After 1998 crisis the development of Russian banking system followed a model that is entirely different from that of the early 90-s. Russian banking system became more credit oriented, and banks were acquiring more and more “banking” behaviour. They are becoming mediators between industries in real sector and public at large, rather than financial companies to operate at the currency market and markets of government and private debt instruments.
Same as in Russian economy in general, where it is appropriate to state that post-crisis development model has exhausted itself, which is manifested in abrupt slow down of growth rates, a new stage is aslo observed in development of banking system that is marked not only by abrupt slow down of qualitative indexes but also by obvious necessity for the banks to alter their behaviour. In new conditions macroeconomic load onto Russian banking system will considerably increase; industrial development growth rates and rate of investment inflows will at a greater scale depend on banks loans inflow. On the other hand, system-bound risks involved into captive nature of many of the leading Russian banks, weak institutional security for investors' rights and deficit of management resources are impediments for the Russian banking system to effectively face the challenge.
The major blocks for the Russian banks are not of quantitative, but of structural and behavioural nature. Internal revitalisation of the banks and corporations-creditors, development of competitive environment become key factors for transition over the stable high rate of economic development and increased national competitiveness. Russian banking system, as well as Russian economy in general, is threatened by internal inability to grow into a new age and weight category, rather then by new default or budget deficit crisis (though both scenarios may be hand made). This will inevitably result in weakening their position among the competitors (no matter how soon or how long it will take to join WTO).
The most important qualitative features of banking sector post-crisis development model are:

• Increase almost 1,7-fold (as % of GDP) active balance in operations with real sector. It is there, not to finance budget, that people's money flow, and this money's role as a financial resource is significantly higher in the post-crisis model. The principle obstacle that prevents investment inflows into economy is scarcity of effective low risk projects, rather then lack of resources. In other words, in investment markets the seller's market is being converted into the buyer's market.
• Banks are less dependent on operations with state debt, which is no wonder in conditions of budget proficit. At the same time the scale and especially liquidity of government securities market are so low that a new approach is needed to restore it and to enhance the role of banks which, together with Pension Fund will become key market players.
• Russian banking system ceased to be a net international debtor and has become a net creditor. Banking system in the post-crisis period has become an important self-sustained capital drainage channel. This is a sign of high-risk assessment of the banking business in Russia and attempts of the banks to secure own reserves outside Russian economy. However, stronger Russian rouble and growth of Russian economy reversed to flows of Russian banking capital, the chances are that in four to five years Russian banking sector would again become net international creditor at the world markets.

Russian banking system is now aiming primarily at implementing classical banking function – transforming people's deposits (the most important liability) into loans to Russian economy (the most important asset). However, at the time these are mainly short-term operations. “Credit boom” of 2000 was facilitated by a number of simultaneous impacts:

• Quick and reliable restoration of Russian banking sector after 1998 crisis. By the end of 2000 the amount of banks liabilities in real terms was 119% as compared to that of mid-1998, own banks equity was 90%, and by July 2002 these figures were as high as 148% and 132% respectively (resource factor);

• Increased number of potentially attractive borrowers due to higher industrial production and higher level of companies' revenues. In 2000 the industrial growth rate was at its high (11,9%) and average annual rate of return was also highest: for industries excluding Fuel & Energy sector it was 14,1%. These figures can be compared to pre-crisis period: in 1997 average annual rate of return was 4,3% (expanding demand factor);

• Stabilisation of the currency exchange rate, this made it unprofitable for the banks to keep significant assets in liquid currency. Over the year 2000 real value of rouble became 13,2% stronger, in 2001 this index amounted to 9,8%. Interest rate for the rouble loans within this period was 23% (alternative investment factor);

• Better quality of loans, manifested primarily in lower share of doubtful debt as a proportion to the total loans issued, from 14% at late 1999 to 6% in the first half year 2002 ã. (risk factor);

• Restricted opportunity to run operations alternative to investments to economy due to the “stale” state of government securities market. However, one should not overestimate this factor, as investments into foreign assets has replaced investment operations into government securities market. It may be stated that at the time being weak development of government securities market does not stimulate banks to provide additional loans to industries, on the contrary, this brings down their liquidity and reduce income, which makes negative impact on capitalisation and reliability of the banking sector.

Restructuring Russian banking system to provide investments into real sector resulted in overall change of cash flow structure. Active balance of operations with real non-financial sector increased in 1998-2001 from 4,5% to 7-8% GDP. In the pre-crisis years disparity between loans to economy and equity of Russian industries were covered by investments from non-residents, (that killed many banks when rouble defaulted by multiple factor), at present they are replaced by private deposits (their volume practically correlate with net liability of companies).
Net crediting for money authorities has almost halved (from 6,7% GDP to 3,2% GDP), Bank of Russia has strengthened its position as a net investor in relation to other banks. In pre-crisis period non-residents were important investors into Russian banks (1,4% of GDP). In the new model, however, they are mostly the place to deposit reserves (2,2% of GDP); the main reason for that is that Russian Banks are making efforts to secure reserves outside Russian economy and bring down monetary and investment risks in Russia, rather then pursue income from investments into international assets.

Table 1. Main indexes for Russian banking sector

*Long term loans are those for more that one-year;
** Excluding liquid assets
*** Including corresponding accounts

Table 2. Russian banking sector balance break down

New development model facilitated higher growth rate for Russian banking sector compared with the rest of economy. Russian bank assets amount to almost 35% of GDP, which is higher than in pre-crisis 1997 year. Initially in the post-crisis years the growth was mainly due to the increase of liquidity, both in roubles and in hard currency, i.e. by means of servicing capital outflows. The truth is that higher monetary liquidity counterbalanced decreased investments into government securities, and in general the level of highly liquid assets (which actually include government securities) remains more or less stable – about 11% GDP. At present the growth points have significantly changed – now this means more loans to real economic sector. Their share has risen from 9% to 10% Of GDP as it was in 1997 to almost 15% of GDP in 2001, and the proportion of loans in the assets has increased to 42%.
At the same time in the first half of 2002-growth rate of the Russian banks were slightly lower. Since January till June 2002 banks assets in real terms (hereafter deflector is applied based on manufacture's price index) were growing by 0,9% per month average against 1,6% in the previous year (in dollar terms the average monthly growth amounted to 1,4% and 1,9% respectively). Nearly the same was the rate of increase of bank capital, compared to the previous year, however, the deceleration appeared to be even greater – 0,9% against 2,9% in real sector and 1,5% against 3,2% in dollar terms. Nevertheless, the banks managed to strengthen their positions in Russian economy: in comparison with GDP, banks assets grew over half year from 34,9% to 36,4%, to greater extend due to the fact that they invested in non-financial sector, their share against GDP increased from 15,1% to 15,7%. This vector of development challenges the end of the “credit boom” phase and a turn to a new stage of banking sector development.

Main sensitive areas of the Russian banking system
Lack of capital

Russian banks’ capital value does not allow them to meet the demand for credit from the largest Russian companies. Apart from that, lack of capital puts Russian banks into a losing position with respect to Western European banks: in the list of 100 largest capitalisation companies Russian industrialists take the first six positions, whereas Russian banks are represented by Sberbank alone. For comparison: Poland is represented by 10 banks.

Excessive dependence of the banks from their parent companies.

