RUSSIAN BANKING: CHANGING ITS STRIPES?

New developments have U.S. investors thinking that, with some caveats, the time is right to help supply a huge need for capital

Financial memories, for better or worse, tend to be short, but 1998 was not that long ago. And with the enormous investment potential represented by those capital vacuums – China and India – who could blame investors and their agents for being tepid over prospects in Russia?

But in fact interest is heating up, and the attention in particular is on the Russian banking system, where economic and regulatory changes are altering the landscape. Investors are interested in financials because to date most Russian equities have been resource-related, in the oil, gas, metals and mining sectors. New sectors would increase the diversification of portfolios with Russian exposures.

"The first wave of telecommunications issues were brought to market in the late 90's," according to Reinout Koopmans, director of equity capital markets at Deutsche Bank in London. "Currently there are a lot of retail and media names. The next wave will be financials.

"The reason that – financials are going to be so interesting is because the financial sector gives exposure to domestic economic development. All the resource companies are driven by global prices, so if the oil price goes down the stock price goes down. What investors are looking for is domestic consumer growth type of exposure. The retail names are very good for that; media names are also very good. But financial institutions are a very popular way of playing that consumer exposure, particularly in the retail banks."

Retail – the current growth wave
The phenomenal growth of the Russian consumer market has paralleled that in other countries of the former Soviet bloc. Erik Koebe, president of Dresdner Bank Russia, likens it to the experience he witnessed as a West German shortly after the fall of the Berlin Wall. "At that time, people in the East wanted to buy new cars, appliances, and every kind of consumer good. They also wanted to have fun. Back then, they had security and no fun. Now they have fun and no security."

During the Soviet era, consumer goods were rationed to individuals who had to save for years to get a new refrigerator, washing machine or minicar. As shown in the attached charts, Russian consumers are now buying on time, just like their Western counterparts, to get the goods they need today. The streets of Moscow are filled with vehicles, many of them luxury SUVs. However, the roads outside the big cities are in desperate need of repair. The reconstruction of Russia's infrastructure will require tremendous resources in the next four years. For example, the Federal Highway Agency of Russia estimates that it will need over 2 trillion rubles, more than US$60 billion, just for its immediate needs through 2010. As a point of comparison, the total value of all deposits in the Russian banking system were 3.3 trillion rubles as of Nov. 1, 2005.

"The last ten years should be counted in dog years in terms of progress and development of sophistication," says Dan Jacobowitz, who as director of corporate finance for Russian financial institutions is Koopman's colleague at Deutsche Bank. "The management teams learn very quickly, they're quick to adopt new practices. I think many of these banks are adopting very good practices and are very focused on getting good returns. Additionally, the margins are very high at this point.

"The higher net interest margins in consumer finance, credit cards, unsecured loans, are attracting a lot of capital, because the corporate loans really had all of the margins squeezed," says Jacobowitz, "especially now that a lot of the Russian corporates have higher ratings and the spreads are very tight. To maintain earnings growth at a rapid clip it's very important to develop a retail banking platform, which is a completely different business than corporate banking, and which requires a lot more infrastructure like investment in IT systems and people training. I think Russian banks have made tremendous strides to start that process. That's the current wave of growth."

Skepticism is still healthy
Western underwriters estimate that $15 billion in new Russian bonds will be offered in 2006, of which two-thirds will be bank-related issues. Another $60 billion will be sought through syndicated loans, up from $15 billion in 2004 and $40 billion in 2005. Russian corporate activity accelerated after the ratings agencies restored the sovereign's investment grade rating in 2005. According to Moody's:

"The Russian banking system has undergone a dramatic recovery since 1998, thanks to strong economic growth and a decrease in the underground economy, together with a more affluent population and an improving regulatory framework which, together, have led to sustained asset growth and an improving quality of assets, as well as comfortable profits. In addition, phenomena such as bank defaults and unpaid depositors, which were common in the 1990s, have become an exception. However, the average bank Financial Strength Rating (FSR) remains very low compared to other Central and Eastern European (CEE) countries, mainly due to still unstable franchises, low market discipline, concerns over corporate governance issues, as well as loan concentrations and a still high level of operations with related parties."

Qualified optimism is not limited to the international rating agencies. RusRatings, a Russian ratings agency run by Richard Hainsworth, an expatriate British subject who is a longtime resident of Moscow, also has taken a generally positive stance toward the Russian banking sector, although with a few special caveats. In formulating his analyses, using data from both the banks and from public sources, Hainsworth says:

"We do not assume that anybody tells us the truth, whereas in the U.S. and England the assumption is that companies tell you the truth in their financial reports. When it can be proved that they didn't tell the truth there is a huge dip in the market price. In Russia, analysis presents a different kind of intellectual challenge, because if you assume that nobody tells you the truth then you have to establish the extent to which you're willing to place your reliance on this particular set of data."

Far from a unique view, many Russian investors and money managers also tend to skepticism when evaluating earnings reports of all Russian enterprises, due largely to the traditional Russian reluctance to submit to the onerous taxation system. Although reforms have been enacted, the move to full financial transparency in Russia has been slow going.

"We don't believe anybody that tells us anything unless we can see that there is a consistency," says Hainsworth. "We look for data that is internally consistent, consistent with other things that we know, and therefore we do a lot of work to understand a bank and its position in the market and the people around it."

