Although major factors that formulated recent trends in the Russian banking system may seem to stem from the financial crisis of August 1998, some important economic trends had been underway since the establishment of Russian commercial banking.

Private banking in Russia became legal shortly after the state bank - GosBank - was split in 1989 into separate functional banks (Sberbank - saving bank, VneshTorgBank - international trade bank, etc.).The banking sector virtually exploded - fueled with cheap "development" discount loans from the Central Bank the industry mushroomed and topped 2500 banks in 1994. From the very start of their history the bankers became accustomed to "easy money": first, that was FOREX speculations, when the discount loans were used to buy hard currency. When the CBR finally stopped subsidizing the banks and started supporting the ruble instead, the number of revoked bank licenses proliferated and the number of "banks" decreased. In 1996 another "easy money" instrument emerged for the effeminate Russian banks. When the federal government no longer was able to finance its deficit with monetarization, the government securities market was created. Banks once again enjoyed unproportionally high income on government short-term securities - GKO. Yet the euphoria did not last long. In 1997 the CBR managed to lower the interest rate and the banks' profits tumbled down. To improve their profitability somehow banks, especially larger ones, started to engage in the FOREX forward market supplying hard currency to foreigners who still played with GKOs. In all, strictly speaking, Russian banks never been traditional banks by a text book definition - channeling funds from depositors to creditors. They were simply speculators.

Graph 1: Number of Banks in Russia

Source: adopted from CBR statistics, www.cbr.ru

In this kind of a deplorable condition the banking sector met the August financial crisis. The first major implication was the GKO default. Overnight the banks were deprived of the most liquid and relatively high earning assets.

The following ruble devaluation added fuel to the fire. Not only did the Russian banks have net dollar denominated assets of minus 8 billion US dollars (they borrowed from abroad more than they lent there), but also, as already mentioned, they acquired extensive forward liabilities to sell dollars to non residents at 6.4-6.5 RR/$ rate in the fall of 1999 . The Russian Central Bank and the government were of great help to banks in avoiding immediate default, announcing a 3-month moratorium for debt payments. Also in mid September, when a bulk of forward contracts were due, the CBR intervened into the FOREX market to increase the ruble exchange rate so that banks could more easily meet their forward obligations.

Just after the default on the GKOs, banking panics started. Deprived of their secondary reserves (GKO), the banks started to undergo large deposits outflows and rapid depletion of their primary reserves and most liquid assets. Banks experienced serious liquidity problems, delaying payments to their corporate clients and depositors. Businesses started to shift their banking accounts from troubled banks to more healthy ones.

Needless to say that it was the larger banks that suffered most. Not only did they actively participate in the government securities market and were engaged in the forward contracts, they also had more customers' deposits, and thus were more vulnerable to the bank panics. In contrast, small and medium banks simply have not had enough of economy of scale to deal with those instruments and a good enough international credit rating to borrow funds from abroad.

As a result, 187 banks finished with negative capital, and 590 or 40% of the Russian banks - with losses. The sharp swings in profitability have not been a healthy environment for the banking industry. From the peak of 2500 in 1994, the number of banks decreased consistently to the current 1474 banks. Concurrently, the share of larger banks has been increasing (see graph). Despite this obvious consolidation, banks are still small, relative to their foreign big brothers. The only Russian bank in the top 200 banks of the world is Sberbank - a government controlled bank with evident dominance in the Russian banking industry. It holds more than three quarters of all individuals' bank deposits and its share has been increasing through out 1998, from 78 % in January 1998 to 87 % in March 1999. As for its share in the top 200 Russian banks: on October 1, 1998 it accounted for 17.9 billion rubles out of 82.7 billion in capital (21.6 %) and 106 billion rubles out of 189 billion in investment in government securities (56.1 %) .

Graph 2: Banks Breakdown by Amount of Capital

Source: adopted from CBR statistics, www.cbr.ru

Finally, an obvious result of such a systematic crisis was a general uncertainty. Everything has been changing so rapidly and unpredictably, that borrowers, lenders and bankers became oriented toward short-term financial instruments with maturity less than a year or even half a year. A mortgage to an individual was a rarity, and was expected to be paid off in three to five years. The situation worsened in the second half of 1998, when the banks completely stopped making loans, as they did not know what the exchange rate and inflation would be in a week, and what the market interest rate was.