Virtually all major Russian banks are under control of a narrow circle of owners where minority shareholders’ rights are not properly protected. This does reduce interest in the banks as investment objects or reliable long-term partners from large potential investors, above all, foreign ones, since serious problems faced by the dominating owner will inevitably result in the same problems within the bank.

The Bank of Russia does not virtually have any bank refinancing mechanisms for accretion of bank loans for Russian enterprises. This limits the banks’ resource base, thus limiting their possibilities of the actual sector crediting. Another substantial constraint of the banks’ resource base is absence of a public deposition guaranteeing system.

Most of the borrowers interesting for the banks are concentrated in highly profitable export-oriented sectors, such as the fuel and energy complex. These borrowers need large and long-term bank loans that can rarely be provided by the banks. There are still very few reliable borrowers among the domestic demand companies, due to low profitability of the majority of enterprises in this sector.

In practice, in case of a borrower refusing to return the loan, lower courts in most cases do not take decisions in favour of the banks. This, along with non-transparent accounting, makes the banks focus on crediting those companies which they can influence/govern. The existing legislation on pawn crediting remains inefficient.

The state liabilities market has the lowest profitability that does not provide the banks with stable margin. Due to the facts that corporate liabilities value is not high, and that the interbank market is narrow and segmented, considerable redistribution of resources is not possible. All of this, along with a lack of reliable borrowers, as mentioned above, results in formation of high value of the retained profits (account balances, deposit balances in Central Bank of the RF, etc.). Lack of competition does nor serve good for the banking sector.

Very few banks have adequate risk control systems. In the light of forthcoming new principles of control focused on the internal control system, which are to be introduced in the global bank community, this might weaken the banks’ reliability. The inspectorate bodies focus their checks/revisions on formal, rather than meaningful issues of the banking activity.

Analysis of many small banks’ structure shows that they are mainly focused on non-traditional operations (deposit primes, issue of credit etc.) for dubious operations, such as cashing and transferring capital oversees. There are currently no effective mechanisms for fighting this

There are a lot of formal difficulties hampering the merging process in the bank sector. Due to this, the interested banks have to transfer the actual business and liquidate unnecessary structures.

There is usually a large time span between withdrawal of licence and actual liquidation of a bank. During this interval almost all assets that have any actual value are withdrawn.

Russian banks remain rather insignificant compared to the major world banks (capital of the City-bank alone is several times as much as the aggregate capital of all Russian banks. There are only 4-5 Russian banks among 1,000 largest world banks; the biggest one – Sberbank – is in the third hundred), and compared to the Russian real sector’s demand (borrowings of Gazprom and the major oil companies are much bigger than Russian bank loans; credit and borrowings share in industrial enterprises’ working capital is no more than ¼ (one forth)).
Despite the fact that it is possible to state formally that the bank capital is totally restored, and that capitalisation process is speeding-up, the capital quality is uncertain. The banks are mainly left on their own – shareholders’ contributions got reduced, and the main source of capital is profit. On the one hand, this indicates high economic activity of the banks. On the other hand, this means relaxation of the owners’ attention. The fact that over one third of the capital growth was due to so-called additional capital, is also causing some anxiety. Much of this additional capital consists of revaluation of real estate objects and the value of gratis transferred property. This means that the banks have received no actual liquid resources.

After the default the turnover of the state-papers market never got restored (during the past year daily turnover in dollar terms was considerably lower than the average value in 1997). During both primary and secondary distribution Sberbank of Russia was the key player; other banks’ share in late 2001 was less than one forth (compared to 40% in 1997). Apart from that, the majority of private banks in 2001 have reduced their contributions into rouble state-papers in absolute terms. This in many respects is due to negative actual profit from investments into these instruments.
Current operations in the corporate securities market “weight” insignificantly: private securities’ share in the bank assets (minus bills of credit) amounts to 1,5-2% only (approximately the same amount was before the crisis). Banks own mainly those securities, which were purchased in order to control the enterprises. There are very few active players in the stock shares and bonds market (RTS, MISEX (International Interbank Currency Exchange)), and even those few players are issuing mainly their own securities (VTB (VneshTorgBank), MDM-bank). Small volumes and high volatility of the private securities market make it unattractive for considerable bank investments.
As a matter of fact, the only alternative to crediting was capital flight from the country (the banks usually provided such services through MBK (Moscow Credit Bank) to non-residents and by increase in balance on foreign correspondent accounts). Compared to the pre-crisis situation, outflow of capital from Russia in this way in dollar terms is more than twice as much; their share in the assets increased to 6-7% against the pre-crisis 2-3%. Till mid-2001 the outflow of capital was the most evident alternative to crediting. This, first of all, meant that it was very risky to do business in Russia: large businesses were forming reserves abroad in case of any cataclysms.

The credit quality, after a long period of improvement started in mid-1999 and lasted over a year and a half, has stabilised at an exceptionally high level. Although the questionable debt value increased by almost 20 billion roubles over the year, the questionable debt share in the banks’ credit portfolio was at the level of 5-7%, which is almost twice as little as the pre-crisis level.
However, the world experience shows that the high credit growth is usually accompanied by bad debt reduction, in many respects due to the effect of advanced base growth. The real test of how the credit risks are managed, will be faced by the banks in case of the “credit boom” suspension.
The main danger is that the banks are highly dependent on their largest borrowers. By the end of the year, large credit risks’ share (credits each making up over 5% of the capital) in the banks’ assets amounted to 33%, whereas in the beginning of the year it was about 30%, and before the 1998 crisis did not exceed one forth. Therefore, deterioration of the large enterprises’ financial position might result in problems in the banks oriented to these enterprises. Due to rather low bank interdependency (internal MBK’s share in the assets does not exceed 3%), bankruptcy of one or two banks, even the large ones, is unlikely to cause a new crisis of the system.

The banking system is becoming more and more depended on the public means. In 2001 there was 36% increase in the bank deposits from individuals in real value, compared to 6% only from the enterprises. Other sources of liabilities replenishment are not to be counted on. Non-residents’ means in the banks liabilities amount to no more than 7%, the most considerable part – non-resident bank credits –did not exceed $3,2 billion dollars by late 2001 (approximately the same amount was in yearly 2001). Looks like the events happened three years ago, are still very well remembered by foreign bankers. The enterprises’ equity capital is growing much slower than the loans: ‘the current accounts and deposits ’ : ‘credits issued’ ratio had reduced from 84% to 69% over the year. In case of unfavourable foreign trade conjuncture the account balances will be growing even slower.

Problems of regulatory background, its flaws and weak application practice
State involvement in the banking sector

At present the State does not withdraw itself from the banks’ capital as announced earlier (as an example, you can consider the games around Vneshtorgbank in more detail). This issue should be addressed “straight forward”, the state share should be retained in those banks that are important strategically (on the federal level or federation subject level). In practice, the state without the controlling packet of shares cannot influence the bank’s activity, nor can it insist that the bank implements the state policy. Since the state should participate in the banks’ capital in order to implement the state policy, rather than obtain profit, we consider expedient that the state does have the controlling stock.
Non-bank organisations fulfilling some bank operations (such as Russian Financial Corporation etc.) do need restructuring. They should become credit organisation or, else, stop their banking operations. In any case, a specialised organisation being created by the state for executing bank operations, should have a licence that will limit the functions this organisation has to fulfil

In the Government and Bank of Russia’s view, competition is formed by better openness of the credit organisations. At the same time, RUIE and Ministry of Anti-Monopoly Policy, under the guise of fighting Sberbank monopoly in the private deposit market, are, in fact, fighting for its actual liquidation, disregarding the possible consequences. Firstly, Sberbank is not an absolute monopolist, in contrast to Ministry of Railway Communications or RAO UES of Russia – the depositors can cooperate with large private banks as well. Secondly, competitive abilities (the main Sberbank’s competitive advantage is that its deposits have the state guarantee) should be flattened by establishment (with the state involvement) of a relevant system of guaranteeing deposits for individuals, rather than depriving Sberbank of the guarantees. The latter will result in outflow of individuals’ savings from the whole banking system.