Slow change, breathtaking opportunity
The head of the Association of Regional Banks in Russia, Alexander Murychev, also has a pragmatic view. "The major problems in Russia are loan defaults, criminal activities including money laundering, and also issues with credit cards – it applies to all banks."

"Russia's difficulties are reflected in its banking system," explains his colleague, Garegin Tosunyan, president of the Association of Russian Banks. On the 1998 collapse of the banking systems, he says, simply, "It was what it was." He uses an old Russian folk expression when he points to the progress being made by Russian banks in money laundering, the most sensitive of financial subjects: "I'm not a wizard, but I'm learning." And, in explaining the slow pace of pension reform and related bank services: "We would like to progress quickly, but the mentality of people must change."

Yet, despite all these reservations, most experts regard the opportunities for bankers in Russia as breathtaking.

"There is a shortage of institutions that provide banking services," says Murychev. "Two-thirds of Russian territory isn't covered by any banks. Russia is huge, and there are many poorer regions, especially those up north."

Loans to all borrowers have more than doubled since the beginning of 2004.

The global American banks have not ignored this opportunity. Since 1993, J.P. Morgan has maintained its presence in Russia, even through the difficult times, and has grown to become the largest dollar clearing bank for Russian correspondents. Now president Bob Fernandez expects big changes in the near future.

"The Russian government, through the Central Bank, continues to raise the bar. I believe the next bars that are coming are international accounting standards and also minimum capital in terms of a hard dollar amount, which will further reduce the 850 [banks accepted in the deposit insurance system] at the end of 2006. One would expect that some of those banks will merge, some will be acquired, and some will just cease doing business."

Fernandez challenges the implicit view of some reporters in the mass media, that the majority of Russian banks are corrupt. "It's not true that all of these banks are involved in the wrong activity. There undoubtedly were a lot and there still are some, but most of them are law-abiding people. The banks were established in a different period. So, they won't exist in the future as commercial banks as we understand them."

An increase in competitive pressures from foreign banks is likely to accelerate the trend toward consolidation, particularly after Russia is accepted into the World Trade Organization. Even before accession, many Western banks had planted their flags in the Russian banking system, particularly the largest banks from the Continental markets.

"From Western Europe you're seeing the strategic investors, both here and in the Ukraine. They think of this region as an extension of Europe... of their own home base. At a bank like Deutsche Bank, the board thinks that Russia is the second most important country after Germany."

Foreign banks yes, branches, no
The competitive issue is foremost on the minds of senior Russian government officials, although for a different reason than might be expected. "Russia does not wish to allow foreign banks to open branches," explains Finance Minister Alexei Kudrin, "because it would make control over financial operations very difficult for Russia. The balances will be in a different country and so it will be harder to monitor the flow of money."

Just as significantly, the Russian banking system would suffer since the cost of capital is much lower outside the country. "Those instruments will also be less expensive [for branches of foreign banks] than those in the internal market," says Kudrin. We will be facing a situation where there is an imbalance of competition."

During the course of the WTO negotiations, it was widely reported that American trade representatives had taken a very hard stance on the issue of foreign branches. Russian officials were equally firm. Although foreign banks could own a Russian bank, they said, there would be no yielding on the issue of opening branches. The damage would be corrosive even in advance of the WTO implementation date.

"Investments in Russian banks might start to decline while everyone expects the opening of direct branches," says Kudrin. "And obviously those branches will be more competitive than domestic banks. And that would lower the rate of capitalization in the Russian banking system."

In 2005, the Russian government and the central bank, with the involvement of the banking community, prepared a "Strategy of Banking Sector Development in the Russian Federation to 2008." A number of initiatives were proposed, including the passage of legislation to strengthen banking supervision and tighten the requirements for credit organizations. Better transparency for the ownership of banks and their financial operations was a key requirement. Among other factors, a mandatory 10% capital adequacy ratio and minimum equity of 5 million euros was imposed on new banks.

"We need to increase the role of banks in the entire structure," explains Finance Minister Kudrin in the context of the government's macroeconomic plan. "This will be more likely if we lower the inflation rate and increase the desire of people to keep their money in rubles, particularly in long-term savings. And banks must take a more active role in transferring capital between different branches of industry and in finding the most favorable sectors in which to invest. At present, capital has not been invested as quickly as desired. That's the main role of the banking system: to move capital and to provide project financing, which is presently very weak in Russia."

State-owned banks in transition
Another element of the plan, welcomed by many private bankers, involves a reduction of the influence of state-owned banks in the Russian economy. These banks are the descendents of Soviet agencies which supported failing government enterprises. To some extent, they contributed to the financial collapse of the Soviet Union by maintaining employment levels at unrealistic efficiency levels. However, right up through the passage of deposit insurance legislation in 2004, these banks were the only financial institutions with the financial backing of the federal government. Although state-owned banks were required to meet the same standards as private banks, their federal guarantee provided a huge advantage over the latter in competition for retail savings. As a result, the level of deposits was both higher and more stable, so that the risk-adjusted cost of funds for state-owned banks was lower. Although state banks provided many services below cost, the surplus balances gained through the float on government pension and other payments added to their competitive advantage.

