1 . This Financial Sector Assessment (FSA) is a summary of some of the findings
of the Financial Sector Assessment Program (FSAP) report for the Russian
Federation which was prepared jointly by the IMF and the World Bank in close
cooperation with the Russian authorities. The FSAP mission visited the Russian
Federation in April and September 2002, and the report was prepared in 2002 and
submitted to the Russian authorities in October 2002. Therefore, the FSA refers to the
data that were available to the team during the preparation of the report. However, the
conclusions indicated in the report are still valid and the Central Bank of Russia has
provided its clearance of the FSA.

2 . Given the small size of the financial sector, the effects of a potential financial
sector distress on the macroeconomy would be relatively small. However, there are
serious weaknesses in the environment and in the financial sector per se impeding the
development of the sector and its ability to efficiently allocate resources in Russian
economy. A few interlinked issues cut across the banking, capital markets and the
insurance sectors. In spite of recent improvements, a lack of transparency in the
ownership structures and poor corporate governance, including banks, slow down the
development of the sector and impede financial decisions and prudential supervision. As
development of a sound, robust Russian banking system will be crucial to the
development of the broader financial system, the authorities are advised to place first
priority on the implementation of the recommendations pertaining to the banking sector.

‘ The FSAP team, jointly led by Arne B. Petersen (IMF) and Tune Uyanik (WB), included Angana Banerji,
Margaret Cotter, Rupa Duttagupta, Jennifer Elliott, Julia Majaha-Jartby, Obert Nyawata, David 0.
Robinson, Gabriel Sensenbrenner, Svetlana Malysheva (Administrative Assistant, Moscow Office), and
Joanna Meza-Cuadra (Staff Assistant) (all IMF); Noritaka Akamatsu, Irina Astrakhan, Thorsten Beck,
Michael Fuchs, Gordon Johnson, Zeynep Kantur, Donald McIsaac, Zubaidur Rahman, Susan Rutledge,
Sergei Shatalov, Marius Vismantas, and Cari Votava (all World Bank); Billy Clarke, (Financial
Supervision Authority, South Africa); Stefan Niessner (Bundesbank); Risto Maattanen (Bank of Finland);
Zoltan Dents (Hungarian Financial Supervisory Authority); and David Sheppard (Bank of England).


3 Development of the Russian financial system was severely jolted by the crisis
of August 1998. Growth since then has rebounded to its pre-crisis level. The total deposit
base (M2) of the country’s banking system amounts to 24 percent of gross domestic
product (GDP) and claims on the private sector to 17 percent of GDP. The markets for
longer-term financial instruments, such as bonds and equity, are small by international
comparison although the value of equity exceeds that of bank claims (see the table ).

Table. Financial Market Depth (2001)
M2 (Money and Claims on Private Total Bonds Equity Market
Quasi-Money Sector Outstanding Capitalization
US$ % of US$ % of US$ % of US$ % of
Country billions GDP billions GDP billions GDP billions GDP
Russia w 74 24 54 17 11 3 78 27
Czech Republic 40 71 25 45 8 15 9 16
H u n g a r y 22 43 18 35 13 26 10 20
Slovak Republic 14 66 5 25 2 13 1 3
Poland 75 43 46 26 35 20 26 15
France 656* 51* 1,232 95 661 51 1,844 142
Germany 1336 71 2,442 130 1,048 56 1,072 57
Italy 559* 56* 871 80 995 91 672 62
Netherlands 326* 89* 668 178 321 86 1,844 492
United Kingdom 1593 113 968 69 607 43 2,150 153
J a p a n 5221 123 4,084 96 4,534 107 3,910 92
United States 6509 64 7,741 76 11,672 115 13.984 137

*end of 2000
Sources: World Development Indicators 2002, BIS Quarterly Financial Statistics for data on bonds.