In our view, the institutional structure of the banking system should be developed evolutionally only. The scope and structure of the Russian economy demand both large multidivisional banks and small credit organisations within the Russian banking system, the latter specialising in a limited set of operations or servicing a small client base. The state can support the banks recapitalisation by gradual toughening of the regulations, first of all – by increase of a minimum value of the banks’ equity capital. The strategy puts off addressing this issue for long. Thus, minimum value of the authorised capital stock for the operating credit organisations will reach EURO 5million only by 2007. In early 2002 about 400 Russian banks (which is a lot) are estimated to have the equity capital in the amount of EURO 5million. If 2000-2001 capital growth tendency will continue, by 2005 the number of such banks might be twice as much – more than 700. In our view, such number of banks in Russia is more than enough.

Foreign capital formation is in direct dependence on overall improvement of the banking system. The Strategy does not envisage concrete measures with a view to facilitate extension of activity of the banks with foreign capital, except introducing informative procedure for acquisition of shares by non-residents up to 100% of the chartered capital. Non-residents’ share in the banks’ aggregate registered chartered capital for the past two years is steadily declining. In yearly 2000 this share amounted to about 11% (according to official data of the Bank of Russia), whereas by the end of 2001 it reduced to 5-6%. In our view, the most serious threat for the Russian bank sector from non-residents is that the largest Russian enterprises (especially those practicing export-import operations) might choose to be serviced in foreign banks, thus disrupting the Russian banks’ resource base. In this case the Russian banks’ position might weaken. However, this process is objectively limited by high integration of the major Russian enterprises and banks. Modern “oligarchs” will never loss total control over their cash flows keeping their finances in the constituent banks. Foreign banks will be used only for some very specific functions, such as organisation of borrowings in the global financial markets (issue of eurobonds, ADR, organisation of syndicated loans etc.).

It is clear that further mobilisation/attraction of the public means into private banks requires creation of a public deposit guaranteeing system that will be working in practice. The mechanism developed by the Ministry of Economic Development suggests that the banks serving the population must quarterly transfer to a special account in the Bank of Russia 0,15% of the average quarterly amount of the deposits attracted. In our view, this will be insufficient, and in order to achieve 5% of the public deposit amounting to about $1,2 billion dollars per annum, the deduction rate should be at least twice as much. Initial means of the deposit insurance fund might be generated by a ÔÎÐ part for the banks within the system. This will require about 0,2% reduction in the reservation rate, which is not much. Apart from that, introduction of an accumulative pension system envisages creation of the market mechanisms for allocation of the accruing pension resources in the banking system, rather than their exclusive usage by specialised financial companies and securities investment funds (Both Russian and foreign ones).

International Standards of Financial Reporting are based on several basic principles. Some of them have been totally implemented in the Russian accounting system, others – only partially. One should take into account that the key purpose of the Russian accounting is to provide an objective and complete information about the business operations not only for its owners and investors, but for the tax authorities as well. Therefore, the accounting reforms should be closely tied up with the relevant amendments in the tax legislation.
The main objective in the area of banking regulation and control is to introduce new approaches to the banking supervision, suggested by the Basle committee in 2001, that will be put into force in 2004. The new approach is based on the following three components: minimum requirements to the capital adequacy, active utilisation of internal risk control systems by the banks, and better transparency of the bank operations (for more details, see the BIS reference).
So far this has resulted in another restructuring: Department for the banking sanitation (what was left after some of its employees had left for ARKO) was affiliated to the Department for prudential banking supervision; Licensing Department was affiliated to the Inspection Department. Apart from that, 2001 year report should be enclosed with a detailed explanatory note describing all actual and potential (!) risks. In practice, this resulted in writing very detailed compositions overfull of specific terminology but often very far from reality.

Structure of the Russian banking system
State banks

Despite the fact that the financial authorities would prefer to have the banks privatised, in 2001 there were quite a lot of state banks in the banking system. It is this year when the two large specialised banks started to work: Russian Development Bank and Rosselkhozbank. Hardly have they appeared, they got in the list of 50 largest Russian banks. The state banks capitalisation process (compared to other banks) was facilitated by 6,5 billion roubles deposited into their chartered capital, along with traditionally high profit shown by Sberbank and Vneshtorgbank.
At the same time, compared to year 2000, the state banks’ positions on some key operations have weakened. This is, first of all, true for crediting; Sberbank and Vneshtorgbank used to be the leaders in credit accretion. New banks that seem to be created specially for crediting are not “rushing headlong” to confirm their appropriation. Thus, Russian Development Bank’s enterprise credit share was less than 8% of the assets by the end of the year, whereas MBK provided 40% of credits to the residents, 20% of the bank assets are government securities

The foreign banks’ role remains insignificant and practically unchanged. After the rouble devaluation jump caused by a higher currency content in the balance (compared to others), the key relative indices of the foreign banks’ performance almost returned to the pre-crisis level. The non-residents are loosing their positions on capitalisation (having restored their losses caused by crisis, they have practically stopped replenishing the equity capital from their “affiliated” banks), which is also true for the state banks that are slowing down the crediting.

The concentration processes in the Russian banking system have virtually stopped in 2001. The major banks’ share (including Sberbank) on the majority of the key operations have reduced a little over the year. It is worth noting that this is true to the most important operations, such as crediting (30 largest banks have reduced enterprise crediting from 42,6% to 41%). Taking into account that even Sberbank has lower indices on credit growth in 2001 compared to the overall system (30,8% in real terms against 34,6%), one can assume that medium-sized banks had been most active in crediting.
The same conclusions come from the comparative analysis of the balance structure across the largest banks and overall banking system. By late 2001 the leading banks have not considerably increased their share of enterprise crediting in the post-crisis period, whereas the overall system has demonstrated a more evident credit tendency: the credit share in their assets for 1999-2001 was almost 1/4^th as much. Apart from that, the largest banks’ capitalisation rates were lower than assets growth rate in 2001 in contrast to the overall system. This has reduced their equity capital.