Graph 3: Amount of Individuals' Deposits, RR bn

Source: adopted from CBR statistics, www.cbr.ru

The regulation of the banking industry is coming from two sources: the Central Bank of Russia (CBR) and the Duma, Lower House of Russian parliament.

The CBR long ago announced its intentions to raise banks’ capital requirements to 1 million European Currency Units (ECU) for limited licensed banks and 5 million ECU for general licensed banks, effective January 1999. (By now only 435 banks out of 1474 (or about 30%) have the capital more than 20 million rubles.). Yet due to the adversity of the financial crisis, the CBR postponed this capital increase requirement to a later date. Moreover, to avoid immediate bankruptcies of significant number of banks it adjusted regulations for the banks to meet old requirements and regulations. For example, for the banks that held significant amount of GKOs at the default, the reserve requirements were lowered. This regulatory forbearance created a situation similar to the financial crisis of 1980s in the USA: currently great number of Russian "zombie" banks keep functioning with negative or zero capitals.

Also there are numerous regulations limiting the ability of foreigners to participate in the Russian banking sector: particularly, foreign investment into the Russian banking sector is limited 12 % of Russian banking industry capital. This limit, however, has never been a problem as there exists other bureaucratic and economic barriers (for example, high risk) that keep the international banks far from Russia. Recently the CBR announced its intentions to eliminate those legislative barriers and thus encourage foreigners to enter the Russian banking industry. It expects that the sum of foreigners in the banks' capital might increase from current 5.3% to 7 %. Some specialists consider foreign banks to be the only force that can handle the reincarnation of the domestic banking, as the CBR and federal government obviously does not have enough resources to do so on their own. According to the estimates of Kommersant-Dengi magazine, if the CBR allowed foreign banks to take over troubled Russian financial institutions by converting Russian banks’ debt into equity, foreigners can eventually have a 25 % stake in the Russian banking system.

The Duma's regulatory input has been mostly of a fiscal nature: a couple of taxes were levied recently on the bank activities: 1).bank deposit income tax of 20 % and 2). 1 % on hard currency sales by banks. The later was said to be intended to decrease the attractiveness of foreign currency as an instrument for savings by individuals.

Another potentially important bill, which can not pass the Lower House of Parliament, is Federal Deposit Insurance Bill. Although it would have been rather helpful in preventing last year's banking panic, now it has minimal use as the population trusts less now than ever the domestic banking systems; and no deposit guarantee by law can return this trust in the near future.

Before the Financial Crisis there was a slow development of debit cards market. In Vladivostok several banks issued debit cards and have several ATMs available. There were also so-called wage programs – a company pays its workers not with cash but transfers the wage to the workers’ debit cards. After the crisis these programs stalled. The card issuers were large banks that had most of the problems. There were also numerous cases of blocking the international and domestic cards, which undermined the trust of the clients in this type of money instrument. As for credit cards, they have never been issued due to two factors: high and volatile interest rates and very low credit history of Russians and lack of efficient control system in this field.

In 1997-98 some regional banks, particularly in Primorye, acquired special technology and remote dealing equipment, that enabled them to conduct real time trading on the Moscow Exchanges. This technological innovation allows local banks to overcome its remoteness from major financial markets and take advantage of large array of financial instruments

The recent history of the Russian financial sector witnessed several crises that undermined the general public's trust in the domestic banking sector. People thus prefer to hold their money denominated in US dollars and then put them under their mattresses. The amount of these savings is estimated to be somewhere from $ 20 to 60 billion. (compare with bank deposits of 158.6 billion rubles, or only $ 6.3 bln!) .

To attract this "mattress money" into the real economy has been one of the headaches of the government and the central bank. After the recent financial crisis the resolution of the dilemma became practically impossible. The only alternative to domestic banks is letting foreign banks, to which the Russians are exposed more friendly, attract individuals' deposits.

Unlike other Russian industries, banking is more or less competitive. Currently there are 1474 banks with 4419 branches operating on the Russian financial market. Most of them are concentrated in Moscow – the Russian financial center where 80% of financial resources are located.

Competition from foreign banks is not significant. Their participation is not only regulated by law, but they themselves are not willing to enter the risky Russian market. Those banks that are in usually do not work with individuals, and their primary clients are foreign companies operating in Russia.