4 Macroeconomic environment in Russia in the year 2002 was characterized by
GDP growth of about 4.3 percent, similar to 2001, and gradually declining inflation
rates (15.1 in 2002). GDP growth continues to be driven by higher energy exports and
consumption. As in 2002, the balance of payments surplus is expected to remain large in
2003. Foreign exchange reserves are high; the 2003 debt servicing spike appears to have
been smoothed, and external financing needs are minimal. A strong balance of payments
position due to high oil prices and lower net private capital outflows has generated
pressures for the exchange rate to appreciate. The Central Bank of Russia (CBR)
continues to resist these pressures through large-scale interventions in the foreign
exchange market to limit inflationary consequences.

5 . There has been progress in implementing structural reforms in key areas-
e.g., the agricultural land market, pension funds, small business taxation-but other
reforms (including in the financial sector) have lagged. Reflecting pressures in global
financial markets, asset markets remain volatile; nevertheless, the stock market has risen
substantially, and Eurobond spreads have declined considerably from the level of end-



6 Banks in Russia appear to be well capitalized, but the quality of capital is
questionable even under the Russian Accounting Standards (RAS), and loan
provisioning does not fully reflect the banks’ credit risks. Highly concentrated assets
around a few large borrowers and related lending are common areas of concern observed
for the major banks in Russia. Given the small size of the sector, the mission’s
expectations are that even a quite large shock to the banking system, on the order of the
1998 financial crisis, would have an impact equivalent to 3-5 percent of GDP, which is
relatively modest by international comparison. However, the capital of the system would
be significantly impaired which, combined with a possible further loss of confidence in
the system, would have serious negative implications for the financing of key sectors as
well as for the monetary policy transmission, and, therefore, could have significant
implications for both macro-stability and the country’s economic growth prospects.

7 Banking sector reform is a matter of the highest priority if Russia is to
achieve its growth potential in the coming years. Reform efforts should be
concentrated on strengthening the supervisory framework; enhancing the transparency of
ownership, governance and financial reporting; and facilitating the consolidation of the
fragmented private banks, and leveling the playing field between private and state banks
partly caused by the dominance of Sberbank and by the blanket guarantee on the
household deposits for state banks.

8 Any strategy for promoting the development of the banking sector will need
to carefully consider the role of Sberbank. Given its size and privileged position,
Sberbank is in a unique position to extend loans to large customers, and its loan portfolio
has increased rapidly; although more recently the rate of growth has been in line with that
of other banks. This increase in its portfolio, coupled with breach of loan concentration
limit and its heavy exposure to the raw materials sector which would make it vulnerable
to a significant downturn in commodities prices, could be counted among the causes for
concern. Sberbank is also the dominant investor in the government securities market,
which could further endanger the capitalization of the bank since, due to recent ample
liquidity, real yields have been negative. Measures would be needed to address potential
risk factors in the short term, including: (a) a full review of the quality of Sberbank’s loan
portfolio and risk-management practices so that measures can be taken to limit undue risk
taking on the part of Sberbank; and (b) introduction of safeguards to strengthen the
governance of Sberbank and to ensure that Sberbank is run on commercial principles,
subject to a hard budget constraint.


9 The legal infrastructure for the banking sector is generally well developed, g
but supporting legislation and regulation for banking supervision and
implementation practices need to be improved by: (i) proactive and aggressive
assessment of the operating condition and integrity of banks; (ii) focus on facilitating the
exit of problem banks; (iii) strengthening guidelines for “fit and proper tests” and


enhancing the transparency of bank ownership; (iv) strengthening the definitions of
capital and prompt enforcement of capital and capital insolvency2; and (v) enforcement of
consolidated supervision.

10 Unreliable financial reporting erodes investor confidence. Russian banks will
be required to prepare financial statements in accordance with IAS starting
January 1, 2004. Provided the reform is implemented with sufficient due diligence, this
will be a very welcome development that should promote more transparency and
disclosure regarding bank financials and structure. However, the application of IAS in
form rather than in substance could mislead rather than inform the users of financial
statements. Therefore, it is crucial to put in place an enabling institutional framework
(e.g. regulations, training, etc.) for proper implementation of IAS in the very short time

1 1 Some improvements in the legal foundation would also complement the
further strengthening of the banking supervision in the areas of: transparency of
bank ownership and suitability of shareholders; qualified immunity for directors, officers
and employees of the CBR; strengthening of criminal statues to define what constitutes
misappropriation of funds, personal benefit and other illegal actions in the financial

1 2 The lack of consolidated supervision of the Russian banking system
potentially poses a systemic risk where the banks hold ownership positions in other
non-bank financial institutions. Usually the quality of the financial data and reports
generated by the affiliates of banks are poor and misleading due to deficiencies in the
applied accounting procedures and controls. These circumstances can lead to
understatement of the banks’ reported large exposures and exposures to related parties.


