FAST AND LOOSE WITH OTHER PEOPLE’S MONEY?

Fast and Loose with Other People’s Money?

By Lidia Lukyanova

There are more than 2,500 commercial banks operating in Russia,more than 1,400 of them in Moscow. According to the Central Bank’sfigures, 300 of these banks are close to bankruptcy. And morethan 120 commercial banks in the capital are in serious financialtrouble.

Sergei Aleksashenko, the bank’s first deputy chairman, admittedto journalists that more than half of his official correspondenceis made up of requests for credit from commmercial banks whichneed the money to pay off their obligations. Such requests cannotbe fulfilled, since the Central Bank of Russia is not in the businessof giving loans. These days it is not only individual depositorswho are upset over the banks’ inability to pay their debts; businesseshave also begun to feel the pinch. Many enterprises and organizationsare finding that their money is "stuck" in their bankaccounts, putting them in danger of insolvency. According to experts’estimates, one out of every four of the 410,000 businesses registeredin Moscow cannot recover money entrusted to banks which have becomeinsolvent.

The giant Mezhekomsberbank–the Federal Fund for Supporting SmallBusiness’ main bank-agent–is just one example. At the end ofMarch, it suspended payments on its obligations. According toreliable sources, 94 billion rubles were kept in this bank.

A banks’ inability to pay sets off a string of nonpayments withserious consequences for society: The cash shortage of the businessmultiplies the number of defaults in payments between it and itsbusiness partners, and holds up the payment of salaries to itsemployees. Moreover, the business no longer has money to pay taxesto the state or make its mandatory contribution to social funds,such as the health care fund and the pension fund. And that leadsto delays in social payments, including pensions and scholarships.The ultimate impact on society of the defaults of many commercialbanks have been quite severe.

So, why are commercial banks going bankrupt in Russia? And whyis their collapse such a tragedy for the depositors, who cannotget their savings back?

The Central Bank of Russia is responsible for the activities ofthe commercial banks which are accountable to it. Therefore, theCentral Bank’s leaders’ explanation of the reasons why commercialbanks are going bankrupt can be regarded as official. Let’s takea look at it.

Banks are failing because of poor management. The leadership andemployees of these banks are not always competent, and this istrue even of those who previously worked in Soviet banks. Manyhave proven to be unprepared for work under commercial conditions.They are accustomed to the conditions of a socialist economy inwhich a bank never fails because it is owned by the state. Theylook at their bank as an ever-living source, and do not take intoaccount that a bank can only get money by engaging in some sortof activity, or else it will run out of money to pay its clients.And that is just whati is happening now.

This lack of management or bad management (both of which leadto bankruptcy) is also explained by the fact that far from allcommercial banks are created with the noble goal of helping theeconomy to develop. Some banks were founded with the single (andsecret) goal of taking their clients’ money and running. For thisreason, the people working in these banks are not selected fromthe ranks of financial experts, but from those of high-class conmen. Unfortunately, many crooked banks have succeded in theirscams.

The question arises: why wasn’t the CBR able to figure out thatthese banks were crooked before it gave them licenses? And whydo its examiners always find out about a bank’s impending failureonly when it is just about to happen?

According to Aleksei Simanovsky, Deputy Chief of the CBR’s Moscowbranch, discovering a bank’s criminal intentions from its foundingdocuments is virtually impossible, due to the great number ofcommercial banks and the shortage of bank examiners. In Moscow,for example, there are more than 50 commercial banks for everyCBR examiner. Or, in other words, the CBR’s leadership acknowledgesthat its checks are, to put it mildly, less than thorough.

Moreover, far from every commercial bank reports its activitieshonestly. Even well-intentioned banks sometimes conceal the realstate of affairs to save their reputation from the bank examiners.This is done so that they can avoid, or at least put off, thedate of sanctions. Criminal banks, on the other hand, concealin their reports that they have already crossed the line intobankruptcy.

But nevertheless, this explanation contains only part of the truthabout why the Central Bank of Russia is unable to predict theimpending failure of a commercial bank, even though it has itsreports.

