see below), the system is still very fragile. This is confirmed in the assessment provided in Figure 3. The growing exposure of State banks is the next crisis waiting to happen; the rapid growth in lending by these banks represents a fast-growing contingent fiscal liability.

3. Why does Russia need a banking system?

In a market economy the banking system fulfills a fundamental role in providing payments, savings and intermediation/lending services in a market economy. There is a clear link between development of market-based financial systems and economic growth — postponement of financial sector development will result in foregone economic growth. The failure of the current banking system to provide meaningful lending services to private enterprises is illustrated in Figure 4.

Sustainable economic growth depends on developing efficient mechanisms for allocating scarce investment resources, thereby improving efficiency in the allocation of funds available for investment. To achieve this, the banking system will need to move permamently away from non-transparent systems based on barter, non-payments, political patronage, directed credits and favors to owners of private banks (connected lending).

Market-based systems depend on developing mechanisms for the reliable exchange of information and developing institutions which can process and assess information, facilitating resource allocation based on transparency and accountability.

4. What has been achieved since Aug. 1998?

Some progress has been made:

• Stabilization of the payments system in the immediate post-crisis period.

• First steps towards legal reform — the Bank Bankruptcy Law (March 1999) and Bank Restructuring Law (July 1999) establishing the Agency for Restructuring of Credit Organizations (ARCO).

• Diagnostics of the major private banks, closure of some banks and referral of some others to ARCO.

• Sberbank published its IAS audit for the first time in mid-2000 (for 1999).

However, in each of these areas the agenda is nowhere near complete:

• Although the payments mechanism is functional, the interbank market remains moribund, as lack of trust encourages banks to keep huge balances with the CBR.

• The legislative agenda is far from complete – in early 1999 authorities agreed to amendments to the Bank Bankruptcy Law and to other banking laws, which are still pending. These amendments address fundamental issues related to restructuring the banking system, such as including insolvency (and not only illiquidity) as a criterion for bank bankruptcy, providing the regulator with the authority to write down shareholdings of insolvent banks, facilitating recourse to unwinding affiliate transactions (asset-stripping) and tightening "fit and proper" criteria for bank owners.

• Commitment to restructuring the banking system has been feeble. Although the number of banks shrank from 2600 to about 1300 (see Figure 5) prior to the 1998 crisis, the number of banks since the crisis has been remarkably stable.

• Although Sberbank has developed its own strategic plan and confirmed its intention to continue to develop as a universal bank, no attempt has yet been made to tackle the strategic issues related to countering the growing dominance of the state banking sector. In addition to the accumulation of contingent fiscal costs, international experience demonstrates that increased dominance by the state sector is associated with less financial sector development (greater intermediation costs and inefficiency), lower productivity and slower economic growth.

5. Which reforms are most urgent?

The current superficial stabilization of the banking system – albeit at a low level of development – and temporary economic growth fuelled by the post-crisis devaluation and rise in raw material prices provides a breathing space in which to implement reforms. The agenda is long, but there seems to be a tendency to squander this opportunity. Reforms in less benign economic circumstances will be that much harder.

As a general statement, the focus of the next generation of reforms needs to be on the enforcement of laws and regulations. If greater reliance is to be placed on intermediation on the financial market, this will depend – as well as on the presence of effective legislation – on the implementation and enforcement of regulations, including taking measures against judicial misconduct, corruption and extortion.

• If banks are to lend to third, unrelated parties, it will be essential to strengthen mechanisms for enforcing and protecting private property rights. Much clearer practices need to be established for those situations where property rights should be forfeited and transferred. Key measures encouraging banks to expand the scope of their lending to non-connected parties would be to improve their recourse to foreclosure on collateral and the introduction of streamlined enterprise insolvency practices.

• The authorities will need to address the process of resolving banks with much greater purpose and urgency. In addition to strengthening the legal framework for bank bankruptcy, the authorities should show commitment to testing and using the law. There is an urgent need for expeditious rationalization of the number of banks, both so as to give franchise value to having a banking license and to make the very difficult task of building and implementing banking supervision manageable. Paradoxically, the previous impetus to rationalize the system appears to have vanished since the crisis.

• Market-based finance depends on the exchange of reliable information on banks and their enterprise clients. By adopting international accounting standards and improved disclosure requirements and by making a concerted effort to develop the accounting and audit professions, the authorities will encourage banks to break the excessive links between bank owners and borrowers, improve disclosure on ownership and larger engagements and work toward effective outside corporate governance.

• Building on reforms to strengthen property rights, accounting and disclosure, steps will be needed to improve implementation of CBR bank supervisory practices. Rather than bank inspection based on norms, the CBR needs to move towards exercise of supervisory judgement and building trust between banks and their supervisors in a concerted effort to contain banking risks. The introduction of deposit insurance should be postponed until the process of resolving banks (above) and improved implementation of supervisory practices are achieved – to avoid instituting unmanageable contingent fiscal risks.

• While market-based finance in Russia is in its infancy, it is essential that the authorities support a more level playing field for competition between state and privately-owned banking institutions. Key elements in supporting competition in the sector include:

- Encouraging rather than inhibiting foreign entry by dismantling restrictions and dissuasion, thereby encouraging dissemination of the best practices and providing a safe haven for depositor savings.

- Supporting the growth of some "best practice" banks with sound financial structures, viable business strategies and the commitment to developing good banking practices.

- Taking measures to restructure the state-banking sector — by containing the potential loss exposures in the near term, by improving their governance structures and by preparing the partial or full divestiture of these banks.

- Restrict the establishment and growth of new specialized financing institutions. Given the weak stage of development of the financial system, investments financed by such institutions should be strictly contained, as they represent fiscal exposures for the government.

• As banks rely on having risk-free assets denominated in local currency as a safe haven for funds to be deployed at a later time, it is essential that the government develop sound sovereign debt management practices. The current benign fiscal environment provides an opportunity for introducing improved institutional arrangements and systems for consolidated management of sovereign domestic and foreign debt.