A man walks out of a branch of Trust Bank in Moscow December 22, 2014. Russian mid-sized lender Trust Bank is to receive up to 30 billion roubles ($530 million) from the central bank to stop it going bankrupt in the first bailout of its kind during the current rouble crisis. REUTERS/Sergei On December 22nd the Russian Central Bank (RCB) announced that it would provide a bail-out of up to Rb30bn (US$500m) to prevent the bankruptcy of Trust Bank, a mid-sized Russian lender. Its Deposit Insurance Agency will take over interim administration of the bank.

The move underlines the growing pressures faced by the banking system as a result of the weakening rouble, international sanctions, the ailing economy and a sharp tightening of monetary policy. Bank profitability and asset quality are likely to deteriorate significantly in 2015.

With banks unable to access external financing or to roll over existing foreign debts, capital-adequacy levels are also set to fall. It is likely that the Central Bank and the Ministry of Finance will be forced to provide additional capital to support the banking sector. Further bank failures are likely, but the authorities retain substantial resources to support systemically important financial institutions.

Even before the latest crisis, Russia's banking sector indicators had been weakening. In June 2014 total banking profits were down by 14% year on year, with more than 25% of Russia's banks recording a loss in that month, compared with 18% a year earlier.

Capital adequacy stood at 13% in August, down from 13.5% at the start of the year; by the end of the third quarter this had slipped to 12.6%, according to RCB data. The share of non-performing loans was rising: overdue unsecured consumer debt rose by 2 percentage points between April and September 2014, to 11.3%.

Triple whammy

Since August, the risks to the banking sector have increased substantially as a result of three factors: the imposition of international sanctions, the worsening economic outlook and the rapid depreciation of the rouble.

In August and September the EU and US imposed sanctions on leading state-owned Russian banks in response to Russia's role in the conflict in eastern Ukraine and the downing of a Malaysian passenger aircraft. The measures prevent the banks-including the country's largest lenders, Sberbank and VTB-from accessing anything but debt with a maturity under 30 days. Although only state-owned banks are formally subject to the sanctions, borrowing costs will have risen for all financial institutions as foreign investors price political and economic risk significantly higher.

Russian President Vladimir Putin speaks during his annual end-of-year news conference in Moscow, December 18, 2014. The rouble edged lower against the dollar on Thursday, with traders saying President Vladimir Putin had offered few concrete measures at his end-of-year news conference to pull Russia out of a crisis. REUTERS/Maxim Zmeyev

Comparisons of Russia's debt-payment schedule and debt stock between the second and third quarters of 2014 suggest that almost no new foreign debt was issued to Russian companies over this period. The sanctions have effectively cut off the banking system from wholesale financing on international markets, and are also forcing banks to redeem outstanding foreign debt as it comes due, rather than rolling it over, thus increasing their foreign-currency liabilities.

The affected banks brushed off the sanctions, suggesting they would have little impact on their operations. Nevertheless, indications quickly emerged that these measures had put their balance sheets under strain. On August 25th the government announced that it would acquire shares in VTB and Rosselkhozbank in exchange for outstanding debt of Rb239bn (US$6.6bn at the exchange rate at the time) owed to the National Welfare Fund (NWF), one of the country's sovereign wealth funds. The move was intended to strengthen the two banks' tier-one capital (a measure of their financial state).

Nevertheless, the significance of the sanctions for Russian banks' financing position should not be overstated. The banking sector's total external debt at the end of the third quarter stood at US$192bn, which was equivalent to around 22% of total domestic claims, based on the exchange rate at the end of October. In addition, the Russian banking sector as a whole has a positive net foreign-asset position. Domestically, the measures did not appear to have a material impact on the sanctioned banks' standing, and there was no evidence of depositor flight from the affected institutions.

Rouble risks

However, the pressure on the banking sector has increased significantly as the result of the devaluation of the rouble since June, which has been driven by high political risk, international sanctions (which have blocked capital inflows) and the falling oil price. Between June and November the rouble fell by 25% against the dollar. This has pushed up the cost of foreign debt service for the banking sector, and also increased the risk of default on foreign-currency-denominated debt issued by the banks.

Russia real effective exchange rate vs Brazil, Korea. Société Générale

In October 2014 (the most recent data available), loans issued by banks in foreign currency accounted for around 23% of the total loan stock. This share will have risen significantly in November and December as a result of the further devaluation of the rouble, to around 30% of the total loan stock.

However, the risk of default is mitigated by the fact that a significant share of these corporate loans will have been to natural resource companies, whose revenue is earned in foreign currency, limiting their exposure to exchange-rate risk. In contrast to some east European countries such as Hungary, the share of personal loans issued in foreign currency is low, at less than 2% of the total.

Panic stations

Exchange-rate pressures on capital levels, external liabilities and asset quality escalated sharply in late November and early December, when the rouble began to fall precipitously against the dollar, raising the risk of a full-blown currency crisis. Following a fall of more than 10% in the rouble on December 15th (the currency's biggest one-day fall since the crisis of 1998), the RCB raised its key policy rate by 650 basis points, to 17%, in an effort to stabilise the currency.

Far from calming sentiment, the move appears to have panicked the market. After early gains, the currency fell by more than 35% to a low of Rb79:US$1, before recovering to around Rb68:US$1, down around 15% from the start of the day. For the first time there were indications that the fall in the rouble had spooked consumers, raising the risk of large-scale deposit flight.