2. Insurance sector
The current market situation
Legislation

The insurance market is one of the most dynamically developing segments of the Russian economy. Despite the fact that a large bulk of activities are traditionally represented by the non-classical insurance (tax saving technologies in life insurance, laundering mechanisms in property and liability insurance, monopolices and other non-risk schemes in voluntary medical insurance), the last three years witnessed a growing trend in classical insurance operations. Positive changes in the market are related both to the legislation improvement and growth in the Russian economy gross indicators.
Adoption of Chapter 25 of the Tax Code became a crucial event that affected the growth in insurance contributions. The Chapter determines that from January 2002 enterprises may charge insurance contributions on the main types of property and liability insurance to the cost of their manufactured products or services provided with no limits (previously it was within 1%, then 3%). Moreover, the contributions on long-term life insurance that do not exceed 12% of the wages fund and contributions on the voluntary medical insurance (VMI) that do not exceed 3% of the wages funds may be charged to the cost as well.
In spring 2002 the Law On Compulsory Civil Liability Insurance of Vehicle Owners was adopted as well. Despite the fact that compulsory liability insurance of vehicle owners is introduced only from July 1 2003, now the bulk of activities in automobile insurance are growing due to activated promotion and organizational and technical work.
Election of a new President of the All-Russian Insurance Association in March 2002 means a lot for further improvement of insurance legislation. The fact that the elections were won by a Chairman of the Sub-Committee for legislation on insurance and non-state pension funds, a member of “Edinstvo” fraction, Alexander Koval, actually means the State Duma support to the initiatives coming from the insurance community. The main regulations of the Insurance Market Development Concept elaborated and adopted by the Government bring evidence to that.
From the point of view of developing a classical insurance market in the current legislation there are only two gaps: a too low limit for charging the VMI contributions to the cost and nonparticipation of insurance companies in the state pension system reform. Along with that, tax benefits on the pension insurance make the cooperation between an Insurer and a Non-state pension fund very attractive in the field of additional non-state pension provision.
The government takes critical measures in the sphere of the insurance market enhancement. Activity run by the Ministry of Anti-Monopoly Policy of RF in accordance with the anti-monopoly legislation is aimed at enhancing the competitive environment in the most corrupted segments of the insurance market – risk insurance at the expense of various budgets and choice of authorized companies. However this activity does not always bring the aspired results: decisions change on paper but in practice everything remains the same. The links between the Ministry of railways and JASO company, the Moscow construction complex and MOSSO company and many others. Currently not the tender results are being controlled but their carrying out as such.
However we should note an amendment to the Tax Code adopted by the State Duma (in course of second reading), which makes the so-called wages scheme unprofitable: starting from 2002 the contributions on life insurance agreements will be subject to income tax for the first five years of their validity period.

During 2000 and 2001 the contributions collected by insurers grew up not only in rubles but in currency equivalent as well. Personal insurance enjoys the best dynamics. Thus in 2000 in life insurance contributions increased by 97,1% in currency, and in 2001 – by 68,4%; in other types of personal insurance (VMI, accident insurance and insurance for traveling abroad) – by 60,6% and 69,4% respectively. Cumulative contributions in the Russian insurance market in 2000 grew up versus 1999 by 57,7% and made up $6,2 bln., and in 2001 – by another 52,5% and made up $9,5 bln. In early 2002 the market growth rate slowed down (in the 1st quarter cumulative contributions increased versus the same period in 2001 just by 1,1% in currency in by 9% in rubles). However this slowdown was mainly caused by decrease in life insurance (by 27,5% in currency). The growth rates in personal insurance dropped down quite naturally after the Tax Code adoption, which limited VMI (from 66.5% a year earlier to 28.3%). The growth rate in property insurance reached the all-time level (64,2% versus the 1st quarter 2001 and even 6,7% versus the 4th quarter 2001, which is quite surprising as usually the conclusion of annual property insurance agreements fall for the 4th quarter). The indicated growth was tied up with cancellation of limits for charging insurance contributions to the cost.

Chart 1 Contribution dynamics in the insurance market

Table 1. Quarterly dynamics of contributions by insurance types, mln. USD.

Up to 2000 the Russian market was typically characterized by the contribution growth exceeding the assets growth, witnessing both an incompliance between the market capitalization growth and the total volume indicators’ growth, and development of the short-term and non-risk insurance types that do not envisage for building up full-value reserves. In 2001 this incompliance started to even gradually. There are no summarized data on the market, however the assets of 50 companies leading in terms of contributions in a competitive segment of the insurance market grew up in 1.8 times, while contributions increased in 2.2 times. If the indicators of 10 companies with the largest volumes in life insurance and the indicators of brand new companies and groups are not included into the leaders’ list, than the assets’ growth rate already exceeding the contribution growth rate. At the same time, the insurance reserves growth in the market exceeded the contribution growth: 74,2% versus 67,2%. By January 1 2002 the insurance reserves made up 88,5 bln. rubles ($2,9 bln.).
In 2001 the accretion of cumulative assets by the list of 50 largest insurance companies achieved 80%, and the accretion of cumulative authorized capital stock – about 150%. Thus we can speak about changing an average structure of the insurers’ liabilities: the leader companies enjoy the growth in the capital adequacy indicator. The formal indicators of performance profitability are growing as well. Thus by the totals for 2001 the insurance leaders began showing profits. The cumulative net profit of 50 leading companies totaled 1.3 bln. rubles, and of 100 companies – just 100 mln. rubles more. The most profitable insurers are: Ingosstrakh, ROSNO, Lukoil, Rosenergo and other companies affiliated to industrial holdings.
Insurers get richer; their own opportunities on taking major risks are growing. The following companies have their authorized capital stock over 500 mln. rubles: Avest Classic, AlfaStrakhovanije, VSK, Interros-Soglasiye, League, Lukoil, Priroda (and all subsidiaries), PSK, RESO-Guarantee, Energogarant. Ingosstrakh and ROSNO compensate their lesser capital stock by reserve funds, accumulation funds and consumption funds, due to which they become leaders in the Russian market by value of their own capital. Sibir, Surgutneft, Sheksna and Yugoria are leading in capitalization among regional companies.
If in early 2002 the share of 50 largest insurers in the cumulative capital stock equaled 57%, a year before they accounted only for 39% of the cumulative capital stock. In 2001 the capital stock accretion for all insurers achieved 84,5% (by January 1 2002 it made up 27,3 bln. rubles), and for leader companies in voluntary insurance - 169,0%. While the leader companies are finding new investors, getting inflows from old owners or reinvesting profits, the capital stock of absolute majority of insurance companies slightly exceed the current requirements of supervisory authorities. The governmental concept for the insurance market development definitely confirms: requirements to capital stock will become tougher. Besides business development requires considerable investments not available to small and medium-size insurers. Eventually we can track a tendency for reducing the number of insurance companies: the large insurance capital either takeover minor competitors or crush them. Formal growth in number of registered insurance companies in 2001 was tied up not with the growing number of actual players in the market, but with the remaining popularity of tax saving technologies. After having taken actual measures on fighting the wages schemes, toughened requirements to the capital stock value and recent changes in the medical insurance taxation that make non-risk VMI not profitable, the total number of companies operating in the market might reduce considerably (from 1300 to 400-500) as the companies refuse to keep “pocket” insurers. The reduction of companies’ number might be affected by the planned decision of the Government of RF, according to which all public organizations will have to withdraw from the insurance companies’ capital stocks. This resolution will become another logical step in the competitive environment development in the insurance market and fighting corruption.
The principal changes of the Russian insurance market are going on in the context of Russia joining the WTO. Insurers activate their activity in the classical segments of the insurance market aiming at two goals: either to send oneself at a higher price to a foreign investor, or to achieve certain results in the nearest 2-3 years to get a place in the market and compete equally with the foreigners.

