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Dog-eat-dog banking full of scope for smaller breeds

This year’s shift to Basel III will be further stimulus to much-needed consolidation, and with the country’s quasi-sovereigns thinking globally, smaller players have a huge opportunity to grab market share, writes Tom Porter.

A thousand banks is far too many, even for a country the size of Russia. Some 17m square kilometres and 143m people should ultimately be served by a tenth of that number, or fewer.

The country’s financial authorities have not hung around in attempting to cut their sprawling banking system down to size.

On October 1 this year Russia will integrate into the global Basel III framework, barely a year after the Central Bank of the Russian Federation published the first draft of the new regulations.

Under current plans, banks will be required to maintain a 5.6% core equity tier one ratio, a 7.5% tier one ratio and a total capital adequacy ratio of 10%.

“Further consolidation of the Russian banking sector can be expected, due to a great overall number of banks and their low level of capitalisation, in comparison to the banking systems of some developed countries,” says Ekaterina Trofimova, first vice-president at Gazprombank. 

“Among the possible factors that could accelerate this process are increasing competition, further asset quality deterioration and the policy of the regulator and its requirements.”

Smoothly does it

While the regulator is keen to set Russia’s banking sector on a path to a more sustainable structure, it is equally keen not to try the faith of Russian depositors, who provide banks with a large proportion of their funding.

“The tactic of the central bank, certainly over the last eight years, has been to introduce new measures gradually,” says Elena Romanov, a senior analyst at Raiffeisen Research. 

“It wants tougher regulations but it should be a smooth transition to Basel III. I do not expect sudden bankruptcies or public punishments, nothing that could cause a panic. The Central Bank of Russia understands that the trust of depositors is fragile.”

The CBR’s measured approach was made clear in June when a senior official said banks would be given an extra month to comply with the new rules, and the proposed minimum capital requirements could still be relaxed.

The transition will be smooth, but that doesn’t mean it can’t give the industry a much-needed shake-up.

The CBR has already introduced stricter rules for the eligibility of banks’ tier one and tier two debt, which since March 1 has had to include loss absorption features. That could put pressure on smaller institutions, which, unable to issue capital at a competitive price, may struggle to survive (see page 26).

Oliver Hughes, president of Tinkoff Credit Systems, the online bank, agrees Basel III will not force banks to consolidate or go out of business, but he sees three things that could put pressure on the smaller banks to do one thing or the other. 

“The first is mandatory reporting to IFRS, which means getting a decent accounting firm, adding an overhead,” he says. “Second is the central bank actually enforcing the minimum capital requirement of $10m. There are plenty of banks under $10m but it’s not enforced too strongly. And third is unilateral regulatory action from the central bank, aimed at individual institutions.”

Stars and dross

Consolidation must happen, and it will in time. But many of the acquisitions in the last five years were rescues aided by the state, as some banks struggled with the effects of the 2008 financial crisis.

In future, there will have to be a positive business case for mergers and acquisitions. “The top 10 banks have got their own dynamic and there will not be much consolidation going on,” says Hughes. “From positions 10 to 50 there are many indistinguishable banks that lack strategy, growth and capital, so there is a business case for others to follow the likes of Nomos Bank and Otkritie Capital [by merging]. Then from 50 to 100 there are some rising stars and a lot of dross. The dross will either be gobbled up or go out of business. There is a lot of potential movement there.”

Sberbank, VTB, Gazprombank and the commercial banks in the VEB group accounted for 53% of total banking assets at the end of 2012, according to a May 2013 report by Raiffeisen Research.

And in the volatile climate that exists for private banks in Russia, the rest is up for grabs.

There have been some impressive growth stories among the vast group of smaller private banks in the years since the financial crisis.

In terms of assets, Nomos and Promsvyazbank have powered into the top 10, at the expense of rivals like Uralsib and MDM.

Otkritie Financial Corp acquired several distressed regional banks, and its takeover of Nomos will create a formidable enterprise in domestic banking.

As Raiffeisen notes in its report, St Petersburg’s Bank Rossiya has gone from being a top 50 to a top 20 bank in just five years, while consumer lending bank Orient Express has joined the top 30, having been ranked 89 by assets in 2007.

The onus may very well fall on these new powers, and others in the top 10 to 50 bracket, to drive consolidation through mergers and acquisitions.

Raiffeisen’s Romanov does not expect any mergers between the smaller banks.

