Vasily Solodkov, Higher School of Economics Moscow
vsolodkov@hse.ru
Thomas Schumann, TU Bergakademie Freiberg
thomas.schumann@vwl.tu-freiberg.de
THE POTENTIAL IMPACT OF FOREIGN BANKS
ON THE RUSSIAN BANKING MARKET
Abstract
Up to now, the Russian banking market has not been opened up completely for foreign banks.
This refers mainly to the still existing restriction to set up branches in the Russian Federation
that will even remain in force after the accession to the WTO. There is a fear by many
incumbent Russian banks of being crowded out by foreign banks entering the market with
low-interest offers for business and consumer loans. Studies of foreign bank entry in other
transitions countries have shown that this fear is reasonable. However, from an economic
point of view the entry of foreign banks has increased the overall efficiency of the banking
markets in those regions and led to a healthy concentration process. Both effects could also
take place on the Russian banking market that is characterised by a comparably low
borrowing to the private sector and a very high number of small banks.
This article addresses these questions by reviewing the potential effects of foreign
bank entry in banking markets of transition countries. This is followed by an analysis of the
current situation on the Russian banking market which has some peculiarities in comparison
to the banking markets of e.g. former socialist countries in Central and Eastern Europe (CEE).
This is mainly due to the size of the country and the existence of large state owned banks
which are dominating the market.
JEL-Classification:
E 44, G21, G32, O16, P34
1 Introduction
Even after nearly 20 years of economic reforms, the Russian banking market has not been
opened up completely for foreign banks. This refers mainly to the still existing restriction to
set up branches in the Russian Federation that will even remain in force after the accession to
the WTO. There is a fear by many incumbent Russian banks of being crowded out by foreign
banks entering the market with low-interest offers for business and consumer loans and better
financial services. Studies of foreign bank entry in other transition countries have shown that
this fear is reasonable.1 However, from an economic point of view the entry of foreign banks
has increased the overall efficiency of the banking markets in those regions and led to a
healthy concentration process. Both effects could also take place on the Russian banking
market that is still characterised by a comparably low borrowing to the private sector and a
very high number of small banks.2 The lack of performance of the banking sector prevents the
channelling of funds from the capital-abound natural resources sector to other non-resource
based industries and thus deters the diversification of the whole Russian economy.3
This article addresses these questions by reviewing the potential effects of foreign
bank entry in banking markets of transition countries. This is followed by an analysis of the
current situation on the Russian banking market which has some peculiarities in comparison
to the banking markets of e.g. former socialist countries in Central and Eastern Europe (CEE).
This is mainly due to the size of the country and the dominance of large state owned banks in
the market.
2 The Potential Effects of Foreign Bank Entry in the Banking Markets of Transition
Countries and the Experiences in CEE
Like foreign direct investments (FDI) in other sectors, FDI in the banking sector can come in
the form of greenfield or brownfield investments. That means by founding a new legal entity
or acquiring a significant stake of an existing bank in the target market. By doing so, the
investments of foreign banks can directly and indirectly influence the banking sector as well
as connected areas (See Figure 1 and 2).4
Direct horizontal effects are composed of employment effects, the inflow of capital
and a fostering of competition in the banking sector. Increased competition could lead to a
crowding out of smaller and inefficient banks so that the whole sector may find a healthy
level of concentration. A large number of competing banks is expected to lead to excessive
competition, too much risk taking and thus to possible breakdowns of banks that may result in
bank runs and a damage of the whole banking sector and the economy. This threat is
especially severe under circumstances of week bank supervision.
Indirect horizontal effects (spillovers) refer to a positive impact on the banking
technology of incumbent banks. They can copy the business strategies of the entering foreign
banks or try to hire staff educated in their branches.
Downward direct vertical effects: Foreign banks may also play an active role in
improving the management of client companies by transferring knowledge concerning
financial organization as well as best-practice corporate governance standards. They may also
monitor their projects along guidelines established in market economies.