"At present," says Kudrin, "we are developing a banking strategy that has been adopted by the government. The goal of that strategy is to reduce significantly the state's share in the banking system. Unfortunately, in the last two years this process has proceeded very slowly. Nevertheless, in several cases the government has decided to abandon its interests in certain privately-owned banks that were previously in the portfolios of state-owned enterprises. In the past two years, the state has abandoned more than 100 of its banking interests. For example, state-owned enterprises had controlling interests in banks in the railroad industry, the nuclear energy industry and the diamond industry. These, which have now been privatized, provide just a few examples of instances in which the state has abandoned its interests in order to concentrate on the larger banks."

The largest state-owned bank is Sberbank, which translates as The Bank for Savings. The government owns 61% percent of Sberbank, which holds 57.3% percent of all Russian retail savings and 27% of all banking assets. Vneshtorgbank deals more with international activities. Vnesheconombank services foreign debt, but has also become a trustee for the national pension plan. Another state-owned bank deals with loans and agriculture. And, Russian Bank for Development deals mostly with small businesses and smaller projects.

Recently, the state-owned banks have begun to contest each other's traditional monopolies, especially in the fast-growing consumer markets. Vneshtorgbank 24, points out Professor Vasily Solodkov, Dean of the Banking Institute at the State University, Higher School of Economics in Moscow, is a retail operation designed to compete with Sberbank. Uralsib, the banking affiliate of state-owned Lukoil and, as such, a natural competitor to Gazprombank, the third-largest state-owned bank, has been merging with small private banks in order to penetrate the regional markets east of Moscow and mount a broad national challenge to the two retail giants. It is as if the monolithic, sector-centric industrial banks have all turned as one, to pay homage to the Russian consumer arising with a credit-driven vengeance from his century of dormancy.

If competition has increased even among state banks before WTO accession, Professor Solodkov believes the situation for Russian banks will be far more intense later. "As competition increases, the profit margin for all banks will get smaller. Today that margin is very comfortable. But the question is this: how many of today's banks will be able to operate with the tighter margins that will exist after WTO?"

Moving in line with international standards
Despite the obvious threat to their banking system, government officials believe that foreign banks must be allowed to bring fresh capital into the system to help local banks to catalyze the re-industrialization of the country. The head of the bank regulatory division of the Central Bank of Russia, Andrey Kozlov, explains:

"The ideology of this new strategy right now is, not only to cope with banking problems, but also to create opportunities for businesses in the local marketplace, that is, 'Marketplace Russia', and to provide local banks (or banks incorporated here in the territory of the Russian Federation) a set of incentives and motivations to support national economic development. Before now, the Russian banking system was seen as a separate industry, so its problems were seen as merely the focus of bankers. People, especially after the crisis, didn't say that the banking system should support the general economic development. They just wanted the industry to survive. Right now the goal is different. The banking system has survived, becoming more sound, so the goal through 2008 is for the banking system itself to speed up the country's general economic development."

Central banker Kozlov then describes a series of initiatives which are intended to strengthen the financial system by bringing Russian banking more in line with international standards, particularly those of the Basel Committee, as well as the received set of anti-money-laundering laws, counter-terrorism-financing and regulations in deposit insurance rules. Like the Ministry of Finance, the Central Bank of Russia is committed to changing the balance between public and private banks in the financial system.

"The main strategic role," according to Kozlov, "is to reduce the influence of the government-owned banks on the banking system, because we understand that this is a competitive advantage, and this doesn't stimulate sound competition when just a couple of big banks dominated by the state are main players. One of the ideas of this new version of the strategy is that we stimulate development of private banking, including banks with foreign capital, in order to balance the influence of state-owned banks. Under the new law, the rules will be equal for all banks, irrespective of the ownership – foreign, domestic, government-owned or not."

As result of the government's Strategic Plan, state-owned banks will lose their position as the only institutions with a federal guarantee. To Westerners, who regularly read reports in their mass media about the Putin administration strengthening its controls over the economy, a policy of state relaxation of its banking assets' control of the financial system may sound less than credible. To Russians, such a policy is not only clear and understandable, but well supported by the facts.

"State control is probably applicable to natural resources and 'strategic areas,' as we call them," says Ilya Scherbovich, president of United Financial Group in Moscow "but I would be very skeptical to say that this is the case for the banking sector. I mean, look at the presence of foreign banks: almost every month you hear somebody new coming. It shows the open and good environment where you can work."

Scherbovich goes on to explain that the general economy of Russia is very dependent on oil prices, so the government's preoccupation for maintaining control of the energy sector is understandable. Russia is the second-largest exporter of oil in the world, after Saudi Arabia, so budget revenues depend on oil prices. With a high oil price, export inflows support the activities of many banks. The indirect redistribution of all this wealth is directed by the financial sector, both as intermediary and beneficiary. Nevertheless, the government has declared its policy to try to diversify the economy away from its natural resources base into industry and technology.

"I don't think it's going as fast as people want, but obviously the development of the banking sector and other sectors is very positive for this idea of diversification. In particular, the banking sector has the task of distributing financing into other sectors, which they are doing quite actively right now."

Too little earnings to support rapid growth
Yet, as in so many other aspects of modern Russian economic life, the surface challenge is only part of a web of underlying, often subtle, but far more vexing problems. As Scherbovich explains, "We can't accuse the private banking sector of under investing in sectors that are not growing, because there are basically very few places to invest. We can't think of the banking sector as one that would actually initiate something new in the economy; to create new sectors. In terms of the actual ability to access capital, the environment is pretty good in Russia. I don't think it's as problematic as it was three or four years ago."