The Russian market structure differs greatly from the developed insurance markets. If in other countries the automobile insurance is dominating among the insurance types other than life insurance (i.e. not life-insurance), in Russia the company property insurance and VMI are domineering. Thus in Germany the share of automobile insurance in cumulative contributions makes up 42,0% (2000, including the compulsory liability insurance – 26,1%), in the USA – 47,6% (1999, civil liability – 28,7%), and in Russia – 11,7% (by estimates for 2001). At the same time it’s automobile insurance which is developing most rapidly in Russia: in 1999 its estimated share in the cumulative insurance contributions for “non-life” insurance made up 8,1%, in 2000 – 9,5% and in 2001 – 11,7% (including civil liability insurance – 1,8%).
The Russian “non-life” insurance market presented the following structure by contributions according to totals for 2001 (estimated data): legal entity property insurance – 32,3%, VMI – 22,9%, automobile insurance (cumulative by risks of Autokasko and civil liability) – 11,7%, cargo insurance – 7,1%, accident insurance – 6,5%, private property insurance – 5,7%, liability insurance for hazardous enterprises – 3,1%, aviation risk insurance – 1,9%, construction and installation risk insurance – 1,4%, insurance of vessels and their owners liability– 1,9%. VMI enjoyed the highest growth (estimated growth in 1999 – 14,8%, in 2000 – 19,8%, contribution accretion in 2001 versus 2000 – 74%), accident insurance (4,0%, 4,7%, 110% respectively), automobile insurance (8,1%, 9,5%, 85,2%) and legal entity property insurance (contribution accretion in 2001 – 90,2%). In 2001 there was no positive dynamics (or very slight ones) in insurance of traveling abroad, water transport insurance, cargo insurance, insurance of construction and installation risks and hazardous enterprises.
In 2001 The correlation between the contributions on life insurance and contributions on other insurance types in the Russian market was 102,0% (a year before – 87,5%). In the USA a similar indicator equaled 136,1% by the totals for 1999, and it grew up starting from 95,5% during the last ten years. However formal analogies in the insurance market structure do not reflect the real picture: the life insurance share growth in contributions in the USA is caused by growing demand for the given product from the physical persons’ side (the USA market structure: 60% - individual funded insurance, 34% - group insurance, 6% - credit insurance), and in Russia – by popularity of unstable “wages schemes” (the estimated structure of the Russian market: 1% - individual funded insurance, 1,5% - group insurance, 97,5% - tax saving technologies).

Despite the fact that most Russian companies have been operating in insurance for 7-10 years, the insurance market complete structure has been formed only during the last two years. Moreover the processes cannot be considered completed at the present moment.
At the previous stage of the insurance market development (1999-2000 can be considered its conditional end) the companies basically did not compete. The insurance companies’ subsidiaries just serviced the interests of parent companies both in the sphere of insurance and in the other “non-classical” financial areas. Due to low popularity of insurance services the universal insurance companies practically did not compete either. The scope of physical persons covered by insurance was very small and left space for all company activities. Legal entities took their decisions on choosing an insurer based not on the analysis of its financial situation and capacities, but on the partner requirements or the manager personal interests. Such practice is very common even now. At the same time the market growth became possible due to growing popularity of insurance services among people and expanding potential corporate clientbase willing and having financial capacity to form a complete insurance protection from risks.
Eventually a backbone of leader companies started to form in the market, which were universal in terms of portfolio and development strategies, but corporate in terms of property structure. The practice, when universal companies were actually universal businesses of their owners, goes to the past. The need of significant investments into development spurs the company owners, who used to be independent of the outside structures, to look for potential investors both among the Russian industrial and financial structures and abroad. However development of the insurance market competitive segments makes them interesting for managers of the captive insurance companies with the accumulated significant non-realized financial potential. On the one hand, for the last two years such important transactions took place as purchase of the Eastern-European Insurance Agency by Alfa financial-industrial group and organizing the AlfaStrakhovaniye group on its basis, purchase of the Industrial-insurance company by NIKOIL corporation, new owners of Ingosstrakh (Siberian Aluminium, NAFTA-Moscow and Millhouse Capital consortium), ROSNO (the leading German re-insurer Allianz AG), Russian Insurance Centre (“Rosoboronexport”), “Rosgosstrakh” (a consortium run by IK Troika-Dialogue), stirring up foreign insurers in the search for strategic partners in the Russian market (except for Allianz AG, that has made its choice already, AIG and Munich Re, EBRD can be noted). On the other hand, such companies as Geopolice, Interros-Soglasiye (Soglasiye group was set up on its basis), neftepolice, Progress-Garant, Energogarant, Lukoil-group successfully stretched beyond their own corporate interests, and SPGAS company has the same plans. Regional insurers are getting more active as they are aiming at keeping their positions in the future. The Russky Mir company goes beyond the St-Petersburg market. Accord insurance group is being set up on the basis of the UralSib bank. Local insurers are developing actively in the industrial centers of Povolzhje, the Urals, the south of Russia, as well as in St.-Petersburg. The market capitalization is growing.
Most likely these processes will develop further in the next two or three years. The competition growth will lead inevitably to the market further concentration. By the totals of 2001 the share of 10 leader companies in the Russian cumulative contributions on “non-life” insurance made up 36.9%, and the share of 100 leader companies – more than 80% (these indicators are slightly lower than in 1999 and in 2000, however the short- and middle-term forecasts say they will exceed the previous level). The market considerable concentration may also be forecast on the basis of the international experience (up to 50% and 90% respectively): 10 largest companies accounted for 41% of contributions in the international market, and 100 companies – for 91 of contributions. Opening the market for foreign companies (either direct or through subsidiaries) also plays an important role in the market concentration growth. The individual life insurance enjoys the highest concentration, as the demand for foreign quality insurance products is especially high there. The same situation was formed in the complex industrial risk insurance where now up to 90% of contributions are being passed on to re-insurance abroad (to the leader companies in the insurance and re-insurance market).

The contents of the Russian pension reform is traditional for the countries with PAYG pension systems and ageing population. Falling birth rates and growing life expectancy inevitably result in a growing pensioner percentage of the population. In the conditions of a PAYG pension system, it means increased "pension load" on every worker, and consequently, necessitates either increased tax on the wage bill or decreased pension rates (to be more precise, decreased replacement ratio i.e., pension-to-average wage ratio). As a rule, both unfavourable circumstances occur simultaneously. The pension load on wage bill turns out to be so excessive that it leads to reduced contributions to the pension system (either because of avoidance or decreased economic growth rate). In such case, relative pension rates are continuously falling, and social dissatisfaction growing.
The crisis of 1998, when the financial resources of the Pension Fund of Russia dropped dramatically, had seriously affected the situation in the Russian pension system. The crisis had resulted in increased arrears of pensions, reduced differentiation between the average pension and the minimum one, and a reduced average pension replacement ratio. However, the devaluation of the ruble had led not only to a loss of value of pensions, but also to a relative reduction of state liabilities to pensioners at the same time. The good economic situation in 2001/01 let the PFR not only meet the arrears, but also form the reserves required to start a pension reform.
The essence of the reform is supplementing the PAYG part of the pension system with a funded part. The idea behind it is that the funded part will be a compulsory part of pension (in is not so in many countries). In addition, the size of the pension component financed on a PAYG basis is linked to future pensioner's earnings. That is, the PAYG pension becomes “quasi-funded”. It must ultimately increase the motivation for the population to earn legal wages, and so to strengthen the financial position of the pension system.