The big bankers say that the reason for this is that the indicatorswhich must be disclosed in these reports are not comprehensiveenough. They were taken from international practice, but are notwell-adapted to Russian conditions. These indicators objectivelyreflect the condition of a bank, but only when it is engaged intraditional, normal, banking activity where the bank lives offthe investments it makes, and not only off interbank credits.In the Alice-in-Wonderland-like Russian financial and economicworld, the internationally accepted indicators do not reflectthe actual situation since they do not answer a question whichwould sound odd in the rest of the world, but is a key questionin Russia: what is the source of the bank’s profit? Does the bank’sprofit come from giving loans to other banks or from the economicactivity of its clients? For Russian banks, this is the main criterionfor assessing a bank’s stability and reliability.

In the rest of the world, banks really are banks. Russian banks,however, have played, and continue to play, only the "shortmoney" game, i.e., they only lend money to each other andlive on the interest from these internal operations. And eachday, such activity leads to sadly predictable results for thebank and its clients, if there are no new receipts. The returnfrom interbank credits alone is not enough to ensure stability.A bank which relies on them can be ruined in an hour.

In September 1995, a number of small and medium-sized commercialbanks, which had relied on attracting money from the population,collapsed, and this process is continuing. These banks used thismoney solely for playing the interbank credit market and the foreigncurrency exchange. When the government introduced the "hardcurrency corridor," they had no other source of income touse to fulfill their financial obligations. And this fact underminedthe public’s faith in such banks, closing the vicious circle..If a bank does not invest in economic activities which can becomethe source of new income, it ceases to be a bank and acts merelyas a brokerage firm: always chasing the same money (which is whythey call it "short-term") on the interbank credit market.This is not wrong in and of itself, and is not even risky, ifa bank invests in economic activity as well. But if there is nosuch investment, then, sooner or later, this "short-termmoney" will inevitably run out, as happened last fall.

Since the indicators on banks’ financial reports do not reflecttheir actual financial condition, the published bank ratings inRussia are not accurate either.

One must assume that the CBR leadership knows about the flawsin the bank reporting system. It has become known that work isunderway to correct them. But for the time being, the realityis that no matter what kind of audit the CBR requires a commercialbank to submit to, it is almost impossible to predict its impendingcollapse. Furthermore, the CBR does not have the legal authorityto tell even new commercial banks which activities it can andcannot engage in. And that is why the dangerous interbank creditmarket, despite the government’s attempts to restrain it withthe "hard currency corridor," continues to flourish.

The cause of the bankruptcies lies not only in the shortcomingsof the commercial banks themselves, but also in the very systemof monetary circulation in the country. The fact is that thereis almost no new money flowing in from the production sector,the traditional source of new money. And, having no influx ofcash, banks inevitably become insolvent.

The large commercial banks have turned out to be more stable thanthe small and medium-sized banks, because their money, at leastto some degree, has been made from economic activity–investmentin trade, production, and construction, and also in the servicesector. Some of their payments, at least, still come in, so thebig banks survive. Yet another reason for the collapse of commercialbanks lies in the country’s macroeconomic situation. In a stagnatingeconomy, not a single sector, including banking, can flourishfor long. The sunset of the golden age of commercial banking inRussia came in the fall of 1995.

As paradoxical as it sounds, the "hard currency corridor,"established by the CBR in order to regulate the ruble/dollar exchangerate and restrain it at a level of no higher than 5,000 rublesto the dollar, is ruining the commercial banks. Such a "corridor"is restraining the rise of inflation, and prices no longer goup as rapidly or as steeply. For the economy, these are positiveprocesses, but they are ruinous for Russian commercial banks.The fact is that Russian banks, like the majority of small Westernbanks, cannot survive under low interest rates. The differenceis in what is considered "high" or "low."A small bank in the US is able to manage at 5-6 percent profitper year, while a similar Russian bank is used to making 100-150percent per year. With inflation and the dollar exchange ratestabilized, such profits are unthinkable. And thus we have whathappened in the first months of this year.

According to Mr. Simanovsky’s figures, in Moscow alone, sevenbanks have been officially declared bankrupt: three of them, bydecision of the Court of Arbitration, the rest, voluntarily. Infact, by January, there had already been hundreds of such bankruptcies.The CBR has to determine which of these bankruptcies are fictitiousand fraudulent, i.e., to expose cases when bank leaders are tryingto use bankruptcy to get out of fulfilling their obligations totheir depositors.