So, according to Scherbovich, the problem for Russian industry is less about access to capital, as it is about the transmission of that capital. As a result, he believes that economic planners in Russia must not only think of ways to create incentives for the financial sector to invest in the economy, but they must also create vehicles in the market system to serve as conduits for those investments, so they find their way to the rebuilding projects in the industrial sector. Furthermore, to maintain the stability of the financial system, the intermediaries must themselves maintain a level of fiscal soundness. And therein lies another problem. Very soon, the banks won't have enough capital to support the financial flows that are required to rebuild the industrial sector.

"The internal capital generation from retained earnings is insufficient to keep pace with the present rapid growth of the banking industry," says Jacobowitz of Deutsche Bank. "The rapid balance sheet growth underpins the rationale for initial public offerings of bank securities. It is a story that investors should be able to understand, that additional capital is required to support the profitable growth and expansion into retail segments or geographic segments of the Russian market for some of the banks that are growing very rapidly."

To support the redevelopment of the industrial sector, most experts agree that Russian banks will need much more capital. However, to compete with foreign banks, while supporting industrial growth, Russian banks will have to obtain that capital on favorable terms. This also goes toward explaining why Russian government officials are adamant against foreign bank branches as a condition of WTO accession. Sergei Stankowski of Barclays Capital explains the predicament:
"The cost of capital of the Russian banks is significantly higher than that of foreign banks, and that's the reason why subsidiaries of foreign banks are less of a competitor to Russian banks than would be the branches. The branch bank is part of the balance sheet of the mother company; and all of their funding, and everything else they do, is done on the basis of the cost of capital for that particular mother company. By comparison, a banking subsidiary is a separate bank, which has its own capital without the parents guarantee and so has to raise money at the same cost of capital like everybody else in that jurisdiction."

Therefore, to protect their domestic banking system, which is necessary for the growth of the economy, the Russians believe they must encourage the growth of domestic banks, including foreign-owned banks, without permitting foreign branches to compete on uneven terms with the domestic banks.

Deposit insurance drives consumer borrowing
It's possible that official views would be less protective and more welcoming of foreign capital on any terms, if the banking system were still as feeble as it was for several years following the 1998 systemic collapse of the Russian economy. But the years have generated many improvements. As Scherbovich explains: "The banking situation now is much more balanced. Banks are actively seeking retail deposits in Russia. They're also financing real sectors of the economy through both the capital markets and direct lending, instead of just buying GKO's [Russian government securities]. Overall, the macroeconomic situation is much healthier than in 1997. It's true that the sharp increase in Russian market capitalization and growth of equity valuations reminds us of 1997, but I don't think the general macroeconomic situation is as volatile and risky as it was back then."

An important element of that formula is the growing willingness of Russian consumers to not only borrow from privately-owned banks, but also to permit the banks to intermediate their savings deposits to other borrowers. The newly-instituted deposit insurance regime has become a cardinal precept in the support of that intermediation process.

"Deposit insurance was discussed for ten years in the legislature," according to Kozlov. "The final decision was made by the government in 2002, so that the law was adopted in December 2003. During the transitional period, the central bank was charged with applying international best practices – they're quite tough – in its qualifying examinations before permitting banks to become members of the deposit insurance system. Any bank that is allowed to deal with household depositors must be in line with the strictest criteria of best international practices. Since February, 2004, the Central Bank's goal has been to verify each bank against this set of criteria."

In some respects, the mere fact of acceptance into the deposit insurance scheme has provided an endorsement for the 850 banks which passed the central bank's tests. Ironically, the examination process threatened to create a wholesale disruption of the banking system after the first few banks were disqualified. Some depositors thought the entire banking system would collapse, as it had in 1998, costing them the value of their life savings. Pictures of angry depositors in line outside Russian banks were transmitted around the world in the spring of 2004. Interestingly, there was just as much rumor mongering within the banking system as on the streets outside.

Credibility requires transparency and stability
Executive vice-president Igor Bulantsev of Moscow-based ORGESBank remembers well the confusion of that time: "There was a list of the banks which were rumored to have problems with Russian authorities. There were 20 or 30 such kinds of lists and every list consisted of 10 to 100 banks. It was spread by competitors, because any of the banks could start their own list and put their competitors there and spread it out through the internet. Unfortunately that is what happened. We were happy to not be among those banks."

Officials at ORGESBank and other sound, fast-growing Russian banks point to their acceptance by the European Bank for Reconstruction and Development, as well as by Western correspondents, as a sort of credential and testimonial to their stability. The due diligence process for credit lines, in the absence of any other certification process, became their ticket to the ranks of credible financial institutions in the pre-depository insurance environment. Such anecdotal forms of credibility, however, leave banks open to equally destructive innuendos from malefactors. For instance, it was an open secret that some bankers were adding sound banks' names to the hot list in order to torpedo their competitors. Little wonder that greater clarity in banking has been defined as a goal by Russian bankers, as well as by their supervisors. Yet, most experts agree that the solution to the credibility issue is not only more transparency for Russian banks, but also a more stable financial footing. And, often, that implies a requirement for fast-growing banks to go to the Western markets in pursuit of additional capital.