The prehistory of supplementary pension provision development (hereinafter referred to as the "SPP") in Russia is ten years long: the RF President's Decree "On non-state pension funds" was issued on 19.09.1992. By the present time, this industry is represented by two main types of financial institutions: non-state pension funds (hereinafter referred to as the "NSPF") and insurance companies offering a special type of service - pension insurance. We review NSPF alone in this document.
This is a list of the basic definition provided in the Federal Law "On non-state pension funds" (hereinafter referred to as the "Law on NSPF"):
non-state pension fund is special organisational and legal form of non-commercial organisation exercising non-state pension provision to fund members under contracts for non-state pension provision to the population concluded with fund contributors for the benefit of fund members as its sole type of activity (article 2);
contributor is a legal entity or individual which is a part to the pension contract and pays pension contributions for the benefit of the members appointed by the contributor (article 3);
member is individual to whom a non-state pension is payable or paid by virtue of a pension contract concluded between the contributor and the fund; the member may be contributor for his or her own benefit (article 3).
The provision of non-state pensions by the fund includes pension contribution accumulation, pension reserve placement, keeping records of fund pension liabilities, and non-state pension payment to fund members (article 2).
Both NSPF representatives and the officials regulating NSPF activities are inclined to assert that the "industry has been established". They mean that NSPF are numerous, have accumulated considerable financial resources, and cover many people. Formally, it is true:
At 01.07.2002, there were about 250 licensed NSPF in Russia; their assets amounted to R51.8 billion (over $1.6 billion) including R41.8 billion of pension reserves; the NSPF membership exceeded 4 million; there were 350,000 non-state pension recipients; the pensions paid in 2001 totalled to R1.025 billion.
Meanwhile, these figures look much less impressive when we consider relative values. Pension reserves amount to R10,400 (about $330) per member on the average. The average pension per person paid in 2001 amounted to R3,100 (about $100), or about R260 per month. Pension reserves accounted for less than 0.5% of the GDP, which provides no grounds for optimism either.

Table 3. Summary financial indicators of the NSPF market from 1996 to 2002

In addition, a very high level of concentration is observed in the industry. Over one half of pension reserves (R22.4 billion or 54% at 01.07.2002) belong to a single fund, GASFOND NSPF, which has been an irreplaceable "industry leader" since 1997. As little as 16 funds (7% of their total number) posses pension reserves exceeding $10 million. In our opinion, one may say that the NSPF industry (or, in broader terms, voluntary pension provision = VPP) has been established when total pension reserves exceed 10% of the GDP, the membership reaches 20% of active population, and the average pension provided by the VPP system is comparable with the subsistence level. However, it is still true that NSPF are a noticeable phenomenon in the financial market already now, which cannot be neglected.

The current situation in Russia's VPP sphere cannot be understood outside the institutional context. Its main feature is the non-market nature of a considerable part of relations in the VPP sphere. We mean relations between large corporate NSPF with their contributors who are founders of such NSPF or are affiliated to founders at the same time.
Two basic models of NSPF activity have manifested themselves since the very beginning of Russian NSPF development: "open" and "corporate" funds. The former have orientated themselves to a free market i.e., either to "retail operations" or relations with individuals playing the roles of contributor and member at the same time, or to "wholesale operations" or contract conclusion with employers that are not founders of the NSPF and select partners for VPP using market criteria (professionalism, financial stability, investment profitability and reliability, precise fulfilment of pension liabilities, etc.).
By the present, this group has failed to win a more or less stable position in the financial market: neither the population no companies feel any trust to the idea of investing resources for decades in an institution beyond their control. It is so despite tha fact that no large-scale scandals involving the loss of resources or deception of contributors/members have taken place in the industry over ten years.
The second type is NSPF established by large companies or groups of companies to serve their own interests. The founder motivation can be as follows:

• the desire to obtain an extra staff management lever (a higher pension to the good worker, a small pension to the poor worker, and no pension to the fired worker);
• encouraging the retirement of elderly workers to make the staff younger;
• the need for an extra source of resources to perform operations that cannot be carried out by the company proper for tax-related, political, or ethic reasons (e.g. the acquisition of a large package of the parent company stocks). The term "captive fund" is used to designate such NSPF in the market: the English word "captive" literally means "taken prisoner", or – in the business – a controlled company providing services to its owner or owners alone.

Why cannot relations between purely corporate funds and their contributors that are their founders or persons affiliated to founders be considered as market relations as a rule? The reason is that there is no free interaction between free and autonomous seller and buyer (or service supplier and consumer) in such case, there is only a reallocation of resources among interrelated entities. An NSPF operatied within a financial and industrial group turns into a subdivision pursuing the social and staffing policy of such group. However, by virtue of legislative requirements, such subdivision is assigned the status of legal entity. The parent company/group usually exercises control over fund operations without using market mechanisms either.
The above said does not mean that corporate funds must not take care of an efficient investment of pension reserves, of keeping records of their liabilities to members, or that they are not accountable for the fulfilment of such obligations. Sure, they are independent legal entities, and the fact that they are subjects of law is not questioned. However, the amount of resources they attract depends on so much on their successful operation, but on the general policy pursued by the parent company, and the managers of such fund are much more concerned with the opinion of their superiors than with the opinion of ordinary members (who naturally enjoy no influence on staffing decision in the fund and, additionally, cannot withdraw their pension savings and leave the fund). The competition between NSPF for new contributors, if any, is expressed very weakly, and does not affect their behaviour significantly.
Unfortunately, there is no reliable statistics on the distribution of pension reserves between open and corporate funds in Russia. However, expert estimates unanimously show that the overwhelming proportion of reserves (at least 90%) has been formed within corporate relations, not in the free market. Open funds have failed to offer topical and competitive services to potential client yet. Therefore, one cannot say that the population or companies consciously choose NSPF as an institution for long-term accumulation so far.
Let us illustrate this situation using some figures on Electric Energy NSPF, one of the largest domestic funds. Its pension reserves in the amount of R1.2 billion place it on the fourth position in Russia (after GAZFOND, Blagosostoyaniye NSPF and Lukoil-Garant), and it occupies the second position in the membership, which amounts to 216 thousand. It cannot be viewed as a purely corporate one: it has 21 founder, and so its dependency on the main parent company i.e., RAO EES Rossii, has always been less vividly expressed in its operations than in other large NSPF (GAZFOND, Lukoil-Garant or Sugrugneftegaz). The Electric Energy NSPF operations are not limited by its industry, it is "open to cooperation with enterprises and organisations all over Russia" as well as with individuals.
However, the statistics is inexorable: "The Fund has 966 contracts including 152 with legal entities and 814 with individuals". That is, as little as 0.4% of 216 thousand members have concluded independent contracts with the fund. 152 legal entities, too, are most probably founder companies too (except RAO EES, they are mainly regional power systems) and affiliated entities. So, this fund cannot be considered open yet.
However, there are no legal obstacles to a large corporate fund entering the open market. Theoretically, such trend may appear in the nearest future if NSPF get an impulse to their development, e.g. in the form of additional tax credits granted to companies on the resources transferred to NSPF or in connection with funded labour pension component investment. NSPF representatives are of the opinion that the majority of the funds initially established as corporate funds may "open up" within the next 3 to 5 years.

