Both the stock and the banking sectors of Russia’s developing financial system are currently unable to satisfy the real sector’s need for outside financing. The government needs to do the lion’s share of work to establish a robust financial system

Ekaterina Shokhina

Historically, countries were divided up by their financial systems. They are either based on banks (traditionally, the financial systems of continental European countries and Japan) or on the stock market (the US, Great Britain, Canada, Australia, Hong Kong, and Singapore are classical representatives of this type). This division is to a great extent merely conventional, since the two systems of corporate financing and control are becoming increasingly similar. Nevertheless, the division makes it easy to analyze how the economy’s real sector is financed, whether mainly via bank loans or via floatation of securities on the stock market.

Where is Russia?

Initially, good formal preconditions for establishing a stock market-based financial system were created in post-Soviet Russia. “After large-scale privatization was complete, about forty million shareholders appeared, more than in the US,” says Pavel Teplukhin, President of Troika Dialog Management Company. “Their number has fallen now. Many have sold their shares to management and some funds went bust. Shareholders are fewer in number but there are still quite a lot of them, around ten million.”
However, world practice shows that a financial system based on the stock market also requires a non-concentrated structure of ownership, limited government interference in the economy, secure protection of minority shareholder rights, substantial willingness on the part of private investors to assume risks, and highly developed investment institutions. It is obvious that Russia does not meet these criteria at all. “The structure of ownership in Russia is extremely concentrated, and the overwhelming majority of companies have controlling shareholders,” says Yakov Mirkin. “This, in its turn, predetermines a lack of owner interest in watering down capital and entering the public stock market.” In terms of state interference in the economy, the level of corporate culture, and protection of shareholders’ rights, the situation is even sadder, and the notorious YUKOS Affair is the most graphic evidence of this. “The awful legislation on joint-stock companies largely impedes development of the stock market in Russia – it doesn’t enable you to use mechanisms available on the stock market for increasing companies’ capital,” says Ilya Yurov, Head of Trust Investment Bank.
As a result of the lack of reliable legislative protection, according to public polls only 0.3% of the Russian population is willing to invest their funds in stocks.
In Russia, institutional investors – insurance companies and pension and investment funds, the major players on the securities market in countries with stock market-oriented financial systems – are in an embryonic stage at present. Over the last two years, mutual funds began to grow but they have only managed to attract 80 billion rubles, a negligible amount in terms of the domestic economy. As a result, the Russian stock market may serve as a source of long-term funds only for a very limited number of companies. “In this context, the stock market can be of interest only to blue chips with transparent financial accounting and normal structures.  Smaller companies outside the natural resource industries, which are supposed to diversify the country’s economy, are as yet unable to meet IPO requirements for financial transparency, company structure, and growth. Participants in this part of the economy are still not able to appeal to a wide circle of non-professional investors,” Yurov believes.