Describing his bank's expansion plans and strategy for funding growth, Bulantsev says, "We have plans to organize Russian ruble bond issues. We have plans for syndicated loans from the western banks. We have plans to develop a retail business. We will concentrate on bigger clients that are more attuned to.

Capital Markets
To many Russian banks, 2005 was a breakout as they capitalized on the tremendous growth of the Russian economy and grew at an even faster pace. The big story for Russian banks last year, according to Western underwriters in London, was the issuance of lower tier II debt as six banks, both state and private, launched subordinated issues. Underwriters believe 2006 will be even better as the boom in consumer finance should contribute to increased profitability and higher growth. The big question is whether banks can manage their balance sheets, so that capital can keep pace with the fast growth in assets. Therefore, Russian banks are going to need to supplement their capital adequacy ratios by continuing to launch lower tier II as well as begin to issue upper tier II, hybrid tier I and pure equity securities.

While investors across the world have been quick to invest in Russian banks' securities, Americans have not been as deeply involved. It is somewhat puzzling considering that emerging market debt was one of the best performing fixed income asset classes last year and there are some strong Russian bank names offering very good diversification and yield. On the flip side, Russian banks have not actively sought out US investors because there has been sufficiently strong demand from investors in Europe, Asia and the Middle East.

The lack of reliance on US capital markets is due to change, however, as Russian banks begin to launch bigger deals with longer tenors that will require participation by fund managers and private banks in the US who are more accustomed to investing in the 7, 10 and 30 year range. Russian banks also want to include a wide investor base that includes Americans in order to procure a degree of political protection from government interference, remote as that risk may be.

Upper tier II, hybrid tier I and a stacked IPO pipeline of Russian banks indicates that 2006 looks to be the most exciting year yet for investors looking to participate in one of the fastest growing financial markets in the world.

Russian banks exploded onto the international capital markets last year and will do even more in 2006.

VTB set the stage in 2005 for subordinated debt and issued the first tier II transaction in January 2005. Sberbank and fellow state-owned banks Industry and Construction Bank and Bank of Moscow quickly followed up with their own sub-debt issuances. In late November, Alfa Bank demonstrated that not only can privately owned banks issue subordinated debt, but they can do so without having issued a senior transaction first. Without the senior curve, the pricing of the $200m subordinated issue was more complicated for underwriters and investors alike, but the deal was nevertheless oversubscribed by strong demand from foreign banks and fund managers.

Russian Standard came back at the end of the year and outdid Alfa Bank with a $750m sub-debt deal in December 2005 to become the second privately-owned bank to issue lower tier II. It was such an impressive launch by a private bank that it won deal of the year from International Financial Review.

VTB had one of the other most impressive deals of the year with their $1bn 30 put 10 with a 6.25% coupon. Another important milestone in 2005 was established as Promsvyazbank became the first single-B rated Russian bank to issue an unsecured five-year Eurobond. The $200m transaction was oversubscribed and distributed primarily among investors in Europe and Asia.

In order to appreciate the significance of lower tier II transactions from Russian banks, one must realize that as recently as 2-3 years ago, banks were just getting started with short-term $100m issues priced at considerably wider spreads. From these humble beginnings in 2003, Russian banks have extended the value, tenor and pricing of their issuances to a level unimaginable a few years ago.

Russian Standard can be used as a good case example of the growth in issuance by Russian banks. In December '03 they issued a $30m 18-month CLN that yielded 11%. By April of 2004 they launched a 3-year transaction for $150m with an 8.75% yield. In September 2004 they doubled that by issuing a 3-year bond for $300m that was priced at 7.8%. Two months later in November 2004, the 3-year $150m was upsized to $300 million.

Therefore, in less than one year Russian Standard went from a $30m 18-month bond priced at 11 % to a huge $300m issue with multiple investors that was priced down to 7.8%. Russian Standard has continued to stand out. Before their remarkable $750m sub debt deal in December, they issued a $500m RegS/144a 5-year transaction in September 2005.

While the bigger banks are now launching lower tier II with ease, the smaller Russian banks still don't have the same access to the international capital markets. However, smaller banks must build a track record with investors. The first step is to issue ruble-denominated bonds on the local market. The next step is to issue a simplified Eurobond version such as a CLN that doesn't require significant disclosure. While CLNs are illiquid and privately placed, they can be issued more quickly than a Eurobond and they still get the bank's name out to the market. The final step is to issue a Eurobond and eventually step up to the subordinated issues and follow in the footsteps of the larger banks. A handful of smaller Russian banks have already successfully secured syndicated loans for up to a year or have placed ruble-denominated bonds on the local market.

A good indicator of what's to come in Russia is what has happened recently in Kazakhstan. Kazkommertsbank was the first bank in Kazakhstan to issue perpetual tier I Eurobonds in 2005 and Bank TuranAlem issued an even larger tier I transaction in January 2006 that was very successful with investors. TuranAlem had initially wanted to raise $150m but because demand was so strong, especially from Asian private banks, they upped the book size to $400m without having to pay any higher spreads. The bonds have performed well in the secondary market, demonstrating that the issue was correctly priced for its size.

Russian banks' retained earnings and owner's equity injections are insufficient to support expansion
Before 2004, retained earnings and equity contributions from owners was sufficient to support asset growth. The average capital adequacy ratio for Russian banks has declined to 16% at the end of 2005 from 19% at the beginning of 2004 (Figure F). This figure is still safely above the 10% requirement set by the Central Bank, but the sector average is also propped up by the relatively higher capital adequacy ratios of the state-owned banks. The average ratio for the privately-owned banks is closer to the 10% mark.