Pension funds are the largest institutional investors all over the world. NSPF assets total to trillions of dollars in developed countries, the bulk of these resources being invested in securities.
Are there any ways to preserve the value of pension savings with an absolute guarantee? In terms of real value (i.e., with due regard to inflation) – definitely no; in terms of nominal value – sooner yes than no. In fact, any assets in which pension reserves can be invested are subject to the risk of depreciation, be it real estate, stocks, or debentures. True, state bonds, bonds issued by large corporations, and deposits with highly reliable banks may be regarded as virtually zero-risk assets, but the risk of deault on such securities still does exist; in addition, they are less profitable than risky securities, and often cannot surpass inflation rates. So, the task of preserving the value of pension savings with an absolute guarantee is sooner a political slogan than an economic problem.
A more correct task is to determine the permissible risk limits in pension savings investment. In this case, the answer depends on the national approach to the degree of freedom granted to future pensioners. One pole is paternalism (including the declarative paternalism) and exaggerated sense of responsibility for the provision of at least some money to retired people. Then permissible objects are limited to highly reliable debt instruments alone. Another pole is transferring this responsibility onto the future pensioner, which implies pensioner's right to invest pension savings anywhere, but no right to lay any claims to the society in case of financial disaster. There are many intermediate grades between them.
Strange as it may seem, the current Russian model of NSPF does not gravitate towards the first pole as one could expect proceeding from the Russian tradition of paternalism, but occupies a position somewhere in between. However, one should not forget that NSPF operate in the sphere of supplementary pension provision alone; once they are included in the second-level pension system, the requirements for permissible investment objects may change significantly.

The corporate nature of Russian NSPF affects their investment activities very much. "Captive" funds invest resources not so much in the assets that provide the best ratio between yield and reliability (from acceptable investment strategies), but in those recommended by the founders. A classical example is the acquisition by the Surgutneftegaz pension fund of the controlling package of AO Surgutneftegaz, its parent company, at a pledge auction in 1995. We assume that the majority of corporate funds are also major holders of either stocks or debentures issued by their founders (who are their largest contributors as well), however there is no such statistics in the public reports of NSPF. By the way, more complicated methods can be used to reinvest the resources invested by founder in NSPF back in the activities of the corporation: acquiring stocks or debentures issued by companies affiliated to founders, placing resources in deposits with banks belonging to the relevant financial and industrial group, etc.
NSPF representatives observe that pension reserves may not be invested on a completely arbitrary basis now as before: the NSPF Inspectorate has developed requirements for the composition and structure of pension reserves and monitors their observation by the funds (the requirements currently in force are approved by NSPF Order no. 1 of 10.01.2002). however, these requirements are too liberal to counteract said investment policy. Indeed, according to paragraph 7 of above mentioned Order, "In investing pension reserves, requirements shall be observed for their composition as follows:

• the value of the pension reserves invested in a single object may not exceed 20 per cent of the total value of the pension reserves invested;
• the total value of the pension reserves invested in securities without recognised quotations may not exceed 20 per cent of the total value of the pension reserves invested;
• the total value of the pension reserves invested in securities issued by fund founders and contributors may not exceed 30 per cent of the total value of the pension reserves invested;
• the value of the pension reserves invested in federal securities may not exceed 50 per cent of the total value of the pension reserves invested except cases when federal securities are acquired as a result of a novation;
• the total value of the pension reserves invested in the state securities issued by subjects of the Russian Federation and municipal securities may not exceed 50 per cent of the total value of the pension reserves invested;
• the value of the pension reserves invested in stocks and bonds issued by enterprises or organisations may not exceed 50 per cent of the total value of the pension reserves invested;
• the value of the pension reserves invested in bills may not exceed 50 per cent of the total value of the pension reserves invested;
• the total value of the pension reserves invested in bank deposits and real estate may not exceed 50 per cent of the total value of the pension reserves invested."

These restrictions are too soft to be efficient: up to 50% in stocks and up to 50% in bills! In addition, the Inspectorate requirements contain no stipulations regarding the maximum amount of investments in the securities issued by the affiliated group. So, 20% of pension reserves may be invested in the stocks issued by the parent company proper (assume that it has recognised quotations), another 20% in the stocks issued by its subsidiary (already without quotations), and the rest 60% can be distributed between bank deposits and bonds issued by various entities within the financial and industrial group, taking care solely that investments in a "singe object" do not exceed 20%. In general, the limit of 20% on the maximum investment in a single object is obviously insufficient to ensure investment portfolio diversification (it might consist of just 5 objects in such case), and this ceiling should be lowered to at least 10%.
However, should even these restrictions seem too binding, it can apply to the NSPF Inspectorate for a so-called "special procedure" of pension reserves investment. The Inspectorate itself defines the "special procedure" as a "temporary measure in exceptional cases when deviation is permitted from the maximum amounts and restrictions on the classes of objects and objects for pension reserves investment as specified in the Requirements". However, according to same Inspectorate, almost all of the largest funds enjoy the special procedure – some estimates show that the bulk of pension reserves are invested using that procedure! The question what for are investment rules required if the bulk of reserves are invested without their observation remains unanswered.
It is interesting to note that, to have the "special procedure" permitted, the NSPF must submit "an economic justification of the necessity of introducing a special investment procedure" to the Inspectorate, which must include:

• a proof that the fund cannot meet its liabilities under pension contracts in full and in time if it is not permitted to use a special pension reserves investment procedure;

• specific measures to ensure financial stability, reliability, safety, liquidity, and diversification of pension reserves investment proposed by the fund to ensure solvency on fund's pension contracts;

• calculations required to confirm the efficiency of the special pension reserves investment procedure proposed.

In such case, the corporate fund will be trying to prove an inconsistent statement: it is impossible to meet liabilities to contributors and members when exercising normal diversified investment, but the liabilities will be met if the fund is permitted to invest a third (or a half) of pension reserves in the stocks issued by the parent corporation. In addition, said restrictions affect the investment of exactly pension reserves i.e., gthe resources that correspond to fund liabilities to clients. As to the investment of the resources that comprise the "property designed to secure fund activities as stipulated in the articles of association" i.e., founders' contributions and return on them, is not regulated at all, and the founders may obtain even the entire money transferred to the fund in the form of refinancing. True, ignoring the safety of these resources looks strange: according to the idea of the Law on NSPF, the property designed to secure the fund activities stipulated in the articles of association is obviously perceived as an internal reserve for the lack of pension reserves to pay pensions.
The above-described forms of NSPF resources investment serve a traditional ground for reproaching NSPF with the use of their resources in some "grey schemes". In our opinion, this statement is not quite true. The issue is not violations of the legislation, but weak risk control even in cases where legislative requirements are formally met. Foreign experience provides vivid examples of collapses of the corporate pension funds that used to actively invest money in the stocks issued by their parent companies, and then went bankrupt, Enron being one of the recent examples.
On the other hand, there exists an opinion that corporate risks are under control in "captive" NSPF: the parent company will not leave its fund without support even in case of financial difficulties, and will help it meet its liabilities to pensioners, and so investments in the assets of affiliated persons are good, not evil, in Russian conditions. However, a favourable resolution of such difficult situation is essentially dependent on the price of the issue. As long as fund's pension liabilities amount to hundreds of thousand dollars, and the turnover of the parent company in hundreds of million dollars, no problem will arise. However, if the benefits payable turn to be comparable with total company assets, the founders may prove to be unable to help the fund even if they wish to do so. We think that as the industry develops, the regulation of permitted classes of assets and proportions of asset investment will be becoming stricter both in respect of diversification and struggle against investment in affiliated persons. Moreover, a system of financial rates (requirements for the ration between the property designed to secure fund activities as stipulated in the articles of association and pension reserves, requirements for internal and external reserves, etc.) should obviously be introduced, which currently exists in embryo.