1
See e.g. Haiss et al. (2005) and Haselmann (2006).
See Sarkisyants (2006) and Moiseev (2006) on the current situation on the Russian banking market.
3
It should be noted that the provision of financing is only one component that could lead to an increasing level
of diversification of the economy. An appropriate legal framework for private economic activity as well as a
certain amount of entrepreneurial individuals are other very important elements.
4
See e.g. Keren/Ofer (2002) and Hermes/Lensink (2004).
2
Upward direct vertical effects: These effects refer to the flow of information to public
bodies like the government or the Central Bank concerning sound forms of regulation and
supervision of the banking system.
Public Bodies
Direct horizontal
Upward direct vertical
 competition
 regulation
 employment
 supervision
 capital
Private
owned
Banks
Foreign
Owned
Banks
State
Owned
Banks
Downward direct vertical
Direct horizontal
 corporate governance
mechanisms
 competition
 cooperation
 project monitoring
Corporations
Figure 1: Direct horizontal and vertical effects of foreign owned banks
Source: Own figure.
The Experience from Central and Eastern European countries has shown that the
opening up of domestic banking markets for foreign banks can have the mentioned vertical
and horizontal effects. There are several studies which provide empirical evidence especially
on the positive effects on competition, efficiency and overall financial development.5 In the
majority of these countries, foreign owned banks now have a stake of over 80% in the
banking sectors and have helped to make them become the backbones of these very fast
growing economies.6 However, there are also doubts whether foreign banks entering credit
markets in emerging economies might be harmful for the financing conditions of small and
medium sized enterprises (SMEs). This could be due to the fact that smaller domestic banks
grant loans to SMEs by looking not only on hard financial facts but also on soft information
about e.g. the reliability of the entrepreneur (relationship lending).7 It is argued that foreign
banks might crowd out domestic banks that are applying this financing technique without
being able to substitute these services.8 Entering foreign banks are typically part of large
organisations that are supposed to be unsuitable for relationship lending. They primarily base
their credit decisions on financial statements and physical assets. A recent study of Giannetti
and Ongena (2005) at least confirms that the positive effects of foreign banks are dampened
5
See e.g. Claessens et al. (2001), Uiboupin (2005) and Haselmann (2006).
See UniCredit Group (2006).
7
See Berger/Udell (2002) on the importance of relationship lending for SMEs.
8
Detragiache et al. (2006) study the impact of foreign banks in poor countries for which a high share of opaque
businesses is typical. There can be circumstances such that entering foreign banks concentrate on the most
valuable clients (cream-skimming) which results in a worsening of the financing conditions for other (smaller)
clients of targeted domestic banks.
6
for SMEs. Clarke et al. (2002), however, provide evidence that rejects the hypothesis that
foreign banks are harmful for the financing conditions of SMEs and points especially on the
positive effects on overall financial development. They further argue that entering foreign
banks that primarily deal with large corporate clients might force domestic banks to look for
new market niches like e.g. SME financing. They also point on the fact that at the very
beginning of the transformation processes relationship lending did not exist anyway, since
banks and their clients just had to begin to built up new business connections.
The positive effects that bank FDI can have were not seen from the very beginning of
the transformation process in the early 1990s. In many of those countries it took some years
until it was recognized that it is impossible to transform the domestic banks that developed
from the former monobank into full-fledged Western style banks without external experience.
In addition, domestic bank associations argued steadily against an opening by citing national
strategic interests.9 Both hindering elements are also playing a great role in Russia where the
market has not been opened up completely for foreign banks. This refers especially to the
restriction to set up branches in the Russian Federation as it is described in chapter 4 of this
article.
Spillovers
techniques & strategies
Private
owned
Banks
Foreign
Owned
Banks
State
Owned
Banks
Figure 2: Indirect horizontal effects of foreign owned banks
Source: Own figure.