The rouble has subsequently recovered against the dollar and was trading at around Rb54:US$1 on December 23rd. It is unclear, however, to what extent this is due to foreign-exchange intervention by the authorities and to administrative pressure. On December 17th the Ministry of Finance announced that it would sell up to US$7bn of foreign currency to support the rouble, which it described as "extremely undervalued".

A retired Russian man counts his pre-1993 money in local bank July 26, 1993. REUTERS / Grigory Dukor On December 23rd Kommersant, a business daily, reported that major state-owned exporting firms had been instructed to sell foreign currency in order to support the rouble. These claims have been contested by the government. With confidence in the rouble and the RCB low, it may only take a small shift in sentiment-most likely from another fall in the oil price-to trigger another round of currency volatility.

The rouble rout has further exacerbated exchange-rate pressures on banks and has also severely damaged confidence in the financial sector. In the days following the RCB interest-rate increase, the interbank lending rate rose to almost 30%-significantly above the peak reached in the 2008-09 financial crisis. The rise in interest rates will squeeze liquidity and severely limit interbank lending, increasing banks' dependence on the RCB.

This will be compounded by high levels of economic uncertainty and concerns over rouble deposit flight. High interest rates will lead to a sharp drop in new lending, reducing bank profitability and increasing the risk of default for borrowers on variable rates or those who need to refinance existing loans. Vedomosti, another business daily, reported on December 22nd that Sberbank, the country's biggest lender, had increased its mortgage rate by 2-3 percentage points to 15-16%-a rate which the Agency for Residential Mortgage Lending describes as a psychological tipping point for borrowers.

In addition to high financing costs and increased exchange-rate risks, banks will have to manage the impact of a serious recession in 2015. The Economist Intelligence Unit now forecasts that the economy will contract by 3.5% next year, with high inflation leading to a fall in earnings of more than 5% in real terms. This will lead to a rise in corporate defaults and non-performing loans, putting further pressure on banks' asset quality and balance sheets.

Feeling the strain

Evidence is building that the banking system is experiencing severe stress and facing significant capital shortfalls. On December 19th the Duma (parliament) passed a bill, following three readings in one day, to provide Rb1trn (US$16.5bn) to recapitalise the banking system. Prior to this, on December 4th, Vladimir Putin, the president, had committed up to 10% of National Welfare Fund assets (which totalled around US$80bn at the start of December) for the same purpose. At present it remains unclear how the recapitalisation will be conducted, what form the capital will take or what collateral the banks will provide in return. Mr Putin has also hinted that the banks may be required to increase lending to priority sectors in exchange for government support.

With access to international markets closed, banks have had to rely heavily on the RCB for foreign-currency liquidity to meet external commitments. The RCB has steadily amended its repo auction programme, by extending the maturity of the loans and reducing the interest rate, to make it easier for banks to access foreign currency. On December 11th the RCB announced that it was expanding the range of assets that it would accept as collateral to provide foreign-currency liquidity, offering further evidence that the banks are undercapitalised and struggling to meet their foreign-currency obligations.

The Central Bank has currently set a limit of US$50bn on the total loans and repurchase agreements it will provide to the banking sector. In a statement on December 24th, the RCB confirmed that this limit could be increased if necessary. The burden of financial risk is thus being shifted gradually from the banks and their debtors to the state.

The RCB has also sought to relieve the pressure on the banks by relaxing its prudential regulations and effectively suspending mark-to-market accounting to assess banks' capital adequacy. On December 18th the Central Bank announced that it would introduce a "temporary moratorium" on the recognition of the negative revaluation of securities portfolios. It also granted credit institutions a temporary right to use the third-quarter exchange rate to assess its prudential requirements for operations in foreign currencies.

This move will provide temporary succour to banks, but also increases systemic risks. It is based on the assumption that the sharp fall in the exchange rate and asset values in mid-December was a temporary phenomenon, which was not driven by market fundamentals, and that the banks therefore face a problem of liquidity rather than solvency.

It is unclear how the RCB will act if the exchange rate continues to fall or when it plans to lift these temporary measures. On December 19th Evgeny Gavrilenkov, chief economist of Sberbank CIB, the investment banking arm of Sberbank, warned that the RCB's willingness to provide refinancing for banks against non-marketable securities could cause a full-scale banking crisis.

Outlook for the sector

We continue to believe that the authorities have the resources to support all of the country's systemic banks to prevent a financial crisis, particularly as almost all of these are already state-controlled. Although the authorities may be using some administrative means to support the currency, the rouble is now effectively floating free, which should enable the government to conserve foreign-currency reserves in order to support the banking sector in meeting its foreign-currency liabilities.

Foreign-currency reserves (including assets in the sovereign wealth funds) total more than US$400bn, equivalent to over 60% of the M2 money supply. Under our current forecast, oil prices will average US$80/barrel in 2015, significantly above the current price level, which should help to stabilise the rouble despite ongoing capital outflows to redeem foreign debt.

Nevertheless, the combination of economic contraction, a liquidity crunch and the falling exchange rate is likely to lead to the failure of a number of banks. Russia has more than 800 banks, many them with low capitalisation, weak finances and weak corporate oversight. As of December, the RCB had withdrawn licences from more than 80 banks in 2014 alone. While the sector is in need of consolidation, however, the disorderly failure of a large number of banks could cause significant economic disruption, deepening the recession and further undermining public confidence in the financial sector. Trust Bank is unlikely to be the last institution to receive a Central Bank bail-out.

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