Unfortunately, we have no official statistics from the NSPF Inspectorate on the current investment portfolio structure in Russian NSPF. Ye.L.Yakushev's presentation "The practice of NSPF asset management" at the Pension Reform Laboratory site of March 2001 contains the following table (with reference to the NSPF Inspectorate as a source):

Table 4. NSPF investment portfolio structure from 1996 to 2001

* Over 9 months of 2000

The NSPF accounts to be submitted to the regulator do to distinguish between stocks and bonds (and, until recently, bills too, which can be seen in the above table), and all of them are shown in the column "Securities issued by other issuers". However, stocks seem to prevail in this column (about 70% to 80% of its total amount), and so, one may note a rather high level of risky assets in the overall portfolio structure.
A stable reduction of the share of RF state bonds from year to year can be accounted for by three reasons. First, this is the default of 1998, which painfully affected NSPF (they failed to obtain desirable privileges during restructuring) and caused a mistrust of the state as a borrower in many veteran funds. Secondly, it is the low yield on state securities and insufficient liquidity of many issues. Thirdly, it is the strengthening "captive" nature of funds, which means their increased interest in the securities issued by their founders. The fact that the share of the real estate proper is low is quite understandable as it is non-liquid and risky an asset, and, moreover, it does not allow the fund to show regular profits (see below on this problem). However, if a market appears in Russia for real estate-based securities i.e., mortgage bonds, real estate investment fund stocks, etc., the NSPF may present a considerable demand for them.
The share of foreign exchange is gradually growing, but remains insignificant so far. Meanwhile, this is a rather painful issue for many funds that form their liabilities as foreign exchange liabilities (to be more precise, accept rubles from contributors and denominate their pension liabilities in foreign exchange). The arising currency risks must be either hedged (but NSPF are denied access to derivatives markets so far) or neutralised by way of acquiring foreign exchange. A severe dilemma arises for the state in this case: to permit NSPF the acquisition of foreign exchange means to take the risk that pension reserves are brought abroad, which will prevent the use of the potential of pension savings for the development of an internal investment market; to ban the acquisition of foreign exchange to NSPF means to increase the risk of default on liabilities to clients in case of devaluation of the national currency.
Bank deposits are the simplest and generally the least profitable investment instrument. As financial markets develop, pension funds will most probably abandon bank deposits or considerably reduce their shares in their portfolios. However, the popularity of deposits is unexpectedly high now: their percentage is comparable to that of investments in state bonds whereas the return rate is still lower.
Corporate securities i.e., stocks, bills and bonds, cannot be divided using official statistical data. However, if our estimates of the share of stocks in this group (70% to 80%) are true, then the total share of stocks in the investment portfolio of Russian NSPF turns out to be 45% to 50%, which is unjustifiably high.
Can the existing trends be extrapolated to the nearest few years? In our opinion, it will hardly be fair. The percentage of fixed-yield instruments is to grow to 50%-70% of pension reserves, and the share of stocks and real estate is to drop down to 30%-40%. The causes are the development of the debentures market (corporate bonds, in the first place), on the one hand, which means both the growth of the number of issuers and amounts of borrowings and the prolongation of the terms of borrowing. On the other hand, NSPF will have to demonstrate a rather high reliability (comparable with PFR reliability) in their struggle for the funded labour pension component, which logically implies a focus on fixed-yield instruments. Finally, as funds size grows, their inclination to risk will drop: a large financial institution is more likely to agree to a lower yield for the sake of a higher reliability.
Another argument against extrapolating the existing trends is an excessive concentration in the industry: R28.2 billion or 77.7% of total pension reserves of the system are concentrated in 10 largest NSPF, and R31.5 billion or 86.8% are concentrated in 20 funds (as at the end of 1 quarter 2002). As a consequence, averaged data proves not quite representative: even small "peculiarities" of the investment policy pursued by the leaders may considerably distort the real general picture in such situation. However, we have no opportunity to see the industry asset structure LESS the assets of the largest funds.
Information on the investment portfolio structure in individual large funds is of interest. So, the Electric Energy NSPF mentioned above invested R1 trillion of its pension reserves as follows at 01.01.02:

state securities: 28.9%
municipal bonds: 7.3%
bank deposits: 14.8%
bank bills: 12.8%
bills issued by enterprises and organisations: 16.7%
bonds issued by enterprises and organisations: 3.2%
stocks: 3.4%
units of unit investment trusts: 1.7%
foreign exchange: 7.4%
real estate: 2%
other asset classes: 1.8%.

Will the units issued by unit investment trusts be interesting investment objects to NSPF? The world practice shows that pension money comprise a very significant percentage of investment fund assets. However, large Russian NSPF are currently of the opinion that such investments are economically disadvantageous as increases, discounts and commissions prove to be much higher in unit investment trusts than the commissions payable to the manager at the conclusion of an individual contract for fiduciary management (see below), and the freedom of manoeuvre is greater in such individual contract. However, this option can be used by small and mid-scale NSPF. In the event that the size of fees and deductions drops significantly as the investment fund industry develops, large pension funds may get a stimulus to review their position.

In investing pension reserves, the fund has to collaborate with two oganisations: management company (MC) and specialist depository (SD). According to the Law on NSPF, funds may invest resources in state securities, securities issued by subjects of the Russian Federation, bank deposits, or other assets. Ordinance no. 1432 by the Government of 23 December 1999 adds municipal securities and real estate to this list. However, a contract must be concluded with a licensed management company (or a few companies) to invest in corporate securities, be it stocks and bonds or bills.
The relations between NSPF and MC are best regulated by a fiduciary management contract. However, the general provisions on fiduciary management in chapter 53, RF Civil Code, contradict the Law on NSPF to some extent. According to article 24 of this Law, "pension reserves shall be invested on the principles of reliability, safety, liquidity, profitability and diversification". Moreover, according to article 25, the manager must "secure the return of the pension reserves transferred by the fund to the manager under fiduciary management contracts or other contracts using methods stipulated in the civil legislation of the Russian Federation". On the contrary, the Civil Code provides for no guarantees of return of the resources transferred into fiduciary management (although it does not prohibit it), as, according to the ideology of this contract, investment risks are with the trust founder i.e., with the fund. As a result, management companies are compelled to guarantee the return of the resources received into management, and additionally to guarantee a minimum rate of return sometimes, which cannot be seen as normal from the viewpoint of the general principles of fiduciary management.
There exist various models of relations between NSPF and manager in practice. There are funds with quite clear ideas of their investment goals and tasks, and the manager is merely a technical performer of the orders to buy/sell some securities. Another extreme position is NSPF specifying only general asset classes in their "Pension reserves investment plans", and then completely trusting in their managers. There is a range of various options between these two extreme models. Unfortunately, there is no quantitative statistics on this issue.
The issue of the degree of activity in managing the NSPF portfolio, in particular the issue of portfolio turnover rate, is of great interest for researchers. According to our estimates, the majority of NSPF are likely to be passive investors, at least as regards strategic investments in the stocks issued by parent or affiliated companies. As to portfolio investments, some funds (especially those working with experienced and active managers) may be active investors, but an excessive inclination to portfolio renewal is fraught with unjustified transaction costs without adequate return rate growth to small and mid-scale funds. However, there is no objective statistics on this issue either. Wher