Unfortunately, Russian laws do not provide for strict punishment,not to mention criminal prosecution, for the policies and actionsof leaders which result in a bank’s collapse. The CBR can raisethe question of replacing a bank’s management, and in extremecases, can take away its license. So what? The same people willset up another bank and start up the same con game over, onlythis time, more elegantly and circumspectly.

The CBR doesn’t even have the legislatively-confirmed right tolaunch a legal proceeding to declare a bank under its jurisdictionbankrupt.

Clients of insolvent commercial banks have virtually no legislativeguarantee that they can get their deposits back. If a bank isofficially declared bankrupt, then a list of creditors is drawnup (one for each social group), according to the Law on InsolventEnterprises. I would not say that this procedure has been completelyworked out yet, but at least there is some legislative guaranteethat the money the bank has left will be divided up fairly.

If a bank has not been officially declared bankrupt, but is, infact, insolvent, the depositors are in a more difficult situation,since in this case no one (including the CBR) will assume thebank’s obligations before its clients.

It is extremely hard to have an insolvent bank officially declaredbankrupt. Although Russia has a law "On the Insolvency (Bankruptcy)of Enterprises," it does not take into account the specificsof credit and banking institutions. A special law is needed onbank bankruptcy, which takes into account the specificities offinancial institutions. The Fifth Duma worked on such a bill,but, like other banking legislation, it was voted down. A detailedmechanism for protecting all forms of deposits was also put forwardin several bills by the Fifth State Duma. It would seem that notonly their authors, but the state itself, would be interestedin such a law, because the savings of its citizens are a signof a state’s strength.

To convince potential depositors not to be afraid to entrust theirsavings to the banks, it is necessary to create legal guaranteesto protect their deposits. Only this can help overcome the mistrustin banks which has already taken hold in society.

The Duma Subcommittee on Banking Legislation prepared a bill "OnMandatory Bank Deposit Insurance." It was passed by the FifthDuma, but rejected by the Federation Council, which was interestedin only one thing: who would pay for the insurance fund envisagedin the bill? When it found out that it would come from the moneyof the depositors themselves (the banks, in putting their contributioninto the fund, would, of course, lower their interest rates ondeposits to compensate for it), the Federation Council immediatelysaid no.

One can only speculate as to the reason for such a decision: itwas either out of a banal sense of populism, or out of fear thatthey would lose the high interest rates on their own savings accounts.As a result, millions of depositors still have no guarantee ofthe safety of their savings, and the economy is still not receivingthe investments it so needs from the population.

The bill’s authors had intended that the implementation of themandatory bank deposit insurance law would strengthen the banksas well. Let me explain why.

This law established the principle of "collective guarantees"in a good sense: all the banks wanting to accept money from thepublic would have to join the Insurance Fund. It is clear thatif a bank collapses, it would increase the load on all the otherbanks in the Fund so this means that it would be in the interestof every participant in the Fund to make sure that its colleaguesstay within the framework of the law, and not on the verge ofcollapse, as is now the case.

It is comforting that serious bankers have already come to understandhow important it is for a bank to be stable and are now readyto make contributions to an Insurance Fund.

The Ministry of Finance, however, rejected the very idea of mandatorycontributions to the Insurance Fund as harmful to the state budget,since the money contributed to the Fund under the proposal wouldnot be taxable. Therefore, the Ministry of Finance insisted onthe contributions being voluntary. And the CBR did not like thefact that, according to the law, the banks had to make contributionsto the Fund rather than to the CBR. Moreover, if many banks defaultedat once, the law obligated the government to support the InsuranceFund with its own resources. And this, also, was not to the government’sliking. And therefore, there is still virtually no banking legislationin this country.

And so we are left with this paradoxical situation: there is aconception for developing banking legislation which would treatthe problem, but the Sixth Duma is in no hurry even to includethese bills on its agenda. The new Duma has at its disposal anumber of documents, which, with a little work, could quicklybe passed as laws. In particular, there is an urgent need to strengthencontrols over the activity of commercial banks. But all this isproceeding at a snail’s pace. And the banks continue to go belly-up.Could somebody be benefiting from this?

Translated by A. Kondorsky and Mark Eckert