Capital adequacy ratios have declined because lending programs have grown so rapidly and internal revenue and equity injections have not kept pace with the rise in risk-weighted assets. Without the issuance of the lower tier II, Russian banks would have seen their capital adequacy ratios fall even lower. The ability to raise subordinated debt to augment capital adequacy ratios is a huge step for Russian banks. An added benefit is that tier II and hybrid tier I debt allow banks' return on equity to remain higher than if they were required to supplement their capital with pure equity.

Great opportunities for investors
The difference in the Russian market right now as compared to the situation in 1997 and 1998 is the strong macro-economic foundation and the high level of liquidity in the market. These two factors have sent spreads down and investors scrambling for yield and duration. Investors have done this by going further down the credit spectrum by looking at banks in the second and third tier or by going down the credit structure by taking the lower tier II and perpetual issues to get more yield. It is interesting to note that the trading levels between the VTB subordinated issues and the VTB senior issues are very close right now, indicating that there is increasing investor demand for the subordinated credit.

"It's a very exciting time for bank capital, for financial institutions all over the CIS," says Carlyle Peake, head of emerging market debt syndicate at Dresdner Kleinwort Wasserstein. "It's an exciting place to be if you're an issuer as well as an investor, because the opportunities you have across different products has expanded and grown in a very material way. [For investors,] you've never had the opportunity to buy perpetual instruments in these institutions, but now you have not only the financial institutions but also the corporates…there are opportunities that are perhaps the most attractive in the world."

"Russian banks present an interesting growth opportunity and investment opportunity to participate in the real economy through an investment in rapidly growing banks that are trying to support their expansion plans over time," says Dan Jacobowitz, Director of Corporate Finance for Russian FIGs at Deutsche Bank.

Russian banks represent an exciting opportunity because growth rates of the banks will exceed the GDP growth rate. The growth will only be augmented by the expansion of the still nascent consumer finance segment.

Lack of US demand for Russian bank issues
Russian banks' capital issuances in the last two years have been vastly oversubscribed by investors from Europe, Asia and the Middle East. There has been interest from American investors, but mainly from US hedge funds and other high-risk investors rather than private banks, fund managers and pension funds.

Due in part to the lack of interest as well as the strong demand from elsewhere in the world, Russian banks have not issued many 144a securities. In addition, 144a issues can cost in excess of $150,000 due to the additional regulatory, legal and overall preparation required. Only a few banks such as VTB and Russian Standard have issued them.

In order to explain the lack of activity on the US capital markets, Ilya Scherbovich, President and head of investment banking at UFG says, "Russians love mushroom picking, but why would you go 10 miles from your door to pick mushrooms if you can take 3 steps and come to the nearest forest and collect as many mushrooms as you need? So the same thing here, why would you go through all of the issues of getting a stock listed in the US if you are only raising a couple hundred million dollars, you can easily do it here or maybe in the London market. However, for large transactions where you really need access to all groups of investors, then America is definitely an option."

Traditionally there is not a strong relationship between Russian issuers and American investors. Latin American banks have been more active in the US market and American investors are therefore more familiar with those names. European, Asian and Middle Eastern investors have the same geographic proximity to Eastern Europe and are therefore more familiar with the Russian banks.

The bottom line is that because it's been unnecessary, Russian issuers haven't taken the time to increase their exposure in America. US investors, meanwhile, have been looking with a more critical eye on the emerging market financial institutions in general and in some cases have been pricing them wider.

However, the Russian Standard $500m 144a Eurobond issue indicates that some Russian banks realize that they will need to access the American capital markets to a greater degree in the future. Just as smaller Russian banks must begin by launching ruble bonds on the local market to establish some sort of track record, Russian Standard has done the same thing with its private placement to American qualified institutional buyers (QIBs). The Russian banks that have accessed the international capital markets already have a 3 year outstanding and the line is getting pushed out to 5 years and now even 7 and 10. The US market is more important in the longer-dated sector than it is on the 3 year. "In Europe there are a lot of banks investing and their sweet spot is typically between 3 and 5 while the US has a lot of long fund managers, insurance companies and pensions that want to go 7, 10 and beyond…. the further you push out the curve, the more you will want to get the US involved," says Peake. "As you grow as a bank and get bigger, you're going to want bigger issue sizes. Part of the reason Russian Standard issued a 144a is because it was for $550 million and it didn't want to push all $500 million into Europe at one time."

This dynamic could also be changing as Russian issuers are becoming more concerned about investor diversification. Investor diversification is always beneficial, but in Russia there is the added benefit of large foreign investors acting as a hedge against political risk. With a wider investor base that includes US institutional investors, the Russian government might not be as quick to interfere. Depending on how one looks at it, however, the one exception or the counter argument to this rule would be the government's hostile takeover of Yukos. It could be argued that the Yukos case is an anomaly because Khodorkovsky broke the gentleman's agreement against oligarchic political participation. Large foreign shareholders would presumably protect against government interference in most other instances.