“The regulatory approval procedure is quite cumbersome and for the banks it is easier to either grow organically or disappear,” she says.

For those hoping for consolidation in the sector, it may be a case of waiting for banks outside the top 100 to die, rather than expecting them to merge and attempt to grow their businesses.

“Mergers between regional banks are quite possible,” says Gazprombank’s Trofimova. “Voluntary acquisitions of the banks that are not in the top 100 are very unlikely as the quality of their assets is not always good enough. However, the government can be expected at some point in time to urge bigger banks to acquire smaller ones to ease the pressure on the Deposit Insurance Agency.”

But the CBR can only go so far in actively encouraging banks to merge or acquire competitors.

It cannot force privately held institutions to load up their balance sheets for the greater good. The CBR has more sway over state-owned institutions, but Sberbank and VTB have made it clear they have little further part to play.

Sberbank, along with the government that owns it, is loath to put its 100m customers’ deposits at risk, and VTB is still digesting its full takeover of Bank of Moscow from the government in September 2012.

Russia’s two banking beasts appear content with their domestic market share and have started devoting more energy to competing with global rivals.

Local knowledge

So can smaller lenders compete with them in the domestic market and by doing so foster competition and drive consolidation? 

Absolutely, says Romanov. “There are still a lot of opportunities for the smaller banks,” she says. “The banking system is still developing and there are plenty of products and customers in Russia that have not yet been tapped. A good example of where smaller banks can compete is SME lending, where they benefit from their regional presence and knowing their clients well.”

VEB’s SME Bank has taken this route. It relies on the local knowledge of a network of regional agents to allocate funds to businesses across Russia.

“It is quite challenging for smaller banks to compete with banks like VTB or Sberbank, because their funding costs are considerably lower,” says Trofimova. “Yet, interest margins on large corporate loans have decreased in the Russian economy. Considering this, smaller banks can compete with the bigger ones for small and medium-size corporates and individual customers, by providing conditions that are more flexible.”

There are other areas that remain largely untapped, where nimbler operators can compete with the behemoths, and none more so than consumer lending.

Banks for the masses

The consumer finance market has grown so fast in recent years that concerns about a future bubble have arisen, and the CBR is set to introduce stricter rules for such lenders to combat it.

The growth has been phenomenal, but it has started to slow this year and consumer lending still only accounts for 13% of GDP in Russia, meaning it has some time to run before reaching bubble proportions.

“We are going to see lots of growth in consumer lending over the next few years,” says Hughes at Tinkoff. “Credit card penetration across the market is 18%, but it is heavily skewed to the big cities. In five years we could see the level of credit card penetration we have seen in other emerging markets like Turkey, Poland and Mexico, in the 40%-70% range.”

Tinkoff is one of the rising stars taking on the biggest banks by reaching regional customers through its online model. The credit card issuer has grown at more than 100% for the last three years and is now knocking on the door of the top 50.

“There are proactive medium-sized banks that are now growing very fast,” says Romanov. “Credit Bank of Moscow, for example, has changed its strategy and is now growing well organically, and Orient Express Bank is benefitting from its consumer finance specialisation.”

The Russian market needs institutions like these to take on VTB and Sberbank, whose size enables them to set the rates in corporate and retail lending. Fiercer competition should lead to cheaper prices and better service for domestic customers.

But there are benefits to the two leaders’ dominance.

“To a certain extent, the size of Sberbank and VTB distorts the market, because they enjoy certain privileges such as an implied state guarantee for corporate and retail depositors, and they have a much lower cost of funding,” says Hughes. “Our average cost of funding at the moment is about 12%, theirs is around 4%.” 

But there is a positive side to the big two’s dominance, in that they create infrastructure in under-served segments, he argues: “In credit cards, Sberbank having a 22% and growing market share is a good thing, because they are establishing the product, educating customers, and driving the spread of acceptance infrastructure.”

Russia’s banking system mirrors its economy in the way it still serves many consumers poorly.

Tinkoff, for example, has been forced to create an in-house courier service to reach its most remote customers – the multinational couriers simply don’t deliver beyond their city hubs. The bank’s service now covers 600 cities through over 1,200 couriers and is probably the biggest in Russia.

It is a neat example of how by focusing on untapped markets, smaller players can squeeze their way on to the banking table, between the elbows of much bigger diners.