In the next five years, Russian banks’ assets will double, while competition with foreign financial institutions will be limited to specialized niches such as loans for major export companies and retail banking for the wealthy.

Stephan Dertnig*

* Head of The Boston Consulting Group’s Representative Office in Moscow

A healthy and efficient financial system is a key factor in Russia’s further economic growth. Though foreign direct investment (FDI) in Russia grew by 1 1/2 times last year, one should not assume that it will become the main source of investment in fixed assets. Even in China the influx of foreign investment, huge by Russian standards, provides for the same share of investment in fixed capital as in Russia. Though in absolute terms FDI for 2003 totaled $51 billion in China and only $6.5 billion in Russia, the share of FDI in total investments in Russia was slightly higher than in China, 8.3 percent versus 7.9 percent. For this reason, the Russian financial system, the stock market and banks, must provide new investments by ensuring that the savings of individuals and institutional investors move into the economy, in addition to the assets of insurance and pension companies. But is the system capable of accomplishing this?

Full Speed Ahead

The Russian banking system in 2003 confidently followed a trajectory of rapid growth. Bank assets grew faster than the economy as a whole. For the first nine months of 2003, they increased by 16 percent in real terms, while the GDP for the entire year grew by 6.8 percent. This trend will continue. Analysis of other emerging markets shows that Russia is at the beginning of a rapid growth curve and has the potential to double its total assets in the next five years.
The necessary condition for rapid asset growth in the banking system is a corresponding growth in capital. This can be achieved either through an influx of foreign bank capital or funds from a financial-industrial group, or via internal growth of banking system capital.
Russia does not have to rely on the first, “foreign” option. It is highly unlikely that Russia will follow Eastern Europe’s path, where in practically every country the five largest banks are foreign. Western European banks see Eastern Europe as their domestic market, as a future part of the EU. They are not interested in a similar active takeover and domination of the Russian market.
The second source for expanding banks’ resources, funds from financial-industrial group parent companies, also dried up after the crisis.
Our analysis shows that the Russian banking system is fully capable of growing by means of its own internal resources. In terms of capital formation, Russian banks feel sufficiently confident at present and often surpass the largest banks on the world market. The average return on Russian banks’ equity is more than 20 percent (30 percent at the leading banks in 2002), while at the best international banks it does not exceed 15 percent to 25 percent. At large German banks, for example, it is only 5 percent.
Nonetheless, the profitability of traditional Russian banking and its rates of capital formation are sinking. Competition is increasing significantly and margins shrinking, especially for loans to large borrowers. The reason for this is both the exodus of the largest companies to foreign lenders and the tendency, following the worldwide trend, for companies to abandon bank financing for stock and bond issues, along with banks’ lower margins of interest. We should expect margins to continue to shrink to approximately 3 percent, the level in Eastern Europe (today the average interest margin at Russian banks is around 6 percent for hard-currency transactions and about 8 percent for ruble transactions).
Yet even with the slight decrease in the return on equity compared to current levels, the Russian banking system is fully capable of financing its own growth using its own internal sources. Maintaining the current capital adequacy level, the two-fold expansion of assets by 2008 will require banks to mobilize $21.6 billion in capital resources with the current total equity at $24.8 billion, which seems completely realistic.
What is required for this to happen? When major borrowers are no longer the main source of growth and capital formation in the banking sector, there are only two options for development: creating new products and attracting to banking services groups of clients still underserved by banks, namely small and mid-sized businesses and the population at large. 
Russian banks have already begun to pursue this strategy. According to The Boston Consulting Group’s estimates, the actual rate of growth in lending to small and mid-sized business is around 20 percent a year, while the rate for big business is less than half that. The total accumulated amount of loans to small and mid-sized business already equals the total amount of loans to big business.

