How to plug the gap in Russian bank capital

Vitaly Bouzoveria, global head of fixed income at VTB Capital Contrary to popular belief, Russian banks do not rely too heavily on external funding: the banking sector is largely deposit-funded, as indicated by a systemic loan-to-deposit ratio historically close to 1x. There are a few exceptions, of course. Russian banks have not been given a chance to overborrow, as global capital markets have gone through a sequence of open and shut borrowing windows since the 2008 global financial crisis. As a side-effect of the volatility, there is simply no immediate refinancing risk: the debt foreign Russian banks have to repay in the next two years is less than $20 billion (including $4.5 billion in Eurobonds), while the bulk of the traded debt has maturities distributed over the next 10 years. The total amount could be repaid out of accumulated cash or using the Central Bank of Russia’s refinancing instruments, as long as the country continues to receive a stable inflow at least through the current account. Banks will almost certainly have to run a tightening liquidity cushion, as corporate deposits in foreign currencies will naturally absorb corporate loan repayments. However, liquidity gaps are manageable, given the size of sovereign foreign-currency reserves (some $450 billion at the end of September 2014) and the availability of short-term refinancing instruments such as foreign-currency swaps. This is the kind of economic firepower that most countries, with much weaker current accounts and fiscal positions, cannot afford.

One of the effects of negative market perceptions is the lack of a marginal buyer of Russian bank equity, because the sector's profitability has declined as external conditions have deteriorated. Furthermore, most investors are naturally uncomfortable with the uncertainties. It is likely that the continuing consolidation of the banking sector – even if it is currently done largely through the liquidation of smaller banks, rather than mergers between equals – will ultimately strengthen the investment case for the financial industry as a whole. However, even the strongest banks need to search for alternative sources of capital to remain competitive in difficult times. In the next few years, tier I capital is likely to be supported by the Russian state through the conversion or extension of existing and new subordinated deposits by the CBR and government agencies, such as Vnesheconombank (VEB). The mechanism has already been tested with the conversion into tier I preferred stock of subordinated deposits previously placed by VEB at the Russian Agricultural Bank and VTB.What actually concerns Russian banks and the financial authorities most is neither the debt maturity profiles of individual banks nor even currency risk mismatches (which are subject to strict regulatory limits), but access to capital in its common equity or hybrid form. Recapitalization has little to do with restricted access to traditional markets – although obviously this does not help. Russian banks would have seen their capital adequacy ratio falling to multi-year lows regardless of external factors. Pressure on capital is partly a cyclical effect of lending expansion in the past few years, and partly a natural result of the implementation of Basle III standards in Russia – an impressive leap from the much more relaxed local analogue of Basle I previously in place – with only a short transitional period. These are structural issues that can be addressed by economic mechanisms and countercyclical adjustments in banking regulation designed to mitigate shocks.

Russia has a track record of providing support to its financial sector in various formats, and, most importantly, it has sufficient financial resources to afford to be supportive in the future. Indeed, the economic incentives for supporting banks have increased. Leveraging that state support, hybrid debt (primarily loss-absorbing subordinated tier II instruments) is what actually has to be refinanced and expanded in order to strengthen the capital base of the banking sector and ensure healthy lending growth through all phases of the economic cycle.

Investment banks can and will play their role in aligning the interests of issuers and investors, providing all necessary advisory, structuring and financial support. Potential solutions can be focused on (and tailored for) domestic or foreign investors or both. In the domestic market, the regulator is open to discussing the potential for extending pension funds’ investment mandates to include rouble-denominated subordinated debt, an instrument that is currently non-existent, as it remains out of reach from national pension fund managers, even if they are allowed to buy stocks. Tapping local pension money requires technical amendments to legislation to clarify the seniority of claims under Russian law, as well as the legal aspects of write-downs and convertibility features. These structural features are historically based on English law and rely on prevailing legal practice in the Eurobond market – as if defaults, debt restructuring and resolutions were bound to forever remain a prerogative of the British courts. Many domestic markets are prepared for alternative solutions, not only in the segment of hybrid capital, but across the whole scope of traded currency-, interest rate- and credit-linked instruments.

In a global context, the overall goal can be said to be the expansion of the foreign investor base to diversify out of core funding markets and tap potential non-US/EU demand. Tapping and expanding into alternative capital markets is a matter of improving deal structures, reducing transactional costs and, last but not least, reinforced marketing to new clients. Demand is there for new instruments, including in currencies other than the US dollar or euro. Creating a liquid and balanced alternative to traditional US- and EU-centric capital markets has been an increasingly important topic for the Brics and other emerging economies – not just an instrument of crisis management for Russian banks.