3 The Russian Banking Market after more than 15 Years of Transition
Currently, there are roughly 1150 operating banks on the Russian banking market. 10 However,
most of them are very small and there is a tremendous concentration of the overall market, in
which the state owned Sberbank is dominating, since it holds roughly 25% of all banking
assets. Together with the next four largest banks it operates with ca. 40% of all banking
assets.11 The total assets of the banking sector (335 billion Euro) correspond to 40% of GDP,
whereby loans with a size of 25% of the GDP are provided to households and corporate
clients. Thus, the level of financial intermediation is lower than in other transition countries.12
The figures show that the banking sector has not jet become a cornerstone of the Russian
economy that channels investment capital from the cash-abound natural resources sector into
future-oriented branches of the economy. In addition to the high number of undercapitalized
banks and the high level of concentration there is still a lack of transparency in the conduct of
business and corporate governance in many of the banks.13 This increases their cost of
9
See Keren/Ofer (2002), p. 8.
The number of registered banks is higher (ca. 1300). See CBR (2007).
11
CBR (2006a), p. 91.
12
See CBR (2006b).
13
See Vernikov (2007), p. 22.
10
refinancing and raises the interest rates for provided loans.14 Furthermore, there is only a
nascent credit information system that encompasses only a couple of banks. This lack of a
comprehensive system increases the transaction costs for the decisions to issue loans.
By far one of the largest problems of the whole Russian banking sector is the still
existing mistrust of the public towards banks, which is the result of the banking crises in
1998. The Russian Central Bank has taken action against this and inaugurated a deposit
insurance scheme. Roughly 930 banks or 77% of all banks have been accredited for
participation in this scheme.15 This process also brought some kind of clearance, since weak
and opaque banks that were found unsuitable for the scheme had to leave the market or were
forced to reorganize. The introduction of the scheme also levelled the playing field for all
banks on the market, since state owned banks lost some portion of their comparative
advantage they possess due to a federal guarantee that is protecting them against failure. The
guarantee enabled the Sberbank to attract the highest share of personal deposits. However, the
introduction of the insurance scheme seems to produce a typical moral hazard problem, since
it leads potential depositors only to look at the interest rates offered by the member-banks, but
not on their track record as stable providers of banking services.16 The Central Bank is aware
of this problem and tries to answer with increased efforts to monitor the conduct of business
in the member-banks.17
The government also promised to withdraw partially from the banking sector by
offering shares to private investors. In the beginning of 2007, it sold a large portion of its
stakes in Sberbank and VTB (Vneshtorgbank). In order to place this large amount of shares
successfully in the market, the banking law was modified to allow foreigners to buy up to
20% of the shares of a Russian bank without prior permission. It is only necessary to report
acquisitions in that range (>1%) to the Central Bank.18 This has been a significant step to
increase the level of openness and could lead to accelerated foreign investment in the Russian
banking sector.
4
The Perspectives of a Complete Opening Up of the Russian Banking Market for
Foreign Banks
The most profound effect on the level of competition in the sector would have an increased
activity of foreign owned banks (see again figure 1 and 2). The government had not
recognized the positive impact of foreign banks in the country till the turmoil of the 1998
financial crises which resulted in a breakdown of many weak banks. This incidence forced the
government to ask representatives of foreign owned banks for advice concerning ways to
overcome the crises. Here, the above mentioned possible upward vertical effects of foreign
owned banks gained ground. After the crises the banking authorities kept on this path and
issued a number of licences for the foundation of new banks by foreigners or by accepting
investments in domestic banks. Currently, there are 153 banks with foreign ownership
including 52 banks that are fully owned by foreigners and 13 with a stake of more than 50%.19
However, altogether only roughly 10% of the banking assets are held by foreigners, whereas
the share in other East European transition countries often reaches more than 80%.20
4.1 Strategies of Foreign Banks in Russia
See Standard & Poor‘s (2005).
See CBR (2007).
16
See Vernikov (2007), p. 21 and Peresetsky et al. (2007), p. 21.