No banking panacea

Clearly, Russia’s financial system should develop using its banking system as a basis. However, it’s not that much easier for the real sector to attract banking capital today than it is to borrow funds on the stock market, although the overall situation looks quite optimistic. The favorable economic conditions of recent years have done their part, and over the last five years the volume of the Russian bank deposits has increased eightfold and reached 1.6 trillion rubles, the equivalent of about $50 billion. However, average terms of deposits are as short as a year or a year and a half, while the real sector needs loans for three to five years at the very least.
The ways to make banking liabilities longer are well known. They are, firstly, to increase household incomes and strengthen people’s confidence in future, and, secondly, to increase confidence in the banking system and the national economy as a whole. Today, there are considerable problems regarding both these approaches.  As a result, only about 10 million out of approximately 100 million economically active Russians are bank customers.
Refinancing the banking system is another possible way to increase bank capitalization and lengthen the terms of the funds they receive from economy. When people discuss sources for refinancing the banking system, they usually mean the Central Bank. The total value of the Central Bank’s gold and foreign currency reserves is currently approaching $80 billion, and many analysts are wondering whether it would possible to allocate some of these funds to strengthen the banking system. Meanwhile, the government document, “The Main Directions of a Unified State Monetary and Credit Policy for 2004,” provides for banking system refinancing by the Central Bank to the tune of 20 billion rubles for terms ranging from one day to three months. This means little to banks and has made many bankers very unhappy.
Another alternative for bank refinancing is securitization, the conversion of “long” tangible assets like real estate and land into liquid securities. For example, a bank gives a mortgage to individuals at the expense of its own liabilities. After that, it gathers a pool of several creditors and issues its own securities, which are covered by the right to the proceeds from these mortgages. “Thus, when investors purchase these securities, they don’t have to bear a bank’s credit risk in full; this risk is covered by a mortgage,” says Askhat Sagdiev, Deputy Chairman of the Moskommertsbank Board of Directors. “Securitization solves one of the most urgent banking problems, the mismatch of liability and asset terms.”
In Russia, asset securitization hits on a number of problems, though. Firstly, the general underdevelopment of the stock market has resulted in the abovementioned insufficient presence of valuable institutional investors on the market. Thus, there is virtually no market for mortgage securitization. “The volume of mortgages in the Russian Federation is negligibly small. The total market is estimated at $500 million, at most. Only when the market volume exceeds a billion dollars could we talk about the possibility of establishing a market for securitized mortgages, because there is no sense in a bank to practicing securitization if the total volume of its loans is less than $30 million,” says Askhat Sagdiev. Here, then, we see yet another vicious cycle: in addition to the evident defects in mortgage legislation, high interest rates are one of the main reasons for the lack of a mass mortgage market in Russia. The reason for high interest rates, however, is that banks are unable to refinance their long-term mortgage assets. In the end, international financial markets prove to be the most available source of long-term funds for Russian banks. However, this luxury is only available to large banks, and Russian banks will have to consolidate to take full advantage of international markets’ potential.
Foreign strategic investors could also be a source for building up bank capital, but this again is the privilege of major banks. “Foreign investors are interested in participating in banks that control a considerable portion of the market and have a recognized brand name,” says Oleg Solntsev. “Today, our top 30 banks have a market share of around 5% each. A large foreign bank could set up a bank of this size itself rather than invest in a Russian one.”

What is to be done?

How can we cure the Russian financial system? Both sides –government and business – should take the initiative. The main complexity of financial system development is that acting alone, neither the state nor the business community can solve the problem. The authorities can pass as many enactments, decrees, and laws as they please, but if these regulations are merely emergency quick fixes and are not systematic and in harmony with entrepreneurs’ interests, nothing will change. Similarly, business will be unable to develop Russia’s financial system without state support, simply because too many things in this sphere are tied to regulation problems.
Business can do the following things to breathe life into the financial system without state involvement. The first thing is to improve financial accounting. “Today, no one is able to meet IPO requirements, meaning to submit an audit and a company strategy and make profits public,” says Pavel Teplukhin of Troika Dialog. The state has a lot more room to maneuver in the banking sector. Individual savings are one of the main sources for long-term funds for both the banking sector and the stock market. Therefore, the state’s first task is to increase household incomes, first and foremost by reducing the income tax. Long-term funds must come from tax reductions and not from redistribution from individuals to real sector companies, as is a common practice in Russia. With this “traditional” approach, there is no point in encouraging economic development, unless the ultimate goal is to increase the budget surplus or the state stabilization fund.
The second required thing is to increase the attractiveness of bank deposits in the eyes of the public by developing an efficient deposit insurance system. To reduce the risks banks take when financing the real sector, business and the government should work together. “A system of credit ratings is required, or in other words a method of regulating how access to loans is handed out to an enterprise, which links the company’s payment discipline with potential access to loans,” says Oleg Solntsev.
As for the stock market being the second major source of long-term funds for the economy’s real sector, the importance of the state’s efforts here cannot be overestimated. First, it is necessary to drastically reduce the number of restrictions on securities issues. Second, it is very important to encourage the development of investment banking. According to Pavel Teplukhin, the state could help investment companies promote businesses not involved in natural resources by participating in investment activity along with private investors.
Finally, the regulatory base of the financial system must be improved fundamentally. The Russian financial system is in its infancy and is developing only thanks to an increase in the monetary supply. The infancy of the Russian financial system is paradoxically accompanied by a senile legislative environment, which is extremely anachronistic and rudimentary.  

More in Russian>> www.expert.ru