Facing the Public

Retail banking is also playing an increasingly noticeable role. The retail banking sector saw the beginning of a real boom in 2003, a boom that analysts were not expecting even a year ago. The substantial growth in retail’s share can be seen in both assets and liabilities transactions at banks.
Individual savings are playing an increasingly active part in forming the resource basis for the banking system. The ratio of private deposits to aggregate bank assets reached 26 percent compared to 19 percent at the beginning of 2001. Nonetheless, Russia is still far from the world norm. In developed countries, the average figure runs between 70 percent and 80 percent. At the present moment, private individuals have already deposited $50 billion in banks, thanks to the growth in personal incomes and economic stability. The Law on Government Deposit Insurance signed by President Vladimir Putin in late December 2003 will further speed up the process.
In their search for new sources of revenue, Russian banks are actively promoting retail credit. Its impressive growth — 4-5 percent a month — was the main event in retail banking in 2003, and it now makes up 9.3 percent of banks’ loan portfolios. Not surprisingly, the gross margin of interest on credit to private individuals was 16 percent in September 2003 (on ruble loans and deposits), while the margin on transactions with companies was only 6.5 percent.
Nonetheless, the sky-high profits from this business are becoming a thing of the past. In Moscow, competition has heated up in a whole range of segments, from express credit in retail chains to car loans, forcing banks to lower their interest rates substantially. They fell by nearly half in a year. One of the reasons behind the competition, which is making it difficult to maintain current growth rates in the retail credit sector, is the relatively underdeveloped nature of retail trade, particularly in regions outside of Moscow and St. Petersburg. All the major Moscow retail chains already have up to 10 (in the case of car dealerships) partner banks providing credit, and sales on credit have already reached 60 percent at some retailers. It is not profitable for banks to work with individual stores and small chains. For this reason, banks have shifted their priorities to credit cards and untied consumer loans, which has also led to lower interest rates due to thorough background checks on borrowers and consequently lower risks.
The potential for further expansion of the retail credit market is significant. In Russia, it equals only 2 percent of the GDP, while it runs 30 percent in Eastern Europe and can reach 130 percent in developed countries. However, presently and in the short-term future, Sberbank will remain the key market player with 40 percent of the market thanks to its large regional network and rates that are some of the most competitive on the market (19 percent for rubles, 12 percent for hard currency on untied consumer loans). Foreign bank subsidiaries have become more active on the Moscow retail market, banks that formerly worked primarily with corporate clients’ employees (Raiffeisenbank and Citibank). The International Moscow Bank (Rus. MMB) is preparing to drastically increase its retail business in 2004, and a new player has appeared on the market, Société Générale. Their target audience is the upper segment of the middle class, and they are gently turning away mass-market clients. To open an account with Citibank or Raiffeisenbank, a customer has to fill out a long questionnaire and present proof of employment with an official income statement. In addition, Raiffeisenbank requires an initial deposit of at least $1500. Both banks reserve the right to refuse to open an account or serve those who do not qualify. According to our estimates, foreign banks will play a significant role for wealthy consumers, thanks to their high level of reliability, up-to-date banking services and excellent customer service. Typically, despite their low interest rates on deposits (2-3 percent p.a.), two foreign banks are already in the top 10 banks in terms of amount of private deposits (Raiffeisenbank and MMB), and Citibank is swiftly catching up. Their limited target consumer group keeps these banks from expanding in provincial Russia for the time being.
The new wave of consolidation among Russian banks is for the most part determined by plans to expand retail banking, and a great amount of attention is being paid to the extent of a bank’s regional representation. Rosbank acquired OVK Bank and its network of 360 branches and more than 1000 ATMs across Russia. A deal in which NIKoil would acquire Uralsib, a major regional retail bank, is currently underway and would make the NIKoil-Avtobank-Uralsib Group one of the top five leading banks on the retail market. MDM Bank acquired Petrosky Bank in St. Petersburg. The goal of these banks is to expand their retail banking market share by several times and to become firmly entrenched as market leaders.

Bank Branches: a Thing of the Past

As retail banking booms, the issue of the proper infrastructure and distribution channels will become increasingly important. The customary expansion of the majority of Russian banks via a dramatic increase in expensive, traditional branches provokes a range of questions.
First of all, traditional bank branches are very expensive. According to BCG estimates, investment in branches is only profitable when serving middle- and upper-middle-class customers, meaning, of course, predominantly individuals with an income of more than $1500 a month and, in the best case scenario, with incomes of $500 to $600 a month. For the time being, these customers are few in number and mostly concentrated in Moscow. Several foreign banks have started fighting over these customers. Increased competition could lead in the medium term to excessive numbers of bank branches in Moscow that are not able to attract enough profitable clients for a positive rate of return, and that will serve the mass market. 
Nonetheless, Russia has a unique chance in retail banking and is in a more favorable position than Western banks on their home markets. Russia does not have to go through Western banks’ phases of development, but rather can leap right to the current phase. Western banks inherited their large networks of retail branches from previous phases of development, and at present, due to high costs, branches are a burden banks would like to rid themselves of in favor of less expensive up-to-date channels of distribution, such as online and phone banking.
New distribution channels and service formats are the main sources of retail profit growth. These include phone and online banking; ATMs with expanded functions; mini-branches with a smaller staff, greater automation and a back office serving clients and the entire branch; and bank mini-offices and express loan kiosks in stores. BCG’s international experience has demonstrated that retail banking transaction costs online or by phone are 20 times lower than traditional service in branches. Offering these services can lead to a 20 percent increase in retail business. A variety of banks in Russia are already pursuing this strategy, such as Alfa-Bank. Alfa plans to stay among the top three banks on the retail market by limiting itself to only 40 branches in Moscow (compared to Sberbank with more than 700). Citibank has the widest range of formats (mini-branches, specialized mini-offices, online and phone banking, ATMs that accept cash deposits, internet terminals and outsourcing and courier services), and its pricing encourages consumers to use alternative channels. Other banks are also working in this direction but are still unable to offer a full range of online and phone services.

New Financial Marketing

Efficient retail growth can and must come from expanded sales of products and services to existing clients. The experience of banks around the world demonstrates that crossover sales are one of the main means for maintaining banks’ retail profitability. Russian banks have yet to make significant effort in this direction and are competing, predominantly via prices, over each separate product. One of the reasons behind this is that retail clients are often not able to choose their personal bank freely. This is done by their employer according to their payroll setup. In this situation, banks do not make enough effort to satisfy individual customers’ demands, as their clients are the companies that employ these customers, and banks prefer to get the maximum revenue from servicing their accounts. Nonetheless there is some movement forward. For instance, Avtobank-NIKoil, Rosbank-OVK and, to some extent, Citibank, Raiffeisenbank and Alfa-Bank are opening financial supermarkets with a full range of banking and financial services, including insurance, retirement planning and investing.
Offering service packages designed for a particular group of consumers is another indicator of a well-developed and competitive retail business. Only Citibank, Alfa-Bank Express and OVK are currently using this approach. Overall, the offerings for private customers are expanding rapidly, and almost every day some bank launches a new product. However, for the time being, no single bank offers a complete line of products. For instance, Alfa-Bank, Citibank, Rosbank-OVK and Avtobank-NIKoil do not give mortgages, while Sberbank, OVK, Avtobank-NIKoil, Uralsib and the Bank of Moscow do not issue credit cards.

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