1 3 Deficiencies in the bank failure resolution system have resulted in a large
number of phantom banks and has undermined depositors’ confidence in the
banking system. While the CBR has the power to revoke a banking license, until 2002
an arbitration court had to find the bank to be bankrupt before the bank could be
liquidated. In many cases, this did not happen, which led to the phenomenon of phantom
banks and delicensed banks that are still awaiting liquidation (around 603 according to the
CBR). The bank liquidation process has proven to be highly ineffective, costly, with
currently more than 6004 banks in the pipeline. While the legislation clearly establishes a
priority for household depositors in liquidations, these rights have been watered down by
settlements in banks outside the scope of the Agency for the Reconstruction of Credit
Organizations (ARCO).

2 After the completion of the FSAP report CBR has issued regulations aiming in enhancing the quality of
banks’ capital
3 This number has come down to 9 as of September 1,2003.
4 This number is 365 as of September 1,2003.


1 4 The planned introduction of a deposit insurance scheme aims at leveling the
playing field, as well as a mechanism to withdraw licenses from unsound and
imprudently managed banks. Ideally a deposit insurance scheme should be introduced
only after the banking system is fundamentally sound and a strong supervisory
framework is in place. Therefore, the mission suggested that the authorities proceed with
the proposed scheme only if they are fully committed to take the necessary difficult
decisions. The entry criteria proposed by the CBR were found to be broadly appropriate
but need to be fleshed out further.

15 In the context of the transition period, a number of banks will lose their
licenses to take household deposits and many may need to be liquidated. Shifting the
bank failure resolution process into an administrative rather than judicial context is
expected to contribute to making the process more expedient and effective. Appointing a
specialized agency as liquidator (as envisaged by the CBR) could increase the efficiency
of the process substantially. A balance should, however, be attained by ensuring the
banks, subject to administrative decisions, access to an appropriate judicial review.


1 6 Since the AML Law became official in February 2002, Russia has made
significant progress in a short time frame in developing and implementing an AML
regime. The major foundational elements of an anti-money laundering framework have
been put in place, but issues relating to legal framework and implementation remain:

As long as laws require credit institutions to accept all customers, banks cannot
protect themselves from abuse by money launderers and will incur the risks
associated with the use of their institutions for money laundering.

The AML Law does not yet apply to important non-bank financial institutions.
However, amendments to extend the reach of the AML Law are currently under

Many important elements of an effective AML program are found in non-binding
recommendations with reliance placed on an uncertain and understaffed system of
prudential supervision.

Sanctions and penalties for AML are weak. The criminal anti-money laundering
provisions apply only if funds being laundered exceed a significant monetary
threshold inviting structuring of transactions to avoid liability. The basic money
laundering offense does not appear to permit confiscation and may result in only a
fine. For other violations, there is an inconsistent and often unclear approach to
sanctions with reliance on unspecified criminal and civil laws and administrative
fines in other legislation. This substantially weakens capacity for deterrence and

Expanding customer identification requirements to cover the entire customer base of
a financial institution (including accounts which predate the AML Law),
strengthening client and beneficial owner identification requirements, and the


establishment of effective central authority responsible for mutual legal assistance in
criminal cases was recommended to support a more effective AML system.


1 7 The payments system in Russia has improved substantially and is not a
major source of systemic risk. Nevertheless, a single unified system is still not in place
and there are major shortcomings in efficiency. Recommendations for improvements
included: drafting of a concept paper defining the current and likely future needs of the
sector including the introduction of RTGS and the separation of the payment system
oversight responsibilities of CBR from its operational payment system responsibilities.