17
The Central Banks plans e.g. to place a special supervisor in each of the participating banks. See Moscow
Times (2007b).
18
See Moscow Times (2007a).
19
See CBR (2007).
20
See UniCredit Group (2006).
14
15
In principle, there are three different strategies of banks going abroad. 21 The first strategy can
be branded as a follow-your-customer-strategy (FYC). That means the bank is accompanying
its domestic client at his expansion abroad. The second can be described as (a rather passive)
push-strategy, that is pursued by a bank that is facing strong competition or decreasing
margins on the home market and is thus forced to look for new markets abroad. Finally, a
third (rather active) strategy is motivated by the expectations of high returns in emerging
markets with increasing demand for banking services and due this labelled as pull-strategy.
Haselmann (2006) revealed in his study of foreign bank entry in CEE transition countries that
foreign institutions overwhelmingly tended to enter these markets with a long-term
orientation and thus were pursuing a pull-strategy. An important factor hereby was surely the
expectation of future EU-membership and its associated benefits for those countries in terms
of growth opportunities and political stability.22 Most of these background factors are not
relevant for Russia. The country is no candidate for EU-membership and suffered from more
than one decade of political instability and economic stagnation. Thus, those banks that came
in the early 1990ies pursued either a rather simple FYC strategy or settled down in certain
very profitable market niches like investment banking or financial advisory, respectively.23
Only the improvement of the overall economic climate at the end of this decade motivated
more entries of foreign banks with business models that need more time to become profitable
like especially retail banking (pull-strategy). Thus, an analysis of the current market structure
reveals a contradictory picture to that of CEE countries: The share of foreign owned banks of
total banking assets remains in a low two-digit range and there is a coexistence of very
specialised banks like Dresdner Bank Russia that do not pay attention to retail banking and
others that were investing large amounts of money to build up a profitable customer base like
e.g. Citibank.24 According to insiders, both areas will be of increasing interest and the Russian
banking market will become one of the most important ones in Europe.25
4.2 Macroeconomic Effects of Foreign Bank Involvement
The described direct and indirect effects of foreign bank involvement could finally lead to an
improvement of the banking sector’s role as financial mediator between the (currently)
capital-abound natural resources sector and other non-resource-based industries that are in
desperate need of financing. This could lead to the development of a more diversified
economy that is less dependent on its depleting natural resources. In this regard (not only
banking) capital is required to build up light-industry and to foster innovations in high-tech
industries by providing appropriate amounts of venture capital.
An improved banking technology would also help to organize cash flow-based project
financing structures in the natural resources sector which needs tremendous investments to
increase development and production. It would also help to apply this financing technique
within public private partnerships to transform and upgrade the Russian infrastructure. An
infrastructure better adapted to the requirements of a market economy would have positive
growth effects for the whole economy.
4.3 Resistance Against a Complete Opening Up of the Market
As already mentioned, it is still impossible for foreign banks to enter the Russian market by
the opening up of branches. The Russian federal law concerning banks and bank services
21
See Haselmann (2006), pp. 284-285.
See Buch (2002), S. 56.
23
See Vernikov (2003) for a critical assessment of the role of foreign banks in Russia during the first years of
economic transition.
24
See ABA Banking Journal (2006), p. 2.
25
See PricewaterhouseCoopers (2006) and Vedomosti (2007)
22
principally allows the setting up of branches, although, includes a link to regulations of the
Russian Central Bank. However, the latter has not allowed that yet. 26 Hereby, three main
arguments are raised in favour of the restriction: First, there is a fear by the Central Bank not
to be able to control the financial flows of these branches, because many of the transactions
will be settled abroad. Second, there is a fear by the incumbent banking sector of being
crowded out by very competitive offers of the bank branches (see horizontal direct effect in
figure 1). This could be possible, since such a branch would be a part of the whole
organization of the foreign bank in question what means that its financial risks are pooled
together in the portfolio with the risks of other less risky markets. Further, it is easier for the
foreign branch to refinance itself abroad due to the relationship with the mother bank. Third,
there is a fear by the government of not being able to realize political-driven economic
projects with a banking sector that might than be dominated by branches of foreign banks.