In the banking sector, the government already has a great deal of control through the large state-owned banks; it doesn't need any additional power in order to control where money flows through the economy. "The state has a stake in the two largest banks, Sberbank is the leader in retail banking and VTB is one of the leading corporate banks, so there's no need for the state to interfere or acquire assets in order to grow in this industry. Concerns about possible state involvement toward these banks over tax claims are all overplayed," says Eugene Popov, chief credit analyst at DrKW.

What Russian banks do need from American banks
While Russian banks might not need capital from American banks at this moment, they do need the assistance, experience and technological capability that American banks can provide. The consumer finance market is going to be the moneymaker for Russian banks in the next several years and American banks have a wealth of consumer finance expertise.

"To maintain earnings growth at a rapid clip it's very important to develop a retail banking platform, which is a completely different business than corporate banking, and which requires a lot more infrastructure like investment in IT systems and people training," says Jacobowitz.

Local capital markets will soon be able to support Russian banks' capital demands
The local capital markets in Russia are developing quickly and soon Russian banks might not even need to go to the western markets to raise capital.

"If we are doing an IPO under 200-300 million dollars sometimes we even suggest don't even do London, just do local, there will be no real price difference. If you're doing above $300m we suggest that they consider London or New York. In this case when you're doing foreign listing we can argue that probably you can get up to 10% and sometimes even 15% premium to your capitalization, because so much more increased demand," says Ilya Sherbovich, the president and head of investment banking at UFG.

Reinout Koopmans, director of equity capital markets at Deutsche Bank agrees that "the history of Russian issues have been largely GDRs…and the larger ones will always have an important GDR component but on the other hand, 6 months ago when we placed the MTS stake out of Deutsche Delecom, we placed $1.5 billion of ordinaries into the local market. Of course this attracted not only local investors but also international investors that have the ability to trade in local stock. This proves the point that you can create a market in ordinaries as long as you have an effective distribution platform."

Investors eagerly await Russian bank IPOs
2006 will be a banner year for bank IPO issuances. 13 Russian companies raised almost $5 billion in IPOs on local and foreign exchanges in 2005. There are supposedly over a dozen Russian banks that could potentially list equity shares in 2006 and 2007. Sberbank and Vozrozhdeniye are currently the only Russian banks with publicly traded equity. Sberbank's "multiples are extremely high, which in part reflects the relative scarcity of banking stocks as well as Sberbank's high returns," says Jacobowitz. Sberbank has been one of the hottest stocks on the Russian stock market since its IPO. When the GDR was initially placed the stock was trading around $400 whereas right now it is all the way up to $1500.

Investors are looking forward to Russian bank equity in order to increase their diversification and exposure to one of the fastest growing sectors of the Russian economy. Currently Central and eastern European banks are trading at high valuations and Russian banks will most likely want to issue as much as possible to take advantage of these very attractive terms of trade. The median of Central and Eastern European banks is 3 times book value whereas Sberbank is around 4 times.

"A lot of people have greatly benefited in this growth of the share price of Sberbank. We remember some of our clients four to five years ago who were buying shares at $30 a share, now selling at $1500. That's a very nice return," says Ilya Sherbovich at UFG.

Russian banks have the added incentive to issue equity because shareholder's equity is necessary from a ratings perspective. "Pure and proper equity is required for maintenance of a bank's ratings," says Jacobowitz. While Russian banks have begun to issue subordinated debt, they also must ensure that they maintain the quality of their capital base. If the Central Bank of Russia were to conform to the Basel Capital guidelines, Russian banks' total lower tier II debt could only be 50% of their total tier I. Upper tier II can only reach 50% of total tier I capital and hybrid tier I issues cannot be in excess of 15%-25% of total tier I.

A number of Russian banks, not only just the largest state-owned banks, have indicated that they are considering issuing equity this year. In addition to VTB and Gazprombank, two of the larger privately-owned banks such as Rosbank and Alfa have also indicated intent to list. In addition, two banks further down the asset list, International Bank of St. Petersburg (77th largest Russian bank ranked by assets) and Uniastrum (ranked 106th), are both reportedly considering an equity issue late this year or early 2007. It is hard to say whether there will be sufficient investor interest in order to support an IPO from banks further down on the list such as International Bank of St. Petersburg and Uniastrum, but the biggest bank names will find plenty of willing investors.

Problems that are holding up banks on the Capital Markets
One of the hurdles preventing Russian banks from issuing upper tier II and hybrid tier I debt is the lack of Central Bank guidance on what constitutes these specific types of capital. Regulations are not in place at this time but the Central Bank has stated that it is serious about providing banks with the necessary support they need to grow. The lack of guidance on upper tier II and tier I debt should not remain in place for long.

A stumbling block preventing greater foreign access to the Russian banking sector is the Central Bank requirement that shares must be 'blessed' before they can be sold to a foreigner. "At the moment we have an acting law that says if you are a holder of Russian banking shares and you want to sell the shares to a foreigner you have to obtain independent special permission from Central Bank," says Ilya Sherbovich from UFG. "This is a fundamental problem for banking IPOs and banking secondary and primary issues. The Central Bank is now thinking about how they can ease it a little bit, maybe allow the circulation for portfolio investors without such restrictions."

There are currently three classes of shares for Russian bank stocks: normal shares that trade on the domestic exchange; shares that are circulating among foreigners which have been given permission to be sold to foreigners; and shares in a GDR program.