1 8 The securities clearing and settlement infrastructure is similarly fragmented
and diverse. The main organized securities exchanges and the over-the-counter market
are served by two central securities depositories (CSDs) and a host of custodians and
registrars, with the CSDs supporting settlement of cross-exchange trades in certain
stocks. Delivery-versus-payment (DVP) in securities settlement is partial, and there are
no plans to introduce a central counter party (CCP) clearing house for the securities
markets. Introduction by the CBR of an RTGS funds transfer system would enable full
DVP to be developed and support the development of a CCP. A single national central
securities depository was also recommended to address these discrepancies.


1 9 Russia’s debt management practices need improvement in several areas. The
system is fragmented and there is no clear-cut legal demarcation of authority over public
debt management among branches of the government. Vneshekonombank plays a central
role as the agent of the federal government in external debt management while the
Ministry of Finance (MoF) focuses on domestic debt. Within the MoF there are several
units working on various aspects of debt, but often without coordination. Coordination
among objectives of debt management, fiscal, and monetary policies is also weak.
Equally weak and fragmented are the databases and analytical capacity of debt
management. The system lacks overall risk management guidelines and practices.

2 0 The authorities are aware of the weaknesses in their current practices and
have adopted a conceptual framework involving: an improvement of the legal basis
for debt management, creation of a unified organizational structure, a public debt
accounting system and a public debt accounting database, a unified system of analysis of
risks, and an integrated system of strategic planning for the public debt management
system, cash management and budget management. If fully implemented, the proposed
debt management system will go a long way in meeting best international practices in
debt management. However, key elements such as the structure and degree of
independence of the debt management agency still need to be clarified. The authorities
should move urgently to implement the new system; currently it looks as if the planned
phases of implementation may take a significantly longer time than initially envisaged.


21 The Russian capital markets remain small and underdeveloped, and its role
in intermediating between savings and investments is very limited. Successful
implementation of reforms to accounting standards and issuer transparency and
disclosure is essential to promote investor confidence in the equity and corporate debt
markets. Further rationalization of market infrastructure including clearing and
depository functions, share registration, and trading would reduce costs and promote
efficiency. The Federal Commission for the Securities Market (FCSM) needs to build
expertise in market surveillance and regulation, and expand its powers to apply (in
particular non-pecuniary) sanctions to fulfill its mandate. The functioning of the FCSM is
impeded by unresolved jurisdictional issues concerning, among others, derivatives
regulation, and regulation of related-party transactions and takeover bids. Better
coordination between the FCSM and the CBR is suggested to help improve the oversight
of the financial sector as a whole.

22 The insurance sector is small and characterized by a large number of mostly
small companies. An estimated 10 percent of all licensed companies do not possess the
minimum capital required by current legislation, and more will not be able to meet the
newly proposed US$l million target. Owing to resource limitations and the outdated
legislative framework, the system of regulation and supervision fails to conform with
international best practices in areas such as corporate governance, internal controls, and
dealing with controls over reinsurance.


23 Insufficient access to finance is one of the major constraints for SME
development. Key measures to increase lending to SMEs include establishment of a
credit information service and a movable property registry (pledge registry). While the
leasing sector is developing at a healthy pace, there is a need to strengthen the regulation
of the leasing sector.

24 In the area of corporate governance, the primary weakness was found to be
the lack of transparency of ownership and control structures. The problem plagues
both the corporate and the banking sector. Although the corporate governance framework
in Russia has improved over the last two years, the mission recommended additional
strengthening in the areas of: (i) increased transparency of ultimate ownership and control
structures; (ii) adopting legislation requiring disclosure of related party translations; and
(iii) developing regulations on insider dealing.

25 The legal framework supporting credit and creditor rights in Russia is
considered to be deficient in important areas, specifically with respect to the taking
of security over movable property and enforcement procedures. Despite the
improvements following the adoption of a new bankruptcy law in 1998 and the legal
framework for corporate insolvency law, there is a need to strengthen legitimate creditor
rights and promote rehabilitation. The bankruptcy process in Russia also suffers from


weak and improper implementation. The continuing lack of regulation and the potential
for arbitrage in the system have continued to foster distrust of the process.

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