Another argument is related to the possibility that banks closed by the Russian bank
supervisory register abroad to come back as branch of a foreign bank. This points again to the
need for a “cleaning up” of the Russian market from opaque banks.
However, experience from Ukraine shows a possible solution for this problem. The
country has recently introduced a regulation that accepts only branches of banks from
countries with high supervision standards, and, sets high thresholds concerning the capital of
the investing banks and the capital they assign to their branches.27
To cope with the problem of opacity the current banking licensing procedure could be
altered to allow for two types of banks: A-level banks that have to apply to strict rules to enjoy
Central Bank refinancing and membership in the deposit insurance system, and, B-level banks
that only have to show adherence to soft rules, but do not receive refinancing from the Central
Bank and have no access to the deposit insurance system.28 The third level can be non-bank
credit institutions like e.g. credit cooperatives. Such a licensing system would signal to the
bank clients the true character of each credit institution, but would also leave enough space
for smaller regional banks or local credit cooperatives to exist despite e.g. a lack of a certain
level of capitalization. Especially the latter group can be important for Russia due to its large
urban space with a low density of population, where the provision of banking services is
typically constrained by high transaction costs.
To further level the playing field for all banks operating in Russia the state influence
in the banking system needs to be reduced quantitatively and qualitatively. This refers
especially to Sberbank and VTB. A future model of the Sberbank could be that of a public
bank as an overall Russian savings and credit institution that is required to provide each
Russian citizen a banking account and to concentrate solely on borrowing to SMEs and
private households.29 The VTB as second largest bank is already applying a highly
commercialised approach and should be sold off to private investors.
5 Conclusions
This introductory paper has argued that foreign banks can have a positive effect on the
banking sectors in transition countries by increasing directly and indirectly the quantity and
26
The restriction has also been one of the most critical issues in the recent bilateral WTO negotiations with the
USA. However, the Russian government managed to keep this regulation for a long period after the foreseeable
accession at the end of year 2007. It also preserved its right to limit the level of foreign investment in banking if
foreign ownership in the whole banking industry exceeds 50%. See Moscow Times (2006).
27
See National Banking Journal (2007).
28
See Steinherr (2004), p. 16. He suggests an obligation for the banks to indicate their “type” with a sign at the
entrance of each bank building.
29
See also Steinherr (2004). Andrianova et al. (2006) propose the reduction of subsidies for state owned banks,
the enhancement of market regulation and the strengthening of disclosure rules as measures to gradually reduce
government ownership in banking.
quality of financial services for private and corporate customers. This is also true for Russia
that would benefit from a higher level of financial intermediation. The Russian government
has become increasingly aware of these positive effects and continues to open up the domestic
banking market for foreign investors. Although, the restriction to open up branches will
remain in force after the accession to the WTO, since there are fears on many sides in Russia
that these branches would lead to a crowding out of domestic banks, a high dependence on
foreign capital and an increased presence of dubious offshore banks. However, concerning the
latter the regulation recently introduced in Ukraine could also be applied in Russia to make
sure that only sound branches of foreign banks enter the market. Although, a further
reorganisation of the Russian banking market is required to increase its transparency and to
diminish state influence.
A deeper study is needed to assess more thoroughly the impact of especially those
foreign owned banks that have started operations after the financial crisis in 1998. In addition,
it has to be analyzed how far the possible positive influences of foreign owned banks on the
domestic banking sector can reach geographically, since Russia is a very large country in
comparison to the rather small transition countries of Central and Eastern Europe. Here, the
result could be the necessity for an improvement of the conditions for smaller regional banks
and non-bank credit organizations like e.g. credit cooperatives.
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