"There is a regulation of the Central Bank which states that if more than 1% of capital of the bank belongs to a nonresident then this nonresident has to get approval from the Central bank. It's very unsuitable for the banks, because it means that it is impossible to realize an IPO and to get a bid for a widespread investor base. Recently, the deputy Chairman, Mr Melnikov said that CBR is thinking about the increase from 1 % to 10%. If this is done, then there will no longer be any serious limitation for IPO procedure, because in framework of IPO it is rare that someone buys more than a 10% stake in a bank immediately," says Oleg Vyugin, head of the Federal Financial Markets Service. It is most likely that the CBR will take steps to provide more opportunities for banks to raise equity capital because Mr Kozlov has indicated that the CBR would like to see an increase in the capital of the Russian banking system through the IPO of the banks.

Russian banks will quickly follow with tier I debt issues of their own as soon as the Central Bank of Russia finalizes the regulatory framework. Moving from subordinated to tier I debt is a natural evolution of the market and will demonstrate that Russia is continuing on the right path.

Additional developments include the emergence of the asset backed securities market. The ability of Russian banks to issue asset backed securities will allow them to expand their lending activity without having to bear all of the risk. In an asset-backed securitization, a Russian bank originates the loans to consumers and enterprises but transfers the credit risk to the buyers of the ABS.

The first securitization backed by local receivables took place last year when Bank Soyuz converted 3,500 dollar denominated car loans into an ABS issue. JPMorgan acted as paying agent and cash manager. The ABS market is expected to grow substantially as the entire consumer finance market expands.

Development of the local stock markets
The local stock markets have developed well over the past two years. In February 2004, total Russian stock market capitalization was slightly higher than $200 billion and in February of 2006 total market cap reached over $500 billion. Mr. Vyugin stated in February that total market cap could reach a stable level of 60% of GDP by 2008. The market is gaining stability and liquidity and smaller companies are finding their way onto the market.

There are two main stock markets in Russia: the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX). RTS was established first in 1995 along the same lines as the OTC Nasdaq Stock Exchange. The RTS Stock Exchange has developed over the last several years into an exchange that focuses more on smaller company's equity securities as well as the quickly growing derivatives market, called FORTS (Futures and Options on RTS).

MICEX was established in 1992 as a currency exchange and first began to trade government bonds in 1993. Only in March 1997 were equities first traded on the MICEX exchange. Starting out as the second major Russian stock exchange, MICEX has quickly developed into the leading exchange in terms of trading volume. Around 85% of total turnover of Russian equities takes place on MICEX. Despite this dominant position, the RTS Index continues to be considered the benchmark index for Russian equities. The majority of blue chips are traded on MICEX; however, the largest trades are often carried out on RTS. The relationship partly resembles that between Nasdaq and NYSE in that American companies often start out on Nasdaq but switch as they become big enough to meet NYSE's listing requirements. Prestige plays a large part in a company moving from Nasdaq to NYSE, but it's harder to make the comparison with the Russian exchanges because RTS has the longer pedigree and the RTS Index is the nation's premier equity index. In addition, Russian stocks trade on both MICEX and RTS, making it even harder to analyze differences between the two trading platforms.

There are also a number of regional currency and stock exchanges such as St. Petersburg, Yekaterinburg, Samara, N. Novgorod, Novosibirsk, Rostov-on-Don, and Vladivostok. The St. Petersburg Stock Exchange actually accounted for close to 15% of total trading volume last year. This was due to the fact that Gazprom shares were only traded on the St. Petersburg exchange. In January of this year, Gazprom shares were first traded on RTS and then a few days later were also traded on MICEX.

In 2005 the RTS Index doubled in value from 600 to over 1300 points as shown in Exhibit G. The RTS Index was around 1450 as of Feb 21, 2006.

New developments that will help the development of the local stock markets include additional regulations designed to reduce the level of insider trading and plans to create a Russian centralized securities depository. In a roundtable discussion held by Institutional Investor last summer, Vyugin said that "it will be much easier for foreign investors to come into Russia if we have a central depository, which would be in a position to keep accounts for central depository insititions abroad, and it will be easier for foreign investors to buy Russian equities. We have a project underway, with the support of the World Bank, to create a central depository. The second task is to create a central clearing counterparty, but that will be the next step, and more complicated than creating a central depository."

Development of the derivatives market
Within the institutional market, asset managers and pension funds in particular, need to hedge their positions and a well-functioning derivatives market is essential to Russia's continued success. One problem in Russia is that derivatives have a bad reputation dating back to 1998 when Russian banks took on too much risk in with dollar forward swaps.

As MICEX has taken over as the main equity exchange, RTS has expanded into derivatives with FORTS and handles over 98% of derivatives trading volume. FORTS was started in 2001 and took over derivatives trading from the Derivatives Division of the St. Petersburg Stock Exchange. FORTS currently offers futures and options on the RTS Index as well as single stock futures of United Energy Systems, Gazprom, Lukoil, Rostelecom, Surgutneftegas, Norilsk Nickel, and Sberbank. Of those seven single stock futures, there are only four on which options are offered: UES, Gazprom, Lukoil, and Rostelecom.

In order for the derivatives market to develop more fully, there are several laws that need to be changed. "We have a number of regulatory limitations," says Vyugin. "Since 1998 all deals with derivatives are recognized as gambling by the Russian court system. In order to change this we have to make some amendments to the serial code, in order to separate derivates as special financial operations.”