Russian regions, the RFE in particular, are the obvious market for large banks, which are based in Moscow. Prior to the August, Moscow based banks were actively deploying their subsidiaries in the Far East, and as a result they were taking customers from local banks. Large banks have at least two advantages over local banks: size and a wider array of services. Yet after the crisis the opposite could be true. The competitive advantage enjoyed by large, Moscow based banks disappeared nearly overnight. One bank, IncomBank stopped operating. As the result, it was as if the small and medium banks (that is, RFE banks) suddenly turned into islands of stability. They had proportionately (to their assets) smaller investments in government notes (GKOs) and had been mostly intact by GKO catastrophe. Despite the instability of the large banks, in the long run they will continue to expand their presence in the region.

As for the non-banks competition, it has never been (and won't be in the near future) a problem in this respect. The number of credit unions is insignificant; insurance companies do not directly compete with banks. Other types of financial intermediaries are either unknown in Russia or underdeveloped.

Since the financial system of Russia is underdeveloped, financial intermediation has been done poorly, and substitutes for banking services are inefficient. A very good substitute for bank deposits is offered by the Federal Reserve System of the United States – US dollar currency, used by individual savers as the safest and most liquid instrument in the Russian economy. As for the other part of traditional banking services – lending, - there are several substitutes – promissory notes, Eurobonds, inter-company loans. These are mostly available to large companies that can access the international bond and equity markets. In fact, Russian monopolies that handle large volumes of financial resources and have direct access to Eurobond markets, provide loans to their subsidiaries and strategic partners. Some companies also provide intra-company consumer loans to their employees.

The Central Bank imposes some regulations and requirements on newly chartered banks. For example, banks are prohibited from taking in individuals' deposits during the first two years of operations. Yet these regulations and capital requirements might be considered mild comparing to the real barriers to bank charter - bureaucratic lags. Taking into consideration problems within the industry, Russian banks are significantly undervalued. Thus, it is a lot easier, quicker, and cheaper to buy a troubled bank and revive it than to charter a brand new one.

As for the foreign banks as potential entrants, the CBR has some extra requirements and regulations for them as well. However, these regulations are expected to be eased (but not completely eliminated) in the near future. Other than that, foreign banks are unlikely to face significant barriers (foreign banks are more mature, larger, have more experience and technology than Russians do), but one - country specific expertise and risk.

If we are to consider a less broad geographic market - the RFE - or even more narrowly - Primorye, where DalRybBank operates, - there is high long term potential threat of Moscow banks' establishing their branches here. This process had been especially active before the August 98 but is expected to stop for a while in the near future.

There are three major types of borrowers: businesses, individuals, and the government. Since the traditional banking has not been a reality in Russia, corporate customers have had little power over the banking industry. Banks earned their money on activities other than making loans, so there is a great deal more alternatives for banks than for their clients. Yet 1998 changed the situation greatly, as decreased profitability is forcing banks to move to the traditional banking.

As for individuals, they have been completely overlooked by commercial banks. Consumer loans share in banks’ portfolios is very insignificant. In this respect, the government has had a much higher influence on commercial banks as about a third of banks’ portfolios were and still are allocated to loans to local governments and the Treasury.

Graph 4: Common Assets of the Russian Banks

Source: adopted from CBR statistics, www.cbr.ru

Savers have had more bargaining power over the banks than borrowers do. So, individuals have a much more secure instrument for saving – the US dollar. Until the banking sector can prove to be stable, banks have no chance of competing with the mighty US dollar. A second competitor to the commercial banks is Sberbank – it is also considered to be much more stable than commercial banks and, thus, attracts more than 85 % of all individuals’ deposits.

Businesses and governments – are more tied to the banking industry, yet the competition among the numerous banks and low costs of switching from one bank to another, make banks compete intensively for this type of customer.

Graph 5: Common Liabilities of the Russian Banks

Source: adopted from CBR statistics, www.cbr.ru

Before the August events the foreign banks were on the good terms with some large and medium banks, providing them with comparative cheap sources of funds. Yet again, the crisis and the default of some banks decreased the overall rating of the Russian banking system, and it is unlikely that foreign banks will continue to make loans to Russian banks. Moreover, the poor liquidity position of domestic banks and the inability to pay their dollar denominated debts put them into a dependent position in respect to foreign creditors.